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Public Information Notice (PIN) No. 03/41
March 31, 2003
International Monetary Fund
700 19th Street, NW
Washington, D.C. 20431 USA

IMF Concludes Article IV Consultation with Bhutan

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

On February 21, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Bhutan.1

Background

The Bhutanese economy has continued to perform strongly. GDP growth dipped below trend to 5.3 percent in 2000 as a result of the flooding in the south. The associated damage to industry was partially offset by strong growth in construction and the financial sector. Manufacturing recovered in 2001, and with construction and financing continuing to boom, GDP growth increased to 6.6 percent in 2001, and to an estimated 7.7 percent in 2002. Private sector credit has picked up strongly after a number of years of stagnation. Even though tourist arrivals declined in the wake of the September 11 attacks, the balance of payments situation has remained comfortable. In line with price developments in India, inflation in Bhutan has fallen below 3 percent, its lowest level in two decades.

Close ties with India have been maintained. India is the dominant trading partner and sole buyer of electricity exports. As Bhutan's largest foreign donor, India has financed the major part of the development of the power sector.

Political reforms have continued. The drafting of a national constitution is the latest step in the process of evolutionary political change that began in 1998 when the King devolved executive powers to a Council of Ministers chosen by the elected National Assembly. A first draft of the constitution was completed in December 2002 and will now be subject to public discussion. A key objective of the Ninth Five-Year Plan is the decentralization of economic power to local governments so as to facilitate implementation of reforms and improve the effectiveness of public spending.

Implementation of policies has been broadly successful. The fiscal stance has remained prudent, while the exchange rate peg to the Rupee has allowed Bhutan to share in the stable monetary conditions that have prevailed in India. Dramatic progress has been made in raising education and health levels. However, the private sector has yet to create jobs for nationals on a sufficient scale. The recently-published Ninth Five-Year Plan (2002-2007), while again balancing exploitation of natural resources and tourist potential against preservation of the environment and culture, therefore gives renewed emphasis to encouraging private sector activity.

Fiscal policy has remained conservative. The authorities have continued to maintain a surplus on the fiscal current account. To improve the buoyancy of the tax system and to promote social equity, personal income taxation was introduced in January 2002 in conjunction with a campaign to educate taxpayers. With regard to capital spending, Bhutan's excellent relations with donors have ensured that projects are largely covered by concessional external finance. Nevertheless, in a departure from previous practice, recourse has been made to domestic financing in recent years. Such financing amounted to 6 percent of GDP in 2000/01 and 2 percent of GDP in 2001/02, but much of this came from the government running down deposits with the banking system. The government's domestic debt stock in June 2002 was 2 percent of GDP.

The fiscal deficit has fluctuated in line with capital spending. The deficit rose to 11.1 percent of GDP in 2000/01 (fiscal year begins July 1), considerably above the budget target of 3.4 percent of GDP. Almost half of this divergence represented spending overruns related to rebuilding flood damaged infrastructure. By contrast, the surplus on the fiscal current account in 2000/01 of 2.4 percent of GDP was close to target. In 2001/02, capital expenditure returned to a more normal level and the fiscal deficit narrowed to 5.4 percent of GDP.

The 2002/03 budget targets a deficit of 4.8 percent of GDP, with higher tax receipts and lower current expenditure expected to more than offset a drop in nontax revenues. The tax/GDP ratio is expected to increase in 2002/03 despite the announcement in the budget of a raft of tax incentives primarily aimed at manufacturing and the IT sector. These included tax holidays for new investments and exemptions for earnings in convertible currency. At the same time, export taxes on apples, oranges and cardamom exports were abolished.

The pace of foreign reserve accumulation has slowed. Exports declined in 2000 and 2001, primarily on account of the flood damage, although there has also been a trend decline in nonelectricity exports since the mid-1990s. The wider trade deficit was aggravated by a sharp drop in inward transfers, including foreign grants. As a result, the current account deficit turned from a surplus in 1999/2000 to a deficit of about 5 percent of GDP in 2000/01 and 2001/02. External loans from India rose sufficiently to finance these current account deficits, but the National Pension and Provident Fund was permitted to invest about US$ 20 million overseas in early 2001, and there was a decline in reserves in 2000/01 of almost exactly that amount. This reserve loss was made up in 2001/02. The higher loan financing is estimated to have increased the ratio of external debt to GDP during 2000/01 and 2001/02 from 39 to 55 percent. Since much of the lending is on concessional terms, the debt service ratio remains low at 6½ percent of exports.

Excess liquidity has persisted, even though credit growth has recovered. Given the fixed exchange rate, money growth has varied in line with the balance of payments. In the absence of investment opportunities in Bhutan, the banks have continued to hold reserves with the Royal Monetary Authority (RMA) averaging about 40 percent of assets. Almost the same amount again has been held on deposit with the Indian banking system. Domestic lending has thus been a relatively small part of the banks' balance sheets. Nevertheless, after several years of sluggish growth, credit to the private sector picked up strongly in 2000, growing by 80 percent during the two years ending June 2002. Lending to trade and commerce was particularly buoyant, but borrowers in the manufacturing and construction sectors were also major beneficiaries.

The RMA has taken steps to consolidate Bhutan's rupee reserves under its control. In March 2001, the RMA issued a directive instructing the banks to repatriate rupee holdings in excess of working balance requirements upon maturity, and the proportion of bank assets held in India has since declined. Upon repatriation, the rupees are being exchanged for RMA bills. The banks were originally permitted to hold Indian assets so as to enhance their earnings opportunities, but have tended to invest in long-term deposits, and on occasion, have been caught short of rupees in their domestic operations. This has led to the rupee trading in the informal market at a premium. The RMA directive is intended to avoid such episodes recurring in the future.

Executive Board Assessment

Executive Directors commended the Bhutanese authorities for having maintained prudent macroeconomic policies, taken steps to modernize the economy, and expanded the population's participation in economic and governance institutions, while preserving Bhutan's environment and culture. As a result, economic growth has been strong and social indicators have improved substantially. In the light of Bhutan's good track record of policy implementation, the potential for further growth in hydro-power and related sectors, and the strong support of development partners, Directors considered Bhutan's growth prospects to be very favorable. Directors, however, noted the vulnerabilities faced by Bhutan, especially the dependence on electricity exports and the adverse impact on tourism of global economic slowdown. The key medium-term challenges, in their view, are to diversify the economy in order to increase employment opportunities, and to expand the private sector.

Stressing the importance of maintaining a surplus on the fiscal current account, Directors urged that the large recurrent expenditure needs envisaged in the Ninth Five-Year Plan be met by mobilizing revenue. They welcomed the introduction of a personal income tax, and suggested that implementation of the new manufacturing tax incentives be monitored closely to minimize the revenue loss. They also advised caution in domestic borrowing to keep the public debt level sustainable.

Directors supported continuation of the currency peg to the Indian rupee, as the current system has served Bhutan well. While noting that excess liquidity in the financial system does not pose immediate macroeconomic problems, the authorities were advised to stand ready to absorb liquidity should the need arise.

Directors welcomed the measures being taken to strengthen the financial system, particularly those to improve prudential regulations and the management of financial institutions. The authorities also were encouraged to increase the degree of private ownership in the financial sector, and to intensify the fight against the financing of terrorism as well as money laundering activities.

Directors endorsed the authorities' efforts to spur private sector development, including the establishment of new industrial estates and a dry port to improve efficiency and reduce production costs, and the approval of a policy on foreign direct investment. They encouraged the authorities to be flexible in implementing the foreign direct investment policy, particularly when a project promises substantial job creation.

Directors urged the authorities to be more liberal in applying employment regulations. While agreeing with the emphasis on vocational training to address the skills mismatch, they cautioned against tightening restrictions on foreign labor in the absence of an adequate supply of local skilled labor. More generally, they noted the importance of labor regulations being conducive to private sector growth.

While recognizing the constraints posed by the tight trade links with India, Directors believed that Bhutan's strong external position provides scope for further trade and exchange liberalization. They urged the authorities to eliminate the remaining restrictions maintained under Article XIV of the Fund's Articles of Agreement.

Directors welcomed the authorities' efforts in recent years to develop Bhutan's statistical database. As considerable work remains to be done, particularly with regard to removing inconsistencies between sectoral data, Directors supported the authorities requests for technical assistance in this area.

Bhutan: Selected Economic Indicators 1/


 

1997/98

 1998/99

 1999/2000

 2000/01

2001/02


           

GDP growth and prices (percent change)

         

Real GDP at factor cost 2/

7.2

6.4

7.6

5.3

6.6

Consumer Prices

9.0

9.2

3.6

3.6

2.7

           

Government budget (in percent of GDP

         

Total revenue and grants

32.9

40.0

39.6

38.5

34.1

Of which: foreign grants

12.1

18.8

16.5

16.5

12.9

Total expenditure and net lending

31.9

41.7

43.4

49.6

39.6

Of which: current expenditure

17.5

18.4

18.6

19.7

18.1

Current balance

3.4

2.8

4.4

2.4

3.1

Overall balance

1.0

-1.8

-3.9

-11.1

-5.4

           

Money, Credit and interest rates (percent change, end of period)

Broad money

41.7

21.4

21.4

5.5

17.6

Credit to private sector

13.2

5.4

4.1

47.9

29.3

Lending rate

13-16.0

13-16.0

12-16.0

12-16.0

13-16

RMA bills (91-days)

8.5

6.0

8.5

4.9

4.5

           

Balance of Payments (In millions of U. S. dollars)

Merchandise exports

111.3

104.7

114.3

99.5

97.7

Merchandise imports

-136.1

-162.3

-185.0

-196.3

-188.4

Current account balance 3/

32.1

21.9

4.0

-26.7

-28.2

(in percent of GDP)

8.2

5.4

0.9

-5.5

-5.3

Loans (net)

4.4

26.0

42.0

49.8

57.3

Overall balance

41.7

48.3

33.6

-24.0

20.4

(in percent of GDP)

10.6

11.9

7.4

-4.9

3.8

           

External indicators

         

Gross official reserves (in millions of U. S. dollars)

215.5

258.5

292.6

294.1

316.6

(In months of imports)

19.0

19.1

19.0

18.0

20.2

External debt (in percent of GDP; end of period)

36.8

40.1

38.7

49.0

55.0

Debt-service ratio (percent of exports)

8.3

8.1

5.6

6.1

6.6

 

 

 

 

 

 

Sources: Data provided by the Bhutanese authorities, and IMF staff estimates.

1/ Fiscal year beginning July 1.

2/ On a calendar-year basis, e.g., the entry under 1997/98 is for 1997, etc.

3/ Including grants, following RMA's new balance of payments presentation introduced in December 2002.


1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.




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