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Economics of Global Trade & Finance

An Understanding of the Economy of Bhutan


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Shah Roll No. : 048 M. Com. - I

DATE: 27|10|2012.

An Understanding of the Economy of Bhutan


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Table of Content
Sr. No. Content Page No.

1.1 1.2 1.3

Economy of Bhutan
Introduction Economic freedom Background

06 10 11

2.1 2.2 2.3 2.4 2.5

Recent Developments
Real Sector Financial Sector Fiscal Sector External Sector Vulnerabilities and Risks

13 15 19 23 25

Sr. No.


Page No.


GDP, CPI & Inflation


3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8

Gross Domestic Product Inflation Fiscal Indicators External Indicators Growth Fiscal Outlook Balance of Payments Risks to Outlook

27 31 34 36 37 38 40 43







Chapter 1 Economy of Bhutan

The economy of Bhutan, one of the worlds smallest and least developed, is based on agriculture and forestry, which provide the main livelihood for more than 60% of the

population. Agriculture consists largely of subsistence farming and animal husbandry. Rugged mountains dominate the terrain and make the building of roads and other infrastructure difficult and expensive. The economy is closely aligned with India's through strong trade and monetary links and dependence on India's financial assistance. The industrial sector is technologically backward, with most production of the cottage industry type. Most development projects, such as road construction, rely on Indian migrant labor. Model education, social, and environment programs are underway with support from multilateral development organizations. Each economic program takes into account the government's desire to protect the country's environment and cultural traditions. For example, the government, in its cautious expansion of the tourist sector, encourages visits by upscale, environmentally conscientious tourists. Detailed controls and uncertain policies in areas such as industrial licensing, trade, labor, and finance continue to hamper foreign investment. Hydropower exports to India have boosted Bhutan's overall growth, even though GDP fell in 2008 as a result of a slowdown in India, its predominant export market.

Economy of Bhutan
Rank Currency Fiscal year Trade organizations 169th ngultrum (BTN); Indian rupee (INR) 1 July - 30 June SAFTA


GDP GDP growth GDP per capita

$3.789 billion (2008 est.) 6.6% (2008 est.) $5,600 (2008 est.)

GDP by sector

Agriculture: 22.3%, Industry: 37.9%, Services: 39.8% (2006)

Inflation (CPI) Population below poverty line Gini coefficient Labor force Labor force by occupation

4.9% (2007 est.) 31.7% (2003)

no data no data (major shortage of skilled labor) agriculture: 63%, industry: 6%, services: 31% (2004 est.)

Unemployment Main industries

2.5% (2004) cement, wood products, processed fruits, alcoholic beverages, calcium carbide, tourism

Ease of Doing Business Rank


1.2 Economic freedom:

Bhutans economic freedom score is 56.6, making its economy the 111th freest in the 2012 Index. Its score has decreased 1.0 point from last year, primarily because of worsening government spending, labor freedom, and trade freedom. Bhutan is ranked 21st out of 41 countries in the Asia Pacific region, and its overall score is below the global average. The foundations of economic freedom are relatively strong, with corruption present but under control, and new steps have been taken to ensure greater security for property rights. Recently, a higher priority has been placed on measures to diversify the economy, particularly in light of demographic shifts that will bring more young people into the labor market. Over the past decade, Bhutan has made progress in modernizing its economic structure and reducing poverty. The public sector, especially hydropower, has long been the main source of economic growth, but the government now recognizes that private-sector development is crucial. Nonetheless, lingering constraints on private-sector development include the inefficient regulatory framework, pervasive non-tariff barriers, and a rudimentary investment code. The financial sector remains small and without adequate regulation or supervision. The lack of access to financing precludes entrepreneurial growth.


1.3 Background:
Bhutan, a small Himalayan constitutional monarchy that made the transition from absolute monarchy to parliamentary democracy in March 2008, has one of the worlds smallest and least-developed economies. Until a few decades ago, the country was still largely agrarian, with few roads, little electricity, and no modern hospitals. Rugged terrain makes the development of infrastructure difficult. Recent interregional economic cooperation, particularly involving trade with Bangladesh and India, is helping to encourage economic growth. Connections to global markets are limited and dominated significantly by India.


Protections for intellectual property rights are stipulated in the Industrial Property Act and the Copyright Act. Property rights are more equally protected than in most of South Asia, with women rather than men inheriting and owning property in some areas. The governments Anti- Corruption Commission has identified misuse of resources, bribery and collusion, and nepotism as major forms of corruption.

The top income tax rate is 25 percent, and the corporate tax rate is 30 percent. Other taxes include a property tax and an excise tax, with the overall tax burden equal to 9.9 percent of total domestic income. A value-added tax (VAT) is set to be introduced in an effort to broaden the tax base. Government spending has increased to 38.6 percent of total domestic output, with public debt reaching 70 percent of GDP.

A modern regulatory framework has not been fully developed. Despite recent efforts, the business climate is still hampered by inconsistent enforcement of regulations. On average, it takes 36 days to start a company. The imbalance between labor supply and demand persists. Economic diversification has not progressed significantly, and unemployment has risen in recent years. Inflation has moderated slightly but remains worrisome.


High tariff and non-tariff barriers prevent dynamic growth in trade. Foreign investment has been a sensitive issue, largely due to concerns about its effect on culture and traditions and possibly because of the domestic private sectors unwillingness to lose the benefits that restrictions provide. The Bank of Bhutan enjoyed a monopoly for many years, but competition has improved with the opening of the sector to more foreign partnerships.

Chapter 2 Recent Developments

2.1 Real Sector:
Real economic growth was above 6 percent in 2008/09, lower than that of the past couple of years. Bhutan averaged about 9 percent annual economic growth during the Ninth FiveYear Plan (9FYP: 2002/032007/08, extended by one year), but this is projected to slow slightly during the Tenth Five-Year Plan (10FYP: 2008/09-2012/13). During the 9FYP, the economy was driven largely by growth of 11-14 percent in 2006/07 and 2007/08, as the

Tala hydropower project came onstream, trebling Bhutans power generation capacity. Growth slowed to about 6.2 percent in 2008/09. The per capita Gross National Income was estimated to be over US$2,000 in 2009 higher than that of other South Asia Region countries, except the Maldives. To sustain a targeted real growth rate of almost 8 percent during the 10FYP, the Royal Government of Bhutan (RGoB) intends to focus on electricity and construction of hydropower projects as its main sources of growth. Updated annual data shows that tourism revenues have fallen in 2009. The Bhutanese economy was not seriously affected by the global economic crisis. However, figures for the final months of 2009 reveal a decline of US$7 million in annual revenues from convertible currency tourism compared to 2008 figures of approximately US$39 million. Earnings in the last quarter of 2009 are 33 percent below the corresponding 2008 figures, indicating that sector recovery is still some distance away.


Damage from natural disasters cost Bhutan about US$67 million in 2009. An earthquake measuring 6.1 on the Richter scale struck eastern Bhutan on September 21, 2009. Over one thousand structures including roads, houses, schools, historical monuments, and government offices were reportedly damaged, mainly in the Mongar and Trashigang districts. The cost of the damage is estimated to be US$52 million. In addition, damage from Cyclone Aila in May is reported to be around US$15 million. Hydropower is a major engine of growth and public revenue in the medium term, and the RGoB has ambitious plans for the sector. The kingdom has the potential to develop capacity of 23,760 MW, of which only 5 percent has been tapped so far. Under the 10FYP, the installed hydropower generation capacity is projected to rise from 1,488 MW in 2007 to 1,602 MW in 2013, with the planned commissioning of the 114 MW Dagachu hydropower project. In addition, the RGoB proposes to add 10,000 MW capacity by 2020. To this end, Bhutan and India have agreed to develop 10 hydropower projects six under an intergovernmental model of 30 percent grant and 70 percent loan from India, and four under a joint venture model whereby public sector companies from both countries will implement the projects.

2.2 Financial Sector:

After some easing of inflationary pressure from the elevated levels of late-2008, there are signs that food inflation is resurging. Since the Bhutanese ngultrum is pegged to the Indian rupee, price developments have tracked Indias inflation closely (Figure 2). When Indias inflation peaked in the summer of 2008 due to high oil prices, Bhutans inflation was in the

8-9 percent range. With the easing of inflationary pressure in India due to a sharp drop in global oil and commodity prices, Bhutans headline inflation rate dropped to 3 percent in the second quarter of 2009, from over 9 percent in the third quarter of 2008. However, the last half of 2009 has seen a slight increase in overall inflation due to higher prices of rice, meat, and vegetables on account of supply shocks from India, from where three-quarters of commodities are imported. Food inflation (which accounts for close to 32 percent of the Consumer Price Index basket) went up by 4.1 percentage points from the second quarter.

Domestic credit growth has been curtailed due to cautious monetary policy, although growth of credit to the private sector remains high. The total volume of credit provided by four financial institutions has increased from Nu8.15 billion to Nu24.25 billion between June 2003 and June 2009 (Figure 3). Credit to the private sector accounted for about 97 percent of the total outstanding credit in June 2009, showing a 28.7 percent increase from

2008. The building and construction sector constituted the highest share with 25 percent, followed by trade & commerce with 17 percent, and services & tourism with 13 percent. An Investment Climate Assessment (ICA) for Bhutan reveals some key constraints to private sector development. The World Bank Group is currently engaged in an ICA followup to the one undertaken in 2002. For the current one, a survey of 248 firms covering Thimphu, Phuentsholing, Gelephu, and Samdrup was completed in June 2009. The survey encompasses firms of various sizes in the industry and services sectors. They suggest that the private sector finds insufficient access to finance, inadequately educated labor force, labor regulations, transportation, and regulatory procedures to be major obstacles to business development in Bhutan (Figure 4). Results from the enterprise survey, ranking access to credit as the leading investment climate constraint, thus confirms the low rank of Bhutans credit accessibility in the Doing Business Report 2010, which places it 177th out of 183 countries. Small firms in particular cite limited access to finance as a constraint, while larger firms are more affected by inadequate education of the labor force. In contrast, key positive factors that confer a regional comparative advantage to Bhutan include political stability, very low crime rates, and the availability of electricity reflective of the countrys hydropower assets. Productivity analysis reveals that, while labor costs are higher than in other parts of the region, labor productivity is high in Bhutan, and suggests that the country should be able to compete in niche services sectors. The assessment will provide a platform for further discussion between the RGoB and the World Bank Group on short and medium term reforms to improve the investment climate.


Financial sector liberalization is well underway and should help to effectively meet the financial needs of the private sector. Bhutans Central Bank, the Royal Monetary Authority (RMA), has taken steps to foster competition in the financial sector by issuing three new bank licenses and one additional insurance license. As a result, the number of financial institutions more than doubled in the first quarter of 2010. The two new private banks, Druk Punjab National Bank and Tashi Bank, are rapidly rolling out their operations in Bhutan. Bhutan Development Bank has also received a specialized bank license, and a new insurance company, Bhutan Insurance Limited, launched operations in August 2009. Regulations accompanying these new licenses require these financial institutions to float at

least 30 percent of their paid-up capital to the public. Increased financial sector liberalization, combined with positive financial sector reforms during 2009 notably the launch of a Credit Information Bureau and the revised Royal Monetary Authority Act are expected to increase the efficiency and depth of the financial sector. In April 2010, the RGoB has also issued guidelines permitting External Commercial Borrowing by companies incorporated under the Companies Act.

The RGoB embarked on important private sector development reforms in 2009, with the drafting of three new investor-friendly policies. The Economic Development Policy (EDP), released in April, 2010, is intended to: (i) achieve economic self-reliance; (ii) generate employment; (iii) harness and add value to natural resources in a sustainable manner; (iv) realize import substitution; (v) promote entrepreneurship; (vi) diversify the economic base; and (vii) increase and diversify exports. The Foreign Direct Investment (FDI) Policy,

currently being finalized, aims to encourage more FDIs to broaden the employment and revenue base, to benefit from technology transfer, and to increase foreign exchange earnings. In addition a Mineral Development Policy was approved in 2009. The EDP has been complemented by a review of all rules and regulations to improve the business environment. There will be further steps, in 2010/11, to draft new rules and regulations to operationalize these policies. The signing, in September 2009, of the first public-private partnership in Bhutan, to develop an Information Technology Park, also marked the governments commitment to leverage foreign private investment flows into Bhutan. A Framework for Private Partnership in Infrastructure was approved by a Cabinet meeting in March, 2010. This will form the basis for a Public-Private Partnership Policy.

2.3 Fiscal Sector:

The currently projected fiscal deficit for 2009/10 is above 4.5 percent, following surpluses of the past four years. This reflects total expenditures that are about one-third higher than 2008/09 revised estimates, due largely to increased civil servant salaries, and higher development spending, balanced partly by a projected increase in grants (particularly those from India). The RGoB seeks to maintain sound macroeconomic performance over the medium term, and targets limiting the overall deficit (including grants) to less than 5 percent of GDP. The fiscal deficit is expected to average about 3.5 percent during the remaining years of the 10FYP (Table 1). The RGoB faces an estimated resource gap of Nu4.3 billion (about US$90 million) for 2009/10, and has introduced T-bills from earlier this year to finance the same. Grants are projected to increase and, combined with slower growth in


forecasted expenditures, are expected to contribute to fiscal deficits lower than 5 percent in the remaining years of the 10FYP. The 2008/09 revised estimates show significantly better fiscal outcomes than originally projected largely on account of higher grants and domestic revenues. For 2008/09, against an estimated fiscal deficit of over 10 percent of GDP, the revised fiscal surplus is about 2.3 percent reflecting grant inflows (chiefly from India) which were higher than originally projected, increased domestic revenues which include higher personal income tax due to recent salary revisions, business income tax, and import and excise duties. This accrued in spite of total budgetary outlays being higher than originally planned. Electricity and budgetary grants are the main projected sources of domestic revenue during the 10FYP, and attainment of fiscal goals depends critically on timely inflow of these revenues. Budgetary grants account for almost 40 percent of Bhutans aggregate revenues during the 10FYP (Figure 5). More than 80 percent of these budgetary grants during the 10FYP is expected to be tied to specific projects, with the remainder classified as programmatic support. India alone accounts for more than 70 percent of budgetary grants during the 10FYP. At the same time, the share of electricity (taxes plus dividends) in domestic revenue is expected to rise from about 43 percent in 2008/09 to over 53 percent by the end of the 10FYP (Table 1). Revenues from personal income tax and business income tax are projected to show modest increases, growing at between 6 and 10 percent annually during the 10FYP. As a share of aggregate revenues, however, non-electricity domestic revenues decline in importance from about a third in 2008/09 to about a quarter by 2012/13.


The countrys debt is projected to increase during the 10FYP, driven largely by borrowing for hydropower development. The debt-to-GDP ratio is projected to rise from about 54 percent in 2008/09 to about 80 percent by the end of the 10FYP (Table 2). This is less of a problem than the numbers might indicate. Almost 98 percent of the countrys debts are external, owed to India and serviced automatically by hydropower receipts. Hydropower projects bring strong growth dividends, boosting the average real GDP growth and exports. The external debt service ratio as a share of exports of goods and services is expected to decline from more than 14 percent to below 13 percent during the 10FYP. A joint IMF / World Bank Debt Sustainability Analysis (DSA) suggests moderate risk of debt distress over 2008/09 2028/29, supported by: (i) Bhutans strong track record of project implementation; (ii) commercial viability of new hydropower projects; and (iii) Bhutans close economic and political ties with India which render minimal the commercial risks of these projects, as India is both the main provider of financing for hydropower projects and the main consumer of the projects output.


2.4 External Sector:

The nominal exchange rate depreciated over the last year. Overall, the ngultrum depreciated by about 11 percent against the US dollar between 2008 and 2009, even though there has been appreciation in the second and third quarters of 2009 (Figure 6).

The current account balance is projected to worsen during the 10FYP, due to a deteriorating trade balance and increased interest payments. The current account balance showed a surplus in 2006/07, for the first time in many years, but is likely to go from a surplus of 14.3 percent of GDP in 2006/07 to a deficit of 2.1 percent of GDP in 2007/08, and further to a

deficit of 4.5 percent in 2008/09 (Table 3). This is due largely to an increase in the trade deficit, particularly with India, and the start of interest payments for the Tala hydropower scheme. More than 80 percent of trade is with India, with electricity and base metals accounting for almost 75 percent of exports to that country. Trade in services constitutes less than 5 percent of aggregate external trade. There is a small deficit on the services account, contributing about 1.5-2.0 percent of the aggregate current account deficit during the 10FYP. Current account deficits are projected to average about 10 percent of GDP from 2009/10 to 2012/13, as domestic demand grows rapidly. The overall balance will continue to show a surplus during the 10FYP period, due to capital inflows. Robust capital inflows in the form of capital transfers from India, foreign direct investment, as well as loans and grants from development partners are expected to finance the current account deficit and enable a modest increase in gross international reserves. Bhutan had reserves equivalent to more than 12 months of import cover in 2009.


Foreign Direct Investment (FDI) is likely to increase during the 10FYP. FDI inflows are projected to increase at about 25 percent per annum during the 10FYP, as the RGoB seeks to encourage partnerships with foreign companies. A Public-Private Partnership (PPP) contract was signed between the RGoB, and a joint venture between the Singapore holding of the global developer, Assetz Property Group, and Bhutan's national holding company, Druk Holding and Investments, for the construction of the first Information Technology (IT) Park in Bhutan. The Oberoi Group has also indicated its plan to build a 75-room luxury resort in Bhutan with a projected cost of US$10.5 million. This resort is expected to employ 150 people, of which 90 percent will be Bhutanese.

2.5 Vulnerabilities and Risks:

While the overall macroeconomic outlook remains bright, implementation of Bhutans development agenda is subject to several constraints. These include: (i) economic constraints associated with debt sustainability, potential overheating due to spillovers from the hydropower and development spending, financial sector vulnerabilities, and gaps in reserve management; (ii) resource constraints from uncertain donor support, especially in the aftermath of the financial crisis; and (iii) implementation capacity constraints within Bhutan. The RGoB continues to face several macroeconomic risks. As a small country, Bhutan faces macroeconomic challenges that increase fiscal volatility. For example, as discussed above, the countrys revenue stream is heavily dependent on the timing of hydropower projects coming onstream, and on external assistance materializing on schedule. Against this

backdrop, the RGoB has adopted a Budget Policy and Fiscal Framework Statement (BPFFS) in its policy analysis, to try to ensure and maintain prudent macroeconomic policies which will help mitigate such volatility. With the sharp rise in the 2009/10 budget deficit, spending prioritization with a near-term tightening bias is needed to avoid stoking excess demand. In the medium term, revenue expansion and prudent expenditure planning are needed to limit domestic debt buildup. With rapid credit growth, financial sector vulnerabilities are on the rise. Credit growth averaged about 30 percent over the last decade, and there are signs of deteriorating asset quality. Banks non-performing loans (NPLs) more than doubled to 18 percent of total loans between December 2008 and June 2009. Banks also have maturity mismatches due to the long term-structure of these loans and the short-term corporate deposits that dominate the funding base. Strengthening the supervision function of the RMA will be helpful in the context of NPLs and entry of new financial institutions in the sector.


Chapter 3 GDP, CPI & Inflation

3.1 Gross Domestic Product:
Real economic growth is estimated to have recovered from 5.7 percent in FY2008/09 to 8.1 percent in FY2010/11.2 this robust performance came mainly from a 10 percent growth in the industrial sector, spurred by construction activities related to the hydropower projects. The services sector also grew at an impressive 8 percent, with tourism rebounding from the decline seen just two years earlier. By contrast, the agricultural sector performed less well, growing only at around 1.8 percent. The healthy growth rates in FY2010/11 closely track the averages for the past decade (figures 1 and 2).


The robust growth in the industrial sector in FY2010/11 kept pace with the average rate recorded in the past decade, but contribution of individual subsectors varied across the years (figure 2). In FY2006/07 and FY2007/08, when the Tala hydropower project went into production, the electricity sector grew at 63 percent and 39 percent respectively. More recently, it was the construction sub-sector that grew at over 20 percent as a result of the new hydropower projects. The manufacturing subsector has grown steadily at over 10 percent during the period.


The services sector in FY2010/11 also grew at the healthy average growth rate of around 8 percent in the past decade, with all subsectors growing strongly. While tourism contributes less than 1 percent of GDP, it is a key source of foreign exchange earnings. Although Bhutan was largely insulated from the global economic crisis, annual revenues from convertible-currency tourism3 fell to US$31.8 million in 2009, from US$38.8 million in 2008. Data from 2010 indicates sector recovery (Figure 3). the number of tourist arrivals and the revenues indicate a continued improvement in the tourism sector.


The lackluster growth in agriculture in FY2010/11 was also in line with the average for the decade at around 2 percent. As in most countries, the sectors share in GDP continued to decline over time from 25 percent in FY2002/03 to 14 percent in FY2010/11. Agriculture is characterized by low productivity for several reasons low levels of technology adoption, predominance of subsistence agriculture, small domestic market, inaccessibility to markets for agricultural products, and large tracts of fallow land. Reasons for fallow land include inability of farmers to protect crops from wildlife damage, distance of land from their homes, and lack of irrigation. In FY2008/09, the cereal yield per hectare in Bhutan was 1,947.1kgs, compared to 2,746.1kgs in South Asia.


3.2 Inflation:
Inflation has surged since mid-2009, and now exceeds 8 percent in FY2010/11. Bhutans inflation peaked at 8-9 percent in the summer of 2008, when food and fuel prices were high (Figure 4). With the easing of global prices, Bhutans inflation rate fell to 3 percent in the second quarter of 2009. However, there has been a steady increase in overall inflation since, largely initiated by supply shocks from India, the source of three-quarters of commodity imports. In the fourth quarter of FY2010/11, food prices increased by 10.5 percent (YoY) while non-food prices rose by 7.1 percent (YoY). Price developments in Bhutan closely track those in India. The Bhutanese ngultrum is pegged to the Indian rupee, and India is Bhutans key trading partner. Food prices rose through 2009 in both countries (Figure 5). As food prices in India declined in 2010, they also moderated in Bhutan. Meanwhile, the recent fuel price hike in India has contributed to rising non-food prices in Bhutan because of possible feed-through effects. Since the poor have a high ratio of food spending in total expenditure, it is possible that this affects poor households disproportionately.


The government has limited mechanisms to influence food prices. A bilateral free-trade agreement with India allows duty-free imports of all food and agricultural commodities. India supplies approximately 50 percent of Bhutans requirements for rice. Indian rice is sold at much lower prices than Bhutanese rice, due to the lower production costs and higher productivity in India, and the strong preference of Bhutanese consumers for locallyproduced rice. Market prices are not much influenced by the activities of the Bhutan Food Corporation (BFC), which helps in the (a) the acquisition, management, and disposal of small public reserves of rice, wheat, vegetable oil, and sugar; and (b) the purchase of selected food commodities from India for sale at controlled prices in district-level retail shops. The BFC receives no direct budget allocation from the government for its operations and is expected to use the profits from parallel commercial activities7 to cover the costs of its public service activities. As a corporate enterprise, it also is expected to pay all taxes nd dividend on profits to the government. The BFCs strategic food stocks consisting of rice, wheat, vegetable oil, and sugar are turned over every 3- 4 months through retail sales.

These stocks are considered too small to have any major impact on market behavior. There are no market or trade restrictions. The Government provides certain direct and indirect subsidies to the agricultural sector, in the form of subsidized inputs. Social protection measures are limited to a school-feeding program operated by the World Food Program. The Government complements the WFP program and is planning on sustaining the program on its own if the WFP phases out its support as planned by 2012. Monetary Indicators The rising inflation in Bhutan not only reflects price developments in India, but also accommodative domestic policies. Broad money rose by 16.2 percent by April 2011 and reserve\ money by 32.5 percent (YoY) in December 2010. Most of the increase in broad money was due to an increase in domestic credit which grew by 33.1 percent. Private sector credit growth has accelerated to nearly 32.4 percent (yoy), driven by housing and construction sectors as well as personal loans. There is considerable excess liquidity in the banking system at 48.5 percent of reserve money (or Nu24.1billion) by December 2010. Although it declined considerably by May 2011 (to Nu.5.7 billion), excess liquidity weakens the monetary transmission mechanism. With weak links to the global markets, Bhutans financial sector remained unaffected by the global financial crisis. The system is well capitalized. The risk-weighted Capital Adequacy Ratio (CAR) and Tier 1 CAR remained strong, at 14.4 percent and 11.4 percent respectively in June 2011. The Non-Performing Loans (NPL) ratio remained constant at 8.5 percent in June 2011. Loan provisions (as a percent of NPL) increased to 56.1 percent in March 2011 as compared to 40.1 percent in March 2010.


The government has undertaken several reforms to modernize the financial sector and strengthen the institutional framework for financial management. These include: (i) issue of new banking/insurance licenses to increase the number of financial institutions in FY2009/10; (ii) establishment of a Credit Information Bureau fully operational since January 2011 to help make the financial system more reliable by increasing the efficiency of credit-risk assessment of borrowers, reducing the extraordinary amounts of collateral, lowering the default risk, and enabling the expansion of credit-based lending; (iii) establishment of payment systems infrastructure with the launch of an Electronic Funds Transfer Clearing System in June 2010; (iv) development of a national switch system and (v) steps to increase the autonomy of the Royal Monetary Authority (RMA). This included a new RMA Act in June 2010 that declared the RMA to be an autonomous body supporting the governments economic policies, and empowering it to regulate electronic payment systems.

3.3 Fiscal Indicators:

Bhutan is expected to run a budget deficit of almost 4.8 percent of GDP in FY2010/11, following several years of small budget surpluses. Strong fiscal discipline and donor assistance resulted in small fiscal surpluses since FY2006/07 (Figure 6). The overall budget framework has been consistently underpinned by the sound principle of covering current expenditure by domestic revenues (Figure 6). Grants and electricity revenues together accounted for almost two-thirds of total government revenue during this period. However, the recent widening of the fiscal deficit in FY2010/11 is primarily on account of 6 percent


of GDP increase in capital expenditure in FY2010/11 as compared to FY 2009-10 and 6 percent of GDP decline in total revenues.

The stock of government debt is high, but the risks to sustainability are mitigated by several factors. In FY2010/11, India accounted for 43 percent of the total government debt, while among multilaterals the Asian Development Bank (21 percent) and the World Bank (16 percent) were the largest creditors. About 98 percent of total government debt is foreign. All external debt is public or publicly guaranteed and long term in maturity. Domestic debt, which is about 2.0 percent of total debt, is raised through government bonds. The recent debt sustainability analysis shows a moderate risk of distress, with public debt is projected to exceed 110 percent of GDP in 2014/15. However, risks to sustainability are mitigated

because of the commercial viability of the hydropower projects, which account for about half of total debt and benefit from Indias strong energy demand. Bhutans strong project implementation record, as well as a comfortable reserves position, also mitigates risks.

3.4 External Indicators:

The current account deficit has widened in the last two years, mainly because of increasing imports for construction work on hydropower projects. The current account deficit deteriorated to around 13 percent of GDP in FY2009/10 and is estimated to have improved slightly to reach 7.9 percent in FY2010/11 (Figure 8). This marked widening of the current account deficit in the past two years compared to the years earlier is because of

increased government imports for hydropower projects, the resumption of interest payments for Tala power project, and a decline in commodity exports (particularly manufactured and mineral-based products) during the global economic crisis. A worsening trade balance is partly offset by higher grants. Meanwhile, the capital account surplus improved in FY2009/10 and FY2010/11, assisted by higher capital transfers and foreign loans. This has resulted in positive overall balance of payments (Figure 8). Foreign reserves have grown at about 13 percent annually since FY2002/03, and stand at about 13.6 months of import cover at present (Figure 8). Bhutans exchange rate is pegged to the Indian rupee. The peg to Indian rupee has contributed to trade integration between the two countries and has helped in macroeconomic stability in Bhutan. The real effective exchange rate has been stable and close to its ten-year average.


3.5 Growth:
The construction of hydropower projects is expected to be the major source of growth in the medium term and once on stream, electricity generation will drive growth. Bhutan is expected to grow at 9-10 percent per annum from FY2010/11 to FY2015/16, with the construction sector growing at rates of about 20-25 percent. Bhutan has the potential to develop a generating capacity of 23,760MW, of which only 5 percent has been tapped so far. The Royal Government proposes to add 10,000MW capacity by 2020, largely with financial assistance from India. The Basochu, Chukha, Kurichu, and Tala hydropower projects are currently in production. In the next few years, construction of the 720MW Dagachu and the 1000MW Punachu II will be the key drivers of growth. By FY2015/16,

Dagachu is expected to come online and contribute to growth through generation of electricity.

3.6 Fiscal Outlook:

The latest projections show a rising fiscal deficit, mainly because of high capital expenditures and declining grants. The fiscal deficit projected by the Budget Policy and Fiscal Framework Statement (BPFFS) is expected to average about 2.4 percent during the entire 10th Five-Year Plan (FYP) period (FY2008/09-FY2012/13). This is much below the governments self-imposed cap of 5 percent of GDP. However, the deficit is expected to rise steadily over the next two years, averaging around 5.2 percent from FY2011/12FY2012/13, and just above the 5 percent cap (Table 1).9 The expenditure projections include the effects of floods and earthquakes, which cost an estimated US$65 million in damages in 2009, and assume full implementation of planned reconstruction activities. In addition, the governments 10FYP envisages ambitious expansion of rural and urban infrastructure. The official projections are based on a near-doubling of capital expenditures from FY2008/09 levels, which may be constrained by implementation capacity. At the same time, on-budget grants are expected to decline as development partners reduce support, and loan financing replaces some of the grant financing. The government introduced short-term Treasury Bills in December 2009, to help finance the resource shortages. Taxes and dividends from the electricity sector and on-budget grants are important sources of revenue during the 10FYP period. The average share of electricity in aggregate revenue is expected to remain high in the remainder of the Plan period (Table 1). Grants account for

another 35 percent of Bhutans projected aggregate revenues. About 81 percent of these grants are expected to be tied to specific projects. India accounts for almost 65 percent of expected grants through FY2012/13. However, grants are expected to decline in importance with economic growth, as development partners gradually reduce such support to Bhutan (Table 1). Tax and non-tax revenues from various sources (excluding electricity) are expected to contribute almost 40 percent of aggregate revenues till FY2012/13.

Bhutans fiscal framework will continue to be underpinned by the principle of covering current expenditures by the domestic revenue stream. According to the Constitution of Bhutan, the government has to ensure that the cost of recurrent expenditures is met from the countrys internal resources. The government has prudently maintained its current expenditures below domestic revenues over the previous decade except in FY2003/04 and FY2004/05, where current expenditures were only 2 percent higher than domestic revenues. Accordingly, the government seeks to ensure that even if grants were to decline, the stream


of domestic revenues would finance current expenditures, and enable the delivery of basic services (Table 1). Bhutans debt stock is projected to increase during the 10FYP period, due to hydropower development loans. The debt burden, which is presently 66 percent of GDP is likely to rise over the next few years, as hydropower projects are launched to meet the governments ambitious vision (Table 2). At the same time, hydropower projects bring strong dividends, boosting the average real GDP growth and exports in the longer term. The Present Value of debt-to-GDP ratio is expected to rise to about 120 percent in FY2014/15, before declining to less than 15 percent by FY2029/30.10 The external debt service ratio as a share of exports of goods and services is expected to remain in the range of 12.5-13.5 percent for the remainder of the 10FYP. Domestic debt as a share of GDP is projected to fall from 1.2 percent at present to 0.5 percent by FY2012/13.

3.7 Balance of Payments:


The current account deficit is projected to deteriorate during the next few years due to imports for construction on hydropower plants and declining external grants. In the short term, imports of goods and services are expected to grow faster than exports, leading to a rising trade deficit (Table 3). Moreover, current transfers including grants from development partners which offset part of the trade deficit, will show a declining trend as budgetary grants taper off (Table 3). Interest payments on hydropower loans will rise steadily. Exports of goods and services are projected to grow at about 20 percent per year till FY2012/13. India accounts for about 93 percent of Bhutans aggregate exports, and is the sole buyer of electricity exports from Bhutan. Electricity is expected to remain the dominant export commodity, accounting for about 45 percent of the total. In addition, minerals and mineral-based products, including base metals and related articles, will likely account for another 40 percent of exports.11 More than 95 percent of exports, even in this category, are to India. This category of exports has been growing steadily during the decade (except for a decline in 2008, when copperexports were adversely affected by volatile global prices), and this is expected to be sustained in the near term. Export diversification prospects are limited. Bangladesh and Hong Kong are Bhutans next-biggest export clients, but each accounting for only about 3 percent of exports. Imports of goods will grow at about 10 percent annually in the short term, primarily due to construction work on hydropower projects. India accounts for more 77 percent of Bhutans imports, followed by Bangladesh, Nepal, and Hong Kong, each providing another 3-5 percent. Imports of capital goods, including machinery and mechanical/electrical

appliances, and transportation equipment, are expected to constitute about 30 percent of aggregate imports although Indias share of this will be relatively low, at around twothirds. Intermediate commodities, including mineral oils and fuels, and articles of base metals, used mainly in the construction and manufacturing sectors, will account for another 40 percent of aggregate imports in line with economic activities related to construction and manufacturing. More than 85 percent of imports in this category will be from India. The share of consumption goods, such as food products, animal products, and products of chemicals and allied industries, will show a marginally declining trend as a share of aggregate imports. However, imports of cereals from India, accounting for about 5 percent of total imports, are expected to rise. The overall external balance is expected to continue to show a surplus between FY2010/11 and FY2012/13 due to robust capital inflows. These will likely take the form of capital transfers from India, and loans from development partners (Table 3). These inflows are expected to finance the current account deficit and enable an increase in gross international reserves. In fact, gross official reserves should largely cover Bhutans total debt stock during the period, mitigating the likelihood of debt distress. The import cover is also projected to remain at a healthy 13.6 months during the period.


3.8 Risks to Outlook:

Bhutans overall macroeconomic outlook remains bright. Real GDP growth for the remainder of the 10FYP period is projected to be around 8 percent. The hydropower sector remains the key driver, given the planned expansion in electricity generation capacity. In the construction phase, projects will boost growth via the construction sector; once on stream, they will contribute through power generation. The current account deficit is estimated to widen significantly as new hydropower projects are under construction. However, adequate


external financing is likely to result in overall surpluses and adequate international reserve cover. Despite the positive macroeconomic outlook, implementation of Bhutans development agenda is subject to several risks: a) With high growth and elevated inflation, recent accommodative fiscal and monetary policies have contributed to the risks of overheating. Fiscal policy could be tightened to address this by saving revenue over performance and cutting non-priority expenditures. Similarly, monetary conditions could be tightened such that credit creation does not stoke excess demand and further increase the trade deficit. Such fiscal and monetary tightening will help contain balance of payments pressures. b) Dealing with revenue volatility and expenditure pressures would require deepening of public financial management reforms. This would include more robust implementation of the multi-year rolling budget framework and the strengthening of public finance oversight institutions. Efforts are also needed to broaden the tax base and improve revenue administration thus countering declines in foreign aid inflows and fluctuating hydropower revenues. c) While the hydropower sector will continue to drive growth for the foreseeable future, it is also important for Bhutan to promote diversification of the economy to create sufficient jobs to absorb the labor force productively. As such, as outlined in the Economic Development Policy, activities that foster private enterprise, attract foreign direct investment, and have job-generating potential need to be encouraged. Addressing investment climate challenges

will help create an enabling environment to foster private sector development and attract foreign direct investment. It is important for growth to be pro-poor so that wider sections of the population have the opportunity to contribute to and benefit from the countrys growth.

Chapter 4 Summary

Real economic growth exceeded 6 percent in 2008/09, but was below the 11-14 percent of the two previous years. However, ambitious plans for hydropower development are expected to yield dividends in growth and revenue in the coming years.

In 2009/10 saw a decline of US$7 million in annual tourism revenues from the levels of 2008, and an estimated loss of US$67 million due to earthquake and cyclone damage.

A fiscal deficit of more than 4.5 percent is projected for 2009/10, though this is expected to reduce over the next few years.

Bhutans debt is projected to increase significantly, but the risk of debt distress in the medium term is moderate, since the debt build-up is due largely to hydropower development loans that can be serviced with hydropower receipts.

The current account is projected to weaken in the next few years due to a worsening trade balance and interest payments on hydropower loans, although capital transfers from India, foreign direct investment, and loans and grants from development partners are expected to finance this.

The authorities are taking important steps to promote private sector development by improving the policy environment and liberalizing the financial sector.

While the outlook for Bhutan remains bright, the authorities should guard against overheating and economic volatility. The outlook for Bhutan remains bright. At the same time, the country remains vulnerable to macroeconomic volatility on account of its dependence on hydropower revenues and external assistance, and potential overheating from higher development spending and credit growth.


The 10FYP projects somewhat slower growth than the 9FYP, but ambitious hydropower development plans are expected to yield future dividends in growth and revenue. The Bhutanese economy was largely isolated from the global economic crisis, but has been affected by natural disasters and declining tourism revenues in the past year.

While the fiscal deficit is expected to average less than 5 percent during the 10FYP, the deficit is expected to widen in 2009/10. Bhutans debt is projected to increase during the 10FYP, but this is largely on account of hydropower development loans, expected to be serviced automatically by hydropower receipts. The current account is expected to deteriorate due to a worsening trade balance and interest payments on hydropower loans, although capital transfers from India, foreign direct investments, and loans and grants from development partners will likely finance this, and enable a modest increase in gross international reserves. The authorities are taking important steps to promote private sector development, by improving the policy environment and liberalizing the financial sector.

Chapter 5


Economic Policy and Poverty, and Finance and Private Sector Team, South Asia

Region, The World Bank Austrian Embassy, Delhi: Mission Report Dec. 2009; regular reports on Bhutan



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