Regions and Countries

	Table of Contents
p. 2 of 20 BACK | NEXT I. Country Performance Assessment A. Economic Performance Assessment B. Poverty Assessment C. Assessment of Socio-Environmental Performance D. Governance: Sound Development Management E. Implementation Assessment II. Country Operational Strategy III. Sector Strategies IV. Regional Cooperation V. Donor Activities and Aid Coordination VI. Cofinancing and Catalyzing External Resources VII. ADB’s Operational Program VIII. Economic and Sector Work Program IX. Local Cost Financing

Country Assistance Plans - Bhutan : I. Country Performance Assessment

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A. Economic Performance Assessment¹

1. Since Bhutan's emergence from virtual isolation from the rest of the world in the early 1960s, the country has witnessed considerable transformation from an economy based on subsistence agriculture to a growing economy with diversification and modernization as well as major improvements in social indicators, communications, governance, and standard of living. These changes have occurred with relatively few adverse effects on the environment or the country's cultural heritage. While work under a series of five-year plans helped establish basic infrastructure in the economy, it was not until the 1980s with the commissioning of the Chukha hydropower plant (336 megawatts [MW])² in 1986 that a diverse economy really began to emerge. With the advent of hydropower in the country-and the manufacturing enterprises benefiting from low-cost power-gross domestic product (GDP) grew by nearly 8 percent a year in real terms during the second half of the 1980s. While real GDP growth has slowed somewhat since, it averaged 5.6 percent a year during 1990-1995 and 6.0 percent annually in 1996-1999. These recent rates, while relatively good in themselves, should accelerate over the medium term with the completion of the Dungsum cement plant, the Basochu hydropower project (adding 22.2MW in 2001 and a further 36.2MW in 2003/4), the Kurichu project (60MW) in 2001, and the Tala project (1,020MW) in 2004. However, inadequate social and physical infrastructure including shortage of skilled and unskilled labor and lack of an efficient road network to markets remain major constraints to further development of the country in the longer term.

2. Developments in the industry and services sectors have overstripped those in agriculture, with the share of agriculture in GDP declined from 53 percent in 1981 to 37 percent in 1999; that of industry, led by manufacturing, electricity, and construction growth, rose from 17 percent to 34 percent; and that of the services sector remained at about 29 percent in 1999. The agriculture sector, while still dominated by subsistence production, has also become somewhat diversified since the early 1980s, and remains by far the country's main source of employment. The Government estimates 85 percent of the population reside in rural areas even though only 8 percent of the country's land area is under cultivation. Rice, maize, and potatoes are the main food crops grown, largely for home consumption. Export crops now gaining significance include medicinal plants, lemongrass, cardamom, and specialty mushrooms. Fruit-growing is also increasing importance: mostly apples and oranges, but including peaches and strawberries, for both domestic consumption and export, primarily to Bangladesh. Livestock-principally, cattle, yak and pigs-also makes important contribution to smallholder diets and incomes although, in some areas, overgrazing has imposed a strain on the fragile mountain environment.

3. The growth of the industry sector comprising mining, manufacturing, electricity, and construction has slowed in recent years, particularly in the electricity subsector; however, the rate of growth in manufacturing remains buoyant. The sector is dominated by a few large firms, State-owned or recently privatized, and supported by myriad small and cottage enterprises, and some medium-size firms in handicrafts, handmade paper, food processing, wood products and construction activities. Currently, most manufacturing output and exports are from a narrow range of products-cement, ferro-alloys, calcium carbide, processed foods, and particle board-which tend to be produced with energy-and capital-intensive methods and dependent on skilled and unskilled expatriate labor from neighboring countries.

4. The Government is firmly committed to the growth of private sector activity. While several institutional, policy, and labor constraints to this growth remain, the Government has been active in privatizing State-owned firms, promoting institutional and legislative reform, and supporting the upgrading of domestic skills. However, industrial policies, particularly with regard to foreign investment, remain somewhat ambiguous but they are now being looked into. Thus, while sectoral diversification, deepening, and privatization have undoubtedly occurred, the sector is heavily concentrated on a narrow range of products; highly dependent on expatriate labor; restricted by the small, fragmented domestic market and a narrow range of readily accessible export markets; limited by poor, expensive transportation; and constrained by national sensitivities concerning resource exploitation (especially for tourism and logging) and by caution with respect to foreign investment and the employment of foreign labor. The main challenge facing the Government, therefore, is how to realize its commitment to promote private sector activity in the face of such constraints.

5. In common with its approach to development policy generally, the Government has managed-and continues to manage-the economy prudently. In practice, however, it is fiscal policy rather than monetary policy that has to play the key role in the macroeconomic management of the economy. In terms of monetary policy, the Government has limited scope to exercise independence, given that (i) the Bhutanese ngultrum is pegged to the Indian rupee at par, which requires a relatively close link between the interest rates of the two countries; (ii) a large stock of Indian rupees circulates freely and widely in Bhutan even though, technically, the ngultrum is the only legal tender; and (iii) trade between Bhutan and India is virtually free of restrictions, which means that Bhutanese price movements closely reflect those of India. Moreover, India receives over 90 percent of Bhutan's exports and supplies some 70 percent of its imports.

6. While monetary expansion (M2) has been significantly faster than nominal GDP growth for several years, this has not been reflected in a rise in domestic inflationary pressure³ but in the increasing monetization of the economy. Moreover, large overall balance of payments surpluses and aid inflows⁴, have led to a buildup in official foreign exchange reserves, which was equivalent to more than 19 months of merchandise imports at the end of FY1999. At the same time, limited domestic investment opportunities have led to a sizable accumulation of excess liquidity in the domestic financial system which, notwithstanding the limits to Bhutan's independence of monetary policy, could possibly be moderated by adopting a rather less rigid and more market-sensitive interest rate structure, and by encouraging greater competition between the two commercial banks. The key questions for the Government in the financial sector for the future are how to address the issue of excess liquidity in the financial system and how to improve financial intermediation so as to encourage private sector operations.

7. The Government's prudence in fiscal policy is evidenced by its attempt to cover its current expenditures with domestic revenue and to finance capital expenditures with grants and soft loans. Current expenditures as a proportion of GDP have been relatively stable over time, despite the significant expansion in the provision of free health and education and the rise in civil service salaries in the past few years. While current deficits (excluding grants) have been the norm in the past, generous grant assistance-mainly from the Government of India-has bolstered the limited domestic resources and served to finance the domestic deficits. With increased domestic revenues emanating from domestic tax and nontax sources and especially from the corporate taxes and profit transfers of the Chukha plant, the latter now representing over 40 percent of domestic revenues, the Government has been able to increase the country's fiscal self-reliance. Since FY1996, the Government has been able to meet current expenditures from domestic sources of revenue, although it is still heavily dependent on assistance from India and other sources for its capital expenditures. While external assistance has been more than adequate to cover capital expenditures in most years, thereby contributing to rising exchange reserves, major increase in capital expenditures for hydropower projects in recent years has led to an overall budget deficit of 2.4 percent of GDP in 1997 and 2.3 percent in 1999.

8. Notwithstanding the general prudence of the country's fiscal management, fiscal issues and risks remain: (i) the dependence of government revenues on the export of energy to India and thus on the volume of sales and the negotiated export price; and (ii) the narrowness of the domestic revenue base (its broadening through the introduction of a personal income tax and increased power tariffs and user charges to cover rising recurrent expenditures for maintaining physical and social infrastructure is being considered). The Government would need to address these issues as the country's large and increasing foreign exchange reserves could potentially serve to slow further inflows of aid or to lead to a hardening in their terms.

9. Throughout the 1980s and the first half of the 1990s, Bhutan had relatively large, fluctuating deficits on its merchandise trade account and its current account with both India and third countries. This situation persists with third countries but with India, Bhutan ran a trade surplus in 1996-1998 following the rise in electricity export prices in 1996. However, this trend reversed in 1999 with a trade deficit at 4.6 percent of GDP with India. Current account deficits continued both overall and with India. Bhutan imports a wide variety of consumer goods, including certain basic food items, petroleum products, and virtually all capital goods. As noted earlier, it is successfully increasing its exports not only of electricity to India but of a variety of other goods to third countries-notably Bangladesh, Netherlands, Singapore, and Thailand-to earn convertible currency. Deficits on the current account of the balance of payments have persisted; however, official capital inflows, mostly to cover infrastructure investment, have exceeded them.

10. Tourist receipts are also increasing. Contrary to popular perception, tourist arrivals are not subject to numerical restriction. As a result of high mandatory expenditure levels for tourists of $200 per day in the high season and $165 per day in the off-season, the number of tourist arrivals remains modest but increasing⁵. At the same time, tourist facilities-hotels, motor vehicles, trekking opportunities, and domestic tour companies-are increasing fairly rapidly not only in Thimphu but also in other regional towns.

11. Both the debt-to-GDP ratio and the debt service ratio remain manageable. The debt-to-GDP ratio has been falling in recent years with the repayment of the national airline's commercial loans and the concessional loans from India and Kuwait. This trend will reverse in the coming years as the share of loan financing from the new power projects being constructed will be greater than that from the Chukha project. The convertible currency debt is beginning to rise as a result of increased lending from multilateral development agencies, including ADB. At the same time, the debt service ratio stands at about 15 percent of merchandise exports, mostly to service nonconvertible debt obligations.

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