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Report and Recommendation of the President to the Board of Directors

Project Number: 46371 February 2013

Proposed Policy-Based Loan and Grant Kingdom of Bhutan: Strengthening Economic Management Program This document is being disclosed to the public prior to Board consideration in accordance with ADB’s Public Communications Policy 2011. Subject to any revisions required following Board consideration, this document is deemed final.

CURRENCY EQUIVALENTS (as of 1 February 2013)

Currency unit – ngultrum (Nu)a

Nu1.00 = $0.0187 $1.00 = Nu53.34

a The ngultrum is pegged to the Indian rupee at par.

ABBREVIATIONS

ADB – Asian Development Bank DPA – Department of Public Accounts GDP – gross domestic product IMF – International Monetary Fund MOF – Ministry of Finance RMA – Royal Monetary Authority

NOTES

(i) The fiscal year (FY) of the Government of Bhutan and its agencies ends on 30 June. “FY” before a calendar year denotes the year in which the fiscal year ends, e.g., FY2013 ends on 30 June 2013.

(ii) In this report, "$" refers to US dollars.

Vice-President X. Zhao, Operations 1 Director General J. Miranda, South Asia Department (SARD) Director B. Carrasco, Public Management, Financial Sector and Trade Division,

SARD Team leader C. Kim, Lead Finance Specialist, SARD Team members K. Emzita, Principal Counsel, Office of the General Counsel

H. Mukhopadhyay, Senior Public Management Economist, SARD Y. Niimi, Economist, SARD

Peer reviewers S. Parvez, Senior Planning and Policy Economist, Strategy and Policy Department

V.B. Tulasidhar, Advisor, Regional and Sustainable Development Department

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS

Page

PROGRAM AT A GLANCE

I. THE PROPOSAL 1

II. THE PROGRAM 1

A. Rationale 1 B. Impact and Outcome 5 C. Outputs 5 D. Development Financing Needs 6 E. Program Implementation Arrangements 7

III. TECHNICAL ASSISTANCE 8

IV. DUE DILIGENCE 8 A. Technical 8 B. Economic 8 C. Governance 9 D. Poverty and Social 9 E. Safeguards 9 F. Risks and Mitigating Measures 10

V. ASSURANCES AND CONDITIONS 10

VI. RECOMMENDATION 10

APPENDIXES

1. Design and Monitoring Framework 11 2. List of Linked Documents 14 3. Development Policy Letter 15 4. Policy Matrix 17

PROGRAM AT A GLANCE

1. Project Name: Strengthening Economic Management Program 2. Project Number: 46371-001 3. Country: Bhutan 4. Department/Division: South Asia Department/Public Management, Financial Sector,

& Trade Division 5. Sector Classification:

Sectors Primary Subsectors Finance Finance sector development

Money and capital markets

Public sector management √ Public expenditure and fiscal management

6. Thematic Classification: Themes Primary Subthemes Economic growth √ Promoting macroeconomic stability Private sector development A conducive policy and institutional environment

Governance Economic and financial governance

Capacity development Institutional development

6a. Climate Change Impact No Climate Change Indicator available.

6b. Gender Mainstreaming Gender equity theme (GEN) Effective gender mainstreaming (EGM) Some gender elements (SGE) No gender elements (NGE) √

7. Targeting Classification:

General Intervention

Targeted Intervention Geographic

dimensions of inclusive growth

Millennium development

goals

Income poverty at household

level √

8. Location Impact: National High

9. Project Risk Categorization: Low

10. Safeguards Categorization: Environment C Involuntary resettlement C Indigenous peoples C

11. ADB Financing: Sovereign/Nonsovereign Modality Source Amount ($ Million) Sovereign Program loan Asian Development Fund 14.2 Sovereign Project grant Asian Development Fund 20.8

Total 35.0

12. Cofinancing: No Cofinancing available.

13. Counterpart Financing:

No Counterpart Financing available.

14. Aid Effectiveness: Parallel project implementation unit No Program-based approach Yes

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on a proposed policy-based loan and grant to the Kingdom of Bhutan for Strengthening Economic Management Program.1

2. The program will pursue policy reforms through budget support for the Government of Bhutan, which currently faces weakening growth prospects and challenges in macroeconomic management. The program will strengthen macro-financial management in the country to ensure adequate and sound development financing that is balanced and without distortions. This is necessary to sustain robust growth in the medium-term and facilitate Bhutan’s transition to a middle-income country.

II. THE PROGRAM

A. Rationale

3. Background. Bhutan has successfully pursued investment-led growth that builds on its comparative advantage and improves socioeconomic development. Despite the impressive growth in income per capita and progress toward Millennium Development Goals over the past years, there has been increasing evidence of an overheating economy. This has been reflected in the buildup of domestic and external imbalances and resulting in the recent rupee liquidity shortage.2

4. The program targets corrective policy measures to address these imbalances and improve macroeconomic management. The program will assist in transitioning the economy on to a sustainable growth track over the medium-term to avoid what could otherwise be a hard landing.

5. The next 3–5 years will be critical as 10 ongoing and forthcoming hydropower projects undergo construction (para. 29). The critical challenge for the government is to ensure the timely completion of such projects in order to develop a sufficiently large generation of export earnings that will sustain the financing through the budget of an increasing demand for public services. Strong macroeconomic management will be imperative to sustain the large investment drive required to complete these projects and attract additional private investment.

6. Driver of growth. Bhutan’s economy performed well during FY2001–2011, with gross domestic product (GDP) growth averaging 8% per annum. Accordingly, per capita income, measured in 2,000 constant dollars, has trebled to $2,428 in 2011 from $778.30 in 2001. These advances were driven mainly by the hydropower sector, which is the engine of economic growth.3 Hydropower contributes a quarter of Bhutan’s GDP and is the main source of public revenue.

7. To sustain Bhutan’s high economic growth trajectory and to meet its Vision 2020 goals, three elements are deemed critical: (i) sound macroeconomic management; (ii) efficient, reliable, and expanding physical infrastructure; and (iii) a strong domestic revenue base. The government has therefore prioritized, in addition to constructing hydropower projects, improving

1 The design and monitoring framework is in Appendix 1.

2 In this report, “rupee” refers to Indian rupees.

3 As part of Vision 2020, the government plans to add 10,000 megawatts of power generating capacity by 2020. To

this end, the government entered into a bilateral agreement with the Government of India during the first Empowered Joint Group Meeting held in Delhi in March 2009 to develop 10 hydropower projects.

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and expanding hard and soft infrastructure, including through investment in health and education under the Tenth Five-Year Development Plan.4

8. Financing of growth. This ambitious buildup of public capital expenditure, especially on hydropower projects, has been financed largely by external development assistance. Following on the introduction of the banking system in Bhutan in the 1970s, despite increasing income per capita, the household savings and overall savings in the national economy remained relatively low. In addition, the banking system has largely been shielded from competition, and savings products in the financial system are largely undeveloped, further inhibiting savings in the economy.

9. India has been Bhutan’s single largest bilateral and trading partner, providing 75% of its imports and absorbing 90% of its exports. Recently, India’s share of development expenditure in Bhutan has declined. More generally, with the rise in Bhutan’s income per capita and overall development, concessional terms of assistance from other development partners have hardened.

10. The transition from an agrarian to a modern economy has increased demands on the government, particularly regarding service delivery and social sector expenditures. This has rapidly expanded public spending in the budget, which has intensified fiscal pressures and built up national debt. While there has been a steady growth of tax revenue, the additional revenue generated from hydropower exports has not fully met rising demand for services provided through the budget and debt servicing obligations.

11. Economic imbalances. Higher household income has also contributed to robust growth in private consumption, which, together with large public spending has led to an increase in imports and widening of the trade deficit with India. On the financial side, the added pressure on consumption has more recently led to the rapid expansion in growth of financial sector credit in the economy which has been outpacing nominal GDP growth rate.5 While inflation has been recently increasing, the resulting pressure has been most clearly manifested in a rupee liquidity crunch in the local economy.

12. Consequently, in FY2012, a fiscal deficit of 4.7% of GDP erased a fiscal surplus of 1.6% in FY2011 and the current account deficit widened to 20.6% of GDP from 10% in FY2011. While the balance of payments remains in surplus, the net rupee balance in the Royal Monetary Authority (RMA), the central bank, has been steadily declining over the past few years, standing at –Rs9.6 billion ($173.6 million) as of early June 2012. Widening domestic and external imbalances, coupled with rising inflation and the rupee liquidity squeeze, pose complex macroeconomic management challenges for the government and are clear symptoms of structural challenges in the economy that need to be addressed.

13. Government reform. Recognizing the seriousness of the issue, the Ministry of Finance (MOF) and the RMA have worked together to address the rupee liquidity crunch and depleted rupee reserves toward improving macro-financial stability.6 The government has adopted three critical measures to strengthen stewardship of the economy. First, the RMA has correctly clarified that the rupee anchors the nominal value of the ngultrum but that there should be no presumption of unlimited convertibility. The dissemination of this important fact should be continued. Second, RMA made it mandatory to use banking channels to settle rupee

4 The Tenth Five-Year Development Plan period covers FY2009–FY2013.

5 The nominal GDP growth rate was 17.2% in FY2007 and 18.0% in FY2012, while finance sector credit grew at 28.2%

in FY2007 and 30.1% in FY2012. 6 The government has established a task force to review the balance of payments with India.

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transactions, especially for cross border purchases between India and Bhutan. This measure should have important spillovers in terms of promoting the development of the banking system, greater disclosure, and strengthening the government’s revenue efforts. Third, the RMA has sought to improve liquidity management through the introduction of the base and policy rates with the goal of keeping short-term interest rates within respective policy corridors and containing growth of monetary aggregates to desired trajectories. This should be complemented by a more robust growth of macro-prudential regulation system to complement monetary management.7

14. Structural considerations. The current rupee liquidity crunch was caused by structural and cyclical factors that reflect weak economic management. On the structural side, Bhutan continues to rely heavily on hydroelectricity exports to India supported by bilateral agreements. Under these agreements, the Government of India provides rupee financing—30% grants and 70% loans—to construct hydropower plants, and the Government of Bhutan earns rupees from exports of electricity to India. The ngultrum’s peg at par with the rupee is a natural foreign exchange hedge. 8 The large and lumpy nature of imports of construction equipment and materials for building power plants, and the long gestation between construction and operations, can push the trade balance sharply into deficit. Over time, as construction is completed and plants go onstream, exports increase, the trade balance gradually improves, and export earnings meet loan servicing requirements. In the meantime, sizable positive capital inflows from capital grants and development assistance keeps Bhutan’s balance of payments in surplus.

15. A more recent phenomenon derives from rising household incomes. As most consumable goods are imported from India, rapidly expanding income per capita in Bhutan has put further pressure on the trade deficit. Growing imports of vehicles and construction materials, including those for the housing boom, have contributed to the large import bill from India. Further, limited ability to contain public spending and fiscal deficits widened trade deficits and put pressure on the balance of payments with India. On the monetary front, the limited effectiveness of monetary and liquidity management instruments to stabilize inflation and avoid asset price buildup, and the limited success in effectively applying macro-prudential regulations to address intensifying macro-financial risks in the economy, contributed to the problem.

16. Cyclical considerations. On the cyclical side, there has been a combination of timing considerations that has adversely affected the BOP position in Bhutan. First, from a debt management perspective, on the demand for rupees, loan payments have spiked with a few lumpy payments having come due in early part of the year (every 1 January in the case of Tala Power Project), which has led to further demand for rupees. In December 2011, when the external imbalance with India became significantly large, the RMA and the government had to sell $200 million from gross international reserves to settle the rupee bills from India. Second, from a fiscal management perspective, this heavy dependence on the timing of hydropower projects coming on stream over the medium-term and on uncertain donor support (grants) amid the global financial crisis has increased the fiscal uncertainty and resource constraints. In addition, with Bhutan reaching middle income status, its share of concessional lending is expected to decline. More recently, it has had to incur in relatively costly borrowing from designated commercial financial institutions in India to provide for rupees, as required under the existing ngultrum–rupee currency peg arrangement. The cyclical nature of electricity exports reflecting the run-of-river hydropower plants results in a relative easing of the tight cash flow and

7 ADB technical assistance will support measures to strengthen liquidity management and introduce macro-

prudential reforms. ADB. 2012. Technical Assistance for Supporting Financial Stability in Bhutan and the Maldives. Manila (TA 8284-REG).

8 Though the rupee is not legal tender in Bhutan, it was used widely as if it were, as there were no regulations

limiting convertibility until recently.

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rupee liquidity positions during the second half of the year as compared to the first half of the year.

17. Strategic considerations. The key challenge for Bhutan is how to maintain high, stable, and sustainable growth over the coming years, coinciding with the concentration of construction of hydropower projects, while avoiding widening domestic and external economic imbalances. Bhutan's weak economic management is attributed primarily to three factors: (i) the rapid buildup in public spending,9 (ii) ineffective liquidity management, and (iii) the lack of savings instruments to mobilize higher domestic savings. 10 All these factors caused high domestic absorption not supported by adequate domestic savings, either public or private. The consequent investment–savings gap generated a high current account deficit. If the critical factors are not properly addressed, the economy may be headed for a hard landing with potentially large economic losses reversing recent gains in socioeconomic development.

18. Political transformation. In 2008, Bhutan successfully completed its political transformation from absolute monarchy to constitutional monarchy through a peaceful and stable process of democratization. The country’s first general election for the National Assembly was held in March 2008. A new election is scheduled in June 2013 and a smooth election process is expected.

19. ADB country partnership strategy. The Bhutan interim country partnership strategy, 2012–2013 acknowledges that “the tight overall balance with India has recently placed great pressure on rupee liquidity” and that “there is limited scope to sell additional reserves” because the constitution requires foreign exchange reserves to be maintained to cover 12 months of essential imports (i.e., $448.9 million).11 The interim strategy also acknowledges that to maintain a high and sustainable growth trajectory, more needs to be done to improve economic management including strengthening of fiscal management. Improved monetary management—including measures for better foreign exchange reserves management—is another priority area for creating an environment conducive for high growth in a sustained manner.

20. Lessons. The current program draws lessons from past ADB experience of public resource management programs in South Asia12 and policy-based loans in the small economies such as the Economic Recovery Program in Maldives and the Financial Sector Development Program in Bhutan.13 Two important lessons are that (i) government commitment is the most important prerequisite for a successful program; and (ii) sustained engagement with government officials, including capacity development, is required to support timely program implementation.

21. Building on the strategic considerations, the program adopts a two-pronged approach to confront the challenges of weak economic management in Bhutan. First, it will improve fiscal management to help the government allocate scarce resources more effectively and efficiently. Moreover, better debt management and Treasury operations will improve cash management, which will make flow of funds more predictable and avoid destabilizing spikes in debt

9 While Bhutan largely pursued prudent fiscal policy, spending since 2010 widened fiscal deficits.

10 Sector Assessment: Public Sector Management (accessible from the list of linked documents in Appendix 2).

11 Article 14, Section 7 of the Constitution of the Kingdom of Bhutan, 2008. As of March 2012, Bhutan’s gross international reserves stood at $769.1 million, of which $196 million was pledged against the overdraft facility extended from State Bank of India, $448.9 million was set aside as reserve to cover 12 months of essential imports, and $120 million backed ngultrum in circulation.

12 ADB. 2007. Special Evaluation Study: ADB Support to Public Resource Management in India. Manila.

13 ADB. 2009. Report and Recommendation of the President to the Board of Directors: Proposed Loan, Technical Assistance Loan, and Technical Assistance Grant to Republic of the Maldives for Economic Recovery Program. Manila (Loan 2597-MLD) and ADB. 2006. Report and Recommendation of the President to the Board of Directors: Proposed Loan and Technical Assistance Grant to the Kingdom of Bhutan for Financial Sector Development Program. Manila (Loan 2279-BHU).

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repayments. Second, it will improve monetary management to ensure that interest rate policy better matches the demand and supply of loanable funds, thereby improving liquidity management. This will help create a stable economic environment to instill investor confidence and encourage private investment to sustain growth.14 This approach will be reinforced by strengthening internal and external audit systems to improve the monitoring of public resources and strengthen administrative and financial efficiency and accountability including at the sub-national level of government.

B. Impact and Outcome

22. The impact will be sustainably strengthened macro-financial management by the government. The outcome will be more effective use of the country’s own financial resources in a predictable manner.

C. Outputs

23. The program is structured around reform and policy actions agreed between ADB and the Government of Bhutan as summarized in the policy matrix (Appendix 4). Four outputs achieved during the program period will better enable the government to address economic risks and lay the foundations of sustainable growth.

24. Output 1: Improved budget and debt management systems. First, the program aims to improve allocative efficiency of scarce public resources, whereby, initiatives under this program component will include expenditure allocations based on medium-term expenditure frameworks in selected municipalities. Second, the program will also strengthen the debt management system in Bhutan to smoothen out debt servicing payments and avoid potentially destabilizing future debt servicing spikes, and enhance debt management capacity. The program will facilitate in developing a debt management strategy over the medium-term and a debt management action plan including the plan for strengthening the debt management division. The action plan will also address the issues and challenges pertaining to (i) narrow investor base, (ii) lack of auction calendar, (iii) promoting price competition in auctioning of government securities, and (iv) functional integration of Treasury Management Division and Debt Management Division for improved cash management.

25. Output 2: Improved revenue effort and revenue management system. The program will help the government improve its revenue collection by introducing a revenue administration management information system.

26. Output 3: Improved macro-prudential management framework. Improving macro-prudential management framework will be a key component under the program for strengthening economic management. Policy actions will be initiated to (i) improve macro-prudential framework, (ii) develop the capital markets, (iii) develop the mutual funds and fund management industry, and (iv) develop regulatory and supervisory structure of the domestic credit rating agency. Under improving macro-prudential framework, RMA will develop policies and rules to deal with, among others (i) loan to value ratio, (ii) debt to equity ratio for project financing, (iii) risk weighted capital requirements, (iv) dynamic capital provisioning, and (v) improve retail to wholesale deposit ratio. The RMA will coordinate with the Royal Securities Exchange of Bhutan to complete a capital markets master plan. Finally, the RMA will take the steps necessary, including approving the regulatory system, to develop the fund management industry in Bhutan.

14

Private investment will be critical to diversifying Bhutan’s exports to other sectors such as tourism and agro-based light manufacturing.

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27. Output 4: Improved external and internal audit operations. Improving audit systems is a prerequisite to better economic management. The Royal Audit Authority will phase in an audit resource management system over the program period. All the major departments will train staff to carry out internal audits.

28. In the absence of reform measures—with inflation, fiscal deficit, and current account deficit increasing and already at relatively high levels—the economy may run the risk of a hard landing and even recession.

D. Development Financing Needs

29. Bhutan’s Vision 2020 fully committed the country to developing 10 hydropower projects through bilateral agreements with India. As of the end of October 2012, three hydropower projects namely Chukha, Kurichu, and Tala, were developed and operating. Construction is under way for four hydropower projects: Punatsangchhu I and II, Dagachhu, and Mandechhu.15 The government is also planning to embark on the construction of six new hydropower projects during FY2014. Therefore, the increase in the external debt stock on account of hydropower projects alone for the period ending FY2013 is estimated at Nu16.68 billion ($313 million or 16.2% of GDP) and is projected to grow by Nu34.13 billion ($609 million) and Nu43.62 billion ($763 million) in FY2014 and FY2015, respectively.

30. Given low domestic savings and limited scope for significantly increasing public revenue, Bhutan has a policy of allocating external concessional loans and grants on capital expenditures and using domestic revenue for current expenditure. Any financing of infrastructure is thus constrained by the limits of external development financing assistance and, more generally, by the fiscal and debt targets under the medium-term fiscal framework. The fiscal deficit during FY2012–FY2015 is estimated at Nu9.62 billion, the bulk of it dependent on external development financing (Table 1). The development resource gap is estimated at $158.25 million during the same period.16 An average ratio of capital expenditure to total expenditure of 47% projects an estimated development resource gap for capital expenditure of $74.26 million. The World Bank provided $36.00 million in late 2012, and ADB will finance $35.00 million equivalent.17 The government will fill the unfunded gap of $3.26 million.18

Table 1: Overall Fiscal Deficit and Development Resource Gap

Particulars FY2012

(revised)

FY2013

(budget)

FY2014

(projection)

FY2015

(projection)

Total Projection

Fiscal deficit (Nu million) 3,752.44 1,595.19 3,832.86 446.96 9,627.45 ($ million) 78.50 31.97 74.71 8.51 193.69 (% of gross domestic product) 4.30 1.56 3.21 0.90

Development resource gapa (Nu million) 3,986.63 670.43 3,056.75 95.58 7,809.39 ($ million) 83.41 13.42 59.59 1.82 158.25

Note: Revised estimates and projections are as of 31 March 2012. a The unfunded gap attributed to capital expenditure.

Source: Government of Bhutan. Ministry of Finance. 2012. National Budget Financial Year 2012–2013. Thimphu.

15

Six of the 10 hydropower projects are funded under bilateral agreements with India on a 70:30 loan-to-grant basis, and four projects are commercial joint ventures between public sector companies in both countries.

16 The development resource gap is the difference between total resources available (receipts plus new borrowing) and total expenditure including repayments. It indicates the additional resources required beyond expected new borrowings.

17 On a parallel basis, ADB is advising the Government of Bhutan on raising rupee resources through market borrowings. Options include (i) an offshore sovereign rupee bond issue with a partial credit guarantee from ADB, (ii) an offshore rupee bond issue by state-owned enterprises with a partial credit guarantee from ADB, which is covered by the sovereign counter guarantee, and (iii) a rupee or dollar syndication loan with a partial credit guarantee from ADB.

18 Fiscal Projections (accessible from the list of linked documents in Appendix 2).

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31. The government has requested a loan in various currencies equivalent to SDR9,224,000 ($14.19 million) and a grant not exceeding $20.81 million from ADB’s Special Funds resources to help finance the program. The loan will have a 24-year term, including a grace period of 8 years, an interest rate of 1.0% per annum during the grace period and 1.5% per annum thereafter, and such other terms and conditions set forth in the draft financing agreement.

32. Development coordination. The World Bank, the International Monetary Fund (IMF), and ADB are the key development partners supporting the government’s undertaking public management reforms. World Bank support under its Second Development Policy Credit Program will strengthen rules and regulations including audit and accounting standards, the Anti-corruption Act 2006, rules on occupational health, the Road Act 2004, and a disaster management bill.19 The IMF does not have a program in Bhutan but will field its Article IV review mission in late 2013, as Bhutan is on a 24-month cycle and had Article IV consultation in 2011.20 Discussions have been held with both the IMF and the World Bank on the program, and coordination has been very effective.21

E. Program Implementation Arrangements

33. Management, tranches, and review. The Department of Public Accounts (DPA) in the MOF will be the executing agency and will oversee and coordinate the timely implementation of agreed policy actions. The implementing agencies will be the DPA, Department of Revenue and Customs, Ministry of Works and Human Settlement, Royal Audit Authority, and RMA. Each will be responsible for undertaking the policy actions or program activities under its responsibilities described in the policy matrix. Ongoing technical assistance will help the government fulfill program conditions (footnote 23). The DPA will be responsible for program administration, disbursements, and maintaining all program records. A program steering committee will be set up and chaired by the secretary and/or joint secretary of the MOF. The committee will have representatives of other departments and authorities concerned, including the Department of Revenue and Customs, Ministry of Works and Human Settlement, Royal Audit Authority, and RMA. The committee will meet once in every quarter and monitor the progress of the program. The loan of SDR9,224,000 and grant of $20.81 million will be provided in two tranches and disbursed upon satisfaction of loan and grant effectiveness conditions—that is, fulfillment of all actions in the program policy matrix. The first tranche will be the grant and the second tranche the loan. The first tranche is expected to be disbursed in March 2013. The government shall undertake periodic reviews during implementation to evaluate program scope, implementation arrangements, progress, and achievement of objectives. In addition to periodic reviews, a midterm review will take place during the fourth quarter of 2013.

34. Procurement, disbursement, and counterpart funds. Loan and grant proceeds will be disbursed in accordance with ADB’s simplification of disbursement procedures and related

requirements for policy-based loans and grants.22

ADB will have the right to audit the use of the proceeds and to verify the accuracy of the government’s certification. Local currency generated from the loan and grant will be deposited into the government’s budget fund account with the Bank of Bhutan toward providing supplementary financing for the 2013 budget.

35. Policy actions and dialogue. The government will ensure that all policies adopted and actions taken under the program, as set forth in the development policy letter (Appendix 3) and the policy matrix (Appendix 4), continue to be in effect for the duration of the program.

19

World Bank. 2012. Bhutan – Second Development Policy Credit Program. Washington, DC. 20

ADB can perhaps join or be in the field at the same time for coordination. 21

Development Coordination (accessible from the list of linked documents in Appendix 2). 22

ADB. 1998. Simplification of Disbursement Procedures and Related Requirements for Program Loans. Manila.

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36. Program performance monitoring and evaluation. The DPA will establish a performance evaluation system for the program within 3 months from grant and loan effectiveness and maintain it. Using this system, the DPA will monitor the program and report to ADB on the implementation of policy actions and their impact on budget outcomes, in line with the program impact and outcome indicators agreed upon with the government.

III. TECHNICAL ASSISTANCE

37. Although the proposed program does not have a piggybacked technical assistance (TA), it will be supported by five TAs.23

IV. DUE DILIGENCE

A. Technical

38. Several outputs of the program have technical components at their core. The introduction of revenue administration and property valuation systems is expected to strengthen tax administration and improve compliance. The rollout of an audit information management system is expected to improve external and internal audit operations and compliance of governance.

B. Economic

39. Despite the current rupee liquidity crunch, the government projects that the economy will grow at an average of 9.8% during the Eleventh Five-Year Plan, 2013–2018 and about 15% by FY2020, the year stipulated in Vision 2020. The hydropower sector will be the main driver, contributing 56% of growth. To finance projected economic growth, external debt service as a percentage of GDP is estimated at 6.81% in FY2014 and 3.92% in FY2015.24

40. The current account deficit with India is projected to reach 15.9% of GDP in FY2013 and to have increased to 28.4% by FY2015, mainly reflecting expanded imports to construct hydropower projects. To manage the anticipated rupee shortage, the RMA has introduced a new policy that requires demand for rupees to be justified to better manage the rupee liquidity position and is accessing the South Asian Association of Regional Cooperation currency swap facility launched in May 2012.25 In addition, the Government of India has recently increased to Rs10 billion its line of credit to the Government of Bhutan for addressing the rupee shortfall. 41. Though the aggregate current account is projected to be in deficit equal to 23.2% of GDP in FY2013 and is expected to deteriorate further to 34.6% of GDP in FY2015, the overall balance of payment is projected to be in surplus equal to 2.8% of GDP in FY2013 and improve

23

Implementation of the program will be complemented by ADB’s (i) two ongoing capacity development technical assistance namely (a) ADB. 2010. Technical Assistance to the Kingdom of Bhutan for Strengthening Public Management. Manila (TA 7724-BHU) and (b) ADB. 2010. Technical Assistance to the Kingdom of Bhutan for Strengthening Audit Resource Management. Manila (TA 7723-BHU); and (ii) three recently approved TAs namely, (a) ADB. 2012. Technical Assistance to the Kingdom of Bhutan for Capital Market Development. Manila (TA 8280-BHU), (b) ADB. 2012. Technical Assistance for Supporting Financial Stability in Bhutan and the Maldives. Manila (TA 8284-REG), and (c) ADB. 2012. Strengthening Royal Monetary Authority's Regulatory Capacity for Nonbank Financial Institutions. Manila (TA 8076-BHU). All will reinforce good practices in revenue and audit in line with the

needs of a maturing and more complex economy. 24

The IMF considers the debt to be sustainable as it is predominantly for building hydropower projects through project finance with high financial rates of return.

25 The$2.0 billion facility was set up by the Reserve Bank of India in May 2012 and is available in both foreign currency and Indian rupees against the domestic currency of member central banks including the RMA. It is short term in nature and targets sudden shortfalls caused by capital outflows resulting from shocks.

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to 6.2% in FY2015, mainly from inflows of external grants and concessional loans. The country’s total reserves are projected to grow from $806 million in FY2013 to $1.1 billion by FY2015, enabling Bhutan to comply with the constitutional requirement of covering 12 months of essential merchandise imports or the guided minimum reserve requirement of $500 million.26

42. The current account deficit, rupee liquidity crunch, and credit and fiscal expansions are placing upward pressure on inflation, forecasted by ADB to reach 10.1% in FY2013 and 10.5% in FY2014. Accordingly, ADB has recently revised its GDP growth forecast for Bhutan down slightly from 8.0% to 7.9% in FY2013 and from 8.5% to 8.4% in FY2014. However, the general consensus is that the rupee liquidity crunch will subside over the longer term once hydropower plants are fully built and generating export revenue.

C. Governance

43. Program preparation included a governance risk assessment conducted along the lines prescribed by the implementation guidelines of ADB’s Second Governance and Anticorruption Action Plan.27 This assessment was complemented by a review of areas of possible risk and vulnerability in state financial management. The assessment found some vulnerability that could affect the proposed program related to (i) political support for the Government of Bhutan and its ownership of the program and (ii) such institutional dimensions as weak capacity. Despite capacity constraints, public resources are managed reasonably well in Bhutan. Some areas that require rectification are (i) inadequate cash management including revenue projections, (ii) weak debt management capacity including institutional arrangements, and (iii) weak audit systems and procedures. While no major risk of resource mismanagement at the executing level can be discerned, issues raised in the assessments are addressed in the program.

D. Poverty and Social

44. Bhutan’s economy performed well during FY2001–2011, achieving an average 8% economic growth rate. As a result, the country has made remarkable progress in reducing poverty incidence, which declined from 32% in 2003 to 23% in 2007. However, if the ongoing Indian rupee liquidity issue persists, it can cause a hard landing, and have a direct impact on poverty. The program will help the government avoid the risks of a contraction or significant slowdown in GDP growth and make further progress in reducing poverty and achieving the Millennium Development Goals.28

E. Safeguards

45. The program’s primary aim is to improve government economic management through budget support. In compliance with ADB’s Safeguard Policy Statement (2009), the program is category C for impacts on the environment, involuntary resettlement, and indigenous peoples.

26

Essential imports are loosely defined to include (i) food, household, and medical items; (ii) raw materials; and (iii) replacement and spares for capital equipment.

27 ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the government. Consistent with its commitment to good governance, the implementation of the program will adhere to ADB’s Anticorruption Policy.

28 For Millennium Development Goals for Bhutan, please refer to Government of Bhutan, Gross National Happiness Commission. 2011. Bhutan National Human Development Report 2011: Sustaining Progress: Rising to the Climate Challenge. Thimphu.

10

F. Risks and Mitigating Measures

46. Major risks and mitigating measures are summarized in Table 2 and described in detail in the risk assessment and risk management plan.29

Table 2: Summary of Risks and Mitigating Measures Risks Mitigating Measures

Absence of risk-based banking supervision or effective liquidity management causing ineffective macroeconomic management

(i) Policy actions introduced to strengthen the systems and (ii) Royal Monetary Authority staff trained with ADB technical assistance support

Lack of a plan to address the structural bottlenecks of the economy

Continued consultations with the Government of Bhutan along with other development partners

Possibility of interdepartmental transfers of key officials adversely impacting implementation

Engagement with the government to stress the importance of staff continuity

Waning government commitment to reform envisaged under the program

(i) Continuous engagement by ADB staff with the government and (ii) an adopt preemptive strategy to obviate potential bottlenecks

Lack of skills at all levels of all sectors Working with Royal Institute of Management and other agencies to plan capacity building

Source: Asian Development Bank.

V. ASSURANCES AND CONDITIONS

47. The government and the DPA have assured ADB that implementation of the program shall conform to all applicable ADB policies including those concerning anticorruption measures, safeguards, gender, procurement, consulting services, and disbursement as described in detail in the financing agreement. The government and DPA have agreed with ADB on certain covenants for the program, which are set forth in the financing agreement. The grant will become effective after all conditions for the release of the Program first tranche, as specified in the Policy Matrix and set out in Attachment 2 to Schedule 3 to the Financing Agreement, have been complied with, to the satisfaction of ADB

VI. RECOMMENDATION

48. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve

(i) the loan in various currencies equivalent to SDR9,224,000 to the Kingdom of Bhutan for Strengthening the Economic Management Program, from ADB’s Special Funds resources, with an interest charge of 1.0% per annum during the grace period and 1.5% per annum thereafter; for a term of 24 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft financing agreement presented to the Board; and

(ii) the grant not exceeding $20,810,000 to the Kingdom of Bhutan from ADB’s Special Funds resources, for Strengthening the Economic Management Program, on terms and conditions that are substantially in accordance with those set forth in the draft financing agreement presented to the Board.

Haruhiko Kuroda President

27 February 2013

29

Risk Assessment and Risk Management Plan (accessible from the list of linked documents in Appendix 2).

Appendix 1 11

DESIGN AND MONITORING FRAMEWORK

Design Summary Performance Targets and Indicators with Baselines

Data Sources and Reporting Mechanisms

Assumptions and Risks

Impact Balance of payments not in deficit by FY2017 (baseline: –3.5% in FY2012) Improved gross international reserves above $900 million by FY2017 (baseline: $782.51 million in FY2012)

(For all indicators) Annual financial statement, MOF Annual performance indicator report, MOF Monthly statistical bulletin, RMA

Risk The global financial crisis persists and increases uncertainty regarding support from development partners.

Government macro-financial management sustainably strengthened

Outcome More effective use of Bhutan’s own financial resources in a predictable manner

Debt-to-GDP ratio no higher than 35% by FY2015 (baseline: 45% in FY2012, net of hydropower loans) Fiscal deficit within the prescribed level of 3% each fiscal year during the Eleventh Five-Year Plan by FY2015 (baseline: 4.70% in FY2012) Private savings-to-GDP ratio increased by 2 percentage points by FY2015 (baseline: 32% in FY2012)

(For all indicators) Annual financial statement, MOF

Assumption The government remains committed to reform program.

Outputs Assumption The government successfully trains the staff concerned, including debt management office staff.

Risk Well-trained debt staff may leave the office.

1. Improved budget and debt management systems implemented

A debt management strategy in place by 2013 (baseline: no such strategy yet developed) Strengthening of debt management office in MOF by third quarter of 2014 (baseline: debt management office understaffed) Medium-term expenditure allocations developed in major municipalities by 2014 (baseline: medium-term expenditure framework not yet developed) A plan to fully integrate the Treasury Management

MOF certification on the approval of the debt management strategy MOF report on the implementation of the debt management strategy Debt sustainability analysis report of MOF Medium-term expenditure framework, MOF Strategy paper approved by the macroeconomic

12 Appendix 1




Division and the Debt Management Division prepared by 2014 (baseline: not integrated at present)

framework coordination committee

National budget, MOF (For all indicators)

2. Improved revenue effort and revenue management system implemented

Introduction of property valuation methodology by 2014 (baseline: not in place) Completed installation of the revenue administration management information system for the Department of Revenue and Customs by 2014 (baseline: the system currently not in place)

Status report on implementation of new methodology by MOWHS MOF certification and approved notification on the new revenue chart of account National budget, MOF (annual) (For all indicators)

3. Improved macro-

prudential management framework implemented

A financial policy committee in place by February 2013 (baseline: none at present) Macro-prudential management framework in place in the RMA by 2014 (baseline: the current macro-prudential system quite weak) A capital markets master plan in place by 2014 (baseline: capital market master plan nonexistent) Regulatory and supervisory framework for a credit rating agency in place by 2014 (baseline: none at present)

RMA circular and/or order on the establishment of financial policy committee RMA approved policy paper and corresponding rules on macro-prudential norms Capital markets master plan approved by MOF and RMA Notification issued by RMA on the establishment of the regulatory and supervisory framework for credit rating agencies Annual report of the RMA (For all indicators)

4. Improved external

and internal audit operations implemented

Put in place an audit resource management system (ARMS) in the head office of the RAA by 2014 (baseline: no system in place)

A report on the completion of first stage pilot ARMS

Appendix 1 13




Adoption of internal audit manuals in major spending departments by 2014 (baseline: audit manuals not available)

Approved internal audit manual and a comprehensive report on training of the internal audit staff

Activities with Milestones Inputs 1. Improved budget and debt management

systems implemented 1.1. Develop a draft public debt management

strategy by February 2013. 1.2. Complete the staffing of debt management

division by February 2013. 1.3. Prepare an integration plan for Treasury

management and debt management divisions by Q3 2014.

2. Improved revenue effort and revenue

management system implemented 2.1. Prepare system requirement specifications for

the revenue administration management information system by February 2013.

2.2. Prepare the draft rules and regulations for property valuation by Q3 2014.

3. Improved macro-prudential management

framework implemented 3.1. Prepare the road map for the liquidity

management system, based on proposed policy actions under the program, by Q3 2014.

3.2. Prepare the regulatory and supervisory structure for a credit rating agency by Q3 2014.

3.3. Prepare the draft of the capital market master plan by Q3 2014.

4. Improved external and internal audit

operations implemented 4.1. Complete auditing module software by Q3

2014. 4.2. Complete the implementation of the audit

resource management system by Q3 2014. 4.3. Approve an internal audit manual and complete

training of all the staff recruited for internal audit by Q3 2014.

ADB: $35 million Grant: $20.81 million Loan: $14.19 million

GDP = gross domestic product, MOF = Ministry of Finance, MOWHS = Ministry of Works and Human Settlement, RAA = Royal Audit Authority, RMA = Royal Monetary Authority. Source: Asian Development Bank.

14 Appendix 2

LIST OF LINKED DOCUMENTS http://www.adb.org/Documents/RRPs/?id=46371-001-3

1. Financing Agreement: Special Operations

2. Sector Assessment (Summary): Public Sector Management

3. Contribution to the ADB Results Framework

4. Development Coordination

5. Country Economic Indicators

6. International Monetary Fund Assessment Letter

7. Summary Poverty Reduction and Social Strategy

8. Risk Assessment and Risk Management Plan

9. List of Ineligible Items

Supplementary Document

10. Fiscal Projections

http://www.adb.org/Documents/RRPs/?id=46371-001-3

http://www.adb.org/Documents/RRPs/?id=46371-001-3

Appendix 3 15

DEVELOPMENT POLICY LETTER

16 Appendix 3

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POLICY MATRIX

OBJECTIVE: To strengthen the government’s ability to effectively address risks and set the foundations for sustainable growth

Objectives and Policy Actions 1st Tranche Policy Actions (QI 2013) 2nd Tranche Policy Actions (12 months after T1)

A. Budget and Debt Management Objective: To improve budget and debt management by improving effectiveness of public spending and synchronization of payments.

1. Sub-national Government Budget

(1) Major municipalities, including Thimphu, Phuentsholling, Samdrup Jongkhar and Galephu, will have prepared a medium-term expenditure framework (MTEF) that is used as the basis for annual budget preparation. (Document required: MTEF reports)

2. Develop a clear national debt strategy

(1) Ministry of Finance (MOF) will have prepared a satisfactory Debt Management Strategy, which includes clear debt management objectives over the medium to long term (3–5 years) and an action plan to implement the strategy. The action plan will also include strengthening of the Debt Management Division (DMD) (Document required: MOF certification that the debt strategy and action plan have been approved by MOF together with the approved strategy attached to the certification)

(2) MOF will have prepared and finalized a report on the implementation of the actions under the debt management strategy covering the period from the date of the loan and grant effectiveness until the review for the 2nd tranche release. (Document required: MOF report on the implementation of the Debt Management Strategy)

3. Support debt market development through creation of a yield curve

(3) Building on approved Debt Management Action Plan, MOF, in coordination with the Royal Monetary Authority (RMA), will prepare and approve a strategy paper on development of government securities market to address: (i) narrow investor base, (ii) lack of auction calendar, (iii) limited price competition in auctioning of Government securities, and (iv) functional integration of Treasury Management Division and DMD for improved cash management. The Debt Management Strategy will have been approved by the Macro-economic Framework Coordination Committee. (Document required: strategy paper approved by the Macro-economic Framework Coordination Committee). (4) MOF and RMA will have implemented the strategy paper on development of Government securities market (Document required: A status report on implementation prepared by MOF)

4. Promote institutional (2) DMD will have appointed and fill all nine staff (5) DMD will have prepared and submitted an annual

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strengthening of the Debt Management Division (DMD)

positions in DMD, which will constitute a full complement of DMD organizational chart to carry out the debt management strategy and the action plan to strengthen debt programming, monitoring and reporting. (Document required: MOF order on the appointment of the nine staff and DMD organizational chart).

debt sustainability analysis to MOF (Document required: Debt sustainability analysis report approved by MOF)

B. Revenue Management Objective: To strengthen revenue effort by enhancing revenue systems

1. Develop a Revenue Administration Management Information System (RAMIS)

(3) Department of Revenue and Customs (DRC) will have prepared and approved the System Requirement Specification (blueprint) for the internal revenue component of RAMIS (Document required: MOF certification on approved system requirement specification with the approved blueprint attached to it)

(6) MOF will have piloted implementation of RAMIS within DRC. (Document required: MOF will submit a pilot implementation report prepared by DRC)

2. Upgrade Revenue Chart of Accounts

(4) DRC will have revised and approved a new Revenue Chart of Account in line with IMF Government Finance Statistics (Document required: MOF certification on the new revenue chart of account has been approved and notification approved by DRC)

3. Develop a Taxpayer Number (TPN)

(5) DRC to approve the new TPN scheme (Document required: MOF notification on the new TPN scheme as approved by DRC)

4. Develop a property valuation methodology to enhance revenue effort at the sub-national level.

(6) MOWHS will have developed a property valuation methodology and submit the same to PAVA.

(7) MOF, in coordination with MOWHS, will have approved the rules and regulations on Property Valuation Methodology (Document required: The regulation on the new property valuation methodology approved by MOWHS and MOF)

(8) MOWHS will have piloted implementation of property valuation methodology in at least one municipality (Document required: A status report on implementation of new methodology prepared by MOWHS)

C. Macro-prudential and Financial Sector Management Objective: To improve the macro-prudential management framework

1. Improve macro-prudential regulations

(7) RMA will have set up a Financial Policy Committee (FPC) on macro-prudential regulations. (Document required: RMA circular/order on the establishment of the FPC)

(9) The FPC will have prepared and finalized the macro-prudential policy paper and its corresponding rules and regulations that will cover, among others, (i) countercyclical capital buffer for banks, (ii) loan to

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value and loan to income restrictions, (iii) sectoral capital requirements, (iv) minimum ceiling on leverage ratio of banks, (v) time-varying capital provisioning and margin requirements, (vi) restrictions on distributions of profit, (vii) debt to equity ratio for the policy paper and the rules will have been approved by RMA. (Document required: The RMA approved policy paper and the corresponding rules )

(10) RMA will have pilot implemented recommendations of the policy paper on macro-prudential regulations (Document required: A report on implementation prepared by RMA)

(8) RMA will have prepared and approved an action plan for improving the retail to wholesale deposit ratio (Document required: RMA order on the approved action plan and the action plan)

(11) RMA will have implemented key recommendations of the action plan (Document required: A status report prepared by RMA on implementation of the action plan)

2. Strengthening the Capital Markets

(12) RMA will have completed a Capital Markets Master Plan that charts the strategic development of the capital markets over the next 10 years (Document required: The Master Plan approved by RMA and MOF)

3. Develop the Mutual Funds and fund management Industry

(9) RMA will have issued a fund management license, based on the approved fund management regulation, and the licensed fund management company is in operation (Document required: copy of license)

4. Develop credit rating infrastructure

(13) RMA will have established the regulatory and supervisory framework for the domestic credit rating agency (Document required: Notification issued by RMA on the establishment of the regulatory and supervisory framework)

D. Audit Functions Objective: To improve external and internal audit operations.

1. Enhance external audit (14) Royal Audit Authority will have implemented the Audit Resource Management System (ARMS) (Document required: A report on the completion of the first stage pilot ARMS)

2. Strengthen internal audit (10) MOF will have appointed and placed internal audit officials for all major spending departments and large autonomous agencies, including Ministry of Foreign Affairs, Thimphu Municipality, National Land

(15) MOF will have prepared and approved an internal audit manual; and completed training of all the staff recruited for internal audit (Document required: Approved internal audit manual and a

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Commission. (Document required: MOF circular/order on the appointment and placement of the officials)

comprehensive report on training of the internal audit staff prepared by MOF)

Note: Certification means confirmation by MOF. ARMS = audit resource management system, DMD = Debt Management Division, DRC = Department of Revenue and Customs, FPC = financial policy committee, IMF = International Monetary Fund, MOF = Ministry of Finance, MOWHS = Ministry of Works and Human Settlement, PAVA = Property Assessment and Valuation Agency, RAMIS = Revenue Administration Management Information System, RAA = Royal Audit Authority, RMA = Royal Monetary Authority, TPN = taxpayer number. Sources: Asian Development Bank and Government of Bhutan.