Bhutan Development Update H A R N E S S I N G U R B A N I Z AT I O N J U LY 2 0 1 9 2 Bhutan Development Update · Harnessing Urbanization Government Fiscal Year: July 1–June 30 Currency Equivalent: Exchange Rate Effective as of June 17, 2019 Currency Unit = Ngultrum (Nu) US$1 = Nu 69 Weights and Measures: Metric System Abbreviations and Acronyms BEFIT Bhutan Economic Forum for Innovative Transformation CAD Current Account Deficit CIT Corporate Income Tax CPI Consumer Price Index CRR Cash Reserve Ratio CSI Cottage and Small Industry DGPC Druk Green Power Corporation DNT Druk Nyamrup Tshogpa DPT Druk Phuensum Tshogpa DSA Debt Sustainability Analysis FYP Five-Year Plan GDP Gross Domestic Product GNH Gross National Happiness GNHC Gross National Happiness Commission GST Goods and Services Tax ICT Information and Communications Technology IMF International Monetary Fund IRC Interest Rate Corridor MoF Ministry of Finance MoLHR Ministry of Labor and Human Resources NKRA National Key Results Area NPL Nonperforming Loan NSB National Statistics Bureau OGOP One Gewog One Product PPP Public-Private Partnership REER Real Effective Exchange Rate RMA Royal Monetary Authority RTM Round Table Meeting RWCAR Risk-Weighted Capital Adequacy Ratio SDG Sustainable Development Goal SOEs State-Owned Enterprises Bhutan Development Update · Harnessing Urbanization 3 Table of Contents ACKNOWLEDGMENTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 OVERVIEW. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Recent developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Outlook and Risks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Harnessing Urbanization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 A. SOCIOECONOMIC DEVELOPMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 1. Political Update. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2. Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 3. Monetary policy and Unemployment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 4. Financial Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 5. External Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 6. Fiscal Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 7. The Twelfth Five Year Plan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 B. OUTLOOK AND RISKS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 C. SPECIAL SECTION: HARNESSING URBANIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 1. Leveraging the Gains of Urbanization to Improve Regional Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 2. Empowering Local Governments to Improve Urban Livability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 3. Improving Housing Affordability to Make Cities More Inclusive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 4. Protecting Cities from Natural Hazards and Climate Change. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 5. Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 List of Figures Figure 1. Hydroelectricity projection declined in 2017/18 and the first half of 2018/19 (growth rate, %). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Figure 2. Price stability has been maintained (annual change, %) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Figure 3. New monetary policy framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Figure 4. Unemployed increased in younger generation (unemployment rate, %). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Figure 5. Despite a strong base, RWCAR has been declining. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Figure 6. …also, liquidity position has been declining.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Figure 7. Gross international reserves are sufficient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Figure 8. Public debt was almost unchanged in 2018/19 (% GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Figure 9. Economic density across Bhutan (Proxied by nighttime lights, VIIRS 2015) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Figure 10. Bhutan population distribution (LandScan 2012). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Listo of Tables Table 1. Macroeconomic outlook (annual percentage change unless indicated otherwise) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Table 3. Snapshot of the labor market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Table 4. Employment and unemployment by education level. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Table 2. Unemployed youth concentrate in urban areas (number of unemployed and unemployment rate, 2018). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Table 5. CAD narrowed in 2017/18. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Table 6. The 12th FYP priorities, the SDGs, and GNH. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Table 7. Fiscal Framework of the 12th FYP (Nu, billions). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Table 8. Delay in hydropower construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Table 9. Impact of a delay in hydropower construction (one-year delay in Puna I or II project). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 4 Bhutan Development Update · Harnessing Urbanization ACKNOWLEDGMENTS The Bhutan Development Update reports on recent economic developments and places them in medium-term and regional and global contexts. It analyzes the implications of these developments and policies for the outlook of Bhutan’s economy. It attempts to make an analytical contribution to the implementation of the 12th Five- Year Plan for 2018–23. The report is intended for a wide audience, including policy makers, business leaders, researchers and academics, and the community of analysts monitoring Bhutan’s economy. The Macroeconomics, Trade, and Investment Global Practice at the World Bank together with Urban, Rural, and Resilience Global Practice has prepared this update. Yoichiro Ishihara (Resident Representative and Senior Economist) and Tenzin Lhaden (Operations Officer and Economist) led the task. David Mason (Urban Development Specialist) from Social, Urban, Rural and Resilience Global Practice led the special section on urban development based on the Urban Policy Notes. Mona Prasad (Lead Economist) provided useful comments. Robert Saum (Acting Country Director), Dandan Chen (Acting Country Director) and Manuela Francisco (Practice Manager) provided over- all guidance. The World Bank team appreciates the valuable contributions of the Ministry of Finance, Royal Monetary Authority, and the National Statistics Bureau. Bhutan Development Update · Harnessing Urbanization 5 OVERVIEW Recent developments The deceleration in growth to 4.6 percent in 2017/18 was primarily because of lower hydropower production owing to the maintenance work in the Tala hydropower project. Growth is likely to pick up to 5.5 percent in 2018/19 and will be supported by the services sector (tourism, in particular) on the supply side and higher net exports on the demand side. The increase in net exports will primarily come from lower imports. The consumer price index (CPI) slowed to about 3 percent in the first half of 2018/19 and remained at 3 percent, year-on-year, in February 2019. The slowdown in inflation was largely driven by lower food prices. Bhutan’s exchange rate policy of maintaining the peg to the Indian rupee has served it well. Since India is the main trading partner, inflation rates between the two countries are strongly correlated. This has helped keep the real effective exchange rate (REER) stable. With the appreciation in the Indian rupee against the U.S. dollar in recent months, the Bhutanese ngultrum also appreciated to Nu 69 to a U.S. dollar in May 2019. The current account deficit (CAD) remains high but has started narrowing. The CAD is likely to narrow from 18.4 percent of gross domestic product (GDP) in 2017/18 to about 15 percent in 2018/19. The decline is primarily because of lower import of capital goods as the Mangdechhu power plant nears completion and the construc- tion of Punatsangchhu I and II gets further delayed. In addition, no new public investment programs were initiated by the government in the first half of the year, also reducing imports. The CAD is mostly financed by capital flows from India for the hydropower projects through a combination of grants and loans. Foreign exchange reserves remain comfortable at nearly US$978 million in December 2018, providing a cover of nearly 10.1 months of imports of goods and services. 6 Bhutan Development Update · Harnessing Urbanization The fiscal deficit is likely to reduce from 1.4 percent of GDP in 2017/18 to 0.7 percent in 2018/19. The low fiscal deficit in FY2018 was primarily because of strong revenue performance, driven by a wider tax base for corporate income tax (CIT) and increased CIT collections from state-owned enterprises (SOEs). In addition, non-tax revenues also increased because of the change in the rules related to valuation and collection of sales taxes on vehicles. In 2018/19, the fiscal deficit is likely to reduce further to 0.7 percent of GDP because of lower spending. In the first half of 2018/19, capital spending fell, as few new capital projects were implemented due to the elections. Bhutan’s financial sector is dominated by banks and remains sound but requires strengthened supervision. Credit to the private sector grew by 17.8 percent in 2017/18, similar to the past two years. In the first half of 2018/19, it grew by about 15 percent. Credit growth is managed through macroprudential instruments and the Royal Monetary Authority (RMA) sterilizes excess liquidity. Gross nonperforming loans (NPLs) stood at 10.4 percent in end-2018, adversely affecting the profitability of financial institutions. The banking sector has ade- quate cushion to absorb potential losses with capital adequacy of 15 percent, provisioning at over 70 percent, and liquidity at over 22 percent. However, there is a need to strengthen prudential oversight and to potentially re-calibrate the role of the state in the financial sector. Outlook and Risks Economic growth is projected to average 6 percent a year over the medium term, supported by the services sector and higher net exports. Growth will spike in 2019/20 following the commissioning of the Mangdechhu hydropower project and then gradually slow down to between 5 and 6 percent, a year. In the services sector, the key drivers are likely to be hotels and restaurants, retail trade and transportation, underpinned by tourism. After a decline in 2018/19, increased spending by the government on capital projects will also support growth. Table 1. Macroeconomic outlook (annual percentage change unless indicated otherwise)   2016/17 2017/18 2018/19 2019/20 2020/21 2021/22 (actual) (estimate) (forecast) (forecast) (forecast) (forecast) Real GDP growth 6.3 4.6 5.5 7.2 5.9 5.1 Private Consumption −0.4 1.0 7.6 10.2 4.2 8.5 Government Consumption 4.3 5.2 6.0 6.0 5.0 4.0 Gross Capital Investment 5.6 −4.2 −7.0 1.2 2.9 −2.8 Exports, Goods and Services 6.8 −2.0 3.0 8.7 0.3 0.4 Imports, Goods and Services −7.1 −7.1 −3.0 −6.9 −4.6 2.2 Real GDP growth 6.3 4.6 5.5 7.2 5.9 5.1 Agriculture 3.6 4.1 4.4 4.2 4.4 4.4 Industry 4.6 1.1 3.9 7.1 3.8 2.9 Manufacturing 4.0 8.0 10.3 10.3 10.3 11.7 Non-Manufacturing (incl hydro) 4.7 −0.6 2.2 6.2 1.9 0.0 Services 8.2 7.4 9.6 11.1 8.9 6.9 Inflation (CPI) 4.3 3.7 3.0 3.8 4.2 4.5 Current Account Balance (% GDP) −23.0 −18.4 −14.9 −12.5 −9.0 −5.3 Fiscal Balance (% GDP) −3.3 −1.4 −0.7 −1.5 −1.5 −0.9 Debt (% GDP) 109 108 110 108 102 95 Source: World Bank staff estimates. Bhutan Development Update · Harnessing Urbanization 7 Inflation is likely to reflect price developments in India and the RMA is taking steps to strengthen its monetary and exchange rate policies by enhancing its liquidity management and forecasting capabilities, establishing an interest rate corridor (IRC) and supporting the development of the interbank market. The CAD is projected to narrow further over the medium term, driven primarily by higher exports from the on-streaming of the Mangdechhu project. In addition, imports are likely to remain moderate. The CAD will continue to be financed mostly by capital flows from India and the surplus in the overall balance of payments is expected to raise international reserves. With a pickup in spending, the fiscal deficit is expected to increase from the current level but will remain low over the medium term. Revenue growth over the projected period will be supported by royalties from Mangdechhu, higher corporate income taxes from Druk Green Power Corporation (DGPC), and the introduc- tion of Goods and Services Tax (GST) in 2020/21. Spending is also likely to increase over the medium term as the government undertakes new public investment programs in line with the 12th Five-Year Plan (FYP), along with higher maintenance spending on hydropower plants and an increase in public sector wages (based on the recommendations of the Fourth Pay Commission). However, public debt as a share of GDP is projected to decline because large amortizations associated with hydropower investments begin with operationalization of the plants and are the main determinant of the debt trajectory. Risks to the outlook stem mainly from (a) further delays in hydropower project completion, which would also delay the expected export and revenue payoffs; (b) managing financing of the budget at higher costs in a context of under-developed domestic debt markets; (c) high NPLs and concentration of loans outstanding in a few sectors; and (d) natural calamities, which could lower electricity generation and reduce agriculture output. Longer-term challenges include the need for diversification of the country’s asset base through investments in physical capital, human capital and institutions. This would help lower the barriers for investment and facili- tate private sector development. In this context, it will be particularly important to reduce the infrastructure and policy gaps in cities so that Bhutan’s urban centers can seize the benefits of agglomeration economies. Harnessing Urbanization The spatial-economic transformation in Bhutan is largely driven by the economic opportunities that cities offer. However, larger urban centers are not well equipped to seize the benefits of agglomeration economies, which enable firm specialization and market access and affect the number and the quality of jobs. These urban centers in Bhutan are also not well equipped to provide good quality urban services which affects livability and competitiveness. The four largest municipalities face infrastructure and service delivery backlogs, traffic con- gestion, a shortage of serviced land and affordable housing, and environmental pollution. Gaps in connectivity infrastructure, both hard (such as roads and telecoms) and soft (information and regulations facilitating market access and knowledge transfer), across cities and regions are also hampering the diversification of the economy and the development of the private sector. Capitalizing on Bhutan’s regional development requires a differentiated yet complementary approach that involves “place” and “people” based levers. The “place-based” levers such as large infrastructure investments that are close to economic centers, where firms and people are concentrated, can enhance the benefits of agglomer- ations. The “people-based” interventions are targeted at rural areas and small towns, where poverty and human capital deprivations are more acute, and where there is a need for basic infrastructure, along with health and 8 Bhutan Development Update · Harnessing Urbanization education investments. These investments are complemented with policies and programs that facilitate better skilled people to migrate to more productive areas. For Thimphu and Phuntsholing, efforts need to be focused on improving livability, providing affordable hous- ing, reducing disparities in access to urban services and leveraging urban agglomerations for deeper and more diverse private sector investments. These cities would also benefit from improvements in the business climate and technical and vocational skills development programs. Regional connectivity, both hard and soft, can also play a key role in extending the economic potential of these towns. For settlements with locational advantages, place-based endowments and nascent economic clusters, such as Gelephu, Samdrup Jongkhar and Mongar, the focus needs to be on improving the conditions for private sector investment. This would include improved links to potential markets and better connectivity (both road and Information and Communications Technology (ICT)). For rural and remote areas and regions with low endowments, higher levels of poverty and infrastructure gaps, efforts should focus on equitable access to and the quality of basic public services, especially health and edu- cation services, that will improve human capital outcomes, enhance the quality of the labor force and provide skills that residents can use to move to larger centers. Bhutan Development Update · Harnessing Urbanization 9 A. SOCIOECONOMIC DEVELOPMENTS 1. Political Update Bhutan shifted from absolute to constitutional monarchy in 2008. Since then, the country held three Parliamentary elections – in 2008, 2013, and 2018. The Parliament consists of the 47-member National Assembly (lower house) and the 25-member National Council (non-partisan upper house). Of the 25 National Council members, 20 are elected and 5 are appointed by His Majesty as Eminent Members. Bhutan’s new government was formed in November 2018. The Druk Nyamrup Tshogpa (People-Centered and Pragmatic Party, DNT) party won the 2018 general election defeating Druk Phuensum Tshogpa (Bhutan’s Peace and Prosperity Part, DPT) which was in power since 2013. DNT formed the new government in November 2018. The vision of DNT is “a prosperous, progressive, equitable and just nation based on the rule of law where social justice, individual freedom, popular participation and sustainable development are guaranteed.” DNT emphasized on ‘Narrowing the Gap’ during the 2018 election campaign. Guided by the principles of gross na- tional happiness (GNH), the overall policy direction to be pursued by the new government is not substantially different from the previous one. The new government endorsed the revised 2018/19 budget and the 12th FYP. The Parliament session in July 2018 had approved only the interim budget for 2018/19 which included current spending and ongoing capital expenditures. The first Parliament session under the new government in January 2019 approved the full 2018/19 budget, including spending on new capital projects, along with the 12th FYP. However, since the full budget runs for only half the year, the overall spending in 2018/19 will be comparatively lower. 10 Bhutan Development Update · Harnessing Urbanization The new government also hosted the 14th Round Table Meeting (RTM) in March 2019. 1 The government hosts the RTM every two years in which it presents various policy updates to the development partners. In the 14th RTM the government presented the following (a) gross national happiness (GNH); (b) 12th FYP and its priori- ties; (c) climate change and disaster-resilient development; (d) development financing; and (e) partnerships with development partners. In the session on development financing, the government provided information on the main issues to be covered in the Bhutan Economic Forum for Innovative Transformation (BEFIT) which will be held in July 2019. 2 The BEFIT will primarily focus on economic diversification through the development of cottage and small industries (CSIs). 2. Growth After slowing down to 4.6 percent in 2017/18, economic growth is likely to accelerate to 5.5 percent in 2018/19. The deceleration in 2017/18 was primarily because of lower hydropower production on account of the maintenance work required in the Tala hydropower project (which accounts for more than 60 percent of total hydroelectricity pro- duction in Bhutan), lower than normal rainfall, and delays in the construction of the other mega hydro projects. In 2018/19, on the supply side, growth has largely been driven by the services sector, especially, hotels and restaurants, retail trade and transportation. On the demand side, the main contribution has come from private consumption and an increase in net exports, primarily owing to lower hydro related imports because of the completion of the Mangdechhu hydropower plant (a 720MW power plant which will begin production in 2019. The other two mega hydro projects which are under construction (Punatsangchhu I and II) are likely to be completed by 2023/24.3 As in past years, the hydropower sector continues to have a significant impact on the Bhutanese economy. Hydropower production declined in 2017/18 and the first nine months of 2018/19. Total production declined by 2.9 percent in 2017/18 from the previous year, followed by further decline of 8.3 percent in the first nine months of 2018/19 (figure 1). The decline came mainly from the Tala Hydropower Plant.4 The weather conditions were also not particularly favorable indicating Bhutan’s vulnerability to adverse climatic conditions. Figure 1. Hydroelectricity projection declined in 2017/18 and the first half of 2018/19 (growth rate, %) 8% 6.6% 6% 4% 4.1% 2% 0% -2% - 3.2% - 2.9% -4% -6% -8% - 8.3% -10% FY2014/15 FY2015/16 FY2016/17 FY2017/18 FY2018/19 (Jul-Mar) Source: RMA. 1 https://rtm.gnhc.gov.bt/ 2 http://www.befit.bt/ 3 Punatsangchhu I and II are large hydropower plants under construction in Bhutan. Their completion has been delayed because of geological complexities. 4 Druk Green Power Corporation Limited Annual Report 2017 http://drukgreen.bt/wp-content/uploads/2019/01/Annual-Report-2017.pdf Bhutan Development Update · Harnessing Urbanization 11 Figure 2. Price stability has been maintained (annual change, %) 9% 8% 7% 6% 3.0% 5% 4% 3% 2% 1% 0% 2017 Mar May Jul Sep Nov 2018 Mar May Jul Sep Nov 2019 Jan Jan Jan food non-food overall Source: NSB. The number of international tourists increased slightly in the first half of 2018/19, supporting services growth. The number of international tourists (excluding regional tourists) was 46,300 in the first nine months of 2018/19, higher by 12.8 percent compared to the same period in 2017/18. As a result, tourism revenues increased by 11.4 percent to US$62 million, year-on-year. To capitalize on the potential from the tourism sector, the government (a) reorganized the Tourism Council which will now be headed by the Minister of Foreign Affairs instead of the Prime Minister; and (b) is formulating its first tourism policy to define the vision and direction of the tourism sector.5 3. Monetary policy and Unemployment Bhutan’s inflation remained low in the first half of 2018/19. With about 85 percent of Bhutan’s imports coming from India and the exchange rate pegged to the Indian rupee, Bhutan’s CPI is closely linked to India’s. The CPI in Bhutan slowed to about 3 percent in the first half of 2018/19 and remained at 3 percent, year-on-year, in February 2019 (figure 2). The slowdown in inflation was largely driven by lower food prices. Bhutan’s exchange rate policy of maintaining the peg to the Indian rupee has served it well. Since India is the main trading partner, inflation rates between the two countries are strongly correlated. This has helped keep the real effective exchange rate stable. With the appreciation in the Indian Rupee against the USD in recent months, the Bhutanese Ngultrum also appreciated to BTN 69 to a USD in April 2019. The monetary policy framework aims to achieve price stability. The intermediate target for achieving price stability in Bhutan is to maintain the one-to-one peg between the Indian rupee and the Bhutanese ngultrum. The pegged exchange rate regime is suitable, as India accounts for a major share of Bhutan’s international trade. While the regime implies that Bhutan accepts India’s monetary policy, the RMA has an important role in ensur- ing that the reserve requirements and prudential measures are maintained. Currently, the RMA conducts mon- etary policy through the Cash Reserve Ratio (CRR) and interest rate policy to influence credit and monetary aggregates. The RMA also relies on sweeping arrangements to manage volatility of liquidity conditions in the money market and commercial bank’s balance sheet. 5 The National Council, upper house, issued the Review Report on Tourism Policy and Strategies in December 2016. http://www.nationalcouncil.bt/assets/uploads/files/FINAL%20Tourism%20 Policy%20EAC%2016th%20Session.pdf 12 Bhutan Development Update · Harnessing Urbanization Figure 3. New monetary policy framework Open market operations (OMOs) Standing facilities (SFs) Cash reserve ratio (CRR) Main liquidity management operations Depositi facility Longer-term liquidity management Lending facility operations Fine-tuning operations Structural operations Source: RMA (2019) Annual Report 2018. The RMA is planning to introduce a new monetary planning framework. To strengthen the conduct of mon- etary policy, the RMA will be enhancing its liquidity management and forecasting capabilities, establishing an IRC and supporting the development of the interbank market. The IRC will be supported by standing marginal lending and deposit facilities. These will help to signal the monetary policy stance to the market, maintain an adequate level of liquidity in the banking system, allow banks to enhance their treasury function, and will sup- port the development of the domestic money market. The new monetary policy framework aims to (a) facilitate monetary policy signaling, (b) maintain an optimal level of liquidity in the banking system, (c) allow banks to enhance their treasury function, leading to reduced liquidity costs and settlement risks, and (d) support devel- opment of the domestic money market which will contribute toward achieving macroeconomic stability (figure 3). The RMA and the government also plan to make joint efforts in promoting capital market, that includes both primary and secondary market for government securities. The overall unemployment and youth unemployment rate increased in 2018.6 The overall unemployment rate increased from 3.1 percent in 2017 to 3.4 in 2018, the highest since 2011. It was primarily driven by an increase in youth unemployment, which increased from 12.3 percent to 15.7 percent during the same period (figure 4). Youth 6 The comparison between years needs to be carefully conducted. While most years are based on annual labor force survey, the 2017 and 2018 data also reflect the 2017 Population and Housing Census. On the other hand, labor force surveys conducted prior to 2017 have been using sampling frame based on earlier Census and predicted changes in populations provided by NSB. Figure 4. Unemployed increased in younger generation (unemployment rate, %) 20% 18% 16% 14% 12% 10% 3.4% 8% 6% 3.1% 4% 2% 0% 15-19 20-24 25-29 30-34 35-39 40-44 45-49 50-54 55-59 60-64 65+ Overall 2017 2018 Source: Ministry of Labor and Human Resources (MoLHR) and National Statistics Bureau (NSB). Bhutan Development Update · Harnessing Urbanization 13 Table 2. Unemployed youth concentrate in urban areas (number of unemployed and unemployment rate, 2018) Youth Non-Youth Total Urban 2,759 3,833 6,592 (24.4%) (4.7%) (7.1%) Rural 2,162 1,660 3,822 (10.8%) (0.8%) (1.8%) Total 4,921 5,493 10,414 (15.7%) (2.0%) (3.4%) Source: NSB. unemployment is particularly high in urban areas (table 2) at 24.4 percent compared to 10.8 percent in rural areas. This is because of queuing for the limited number of public sector jobs among the increasingly educated youth. It is also because of a mismatch in the skills desired by the private sector and those imparted by the educational system. In addition, female youth unemployment at 16.1 percent is marginally higher than that for males at 15.4 percent and female labor force participation remains low (tables 3 and 4). Table 3. Snapshot of the labor market 2010 2015 2016 2017 2018 Labor Force Participation Rate 68.6 63.1 62.2 65.7 62.6 Male 73.6 71.2 71.7 72.1 70.1 Female 63.9 55.9 53.6 59.9 55.5 Unemployment Rate 3.3 2.5 2.1 3.1 3.4 Urban 5.1 6.3 3.9 5.6 7.1 Rural 2.6 1.0 1.5 1.7 1.8 Youth Unemployment Rate 9.2 10.7 13.2 12.3 15.7 Urban 21.1 28.0 23.3 17.0 24.4 Rural 4.9 4.8 9.9 8.6 10.8 Source: MoLHR and NSB. Table 4. Employment and unemployment by education level % of total Employed Unemployed Youth Unemployed No education 52 8 2 Primary and Lower education 16 12 12 Middle and Higher education 18 53 66 Bachelor’s degree 6 26 19 Master’s degree and above 1 1 0 Religious Professionals 2 0 1 No-formal education 5 0 0 Total 100 100 100 Source: NSB. 14 Bhutan Development Update · Harnessing Urbanization Figure 5. Despite a strong base, RWCAR has been declining 160,000 20% 17.8% 15.1% 140,000 120,000 15% 100,000 80,000 10% 60,000 40,000 5% 20,000 - 0% Mar Jun Sep Dec Mar Jun Sep Dec 2017 2018 Capital fund (Nu million LHS) Risk weighted asset (Nu million, LHS) RWCAR (RHS) Source: RMA. 4. Financial Sector Credit to the private sector grew by 17.8 percent in CY2018, similar to the past two years. In the first half of 2018/19, it grew by about 15 percent. Credit growth is primarily driven by the construction sector and there is boom in the construction of hotels. Credit growth is managed through macroprudential instruments and the RMA sterilizes excess liquidity. Gross NPLs stood at 10.4 percent in end-2018, adversely affecting the profitability of financial institutions. The banking sector, however, has adequate cushion to absorb potential losses given its capital adequacy, provisioning levels and liquidity. However, the risk-weighted capital adequacy ratio (RWCAR) and the liquidity indicators have been declining. The RWCAR stood at 15.1 percent in December 2018, well above the minimum regulatory requirement of 12.5 percent. However, the ratio has been declining in 2017 and 2018 from 17.8 percent in March 2017 (figure 5). While the level of capital has been almost unchanged, risk-weighted capital increased partly due to the decline in asset quality. The overall liquidity position of the financial sector remains adequate. Against the Figure 6. …also, liquidity position has been declining. 45,000 31% 35% 40,000 22% 30% 35,000 25% 30,000 25,000 20% 20,000 15% 15,000 10% 10,000 5% 5,000 - 0% Mar Jun Sep Dec Mar Jun Sep Dec 2017 2018 Quick asset (Nu million, LHS) SLR (RHS) Source: RMA. Bhutan Development Update · Harnessing Urbanization 15 minimum requirement of Nu 26.6 billion, the actual liquidity was Nu 31.8 billion. However, the share of quick assets has been declining, resulting in the decline in the Statutory Liquidity Ratio7 to 22 percent in December 2018 (figure 6). The non-banking sector, on the other hand, witnesses significant fluctuations in its NPL ratio, primarily because of write-off of NPLs, periodically. There is a need to strengthen prudential oversight and to potentially re-calibrate the role of the state in the financial sector. Although the financial sector remains sound, there is a need to strengthen it. In addition, to further increase access to finance, the RMA has introduced the National Financial Inclusion Strategy, 2018-23. The main building blocks of the strategy include the provision of appropriate financial products and services, boosting access to finance, facilitating economic growth through financing of CSIs, and increasing financial literacy and consumer protection. 5. External Sector The CAD remains high but has started narrowing. The CAD is likely to narrow from 18.4 percent of GDP in 2017/18 to about 15 percent in 2018/19. The decline is primarily because of lower import of capital goods as the Mangdechu power plant nears completion and the construction of Puna I and II gets delayed. In addition, no new public investment programs were initiated by the government in the first half of the year, also reducing imports. In addition, the number of international tourists (excluding regional tourists) was 31,400 in the first half of 2018/19, higher by 8 percent compared to the same period in 2017/18, boosting services exports. The current account deficit is mostly financed by capital flows from India for the hydropower projects through a combination of grants and loans. Foreign exchange reserves remain comfortable at nearly US$978 million in December 2018, providing a cover of nearly 10.1 months of imports of goods and services. Table 5. CAD narrowed in 2017/18 2016/17 2017/18 Change Contribution (% GDP) (% GDP) Credit 40.2% 39.2% −0.9% −21% Goods 23.5% 22.4% −1.1% −23% Services 6.7% 6.9% 0.2% 4% Primary and Secondary 10.0% 9.9% 0.0% −1% Income Debit 63.1% 57.7% −5.5% 121% Goods 43.4% 38.3% −5.0% 110% Services 8.9% 8.8% −0.1% 2% Primary and Secondary 10.9% 10.5% −0.4% 9% Income Current Account −23.0% −18.4% 4.6% 100% Source: RMA and the World Bank. Note: 2017/18 figures are based on estimated GDP 7 The minimum reserve requirement that a bank must maintain against its total deposit. 16 Bhutan Development Update · Harnessing Urbanization Figure 7. Gross international reserves are sufficient 1,300 13 1,200 12 1,100 11 1,000 10 900 9 800 700 8 600 7 2017 Mar May Jul Sep Nov 2018 Mar May Jul Sep Nov Jan Jan Reserves (US$ million, LHS) Months of goods and services imports (RHS) Source: NSB. 6. Fiscal Performance The fiscal deficit in 2017/18 was low at 1.4 percent of GDP. The low fiscal deficit in 2017/18 was primarily because of strong revenue performance. Tax revenues increased because of an increase in the tax base for CIT and increased CIT collections from SOEs. In addition, non-tax revenues also increased because of the change in the rules related to valuation and collection of sales taxes on vehicles. In 2018/19, the fiscal deficit is likely to reduce further to 0.7 percent of GDP because of lower spending. In the first half of 2018/19, capital spending fell, as few new capital projects were implemented due to the elections. Revenues are also lower in 2018/19, particularly the grants from India, because they are linked to overall spend- ing by the government for the implementation of the FYP projects. Indirect tax revenues also fell in the current year because there are no more excise duty refunds from India. On alcohol and other excisable products that were exported from India to Bhutan, the government of India collected excise duties and transferred them to the government of Bhutan. With the introduction of GST in India, this arrangement has come to an end because of removal of excises on exports from India. Since these revenues are transferred with a delay of one year, the impact is evident in the current year. As in other countries, non-tax revenues in Bhutan vary depending on the dividends received from SOEs and they were also lower in the current year. Public debt as a share of GDP is broadly unchanged at about 110 percent of GDP in 2018/19. Figure 8. Public debt was almost unchanged in 2018/19 (% GDP) 120 110 109 100 90 80 70 60 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 Source: Ministry of Finance (MoF). Bhutan Development Update · Harnessing Urbanization 17 7. The Twelfth Five Year Plan The new government’s program is articulated in the 12th FYP which seeks to build a ‘Just, Harmonious and Sustainable Society through enhanced Decentralization’. The 12th FYP for 2018-23 was finalized in January 2019 and focuses on four key areas: (a) A just society, which would require efforts aimed at poverty reduction, creating gainful employment, improving health and education services, strengthening democracy and decentralization, reducing corruption, improving justice services and promoting greater gender equality; (b) A harmonious society, which would need efforts aimed at preserving and promoting culture, maintaining climate resilience, promoting a caring society, and ensuring happy human settlements; (c) A sustainable society, which would require efforts aimed at enhancing macroeconomic stability, ensuring economic diversity, ensuring water, food and nutrition security, improving public service delivery, preserving cultural authenticity, and ensuring community vitality; and (d) Decentralization, which would require empowering local governments and other sub-national bodies. The government has identified 17 National Key Result Areas (NKRAs) to be achieved over the next five years. These NKRAs are closely aligned with the Sustainable Development Goals (SDGs) and with the nine domains of Gross National Happiness (GNH, table 6). These domains include psychological wellbeing, health, time use, education, cultural diversity, good governance, community vitality, ecological diversity and living standards. The Division of Responsibility Framework and Flagship Programs are new features in the 12th FYP. The hall- mark of the 12th FYP is the sharpened focus on decentralization. The other new element in the 12th FYP is the identification of flagship programs to support national priority projects. These projects will help address critical issues related to youth unemployment, water security, and poverty reduction. The Division of Responsibility Framework (increased focus on decentralization) aims to clarify responsibilities between local governments and central agencies including the following: (a) decentralize expenditures with assigned functions to local govern- ments; (b) strengthen coordination and implementation among different levels of government; (c) provide a basis for resource sharing; and (d) determine other aspects of decentralization (for example, human resource and staff allocation). Flagship Programs aim to address high priority/cross-cutting national issues through multi-sec- toral collaboration and coordination. While actual implementation of Flagship Programs is subject to the design of blueprint plans, Flagship Programs include (a) water; (b) cottage and small industries (CSI); (c) tourism; (d) Digital Drukyul (use of ICT for development); (e) organic Bhutan; and (f) health. Table 6. The 12th FYP priorities, the SDGs, and GNH 12th FYP (2018–23) SDGs (2015–30) GNH Domains National Key Results Areas (NKRAs) 1. Macroeconomic stability ensured 8. Decent work and economic growth Living standard 2. Economic diversity and productivity enhanced 9. Industry 11. Productive and gainful employment created 8. Decent work and economic growth Psychological well-being Good governance Living standard Time use 3. Poverty eradicated, and inequality reduced 1. No poverty Living standard 10. Reduced inequalities Good governance 7. Quality of education and skills improved 4. Quality education Education 8. Food and nutrition security ensured 2. Zero hunger Living standard 5. Healthy ecosystem services maintained 11. Sustainable cities and communities Ecological diversity and resilience 15. Life and land Good governance 6. Carbon neutral, climate and disaster-resilient 7. Affordable and clean energy development enhanced 9. Industry, innovation and infrastructure 13. Climate action Source: Presentation of the Gross National Happiness Commission (GNHC). 18 Bhutan Development Update · Harnessing Urbanization Financing the 12th FYP program will be a challenge. During the 12th FYP period, the government has projected a total financing gap of Nu 29.2 billion (table 7). While domestic revenue mobilization through tax reforms and rationalization of expenditures are critical, the remainder will be financed through concessional loans from multilateral organizations, issuance of government bond and treasury bills, and increased use of public-private partnerships (PPP). However, accessing these revenues will require the development of capital markets for gov- ernment bonds and an improved investment climate to attract PPPs. Table 7. Fiscal Framework of the 12th FYP (Nu, billions) 2018/19 2019/20 2020/21 2021/22 2022/23 Total Total Resources 38.3 60.4 61.3 61.1 59.7 280.8 1. Domestic Revenues 33.9 45.8 43.2 46.1 48.7 217.7 2. Grants 4.4 14.6 18.1 15.0 10.9 63.0 Total Expenditures 39.6 66.2 68.9 68.0 67.3 310.0 1. Current 28.8 39.5 41.1 41.2 43.3 193.9 2. Capital 10.8 26.7 27.9 26.7 24.0 116.1 Fiscal Balance −1.3 −5.8 −7.6 −6.8 −7.6 −29.2 (% GDP) (−0.7) (−2.7) (−3.2) (−2.6) (−2.6) (−2.4) Source: The 12th FYP. Bhutan Development Update · Harnessing Urbanization 19 B. OUTLOOK AND RISKS Economic growth is projected to average 6 percent a year over the medium term, supported by the services sector and higher net exports. Growth will spike in 2019/20 following the commissioning of the Mangdechhu hydropower project and then gradually slow down to between 5 and 6 percent, a year. In the services sector, the key drivers are likely to be hotels and restaurants, retail trade and transportation, underpinned by tourism. With the operationalization of the Mangdechhu hydropower project in 2019, exports are projected to increase, while imports remain moderate due to delays in the construction of Punatsangchhu I and II. In addition, hydropower production and exports from the Tala project will also increase with the completion of the main- tenance work. After a decline in 2018/19, increased spending by the government on capital projects will also support growth (table 1). Inflation is likely to reflect price developments in India and the RMA is taking steps to strengthen its mone- tary and exchange rate policies. The inflation rate is expected to pick up in the near future with an increase in food prices in India and higher fuel prices. The exchange rate peg with the Indian rupee has anchored inflation and facilitated Bhutan’s trade relations with India. To ensure coordination between monetary and fiscal policy, the Secretaries of the MoF and the GNHC act as members of the Board of Directors of the RMA. To strengthen the conduct of monetary policy, the RMA will enhance its liquidity management and forecasting capabilities. The CAD is projected to narrow further over the medium term. The reduction in the CAD is expected to be driven primarily by higher exports with the on-streaming of the Mangdechhu project. In addition, imports are likely to remain moderate. The lower CAD will help reduce external debt levels. The CAD will continue to be financed mostly by capital flows from India and the surplus in the overall balance of payments is expected to raise international reserves. 20 Bhutan Development Update · Harnessing Urbanization With a pickup in spending, the fiscal deficit is expected to increase from the current level but will remain low over the medium term. Revenue growth over the projected period will be supported by royalties from Mangdechhu, higher corporate income taxes from DGPC, and the introduction of GST in 2020/21. In addition, the government is also introducing the green tax on fuel from 2019/20. Indirect taxes will be lower than in the past because of the discontinuation of excise duty refunds from India. Non-tax revenues will spike in 2019/20 due to the on-streaming of Mangdechhu. Spending is also likely to increase over the medium term as the government undertakes new public investment programs in line with the 12th FYP.8 Current expenditures are projected to increase with higher spending on the maintenance of hydropower plants and an increase in public sector wages (based on the recommendations of the Fourth Pay Commission, Box 1). The increase in wages has been estimated at Nu 4–5 billion a year and a part of the higher revenues from the Mangdechhu project royal- ties will be used to finance the increased wages. In 2021/22, in line with the spending projected in the 12th FYP, capital spending will be lower and there will be a corresponding decline in the grants from India. The dynamics of the non-hydropower fiscal deficit reflect the pro-cyclical fiscal policy stance of the government and it is also influenced by the grants from India. The difference between the average non-hydro deficit in the past (2013/14 to 2017/18) and the projected non-hydro deficit (2019/20–2021/22) is almost entirely because of the reduction in the grants from India. Nevertheless, the non-hydropower deficit is high. Therefore, efforts aimed at increasing own tax revenues through the GST and reduction in expenditure surges through fiscal rules will be crucial. Public debt as a share of GDP is projected to decline because large amortizations associated with hydropower investments begin with operationalization of the plants and are the main determinant of the debt trajectory. Fiscal policy has generally been prudent and deficits have been at around 3 percent of GDP or lower. In the event of unexpected changes that threaten macro-fiscal sustainability, the budget can be revised, as stipulated in Paragraph 57 of the 2007 Public Finance Act. In response to the introduction of GST in India, the MoF in Bhutan changed the rules on the valuation, collection, and deposit of sales tax on vehicles. On the budget allocation, the government strikes a good balance between provision of public services and economic devel- opment. The Government Performance Management System defines targets and objectives and serves as the basis of budget allocation among the agencies. Going forward the government plans to adopt fiscal rules and to improve spending efficiencies through strengthened public financial management (supported by this opera- tion). Nevertheless, continued widespread tax exemptions, informality, and the narrow tax base will continue to hinder the effectiveness of fiscal policy. As of December 2018, external public debt stood at US$2.5 billion or 103 percent of GDP. The borrowings by SOEs for hydropower accounted for about 77 percent of external debt. Nearly 90 percent of hydro external debt is from India with interest rates of 9–10 percent for Punatsangchhu I and II, and Mangdechhu projects.9 Also, hydro construction costs are swelling, further increasing indebtedness. The delays and cost escalations raise concerns on growth prospects and revenue collections. However, there is a contract between the Indian and the Bhutanese governments whereby India will cover both the financial and construction risks related to the hydro projects and buy the surplus electricity at cost plus 15 percent net return. Therefore, as long as the 15 percent net return is secured, hydropower external debt will remain sustainable. 8 It is important to note that all hydro-related capital expenditures are off-budget and government capital expenditure pertains to the non-hydro sectors only. 9 Interest rates differ depending on projects. For example, interest rate for the Chhukha project was 5 percent and the Kurichhu project was 10.75 percent. Bhutan Development Update · Harnessing Urbanization 21 Box 1: The Fourth pay Commission The 2018/19 budget incorporates the recommendations of Box table 1. Financing allowance and benefit the Fourth Pay Commission. The government formulated increase 2019/20–2022/23 (Nu, billions) the Fourth Pay Commission in January 2019. The report was prepared based on three principles: (a) protecting erosion of Item Nu, billions income from past-unadjusted inflation, (b) linking salary to performance, and (c) enhancing the post-retirement benefits. Also, to improve effectiveness and efficiency, the report rec- Expenditure 17.9 ommends introducing performance-based incentives (PBI). Additional pay and allowance 17.9 ·· Coverage: The recommendations cover not only civil servants, but also Members of Parliament and independent agencies. As Financing (a+b) 30.6 of 2018, there were 29,543 civil servants and 7,908 other pub- lic servants (including elected ones such as parliamentarians and local government functionaries). Together, they accounted Fiscal measures 11.0 for 12.5 percent of the total labor force employed in 2018. Increase in personal income tax 0.6 ·· PBI and indexation: The Fourth Pay Commission intro- from pay increase duced PBI and indexation. Under the PBI, 10 percent of basic salary (5 percent at agency level, and 5 percent at the individual level) is allocated based on performance. Monetization of vehicle tax 2.4 The annual salary indexation links salary increases with inflation rate (5 percent or inflation, whichever is lower). Green tax on fuel 1.8 ·· Financial implications: If all recommendations are implemented, the total expenditures on allowance and GST 4.4 benefits will increase by Nu 4.2 billion (30 percent increase from the 2018/19 level) or Nu 18.0 billion Sustainable development fees from 1.7 for the remaining four years under the 12th FYP. regional tourists ·· Macroeconomic impacts: Based on the experience of the pay and benefits revisions in 2011 and 2014, the report foresees a Revenues from Mangdechhu 19.6 positive impact on growth due to the increase in government hydropower spending. At the same time, the report recognizes the potential for inflationary pressures from the pay increase. Balance 12.7 Source: Pay Commission Report. The 2018 Debt Sustainability Analysis (DSA) concluded that Bhutan’s risk of external debt distress is moderate. The DSA observes that Bhutan’s rapid hydropower development has led to a substantial buildup of external debt, with external debt ratios breaching all indicative thresholds and projected to continue doing so for several more years. At the same time, the DSA recognizes key factors mitigating the risk, particularly that the large share of external debt is linked to hydropower project loans from the Government of India and that these loans are backed up by the intergovernmental contract between the two countries which guarantees returns. In addition, the hydro debt is denominated in Indian rupees and export proceeds accrue in Indian rupees, thereby reducing exchange rate risks. External debt outside hydropower projects is primarily from concessional loans from multilateral financial institutions and bilateral donors (Austria, Denmark, and Japan). Domestic debt to GDP was low at 5 percent in 2017/18. Risks to the outlook stem mainly from the following: (a) further delays in hydropower project implementa- tion/completion, which would also delay the expected export and revenue payoffs; (b) financing of the budget at higher costs in the context of under-developed domestic debt markets; and (c) natural calamities, which could lower electricity generation from existing hydropower plants and reduce agriculture output. (a) Delays in the completion of hydropower projects in the past few years has had an adverse impact. Although the Mangdechhu hydropower project is likely to be operationalized in 2019, there are uncertainties on the Punatsangchhu I and II projects due to geological problems. These delays impact the economy through lower growth, exports, and revenues (table 8, 9). For example, a one-year delay could negative- ly affect growth by 3–4 percent. 22 Bhutan Development Update · Harnessing Urbanization Table 8. Delay in hydropower construction Project MW Planned completion year In 2015/16 budget In 2016/17 budget In 2017/18 budget In 2018/19 budget In 2019/20 budget Punatsangchhu I 1,200 2019 2019 2021 2022/23 2024/25 Punatsangchhu II 1,020 2018 2018 2019 2020/21 2022 Mangdechhu 720 2018 2018 2018 2018 2019 Source: MoF. Table 9. Impact of a delay in hydropower construction (one-year delay in Puna I or II project) Subject Source of impact Estimated impact GDP (production account) Decline in electricity production About 3–4 percentage points of GDP Exports Decline in export growth About US$250–300 million a year (about 50 percent of actual exports in 2015) Government revenues Decline in corporate taxes, dividend, and royalty About 0.5–1 percent of GDP Source: World Bank staff estimates. (b) Grant financing as a share of GDP declined significantly from 18 percent in 2003/04 to 8 percent in 2016/17. The increase in the size of the economy and graduation from the list of LDCs suggest that this trend is likely to continue. Therefore, it will be important to broaden financing options. On domestic revenue mobilization, the implementation of GST in 2020/21 without delay is critical. Also, developing the capital market will help, both for financing the budget and for developing the financial sector. (c) Bhutan is exposed to hydro-meteorological hazards which increases the risks posed to the hydropower and other sectors. The country lies in the seismically active eastern portion of the Himalayan Arc. Some of the major hazards facing Bhutan include glacial lake outburst floods, flash floods, riverine floods, landslides, landslide dam outburst floods, cloudbursts, forest fires, windstorms and earthquakes. With climate change, the frequency and intensity of extreme events is expected to increase. Most of Bhutan’s productive infrastruc- ture (hydropower plants, roads, airports), fertile agricultural land, and over 70 percent of the settlements are located along the main drainage basins, which puts them at high risk of flooding. Furthermore, the transboundary monsoon system influences key productive sectors in the entire region, and small variations in the timing and quantity of rainfall can have profound consequences on water availability, agricultural productivity, and food security. Such disasters can reverse hard-won development gains. Longer-term challenges include the need for diversification of the country’s asset base through investments in physical capital, human capital, and institutions. This would help lower the barriers for investment and facilitate private sector development. In this context, it will be particularly important to reduce the infrastruc- ture and policy gaps in cities so that Bhutan’s urban centers can seize the benefits of agglomeration economies (discussed in the next section). Bhutan Development Update · Harnessing Urbanization 23 C. SPECIAL SECTION: HARNESSING URBANIZATION Despite its small population and land area, Bhutan is among the most rapidly urbanizing countries in South Asia. While this urbanization parallels robust economic growth and the expansion of job and investment opportunities in cities, there remain challenges to fully leveraging the potential of urban areas. Bhutan has made impressive gains toward the conver- gence of access to basic services across the country, but there are gaps in the quality of coverage, particularly for water and sanitation. Local governments will have an increased role in basic service provision and capital investment, but it requires enhanced capacity and resources to improve efficiency and responsiveness to local needs. Urban growth has increased demand for quality housing, which has resulted in a scarcity of affordable units and has increased pressure for urban expansion. Finally, the concentration of people and property in growing cities also changes the hazard risk profile of these areas, which is not adequately understood due to a lack of adequate data systems and poor integration into planning mechanisms. An integrated approach to urbanization is essential; one that leverages the benefits of agglomeration while also managing the diseconomies and negative externalities of urban growth. 1. Leveraging the Gains of Urbanization to Improve Regional Equity Cities are a critical driver of economic growth. Bhutan’s urbanization trends are starting to reflect this shift. The total population in 2017 was 735,553, of which 37.8 percent resided in urban areas, driven by strong rural-urban migration. The intercensal average annual urban population growth rate was 2.5 percent, four times the overall population growth rate of 0.6 percent. The population and economic base are concentrated in the western region. Thimphu district is home to 15 percent of the entire population and its synonymous thromde (municipal- ity) comprises around 40 percent of the total urban population. Phuentsholing, Samdrup Jonkhar, and Gelephu are the next most populous municipalities. Figures 9 and 10 show the concentration of population and economic activity using satellite data. 24 Bhutan Development Update · Harnessing Urbanization Figure 9. Economic density across Bhutan (Proxied by nighttime lights, VIIRS 2015) Paro Thimphu Wangdue Phodrang and Punakha Valley Trongsa Samdrup Jongkhar Gelephu Phuentsholing Source: Authors’ own, using VIIRS 2015 nighttime lights data10 Note: Nighttime lights (VIIRS 2015) data provide a proxy to visualize the economic density across space, accounting for both urban and rural economic density. Here, we map economic density within Bhutan. This exercise highlights the primacy of Thimphu in the urban system. Figure 10. Bhutan population distribution (LandScan 2012) Thimphu Wangdue Phodrang and Punakha Valley Paro Trongsa Gelephu Samdrup Jongkhar Phuentsholing Source: Authors’ own, using LandScan 2012 population density data. 11 Note: This map shows an estimate of population distribution across Bhutan, using 2012 LandScan data. Concentration in the same centers is observed, though as expected, compared to economic density, the population is more spread across rural areas, while certain secondary cities (such as Phuentsholing and Samdrup Jongkhar) have relatively high population density relative to economic density, suggesting a greater need for interventions to support growth in these cities. Urbanization trends suggest that migration may be driven more by the ‘pull’ factors of urban areas, such as employment—especially the higher wages in urban areas—and education opportunities or family linkages, than by ‘push’ factors such as infrastructure scarcity, landlessness, or conflict in rural areas. 10 VIIRS Day/Night Band Nighttime Lights (yearly VIIRS Cloud Mask - Outlier Removed - Nighttime Lights), Earth Observation Group, NOAA National Centers for Environmental Information (NCEI) 11 LandScan 2012 global population database. Oak Ridge, TN: Oak Ridge national laboratory. This is the most recent population dataset available for the LandScan analysis. Bhutan Development Update · Harnessing Urbanization 25 There are critical urban-rural divides in poverty and the quality of services. Median household incomes in the urban areas (Nu 150,000) are nearly triple those in the rural areas. Rural districts (dzongkhags) in the central and south have the highest incidence of service deprivation. The poverty rates in rural Dagana, Zhemgang, and Mongar districts are up to 10 times higher than Thimphu municipality. Literacy rates in these areas hover around 66 percent, far below Thimphu (80.2), Gelephu (85.6), and Phuntsholing (83.2). Overall, the literacy rate of urban dwellers is 23 percent higher than rural areas. Gaps in improved sanitation coverage are also substantial: 97.6 percent in urban versus 88.1 percent in rural areas overall, while 8 of 20 districts have under 80 percent coverage, with the lowest coverage rate just 55 percent in Gasa.12 Overall, spatial-economic transformation in Bhutan is largely driven by the economic opportunities that cit- ies offer. However, Bhutan’s larger urban centers are not well equipped to seize the benefits of agglomeration economies, in terms of specialization and market access, which affect the number and the quality of jobs, and in terms of quality of services, which affects their livability and competitiveness. The four largest thromdes face infrastructure and service delivery backlogs, shortage of serviced land and affordable housing, and environ- mental pollution. For example, Thimphu Dzongkhag (with Thimphu Thromde) and Chhukha Dzongkhag (with Phuentsholing Thromde) have the greatest concentrations of households without reliable water service; traffic congestion is also a key issue in these two thromdes; and only 20 percent of households in Thimphu have sewer connections. Around 60 percent of urban dwellers rent, though apartments are increasingly unaffordable for households at or below the median income level. Since the early 1980s, decentralization has been a key policy objective of the government; an objective detailed in Section 1 of the Constitution. The 12th FYP aims toward “empowering local governments through greater fi- nancial, planning, administrative responsibility and authority.” However, despite the focus, the decentralization agenda is not fully integrated or supported by other policy and program initiatives. Currently, most local gov- ernments have limited capacity and experience in managing urban service delivery, undertaking medium-term capital investment planning, and including robust and transparent accountability mechanisms. As urbanization continues, local governments will need to strengthen each of these areas to play a greater role in efficient, responsive service delivery. A critical concern for policy makers is how to strengthen and extend Bhutan’s structural transformation toward an economy driven by the private sector and based on employment in manufacturing and services, with sustain- able jobs for the educated, the skilled, the youth, and women. Bhutan is reaching the point where gaps in urban planning, service delivery, and affordable housing within cities can start to negatively affect economic growth and competitiveness as well as quality of life over the long term. National policies on urbanization and local ac- tions by municipal governments can play a critical role in planning and managing this urban growth to not only sustain the economic advantages that cities provide, but also to ensure that they are livable and socially inclusive. Through the 12th FYP and the Comprehensive National Development Plan, the government aims for ‘equitable’ and ‘balanced regional development’. Towns and cities cluster jobs and investment unevenly across the country as a response to market forces. A balanced approach to regional development should not attempt to spread jobs and private investment more evenly, but should instead address the gaps in connectivity and basic services such as health and education to provide more equitable opportunities for people anywhere in the country. The concentration of people and economic activity in two main hubs (Thimphu and Phuntsholing) requires a different approach than smaller market towns or rural villages. Larger cities need to support agglomeration and scale economies while managing congestions forces, while smaller settlements and rural areas need to ensure that 12 PHCB 2017. 26 Bhutan Development Update · Harnessing Urbanization residents have quality basic infrastructure, health care, and skills for more equitable human capital development. Figure 11 develops a simple framework for this based on the level of concentration of people and economic endowments, using indicative settlements as examples. Support agglomerations, improve equity of Thimphu and access to housing Phuentsholing and services Tier I Concentration of People Improvements in connectivity and communication Samdrup Jhonkar infrastructure to link Gelephu and Mongar with other places Tier II Basic infrastructure, health and education to improve human Gasa and Dagana capital Tier III Concentration of Economic Endowments For settlements such as Thimphu and Phuntsholing (Tier I), efforts should be on improving livability, reducing disparities in access to services, and leveraging urban agglomerations for deeper and more diverse private sector investments. To do that, it is important to ameliorate emerging congestion forces, such as land and housing shortages, traffic congestion, and environmental pollution. These cities can make density work better through improved planning and land administration, re-densifying existing built-up areas, and strengthening urban resilience to reduce exposure to natural disasters. The municipal governments in these urban centers need to be equipped to play a greater role in planning and managing their land resources and assets and strengthening their service delivery mechanisms. These towns would also benefit from improvements to the business climate and technical and vocational skills development programs to enhance the labor force. Finally, regional connectivity, both hard and soft, can also play a key role in extending the economic gravity of these towns. For settlements with locational advantages and nascent economic clusters, such as Gelephu, Samdrup Jongkhar, and Mongar (Tier II), the focus should be on improving the conditions for private investment to link to potential mar- kets in emerging sectors such as agribusiness/processing, and scaling up SMEs and cottage industries by improving connectivity. This could include identifying demand-side obstacles that have limited access to finance and customs processing, and have constrained links in product value chains, and impeded the dissemination of knowledge, skills, and technology. These cities also need to boost capacity in urban planning and land administration as well as strengthen infrastructure and service delivery to accommodate new growth. These settlements also require improv- ing the road and ICT connectivity with larger regional hubs and ports of entry, both within Bhutan and to India. For rural and remote regions and regions with low endowments (Tier III), higher levels of poverty, and infra- structure gaps, efforts should focus on equitable access to basic public services, especially health and education services, that will improve human capital outcomes, enhance the quality of the labor force and provide skills that residents can use to move to larger centers. Bhutan Development Update · Harnessing Urbanization 27 2. Empowering Local Governments to Improve Urban Livability As Bhutan gets more urbanized and its economy becomes more urban centric, the four existing thromdes and other municipal governments will become key institutional actors to ensure good quality services, attract private investments to cities, and provide proximate and accountable outreach to citizens. A flexible and incremental roadmap of reforms and institutional strengthening is necessary to deepen the policy of decentralization and strengthen local governments. In furthering regional development, Bhutan could consider an asymmetric model of decentralization and local autonomy. This would entail two critical policy imperatives. First, encouraging greater population consolidation, with a view to improve quality and reduce cost of service provision, as well as to enhance safety, resilience, and economic agglomeration. While this is already happening organically, the government could support this process through improving connectivity to and infrastructure in key cities and towns. Second, imparting greater powers, responsibilities, and resources to Tier I (Thimphu and Phuentsholing) and Tier II municipal governments (for example, Gelephu, Samdrup Jhonkar, and Mongar) to set them on a path of greater fiscal and administrative self-reliance and direct citizen accountability, and enabling them to better utilize their local social and economic endowments. The institutional roles and responsibilities among different levels of government (dzongkhags, thromdes, and gewogs) and central government units, such as the Ministry of Works and Human Settlements, GNHC, and MoF, would need to be clarified to ensure coherent governance arrangements. This could be further enhanced to ensure vertical and horizontal coordination and cooperation across the different levels of governments by es- tablishing an institutional modality for intergovernmental dialog and coordination. Such models could include, for example, an independent grants commission (India, Uganda, South Africa), an intergovernmental forum (Canada, Germany), and administrative bodies/arrangements (the Philippines). With greater devolution, there is a need for local governments to have a stronger financing system. This is especially critical given the 12th FYP’s proposed plans to devolve 50 percent of the capital budget expenditures to local governments. To manage this effectively, the system needs to include a clear policy on vertical fiscal balance and equalization, not only to strengthen the local government system, but also serve as a positive policy for regional convergence; adoption of fiscal and institutional incentives, such as performance transfers, hard budget constraints, and service delivery benchmarking, for greater own-source revenue collection, more efficient public expenditures, and transparency and predictability in the fiscal regime. To improve own-source revenue collec- tion, thromdes will need greater regulatory empowerment as well as systems and capacity support, which can be complemented with incentives such as performance-based transfers. Thromdes will also require greater human resource capacity and staffing expertise for planning and management of investments and services. The government may consider a trained cadre of municipal staff, especially focusing on core competencies such as revenue, expenditure and financial management, urban management, service de- livery, and so forth, as well as flexible models for staffing through which the larger thromdes are able to provide better incentives and to tap the market for higher level technical skills in a flexible manner. As thromdes become fully functional municipal governments, they will need to strengthen accountability to their constituents as part of enhancing the overall social contract. Appropriate structures for effective citizen engagement would need to be bolstered in the thromde governance system. These systems should link engage- ment to participatory mechanisms that can strengthen upward accountability arrangements such as public expenditure and financial management. 28 Bhutan Development Update · Harnessing Urbanization 3. Improving Housing Affordability to Make Cities More Inclusive The availability of serviced, affordable housing is critical to inclusive and equitable urbanization. The location of housing relative to jobs and services not only determines a significant portion of its cost but also affects the urban form and function of the city. Housing that is far from jobs and services may be more affordable, but requires additional time and costs for travel which contributes to congestion and pollution. For a country undergoing rapid urbanization, Bhutan has largely been successful in reducing the incidence of urban informal settlements due in part through government subsidy programs, and in the case of Thimphu, through the deployment of land readjustment to enable greater housing unit supply while also managing urban expansion. Overall, most citizens have access to serviced housing units. Estimates suggest that the quantitative housing deficit is low and will likely stabilize as the population growth rate declines in the coming decades. However, there are a several important qualifications. First, housing in rural areas is largely self-built, owner-occupied, and more likely to have quality deficits (in terms of construction material and basic service connections) than urban housing units. Urban areas consist primarily of rental housing and a few informal settlements which lack decent services and have substandard and impermanent dwelling units. Data on expenditures and rental rate increases suggest that urban housing is unaffordable for the median income household, meaning that middle- and lower-income quintiles would spend more than one-third of their incomes on housing costs. Housing is delivered through a process of exchange across supply and demand value chains. How well these value chains function will determine the supply and cost of housing, which has direct implications on affordability. For each, there are several areas that require additional study and policy attention to improve the function of housing markets. On the supply side, land scarcity and the construction sector could be improved to increase the supply and affordability of housing. While land readjustment has been successful in Thimphu, the city has more than tripled in area to 26 km2 since 2000, which has induced new development to encroach along hillsides that can be prone to landslides. Construction materials are expensive due to import and transport costs. There is also a lack of a consistent application of testing and quality assurance of building materials and code compliance for new con- struction. This not only affects the safety and design of housing, but also disincentivizes insurance and financing tools for new construction. On the demand side, formal participation in banks and savings institutions is low. As a result, mortgage fi- nance for housing is uncommon, expensive, and a small fraction of consumer finance. Even if incomes and savings rates increase and banks offer more competitive mortgages, it is unlikely such products will reach far beyond upper-middle-income groups. There is a lack of alternative products, such as housing microfinance, which could reach low- and middle-income groups with limited credit history. Such loans can also complement the incremental and savings-based approaches to home expansion and improvement which is already common throughout the country. The revised Housing Policy (2019) laudably emphasizes affordability as a key goal to be achieved through improving homeownership. While homeownership has benefits, there remain a number of challenges for the development of urban property markets in Bhutan. These include the lack of data systems on market activity, volumes, and prices, which are necessary for both consumers and banks. This is further compounded by the low levels of savings, and as well as policies that cap the amounts that banks can lend to consumers and developers. The policy should also consider how to improve affordability for urban renters, especially the potential for demand-side subsidies as is done in a number of other countries. Bhutan Development Update · Harnessing Urbanization 29 4. Protecting Cities from Natural Hazards and Climate Change Bhutan’s vulnerability to natural disasters and climate-related hazards requires improvements in the planning of settlements and enhancement of resilience in urban development and basic services. The country is located in a seismically active portion of the eastern Himalayas and is also prone to flooding, landslides, and wildfires. The impact of natural disasters and a changing climate have potentially devastating effects in terms of human lives lost, economic livelihoods destroyed, and losses in sectoral productivity; in 2016, flooding affected the entire country, causing major destruction in the southern region. Urban resilience refers to the ability of an urban system to withstand shocks and stresses, including preparedness, response, and recovery capacities. Bhutan has a strong policy and legislative framework but with relatively weak implementation capacity for disaster risk management (DRM). Geospatial analytics and related multi-hazard mapping are key components for integrating DRM into the urban planning process, enhancing service delivery, and ultimately informing the risk reduction and emergency preparedness strategies, but these are in nascent stages. There are gaps in reliable and comprehensive hazard information (geological, hydrological, meteorolog- ical) and limited technical expertise to identify vulnerabilities and assess risks, which hinders the planning of settlements. At present, hazard maps are prepared on an as-needed basis, which leads to duplication and wasted resources. Bhutan needs a robust system to make informed decisions to protect development gains, adapt development to changing country trends/contexts, and prevent unsustainable development pathways, especially for urban areas. Specifically, informed decision making can mitigate Bhutan’s susceptibility to increasingly intense and frequent urban shocks and stresses (as compared to service and infrastructure failure for lack of robust risk information). 30 Bhutan Development Update · Harnessing Urbanization In the aftermath of a hazard event, informed decision making also can support fluid recovery and reconstruc- tion, better delivering services to the citizenry, especially to the poor and vulnerable. Urban areas are facing increased pressure for expanded service delivery. Rapid urbanization has increased the demand for clean drinking water and managing stormwater runoff, wastewater, sewage, and solid waste. One measure of urban resilience is the quality of and access to utility services delivery in shocks (weather, water, climate, and earthquakes). As discussed above, this requires designating resources for local governments to im- prove operations and maintenance (O&M) of capital infrastructure; compromising on O&M can lead to faster depreciation of the investment and increase vulnerability to disasters. The first step toward improving urban resilience is the establishment of a strong data system including spatial analytics, hazard mapping, and risk assessment tools. This geospatial information needs to be accessible and in formats that are usable by urban planners, service providers, and investment planners for decision making. The actors can use the information to improve planning, prioritize investments, and address critical infrastructure gaps. In turn, this work can reduce Bhutan’s exposure to property damage, household economic shocks, environ- mental degradation, and the incidence and spread of serious public health threats. Urban resilience also needs to be further integrated into planning systems and approaches to public engagement and participation. This includes the linking of hazard mapping and risk assessments for land use and capital investment planning, as well as construction and building design standards, financing options, and O&M prac- tices. Other stakeholder groups also play an important role in strengthening the application of resilience princi- ples; improving citizen engagement and public awareness of preparedness and response activities is critical. An informed private sector can also be a resource to mobilize finance and improve the quality of infrastructure and service delivery. Finally, mechanisms for regional collaboration and learning are key to improve coordination in preparing and responding to issues with cross-border dimensions such as weather and climate services. 5. Conclusion Bhutan is undergoing rapid urbanization and a structural transformation to a service-based economy. While population growth and economic activity are concentrated in only a few settlements, it is important to under- take a spatially differentiated approach to achieving balanced regional development outcomes. This requires unity and coordination of the policy objectives in ways that support existing urban agglomerations, aim for an equitable distribution of living standards, and integrate poor and lagging places through connectivity. Under this framework, local governments will also require additional support and capacity to more effectively plan and manage necessary capital investments and service delivery obligations. In larger cities, the key is to further harness the existing economic clusters by improving the livability, affordability, competitiveness, and resilience. For smaller towns and villages, it is critical to reduce the gaps in the quality of basic infrastructure and human capital development and to strategically improve connectivity to markets.