BHUTAN
COUNTRY ECONOMIC
MEMORANDUM
Maximizing Bhutan’s Potential for Economic
Diversification and Structural Transformation
Bhutan Country Economic Memorandum
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Bhutan
Country Economic
Memorandum
Maximizing Bhutan’s Potential for Economic
Diversification and Structural Transformation
Macroeconomics, Trade and Investment (MTI) Global Practice
SEPTEMBER 2024
Contents
Bhutan Country Economic Memorandum
Contents
Acknowledgements
x
Abbreviations and Acronyms xi
Executive Summary 1
1. Hydropower Revenue Management for
Economic Diversification 22
1.1. Introduction 23
1.2. Bhutan’s hydro and non-hydro growth nexus 25
by the publicly led and capital-intensive hydro
1.2.1. Past growth has been driven
sector 25
with limited employment opportunities 28
1.2.2. The private sector has remained small,
and symptoms of the Dutch Disease 31
1.2.3. Economy-wide effects of the hydro sector
1.3. Economic diversification in Bhutan: a framework for managing
hydropower rents 37
for investing domestically
1.3.1. The case 37
for economic diversification in Bhutan
1.3.2. Current policies 41
for effectively channeling hydropower
1.3.3. A suitable institutional framework
rents towards productivity enhancing assets in Bhutan. 45
1.4. Policy priorities 54
the current comparative advantage
1.4.1. Hydropower development to leverage
and ensure future hydro rents 54
1.4.2. Policies to lay the foundationfor (new) comparative advantages in the
non-hydropower sectors 55
1.4.3. Institutional setup to frameand implement sector-specific policies 57
2. Structural Transformation Through
Agricultural Productivity 60
2.1. Introduction 61
2.2. Structural shifts in the agricultural sector 61
2.2.1. Agriculture continues to be Bhutan’s main employer,especially in rural areas 61
D
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Bhutan Country Economic Memorandum
behind other sectors and comparators
2.2.2. Agricultural value-added has fallen 63
is driven by the reduced
2.2.3. The slow growth in agricultural value-added
production of Bhutan’s traditional crops 65
2.2.4. The agricultural sector is gradually transitioningfrom traditional to higher
value products 67
2.3. Productivity as a kick-starter of structural transformation 69
more productive
2.3.1. Within Bhutan there is a statistical relation between
agriculture and the release of labor 70
in Bhutan is below its potential
2.3.2. Agricultural productivity 71
by alleviating production constraints
2.3.3. Productivity gaps can be closed 72
can accelerate structural transformation
2.3.4. Closing productivity gaps 75
2.4. Climate change may increase agricultural output but also lead to
yield variability 79
to raise both temperatures and precipitation
2.4.1. Climate change is expected
levels 79
are expected to alter Bhutan’s yield structure 81
2.4.2. The impacts of climate change
2.4.3. Short-term climate-induced yield changes can temporarily increase output,
but risk distracting from longer-term diversification opportunities 84
2.5. Policy priorities 86
2.5.1. Strategic infrastructureinvestments 87
2.5.2. Policy reforms 88
to farmers
2.5.3. Targeted support 89
3. Bhutan’s Financial Sector: Issues and the
Way Forward 91
3.1. Introduction 92
3.2. Concentration and credit allocation in the financial sector 93
3.3. Financial sector challenges and recent measures 97
3.4. Policy priorities 103
3.4.1. Financial stabilityand governance of FIs 103
financial intermediation
3.4.2. Deepening 105
limate finance
3.4.3. Bolstering c 106
Reference List 109
Annexes 112
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Bhutan Country Economic Memorandum
Figures
Figure 1: Impact of hydropower on GDP (percent), 1985-2021 2
Figure 2: Growth rates of hydropower and non-hydropower sectors (percent), 2001-2019 2
Figure 3: Hydro and non-hydro sector growth decomposition (contribution to growth), 2001-2019 4
Figure 4: Spillovers from hydro to non-hydro sector, 2001-2019 4
Figure 5: Bilateral real exchange rate with India (Index average 1980-2021 = 1), real power exports
and real capital inflows from India, 1980-2021 4
Figure 6: Change in sectoral productivity and employment shares, 2013-2021 4
Figure 7: Unemployment rate (percent), 2010-2022 6
Figure 8: Monthly migration, Paro International Airport, Jan 2015 – Mar 2023 6
Figure 9: Pathways for managing resource revenues 8
Figure 10: Agricultural productivity growth is key to facilitate a movement of labor into non-primary
sectors… 13
Figure 11: …Productivity growth in agriculture was significantly lower than for peer countries. 13
Figure 12: Closing yield gaps by augmenting non-labor production inputs raises relative wages of
non-agricultural workers… 14
Figure 13: …which induces a shift of labor out of agriculture and accelerates structural transformation,
especially in the southern part. 14
Figure 14: Sectoral composition of credit 16
Figure 15: Credit composition by firm size 16
Figure 16: Share of banks and non-banks in credit and assets (percent), 2012 and 2022 17
Figure 17: Gross NPL and credit growth (percent), 2012-2023 17
Figure 18: Impact of hydropower on GDP in Bhutan (percent), 1985-2021 23
Figure 19: Installed capacity, hydropower (MW), 1987-2029 24
Figure 20: Net capital inflows from India and power export revenues (percent of GDP), 1980-2021 24
Figure 21: Growth decomposition, 2001-2019 26
Figure 22: Labor contribution decomposition, 2001-2019 26
Figure 23: Hydro sector growth decomposition, 2001-2019 26
Figure 24: Non-hydro sector growth decomposition, 2001-2019 26
Figure 25: Hydro investments and TFP growth, 2000-2020 27
Figure 26: Bhutan vs. peers: contributions to growth 2001-2019 27
Figure 27: Labor force participation rates by gender, 2013-2022 28
Figure 28: Spillovers from hydro to non-hydro sector, 2001-2019 28
Figure 29: Sector shares in GDP, constant 2000 prices, 1980-2021 29
Figure 30: Change in sectoral productivity and employment shares, 2013-2021 29
Figure 31: Establishment size and employment share, 2022 30
Figure 32: Type of employment, by sector (excluding agriculture), 2022 30
Figure 33: Comparison between the distribution of expected labor demand and the current labor
force and inactive population (percent of total), by education, 2022 30
Figure 34: Percent change in power exports and consumption (in constant 2000 prices), 1991-2019 31
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Bhutan Country Economic Memorandum
Figure 35: Correlation of power exports with consumption and investment (annual data), 1991-2019 31
Figure 36: BRER with India (Index average 1980-2021 = 1), real power exports and real net capital
inflows from India, 1980-2021 32
Figure 37: Correlation of BRER with India with the sum of capital inflows and export revenues, 1986-
2021 32
Figure 38: GDP growth by economic activity (Index, 1986=100), 1986-2021 33
Figure 39: Hydro and non-hydro goods exports (in million Nu), 2001-2022 33
Figure 40: Additional hydro revenues after 2019 in the reference scenario, 2020-2030 34
Figure 41: Dutch Disease-type effects (spending and resource movement), 2030 37
Figure 42: Pathways for managing resource revenues 38
Figure 43: Bhutan (non-hydro) capital expenditure in international perspective 40
Figure 44: Public capital Spending versus quality of infrastructure 40
Figure 45: The projected balance of BESF in percent of GDP, 2023-2040 43
Figure 46: Institution types, objectives, and asset types 45
Figure 47: Mapping of potential sectors and activities on a complexity/returns matrix 52
Figure 48: Education expenditure and LAYS 56
Figure 49: DEA Frontier analysis, health 56
Figure 50: While agriculture’s contribution to GDP is low, the sector continues to act as the main
employer in Bhutan… 62
Figure 51: …and any decline in agricultural transformation has occurred exclusively through a
reallocation of labor from agricultural to non-agricultural areas. 62
Figure 52: Structural transformation has centered around urban centers and select trading points
at the southern border, whereas more rural regions have witnessed an increase in agricultural labor
shares. 63
Figure 53: Agricultural productivity growth is key to facilitating a movement of labor to non-primary
sectors… 64
Figure 54: …but productivity growth in agriculture has lagged in other sectors within Bhutan… 64
Figure 55: …and was significantly lower than for peer countries… 64
Figure 56: …in stark contrast to productivity developments in the service and industrial sectors. 64
Figure 57: Paddy and maize dominate Bhutan’s harvested area. 65
Figure 58: Harvested area has declined across Bhutan… 66
Figure 59:…driven by cereals (maize and paddy). 66
Figure 60: Cereal yield changes were heterogeneous across Bhutan, with reductions focused in the
south of the country… 66
Figure 61: …which is also the area where most agricultural production is located. 66
Figure 62: Declines in harvested areas and yields have led to a drop in agricultural output of
traditional crops… 67
Figure 63: …whereas the number of fruit trees planted has increased due to a rise in areca nut
production. 67
Figure 64: Bhutan has an export niche in fruits, spices, and a few vegetables… 67
Figure 65: …with fruit production dominated by areca nuts, followed by mandarins and bananas. 68
Figure 66: Spice, fruit and nut exports to global markets have gradually replaced potato exports to
India… 68
Figure 67: …allowing Bhutan to capture market shares in select niche products. 68
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Bhutan Country Economic Memorandum
Figure 68: Over time export intensity of export-oriented products has increased… 69
Figure 69: …whereas Bhutan increasingly relies on imports for products for which it is at a
comparative disadvantage. 69
Figure 70: Regions that experienced higher cereal yield growth increase their own agricultural labor
share… 70
Figure 71: … while decreasing their share of national employment 70
Figure 72: The dzongkhags with the largest drop in harvested area had the largest increases in the
number of fruit trees… 71
Figure 73: …and the largest decline in agricultural labor share. 71
Figure 74: Current yields are significantly below their potential 72
Figure 75: Yield increase potentials vary significantly by crop and region 72
Figure 76: Irrigation problems, labor shortages, and crop damage are among the main constraints
reported by farmers. 73
Figure 77: Ensuring access to water, overcoming labor shortage through productivity, and protecting
crops from damage can trigger substantial yield increases. 74
Figure 78: Bhutan’s ranking in trade logistics has decreased in recent years… 75
Figure 79: …owing to a decrease in infrastructure, international shipments and timeliness ratings, and
only a modest improvement in other areas. 75
Figure 80: Bhutan is ranked 170th among 208 countries in terms of its agricultural land area… 76
Figure 81: …but 68th when the low population density is considered. 76
Figure 82: Production structure for labor saving productivity improvements 77
Figure 83: Closing 20 percent of the existing yield gaps by augmenting non-labor production inputs… 78
Figure 84: …raises relative wages of non-agricultural workers… 78
Figure 85:…and induces a shift of labor out of agriculture… 78
Figure 86: …which accelerates structural transformation, especially in the southern part. 78
Figure 87: Higher agricultural productivity reduces crop prices… 79
Figure 88:…which generates an income effect that augments the direct impact of productivity
increases and leads to spillovers to the service sector. 79
Figure 89: Minimum temperatures have increased significantly across Bhutan over the last three
decades… 80
Figure 90: …and rainfall has become more variable and extreme in the southern parts of the country. 80
Figure 91: Going forward, minimum temperatures are expected to continue to increase… 81
Figure 92: …and rainfall variability will increase with climate change severity. 81
Figure 93: Yields for rainfed maize are projected to increase going forward, but that increase will be
temporary if more severe climate change materializes. 82
Figure 94: Irrigation of vegetables, such as carrots, is key to turning climate change into an
opportunity. 82
Figure 95: More severe climate change is expected to temporarily benefit maize and rice yields
under rainfed conditions, but cause a deterioration in the longerrun… 83
Figure 96: …whereas yields under irrigated conditions are expected to systematically benefit from
more severe climate change. 83
Figure 97: A short-term climate-induced increase in maize and cereal yields… 85
Figure 98: …induces a modest production shift towards these crops. 85
Figure 99: Lower maize and cereal prices are partially offset by higher prices of crops whose yields
decrease, thus leaving wages almost unaffected… 86
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Bhutan Country Economic Memorandum
Figure 100:…and generating practically no spillovers to the non-agricultural sector. 86
Figure 101: Overview of the financial sector in Bhutan 92
Figure 102: Banking sector asset size (Nu. Billion), 2015 and 2021 94
Figure 103: Banking sector deposits (Nu. Billion), 2015 and 2021 94
Figure 104: Share of banks and non-banks in financial sector assets, 2022 94
Figure 105: Share of banks and non-banks in assets and credit, 2012 and 2022 95
Figure 106: Share of state-owned commercial banks assets to total banking system assets, 2017-2019 95
Figure 107: Distribution of firms and credit as per economic sectors 96
Figure 108: Distribution of firms by size (percent), 2018 and 2022 96
Figure 109: Credit composition by firm size (percent of total), 2017, 2019, and 2022 96
Figure 110: Government Bond issuance, Sep 2020-Jun 2023 97
Figure 111: Gross NPL and credit growth (percent), 2012-2023 98
Figure 112: Sectoral composition of NPLs, 2017, 2019, and 2022 98
Figure 113: Gross NPL, banks and non-banks (percent), 2015-2022 98
Figure 114: Net interest margin (percent), 2015-2021 100
Figure 115: Return on assets of banks (percent), 2015-2022 100
Figure 116: Capital adequacy ratio of banks (percent), 2015-2022 100
Figure 117: Access to finance (per 10,000 adults), 2017 and 2021 101
Figure 119: Impact of the BIG on household income by source, 2030 115
Figure 118: Value and composition of government transfers to households including BIG, 2019-2030 115
Tables
Table 1: Economic development in different scenarios, 2030 9
Table 2: Policy objectives and priority reform options 20
Table 3: Economic development in different scenarios, 2030 36
Table 4: Factors to consider for the resource revenue management framework 39
Table 5: Evolution of Economic Zones 50
Table 6: The four do’s and four don’ts of SEZs 51
Table 6: Share of ownership (equities and bonds), 2021 97
Tabla 7: Economic development in different scenarios, 2030 116
I
Acknowledgements
Bhutan Country Economic Memorandum
Acknowledgements
This report is a product of the Macroeconomics, Trade and Investment (MTI) Global Practice. The prepa-
ration was led by Melanie Trost, Rangeet Ghosh, and Florian Blum, Senior Economists in the MTI Global
Practice, with a core team comprising
Melanie Trost (author); Rishabh Sinha, Economist at the Development Economics Vice Presidency;
Lindsay Shutes, Arndt Feuerbacher, Scott McDonald, Tony Addison, Amir Lebdioui, Pavel Bilek. Tan Sri
Azman Mokhtar, Federico Ganz, and Zi Cheng Kok — Consultants in the MTI Global Practice (Chapter 1:
Hydropower Revenue Management for Economic Diversification).
Florian Blum, Senior Economist in the MTI Global Practice (author); Felipe Dizon, Senior Economist
in the Agriculture and Food Global Practice; Christine Heumesser, Senior Agriculture Economist in
the Agriculture and Food Global Practice; Saad Imtiaz, Consultant in the Agriculture and Food Global
Practice; Federico Ganz, Lindsay Shutes, Arndt Feuerbacher, and Scott McDonald – Consultants in the
MTI Global Practice; Jorge Alvar Beltrán, Riccardo Soldan, and Gianluca Franceschini from the Office of
Climate Change, Biodiversity and Environment of the Food and Agricultural Organization of the United
Nations (Chapter 2: Structural Transformation Through Agricultural Productivity).
Venkat Sreedhara, Financial Sector Specialist in the Finance, Competitiveness & Innovation (FCI) Global
Practice, and Rangeet Ghosh (authors); Dubthob Wangchug, Consultant in the FCI Global Practice
(Chapter 3: Bhutan’s Financial Sector: Issues and the Way Forward).
The report was prepared under the oversight of Hoon Soh, South Asia Region Practice Manager for
MTI and Public Sector, and Mathew Verghis, South Asia Regional Director in the Equitable Growth,
Finance and Institutions (EFI) Vice Presidency of the World Bank, in close collaboration with Abdoulaye
Seck, World Bank Country Director for Bangladesh and Bhutan; Adama Coulibaly, World Bank Resident
Representative for Bhutan; and Souleymane Coulibaly, Lead Country Economist and Program Leader
in the EFI Vice Presidency.
The team is grateful for the useful comments and suggestions on earlier drafts provided by Jumana
Alaref, Senior Economist at the Social Protection & Labor Global Practice; Amer Ahmed, Lead Economist
and Program Manager in the Human Development Vice Presidency; Michel Mallberg, Senior Public
Sector Specialist, MTI and Public Sector; Fanny Missfeldt-Ringius, Lead Energy Specialist in the Energy
& Extractives (EEX) Global Practice; Dzenan Malovic, Senior Energy Specialist in the EEX Global Practice;
Joachim Vandercasteelen, Economist in the Agriculture and Food Global Practice; Alexander Pankov,
Lead Financial Sector Specialist in the FCI Global Practice; and Sadia Afrin, Financial Sector Specialist
in the FCI Global Practice.
Zi Cheng Kok, Consultant in the MTI Global Practice, provided support to the overall report. Tshering
Yangki, ET Consultant in the Bhutan Country Unit, and Dorji Drakpa, Team Assistant in the Bhutan Country
Unit, provided valuable administrative support.
The peer reviewers are Marek Hanusch, Lead Economist and Program Leader in the MTI Global Practice,
and Emilija Timmis, Senior Economist in the MTI Global Practice.
x
Abbreviations and Acronyms
Bhutan Country Economic Memorandum
Abbreviations and Acronyms
AED Agriculture Engineering Division CSI Cottage and Small Industry
ATM Automated Teller Machine DD Dutch Disease
B2B Business to Business DEA Data Envelopment Analysis
BAU Business-As-Usual DGPC Druk Green Power Corporation
BCC Bhutan Care Credit DHI Druk Holding and Investments
BDB Bhutan Development Bank ECB External Commercial Borrowing
BESF Bhutan Economic Stabilization Fund EEC Eastern Economic Corridor
BIG Basic Income Grant EPZ Export Processing Zone
BIL Bhutan Insurance Limited ESG Environmental, Social, and Governance
BLFS Bhutan Labour Force Survey ESSF Economic and Social Stability Fund
BNB Bhutan National Bank EVI Environmental Vulnerability Index
BoB Bank of Bhutan EWI Early Warning Indicator
BRER Bilateral Real Exchange Rate FAO Food and Agriculture Organiza-
tion of the United Nations
BTN Bhutanese Ngultrum
FDI Foreign Direct Investment
C4CS Committee 4 Coordinating Secretaries
FI Financial Institution
CAD Current Account Deficit
FINAP Financial Inclusion National Action Plan
CAR Capital Adequacy Ratio
FYP Five-Year Plan
CBDC Central Bank Digital Currency
G2C Government to Citizens
CCDL Dungsam Cement Company Limited
GDP Gross Domestic Product
CCDR Country Climate and Devel-
opment Report GHG Greenhouse Gas
CDCL Construction Development GLC Government-Linked Company
Corporation Limited GLOF Glacial Lake Outburst Flood
CDP United Nations Committee GNH Gross National Happiness
for Development Policy
GNHC Gross National Happiness Commission
CEM Country Economic Memorandum
GNI Gross National Income
CGE Computable General Equilibrium
GoI Government of India
CGRR Corporate Governance
GRI Global Reporting Initiative
Rules and Regulations
HAI Human Assets Index
CIAT International Center for Trop-
ical Agriculture HS Harmonized Classification
CIB Credit Information Bureau ICAAP Internal Capital Adequacy
Assessment Process
CIT Corporate Income Tax
ICMA International Capital Market Association
CMIP5 Coupled Model Inter-com-
parison Project Phase 5 IEU Investment Evaluation Unit
xi
Abbreviations and Acronyms
Bhutan Country Economic Memorandum
IFPRI International Food Policy OCASC Office of the Cabinet Affairs
Research Institute and Strategic Coordination
IFRS9 International Financial Report- ODA Official Development Assistance
ing Standard-9 P2P Peer to Peer
ILAAP Internal Liquidity Adequacy PCA Prompt Corrective Action
Assessment Process
PER Public Expenditure Review
IMF International Monetary Fund
PES Payment for Ecosystem Services
INR Indian Rupee
PHC Population and Housing Census
IPCC Intergovernmental Panel
PIM Public Investment Management
on Climate Change
PPP Public-Private Partnership
IPO Initial Public Offering
PRF Pension Reserve Fund
IT Information Technology
PSL Priority Sector Lending
JV Joint Venture
R&D Research and Development
KPI Key Performance Indicator
RGoB Royal Government of Bhutan
KRI Key Risk Indicator
RICB Royal Insurance Corporation of Bhutan
KWAN Kumpulan Wang Amanah Negara
RMA Royal Monetary Authority
LAYS Learning Adjusted Years of Schooling
RNR Renewable Natural Resources
LDC Least Developed Country
RoA Return on Assets
LLC Limited Liability Company
RSEB Royal Stock Exchange of Bhutan
LPI Logistics Performance Index
RTGS Real-Time Gross Settlements
MFI Microfinance Institutions
SAM Social Accounting Matrix
MoAF Ministry of Agriculture and Forests
SAR South Asia Region
MoESD Ministry of Education and
Skills Development SDF Sovereign Development Fund
MoICE Ministry of Industry Commerce SEZ Special Economic Zone
and Employment SME Small and Medium Enterprise
MSME Micro, Small, and Medium Enterprise SOE State-Owned Enterprise
MYR Malaysian Ringgit SOFI State-Owned Financial Institution
NAS Statistical National Accounts SWF Sovereign Wealth Fund
NBFI Non-Banking Financial Institution TFP Total Factor Productivity
NCGS National Credit Guarantee Scheme TVET Technical and Vocational
NCSI National CSI Development Bank Education and Training
NDB National Development Bank UAE United Arab Emirates
NGFS Network for Greening the UN United Nations
Financial System UNCTAD United Nations Conference on
NPL Non-Performing Loan Trade and Development
NPPF National Pension and Provident Fund WB World Bank
NRF National Resilience Fund WDI World Development Indicators
NSB National Statistics Bureau
xii
Bhutan Country Economic Memorandum
Executive
Summary
© Ipek Morel/Shutterstock
1
Executive Summary
Bhutan Country Economic Memorandum
Bhutan has made significant strides in diminishing poverty and advancing human development,
supported by strong economic growth and its unique development approach.
Bhutan’s economy is intricately linked to its geography, mountainous landscape, and its special relationship with
India. Situated deep in the eastern Himalayas, Bhutan is a small landlocked country that shares borders with India to the
south, east, and west, and with China to the north. Bhutan has capitalized on its mountainous topography and abundant
water resources to develop and export hydroelectric power, a sector that has grown since the mid-1980s with signifi-
cant support from the Government of India (GoI). Despite these advantages, Bhutan contends with high transportation
and trade costs that hinder access to international markets. The challenges of providing infrastructure and services are
amplified by its small population of around 800,000 and the difficulty in achieving economies of scale.
The country’s pursuit of Gross National Happiness (GNH) reflects a unique development strategy that prioritizes the
well-being of its citizens and the environment. This philosophy underpins a commitment to sustainable and equitable
socioeconomic growth. Bhutan’s environmental stewardship and sustainable development initiatives have earned it
recognition as a leader in climate change. With nearly half of its territory under protection to safeguard its rich biodiversity
and forest cover exceeding 70 percent, Bhutan stands out as one of the few nations with a negative carbon footprint.
Over the past two decades, the country has experienced high real GDP growth, averaging 7 percent from 2001 to
2019, supported by the hydropower sector. Hydropower plays a significant role in the economy, contributing for more
than a third of goods exports and domestic revenues, and constituting 16 percent of GDP in 2021.1 Since the inauguration
of the first large hydropower project in 1987 (Chhukha), Bhutan’s installed hydropower capacity has increased seven-
fold, reaching 2,326 MW. The Tala and Mangdechhu projects, commissioned in 2007 and 2019 respectively, are among
the largest projects (Figure 20). Notably, periods of high GDP growth have coincided with the commissioning of major
hydropower projects (Figure 1). However, the growth in the hydro sector was considerably higher from 2001 to 2008, at
21.6 percent, compared to a mere 0.4 percent between 2009 and 2019. (Figure 2).
Figure 1: Impact of hydropower on GDP Figure 2: Growth rates of hydropower and
(percent), 1985-2021 non-hydropower sectors (percent), 2001-2019
35 25.0
Chhukha (1987)
30
Tala (2007) 21.6%
25
20.0
20
Mangdechhu (2019)
15
10 15.0
5
0 9.3%
10.0
8.6%
-5
7.0% 6.9% 6.5% 7.2%
-10 5.8%
5.0
-15
-20
0.4%
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
0.0
2001-19 2001-08 2009-19
GDP growth GDP growth, excluding electricity and water
Total growth Hydro Non-hydro
Source: National Statistics Bureau. Source: Penn World Table, World Bank staff calculations.
1 This excludes the construction sector, which is partly hydropower construction. The agriculture sector accounts for 19 percent of GDP, the industry sector (including hydro) for 34
percent, and the service sector for 47 percent of GDP in 2021. Measures in current prices.
2
Executive Summary
Bhutan Country Economic Memorandum
Bhutan has achieved impressive gains in economic growth and reducing poverty over the past two decades. From
1980 to 2021, GDP per capita expanded at a relatively high rate of 6.3 percent annually. By 2021, Bhutan’s GNI per
capita reached US$3,040, bringing the country close to the World Bank’s threshold for upper-middle-income status.
Extreme poverty based on $2.15/day was eliminated by 2022, and the population living below the $6.85/day, poverty
line for upper-middle-income countries, decreased from 39.5 percent to 8.5 percent between 2017 and 2022, despite
the challenges posted by the COVID-19 pandemic, although Bhutan had one of the lowest infection rates in the South
Asia Region (SAR).2 The Gini index, which measures income inequality, declined from 37 in 2017 to 28 in 2022. Despite
these achivements, Bhutan still faces significant challenges related to vulnerability to poverty and spatial inequality.
The country has also made substantial progress in human development. Bhutan’s hydropower revenue has funded
significant improvements in education and healthcare, and access to basic utilities. The country has achieved nearly
universal primary school enrollment, increased literacy rates from 55.5 percent in 2005 to 70.6 percent in 2022,
achieved universal access to electricity since 2019, and attained nearly universal access to piped water by 2022. These
accomplishments are particularly notable given the logistical challenges posed by Bhutan’s topography and scattered
population, which make public service delivery more costly. However, issues persist in service quality and equitable
access, especially in higher education. 3
Despite these stellar achievements, structural transformation has been slow and job opportunities
have been limited, especially for the educated and youth.
The non-hydro economy is predominantly service-oriented, complemented by a narrow range of resource-intensive
manufacturing industries. Annual non-hydro sector growth averaged 6.9 percent from 2001 to 2019, driven by services
and non-hydro industry. The service sector, which constituted 47 percent of GDP in 2021, has been a key growth driver,
with public administration (including health and education), trade, transport, and the financial sector (including real
estate) contributing significantly. Since the beginning of tourism in 1974, Bhutan has strategically focused on attracting
high-value tourists to mitigate environmental impacts. The hotel and restaurant industry, excluding the pandemic year,
grew at an impressive average rate of 16 percent annually between 2001 and 2019. The non-hydro industry, accounting
for 19 percent of GDP, primarily comprises construction and manufacturing industries like ferro-alloy and ferro-silicon.
Agriculture accounted for 19 percent of GDP in 2021 and remains vital for nearly half the population, especially the rural
poor, who depend on it for their livelihoods.
Productivity gains have been limited, with labor predominantly employed in the low productivity agricultural and
public sectors. The share of agriculture in GDP has significantly declined, and the share of services has increased
from 37 to 50 percent. The contribution of the non-hydro industry sector, excluding electricity, has remained relatively
stable at about 25 percent before the COVID-19 pandemic. Despite the decreasing share of agriculture, the labor
force continues to be largely confined to the agricultural sector. In 2022, the labor market was mostly dominated by
low-productivity agricultural employment (40 percent), followed by the public sector (25 percent, including education
and health). Although more productive sectors like electricity, transport and communication, financial intermediation,
and mining, have experienced an increase in their share of total employment between 2013 and 2022, they still have
a relatively small presence in terms of employment. Sectors like construction have grown but have lower productivity
levels compared to smaller and slowly growing sectors.
Over-reliance on hydropower has hampered economic diversification and job creation. The hydropower sector has
contributed significantly to the economy, but its capital-intensive nature has provided limited employments opportunities,
employing less than 1 percent of the labor force. The reliance on foreign labor, as well as machinery and raw material
imports for hydropower projects, has led to minimal direct spillover effects on the non-hydro economy (Figure 4).4 But
with rising hydro investments since 2009, the spillover has contributed 2.1 percentage points to the 7.2 percent growth
2 Forthcoming World Bank Poverty and Equity Assessment.
3 WBG Country Partnership Framework (CPF) FY21-24 discussed by the Board on January 14, 2021 (Report No. 154927-BT); World Bank Bhutan Systematic Country Diagnosis (SCD),
2020.
4 To quantify the effect of hydro sector investments on the growth of the non-hydro sector, it is assumed that the hydro sector’s capital expenditures generate income in the
non-hydro sector through the supply of goods (e.g., construction materials) and services (e.g., labor used in construction). The incremental growth of the non-hydro sector is
then assessed by comparing its actual output against a counterfactual scenario where hydro sector investments are absent. See Annex 1 for more details on the calculation of
hydropower spillovers.
3
Executive Summary
Bhutan Country Economic Memorandum
Figure 3: Hydro and non-hydro sector growth Figure 4: Spillovers from hydro to non-hydro
decomposition (contribution to growth), sector, 2001-2019
2001-2019
12.0% 7.5%
9.3%
6.5% 1.1%
10.0%
2.1%
5.5%
8.0% 7.0%
6.9%
4.5%
6.0%
3.5% 6.9%
4.0% 5.8%
2.5% 5.1%
2.0%
1.5%
0.0% 0.5%
-2.0% Total Hydro Non-hydro -0.5% -0.3%
TFP Total growth Labor 2001-19 2001-08 2009-19
Capital Interaction Core Hydro spillover
Source: Growth accounting, World Bank staff calculations. Note: To assess spillovers from the hydro to non-hydro sector, the non-hydro
sector output is split into a core and hydro-driven part. See Annex 1 for more
details.
Figure 5: Bilateral real exchange rate with India Figure 6: Change in sectoral productivity and
(Index average 1980-2021 = 1), real power exports employment shares, 2013-2021
and real capital inflows from India, 1980-2021
1.4 Depreciation 6,000 3.0
2.5 Electricity/water
1.3 5,000
BRER (Nu/INR), index avg. 1980-2021 = 1
2.0
Financial interm
Log(Sector value added/ Sector employment), 2021
1.2
Nu. Millions in constant 1980 prices
Appreciation 1.5
4,000
Real estate/ Mining
1.1 1.0 bus service
3,000
0.5 Transport/info and comm
1.0 Construction
2,000 0.0
0.9 Public admin/ Whole/retail
-0.5 educ/ health
1,000
0.8 -1.0 Manufacturing
Agriculture
0 -1.5
0.7
-2.0
0.6 -1,000 Hotel/rest
-2.5
1983
1986
1989
1992
1995
1998
2013
1980
2016
2019
2001
2010
2007
2004
-50% 0% 50% 100% 150%
Power exports Net capital flows, India BRER (Nu/INR) Change in employment share, percent, 2013-2021
Source: National Statistics Bureau and World Bank staff calculations. Source: National Statistics Bureau and World Bank staff calculations.
Note: The size of each circle reflects sector employment in 2021. Productivity is
measured as the sector-level value-added, per worker in 2021.
recorded by the non-hydro sector in the second period. Growth in the non-hydro sector has been driven by both capital
and labor inputs, but contributions from productivity improvements have been limited. Human capital has been the
dominant growth driver, though its contribution has declined over time. Changes in labor force participation have had a
minimal impact on non-hydro sector growth. The private sector remains relatively small, with jobs concentrated primarily
in agriculture, followed by the public sector (Figure 6).5
5 Agriculture accounted for 43 percent of employment in 2022, followed by services (41 percent), and the industry sector (15 percent).
4
Executive Summary
Bhutan Country Economic Memorandum
Large foreign currency inflows during the construction and export phase of hydropower projects caused the real
exchange rate to appreciate, negatively impacting the competitiveness of the non-hydro sector (Figure 5). This
phenomenon, known as the Dutch Disease, is similar to the effects observed in resource-rich economies. While hydro
exports generally avoid certain oil-related symptoms (i.e., shocks after resource depletion, volatile tariffs, and compe-
tition for a fixed amount of resources), the expansion of hydropower production in Bhutan shares characteristics with
the discovery of fossil reserves since it involves large inflows of foreign currency. In Bhutan, the output of the tradable
sector, including agriculture, mining, and manufacturing, has remained below the non-tradable sector and the booming
electricity sector. Growth in non-hydro exports has been driven by mineral products such as boulders and base metals,
while other exports have shown limited progress, indicating a lack of economic diversification. This suggests that hydro-
power exports and hydro-related capital inflows may have impeded the growth of the lagging tradable sector relative
to the non-tradable sector.
There is significant scope for the private sector, which is largely comprised of low-productivity
microenterprises, to diversify and grow.
To diversify beyond hydropower and generate employment, Bhutan has promoted a development strategy that
emphasizes environmental sustainability, with a focus on major investment projects through state-owned enterprises
(SOEs). The Government has attempted to promote economic diversification through various initiatives that support
sustainable growth in sectors such as organic farming, green industry and manufacturing, and sustainable tourism. SOEs
have played a significant role in providing critical infrastructure services and developing strategic sectors to support
economic diversification. More recently, the state holding company Druk Holding and Investments (DHI) has made a
substantial national investment in cryptocurrency mining to accelerate digital transformation and create new revenue
streams. Furthermore, Bhutan has launched an ambitious initiative, the Gelephu Mindfulness City project, aimed at
transforming the southern city Gelephu into a Special Administrative Region that emphasizes ‘mindfulness’, mirroring
the unique Bhutanese identity and fostering the establishment of conscious and sustainable businesses that are in line
with the values of GNH.
In contrast to the SOE sector, the private sector has remained small and is largely comprised of low-productivity
microenterprises, with limited dynamism, diversification, and productive job opportunities. In 2022, only 2.7 percent of
firms were new, indicating a lack of entrepreneurial activity. Very small firms tend to remain small, likely due to restrictions
on growth, and inefficient firms do not exit. Between 2018 and 2022, firms became older and smaller, with the share of
long-established firms increasing from 24 percent to 26 percent, and the share of cottage firms rising from 89 percent
to 96 percent.6 Most firms (nearly 97 percent) are owned as individual proprietorships. In terms of employment, the
average number of workers hired by firms decreased from 1.1 in 2019 to 0.7 in 2020 and 2021, indicating declining job
opportunities in the private sector. Wholesale and retail trade, and accommodation and food services sectors account
for nearly 80 percent of firms, indicating a lack of economic diversification.
Compared to the public sector, the private sector employs more low- and middle-paying occupations, leading to
fewer employment opportunities and high unemployment for the educated workforce. Private employment is most
prevalent in construction (60 percent), administrative and support service activities (60 percent), and arts, entertainment,
recreation and other service activities (66 percent). Most employed workers are in low to mid-skilled positions, creating
relatively few opportunities for educated job seekers. In 2022, approximately 58 percent (24 percent) of job seekers
held a secondary degree (university degree), compared to 29 percent (9.5 percent) of employed workers, indicating an
oversupply. As a result, unemployment rates are high for individuals with a secondary diploma (11.5 percent in 2022) and a
tertiary diploma (11.8 percent in 2022). The lack of productive jobs that offer competitive wages for educated individuals is
likely contributing to emigration, especially among the most skilled workers, including those employed in the public sector.
6 The Ministry of Industry, Commerce and Employment defines cottage-scale industries as those industries, whose initial fixed capital investment is less than Nu1 million and employ
up to 4 people.
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Executive Summary
Bhutan Country Economic Memorandum
The COVID-19 pandemic and the global impact of geopolitical crisis have disrupted Bhutan’s growth
trajectory and exacerbated structural challenges.
The pandemic highlighted the country’s vulnerability to external shocks and structural challenges. The COVID-19
pandemic had a significant impact on Bhutan’s economy, causing a contraction of 2.5 and 3.3 percent in FY19/20 (June
2019 to July 2020) and FY20/21.7 The hydropower sector experienced positive growth, due to the commissioning of
the Mangdechhu hydropower plant in 2019, but the non-hydro industry and services sectors were adversely affected.
Disruptions in supply chains, shortages of foreign labor, and a decline in tourism-related activities led to a contraction of
7.8 and 5.9 percent in industry in FY19/20 and FY20/21, respectively, and 1.2 percent in the services sector in FY20/21.
Despite these challenges, Bhutan has graduated from the United Nations’ (UN) Least Developed Country (LDC) status
in 2023. However, it did not meet the LDC graduation threshold for economic and environmental vulnerability.
Unemployment has surged since the COVID-19 pandemic, and emigration has increased. Unemployment rates in
Bhutan rose from an average of 2.8 percent between 2015 and 2019, to 5.9 percent in 2022, with urban areas, and
particularly young and educated individuals, experiencing the highest increase (Figure 7).8 According to media reports, the
average number of Bhutanese emigrating increased significantly with the reopening of the borders in mid-2022, to more
than 5,000 per month in early 2023 compared to less than 500 per month before the pandemic (Figure 8).9 Various factors
may have contributed to the surge in emigration, including push factors such as limited job opportunities. Vacancies in
the civil service, the biggest employer in Bhutan, have also been increasing in recent years. Pull factors, including relaxed
visa restrictions by Australia to address its labor market challenges and social pressure to follow successful migrants,
may have also played a role. This has raised concerns about brain drain, which can hinder economic diversification and
export sophistication, which require skilled human capital for knowledge-intensive activities.
Figure 7: Unemployment rate (percent), Figure 8: Monthly migration, Paro International
2010-2022 Airport, Jan 2015 – Mar 2023
40 6,000
5,500
35
5,000
30 28.6 4,500
4,000
25 22.6
No. of people
20.9 3,500
20 3,000
15.7 2,500
15 13.2 12.3 11.9
10.7 2,000
10 1,500
5.0 5.9
4.8 1,000
5 3.1 3.4 2.7
2.5 2.1 500
0 0
2015 2016 2017 2018 2019 2020 2021 2022
Jan-20
Jan-22
Jan-23
Jan-15
Jan-16
Jan-18
Jan-19
Jan-21
Jan-17
Jul-20
Jul-22
Jul-15
Jul-16
Jul-18
Jul-19
Jul-21
Jul-17
Youth, urban Youth, total National, total
Source: National Statistics Bureau. Source: Kuensel (May 20, 2023).
Macroeconomic vulnerabilities have increased amid the pandemic due to a significant deterioration of the external
balance and international reserves. Macro-fiscal sustainability was maintained over the past two decades because of
large hydro revenues and external grants. However, increased spending to fund the COVID-19 relief measures for indi-
viduals and businesses, coupled with subdued revenue performance, resulted in high fiscal deficits and rapid non-hydro
7 The fiscal year runs from June to July.
8 Unemployment is significantly higher among youth (28.6 percent), educated workers (11.5 and 11.8 percent for workers with a secondary and tertiary diploma, respectively), in
urban areas (10.4 percent compared to 3.4 percent in rural areas), and among females (7.9 percent compared to 4.4 percent for males).
9 Migration is assumed for Bhutanese who exited but have not reentered the country. Data is restricted to Paro Airport and does not include other land exits. See https://kuensel-
online.com/migration-of-bhutanese/
6
Executive Summary
Bhutan Country Economic Memorandum
public debt since FY20/21, with limited fiscal space to absorb additional shocks. Vulnerabilities in the financial sector,
with high levels of non-performing loans (NPL), have increased fiscal risks, given that about 60 percent of assets of
the financial sector are controlled by the public sector.10 The national investment in cryptocurrency mining operations
resulted in a significant decline in international reserves in FY21/22 and a widening of the current account deficit (CAD)
due to imports of information technology (IT) equipment and related goods for cryptocurrency mining. While the reserve
decline is set to be partially replenished through coupon payments, the reserve level remains low
Bhutan faces high vulnerability to natural hazards and climate change, necessitating a focus on adaptation and resil-
ience. Climate change poses significant risk to Bhutan’s development, with potentially significant impacts on the economy
and people. The rugged terrain and unique climatic conditions of the Himalayas contribute to challenges such as flash
floods, glacial lake outburst floods (GLOFs), landslides, forest fires, and windstorms. Climate models predict rising tempera-
tures, irregular precipitation patterns, and more frequent extreme weather events. These factors pose significant risks
to the economy, natural resources, and people. However, Bhutan has opportunities to leverage its leadership on climate
change and net-zero carbon status. Building on the CEM, the World Bank will prepare a Country Climate and Development
Report (CCDR), which will analyze the country’s development and climate change challenges and opportunities in an inte-
grated manner. It will identify trade-offs, such as maintaining carbon negativity while promoting growth and job creation,
by promoting, for example, climate financing, supporting a just transition for people, and enhancing institutional capacity.
The current growth model is not sustainable.
Bhutan expects to double its hydropower capacity over the next decade, which is expected to have significant effects
on the economy. Estimates using a Computable General Equilibrium (CGE) model (“the business-as-usual (BAU) scenario”)
indicate that the anticipated doubling of the hydropower generation capacity is expected to result in higher growth.
However, in keeping with past experience, this growth will not be accompanied by a diversification of the economy.
The economy is expected to shift towards electricity and closely related sectors. The appreciation of the real exchange
rate is expected to reduce output in non-hydro tradable sectors, especially tourism-related exports. This suggests that
there is scope to strengthen the Government’s current approach for managing and distributing hydropower revenues
to support the development of non-hydro sectors and address the negative effects of the Dutch Disease.
The availability of hydropower rents provides the Government with an opportunity to actively support non-hydro
productivity growth and generate employment. The CEM identifies three key areas that require urgent policy focus for
achieving more robust and broad-based growth and creating more and better jobs while bolstering climate resilience:
(I) facilitating economic diversification, (II) enhancing agricultural productivity and crop diversification, and (III) reforming
the financial sector to support economic diversification.
I. Facilitating economic diversification to expand beyond the hydropower and agriculture sectors.
Economic diversification is crucial to increase resilience and generate more and higher quality jobs within the economy.
Greater economic and export diversification is associated with lower growth volatility and higher long-term average growth
in smaller economies such as Bhutan. 11 Bhutan is especially vulnerable to shocks because of its trade openness, economic
concentration, and susceptibility to natural disasters and climate change. By diversifying its economy, Bhutan can reduce
its dependence on the hydropower sector and generate more employment opportunities, making the economy and its
people more resilient to shocks.
Effective management of hydropower rents is crucial in preventing the adverse effects of Dutch Disease and in
supporting economic diversification. The allocation of these resource rents can take various forms: (i) they can be used
to boost domestic consumption through public or private spending, such as citizen dividends or subsidies; (ii) they can
be saved in financial assets, either domestically or abroad, to smoothen expenditure of natural resources or act as a
buffer for future generations, thereby mitigating Dutch Disease-type effects (for instance, through a fiscal stabilization or
10 The financial sector is dominated by SOEs, which at end-2020 accounted for 60 percent of the assets of the banking system and 51 percent of the assets of the non-banking
financial institutions (NBFIs), including the pension fund. This includes assets of financial institutions where the RGoB has 50 percent of shares or more. The assets are weighted
with the RGoB’s share in the companies.
11 World Bank. 2023a. “Global Economic Prospects”. January 2023. World Bank, Washington, D.C:
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Executive Summary
Bhutan Country Economic Memorandum
sovereign wealth fund); or (iii) they can be invested in tangible assets to stimulate the public or private sectors by means
of subsidized credits, production or export subsidies, The latter can also counter Dutch Disease-type effects by promot-
ing economic diversification into new sectors and industries. This Report highlights economy-wide and sector-specific
policies as well as complementary institutional reforms that can lead to greater diversification. International payments
for ecological services, high-value tradable services, eco-tourism, high-value IT services are identified as some of the
sectors that can contribute to sustainable diversification of the Bhutanese economy.
Bhutan’s high resource dependence, low per capita resource rents, and domestic investment shortfall underscore the
necessity of utilizing hydropower resources to invest in economic diversification. Natural resource management should
consider various factors, such as the extent of resource dependence, per capita resource rent levels, domestic investment
rates, and deficits. Notable trade-offs exist, particularly the high opportunity cost associated with excessive investment in stabi-
lization funds at the expense of social spending and domestic productive capacity development. Fiscal savings in stabilization
funds, typically held as liquid financial assets abroad, come at a significant opportunity cost, as these funds are not available for
domestic investment in productive capabilities that could promote economic diversification. Bhutan’s reliance on hydropower
is substantial, yet its per capita hydro resource rents are modest at US$400, in contrast to the higher rents of resource-rich
nations like Norway and the UAE. Bhutan also faces considerable investment needs in essential social and infrastructure sectors.
In order to promote diversification, Bhutan could allocate more of its resource rents towards long-term investments. Currently,
the majority (54 percent) of domestic revenues, 40 percent of which comes from hydropower, is consumed by public spending
on wages, goods and services, rather than financing investments. Private spending accounted for 18 percent and was directed
to social transfers, including allowances and contributions to the National Provident Fund. A minimal amount (0.2 percent) is
allocated to fiscal stabilization, which is insufficient to cushion the volatility of hydro revenues and public expenditure during down-
turns. The remaining domestic revenues (28 percent) have been allocated towards investments. With Bhutan’s capital spending
largely supported by external grants and the anticipated decline in Official Development Assistance following its graduation
from the LDC status, it is crucial to reallocate domestic resources, including resource rents, towards capital investments. Such
strategic public investment can enhance productivity in non-resource tradable sectors and mitigate the effects of Dutch Disease.
Figure 9: Pathways for managing resource revenues
Bhutan's current model of Scenario 2: expanded Scenario 3: spending on Scenario 4: transfers to
investment of hydro rents government expenditures human and physical capital citizens through BIG
Resource revenues
Investment Consumption
Real assets Financial assets
Public Private spending
spending
Abroad Domestically Domestically Abroad
Bhutan:
Goods and Untargeted Targeted
services, spending spending
Public sector Private sector Safe assets High yielding interest,
Bhutan: assets transfers, Citizen Bhutan:
Investments of wages dividend, Current
the Bhutan schemes, nota transfers to
General Sector- specific applicable to individuals,
Economic
capabilities capabilities Bhutan contributio ns
General Sector- specific Stabilization
capabilities capabilities Fund (BESF) to national
Bhutan: Bank Conditional provident
lending, support upon fund,
Bhutan: Bhutan:
subsidized certain allowances
Infrastructure, Investments to
credit, Bhutan activities
human capital promote the non-
Development
spending hydro tradable
Bank
sector, SOE sector
Economic diversification Fiscal stabilization
Source: Adaptation from Chang, H. J., and Lebdioui, A. 2020.12
12 Chang, H. J., and Lebdioui, A. 2020. “From Fiscal Stabilization to Economic Diversification: A Developmental Approach to Managing Resource Revenues”. WIDER Working Paper
2020/108. UNU-WIDER. Helsinki, Finland.
8
Executive Summary
Bhutan Country Economic Memorandum
Furthermore, to enhance fiscal stabilization, it is necessary to reserve more hydropower resources. As indicated in
the Bhutan Public Expenditure Review (PER), Bhutan’s government spending is among the most procyclical compared
to its peers, largely due to the fluctuating nature of hydropower revenues. Allocating a portion of the resource rent to the
Bhutan Economic Stabilization Fund (BESF) could help stabilize these volatile hydro revenues and public expenditures
in the face of negative shocks. This would mitigate the need for spending reductions during economic downturns that
could exacerbate the growth decline, particularly in areas such as infrastructure and human capital investment.
Channeling additional hydropower revenues to improve physical and human capital can result in higher growth
and diversification compared to the business-as-usual (BAU) scenario. Estimates from the CGE model indicate that
channeling additional hydropower revenues into physical and human capital leads to labor productivity improvements
and enhances capital accumulation.13 Under the physical and human capital scenario, the economy becomes more
diversified, as shown by a lower economic concentration index compared to the BAU scenario (Table 1). The industrial
and construction sectors, which rely heavily on labor, are estimated to benefit the most in terms of value-added. More-
over, all sectors experience higher growth due to the direct impact on factors of production and the indirect effect of
increased household spending. As a result, all households benefit from these investments, with higher consumption
growth compared to the BAU scenario. On the other hand, distributing additional hydropower revenues directly to house-
holds through fiscal transfers, such as through a Basic Income Grant (BIG), is estimated to result in greater economic
diversification (reflected by a smaller economic concentration index) but at the cost of slower growth. However, such a
fiscal transfer program may be easier to implement but may not guarantee the necessary investments for diversification
in case such transfers are channeled to consumption.
Table 1: Economic development in different scenarios, 2030
2019 Scenario 1: No Hydro-led Scenario 3: Scenario 4:
hydro scenario 2: Physical and BIG
BAU human capital
GDP 180.9 260.8 280.6 293.3 277.1
Domestic Absorption 205.2 292.8 271.3 292.7 264.1
Savings 69.2 98.2 98.2 107.8 98.2
Hydro production (real) 20.2 23.5 44.7 45.6 45.1
Non-hydro production (real) 257.0 354.6 331.3 350.3 334.4
Economic concentration index 623.0 685.8 725.6 722.2 719.5
Government consumption 32.6 47.7 56.1 50 34.7
Household consumption per-capita (in thousands of Nu) 129.8 184.5 147.3 169.8 165.3
Source: Shutes, Feuerbacher, and McDonald. 2022. CEM Background Paper. Note: All figures in Nu billions unless otherwise indicated. Please note that estimates are
indicative and should not be interpreted as actual growth estimates.
Investments in physical and human capital may not be sufficient to ensure economic diversification. Bhutan faces
inherent structural challenges such as being landlocked, having a small labor force, and a small domestic market. High
fixed costs for establishing and operating businesses, along with labor market rigidities, hinder competitiveness and
typically discourage diversification efforts in smaller economies.14 For instance, the small labor force hampers Bhutan’s
ability to engage in labor-intensive manufacturing that generally requires a larger workforce, and the small domestic
market limits economies of scale. Such economies can significantly benefit from harnessing external (global) demand,
13 Compared to the BAU scenario, additional hydropower rents are redirected from general government spending towards investments in human and physical capital. A stylized
approach is taken in which additional revenues are split equally between spending on training, resulting in labor productivity improvements, and spending on capital investments
via government savings. The CGE scenarios are indicative and aim to demonstrate broad trends and trade-offs.
14 World Bank. 2023a. “Global Economic Prospects”. January 2023. World Bank., Washington, D.C.
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Bhutan Country Economic Memorandum
given the limited scale of internal (domestic) demand. The non-hydro sector also suffers from the effects of the appre-
ciation in the real exchange rate, which further undermines its competitiveness. Although they are critical, conventional
policies such as macro stability, trade openness, investments in physical and human capital, and a favorable business
environment can be insufficient to ensure economic diversification. Given the early stage of development of the private
sector, sector specific policy interventions will be required to achieve this objective.
Bhutan has implemented sector-specific policies to facilitate economic diversification, but the measures have had
limited success in stimulating export diversification and creating new job opportunities. Notable policy measures
have included reliance on SOEs in competitive sectors, tax incentives, directed lending, skills development programs,
and the establishment of special economic zones (SEZs). However, profitability of SOEs is lower in competitive sectors
such as manufacturing, retail, and transport in comparison to non-competitive sectors. Fiscal incentives have primarily
favored medium and large businesses in manufacturing, finance, and tourism. Directed lending programs targeting the
agriculture and Cottage and Small Industries (CSI) sectors have contributed to high NPLs, while limited credit availability
remains a significant constraint to their development.
Sector-specific policies have been implemented in many countries as part of their growth strategies, but there
are many examples of failed and ineffective policies. Governance failures, including state capture by rent-seeking
interests and short-term electoral considerations, can result in suboptimal outcomes. In order to mitigate these risks, it
is crucial to establish strong institutional mechanisms that incentivizes beneficiaries to engage in market competition
with clear performance criteria for selective interventions. Policy support could focus on export promotion to leverage
international competition and target sectors instead of specific firms for the policy support. Additionally, independent
and appropriately qualified experts in the selection of projects that qualify for public support can further enhance the
effectiveness of these policies.15
The hydropower sector could be developed further, given untapped potential and opportunities in the regional
electricity market in South Asia. Establishing stronger backward linkages with the hydro sector, for instance through
enhancing domestic capabilities for hydropower maintenance and engineering, could lead to greater spillovers to the
non-hydro sector. This, in turn, could stimulate demand for goods, services, and labor from various sectors. The forth-
coming Bhutan CCDR will assess the impact of climate change on hydropower assets and electricity generation, the
potential to expand hydropower, options for the end-use of the additional generation capacity (domestic consumption
or export), and quantify investment needs and financing options, including from the private sector.
Policies that create a conducive environment for the development of the non-hydropower sector will be key to sustain
future growth. Over the past two decades, productivity growth in the non-hydropower sector has been relatively weak.
Policies that strengthened macroeconomic stability, improve institutions and business environment, facilitate flexible
and efficient labor market regulations, reduce barriers to trade, and investments in infrastructure and human capital,
remain critical for promoting continued growth in the non-hydro sector.
⊲ The capacity and performance of SOEs could be improved given their significant role in the economy. SOEs in the
electricity sector have consistently reported profits, but the performance of SOEs in other sectors has been mixed.
The 2023 Public Expenditure Review (PER) recommends strengthening SOE oversight and corporate governance
by implementing a more centralized ownership model with clear reporting lines and responsibilities.16 Additionally,
it suggests reviewing the current Annual Performance Compacts system and performance-based compensation of
Druk Holding and Investments (DHI) and MoF to improve performance management. Promoting the professionaliza-
tion and diversification of SOE Boards and enhancing SOE investment management are also crucial steps towards
improving the overall performance of SOEs.
15 See, for instance Cherif, R. et al. 2022. “Industrial Policy for Growth and Diversification: A Conceptual Framework”. IMF, Washington D.C., and Cherif, R. and Hasanov, F. 2019.
“The Return of the Policy That Shall Not Be Named: Principles of Industrial Policy”. IMF, Washington D.C. and Cherif, R. et al. 2022. Industrial Policy for Growth and diversification:
a conceptual framework. Washington DC: IMF.
16 The current SOE ownership model current ownership model has multiple actors and is complex. MoF, in addition to holding shares in socially oriented SEs, holds shares directly
and indirectly in commercially oriented companies, including companies where DHI holds shares.
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Bhutan Country Economic Memorandum
⊲ The efficiency of public expenditure in health and education could be improved. Bhutan spends more than
its peers on education and health, but there is room for efficiency gains in both sectors. According to the 2023
Bhutan PER, the country ranks 68th out of 131 countries in education expenditure per school-age child, and 86th
based on learning adjusted years of schooling. Bhutan is facing a relatively low efficiency level for education
spending compared to other middle-income countries. In health, Bhutan’s per capita spending in purchasing
power parity terms is significantly higher than its regional peers and countries in a similar income group. A
stochastic frontier analysis suggests that Bhutan’s health expenditure is relatively efficient, but it could still
achieve the same health outcomes with 6 to 9 percent less spending it matched the most efficient countries in
the sample.
⊲ Upskilling policies, including vocational training and more demand-driven Technical and Vocational Education
and Training (TVET) programs could help integrate the youth and low-skilled individuals (particularly women)
into the labor market and emerging industries. Strengthening the linkages between public TVET institutions and
the labor market is crucial, as highlighted in the World Bank Labor Market Assessment Report. Reforms in the labor
market, including labor regulations that facilitate job switching, a functional Labor Market Information System (LMIS)
to identify available skills, and skill-related policies to enhance managerial practices and soft skills, can support
workers’ mobility and firms’ access to labor. Additionally, on-the-job assistance can be provided to self-employed
and family workers with low education levels, helping them find wage employment opportunities in different
regions. Employment service centers under the Ministry of Industry Commerce and Employment (MoICE) can play
a significant role in facilitating these efforts.
⊲ Strengthening the Public Investment Management (PIM) system can help expand high quality infrastructure
services and crowd in private investments. The contribution of physical capital to non-hydro sector growth has
declined over the recent decade. Bhutan has one of the highest levels of public capital spending as a percent of
GDP (excluding hydro investments) in the world, but there are significant investment deficits, including in infrastruc-
ture. The quality of infrastructure remains below many comparator countries.17 A recent diagnostic assessment
of the PIM system highlighted that Bhutan has not yet established a fully operational PIM system that aligns with
international standards.18
Sector-specific policies could support diversification, provided they are targeted, transparent and minimize budget-
ary costs. Given the critical role of human capital in economic diversification, and to avoid further brain drain, several
initiatives could be implemented in the short term as outlined below.
⊲ Bhutan could create strategic partnerships with universities to establish tailored executive programs to meet
specific needs in the Bhutanese context. Strategic partnerships with universities can provide the Government with
more leverage over the training content, aligning it with the national objectives and reducing the dependence on
foreign technical assistance. Such programs have been critical for the development of competitive sectors across
the globe, for instance, the fruit sector in Chile through the Chile and University of California Program.19
⊲ The skills of non-resident Bhutanese could be leveraged for the transfer of learning, technology, and social
capital back to Bhutan. The Government could liaise with non-resident Bhutanese to explore channels through
which they can contribute to the emergence of new activities. For example, Malaysia established TalentCorp in 2011
to attract talent back from abroad and bring in foreign talent to address the shortage of technical skills in science
and ICT (Mukherjee et al., 2011).
⊲ The existing incubation and acceleration centers could be strengthened to promote entrepreneurship
and innovation. These centers have the mandate to drive economic growth and create job opportunities for
educated workers. However, they currently face funding uncertainties. Improving the quality of their services,
17 WB. 2023b. “Bhutan Public Expenditure Review.” WB, Washington, DC.
18 RGoB. Ministry of Finance. 2021. Strategic Diagnostic Assessment of the Public Investment Management System in Bhutan.
19 In Chile, to remedy the absence of adequate human capital, which was for a long time the obstacle for the development of the fruit sector, an exchange program was established
in 1965 with the University of California, which sent more than 80 Chilean graduate students to study agricultural economics in California to learn how to cultivate and export
fresh fruits in Chile. This appears to have been an extremely successful and impactful grant considering the growth of the sector during the following decades (Bravo-Ortega and
Eterovic, 2015).
11
Executive Summary
Bhutan Country Economic Memorandum
including access to financing, market validation, business plan development, research and development support,
mentorship, and connections to supply chains and markets are critical for effective promotion of entrepreneur-
ship and innovation.
The Government could strengthen the institutions for designing and implementing sector-specific policies.
⊲ A new fiscal strategy outlining a long-term vision could introduce a minimum share of reinvestment of hydro-
power rents to support economic diversification away from the overreliance on the hydropower sector. In parallel,
the Bhutan Economic Stabilization Fund (BESF) and the fiscal stabilization measures that regulate contributions to
and uses of the BESF could be operationalized to smooth volatile hydro revenues and public spending. One option
could be to apply the Hartwick rule, which suggests that the value of (net) investment needs equal the value of rents
on extracted resources at each point in time.20
⊲ Given the importance of effectively allocating resources, concentrating resources on a select few development
finance institutions and initiatives can be beneficial. Public development finance institutions can bring in private
and foreign investments, but they require adequate managerial and regulatory capacity. Bhutan has various institu-
tions such as the Bhutan Development Bank (BDB), DHI, the Bank of Bhutan (BoB), and the BESF. The government
could consolidate the total number of these institutions, while broadening the scope of select entities to invest
hydropower rents in productivity-enhancing assets. One option to channel hydropower revenues into domestic
investments for export diversification is to broaden the mandate of DHI from a holding company to a development
fund, in line with the experience of Khazanah in Malaysia. Alternative options include an expansion of the mandate
of the Bank of Bhutan (BoB) to include development banking, increasing the capacity of the BDB, which is currently
engaged in providing loans to Small and Medium Enterprises (SMEs) in the agriculture sector, and reorienting BESF
into a development fund.
⊲ Irrespective of the institutional setup, improving the ability to appraise, monitor, and evaluate investments is
essential for the success of utilizing hydropower revenues for productive diversification. The establishment
of an autonomous and technically equipped public Investment Evaluation Unit (IEU) is key to supporting the
development of strong analytical capacity to evaluate development projects and policies. The existence of a
strong IEU could send a market signal to potential investors regarding the quality of economic management.
The IEU could evaluate the existing sector-specific policies to determine whether they are sufficiently targeted,
transparent and minimize budgetary costs (and risks). When considering new policies and projects, emphasis
could be placed on identifying those with the greatest potential returns and manageable financial, environmental
and social risks.
II. Enhancing agricultural productivity and crop diversification to “push” workers out of agriculture
Bhutan’s agricultural sector has undergone a significant transformation in recent decades. This shift, occurring across
three dimensions (macro, spatial, sectoral), is driving the specialization of the agriculture sector.
a. On a macro level, the contribution of agricultural to total output has started to decline but the decline in agricultural
employment has been much smaller. The movement of labor from agriculture to other sectors has been slow.
Between 2005 and 2017, the share of agricultural labor only decreased by 1 percentage point.
b. However, there are variations in the pace of structural transformation across different geographic areas. At a spatial
level, Bhutan has witnessed a reallocation of workers from more to less agricultural areas, which has increased
agricultural labor shares in labor shedding areas. Areas close to India, urban centers, and regions connected to
urban centers and the Indian market through road infrastructure have experienced faster structural transformation.
This has led to a significant decline of the share of agricultural labor. Conversely, rural and mountainous areas,
20 The Hartwick Rule suggests that countries should invest resource rents into other types of assets, and that a constant level of consumption can be sustained if the value of
investment equals the value of rents on extracted resources at each point in time (Hartwick, 1977). Malaysia is one of the few countries that has followed the Hartwick rule. Other
countries that have established mechanisms similar to the Hartwick rule, aiming to invest resource rents into long-term assets include Norway (Pension Fund), or Botswana (Pula
Fund). See Hartwick, J.M. 1977. “Intergenerational Equity and the Investing of Rents from Exhaustible Resources.” American Economic Review, 66, 972-74.
12
Executive Summary
Bhutan Country Economic Memorandum
particularly in the Northwest of the country, have witnessed an increase in agricultural labor share. This spatial
polarization has resulted in economic activity being concentrated in urban and connected centers, while rural areas
remained focused on agriculture.
c. Within the agricultural sector, there has been a significant shift with a decrease in the production of traditional
crops like maize and paddy rice and increase in the growth of higher value-added products such as spices and
fruits. This shift has reoriented agriculture towards its export-oriented comparative advantage. Overall productivity
has remained stagnant but there are significant spatial heterogeneities.
Productivity growth of the agriculture sector has been significantly lower than in peer countries (Figure 11). The
process of specialization is still at an early stage, with agricultural productivity gaps remaining large and stemming
primarily from inadequate access to irrigation, crop damages, labor shortages, difficult transport and export logistics,
and challenging topography. Lack of adequate irrigation facilities leads to substantial reduction in yields for paddy rice
and maize. Estimates show that addressing issues related to irrigation could raise average yields for these crops by
about 6 percent each, and for cardamom by 11 percent. Protecting crops from damages could raise maize and paddy
yields by 15 and 9 percent, respectively. Removing the impact of labor shortages – for instance through the adoption of
labor-saving technology – could increase paddy, cardamom and areca nut yields significantly.
Closing agricultural productivity gaps would accelerate structural transformation. In the past, areas that have experi-
enced larger yield growth have also experienced declining agricultural labor shares, which suggests that yield increases
drive spatial specialization (Figure 12, Figure 13). This is consistent with the literature that highlights the importance of
labor-saving technologies in agriculture to free excess labor for non-agricultural enterprises (Figure 10). Estimates from
a spatially disaggregated CGE model calibrated to Bhutan corroborates this assessment. Simulations involving a 20
percent reduction in existing yield gaps through policies to improve the quality of agricultural capital (better machines)
and expand access to fertilizers and pesticides (more effective chemicals) and fuel (better quality fuels) would result in
agricultural wages increasing by less than low-skilled and unskilled wages, prompting households to seek employment
outside agriculture. This would reduce the supply of agricultural labor and increase the supply of unskilled and low-skilled
labor, which benefits both the service sector and households that switch sectors.
Figure 10: Agricultural productivity growth Figure 11: …Productivity growth in agriculture was
is key to facilitate a movement of labor into significantly lower than for peer countries.
non-primary sectors…
Agriculture value added per worker (1997=100)
8 300
7
Annual change in productivity, percent
Bhutan
6 250
5
4 200
3
2 150
1
0 100
-1
-2 50
-3
-5 -4 -3 -2 -1 0 1 2 3 4 5
Annual change in employment share, percent 0
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019
Agriculture Industry Services Bhutan Peru Paraguay Cambodia
Source: World Development Indicators. Source: World Development Indicators.
Note: The left-hand side figure presents average annual changes (in percent-
age points) for the period from 2000 to 2017 using the World Bank Group’s Job
Structure Tool.
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Executive Summary
Bhutan Country Economic Memorandum
Figure 12: Closing yield gaps by augmenting non-labor production inputs raises relative wages of
non-agricultural workers…
0.8%
0.6%
0.4%
0.2%
0.0%
-0.2%
-0.4%
-0.6%
-0.8%
HighSkilledLab
SemiSkilledLab
LowSkilledLab
UnskilledLab
C_AgriLab
C_Cropland
C_Pastureland
E_AgriLab
E_Cropland
E_Pastureland
SE_AgriLab
SE_Cropland
SE_Pastureland
SW_AgriLab
SW_Cropland
SW_Pastureland
W_AgriLab
W_Cropland
W_Pastureland
National Central East SouthEast SouthWest West
Labour Cropland Pastureland
Source: World Development Indicators.
Water supply is a critical constraint to agricultural Figure 13: …which induces a shift of labor
productivity and is likely to be exacerbated by climate out of agriculture and accelerates structural
change. Currently, inadequate water supply reduces transformation, especially in the southern part.
crop yields by 4 to 11 percent. While climate change may 1.0%
temporarily increase rainfed yields for traditional crops
like maize, it will also lead to increased rainfall variability
0.5%
in the medium term, highlighting the need for irrigation
infrastructure. However, climate change also presents
0.0%
an opportunity to specialize in higher value-added crops
such as vegetables, fruits, and spices, as favorable climatic
conditions will support their production and create export -0.5%
opportunities. To realize this potential in full, it is crucial to
consider the medium-term impacts of climate change and -1.0%
invest in irrigation infrastructure accordingly. Failure to do
so may delay necessary investments and hamper the agri-
-1.5%
cultural sector’s ability to specialize in higher value-added
products and capitalize on export opportunities.
-2.0%
National Central East SouthEast SouthWest West
The analysis leads to three principles that can guide agri-
cultural policy: Source: World Development Indicators.
d. As structural transformation progresses, agricultural
labor shortages will increase as people move towards
urban and connected centers. The goal of growth policy is to facilitate this movement while enabling investments
in technologies that compensate for the labor loss.
e. Avoiding investments into traditional rainfed crops with limited growth prospects is key to supporting the transition
towards Bhutan’s comparative advantages and to enable the country to benefit from crops that are likely to expe-
rience increasing yields with climate change in the longer run.
f. Investing and enabling private investment into irrigation is critical to increase yields, adapt to climate change and
enhance structural transformation.
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Executive Summary
Bhutan Country Economic Memorandum
Policy interventions could focus on promoting private investments, access to technology and production inputs, and
targeted assistance to farmers.
⊲ Attracting additional Foreign Direct Investment (FDI) to agriculture can help boost productivity growth. Foreign
Direct Investment provides the capital needed for investments and facilitates technology transfers that can help
agricultural producers make better use of their resources and land. Bhutan has made significant progress in the
liberalization of its FDI regime, but investment in the agriculture sector is still subject to minimum project cost and
a cap on foreign ownership, which precludes investment into smaller scale and niche farming operations with
potential for high growth. To attract more FDI, Bhutan could consider eliminating the foreign ownership cap and
reducing the minimum investment threshold. It could also consider providing free visas to prospective investors.
⊲ Marketing Bhutan’s unique global brand can help attract foreign investment and promote agricultural exports.
Branding Bhutanese agricultural products with the country’s focus on environmental conservation and sustainable
development can stimulate global demand and help attract investments. A dedicated investment promotion agency
can participate in international trade fairs, initiate marketing campaigns, and identify and approach prospective
investors.
⊲ Providing farmers with guidance and financial incentives to adopt sustainable land management practices is
crucial for increasing productivity and ensuring climate-resilient agricultural production. While temporary short-
term yield changes induced by climate change may encourage farmers to invest in traditional crops with limited
long-term profitability, it is important to promote the adoption of higher value-added crops such as vegetables, fruits,
and spices. These crops can benefit from favorable climatic conditions and create export opportunities. However,
transitioning to sustainable and climate-resilient practices may require upfront costs and changes in production
methods. To support farmers in overcoming this timing inconsistency, targeted support measures such as guaran-
tees for loans, matching grants, or direct, well-targeted subsidies can be implemented.
III. Financial sector reforms to support economic diversification and finance private non-hydro
investments
State Owned Financial Institutions (SOFIs) dominate the financial sector in Bhutan and the banking system is highly
concentrated. In 2020, SOFIs accounted for 60 percent of the banking system’s assets and 51 percent of the assets of
Non-Banking Financial Institutions (NBFIs), including the National Pension and Provident Fund (NPPF). The BoB, which
is mostly government-owned, is the largest bank in terms of asset size and deposits. It holds 44 and 48 percent of the
banking sector’s assets and deposits.
The allocation of credit in the economy remains skewed, with the majority directed towards ‘non-enterprises’. Prior to
the pandemic, the financial sector expanded to provide the necessary credit and financing for hydropower projects. Even
though there was a rapid increase in credit for the non-hydro sectors, it was not broad-based. The tourism and housing
sectors accounted for nearly 50 percent of the total credit in 2022. Conversely, the share of trade and manufacturing
sectors declined in recent years (Figure 14). Cottage firms, defined as firms that employ less than five workers, account
for more than 95 percent of firms but receive less than 10 percent of the total credit in the economy. The credit share
of small and medium firms declined significantly in recent years, while the share of non-enterprises, including housing,
transport, personal, employee loans, and education loans, increased to nearly 60 percent of total credit in 2023 (Figure
15). This is in line with the lack of economic diversification and the absence of a thriving private sector. Limited access
to finance is cited as one of the top constraints for small and medium-sized companies.
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Executive Summary
Bhutan Country Economic Memorandum
Figure 14: Sectoral composition of credit Figure 15: Credit composition by firm size
(percent of total), 2017, 2019, and 2022 (percent of total), 2017, 2019, and 2022
35 70
30 60
25 50
20 40
15 30
10 20
5 10
0 0
o
ge
all
ium
e
e
m
ce
g
re
rt
ns
rs
f
rg
ris
u
cr
sin
po
ris
Sm
he
an
ltu
tta
r
oa
Mi
La
me
rp
d
ou
ns
u
Ot
Me
/M
icu
Co
lL
te
Ho
om
s/T
Tra
od
na
en
r
Ag
/C
ce
so
Pr
n-
de
rvi
No
r
Pe
Tra
Se
2017 2019 2022 2017 2019 2022
Source: Royal Monetary Authority (RMA).
Note: Sectoral shares in figures add up to 100. “Others” include education loans. Non-enterprises include housing, transport, personal, staff, and education loans.
Banks mostly provide traditional lending products and have not adopted risk-based pricing. The range of financial
instruments offered by commercial banks has expanded but is still dominated by traditional banking products. Banks
typically offer basic credit products with fixed interest rates and terms.21 Loan requests are primarily evaluated based on
collateral rather than the borrower’s financial viability. Risk-based pricing, which links the borrower’s credit score to the
loan’s interest rate, is not commonly used by financial institutions. The bank’s strong preference for collateral over longer-
term cashflow projections has resulted in borrowers seeking alternative sources of financing from non-bank lenders.
Capital markets remain shallow, with limited liquidity and trading activity. One contributing factor is the small number of
listed companies compared to other regional markets. The limited development of the capital market can be attributed to
various factors, including issuer and investor-related issues, and the absence of regulations and capabilities for underwrit-
ing in the market. Due to the lack of deep capital markets and investment opportunities, insurance and pension funds are
engaging in credit business with individuals and firms and competing with banks. As a result, the share of the non-bank
sectors in total financial sector assets has increased between 2012 and 2022 (Figure 16). However, non-banks are more
susceptible to maturity mismatches and are subject to weaker supervision and possess lower capacity to absorb losses.
Asset quality has deteriorated following the pandemic, especially in the non-banking sector. The significant credit
expansion from 2014 to 2019, without robust credit appraisal practices, has worsened asset quality. Credit growth sharply
declined during the pandemic before recovering in recent years (Figure 17). Non-banks, in particular Royal Insurance
Corporation of Bhutan (RICB) and Bhutan Insurance Limited (BIL), reported higher NPLs compared to commercial banks.
Lax credit management, monitoring, and recovery practices contributed to NPLs. By June 2020, the ratio of NPLs to
total loans increased to nearly 15 percent as micro, small, and medium enterprises (MSMEs) struggled to meet debt
repayments. In December 2021, NPLs had declined to 9 percent, primarily due to the moratorium on loan repayments
and other measures introduced by the Royal Monetary Authority (RMA). The NPL ratio declined further in 2022, largely
due to the lack of recognition of potentially stressed assets. The majority of NPLs are concentrated in the services and
tourism sectors (33 percent), followed by trade, production and manufacturing, and housing sectors.
21 Since 2016, they have also started to offer some credit products with floating interest rate.
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Executive Summary
Bhutan Country Economic Memorandum
Figure 16: Share of banks and non-banks in Figure 17: Gross NPL and credit growth (percent),
credit and assets (percent), 2012 and 2022 2012-2023
16 30%
14.6
Assets, 2012 14
25%
10.9
12
10.4
20%
Assets, 2022 10
8.9 8.7
8.0 7.9
8 15%
6.6 6.3 6.5
6.0
Credit, 2012 6 5.2
10%
4
5%
Credit, 2022 2
0 0%
0% 20% 40% 60% 80% 100%
20
22
*
12
15
16
19
18
21
13
14
17
23
20
20
20
20
20
20
20
20
20
20
20
20
Banks Non-banks NPL ratio Credit growth (RHS)
Source: Royal Monetary Authority.. Source: Royal Monetary Authority, World Bank annual reports.
Measures to tackle rising NPLs in the aftermath of the pandemic need to be strengthened. In 2022, the RMA adopted
a Prompt Corrective Action (PCA) Framework to facilitate early supervisory intervention and mitigate risks that could
jeopardize the stability of financial service providers. It is crucial that financial institutions implement the NPL resolution
framework, ensuring that only viable accounts are restructured, and establish a robust early warning, monitoring, and
recovery system. Strengthening credit information systems and enhancing governance of financial institutions can
prevent the emergence of new NPLs. Specific steps are highlighted below.
⊲ Ensuring the implementation of the guidelines for credit underwriting will reduce risks during loan origination.
While the Risk Management Guidelines 2019 provide an overview of the procedures for assessment, review,
approval, disbursement, and administration of credit, the rise in NPLs in recent years indicates uneven compliance
with these guidelines. All lenders have comprehensive credit manuals that cover essential areas of credit under-
writing and monitoring. However, further examination is needed to evaluate the implementation of these internal
manuals.
⊲ Financial institutions could develop internal procedures and reporting mechanisms to identify and manage
potential non-performing customers at an early stage. They could monitor credit risk using Early Warning Indicators
(EWIs) and Key Risk Indicators (KRIs) at loan origination and throughout the loan’s lifespan. Conducting sensitivity
analysis and stress testing can mitigate the likelihood of adverse impacts in the future. The RMA could issue a
guideline outlining the fundamental principles for establishing an early warning system and incentivize financial
institutions to assess and address any gaps based on these guidelines.
⊲ The loan pricing mechanism could be modified to reflect borrower risks. The absence of risk-based pricing
highlights the need for a framework that aligns loan pricing with risk appetite, business strategies, profitability,
and risk perspective. Financial institutions could define pricing approaches based on the type and credit quality of
borrowers, allowing for different loan prices to be offered based on these attributes.
⊲ The Government could further develop the bankruptcy and insolvency framework to facilitate prompt resolu-
tion of NPLs. The Bankruptcy Act could be reviewed and amended to establish a comprehensive framework that
enables businesses to effectively address insolvency and reinforce the rights of secured creditors. So far, there
has never been a filing for protection under the Bankruptcy Act. Instead, financial institutions are opting for out-of-
court settlement for faster settlement of insolvency cases under the provisions of the NPL resolution framework.
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Executive Summary
Bhutan Country Economic Memorandum
Expanding the coverage of service providers and data systems in the Credit Information Bureau (CIB) can reduce
collateral-based lending. Currently, only financial institutions, some microfinance institutions, and utility companies
report to the CIB. As a result, the utilization of credit information by lenders is limited. To provide a comprehensive credit
history and a new credit scoring system, it is critical to expand the coverage of information by including a wider range
of financial service providers in the CIB.
Ensuring a level playing field between state-owned commercial banks and other banks can address risks to financial
stability. State-owned commercial banks hold a majority of deposits in the economy. For example, the BoB benefits from
a significant advantage in cost of funds compared to other banks, due to its large public sector demand deposit, resulting
in a substantial increase in the BoB’s market share. Promoting competition among banks by establishing a level playing
field will help distribute risks more evenly across the financial system.
Developing the domestic capital market and facilitating access to external capital is a priority. This can be achieved
by extending the range and maturity of marketable government securities, which would deepen the securities market.
This would improve monetary policy implementation, create a yield curve for a corporate bond market, and support
better loan pricing and long-term investment opportunities for the non-banking sector. The role of domestic and foreign
private sector capital is limited. Bhutan has one of the most restricted capital accounts in the world, with long-standing
capital controls in all categories of transactions. While the FDI framework has been gradually liberalized, it still includes
relatively high minimum thresholds, local participation rules, and sectoral restrictions. As a result, the number of approved
FDI projects and their aggregate size has been declining. The Government has recently eased access to External
Commercial Borrowings (ECBs) for the real sector (i.e., non-equity capital flows) to improve access to international finance
for domestic firms but continues to limit ECB for the banking sector. Medium-term reforms could include opening the
banking sector to ECB under strict regulatory oversight, raising the debt-equity ratio for ECB beyond the current 3:1 limit
to support projects with higher leverage, potentially with sector-specific variations, and allowing shorter-term ECBs for
borrowers with a natural hedge in foreign exchange earnings.
To promote private finance and develop green financial instruments, the Government can develop a detailed plan
based on its Green Finance Roadmap. Bhutan is highly vulnerable to climate change impacts and faces various natural
hazards. Investment at scale is required to meet climate-related goals, as public funding alone is insufficient. The Govern-
ment has adopted the Green Finance Roadmap and the Green Taxonomy to increase lending and investment in climate
objectives. The Government has also introduced reporting requirements and environmental standards. Blended finance
tools such as risk-sharing instruments, guarantees, and funds leveraging philanthropic capital can be used to combine
public and concessional finance with private capital. Blended finance, tailored to the local context, can mitigate risks
associated with new technologies or pioneering projects by shifting the investment risk-return profile through flexible
capital and favorable terms. Enhancing market transparency and embedding the national green taxonomy in regulatory
frameworks can further strengthen climate finance in Bhutan.
Digital technologies are critical for promoting financial inclusion, especially in Bhutan where cash still dominates
the payment system. Citizens face challenges in accessing finance, with limited access to credit due to banks’ reliance
on collateral rather than financial viability. Many rural communities lack access to formal remittance services and digital
payment systems, due to low presence of bank branches and ATMs. To promote financial inclusion, digital technologies
are crucial, enabling faster and affordable payments, promoting collateral-free lending, and introducing innovative
capital market and insurance products for retail customers. Investment in digital technologies, including blockchain, can
drive innovation, manage risks, reduce fraud, and facilitate secure transactions. The emergence of digitized assets and
technologies has the potential to transform the financial services industry.
18
Executive Summary
Bhutan Country Economic Memorandum
Summary of policy options
The report suggests three areas of policy focus to diversify Bhutan’s economy and add resilience to growth going forward:
i. Bhutan will continue to harness its hydropower resources. However, economic diversification will benefit from
allocating a much larger share of hydropower revenue towards domestic investment in tangible assets including
infrastructure and industries. This can be achieved by improving the intermediation of hydro resources through
the appropriate choice of institutional arrangements. Chapter 1 provides a detailed analysis of this issue and high-
lights institutional choices that can help achieve this objective by directing a significant share of hydro revenue for
investments rather than consumption.
ii. Raising agricultural productivity by diversifying into high-value crops as per Bhutan’s comparative advantages can
support the broader process of diversification by releasing labor for non-agrarian sectors and boosting agricultural
exports. Greater investments into irrigation to increase yields and removing existing barriers to FDI can contribute
to this.
iii. Modernizing the financial sector by strengthening risk management practices, creating a level playing field between
public and private players, and ensuring greater contribution from private finance will be critical to support the
process of economic diversification.
Table 2 presents a detailed summary of policy actions for sustained and inclusive growth. This table distinguishes
between policies which aim to create a favorable environment for the non-hydropower sector, and policies which support
specific sectors. Additionally, there are options to strengthen the institutional framework for implementing sector-spe-
cific policies. The recommendations for the agriculture sector (Chapter 2) and the financial sector (Chapter 3) can be
implemented in the short- and medium-term to achieve the objective. Table 1 also includes information on the timeline,
complexity, and probable development returns associated with each policy option.
Sector-specific policies are further arranged in three categories – foothills, mountains, and peaks – each with vary-
ing levels of rewards and risks. Foothills offer attainable rewards with low risks, such as strategic branding initiatives
like “Made in Bhutan” or export promotion agencies. Mountains, while still feasible, require more financial commitment
and carry higher risks, such as government intervention in the agriculture and CSI sectors. Peaks have the potential for
transformative growth but come with significant risks, such as the Government’s strategic investments in cryptocurrency
mining and the Gelephu Mindfulness City. These projects require substantial financial investments and careful consid-
eration of environmental, technical, and financial risks. The policies outlined here are illustrative and based on existing
initiatives, such as hydropower and directed lending.
19
Executive Summary
Bhutan Country Economic Memorandum
Table 2: Policy objectives and priority reform options
Policies Timeline Degree of complexity Development returns
Policies to promote a conducive environment for the development of the non-hydropower sector
Strengthen the PIM system to expand high quality infrastructure services ST Low High
and crowd in private investments
Improve efficiency of health and education expenditure to improve MT Medium High
human capital
Strengthen oversight and performance of the SOE sector ST-MT High Medium
Support workers’ mobility and firms’ access to labor, including through ST Medium High
a functional LMIS and strengthened linkages between public TVET
institutions and the labor market
Policies to enhance agricultural productivity (Chapter 2)
Enhance irrigation infrastructure and eliminate regulatory obstacles to ST Medium High
cultivate export-oriented crops on paddy land and irrigate non-paddy
crops to boost productivity, enable climate change adaptation, and drive
structural transformation in agriculture
Promote a fair and competitive environment in the agricultural input MT High Medium
industries by leveling the playing field between SOEs and the private
sector
Policies to enhance financial sector stability and financial intermediation (Chapter 3)
Prevent the emergence of new NPLs by strengthening credit appraisal ST Medium Medium
and pricing mechanisms and enhancing governance of financial
institutions
Ensure a level playing field between SOFIs and other banks to support MT High Medium
financial sector stability and
Promote access to finance and financial inclusion by strengthening the ST Medium Medium
CIB, implementing a robust collateral valuation system, and adopting
digital technologies
Promote private finance and develop green financial instruments ST Medium High
Policies to support specific sectors: Peaks Mountains Foothills
Create strategic partnerships with universities to establish tailored ST Medium
executive programs for the development of competitive sectors
Leverage Bhutanese living abroad for the transfer of learning, technol- ST Medium
ogy, and social capital back to Bhutan
Strengthen incubation and acceleration centers to promote entrepre- ST Medium
neurship and innovation
Hydropower (Chapter 1): Leverage additional hydropower resource rents
Develop the hydropower sector further, subject to economic, environ- ST-MT High
mental, and social impact analysis
Establish stronger backward linkages with the hydro sector to increase MT Medium
spillovers to the non-hydro sector (i.e., hydro maintenance and
engineering)
20
Executive Summary
Bhutan Country Economic Memorandum
Policies Timeline Degree of complexity Development returns
Agriculture: Specialize in higher value-added products and capitalize on export opportunities (Chapter 2)
Attract additional FDI, including for smaller-scale and niche farming ST Medium
operations with potential for high growth
Initiate a proactive investment and export promotion campaign, and ST Medium
leverage Bhutan’s brand to boost agricultural exports
Provide (digital) extension services and financial incentives to farmers to ST Medium
adopt sustainable land management practices to increase productivity
and ensuring climate-resilient agricultural production
Review directed and direct lending to enhance its effectiveness (Chapter 3)
Review the design of the PSL and NCGS schemes to effectively alleviate ST Medium
credit constraints in risky sectors, such as CSI or MSMEs
Institutional framework to frame and implement sector-specific policies
Develop a fiscal strategy with a long-term vision and a minimum share of MT Medium Medium
re-investment of hydro rents for productive capacity building in tradable
sectors
Consolidate development finance institutions to avoid the spreading of MT Medium Medium
available resources too thinly
Improve the ability to appraise, monitor, and evaluate investments, for ST High High
instance through the establishment of an autonomous and technically
equipped public Investment Evaluation Unit (IEU)
Evaluate existing sector-specific policies to determine whether they are ST Medium Medium
sufficiently targeted, transparent and minimize budgetary costs (and
risks)
21
Bhutan Country Economic Memorandum
1. Hydropower
Revenue
Management
for Economic
© Mathias Berlin/Shutterstock
Diversification
22
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
1.1. Introduction
Bhutan’s growth is heavily dependent on hydropower Figure 18: Impact of hydropower on GDP in
generation and exports. Real GDP growth averaged 7 Bhutan (percent), 1985-2021
percent from 1980 to 2020, but episodes of high growth
largely coincided with the operationalization of hydro- 35
Chhukha (1987)
power projects (Figure 18). The economy contracted in 30
Tala (2007)
2019, despite the commissioning of the Mangdechhu plant, 25
due to the impact of the COVID-19 pandemic. Since the 20
first large hydropower project came into operation in 1987 Mangdechhu (2019)
15
(Chhukha), Bhutan has increased the country’s installed
10
hydropower capacity seven-fold, from 336 MW to 2,326
5
MW, with Tala (2007) and Mangdechhu (2019) being the
largest projects (Figure 19). Moreover, there are several 0
plants under construction and the Puna I and II projects, -5
on completion, will more than double the current installed -10
capacity.22 The hydropower projects are mostly financed -15
through commercially priced loans and capital grants from
-20
the GoI, with the surplus electricity exported to India.23
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
Bhutan is also planning to add substantial capacity through
GDP growth GDP growth, excluding electricity and water
the 1125 MW Dorjilung project. According to the Power
Source: National Statistics Bureau (NSB)
System Master Plan 2040, Bhutan to date has an installed
hydroelectric power capacity of about one-tenth of its tech-
nically feasible potential. However, hydropower already accounts for more than one-third of the country’s goods exports
and domestic revenues and constitutes 26 percent of its GDP.
Bhutan’s fiscal accounts and debt dynamics are intrinsically tied to its hydropower sector. From FY10/11 to FY21/22,
the country’s revenue as a percentage of GDP maintained an average of around 30 percent, bolstered by income from
hydropower and substantial external grants, with India contributing two-thirds of these grants. Public expenditure during
this period averaged 34 percent of GDP, with the fiscal deficit averaging a modest 0.3 percent of GDP. Capital spending
was a major component of government expenditure, accounting for nearly half of it over the past decade, supported
by external grants. Bhutan’s spending patterns are more procyclical than those of comparable economies. Hydro-
power revenue is volatile, with annual profits and dividends from SOEs fluctuating based on the commissioning of new
hydropower plants and weather conditions.24 Public and publicly guaranteed increased significantly from 69.1 percent
of GDP in FY10/11 to 133.3 percent in FY21/22, largely due to external loans for hydropower development. Despite this
substantial increase in external debt, the risk of debt distress is expected to be remain moderate, as the majority of this
debt is linked to hydropower project loans from India, which are expected to be repaid with future hydro revenues and
carry low refinancing and exchange rate risks.25
Hydropower exports have generated large foreign currency inflows, raising concerns about the Dutch Disease.
Additionally, there have been significant inflows related to hydro investments since the 1980s, primarily through grants
and loans during the construction phase, with most of the investments funded by inflows from India (Figure 20). If the
increased foreign exchange is used solely for imports, it would not directly affect the money supply or demand for
domestic goods. However, if the foreign currency is converted into local currency and spent on nontraded goods within
the country, it can increase the money supply and lead to higher domestic prices under a fixed exchange rate regime.
22 Four hydropower projects—Nikachhu (118 MW, expected in 2024), Punatsangchhu 2 (1,020 MW, expected in 2024), Punatshangchhu 1 (1,200 MW, expected in 2027) and
Kholongchhu (600 MW, expected in 2029)—will significantly expand the installed generation capacity between 2023 and 2031, from 2,334 MW to 5,273 MW. The Government
also commenced work on eight smaller hydro plants in 2022, which will come onstream between 2025 and 2028 (with total capacity of 1501.69 GWh). The smaller hydro plants
are financed by Druk Green Power Corporation, the hydropower SOE.
23 The hydropower projects are implemented under a special inter-governmental agreement between Bhutan and India, in which the GoI covers both financial and construction
related risks and commits to buying all surplus electricity at a price reflecting cost plus a net return.
24 While Bhutan’s Public Finance Act stipulates that the cost of current expenditure must be met from domestic resources, this rule does not constrain the growth of current spending
when there is a temporary increase in domestic revenues.
25 WB. 2023b. “Bhutan Public Expenditure Review.” WB, Washington, DC.
23
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
Figure 19: Installed capacity, hydropower (MW), 1987-2029
6,000
5,000
4,000
3,000
2,000
1,000
0
2000
2002
2005
2006
2008
2009
2020
2003
2004
2022
2025
2026
2028
2029
2023
2024
2007
2027
2001
2010
1990
2012
2015
2016
2018
2019
2021
1989
1992
1995
1996
1999
1988
1998
2013
1993
2014
1994
2017
1987
1997
2011
1991
Kholongchhu (2029) Punatsangchhu II (2024) Mangdechhu (2019) Tala (2007) Basochhu I (2002) Chhukha (1986)
Punatsangchhu I (2027) Nikachhu (2024) Dagachhu (2015) Basochhu II (2004) Kurichhu (2001)
Source: National Statistics Bureau and World Bank staff calculation.
Figure 20: Net capital inflows from India and power export revenues (percent of GDP), 1980-2021
Chukka Tala Puna I Puna II Kholongchhu
(1980) (1997) (2008) (2010) (2015)
50
Chukka Tala Mangdechhu Mangdechhu
(1986) (2007) (2012) (2019)
40
30
20
10
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
-10 Power exports Net capital flow India Only hydro-related Construction start Comissioning
Source: National Statistics Bureau and World Bank staff calculations.
Note: Power exports vary due to changes in generation and domestic consumption given that all surplus generation is exported to India. Net capital inflows include
budgetary grants, grants for hydropower development, and hydropower loans (disbursements minus reimbursement) from India. Net capital inflows, which consist of
budgetary grants, grants for hydropower development, and hydropower loans from India, decrease with the commissioning of a new hydropower plant due to reduced
inflows and increased outflows caused by debt servicing starting the year after commissioning.
The large capital inflows from the construction of hydropower projects and the subsequent export revenues have caused
the Bhutanese Ngultrum to appreciate against the Indian Rupee. This has raised concerns about the Dutch Disease,
where tradable sectors become less competitive compared to the booming hydropower sector due to appreciation of
the real exchange rate. The contraction in the lagging tradable sector is known as the “spending effect”. Simultaneously,
a “resource movement effect” occurs when resources (capital and labor) shift towards producing non-traded goods to
meet the increase in domestic demand and the booming export sector, leading to a reduction in production in the lagging
tradable sector (Corden and Neary, 1982).26
26 Corden, W.M., and Neary, P.J. 1982. ”Booming Sector and Deindustrialization in a Small Open Economy”.. Economic Journal, 92, 825-48.
24
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
The hydropower-led growth model is characterized by the lack of economic diversification and adequate employment
opportunities. While the hydropower sector contributed significantly to the economy, its capital-intensive nature led to
the creation of very limited gainful employment opportunities, employing less than 1 percent of the labor force, despite
accounting for 16 percent of GDP in 2021.27 The reliance on hydropower has led to limited private sector development,
with the bulk of the jobs concentrated in low-productivity agriculture and public administration. Large private-sector
firms are rare; only 2 percent of firms hold limited liability company (LLC) status, and only 2 percent of firms attract foreign
ownership.28 Unemployment increased from an average of 2.8 percent between 2015 and 2019 to 5.9 percent in 2022
(Figure 6). The rise in unemployment rates since 2020 was mostly witnessed in urban areas, especially amongst young
and educated women and men.29 Bhutan’s topography, landlocked and mountainous terrain, coupled with a small popu-
lation (around 800,000), entails high transport costs, market fragmentation, and a limited size of the domestic market
for goods and services.
The non-hydro sector largely consists of services and a narrow set of resource-intensive manufacturing. Annual
non-hydro sector growth averaged 6.9 percent from 2001-2019, driven by services and non-hydro industry, mainly
construction and manufacturing (ferro-alloy and ferro-silicon). Growth in services was driven equally by public administra-
tion (including health and education), trade and transport (accounting for 75 percent of growth), followed by the financial
sector (including real estate). Since the beginning of tourism in 1974, Bhutan has targeted high value tourists to minimize
the impact on the environment. The hotel and restaurant sector grew at an average rate of 16 percent per annum from
2001-2019, excluding the COVID-19 pandemic year when the tourism industry was severely hit.
This chapter focuses on the macroeconomic impacts of different diversification policies on managing the growing
hydropower revenue. The rest of the chapter is organized as follows: Section 1.2 presents an analytical review of the
hydro and non-hydro growth nexus, including a review of the current growth model, and its impact on the labor market
and job creation. The section also analyzes the overall impact of the planned expansion in hydropower on the economy
under a BAU scenario. In addition to the BAU scenario, two policy scenarios are simulated to examine the impact of the
utilization of the additional hydro revenue for promoting economic diversification. Section 1.3 examines options to manage
resource revenues and discusses economic diversification policies, as well as the institutional set-up for effectively chan-
neling hydropower rents towards productivity-enhancing assets in Bhutan. Section 1.4 provides policy recommendations.
1.2. Bhutan’s hydro and non-hydro growth nexus
y the publicly led and capital-intensive hydro sector
1.2.1. Past growth has been driven b
Growth was capital and labor intensive, with limited productivity improvements. A growth accounting analysis over
two periods — (i) 2001-2008, which coincided with the commissioning of the Tala hydropower project in 2007, and (ii)
2009-2019, which witnessed the construction of several major hydro plants, up to the commissioning of Mangdechhu
project in 201930 — indicates that capital accumulation and labor contributed 3.7 and 2.5 percent, respectively, on average,
over the first period (Figure 21). However, the contribution of both capital and labor declined over the second period,
and growth slowed from 8.6 percent to 5.8 percent. Total Factor Productivity (TFP) growth played only a minor role in
driving growth and was lower than structural and aspirational peers, except Botswana, from 2000-2019 (Figure 26).
27 This excludes the construction sector, which is partly hydropower construction. The agriculture sector accounted for 19 percent of GDP, the industry sector (including hydro) for
34 percent, and the service sector for 47 percent of GDP in 2021. Measures in current prices.
28 According to the economic census, 90 percent of the firms in the country are small firms with 1-5 workers, while large firms with more than 100 workers are very limited (0.6 percent
of total firms). Excluding household-based businesses in agriculture, the majority of establishments (91 percent) belong to the service sector, followed by the industry sector (7
percent).
29 Unemployment is significantly higher among youth (28.6 percent), educated workers (11.5 and 11.8 percent for workers with a secondary and tertiary diploma, respectively), in
urban areas (10.4 percent compared to 3.4 percent in rural areas), and among females (7.9 percent compared to 4.4 percent for males). Alaref, J., et al. Forthcoming. “Bhutan
Labor Market Assessment Report. Social Protection & Jobs Global Practice”. World Bank, Washington, D.C.
30 The growth accounting does not include the impact of the COVID-19 pandemic in 2020, given the unique situation. The economy contracted by 10 percent in 2020.
25
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
Figure 21: Growth decomposition, 2001-2019 Figure 22: Labor contribution decomposition,
2001-2019
10.0% 3.5%
9.0% 8.6%
3.0%
8.0%
7.0% 2.5%
7.0%
5.8%
6.0% 2.0%
5.0%
1.5%
4.0%
1.0%
3.0%
2.0% 0.5%
1.0%
0.0%
0.0%
2001-19 2001-08 2009-19 -0.5% 2001-19 2001-08 2009-19
TFP Total growth Labor
Capital Interaction Human capital WAPR Population LFPR
Source: Growth accounting, World Bank staff calculations. Source: Penn World Table, World Bank staff calculations.
Hydro sector growth was driven by capital accumulation and increases in productivity once new projects were
commissioned. The growth accounting exercise assumes that the output of the hydro sector is a function of capital and
productivity (labor is only used temporarily during the construction period), while the output in the non-hydro sector is a
function of labor, capital, and productivity (see Annex 1 for details). The analysis indicates that growth in the hydro sector
from 2001-2008 (21.6 percent) was considerably higher than during the 2009-2019 period (0.4 percent) (Figure 23). Phys-
ical capital accumulation contributed 9.3 percent to this growth, on average, each year, in both periods, but productivity
loss (measured by TFP as a residual) caused hydro output to decline by 9.2 percent each year from 2009-2019, as no
new hydropower projects were commissioned over this period. Hydro projects are multi-year projects and new hydro
investments are utilized after a significant time lag. The productivity growth in later years partially reflects this increase
in capital utilization (Figure 25).
Figure 23: Hydro sector growth decomposition, Figure 24: Non-hydro sector growth
2001-2019 decomposition, 2001-2019
25% 21.6% 25.0%
20% 20.0%
15% 15.0%
9.3%
10% 10.0% 6.9% 7.2%
6.5%
5% 5.0%
0.4%
0% 0.0%
-5.0%
-5%
-10.0%
-10%
-15.0%
-15% 2001-19 2001-08 2009-19 2001-19 2001-08 2009-19
TFP Total growth TFP Total growth Labor
Capital Interaction Capital Interaction
Source: Growth accounting, World Bank staff calculations. Source: Penn World Table, World Bank staff calculations.
26
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
Figure 25: Hydro investments and TFP growth, Figure 26: Bhutan vs. peers: contributions to
2000-2020 growth 2001-2019
Rapid productivity growth is recorded as unutilized 9%
3000 capital starts getting used in production 100% 7.6%
8% 7.2%
7.0%
2500 80% 7%
6%
60%
2000 4.6% 4.3%
5% 4.3%
40% 4%
1500
3%
20%
2%
1000
0%
1%
500 -20% 0%
-1%
0 -40%
-2% Bhutan
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Tajikistan Mongolia Bolivia Paraguay Botswana
Hydro investment spending TFP growth contribution Total Factor Productivity Labor Capital Stock Real GDP
Source: Growth accounting, World Bank staff calculations. Source: Penn World Table, World Bank staff calculations.
Non-hydro growth was capital and labor intensive, with limited productivity improvements. Non-hydro sector growth
from 2001-2019 was 6.9 percent, lower than hydro sector growth in the same period (9.3 percent) (Figure 24). Non-hy-
dro capital accumulation, driven by public investments using the hydro rents and sizable external grants, contributed
3.4 percent on average from 2001-2019, but its contribution has waned over time. Labor contributed less than capital
and the contribution declined over time (from 2.9 percent to 2.3 percent). Non-hydro sector growth increased from 6.5
percent in 2001-2008 to 7.2 percent in 2009-2019, mainly due to an increase in TFP, which offset the decline in capital
and labor contributions.31
Among labor components, human capital was the dominant growth driver, though its contribution has declined over
time. Human capital, measured by returns to level of schooling, accounted for about half of the overall increase in labor
input but decreased in the second period (2009-2019). The other half was attributed to the growth in population and the
working-age population ratio. Conversely, On the other hand, changes in labor force participation had a minimal impact
(Figure 22). Labor force participation rates in Bhutan show significant disparities, particularly with lower participation
among low-skilled women in urban areas (Figure 27). The labor force participation of prime-aged women is strongly
influenced by factors such as marital status, the presence of young children, and the participation of other women in
their family and community. Further, women in Bhutan tend to work in sectors with low productivity, and often as own
account or family workers, and have limited access to private employment or public sector jobs.32
Spillovers from hydropower investments on non-hydro growth have been limited. Hydro investments can generate
income in the non-hydro sector through the supply of goods (e.g., construction materials) and services (e.g., labor used
in construction). To assess spillovers from the hydro to non-hydro sector, the non-hydro sector output is split into a core
and hydro-driven part (see Annex 1 for more details).33 Over the past two decades, spillovers from hydro investments to
non-hydro growth in Bhutan are estimated to be small, about 0.8 percentage points of 5.8 percent. But with rising hydro
investments since 2009, the spillover has contributed 1.5 percentage points to the 5.3 percent growth recorded by the
non-hydro sector in the second period (Figure 28). Spillovers remain limited because the hydro projects are mostly
31 Bhutan currently does not have granular firm-level productivity data to assess possible explanations for the lagging productivity performance in the non-hydro sector.
32 Alaref, J., et al. Forthcoming. “Bhutan Labor Market Assessment Report. Social Protection & Jobs Global Practice”. World Bank, Washington, D.C.
33 To quantify the effect of hydro sector investments on the growth of the non-hydro sector, it is assumed that the hydro sector’s capital expenditures generate income in the
non-hydro sector through the supply of goods (e.g., construction materials) and services (e.g., labor used in construction). The incremental growth of the non-hydro sector is
then assessed by comparing its actual output against a counterfactual scenario where hydro sector investments are absent. See Annex 1 for more details on the calculation of
hydropower spillovers.
27
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
developed with (temporary) foreign labor from India and the majority of machinery and raw materials are imported.34
More recently, some SOEs have provided goods and services to hydro projects, in particular for the plants developed
under the Public Private Partnership (PPP) and Joint Venture (JV) models (Dagachhu, Nikachhu, Kholongchhu),35 and
some projects have used domestic labor during the COVID-19 pandemic due to restrictions on foreign workers.
Figure 27: Labor force participation rates by Figure 28: Spillovers from hydro to non-hydro
gender, 2013-2022 sector, 2001-2019
80 7.5%
6.5%
1.1%
2.1%
70
5.5%
4.5%
Participation rate (%)
60
3.5% 6.9%
5.8%
50 2.5% 5.1%
1.5%
40
0.5%
-0.3%
-0.5%
30 2001-19 2001-08 2009-19
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Female Male Core Hydro spillover
Source: Alaref, J., et al. Forthcoming. “Bhutan Labor Market Assessment Report: Source: Growth accounting, World Bank staff calculations.
Social Protection & Jobs Global Practice”. World Bank, Washington, D.C.
ith limited employment opportunities36
1.2.2. The private sector has remained small, w
Limited productivity gains have hindered structural transformation, and labor remains predominantly employed in the
low productivity agricultural and public sectors. While the share of agriculture in GDP has declined significantly over the past
two decades, dropping from 25 percent of GDP in 2000 to 12 percent in 2021, the share of services has increased from 37 to
50 percent. The contribution of the non-hydro industry sector, excluding electricity, has remained relatively stable at about 25
percent (Figure 29). Despite the decreasing share of agriculture in value-added, the labor force continues to be largely confined
to the agricultural sector. In 2022, the labor market was mostly dominated by low-productivity agricultural employment (40
percent), followed by the public sector (25 percent, including education and health). Although more productive sectors like
electricity, transport and communication, financial intermediation, and mining, have seen an increase in their share of total
employment between 2013 and 2022, they still have a relatively small presence in terms of employment (Figure 30). Sectors
like construction have grown in size but have lower productivity levels compared to smaller and slowly growing sectors.
The labor market is segmented based on gender, location, and education. Men and high-skilled workers in urban
areas dominate public sector employment, while women are more likely to remain employed in agriculture and work as
own-account or family workers. Workers with no education dominate agricultural employment and workers with tertiary
education tend to self-select into the public sector.
The private sector in Bhutan largely comprises low-productivity microenterprises, lacking dynamism, diversification,
and productive job opportunities. In 2022, only 2.7 percent of firms were new, indicating a lack of entrepreneurial activity.
These very small firms tend to remain small, likely due to restrictions on growth, and inefficient firms are not exiting the
34 See Intergovernmental Agreement between the GoI and the RGoB, which states under Article 5 that “Except in regard to lower categories of staff and the labour force, the
recruitment of technical, administrative and other personnel of the Authority will be confined to the nationals of either country.” https://www.mea.gov.in/bilateral-documents.
htm?dtl/6349/Agreement
35 See Annual Report 2021 CDCL (Construction Development Corporation Limited). (file:///C:/Users/wb506822/Downloads/CDCL%20AR%202021.pdf), a fully owned SOE under
DHI, and Annual Report 2021 Dungsam Cement Company Limited (CCDL) (file:///C:/Users/wb506822/Downloads/Annual%20Report%202021%20Final_compressed.pdf), a DHI
controlled SOE.
36 Based on Alaref, J., et al. Forthcoming. “Bhutan Labor Market Assessment Report. Social Protection & Jobs Global Practice”. World Bank, Washington, D.C.
28
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
Figure 29: Sector shares in GDP, constant 2000 Figure 30: Change in sectoral productivity and
prices, 1980-2021 employment shares, 2013-2021
100% 3.0
2.5 Electricity/water
Log(Sector value added/ Sector employment), 2021
80% 2.0
Financial interm
1.5
Real estate/ Mining
60% 1.0 bus service
0.5 Transport/info and comm
Construction
0.0
40% Public admin/ Whole/retail
-0.5 educ/ health
-1.0 Manufacturing
20% Agriculture
-1.5
-2.0
0% Hotel/rest
1980 1990 2000 2010 2020 -2.5
Agriculture Power/water -50% 0% 50% 100% 150%
Industry, excl. power/water Services Change in employment share, percent, 2013-2021
Source: National Statistics Bureau and World Bank staff calculations.
Note: The circle size in the right hand graph reflects sector employment in 2013. Productivity is measured as the sector-level value-added per worker in 2021.
market. Between 2018 and 2022, firms became older and smaller, with the share of long-established firms increasing
from 24 percent to 26 percent, and the share of cottage firms rising from 89 percent to 96 percent (Figure 31). Further,
most firms (nearly 97 percent) are owned as individual proprietorships. In terms of employment, the average number
of workers hired by firms decreased from 1.1 in 2019 to 0.7 in 2020 and 2021, indicating a decline in job opportunities
within the private sector. Additionally, there is a lack of diversification in terms of economic activity, with the wholesale
and retail trade, and accommodation and food services sectors accounting for nearly 80 percent of firms. These sectors
typically have low labor productivity and employ low-skilled workers.
The private sector hires more individuals in low- and middle-paying occupations, in comparison to the public sector.
Own-account workers outside agriculture are mostly service and sales workers, whereas employers are mostly in
high-skilled occupations, such as managers. The private sector accounted for 14 percent of total employment in 2022.
Private employment was the most prevalent in construction (60 percent), administrative and support service activities (60
percent), and in arts, entertainment, recreation, and other service activities (66 percent). Apart from public administration
and defense, public employment dominated in human health and social work activities (97 percent), and education (87
percent). Employees also worked in SOEs in the energy, water, and waste management activities, and financial and real
estate activities (Figure 32).
The limited development of the private sector has resulted in a shortage of productive jobs for educated individuals.
The majority of employed workers are in low to mid-skilled positions, creating a disparity between the profile of job
seekers and the available jobs. In 2022, approximately 58 percent (24 percent) of job seekers held a secondary degree
(university degree), compared to 29 percent (9.5 percent) of employed workers, indicating an oversupply of educated
workers (Figure 33). As a result, unemployment rates were high for individuals with secondary diplomas (11.5 percent in
2022) or tertiary diplomas (11.8 percent in 2022). This lack of productive jobs that offer competitive wages for educated
individuals is likely contributing to emigration, especially among the most skilled workers, including those employed in
the public sector.
As a result, unemployed workers, especially the youth, tend to prefer the public sector. In 2021, a higher percentage
of youth (86 percent) compared to non-youth (75 percent) expressed a preference for public sector employment. The
reasons for preferring public sector employment mostly relate to job security and working conditions. Youth place more
emphasis on job security, with 83 percent citing it as the main reason for preferring public sector employment, compared
to 74 percent of non-youth.
29
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
Figure 31: Establishment size and employment Figure 32: Type of employment, by sector
share, 2022 (excluding agriculture), 2022
100.0% 95.9% 100%
80%
80.0%
60%
Percent
60.0%
40%
40.0% 36.8%
31.9% 20%
20.0% 19.6%
0%
11.7%
er ring
tru r
on
te po e
ma taur n
an n/c s
m.
te
nis e
n
Ed blic
ion
h
es
ns ate
Fin tio ant
Inf /res tatio
tio
alt
d
mi enc
ta
vic
ce om
cti
Tra
at
Pu
ot He
tra
tu
es
Co y/w
Ad Sci
uc
er
ls r
fac
al
rs
2.9% 0.9% 0.3% g
/re
nu
Ho ns
he
En
0.0%
Ma
Tra
ts/
or
Cottage Small Medium Large
Ar
Self-employed Salaried worker (public)
Establishment Employment
Salaried worker (private) Employer
Figure 33: Comparison between the distribution of expected labor demand and the current labor
force and inactive population (percent of total), by education, 2022
70
Undersupply
60
ply
50
rsup
Ove
40
Percent
30 Important to activate, esp.
among women
ply
up
20 Un
ers
der
sup
Ov
ply
10
0
No education Primary Secondary Certificate Diploma University and above
Future demand Working-age population Employed Job-seekers Inactive
Source: Bhutan Labour Force Survey (BLFS) 2021, 2022. Establishment Survey, World Bank Labor Market Assessment Report. Forthcoming.
Conversely, the private sector is facing labor shortages due to a mismatch in skills and spatial distribution, which can
impede growth and result in low productivity. Firms in Bhutan require workers with specific technical skills and lower
levels of education, particularly in the services sector. However, accessing this labor is challenging because there is a high
proportion of lower-educated workers, especially women, who are not in the labor force but could potentially fill these
vacancies with appropriate training and support. The labor shortages also have a spatial dimension, where job seekers
with the required qualifications, especially those with lower levels of education, are not located in regions experiencing
supply shortages. For example, regions like Samdrup Jongkhar and Trashigang, both close to the Indian border, face the
most hiring difficulties, with tight labor markets for non-educated workers and graduates with primary education. Firms
also struggle to find workers with the necessary technical skills because of a lack of linkages with vocational training
institutes. While some firms may consider hiring foreign workers to address the shortages, the percentage of firms doing
so has declined over time, with only 7 percent hiring at least one foreign worker in 2022. Many firms have expressed
that hiring difficulties have a negative impact on their performance and potential for growth.
30
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
nd symptoms of the Dutch Disease
1.2.3. Economy-wide effects of the hydro sector a
Despite limited spillovers from the hydro to the non-hydro sectors, large hydro resource rents could have impacted
the competitiveness and diversification of the non-hydro economy. While hydro avoids certain oil-related symp-
toms (i.e., shocks after resource depletion, volatile tariffs, competition for a fixed amount of resources), the expansion
of hydropower production in Bhutan shares characteristics with the discovery of fossil reserves due to the large
foreign currency inflows from hydropower exports. Resource-dependent economies are known to experience Dutch
Disease with large foreign currency inflows leading to an appreciation of the real exchange rate that adversely affects
(non-booming) export sectors. This section assesses the economy-wide effects of the booming hydro sector, and its
impact on the growth of the non-hydro sector, by examining past trends and projecting a forward-looking scenario
using a CGE model.37
Hydro rents have been absorbed by the economy through an increase in private and public consumption. Hydro-
power export revenues are transferred from the hydro SOE Druk Green Power Corporation (DGPC) to the Central
Government as general government revenue in the form of Corporate Income Tax (CIT), royalties, dividends, and profit
transfers. A small fraction is transferred into the Bhutan Economic Stabilization Fund (BESF), and the majority is used to
cover the current and capital expenditure of the general Government (i.e., public sector wages, health, education, public
investment). Meanwhile, a portion of the rents accrues to Druk Holding and Investments (DHI), which uses a part of it to
cross subsidize and invest in other SOEs. Both private and public consumption correlate positively with power exports
(Figure 34). Public investment is negatively correlated, and private investment and imports demonstrate no correlation
with power exports (Figure 35). This indicates that hydro-related revenue has not resulted in significant increases in
private investment or imports.
Figure 34: Percent change in power exports and Figure 35: Correlation of power exports with
consumption (in constant 2000 prices), 1991-2019 consumption and investment (annual data),
1991-2019
100 60.0
80
30.0
60
Growth rate (%)
40
0.0
20
-30.0
0
-20
-60.0
-30.0 0.0 30.0 60.0 90.0
2000
2002
2005
2006
2008
2009
2003
2004
2007
2001
2010
1990
2012
2015
2016
2018
2019
1992
1995
1996
1998
1999
2013
2014
1993
1994
2017
1997
2011
1991
-40 Hydropower export growth rate (%)
Consumption Power export Consumption Investment Import
Source: National Statistics Bureau and World Bank staff calculations Source: World Bank staff calculations.
Note: The correlation coefficients for private and public consumption are 0.26
and 0.21, respectively. The correlation coefficient for private investment is 0.02,
while for public investment it is -0.39. The correlation coefficient for imports is
-0.07. These coefficients remain relatively stable even when considering lags.
37 While the first economic census from 2018 includes data on establishments, such as size and economic activity, it does not include firm-level output data.
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The Bhutanese Ngultrum (BTN) has experienced an appreciation against the Indian Rupee (INR) due to capital inflows
and export revenues. The starting point for examining Dutch Disease effects is to estimate the resultant change in the
real exchange rate. Under Bhutan’s fixed exchange rate regime, the large inflows are expected to increase domestic
demand and prices, leading to an appreciation of the real exchange rate. Figure 36 and Figure 37 illustrate the bilateral
real exchange rate (BRER) with India, power exports to India, and net capital flows from India.38 There is a negative correla-
tion between hydro-related inflows and the BRER with the INR. From 1980 to 2000, the BTN appreciated vis-à-vis the
INR, coinciding with the construction of the Chhukha project (the first large hydropower project) and subsequent hydro
exports. The BRER remained relatively stable until 2012, despite a significant increase in hydro exports. However, in the
last decade, the rate of appreciation has accelerated, coinciding with significant net capital flows for the construction of
Mangdechhu, Puna I and Puna II projects.
Figure 36: BRER with India (Index average Figure 37: Correlation of BRER with India with
1980-2021 = 1), real power exports and real net the sum of capital inflows and export revenues,
capital inflows from India, 1980-2021 1986-2021
1.4 Depreciation 6,000 2
1.3 5,000 2
BRER (Nu/INR), index avg. 1980-2021 = 1
BRER (Nu/INR), standardized
1.2 1
Nu. Millions in constant 1980 prices
Appreciation
4,000
1.1 1
3,000
1.0 0
2,000
0.9 -1
1,000
0.8 -1
0.7 0 -2
0.6 -1,000 -2
1983
1986
1989
1992
1995
1998
2013
1980
2016
2019
2001
2010
2007
2004
-3
-2 -1 0 1 2 3
Power exports Net capital flows, India BRER (Nu/INR) Real net capital flows from India + Power exports, standardized
Source: National Statistics Bureau and World Bank staff calculations. Source: World Bank staff calculations.
Note: The correlation coefficient for real power exports and real net capital inflows
from India is 0.76.
In Bhutan, both the non-tradable and tradable sectors have exhibited lower growth and output levels compared to
the booming electricity sector. Dutch Disease-type effects typically lead to a shift towards non-tradable services and a
reduction in the size of the lagging tradable sectors. In Bhutan, the output of the tradable sector, including agriculture,
mining, and manufacturing, has remained below that of the non-tradable sector as well as the booming electricity sector
(Figure 38). Although there has been notable growth in non-hydro exports, this growth has been driven by mineral
products such as boulders and base metals like ferro-alloy and silicon. In contrast, other exports have shown limited
progress, indicating a lack of economic diversification (Figure 39). This suggests that hydropower exports and hydro-re-
lated capital inflows may have stymied the growth of the lagging tradable sector relative to the non-tradable sector. An
earlier study by Kojo (2005) did not find evidence of contraction or stagnation in the tradable sector. 39 However, the
study suggested that the non-tradable sector may have experienced faster growth if the BTN had not appreciated and
that future expansion of hydro exports or aid inflows could further pressure the BTN and negatively impact the tradable
sector. The evidence in the previous paragraph shows that this has indeed been the case.
38 The real exchange rate, RER, is defined as the nominal exchange rate, ER, multiplied by the ratio of the index of non-domestic prices, pw_ind, to the index of domestic prices,
[_ ]
pw _ ind
RER = ER * pd _ ind
. A fall in the real exchange rate index is an appreciation in the real exchange rate.
39 Kojo (2005) investigated the Dutch Disease effects in Bhutan and found that hydro exports led to the appreciation of the BTN. While there was no evidence of contraction or
stagnation in the tradable sector, the study highlighted important caveats. First, the lagging non-tradable sector may have grown faster without the real appreciation of the BTN.
Second, limited labor mobility between the tradable and non-tradable sectors, especially for farmers in remote areas, may have hindered relocation to the capital city. Third,
agriculture’s subsistence-based nature may exclude it from being considered a tradable sector in Bhutan. The study also suggested that future expansion of hydro exports or aid
inflows could further pressure the BTN and negatively impact the tradable sector. See Kojo, N. 2005. ”Bhutan: Power Exports and Dutch Disease”. The Centre for Bhutan Studies,
Thimphu, Bhutan.
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Figure 38: GDP growth by economic activity Figure 39: Hydro and non-hydro goods exports
(Index, 1986=100), 1986-2021 (in million Nu), 2001-2022
3000 70,000
60,000
2500
50,000
2000
40,000
1500
30,000
1000 20,000
10,000
500
0
2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
0
1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019 Total exports Non-hydro total Non-hydro, minerals/metals
Boosted Non-Tradable Tradable Hydro Non-hydro, other
Source: NSB and World Bank staff calculation. Source: NSB.
Note: Boosted: electrcity and water; Tradable: crops, livestock, mining, manufac- Note: Non-hydro goods exports consist of minerals and metals exports (Bhutan
turing; Non-tradable: forestry, construction, services. Trade Classification, Section V and XV, respectively), as well as other exports.
Four scenarios are simulated to analyze how hydro revenues impact the real economy, taking into account assump-
tions about their future utilization. A CGE model, calibrated to a Social Accounting Matrix (SAM) for Bhutan in 2019, is
used to simulate the following scenarios:40
⊲ Scenario 1: No additional hydropower. This scenario assumes that investments in hydropower end in 2020.
⊲ Scenario 2: Additional hydropower investments. This scenario includes the construction and commissioning of
four planned hydropower projects: Punatsangchhu I, Punatsangchhu II, Nikachhu, and Kholongchhu. The additional
planned investment results in an expansion in hydro capacity and production after 2023 and 2025 (Figure 41). The
Puna I and Puna II projects are expected to generate additional revenue per capita, from 12,652 Nu (US$164) during
the construction phase to 25,702 Nu (US$334) during the revenue phase. While there are other hydropower proj-
ects in the pipeline, including the Dorjilung hydropower project that will likely come online after 2030, this scenario
assumes that no additional projects are planned after 2025.
⊲ A comparison of Scenario 1 and Scenario 2 demonstrates the impact of the planned hydropower projects on
the economy (the Dutch Disease).
⊲ Scenario 3: Scenario 2 with hydropower rents invested in physical and human capital. This scenario is identical
to Scenario 2, but with the assumption that public policy is used to diversify the economy by investing additional
hydro revenues in human and physical capital accumulation, rather than in general public spending on wages,
goods and services. Additional revenues are split equally between (i) focused education expenditures such as
skills training to improve labour productivity; and (ii) capital investments through government savings. A compar-
ison between Scenario 3 and the reference Scenario 2 shows the impact of allocating additional hydropower
revenues towards a diversification policy. 41
40 The detailed results are reported in Shutes, F., and McDonald. 2022. CEM Background Paper. World Bank, Washington, DC.
41 Compared to the BAU scenario, additional hydropower rents are redirected from general government spending towards investments in human and physical capital. A stylized
approach is taken in which additional revenues are split equally between spending on training, resulting in labor productivity improvements, and spending on capital investments
via government savings. The CGE scenarios are indicative and aim to demonstrate broad trends and trade-offs.
33
Hydropower Revenue Management for Economic Diversification
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Figure 40: Additional hydro revenues after 2019 in the reference scenario, 2020-2030
400 160000
350 140000
300 120000
Nu ('00s) or USD
250 100000
Nu (millions)
200 80000
150 60000
100 40000
50 20000
0 0
2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Additional revenues per capita (Nu, '00s) Additional revenues per capita (USD, 1Nu = 0.013 USD)
Additional revenues cf 2019 (Nu, millions) Cumulative additional revenues (Nu, millions)
Source: Shutes, F., and McDonald. 2022. CEM Background Paper, World Bank.
⊲ Estimates from the CGE model indicate that channeling additional hydropower revenues into physical and human
capital, specifically through focused educational expenditures such as skills training, leads to labor productivity
improvements and enhances capital accumulation.
⊲ Scenario 4: Scenario 2 with hydropower rents distributed through fiscal transfers – a Basic Income Grant (BIG).
A least cost allocation of hydro rents is assumed, whereby the Grant is assumed to be untargeted and unweighted,
such that all individuals receive an equal per capita payment. No explicit welfare objective is associated with the
allocation of rents. A comparison of this scenario with the reference Scenario 2 shows the impact on the econ-
omy of targeting additional hydropower revenues on fiscal transfers, instead of funding government efforts to
create human or physical capital.42
⊲ Scenarios 3 and 4 capture the impacts stemming from two different policies related to the utilization of hydro-
power revenues with the aim to diversify the economy.
Scenario 3 presents a growth model that utilizes hydropower rents to finance key investments, while Scenario
4 simulates a situation where the rents are channelled to households through direct fiscal transfers. Scenario 3
captures policies to facilitate the availability of factor inputs, including human capital, infrastructure, and physical capital,
technological know-how, institutional quality such as macro stability and the regulatory environment, removal of trade
barriers, and access to financing.43 In Scenario 4, the idea is to make growth more inclusive through a universal BIG.
The concept of distributing resource revenues directly to citizens through cash transfers is often advocated as a means
to improving accountability; it encourages citizens to monitor resource income and widens the opportunity for citizens
to invest in human capital. A few resource-rich states, such as Alaska or Alberta (Canada), have implemented citizen
dividend schemes.
Scenario 1, with no additional hydropower investments, exhibits the lowest growth rate. The primary sectors expand
without the additional hydropower projects, resulting in a broader economic base (Figure 42). As a result, real house-
hold consumption per capita increases because capital growth is distributed more evenly across the economy, even
though it is lower without the additional investment in hydropower. The shift in labor demand resulting from greater
42 The implementation of the Basic Income Grant (BIG) does not account for administration costs as these are unknown. As such the results should be viewed as an outer bound
on the likely impacts of the policy.
43 Lian, W, et al. 2021. “A Diversification Strategy for South Asia”. IMF, Washington, DC. While the scenario does not specify where and how to invest the resources (see section 1.3.2
for discussion on sector-specific policies), it can assess whether the growth model can outweigh the impact of the hydropower expansion through the real exchange rate effects
(Dutch Disease-type effects) by comparing the economy with the reference scenario, as well as the no-additional hydro scenario.
34
Hydropower Revenue Management for Economic Diversification
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diversification leads to a more balanced rate of wage growth across sectors compared to Scenario 2. Urban households
benefit from higher capital returns, which boosts their consumption growth. Where additional hydropower is present, all
households experience higher consumption levels compared to Scenario 2. 44 However, without additional hydropower
plants, electricity production and exports decrease significantly, leading to lower hydropower revenues and government
consumption growth. This, in turn, affects education and health spending, resulting in a slower rate of future human
capital accumulation.
The results from Scenario 2 align with Bhutan’s previous experience, indicating that the economy would grow more
rapidly with the additional hydropower investments, but diversification would be limited. The heavy reliance on
hydropower has stymied economic diversification and job generation. In Scenario 2, the anticipated doubling of the hydro
generation capacity is expected to result in higher growth, albeit at the cost of higher economic concentration due to
Dutch Disease-type effects. This includes higher net exports, appreciation of the real exchange rate, and constraints on
the growth of non-hydro sectors (except construction), as well as lower domestic absorption and household consumption.
This is reflected in an increase in the index of economic concentration, indicating a less diversified economy by 2030
compared to Scenario 1, where no additional hydropower is assumed.45
The CGE model shows that Dutch Disease-type effects are evident in the tradable service sectors. The non-hydro
export sectors related to tourism, such as airport transport, hotels and restaurants, and travel agencies, are significantly
affected by spending and resource movement effects. The contraction in the tourism sectors is led by a strong reduc-
tion in export demand, compounded by falling intermediate demand from interlinked contracting sectors.46 Electricity
production is projected to increase by 122 percent from 2019 to 2030, with a significant portion of the additional supply
being directed towards meeting export demand, which is expected to grow by 138 percent (8.2 percent per annum)
(Figure 122, Annex 2). The remaining three sectors to benefit from the expansion in hydropower are all non-tradables
linked to the hydropower sector: electricity distribution, hydropower construction, and public administration (Figure 43). 47
GDP growth is highest in Scenario 3. Higher government spending in human as well as physical capital results in an
increase in productivity through higher supply of labor and capital. The economy is more diversified as indicated by the
lower concentration index compared to Scenario 2 (Figure 42, and Annex 2). The labor intensive industrial and construc-
tion sectors benefit most in terms of value-added, but there is also higher growth in all sectors through the direct factor
effect and indirect spending effect via higher household consumption (as evident in the higher growth of domestic
absorption compared to both Scenario 2 and Scenario 4). Households benefit from the investments, with higher growth
in consumption across all household types compared to Scenario 2.
Scenario 4 results in a more diversified economy but also results in lower growth compared to reference Scenario 2
and Scenario 3. Many sectors that stagnate in Scenario 2 receive a boost, which results in a more diversified economic
base. Agriculture, natural resources, food and beverages, and industry sector exhibit higher growth due to the pattern
of household consumption. This is so because non-poor agricultural households receive a boost to agricultural incomes
through higher land and capital returns, in addition to the large BIG transfers. The service sector experiences lower growth
compared to Scenarios 2 and 3 due to reduced government service spending. However, export-led services increase,
compared to Scenario 2, albeit to a smaller extent compared to Scenario 3. Given that non-poor agricultural households
44 Scenario 2 leads to an increase in real household consumption per capita, but the distribution of benefits is uneven. Wage rates and returns to capital grow moderately, except in
agriculture. Agricultural households experience the lowest consumption growth due to slower growth in the agricultural sector. Urban households, which contribute significantly
to private savings, experience income growth but increase their savings, keeping consumption levels close to 2019 levels. Urban households play a key role in raising private
investment funds as total non-hydro investment increases.
45 An index of economic concentration, akin to the Herfindahl-Hirschman index used to measure market concentration. The index of economic concentration is equal to the squared
share of each activity’s output, QXa, in total output expressed as an integer, summed across all activities. For the 29 activities considered, the limits of the index are 344 if all
activities contribute equally to production, and 10,000 if only one activity produces all output.
a [ * 100]
2
(_ )
QXa
,s,t
,t
Economic concentrations ∑
=
QX
∑ a
a,s,t
.
46 The manifestation of Dutch Disease effects in the CGE model is in the export-led service sectors. This is in line with the findings of Benjamin et al. (1989), who show that it is the
exportable sector that suffers, whether that be manufacturing in developed countries, agriculture in developing countries, or, for Bhutan, tourism services. The non-tradable sectors
will also see a slowdown in growth, although lesser compared to the export sectors. This is in line with the Dutch Disease-type effects where non-tradable sectors which do not
compete with imported goods and services are less affected from the appreciation of the real exchange rate and benefit from the growth in national income from the booming
resources sector. Exceptions to this are the finance, telecommunications, and utilities non-tradable sectors. Bhutan’s strategy of high value, low volume tourism is sensible as
it focuses on tourists that are likely to be less sensitive to price increases from the appreciation of BRER. See Benjamin, N.C., Devarajan, S., and Weiner, R. 1989. “The ‘Dutch’
Disease in a Developing Country. Oil Reserves in Cameroon.” Journal of Development Economics, 30, 71-92.
47 The expansion of the hydro projects would lead to an almost doubling of labor demand and share of labor in the electricity sector by 2030 (albeit from a small share of labor in
2019 to 4.6 percent in 2030). The movement of labor into public administration following hydropower investment is in line with the findings of Norbu, N. 2017. “Diagnosing the
Dutch Disease: Are the Symptoms Present in Bhutan?” Munich Personal RePEc Archive (MRPA) Paper No. 93249. Munich, Germany.
35
Hydropower Revenue Management for Economic Diversification
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comprise approximately half the population, this impact, alongside the induced diversification of the economy, makes
BIG an attractive policy to consider, if the slower growth in the services sector can be addressed (see Annex 2 for more
details on BIG).48
However, the interventions outlined in Scenarios 3 and 4 are not sufficient to outweigh the adverse effects of the
Dutch Disease on the non-hydro sectors. The performance of non-hydro sectors including the export-oriented service
sector, which was significantly affected by the Dutch Disease-type effects, is stronger compared to the hydro-led refer-
ence Scenario 2, but weaker compared to the no additional hydro Scenario 1. The type of policies modeled in Scenario
3 need to be supported by other policies to foster economic diversification in Bhutan. First, Bhutan’s landlocked nature
and the mountainous local topography result in high transport costs and market fragmentation. Transport costs can be
reduced by investments in transport infrastructure but the absence of a coastline limits scope for export opportunities.
Second, the population is small, resulting in a small domestic market for goods and services. Such economies need to
look more to the engine of external (global) demand than internal (domestic) demand for their prosperity. Additionally,
while a fiscal transfer program may be easier to implement, it does not necessarily ensure the required investments for
economic diversification, as it may predominantly encourage higher consumption rather than investment.
Therefore, Bhutan may need to implement targeted policies to foster the development of tradable sectors instead
of relying solely on creating an enabling environment for the spontaneous emergence of a sophisticated export
sector. In this spirit, the next sections discuss options to effectively utilize additional hydro rents for enhancing domes-
tic investment, followed by a discussion on complementary policies to mitigate the effects of the Dutch Disease and
promote economic diversification.
Table 3: Economic development in different scenarios, 2030
2019 Scenario 1: No Hydro-led Scenario 3: Scenario 4: BIG
hydro scenario 2: Physical and
human capital
GDP 180.9 260.8 280.6 293.3 277.1
Domestic absorption 205.2 292.8 271.3 292.7 264.1
Savings 69.2 98.2 98.2 107.8 98.2
Hydro production (real) 20.2 23.5 44.7 45.6 45.1
Non-hydro production (real) 257.0 354.6 331.3 350.3 334.4
Economic concentration index 623.0 685.8 725.6 722.2 719.5
Government consumption 32.6 47.7 56.1 50 34.7
Household consumption per-capita (in thousands of Nu) 129.8 184.5 147.3 169.8 165.3
Source: Shutes, Feuerbacher and McDonald. 2022. CEM Background Paper, World Bank.
Note: All figures in Nu billions unless otherwise indicated. Please note that estimates are indicative and should not be interpreted as actual growth estimates.
48 Services sector includes trade, hotels and restaurant, land transport, air transport, travel agency, telecommunication, finance, public admin, education, health, and other services.
36
Hydropower Revenue Management for Economic Diversification
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Figure 41: Dutch Disease-type effects (spending and resource movement), 2030
100%
ElecGen
80%
60%
Resource movement e ect (%)
ElecDnT
40% ConstrHydro
20% PublicAdmin
Agric
Mining FoodBevTob
0%
-40.0% -20.0% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0%
LandTrans ConstrNonHydro
HotelsRestaurant -20%
OtherServ TravelAgency
TeleComm Utilities
AirTrans Finance -40%
Spending e ect (%)
Source: Shutes, Feuerbacher and McDonald. 2022. CEM Background Paper, World Bank.
Note: green – booming resource sector, orange lagging export sector, purple – non-tradable sector.
1.3. Economic diversification in Bhutan: a
framework for managing hydropower rents
or investing domestically
1.3.1. The case f
There are different options to manage resource rents (Figure 42). Resource revenues can be consumed or invested.
First, the Government can use the resource revenue for public or private spending through citizen dividends, subsidies,
and the tax/benefits system, which would increase domestic consumption. Second, resource revenues can be invested
in financial assets domestically or abroad, which can be used as savings for future generations or as a means of fiscal
stabilization if invested in low-risk assets (as has been done by Chile’s government, Botswana’s Pula Fund and Norway’s
Pension Fund, and as anticipated by Bhutan’s BESF). Third, resource revenues can be invested in real assets through the
public sector or private sector in the form of subsidized credits, production or export subsidies, or by reducing public debt.
The framework for the efficient management of natural resource revenues to mitigate potential Dutch Disease-effects
needs to consider several factors. There are two broad strategies to address Dutch Disease-effects: (i) smoothening
of the spending of revenues earned from the export of natural resources, which can be achieved through the creation
of a fiscal stabilization or sovereign wealth fund; (ii) promoting economic diversification into new sectors and industries.
Greater economic diversification, in turn, is associated with lower growth volatility and higher long-term average growth
in small states.49 This is important for small economies like Bhutan, which are especially vulnerable to external shocks
because of their remoteness, trade openness and economic concentration, and susceptibility to natural disasters and
climate change. There is no consensus in the literature on the optimal resource revenue management framework, but
several factors have been identified as important:
49 McIntyre, A., et al. 2018. “Economic Benefits of Export Diversification in Small States.” IMF Working Paper WP/18/86, IMF, Washington, D.C.
37
Hydropower Revenue Management for Economic Diversification
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Figure 42: Pathways for managing resource revenues
Bhutan's current model of Scenario 2: expanded Scenario 3: spending on Scenario 4: transfers to
investment of hydro rents government expenditures human and physical capital citizens through BIG
Resource revenues
Investment Consumption
Real assets Financial assets
Public Private spending
spending
Abroad Domestically Domestically Abroad
Bhutan:
Goods and Untargeted Targeted
services, spending spending
Public sector Private sector Safe assets High yielding interest,
Bhutan: assets transfers, Citizen Bhutan:
Investments of wages dividend, Current
the Bhutan schemes, nota transfers to
General Sector- specific applicable to individuals,
Economic
capabilities capabilities Bhutan contributio ns
General Sector- specific Stabilization
capabilities capabilities Fund (BESF) to national
Bhutan: Bank Conditional provident
lending, support upon fund,
Bhutan: Bhutan:
subsidized certain allowances
Infrastructure, Investments to
credit, Bhutan activities
human capital promote the non-
Development
spending hydro tradable
Bank
sector, SOE sector
Economic diversification Fiscal stabilization
Source: Adaptation from Chang, H. J., and Lebdioui, A. 2020.50
i. Nature of resource rent (temporary or permanent): If resources are expected to be depleted rapidly, policymakers
may want to protect the vulnerable sectors through fiscal stabilization and the buildup of official foreign exchange
reserves to insulate the economy from the time-bound and short-run disturbances of Dutch Disease. If resources
are likely to be permanent, policymakers may want to boost productivity in the nontraded goods sector and diversify
exports to reduce dependence on the booming sector and make them less vulnerable to external shocks, such as
a sudden drop in commodity prices (IMF, 2023).51
ii. Degree of resource dependence: The more dependent a country is on a resource, the more urgent the need for
diversification, as the economy is vulnerable to the fortunes of the resource sector.
iii. Levels of resource rents per capita: Low resource rents per capita (i.e., below US$600) can often entail a high
opportunity cost of investing in financial assets overseas, given that their returns are unlikely to free up sufficient
capital for domestic investment, in contrast to high resource rents per capita countries (e.g., Norway, Canada, United
Arab Emirates (UAE), and Australia).
iv. Institutional capacity to invest: The efficiency of ‘riskier’ investments in domestic real assets is heavily influenced
by the domestic capacity to appraise, monitor, and evaluate investment projects. Weak capacity carries the risk that
the resource rents will not be invested effectively and would have been better saved.
v. The level of public savings: The savings rate determines the ability of the country to invest domestically. A country
with high savings has greater protection against shocks and can allocate more revenues to investments.
50 Chang, H. J., and Lebdioui, A. 2020. “From Fiscal Stabilization to Economic Diversification: A Developmental Approach to Managing Resource Revenues”. WIDER Working Paper
2020/108. UNU-WIDER. Helsinki, Finland.
51 IMF. 2023. “Dutch Disease: Wealth Managed Unwisely.” Back to Basics Compilation, IMF, Washington, DC.
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Hydropower Revenue Management for Economic Diversification
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vi. Domestic investment rates and deficit: Investment deficits (including low spending on human capital, education
or Research and Development [R&D]) increase the opportunity costs of saving resource revenues (e.g., in financial
assets overseas) as funds would not be available for domestic investments to improve productive capabilities.
There are important tradeoffs, including high opportunity costs of over-investing in stabilization funds at the expense
of social spending and investment in domestic productive capabilities. Fiscal savings in stabilization funds (often in the
form of holding liquid overseas financial assets) have a high opportunity cost given that the funds would not be available
for domestic investment in the acquisition of productive capabilities that can foster economic diversification. Although
increased government spending can generate demand pressures on non-traded goods, leading to a real appreciation
and a decline in traded-good production, efficient public investment can also raise productivity in non-resource tradable
sectors, counteracting the Dutch Disease. Box 1 discusses the contrasting resource management frameworks in Malaysia
and Chile. While Malaysia has converted natural wealth into productive capital assets, Chile has used its natural resource
rents to pursue fiscal stabilization and savings for future generations.
Bhutan’s high resource dependence, low resource rents per capita, and a domestic investment deficit indicate the
importance of using hydropower resources to invest in economic diversification. Despite Bhutan’s high dependence
on natural resources, the country has a relatively low resource rent per capita of US$400, compared to other resource-
rich countries like Norway and UAE (Table 4). Although Bhutan has a high share of gross fixed capital formation, which
serves as a proxy for investment, it masks the significant investment needs in key social and infrastructure sectors. The
human capital index for Bhutan reveals that a child’s productivity in adulthood is only 48 percent of what it could have
been with access to complete education and better healthcare.52 Additionally, Bhutan ranks 97th out of 139 countries
in the World Bank’s 2023 Logistics Performance Index (LPI), indicating lower infrastructure quality compared to other
nations. Given the urgent need for economic diversification and the country’s modest savings rates, there is substantial
potential for investing hydropower rents domestically.
Table 4: Factors to consider for the resource revenue management framework
Factors Description Bhutan Malaysia Chile Norway UAE
Degree of Resource Total natural resource rents (% of GDP) (average; 2017-2021)1 2.6+10.12 6.2 7.2 6.6 15.8
dependence (12.7)
Levels of resource Total natural resources rents (US$ per capita) (average; 84+3202 671 1,113 5,326 6,931
rents per capita 2017-2021) (404)
Domestic Gross capital formation (percent of GDP) (2017-2021) 41.3 22.5 23.8 28.3 23.4
investment rates
and deficit Gross savings rate (percent of GDP) (2017-21) 21.3 25.8 19.6 34.7 --
Government expenditure on education (% of GDP) (2017-2021) 6.6 4.3 5.5 2.7 7.4
Government expenditure on health (% of GDP) (2017-2021) 2.8 2.0 4.9 9.0 2.5
Human capital index (2020) 0.48 0.61 0.65 0.77 0.67
Learning adjusted years of schools (years) (2020) 6.3 8.9 9.4 11.2 9.6
LPI score (and rank, out of 139 countries), 2022 2.5 (97) 3.6 (26) 3.0 (61) 3.7 (19) 4.0 (7)
Source: World Bank, World Development Indicators, Human Capital Project, Logistics Performance Index (LPI) 2023, and World Bank staff calculation.
Note: 1Total natural resource rents are the sum of oil rents, natural gas rents, coal rents (hard and soft), mineral rents, and forest rents. 2 For Bhutan, hydropower exports
have been included
Bhutan’s current hydropower revenue management involves a mix of consumption and investment. Over the past
five years, the majority (54 percent) of domestic revenue, 40 percent of which is generated from hydropower, was
consumed through public recurrent spending in the form of wages and the provision of goods and services. Private
spending accounted for 18 percent and was directed to social transfers, including allowances and contributions to the
52 Human Capital Project. World Bank. 2020. “Human Capital Index Report”. Human Capital Project, World Bank, Washington, DC. https://www.worldbank.org/en/publication/
human-capital
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Hydropower Revenue Management for Economic Diversification
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National Provident Fund.53 The remaining resources (28 percent) have been allocated towards investments. This includes
domestic investments in the public sector (in infrastructure and human capital) and the private sector (for instance directed
lending through subsidies to state-owned financial institutions and development finance institutions, such as the BDB).
A small fraction was channeled to the BESF for fiscal stabilization purposes (0.2 percent), mainly foreign assets in INR.
The Government’s current revenue management model is highlighted in Figure 44.
However, to promote economic growth and diversification, Bhutan needs to allocate more of its resource rents
towards investments. Currently, Bhutan has one of the highest levels of public capital spending in the world (excluding
hydro investments), which has been largely financed by external grants (Figure 43). These grants have covered almost
50 percent of capital spending over the past five years. However, there has been a decrease in external grants, from 14.0
percent of GDP in 2012 to 7.1 percent in 2022. This decline is expected to continue as Bhutan is projected to graduate
from the status of Least Developed Country (LDC) by 2023, which is expected to reduce Official Development Assistance
(ODA).54 Given the current high allocation of domestic resources to public spending, Bhutan has the potential to allocate
more of its domestic resources, including resource rents, towards real assets. This would involve directing more funds
towards investments in tangible assets such as infrastructure, industries, and other productive sectors.
Further, Bhutan has ample scope for improvement in the efficiency of government-funded public investment. Despite
having one of the highest levels of public capital spending globally, there are notable investment deficits, particularly in
soft and hard infrastructure, and the quality of infrastructure remains below that of many other countries (Figure 44). A Data
Envelopment Analysis (DEA) conducted as part of the Bhutan Public Expenditure Review (PER) revealed opportunities
for efficiency gains, with an overall efficiency score of 60 for infrastructure. Additionally, a recent diagnostic assessment
of the Public Investment Management (PIM) system highlighted several issues in government-funded investment proj-
ects, including: a lack of strategic guidance, ambiguity in project appraisal and independent review of project proposals,
weaknesses in project selection and review processes, inadequate identification and management of high-risk projects,
shortfalls in funding for current expenses and maintenance, and a lack of ex-post evaluation or impact assessments.55
Figure 43: Bhutan (non-hydro) capital Figure 44: Public capital Spending versus quality
expenditure in international perspective of infrastructure
6.5
20%
6.0
5.5
Average capital spending (% of GDP)
Infrastructure quality (WEF)
5.0
4.5
10% Bhutan
4.0
3.5
3.0
2.5
0%
Bhutan South Asia Upper-middle Lower-middle
income income 2.0
0% 5% 10% 15%
Infrastructure Education Health Agriculture Agriculture Capital spending (% GDP)
Source: Bhutan Public Expenditure Review. 2023..56
53 The Bhutan BOOST expenditure database was used to approximate allocation of domestic revenues, of which 40 percent is from hydropower revenues in the form Corporate
Income Tax (CIT), royalties, dividends, and profit transfers. Public spending includes wages, goods and services, interest and debt amortization payments, select transfers, and
other expenditure. Private spending includes select transfers, including contributions to the provident fund, current grants to individuals and non-profit organizations, and pensions.
Investments include capital goods and services, net acquisition of fixed assets, plant and equipment, structures, training, and transfers, equities, and on-lent loans (mainly to
SOEs).
54 Officla Development Assistance (ODA) accounts for approximately 30 percent of total grant receipts. The remainder is received from India and is not expected to be affected by
the Least Developed Country (LDC) status. However, grant receipts from India are subject to uncertainty, as they are renegotiated as part of the (Five Year Plan) FYP cycle and
are tied to the Royal Government of Bhutan’s (RGoB’s) ability to execute spending under the FYPs.
55 RGoB. Ministry of Finance. 2021. Strategic Diagnostic Assessment of the Public Investment Management System in Bhutan.
56 World Bank. (2023b). “Bhutan Public Expenditure Review.” World Bank, Washington, DC.
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To promote economic growth and diversification, Bhutan can consider investing some of the future hydropower rents
in the progressive accumulation of productive capabilities in tradable sectors. These investments could help overcome
domestic structural constraints such as its small domestic market and mountainous topography, while also mitigating
the risks associated with resource revenues, including public investment inefficiency, absorptive capacity constraints,
and Dutch Disease-type effects. The principle underlying this course of action is the Hartwick rule that suggests that
the value of (net) investment needs equals the value of rents on extracted resources at each point in time. 57 Bhutan
could opt for a two-pronged approach comprising (i) a gradual scaling up of domestic investments in real assets along
with the expanding capacity to invest, and (ii) supporting sectors that are affected by Dutch Disease-type effects. In this
sense, Bhutan can benefit from a resource management framework that is, in principle, more akin to Malaysia (Box 1).
Going forward, more hydropower resources will need to be set aside to promote fiscal stabilization. As highlighted
in the Bhutan PER, Bhutan has one of the most procyclical government spending among its peers, primarily due to
the volatility of hydropower revenues. Profit transfers and dividends from SOEs fluctuate from year to year based on
factors such as the commissioning of new plants and weather patterns. Therefore, some of the resource rent should
be allocated to the BESF to help smoothen volatile hydro revenues and public spending in the face of negative shocks,
thereby reducing the need to undertake expenditure cuts with adverse growth development effects (on infrastructure
and human capital investment in particular) (Box 2).
or economic diversification in Bhutan
1.3.2. Current policies f
Bhutan has been actively conducting sector-specific policy interventions to support economic diversification and
job generation. These interventions aim to address the unique structural constraints, including being landlocked, having
a small labor force, and a limited domestic market. Bhutan has been implementing diversification policies to facilitate
the availability of factor inputs, including investments in human capital, infrastructure, physical capital, technological
know-how, institutional quality, removal of trade barriers, and access to financing. However, as illustrated in Section 1.2,
these policies alone may not be sufficient to stimulate economic diversification. Market failures, specifically informa-
tion and coordination externalities, can pose significant constraints to the development of specific sectors. 58 Firms in
Bhutan may not fully internalize the productivity gains from potential activities due to information externalities, where
they lack knowledge about which products are likely to succeed. Additionally, coordination externalities can hinder the
development of new sectors that require specialized intermediate goods, skills, or infrastructure to achieve a critical
scale and scope to be viable.
In the case of a small landlocked economy like Bhutan, market failures can be more pronounced due to several
reasons. The limited market size and infrastructure constraints contribute to coordination failures, making it challenging
for industries to effectively coordinate their activities. The lack of economies of scale further compounds this issue, as
firms struggle to achieve cost efficiencies and compete with larger economies. Bhutan’s geographical location presents
challenges in terms of transportation and logistics, leading to higher costs and limited access to international markets.
These constraints can impede the development of industries, hinder scalability, and make it difficult for them to compete
globally. Bhutan may also face difficulties in acquiring and adopting advanced technologies due to limited access to
knowledge networks and innovation hubs.
The Royal Government of Bhutan (RGoB) uses a wide range of tools to implement targeted sectoral interventions
in the product, capital, labor, and land markets with different degrees of complexity. The most prominent example is
the State’s role as a producer and consumer in the economy, reflected in the large SOE sector. SOEs are concentrated
in strategic sectors, including hydropower and electricity, manufacturing, the financial sector, and also industries in
which private firms operate, such as, air transport, mining, agriculture, communication, Information Technology [IT], and
healthcare. The number of SOEs increased from 18 in 2005 to 39 in 2020, driven by the Government’s dual strategy to
(i) harness the hydropower potential by developing new hydropower plants and associated services, and (ii) promote
economic diversification and job creation through investments in SOEs.
57 The Hartwick Rule suggests that countries should invest resource rents into other types of assets, and that a constant level of consumption can be sustained if the value of
investment equals the value of rents on extracted resources at each point in time (Hartwick, 1977). See Hartwick, J.M. 1977. “Intergenerational Equity and the Investing of Rents
from Exhaustible Resources.” American Economic Review, 66, 972-74.
58 Cherif, R., et al. 2022. “Industrial Policy for Growth and Diversification: A Conceptual Framework.” IMF, Washington, D.C.
41
Hydropower Revenue Management for Economic Diversification
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Box 1: Two contrasting frameworks: resource management in Malaysia and Chile
Active domestic reinvestment of resource rents - the case of Malaysia. Malaysia’s resource revenue management practices
are oriented towards achieving structural transformation and diversification objectives. During most of the period from 1970-
1998, Malaysia’s overall fiscal management was characterized by very high fiscal deficits to finance public investments, with
transformative effects on the export basket in the long run.59 Malaysia’s impressive economic performance is closely tied to
its sound management of natural resource revenues and that it is one of the few countries that has followed the Hartwick rule,
according to which the value of (net) investment needs to equal the value of rents on extracted resources at each point in
time.60 Malaysia has converted natural wealth into productive capital assets (namely infrastructure, machinery, human capital
and institutions) that have supported economic diversification towards manufacturing and services.
Oil and gas revenues in Malaysia have been mostly spent domestically, either through re-investments by Petronas (the national
oil corporation), government expenditures, or subsidies.61 After paying dividends to the Government, Petronas also retains
between 25 percent and 50 percent of its oil and gas revenues, which it reinvests in different segments of the oil and gas supply
chain, as well as in petroleum-related sectors and non-petroleum-related sectors such as car manufacturing and property devel-
opment (International Monetary Fund, 2015).62 Because of its mandate and significant resource-revenue investments, it can be
argued that Petronas has in some instances played a similar role to a resource fund (ibid). It has provided some insulation to the
budget against volatility in oil prices, especially in the 1980s, with oil price changes only partially transmitted to the budget (ibid.).
Meanwhile, the share of the revenues allocated through the annual budget is primarily spent on development projects, although
there is no exact way to calculate how much oil revenues feed into specific projects because revenues from all industries
are “pooled” together.63,64 The Federal Government decides how to manage and divide the revenues into three broad areas:
expenditure (both recurrent and investments) and savings.
A much smaller portion of oil and gas revenues (about US$25 million a year) also goes into the National Trust Fund, also called
Kumpulan Wang Amanah Negara (KWAN) – set up in 1988 with the purpose of securing national wealth for future generations
– in which they are earmarked for future investments and savings.
In addition, while Khazanah Nasional Berhad, unlike Petronas, does not manage resource revenues and receives no ‘sovereign’
wealth per se, it acts as a strategic investment fund to spur structural transformation and to create strategic value, understood
both in terms of commercial profit, as well as potential for knowledge intensity, transformative effects, and spillovers for the
national economy.
Over-emphasis on fiscal stabilization at the expense of domestic investment: the case of Chile. Chile’s copper-financed
sovereign wealth funds do not invest domestically. Since the 1980s, copper windfalls, which have represented around 50
percent of Chile’s export revenues in the past decade, have mainly been used for fiscal stabilization and savings for future
generations. Chile has indeed implemented a successful counter-cyclical fiscal policy. However, this fiscal stabilization agenda
was followed at the expense of financing for structural transformation.
The copper price boom in the 2000s led to an increase in state revenues and allowed the creation of three funds in 2006:
the Economic and Social Stability Fund (ESSF), the Pension Reserve Fund (PRF) and the Innovation for Competitiveness Fund
(ICF), which is much smaller in size. The ESSF replaced the original Copper Stabilization Fund (created in 1985) and inherited its
assets (of around US$5 billion). Its objective was to finance potential fiscal deficits, therefore avoiding the negative effects on
government income associated with copper price volatility. The PRF is a savings fund that receives between 0.2 and 0.5 percent
of GDP, depending on the size of Chile’s overall surplus each year.65 Both the PRF and the ESSF funds are administered by the
Central Bank and invested in international markets in low-risk financial instruments (financial assets with a high level of liquidity
and low credit risk and volatility), and consequently do not contribute to the local economy through domestic investments.
59 Di John, J. 2009. “From Windfall to Curse? Oil and Industrialization in Venezuela, 1920 to the Present.” Penn State University Press, University Park, PA.
60 World Bank. 2013. “Malaysia Economic Monitor: Harnessing Natural Resources”. World Bank, Washington, D.C.
61 Lebdioui, A. 2019. “Economic Diversification and Development in Resource-dependent Economies: Lessons from Chile and Malaysia.” Apollo - University of Cambridge Repository, Cambridge,
UK.
62 IMF. 2015. “Malaysia: Selected Issues”. Selected Issues Paper on Malaysia, January 30, IMF, Washington, D.C.
63 Yeoh, T. 2008. “Promoting Revenue Transparency in Malaysia”. Centre for Public Policy Studies, London. UK.
64 Centre for Public Policy Studies. 2017. “CPPS Policy Factsheet: Oil and Gas”. London. UK.
65 Ruiz-Dana, A. 2007. “Commodity Revenue Management: The Case of Chile’s Copper Boom.” International Institute for Sustainable Development, Winnipeg, Canada.
42
Hydropower Revenue Management for Economic Diversification
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Chile’s fiscal stabilization agenda has been successful in smoothing expenditures over time. However, it falls short in effectively
supporting local economic development goals. The country’s persistent high income inequality is evident, with a peak poverty
headcount ratio of 25 percent in the past decade.66 The management of copper revenue in Chile reveals the significant oppor-
tunity costs associated with excessive investment in stabilization funds at the expense of social spending and investment in
productive capabilities.67 The current assets of the ESSF, PRF, and copper-funded defense fund represent nearly 10 percent
of GDP, while public spending on education, health, pensions, and other social sectors consistently lags behind that of OECD
and other Latin American economies.
Box 2: Bhutan Economic Stabilization Fund
The BESF was set-up to stabilize hydro inflows (and other revenue from natural resources) into the Budget, but proceeds
have been largely used to finance current expenditures. The Government established the BESF in 2018 as per the Royal
Charter and defined fiscal stabilization rules in 2020 that regulate
contributions to and uses of the Fund (mainly covering royalties Figure 45: The projected balance of BESF in
from hydro and other natural resources and lumpy profit transfers percent of GDP, 2023-2040
from hydro projects and the Central Bank). Hydropower reve- 18%
nue fluctuates year-to-year depending on the power generated. 16%
Hydropower revenue is volatile, as profit transfers and dividends
14%
from SOEs fluctuate year-to-year depending on the commis-
sioning of new plants and weather patterns. Over the period 12%
2001-2021, the standard deviation of the real annual value of
BESF (% of GDP)
10%
total hydropower revenues, excluding the newly commissioned
8%
Mangdechhu hydropower plant, was 17 percent or 1.9 percent
of GDP. On the other hand, current expenditures are structurally 6%
more rigid. The Public Finance Act states that current expendi- 4%
tures should be met entirely with domestic resources. This rule 2%
does not constrain the growth of current spending when there
0%
is a temporary increase in domestic revenues from hydropower.
As a result, domestic revenue increases from the hydropower -2%
30
25
26
29
28
40
36
39
23
32
35
38
24
33
34
27
37
sector have typically been accompanied by increased current
31
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
expenditures, leading to a procyclical fiscal policy stance. Thus, Inflows Outflows Stock
volatility in hydropower poses fiscal risks as they create moments Source: MoF Medium-term Macroeconomic Framework (MTMF), World Bank
estimates
of fiscal space that allow the expansion of outlays that are not
easy to roll back when the cycle is reversed.
The BESF could accumulate significant funds if the stabilization measures are operationalized. The Fund held 825 million
Nu as of March 2022 or approximately 0.44 percent of GDP. The contribution to the Fund was stopped during the COVID-19
pandemic and withdrawals are not planned from it in the near term. Assuming a resumption of contributions by the Government,
the BESF balance would reach about 16 percent of GDP in the medium term (Figure 47). The investment policy stipulates that the
assets of the Fund should be invested in relatively liquid foreign assets with low risks (INR and convertible currency) managed
by the RMA. While the implementation of the BESF could help achieve a more sustainable fiscal path, it would be important to
reconsider the investment policy if the Fund attains a critical size. The BESF rules and regulations specify that once the BESF
reaches 10 percent of GDP, additional revenues shall be transferred to a newly created savings fund, which the Government
may choose to establish.
66 Lebdioui, A. 2019. “Economic Diversification and Development in Resource-Dependent Economies: Lessons from Chile and Malaysia.” Apollo - University of Cambridge Repository, Cambridge,
UK.
67 Solimano, A, and Calderon Guajardo, D 2017. “The Copper Sector, Fiscal Rules, and Stabilization Funds in Chile: Scope and Limits.” WIDER Working Paper 2017/53. United Nations University
– World Institute for Development Economics Research (UNU-WIDER), Helsinki, Finland.
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Hydropower Revenue Management for Economic Diversification
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Other sector-specific interventions include marketing boards and strategies, tax incentives, directed and direct
lending, skills development programs, and SEZ. The Government has launched several initiatives to promote prod-
uct quality and complexity and help boost export, for instance “Brand Bhutan”, which supports premium quality and
sustainably made agricultural products, manufactured goods, and high value tourism. Further, the Government has
been providing fiscal incentives since 2010 in the form of tax holidays and exemptions to promote investment in priority
sectors, including agriculture, tourism, and energy. Capital market interventions include the Priority Sector Lending (PSL)
program,68 the National Credit Guarantee Scheme (NCGS), and two national development banks, and the BDB, mainly
promoting access to finance for the agriculture and CSI sector (see Chapter 3). Additionally, Bhutan has a wide range of
skills development and employment promotion services to address shortages of skills. Finally, Bhutan has established
several SEZs to spur industrialization, exports, youth employment opportunities, and Foreign Direct Investment (FDI).
These policies have yielded mixed results, with limited impact on job creation. While SOEs contribute to a significant
part of economic activities and budget revenues – primarily driven by the electricity sector – the profitability of SOEs
across sectors has exhibited mixed and volatile performance. The profitability of SOEs is lower in competitive sectors
(manufacturing, retail, construction, and transport) compared to non-competitive sectors, which could reflect conflicting
objectives and a lack of competition (World Bank, 2023b). Fiscal incentives have benefitted mostly medium and large
businesses in the manufacturing, financial, and tourism sectors (World Bank, 2023b). Credit to the agriculture and CSI
sector has remained stagnant, and access to credit remains a key constraint to private sector development (see Chapter
3). Finally, a recent World Bank firm-level survey suggests that firms inside Bhutanese SEZs tend to have significantly larger
exports and employment than those outside these zones. However, there are no significant positive impacts on FDI (Box 5).
Sector-specific policies have been implemented in many countries as part of their growth strategies, but many have
been ineffective and inefficient. Governance failures, including state capture by rent-seeking private interests and
short-term electoral considerations, can result in suboptimal outcomes. This can result in disappointing returns in terms
of growth, job creation, and high financial, environmental, and social costs and, in the worst case, hinder growth and
destabilize economies and societies. The following principles can mitigate these risks: 69
⊲ Establish strong institutional mechanisms that incentivize beneficiaries to engage in market competition, with
clear performance criteria for selective interventions. The implementation of governance mechanisms, trans-
parency, and public disclosure can help enhance spending efficiency of resource rents and promote effective
allocation of resources. Appropriate benchmarks for the support received can be set up (i.e., specific performance
targets such as export market shares).
⊲ Focus on export orientation (rather than import-substitution) to leverage international competition, and target
sectors rather than specific firms. Countries that implement successful sectoral interventions rely on market signals
to hold themselves accountable, sustain competitive pressures, and drive innovation in the development and export
of new products. In contrast, import-substitution policies through high tariffs and other barriers to entry can limit
competition in the domestic market and the incentive to innovate, export and compete in international markets.
⊲ Using independent, appropriately qualified experts to select projects for public support. Since there are financing
constraints as well as constraints in implementation capacity, investments must be carefully analyzed to determine
their feasibility and rate of return. Balancing social, political, and economic considerations in investment evaluation
is complex. Therefore, it is crucial to set up the necessary institutions to evaluate potential investments and loans,
in addition to the essential transparency and oversight that yields effective governance of development finance
institutions.
The next section lays out institutional options to improve sector-specific policy interventions in Bhutan, focusing on
public finance institutions, evaluation and reporting arrangements, and coordination with education and territorial
policies.
68 The RMA prescribes lending targets for the banks, and ceiling preferential lending rates for lending to the agricultural and non-agricultural CSI sectors. Financial institutions which
have any shortfalls in meeting their priority sector targets may allocate their funds for on-lending to a microfinance institution or BDB.
69 Cherif, R. & Hasanov, F. 2019. “The Return of the Policy That Shall Not Be Named: Principles of Industrial Policy.” IMF, Washington, DC. and Cherif, R. et al. 2022. “Industrial Policy
for Growth and Diversification: A Conceptual Framework.” IMF, Washington, DC.
44
Hydropower Revenue Management for Economic Diversification
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Box 3: Institutional options
Fiscal stabilization funds can provide a fiscal buffer in case of a shock, reduce exchange rate volatility, and help mitigate
the Dutch Disease. Sovereign Development Funds and NDBs can encourage national development by providing financ-
ing and investing in domestic infrastructure and local enterprises with growth potential. In principle, an SDF makes equity
investments in companies, while NDBs provide loans, but in practice, some SDFs also make loans and some NDBs take
equity positions, and the difference between the two can be indistinct.
National Development Banks and SDFs can issue bonds to draw on private capital (which also contributes to growing
domestic financial markets) and establish partnerships with foreign firms and investors. Sovereign Development Funds
might also be able to attract investment from larger global Sovereign Wealth Funds (SWFs), including those of the Gulf
nations and Singapore’s Temasek, which have large international investment portfolios. Sovereign Development Funds
can assist in privatization programs if government shares in SOEs are put into the fund, with the goal of attracting private
investment to help reform them and turn the former SOEs into profitable commercial enterprises. Finally, NDBs and SDFs
can also extend loans to enterprises during downturns and ease back during booms (to reduce over-heating), thereby
acting as counter-cyclical instruments.
Figure 46: Institution types, objectives, and asset types
Typeo institution Objectives Asset types Examples
• Provide a fiscal bu er ni the case of a shock, to avoid increasing debt, or at least cushion
the impact Liquid &low yielding
Stabilisation Fund • Dampen the exchange rate volatility associated with shocks (e.g. sovereign
• Aims to prevent the 'resource curse' and the Dutch disease more specifically bonds)
• Encourage national development by providing financing for domestic infrastructure and firms
• Can draw on private capital by issuing bonds, and partner with foreign investors. Illiquid &low yielding
National Development • Helps overcome market failures preventing investments ni productive activities (e.g. loans or equity
Banks • NDs face more scrutiny than SDFs as the former have commercial credit ratings fi they issue positions)
bonds
• Encourage national development by investing in domestic infrastructure & equity of
Relatively illiquid
• companies with growth potential
Development Fund • Transfer and manage 'privatised' assets (e.g. equity in unlisted
• Invest ni equity abroad to foster technology transfer and JVs with domestic partners start-ups)
Source: Lebdioui et. al. (2023). CEM Background Paper.
or effectively channeling hydropower rents
1.3.3. A suitable institutional framework f
towards productivity enhancing assets in Bhutan.70
Public development institutions – building one well-managed and well-regulated institution is
preferable to having multiple weak ones.
Public development finance institutions play a crucial role in attracting private and foreign investments, but their
effectiveness depends on having adequate managerial and regulatory capacity. Box 3 provides an overview of the
different types of development finance institutions, their objectives, and the types of assets they manage. Fiscal stabili-
zation funds can serve as a buffer during economic shocks, reduce exchange rate volatility, and help mitigate the Dutch
Disease-type effects. Sovereign Development Funds (SDFs) and National Development Banks (NDBs) can contribute to
national development by providing financing and investing in domestic infrastructure and local enterprises with growth
potential. However, the mere establishment of NDBs and SDFs is not enough to ensure the proper management of
70 Based on Lebdioui, A., et al. 2023. CEM Background Paper. World Bank, Washington, D.C.
45
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
Box 4: From a Government Holding Company to a Sovereign Development
Fund: The Case of Malaysia’s Khazanah Nasional Berhad
Khazanah Nasional Berhad (“Khazanah”) was incorporated in 1994 as the strategic investment arm of the Government
of Malaysia. This was initially to house the Government’s shareholding in industries deemed strategic to the nation,
such as in the provision of electric utility, telecommunications and airports services that had been corporatized from
government departments into public companies. Its initial objective was to manage and turn around those SOEs that
were underperforming but overtime also transitioned to an SDF and a Sovereign Venture Fund.
For the first ten years, Khazanah’s investment style was principally custodial and passive, with more than 90 percent of the
value of assets under management being in Malaysia. In the aftermath of the Asian Financial Crisis of 1997/1998, several
other companies deemed strategic to the nation were added, including in airlines, infrastructure, banking, and telecom-
munications. In 2004, a radical change in strategy was undertaken as Khazanah was mandated with the multiple tasks of:
(i) uplifting the erstwhile poor performance of what became known as Government-Linked Companies (GLCs, essentially
SOEs wholly or partially owned or guaranteed by the Government); (ii) to restructure companies and industries affected by
the Asian Financial Crisis; (iii) to expand the investment footprint into new sectors and geographies; and (iv) to build human
capital and talent in the area of investment, corporate management and development management for the state-owned
sector and the nation at large. In order to undertake this significant shift in its mandate, several key measures were under-
taken. These included (i) changing its investment style to become significantly more active and hands-on; (ii) revamping the
management team and board (civil servants were replaced with leading talent from the relevant fields, including from asset
management, investment banking, and strategy consulting); and (iii) upgrading and strengthening its core systems, including
risk management, investment evaluation and execution, operational management, human capital management, and strategy.
From 2004-2018, Khazanah’s portfolio grew to Malaysian Ringgit (MYR) 157 billion (US$40 billion), while net assets rose signifi-
cantly from MYR 33.3 billion (US$ 8.5 billion) to MYR 115.6 billion (US$ 29.5 billion), an increase of 3.5 times. This translated
into a compounded annual growth rate of approximately 9.6 percent per annum over this period, which was significantly
higher compared to many of its peers. These improvements in financial performance were achieved with essentially no new
equity capital injections from the Government and with risk tolerance set at appropriately prudent levels. Equally importantly,
Khazanah also pioneered an investment style that has been described as not just executing a Sovereign Wealth Fund (SWF)
investment strategy, but also achieving developmental outcomes in delivering strategic outcomes. These include investing
in and driving industrial policy (in industries including healthcare, life sciences and biotechnology, sustainable development,
creative industries among others), developing new SEZs (a US$100 billion, Iskandar Malaysia), significantly restructuring GLCs
under a 10-year GLC Transformation Program (2005 to 2015), and expanding its regional and international investment footprint.
Today, Khazanah, remains a key national institution in delivering financial, economic, and socio-developmental outcomes
for Malaysia. In various studies analysing its performance, the key drivers for success have been identified under three
categories—(i) a clear and empowered mandate; (ii) critical capacity in key enablers, including the right talent, manage-
ment systems, and program management capabilities; and (iii) sound execution and consequence management systems.
hydropower revenues. There are many examples of resource revenues wasted through ill-conceived investments; NDBs
and SDFs can be subject to political capture, increasing the risk of investments being directed away from projects that
benefit national development.
Given the importance of effectively allocating resources, concentrating resources on a select few institutions and
initiatives can be beneficial. Bhutan already has several development institutions, including BDB, DHI, BoB, and the
BESF. The state-owned National CSI Development Bank Limited was merged with the BDB in 2023 due to financial losses
and overlapping mandates. Drawing from international experiences, one option to channel hydropower revenues into
domestic investments for export diversification could involve expanding the mandate of DHI from a holding company to
an SDF, similar to the model of Khazanah in Malaysia (Box 4). Other alternatives include expanding the mandate of the
BoB, increasing the capacity of the BDB, or re-orienting the BESF into an SDF.
46
Hydropower Revenue Management for Economic Diversification
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Setting up a public Investment Evaluation Unit for efficient evaluation and monitoring
The establishment of an autonomous and technically equipped public Investment Evaluation Unit (IEU) is crucial
to supporting the development of strong analytical capacity to evaluate development projects and policies. An IEU
comprises well-qualified economists and other specialists who evaluate projects and policy reforms in all their dimen-
sions: costs and benefits, economic rates of return, risk assessment, financing, and environmental and community
impacts. Ideally, an IEU is independent and maintains a long-term vision of economic transformation, irrespective of the
macroeconomic cycle. An IEU has a broader mandate than a PIM unit within the central government, which is tasked
with aiding government agencies in the preparation of investment projects. In addition to strengthening investment
project decisions, setting up an IEU can also send a strong market signal to potential investors regarding the quality of
economic management. A strong IEU has the following characteristics:
⊲ Technical integrity and independence, with some degrees of autonomy from day-to-day political influence; a
commitment from other government branches to provide information and data and avoid ‘lobbying’.
⊲ A pool of well-trained professionals with analytical capacity to assess investment projects, including environmental
and community impacts (human development, poverty, and social inequality effects). Experience can be drawn from
outside government and foreign expertise when required.
Efficient evaluation and monitoring require transparent reporting. Transparency can be enforced in multiple ways, both
ex-ante (about how decisions get authorized) and ex-post (evaluation). In addition, monitoring and evaluation mechanisms
can derive from top-down authority, bottom-up pressure from citizens and their representatives, civil society groups, as
well as norms internalized by the public sector workforce .71 Sovereign Wealth Funds that are permitted or mandated to
invest domestically should issue publicly available reports on a timely basis, covering their activities, assets, and returns,
as well as allowing themselves to be audited both internally and externally.72 While all funds embody “vertical account-
ability” (reporting to the government), some also mandate “horizontal accountability” to a wider audience, by making
information on balances, earnings, and deposits and withdrawals publicly available, or by sharing decision-making power
among a range of interest groups independent of the government.73 A good example is Norway’s wealth fund, which is
administered by the Central Bank, but decisions on transfers must be approved by Parliament.
The altitude economy – an approach to balance ambitions with risks and identify sectors
Bhutan’s sector-specific support policies could be formulated around the concept of the altitude economy, which
balances ambitions with risks. The principle of the altitude economy identifies different ‘elevations’ with the aim of
ascending to higher levels over time. Some policies and projects are readily attainable with current financial and human
resources and have good returns with few risks — the ‘foothills’. A more ambitious policy effort beyond the foothills
requires more resources and preparation to mitigate the risks. ‘Mountains’ are initiatives with potentially high rewards
for economic development but significant financial and environmental risks. ‘Peaks’ could be transformative in achieving
a much higher growth path, quality job creation and increased government revenue, but the risks can be the highest
and must be carefully weighed alongside the rewards. The principle of the altitude economy is illustrated below, using
examples from Bhutan’s current policy measures and select policies proposed in the draft 13th Five Year Plan (FYP):
1. Foothills – relatively attainable rewards with low risks: Such policies or projects have high rewards, low costs,
and low risks. They are readily achievable without too much effort or cost and policymakers can be almost
certain of success. Examples in Bhutan include strategic branding such as ‘Made in Bhutan’ or ‘Bhutan Believe’,
export promotion agencies to match buyers with suppliers, and skill development programs to address skills
mismatches.
71 Collier, P., et al. 2010. “Managing Resource Revenues in Developing Economies.” IMF Staff Papers, 51(7): 84-118, IMF, Washington, D.C.
72 Gelb, A., Tordo, S. and Halland, H. 2014a. “Sovereign Wealth Funds and Domestic Investment in Resource-Rich Countries: Love Me or Love Me Not?” Economic Premise, Poverty
Reduction and Economic Management Network (PREM), World Bank, 133, 1-5.
73 Gelb, A. and Grasmann, S. 2009. “Déjouer la alediction pétrolière”, Afrique Contemporaine, 229 (1), 87-135..
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2. Mountains – high potential rewards and high risks: Such initiatives can be realistically developed with rela-
tively modest financial commitment but are costlier to achieve and carry greater risks compared to foothills.
The Government’s capital market interventions, including direct and directed lending to the agriculture and CSI
sector could be considered mountains. While interventions like the NCGS and the National CSI Development
Bank (NCSI) offering government guarantees and subsidized microloans can enhance credit accessibility for
respective firms, stimulate production, and boost employment, they can also pose risks to financial sector
profitability and entail fiscal costs and contingent liabilities. For instance, the NCSI had to be recapitalized and
subsequently merged with BDB in 2023 due to high NPLs.
3. Peaks – potentially transformative but with the most significant risks: These policies or projects offer consid-
erable rewards and may be transformative in achieving higher growth and government revenue, and quality
job creation. Yet, the risks can also be high and must be carefully weighed alongside the rewards. They may
lock up very large amounts of finance, thereby risking public finances if the returns are disappointing. Such
projects may also carry environmental risks, resulting in damage to natural capital, which could be irreversible
if not well-identified and managed. An example of a peak initiative is the government’s strategic involvement
in the hydropower sector, which involves large fixed-capital investments and a long-term horizon.74 While the
sector has significantly contributed to economic growth, government revenues, and exports, it is important to
consider environmental, technical, and financial risks associated with such projects.
The Gelephu Mindfulness City (MC) initiative could be considered another peak as it represents a significant and
transformative investment with the potential for substantial impact, yet it carries considerable risks. Gelephu is a
town in Sarpang district, about 30 km from the southern border with India. It is envisaged that the new megacity project
will be a Special Administration Region (SAR) of 1000+ km2, with legal autonomy. The project is envisaged with, inter alia,
the following features: construction with the help of foreign capital and expertise; development of a green city; incorpo-
ration of research and energy efficient data centers for expanded data hosting capacity and with a vision to serve as a
hub for digital innovations including emerging technologies such as blockchain and artificial intelligence; and provision
of world-class infrastructure and amenities.
The Gelephu MC is envisioned to be one-of-a-kind, anchored in the values of GNH and grounded on the Bhutanese
identity. Businesses will operate only on invitation to ensure alignment with this vision. Like other economic hubs, the goal
will be to stimulate economic growth by developing new industries, host an international airport to serve as a gateway to
South Asia, boost trade, create employment to arrest outmigration and encourage the return of the Bhutanese diaspora.
The SAR is not expected to be densely populated, and farmlands and forest coverage will be retained.
The ambitious vision will require significant investments, including from the private sector, in energy, digital connec-
tivity, and infrastructure. Given its location, Gelephu has potential to be developed as a freight consolidation center
and trade gateway, with multimodal transport links. Significant FDI and expertise will be required to fulfill this vision. FDI
is expected to bring opportunities, particularly for the youth, increase access to technology and innovation; an attempt
to address the outmigration challenges facing the country.
Economic zones are often a “high-risk, high reward” endeavor with mixed results. Global experiences offer lessons
and good practices that could be considered for the Gelephu SAR. Box 5 lists good practices and examples from SEZ
experiences globally and in Bhutan. The proposed SAR includes interesting features, including a focus on blockchain
technologies, research and data centers, and environmental compliance. Therefore, global lessons from smart city
projects, highlighted below, are relevant as well:
1. Leveraging benefits of agglomeration economies: World Bank analytical work on Regional Development and
Economic Transformation in Bhutan has highlighted that settlements with locational advantages and nascent
economic clusters like Gelephu should focus on improving the conditions for private investment in emerging
sectors such as agribusiness, agro-processing and manufacture and scaling up SMEs and cottage industries by
74 As of FY21/22, the project cost (loan component) of Puna I, Puna II, and Mangdechhu hydropower projects represents approximately 25 to 30 percent of GDP.
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improving connectivity.75 Connectivity has both physical and policy dimensions. This could include addressing
demand-side obstacles, including limited access to finance, constrained linkages in product value chains, and
impeded spillover of knowledge, skills, and technology. Cities like Gelephu also need to boost capacity in urban
planning and land administration as well as strengthen infrastructure, service delivery and ICT connectivity to
catalyze growth. Instead of an “enclave” approach centered on Gelephu, a “corridor” approach that connects
Gelephu to other urban centers (such as Thimphu and Paro) and their hinterlands, as well as to the regional
Indian market, can help harness agglomeration economies and benefit lagging regions.
2. Ensuring strategic planning: This, based on rigorous market demand assessment, will be the key to determine
the extent of private sector (especially overseas) interest and participation. Once demand is ascertained, a
detailed economic feasibility analysis should be undertaken to target the type of businesses that can be invited.
A purely supply-driven approach can be problematic. It is also important to adopt a long-term planning mindset,
as there can often be political pressure to achieve quick-win results.
3. Efforts to maximize potential positive spillovers: The SAR could aim to boost quality jobs (direct and indirect),
investment, exports, and support the inclusion and sustainability agendas. To accomplish these goals, spill-
over effects such as technology transfer, skills upgrading, backward and forward linkages, and productivity
enhancement must be kept in mind.
4. Implementing a robust policy, institutional, and legal framework: Success would require timely and mean-
ingful policy, regulatory, and legal reforms to address critical market failures (such as infrastructure and
connectivity) and government failures (such as effective coordination and implementation). This would require
willingness as well as the capacity of the relevant authorities to undertake such reforms. Many economic hubs
have failed as they were disrupted by political interference, corruption, and lack of transparency. Regulatory
ring-fencing to address these will contain risks and promote agility in planning and management. Clarity on
roles and responsibilities as well as a transparent and predictable legal, institutional, and policy framework will
provide certainty for investors. Since developing an economic zone is an expensive undertaking, many end
up as “white elephants” without sufficient planning, capacity, and management.
5. Clarity on modality, financing, and risk mitigation: Further clarity is required on the business model and
modality of the zone and on whether it will be developed by the government, or through public-private
partnerships (PPPs), or by private investors (private capital, bank lending, capital markets). The role of the
government will be critical (including, implementation of a regulatory framework, provision of land and public
services), modes of financing (general government budget, domestic or external debt issuance) and fiscal risks
management. Risks and mitigation measures need to be properly identified.
The models of zones have evolved over time (Table 5). Fourth generation zones focus on higher value-added service
sectors (such as finance and trade service) and are more business-friendly in terms of laws and regulations. A successful
example is the Shanghai Pilot Free Trade Zone (FTZ) launched in 2013. In 2017, Malaysia launched the world’s first Digital
Free Trade Zone to facilitate the entry of SMEs into the e-commerce market via a conducive business environment. Fifth
generation zones are centered around emerging digital technologies and strong integration with urban development.
An example is the NEOM giga-city under construction in Saudi Arabia.76
Gelephu could aspire to be a fifth generation economic zone For instance, it could aim to become a regional data and
innovation hub by attracting private investments in green data centers.77 Enabling cloud computing technology and
services in these centers could help Gelephu position itself as an innovation hub by offering, as-a-service, emerging
technologies such as artificial intelligence (AI), distributed ledger technology, and blockchain, to leap-frog digital solu-
tions. Blockchain can also help track and validate carbon emissions and environmental impacts of the data center.78
75 World Bank. Bhutan Urban Policy Notes: Regional Development and Economic Transformation, World Bank, 2019 (https://elibrary.worldbank.org/doi/epdf/10.1596/31816).
76 The Past, Present, and Future of Special Economic Zones and Their Impact. Douglas Zeng. World Bank; Journal of International Economic Law (2021).
77 The “Green Data Center Strategy” (2017) concluded that Bhutan’s cold climate, negative carbon footprint, and low cost of electricity makes it an ideal location to attract investments
in green data centers.
78 Green Data Centers: Towards a Sustainable Digital Transformation. A Practitioner’s Guide. World Bank and ITU (2023).
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Another possibility is to provide services as a disaster recovery data center for non-critical data/systems for neighboring
countries such as India. However, gaps remain, for instance, high price and low reliability of high-speed internet, lack of
human capital, policy and regulatory gaps that might not be conducive to FDI facilitation, and weak digital safeguards to
protect data and systems from the rapidly evolving risks such as cyber-attacks and data leaks. If not addressed, these
risks can lead to low investor confidence.
Table 5: Evolution of Economic Zones
Zone type Generation Characteristics
Export Processing Zone First Focusing on FDI and exports; little linkage to local economy.
Multi-functional SEZ Second Larger, multisectoral, multifunctional; better linkage to local economy.
Eco-Industrial Parks Third Emphasizing both economic competitiveness and environmental sustainability, with an integrated approach.
Modern Free Trade Zone Fourth Focusing on high value-added modern service sectors and more business-friendly reforms.
Intelligent City Fifth Also called ‘digital zone’ or ‘smart city’, where digital technologies are embedded in production and services,
and industrial and business activities are fully integrated with urban and eco-development concepts.
Source: World Bank; Journal of International Economic Law (2021).
To achieve economic diversification, Bhutan can focus on high value-added and tradable low carbon activities,
particularly in the services sector, while taking advantage of the country’s track record in ecological preservation
and commitment to sustainable development. Some examples of foothills, which are relatively easy to implement,
include international payments for ecological services and eco-tourism (see Box 6). These activities have low complexity
but can still generate economic benefits. More complex activities like value-added agriculture offer higher development
returns and knowledge spillovers. There are also high peaks, such as value-added IT services and biodiversity-based
innovation, which have a potential for significant returns. These sectors can be prioritized to create a virtuous circle
of sustainable diversification. For instance, ecotourism, especially in the emerging high-tech retreat industry, can be
linked with the local start-up and IT services sector to foster economic growth. However, these activities would require
improvements in basic capabilities, including country-wide high-speed internet access, access to clean and reliable
electricity, as well as the development of necessary infrastructure. While selecting sectors and activities, the following
indicative criteria can be considered:
⊲ Proximity to existing productive structures: How easy would it be to repurpose existing capabilities for this new
activity?
⊲ Global technology trends: How could innovations cause disruptions to some activities and related supply chains
but also open up opportunities for others?
⊲ Regional market demand: What are the goods neighboring countries import, which Bhutan could export
competitively?
⊲ Degree of market competition regionally and globally: Even if there is demand for a product, are there other
nations that can meet this demand more competitively than Bhutan?
⊲ Conformity with Bhutan’s geographic conditions and trade costs
⊲ Potential for value addition and job creation: Are those activities sufficiently labor intensive to reduce unemploy-
ment in Bhutan, in particular for youth and women?
⊲ Alignment with Bhutan’s ecological sustainability agenda: Do these activities cause ecological damage that is
incompatible with Bhutan’s environmental agenda?
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Box 5: Special economic zones – global results and recent evidence from
Bhutan
SEZ have been used by many developing countries as a policy tool to promote industrialization and economic trans-
formation, but global results of SEZ in developing countries have been mixed. A SEZ is supposed to complement
market forces by helping to overcome market and policy failures such as malfunctioning land market, deficient industrial
infrastructures, or a poor business environment. Results from SEZ vary significantly; some regions or countries (espe-
cially in East Asia) are generally more successful while others (especially in Sub-Saharan Africa) struggle to make zones
work.79 Even in the same country, it is normal to have both successful and failed zones. SEZ “poster children” countries
include Korea, Malaysia, China, Mauritius, and UAE (Jebel Ali). There are also examples of “white elephants” as well, for
instance in Nigeria, several zones in India, and even a few in China.
Bhutan has established an economic zone program in 2010 and an economic zones policy (“Business Infrastructure
Policy”) in 2018. Bhutan has six industrial parks, including five in the South (Pasakha, Bondeyma, Dhamdum, Jigmeling,
and Motanga), and one near Thimphu (Bjemina). In addition, Thimphu TechPark was established in 2012. A recent World
Bank report assessed the performance of economic zones within the Bangladesh, Bhutan, Nepal, and India’s Eastern
Economic Corridor (EEC) by interviewing 122 Bhutanese firms (60 inside the zones and 62 outside zones) in three indus-
trial parks: Motanga, Bjemina, and Pasakha. The results are as follows:
⊲ Bhutanese firms inside zones perform reasonably well relative regional peers. On employment generation, exports,
and FDI, they outperform India and Nepal, but fall short of Bangladesh.
⊲ Firms inside zones tend to have significantly larger exports and employment than those outside zones. However,
there are no significant positive impacts on FDI.
Expanding zone programs could seem a promising direction for policies aimed at promoting greater exports and
job creation. Among the lessons learnt for the successful implementation of SEZ include having a strategic location;
integrating the zone strategy with the overall development strategy; (ii) increasing the market contestability through a
rigorous market demand assessment focusing on comparative advantages and private sector participation und; (iii) and
ensuring that zones are “special” in terms of piloting reforms for a business-friendly environment and are resilient to
various external shocks. The lessons can be broadly classified into four do’s and four don’ts (see Table 6).
Table 6: The four do’s and four don’ts of SEZs
DOS DON’TS
1. Choose the right location 1. Lack of strategic planning and demand-driven approach
2. Foster a conducive business environment with a reform-oriented 2. Fail to address the critical market and government failures (such as
mindset (use SEZs to pilot policy reforms) infrastructure and government coordination)
3. Increase the market contestability through a rigorous market demand 3. Poor policy and legal environment and weak implementation capacity
assessment and private sector partici- pation
4. Maximize the positive spillovers through an inclusive and sustainable 4. Inability to mitigate the environmental and social risks
approach
Source: Bangladesh, Bhutan, India, and Nepal: How can economic zones contribute to the 200 million job challenge80; World Development Report. Trading for Devel-
opment in the Age of Global Value Chains81; The Dos and Don’ts of Special Economic Zones.82
79 World Bank. 2019. “World Development Report 2020: Trading for Development in the Age of Global Value Chains.” WB, Washington, DC.
80 WB. 2022. “Bangladesh, Bhutan, India, and Nepal: How can economic zones contribute to the 200 million job challenge.” WB, Washington, DC.
81 WB. 2020. “World Development Report: Trading for Development in the Age of Global Value Chains.” WB, Washington, DC.
82 WB. 2021. “The Dos and Don’ts of Special Economic Zones.” WB, Washington, DC.
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Box 6: Mapping of potential sectors and activities
⊲ International payments for ecological services: a valuable foothill. Biodiversity and natural ecosystems are among
the country’s most valuable assets, and policy efforts exist to marketize and compensate for the protection of such
assets. Given that Bhutan is one of the first carbon negative countries in the world, monetizing ecosystem services
and engaging in carbon emissions trading could represent a low hanging fruit as part of Bhutan’s diversification
strategy. To achieve this objective, Bhutan would need to engage in international carbon trading systems and
develop bilateral frameworks with other countries or firms, aiming to offset their carbon emissions. Such objective
will require considerable diplomatic action and international negotiations. The revenues from such trade could
help finance a domestic Payment for Ecosystem Services (PES) program, which would enable the Government to
remunerate communities involved in conservation across the country.83
⊲ High value tradable services; another foothill. High value tradable services constitute a promising area for produc-
tive diversification as they can circumvent the high trade costs associated with traditional merchandise exports.
However, improving the provision of basic capabilities (especially universal, country-wide high-speed internet
access, and access to clean, reliable and affordable electricity) will be important to attract investment in energy
intensive services (i.e., low carbon data centers).
⊲ Hydrogen: a peak - opportunities but also important challenges. Given Bhutan’s ambitious increases in installed
hydropower capacity, Bhutan is exploring the use of excess hydropower generation for green hydrogen production
(a roadmap was expected to be completed by end-2023).84 However, careful analysis is needed to avoid poten-
tial bad investments. Green hydrogen production costs are still high and may not align with Bhutan’s long-term
development strategies. Additionally, using green hydrogen for electricity generation has high conversion and
storage losses. In the transport sector, hydrogen-powered mobility may be too expensive or better substituted
with electro-mobility.85 Investing in green hydrogen requires a well-coordinated strategy that considers opportunity
costs and infrastructure needs. Export potential to India should also be assessed, considering India’s own green
hydrogen strategies.
Figure 47: Mapping of potential sectors and activities on a complexity/returns matrix
Degree of complexity
(Low Hanging fruits: foothils) (High hanging fruits: high peaks)
(Low) International Payments for
Developmental Returns & Ecological Services
Value-added
knowledge spill overs Textile &Crafts / cottage Textile & creative crafts
industries Value-added Agriculture
Ecotourism and established retreat Green Hydrogen
services for high-tech firms Zero Carbon Data
centres & cloud services Value added IT services
(High) Biodiversity-based innovation services
Source: Lebdioui et. al. (2023). CEM Background Paper.
Note: The mapping of potential sectors and activities serves as an illustration. More in-depth analysis would be required to explore and validate potential sectors and
activities, including consultations with sector experts.
83 PES, which were pioneered in Costa Rica, are financial mechanisms whereby landowners receive direct payments for the ecological services that their lands produce when they
adopt environmentally friendly land uses and forest management techniques (Malavasia, E.O. and Kellenberg, J. 2002). Such mechanisms to marketize the value of ecosystem
services provided by local communities have often been limited to national boundaries and local communities often struggle to receive remuneration from the international
community for this ‘tradable’ service (Lebdioui, 2022), which is why linking this agenda with an international carbon trading system is key to ensure its financial sustainability
in the long term. A project such as this would represent a foothill in the sense that it requires relatively low financial investments, while creating jobs and providing revenues in
remote rural areas without compromising Bhutan’s ecological agenda. See Malavasi, E.O. & Kellenberg, J., 2002. “Program of Payments for Ecological Services in Costa Rica.” In
Building Assets for People and Nature: International Expert Meeting on Forest Landscape Restoration, 27, 1-7. Heredia, Costa Rica and Lebdioui, A. 2022. “Inequality and Trade
Diversification: How can Income Inequality in Latin America be Reduced Beyond Commodity Booms?” Canning House, LSE, London, UK.
84 End-use possibilities may include decarbonizing various sectors (e.g., industry, transportation), using hydrogen to generate electricity in periods of low hydro production or
exporting hydrogen products (e.g., ammonia) to neighboring countries.
85 Not only for passenger vehicles, but also two- and three-wheelers, public transportation, and long-haul trucks. While there are significant infrastructural requirements, the tech-
nologies in general are further developed with promise of further cost reductions due to economies of scale and well-funded technological innovation.
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Box 7: Costa Rica’s experience attracting FDI in green activities and impact
on inequality
Costa Rica is often cited as an example of successful diversification from commodities to knowledge-intensive electronics
and medical goods exports. In the 1980s, Costa Rica abandoned a development model based on import substitution
industrialization and started implementing new policies to foster export diversification. Such policies included the creation
of Export Processing Zones (EPZs) to attract FDI in high value-added and high-tech sectors, introduction of export tax
reduction, and government subsidies. Such policies were largely successful, as Costa Rica’s exports experienced high
and almost uninterrupted growth from the mid-1980s to 2020 (with the exceptions of the 2009 financial crisis and the
COVID-19 crisis in 2020).
Costa Rica’s well designed public policies to support diversification enabled the country to benefit from major
investments in the industrial sector, including Intel’s investment in a microprocessor plant in 1997, which remains one
of the largest FDIs in Costa Rica’s history. This investment has been important to Costa Rica, as it helped reverse
the drop in Costa Rica’s terms of trade due to low world prices of its most traditional exports and was responsible
for a surplus in Costa Rica’s trade balance.86,87. Costa Rica went from being highly reliant on commodity exports to
having booming high-tech and medical equipment manufacturing exporting industries. By 2000, computer parts
alone accounted for almost 40 percent of total value of the country’s exports. In 2019, Costa Rica’s largest exports
were medical Instruments and appliances (around US$4 billion, which represents almost one-third of Costa Rica’s
exports).
Additionally, Intel’s investment had a subsequent “signaling” effect on other potential investors, and the country’s export
promotion agency, CINDE, used this “stamp of approval” to launch an aggressive campaign to attract other electronic
manufacturers (ibid). In more recent years, Costa Rica’s export promotion has also successfully leveraged the country’s
natural capital to attract new types of investments in decarbonized services and activities. Benefiting from an electricity
matrix that is 99 percent reliant on renewable energies, Costa Rica has become a world leader in attracting eco-con-
scious foreign investors.
However, it is worth highlighting that while diversification was accompanied by a high growth rate, reduction in poverty,
and large social investments in public health care and education, income inequality has persisted.88 This has notably
been the result of the increasing wage premium for skilled workers, whereas unskilled workers have not been able to
benefit as much from the emerging high-tech manufacturing sectors. Another issue is that Costa Rica’s industrial clusters
are mostly located in the center of the country, while people living in coastal areas remain dependent on commodities
and tourism as a means of livelihood. The dynamics of rebalancing regional growth and promoting a more socially
inclusive diversification model by ensuring that workers excluded from the labor market also benefit from employment
opportunities arising out of new industries, therefore, remain key considerations in Costa Rica and ones that bear high
relevance in Bhutan’s context.
Coordination between diversification, education, and territorial policies
Coordination between diversification, educational and territorial policies is crucial to ensure that job creation from
economic diversification does not increase inequality or result in spatial misalignments. Sector-specific policies may
increase inequality if they focus exclusively on sophisticated sectors that only create better jobs for a few high-skilled
people (see example of Costa Rica in Box 7). Additionally, there is a risk of spatial misalignments if new job opportunities
arise in communities or regions that do not have high unemployment rates. This can lead to disparities and uneven
development across different areas. Ensuring that low-income groups can benefit not only from unskilled employment
86 World Bank. 2006. “The Impact of Intel in Costa Rica: Nine Years After the Investment.” World Bank, Washington, D.C.
87 Ferreira, G.F.C, Fuentes, P.A.G., and Ferreira, J.P.C. 2018. “The Successes and Shortcoming of Costa Rica Exports Diversification Policies.” Background Paper to the UNCTAD-FAO
Commodities and Development Report. 2017. FAO, Rome, Italy.
88 Lebdioui, A. 2022. “Inequality and Trade Diversification: How can Income Inequality in Latin America be Reduced Beyond Commodity Booms?” Canning House, LSE, London, UK.
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opportunities in labor intensive sectors but also from the skilled employment opportunities that arise from Bhutan’s
diversification towards value-added sophisticated sectors, emphasizes the importance of coordinating industrial and
education policy.
Special incentives and investments can target high-unemployment areas to allow for regional rebalancing. If hydro-
power rents are invested in different areas compared to where higher unemployment rates prevail, measures can be
implemented to encourage labor reallocation. This means incentivizing individuals to move to areas with priority invest-
ment projects that cannot be located elsewhere. These measures can take various forms, such as providing financial
incentives for individuals to relocate, offering training and skill development programs specific to the needs of the
investment projects, or establishing support systems to facilitate the transition and integration of workers into new areas.
Bhutan needs to create attractive job prospects for its growing number of young university graduates, while also
making low-skilled positions appealing and accessible to the unemployed and inactive population, particularly
women in urban areas. Given the skills and mismatches in Bhutan in the low-skilled segment, several sector-specific
policies could be supported, including (i) upskilling policies such as vocational training after secondary education
(through certificates and diplomas) and more demand-driven TVET (e.g. on-the-job training) to support employers with
their training and vacancy needs, (ii) activation policies to stimulate the supply from uneducated individuals currently
out of the labor force, especially women, and (iii) adequate job intermediation and matching systems to connect people
to jobs and to track where the new jobs are created.
1.4. Policy priorities
This chapter has examined the growth trajectories of the Bhutanese economy under different resource revenue
management models. The findings from this chapter translate into three principles that economic policy could follow
to stimulate economic diversification:
⊲ Bhutan is encouraged to capitalize on its existing comparative advantage in the hydropower sector, ensuring
continued benefits for the country. The CGE model with no expansion of the hydropower sector has the lowest
GDP as compared to the other three models with expansion of the hydropower sector, but it differs in how the extra
hydropower revenues are being utilized.
⊲ The growing hydropower rents could be re-invested in non-hydro sectors to support economic diversification.
A diversified economy will be resilient towards shocks that could adversely affect the economy – for example,
prolonged drought due to climate change (see Chapter 2 for discussion on climate change and agriculture in
Bhutan).
⊲ A successful diversification strategy should encompass both sector-neutral and sector-specific policies, and a sound
institutional framework for supporting the latter.
The recommendations are categorized into hydropower, non-hydropower, and institutional options for managing hydro
rents.
he current comparative advantage and ensure
1.4.1. Hydropower development to leverage t
future hydro rents
The hydro sector could be developed further (subject to economic, environmental, and social impact analysis) given
the untapped potential and opportunities in the regional electricity market in South Asia. The results of the CGE
model indicate that the planned investment in additional hydropower leads to higher growth and government revenues.
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As a carbon neutral country, Bhutan is in a unique, win-win position to positively contribute to its neighbors’ Nationally
Determined Contributions under the Paris Agreement on Climate Change by exporting its green hydropower. In addition,
Bhutan’s untapped potential can contribute to a regional power market fueled by clean power.89 However, additional
hydro investments require careful feasibility and impact assessments, including financing aspects (and macro-fiscal
implications, including debt sustainability), in line with the Government’s sustainable hydropower development strat-
egy. Important trade-offs, including whether additional hydro capacity should be used to increase electricity exports or
ensure adequate supply for domestic industries could be clarified by an IEU, as explained below. While serious technical
issues can be a challenge even for the most advanced utilities, the capacity of the hydro sector institutions could be
strengthened to effectively manage operations and trade.90
The financing for future hydro projects will have to increasingly come from the private sector. Hydropower projects,
so far, have been mostly financed through commercially priced loans and capital grants from the GoI, implemented
under a special agreement between Bhutan and the GoI, in which the GoI covers both financial and construction related
risks and commits to buying all surplus electricity at a price reflecting cost plus a net return. This has supported debt
sustainability in the past.91 To date, three hydropower project have been developed under the Joint Venture (JV) and
PPP model.92 Future projects will have to increasingly rely on private sector financing, given limited fiscal space and
elevated public debt. Since guarantees from the GoI are not available, it will be necessary to have sufficient capacity to
assess and handle the risks associated with these projects.
By establishing stronger backward linkages with the hydro sector, Bhutan could facilitate greater direct spillovers
to the non-hydro sector and stimulate the demand for goods, services, and labor. Spillovers from the hydro sector to
the non-hydro sector have been small due to the former’s limited linkages with the rest of the economy, constraining
the distributive effects of growth. The DGPC has established three subsidiaries to build domestic capabilities for hydro
maintenance and engineering, and to construct small hydro plants.93 Advancing these initiatives, possibly by increasing
private sector involvement, has the potential to reinforce production linkages with other sectors and foster structural
transformation.
The forthcoming Country Climate and Development Report (CCDR) will complement the analysis presented in the
CEM by conducting an assessment on the potential to expand hydropower generation and exploring financing
options. It will also evaluate the impact of climate change on hydropower generation and assets, examine the nexus
with the agriculture sector and water availability and management, and identify climate resilient measures.
Positive spillovers from the hydro sector and the emergence of new sectors in the non-hydro sector will require
adequate human and physical capital to diversify the economy further. Section 1.4.2 complements the macro agenda
on economic diversification.
1.4.2. Policies to lay the foundationfor (new) comparative advantages in the
non-hydropower sectors
Policies to create a conducive environment for the development of the non-hydropower sector will help to sustain
future growth. Over the past two decades, productivity growth in this sector has been relatively weak. This has become
more prominent with the recent emigration. Policies that strengthen macroeconomic stability, improve institutions and
the business environment, facilitate flexible and efficient labor market regulations, reduce barriers to trade, and invest-
ments in infrastructure as well as human capital remain critical for promoting continued growth in the non-hydro sector,
as shown in CGE Scenario 3 (policies were proxied by human capital and infrastructure investments). A focus on the
following areas, in particular, will help to achieve these objectives:
89 World Bank. 2021. “Program Document: Sustainable Hydropower Development Project”. Project ID: P174327, World Bank, Washington, D.C.
90 The hydropower projects so far developed in Bhutan (and currently under preparation) have suffered complications due to unexpected complex geology and other technical
challenges, which have resulted in significant cost-overruns and delays in commissioning.
91 The share of capital grants in the total capital cost is about 30 to 60 percent depending on the project (with the remainder being financed by commercially priced loans).
92 Dagachhu (126 MW) and Nikachhu (118 MW, ongoing) have been implemented under the PPP model with the support of the Asian Development Bank (ADB) and the Government
of Austria. Kholongchhu (600 MW, ongoing), which was initially implemented under the JV model between DGPC and an Indian SOE, has recently been taken over by DGPC.
93 DGPC has established three subsidiaries since 2012: (i) Bhutan Hydropower Services Limited to repair and manufacture hydro turbine runners and associated components; (ii)
Bhutan Automation to manufacture automation systems for hydropower plants; and (iii) Druk Hydro Energy Limited to construct small hydro projects up to 150 MW.
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⊲ The capacity and performance of SOEs could be improved given their significant role in the economy. While
SOEs overall have consistently reported profits, driven by the electricity sector, SOEs in other sectors have shown
a mixed performance. The 2023 Public Expenditure Review (PER) recommends strengthening SOE oversight and
corporate governance by implementing a more centralized ownership model with clear reporting lines and respon-
sibilities. Additionally, it suggests reviewing the current compact system and performance-based compensation of
DHI and MoF to improve performance management. Promoting the professionalization and diversification of SOE
Boards, as well as enhancing SOE investment management, are also crucial steps towards improving the overall
performance of SOEs.
⊲ The efficiency of public expenditure in health and education could be improved. The contribution of human
capital to non-hydro sector growth has declined in the recent decade. While Bhutan spends more than most peers
on education and health, there is significant scope for efficiency gains in both sectors. According to the Bhutan
PER, Bhutan ranks 68th in education expenditure per school-age child among 131 countries with available data,
while its ranking based on Learning Adjusted Years of Schooling (LAYS) is 86th (Figure 48). Bhutan’s current health
expenditure per capita in purchasing power parity terms is significantly higher than its regional peers and countries
in the similar income group.94 A Data Envelopment Analysis (DEA) using data from 164 countries shows that Bhutan
could have achieved the same level of health outcomes with approximately 6 to 9 percent fewer resources if health
expenditures were as efficient as the most efficient countries in the sample (Figure 49).
Figure 48: Education expenditure and LAYS Figure 49: DEA Frontier analysis, health
3,000 10 100
2,500
9 90
Health: Multi-dimentional health index
2,000
8 80 Bhutan 0.91
1,500
7 70
1,000
6 60
500
0 5 50
Pa a
Mo a
Na a
Bh a
Es n
Pa tini
Le y
rg o
n
lic
l
Ta nin
an
pa
a
an
m
oli
bi
a
La zsta
Ky th
ub
gu
ut
ist
mi
wa
Ne
Be
na
so
ng
tsw
ep
jik
ra
y
Bo
oR
40
Education expenditure per school going population 0 2 4 6 8 10 12 14
LAYS (right axis) Spending: Public, 2010-20
Source: Bhutan Public Expenditure Review (2023)
⊲ In view of the potential skills mismatches in the low-skill segment, upskilling policies including vocational train-
ing after secondary education (through certificates and diplomas) and more demand-driven TVET programs,
could help integrate the youth and low-skilled (particularly women) into the labor market and emerging indus-
tries. While Bhutan has many public TVET institutions under the Ministry of Education and Skills Development
(MoESD), their linkages with the labor market could be strengthened. In addition, labor activation policies and job
intermediation and matching policies are essential for connecting job seekers with employers. Many self-employed
and family workers, particularly those with low education and engaged in low-quality livelihood activities, could
be provided with on-the-job assistance to cover some of their search costs and place them directly in regions with
94 Healthcare expenditures are predominantly financed by the Government and citizens receive free access to basic public health services, resulting in lower out-of-pocket expen-
diture than in upper middle-income countries.
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Hydropower Revenue Management for Economic Diversification
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available wage employment opportunities. Employment service centers under the Ministry of Industry Commerce
and Employment (MoICE) can play a strong role in this respect.95
⊲ Improving the efficiency in the PIM system is crucial to provide high quality infrastructure services and crowd in
private investments. The contribution of physical capital to non-hydro sector growth has declined over the recent
decade, and there are significant investment deficits, including both soft and hard infrastructure. To improve the
efficiency of public investments, the government could issue PIM guidelines, prepare and appraise new public
investment projects in line with the guidelines, publish prioritization and selection criteria for projects, and designate
a central entity to prioritize projects based on the criteria prior to their inclusion in the budget. Module 3 discusses
some options for strengthening the financial sector to better channel hydro rents to non-hydro sector.
Sector-specific policies could complement other policies to support diversification, provided they are targeted,
transparent and minimize budgetary costs. Given the critical role of human capital and talent for the diversification
process, and to avoid further brain drain, several initiatives could be implemented in the short term as outlined below.
⊲ Bhutan could create strategic partnerships with universities to set up tailored executive programs adapted to
the Bhutanese context. Instead of relying on the provision of sector-neutral scholarships for Bhutanese citizens
to study overseas, strategic partnerships with universities could constitute a promising way forward. This would
provide the Government with greater leverage over the content of the training provided, to ensure it is aligned to
government objectives and thereby reducing the need for foreign technical assistance over time. Such programs
have been critical for the development of competitive sectors across the globe – for instance in the fruits sector in
Chile through the Chile and University of California Program.96
⊲ The Bhutanese living abroad could be leveraged for the transfer of learning, technology, and social capital back
to Bhutan. The IEU could identify and liaise with the Bhutanese living abroad to assess how they can contribute to
the emergence of new activities in Bhutan. For instance, in Malaysia, to counter the shortage of technical skills for
science and ICT, the Government set up the TalentCorp in 2011 to attract Malaysian talent back from abroad and
to bring in foreign talent.97
⊲ The existing incubation and acceleration centers could be strengthened to promote entrepreneurship and
innovation. These centers have the mandate to drive economic growth and create job opportunities for educated
workers. However, they currently face funding uncertainties. Improving the quality of their services, including
access to financing, market validation, business plan development, research and development support, mentorship,
and connections to supply chains and markets, can better connect entrepreneurs to the broader entrepreneurial
ecosystem.
1.4.3. Institutional setup to frameand implement sector-specific policies
A new fiscal strategy outlining a long-term vision and a minimum share of re-investment of hydro rents for produc-
tive capacity building in tradable sectors, could ensure that such rents support economic diversification away from
over-reliance on the hydro sector. At the same time, the BESF and the fiscal stabilization measures that regulate contri-
butions to and uses of the BESF could be operationalized to smoothen volatile hydro revenues and public spending in
the face of negative shocks. One option could be the Hartwick rule, which suggests that the value of (net) investment
needs equal the value of rents on extracted resources at each point in time.
95 Alaref, J., et al. Forthcoming. “Bhutan Labor Market Assessment Report”. Social Protection and Jobs Global Practice. World Bank, Washington, D.C
96 In Chile, to remedy the absence of adequate human capital, which was for a long time the obstacle for the development of the fruit sector, an exchange program was established
in 1965 with the University of California. More than 80 Chilean graduate students were sent to study agricultural economics in California to learn how to cultivate and export
fresh fruits in Chile. This appears to have been an extremely successful and impactful grant considering the growth of the sector during the following decades (Bravo-Ortega
and Eterovic, 2015). See Bravo-Ortega, C. and Eterovic, N. 2015. “A Historical Perspective of a Hundred Years of Industrialization: From Vertical to Horizontal Policies in Chile.”
Working Paper No. 399. Department of Economics, University of Chile, Santiago, Chile.
97 Mukherjee, H., et al. 2011. “Affirmative Action Policies in Malaysian Higher Education”. Draft report submitted to the World Bank, Washington, D.C.
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Given limited institutional capacity and human resources, it may be beneficial to consolidate different development
finance institutions instead of spreading available resources too thinly. The CEM report highlights the different exist-
ing institutions, whose mandate could be expanded to invest hydropower rents in productivity-enhancing assets. While
such a decision is political, the advantages and possible challenges of the different institutions are summarized below:
⊲ BDB: The Bank has experience providing loans to SMEs. National development banks usually face more scrutiny
than SDFs as the former have commercial credit ratings if they issue bonds. However, the current mandate and
expertise of BDB is centered around SMEs in the agricultural sector and the Bank has limited capacity to take on a
larger scope for funding structural transformation across various sectors and business types.
⊲ DHI: There are various international experiences of government holding companies turning into development funds
(e.g., Malaysia), and using DHI could avoid the creation of another fund and associated institutional costs. However,
this would require a clear strategy to separate SOE management functions from the mandate of new investments
(including in private companies) to stimulate structural transformation.
⊲ BoB: The (state-owned) commercial bank has a track record of efficient lending and could expand its mandate to
include development banking. However, this would require some restructuring and setting up legal frameworks to
take on a broader mandate on behalf of the government.
⊲ BESF: Expanding the mandate of the BESF to an SWF or SDF would enable it to attract private capital and engage in
partnerships with foreign investors. However, SWFs and SDFs face less scrutiny than national development banks
as the latter have commercial credit ratings if they issue bonds.
Irrespective of the institutional setup, it is crucial to enhance the capacity for investment appraisal, monitoring, and
evaluation.
The establishment of an IEU-type structure in Bhutan could improve investment project decisions and efficiency.
Ideally, an IEU should not only be high quality, but also be independent of the day-to-day pressures of policymaking as its
aim is to work on the achievement of the long-term development vision. Possible candidates are the Ministry of Finance,
given its central role in managing the nation’s budget. Another potential home for the IEU is the newly created Office of
the Cabinet Affairs and Strategic Coordination (OCASC) under the Committee for Coordinating Secretaries (C4CS), which
replaced the Gross National Happiness Commission (GNHC). Among other responsibilities, OCASC oversees a strategic
planning division, national policy coordination division, strategic evaluation division, and is in charge of the preparation
of the FYP Strategic Planning. The C4CS is led by four coordinating secretaries (governance, economic, security, and
social cluster), headed by the Cabinet Secretary, which could help improve cross-government coordination (especially
when the project’s impacts cross the boundaries of ministries), and also build a culture of evaluation across government.
The existence of a strong IEU could send a strong market signal to potential investors regarding the quality of
economic management. An IEU could generate benefits such as larger FDI as well as greater portfolio investments, and
policy credibility for international ratings agencies. For instance, further strengthening the capacity of the hydropower
institutions to ensure that the development and construction, environmental and social stewardship, maintenance, dam
safety regulations, and inspections of hydropower plants are line with international best practices, could attract more
foreign investment in other sectors. It could also assist multilateral agencies and bilateral donors in identifying poten-
tial ways to assist Bhutan with concessional finance and speed up their final decisions on committing funds, as there
would eventually be a pipeline of rigorously assessed projects awaiting funding. In this way, a strong IEU would further
strengthen Bhutan’s international ‘brand’, and over time help establish a global reputation in delivering key investments,
in line with the 13th FYP objective “To Rank Among the Top 20 Countries on Trust, Credibility and Integrity Indices” by
2030”. This could attract additional FDI, venture and philanthropic capital, portfolio capital with an Environmental, Social
and Governance (ESG) mandate, through, for example, ‘green-tech’.
The IEU could grow in an incremental way, focusing on the peaks that have potentially the greatest returns, but
which also pose the greatest risks. The IEU would need to carefully prioritize the allocation of its expertise across the
evaluation of projects, especially in its early years when it is still building its own institutional capacities and will have a
58
Hydropower Revenue Management for Economic Diversification
Bhutan Country Economic Memorandum
limited number of staff. Initially, experts from other ministries, including sector ministries, could be seconded for limited
periods of time to work with an IEU in the Ministry of Finance (or whichever institution provides the IEU’s home) on eval-
uations that concern their sector focus, or for periods of training in evaluation techniques. Such secondments would
also help sector ministries prepare requests for evaluation by the IEU when these involve large budgetary allocations or
are likely to have complex effects (including larger than usual project risks). The IEU could prioritize the following tasks:
The IEU could evaluate existing policies to determine whether they are targeted, transparent and minimize budget-
ary costs (and risks). The recent PER has highlighted that several policy measures in Bhutan could be improved. For
instance, tax incentives could be better targeted as they are costly and benefit mostly large and medium businesses in
the manufacturing, financial, and tourism sectors. Similarly, TVET programs and their linkages with the labor market could
be strengthened. SOEs generate substantial revenues (mainly through the hydro sector) but there are also opportunities
to reduce fiscal costs and risks, including from loss-making real sector SOEs and SOEs in the financial sector. Strength-
ening the fiscal risk assessment, better SOE oversight, reporting and performance management, strong governance,
and improved SOE investment management, could improve the performance of SOEs.
When considering new policies and projects, emphasis could be placed on evaluating those with the potentially
greatest returns and risks (financial risks, but also environmental and community risks). These are the ‘high peaks’
discussed earlier in the report: they are projects that have the potential to be truly transformative for the economy but
have a notable risk for failure, which can lead to large financial losses for the public sector (including debt service if the
project is to be partly debt-financed) or irreversible environmental and social damage. The evaluation can also identify
means to mitigate these risks if available.
59
Bhutan Country Economic Memorandum
2. Structural
Transformation
Through
© Mathias Berlin/Shutterstock
Agricultural
Productivity
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Structural Transformation Through Agricultural Productivity
Bhutan Country Economic Memorandum
2.1. Introduction
Bhutan’s development path is characterized by a disparity between the composition of value-added and employment.
While Bhutan’s growth has been driven by an expansion of industry and services, the country’s population continues to
be employed predominantly in the agricultural sector. Structural transformation has been much slower than that expe-
rienced in peers. Economists have long documented that structural transformation is the result of an interplay between
agricultural productivity growth that reduces demand for agricultural labor and growth in industrial or service sectors
that attracts former agricultural workers. Bhutan has not experienced this pattern because growth has been driven by
hydropower, which is not labor-intensive, and thus does not tempt workers to leave agriculture. It does not directly impact
agricultural productivity, leaving labor demand in agriculture unaffected. As the linkages of hydropower to the remainder
of the economy are limited (see Chapter 1), Bhutan is yet to experience the forces of structural transformation that have
helped other countries ignite high growth spells.
This Chapter explores whether efforts to increase productivity in agriculture can help kick-start structural transfor-
mation. The Chapter thus complements Chapter 1 by exploring factors that ‘push’ workers out of agriculture. It argues
that while structural transformation has been slow, Bhutan has experienced a gradual reallocation of workers from rural
to urban areas. This shift has been associated with industrialization and service sector expansion in destination areas and
increasing agricultural labor shares in the regions of origin. At the same time, agricultural production has remained rudi-
mentary, with large productivity gaps and a decline in both yields and harvested areas of Bhutan’s staple crops, rice and
maize, on average. Simultaneously, however, pockets of modernization, such as increasing cereal yields in some areas,
have emerged, and the sector has gradually reoriented itself towards its comparative advantages. This Chapter shows that
precisely those areas, which have experienced cereal yield growth, have released workers into non-agricultural employ-
ment. Simulations from a CGE model also show that continued investment in agricultural productivity can be a driving
force for structural transformation and can generate spillovers to wages and the service sector if production constraints
– especially related to irrigation – can be overcome. Climate change may, however, present a challenge to this transition.
The Chapter is organized as follows: Section 2.2 provides an overview of the agricultural sector in Bhutan, examining
both its contribution to employment, production structures and trends towards diversification. Section 2.3 explores the
link between agricultural productivity and structural transformation, highlighting the existence of productivity gaps,
identifying the constraints that drive the productivity gaps, and simulating the impact of their closure on the country’s
economic structure. Section 2.4 focuses on climate change, its impact on yields and on the sector’s broader production
structure. Section 2.5 concludes with a policy discussion.
2.2. Structural shifts in the agricultural sector
2.2.1. Agriculture continues to be Bhutan’s main employer,especially in rural areas
The composition of value-added in Bhutan’s economy has changed dramatically in recent years. The contribution
of agriculture to output has declined significantly over the last two decades, from 25 percent of GDP in 2000 to only 12
percent in 2021. In contrast, the share of services in GDP has increased by 13 percentage points over the same period,
from 37 to 50 percent.
Despite the decreasing share in value-added, labor continues to be confined to the agricultural sector. Structural
transformation, defined as the movement of labor out of agricultural into industrial or service sectors, has been slow,
with agricultural labor share declining by only 1 percentage point between the 2005 and 2017 census98, from 45 to 44
98 This analysis relies on census data for the labor shares as subsequent analysis relies on a decomposition of labor shares at low geographic levels. Alternative, more frequent and
recent data sources, such as the Labor Force Surveys, are not representative at the village level.
61
Structural Transformation Through Agricultural Productivity
Bhutan Country Economic Memorandum
percent (Figure 50). This highlights that Bhutan has experienced an asynchronous process of structural transformation,
in which economic output has effectively transitioned out of agriculture but workers continue to be engaged in the sector.
The low overall figure of labor movement out of agriculture masks differences across geographic areas. The spatial
pattern of structural transformation indicates four types of areas that have experienced more rapid structural transfor-
mation than the rest of the country:
1. Areas close to India benefit from reduced trade costs and access to a larger market, which facilitates structural
labor market shifts. For instance, the gewog of Samrang in the south-east borders the Indian state of Assam
and has experienced a 60 percentage point reduction in agricultural labor share between 2005 and 2017, the
largest reduction in Bhutan.
2. Urban centers, including those surrounding Paro, Thimphu, and Punakha in the center of the country, can
produce agglomeration effects and economies of scale, and have seen substantial reduction in agricultural
employment. These areas are also the most frequented by tourists, which has driven a reallocation towards
services.
3. Large hydropower developments produce localized spillovers during construction and after commissioning.
Examples include the Chukhha district, south of Thimphu, where the Tala hydropower plant was commissioned
in 2007, and Trongsa district in the center of the country, where the Mangdechhu plant was commissioned
in 2019.
4. Areas connected to urban centers and the Indian market through road infrastructure, such as Trashigang
district in the south-east, have also experienced a modest movement of labor out of agriculture.
In contrast, rural and mountainous areas, such as in the north-west of the country, have increased their agricultural labor
share (Figure 51).
Figure 50: While agriculture’s contribution to Figure 51: …and any decline in agricultural
GDP is low, the sector continues to act as the transformation has occurred exclusively through
main employer in Bhutan… a reallocation of labor from agricultural to
non-agricultural areas.
50% 48% 47%
45% 46%
45% 44%
46%
40%
40%
45%
35% 34%
31% 44%
30%
25% 43%
20%
20% 20% 19%
20% 42%
16%
15% 14%
41%
10%
6% 40%
5%
39%
0%
re
es
try
rs
re
es
try
38%
he
ltu
ltu
c
c
us
us
rvi
rvi
Ot
Actual Actual Spatial Regional
u
u
Ind
Ind
ric
ric
Se
Se
Ag
Ag
Labor Shares Shares in Value Added Reallocation Transformation
2005 2017 2005 2017
Source: World Development Indicators and Bhutan National Accounts Statistics. Source: World Bank staff calculations using data from the Population and Housing
Note: The right-hand side graph uses gewog-level data. Due to changes in Census 2005 and 2017, and the decomposition proposed by Eckert and Peters
some gewog boundaries between 2005 and 2017, it only incorporates data of (2022).
unchanged gewogs, which means that the figure on the aggregate change in the
labor share differs from the national average highlighted in this section.
62
Structural Transformation Through Agricultural Productivity
Bhutan Country Economic Memorandum
Structural transformation has occurred through a spatial reallocation of workers rather than through a homogenous
transition across space. Eckert and Peters (2022) show that the change in the agricultural labor share over time can be
decomposed into two factors.99 The first one – termed spatial reallocation component – is the share of structural transfor-
mation driven by workers moving from more to less agricultural areas, thus increasing the share of these areas in national
employment. The second component is called regional transformation component; it measures the contribution of with-
in-region changes in agricultural employment. Applying this decomposition methodology to gewog-level data from the 2017
and 2005 waves of Bhutan’s Population and Housing Census (PHC) shows that structural transformation was exclusively
driven by a reallocation of workers from more to less agricultural areas. In the absence of within-region structural trans-
formation, the reallocation of labor that occurred between 2005 and 2017 would have reduced the national agricultural
labor share by almost 3 percentage points below its actual level in 2017 (Figure 51). By contrast, had there been no internal
reallocation of workers, the agricultural labor share would have exceeded the 2017 value by over 2 percentage points.
Figure 52: Structural transformation has centered around urban centers and select trading points
at the southern border, whereas more rural regions have witnessed an increase in agricultural labor
shares.
Change in agricultural
labor share (2005-17)
-0.620 - -0.160
-0.160 - -0.072
-0.072 - -0.038
-0.038 - 0
0- 0.02
0.020 - 0.080
0.080 - 0.138
0.138 - 0.170
0.170 - 0.266
0.266 - 0.750
Source: World Bank staff calculations using data from the Population and Housing Census 2005 and 2017.
Note: Gewogs for which no data was available are shaded in white.
The heterogeneous progress in structural transformation aligns workers with emerging cross-regional differences in
comparative advantages. The structural transformation experienced by Bhutan has resulted in (i) a relative polarization
of agricultural labor in rural areas and (ii) a modest absolute reduction in agricultural activity. The reallocation of workers
and the associated polarization of labor are a central mechanism that enables Bhutan’s economy to overcome inherent
characteristics that inhibit its competitiveness, including its mountainous terrain, high transport costs, and a low population
density. This is because it allows for an accumulation of factors in areas that are relatively more competitive and have a
comparative advantage in industry or service activities. This implies that economic policy should provide incentives and
opportunities for labor to move from more to less agricultural regions, rather than attempting to achieve homogenous
structural change throughout the country. The discussion in Chapter 1 aims to achieve this objective. It also implies that
supporting growth in more agricultural regions will hinge on strengthening their comparative advantage in agriculture.
The discussion in this module focuses on this aspect.
ehind other sectors and comparators
2.2.2. Agricultural value-added has fallen b
Bhutan has experienced only slow gains in agricultural value-added per worker. Agricultural productivity growth
averaged just 1 percent per year between 2000 and 2017, which puts Bhutan among the lower half of its peer countries
(Figure 53). Between 1997 and 2019, value-added per worker in agriculture increased by only 26 percent, much less
than in industry (84 percent) and services (178 percent; Figure 54).
99 Eckert, F. and Peters, M. 2022. “Spatial Structural Change” Working Paper W30489. National Bureau of Economic Research, Massachusetts.
63
Structural Transformation Through Agricultural Productivity
Bhutan Country Economic Memorandum
Figure 53: Agricultural productivity growth Figure 54: …but productivity growth in
is key to facilitating a movement of labor to agriculture has lagged in other sectors within
non-primary sectors… Bhutan…
Bhutan value added per worker, by sector (1997=100)
8 300
7
Annual change in productivity, percent
Bhutan
6 250
5
4 200
3
2 150
1
0 100
-1
-2 50
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
-3
-5 -4 -3 -2 -1 0 1 2 3 4 5
Agriculture, forestry, and fishing, value added per worker (constant 2015 US$)
Annual change in employment share, percent
Industry (including construction), value added per worker (constant
Agriculture Industry Services Services, value added per worker (constant 2015 US$)
Source: World Development Indicators. Source: World Development Indicators.
Note: Figure 52 presents average annual changes (in percentage points) from 2000 to 2017 using the World Bank’s Job Structure Tool.
The productivity gains were dwarfed by the performance of aspirational peer countries, which have undergone a
successful structural transformation process. Paraguay and Cambodia, for instance, were able to more than double
value-added per worker in the agricultural sector over the same period (Figure 55). Peru’s value-added per worker in agri-
culture exceeded Bhutan’s level by 42 percent only in 1992 but had diverged by almost 100 percent by 2019 (Figure 56).
Figure 55: …and was significantly lower than for Figure 56: …in stark contrast to productivity
peer countries… developments in the service and industrial sectors.
Agriculture value added per worker (1997=100) Service value added per worker (1997=100)
300 300
250 250
200 200
150 150
100 100
50 50
0 0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
Bhutan Paraguay Bhutan Paraguay
Peru Cambodia Peru Cambodia
Source: World Development Indicators. Source: World Development Indicators.
An empirical cross-country comparison showed that countries with larger agricultural productivity gains experienced
more rapid structural transformation. Comparing Bhutan to the set of structural and aspirational peers revealed a strong
negative association between agricultural productivity growth and agricultural employment share (Figure 55). Bhutan
stands out as one of a few countries to have experienced slow productivity growth and a slow movement of labor out
of agriculture.
64
Structural Transformation Through Agricultural Productivity
Bhutan Country Economic Memorandum
s driven by the reduced production of
2.2.3. The slow growth in agricultural value-added i
Bhutan’s traditional crops
Bhutan’s traditional crops are irrigated and rainfed paddy and rainfed maize. These two crops account for almost half
of Bhutan’s harvested area, with paddy occupying a 25 percent and maize a 21 percent (Figure 57) share. Cardamom
(12 percent) and potato (9 percent) are the third and fourth largest crops produced. Within broader product groups,
cereals account for most of the harvested area at 57 percent, followed by spices and vegetables. Most cereal produc-
tion in Bhutan operates on a small scale, with farm sizes averaging about 2.5 acres and less than 18 percent of irrigated
harvested area. Bhutan also limits irrigation to paddy, with most other crops produced under rainfed conditions or using
wetland farming.
Figure 57: Paddy and maize dominate Bhutan’s harvested area.
Cereals Spices Vegetables
Beans,
Chili, 3.6 1.7
Cabbage, Turnip, Raddish,
1.4 1.3 1.2
Cauliflower, Carrot,
Cardamom, 12.1 1.0 0.5
Cucumber,
0.6
Garlic,
0.3 Bunching Onion, 0.3
Onion, Tomato, 0.2
Tumeric, 0.4
0.2 Eggplant, 0.2
Maize, 21.2 Coriander, Broccoli, Peas, Asparagus, 0.2
Ginger, 3.2 0.2 0.9 0.4
Beetroot, 0.0
Roots and Tubers Oilseeds
and Legumes
Casava, 0.2
Mustard, Mung Beans, 1.1
Millet, 2.4 1.2
Taro, 0.1 Soya Beans, 0.3
Tumeric, 0.2 Groundnut, 0.2
Buckwheat, Wheat, Barley, Perilla, 0.1
Paddy, 25.1 3.9 2.4 1.7 Potato, 8.6 Tumeric, 0.2
Sunflower, 0.0
Beans Dry, 0.8 Lentil, 0.0
Rajma Beans, 0.7
Source: Agriculture Statistics Reports, National Statistics Bureau. Note: The numbers show shares of a specific crop in total harvested area in 2021.
The area dedicated to these crops has declined in recent years. Bhutan’s harvested area has declined consistently
over the last decade, from a high of 214,000 acres in 2009 to 96,000 acres in 2021. This decline occurred across most
districts but was most pronounced in the southern (e.g., in Samtse and Sarpang) and the eastern part (e.g., Trashigang;
Figure 58) of the country. Underlying this development was a 57 percent reduction in the harvested area for cereals
between 2004 and 2021 (Figure 59).
65
Structural Transformation Through Agricultural Productivity
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Yields of maize and paddy also decreased. Using data from two rounds of Bhutan’s Renewable Natural Resource (RNR)
Census, Dizon, Imtiaz and Yu (2022)100 documented that irrigated paddy yields decreased over the last ten years. Between
2009 and 2019, the years of the RNR census, irrigated paddy yields decreased from 1.6 tons per acre to 1.1 tons per acre.
A similar picture emerged for maize, for which yields decreased from 0.94 to 0.89 tons per acre.
Figure 58: Harvested area has declined across Figure 59:…driven by cereals (maize and paddy).
Bhutan…
-56
Trashigang -70
Bhutan -41
-56
Dagana -44
-43
Mongar -40 Oilseeds_Legumes -44
-30
Lhuentse -50
-33 Roots_Tuber 1
Wangdue Phodrang -20
-28
Trongsa -35
Vegetables 12
-25
Thimphu -45
-33
Bumthang SPices 96
-16
12
Gasa -39
20 Cereals -57
Chukha 20
-80 -60 -40 -20 0 20 40 -100 -50 0 50 100 150
Change in harvested ares (% of 2004 value) Change in harvested area (% of 2004 value)
Source: Agriculture Statistics Reports, National Statistics Bureau. Source: Agriculture Statistics Reports, National Statistics Bureau.
Changes in cereal yields differ across the country. Decreases in paddy and maize yields were concentrated in the
southern regions, whereas the rest of the country experienced rising yields (Figure 60). With most arable land located
in the south (Figure 61), this resulted in an overall decline in cereal yields.
Figure 60: Cereal yield changes were Figure 61: …which is also the area where most
heterogeneous across Bhutan, with reductions agricultural production is located.
focused in the south of the country…
150 Gasa District
100
Number of gewogs
50
Share in percent
0
-1000 -500 0 500 1000 1500 0 5
Change in weighted cereal yields b/w 08/09 and 18/19
Source: World Bank staff calculations using data from the Renewable Natural Source: World Bank staff calculations using data from Agriculture Statistics Reports
Resources (RNR) Censuses 2009 and 2019. and Statistical Yearbook 2022, National Statistics Bureau.
100 Dizon, F., Imtiaz, S., & Yu, J. 2022. “Water Constraints to Agricultural Productivity in Bhutan.” Background Paper to the Bhutan CEM. World Bank, Washington, DC.
66
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Lower harvested areas and lower yields for paddy, maize and other cereals resulted in reduced production. Between
2004 and 2021, paddy and maize output declined by 25 and 66 percent, respectively (Figure 62). This is symptomatic of
a broader development for cereals, for which output declined across the board and was most pronounced in the case
of wheat, for which output decreased by 72 percent over the same period.
Figure 62: Declines in harvested areas and Figure 63: …whereas the number of fruit trees
yields have led to a drop in agricultural output of planted has increased due to a rise in areca nut
traditional crops… production.
4.0
Oil seed
Mustard -81.2 3.4
and legumes
3.5
Roots Potato -18.6
and Tubers 0.4
3.0 2.8
Ginger 14.9
0.1
Spices Million of fruit bearing trees 2.5
Cardamom 97.5
2.1 0.8
2.0 0.1
Wheat -72.1
1.5
Millet -52.6 1.5 0.0
1.6
0.8
Cereals Buckwheat -26.1 1.0
1.8
1.0
Paddy -25.4 0.5
0.8
0.6
Maize -65.8 0.2
0.0
2004 2009 2015 2021
-100 -50 0 50 100 150
Change in production b/1 2004 and 2021 (percent) Areca nut Mandarin Banana Apple Other fruit
Source: Agriculture Statistics Reports, National Statistics Bureau. Source: Agriculture Statistics Reports, National Statistics Bureau.
2.2.4. The agricultural sector is gradually transitioningfrom traditional to higher value
products
In contrast to maize and paddy, agricultural production- Figure 64: Bhutan has an export niche in fruits,
64for select spices and fruits increased in recent years. spices, and a few vegetables…
The harvested area for spices increased by 96 percent
White Bean
between 2004 and 2021 (Figure 59), driven by increased 120
Pineapple Lentil
cardamom production, the output for which increased 110 Eggplant
by 98 percent over this period (Figure 64). Fruit-bearing 100 Tomato
Onion bulb
trees also increased substantially, rising by 126 percent Paddy
Import/Production, in percent
90
(Figure 64). Fruit production is concentrated among three 80 Mango
products (areca nut – 52 percent, mandarin – 24 percent, 70 Import Oriented (9)
and bananas – 8 percent; Figure 65), with expanded 60
output driven by an expansion of areca nut production, 50
which increased from 200,000 trees in 2004 to almost 2 40 Maize Papaya Export Oriented (8)
million trees in 2021 (Figure 65). 30
Peas
Cucumber Cabbage Carrot
20 Banana Potato
Increased production of cardamom and areca nuts has Chili
Areca nut
10 Mandarin
allowed Bhutan to increase its global market share Buckwheat Ginger Apple Cardamomo
0 Millet
in these products. Bhutan’s agricultural exports have 0 10 20 30 40 50 60 70 80 90 100 110 120
remained relatively constant over time and stood at 1.7 Exports/Production, in percent
percent of GDP in 2021 (Figure 68). Cereals, even though
they account for 57 percent of total harvested area, are Source: World Bank Staff calculations based on “Self-sufficiency and Dietary
Energy Supply of Food Crops in Bhutan” report, October 2021.
negligible in terms of exports and most of them are used
67
Structural Transformation Through Agricultural Productivity
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Figure 65: …with fruit production dominated by areca nuts, followed by mandarins and bananas.
Banana, 7.7 Apple, 3.9
Tree
Others, tomato,
1.6 1.4
Pineapple,
3.1 Guava, Pear, Peach,
1.3 0.7 0.7
Hazelnut, Mango, Litchi, Lemon,
Areca nut, 52.4 Mandarin, 23.6 1.8 0.8 0.6 0.3
Source: Agriculture Statistics Reports, National Statistics Bureau.
Note: The numbers show shares of a specific tree in the total number of fruit trees in 2021.
for domestic consumption. In contrast, exports under Harmonized Classification (HS classification) chapter 9 (including
coffee, tea, maté, and spices) account for 60 percent of agricultural exports (with 61 percent for India). This has been
driven by an increasing market share in global cardamom production, with Bhutan supplying 1.5 percent of the global
market in 2021 (Figure 67). Exports under chapter 8 (edible fruits and nuts) account for 22 percent of total agricultural
products exports, with only 40 percent destined for India. Most nut exports are accounted for by areca nut production,
for which Bhutan has consistently increased its global market share in recent years, supplying almost 1 percent of the
total global production in 2021 (Figure 65). In contrast, vegetable exports are highly concentrated and declining, with
most accounted for by potatoes destined for India.
Figure 66: Spice, fruit and nut exports to global Figure 67: …allowing Bhutan to capture market
markets have gradually replaced potato exports shares in select niche products.
to India…
2.5 4.5
2.0 4.0
Bhutan's share in total tonnes produced
2.0
3.5
Bhutan's agricultural export (% of GDP)
1.7 1.7 1.7
3.0
worldwide (percent)
1.5
2.5
1.0 2.0
1.5
0.5 1.0
0.5
0.0
2005 2009 2015 2021 0.0
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Chapter 10: Cereals Chapter 9: Co ee, tea, mate and spices
Chapter 8: Edible fruit and nuts; Chapter 7: Edible vegetables
peel of citrus fruit or melons and certain roots and tubers Areca nuts Cardamoms
Source: Food and Agriculture Organization Corporate Statistical Database Source: Food and Agriculture Organization Corporate Statistical Database
(FAOSTAT). (FAOSTAT).
The move towards export niches indicates a broader re-orientation of the agricultural sector towards its compara-
tive advantages. Bhutan’s agricultural production can be classified into three groups — (i) Import-dependent crops, for
which the import to production share exceeds 50 percent. These include, among others, paddy and wheat (Figure 66).
These are items for which Bhutan has a revealed comparative disadvantage; (ii) Export-oriented crops, for which over
68
Structural Transformation Through Agricultural Productivity
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25 percent of production is exported. This includes high-value goods such as cardamom, areca nuts, and mandarins, in
which Bhutan has a comparative advantage; and (iii) Other products in which Bhutan is self-sufficient, including maize.
Over time, Bhutan has moved towards its comparative advantage, exporting more of its export-oriented production and
importing more of its import-dependent products (Figure 68, Figure 69).
Figure 68: Over time export intensity of export- Figure 69: …whereas Bhutan increasingly relies
oriented products has increased… on imports for products for which it is at a
comparative disadvantage.
80 700
70 67
600
Imports as a share of production (percent)
Exports as a share of production (percent)
60
500
502
50
400
40
300
30
22
200
20
10 100 78
0 0
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
Source: World Bank Staff calculations based on Self-sufficiency and Dietary Energy Source: World Bank Staff calculations based on Self-sufficiency and Dietary Energy
Supply of Food Crops in Bhutan report, October 2021. Supply of Food Crops in Bhutan report, October 2021.
2.3. Productivity as a kick-starter
of structural transformation
The literature has long documented a link between agricultural productivity and the movement of labor out of agri-
culture. On the one hand, increasing agricultural productivity directly supports growth in areas that have a comparative
advantage in agriculture and can generate positive spillover effects to the livelihoods of predominantly rural popula-
tions.101 On the other hand, agricultural productivity growth can reduce labor demand in the sector and help harmonize
marginal returns to labor between agricultural and non-agricultural activities, thus providing an incentive for workers to
seek employment in industries and services.102
This section shows that agricultural productivity increases in Bhutan have driven structural transformation in the past
and will be crucial to accelerating it going forward. It shows – using two separate sources of geographic variation – that
those areas which experienced yield growth or transitions towards higher value products also experienced changes in
their agricultural labor shares. The section then uses an econometric estimation technique to argue that current yields
in Bhutan remain below their potential due to production constraints. Simulating the closure of these productivity gaps
using a CGE model shows that such a policy intervention has the potential to rapidly increase structural transformation
and generate significant spillovers to non-agricultural sectors.
101 There is, for instance, evidence that the adoption of higher productivity crops during the Indian green revolution significantly enhanced agricultural employment and incomes.
See Moscona, J. (2018). “Agricultural Development and Structural Change Within and Across Countries”. Mimeo, MIT.
102 See Bustos, P., Caprettini, B., and Ponticelli, J. 2016. “Agricultural Productivity and Structural Transformation: Evidence from Brazil”. American Economic Review, 106(6), 1320-65.
69
Structural Transformation Through Agricultural Productivity
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ore productive agriculture and
2.3.1. Within Bhutan there is a statistical relation between m
the release of labor
A relation between agricultural labor shares and productivity in the sector exists both on the intensive and the exten-
sive margin. On the intensive margin, areas that have experienced cereal yield growth have increased their agricultural
labor share and have experienced an outward movement of workers. A similar pattern, albeit less pronounced, is visible
in the extensive margin shift from cereals towards fruit trees. Both patterns indicate that productivity improvements
release labor to other sectors.
Cereal yield increases are associated with increasing agricultural labor shares and an emigration of workers. Figure
62 in section 2.2.3 has documented substantial heterogeneity between gewogs in yield changes between the 2009
and 2019 RNR census. Combining the data on yield changes with information on changes in employment changes from
the PHC shows that those gewogs, which experienced a larger change in cereal yields between 2009 and 2019, experi-
enced an increase in their own agricultural labor share (Figure 70) and a decrease in their share of national employment
(Figure 71).
A regression approach confirms that the visual relation is statistically significant. A 1 ton per acre increase in yields is
associated with a 0.04 percentage point reduction in a gewog’s share in national employment. At the same time, gewogs
that experience cereal yield increases become more agricultural, with a 1 ton per acre increase associated with a 2.7
percentage point increase in agricultural labor share. Both estimates are statistically significantly different from zero
at conventional levels of confidence. The increase in cereal yields is also concentrated among those regions that had
relatively higher agricultural labor shares in 2005. These factors provide prima facie evidence that the geographically
focused structural transformation experienced by Bhutan is linked to agricultural productivity growth.
Figure 70: Regions that experienced higher Figure 71: … while decreasing their share of
cereal yield growth increase their own national employment
agricultural labor share…
1.0 0.010
Change in national employment shares
0.5
Infrastructure quality (WEF)
0.005
0.0
0.000
-0.5
-0.005
-1000 -500 0 500 1000 1500 -1000 -500 0 500 1000 1500
Capital spending (% GDP) Change in weighted cereal yields
Source: World Bank staff calculations based on data from the PHCs 2005 and Source: World Bank staff calculations based on data from the PHCs 2005 and
2017 and the RNR censuses 2008 and 2018. 2017 and the RNR censuses 2009 and 2019.
Note: The scatter plot excludes outliers where change in employment share
exceeds 3 percent and -0.5 percent. The linear fit line includes these outliers.
Similarly, districts that reduced their harvested area from crops in favor of fruit trees are more likely to have expe-
rienced a reduction in their agricultural labor share. Section 2.2.4 has documented a reduction of harvested area in
some parts of Bhutan and an increased reliance of production on fruit trees for areca nuts. These two developments
70
Structural Transformation Through Agricultural Productivity
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are linked, as those gewogs which experienced a reduction in harvested area are also more likely to experience an
increased number of fruit-bearing trees (Figure 72). At the same time, the two districts – Samtse and Sarpang – which
experienced the largest reduction in harvested area and increase in fruit-bearing trees, also experienced consider-
able increases in their agricultural labor shares of 3.8 and 7.7 percentage points between the 2005 and 2017 census
(Figure 73). Samtse’s share in national employment decreased by 1 percentage point and Sarpang’s share marginally
increased by 0.6 percentage points over the same period.
Figure 72: The dzongkhags with the largest drop Figure 73: …and the largest decline in agricultural
in harvested area had the largest increases in the labor share.
number of fruit trees…
0.7 25
Change in fruit – bearing trees b/w 2004 and 2021 (million trees)
Zhemgang
Samtse Sarpang
0.6 20
0.5 Share of agricultural employment in Dzonghag's 15
Chukha
total employment, delta 2005-2017
0.4 10 Mongar Gasa
Pema Gatshel Sarpang Bumthang
0.3 Dagana 5 Samdrup Jongkhar
Samtse
Punakha
Tsirang Lhuentse Haa
0.2 Trongsa 0
Mongar Trashigang Trashi Yangtse
Zhemgang Paro
Samdrup Jongkhar Dagana Thimphu
0.1 Trashi Yangtse -5
Trashigang Gasa Tsirang
Lhuentse Haa
0.0 -10 Wangdue Phodrang Pema Gatshel
Wangdue Phodrang Bumthang
Paro
Thimphu -15 Punakha
-0.1
Chukha Trongsa
-0.2 -20
-20 -15 -10 -5 0 5 -20 -15 -10 -5 0 5
Change in harvested area by Dzongkhag,
Change in harvested area b/w 2004 and 2021 (1000 acres) in thousand acres, 2004-2021
Source: Agriculture Statistics Reports, National Statistics Bureau
These patterns are consistent with the broader experience of structural transformation in South Asia. Asher et al.
(2022) studied irrigation canals in India over 150 years and found that canal areas have higher land productivity and
population density relative to neighboring non-canal areas, but that there is no long-run change in the share of the work-
force outside of agriculture or even in agro-processing. Instead, structural transformation occurs via higher growth rates
in nearby towns, suggesting that the transformation is one that occurs in movement across space as opposed to across
sectors (within the same area). Related work in India by Blakeslee, et al. (2023) found that large-scale irrigation increased
agricultural output, population, and wealth in the program areas, but there was a decline in population, non-agricultural
employment, and firm activity in nearby towns.
n Bhutan is below its potential
2.3.2. Agricultural productivity i
Yield potential can be estimated through a regression that predicts potential yields at the chiwog-level based on
reported constraints and controlling for local conditions.103 This exercise highlights that Bhutan has substantial poten-
tial to increase yields and kick-start structural transformation. Yield potential growth is largest for maize, for which the
predicted potential yield is over 1.3 tons per acre, 44 percent more than the average current yield (Figure 74). Irrigated
paddy also has substantial yield potential at 1.6 tons per acre, 39 percent more than the actual average. In addition to
cereals, vegetables – including chili, beans, cauliflower, and potato – also hold significant potential to increase yields.
103 The analysis presented in this section uses data from the two RNR censuses and compares yield differentials across neighboring chiwogs, thus controlling for differences in
exogenous production determinants that are fixed for neighboring villages and for other, observable, production characteristics. In addition, the analysis controls for self-reported
production constraints through a regression approach. Yield potential is then defined as the predicted yield of the top 10 percent of holdings when production constraints are
alleviated.
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Structural Transformation Through Agricultural Productivity
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Figure 74: Current yields are significantly below their potential
Cardamom
Spinaches and sags
Cabbages
Radish
Mandarin
Ginger
Potato
Cauliflower
Beans
Chili
Paddy (Irrigated)
Maize
0% 10% 20% 30% 40% 50%
Source: World Bank staff calculations based on data from the Renewable Natural Resources (RNR) Census.
Note: The figure shows the estimated yield gaps by crop.
Yield potentials vary by region. The regressions highlight that there is substantial potential to increase maize production
in the south-eastern region104, with potential increases amounting to 52 percent of current yields (Figure 75). Similarly,
growth potential in the central region105 amounts to 29 percent of current yields. While the data also suggests large growth
potential for the Western region106, these estimates are associated with a large variance due to a limited sample size. In
contrast to maize, irrigated paddy potential is more focused on the eastern region107. The south-western region108 has large
yield gaps for select vegetables, such as potatoes, beans, and cabbage, in addition to considerable growth potential in rice.
Figure 75: Yield increase potentials vary significantly by crop and region
160%
140%
120%
100%
80%
60%
40%
20%
0%
Central
East
South-East
South-West
West
Central
East
South-East
South-West
West
Central
East
South-East
South-West
West
Central
East
South-East
South-West
West
Central
East
South-East
South-West
West
Central
East
South-East
South-West
West
Central
East
South-East
South-West
West
Rice (Irrigated) Maize Potato Beans Spinach Chili Cabbages
Source: World Bank staff calculations based on data from the Renewable Natural Resources (RNR) Census.
Note: The figure shows the potential increase in yields by crop and region.
y alleviating production constraints
2.3.3. Productivity gaps can be closed b
Productivity gaps arise because farmers face production constraints. To estimate the importance and impact of different
constraints on yields, this section presents results from an econometric analysis that compares average yields between
villages with higher and lower shares of households reporting a given constraint.109 This approach controls for factors that
are similar between neighboring villages, such as climatic conditions or soil suitability. In addition, the estimates control
104 The south-eastern region as defined here contains Samdrup Jongkha, Sarpang and Zhemgang dzongkhags.
105 The central region has Bumthang, Gasa, Punakha, Trongsa and Wangdue Phodrang dzongkhags.
106 The western region comprises Haa, Paro and Thimphu dzongkhags.
107 The eastern region includes Lhuentse, Mongar, Pema Gatshel, Trashigang, and Trashi Yangtse.
108 The south-western region comprises Chukja, Dagana, Samtse, and Tsirang dzongkhags.
109 The detailed econometric results are reported in Dizon, F., Imtiaz, S., and Yu, J. 2022. “Water Constraints to Agricultural Productivity in Bhutan”. Background Paper to the Bhutan
CEM. This spatial first difference approach is based on Druckenmiller, H., and Hsiang, S., 2018. “Accounting for Unobservable Heterogeneity in Cross Section Using Spatial First
Differences”. NBER Working Papers 25177, National Bureau of Economic Research.
72
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for a set of farm-level characteristics. The production constraints considered in the analysis are those reported in the RNR
censuses, including irrigation problems, drought, unproductive land, shortage of land, labor shortage, limited access to
market, excessive rain, hailstorm or winds, landslides, crop damage by wild animals, and crop damage by insects or diseas-
es.110 The section first discusses the prevalence of these constraints and then presents estimates of their impact on yields.
Challenges related to water supply are frequently reported by farmers. Problems with irrigation are consistently the
most frequently reported problem across all crop-producing villages. Among rice-producing chiwogs, about 40 percent
of holdings reported irrigation problems as a constraint in the 2019 RNR census (Figure 76). Similarly, about 6 percent
of holdings reported drought as a constraint. These shares are similar for other crops, ranging from 37 percent for
maize-producing to 49 percent for areca nut-producing chiwogs.
Human-wildlife interactions also reportedly result in production constraints. Crop damage by wild animals was
reported more frequently in 2019 compared to 2009, with 68 percent of rice-producing holdings and 71 percent of
maize-producing holdings reporting it as a constraint in 2019. This was 5 and 7 percentage points more for rice-producing
holdings and maize-producing holdings, respectively, than in the previous census round. In contrast, crop damage by
insects and disease is now less prevalent, with only 23 percent of households in rice- and 24 percent of households in
maize-producing villages reporting it as a constraint. Similarly, about three-quarters of cardamom- and areca nut-pro-
ducing holdings report crop damage by wild animals as a major concern.
Labor shortages are another constraint reported by farmers. Between 42 and 45 percent of holdings producing
paddy, maize, cardamom, and areca nuts report that labor shortages impede their production. While labor shortages
thus remain a challenge, the share of holdings reporting it as a key obstacle dropped by about 6 percentage points on
average between the 2009 and 2019 RNR census.
Figure 76: Irrigation problems, labor shortages, and crop damage are among the main constraints
reported by farmers.
80%
70%
60%
50%
40%
30%
20%
10%
0%
Irrigation problem
Drought
Unproductive land
Shortage of land
Labour shortage
Limited access to markets
Crop damage by wild animals
Crop damage by insects and diseases
Irrigation problem
Drought
Unproductive land
Shortage of land
Labour shortage
Limited access to markets
Crop damage by wild animals
Crop damage by insects and diseases
Irrigation problem
Drought
Unproductive land
Shortage of land
Labour shortage
Limited access to market
Crop damage by wild animals
Crop damage by insects /diseases
Irrigation problem
Drought
Unproductive land
Shortage of land
Labour shortage
Limited access to market
Crop damage by wild animals
Crop damage by insects /diseases
Irrigated Paddy Maize Cardamom Areca Nut
Source: World Bank staff calculations based on data from the Renewable Natural Resources (RNR) Census.
Note: The figure shows the percentage of farmers reporting a given constraint.
The estimation results show that these challenges result in significant yield losses for farmers. Irrigation problems
cause a substantial reduction in yield for paddy rice. Removing irrigation problems for the 40 percent of affected holdings
would raise average yields by 68 kg per acre, or about 6 percent for irrigated paddy (Figure 77). Similarly, alleviating
the constraint for maize would raise average yields by 6.1 percent. Droughts result in lower yields for maize (removing
110 This section focuses on Bhutan’s two traditional crops, rice and maize, and two export-oriented crops, cardamom and areca. A broader set of results is available in the background
paper.
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their impact would raise yields by 1.5 percent) but have an insignificant impact on rice yields. This is expected because
maize – in contrast to irrigated paddy – relies to a larger extent on rainfall. Irrigation problems also severely affect yields
for cardamom and areca nuts. The alleviation of this constraint could raise cardamom yields by 11 percent and areca nut
yields by a more modest 4 percent. Cardamom yields also suffer because of droughts, so a reliable water supply could
raise yields by 2.2 percent.
Crop damage has, by far, the largest impact on yields for paddy and maize. The estimation results suggest that remov-
ing this constraint for affected farmers could raise yields by 9 and 15 percent for paddy and maize, respectively. Besides
crop damage by wild animals and water constraints, crop damage by insects and disease are a tertiary constraint for
paddy and maize, which, if addressed, would increase average yields by 4.7 and 4.4 percent, respectively.
Removing the impact of labor shortages – for instance through the adoption of labor-saving technologies – could
also raise yields. Overcoming labor shortages could increase paddy, cardamom and areca nut yields by 5, 6, and 4
percent, respectively. The alleviation of this constraint does not necessarily require the allocation of additional labor to
the sector. This could be achieved through the adoption of labor-saving technologies (see simulations in section 2.3.4).
Figure 77: Ensuring access to water, overcoming labor shortage through productivity, and protecting
crops from damage can trigger substantial yield increases.
18%
16% 15.38%
14%
12% 11.35%
10%
8.92%
8%
5.97% 6.09% 6.11%
6%
4.77% 4.74% 4.42%
4.04%
4% 3.62%
1.83% 2.20%
2%
0%
Irrigation Labour Crop Crop Irrigation Drought Crop Crop Irrigation Drought Labour Irrigation Labour
problem shortage damage damage by problem damage damage by problem shortage problem shortage
by wild insects and by wild insects and
animals diseases animals diseases
Irrigated Paddy Maize Cardamom Areca Nut
Source: World Bank staff calculations based on data from the Renewable Natural Resources (RNR) Census.
Note: The figure shows the impact on yields (as a percentage of 2019 average yields for the overall country) of removing a given constraint. It only reports statistically
significant constraints.
The impact of different constraints varies by geographic area. For instance, in the eastern and south-western part of
Bhutan, maize production is most constrained by water scarcity, whereas the effect on paddy is driven by the western
region. Crop damage by wild animals is also most likely to impact paddy in the western region, whereas this constraint
is most prevalent in the south-east for maize.
The results are consistent with a broader literature linking production constraints to yields in Bhutan and beyond.
Using the 2009 RNR census, the International Food Policy Research Institute (IFPRI) (2010) notes that the self-reported
top constraints to farming are wildlife, insects/plant diseases, irrigation, and labor shortage. Using propensity score
matching techniques, they find that improved quality of land (i.e., irrigation) is strongly related to productivity. Cursory
policy simulations indicate that irrigation investment programs provide larger returns, compared to, for instance, rural
roads and wetland protection. More broadly, yield growth in the South Asia Region (SAR) has been attributed to an extent
to the expansion of irrigation (Morita, 2021). In other contexts, Jones et al. (2023) study hillside irrigation schemes in
Rwanda and find that such schemes enable dry season horticultural production (essentially adding a season focused
on water-intensive crops), thereby boosting on-farm cash profits by 70 percent.
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The impact of other constraints, which cannot be captured quantitatively using RNR census data, include difficult
transport and export logistics. Due to its mountainous topography and low population density, improving transport
logistics is a major challenge in Bhutan. The country’s infrastructure has started falling behind its peer countries. For
instance, Bhutan’s ranking in the Logistics Performance Index has decreased, from 69 in 2012 to 93 in 2018 (Figure 78).
This decline is driven by slow progress (and marginal regressions) in key areas, such as infrastructure, customs, and
international shipments, whereas Bhutan’s comparator countries have consistently improved (Figure 79).
Figure 78: Bhutan’s ranking in trade logistics has Figure 79: …owing to a decrease in infrastructure,
decreased in recent years… international shipments and timeliness ratings,
and only a modest improvement in other areas.
3.0
2007 2010 2012 2014 2016 2018
0
2.6
10 2.5
Better Performancs 2.3 2.4 2.5
2.1 2.1 2.3
20 2.2
2.0 1.9
Better Performancs
2.0
1.9
30
1.5 1.8
40
50 1.0
60
0.5
70 69
0.0
80 2007 2018 2007 2018 2007 2018 2007 2018 2007 2018 2007 2018
83 84
Customs
Infrastructure
International
shipments
Logistics
Services
Tracking
and Tracing
Timeliness
85
90
89
93
100
Source: World Bank’s International Logistics Performance Index.
Bhutan’s difficult topography also impacts land productivity. Only 13.5 percent of Bhutan’s land surface is arable,
under permanent crops, or under permanent pastures, putting it at the bottom of the global distribution of agricultural
land area (Figure 82). While having a low agricultural area is often cited as a constraint to growth in the sector, Bhutan’s
low population density means that substantial growth opportunities remain. Indeed, the country ranks 68th in the world
when calculating the share of arable land per capita (Figure 83). More than 31 percent of agricultural land is on slopes
greater than 50 percent111, which is not only challenging to cultivate but is also associated with soil and nutrient losses
when traditional farming practices are applied. As a result of the difficult topography, around 64,000 acres of farmland
remain fallow.
an accelerate structural transformation
2.3.4. Closing productivity gaps c
This section estimates the macroeconomic impacts of closing parts of the yield gap shown in Figure 74.112 The estima-
tion relies on a CGE model designed specifically to capture the key characteristics of Bhutan’s economy (see description
in Box 8). In order to evaluate the ability of agricultural productivity growth to accelerate structural transformation, the
model is used to simulate a 20 percent reduction in Bhutan’s existing yield gaps through a joint improvement in the quality
of agricultural capital (better machines), fertilizers and pesticides (more effective chemicals), and fuel (better quality fuels).
The simulated yield improvements that form the basis of the productivity improvement scenario are shown in Figure 83.
111 MoAF. 2017: “Agriculture Land Development Guideline (ALDG) – 2017”. Thimphu, Bhutan, citing the National Soil Services Center, MoAF. 2011. Land Cover Mapping Project 2010.
112 In the stylized CGE scenarios, estimates for specific crops are taken as representative of the broader crop group weighted by land area under cultivation where necessary.
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Figure 80: Bhutan is ranked 170th among 208 Figure 81: …but 68th when the low population
countries in terms of its agricultural land area… density is considered.
90 400
80 350
Square kilometre of agri. land oer 1000 people
70
Agricultural land (% of total land area)
300
60
250
50
200
40
150
30
100
20
Bhutan
50
10
Bhutan
0 0
Source: World Development Indicators
Note: Agricultural land refers to the share of land area that is arable, under permanent crops, and under permanent pastures. Arable land includes land defined by
the Food and Agricultural Organization of the United Nations (FAO) as land under temporary crops (double-cropped areas are counted once), temporary meadows for
mowing or for pasture, land under market or kitchen gardens, and land temporarily fallow.
The model shows that increasing non-labor productivity affects marginal returns to different production factors,
and thus impacts wages and returns to land. Increasing productivity and yields have modest and ambiguous impacts
on agricultural wages. On the one hand, agricultural wages in the central, eastern, and western regions decline slightly,
as marginal products decline, and labor gets crowded out by technology (’the crowding-out effect’; Figure 84). On the
other hand, more efficient agricultural production also has an ‘income effect’, because it increases output and incomes
of landowners, among others, and therefore boosts demand. The income effect dominates the crowding-out effect in the
southern parts, where agricultural wages increase slightly in response to the increase in non-labor productivity. Outside
of agriculture the income effect prevails throughout the country, with higher yields increasing un- and low-skilled wages.
As low-skilled and unskilled wages rise by more than agricultural wages, households are incentivized to supply labor
outside of agriculture. As a result of changing relative wages, the supply of agricultural labor is lower, and the supply
of unskilled and low-skilled labor is higher in the agricultural productivity scenario compared to the reference scenario
(Figure 85). This structural change in the labor market occurs when higher relative wages outside agriculture incentivize
households to supply their labor to the pool of unskilled and low-skilled workers, rather than as agricultural labor.113 Thus,
the agricultural productivity ‘shock’ triggers a movement of labor out of agriculture into the secondary and tertiary sectors.
The movement of labor out of agriculture can accelerate structural transformation. The agricultural labor share in
the productivity improvement scenario is 0.8 percentage points lower by the year 2030 than in the reference scenario
(Figure 86). This reduction is driven by all regions, apart from the western region, as it retains more agricultural workers
than in the reference scenario, in the face of the largest yield increases and thus the largest income effect (Figure 93).
113 Part of the workforce is also absorbed by non-crop-producing agricultural sectors, such as in livestock and forestry production.
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Box 8: A description of the CGE modeling approach
The results shown in this Chapter are derived from a recursive dynamic variant of the STAGE single-country CGE
model114. The model is a member of the class of single country CGE models that are descendants of the approach to
CGE modeling described by Dervis et al., (1982)115. The model is centered around a SAM that identifies the agents in the
economy and provides the transactions database with which the model is calibrated. It differentiates between different
sectors and five regions (central, eastern, western, south-eastern, and south-western (see definition above).
In this Chapter, the model is first used to explore agricultural productivity improvements and then also used to assess
the impact of climate change (see section 2.4). It does so through a total of three policy scenarios and a reference baseline
scenario. Each scenario spans an 11-year period from 2019 (the base year of the SAM) to 2030. Outcomes under each scenario
are compared to a reference scenario, which corresponds to the hydro-led growth scenario discussed in module 1 of this CEM.
The considered scenarios are the following:
Reference Scenario (A1_HydroLed): This scenario includes the continuation of past trends and current policies in place,
plus the construction and commissioning of four planned hydropower projects: Punatsangchhu I, Punatsangchhu II,
Nikachhu, and Kholongchhu. The additional planned investment results in an expansion in hydro capacity and production
after 2023/2025. No additional projects are planned after 2025.
Productivity Improvement Scenario (A2_HydroLed_Prod_LabSav): In this scenario, the reference scenario is augmented
by adding labor-saving productivity improvements in agriculture. A comparison of this scenario with the reference
scenario shows the impact of crop- and region-specific productivity improvements in crop-based agriculture that release
labor to other sectors of the economy.
Climate Change Scenario (A3_HydroLed_CC): This scenario augments the yields in the reference scenario by including
climate-induced yield changes. A comparison of this scenario with the reference scenario shows the impact of crop
specific climate change impacts on land productivity.
Combined Scenario (A4_HydroLed_Prod_CC): As scenario 1, but with productivity improvements in agriculture and
climate change impacts. A comparison of this scenario with the reference scenario shows the impact of the productivity
improvements and climate change together. A comparison of this scenario with the productivity improvement scenario
shows the augmenting/dampening effects of climate change on yield changes from agricultural productivity improvements.
The production structure of the model is designed to capture labor-saving productivity improvements in agriculture.
The production structure places labor as a substitute to aggregate non-labor factors (Figure 84). Under an elastic degree
of substitution (5) between the labor and non-labor input aggregates in crop production improvements in the productivity
of non-labor factors leads producers to move away from less productive labor inputs, towards more productive non-la-
bor inputs, leading to labor shedding from these sectors. Conversely, reductions in land productivity, such as those that
may arise under climate change, will increase the use of other non-labor and labor factors in the production process.
Figure 82: Production structure for labor saving productivity improvements
Value added
Labour Non-labour
Labour by skill type Capital Land Chemicals Energy
Capital by type Cropland Pastureland Fertilizer Pesticides Electricity Non-electricity
Electricity by type Fuels by type
114 McDonald, S. 2022. “STAGE: A Standard Applied General Equilibrium Model: Technical Documentation”,
115 Dervis, K., De Melo, J. and Robinson, S. 1982. “General Equilibrium Models for Development Policy”. Cambridge University Press.
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Figure 83: Closing 20 percent of the existing Figure 84: …raises relative wages of
yield gaps by augmenting non-labor production non-agricultural workers…
inputs…
45% 0.8%
0.6%
40%
0.4%
35%
0.2%
30%
0.0%
25% -0.2%
20% -0.4%
-0.6%
15%
-0.8%
10%
HighSkilledLab
SemiSkilledLab
LowSkilledLab
UnskilledLab
C_AgriLab
C_Cropland
C_Pastureland
E_AgriLab
E_Cropland
E_Pastureland
SE_AgriLab
SE_Cropland
SE_Pastureland
SW_AgriLab
SW_Cropland
SW_Pastureland
W_AgriLab
W_Cropland
W_Pastureland
5%
0%
Rice Maize Other Cereals Vegetables Fruit & Spices National Central East SouthEast SouthWest West
& Pulses Labour Cropland Pastureland
Source: Shutes, Feuerbacher, and McDonald. 2022. CEM Background Paper.
Note: Both figures show outcomes in the year 2030 and compare outcomes between the agricultural productivity and the reference scenarios.
Figure 85:…and induces a shift of labor out of Figure 86: …which accelerates structural
agriculture… transformation, especially in the southern part.
1.0% 1.0%
0.8%
0.5%
0.6%
0.4% 0.0%
0.2%
-0.5%
0.0%
-0.2%
-1.0%
-0.4%
-1.5%
-0.6%
-0.8%
Agricultural Unskilled Low skilled -2.0%
National Central East South East South West West
Source: Shutes, Feuerbacher, and McDonald. 2022. CEM Background Paper.
Note: Both figures show outcomes in the year 2030 and compare outcomes between the agricultural productivity and the reference scenarios.
The impact of agricultural productivity improvement on GDP is modest. The introduction of labor-saving productivity
improvement in crop-based agriculture leads to a small headline impact on GDP of 0.4 percent by 2030 (Figure 88),
which is in line with the small initial share of crop production in total output (6 percent in 2019). The impact on domestic
demand (consumption and investment, or absorption) is larger at 1.6 percent, consistent with the boost to a part of the
economy that is largely consumed domestically (only 11 percent of crop production was exported in 2019).
In contrast to the modest headline figures, increasing agricultural productivity can cross-fertilize growth in the
service sector. Service GDP is almost 1 percent higher under the agricultural productivity scenario in comparison to the
reference scenario (Figure 90). The impacts outside agriculture arise from the increased availability of low-skilled labor
and an increase in household spending arising from lower food costs (Figure 87), as well as higher non-agricultural
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wages. Within services, almost all sectors expand, with the strongest growth estimated in the air and transport, and
telecommunications sectors. The hotels and restaurants sector also benefited from the direct effect of lower crop prices
as it accounted for 20 percent of total intermediate demand for crops in 2019, and used 34 percent of all vegetables
and 71 percent of all fruits and spices.
Figure 87: Higher agricultural productivity Figure 88:…which generates an income effect that
reduces crop prices… augments the direct impact of productivity increases
and leads to spillovers to the service sector.
4%
0.0%
-0.5% 3%
-1.0% 2%
-1.5%
1%
-2.0%
0%
-2.5%
-1%
-3.0%
-3.5% -2%
Absorption
Real GDP
Agriculture
Natural
resources
Food
Industry
Construction
Utilities
Services
-4.0%
Rice Maize Other Vegetables Fruit
Cereal Pulses & Spices Sector output
Source: Shutes, Feuerbacher, and McDonald. 2022. CEM Background Paper.
Note: Absorption comprises domestic private and public consumption and investment. Both figures show outcomes in the year 2030 and compare outcomes between
the agricultural productivity and the reference scenarios.
The CGE analysis shows that a closure of agricultural productivity gaps can contribute to structural transformation
and generate spillovers to non-primary sectors. Labor-saving crop productivity improvements lead to growth in the
agricultural and service sectors, via the direct effect of lower food prices and indirect effect on wages, both of which
increase household consumption, which, in turn, stimulates services demand. The structural transformation effect of
labor mobility augments the boom in the service sector.
2.4. Climate change may increase agricultural
output but also lead to yield variability
This section considers the effect of climate change on yields in Bhutan and the associated macroeconomic impact.
The section begins by briefly summarizing the past and future impacts of climate change on temperatures and precipita-
tion in Bhutan. It then uses estimates from global climate models developed by the FAO to estimate the impact of future
climatic changes on yields by crops and geographic regions. These estimates are then fed into the CGE model, described
in section 2.3.4, to understand how climate-induced agricultural output changes will affect Bhutan’s broader economy.
o raise both temperatures and precipitation levels
2.4.1. Climate change is expected t
Over the last 70 years, average temperatures in Bhutan have increased at an accelerated pace. Mean temperatures in
Bhutan increased by 1.4 degrees Celsius between 1951 and 2020, an average pace of 0.2 degrees per decade. The speed
of heating has accelerated in recent years, with mean temperatures rising by 0.3 degrees per decade between 1991 and
2020. The increase has occurred across the temperature distribution, with minimum temperatures also rising (Figure 89).
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The rise in temperatures was accompanied by changing precipitation patterns. While annual average precipitation
has not changed significantly over the last three decades, the average effect masks a changing composition of precip-
itation patterns across regions and an increased divergence between the northern and southern parts of the country.
The northern parts of Bhutan, traditionally the driest, have experienced annual declines of between 5 and 10 millimeters
of rainfall per year, making them even drier. In contrast, rainfall in the wetter southern parts has increased by up to 10
millimeters per year (Figure 90). Seasonality has also increased over the same period, with pre-monsoon and monsoon
periods (April to September) experiencing more rainfall, with little changes in the other months.
Figure 89: Minimum temperatures have Figure 90: …and rainfall has become more
increased significantly across Bhutan over the variable and extreme in the southern parts of the
last three decades… country.
30°N 30°N
°C/year N° daysyear
29°N 0.040 29°N
0.038 1.2
0.036
28°N 0.034 28°N 1.0
Latitude
Latitude
0.032 0.8
0.030
27°N 0.028 27°N 0.6
0.026 0.4
0.024
26°N 0.022 26°N 0.2
0.020 0.0
25°N 25°N
87°E 88°E 89°E 90°E 91°E 92°E 93°E 87°E 88°E 89°E 90°E 91°E 92°E 93°E
Longitude Longitude
Source: Food and Agriculture Organization of the United Nations. 2022.
Note: The left figure shows the yearly change in minimum temperatures between 1981 and 2010. Changes that are statistically significantly different from zero are marked
by a black dot. The right figure shows yearly changes in heavy rainfall conditions (precipitation ≥20mm/day) over the 1981 to 2010 period, with statistically significant
changes marked by a red dot.
Going forward, climate models predict rising temperatures and more irregular precipitation patterns. Between 2021
and 2099, mean temperatures are expected to increase by a further 1.2 degrees under a low climate change scenario
(RCP2.6)116, 2.4 degrees under an intermediate scenario (RCP4.5), and 4.5 degrees under the most extreme scenario
(RCP8.5).117 These values exceed the global average temperature increases. Similar increases are expected for minimum
temperatures (Figure 91). Rainfall is expected to increase by between 10 and 30 percent per year overall, particularly
during the pre-monsoon and monsoon months (Figure 92). Most of the precipitation increase is projected to affect the
lowlands and the south-eastern parts of Bhutan. Concurrently, the number of dry days is also expected to increase,
which implies that heavy precipitation events are likely to become more frequent. These are especially likely to affect
the south-western parts of the country.118
Extreme temperature and weather events are also expected to become more frequent. The temperature and precipi-
tation projections highlight that the frequency and intensity of extreme weather events is likely to increase going forward.
Higher rainfall will increase the potential for flash floods, landslides, and soil erosion. Extreme heat events are likely to
affect Bhutan’s lowlands. For instance, the number of tropical nights, defined as nights where the minimum temperature
does not dip below 20 degrees, are expected to increase by 20 to 30 days per year by the end of the century for the
country, and by 70 to 90 days in the lowlands when compared with a 1981 to 2005 baseline.
116 RCP8.5 is the highest emissions pathway in the Intergovernmental Panel on Climate Change (IPCC) baseline, associated with the most severe climate impacts. In comparison,
RCP2.6 is consistent with a global mean temperature increase of up to 2°C.
117 Source: Coupled Model Inter-comparison Project Phase 5 (CMIP5) models, which are utilized within the Fifth Assessment Report (AR5) of the IPCC, providing estimates of future
temperature and precipitation, are provided by the World Bank Group and the Asian Development Bank (2021), Climate Risk Country Profile: Bhutan (2021).
118 These and other estimates presented in this section are based on a background paper prepared for this report. See Alvar Beltrán, J., Soldan, R., and Franceschini, L. 2022. “Climate
Risk Assessment. Climate Impacts in Bhutan’s Agroecological Zones and Opportunities for Climate Smart Agriculture Practices”. Food and Agriculture Organization.
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Figure 91: Going forward, minimum temperatures are expected to continue to increase…
2010-2039 2040-2069 2070-2099 °C
7
29°N
28°N
Latitude
6
RCP 2.6
27°N
26°N 5
25°N
4
29°N
28°N
Latitude
RCP 8.5 3
27°N
26°N 2
25°N
87°E 88°E 89°E 90°E 91°E 92°E 93°E 94°E 87°E 88°E 89°E 90°E 91°E 92°E 93°E 94°E 87°E 88°E 89°E 90°E 91°E 92°E 93°E 94°E 1
Longitude
Figure 92: …and rainfall variability will increase with climate change severity.
3000
Slope p.value
2500
obs 0.63 0.89
mm
2000 Slope p.value
RCP 2.6 -0.96 0.16
1500 Slope p.value
RCP 8.5 1.23 0.18
1000
1980 1989 1998 2007 2016 2025 2034 2043 2052 2061 2070 2079 2088 2097 obs RCP 2.6 RCP 8.5
Date
Source: Food and Agriculture Organization of the United Nations. 2022.
Note: The left figure shows projected changes in mean minimum temperatures in comparison to the historical reference period (1981-2010). The analysis differentiates
by (i) projection horizon, and (ii) climate change severity. The black dot indicates whether at least 60 percent of the calculated models agree in the sign of the climate
change signal (positive or negative). The right figure shows the path of inter-annual rainfall variability over the 21st century.
re expected to alter Bhutan’s yield structure
2.4.2. The impacts of climate change a
The developments induced by climate change are expected to impact the agricultural sector both on the intensive
and the extensive margins. On the intensive margin, yields, especially in rainfed production systems, are expected to
be adversely affected by the impacts of increased heat and more erratic rainfalls on, among others, agricultural water
availability, crop losses due to flash floods, and the emergence of new diseases. This impact will be exacerbated by the
absence of widespread irrigation facilities to modulate rainfall and temperature variability.
On the extensive margin, land in higher altitudes may become suitable for crop production. While production in the
southern lowlands of Bhutan is likely to suffer from climate change, land in higher altitudes may become suitable for crop
production due to more adequate temperatures and increased rainfall. In the case of rice, for instance, land suitability is
expected to increase by 10 percent by 2050, subject to land being cleared and available for cultivation.
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Model estimates highlight that climate change will affect the yields of maize and rice in a non-linear fashion.119 The
yield projections for both crops depend on the severity of climate change. Under a moderate RCP2.6 climate change
scenario, rainfed maize yields are expected to increase over the next century and exceed the 2021 level by 4.4 percent
(Figure 93). In contrast, more severe climate change (RCP8.5) would induce a short-term yield boom, increasing rainfed
yields by 7 percent over the next decade, but a longer-term yield decline below the 2021 level at the end of the century.
Rainfed rice yields are expected to decrease systematically, falling below their 2021 level by 2.1 and 21.3 percent by
2099, under RCP2.6 and RCP8.5, respectively. In contrast, irrigated rice is significantly less sensitive to climate change
severity and yields are expected to remain close to 2021 levels over the forecast horizon.
More generally, a failure to contain climate change will benefit rainfed yields initially, but will lead to a longer-term
yield decline compared with a more moderate climate change scenario. By 2099, rainfed rice and maize yields are
projected to be 15 and 7 percent lower under RCP8.5 than under RCP2.6, respectively (Figure 97). This trend, however,
masks some non-linearity, with these yields benefiting from higher rainfall and increased temperatures associated with
more climate change until 2040 or, in the case of rainfed rice, mid-century, and then consistently falling short of yields
under RCP2.6.
Figure 93: Yields for rainfed maize are projected Figure 94: Irrigation of vegetables, such as
to increase going forward, but that increase will carrots, is key to turning climate change into an
be temporary if more severe climate change opportunity.
materializes.
108 107
107
105
Yield Index (RCP2.6 yields in 2021=100)
Yield Index (RCP2.6 yields in 2021=100)
106
105 103
104
101
103
102 99
101
97
100
95
99
98 93
0
0
30
9
0
0
0
80
06
09
09
05
04
07
0
90
30
99
0
0
70
0
0
0
06
05
04
08
-2
-2
-2
-2
-2
-2
-2
-2
0
0
0
0
-2
-2
-2
-2
-2
-2
-2
-2
61
91
21
51
81
31
41
71
61
91
21
51
81
31
41
71
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
Rainfed Maize RCP2.6 Rainfed Maize RCP8.5 Irrigated Carrot RCP8.5 Rainfed Carrot RCP8.5
Source: Food and Agriculture Organization of the United Nations. 2022.
Note: All projections are drawn from the MPI-M-MPI-ESM-LR model.
The irrigation status of crops is a key determinant of yield trajectories until the end of the century. The example of
carrots – one of the exportable vegetables identified in section 2.2.4 – illustrates this (Figure 94). Under the RCP8.5
scenario, rainfed yields are expected to plummet by mid-century and remain 4 percent below their 2021 level by 2099.
In contrast, irrigated carrot yields avoid this decline and are projected to exceed 2021 levels by 5 percent by the end
of the century.
119 As part of a background paper for this report, the Food and Agriculture Organization of the United Nations applied an agro-ecological zoning tool on an eco-physiological model
to estimate climate change impacts on crop yields for rainfed and irrigated conditions. The approach follows Kassam, A.H. 1977. “Net Biomass Production and Yield of Crops”. FAO,
Rome, and Kassam, A.H., et al. 1991. “Agroecological Land Resources Assessment for Agriculutral Development Planning”. World Soil Resources Reports (71/ vol. 1-8) FAO/IIASA,
Rome; summarized in Alvar Beltrán, J., Soldan, R., and Franceschini, L. 2022. “Climate Risk Assessment: Climate Impacts in Bhutan’s Agroecological Zones and Opportunities for
Climate Smart Agriculture Practices”. FAO, Rome, Italy. 2].
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Transitioning from rainfed to irrigated production methods provides a unique opportunity for Bhutan to safeguard
against the adverse impacts of climate change on agriculture. For instance, under irrigated conditions, maize yields are
expected to increase over the projection period in comparison with historic values and between RCP8.5 and RCP2.6. Specif-
ically, by 2099, irrigated maize yields under RCP8.5 are projected to exceed yields under RCP2.6 by 2.8 percent. This will
be driven by (i) closer to optimal temperatures at pollination, and (ii) a decrease in frost stress conditions at the early stages
of crop development. Also, considering that irrigated yields exceed rainfed yields by 20 percent on average, the difference
in climate impacts between rainfed and irrigated production systems highlights the importance of irrigation in adapting
agricultural production to climate impacts. Since irrigation for crops, other than for rice, is virtually absent in Bhutan today, this
analysis highlights that addressing this key constraint will make agriculture more resilient to the effects of climate change.
The yields of select vegetables are expected to increase as climate change makes climatic conditions more favorable
to their production, even under rainfed conditions, thereby opening an export opportunity for Bhutan. Cabbage and
white potato yields are projected to benefit substantially from climate-induced temperature and precipitation changes.
Rainfed cabbage yields, for instance, are expected to exceed 2021 levels by 5 and 13 percent at the end of the century
under RCP2.6 and RCP8.5, respectively. These increases outweigh the expected yield growth even under irrigated
conditions. In addition, more severe climate change is expected to benefit cabbage yields, with 2099 RCP8.5 yields
exceeding RCP2.6 yields by 8 and 10 percent, respectively (Figure 95, Figure 96).
Figure 95: More severe climate change is Figure 96: …whereas yields under irrigated
expected to temporarily benefit maize and rice conditions are expected to systematically
yields under rainfed conditions, but cause a benefit from more severe climate change.
deterioration in the longerrun…
15% 12%
10%
10%
8%
5%
6%
0%
4%
-5%
2%
-10%
0%
-15% -2%
0
90
30
99
0
0
70
0
0
90
30
99
50
0
70
0
06
05
04
08
06
04
08
0
0
0
0
-20%
0
0
0
0
0
-4%
-2
-2
-2
-2
-2
-2
-2
-2
-2
-2
-2
-2
-2
-2
-2
-2
61
91
21
51
81
31
41
71
51
61
91
21
81
31
41
71
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
Rainfed Cabbage Rainfed Carrot Rainfed Maize Rainfed Rice Irrigated Cabbage Irrigated Carrot Irrigated Maize Irrigated Rice
Source: Food and Agriculture Organization of the United Nations. 2022.
Note: The left figure shows impacts under rainfed conditions, whereas the right figure shows impacts under irrigated conditions. All projections are drawn from the
MPI-M-MPI-ESM-LR model.
The increase in select crop yields is consistent with predictions made by other models in the literature. The Interna-
tional Center for Tropical Agriculture (CIAT, 2017), by applying the International Model for Policy Analysis of Agricultural
Commodities and Trade model to assess climate impacts on agricultural commodities for a climate and non-climate
scenario,120 finds that almost all crop yields are expected to increase between 2020 and 2050, and that yield increases
under climate change are likely to be higher than under no climate change conditions. Under this model, higher tempera-
tures could increase the yields of fruits (apples), tropical fruits (oranges), rice, vegetables (cardamom and chili), and potato
by 0.8, 6.2, 0.9, 4.9 and 5.0 percent, respectively, compared to a non-climate change scenario. The only exception in
this paper is maize yields, which are projected to decrease by about 10 percent by 2050.
120 CIAT and World Bank. 2017. “Climate-Smart Agriculture in Bhutan”. CSA Country Profiles for Asia Series. Washington, D.C.
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Heat stress, dry spells and extreme rainfall are also expected to impact agricultural production. The estimates provided
by the model incorporate the impact of extreme events on projected crop yields. Extreme events have a higher predictive
power under RCP8.5 than under RCP2.6, consistent with a higher expected frequency and severity of extreme events.
The most common projected climate hazard is heat stress, followed by dry spells. Although wet days affect a small
proportion of crops, their impact is particularly high under RCP 8.5. These results suggest that irregular rainfall patterns,
which combine heavy rain with subsequent dry spells, are most likely to affect crop yields under RCP 8.5.
There are additional adverse impacts of climate change, which the model projections are unable to capture. Water
shortages are expected to arise not because of an absence of water – Bhutan has the highest per capita availability
of water in the world – but because of its unequal distribution between seasons and locations, as well as a lack of
comprehensive and efficient irrigation infrastructure. This will be exacerbated by a reduction of snowmelt water in the
spring, which currently provides an important water source for irrigation. Risks of soil erosion arise because of steep
terrain and anticipated extreme rainfall, and could damage soil fertility, irrigation schemes, and market-access roads.
A warmer climate could also lead to more and different type of pests and diseases. For instance, leeches, which previ-
ously predominated in warmer areas, are now found in cooler regions. Potato tuber moths, a common pest in the lower
subtropical region, are increasingly found at higher elevations, and the caterpillar fungus is disappearing at elevations
below 3000 meters.
The projected climate impact emphasize three aspects for adaptation policy to consider. First, an expansion of irriga-
tion is crucial, as irrigated crop yields are less volatile over the century and less susceptible to more severe temperature
and precipitation changes. Second, climate change has the potential to open production and export possibilities in select
vegetables, such as cabbage, from about mid-century. Acknowledgement of this fact ahead of time will allow Bhutan to
establish the necessary infrastructure and support facilities for farmers to benefit from this opportunity. Third, the yield
changes associated with climate change can be deceptive. For instance, rainfed maize yields may increase temporarily,
which may distract from necessary investments to benefit from longer-term yield gains from vegetables. The next section
illustrates the latter point by using a modeling approach.
2.4.3. Short-term climate-induced yield changes can temporarily increase output,but risk
distracting from longer-term diversification opportunities
This section uses the CGE model, described in section 2.3.4, to evaluate the medium-term macroeconomic implica-
tions of the yield changes associated with more extreme climate change. The impact of more extreme climate change
on agricultural yields is calculated as the average difference in yields under RCP8.5 and RCP2.6 from 2019 to 2030,
using the same data source as the previous section. As such, RCP2.6 is taken as a reference scenario against which
the additional change in yields from more extreme climate change is identified. The estimates include both systemic
climate change and stochastic occurrences of localized natural disasters. The CGE model is only calibrated until 2030,
as it relies on underlying macroeconomic projections. As such, it can only evaluate the impact of climate change in the
medium term, which, as discussed in the previous section, differs from its longer-term impacts.
The scenario models climate change as a shock to land productivity, which is calibrated to match the yield differ-
ences between RCP8.5 and RCP2.6. The impact of more extreme climate change on yields is shown in Figure 97, which,
consistent with the practice in Bhutan, assumes that paddy is irrigated, and all other crops are rainfed. The estimates
show that more severe climate change is expected to increase rainfed maize and other cereal and pulse yields by 2030,
whereas yields are expected to decline for (irrigated) rice, vegetables, fruits, and spices, compared to a less serious
climate scenario.
This simulation only considers a partial impact of climate change, operating through agricultural production. Other
possible climate change impacts, such as reduced labor productivity of outdoor workers under higher average tempera-
tures and the loss of infrastructure assets, are not considered. The simulation also does not model the aggregate macro-
economic impact of large-scale disasters, such as glacial outburst floods, to which Bhutan is vulnerable.
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Figure 97: A short-term climate-induced Figure 98: …induces a modest production shift
increase in maize and cereal yields… towards these crops.
10% 16.0%
14.0%
8%
12.0%
6% 10.0%
8.0%
4%
6.0%
4.0%
2%
2.0%
0% 0.0%
Rice Maize Other Vegetables Fruit -2.0%
-2% Rice Maize OtherCerPulses Vegetables FruitNSpices
Cereal Pulses & Spices
S2_HydroLed_Prod_LabSav S3_HydroLed_CC
Average yield change Land productivity change S4_HydroLed_Prod_LabSav_CC
Source: Shutes, Feuerbacher, and McDonald. 2022. CEM Background Paper.
Note: Both figures show outcomes for the year 2030 and compare outcomes between the agricultural productivity and the reference scenarios.
Climate-induced yield changes affect relative prices and production in equilibrium, counteracting Bhutan’s recent trend
towards export-oriented crops. The model shows that crops for which yields improve under climate change see a fall in
prices (maize, other cereals, and pulses), while prices increase for those crops for which yields fall (rice, vegetables, fruits,
and spices). These price changes increase the output of maize, cereals and pulses and reduce the production of other crops
(Figure 98). Climate change thus induces a shift back towards Bhutan’s traditional rainfed mainstay – maize – at the expense
of crops that are expected to experience stronger yield increases later in the century (vegetables, including cabbage).
The yield improvements brought about by climate change do not induce a labor movement effect, as observed for
the productivity improvement scenario. With price increases for some goods offsetting price decreases for other goods,
climate-induced yield changes do not affect relative wages (Figure 99). As a result, more severe climate change – even
though it seems to increase some yields and land productivity on the surface – results in much smaller labor mobility
effects than the broader agricultural productivity improvements discussed in section 2.3.4, that is, more severe climate
changes reduce the agricultural labor supply by 0.1 percent, compared to the 0.7 percent reduction in response to input
productivity improvements.
Consequently, even though climate change increases some yields in the short term, these do not increase demand
and thus do not generate spillovers to non-agricultural sectors. Despite the increase in agricultural productivity for
some crops, the expansion in the services sector, as observed in the scenario on agricultural productivity improvements,
is absent in the climate change scenario. This is because household expenditure increases by only 0.1 percent compared
to the reference scenario in response to the climate-induced yield changes, compared to a 5 percent increase observed
in response to agricultural productivity increases. The exception to this is the food sector, which uses maize, cereals,
and pulses as inputs and benefits from lower prices, but does not receive a growth stimulus through higher demand.
Considering these countervailing forces, the headline impact of climate-induced yield changes on output is modest.
The model highlights that the effect of more extreme climate change on agricultural production will primarily impact the
economy via lower prices of maize, which will reduce food prices and stimulate agricultural and food sector output. This,
in turn, will filter through to a small increase in domestic consumption, investment, and GDP (Figure 100).
Therefore, the model, illustrates the deceptive nature of climate-induced yield changes. While climate change may
increase some yields and enable production in more mountainous and drier areas, its benefits need to be appreciated
cautiously. First, as highlighted by the model, the superficial yield changes generate little macroeconomic spillovers.
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Second, unless longer-term expectations on yield changes are considered when making investment decisions, there is
a risk that short-term yield and output increases of rainfed maize may attract investments to this crop and distract from
longer-term adaptation needs.
Figure 99: Lower maize and cereal prices are Figure 100:…and generating practically no
partially offset by higher prices of crops whose spillovers to the non-agricultural sector.
yields decrease, thus leaving wages almost
unaffected…
0.8% 4%
0.6%
3%
0.4%
2%
0.2%
0.0% 1%
-0.2%
0%
-0.4%
-1%
-0.6%
-0.8% -2%
HighSkilledLab
SemiSkilledLab
LowSkilledLab
UnskilledLab
C_AgriLab
E_AgriLab
SE_AgriLab
W_AgriLab
SW_AgriLab
Absorption
Real GDP
Agriculture
Natural resources
Food
Industry
Construction
Utilities
Services
National Central East South South West Sector output
East West
S2_HydroLed_Prod_LabSav S3_HydroLed_CC S2_HydroLed_Prod_LabSav S3_HydroLed_CC
S4_HydroLed_Prod_LabSav_CC S4_HydroLed_Prod_LabSav_CC
Source: Shutes, Feuerbacher, and McDonald.2022. CEM Background Paper. Note: Both figures show outcomes in the year 2030 and compare outcomes between the
agricultural productivity and the reference scenario.
2.5. Policy priorities
This Chapter has argued that slow agricultural productivity growth is a constraint to structural transformation. Even
though progress has been slow, this Chapter has documented that productivity pockets are emerging and Bhutan has
started exploiting its comparative advantages. However, climate change poses a risk to this transition, as it will temporarily
alter economic incentives towards the production of traditional crops.
The findings lead to three principles that agricultural policy can follow to stimulate growth:
a. As structural transformation progresses, agricultural labor shortages will increase because people will gravitate
towards industrial and service centers. The goal of the growth policy is to facilitate this movement, while enabling
investments in technology to compensate for the labor loss.
b. To support the transition towards Bhutan’s comparative advantages and enable the country to benefit from crops
whose yields will increase with climate change in the longer run, it is crucial to avoid investments in traditional
rainfed crops with limited growth prospects.
c. Investing and enabling private investment in irrigation is central to increasing yields, adapting to climate change,
and enhancing structural transformation.
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This section discusses ideas for public policy options that can support agricultural productivity growth. These are
grouped into three complementary approaches: (i) strategic infrastructure investments, (ii) policy reforms that will facil-
itate private investments, as well as access to technology and production inputs, and (iii) targeted support to farmers.
2.5.1. Strategic infrastructureinvestments
The most important investment in agricultural productivity that Bhutan can make is in developing irrigation infrastruc-
ture. As documented in this chapter, irrigated yields exceed those of rainfed crops; irrigation can help overcome water
shortages and directly increase yields. In contrast to rainfed yields, irrigated yields are likely to be positively affected by
climate change, providing a unique opportunity for Bhutan to adapt to changing temperature and precipitation patterns.
Despite its significance, irrigation infrastructure in Bhutan is underdeveloped and public investment in it is lacking.
Irrigation investments are often highlighted as a policy priority by authorities. For instance, the 12th and the 13th Five Year
Plans (FYPs) identified water scarcity as a priority area to be addressed to improve agriculture productivity. Despite these
commitments, public investments in agriculture have been modest. As of May 2018, the Government had planned at
least 14 schemes for irrigation development that are on hold due to a shortfall in the availability of funds. In the absence
of public investments, farmers have been relying on small-scale and traditional practices, such as, about 1,000 functional
community-managed irrigation systems.
Public investment is constrained by an institutional fractionalization between the central and subnational govern-
ments. Bhutan devolved certain irrigation-related activities to the dzongkhag level as part of the 9th FYP in 2002. This
resulted in a loss of irrigation development capacity, as expert staff was not devolved together with the expenditure
responsibilities. As a result, local capacity to plan any major irrigation works is limited.121 Instead of delegating specialized
staff, centrally employed irrigation engineers and professionals were reassigned to other infrastructure development
departments, such as roads and building construction, as the central department of agriculture no longer maintains a
focused irrigation division.122
Bhutan does not only lack in irrigation infrastructure, it struggles to maintain the existing facilities. It is estimated that
20 percent of irrigation facilities are inoperable due to technical problems, 18 percent due to social issues, and 8 percent
due to problems with the water source. The inadequate knowledge and lack of experience of district-level engineers in
irrigation planning, design, building, and maintenance are major contributors to their inability to maintain facilities and,
in some cases, identify the root cause of dysfunction.123
The design of current irrigation schemes can potentially be improved for efficiency and climate resilience. Currently,
most irrigation systems are open-earth systems with low efficiency and little resilience to extreme events. This leads to
blockages, water loss through seepage, and water conveyance loss, which can cause high percolation of water through
the soil and lead to erosion and landslides downstream. Outdated irrigation infrastructure is a bigger cause of land
degradation than sustainable and resilient productivity increases.
Water availability is not a crucial constraint compared to investment, maintenance, and design. An assessment of
water availability through surface runoff showed that it was not a constraint for irrigation development. According to this
analysis, 71 percent of the present systems can be upgraded for increasing irrigated areas and/or cropping intensities,
and the remaining systems (29 percent) can only be updated through the diversification of water sources. Using observed
meteorological data from Class A weather stations, the assessments also suggest that the availability of 80 percent
dependable water at the level of a district will not be a constraint for developing new irrigation systems.124
121 AED. 2018. Irrigation Section Report, Department of Agriculture, Bhutan. Also, Dizon, F., et al. 2019. “Bhutan Policy Note: Harnessing Spatial Opportunities in Agriculture for
Economic Transformation”. World Bank, Washington, D.C.
122 AED2018. Irrigation Section Report, Department of Agriculture, Bhutan.
123 Dizon, F., et al. 2019. “Bhutan Policy Note: Harnessing Spatial Opportunities in Agriculture for Economic Transformation”. World Bank, Washington, D.C.
124 Agriculture Engineering Division. 2018. Irrigation Section Report, Department of Agriculture, Bhutan.
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In addition to infrastructure investments, rural roads are also critical to enable a reorientation of the agricultural
sector towards its comparative advantages. This chapter has argued that transport logistics are a challenge to an
export-oriented agricultural sector. As an increasing share of Bhutan’s agricultural output is exported, these constraints
will likely become more binding. Despite the importance of rural connectivity, rural roads are mostly unpaved, not resilient
to extreme rainfall during intense monsoon seasons or extreme events, and increasingly impassable after landslides.
These challenges will be exacerbated by climate change.
Priority actions to overcome these constraints include the following:
⊲ Instituting a multi-year, centrally funded, irrigation investment program: This program can either be centrally
administered or instituted through the combination of a conditional grant to dzongkhags and capacity building for
subnational implementation. The program should support components involving (i) the construction of new irrigation
facilities to increase the irrigated area; (ii) climate-proofing of new and existing irrigation infrastructure through, for
instance, lining and concreting of earthen irrigation canal sections, mitigation of slope instability and slope failure,
and the use of pipes to enhance functionality; and (iii) the rehabilitation of existing schemes.
⊲ Transferring irrigation planning and management capacity to dzongkhags: Departments responsible for irrigation
maintenance and investments need to be equipped with the necessary skills and manpower to undertake detailed
assessments, plan and implement climate-proof irrigation systems, and engage in water resource management and
planning. Building this capacity could require a two-pronged approach. On the one hand, the Central Government
can institute a staff rotation program that delegates specialized engineers to dzongkhags. On the other hand,
dzongkhags could benefit from targeted staff training programs that build missing capacity.
⊲ Investing in the climate-proofing of roads: This could involve investments in slope stabilization, drainage, and
culverts. Investments should be combined with a strategic assessment, which identifies roads that are in poor
condition and roads that lead to high potential agricultural areas.
eforms
2.5.2. Policy r
Attracting additional FDI to agriculture can help boost productivity growth. FDI does not only provide farms with capital
needed for investment, it is also frequently associated with technology transfers, which can help agricultural producers
make better use of their resources and land. Despite these benefits, Bhutan only attracts a limited level of FDI to the
sector.125 While Bhutan has made significant progress in the liberalization of its FDI regime, more can be done to reduce
regulatory hurdles. Although Bhutan has included agro-processing – including horticulture – as a priority activity in its FDI
policy, investment in this sector is still subject to a BTN 20 million minimum project cost (approximately US$240,000) and
a 74 percent cap on foreign ownership. This precludes investment into smaller-scale and niche farming operations with
potential for high growth. The cap on foreign ownership can also pose investment challenges if finding a local partner
proves difficult. These regulatory burdens are compounded by challenges in obtaining (cost-efficient) business visas to
explore investment opportunities.
Marketing Bhutan’s unique global brand can also help attract investments and promote agricultural exports. Bhutan
is known globally for its focus on happiness, sustainable natural resource use, and carbon neutrality. This global brand
is a central asset at the country’s disposal. Despite its value, Bhutan has done little up until now to tap into global export
markets using these strengths.
There are opportunities to enhance efficiency through competition in the agricultural input industries. Bhutan does
not levy import duties on most agricultural inputs, such as seeds and fertilizers. This ensures that farmers can access
these inputs at competitive prices from abroad. Domestically, however, input industries are predominantly owned by the
public sector, which limits competition and incentives for innovative firms to enter the market and for foreign investors
to help foster the growth of the sector.
125 World Bank Group. 2017. “Increasing Agribusiness Growth in Bhutan”. World Bank, Washington, DC. https://openknowledge.worldbank.org/handle/10986/28538 License: CC BY
3.0 IGO.”
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Land designation changes and the expansion of irrigation also face regulatory policy constraints. Land use is regu-
lated by the Land Act of Bhutan (2007), which imposes some restrictions that can hamper the transformation of the
agricultural sector. Specifically, the Act imposes regulatory restrictions on the conversion of chhuzhing (paddy land)
to other uses. It also limits the use of irrigation to chhuzhing, excluding kamzhing (the type of land on which maize and
other rainfed crops are grown).
A careful balance is required between Bhutan’s ambition to promote organic agriculture and its focus on growth.
Bhutan is ambitious to become the first country to exclusively produce organic agricultural products. However, evidence
suggests that organic crop yields are 24 percent lower than conventional yields and a full transition to organic agriculture
could considerably reduce GDP.126
Priority actions to reform the policy environment include the following:
⊲ Easing regulatory hurdles for FDI: To attract more FDI, Bhutan could consider eliminating the foreign ownership cap
and further reducing the minimum investment threshold. It could also consider providing free visas to prospective
investors.
⊲ Initiating a more aggressive investment and export promotion activity: Branding Bhutanese agricultural products
with the country’s focus on environmental conservation and sustainable development can stimulate global demand
and help attract investment for their production. Realizing this opportunity depends on the establishment of a dedi-
cated investment promotion agency, which can initiate marketing campaigns and identify and approach prospective
investors directly. This kind of export promotion will also be crucial for successfully implementing a transition towards
more organic agriculture, as it would yield losses to be compensated by price premiums in international markets.
⊲ Stimulating domestic input competition: Bhutan passed a new National Competition Policy in 2020, which now
needs to be operationalized. As part of this operationalization, the competition administration could critically
evaluate the role of SOEs in the agricultural input value chain and determine options to enhance competition and
opportunities for entry into the sector.
⊲ Easing regulatory hurdles to allow for the expansion of irrigation to kamzhing and the production of export-ori-
ented crops on chhuzhing: This report has shown that irrigation is key for productivity growth and climate adapta-
tion, and that its benefits extend beyond paddy. However, extension of irrigation to chhuzhing remains restricted.
Expanding irrigation privileges to kamzhing will be a central step in enhancing growth and the sector’s resilience.
Farmers would also benefit from the ability to redesignate their plots towards internationally competitive crops,
such as, cardamom, cabbage, and areca nuts, if their production is feasible. Facilitating the regulations that currently
hamper such a transition would be critical.
o farmers
2.5.3. Targeted support t
Sustainable land management practices are critical to raising productivity and ensuring climate-resilient agriculture,
but these have not yet been streamlined into official policies. Sustainable land management practices aim to prevent
land degradation and are needed to minimize the risks of climate-induced disasters, including landslides, flooding, and
water scarcity. They include activities related to soil and water conservation, natural resource management, terracing,
integration of leguminous crops into the rotation, and other practices.127 Such practices are especially relevant in Bhutan,
which is at high risk of land degradation and associated natural disasters due to its steep-slope topography.
Temporary yield changes induced by climate change may encourage farmers to undertake investments with limited
long-term profitability. This chapter has shown that climate change may temporarily increase yields of rainfed maize,
one of Bhutan’s traditional crops, and these temporary yield changes could distract farmers from taking advantage of
126 Feuerbacher A, et al. “Is Bhutan Destined for 100% Organic? Assessing the Economy-Wide Effects of a Large-Scale Conversion Policy”. PLoS One. 2018 June 13;13(6) e0199025.
doi: 10.1371/journal.pone.0199025. PMID: 29897989; PMCID: PMC5999226.
127 See, for instance, https://www.fao.org/land-water/land/sustainable-land-management/en/ and http://bhutantrustfund.bt/wp-content/uploads/2020/01/CIF-Report1.pdf
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opportunities to invest in exportable vegetables. Government policies should encourage avoiding such lock-ins by
providing advice and financial incentives to farmers.
The following considerations can help provide targeted support:
⊲ Incorporating indicators and activities related to sustainable land management in planning documents: An inclu-
sion of such indicators in the upcoming FYPs would ensure their mainstreaming into agricultural policy-making. This
could be complemented by district- or local-level sustainable land management plans, developed in consultation
with experts and local communities, who lay out applicable practices.
⊲ Exploring opportunities for providing targeted advice and extension services through text messages: Fabre-
gas, Kremer and Schilbach (2019) document the potential of providing digital extension services through mobile
phones.128 They also highlight the importance of feedback mechanisms to ensure that information is applicable
and usable for farmers, and the need for public financing to establish a well-functioning system. Once a system
is established, the marginal costs of extension provision through mobile phones are close to zero, making this a
potentially scalable undertaking. Such a system could also be used to provide weather information to farmers.
⊲ Complementing advice with financial incentives for sustainable land management and critical production inputs:
Sustainable and climate-resilient practices impose an up-front cost (through required investments and changing
production) in return for a longer-term gain. Targeted support, for instance, through guarantees to financial sector
loans, matching grants, or well-targeted subsidies, can help farmers overcome this timing inconsistency. This would
also enable them to invest in production inputs that prevent human-wildlife conflicts, such as fences to ramp up
local-level irrigation, and to enable farmers to overcome labor shortages by investing in mechanized production
devices and other labor-saving technologies. These incentives need to not only reach intended beneficiaries,
but also encourage continued climate adaptation, including by discouraging lock-in investments in crops that are
expected to experience reduced yields as climate change progresses (e.g., maize).
128 Fabregas, R., Kremer, M., and Schilbach, F. 2019. Realizing the Potential of Digital Development: The Case of Agricultural Advice”. Science, 366(6471), eaay3038.
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3. Bhutan’s
Financial Sector:
Issues and the
Way Forward
© Shekhar Pillay/Shutterstock
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3.1. Introduction
The financial sector in Bhutan has experienced significant growth from the infusion of investments in hydropower
projects. This growth has been primarily driven by the public sector and banks, while the capital market has not seen
much development (Box 9). In the pre-pandemic years, the expansion of the financial sector resulted in a rapid increase in
credit to the non-hydro sectors in the economy.129 Despite this, the distribution of credit has been heavily concentrated in
only a few sectors. Strengthening the financial sector is critical to efficiently intermediate hydropower rents for financing
productive investments in the private sector.
Box 9: Overview of the financial sector
Bhutan’s financial sector is dominated by banks, which are pre-dominantly state-owned. The financial sector
comprises five commercial banks (including two state-owned banks), the non-banking sector includes three insurance
companies, one pension fund, one Credit Information Bureau (CIB), one securities exchange, one loss adjuster, and nine
brokers (seven securities and two insurance brokers) (Figure 103). The financial sector is dominated by SOEs, which, at
end-2020, accounted for 60 percent of the assets of the banking system and 51 percent of the assets of the non-banks,
including the pension fund.
The capital market remains shallow. As of 2021, there were 19 listed companies with a market capitalization of Nu 47
billion (27.4 percent of GDP). The sector is regulated by the Royal Monetary Authority (RMA). Capital markets are regu-
lated by the Royal Stock Exchange of Bhutan (RSEB), which is under the purview of the RMA, with transactions facilitated
through a central registration depository130.
Figure 101: Overview of the financial sector in Bhutan
Structure of Financial Sector in Bhutan
Royal Monetary Authority
Banks Non-Banks Capital Market Pension
Bankof Bhutan Royal Insurance Corporation Royal Securities Exchange of Bhutan National Pension and Provident Fund
Bhutan National Bank Bhutan Insurance
Bhutan Development Bank GIC-Bhutan Reinsurance Company
Druk PNB Bank National CSI Development Bank
Tbank MFIs
Source: Royal Monetary Authority, Annual Supervision Report 2021.131
129 Hydropower resource rents are deposited into Bhutan’s financial sector by the Central Government and SOEs and have resulted in high liquidity levels.
130 Market intermediaries include seven registered brokerage firms, four brokers, and three private brokerage firms.
131 RMA. 2021a. “Annual Supervision Report 2021”. Royal Monetary Authority, Thimphu, Bhutan.
https://www.rma.org.bt/RMA%20Publication/Annual%20Supervision%20Report%202021.pdf
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The allocation of credit in Bhutan is skewed, and this has hampered the development of the private sector. Despite
rapid expansion of credit to the private sector in the past two decades, the lack of access to finance remains one of
the top growth constraints for small- and medium-sized companies. The share of credit extended to cottage and small
firms, which account for more than 96 percent of firms in the country, remains very low, while the credit extended to
large firms is stagnating. Sectors like tourism and housing account for most of the credit in the economy (see Section
3.2). Further, banks rely heavily on collateral and owner’s equity when providing loans. This makes it difficult for micro,
small, and medium-sized enterprises (MSMEs) to access finance, as they may not have sufficient collateral or equity.
This approach is not in line with international best practices, which emphasize the importance of financial assessments
and credit history in lending decisions. There are several other constraints that hamper the flow as well as the allocation
of credit, including: (i) weakening financial sector performance and rising non-performing loans (NPLs); (ii) an underde-
veloped non-bank sector, limiting alternative sources of finance for businesses; and (iii) inadequate financial inclusion.
The financial system has been significantly weakened by the COVID-19 pandemic. Loan recovery and asset quality
are likely to remain weak due to the slow recovery of the tourism industry and because of outward migration. Subdued
tourist arrivals and emigration can have negative repercussions on financial sector soundness since 61.3 percent of loans
were concentrated in the services, tourism, and housing sectors as of December 2022. Emigration can have a damp-
ening effect on prices of rental property and newly developed real estate as migrating people may sell their properties
before migrating. The loan repayment capacity of migrants is not expected to strengthen in the short term, as people
are migrating mostly on student visas. Given that over 60 percent of the assets in the financial sector are owned by the
State, this poses fiscal risks through increased contingent liabilities.
Bhutan is highly susceptible to the adverse effects of climate change, and it is crucial to take further action to mitigate
the financial risks associated with climate events. Key risks and natural hazards include flash floods, riverine floods,
landslides, dam outburst floods, cloudbursts, glacial lake outbursts, forest fires, and windstorms. These climate events
not only pose a threat to natural resources, economic sectors, and communities, but also have the potential to result
in financial risks. While Bhutan has taken important steps at the national level to adapt to the impact of climate change
and pursue a low-emission development path, more can be done to enhance resilience and ensure a sustainable,
low-carbon future.
This Chapter is organized as follows: Section 3.2 highlights the concentrated nature of Bhutan’s financial sector and
discusses credit constraints in the non-hydro sectors. Section 3.3 discusses the challenges, including those emanating
from the COVID-19 pandemic, financial inclusion, and potential impacts from climate change. Section 3.4 provides policy
recommendations.
3.2. Concentration and credit allocation
in the financial sector
The banking sector is highly concentrated, with the BoB receiving the majority of deposits and benefiting from a lower cost
of funds. The banking sector accounts for 75 percent of the financial sector’s assets and nearly 80 percent of its credit. The
BoB, which is mostly government-owned (with a 20 percent stake held by the State Bank of India), dominates the sector (Figure
102, Figure 103).132 It holds 44 and 48 percent of the banking sector’s assets and deposits, respectively, making it the largest
commercial bank in the country. 133 The BoB has a widespread presence, with branch offices, extension offices, and agents in
every Dzongkhag and major township. While competition has increased with the establishment of three additional banks during
the 2008-2010 period – Bhutan Development Bank (BDB), Druk PNB Bank, and T Bank – the BoB maintains a lower cost of
funds compared to the other banks. This is due to large SOEs and projects maintaining their main accounts with this bank.134
132 The BoB was the only commercial bank until 1997 when the BNB was launched as the country’s second commercial bank. The BoB served as the country’s central bank until the
RMA was established in 1983.
133 In 2021, BoB’s deposit market share was 47.6 percent followed by BNB at 23.8 percent and BDB at 14.4 percent.
134 The BoB’s demand deposit comprises 31.4 percent of its total deposit portfolio and continues to include deposits from the Government as well as major SOEs and projects.
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The market share of non-banks has been growing over the last decade, although it still represents less than a quar-
ter of the total financial sector assets (Figure 104). The non-banking sector comprises three insurance companies,
namely the Royal Insurance Corporation of Bhutan (RICB), Bhutan Insurance Limited (BIL), and the Bhutan GIC Reinsur-
ance Company, as well as the National Pension and Provident Fund (NPPF)135 and five microfinance institutions (MFIs).136
The share of non-banks in total financial sector assets has increased from below 10 percent in 2012 to 23 percent in
2022, while their share in credit doubled from 11 to 22 percent during the same period (Figure 105). Non-banks, such
as insurance firms, were permitted to compete with banks in lending to individuals and firms due to limited investment
opportunities, particularly in corporate bonds. However, non-banks are more susceptible to maturity mismatches and
weak supervision compared to banks. They also possess a lower capacity to absorb losses.
Figure 102: Banking sector asset size (Nu. Billion), Figure 103: Banking sector deposits (Nu. Billion),
2015 and 2021 2015 and 2021
120 100
100.7 90 88.5
100
80
80 70
60
60 50
52.8 44.2
39.1 40
40 32.1
31 30
22.0
20
20
10
0 0
BOB BNB BDB Druk PNB Bank T Bank BOB BNB BDB Druk PNB Bank T Bank
2015 2021 2015 2021
Figure 104: Share of banks and non-banks in financial sector assets, 2022
35% 35%
30% 29.5% 30%
25% 25%
21.2%
20% 20%
15% 15%
12.4% 11.5%
9.8%
10% 10%
7.8%
6.3%
5% 5%
1.5%
0% 0%
BOB BNB BDN Druk PNB Bank Tbank Pension Fund RICB BIL
Banks Non–banks
Source: Royal Monetary Authority Financial Sector Performance Review Reports.
State-Owned Financial Institutions (SOFIs) dominate the financial sector. Three out of five banks are state-owned. In
2020, SOFIs accounted for 60 percent of the assets of the banking system and 51 percent of the assets of the Non-Bank-
ing Financial Institutions (NBFIs), including the NPPF. Bhutan has the second highest level of state-ownership in the
banking sector in the South Asia Region (SAR), exceeding by a large margin the average levels seen in other countries
(Figure 106).
135 In 2000, the NPPF was established as an autonomous agency to manage pension and provident fund schemes of civil servants, employees of state-owned corporations and
the armed forces. The plan is managed on a partially funded pay-go system and therefore maintaining sustainability is a major issue. Private pensions are managed by insurance
companies through a fully funded private provident fund scheme. However, to expand coverage, the NPPF has also started to manage private provident fund schemes.
136 These include RENEW, Bhutan Care Credit (BCC), BAOWE, Microfinance Bhutan, and Tarayana Foundation. The MFIs currently operate in all 20 Dzongkhags.
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Figure 105: Share of banks and non-banks in Figure 106: Share of state-owned commercial
assets and credit, 2012 and 2022 banks assets to total banking system assets,
2017-2019
a. Share of SOCB assets to total bankiun system assets, 2017-19
80
Assets, 2012
70
60
Bhutan
Assets, 2022 50
Sri Lanka
Percent
40
Credit, 2012 30
Bangladesh
20 Pakistan
y = 4.7324x – 38.368
Credit, 2022 10 R2=0.065
0
8 9 10 11 12 13 14
0% 20% 40% 60% 80% 100%
Size of the economy, log of GDP in 2016
Banks Non-banks (constant 2017 international dollars, million)
Source: Royal Monetary Authority Financial Sector Performance Review Reports. Source: World Bank (2021). Hidden Debt: Solutions to Avert the Next Financial
Crisis in South Asia.
Credit flow is concentrated in a few sectors, reflecting the lack of diversification in the private sector, and is declining
for production and manufacturing activities. A comparison between the Economic Census of 2018 and the Enterprise
Survey of 2022 indicates that wholesale and retail trade, as well as accommodation and food services, continue to
dominate the share of firms albeit a modest decline in their share of total credit from nearly 83 percent in 2018 to around
80 percent in 2022 (Figure 107). On the other hand, the share of firms in construction, administrative support service
activity, and manufacturing sectors has increased slightly. In terms of credit outstanding, the housing sector, along
with services and tourism, accounted for around 50 percent of total credit in 2022. However, the share of trade and
commerce, as well as production and manufacturing in total credit declined by more than 5 percentage points of GDP
between 2014 and 2022. Banks have the highest exposure to the housing sector, while non-banks have the highest
exposure to services and tourism.
The share of cottage firms increased between 2018 and 2022, although their share in credit remained below 10
percent. The share of cottage firms increased from 89 to 96 percent, while the share of medium, large and small firms
declined (Figure 108). This shift could indicate the entry of new firms or the exit of older and larger firms in response to
the pandemic. Despite the overwhelming share of cottage firms, only 8 percent of the total credit is directed towards
them (Figure 109). Around 60 percent of credit is directed to non-enterprises, which reflects the increasing prevalence of
housing and educational loans in recent years and further highlights the lack of diversification in the economy. Notably,
the allocation of credit to small- and medium-enterprises has declined significantly in recent years. The share of large
firms, however, has remained mostly unchanged at around 14 percent.137
The capital markets are shallow. Although there has been an increase in the market capitalization-to-GDP ratio from
15.6 percent in 2016 to 27.4 percent in 2021, it remains relatively low compared to peers. Market capitalization expe-
rienced a decline from 2019 due to the fluctuation in share prices and the delisting of two companies in 2020. Market
liquidity, measured by the turnover-to-GDP ratio, increased to 1.8 percent in 2020 but declined to 1.5 percent in 2021,
and it remains the lowest in the SAR. One of the contributing factors to this low liquidity and trading activity is the lack of
diversification in the economy, which limits the number of listed companies. Listings on the main exchange have stag-
nated in recent years. Further, the pace of growth has been constrained by minimal Initial Public Offering (IPO) activity
137 As per the Annual Report 2021 of the Department of Cottage and Small Industries, CSIs constitute the overwhelming majority of industry in Bhutan, accounting for about 95 of
the total industries. Despite the pandemic, the number of active licensed CSIs increased to 26,945 in 2021, from 21,813 in 2020.
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Figure 107: Distribution of firms and credit as per economic sectors
a. Distribution of firms, 2018 and 2022 b. Distribution of credit, 2017, 2019, and 2022
35
Agriculture, forestry, and fishing 2.62
0.57
Mining and quarrying 0.24 0.40
5.44 30
Manufacturing 6.39
Electricity, gas, steam, and air-conditioning 0.02 0.18
Water supply, sewerage, and waste management 0.04 25
0.14
Construction 1.21 2.60 61.59
Wholesale and retail trade 20
55.87
Transportation and storage 0.33 0.67
21.29 15
Accommodation and food services 23.85
Information and communication 0.41 0.50
Finance and insurance 0.12 0.16 10
Real estate 0.02 0.05
Professional, scientific, and technical services 0.51 1.04 5
Administrative and support services 1.25 2.44
Education 0.62 0
1.04
Human health and social work 0.14
re
rce
m
ing
rt
ns
rs
uf
po
he
ris
an
ltu
oa
0.13
us
me
ns
ou
Ot
/M
icu
lL
Ho
om
Tra
s/T
Arts, entertainment, and recreation 1.24
od
na
r
Ag
1.23
/C
ce
so
Pr
de
r
rvi
Pe
2.90
Tra
Se
Other services 2.74
2017 2019 2022
2018 2022
Source: World Bank staff calculations based on the 2022 Enterprise Survey and the 2018 Economic Census.
Note: “Others” include education loans.
Figure 108: Distribution of firms by size (percent), Figure 109: Credit composition by firm size
2018 and 2022 (percent of total), 2017, 2019, and 2022
70
88.81
Cottage 60
95.88
50
8.79
Small 40
2.93
30
1.85
Medium 20
0.86
10
0.54
Large 0
cro
ge
all
m
ge
ise
0.33
diu
Sm
tta
r
r
Mi
La
rp
Me
Co
te
en
n-
2018 2022 2017 2019 2022
No
Source: Royal Monetary Authority.
Note: Non-enterprises include housing, transport, personal, staff, and education loans. Cottage firms have less than five employees, small firms have between five and
19 employees, medium firms have between 20 and 99 employees, and large firms have 100 employees or more.
and the consequent stagnation in listings on the stock exchange. There are several possible reasons for this low growth,
including factors related to issuers and investors (see section 3.3), as well as the absence of underwriting regulation and
capability in the market. The lack of deep capital markets has also led to insurance and pension funds lacking feasible
investment options, resulting in some of them engaging in credit business and competing with banks.
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In terms of the bond market, its financial significance remains marginal. Domestic public sector debt has increased
from 1 percent of GDP in 2012 to 13 percent of GDP in 2022, mostly reflecting the authorities’ development of the domes-
tic debt market in response to the COVID-19 pandemic, which led to a decline in tax revenues and increased spending
pressures. Domestic debt is mostly in the form of treasury bills and 3- to 12-year treasury bonds. The Government issued
eight longer term bonds between September 2020 and June 2023, with banks and the public pension fund being the
main subscribers (Figure 110,Table 6).138 There have been no bond issuances in recent years by corporates or banks.139
Figure 110: Government Bond issuance, Sep Table 6: Share of ownership (equities and bonds),
2020-Jun 2023 2021
14 9
Ownership (%) Stocks Bond market
12.0 8 2021 2021
12
7
10.0 10.0 10.0 Banks 7 45
10
9.0 6
8 5
7.0 Insurance firms 5 3
6 4
5.0 5.0 5.0
4.0 3 Pension fund 11 28
4
3.0 3.0 3.0 2
2.5
2 1.5 Retail investors and HNIs 48 0.5
1
0.7
0 0
Sep Jan Jan Apr Jun Dec Apr Jun Others 27 23.5
2020 2021 2022 2023
Period (years) Amount (billion) Coupon rate (%, RHS)
Source: Royal Monetary Authority, Royal Stock Exchange of Bhutan (RSEB) Source: Royal Stock Exchange of Bhutan. ‘Others’ include corporate portfolios,
trust funds, religious institutions and associations.
3.3. Financial sector challenges and recent measures
Banks in Bhutan primarily offer traditional lending products and have not adopted risk-based pricing. Despite some
expansion in the range of financial instruments offered by banks, financial instruments are still dominated by traditional
banking products. Banks mostly offer basic credit products with fixed interest and terms.140 This is partly because banks
still assess loan requests against collateral, and not based on the borrower’s financial viability. Financial Institutions
(Fis) in Bhutan do not use risk-based pricing that links the credit score of the borrower to the interest rate of the loan.
The reliance on collateral by banks has led borrowers to seek alternative sources of financing from non-bank lenders.
The surge in credit witnessed during the middle of the past decade was not sustained. The private credit to GDP
ratio increased from 46 percent in 2015 to 74 percent in 2021,141 primarily driven by hydropower-related flows. However,
the adverse impact of the pandemic on tourism and hospitality, as well as the construction and manufacturing sectors,
impacted credit growth. Due to weaker demand from the private sector, credit growth moderated to an average of 7
percent in 2021 and 2022, in nominal terms, compared to an average of 18 percent between 2014 and 2019.
138 It started with the issuance of a three-year bond at the prefixed rate of 6.5 percent and then two 10-year bonds through open auction.
139 However, since 2017, there have been a total of 21 issuances of Commercial Papers with a maturity of 180 days by various SOFIs. The issuance size has mostly been small.
140 Since 2016, they have also started to offer some credit products with floating interest rate.
141 Bhutan’s private credit to GDP ratio is much higher than that for other South Asian countries such as India, Sri Lanka and Maldives (Figure 5). Only Nepal has a higher private
credit to GDP ratio of around 97.7 percent in the region.
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Bhutan’s Financial Sector: Issues and the Way Forward
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Loan asset quality has steadily deteriorated. Between 2014 and 2019, the deterioration in loan asset quality can be
attributed to overexuberant lending practices, without sufficient credit appraisal, monitoring and recovery management.
Non-banks, in particular RICB and BIL, reported higher NPLs compared to banks (Figure 113, Figure 114).142 High NPLs
in the non-banking sector resulted from the fact that the insurance companies were engaged in intermediation due to
lack of investment opportunities in the capital markets. Within the banking sector, the BDB reported the highest NPLs—
largely due to the nature of its activities—followed by the Bhutan National Bank (BNB). By June 2020, with the onset of
the pandemic and a sharp slowdown in economic growth, the NPL ratio increased to nearly 15 percent as most firms
faced significant challenges in meeting their debt repayments. The majority of NPLs are concentrated in the services
and tourism sector (33 percent), followed by trade, production and manufacturing, and the housing sectors (Figure 115).
The RMA has suspended fresh lending to the housing sector until December 2023 due to high credit concentration and
non-performing loans in the sector.
Figure 111: Gross NPL and credit growth (percent), Figure 112: Sectoral composition of NPLs, 2017,
2012-2023 2019, and 2022
16 30% 35
14.6
14 30
25%
12 25
10.9
10.4 20%
10 20
8.9 8.7
8 8.0 7.9 15% 15
6.6 6.3 6.5
6.0 10
6
5.2 10%
5
4
5% 0
2
re
rce
re
m
ing
rt
ns
rs
po
he
ris
ltu
tu
oa
us
me
ac
ns
ou
Ot
icu
lL
Ho
om
uf
Tra
s/T
na
r
0 0%
Ag
an
/C
ce
so
/M
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023*
de
r
rvi
Pe
od
Tra
Se
Pr
NPL ratio Credit growth (RHS) 2017 2018 2022
Figure 113: Gross NPL, banks and non-banks (percent), 2015-2022
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
2015 2016 2017 2018 2019 2020 2021 2022
Bank BOB BNB BDB Druk PNB Bank TBank Non-Bank Pension RICB BIL
Source: Royal Monetary Authority, World Bank annual reports. Note: *data for 2023 is for the month of March, while data for other years is for the month of December. In
Figure 115, the 2022 data for Bhutan National Bank and Bhutan Development Bank is for September while the rest pertains to December.
142 The NPL for the non-bank sector was rising even before the COVID-19 impact, mainly due to low government expenditure in the construction and contract sector and greening
of loans.
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The NPL ratio is expected to rise once forbearance measures are withdrawn. The decline in the NPL ratio in 2021
and 2022 largely reflects the lack of recognition of potentially stressed assets. Financial sector risks are underreported
in official statistics due to regulatory forbearances. Borrower relief measures included measures such as full or partial
interest waiver and loan repayments deferments, funded through the National Resilience Fund (NRF). As a result, the
decline in the NPL ratio in 2021 and 2022 reflects adjustments in NPL accounting, changes in risk-weights for NPLs, and
the writeback of provisions from NPLs as part of the NPL management strategy and resolution framework.143 The NPL
ratio may increase further with better recognition of asset quality over the coming years. Persistent NPLs may hinder the
extension of fresh credit, particularly to riskier segments such as MSMEs. In 2022, the RMA adopted a Prompt Corrective
Action (PCA) Framework to enable early supervisory intervention and mitigate any risk that could threaten the viability
of financial service providers and the overall system. Two out of five commercial banks and one insurance company
were under PCA as of May 2022.
The rise in NPLs, prior to forbearance, mirrors a decline in profitability within the banking system. The net interest
margin — the difference between the interest earned and the interest paid – has declined for most banks in recent years
(Figure 114).144 The decline is a result of slower credit growth and an increase in deposits, which has compressed interest
margins. The overall return to assets (RoA) of the financial sector declined from 2.6 percent in 2015 to 0.9 percent in 2020,
before improving in 2022 due to the monetary measures implemented by the RMA. The moderate growth in outstanding
loans was mostly due to an increase in interest outstanding, owing to loan deferment measures by the RMA. Currently,
the declining RoA of banks reflects the lack of profitable opportunities available in the market (Figure 115).
The financial sector remains capitalized above the regulatory threshold of 12.5 percent; however, the Capital
Adequacy Ratio (CAR) shows a declining trend.145 The CAR has been declining for most banks over the past few years
(Figure 116). For the non-bank sector, capital adequacy improved from 9.4 percent in 2019 to 19 percent by December
2021, supported by the infusion of fresh capital by some of the financial institutions (Fis) and monetary measures intro-
duced by the RMA. Overall capital adequacy declined from 18.3 percent in 2012 to 15 percent in December 2021 because
of increasing NPLs and lower profits. In particular, BDB and one of the insurance companies faced difficulties in meeting
the capital requirements due to high NPL levels. The risk weighted CAR of banks increased marginally from 15.1 percent
in March 2022 to 15.7 percent in March 2023.
Bhutan is highly vulnerable to the physical and financial risks emanating from climate events. The country is suscep-
tible to physical risks resulting from the gradual and sudden impacts of climate change on its real assets, which in turn
have financial implications. To some extent, it is also exposed to climate transition risks that arise from the ongoing efforts
to decarbonize the economy. These transition risks can impose economic adjustment costs on firms and investors who
did not anticipate the transition.
Investment at scale will be required for Bhutan to meet its climate-related and environmental goals because funding
from public sources alone will not meet the financing gap. The financial sector could play an important role in bringing
private finance to meet climate goals – by deepening green finance markets and improving the management and pricing
of climate-related financial risks. Despite taking important steps, financial sector authorities, such as the RMA and MoF,
are still at the initial stages of developing the infrastructure and policy environment to help financial institutions manage
climate risks and better leverage opportunities (Box 10).
Access to finance is a concern for both individuals and businesses. As of December 2021, 79.5 percent of the adult
population held savings accounts; the percentage was higher for men (52.6 percent) than for women (47.4 percent).
However, only 22.9 percent of the adult population had access to credit, of which 56.7 percent were men and 43.3
percent were women. Only 19.4 percent of adults had life insurance coverage, with most being men (55 percent). Despite
a high mobile phone penetration rate of 95 percent, only 21.6 percent of adults had access to eMoney. Many rural
communities still lack access to formal remittance services, preventing them from benefiting from modern electronic
143 The framework focuses on (i) preventing a loan from becoming an NPL (flow) by implementing effective and efficient processes and systems, and (ii) resolving the current NPLs
(stock).
144 The RMA’s loan moratorium led to borrowers not making payments and interest accruing on outstanding balances. Since the accrued interest is added to the outstanding loan
amount, the outstanding credit increased.
145 Capital adequacy is aligned with Basel III regulations, while the liquidity coverage ratio is only monitored and not enforced. The minimum CAR threshold was lowered from 12.5
percent to 10 percent during COVID-19, by removing the 2.5 percent capital buffer as a regulatory forbearance measure to address the impact.
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Bhutan’s Financial Sector: Issues and the Way Forward
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Figure 114: Net interest margin (percent), Figure 115: Return on assets of banks (percent),
2015-2021 2015-2022
7 3%
2.5%
6 2% 1.6% 1.1%
5.7
5 1%
4.4
4 0%
3.7 0.9%
3.3 -1%
3 3.7 3.0
-2%
2 2.1
1.7
-3%
1
-4%
0
2015 2016 2017 2018 2019 2020 2021
-5% 2015 2016 2017 2018 2019 2020 2021 2022
BOB BNB BDB Druk PNB Bank TBank BOB BNB BDB Druk PNB Bank TBank
Figure 116: Capital adequacy ratio of banks (percent), 2015-2022
25%
23.4%
20%
17.5%
15% 15.7%
12.7%
10%
5%
0%
2015 2016 2017 2018 2019 2020 2021 2022
BOB BNB BDB Druk PNB Bank TBank
Source: Royal Monetary Authority. Note: In Figure 116, data for the year 2022 is not available for Bhutan National Bank (BNB) and Bhutan Development Bank (BDB). In
Figure 117, 2022 data for BNB and BDB is as of 30 September, all other data is as of 31 December.
and online payment systems. The penetration of bank branches and ATMs remains very low, with Bhutan having the
lowest numbers compared to other countries in SAR (Figure 119). Access to finance remains a major concern for private
businesses and rural entrepreneurs. Uneven access to bank credit, complex loan procedures, and a limited range of
financial instruments offered by banks, continue to impede access to finance. In rural areas, there is a significant unmet
demand for simpler banking services.
Access to finance is further constrained by the absence of appropriate risk sharing and credit enhancement instru-
ments, as well as banks’ risk aversion to lend to MSMEs. A sustainably designed risk sharing facility, such as a partial
credit guarantee scheme, can incentivize banks to lend to these sectors without generating contingent liabilities. Such
schemes should be introduced on a long-term basis, with the goal of promoting MSMEs in order to diversify the non-hydro
sectors, rather than only as short-term measures like the existing NCGS. The design of the scheme can follow international
best practices and could be complemented by capacity-building support for the borrowers.
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Box 10: Recent steps to encourage green finance
The Green Finance Roadmap for Bhutan is an important step taken by the RMA to align financial sector policies,
regulations, and incentives with the countr’’s environmental and climate goals. This roadmap outlines the strategic
direction to promote sustainability within the financial system and identifies necessary developments to advance Bhuta’’s
green finance agenda. The roadmap will help prioritize actions and coordinate efforts among various stakeholders,
including financial and environmental policymakers, supervisors, regulators, and sector participants. Bhutan’s Green
Finance Roadmap covers key elements for effectively greening the financial system. It includes high-level policy actions
with implementation timeframes. It also addresses governance and coordination, risk management, and a discussion
of green finance flows. Further, it recognizes the potential for more reforms, beyond the banking sector, encompassing
non-banks, insurance companies, capital markets, and institutional investors.
Bhutan has developed a national green taxonomy to support informed decision-making by financial actors regarding
environment-friendly investments. This taxonomy aims to scale up finance for climate mitigation, adaptation, and other
environmental goals; facilitate reliable and comparable disclosures related to sustainability risks and opportunities; and
provide a starting point for standard setters and product developers. It complements actions taken by authorities to
align environmental regulations with fiscal policies that support the greening of the economy. A taxonomy can further
promote market integrity by reducing ‘greenwashing’. The Bhutanese green taxonomy demonstrates good practices by
clearly formulating its purpose, environmental objectives, conceptual framework, and target users, and by incorporating
key principles such as the do-no-harm clause. Additionally, it considers taxonomies from other countries and initiatives
to lay the foundation for future harmonization efforts.
Figure 117: Access to finance (per 10,000 adults), 2017 and 2021
10
9
8
7
6
5
4
3
2
1
0
an
ia
a
a
y
an
an
ia
a
a
y
an
an
ia
a
a
y
an
ua
ua
ua
an
oli
an
oli
an
oli
liv
liv
liv
ut
t
ut
ist
ut
t
kis
kis
ag
ag
g
ng
ng
ng
tsw
tsw
tsw
Bo
Bo
Bo
Bh
Bh
Bh
jik
ra
ji
ji
r
r
Mo
Mo
Mo
Pa
Pa
Pa
Ta
Ta
Ta
Bo
Bo
Bo
Commercial bank branches Microfinance institution branches ATMs
2017 2021
Source: Financial Access Survey.
Access to foreign private capital for domestic firms is limited in Bhutan, reflecting significant restrictions on capital
account movements.146 Bhutan has one of the most restricted capital accounts in the world, with long-standing capital
controls to all categories of transactions (see AREAER 2020).147 While the FDI framework has been gradually liberal-
ized, the number of approved FDI projects and their aggregate size has been declining.148 Further, there are only five
instances where Bhutanese companies have been permitted to borrow from external sources in the recent decade. The
146 World Bank. 2022. “Assessment of the External Commercial Borrowing (ECB) Regime in Bhutan”. World Bank, Washington DC.
147 See AREAER Country Reports for Bhutan on https://www.elibrary-areaer.imf.org/Pages/Reports.aspx
148 The FDI framework still includes relatively high minimum thresholds, local participation rules, and sectoral restrictions.
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Bhutan’s Financial Sector: Issues and the Way Forward
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Government has recently eased access to External Commercial Borrowing (ECB) for the real sector (i.e., non-equity capital
flows) to improve access to international finance for domestic firms but continues to limit ECB for the financial sector.149
ECB is relatively closely regulated in South and Southeast Asia but is less prevalent elsewhere.150 Other countries usually
restrict the outflow of capital but not the inflow.
The payment system is still predominantly cash-based, with limited use of digital technologies. However, the COVID-
19 pandemic emphasized the importance of digital services during lockdown periods. During this time, the Government,
FIs, schools, and institutions increasingly relied on digital finance and payment systems (Government to Citizens [G2C])
to meet their needs. In line with the RMA 10-year Roadmap (2021-2030), Bhutan aims to leverage the National Digital
Identity as a key foundation for transforming the financial sector through FinTech services, and peer to peer (P2P) and
business to business (B2B) lending models. To support and encourage the growth of the FinTech ecosystem, the RMA
adopted the FinTech Regulatory Sandbox. Additionally, the RMA developed the Data Warehouse and Analytics System
to modernize the financial sector and enhance policy decision-making using emerging digital technologies. The Govern-
ment, RMA and fIs should ensure that FinTech is utilized to bridge the gaps in financial inclusion in Bhutan. This can be
achieved through faster and more affordable payments, collateral-free digital lending, and the introduction of innovative
capital market and insurance products for retail customers.
Various steps have been undertaken recently to bolster access to finance. The regulatory approach of the RMA has
often prioritized credit affordability, but the banks may not always have the incentives or opportunities to appropriately
price risks. To improve access to finance, the RMA launched the Priority Sector Lending Guidelines in 2017, along with
amendments to the Credit Information Bureau Rules and Regulations, to enable better assessment of borrowers’ cred-
itworthiness beyond collateral considerations. In 2020, the Government launched the National CSI Development Bank
and the NCGS to improve access to credit (Box 11).151 However, despite the establishment of the CIB, bank lending still
relies primarily on collateral. Recognizing challenges such as the lack of formal credit history, collateral, and low financial
literacy, the RMA launched the Financial Inclusion National Action Plan (FINAP, 2019-2023) to improve access and finan-
cial inclusion.152 The FINAP focuses on leveraging innovative technologies to expand the benefits of modern electronic
and online payment systems in rural areas.153 In 2021, two mobile operators started eTeeru and B-Ngul wallets, enabling
individuals to make payments through mobile phones without needing bank accounts.
The RMA has implemented various reforms to make the financial sector more responsive to emerging priorities and
maintaining financial stability. These reforms include regulatory interventions aimed at improving credit intermediation,
facilitating fund flow to CSIs, strengthening corporate governance and risk management systems, and promoting the
digital economy. Regulations have been updated to comply with International Financial Reporting Standard-9 (IFRS 9)
and Basel III, ensuring prudential regulations are in line with international standards. The payments and clearing systems
have been modernized, with the introduction of Real-Time Gross Settlements (RTGS) and the use of the SWIFT system.
The RMA is proposing amendments to the Financial Services Act 2011, to allow insurance companies to offer composite
insurance (both life as well as non-life). A feasibility study for Central Bank Digital Currency (CBDC) has been completed
to align with the RMA’s efforts to embrace a digital economy. The RMA has prepared a Ten-Year (2021-2030) Strategic
Plan (Druk Nguldrel-Lamtoen 2030) to respond to the changing demands of an economy that is increasingly driven by
technology and innovation.154
149 The 2023 ECB Guidelines shortened the minimum required loan maturity, broadened the allowable end-use (utilization) of ECB proceeds, including working capital to liberalize
refinancing options and increase the maximum allowed interest rates. The guidelines also introduced an automatic approval process for loans that meet eligibility criteria (amount,
end-use of the funds, minimum maturity period).
150 The current ECB framework in Bhutan is largely built on criteria used in other countries in the region, including India, Nepal, Bangladesh.
151 The National CSI Development Bank was merged with the BDB in 2023 as a result of financial losses and overlapping mandates.
152 See RMA. 2019. “Financial Inclusion National Action Plan (FINAP), 2019-2023”. RMA, Thimphu, Bhutan. https://www.rma.org.bt/RMA%20Publication/papers/FINAP%20Four%20
Pillers%20Brochure.pdf
153 The FINAP targets 85 percent financial inclusion by 2023 from the baseline of 64 percent in 2017.
154 RMA. 2021b. “Druk Nguldrel-Lamtoen 2030” RMA, Thimphu, Bhutan.
https://www.rma.org.bt/assets/images/news_image/druk%20nguldrel%20lamtoen.pdf
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Box 11: Recent steps to improve access to finance
Priority Sector Lending. Bhutan launched a Priority Sector Lending (PSL) program and guidelines to improve access to
finance. Under this program, agricultural Cottage and Small Industry (CSI) loans for primary production are insured to
address collateral requirements, while loans for other activities are based on cash-flow or project financing practices
instead of collateral. Priority Sector Lending (PSL) clients can receive loans up to Nu. 500,000 for primary production
in agricultural CSI. The preferential interest rates are 8 percent per annum for non-agricultural CSI and 8.5 percent per
annum for value addition in agricultural CSI. The majority of outstanding PSL loans (61 percent) are in the non-agricultural
CSI sector, followed by agricultural CSI sectors (39 percent). However, more loans were sanctioned to the agricultural
CSI sector in terms of the number of accounts. Approximately 80 percent of the loans were disbursed through the BNB
and the BoB.
National CSI Development Bank. The National CSI Development Bank was established by the Government in February
2020 as a government-owned non-deposit bank SOE. Since its inception, the NCSI has been providing microloans to
the agriculture sector at 2 percent, and to the non-agriculture sector at 4 percent, in order to mitigate the impact of the
pandemic. Because of high NPLs and failure to recover loans, the authorities have decided to merge the national CSI
bank with BDB.
National Credit Guarantee Scheme. The NCGS was launched in October 2020 in response to the COVID-19 pandemic
to improve access to credit. Participating banks, including BOB, BNB, and the National CSI Development Bank, receive
government guarantees to enable lending without the need for collateral. The scheme has been successful in improving
access to credit and promoting financial inclusion. Currently, there are 213 projects under the scheme, with a total loan
amount of Nu. 852.08 million.155
3.4. Policy priorities
Despite the rapid development in Bhutan’s financial sector, it faces numerous systemic risks and challenges. Moving
forward, reforms are necessary to mitigate systemic risks, promote financial deepening, improve governance, strengthen
regulations and oversight mechanisms, and bolster inclusion. These measures are crucial to complementing the diversi-
fication of the economy and fostering private sector growth. The following policy recommendations could be considered
for addressing the existing gaps and vulnerabilities.
3.4.1. Financial stabilityand governance of FIs
Despite efforts made by the RMA in recent years, significant improvements in supervision and regulation ae
still required. The regulatory regime can be further enhanced by moving from the existing compliance and perfor-
mance-based supervisory models towards a risk-based supervisory approach. The insurance sector, in particular, faces
challenges due to limited regulatory and supervisory capacity. Therefore, it is crucial for the RMA to strengthen its capacity
to effectively supervise the insurance sector and promote the development of a resilient and credible insurance industry.
Further, implementing risk-based solvency requirements for the insurance sector and amending the Financial Services
Act 2011, to allow composite insurance by insurance companies for example, should be prioritized. Given the high attrition
rate in the RMA and public services, it is also important to develop a new pool of supervisors with the necessary skills.
155 The guarantee is limited to the debt financing of the project. It covers loans not exceeding Nu. 30 million by way of term loans. Debt to Equity Ratio under scheme is 90:10, which
is significantly lower than the existing levels of the financial institutions.
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Detailed guidelines for credit underwriting are essential to reduce risks during loan origination. According to the
NPL Management Strategy, the top 20 NPLs were primarily caused by two factors: common clients with high loan
exposures and inadequate securities being pledged.156 This highlights the need for comprehensive guidelines, which
fIs must adhere to during the credit underwriting process. While the Risk Management Guidelines 2019 provide an
overview of procedures for credit appraisal, the increase in NPLs suggests uneven compliance. Although lenders have
comprehensive credit manuals in place, it is crucial to assess the level of their application. Therefore, addressing credit
underwriting needs to be prioritized.
Strengthening credit monitoring is crucial for fIs to address the risk of borrowers failing to meet their contractual
commitments. This can be achieved by developing appropriate internal procedures and reporting mechanisms to identify
and manage potential non-performing customers at an early stage and prevent deterioration in credit quality. Effective
credit risk monitoring involves using Early Warning Indicators (EWIs) and Key Risk Indicators (KRIs) during loan origination
and throughout the life cycle of the loan. Sensitivity analysis and stress testing should also be conducted. The RMA could
issue a guideline that outlines the fundamental principles for establishing an early warning system. Financial institutions
could assess any gaps in their systems using this guideline, and the RMA could request a timeline for implementing
necessary improvements. Regular reviews and assessments can be conducted during onsite inspections. Further, insti-
tutions need to align their credit risk strategy, including credit-granting decisions, with capital and liquidity planning, the
Internal Capital Adequacy Assessment Process (ICAAP), the Internal Liquidity Adequacy Assessment Process (ILAAP),
and the broader risk appetite framework.
The current loan pricing mechanism could be modified to reflect borrower risks. It is important to have a system of
risk-based pricing that considers factors such as risk appetite, business strategies, profitability, and risk perspective.
Financial institutions should develop approaches to pricing that are tailored to the type and credit quality of borrowers,
offering different loan prices based on the specific type and credit quality of borrowers. For MSMEs, the pricing could
be more focused on the overall portfolio and specific product offered, whereas for medium and large enterprises, the
pricing could be more customized to the individual borrower’s circumstances.
The bankruptcy and insolvency framework could be further developed to facilitate the prompt resolution of NPLs.
The Bankruptcy Act of 1999 currently offers protection for insolvent companies seeking bankruptcy. Further, the enforce-
ment of this law falls under the jurisdiction of the judiciary. Currently, most cases of loan defaults are litigated in court
by borrowers and financial services providers, which can be both expensive and time-consuming. The Bankruptcy Act
should be reviewed and amended to establish a framework that enables businesses to effectively resolve insolvency
and strengthen creditor rights. Up until now, no one has sought protection under the Bankruptcy Act. Instead, the FIs
are opting for out-of-court settlements to expedite insolvency cases, using provisions outlined in the NPL resolution
framework. Given that this practice is relatively new in Bhutan, it will be essential to further enhance institutions such
as arbitration and build capacity for the settlement of insolvency and bankruptcy cases. The court processes to seize
collateral in a timely manner have improved in recent years, particularly with the establishment of commercial benches
in Thimphu. However, additional benches are needed in major Dzongkhags.
Ensuring a level playing field for SOFIs and other banks can address risks to financial stability. Public-owned banks
hold the majority of deposits in the economy. For example, the BoB’s advantage in cost of funds, compared to other
banks, can be attributed to its large deposit base in the public sector. Consequently, BoB’s market share has increased
significantly over the years. To promote a more diverse banking system and reduce reliance on a single dominant player,
it is important to enhance competition among banks for government deposits. This will ultimately contribute to a more
stable financial system. Given the relatively weak balance sheets and performance of state-owned banks in recent
years, and the ongoing efforts to clean up balance sheets of state-owned financial institutions, full or partial divestiture of
state-owned banks could be a medium-term objective for the Government. However, this should only be pursued when
the financial sector is more stable, and the efficiency and performance indicators of state-owned banks have improved.
Thus, sequencing plans for divesture, after addressing immediate financial sector performance issues, could improve
the attractiveness of these banks to private investors.
156 KPMG and ADB. 2021. “Credit Risk and NPL Management for Bhutan. NPL Management Strategy Report.” https://www.adb.org/sites/default/files/project-docu-
ments/51252/51252-004-tacr-en_2.pdf
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Bolstering corporate governance and risk management frameworks is essential to improving good corporate gover-
nance practices. In 2020, the RMA introduced the Corporate Governance Rules and Regulations (CGRR) to promote
sound governance by encouraging high standards of governance principles. According to Clause 15 of the CGRR, there
should be a transparent accountability framework to ensure effective accountability of the board and senior management
positions in FIs. The regulations limit the number of directors to seven, including the chairperson and CEO, with at least
two being independent directors. However, this limitation poses challenges for FIs in forming board-level committees,
such as, governance, risk, and audit with sufficient directors. To address this issue, revising regulations may be necessary
to ensure an optimal number of board members in these committees, thereby improving good governance practices.
inancial intermediation
3.4.2. Deepening f
Strengthening the CIB, by expanding the coverage of service providers and data systems, is essential to reducing
collateral-based lending. The utilization of credit information by lenders appears to be limited.157 Expanding the coverage
of information is critical to developing a comprehensive credit history and implementing a new credit scoring system in
the country. Presently, only FIs, several MFIs, and the utility company report to the CBI. There is significant potential to
expand the coverage of CIB by creating an enabling environment for other financial service providers to share informa-
tion. This expansion would help reduce information asymmetry and enhance the credit history database. Looking ahead,
the CIB could consider incorporating the land record system and the Road Safety Transport Authority in its coverage of
service providers. Making CIB reports mandatory during loan origination would also help mitigate the risks of NPLs. The
CIB is working on a credit scoring model specifically for retail borrowers, which will be integrated with the credit reports.
However, these reports are primarily used as compliance tools rather than comprehensive credit assessment tools.
A review of the design of the PSL scheme can improve its effectiveness by tackling disincentives to lend to the CSI
sector. Amajor challenge is that many projects are rejected due to poor credit history and lack of bankable projects.
Banks have raised concerns about restrictions on their ability to determine the lending conditions under the PSL, such
as interest rate caps, loan tenures, payment structures, and mandatory insurance coverage for agricultural lending
instead of collateral requirements. These concerns are compounded by the lack of credit risk-sharing arrangements
and institutional capacity to serve the CSI sector. While the PSL approach allows banks to make the final decision in the
credit approval process, there is a need to review the role of all commercial banks involved in the PSL initiative. This
includes addressing issues related to generalized lending obligations, the absence of a risk-sharing framework, oper-
ational constraints, pricing limitations, technical capacity, and prudential norms and regulations. The aim is to eliminate
disincentives for lending to the CSI sector.
A sustainable credit guarantee scheme can effectively alleviate credit constraints in risky sectors, such as MSMEs.
However, there are potential risks associated with the limited guarantee coverage period of three years under the NCGS,
as loans are not collateralized after the sunset clause. To ensure the success of such schemes, it is crucial to improve
monitoring and support mechanisms. This can be achieved by reviewing the design, guarantee coverage period, guar-
antee ratio system, and fees of the schemes. Additionally, enhancing coordination between the scheme, CIB, and FIs,
in assessing and managing loans, is essential. To address concerns raised by banks regarding the temporary nature of
the NCGS, it could be made permanent and capitalized separately. This would provide guarantees for the entire loan
duration, ensuring sustained lending support. Further, simplifying the current claims process and expanding the scope
of the NCGS would contribute to its effectiveness.
Implementing a robust collateral valuation system is crucial to mitigating loan losses and safeguarding banks. The
quality and accurate valuation of collateral plays a significant role in securing banks against potential loan losses. In order
to achieve this, the RMA can develop a comprehensive framework for collateral valuations, which is in accordance with
international accepted standards, and conduct capacity building on collateral valuation for lenders and supervisors. In
addition, having an independent valuer will be vital during legal settlements, as borrowers generally seek a higher value
for the surrender of their collateral.
157 The CIB is governed by the Credit Information Bureau Rules and Regulations, 2017, issued by the RMA. It currently provides consumer and commercial information through an
automation platform.
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Facilitating access to international finance for domestic firms can support private sector development and firm
growth. Expanded ECB for the larger companies could free up access to domestic financing for the smaller companies
and thereby enhance financial inclusion. It could also reduce the maturity mismatches of domestic banks (banks are
financing long-term assets with very short-term funding, i.e., deposits) and concentration risks (banks are relatively small,
therefore taking larger export-oriented projects could create industry concentration risks in their balance sheets) by
taking some loans off the banking sector balance sheet. Although the government has already made strides in easing
ECB for the real sector, further medium-term reforms could be beneficial. These reforms include opening the banking
sector to ECB under strict regulatory oversight, easing foreign exchange conditions to allow borrowers more flexibility in
meeting repayment obligations, for instance by considering alternative measures for hedging, such as by focusing on the
production of tradable goods. Moreover, raising the debt-equity ratio for ECB beyond the current 3:1 limit could support
projects with higher leverage, potentially with sector-specific variations. Regulations might also permit shorter-term ECBs
below a certain level or for borrowers with a natural hedge in foreign exchange earnings.
The adoption of digital technologies can enhance efficiency and boost financial inclusion. Digitized assets and emerg-
ing technology are shaping the financial services landscape. Banks can leverage digital technology to improve their
services by reducing overhead costs, eliminating the need for branch expansion. This is also vital for building capacity
to address the skills gap and promoting digital financial literacy. The drive towards digitalization will facilitate validation
of digital signatures and digital documents, which can modernize the financial industry.
limate finance
3.4.3. Bolstering c
Strategy and coordination
The Green Finance Roadmap lacks some specific details, and a comprehensive coordination mechanism is necessary
to support its implementation. To promote a more coordinated approach and build a strong and efficient domestic
green finance market, it is important to establish an overarching coordination mechanism that involves all financial sector
authorities, relevant government bodies, and the financial sector as a whole. The establishment of the National Sustain-
able Finance Committee is a positive step in this direction. This committee will include all authorities, such as the RMA,
relevant departments at the Ministry of Finance, National Environment Commission, Royal Stock Exchange of Bhutan
(RSEB), and the Bhutan Chamber for Commerce and Industries. It will also try to work closely with international partners
and networks in the sustainable finance field. As a next step, the committee could focus on developing a detailed work
plan that includes specific deliverables. Where relevant, technical subgroups (comprising both public and private sector)
could be established to support implementation.
Developing a national climate finance strategy can provide additional clarity on investment objectives and offer
assurance to investors about the Government’s long-term policy direction, including priority investment sectors. For
Bhutan, it would be important to consider the potential sources of financing required to meet its adaptation and resil-
ience objectives. This is especially important as adaptation investments require different mechanisms, incentives, and
actors, compared to mitigation financing. Building institutional capacity across the government is necessary to develop
innovative approaches that can unlock finance for adaptation and resilience projects.
Building skills and capacity
Enhancing awareness of climate-related and environmental risks and opportunities will be critical for supporting
the implementation of the Green Finance Roadmap and the development of the green finance market. This can be
achieved by developing a detailed plan to identify the specific training needs of authorities and the sector. It is important
to identify relevant partners to engage in addressing specific topics. There are training and capacity-building opportuni-
ties, which can be accessed by the public and private sectors, including the Central Banks and Supervisors Network for
Greening the Financial System (NGFS). The NGFS supports central banks, prudential supervisors, and policymakers to
take steps to green the financial sector. Its workplan includes micro prudential supervision, scenario analysis, monetary
policy, and other topics related to the greening of central bank activities, including portfolio management. Given that the
NGFS is currently the primary mechanism for international coordination on the topic, the RMA may seek membership of
the NGFS to benefit from its deep expertise and share best practices with other members.
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Climate-related risks and supervisory practice
Conducting a climate-related or environmental risk assessment can help identify the main climate-related and envi-
ronmental financial risks and assess their potential impact on the Bhutanese financial sector. The insights gained from
this assessment can guide the development of a suitable approach to incorporate these risks into the RMA’s supervisory
practices, including internal organization and governance structure. Further, the RMA could provide supervisory guid-
ance to FIs on climate and environmental financial risks in important areas such as corporate governance, strategy, risk
management, scenario analysis and stress testing, and disclosure.158 Such assessments primarily focus on the financial
risks faced by institutions; they could begin with a high-level exposure analysis, progressing to more advanced scenario
analysis as capacity and data improve. Given Bhutan’s reliance on hydropower and low per capita Greenhouse Gas (GHG)
emissions, the assessment of transition risk may be relatively less important at present. However, the scope of assess-
ments can be expanded to include other environmental and social risks, including nature-related and biodiversity risks.
Greening central bank activities
Internationally, there is growing interest in greening the central bank’s activities and operations. Examples of greening
central bank operations include adopting sustainable and responsible investment practices in portfolio management,
disclosing climate-related information, and greening of monetary policies (e.g., through credit operations, collateral
policies and asset purchase). However, many of these options are still under review by the international central bank
community, including the NGFS. While some of these options may be of less immediate relevance to Bhutan and the
RMA, they could integrate climate-related considerations in the macroeconomic analysis and forecasting, which can
inform future monetary policy interventions. In addition, the RMA is considering direct green credit policy instruments
(for example, subsidized loan rates for priority sectors, interest rate discounts, differentiated reserve requirements).
Although this intervention is less tested, it could be effective in redirecting financing flows, provided it aligns with the
Central Bank’s mandate and does not compromise other financial stability objectives.
Transparency, disclosure, and reporting
Enhancing market transparency is crucial to ensuring the efficient allocation of capital for Bhutan’s climate and envi-
ronmental financing objectives. Investors and lenders need adequate information on climate-related and environmental
risks and opportunities to understand, price and manage the risk in their portfolios and operations. The RMA, Ministry
of Finance, and RSEB have launched several initiatives, including reporting and disclosure requirements for financial
institutions, and Environmental Social and Governance (ESG) reporting standards under the support of Global Reporting
Initiative (GRI), to align with international best practice. As a next step, the RMA and other stakeholders could develop a
plan to embed the national green taxonomy in relevant regulatory and policy frameworks, to mainstream green consid-
erations in the financial sector. This could include green bond guidelines or green finance-related reporting frameworks.
Greening financial institutions
The National Development Bank (NDB), or other domestic public financial institutions, can help address the financing
gap to achieve climate and environmental objectives. It is important to ensure that these institutions, including the BDB,
have the appropriate mandate and policy objectives to promote green lending and investment.159 NDBs generally have
a good understanding of local sectors, enabling them to target technical support and private investments effectively.
It is therefore worth considering if public banks such as the BDB can enhance private finance by offering de-risking
instruments like credit enhancements and guarantees. By explicitly incorporating environmental and climate objectives
into their mandates, these institutions can ensure that financing flows align with green objectives. In the case of BDB,
this would involve a specific reference to sustainable low-emissions agriculture in its mandate.
158 The Basel Committee on Banking Supervision has just published its “Principles for the Effective Management and Supervision of Climate-Related Financial Risks,” providing a
global baseline standard.
159 BDB is a DFI with a focus on rural financial inclusion. The Bhutan Development Finance Corporation was established in 2010 with the social mandate to cater to the financial
needs of the micro, small and medium enterprises, with a special focus on agricultural development. Some of the challenges faced by the BDB includes high NPLs and funding
costs.
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Green financial tools and instruments
New blended finance instruments could leverage public and concessional finance to mobilize private capital for green
investments. Mechanisms such as risk sharing instruments, guarantees, and funds that leverage philanthropic capital,
can help bridge the financing gap in Bhutan’s green development objectives. In cases where private investments are
not commercially viable, suitable financial structuring through blended finance can unlock private investment. This can
be made possible by addressing perceived or actual risks with new technologies or pioneering projects. By providing
flexible capital and favorable terms, blended finance, tailored to the local context, can mitigate risks and re-balance the
risk-reward profiles of impact investments, making them commercially viable over time.
Green bonds can mobilize long-term capital flows. Regulators and policymakers have several tools at their disposal to
promote the development of green bond markets and stimulate domestic bond issuance, some of which have already
been covered in the Green Finance Roadmap. The adoption or development of green bond guidelines and standards,
aligned with internationally recognized frameworks like the International Capital Market Association’s (ICMA) Green Bond
Principles, would ensure comparability on an international level. While green bonds may initially have higher transaction
costs due to compliance independent review and reporting requirements, fiscal incentives can help offset these costs
for first-time or small issuers, facilitating market entry. To lead by example and signal Bhutan’s commitment to meeting its
climate goals and green growth objectives, the Government could also consider issuing a green sovereign bond. This
can support the development of the local green finance market and diversify the investor base.
To scale-up private finance and develop green financial instruments, the authorities could develop a detailed plan for
the operationalization of its green finance objectives, which is outlined in the Green Finance Roadmap. To facilitate
this process, gaining more insights into the barriers that prevent the flow of financing to where it is needed, would be
beneficial in tailoring the instruments to the local context. Specific consideration should be given to mobilizing adaptation
financing, which can be particularly challenging.
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Reference List
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Bhutan Country Economic Memorandum
Annexes
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Annex 1: Growth accounting of
the hydro and non-hydro sectors
Growth accounting using two sectors
Yt
The economy consists of two sectors, hydro and non-hydro. Aggregate output ( ) during period ������ is the sum of the two
sectoral outputs (as in national accounts):
Yt
=
YH , t
+
YN ,t
YH
, t (function of capital and productivity)
: Output of the hydro sector
YN ,t
(
: Output of the non − hydro sector )
function of labor, capital, and productivity
Decomposing hydro sector growth
gY
Hydro output growth ( ,H,t
) is decomposed into two components:
gY
,H,t (1 +
= gA ,H,t
)(1 +
gK )
,H,t − 1
gA ,H,t
: growth of hydro sector TFP
gK
,H,t
: growth of capital stock used in hydro production
Decomposing non-hydro sector growth
gY
Non-hydro output growth ( ,N,t
) is decomposed into four components:
gY ,N,t
(1 +
= gA )
,N,t [
(1 +
gs )
,t (1 +
gL )
,t ]
(1 +
gK )
,N,t − 1
β 1−β
gA
,N,t
: growth of non − hydro sector TFP
gs
,t
: growth of human capital
gL
,t
: growth of labor stock
gK
: growth of capital stock used in non − hydro production
,N,t
(
β : labor intensity of production technology )
time invariant
Decomposing Labor Growth
gL
Labor growth ( ,t
) can be further decomposed into three components:
gL
,t
(1 +
= gω )
,t (1 +
gρ )
,t (1 +
gP )
,t
gω
,t
: growth in working age population ratio
gρ ,t
: growth in labor force participation rate
gP
: growth in population
,t
gY
Substituting the labor growth equation into the non-hydro sector growth equation, the non-hydro sector growth ( )
,N,t
becomes:
β
gY
,N,t
(1 +
= gA )
,N,t
[(
1 +
gs )
,t (1 +
gω ,t
)(1 +
gρ )
,t (1 +
gP ,t
)]
(1 +
gK )
,N,t
− 1
1−β
gA
: growth of non − hydro sector TFP
,N,t
gs
,t
: growth of human capital
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gω
,t
: growth of working age population
gρ
,t
: growth of labor force participation rate
gP ,t
: growth of population
gK
: growth of capital stock used in non − hydro production
,N,t
Hydro Spillovers
Capital expenditure in the hydro sector (investment) generates income in non-hydro sector, for example, through supply
of goods (e.g., construction materials) and services (e.g., labor used in construction).
~
In the absence of hydro investment ( IH
,t
), non-hydro output in period t equals to
Y
N,t
:
~
Y
N,t
=
YN , t
−
,t
IH
Recover the hydro spillover to non-hydro growth using the above expression:
~ ~
Y
−
Y
IH
,t+1
IH
−
,t
gY
,N,t _
=
N,t+1
_
N,t
Y
N,t
+ Y
N,t
Where the first part represents the core non-hydro growth, and the second part represents the spillover effect.
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Annex 2: Detailed CGE scenario results
Basic Income Grant (BIG) Figure 118: Value and composition of
government transfers to households including
In Scenario 4 (hydro-led with fiscal transfers), revenues are BIG, 2019-2030
channelled into (untargeted) fiscal transfers in the form of a 25000
BIG to households. In this model, growth is driven through
private spending. The BIG is assumed to be untargeted 20000
and unweighted, such that all people receive the same per
capita transfer. The BIG changes both the size (transfers 15000
increase from 4,735 million Nu in 2019 to 24,542 million Nu Nu (millions)
in 2030) and distribution of government transfers to house- 10000
holds (Figure 118). While agricultural households accounted
for 27 percent of total government transfers in 2019, their
5000
share increases to 51 percent in 2030 under the BIG,
reflecting the large transfers to agricultural households
0
under the BIG scenario due to their share in the population 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
(Figure 119). Urban Rural Agricultural
Source: CGE model.
Figure 119: Impact of the BIG on household income by source, 2030
8000
7000
6000
5000
4000
Nu, millions
3000
2000
1000
0
-1000
-2000
Urban Urban Urban Urban Urban Rural Rural Rural Rural Rural Non-Poor Poor
Skilled Semi-Skilled Low-Skilled Unskilled Other Income Skilled Semi-Skilled Low-Skilled Unskilled Other Income Agricultural Agricultural
Labour Government transfers Capital Land Total di erence
Source: CGE model. Note: The graph shows the difference in average household income by source between 2020 and 2030 (S4_HydroLed_BIG minus the reference
scenario).
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Overview of the economic development under the different scenarios
Tabla 7: Economic development in different scenarios, 2030
s2_HydroLed Reference Scenario S1_NoAddHydro S3_HydroLed_Div S4_HydroLed_BIG
annual compound Values Annual compound growth 2019-2030. Shading shows
growth 2019-2030 2019-2030 percentage change compared to S2_Hydroled
cGDP GDP 4.1% 3.4% 4.5% 4.0%
Macro
cABSORP Domestic absorption 2.6% 3.3% 3.3% 2.3%
cVAAgr Agriculture 1.1% 1.9% 1.7% 1.9%
cVANat Natural resources 1.4% 2.5% 2.4% 2.3%
cVAFd Food and beverages 0.8% 1.4% 1.3% 1.4%
cVAInd Industry 2.7% 4.1% 3.6% 3.6%
cVAUti Utilities 11.0% 5.0% 11.3% 11.1%
Value added
cVACon Construction 3.8% 3.8% 4.6% 3.7%
cVASer Services 3.0% 3.6% 3.2% 2.1%
cEMPAgr Agriculture 2.5% 2.6% 3.2% 2.6%
cEMPNat Natural resources -0.8% 1.3% 1.1% 1.6%
cEMPFd Food and beverages 2.3% 1.9% 2.8% 2.0%
cEMPInd Industry 0.8% 2.5% 2.5% 2.5%
cEMPUti Utilities 7.6% 2.6% 8.3% 8.4%
Labour demand
cEMPCon Construction 2.4% 2.9% 4.0% 3.6%
cEMPSer Services 2.0% 2.3% 2.1% 1.0%
cCAPAgr Agriculture -1.8% -1.6% -1.6% -1.7%
cCAPNat Natural resources 1.5% 1.7% 2.2% 1.6%
cCAPFd Food and beverages 1.2% 1.4% 1.9% 1.3%
cCAPInd Industry 1.8% 2.1% 2.5% 1.9%
cCAPUti Utilities 7.8% 1.7% 8.0% 7.9%
cCAPCon Construction 1.3% 1.5% 2.0% 1.4%
cCAPSer Services 1.8% 2.1% 2.4% 1.9%
Capital demand
cCAPHydro Hydro 7.8% 1.7% 8.0% 7.9%
cCAPNonHydro Non-hydro 1.4% 1.7% 2.1% 1.5%
cLABAgri Agriculture 2.6% 2.6% 3.3% 2.6%
cLABUnLow Unskilled & low-skilled 2.3% 2.3% 2.9% 2.3%
cLABSemi Semi-skilled 2.5% 2.5% 3.2% 2.5%
cLABHigh Highly-skilled 2.6% 2.6% 3.2% 2.6%
Factor supply
cCAP Capital 3.1% 1.7% 3.6% 3.2%
cLAND Land 0.9% 0.9% 0.9% 0.9%
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s2_HydroLed Reference Scenario S1_NoAddHydro S3_HydroLed_Div S4_HydroLed_BIG
annual compound Values Annual compound growth 2019-2030. Shading shows
growth 2019-2030 2019-2030 percentage change compared to S2_Hydroled
cWFAgri Agriculture -1.0% -0.3% -1.1% -0.4%
cWFUnLow Unskilled & low-skilled 1.1% 1.0% 0.6% 0.3%
cWFSemi Semi-skilled 0.9% 1.0% 0.2% -0.2%
cWFHigh Highly-skilled 1.3% 1.1% 0.4% 0.1%
Factor returns
cWFCAP Capital 1.8% 1.9% 1.9% 2.0%
cWFLAND Land -0.03% 0.6% 0.3% 0.4%
cHEXPUrban Urban 0.1% 4.0% 2.5% 0.1%
cHEXPRural Rural 2.5% 3.5% 3.2% 2.9%
cHEXPUnLow Unskilled & low-skilled 2.6% 3.2% 3.1% 3.2%
Household consumption
cHEXPSemi Semi-skilled 2.5% 3.9% 3.3% 2.5%
cHEXPSkilled Highly-skilled 2.2% 4.5% 3.5% 1.8%
cHEXPPoorAgri Poor agricultural 1.5% 2.0% 1.9% 6.7%
CHEXPNonPoorAgri Non-poor agricultural 1.6% 2.4% 2.2% 3.4%
cElecGen Electricity output 7.5% 1.4% 7.7% 7.6%
cElecPrice Electricity price 4.7% 3.9% 4.7% 4.6%
Electricity
cElecExp Electricity exports 8.2% 1.7% 8.3% 8.3%
cElecDom Electricity domestic sales 4.0% -0.2% 4.2% 4.0%
cHydroRev Hydro revenue 6.6% 3.9% 7.1% 6.8%
Govt
cGovCons Government consumption 5.1% 3.5% 4.0% 0.6%
Key: < -50% -10% to -50% Up to -10% Up to 10% 10% to 50% >50%
Percentage change relative to S2_HydroLed reference scenario
Example: Annual compound growth in GDP is 0.4 percentage points higher in S3 than the reference scenario (4.5 percent vs. 4.1 percent). The annual compound growth rate is between
10 percent and 50 percent higher in S3 than the reference scenario as indicated by the shading.
117
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