On June 20, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹with Bhutan.

GDP growth in Bhutan has slowed from around 10 percent in Fiscal Year (FY) 2011(July 1-June 30) to 5 percent in FY2013. Slower growth reflects policy efforts to contain overheating pressures in the form of restrictions on credit for construction and vehicle. Inflation has remained elevated, tracking closely that of India (Bhutan’s main trading partner). Social development indicators have improved steadily, and Bhutan is on track or has achieved most of its Millennium Development Goals. The fiscal deficit worsened sharply in FY2013 due to a shortfall in grants. The current account deficit has widened due to hydropower-related imports, as well as a consumption and housing boom. Nonetheless, robust aid inflows (loans and grants) have led to a positive overall balance of payments position, enabling the continued accumulation of international reserves. External pressures have led to a recurrent shortfall in Indian rupee reserves.

Growth is projected to recover to 6½ percent in FY2014, driven mainly by a pick-up in hydropower-related construction activities and domestic services. In addition, policy measures to revive the economy, including a capital infusion as a part of an Economic Stimulus Package, are likely to exert a modest positive impact on growth. The current account deficit is projected to widen further to around 25 percent in 2013/14 due to stronger hydro-related imports but financing from India and other development partners in the forms of loans and grants is expected to be adequate. The fiscal deficit is budgeted to remain high in 2013/14.

Risks stem from high debt levels and the possible surfacing of financial sector vulnerabilities following a prolonged period of rapid credit growth. There is also a risk of renewed external pressures, including pressures on rupee reserves, if macro policies remain expansionary and credit growth rebounds strongly. Additionally, risks emanate from slower growth in India—including due to financial market volatility—though these risks are mitigated by the concentration of exports in the hydropower sector, which enjoys healthy demand from India.

Executive Board Assessment²

Executive Directors welcomed Bhutan’s continuing progress driven by hydropower development, which has led to robust economic growth and much improved social indicators. However, they noted that rapid economic growth and credit expansion had led to overheating pressures in the past and to continued deterioration in the current account balance. While the expansion of hydropower capacity offers good medium-term economic growth prospects, Directors encouraged the authorities to carefully manage macroeconomic pressures and to continue to diversify the economy to reduce economic volatility, create more jobs, and enhance inclusiveness.

Directors recommended tightening fiscal policy to preserve macroeconomic stability and contain public debt. They considered that revenue reforms are essential to achieve greater fiscal self-reliance over the medium term and support critical social and infrastructure spending. They noted the need for measures to widen the tax net in the near term and to consider introducing a value-added tax over the medium term. Improved fiscal management and public spending efficiency, including prioritizing expenditures to mitigate the risk of grant shortfalls, and better cash forecasting will also be crucial.

Directors considered that monetary policy should complement a tighter fiscal stance by curbing the build-up of excess liquidity and sterilizing large capital inflows. They noted that more regular and increased issuance of treasury bills would help liquidity management, deepen financial markets, and improve monetary transmission.

Directors recommended strengthening bank supervision and regulation, including by regular stress testing and closing regulatory gaps, and putting in place institutional arrangements including crisis management and deposit insurance. Directors looked forward to the preparation of Bhutan’s Financial Sector Development Strategy.

Given Bhutan’s close economic relationship with India, Directors agreed that the peg to the Indian rupee has served Bhutan well and remains an appropriate nominal anchor. They saw merit in closer alignment of reserve currency composition with the structure of external liabilities through a gradual increase in the share of Indian rupees in overall reserves. A few Directors noted that the authorities’ reserves adequacy framework has a threshold for changing convertible currencies to rupees when conditions are favorable.

Directors took note of the staff’s assessment that the real exchange rate is overvalued. They encouraged the authorities to make progress on structural reforms, including reducing skills mismatches in the labor market and increasing access to finance particularly for small and medium enterprises, to boost competitiveness, create jobs, and help diversify the economy.

Directors encouraged elimination of exchange restrictions subject to approval under Article VIII and the restrictions maintained under Article XIV as soon as macroeconomic conditions allow.