Bhutan: Staff Report for the 2014 Article IV Consultation—Enhancing Financial Sector Surveillance

This 2014 Article IV Consultation highlights that the GDP growth in Bhutan has slowed from about 10 percent in FY2011 (July 1–June 30) to 5 percent in FY2013. Slower growth reflects policy efforts to contain overheating pressures in the form of restrictions on credit for construction and vehicle. Inflation has remained elevated, tracking closely that of India (Bhutan’s main trading partner). Social development indicators have improved steadily, and Bhutan is on track or has achieved most of its Millennium Development Goals. Growth is projected to recover to 6½ percent in FY2014, driven mainly by a pick-up in hydropower-related construction activities and domestic services.


This 2014 Article IV Consultation highlights that the GDP growth in Bhutan has slowed from about 10 percent in FY2011 (July 1–June 30) to 5 percent in FY2013. Slower growth reflects policy efforts to contain overheating pressures in the form of restrictions on credit for construction and vehicle. Inflation has remained elevated, tracking closely that of India (Bhutan’s main trading partner). Social development indicators have improved steadily, and Bhutan is on track or has achieved most of its Millennium Development Goals. Growth is projected to recover to 6½ percent in FY2014, driven mainly by a pick-up in hydropower-related construction activities and domestic services.


1. Bhutan was selected as pilot case for the initiative on Enhancing Financial Sector Surveillance called for by Executive Board in May 2012 (FO/DIS/12/66).1, 2 As an input to the Article IV consultation, this supplement assesses the extent to which a shallow and undiversified financial sector in Bhutan has created macro-financial vulnerabilities that impact the economy, and its ability to sustain growth and reduce poverty, how the country can generate financial deepening that will provide greater access to credit and financial services, and whether the process of deepening itself has increased risks in the financial sector. It also explores how the state of development of the financial system may have constrained monetary policy implementation and the efficacy of the transmission mechanism.

2. Bhutan is a small, fast-growing, lower middle-income country with deep economic ties to India and a peg to the Indian rupee. Hydropower projects exporting electricity to India and credit-fuelled private consumption have driven a decade of high growth, which in turn has led to improving living standards and appears to have been a key driver of a rapid expansion of the banking system. However, the country is vulnerable given the rapidly growing (until recently) borrowing from banks against the backdrop of weak regulation and supervision. A key challenge is mediating large expected flows from hydropower development into productive uses for the economy, while coping with volatility in the associated external financing and proceeds.

3. The country faces recurring balance of payments pressures stemming from a combination of factors. These include loose macroeconomic policies, rapid credit growth (which has led to higher imports), and time-inconsistency in bulky hydro-related transactions in particular, rupee debt repayments in January and hydro-related export receipts during the rainy season in July–September. As a result, the authorities have had to resort to recurrent short-term borrowing of rupees from Indian commercial banks (now refinanced by the Indian government and Reserve Bank of India (RBI)) at considerable cost. A pronounced rupee shortage in 2011–resulting from excessive credit growth, house price appreciation, and a consumption boom–led the Royal Monetary Authority (RMA) to sell 20 percent of its U.S. dollar reserves in December 2011, with a subsequent sale in June 2013.3 Continued shortages led to the adoption in 2012, at the recommendation of a government Task Force, of corrective measures including banning of imports of vehicles and construction materials. Reserve requirements were relaxed to ease the liquidity stress on commercial banks, as were provisioning requirements, and lending for construction and vehicle imports was banned, while planned macroprudential measures that would have strengthened capital standards were not implemented. In 2013, the newly elected government has proposed an Economic Stimulus Plan that would inject funds equivalent to 4 percent of GDP into the financial system “to restart lending to productive and priority sectors”.

4. The banking system has grown rapidly and competition has intensified with the entry of new domestic private banks. Credit growth averaged above 30 percent over the past 10 years, increasing credit from 11 percent to 49 percent of GDP.4 This compares with a median of 32 percent for lower middle-income countries (16 percent for low-income countries), and an “expected norm” of 27 percent based upon a regression controlling for relevant country-specific characteristics,5 while coinciding with the median of 49 percent for South Asia. The rapid expansion stemmed from the initially low penetration, ample liquidity from large government deposits tied in part to concessional loans and grants, growth in civil services wages, a more liberal land use policy, and in recent years, spillovers from large hydropower projects and the entry of three new banks in 2010. Other factors have included loose monetary conditions (including low and often negative interest rates), the establishment of a state pension fund, and growth in corporate borrowing particularly in special economic zones. In addition, non banks such as the pension fund and insurance companies have also engaged in lending in the absence of alternative investment opportunities.6

Figure 1.
Figure 1.

Private Credit / GDP (in percent)

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: World Bank FinStat database

5. The next sections provide background on the financial sector and present recommendations on deepening the financial system, enhancing regulation and supervision, and strengthening monetary operations. A concluding section summarized the detailed recommendations of the report.

Background on the Financial Sector

6. Financial service providers in Bhutan can be broadly categorized as formal financial institutions (banks and nonbank financial institutions), informal moneylenders, and semiformal providers such as NGOs and cooperatives. In addition, Bhutan Post provides remittance services. The formal financial sector has recently undergone significant transformation and modernization but remains bank led. The financial sector remains shallow, with the banking sector accounting for over 80 percent of total financial sector assets (excluding the stock exchange).

Table 1.

Structure of the Financial System

article image
Source: Royal Monetary Authority - Bhutan Financial Sector Performance Overview (March 2012–13)

Excludes a reinsurance company licensed in 2013.

A. Formal Financial Service Providers

7. Bhutan’s financial sector has undergone rapid changes since 2009, notably with the entry of three new banks and one private insurance company.7 Five banks operate in Bhutan: two incumbents—Bank of Bhutan Limited (BOB) and Bhutan National Bank Limited (BNB)—and the three new banks—Druk Punjab National Bank Limited (Druk PNB), T Bank, and Bhutan Development Bank Limited (BDBL). Banks offer credit facilities, savings or deposit services, insurance, remittance services, foreign exchange services, and other financial services such as ATM services, mobile (SMS) banking, and internet banking. BDBL is mandated by the Royal Government of Bhutan, which owns 94 percent of its capital, to operate in rural regions of the country. BDBL grants around 99 percent of the formal loans going to the agricultural sector. Commercial financial institutions remain mostly concentrated in urban areas, viewing rural operations as unprofitable because of high costs and low profits. The predominance of lending based on collateral further reduces the demand for services in rural areas, since rural clients often lack sufficient collateral or large savings in a bank.

8. Three nonbank financial institutions (NBFIs) provide insurance and pension services. These are the Royal Insurance Corporation of Bhutan Limited (RICBL), the newly licensed Bhutan Insurance Limited (BIL), and the National Pension and Provident Fund (NPPF). RICBL is the dominant insurance provider, though BIL has quickly captured a large share of the market in its three years of operation. Nonbank financial institutions in Bhutan—insurance companies as well as pension boards—have been allowed to engage in retail lending activities. These institutions were initially allowed to lend because of the small market size and limited avenues for investment. A reinsurance company has also been licensed.

9. The Royal Securities Exchange of Bhutan Limited (RSEBL) is at an early stage of development. It has 21 listed companies. While liquidity remains low, the RSEBL has been automated, leading to a 230 percent increase of the total value traded in the secondary market between 2011 and 2012.

Figure 2.
Figure 2.

Financial Sector Assets, 2005–12

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: World Bank analysis based on RMA data.Note: Data exclude RSEBL. BDFC = Bhutan Development Finance Corporation.

B. Informal and Semi-formal Financial Service Providers

10. There is no formal microfinance sector in Bhutan, although several civil society organizations or intermediaries provide financial services. A number of regulations aimed at increasing financial access have been finalized, including for non deposit-taking and deposit-taking microfinance institutions. In addition, a Financial Inclusion Policy has been drafted (see below) and is awaiting Cabinet approval. There is growing interest among the Bhutanese in forming cooperatives and self-help groups for saving and lending, especially in rural communities. The existing ones provide only group savings, though many are considering expanding to lending services in the future.

11. Informal creditors dominate the market in communities where financial institutions have little presence. Recent research found that that, unlike formal financial service providers, informal providers typically only offer loans, though anecdotal evidence suggests that a few informal lenders may also accept deposits. Informal providers can be broadly categorized into two groups: moneylenders (individuals or businesses) and family members, relatives, friends, or neighbors. Bhutan is a cash-based economy where households have a vibrant, if informal, savings and lending culture. Basic access indicators in Bhutan compare favorably with benchmark countries, although segments of the population (rural areas, women) remain underserved.8

Table 2.

Bank Outreach in Bhutan and Peer Countries, 2011

article image
Source: Financial Access Survey, IMF *2010

12. From the perspective of the private sector, access to basic banking and savings is good, but firms have few financing options besides credit. The World Bank Enterprise Survey has noted the need to improve accounting, cumbersome bank procedures, difficult collateral recovery, and limited financing instruments beyond bank credit. The difficult mountain terrain and scattered settlements in rural areas are important constraints on financial inclusion.

Figure 3.
Figure 3.

Share of Firms with a Checking or Savings Account

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: World Bank Group Surveys 2009 (*2007).
Figure 4.
Figure 4.

Share of Firms Using Banks to Finance Investments

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: World Bank Group Surveys, 2009 (*2007)
Figure 5.
Figure 5.

Share of Firms Using Banks to Finance Working Capital

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

13. Uneven access to bank credit and lack of access to other financial services are possible explanations of the private sector’s perception that access to finance remains a problem in Bhutan. According to a series of nationally representative World Bank enterprise surveys, when asked to rank the severity of access to finance as a constraint, the percentage of firms responding that access to finance is a major obstacle more than doubled from 14 percent to 30 percent between 2001 and 2009. The 2009 survey also indicated that that 22 percent of surveyed firms identified access to finance as their biggest obstacle to doing business, more than all other investment climate obstacles in the enterprise survey. Similarly, Bhutan ranks low among countries worldwide in the Doing Business survey on access to credit—which does not appear to reflect recent improvements in credit infrastructure.

Figure 6.
Figure 6.

Share of Firms with Access to Finance as Biggest Obstacle

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: World Bank Group Surveys 2009 (*2007)

14. The range of financial instruments offered by banks has expanded. Banks have increasingly been using cash flow based lending in lieu of collateral for enterprises. Non-loan financial products such as letters of credit and products similar to factoring are now being offered.9 Most loans to individuals continue to be collateralized.

15. The limited availability of financial statements for borrowers makes it difficult for the commercial banks to carry out a proper loan appraisal for the borrowers’ credit worthiness. As a result, they require more collateral from the borrowers.10 Overall, only half of firms in Bhutan prepare certified financial statements.11 This is low compared to regional averages and comparator countries.

Figure 7.
Figure 7.

Share of Firms with Financial Statements Reviewed by External Auditors

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: World Bank Group Surveys 2009 (*2007)

16. Commercial banks are also facing a lack of skilled workers in their efforts to expand the range of financial products they offer. The need for capacity building of financial sector staff has become increasingly important to provide efficient and transparent banking services, particularly in an environment of increased competition among banks, due to the new entrants.

17. From the perspective of the private sector, firms see loan procedures as complex and lacking in transparency. In Bhutan, 37 percent of surveyed firms responded that they had not applied for any loan in 2008, although they needed a loan for their businesses. Of these firms, 17 percent also indicated that they did not apply for a loan because application procedures for loans or lines of credit are complex and difficult to understand.

Deepening the Financial System

18. Bhutan has taken recent steps to modernize financial sector infrastructure, including the establishment of a credit bureau, a collateral registry, and an improved payments system. The Credit Information Bureau (CIB), established in 2009, is now an independent institution and is used by all financial institutions. Coverage is now complete except for microfinance loans. It incorporates information on 97 percent of individuals and 50 percent of corporate borrowers as of May 2013 (see Figure 8). A collateral registry for moveable collateral was launched in August 2013 and may be an important enabler to diversify sources of collateral. An electronic funds transfer and clearing system was inaugurated in June 2010. The system’s functionalities include credits (such as salaries and dividends) and debits (such as utility bill payments). The RMA plans to draft a Payment and Settlement Systems Act with technical assistance from the Reserve Bank of India. To allow for the interoperability of ATMs and bank point-of-sale terminals, the Royal Monetary Authority launched Bhutan Financial Switch, a national card switch system, in December 2011. The RMA has also made the National Electronic Funds Transfer System available to the public since December 2011. This system is a nationwide inter-bank fund transfer system that facilitates transfer of funds among individuals and institutions. The CIB could be expanded to include microfinance clients and supporting secured transactions including by movable collateral by expanding the collateral registry.

Figure 8.
Figure 8.

Average of Daily Reports Generated in Credit Information Bureau

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: Credit Information Bureau of BhutanNote: Lower daily volumes in 2012 can be explained by the rupee shortage and the ensuing credit contraction in the banking sector.

19. Sectoral initiatives could also be taken within the framework of a wider development strategy. In the banking sector, there is a need to break out of current practices that limit the range and types of loan available to borrowers while adding complexity to asset and liability management. The CIB could continue to develop its services to include a credit scoring or credit assessment capacity so as to equip banks to make more credit decisions based on underlying creditworthiness. In insurance, divestment of banking business from insurance company balance sheets would provide an impetus for widening and deepening the range of insurance services. Implementation of the divestment requirements would need to be managed by the authorities in conjunction with efforts to stimulate a wide range of investment securities.

20. The formulation of a Financial Sector Development Strategy would provide a framework for considering any trade-offs between effective regulation and supervision and financial sector development. Analysis could be undertaken of the areas where regulatory requirements are unnecessarily prescriptive or create obstacles to financial sector development disproportionate to the regulatory benefit. This could be undertaken in the context of changes in supervisory approach recommended in this paper including more risk-based supervision, increased focus on holding management responsible and more impact assessment of regulatory changes. While participating fully in such a review and resulting decisions, the RMA would clearly retain the final responsibility for any changes in its approach, taking into account its statutory objectives.

21. Extending the range and maturity of marketable government securities would deliver many benefits. These include more effective monetary policy implementation (as discussed below), increased bank prudential liquidity, the creation of a yield curve to underpin a corporate bond market and support for better loan pricing as well as the long term investments required by insurance and the NPPF as they exit lending. These benefits would have to be set against the cost implications of government issuance given the low costs of current borrowing.

22. Similarly, floating minority shares in public enterprises would broaden the range of investment channels while enhancing corporate governance. The government benefits at present from dividend income streams from these companies via its investment vehicle Druk Holdings and Investments (DHI). Divestment of minority shares in public enterprises through an RSEBL flotation would boost both demand and supply of marketable securities—extending the range of shares available for investment and releasing resources for DHI to invest in a wider range of assets. In particular, it would broaden the range of assets available to the NPPF, whose liabilities are a state responsibility. The companies divested could include the Bank of Bhutan, which would put it on the same basis as financial institutions required under the Financial Services Act to float at least 40 percent of their equity.

23. The wider share ownership that could result would also make it appropriate for the government to reconsider the taxation of corporate dividends. At present, dividends are subject to income tax on the recipients (i.e., there is double taxation of company profits). Relief in this area would raise returns on holdings of equities and create more options for corporate structures, including holding companies. At present, the large share of corporate equity held by government itself creates limited incentives for reform. Again, there would need to be a consideration of the benefits of reform against the costs in tax income foregone.

24. A Financial Inclusion Policy (FIP) has been drafted to facilitate access to finance for all as a means to improving livelihoods, raising income levels and reducing vulnerability. Financial inclusion has improved significantly, but the geography of the country remains a major constraint to access to finance. Many rural communities are half a day’s walk or more from the nearest farm road and are one or two days travel away from the nearest bank. The FIP was drafted through an extensive consultation process and includes “guiding principles” used to formulate its strategies. The authorities should consider:

  • The need to formulate proportionate regulation which will consider risk management, while avoiding stifling innovation and making evidence-based analysis, is a key principle.

  • In cases where market failures call for Government support, subsidies should be carefully targeted to improve the supply of financial services to underserved individuals, time bound, and not impact the overall soundness of the financial sector.

  • Directed lending, to rural areas or to the agriculture sector, should be avoided, given the high risk based on international experience that directed loans are likely to become nonperforming.

  • The government should facilitate access to funding for microfinance institutions (MFIs), support the creation of a microfinance association possibly with a shared technology infrastructure, and provide technical assistance to MFIs, help them expand their businesses, assist in their coordination.

  • Proportionate increased supervisory controls and oversight mechanisms will be needed. These controls are important to ensure that the consumer protection regulatory environment and dispute resolution mechanisms work as intended.

25. As highlighted in the draft FIP, support to financial literacy and to a consumer protection regulatory environment will be a key enabler of financial outreach. Savings strategies and attitudes suggest that Bhutanese households could benefit from financial literacy education, as they display poor financial management skills. The research undertaken established that savings are an afterthought as opposed to the first step in financial management. Efforts to increase financial management skills among the Bhutanese would also likely improve their ability to access formal financial services. In addition, no regulation on financial consumer protection exists in Bhutan, although the Companies Act 2000 and Consumer Protection Bill of Bhutan 2010 broadly address some consumer protection rights.12 One key client protection measure includes establishing mechanisms and processes that ensure clients have an affordable, independent, fair, accountable, and timely access. A clear and direct pathway for dispute resolution that is easily accessed will greatly increase trust in the financial sector.

26. Lenders need technical assistance to develop capacity to work with small- and medium-sized enterprise (SME) borrowers. The Government has established an Accounting and Auditing Standards Board of Bhutan (AASBB), and has started adopting standards aligned to IAS/IFRS. This should help increase the reliability of financial information and reduce collateral requirements. In addition, technical assistance to financial institutions and enterprises should help financial institutions build their capacity to provide financing instruments to micro, small and medium enterprises and ensure that the private sector has the capacity to effectively utilize finance.

27. Development of a private equity market is a priority. There have been some positive developments, including the licensing of Nubri Capital, a local fund management company. The International Finance Corporation (IFC) has been exploring supporting the launch of a private equity fund in Bhutan, in collaboration with Druk Holding and Investment and an international private equity fund. These encouraging developments would however benefit from a better enabling policy and regulatory environment:

  • The restriction to 100 percent domestic ownership rules out knowledge transfer from experienced foreign firms. The clause requiring ownership and management to be 100 percent domestic may be difficult to reconcile with requirements such as a minimum of 10 years experience of the CEO in the investment and finance-related business.

  • The regulations seem to rule out venture capital funds, since the total investment in venture capital cannot exceed Nu 5 million, whereas minimum capital requirements are of Nu 50 Million. Given the nascent risk capital market and given Bhutan’s small private sector, venture capital will be critical to boost access to finance for Bhutanese firms. Private equity regulations should ensure venture capital can develop in Bhutan.

28. Development of corporate bonds market would provide an alternative to bank financing. Only Nu 4.2 billion of corporate bonds are outstanding, all four issuers being financial institutions or state-owned companies. Several private sector firms have shown interest in issuing bonds. A key question is whether financial institutions should be allowed to guarantee bonds, which would jumpstart the market but could carry prudential risks and potential overleveraging of financial institutions. The RMA is exploring how to encourage the availability of credit ratings to support development of a corporate bond market.

Enhancing Regulation and Supervision

A. Recent Developments in the Financial Sector

29. Notwithstanding entry by new banks, the dominance of existing institutions remains mostly unchallenged. The largest institutions remain the two established banks, with 75 percent of total bank assets of Nu 80 billion as well as the most extensive branch networks, and the long-established insurance company (life and general), with 75 percent of total gross premium income of Nu 1.1 billion. The NPPF, which provides pensions for government and public sector employees, remains Bhutan’s largest institutional investor, with the assets of its various funds totaling Nu 15 billion.

30. Recent institutional diversification has not been matched by broadening of the sector. Finance in Bhutan is dominated by traditional banking products and credit continues to account for most financial assets:

  • Loans and advances, mostly medium and longer term and at fixed rates, represent 65 percent of banking sector assets and off-balance sheet business of Nu 6.5 billion is mostly in the form of credit substitutes—guarantees, letters of credit and performance bonds.

  • The insurance companies and NPPF offer their customers loans and advances, which for the insurers represent 70 percent of assets and which are partly funded by borrowing from banks (insurers may not take deposits). NPFF is more restricted in the loans it can make.

  • Insurance penetration is limited to 1.3 percent of GDP and density to US$25 per capita; only limited life insurance products are available.

  • The government does not generally finance itself (or major projects) by issuing marketable securities. Nu 2.5 billion of Treasury bills are outstanding and there are no longer term bonds.

  • Banks’ earnings derive mostly from net interest margins, with limited fees and commissions.

31. Rapid credit growth has taken place without significant growth in reported loan losses until recently. Banking sector capital has also been growing strongly, supported by high returns and capital-raising by the new and existing private sector banks. However, the economic slowdown increased NPLs from 8 percent at end-June 2012 to 12 percent at end-September 2013 (Table 4), potentially indicating latent problems that have not yet emerged.

32. There have been costs to the economy and banks themselves from rapid credit growth. Import demand has been stoked by activity supported by bank lending, especially for housing and construction (over 25 percent of the total), personal loans (18 percent) and transport (7 percent). The banks face greatly increased challenges in asset and liability management from balance sheets comprising traditional forms of lending (fixed rate, medium and long term) and increasingly short term, mobile and individually large deposits. Corporate deposits are now 60 percent of the total, while retail deposits are hard to mobilize, given interest rates of 5 to 7 percent up to two years against inflation of over 8 percent. Given the fixed rate, long-term basis of much lending, there is limited scope for banks to raise deposit rates without cutting into their net interest margin. There has also been a shift from term to demand deposits (now 55 percent of the total). The resulting mismatches have given risen to significant liquidity and interest rate risks in the banking system.

Figure 9.
Figure 9.

Bank Lending, End-June 2013

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: RMA and staff calculationse

33. These reforms have not, however, yet contributed to a broadening of the range of banking products, while the infrastructure falls short in other respects. The CIB has yet to stimulate wider availability of unsecured credit or lending practices (and loan pricing) based on the credit assessment of the individual borrower rather than on the sector, maturity, and availability of security. Most lending in Bhutan is collateralized, with loans typically an initial 75 percent of the security value. However, increasing numbers of borrowers in public and private sector employment have access to unsecured credit serviced directly from their salary payments. Other aspects of financial infrastructure have to be sourced outside Bhutan, including professional services such as accounting, audit, and actuarial. The financial statements of all Bhutanese companies are heavily reliant in practice on Indian accounting standards and audit practices.

34. The regulatory framework has been strengthened:

  • A new Financial Services Act was passed in 2011, updating previous legislation, strengthening the RMA’s independence from government and making provision for RMA to issue regulations (those issued include comprehensive corporate governance standards).13

  • Capital requirements applying to banks and insurance companies have been substantially increased since 2012 through changes to risk weightings.

  • Banks are now subject to base rate regulation that prescribes how rates are to be calculated, based on funding and other costs, subject to RMA approval. Publication of base rates is required, which is helping to improve transparency.

35. There remain significant gaps in regulation, however. The RMA has not yet issued all regulations mandated by law, including insurance risk requirements (i.e., basic requirements on valuation of liabilities, acceptable investments and a solvency margin).14 Limits on maturity mismatches between bank assets and liabilities, although provided for in the Prudential Regulations 2002, have not yet been set in practice owing to lack of readiness at banks and to skills and resourcing constraints at the RMA.15 Even allowing for the significance of lending, the RMA’s prudential requirements remain overly focused on credit risk, while other risks faced by financial institutions, including liquidity, interest rate, insurance, operational and foreign exchange risks, as well as risks in off balance sheet business, are addressed incompletely or not at all, in both regulation and supervision. Stress testing is not routinely undertaken and is not used by financial institutions, although the RMA has provided input to stress tests undertaken by the IMF. Pressure on resources in the supervision function contributed to a severe curtailment of onsite supervision work, although this is being reversed.

36. The RMA has been taking a more macroprudential approach to supervision and is working on its policy approach. The RMA responded to escalating current account pressures from 2011 with a series of monetary, foreign exchange, and supervisory measures. Capital requirements were increased significantly from end-2012, targeting sectors where banks had the largest exposure as a result of loan growth, and were increased further from the end of 2013. At the same time (November 2012), provisioning requirements and maximum gestation periods (the time over which loans must be disbursed) were eased. A new RMA Financial Policy Committee is coordinating macroprudential policy and has developed a policy framework for its approach, to be implemented through RMA Board-approved regulations from November 2014. There are limited specific crisis management arrangements in place. Deposit insurance arrangements are also now planned.

37. Some recent policy changes should have a positive impact on financial sector development.

  • A major project has been started by government to develop local accounting standards based on IFRS with a view to full IFRS implementation by 2021. For financial institutions, listed and large public sector companies, an initial 18 Bhutan Accounting Standards, likely to be complemented by International Auditing Standards, take effect for audits in 2014.

  • There are plans to develop a local accounting professional body with training accredited by one or more foreign institutes. These developments should over time increase the extent and quality of disclosures by financial institutions and other companies and address risks associated with reliance on foreign standards and practices.

38. Other policy initiatives may be hard to implement without some adverse impacts.

  • The licensing in 2013 of a new (Indian-owned) reinsurance company will create capacity within Bhutan (insurance companies currently cede large shares of premium income to foreign reinsurance companies); however, the RMA’s requirement that insurers cede to the new company a minimum of 20 percent of premiums across all lines may unduly favor that company over foreign competition and could lead to distortions in insurers’ risk management decisions, while raising costs.

  • The RMA’s April 2012 directive to insurance companies and the NPPF to plan for the discontinuance of existing and past lending activities by January 2015 rightly sought to address risks associated with the current combination of banking with insurance business. However, it does not by itself tackle the underlying lack of appropriate investments for companies seeking to invest premiums and manage significant insurance risks, including, in life insurance, some exposure to interest rate changes arising from long-term guaranteed savings products.16

  • The new RMA base rate system could stimulate improved loan pricing by banks and more lending at floating rates of interest (i.e., base rate plus a margin), but at the cost of reducing the flexibility for banks to compete on the basis of lending rates determined by themselves.

B. Developments in Financial Soundness

39. Financial soundness indicators for banks remain positive despite the shocks of 2012. Bank capital ratios vary but averaged 18.2 percent for the Capital Adequacy Ratio (CAR, minimum 10 percent) at June 2013. The Statutory Liquidity Requirement was also comfortably met (34 percent compared with a minimum 20 percent). Capital quality appears high. Most is in the form of equity and the average Tier 1 CAR was 14.9 percent at June 2013. The large share of loans in the balance sheet and high risk weights for some loans and for concentrated sectors results in high ratios of risk-weighted assets to total assets (90 percent) and low leverage ratios (6 times on average and as low as 4 times for one bank). Loan books are relatively concentrated, with individual exposures up to 25 percent of capital (the limit is 30 percent).

40. The capital position of banks needs careful monitoring, however, given gaps in the capital framework and the uncertain impact of recent risk weighting changes. Capital requirements are based on the Basel I framework, covering only credit risk and using a definition of capital that excludes all the deductions required under the latest international standards. The RMA has used changes in risk weighting percentages to fine tune overall requirements for macroprudential purposes. From end-2013, these will range from 300 percent for personal loans to 50 percent for agriculture.17 The impact of these changes will vary by bank but banks have argued that they could result in CARs falling by 3 to 4 percentage points. The new framework of risk weights does not, however, apply to off balance sheet business (most are 100 percent risk weighted), reducing the risk sensitivity of the new requirements and potentially creating opportunities for regulatory arbitrage.

41. There are uncertainties over bank asset quality given macroeconomic developments, and NPLs have already begun increasing as noted above. The recent depreciation of the Indian rupee may affect the quality of loans to borrowers with convertible currency liabilities. Provisioning levels are lower than they were in 2012 (averaging around 50 percent of NPLs) as a result of the relaxation in provisioning requirements in late 2012, which should be reversed.

42. Overall loan growth is already increasing again and would be boosted by government plans to ease bank liquidity, and credit standards need careful monitoring. Loan growth has continued, although at a lower rate since the RMA measures in 2012. Notwithstanding the RMA’s decision to cease making Indian rupees available for imports of vehicles and construction materials, bank lending for housing continues to rise, as disbursements continue under existing facilities, although lending to the transport sector has fallen. In recent months, total lending has been rising at a more rapid rate than in 2012.18 The government is proposing measures to support the availability of liquidity for bank lending to sectors which generate low demand for imports. It will be important to ensure that credit standards are not relaxed as banking sector liquidity eases. Banks have indicated that demand for loans remains high.

43. Collateral values are a key driver of loan loss and may be under pressure. Collateral values are reported to have fallen, including land prices in parts of the country where there was a surge in prices in the run-up to March 2012, which may lead to higher write-offs (loan losses have been limited owing to the prevalence of collateralized forms of lending). Revaluation practices appear to vary by bank, there are no generally accepted or widely-used price indices, and supervisory oversight of banks’ approaches to revaluation is limited.

44. Bank liquidity remains constrained and the Statutory Liquidity Ratio (SLR) does not take into account balance sheet mismatches and vulnerability to stress. Genuine high quality liquid assets that could meet prudential liquidity standards are limited given the low issuance of marketable government securities. In the circumstances, banks are rightly permitted to meet SLR using claims on other banks, but these may include interbank claims up to one year and real liquidity is dependent on RMA balances. Few banks meet the minimum SLR, when liquid assets (known as “quick assets”) are redefined to exclude such assets. In addition to extensive maturity mismatching (on which no supervisory information is collected), banks’ deposit books are concentrated, i.e. large deposits account for a significant share, mirroring the concentration of lending. Credit demand drives balance sheet management, leading to some high Credit to Deposit ratios, exceeding 100 percent for one bank at June 2013.

45. Stress tests of the banks based on end-2012 data conducted by the mission highlighted some vulnerabilities, varying by bank (Box 1). Tests based on end 2012 data (see Box) measured the adverse impact on banks of a number of credit risk and one liquidity shocks. The results highlighted a concentration of lending, and susceptibility to increased NPLs, whether a proportionate increase in current NPLs or increases in particular sectors. Under all the credit risk scenarios, a number of banks’ CARs fell below the 10 percent minimum and one bank’s ratio was below 10 percent on all three tests.

46. The financial soundness of the insurance sector is harder to judge in the absence of full prudential standards.19 The CAR and SLR requirements, although designed for banks, have some relevance to Bhutanese insurers given their significant credit risk. The minimum standards are met by both companies. Claims ratios are healthy. Insurance risk is limited on account of the extensive use of reinsurance, including for catastrophe risk (particularly earthquake in Bhutan). The RMA needs to monitor exposures to reinsurers and how these are managed. Life business has been written with high guaranteed returns, but amounts remain low.

47. The insurance sector faces significant challenges, including divestment of banking business. A priority for supervisors will be to monitor the impact of reduced premium income due to the slowdown in activity in some sectors (e.g., importers and purchasers of cars) and to continue to plan for the implications of insurance companies ceasing to act also as banks. Whether they divest their banking business into subsidiaries or cease operations altogether, a long transitional period may be required if the companies are to diversify from loans into a wider range of investments.

Stress Testing of the Banking Sector

Rapid credit growth in the previous 10 years, the run up in real estate prices, and entry by new banks highlight the need to closely monitor vulnerabilities in bank balance sheets. Stress testing provides a tool for quantifying vulnerabilities under specific macro-financial shocks, and bank-by-bank analysis is particularly important given the concentration of loans in the two large state-owned banks and the rapid growth by three new domestic private banks that began taking deposits in 2010. By 2012, the new banks already represented 18 percent of deposits and 24 percent of loans.

As of December 2012—the baseline for the stress tests—the banking system capital adequacy ratio (CAR) was 19.1 percent, with non performing loans (NPLs) of 8.2 percent and provisioning as a ratio of NPLs of 81 percent. Stress tests are described below in three scenarios involving credit risks and one involving liquidity risks:1

A proportional increase in NPLs scenario, in which NPLs increase from 8.2 percent to 18.4 percent—the level reached in 2008/09;

  • A sectoral shocks scenario, in which a certain percentage of loans become nonperforming in three sectors: construction and personal loans (50 percent become nonperforming), trade (10 percent), and tourism (20 percent);

  • A scenario entailing a souring of large exposures, in which a bank’s five largest loans need to be fully written off;

  • A liquidity shock scenario, in which 15 percent of baseline demand deposits are withdrawn each day for five days, and 95 percent of liquid assets are available for immediate sale.


Fall in the Capital Adequacy Ratio under Different Shocks

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: RMA and IMF staff estimates.

The findings of the stress tests are:

  • A souring of large exposures, which account for 13½ percent of total loans, lowers system-wide CAR by 8.6 percentage points, with a decline of 12.6 percentage points for one bank;

  • Sectoral shocks lower banking system CAR by 3.9 percentage points for all banks, and by 4.5 percentage points for private banks;

  • A proportionate increase in NPLs to 18.4 percent reduces the banking system’s CAR by 6.7 percentage points;

  • In the liquidity shocks scenario, all five banks remain liquid after five days despite the hypothetical deposit run, given the initial high level of liquid assets relative to demand deposits.

The results highlight a concentration of lending and susceptibility to increased NPLs in particular sectors. Under all the credit risk scenarios, a number of banks’ CARs fell below the 10 percent minimum and one bank’s ratio was below 10 percent on all three tests. Overall, the assessment is that the financial system is vulnerable to shocks, and close monitoring is warranted.

1 The analysis does not focus on other types of risks for the following reasons: for interest rate risks, because banks’ holdings of long-term government bonds are not significant; for foreign exchange risks, because banks do not have significant open foreign exchange positions; and for interbank exposure risks, because these exposures are small.

48. Looking ahead, there are vulnerabilities and financial institutions and the authorities need to adopt a more forward-looking approach. Balance sheets have been bolstered against potentially worsening credit losses, and economic indicators such as unemployment are relatively benign. However, the financial strength of individual institutions varies significantly. Moreover, for all the banks, recent liquidity pressures have highlighted serious asset and liability mismatches—preexisting but growing—as well as exposure to the sudden and severe measures (those of March 2012 in particular) to which the authorities had to resort to address financial imbalances in the absence of developed financial markets and functioning fiscal and monetary policy tools. Financial institutions are vulnerable to adverse impacts of future such measures. Given balance sheet mismatches, they would also face significant challenges in case of financial sector reform that exposed them to more volatile and particularly to rising funding costs.

C. Policy Recommendations

Regulation and Supervision

49. There are a number of areas where RMA should develop its approach, both in substance and supervisory process. The RMA’s approach has a number of strengths, including intensive offsite supervision, based on extensive and frequent reporting by financial institutions; oversight of the banks’ preparation of their annual accounts, including meetings with auditors and bank management; and a readiness to hold financial institutions to its standards (i.e., not granting waivers and exemptions) and to say “No” when necessary. However, regulatory gaps should be filled over time, and the RMA should consider how it can move from a relatively prescriptive approach in some areas (for example, bank base rates, requirements to purchase reinsurance, restrictions on guaranteeing corporate bond issues) towards one based more on holding management responsible for how they run the business, the supervisory role being to assess whether they are meeting that responsibility and to respond where they are not. All of these changes will require RMA to rebuild supervisory capacity through recruitment and training.

50. Priorities should include:

  • Ensuring that supervisors have a view of the full range of risks in financial institutions. This will require starting to use scenario and stress testing, for example requiring banks to quantify their key risks including credit, interest rate, liquidity and foreign exchange risks on the basis of certain assumptions or insurance companies to evaluate the impact of catastrophic events. In addition, the resumption of onsite work subsequent to the mission will be essential to monitor financial system soundness and to evaluate systems and controls, developments in credit standards and the adequacy of management and governance.

  • Developing a policy framework and issuing regulations in key areas where there are gaps, including prudential standards applicable to insurance and reinsurance, and bank liquidity. The latter needs careful consideration given the lack of high quality liquid instruments that would normally be at the core of any requirement for stock liquidity. The alternative is to develop a mismatch limit approach as envisaged in Section 7 of the Prudential Regulations, and it is recommended that the RMA begin with such an approach.

  • Developing a strategy for updating the bank capital adequacy framework in areas such as the definition of capital (introducing a minimum Core Tier 1 Equity concept from the Basel III framework), capturing operational risk (using the non-advanced approaches) and interest rate in the banking book (taking into account the results of stress tests that would help establish the extent of the risks); and developing a Pillar 2 framework to relate the capital adequacy of financial institutions to the supervisory assessment of risks in individual companies.

  • Using the results of the results of the deeper risk assessment of individual financial institutions to develop supervisory strategies in relation to each company, which would include challenging on business strategy, controls and financial strength; in particular, any weak banks should be identified and challenged to develop remedial action plans. With a small number of financial institutions, RMA is well placed to take a more bank specific approach to its supervisory work, which would also address the variable financial conditions of the individual institutions.

  • Developing a crisis management framework in case of a future bank failure. This should start with the authorities evaluating what additional information they may need in case of a crisis (for example, on immediately maturing liabilities) and ensuring that this information would be available at short notice, and making sure that practical preparations are in place, including updated contact details of key officials etc. In due course the work could extend to consideration of potential changes to the Bankruptcy Act to create a bank insolvency framework. In this context, it is important that planning for the introduction of deposit insurance resumes, as the availability of insurance can help support retail depositor confidence in case of crisis.

  • Developing a policy framework on its approach to setting new standards and regulations, covering consultation with financial institutions and preparation of impact assessments. A number of regulatory changes have been introduced at short notice without consultation or reference to RMA’s objectives, triggering pushback from financial institutions which it has sometimes been hard for the RMA to resist in the absence of its own impact analysis.

  • Strengthening its capacity in the framing of regulations and standards through the creation of a function within the Financial Regulation and Supervision Department dedicated to the preparation and promulgation of new standards.

51. The RMA should also build on its existing readiness to take macroprudential policy measures with:

  • A regular review of sector-wide risks, extending the analysis in the Financial Sector Performance Review; and

  • An internal policy statement on future choice and use of macroprudential tools.

The objectives should be to move away from the current reliance on one tool, the adjustment of risk weightings, and, in the current context, to ensure that supervisors seek to identify and address what may be the next source of stress rather than focusing only on present stresses related to current account pressures.20 It must be emphasized that macroprudential tools cannot substitute for an appropriate monetary and fiscal stance in addressing overheating pressures.

52. Debt-to-income limits should in particular be considered, in conjunction with the development of monetary policy tools. Some macroprudential tools used in other countries appear to have limited relevance at present. Loan-to-value ratio limits would have limited impact given that high levels of collateralization are part of established lending practice. Limiting credit to deposit ratios could be introduced if and when money and capital markets develop, at which point banks would have the scope to manage balance sheets to meet such minimums. Making monetary policy implementation more effective should be the starting point and priority. However, the RMA could also consider setting debt-to-income ratio limits, which have been effective in other countries, and may also support increased focus on individual credit assessment. Limits on overall credit growth could be considered but would be hard to calibrate.

53. The authorities also need better to distinguish macroprudential measures from those designed to encourage lending to particular sectors and to take action preemptively. Recent changes to risk weighting have been driven mainly by analysis of risks in bank lending, but are also designed to encourage lending to targeted sectors such as agriculture—reflecting the wider government objective to stimulate sectors with lower demand for imports. The adequacy of overall capital requirements resulting from recent changes is hard to assess, and the RMA’s recent increases are consistent with a higher risk environment, but increasing the requirements at an earlier stage (for instance as proposed in early 2012) might have helped moderate the rapid build-up in credit.

Developing the Financial Sector

54. A number of obstacles have frustrated the development of Bhutan’s financial markets, notwithstanding the significant expansion of the banking sector. The challenges include:

  • The absence of fully market-determined interest rates and the development of a yield curve to support pricing in financial markets generally.

  • Inflexibility in credit provision—entrenched approaches to banking products and services, partly reflecting the absence of any alternatives to bank finance, limited openness to foreign participation and low penetration of technology.

  • Limited availability of risk management instruments—in insurance (i.e. limited scope of products, especially for life insurance and low penetration generally) and no scope for hedging of risks through financial transactions.

  • Still limited infrastructure and business services, with no ratings agency, other sources of independent evaluations of risk in financial assets or local accounting, auditing and actuarial services; and limited expertise in modern finance.

  • Government ownership and control of large parts of the economy, limiting the scope for broader participation in ownership of financial assets. (The government is committed to retaining its most significant interests.)

  • Limited understanding of finance amongst investing public.

  • The difficulty of achieving scale in a country of only 700,000 people.

55. Equally, Bhutan has a number of advantages that could be exploited:

  • Institutional and high net worth investors including the NPPF, life insurance, the funds of the new fund management company, and DHI which manages the government’s investments and investor interest from abroad.

  • A number of large public and private sector companies with a need for longer term finance and a government with a deficit to finance.

  • A legal framework that is broadly understanding of and ready to support the enforcement of financial contracts.

  • High quality infrastructure in payments and settlement.

  • Policy-makers ready to take a strategic approach as evidenced, for example, by the government project on accounting and auditing standards.

56. While a number of initiatives have been taken, and improvements in supervision and regulation will contribute, more is needed. The recent expansion of the financial sector has contributed to financial development by bringing in foreign capital and expertise and adding to listings on the RSEB. Developing regulation and supervision will have the same effect. Strong supervision that, for example, addresses weak banks and requires all banks to recognize full costs of their lending decisions (for example, by addressing the risks in maturity mismatches), will support the better allocation of resources through bank intermediation as well as promoting confidence and helping to safeguard financial stability. Good supervisory process enables institutions to plan for the development of their business. However, more is required.

Strengthening Monetary Operations

A. Overview

57. Bhutan has a potential to make monetary policy contribute more effectively to macroeconomic stability and financial sector deepening, despite a number of constraints. Due to the peg to the Indian rupee, exchange rate changes cannot be used for macroeconomic adjustment. As monetary transmission through interest rates also is weak (or non-existent), there is a need to deepen financial markets, starting with an interbank market and short-term securities market and continuing with to government and corporate bond markets. The room for an independent monetary policy is limited due to the exchange rate regime, but there should be sufficient scope to build a meaningful interest rate transmission channel.

58. The RMA has until recently neither had the mandate nor the instruments to develop a monetary regime to address the challenges of operating under the fixed exchange rate regime. The new RMA Act of 2010 has given a clear mandate to pursue price stability as the primary objective while secondary objectives include regulation and supervision of the financial system. As a central bank, the RMA now has the independence to formulate and implement a monetary policy adequate to meet its objectives. However, to a large extent, the monetary policy function has since becoming a full-fledged central bank had a focus on dealing with a shortage of Indian rupees in the context of limited rupee reserves. Although this is a complex problem which has been building up over a long period, part of the unsustainable expansion of credit has been caused by high levels of excess liquidity in the banking system over several years. Also for this reason, it is important to establish a liquidity management system with effective market-based instruments which can contribute to macro stability in the future and prevent recurrence of the rupee problem.

59. Active liquidity management is the starting point for improving monetary transmission. This is important under a fixed exchange rate arrangement as in other monetary regimes. A strong focus on balancing and controlling short-term developments in bank reserves is a precondition for establishing an interbank market. Although the distribution of liquidity across banks is uneven and bank reserves are displaying large swings, a banking system which now consists of five banks should accommodate interbank trading of short-term funds (see Figure 10). As discussed below, the liquidity management framework has to provide stable and predictable incentives to induce individual banks to plan and take responsibility for their own liquidity, as described in Section C below. By giving commercial banks the right incentives to manage their liquidity, the resulting interest rate from the transactions in the interbank market will in turn affect other money market interest rates and influence the term structure of interest rates.

Figure 10.
Figure 10.

Banks’ Current Accounts with RMA (Excess Reserves), January 2012 – August 2013 (weekly)

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: RMA.

60. More active and deeper money and credit markets will absorb and smooth out erratic fluctuations and provide more stability through market determination of interest rates. From this basis, the interest channel for the transmission of monetary policy impulses will evolve, which will improve the central bank’s potential to implement an effective monetary policy in the future.

B. Government Securities Market

Present Situation

61. Treasury bills were introduced in December 2009 to replace RMA bills with the objectives of improving government cash management, allowing the use of market-based instruments of monetary policy, and providing a benchmark for short term interest rates. These objectives have not been met because of erratic issuance, unpredictable and insufficient amounts, small market size, limited market participation, and the lack of other financial instruments (see Figure 11).21

Figure 11.
Figure 11.

Government Financing, July 2011-July 2013

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Sources: RMA and MoF

62. Treasury bills are also not being issued at market-determined interest rates. The issuance of Treasury bills started out as a conventional market auctions, but the MoF found it difficult to accept the interest rate outcome. Since February 2013, the interest rate has been fixed at 3 percent which is far below deposit interest rates and RMA’s policy rate. A so-call “tap-sale” mechanism has been used in which the MoF determines the interest rate and the amount. On redemption, Treasury bills are often rolled over and the same holders keep the security at unchanged interest rates. Maturities have varied from 14 to 90 days, with issuance primarily at 30 days.

63. Despite a substantial financing requirement in recent months, the government has continued to rely on bank financing rather than T-bill issuance. First, an overdraft facility (OD) is available at the RMA up to a limit determined as 10 percent of average revenue over the last two years. This limit was recently raised from Nu 1.9 billion to Nu 2.1 billion reflecting this guideline. The RMA charges an interest rate, currently 4 percent, at 1 percentage point above the rate for the most recent Treasury bill issuance. Second, the Ways and Means (W&M) account with the largest commercial bank (BOBL) can be overdrawn without a limit. The interest rate charged is currently 5.5 percent. As shown in Figure 11, the government will first utilize the cheaper overdraft in RMA before making use of Ways and Means. It is also noticeable that the issuance of Treasury bills has to a large extent been detached from the financing requirement. In the period under review, Treasury bills have not been issued for monetary policy purposes.

Discussion and Recommendations

64. Developing a government securities market is the most critical element for making monetary policy more effective and for enhancing financial markets in Bhutan. The availability of sufficient amounts of government securities at market-determined rates will provide a range of benefits. First, financial institutions will be given an investment alternative which at present is lacking for necessary portfolio adjustments and liquidity management, including meeting prudential liquidity requirement. Second, the central bank will directly and indirectly have a basis for effectively managing banking sector liquidity. Third, the government will have access to market financing necessary for efficient cash management. Finally, building a (risk-free) benchmark yield curve will have a number of positive externalities for financial sector development.

65. The current arrangements for financing the government hamper the development of a Treasury bill market and money markets more generally. The main sources for financing of government should be gradually shifted from bank to market financing as the government cash management improves and the financing requirement can be covered through an operational issuance program of Treasury bills. At that point, the Ways and Means account with a commercial bank should not be allowed to be overdrawn and the use of the overdraft facility in RMA should be made more restrictive. Even though drawings stay within the legal limits, this arrangement weakens incentives to strengthen government cash management.22 Consideration should be given to limiting direct access to financing from the central bank to emergency situations in which access to other funding sources is difficult. Moreover, overdraft drawings should have a limited maturity and not generally be rolled over. This would put additional pressure on the Department of Public Accounts to impose strict discipline on budgetary agencies to follow their cash plans and give incentives to an active management of public debt.

66. Although the main responsibility for a meaningful Treasury bill issuance program rests with the MoF, the central bank has also an obligation to persistently promote the development of a short-term securities market. Without such a market, the implementation of monetary policy will be less effective and the transmission of interest rates more limited. It must therefore be a joint responsibility of the MoF and RMA to establish a reliable issuance calendar for Treasury bill and to ensure that meaningful amounts are issued also when there are no immediate financing needs of the Government. Establishing an issuance calendar of Treasury bills (used for fiscal and monetary policy purposes) will require a proven capacity at the central bank to forecast liquidity and at the Ministry of Finance to forecast government cash flows.

67. The arrangement in place for using Treasury bills both for government financing and monetary policy purpose should be fully utilized.23 This is a progressive and forward-looking decision by the authorities which could have important advantages for market development and the use of RMA bills should not be resumed. A combined issuance program using Treasury bills for both fiscal and monetary purposes would broaden the basis for establishing reference rates for the pricing of financial assets. On its part, the RMA should for liquidity management purposes preferably issue Treasury bills with shortest maturities, with maturities and amounts being determined by the expected liquidity management needs. Issuance of Treasury bills for both fiscal and monetary purposes will necessitate robust arrangements to prevent the government from utilizing the liquidity that has drained from the system for monetary policy purposes, as well as an appropriate communication strategy with market players to communicate the policy direction.

68. Market financing of government cash requirements and liquidity absorption at market rates will imply increased costs to the budget and to the RMA. These costs are outweighed by the benefits of having a more developed financial sector and better tools for achieving stability in the economy. It is also not obvious that the cost of Treasury bill issuance for monetary purposes should be born exclusively by the RMA. The present arrangement as specified in the November 2009 Memorandum of Understanding (MoU) clearly states that the cost of Treasury bills issued for monetary policy purposes should be borne by the RMA. In general, providing liquidity to the banking system generates interest earnings for the central bank while draining liquidity using market-based instruments carries costs. Too much focus by a central bank on the profit position may defer necessary market operations.

69. It is important to establish an acceptance that the cost of monetary policy ultimately—directly or indirectly—must be borne by the budget. This is because the finances of the government and the RMA must in the final analysis be considered on a consolidated basis. Taking sterilization costs directly into the budget—for example through the issuance of Treasury bills for monetary policy purpose—may be a better alternative than having to repeatedly recapitalize the central bank.24 In order to provide certainty to the institutional arrangement safeguarding RMA’s financial position and its ability to conduct monetary policy, the RMA and the MoF could consider adjusting the existing MOU on this point. A binding cost-sharing arrangement should be established in which the government’s willingness to protect the central bank for taking on these costs as part of implementing monetary policy is clearly stated. The revised MOU should specify how the RMA could be reimbursed for the costs that cannot be absorbed on its own balance sheet in connection with issuing Treasury bills for sterilizing liquidity. This would support to the independence and autonomy of the RMA. Public knowledge of such an arrangement will strengthen confidence in the RMA, as it would not be constrained by profit considerations when it needs to tighten monetary policy. Although the Treasury bills issued for different purposes are identical for the investors, there should be full transparency as to the distribution of issued amounts between the MoF and RMA.

70. Apart from cost sharing, cooperation and coordination between the MoF and the RMA on debt and liquidity management should be strengthened. While the management of public debt is clearly the responsibility of the MoF, the RMA should be given the opportunity to comment on the debt strategy before final decisions are taken. The choice of instruments, maturities, and amounts may have implications for monetary policy implementation and should therefore be factored in, if possible. The existing Treasury Bills Management Committee should meet regularly (e.g. weekly)25 and be fully used as a platform for sharing all relevant information in relation to the implementation of fiscal and monetary developments between the two institutions on an ongoing basis. Furthermore, in determining the short-term borrowing requirement of the government, there should be some flexibility to take into account factors which can influence RMA’s liquidity management.

71. The technical infrastructure supporting a Treasury bill program needs to be strengthened. At present, the ownership records are maintained in an Excel spreadsheet at the RMA. An automated depository system should be developed to facilitate transfer of ownership resulting from secondary market trades and allow for temporary transfers in connection with the use of securities as collateral and in repurchase transactions. Ideally, the depository should be integrated with the payment system to ensure delivery versus payment. As the payments system recently adopted by the RMA is based on the RBI system, the RBI could be approached for support in extending this system to include a depository.26

72. Along with the technical infrastructure, a viable Treasury bill program should also be supported by market infrastructure. This should include regulations and market practices, and clear guidelines for trading and settlement. The RMA should assume the main responsibility for this task, in close collaboration with MoF.27 It would be useful if the traders themselves established a Code of Conduct. For example, under the umbrella of the Financial Institutions’ Association of Bhutan (FIAB), a forum of bank treasurers should be set up. One of the first tasks of this group should be to discuss and adopt a Code of Conduct for trading in the domestic money market and, perhaps, foreign exchange market. This activity should be utilized as a vehicle for training and increasing trading skills among bank treasurers.

C. Enhancing Monetary Operations

Present Situation

73. The RMA continues to rely heavily on direct instruments and administrative intervention to implement monetary policy. As such, the use of the reserve requirement (cash reserve ratio (CRR)) and liquidity regulations (SLR) have been central tools. Banks have separate CRR accounts, and there is not a provision for banks to meet the requirement on average during a maintenance period. Efforts have been made to move in the direction of more market based instruments, but the use of RMA bills and, more recently Treasury bills, has not achieved the intended objectives. In connection with the rupee stabilization measures introduced in March 2012, a number of new monetary policy instruments were announced with the intention to make monetary policy more effective. This included a “lender of last resort” facility (RMA Short-Term Liquidity Adjustment Window (RSTLAW)) which would provide funds up to 90 days. This facility was priced 1 percentage point above the Policy Rate which also was introduced. It is currently set at 6 percent. The facility has been used only once, mainly because banks lack collateral but also reflecting excess liquidity. The intention was also that the Policy Rate should set the price for central bank funds in ordinary market operations, but as such operations have not yet taken place the Policy Rate has so far had no practical purpose. Base rate regulation was also introduced (see above) with the aim of increasing transparency and improving the transmission of monetary policy. While there may have been some positive effects in meeting the first objective, it does not appear that transmission has been improved by the introduction of base rates.

74. A fairly recent administrative measure to influence banking system liquidity is to sweep balances of selected accounts in commercial banks to the RMA overnight. This is a normal practice in connection with the management of Treasury Single Accounts (TSA) in central banks where funds collected by commercial banks or any unused balances on settlement accounts are swept overnight to the central bank. In Bhutan, sweeping has been used to manage liquidity, and the practice has been extended to a number of large accounts (currently 8), including mostly, but not only, hydropower project accounts. The daily amounts involved vary between Nu 500 million - Nu 1.2 billion. The sweeping was discontinued at the end of May 2012 when liquidity became tight, but was resumed in the beginning of July 2013. This indicates that although the stated objective is to sterilize volatile hydropower related funds, the measure has also been used as a general liquidity management tools (see discussion below).

75. There is a limited interbank market in Bhutan, with banks and other financial institutions making unsecured placements with each other on a regular basis. These placements are almost never short-term, and normal maturities range from 90 days to one year. The interest rates are said not to fluctuate much (according to a “gentlemen’s agreement”), but follows the interest rates for corporate deposits. An indication of this activity is shown in the Figure 12 below. Both demand and time deposits with other banks qualify as Quick Assets in relation to the SLR, and bank placements make up about one-third of all Quick Assets.

Figure 12.
Figure 12.

Banks’ Placements with Other Domestic Banks, January 2012-June 2013 1/

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: RMA.1/ Only quarterly data is available for 2013.

76. There are no foreign exchange transactions between banks, and banks are only allowed to deal in foreign exchange with their customers at rates fixed by the RMA. The RMA fixes buying and selling rates daily based on the US$/INR closing rate the day before. Banks are obliged to use these rates in their retail transactions and they are not allowed to make transactions within this margin. (Under a similar system in India, banks are allowed to trade within this margin). Banks can at any time sell convertible currencies to the RMA when they are approaching a fixed limit (US$10 million for larger banks and US$5 million for smaller banks). All sales and purchases of foreign exchange with the RMA take place at the mid-rate. This arrangement gives no incentives to interbank trading.

Discussion and Recommendations

77. An operational liquidity framework will be an important mechanism to develop the capacities for formulating monetary policy and analyzing financial stability. By monitoring the factors influencing liquidity developments and banks’ behaviors, the central bank can develop a better understanding of current and future trends affecting liquidity developments in the banking sector. The standard approach for most central banks is to make forecasts in order to observe banks’ reserves and calibrate open market operations to deal with disrupting fluctuations. Technical assistance has been given in the past to set up a liquidity monitoring framework, but availability of data to the RMA has made the updating very difficult. As the most difficult and important data input is government cash flows, the ongoing TA to the Department of Public Accounts on cash management and the introduction of a TSA should improve the basis for liquidity forecasts. It is important that the RMA becomes involved in this work so that the cash flow projections can be directly entered into the liquidity forecasts. Cash flow forecasts would also need to reflect information about large hydropower related flows. It is important to note that not all cash flows have immediate liquidity effects, such as foreign exchange transactions and other transactions between the government and RMA. Under a fixed exchange rate arrangement, the RMA should develop its capacity to offset domestic sources of volatility in bank reserves to avoid corresponding adverse fluctuations in interest rates.

78. The reserve requirement system (CRR) should be redesigned to enable reserve requirements to be more effective as a supplement to other monetary instruments. In particular, the practice that required reserves are kept in separate CRR accounts should be changed. Banks should have only one account with the RMA which should be used to meet the reserve requirements as well as serving as an ordinary settlement account. Having one current account in RMA would also make it possible to allow banks to meet the reserve requirement on average over the maintenance period. The averaging mechanism would provide more flexibility in banks’ liquidity management and reduce the demand for excess reserves. In an averaging system, individual banks may draw on their reserve account in case of unexpected liquidity needs, but they would then have to overfulfill later in order to meet the requirement. This gives the banks more responsibility and incentive to manage their own liquidity more actively, which in itself is a precondition for improving the monetary transmission mechanism. The current practice that the RMA makes the posting on the banks’ reserve account will become unnecessary. At the present relatively low level of the reserve ratio (5 per cent), this is now a good opportunity to make the change. Should the ratio increase in the future, the averaging provision could be combined with a minimum daily requirement in order to limit the potential for a large reserve drawdown on any given day. This floor could be lowered as experience with the new system increases. At the end of the maintenance period, non-fulfillment should be penalized.

79. Reserve requirements are an effective but a blunt instrument which should be used with care. The RMA has (understandably) actively used changes in the reserve ratio in response to tight liquidity resulting from the measures taken in March 2012 to deal with the rupee shortage.28 The RMA should in the future avoid frequent and large changes in the cash reserve ratio, as this can be disruptive for financial intermediation. Changes in the reserve ratio have a direct impact on the money multiplier and reserve requirements generally serve as a tax on financial intermediation, which may result in wider spreads between retail deposit and lending rates. As the reliance on market-based instruments in liquidity management increases, large and frequent changes in the reserve requirement should not be necessary.

80. The application of sweeping is an administrative tool for direct regulation of liquidity and should not be used as a general liquidity instrument as alternative tools are developed. Future use of this arrangement should be analyzed and clarified in cooperation with commercial banks. Although the arrangement can serve a useful purpose, namely to sterilize huge, very short-term and potential destabilizing funds in connection with the hydro-power projects, the selection of accounts could be reviewed.

81. With a stronger focus on short-term liquidity management, the RMA should consider introducing a short-term standing lending facility. The RSTLAW is much too long term, and banks need to become more active and responsive in their short-term liquidity management. Many central banks have introduced an overnight standing facility, which allows banks to borrow funds overnight. The arrangement should normally not be extended beyond overnight, to give banks incentive to repay any outstanding balances in the morning when the interbank market opens. As it will take time to develop an interbank market in Bhutan, the short-term facility could be extended to, say, one week. To encourage banks to first try to find the funds needed from other banks before making use of the central bank facility, the short-term loan facility should be offered at a reasonably penal interest rate relative to the cost of borrowing in the interbank market. This interest rate on the facility should be determined by the RMA, and it will normally form the ceiling for the interbank market rate. The purpose of the facility is therefore to induce banks to take a reasonable risk in their liquidity management which will help to increase activity in the short-term money market and reduce interest rate volatility. Access to the RMA standing loan facility would be at the discretion of the banks that have appropriate collateral. It is important that occasional use of this facility should be considered as a normal part of a bank’s liquidity management, and no stigma should be attached to frequent drawings.

82. It should be emphasized that the standing lending facilities are meant only to provide very short-term liquidity support. Banks with longer-term liquidity problems or structural liquidity needs in the banking system should be addressed through other measures. The RMA should consider the need for introducing a properly designed Lender-of-Last-Resort (LoLR) facility for banks that are faced with longer-term liquidity problems. The already existing RSTLAW, which can extend credit up to 90 days in the form of an overdraft, could perhaps serve such purpose in the meantime should the need arise.29 LoLR support should not be considered as part of monetary policy implementation, although the liquidity effects of longer-term support have to be taken into account.

83. Many central banks have also introduced a standing deposit facility to provide an interest rate floor in the interbank market. As a standing facility, banks can deposit any excess funds overnight at their discretion. Similar to the overnight lending facility, the interest rate on the deposit facility should have a penalty element in the form of a low rate and be lower than the deposit rates offered in the interbank market. This should discourage its use and provide incentive to first try to place available funds in the interbank market. The need for a standing deposit facility is not pressing in Bhutan, but such a facility would in due course assist monetary policy in case of a sudden capital inflow by preventing interest rates from falling significantly (and in this respect be an alternative to sweeping). The cost of these operations has to be kept in mind, as the RMA would need to pay interest on all excess reserves. A standing deposit facility will only become relevant when the RMA is able to manage the banking system liquidity in such a way that the use of the standing facilities would be for marginal funds only. The RMA should consider introduction of these tools in the context of a broader package aimed at fostering market development and effective monetary policy implementation.

84. As part of a more market-based monetary policy framework, some increased flexibility also in the foreign exchange market should be considered. Banks could—as in India—be allowed to determine the exchange rate for transactions with their retail customers within the margin prescribed by the RMA. Allowing banks to compete on price for attracting foreign currency transactions is necessary to create a more competitive environment. Banks should also be allowed to sell foreign exchange a bit cheaper as part of their overall banking relations with their customers. Also, the foreign exchange transactions between the RMA and the commercial banks should not be at mid-rate and available at all times. As a start, the RMA should provide a daily window (at a fixed time) with a buy and sell rate around a parity rate of the USD/Nu rate determined on the basis of the US$/INR market rate. This would give banks an incentive to obtain a better price from each other. At a later stage, the RMA should only open the window on a few predetermined days during the week. A functioning inter-bank market is internationally the main mechanism for facilitating an efficient distribution of foreign exchange from institutions with a surplus to institutions with a deficit. Giving banks incentives to become more responsive and active also in this area will support the orientation toward a more effective implementation of monetary policy. This established practice of stable interest rates appears to have contributed to the build-up of substantial maturity and interest rate mismatches on banks’ balance sheets.

D. Strengthening Monetary Transmission

Present Situation

85. The transmission of interest rates is currently weak in Bhutan. Despite large swings in banking system liquidity and macro-economic developments, banks’ retail deposit and lending rates have remain remarkable stable (see Figure 13). Although banks are in principle free to determine their interest rates, there appears to have been limited attempts to make adjustments in their portfolios by changing their interest rates.30 As discussed earlier, there has also been very limited impact on bank funding costs coming from monetary policy instruments, such as Treasury bills (see Figure 14).

Figure 13.
Figure 13.

Banks’ Deposit and Lending Rates (mid-rate), 2002-Aug 2013

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: RMA.
Figure 14.
Figure 14.

Treasury Bill Activities, July 2011-July 2013

Citation: IMF Staff Country Reports 2014, 178; 10.5089/9781498357708.002.A004

Source: RMA.

Discussion and Recommendations

86. Liquidity management should aim at influencing the functioning of money and securities markets. This would strengthen the transmission channel through interest rates and pave the way for changes in the rates determined by the central bank (policy rates) having an effect on the economy through changes in bank retail interest rates and asset prices. A reasonably competitive and responsive banking sector is necessary in order for interest rates to respond to changing market conditions so that the allocation of funds from savers to debtors in the retail market is influenced in the desired direction. Usually, there are two important interest rate transmission mechanisms. The first goes from the policy rate to the interest rates in the wholesale interbank and Treasury bill markets. As these interest rate changes are influencing the banks’ cost of funds, the second channel will lead to adjustments in banks’ retail deposit and lending rates. By integrating the two channels, the transmission of monetary policy decisions would become significantly stronger. The challenge for most central banks trying to influence interest rate transmission through changes in the policy rate is to have a liquidity management framework that ensures short-term market interest rates are determined close to the policy rate. It is also important in a fixed exchange rate regime that changes in the policy rate can be used to correct market interest rates from diverting too much from the interest rate of the anchor currency.

87. Developing these transmission channels in Bhutan will take some time, particularly as banks’ current lending practices should be changed. Because banks mostly lend medium to long term at fixed interest rates, a tightening of monetary policy with corresponding increase in funding costs will have a first-round effect of declining profits and perhaps capital depletion. The effect on bank lending and on overall demand would be stronger if interest rates on existing loans could be adjusted, and not only the interest rate on new loans.

88. In practical terms, liquidity management should attempt to ensure stability in bank reserves in order to establish a link between quantities (bank reserves) and the price of reserves (market interest rates). Large volatility in banks’ reserves makes liquidity planning by banks difficult and without a consistent framework to absorb large swings in liquidity flows, it will be difficult to establish an interbank market. In addition to monitoring and forecasting the supply of reserves, the approach must also be to determine banks’ demand for reserves and “true” excess reserves (or surplus reserves).

89. For Bhutan, the demand for bank reserves is primarily linked to the banks’ need to meet the reserve requirement (CRR) and the liquidity requirements (SLR). The latter is unusual as banks normally will meet prudential liquidity requirements with other interest bearing assets rather than unremunerated current accounts at the central bank. A credible Treasury bill program, as discussed earlier, should provide more appropriate assets for meeting the SLR in the future. In any event, banks often may want to hold additional reserves over the legally required minimum (CRR or SLR) for clearing purposes and other contingencies. This portion of banks’ reserves is often referred to as banks’ “own demand” for reserves. Banks’ own demand cannot be directly observed, but has to be estimated or critically assessed in some manner. Surveys can be used as a starting point to capture banks’ expressed preferences, but they should be supplemented by frequent contacts with individual banks. In a liquidity framework with a focus on bank reserves, it will be necessary to manage “true” excess reserves (also referred to as surplus reserves), which is the residual portion above statutory requirement and banks’ own demand.

90. In order for the link between banks’ reserves and market interest rates to work efficiently, the market for bank reserves should be in approximate balance. Any “surplus reserves” held beyond the demand for reserves will then become particularly important for liquidity management. A rise (decline) in surplus reserves will normally induce banks to expand (reduce) their balance sheets and to lend more (less) on the interbank market, putting downward (upward) pressure on short-term interest rates. An analysis of the interrelationship between the level of surplus reserves and interest rates will become important in a monetary regime with interest rates as the operating variable.


91. Notwithstanding substantial progress with key financial reforms, recent experience has shown that Bhutan needs a comprehensive strategy for deepening and broadening the financial sector. Accomplishments have included new entry into banking and insurance, amendment of the Royal Monetary Authority (RMA) Act and passage of the Financial Services Act, and improved financial infrastructure including a new payments system, credit bureau, and collateral registry. However, financial institutions’ risk management has not kept pace with the five-fold increase in credit/GDP in the last decade, and assets are not available for liquidity management or investment diversification. Growing liquidity and interest rate mismatches need to be addressed by the regulatory framework. Furthermore, there is a risk that ad hoc measures may create uncertainty, increase vulnerabilities, and impede financial sector development.

92. A comprehensive Financial Sector Development Strategy (FSDS) is needed aimed at improving the ability of the financial system to contribute to long-term economic growth by channeling savings efficiently to productive investments in a sound and stable financial environment and by providing opportunities to smooth consumption and manage risk. A broader range of financial assets is needed, most importantly government debt with a range of maturities to provide a benchmark yield curve, but also public and private equity, corporate bonds, and micro-finance. Monetary policy could be made more effective by developing financial markets, starting with an interbank market and short-term securities market and continuing with government and corporate bond markets. It must be a joint responsibility of the MoF and RMA to promote the development of a short-term securities market. The strategy would also strengthen regulation and supervision while broadening access to the financial system of excluded groups. It would encompass a detailed, prioritized, and sequenced action plan to address gaps and vulnerabilities while deepening and broadening in the financial system and would benefit from consultation with relevant stakeholders. It is recommended that the strategy forms part of a masterplan that would also include a financial sector review and diagnostic covering both the bank and non-bank financial sectors and the establishment of a mechanism to monitor the implementation of the strategy and coordinate technical assistance.

93. There are also opportunities for enhancing affordable access to financial services, in the context of the authorities’ Financial Inclusion Policy; identified priority areas for strengthening of regulation and supervision of banks and non-banks; recommended measures to enhance monetary operations and monetary transmission; and suggested areas for future technical assistance.

Table 3.

Detailed Recommendations

article image
article image

Pilot cases thus far have included Benin, Ghana, Haiti, Senegal, and the West African Economic and Monetary Union, and Haiti.


This document reflects information available as of the September 2013 mission, except where noted.


Although Bhutan primarily needs Indian rupees for trade settlement and debt service, with de facto full convertibility for rupee (but not convertible currency) current and capital transactions, the Constitution of Bhutan stipulates that foreign currency reserves of at least one year’s “essential imports” must be maintained.


Data exclude lending by insurance companies and the state pension fund.


These characteristics are GDP per capita, population size and density, young and old age dependency ratios.


See “Bhutan: Selected Issues”, Chapter II on “Rapid Private Sector Credit Growth, Macroeconomic Risks, and Financial Sector Soundness”, IMF Country Report 07/349.


Two new banks were licensed, one a subsidiary of an Indian state-owned bank and the other owned by private Bhutanese investors. Both have been listed and issued shares on the Royal Securities Exchange of Bhutan (RSEB), meeting a legislative requirement that any new financial institution is at least 40 percent public. The established development finance company has also been licensed as a bank.


See World Bank, Connecting the Disconnected: Coping Strategies of the Financial Excluded in Bhutan, 2013.


Factoring is a financial transaction in which a business sells its accounts receivable to a third party (called a factor) at a discount.


The January 2010 follow on survey included interviews with banks which corroborated banks’ difficulty in evaluating creditworthiness of borrowers in the absence of financial statements and requiring the use of collateral.


Bhutan Enterprise Survey, World Bank Group, 2009.


Other acts that address financial consumer protections through increased competition and an enabling environment in the financial sector include the RMA Act 2010, Prudential Regulations 2002, Financial Services Act of Bhutan 2011, Corporate Governance Regulations 2011, and Moveable and Immovable Property Act of the Kingdom of Bhutan 1999, among others.


Also issued were Regulations for Fund Management Companies in 2011; Investment Advisors Regulations, 2011; Insurance Brokers Regulations, 2011; and Securities Brokers Regulations, 2011.


Draft regulations have been prepared by a consultant and a revised version was in preparation at the time of the EFSS mission, drawing on consultancy services funded by the Asian Development Bank.


The RMA is actively working with consultants funded by the Asian Development Bank on a reporting format for banks to use (only one bank has been able to make reports under the existing format) and on developing supervisory expertise in the area of asset and liability management.


The directive was lifted subsequent to the mission, and the authorities are now developing investment guidelines for non-banks to encourage them to gradually lend less.


The RMA has made clear that this new framework is an interim measure and will be reviewed after six months, taking into account how financial institutions respond.


Lending by banks grew at a rate of nearly 5 percent in the second quarter of 2013 compared with rates of less than 2 percent per quarter since the measures introduced in March 2012.


Regulations have been drafted but implementation has been delayed by conflicting technical assistance recommendations.


Subsequent to the mission, the authorities issued proposed regulations to introduce a range of new tools, including countercyclical capital buffers, loan-to-value and debt-to-income limits, sectoral capital requirements, restrictions on profit distributions, and dynamic provisioning. The MCM department has offered to provide a desk review of the proposed framework which is now being revised.


See RMA Annual Report 2011–2012.


TA is currently being provided to MoF by the IMF Fiscal Affairs Department on developing cash planning and cash management.


An MOU between MoF and RMA of November 2009 gives the RMA the authority to issue Treasury bills for monetary policy purposes; this arrangement replaces the earlier use of RMA bills.


Proceeds from issuances of government securities for monetary policy purposes would be placed in a blocked account where they would not be available for financing government expenditures.


The present arrangement specifies that meetings should take place as and when necessary but not less than once a quarter. In a dynamic market environment, with an active Treasury bill issuance program, the frequency of meetings should be considered.


The Royal Securities Exchange of Bhutan (RSEB) has a depository in place for debt instruments. While multi-year government bonds may be listed and traded at the RSEB, it is generally advisable to start the infrastructural development with a separate depository—most often in the central bank—for Treasury bills (and other money market instruments). In addition to fast and secure settlements, this will allow for Over the Counter (OTC) trading which has proven to be the most effective way for developing a secondary market for these instruments.


This is also the recommendation of a Fiscal Affairs Department mission.


The reserve ratio was reduced from 17 percent to 10 percent in March 2012 and further to 5 percent in June 2012.


To grant commercial banks an overdraft facility in the central bank, for any period, is unusual. Standing facilities should be available for covering unexpected short-term liquidity needs; 90 days are in the context of short-term liquidity management much too long.


Data on interest rates are limited and only ranges of interest rates in various categories of deposit and lending are available.

Bhutan: Staff Report for the 2014 Article IV Consultation
Author: International Monetary Fund. Asia and Pacific Dept