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Country Strategy and Program Update 2003-2005: Bhutan

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I. Current Development Trends and Issues

A. Recent Political and Social Developments

1. The Ninth Plan (July 2002–June 2007) was launched in July 2002. It is based on the needs of local governments and will give them substantial autonomy and independence to execute development plans and activities. The plan's strategic thrust is to focus on rural infrastructure, quality of health and education facilities, private sector development, and decentralization of planning and implementation.

2. Due to insufficient data the progress of the millennium development goals and targets cannot be fully assessed. However, the plan and the partnership agreement with the Asian Development Bank (ADB) were set up to achieve them (Appendix 1, Table A1.1). The ADB-assisted Household Income and Expenditure Survey 2000¹ partly revealed the country's poverty situation (Appendix 1, Table A1.2). Based on a preliminary pilot study, the lower poverty line was established at Nu612.1 per capita per month and the upper poverty line at Nu748.1. Severe poverty affects 29% of the rural population but only 3% of the urban population. To improve social protection, the Government is strengthening the Department of Employment and Labor and the National Pension Fund Board.

3. In March 2001, the Council of Ministers established a committee of secretaries to help govern the country, focusing on enhancing efficiency, transparency and accountability, and on curbing corruption. The National Assembly passed the Civil and Criminal Procedure Code of Bhutan in July 2001, representing a major judicial reform. The code includes institutional, procedural, and substantive law, and penal reforms, and consolidates different sections of existing acts and the Thrimzhung Chhenmo (Supreme Law). Bhutan is taking a momentous stride into the future with the drafting of a constitution, which started on 30 November 2001. The written constitution will separate and strengthen the legislative, judicial, and executive arms of the Government, and will be the culmination of the reforms initiated by the King of Bhutan, which started with the decentralization policy in 1981. As decreed by His Majesty, the constitution must “promote and protect the present as well as the future well-being of the people, and safeguard the security and sovereignty of the nation.” In the interest of promoting good governance and strengthening transparency, the Royal Audit Authority made an annual report public for the first time in 2002.

4. The Government continues to be besieged by the problem of people in the refugee camps in eastern Nepal. The governments of Bhutan and Nepal have completed the citizenship verification of the people in the first camp in December 2002, and are now negotiating a next step. On the other hand, the presence of armed foreign militants in southern Bhutan poses a grave security threat. The Government is pressuring the militants to leave Bhutan so that it need not resort to military action, which is the last step following peaceful dialogue, cutting off ration supplies to the camps, and prosecuting and punishing people assisting the militants.

B. Economic Assessment and Outlook

5. Economic activity, vigorous for the past years, was robust in 2001 as gross domestic product (GDP) grew by 6.5%² from 6.0% during the 1990s and 5.7% in 2000 (Appendix 1, Table A1.3). The country's close link with India helped Bhutan avoid the direct impact of the global economic slowdown. The main driving force of the high economic growth was the construction of three hydropower projects. In the services sector, electricity continued to lead the economy and maintained 12.5% of GDP. Tourism, which registered double-digit growth in the 1990s, witnessed a drop of 14.5% in tourist numbers and a decrease of $1 million in revenue in 2001 due to the aftermath of 11 September, poor weather earlier in the year, and logistical difficulties with air transport. Agricultural growth was lower than in 2000, when investment targeted improving access to agricultural farming inputs.

6. The Government has traditionally pursued a prudent fiscal policy; current expenditures were maintained at a level that could be completely financed by domestic revenues. The contribution of electricity exceeded 45% of total domestic revenue through surplus transfers from public enterprises. Two sales taxes were introduced for television cable operations and beer in 2001. However, the fiscal deficit expanded to 5.1% of GDP from 4.1% in the previous year because of increased large capital investments, including in housing, expressway, and old capital city renovation projects. Some favorable factors are expected to mitigate the fiscal constraint. As one hydropower plant is commissioned over the coming months, power export tariffs are likely to be revised upward. A personal income tax was introduced in January 2002. Corporate and business income taxes will also be updated.

7. Given that monetary policy is geared to support the exchange rate peg with the Indian rupee, inflation and interest rates were kept in line with those in India and the scope of the monetary policy is substantially limited. Inflation remained at 3.6% in 2001. The high level of deposits over credit in the banking sector persisted for many years due to the scarcity of bankable projects. Such scarcity is due to the weakness of the private sector and low lending capacity of commercial banks, which is caused by the lack of credit assessment competence, difficulty in finding collateral and in using the legal system for credit recovery, and higher default risk.

8. The trade deficit increased, but improved services and transfers kept the current account at the previous year's level. Capital inflows in the form of grants and loans have continued to exceed the current account deficit by some margin. The net effect kept foreign exchange reserves at a level equivalent to 16 months of merchandise imports. Total external debt increased by 37% largely in response to the loans from India for the new hydropower projects, but the debt service ratio remained at a sufficiently manageable level: 5.6% of merchandise exports.

9. Medium-term prospects based on the Ninth Plan are good, growing by 7-10% annually. Electricity and related construction will continue to boost the industry sector, while private sector development will determine the prospects of mining and manufacturing. The services, particularly transport and communication, will also benefit from the commissioning of a hydropower project and the recovery of tourism. Other than tourism, the economy is relatively well insulated from the direct effects of global economic volatility, although the country would be vulnerable to the effects of major developments in India.

10. Despite generally good medium-term prospects, however, risks could arise from internal and external forces. A drastic change in the economic structure³ could have an impact on the labor market and give rise to social instability. If India’s fiscal situation worsens, the hydropower projects could be delayed. Given the importance of external finance to Bhutan's development plans, the flow of resources must be maintained. Its reduction could slow the implementation of the development plan and limit the Government’s financial maneuverability. Of greater significance is the risk that the economy will fail to create adequate new jobs for the rapidly increasing number of school leavers, and that labor skills will not sufficiently improve to meet market demand. These risks increase unemployment, while inadequate skilled labor supply may require importing skilled foreign labor.

C. Implications for the Country Strategy and Program

11. ADB’s 2000 country operational strategy for Bhutan is consistent with the Ninth Plan. The Government recognizes that rural production capacities and income need to be enhanced and that the private sector has to be a catalyst in economic development. ADB should continue to place high priority on rural development and private sector development.

12. The expanding electricity sector will contribute to fiscal revenue and economic growth. However, reliance on a single sector will also increase the vulnerability of the economy. Efficiency and governance in the electricity sector have to be improved. The impact of energy sector development has to be closely monitored, focusing on areas such as economic growth, economic and social structure, balance of payments, labor market, etc. Development of the electricity sector, however, will not automatically create jobs. The economic base should be built up through private sector development.

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