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Executive SummaryDuring the past 5 years, Bhutan’s real average gross domestic product (GDP) grew by 6.7% per annum. In this period, the agriculture sector grew by 3.7% per annum, industry sector by 9.6%, and services sector by 7.2%. In recent years, the main drivers of GDP growth have been the hydroelectric power, construction, and transport sectors. The hydroelectric sector accounts for some 12% of GDP and 45% of the Government revenues. The average per annum savings rate over the past 5 years is 17% of GDP, whereas gross domestic investment rate is 42%. Tax revenues, which have exhibited an average annual growth rate of 19%, have not shown corresponding buoyancy. Direct tax collections during 2002 recorded a 7% growth over the previous year and accounted for 61% of tax revenues and 32% of total revenues. The overall budget deficit rose from 3.9% of GDP in FY2000 to 11.1% of GDP in FY2002, before declining to 5.5% of GDP in the following year. As measured by the consumer price index, inflation continued to decline, falling to 2.3% in December 2002 from 2.7% at the end of June 2002. This is the lowest inflation rate in the past 3 years. To enhance the domestic revenue base, effective 1 January 2002, the Government instituted the personal income tax (PIT) applicable on six sources of income. Over the past 5 years, Bhutan’s trade balance has been negative. The composition of Bhutan’s merchandise trade shows that India remains its largest trading partner accounting, on average, for some 90% of Bhutan’s exports and about 70% of imports. Power exports are the largest export item to India. Bhutan’s stock of external debt outstanding increased by 23.2% to $292 million at the end of FY2002. Corresponding to the growth in total debt, the ratio of outstanding debt to GDP rose to 55% in FY2002, while the debt service ratio rose to 5%. According to Government estimates, over 60% of the soft loans (both convertible currency and rupee) were disbursed to the power sector, while another 25% were shared by the agriculture, education and industry sectors. As of June 2002, India had provided most soft loans to Bhutan, with cumulative gross disbursements totaling $216 million primarily for the development of the hydropower sector. During FY2002, growth in commercial bank deposits with the Royal Monetary Authority (RMA) led to an increase in reserve money by 27.9%. Thus, managing excess liquidity remains a key financial sector challenge. Fortuitously, the exchange rate policy––which pegs the ngultrum at par with the Indian rupee––and capital controls ensure that excess liquidity does not act as a destabilizing factor for balance of payments, price stability, and monetary policy. RMA has taken steps to reduce excess liquidity by issuing RMA bills and raising the cash reserve ratio. Nonetheless, as of June 2002, commercial banks were holding excess reserves with RMA equivalent to about 40% of their assets. The cost of financial intermediation in Bhutan appears high, given the prevailing 4-6% spread between the lending and deposit rates (Royal Monetary Authority Annual Report 2001/02, December 2002). At the same time, the financial system has excess liquidity and the banking system continues to hold some 40% of its assets in non-interest earning deposits with RMA. The high intermediation costs and continued excess liquidity (also reflected in the proportion of nonperforming loans, which at end-2002 was some 10%) reflect inefficiencies of the banking system, which are further exacerbated by the lack of competition. The high lending rates and collateral requirements, generally around three times the amount of financing being sought, act as effective barriers for the private sector to access credit from financial institutions. With a labor force participation rate of 56.5%, the Government estimates the overall open unemployment rate at 1.9% compared with 1.4% in 1998. Within the framework of the Ninth five-Year Plan (NFYP), the Government prepared a Human Resource Development (HRD) Master Plan for Private and Corporate Sectors and assigned 50% of NYFP's HRD allocation for implementing this master plan. To make private sector employment more attractive, the Government drafted labor laws that will be presented to the National Assembly for approval. In addition, an Apprenticeship Act was drafted whereby the Government and the private sector, on a 50:50 cost-sharing basis, will train new entrants in the labor market. However, over the next 5 years, the task of providing employment to about 50,000 school graduates and another 20,000 unskilled workers migrating to urban areas remains challenging. Under the NFYP’s emphasis on devolution and decentralization of planning, the district development committees and block development committees have been granted autonomy to make development plans, allocate resources, and make rules and regulations applicable within their jurisdictions. In 2002, effective measures were undertaken to deepen the decentralization process. District and village development committees were vested with greater administrative and financial powers, including the authority to retain and spend rural taxes for local development. During the implementation of the NFYP, the Government plans to maintain the pro-poor focus of its development objectives. The primary school gross enrollment rate increased from 67% in 1990 to 72% in 2000. Although health care coverage is high—90%—the Government plans to improve delivery of health services. Inflows of external assistance as grants and concessional loans are the primary source of financing for capital expenditures. Given growing pressures on global official development assistance, the quantum of external assistance available to Bhutan may possibly decline in the future. Should this happen, the Government may have to increasingly rely on domestic borrowings or adjust the scope of the NFYP. The NFYP explicitly acknowledges that the private sector will be the engine of growth and prime source of employment. To promote private sector development, a number of incentives were announced as part of the national budget for 2002/03. They included time-based tax holidays and incentives for establishing businesses in rural areas. Private sector representatives have submitted to the Government recommendations for boosting private sector activity in the country. Almost all pertain to the need for reform of financial institutions existing policies and practices for extending credit to the private sector. Foreign exchange revenues of $10.5 million from the tourism sector reached their peak value in FY2000. Thereafter, they have been reflecting a declining trend and were $9million for FY2002. In the NFYP, the Government’s objective is to increase tourist arrivals to 15,000 per year by 2007. Over the past years, domestic resources financed only 15% of the average annual development budget, making Bhutan highly dependent on external assistance to fund its development programs and initiatives. The Bhutanese economy is overly dependent on hydropower (accounting for 11% of GDP in 2003), whose exports account for some 45% of Government revenues. While this is not likely to change in the near term, given the high capital intensity and low employment elasticity of this sector, alternative sources of employment and income generation would have to be explored to reduce the incidence of poverty, increase per capita incomes, and reduce the economy’s current high dependence on the one-country-one-export- commodity framework.
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