Bhutan: 2018 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Bhutan

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Bhutan


2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Bhutan

Recent Developments, Outlook, and Risks

1. Bhutan has made significant strides in improving per capita income and reducing poverty in the context of the 11th Five-Year Plan (FYP). Poverty has declined significantly from 12 percent in 2012 to 8.2 percent in 2017, with extreme poverty falling to just 1.5 percent, while the Gini coefficient remained roughly unchanged at 0.38 (Box 1). With the country now transitioning to middle-income status, continuous reforms and prudent policies are needed to contain economic and financial vulnerabilities, diversify the economy and enhance its overall competitiveness to sustain growth, and further improve gross national happiness.

Poverty Trends

Bhutan continues to make inroads into reducing poverty at an appreciable pace. Backed by average GDP growth of 7.5 percent over the decade to 2017, driven in large part by hydropower construction and exports, the poverty rate in Bhutan has declined from 23.2 percent in 2007, to 12 percent in 2012, and further to 8.2 percent in 2017. Poverty reduction was a key focus of the 10th FYP, the period corresponding to the steepest decline in poverty, with further reduction in poverty and improved social outcomes observed during the 11th FYP.


Bhutan Poverty Rates

(In percent)

Citation: IMF Staff Country Reports 2018, 300; 10.5089/9781484382073.002.A001

Source: Bhutan Poverty Analysis Report (2017); Royal Government of Bhutan, and World Bank.

Poverty in Bhutan is largely a rural phenomenon. Even so, impressive gains have been in reducing rural poverty from nearly 31 percent in 2007 to 12 percent in 2017, whereas urban poverty has also declined from very low initial levels (1.7 percent in 2007) to 0.7 percent in 2017.1 Subsistence (or extreme) poverty is even lower, about 1.5 percent in aggregate, and just over 2¼ percent in rural areas. The depth of poverty, measured as the average gap in per-capita consumption of the poor from the poverty line (assumed to be zero for the non-poor, expressed in percent of the poverty line) too is greater in rural areas, but, at 2.4 percent on average, it does not appear to be particularly severe.

The statistics on access to public services and information are encouraging. The overwhelming majority (99.9 percent) of the population is reported to have access to improved water sources, with no significant differences across income groups. At least 92 percent of households have access to improved sanitation, with only an eight percent difference between poor and non-poor households. 67 percent of non-poor households have at least one smart phone, compared to 29 percent in poor households. Going forward, most surveyed poor households in rural areas specified public transport as a priority concern, while those in urban areas mentioned employment generation as an area for improvement.

An analysis of the change in poverty suggests that the main driver has been an increase in non-food consumption, with no appreciable change in food consumption patterns. Further understanding the drivers of poverty reduction would require more research, which the authorities are planning to conduct in the near future, supported by the World Bank and other donors.

1Bhutan Poverty Analysis Report (2017), Royal Government of Bhutan and World Bank.

Gross Domestic Product, Per Capita

(Constant 2010 U.S. dollars)

Citation: IMF Staff Country Reports 2018, 300; 10.5089/9781484382073.002.A001

Sources: World Bank, World Development Indicators.

2. Growth remains robust (Figures 13, Tables 16). GDP grew at 7.3 percent during FY2015–16, driven by the hydropower sector, and is estimated to have maintained momentum at 7.4 percent in FY2017, with strong growth in services and manufacturing offsetting a tapering in hydropower construction. Headline inflation increased from a historic low of 3.2 percent in December 2016 to 4.3 percent in December 2017, with both food and non-food inflation rising.

Figure 1.
Figure 1.

Bhutan: Recent Macroeconomic Developments

Citation: IMF Staff Country Reports 2018, 300; 10.5089/9781484382073.002.A001

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

Bhutan: External Developments

Citation: IMF Staff Country Reports 2018, 300; 10.5089/9781484382073.002.A001

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

Bhutan: Fiscal, Monetary, and Financial Developments

Citation: IMF Staff Country Reports 2018, 300; 10.5089/9781484382073.002.A001

Sources: IMF International Financial Statistics, Royal Monetary Authority of Bhutan, and IMF staff calculations.
Table 1.

Bhutan: Selected Economic Indicators, 2012/13–2018/19 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, 2012/13–2022/23

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

Excluding DGPC dividends.

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

Table 3.

Bhutan: Balance of Payments, 2013/14–2022/23

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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 Macroeconomic Framework, 2012/13–2022/23

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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.

GST is not included in the baseline.

Includes budgetary grants only.

Table 5.

Bhutan: Monetary Survey, 2013/14–2017/18

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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.

Table 6.

Bhutan: Financial Soundness Indicators, 2008/09–2017/18 1/

(In percent, unless otherwise specified)

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Source: Royal Monetary Authority of Bhutan.

Data are for July-June fiscal years.


Sectoral Composition of GDP

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 300; 10.5089/9781484382073.002.A001

Sources: Royal Monetary Authority of Bhutan, and IMF staff estimates.* 2017/18 and 2018/19 are projections

3. External imbalances are large but beginning to decline. The current account deficit (CAD) averaged 26 percent of GDP during FY2012–16 reflecting investments in the hydropower sector and is estimated to have narrowed to 22.8 percent in FY2017 due to lower hydropower-related imports and increased electricity exports. Reserve coverage is adequate at nearly 13 months of imports of goods and services.1

4. The financial performance of the banking sector remains weak but risks appear contained overall. Profitability is low and some banks have high rates of non-performing assets. At the same time, liquidity and provision coverages are high and interest rate risks are contained due to adjustable rate lending. Recently, four microfinance institutions have been licensed. Progress is being made on modernizing the payment system and financial inclusion. The Royal Monetary Authority (RMA) has recently launched a Priority Sector Lending (PSL) program (Appendix I) as part of a holistic effort to improve access to credit for cottage and small industries (CSI) sector.

5. Work on formulating the 12th FYP is underway. The draft 12th FYP intends to deepen decentralization by increasing the share of capital expenditure by local governments (from 30 to 50 percent); further reduce poverty and create jobs; enhance the quality of education and health; and improve institutions and the justice system. The current draft will have to be endorsed by the incoming government (which will take over in October) to become final. The Gross National Happiness Commission recently began work on articulating a new long-term vision (the current 20-year vision expires in 2020).

6. Medium-term growth will be driven by new hydropower plants coming on stream, services, and manufacturing. On current policies, real GDP growth is projected to decelerate to 4.8 percent in FY2019, reflecting a sharp decline in public investment in the transition to the 12th FYP and continued tapering of hydropower construction, but moderated by the coming on stream of the large Mangdechhu hydropower plant. Subsequently, growth is expected to recover to about 6 percent in FY2019–20, with a further acceleration in FY2021–22 due largely to the expected coming on stream of two other hydropower projects. Inflation is projected to remain broadly in line with that in India, given the ngultrum’s peg to the rupee. The current account balance and reserve coverage are expected to improve due to a decline in hydropower-related imports and a sharp increase in hydropower exports.

7. Risks to the outlook are skewed to the downside in the baseline, but active policies could lead to higher growth outcomes (Appendix II). On the domestic side, delays in implementing the GST and completing hydropower projects could lead to lower electricity exports and larger fiscal deficits. Vulnerabilities exist in the financial sector due to the quality of banks’ lending and weak profitability. However, avoidance of a sharp spending cliff in FY2019 and more gradual fiscal consolidation in the medium term, coupled with higher domestic revenue mobilization, could lift growth above the baseline forecast. External risks stem from the possibility that Indian growth, Indian inflation, or global oil prices could deviate from baseline assumptions as these variables have substantial effects on the Bhutanese economy.

8. Policies have been largely in line with past Fund advice. Weaknesses in the domestic revenue base will be addressed by the impending introduction of the GST, while volatility in fiscal revenues and expenditures will be reduced through the Bhutan Economic Stabilization Fund (BESF) (Appendix III). In addition, efforts are underway to strengthen the fiscal institutional framework. Monetary management is being enhanced by the introduction of the new policy framework, and reserve management has been improved, inter alia, by the increased share of Indian rupees in total reserves. Finally, the prudential regulatory framework for banks has been bolstered, and regulatory gaps in other areas (e.g., insurance regulation and risk management) are being addressed.

Authorities’ Views

9. The authorities broadly agreed with the outlook and risks for the economy, but they were more optimistic about the short-term growth prospects. They stressed the importance of having a risk-mitigating framework underpinned inter alia by the BESF, which is currently being established. While acknowledging the potential fiscal drag on GDP growth from low capital expenditures in FY2019, they were hopeful that the coming on stream of the Mangdechhu plant would keep the growth in line with previous years, surprising on the upside.

Macroeconomic and Financial Policies

10. Bhutan’s transition from the 11th to the 12th FYP, its forthcoming graduation from Least Developed Country status, and the growing importance of hydropower raise important policy issues. The most immediate concern is avoiding a sharp reduction in public investment budgeted for FY2019 that would hurt growth. Key medium-term policy challenges include the mobilization of domestic revenues and prudent management of hydropower revenues to support adequate levels of public spending against the background of declining foreign grants, while maintaining macroeconomic stability. Plans to upgrade the monetary policy framework and to establish a stabilization fund for hydropower revenues will support these goals. On the structural front, the key challenge is to enhance competitiveness and diversify the sources of growth.

A. Fiscal Policy

11. While prudent on average over each FYP cycle, fiscal policy in Bhutan is characterized by large swings in expenditures and deficits within these cycles. After recording overall surpluses in the first two years of the 11th FYP, fiscal policy became expansionary in FY2016–17. Although lower than budgeted (at 5.3 percent of GDP), the deficit widened to 3.3 percent in FY2017 from 1.1 percent in FY2016, driven largely by a sizable expansion of capital expenditure, while domestic direct tax revenues declined, in part due to weaker hydropower-related revenues. The estimated FY2018 budget outcome is a deficit of 1 percent of GDP, with the improvement driven by higher hydropower revenues and excise duty refunds from India.

12. Staff assess Bhutan’s risk of debt distress as moderate (see 2018 Debt Sustainability Analysis). Outstanding hydropower debt makes up 77 percent of Bhutan’s external public and publicly-guaranteed debt.2 All hydropower projects but one are financed by India under the intergovernmental agreement wherein India is contractually obligated to purchase the electricity at tariffs based on cost-plus-margin pricing, decreasing risks associated with the high level of external debt. Plants and equipment are insured for replacement value against calamities, and Bhutan only carries the production risks.

13. The budget for FY2019—proposed by the outgoing government and adopted by the parliament on an interim basis—implies a sharp fiscal withdrawal.3 The overall balance would swing to a 2.2 percent of GDP surplus, owing mainly to a massive decline in capital expenditure from 17 percent of GDP in FY2018 to 5.6 percent in FY2019. Moreover, current spending is set to remain flat in nominal terms, implying a 1.2 percent of GDP decline relative to FY2018. Revenues and grants are set to decline by 9 percent of GDP, reflecting mainly lower foreign grants and a decline in excise duty refunds from India, which will fall in the next year and cease after FY2020, following the introduction of India’s GST in July 2017.4

14. The draft 12th FYP implies an average overall budget surplus of 1.4 percent of GDP for the period FY2019–23.5 Under this plan, capital expenditures would amount to around 9½ percent of GDP annually on average, well below the 15½ percent of GDP recorded on average during the 11th FYP. While capital spending is partly constrained by the expectation of declining foreign grants (projected to reach 5¼ percent of GDP annually on average, as compared to 9½ percent of GDP under the 11th FYP) and the loss of excise duty refunds from India of about 1¾–2 percent of GDP, the lower spending envelope also appears to be a policy choice.

15. Staff proposed higher fiscal spending in FY2019 and a more gradual fiscal consolidation over the medium term. The programmed investment cliff will negatively affect growth in FY2019. While implementation lags limit the possible increase in capital spending in the short term, expenditures on maintenance can be frontloaded to limit the fiscal withdrawal in FY2019. Moreover, given Bhutan’s significant infrastructure needs (see Structural Issues section), staff saw scope to raise capital spending by about 2 percent of GDP annually on average over the medium term and recommends a more even spending path than implied in the draft 12th FYP. Higher capital spending could be supported by additional domestic tax revenue mobilization as well as a modest amount (about 1 percent of GDP annually on average) in domestic financing. This alternative fiscal path would allow the continued expansion of much needed productive infrastructure and support higher growth.


Medium-term Fiscal Outlook

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 300; 10.5089/9781484382073.002.A001

Source: Draft 12th Five Year Plan fiscal projections, and staff projections.In the alternative scenario, it is assumed that authorities will implement a GST by July 2020, that will make up for the loss of excise duty refunds from India, and the current sales tax, with modest buoyancy over the medium term. The additional capital spending is financed partly by the higher revenue mobilization and partly by increased domestic debt.

16. To boost the domestic revenue base, the authorities should implement their plans for a broad-based GST without delay (Box 2). While currently not in the baseline projections, the authorities have begun planning for GST implementation scheduled for July 2020, supported by Fund technical assistance (TA). Early endorsement of the project by the incoming government and passage of the associated legislation will be critical to meet the implementation timeline. In terms of design, the GST should be broad-based (to include services) and have a simple rate structure (preferably a single tax rate). Some additional domestic revenue could be collected in the short term by updating the bases of user charges and land/property taxes, which have been eroded by inflation. Finally, the authorities should seek to rationalize and gradually curtail the use of tax exemptions (mainly indirect taxes), which were estimated to amount to 2¾ percent of GDP in FY2017.

Goods and Services Tax

With India’s implementation of the GST in July 2017, the adoption of a GST in Bhutan has become a high priority. This box outlines some of the key considerations in adopting a GST in Bhutan, including the benefits and important milestones to be accomplished to meet the July 2020 deadline for its implementation.

At present, Bhutan raises around 5½ percent of GDP in indirect tax revenues. Sales taxes account for 2½ percent of GDP, while around 2 percent of GDP is raised from the excise duty refund (EDR), which reflects excises levied by India on exports to Bhutan. The remainder is raised from domestic excises, a green tax, and customs duties.

With India’s adoption of the GST (and removal of excises on exports), the EDR will effectively cease in FY2020, leaving a large revenue gap to be filled. While the authorities have identified a set of primarily sales tax-related measures that could potentially make up for the loss of EDR revenue, a broad-based GST will help to cover the revenue gap in a sustainable and more efficient manner. Moreover, a GST is likely to be buoyant; in a sample of nearly 70 countries compiled by staff, the average increase in VAT revenue as a percent of GDP was about ½ percent of GDP over a five-year period.1

Furthermore, the potential to increase indirect tax revenues from other sources, such as raising customs duties, is severely limited by Bhutan’s free trade agreement with India (which covers 90 percent of imports), as well as South Asian Association for Regional Cooperation preferences and the preferential trade agreement with Bangladesh. Thus, indirect tax revenues will rely heavily on GST implementation.

While the benefits of a broad-based GST are well understood, the key challenge from a tax policy perspective will be to design and implement a GST that does not “resemble” the existing sales tax. This requires: (i) a broad base, (ii) effective input tax credit/refund management, and (iii) administrative simplicity (e.g., few rates), in particular given capacity constraints. The GST under consideration presently in Bhutan resembles a standard VAT with input tax crediting, a mandatory turnover-based registration threshold, and adherence to the destination principle (with zero-rated exports and taxed imports, including service imports).

Bhutan is receiving extensive IMF support for implementing the GST. Bhutan created a project office and prepared a GST implementation plan, consisting of a detailed timeline, in line with IMF recommendations. IMF TA has provided further recommendations in key areas including: (i) legislation and rules including to draft the GST law; (ii) establishing and guiding business processes related to the GST; (iii) selection of the appropriate information technology (IT) system; (iv) taxpayer outreach; and (v) capacity building. TA on the GST law is currently on-going. The draft law is being reviewed by the GST Working Group at the Department of Revenues and Customs. In terms of challenges, the ability of the revenue authority to develop and implement an IT system that can underpin GST processing is considered one of the potential stumbling blocks that could delay the adoption of the GST.

1 There is substantial variation over the sample, however, and this does not control for tax policy changes.

17. Staff encouraged the authorities to develop a domestic public debt market in Bhutan. At present, domestic financing is based on a small Treasury bill market, which is subject to high rollover risk. With concessional financing decreasing, the authorities need to develop a source of stable and inexpensive domestic funding. To function properly and without undue risk, this needs to be based on a medium-term debt strategy and a comprehensive market development strategy.

18. The ongoing initiatives to strengthen public financial management (PFM) are commendable and should be deepened further. The authorities are currently in the process of implementing a fully electronic system for government payments. It will be advisable to replace the current five-year planning cycle, which creates large and undesirable aggregate demand shocks, with a rolling multi-year budget framework that will enable greater stability. Staff encouraged the authorities to further improve fiscal transparency by enhancing the scope and content of budget documents and more frequent reporting.

19. The authorities have embarked on an effort to establish a stabilization fund to manage hydropower revenues and business cycle fluctuations. The draft Royal Charter is under review and the Rules and Regulations are expected to be issued shortly, with seed money (in the amount of Nu 100 million) allocated to be invested in Indian rupee assets. Staff noted the importance of transparent and rules-based principles for the fund’s operations. In addition, it viewed the proposed floor for transfers to the fund (5 percent of hydropower royalties) to be insufficient and urged the authorities to set a more ambitious target to ensure meaningful (countercyclical) contributions from the fund to the expenditure envelope.

Authorities’ Views

20. The authorities agreed with staff’s assessment of the fiscal stance under the 11th FYP, noting that it had been prudent, achieving on average a balanced budget for the five-year period. They also agreed that a projected sharp contraction in capital spending in FY2019 was of concern, but that it was constrained by the electoral cycle, limiting expenditures to essential activities and spillovers from the 11th FYP. They noted that—while desirable—higher spending in FY2019 will not be feasible as the new Cabinet, which would need to approve the spending, will only be appointed in October. Overall, the authorities assessed positively the staff’s alternative scenario for the medium-term, noting that it provides somewhat higher and stable investment, but stated that it will be subject to the approval of the final 12th FYP.

21. The authorities expressed concern about the risks of the tax-to-GDP ratio declining in coming years and agreed on the need to undertake revenue reforms. While reaffirming their commitment to GST implementation, including mobilization of the required project funding, they noted that the project is subject to final approval by the new Cabinet. The authorities also agreed that the proposed 5 percent minimum on royalties from hydropower to be transferred to the BESF was low, but noted that the rate of transfer can be raised, if necessary. The authorities acknowledged that the public debt level remains high but agreed that the debt-related risk is moderate due to the foreign direct investment (FDI)-like nature of most of Bhutan’s debt. Finally, on PFM reforms, they expressed interest in a medium-term rolling budgetary framework, as a way of reducing the cyclicality of budgetary spending and avoiding unnecessary volatility in the fiscal stance, and stated their commitment to improving budget transparency and more frequent fiscal reporting.

B. Monetary Policy

22. Monetary conditions have remained stable in recent years. Credit growth has slowed from 35 percent on average in 2005–11 to a more manageable 15 percent in 2012–17 including due to the use of macroprudential instruments. To avoid a repeat of the excess liquidity-fueled external imbalances of 2011–12, the RMA is sterilizing hydropower-related liquidity through a daily sweeping of related bank balances. Staff analysis shows that only a small positive credit gap has emerged in recent quarters, much lower than in the run-up to the rupee crisis in 2012 (Appendix IV).

23. The authorities are in the process of modernizing their monetary policy framework, supported by TA from the South Asia Regional Training and Technical Assistance Center (SARTTAC). The RMA’s liquidity management and forecasting capabilities are being enhanced, along with the establishment of an interest rate corridor (IRC) and development of the interbank market. The new monetary policy framework—including standing marginal lending and deposit facilities to support the IRC—is expected to become operational shortly.

24. Staff welcomed the ongoing reforms, which will enhance the policy toolkit to maintain macroeconomic stability. Once fully operational, the liquidity management framework will allow the RMA to align money market conditions with the monetary policy stance that is needed to support the currency peg. Because of the uncertainties about inflation dynamics and the need to gain experience in the operation of the IRC while preserving credibility, the RMA should start with a relatively wide corridor (e.g., +/− 200 bps) and then reduce it gradually over time to allow for better interest-rate control and market development. Once the framework is in place, staff recommended a review of the Minimum Lending Rate (MLR), which is only remotely related to RMA’s monetary policy stance and appears to create distortions in the credit market.6

Authorities’ Views

25. The authorities acknowledged the challenges of moving from a quantity to interest rate signaling of the policy stance but reaffirmed their commitment to putting the new monetary policy framework in place soon. They welcomed the capacity development provided by the Fund and agreed with the need to further strengthen the capacity to analyze macroeconomic and monetary developments. They concurred on the need to have the benchmark interest rate aligned with that in India and to have market-based interest rate signals from a properly functioning domestic debt market, which would also make more instruments available for banks to access short-term funds through the liquidity facility.

C. Financial Sector

26. The banking sector is nascent and suffers from low profitability. The return on assets dropped from 1.8 percent in 2016 to just 0.7 percent in 2017, while the return on equity declined from 11.3 percent to 4.8 percent. The system-wide non-performing loan (NPL) ratio was at 8.4 percent in December 2017, up from 7.2 percent in December 2016. NPLs continue to show a strong seasonal pattern, with sharp declines in December (end of the banking financial year). Adjustment in risk weights and provisioning requirements resulted in a fall in the capital adequacy ratio (CAR) from 19 percent in 2016 to 16 percent in 2017. On the positive side, provisions are high and required provisions are calculated on a (conservative) gross basis. The sector’s liquidity levels are high (above the already demanding regulatory requirements of 10 percent of the cash reserve ratio (CRR), kept with the RMA, and an additional 20 percent statutory liquidity ratio (SLR), kept in liquid assets).7 The risks of financial contagion appear to be contained by the relatively small size of gross exposures between banks, corporations, households, and the budget.

27. While the prudential framework of the financial sector needs continued improvement, progress has been made in some key areas aided by SARTTAC. Corporate governance regulations for financial institutions and a new regulatory framework for the insurance sector are being implemented; a review of the macroprudential framework is underway; the collateral credit registry has recently moved to the RMA; risk management regulations and guidelines are under preparation; and the pension fund guidelines and regulatory strategy are under review. However, bank supervision remains largely compliance-based, and only a subset of the main prudential rules is monitored on a quarterly basis (the rest being enforced at year-end), with no penalties for non-compliance before year-end. While loan loss provisioning rules appear reasonably stringent, the rules and the practical application of loan classification remain somewhat lax.8

28. The financial sector’s resilience should be further strengthened and the regulatory regime modernized to avoid a build-up of risks. Staff urged the authorities to tighten loan classification requirements for banks (including by enforcing and extending the period of satisfactory performance before an impaired loan can be reclassified as performing, which will help address the sharp seasonal NPL swings) and mandate the banks to supplement the current rules with risk-based provisioning (which some banks practice already). With the coming on stream of RMA’s new liquidity facility, the authorities should gradually reduce the current liquidity requirements for banks, since high liquidity buffers affect profitability and may increase, rather than reduce, financial risk. On PSL, staff recommended maintaining the credit assessment of proposals under the program at par with those for market-based lending and evaluating program outcomes on a regular basis to avoid creating market distortions. Finally, staff urged continued vigilance in the face of potential financial stability risks, adjusting macroprudential policies when needed.

Authorities’ Views

29. The authorities were encouraged by recent improvements in regulatory compliance of some banks but nonetheless agreed with staff on the need to further tighten financial sector regulation and supervision. They pointed to several key financial sector-related policy changes taking place now and stressed the role they will play in broadening and deepening access to finance. They noted that the financial inclusion strategy (to be issued by December 2018) is expected to be the cornerstone of their efforts in this direction. Finally, the authorities agreed that there might be scope to review and possible reduce liquidity requirements once the new monetary framework, with the supporting liquidity facility, is operational.

D. External Sector and Exchange Rate Policy

30. The ngultrum’s peg to the rupee has served the economy well. It has important implications for debt and reserve management due to the economy’s exposure to the rupee. About three-quarters of public external debt is denominated in Indian rupees, and both exports and imports are predominantly with India (70–90 percent). In the past, a low share of rupee reserves in total reserves resulted in a drying up of rupee liquidity. This has improved, with rupee reserves constituting 36 percent of total reserves in September 2017, up from 16 percent in July 2015. This, along with access to a swap line with The Reserve Bank of India (RBI, for US$100 million) and a rupee facility with the Government of India (GoI, with an outstanding amount of 7 billion Indian rupees), improves financial buffers. However, staff continued to advise the authorities to further increase the share of rupee reserves (to above 50 percent), based on trade patterns and the structure of the RMA’s balance sheet.

31. Staff assesses Bhutan’s external position to be moderately weaker than warranted by fundamentals and desirable policies (Appendix V). Vulnerabilities relate to India’s recent GST implementation (which makes Indian exports zero-rated and therefore cheaper in Bhutan) and an increase in oil prices (which will increase the current account deficit). Bhutan’s reserve coverage remains adequate.

Authorities’ Views

32. The authorities agreed that the peg continues to be the appropriate exchange rate regime for Bhutan. They noted that the share of Indian rupees (INR) has exceeded 30 percent of total reserves in recent months and rupee liquidity is further bolstered by the facilities available to them via RBI and GoI. As in the past, maintaining an adequate buffer of INR has been a critical part of overall reserve management system. Although, currently, the RMA has been managing the INR using the RBI and GoI facilities, it would be important to institute a more formal INR management system to meet the day-to-day INR demand of the economy. While a proposal to increase the rupee share of reserves to 40 percent was recently rejected by the RMA Board, the authorities noted that, based on the projections, electricity exports due to the commissioning of three hydroelectric plants by FY2023 are expected to turn the current account positive in the medium term, which would structurally improve rupee liquidity. However, any delays in the hydropower projects would entail challenges in managing the external sector.

E. Structural Issues

33. While the development of the hydropower sector has contributed significantly to progress, associated risks and the need to generate high-quality jobs for Bhutan’s youth have heightened the need for diversification. The guideline for the 12th FYP emphasized the importance of developing industries other than hydropower including the CSI. The authorities have identified five sectors—agriculture, CSI, hydropower, tourism, and mining—to help expand domestic production and reduce import dependency.

34. Improving the business environment will aid private sector development.9 Bhutan is ranked 75th in Doing Business 2018, and the World Bank’s Investment Climate Assessment in 2016 identified access to finance, access to skilled labor, and access to external markets as three binding constraints. The authorities have taken measures to address some of these bottlenecks in recent months.

35. Further progress with improving access to finance is important. On the supply side, the recent expansion of the Credit Information Bureau coverage (to include information on utilities’ payments and borrowing from micro-finance institutions) will facilitate better risk assessment of borrowers and the PSL policy is expected to improve access to finance for the CSI sector, previously largely underserved by the financial sector. An insolvency bill is currently awaiting parliamentary approval. The authorities also should open more specialized courts to adjudicate commercial (specifically, credit-related) disputes and initiate a review of procedures for out-of-court restructuring of impaired loans to reduce delays in loan recoveries and the transaction cost for bank lending.10 Related to this, the RMA should issue guidelines to encourage banks to write off legacy bad loans (e.g., classified as loss for more than three years) to free up their balance sheet. Legislation should be amended to allow secondary purchases of impaired loans. On the demand side, the ongoing review of the Movable and Immovable Properties Act—which has served the financial sector well by facilitating impaired loan resolutions—should not weaken creditor rights. Finally, improving the registration and validation of land would improve the availability of collateral, especially for farmers. Additional efforts are underway to improve financial literacy and inclusion.

36. Skilled labor is in short supply and skill mismatches are an ongoing concern. While school enrollment has improved in recent years, Bhutan’s gross tertiary enrollment remains at around 10 percent, lower than in the neighboring countries.11 To meet short-term labor needs, more training and lower barriers for skilled immigration would be needed. A recent World Bank report found that the public sector is the choice for educated youth due in large part to a significant wage and compensation gap.12 To make private sector employment more attractive, the authorities could promote voluntary private-sector pension schemes.

37. Further improvements are also needed in infrastructure development. Bhutan is ranked 135th among 160 economies in the World Bank’s 2016 Logistics Performance Index, suggesting a continued need for public investment in infrastructure. Information and Communication Technology connectivity also needs to be improved, with potentially significant implications for private sector development in the services sector. In this regard, the minimum threshold for FDI—a key channel for investment in technology and employment generation—is high (currently at US$20 million). There is also a case for liberalizing access of foreign investors to select CSI activities that are presently on the negative list for FDI.13

Authorities’ Views

38. The authorities stated their strong commitment to diversifying the economy and providing high-paying jobs for the population, especially the youth. They noted that deep-rooted reforms are needed in the education system, in addition to improvements in access to finance. While they acknowledged the existence of skills’ mismatch and a strong preference by youth for public sector jobs, large-scale donor-funded training programs are being provided and that a review of the education system is underway. While they agreed to undertake a review of the FDI thresholds (with an eye on providing employment opportunities and enhancing technology transfer), they indicated that in some sectors (e.g., retail trade) FDI is likely to reduce aggregate employment. They also said that second annual event of the Bhutan Economic Forum for Innovative Transformation, to be held in July 2019, will be on issues of economic diversification. On access to finance, the authorities agreed with staff recommendations and pledged to work with the judicial branch to expedite the implementation of the proposed measures. They also reaffirmed their commitment to limiting market distortions from the recently launched PSL program and to undertake a review of its progress on a regular basis.

Staff Appraisal

39. Bhutan’s growth has been strong and poverty has declined significantly. Growth has been driven by the hydropower and services sectors, while inflation has been and is expected to remain in single digits, underpinned by price developments in India due to the currency peg. While still large, external imbalances are beginning to decline. The most immediate policy challenge is to limit the sharp fiscal withdrawal programmed for FY19. Medium-term challenges include mobilizing domestic revenues and prudently managing rising hydro revenues against the background of declining grants, and enhancing competitiveness to diversify the sources of growth and employment.

40. Staff supports fiscal consolidation over the medium term, which will strengthen the fiscal position and reduce external imbalances. However, a more gradual consolidation path (in line with staff’s illustrative alternative scenario) would be more appropriate for growth while still maintaining macroeconomic stability. This path should be supported by measures to enhance the domestic revenue base, of which the GST project remains a key ingredient. Staff urged the authorities to secure the required resources for the GST project to avoid delays. PFM should be strengthened and the current five-year planning cycle replaced by a rolling multiyear budget framework. The establishment of a stabilization fund for hydro revenues is welcome and rules governing its operation should be completed soon. Finally, staff noted that measures to develop a public debt market would bring economic benefits far outweighing the financial cost of market-based interest on outstanding debt securities required to support the market.

41. Staff views monetary conditions to be broadly appropriate. Credit growth rates have declined, and the credit gap has been negative until recently. Following the rupee crisis in 2012, the share of rupees in total reserves has been markedly increased. Staff welcomed the authorities’ efforts to revamp the monetary policy framework, which will help align the monetary conditions with a policy stance required for the ngultrum’s peg to the rupee.

42. To better safeguard financial stability and provide a solid foundation for the private sector’s access to finance, continuous efforts to modernize the regulatory framework would be needed. The banking sector has adequate buffers to absorb potential losses, but bank profitability is low and maintaining liquidity comes at a cost. These conditions require continued supervisory vigilance and calibration of both micro- and macro-prudential frameworks to contain financial risks and minimize the potential economic costs of a crisis.

43. The authorities’ emphasis on diversification of the economy is appropriate and should prioritize further improving access to finance and educational and labor market outcomes. A holistic approach to making credit available for sectors that have been previously underserved by the financial sector is welcome, but caution should be exercised to limit potential distortions. To reduce unemployment, especially among the youth, and enhance labor productivity, efforts should focus on targeted training of workers and improved tertiary educational enrollment. Relaxing rules for foreign direct investment, at least in select areas where the spillovers for both the upstream and downstream sectors could be significant, should also be pursued.

44. Staff supports the ngultrum’s peg to the rupee, which—given the degree of interconnectedness with India—has served the economy well. Developments in 2017 suggest that Bhutan’s external position remains moderately weaker than warranted by fundamentals and desirable policies.

45. The authorities did not request and staff does not recommend approval of the exchange restrictions that are inconsistent with Article VIII obligations. Bhutan continues to maintain exchange restrictions under the transitional arrangements of Article XIV, Section 2. Staff encouraged the authorities to gradually ease the exchange restrictions towards their eventual elimination, which should be eliminated as soon as Bhutan’s balance of payments positions permits. Staff is encouraged by the authorities’ use of Fund TA to explore options for the removal of these restrictions.

46. The staff recommends that the Article IV consultation with Bhutan remain on a 24-month cycle.

Appendix I. Priority Sector Lending Guidelines

1. Bhutan began implementing Priority Sector Lending (PSL) Guidelines in January 2018. The Guidelines form an integrated platform to coordinate interventions from several government agencies to stimulate the cottage and small industries (CSI) sector. It was developed based on consultations with several government agencies, commercial banks, and insurance companies. A PSL Council has been formed to monitor and evaluate implementation. It is chaired by the RMA and comprises representatives from all relevant government and financial sector entities.

2. The Guidelines recognize the CSI sector as the largest source of domestic production and employment as critical for addressing challenges facing the agriculture sector and stemming from rural-urban migration, which has risen markedly. In consultation with financial institutions, the RMA has prescribed lending targets (a function of their outstanding loan portfolio in priority sectors), and ceiling preferential lending rates for lending to the agricultural (8 percent) and non-agricultural (8.5 percent) CSI sectors. Financial institutions having any shortfalls in meeting their priority sector targets may allocate their funds for on-lending to a microfinance institution or Bhutan Development Bank. Notably, financial institutions lending to the CSI sector at preferential interest rates are exempt from paying taxes on the income from such lending as per the Fiscal Incentives Act of 2017. In addition, the Guidelines prescribe mandatory insurance coverage to accompany loans to agricultural projects, with insurance to substitute for collateral. Finally, the Guidelines provide for training at the RMA’s Financial Institutions Training Institute (FITI).

3. The Guidelines set an important coordination platform to address key challenges in Bhutan. Based on lessons learned and good practices from other countries, the following recommendations may help achieve PSL’s objectives and reduce risks associated with the plan:

  • First, the rigor of credit assessments under the CSI program should be kept at par with those for market-based lending. In addition, the experience and progress under the program should be evaluated frequently to avoid a build-up of risks and contingent liabilities.

  • Second, incentives rather than quantitative targets should be used to encourage lending.1 Commercial banks may face barriers and risks given the lack of relevant expertise, reach, and operational efficiency.2

  • Third, interest rate caps need to be frequently reviewed. Global experience suggests that the effectiveness and any unintended side-effects will depend on the type and specification of the cap. Calibrating interest caps at the “right” level to achieve operational efficiency is difficult, while binding caps set below market levels can affect not only profitability and risk in financial institutions, but also the overall credit supply.

  • Fourth, any deviations from market conditions should be fully compensated. Tax benefits can be perceived as an offset to below-market pricing. This may, however, not be enough to compensate for the full difference between preferential and commercial rates, as well as for the losses of targeting a potentially riskier market segment.

  • Finally, technical capacity and coordination among all relevant parties should be strengthened. PSL loan proposals are routed through Special Technical Window Services that involve coordination with multiple agencies, including regional and local administration officials. Given the complexity of the undertaking and the moral hazard involved, capacity building and inter-agency coordination are critical. FITI is the designated institution to provide training, but its effectiveness is yet to be tested.

Appendix II. Risk Assessment Matrix

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“L”=Low; “M”=Medium; “H“=High.The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“L” indicates a probability below W percent, “M” indicates a probability between W and 30 percent, and “H” indicates a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and the overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

Appendix III. Guiding Principles for the Stabilization Fund Management

1. Bhutan’s Sovereign Wealth Fund (SWF), known as the Bhutan Economic Stabilization Fund, gained ground following the Indian Rupee shortage in 2012. Initial considerations included addressing volatile liquidity conditions, economic stabilization through countercyclical fiscal policies, and intergeneration equity and economic diversification through investment of surplus revenues. Subsequently, the stabilization objective has gained primacy, in line with IMF recommendations. A draft Royal Charter and a Concept Note have been drafted, and a seed capital allocation of Ng 100 million has been made available through the FY2018 budget.

2. SWF assets—and the returns they generate—can have a significant effect on public finances, monetary conditions, external accounts, and balance sheet linkages with the rest of the world. In particular (i) fiscal policy might be affected by SWF funding and withdrawal rules (usually derived from a fiscal rule), (ii) monetary policy may be impacted by wide fluctuations in fiscal revenues and procyclical implications for aggregate demand that typically affect inflation and the real exchange rate; and (iii) exchange rate variations could be mitigated by investing the SWF’s resources abroad.

3. The 24 Generally Accepted Principles and Practices for SWFs, usually referred to as the “Santiago Principles”, are typically the cornerstone of setting up and managing SWFs. The Principles are designed to promote good governance, prudent investment practices, accountability, and transparency, whilst encouraging a more open dialogue and deeper understanding of SWF activities.1 The remainder of this appendix lists recommendations and considerations for setting up a well-functioning SWF in Bhutan’s context.

  • The draft Charter and the Concept Note can be improved in terms of defining objectives for governance and investment mandates. The establishment and management of the SWF should be based on sound foundations and reaching consensus around such foundations is essential. The objectives and investment decisions/portfolio allocations of SWFs need to be closely linked, as well as the stated investment objectives and governance structure.

  • The authorities must decide on a fiscal (responsibility) law that is consistent with the macroeconomic setting. The Constitutional fiscal rule that constrains current expenditure to be met from domestic revenues, and deficit caps as articulated under the FYP, are not countercyclical by design. A new law would have to be designed to reflect the countercyclical role envisaged for the SWF and its operations included into the medium-term fiscal framework.

  • A legal framework is required to promote sound institutional and governance arrangements for the effective management of SWFs. The legal framework should among other things: (i) provide clearly for the legal form and structure of the SWF and its relationship with other state bodies (including the ministry of finance and the central bank); (ii) be consistent with the broader legal framework governing government‘s budgetary processes; (iii) ensure legal soundness of the SWF and its transactions; (iv) support its effective operation and the achievement of its stated policy objectives, which should be economic and financial in nature; and (v) promote effective governance, accountability, and transparency.

  • The institutional frameworks of SWFs differ across countries, and a framework suitable for Bhutan should be pursued. Regardless of the governance framework, the operational management of the SWF should be conducted on an independent basis to minimize potential political influence or interference that can affect the achievement of the SWF’s objectives. The governance structure must be commensurate with the risks and complexities of the investment strategy.

  • Suitable SWF funding and withdrawal rules are found to be critical components of an effective governance structure. Also, a strong institutional development and risk management framework is typically required to ensure an appropriate timing and frequency of asset allocation changes, especially in periods of high or intensifying market volatility. As an example, only once a stabilization fund reaches an adequate size to address anticipated deficits, then excess assets can be placed in a savings fund, provided that the country’s public debt is sustainable.

  • Framing the SWF in the context of the overall sovereign balance sheet would be particularly important to Bhutan given its large hydropower assets and liabilities. A sovereign-asset liability management (SALM) approach can help detect and monitor sovereign risk exposures from a consolidated public-sector portfolio perspective. In this context, the interaction between the public debt management strategy and SALM would be clear and helps communicate logical and detailed explanations of policy decisions, ex ante.

Appendix IV. Composition of Credit and Economic Activity

1. The credit gap has been negative until recent quarters. A small positive credit gap has emerged but it remains significantly smaller compared to values witnessed in the run-up to the rupee crisis. The credit gap measures the extent to which the credit-to-GDP ratio exceeds its (HP-filtered) trend and is reported in percent of the trend value. The credit gap has been positive in recent quarters, but remains small at below 1 percent.


Credit-to-GDP Gap

(In percent)

Citation: IMF Staff Country Reports 2018, 300;