Activity has returned to Bahrain’s restaurants and malls, and bankers are saying a sense of normality has been restored. But the presence of the security forces in late September still hangs heavy across the tiny island – a stark reminder of how much Bahrain has changed in just nine months, and the fragility of that normality.

The extent of the damage done to Bahrain’s economy after widespread anti-government protests brought the country to a halt in March is gradually becoming clear. More worrying, is the future for a nation that lacks the oil wealth of its neighbours and had hoped a thriving private sector would drive growth.

Restoring growth in Bahrain

“The economy may be more deeply affected than the numbers we have seen so far suggest,” says Liz Martins, a Dubai-based economist at the UK’s HSBC. “Tourism is down, there has been a huge decline in investor confidence and inflation has fallen dramatically.”

Martins is predicting Bahrain’s economy to shrink by 0.7 per cent in 2011 and although she expects growth to pick up in 2012, there are substantial risks ahead. Bahrain’s Economic Development Board (EDB), set up to attract foreign investment and create a strategy for economic and social reform, is more sanguine. It says in the first quarter of 2011, during the peak of the unrest, the economy grew by 1.76 per cent, and that full year growth will be around 1.6 per cent.

Bahraini officials are keen to draw parallels between the impact of the unrest and the financial crisis. “Bahrain grew throughout the downturn, at no point falling into recession, and will achieve growth this year as well, which demonstrates the fundamental strength of our economy,” says Sheikh Mohammed bin Issa al-Khalifa, chief executive officer of the EDB.

A promised $10bn from the GCC, primarily Saudi Arabia, has also yet to arrive. The government had hoped that this would kick-start the economy in the second half, but it looks more likely that it will be in place for early 2012.

“The Finance Ministry is finalising the technical arrangements of the Gulf Development Programme with the other GCC countries,” says Sheikh Mohammed. “The programme will aim to aid key developmental projects in priority sectors such as housing and infrastructure.”

Banking industry figures say the GCC cash is expected to be expedited to help drive economic growth as soon as possible, rather than the $1bn a year over 10 years that had originally been proposed. That would serve the economy better and several investments to improve infrastructure and address some of the issues raised by the protests have been outlined.

However, Bahrain’s sovereign rating suffered significantly as a result of the unrest, with downgrades by all three major ratings agencies causing the government to pull a planned $1bn bond issue. The proceeds of the bond would have been used to fund new infrastructure, particularly a $5.3bn programme to build 50,000 new homes in three years.

Khalid Hamad, executive director at the Central Bank of Bahrain (CBB), says the ratings downgrades were “totally unjustified”. He says Bahrain is “looking forward to receiving a better rating by the end of the year”.

While the GCC aid and a rating upgrade will be welcome for Bahrain’s constrained finances, the civil unrest presents the country with a bigger challenge. Its Vision 2030 masterplan is based on the government taking a backseat while the private sector drives the economy. But attracting private companies to Bahrain after the political unrest will be difficult. Some firms, notably France’s Credit Agricole, have already pulled out of the country. Although publicly most firms say they are sticking with Bahrain, privately they admit that slower economic growth will affect their activities in the country.

Hamad says the firms that are withdrawing are doing so more as part of a wider pull out of the Middle East, rather than reacting exclusively to problems in Bahrain. He says the country is still receiving interest from new investors. The CBB has issued eight new licences so far in 2011 and the EDB is leading a series of roadshows to the US, Europe and Asia to convince investors that they should use Bahrain to access the GCC market.

Uncertainty looms in Bahrain

Bahrain may well rebound in 2012, but a cloud of uncertainty still hangs over the island. “Bahrain has already been losing its competitive advantage to Dubai and the increased political risk exacerbates that,” says Martins.

The country’s fiscal position is also susceptible to the oil price and reserves are not as large as regional peers. Any significant fall in the oil price would lead to a retrenchment of government spending, damaging its ability to stimulate the economy.

The bigger challenge will be restoring the impetus to the economic reform outlined by the EDB, particularly plans to double disposable income for Bahraini households by 2030. This has been made harder by the sacking of Shias for suspected involvement in the unrest. “The objectives of the EDB remain unchanged,” says Sheikh Mohammed. “We have made clear progress in recent years and Bahrain will recover from this period and emerge stronger, politically, socially and economically.”

The danger for Bahrain if it does not restore growth and stability, is that protests will continue. The current optimism that growth is returning could also be derailed by a drop in oil prices, an inability to heal the Sunni-Shia rift, or a slower global economy weighing on the region as a whole. At the moment, all three events are worrying policymakers.