## _cr07350

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### Executive summary and macro setting
- Real GDP growth averaged 7 percent during 1997/98−2006/07, raising per capita GDP to around US$1,400.
- Real GDP growth estimated to have risen from 9 percent in 2005/06 to 17 percent in 2006/07, driven largely by Tala coming on stream.
- With the exchange rate peg to the Indian rupee, inflation is expected to be in line with price developments in India; consumer prices (period average) reported: 4.3, 4.8, 4.9, 5.0, 4.8 (series).
- Construction/commissioning of hydropower projects central to macro dynamics: Tala commissioning in 2007/08 will triple generation capacity; projects under consideration/starting in 2007/08 include Punatsangchu I (1095 MW, cost projected at 165 percent of 2007 GDP) and Dagachu (114 MW, cost projected at 15 percent of 2007 GDP); Punatsangchu II (992 MW) and Mangdechu (672 MW) in preliminary stages.
- Three key economy features: long horizon required for fiscal/project sustainability due to hydropower cycles; India as principal trading partner and sole purchaser of electricity exports; high ratio of external aid to GDP and domestic revenues with high aid and revenue volatility.

### Recent fiscal and public debt developments
- Fiscal outcomes and near-term budget:
  - 2005/06: budget made a net repayment to the banking system of ¾ percent of GDP.
  - 2006/07: domestically financed deficit was 2 percent of GDP (higher-than-budgeted 1½ percent of GDP).
  - 2007/08 budget targets: overall deficit 4 percent of GDP and domestically financed deficit 2¾ percent of GDP.
  - Full-year contribution of Tala to corporate income tax and dividends estimated at Nu. 2½ billion (4½ percent of GDP).
- Public debt and debt service:
  - Public debt doubled to over 80 percent of GDP at end-2005/06 from mid-2000; bulk of increase from rupee borrowings from India for Tala.
  - Purchase of an aircraft for Druk Air cost about US$39 million (4½ percent of GDP) and contributed to the increase.
  - Debt service on Tala scheduled to begin in 2007/08; debt service ratio remained around 6(10) percent of exports (revenue) during the past five years.
- Public sector debt (percent of GDP, selected): 2004/05 86.3; 2005/06 81.9; 2006/07 71.3; 2007/08 73.5; projected peak in 2012/13 and decline thereafter with GDP growth and adequate external financing.
- Debt indicators:
  - Overall NPV-to-GDP ratio estimated at around 76 percent in 2006/07 (LIC-DSA threshold: 50 percent for strong policy performers).
  - NPV of convertible currency external debt: 17¼ percent of GDP.
  - NPV of rupee debt (with 9 percent interest on Tala loans and 5 percent discount rate) about 60 percent of GDP (about 20 percentage points of GDP higher than face value, does not include Tala IDC).

### External sector, reserves, and balance of payments
- Trade and current account:
  - Electricity exports from Tala shifted the trade balance into a small surplus in 2006/07.
  - Current account (including grants) reported: -217; -291; 161; 41; 38; -54; -185; -206; -137 (series for 2004/05–2012/13 in millions of U.S. dollars).
- Reserves and rupee liquidity:
  - Total reserve cover (convertible currency and Indian rupees) at end-2006/07 was over nine months of goods and services imports; gross official reserves series (millions of U.S. dollars): 367; 479; 524; 689; 816; 915; 1,010; 1,089; 1,134.
  - Rupee reserves fell to ½ month of (rupee) imports at end-2006/07; near-term risk of temporary decline in official rupee reserves to critical levels.
  - RMA secured a rupee line of credit with an Indian commercial bank against its convertible currency deposits to tide over rupee shortfall.
- Projections:
  - International reserves projected at 9−11 months of goods and services imports.
  - Trade and current account deficits projected starting 2009/10 due to debt service payments for Tala beginning in 2007/08 and rising imports for new power projects thereafter; deficits offset by adequate aid flows maintaining overall balance of payments in surplus.

### Financial sector performance and risks
- Credit and liquidity:
  - Private sector credit growth averaged around 30 percent per year over the last seven years; credit to private sector (12-month percent change) series: 20.2; 35.9; 29.3; 33.3; 34.0; 26.7; 31.8.
  - Broad money levels (selected): 14,255; 14,832; 16,416; 20,486; 20,984; 21,655; 22,040 (in millions of ngultrum).
  - Excess liquidity skewed toward one commercial bank holding bulk of RGB and government corporations’ deposits.
  - Distribution of credit: housing accounted for 36 percent of total outstanding at end-2006.
- Asset quality and soundness indicators (selected):
  - Banks (selected ratios): Risk weighted CAR 20.8 (2003 Jun), 17.1 (2004 Dec); Core capital ratio 19.5 (2003 Jun), 15.7 (2004 Dec); Gross NPL 20.5 (2003 Jun), 27.4 (2004 Dec); Net NPL 10.7 (2003 Jun), 12.0 (2004 Dec).
  - Nonbanks (selected ratios): Risk weighted CAR 32.3 (2005 Dec), 36.5 (2006 Dec); Gross NPL 20.9 (2005 Dec), 21.1 (2006 Dec); Net NPL 9.0 (2006 Dec).
- Stress tests (baseline at end-2006):
  - Baseline banking-system risk-weighted CAR: 17 percent.
  - Ratio of NPLs to total loans: 5 percent.
  - Shocks: (i) 25 percent increase in NPLs proportional to existing NPLs; (ii) 25 percent increase in NPLs proportional to performing loans; (iii) 25 percent of PLs in the housing/construction sector becoming NPLs; (iv) appreciation of the ngultrum by 10 percent vis-à-vis the U.S. dollar.
  - CAR declines by 0.1–3¾ percentage points under shocks but remains above the 8 percent required minimum for the banking system as a whole; distribution of risk varies across banks, with Bank 2 more susceptible.
- Authorities’ remedial measures:
  - RMA directed increase in provisioning on substandard and doubtful loans from 20 percent to 30 percent; provisioning on housing loans in these categories raised from 50 percent to 60 percent, effective December 2007.
  - RMA in process of raising the CRR ratio to 15 percent (CRR had been reduced from 20 percent to 13 percent in 2004).
  - Proposed steps: stepped up issuance of RMA bills; introduction of 3-month and 6-month T-bills; build capacity for monitoring and reserve management; quarterly updating/refinement of stress testing.

### Outlook, risks, and policy imperatives
- Outlook:
  - Medium-term prospects bright due to hydropower projects; Tala commissioning expected to lift GDP, exports, and government revenue.
  - Real GDP growth is projected to average about 7 percent (medium term statement) with electricity exports to India expected to provide a fairly stable source of growth.
- Near-term risks:
  - Temporary decline in rupee reserves to critical levels; unrecorded rupee outflows related to interest rate spreads with India and tapering of Tala-related aid inflows.
- Medium-term risks:
  - “Dutch disease” type pressures and real exchange rate appreciation when Tala is fully commissioned.
  - Rapid private sector credit growth (around 30 percent per year), housing concentration (36 percent of outstanding credit at end-2006), and excess liquidity concentrated in one bank could impair financial stability.
  - Debt sustainability concerns reemerge as pipeline power projects (Punatsangchu I cost projected at 165 percent of 2007 GDP; Dagachu projected at 15 percent of 2007 GDP) commence.
- Policy imperative:
  - Private sector development is key to create jobs to absorb a young, rapidly growing labor force and to generate durable poverty reduction given limited public and power sector absorption capacity.

### Key policy recommendations (monetary, fiscal, financial, structural)
- Monetary, reserves, and exchange rate:
  - Maintain the exchange rate peg to the Indian rupee; the level of the peg is considered appropriate.
  - RMA should remain watchful of excess liquidity, credit growth and financial sector soundness.
  - Mop up excess liquidity via stepped up issuance of RMA bills and an increase in the CRR ratio.
  - RMA: develop short-term financial instruments, upgrade capacity to monitor/forecast/manage rupee flows and reserves, and enhance domestic money market liquidity.
- Financial sector:
  - Enhance financial sector supervision and build capacity in monetary and foreign exchange reserve management.
  - Limit financial institutions’ balance sheet exposures to sectoral and macroeconomic risk factors (notably housing); raise provisioning and create alternative investment avenues including T-bills and government bonds.
  - Continue stress-testing and use supervisory early warning tools.
- Fiscal policy and debt management:
  - Limit domestically financed deficits and mobilize external aid (grants and concessional loans) on a timely basis.
  - Plan expenditures in a medium-term framework (Tenth Five-Year Plan 2008/09−2012/13): aim for current surpluses and fiscal sustainability by achieving an average annual revenue-to-GDP ratio of around 18½ percent and containing average annual expenditure to 31 percent of GDP; limit domestically financed deficits to 1–2 percent of GDP.
  - Prepare contingency plans should external assistance fall below projected levels and reexamine spending priorities to cut low-priority projects.
- Structural reforms for growth and jobs:
  - Foster private sector growth by aligning education to market needs, streamlining the regulatory regime, liberalizing trade and FDI, implementing financial sector reforms, and investing in infrastructure to lower nonlabor costs.
  - Caution on labor policy: introducing a private sector minimum wage at too high a level could contribute to unemployment among young labor force participants.
- Legal/regulatory:
  - Adopt the revised RMA Act, Financial Institutions Act, and Foreign Exchange Regulations early in 2008.

### Employment, poverty, and social policies
- Poverty profile (RGB 2004 Poverty Analysis Report):
  - 32 percent of the population was poor (national poverty line Nu. 740 per month or US$17).
  - Rural poverty: 38 percent.
  - Less developed Eastern region poverty: 50 percent.
  - Projection: more than 15 years for the severely poor to exit poverty assuming sustained real per capita income growth of 4 percent and unchanged income distribution.
- Employment effects and constraints:
  - Employment effects of power sector projects are limited.
  - Constraints: landlocked location, small size, and limited potential for diversification.
- Policy priorities to alleviate poverty and create jobs:
  - Private sector development, targeted rural programs to increase land and labor productivity, investments in social sectors (health and education), infrastructure investments to improve market access, vocational training and regulatory improvements.

### Data and statistical issues
- Main statistical weaknesses:
  - Fiscal data are not consolidated; large errors and omissions in the balance of payments; inconsistencies between fiscal account and monetary survey; significant limitations in national accounts and price statistics.
  - First modern population census conducted in 2005; population revised from over 2 million (IFS) to below 0.7 million.
- Recommendations:
  - Further improve fiscal and external sector statistics, reconcile fiscal and monetary data, publish monetary accounts in Monthly Statistical Bulletin, and continue technical assistance programs.
- Timeliness and frequency (Table of Common Indicators): examples include reserve/base money (latest 05/2007, received 09/2007, Frequency M), CPI (latest 03/2007, received 09/2007, Frequency Q), consolidated banking balance sheet (latest 03/2007, received 09/2007, Frequency Q).

### Debt sustainability assessment and stress-test highlights
- Staff characterization: debt dynamics described as subject to a moderate risk of distress after accounting for mitigating factors.
- Mitigating factors:
  - Experience with hydropower projects (Chukha, Kurichhu, Tala) with past successful commissioning and sustained repayment records.
  - Favorable economics of Puna I and strong Bhutan–India relationship providing concessional financing and assured market for electricity.
- Selected public sector debt trajectory (percent of GDP): 2004/05 86.3; 2005/06 81.9; 2006/07 71.3; 2007/08 73.5; 2017/18 44.8; 2027/28 11.7.
- Gross financing need (percent of GDP, selected): 2004/05 8.3; 2005/06 11.0; 2006/07 4.8; 2007/08 12.5; 2008/09 12.9; 2017/18 4.5; 2027/28 1.4.
- NPV of external debt-to-GDP (selected): 2007/08 76.2; 2008/09 57.5; 2009/10 52.2; 2012/13 59.3; 2017/18 59.8; 2027/28 34.5.
- Stress-test outcomes:
  - CAR declines by 0.1–3¾ percentage points under specified shocks but remains above the 8 percent minimum for the system as a whole.
  - Under alternative and bound scenarios, debt ratios decline over time under most alternatives but can deteriorate materially under extreme shocks (e.g., new borrowing on less favorable terms or large export shocks).

### Selected key statistics (as presented)
- Nominal GDP (2005): US$819 million.
- Population (2005): 0.64 million.
- GDP per capita (2005): US$1,287.
- Real GDP at market prices (percent change series, 2003/04–2007/08): 7.2; 6.9; 9.1; 17.0; 14.4.
- Total revenue and grants (percent of GDP series): 33.9; 30.3; 33.9; 35.1; 30.7.
- Total expenditure and net lending (percent of GDP series): 32.1; 37.4; 35.0; 38.2; 36.5.
- Public sector debt (percent of GDP series): 84.7; 86.3; 81.9; 71.3; 73.5.
- Electricity export (percent of total goods exports): 40.3; 31.0; 25.1; 26.6; 34.7.
- Unemployment rate (percent, calendar-year basis): 1.8; 2.5; 3.1 (selected entries).
- Broad money growth (12-month percent change series): 29.7; 4.0; 10.7; 24.8; 13.0; -0.2; 7.6.
- Gross official reserves (months of imports): 8.9; 9.8; 9.2; 9.8; 9.9; 9.4; 9.7; 10.4; 10.9 (series).

*Source: Staff Report for the 2007 Article IV Consultation with Bhutan, _cr07350 (September 20, 2007).*

### 8.00 a copy

### INTERNATIONAL MONETARY FUND — BHUTAN: Staff Report for the 2007 Article IV Consultation

### Executive Summary
- Political stability and prudent economic management contributed to a significant rise in living standards and development indicators; real GDP growth averaged 7 percent during 1997/98−2006/07, raising per capita GDP to around US$1,400.
- Construction of two hydropower projects will help sustain real GDP growth over the medium term; when fully commissioned in 2007/08, Tala will triple generation capacity.
- With the exchange rate peg to the Indian rupee, inflation is expected to be in line with price developments in India.
- The overall balance of payments is projected to be in surplus and would help maintain adequate international reserves, but near-term risks include a (temporary) decline in official rupee reserves to critical levels.
- Other risks: potential “Dutch disease” type overheating and exchange rate appreciation with full commissioning of Tala; rapid credit growth and vulnerabilities in banks’ balance sheets; concerns about debt sustainability as power projects in the pipeline begin; rapidly growing labor force and limited public sector absorption capacity requiring private sector job creation measures.

Key Policy Recommendations (bulleted)
- RMA should remain watchful of excess liquidity, credit growth and financial sector soundness.
- Mop up excess liquidity via stepped up issuance of RMA bills and an increase in the CRR ratio.
- Limit financial institutions’ balance sheet exposures to factors posing potential higher NPL risk by developing markets in financial instruments to manage short-run liquidity and provide alternative investment vehicles over the medium term.
- Enhance financial sector supervision and build capacity in monetary and foreign exchange reserve management.
- Maintain the exchange rate peg to the Indian rupee; the level of the peg is considered appropriate.
- Use fiscal tightening, should pressures arise, to alleviate real exchange rate appreciation when Tala comes on stream; improve private sector efficiency and lower costs to enhance competitiveness.
- Fiscal sustainability requires limiting domestically financed deficits and mobilizing external aid; plan expenditures in a medium-term framework and broaden the tax base and improve administration to increase revenue.
- Foster private sector growth and employment by aligning education to market needs, streamlining the regulatory regime, liberalizing the trade regime, implementing financial sector reforms, and investing in infrastructure to lower nonlabor costs.
- Adopt the revised RMA Act, Financial Institutions Act, and Foreign Exchange Regulations early in 2008.

### Background and Macroeconomic Setting
- Political developments: King abdicated in December 2006; national assembly elections scheduled for early 2008; new parliament to debate and pass Bhutan’s first written constitution.
- Recent legislation passed by National Assembly: Public Finance Act, Audit Act, Labor Act, Environment Protection Act; Office of the Attorney General established; Anti-Corruption legislation passed.
- Pending legislation to await new government: revised RMA and Financial Institutions Acts and Foreign Exchange Regulations.
- Hydropower cycles are central to Bhutan’s macroeconomic dynamics: construction on Tala began in 1997; Tala commissioning in 2007/08 will have major effects on GDP, exports, and government revenue.
- Projects under consideration/starting in 2007/08: Punatsangchu I (1095 MW) and Dagachu (114 MW) — projected costs are 165 percent and 15 percent of 2007 GDP, respectively; Punatsangchu I to be financed by India; Dagachu to be financed by Austria, AsDB, and RGB. Punatsangchu II (992 MW) and Mangdechu (672 MW) are in preliminary stages.
- Three key features of the economy: long horizon required for fiscal/project sustainability due to hydropower cycles; India as principal trading partner, sole purchaser of electricity exports, largest donor/lender for hydropower projects; high ratio of external aid to GDP and domestic revenues with high aid and revenue volatility requiring medium-term planning.

### Economic Developments in 2005/06–2006/07
- Real GDP growth: estimated to have risen from 9 percent in 2005/06 to 17 percent in 2006/07, driven largely by Tala coming on stream.
- Inflation: remained in line with price developments in India due to the exchange rate peg.
- Fiscal developments:
  - 2005/06: delay in excise duty refunds from India offset by higher grants and lower capital spending; budget made a net repayment to the banking system of ¾ percent of GDP.
  - 2006/07: domestically financed deficit was 2 percent of GDP (higher-than-budgeted 1½ percent of GDP); factors included revenue shortfall from delayed excise duty refunds, higher-than-budgeted spending, and lower-than-budgeted loan inflows. Overall and domestically financed deficits averaged 4 percent and 1½ percent of GDP, respectively, during the Ninth Plan.
  - Public infrastructure spending rose to mark a century of the monarchy, coronation of a new king, and the first elected national parliament in 2008.
- Public debt:
  - Public debt doubled to over 80 percent of GDP at end-2005/06 from mid-2000; the bulk of the increase was rupee borrowings from India for Tala.
  - Purchase of an aircraft for state-owned Druk Air cost about US$39 million (4½ percent of GDP) and contributed to the increase.
  - Debt service on Tala scheduled to begin in 2007/08; debt service ratio remained around 6(10) percent of exports (revenue) during the past five years.
- External reserves and balance of payments:
  - Trade balance improved in 2005/06; in 2006/07 electricity exports from Tala shifted the trade balance into a small surplus.
  - Total reserve cover (convertible currency and Indian rupees) at end-2006/07 was over nine months of goods and services imports.
  - Rupee reserves fell to ½ month of (rupee) imports at end-2006/07.
  - To tide over rupee shortfall, RMA secured a rupee line of credit with an Indian commercial bank against its convertible currency deposits.
- Financial sector and credit:
  - Financial system has witnessed excess liquidity and rapid private sector credit growth; private sector credit growth averaged around 30 percent per year during the last seven years.
  - Rapid credit growth facilitated by balance of payments surpluses, excess liquidity, institutional and policy changes, strong credit demand, and limited alternative investment avenues for commercial banks.
  - Excess liquidity skewed toward one commercial bank, which holds bulk of RGB and government corporations’ deposits.
  - Distribution of credit: bulk of private sector credit (36 percent of total outstanding at end-2006) was extended for housing; exposure to housing sector increased.
  - NPL ratios: gross NPL and net NPL series reported (see financial soundness table excerpts).
    - Banks: Risk weighted CAR 20.8 (2003 Jun), 17.1 (2004 Dec); Core capital ratio 19.5 (2003 Jun), 15.7 (2004 Dec); Statutory liquidity ratio 54.2 (2003 Jun), 47.6 (2004 Dec); Gross NPL 20.5 (2003 Jun), 27.4 (2004 Dec); Net NPL 10.7 (2003 Jun), 12.0 (2004 Dec).
    - Nonbanks: Risk weighted CAR 32.3 (2005 Dec), 36.5 (2006 Dec); Core capital ratio 23.1 (2005 Dec), 26.0 (2006 Dec); Statutory liquidity ratio 6.4 (2005 Dec), 15.9 (2006 Dec); Gross NPL 20.9 (2005 Dec), 21.1 (2006 Dec); Net NPL 9.0 (2006 Dec).
  - Stress tests and financial sector soundness issues highlighted (see Selected issues, Chapter II).

### Outlook, Risks, and Challenges
- Outlook:
  - Medium-term prospects bright due to hydropower projects; Tala commissioning expected to lift GDP, exports, and government revenue.
  - With the exchange rate peg, inflation aligned with India; overall balance of payments projected to be in surplus supporting reserve adequacy.
- Near-term risks:
  - Temporary decline in rupee reserves to critical levels (rupee reserves at ½ month of rupee imports at end-2006/07).
  - Potential unrecorded rupee outflows related to interest rate spreads with India and tapering of Tala-related aid inflows.
- Medium-term risks:
  - “Dutch disease” type pressures and real exchange rate appreciation when Tala is fully commissioned.
  - Rapid private sector credit growth (around 30 percent per year), skewed exposure to housing (36 percent of outstanding credit at end-2006), and lingering excess liquidity concentrated in one bank pose financial stability risks, especially if real estate prices decline.
  - Debt sustainability concerns with pipeline power projects: Punatsangchu I cost projected at 165 percent of 2007 GDP; Dagachu cost projected at 15 percent of 2007 GDP.
- Challenges for employment and poverty:
  - Rapidly growing labor force and limited public sector absorption capacity mean policy measures are needed to foster private sector job creation.
  - Box on Poverty in Bhutan included in the report (see main text).

### Policy Discussions (summarized)
- Monetary, reserves, and exchange rate management:
  - Maintain exchange rate peg to Indian rupee; appropriate to anchor inflation expectations and benefit from close economic links with India.
  - RMA actions: mop up excess liquidity, issue RMA bills, raise CRR, develop short-term financial instruments, and enhance reserve management capacity.
- Financial sector soundness:
  - Supervision needs strengthening; adopt revised RMA Act, Financial Institutions Act, and Foreign Exchange Regulations early in 2008.
  - Limit banks’ exposures to housing and develop alternative investment avenues for financial institutions.
  - Stress tests conducted (see Box 2 and Selected issues, Chapter II).
- Fiscal sustainability:
  - Limit domestically financed deficits and mobilize external aid to keep public debt-to-GDP on a downward trajectory over the power cycle.
  - Improve budget planning with a medium-term framework; broaden the tax base and improve administration to increase revenue.
- Structural reforms for sustained growth and poverty alleviation:
  - Streamline regulatory regime, liberalize trade and FDI, align education to market needs, invest in infrastructure to lower nonlabor costs, and implement financial sector reforms to foster private sector growth and employment.

*Staff Report for the 2007 Article IV Consultation with Bhutan, approved September 20, 2007.*

### 12.      Bhutan’s economic prospects are bright. Construction of hydropower stations

### 12.      Bhutan’s economic prospects are bright. Construction of hydropower stations

### Economic outlook
- Real GDP growth is projected to average about 7 percent.
- Electricity exports to India from current and prospective projects are expected to provide a fairly stable source of growth.
- Trade and current account deficits are projected starting 2009/10 due to debt service payments for Tala beginning in 2007/08 and rising imports for new power projects thereafter.
- Deficits are offset by adequate aid flows, helping maintain the overall balance of payments in surplus.
- International reserves are projected at 9−11 months of goods and services imports.

### Risks and challenges
- Near-term risks:
  - Decline in official rupee reserves to critical levels.
  - Potential for “Dutch disease” type overheating and exchange rate appreciation with the full commissioning of Tala.
- Medium-term risks:
  - Spikes in economic activity from power sector projects could spill over to other sectors, including through demonstration effects of government wage increases, undermining external competitiveness.
  - Continued rapid credit growth concentrated in the housing sector raises concerns over vulnerabilities in banks’ balance sheets.
  - Concerns about debt sustainability likely to reemerge as power projects in the pipeline begin.
  - High poverty rate, especially in rural areas and the less developed Eastern region.
- Policy imperative:
  - Private sector development is key to job creation to absorb a young, rapidly growing labor force and to generate durable poverty reduction given limited public and power sector absorption capacity.

### Poverty in Bhutan (Box 1)
- RGB’s 2004 Poverty Analysis Report estimated that 32 percent of the population was poor (national poverty line of Nu. 740 per month or US$17).
- Poverty incidence:
  - Rural areas: 38 percent.
  - Less developed Eastern region: 50 percent.
- Higher poverty in larger households in agriculture with less educated members and fewer assets (land, livestock, and equipment).
- Proximate causal factors: remote location and difficult terrain, lack of wage employment, limited access to social and economic services, including credit.
- Projection: It would take more than 15 years for the severely poor to exit from poverty assuming sustained real per capita income growth of 4 percent and unchanged income distribution.

### Policy discussions — overall
- Principal policy issues addressed: (i) monetary, reserves and exchange rate management; (ii) risks to financial sector soundness; (iii) fiscal sustainability; and (iv) structural reforms for job creation and private sector development.
- Authorities expect economic policies to remain broadly unchanged during the transition to constitutional monarchy and parliamentary democracy, balancing growth and poverty alleviation with protection of cultural heritage and environment.

### Monetary, reserves and exchange rate management
- Agreement that monetary conditions need to be tightened to shore up rupee reserves and manage pressures on the exchange rate peg.
- Views and suggested measures:
  - Authorities viewed the rupee reserves shortfall as temporary; aid inflows from India for the Puna I project were expected to resume later in 2007. RMA could sell convertible currency reserves and secure additional rupee credit lines (preferably concessional) if needed.
  - Need to mop up excess liquidity through stepped up issuance of RMA bills and an increase in the CRR ratio (which was reduced from 20 percent to 13 percent in 2004).
  - Steps to slow private sector credit creation, especially housing, by raising provisioning requirements for loans to the sector.
  - RMA was in the process of raising the CRR ratio to 15 percent.
  - RMA needs to upgrade capacity to monitor, forecast, and manage rupee flows and reserves, and domestic money market liquidity.
- Exchange rate peg:
  - Broad agreement that the exchange rate peg to the Indian rupee remains the appropriate nominal anchor and the level of the peg is appropriate.
  - Bilateral real exchange rate (RER) with India, accounting for over 75 percent of Bhutan’s trade, has fluctuated within a narrow band since 2003.
  - RER may appreciate if expansion in national income from Tala is directed to nontradables, with limited impact on tourism but likely adverse effects on manufacturing via higher wage costs and possible real estate price escalation.
  - Near-term staff suggestion: some fiscal tightening to help contain appreciation pressures.
  - Medium-term focus: productivity improvements, infrastructure upgrading, education and vocational training, and creating an enabling environment to reduce transportation and transaction costs.
  - Assessment: current account deficits have been appropriately financed by capital inflows (mostly concessional external aid); power sector related outflows have assured financing and debt service payments can be met with electricity export earnings.

### Risks to financial sector soundness
- Identified balance sheet risks after sustained rapid credit growth:
  - High levels of nonperforming loans (NPLs) in two nonbank financial institutions.
  - Potential increase in NPLs in commercial banks following a general downturn or sectoral shock.
  - Interest rate risks from maturity mismatch between banks’ assets and liabilities.
- Stress-test framework findings (baseline at end-2006):
  - Baseline risk-weighted capital adequacy ratio (CAR) for the banking system: 17 percent.
  - Ratio of NPLs to total loans: 5 percent.
  - Shocks considered: (i) 25 percent increase in NPLs proportional to existing NPLs; (ii) 25 percent increase in NPLs proportional to performing loans; (iii) 25 percent of PLs in the housing/construction sector becoming NPLs; and (iv) appreciation of the ngultrum by 10 percent vis-à-vis the U.S. dollar.
  - CAR declines by 0.1–3¾ percentage points under shocks but remains above the 8 percent required minimum for the banking system as a whole.
  - Distribution of risk varies across banks; Bank 2 is more susceptible to CAR decline from exchange rate appreciation and housing loan NPL increases.
  - Low existing level of interbank lending limits potential contagion; liquidity risks currently limited.
- Authorities’ measures:
  - RMA directed all financial institutions to increase provisioning on substandard and doubtful loans from 20 percent to 30 percent; provisioning on housing loans in these categories raised from 50 percent to 60 percent, effective December 2007.
  - Quarterly updating and refinement of stress testing framework as supervisory early warning and risk management tool.
  - Build internal capacity to monitor credit risk.
  - Address maturity mismatches by creating avenues for alternative portfolio investments, including government bonds; RMA proposed introduction of 3-month and 6-month T-bills for budget financing to replace ways and means advances from commercial banks.

### Fiscal sustainability
- 2007/08 budget considerations:
  - Tala will induce a significant increase in GDP and increase the revenue-to-GDP ratio.
  - Full-year contribution of Tala to corporate income tax and dividends estimated at Nu. 2½ billion (4½ percent of GDP).
  - Other nontax revenue and receipts set to increase but earmarked for debt service payments for Tala.
  - Budget provided for capital spending for infrastructure in advance of centenary and coronation celebrations and formation of new constitutional bodies in 2008.
  - Overall and domestically financed deficit targets set at 4 percent and 2¾ percent of GDP, respectively.
  - Risks: extended delay in commissioning of remaining turbines at Tala or overruns in capital spending could increase domestically financed deficit; staff recommended cutting low-priority spending if needed.
- Medium-term fiscal framework recommendations for the Tenth Five-Year Plan (2008/09−2012/13):
  - Aim for current surpluses and fiscal sustainability by:
    - Achieving an average annual revenue-to-GDP ratio of around 18½ percent (with higher revenue from Tala).
    - Containing average annual expenditure to 31 percent of GDP, roughly equally divided between current and capital spending.
    - Limiting domestically financed deficits to 1–2 percent of GDP.
  - Assumptions: external grants averaging 9 percent of GDP and (net) loans of 2½ percent of GDP.
  - Recommendation: prepare contingency plans should external assistance fall below projected levels and reexamine spending priorities to cut low-priority projects.
- Public debt trajectory:
  - Public debt-to-GDP ratio follows the power sector cycle: dip in 2006/07, rise in 2007/08 as accumulated interest during construction (IDC) is added to the debt stock.
  - Significant repayments for Tala would be offset by disbursements for new hydropower projects; public debt ratio projected to peak in 2012/13 and decline thereafter with GDP growth, adequate external financing, and limited domestic financing.
  - External debt service ratios projected to remain manageable as external loans are expected to remain concessional.
- Debt dynamics assessment:
  - Conventional indicators and stress tests suggest external debt dynamics characterized as subject to a high risk of distress.
  - Mitigating factors:
    - Bhutan’s experience with construction, commissioning, and management of large hydropower projects suggests dynamics can be sustainable; loan repayments for Chukha will be successfully completed in 2007/08 (almost twenty years after mid-1980s commissioning).
    - Strong Bhutan–India relationship provides financing and close dialogue on financial and technical aspects of projects and broader support.
  - Conclusion: characterization of debt dynamics as subject to a moderate risk of distress is appropriate in light of mitigating factors.
- Debt indicator specifics:
  - Overall NPV-to-GDP ratio estimated at around 76 percent in 2006/07 (LIC-DSA threshold: 50 percent for strong policy performers).
  - NPV of convertible currency external debt: 17¼ percent of GDP.
  - NPV of rupee debt (with 9 percent interest rate on Tala loans and 5 percent discount rate) about 60 percent of GDP, about 20 percentage points of GDP higher than face value (does not include Tala IDC).
  - Baseline projection: NPV-to-GDP ratio falls as Tala comes fully on stream in 2007/08, rises as additional power projects commence, and falls below the threshold as additional projects come on stream.
  - Using an 11¼ percent discount rate (as in 2005 Article IV staff report), NPV of rupee debt estimated at 44 percent at end-2006/07, about 5 percentage points of GDP higher than face value (does not include Tala IDC). Adjusting for IDC and grant disbursements for Tala, implied grant element for rupee debt is over 50 percent.

### Structural reforms for sustained growth and poverty alleviation
- Tenth Five-Year Plan priorities (preparatory stage): reducing poverty, promoting balanced regional development, enhancing private sector development, expanding infrastructure.
- Fiscal and policy emphasis: limit domestically financed deficits while financing ambitious public expenditure program; focus on private sector to create jobs and absorb labor force; upgrade infrastructure, education, and vocational training; improve enabling environment to reduce transportation and transaction costs.

*Source: _cr07350 - 12.      Bhutan’s economic prospects are bright. Construction of hydropower stations*

### 23.      The authorities are aware that the employment effects of the power sector

### _cr07350 - 23.      The authorities are aware that the employment effects of the power sector

### Employment effects, structural constraints, and private sector development
- Findings:
  - Employment effects of the power sector projects are limited.
  - Key constraints: landlocked location, small size, and limited potential for diversification of production and exports.
  - The second large hydropower project was commissioned in 2006/07 and Tala powered rapid growth over the last decade.
- Authorities’ measures to foster private sector development and employment generation:
  - Improvements in the regulatory environment.
  - Promotion of vocational training.
  - Elimination of inconsistencies among legislation to improve prospects for tourism.
  - Issuance of rules and regulations for the revised FDI policy of 2002 in 2005.
  - Enactment of the Labor and Employment Act in 2006, containing provisions for occupational safety, formalization of contractual employment arrangements, and a minimum wage.
  - Approval of the Bhutan Micro Trade Regulations to streamline procedures for starting retail and wholesale businesses.
- Policy implications:
  - Job creation requires implementation of government strategies in other sectors, exploitation of tourism potential, strengthening infrastructure, developing flexible labor and efficient credit markets, upgrading skills, and improving the investment climate.
  - Sustaining balanced growth requires expansion of nonpower sectors through structural reforms that create an enabling environment for the private sector.

### Poverty, social policies, and human capital
- Findings:
  - While acknowledging the high poverty rate, authorities note mitigating factors: formal state welfare policies and informal social safety nets mean abject poverty is virtually nonexistent.
  - The poverty rate also reflects difficult terrain and sparse population, increasing the cost of providing government services.
- Policy recommendations:
  - The Tenth Plan would address service delivery and access issues.
  - Continued strong growth helps alleviate poverty, but active intervention is also needed.
  - Key elements for faster poverty alleviation:
    - Private sector development.
    - Targeted programs for the rural poor to increase land and labor productivity.
    - Investments in social sectors—health and education—to improve human capital.
    - Infrastructure investments to make market opportunities accessible to rural and remote areas.

### Trade liberalization and WTO accession
- Findings and plans:
  - Bhutan aims to join the WTO in 2008.
  - Accession commitments will provide a blueprint for further trade liberalization.
- Policy advice from staff:
  - Reduce the number of tariff rates on imports from third countries.
  - Reduce dispersion by lowering exceptional rates (of 50 percent and 100 percent).
- Note:
  - All imports from India are duty free.
  - Bhutan joined the IFC in December 2003, and BIMSTEC in February 2004.

### Exchange restrictions, convertible currency concerns, and Fund relations
- Authorities’ concerns:
  - Potential unsustainable net outflows of hard currency reserves should Bhutan accept obligations of Article VIII, Sections 2, 3, and 4.
  - Sources of hard currency reserves are essentially limited to unpredictable aid flows.
  - Easing restrictions could shift imports from India to third countries and rapidly erode hard currency reserves.
  - Need to limit demand from importers through a system of case-by-case quantity restrictions.
- Staff view and recommendations:
  - Current level of convertible currency affords room to experiment with eliminating restrictions and ease administrative burden.
  - Authorities open to cautiously experimenting with market-based instruments to manage demand for convertible currencies, with Fund technical assistance.
  - Staff urges authorities to eliminate the restrictions subject to approval under Article VIII as soon as possible, and to eliminate the restrictions maintained under Article XIV as soon as Bhutan’s balance of payments position permits.
  - Staff does not recommend approval of the restrictions subject to Fund approval under Article VIII as the authorities have not provided a timeframe for elimination.
  - The IMF stands ready to provide assistance, including development of a foreign exchange market and market-based instruments to manage hard currency flows.
- Details on maintained restrictions (as provided in the source):
  - Bhutan maintains exchange restrictions in connection with: (i) the availability of foreign exchange for travel, invisibles, and private transfers; (ii) foreign exchange balancing requirements on remittances of income from foreign direct investment; and (iii) the availability of foreign exchange for importers who have not provided evidence that goods for which payments have been made were actually imported.
  - Changes to Bhutan’s import licensing rules in 2005 introduced new foreign exchange balancing requirements for certain imports, giving rise to exchange restrictions subject to Fund approval under Article VIII, Section 2(a).
  - Bhutan also maintains restrictions notified to the Fund pursuant to Decision 144−(52/51).

### Data issues
- Findings:
  - Data provision is adequate for surveillance purposes but shortcomings remain that hamper policy formulation and implementation.
  - Fiscal data are not consolidated.
  - Large errors and omissions in the balance of payments preclude a more accurate assessment of external flows.
  - Data between the fiscal account and the monetary survey need reconciliation, particularly clear identification and classification of government accounts in the banking system.
  - The first modern population census was conducted in 2005.
- Recommendation:
  - Further improvements in upgrading fiscal and external sector statistics should remain high on the authorities’ agenda.

### Macroeconomic assessment, risks, and financial sector policies
- Staff appraisal—findings:
  - Political stability and prudent economic policies have contributed to a steady rise in per capita income.
  - The successful commissioning of a second large hydropower project in 2006/07 contributed to robust growth and improved living standards.
  - Social indicators have registered appreciable improvement.
  - The exchange rate peg to the Indian rupee and the level of the peg remain appropriate.
  - Inflation should continue to remain in line with price developments in India.
  - International reserves are projected to remain in a comfortable margin.
- Risks and challenges:
  - Tala’s limited capacity for job creation is likely to remain true for other power sector projects.
  - High poverty ratio despite small absolute numbers.
  - Need for significant infrastructure spending, especially road access, while maintaining a sound fiscal position.
  - High ratio of external aid to GDP and domestic revenues, and aid and revenue volatility, underline need for careful, medium-term planning.
- Financial sector recommendations:
  - RMA should remain watchful of excess liquidity, credit growth and financial sector soundness.
  - Further steps to mop up excess liquidity and curb private sector credit growth.
  - Limit financial institutions’ balance sheet exposures to sectoral and macroeconomic risk factors to prevent rising NPLs.
  - Develop markets in financial instruments, including T-bills and government bonds, to manage liquidity and provide alternative investment vehicles.
  - Further enhance financial sector supervision and build capacity, especially in monetary and foreign exchange reserve management.
  - Financial institutions need to build capacity to monitor and manage balance sheet risks.
- Exchange rate policy guidance:
  - To tide over temporary shortfall in rupee reserves and manage pressures on the exchange rate, monetary and fiscal tightening would be appropriate in the near term.
  - Monetary tightening would help curb private sector credit growth.
  - If real exchange rate appreciation occurs after Tala comes on stream, appropriate policy response would include some fiscal tightening to moderate a rise in nontradable goods’ prices.
  - Competitiveness can be enhanced by raising private sector efficiency and lowering costs.

### Fiscal sustainability and public finance
- Findings and recommendations:
  - Fiscal sustainability requires limiting domestically financed deficits and mobilizing external aid (grants and concessional loans) on a timely basis.
  - Maintain the public debt-to-GDP ratio on a downward trajectory as the power sector cycles progress by limiting domestically financed deficits.
  - Plan expenditures in a medium-term framework.
  - Enhance revenue buoyancy by broadening the tax base and better tax administration, including rationalization of the sales tax and import duty rates.
  - External debt service obligations are sustainable.
  - Even as some LIC-DSA thresholds are breached in NPV terms, the presence of mitigating factors suggests a moderate risk of debt distress.
  - The Public Finance Act provides a disciplining framework for budget preparation, management, and execution.
- Structural and labor market caution:
  - Align the education system to market needs, further streamline the regulatory regime, liberalize the trade regime, implement financial sector reforms, and invest in infrastructure to lower nonlabor costs.
  - While the new Labor Act seeks to balance contractual obligations and social protection, introducing a private sector minimum wage at too high a level could contribute to unemployment, especially among young labor force participants.
  - The revised RMA Act, Financial Institutions Act and Foreign Exchange Regulations should be adopted early in 2008.

*Source: _cr07350 - 23–36.*

### 37.      It is recommended that Bhutan remain on the 24–month consultation cycle.

### _cr07350 - 37.      It is recommended that Bhutan remain on the 24–month consultation cycle.

### Recommendation
- It is recommended that Bhutan remain on the 24–month consultation cycle.

### Medium-Term Prospects and Growth Outlook
- Real GDP growth is projected to rise significantly as electricity exports to India increase.
- Real GDP growth (selected years, annual percentage change):  
  - 2003/04: 4 (plot scale label) through 2011/12: 24 (plot scale label) — charted in source figure (annual percentage change).
- Exports and imports (annual percentage change) show large swings consistent with hydropower-related trade dynamics.

### Fiscal Trends and Public Debt
- Revenue and expenditure (In percent of GDP) plots indicate:
  - Revenue-to-GDP ratio will be boosted by increased electricity exports.
  - Financing new hydropower projects will initiate a renewed public debt cycle.
- Deficit and public debt (In percent of GDP): overall deficit (left scale) and public debt (right scale) increase as hydropower projects proceed.
- Table 1 (selected indicators, nominal and percent values):
  - Nominal GDP (2005): US$819 million
  - Population (2005): 0.64 million
  - GDP per capita (2005): US$1,287
  - Quota: SDR 6.3 million
  - Real GDP at market prices (percent change): 2003/04–2007/08 series includes 7.2, 6.9, 9.1, 17.0, 14.4 (as presented)
  - Consumer prices (percent change, period average): 4.3, 4.8, 4.9, 5.0, 4.8 (as presented)
  - General government (percent of GDP):
    - Total revenue and grants: 33.9, 30.3, 33.9, 35.1, 30.7 (series)
    - Of which: foreign grants: 17.5, 12.7, 16.3, 14.0, 11.1 (series)
    - Total expenditure and net lending: 32.1, 37.4, 35.0, 38.2, 36.5 (series)
    - Of which: capital expenditure: 17.1, 19.8, 17.3, 21.0, 18.4 (series)
    - Current balance (excluding grants): -0.3, -0.3, 0.6, 4.0, 0.9 (series)
    - Overall balance (including grants): 1.8, -7.1, -1.1, -3.1, -5.8 (series)
    - Public sector debt 2/: 84.7, 86.3, 81.9, 71.3, 73.5 (percent of GDP series)
  - Memorandum items:
    - Electricity export (in percent of total goods exports): 40.3, 31.0, 25.1, 26.6, 34.7 (series)
    - Unemployment rate (in percent) 5/: 1.8, 2.5, 3.1 (series for calendar-year basis)

### Government Budget Summary (Table 2 highlights)
- Revenue and grants (In millions of ngultrum; selected years shown):
  - 2003/04 Actual: 10,421
  - 2004/05 Actual: 10,945
  - 2005/06 Actual: 10,439
  - 2006/07 Budget: 12,866
  - 2006/07 Est.: 13,328
  - 2007/08 Budget: 16,357 (additional rows continue in table)
- Domestic revenue (In millions of ngultrum): 5,055; 6,570; 6,066; 7,388; 6,903; 10,122; ...
- Tax revenue (In millions of ngultrum): 2,467; 3,326; 3,069; 4,094; 3,717; 5,139; ...
  - Income taxes: 1,533; 1,609; 1,530; 1,686; 1,833; 2,476; ...
- Nontax revenue (In millions of ngultrum): 2,589; 3,244; 2,997; 3,294; 3,186; 4,983; ...
  - Profit transfers: 198; 219; 384; 296; 503; 272; 2,797; ...
  - Dividends: 1,753; 2,271; 1,551; 1,997; 1,542; 3,461; ...
- Foreign grants (In millions of ngultrum): 5,366; 4,375; 4,373; 5,478; 6,425; 6,235; ...
  - From India: 3,533; 2,725; 2,625; 3,730; 3,417; 4,175; ...
- Expenditure and net lending (In millions of ngultrum): 9,865; 13,232; 12,893; 14,701; 13,771; 17,902; ...
  - Current expenditure: 5,149; 5,969; 6,171; 6,888; 6,672; 7,962; ...
  - Wages and salaries: 1,980; 2,125; 2,398; 2,797; 2,817; 3,403; ...
  - Interest 5/: 220; 377; 405; 530; 382; 448; 448; 2,738; 1,947 (selected entries include Tala-related interest)
  - Capital expenditure 6/: 5,265; 7,158; 6,810; 7,764; 6,809; 9,814; ...
- Overall balance (including grants) (In millions of ngultrum): 556; -2,287; -2,454; -1,834; -443; -1,545; -1,476; -2,328; -3,337 (series)
- Foreign financing (In millions of ngultrum): 932; 988; 739; 833; 715; 811; 475; 788; 788 (series)
- Notes and memoranda:
  - Tala-related items: Debt service related to Tala starts in 2007/08; Tala debt disbursement is off budget, but debt service is channeled through budget. Nu. 1,256 million Tala amortization noted for 2007/08 budget; other Tala receipts and timing issues documented in notes.

### External Sector and Balance of Payments (Table 3 highlights)
- Current account (In millions of U.S. dollars; selected years):
  - 2004/05: -217
  - 2005/06: -291
  - 2006/07: 161
  - 2007/08 Prov.: 41
  - Staff projection year series continues through 2012/13.
- Trade balance (In millions of U.S. dollars): -249; -123; 128; 88; 11; -73; -183; -207; -161 (series)
- Exports, f.o.b. (In millions of U.S. dollars): 212; 312; 521; 687; 749; 785; 833; 882; 933 (series)
  - Of which: electricity (units shown): 667; 813; 823; 825; 625; 425; 926; 2265 (series aligned in table)
- Imports, c.i.f. (In millions of U.S. dollars): -461; -435; -509; -598; -738; -858; -1,016; -1,088; -1,094 (series)
  - Of which excluding hydropower-related: -346; -405; -502; -582; -670; -732; -797; -865; -938 (series)
- Capital and financial account (In millions of U.S. dollars): 215; 144; 392; 488; 154; 281; 284; 182 (series)
  - Of which: foreign direct investment: 9; 6; 11; 13; 13; 14; 14; 15; 15 (series)
  - Loans (net): 78; 78; 16; -133; 261; 151; 151; 152; 91 (series)
- Gross official reserves (In millions of U.S. dollars): 367; 479; 524; 689; 816; 915; 1,010; 1,089; 1,134 (series)
  - In months of imports of goods and services: 8.9; 9.8; 9.2; 9.8; 9.9; 9.4; 9.7; 10.4; 10.9 (series)
- External debt (public and private, percent of GDP): 78.7; 77.5; 64.8; 64.0; 59.0; 57.1; 60.1; 62.4; 61.2 (series)
- Debt service (in percent of exports of goods and services): 7.2; 5.8; 4.0; 14.2; 12.5; 11.6; 10.5; 9.6; 8.9 (series)

### Monetary Sector and Reserves (Table 4 highlights)
- Monetary survey (selected levels, in millions of ngultrum or as indicated):
  - Broad money: 14,255; 14,832; 16,416; 20,486; 20,984; 21,655; 22,040 (series)
  - Reserve money: 8,008; 9,370; 9,340; 13,475; 12,284; 12,158; 12,043 (series)
  - Net foreign assets (monetary survey): 17,520; 16,457; 16,397; 22,505; 24,425; 21,549; 19,360 (series)
  - Credit to private sector (12-month percent change): 20.2; 35.9; 29.3; 33.3; 34.0; 26.7; 31.8 (series)
- Memorandum monetary rates and ratios:
  - Broad money growth (12-month percent change): 29.7; 4.0; 10.7; 24.8; 13.0; -0.2; 7.6 (series)
  - Reserve money growth (12-month percent change): 34.9; 17.0; -0.3; 44.3; -3.5; -7.7; -10.6 (series)
  - Money multiplier: 1.8; 1.6; 1.8; 1.5; 1.7; 1.8; 1.8 (series)
  - Broad money/GDP: 0.51; 0.48; 0.48; 0.52; 0.44; 0.45; 0.46 (series)

### Medium-Term Macroeconomic Framework (Table 5 highlights)
- Real sector (percent change, selected series):
  - Real GDP at market prices: 6.9; 9.1; 17.0; 14.4; 7.2; 6.3; 6.2; 6.1; 6.4 (2004/05–2012/13 series)
  - Consumer prices (period average): 4.8; 4.9; 5.0; 4.8; 4.5; 4.1; 4.0; 4.0; 3.9 (2004/05–2012/13 series)
- Fiscal sector (in percent of GDP, selected series):
  - Revenue and grants: 30.3; 33.9; 35.1; 30.7; 28.9; 27.9; 26.9; 26.2; 25.3 (2004/05–2012/13 series)
  - Expenditure and net lending: 37.4; 35.0; 38.2; 36.5; 33.5; 31.5; 31.4; 29.9; 28.5 (series)
  - Overall balance (including grants): -7.1; -1.1; -3.1; -5.8; -4.6; -3.6; -4.5; -3.7; -3.2 (series)
  - Public sector debt (in percent of GDP): 86.3; 81.9; 71.3; 73.5; 69.2; 68.2; 70.6; 72.2; 71.7 (series)
- External sector (selected series in millions of U.S. dollars and percent of GDP):
  - Current account balance (including grants) (In millions of U.S. dollars): -217; -291; 161; 41; 38; -54; -185; -206; -137 (series)
  - Current account balance (In percent of GDP): -28.2; -3.3; 10.6; 10.1; 2.4; -3.2; -9.9; -10.2; -6.2 (series)
  - Gross foreign reserves (In millions of U.S. dollars): 367; 479; 524; 689; 816; 915; 1,010.4; 1,089.0; 1,133.6 (series)
  - Gross foreign reserves (In months of goods and services imports): 8.9; 9.8; 9.2; 9.8; 9.9; 9.4; 9.7; 10.4; 10.9 (series)

### Social and Development Indicators (Millennium Development Goals, Table 6 highlights)
- General indicators (selected):
  - Population (millions): 0.6 (series shown for 1990, 1995, 2000, 2005)
  - Gross national income (in million U.S. dollars): 292.3; 265.1; 460.3; 512.1 (selected years)
  - GNI per capita (in U.S. dollars): 500.0; 500.0; 720.0; 1,250.0 (selected years)
  - Life expectancy at birth (in years): 54.0; 58.0; 61.0; 64.0 (selected years)
  - Aid (in percent of GNI): 17.6; 12.6; 12.9; 13.7 (selected years)
  - External debt (in percent of GNI): 31.4; 39.2; 56.3; 70.4 (selected years)
- Health and education indicators (selected):
  - Prevalence of child malnutrition (in percent of children under 5): 37.9; 18.7 (selected years)
  - Under 5 mortality rate (per 1,000): 166.0; 133.0; 100.0; 75.0 (selected years)
  - Infant mortality rate (per 1,000 live births): 107.0; 93.0; 77.0; 65.0 (selected years)
  - Immunization, measles (in percent of children under 12 months): 93.0; 85.0; 76.0; 92.0; 93.0 (selected entries)

### Sources and Notes
- Sources: Data provided by the Bhutanese authorities; Fund staff projections, estimates, and tables as presented in the informational annex and staff report.

*Prepared by the Asia and Pacific Department; Staff Report for the 2007 Article IV Consultation—Informational Annex (September 20, 2007).*

### Section 2. Bhutan also maintains an exchange restriction subject to Fund approval under

### _cr07350 - Section 2. Bhutan also maintains an exchange restriction subject to Fund approval under

### Article IV Consultation
- Bhutan is on a 24-month consultation cycle.
- The 2005 Article IV consultation was concluded by the Executive Board on July 11, 2005.

### Technical Assistance (by area and year)
- Fiscal (FAD):
  - 1982, 1983 - Tax policy, budgeting, and accounting
  - 1984 - Tax legislation
  - 1984–86, 1988–89 - Technical experts assigned as General Fiscal Advisor to the Ministry of Finance
  - 1987, 1989 - Tax system and public enterprises
  - 1992, 2003 - Income taxation
  - 2003 - Workshop on tax auditing and revenue forecast
  - 2004 - Accounting (with MFD)
- Legal (LEG):
  - 1982–84 - Tax legislation
  - 2004, 2005 - Central banking and financial services legislation and foreign exchange regulations (with MFD)
- Monetary and Financial (CBD/MAE/MFD/MCM):
  - 1983 - Set-up the Royal Monetary Authority (RMA)
  - 1980–92 - Technical experts assigned as General Advisors to RMA
  - 1989 - Financial system review
  - 1991 - Financial sector legislation/development of supervisory capabilities
  - 1991 - Technical experts assigned as Advisor for Bank Supervision
  - 1992 - Issuance of government securities
  - 1993–96 - Implementation of issuance of government securities
  - 2003 - Monetary and exchange operations / financial systems
  - 2004 - Accounting
  - 2004, 2005 - Central banking and financial services legislation and foreign exchange regulations
  - 2005, 2007 - Risk based internal audit policies and practices
  - 2006, 2007 - Implementation of accounting reforms
  - 2006, 2007 - Debt management and financial markets development
  - 2007 - Follow-up on excess liquidity issues
  - 2007 - Follow-up on reserve management
- Statistics (STA):
  - 1988 - Trade statistics
  - 1990 - Statistics database
  - 2004 - Multisector statistics/GDDS mission
  - 2005 - Balance of payments statistics
- Resident Representative/Advisor:
  - None.

### Relations with the World Bank Group — International Development Association (IDA)
- Active IDA projects (Commitments (Original) / Disbursed (In percent) / Board Approval/Effectiveness):
  - Second Rural Access Project: 10.0 / 0 / 4/10/07
  - Decentralized Rural Development Project: 7.0 / 25.5 / 3/01/07
  - HIV/AIDS and STI Prevention and Control Project: 5.8 / 49.5 / 6/17/04
  - Education Development Project: 31.0 / 43.3 / 8/21/03
  - Sub-total: 53.8
- Pipeline:
  - Avian Influenza Control Project: 1.0
  - Private Sector Development: 8.0 / 6/20/07
  - Second Development Policy Grant: 12.0 / 6/20/07
  - Urban Development-II: 10.0 / TBD
- Nonlending:
  - Trust Fund for Statistical Capacity Building: 0.25 / 2/20/07
  - Public Financial Management IDF Grant: 0.29 / 4/12/07
  - Multi-Year Rolling budget IDF grant: 0.33 / 4/13/07
- IDA eligibility and allocations:
  - Bhutan is an IDA-only country and qualifies for 100 percent grants in FY07 because (i) the ratio of the present value of external debt to GDP exceeds the threshold value of 50 percent, and (ii) the ratio of the present value of external debt to exports is more than the threshold value of 200 percent.
  - Bhutan’s IDA allocation in FY07 and FY08 is about US$15.7 million in each year.
  - As a small state with a population of less than 1.5 million, Bhutan can cumulatively frontload up to 80 percent of its overall IDA14 indicative allocation.
  - The actual allocation for FY08 and whether Bhutan will again qualify for grants will depend on a number of factors, including country performance and the findings of a more complete debt sustainability analysis.

### World Bank — Country Assistance Strategy and Lending Program
- CAS pillars (FY06/09):
  - (i) Expanding access to better infrastructure and quality social services, and connecting communities to markets.
  - (ii) Promoting private sector development and employment.
  - (iii) Strengthening the management of public resources, and monitoring and evaluation of development outcomes.
  - Crosscutting support: decentralization, good governance, environmental management.
- Recent lending and projects (highlights):
  - Over US$30 million in IDA grants committed or about to be approved in final six months of 2006/07, involving substantial frontloading of Bhutan’s IDA14 allocation.
  - US$10 million Second Rural Access Roads Project approved by the Board on April 10, 2007; objective: improve access for about 12,000 rural residents in geogs of Wangdue, Dagana, and Pemagtsel Dzongkhags. Project components: 1) road access component; 2) capacity development and implementation support component.
  - Proposed US$12 million Second Development Policy Grant (submitted June 20): aims to (a) strengthen fiscal management and public service delivery; (b) improve financial management and procurement; (c) improve investment climate and labor market flexibility; (d) raise educational attainment by expanding access to high quality education services; (e) reduce maternal mortality by increasing births delivered in health facilities.
  - Proposed US$8 million Private Sector Development Project (submitted June 20, 2007) with three components:
    - Development of IT/ITES Sector (US$5.0 million): establishment of an IT Park and IT promotion services.
    - Development of IT/ITES Skills Program (US$2.0 million): Generic Skills, Distance learning/CMS for IT Skills, IT Entrepreneurship Development Program.
    - Strengthening Financial Sector through IT Use (USD1.0 million): IT system upgradation in the Bank of Bhutan; ‘Financial sector IT development strategic plan’; establishing Inter-bank Electronic Fund Transfer Clearing System at the RMA.
  - US$2.5 million National Influenza Preparedness and Response Project (Avian Flu) under preparation, scheduled to be approved by end of June 2007; funded from a global trust fund and does not draw on Bhutan’s IDA14 allocation.
  - Projects under preparation for FY2008 include the second Urban Development Project; ongoing IDA-financed projects to expand rural access roads and improve education outcomes.

### World Bank — Nonlending Program (grants and objectives)
- US$250,000 Trust Fund for Statistical Capacity Building (effective 2/20/07): build statistical capacity at the National Statistical Bureau to coordinate, consolidate and harmonize data generation and facilitate poverty monitoring.
- US$287,000 Public Financial Management IDF Grant (approved 4/12/07): assist Ministry of Finance and Royal Audit Authority to strengthen accounting and auditing staff technical competence and improve operational capacity to produce quality financial and audit reports meeting international standards.
- US$330,000 Multi-Year Rolling Budget IDF Grant (approved 4/13/07): help RGoB introduce Multi-Year Rolling Budgets (MYRB) and move towards performance budgeting.

### International Finance Corporation (IFC) engagement
- Membership since 2003.
- Investment Services:
  - IFC currently has US$9.4 million of senior debt outstanding in one tourism project in Bhutan.
  - A maximum of US$10−15 million of additional investment is envisaged over the next three years (subject to exposure limits).
- Advisory Services and Programs:
  - IFC-SEDF activities include financial training, gender development, Knowledge Center initiatives, and integration of Corporate Social Responsibility (CSR) principles.
  - Access to Finance (ATF) Program: training targeted to senior officials of RMA and senior bankers from Bank of Bhutan (BOB), Bhutan National Bank (BNB), Bhutan Development Finance Corporation Ltd. (BDFC), and Royal Insurance Corporation of Bhutan (RICB).
  - Business Enabling Environment (BEE) Program: initiatives include reducing number of days required to register a business from 62 days to 47 days (example target), supply chain study of timber and wood products, pilot gender empowerment projects with National Women’s Association of Bhutan (NWAB).
  - Investment Climate Assessments/Foreign Investment Advisory Service (FIAS): since 2000, five small projects to help RGoB develop an operational framework for introduction of FDI, including desk review of proposed “Foreign Investment Law”, drafting of investment policy statement, drafting guidelines for FDI legislation, procedures to operationalize Executive Order (Foreign Direct Investment Policy), and institutional structure recommendations (report finalized August 2004).
- Future vision: IFC-SEDF plans to extend activities in Bhutan and replicate successful regional projects with meaningful Bhutanese partnerships mindful of socio-economic and cultural uniqueness.

### Relations with the Asian Development Bank (ADB)
- Membership since 1982; lending operations began in 1983.
- Classification: group “A” with full access to ADF and 80 percent cost-sharing limit for project financing.
- Country Strategy and Program (CSP) strategic thrusts (approved September 2005):
  - (i) Lending assistance focused on transport, power (including rural electrification), urban development, and financial and private sector development.
  - (ii) Nonlending assistance for capacity building for sustainable development.
- Indicative cumulative value for 2007−2008: $37.6 million.
  - Programmed loans: one for development of small and medium-sized enterprises (2007), another for rural electrification and renewable energy (2008).
  - Nonlending program cumulative value for 2007−2008: $3.8 million.
- Ongoing ADB projects (As of December 31, 2006):
  - Basic skills development: Year of Approval 2001; Project Amount $7.0 million; Disbursements $5.5 million.
  - Rural electrification: Year of Approval 2003; Project Amount $9.4 million; Disbursements $9.7 million.
  - Road network project: Year of Approval 2005; Project Amount $6.8 million; Disbursements $0.2 million.
  - Financial sector development program: Year of Approval 2006; Project Amount $13.0 million; Disbursements $0.0 million.
  - Urban infrastructure development: Year of Approval 2006; Project Amount $24.6 million; Disbursements $0.0 million.

*Source: _cr07350 - Section 2. Bhutan also maintains an exchange restriction subject to Fund approval under*

### ANNEX IV: BHUTAN—STATISTICAL ISSUES

### ANNEX IV: BHUTAN—STATISTICAL ISSUES

### Overview
- Data provision is adequate overall, but shortcomings hamper surveillance in key areas.
- Main statistical weaknesses:
  - Lack of consolidation of government accounts and lags in availability for fiscal data.
  - Large errors and omissions in the balance of payments.
  - Significant limitations in national income accounts, price, and fiscal statistics.
  - Inconsistencies between monetary, fiscal and balance of payments statistics.
  - Frequent and at times substantial revisions of data.
- Key contributing factors: shortage of qualified personnel and facilities; absence of a Statistics Act constraining the National Statistical Bureau (NSB).
- Authorities are addressing deficiencies with technical assistance from ADB, IMF and others.
- March 2004 Multisector Statistics Mission: assisted in preparing metadata and plans to improve macroeconomic statistics and sociodemographic indicators.
- Formal participation in the GDDS requires an official notification from Bhutan.

### Real Sector
- Compilation methods and data sources:
  - National accounts rely heavily on production data collected by line ministries; volume data often lack quality control.
  - Manufacturing estimates mainly from annual data obtained directly by the national accounts section.
  - Construction estimated using government accounts and the commodity flow method using cement and logs supply data.
  - Expenditure components derived from same sources as production estimates; private consumption calculated as a residual.
- Recent methodological changes and issues:
  - In 2005, NSB began reporting GDP at market prices, replacing estimates at factor cost.
  - New estimates have significant lags; some estimation procedures are ad hoc.
  - Base year shifted from 1980 to 2000 based on Household Income Expenditure Survey in 2000.
  - Several potentially useful data sources are not used in calculations.
  - Some deflators, including for government services, are inappropriate and bias constant-price output measures.
  - Gross domestic savings defined as gross investment minus net capital inflow, but net capital inflow concept does not correspond to trade or current account balances.
- Price and demographic statistics:
  - Starting in 2004, the consumer price index (CPI) is compiled quarterly, with a greatly expanded commodity list and broader geographical scope.
  - Major constraint: lack of reliable population data (overall count and age-gender distribution).
  - Indicators for MDGs are not calculated systematically.
  - Population census in 2005 revised population estimates from over 2 million reported in IFS to below 0.7 million.

### Monetary Statistics
- Monetary survey:
  - Balance sheets of the Royal Monetary Authority (RMA) and the two commercial banks (Bank of Bhutan and Bhutan National Bank) consolidated into a monetary survey.
  - Statistics based on end-month balance sheets and generally consistent with Fund classification guidelines.
- Areas for improvement:
  - Valuation of financial assets uses purchase price; market or market-price equivalents preferred.
  - Need a list of government units and nonfinancial public enterprises to avoid misclassifications; share with reporting financial institutions.
  - Monetary accounts for the RMA and other deposit money banks should be published in the Monthly Statistical Bulletin.
- Timeliness and dissemination:
  - Timeliness and coverage of reporting to STA have improved; RMA submits monetary data in IFS and via Standardized Report Forms (SRFs).
  - RMA website and Monthly Statistical Bulletin publish monetary and financial statistics with one-month lag, including:
    - monetary survey, deposit liabilities of commercial banks, sectoral credit by financial institutions, gross international reserves, exchange rates, and selected interest rates.
  - As of June 2007, RMA reported monetary data to STA with a two-month lag.
  - Authorities and STA are working to improve timeliness of reporting to STA to align with national publications.

### Public Finance
- Quality and availability:
  - Recent improvements in government finance statistics (GFS), but fiscal data are subject to frequent and substantial revisions, particularly in expenditure.
  - Compilation and dissemination of budget execution data and GFS are very limited.
  - Only annual budget execution data compiled and disseminated, with a long lag; no GFS disseminated nationally.
  - Sub-annual budget execution data are not available.
- Coordination and consistency:
  - More accurate revenue data could be compiled with closer coordination among Ministry of Finance departments.
  - Inconsistencies between fiscal and monetary data on bank financing stem from differing definitions of government.

### External Sector (Balance of Payments)
- Classification and improvements:
  - Since 2002, efforts to follow BPM5 classifications, improve estimates of travel, other services, and transfers, and enhance consistency with GFS.
- Remaining weaknesses:
  - Balance of payments (BOP) statistics cover a limited range of transactions; many key data are estimated.
  - Unique exchange and trade system with India and a large porous border result in substantial unrecorded trade.
  - No attempt made to estimate unrecorded trade with India.
  - Travel receipts/payments vis-à-vis India based on assumptions rather than entry/exit tourist surveys.
  - Trade data compiled on a calendar year basis, while other external transactions are on a fiscal year basis, contributing to large and fluctuating errors and omissions.
- Recent technical assistance and developments:
  - January-February 2005 TA mission (with RMA) developed a plan to improve BOP statistics: quarterly business survey, improved estimation methods, and increased timeliness.
  - RMA plans to compile quarterly balance of payments data.
  - Bhutan began supplying BOP data for publication in IFS in June 2007.

### Table of Common Indicators Required for Surveillance (as of September 7, 2007) — selected entries
- Exchange rates: Date of Latest Observation 09/2007; Date Received 09/2007; Frequency: D (Daily) for data, reporting, and publication.
- International reserve assets and reserve liabilities of the Monetary Authorities: Date of Latest Observation 05/2007; Date Received 09/2007; Frequency: M (Monthly) for data, reporting, and publication.
- Reserve/base money: 05/2007 (latest), 09/2007 (received), Frequency: M M M.
- Broad money: 05/2007 (latest), 09/2007 (received), Frequency: M M M.
- Central bank balance sheet: 05/2007 (latest), 09/2007 (received), Frequency: M M M.
- Consolidated balance sheet of the banking system: 03/2007 (latest), 09/2007 (received), Frequency: Q Q Q.
- Interest rates: 03/2007 (latest), 07/2007 (received), Frequency: M M M.
- Consumer price index: 03/2007 (latest), 09/2007 (received), Frequency: Q Q Q.
- Revenue, expenditure, balance and composition of financing – general government: 2005/06 (latest), 06/2007 (received), Frequency: A A A.
- Revenue, expenditure, balance and composition of financing – central government: 2005/06 (latest), 06/2007 (received), Frequency: A A A.
- Stocks of central government and central government-guaranteed debt: 2005/06 (latest), 01/2007 (received), Frequency: A A A.
- External current account balance: 2005/06 (latest), 07/2007 (received), Frequency: A A A.
- Exports and imports of goods and services: 2005/06 (latest), 07/2007 (received), Frequency: A A A.
- GDP/GNP: 2005 (latest), 11/2006 (received), Frequency: A A A.
- Gross external debt: 03/2007 (latest), 07/2007 (received), Frequency: Q Q Q.

(Note: Frequency codes — Daily (D), Weekly (W), Monthly (M), Quarterly (Q), Annually (A), Irregular (I); Not Available (NA).)

### Public Sector Debt — Selected Figures (in percent of GDP)
- Total debt: 2001/02 59.6, 2002/03 77.5, 2003/04 84.7, 2004/05 86.3, 2005/06 81.9.
- Domestic debt: 2001/02 2.3, 2002/03 7.5, 2003/04 6.5, 2004/05 7.6, 2005/06 4.5.
- External debt: 2001/02 57.3, 2002/03 70.0, 2003/04 78.2, 2004/05 78.8, 2005/06 77.5.
- Of which: hydropower projects: 2001/02 36.1, 2002/03 45.5, 2003/04 53.8, 2004/05 55.7, 2005/06 53.6.
- Tala: 2001/02 21.5, 2002/03 29.8, 2003/04 37.9, 2004/05 41.5, 2005/06 41.6.
- Source: Royal Monetary Authority of Bhutan; and staff estimates.

### Joint IMF/World Bank Debt Sustainability Analysis — Key Points
- Document: Joint IMF/World Bank Debt Sustainability Analysis 2007 (prepared by IMF and IDA staffs; approved September 20, 2007).
- Assessment summary:
  - Debt ratios remain elevated in coming years due to additional hydropower projects.
  - Despite breach of some LIC-DSA indicative thresholds, staffs assess external debt dynamics are subject to a moderate risk of distress.
  - Rationale: near absence of commercial risk from major energy projects and high foreign exchange reserves relative to external indebtedness.
- Background:
  - At end 2005/06, total public and publicly guaranteed (PPG) debt about 82 percent of GDP; about half related to the Tala hydropower project financed by India.
  - Public debt increased by about 20 percentage points of GDP since 2001/02; Tala debt accounts for most of the increase.
  - Domestic debt, denominated in local currency and held by domestic financial institutions, remains moderate.
  - Indian rupee debt for the power sector amounted to 46¾ percent of GDP; convertible currency debt about 30 percent of GDP.
- Baseline assumptions (selected):
  - Real sector: Real GDP spikes as Tala comes on stream in 2006/07; Punatsangchu I commissioned in 2016. Hydropower construction and commissioning of Dagachu support interim growth. Inflation projected to remain in line with price developments in India; ngultrum pegged to the Indian rupee.
  - Fiscal sector: Higher revenues from hydropower corporations and tax base broadening will raise domestic revenue-to-GDP ratio; budgetary grants expected to moderate in absolute terms as national income rises.
  - External sector: Electricity exports jump when new projects come on stream; strong import growth for hydropower construction and increased debt service associated with Tala projected; current account deteriorates over medium term; long-run power sector contributes to balance of payment surpluses.
  - New non-hydropower financing assumed to have similar concessional terms as past loans.
- NPV and discounting:
  - NPV calculation uses a standard five percent discount rate for all loans.
  - Debt service for Tala includes repayment of interest during construction (IDC, which was deferred) but not interest on IDC.
- External debt sustainability — baseline:
  - Power sector Indian-rupee debt shapes external PPG debt and debt service dynamics.
  - In NPV terms, total and external public debt-to-GDP ratios projected to dip in 2006/07 and 2007/08 when Tala boosts GDP.
  - Over medium term, disbursements for new projects projected to offset repayments for Tala.
  - When Puna I comes on stream in 2016/17, NPV-to-GDP dips and remains below LIC-DSA indicative thresholds for strong policy performance countries.
  - Debt service ratios rise when repayments for large power projects begin, but moderate in the long run and remain below thresholds over most of the projection period.
  - Level of reserves: about 50 percent of GDP and ten months of import cover; projected to rise further, making repayment difficulties unlikely during periods when thresholds are breached.
- Sensitivity analysis (external):
  - Debt ratios decline over time under most alternative scenarios and eventually fall below thresholds.
  - Two most extreme stress tests: (i) new borrowing on less favorable terms; (ii) applying a one standard deviation shock to export growth.
  - Indicators deteriorate over medium term if current account excluding interest payments is set at historical average (biased upward by Tala-related imports and airplane purchases); scenario considered highly unlikely given recent electricity export pickup from Tala.
- Public debt sustainability — baseline:
  - Baseline public debt dynamics driven by external debt of power sector.
  - Over medium term, grant inflows of about 8−9 percent of GDP expected to limit overall fiscal deficit to 3−6 percent of GDP.
  - With foreign financing about 3⅓ percent of GDP, domestic financing should be limited to 1−2 percent of GDP, keeping domestic debt below 11 percent of GDP over medium term.
  - Long run: domestic revenue ratio projected at about 18 percent of GDP (via tax base broadening and administration improvements) to help achieve small overall fiscal surplus and reduce domestic debt.
- Public debt sensitivity analysis:
  - Public debt ratios remain on a declining path over long term under various stress tests.
  - Under a no-reform scenario with a primary deficit of 3.6 percent of GDP, debt ratios would not improve drastically.
  - Key policy priorities: contain capital expenditure and broaden domestic tax base to ensure public debt sustainability.

*Source: ANNEX IV: BHUTAN—STATISTICAL ISSUES (IMF staff report material).*

### 9.      Staffs view Bhutan’s debt dynamics as sustainable but subject to a moderate risk

### 9.      Staffs view Bhutan’s debt dynamics as sustainable but subject to a moderate risk

### Staff assessment
- The LIC-DSA indicators and stress tests show the breaching of some LIC-DSA thresholds and, on that basis alone, suggest that external debt dynamics should be characterized as subject to a high risk of distress.
- Taking into account mitigating factors (see below), staff characterize Bhutan’s debt dynamics as subject to a moderate risk of distress.

### Mitigating factors (supporting moderate risk characterization)
- Experience with hydropower projects:
  - Bhutan’s experience with construction, commissioning and management of large hydropower projects (which constitute the bulk of external debt) suggests the projects are subject to low implementation risk.
  - Hydropower projects have yielded expected growth dividends in the past: when Chukha came on stream in 1986, the electricity sector grew by 800 percent in 1985/86, 370 percent in 1986/87, and 60 percent in 1987/88, boosting overall GDP growth rate to 10 percent, 23 percent, and 17 percent, respectively.
  - Tala commissioning (delayed by a year to mid-2006) increased total electricity sales by 80 percent and exports by over 90 percent in 2006/07 compared to a year earlier, and was the main source of the 17 percent increase in real GDP over the same period.
  - Loan repayments for the Chukha hydropower project are expected to be completed in 2007/08, twenty years after commissioning in the mid-1980s.
- Puna I project economics:
  - Puna I is currently expected to have smaller real costs of construction than Tala for a larger generation capacity.
  - Puna I’s internal rate of return is estimated to be about 2 percentage points higher than Tala.
- Strong relationship with India reduces commercial risk:
  - India is both provider of financing for these large projects and the main consumer of their output.
  - Close bilateral dialogue covers financial and technical aspects, and wider support for annual budgets and five-year plans.
  - In the case of Tala, cost overruns were financed by India on the same concessional terms as the original loan agreement.

### Debt sustainability indicators and projections (selected baseline numbers and assumptions)
- Public sector debt (percent of GDP):
  - 2004/05: 86.3
  - 2005/06: 81.9
  - 2006/07: 71.3
  - 2007/08: 73.5
  - 2008/09: 69.2
  - 2009/10: 68.2
  - 2010/11: 70.6
  - 2011/12: 72.2
  - 2012/13: 71.7
  - 2017/18: 44.8
  - 2027/28: 11.7
- Of which external debt (percent of GDP):
  - 2004/05: 78.7
  - 2005/06: 77.5
  - 2006/07: 64.8
  - 2007/08: 64.0
  - 2008/09: 59.0
  - 2009/10: 57.1
  - 2010/11: 60.1
  - 2011/12: 62.4
  - 2012/13: 61.2
  - 2017/18: 38.1
  - 2027/28: 11.7
- Primary (noninterest) expenditure (percent of GDP):
  - 2004/05: 36.2
  - 2005/06: 34.1
  - 2006/07: 37.2
  - 2007/08: 33.1
  - 2008/09: 30.6
  - 2009/10: 28.9
  - 2010/11: 29.1
  - 2011/12: 27.9
  - 2012/13: 26.7
  - 2017/18: 19.8
  - 2027/28: 16.8
- Gross financing need 2/ (percent of GDP):
  - 2004/05: 8.3
  - 2005/06: 11.0
  - 2006/07: 4.8
  - 2007/08: 12.5
  - 2008/09: 12.9
  - 2009/10: 9.5
  - 2010/11: 10.1
  - 2011/12: 7.7
  - 2012/13: 6.7
  - 2017/18: 4.5
  - 2027/28: 1.4
- NPV of public sector debt-to-revenue and grants ratio (percent):
  - 2007/08: 235.7
  - 2008/09: 218.2
  - 2009/10: 215.5
  - 2010/11: 222.9
  - 2011/12: 244.6
  - 2012/13: 263.8
  - 2017/18: 191.3
  - 2027/28: 52.3
- Debt service-to-revenue and grants ratio (percent):
  - 2004/05: 7.7
  - 2005/06: 5.9
  - 2006/07: 7.7
  - 2007/08: 27.1
  - 2008/09: 25.3
  - 2009/10: 23.8
  - 2010/11: 22.1
  - 2011/12: 20.4
  - 2012/13: 19.2
  - 2017/18: 28.7
  - 2027/28: 11.1
- Key macroeconomic assumptions (selected):
  - Real GDP growth (percent):
    - 2004/05: 6.9
    - 2005/06: 9.1
    - 2006/07: 17.0
    - 2007/08: 8.6
    - 2008/09: 3.1
    - 2009/10: 14.4
    - 2010/11: 7.2
    - 2011/12: 6.3
    - 2012/13: 6.2
    - 2017/18: 6.4
    - 2027/28: 7.8
    - Medium-term averages include 4.0, 4.2, 5.2 in later projections.
  - Average nominal interest rate on forex debt (percent):
    - 2004/05: 1.4
    - 2005/06: 1.7
    - 2006/07: 1.4
    - 2007/08: 1.4
    - 2008/09: 0.2
    - 2009/10: 1.3
    - 2010/11: 1.4
    - 2011/12: 1.6
    - 2012/13: 1.7
    - 2017/18: 2.2
    - 2027/28: 2.5
  - Average real interest rate on domestic currency debt (percent) 6/ (including rupee debt):
    - 2004/05: -3.1
    - 2005/06: -3.4
    - 2006/07: -2.8
    - 2007/08: -4.3
    - 2008/09: 1.7
    - 2009/10: 3.0
    - 2010/11: 0.8
    - 2011/12: 0.6
    - 2012/13: 0.1
    - 2017/18: -0.4
    - 2027/28: -0.9

### External debt specifics and indicators
- External debt (nominal, percent of GDP):
  - 2004/05: 78.7
  - 2005/06: 77.5
  - 2006/07: 64.8
  - 2007/08: 64.0
  - 2008/09: 59.0
  - 2009/10: 57.1
  - 2010/11: 60.1
  - 2011/12: 62.4
  - 2012/13: 61.2
  - 2017/18: 38.1
  - 2027/28: 11.7
- Convertible currency debt (percent of GDP):
  - 2004/05: 30.5
  - 2005/06: 30.7
  - 2006/07: 26.2
  - 2007/08: 22.3
  - 2008/09: 22.7
  - 2009/10: 22.5
  - 2010/11: 24.6
  - 2011/12: 26.2
  - 2012/13: 25.7
  - 2017/18: 19.1
  - 2027/28: 11.7
- Rupee debt (percent of GDP):
  - 2004/05: 48.2
  - 2005/06: 46.8
  - 2006/07: 38.6
  - 2007/08: 41.7
  - 2008/09: 36.3
  - 2009/10: 34.6
  - 2010/11: 35.5
  - 2011/12: 36.2
  - 2012/13: 35.5
  - 2017/18: 19.1
  - 2027/28: 0.0
- Power sector debt (percent of GDP):
  - 2004/05: 55.7
  - 2005/06: 53.6
  - 2006/07: 44.0
  - 2007/08: 45.8
  - 2008/09: 40.7
  - 2009/10: 39.1
  - 2010/11: 41.7
  - 2011/12: 43.9
  - 2012/13: 42.9
  - 2017/18: 22.2
  - 2027/28: 0.0
- NPV of external debt (percent of GDP, selected):
  - 2007/08: 76.2
  - 2008/09: 57.5
  - 2009/10: 52.2
  - 2010/11: 51.1
  - 2011/12: 55.2
  - 2012/13: 59.3
  - 2017/18: 59.8
  - 2027/28: 34.5
  - Long-term projection point: 9.1

### Stress tests, sensitivity analyses, and scenarios
- Scenario labels and key stress tests (Table summaries retained):
  - Baseline projections provided for 2007/08–2027/28.
  - Alternative scenarios include:
    - A1. Real GDP growth and primary balance at historical averages.
    - A2. Primary balance unchanged from 2007/08.
    - A3. Permanently lower GDP growth.
  - Bound tests include shocks such as:
    - B1. Real GDP growth at historical average minus one standard deviation in 2008/09–2009/10.
    - B2. Primary balance at historical average minus one standard deviation in 2008/09–2009/10.
    - B4. One-time 30 percent real depreciation in 2008/09.
    - B5. 10 percent of GDP increase in other debt-creating flows in 2008/09.
- Outcomes:
  - Stress tests show that certain shocks can produce large increases in NPV of debt-to-GDP, debt-to-exports, and debt-service ratios in intermediate years (figures and tables present scenario trajectories through 2027/28).
  - Table 2 and Table 4 present sensitivity results for NPV of debt-to-GDP, NPV of debt-to-revenue, and debt service-to-revenue under alternative scenarios and bound tests (detailed numeric paths are in the tables).

### Policy recommendations and authorities’ actions (Executive Board and staff)
- Fiscal policy and debt management:
  - Limit domestically financed deficits and mobilize external aid on a timely basis to maintain public debt-to-GDP on a downward trajectory.
  - Plan expenditure in a medium-term framework.
  - Efforts to raise domestic revenues by broadening the tax base and strengthening tax administration, including through rationalization of the sales tax and import duty rates.
- Monetary and financial sector:
  - RMA should remain watchful of excess liquidity and rapid credit growth; steps to tighten monetary conditions were welcomed.
  - Enhance RMA capacity in monetary and foreign exchange reserve management; staff-supported technical assistance requested.
  - Limit balance sheet exposures of financial institutions to sectoral and macroeconomic risks; strengthen supervision and develop government securities markets to help manage liquidity.
- Exchange regime and external liberalization:
  - The peg of the ngultrum to the Indian rupee and the level of the peg remain appropriate.
  - If Tala revenues create upward pressures on the real exchange rate, fiscal tightening to moderate nontradables prices is advised.
  - Gradual liberalization of exchange restrictions is feasible given strong external position; eliminate restrictions subject to Article VIII approval as soon as possible and eliminate Article XIV restrictions when balance of payments permits.
  - Fund technical assistance to develop a foreign exchange market and market-based instruments to manage hard currency flows would facilitate removal of restrictions.
- Structural and growth-enhancing reforms:
  - Priority to private sector development and economic diversification to ensure job creation.
  - Align education system to market needs, strengthen infrastructure, and streamline regulatory regime.
  - Authorities’ plans to join the World Trade Organization were welcomed.
- Data and statistics:
  - Continue strengthening fiscal and external sector data.

### Key macro and fiscal snapshots (selected table and PIN highlights)
- Real GDP growth:
  - 2003/04: 7.2
  - 2004/05: 6.9
  - 2005/06: 9.1
  - 2006/07: 17.0
  - 2007/08 (Est./Proj): 14.4
- Consumer prices (period average, percent):
  - 2003/04: 4.3
  - 2004/05: 4.8
  - 2005/06: 4.9
  - 2006/07: 5.0
  - 2007/08 (Proj.): 4.8
- External sector (in millions of U.S. dollars):
  - Current account balance:
    - 2003/04: -73
    - 2004/05: -217
    - 2005/06: -29
    - 2006/07: 116
    - 2007/08 (Est.): 141
  - Exports (goods):
    - 2003/04: 158
    - 2004/05: 212
    - 2005/06: 312
    - 2006/07: 521
    - 2007/08 (Est.): 687
  - Imports (goods):
    - 2003/04: 263
    - 2004/05: 461
    - 2005/06: 435
    - 2006/07: 509
    - 2007/08 (Est.): 598
  - Gross official reserves (levels):
    - 2003/04: 383
    - 2004/05: 367
    - 2005/06: 479
    - 2006/07: 524
    - 2007/08 (Est.): 689
    - Reserve cover (months of goods and services imports): generally over nine months in recent years (e.g., 8.9, 8.9, 9.8, 9.2, 9.8).
- Public sector debt and composition:
  - Public sector debt (percent of GDP): see Public sector debt bullets above (e.g., 2006/07: 71.3; 2007/08: 73.5).
  - External debt (percent of GDP): see External debt bullets above (e.g., 2006/07: 64.8; 2007/08: 64.0).
  - Power sector debt (percent of GDP): 2006/07: 44.0; 2007/08: 45.8.
- Notable fiscal and debt events:
  - In 2006/07, domestically financed deficit (2 percent) was higher-than-budgeted (1½ percent of GDP projected earlier); purchase of an aircraft by Druk Air cost about US$39 million (4½ percent of GDP).
  - Debt service payments on Tala scheduled to begin in 2007/08; prior to that debt service ratio remained around 6(10) percent of exports (revenue) during the past five years.
  - In 2007/08, cumulative interest during construction for Tala (12 percent of GDP) is added to debt stock (as noted in tables).

*Sources: Data provided by the Bhutanese authorities; and Fund staff estimates and projections (IMF staff report and PIN, Article IV consultation with Bhutan, October 2007).*

### 1. On behalf of my authorities, I thank staff for the constructive policy discussions and

### _cr07350 - 1. On behalf of my authorities, I thank staff for the constructive policy discussions and

### Overview and recent macroeconomic performance
- Authorities welcome the staff appraisal and policy recommendations.
- Bhutan's macroeconomic performance since the last Article IV consultation has strengthened further, aided by prudent policymaking and strong donor support.
- Growth and social outcomes:
  - GDP growth targets have been exceeded.
  - Remarkable progress in social indicators; Bhutan is set to meet many Millennium Development Goals.
  - The ambitious growth targets of the 9th Plan have by and large been achieved, with external assistance flowing as anticipated.
- Political and international context:
  - Adoption of the Constitution and introduction of parliamentary democracy in 2008 represent a historic transformation, progressing peacefully and orderly.
  - Accession to the WTO is planned during 2008.
  - Bhutan has joined BIMSTEC, the IFC, SAFTA and the World Customs Organization.
  - Trade direction is gradually diversifying; share of partners like Hong Kong grew since the last review.
  - Strong economic links with India offer opportunities but also pose concentration risks.

### Key macroeconomic indicators and external accounts
- Growth and inflation:
  - Real GDP growth during 2006-07 is projected to almost double to 17 percent from 9 percent in the year before.
  - Annual inflation in 2006-07 at 5 percent, in line with price developments in India under the 1:1 peg to the Indian rupee.
- Exchange rates and reserves:
  - The Ngultrum has appreciated marginally against the US dollar; no significant bearing on competitiveness reported.
  - With electricity exports from Tala commencing in 2006-07, the current account balance shifted to a surplus of 10.6 percent of GDP.
  - Bhutan's foreign reserves presently cover 9 months of goods and services imports.
  - Rupee reserve ratio has declined to under one month (noted as a cyclical issue).
- Projected 2007-08 external position:
  - With commissioning of the Tala project, the current account is likely to remain in a surplus of about 10 percent of GDP.
  - Reserves expected to grow beyond present level of about 9 months of goods and services imports.
- Short-term rupee liquidity issue:
  - Rupee reserves dropped to less than one month's imports in July 2007; viewed as temporary and cyclical.
  - Contingency: negotiating a concessional rupee credit line with India if the situation persists.

### Fiscal policy: objectives, outcomes, and risks
- Overarching challenge:
  - Strengthen fiscal prudence and limit domestically financed deficits while financing ambitious infrastructure projects into the 10th Plan.
- Historical fiscal performance:
  - With generous grant assistance and expenditure control, overall deficits averaged 4 percent of GDP, below policy ceiling of 5 percent.
- Medium-term fiscal framework endorsed by authorities (staff assessment agreement):
  - Revenue receipts to GDP ratio should be maintained at about 18.5 percent.
  - Expenditure contained to about 31 percent of GDP, divided equally between capital and current expenditure.
  - Domestically financed deficits moderated to 1 - 2 percent of GDP.
  - Preconditions include ensuring Tala is fully commissioned by 2008, negotiating grant financing from India, and preparing contingency plans for shortfalls.
- 2006-07 and 2007-08 budget specifics:
  - 2006-07 domestically financed fiscal deficit target of 1.5 percent expected to be exceeded, leaving a deficit of about 2 percent of GDP due to centenary and constitutional setup spending.
  - 2007-08 budget (endorsed 11 June 2007): fiscal deficit anticipated at 4 percent of GDP in budget estimates, with 2.75 percent being the domestically financed deficit.
  - Budget priorities: 22 percent of the budget allocated to education and health (construction of outreach clinics, basic health units, expansion of educational infrastructure).
  - Domestic revenues expected to increase due to higher contributions from the Tala project.
  - If external aid shortfalls occur, the Royal Government may rely on domestic finances to meet expenditure plans.
- Debt sustainability:
  - Authorities aware of risks on debt sustainability but cite mitigating factors:
    - Most contracted debt intended for hydro-electric projects.
    - Strong implementation record: Chukha (336 MW), Kurichhu (60 MW), Tala (1020 MW).
    - Punatsangchhu and Dagchhu projects are in pipeline.
    - India committed to purchase at least 5000 MW of power from Bhutan by 2020.
    - Regular plan assistance is received as grants; Indian and Bhutanese authorities maintain regular contact.

### Monetary policy and financial sector oversight
- Exchange rate regime:
  - The Ngultrum–Indian rupee peg has served Bhutan well; peg and its level remain appropriate.
  - Immediate challenge: tighten monetary conditions to support the peg.
  - RMA monitoring and tools:
    - RMA maintaining close watch on liquidity; prepared to absorb excess liquidity.
    - Authorities are contemplating stepped up issuance of RMA Bills and an increase of the Cash Reserve Ratio.
- Article XIV/Article VIII and convertibility stance:
  - RMA authorities find it difficult to eliminate remaining restrictions under Article XIV and to accept obligations under Article VIII given currency composition of the balance of payments and concerns over hard currency outflows.
  - Given limited and unpredictable convertible currency inflows, liberalization must proceed cautiously, with further export diversification and developments in greater convertibility of the Indian rupee.
  - Authorities seek support for an extension to the arrangement.
- Financial sector performance and risks:
  - Private sector growth in credit exceeded 30 percent.
  - RMA conscious of risks from rapid private sector credit growth, notably concentration of credit in the housing sector; RMA closely monitoring and prepared to take prudential measures.
  - Need to provide more investment opportunities for commercial banks to address maturity mismatches by developing government bond market.
  - Financial market development requires strengthening RMA institutional capacity due to lack of adequate technical expertise.
  - RMA authorities seek long-term technical assistance on central banking from the Fund, preferring expertise familiar with Reserve Bank of India operations.

### Structural policies and sectoral developments
- Hydropower sector:
  - Hydropower is the engine of economic growth and expected to account for a larger share of the economy by the end of the Tenth Plan.
  - Tala project expected to generate up to installed capacity of 1020 MW by 2008.
  - July 2007 agreement signed for 1095 MW Punatsangchhu-I, expected completion by 2014.
  - Dagchhu project being implemented with Austrian assistance.
  - India committed to import minimum of 5000 MW by 2020, assuring evacuation.
- Tourism:
  - Authorities recognize significant potential; aim to promote Bhutan as a high-quality destination.
  - Target: increase annual tourist arrivals from about 13,000 in 2005 to about 30,000 by end of the Tenth Plan period.
  - Sector attracted largest FDI in recent years; some hotel chains investing.
- Employment and skills:
  - Challenge: providing employment to a rapidly growing labor force.
  - Policies: promote small scale industries, horticulture, floriculture and handicrafts to boost self-employment.
  - Royal Bhutan Vocational and Qualifications Authority to improve vocational training, job-oriented skill upgradation, and conduct job fairs to promote private sector employment.
- Trade liberalization and WTO accession:
  - Close trade links with India imply further liberalization will broadly follow India.
  - Regional trade agreements and WTO accession commitments will help streamline regulatory environment to international standards.
  - Authorities seeking IMF technical assistance to meet WTO accession commitments by 2008.

### Statistical improvements and data management
- Statistical modernization efforts:
  - CPI periodicity increased from half yearly to quarterly.
  - National income accounts shifted to SNA 1993.
  - Trade statistics compiled on fiscal year basis for Balance of Payments statistics; composition and direction of trade still on calendar year basis.
  - Efforts to improve frequency of RMA balance sheet preparation from monthly to weekly.
  - Efforts to reconcile domestic financing of the budget between fiscal accounts and the monetary survey.

### Concluding remarks
- Authorities acknowledge remaining challenges, including dependency on external aid and the need to avoid fiscal complacency.
- Authorities express gratitude to the IMF Executive Board and staff for continued support and helpful advice.

*Source: Address and authorities' statement in IMF staff report _cr07350.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07350.pdf_