Countries and Regions

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p. 1 of 4 BACK | NEXT I. Current Development Trends and Issues II. Implementation of the Country Strategy and Program III. Portfolio Management Issues IV. Country Performance and Assistance Levels

Country Strategy and Program Update 2005-2006: Bhutan

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I. Current Development Trends and Issues

A. Recent Political and Social Developments

1. Bhutan’s Ninth Five-Year Plan 2002-2007 (9FYP) anticipates annual gross domestic product (GDP) growth rates of 7–9%. To achieve these growth targets, the 9FYP emphasizes strengthening infrastructure, improving the quality of social services, ensuring good governance, promoting private sector growth and employment generation, and preserving Bhutan's culture and environment. The proposed outlay in the 9FYP at Nu70 billion represents a 75% increase compared with the 8FYP.

2. Bhutan has continued to make good progress in achieving the millennium development goals (MDGs) as well as improving good governance. A draft constitution was prepared in June 2003 and will be finalized after thorough consultation with the people at all levels. Decentralization efforts continue such that annual budgeting and accounting and development planning, including the 9FYP, have been undertaken at the gewog¹ level. The Government will soon undertake its first population census with assistance from the United Nations Population Fund (UNFPA) in 2004/05 and this will help clarify all statistical information in the country. Through (ADB) assistance, the Government undertook a first poverty assessment in the country in 2000. With a comprehensive living standard survey completed in 2003, also with ADB assistance, a first-ever poverty line in the country will soon be established. The conversion of the Central Statistical Organization to the National Statistical Bureau as an autonomous body is also a step to further improve the statistical system in the country. A poverty assessment and monitoring system is being established in the Department of Planning through United Nations Development Programme (UNDP) assistance. It was understood that this system together with the 9FYP will essentially form the Government’s Poverty Reduction Strategy Paper (PRSP), which will be further discussed by the Government and the World Bank before finalization.

3. As for external economic relations, the Bhutan-Bangladesh Bilateral Trade Agreement that expired in 2000 was renewed in May 2003. Bangladesh, which is Bhutan’s second largest destination for exports after India, has agreed to reduce duty and value-added tax from 50% to 15% on the import of 18 products of Bhutanese origin. Bhutan joined the Bangladesh, Indian, Myanmar, Singapore, Thailand Economic Cooperation Forum (BIMSTEC) in February 2004 to further economic cooperation in the region. Bhutan is also proceeding ahead for its accession to the World Trade Organization.

4. The security issue in Bhutan has two dimensions. One was the presence until early December 2003 of three armed anti-Indian groups with camps in the southern part of Bhutan. The Government had been negotiating for over six years for the removal of the camps from the country. After their final negotiation in December 2003 failed to persuade the militants to leave the country peacefully, the Government was left with no option but to reluctantly take military action to destroy the camps and flush out the militants from the country. The Government has remained cautious and continued to monitor the security situation in the south. The second problem, which still remains an issue, is the people in the camps in Nepal claiming to be Bhutanese refugees. The Joint Verification Team appointed by the governments of Bhutan and Nepal concluded the categorization of the people in the first camp in May 2003. However, on 22 December 2003, the members of the Bhutanese Verification Team were attacked and suffered serious injuries during a briefing session at the camp, forcing the team to return to Bhutan. The Government of Bhutan has called on Nepalese Government for an investigation into the incident, punishment for the perpetrators and putting in place adequate security measures to enable the resumption of the process to ensure that such incidents are not repeated in the future.

B. Economic Assessment and Outlook

5. GDP grew at an estimated 6.5% in 2003, close to the 6.7% achieved in 2002. The power and construction sectors continued to be the main drivers of the economy, accounting for 10.8% and 19% of the GDP, respectively. Major investments that sustained strong growth included the Tala hydropower project, housing project, and road network expansion.

6. During FY2003,² the Government continued to exercise prudent macroeconomic management. All current expenditures were again fully covered by domestic revenue. However, the development budget remains overly dependent on external grants for financing. The budgetary expenditure for FY2003 increased by 11.4% over the planned level due to a 13.5% increase in capital expenditures. With domestic revenues remaining flat in FY2003 and a 43% decline in grant assistance from India, the overall fiscal deficit doubled to 10.0% of the GDP.

7. During successful talks between the Bhutanese and Indian governments in 2003, India has, however, confirmed substantial grant resources to help finance the requirements in the first 3 years of the 9FYP. As a result of this projected recovery of grant resources from India, coupled with the marginal increase of domestic revenue (due to government reluctance to increase or introduce new taxes that might undermine private sector development), and with a modest increase for both current and capital expenditure, the overall fiscal deficit in FY2004 is targeted to decline to 4.2% of GDP.

8. As measured by the consumer price index (CPI), inflation decreased to 1.8% in June 2003 down from 2.7% in June 2002. The drop in the CPI³ growth rate since 1999 has been mostly due to price decreases in nonfood items. Efforts are ongoing to revise the base year to 2003 under ADB assistance. Broad money supply (M2) grew by an estimated 29.7% during FY2003. Despite a net increase of credit to the private sector, commercial banks still maintain some 38.9% reserves with the Royal Monetary Authority (RMA), which shows that excess liquidity continues to persist in the banking system. Managing the excess liquidity remains a key challenge. After interest rate liberalization in 1999, financial institutions gradually lowered their interest rates from 2000. Housing loan interest rates also started to decrease from July 2003.

9. Provisional balance of payments data for FY2003 show the overall trade balance reduced by 8.5% as a result of 8.9% increase in exports, while imports increased by 1.2%. Large inflows of nonbudgetary grants and concessional loans have led to current account surplus. The capital account registered additional inflows with recent foreign direct investments (FDI) in the tourism industry due to the new FDI policy approved in December 2002. These factors have contributed to the expansion in the overall external balance. As of 30 March 2004, total foreign reserves increased to $397.5 million (of which $303.7 million equivalent is in convertible currency and the balance in Indian rupee) equivalent to an import cover of 23.7 months.

10. As of end FY2003, the total external debt outstanding was $405.5 million equivalent or 70% of GDP, while the debt service ratio was 4.9% of exports of goods and services. Although the convertible currency debt of $176.8 million equivalent is currently fully covered by the convertible currency reserves, the debt service ratio of the convertible loans increased to 25.4% in FY2003. The total debt service ratio remained stable at 4.9% in FY2003, but there is a currency mismatch in foreign earnings and debt repayment obligations between convertible and nonconvertible currencies.

11. The outlook for economic growth over the medium term appears favorable despite the continued heavy reliance on two sectors only—power and construction. The country’s major hydropower project at Tala, with capacity of 1,020 megawatts, is expected to be commissioned by end 2005. Its export of electricity to India will eventually decrease the trade deficit and increase government revenues, which would facilitate the progressive reduction of the existing total reliance on external resources to finance capital expenditure. However, given the low employment elasticity of the power sector, the task of absorbing a labor force of 70,000 estimated to enter the labor market during the 9FYP is challenging and adds urgency to the promotion of private sector activity. Implementation of planned financial sector reforms would result in increased competition and enhanced corporate governance. Tourism, which is the major source of hard currency revenue, has started to show signs of recovery after the global slowdown in the travel industry. With the FDI for luxury hotels and resorts, the sector will contribute to private sector development and absorb part of the incoming labor force. Expansion of existing and planned subregional economic cooperation activities will lead to export diversification and expansion of Bhutan’s economic base.

C. Implications for the Country Strategy and Program

12. ADB's operations in Bhutan are fully consistent with the country's 9FYP and Vision 2020. ADB's program has aimed at reducing rural poverty through rural electrification, road network expansion and basic skills development. Given the growing concerns over the expanding labor force, government policies have started to put more emphasis on private sector development and financial sector reform. As detailed in the next section, ADB operations will also aim to address those concerns. Physical isolation is identified in the 9FYP Plan as the main cause of poverty. ADB will continue to support road expansion followed by assistance to promote integrated rural development. The preparation of the full country strategy and program (CSP) is scheduled in 2005 will reflect the evolving development constraints, objectives, and opportunities envisaged for the country.

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