Abstract
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. On behalf of our authorities, we thank the staff for a comprehensive and well-written report, which reflects a strong understanding of the economic dynamics and macroeconomic challenges faced by Bhutan. Our authorities appreciate the Mission’s hard work and diligence in discussing the issues with Bhutanese authorities in a collaborative manner, for their efforts to include and cover issues of importance to the authorities, and for providing assistance with requests for technical assistance and in institutional capacity building. Our authorities broadly share the staff’s assessment.
Recent Economic Developments
2. The Bhutanese economy recorded strong growth during the 10th Plan (2008–13). Real GDP growth averaged 8 percent during this period, buoyed by electricity, construction and services activity. Strong growth, along with other inclusive policies, pushed down poverty from 23 percent in 2007 to 12 percent in 2012. The unemployment rate dropped from 3.1 percent in 2011 to 2.1 percent in 2012.
3. Strong growth over the 10th Plan period, however, also led to external imbalances and was accompanied by high credit growth. In response to some signs of overheating, the authorities implemented monetary policy and prudential measures to rein in aggregate demand. Accordingly, real GDP growth in Bhutan slowed during 2012 to 4.6 percent from 8.6 percent during the previous year.
4. The hydropower sector remains a key sector of economic activity – construction and electricity sub-sectors constitute almost one-fourth of GDP. Hydropower sector and related growth has, however, slowed down in recent years due to the plateauing of production, which has also contributed to the deceleration in growth in the recent years. Electricity and related growth can be expected to pick-up in 2016–17, when the next project starts production. This will lead to a spike in the growth rate in 2016–17; given the bulky nature of these projects, such spikes have occurred in the past and can be expected to occur in the future as well. Efforts are underway to increase the power generation capacity from the current level of 1500 MW to 10,000 MW by 2020, predominantly with support from India. The hydropower sector is expected to start adding to growth momentum, as the new capacity starts production.
5. The power generated from the existing and the prospective hydropower plants will be largely sold to India. Concomitantly, the import requirements associated with these power plants are expected to maintain pressure on the current account deficit during the construction stage of these projects; however, financing of such deficits is not an issue. The current account position is expected to move from deficit to surplus, once these projects start production. Similarly, the public debt as well as external debt position will improve significantly, as the various hydropower projects start generation.
6. Continued expansion in the hydropower sector is critical for socio-economic development; however, given the strong possibility of further harnessing of hydropower potential beyond the 10,000 MW target by 2020, sequencing of these investments and negotiation of project modalities is critical.
7. Consumer price inflation moderated from 13.5 percent in 2012:Q2 to 5.5 percent in 2013:Q2, reflecting easing in both food and non-food inflation; it has since then, however, edged again up to 11.3 percent in 2013:Q4, largely due to upward pressures in food-related prices. The RMA continues to maintain a tight monetary policy stance and has launched new initiatives and macro prudential policies to strengthen financial sector regulation and supervision under the scope of a Financial Sector Development Strategy.
8. The fiscal deficit remained modest and decreased slightly from 1.2 percent of GDP in 2011–12 to 1 percent of GDP in 2012–13.
External Sector Management
9. As noted earlier, strong growth during the 10th Plan period was, inter alia, mirrored in widening current account deficits. In response, the authorities put in place demand management measures as also some temporary restrictions on selected imports in 2011–2012. Accordingly, there was a modest reduction in the merchandise trade deficit. Nevertheless, the current account deficit widened to 25 percent of GDP in 2012–13 from 23 percent of GDP in 2011–12 due to reduced inflows in budgetary grants. As of March 2014, Bhutan’s international reserves were USD 965 million, providing a cover for 22 months of merchandise imports.
10. While the overall balance of payments (BoP) position has recorded modest deficits or surpluses in recent years, the BoP position with India has recorded persistent deficits. This reflects the heavy dependence of the economy on India to meet its import requirements amidst high domestic demand. Thus, while there is a deficit BoP position with regard to India, there is a surplus BoP position with respect to other countries. This has created challenges for the authorities to raise Indian rupee (INR) resources, even though overall foreign exchange reserves are equivalent to 22 months of merchandise imports.
11. During 2012 and 2013, the Royal Monetary Authority (RMA) also took steps to address volatility in the external sector and pressures on Rupee reserves. The RMA entered into an INR Swap arrangement with the Reserve Bank of India (RBI) and raised INR 5.4 billion in March 2013 for 6 months; the Swap was liquidated in September 2013. In addition, USD 200 million was sold against INR in June 2013 to raise INR resources, in light of a comfortable convertible currency reserve position and favorable exchange rate conditions. The authorities continue to be vigilant on external sector developments. Overall, given strong trade and economic ties with India, the currency peg to the INR has served Bhutan well.
Reserve Adequacy Issues
12. On reserve adequacy and management [Selected Issues - Chapter 2], staff estimates that if Bhutan had invested on average 30 percent of its reserves in INR denominated government bonds, it would have earned net interest of INR 4 billion in 2005–12 period. Second, staff notes that the actual interest cost of INR overdraft facilities to which the RMA resorted to periodically has added to the cost of holding convertible currency reserves. Finally, staff recommends that the currency composition of reserves should be more aligned with the structure of Bhutan’s external liabilities and trade, with consideration being given to a gradual increase in the share of INR reserves. To begin with, staff recommends any excess of convertible currency reserves a certain nominal threshold should be converted into rupees and managed in a liquidity portfolio.
13. In this context, we may note that staff’s estimates of interest earnings foregone are unlikely to be realized, since INR funds would need to be maintained in the most liquid form (under the reserve management policy) to meet daily payment obligations which are very unpredictable in nature. Moreover, the currency composition of reserves reflects the fact that (i) reserves build up is largely due to aid inflows; (ii) Bhutan has sizable convertible currency payment obligations largely denominated in USD; (iii) since INR is a non-convertible currency, it is more efficient to keep reserves in USD terms and convert them into rupees as and when needed. Besides, as staff acknowledge, Bhutan is also bound by the Constitutional requirement of an import cover of 12 months in foreign currency.
14. The RMA has a Reserve Management Policy and is developing guidelines. This process has benefited from the Fund TA on Reserves Management. The RMA has developed and is implementing its Reserve Adequacy Framework with a threshold limit, beyond which RMA shall convert its convertible currency reserves and increase Rupee reserves as and when conditions are favorable. The value of the threshold can be expected to change from time to time in line with economic conditions and pattern of financial flows. It should, therefore, be treated as an element of RMA’s internal operational framework and it would be inappropriate to mention a specific nominal threshold.
15. Bhutan has prudential restrictions on the foreign exchange usage and the authorities avail of the transitional arrangements under Article XIV, section 2. Our authorities have followed prudent foreign exchange policies so as to safeguard international reserves which serve as the foundation of Bhutan’s macroeconomic and exchange rate policy and to support sustainable development. Bhutan’s reserves have been accumulated over the past 5 decades through gradual inflows of aid and debt as opposed to export performance. Until such time Bhutan’s macroeconomic fundamentals do not improve, removing exchange measures would not be prudent. The current INR exchange restrictions related to the import of vehicles and construction materials (in line with credit controls) since 2012 are temporary and the RMA has plans to remove these restrictions this year in line with the introduction of fiscal measures by the Royal Government.
16. During the year, Bhutan started disseminating BoP and international investment position (IIP) statistics, including quarterly statistics, compiled under IMF’s Balance of Payments Manual 6th Edition (BPM6). Successful migration of Bhutan’s BOP to BPM6 was carried out under the IMF TA and Japan Subaccount (JSA) Project on the Improvement of External Sector Statistics (ESS) in the Asia and Pacific Region. This makes Bhutan one of the first Asian countries and IMF Member nations to implement the BPM6 framework on a quarterly basis and ensures international comparability of Bhutan’s BOP statistics.
Financial Sector
17. Financial soundness indicators for Bhutan remain generally comfortable, with capital adequacy and liquidity well above the required prudential norms, although the proportion of non-performing loans has increased in the recent period. In order to strengthen the regulatory system, the central bank has recently supplemented its micro-prudential regulations with a macro-prudential system to make the Bhutanese financial system more resilient. Macro-prudential regulations covering counter-cyclical capital buffers, sectoral capital requirements, leverage ratio, loan to value and loan to income ratios, debt to equity ratio, time-varying capital provisioning and margin requirement and profit distribution are being put in place. These macro-prudential regulations, in conjunction with the existing micro-prudential regulations, are expected to foster financial stability in an environment of continued financial deepening amidst high growth.
18. To promote lending to productive and priority economic sectors, the Government is implementing an Economic Stimulus Plan (ESP) from 2014. Under the ESP, INR 5 billion secured by the Government as grant support outside of the 11th Five Year Plan (FYP) (2013–18) from the government of India (GoI) is being injected into the financial institutions to improve financial sector liquidity levels and lending.
19. A Central Registry for Movable Property was established in September 2013, which has helped the RMA facilitate smooth credit appraisal. As part of its strategy to contain over-exposure of financial institutions towards select credit portfolios and to regulate rapid credit expansion, the RMA adjusted prudential provisions pertaining to loan provisioning, risk weight limits during 2012 and 2013.
Capacity Development and Small States
20. Our authorities are highly appreciative of the Fund for providing opportunities for enhancing human resource capacities through training and technical assistance (TA). During 2013, Bhutan benefitted tremendously from TAs in the areas of National Accounts Statistics, Treasury Management, Financial Sector Surveillance, Balance of Payments (External Sector Statistics), and Foreign Exchange and Reserve Management. Notably, as noted earlier, Bhutan has become one of the success stories in enhancing compilation and quality of BoP and IIP statistics.
21. Our authorities would like to request the Fund to explicitly support Bhutan in its need for continued external resource support and assistance when pursuing these reforms. As the staff projections indicate, Bhutan’s level of official development assistance is expected to decline gradually in line with improvements in per capita income. However, as the staff assessment shows, growth in Bhutan has been driven primarily on the back of a single sector (hydropower development) which generates limited employment. Bhutan continues to remain an import and aid-dependent country. To strengthen economic fundamentals, and to pursue economic diversification, Bhutan will continue to rely on the goodwill and assistance from its key multilateral development partners including the IMF, World Bank and ADB.
Outlook
22. Bhutan has achieved noteworthy progress in recent years. The poverty rate has been reduced from 32 percent in 2003 to 12 percent in 2012. The authorities are working towards self reliance and reducing dependence on external assistance by 2020. Notwithstanding the creditable progress achieved in social indicators and robust growth performance during the 10th FYP period (2008–13), the authorities recognize that Bhutan faces numerous structural weaknesses and challenges that need close attention to ensure long term sustainability. The economy can no longer be sustained on the back of a single economic sector, although hydropower development remains a vital catalyst for socio-economic development.
23. The 11th Five Year Plan, covering the period 2013–14 to 2017–18, envisages average annual growth of 12 percent as compared with that of 8 percent in the 10th Plan. As the 11th Plan notes, the macroeconomic challenges of recent years underscore the need to prudently address various issues in the real, external and monetary sectors. In this regard, the prudent management and use of hydropower inflows will be critical in the long-run; in the short-to-medium-term, our authorities recognize that managing the spillovers from the hydropower sector and related activities during the gestation period of these projects on INR reserves will be important for macroeconomic and financial stability.