Country Partnership Strategy: Bhutan, 2019–2023

INCLUSIVE AND SUSTAINABLE GROWTH ASSESSMENT A. Recent Growth, Poverty, Inequality, and Environmental Dynamics

1. This assessment of Bhutan’s prospects for inclusive and sustainable growth is intended to contribute to the formulation of the Asian Development Bank (ADB) Bhutan country partnership strategy (CPS), 2019–2023. The CPS is aligned with both the Government of Bhutan’s Twelfth Five-Year Plan, 2018–2023 and ADB’s long-term corporate strategy, Strategy 2030.1 2. The assessment covers Bhutan’s recent socioeconomic development trends and policy and institutional challenges. Of particular concern are progress, challenges, and priorities that relate to the three pillars of ADB's conceptual framework for inclusive growth: (i) rapid and sustainable growth to expand economic opportunities; (ii) expanded human capacities to promote equitable access to the opportunities that economic growth creates; and (iii) strengthened social protection to reduce vulnerabilities and prevent extreme deprivation. These concerns mirror the ambition of Bhutan’s development philosophy of Gross National Happiness. The philosophy pervades all government policies and aims to achieve sustainable shared prosperity. It attempts to combine spiritual and material advancement by balancing modernity and tradition while preserving cultural heritage and the environment and strengthening good governance. The adoption of the Gross National Happiness philosophy in its development approach has enabled Bhutan to start developing on its own terms and at its own pace, which is why the traditional way of life in Bhutan has, until recently, seen little disruption. 3. Growth driven by hydropower development. Bhutan’s economy has witnessed rapid growth over the past three decades from fiscal year (FY) 2008–FY2018, recording an average annual growth of 7.0%.2 A combination of prudent fiscal and monetary policy coupled with large investments in hydropower have boosted the economy. The outstanding performance has been driven mainly by public-sector-led hydropower development.3 Hydropower contributes about 25% of total gross domestic product (GDP) annually and generates about 25% of the government’s total domestic revenues. However, the total production capacity of 1,660 megawatts has remained stagnant since 2015 because of repeated delays in commissioning mega-hydropower projects. The large scale of hydropower projects in such a small economy means that aggregate demand fluctuates significantly, both during construction and after operation commences. 4. Foreign trade and foreign exchange regime. Bhutan is a small country with a narrow resource base that depends greatly on India for trade and development. 4 The country’s dependence on imports has resulted in a chronically imbalanced foreign trade situation. In 2018, exports were equivalent to 58% of imports, while geographically trade continues to be concentrated on India. India received about 78% of Bhutan’s total exports, while about 84% of Bhutan’s imports originated from India.5 Since its first issue in 1974, the ngultrum has been officially pegged to the Indian rupee at par. The government, therefore, maintains international

1 ADB. 2018. Strategy 2030: Achieving a Prosperous, Inclusive, Resilient, and Sustainable Asia and the Pacific.

Manila. 2 The average real GDP growth rate has been calculated from the fiscal years 1988–2018. 3 Hydropower development is solely undertaken by a fully state-owned entity, Druk Holding and Investments. 4 India has been Bhutan’s biggest development partner, contributing on average about 70% of total grant inflows

between FY2008 to FY2018. 5 Government of Bhutan. Ministry of Finance, Department of Revenue and Customs. 2018. Bhutan Trade Statistics

2018. Thimphu.

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reserves in both United States dollars (convertible currency) and Indian rupees to meet foreign currency liabilities including debt repayment, financing imports, and other contingencies.

5. Exports of hydropower-generated electricity, which is the leading export item, have been fluctuating within the 30%–36% range of total exports but have on average comprised 33% of total exports between FY2014 and FY20186 GDP has grown faster than the rise in electricity exports. Consequently, electricity exports as a share of GDP fell from about 8.9% in 2015 to 6.2% in 2018. The declining share of electricity exports in both total exports and GDP signals the much-desired onset of trade diversification, which is also evidenced by rising exports of minerals and base metals to Bangladesh and Nepal.7

6. On average, Bhutan’s exports have increased by 5.57% annually during FY2014–FY2018, while imports have grown 5.55% annually in the same period. In FY2018, exports grew by an estimated 8.5% while imports slightly 3.2%. Albeit declining, the current account deficit remains high, estimated at 18.2% of GDP. 8 The high deficit is explained by the country’s heavy dependence on imports and limited export capability. However, the current account deficit is expected to trend downward as hydropower-related imports are declining and power export capacity is increasing. 7. During FY2013–FY2018, gross international reserves fluctuated within the narrow range of $0.9 billion–$1.2 billion, remaining at $1.1 billion in FY2018. The fluctuations were attributable to changes in the annual capital and financial accounts, which helped build international reserves.9 The level of reserves in FY2018 was equivalent to the value of 13.0 months of merchandise imports.10 8. Inflation. Because of Bhutan’s close trade relationship with India and with the ngultrum pegged at par with the Indian rupee, consumer prices in Bhutan have closely mirrored wholesale price movements in India, with a slight divergence in the past few years because of different weights on products. Inflation in Bhutan has been volatile, reaching an all-time high of 10.2% in FY2012. Inflation in FY2017 averaged 4.3%, up from 3.3% in FY2016, before dropping to 3.6% in FY2018 (footnote 7). While increases in food prices remained high at around 6%, the lower prices of nonfood imported items caused the inflation rate to drop. In August 2018, inflation declined further to 2.0% before starting to increase, reaching 3.1% in April 2019. 9. Fiscal performance. Bhutan’s fiscal policy follows the pattern of implementing the country’s 5-year planning cycle. As it begins implementing the 12th plan, government expenditures are typically low, with only a small budget deficit or surplus. As implementation proceeds, expenditures accelerate, which leads to larger deficits in the third and fourth year, after which it tapers off towards the last year of the plan.

10. Bhutan’s domestic mobilization of tax and nontax revenues represents about 20.3% of GDP. From FY2013–FY2018, the composition of revenues has remained fairly consistent with an average 70% of total revenue deriving from domestic revenue and the balance from international

6 Government of Bhutan, Ministry of Finance, Department of Revenue and Customs. 2018. Bhutan Trade Statistics

2018. Thimphu. 7 ADB. 2018. Asian Development Outlook Update. Manila. 8 ADB. 2019. Asian Development Outlook. Manila. 9 In three of the last 5 years, capital and financial accounts exceeded the respective current account deficits. The

surpluses contributed to the build-up of international reserves. World Bank Group. 2018. Bhutan Development Update - Youth Unemployment Rate Increased Under High Growth. Washington, DC.

10 Royal Monetary Authority. 2018. Monthly Statistical Bulletin September 2018. Thimphu.

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grants (footnote 8). However, government expenditure fluctuated between 29.0% and 34.1% of GDP during the Eleventh Five-Year Plan (2013–2018). After recording overall surpluses in the first 2 years of the 11th plan, the government incurred deficits of 1.1% of GDP in the third year of the plan and 3.4% in the fourth year. At the conclusion of the 11th plan in FY2018, the budget deficit was 0.7% of GDP, a considerable drop from 3.4% in FY2017.

11. External public debt and risk of debt distress. The government’s external debt ratio declined from 111.3% of GDP in FY2016 to 105.4% in FY2018, because GDP growth exceeded the growth of external debt. The International Monetary Fund Article IV mission of July 2018 assessed the risk of public debt distress as moderate, which was unchanged from the 2016 assessment. About 70% of the external debt results from Bhutan’s hydropower projects. The earnings of the projects will likely exceed the debt incurred by them and will thus generate a net surplus. The Government of India is both the main financier and the main buyer of the power generated by these projects. No exchange rate risk is associated with the debt, because the transactions are in Indian rupees. External debt outside of hydropower projects—as concessional loans from development partners—stands at only 25.9% of GDP. 12. Finance sector. Bhutan’s finance sector, dominated by banks, remains sound. Private credit growth has rebounded since the government eased restrictions that it implemented in response to the Indian rupee shortage crisis in 2012. Credit growth in the private sector has accelerated to about 14.0%–15.4% from FY2015–FY2018. The banks’ capital adequacy ratio has remained high, peaking at 18% in March 2017. It then fell slightly a year later to about 15.0% in March 2018 and 16.7% in December 2018 but remains above the 12.5% minimum required.11 As credit growth has picked up in the last few years, asset quality in the finance sector has slightly deteriorated. During FY2018, asset quality deteriorated, with an increase in nonperforming loans from Nu10.80 billion in June 2017 to Nu12.54 billion with the nonperforming loan ratio reaching 11.5% in June 2018. 13. The Royal Monetary Authority has launched a priority sector lending program to improve access to credit for cottage and small industries. Since 2017, the Royal Monetary Authority has issued licenses to three additional microfinance institutions following the establishment in May 2016 of the Rural Enterprise Development Corporation, Bhutan’s first microfinance institution.12 Progress is also being made on modernizing the payment system and financial inclusion. Infrastructure to enable interbank transfers within Bhutan was launched in 2017.

14. The capital market is expanding. As of December 2017, market capitalization of the 21 companies listed with the Royal Security Exchange Board increased by 12.5% on a year-over-year basis to Nu25.6 billion. The debt market—while still relatively small—is also expanding. In 2017, there were 19 bonds with a total outstanding value of about Nu11 billion. A separate market bond for small and medium-sized enterprises has been created to provide such enterprises an opportunity to raise funds from the capital market. In addition, a commodities market initiative was launched in 2016, while commercial papers were introduced in 2017.

15. Poverty. Bhutan has achieved almost all the Millennium Development Goals, notably the goals of eradicating extreme hunger and poverty, achieving universal primary education, reducing

11 Royal Monetary Authority. 2018. Financial Sector Performance Review Report. Thimphu. 12 They include the Bhutan Association of Women Entrepreneurs (licensed in January 2017); Bhutan Care Credit

Limited (licensed in July 2018); and Respect, Educate, Nurture and Empower Women (licensed in August 2018).

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child mortality, and ensuring environmental sustainability.13 Poverty reduction in Bhutan has been rapid and broadly based. Both consumption-based poverty measures and multidimensional poverty indicators show that the percentage of poverty was reduced drastically from 23.0% in 2007 to 12.0% in 2012, and further to 8.2% in 2017.14 The decline in multidimensional poverty is also reflected in the significantly improved access to basic infrastructure and social services. Basic services are provided throughout the country and the coverage and quality of these services have been steadily improving. About 98.6% of households have electricity, 98.6% of households have access to improved drinking water, and 74.8% have improved sanitation.15

16. On average, per capita consumption among the bottom 40% of the population has grown faster than for the remaining 60%. Bhutan has come close to eliminating extreme poverty ($1.90 purchasing power parity terms, per day per person in 2017) during 2007–2017, meeting the first Millennium Development Goal of halving the extreme poverty rate ahead of the 2015 deadline. Primary drivers of poverty reduction and shared prosperity are agricultural commercialization, rural infrastructure improvements, and spillovers from the construction of hydropower projects. However, inequality remains. While the Gini coefficient—a measure of inequality—declined from 0.42 in 2004 to 0.35 in 2007, the coefficient increased to 0.36 in 2012 and to 0.38 in 2017.16 17. Human development. Bhutan has made significant progress in all key areas of human development, elevating the country to the “medium human development” category and positioning it at rank 134 of 189 countries on the 2017 Human Development Index of the United Nations Development Programme (UNDP).17 From 1995 to 2017, life expectancy at birth rose from 55.0 years to 70.6 years, years of schooling from 5.5 to 12.2, and gross national income per capita from $2,106 to $8,065. The gross enrollment ratio for primary education has risen to 95%, and for secondary education to 84%.18 18. Gender equality. Bhutan has made impressive efforts in achieving gender equality outcomes, especially in the areas of education and health. The adjusted net primary enrolment rate for girls is 98.9% as compared to 98.7% for boys, and the most recent enrolment figure shows more girls at the lower, middle, and higher secondary levels.19 The maternal mortality ratio was 121 per 100,000 live births in 2017, far less than the 423 recorded in 2000.20 Gender results are defined as national key results in the 5-year plans. Gender-responsive planning and budgeting has also been launched. Nonetheless, gender inequality remains a prominent issue in Bhutan’s socioeconomic development. Women have not shared equitably in the progress on the Human Development Index. In 2017, the UNDP Human Development Report ranked Bhutan—with a

13 The eight Millennium Development Goals, to be achieved by 2015 from the baseline year of 1990, comprised the

primary goals of halving extreme poverty and hunger; achieving universal primary education; promoting gender equality; reducing child mortality; improving maternal health; combating HIV/AIDS, malaria, and other diseases; ensuring environmental sustainability; and developing a global partnership for development. http://www.bt.undp.org/content/bhutan/en/home/post-2015/mdgoverview.html.

14 National Statistics Bureau of Bhutan. 2017. Poverty Analysis Report 2017. Thimphu. Retrieved from: http://www.nsb.gov.bt/publication/files/2017_PAR_Report.pdf

15 National Statistics Bureau. 2018. 2017 Population and Housing Census of Bhutan. Thimphu. 16 The Gini coefficient ranges from 0 to 1, with 0 representing perfect equality and 1 representing perfect inequality. 17The index consists of four components: life expectancy at birth, expected years of schooling, mean years of schooling,

and the GNI per capita (2011 purchasing power parity $). UNDP. 2018. Human Development Report 2017. Human Development Report 2016. New York.

18 UNDP. Footnote 17. 19 Government of Bhutan. 2017. Ministry of Education. Annual Education Statistics 2017. Thimphu. 20 Government of Bhutan. 2017. Ministry of Health. . Annual Health Bulletin 2018. Thimphu.

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Gender Inequality Index (GII) of 0.47621—117th of 160 countries in GII, and included the country in Group 5,22 based on Bhutan’s Gender Development Index of 0.893.23 Compared to other countries, Bhutan’s relatively low representation of women in parliament and their low attainment in secondary and higher education caused Bhutan to have a comparatively low performance on the GII. 19. Environment. Of Bhutan’s total land area, 71% is under forest cover. Bhutan’s constitution mandates the government to maintain at least 60% of the country’s total land area under forest cover for all times. Bhutan has become the only country in the world with negative carbon emissions. It is estimated that the country’s annual emissions of around 1.6 million tons of carbon are more than offset by its forests that serve as carbon sinks, absorbing about 6.3 million tons annually. B. Key Impediments to Inclusive and Sustainable Growth

20. From 1968–2018, Bhutan has experienced rapid economic growth, substantial poverty reduction, and significant progress in good governance. As a result, the country has advanced from a narrow subsistence stage toward a low middle-income economy. With the rapid increase in Bhutan’s per capita gross national income and the significant progress the country has made in key socioeconomic indicators, Bhutan is set to graduate from its least-developed country status by 2023.24 Nonetheless, the country will remain economically vulnerable for some time given its small size, narrow economic base, limited connectivity, and susceptibility to natural disasters. 21. Bhutan is now entering a new phase in which the past gains will have to be consolidated. At the same time, innovative and dynamic solutions will be needed to address emerging challenges effectively and in a timely manner. The new phase will test Bhutan’s ability to confront various obstacles, which—in the wake of its past success—have emerged on the road to Gross National Happiness.25 The challenges which the country will have to tackle encompass a variety of diverse structural problems going beyond the fundamental economic issue of creating growth and expanding incomes. These challenges are vulnerability to external shocks, market distortions, and inequitable distribution of economic gains. Appendix 1 presents the cause–effect relationship of these challenges. The identified root causes are considered binding constraints as they emanate from Bhutan’s geographical condition, the size of the country, and its stage of development. The problems at the root cascade to a series of subproblems and outcomes, which, in turn, create knock-on impacts at higher levels. In the new development phase, the government will need to create an enabling environment to facilitate successful economic transformation and address remaining and emerging disparities.

21 As part of UNDP’s Human Development Report, the gender inequality index (GII) reflects gender-based inequalities

in four dimensions: reproductive health, share of seats in parliament, population with at least some secondary education, and labor force participation rate.

22 Group 5 comprises countries with low equality in Human Development Index achievements between women and men (absolute deviation from gender parity of more than 10%). The Human Development Index is a composite index measuring average achievement in three basic dimensions of human development—a long and healthy life, knowledge (education), and a decent standard of living (per capita income).

23 UNDP. Footnote 17.

24 UNDP. 2013. Graduation from the Group of Least Developed Countries: Prospects and Challenges for Bhutan - 12th Round Table Meeting, 11–12 December 2013. Thimphu.

25 Gross National Happiness is built on four pillars: sustainable and equitable socioeconomic development, conservation of environment, preservation and promotion of culture, and good governance.

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22. Narrow economic base and its implications for trade and fiscal imbalances. Bhutan is a small country with a narrow resource base. Exports amount to only about half of imports and are largely concentrated on a few commodities. Geographically, trade also continues to be concentrated on India. The key exports to India are hydropower-generated electricity, base metals, and agricultural products, while imports are relatively high-valued machines and mechanical appliances, consumption goods, and fossil fuels. As a result, Bhutan’s terms of trade have deteriorated, as increasingly more units of exports are needed to pay for one unit of import. These economic imbalances pose a risk to the country’s stability. For instance, rising import demand in relation to volatile exports to India during the Indian rupee shortage in 2012 put pressure on the net inflows of Indian rupees to Bhutan, which rapidly depleted Indian rupee reserves at the country’s central bank and caused a sharp downturn in the domestic economy.26

23. Bhutan will remain economically vulnerable for some time given the country’s narrow economic base, volatility in exports, and weak agricultural production. While existing hydropower projects have generated about 25% of the government’s total domestic revenues,27 tax collection is low by international standards and has been on a declining trend relative to GDP. Key challenges over the 12th plan period will also include mobilization of domestic revenues and prudent management of hydropower resources. While the government needs to control public spending, it has an obligation to provide free access to basic public health services and education up to the “10th standard” for its citizens.28 Hence, the government will have to accelerate revenue mobilization efforts over the next plan period. Furthermore, Bhutan will receive the last sum of excise duty rebates from India in FY2019. Prior to India’s introduction of a goods and services tax in July 2017, the Government of India agreed collect and refund to Bhutan annually the tax that India levies on goods it exports to Bhutan. The remittance of the excise duty rebate has a time lag of 2 years. The rebate accounted for over 15% of Bhutan’s total tax revenue in FY2018. 24. Delays in three mega-hydropower projects will further constrict tax revenue inflows. Three units of one of these three hydropower projects was commissioned in July 2019 and full operations expected by end of August 2019. The remaining two are expected to be commissioned only in or after 2023, i.e., beyond the 12th plan period. The heavy reliance on the hydropower industry creates a risk that volatile revenue inflows will affect aggregate domestic demand. Rapid credit growth, high inflation, and an Indian rupee shortage may ensue without timely economic reforms being in place. To help manage volatility, the government budgeted Nu100 million in FY2018 to kick-start a stabilization fund. In November 2017, Parliament approved the establishment of a stabilization fund that will enable the government to set aside some hydropower revenue for more even distribution of expenditure. 25. In trying to mitigate vulnerability to trade imbalances, Bhutan must also address trade in services. Tourism partly helps to offset the merchandise trade deficit and reduce the overall current account deficit and is a significant source of both foreign exchange earnings and government revenue. However, tourism in Bhutan is susceptible to seasonality, and tourist destinations are not evenly distributed across the country. Moreover, limitations on transport and hotel capacity also constrain tourism growth. With limited domestic air connectivity across the country, tourism activities are concentrated in the most-developed western region. The

26 K. Ura. 2015. Bhutan’s Indian Rupee Shortage: Macroeconomic Causes and Cures. ADB South Asia Working Paper

Series No. 40. Manila: ADB. 27 Government of Bhutan, Ministry of Finance. 2019. National Budget Financial Year 2018-19. Thimphu. 28 Government of Bhutan, National Council. 2008. Constitution of the Kingdom of Bhutan. Thimphu. (The 10th standard

refers to the 10th year of school after kindergarten.)

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government is pursuing a policy of high-value, low-impact tourism to conserve the environment, preserve its cultural heritage, and create an image of exclusivity for the country. The strategy aims to diversify tourist destinations, integrate green and sustainable approaches, and promote links between tourism and other sectors, such as agriculture. Bhutan could implement an “open sky” policy to increase its air transport capacity and thereby promote tourism.29 Tourism also holds great potential for foreign direct investment (FDI) and public–private partnerships (PPPs) that could maintain the exclusivity, comfort, and efficiency of the travel experience while promoting both employment for youth and economic diversification. 26. Demographic challenges. In addition to diversifying and expanding the country’s economic base, a key concern of the 12th plan is Bhutan’s rapidly changing demographics. The 2017 population and housing census recorded a rapid decline in the fertility rate in each of Bhutan’s 20 districts compared with the previous census in 2005. The fertility rate declined from 2.5 in 2005 to 1.7 in 2017. The fertility rate of 1.7 is below the replacement level of 2.1. As a consequence, Bhutan’s society is aging. The percentage of children aged 0–14 years declined

from 33.1% in 2005 to 26.0% in 2017.30 At the same time, the total labor force has marginally increased. In 2017, the labor force accounted for about 50% of Bhutan’s total population. Male workers dominate employment in the civil service, government agencies, and government companies, while women represented about 39% of the labor force. However, the majority of female workers are engaged in agriculture (67.4%), where working conditions are difficult and earnings are low and unstable. Substantial differences in wages are also evident across genders. On average, female workers’ monthly earnings were 30% lower than those of men in 2016.31 27. Human capital potential not realized. Youth unemployment has risen significantly, from 7.3% in 2012 to 15.7% in 2018, compared to the overall unemployment rate of 3.4%.32 Bhutan’s labor force will likely increase by an estimated 6% per year, with about 25,000 people expected to join the labor force over the 2019–2023 period.33 An estimated 50% of the newcomers are college graduates. However, the labor force participation rate declined from 69.0% in 2010 to 62.6% in 2018, indicating a weakening demand for labor.34 A mismatch between skills and employment is the principal cause of high unemployment among young people.35

28. Bhutan’s economy offers few opportunities for productive and reliable employment. With a share of 54.0% of the labor force, agriculture remains the main employer in the economy. However, the sector’s ability to absorb new, young workers is limited. In rural areas, low unemployment has concealed relatively high underemployment. Bhutan’s state-owned

29 The policy would foster market competition by lifting restrictions on international route rights, the number of

designated airlines, and service frequencies. 30 Government of Bhutan. 2018. National Statistics Bureau. 2017 Population and Housing Census of Bhutan.

Thimphu. 31 ADB. 2018. Report and Recommendation of the President to the Board of Directors: Proposed Grant to Bhutan for

the Skills Training and Education Pathways Upgradation Project. Sector Assessment (Summary): Education (accessible from the list of linked documents in Appendix 2). Manila.

32 Government of Bhutan, National Statistics Bureau. 2018. 2018 Labour Force Survey Report Bhutan. Thimphu. 33 These estimates are based on an extrapolation of the average annual growth rate of the labor force (1.2%) during

2009–2016. Government of Bhutan, Ministry of Labour and Human Resources. 2017. Labour Force Survey-Annual Report 2016. Thimphu.

34 The labor force participation rate is defined as the number of people actively participating in the labor force divided by the total number of people eligible to participate in the labor force. World Bank. 2018. Bhutan Development Update – Youth unemployment rate increased under high growth. Washington, DC.

35 World Bank. 2017. Performance and Learning Review of the Country Partnership Strategy for the Kingdom of Bhutan for the Period FY2015–2019. Washington, DC.

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enterprises generate almost half of all jobs outside agriculture (footnote 35). In comparison, the private sector in Organisation for Economic Co-operation and Development countries generates roughly eight out of 10 jobs.36 Capital-intensive hydropower projects, the main driver of Bhutan’s economic growth, have created relatively fewer new jobs than tourism and cottage and small industries. 29. The education system overvalues general education that prepares students for tertiary education while neglecting vocational training. Secondary schools do not teach the skills needed in the labor market. They also do not improve workforce productivity or economic competitiveness by providing appropriate types and levels of skilling. Overall, secondary education and technical and vocational education and training (TVET) are not well-aligned. Investment in TVET is insufficient to meet the predicted growth in demand from students, and the quality of TVET training is generally poor. Tertiary school graduates tend to seek employment in the public sector and appear unwilling to accept available blue-collar jobs.37 The income and productivity gap between agriculture and other sectors of the economy, and the consequent rural–urban drift, could potentially exacerbate the employment problem. The productivity gap is evident in the overall rapid economic growth as compared with the declining share of agriculture in GDP. 38 The underlying reason is that agricultural production is predominantly a subsistence activity that is constrained by limited mechanization and weak marketing. 30. Weak private sector participation. The public sector is the main source of economic activity and is the preferred employer because of the benefits and job security that job seekers associate with it. Bhutan’s state-owned enterprises generate about 40% of government revenues and almost half of all jobs outside agriculture (footnote 36). Over 98% of the Bhutanese private sector is represented by micro, small, and medium-sized enterprises (MSMEs) in agricultural, cottage, and service industries. MSMEs have in the past played a vital role in fostering entrepreneurship, providing employment, and reducing poverty. The subsector has achieved major improvements including major institutional reforms.39 Nevertheless, the country has still not fully exploited the potential of MSMEs to drive further growth. High costs, limited availability of raw materials, poor transport logistics and infrastructure, as well as limited access to finance are major impediments to the competitiveness of agricultural and cottage industries. Agricultural and cottage enterprises depend on the processing of primary products, such as food processing, sawmilling, distilling, and furniture making. In the agricultural processing industry, Bhutan produces a narrow range of fresh produce and food products in a narrow range of product categories. Bhutan has great potential in two areas: (i) low-volume, high-value products aimed at niche markets; and (ii) larger-scale, foreign-investment businesses located in border areas that can benefit from the comparative advantages of a flexible labor market and a stable political environment. Bhutan can tap this potential by integrating local producers into global value chains.

36 In Organisation for Economic Co-operation and Development countries, the average public sector employment rate

was 21.3% in 2013. Organisation for Economic Co-operation and Development. 2015. Employment in the Public Sector – Government at a Glance 2015. Paris.

37 Ministry of Labour and Human Resources. 2018. 12th Five-Year Plan Human Resources Development Masterplan for the Economic Sectors (2018–2023). Thimphu.

38 Agriculture in Bhutan is still a predominantly subsistence sector. The share of agriculture in Bhutan’s GDP has been shrinking, similar to other countries that have experienced high economic growth. With declining contributions to GDP, the productivity of the agriculture sector has also decreased.

39 Such improvements include (i) introducing a central registry for movable collateral at the Royal Monetary Authority, which has expanded the base of bankable clients for banks; (ii) enabling community centers and regional trade and industry offices to receive applications for micro trade registration certificates, thus facilitating business registration in remote areas; (iii) creating the Department of Cottage and Small Industry responsible for MSME strategy and programs; and (iv) enhancing the capacity of the Bhutan Standard Bureau to monitor product quality and standards.

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31. Bhutan needs to attract more FDI that can help create jobs, build capacity, and supplement inadequate investments in the private sector from domestic sources. To date, inflows of FDI have been small, primarily because of the country’s small domestic market, low integration in the global economy, and its landlocked location. The total stock of FDI flows was about 5% of GDP in FY2017 (footnote 30). The low level of FDI may also be related to difficulties in doing business in Bhutan. For FDI to increase, stringent restrictions on capital account transactions using foreign currencies will have to be partially lifted. In 2014, the government adopted a more liberal policy that encourages FDI in the priority sectors, where full foreign equity is allowed. In 2017, it passed the Fiscal Incentives Act, which provides fiscal incentives in the form of tax holidays and customs and sales tax exemptions.40

32. The government is aware that a sustained effort is needed to expand the role of the private sector. A coherent long-term approach will have to remove existing constraints on the enabling environment and promote private sector initiatives. A willingness to take risks and explore innovative business concepts and areas will have to underpin the private sector strategy. Economic policies and facilitating infrastructure and services will be required to ensure that new priority sectors—cottage and small industries, tourism, and agriculture—will increase exports and bolster competitiveness, thereby reducing the current account deficit. In 2010, the government issued (and in 2016 updated) the Economic Development Policy that sets forth its economic plan and identifies priority sectors for sustainable growth and investments. For the 12th plan to be effective, it is crucial for the government to implement reforms that will further diversify the economy.

33. Infrastructure shortages, poor connectivity, and the high cost of trade logistics. Accessibility is among Bhutan’s key development issues. The country’s trunk road network has limited coverage and is unable to meet the growing demand of larger and heavier vehicles. Limited provision of reliable feeder roads adds to the isolation of remote rural areas. While the country has expanded the national road network, and most national highways and district and feeder roads are paved, some national highways and district roads are still in poor condition. Roads with narrow carriageways built along steep hillsides are prone to landslides, and weather conditions during the winter months and rainy season render road travel difficult.

34. The relatively poor transport infrastructure has impeded the country’s competitiveness. This is illustrated by Bhutan’s logistics performance, which is lagging behind the performance of other South Asia Subregional Economic Cooperation Program (SASEC) member countries. The main underlying causes are the country’s mountainous topography, which makes building and maintaining roads costly and makes transport operations inefficient.41 Being landlocked creates difficulties similar to those that Nepal and Mongolia have experienced. Bhutan’s border with the People’s Republic of China is closed, so all trade between the two countries must pass through India, mainly through southern border towns. These constraints are evidenced in transport infrastructure and transport services indicators, which are rated lowest among the six components of the Logistic Performance Index and in the Enabling Trade Index of the World Economic Forum.42

40 Government of Bhutan, Ministry of Finance. 2017. Rules on the Fiscal Incentive Act of Bhutan 2017. Thimphu. 41 For example, the dimensions of most roads in Bhutan are inconsistent with the operation of articulated trucks

carrying 40-foot (12.2 meter) shipping containers. An articulated truck is a multi-axle truck consisting of a prime mover and a trailer.

42 World Bank. 2018. Logistics Performance Index. Washington, DC; World Economic Forum. 2016. The Global Enabling Trade Report 2016. Geneva.

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35. Bhutan is one of the founding members of SASEC, which since 2001 has been promoting regional cooperation and integration. 43 While Bhutan has made significant strides towards becoming integrated in the region, the country’s weak trade competitiveness has stood in the way of deeper integration, despite regional support that Bhutan has received to develop its transport infrastructure and logistics facilities, as well as support for policy, regulatory, and institutional reforms in the SASEC region.44

36. Development of market and institutional capacities at the early stage. Rapid economic growth has lifted the majority of Bhutan’s population out of poverty. Given the increasingly visible fallout from rising inequality, environmental degradation, and climate change, strategies and policies that focus narrowly on economic growth will no longer be sufficient. Adjustments are needed to promote inclusive and sustainable growth. Achieving higher development dividends from growth will require improvements in governance, which is a key determinant of development outcomes, such as poverty reduction, human development, gender equality, infrastructure quality, and water security. The positive governance performance which Bhutan has demonstrated to date will have to be sustained in bringing the planned and already initiated reforms to successful conclusion.45

37. It is critical for the government to implement sophisticated institutional reforms to develop a well-functioning market and business environment. As a conduit of all economic activities, the financial market will need to be broadened and deepened to keep pace with overall economic development. Bhutan’s financial system is dominated by the formal banking subsector, which accounted for 85.6% of total financial system assets as of December 2016. However, both the treasury bond market and the corporate bond market are thin. The government does not maintain an active treasury bond market, even though it began issuing treasury bonds in 2009. Instead it borrows directly from state-controlled banks.46 Currently, the government meets its domestic financing needs predominantly through the narrow treasury bill market, which is subject to a high rollover risk.47 With concessional financing decreasing, a deep and well-functioning public debt market will be a reliable and inexpensive source of domestic financing for funding long-term investment in infrastructure. It will at the same time offer an opportunity for institutions like pension funds to deposit their long-term savings. 38. Availability of affordable finance is a major impediment to private investment and doing business in Bhutan.48 The domestic credit–GDP ratio was over 50% in FY2018. Banks have responded to the large household credit demand that economic growth has fueled. Credit grew significantly during FY2013–FY2017, contributing to an increase in nonperforming loans, especially after the government began to enforce restrictions on Indian rupee loans in 2012. However, banks’ assets have increased faster, which has resulted in the capital–assets ratio exceeding 16% in FY2018. While the banking subsector has grown significantly in terms of financial viability, profitability, and competitiveness, access to finance for private sector and small-

43 Other SASEC members are Bangladesh, India, the Maldives, Nepal, and Sri Lanka. 44 ADB. 2016. South Asia Subregional Economic Cooperation Operational Plan 2016–2025. Manila. 45 Bhutan is ranked 26 on the Corruption Perceptions Index 2017 out of 180 countries. After Singapore; Hong Kong,

China; and Japan, Bhutan is the highest ranked Asian country. Transparency International. 2018. Corruption Perceptions Index 2017. Berlin.

46 R. A. Cole and S. Carrington. 2017. ADB South Asia Working Paper Series No. 44. An Assessment of Financial Sector Development in Bhutan. Manila.

47 A rollover risk is a risk associated with the refinancing of debt, i.e., the need for the treasury to roll over the debt that is about to mature into a new debt.

48 World Bank. 2017. Investment Climate Assessment of Bhutan: Removing Constraints to Private Sector Development to Enable the Creation of More and Better Jobs. Washington, DC.

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scale businesses in rural areas remains a problem. People in rural areas, women, and youth constitute an untapped market of potential customers for financial services, and thus represent an area of opportunity. Another area with potential for reform is the pent-up demand for less complex and less time-consuming banking services, including more accessible deposit and withdrawal procedures, flexible loan requirements, and small periodic savings and loans services. In this regard, many households would benefit from greater financial literacy that would enable them to make more use of formal banking services.

39. Vulnerability to natural disasters and climate change. As a country that is not just carbon-neutral but is indeed carbon-negative, Bhutan has contributed greatly to environmental conservation within its border, and to the region because the renewable energy it has exported has replaced fossil-fuel-generated electricity. However, the global phenomenon of climate change threatens Bhutan’s economy in the medium term. The country is vulnerable to natural disasters including earthquakes, floods caused by glacial lake outburst, landslides, rainstorms, windstorms, and forest fires. Economic progress and modernization have also brought about lifestyle changes that threaten the country’s ability to implement green policies effectively. A case in point is rapid and uncontrolled urbanization, with all of the problems that it normally entails. These include poor public transport, reliance on private motor vehicles, air pollution, health hazards, and the shortcomings caused by inadequate urban planning. Greater and concerted efforts will be required to tackle climate change, build climate and disaster resilience, and enhance environmental sustainability.

40. Climate change is also expected to cause glacial retreat, which over time will reduce river discharge from glaciers on which hydropower plants in Bhutan depend. The runoff to rivers will increase in the short term because of the large volumes of stored ice melting away. Eventually these stores of ice may disappear entirely, resulting in a long-term decrease in annual runoff and thus in declining electricity generation. 49 On the social front, water security and waste management have become more challenging in the wake of changed weather patterns and rapid urbanization, affecting livelihoods and quality of life for rural and urban populations. 41. Other emerging environmental issues include water scarcity, food insecurity, urbanization, and natural disaster risks:

(i) The risk of water scarcity increases as temperatures rise. In 2016, the government launched the National Integrated Water Resource Management Plan, which recommends developing a Bhutan water security index as a key result area in the 12th plan.

(ii) Climate change detrimentally affects agriculture and food resources. The impacts include loss of crop diversity, the drying up of water sources, loss of soil moisture, forest degradation, soil erosion, and loss of arable land. The issue of food security is therefore addressed in the 12th plan.

(iii) Rapid urbanization as a result of rural–urban drift has caused an acute shortage of farm labor and is in turn leaving increasing areas of Bhutan’s agricultural land fallow. Population growth in urban areas has resulted in rising vehicular emissions, traffic congestion, and waste problems. The management of municipal and industrial waste has emerged as a serious environmental problem. The large urban centers have infrastructure and service delivery backlogs, shortages of serviced land and affordable housing, and rising levels of pollution. In the absence of

49 J. E. Cherry et al. 2017. Planning for climate change impacts on hydropower in the Far North. Fairbanks, Alaska.

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systemic risk assessments and preparedness plans, they are also vulnerable to natural disasters.

C. Implications for ADB Country Engagement

42. The government formulated the Twelfth Five-Year Plan, 2018–2023 while the country was transitioning to middle-income status. The forthcoming 5-year period will be critical for Bhutan to enhance its socioeconomic foundation so that it will be resilient in a more complex environment and able to minimize risks associated with anticipated changes. The 12th plan recognizes the importance of its development challenges. The priorities of the plan, as reflected in 17 national key result areas, include the need to diversify the economy by focusing on job creation and private sector promotion in addition to alleviating poverty and vulnerability, mitigating climate change, and closing infrastructure gaps. Emerging issues, such as equipping youth with employable skills, urbanization, and changing demographics, present opportunities and challenges. The plan will apply the fundamental principle of “triple Cs” to enhance implementation efficiency, i.e., coordination, consolidation, and collaboration.

43. As Bhutan’s long-term development partner with the second-largest investment portfolio, ADB is well-positioned to play an active role in assisting the government with addressing the challenges outlined in paras 20–40. Like the 12th plan’s triple Cs principle, ADB’s Strategy 2030 applies an integrated approach in implementing ADB operations in both sovereign and nonsovereign interventions. ADB is committed to supporting private sector operations by attracting private investments and bringing in commercial cofinanciers to sovereign projects.

44. The focus of ADB’s CPS, 2019–2023 for Bhutan is to help the government transform Bhutan’s economy, address market distortions, and ensure an equitable distribution of economic progress and development. It is essential for Bhutan to foster a more competitive, dynamic, diversified, and resilient economy, based on an environment that enables the private sector to participate in economic growth. ADB will add value to Bhutan’s development by combining finance, knowledge, and partnership in its ongoing and future engagement. ADB’s Strategy 2030 accords priority to seven areas (footnote 1), all of which will be highly relevant in addressing constraints on Bhutan’s development. 45. The needs that are prioritized in Bhutan’s 12th plan and the focus of Strategy 2030 are closely aligned, so ADB has scope to deliver interventions in almost all priority areas. Based on Bhutan’s national development priorities, ADB’s comparative advantage, and ongoing operations, ADB should develop a country-focused and differentiated approach. The CPS, 2019–2023 is based on three strategic priorities:

(i) Dynamic economic reforms. ADB will help the government identify and

implement reforms that will respond in a timely way to the socioeconomic changes of the country and region, while also developing a sound economic structure that can withstand existing and anticipated risks and vulnerabilities. This will include (a) promoting greater participation by the private sector (including MSMEs), developing an attractive FDI framework, and fostering PPPs; (b) support for public management and administration reforms, including prudent and innovative hydropower investment management (such as carbon market mechanisms); (c) assistance to deepen and broaden the finance sector to increase access to finance for the private sector, create a balance between banks and nonbanks, and deepen

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the capital market; and (d) support for policies and for implementing efficient trade facilitation.

(ii) Improved connectivity. ADB will help Bhutan to overcome the challenges that result from its landlocked geography and mountainous topography by (a) improving access to public services, information, and markets; and (b) bringing local Bhutanese producers closer to global value chains. Within the country, ADB will support sustainable investments and know-how to maintain and upgrade rural and urban land and air transport structures and services. Deeper regional cooperation and integration through improved physical connectivity and trade facilitation will help strengthen the country’s capacity in tourism and agricultural trade. Information and communication networks and capacities will be developed to improve access to market information and knowledge.

(iii) More equitable socioeconomic development. ADB will support government efforts to improve health and education and to address remaining poverty and inequality. This support will include (a) sustainable investment to improve health, education, and skills development; (b) increased agricultural productivity and food security; (c) innovative and systematic infrastructure and services that will improve productivity and the standards of local products and services, including investments in inventory systems, production technology, standardization, and certification; (d) support for gender mainstreaming in ADB operations and empowering women in economic activities; and (e) comprehensive urban development to increase quality of life and living standards.

46. The crosscutting themes of ADB’s interventions will include private sector development, enhanced environmental sustainability, information and communication technology development, and improved participation by disadvantaged groups, including youth, women, rural dwellers, and urban poor people. ADB will focus on ensuring that Bhutan continues to achieve its aspiration of green development. ADB will build on earlier support to help the government design, implement, and enforce laws, regulations, standards, and strategies that address environmental sustainability issues. These include (i) conserving and managing natural resources, (ii) improving urban environmental, (iii) promoting eco-efficiency, i.e., reducing ecological damage to a minimum while at the same time maximizing productivity and efficiency, (iv) incorporating global and regional transboundary environmental concerns, and (v) managing disaster risk.

47. ADB’s country program pipelines throughout the CPS period will be aligned with national priorities and closely coordinated with the strategic partnerships of development partners, civil society, the private sector, and other key stakeholders. At the same time, ADB must be flexible when shaping future country programs to respond effectively to the volatility and vulnerability of the country’s socioeconomic and environmental situation. Assistance will be selected based on ADB’s broader contribution to strategic objectives, rather than being aligned with individual sector or thematic areas. In addition to financing, ADB will offer innovative and sound knowledge solutions and capacity development in all priority areas. This will enable ADB to take a long-term perspective that extends beyond the CPS, 2019–2023 time frame.

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Bhutan’s Development Constraints

Problem Tree