On behalf of our Bhutanese authorities, we thank staff for a balanced and well-written report that captures the candid and comprehensive discussions during the mission. The authorities share staff’s assessment on many aspects while highlighting that Bhutan’s development experience warrants an appropriate tailoring of macroeconomic policy settings. Our authorities emphasize that they attach the highest value to their engagement with staff and broadly concur with the thrust of the policy advice in the staff report.
Recent Economic Developments and Outlook
At the outset it is important to note the distinguishing characteristics of the economic and social conditions in Bhutan. A small, landlocked country, with an economy closely intertwined with India, Bhutan is experiencing rapid and robust growth in an environment of societal well-being and political stability that now encompasses a vibrant and inclusive democracy. Real GDP growth is expected to remain 8 percent or above in the near term with an upside outlook that reflects positive spillovers from India’s rapid growth and associated expansion of Bhutan’s hydropower sector.
Inflation, which is essentially driven by food prices as in other emerging and developing countries, is emerging as a key risk to this outlook. Our authorities are conscious of the danger of inflation pressures getting entrenched and are accordingly monitoring the price situation with a readiness to take remedial policy action. So far, however, inflation is mainly related to food prices.
While the current account deficit has widened sharply since 2009/10, this is essentially related to imports for large expansion of hydropower capacity in response to buoyant power demand from India. As staff has noted, the current account deficit is comfortably financed by loans from India tied to hydroelectricity projects. This has shored up the foreign exchange reserves which are currently equivalent of nearly a year’s imports. Going forward, our authorities expect the current account deficit to narrow as hydropower exports rise, and become self-financing.
Although signs of overheating are muted at the current juncture, our authorities are aware that it could become a policy challenge. They remain vigilant on this account and agree with staff that fiscal and broader structural reforms are essential to diversify the economy, improve absorptive capacity and enhance productivity over the medium-term. Infrastructure development has a vital role to play in catalyzing structural change and in this context, the role of fiscal policy is central.
After remaining in surplus, the overall balance is likely to be negative in 2010/11 due to large increase in capital spending. An overall deficit is likely to persist in view of planned capital spending on new hydroelectric power plants in the coming years. Since these capital spending are financed by capital grants (which are likely to grow accordingly), and are productive, our authorities do not see it as a source of concern.
Other factors which have also contributed to the deficit are the decrease in non-tax revenues, and modest increase in current spending. In this context, it is important to note that the decline in the non-tax revenues partially reflects the seasonal nature of hydropower revenue as well as their re-classification under tax revenues as stated by staff in Box 2. Also, the increase in current expenditure last year was due to a one-off salary increase based on the recommendation of a commission set up to examine the case for an increase in public sector wages, which was due for some time.
As noted by the staff, fiscal policy has been generally prudent. However, to meet the near-term and longer-term challenges, our authorities value the dialogue with staff on the desirability of introducing a nominal ceiling on current spending. For our authorities, a key medium-term macroeconomic priority is to increase tax revenue. This is important not only for fiscal sustainability and a prudent level of public debt, but also to meet the growing development needs. As noted by staff, debt sustainability risks are mitigated by the concentration of debt in commercially viable hydropower projects. Given that the energy demand from India is not likely to go down and that there is a good track record in project implementation and governance, the authorities do not see the risk of debt distress materializing. Nevertheless, they recognize the need to diversify the tax base, increase non-hydroelectric tax revenue, improve the efficiency of tax administration, reduce the volatility of tax-revenues, and improve the revenue productivity. Our authorities note staff’s advice to introduce VAT, but considering that it will require considerable amount of ground work and capacity building, they look forward to further in-depth discussion in this regard.
Monetary, Financial and Exchange Rate Policies
Monetary conditions are stable and the monetary policy stance has been appropriate so far, although recent inflation developments pose risks and challenges, calling for intensified monitoring, as stated earlier.
With the opening of two new banks, competition has increased in the banking sector. NPLs have declined on account of improved loan recoveries and financial stability indicators have remained largely stable. Our authorities are mindful of risk factors such as rapid growth in private sector credit and excess liquidity in the banking system, especially in the context of preserving financial stability. Our authorities will, therefore, continue to carefully monitor credit and liquidity conditions and stand ready to take appropriate policy measures to ensure macroeconomic and financial stability. The suggestion to develop an interbank market in conjunction with the finance ministry is welcome as also the deepening of macro prudential supervision, including through periodical stress tests.
As pointed out by staff, the exchange rate has evolved in alignment with macroeconomic fundamentals. The peg with the Indian Rupee is also deemed appropriate in the context of Bhutan’s high degree of integration with the Indian economy. It is in this context that our authorities also emphasize reserve management policies that shore up Indian rupee reserves while flexibly managing convertible currency reserves.
Bhutan is continuing to make rapid progress in improving all social indicators and is well on course to achieve most of the Millennium Development Goals. In this context, Bhutan’s experience can be regarded as unique in at least one key aspect. Bhutan follows the concept of “Gross National Happiness” or GNH which rests on four pillars of values – sustainable and equitable development, good governance, environmental conservation, and cultural preservation and promotion. These pillars are divided into nine domains which, in turn, are broken down to 72 measurable variables. For example, one variable reflects Bhutan’s commitment to maintain at least 60 percent forest cover forever. While keeping GNH as central to its development planning, our authorities are vigorously diversifying the economy.
The most critical sector for Bhutan’s development is the hydropower sector; the developments therein have been presented well in Box-1 of the Staff Report. We would like to inform that projects under construction are well on schedule, with a few ahead of timelines. Another sector where our authorities are putting in substantial effort is the tourism sector. They are aiming to attract one hundred thousand visitors in the next couple of years, up scaling from the current level of thirty five thousand tourists a year. They are focused on diversifying tourism from cultural to nature-based products, opening of new areas and strengthening infrastructure and connectivity therein.
In conclusion, our Bhutanese authorities look forward to sustained support and engagement with the international community as they strive to achieve their developmental goals. They regard as vital to this effort sound macroeconomic advice from the Fund on a regular basis and support in terms of capacity building in the Central Bank and other institutions through technical support and training.