Public Information Notice No. 05/91

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Bhutan

July 18, 2005

On July 11, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Bhutan.¹

Background

Macroeconomic outcomes remained favorable in 2002/03-03/04. The economy continued to expand at a brisk pace. Real GDP growth averaged 7¼ percent, fueled by public investment in infrastructure, private investment in housing, and continued work on the Tala hydropower project. Other sectors, including agriculture, manufacturing, and financial services also performed strongly. In particular, tourism appears to have revived following a protracted downturn after September 11, 2001 and the SARS epidemic in 2003. Inflation remained in low single digits.

External grants disbursements shaped fiscal outcomes. In 2002/03, grants (and revenue) were lower-than-targeted. Although capital expenditures were scaled back in response to this shortfall, domestic financing approached 5 percent of GDP. Based on this experience, in 2003/04, implementation of capital projects was slowed down during the earlier part of the year. In the event, grants from India resumed during the latter part of the year. This combination of slow project implementation and higher-than-budgeted grants shifted the overall budget balance into a surplus. As a result, the budget reduced its borrowings from domestic sources by 5 percent of GDP. However, in a departure from past practice, the current account registered a small deficit.

The 2004/05 budget envisaged a domestically financed deficit of 4 percent of GDP which is expected to be exceeded by a significant margin.² The overall deficit was targeted at 6¾ percent of GDP. However, spending during the year is now projected to be much larger than targeted as a result of the civil service salary increase effective January 2005—the first since 1999 and estimated to cost the budget more than 1½ percent of GDP on an annual basis; and the purchase of aircraft and higher subsidies for Druk Air. On the revenue front, some shortfalls are expected. The revision of the tariff rate for Chukha hydropower project's exports, effective January 1, 2005, will only have a minimal impact on revenues in 2004/05. With these factors, the overall and domestically financed deficits for 2004/05 are projected at 15 percent and 11½ percent of GDP, respectively.

Debt service obligations remained manageable even as the public debt-to-GDP ratio rose. From 40 percent of GDP in mid-2000, public debt rose to around 90 percent of GDP in mid-2004. The bulk of the increase (30 percentage points of GDP) was rupee borrowings from India for the Tala hydropower project. At the same time, domestic financing of budget deficits and other factors also contributed to the rise in the debt-to-GDP ratio. In particular, the purchase of aircraft for Druk Air contributed to higher domestic debt. The NPV of external debt in mid-2004 is estimated at 65 percent of GDP, of which rupee debt was about 45 percent of GDP. Meanwhile, external debt service ratios remained low (4-8 percent of exports/revenue).

The balance of payments and monetary aggregates fluctuated with external aid. In 2003/04, exports picked up strongly led by nonelectricity exports to India; imports also grew strongly, mostly reflecting equipment needs for the Tala hydropower project. On the service account, tourism receipts rose, especially in 2003/04. While the current account registered a deficit, substantial capital transfers for Tala and loan disbursements led to an overall balance of payments surplus and helped raise gross reserves. The bulk of this increase came in 2002/03 as prepayment for Druk Air aircraft limited reserve accumulation in 2003/04. As a result, the reserve cover fell from about 23 months of imports at end-2002/03 to around 19 months at end-2003/04. As regards monetary aggregates, the favorable balance of payments position led to rapid reserve and broad money growth in 2002/03; the growth of monetary aggregates slowed down in 2003/04. The higher deficit levels in 2004/05 are expected to accelerate growth in monetary aggregates, reduce excess liquidity in the financial system and limit reserve accumulation.

Rapid private sector credit growth led to a decline in reported NPLs but increased financial institutions' balance sheet risks. Private sector credit growth averaged over 35 percent during 2002/03 and 2003/04. Low interest rates abroad and policy changes—stricter limits on banks' Indian rupee holdings, reduction in reserve requirements and lower remuneration on reserves—contributed to this credit expansion. The bulk of the lending was for construction and real estate which had longer maturities. The resulting shift in sectoral concentration in the asset portfolios increased the maturity mismatch, with an accompanying rise in liquidity and interest rate risks.

The government took steps to enhance Bhutan's international integration and structural reforms proceeded. Bhutan joined the IFC in December 2003, the Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation (BIMST-EC) in February 2004 and held the first WTO working party meeting in November 2004. In the financial sector, the central bank act, the financial services act, and foreign exchange regulations are being upgraded, with technical assistance from donors and the Fund.

Growth is projected to pick up when Tala comes on stream and medium-term macroeconomic prospects remain favorable. A spike in the growth rate to around 19 percent when Tala comes on stream in 2006/07 would push the annual average growth rate to 8-9 percent in the period 2005/06-2009/10. Inflation should remain in the single digits, broadly in line with price developments in India. The overall balance of payments is projected to remain in surplus, and international reserves are expected to remain around 15-16 months of imports.

Going forward, the authorities are mindful of the risks. First, with a rapidly growing labor force and limited public sector absorption capacity, policy measures are contemplated to generate private sector employment. Second, the Royal Government of Bhutan intends to monitor public debt and debt service obligations carefully and to mobilize external aid for fiscal sustainability. Finally, the Royal Monetary Authority (RMA) and financial institutions see the need for strengthened supervision and reforms to manage balance sheet risks.

Executive Board Assessment

They commended Bhutan's prudent macroeconomic policies which, along with political stability, have contributed to robust economic growth and an appreciable improvement in social indicators towards meeting its Millennium Development Goals. In this regard, Directors also commended the authorities for their holistic approach to economic development.

Directors considered Bhutan's medium-term growth prospects to be favorable in light of its policy record and further potential for growth in hydropower and related sectors, as well as the strong support of development partners. The main challenge will be to spur private sector development and economic diversification in order to generate jobs for a growing number of school leavers and further reduce poverty. This will also involve continuing to balance greater economic activity with the protection of Bhutan's unique culture and fragile environment as envisaged in Bhutan 2020: A Vision for Peace, Prosperity, and Happiness.

Directors agreed that the authorities should accord a high priority to creating an enabling environment for private sector activity and growth in the nonpower sectors. Actions to be taken in this regard would include streamlining the regulatory regime and liberalizing the trade and foreign direct investment regimes, while continuing investments in infrastructure to help lower nonlabor costs. To increase labor productivity, Directors also saw scope for better aligning Bhutan's education system to market needs. In this context, they cautioned that establishing the minimum wage at a high level could result in higher unemployment, especially among the young labor force participants. Directors welcomed Bhutan's efforts towards regional and global integration, including WTO accession.

Directors underscored the importance of ensuring fiscal sustainability by limiting the rise of domestic debt and mobilizing external aid at concessional terms. To limit domestically financed deficits, they encouraged the authorities to improve expenditure planning in the context of a medium-term expenditure framework. In addition, strengthened coordination with donors should help ensure that external aid is mobilized on a timely basis. Directors also encouraged efforts to raise domestic revenues by broadening the tax base and improving tax administration. Rationalization of the sales tax and import duty regimes would be among the measures to be considered in this regard.

Directors supported continuation of the exchange rate peg to the Indian rupee given the benefits of the existing arrangement, namely, to help anchor inflation expectations and facilitate trade with India. Greater private sector efficiency would have to absorb any potential appreciation of the real exchange rate after the Tala hydropower project comes on stream. In addition, some fiscal tightening would moderate a rise in the prices of nontradables and limit potential adverse effects on competitiveness. Directors advised the Royal Monetary Authority (RMA) to remain watchful that excess liquidity does not fuel excessive credit growth, especially to the construction sector, which could create a problem of nonperforming loans.

Directors commended the authorities for the measures being taken to strengthen the financial system, particularly the upgrades to legislation and steps to improve supervision. They underscored the need to build capacity to monitor and manage balance sheet risks on the part of the RMA and commercial banks.

Directors considered that Bhutan's strong external position provides scope for further liberalization of the exchange system. They urged the authorities to eliminate restrictions maintained under Article XIV as soon as Bhutan's balance of payments position permits, and to accept the obligations of Article VIII as soon as possible. In light of the authorities' concerns about a potential, unsustainable drain on hard currency reserves, Directors suggested a gradual approach to eliminating these restrictions, including by developing a foreign exchange market and market-based instruments to manage hard currency flows. They supported the provision of Fund technical assistance in this area.

Directors welcomed the authorities' efforts to strengthen Bhutan's data over the past few years, including the increased periodicity of price statistics and upgrades to national accounts data. Nonetheless, considerable work remains to be done to upgrade statistical systems, particularly in the fiscal and external sectors.