DUBAI (Reuters) - Bahrain may be tiny, and fairly insignificant as an oil producer, but nearly $10 billion parked in mutual funds in the kingdom mean plenty is at stake if protests inspired by Egypt and Tunisia spiral out of control.
It is the Gulf Arab state seen as most vulnerable to unrest because of deep-rooted discontent among its majority Shi'ite population against the ruling Sunni dynasty, the al-Khalifas. The populace complains of economic hardships, lack of political freedoms and discrimination in jobs in favour of Sunnis.
This has always sat awkwardly with its status as a regional banking, trading and Islamic finance hub, but its advantages, as a diversified economy and relatively liberal society, have outweighed the risks -- thus far.
"If you're trying to set yourself as a financial hub you need to provide security and stability above all else," said Sven Richter, managing director and head of frontier markets at Renaissance Asset Management.
So far there is no sign of money leaving. The stock market is flat this week and funds say they are still waiting to see how protests, in which two people have died this week, play out.
Markets are open and banks are functioning as usual on the island, home to 1.3 million people, half of whom are foreigners.
Yet the cost of insuring Bahrain's debt climbed to its highest level since August 2009 with 5-year credit default swaps rising 13 percent in two days to 275 basis points. [nLDE71F0SE]
Investors are watching the situation closely.
In Saudi Arabia, connected to Bahrain via a causeway, the main share index fell 1.2 percent on Wednesday.
Aqber Naqvi, a fund manager with Al Masah Capital in Dubai, said he could consider changing his exposure to Bahrain if the unrest grew: "If there is traction to these protests, we might take a call," he said. "But as of now it's too early to say."
The financial industry accounts for 25 percent of Bahrain's GDP and is an important provider of jobs. Assets of Bahraini banks more than tripled between 2002 and 2008 to $252 billion, but have since fallen to $217 billion as of October 2010.
The key will be the degree of outflows, if any. With a currency pegged to the dollar, Bahrain's $3.77 billion in foreign exchange and gold reserves could be quickly depleted.
Bahrain's stability is important for neighbouring Saudi Arabia, a key supporter of Bahrain's royal family and where key oilfields are home to an oppressed and occasionally restive Shi'ite minority. Bahrain also hosts a major U.S. naval base.
The Shi'ites have long complained of government neglect and discrimination, well before uprisings in Tunisia and Egypt emboldened activists across the region. Discontent has been expressed in on-and-off unrest since the mid-1990s.
With little oil of its own, Bahrain has little spare cash to throw at social problems. But it said last week it would spend an extra $417 million on social items, including food subsidies.
Protesters want the removal of the prime minister, Sheikh Khalifa bin Salman al-Khalifa, who has governed since British rule ended in 1971. For now, they have not sought change at the very top -- his nephew King Hamad bin Isa al-Khalifa has ultimate control over the kingdom.
King Hamad announced last week he would give 1,000 dinars ($2,650) to each local family, and the government has indicated that it may free minors arrested under a security crackdown last year ahead of parliamentary elections.
"That hasn't seemed to really calm the situation," said Richter at Renaissance.
The introduction of a new constitution and parliamentary elections a decade ago helped quell Shi'ite unrest then. But tensions have risen again in recent years as Shi'ites have been disappointed with the assembly's limited clout.
Shi'ites want their rulers to stop granting Sunnis from outside Bahrain citizenship and jobs in the armed forces and security services. They see that as a tactic to change the demographic balance of the nation.
The government had been planning to cut subsidies to improve its finances, after posting a 10 percent budget deficit in 2009, and one factor making spending possible is oil's climb well above Bahrain's budget break-even price of about $80 per barrel.
There is great income disparity in Bahrain, but not to the degree seen in Egypt. Per capita gross domestic product in Bahrain is over $40,000, ranked 20th in the world. But while no Bahraini lives on less than $1 a day, an internationally used guide to extreme poverty, many live on just a few dollars.
As unrest spread from Tunisia to Egypt, Gulf states were in the spotlight but mostly seen immune to similar unrest, thanks to an unwritten pact under which their rulers have traded a share of their oil wealth for their subjects' loyalty.
"Bahrain is on the end of that scale," said Lars Christensen, emerging markets senior analyst at Danske Bank, referring to Bahrain's lower level of social stability compared with its Gulf neighbours. "I can't really see this in Qatar or Kuwait. That's hard for me to imagine."
Neighbouring Saudi Arabia, Bahrain's biggest trading partner, is already watching events closely.
Both countries are also close U.S. allies -- Bahrain is home to the U.S. Navy's Fifth Fleet, which Washington depends on to curtail the regional influence of Shi'ite Iran.
Saudi Arabia will likely step in to provide aid if Bahrain becomes unstable. Bahrain is part of the Gulf Cooperation Council (GCC), a loose economic and political bloc that also includes, the United Arab Emirates, Qatar, Oman and Kuwait.
Christian Shomber, Chief Investment Officer at asset management firm KMEFIC in Kuwait, said: "I am confident the GCC has an interest in getting this resolved quickly."
(Additional reporting by Dinesh Nair in Dubai and Frederik Richter in Manama; editing by Samia Nakhoul)
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