According to the 2007 Index of Economic Freedom published by the Heritage Foundation and the Wall Street Journal, Bahrain has the 2nd most free economy in the Middle East and is 39th in the world. According to this assessment Bahrain's economy is ideal in several respects, including but not limited to taxation and banking transparency. The complete absence of income or corporate taxes in all industries except oil gives Bahrain a competitive commercial advantage globally.

Bahrain has become one of the Arabian Gulf's most advanced economies and most progressive political systems since gaining its independence from Britain in 1971. Under a constitution promulgated by His Majesty King Hamad bin Isa al-Khalifa, the country became a constitutional monarchy in 2002, and the government has sought to reduce dependence on declining oil reserves and encourage foreign investment by diversifying the economy. Because of its communications and transportation infrastructure, regulatory structure, and cosmopolitan outlook, Bahrain is home to many multinational firms that do business in the region. In 2005, the U.S. and Bahrain ratified a free trade agreement.

Bahrain's current account balance is characterized by surpluses in merchandise trade and international services, and a large deficit in unilateral transfers, which is accounted for by the country's large expatriate workforce sending home a portion of its earnings. From 2003 and beyond, the balance of payments performance improved due to rising oil prices and increased receipts from the services sector. As a result, the current account balance registered a surplus of US$1,912 million in 2006 compared with a deficit of US$35 million in 2002. Bahrain's gross international reserves increased substantially in 2004 to US$1.6 billion.

Though Current GDP per capita shrank by 2.4% in the Eighties, it bounced back to a growth of 36% in the Nineties as a result of successful diversification initiatives. Bahrain's urgency in embracing economic liberalisation is due to its need to diversify the economy away from its limited oil supplies. Unlike its Gulf neighbours, Bahrain has little oil wealth and the economy has expanded into banking, heavy industries, retail and tourism. The Kingdom is the main banking hub for the Gulf and a centre for Islamic finance, which has been attracted by the strong regulatory framework for the industry. According to the International Monetary Fund's Financial System Stability Assessment of Bahrain's financial regulatory environment, published in 2006, found:

• The financial system enjoys strong performance under favourable circumstances, and is likely to remain a major contributor to overall growth. The main risk stems from potential overheating in the economies of the region, but the system should be resilient to expected shocks.
• Prudential regulations are modern and comprehensive, and supervision is generally effective, especially in the dominant banking sector. Supervisory capacity needs to be expanded in line with new regulations and to keep up with the growth and increasing sophistication of financial institutions.
• The further expansion of the Islamic sector, the development of housing finance, and the deepening of the securities markets are important for the future growth of the financial system. The banking and insurance sectors will eventually undergo consolidation.

In 2005, Bahrain signed the US-Bahrain Free Trade Agreement, becoming the first Gulf state to sign such a bilateral trade agreement with the United States. A massive privatisation programme is underway to sell off key government assets: utilities, banks, financial services, and telecommunications have started to come under the control of the private sector.

As a result the economy has been well positioned to exploit the extra revenues generated in the region thanks to the sustained high oil prices since 2002. In January 2006, the United Nations Economic and Social Commission for Western Asia cited Bahrain as the fastest growing economy in the Arab world.

The government has used its modest oil revenues to build an advanced infrastructure in transportation and telecommunications. Bahrain is a regional financial and business centre. Tourism, especially from the region, has proved another significant source of income.

Bahrain has benefited from the oil boom since 2001, with economic growth of 5.9%. It has succeeded in attracting investment from other Gulf states partly because it used the revenues of the 1970s-early 80s boom to invest in infrastructure development and other projects to improve the standard of living; health, education, housing, electricity, water, and roads all received attention.

As part of its efforts to build a modern economy, Bahrain has initiated a series of labour reforms in order to bring the labour market in to line with international standards.

Petroleum and natural gas, the only significant natural resources in Bahrain, dominate the economy and provide about 60% of budget revenues. Bahrain was the first Gulf state to discover crude oil. Because of limited reserves, Bahrain has worked to diversify its economy over the past decade. Bahrain has stabilized its oil production at about 40,000 barrels (6,400 m³) per day, and reserves are expected to last 20 to 25 years. The Bahrain Oil Company (BAPCO) refinery has a capacity of about 250,000 barrels (40,000 m³) per day, and was the first in the Gulf. Saudi Arabia provides most of the crude for refinery operation via pipeline. Bahrain also receives a large portion of the net output and revenues from Saudi Arabia's Abu Saafa offshore oilfield.

The Bahrain National Gas Company (BANAGAS) operates a gas liquefaction plant that utilizes gas piped directly from Bahrain's oilfields. Gas reserves should last about 50 years at present rates of consumption.

The Gulf Petrochemical Industries Company (GPIC) is a joint venture of the petrochemical industries of Kuwait, Saudi Arabia, and the Government of Bahrain. The plant, completed in 1985, produces ammonia, methanol and urea.

Bahrain's other industries include Aluminium Bahrain, which operates an aluminium smelter--the largest in the world with an annual production of about 830,000 metric tons --and related factories, such as the Bahrain Aluminium Extrusion Company and the Gulf Aluminium Rolling Mill Company (GARMCO). Other plants include the Arab Iron and Steel Company's iron pelletizing plant and a shipbuilding and repair yard.