Heavy dependence of the Bhutanese economy and government revenues on the hydropower sector raises concerns
The economy is projected to grow by 4.9% in FY23/24. Growth is expected to be supported by the service sector, including higher growth in tourism-related services, and the industry sector due to a gradual increase in mining (mineral products) and manufacturing activities (base metals). New incentives for longer-staying international tourists are expected to support tourism in FY23/24. However, total arrivals are expected to remain below pre-COVID.
According to the latest Bhutan Development Update (BDU) published annually by the World Bank, on the demand side, growth is supported by services exports and consumption, reflecting higher government spending. Medium term growth is expected to be supported by a robust growth in exports, construction, and services sectors. The commissioning of the Punatsangchhu II hydropower plant will support growth, adding 1,020 MW to the current hydro generation capacity of 2,300 MW.
Inflation is projected to remain elevated in the short term due to extended global supply disruptions resulting from Russia’s invasion of Ukraine and tensions in the Middle East. For Bhutan, imported consumer goods and services carry 55% weight in the CPI basket, of which food products account for 24%.
In the medium term, inflation is expected to moderate and be in line with inflation in India, given the Bhutanese Ngultrum’s peg to the INR. The fiscal deficit is expected to increase due to a decline in revenues and a major salary increase to address significant staff attritions. The deficit is projected to increase to 5% of GDP in FY23/24 from 4.7% in FY22/23.
Current expenditure is expected to increase due to the major salary hike last year for public servants between 55 and 74% amounting to 2.8% of GDP. The salary increases are expected to be partly financed by proceeds from DHI’s crypto mining operations. However, total expenditures are expected to remain moderate because of lower capital expenditures in the first year of the 13th FYP given that capital spending is typically lower in the first two years of the FYP.
The increase in tax collection from higher royalties from tourism and hydropower will be offset by lower one-off profits from hydropower projects and external grants. The fiscal deficit is expected to decline beyond FY24/25 driven by fiscal consolidation and an increase in hydropower revenues. Capital expenditure and primary non-wage recurrent expenditure is expected to moderate in the medium-term, reflecting a normalization in spending after the COVID-19 pandemic and the election year in FY23/24.
Domestic revenues are expected to reach 24.1% of GDP in FY25/26, reflecting higher hydro revenues in the form of one-off profits and royalties from the commissioning of the Punatsangchhu II hydropower plant. However, increase in hydropower revenues is expected to be partly offset by a decline in overseas development assistance (ODA) following the LDC graduation in 2023.
The government has initiated several reforms to improve public spending efficiencies and increase domestic revenue mobilization through improved tax policy and administrative reforms. However, the impact of these reforms on revenues is difficult to estimate and therefore the macroeconomic framework conservatively assumes minimal impact over the medium term.
Debt is expected to remain sustainable. Hydro debt is expected to decline (as a share of GDP) due to debt repayments, but non-hydro debt is expected to increase in the short term, reflecting the high fiscal deficit, before moderating in the medium term.
The 2022 joint IMF-World Bank Debt Sustainability Analysis (DSA), the most recent joint DSA, assesses the risks of debt distress to be moderate. Although the significant stock of debt would normally point to a high risk of overall and external debt distress, the risk was assessed to be moderate given unique mitigating factors.
Most of the outstanding PPG debt is linked to hydropower project loans from the GoI which are implemented under an intergovernmental agreement where the GoI covers financial and construction risks, and commits to purchase all surplus electricity at a price reflecting cost plus a margin. Second, the debt dynamics are set to improve over the medium term, driven by a significant increase in electricity exports and a decline in imports associated with hydropower construction.
The current account deficit (CAD) is projected to fall sharply as lumpy IT equipment imports fall, and to moderate further in the medium term supported by an increase in tourism and electricity exports. The expected improvement in the CAD in FY23/24 to 15.7% of GDP is driven by a lower trade deficit, led by a significant reduction in goods imports. This reflects the decline of lumpy imports of crypto IT equipment, which accounted for 6% GDP in 2022 (DHI also imported related goods to expand the electricity network).
The CAD is expected to moderate further in the medium term due to an increase in tourism exports from FY24/25, the on-streaming of the Punatsangchhu II hydropower project in FY25/26, as well as a decline in imports following the completion of the hydropower projects. International reserves are expected to remain at USD 516 million in FY23/24 (equivalent to 3.3 months of import coverage).
Meanwhile, it has been projected that there would be risks, challenges, and opportunities as well during the period, with downside risks to the economy also highly persistent. Domestic risks include delays in hydropower projects, which could affect fiscal and external balances. Delayed fiscal consolidation and the materialization of financial sector contingent liabilities could further erode buffers.
External risks include rising and volatile commodity prices due to geopolitical tensions, which could exert further pressure on the external balance and international reserves. Lower than expected returns from crypto operations and continued immigration of the educated workforce could also weigh on the economy in the medium term. It would be important to ensure macro-fiscal sustainability in the medium to long term.
Although macro-fiscal sustainability has been maintained over the past two decades, supported by large hydro revenues and external grants, spending to fund the COVID-19 relief measures for individuals and businesses coupled with subdued revenue performance have resulted in high fiscal deficits and non-hydro public debt since FY20/21, with limited fiscal space to absorb additional shocks.
Vulnerabilities in the financial sector with high levels of non-performing loan (NPL) have increased fiscal risks, given that about 60% of assets of the financial sector are controlled by the public sector. The government has outlined ambitious reforms to support economic diversification and green and inclusive development, including through the upcoming 13th FYP. However, limited fiscal space and high debt levels limit the government’s ability to support the economic recovery during global economic uncertainties. Based on a World Bank analysis, absence of fiscal consolidation and delayed implementation of the hydropower projects could make the macro situation unsustainable in the medium to long term.
The heavy dependence of the economy and government revenues on the hydropower sector raised concerns of a Dutch Diseases effect, resulting in a loss of competitiveness in non-hydro sectors. Proper management of hydropower revenues in stimulating economic diversification ameliorates such adverse effects.
Access to finance in Bhutan has been traditionally limited to large corporations with collaterals. Improving access to finance for the private sector, especially the smaller businesses have the potential to support the growth of private businesses and employment opportunities among them. Bhutan’s long term economic prospect will depend on effective implementation of its plans.
The government’s strategic support of the hydropower sector involves large fixed-capital investments over a long-term horizon. The government has also placed big bets on several national initiatives, such as the investment in cryptocurrency mining to accelerate the country’s digital transformation and generate additional revenues, and the government’s plan to establish a Mindfulness City in Gelephu near the southern border with India.
The BDU is published annually. It assesses recent economic and social developments, prospects, and policies in Bhutan. The BDU also provides an in-depth analysis of selected economic and policy issues. The report is intended for a wide audience, including policy makers, business leaders, researchers and academics, the community of analysts monitoring Bhutan’s economy, and the general public. The update was prepared by the Macroeconomics, Trade, and Investment (MTI) Global Practice of the World Bank.
By Tashi Namgyal, Thimphu
