Bhutan’s rapid growth has been underpinned by hydropower sector development with donor support. However, fiscal policy should be tightened to address overheating, and spending and revenue reforms are needed to bolster the fiscal framework. Executive Directors suggested to adopt multiyear rolling budget to ensure debt sustainability. They assessed the need to strengthen the Royal Monetary Authority (RMA's) power to safeguard financial stability. They welcomed the comprehensive strategy embedded in the Economic Development Policy (EDP) that identifies activities that have strong job-generating potential and also promote foreign direct investment and private sector development.

Abstract

Bhutan’s rapid growth has been underpinned by hydropower sector development with donor support. However, fiscal policy should be tightened to address overheating, and spending and revenue reforms are needed to bolster the fiscal framework. Executive Directors suggested to adopt multiyear rolling budget to ensure debt sustainability. They assessed the need to strengthen the Royal Monetary Authority (RMA's) power to safeguard financial stability. They welcomed the comprehensive strategy embedded in the Economic Development Policy (EDP) that identifies activities that have strong job-generating potential and also promote foreign direct investment and private sector development.

I. Background

1. After peaking in 2004/05, Bhutan’s public and publicly guaranteed debt declined by 17 percentage points to 68 percent of GDP at end 2008/09.3 Public debt declined following the completion of the Tala hydropower project—which was entirely financed by India—and by the onset of the repayment of the associated Indian rupee debt.4 Rupee-denominated hydropower sector debt (41 percent of GDP) accounts for 62 percent of external debt, which in turn accounts for more than 95 percent of total public debt. Convertible currency debt has remained relatively range bound, reaching 34 percent of GDP in 2009/10.5 The actual outturn of public debt indicators for last two years was slightly more favorable than projected in the previous DSAs since better-than-expected fiscal outturns compensated for the more rapid accumulation of rupee debt.6 Domestic debt, all denominated in local currency and held by domestic financial institutions, has also declined on the back of rapid growth and relatively strong fiscal outturns during the same period.

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. The baseline scenario continues to be predicated on the assumption that Bhutan stays on schedule on its planned expansion in power generation capacity (10,000 MW of installed capacity by 2020).7 The baseline scenario incorporates Punatsangchu I (Puna I), Punatsangchu II (Puna II), and Mangdechu hydropower projects.8 These projects are financed by the Government of India (GOI) through a combination of loans and grants (see also Box 1 in the 2011 Staff Report).9 The intergovernmental implementation agreements on Puna II and Mangdechu were signed in April 2010 and pre-construction works are underway. 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.

3. The overall economy will remain driven by the hydropower sector, as outlined in the following baseline macroeconomic assumptions:

  • Real sector: As in the case of the Tala project, when real GDP growth spiked in 2006/07, the Puna I, Mangdechu and Puna II projects are expected to boost economic growth as they come on stream. In addition, hydropower construction will also be a main contributor to growth. Real growth excluding hydropower-related activity is projected to remain robust at about 6–7 percent over the medium and long term, underpinned by tourism and other services. With the ngultrum pegged to the rupee, inflation is projected to remain broadly in line with inflation in India, initially averaging 7-8 percent in the near term and declining gradually to 4–5 percent over the medium term.

  • External sector: The current account deficit is expected to widen over the medium term because of strong growth in import demand associated with the construction phase of the new hydropower projects, as well as Tala’s debt service. Upon the completion of hydropower projects, however, electricity exports are expected to more than triple from current levels, and the current account deficit should decline over the longer term, leading to balance of payment surpluses from 2019.10

  • Fiscal sector: The hydropower projects will boost the domestic revenue-to-GDP ratio as they are completed after the new hydropower projects come on stream around 2017/18. Revenue will also benefit from an envisaged broadening of the tax base over time as well as improvements in tax administration.11 Offsetting those developments, however, is the sharp projected decline in external aid, leaving the overall fiscal balance should remain broadly stable over the forecast horizon. Primary deficits arise over the medium term mainly because the decline in aid inflows does not lead to a similar compression of public investment, which would be detrimental to growth.

Key Macroeconomic Assumptions

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III. External Debt Sustainability Analysis

A. Baseline

4. The hydropower sector cycles will remain the driver of Bhutan’s external debt. External debt in relation to GDP is projected to rise by 26 percentage points between 2009/10 and 2012/13 as disbursements for new hydropower projects increase. The debt ratios remain above the LIC-DSA indicative threshold for strong policy performance countries until 2016/17 for the PV of external debt as a share of exports and revenue, and until 2019/20 for the PV of external debt to GDP.12 Debt ratios are projected to decline steadily with the start of debt repayment even as new projects are commissioned. The debt service-to-export and the debt service-to-revenue ratios are expected to remain below the indicative thresholds for the entire projection period.

B. Sensitivity Analysis

5. Debt ratios are most vulnerable to exchange rate shocks, export growth shocks, and unfavorable financing terms, but are expected to decline under almost all alternative scenarios. Importantly, the debt ratios are also projected to fall below the thresholds by 2020 in almost all cases considered. In the case of a 30 percent nominal depreciation in 2009/10, the PV of debt rises to more than 140 percent of GDP. But such extreme scenario overestimates Bhutan’s debt vulnerability since a large share of Bhutan’s receipts are in rupees, which provide a natural hedge to the rupee-denominated debt. The export growth shock and more unfavorable financing terms for new borrowing increase debt ratios.13 If the growth rate is slower than envisaged, debt distress indicators will only slightly deviate from the baseline scenario.

6. Under the most extreme shock scenario, the debt service-to-revenue ratio would temporarily breach the indicative threshold as Puna II and Mangdechu’s debt service begins; but even in this scenario, it is expected to remain below the threshold for the rest of the projection period. The historical scenario shows explosive debt dynamics, as it does not fully capture the entire cycle of construction and operation of the hydropower projects.

IV. Public Debt Sustainability Analysis

A. Baseline

7. The baseline public debt dynamics is determined by that of external debt. The public debt-to-GDP ratio is expected to rise with the start of new hydropower projects (peaking at 110 percent of GDP in 2014/15) and subsequently decline until it reaches 35 percent of GDP by end 2029/30. In spite of the volatility in hydropower-related revenue related to seasonality, it is assumed that revenue gains materialize when the new hydropower projects come on stream, and revenues stabilize at around 20 percent of GDP.14 Given Bhutan’s robust growth and strong overall performance, external financing is projected to shrink as a share of GDP. As domestic financing increases temporarily during the 2010–2015 to offset declining grants, domestic debt is projected to reach about 20 percent of GDP by 2014/15 and be broadly stable around that level as share of GDP for the remainder of the projection period.

B. Sensitivity Analysis

8. Given the large share of external debt in total public debt and the impact of exchange rate shocks on the former, overall public debt is most vulnerable to exchange rate shocks. A one-time depreciation leads to an upward shift in the various public debt indicators, while leaving the broad shape of the debt indicators’ path unchanged. Under the historical scenario (assuming a primary deficit of 2⅓ percent of GDP), public sector debt would rise and remain at a high level over the long term. Such a scenario also shows the importance of containing fiscal deficits to help ensure that public debt remains sustainable. Finally, if borrowed resources were not used productively, the debt ratios would deteriorate markedly. The “high investment, low growth” scenario is unlikely given the commercial viability of the projects and Bhutan’s strong implementation capacity, but such scenario highlights the risks from lower than anticipated growth payoff of the debt-financed hydropower projects. For instance, if investment in the hydropower sector does not generate any growth, public debt will peak at 125 percent of GDP and decline at a much slower speed (Table 2a).

Table 1a.

Bhutan: Public Sector Debt Sustainability Framework, Baseline Scenario, 2007–2030

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

[Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.]

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 2a.

Bhutan: Sensitivity Analysis for Key Indicators of Public Debt 2010–2030

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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.

V. Staff Assessment

9. As in the 2009 IMF/World Bank Joint DSA, Bhutan’s external debt dynamics are deemed sustainable but subject to a moderate risk of distress. As noted above, policy-related LIC-DSA thresholds for external debt are breached for several indicators, but they remain so for a shorter period than in the previous DSA. In addition, the new hydropower projects are widely expected to boost exports and overall GDP growth.15 While the debt stock is expected to increase substantially, the new hydropower projects do not entail significant vulnerabilities to debt servicing as debt-service ratios remain below indicative thresholds.

uA03fig01

Bhutan: External Public and Publicly Guaranteed Debt

Citation: IMF Staff Country Reports 2011, 123; 10.5089/9781455288663.002.A003

uA03fig02

Bhutan: Macroeconomic Impact of Hydropower Projects

Citation: IMF Staff Country Reports 2011, 123; 10.5089/9781455288663.002.A003

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

10. In addition, as in previous DSAs, several mitigating factors are at play:

  • Commercial viability of new hydropower projects. Puna I is expected to have a higher internal rate of return, given lower costs of construction than Tala and a larger generation capacity. At the same time, the internal rate of return for Puna II and Mangdechu are expected to remain high at about 11–14 percent,16 significantly higher than the effective cost of financing (estimated at about 8 percent).

  • Bhutan’s strong track record of project implementation. In light of this, new hydropower projects are expected to remain subject to low implementation risk.

  • Strong ties with India. Bhutan is widely expected to maintain close economic ties with India, which has been the main provider of financing for hydropower projects. Given India’s sizable power deficit, its demand for Bhutan’s hydropower electricity should remain high for decades to come. At the project level, operational risks (including those related to natural disasters) shall be borne by the Government of India; hydropower-related loans do not represent contingent liabilities for the Royal Government of Bhutan.

11. The authorities broadly agreed with the debt projections underlying the staff’s DSA as well as the staff’s assessment. However, they underscored the importance of the mitigating factors outlined in the staff’s analysis, particularly the commercial viability of the projects and strong donor support.

Figure 1.
Figure 1.

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

Citation: IMF Staff Country Reports 2011, 123; 10.5089/9781455288663.002.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 shock
Figure 2.
Figure 2.

Bhutan: Indicators of Public Debt Under Alternative Scenarios, 2009/10-2029/30 1/

Citation: IMF Staff Country Reports 2011, 123; 10.5089/9781455288663.002.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 3a.

Bhutan: External Debt Sustainability Framework, Baseline Scenario, 2007-2030 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 - ρ(1+g)]/(1+g+ρ+gρ) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and ρ = 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 3b.

Bhutan: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2010-2030

(In percent)

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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.

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.

1

This DSA was prepared jointly by the IMF and the World 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

Public debt does not include state-owned enterprise debt, with the exception of hydropower projects loans and the purchase of one aircraft for state-owned Druk Air in 2004/05. The other SOEs’ debt is very small.

4

In the whole Annex, the term rupee refers to the Indian rupee.

5

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.

6

For instance, in the 2009 DSA, growth was projected at 6½ percent in 2009/10, with external debt reaching 69 percent of GDP. Instead, provisional estimates put growth at 7½ and external debt was 3½ percentage points lower. Likewise, average GDP growth is projected to be nearly 2 percentage points over the next five years, owing to stronger construction activity and higher capital spending. The higher GDP growth projection accounts for the bulk of the slower pace of debt accumulation relative to the previous DSA.

7

The new hydropower development policy of Bhutan consists of ten hydropower projects, which would quintuple Bhutan’s power generation capacity. The other projects are still on paper and the exact financing arrangements are under discussion with the GOI and other partners such as Indian companies (see Box 1 of the 2011 Staff report).

8

Puna I’s power generation capacity is 1,200 MW. Puna II’s power generation capacity will be 990 MW, while Mangdechu’s will be 720 MW. Debt service will begin after the commissioning of the projects and will continue for 12 years. As in the cases of Tala and Puna I, the interest payments accumulated during construction are expected to be repaid following project completion, but without being capitalized.

9

Although the financing of hydropower projects is non-concessional (i.e., below the 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.

10

The unusual shape of the grant element of new disbursement in figure 1a reflects the composition of new loans. Under the standard DSA assumptions, rupee debt appears non-concessional since the interest rate of 11 percent exceeds the 4 percent discount rate. Thus, until 2016/17, when rupee disbursements dominate external financing, the grant element appears low. However, it starts rising once the rupee-financed hydropower projects are completed, and concessional loans from multilateral and bilateral development partners take stage.

11

Measures to broaden the tax base and improve administration include rationalizing sales and customs tax rates, broadening the sales tax base, and eventually introducing a VAT.

12

Bhutan’s Country Policy and Institutional Assessment (CPIA) index for 2009 was 3.89 (average of 3.86 for 2006–08), which classifies it 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. The PV of external debt is calculated assuming the standard discount rate of 4 percent for both rupee and convertible currency debt.

13

This scenario envisages real GDP growth at its historical average minus one standard deviation (tables 2a and 3b).

14

The strong seasonal patterns of electricity generation stem from seasonality in water levels. While such seasonal patterns generate volatility in revenues from hydropower exports within the fiscal year, annual hydropower exports can be reasonably well estimated. Hence, the effect of revenue volatility on debt sustainability is small.

15

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.

16

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

Bhutan: 2011 Article IV Consultation-Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Bhutan
Author: International Monetary Fund
  • View in gallery

    Bhutan: External Public and Publicly Guaranteed Debt

  • View in gallery

    Bhutan: Macroeconomic Impact of Hydropower Projects

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

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    Bhutan: Indicators of Public Debt Under Alternative Scenarios, 2009/10-2029/30 1/