Bhutan: Staff Report for the 2016 Article IV Consultation

Macroeconomic conditions have improved recently. Growth appears to be picking up while inflation has declined to low single digits; foreign reserves have been increasing on the back of a strong financial account; the fiscal balance has recorded a surplus in the past two years; and credit growth remains moderate. Financial soundness indicators point to a modest improvement in the health of the financial sector.

Abstract

Macroeconomic conditions have improved recently. Growth appears to be picking up while inflation has declined to low single digits; foreign reserves have been increasing on the back of a strong financial account; the fiscal balance has recorded a surplus in the past two years; and credit growth remains moderate. Financial soundness indicators point to a modest improvement in the health of the financial sector.

Introduction

1. Significant economic and social gains have been realized in Bhutan in recent years. Bhutan has enjoyed political stability, with national parliamentary elections and a smooth political transition to the victorious opposition People’s Democratic Party taking place in 2013. Political stability, large donor assistance, and increased hydropower generation capacity combined to support a more than doubling of GDP per capita during 2004–2014, rising from $1,108 to $2,612—a significantly faster growth than that of regional peers.

Poverty and Social Indicators, Bhutan

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Sources: World Bank, World Development Indicators; UNDP, Human Development Report.

Percent of school age population.

World Human Development Index: .71; Global ranking: 132.

2. However, these achievements came with some important policy challenges. While it brought significant economic benefits, large hydropower investment and hydropower-related imports have also presented significant challenges to macroeconomic management. This was illustrated during the “rupee shortage crisis” of 2012–13, when large hydropower investment and hydropower-related imports, together with the boom in housing lending, led to a sharp widening of the current account deficit and a shortfall in Indian rupee reserves.

A01ufig1

Gross Domestic Product, Per Capita

(In U.S. dollars)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Source: IMF, World Economic Outlook.

3. The authorities’ past macroeconomic policies have been broadly in line with staff advice. The authorities have exercised fiscal restraint by introducing revenue measures and keeping current expenditures under control, both in accord with the previous staff recommendations. In response to rapid credit growth, they took steps in 2015 to tighten liquidity, and have removed administrative credit restrictions. The authorities have also made progress in expanding the toolkit of macroprudential instruments,

Recent Developments, Outlook and Risks

4. Following a slowdown in activity in the wake of the rupee shortage episode, economic growth has picked up more recently. From an average of around 8 percent during the Ninth and Tenth Five-Year Plan (FYP) spanning fiscal years (FY) 2003/04–2012/13, real GDP growth fell to below 4 percent in FY2012/13 and FY2013/14. Measures to dampen the activity contributed to the slowdown. However, real GDP growth is estimated to have picked up to 5.2 percent in FY2014/15 and is projected to reach 6 percent in FY2015/16, driven by a pickup in mining, construction and services.

A01ufig2

Sectoral Composition of GDP

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan, and IMF staff estimates.

5. Inflation has fallen rapidly recently, reaching a record-low level. After peaking at 11.3 percent in Q4 2013 (y-o-y), consumer price inflation fell to 3.5 percent at the end of 2015, and further to below 3 percent in February and March 2016, below India’s 4.8 percent inflation rate (Box 1). Imported goods inflation has been falling more rapidly than domestic goods inflation: in the last twelve months, imported goods inflation fell from 6.2 percent to 1.8 percent, while domestic goods inflation eased less, from 6.5 percent to 4.2 percent.

6. Despite the overall low unemployment rate, some problems in the labor market persist. Overall unemployment in 2014 was relatively low, at 2.6 percent of the labor force, a modest decline from 2.9 percent in 2013. Nonetheless, the unemployment problem is serious in some segments of the labor market. In particular, youth unemployment and urban unemployment are much higher. The authorities view these problems as worrisome, and are taking active steps to address them through training and labor market reforms (Box 2).

7. The current account deficit remains close to record-high levels, but continues to be financed by large aid flows. Reflecting higher interest payments on hydropower-related loans, the FY2014/15 current account deficit increased to close to 29 percent of GDP. The overall balance turned slightly negative and international reserves fell marginally to $960 million by June 2015, before recovering to $1,022 million in February 2016. However, the trade deficit has widened recently, to Nu.13.3 billion in July-December 2015 compared to Nu.6.8 billion in the same period of 2014.1 This widening reflects both a pickup in imports (partly reflecting one-off items) and a decline in exports.

A01ufig3

Exports and Imports, 2015

(y/y percent change)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Source: Royal Monetary Authority of Bhutan.

8. Private sector credit growth has accelerated recently, but remains moderate. Following a deceleration in 2012–2014 to below 10 percent, growth of bank credit to the private sector has picked up in 2015, to about 13–14 percent and around 46 percent of GDP. Credit growth acceleration has been significantly faster in the nonbank sector. Between end-2013 and end-2015, credit outstanding by nonbank financial institutions (NBFIs) has almost doubled, and now represents 17 percent of total financial institutions’ credit, compared to 12 percent in 2013.

9. Financial soundness indicators point to a generally healthy financial system. Banks’ capital adequacy ratio has remained high, at 17 percent by September 2015, above the 10 percent required minimum, and’ non-performing loans (NPLs) have remained relatively stable, at around 10 percent of outstanding loans. Banks’ liquidity positions remain solid. The reduction in credit growth also resulted in a lower bank credit-to-deposit ratio, which fell from 86.4 percent in 2013 to 73 percent in 2014, before increasing to about 80 percent in 2015.

A01ufig4

Domestic Credit

(Annual percent change)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan; and IMF staff estimates.

10. Fiscal performance in recent years has reflected the expenditures dynamics of Bhutan’s five-year plans. Specifically, capital expenditure tends to ramp over the course of the plan, as projects get underway. This has been reflected in a deterioration of the fiscal balance as the plan progress. A surplus of 3.8 percent of GDP was recorded in FY2013/14, the first year of the 11th FYP, compared to the deficit of 3.7 percent of GDP projected in the original budget. The FY2014/15 (revised) budget envisaged a deficit of 2.3 percent of GDP, mainly on account of rapid growth in current spending, which grew by 22 percent in FY2014/15 (partly reflecting the 20 percent public salary increase recommended by the Second Pay Commission). Capital spending was projected to increase by 13 percent. However, the budget outturn entailed a surplus of 1.5 percent of GDP, with somewhat stronger tax and nontax revenues and grants, and lower capital spending.

A01ufig5

Fiscal Deficit and Financing

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Bhutanese Authorities, and IMF staff estimates.

11. Bhutan’s medium-term outlook remains favorable. Commissioning of new hydropower generation projects will boost output, exports and fiscal revenues. Growth is projected to accelerate to over 11 percent in FY2017/18 and to around 14 percent in FY2018/19, supported by a tripling of hydropower electricity generation. The current account deficit is projected to peak at 31.5 percent of GDP in FY2016/17, and then fall quickly in FY2017/18 and eventually to turn into a surplus. The overall balance is projected to be mostly positive, supported by hydropower grants and loans.

12. Risks to the outlook are skewed to the downside. Domestic risks stem from the need to manage high debt and potentially volatile hydropower-related inflows that may fuel rapid credit growth and lead to renewed external pressures. External risks result from weaker tourism and the adverse impact of developments in China on Bhutanese exports. Nepal’s earthquake and regional security concerns have adversely affected tourism. At the same time, China’s excess capacity in the steel industry could adversely affect the position of Bhutanese ferroalloy producers exporting to the Indian market. On the positive side, growth in India remains strong, though reform setbacks could weaken activity.

Policy Discussions

Policy discussions focused on the appropriate fiscal policy stance in the final years of the 11th Five-Year Plan and how to boost domestic revenues, on strengthening the monetary policy transmission mechanism, and how to manage the expected spike in hydropower exports and revenues.

A. Fiscal Policy

Background

13. For FY2015/16, while the revised budget projected a deficit of 3 percent of GDP, the outturn is projected to be a surplus of 0.6 percent. While growth in current expenditure has been tepid, the revised budget assumed an unrealistically high jump in capital spending by over 70 percent, which is now projected at about 30 percent. The increase in spending is to be financed primarily by higher GoI grants. In the absence of new revenue measures, domestic revenue growth is projected to be modest. Even though discussion of the FY2016/17 budget in the Cabinet has not yet been finalized, the authorities suggested that the budgeted capital spending will likely remain elevated, and if fully implemented, would result in a deficit of over 5 percent of GDP. Over the medium term, with the commissioning of new hydropower plants, hydropower-related revenues are projected to increase. At the same time, donor financing is projected to fall as per capita incomes rise.

14. The authorities are working towards a major reform of the tax system. With the help of IMF/World Bank technical assistance, the authorities have launched the project of introducing a modern goods and services tax (GST) by end-2018. Numerous deficiencies in Bhutan’s tax system have contributed to a gradual decline of tax revenues. The objective of tax reform is to mitigate these deficiencies and replace the current sales tax with a simple broad-based GST that would boost government revenues, while minimizing tax-related distortions and supporting an investment-friendly environment.

Staff Views

15. In the near term, fiscal policy should avoid contributing to the reemergence of overheating pressures and large shifts in the fiscal stance. Staff cautioned against attempts to boost capital spending excessively in an effort to “catch up” to originally budgeted public investment plans. Large increases in current spending, including wage increase, should be avoided as well. The recent increase of pay and allowances of public servants, the resumption of credit growth, and the pickup in import growth point to a strengthening in domestic demand. At this juncture, a fiscal deficit of around 5 percent of GDP (as under consideration by the authorities) would entail a large fiscal stimulus that could start undermining macroeconomic stability. Staff cautions against such fiscal loosening, and recommends targeting a smaller fiscal deficit in the range of 1–2 percent of GDP in FY2016/17. In FY2017/18, with the projected acceleration of economic growth, further strengthening of the fiscal balance is recommended. Staff recommends targeting a small surplus of around ½ percent of GDP.2

16. While in recent years the fiscal balance has been stronger than originally targeted, revenue performance has remained weak and needs to be addressed as a matter of priority. Tax revenues are projected to fall to 13.2 percent of GDP in FY2015/16 and FY2016/17, down from 15.2 percent of GDP in FY2012/13. As in other countries, the widespread and expanding use of tax incentives has resulted in a weakening of tax revenue collection. The authorities estimate that tax exemptions and holidays result in a loss of revenue of up to 2 percent of GDP. Thus, staff recommends that new tax exemptions should be avoided, expiring exemptions should not be renewed, and existing exemptions should be phased out. To increase fiscal transparency, listing and costing all tax expenditures should become an integral part of the budget. The authorities should aim for a simple, broad-based tax system. In this context, the authorities’ decision to replace the current sales tax with a simple broad-based GST is welcome. This will increase government revenues while minimizing tax-related distortions and help create an investment-friendly environment.3

17. Over the medium-term, the priority should be to place public finances on a more solid footing, to contain the already-high public debt, and to avoid excessive volatility in the fiscal stance and emergence of external pressures. On the revenue side, the priority should be the implementation of a broad-based GST. On the expenditure side, the main objectives should be: (i) keep current spending growth moderate, in support of debt reduction; and (ii) to ensure that volatility in revenues and grants does not lead to high spending and fiscal stance volatility. This may require strengthening the fiscal institutional framework to effectively manage the expected spike in hydropower-related revenues. The objective should be to avoid hurried spending of temporarily higher revenues that would pose a risk to both fiscal sustainability and the external position.4 One option—discussed in the 2011 Article IV Staff Report—would be to introduce a fiscal rule that would constrain the growth of current spending.5 In addition, a separate account (or stabilization fund) could be created to temporarily “park” additional hydropower revenues, shield them from pressures to be spent quickly and less effectively, and avoid the real exchange rate appreciation that would harm competitiveness and diversification of the economy.

Authorities’ Views

18. The authorities explained that actual fiscal outcomes are typically stronger than budgeted. They observed that in the early years of the FYPs, capital spending is usually lagging behind, as it is a period of carrying out preparatory work for capital investment, and for mobilizing resources, with donor coordination taking time. As a result, capital spending tends to pick up only in the later years of the FYP. Thus, capital spending is budgeted to increase significantly in FY2015/16 and FY2016/17. However, the authorities agreed with the staff’s point that limited absorptive capacity puts a cap on how much capital spending can be usefully increased, and noted that government agencies do not usually spend the full budgeted amounts. Accordingly, they agreed with staff that in FY2015/16, the actual deficit could end up lower than budgeted. In the same vein, the authorities cautioned that while the FY2016/17 budget could target a deficit in excess of 5 percent of GDP, the actual deficit may well be less. The authorities noted that they have been exercising tight control over recurrent spending.

A01ufig6

Sectoral Distribution of Credit Allocation

(In percent of total credit)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan; and IMF staff estimates.

19. The authorities noted that improving revenue collection and increasing reliance on domestic revenues in covering budgetary spending poses a big challenge. The original target of financing 85 percent of total spending from domestic revenues at the end of the 11th FYP will not be met. The authorities noted that domestic revenues have been flat in recent years, and that to increase tax revenues would require measures to be taken by parliament. They recognized the importance of introducing the reformed GST, and underscored the need to have it in place before the 2018 elections, to avoid possible delays.

20. The authorities agreed that the projected increase in hydropower-related revenues needs to be managed carefully. They have been discussing the pros and cons of establishing stabilization fund for some time, but no decision has yet been made. The authorities emphasized the need to avoid tying their hands too tightly, as Bhutan needs to use the expected hydropower revenues to finance economic development, given the likely gradual phasing out of external support.

B. Monetary and Financial Sector Policies

Background

21. The slowdown in credit growth during 2013 and 2014 partly reversed in 2015. After a period of rapid growth in credit to the private sector averaging 35 percent in 2005–2011, credit growth fell to below 10 percent in 2013 and 2014.6 However, following the September 2014 termination of the ban on vehicle and housing loans (introduced during the “rupee shortage crisis”), credit growth picked up in 2015, though it remained in the 13–14 percent range for most of the year. To sterilize persistent excess liquidity in the banking system, in March 2015, the Royal Monetary Authority (RMA) increased the cash reserve ratio (CRR) from 5 to 10 percent—as also recommended by staff during 2014 Article IV consultation. In the wake of the credit slowdown, financial soundness indicators have improved modestly.

22. The RMA is expanding its toolkit of prudential measures, by increasing its reliance on macro-prudential regulations. In 2014, with the support of the Asian Development Bank (ADB), the RMA outlined a comprehensive framework for macro-prudential policy.7 During 2014–2016, some macro-prudential regulations such as the loan to value and loan to income were implemented, while others — including counter-cyclical capital buffer and sectoral capital requirements—are yet to be operationalized and used.8

A01ufig7

Bank Credit

(y/y percent change, 3-month moving average)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Bhutanese Authorities, and IMF staff estimates.Note: Percentages in the series’ legends denote sector’s weight in total stock of bank credit.

Staff Views

23. In staff’s view, current monetary conditions appear broadly appropriate. The decline in inflation does not reflect slack in the economy and is likely to be partly reversed in the future, and domestic demand and economic activity appear to be picking up, as suggested by accelerating import and growth. The fiscal policy stance is likely to continue to be expansionary in FY2016/17, adding to demand growth. The RMA should monitor liquidity and stand ready to promptly respond in case of a resumption of excessive credit growth that would lead to a pickup in inflation or external pressures. Rupee inflows related to hydropower projects and grants should continue to be sterilized. At this stage, the RMA needs to rely on CRR and the statutory liquidity ratio (SLR) as the main available monetary policy instruments.

A01ufig8

Bhutan: Government Issuance of Treasury Bills

(Outstanding stock [LHS]; and interest rate on new issues, in percent [RHS])

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan, and IMF staff estimates.

24. Looking ahead, RMA’s monetary management should be further strengthened. The CRR and the SLR are rather blunt instruments, and adding further tools could help improve monetary transmission. This would require: (i) developing the short-term government securities market, with T-bills at market-determined rates providing a tool for liquidity management (which includes meeting the SLR requirements) and an investment alternative; (ii) improving RMA’s ability to forecast liquidity in the financial sector and the Ministry of Finance’s (MoF) ability to forecast government cash flow;9 (iii) promoting further development of the interbank lending market as a tool of first resort for banks to meet their short-term financing needs; (iv) introducing a RMA short-term (overnight) standing facility at a penalty rate, to complement the interbank markets and RMA’s longer-term RSTLAW facility, and help the banks meet their short-term liquidity needs; and (v) consider introducing a similar RMA standing deposit facility, to allow banks to deposit excess liquidity overnight, with penalty (low) rates setting the floor for interbank deposit rates. In step with these measures, consideration should also be given to reforming the system of base interest rates (Box 3).

25. A more developed framework for monetary operations would bring numerous benefits. Monetary policy transmission would become more effective, as the transition from the policy rate to interbank rates and government securities rate, and from the interbank rates to bank deposit and lending rates, would strengthen. Increased supply of government securities would provide financial institutions a tool for better liquidity management, and an asset for investment. Finally, creating a risk-free benchmark yield curve should help develop an alternative source of corporate funding in corporate bonds and equity markets. Staff understands that discussions are under way in the working committee on the publication of the T-bill issuance calendar, and on improving the debt management policy, including the developments of a long-term domestic debt market, and supports these efforts.

26. The RMA’s efforts to expand its toolkit of prudential regulation are important. Staff welcomes the introduction of additional macroprudential tools, including limits on loan-to-value and loan-to-income ratios. Despite these improvements in prudential regulations, further strengthening of the RMA’s capacity to detect and prevent development of weaknesses in the financial sector is needed, in line with the recent IMF technical assistance recommendations. This includes the need to fill the regulatory gap in the supervision of NBFIs. Currently, the NBFIs are supervised as banks, and some specific risks, such as insurance risk, are not properly monitored and covered.

27. The RMA’s steps to strengthen prudential regulation and supervision should put it on firmer ground to support financial sector development. The mission notes the concerns that parts of the economy, including small and medium enterprises (SMEs), still lack access to financial services. The Financial Sector Development Action Plan, prepared with the assistance of the World Bank, provides a good opportunity to formulate a financial sector development strategy that would properly balance prudence and development.

Authorities’ Views

28. The authorities broadly shared staff’s view about monetary conditions and agreed with the staff’s assessment that further strengthening of the monetary transmission mechanism is needed. They noted that in view of the ngultrum’s peg to the Indian rupee and close economic and financial ties to India, they need to closely follow India’s monetary stance. Regarding monetary transmission, the authorities agreed that the CRR is a blunt instrument, used currently to address both frictional and structural liquidity problems. They noted that the RMA is already considering the introduction of short term (overnight) lending and deposit windows, to replace the system of sweeping overnight balances. However, while the RMA is ready to deploy new monetary policy instruments, for the successful development of the interbank market, short-term instruments to be used as collateral are required, including banks’ certificate of deposits and short-term government securities. In addition, a proper legal framework to regulate the creditor-debtor relationships needs to be developed, so that both creditors and debtors understand their rights and obligations. The authorities also noted that there is widespread dissatisfaction with the current system of the base interest rate, and that calls are growing on the RMA to come up with a fairer system of interest rate setting. In response, the RMA is envisaging a review of the base rate system, possibly introducing a single base rate.

29. The authorities expressed concern about insufficient access of certain borrowers to credit. They are concerned about the lack of credit availability to certain sectors and segments of the economy. In their view, too much credit goes to finance consumption rather than investment, and some sectors—in particular micro, small and medium-sized enterprises (MSMEs)—face difficulties in accessing credit. Establishing a specialized credit institution is one option under consideration. The authorities expect that these issues will be addressed in the World Bank’s Financial Sector Development Action Plan that is currently being finalized.

C. External Sector

Background

30. The current account deficit remains extremely large, driven by hydropower investment, but international reserves have been increasing. The current account deficit is estimated to have approached 29 percent of GDP in FY2014/15, of which about one half was the deficit with India. Following two years of decline or stagnation, growth of exports and imports (goods) picked up in FY2014/15, to about 8 percent.10 The current account has been financed by surpluses in capital and financial accounts. However, the overall balance turned into a small deficit in FY2014/15 and reserves fell slightly. Subsequently, foreign currency reserves have recovered again in FY2015/16, reaching US$ 1,022 million by February 2016, covering about 11 months of imports of goods and services, and represent about 53 percent of external debt. In the medium-term, with the commissioning of new hydropower plants, hydropower exports will increase sharply, and the current account deficit is projected to turn into a surplus.

Staff Views

31. The current account deficits and external public debt are very high, but reflect Bhutan’s hydropower-centered development strategy, with unique mitigating factors mitigating external vulnerability. External public and publicly guaranteed (PPG) debt has increased moderately in 2015, to 94.5 percent of GDP, from 93.6 percent of GDP in 2014, and is projected to peak at around 113 percent of GDP in 2017, before starting to decline. The construction of hydropower projects has led to increased external debt-to-GDP, and all indicative thresholds of the LIC-DSA are breached in the baseline (see the Debt Sustainability Analysis Annex). While the extent and length of the breaches would indicate a high risk of external debt distress, there are unique mitigating factors that point to risk remaining moderate. As was explained in the 2014 Debt Sustainability Analysis (see 2014 Article IV Staff Report), explicit guarantees from India that cover financial and construction risks for all hydropower projects allows for the exceptional treatment of hydropower loans from India similar to that of FDI.11 These unique mitigating circumstances are still in place.

32. Staff assesses the real effective exchange rate to be moderately overvalued relative to the level suggested by fundamentals. Using the adjusted external sustainability approach, which takes into account temporary effects of hydropower related flows, staff assess the ngultrum to be moderately overvalued (see Box 4). The peg to the Indian rupee continues to remain appropriate and given that India is Bhutan’s largest trade and development partner, provides Bhutan with a key nominal anchor. To continue benefitting from the peg, Bhutan needs to avoid loose macroeconomic policies that would be incompatible with maintaining the peg and that would create the risk of renewed rupee shortages.

33. Bhutan’s foreign reserves are adequate, but further improvement in their composition is advisable. All standard measures of reserve adequacy for Bhutan are met by a wide margin (Box 5). However, when interpreting the reserve metric indicators, it should be kept in mind that Bhutan’s reserves reflect more external assistance than export earnings—though this is projected to change as electricity exports pick up. While the level of reserves is adequate, their composition remains suboptimal. Further gradual increase in the share of rupee reserves is advised, in line with the recommendation of the recent IMF TA, to better align the currency composition of reserves with Bhutan’s external liabilities and trade structure. 12

34. Staff encourages the authorities’ efforts to improve reserve management. The mission welcomes the recent steps to strengthen reserve management, including the swap agreement with the Reserve Bank of India (RBI) to receive liquidity support.13 It also welcomes the ongoing discussion with the RBI to sell or buy Indian rupee (INR) against USD, and gain access to Indian Government securities. In addition, Bhutan’s planned participation in the World Bank’s Reserve Advisory Management Program will provide an opportunity to improve RMA’s debt management skills. The new reserve management framework should mitigate the liquidity and the currency risk, avoid the risk of renewed Indian rupee shortages, reduce credit risk and at the same time improve the return on reserves.

35. Staff welcomes the removal of some of the exchange restrictions introduced in 2012. In response to the rupee shortage, Bhutan introduced regulatory measures that gave rise to new exchange restrictions subject to Fund approval under Article VIII, Section 2(a). Subsequently, as the situation stabilized, the restrictions on INR access for certain imports were removed in 2014. The mission understands that since then, no new measures that would give rise to restrictions on the making of payments and transfers for current international transactions or multiple currency practices were introduced.

Authorities’ Views

36. The authorities shared staff’s assessment of external debt vulnerability, and agreed with staff’s view that reserve management needs to be improved. They noted the agreement with the RBI that will provide them with more flexibility to actively manage the composition of foreign reserves and address eventual temporary liquidity pressures. The authorities agreed that the projected increase in hydropower exports should help repay a large part of the external debt, and underscored the need to take this factor into account when assessing external debt vulnerability. However, far from being complacent, they have also cautioned against relying too much on the hydropower sector to cushion all external pressures. The authorities underscored the need to monitor separately the hydro and non-hydro parts of the balance of payments, to better understand the current developments and future prospects. They noted that although the hydropower projects are fully financed, the development of the hydropower sector can have repercussions on the current account balance, and suggested that to address long-term balance of payment challenges, policies to encourage domestic production of imported items may be needed. As Bhutan’s foreign reserves are built mainly on external aid inflows and borrowing, the authorities continue to consider as necessary the maintenance of existing restrictions under Article XIV, and those inconsistent with the Article VIII obligations (see Information Annex).

Staff Appraisal

37. Bhutan’s economic performance has improved in recent years, but challenges lie ahead. Following its deceleration in the wake of the “rupee shortage crisis” of 2012–13, growth has picked up more recently. At the same time, inflation has been falling rapidly to record-low levels, reflecting a decline in both imported and domestic goods inflation. The unemployment rate has been trending down, though high youth unemployment continues to pose a problem. In the medium-term, growth is projected to gain further momentum with the commissioning of new hydropower plants. As growth accelerates, it will be important to ensure that overheating and imbalances do not arise.

38. A disorderly easing of the fiscal stance should be avoided. In the first two years of the 11th Five-Year Plan (FYP), capital spending has been subdued, despite higher-than-budgeted external grants. Together with tight control on current spending, this resulted in a stronger fiscal balance. In the final years of the current FYP, capital spending is expected to accelerate as project implementation gathers speed. However, while some acceleration of capital spending is to be expected, staff cautions against big jumps in capital spending. Large swings in the fiscal balance—as that implied by a FY2016/17 deficit in excess of 5 percent of GDP—would provide an unsuitably large stimulus and could stretch the absorption capacity of the economy. Looking ahead, a stronger fiscal institutional framework could help effectively manage the projected spike in revenues related to increased hydropower production.

39. Addressing weak revenue performance is crucial for maintaining long-term fiscal sustainability and the exchange rate peg. The pegged exchange rate, together with the mild overvaluation of the exchange rate, underscores the importance of fiscal sustainability and improved domestic revenue performance. With external grants expected to gradually decline, the authorities are properly emphasizing the need to increase reliance on domestic revenues to finance government spending. However, in recent years, tax revenues have been weak, reflecting increased use of tax expenditures that have been eroding the tax base, weakening tax compliance and complicating tax administration. The policy of granting tax exemptions and incentives needs to be reassessed. Tax expenditures usually do not deliver the expected benefits in terms of higher investment and growth, but often entail high costs in terms of revenue erosion. At the same time, the reform of the sales tax, with the objective of replacing the existing inefficient sales tax with a modern GST, should proceed as planned and be implemented by 2018.

40. Staff views monetary conditions to be broadly appropriate. After a sharp slowdown in the wake of the “rupee shortage crisis” of 2012-13, credit growth has picked up more recently, but remains within a moderate range. To absorb excess liquidity, the RMA appropriately increased the cash reserve ratio (CRR) in March 2015, and at this time, there are no signs of excess or shortage of banking sector liquidity. This being said, the RMA needs to remain vigilant, monitor liquidity conditions and credit growth closely, and stand ready to respond as needed. In parallel, Bhutan’s still rudimental system of liquidity management needs further improvement.

41. Steps to strengthen financial supervision and regulation are welcome. The RMA is to be commended for the effort to expand its toolkit of macroprudential regulation. Looking ahead, the authorities need to close the gaps in the regulation of nonbank financial institutions. A more robust and effective regulation and supervision framework should also provide a more solid ground for policies to promote financial deepening, without incurring a risk to financial stability. Financial soundness indicators point to a generally sound financial system: the capital ratio remains solid, and NPLs have declined moderately.

42. Even though the real exchange rate is assessed as moderately overvalued, the exchange rate peg with India continues to serve Bhutan well. The adjusted external sustainability approach, tailored to take into account the temporary effects of electricity-related exports and imports on the current account balance, suggests a moderate real effective exchange rate overvaluation. Disciplined fiscal and monetary policies supporting moderate inflation, as well as measures to improve business climate, are needed for Bhutan to continue benefitting from the peg and ensure that the exchange rate does not deviate significantly from its fundamentals.

43. The level of external reserves is adequate, but further improvement in reserve management is needed. All standard metrics of reserve adequacy show that Bhutan’s reserves are adequate. With external reserves amounting to about one half of GDP, proper reserve management is even more important. First, the currency composition of reserves needs to be better aligned with the composition of external debt and trade flows, by reducing the share of convertible currency reserves and increasing the share of the Indian rupee-denominated reserves. Second, new reserve management policies and investment guidelines need to be implemented.

44. The authorities did not request and staff does not recommend approval of the exchange restrictions maintained inconsistent with Article VIII obligations. Bhutan continues to maintain exchange restrictions under the transitional arrangements of Article XIV, Section 2. Staff recognize the limited and unpredictable sources of convertible currency inflows and justifiable concerns over outflows, and encourages the authorities to gradually ease the exchange restrictions towards their eventual elimination, including restrictions that have been maintained under Article XIV, Section 2, which should be eliminated as soon as Bhutan’s balance of payments positions permits. The authorities are encouraged to consider accepting the obligations under Article VIII, Sections 2(a), 3 and 4, of the IMF’s Articles of Agreement in due course.

45. It is recommended that the next Article IV consultation take place on a 24-month cycle in accordance with the Decision on Article IV Consultation Cycles (Decision No. 14747-10/96).

Inflation in Bhutan: Near-Term Outlook and Considerations for the Long-Term1

Bhutan’s rate of inflation is closely linked to Indian inflation. This link is underpinned by a combination of factors, namely:

  • (i) Broadly similar consumption baskets between India and Bhutan. For example, food accounts for about 40 percent of the CPI basket in Bhutan and about 50 percent in India;

  • (ii) Large reliance of Bhutan’s economy on imports, of which 90 percent come from India;

  • (iii) Long-standing free trade agreement (FTA) between India and Bhutan, which facilitates trade, commerce, and transit between the two countries;

  • (iv) Ngultrum’s peg to the Indian rupee, supported by the FTA’s provisions for facilitating trade transactions in both currencies.

Over the near-term, Bhutan’s inflation is likely to remain slightly below that of India. Empirical evidence featured in Bhutan’s 2014 Article IV Consultation (IMF Country Report No. 14/178) suggests that (i) the inflation rates in the two countries co-move in the long-term, (ii) Indian inflation is exogenous to that of Bhutan, and (iii) when a temporary divergence between the inflation rates in the two countries emerges, Bhutan’s inflation tends to converge to that of India within about one year. The extension of the VECM-based model of Bhutanese inflation to recent data indicates that the actual CPI level as of March-2016 has exceeded the model predicted level by about 1 percentage point, essentially reflecting Bhutan’s positive inflation differential with India over 2014–2015H1. Thus, owing to the error-correction dynamics, Bhutan’s near-term baseline inflation outlook is likely to entail a continued lower inflation rate relative to that of India.

A01ufig9

Inflation Relative to India

(year-over-year percent change)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan; IFS; and IMF staff estimates.

India’s progress on the inflation front will favorably shape Bhutan’s inflation prospects in the long term. The adoption of a flexible inflation targeting regime with a 4 percent headline CPI inflation target and a +/- 2 percent band around it has been central to India’s anti-inflationary drive of the past few years. Progress has also been made to enhance monetary transmission and underpin food supply through productivity enhancing and market efficiency reforms. This has also helped to bring down both food and non-food inflation in Bhutan. Going forward, the Bhutanese economy is set to benefit from India’s improved inflation outlook, but idiosyncratic drivers will require continued careful monetary policy management.

A01ufig10

Non-Food Inflation: Bhutan vs. India

(Annual percent change)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan, and IMF staff estimates.
A01ufig11

Food Inflation: Bhutan vs. India

(Annual percent change)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan, and IMF staff estimates.
1 Prepared by Volodymyr Tulin.

Bhutan’s Labor Market: Problems and Solutions1

Problem. Bhutan’s unemployment rate in 2014 was 2.6 percent (11,000 unemployed; this compares with 50,000 foreign workers currently in Bhutan). The female unemployment rate was 3.5 percent, almost twice as much as the male unemployment rate of 1.9 percent. However, the unemployment rate among young people is particularly high, and reached 9.7 percent in 2014. The unemployment rate is also higher in urban areas (6.7 percent) than in rural areas (1.2 percent).

Causes. There are several causes of high unemployment among the youth. One is the mismatch between the existing skills of young people and skills demanded by employers. Some occupations are not perceived by youth as sufficiently “well-regarded” and there is not enough interest in pursuing them. Furthermore, public sector jobs are often perceived as offering a better combination of security and pay than private sector jobs. Urban youth also have high reservation wage, and while there is no unemployment support, they receive support from their families while unemployed. Finally, the hydropower sector— an important part of the economy—is not offering many job opportunities. The construction phase is labor-intensive (up to 18,000 workers are working at the ongoing three hydropower projects), but only about 20 percent are Bhutanese citizens. This low number reflects either a lack of skills or unwillingness to take up jobs requiring manual work.

Solutions. The government target is to bring the unemployment rate down to 2.5 percent. The challenge is how to absorb the large number of unemployed young people, particularly as the absorption capacity of the public sector is approaching its limits. There is no silver bullet. Improving skills is one solution. The authorities have started six hydropower training centers to provide workers with the qualifications for hydropower construction jobs, and they have been organizing job fairs. All government agencies are required to build crèches, to facilitate employment of women. The authorities have also launched a program of sending people overseas for employment (mainly to India, Thailand and Middle East). The development of labor-intensive SMEs, supported by better access to finance, could also help.

Unemployment rate (%)

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A01ufig12

Bhutan: Labor Force Indicators

(In percent)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Source: Royal Monetary Authority of Bhutan.
1 Prepared by Jiri Jonas.

Base Rate System in Bhutan1

The objective of Bhutan’s base rate system for interest rates is to improve credit market transparency and efficiency, and monetary policy management. Bhutan’s base rate system has been in place since 2012 and is modeled on the Indian base rate system implemented in 2010. A bank’s base rate is a minimum rate at which it can lend, as loans are to be priced from the base rate with the addition of bank-determined borrower-specific charges to account for loan product, credit risk, and term premium. As in India, a base rate of a bank in Bhutan takes into account its cost of funds, costs of complying with certain regulations (such as CRR or SLR), overhead costs, and profitability. A range of exemptions from the base rate is also stipulated for lending to priority sectors, such as agriculture, small and artisan schemes, and entrepreneurship. The base rates have been reviewed annually on the basis of banks’ audited annual accounts. In India, banks were required to take these variables into consideration but ultimately were free in deciding on their base rates. In contrast, the Royal Monetary Authority has played an active role in base rate setting, including by imposing ad hoc adjustments to the base rates to engender a greater uniformity of lending rates across the financial system.

A01ufig13

Select Bank Lending Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan, and IMF staff estimates.

Addressing shortcomings of the current base rate system is a policy priority. Steps have been taken to initiate semi-annual computation of base rates, as the current practice of annual revisions significantly hampers monetary transmission by essentially imposing one year-lagged monetary conditions onto the next year’s base rate. The lack of uniformity in the application of the base rate methodology, prompted by the practice of ad hoc adjustments to reduce variation of the base rates across banks and financial institutions, has led to inefficiencies and hampered transparency. Specifically, banks with access to external aid and hydropower-related funds have had significantly lower calculated base rates, with further variation due to differences in capital base, operating environment, and profitability parameters. In theory, a base rate should enhance monetary transmission by serving as a reference for floating-rate loans, but in practice bank loans and advances in Bhutan are mostly medium-and longer-term and are set at fixed rates.

Improving the responsiveness of the base rate system to changes in monetary stance is of key importance. As is also suggested by the Indian experience, the base rate system has proven ineffective in responding to changes in the monetary policy stance as the average cost of funds used in the calculation tends to adjust slowly relative to the marginal cost of funds. Indeed, India’s recently implemented Marginal Cost of Funds-based Lending Rate (MCLR) which has replaced its base rate system, limits the funding costs used in its calculation to more recently raised funds, assigns these funds a greater weight, and stipulates monthly-based reviews. Adopting similar features could also be contemplated in Bhutan, in part to ensure a more timely adjustment of Bhutan’s financial conditions to India’s improved inflation outlook and its new monetary policy framework. In addition, this would help avoid an undue increase in real interest rates in Bhutan that could chip away at the economic activity. Enhancing monetary transmission would also benefit from promoting greater use of variable rate lending.

1 Prepared by Volodymyr Tulin.

External Sector Assessment1

The standard External Balance Assessment (EBA) methodologies are not well suited for Bhutan. The application of the EBA Lite current account (CA) methodology for Bhutan in FY2015/16 suggests a current account norm of about -8.7 percent of GDP, while the external sustainability (ES) approach suggests a norm of about -5.5 percent of GDP. These approaches do not take into account the temporary nature of hydropower-related imports and future electricity exports, and incorrectly interpret large near-term CA deficits as sign of significant overvaluation. As Bhutan is not part of the EBA Lite sample, country-specific constant in the REER methodology was set at a level that ensures that the sum of sample residuals is zero during 1995–2013. As a result, the 2015 REER is estimated to be undervalued by 7.8 percent.

The adjusted ES approach2, in turn, suggests that Ngultrum is mildly overvalued. The adjustment incorporates the temporary effect of electricity-related exports and imports on the CA path. Initially, there is an accumulation of foreign liabilities associated with imports of goods and services related to the construction of hydropower plants. When the plants are commissioned, the increase in electricity exports will turn the CA into a surplus and the net foreign assets (NFA) will begin to rise. Specifically, in line with staff’s baseline macroeconomic scenario, the simulations assume that Bhutan’s total electricity generation capacity will reach around 6,800 MW over the next two decades. From then onwards, the generation capacity is held constant and the annual growth of domestic consumption is assumed at 5 percent. From 2075, a year when electricity generation is estimated to be sufficient to meet domestic consumption3, net electricity exports are assumed at zero. The calculated equilibrium exchange rate ensures constant real income from net electricity exports. This approach suggests a CA norm of a deficit of around 25 percent of GDP for FY2015/16. While uncertainty around the estimated norm is large, based on the current account elasticity to the real effective exchange rate of -0.25 percent, real exchange rate overvaluation is estimated at around 6 percent.

A01ufig14

Adjusted External Sustainability Approach: Constant Real Annuity

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: IMF staff estimates.

Based on the empirical EBA-type estimates and factoring in the uncertainties and variability of external flows related to hydropower development, the exchange rate is assessed to be mildly overvalued. The external position is expected to follow a path that results in a reversal of the large current account deficits and the negative net foreign asset position over the medium term. Bhutan has an exchange rate peg with the Indian rupee, and macroeconomic policies are broadly appropriate with this arrangement. International reserves have grown steadily over the recent years and are adequate for precautionary purposes.

1 Prepared by Volodymyr Tulin.2 The adjustment methodology is described in IMF WP/09/281 “Exchange Rate Assessments: Methodologies for Oil Exporting Countries” by R. Bems and I. de Carvalho Filho.3 Under this assumption, the Bhutanese per capita electricity consumption at that time will be close to that of the United States as of 2015.

Assessing Reserve Adequacy1

After a dip in reserves in FY2011/12 due to overheating pressures, Bhutan’s international reserves have grown steadily over the last three years in large part resulting from aid inflows. At the end of FY2014/15 reserve holdings stood at US$958 million, corresponding to 10.4 months of prospective year imports. As of February 2016, reserve holdings reached US$1,022 million. Bhutan’s reserve position is higher than suggested by standard “rules of thumb” metrics, such as coverage of 3 months of imports of goods and services, 100 percent of short-term debt and 20 percent of broad money in the economy2.

However, a mismatch between the currency composition of reserves and the structure of Bhutan’s external liabilities and trade remains. Although Bhutan’s currency is pegged to the Indian rupee (INR) and its international transactions are predominantly with India, the share of INR-denominated assets in Bhutan’s external reserves has been low. During 2010-13, overheating pressures led to a shortage of rupee reserves, with rupee- imports coverage ratio falling to less than 1 month, while convertibility of hard currency reserves was hindered. To ease rupee liquidity the Royal Monetary Authority (RMA) borrowed large INR amounts at costly terms from select Indian commercial banks and tapped its currency swap arrangement with the Reserve Bank of India (RBI). Subsequently, the RMA decided to convert convertible currency (CC) reserves in excess of US$700 million into INR, which resulted in an increase in the share of INR reserve holdings from 1.5 percent to 21 percent in mid-2013. In addition, recent agreement with the RBI to receive liquidity support will help in strengthening reserve management. At the end of FY2014/15, INR reserve holdings had a share of 17 percent providing cover for 2.3 months of imports from India, whereas CC reserve holdings stood at US$815 million, corresponding to 35 months of non-Indian import cover.

A01ufig15

Gross Official Reserves

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan; and IMF staff calculations.
A01ufig16

Gross INR Reserves

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: Royal Monetary Authority of Bhutan; and IMF staff calculations.
A01ufig17

Optimal Level of Reserves

(Months of current imports)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: IMF staff calculations

The optimal level of international reserves is assessed using IMF metrics tailored to low-income countries.3 A cost-benefit approach focusing on the role of reserves in preventing and mitigating absorption drops triggered by large external shocks is weighed against the costs to the economy of holding reserves.4

Calibrating the model for Bhutan yields optimal levels of aggregate gross reserves in the range of 1½ to 5½ months of import cover depending on assumptions about the cost of holding reserves. Although this suggests that Bhutan’s reserves exceed the optimal level implied by the model, when currency composition is taken into account, the INR reserves cover less than the model-implied optimal level of 2-6½ months of Indian imports while the CC holdings significantly exceed the model-implied optimal coverage level of 7–10 months of imports. The large number of hydropower projects in the pipeline and volatility in external flows to and from India will likely contribute to volatility in rupee reserves, requiring more active reserve management. In addition, the arrangements with the RBI will play a useful role in addressing short-term mismatches in rupee inflows and outflows.

1 Prepared by Purva Khera.2 The composite IMF metric for Bhutan is constructed by assuming that reserves have to fully cover the debt service requirements, part of the import bill and M2. The estimated metric shows that the reserve coverage has stayed comfortably above the 150 percent range (upper bound) during the past decade.3www.imf.org/external/pubs/cat/longres.aspx?sk=25316.04 IMF (2013), “Assessing Reserve Adequacy – Further Considerations,” IMF Policy Paper, November 13, 2013.
Figure 1.
Figure 1.

Bhutan: Recent Macroeconomic Developments

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: IMF, International Financial Statistics, Royal Monetary Authority of Bhutan, and IMF staff calculations.
Figure 2.
Figure 2.

Bhutan: External Developments

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: IMF, International Financial Statistics, Royal Monetary Authority of Bhutan, and IMF staff calculations.
Figure 3.
Figure 3.

Bhutan: Fiscal and Monetary Developments

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Sources: IMF, International Financial Statistics, Royal Monetary Authority of Bhutan, and IMF staff calculations.
Figure 4.
Figure 4.

Bhutan: Business Environment and Governance

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A001

Note: As pointed out in an independent evaluation of the Doing Business survey (see www.worldbank.org/ieg/doingbusiness), care should be exercised when interpreting these indicators given subjective interpretation, limited coverage of business constraints, and a small number of informants, which tend to overstate the indicators' coverage and explanatory power.
Table 1.

Bhutan: Selected Economic Indicators, 2012/13–2017/18 1/

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Sources: Bhutanese authorities; and IMF staff estimates and projections.

Fiscal year begins July 1.

Public and publicly guaranteed debt, including loans for hydropower projects.

On a calendar year basis (e.g., the entry for 2012/13 is for 2012).

Table 2.

Bhutan: Government Budget Summary, 2012/13–2017/18

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Sources: Data provided by the Royal Government of Bhutan; and IMF staff estimates and projections.

Includes corporate tax on Druk Green Power Corporation (DGPC), new power projects and Bhutan Power Corporation (BPC).

Druk Holding and Investment Ltd. (DHI) portfolio includes hydropower, namely DGPC and BPC shares, as well as non-energy assets.

Includes dividend from DGPC, new power projects and BPC, and profits transfer from Tala Hydroelectric Project Authority (THPA).

Table 3.

Bhutan: Balance of Payments, 2012/13–2019/20

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

Includes budgetary grants only.

Including grants for hydropower projects (Tala, Puna I, Puna II, Mangdechhu, Kholongchhu, Bunakha, Chamkarchhu, and Wangchhu)

Including trade credit, rupee credit lines, short-term capital flows and IMF SDR allocation in 2009.

Table 4.

Bhutan: Medium-Term Macroframework, 2012/13–2020/21

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

Government budgetary accounts. Revenues, interest payments, and foreign financing include flows related to hydropower projects.

Includes budgetary grants only.

Table 5.

Bhutan: Monetary Survey, 2010/11–2014/15

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

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

From 2011/12 onward, public enterprises include government corporations and other public corporations as in the previous definition.

From 2011/12 onward, private sector credit includes joint corpoerations, NBFIs and private sector as in the previous definition.

Includes foreign exchange valuation adjustments and capital accounts.

Includes time and foreign currency deposits.