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The World Bank Strengthening Fiscal Management and Private Sector Employment Opportunities (P168166)

Document of

The World Bank

FOR OFFICIAL USE ONLY Report No: PGD109

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT FOR A

PROPOSED DEVELOPMENT POLICY CREDIT

IN THE AMOUNT OF SDR 21.7 MILLION (US$30 MILLION EQUIVALENT)

TO

THE KINGDOM OF BHUTAN

FOR THE SECOND PROGRAMMATIC

STRENGTHENING FISCAL MANAGEMENT AND PRIVATE SECTOR EMPLOYMENT OPPORTUNITIES DEVELOPMENT POLICY CREDIT

May 22, 2019

Macroeconomics, Trade and Investment Global Practice South Asia Region

This document has a restricted distribution and may be used by recipients only in the performance of their official

duties. Its contents may not otherwise be disclosed without World Bank authorization.

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Kingdom of Bhutan

GOVERNMENT FISCAL YEAR

July, 1 – June, 30

CURRENCY EQUIVALENTS

(Exchange Rate Effective as of May 22, 2019)

Currency Unit

US$1.00 = BTN 70

ABBREVIATIONS AND ACRONYMS

ADB Asian Development Bank ICT Information and Communication Technology

AMCHP Accelerating Maternal and Child Health Program

IFC International Finance Cooperation

APA Alternative Procurement Arrangement IFMIS Integrated Financial Management Information System

ASA Advisory Services and Analytics IMF International Monetary Fund BCSE Bhutan Certificate of Secondary

Examination INR Indian rupee

BEFIT Bhutan Economic Forum for Innovative Transformation

IRC Interest Rate Corridor

BoP Balance of Payments LDP Letter of Development Policy BTN Bhutanese ngultrum LFPR Labor Force Participation Rate CAD Current Account Deficit MDF Multi-Donor Fund CIB Credit Information Bureau MFI Micro-Finance Institution CIT Corporate Income Tax MIPA Moveable and Immovable Property Act CPI Consumer Price Index MNCH Maternal, Neonatal and Child Health CPS Country Partnership Strategy MoF Ministry of Finance CSIs Cottage and Small Industries MSME Micro, Small and Medium Enterprises CRST Central Registry Secured Transaction MW Mega Watts DGPC Druk Green Power Corporation Limited MYRB Multi-Year Rolling Budget DMEA Department of Macroeconomic Affairs NEC National Environment Commission DPC Development Policy Credit NER Net Enrollment Rate DPR Detailed Project Report NFE Non-Formal Education DRM Domestic Revenue Mobilization NKRA National Key Result Area DSA Debt Sustainability Analysis NPL Non-Performing Loan ECB External Commercial Borrowing ODS Ozone Depleting Substances EDP Economic Development Policy PDO Program Development Objective EFTCS Electronic Fund Transfer and Clearing

System PEFA Public Expenditure and Financial

Accountability e-GDDS Enhanced General Data Dissemination

System PEMS Public Expenditure Management System

eGP Electronic Government Procurement PFM Public Financial Management

ESIA Environmental and Social Impact Assessment

PFM MDF

Public Financial Management Multi Donor Fund

ESMP Environmental and Social Management Plan

PLR Performance and Learning Review

FDI Foreign Direct Investment PPP Public Private Partnership FY Fiscal Year RAMIS Revenue Administration Management

Information System FYP Five-Year Plan RBI Reserve Bank of India GDP Gross Domestic Product RGoB Royal Government of Bhutan GIFT Global Interchange for Financial

Transactions RI Result Indicator

GLOFs Glacial Lake Outburst Floods RNR Renewable Natural Resources GNH Gross National Happiness RMA Royal Monetary Authority (Central Bank) GNHC Gross National Happiness Commission RTGS Real Time Gross Settlement GOI Government of India SDGs Sustainable Development Goals GRPB Gender Responsive Planning and

Budgeting SOEs State-Owned Enterprises

GRS Grievance Redress Service SDR Special Drawing Rights GST Goods and Services Tax TA Technical Assistance ICA Investment Climate Assessment TVET Technical and Vocational Education and

Training ICRR Implementation Completion and Results

Report WB(G) World Bank (Group)

.

Regional Vice President: Hartwig Schafer

Country Director: Robert J. Saum

Senior Practice Director (s): Lalita M. Moorty

Practice Manager (s): Maria Manuela Do Rosario Francisco

Task Team Leader (s): Kenechukwu Maria Ezemenari, Yoichiro Ishihara


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KINGDOM OF BHUTAN

STRENGTHENING FISCAL MANAGEMENT AND PRIVATE SECTOR EMPLOYMENT OPPORTUNITIES

TABLE OF CONTENTS

SUMMARY OF PROPOSED FINANCING AND PROGRAM .......................................................................3

1. INTRODUCTION AND COUNTRY CONTEXT ...................................................................................5

2. MACROECONOMIC POLICY FRAMEWORK ....................................................................................7

2.1. RECENT ECONOMIC DEVELOPMENTS ............................................................................................ 8

2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ........................................................ 10

2.3. IMF RELATIONS ............................................................................................................................ 13

3. THE GOVERNMENT PROGRAM .................................................................................................. 14

4. PROPOSED OPERATION ............................................................................................................ 14

4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION .......................................... 14

4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS .................................................. 15

Pillar 1: Strengthening the policy framework to improve fiscal management ..................................... 16

Pillar 2: Enhancing policies to promote private sector employment opportunities ............................. 20

4.3. LINK TO CPF, OTHER BANK OPERATIONS AND THE WBG STRATEGY .......................................... 31

4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS ............................... 32

5. OTHER DESIGN AND APPRAISAL ISSUES .................................................................................... 32

5.1. POVERTY AND SOCIAL IMPACT .................................................................................................... 32

5.2. ENVIRONMENTAL ASPECTS ......................................................................................................... 33

5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS .......................................................................... 34

5.4. MONITORING, EVALUATION AND ACCOUNTABILITY .................................................................. 35

6. SUMMARY OF RISKS AND MITIGATION ..................................................................................... 36

ANNEX 1: POLICY AND RESULTS MATRIX .......................................................................................... 38

ANNEX 2: LETTER OF DEVELOPMENT POLICY ..................................................................................... 42

ANNEX 3: IMF ASSESSMENT LETTER ................................................................................................. 45

ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE .................................................. 50

ANNEX 5: IMPLEMENTATION OF DPC1 REFORMS .............................................................................. 51

ANNEX 6: GENDER ASPECTS IN EDUCATION REFORMS ....................................................................... 53

ANNEX 7: DELAYS IN HYDROPOWER PROJECTS .................................................................................. 54

This Development Policy Credit was prepared by a World Bank Group team co-led by Kene Ezemenari (Senior Economist, GMTSA) and Yoichiro Ishihara (Senior Economist/Resident Representative, SACBT), and consisting of: Christian Eigen-Zucchi (Program Leader, SACBN), Marcelo Hector Acerbi (Sr. Environmental Specialist, GEN06), Francesca Lo Re (Sr. Financial Sector Specialist, GFM06), Sabin Raj Shrestha (Sr. Financial Sector Specialist, GFM06), Yeon Soo Kim (Economist, GPV06), Tenzin Lhaden (Operations Officer, SACBT), Robert Carl Michael Beyer (Economist, SARCE), Savinay Grover (Sr. Financial Management Specialist, GGOIS), Vidya Venugopal (Counsel, LEGES), Zoe Kolovou (Consultant, LEGES), Mohan Nagarajan (Senior Economist, GGOIS), Satish Kumar Shivakumar (Finance Officer, WFACS), Vidya Narasimhan (Finance Officer, WFACS), Suiko Yoshijima (Sr. Environment Specialist, GENSA), Rikard Liden (Lead Energy Specialist, GEE06), Richard Olowo (Lead Procurement Specialist, GGOPZ), Peter Darvas (Sr. Economist, GED06), Ali Zafar (Sr. Economist, GFCS1) and Rianna L. Mohammed (Sr. Health Specialist, GHN19). The team gratefully acknowledges the support and guidance provided by Qimiao Fan (Former Country Director, GGEVP), Robert J. Saum (Acting Country Director, SARRP), Manuela Francisco (Practice Manager, GMTSA), Mona Prasad (Lead Economist, GMTSA), Tekabe Ayalew Belay (Program Leader, SACBN) and Sanjay Srivastava (Program Leader, SACBN). Finally, the team would like to express their gratitude to the Royal Government of Bhutan for their collaboration in the preparation of this operation.


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SUMMARY OF PROPOSED FINANCING AND PROGRAM

BASIC INFORMATION

Project ID Programmatic If programmatic, position in series

P168166 Yes 2nd in a series of 2

Proposed Development Objective(s)

This Development Policy Credit series will support the government in its efforts to (i) strengthen the policy framework to improve fiscal management (Pillar 1) and (ii) enhance policies to promote private sector employment opportunities (Pillar 2).

Organizations

Borrower: THE KINGDOM OF BHUTAN

Implementing Agency: MINISTRY OF FINANCE

PROJECT FINANCING DATA (US$, Millions)

SUMMARY

Total Financing 30.00

DETAILS

International Development Association (IDA) 30.00

IDA Credit 30.00

INSTITUTIONAL DATA

Climate Change and Disaster Screening

This operation has not been screened for short and long-term climate change and disaster risks

Overall Risk Rating

Moderate


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. Results

Indicator Name Baseline (2016) Target (2021)

Real expenditure growth 4 percent (2017) 4 percent or lower

Revenues collected under GST

0 (Sales tax was 12.8 percent

of FY2016 revenues excluding

grants)

At least 14 percent of FY2016

revenues excluding grants

Number of budget agencies using e-PEMS 0 All 10 ministries and at least

10 districts

Number of registered bidders in the eGP system 0 At least 700

Number of CSIs under incubation 7 total, o/w female-owned 0. At least 20 total, o/w female-

owned is at least 3

Value of non-cash transactions in the Bhutanese economy BTN 95.4 billion (2017) at least 20 percent increase

Cumulative non-hydro FDI inflows into Bhutan BTN 9.4 billion At least 10 percent increase

Number of entities reporting to CIB 988 At least 10 percent increase

External Commercial Borrowings by the private sector 0 At least US$10 million

Transition to higher secondary schooling Girls (2018) 72.8 percent

Boys (2018) 71.7 percent

Girls 80 percent

Boys 80 percent

Proportion of pregnant women who complete all 8 antenatal care

(ANC) visits 26 percent (2018) At least 30 percent

Percent of Teachers tested by the newly established Teaching

Standards and Teacher Professional Development Program 0 percent At least 10 percent

Energy consumption in the transport sector in tons of oil equivalent

(TOE) 121,218 TOE (2014)

Reduction of at least 10

percent

.


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IDA PROGRAM DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY CREDIT

TO THE KINGDOM OF BHUTAN

1. INTRODUCTION AND COUNTRY CONTEXT

1. The proposed operation is the second in a programmatic series of three operations focused on strengthening the policy framework to improve fiscal management and promote private sector employment opportunities in Bhutan. Bhutan’s state-led hydropower development has yielded an annual average growth rate of 7.5 percent since the early 1980s. Fiscal revenues from hydropower have helped finance investments in physical and human capital and raised living standards. However, hydropower led development has resulted in macroeconomic vulnerabilities. In addition, the private sector in Bhutan is still at a nascent stage and creates few quality jobs. The creation of more and better jobs (hydropower employs only 1 percent of the labor force) will require a stable macroeconomic environment, enhanced private sector competitiveness, and investments in human capital. Some of these objectives will be supported by this operation through reforms in fiscal and public financial management, improved access to finance, support to e-commerce, and investments in human capital. The DPC series is consistent with the World Bank Group Country Partnership Strategy (CPS) for Bhutan for FY2015-19 and the 2017 Performance and Learning Review (PLR) and supports all the three pillars of the CPS: (i) improving fiscal and spending efficiency; (ii) increasing private sector growth and competitiveness; and (iii) supporting green development. It is also well aligned with Bhutan’s 11th (2013-18) and 12th Five-Year Plans, FYP (2018-23). The proposed operation is for US$30 million.

2. Large-scale hydropower development has created macroeconomic vulnerabilities. The massive scale of hydropower projects, relative to the size of the economy, generates large fluctuations in aggregate demand, both during the construction and commissioning phase. The high import content of hydropower construction has resulted in a large external imbalance and high foreign currency debt (mostly in Indian Rupees). Hydro-related contributions to the budget have expanded the public sector and led to pro-cyclical spending. A proliferation of tax expenditures and the nascent non-hydro private sector have limited the tax and production base. The hydropower sector currently accounts for 21 percent of GDP, 18 percent of fiscal revenues and 29 percent of exports.

3. In addition, state dominance along with other factors have inhibited the growth of a vibrant job-creating private sector. Given the capital-intensive nature of the country’s primary growth driver and extensive use of foreign labor in hydropower construction, the structure of employment remains overwhelmingly agrarian, accounting for about 60 percent of the jobs in the private sector. This is also reflected in a lack of job opportunities for youth, for whom the unemployment rate is 12 percent. Bhutan’s small domestic market, sparse population, landlocked geography and mountainous topography have inhibited private sector development. It also led the government to create commercially oriented state-owned enterprises (SOEs) that currently operate in the manufacturing, energy, financial, and other sectors. The private sector is also constrained by skills shortages, limited access to foreign markets, challenges of connectivity, and limited access to finance.

4. Despite the challenges, Bhutan has seen significant poverty reduction. The official poverty headcount declined from 23.2 percent in 2007 to 12 percent in 2012, and then further to 8.2 percent in 2017. Extreme poverty, measured at US$1.90 per day, fell below 2 percent in 2017. Poverty reduction was likely driven by improvements in agricultural productivity and better prices of cash crops. However, poverty is highly concentrated in rural areas, and there is wide variation in poverty across districts. Bhutan


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performs relatively well in shared prosperity, measured as the per capita consumption growth of the bottom 40 percent, though progress has slowed down in recent years: between 2007 and 2012, the consumption growth of the bottom 40 percent grew by an annualized rate of 5.2 percent, but the consumption growth rate fell to 2.6 percent between 2012 and 2017. This stands in contrast to the acceleration of average consumption growth across all households from 4.2 percent during 2007-2012 to 4.8 percent during 2012-2017. Despite large improvements across broad measures of monetary and non-monetary welfare, vulnerability is high, partly because rural households are exposed to various uninsured risks.

5. The current DPC series will help the government address some of the challenges faced by the country. The first pillar supports reforms that will strengthen macroeconomic management, domestic resource mobilization and public financial management. The second pillar supports measures which will improve access to finance, facilitate trade and investment and enhance skills and human capital. This DPC series also supports the government’s efforts to ensure a sustainable economic growth model by promoting gender equality policies and climate change initiatives. In addition, the World Bank administered Public Financial Management Multi-Donor Fund (PFM MDF) is providing technical assistance on key PFM reforms based on the 2017 PFM Reform Action Plan. The International Monetary Fund (IMF) is also providing technical assistance on PFM reforms including the legal framework of the Goods and Services Tax (GST).

6. There has been significant progress in implementing reforms supported by the first operation. Pillar I of DPC1 supported parliamentary approval for the establishment of the stabilization fund and was followed by an allocation of BTN 100 million as seed money to operationalize the fund. In addition, the rules and regulations to govern the fund have been established (supported by DPC2). The World Bank is also providing technical assistance to help it frame the fiscal rules which will be supported in DPC3. Following Cabinet approval to introduce the GST in DPC1, a GST design paper was approved by the cabinet of the new government (which assumed office in November 2018) and the Ministry of Finance (MoF) has approved the draft GST bills (in April 2019). The government is currently undertaking an assessment of the distributional impacts of GST introduction and is also organizing consultations with stakeholders.

7. Good progress has also been made under the second pillar of DPC1. The operation supported the operationalization of the business incubation centers for cottage and small industries (CSIs). The first incubator was established in July 2018 and currently houses 25 entrepreneurs. Since Cabinet approval of the Renewable Natural Resources (RNR) Marketing Policy for agricultural products, an action plan to transform the sector from subsistence-based to commercial and market oriented was adopted and is currently under implementation. The amendments to the credit information bureau (CIB) rules, supported by DPC1, has enabled the collection of additional data from nonfinancial institutions and microfinance institutions. Furthermore, two telephone companies and one commercial bank have been licensed as E-money institutions, following the Royal Monetary Authority (RMA) Board approval of E-money issuer Rules and Regulations. By February 2019, there were 47,850 users of mobile banking. The International School Guidelines are under implementation while the Energy Efficiency and Conservation Policy still requires cabinet approval (Annex 5).

8. Parliamentary elections and the transition to a new government delayed progress on DPC2 but the new government remains committed to the reforms supported by this DPC series. Bhutan had an interim government from May to October 2018 which was not authorized to undertake key reforms or take strategic decisions. Even after the new government assumed office in November 2018, it took time to settle in and familiarize itself with ongoing initiatives and align them with their own priorities. As a result,


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progress on DPC2 slowed down and has resulted in some changes to the policy and results matrix and some backloading on reforms. Despite these changes, program development objectives, pillars and reform areas remain relevant. The new government has expressed its firm commitment to the reforms supported by this DPC series and has started making progress on key reforms. In addition, the World Bank will provide technical assistance to the government to ensure that all policy reforms supported by DPC3 are completed on time. The political environment is stable but maintaining reform momentum will be crucial.

9. The operation faces moderate risks. Among the risk categories, (i) macroeconomic, (ii) sector strategies and policies, (iii) fiduciary, and (iv) stakeholder risks are deemed moderate, while environmental and social risks are low. The political and governance risk, technical design risks and institutional capacity risks are substantial. This is primarily because there is a new government in office which is in power for the first time; there has been backloading of reforms because of the elections; some of the reforms supported by the operation are complex in nature and the government has weak institutional capacity. Risk mitigation includes strong government ownership of these reforms. In addition, the World Bank’s existing and planned engagements will support reform implementation, focus on capacity development and foster greater coordination across implementing agencies.

2. MACROECONOMIC POLICY FRAMEWORK

10. Bhutan is a hydropower driven economy and the sector has significant implications on macroeconomic performance. Drained by the watershed of the Brahmaputra river basin, Bhutan has considerable hydropower generation potential, estimated at 30,000MW. So far, 1,606 MW has already been constructed and another 3,658 MW is under construction and is scheduled to be completed by 2023/24. The sector has contributed through higher growth, fiscal revenues and exports. Growth gets a boost both during the construction and on streaming of the hydropower projects. All surplus hydroelectricity is exported to India which is nearly 70 percent of total hydropower generation in Bhutan. Hydro-related revenues flow into the budget in the form of royalties, one-time profit transfer when a project is handed over to the government of Bhutan, and corporate income taxes and dividends from the Druk Green Power Corporation Limited (DGPC, a 100 percent government owned state-owned enterprise, SOE). However, expenditure on hydropower projects are not included in the budget and therefore do not impact the fiscal deficit. They are however a part of the public debt stock. In addition, significant hydropower investment in the small economy has resulted in a saving-investment imbalance with high external deficits and debt.

11. Bhutan shares a special relationship with India. The hydropower projects are financed through commercially priced loans and capital grants from India, on average, in the ratio of 70:30. However, in recent years, the share of loans has gone up. The hydropower projects are implemented under an intergovernmental agreement between Bhutan and India in which the government of India covers both financial and construction related risks to the projects and buys surplus electricity at a price reflecting cost plus a 15 percent net return. In addition, debt service begins only after the projects are on streamed. This arrangement has supported debt sustainability in Bhutan. The government of India also provides grants to finance a part of the spending undertaken in each FYP. These grants flow into the budget and are linked to the progress in implementing the FYP projects. Imports from India are not taxed because of the bilateral free trade agreement between the two countries. Therefore, despite very high imports linked to the construction of hydropower projects, import duty collections are negligible in Bhutan.


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12. State owned enterprises play a significant role in Bhutan’s economy. Their contributions, through dividends and taxes, accounted for more than 40 percent of the government’s revenues in 2016. There are 38 SOEs which are concentrated in the financial and energy sectors (especially hydropower), but also operate in areas such as manufacturing and telecommunications. Bhutan has a centralized SOE ownership arrangement whereby the Ministry of Finance (MoF) is the sole shareholder of all SOEs. Most SOEs in Bhutan are profitable, but this performance is largely driven by the energy and financial sectors and the lack of competition. Due to the small domestic market and nascent private sector, SOEs are significantly relied on to provide essential goods and services.

2.1. RECENT ECONOMIC DEVELOPMENTS

13. After slowing down to 4.6 percent in FY2018 (2017/18), economic growth is likely to accelerate to 5.5 percent in FY2019. The deceleration in FY2018 was primarily because of lower hydropower production on account of the maintenance work required in the Tala hydropower project (which accounts for more than 60 percent of total hydroelectricity production in Bhutan), lower than normal rainfall, and delays in the construction of the other mega hydro projects (Annex 7). In FY2019, on the supply side, growth has largely been driven by the services sector, especially, hotels and restaurants, retail trade and transportation, and a pickup in hydropower production from last year (as maintenance work on Tala progressed). On the demand side, the main contribution has come from the pickup in net exports, with higher exports from Tala and lower hydro related imports because of the completion of the Mangdechhu hydropower plant (a 720MW power plant which will begin production in 2019). The other two mega hydro projects which are under construction (Punatsangchhu I and II) are likely to be completed by 2023/24.1 As in past years, the hydropower sector continues to have a significant impact on the Bhutanese economy.

14. Bhutan’s inflation is strongly correlated with that of India. With 80 percent of Bhutan’s imports coming from India and the exchange rate pegged to the Indian rupee, Bhutan’s consumer price index (CPI) is closely linked to India’s. The CPI in Bhutan slowed to about 3 percent in the first half of FY2019 and remained at 3 percent, year-on-year, in February 2019. The slowdown in inflation was largely driven by lower food prices. Bhutan’s exchange rate policy of maintaining the peg to the Indian rupee has served it well. Since India is the main trading partner, inflation rates between the two countries are strongly correlated. This has helped keep the real effective exchange rate stable. With the appreciation in the Indian Rupee against the USD in recent months, the Bhutanese Ngultrum also appreciated to BTN 69 to a USD in April 2019.

15. The current account deficit (CAD) remains high but has started narrowing. The CAD is likely to narrow from 18.4 percent of GDP in FY2018 to about 15 percent in FY2019. The decline is primarily because of lower import of capital goods as the Mangdechu power plant nears completion and the construction of Puna I and II gets delayed. In addition, no new public investment programs were initiated by the government in the first half of the year, also reducing imports. Along with a decline in imports, exports from the existing Tala project have picked up during FY2019 as the maintenance work progressed. In addition, the number of international tourists (excluding regional tourists) was 31,400 in the first half of FY2019, higher by 8 percent compared to the same period in FY2018. The current account deficit is mostly financed by capital flows from India for the hydropower projects through a combination of grants and

1 Punatsangchhu I and II are large hydropower plants under construction in Bhutan. Their completion has been delayed because of geological complexities.


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loans. Foreign exchange reserves remain comfortable at nearly US$ 978 million in December 2018, providing a cover of nearly 10.1 months of imports of goods and services.

16. The fiscal deficit is likely to reduce from 1.4 percent of GDP in FY2018 to 0.7 percent in FY2019. The low fiscal deficit in FY2018 was primarily because of strong revenue performance. Tax revenues increased because of an increase in the tax base for corporate income tax (CIT) and increased CIT collections from SOEs. In addition, non-tax revenues also increased because of the change in the rules related to valuation and collection of sales taxes on vehicles. In FY2019, the fiscal deficit is likely to reduce further to 0.7 percent of GDP because of lower spending. In the first half of FY2019, capital spending fell, as no new capital projects were implemented due to the elections. Revenues are also lower in 2018/19, particularly the grants from India, because they are linked to overall spending by the government for the implementation of the FYP projects. Indirect tax revenues also fell in the current year because there are no more excise duty refunds from India. On alcohol and other excisable products that were exported from India to Bhutan, the government of India collected excise duties and transferred them to the government of Bhutan. With the introduction of GST in India, this arrangement has come to an end because of removal of excises on exports from India. Since these revenues are transferred with a delay of one year, the impact is evident in the current year. As in other countries, non-tax revenues in Bhutan vary depending on the dividends received from SOEs and they were also lower in the current year. Public debt as a share of GDP is broadly unchanged at about 110 percent of GDP in FY2019.

17. Bhutan’s financial sector is dominated by banks and remains sound but requires strengthened supervision. Credit to the private sector grew by 17.8 percent in FY2018, similar to the past two years. In the first half of FY2019, it grew by about 15 percent. Credit growth is managed through macroprudential instruments and the RMA sterilizes excess liquidity. Gross non-performing loans (NPLs) stood at 10.4 percent in end-2018, adversely affecting the profitability of financial institutions. The banking sector however has adequate cushion to absorb potential losses with capital adequacy of 15 percent, provisioning at over 70 percent, and liquidity at over 22 percent. However, there is a need to strengthen prudential oversight and to potentially re-calibrate the role of the state in the financial sector. The RMA has introduced the National Financial Inclusion Strategy 2018-23. The main building blocks of the strategy include the provision of appropriate financial products and services, boosting access to finance, facilitating economic growth through financing of cottage and small industries (CSIs), and increasing financial literacy and consumer protection.

Table 1. Key Economic Indicators 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22

(act.) (act.) (act.) (act.) (est.) (pro.) (pro.) (pro.) (pro.)

Real Sector Annual percentage change, unless otherwise indicated

Real GDP 4.0 6.2 7.4 6.3 4.6 5.5 7.2 5.9 5.1

GDP per capita (in US$) 2,433 2,633 2,728 2,972 3,243 3,387 3,762 4,068 4,465

Agriculture 2.4 3.7 4.4 3.6 4.1 4.4 4.2 4.4 4.4

Industry 3.8 6.0 7.6 4.6 1.1 3.9 7.1 3.8 2.9

Manufacturing 1.8 6.7 3.4 4.0 8.0 10.3 10.3 10.3 11.7

Non-manufacturing (including hydro) 4.4 5.8 8.6 4.7 -0.6 2.2 6.2 1.9 0.0

Services 5.0 8.4 9.2 8.2 7.4 9.6 11.1 8.9 6.9

Unemployment (ILO definition) 2.8 2.5 2.4 2.3 2.2 - - - -

CPI, average 9.6 6.7 3.3 4.3 3.7 3.0 3.8 4.2 4.5

GDP deflator 6.7 5.4 4.1 5.0 5.6 5.4 4.8 5.2 5.5

Fiscal Accounts Percent of GDP, unless otherwise indicated

Revenue and grants 33.3 27.9 30.5 27.0 29.1 19.9 29.0 27.3 25.0

Hydropower 3.9 3.2 3.4 3.1 3.8 3.6 7.3 4.3 3.9

Non-hydropower 29.4 24.7 27.2 23.8 25.3 16.3 21.7 23.0 21.0


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Expenditure 29.8 27.3 31.0 30.1 30.3 20.6 30.4 28.8 25.9

Fiscal balance 3.8 1.5 -1.1 -3.3 -1.4 -0.7 -1.5 -1.5 -0.9

Primary balance 5.7 3.1 0.4 -2.1 -0.3 0.1 -0.6 -0.2 0.3

Selected Monetary Accounts Annual percentage change, unless otherwise indicated

Credit to the private sector 6.4 14.0 14.7 15.4 15.2 17.2 16.7 15.3 15.3

Balance of Payments Percent of GDP, unless otherwise indicated

Current account balance -26.8 -27.2 -30.8 -23.0 -18.4 -14.9 -12.5 -9.0 -5.3

Merchandise exports (% change, y/y) 9.8 9.4 -8.9 12.5 5.4 16.5 13.1 11.0 6.9

hydropower exports -0.7 10.3 -6.4 22.4 -14.2 15.9 21.0 13.4 1.4

non-hydropower exports 15.4 9.1 -10.0 7.7 16.0 16.7 10.0 10.0 10.0

Merchandise imports (% change, y/y) 12.7 9.8 12.1 -3.2 -2.4 -2.1 4.6 3.6 1.7

Foreign direct investment 1.3 0.3 0.6 -1.0 0.1 0.3 0.5 0.5 0.4

Gross reserves (months of imports, GNFS)

8.2 7.4 8.3 8.7 9.5 10.5 12.5 13.7 15.3

Total public debt 96 96 114 109 108 110 108 102 95

External public debt 94 94 111 102 103 104 100 91 83

hydro debt 61 68 81 79 76 80 75 70 65

non-hydro debt 33 27 30 23 27 24 25 21 17

Domestic public debt 3 2 3 6 5 6 8 11 13

Memorandum items

Nominal GDP, US$ Million 2,612 2,860 2,956 3,244 3,523 3,646 4,031 4,351 4,755

Exchange Rate (Nu/USD), FY average 61 62 66 66 65 71 70 70 69

Source: Government of Bhutan and WB staff estimates.

2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

18. Economic growth is projected to average 6 percent a year over the medium term, supported by the services sector and higher net exports. Growth will spike in FY2020 following the commissioning of the Mangdechhu hydropower project and then gradually slow down to between 5 and 6 percent, a year. In the services sector, the key drivers are likely to be hotels and restaurants, retail trade and transportation, underpinned by tourism. With the operationalization of the Mangdechhu hydropower project in 2019, exports are projected to increase, while imports remain moderate due to delays in the construction of Punatsangchhu I and II. In addition, hydropower production and exports from the Tala project will also increase with the completion of the maintenance work. After a decline in FY2019, increased spending by the government on capital projects will also support growth (Table 1).

19. Inflation is likely to reflect price developments in India and the RMA is taking steps to strengthen its monetary and exchange rate policies. The inflation rate is expected to pick up in the near future with an increase in food prices in India and higher fuel prices. The exchange rate peg with the Indian rupee has anchored inflation and facilitated Bhutan’s trade relations with India. To ensure coordination between monetary and fiscal policy, the Secretaries of the Ministry of Finance and the Gross National Happiness Commission (GNHC) act as members of the Board of Directors of the RMA. To strengthen the conduct of monetary policy, the RMA will be enhancing its liquidity management and forecasting capabilities, establishing an interest rate corridor (IRC) and supporting the development of the interbank market. The IRC will be supported by standing marginal lending and deposit facilities. These will help to signal the monetary policy stance to the market, maintain an adequate level of liquidity in the banking system, allow banks to enhance their treasury function, and will support the development of the domestic money market.

20. The current account deficit is projected to narrow further over the medium term. The reduction in the CAD is expected to be driven primarily by higher exports with the on streaming of the Mangdechu project. In addition, imports are likely to remain moderate. The lower CAD will help reduce external debt


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levels. The CAD will continue to be financed mostly by capital flows from India and the surplus in the overall balance of payments is expected to raise international reserves.

21. With a pickup in spending, the fiscal deficit is expected to increase from the current level but will remain low over the medium term. Revenue growth over the projected period will be supported by royalties from Mangdechhu, higher corporate income taxes from Druk Green Power Corporation (DGPC), and the introduction of GST in FY2021. In addition, the government is also introducing the green tax on fuel from FY2020. Indirect taxes will be lower than in the past because of the discontinuation of excise duty refunds from India. Non-tax revenues will spike in FY2020 due to the on streaming of Mangdechu. Spending is also likely to increase over the medium term as the government undertakes new public investment programs in line with the 12th FYP.2 Current expenditures are projected to increase with higher spending on the maintenance of hydropower plants and an increase in public sector wages (based on the recommendations of the Fourth Pay Commission). The increase in wages has been estimated at BTN 4-5 billion a year and a part of the higher revenues from the Mangdechu project royalties will be used to finance the increased wages (Table 2). In FY2022, in line with the spending projected in the 12th FYP, capital spending will be lower and there will be a corresponding decline in the grants from India. The dynamics of the non-hydropower fiscal deficit reflect the pro-cyclical fiscal policy stance of the government and it is also influenced by the grants from India. The difference between the average non-hydro deficit in the past (2013/14 to 2017/18) and the projected non-hydro deficit (2019/20-2021/22) is almost entirely because of the reduction in the grants from India. Nevertheless, the non-hydropower deficit is high. Therefore, efforts aimed at increasing own tax revenues through the GST and reduction in expenditure surges through the fiscal rules will be crucial. Public debt as a share of GDP is projected to decline because large amortizations associated with hydropower investments begin with operationalization of the plants and are the main determinant of the debt trajectory.

22. Fiscal policy in Bhutan has generally been prudent and deficits have been at around 3 percent of GDP or lower. In events of unexpected changes that threaten macro-fiscal sustainability, the budget can be revised, as stipulated in Paragraph 57 of the 2007 Public Finance Act. In response to the introduction of GST in India, the Ministry of Finance in Bhutan changed the rules on the valuation, collection and deposit of the sales tax on vehicles (supported by DPC1). On the budget allocation, the government strikes a good balance between provision of public services and economic development. The Government Performance Management System defines targets and objectives and serves as the basis of budget allocation amongst the agencies. Going forward the government plans to adopt fiscal rules and to improve spending efficiencies through strengthened public financial management (supported by this operation). Nevertheless, continued widespread tax exemptions, informality, and the narrow tax base will continue to hinder the effectiveness of fiscal policy.

Table 2. Selected Fiscal Indicators (in percent of GDP) 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22


Resources 33.3 27.9 30.5 27.0 29.1 19.9 29.0 27.3 25.0

Taxes 14.4 14.6 14.1 13.5 15.4 13.0 13.1 14.2 14.2

Direct taxes 9.9 9.2 8.7 7.9 9.2 8.3 9.4 9.9 10.2

hydropower 2.1 1.7 1.9 1.8 1.3 1.2 1.1 1.4 1.3

non-hydropower 7.8 7.5 6.8 6.1 7.9 7.1 8.4 8.4 8.9

Indirect taxes 4.5 5.4 5.5 5.6 6.3 4.7 3.6 4.3 4.0

sales tax/GST 1.9 2.4 2.5 2.4 2.5 2.2 2.2 3.1 3.1

2 It is important to note that all hydro-related capital expenditures are off-budget and government capital expenditure pertains to the non-hydro sectors only.


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Non-tax revenues 6.3 5.4 5.8 5.3 5.5 4.6 9.1 5.5 5.0

hydropower 1.8 1.5 1.4 1.3 2.5 2.4 6.2 2.8 2.6

non-hydropower 4.4 3.9 4.4 4.0 3.0 2.2 2.9 2.7 2.4

Grants 12.7 7.9 10.6 8.1 8.1 2.3 6.8 7.6 5.8

Expenditure 29.8 27.3 31.0 30.1 30.3 20.6 30.4 28.8 25.9

Current expenditure 16.0 16.7 16.3 15.1 15.0 15.0 18.1 17.0 15.6

interest payments 1.9 1.6 1.5 1.3 1.2 0.8 0.9 1.3 1.3

salary and allowances 6.8 7.4 6.7 5.9 5.6 6.1 6.9 6.3 5.8

Capital spending 14.8 12.3 15.5 16.2 16.4 5.6 12.3 11.8 10.3

Fiscal balance 3.8 1.5 -1.1 -3.3 -1.4 -0.7 -1.5 -1.5 -0.9

Non-hydropower fiscal balance -0.4 -2.6 -3.8 -6.2 -5.0 -4.3 -8.7 -5.8 -4.9

Financing (net) -0.9 -0.9 -0.9 0.3 0.1 0.8 0.7 -1.8 -1.7

External borrowing (net) 2.1 -0.2 -2.7 -3.1 1.2 -0.9 -1.9 -5.7 -4.6

Domestic borrowing (net) -3.0 -0.6 1.8 3.4 -1.1 1.7 2.6 3.9 2.9


23. The external debt of Bhutan increased significantly over the past two decades. As of December 2018, external public debt stood at 103 percent of GDP. The borrowings by state-owned enterprises for hydropower accounted for about 77 percent of external debt. Nearly 90 percent of hydro external debt is from India with interest rates at 9-10 percent for Punatsangchhu I and II, and Mangdechhu projects.3 Also, hydro construction costs are swelling, further increasing indebtedness. The delays and cost escalations raise concerns on growth prospects and revenue collections. However, there is a contract between the Indian and the Bhutanese government whereby India will cover both the financial and construction risks related to the hydro projects and buy the surplus electricity at cost plus 15 percent net return. Therefore, as long as the 15 percent net return is secured, hydropower external debt will remain sustainable.

24. The 2018 Debt Sustainability Analysis (DSA) concluded that Bhutan’s risk of external debt distress is moderate. The DSA observes that Bhutan’s rapid hydropower development has led to a substantial buildup of external debt, with external debt ratios breaching all indicative thresholds and projected to continue doing so for several more years. At the same time, the DSA recognizes key factors mitigating the risk, particularly that the large share of external debt is linked to hydropower project loans from the Government of India and that these loans are backed up by the inter-governmental contract between the two countries which guarantees returns. In addition, the hydro debt is denominated in Indian rupees and export proceeds accrue in Indian rupees, thereby reducing exchange rate risks. External debt outside hydropower projects is primarily from concessional loans from multilateral financial institutions and bilateral donors (Austria, Denmark and Japan). Domestic debt to GDP was low at 5 percent in 2017/18 (Table 3 and Figures 1 and 2).

25. To manage public debt, the government adopted the 2016 Debt Policy which imposes ceilings on various debt indicators. The approval of the Debt Policy in August 2016 was a major step to ensure debt sustainability (supported by the previous DPC series). The debt policy imposed a ceiling for non-hydro debt at 35 percent of GDP on average in a 5-year period. The debt policy also mandates the formulation of a Medium-Term Debt Management Strategy and regular debt sustainability analyses. To support the implementation of the debt policy, the Debt Management Unit was formally transferred to the Department of Macroeconomic Affairs (DMEA), which coordinates all policies relating to macroeconomics. The DMEA is responsible for ensuring that public debt is sustainable and is contracted at low costs and with a reasonable degree of risk. It also recommends debt thresholds and is responsible for preparing the medium-term debt management strategy. In addition, it advises the government on on-

3 Interest rates differ depending on projects. For example, interest rate for the Chhukha project was 5 percent and the Kurichhu project was 10.75 percent.


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lending, loan guarantees, public private partnerships (PPPs), dividends and divestment proposals. A quarterly debt report is produced and shared with key stakeholders, though the report is not publicly available.

Table 3. BoP (in USD millions) 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22


Financing Requirements 626 643 711 690 625 634 431 446 375

Current Account 491 551 654 542 490 408 386 313 252

Loan Repayment 135 92 57 147 135 226 45 133 122

Financing Sources 626 643 711 690 625 634 431 446 375

Capital Transfer 337 291 288 361 338 311 467 463 423

Foreign Direct Investment 23 6 12 -24 3 9 15 16 17

Loan Borrowings 293 331 572 243 361 310 238 149 144

Change in reserves (+ decrease) -81 39 -160 15 -20 4 -290 -182 -209

Net Errors & Omissions 53 -24 0 95 -56 0 0 0 0


Figure 1: Public Debt Sustainability Analysis Figure 2: External Public Debt Sustainability Analysis

Source: IMF WB DSA 2018.

26. Bhutan’s macroeconomic policy framework is adequate for development policy financing. Despite the delay in completion of the large hydropower projects in recent years, Bhutan’s macroeconomic fundamentals have been sound. Although external debt is high, the intergovernmental contract with India guarantees returns and mitigates risks. Going forward the government remains committed to macro-fiscal prudence as evidenced by its efforts to adopt fiscal rules, implement the GST, improve spending efficiencies through strengthened public financial management (supported by this operation), adopt a debt strategy, and maintain the peg with the Indian rupee. The government is also committed to reforms which will support the non-hydro sectors, many of which are supported by this DPC series (FDI policy, Insolvency Act, credit information bureau, external commercial borrowings and others). Going forward, the key risk stems from further delays in hydropower project implementation / completion, which would also delay the large expected export and revenue payoffs. This risk will partly be mitigated by the strengthening of the tax base, improving PFM systems and the reforms which support the development of the private sector. Going forward it will be important to better manage the flows from the hydropower sector and also widen the production base.

2.3. IMF RELATIONS


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27. The last IMF Article IV review for Bhutan was approved in October 2018. The Article IV Staff Assessment noted the progress made in reducing poverty and the robust growth during the 11th FYP period. It also highlighted the risks to the outlook, primarily from delays in the completion of hydropower projects and the implementation of the GST. It noted the policy challenges related to prudent management of anticipated hydropower revenues and the timely implementation of the GST. The IMF also provides technical assistance which is focused on macro-fiscal management, cash management, GST and e-payments. The proposed DPC operation is consistent with and complements the IMF’s engagement with the government.

3. THE GOVERNMENT PROGRAM

28. The new government’s program is articulated in the 12th FYP which seeks to build a ‘Just, Harmonious and Sustainable Society through enhanced Decentralization’. The 12th FYP for 2018-23 was finalized in January 2019 and focuses on four key areas: (i) A just society, which would require efforts aimed at poverty reduction, creating gainful employment, improving health and education services, strengthening democracy and decentralization, reducing corruption, improving justice services and promoting greater gender equality; (ii) A harmonious society, which would need efforts aimed at preserving and promoting culture, maintaining climate resilience, promoting a caring society, and ensuring happy human settlements; (iii) A sustainable society, which would require efforts aimed at enhancing macroeconomic stability, ensuring economic diversity, ensuring water, food and nutrition security, improving public service delivery, preserving cultural authenticity, and ensuring community vitality; and (iv) Decentralization, which would require empowering local governments and other sub-national bodies. The new government has identified 17 National Key Result Areas (NKRAs) to be achieved over the next five years. These NKRAs are closely aligned with the Sustainable Development Goals (SDGs) and with the nine domains of Gross National Happiness (GNH). These domains include psychological wellbeing, health, time use, education, cultural diversity, good governance, community vitality, ecological diversity and living standards. The hallmark of the 12th FYP is the sharpened focus on decentralization. The other new element in the 12th FYP is the identification of flagship programs to support national priority projects. These projects will help address critical issues related to youth unemployment, water security, and poverty reduction.

4. PROPOSED OPERATION

4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION

29. The proposed operation primarily supports the government in the first and third areas of the 12th FYP which includes efforts to build a just and sustainable society. In building a just society, the proposed operation supports improvements in the education and health sectors, and the development of a private sector which will help create jobs and contribute to sustainable poverty reduction. Towards a sustainable society, the proposed operation supports macroeconomic stability, and improvements in nutrition. Among the GNH domains, the operation supports the areas of education, health, good governance and living standards. Reforms supported in the education and health sectors will help strengthen human capital and will have a positive welfare effect. In addition, improvements in public financial management will support good governance. The operation also supports the development of the private sector which will help address, in part, youth unemployment, one of the areas identified for the flagship programs. Many of the reforms will have a positive effect on poverty reduction, in the medium to long term. On the NKRAs, the first pillar is aligned with NKRA 1 on ‘macroeconomic stability ensured’. The second pillar is


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aligned with NKRA 2 on ‘economic diversification and productive capacity enhanced’, NKRA 7 on ‘quality of education and skills improved’, NKRA 11 on ‘productive and gainful employment created’ and NKRA 14 on ‘health and caring society enhanced’.

30. The design of this operation includes country-specific lessons from past operations. The 2014 Implementation Completion and Results Report (ICR) on the previous programmatic DPC series included the following lessons: (i) policy reforms need to be underpinned by analytical work as it provides insights on cross cutting issues and improves the quality of technical discussions; (ii) policy based lending needs to be complemented with capacity building; (iii) DPCs need to focus on fewer key areas; (iv) technical assistance needs to be provided to build capacity which will make reforms sustainable; (v) a programmatic DPC series helps maintain reform momentum; and (vi) hands-on real time support is very helpful in implementing reforms. Many of these lessons have been incorporated into the current DPC series. Many of the lessons from the ICR have been incorporated in the current operation: it is underpinned by significant analytical work, capacity building efforts and technical assistance is being provided on most of the reforms, and the DPC series is designed as a programmatic series to maintain reform momentum.

4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS

31. The first operation in the DPC series supported reforms to strengthen fiscal management, promote private sector development and make improvements in the education sector. To better manage large revenue inflows from the hydropower sector, DPC1 supported the creation of the stabilization fund which will be an integral part of the functioning of the fiscal rules (to be supported by DPC3). In addition, to increase tax revenues and build fiscal space, the cabinet approved the introduction of the GST and the new cabinet recently endorsed the GST concept. To support further development of the cottage and small-scale industries, the government approved the establishment of the Business Incubation Center which is already functional. In addition, the renewable natural resources marketing policy was followed by an action plan and is under implementation. The approval of the regulations on the credit information bureau (CIB) and e-money issuer, has helped improve access to finance through increased availability of credit information and the provision of mobile banking and payment services. DPC1 also supported the adoption of the international school guidelines which will help with the introduction of best international practice in education. Lastly, the ministerial approval of the National Energy Efficiency and Conservation Policy will encourage general improvements in the energy performance standards of the major economic sectors (Annex 4).

32. Building on the progress achieved in the first operation, DPC2 aims at furthering many of these reforms. The approval of the governance framework of the stabilization fund, supported by DPC2, is crucial for effective functioning of the fund. To enhance spending efficiencies, the current operation supports electronic payments by the government and improved procurement rules and regulations. Building on the measures undertaken to support private sector development, DPC2 supports the implementation of e-payments which will support e-commerce. Following the amendments to the CIB regulations, DPC2 supports the adoption of the supervision manual for CIBs which will ensure effective functioning of the bureau. DPC2 also supports further reforms in the education and health sectors which will eventually help build skills and human capital.

33. Technical assistance by Development Partners will be crucial for reform implementation and sustainability. Implementation capacity in Bhutan is limited and the government relies on development partners for technical assistance and capacity building. In addition to the World Bank, which is providing technical assistance in most of the areas supported by the DPC series, the government also works closely


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with the Asian Development Bank and the IMF in many of the areas supported by the DPC series. The World Bank administered Public Financial Management Multi-Donor Fund is providing technical assistance on key PFM reforms based on the 2017 PFM Reform Action Plan. The IMF is also providing technical assistance on PFM reforms including the legal framework of the GST. In addition, the World Bank sector teams are providing technical assistance in their respective areas.

34. The proposed operation is structured under two pillars. The first pillar aims to strengthen the policy framework to improve fiscal management. Reforms supported under this pillar in DPC2 include the establishment of the governance framework for the stabilization fund, improvements in public financial management and strengthening of the public procurement system. The second pillar aims to enhance policies to promote private sector employment opportunities. Reforms supported under this pillar in DPC2 include operationalization of the Global Interchange for Financial Transactions (GIFT) which will facilitate e-payments and support e-commerce, approval of the supervision manual for the credit information bureau, and reforms in the education and health sector to strengthen human capital and improve skills.

Pillar 1: Strengthening the policy framework to improve fiscal management

35. The hydropower sector will continue to play a dominant role in Bhutan’s economy in the medium to long term. The sector accounts for 18 percent of the government’s revenues. The Public Finance Act (2007) stipulates that the cost of recurrent expenditure must be met from the internal resources of the country. However, this rule does not constrain recurrent spending when there is a spike in revenues. These spikes happen every time a large hydropower project is on streamed leading to pro-cyclical fiscal policy and fluctuations in aggregate demand. Consequently, adequate tools to manage aggregate demand are critical. The completion of the 3 large hydro projects (Mangdechu in 2019, and Puna 1 and 2 by 2023/24) will generate significant cashflows for the government in the near to medium term. Therefore, an appropriate framework to manage these flows is critical to ensure proper macroeconomic management. With the objective of effectively managing these cash flows, the government established the stabilization fund which was supported by DPC1.

Fiscal Management:

DPC2, Prior Action 1: The Cabinet has approved the governance framework of the stabilization fund.

DPC3, Trigger 1: The Cabinet approves the fiscal rules. DPC3, Trigger 2: The GST Act is gazetted.

36. The current operation supports the establishment of the governance framework for the stabilization fund. This framework defines the rules for the operation of the fund which include: (i) sources of revenue for the fund; (ii) conditions for the use of fund resources; (iii) procedures for transfer to and withdrawal from the fund; (iv) investment policy; (v) governance framework; and (vi) internal control systems and oversight mechanisms. The approved framework will help set the basis for the operationalization of the fund. Initial seed money has already been transferred and further inflows will be decided along with the fiscal rules which are currently being framed.

37. The adoption of fiscal rules will help promote counter-cyclical fiscal policies. The operationalization of each mega-hydropower project leads to a jump in revenues. For example, the commissioning of Tala hydropower in 2007 resulted in a doubling of government revenues, leading to calls for sharply higher spending. However, debt repayments also begin one year after commissioning and there is a need to lean against the pro-cyclical effects of hydropower related revenues. Historically, the commissioning of hydropower has enabled a fiscal surplus for one or two years, before deficits re-emerge, highlighting the


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need to ensure the sustainability of spending trajectories. The adoption of fiscal rules, supported by DPC3, will help the government implement counter-cyclical fiscal policies, thereby reducing fluctuations in aggregate demand and will also help build fiscal buffers.

38. To further consolidate its fiscal position, Bhutan needs to strengthen Domestic Revenue Mobilization (DRM). Total revenues stood at about 20 percent of GDP in 2017-18. Income tax, indirect taxes and duties constituted 72 percent of the total revenues (14.3 percent of GDP) during the year and the remainder came from non-tax revenues including dividend, interest on loans from corporations, and others. The country’s DRM faces various challenges. The delays in the completion of the large hydropower projects could potentially lead to foregone revenues of 2 percent of GDP. In addition, tax expenditures through fiscal incentives such as tax holidays and zero rates for goods and services accounts for another 2.6 percent of GDP. The enhancement and consolidation of the tax base in terms of revenue collection, beyond the hydro power sector, has also been challenging.

39. The approval of the GST Bill will help increase revenues and build fiscal buffers. The existing sales tax structure has evolved into tax collection at point of entry into the country rather than at point of sale. Although it is easier to collect taxes at the border as goods are released, it disincentivizes tax administration from enhancing the domestic tax base in a more systematic manner and makes domestically produced goods hard to tax. Indirect taxation will improve with the introduction of the GST in Bhutan. The GST is expected to: (i) enhance the tax base as the tax credit mechanism starts working; (ii) remove economic distortions through the introduction of a single rate; and (iii) ease tax compliance by introducing electronic tax return submission and payment based on self-assessment. The introduction of the GST will replace the existing sales tax and result in improved efficiency in tax collection along with an increase in the collection of domestic revenues by 1 to 1.5 percent of GDP in the first two years after introduction. The government remains committed to moving forward with the adoption of the GST bill, which will be supported by DPC3, with implementation from July 2020.

Public Financial Management:

DPC2, Prior Action 2: The Ministry of Finance (MoF) has issued a notification to rollout the electronic public expenditure management system (e-PEMS) which includes the electronic payment functionality to all budgetary bodies.

DPC3, Trigger 3: The MoF issues an order establishing interconnectivity of new/existing PFM information systems for automated exchange of data.

40. Bhutan was the fifth country in the world to receive the Public Expenditure and Financial Accountability (PEFA) CHECK4 but further improvements in the country’s PFM systems are needed. According to the 2016 PEFA report, the three areas which could be strengthened include transparency; predictability and control in budget administration; and accounting and reporting. The government updated its Public Financial Management (PFM) strategy based on the PEFA results. In addition, enhanced use of Information and Communication Technology (ICT) is a cross cutting theme that can further help the government to bring efficiency and improvements in PFM as the present procurement system is largely paper-based. The government currently uses many stand-alone systems to cover various aspects of PFM. Given the limitations in some of these systems and that they are not integrated, the government has not been able to achieve an integrated financial management system.

4 PEFA CHECK is a mechanism instituted by PEFA Secretariat for confirming the adequacy of the quality assurance processes used in planning and implementing a PEFA assessment. The objective is to increase users’ confidence in the findings of a given PEFA assessment and confirm that the assessment contributes to a pool of reliable information on PFM system performance.


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41. The government introduced a public expenditure management system (PEMS) in 2009 as a home-grown system with basic functionalities in expenditure management. Since then, improvements have been made to strengthen the PEMS but more is needed to strengthen payment modalities. On payments, the current system exhibits problems including: (a) delays in the manual cheque issuing system for payments processed in PEMS; (b) difficulties in preparing accurate and timely bank reconciliation statements because of manual systems; and (c) difficulties in timely reporting.

42. The adoption of electronic (e)-PEMS, supported by DPC2, will help address the challenges associated with payment modalities. To address payment related problems, the government has been working to revamp the existing PEMS system to include the electronic payment or e-Payment functionality and thereby introduce the e-PEMS. The introduction of e-PEMS is a step towards creation of an integrated financial management system (IFMIS) and an e-PEMS interconnected with other PFM systems which include revenue management, procurement and budget. The e-PEMS is expected to significantly improve the efficiency in the overall government financial management system with the following features: (a) real-time digital payment for all government payments; (b) direct transfer of government payments to suppliers / employees’ bank account; (c) generation of real-time government consolidated account position and automated bank reconciliation process; and (d) production of real-time financial information to support improved decision making process. The e-Payment or electronic payment system will be a cashless payment modality, involving an electronic medium for the transfer of payments between government (ePEMS in this case) and banking systems (i.e., Bank of Bhutan and Royal Monetary Authority), with no physical or human intervention during the payment settlement process. This will improve efficiency and reduce corruption. To rollout the e-PEMS, the Ministry of Finance issued a notification to all budget agencies (includes 10 ministries, 20 districts and 205 sub-districts).

43. The DPC series will also support the integration of the various PFM systems. The government is working towards an integrated public financial management system. DPC3 will support these efforts of the government which will include interconnectivity between PEMS and the Revenue Administration Management Information System (RAMIS) and thereafter the civil service system, multi-year rolling budget (MYRB), performance management system and the procurement system. An integrated PFM system will support greater efficiency, transparency and accountability and ultimately result in improved quality of spending.

DPC2, Prior Action 3: The MoF has approved amendments to the existing Procurement Rules and Regulation 2009, including environmental considerations.

DPC3, Trigger 4: The Cabinet approves the new Public Procurement Bill.

44. Bhutan has a functioning regulatory framework for public procurement, but challenges remain. Bhutan’s Public Procurement system is open to competition, has checks and balances and is audited. However, there is no law to buttress the 2009 Procurement Rules and Regulations which are currently governed by the Public Finance Act of 2007. This has resulted in weak enforcement of procurement rules, putting at risk the efficiency and transparency of budget planning and execution.

45. To strengthen public procurement, the government has amended the 2009 procurement rules and regulations to introduce innovations and flexibility. The amendments will help modernize the procurement system, update standard bidding documents and provide for strategic issues such as environmental considerations and the use of electronic government procurement (eGP). The amended rules will strengthen the public procurement system which will result in more cost-effective use of public


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money. The following key features of the amended procurement rules will help improve spending efficiency and transparency: (i) mandatory market research and analysis, for goods contracts valued at $0.3 million or more and works contracts valued at $0.7 million or more, will make the procurements fit-for-purpose, and more effective; (ii) harmonized Standard Bidding Documents will increase the efficiency of inviting bids and enhance transparency; (iii) higher procurement thresholds requiring Tender Committee approvals will make it more efficient to process low value procurements; (iv) mandatory use of eGP for public procurement will enhance the automation and audit trail capabilities, increase transparency of the public procurement system and support spending efficiency through reduced transaction costs and lower corruption. The mandatory use of eGP will cut on the use of paper and travel for bidders to submit bids or to sign contracts. Furthermore, eGP would be used in monitoring the appropriateness of climate change considerations of technical specifications used for procuring equipment, goods and materials and also to confirm the specifications of the equipment, goods and materials offered by the winning bidders; (v) the requirement to specify environmentally friendly equipment, goods, or materials when preparing bidding documents will address environmental concerns and thereby promote green/ sustainable procurement. This requirement obligates specialists conducting procurement to draw from relevant environmental policies and use appropriate technical specifications of equipment, goods and materials that are resource efficient, produce less waste and come with improved recyclability to help address concerns on climate change. Where national standards do not exist or are inappropriate, international standards may be used to ensure environmental sustainability and to address concerns on climate change; and (vi) increase in the margin of preference for Bhutanese contractors from 5 percent to 10 percent will promote compliance with Bhutanese standards for green/sustainable procurement and will also address concerns on climate change which are embedded in the national standards. The national standards include, among others, climate change provisions prohibiting the use of ozone depleting substances (ODS), ODS production, products containing or made with ODS and ODS using equipment.5 The national environmental assessment process includes provisions which require the use of renewable resources and clean technologies, the water regulations includes inter alia, provisions to prevent water waste and the waste prevention regulations require efficient collection, segregation, treatment storage, transportation, reduction, reuse, recycling and safe disposal of solid, liquid and gaseous wastes.6 In addition, promoting use of local goods/products will minimize transportation, which contributes to mitigating climate change. The World Bank is providing technical assistance on procurement issues. The amended procurement rules are aligned with international good practice and will be consistent with the proposed new procurement law, to be supported by DPC3.

46. The inclusion of environmental provisions in the procurement rules and regulations will be beneficial as Bhutan is vulnerable to climate change. Bhutan is exposed to hydro-meteorological hazards as it lies in the seismically active eastern portion of the Himalayan Arc. Some of the major hazards facing Bhutan include glacial lake outburst floods (GLOFs), flash floods, riverine floods, landslides, landslide dam outburst floods, cloudbursts, forest fires, windstorms and earthquakes. Extreme events cause significant losses to the economy. Between 1994 and 2011, approximately 87,369 people were affected, and 304 deaths occurred because of natural disasters in the country. With climate change, the frequency and intensity of extreme events is expected to increase. Most of Bhutan’s productive infrastructure (hydropower plants, roads, airports), fertile agricultural land, and over 70 percent of the settlements are

5 Regulation on Control of Ozone Depleting Substances, 2008. 6 Waste Prevention and Management (Amendment) Regulation, 2016; The Water Regulation of Bhutan, 2014; Regulation for Environmental Clearance of Projects, 2016.


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located along the main drainage basins, which puts them at high risk of flooding. Furthermore, the transboundary monsoon system influences key productive sectors in the entire region, and small variations in the timing and quantity of rainfall can have profound consequences on water availability, agricultural productivity, and food security. Such disasters can reverse hard-won development gains.

47. DPC3 will support the adoption of a new procurement law. The law will help: (i) establish and mandate a Public Procurement Regulator that would (a) enforce and proactively provide procurement oversight, (b) formulate procurement policy and develop secondary legislation including regulations, standard bidding documents, and manuals, (c) oversee the handling of procurement complaints’ and (d) monitor compliance and progress with the implementation of the procurement legislation; (ii) provide guidance to the procurement cadre and mandate them to conduct procurement; (iii) legalize procurement methods, approaches and tools including electronic government procurement (eGP); (iv) provide for procurement audits and follow up with targeted capacity development and system improvement as well as fraud and corruption prevention; and (v) provide the legal basis for the engagement between the public and private sector in the contracting industry, and collaboration with other systems or jurisdictions including strengthening the domestic market, creation of jobs, handling of gender issues and promotion of trade.

48. Expected results under pillar 1: The reforms supported by pillar 1 will help achieve the following results (i) a move towards counter cyclical fiscal policy; (ii) higher domestic revenue mobilization; and (iii) strengthened public financial management and procurement systems.

Pillar 2: Enhancing policies to promote private sector employment opportunities

49. Despite the benefits that have accrued from hydropower development, employment remains concentrated in agriculture and the public sector. The capital-intensive hydropower sector employs only 0.8 percent of the labor force. The agricultural sector accounts for 60 percent of employment followed by the public sector with a share of 20 percent. The non-farm private sector accounts for the remaining 20 percent. The private sector in Bhutan faces various constraints related to topography, geography, small market size, skills shortages, infrastructure bottlenecks and limited access to finance.

Economic Diversification:

DPC2, Prior Action 4: The Royal Monetary Authority (RMA) has operationalized the Global Interchange for Financial Transactions (GIFT) to facilitate e-payments and support e-commerce.

DPC3, Trigger 5: The Cabinet approves the revised FDI Policy to ease and harmonize equity restrictions.

50. Given the constraints posed by Bhutan’s landlocked location, an international payment gateway which supports e-commerce will be very beneficial. The RMA has initiated the implementation of the Global Interchange for Financial Transaction (GIFT) to replace the current Electronic Fund Transfer and Clearing System (EFTCS). GIFT is a real time gross settlement (RTGS) type software developed specifically for Bhutan and being launched through RMA to facilitate payments from government to citizens, government to government, government to employees, and government to businesses. It is a key component of Digital Transactions. The GIFT will result in instant settlement of funds, reduced default and settlement risk, settling of bulk transactions in real time, easy traceability and safety measures for the movement of funds, and a calendar feature to view future and past transactions. A safe and efficient payments system will support e-commerce and economic growth by enabling smooth circulation of money, reducing the cost of exchange for goods and services, and ensuring sound functioning of money


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and capital markets. This will contribute to financial stability by reducing settlement and systemic risks and fostering financial inclusion as payment systems provide an entry point and platform for broader financial services. The implementation of GIFT is being supported by the proposed operation.

51. It will also be crucial to attract more foreign direct investment. FDI is important for Bhutan’s economic development as a source of capital, innovation, management expertise, and in enabling access to external markets. However, equity restrictions exist and differ for various nonpriority sectors. The 2010 FDI policy has used a ‘negative list’ approach towards entry barriers. However, some equity restrictions might need to be revised to ensure that desirable investments are not inhibited. One example is the minimum investment threshold in the hotel sector. The purpose of the restriction is to attract high-value, low-impact tourism, but investment size is not necessarily the best tool to achieve this objective. The revised FDI policy, supported by DPC3, will look to address issues around the minimum level of investment required and the enabling environment for profit repatriation. The World Bank is providing technical assistance to the government on this reform.

Access to Finance:

DPC2, Prior Action 5: The RMA Executive Committee has approved the Supervision Manual for CIB and data providers.

DPC3, Trigger 6: The MoF issues rules and regulations to facilitate external commercial borrowings.

52. Bhutan’s private sector is constrained by insufficient access to finance. Recent reforms have laid the foundations for the development of Bhutan’s financial sector. However, the growth of private sector firms – and the growth of micro-enterprises, in particular – continues to be impeded by inadequate access to finance. Further analysis reveals that access to finance is restricted both by supply-side factors, such as a lack of financial competition; insufficient credit information; and an unpredictable restructuring and insolvency regime, and by demand-side factors, such as an inability to collateralize assets and a lack of financial literacy. According to the World Bank Investment Climate Assessment (ICA, 2017), the top constraint that firms faced was a lack of access to finance. The procedures for acquiring a loan are complex, collateral requirements are high and the regulations governing their use are restrictive.

53. The proposed operation supports the government in strengthening the functioning of the credit information bureau. Previously, CIB only collected information from banks, which limited the system’s utility and put farmers at a disadvantage, given that fewer than one-in-five have access to bank credit. DPC1 supported amendments to CIB rules which expanded the reporting of credit information to include utilities, insurance companies and more recently, micro-finance institutions. The approval of the CIB Supervision Manual is one of the key building blocks for improving operations of the CIB and facilitating improved access to finance and protecting consumer rights. Access to finance is restricted by inter-alia insufficient credit information. Through the direct supervision of the credit bureau, the supervisor will identify and address weaknesses in practices, data quality and security, which will lead to improved data quality, market coverage and utilization. Utilization of improved credit bureau data leads to improved efficiency, better client selection and lower credit risk, by extension increasing access to finance. Furthermore, the central bank can also utilize the improved credit bureau data for bank supervision, which improves market monitoring and leads to more stable and effective bank intermediation. In addition, the supervision will ensure that appropriate procedures are in place to protect consumer rights and the security and confidentiality of data.

54. The Ministry of Finance is revising the framework to facilitate access to external commercial borrowings by the private sector. In 2010, the MoF had developed guidelines for external commercial


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borrowings (ECB) by the Bhutanese business and industrial sector. The 2010 ECB guidelines included conditions on (i) the eligibility of borrowers; (ii) the foreign exchange amount and maturity; (iii) all-in-cost ceilings on loans; (iv) end use; and (v) conversion to equity. As a result, there was limited uptake of such borrowings by the private sector. The government is now planning to issue a new set of rules to facilitate easier access to ECBs while also addressing the drawbacks on the lengthy approval process, debt ceilings, the requirement to earn in foreign currency, and ambiguity on the treatment of shareholder loans. The adoption of these rules will be supported by DPC3.

Skills and Human capital:

DPC2, Prior Action 6: The Ministry of Education has approved the Non-Formal Education Equivalency Framework. DPC2, Prior Action 7: The Cabinet has approved the waiving of cut-off points for admission of class X passed students into class XI in public and private schools.

DPC3, Trigger 7: The Cabinet approves the Teacher Standards and Teacher Professional Development Program. DPC3, Trigger 8: The Cabinet approves the National Education Policy.

55. A limited supply of skilled labor impedes the development of the private sector. Labor was the second most frequently cited constraint in the 2017 ICA, a complaint likely triggered by the limited access of firms to skilled labor. The private sector employers indicate that workers have insufficient skills including ICT, teamwork, leadership and problem-solving skills. Due to Bhutan’s historically low levels of education, the domestic supply of skills is limited. In more recent years, free public education at the primary and secondary level and substantial investment in the sector have helped achieve high enrolment rates, although quality remains a concern. As of 2017, there was almost universal enrolment in primary education. Girls have higher survival and transition rates and lower dropout and repetition rates than boys. Access to tertiary education is at nearly 40 percent for men and 32 percent for women. However, in rural areas, about half of the adult population is still without any level of education. Given this backdrop, the younger generation in Bhutan is relatively better educated but youth unemployment is high. The shortage of skilled labor together with youth unemployment indicates a mismatch between the skills imparted by the education system and those desired by the private sector. 56. Learning outcomes are considered low by international standards. In a recent pilot for PISA for Development (PISA-D), 41 percent of the grade IX and X students could not reach proficiency level 1 out of six levels of reading proficiency. To improve learning outcomes, teacher quality and performance needs to be boosted. In addition, tertiary education faces pressures from increasing demand, limited resources, and changing skills requirement. As a result, there is limited absorption by the private sector of skilled manpower.

57. To improve education outcomes and enhance skills, work is required on several fronts and the current DPC series addresses some of them. The current operation supports measures which will increase expected years of education and help provide basic competencies for those (mostly in the bottom 40) who missed formal schooling. DPC3 will support measures which will improve teacher quality which has an impact on learning outcomes. It will also support an overarching education policy primarily focused on improving quality. Some of the other areas to improve education and skills are being supported by other World Bank engagements.


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58. To address the skills mismatch, the government plans to improve primary and secondary education, vocational training, higher education and adoption of the Non-Formal Education Framework. These efforts require better interagency coordination, equivalency, harmonized certification and incentives to the private sector to invest in skills development. The proposed operation supports the approval of the Non-Formal Education (NFE) equivalency framework. NFE provides education to those children, youth and adults who missed the opportunity to participate and complete formal schooling or training. It provides opportunities for such learners (mostly women – Annex 6) to acquire basic competencies in literacy, numeracy and vocational skills, potentially helping them get a primary education equivalency. Women (who missed out on formal education) form the majority of adults who opt for the NFE program to acquire basic skills whereas men who did not complete their education are typically in formal training or apprenticeship. NFE is mostly tailored to providing skills to women and 99 percent of the trainees in NFE are women. NFE programs cover basic literacy and numeracy in the first two years and, for now, teach stitching/tailoring in the third year. The NFE equivalency framework will create equivalency among formal, non-formal and vocational education in learning, skills and recognition of competencies. This will help increase livelihood and skilled job opportunities for all, and particularly for women since they form the majority of NFE trainees. However, NFE is only one component of the bigger agenda. It will be followed by setting up a national qualification framework that cuts across government entities. Beyond the DPC, the World Bank is providing technical assistance to the government to address the root causes of skills mismatch.

59. In addition, the government is taking measures to increase educational attainment or expected years of education which is currently estimated at 9.5 years. The proposed operation supports the waiving of the cut-off points for class XI admission in public and private schools. This will help improve access to higher secondary education, particularly for those in the bottom 40. While it will improve access, it does not specifically address the quality issue. Lower and middle secondary education in Bhutan (class VII-X) leads to the Bhutan Certificate of Secondary Examination (BCSE). A cut-off percent in the BCSE (59.4 percent in 2018), at the end of grade 10 (class X), determines whether students advance to government-funded higher secondary school for grades 11-12 (classes XI and XII) or get into alternate streams which could include private schools, technical institutes, adult education programs or certificate programs. The waiving of the cut-off implies that all students who pass the class X examination (score 35 percent or more), will be admitted into free public schools or private schools with full scholarship in 2019. From 2020 onwards, all students who pass will be placed in public, private or Technical and Vocational Education and Training (TVET) institutions with full scholarship. The total cost of this initiative is estimated at BTN 164 million and this initiative is likely to increase access to higher secondary education which will help impart foundational skills needed for later learning.

60. The government is also taking measures to strengthen teacher standards and adopt an overarching National Education Policy. The latter articulates the government’s vision and goals in achieving a more integrated and coordinated education system with the aim of improving quality. To improve learning outcomes, the government is focusing on teacher quality and performance. Teacher standards need to be established to make them accountable for performance while regular coaching needs to be provided to upgrade their skills. In addition, incentives need to be provided to highly skilled youth to choose the teaching profession and to trained teachers to teach in remote locations. The Teacher Professional Development Program targets improvements in the quality of the existing teaching force and also requires complementary measures to improve the new incoming teachers through pre-service training. These reforms will be supported by DPC3.


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DPC2, Prior Action 8: The Ministry of Health has approved the Accelerating Maternal and Child Health Program for investing in human capital.

61. Investing in human capital, through better health outcomes, will support the development of better skilled manpower. Undernutrition, in particular, undermines physical and cognitive development with long-term impacts on education, productivity, vulnerability to illnesses and quality of life. The effects of undernutrition can be transmitted across generations, as undernourished mothers are more likely to have small children. Overall, although health and nutrition outcomes in Bhutan have improved, there remain socio-economic and geographic disparities.

62. In Bhutan critical challenges remain in terms of maternal, neonatal and child health (MNCH). Recent estimates show that more than one-fifth of all children over five in Bhutan are stunted, (or have low height-for-age), which is a marker for chronic undernutrition. Stunting is a red flag indicator for future losses in cognitive ability, productivity and earning capacity. Also, anemia rates among women and adolescent girls range between 27 percent and 36 percent, which can have long-lasting impacts on the growth, development and health of children in their first 1000 days of life. These outcomes are compounded by the coverage of antenatal care and institutional delivery rates, which are much lower in some regions (the central and eastern parts of the country) and among the poor.

63. The approval of the Accelerating Maternal and Child Health Program (AMCHP), supported by this operation, establishes the framework for implementation of a multi-sectoral approach to investing in human capital. AMCHP’s multisectoral approach (linked to social protection, health and education) focuses on the first 1000 days of a child’s life. These early investments are critical and have a significant impact on skills attainment and physical and mental health of children as they grow. The incidence of stunting can have a profound impact on brain development affecting learning, health, and productivity. Focusing on human capital during the first 1,000 days of a child’s life, therefore, is one of the most cost-effective investments governments can make. Specifically, the AMCHP aims to: (a) reduce income constraints that hinder the use of available public health services, through direct cash transfers to households with pregnant women and children of pre-school age; (b) boost demand for utilization of health services through tailored information campaigns and messaging delivered directly to women and girls regarding, for example, the importance of proper maternal, adolescent and child health; (c) improve maternal health, nutrition and early learning of children to support development of babies and toddlers; and, (d) reduce parental stress caused by economic or natural shocks. The Ministry of Health will also put in place institutional arrangements for developing a Maternal and Child Health Identification and Tracking System, for improved targeting and monitoring of progress.

Sustainable and Inclusive Private Sector Development:

DPC3, Trigger 9: The Cabinet approves (i) the National Energy Efficiency and Conservation Policy and (ii) the National Climate Change Policy. DPC3, Trigger 10: The Cabinet approves the National Gender Equality Policy.

64. The overarching objective of the 12th FYP is to create a ‘Just, Harmonious, and Sustainable Society through Enhanced Decentralization’. Under these overarching objectives, the 12th FYP includes policies that promote gender equality, maintain a healthy eco-system and foster carbon-neutral and climate-resilient development. Work remains to be done in translating these stated objectives into public policy and this DPC series aims to some of these policy priorities.


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65. Promoting sustainable and inclusive private sector development will be crucial to meet Bhutan’s long-term development goals. While Bhutan’s policy planning process naturally incorporates climate change impact, energy efficiency and conservation measures need to be institutionalized and promoted.7 This will be supported by cabinet approval of the National Energy and Conservation Policy which aims to encourage general improvements in the energy performance standards of the major economic sectors. The overall economy will benefit from energy efficiency and conservation measures through reduced energy intensity, avoided greenhouse gas emissions and higher revenues accruing from additional export of electricity. The government has also advanced preparation of the National Climate Change Policy which aims to put in place measures to help Bhutan anticipate and mitigate effects of climate change. The National Environmental Commission has completed the draft Climate Change Policy.

66. In addition, improving job quality and productivity for women would not only enhance gender equality, but it would also contribute to economic growth. In recent years, the labor force participation rate (LFPR) for women has declined significantly and the quality of jobs for women is still a concern. Female LFPR declined from 64 percent in 2010 to 60 percent in 2017. The Labor Force Survey shows that Bhutanese women work in lower quality jobs than men. Earnings for women who work outside the home is only 75 percent of men’s earnings. Gender disparities also seem to persist in terms of sectors of employment. For example, among those employed, men were twice as likely to be in formal wage employment than women. Unemployment, particularly among educated youth is higher among females. In this regard, it is important to ensure that women become competitive in the labor force and measures to improve skills need to be made gender responsive. To achieve these goals, the government is planning to adopt a Gender Equality Policy which will be supported by this DPC series.

67. Expected results under pillar 2 are: The reforms supported by pillar 2 will help achieve the following results (i) improvement in the enabling infrastructure (incubators, GIFT) and policies to support sustainable private sector development; (ii) enhanced access to finance; and (iii) improved skills and a boost to human capital.

68. Parliamentary elections and the transition to a new government in 2018 necessitated changes in the reforms supported by the proposed operation. Despite the changes, the strength of the overall package of reforms supported by the programmatic DPC series has been maintained. With an interim government in place for a few months in 2018 and the time needed for the newly elected government to form its cabinet, define policy priorities and review on going reforms, some policy measures supported by the ongoing DPC series required adjustments. As a result, some new reforms were included, some were dropped, and some were moved to DPC3 and one reform was brought forward from DPC3 to DPC2. This resulted in some backloading of reforms. Despite these changes, the program development objectives, pillars and reform areas of the DPC series remain relevant. In addition, crucial reforms like the GST, fiscal rules, improvements in skills, and strengthening of the CIB and the FDI policy provide strength to the overall matrix of reforms. Table 4 summarizes the changes to DPC2 and DPC3 reforms and result indicators. The changes in the result indicators have largely been necessitated because of the changes in the reforms supported by DPC2 and DPC3.

Table 4: Changes to the Policy and Results Matrix Original Revised Reason

DPC2

7 All policies are reviewed by the Gross National Happiness Commission which evaluates policies on various parameters, one of which is environmental sustainability.


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Trigger 2: The Cabinet approves the draft GST bill and submits to Parliament

Dropped from DPC2 but the enactment of the GST act retained in DPC3.

Due to the elections, progress on the approval of GST by the cabinet got delayed. However, the new government is fully committed to going ahead with GST and the new cabinet approved the GST design paper and the Ministry of Finance has already approved the draft GST bill. The government is currently undertaking an assessment of the distributional impacts of GST introduction and is also organizing consultations with stakeholders. Cabinet approval of GST is likely in September 2019 and Parliamentary approval by January 2020. The new government is committed to implement GST from July 2020.

Trigger 3: The Parliament approves fiscal tax rationalization measures to minimize impact on revenues in response to India’s GST introduction.

Dropped. This action is not needed anymore because the Government of India agreed to provide additional support to Bhutan. Bhutan is receiving rebates from India to make up for the loss in revenues because of GST introduction in India.

Trigger 5: The MoF issues a Budget Call Notification incorporating recognition of gender and climate change initiatives in FY2018-19.

Dropped but gender and climate aspects are supported by other prior actions in the operation.

The government clarified that the Budget Call notification could be changed in following years and the proposed reform might not be sustainable. Hence, it was dropped. However, the government has been piloting gender responsive budgeting. A manual on Gender Responsive Planning and Budgeting (GRPB) has been framed and a “Strategic Framework for Gender Mainstreaming and GRPB for Bhutan” has been developed to operationalize gender responsive budgeting.

Trigger 6: The Cabinet approves the revised Foreign Direct Investment (FDI) Policy amended to ease and harmonize equity restrictions.

Moved to DPC3. Due to the change in government, limited progress was made on this front. However, the new government is committed to taking this reform forward as emphasized in the 12th FYP which was recently approved by the new government. Hence, it was moved to DPC3.

Trigger 7: The Cabinet approves the revised Cottage and Small Industries (CSI) Policy.

Dropped. The government remains committed to the CSI agenda and is undertaking a review of the CSI policies during the Bhutan Economic Forum for Innovative Transformation (BEFIT) to be held in July 2019. The BEFIT will inform further steps on the CSI policy and the government does not want to undertake any reforms till the Forum findings are known. Hence, the proposed reform was dropped from the current operation and the government will undertake future reforms in this area based on the outcome of BEFIT.

Trigger 8: (i) The RMA Board issues regulation for Micro-finance

The RMA Executive Committee has approved the Supervision Manual for CIB and data

A decision was taken not to issue new guidelines for MFIs and information sharing by MFIs to CIB was implemented within the purview of the


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Institutions (MFIs) to start sharing credit information with CIB. (ii) The RMA Board approves CIB Supervision Manual.

providers. existing 2016 MFI guidelines. Hence this part of the prior action was dropped. The second part of the prior action reflects the change in the approving authority from RMA Board to the RMA Executive Committee.

Trigger 9: The Cabinet approves the Teachers Standards Policy.

Enhanced and moved to DPC3. Due to the elections, progress was slow on this reform. However, the government is committed to it and they plan to adopt both the Teachers Standards Policy and the Teachers professional Development Program which will be supported by DPC3.

Trigger 10: The Cabinet approves the revised National Human Resource Development Policy.

Dropped but content captured in the education policy supported by DPC3.

The new government plans to capture the key aspects of human resource development in the National Education Policy (supported by DPC3). Hence this action was dropped.

Trigger 11: The Cabinet approves the Gender Equity Policy.

Moved to DPC3. Due to the elections, limited progress happened on this reform. However, the government is committed to it and it will be supported by DPC3.

Trigger 12: The Cabinet approves: i) the National Climate Change Policy and ii) the National Energy Efficiency and Conservation Policy.

Moved to DPC3. Due to the elections, limited progress was made to achieve these reforms, but the government remains committed to them. Hence, they have been moved to DPC3.

Prior Action 2 (new): The Ministry of Finance (MoF) has issued a notification to rollout the electronic public expenditure management system (e-PEMS) which includes the electronic payment functionality to all budgetary bodies.

This policy reform will strengthen the public financial management system by introducing the e-payments functionality. It will also support the eventual integration of all PFM systems (supported by DPC3).

Prior Action 4 (new): The Royal Monetary Authority (RMA) has operationalized the Global Interchange for Financial Transactions (GIFT) to facilitate e-payments and support e-commerce.

In a landlocked country like Bhutan, an international payment gateway which supports e-commerce will be very useful. This reform will help create a safe and efficient payments system which will support e-commerce. It will also contribute to financial stability by reducing settlement and systemic risks and fostering financial inclusion.

Prior Action 6 (from DPC3): The Ministry of Education has approved the Non-Formal Education Equivalency Framework.

Faster than anticipated progress was made on this action. Therefore, is was brought forward from DPC3.

Prior Action 7 (new): The Cabinet has approved the

This reform will help increase educational attainment or expected years of education by


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waiving of cut-off points for admission of class X passed students into class XI in public and private schools.

improving access to higher secondary education. It will contribute to imparting foundational skills.

Prior Action 8 (new): The Ministry of Health has approved the Accelerating Maternal and Child Health Program for investing in human capital.

This reform focuses on the first 1000 days of a child’s life which have a significant impact on skills attainment and physical and mental health and productivity. This action will also contribute to skills enhancement.

DPC3

Trigger 1: Cabinet approves Rules and Regulations defining procedures for land acquisition and leasing for FDI projects under the Land Act.

Dropped. The government has postponed this action till the new FDI policy has been adopted. The completion of this action will go beyond the timeframe of the current DPC series and has therefore been dropped.

Trigger 6: Parliament approves the amendments to the Movable and Immovable Property Act.

Dropped. Cabinet approval of this reform was supported by the previous DPC series. With the backloading of reforms in the current DPC matrix, this trigger was dropped to streamline the matrix. In addition, IFC is providing technical assistance to the government on this reform.

Trigger 7: Parliament approves the new Insolvency Act.

Dropped. Cabinet approval of this reform was supported by the previous DPC series. With the backloading of reforms in the current DPC matrix, this trigger was dropped to streamline the matrix. In addition, IFC is providing technical assistance to the government on this reform.

Trigger 9: Cabinet approves the amendment of the Labor and Employment Act (2007) and submits to Parliament.

Dropped. The new government has decided to postpone the proposed amendments because of ongoing work on pension reforms which will also require changes to the Labor and Employment Act of 2007.

Trigger 2: Ministry of Economic Affairs approves revised rules and regulations of the Alternative Renewable Energy Policy 2013.

Dropped. Due to the elections, the proposed reform has been delayed and will not be completed in time for DPC3.

Trigger 3: Cabinet approves the National Gender Equity Action Plan.

Dropped. The Gender Equality Policy will be supported by DPC3 and while the government is committed to approving the action plan, it will go beyond the timeline of DPC3. Hence, it was dropped.

Trigger 6 (new): The MoF issues rules and regulations to facilitate external commercial borrowings.

These rules will facilitate increased access to external commercial borrowings by the private sector by addressing the drawbacks in the existing rules.


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Trigger 8 (new): The Cabinet approves the National Education Policy.

This action outlines a coherent framework that articulates the government’s vision and goals in achieving a more integrated and coordinated education system with the aim of improving quality and strengthening skills.

Result Indicators

Stabilization Fund is established as evidenced by the appointment of all members of the Governing Board: Baseline (2016): 0 Target (2021): All

RI#1: Real expenditure growth: Baseline: 4 percent Target: 4 percent or lower

The team was advised to include an indicator which would better capture the results from the fiscal rules. Hence the original RI was dropped and replaced by an alternate RI.

Number of PFM systems interconnected Baseline (2016): 0 Target (2021): 5

RI#3: Number of budget agencies using e-PEMS: Baseline: 0 Target: All 10 ministries and at least 10 districts

Since the original indicator would be captured by the associated prior action, it was replaced by an alternate indicator which would capture implementation of the e-PEMS.

Percentage of Teachers meeting new Teachers’ Standards Baseline (2016): 0 percent. Target (2021): 15 percent.

RI#12: Percent of Teachers tested by the newly established Teaching Standards and Teacher Professional Development Program: Baseline: 0 percent. Target: At least 10 percent

The change reflects the change to the associated policy reform and the parameter that will be tested. It is hard to predict the share of the teachers who will meet the standards.

Energy consumption tons of oil equivalent (TOE): i) Building & appliance sectors: Baseline 2014: 270,356 TOE Target 2021: 8,000 TOE reduction ii) Industry Sector: Baseline 2014: 241,972 TOE Target 2021: 15,000 TOE reduction iii) Transport Sector: Baseline 2014: 121,218 TOE Target 2021: 7,000 TOE reduction

RI#13: Energy consumption in the transport sector in tons of oil equivalent (TOE): Baseline (2014): 121,218 TOE Target: Reduction of at least 10 percent

The reduction in energy consumption in the building and industry sectors are likely to be marginal. The main impact of the policy reforms is expected to be on the transport sector. The revised indicator reflects this change.

RI#4 (new): Number of registered bidders in the eGP system: Baseline: 0 Target: At least 700

Introduced to capture results from the procurement related reforms.

RI#6 (new): Value of non-cash transactions in the Bhutanese economy:

Introduced to capture results from the introduction of the prior action on GIFT.


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Baseline (2017): BTN 95.4 billion Target (2021): at least 20 percent increase

RI#7: Cumulative non-hydro FDI inflows into Bhutan: Baseline: BTN 9.4 billion Target: At least 10 percent increase

Introduced to capture results from the FDI related policy reform.

RI#9: External Commercial Borrowings by the private sector: Baseline: 0 Target: At least US$10 million

Introduced to capture results from the introduction of the prior action on external commercial borrowings.

RI#10: Transition to higher secondary schooling: Baseline (2018) girls: 72.8 percent Baseline (2018) boys: 71.7 percent Target girls: At least 80 percent Target Boys: At least 80 percent

Introduced to capture results from the introduction of the prior action on removal of cut-off grades for admission to class XI.

RI#11: Proportion of pregnant women who complete all 8 antenatal care (ANC) visits: Baseline: 26 percent Target: At least 30 percent

Introduced to capture results from the introduction of the prior action on Accelerating Maternal and Child Health Program

69. This operation is underpinned by extensive analytical work. The prior actions of this operation are supported by analytical work prepared by the WBG and are complemented by additional work undertaken by the government and other development partners. Several pieces are especially salient in informing the DPCs, including the Public Finance Think Piece (2016), the semiannual Bhutan Economic Updates, Debt sustainability analysis (2018), and the Investment climate assessment (2017). The government proactively draws upon the WBG’s analytical work and technical assistance to formulate the key reform programs (Table 5).

Table 5: Analytical Underpinnings

Prior Actions Analytical Underpinnings

Pillar 1: Strengthening the policy framework to improve fiscal management Prior Action 1: The Cabinet has approved the governance framework of the stabilization fund.

Bhutan: Boosting Public Savings, Considerations and Options Policy Note; Bhutan Public Finance Think Piece; On-going TA on establishment of a Stabilization Fund.

Prior Action 2: The Ministry of Finance (MoF) has issued a notification to rollout the electronic public expenditure management system (e-PEMS) which includes the electronic payment functionality to all budgetary bodies.

IMF Report on ‘Simplifying the Treasury Single Account’.


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Prior Action 3: The MoF has approved amendments to the existing Procurement Rules and Regulation 2009, including environmental considerations.

PFM Strategy and Action Plan 2017-21; Bhutan Country Procurement Assessment of 2016; Alternative Procurement Arrangements Assessment of Thimphu Thromde.

Prior Action 4: The Royal Monetary Authority (RMA) has operationalized the Global Interchange for Financial Transactions (GIFT) to facilitate e-payments and support e-commerce.

Policy Note on Bhutan’s National Payments & Systems Development Strategy.

Prior Action 5: The RMA Executive Committee has approved the Supervision Manual for CIB and data providers.

Bhutan Financial Sector Reform Policy Note; Bhutan Competitiveness Policy Note.

Prior Action 6: The Ministry of Education has approved the Non-Formal Education Equivalency Framework.

Based on regular policy dialog with the government.

Prior Action 7: The Cabinet has approved the waiving of cut-off points for admission of class X passed students into class XI in public and private schools.

Based on regular policy dialog with the government.

Prior Action 8: The Ministry of Health has approved the Accelerating Maternal and Child Health Program for investing in human capital.

Nutrition in Bhutan: situational analysis and policy recommendations. K. Damrongplasit and T. Wangdi. 2017. “Healthcare utilization, bypass, and multiple visits: the case of Bhutan.” International Journal of Health Economics and Management; Tashi Dendup, Yun Zhao and Deki Dema. Factors associated with under-five mortality in Bhutan: an analysis of the Bhutan National Health Survey 2012. BMC Public Health.

4.3. LINK TO CPF, OTHER BANK OPERATIONS AND THE WBG STRATEGY

70. This DPC series underpins all three objectives of the Country Partnership Strategy (FY2015-19). They include: (a) improving fiscal and spending efficiency; (b) increasing private sector and competitiveness; and (c) supporting green development. The operation is designed to improve spending efficiencies through strengthened PFM and procurement frameworks. It will also support private sector development through improved access to finance, human capital development and greater macroeconomic stability. Green development would be supported through environmentally friendly procurement regulations.

71. This operation supports progress towards the WBG’s twin goals in Bhutan. Strengthened procurement rules and an enhanced public financial management system will enable efficient use of public resources. These measures will together help increase fiscal buffers and improve public spending which will be beneficial for the poor and those in the bottom 40. A well performing CIB will support greater access to finance and strengthen private sector development. This will in turn help create jobs which are important for sustainable poverty reduction. In addition, the reforms in the education and health sectors will support the development of human capital and skills which will also have a positive impact on earning capacity.

72. Other Bank operations/activities complementing the proposed DPC series include: (a) an investment climate assessment, and implementation of the plan; (b) policy dialogue on macro-fiscal developments and the preparation of the public finance think piece; (c) support to the MoF through the PFM MDF; (d)


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financial sector technical assistance; (e) IFC’s Financial Infrastructure Project; and (f) technical assistance on the assessment of Bhutan’s Labor Market.

4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS

73. Bhutan’s policy making process is broadly consultative and inclusive. Bhutan generally follows an extremely consultative policymaking process with policies going through extensive rounds of public scrutiny. The country has developed a comprehensive system for management of public policies founded on the principles of GNH. Government strategies are rooted in the constitution and the GNH Commission (GNHC) serves a central role in ensuring compliance of the public policies and processes with principles of GNH. The four principles of GNH are: (a) good governance; (b) sustainable socio‐economic development; (c) preservation and promotion of culture; and (d) environmental conservation. Every policy is screened for compliance with these principles and extensive public consultations with relevant stakeholders are carried out prior to their adoption. All draft policies are uploaded on the GNHC website and the initiating ministry holds stakeholder consultations through workshops. Stakeholders can provide comments during workshops and/or send their comments by email to the GNHC. The government provides responses to each comment. In addition, Parliament sessions are telecast live so that the citizens can follow the discussions taking place in the Parliament. The reforms supported by this operation have gone through the GNH screening tool which includes broad and extensive consultations with all relevant stakeholders.

74. Coordination with development partners. Collaboration between the IMF and the World Bank staff is effective with regular consultations on macroeconomic, debt management, and financial sector issues. Another development partner engaged in macro-fiscal technical assistance is the Asian Development Bank (ADB). The World Bank and the ADB coordinate in the areas of financial sector and private sector development, with the ADB providing a variety of technical assistance services. As part of the preparation of this programmatic series the task team also consulted extensively with the ADB in Bhutan.

5. OTHER DESIGN AND APPRAISAL ISSUES

5.1. POVERTY AND SOCIAL IMPACT

75. Overall, the policy reforms supported by DPC2 are expected to have positive and neutral effects on poverty reduction. The action linked to improved supervision of the CIB could have an indirect but potentially positive effect on the poor in the long run if it can mitigate insufficient access to finance and contribute to job creation. The adoption of the Non-Formal Education Equivalency Framework would help potential employers evaluate the education credentials of candidates who may have missed the opportunity to pursue formal education but opted for alternative pathways. This policy reform could increase access to jobs among the low-skilled and have a positive impact on poverty. The waiving of the cut-off points for admission into class XI in public and private schools is also likely to have a positive effect on the poor in the long run and will raise the number of years of schooling for them and thereby improve access to jobs. The adoption of the Accelerating Maternal and Child Health Program will also benefit the poor and help them invest in human capital. All other prior actions are expected to have a neutral effect on poverty. Overall, the results suggest that the poverty and social effects will be positive in the medium- to long-term. These results are summarized in Annex 4.

76. The adoption of the Non-Formal Education (NFE) equivalency framework is expected to have a positive distributional, gender and poverty impact. The share of individuals that never attended school came down dramatically in recent decades, yet data reveals that the educational gaps are still large: 17


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percent of individuals between ages 15 and 29 have never attended school as of 2017 and the share is higher among the poor. NFE aims to provide alternative educational programs to individuals who missed the opportunity to participate in formal schooling or training. The availability of NFE has had a positive impact on narrowing the gap in educational attainment, particularly between females and males (Annex 6). A total of 203,471 learners have benefitted from the NFE program from 1992 to 2017 of which 71 percent are female. The new NFE framework provides a solid basis for evaluating alternative educational programs by linking it to formal education levels, while at the same time offering flexible pathways to achieve education and obtain relevant skills. The approval of the NFE Framework could increase accessibility to jobs of disadvantaged groups by allowing employers to better evaluate the education credentials of potential job candidates. As the rural population, women, and the vulnerable and poor are more likely to have obtained non-formal education, this measure could help increase their productivity and earnings, and thereby reduce poverty. The framework could further incentivize participation in NFE in the working age population, reduce the share of people that has never attended school and improve basic and functional literacy skills.

77. Waiving the cut-off grade for class X and adoption of the AMCHP are both expected to have positive effects on poverty reduction. The increased access to higher education for a larger share of the population following the waiving of the cut-off grade for class X will complement the broader reforms to strengthen skills development. This should have a positive effect on poverty reduction. Adoption of the AMCHP is expected to have a positive effect on poverty through improved investments in human capital during the most critical development period for young children. The resulting positive effects on their productivity as adults is expected to help contribute to poverty reduction.

5.2. ENVIRONMENTAL ASPECTS

78. The proposed operation is likely to have an overall positive effect on the environment. The environmental considerations included in the amended procurement rules could have a potentially positive effect on the environment. The NFE framework could also have a potentially positive effect if environmental issues are reflected in the curriculum for teachers and students. All other prior actions supported by this operation will have no significant effects on the environment.

79. In terms of government’s country environmental system, the National Environment Protection Act 2007 is the overarching umbrella legislation that governs the use of land, water, forests, minerals and other natural resources. This provides for an effective system for conservation and protection through the National Environment Commission (NEC) and other specified authorities / committees to independently regulate and promote sustainable development in an equitable manner. Other relevant regulations include the Environmental Assessment Act 2000 and its regulations, Waste Prevention and Management Act 2009 and its Regulations, Water Act 2011 and its Regulations and the Listed and Exempted Activities 2016. Together these legislations and regulations and the relevant institutions constitute the country’s environmental systems. These existing systems support environmental sustainability in the country.

80. While the legal framework for environmental protection is sound in Bhutan, implementation capacity could be strengthened. Potential impacts from facilitating private sector development will have moderate impacts depending on the nature of investments. These impacts are being managed with the existing country systems. As Bhutan gets exposed to new types of industries and larger projects, the country will need to strengthen its capacity to conduct proper environmental assessment and identify mitigation measures. To complement the limited resources at NEC, efforts to mainstream the


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environment are made by introducing standards and guidelines in relevant sectors. Also, fiscal incentives have been introduced in various industries to promote modernization and use of resource efficient and cleaner technologies. While these efforts are commendable and help reduce potential impacts on environment and climate change, monitoring and enforcement could be further strengthened by improving data collection and enhancing technical training to NEC staff.

81. The climate Co-Benefits for this operation are being assessed.

5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS

82. The government’s PFM structures and processes have improved. While challenges remain, the core elements of an adequate public financial management system are in place, including publication of the budget. The positive trajectory of improvements in financial management stems from the government’s commitment to: (a) strengthen the legal framework; (b) enhance institutional capacity and the internal control framework; (c) improve the financial management information system, and (d) strengthen the oversight of public finances. Together, these actions are aimed at increasing accountability and improving the timeliness, quality, transparency and reliability of the government’s accounting and reporting functions. These positive steps, as well as the government’s demonstrated focus on results and strong commitment for continued PFM reforms, provide a satisfactory basis for proceeding with the proposed operation. The PEFA update of 2016 confirms that Bhutan has good fiscal discipline through comprehensive coverage of the budget, orderly execution, good control over expenditure commitments and fiscal risks, timely and reliable financial reporting, and improved audit and legislative scrutiny. The World Bank also provides technical assistance on PFM issues through the PFM-MDF.

83. Bhutan’s public procurement system is open to competition, has checks and balances and is audited. The reforms to the public procurement system over the last decade are visible. The government demonstrated its commitment to further develop the procurement system by implementing Phase 1 of the eGP. In 2016, the World Bank conducted and approved the first ever Alternative Procurement Arrangements (APA) assessment of Thimphu Thromde. The APA assessment found several key good international practices in Bhutan’s public procurement system like a strong framework for control and audit, use of quality/cost rated criteria using a point-based system in works contracts and use of Conflict of Interest Declaration. The amendments to procurement rules supported by this operation will further improve the procurement framework in the country. In addition, the adoption of a procurement law, supported by the next operation in this DPC series, will help buttress the procurement rules and regulations.

84. The MoF discloses the National Budget which is publicly available on the MoF website. The budget document is comprehensive: it includes an analysis of the previous year’s financial statements, the budget for the coming year by economic and administrative classification, tax measures, a macro-fiscal economic outlook, a report on state-owned enterprises and government share-holdings, on the RMA and the pension fund. Quarterly and monthly execution reports are produced, but not disclosed. Financial statements of the previous year are disclosed after being audited.

85. On external audit, Bhutan has a reasonably well-functioning system. The Royal Audit Authority conducts financial audits at two tiers: (i) at the national level, the consolidated annual financial statements of the Royal Government; and (ii) at the individual agency level. The Auditor General submits the annual audit report during the fourth quarter of the fiscal year on the audits carried out during the previous fiscal year. The FY2017 Audit report was submitted to the Parliament in June 2018 while the FY2018 audit report


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will be submitted to the Parliament in the forthcoming (May/June 2019) session of the Parliament. The report contains the result of the audit of the annual financial statements of the government, the overall financial condition and recommendations to improve the economy and efficiency and effectiveness of the government. Besides, the Royal Audit Authority also conducts the financial audits of the donor assisted projects and performance audits.

86. The foreign exchange control environment of the central bank is satisfactory. The annual audit reports are published on the RMA website and are annually audited by external auditors. The accounts and audits are compiled and conducted in accordance with generally accepted accounting and auditing standards. Based on the audit reports and the satisfactory track record in the operation of special (designated) accounts in several IDA-financed operations held in the RMA in the past, it was concluded that the World Bank has reasonable assurance that the control environment for foreign exchange at the RMA is satisfactory. The IMF has not carried out a Safeguards Assessment of the RMA.

87. Disbursements. The proposed operation is the second in a programmatic series of three DPCs. The credit proceeds will be made available to the government upon approval of credit effectiveness and meeting of the standard withdrawal tranche release conditions. The government will submit a withdrawal application in the requested format to the World Bank once the credit has been approved and the World Bank has notified the credit effectiveness to the government. At the request of the MoF, the disbursement in USD will be made into the treasury account of the government maintained at the RMA that forms part of the country’s foreign exchange reserves which will later be transferred into Ngultrum equivalent of the government’s consolidated fund. The government will confirm to the World Bank, within 30 days, of receipt of the proceeds and its credit in the Treasury account, including the date of receipt, and the exchange rate applied to convert the credit proceeds into Bhutanese Ngultrum.

88. Disbursement of the credit proceeds will not be linked to specific purchases. The government will not use the credit proceeds to pay for expenditures included in the Bank’s standard negative list, which includes expenditures on military hardware and environmentally hazardous goods. If any portion of the credit is used to finance ineligible expenditures as so defined in the Financing Agreement, IDA shall require the government to refund the amount. Money refunded to IDA in respect of payments made for ineligible expenditures would be cancelled.

89. Reporting, auditing and closing date. No audit will be required for the proposed operation as funds will be transferred to the government’s treasury and not to a dedicated account. The closing date of the proposed operation will be June 30, 2020.

5.4. MONITORING, EVALUATION AND ACCOUNTABILITY

90. The MoF leads the effort in coordinating the overall implementation of the DPC. The MoF has experience and is conversant with World Bank policies and procedures through lending and TA operations. Given the history of budget lending operations in Bhutan, some institutional capacity has been built up on data requirements and overall monitoring arrangements. Bhutan is one of the first countries in the Asia and Pacific Region to implement the recommendations of the Enhanced General Data Dissemination System (e-GDDS). The National Summary Data Page utilizing the Statistical Data and Meta Data Exchange is available on the National Statistics Bureau’s website. In addition, data is generally available through the MoF and the central bank’s website. The World Bank team will continue to provide support to the government in monitoring the reform progress and results.


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91. The World Bank team works closely with relevant ministries and agencies to monitor progress. This includes the MoF, Ministry of Economic Affairs, GNHC, RMA and other relevant ministries. The MoF monitors progress of fiscal indicators both through their annual budget report and their performance agreement signed with the Prime Minister.

92. Grievance redressal. Communities and individuals who believe that they are adversely affected by specific country policies supported by prior actions or tranche release conditions, under a World Bank Development Policy Operation, may submit complaints to the responsible country authorities, appropriate local/national grievance redress mechanisms, or the WB’s Grievance Redress Service (GRS). The GRS ensures that complaints received are promptly reviewed to address pertinent concerns. Affected communities and individuals may submit their complaint to the WB’s independent Inspection Panel which determines whether harm occurred, or could occur, because of WB non-compliance with its policies and procedures. Complaints may be submitted at any time after concerns have been brought directly to the World Bank's attention, and Bank Management has been given an opportunity to respond. For information on how to submit complaints to the World Bank’s corporate GRS, please visit http://www.worldbank.org/GRS. For information on how to submit complaints to the World Bank Inspection Panel, please visit www.inspectionpanel.org.

6. SUMMARY OF RISKS AND MITIGATION

93. The overall risk rating for this operation is Moderate. Among the risk categories, (i) macroeconomic, (ii) sector strategies and policies, (iii) fiduciary, and (iv) stakeholder risks are deemed moderate, while environmental and social risks are low (Table 6). The political and governance risk, technical design risk and institutional capacity risks are substantial. This is primarily because there is a new government in office which is in power for the first time; there has been backloading of reforms because of the elections; some of the reforms supported by the operation are complex in nature and the government has weak institutional capacity. Risk mitigation includes strong government ownership of these reforms. In addition, the World Bank’s existing and planned engagements will support reform implementation, focus on capacity development and foster greater coordination across implementing agencies. Close supervision of this operation will help address emerging challenges related to institutional capacity.

94. Political and governance risks are substantial. Although the new government is committed to the reforms supported by this operation, it has its own set of priorities as would be expected and it is also in power for the first time. The new government continues to engage in a participatory process in formulating development strategies which includes members of the opposition party. However, some of the reforms now require approval first by the Committee of Secretaries of the various ministries before they go to Cabinet. This could add to the timeline for achievement of reforms that require Cabinet approval. In addition, there have been instances in past DPC operations, where some prior actions supporting cabinet approval of bills were not approved by the Parliament. These risks are mitigated, in part, by the explicit commitment of the new government to support the reforms envisaged in the ongoing DPC series as well as continuous dialog with the World Bank team.

95. Technical design risks are substantial. The parliamentary elections have resulted in a backloading of reforms with many of them requiring Cabinet approvals. There could be potential delays in the passage of certain policies and some of the approval procedures could be lengthy. In addition, some of the reforms like GIFT, e-payments and the GST could be technically challenging. These risks are somewhat mitigated by the technical assistance being provided by the Bank on many of these reforms and the high level of engagement between the government and the World Bank which helps address issues as they arise.

http://www.worldbank.org/GRS

http://www.inspectionpanel.org/


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96. Risks related to institutional capacity for implementation and sustainability, are substantial. Limited technical capacity, a complex organizational structure, and weak interagency coordination pose risks to the achievement of the PDO. Due to the crosscutting nature of this operation, many ministries and agencies are involved in the implementation of the program of policy and institutional reforms. Coordination is weak, and the government faces challenges in collaborating across boundaries. To mitigate this risk, the World Bank’s existing and planned ASAs supporting reform implementation are focusing on capacity development and fostering coordination across the implementing agencies. These engagements include the following initiatives: Bhutan Macro-Fiscal Monitoring, Analysis and Management Program; Bhutan Tax Rationalization Technical Assistance; Bhutan: Implementation of Financial Sector Development Action Plan; and Improving Bhutan Investment Climate. In addition, there will be close supervision of this operation to help address emerging challenges related to institutional capacity.

Table 6: Summary Risk Ratings

Risk Categories Rating

1. Political and Governance ⚫ Substantial

2. Macroeconomic ⚫ Moderate

3. Sector Strategies and Policies ⚫ Moderate

4. Technical Design of Project or Program ⚫ Substantial

5. Institutional Capacity for Implementation and Sustainability ⚫ Substantial

6. Fiduciary ⚫ Moderate

7. Environment and Social ⚫ Low

8. Stakeholders ⚫ Moderate

9. Other

Overall ⚫ Moderate

.


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ANNEX 1: POLICY AND RESULTS MATRIX

Prior actions and Triggers Results (Baseline: 2016; Target: 2021)

Prior Actions under DPC 1 Prior Actions under DPC 2 Triggers DPC 3 Indicator Name Baseline Target

Pillar 1: Strengthening the policy framework to improve fiscal management

Fiscal Management:

Prior Action 1: The Parliament has approved the establishment of a stabilization fund.

Prior Action 1: The Cabinet has approved the governance framework of the stabilization fund.

Trigger 1: The Cabinet approves the fiscal rules.

RI#1: Real expenditure growth

4 percent (2017)

4 percent or lower

Prior Action 2: The Cabinet has approved the introduction of GST.

Prior Action 3: The MoF has issued administrative measures to minimize impact on revenues in response to India’s GST introduction.

Trigger 2: The GST Act is gazetted.

RI#2: Revenues collected under GST

0 (Sales tax was 12.8 percent of FY2016 revenues excluding grants)

At least 14 percent of FY2016 revenues

excluding grants

Public Financial Management:

Prior Action 2: The Ministry of Finance (MoF) has issued a notification to rollout the electronic public expenditure management system (e-PEMS) which includes the electronic payment

Trigger 3: The MoF issues an order establishing interconnectivity of new/existing PFM information systems for automated exchange of

RI#3: Number of budget agencies using e-PEMS

0

All 10 ministries and at least 10 districts


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functionality to all budgetary bodies.

Prior Action 3: The MoF has approved amendments to the existing Procurement Rules and Regulations 2009, including environmental considerations.

data.

Trigger 4: The Cabinet approves the new Public Procurement Bill.

RI#4: Number of registered bidders in the eGP system

0

At least 700


Economic Diversification

Prior Action 4: The Ministry of Economic Affairs (MoEA) has approved Guidelines for Operationalization of Business Incubation Center for Cottage and Small Industries (CSI).

Prior Action 5: The Cabinet has approved the Renewable Natural Resources (RNR) Marketing Policy for agricultural products.

Prior Action 4: The Royal Monetary Authority (RMA) has operationalized the Global Interchange for Financial Transactions (GIFT) to facilitate e-payments and support e-commerce.

Trigger 5: The Cabinet approves the revised FDI Policy to ease and harmonize equity restrictions.

RI#5: Number of CSIs under incubation

RI#6: Value of non-cash transactions in the Bhutanese economy

RI#7: Cumulative non-hydro FDI inflows into Bhutan

7 total, o/w female-owned 0

BTN 95.4 billion (2017)

BTN 9.4 billion

At least 20 total, o/w female-owned

is at least 3.

20 percent increase

At least 10 percent increase

Access to Finance

Prior Action 6: The RMA Board has approved

Prior Action 5: The RMA Executive Committee has

Trigger 6: The MoF issues rules and regulations to

RI#8 Number of entities reporting to CIB

988 At least 10% increase


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Amendment to Credit Information Bureau Rules and Regulations 2017.

Prior Action 7: The RMA Board has approved E-money issuer Rules and Regulations 2017.

approved the Supervision Manual for CIB and data providers.

facilitate external commercial borrowings.

RI#9: External Commercial Borrowings by the private sector

0

At least US$10 million

Skills and Human Capital:

Prior Action 8: The Ministry of Education has approved the International School Guidelines 2017.




Trigger 7: The Cabinet approves the Teacher Standards and Teacher Professional Development Program.

Trigger 8: The Cabinet approves the National Education Policy.

RI#10: Transition to higher secondary schooling

RI#11: Proportion of pregnant women who complete all 8 antenatal care (ANC) visits

RI#12: Percent of Teachers tested by the newly established Teaching Standards and Teacher Professional Development Program

Girls: 72.8 percent (2018);

Boys 71.7 percent (2018)

26 percent (2018)

0 percent

Girls: At least 80 percent

Boys At least 80 percent

At least 30 percent

At least 10 percent

Sustainable and inclusive Development:


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Prior Action 9: The Ministry of Economic Affairs (MoEA) has approved National Energy Efficiency and Conservation Policy

Trigger 9: The Cabinet approves (i) the National Energy Efficiency and Conservation Policy and (ii) the National Climate Change Policy.

Trigger 10: The Cabinet approves the National Gender Equality Policy.

RI#13: Energy consumption in the transport sector in tons of oil equivalent (TOE)

121,218 TOE (2014) Reduction of at least 10 percent


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ANNEX 2: LETTER OF DEVELOPMENT POLICY


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ANNEX 3: IMF ASSESSMENT LETTER


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ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE

Prior actions Significant positive or negative

environment effects (yes/no/to be determined)

Significant poverty, social or distributional effects positive or negative (yes/no/to be

determined) Pillar 1: Strengthening the policy framework to improve fiscal management

Prior action 1: The Cabinet has approved the governance framework of the stabilization fund.

No significant environmental effects. No significant poverty effects in the short run is expected.

Prior action 2: The Ministry of Finance (MoF) has issued a notification to rollout the electronic public expenditure management system (e-PEMS) which includes the electronic payment functionality to all budgetary bodies.

No significant environmental effects. Nevertheless, removal of paper transactions could have a small positive effect.

No significant poverty effects.

Prior action 3: The MoF has approved amendments to the existing Procurement Rules and Regulations 2009, including environmental considerations.

Could potentially be positive depending on the implementation of the environmental considerations in the procurement rules.

No significant poverty effects.


Prior action 4: The Royal Monetary Authority (RMA) has operationalized the Global Interchange for Financial Transactions (GIFT) to facilitate e-payments and support e-commerce.

No significant environmental effects. No significant poverty effects in the short run is expected.

Prior Action 5: The RMA Executive Committee has approved the Supervision Manual for CIB and data providers.

No significant environmental effects. Indirect but potentially positive poverty effects in the long run if this reform can mitigate insufficient access to finance and contribute to job creation.


Could potentially have positive effects if environmental issues are reflected in the curriculum for teachers and students.

Potentially positive poverty effects through increased accessibility to jobs of disadvantaged groups. The rural population, women, and the vulnerable and poor are more likely to have obtained non-formal education and this measure could help increase their productivity and earnings, and thereby reduce poverty.


No significant environmental effects. Potentially positive poverty effects in the long run through increased access to higher education and skills development.


No significant environmental effects. Potentially positive poverty effects through improved investments in human capital and resulting positive effects on productivity as adults.


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ANNEX 5: IMPLEMENTATION OF DPC1 REFORMS

DPC 1 Prior Action Achievements to date (as of February 27, 2019)

Prior Action 1: The Parliament has approved the establishment of a stabilization fund.

The fund was established and seed money of Nu 100 million was transferred into the fund. Thereafter, the governance framework has been adopted which provides the rules and regulations related to: (i) sources of revenue for the fund; (ii) conditions for the use of fund resources; (iii) procedures for transfer to and withdrawal from the fund; (iv) investment policy; (v) governance framework; and (vi) internal control systems and oversight mechanisms. The approved framework has helped set the basis for the operationalization of the fund.

Prior Action 2: The Cabinet has approved the introduction of GST.

Following Cabinet approval to introduce the GST in DPC1, a GST design paper was approved by the cabinet of the new government (which assumed office in November 2018). Thereafter, the Ministry of Finance has approved the draft GST bills. The government is currently undertaking an assessment of the distributional impacts of GST introduction and is also organizing consultations with stakeholders. Cabinet approval of the GST Bill is expected by September 2019 and Parliamentary approval by December 2019/January 2020. The new government remains committed to moving forward with GST implementation in July 2020.

Prior Action 3: The MoF has issued administrative measures to minimize the impact on revenues in response to India’s GST introduction.

Administrative measures were adopted to counter the impact of eliminating the excise rebates from India. Excise rebates to Bhutan were eliminated because India introduced GST. The measures included: (i) Taxes for high end consumer goods such as luxury cars charged at point of sale (instead of point of entry); and (ii) Excise duty is now charged on beer. These two reforms have helped increase revenues. In addition, there are plans to increase the number of service tax payers in the tax net by lowering the registration threshold which would increase the tax base from 10,000 to almost 50,000 tax payers. Also, an agreement is being negotiated with India so that between the two countries, GST is charged by the importing country. This will avoid double taxation and will not penalize Bhutan’s exports to India.

Prior Action 4: The Ministry of Economic Affairs (MoEA) has approved Guidelines for Operationalization of Business Incubation Center for Cottage and Small Industries (CSI).

The first CSI incubation center was inaugurated in July 2018 to provide an enabling space to aspiring entrepreneurs to shape and develop their business ideas. Space would be provided for up to two years to set up and run their businesses after the incubation period. The center has space for 28 entrepreneurs and includes a fabrication laboratory to translate the development of ideas into products through prototyping. The center currently houses 25 entrepreneurs mainly engaged in IT, packaging of agro-processed products, candle making and others. The center provides shared space for CSIs to grow their business and provides mentoring, training, marketing, product designing and development, linkages to financial institutions and other business development services among others.

Prior Action 5: The Cabinet has approved the Renewable Natural Resources (RNR) Marketing Policy for

After adoption of the RNR policy, an action plan was completed and is under implementation by the Ministry. The action plan is fully consistent with the 12th FYP.

http://www.businessbhutan.bt/2018/07/04/startup-center-to-facilitate-entrepreneurs-inaugurated/


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agricultural products.

Prior Action 6: The RMA Board has approved the Amendments to Credit Information Bureau Rules and Regulations 2017 to allow reporting by other entities.

Amendment to the Credit Information Bureau rules has enabled reporting of credit information by other entities like utilities, microfinance institutions, and insurance companies. CIB is now collecting alternate data from non-bank financial institutions. However, there are some challenges with data quality. To respond to this, RMA appointed a focal point from the Financial Regulation and Supervision Department to oversee and supervise the quality of data from the reporting institutions and ensure compliance with data requirements and quality. In addition, the Governor of the RMA sits on the Board of the CIB and all financial institutions are required to be members of CIB and they pay fees as members. All lenders (microfinance and including private money lenders) are required to report to CIB. Micro-finance institutions have started reporting. New rules include provisions for ensuring safety of data. WB is providing advice. Data improvement is an ongoing process. RMA now has reporting templates for CIB to report to RMA.

Prior Action 7: The RMA Board has approved E-money issuer Rules and Regulations 2017.

E-money issuer rules establish legal regulations for provision of mobile banking and payments services that have not existed before in Bhutan. After the regulations two telephone companies and one commercial bank have been licensed as e money institutions. The objective was to capture more of the unbanked population and from a base of zero in 2018, 45,234 users have now been engaged with mobile banking and this figure has increased to 47,850 as of February 2019. The RMA is monitoring progress closely to determine whether the system is ready for merchant payments and whether licensing should be expanded, to more e-money issuers. Government is concerned about fragmentation in the market and is seeking advice/TA from the WB on how to proceed.

Prior Action 8: The Ministry of Education has approved the International School Guidelines 2017.

The guidelines serve as the primary document for the education ministry regarding the establishment and operations of all international schools. Any new proposal that will be submitted/developed should therefore, adhere to the approved guidelines. The ministry confirmed that they have not received any proposals yet but have been informed (informally) that proposals are being developed which are expected to be submitted to the ministry soon.

Prior Action 9: The Ministry of Economic Affairs has approved National Energy Efficiency and Conservation Policy.

After ministerial approval of the policy, approval of the GNHC was obtained and the policy was submitted to the cabinet of the previous government. However, owing to the political transition, the policy was not approved. The policy will be presented to the new cabinet in June 2019. The action plan accompanying the policy has been drawn up and will be submitted to the new cabinet along with the policy.


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ANNEX 6: GENDER ASPECTS IN EDUCATION REFORMS Gender equality in access to education has been a longstanding issue that has drawn the attention of the government, World Bank and development partners in Bhutan. The country has made significant progress towards meeting the third Millennium Development Goal (promote gender equality and empower women) target.

Free public education at the primary and secondary level (kindergarten to grade 10) and substantial investment in the sector has helped achieve high enrolment rates, although quality varies across different regions. As of 2017, there was almost universal enrolment in primary education [Net Enrolment Rate (NER) 98.8 percent] and very high enrollment at the secondary education level (grades 7-10 NER 70 percent). In 2015, the completion rate of lower secondary education had reached above 90 percent for both girls and boys. Girls have higher survival and transition rates and lower dropout and repetition rates than boys. Bhutan has successfully bridged the gender gap in primary schooling. However, transition to lower secondary education has become the next challenge for the government. Approximately 25 percent of all students in primary education drop out before reaching the BCSE exam. Many barriers to secondary school entry have been recorded. Girls’ participation in household chores such as babysitting, and cleaning continue to be prevalent practices. The twin policies of: (a) the declared working age of 18 years, and (b) free but not compulsory primary education, have not yielded the desired outcomes. One in five children continue to work to support their families. Child labor rates for girls was noted to be higher than boys in 2012. In addition, participation in secondary education is also thwarted by: (a) additional school fees, (b) cost of uniforms, (c) the cost of learning materials, (d) lack of secondary schools in rural areas, (e) traditional views about girls’ education, (f) high turnover rate among teachers and other instructors, and (g) the fact that, like primary education, secondary education is not compulsory. The government’s recent introduction of waiving the cut-off points for admission will benefit both girls and boys, helping them to transition to lower secondary education in greater numbers. The good news is that more girls than boys participate in secondary education at the right age. The proposed action on waiving the cut-off point for admission will support gender equity later on in life as primary and secondary education imparts foundational skills needed for later learning. The recommended action is necessary, fundamental, and adequate in the short-run to lay the foundation to address the barriers to greater number of girls moving up to higher secondary schooling and further.


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ANNEX 7: DELAYS IN HYDROPOWER PROJECTS Delays in the completion of large hydropower projects has resulted in significant time and cost over runs. The hydropower projects so far developed in Bhutan have suffered complications due to unexpected complex geology and other technical challenges, which have resulted in significant cost-overruns and delays in commissioning. While cost and time overruns are borne by the government of India, these delays have implications for Bhutan in terms of lower growth, loss in fiscal revenues and lower exports. As an example, a 20 percent increase in cost and a two-year delay in commissioning raises the tariff by 30 percent which makes Bhutanese hydropower less competitive on the regional power market. A performance audit of the Punatsangchhu Hydroelectric Project Authority-I indicated a three-year delay in completion and estimated cost overruns of 166 percent of the initial estimated cost. This in turn had an adverse impact on electricity tariffs and revenue generation. The kilowatt per hour tariff increased to BTN 2.70 (compared to the Detailed Project Report (DPR) estimation of BTN 1.03) and the Internal Rate of Return of the project was reduced to 10.8 percent (compared to the DPR estimate of 12.2 percent). The World Bank has provided technical assistance to the government of Bhutan in the adoption of hydropower guidelines which will help reduce these time and cost overruns and the associated fiscal costs. The primary purpose of these guidelines are to provide clear guidance on how to prepare DPRs. In the past, DPRs were prepared using different standards and practices with inadequate investigations carried out. This resulted in large deviations in work quantities and specifications and led to increased construction costs and time overruns. The new guidelines take into account Bhutan’s unique and complex geology and will help better ascertain technical feasibility and economic and financial viability of hydropower projects. The guidelines also take into account past experiences and international best practices in hydropower development. Technical assistance from the World Bank is being provided to support the implementation of the guidelines. Given Bhutan’s vulnerability to natural disasters, the hydropower guidelines include provisions on environmental and social aspects of sustainable hydropower development and management. These provisions are aligned with international good practice and are in two broad areas. The first area includes Environmental and Social Impact Assessment (ESIA) and Environmental and Social Management Plan (ESMP) processes and methods. It addresses institutional responsibilities, regulatory processes, stakeholder engagement, ESIA scoping and terms of reference and sections required in the ESIA and ESMP. The second part provides topic specific guidance on eleven topics which are consistently the most important for hydropower projects globally: water use and downstream flows, water quality, erosion and sedimentation, waste disposal and waste management, air quality noise and vibration, terrestrial biodiversity and invasive species, aquatic biodiversity and invasive species, project affected communities, community health and safety, cultural heritage, and labor and working conditions. Each topic guideline provides a rich set of information including in relation to scope, risks, opportunities, baseline datasets, mitigation options, management plans and monitoring. These provisions will help Bhutan better manage the environmental aspects related to hydropower development.

http://www.bhutanaudit.gov.bt/oldweb/Publication/PA-Report-PHPA-I.pdf