Background
Private sector contribution to economic growth in Bhutan is very limited. This is due to stringent government control over private sector business activities, lack of access to credit, inadequate legal framework for private sector activities, limited entrepreneurial skills, and an inefficient government-controlled financial system that does not meet private sector credit needs. Also, Bhutan's financial system was heavily burdened with nonperforming loans that, on average across all financial institutions, were close to 40%. It was therefore imperative to strengthen the financial institutions in many basic ways, to move toward a market-based system as distinct from a centrally administered system, to privatize financial institutions, and to establish an effective banking supervision system.
The Financial Sector Intermediation Facility (FSIF) aimed to (i) address key problems in the financial sector, including lack of competition and market-orientation, limited institutional capacities, and limited access by small and medium enterprises (SMEs) to credit, especially in rural areas; (ii) support effective policies and institutional frameworks promoting private sector development and investment; and (iii) alleviate a critical shortage of long-term foreign currency resources for private investment.
The FSIF is the first sector development program and first major finance sector intervention of ADB in Bhutan, and so it is important to assess the appropriateness of this particular modality and the impact of the program on the development of the financial sector in Bhutan. This study also served as an input to the assessment of the finance sector in the country assistance program evaluation for Bhutan. Finally, lessons from the experience in designing and implementing the FSIF will help improve ADB's future operations in the financial sector in Bhutan.
Key Findings
Overall, the FSIF was rated partly successful. This was based on the partly successful ratings of each of the public sector components, namely, the policy-based program loan, the development finance loan, and the technical assistance grant, and the successful rating of the equity investment in Bhutan National Bank. The partly successful ratings of the three public sector components were in turn based on overall assessments of relevant, less effective, less efficient, and less likely sustainable. On the other hand, the successful rating of the equity investment in Bhutan National Bank resulted from excellent ratings in ADB profitability and ADB work quality, and satisfactory ratings in development impact and ADB additionality.
Key Issues
The FSIF was not sufficiently selective. Several diverse initiatives bundled into the FSIF offered some opportunities for synergy, but, on the whole, resulted in a lack of focus. This lack of focus was evidenced in the insufficient analysis of the substantive underlying problems, insufficient depth in ADB's assistance to some areas, as well as a lack of follow-through. Consequently, ADB may have accepted formal compliance, in some instances, where a stronger push for substantive reforms may have been more appropriate.
A stronger emphasis on business skills was needed. More opportunities could have been developed and pursued to work directly with the private sector to develop entrepreneurial skills, and lending to SMEs should have been better supported with skill development and safeguard monitoring.
Monitoring of costs and benefits should have been more rigorous. The reports of the review and reconnaissance missions, and the two completion reports, had a tendency to overstate the outcomes achieved. It seems clear, for example, that the excellent nonperforming loan ratios that were claimed for the ADB-supported subloans to SMEs were largely a result of selection bias; and the "job creation" estimates by Bhutan Development Finance Corporation were unreliable. Similarly, the high rate of return on ADB's investment in the common shares of Bhutan National Bank ignored some significant investment costs related to cleaning up the nonperforming loans prior to ADB's purchase of shares; and divestiture of those shares had strategic costs for the ADB that might not have been sufficiently considered.
Lessons and Recommendations
Insufficient analytical underpinnings led to formal rather than substantive compliance with tranche release conditions. Joint undertakings with other donors and the Government might have strengthened the substantive analysis of policies and the robustness of the dialogue with the Government. If ADB wishes to influence foreign direct investment policy in Bhutan, it needs to contribute to public and official awareness of its benefits.
Costs were underestimated and the problems were not fully understood. Founding a credit information bureau in Bhutan is not only a problem of coordination among the lending institutions. The challenge is more fundamental, with the essential problem being the poor data systems and practices of the lending institutions. If the lending institutions do not have good records of the credit history of their own borrowers, then a joint credit information bureau is unlikely to succeed.
Removing overt administrative control of interest rates may make little difference to prevailing rates and practices if there is little competition between lenders because of the sector's oligopolistic and closely held structure.
The key problems and constraints of SME access to credit in Bhutan needed to be better understood. Problems included high interest rates, short loan amortization periods, and excessive collateral requirements. The FSIF loan had no effect on these.
A small equity investment can have a large impact in the right circumstances, especially if it is supported by technical assistance and policy reforms. Although ADB's equity investment in Bhutan National Bank was largely effective in achieving its aims, it illustrates that small investments are not easy for ADB to handle within its cost structure.
If ADB brings a private partner into the deal with the aim of facilitating capacity development, it should only go with a strategic investor with relevant banking experience, who will remain as a shareholder for a long time and thus play an active role in the management and corporate governance of an institution.