Bhutan: Selected Issues and Statistical Appendix

This Selected Issues paper and Statistical Appendix on Bhutan underlie the macroeconomic impact of Tala, rapid private sector credit growth, and macroeconomic risks. In Bhutan, as the bulk of Tala-related flows go through the government accounts, this requires an appropriate fiscal stance and skillful expenditure management. Strong economic growth will require and lead to a deepening and further development of the financial system in Bhutan. The financial sector seems to be relatively shielded from adverse events, although risks remain.

Abstract

This Selected Issues paper and Statistical Appendix on Bhutan underlie the macroeconomic impact of Tala, rapid private sector credit growth, and macroeconomic risks. In Bhutan, as the bulk of Tala-related flows go through the government accounts, this requires an appropriate fiscal stance and skillful expenditure management. Strong economic growth will require and lead to a deepening and further development of the financial system in Bhutan. The financial sector seems to be relatively shielded from adverse events, although risks remain.

II. Rapid Private Sector Credit Growth, Macroeconomic Risks, and Financial Sector Soundness4

1. This chapter reviews trends in bank lending in Bhutan, and discusses the implications of rapid credit growth for macroeconomic stability and financial sector soundness. Private sector credit growth in Bhutan has been high, averaging more than 30 percent per annum over the past seven years. While private sector credit growth and financial deepening are important underpinnings for economic growth and development (see Levine, 2005, for a survey), cross-country experience also indicates that excessively rapid credit expansion can bring substantial risks, including inflationary pressures, weakening of the current account, and financial sector vulnerabilities. Section A reviews the factors underlying rapid credit growth; Section B explores its macroeconomic implications; Section C focuses on the associated risks to the financial sector. Section D concludes.

A. Causes and Nature of Credit Growth

2. Bhutan has experienced rapid expansion of bank credit to the private sector. Over the last seven years, private sector credit increased by about 30 percent a year on average. In the previous six years, the annual growth rate was less than 4½ percent. With this growth, private credit as a share of GDP more than doubled from 9½ percent in 2001 to about 20 percent in 2007.

Figure II.1.
Figure II.1.

Bhutan: Private Sector Credit Growth, 1994/95–2006/07

(Annual percentage change)

Citation: IMF Staff Country Reports 2007, 349; 10.5089/9781451806267.002.A002

Sources: Data provided by the Bhutanese authorities; and staff estimates.

3. Credit expansion in Bhutan was facilitated by a number of factors.

  • Bhutan’s low initial level of financial development could partially explain the rapid growth of credit. Several studies suggest that during the early development phase of an economy, financial deepening occurs and credit growth outpaces growth in output (Levine, 1997). Even after seven years of rapid growth, credit to the private sector amounts to only one-fifth of GDP. When compared with other countries in the region, Bhutan remains one of the countries with the lowest level of credit to the private sector relative to the size of the economy.

Table II.1.

Credit to Private Sector in Cross-Country Perspective

(In percent of GDP)

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Sources: Data provided by the Bhutanese authorities; IMF, International Financial Statistics; and staff estimates.
  • The financial sector has ample liquidity, due to large, unsterilized foreign exchange inflows from accumulated concessional loans and grants. While excess liquidity is hard to measure, the Royal Monetary Authority (RMA) estimates that as of May 2007, the banking sector had nearly Nu 7 billion in excess reserves (26½ percent of total assets).5 This level has been maintained for the past 12 months, with a peak of Nu 7.7 billion in January 2007. Excess reserves rose not only in levels but also as a share of banks’ assets. While current accounts with the RMA represented less than 20 percent of banks’ assets in 2003, they averaged almost 30 percent of assets from January 2006 to May 2007. There is great variation in the distribution of liquidity across financial institutions. Bank of Bhutan (BOB) commands more than 97 percent of the total amount, with Bhutan National Bank (BNB) keeping almost no excess reserves.

Figure II.2.
Figure II.2.

Bhutan: Excess Reserves in the Banking Sector

Citation: IMF Staff Country Reports 2007, 349; 10.5089/9781451806267.002.A002

  • Monetary conditions in Bhutan have been loose relative to India. The discount rate of the RMA bills has been gradually declining from 6 percent in April 2001 to 3½ percent in May 2003. It has remained constant at that level since then, against a background of tightening of monetary conditions in India and the peg of the ngultrum to the Indian rupee. A reduction in the cash reserve requirement (CRR) may have contributed to the loose monetary environment. In order to spur credit growth and support investment, the RMA revised the CRR down from 20 percent to 13 percent of total deposit liabilities effective March 1, 2004, a level at which it has remained since then. The CRR was raised to 15 percent on September 1, 2007.

  • The establishment of the National Pension and Provident Fund (NPPF), as an autonomous player in the financial sector, contributed to credit growth. The NPPF took over the government employment and provident fund from the Royal Insurance Corporation of Bhutan in 2002. Since then, its assets have grown at a rapid pace as civil servants’ wages increased substantially, boosting the monthly inflow of funds and turning the NPPF into the largest institutional investor in the country. Due to limited investment opportunities, the investment mandate of the NPPF permits investments in limited financing activities, including housing (starting July 1, 2003) and education loans (starting March 1, 2004). The entry of the NPPF put substantial downward pressure on lending rates on housing loans, driving the interest rate from 13 percent to 10 percent in 2003.

  • A stable macroeconomic environment contributed to favorable economic outcomes and a demand for bank loans from households. Rising personal income growth appears to have encouraged household borrowing against current and expected future income. In particular, to respond to a substantial pent up demand, urban land use policy was revised, and a new housing policy instituted under the Urban Development Corporation in 2002. This change in policy generated an increased demand for housing loans from the banking sector skewing the sectoral composition of new credit towards a few sectors. The growth rate of credit to the building and construction sector and for personal loans has outpaced the growth of credit to other sectors in the economy by a large margin especially in the last three years. As of December 2006, 35 percent of the investments of BoB and BNB were accounted for by loans for construction and housing. In the nonbank financial institutions, the percentage of loans to these sectors is similar. Just seven years ago, the construction and housing sector comprised only 20 percent of the financial sector loan portfolio.

Figure II.3.
Figure II.3.

Bhutan: Sectoral Composition of Credit

Citation: IMF Staff Country Reports 2007, 349; 10.5089/9781451806267.002.A002

Sources: Data provided by the Bhutanese authorities; and staff estimates.
  • The corporate sector contributed to the strong demand for credit as well. The establishment of special economic zones (SEZ) in southern Bhutan led to the emergence of a number of new industries, such as palm oil processing, copper processing, and ferro-alloys. In particular, five new ferro-alloy factories are under construction with financing predominantly from the domestic banking sector.

  • Alternative investment avenues for banks are scarce. Financial instruments that could absorb excess liquidity in the financial sector are limited to RMA bills. There are no government T-bills or bonds. Both the money market and capital market are in their infancy, offering limited options for diversification.

B. Credit Growth and Macroeconomic Risks

4. Cross-country evidence suggests that while financial development is associated with faster economic growth, rapid credit growth has also been linked to substantial macroeconomic risks. Rapid credit growth can lead to overheating in the economy reflecting the surge in domestic demand, consumption and investment, thus raising the risk of inflation. The increase in domestic demand may lead to worsening in the current account from the stronger import demand and a loss of competitiveness due to a real exchange rate appreciation. Problems of reserves management may arise in the case of pegged currency, as foreign currency flows out of the country to pay for rising imports.

5. In Bhutan, despite the substantial foreign aid inflows, the buildup of excess liquidity, and the rapid credit growth, the exchange rate peg has helped anchor inflation expectations. Inflation in Bhutan has mostly followed price developments in India. Over the last seven years, inflation was contained at an average rate of 4 percent with no pronounced upward trend. While data constraints prevent the construction of a longer series of the real exchange rate, there is no evidence of a significant, sustained real appreciation of the Bhutanese currency. The real exchange rate has fluctuated within a narrow band since 2003.

6. However, rapid credit growth affects the rupee reserve position by potentially fueling non-hydropower related import demand. Bhutan is closely linked to the Indian economy with the ngultrum peg to the Indian rupee and free trade between the two countries. Over 75 percent of Bhutan’s trade is with India; imports from India are 77 percent of total imports since 2000/01. As credit expansion accelerated, non-hydropower related import growth jumped from an average of 15 percent per annum between 1996/97 and 1999/00 to more than 20 percent per annum between 2000/01 and 2006/07. Non-hydropower related current account deficits also rose from an average of 4 percent to 13 percent of GDP over this time period. The high growth in import demand, stemming in part from the high growth in credit, for given rupee inflows in loans and grant aid from India, affects the rupee reserve position in the banks. Since January 2006, rupee reserves were at Rs. 5¼ billion (four months of imports from India). At end-June 2007, these reserves stood at Rs. % billion (% month of imports from India).

7. The open, porous border between Bhutan and India permits exploitation of arbitrage opportunities arising from interest rate differentials. The availability of banking sector credit can facilitate this arbitrage. As noted above, the RMA bill rate has remained unchanged at 3½ percent since 2003, the T-bill rate in India is currently 7 percent. The rate for time deposits of less than one year at the commercial banks is 4½ percent; the comparable deposit rate is 7 percent in the border branches of Indian banks. Anecdotal evidence suggests that these interest rate spreads may have generated some shifts in deposits from Bhutanese banks.

Figure II.4.
Figure II.4.

Bhutan: Monetary Conditions

Citation: IMF Staff Country Reports 2007, 349; 10.5089/9781451806267.002.A002

C. Credit Growth and Financial Sector Soundness

8. Rapid credit growth may also undermine financial soundness. There is a large body of literature that links credit overexpansion and banking crises (see for example IMF, 2004). This can be attributed to the procyclicality of bank lending behavior. Banks may underestimate risks during periods of high growth, thus loosening credit standards and attracting lower quality of borrowers on average. This in turn will lead to higher credit losses during an economic downturn (Arcalean and others, 2007). In addition, the speed of credit growth may put a strain on banks’ risk assessment and management capacities, which may lead to credit misallocation (Hilbers and other, 2005). When investment avenues in a country are limited, banks may concentrate lending to a particular sector, overexposing themselves to potential adverse shocks to that sector and/or generating mismatches between the maturity of their assets and liabilities.

9. Several prudential indicators point to the general health of the banking sector in Bhutan. However, significant differences between the performance and strategies of the two banks in Bhutan should be noted. Despite the ongoing credit expansion, both banks are well-capitalized and liquid, with healthy profitability and low nonperforming loan ratios. Audited data from December 2005 and December 2006 indicate that return on equity for the financial sector as a whole has increased from 15¼ percent to 16½ percent, with both banks registering an improvement in their profitability. The banking sector maintains adequate buffers, well in excess of the minimum requirements. The capital adequacy ratio (CAR) for the two banks declined slightly from its 2005 level, but it stands at a comfortable 17 percent as compared to the minimum requirement of 8 percent. The nonbank financial institutions maintained an even higher CAR of 36 percent. Judging from the change in nonperforming loan ratios over the past two years, asset quality seems to have improved in the banking sector. The NPL ratio dropped from7 percent to 5 percent, with the decline driven by an almost flat absolute amount of NPL. Among the nonbanks however, NPL ratios were and continue to be very elevated, comprising almost a quarter of total loans.

10. The positive indicators notwithstanding, there is substantial sectoral concentration in the financial institutions’ asset portfolios. The bulk of private sector credit was extended for the housing and construction sector boosted by rising property prices. These borrowings are inherently long term, which creates vulnerability for the banks whose liabilities are of much shorter maturity. In addition, despite the low NPL ratios within the housing sector loans at present, a decline in real estate prices would likely lead to a deterioration in asset quality.

11. Stress testing of the banking sector suggests that the banking system is relatively shielded from shocks. Stress tests were used to quantify the impact of various shocks on key measures of banking system soundness, such as the capital adequacy ratio and NPL ratios (Cihak, 2007). The shocks considered were (i) a 25 percent increase in NPLs proportional to existing NPLs; (ii) a 25 percent increase in NPLs proportional to performing loans; (iii) 25 percent of performing loans in the housing/construction sector becoming NPLs; and (iv) an appreciation of the ngultrum by 10 percent.

Figure II.5.
Figure II.5.

Change in Selected Banking Sector Soundness Indicators Relative to the Baseline

(In percentage points)

Citation: IMF Staff Country Reports 2007, 349; 10.5089/9781451806267.002.A002

  • The banking sector CAR declines by varying amounts but remains above the 8 percent required minimum under all shocks. The range of decline is 0.1-3.8 percentage points for the banking system as a whole. The large decline in the CAR from a 25 percent increase in NPLs proportional to performing loans.

  • An appreciation of the ngultrum slightly lowers the capital adequacy ratio of the banking sector. The entire effect stems from one of the banks which has a sizable net open position.

  • The NPL ratio is substantially more sensitive to the shocks analyzed. A decline in the quality of the housing and construction sector loans leads to an increase in NPLs, corroborating the potential negative impact a sharp decline of housing prices may have on the health of the banking sector.

  • The low existing levels of interbank lending limit potential contagion within the financial sector.

D. Conclusion

12. Strong economic growth will require and lead to a deepening and further development of the financial system in Bhutan. However, rapid credit expansion can also expose the economy to macroeconomic and financial risks that require careful monitoring. The findings of this chapter suggest that the strong growth of credit to the private sector may have been accompanied by growing vulnerabilities on the external side. While there are no signs of domestic overheating as of now and inflation has generally been contained, growth in non-hydropower related imports has been strong. In recent months, short-term problems of rupee reserve management have also emerged, partially a by-product of the strong growth in credit. However, there are a number of mitigating factors. Current account deficits have been matched by capital inflows in the form of concessional loans and grants. Moreover, despite the sharp decline in rupee reserves, total foreign exchange reserves have continued to increase and remain at a comfortable level.

13. The financial sector seems to be relatively shielded from adverse events, though risks remain. The significant sectoral concentration in the financial institutions’ asset portfolio has created an asset/liability maturity mismatch and could lead to a sharp deterioration in banks’ asset quality in the case of a negative correction in the housing market.

14. To reap the full benefits of credit expansion and minimize the vulnerabilities that might arise from it, several steps could be taken:

  • The RMA needs to ensure that the excess liquidity does not translate into excessive credit growth through several measures:

    • Issuance of RMA bills could be stepped up and the interest rate could be increased and more closely aligned with monetary policy in India.

    • The CRR should be raised, and provisioning against housing/construction loans could be increased to cool down real estate lending. Effective December 2007, the provisioning rate on substandard and doubtful loans is to be raised from 20 percent to 30 percent and from 50 percent to 60 percent on housing loans effective. The RMA was also in the process of increasing the CRR from 13 percent to 15 percent.

  • Bank supervision and regulation should be strengthened ensuring that banks’ risk management practices are up to the challenges of a rapid expansion of credit. Regular stress testing of the resilience of the banking sector should be performed.

  • With the ngultrum peg, fiscal policy should be used to contain demand pressures that may worsen non-hydropower related current account deficits or generate inflationary pressures.

References

  • Arcalean, C., O. Calvo-Gonzalez, C. More, A. van Rixtel, A. Winkler, and T. Zumer, 2007, “The Causes and Nature of the Rapid Growth of Bank Credit in the Central, Eastern and South-Eastern European Countries,” in Rapid Credit Growth in Central and Eastern Europe. Endless Boom or Early Warning?, ed. by Charles Enoch and Inci Otker-Robe, International Monetary Fund (London, United Kingdom: Palgrave Macmillan).

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  • Cihak, Martin, 2007, “Introduction to Applied Stress Testing,” IMF Working Paper 07/59 (Washington: International Monetary Fund).

  • Hilbers, P., I. Otker-Robe, C. Pazarbasioglu, and C. Johnsen, 2005, “Assessing and Managing Rapid Credit Growth and the Role of Supervisory and Prudential Policies,” IMF Working Paper 05/151 (Washington: International Monetary Fund).

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  • International Monetary Fund, 2004, “Are Credit Booms in Emerging Markets a Concern?” Chapter IV in World Economic Outlook, April 2004: Advancing Structural Reforms, World Economic and Financial Surveys (Washington).

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  • Wangdi, Phuntsho, “Bhutan’s Software Industry?,” KuenselOnline, August 11, 2007. Available via the Internet: http://www.kuenselonline.com/modules.php?name=News&file=article&sid=8879.

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  • Levine, Ross, 2005, “Finance and Growth: Theory and Evidence,” in Handbook of Economic Growth, ed. by Philippe Aghion and Steven Durlauf (The Netherlands: Elsevier Science).

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  • Levine, Ross, 1997, “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, Vol. 35(2), pp. 668726.

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Table 1.

Bhutan: Gross Domestic Product by Origin at 2000 Prices, 2001–2005

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Source: National Accounts Statistics, 2006, National Statistical Bureau.
Table 2.

Bhutan: Gross Domestic Product by Origin at Current Prices, 2001–2005

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Source: National Accounts Statistics, 2006, National Statistical Bureau.
Table 3.

Bhutan: Crop Production Estimates, 2001–2005

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Source: Data provided by the Bhutanese authorities.
Table 4.

Bhutan: Livestock and Poultry Production, 2000–2004

(In thousands)

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Source: Ministry of Agriculture.
Table 5.

Bhutan: Logging Volume, 2001–2005

(In cubic meters)

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Source: Forestry Development Corporation, Ministry of Agriculture.
Table 6.

Bhutan: Imports of Essential Food Items by the Food Corporation of Bhutan, 2001–2005

(In metric tons)

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Source: Food Corporation of Bhutan.
Table 7.

Bhutan: Gross Sales and Output of Selected Industries, 2001–2005

(In millions of ngultrum)

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Source: Department of Trade and Industry.
Table 8.

Bhutan: Electricity Generation, Tariff Rates, and Trade with India, 2001/02–2005/06

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Source: Department of Energy.

Rates shown are for Chukha exports and were in effect from April 1, 1995 to March 31, 1997, from April 1, 1997 to June 30, 1999, and from July 1, 1999 to end-2004.

Tariff rates for low voltage electricity. A lifeline tariff rate of Nu 0.6 for the first 80 Kwh of consumption was introduced in 2002/03.

Table 9.

Bhutan: Tourism Statistics, 2002–2006 1/

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Source: Department of Tourism, Ministry of Trade and Industry.

Data relate to tourists paying in convertible currencies.

Includes hotels approved by the Department of Tourism.

Table 10.

Bhutan: Consumer Price Index, 2002–2006 1/

(1979=100, unless otherwise indicated)

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Sources: National Statistical Bureau; and CEIC Data Company Ltd.

The consumer price index was re-based in the third quarter of 2003, and the frequency was changed to quarterly. Weights for the quarterly CPI also changed as follows: food (31.7); nonfood (68.3); total (100.0).

Table 11.

Bhutan: Government Budget Summary, 2001/02–2006/07

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Sources: Data provided by the Bhutanese authorities; and staff estimates.
Table 12.

Bhutan: Government Revenue, 2000/01–2005/06

(In millions of ngultrum)

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Source: Data provided by the Bhutanese authorities.
Table 13.

Bhutan: Economic Classification of Government Current Expenditure, 2000/01–2005/06

(In millions of ngultrum)

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Source: Data provided by the Bhutanese authorities.
Table 14.

Bhutan: Functional Classification of Government Current Expenditure, 2000/01–2005/06

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Source: Data provided by the Bhutanese authorities.
Table 15.

Bhutan: Functional Classification of Government Capital Expenditure, 2000/01–2005/06

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Source: Data provided by the Bhutanese authorities.
Table 16.

Bhutan: Functional Classification of Total Government Expenditure, 2000/01–2005/06

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Sources: Data provided by the Bhutanese authorities; and staff calculation.
Table 17.

Bhutan: Monetary Survey, 2001–2007 1/

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Source: Data provided by the Bhutanese authorities.

A major reclassification in 2003 renders data before and after January 2003 incomparable.

Includes deposits of some public enterprises and off-budgetary entities. Data differ from the bank financing data reported in the fiscal accounts.

Ratio of broad money to reserve money.

Table 18.

Bhutan: Assets and Liabilities of the Royal Monetary Authority of Bhutan, 2001–2007

(In millions of ngultrum)

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Source: Data provided by the Bhutanese authorities.

Includes other financial institutions.

Includes advances to RMA staff.

Rupee overdraft facilities.

Table 19.

Bhutan: Assets and Liabilities of the Bank of Bhutan, 2001–2007

(In millions of ngultrum)

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Source: Data provided by the Bhutanese authorities.

Includes deposits of public enterprises and off-budgetary entities.

Table 20.

Bhutan: Assets and Liabilities of the Bhutan National Bank, 2001–2007

(In millions of ngultrum)

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Source: Data provided by the Bhutanese authorities.
Table 21.

Bhutan: Assets and Liabilities of the Royal Insurance Corporation of Bhutan, 2001–2007

(In millions of ngultrum)

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Source: Data provided by the Bhutanese authorities.

Includes deposits with the Bank of Bhutan.