## cr18300

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**Canonical URL:** [cr18300](https://www.imf.org/-/media/files/publications/cr/2018/cr18300.pdf)

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### Poverty trends and social outcomes
- Poverty declined from 12 percent in 2012 to 8.2 percent in 2017.
- Extreme (subsistence) poverty: 1.5 percent in aggregate in 2017; just over 2¼ percent in rural areas.
- Gini coefficient remained roughly unchanged at 0.38.
- Backed by average GDP growth of 7.5 percent over the decade to 2017.
- Rural poverty: nearly 31 percent in 2007 to 12 percent in 2017.
- Urban poverty: 1.7 percent in 2007 to 0.7 percent in 2017.
- Depth of poverty (average gap): 2.4 percent.
- Access to services and information:
  - 99.9 percent access to improved water sources.
  - At least 92 percent of households have access to improved sanitation (eight percent difference between poor and non-poor).
  - 67 percent of non-poor households have at least one smart phone versus 29 percent of poor households.
- Main driver of poverty reduction: increase in non-food consumption with no appreciable change in food consumption patterns.

### Growth, inflation, and external sector
- GDP growth:
  - 7.3 percent during FY2015–16 (hydropower-driven).
  - Estimated 7.4 percent in FY2017.
  - Projected to decelerate to 4.8 percent in FY2019 on current policies (sharp decline in public investment; tapering hydropower construction).
  - Expected to recover to about 6 percent in FY2019-20.
  - Further acceleration expected in FY2021–22 due to two hydropower projects coming on stream.
- Inflation:
  - Headline inflation: 3.2 percent in December 2016 to 4.3 percent in December 2017.
  - CPI inflation recorded at 2.55 percent in June 2018; domestic inflation 1.47 percent in June 2018; imported inflation 3.56 percent in June 2018.
  - Staff: inflation projected to remain broadly in line with India given the ngultrum’s peg to the rupee.
- External sector:
  - Current account deficit (CAD) averaged 26 percent of GDP during FY2012–16; estimated 22.8 percent in FY2017.
  - Reserves: nearly 13 months of imports of goods and services; reserves currently cover around 23 months of “essential imports.”
  - Rupee reserves improved to 36 percent of total reserves in September 2017 (from 16 percent in July 2015).
  - Swap line with RBI: 100 million USD; rupee facility outstanding with GoI: 7 billion Indian rupees.
  - Exports and imports predominantly with India (70–90 percent).

### Fiscal policy, budgets, and stabilization
- Fiscal swings:
  - Deficit widened to 3.3 percent of GDP in FY2017 from 1.1 percent in FY2016 (sizable expansion of capital expenditure; domestic direct tax revenues declined).
  - Estimated FY2018 budget outcome: deficit of 1 percent of GDP (driven by higher hydropower revenues and excise duty refunds from India).
- FY2019 budget (proposed/adopted interim):
  - Implies a 2.2 percent of GDP surplus, primarily due to capital expenditure falling from 17 percent of GDP in FY2018 to 5.6 percent of GDP in FY2019.
  - Current spending set to remain flat in nominal terms, implying a 1.2 percent of GDP decline relative to FY2018.
  - Revenues and grants set to decline by 9 percent of GDP (lower foreign grants and decline in excise duty refunds from India).
- Draft 12th FYP fiscal profile:
  - Average overall budget surplus of 1.4 percent of GDP for FY2019–23.
  - Capital expenditures average around 9½ percent of GDP annually (below 15½ percent average in the 11th FYP).
  - Foreign grants projected at 5¼ percent of GDP annually on average (down from 9½ percent under the 11th FYP).
- Stabilization fund for hydropower revenues (BESF):
  - Seed money: Nu 100 million to be invested in Indian rupee assets (authorities cite USD 1.54 million seed money in their statement).
  - Draft Royal Charter under review; Rules and Regulations expected shortly.
  - Staff view: a proposed floor of 5 percent of hydropower royalties for transfers to the fund is insufficient; staff urge a more ambitious target.
- Staff recommendations:
  - Avoid sharp spending cliff in FY2019; pursue more gradual fiscal consolidation.
  - Scope to raise capital spending by about 2 percent of GDP annually on average over the medium term, supported by additional domestic tax revenue mobilization and modest domestic financing (~1 percent of GDP annually on average).

### Debt profile, hydropower financing, and risk assessment
- Public and publicly guaranteed (PPG) debt: 107 percent of GDP in FY2017.
- Hydropower debt share: 77 percent of PPG external debt in FY2017.
- Creditor composition (PPG external debt, FY2017): India 74 percent, ADB 11 percent, World Bank (IDA) 9 percent.
- Treatment of GoI hydropower financing: closer in nature to FDI under intergovernmental agreements; GoI bears construction and financial risks and buys surplus electricity at cost-plus-margin pricing (15 percent net return noted in DSA excerpts).
- Present value (PV) of non-Indian debt-to-GDP (highest): 21 percent; high-risk threshold: 40 percent of GDP.
- DSA projections and dynamics:
  - Under the baseline, each debt indicator breaches its indicative threshold; breaches are large and sustained into the long run.
  - PV of debt-to-GDP ratio falls below threshold only after 2031; nominal debt-to-GDP below threshold in 2028.
  - Debt service indicators worsen relative to the previous DSA due to higher debt service and more moderate export growth.
  - All five indicators breach thresholds under stress tests.
- Hydropower projects incorporated in baseline:
  - Mangdechhu: 720 MW (FY2019).
  - Puna II: 1,020 MW (FY2021).
  - Puna I: 1,200 MW (FY2023).
- Authorities and staff view: risk of debt distress assessed as moderate given dominance of intergovernmental hydropower financing and concessional non-hydropower borrowing.

### Reserve adequacy and medium-term external outlook
- Reserve adequacy benchmark: around 6 months of imports (cost of reserves = 6.2 percent).
- Alternative adequacy range: between 4 to 9 months of imports.
- Actual reserves: nearly 13 months of imports.
- Rupee reserves: 36 percent of total reserves.
- Swap line with RBI: 100 million USD.
- Medium-term projections:
  - Growth projected to average around 6 percent (medium and long term).
  - Electricity exports projected to increase from around 7 percent of GDP to around 20 percent of GDP.
  - CAD projected to reach a surplus in FY2023.
  - Imports for hydropower sector expected to decline to nearly nil over the medium term.
  - Overall balance of payments expected to remain positive over the medium term; reserve accumulation supported as grant financing declines.

### Monetary policy framework, liquidity management, and financial sector
- Transition to interest-rate signaling:
  - Authorities acknowledge challenges moving from quantity to interest rate signaling but reaffirm commitment to implement new framework soon.
  - RMA, with SARTTAC TA, is enhancing liquidity management and forecasting, establishing an interest rate corridor (IRC), and developing the interbank market.
  - New framework to include standing marginal lending and deposit facilities; expected to become operational shortly (authorities planned rollout by November 2018).
  - Staff recommendation: start with a relatively wide corridor (e.g., +/- 200 bps) and reduce it gradually.
  - Staff recommendation: review the Minimum Lending Rate (MLR) once framework is in place; MLR is calculated using three cost parameters.
- Liquidity management:
  - RMA sterilizes hydropower-related liquidity through daily sweeping of related bank balances.
  - Staff analysis: only a small positive credit gap in recent quarters, much lower than pre-rupee crisis levels.
- Banking sector performance and risks:
  - Return on assets: 1.8 percent in 2016 to 0.7 percent in 2017.
  - Return on equity: 11.3 percent in 2016 to 4.8 percent in 2017.
  - System-wide NPL ratio: 7.2 percent in December 2016 to 8.4 percent in December 2017; authorities reported NPLs at 11.5 percent in June 2018 (11.4 percent in June 2017 noted).
  - Capital adequacy ratio (CAR): 19 percent in 2016 to 16 percent in 2017 (adjustments in risk weights and provisioning).
  - Liquidity buffers: above regulatory requirements (10 percent CRR kept with RMA and additional 20 percent SLR kept in liquid assets).
  - Provisions: high; provisioning schedule requires 20, 50, and 100 percent provisioning after 90, 180, and 350 days past due, respectively; NPLs can be reclassified as performing once arrears cleared.
- Staff recommendations for financial sector:
  - Tighten loan classification requirements and enforce longer satisfactory-performance periods before reclassification.
  - Mandate risk-based provisioning (some banks already practice this).
  - Gradually reduce current liquidity requirements with new RMA liquidity facility operational (high liquidity buffers affect profitability and may increase risk).
  - Maintain credit-assessment rigor under PSL and evaluate outcomes regularly.
  - Continue vigilance on financial stability risks and adjust macroprudential policies as needed.

### Priority Sector Lending (PSL) for CSI — Appendix I
- PSL Guidelines implemented January 2018; PSL Council chaired by RMA established.
- Recognizes CSI as largest source of domestic production and employment.
- Prescribed lending targets: function of financial institutions’ outstanding loan portfolio in priority sectors.
- Ceiling preferential lending rates:
  - agricultural CSI sector: 8 percent.
  - non-agricultural CSI sector: 8.5 percent.
- Shortfalls may be allocated to on-lending to microfinance institutions or Bhutan Development Bank.
- Preferential-lending tax exemption under Fiscal Incentives Act of 2017 for income from such lending.
- Mandatory insurance coverage for agricultural loans (insurance can substitute for collateral).
- Training provision at FITI.
- Recommendations/good practices:
  - Keep credit-assessment rigor at par with market-based lending.
  - Use incentives rather than quantitative targets where possible (e.g., partial credit guarantees, financial infrastructure).
  - Review and calibrate interest rate caps frequently.
  - Compensate deviations from market conditions; tax benefits may not fully offset below-market pricing.
  - Strengthen technical capacity and inter-agency coordination; FITI to provide training (effectiveness yet to be tested).

### Goods and Services Tax (GST) — Box 2
- Bhutan currently raises around 5½ percent of GDP in indirect tax revenues.
  - Sales taxes: 2½ percent of GDP.
  - Excise duty refund (EDR): around 2 percent of GDP (reflects excises levied by India on exports to Bhutan).
- India’s GST removes excises on exports; EDR will effectively cease in FY2020, creating a large revenue gap.
- A broad-based GST expected to cover the revenue gap; VAT buoyancy evidence: average increase ~½ percent of GDP over five years in staff sample of nearly 70 countries.
- GST design recommendations:
  - Broad base including services; effective input tax credit/refund management; administrative simplicity (few rates, preferably single rate).
  - GST under consideration resembles standard VAT with input tax crediting, mandatory turnover-based registration threshold, and destination principle (zero-rated exports and taxed imports including services).
- Implementation timetable and support:
  - Bhutan targeted July 2020 for GST implementation.
  - Project office created; IMF TA supporting legislation, business processes, IT selection, taxpayer outreach, capacity building.
  - Critical milestone: finalization and passage of GST legislation and operationalization of IT systems and taxpayer outreach ahead of implementation.
  - Potential stumbling block: revenue authority’s ability to develop and implement supporting IT system.

### Structural issues, diversification, and reform priorities
- Diversification priority sectors: agriculture, CSI, hydropower, tourism, mining.
- Business environment:
  - Bhutan ranked 75th in Doing Business 2018 (improvement from 148th in 2013).
  - Binding constraints: access to finance, access to skilled labor, access to external markets (World Bank Investment Climate Assessment 2016).
  - Minimum FDI threshold: US$20 million; recommendation to review and liberalize for select CSI activities.
  - Logistics performance: ranked 135th among 160 economies (World Bank 2016).
  - ICT connectivity needs improvement.
- Access to finance and insolvency:
  - Expand Credit Information Bureau coverage to include utilities’ payments and microfinance borrowing.
  - Insolvency bill awaiting parliamentary approval.
  - Recommend specialized commercial courts and revised out-of-court restructuring procedures.
  - RMA guidance to encourage write-off of legacy bad loans (e.g., loss-classified >3 years) and amend legislation to allow secondary purchases of impaired loans.
  - Ongoing review of Movable and Immovable Properties Act should not weaken creditor rights.
  - Improve land registration and validation to enhance collateral availability.
- Labor and education:
  - Gross tertiary enrollment around 10 percent.
  - Short-term labor gaps require more training and lower barriers for skilled immigration.
  - Public sector employment remains attractive due to wage/compensation gap; promote voluntary private-sector pension schemes to make private sector more attractive.
- Authorities’ planned actions:
  - Financial inclusion strategy issued August 2018 (2018–2023).
  - Second annual Bhutan Economic Forum for Innovative Transformation planned for July 2019 on economic diversification and CSI.

### Authorities’ views and concluding statements
- Authorities broadly agree with Article IV assessment and value Fund TA and training.
- Objective: graduate to middle-income status by 2023.
- Authorities’ macro figures and views:
  - Poverty: "12 percent in 2012 to 8.2 percent in 2017"; extreme poverty "just 1.5 percent."
  - GDP maintained momentum at "7.4 percent in FY2017."
  - Headline inflation: historic low of 2.6 percent in June 2018 (from 4.9 percent in June 2017); CPI expected around 3 to 5 percent.
  - Gross international reserves at end-June 2018: USD 1,110.9 million, sufficient for 13.01 months of merchandise imports.
  - Authorities more optimistic than staff on FY2019 growth due to expected hydropower commissioning and 12th Five-Year Plan implementation.
  - Stabilization fund seed money cited as "USD 1.54 million"; proposal for 5 percent minimum royalty transfers to BESF (staff consider insufficient).
  - Financial soundness: capital adequacy and liquidity above prudential norms; NPLs reported at 11.5 percent in June 2018.
  - Planned rollout of upgraded monetary framework by November 2018; GST implementation scheduled for July 2020.
- Authorities seek continued Fund engagement and support to balance inclusive growth with macroeconomic stability.

### Staff appraisal and policy priorities
- Growth and poverty: growth strong; poverty declined significantly; external imbalances beginning to decline though still large.
- Fiscal policy: immediate challenge is to limit sharp fiscal withdrawal in FY2019; medium-term priorities are domestic revenue mobilization and prudent management of rising hydro revenues vs declining grants.
  - Staff supports medium-term fiscal consolidation but recommends a more gradual path (illustrative alternative scenario).
  - GST is a key measure to enhance domestic revenue; staff urged authorities to secure resources to avoid GST delays.
  - Replace five-year planning cycle with rolling multi-year budget framework; strengthen PFM and fiscal transparency.
- Monetary and financial stability:
  - Monetary conditions broadly appropriate; credit gap negative until recently.
  - Support for revamping monetary framework to align with the rupee peg.
  - Need for continuous modernization of regulatory framework to safeguard financial stability and support private-sector access to finance.
  - Banking sector has buffers but low profitability; supervisory vigilance and calibration of micro- and macroprudential frameworks required.
- Structural policy:
  - Diversification emphasis appropriate; prioritize access to finance, education, and labor market outcomes.
  - Caution on holistic credit measures to underserved sectors to limit distortions.
  - Promote targeted training and improved tertiary enrollment; relax FDI rules selectively where upstream/downstream spillovers are significant.
- External and exchange rate:
  - Staff supports ngultrum peg to the rupee.
  - External position considered moderately weaker than warranted by fundamentals and policies.
- Exchange restrictions and Article IV cycle:
  - Authorities did not request and staff does not recommend approval of exchange restrictions inconsistent with Article VIII.
  - Bhutan maintains exchange restrictions under transitional arrangements of Article XIV, Section 2.
  - Staff encouraged gradual easing toward elimination as balance of payments permits.
  - Staff recommends Article IV consultations remain on a 24-month cycle.

*Source: cr18300 (IMF staff report excerpts).*

### 1. Poverty Trends _________________________________________________________________________________ 16

### 1. Poverty Trends

### Recent poverty and income outcomes
- Poverty declined from 12 percent in 2012 to 8.2 percent in 2017.
- Extreme poverty fell to 1.5 percent in 2017.
- The Gini coefficient remained roughly unchanged at 0.38.
- Improvements occurred in the context of the 11th Five-Year Plan (FYP) and rising per capita income while the country transitions to middle-income status.

### Growth, inflation, and external balances
- GDP growth:
  - Grew at 7.3 percent during FY2015–16, driven by the hydropower sector.
  - Estimated at 7.4 percent in FY2017, with strong growth in services and manufacturing offsetting a tapering in hydropower construction.
  - Projected to decelerate to 4.8 percent in FY2019 on current policies (reflecting a sharp decline in public investment and continued tapering of hydropower construction).
  - Expected to recover to about 6 percent in FY2019-20.
  - Further acceleration is expected in FY2021–22 due largely to the coming on stream of two other hydropower projects.
- Inflation:
  - Headline inflation increased from 3.2 percent in December 2016 to 4.3 percent in December 2017.
  - Inflation projected to remain broadly in line with that in India given the ngultrum’s peg to the rupee.
- External sector:
  - The current account deficit (CAD) averaged 26 percent of GDP during FY2012–16.
  - 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; reserves currently cover around 23 months of “essential imports.”

### Financial sector and inclusion
- Banking sector:
  - Financial performance remains weak: profitability is low and some banks have high rates of non-performing assets.
  - Liquidity and provision coverages are high; interest rate risks are contained due to adjustable rate lending.
- Microfinance and payments:
  - Four microfinance institutions have recently been licensed.
  - Progress is being made on modernizing the payment system and financial inclusion.
  - The Royal Monetary Authority (RMA) launched a Priority Sector Lending (PSL) program to improve access to credit for the cottage and small industries (CSI) sector (Appendix I).

### Medium-term outlook drivers and reserves
- Medium-term growth drivers: new hydropower plants coming on stream, services, and manufacturing.
- Expected improvement in current account balance and reserve coverage due to a decline in hydropower-related imports and a sharp increase in hydropower exports.

### Risks to the outlook
- Risks skewed to the downside in the baseline; active policies could lead to higher growth (Appendix II).
- Domestic risks:
  - Delays in implementing the GST and completing hydropower projects could reduce electricity exports and increase fiscal deficits.
  - Financial sector vulnerabilities due to loan quality and weak profitability.
- Policy-mitigation upside:
  - Avoiding a sharp spending cliff in FY2019 and pursuing more gradual fiscal consolidation, coupled with higher domestic revenue mobilization, could lift growth above the baseline.
- External risks:
  - Deviations in Indian growth, Indian inflation, or global oil prices from baseline assumptions could materially affect the Bhutanese economy.

### Fiscal policy stance and public finances
- Fiscal swings:
  - Fiscal policy is prudent on average over each FYP cycle but characterized by large within-cycle swings.
  - Deficit widened to 3.3 percent of GDP in FY2017 from 1.1 percent in FY2016, driven largely by a sizable expansion of capital expenditure; domestic direct tax revenues declined in part due to weaker hydropower-related revenues.
  - Estimated FY2018 budget outcome is a deficit of 1 percent of GDP, with improvement driven by higher hydropower revenues and excise duty refunds from India.
- Debt and hydropower financing:
  - Staff assess Bhutan’s risk of debt distress as moderate.
  - Outstanding hydropower debt makes up 77 percent of Bhutan’s external public and publicly-guaranteed debt.
  - All hydropower projects but one are financed by India under intergovernmental agreements with contractual obligations for India to purchase electricity at tariffs based on cost-plus-margin pricing.
- FY2019 budget implications:
  - The FY2019 budget (proposed by the outgoing government and adopted on an interim basis) implies a 2.2 percent of GDP surplus, primarily due to a decline in capital expenditure from 17 percent of GDP in FY2018 to 5.6 percent in FY2019.
  - Current spending 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 lower foreign grants and a decline in excise duty refunds from India.
- Draft 12th FYP fiscal profile:
  - Implies an average overall budget surplus of 1.4 percent of GDP for FY2019–23.
  - Capital expenditures would average around 9½ percent of GDP annually (below the 15½ percent average in the 11th FYP).
  - Foreign grants projected to reach 5¼ percent of GDP annually on average (down from 9½ percent under the 11th FYP).
- Staff recommendations on fiscal path:
  - Staff proposed higher fiscal spending in FY2019 and a more gradual fiscal consolidation over the medium term to avoid negative growth impacts from the investment cliff.
  - Scope identified to raise capital spending by about 2 percent of GDP annually on average over the medium term, supported by additional domestic tax revenue mobilization and modest domestic financing (about 1 percent of GDP annually on average).

### Revenue mobilization and public financial management
- GST and revenue measures:
  - Authorities plan a broad-based GST implementation scheduled for July 2020 (not in baseline projections); Fund technical assistance supporting implementation.
  - Design advice: GST should be broad-based (to include services) with a simple rate structure (preferably a single tax rate).
  - Short-term revenue measures: update bases of user charges and land/property taxes; rationalize and gradually curtail tax exemptions (estimated at 2¾ percent of GDP in FY2017).
- Domestic debt market:
  - Staff encouraged development of a domestic public debt market to reduce rollover risk from the small Treasury bill market; recommend medium-term debt strategy and market development strategy.
- PFM reforms:
  - Ongoing initiatives include implementing a fully electronic system for government payments.
  - Staff advise replacing the five-year planning cycle with a rolling multi-year budget framework to reduce aggregate demand shocks and improve stability.
  - Recommend enhancing fiscal transparency through improved budget documents and more frequent reporting.

### Stabilization fund for hydropower revenues
- Authorities are establishing a stabilization fund (BESF) to manage hydropower revenues and business cycle fluctuations.
- Institutional details:
  - Draft Royal Charter under review; Rules and Regulations expected shortly.
  - Seed money allocated: Nu 100 million to be invested in Indian rupee assets.
  - Staff view: importance of transparent and rules-based principles; proposed floor of 5 percent of hydropower royalties for transfers to the fund is insufficient and staff urge a more ambitious target to ensure meaningful countercyclical contributions.

### Monetary policy framework and liquidity management
- Credit growth and macroprudential actions:
  - Credit growth slowed from 35 percent on average in 2005–11 to 15 percent in 2012–17, partly due to macroprudential instruments.
  - RMA sterilizes hydropower-related liquidity through daily sweeping of related bank balances.
  - Staff analysis shows only a small positive credit gap in recent quarters, much lower than in the run-up to the rupee crisis in 2012 (Appendix IV).
- Modernization of monetary policy:
  - RMA, supported by SARTTAC TA, is enhancing liquidity management and forecasting, establishing an interest rate corridor (IRC), and developing the interbank market.
  - New framework to include standing marginal lending and deposit facilities; expected to become operational shortly.
- Staff recommendations:
  - Start with a relatively wide corridor (e.g., +/- 200 bps) and reduce it gradually to allow for better interest-rate control and market development.
  - Review the Minimum Lending Rate (MLR) once the framework is in place, as the MLR appears only remotely related to RMA’s monetary policy stance and creates distortions in the credit market.

*Source: cr18300 - 1. Poverty Trends (chapter text).*

### 25. The authorities acknowledged the challenges of moving from a quantity to interest

### 25. The authorities acknowledged the challenges of moving from a quantity to interest 

### Monetary policy framework
- Authorities acknowledged challenges of moving from quantity to interest rate signaling of the policy stance but reaffirmed commitment to put the new monetary policy framework in place soon.
- They welcomed Fund capacity development and agreed on the need to further strengthen capacity to analyze macroeconomic and monetary developments.
- Authorities 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.
- Note on MLR: "The MLR is a single reference rate for all financial institutions calculated using three cost parameters across all banks: (i) marginal cost of funds, (ii) negative carry charges on cash reserve ratio, and (iii) operating costs."

### Financial sector — current conditions and vulnerabilities
- Banking sector described as nascent and suffering from low profitability:
  - Return on assets dropped from 1.8 percent in 2016 to just 0.7 percent in 2017.
  - Return on equity declined from 11.3 percent to 4.8 percent.
- Asset quality and capital:
  - System-wide non-performing loan (NPL) ratio was at 8.4 percent in December 2017, up from 7.2 percent in December 2016.
  - Capital adequacy ratio (CAR) fell from 19 percent in 2016 to 16 percent in 2017 due to adjustments in risk weights and provisioning requirements.
  - Provisions are high and required provisions are calculated on a gross basis (conservative).
- Liquidity and exposures:
  - Sector’s liquidity levels are high (above regulatory requirements of 10 percent cash reserve ratio (CRR) kept with the RMA, and an additional 20 percent statutory liquidity ratio (SLR) kept in liquid assets).
  - Risks of financial contagion appear to be contained by the relatively small size of gross exposures between banks, corporations, households, and the budget.
- Prudential framework and supervision:
  - Progress aided by SARTTAC: corporate governance regulations for financial institutions and a new regulatory framework for the insurance sector are being implemented; review of macroprudential framework is underway; collateral credit registry moved to the RMA; risk management regulations and guidelines under preparation; pension fund guidelines and regulatory strategy under review.
  - Bank supervision remains largely compliance-based; only a subset of main prudential rules is monitored quarterly (the rest enforced at year-end), with no penalties for non-compliance before year-end.
  - Loan loss provisioning rules are reasonably stringent but rules and practical application of loan classification are somewhat lax.
  - Provisioning schedule noted: "They require 20, 50, and 100 percent provisioning on the gross value of the loan after 90, 180, and 350 days past due, respectively. NPLs can be reclassified as performing as soon as arrears have been cleared."

### Financial sector — staff recommendations and policy priorities
- Tighten loan classification requirements for banks, including:
  - Enforce and extend the period of satisfactory performance before an impaired loan can be reclassified as performing (to address sharp seasonal NPL swings).
- Mandate banks to supplement current rules with risk-based provisioning (some banks already practice this).
- With the coming on stream of RMA’s new liquidity facility, gradually reduce current liquidity requirements for banks, since high liquidity buffers affect profitability and may increase, rather than reduce, financial risk.
- On PSL (priority sector lending), maintain the credit assessment of proposals under the program at par with those for market-based lending and evaluate program outcomes on a regular basis to avoid creating market distortions.
- Continue vigilance on potential financial stability risks and adjust macroprudential policies when needed.

### Authorities’ views (financial sector)
- Authorities encouraged by recent improvements in regulatory compliance of some banks but agreed with staff on the need to further tighten financial sector regulation and supervision.
- Financial inclusion strategy expected to be issued by December 2018 and seen as cornerstone of efforts to broaden and deepen access to finance.
- Authorities agreed there might be scope to review and possibly reduce liquidity requirements once the new monetary framework and supporting liquidity facility are operational.

### External sector and exchange rate policy
- Ngultrum peg to the rupee assessed as having served the economy well; important implications for debt and reserve management given exposure to the rupee.
- External exposure and reserves:
  - About three-quarters of public external debt is denominated in Indian rupees.
  - Both exports and imports are predominantly with India (70–90 percent).
  - Rupee reserves improved to 36 percent of total reserves in September 2017, up from 16 percent in July 2015.
  - 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.
- Staff advice: further increase the share of rupee reserves (to above 50 percent) based on trade patterns and RMA’s balance sheet structure.
- Staff assessment: Bhutan’s external position is moderately weaker than warranted by fundamentals and desirable policies. Vulnerabilities include India’s GST implementation and an increase in oil prices; reserve coverage remains adequate.

### Authorities’ views (external sector)
- Authorities agreed the peg continues to be the appropriate exchange rate regime.
- Reported rupee share exceeded 30 percent of total reserves in recent months; rupee liquidity bolstered by RBI and GoI facilities.
- Suggested need to institute a more formal INR management system for day-to-day INR demand.
- A proposal to increase rupee share of reserves to 40 percent was recently rejected by the RMA Board.
- Based on projections, electricity exports due to commissioning of three hydroelectric plants by FY2023 are expected to turn the current account positive in the medium term, structurally improving rupee liquidity; delays in hydropower projects would challenge external sector management.

### Structural issues and reform priorities
- Diversification:
  - Hydropower development contributed to progress but heightened need to diversify and generate high-quality jobs.
  - Five sectors identified to expand domestic production and reduce import dependency: agriculture, CSI, hydropower, tourism, and mining.
- Business environment and access to finance:
  - Bhutan ranked 75th in Doing Business 2018.
  - World Bank Investment Climate Assessment (2016) identified access to finance, access to skilled labor, and access to external markets as three binding constraints.
  - Expansion of Credit Information Bureau coverage (including utilities’ payments and borrowing from micro-finance institutions) expected to improve risk assessment.
  - PSL policy expected to improve access to finance for the CSI sector.
  - Insolvency bill awaiting parliamentary approval.
  - Recommendation to open more specialized courts for commercial disputes and review procedures for out-of-court restructuring to reduce delays in loan recoveries and transaction costs.
  - RMA should issue guidelines encouraging banks to write off legacy bad loans (e.g., classified as loss for more than three years) to free up balance sheets.
  - Legislation should be amended to allow secondary purchases of impaired loans.
  - Ongoing review of the Movable and Immovable Properties Act should not weaken creditor rights.
  - Improving registration and validation of land would improve collateral availability, especially for farmers.
  - Additional efforts to improve financial literacy and inclusion underway.
- Labor and skills:
  - Gross tertiary enrollment remains at around 10 percent, lower than neighboring countries.
  - Short-term labor needs require more training and lower barriers for skilled immigration.
  - World Bank report found public sector is the choice for educated youth due in large part to a significant wage and compensation gap.
  - To make private sector employment more attractive, authorities could promote voluntary private-sector pension schemes.
- Infrastructure and FDI:
  - Bhutan ranked 135th among 160 economies in the World Bank’s 2016 Logistics Performance Index.
  - ICT connectivity needs improvement.
  - Minimum threshold for FDI is high (currently at US$20 million).
  - Case for liberalizing foreign investor access to select CSI activities presently on the negative list for FDI.

### Authorities’ views (structural)
- Strong commitment to diversifying the economy and providing high-paying jobs, especially for youth.
- Deep-rooted reforms needed in education system and improvements in access to finance; large-scale donor-funded training programs are being provided and a review of the education system is underway.
- Agreed to review FDI thresholds with an eye on employment opportunities and technology transfer, but noted concerns that FDI in some sectors (e.g., retail trade) could reduce aggregate employment.
- Planned second annual Bhutan Economic Forum for Innovative Transformation in July 2019 focusing on economic diversification.
- Agreed with staff recommendations on access to finance and pledged to work with the judiciary to expedite implementation of proposed measures.
- Reaffirmed commitment to limiting market distortions from PSL program and to undertake a regular review of its progress.

### Staff appraisal — growth, fiscal, monetary, and structural recommendations
- Growth and poverty:
  - Bhutan’s growth has been strong and poverty has declined significantly.
  - Growth driven by hydropower and services; inflation expected to remain in single digits, underpinned by price developments in India due to the currency peg.
  - External imbalances beginning to decline though still large.
- Fiscal policy:
  - Most immediate policy challenge is to limit sharp fiscal withdrawal programmed for FY19.
  - Medium-term priorities: mobilize domestic revenues and prudently manage rising hydro revenues against declining grants; enhance competitiveness to diversify growth and employment sources.
  - Staff supports fiscal consolidation over the medium term but recommends a more gradual consolidation path (in line with staff’s illustrative alternative scenario) to be more appropriate for growth while maintaining macroeconomic stability.
  - Recommended measures to enhance domestic revenue base with the GST project as a key ingredient; urged authorities to secure required resources for the GST project to avoid delays.
  - PFM should be strengthened and current five-year planning cycle replaced by a rolling multiyear budget framework.
  - Establishment of a stabilization fund for hydro revenues is welcome; rules governing its operation should be completed soon.
  - Developing a public debt market would bring economic benefits far outweighing the financial cost of market-based interest on outstanding debt securities.
- Monetary and financial stability:
  - Staff views monetary conditions as broadly appropriate; credit growth rates have declined and the credit gap has been negative until recently.
  - Staff welcomed efforts to revamp the monetary policy framework to align monetary conditions with policy stance required for the ngultrum peg to the rupee.
  - Continuous efforts to modernize regulatory framework needed to better safeguard financial stability and support private sector access to finance.
  - Banking sector has adequate buffers to absorb potential losses but profitability is low and maintaining liquidity comes at a cost; requires continued supervisory vigilance and calibration of micro- and macro-prudential frameworks.
- Structural policy:
  - Emphasis on diversification appropriate; should prioritize improving access to finance and educational and labor market outcomes.
  - Holistic approach to making credit available for previously underserved sectors is welcome but caution advised to limit distortions.
  - To reduce unemployment and enhance labor productivity, focus on targeted training and improved tertiary educational enrollment.
  - Relaxing FDI rules in select areas with significant upstream and downstream spillovers should be pursued.
- Exchange rate and external:
  - Staff supports the ngultrum’s peg to the rupee given interconnectedness with India.
  - Developments in 2017 suggest Bhutan’s external position remains moderately weaker than warranted by fundamentals and desirable policies.
- Exchange restrictions:
  - Authorities did not request and staff does not recommend approval of exchange restrictions inconsistent with Article VIII obligations.
  - Bhutan continues to maintain exchange restrictions under transitional arrangements of Article XIV, Section 2.
  - Staff encouraged gradual easing of exchange restrictions toward eventual elimination as soon as Bhutan’s balance of payments permits.
  - Staff is encouraged by authorities’ use of Fund TA to explore removal options.
- Article IV consultation cycle:
  - Staff recommends that the Article IV consultation with Bhutan remain on a 24-month cycle.

### Box 1 — Poverty trends (key statistics)
- Backed by average GDP growth of 7.5 percent over the decade to 2017, poverty rate declined:
  - From 23.2 percent in 2007,
  - To 12 percent in 2012,
  - To 8.2 percent in 2017.
- Rural and urban poverty:
  - Rural poverty reduced from nearly 31 percent in 2007 to 12 percent in 2017.
  - Urban poverty declined from 1.7 percent in 2007 to 0.7 percent in 2017.
- Subsistence (extreme) poverty:
  - About 1.5 percent in aggregate, and just over 2¼ percent in rural areas.
- Depth of poverty (average gap in per-capita consumption of the poor from the poverty line) is 2.4 percent on average.
- Access to public services and information:
  - 99.9 percent of the population reported to have access to improved water sources.
  - At least 92 percent of households have access to improved sanitation, with 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.
- Main driver of poverty reduction identified as an increase in non-food consumption with no appreciable change in food consumption patterns.

*IMF Staff Report excerpt: "25. The authorities acknowledged the challenges of moving from a quantity to interest rate signaling of the policy stance" (Bhutan Article IV staff report).*

### Box 2. Goods and Services Tax

### Box 2. Goods and Services Tax

### Rationale and expected revenue impact
- Bhutan currently raises around 5½ percent of GDP in indirect tax revenues.
- Sales taxes account for 2½ percent of GDP.
- Around 2 percent of GDP is raised from the excise duty refund (EDR), which reflects excises levied by India on exports to Bhutan.
- With India’s adoption of the GST (and removal of excises on exports), the EDR will effectively cease in FY2020, creating a large revenue gap to be filled.
- A broad-based GST is expected to cover the revenue gap in a sustainable and more efficient manner; GST/VAT is likely to be buoyant:
  - In a staff sample of nearly 70 countries, the average increase in VAT revenue as a percent of GDP was about ½ percent of GDP over a five-year period.
- Potential to raise indirect tax revenues from other sources (e.g., raising customs duties) is severely limited by:
  - Bhutan’s free trade agreement with India (which covers 90 percent of imports),
  - South Asian Association for Regional Cooperation preferences,
  - Preferential trade agreement with Bangladesh.
- Conclusion: Indirect tax revenues will rely heavily on GST implementation to replace the EDR.

### Key tax-policy design considerations
- Main policy objective: 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,
  - (iii) administrative simplicity (e.g., few rates), given capacity constraints.
- The GST under consideration presently in Bhutan resembles a standard VAT with:
  - input tax crediting,
  - a mandatory turnover-based registration threshold,
  - adherence to the destination principle (with zero-rated exports and taxed imports, including service imports).

### Implementation timetable, institutional arrangements, and IMF support
- India implemented GST in July 2017; Bhutan has made GST adoption a high priority with a July 2020 deadline for implementation.
- Bhutan created a project office and prepared a GST implementation plan, consisting of a detailed timeline, in line with IMF recommendations.
- IMF technical assistance (TA) areas and recommendations include:
  - (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;
  - (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.

### Main challenges and milestones to meet July 2020
- Critical milestone: finalization and passage of GST legislation, and operationalization of business processes and taxpayer outreach ahead of implementation.
- Potential stumbling block: the ability of the revenue authority to develop and implement an IT system that can underpin GST processing — this is considered one of the potential stumbling blocks that could delay adoption of the GST.
- Administrative design milestones implied by policy recommendations:
  - Establish broad base and rate structure (few rates) to ensure administrative simplicity.
  - Put in place effective input tax credit/refund mechanisms.
  - Implement mandatory turnover-based registration threshold and destination-based treatment for cross-border transactions.
- Continued IMF TA is supporting legislation drafting, business processes, IT selection, outreach, and capacity building to meet implementation targets.

*Source: IMF staff (Box 2, "Goods and Services Tax").*

### Appendix I. Priority Sector Lending Guidelines

### Appendix I. Priority Sector Lending Guidelines

### Background and purpose
- 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.
- 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.
- The Guidelines were developed based on consultations with several government agencies, commercial banks, and insurance companies.

### Key provisions of the Guidelines
- The Guidelines recognize the CSI sector as the largest source of domestic production and employment and critical for addressing challenges facing the agriculture sector and stemming from rural-urban migration.
- Prescribed lending targets: a function of financial institutions’ outstanding loan portfolio in priority sectors (targets set in consultation with financial institutions).
- Ceiling preferential lending rates:
  - agricultural CSI sector: 8 percent
  - non-agricultural CSI sector: 8.5 percent
- Financial institutions with shortfalls in meeting priority sector targets may allocate funds for on-lending to a microfinance institution or Bhutan Development Bank.
- Preferential-lending tax exemption: 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.
- Mandatory insurance coverage for loans to agricultural projects, with insurance to substitute for collateral.
- Training provision: the Guidelines provide for training at the RMA’s Financial Institutions Training Institute (FITI).

### Incentives and risk-mitigation features
- The Guidelines allow transfers of shortfall amounts to more appropriate financial institutions when commercial banks face barriers or risks (recognizing lack of relevant expertise, reach, and operational efficiency).
- Insurance as collateral substitute for agricultural loans aims to reduce collateral constraints.
- Tax exemption under the Fiscal Incentives Act of 2017 is intended as an offset to preferential pricing.

### Recommendations and good practices (from lessons learned and international experience)
- Maintain credit-assessment rigor:
  - "The rigor of credit assessments under the CSI program should be kept at par with those for market-based lending."
  - Frequently evaluate experience and progress under the program to avoid a build-up of risks and contingent liabilities.
- Prefer incentives to quantitative targets:
  - "Incentives rather than quantitative targets should be used to encourage lending."
  - Examples of such incentives include partial credit risk guarantees or the provision of financial infrastructure to mitigate risks and reduce costs (e.g., reverse factoring platforms for value chains, broader and better credit and collateral information, efficient payment systems, and digital financial channels).
- Review and calibrate interest rate caps frequently:
  - "Interest rate caps need to be frequently reviewed."
  - Global experience shows effectiveness and unintended side-effects depend on the type and specification of the cap; binding caps set below market levels can affect profitability, risk in financial institutions, and overall credit supply.
- Compensate deviations from market conditions:
  - "Any deviations from market conditions should be fully compensated."
  - Tax benefits can be perceived as an offset to below-market pricing but "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."
- Strengthen technical capacity and inter-agency coordination:
  - 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 designated to provide training, but "its effectiveness is yet to be tested."

*Source: cr18300 - Appendix I. Priority Sector Lending Guidelines*

### 6. Bhutan has adequate reserve buffers. Reserve

### cr18300 - 6. Bhutan has adequate reserve buffers. Reserve

### Reserve adequacy assessment
- Reserve adequacy is assessed to be around 6 months of imports using a cost of reserves equal to the marginal product of capital estimated to be 6.2 percent.
- Other measures of cost suggest a range between 4 to 9 months of imports.
- Bhutan currently holds nearly 13 months of imports in reserves.

### Composition of reserves and bilateral arrangements
- The share of rupee reserves has increased to 36 percent of total reserves.
- Bhutan has a 100 million USD swap line with the Reserve Bank of India, which, together with the rupee reserve share, improves buffers with Bhutan’s largest trading partner.

### External position and debt context
- Public and publicly guaranteed (PPG) debt stood at 107 percent of GDP in FY2017.
- Hydropower projects comprised 77 percent of the PPG external debt stock in FY2017.
- Creditor composition of PPG external debt in FY2017: India 74 percent, Asian Development Bank (ADB) 11 percent, World Bank (IDA) 9 percent.
- Debt from the Government of India (GoI) to finance hydropower projects is treated as closer in nature to foreign direct investment (FDI) under intergovernmental agreements where GoI bears construction and financial risks and buys surplus electricity at cost plus a 15 percent net return.
- At its highest level, the present value (PV) of non-Indian debt-to-GDP is 21 percent and remains below the high-risk threshold of 40 percent of GDP.

### Macroeconomic assumptions and projections affecting reserves
- Real sector: Historical growth estimates for FY2016 and FY2017 have been revised up by around one percentage point each year. Over the medium term, growth is projected to remain strong, averaging around 6 percent; long-term growth is projected to be around 6 percent.
- Fiscal sector: When hydropower projects are completed, government revenues increase through both tax and non-tax revenues. Delays in project completion have pushed these revenue gains toward the end of the medium term. The fiscal deficit remains broadly balanced over the medium term, exhibiting a surplus towards the end of the five-year planning cycle as hydropower revenues from newly commissioned projects are received.
- External sector: The current account deficit (CAD) is expected to narrow sharply over the medium term, reaching a surplus in FY2023.
  - Electricity exports are projected to increase from around 7 percent of GDP to around 20 percent of GDP.
  - Imports for the hydropower sector are expected to decline to nearly nil over the medium term.
- Overall balance of payments is set to remain positive over the medium term, supporting reserve accumulation; as grant financing declines over the long run, the current account surplus will support the overall balance.
- Bhutan’s borrowing from IDA is set to remain on concessional terms under IDA’s small economy terms.

### Hydropower projects incorporated in the baseline microframework
- Mangdechhu: capacity of 720 MW in FY2019.
- Puna II: capacity of 1,020 MW in FY2021.
- Puna I: capacity of 1,200 MW in FY2023.

### Key statistics and findings (exact figures preserved)
- Reserve adequacy benchmark: around 6 months of imports (cost of reserves = 6.2 percent).
- Alternative adequacy range: between 4 to 9 months of imports.
- Actual reserves: nearly 13 months of imports.
- Rupee reserves: 36 percent of total reserves.
- Swap line with Reserve Bank of India: 100 million USD.
- PPG debt: 107 percent of GDP in FY2017.
- Hydropower share of PPG external debt: 77 percent.
- Creditor shares: India 74 percent, ADB 11 percent, World Bank (IDA) 9 percent.
- PV of non-Indian debt-to-GDP (highest): 21 percent; high-risk threshold: 40 percent of GDP.
- Projected growth (medium term and long term): around 6 percent.
- Electricity exports: from around 7 percent of GDP to around 20 percent of GDP.
- CAD: projected to reach a surplus in FY2023.
- Hydropower project capacities and commissioning years: Mangdechhu 720 MW (FY2019); Puna II 1,020 MW (FY2021); Puna I 1,200 MW (FY2023).

*International Monetary Fund staff report excerpts (August 7, 2018).*

### 5.      The composition of hydropower debt is

### 5.      The composition of hydropower debt is

### Composition and risk characteristics
- Hydropower debt is projected to remain dominated by debt contracted with India under the intergovernmental agreement.
- Other hydropower projects will be constructed under joint venture agreements and public-private partnerships (PPPs), where guarantees from the GoI are not available.
- Since the stock of debt will remain dominated by projects constructed under the intergovernmental agreement, which is more like FDI, vulnerabilities are contained.
- The government’s liabilities under projects already financed through PPPs are reflected in the DSA.
- Other contingent liabilities, for example from the banking sector, and external borrowing outside of hydropower are not a source of immediate risk.
- 77 percent of Bhutan’s external PPG debt is hydropower related, and most are hydropower projects constructed under the intergovernmental agreement in which the GoI covers both the financial and construction risks of these projects and buys surplus electricity at a price reflecting cost plus a 15 percent net return.
- As it stands, the ngultrum is only moderately overvalued (see External Sector Assessment in accompanying staff report), and risks remain contained given the projected improvement of the current account. Notwithstanding, efforts must remain vigilant to contain inflation near that of India.
- The ngultrum is pegged to the rupee, and nearly 80 percent of the debt stock is denominated in rupees; this does not preclude risks to the debt stock from an overvaluation of the ngultrum.

### Baseline scenario outcomes and timing
- Under the baseline scenario, each debt indicator breaches its indicative threshold.
- The breaches are large and will be sustained into the long run.
- The PV of debt indicators are higher than their nominal values because the loan portion of hydropower projects financed by India are not concessional. The total package—loan and grant—has a positive grant element.
- The PV of debt-to-GDP ratio falls below threshold only after 2031 whereas the nominal debt-to-GDP ratio goes below the threshold in 2028.
- The profile of debt service indicators has worsened relative to the previous DSA, due to both higher debt service, and in the case of exports, a more moderate rate of growth.
- Volatility in the debt service indicators is due to a lumpy amortization schedule.
- Breaches in debt service indicators occur beyond the medium term and do not return to the threshold until the end of the projection horizon. This is in line with the repayment schedule for hydropower debt.

### Stress tests and vulnerabilities
- All five indicators breach their indicative threshold under stress tests.
- Although nearly 80 percent of the debt stock is denominated in rupees, risks remain linked to the potential overvaluation of the ngultrum.
- Risks stemming from non-hydropower debt are low, as the stock of non-hydropower debt-to-GDP is modest and owed mostly to the ADB and World Bank contracted on highly concessional terms.

### Domestic debt, market development, and policy actions
- Domestic debt is 6 percent of the debt stock in FY2017 and does not pose an additional risk to the debt profile.
- Movements in the public debt profile mirror those for external debt.
- As Bhutan relies less on grant financing and external concessional borrowing over the medium term, developing a deep and liquid domestic debt market will be important to meet financing needs going forward.
- The debt management office is preparing a Medium-Term Debt Strategy for FY2019–2023 and studying the possibility of issuance of longer term domestic instruments.

### Key macroeconomic assumptions (Text Table 1. Key Macroeconomic Assumptions, 2018–2036)
- Real GDP growth (in percent): 6.4 6.1
- GDP deflator in US dollar terms (change in percent): 2.0 1.8
- Growth of exports of G&S (US dollar terms, in percent): 9.7 6.7
- Growth of imports of G&S (US dollar terms, in percent): 5.7 1.9
- Grant element of new public sector borrowing (in percent): 27.3 30.4
- Government revenues (excluding grants, in percent of GDP): 21.6 22.2
- Aid flows (in Billions of US dollars): 0.1 0.1
- of which: Grants: 0.1 0.1
- of which: Concessional loans: 0.0 0.0
- Grant-equivalent financing (in percent of GDP): 2.6 2.9
- Non-interest current account deficit: 1.1 -3.3
- Net FDI (negative = inflow): -1.5 -0.6
- Public sector balance: -1.8 -1.7

### Conclusion
- The current assessment remains broadly the same as the assessments made in the 2014 and 2016 Article IV DSAs, which assessed Bhutan’s debt at a moderate risk of debt distress.
- Even though under the baseline each indicator breaches its threshold, the unique mitigating factors discussed in detail in the last two DSAs remain valid and underpin the assessment that vulnerabilities are contained given the dominance of intergovernmental hydropower financing and concessional non-hydropower borrowing.

*Source: IMF staff analysis (excerpts from the DSA chapter provided).*

### 11.      The authorities agreed with staff’s assessment of a moderate risk of debt distress. They

### cr18300 - 11.      The authorities agreed with staff’s assessment of a moderate risk of debt distress. They

### Key assessment
- The authorities agreed with staff’s assessment of a moderate risk of debt distress.
- The authorities expect electricity exports from the commissioning of Mangdechhu (in FY2019), Puna II (in FY2021), and Puna I (in FY2023) will reverse the current account deficit by the end of the medium term.
- The authorities acknowledged that debt levels are high but that debt vulnerabilities are contained as financing is secured through the intergovernmental agreement with the GoI.

### Medium-term projections and key macroeconomic assumptions
- Real GDP growth (in percent): 6.2, 7.3, 7.4, 7.0, 2.4, 5.8, 4.8, 6.3, 6.0, 7.2, 7.5, 6.3, 6.0, 7.3, 6.2 (series across historical and projection periods as shown).
- GDP deflator in US dollar terms (change in percent): 4.4, -2.7, 5.8, 2.1, 7.8, 3.1, 3.2, 0.7, 1.6, 1.8, 1.8, 2.0, 1.8, 1.8, 1.8.
- Effective interest rate (percent): 2.3, 1.9, 1.6, 3.7, 1.4, 1.7, 1.6, 3.0, 3.1, 3.1, 5.2, 2.9, 11.6, 11.5, 14.6 (series as presented).
- Growth of exports of G&S (US dollar terms, in percent): 8.4, -15.0, 12.6, 0.5, 13.4, 3.0, 25.2, 12.3, 5.6, 15.9, 29.0, 15.2, 2.5, 3.3, 2.9.
- Growth of imports of G&S (US dollar terms, in percent): 8.8, 2.4, -0.9, 9.0, 19.7, 0.8, -8.7, 2.0, 1.1, 4.4, 4.6, 0.7, 2.7, -1.2, 2.1.
- Grant-equivalent financing (in percent of GDP): 11.4, 4.5, 8.8, 8.5, 6.4, 2.9, 7.1, 1.2, 0.5, 0.9 (series as shown).

### Debt indicators (selected levels and ratios)
- External debt (nominal), 2018: 96.2 (percent of GDP) with series including 99.7, 103.2, 98.8, 90.1, 79.6; historical averages and projections shown in table.
- PV of external debt (selected projection values): 151.8, 148.4, 139.3, 126.5 (series across projection years as presented).
- PV of debt—in percent of exports (selected values): 644.4, 664.5, 587.6, 574.1, 572.6, 506.0, 389.6 (as shown).
- PV of PPG external debt (in percent of GDP) (selected): 148.7, 144.9, 148.2, 151.8, 148.4, 139.3, 126.5.
- PV of PPG external debt (in percent of government revenues) (selected): 799.0, 683.1, 761.6, 716.8, 734.7, 687.3, 531.0.
- Debt service-to-exports ratio (in percent) (selected): 22.8, 18.7, 33.3, 38.0, 9.9, 18.0, 26.6, 17.5, 22.7, 31.4.
- PPG debt service-to-revenue ratio (in percent) (selected): 31.2, 22.6, 41.3, 39.1, 12.8, 22.5, 34.1, 23.7, 30.9, 41.1.
- Total gross financing need (Billions of U.S. dollars) (selected): 0.7, 0.7, 0.8, 0.7, 0.4, 0.3, 0.3, 0.2, 0.0, -0.1, -0.4 (series as shown).
- Nominal GDP (Billions of US dollars) (selected): 2.0, 2.1, 2.4, 2.6, 2.8, 3.0, 3.3, 3.6, 3.9, 5.7, 12.5.

### Debt dynamics drivers (selected contributions)
- Non-interest current account deficit (selected series): 19.7, 8.6, 21.2, 13.6, 7.8, 4.5, 0.7, -7.1, -9.5, -4.3.
- Endogenous debt dynamics (selected): -3.8, -2.9, -3.1, -2.8, -3.8, -1.9, 2.3, 0.2.
- Contribution from nominal interest rate (selected): 1.5, 1.4, 2.8, 2.9, 2.8, 4.3, 4.8, 0.5.
- Contribution from real GDP growth (selected): -5.3, -4.3, -5.9, -5.8, -6.5, -6.2, -2.5, -0.3.
- Residual (including exceptional financing) (selected): -20.1, -5.9, 0.3, -5.1, -5.2, -1.1, 1.0, 3.8.

### Public sector debt dynamics (selected)
- Public sector debt (percent of GDP) (selected): 102.7, 103.9, 107.4, 104.6, 95.8, 82.8, 66.3, 39.5.
- Of which: foreign-currency denominated (selected): 96.2, 99.7, 103.2, 98.8, 90.1, 79.6.
- Primary deficit (selected): -2.3, 2.7, -0.7, -3.8, -2.5, -2.9, -4.1, -9.1.
- Revenue and grants (percent of GDP) (selected): 31.1, 22.1, 28.1, 28.0, 26.3, 26.6, 22.1, 24.2.
- PV of public sector debt (selected): 155.0, 151.4, 152.4, 156.0, 154.2, 145.0, 129.6, 92.8, 42.0.
- Gross financing need (selected): 7.7, -1.1, 2.5, 4.2, 1.0, -1.5, 8.3, 3.4.

### Sensitivity analysis and stress tests (selected outcomes)
- Baseline PV of debt-to-GDP ratio (percent): 145 (2018), 148 (2019), 152 (2020), 148 (2021), 139 (2022), 126 (2023), 65 (2028), 57 (2038) as indicated in Table 2 baseline series.
- A1. Key variables at their historical averages in 2018-2038: PV of debt-to-GDP ratio examples: 145, 152, 162, 169, 173, 180, 211, 209 (series in Table 2).
- B6. One-time 30 percent nominal depreciation relative to the baseline in 2019: PV of debt-to-GDP ratio examples: 145, 215, 216, 207, 194, 176, 90, 9 (series in Table 2 B6).
- PV of debt-to-exports ratio (baseline and stress highlights): baseline 665, alternatives and bound tests produce values up to 1,187 in B2 (Export value growth shock) and other high stress outcomes shown in Table 2.
- PV of debt-to-revenue ratio (baseline and stress highlights): baseline 683 with stress scenarios producing values up to 1,107 in B6 (one-time 30 percent nominal depreciation) and other outcomes as tabulated.
- Debt service-to-revenue ratio (baseline and stress highlights): baseline 38 (selected), stress scenarios produce values up to 70–291 in various tests (see Table 4 for detailed series).

### Policy implications / observations reported by authorities
- Expected commissioning of Mangdechhu (FY2019), Puna II (FY2021), and Puna I (FY2023) is central to the authorities’ projection that electricity exports will reverse the current account deficit by the end of the medium term.
- Authorities view high debt levels as mitigated by financing arrangements secured through the intergovernmental agreement with the GoI.

*Statement by Subir Gokarn, Executive Director for Bhutan and Petal Dhillon, Advisor to Executive Director October 26, 2018*

### 1.  Our Authorities would like to thank the IMF team led by Mr. David Gregorian for the

### cr18300 - 1.  Our Authorities would like to thank the IMF team led by Mr. David Gregorian for the

### Summary and Authorities' view
- Authorities thank the IMF team led by Mr. David Gregorian for "very constructive and productive discussions."
- Authorities "broadly agree with the assessment made in the Article IV report" and value Fund training and technical assistance.
- Authorities are "committed to building on the progress so far to ensure both inclusive growth and macroeconomic stability."

### Recent economic developments and outlook
- Objective: "Bhutan is committed to graduate to middle-income status by 2023."
- Poverty:
  - Declined from "12 percent in 2012 to 8.2 percent in 2017."
  - "Extreme poverty falling to just 1.5 percent."
- Growth and inflation:
  - "GDP has maintained momentum at 7.4 percent in FY2017."
  - "Headline inflation decreased to a historic low of 2.6 percent in June 2018 from 4.9 percent in June 2017."
  - CPI inflation expected to be "around 3 to 5 percent."
- Reserves and external position:
  - "At the end of June 2018, the gross international reserves were recorded at USD 1,110.9 million, sufficient to finance 13.01 months of merchandise imports."
- Authorities' outlook:
  - More optimistic than staff projection of "4.8 percent in FY2019 and 6 percent in FY2019-20" due to expected hydropower project commissioning, and steady growth in agriculture and tourism.
  - Implementation of the "12th Five-year plan" expected to positively stimulate activity.

### Fiscal policy
- Budgetary stance:
  - "Bhutan has achieved a balanced budget over a five-year period."
  - "The revised budget saw the fiscal deficit improve from 2.47 percent of GDP to 1.01 percent."
- Key reform measures (core elements):
  - "GST implementation is scheduled for July 2020, supported by Fund Technical Assistance."
  - "Establishment of a stabilization fund to manage hydropower revenues and business cycle fluctuation."
    - Seed money: "USD 1.54 million."
    - Proposal: "5 percent minimum on royalties from hydropower be transferred to the Bhutan Economic Stabilization Fund (BESF)."
  - Commitment to "public financial management reforms, including an electronic payment system," improved budget transparency, and more frequent fiscal reporting.
- Debt and revenue:
  - Authorities view debt-related risk as "moderate due to the foreign direct investment-like nature of most of Bhutan’s debt."
  - Expect improvement in debt dynamics with "substantial increase in electricity exports and decline of construction related imports."
- Implementation emphasis:
  - "Speedy implementation of these measures will be critical to boost revenue flows, incentivize investment and economic growth."
  - Authorities "welcome a thorough analysis of the demand patterns and market requirements" for developing a domestic public debt market.

### Monetary policy
- Recent monetary indicators:
  - Credit growth slowed from "35 percent on average in 2005–11 to 15 percent in 2012-17."
  - "Private sector credit growth was 15.69 percent in June 2018, about the same as the 15.39 percent rate in June 2017."
  - "The overall CPI inflation recorded at 2.55 percent in June 2018 compared to 4.94 percent during the same month of the previous year."
  - "Domestic inflation during June 2018 was recorded at 1.47 percent while imported inflation was recorded at 3.56 percent."
- Policy framework changes:
  - Authorities will "follow a graduated approach" to move from quantity to interest rate signaling, mindful of institutional capacity and legal frameworks.
  - Aligned with staff on "upgrading to a more modern monetary policy framework," supported by TA from the South Asia Regional Training and Technical Assistance Center, especially on forecasting and establishment of an interest rate corridor.
  - Planned rollout of the upgraded framework "by November 2018."

### External sector and exchange rate policy
- Exchange rate regime:
  - Authorities "agree that the peg continues to be the appropriate exchange rate regime."
  - Maintaining an adequate buffer of Indian rupees is critical; existing supportive arrangements include "the RMA’s swap agreement with the RBI and access to the Government of India Credit line."
- Additional arrangements and expectations:
  - "Alternate arrangements to sell or buy Indian Rupees against USD and gain access to Indian Government securities are being currently pursued."
  - Electricity exports from commissioning of three hydroelectric plants "beginning FY 2019 and up to by FY2023 are expected to turn the current account positive in the medium term and structurally improve the Rupee liquidity."

### Financial sector
- Soundness and vulnerabilities:
  - "Financial soundness indicators for Bhutan remain generally comfortable, with capital adequacy and liquidity well above the required prudential norms."
  - Non-performing loans have increased slightly: "11.5 percent in June 2018, up from 11.4 percent in June 2017."
- Regulatory and supervisory actions:
  - Progress on "corporate governance regulations for financial institutions, a new regulatory framework for insurance, review of the macroprudential framework and pension policy review."
  - Authorities plan to further tighten regulation and supervision where needed, while balancing financial inclusion objectives.
  - Preference currently to deepen access to finance "even while containing risk."
- Financial inclusion:
  - "The financial inclusion strategy 2018-2023 was issued in August 2018."
  - Priority sector lending (PSL) initiative for cottage and small industries (CSI) started in "January 2018" to encourage entrepreneurship; authorities will monitor before recalibrating guidelines.

### Structural issues, diversification, and human capital
- Development philosophy:
  - Continued emphasis on "Gross National Happiness" and holistic development.
- Diversification and competitiveness:
  - Authorities committed to "diversifying the economy and providing high-paying jobs," leveraging "political stability, education in English, very low levels of corruption, good governance and preferential access to the vast Indian market."
  - Strategy focuses on "developing infrastructure and easing of structural bottlenecks" and catalyzing the CSI sector.
  - The "second annual event of the Bhutan Economic Forum for Innovative Transformation, to be held in July 2019, will be on issue of economic diversification through catalyzing the cottage and small industries (CSI) sector."
- Education and labor market:
  - Concerns about "education quality, with a predominant base in the urban areas" and "the mismatch between the products of the education system and the present and future needs and demands of the market."
  - "A review of the educational system is ongoing."
- Business environment and FDI:
  - Improvement noted: Bhutan rose from "148th in 2013 to 75th in 2018 in the World Bank’s global Doing Business survey."
  - Authorities recognize the role of FDI thresholds and aim for the "right mix of employment generation and technology enrichment."

### Authorities' closing views
- Authorities "are very appreciative of the Fund’s inputs and support over the years" and seek continued engagement.
- They aim to maintain a balance between "inclusive and sustainable growth, macroeconomic stability and tangible improvements in the welfare of the citizens," while implementing strategies to diversify the economy and expand livelihood opportunities.

*IMF staff report — Authorities' concluding statement*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18300.pdf_