Bhutan Staff Report for the 2016 Article IV Consultation—Debt Sustainability Analysis1
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International Monetary Fund. Asia and Pacific Dept
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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.

Background

1. Bhutan’s public and publicly guaranteed (PPG) external debt jumped to 94 percent of GDP in 2013, up from 75 percent of GDP in 2012, and has remained relatively stable in 2014 and 2015.3 The earlier rise in public debt was driven mainly by hydropower sector-related external borrowing (see text chart below). Hydropower projects are primarily financed by India with a mix of loans (70 percent) and grants (30 percent).4 External debt continues to be dominated in Indian rupees (and related to hydropower sector debt), which accounts for about 70 percent of total external debt, with convertible currency debt accounting only 30 percent of GDP. Domestic debt remains a small fraction of public debt.

A03ufig1

Hydro and Non-hydro Power Debt Outstanding

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A003

Underlying Debt Sustainability Analysis Assumptions

2. The baseline scenario assumes that additional expansion of Bhutan’s power generation capacity will triple the generation capacity. Presently, five hydropower plants are operating, with total capacity about 1,600 megawatts (MW). The hydropower development policy of Bhutan currently envisages eight new hydropower projects to be commissioned by 2026 (see table below), adding 5,200 MW to Bhutan’s power generation capacity.5 Total techno-economically feasible hydropower potential is estimated to be 24,000 MW. External financing for non-hydropower sector activities continues to remain predominantly from multilateral and bilateral donors at concessional terms.

Hydropower Projects in the Pipeline

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3. The hydropower sector will continue to have a major impact on the rest of the economy as summarized by the following key baseline macroeconomic assumptions.

  • Real sector: Similar to the spike in real GDP when Tala was commissioned in 2006/07, Puna I, Mangdechhu and Puna II will continue to boost economic growth as they come on stream in 2017/18 and 2018/19.6 Real growth is projected to average around 9 percent in 2016–21, higher than the 10-year historical average of 7.4 percent. Growth will accelerate significantly in 2018-2019, with the commissioning of the above-mentioned plants, and then moderate to an average 5.5 percent in 2022–36.

  • Fiscal sector: Upon completion, the commissioning of hydropower projects will boost temporarily the domestic revenue-to-GDP ratio, mainly as a result of higher nontax revenues (transfer of profits and dividend payments). External budgetary aid is assumed to decline sharply during the 13th FYP (2024–2028) as Bhutan’s per capita income rises. On average, the overall fiscal deficit remains broadly balanced over the long term.

  • External sector: The current account deficit is projected to remain close to the current levels till 2017, and then to start declining rapidly, as a result of significant increase in electricity exports upon the completion of hydropower projects. In the medium-term, electricity exports are estimated to more than quintuple from current levels, and the current account balance should move to a surplus by 2025, with external reserves increasing significantly.

Key Macroeconomic Assumptions

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External Debt Sustainability Analysis

A. Baseline

4. Bhutan’s external debt ratios remain above the LIC-DSA indicative thresholds during the first half of the projected period under the baseline, but the commissioning of the hydropower projects in 2017/18 and 2018/19 and the start of debt repayment put the debt ratio on a steady downward trajectory. Bhutan’s external debt is driven mainly by hydropower developments. External PPG debt as a share of GDP is projected to peak at 113 percent in 2017, with disbursements for hydropower-sector projects, before declining slightly to 111 percent of GDP in 2018.7 As the first phase of hydro construction comes to an end (see table above) and debt repayment starts, the stock of PPG debt is projected to start falling briskly, to below the 50 percent of GDP by 2026, and to below 10 percent of GDP by 2036. As a result, the present value (PV) of PPG external debt-to-GDP gradually declines to only 5 percent over the long term, crossing the 40 percent indicative threshold in 2027. The PV of PPG debt-to-exports ratio remains above the threshold of 150 percent until 2024, but falls to 15 percent at the end of the projected period. Similarly, the PV of PPG external debt-to-revenues ratio peaks at close to 722 percent in 2018, but falls below the 250 percent threshold in 2025, and to 24 percent by 2036.

5. The PPG debt service-to-export ratio is projected to exceed the indicative thresholds in the medium term intermittently by a relatively small margin. The PPG debt service-to export ratio peaks at around 24 percent in 2017 and 2018. However, as exports pick up and debt repayment declines, the ratio falls below the 20 percent threshold by 2019, before rising above the threshold again marginally in 2020–22. In contrast, reflecting partly conservative revenue projection, the debt service-to-revenue ratio remains moderately above the 20 percent indicative threshold for most of the projected period, falling below only in 2032.

B. Sensitivity Analysis

6. The indicative thresholds for the PV of PPG external debt-to-GDP, debt-to-exports and debt-to-revenue ratios are breached under alternative scenarios and stress tests. All these indicators breach their respective thresholds after the shocks in 2016, and most continue to breach the threshold for an extended period of time. The standard sensitivity analysis points to a high risk of debt distress (Figure 1 and Table 2). In particular, historical alternative scenario and bound test with exports in 2017–18 linked to historical average show very large breach. However, these scenarios fail to capture the projected jump in hydropower exports or fiscal revenues. Similarly, the worsening of external debt indicators under the bound test of 30 percent nominal depreciation in 2017 overestimates Bhutan’s debt vulnerability as a large share of Bhutan’s external income is in Indian rupees, which act as a natural hedge to the largely rupee-denominated external debt.

Figure 1.
Figure 1.

Bhutan: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2016–2036 1/

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio on or before 2026. In figure b. it corresponds to a One-time depreciation shock; in c. to a Exports shock; in d. to a One-time depreciation shock; in e. to a Exports shock and in figure f. to a One-time depreciation shock2/ Sharp drop in grant element of new borrowing reflects a decline in the amount of new external borrowing, in part as a result of growing reliance on domestic financing.
Table 1.

Bhutan: External Debt Sustainability Framework, Baseline Scenario, 2013–2036 1/

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Sources: Country authorities; and staff estimates and projections.

Includes both public and private sector external debt.

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

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

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

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

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

Defined as grants, concessional loans, and debt relief.

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

7. Debt service ratios indicative thresholds, too, are breached for large part of the projection period. As in the case of PPG external debt ratios, the historical scenario shows the largest breach for the debt service ratios as well. Debt service ratios remain above their respective thresholds under the historical scenario for the whole projection period. Under the bound tests, debt service ratios return eventually below their thresholds, but mostly late in the projection period.

Public Debt Sustainability Analysis

A. Baseline

8. The baseline public debt dynamics follows closely that of the external debt. The PV of public debt exceeds the public debt benchmark by a significant amount. The public debt-to-GDP ratio is projected to peak at around 115 percent of GDP in 2017, less than the 129 percent of GDP peak in the 2014 DSA. After 2017, public debt is projected to decline steadily, falling to below 60 percent in 2027 and to 49 percent by 2036. Bhutan’s public debt consists mainly of the external debt, and thus the same assessment of the unique mitigating circumstances as in the case of the PPG external debt above applies. With the gradually declining role of external financing, domestic financing is assumed to start playing a larger role in the financing of the development agenda, and the share of domestic debt in the public debt will increase.

B. Sensitivity Analysis

9. The public debt ratios are projected to be on a declining path over the long term under alternative scenarios and various stress tests. However, the scenario with the primary balance unchanged from the 2016 level fails to capture additional revenues from the commissioned hydropower plants, and shows only a very gradual decline in the debt ratio. The sensitivity analysis also suggests that the debt and debt service ratios are sensitive to negative growth shocks. However, the size of the negative growth shock in 2017-20 is substantially magnified by the fact that growth is projected to peak during this period, with the commissioning of the new hydropower plants.

Staff Assessment

10. The current assessment remains broadly the same as the assessment made in the 2014 IMF/World Bank Joint DSA, which found that Bhutan’s debt dynamics are subject to a moderate risk of distress. Even though Bhutan’s PPG external debt indicators continue to breach external debt thresholds by large margins and for a long period, the unique and mitigating factors discussed in detail in the 2014 DSA remain valid and underpin staffs’ unchanged assessment.

  • The current and projected PPG external debt is now somewhat less than projected in the 2014 DSA, due to the fact that some hydropower projects have been put on hold. In 2015, PPG external debt stock reached 94.5 percent of GDP, 20 percentage points less than projected in the previous DSA. However, as mentioned above, Bhutan’s CPIA rating has also worsened, from ‘strong” to “medium”—even though the overall decline in CPIA score was relatively modest, to 3.74 and 3.71, marginally below the “strong” rating threshold of 3.75. Even with the lower CPIA rating and thus lower debt and debt service thresholds, these are mostly breached for similar or shorter period than in the previous DSA, reflecting the lower current and projected debt.

  • India provides explicit guarantees that cover financial and construction risks for the intra-governmental hydropower projects. In addition, India buys all surplus power that is not consumed domestically, and the price is on a cost-plus basis which includes a net return of 15 percent. As a result, hydropower loans from India are more akin to foreign direct investment rather than debt-creating loans. Moreover, in power-hungry India, there is little risk of insufficient demand for future hydropower supply. This arrangement significantly reduced the risk of external debt distress.

  • Bhutan’s hydropower production, exports and thus the capacity to service its debt will increase only in the medium term. Therefore, staff continue to advice against any nonconcessional borrowing at this stage. As highlighted previously and confirmed again by the present DSA, Bhutan is vulnerable to adverse shocks. DSA’s stress testing illustrates potential vulnerabilities in Bhutan’s external debt situation to export and growth shocks, as well as to shortfalls in aid inflows and failure to reverse declining tax revenues.

  • Assuming they are effectively executed and associated macroeconomic challenges properly managed, the additional hydropower projects should eventually bring solid economic dividends, supporting higher exports and income.

  • The authorities agreed with staff’s assessment of external risk. They emphasized that the projected increase in hydropower exports should help repay a big part of the external debt, and underscored the need to take this factor into account when assessing the external debt vulnerability.

Figure 2.
Figure 2.

Bhutan: Indicators of Public Debt Under Alternative Scenarios, 2016–2036 1/

Citation: IMF Staff Country Reports 2016, 206; 10.5089/9781475567342.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio on or before 2026.2/ Revenues are defined inclusive of grants.
Table 2.

Bhutan: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2016–2036

(In percent)

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Sources: Country authorities; and staff estimates and projections.

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

Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline., while grace and maturity periods are the same as in the baseline.

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

Includes official and private transfers and FDI.

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

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

Table 3.

Bhutan: Public Sector Debt Sustainability Framework, Baseline Scenario, 2013–2036

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Gross government debt including hydro-related liabilities.

Positive residuals reflect off-budget hydropower sector transactions, debt financing of which is included in the stock of public debt, and the associated interest payments are financed through the budget.

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

Revenues excluding grants.

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

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

Table 4.

Bhutan: Sensitivity Analysis for Key Indicators of Public Debt, 2016–2036

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Sources: Country authorities; and staff estimates and projections.

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

Revenues are defined inclusive of grants.

1

This DSA was prepared by IMF and International Development Association staff in collaboration with the Asian Development Bank and Bhutanese authorities. The analysis updates the previous Joint DSA dated May 30, 2014 (IMF Country Report No. 14/178). The DSA follows the IMF and World Bank Staff Guidance Note on the Application of the Joint Fund-Bank Debt Sustainability Framework for Low-Income Countries (November 7, 2013). The data underlying the analysis are from the Bhutanese authorities, IMF, and World Bank staff estimates.

2

The magnitude of the breach has increased due to the revision of the Country Policy and Institutional Ratings (CPIA) to medium, from a strong rating in the 2014 DSA. In 2013 and 2014, Bhutan’s 3-year moving average CPIA ratings were 3.74 and 3.71, marginally below the “strong” rating threshold of 3.75.

3

The DSA uses fiscal years (FY). For example, 2013 means FY 2012/13.

4

The second generation of hydropower projects will be based on joint venture (JV) models (see text table below). In this model, 70 percent of the project will be financed by loans from India, while the remaining 30 percent will the financed by equity equally split between India and Bhutan’s governments. India will provide a grant to Bhutan to finance its equity share.

5

There is uncertainty surrounding the exact timing of the projects, as well as the future of some additional projects under discussion that are not included in the projection.

6

Prior to commissioning, construction of these hydropower plants has been the second largest contributor after services to real growth during the 10th FYP. A more than doubling of electricity generation capacity with the commissioning of these plants will lead to a jump in electricity exports and fiscal revenue, providing a much larger boost to economic growth in comparison to the construction phase.

7

In the 2014 DSA, public external debt was projected to peak at 120 percent of GDP. The main reason for the lower debt in the present DSA is the lower number of hydropower projects in the pipeline (three projects less).

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Bhutan: 2016 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Bhutan
Author:
International Monetary Fund. Asia and Pacific Dept