## Bhutan: IMF staff report content unit _cr14178

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### INTRODUCTION — Key findings and context
- Significant gains during the Tenth Five Year Plan (2008/09–2012/13): steady increase in per capita incomes to middle-income levels and substantial reduction in poverty; marked improvement in social indicators; Bhutan has attained or is on track to achieve most of the MDGs.
- Bhutan pioneered a development approach based on Gross National Happiness (Box 1).
- Political stability maintained with elections and a smooth political transition in mid 2013.
- Growing external imbalances: rapid growth accompanied by overheating pressures and a sharp widening of the current account deficit, in part due to substantial hydro-power related imports.
- Macroeconomic policies and past Fund advice broadly aligned, but progress on fiscal consolidation and structural reforms has been slow; fiscal stance looser than staff recommended in 2011 and budgeted to remain high in FY2014.
- Important exact figures (selected):
  - FY2014 budgeted fiscal stance: described as "high in FY2014" (no additional number provided in this section).

### RECENT ECONOMIC DEVELOPMENTS
- Growth and sectoral developments:
  - GDP growth driven by the hydropower sector during the Tenth FYP.
  - Growth projected to have slowed to 5 percent in FY 2013 from over 10 percent in FY2011; slowdown attributed to policy efforts to moderate credit growth to contain overheating pressures.
  - Restrictions on credit for construction and vehicle imports led to a decline in services sector growth (particularly transport and financial services) and a decline in construction sector growth.
- Inflation:
  - Headline inflation reached 11.3 percent in December 2013, accelerating from 9.5 percent in December 2012.
  - Inflation remains elevated above double digits, mostly reflecting price developments in India given the peg to the Indian rupee.
  - Inflation projected to average above 10 percent in FY 2014, with an expectation to decline over the medium term in line with moderation in India’s inflation.
  - Staff analysis finds inflation in Bhutan is closely related to Indian inflation.
- External sector and reserves:
  - The current account (CA) deficit widened to 22.8 percent of GDP in FY 2013 from 15 percent of GDP on average over the 10th FYP, reflecting large hydropower-related imports and non-hydro imports from auxiliary activities and consumption/housing boom.
  - International reserves stood at US$ 933 million (over 10 months of import cover) in December 2013.
  - Robust aid inflows have led to a positive overall balance of payments position and enabled accumulation of international reserves.

### OUTLOOK AND RISKS
- Growth and current account projections:
  - Growth projected to recover to 6½ percent in FY2014.
  - Growth projected to rise to about 7½ percent in FY2015, driven mainly by pick-up in hydropower-related construction and domestic services.
  - CA deficit projected to widen further to around 25 percent in FY 2014 due to stronger hydro-related imports.
  - Over the medium term (Eleventh FYP): growth projected to average 8½ percent over the course of the Eleventh FYP, initially boosted by hydropower construction and later by electricity generation.
  - CA deficit projected to widen to more than 27 percent of GDP by FY2017.
  - If well managed, per-capita incomes could double to around US$5,000 by FY2019.
- Risks (tilted to the downside):
  - High debt levels and possible surfacing of financial sector vulnerabilities after prolonged rapid credit growth.
  - Potential renewed external pressures, including pressures on rupee reserves, if macroeconomic policies remain expansionary and credit growth rebounds strongly.
  - A potential slower-than-expected recovery in India—including due to financial market volatility.
- Mitigating factor:
  - Concentration of exports in hydropower, which enjoys healthy demand from power-constrained India.

### POLICY THEME #1 — MAINTAINING MACRO-ECONOMIC STABILITY

A. Fiscal Policy — background, figures and staff recommendations
- Recent fiscal outcomes and plans:
  - FY2013 fiscal deficit revised to 4 percent of GDP (from previous estimate of 1 percent), driven primarily by a shortfall in grants.
  - FY2014 budget aims for a deficit of 3.6 percent of GDP, mainly due to lower projected revenues and grants.
  - Off-budget Economic Stimulus Plan (ESP) financed by official grants from India: ngultrum 5 billion (about 4 percent of GDP) to be spent over 5 years:
    - ngultrum 4 billion to be provided to banks as subordinated debt and revolving funds to reinvigorate credit growth.
    - ngultrum 1 billion for subsidies for education, free electricity, financial support for senior citizens, and unemployment benefits.
  - Over the medium term (Eleventh FYP):
    - Grants expected to decline from 9 percent of GDP in 2012/13 to 6 percent by 2017/18.
    - Fiscal deficit projected to be around 1 percent of GDP (on average) during the plan period.
    - Government of India to provide Nu. 45 billion (or 21 percent of plan outlay) in the form of grants.
- Staff near-term recommendations:
  - Fiscal consolidation to prevent reemergence of overheating pressures.
  - Risks of persistent large deficits financed by domestic borrowing: crowding out private sector and buildup of public debt.
  - Revenue reforms essential:
    - Reduce number of zero-rated goods.
    - Simplify indirect tax rate structure.
    - Widen taxation of domestic activity.
    - Improve tax administration.
  - If further grant shortfalls occur, restrain spending while preserving social and productivity-enhancing expenditure.
  - Further civil service wage hikes without complementary revenue measures would deteriorate fiscal balances.
  - The ESP risks stoking overheating pressures which could translate into external pressures.
- Staff medium-term recommendations:
  - Spending restraint and prioritization to create fiscal space while avoiding public debt buildup.
  - Consider introducing a value-added tax to replace the existing system of indirect taxes.

Fiscal management improvements recommended
- Improve cash management (Fund TA being provided).
- Issue treasury bills planned and based on a cash forecasting framework rather than ad-hoc short-term borrowing.
- Enhance multi-year budget framework to better mobilize donor support.
- Coordinate development of a treasury bill market to facilitate issuance and develop demand for T-bills.

Authorities’ views (summary)
- Authorities broadly agreed with need for fiscal restraint and additional revenue-raising measures.
- Next Budget expected to include near-term tax measures and a broader medium-term tax policy review.
- Clarified ESP implementation to minimize risks to banks and possible excess aggregate demand; banks will serve as conduit and may advance loans on commercial basis if loans meet criteria of import substitution, export promotion, or employment promotion.
- A Pay Commission will recommend wage adjustments in public sector; recommendations expected in the near future.

B. Monetary Policy — background, figures and staff recommendations
- Recent developments and tools:
  - Banking system liquidity: ample at around 10 percent of GDP (recently).
  - Tight liquidity emerged in June 2011 (shortfall of Nu 1.1 bn or 1.5 percent of GDP).
  - RMA responses included cutting CRR twice, banning construction and vehicle loans, relaxing provisioning requirements, suspending overnight sweeping of government accounts, introduction of RSTLAW in March 2012, and a base rate system.
  - Persistent negative interest rate differential with India remains.
- Treasury bills and government financing:
  - Ways and Means (W&M) account available at RMA up to a limit of 10 percent of average revenues over the last two years.
  - Overdraft facility with the largest commercial bank could be overdrawn without limit.
  - Treasury bills rarely issued for monetary policy purposes nor at market-determined interest rates; since February 2013 T-bill interest rate fixed at about 3 percent.
- Staff recommendations:
  - Tighten monetary conditions to ward off prospective overheating and better manage pressures on rupee reserves.
  - Monitor liquidity conditions closely and adjust promptly to prevent excessive credit growth.
  - Specific measures:
    - Adjust the CRR upward.
    - Regularly and increasingly issue T-bills to mop up excess liquidity as markets develop.
    - Fully sterilize hydropower-related inflows and aid flows.
    - Maintain tighter macropolicy stances to help address competitiveness concerns.

### ENHANCING MONETARY TRANSMISSION AND GOVERNMENT SECURITIES MARKET
- Key constraints:
  - Interest rates need to be higher and more closely aligned with those prevailing in India.
  - New policy rate introduced but "not yet operationally effective".
  - Framework constrained by limited range of government securities and lack of money and securities markets.
- Medium-term development priorities:
  - Formal interbank market.
  - Increased and regular issuance of T-bills and bonds.
- Rationale for government securities market:
  - Critical for making monetary policy more effective; enhances financial markets and banking health; provides a risk-free benchmark and a yield curve; creates an investment vehicle for financial institutions and a tool for open market operations.
- Operational recommendations (selected):
  - Publish an issuance calendar for Treasury bills and commit to float meaningful amounts even when there is no financing need.
  - Establish an automated depository for registering treasury bills at the RMA.
  - Issue T-bills with maturities and amounts determined by expected liquidity management needs; RMA to persistently promote short-term securities market development.
  - Redesign reserve requirement system: merge CRR and current account into one account and allow averaging over a maintenance period (current reserve ratio noted as 5 per cent).
  - Introduce a short-term overnight standing lending facility (one week) and redesign RSTLAW as a Lender-of-last-resort facility.

### LIQUIDITY MANAGEMENT AND BANK RESERVES
- Liquidity management should ensure stability in bank reserves to link quantities (bank reserves) and the price of reserves (market interest rates).
- Demand for reserves in Bhutan linked to CRR and SLR; SLR currently unusual and high (statutory levels later cited at 34–36 percent).
- Surplus reserves concept: manage "true" excess reserves above statutory requirements and banks’ own demand.
- Recommended actions:
  - Reactivate liquidity monitoring framework using government cash flow projections (including hydropower flows).
  - Limit use of sweeping arrangement to clearly eligible accounts and refrain from using sweeping for normal liquidity flows.
  - Strengthen coordination between MoF and RMA on debt and liquidity management; regular Treasury Bills Management Committee meetings.

### EXTERNAL SECTOR, RESERVES, AND EXCHANGE RATE
- Exchange rate peg with India has served Bhutan well; peg remains appropriate given trade and development ties.
- The ngultrum is currently assessed to be overvalued by between 8–21 percent (various REER methodologies).
- Reserve composition and rupee needs:
  - Rupee debt constitutes 61 percent of total external debt; convertible currency debt accounts for 29 percent.
  - Recommendations: gradually increase share of rupee reserves; adopt reserve management and investment guidelines; consider converting convertible currency reserves to rupees beyond a threshold while considering constitutional and essential import cover requirements.
- Recent facilities and interventions used:
  - Reserve sales of US$200 million each by the RMA in December 2011 and June 2013.
  - Bilateral swap agreement of US$100 million with the Reserve Bank of India agreed in March 2013 (subsequently used and reversed in September 2013).
  - Foreign exchange overdrafts with Indian commercial banks; line of credit with the Government of India.
- External debt and borrowing stance:
  - Avoid additional non-concessional borrowing given substantially increased debt levels relative to previous DSAs.
  - LIC-DSA indicates moderate risk of distress with several thresholds breached for prolonged periods.

### FINANCIAL SECTOR STABILITY — Key indicators and vulnerabilities
- Credit and leverage:
  - Private sector credit grew at an average annual rate of 30 percent during 2002–11; credit increased from 11 to 47 percent of GDP over that period.
  - Private credit growth decelerated to 7.4 percent year-on-year in November 2013; credit-to-GDP ratio fell to 43 percent in 2013.
- Financial soundness indicators (system-wide, September 2013):
  - Capital Adequacy Ratio (CAR): 18 percent (with variation across banks).
  - Statutory Liquidity Requirement (SLR): 36 percent (regulatory minimum 20 percent).
- Asset quality:
  - Non-performing loans (NPLs) rose from 8 percent in June 2012 to 12 percent in September 2013.
- Funding and liquidity structure:
  - Bank credit-to-deposit ratio eased to 86 percent in September 2013 from over 105 percent in June 2012.
  - Corporate deposits constitute a significant and volatile share of deposit base.
- Concentration of lending:
  - Building and construction loans: more than a quarter of the financial sector’s portfolio.
  - Personal loans: around 16–18 percent of credit outstanding (figures vary across sections).
- Stress test findings:
  - Proportional increase in NPLs to 18.4 percent reduces system-wide CAR by 6.7 percentage points.
  - Souring of large exposures lowers system-wide CAR by 8.6 percentage points and by 12.6 percentage points for one bank.
  - Under all credit risk scenarios, several banks’ CARs fell below 10 percent.

Policy recommendations on financial regulation and deepening
- Strengthen regulation and supervision:
  - Close gaps in regulation; resume onsite supervision; adopt risk-based supervisory approach; require regular stress-testing by RMA and by banks.
  - Put in place crisis management and deposit insurance arrangements.
- Macroprudential framework:
  - Continue macroprudential policies but reduce reliance on a single tool; introduce additional tools including credit-to-deposit, loan-to-value, and debt-to-income limits.
  - Debt-to-income ratio limits could be considered to support individual credit assessment.
- Market and non-bank development:
  - Prepare and implement a comprehensive Financial Sector Development Strategy (FSD Strategy).
  - Develop a government securities market, corporate bond market, and promote alternatives to bank financing.
  - Institute investment guidelines for non-banks.
- Financial inclusion and capacity:
  - Improve finance for micro and small/medium enterprises; expand credit information and collateral registry use.
  - Support financial literacy and consumer protection frameworks.
  - Address skills shortages in the banking sector and promote accounting, auditing, actuarial capacity.

### HYDROPOWER DEVELOPMENT, DEBT SUSTAINABILITY, AND MACRO IMPLICATIONS
- Hydropower pipeline:
  - Baseline plan to expand capacity toward about 10,000 MW by 2020; total pipeline capacity listed as 11,066 MW across projects.
  - Selected projects and capacities include Punatsangchhu I: 1,200 MW; Punatsangchhu II: 1,020 MW; Mangdechhu: 720 MW; Sankosh Storage: 2,650 MW; Kuri Gongri: 2,640 MW; Amochhu Storage: 540 MW; Wangchhu: 570 MW; Bunakha Storage: 180 MW; Kholongchhu: 600 MW; Chamkarchhu I: 770 MW; Dagachhu: 126 MW (completed).
- Public and external debt figures and projections:
  - PPG external debt increased to 85 percent of GDP at end 2012/13, adding 14 percentage points of GDP to the previous year.
  - Hydropower-related external borrowing accounts for an outstanding stock of 48 percent of GDP.
  - Currency composition of external debt: Indian rupee-denominated debt 61 percent; convertible currency debt 29 percent.
  - Baseline External DSA projections:
    - External debt projected to rise to 121 percent of GDP in 2016/17 (in line with hydropower disbursements) and decline slightly to 116 percent of GDP in 2017/18.
    - Stock of PPG external debt expected to gradually decline to about 29 percent in 2034.
    - PV of PPG external debt-to-GDP projected to decline to 25 percent in the long term.
    - PV of PPG external debt to revenue peaks at 750 percent in 2014/15 and falls below 300 percent only in the long run.
  - Staff assessment: risk of external debt distress is moderate given mitigating factors (explicit guarantees from India, cost-plus power purchase terms with a net return of 15 percent, strong project track record, India’s demand for electricity, committed donor support, and high international reserves).
  - Staff cautions against further non-concessional borrowing.

### DIVERSIFICATION, PRIVATE SECTOR, AND JOB CREATION
- Government objectives:
  - Use hydropower revenues to encourage broad-based growth: tourism, niche products (organic foods, horticulture), forestry, ICT-related industries, and green growth.
  - Tourism target: increase tourist arrivals to 200,000 by 2018 (a fourfold increase from 2012).
- Staff views and policy guidance:
  - Diversification will ease pressures on external balances, lower output volatility and promote employment creation.
  - Use hydropower revenues to address skills mismatch and invest in infrastructure; improve connectivity and enhance FDI to facilitate technology transfer.
  - Monitor tax incentives closely; include sunset clauses.
- Measures to support diversification:
  - Improve business climate indicators.
  - Improve access to finance for micro and SMEs and develop capital markets for larger corporates.
  - Address skills mismatches through training, vocational training, and expanded technical education.

### DATA, STATISTICS, AND TECHNICAL ASSISTANCE
- Data adequacy and quality (as of April 30, 2014):
  - Data provision has shortcomings but is broadly adequate for surveillance; most affected areas: national accounts, balance of payments, and fiscal data.
  - CPI compiled quarterly since 2004; monthly CPI series for domestic and imported goods starting January 2013; monthly series short for surveillance.
  - RMA compiles and disseminates quarterly balance of payments data; began supplying BOP data for publication in IFS in November 2010 and submits BPM6-format data to the Fund.
- Technical assistance and development partner engagement:
  - IMF TA provided in National Accounts Statistics, Treasury Management, Financial Sector Surveillance, Balance of Payments, and Foreign Exchange and Reserve Management.
  - World Bank, ADB, IDA, IFC and MIGA engagement summarized across lending, grants and advisory programs with specific project amounts and disbursements noted in source.

### ANNEX I — Key recommendations on enhancing financial sector surveillance and development (selected, timing and priority preserved)
- Develop a comprehensive Financial Sector Development Strategy. (Timing: Medium Term; Priority: High)
- Publish an issuance calendar for Treasury bills and commit to float meaningful amounts even when there is no financing need. (Timing: Short Term; Priority: High)
- Establish an automated depository for registering treasury bills at the RMA. (Timing: Medium Term; Priority: High)
- Enable secured transactions by expanding the collateral registry. (Timing: Short Term; Priority: High)
- Resume onsite supervision within an annual supervisory plan for risk-based work. (Timing: Short Term; Priority: High)
- Introduce occasional stress testing exercises; require banks to run simple adverse scenarios and report results. (Timing: Short Term; Priority: High)
- Merge reserve requirement and current accounts and allow reserve averaging. (Timing: Short Term; Priority: High)
- Reduce gradually use of the government’s overdraft facility in a commercial bank and restrict use of the overdraft facility at the RMA. (Timing: Short Term; Priority: High)
- Agree on a Memorandum of Understanding specifying how RMA could be reimbursed for the cost of monetary policy. (Timing: Short Term; Priority: High)
- Continue expanding financial literacy campaigns among underserved groups. (Timing: Short Term; Priority: High)

Key actionable recommendations (selected summary)
- Develop a credible Treasury bill program and issuance calendar; float meaningful amounts regularly.
- Reduce reliance on bank financing for government needs; restrict overdrafts and Ways-and-Means abuse.
- Strengthen RMA–MoF coordination on liquidity and debt management; establish automated depository and market infrastructure.
- Tighten fiscal and monetary stances in near term; sterilize hydropower and aid inflows; adjust CRR upward and use T-bills to mop up liquidity.
- Strengthen supervision, introduce regular stress testing, develop macroprudential toolkit (including debt-to-income and loan-to-value limits), and prepare a phased financial sector development strategy.
- Use hydropower revenues to support diversification, skills, connectivity and private-sector development while avoiding overheating and non-concessional borrowing.

*Source: INTRODUCTION, RECENT ECONOMIC DEVELOPMENTS, OUTLOOK AND RISKS, POLICY THEME #1—MAINTAINING MACRO-ECONOMIC STABILITY, monetary and fiscal sections, financial sector assessment, hydropower and DSA material, boxes and Annex I from IMF staff report content unit _cr14178.*

### INTRODUCTION __________________________________________________________________________________  4

### INTRODUCTION

### Key findings and context
- Significant economic and social gains during the Tenth Five Year Plan (spanning 2008/09–2012/13): steady increase in per capita incomes to middle-income levels and substantial reduction in poverty; marked improvement in social indicators; Bhutan has attained or is on track to achieve most of the MDGs.
- Bhutan pioneered a development approach based on Gross National Happiness (Box 1).
- Political stability maintained with elections and a smooth political transition in mid 2013.
- Notwithstanding successes, growing external imbalances have emerged: rapid growth accompanied by overheating pressures and a sharp widening of the current account deficit, in part due to substantial hydro-power related imports.
- Macroeconomic policies and past Fund advice broadly aligned, but progress on fiscal consolidation and structural reforms has been slow; fiscal stance looser than staff recommended in 2011 and budgeted to remain high in FY2014.

### Important exact figures (selected)
- Per capita incomes described as reaching middle-income levels (no additional number provided in this section).
- FY2014 budgeted fiscal stance: described as "high in FY2014" (no additional number provided in this section).

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### RECENT ECONOMIC DEVELOPMENTS

### Growth and sectoral developments
- GDP growth driven by the hydropower sector during the Tenth FYP.
- Growth projected to have slowed to 5 percent in FY 2013 from over 10 percent in FY2011; slowdown attributed to policy efforts to moderate credit growth to contain overheating pressures.
- Restrictions on credit for construction and vehicle imports led to a decline in services sector growth (particularly transport and financial services) and a decline in construction sector growth.

### Inflation
- Inflation remains elevated above double digits, mostly reflecting price developments in India given the peg to the Indian rupee.
- Headline inflation reached 11.3 percent in December 2013, accelerating from 9.5 percent in December 2012.
- Inflation projected to average above 10 percent in FY 2014, with an expectation to decline over the medium term in line with moderation in India’s inflation.
- Staff analysis finds inflation in Bhutan is closely related to Indian inflation (see Box 2).

### External sector and reserves
- The current account (CA) deficit widened to 22.8 percent of GDP in FY 2013 from 15 percent of GDP on average over the 10th FYP, reflecting large hydropower-related imports and non-hydro imports from auxiliary activities and consumption/housing boom.
- Robust aid inflows have led to a positive overall balance of payments position and enabled accumulation of international reserves.
- International reserves stood at US$ 933 million (over 10 months of import cover) in December 2013.

---

### OUTLOOK AND RISKS

### Growth and current account projections
- Near-term growth momentum expected to pick up:
  - Growth projected to recover to 6½ percent in FY2014.
  - Growth projected to rise to about 7½ percent in FY2015, driven mainly by pick-up in hydropower-related construction and domestic services.
- CA deficit projected to widen further to around 25 percent in FY 2014 due to stronger hydro-related imports.
- Over the medium term (Eleventh FYP):
  - Growth projected to average 8½ percent over the course of the Eleventh FYP, initially boosted by hydropower construction and later by electricity generation.
  - CA deficit projected to widen to more than 27 percent of GDP by FY2017.
  - If well managed, per-capita incomes could double to around US$5,000 by FY2019.

### Risks (tilted to the downside)
- Risks stem from:
  - High debt levels and possible surfacing of financial sector vulnerabilities after prolonged rapid credit growth.
  - Potential renewed external pressures, including pressures on rupee reserves, if macroeconomic policies remain expansionary and credit growth rebounds strongly.
  - A potential slower-than-expected recovery in India—including due to financial market volatility.
- Mitigating factor:
  - Concentration of exports in hydropower, which enjoys healthy demand from power-constrained India (see Box 4).

---

### POLICY THEME #1—MAINTAINING MACRO-ECONOMIC STABILITY

### Overarching near-term challenge
- Support growth while ensuring macroeconomic stability and containing external pressures.
- Fiscal and monetary policies should be tightened and reserve management strengthened in face of recurrent pressures on rupee reserves.

### A. Fiscal Policy

Background and recent developments
- FY2013 fiscal deficit revised to 4 percent of GDP (from previous estimate of 1 percent), driven primarily by a shortfall in grants.
- FY2014 budget aims for a deficit of 3.6 percent of GDP, mainly due to lower projected revenues and grants.
- An off-budget Economic Stimulus Plan (ESP), financed by official grants from India, prepared in the amount of ngultrum 5 billion (about 4 percent of GDP) to be spent over 5 years:
  - ngultrum 4 billion to be provided to banks as subordinated debt and revolving funds to reinvigorate credit growth.
  - ngultrum 1 billion for subsidies for education, free electricity, financial support for senior citizens, and unemployment benefits.
- Over the medium term (Eleventh FYP), donor financing projected to fall as per capita incomes rise:
  - Grants expected to decline from 9 percent of GDP in 2012/13 to 6 percent by 2017/18.
  - Fiscal deficit projected to be around 1 percent of GDP (on average) during the plan period.
  - Government of India to provide Nu. 45 billion (or 21 percent of plan outlay) in the form of grants.

Staff views and recommendations (near term)
- Fiscal policy should aim for consolidation to prevent reemergence of overheating pressures.
- Risks of persistent large deficits financed by domestic borrowing: crowding out private sector and buildup of public debt.
- Revenue reforms essential:
  - Reduce number of zero-rated goods.
  - Simplify indirect tax rate structure.
  - Widen taxation of domestic activity.
  - Improve tax administration.
- If further grant shortfalls occur, restrain spending while preserving social and productivity-enhancing expenditure.
- Further civil service wage hikes without complementary revenue measures would deteriorate fiscal balances.
- The ESP risks stoking overheating pressures which could translate into external pressures.

Staff views and recommendations (medium term)
- Place public finances on more solid footing given projected decline in donor financing and potential delays in hydropower project commissioning:
  - Spending restraint and prioritization to create fiscal space for development-related expenditure while avoiding public debt buildup.
  - Consider introducing a value-added tax to replace the existing system of indirect taxes to boost revenue collection through a wider base and better enforcement.

Fiscal management improvements
- Need to improve cash management (Fund TA being provided).
- Government cash balances prone to sharp fluctuations due to erratic and volatile inflows, particularly grants, necessitating large precautionary balances.
- Domestic financial markets are shallow and underdeveloped; treasury bills are not issued regularly enough to handle fiscal volatility.
- Recommendations:
  - Issue treasury bills planned and based on a cash forecasting framework rather than ad-hoc short-term borrowing.
  - Enhance multi-year budget framework to better mobilize donor support.
  - Coordinate development of a treasury bill market to facilitate issuance and develop demand for T-bills.

Authorities’ views
- Authorities broadly agreed with need for fiscal restraint and additional revenue-raising measures.
- Next Budget expected to include near-term tax measures and a broader medium-term tax policy review.
- Fiscal measures likely to replace administrative measures restricting imports of vehicles and construction items.
- Authorities noted larger domestic borrowing in FY2013 resulted from cash management needs as grants were delayed.
- Clarified ESP will be implemented to minimize risks to banks and possible excess aggregate demand: banks will serve as conduit for financing and may advance loans on commercial basis if loans meet criteria of import substitution, export promotion, or employment promotion.
- A Pay Commission will recommend wage adjustments in public sector; recommendations expected in the near future.

### B. Monetary Policy

Background and recent developments
- Banking system experienced tight liquidity in 2011–2012 but conditions have eased recently; presently banking sector liquidity ample at around 10 percent of GDP.
- Excess bank liquidity existed from 2008 to early-2011 due to hydropower and non-hydro inflows only partially sterilized.
- Tight liquidity conditions emerged in June 2011 (shortfall of Nu 1.1 bn or 1.5 percent of GDP) due to:
  - Persistent growth in rupee imports with equivalent drain on local currency liquidity.
  - Reduction in retail deposits.
  - Over-dependence on volatile and seasonal corporate and government deposits.
  - Bank financing of large investment projects.
- RMA responses included cutting CRR twice, banning construction and vehicle loans, relaxing provisioning requirements, and suspending overnight sweeping of government accounts from banks to the RMA, which eased liquidity.
- RMA introduced a Short-Term Liquidity Adjustment Window (RSTLAW) in March 2012 with a newly-introduced policy rate linked to the RSTLAW facility.
- A base rate system was introduced to influence credit growth, increase transparency of loan pricing, and foster lending discipline.
- Persistent negative interest rate differential with India remains.

Treasury bills and government financing
- Despite substantial financing requirements recently, government has continued to rely on bank financing rather than Treasury bill issuance.
- Ways and Means (W&M) account available at RMA up to a limit of 10 percent of average revenues over the last two years.
- Overdraft facility with the largest commercial bank could be overdrawn without limit.
- Government first utilizes cheaper W&M account before making use of overdraft.
- Treasury bill issuance largely detached from financing requirements since December 2009; T-bills rarely issued for monetary policy purposes nor at market-determined interest rates.
- Since February 2013, T-bill interest rate fixed at about 3 percent, far below deposit rates and the policy rate.

Staff views and recommendations
- Monetary conditions should be tightened to ward off prospective overheating and better manage pressures on rupee reserves.
- Monitor liquidity conditions closely and adjust promptly to prevent excessive credit growth.
- Specific measures:
  - Adjust the CRR upward.
  - With further market development, regularly and increasingly issue T-bills to mop up excess liquidity.
  - Fully sterilize hydropower-related inflows and aid flows to dampen inflation pressures and credit growth, thereby obviating the need for import compression.
  - Maintain tighter macropolicy stances to help address competitiveness concerns.

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*Source: INTRODUCTION, RECENT ECONOMIC DEVELOPMENTS, OUTLOOK AND RISKS, POLICY THEME #1—ENSURING MACRO-ECONOMIC STABILITY, A. Fiscal Policy, and B. Monetary Policy (excerpts) from the IMF staff report content unit _cr14178.*

### 20. Despite progress, considerable enhancements to the monetary transmission

### 20. Despite progress, considerable enhancements to the monetary transmission

### Monetary transmission and government securities
- Interest rates need to be higher and be more closely aligned with those prevailing in India.
- A new policy rate has been introduced but is "not yet operationally effective".
- The framework for monetary operations is underdeveloped, constrained by:
  - limited range of government securities;
  - lack of money and securities markets.
- Over the medium term, development priorities include:
  - a formal interbank market;
  - increased and regular issuance of T-bills and bonds.
- Rationale for a government securities market:
  - critical for making monetary policy more effective;
  - enhances financial markets and banking system health;
  - provides a risk-free benchmark and eventually a yield curve;
  - creates an investment vehicle for financial institutions and a tool for open market operations.
- Authorities are exploring additional liquidity management instruments beyond current tools (including the overnight sweeping facility).

### Authorities’ views on liquidity and credit measures
- Authorities agreed on the need to monitor bank liquidity and credit conditions more closely.
- External flows should be fully sterilized.
- Current tools are insufficient; exploring other instruments to manage liquidity.
- Administrative restrictions have reduced credit growth but are "not optimal" and will be rolled back once the macroeconomic policy stance is sufficiently tight.

### External sector issues — background and recent measures
- Convertible currency reserves are much larger than rupee reserves; rupee reserves have constituted less than 3 percent of reserves on average during the past 5 years.
- Rapid credit growth and hydropower-related imports contributed to strong demand for rupees, culminating in rupee shortages.
- Reserve responses and facilities used:
  - two reserves sales of US$200 million each by the RMA in December 2011 and June 2013;
  - foreign exchange overdrafts with Indian commercial banks;
  - line of credit with the Government of India;
  - bilateral swap agreement of US$100 million with the Reserve Bank of India agreed in March 2013 (subsequently used and reversed in September 2013).
- These instruments provided immediate relief but are expensive and do not address structural need to mobilize rupee reserves.

### Staff assessment of exchange rate and reserves
- The exchange rate peg with India has served Bhutan well; peg remains appropriate as India is Bhutan’s largest trade and development partner.
- The ngultrum is currently assessed to be overvalued by between 8–21 percent.
- This overvaluation is projected to dissipate once additional hydropower revenues materialize over the medium term.
- Bhutan has ample reserves: reserve cover exceeds standard measures of reserve adequacy and is much higher than peer countries.
- Risks to reserve management:
  - hydropower-related rupee debt service payments are lumpy with timing mismatches between rupee inflows and outflows;
  - currency composition of reserves should be more closely aligned with external liabilities and trade (sources of rupee-currency liquidity needs).
- Rupee debt constitutes 61 percent of total external debt in Bhutan; convertible currency debt accounts for 29 percent.
- India is the largest trading partner: about 80 percent of Bhutan’s commodity exports are destined for India and about 70 percent of Bhutan’s imports are from India.
- Recommendations:
  - gradually increase the share of rupee reserves;
  - adopt reserve management and investment guidelines;
  - consider converting convertible currency reserves to rupees beyond a threshold based on essential imports and other payments, while taking into account the constitutional requirement that the RMA hold 12 months of essential imports cover, third country imports, and debt servicing requirements.
- Recent exchange restrictions introduced (identified as subject to Fund approval under Article VIII, Section 2(a)) include a set of measures limiting access to foreign exchange and Indian rupees for certain residents and transactions; authorities should eliminate these restrictions upon establishing necessary macroeconomic and structural conditions.

### External debt and borrowing stance
- External debt is projected to rise significantly over the medium term due to construction of new hydropower projects.
- LIC-DSA indicates Bhutan’s debt dynamics are subject to moderate risk of distress; several LIC-DSA thresholds are breached for prolonged periods.
- Mitigating factors: strong track record of project implementation, commercial viability, close ties with India (main financier and key electricity consumer).
- Recommendation: avoid additional non-concessional borrowing given substantially increased debt levels relative to previous DSAs.

### Financial sector stability — key indicators and vulnerabilities
- Private sector credit:
  - grew at an average annual rate of 30 percent during 2002–11;
  - credit increased from 11 to 47 percent of GDP over that period;
  - median for lower middle-income countries: 32 percent;
  - "expected norm" based on regression: 27 percent.
- Credit dynamics and policy responses:
  - administrative measures (banning housing and vehicle loans) were used to slow credit in response to rupee shortages;
  - private credit growth decelerated to 7.4 percent year-on-year in November 2013;
  - credit-to-GDP ratio fell to 43 percent in 2013.
- Financial soundness indicators (system-wide, September 2013):
  - Capital Adequacy Ratio (CAR) remained high at 18 percent in September 2013 (with considerable variation across banks);
  - Statutory Liquidity Requirement (SLR) was 36 percent in September 2013 (regulatory minimum 20 percent) but SLR includes unsecured longer-term bank deposits with other banks and non-banks, heightening systemic risk.
- Asset quality:
  - Non-performing loans (NPLs) rose from 8 percent in June 2012 to 12 percent in September 2013;
  - some sectors (trade and commerce, personal loans) show much sharper increases in NPLs.
- Liquidity and funding structure:
  - bank credit-to-deposit ratio eased to 86 percent in September 2013 from over 105 percent in June 2012;
  - a significant proportion of deposit base is corporate deposits which tend to be short-term, seasonal, and volatile, while bank credit is concentrated in longer-term loans, creating asset-liability mismatches.
- Concentration of lending:
  - more than a quarter of the financial sector’s portfolio consists of building and construction loans;
  - personal loans constitute around 16 percent of credit outstanding.
- Stress testing:
  - scenario (i) large increase in NPLs would reduce the banking system’s CAR by 7 percentage points;
  - scenario (ii) souring of large exposures would have a sizeable impact on a large state-owned bank and a private bank with most significant large exposures.

### Policy recommendations on financial regulation and deepening
- Strengthen financial sector regulation and supervision:
  - close gaps in regulation;
  - regular stress-testing by the RMA to monitor risks;
  - encourage banks to conduct their own stress tests;
  - put in place crisis management and deposit insurance arrangements.
- Macroprudential policy:
  - continue using macroprudential policies but reduce reliance on a single tool (adjustment of risk weightings);
  - undertake regular review of sector-wide risks;
  - introduce additional macroprudential tools including credit-to-deposit, loan-to-value, and debt-to-income limits, sequenced appropriately with sufficient compliance time for financial institutions.
- Non-bank sector:
  - institute investment guidelines for non-banks;
  - complement limits on non-bank lending with measures to enhance investment opportunities (e.g., development of long-dated government securities).
- Financial deepening and inclusion:
  - prepare and implement a comprehensive Financial Sector Development Strategy (under way with World Bank assistance) to sequence reforms in a medium-term plan;
  - promote alternatives to bank financing—develop commercial bond market and private equity markets over the medium term;
  - consider floating minority shares of public enterprises to broaden investment opportunities;
  - continue efforts to promote financial literacy.

### Diversifying growth and inclusiveness
- Policy priority: diversify the economy to make growth more sustainable and less volatile and reduce reliance on hydropower.
- Diversification rationale:
  - cross-country research links trade and real sector diversification to lower output volatility;
  - hydropower expansion boosted growth but increased growth volatility and provides limited employment opportunities;
  - exports have become more concentrated over the last decade.
- Medium-term objective: greater private sector development and job creation to support sustainable and inclusive growth.

*Source: IMF staff report.*

### 36. The development of new sectors, export diversification and job creation are central

### 36. The development of new sectors, export diversification and job creation are central

### Government policy and objectives
- Economic Development Policy (Five Year Plans; “Vision 2020”) emphasizes leveraging hydropower development to achieve broad-based growth by encouraging:
  - Tourism and related services
  - Niche products and activities: organic foods, horticulture, cash cropping, forestry and related activities, ICT-related industries
  - Green growth consistent with environmental conservation and sustainable development
- Tourism target: increase tourist arrivals to 200,000 by 2018 (a fourfold increase from 2012).

### Staff views on diversification and growth
- Rationale:
  - Economic diversification will ease pressures on external balances, lower output volatility and promote employment creation.
  - Hydropower exports are expected to dominate export receipts in the medium term as large projects come on-stream, but hydropower revenues should be leveraged to encourage a wider range of private sector activity.
- Sectors for focus:
  - Tourism, education and other green services
  - Niche agricultural products (such as organic products)
  - Power-intensive manufacturing industries
- Policy instruments and cautions:
  - Use hydropower revenues to address skills mismatch and invest in infrastructure
  - Improve connectivity and enhance FDI to facilitate technology transfer
  - Monitor tax incentives closely; include sunset clauses

### Measures to support diversification: investment climate, finance, and skills
- Investment climate:
  - Address Bhutan’s relatively weak performance on various business climate indicators
- Access to finance:
  - Improve finance for micro and small/medium enterprises
  - Encourage development of capital markets for large corporates
  - Increase bank finance for micro and small and medium-sized enterprises (including enhanced credit information)
- Labor market and skills:
  - Address skills mismatches through enhanced training, vocational training, and expanded technical education
  - Improve access to job-related information to upgrade labor force skills and promote employment creation

### Authorities’ perspectives
- Agreement that diversification is critical for long-term development prospects.
- Expect limited options for raising competitiveness concentrated in niche sectors (particularly agricultural products), which can boost employment given limited employment potential in hydropower.
- In tourism, infrastructure development (including improved connectivity) is key to reducing seasonality and concentration in western Bhutan.

### Staff appraisal — macroeconomic risks, projections, and policy priorities
- Recent history and risks:
  - Rapid growth produced rising incomes and improved social indicators but led to overheating and pressure on the external position.
  - Demand management policies have slowed growth; future hydropower expansion risks reemergence of overheating and wider external imbalances.
- Near-term and medium-term growth outlook:
  - Growth projected to recover modestly in the current fiscal year, driven by a pick-up in hydropower-related construction and policy measures.
  - Over the medium term (Eleventh Five-Year Plan), growth expected to pick up more robustly, initially from hydro-related construction and later from electricity generation.
  - Inflation expected to remain elevated, closely tracking Indian inflation.
  - Current account deficit projected to widen considerably due to stronger hydro-related imports.
  - Risks tilted to the downside because of high public debt, potential financial sector vulnerabilities, and pressures on Indian rupee reserves.
  - Mitigating factors: concentration of exports in hydropower with healthy demand from India and long-term India-financed investment projects and electricity purchase agreements.

- Fiscal policy recommendations:
  - Tighten fiscal stance in the near term to prevent reemergence of overheating and contain public debt.
  - Revenue reforms: reduce number of zero-rated goods; widen taxation of domestic activity; improve tax administration.
  - If grants fall short, restrain expenditure while prioritizing social and productivity-enhancing capital spending.
  - Any civil service wage hike should be accompanied by complementary revenue measures.
  - Over the medium term, consider introducing a value added tax to boost revenue collection.

- Monetary policy and liquidity management:
  - Tighten monetary conditions to ward off overheating and manage rupee reserve pressures.
  - Monitor liquidity and promptly adjust to prevent excessive credit growth.
  - Specific measures: adjust the CRR upward; use more regular and increased issuance of treasury bills to mop up excess liquidity as markets develop.
  - Fully sterilize hydropower-related and aid inflows.
  - Narrow interest rate spreads to reflect market conditions.
  - Over the medium term, improve monetary transmission and further deepen the financial system.

- Exchange rate and competitiveness:
  - The exchange rate peg with India has served Bhutan well, though the real effective exchange rate is assessed to be above levels suggested by fundamentals; the ngultrum is currently assessed to be overvalued.
  - Tighter macro policy stances and structural reform to enhance the business climate should help address competitiveness concerns.
  - Over the medium term, once hydropower revenues materialize, the overvaluation is projected to dissipate.

- Reserves and external management:
  - Manage external reserves carefully to contain recurrent pressures from timing mismatches in hydropower-related rupee inflows and outflows; provision necessary rupees in advance.
  - Align currency composition of reserves more closely with structure of external liabilities and trade.
  - With tightened policy stance and revenue reforms, pursue gradual withdrawal of import restrictions.

- Financial stability:
  - Growing risks due to past rapid private credit growth, sectorally-concentrated lending, growing asset-liability mismatches, and lending by non-banks.
  - Strengthen supervision and regulation; use macroprudential measures to limit systemic risk.
  - Specific measures: close regulatory gaps; regular use of stress-testing by the RMA; encourage financial institutions to conduct their own stress tests; put in place crisis management and deposit insurance arrangements.
  - Balance further financial deepening with maintaining financial stability.

- Exchange restrictions and IMF obligations:
  - Authorities did not request and staff does not recommend approval of exchange restrictions inconsistent with Article VIII obligations.
  - Bhutan maintains exchange restrictions under transitional arrangements of Article XIV, Section 2.
  - Staff encourages gradual easing of exchange restrictions toward eventual elimination as balance of payments permits, and elimination of restrictions arising from legal inconsistencies or where practice is more liberal than legal framework.
  - Authorities are encouraged to consider accepting obligations under Article VIII, Sections 2(a), 3 and 4, in due course.

- Article IV consultation cycle:
  - Recommendation that the next Article IV consultation take place on a 24-month cycle in accordance with Decision No. 14747-(10/96) (9/28/2010).

### Box summaries — notable facts and projections
- Gross National Happiness (GNH):
  - GNH measures well-being across 9 domains: psychological well-being, time use, community vitality, cultural diversity, ecological resilience, living standard, health, education, good governance.
  - According to the 2010 GNH Survey, 40.9 percent of Bhutanese are “happy.”
  - In March 2012, the United Nations adopted UN Resolution 65/309 recognizing the pursuit of happiness as a fundamental human goal.

- Inflation dynamics:
  - Bhutan is in the top decile of world inflation, tracking frontier and developing (FD) Asia more closely since mid-2009.
  - Much of recent inflation rise explained by greater non-food inflation, coinciding with expansion of domestic demand driven by rapid credit growth after commissioning of the Tala hydropower project.
  - About three quarters of Bhutan’s imports are sourced from India; Bhutan’s CPI and India’s CPI (industrial workers) track closely.
  - A simple inflation forecasting model indicates about 40 percent of change in Bhutanese inflation is due to contemporary change in India’s inflation, and 60 percent due to the lagged difference between India and Bhutan’s inflation.
  - Given this dynamic and forecasts of India’s inflation, Bhutan’s inflation is expected to moderate but remain high, at an average of over 9 percent in the near-to-medium term.

- Macroeconomic effects of hydropower development:
  - Bhutan plans to expand power generation capacity to 10,000 megawatts (MW) by 2020, compared with current level of 1,480 MW.
  - Hydropower is key to national income: about one-fifth of Bhutan’s GDP and about 30 percent of total government revenues.
  - External debt increased to 85 percent of GDP at end 2012/13, largely due to hydropower-related borrowing.
  - During the Eleventh Five Year Plan, Puna I, Puna II and Mangdechu are projected to boost growth during construction and commissioning (come on stream in 2017/18). The current account deficit is projected to deteriorate over the medium term due to strong import growth associated with construction and hydro debt service; upon project completion, electricity exports and trade balance should improve.
  - Risks observed historically after Tala commissioning: surge in power exports and government revenues, build-up of reserves, credit boom, overheating (housing and vehicle loans), sharp widening of current account deficit, rupee shortage, recurrent short-term rupee borrowing from India and use of U.S. dollar reserves, contraction of monetary base and tight liquidity.
  - Going forward, coordinated fiscal and monetary policies are essential to manage spillovers from hydropower-related inflows and avoid excessive credit growth and rupee shortages.

- Summary of hydropower projects in the pipeline (selected capacities and schedules):
  - Punatsangchhu I: 1,200 MW — Under construction; DPR schedule 2008-2017; Development Model: Intergovernment
  - Punatsangchhu II: 1,020 MW — Under construction; DPR schedule 2010-2017; Development Model: Intergovernment
  - Mangdecchu: 720 MW — Under construction; DPR schedule 2010-2017; Development Model: Intergovernment
  - Sankosh Storage: 2,650 MW — DPR yet to be cleared; schedule 2015-2023; Intergovernment
  - Kuri Gongri: 2,640 MW — DPR to be prepared in 11FYP; schedule 2017-2026; Intergovernment
  - Amochhu Storage: 540 MW — DPR cleared by CEA; schedule 2015-2023; Intergovernment
  - Wangchhu: 570 MW — DPR yet to be cleared by CEA, GoI; schedule 2015-2023; Joint Venture
  - Bunakha Storage: 180 MW — DPR cleared by CEA; schedule 2014-2020; Joint Venture
  - Kholongchhu: 600 MW — DPR approved by two Governments; schedule 2014-2021; Joint Venture
  - Chamkarchhu I: 770 MW — DPR yet to be cleared; schedule 2015-2024; Joint Venture
  - Dagachhu: 126 MW — Completed; schedule 2009-2014; PPP
  - Total capacity in table: 11,066 MW

*International Monetary Fund — Bhutan: Staff appraisal and associated sections summarized from the source content provided.*

### Box 4. Spillovers from India to Bhutan

### Box 4. Spillovers from India to Bhutan

### Overview of economic linkages
- India is Bhutan’s largest trading partner: about 80 percent of Bhutan’s commodity exports are destined for India and about 70 percent of Bhutan’s imports are from India.
- India is the primary destination for Bhutan’s electricity exports and supplies most financing for hydropower development in the form of grants and loans.
- Of the total rupee debt, 85 percent is outstanding public debt on hydropower projects while the remaining 15 percent represented overdrafts from Indian commercial banks and the Government of India line of credit.
- About 35,000 Indian tourists visit Bhutan annually.
- There is a strong long-run relationship between India and Bhutan’s inflation rates.

### Model and data
- A long-run structural macro-econometric model for Bhutan was developed to evaluate linkages with India and inward spillovers from output shocks in India.
- Sample period: quarterly data between 1981Q2 and 2011Q2.
- Model variables: real GDP, inflation, interest rate differential between Bhutan and India, real exchange rate, the price of oil, real GDP of India and Indian CPI inflation.
- Annual data were linearly interpolated backward when quarterly observations were missing for Bhutan.
- Two long-run relationships were identified:
  - an augmented Purchasing Power Parity (PPP) relationship linking “India and Bhutan’s output differential” and “real exchange rate”.
  - an equation linking Indian and Bhutanese inflation rates.

### Empirical spillover findings
- A one percent decline in the GDP of India generates significant output losses in Bhutan, corresponding to around 0.18 percent after one year.
- Estimated median impulse responses were computed for up to 40 quarters, with 16th and 84th percentile error bands.
- A growth slowdown in India:
  - decreases inflation in Bhutan (as output gap widens in India),
  - causes a real-exchange-rate depreciation in Bhutan.

### Channels and amplification
- Bhutan’s growth is driven by hydropower exports to India; electricity generation and exports depend on long-term India-financed investment projects and electricity purchase agreements.
- Indian demand for electricity is inelastic, which helped dampen negative spillovers to Bhutan.
- In mid-2013, global investor risk aversion moderated capital inflows to India, increased long-term bond yields, and led to exchange rate depreciation. Investor concerns were amplified by India’s persistently-high inflation, worsening growth prospects, and large external current account and fiscal deficits.
- Because Bhutan pegs to the Indian rupee, it was only moderately affected by those shocks; negative spillovers to Bhutan were dampened and could have been much larger otherwise.

### Attribution of Bhutan’s slowdown
- Most of the slowdown in Bhutan is attributable to demand side measures put in place by the authorities.

*Prepared by Mehdi Raissi. Content based on the specified IMF Box text.*

### Box 5. Real Exchange Rate Assesment

### Box 5. Real Exchange Rate Assesment

### Methodology and adjustments
- Three model-based approaches are used: the external sustainability (ES) approach; the macroeconomic balance (MB) method; and a (reduced form) equilibrium real exchange rate (ERER) technique.
- Several adjustments to standard frameworks were made to address low-income and renewable-resource-rich economy features and data constraints:
  - Use of a large sample of countries (including those with characteristics similar to Bhutan) over the period 1973–2012 and correction for structural breaks to calculate the CA norm and the equilibrium exchange rate misalignment, reducing multilateral inconsistency, sample selection bias, and overfitting.
  - Augmentation of CA determinants with aid flows and remittances to better reflect LIC characteristics.
  - Application of an econometric technique that mitigates potential endogeneity and exploits panel data.
  - Stripping the CA of Bhutan-specific temporary factors (notably over importation that will be accompanied by higher hydro-exports in the long run) to estimate a more reasonable underlying CA.

### Quantitative assessment of misalignment
- The three methodologies indicate a real exchange rate overvaluation in the range of 8.5 to 21 percent.
- Macroeconomic balance (MB) approach:
  - Suggests a CA norm of -12 percent of GDP.
  - This CA norm is about 4 percentage points less than the underlying CA in the medium-term.
  - Using an elasticity of the CA to the real effective exchange rate of -0.25 percent (as referenced by Vitek (2009)), this implies an exchange rate misalignment of about 16 percent (this result also involves a multilateral consistency adjustment).
- External sustainability (ES) approach:
  - Estimates a CA norm for Bhutan which stabilizes the NFA/GDP around its norm (estimated from a panel data model).
  - Comparing this CA norm with its underlying value, and using the above elasticity, implies a REER overvaluation of 21 percent.
- Reduced form equilibrium real exchange rate (ERER) approach:
  - Suggests an overvaluation of around 8.5 percent.

### Limitations, caveats, and structural factors
- The methodologies are subject to limitations and sensitive to assumptions; findings should be viewed with caution.
- Specific challenges include:
  - Assessing REER misalignment in countries with foreign exchange rationing is especially difficult because the equilibrium may not be found within the data (such countries are persistently on the supply curve for foreign exchange and off their demand curve).
  - Using estimated coefficients from a panel of countries at different development stages (relative to Bhutan) may bias results.
- Structural transition consideration:
  - Bhutan is undergoing a major transition by scaling up hydropower generation capacity, mainly financed by bilateral aid from India.
  - Given this structural characteristic, standard exchange rate assessment tools may suggest overvaluation, but some required adjustment in the external position will occur naturally as import-intensive investments lead to a permanent boost in hydropower-related exports in the long run.

### Policy recommendations and structural priorities
- Over the medium term, further structural reforms are central to strengthening competitiveness:
  - Address key structural deficiencies such as shortage of skilled labor and access to finance.
  - Encourage niche sectors such as tourism, agri-business, and energy intensive activities that could take advantage of access to cheap and clean power (Selected Issues Paper III).
  - Enhance the business climate and achieve productivity gains to help offset any potential real exchange appreciation that may follow from rapid growth and resulting increased demand for nontradables.
- These measures will support competitiveness and help manage implications of REER movements tied to growth and nontradable demand.

*Prepared by Mehdi Raissi. Sources cited internally: Vitek, F., 2009; Chen, S., Dwight, L., Nkusu, M., Raissi, M., Ter-Martirosyan, A., Vitek, F., and A. Watson, 2014.*

### Annex I. Key Recommendations on Enhancing Financial Sector

### Annex I. Key Recommendations on Enhancing Financial Sector Surveillance in Low-Income Countries

### Financial sector development and market infrastructure
- Develop a comprehensive Financial Sector Development Strategy, with a careful sequencing of reforms while balancing any tradeoffs between financial stability and deepening.
  - Timing: Medium Term
  - Priority: High
- Float minority stakes in state-owned enterprises. Draft private equity regulations. Review options for providing corporate bond credit ratings.
  - Timing: Medium Term
  - Priority: High
- Establish an automated depository for registering treasury bills at the RMA.
  - Timing: Medium Term
  - Priority: High
- Initiate systematic work on strengthening the market infrastructure for securities trading.
  - Timing: Short Term
  - Priority: Medium
- Publish an issuance calendar for Treasury bills and commit to float meaningful amounts even when there is no financing need.
  - Timing: Short Term
  - Priority: High
- Utilize regular meetings of the Treasury Bill Management Committee to share information and coordinate public debt management and liquidity management.
  - Timing: Short Term
  - Priority: Medium
- Establish a liquidity management framework in which monetary instruments ensure market rates are determined close to the policy rate.
  - Timing: Medium Term
  - Priority: High

### Regulation, supervision, and prudential frameworks
- Enable secured transactions by expanding the collateral registry.
  - Timing: Short Term
  - Priority: High
- Resume onsite supervision, within the framework of an annual supervisory plan for risk-based supervisory work.
  - Timing: Short Term
  - Priority: High
- Develop mismatch approach to liquidity risk regulation, moving to a stress-based framework once high quality liquid assets are available.
  - Timing: Short Term
  - Priority: High
- Introduce occasional stress testing exercises, requiring banks to run simple adverse scenarios and report results.
  - Timing: Short Term
  - Priority: High
- Review latest capital risk weightings after six months to reflect development of risks; extend requirements to off balance sheet credit risk.
  - Timing: Short Term
  - Priority: Medium
- Complete regulations on insurance and reinsurance solvency requirements based potentially on EU Solvency I or equivalent framework.
  - Timing: Short Term
  - Priority: High
- Merge reserve requirement and current accounts and allow reserve averaging.
  - Timing: Short Term
  - Priority: High
- Reduce gradually use of the government’s overdraft facility in a commercial bank and restrict use of the overdraft facility at the RMA.
  - Timing: Short Term
  - Priority: High
- Agree on a Memorandum of Understanding specifying how RMA could be reimbursed for the cost of monetary policy.
  - Timing: Short Term
  - Priority: High
- Limit the use of the sweeping arrangement to clearly eligible accounts, selected in cooperation with commercial banks, and refrain from using sweeping to manage normal liquidity flows.
  - Timing: Short Term
  - Priority: Medium

### Regulatory policy, financial inclusion, and consumer protection
- Formulate short statement of regulatory approach to making and changing regulation addressing consultation and impact assessment.
  - Timing: Short Term
  - Priority: High
- Create a regulatory policy function.
  - Timing: Short Term
  - Priority: Medium
- Review and approve the Financial Inclusion Policy, in light of need to extend outreach while maintaining a sound financial system.
  - Timing: Short Term
  - Priority: High
- Provide technical assistance to MFIs to support new product development.
  - Timing: Short Term
  - Priority: High
- Establish a “Code of Conduct” on disclosure of bank products, prices, and procedures (as per Financial Services Act 2011).
  - Timing: Short Term
  - Priority: High
- Continue expanding financial literacy campaigns among underserved groups, on financial products and services including mobile banking.
  - Timing: Short Term
  - Priority: High
- Develop policy on selection and use of macroprudential tools.
  - Timing: Short Term
  - Priority: High

### Treasury, debt, and operational recommendations
- Publish an issuance calendar for Treasury bills and commit to float meaningful amounts even when there is no financing need.
  - Timing: Short Term
  - Priority: High
- Establish an automated depository for registering treasury bills at the RMA.
  - Timing: Medium Term
  - Priority: High
- Utilize regular meetings of the Treasury Bill Management Committee to share information and coordinate public debt management and liquidity management.
  - Timing: Short Term
  - Priority: Medium

### Other supervisory and regulatory follow-ups
- Review latest capital risk weightings after six months to reflect development of risks; extend requirements to off balance sheet credit risk.
  - Timing: Short Term
  - Priority: Medium
- Create a regulatory policy function.
  - Timing: Short Term
  - Priority: Medium

### Notable contextual and institutional details (selected numerical and timing facts)
- Article IV Consultation cycle: 24-month consultation cycle. The 2011 Article IV consultation was concluded by the Executive Board on May 27, 2011.
- Membership: Joined: September 28, 1981; Article XIV.
- Quota and Fund positions (SDR Million and percent of Quota):
  - Quota 6.30 100.00
  - Fund Holdings of Currency (Exchange Rate) 5.28 83.81
  - Reserve Tranche Position 1.02 16.20
  - Net cumulative allocation 5.99 100.00
  - Holdings 6.43 107.35
- Projected Payments to Fund (SDR million; based on existing use of resources and present holdings of SDRs) — Forthcoming 2014 2015 2016 2017 2018:
  - Principal 0.00 0.00 0.00 0.00 0.00
  - Charges/interest 0.00 0.00 0.00 0.00 0.00
  - Total 0.00 0.00 0.00 0.00 0.00
- Exchange and FX-related limits and illustrative amounts:
  - For Bhutanese citizens, the annual private travel FX allowance is set at $3,000 (plus $1,000 per each credit or debit card), the annual FX allowance for living expenses and stipend for education-related travel are set at $1,500 and $900, respectively.
  - Resident non-citizens must use their own foreign currency sources for subscriptions, application and testing fees and professional membership fees. Resident Bhutanese citizens may access FX exceeding the limits (currently US$300 without documentation and US$3,000 upon providing documentary evidence) with RMA approval.
  - Importers making advance payments for imports in Indian rupee must submit evidence that the relevant goods entered Bhutan within 91 days.
  - The RMA intends to remove certain measures by July, 2014.
  - RMA 2012 guidelines reference date: March 8, 2012.

*Prepared by Asia and Pacific Department.*

### 2013.  The government shall focus on Self Reliance and Inclusive Green Socio-economic

### 2013.  The government shall focus on Self Reliance and Inclusive Green Socio-economic Development in the Eleventh Five year Plan

### Government strategy and definitions
- Self-Reliance: “ability to meet all national development needs as articulated through 5 year plans by 2020”.
- Inclusive development: “reducing poverty and inequality by enhancing the standard of living and the quality of life of the most vulnerable sections of the society”.

### World Bank Group — Country Partnership Strategy (CPS) FY11–14 and outlook
- CPS period: FY11–14.
- CPS alignment: Principles of Gross National Happiness (GNH); Bhutan 2020 Vision; Tenth Five-Year Plan (2008–2013).
- CPS areas of engagement:
  - (i) Economic Diversification, Job Creation and Financial Inclusion
  - (ii) Spatial Planning and Public Services
- CPS cross-cutting themes: capacity building and environmental sustainability.
- Next CPS: scheduled to begin in FY 2015; anticipated continuity of many current CPS themes.
- Financing expectations:
  - Bulk of IDA financing expected to continue as development policy lending, supplemented by a limited number of specific investments and a robust knowledge program.
  - Next CPS likely to reflect a shift toward IDA-IBRD blend status for Bhutan in keeping with emerging middle-income country (MIC) status.

### International Development Association (IDA) — Lending and non-lending programs
- Annual new IDA resources to Bhutan: around $15–20 million per year.
- Ongoing specific investment operations: net commitment of $82 million of IDA resources, including:
  - Decentralized Rural Development (country specific)
  - Urban Development II (country specific)
  - Remote Rural Communities Development (country specific)
  - Regional Cooperation on Wildlife Protection (regional IDA project)
  - Sustainable Financing for Biodiversity Conservation (GEF grant operation)
- Additional: financial project for Urban Development II being prepared.
- World Bank grant management: Disaster Management, Public Private Partnerships, Corporate Governance, Public Financial Management and inter-governmental fiscal relations, Urban Budget Processes, social protection.
- Development policy operations over last six years: three operations; most recent Development Policy Credit-2 (DPC-2) approved November 2012 for a total of $36 million. DPC-2 focused on:
  - (i) Promoting government efficiency and effectiveness through sound fiscal and public financial management and procurement, and strong public administration;
  - (ii) Fostering private-sector development by improving the policy environment and facilitating productive employment opportunities;
  - (iii) Expanding access to infrastructure in a sustainable manner.
- Non-lending analytical and technical assistance work (recent and ongoing):
  - Gender Policy Note, Nutrition Assessment, Poverty and Social Impact Analysis of the proposed Bill on Cultural Heritage, Human Development Public Expenditure Review, review of higher education, Investment Climate Assessment (underpinned DPC-2).
  - Underway: poverty assessment, Financial Sector Assessment, green growth study, financial sector technical assistance to support design of a financial sector strategy.

### International Finance Corporation (IFC)
- Total committed investment portfolio in Bhutan: over $31 million.
- Portfolio composition: predominantly equity participation in Bhutan National Bank.
- Advisory portfolio: PPP structuring, investment climate improvement, enhancing access to financial services.
- Areas being explored: hydropower, tourism, manufacturing, agribusiness, health and education.
- Expected continuity: advisory support on investment climate reforms, PPP development and the financial sector.

### Multilateral Investment Guarantee Agency (MIGA)
- January 2013: Bhutan signed the MIGA Convention.
- Convention ratified by the National Assembly and the National Council.
- Bhutan completing other membership requirements; upon completion MIGA will be able to support investments in Bhutan by providing guarantees.

### Relations with the Asian Development Bank (ADB) and program
- Bhutan ADB membership: since 1982; ADB lending operations began in 1983.
- Classification: Group A country; eligible for Asian Development Fund (ADF) resources.
- Debt classification: moderately debt stressed; receiving a 50:50 mix of ADF loan and ADF grant assistance since 2011.
- Cost-sharing ceiling: set at 99 percent for loans, technical assistance, and other grants.
- ADB strategy alignment: closely follows Five Year Plans and ADB’s CPS and COBP; preparing new CPS for 2014-2018 aligned with Eleventh FYP (2013–2018) and Strategy 2020.
- Core sectors historically: energy (including rural electrification and renewable energy), finance, transport, urban development.
- Coordination with development partners: examples include parallel financing with World Bank (urban development in Thimphu), rural electrification with JICA and Austrian Development Agency, collaboration with SNV on renewable energy and pilot biogas project.
- New resident mission in Thimphu to strengthen partnership and coordination.
- Current COBP period: 2014–2016.
  - Indicative cumulative ADF allocation for 2014–2016: $147 million.
  - 2014–2016 lending program priorities:
    - Nicachhu hydropower project (Green Power Development Project II)
    - Transport connectivity and trade facilitation (SASEC Road Connectivity Project and SASEC Transport, Trade Facilitation and Logistics Project)
    - Urban infrastructure (Improved Urban Environmental Infrastructure Project)
    - Additional financing to improve infrastructure at three domestic airports (Additional Financing for Air Transport Connectivity Enhancement Project)
  - Nonlending program programmed for 2014−2016: $14.253 million.

### Bhutan: Ongoing ADB Loans and Grants (As of 31 March 2014)
- Loans
  - Urban Infrastructure Development Project — Year of Approval: 2006 — Project Amount ($ million): 25.5 — Disbursements ($ million): 20.8
  - Green Power Development Project (OCR Loan) — Year of Approval: 2008 — Project Amount ($ million): 51.0 — Disbursements ($ million): 51.0
  - Green Power Development Project — Year of Approval: 2008 — Project Amount ($ million): 29.4 — Disbursements ($ million): 29.4
  - Urban Infrastructure Project — Year of Approval: 2011 — Project Amount ($ million): 19.7 — Disbursements ($ million): 2.1
  - SASEC Trade Facilitation Program — Year of Approval: 2012 — Project Amount ($ million): 8.3 — Disbursements ($ million): 3.1
  - Strengthening Economic Management Program — Year of Approval: 2013 — Project Amount ($ million): 14.3 — Disbursements ($ million): 0.0
  - Additional Financing for Green Power Development Project — Year of Approval: 2013 — Project Amount ($ million): 39.6 — Disbursements ($ million): 19.5
- Grants
  - Micro, Small, and Medium-sized Enterprise Sector Development Project — Year of Approval: 2007 — Project Amount ($ million): 8.3 — Disbursements ($ million): 8.3
  - SASEC Information Highway Project — Year of Approval: 2007 — Project Amount ($ million): 4.7 — Disbursements ($ million): 2.1
  - Green Power Development Project — Year of Approval: 2008 — Project Amount ($ million): 25.3 — Disbursements ($ million): 23.9
  - Road Network Project II — Year of Approval: 2009 — Project Amount ($ million): 38.8 — Disbursements ($ million): 21.1
  - Rural Renewable Energy Development Project — Year of Approval: 2010 — Project Amount ($ million): 21.6 — Disbursements ($ million): 10.2
  - Air Transport Connectivity Enhancement Project — Year of Approval: 2012 — Project Amount ($ million): 6.9 — Disbursements ($ million): 1.5
  - SASEC Trade Facilitation Program — Year of Approval: 2012 — Project Amount ($ million): 3.3 — Disbursements ($ million): 3.3
  - Strengthening Economic Management Program — Year of Approval: 2013 — Project Amount ($ million): 20.8 — Disbursements ($ million): 20.8
- Notes: OCR = Ordinary Capital Resources, SASEC = South Asia Subregional Economic Cooperation.
- Additional note from source: Loans and grants include those funded by ADF and OCR. The first tranche of both the SASEC Trade Facilitation Program and the Strengthening Economic Management Program was released in 2013, and the second/final tranche is expected to be released in 2014.

### Statistical issues — data adequacy and quality (as of April 30, 2014)
- General: Data provision has some shortcomings, but is broadly adequate for surveillance. Most affected areas: national accounts, balance of payments, and fiscal data.
- Real sector:
  - Japan-funded technical assistance project for Implementation of the System of National Accounts and the International Comparison Project will take place over the next three years; IMF STA to provide technical assistance to improve national accounts and develop a producer price index.
- National Accounts: Key shortcomings:
  - Heavy reliance on production data collected by line ministries, often lacking quality control.
  - Long lags in providing estimates.
  - Large revisions of historical data.
  - In certain cases ad hoc estimation procedures.
  - Lack of reliable data on expenditure components hampers estimation of national savings and domestic investment.
  - Contributing factors: shortage of qualified personnel and facilities; absence of a Statistics Act constraining National Statistical Bureau (NSB).
- Price statistics:
  - CPI compiled quarterly since 2004; number of commodity prices expanded and geographical scope broadened.
  - Quarterly CPI series available from March 2008 onwards.
  - Monthly CPI series for domestic and imported goods starting from January 2013 have recently been released but series are too short for surveillance.
  - NSB released first monthly PPI series starting Q2 of 2012.
- Government finance statistics (GFS):
  - Recent improvements observed, but fiscal data 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 are compiled and disseminated, but with a long lag. No GFS are disseminated nationally. Quarterly data are now produced and made available internally.
  - Inconsistencies between fiscal and monetary data regarding bank financing due to differences in definition of government.
- Monetary statistics:
  - Generally consistent with Fund guidelines but improvements needed:
    - (i) valuation of financial assets is based on purchase price while market or market-price equivalents would be preferable;
    - (ii) to avoid misclassifications, a list of government units and nonfinancial public enterprises should be prepared and shared with reporting financial institutions.
  - March 2010 MFS technical assistance mission: authorities and STA improved timeliness of data reporting to STA to be in line with national publications.
  - RMA has submitted Financial Soundness Indicators (FSI) for Bhutan on a quarterly basis; published on IMF’s FSI website.
- Balance of payments:
  - Improvements noted but shortcomings remain: (i) limited coverage of services’ transactions in the current account; (ii) long lags in dissemination.
  - Missions in June 2009 and March 2011 supported development of International Investment Position for Bhutan and a plan for improvement, including quarterly business survey, improved estimation methods, and increased timeliness.
  - RMA compiles and disseminates quarterly balance of payments data; Bhutan began supplying BOP data for publication in IFS in November 2010 and submits BOP data in BPM6 format to the Fund.
  - Authorities participating in IMF’s Coordinated Direct Investment Survey from 2011.
- Data Standards and Quality:
  - Bhutan participates in the General Data Dissemination System (GDDS); posted metadata for the first time on the Fund’s DSBB in May 2010.
  - No data ROSC available.

### Table of common indicators required for surveillance (as of March 18, 2014) — selected entries (dates and frequencies preserved)
- Exchange rates — Date of Latest Observation: 03/2014 — Date Received: 03/2014 — Frequency of Data: D — Frequency of Reporting: D — Frequency of Publication: D
- International reserve assets and reserve liabilities of the Monetary Authorities — Date of Latest Observation: 11/2013 — Date Received: 02/2014 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M
- Reserve/base money — Date of Latest Observation: 11/2013 — Date Received: 02/2014 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M
- Broad money — Date of Latest Observation: 11/2013 — Date Received: 02/2014 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M
- Central bank balance sheet — Date of Latest Observation: 11/2013 — Date Received: 02/2014 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M
- Consolidated balance sheet of the banking system — Date of Latest Observation: 11/2010 — Date Received: 3/2011 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M
- Consumer price index — Date of Latest Observation: 06/2013 — Date Received: 06/2013 — Frequency of Data: Q/M — Frequency of Reporting: M — Frequency of Publication: M
- Revenue, expenditure, balance and composition of financing — general government — Date of Latest Observation: 2012/13 — Date Received: 01/2014 — Frequency of Data: A — Frequency of Reporting: A — Frequency of Publication: A
- External current account balance — Date of Latest Observation: 2013 — Date Received: 01/2014 — Frequency of Data: A — Frequency of Reporting: A — Frequency of Publication: A
- Exports and imports of goods and services — Date of Latest Observation: 2013 — Date Received: 01/2014 — Frequency of Data: A — Frequency of Reporting: A — Frequency of Publication: A
- GDP/GNP — Date of Latest Observation: 2013 — Date Received: 01/2014 — Frequency of Data: A — Frequency of Reporting: A — Frequency of Publication: A
- Gross external debt — Date of Latest Observation: 06/2013 — Date Received: 01/2014 — Frequency of Data: Q — Frequency of Reporting: Q — Frequency of Publication: Q
- International investment position — Date of Latest Observation: 06/2009 — Date Received: 10/2009 — Frequency of Data: Q — Frequency of Reporting: Q — Frequency of Publication: Q

### Debt Sustainability Analysis (DSA) summary — 2014 Article IV Consultation
- Framework: Joint Fund-Bank Debt Sustainability Framework for Low-Income Countries (LIC DSA).
- Staff assessment of risk of external debt distress: moderate.
- Projections and risks:
  - Rapid hydropower development projected to lead to substantial buildup of external debt in the medium-term, with debt ratios breaching most country-specific indicative thresholds for protracted periods of time.
  - Risks also stem from volatile hydro-related debt service payments.
  - Debt situation expected to improve over the long run due to significantly higher electricity exports when more hydropower projects come on stream.
- Primary basis for staff assessment — mitigating factors:
  - Explicit guarantees from India that cover financial and construction risks for the hydropower projects, allowing exceptional treatment of hydropower loans from India as similar to FDI (i.e., non-debt creating).
  - India buys surplus output (after domestic use) with price based on a cost-plus basis (building in a net return of 15 percent).
  - Bhutan’s strong track record of project implementation.
  - Rapid growth in energy demand from India.
  - Committed donor support.
  - Bhutan’s high level of international reserves.
- Policy advice and cautions:
  - Staff cautions against further new non-concessional borrowing as the level of debt has increased substantially compared to previous DSAs.
  - Stress tests to public sector debt dynamics reveal the need for fiscal consolidation and the importance of sustaining rapid economic growth going forward.
- DSA preparation: jointly by IMF and World Bank staff, in consultation with the authorities, using the debt sustainability framework for low-income countries approved by the Boards of both institutions.
- DSA document date: May 30, 2014.

*Source: _cr14178 - 2013.  The government shall focus on Self Reliance and Inclusive Green Socio-economic Development in the Eleventh Five year Plan (IMF staff report content provided).*

### 1. Bhutan’s public and publicly guaranteed (PPG) external debt increased to 85 percent of

### _cr14178 - 1. Bhutan’s public and publicly guaranteed (PPG) external debt increased to 85 percent of

### Overview and current debt structure
- PPG external debt increased to 85 percent of GDP at end 2012/13, adding 14 percentage points of GDP to the previous year.
- Hydropower-sector related external borrowing accounts for an outstanding stock of 48 percent of GDP.
- Hydropower projects are primarily financed by India with a mix of loans (70 percent) and grants (30 percent).
- Currency composition of external debt:
  - Indian rupee-denominated debt: 61 percent of total external debt.
  - Convertible currency debt: 29 percent of total external debt.
- Domestic debt:
  - Entirely due to the loan to purchase aircraft for Druk Air in 2009/10.
  - Domestic debt-to-GDP ratio about 6 percent of GDP in 2012/13, reflecting fiscal outturns in the following three years.

### Hydropower pipeline and development model
- Baseline plans: expand power generation capacity to about 10,000 MW by 2020 through eleven new hydropower projects (total capacity listed as 11,066 MW).
- Summary of projects (Capacity, DPR/approval status, Construction Schedule, Development Model):
  - Punatsangchhu I — 1200 MW — Under construction — 2008-2017 — Intergovernment
  - Punatsangchhu II — 1020 MW — Under construction — 2010-2017 — Intergovernment
  - Mangdecchu — 720 MW — Under construction — 2010-2017 — Intergovernment
  - Sankosh Storage — 2650 MW — DPR yet to be cleared — 2015-2023 — Intergovernment
  - Kuri Gongri — 2640 MW — DPR to be prepared in 11FYP — 2017-2026 — Intergovernment
  - Amochhu Storage — 540 MW — DPR cleared by CEA — 2015-2023 — Intergovernment
  - Wangchhu — 570 MW — DPR yet to cleared by CEA, GoI — 2015-2023 — Joint Venture
  - Bunakha Storage — 180 MW — DPR cleared by CEA — 2014-2020 — Joint Venture
  - Kholongchhu — 600 MW — DPR approved by two Governments — 2014-2021 — Joint Venture
  - Chamkarchhu I — 770 MW — DPR yet to be cleared — 2015-2024 — Joint Venture
  - Dagachhu — 126 MW — Completed — 2009-2014 — PPP
  - Total pipeline capacity: 11066 MW
- External financing for non-hydropower activities remains predominantly concessional from multilateral and bilateral donors.
- Government facilities that can add to external debt stock when availed:
  - Stand-by facility with the Government of India.
  - Swap line with the Reserve Bank of India.
  - Overdrafts with Indian commercial banks.

### Key baseline macroeconomic assumptions governing hydropower developments
- Real sector:
  - Medium-term real growth projected at around 8½ percent.
  - Ten-year historical average: 8 percent.
  - Long-term growth expected to gradually return to around 6¾ percent as construction phases out.
- Fiscal sector:
  - Upon completion, hydropower projects will boost the domestic revenue-to-GDP ratio.
  - External budgetary aid projected to decline as a share of GDP as per capita income rises.
  - On average, the overall fiscal deficit remains broadly balanced over the long term.
- External sector:
  - Current account deficit projected to deteriorate over the medium term due to import demand during construction and hydro debt service.
  - Electricity exports are likely to more than triple from current levels upon completion, leading to balance of payment surpluses from 2020 onwards.

### Baseline External Debt Sustainability Analysis (DSA) findings
- External debt trajectory:
  - External debt as share of GDP projected to rise to 121 percent of GDP in 2016/17 (in line with hydropower disbursements).
  - Declines slightly to 116 percent of GDP in 2017/18 with completion of first phase.
  - Stock of PPG external debt expected to gradually decline to about 29 percent in 2034.
  - PV of PPG external debt-to-GDP projected to decline to 25 percent in the long term.
- PV of debt-to-exports and PV of debt-to-revenue:
  - PV of debt-to-exports ratio falls below the 200 percent threshold only in the long run and remains above the threshold for most of the projection period.
  - PV of PPG external debt to revenue peaks at 750 percent in 2014/15 and projected to fall below the 300 percent threshold only in the long run.
- Debt service indicators:
  - Debt service-to-export ratio expected to remain below indicative thresholds for most of the projection period.
  - Debt service-to-revenue ratio breaches the indicative threshold when Puna II and Mangdechu debt service begin in 2018/19; expected to fall below the threshold over the long run.
- Excluding hydropower debt (treating these loans like FDI):
  - Non-hydro debt ratios are well below thresholds for PV of debt-to-GDP, exports and revenues.
  - Temporary breaches occur in debt service indicators.

### Sensitivity analysis and stress tests
- Stress tests applied: exports shock, exchange rate depreciation, growth shock, unfavorable financing terms.
- Results:
  - PV of debt-to-exports and debt-to-revenue ratios are breached under stress tests.
  - All debt burden indicators (PV of debt-to-exports, debt-to-revenue, and debt-to-GDP) breach thresholds after shocks in 2014 and come down only in the long run (except under the historical scenario).
  - The most extreme stress for PV of debt-to-exports or revenue ratios is a one-standard deviation shock to the exchange rate in 2013–14.
    - Caveat: This shock overestimates vulnerability because a large share of Bhutan’s external income is in Indian rupees, a natural hedge to rupee-denominated debt.
  - Debt service ratios breach thresholds under parts of the projection period:
    - Debt service-to-export ratio breaches the threshold under a growth shock.
    - Debt service-to-revenue ratio breaches the indicative threshold continuously under the shock scenarios.
- Overall stress-test classification: moderate risk of debt distress.

### Public debt sustainability analysis
- Baseline public debt dynamics:
  - Public debt-to-GDP ratio expected to rise to 129 percent in 2016/17 and decline to 35 percent of GDP by end 2033/34.
  - External financing projected to shrink as a share of GDP, with domestic financial markets playing a larger financing role over time.
- Sensitivity:
  - Public debt ratios decline over the long term under various stress tests.
  - A one-time depreciation results in an upward shift in public debt indicators but does not change the shape of the path.
  - Debt service ratios vulnerable to extreme shocks due to bunching of repayments in outer years.
  - Policy implication: importance of containing fiscal deficits to ensure public debt sustainability.

### Staff assessment and policy implications
- Staff assessment: risk of external debt distress is moderate despite worsening debt ratios compared to the 2011 DSA, due to strong mitigating factors.
- Primary mitigating factors:
  - Explicit guarantees from India covering financial and construction risks for hydropower projects.
  - India purchases surplus output (after domestic use) on a cost-plus basis, building in a net return of 15 percent, permitting exceptional treatment of Indian hydropower loans as similar to FDI (i.e., non-debt creating).
  - Bhutan’s strong track record of project implementation.
  - Close economic and political ties with India; India is main financier and consumer of electricity output.
- Staff cautions:
  - Additional non-concessional borrowing is discouraged as Bhutan’s debt carrying capacity improves only in the long run.
  - Vulnerabilities include:
    - Concentrated export base.
    - Rupee-reserves mismatch with external debt and trade structure (leading to overdrafts).
    - Fiscal stance leaving the country vulnerable to export and constant primary-deficit shocks and shortfalls in aid inflows.
  - Two historical episodes of rupee shortage cited: 2006/2007 and 2011/12, partly explained by lumpy debt service payments.
- Net assessment: guarantees and India arrangements materially mitigate hydropower loan risks; excluding hydropower loans significantly reduces breaches and confirms long-term economic dividends from projects.

*Source: IMF staff report content extracted from the provided chapter.*

### Box 1. Institutional and Legal Arrangements of Inter-Governmental

### Box 1. Institutional and Legal Arrangements of Inter-Governmental Hydropower Projects in Bhutan

### Institutional framework and bilateral agreement
- Projects undertaken under the “10,000 MW by 2020” bilateral cooperation agreement signed on 26th July 2006 and the protocol to the agreement signed on 16th March 2009.
- Royal Government of Bhutan (RGoB) and Government of India (GoI) agreed to develop 5 intergovernmental projects: Chhuka, Kurichhu, Tala (commissioned), and Punatsangchhu I, Punatsangchhu II, Mangdechhu (under construction).
- Under the intergovernmental agreement, a detailed project report (DPR) is prepared by a GoI undertaking and reviews all technical and financial aspects; once final and endorsed by the 2 countries, a Project Agreement is signed between Bhutan (Ministry of Foreign Affairs) and India (Ministry of External Affairs).

### Project Agreement: ownership, responsibilities, and governance
- Establishes sole ownership of the project by the RGoB.
- Establishes estimated cost of project, and GoI’s sole responsibility for funding (including additional costs).
- Establishes terms of financing including: share of grant versus loan financing from India; simple - non capitalized interest rate; amortization period; with the first repayment starting one year from the mean date of commercial operation.
- Provides for setting-up of a project authority for the construction, operation, maintenance and evacuation of the surplus power, with a chairperson appointed by RGoB.
- Requires handing over of the project by the project authority to the RGoB within 2 years of completion of the project and dissolution of the project authority at that time.
- Establishes that the GoI will purchase all the surplus power from the project (over and above domestic use).
- Establishes the principle of a “cost plus” approach for determination of the power rate at the time of commissioning the project; Cost plus includes the costs of the project, financing costs, operation and maintenance charges, (accelerated) depreciation and market conditions and a net return of 15 percent.
- Establishes the principle of reviewing the rate every 3 years.

### Post-commissioning protocols and contracting
- Once the project is commissioned:
  - A protocol to the Project Agreement is signed between RGoB (Ministry of Economic Affairs) and GoI (Bhutan Embassy), which establishes the rate at which the surplus power will be sold to GoI, and authorizes the designated nodal agencies to enter into a Power Purchasing Agreement (PPA) following the principles established in the Protocol.
  - A protocol to the Project Agreement is signed between RGoB (Ministry of Finance) and GoI (Bhutan Embassy), which establishes the principal to be repaid, repayment schedule and interest.
  - A subsidiary loan agreement is signed between the Government of Bhutan and Druk Green Power Corporation (DGPC), a Public Holding company part of Druk Holding Investments (DHI), treating the MoF loan as on-lending to DGPC. The agreement follows the same terms as the umbrella agreement, with DGPC payments to MoF treasury having to be made a week before the due date to GoI.

### Assessment of debt sustainability risks for intergovernmental hydropower projects
- Debt sustainability risks are minimal because:
  - (i) construction risks are borne by GoI;
  - (ii) power rates are determined at the time of the project commissioning, when the actual project cost is known, and are set to allow revenues to service debt and a financial return;
  - (iii) hydropower projects are insured (and re-insured) for natural disaster.
- The only identified risk after commissioning is hydrological risk: if electricity, once the project is commissioned, could not be generated.

*Source: Box 1, Institutional and Legal Arrangements of Inter-Governmental Hydropower Projects in Bhutan.*

### INTRODUCTION __________________________________________________________________________________  5

### INTRODUCTION

### Purpose and scope
- Bhutan was selected as a pilot case for the initiative on Enhancing Financial Sector Surveillance called for by Executive Board in May 2012 (FO/DIS/12/66).
- The supplement assesses:
  - the extent to which a shallow and undiversified financial sector in Bhutan has created macro-financial vulnerabilities that impact the economy, and its ability to sustain growth and reduce poverty;
  - how the country can generate financial deepening that will provide greater access to credit and financial services;
  - whether the process of deepening itself has increased risks in the financial sector;
  - how the state of development of the financial system may have constrained monetary policy implementation and the efficacy of the transmission mechanism.
- This document reflects information available as of the September 2013 mission, except where noted.

### Macroeconomic context and vulnerabilities
- Bhutan is a small, fast-growing, lower middle-income country with deep economic ties to India and a peg to the Indian rupee.
- Growth drivers:
  - Hydropower projects exporting electricity to India.
  - Credit-fuelled private consumption.
- Key vulnerabilities and episodes:
  - Recurring balance of payments pressures caused by loose macroeconomic policies, rapid credit growth (which increased imports), and time-inconsistency in bulky hydro-related transactions (rupee debt repayments in January and hydro-related export receipts during July–September).
  - Authorities resorted to recurrent short-term borrowing of rupees from Indian commercial banks (now refinanced by the Indian government and Reserve Bank of India (RBI)) at considerable cost.
  - A pronounced rupee shortage in 2011—resulting from excessive credit growth, house price appreciation, and a consumption boom—led the Royal Monetary Authority (RMA) to sell 20 percent of its U.S. dollar reserves in December 2011, with a subsequent sale in June 2013.
  - In 2012, corrective measures at the recommendation of a government Task Force included banning of imports of vehicles and construction materials, relaxing reserve requirements and provisioning requirements to ease bank liquidity stress, and banning lending for construction and vehicle imports. Planned macroprudential measures that would have strengthened capital standards were not implemented.
  - In 2013, the newly elected government proposed an Economic Stimulus Plan that would inject funds equivalent to 4 percent of GDP into the financial system “to restart lending to productive and priority sectors”.

### Financial deepening and recent credit trends
- The banking system has grown rapidly and competition intensified with the entry of new domestic private banks.
- Credit growth averaged above 30 percent over the past 10 years, increasing credit from 11 percent to 49 percent of GDP.
- Comparative benchmarks:
  - Median private credit: 32 percent for lower middle-income countries and 16 percent for low-income countries.
  - An “expected norm” of 27 percent based upon a regression controlling for GDP per capita, population size and density, young and old age dependency ratios.
  - Median for South Asia: 49 percent.

### BACKGROUND ON THE FINANCIAL SECTOR

### Structure and composition
- The financial sector is bank-led and remains shallow; the banking sector accounts for over 80 percent of total financial sector assets (excluding the stock exchange).
- Table of key system aggregates (as presented):
  - Total Financial System — Number: 888.8; Total Assets in Billions Nu.: 100.0 (percent of total assets column header alignment in source).
  - Commercial Banks — 573.2; 82.5 (percent of total assets).
  - Insurance Companies — 28.8; 9.9 (percent of total assets). (Excludes a reinsurance company licensed in 2013.)
  - Pension Fund — 16.7; 7.5 (percent of total assets).
  - GDP (current US$) — 1.8 billion.
  - GDP (current Nu) — 94.9 billion.
  - Total financial sector assets/GDP — 94 percent.
  - Source: Royal Monetary Authority - Bhutan Financial Sector Performance Overview (March 2012-13).

### Formal financial service providers
- Banks and NBFIs:
  - Five banks operate in Bhutan: Bank of Bhutan Limited (BOB), Bhutan National Bank Limited (BNB), Druk Punjab National Bank Limited (Druk PNB), T Bank, and Bhutan Development Bank Limited (BDBL).
  - BDBL is 94 percent owned by the Royal Government of Bhutan and is mandated to operate in rural regions; it grants around 99 percent of formal loans to the agricultural sector.
  - Three nonbank financial institutions provide insurance and pension services: Royal Insurance Corporation of Bhutan Limited (RICBL), Bhutan Insurance Limited (BIL), and the National Pension and Provident Fund (NPPF). A reinsurance company was licensed in 2013.
  - Nonbank financial institutions have been allowed to engage in retail lending activities.
- Royal Securities Exchange of Bhutan Limited (RSEBL):
  - Early stage of development with 21 listed companies.
  - Automation led to a 230 percent increase of the total value traded in the secondary market between 2011 and 2012.
- Financial products and practices:
  - Banks offer credit facilities, savings/deposit services, insurance, remittance, foreign exchange, ATM, mobile (SMS) banking, and internet banking.
  - Cash-flow based lending has expanded alongside continued predominance of collateralized lending for individuals.
  - Non-loan products (letters of credit, factoring-like products) are being offered.

### Informal and semi-formal providers; financial inclusion
- No formal microfinance sector; civil society organizations and intermediaries provide financial services.
- A Financial Inclusion Policy has been drafted and is awaiting Cabinet approval.
- Cooperatives and self-help groups are growing interest points in rural areas; existing cooperatives largely provide group savings.
- Informal creditors dominate in communities with little formal presence; informal providers typically offer loans and may occasionally accept deposits.
- Access to basic banking and savings is relatively good by some indicators, but firms have few financing options beyond bank credit; access to finance as a major obstacle rose from 14 percent to 30 percent between 2001 and 2009 in World Bank enterprise surveys.
- Only half of firms in Bhutan prepare certified financial statements, limiting banks’ ability to assess borrower creditworthiness and increasing collateral reliance.

### Bank outreach (selected indicators, 2011)
- Bank branches per 100,000 adults — Bhutan: 16.4
- Bank branches per 1,000 km2 — Bhutan: 2.2
- ATMs per 100,000 adults — Bhutan: 14.1
- (Source: Financial Access Survey, IMF)

### KEY FINDINGS AND IMPLICATIONS (drawn from the introduction and background)
- Rapid credit expansion (average above 30 percent over past 10 years) and a sharp rise in credit-to-GDP from 11 percent to 49 percent have contributed to macro-financial vulnerabilities, including rupee shortages and recurrent balance of payments pressures.
- Large, bulky and time-concentrated hydro-related transactions complicate external financing and reserve management.
- Policy responses in 2011–2013 included reserve sales, import bans, relaxation of reserve and provisioning requirements, and a proposed 2013 Economic Stimulus Plan equivalent to 4 percent of GDP—measures that have implications for both macro stability and financial sector soundness.
- The financial system is concentrated in commercial banks, with limited depth in nonbank instruments and a nascent capital market (RSEBL), constraining financing options for firms and rural outreach.
- Weak credit information and limited availability of audited financial statements for firms increase collateralization and limit efficient credit allocation.

*Source: _cr14178 - INTRODUCTION. This document reflects information available as of the September 2013 mission, except where noted.*

### 16.      Commercial banks are also facing a lack of skilled workers in their efforts to expand

### _cr14178 - 16.      Commercial banks are also facing a lack of skilled workers in their efforts to expand

### Capacity constraints and skills
- Commercial banks face a lack of skilled workers needed to expand the range of financial products and to provide efficient and transparent banking services in an environment of increased competition due to new entrants.
- Need for capacity building of financial sector staff is increasingly important.

### Credit access, procedures, and private-sector perspective
- Firms view loan procedures as complex and lacking in transparency.
- Bhutan: 37 percent of surveyed firms responded that they had not applied for any loan in 2008, although they needed a loan for their businesses.
- Of these firms, 17 percent indicated they did not apply because application procedures for loans or lines of credit are complex and difficult to understand.

### Financial infrastructure modernization
- Credit Information Bureau (CIB) established in 2009; now an independent institution used by all financial institutions.
- CIB coverage as of May 2013: 97 percent of individuals and 50 percent of corporate borrowers.
- Collateral registry for moveable collateral launched in August 2013.
- Electronic funds transfer and clearing system inaugurated in June 2010; functionalities include credits and debits.
- Royal Monetary Authority (RMA) plans to draft a Payment and Settlement Systems Act with technical assistance from the Reserve Bank of India.
- Bhutan Financial Switch (national card switch system) launched in December 2011 to allow interoperability of ATMs and bank point-of-sale terminals.
- National Electronic Funds Transfer System made available to the public since December 2011.
- Suggested expansions: CIB could be expanded to include microfinance clients and support secured transactions including by movable collateral.

### Sectoral development priorities and recommendations
- Break out of practices limiting the range and types of loans while adding complexity to asset and liability management.
- CIB could develop credit scoring or credit assessment capacity to support credit decisions based on underlying creditworthiness.
- In insurance, divestment of banking business from insurance company balance sheets would help widen and deepen insurance services; implementation would need management by authorities alongside efforts to stimulate investment securities.

### Financial Sector Development Strategy (FSD Strategy) and regulatory trade-offs
- Formulating a Financial Sector Development Strategy would provide a framework for trade-offs between effective regulation/supervision and financial sector development.
- Analysis recommended of regulatory requirements that are unnecessarily prescriptive or create disproportionate obstacles.
- Review to be considered in context of supervisory approach changes: more risk-based supervision, increased focus on holding management responsible, more impact assessment of regulatory changes.
- Final responsibility for changes remains with the RMA, taking into account its statutory objectives.

### Marketable government securities, share divestment, and taxation
- Extending the range and maturity of marketable government securities would:
  - Improve monetary policy implementation,
  - Increase bank prudential liquidity,
  - Create a yield curve to underpin a corporate bond market and support better loan pricing,
  - Support long term investments required by insurance and the NPPF as they exit lending.
- Floating minority shares in public enterprises would broaden investment channels and enhance corporate governance.
  - Present government benefits from dividends via Druk Holdings and Investments (DHI).
  - Divestment through an RSEBL flotation would boost demand and supply of marketable securities and release resources for DHI to invest more widely.
  - Companies for potential divestment could include the Bank of Bhutan, aligning it with Financial Services Act requirement to float at least 40 percent of equity.
- Government should reconsider taxation of corporate dividends: currently dividends are subject to income tax on recipients (double taxation). Relief would raise returns and create more corporate structure options; benefits must be weighed against foregone tax revenue.

### Financial Inclusion Policy (FIP) and outreach
- A Financial Inclusion Policy has been drafted to facilitate access to finance, improve livelihoods, raise income levels, and reduce vulnerability.
- Geography remains a major constraint: many rural communities half a day’s walk or more from nearest farm road and one or two days travel from nearest bank.
- Draft FIP guiding considerations:
  - Formulate proportionate regulation balancing risk management and avoiding stifling innovation; use evidence-based analysis.
  - Where market failures call for government support, subsidies should be carefully targeted, time bound, and not impact financial sector soundness.
  - Avoid directed lending to rural areas or agriculture given high nonperforming loan risk internationally.
  - Government should facilitate funding access for microfinance institutions (MFIs), support creation of a microfinance association possibly with shared technology infrastructure, provide technical assistance, and assist coordination.
  - Proportionate increased supervisory controls and oversight mechanisms needed to ensure consumer protection regulatory environment and dispute resolution mechanisms function.

### Financial literacy and consumer protection
- Support for financial literacy and consumer protection regulatory environment is a key enabler of financial outreach.
- Bhutanese households display poor financial management skills; savings are an afterthought rather than the first step.
- No specific regulation on financial consumer protection exists; Companies Act 2000 and Consumer Protection Bill of Bhutan 2010 broadly address some consumer protection rights.
- Key client protection measure: establish mechanisms ensuring affordable, independent, fair, accountable, and timely access to dispute resolution to increase trust.

### SME lending and technical assistance
- Lenders need technical assistance to develop capacity to work with SME borrowers.
- Government established Accounting and Auditing Standards Board of Bhutan (AASBB) and started adopting standards aligned to IAS/IFRS to improve reliability of financial information and reduce collateral requirements.
- Technical assistance should help financial institutions build capacity to provide financing instruments to micro, small and medium enterprises and ensure private sector capacity to effectively utilize finance.

### Private equity, venture capital, and corporate bonds
- Development of a private equity market is a priority; positive developments include licensing of Nubri Capital and IFC exploration of supporting a private equity fund with DHI and an international private equity fund.
- Regulatory barriers:
  - Restriction to 100 percent domestic ownership rules out knowledge transfer from experienced foreign firms and may conflict with requirements like minimum CEO experience.
  - Regulations seem to rule out venture capital: total investment in venture capital cannot exceed Nu 5 million, whereas minimum capital requirements are of Nu 50 Million. Venture capital is critical given nascent risk capital market and small private sector.
- Corporate bond market development:
  - Nu 4.2 billion of corporate bonds outstanding, all four issuers being financial institutions or state-owned companies.
  - Several private sector firms have shown interest in issuing bonds.
  - Question of allowing financial institutions to guarantee bonds could jumpstart market but carries prudential risks and potential overleveraging.
  - RMA exploring how to encourage availability of credit ratings.

### Recent developments, structure, and key statistics
- Largest institutions: two established banks hold 75 percent of total bank assets of Nu 80 billion and most extensive branch networks; the long-established insurance company accounts for 75 percent of total gross premium income of Nu 1.1 billion.
- NPPF assets total Nu 15 billion.
- Sector composition and figures:
  - Loans and advances represent 65 percent of banking sector assets.
  - Off-balance sheet business of Nu 6.5 billion is mostly in form of credit substitutes—guarantees, letters of credit and performance bonds.
  - Insurance companies: loans and advances represent 70 percent of assets and are partly funded by borrowing from banks (insurers may not take deposits).
  - Insurance penetration is 1.3 percent of GDP and density is US$25 per capita.
  - Government marketable securities: Nu 2.5 billion of Treasury bills outstanding; no longer term bonds.
  - Bank earnings derive mostly from net interest margins, with limited fees and commissions.
- Credit growth and asset quality:
  - NPLs increased from 8 percent at end-June 2012 to 12 percent at end-September 2013.
- Composition of bank lending and deposit structure:
  - Housing and construction over 25 percent of lending.
  - Personal loans 18 percent.
  - Transport 7 percent.
  - Corporate deposits now 60 percent of total; retail deposits are hard to mobilize given interest rates of 5 to 7 percent up to two years against inflation of over 8 percent.
  - Shift from term to demand deposits; demand deposits now 55 percent of total.
- Resulting mismatches have created significant liquidity and interest rate risks.

### Infrastructure, regulation, and supervisory gaps
- CIB has yet to stimulate wider availability of unsecured credit or lending practices based on individual credit assessment rather than sector/maturity/security.
- Most lending in Bhutan is collateralized; loans typically an initial 75 percent of the security value.
- Increasing numbers of borrowers in public and private sector employment have access to unsecured credit serviced from salary payments.
- Some professional services (accounting, audit, actuarial) are sourced outside Bhutan; financial statements heavily reliant in practice on Indian accounting standards and audit practices.
- Regulatory strengthening:
  - Financial Services Act passed in 2011, updating legislation, strengthening RMA independence, and providing for RMA to issue regulations (including comprehensive corporate governance standards).
  - Capital requirements for banks and insurance companies substantially increased since 2012 through changes to risk weightings.
  - Banks now subject to base rate regulation requiring publication of base rates and prescribes calculation methods.
- Remaining gaps:
  - RMA has not yet issued all regulations mandated by law, including insurance risk requirements (valuation of liabilities, acceptable investments, solvency margin).
  - Limits on maturity mismatches in Prudential Regulations 2002 not set in practice due to lack of bank readiness and RMA skills/resourcing constraints.
  - Prudential requirements remain overly focused on credit risk; liquidity, interest rate, insurance, operational, foreign exchange, and off-balance-sheet risks are addressed incompletely or not at all.
  - Stress testing not routinely undertaken or used by financial institutions.
  - Resource pressures curtailed onsite supervision work, though this is being reversed.

### Macroprudential and supervisory developments
- RMA adopted a more macroprudential approach in response to escalating current account pressures from 2011 via monetary, foreign exchange, and supervisory measures.
- Capital requirements increased significantly from end-2012, targeting sectors with largest bank exposure, and increased further from end-2013.
- In November 2012, provisioning requirements and maximum gestation periods were eased.
- New RMA Financial Policy Committee coordinates macroprudential policy and developed a policy framework to be implemented through RMA Board-approved regulations from November 2014.
- Limited specific crisis management arrangements in place; deposit insurance arrangements are planned.

*International Monetary Fund — Bhutan country report content unit _cr14178*

### 37.      Some recent policy changes should have a positive impact on financial sector

### _cr14178 - 37.      Some recent policy changes should have a positive impact on financial sector

### Recent policy changes and expected impacts
- A major government project to develop local accounting standards based on IFRS with a view to full IFRS implementation by 2021.
- For financial institutions, listed and large public sector companies, an initial 18 Bhutan Accounting Standards, likely to be complemented by International Auditing Standards, take effect for audits in 2014.
- Draft regulations prepared by a consultant; a revised version was in preparation at the time of the EFSS mission.
- The RMA is working with consultants funded by the Asian Development Bank on:
  - a reporting format for banks (only one bank has been able to make reports under the existing format), and
  - developing supervisory expertise in asset and liability management.
- Plans to develop a local accounting professional body with training accredited by one or more foreign institutes; expected over time to increase disclosures and address risks associated with reliance on foreign standards.

### Other policy initiatives and potential adverse effects
- Licensing in 2013 of a new (Indian-owned) reinsurance company will create local capacity; however, the RMA requirement that insurers cede to the new company a minimum of 20 percent of premiums across all lines may:
  - unduly favor that company over foreign competition,
  - lead to distortions in insurers’ risk management decisions, and
  - raise costs.
- RMA’s April 2012 directive to insurance companies and the NPPF to plan discontinuance of existing and past lending activities by January 2015:
  - sought to address risks from combining banking and insurance businesses,
  - did not by itself tackle the lack of appropriate investments for companies seeking to invest premiums and manage significant insurance risks (including exposure in life insurance to interest rate changes from long-term guaranteed savings products).
  - Note: The directive was lifted subsequent to the mission, and the authorities are now developing investment guidelines for non-banks to encourage them to gradually lend less.
- The new RMA base rate system could:
  - stimulate improved loan pricing and more lending at floating rates (base rate plus a margin),
  - reduce flexibility for banks to compete on lending rates determined by themselves.

### Developments in financial soundness — key statistics (banks)
- Capital Adequacy Ratio (CAR) averaged 18.2 percent at June 2013 (minimum 10 percent).
- Statutory Liquidity Requirement: 34 percent compared with a minimum 20 percent.
- Average Tier 1 CAR was 14.9 percent at June 2013.
- Risk-weighted assets to total assets: 90 percent.
- Leverage ratios: 6 times on average and as low as 4 times for one bank.
- Individual exposures up to 25 percent of capital (the limit is 30 percent).
- Capital requirements currently based on the Basel I framework; definition of capital excludes deductions required under latest international standards.
- From end-2013, RMA risk weightings will range from 300 percent for personal loans to 50 percent for agriculture.
  - Banks have argued these changes could result in CARs falling by 3 to 4 percentage points.
- Off balance sheet business mostly 100 percent risk weighted; new framework does not apply to off balance sheet business.
- Provisioning levels averaging around 50 percent of NPLs (lower than in 2012 due to late-2012 relaxation; should be reversed).
- Collateral values reported to have fallen in parts of the country; revaluation practices vary and supervisory oversight of revaluation is limited.
- Credit to Deposit ratios: exceeding 100 percent for one bank at June 2013.
- Lending growth: lending by banks grew at a rate of nearly 5 percent in the second quarter of 2013 compared with rates of less than 2 percent per quarter since measures introduced in March 2012.

### Developments in financial soundness — insurance sector
- CAR and SLR requirements (designed for banks) are met by both insurance companies; claims ratios are healthy.
- Insurance risk limited due to extensive use of reinsurance (including catastrophe risk).
- Life business written with high guaranteed returns, but amounts remain low.
- Prudential regulations for insurance have been drafted but implementation delayed by conflicting technical assistance recommendations.
- Insurance sector faces challenges from divestment of banking business; transitional period may be required for diversification of investments.

### Stress testing of the banking sector (Box 1) — baseline and scenarios
- Baseline as of December 2012:
  - Banking system CAR: 19.1 percent.
  - Non performing loans (NPLs): 8.2 percent.
  - Provisioning as a ratio of NPLs: 81 percent.
- Stress test scenarios:
  1. Proportional increase in NPLs: NPLs increase from 8.2 percent to 18.4 percent.
  2. Sectoral shocks: certain percentages of loans become nonperforming in three sectors:
     - construction and personal loans: 50 percent become nonperforming,
     - trade: 10 percent,
     - tourism: 20 percent.
  3. Souring of large exposures: a bank’s five largest loans need to be fully written off.
  4. Liquidity shock: 15 percent of baseline demand deposits withdrawn each day for five days; 95 percent of liquid assets available for immediate sale.

### Stress testing — key results (system-wide and bank-level impacts)
- Souring of large exposures (which account for 13½ percent of total loans):
  - lowers system-wide CAR by 8.6 percentage points,
  - decline of 12.6 percentage points for one bank.
- Sectoral shocks:
  - lower banking system CAR by 3.9 percentage points for all banks,
  - lower by 4.5 percentage points for private banks.
- Proportionate increase in NPLs to 18.4 percent:
  - reduces the banking system’s CAR by 6.7 percentage points.
- Liquidity shocks scenario:
  - all five banks remain liquid after five days despite the hypothetical deposit run, given the initial high level of liquid assets relative to demand deposits.
- Under all credit risk scenarios, a number of banks’ CARs fell below the 10 percent minimum and one bank’s ratio was below 10 percent on all three tests.
- Overall assessment: the financial system is vulnerable to shocks; close monitoring is warranted.

### Emerging vulnerabilities and forward-looking concerns
- Balance sheets have been bolstered, and unemployment and some economic indicators are relatively benign, but:
  - Financial strength of individual institutions varies significantly.
  - Recent liquidity pressures highlighted serious asset and liability mismatches and exposure to sudden and severe policy measures (notably March 2012).
  - Financial institutions are vulnerable to adverse impacts of future such measures and would face challenges if reforms exposed them to more volatile or rising funding costs.

### Policy recommendations — Regulation and Supervision (priorities)
- Build supervisory capacity through recruitment and training; move from a prescriptive approach toward holding management responsible and assessing whether they meet that responsibility.
- Ensure supervisors have a view of the full range of risks:
  - start using scenario and stress testing (credit, interest rate, liquidity, foreign exchange risks),
  - require insurance companies to evaluate catastrophic event impacts,
  - resume onsite work to monitor system soundness, controls, credit standards, management and governance.
- Develop policy framework and issue regulations in key gap areas:
  - prudential standards for insurance and reinsurance,
  - bank liquidity regulation considering lack of high quality liquid instruments,
  - consider a mismatch limit approach as envisaged in Section 7 of the Prudential Regulations and begin with such an approach.
- Update the bank capital adequacy framework:
  - introduce a minimum Core Tier 1 Equity concept from the Basel III framework,
  - capture operational risk (non-advanced approaches),
  - address interest rate risk in the banking book (informed by stress tests),
  - develop a Pillar 2 framework linking capital adequacy to supervisory risk assessment.
- Use deeper risk assessment results to develop bank-specific supervisory strategies:
  - challenge business strategy, controls and financial strength,
  - identify weak banks and require remedial action plans.
- Develop a crisis management framework for possible bank failure:
  - evaluate additional information needed in a crisis (e.g., immediately maturing liabilities),
  - ensure information availability at short notice,
  - make practical preparations (updated contact details of key officials),
  - in due course consider changes to the Bankruptcy Act to create a bank insolvency framework,
  - resume planning for deposit insurance to support depositor confidence.
- Develop a policy framework for setting new standards and regulations:
  - include consultation with financial institutions and preparation of impact assessments,
  - strengthen the Financial Regulation and Supervision Department with a dedicated function for preparation and promulgation of new standards.
- Build on existing macroprudential readiness with:
  - regular review of sector-wide risks (extending the analysis in the Financial Sector Performance Review),
  - an internal policy statement on choice and use of macroprudential tools.
  - Objective: move away from reliance on one tool (adjustment of risk weightings) and seek to identify and address potential next sources of stress rather than focusing only on present stresses related to current account pressures.
  - Emphasis: macroprudential tools cannot substitute for an appropriate monetary and fiscal stance in addressing overheating pressures.

*Source: INTERNATIONAL MONETARY FUND.*

### 52.      Debt-to-income limits should in particular be considered, in conjunction with the

### _cr14178 - 52.      Debt-to-income limits should in particular be considered, in conjunction with the

### Macroprudential measures and debt-to-income limits
- Debt-to-income ratio limits could be considered by the RMA and have been effective in other countries.
- Debt-to-income limits may support increased focus on individual credit assessment.
- Loan-to-value ratio limits would have limited impact given that high levels of collateralization are part of established lending practice.
- Limiting credit to deposit ratios could be introduced if and when money and capital markets develop, at which point banks would have the scope to manage balance sheets to meet such minimums.
- Limits on overall credit growth could be considered but would be hard to calibrate.
- Making monetary policy implementation more effective should be the starting point and priority.

### Distinguishing macroprudential policy from targeted lending measures
- Authorities need to better distinguish macroprudential measures from measures designed to encourage lending to particular sectors and to take action preemptively.
- Recent changes to risk weighting have been driven mainly by analysis of risks in bank lending, but are also designed to encourage lending to targeted sectors such as agriculture—reflecting the wider government objective to stimulate sectors with lower demand for imports.
- The adequacy of overall capital requirements resulting from recent changes is hard to assess.
- The RMA’s recent increases in capital requirements are consistent with a higher risk environment; earlier increases (for instance as proposed in early 2012) might have helped moderate the rapid build-up in credit.

### Obstacles frustrating financial market development in Bhutan
- Absence of fully market-determined interest rates and the development of a yield curve to support pricing in financial markets generally.
- Inflexibility in credit provision—entrenched approaches to banking products and services, partly reflecting the absence of any alternatives to bank finance, limited openness to foreign participation and low penetration of technology.
- Limited availability of risk management instruments—in insurance (i.e. limited scope of products, especially for life insurance and low penetration generally) and no scope for hedging of risks through financial transactions.
- Still limited infrastructure and business services, with no ratings agency, other sources of independent evaluations of risk in financial assets or local accounting, auditing and actuarial services; and limited expertise in modern finance.
- Government ownership and control of large parts of the economy, limiting the scope for broader participation in ownership of financial assets. (The government is committed to retaining its most significant interests.)
- Limited understanding of finance amongst investing public.
- The difficulty of achieving scale in a country of only 700,000 people.

### Advantages and potential for financial development
- Institutional and high net worth investors including the NPPF, life insurance, the funds of the new fund management company, and DHI which manages the government’s investments and investor interest from abroad.
- A number of large public and private sector companies with a need for longer term finance and a government with a deficit to finance.
- A legal framework that is broadly understanding of and ready to support the enforcement of financial contracts.
- High quality infrastructure in payments and settlement.
- Policy-makers ready to take a strategic approach as evidenced, for example, by the government project on accounting and auditing standards.

### Supervisory and regulatory priorities
- Improvements in supervision and regulation will contribute to financial development, and strong supervision that addresses weak banks and requires recognition of full costs of lending decisions (for example, by addressing the risks in maturity mismatches) will support better allocation of resources, promote confidence, and help safeguard financial stability.
- Good supervisory process enables institutions to plan for the development of their business; however, more is required beyond recent initiatives.

### Strengthening monetary operations — overview
- Due to the peg to the Indian rupee, exchange rate changes cannot be used for macroeconomic adjustment; interest rate transmission is weak or non-existent.
- Need to deepen financial markets starting with an interbank market and short-term securities market and continuing to government and corporate bond markets.
- Room for an independent monetary policy is limited due to the exchange rate regime, but there should be sufficient scope to build a meaningful interest rate transmission channel.
- The new RMA Act of 2010 gave a clear mandate to pursue price stability as the primary objective while secondary objectives include regulation and supervision of the financial system; the RMA now has independence to formulate and implement monetary policy.
- Part of the unsustainable expansion of credit has been caused by high levels of excess liquidity in the banking system over several years; it is important to establish a liquidity management system with effective market-based instruments to prevent recurrence of the rupee problem.

### Active liquidity management and interbank market development
- Active liquidity management is the starting point for improving monetary transmission; balancing and controlling short-term developments in bank reserves is a precondition for establishing an interbank market.
- A banking system consisting of five banks should accommodate interbank trading of short-term funds.
- The liquidity management framework must provide stable and predictable incentives to induce individual banks to plan and take responsibility for their own liquidity; interbank market interest rates will affect other money market interest rates and influence the term structure of interest rates.
- More active and deeper money and credit markets will absorb and smooth erratic fluctuations and provide more stability through market determination of interest rates, enabling the interest channel of monetary policy.

### Government securities market — present situation
- Treasury bills were introduced in December 2009 to replace RMA bills with the objectives of improving government cash management, allowing the use of market-based instruments of monetary policy, and providing a benchmark for short term interest rates; these objectives have not been met because of erratic issuance, unpredictable and insufficient amounts, small market size, limited market participation, and the lack of other financial instruments.
- Treasury bills are not being issued at market-determined interest rates: since February 2013, the interest rate has been fixed at 3 percent which is far below deposit interest rates and RMA’s policy rate.
- A “tap-sale” mechanism has been used in which the MoF determines the interest rate and the amount; maturities have varied from 14 to 90 days, with issuance primarily at 30 days.
- Despite a substantial financing requirement in recent months, the government has continued to rely on bank financing rather than T-bill issuance.
  - An overdraft facility (OD) is available at the RMA up to a limit determined as 10 percent of average revenue over the last two years; this limit was recently raised from Nu 1.9 billion to Nu 2.1 billion reflecting this guideline. The RMA charges an interest rate, currently 4 percent, at 1 percentage point above the rate for the most recent Treasury bill issuance.
  - The Ways and Means (W&M) account with the largest commercial bank (BOBL) can be overdrawn without a limit. The interest rate charged is currently 5.5 percent.
- Treasury bill issuance has been largely detached from financing requirements and has not been used for monetary policy purposes in the period under review.

### Government securities market — discussion and recommendations
- Developing a government securities market is the most critical element for making monetary policy more effective and for enhancing financial markets in Bhutan.
- Benefits of sufficient government securities at market-determined rates:
  - Provide financial institutions with an investment alternative for portfolio adjustments and liquidity management, including meeting prudential liquidity requirement.
  - Give the central bank a basis for effectively managing banking sector liquidity.
  - Give the government access to market financing necessary for efficient cash management.
  - Build a (risk-free) benchmark yield curve with positive externalities for financial sector development.
- Main sources of government financing should be gradually shifted from bank to market financing as government cash management improves and financing requirements can be covered through an operational issuance program of Treasury bills.
  - At that point, the Ways and Means account with a commercial bank should not be allowed to be overdrawn and the use of the overdraft facility in RMA should be made more restrictive.
  - Consideration should be given to limiting direct access to financing from the central bank to emergency situations only.
  - Overdraft drawings should have a limited maturity and not generally be rolled over to incentivize strict budgetary cash plans.
- RMA should persistently promote development of a short-term securities market; it must be a joint responsibility of the MoF and RMA to establish a reliable issuance calendar for Treasury bills and ensure meaningful amounts are issued also when there are no immediate financing needs of the Government.
- The arrangement for using Treasury bills both for government financing and monetary policy purposes should be fully utilized; the use of RMA bills should not be resumed.
  - RMA should for liquidity management purposes preferably issue Treasury bills with the shortest maturities, with maturities and amounts determined by expected liquidity management needs.
  - Robust arrangements are needed to prevent the government from utilizing liquidity that has drained from the system for monetary policy purposes, and an appropriate communication strategy with market players is required.
- Market financing and liquidity absorption at market rates will imply increased costs to the budget and to the RMA, but benefits outweigh costs.
  - The present arrangement (November 2009 MoU) states that the cost of Treasury bills issued for monetary policy purposes should be borne by the RMA.
  - It is important to establish acceptance that the cost of monetary policy ultimately—directly or indirectly—must be borne by the budget; taking sterilization costs directly into the budget may be preferable to repeatedly recapitalizing the central bank.
  - The RMA and the MoF could consider adjusting the existing MOU to include a binding cost-sharing arrangement specifying how the RMA could be reimbursed for costs that cannot be absorbed on its balance sheet in connection with issuing Treasury bills for sterilizing liquidity.
  - Full transparency should exist as to the distribution of issued amounts between the MoF and RMA, even though Treasury bills issued for different purposes are identical for investors.
- Cooperation and coordination between the MoF and the RMA on debt and liquidity management should be strengthened:
  - The RMA should be given the opportunity to comment on the debt strategy before final decisions are taken.
  - The existing Treasury Bills Management Committee should meet regularly (e.g. weekly) and be fully used as a platform for sharing relevant information.
- Technical infrastructure improvements:
  - Ownership records are currently maintained in an Excel spreadsheet at the RMA; an automated depository system should be developed to facilitate transfer of ownership resulting from secondary market trades and allow for temporary transfers in connection with use of securities as collateral and in repurchase transactions.
  - Ideally, the depository should be integrated with the payment system to ensure delivery versus payment; as the payments system recently adopted by the RMA is based on the RBI system, the RBI could be approached for support in extending this system to include a depository.

*Source: _cr14178*

### 72.      Along with the technical infrastructure, a viable Treasury bill program should also be

### _cr14178 - 72.      Along with the technical infrastructure, a viable Treasury bill program should also be

### Market infrastructure for a viable Treasury bill program
- A viable Treasury bill program requires market infrastructure in addition to technical infrastructure, including:
  - Regulations and market practices.
  - Clear guidelines for trading and settlement.
- Institutional roles and market organization:
  - The RMA should assume the main responsibility for market infrastructure tasks, in close collaboration with MoF.
  - Traders should establish a Code of Conduct; recommendation to set up a forum of bank treasurers under the Financial Institutions’ Association of Bhutan (FIAB).
  - One of the first tasks for the treasurers’ forum: discuss and adopt a Code of Conduct for trading in the domestic money market and possibly the foreign exchange market.
- Market infrastructure operational notes:
  - While the Royal Securities Exchange of Bhutan (RSEB) has a depository for debt instruments, it is generally advisable to start Treasury bill depository infrastructure in the central bank to allow fast and secure settlements and enable Over the Counter (OTC) trading to develop a secondary market.
  - Meeting frequency for relevant forums: present arrangement specifies meetings “as and when necessary but not less than once a quarter”; frequency should be reconsidered in a dynamic market environment with active Treasury bill issuance.

### Enhancing monetary operations — Present situation
- Monetary policy implementation tools and usage:
  - RMA relies heavily on direct instruments and administrative intervention (reserve requirement (cash reserve ratio (CRR)) and liquidity regulations (SLR)).
  - Banks maintain separate CRR accounts; no provision to meet requirement on average over a maintenance period.
  - Attempts to move to market-based instruments have been limited; RMA bills and Treasury bills have not achieved intended objectives.
- New instruments and pricing:
  - A “lender of last resort” facility (RMA Short-Term Liquidity Adjustment Window (RSTLAW)) provides funds up to 90 days, priced 1 percentage point above the Policy Rate.
  - The Policy Rate is currently set at 6 percent.
  - The RSTLAW has been used only once, mainly due to banks’ lack of collateral and excess liquidity.
  - Base rate regulation introduced; some improvement in transparency but no evident improvement in transmission.
- Sweeping practice and magnitudes:
  - Sweeping balances of selected commercial bank accounts overnight to the RMA used as an administrative liquidity measure; extended to a number of large accounts (currently 8), including mostly hydropower project accounts.
  - Daily swept amounts vary between Nu 500 million - Nu 1.2 billion.
  - Sweeping was discontinued end-May 2012 when liquidity tightened, but resumed beginning of July 2013.
- Interbank market characteristics:
  - Limited interbank market; unsecured placements among banks are regular but almost never short-term, with normal maturities from 90 days to one year.
  - Bank placements constitute about one-third of all Quick Assets.
- Foreign exchange market arrangements:
  - No FX transactions between banks; banks deal in FX only with customers at rates fixed daily by the RMA based on the US$/INR closing rate the day before.
  - Banks cannot transact within the RMA-prescribed margin; contrast with India where banks can trade within the margin.
  - Banks can sell convertible currencies to the RMA when approaching fixed limits: US$10 million for larger banks and US$5 million for smaller banks.
  - All RMA–bank FX sales and purchases take place at the mid-rate, giving no incentive to interbank FX trading.

### Enhancing monetary operations — Discussion and recommendations
- Liquidity framework and forecasting:
  - Develop an operational liquidity framework to monitor liquidity drivers and banks’ behavior; make forecasts of banks’ reserves and calibrate open market operations.
  - RMA involvement in government cash flow forecasting (including hydropower-related flows) is important; TA to the Department of Public Accounts and introduction of a TSA should improve data for liquidity forecasts.
  - Recognize not all government cash flows have immediate liquidity effects (e.g., FX transactions and government–RMA transactions).
- Redesign reserve requirement system:
  - Change practice of separate CRR accounts: banks should have only one account with the RMA serving as both reserve account and ordinary settlement account.
  - Allow banks to meet reserve requirement on average over the maintenance period (averaging mechanism) to provide flexibility and reduce demand for excess reserves.
  - If reserve ratio increases in future, combine averaging with a minimum daily requirement (a floor) that can be lowered with experience; penalize non-fulfillment at end of maintenance period.
  - Current reserve ratio noted as 5 per cent; present level is seen as a good opportunity to implement the change.
- Use of reserve requirements:
  - Reserve requirements are effective but blunt; avoid frequent and large changes as they disrupt financial intermediation and act as a tax on intermediation.
  - Historical changes: the reserve ratio was reduced from 17 percent to 10 percent in March 2012 and further to 5 percent in June 2012.
- Sweeping policy:
  - Sweeping is an administrative tool useful to sterilize very short-term, large, potentially destabilizing hydropower funds, but should not be a general liquidity instrument as alternatives are developed.
  - Future use should be analyzed and clarified with commercial banks; account selection could be reviewed.
- Short-term standing lending facility:
  - Introduce a short-term overnight standing lending facility; RSTLAW (up to 90 days) is too long-term for routine liquidity needs.
  - Facility could be extended up to one week while interbank market develops.
  - Rate should be reasonably penal relative to interbank market to encourage banks to borrow from each other first; the facility rate should form the ceiling for the interbank market rate.
  - Access conditional on appropriate collateral; occasional use should not carry stigma.
- Lender-of-Last-Resort (LoLR) considerations:
  - Standing facilities are for very short-term support; longer-term/structural liquidity problems require LoLR arrangements.
  - RSTLAW could serve as an interim LoLR although granting overdrafts up to 90 days is unusual; LoLR support should not be part of monetary policy implementation but its liquidity effects must be considered.
- Standing deposit facility:
  - Consider introducing a standing deposit facility to provide an interest rate floor; rate should be low (penalty element) to discourage automatic use and incentivize interbank placements.
  - Not urgently needed but useful later to absorb sudden capital inflows and as an alternative to sweeping; requires careful cost consideration (RMA would pay interest on excess reserves).
  - Introduce within a broader package to foster market development and effective monetary policy implementation.
- FX market flexibility to support transmission:
  - Consider greater FX market flexibility: allow banks to determine customer rates within RMA-prescribed margins (as in India) to create competitive pricing for FX transactions.
  - Permit banks to sell FX a bit cheaper as part of customer relations.
  - RMA–bank FX transactions should not always be at mid-rate and available at all times; start with a daily window (fixed time) with buy and sell rates around a parity USD/Nu rate determined from US$/INR market rate, later restrict to a few predetermined days.
  - A functioning interbank FX market would facilitate efficient distribution of FX from surplus to deficit institutions and support monetary policy implementation.

### Strengthening monetary transmission — Present situation
- Interest rate transmission is weak:
  - Banks’ retail deposit and lending rates remained remarkably stable despite large swings in system liquidity and macro developments.
  - Banks are in principle free to set interest rates but have made limited adjustments to portfolios via interest rate changes.
  - Limited impact observed on bank funding costs from monetary policy instruments (e.g., Treasury bills).
- Lending practices and implications:
  - Banks mostly lend medium to long term at fixed interest rates.
  - A tightening of monetary policy that increases funding costs will first reduce bank profits and possibly capital, with stronger effects on lending and demand only if interest rates on existing loans can be adjusted (not only new loans).

### Strengthening monetary transmission — Discussion and recommendations
- Liquidity management objectives:
  - Aim liquidity management at influencing money and securities market functioning to strengthen the policy-rate-to-retail-rate transmission channel.
  - Two transmission channels to develop:
    - Policy rate → wholesale interbank and Treasury bill markets.
    - Wholesale rates → banks’ retail deposit and lending rates.
  - Ensure short-term market rates are determined close to the policy rate, especially under a fixed exchange rate regime to prevent divergence from the anchor currency interest rate.
- Institutional and market development expectations:
  - Developing transmission channels will take time and require changes in banks’ lending practices toward greater responsiveness to market conditions.

*Source: IMF staff report excerpt contained in the provided PDF content unit.*

### 88.      In practical terms, liquidity management should attempt to ensure stability in bank

### In practical terms, liquidity management should attempt to ensure stability in bank reserves

### Liquidity management and bank reserves
- Liquidity management should attempt to ensure stability in bank reserves in order to establish a link between quantities (bank reserves) and the price of reserves (market interest rates).
- Large volatility in banks’ reserves makes liquidity planning by banks difficult and without a consistent framework to absorb large swings in liquidity flows, it will be difficult to establish an interbank market.
- In addition to monitoring and forecasting the supply of reserves, the approach must also be to determine banks’ demand for reserves and “true” excess reserves (or surplus reserves).

### Demand for reserves in Bhutan
- For Bhutan, the demand for bank reserves is primarily linked to the banks’ need to meet the reserve requirement (CRR) and the liquidity requirements (SLR).
- The SLR is unusual as banks normally will meet prudential liquidity requirements with other interest bearing assets rather than unremunerated current accounts at the central bank.
- A credible Treasury bill program, as discussed earlier, should provide more appropriate assets for meeting the SLR in the future.
- Banks often may want to hold additional reserves over the legally required minimum (CRR or SLR) for clearing purposes and other contingencies; this portion is often referred to as banks’ “own demand” for reserves.
- Banks’ own demand cannot be directly observed and has to be estimated or critically assessed; surveys can be used as a starting point and should be supplemented by frequent contacts with individual banks.
- In a liquidity framework with a focus on bank reserves, it will be necessary to manage “true” excess reserves (also referred to as surplus reserves), which is the residual portion above statutory requirement and banks’ own demand.

### Surplus reserves and interest-rate transmission
- For the link between banks’ reserves and market interest rates to work efficiently, the market for bank reserves should be in approximate balance.
- Any “surplus reserves” held beyond the demand for reserves will be particularly important for liquidity management.
- A rise (decline) in surplus reserves will normally induce banks to expand (reduce) their balance sheets and to lend more (less) on the interbank market, putting downward (upward) pressure on short-term interest rates.
- An analysis of the interrelationship between the level of surplus reserves and interest rates will become important in a monetary regime with interest rates as the operating variable.

### Conclusion: financial sector gaps and strategic priorities
- Despite substantial progress with key financial reforms, Bhutan needs a comprehensive strategy for deepening and broadening the financial sector.
- Accomplishments to date include: new entry into banking and insurance; amendment of the Royal Monetary Authority (RMA) Act; passage of the Financial Services Act; and improved financial infrastructure including a new payments system, credit bureau, and collateral registry.
- Shortcomings and risks:
  - Financial institutions’ risk management has not kept pace with the five-fold increase in credit/GDP in the last decade.
  - Assets are not available for liquidity management or investment diversification.
  - Growing liquidity and interest rate mismatches need to be addressed by the regulatory framework.
  - Risk that ad hoc measures may create uncertainty, increase vulnerabilities, and impede financial sector development.
- A comprehensive Financial Sector Development Strategy (FSDS) is needed with objectives to:
  - Improve the ability of the financial system to contribute to long-term economic growth by channeling savings efficiently to productive investments in a sound and stable financial environment.
  - Provide opportunities to smooth consumption and manage risk.
  - Broaden the range of financial assets, most importantly government debt with a range of maturities to provide a benchmark yield curve, but also public and private equity, corporate bonds, and micro-finance.
  - Develop financial markets starting with an interbank market and short-term securities market and continuing with government and corporate bond markets.
- It must be a joint responsibility of the MoF and RMA to promote the development of a short-term securities market.
- The strategy would also:
  - Strengthen regulation and supervision while broadening access to the financial system of excluded groups.
  - Encompass a detailed, prioritized, and sequenced action plan and benefit from consultation with relevant stakeholders.
  - Form part of a masterplan including a financial sector review and diagnostic covering both the bank and non-bank financial sectors and establishment of a mechanism to monitor implementation and coordinate technical assistance.

### Key actionable recommendations (selected)
- Develop a credible Treasury bill program and start systematic work toward establishing an issuance calendar for Treasury bills and commit to float meaningful amounts on a regular basis even when there is no financing need.
- Reduce gradually use of the government’s overdraft facility in a commercial bank and agree on more restrictive use of the overdraft facility at the RMA.
- Agree on a MoU specifying how RMA could be reimbursed for the cost of monetary policy.
- Utilize regular meetings of the Treasury Bill Management Committee to share information and coordinate public debt management and liquidity management.
- Establish an automated depository for registering treasury bills at the central bank.
- Initiate systematic work on strengthening the market infrastructure for securities trading and establish a Code of Conduct by treasurers in financial institutions.
- Reactivate the liquidity monitoring framework by ensuring that the government cash flow projections can serve as direct input to the liquidity framework.
- Redesign the reserve requirement system (CRR) by merging the CRR account and the current account into one account and allow for averaging over the maintenance period.
- Limit use of the sweeping arrangement to clearly eligible accounts, selected in cooperation with commercial banks, and refrain from using sweeping to manage normal liquidity flows.
- Use Treasury bills on a regular basis with maturities and amounts determined by expected liquidity flows to stabilize as much as possible bank reserves.
- Introduce a short-term standing lending facility (one week) and redesign the RSTLAW as a Lender-of-last resort facility to assist banks with longer-term liquidity problems.
- Allow banks to trade foreign exchange with their retail customers at rates within the prescribed margin and redesign the trading of convertible currencies between banks and RMA to give incentives to interbank trading.
- Establish a liquidity management framework in which monetary instruments are available that can ensure that market interest rates are determined close to the policy rate.
- Start work to analyze and identify the various components of banks’ demand for reserves in order to determine the level of “true” excess reserves or surplus reserves.

*Source: IMF staff report and related material on Bhutan (excerpt).*

### 1.      On behalf of our authorities, we thank the staff for a comprehensive and well-

### _cr14178 - 1.      On behalf of our authorities, we thank the staff for a comprehensive and well-

### Recent Economic Developments
- Real GDP growth averaged 8 percent during the 10th Plan (2008-13), driven by electricity, construction and services activity.
- Poverty declined from 23 percent in 2007 to 12 percent in 2012.
- Unemployment rate fell from 3.1 percent in 2011 to 2.1 percent in 2012.
- Real GDP growth slowed to 4.6 percent in 2012 from 8.6 percent in 2011 after policy measures to rein in aggregate demand.
- Hydropower, construction and electricity sub-sectors constitute almost one-fourth of GDP.
- Power generation capacity target: increase from current level of 1500 MW to 10,000 MW by 2020, predominantly with support from India.
- Electricity and related growth expected to pick up in 2016-17 when the next project starts production, leading to a spike in the growth rate in 2016-17.
- Consumer price inflation: moderated from 13.5 percent in 2012:Q2 to 5.5 percent in 2013:Q2; rose to 11.3 percent in 2013:Q4 largely due to food-related prices.
- RMA maintains a tight monetary policy stance and has launched macro prudential policies under a Financial Sector Development Strategy.
- Fiscal deficit decreased from 1.2 percent of GDP in 2011-12 to 1 percent of GDP in 2012-13.

### External Sector Management
- Current account deficit widened to 25 percent of GDP in 2012-13 from 23 percent of GDP in 2011-12 due to reduced inflows in budgetary grants.
- As of March 2014, international reserves were USD 965 million, providing a cover for 22 months of merchandise imports.
- Overall BoP position has recorded modest deficits or surpluses in recent years; BoP position with India has recorded persistent deficits while there is a surplus with other countries.
- RMA actions in 2012-2013:
  - INR Swap arrangement with RBI raising INR 5.4 billion in March 2013 for 6 months; Swap liquidated in September 2013.
  - Sale of USD 200 million against INR in June 2013 to raise INR resources.
- Authorities view the currency peg to the INR as having served Bhutan well given strong trade and economic ties with India.
- Import requirements for hydropower projects expected to maintain pressure on the current account deficit during construction; current account expected to move from deficit to surplus once projects start production.
- Public debt and external debt positions expected to improve significantly as hydropower projects start generation.
- Sequencing of further hydropower investments and negotiation of project modalities considered critical given potential to harness beyond 10,000 MW.

### Reserve Adequacy Issues
- Staff estimate: if Bhutan had invested on average 30 percent of its reserves in INR denominated government bonds, it would have earned net interest of INR 4 billion in 2005-12 period.
- Staff notes actual interest cost of INR overdraft facilities periodically used has added to the cost of holding convertible currency reserves.
- Staff recommendation: align currency composition of reserves with structure of Bhutan’s external liabilities and trade, consider gradual increase in share of INR reserves; convert any excess of convertible currency reserves above a certain nominal threshold into rupees and manage in a liquidity portfolio.
- Authorities' responses and considerations:
  - INR funds would need to be maintained in the most liquid form to meet unpredictable daily payment obligations, making staff’s interest earnings estimates unlikely to be realized.
  - Currency composition reflects: (i) reserves build up largely due to aid inflows; (ii) sizable convertible currency payment obligations largely denominated in USD; (iii) INR is non-convertible, so keeping reserves in USD and converting as needed is more efficient.
  - Constitutional requirement of an import cover of 12 months in foreign currency.
- RMA has a Reserve Management Policy, is developing guidelines, and is implementing a Reserve Adequacy Framework with a threshold limit beyond which convertible currency reserves will be converted and Rupee reserves increased when conditions are favorable.
- Authorities use transitional arrangements under Article XIV, section 2 and maintain prudential foreign exchange restrictions; current INR exchange restrictions related to import of vehicles and construction materials have been in place since 2012 and are described as temporary with plans to remove them this year in line with introduction of fiscal measures by the Royal Government.
- Bhutan began disseminating BoP and IIP statistics compiled under IMF’s BPM6, including quarterly statistics, following IMF TA and Japan Subaccount (JSA) Project assistance.

### Financial Sector
- Financial soundness indicators: capital adequacy and liquidity well above prudential norms; proportion of non-performing loans has increased recently.
- Central bank supplemented micro-prudential regulations with macro-prudential system.
- Macro-prudential regulations being put in place covering: counter-cyclical capital buffers, sectoral capital requirements, leverage ratio, loan to value and loan to income ratios, debt to equity ratio, time-varying capital provisioning, margin requirement and profit distribution.
- Government Economic Stimulus Plan (ESP) from 2014: INR 5 billion secured by the Government as grant support outside of the 11th Five Year Plan (FYP) (2013-18) from the government of India injected into financial institutions to improve liquidity and lending.
- Central Registry for Movable Property established in September 2013 to facilitate credit appraisal.
- RMA adjusted prudential provisions pertaining to loan provisioning and risk weight limits during 2012 and 2013 to contain over-exposure and rapid credit expansion.

### Capacity Development and Small States
- Authorities appreciate Fund support for training and technical assistance (TA).
- In 2013, Bhutan received TA in National Accounts Statistics, Treasury Management, Financial Sector Surveillance, Balance of Payments (External Sector Statistics), and Foreign Exchange and Reserve Management.
- Bhutan is cited as a success story in enhancing compilation and quality of BoP and IIP statistics.
- Authorities request continued external resource support and assistance from the Fund while pursuing reforms.
- Staff projections indicate official development assistance expected to decline gradually in line with improvements in per capita income.
- Authorities note growth has been driven primarily by hydropower development which generates limited employment; Bhutan remains import and aid-dependent and seeks economic diversification with support from multilateral partners including IMF, World Bank and ADB.

### Outlook
- Poverty reduced from 32 percent in 2003 to 12 percent in 2012.
- Authorities aim for self reliance and reducing dependence on external assistance by 2020.
- Recognition of structural weaknesses and challenges that require attention to ensure long-term sustainability; economy cannot be sustained on a single sector despite hydropower’s catalytic role.
- 11th Five Year Plan (2013-14 to 2017-18) envisages average annual growth of 12 percent compared with 8 percent in the 10th Plan.
- Prudent management and use of hydropower inflows critical in the long run; short-to-medium-term focus on managing spillovers from hydropower sector on INR reserves during project gestation to preserve macroeconomic and financial stability.

*Source: _cr14178 - 1.      On behalf of our authorities, we thank the staff for a comprehensive and well-*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14178.pdf_