Joint IMF/World Bank Debt Sustainability Analysis 20091
Author: International Monetary Fund
Publication Date:
30 Dec 2009
eISBN:
9781451806281
Language:
English
Keywords:
ISCR; CR; Bhutan; real GDP; rupee; debt ratio; Indian rupee; rupee debt; public debt debt ratio; rupee disbursement; creating flow; Debt sustainability analysis; Depreciation; Export performance; GDP increase
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This 2009 Article IV Consultation highlights that Bhutan’s fiscal policy has been anchored by keeping current spending below domestic revenue. Bhutan’s large and volatile trade deficits have been offset by sizable foreign aid flows, resulting in a balance of payments (BOP) surplus and reserve accumulation. The BOP surplus has averaged about 8 percent of GDP over the last few years. Executive Directors have commended the authorities for the strong economic performance anchored by hydropower sector development, and supported by prudent economic management, firm donor support, and political stability.

Abstract

This 2009 Article IV Consultation highlights that Bhutan’s fiscal policy has been anchored by keeping current spending below domestic revenue. Bhutan’s large and volatile trade deficits have been offset by sizable foreign aid flows, resulting in a balance of payments (BOP) surplus and reserve accumulation. The BOP surplus has averaged about 8 percent of GDP over the last few years. Executive Directors have commended the authorities for the strong economic performance anchored by hydropower sector development, and supported by prudent economic management, firm donor support, and political stability.

Bhutan’s external and public debt dynamics are analyzed within the IMF-World Bank Debt Sustainability Framework for Low Income Countries (LIC-DSA).2 Bhutan’s rapid hydropower development will lead to a substantial buildup of external debt, with debt ratios breaching some of the country-specific LIC-DSA indicative thresholds. However, given the commercial viability of the hydropower projects, Bhutan’s strong track record of project implementation, committed donor support and its high level of international reserves, staff’s assessment is that the external debt dynamics continue to be subject to a moderate risk of distress. Nevertheless, the results of the DSA underscore the importance of containing domestically financed fiscal deficits and sustaining economic growth going forward to ensure a declining debt profile.

I. Background

1. Bhutan’s public and publicly guaranteed debt declined to 69 percent of GDP at end 2008/09, 19 percentage points of GDP below its 2003/04 peak.3’4 The sharp decline in public debt was driven by the completion of the Tala hydropower project that was financed by India, which boosted economic output by 20 percent in 2007, and by the onset of the repayment of the associated rupee debt. Reflecting the favorable fiscal outturns in recent years, domestic debt, all denominated in local currency and held by domestic financial institutions, has also declined.5 External debt, which accounts for more than 97 percent of total public debt, continues to be dominated by the mostly Indian rupee-denominated hydropower sector debt (36 percent of GDP and 54 percent of external debt). Convertible currency debt, accounting for 44 percent of external debt, declined to 29 percent of GDP.6 The actual outturn of public debt indicators for 2007/08 and 2008/09 was slightly more favorable than projected in the previous DSA, as better than expected fiscal balances compensated for the more rapid accumulation in rupee debt and the downward revision of historical nominal GDP figures.

Bhutan: Structure of Public Sector Debt

(In percent of GDP)

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Source: Royal Monetary Authority of Bhutan; and staff estimates.

II. Underlying Debt Sustainability Analysis Assumptions

2. Under the baseline scenario, Bhutan pursues its planned expansion in its power generation capacity.7 In addition to the Punatsangchu I and Dagachu projects, included in the 2007 DSA, the baseline scenario incorporates two new hydropower projects, Punatsangchu II and Mangdechu.8 Both projects will be financed by the Government of India (GOI) through a combination of loans and grants.9 The intergovernmental agreements are expected to be finalized and signed by end-2009 and project disbursements to begin in 2009/10. Repayments will start after the projects come on stream in 2019. External financing for non-hydropower sector activities is expected to remain predominantly from multilateral and bilateral donors at concessional terms.

Bhutan: Major Hydropower Projects

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Sources: Department of Energy; and IMF staff calculations.

In 2007 prices in percent of 2007 GDP.

The financing for Puna II and Mangdechu is yet to be finalized. The table reflects the financing modalities assumed for the purpose of the DSA.

Assuming 10 percent scrap value of total cost at the end of 35 years of commercial operation, annual operation and management cost at 1.5 percent of the total costs with 4 percent annual increase, and 15 percent spared for domestic sales.

The projects’ internal rates of return are provided by authorities.

3. The hydropower sector will also govern the rest of the economy as summarized by the following key baseline macroeconomic assumptions.

  • Real sector: Similar to the spike in real GDP when Tala was commissioned in 2006/07, Puna I, Mangdechu and Puna II will substantially boost economic growth as they come on stream in 2016/17, 2018/19 and 2019/20, respectively. In the interim, growth will be supported by the hydropower construction activities and the commissioning of Dagachu in 2013/14. Real growth excluding hydropower-related activity is projected to hover between 5-6 percent. Inflation is expected to remain in line with price developments in India, with the ngultrum pegged to the Indian rupee.

  • Fiscal sector: Upon completion, the hydropower projects will boost the domestic revenue-to-GDP ratio, which also benefits from a gradual broadening of the tax base and improvement in tax administration.10 External budgetary aid, on the other hand, is projected to decline sharply as a share of GDP as Bhutan’s per capita income rises. On average, the overall fiscal deficit remains broadly balanced over the long term.

  • External sector: The current account is projected to deteriorate over the medium term due to Tala’s debt service and the higher import demand associated with the construction phase of the new hydropower projects. In the long run, as electricity exports more than quadruple, the power sector contributes to balance of payment surpluses.

Key Macroeconomic Assumptions

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III. External Debt Sustainability Analysis

A. Baseline

4. Bhutan’s external debt will continue to trace the cycles of the hydropower sector. The PV of external debt as a share of GDP is projected to rise by 47 percentage points between 2009/10 and 2014/15 as disbursements for new hydropower projects pick up.11 The debt ratios remain above the LIC-DSA indicative threshold for strong policy performance countries until 2022/23 for the PV of external debt to GDP, and until 2017/18-2019/20 for the PV of external debt as a share of exports and revenue.12 The commissioning of the new hydropower projects, which also marks the start of the debt repayment, puts the debt ratios on a steady downward trajectory.

5. The debt service-to-export ratio is expected to remain below the indicative thresholds for the entire projection period. The debt service-to-revenue ratio may temporarily breach the indicative threshold as Puna II and Mangdechu’s debt service begins; however, it is expected to remain below the threshold for the rest of the projection period. The high level of foreign reserves, projected to average 10 months of imports and 50 percent of GDP over the period when indicative thresholds are breached (i.e. 2009/10-2023/24), provides further cushion in the unlikely event of debt repayment difficulties.

B. Sensitivity Analysis

6. Bhutan’s external debt profile is sustainable under most alternative scenarios. While the debt ratios are most vulnerable to exchange rate and export growth shocks, as well as unfavorable financing terms, under almost all alternative scenarios considered the debt ratios decline over time, and eventually fall below the thresholds. In case of a 30 percent nominal depreciation in 2009/10, the PV of debt rises to more than 170 percent of GDP and 835 percent of revenue. The debt service-to-revenue ratio is also negatively impacted. However, the exchange rate shock overestimates Bhutan’s debt vulnerability since a large share of Bhutan’s receipts are in Indian rupees which act as a natural hedge to the rupee-denominated debt.13 The export growth shock and higher financing terms for new public sector borrowing also increase the various debt ratios.

IV. Public Debt Sustainability Analysis

A. Baseline

7. The baseline public debt dynamics follows closely that of the external debt. The public debt-to-GDP ratio is expected to rise until the commissioning of the new hydropower projects and then rapidly decline until it reaches 32 percent of GDP by end 2029/30. In light of Bhutan’s strong economic performance, external financing is projected to shrink as a share of GDP, making room for domestic financial markets to play a larger role in financing the development agenda. Domestic debt is projected to reach about 11 percent of GDP by 2015/16 and be contained below that level as share of GDP for the remainder of the projection period.

B. Sensitivity Analysis

8. The public debt ratios remain on a declining path over the long term under various stress tests. Not surprisingly, given the large share of external debt in total public debt and the analysis above, overall public debt is most vulnerable to shocks to the exchange rate. A one time depreciation results in an upward shift in the various public debt indicators without affecting the shape of the debt indicators’ path. However, the sensitivity analysis suggests that under a historical scenario, public sector debt will rise and remain at an elevated level over the long-term. This scenario, which assumes a constant primary deficit of 2.2 percent of GDP (compared to the projected primary surplus of 3.8 percent of GDP over the 20 year period), underscores the importance of containing fiscal deficits to ensure the sustainability of public debt.

V. Staff Assessment

9. The assessment made in the 2007 IMF/World Bank Joint DSA—that Bhutan’s debt dynamics are sustainable but subject to a moderate risk of distress—still holds.

  • The addition of the two new hydropower projects leads to a substantial build-up in external debt, relative to the analysis in the 2007 DSA. The policy-related LIC-DSA thresholds are breached for several of the indicators and remain breached for a longer period of time compared to the previous analysis. However, the additional projects bring strong economic dividends, boosting average real GDP growth and exports. Real GDP growth and growth of exports of goods and services are projected to average 6.2 percent and 11.2 percent respectively over 2013/14-2027/28, compared to 5.2 percent and 8.6 percent in the 2007 IMF/World Bank Joint DSA.14 Moreover, despite the large increase in the stock of debt, the addition of the new hydropower projects does not bring in substantial vulnerabilities with regards to debt servicing.

  • Furthermore, the mitigating factors that were highlighted in the 2007 assessment remain valid, namely:

  • Bhutan has a strong track record of project implementation as detailed in the 2007 DSA suggesting that the new hydropower projects are subject to low implementation risk.

  • The new hydropower projects are commercially viable. Puna I is expected to have smaller real costs of construction than Tala for a larger generation capacity, leading to a higher internal rate of return. Similarly Puna II and Mangdechu are expected to have a solid internal rate of return of about 11-14 percent.

  • Bhutan maintains close economic and political ties with India which mitigate the commercial risks of these projects. India has been both the main provider of financing for hydropower projects and the main consumer of the projects’ output. Going forward, India’s favorable economic outlook and its sizeable power deficit will continue to support the demand for Bhutan’s hydropower. This is reflected in India’s commitment to developing 10,000 MW of hydropower in Bhutan by the year 2020 and its pledge of Rs 100 billion support over the 10th Plan Period.

A03ufig04

Bhutan: External Public and Publicly Guaranteed Debt

Citation: IMF Staff Country Reports 2009, 334; 10.5089/9781451806281.002.A003

A03ufig05

Bhutan: Macroeconomic Impact of Hydropower Projects

Citation: IMF Staff Country Reports 2009, 334; 10.5089/9781451806281.002.A003

1/ Period averages are shown for years except for hydro projects commissioning.
Figure I.1.
Figure I.1.

Bhutan: Indicators of Public and Publicly Guaranteed External Debt under Alternatives Scenarios, 2009/10-2029/30 1/

Citation: IMF Staff Country Reports 2009, 334; 10.5089/9781451806281.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2019/20. In figure b. it corresponds to a One-time depreciation shock; in c. to a Exports shock; in d. to a One-time depreciation shock; in e. to a Exports shock and in figure f. to a One-time depreciation shock2/ The shape of the grant element of new borrowing reflects the composition of new loans. Under the standard DSA assumptions, rupee debt appears nonconcessional since its interest rate of 11 percent exceeds the 4 percent discount rate. Thus, until 2018/19, when rupee disbursements dominate external financing, the grant element seems low. However, it starts rising once the rupee financed hydropower projects are completed, and concessional loans from multilateral and bilateral development partners take stage.
Figure I.2.
Figure I.2.

Bhutan: Indicators of Public Debt Under Alternative Scenarios, 2009/10-2029/301/

Citation: IMF Staff Country Reports 2009, 334; 10.5089/9781451806281.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2019/20.2/ Revenues are defined inclusive of grants.
Table I.1.

Bhutan: External Debt Sustainability Framework, Baseline Scenario, 2006/07-2029/30 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Includes both public and private sector external debt.

Derived as [r - g - p(1+g)]/(1+g+p+gp) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and p = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Assumes that PV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the PV of new debt).

Table I.2

Bhutan: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2009/10-2029/30

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Sources: Country authorities; and staff estimates and projections.

Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.

Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline, while grace and maturity periods are the same as in the baseline. This shock is applied only to non-rupee new borrowing.

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels).

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent.

Applies to all stress scenarios except for A2 (less favorable financing) in which the terms on all new financing are as specified in footnote 2.

Table I.3.

Bhutan: Public Sector Debt Sustainability Framework, Baseline Scenario, 2006/07-2029/30 (In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Gross public and publicly guaranteed debt.

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium and long-term debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Table I.4.

Bhutan: Sensitivity Analysis for Key Indicators of Public Debt 2009/10-2029/30

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Sources: Country authorities; and staff estimates and projections.

Assumes that real GDP growth is at baseline minus one standard deviation divided by the square root of the length of the projection period.

Revenues are defined inclusive of grants.

1

This DSA was prepared jointly by the IMF and the World Bank, in consultation with the Asian Development Bank, and in accordance with the Debt Sustainability Framework for low-income countries approved by the Executive Boards of the IMF and the IDA. The data underlying the analysis are from the Bhutanese authorities and IMF and World Bank staff estimates.

2

See “Debt Sustainability in Low-Income Countries: Proposals for an Operational Framework and Policy Implications” (http://www.imf.org/external/np/pdr/sustain/2004/020304.htm), “Debt Sustainability in Low- Income Countries: Further Considerations on an Operational Framework and Policy Implications” (http://www.imf.org/external/np/pdr/sustain/2004/091004.htm) and reference to “Staff Guidance Note on the Application of the Joint Bank-Fund Debt Sustainability Framework for Low-Income Countries.”

3

Fiscal year starting July 1.

4

Public debt does not include state-owed enterprise debt, with the exception of hydropower projects loans and the purchase of one aircraft for state-owned Druk Air in 2004/05.

5

Domestic debt data compiled by the Royal Government of Bhutan include fixed rate debt relating to the purchase of one airplane for state-owned Druk Air in 2004/05, amounting to about half of total domestic debt.

6

Convertible currency debt mainly comprises loans from multilateral institutions, including $9½ million commercial debt extended by the IFC, making all external debt public or publicly guaranteed.

7

The new hydropower development policy of Bhutan outlines 10 potential hydropower projects, which would quintuple Bhutan’s power generation capacity by adding further 10,000 MW of installed capacity by 2020 out of the estimated potential capacity of 23,760 MW. However, since most of these projects are at early stages of conception, they are not included in the projections.

8

Puna II’s power generation capacity will be 992 MW, while Mangdechu’s will be 672 MW. The financing terms for both projects are yet to be finalized, however they are expected to be similar to Puna I’s with 30 percent grants, and 70 percent loan in Indian rupees at 11 percent interest rate from the GOI. Debt service will begin after the commissioning of the projects and will continue for 12 years. Similar to Tala and Puna I, the interest payments accumulated during construction are expected to be repaid after the project completion without being capitalized.

9

Although strictly speaking the financing of hydropower projects is non-concessional (i.e., below the usual 35% grant element for LICs), there is a certain level of concessionality stemming from the grant portion of financing and the exemption from payment of interest during construction. In addition, as discussed in footnote 11, a higher discount rate to calculate the present value of the rupee loans may be appropriate in view of the higher inflation and risk-free long-term interest rates in India, which would further raise the grant element of these loans.

10

Measures to broaden the tax base and improve administration include rationalizing sales and customs tax rates, broadening the sales tax base and eventually introducing the VAT. Further domestic revenue improvements could be achieved by harmonizing the direct income tax rates and limiting tax holidays.

11

The PV of external debt is calculated assuming the standard discount rate of 4 percent for both rupee and convertible currency debt. Using a discount rate for rupee denominated debt of 11.25 percent in view of the higher inflation and risk-free long-term interest rates in India, lowers the various PV of debt ratios substantially: the PV of debt-to-GDP ratio peaks at 89 percent, while the PV of debt-to-revenue ratio peaks at 430 percent in 2014/15. The PV of debt-to-exports ratio remains below the indicative threshold.

12

Bhutan, with an average 2006-08 Country Policy and Institutional Assessment (CPIA) index of 3.86, is currently classified as a strong performer with regard to its policies and institutions. The indicative thresholds for strong performers are 50, 200 and 300 for the PV of debt in percent of GDP, exports, and revenue respectively, and 25 and 35 for debt service in percent of exports and revenue.

13

Staff estimates that rupee denominated revenues will account for more than 40 percent of the non-grant fiscal revenue over the projection period.

14

Focusing on the average growth over a 20 year period, which appears little affected by the addition of the new hydropower projects, understates the economic impact of these projects. At commissioning, these projects will generate large spikes in real GDP growth, boost incomes and exports; however, with generation capacity fixed, the impact on growth after commissioning will be limited.