Bhutan: Strengthening Economic Management Program (Second Tranche)

Transcription

1 Progress Report on Tranche Release Project Number: Loan/Grant Number: 2994/0338 July 2014 Bhutan: Strengthening Economic Management Program (Second Tranche) This document is being disclosed to the public in accordance with ADB's Public Communications This consultant s report Policy does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s design.]

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3 CURRENCY EQUIVALENTS (as of 1 July 2014) Currency unit ngultrum (Nu) a Nu1.00 = $ $1.00 = Nu60.04 a The ngultrum is pegged to the Indian rupee at par. ABBREVIATIONS ADB Asian Development Bank ARMS audit resource management system CRA credit rating agency DMD Debt Management Division DPA Department of Public Accounts DRC Department of Revenue and Customs DSA debt sustainability analysis FDI foreign direct investment FY fiscal year GDP gross domestic product IMF International Monetary Fund IT information technology MOF Ministry of Finance MOWHS Ministry of Works and Human Settlement MTEF medium-term expenditure framework PAVA Property Assessment and Valuation Agency PVM property valuation methodology RAA Royal Audit Authority RAMIS revenue administration management information system RMA Royal Monetary Authority SDR special drawing right SEMP Strengthening Economic Management Program TA technical assistance TBMC Treasury Bill and Management Committee NOTES (i) The fiscal year (FY) of the Government of Bhutan and its agencies ends on 30 June. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2013 ends on 30 June (ii) In this report, "$" refers to US dollars.

4 Vice-President W. Zhang, Operations 1 Director General H. Kim, South Asia Department (SARD) Director B. Carrasco, Public Management, Financial Sector and Trade Division, SARD Team leader Team members C. Akin, Public Management Economist, SARD K. Emzita, Principal Counsel, Office of the General Counsel K. Formanes, Operations Assistant, SARD M. K. Hidalgo, Financial Sector Officer, SARD C. Kim, Lead Finance Specialist, SARD In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

5 CONTENTS Page I. INTRODUCTION 1 II. RECENT MACROECONOMIC AND POLITICAL DEVELOPMENTS 1 A. Macroeconomic Developments 1 B. Political Developments 2 III. STATUS OF PROGRAM IMPLEMENTATION 2 IV. THE TECHNICAL ASSISTANCE GRANTS 9 V. PROGRAM ASSURANCES AND MONITORING FRAMEWORK 10 VI. ASSESSMENT 10 VII. THE PRESIDENT S DECISION 11 APPENDIXES 1. A. Policy Matrix 12 B. Status of Second-Tranche Policy Actions Design and Monitoring Framework Program Assurances and Conditions Analysis of Macroeconomic Developments Bhutan: Key Economic Indicators 32

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7 I. INTRODUCTION 1. The Strengthening Economic Management Program (SEMP) was designed against the backdrop of an acute episode of macroeconomic instability that began with the rupee liquidity crunch in fiscal year (FY) 2012, instigated by both structural and cyclical factors in Bhutan. On the structural side, the economy relies heavily on exports of hydroelectricity to India, which requires large imports of construction materials for hydropower plants before the ensuing export revenue flows are generated. On the cyclical side, and related to the nature of hydropower development, the large imports of construction materials lead to a pattern of protracted buildup in domestic and external imbalances that is overcome once the hydropower plant is completed and revenues are generated to repay the investment. During this construction cycle, the authorities need to carefully monitor demand for rupees associated with the import of construction materials and debt repayments because the spikes in demand can worsen the balance of payments position. To complicate matters, reflecting Bhutan s rapid increase in income per capita, consumption patterns have been changing, resulting in an increase in import demand for consumption goods from India. During the liquidity crunch of FY2012, the peak of the cycle coincided with a rising import demand for consumption goods that added further pressure on liquidity management. 2. Based on the strategic consideration of addressing the challenges of weak economic management in Bhutan, the Asian Development Bank (ADB) approved and made effective the SEMP for the equivalent of $35 million on 21 March The program has two tranches: (i) the first tranche, a grant of $20.81 million, was fully disbursed and financially closed on the same day as program approval and effectiveness, reflecting full compliance with 10 policy conditions under the first tranche; and (ii) the second and final tranche, a loan of SDR million ($14.19 million equivalent), is scheduled to be released in July 2014, subject to full compliance by the Government of Bhutan with the 15 policy actions. 3. The program set the objectives of improving (i) fiscal management to help the government allocate scarce resources more effectively and efficiently; (ii) debt management to strengthen cash management, and smooth flow of funds related to debt repayments; (iii) monetary and liquidity management to ensure that the interest rate policy better matches the demand and supply of loanable funds; and (iv) internal and external audit systems to enhance the monitoring of public resources and accountability. The impact will be sustainably strengthened macrofinancial management by the government. The outcome will be more effective use of the country s own financial resources in a predictable manner and creation of greater fiscal space in the government budget. The program is fully consistent with ADB s interim country partnership strategy, which acknowledges that improved fiscal and monetary measures, including better management of foreign exchange reserves, are the priority areas for creating an environment that is conducive to sustainable economic growth. II. RECENT MACROECONOMIC AND POLITICAL DEVELOPMENTS A. Macroeconomic Developments 4. Growth slowed in Bhutan from 8.6% in FY2012 to 4.6% in FY2013, well below the average growth rate of over 8% during the last decade since This deceleration was in part engineered by the authorities through targeted policy measures to cool down an overheated 1 ADB Report and Recommendation of the President to the Board of Directors: Proposed Policy-Based Loan and Grant to the Kingdom of Bhutan for the Strengthening Economic Management Program. Manila.

8 2 economy and avoid the risk of a hard landing. The slowdown reflected (i) credit restrictions in 2012 and an import ban, particularly in import-heavy activities such as construction and transport that required large rupee payments, to alleviate the balance of payment crisis with India and the rupee liquidity shortage; (ii) delays in the construction of new hydropower projects; and (iii) a slowdown in tourist arrivals. The analysis of macroeconomic developments and key economic indicators during the program implementation is provided in Appendix 4. B. Political Developments 5. Bhutan held National Assembly elections on 31 May and 13 July The result was a victory for the opposition People's Democratic Party (PDP), which won 32 of the 47 seats. The elections were the second general elections since 2008, when Bhutan successfully completed its political transformation from absolute monarchy to constitutional monarchy. The current government is fully supportive of the SEMP reforms, which reinforce its efforts to promote sustainable and broad-based economic growth in Bhutan. III. STATUS OF PROGRAM IMPLEMENTATION 6. The government has made considerable effort to fulfill all the second-tranche release actions. The release requires compliance with 15 policy actions under four broad policy reform areas, which target improvements in (i) budget and debt management, (ii) revenue management, (iii) macroprudential and financial sector management, and (iv) external and internal audit operations. The policy matrix and the achievement status of second tranche are in Appendix 1. The detailed compliance status for each of the second-tranche policy actions follows below Budget and Debt Management 7. Major municipalities, including Thimphu Municipality, Phuentsholing Municipality, Samdrup Jongkhar Municipality, and Gelephu Municipality, shall have prepared a medium-term expenditure framework (MTEF) that shall be used as the basis for annual budget preparation. (Tranche 2 T2] action 1: complied with.) The aforementioned municipalities submitted their MTEF reports on 4 June The preparation of multi-year rolling budgets based on the MTEF aimed to improve the allocative efficiency and effectiveness of public spending by subnational governments and to reduce the dependence of municipalities on central government transfers and subsidies for financing their current expenditures in the future. The reports assisted these municipalities in (i) budgeting and managing their expenditures based on spending agencies target outcomes; (ii) building detailed revenue mobilization plans, including their own sources of revenue and tariffs for services; (iii) modernizing tax administration to bolster the revenue base; (iv) enhancing accountability across spending divisions through performance indicators; and (v) creating alternative fiscal deficit scenarios for objective, formula-based institutional arrangements in revenue sharing between central government and the municipalities. During the preparatory stages, 42 local government officials from these municipalities were trained in municipal fiscal data collection and assessment, and effective use of the MTEF methodology and templates. 8. The Ministry of Finance (MOF) shall have prepared, finalized and submit to ADB a report on the implementation of the action plan under the Debt Management Strategy. The report shall cover the period from the effective date until the review for second- 2 The language of the policy actions in this section reflects the Attachment 3 of Schedule 3 in SEMP Financing Agreement signed on 21 March 2013 between the Government of Bhutan and ADB.

9 3 tranche release. (T2 action 2: complied with.) Under the first tranche of the SEMP, the medium-term debt management strategy and action plan, covering FY2014 FY2018, were approved with the aim of (i) strengthening the organizational capacity for debt management, (ii) optimizing the portfolio composition of debt with minimum cost and risk in the medium term, (iii) enhancing liquidity and cash management to streamline the debt service payments, (iv) developing a domestic debt market, and (v) improving debt recording and reporting in Bhutan. MOF submitted the implementation report on 22 April Policy actions on staffing of the debt management office; annual update and endorsement of the debt management strategy; capacity building of two MOF officials in debt sustainability analysis; inclusion of on-lending, cost and risk indicators, and strategy in the debt situation report; and participation of non-bank financial institutions in the primary market were fully achieved. Policy actions that are in progress are supported by various technical assistance (TA) programs: (i) development of domestic debt market instruments, extension of the yield curve, and announcement of the auction calendar are ongoing under ADB TA on Capital Market Development; 3 (ii) training for management of reserves and open market operations is covered under ADB TA on Supporting Financial Stability in Bhutan and the Maldives; 4 and (iii) monitoring of government central accounts and strengthening of cash forecasting by the treasury management division, and establishment of online fund transfers are in progress under TA from the International Monetary Fund (IMF). Capacity building in cost and risk analysis, and use of debt management software need to be achieved with additional support from multilateral agencies. 9. Building on an approved Debt Management Strategy and the action plan, MOF, in coordination with the Royal Monetary Authority (RMA), shall have prepared a strategy paper on debt market development (Debt Market Development Strategy) that will address the following issues: (a) narrow investor base, (b) lack of auction calendar, (c) promoting price competition in auctioning of government securities, and (d) functional integration of the Treasury Management Division and Debt Management Division (DMD) for improved cash management. The Debt Market Development Strategy shall have been approved by the Macroeconomic Framework Coordination Committee. (T2 action 3: complied with.) Sound public debt management in Bhutan requires a liquid and deep government securities market that will provide government with cost-effective on-demand financing. Development of an efficient government securities market will serve several objectives: (i) minimization of debt service costs, (ii) management of liquidity and monetary policy, (iii) creation of a benchmark for other interest rates in the economy, and (iv) supply of instruments for banks and institutional investors. The Macroeconomic Framework Coordination Committee approved the paper for debt market development strategy on 14 April 2014, which will be the guiding framework for MOF and the RMA in furthering these objectives. The strategy paper presents policies to develop (i) an efficient primary market by improving cash management and forecasting tools to increase the transparency of the government s funding needs, and by publicizing a schedule of treasury bill (T-bill) issuance, volumes, and tenors to give market participants advance notice; (ii) secondary markets by strengthening the RMA s liquidity management tools; (iii) a more diversified investor base with different risk preferences comprising banks, non-bank financial institutions, non-financial corporations, retail investors, professionally managed investment and/or pension funds to stimulate efficiency in the primary market and diffuse the liquidity in the financial system; (iv) a robust and well-functioning clearing, settlement, custody, and price discovery infrastructure to facilitate the orderly flow of transactions in the primary and secondary markets; This consultant s and (v) report robust does regulation not necessarily by MOF reflect in primary the views market of ADB (e.g., or the government government concerned. debt issuance, [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s 3 design.] ADB Technical Assistance to Bhutan for Capital Market Development. Manila (TA 8280-BHU). 4 ADB Technical Assistance for Supporting Financial Stability in Bhutan and the Maldives. Manila (TA REG).

10 4 auction rules, and procedures) and by RMA in secondary-market areas (e.g., market intermediaries, surveillance, transparency requirements, and clearing and settlement of transactions) The MOF and the RMA shall have implemented the Debt Market Development Strategy and submit to ADB report on its implementation. (T2 action 4: complied with.) MOF submitted the implementation status report on the debt market development strategy on 5 June MOF established the primary market s regulatory framework for government securities, including auction rules and procedures, with the 2009 Treasury Bill Operation Guidelines. The role and mandate of the Treasury Bill and Management Committee (TBMC) will be broadened and a technical committee will be established to oversee the development of the government securities market. The TBMC currently convenes on an ad-hoc basis if a short-term need requires T-bill issuance. Within the next 2 years from the approval of the debt market development strategy, MOF will adopt a government securities issuance framework to announce T-bill auction dates with tenors and volumes. Auctions for T-bills will be conducted on a multiple-price, competitive basis, encouraging broader investor participation. Both MOF and the RMA are working toward enhancing liquidity management and forecasting tools to ensure more accurate estimation of the government s future funding needs. 6 Expenditure and revenue forecasting templates have been developed and piloted by the Department of Public Accounts (DPA). Electronic payment options have been explored to reduce concentration of liquidity in the banking system. Regulations for the establishment of a central depository and clearing house have been drafted and circulated. Over the medium term, MOF and the RMA will implement policies to develop secondary-market infrastructure and an institutional investor base. 11. The DMD shall have prepared and submitted an annual debt sustainability analysis to MOF and ADB. (T2 action 5: complied with.) Bhutan has developed rapidly in recent decades thanks to the successful strategy of optimizing its growth by financing its capital expenditures at the lowest cost through a mix of official development assistance and concessional debt. 7 By 2020, the government has designated hydropower development as the key engine of economic growth, and targeted a capacity addition of 10,000 megawatts. Investments in projects of such magnitude are highly capital intensive and, when funded through foreign-currency-denominated loans, will likely have an impact on the economy due to an increase in the stock of debt and debt service obligations. The debt sustainability analysis determines whether the beneficial effects of these investments outweigh the increase in financial stress in the long run. Against this background, MOF submitted the report on Debt Sustainability Analysis (DSA) on 22 April The DSA shows that when all borrowings, including hydropower loans from Government of India, are considered for the analysis (option 1), external debt thresholds are breached under all scenarios except the ratio of external debt service to exports, which shows a minor breach under an extreme stress scenario. Although the breaches would indicate high risk, the increase in debt ratios is mainly due to the high investment requirement in hydropower projects met through off-budget borrowings during the implementation phase. The debt ratios rapidly improve once the projects become operational and start yielding economic returns through the creation of jobs; higher exports, foreign direct investment (FDI) inflows, and operational expenditures; and revenue surpluses for the 5 During the stakeholder seminars on 18 February 2014 and 13 May 2014, more than 70 representatives from MOF, the RMA, and Bhutan s financial sector discussed these policies. 6 TA 8284-REG (footnote 4) and IMF TA on Cash Planning and Cash Flow Forecasting are supporting these efforts. 7 In FY2012, external (public) debt stood at 91.6% of gross domestic product (GDP), and the loans to the hydropower sector constituted 60% of total external debt, of which 39% is concessional. Borrowing from Government of India dominated the hydropower loans, accounting for 47% of external (public) debt. 8 The DSA for Bhutan was conducted using the IMF methodology from the base year of FY2013 until FY2034.

11 5 government via increasing dividends, corporate taxes, and royalties. The baseline scenario did not breach the thresholds for any indicator under option 2 when hydropower loans from Government of India are excluded. 9 For example, the ratio of present value of public sector debt to GDP remains below the benchmark of 74% for the baseline and extreme stress scenarios. It was only the debt service revenue ratio that breaches its threshold under the extreme stress scenario. Therefore, Bhutan s debt dynamics (including hydropower loans) is classified as moderate risk in the DSA. The debt portfolio and debt service requirements are considered to be manageable and there is sufficient hedge against the risks. 2. Revenue Management 12. MOF shall have piloted the implementation of the revenue administration management information system (RAMIS) within the Department of Revenue and Customs (DRC). (T2 action 6: complied with.) With the RAMIS, the DRC establishes a webbased integrated information technology (IT) infrastructure for strengthening revenue administration and making tax collection in Bhutan more effective. Full implementation of RAMIS will expand the revenue base and help rein in the budget deficits through greater tax compliance and efficient administration. In addition, technical training programs for tax officials and public awareness programs for taxpayers, as well as a study on revenue policies and a regulatory framework for expanding the revenue base and streamlining administration are expected to give momentum to additional tax reform efforts. The internal revenue component of RAMIS Phase I 10 including income tax, sales tax at point of sale, and revenue accounting modules that are directly linked to the SEMP was piloted on 25 April 2014 at the head office and two regional offices in Thimphu and Phuentsholing, and a pilot report was submitted. Beforehand, RAMIS hardware setup and software installation had been successfully completed, and DRC IT officials had been trained on the architectural design of the system on 27 March From 31 March to 18 April 2014, the functionalities of all modules had been tested with real life data simulation through a user acceptance testing program, and training of trainers was conducted for 60 participants from the DRC s income and sales tax, revenue accounting, and IT divisions. Major functions such as taxpayer registration, issuance of taxpayer numbers, creation and monitoring of chart of accounts, return filing, return assessment, and payment at the DRC cash counter are working well. The Phase I modules will go through continuous refinement until full stabilization is achieved and the system is ready for rollout in the public domain, which is expected in October The MOF, in coordination with the Ministry of Works and Human Settlement (MOWHS), shall have prepared and approved the rules and regulations on property valuation methodology (PVM). (T2 action 7: complied with.) The PVM rules and regulations, as prepared by the Property Assessment and Valuation Agency (PAVA) task force, were approved by MOF and came into effect on 21 March They will apply to all cases of valuation of land and property, and extend to the whole of the country. The PVM is based on the objective valuation of land and properties rather than unit- or area-based fixed rates. 11 The new 9 The exclusion of debt from the Government of India is justified on the grounds that these hydropower projects are developed under joint venture agreement, where the 50:50 equity contribution comes from an equivalent grant from Government of India as well as under a 30% grant and 70% loan arrangement. Repayment is linked to export revenue flows in Indian rupees, guaranteed by purchase assurance, and thus the default risks are minimized. 10 This RAMIS consultant s Phase II includes report does customs, not necessarily excise, and sales reflect tax the at views point of of entry ADB modules, or the government which are directly concerned. linked to [For the South Asia Subregional Economic Cooperation (SASEC) Trade Facilitation program. 11 PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s Under the new rules and regulations, land valuation is based on a zonal classification and a weighted average of (i) design.] capacity of the land to produce monetary income, (ii) official records of land transactions, (iii) market rates from land sellers, and (iv) rates used for insurance and mortgage purposes. The valuation of urban buildings is based on construction costs. Factors such as distance from highways, water availability, and land use are also considered.

12 6 rules and regulations and subsequent pilot implementation of the PVM will improve the financial self-sufficiency of municipalities in Bhutan by enhancing local revenue collection at the subnational government level and help reduce dependence on central government transfers. 14. MOWHS shall have implemented the Property Valuation Methodology in at least one municipality. (T2 action 8: complied with.) The status report on the implementation of PVM was submitted on 25 June MOWHS selected the Phuentsholing municipality as the pilot location before the PVM is introduced to all municipalities in the country. The scope of the implementation was defined as (i) the valuation of a representative sample of 50 properties along with the associated land, building, and other structures (e.g. parking, fence or boundary walls), based on the new PVM rules and regulations, and Bhutan schedule of rates guidelines. These properties were selected based on different characteristics across all precincts in Phuentsholing; (ii) preparation of a PVM-based property tax model and installation of an Excelbased template and toolkit, which, among other functionalities, enables a scenario and tax burden analysis for identifying the optimal property tax rates in the municipality; (iii) capacity building of 16 officials on 24 June 2014 from Phuentsholing and Samdrup Jongkhar municipalities as well as the Department of Engineering Services and MOWHS on the implementation of the PVM, tax model, and toolkit. The municipality conducted site verification of selected properties, and completed the information on their characteristics in the digital land and property database at the start of the pilot. 3. Macroprudential and Financial Sector Management 15. The Financial Policy Committee shall have prepared and approved by RMA, the macroprudential policy paper and its corresponding rules on: (a) countercyclical capital buffer for banks; (b) loan to value and loan to income restrictions; (c) sectoral capital requirements; (d) minimum ceiling on leverage ratio of banks; (e) time-varying capital provisioning and margin requirements; (f) restrictions on distributions of profits; (g) debt to equity ratio for project financing; and (h) bank disclosure requirements. (T2 action 9: complied with.) Following the rupee liquidity crunch, the need for a comprehensive approach to banking sector regulation became more evident, so as to strengthen the resilience of Bhutan s financial system and contain the risks arising from the procyclicality of bank lending. Given that the current regulatory framework is mostly microprudential in nature, and includes only few macroprudential elements such as sector-specific risk weights, on 7 May 2014, the RMA approved a comprehensive macroprudential policy paper and the corresponding rules and regulations on the following seven items: (i) countercyclical capital buffer aims to safeguard the intermediation activities of banks by ensuring that they have sufficient capital to meet their minimum capital adequacy requirements during downturns; (ii) loan-to-value and loan-to-income restrictions, applicable only to loans for residential properties, mitigate the risks of default arising from a fall in collateral values or inadequate repayment capacity of borrowers; (iii) sectoral capital requirements impose additional capital against exposures to sectors that contribute to risk buildup during economic booms; (iv) minimum ceiling on leverage ratio is supplementary to the capital adequacy ratio and ensures that financial institutions maintain adequate levels of capital at more than a certain threshold at all times, in line with the riskiness of their asset portfolio; (v) time-varying capital provisioning requires banks to make higher provisioning during good times to compensate for loan losses during bad times, and minimum margin requirements prevent procyclicality in loan underwriting standards; (vi) restrictions on distribution of profit strengthen the banking capital through retained earnings by linking the dividend payout ratio to a minimum level of capital adequacy ratio and a limit on the net non-performing loan ratio; and (vii) the debt equity ratio mandates that a certain proportion of a project loan must come from the borrower s resources (equity) to contain the credit risk.

13 7 16. The draft rules and regulations on bank disclosure requirement were posted on RMA website on 24 June 2014 and RMA notification was sent to the public to receive comments until 24 July 2014 before it is considered for RMA Board approval. The new regulation supplement the existing disclosure requirements in the Financial Services Act, 2011 (section 96); the Corporate Governance Regulations, 2011 (Section 14-i), which set the disclosure norms of companies and a code of conduct specifically for financial institutions; and the Accounting Standards Rules for Companies in Bhutan, With this regulation, the annual and quarterly bank disclosures will include, among others, Tier 1 and Tier 2 capital, risk weighted assets, loans classified by sectoral composition, quality, counter-party, as well as interest and credit risk. 17. The RMA shall have piloted the implementation of the recommendations of the policy paper on macroprudential regulations. (T2 action 10: complied with.) The RMA submitted the report on the pilot implementation of the macroprudential regulations on 5 June The scope of the pilot implementation included (i) notification to the financial sector of the seven rules and regulations (as listed in T2 action 9: a-g) that became effective on 7 May 2014; (ii) approval of a timeline for implementation of the regulations as specified in the notification; 12 (iii) capacity building provided to 45 RMA officials and representatives of the Bhutanese banks and other financial institutions through a stakeholders workshop held in Paro on 4 April 2014, where the proposed regulations were discussed; and (iv) training of 7 RMA officials on the conceptual aspects of the stress-testing framework and the ongoing efforts to develop stresstesting and scenario-analysis templates for banks for assessing credit, liquidity, interest, foreign exchange, and lending risks, and collection of financial data to build macroeconomic and financial soundness indicators. 18. The RMA shall have implemented key recommendations of the action plan on improving retail to wholesale deposit ratio. (T2 action 11: complied with.) A major structural bottleneck in Bhutan s banking system is the asset liability mismatch. 13 To align the maturity of the banking assets with the duration of their liabilities, a deposit mobilization action plan was developed under the first tranche of the SEMP. The RMA submitted the status report on its implementation on 25 June On the liability side, short-term investment instruments such as T-bills of multiple maturities will be introduced once the government securities market, including repo transactions, is developed (paras. 9 and 10). Subsequently, other short-term liquidity management tools such as negotiable certificates of deposits, bankers acceptances, and commercial paper are likely to follow. Another policy action proposed for liquidity management is the equitable distribution of government central accounts, which are considered to be more stable than the corporate deposit accounts, among all the banks, so that banks could use these funds to participate in the interbank market, T-bill auctions, and other debt instruments. On the asset side, banks have offered new types of savings accounts that cater to different demographic groups; however, the retail deposit base has not picked up due to low or negative real rates on bank deposits. The RMA has made proposals in the 2001 Income Tax Act to link the tax exemption limit for individual account holders incrementally with the term of the fixed deposit to extend the duration of bank deposits to match the maturity of assets. Actions related to branchless mobile banking were only partially implemented the RMA has approved 12 The implementation date for the minimum ceiling on leverage ratio, loan-to-value and loan-to-income restrictions, debt equity ratio, and margin requirements will start on 1 November Restrictions on distribution of dividends This will consultant s begin for the report accounting does year not necessarily ending on 31 reflect December the views of For ADB the or countercyclical the government capital concerned. buffer, sectoral [For capital requirements and time-varying capital provisioning, the regulations will be implemented after 1 January PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s 2016, as per Basel III recommendations, following the adjustment of banks and the RMA to the new provisions. design.] The RMA will build capacity to monitor the financial risk indicators. 13 In Bhutan, demand deposits accounted for over 60% of total deposits in 2013, most of which were volatile corporate deposits. The asset portfolio is concentrated on long-term fixed-rate housing and construction loans.

14 8 the regulation, but the launch of agencies throughout rural Bhutan is not yet completed. Training programs are necessary to spread financial literacy. The deposit insurance scheme was partially implemented with the 2011 Financial Services Act, which mandates the RMA to set up a deposit insurance fund up to a maximum of Nu100,000, with further recommendations to increase the limit for long-term deposits over 3 years. In addition to this action plan, RMA officials recently adopted new initiatives following their participation in Toronto Center International Program for Banking Supervisors in June Five new actions that are under implementation during 2014, aim at (i) segregation of deposit liabilities, (ii) reducing the share of wholesale deposits by 30%, (iii) lowering the sectoral concentration in the banking system, (iv) reducing asset-liability mismatch and (v) issuance of relevant microprudential guidelines. 19. The RMA shall have completed a master plan on capital markets that charts the strategic development of the capital markets over the next 10 years. MOF and the RMA approve the master plan. (T2 action 12: complied with.) Bhutan s financial system is marked by an overreliance on bank financing, whereas capital markets i.e., equity and bonds are small, illiquid, and inactive. The Eleventh Five-year Plan ( ) has highlighted the need to develop Bhutan s capital markets for the next decade in a systematic and sequenced way in support of the national growth agenda. For this purpose, on 30 May 2014, MOF and the RMA approved the capital markets master plan for , which has four pillars: (i) the policies to increase the supply of a broad range of investment instruments by central and local governments, public and private enterprises, bank and non-bank financial intermediaries; (ii) the policies to meet the demand from retail and institutional investors (such as private pension and insurance funds) for a broad range of investment opportunities; (iii) the policies for a market infrastructure that encompasses effective, efficient, and resilient trading, clearing, settlement, and payments systems and central depositories; and (iv) the legal, regulatory, and supervisory framework as well as policies governing such areas as taxation, competition, and entry of foreign participants. The master plan provides the foundation for an active market for equities, corporate bonds, and the fund management industry. Additionally, the role of venture capital firms, institutional investors such as the National Provident and Pension Fund, and FDI is formulated to stimulate private-enterprise-focused lending in Bhutan. Other policies to increase the depth of the stock exchange include privatization of state-owned enterprises The RMA shall have established the regulatory and supervisory framework for the domestic credit rating agency (CRA). (T2 action 13: complied with.) Another important component of the capital market development is the establishment of a domestic CRA in Bhutan. On 30 May 2014, the RMA approved the regulatory and supervisory framework, which became effective from 12 June The framework requires the CRA to be registered and licensed by the RMA, combined with a compliance requirement as per the International Organization of Securities Commissions principles and code of conduct for CRAs. The scope of the services of the CRA include: (i) issuance of credit ratings on debt instruments (equities and bonds), (ii) rating of creditworthiness of small and medium-sized enterprises, (iii) rating of initial public offerings of equity securities, (iv) rating of companies listed on the Royal Securities Exchange of Bhutan as to their corporate governance practices, and (v) rating of the performance of investment funds. Given the cost and lack of expertise, and the need to make the credit rating services available in the shortest time, the CRA regulation allows for the establishment of jointventures with foreign CRAs, which is expected to contribute to transfer of know-how and 14 The master plan along with regulations on CRAs was presented to representatives of financial institutions in Bhutan during the stakeholder seminars on 18 February 2014 and 13 May 2014.

15 9 development of full-time national professional staff until a large-enough market for rating services develops to support more agencies including locally incorporated entities External and Internal Audit Operations 21. The Royal Audit Authority (RAA) shall have implemented the audit resource management system (ARMS). (T2 action 14: complied with.) The RAA submitted the report on the completion of the pilot implementation of ARMS on 9 April All 11 modules of ARMS were successfully piloted. 16 Fifty-five RAA auditors, including from regional offices, received training on the functionalities of the system. An in-house technical team was formed for sustainability of the ARMS software, and 7 officers underwent training on programming. ARMS provides the IT infrastructure to efficiently plan and schedule audit assignments, monitor the progress of audits in the field, and track the audit observations through computerized processes. The improvement in the compliance of government agencies and higher accountability in the use of public funds, as measured by the reduced amount of unsettled funds, and reduction of total field audit time spent by RAA auditors, primarily benefit the government amid a growing and complex administration, and ongoing fiscal decentralization efforts. Through ARMS, institutional infrastructure will be strengthened to deter waste, fraud, and corruption. 22. RAA shall have prepared and approved an internal audit manual and completed training of all the staff recruited for internal audits. (T2 action 15: complied with.) The approved internal audit manual and a comprehensive training report of internal auditors were submitted on 18 April The manual was prepared in collaboration with the World Bank and approved by MOF in the policy and planning coordination meeting on 13 March It details the structure and international standards of the internal audit framework; risk and fraud management and assessment; periodic reporting and strategic audit planning; and the audit process with field activities, monitoring, documentation, and quality assessment. The training report contains the list of 45 internal auditors placed in 10 ministries, 20 dzongkhags (districts) and 2 autonomous bodies who received training during , and a summary of courses (ranging from certified internal auditor and certified government auditing professional qualifications to internal control and auditing techniques). The courses were funded by the World Bank, United Nations Development Programme, and the Government of Bhutan. IV. THE TECHNICAL ASSISTANCE GRANTS 23. Although the SEMP did not have any piggybacked TA, five ongoing ADB TA grants have supported the implementation of the following policy actions under the second tranche of the program. The preparation of MTEF reports, part of the implementation of RAMIS, and preparation of the PVM (T2 actions 1, 6, and 7) took place under Strengthening Public Management in Bhutan. 17 The pilot implementation of RAMIS (T2 action 6) took place under Developing a Revenue Administration Management Information System. 18 Actions related to the development of a government securities market, banking sector deposit mobilization, capital 15 To study the feasibility of various CRA models and regulatory approaches in Asia, RMA officials conducted field trips to securities and exchange commissions, and CRAs in Nepal and the Philippines from 28 April to 2 May ARMS has 11 modules audit management, execution, reporting, follow-up; quality assurance review and team evaluation; human resource management; training; inventory management; system administration; attendance and This leave, consultant s and general report administration. does not necessarily reflect the views of ADB or the government concerned. [For 17 ADB Technical Assistance to Bhutan for Strengthening Public Management in Bhutan. Manila (TA PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s BHU). ADB provided $850,000 from Technical Assistance Special Fund (TASF-IV) on 15 December design.] ADB Technical Assistance to Bhutan for Developing a Revenue Administration Management Information System. Manila (TA 7881-BHU). ADB provided $500,000 from a grant by the Republic of Korea e-asia and Knowledge Partnership Fund on 7 October 2011.

16 10 markets master plan, and CRAs (T2 actions 3, 4, 11, 12, and 13) took place under Capital Market Development. 19 The preparation of macroprudential rules and regulations (T2 actions 9 and 10) took place under Supporting Financial Stability in Bhutan and the Maldives. 20 Finally, the implementation of ARMS (T2 action 14) took place under Strengthening Audit Resource Management. 21 The TA resources have been used effectively, as has been common to all TA operations in Bhutan. Coordination of TA inputs has been successful thanks to the strong teamwork across MOF, the RMA, and other implementing agencies in Bhutan, and among project officers of the SEMP and supporting TAs at the ADB. Notwithstanding the capacity and institutional constraints during program implementation, the intense training support provided by TA interventions benefited more than 300 participants, enhancing the sustainability of reforms. V. PROGRAM ASSURANCES AND MONITORING FRAMEWORK 24. Appendix 3 shows that all of the program assurances provided by the state have been complied with. DPA MOF as the executing agency has been responsible for overall program administration, including (i) overseeing and coordinating timely implementation of all policy actions across five implementing agencies; (ii) maintenance of program records; (iii) compliance with reporting requirements; and (iv) disbursement. The program activities related to secondtranche release were monitored at different levels through (i) four loan review missions on 3 8 November 2013, February 2014, 2 5 April 2014, and May 2014; (ii) steering committee meetings; and (iii) aides-mémoires. VI. ASSESSMENT 25. The Government of Bhutan has fully complied with the policy actions envisaged in the SEMP. The implementation success critically hinges on the political commitment of the government to bring about the essential yet difficult reforms to remove major bottlenecks in fiscal and monetary management, and in Bhutan s financial sector, so that it can set the economic recovery on a sustainable trajectory following the rupee liquidity crisis. The commitment rests on various factors, such as (i) greater understanding of the objectives and the needs for reforms among the stakeholders; (ii) strong partnership and effective coordination of ADB staff, program management, and government officials; and (iii) a strong sense of purpose and appreciation of the program benefits across the departments involved in the program. 26. Various policy actions carried out under the SEMP create a comprehensive approach to improved macrofinancial management in Bhutan. MTEF-based annual budget preparation in major municipalities aims to create the fiscal space needed by subnational governments. Actions related to debt management and establishment of a government debt securities market constitute the essential part of fiscal and monetary policy, and liquidity management, which will make the flow of funds more predictable and help avoid destabilizing spikes in debt repayments. 27. RAMIS and PVM pilot implementation under the revenue management component are other examples of milestone achievements, where DRC and MOWHS, as the implementing agencies, have shown dedication for their successful completion. Broadening of the tax base, higher revenue mobilization, and enhanced effectiveness of tax administration will pave the way for reining in budget deficits and financing a larger share of developmental outlays from 19 Under TA 8280-BHU (footnote 3), ADB provided $1,250,000 from TASF-IV resources on 15 December Under TA 8284-REG (footnote 4), ADB provided $500,000 from the Financial Sector Development Partnership Fund on 19 December 2012 for development of macroprudential regulations and liquidity management in Bhutan. 21 ADB Technical Assistance to Bhutan for Strengthening Audit Resource Management. Manila (TA BHU). ADB provided $450,000 for ARMS from TASF-IV resources on 13 December 2010.

17 11 domestic resources. Also, improvement of the fiscal space will serve to promote resources outside the hydropower industry, which will diversify the economy. 28. The policy actions under the financial sector management component of the program have made very important contributions to the strengthening of Bhutan s financial system. The formulation of macroprudential rules and regulations will boost the banking system s resilience against the risks arising from the procyclicality of bank lending. The RMA has undertaken the steps to build a stress-testing framework for assessing risks, and to collect financial data for macroeconomic and financial soundness indicators. The action plan related to the improvement of the wholesale retail deposit ratio addresses the structural problem of asset liability mismatch in the Bhutanese banking sector. Most importantly, formulation of a capital markets master plan allows positioning of the capital markets to support broad-based economic growth and socioeconomic development objectives including poverty reduction. Capital markets can stimulate healthy competition, which results in lower financing costs for all borrowers. Diversification away from Bhutan s predominantly bank-based system of financial intermediation will expand alternative sources of credit, and thereby help limit systemic impacts of economic shocks and improve the financial sector s resilience. During the implementation of the financial sector related actions, the SEMP has played a significant role in building a constituency for reforms through stakeholder seminars and policy dialogues. 29. Finally, policy actions related to the pilot implementation of ARMS, internal audit manual, and training of audit staff set the foundation for improving the accountability in public financial management and the effective use of public resources. 30. The full compliance of the policy actions contributed to the successful progress towards achievement of the program targets and outcomes as laid out in the design and monitoring framework in Appendix 2. The ratio of balance of payments to GDP turned into a surplus of 9.3% in FY2013, and is projected to remain in surplus of 3.8% in FY2015 and 2.7% in FY2016. The gross international reserves position improved significantly as discussed in Appendix 4 and reached over $900 million before the target period of FY2017. The ratio of non-hydropower debt to GDP is projected to stabilize at 31.6% in FY2014, which is well below the program target of 35% by FY2015. The fiscal deficit has been brought under control at 0.9% of GDP in FY2013 and is projected to remain around 3% in FY2015 and onward. Finally, the savings to GDP ratio reached over 37% in FY2012, and the steady improvement of the ratio is likely to be sustained over time with the deepening of the financial system. 31. Recognizing the government s strong ownership of the SEMP, a follow-up program is recommended to sustain and deepen the thrust of the reforms and to strengthen the overall management and resilience of the economy. The proposed follow-up program will be formulated in line with the long-term national capital markets master plan designed under the program. VII. THE PRESIDENT S DECISION 32. In view of the significant progress made in the implementation of the overall program, and full compliance with 15 policy actions for release of the second tranche, the President is satisfied with the overall implementation of the Strengthening Economic Management Program and that the necessary actions for the release of the second tranche have now been fulfilled. In This consultant s report does not necessarily reflect the views of ADB or the government concerned. [For accordance PPTAs: Also, with all of the the established views expressed procedure, herein may the not President be incorporated will authorize into the the proposed release project s of the second design.] tranche in the amount of SDR million ($14.19 million equivalent). The authorization shall be effective not less than 10 working days after the circulation of this progress report to ADB s Board of Directors.

18 12 Appendix 1 A. POLICY MATRIX OBJECTIVE: To strengthen the government s ability to effectively address risks and set the foundations for sustainable growth Objectives and Policy Actions 1st Tranche Policy Actions (Q1 2013) 2nd Tranche Policy Actions (12 months after T1) A. Budget and Debt Management Objective: To improve budget and debt management by improving effectiveness of public spending and synchronization of payments. 1. Sub-National Government (1) Major municipalities, including Thimphu, Budget Phuentsholing, Samdrup Jongkhar and Gelephu, will have prepared a medium-term expenditure framework (MTEF) that is used as the basis for annual budget 2. Develop a Clear National Debt Strategy 3. Support Debt Market Development through Creation of a Yield Curve (1) Ministry of Finance (MOF) will have prepared a satisfactory Debt Management Strategy, which includes clear debt management objectives over the medium to long term (3 5 years) and an action plan to implement the strategy. The action plan will also include strengthening of the Debt Management Division (DMD). (Document required: MOF certification that the debt strategy and action plan have been approved by MOF together with the approved strategy attached to the certification) preparation. (Document required: MTEF reports) (2) MOF will have prepared and finalized a report on the implementation of the actions under the debt management strategy covering the period from the date of the loan and grant effectiveness until the review for the 2nd tranche release. (Document required: MOF report on the implementation of the Debt Management Strategy) (3) Building on approved Debt Management Action Plan, MOF, in coordination with the Royal Monetary Authority (RMA), will prepare and approve a strategy paper on development of government securities market to address: (i) narrow investor base, (ii) lack of auction calendar, (iii) limited price competition in auctioning of Government securities, and (iv) functional integration of Treasury Management Division and DMD for improved cash management. The Debt Management Strategy will have been approved by the Macro-economic Framework Coordination Committee. (Document required: strategy paper approved by the Macro-economic Framework Coordination Committee). (4) MOF and RMA will have implemented the strategy paper on development of Government securities market. (Document required: A status report on implementation prepared by MOF)

19 Appendix 1 13 Objectives and Policy Actions 1st Tranche Policy Actions (Q1 2013) 2nd Tranche Policy Actions (12 months after T1) 4. Promote Institutional Strengthening of the Debt Management Division (DMD) (2) DMD will have appointed and fill all nine staff positions in DMD, which will constitute a full complement of DMD organizational chart to carry out the debt management strategy and the action plan to strengthen debt programming, monitoring and reporting. (Document required: MOF order on the appointment of the nine staff and DMD organizational chart). B. Revenue Management Objective: To strengthen revenue effort by enhancing revenue systems 1. Develop a Revenue Administration Management Information System (RAMIS) 2. Upgrade Revenue Chart of Accounts 3. Develop a Taxpayer Number (TPN) (3) Department of Revenue and Customs (DRC) will have prepared and approved the System Requirement Specification (blueprint) for the internal revenue component of RAMIS. (Document required: MOF certification on approved system requirement specification with the approved blueprint attached to it) (4) DRC will have revised and approved a new Revenue Chart of Account in line with IMF Government Finance Statistics. (Document required: MOF certification on the new revenue chart of account has been approved and notification approved by DRC) (5) DRC to approve the new TPN scheme (Document required: MOF notification on the new TPN scheme as approved by DRC) (5) DMD will have prepared and submitted an annual debt sustainability analysis to MOF. (Document required: Debt sustainability analysis report approved by MOF) (6) MOF will have piloted implementation of RAMIS within DRC. (Document required: MOF will submit a pilot implementation report prepared by DRC) 4. Develop a Property Valuation (6) MOWHS will have developed a property valuation (7) MOF, in coordination with MOWHS, will have Methodology to Enhance methodology and submit the same to PAVA. approved the rules and regulations on Property Revenue Effort at the Sub- Valuation Methodology. National Level. (Document required: The regulation on the new property valuation methodology approved by MOWHS and MOF) (8) MOWHS will have piloted implementation of This consultant s report does not necessarily reflect the views of ADB or the government concerned. property valuation [For methodology in at least one PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed municipality. project s design.] (Document required: A status report on implementation of new methodology prepared by MOWHS)

20 14 Appendix 1 Objectives and Policy Actions 1st Tranche Policy Actions (Q1 2013) 2nd Tranche Policy Actions (12 months after T1) C. Macro-prudential and Financial Sector Management Objective: To improve the macro-prudential management framework 1. Improve Macroprudential (7) RMA will have set up a Financial Policy Regulations Committee (FPC) on macroprudential regulations. (Document required: RMA circular/order on the establishment of the FPC) 2. Strengthening the Capital Markets 3. Develop the Mutual Funds and Fund Management Industry 4. Develop Credit Rating Infrastructure (8) RMA will have prepared and approved an action plan for improving the retail to wholesale deposit ratio (Document required: RMA order on the approved action plan and the action plan) (9) RMA will have issued a fund management license, based on the approved fund management regulation, and the licensed fund management company is in operation. (Document required: copy of license) (9) The FPC will have prepared and finalized the macro-prudential policy paper and its corresponding rules and regulations that will cover, among others, (i) countercyclical capital buffer for banks, (ii) loan to value and loan to income restrictions, (iii) sectoral capital requirements, (iv) minimum ceiling on leverage ratio of banks, (v) time-varying capital provisioning and margin requirements, (vi) restrictions on distributions of profit, (vii) debt to equity ratio for the policy paper and the rules will have been approved by RMA. (Document required: The RMA approved policy paper and the corresponding rules ) (10) RMA will have pilot implemented recommendations of the policy paper on macroprudential regulations. (Document required: A report on implementation prepared by RMA) (11) RMA will have implemented key recommendations of the action plan (Document required: A status report prepared by RMA on implementation of the action plan) (12) RMA will have completed a Capital Markets Master Plan that charts the strategic development of the capital markets over the next 10 years. (Document required: The Master Plan approved by RMA and MOF) (13) RMA will have established the regulatory and supervisory framework for the domestic credit rating agency. (Document required: Notification issued by RMA on the establishment of the regulatory and supervisory framework)

21 Appendix 1 15 Objectives and Policy Actions 1st Tranche Policy Actions (Q1 2013) 2nd Tranche Policy Actions (12 months after T1) D. Audit Functions Objective: To improve external and internal audit operations. 1. Enhance External Audit (14) Royal Audit Authority will have implemented the Audit Resource Management System (ARMS) (Document required: A report on the completion of the first stage pilot ARMS) 2. Strengthen Internal Audit (10) MOF will have appointed and placed internal audit officials for all major spending departments and large autonomous agencies, including Ministry of Foreign Affairs, Thimphu Municipality, National Land Commission. (Document required: MOF circular/order on the appointment and placement of the officials) (15) MOF will have prepared and approved an internal audit manual; and completed training of all the staff recruited for internal audit. (Document required: Approved internal audit manual and a comprehensive report on training of the internal audit staff prepared by MOF) Note: Certification means confirmation by MOF. ARMS = audit resource management system, DMD = Debt Management Division, DRC = Department of Revenue and Customs, FPC = financial policy committee, IMF = International Monetary Fund, MOF = Ministry of Finance, MOWHS = Ministry of Works and Human Settlement, PAVA = Property Assessment and Valuation Agency, RAMIS = Revenue Administration Management Information System, RAA = Royal Audit Authority, RMA = Royal Monetary Authority, TPN = taxpayer number. Sources: Asian Development Bank and Government of Bhutan. This consultant s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s design.]

22 16 Appendix 1 B. STATUS OF SECOND-TRANCHE POLICY ACTIONS OBJECTIVE: To strengthen the government s ability to effectively address risks and set the foundations for sustainable growth. Objectives and Policy Actions 2nd Tranche Policy Actions (12 months after T1) Achievement Status A. Budget and Debt Management Objective: To improve budget and debt management by improving effectiveness of public spending and synchronization of payments. 1. Sub-National Government Budget (1) Major municipalities, including Thimphu, Phuentsholing, Samdrup Jongkhar and Gelephu, will have prepared a medium-term expenditure framework (MTEF) that is used as the basis for annual budget preparation. (Document required: MTEF reports) 2. Develop a Clear National Debt Strategy 3. Support Debt Market Development through Creation of a Yield Curve 4. Promote Institutional Strengthening of the Debt Management Division (DMD) (2) MOF will have prepared and finalized a report on the implementation of the actions under the debt management strategy covering the period from the date of the loan and grant effectiveness until the review for the 2nd tranche release. (Document required: MOF report on the implementation of the Debt Management Strategy) (3) Building on approved Debt Management Action Plan, MOF, in coordination with the Royal Monetary Authority (RMA), will prepare and approve a strategy paper on development of government securities market to address: (i) narrow investor base, (ii) lack of auction calendar, (iii) limited price competition in auctioning of Government securities, and (iv) functional integration of Treasury Management Division and DMD for improved cash management. The Debt Management Strategy will have been approved by the Macro-economic Framework Coordination Committee. (Document required: strategy paper approved by the Macro-economic Framework Coordination Committee). (4) MOF and RMA will have implemented the strategy paper on development of Government securities market (Document required: A status report on implementation prepared by MOF) (5) DMD will have prepared and submitted an annual debt sustainability analysis to MOF. (Document required: Debt sustainability analysis report approved by MOF) Complied with. The aforementioned municipalities submitted their MTEF reports on 4 June 2014 with letter No. DPA/ADB/SEMP/2014/2645. Complied with. MOF submitted the report on the implementation of the Debt Management Strategy on 22 April 2014 with Office Order No. MOF/DPA/ADB- SEMP/2014/6869. Complied with. The Macroeconomic Framework Coordination Committee approved the strategy paper for Debt Market Development Strategy on 14 April 2014 and submitted on 5 June 2014 with Office Order No. MoF/DPA/ADB- SEMP/2014/7252. Complied with. MOF submitted the implementation status report on Debt Market Development Strategy with letter No. DPA/ADB/SEMP/2014/2683 on 5 June Complied with. MOF submitted the report on Debt Sustainability Analysis on 22 April 2014 with Office Order No. MoF/DPA/ADB- SEMP/2014/6868.

23 Appendix 1 17 Objectives and Policy Actions 2nd Tranche Policy Actions (12 months after T1) Achievement Status B. Revenue Management Objective: To strengthen revenue effort by enhancing revenue systems 1. Develop a Revenue Administration (6) MOF will have piloted implementation of RAMIS within Management Information System DRC. (Document required: MOF will submit a pilot (RAMIS) implementation report prepared by DRC) 2. Upgrade Revenue Chart of Accounts 3. Develop a Taxpayer Number (TPN) 4. Develop a Property Valuation Methodology to Enhance Revenue Effort at the Sub-National Level. (7) MOF, in coordination with MOWHS, will have approved the rules and regulations on Property Valuation Methodology. (Document required: The regulation on the new property valuation methodology approved by MOWHS and MOF) (8) MOWHS will have piloted implementation of property valuation methodology in at least one municipality. (Document required: A status report on implementation of new methodology prepared by MOWHS) C. Macro-prudential and Financial Sector Management Objective: To improve the macro-prudential management framework 1. Improve Macroprudential Regulations Complied with. The piloting of RAMIS was conducted on 25 April 2014 in the head office and two regional offices in Thimphu and Phuentsholing, and the DRC submitted a pilot implementation report on RAMIS with Office Order No. DRC/PM-RAMIS (ADB) Complied with. The rules and regulations for the property valuation methodology (PVM), as prepared by the Property Assessment and Valuation Agency (PAVA) task force, were approved by MOWHS and MOF and came into effect on 21 March 2014 with Notification No. FM/DNP/PA- 08/2014/5784. Complied with. Phuentsholing municipality was selected for the pilot implementation. The status report on implementation of the PVM was submitted by MOWHS with letter No. MoWHS/DoHS/C&DRD/Phuntsholing Thromde/ /146 on 25 June (9) The FPC will have prepared and finalized the macroprudential Complied with. The RMA approved the policy paper and its corresponding rules and macroprudential policy paper and seven of regulations that will cover, among others, (i) countercyclical the corresponding rules and regulations capital buffer for banks, (ii) loan to value and loan to during the 96th RMA Board Meeting on 7 income restrictions, (iii) sectoral capital requirements, (iv) May 2014, and these regulations became minimum ceiling on leverage ratio of banks, (v) timevarying effective on 7 May 2014 with Notification capital provisioning and margin requirements, (vi) No. RMA/FRSD/34/ /4492 dated This consultant s report does not necessarily restrictions reflect on the distributions views of ADB of or profit, the (vii) government debt to equity concerned. ratio [For 5 June The policy paper and seven PPTAs: Also, all of the views expressed for herein the policy may paper not and be incorporated the rules will into have the been proposed approved project s corresponding rules and regulations were design.] by RMA. (Document required: The RMA approved policy paper and the corresponding rules ) submitted with letter No. RMA/FRSD/32/ /4523 on 5 June The draft rules and regulations on

24 18 Appendix 1 Objectives and Policy Actions 2nd Tranche Policy Actions (12 months after T1) Achievement Status (10) RMA will have pilot implemented recommendations of the policy paper on macro-prudential regulations. (Document required: A report on implementation prepared by RMA) (11) RMA will have implemented key recommendations of the action plan. (Document required: A status report prepared by RMA on implementation of the action plan) 2. Strengthening the Capital Markets (12) RMA will have completed a Capital Markets Master Plan that charts the strategic development of the capital markets over the next 10 years. (Document required: The Master Plan approved by RMA and MOF) 3. Develop the Mutual Funds and Fund Management Industry 4. Develop Credit Rating Infrastructure (13) RMA will have established the regulatory and supervisory framework for the domestic credit rating agency. (Document required: Notification issued by RMA on the establishment of the regulatory and supervisory framework) bank disclosure requirement were posted on RMA website for one month from 24 June 2014 to 24 July 2014 as per requirements of Section 208 of the 2011 Financial Services Act of Bhutan, and RMA public Notification No. RMA/FRSD/35/ /4739 was sent to receive public comments before it is considered for RMA Board approval. Complied with. The RMA submitted the report on pilot implementation of the macroprudential regulations on 5 June 2014 with letter No. RMA/FRSD/32/ /4523. Complied with. The RMA submitted the status report on the implementation of the action plan for improving the retail to wholesale deposit ratio on 25 June 2014 with letter No. RMA/FRSD/32/ /4725. Complied with. MOF and the RMA approved the capital markets master plan during the 97th RMA Board Meeting on 30 May The Capital Markets Master Plan was submitted by RMA with letter No. RMA/FRSD/32/ /4597 on 12 June Complied with. The RMA approved the regulatory and supervisory framework during the 97th RMA Board Meeting on 30 May 2014, and the regulations became effective on 12 June 2014 with Notification No. RMA/FRSD-SU/86/ /4596. The RMA submitted the credit rating agency regulation with letter No. RMA/FRSD/32/ /4598 on 12 June 2014 along with the notification.

25 Appendix 1 19 Objectives and Policy Actions 2nd Tranche Policy Actions (12 months after T1) Achievement Status D. Audit Functions Objective: To improve external and internal audit operations. 1. Enhance External Audit (14) Royal Audit Authority will have implemented the Audit Resource Management System (ARMS). (Document required: A report on the completion of the first stage pilot ARMS) 2. Strengthen Internal Audit (15) MOF will have prepared and approved an internal audit manual; and completed training of all the staff recruited for internal audit. (Document required: Approved internal audit manual and a comprehensive report on training of the internal audit staff prepared by MOF) Complied with. RAA submitted the report on pilot implementation of ARMS on 9 April 2014 with letter No. RAA (DAG-SP) ARMS/2014/969. Complied with. MOF submitted the approved internal audit manual and the report on training of internal auditors on 18 April 2014 with letter No. MoF/CCA- Gen/ /114. Note: Certification means confirmation by MOF. ARMS = audit resource management system, DMD = Debt Management Division, DRC = Department of Revenue and Customs, FPC = financial policy committee, MOF = Ministry of Finance, MOWHS = Ministry of Works and Human Settlement, PAVA = Property Assessment and Valuation Agency, PVM = property valuation methodology, RAA = Royal Audit Authority, RAMIS = revenue administration management information system, RMA = Royal Monetary Authority, TPN = taxpayer number. Sources: Asian Development Bank and Government of Bhutan. This consultant s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s design.]

26 20 Appendix 2 DESIGN AND MONITORING FRAMEWORK Design Summary Impact Government macrofinancial management sustainably strengthened Performance Targets and Indicators with Baselines Balance of payments not in deficit by FY2017 (baseline: 3.5% in FY2012) Achievement Status On track towards achievement: The ratio of balance of payments to GDP had a surplus of 9.3% in FY2013 and is projected to have a surplus of 3.8% in FY2015 and of 2.7% in FY2016. Source: National Budget 2013/14, MOF, September 2013, p. 61. (The projections for FY2015 and FY2016 are preliminary.) Data Sources and Reporting Mechanisms (For all indicators) Annual financial statement, MOF Annual performance indicator report, MOF Monthly statistical bulletin, RMA Assumptions and Risks Risk The global financial crisis persists and increases uncertainty regarding support from development partners. Outcome More effective use of Bhutan s own financial resources in a predictable manner Improved gross international reserves above $900 million by FY2017 (baseline: $ million in FY2012) Debt-to-GDP ratio no higher than 35% by FY2015 (baseline: 45% in FY2012, net of hydropower loans) On track towards achievement: In FY2013, gross international reserves reached $916.9 million (Appendix 4). On track towards achievement: The ratio of nonhydropower debt to GDP will be at 31.6% in FY2014. Source: National Budget 2013/14, MOF, September 2013, p. 58. (The projections for FY2014 are preliminary.) (For all indicators) Annual financial statement, MOF Assumption The government remains committed to reform program. Fiscal deficit within the prescribed level of 3% each fiscal year during the Eleventh Five-Year Plan by FY2015 (baseline: 4.70% in FY2012) On track towards achievement: Fiscal deficit for FY2013 is 0.9%, and for FY2014 it is estimated at 3.7% of GDP and will decline to 3.1% in FY2015 and remain within the target of 3% from FY2016 onward. Source: National Budget 2013/14, MOF, September 2013, p. 58. (The projections for FY2014, FY2015 and FY2016 are preliminary.) Outputs 1. Improved budget and debt Private savings-to- GDP ratio increased by 2 percentage points by FY2015 (baseline: 32% in FY2012) A debt management strategy in place by On track towards achievement: Gross domestic savings rate increased by 2.71 percentage points between FY2011 and FY2012 (Appendix 4). Achieved. MOF s Office Order No. MoF/PPD/ PPC/25/2776 MOF certification on the approval of Assumption The government

27 Appendix 2 21 Design Summary management systems implemented Performance Targets and Indicators with Baselines 2013 (baseline: no such strategy yet developed) Strengthening of debt management office in MOF by third quarter of 2014 (baseline: debt management office understaffed) Achievement Status dated 19 February 2013, on the approval of the MTDS. Achieved. Department of Public Accounts Internal Memo No. DPA/ADM/ /1667, dated 18 February 2013, on the appointment of staff to the DMD, and on the DMD organizational chart. Data Sources and Reporting Mechanisms the debt management strategy MOF report on the implementation of the debt management strategy Debt sustainability analysis report of MOF Assumptions and Risks successfully trains the staff concerned, including debt management office staff. Risk Well-trained debt staff may leave the office. Medium-term expenditure allocations developed in major municipalities by 2014 (baseline: medium-term expenditure framework not yet developed) Achieved: Thimphu, Phuentsholing, Samdrup Jongkhar, and Gelephu prepared their budgets based on the MTEF and submitted them on 4 June 2014 with Office Order No. DPA/ADB/SEMP/2014/2645. Medium-term expenditure framework, MOF Strategy paper approved by the macroeconomic framework coordination committee 2. Improved revenue effort and revenue management system implemented A plan to fully integrate the Treasury Management Division and the Debt Management Division prepared by 2014 (baseline: not integrated at present) Introduction of property valuation methodology by 2014 (baseline: not in place) Achieved: Since TMD and DMD are under the same department, close working relationship and information sharing have been established. Achieved: The new rules and regulations for the PVM, as prepared by the PAVA task force, were approved by MOF and came into effect on 21 March 2014 with Notification No. FM/DNP/PA-08/2014/5784. National budget, MOF (For all indicators) Status report on implementation of new methodology by MOWHS Completed Achieved: RAMIS hardware MOF certification installation of the setup and software installation and approved revenue was successfully completed, and notification on the administration training was provided to DRC IT new revenue chart management officials on the architectural of account information system design of the system on 27 for the Department of March RAMIS Phase I National budget, This consultant s Revenue report does and not necessarily (including reflect income the views tax, sales of ADB tax or the MOF government (annual) concerned. [For PPTAs: Also, all Customs of the by views 2014 expressed at point herein of sale, may and not revenue be incorporated (For into all the indicators) proposed project s design.] (baseline: the system currently not in place) accounting modules) was piloted on 25 April 2014 in the head office and two regional offices in

28 22 Appendix 2 Design Summary 3. Improved macroprudential management framework implemented Performance Targets and Indicators with Baselines A financial policy committee in place by February 2013 (baseline: none at present) Achievement Status Thimphu and Phuentsholing, and a pilot report was submitted with Office Order No. DRC/PM- RAMIS (ADB) Achieved: The RMA set up the financial policy committee on 7 February 2013 with Order No. RMA: MS/BOD-POLICY/ /2851. Data Sources and Reporting Mechanisms RMA circular and/or order on the establishment of financial policy committee Assumptions and Risks Macro-prudential management framework in place in the RMA by 2014 (baseline: the current macro-prudential system quite weak) Achieved: The RMA approved the macroprudential policy paper and the corresponding rules and regulations during the 96th RMA Board Meeting on 7 May 2014, and the regulations became effective on 7 May 2014 with Notification No. RMA/FRSD/34/ /4492. The policy paper and the corresponding rules and regulations were submitted with letter No. RMA/FRSD/32/ /4523 on 5 June The draft regulations on bank disclosure requirement were posted on RMA website on 24 June 2014 with RMA Notification No. RMA/FRSD/35/ /4739 to receive public comments for one month before it is considered for RMA Board approval. RMA approved policy paper and corresponding rules on macroprudential norms A capital markets master plan in place by 2014 (baseline: capital market master plan non-existent) Achieved: MOF and RMA approved the capital market master plan for on 30 May 2014 during the 97th RMA Board Meeting and submitted it with letter No. RMA/FRSD/32/ /4597 on 12 June Capital markets master plan approved by MOF and RMA Regulatory and supervisory framework for a credit rating agency in place by 2014 (baseline: none at present) Achieved: The RMA approved the regulatory and supervisory framework for a credit rating agency on 30 May 2014 during the 97th RMA Board Meeting and the regulations became effective on 12 June 2014 with Notification No. RMA/FRSD- SU/86/ /4596. RMA submitted Regulation on Credit Notification issued by RMA on the establishment of the regulatory and supervisory framework for credit rating agencies

29 Appendix 2 23 Design Summary 4.Improved external and internal audit operations implemented Performance Targets and Indicators with Baselines Put in place an audit resource management system (ARMS) in the head office of the RAA by 2014 (baseline: no system in place) Achievement Status Rating Agencies with letter No. RMA/FRSD/32/ /4598 on 12 June Achieved: RAA submitted the report on the completion of the pilot implementation of ARMS on 9 April 2014 with Office Order No. RAA (DAG-SP) ARMS/2014/969. Data Sources and Reporting Mechanisms Annual report of the RMA (For all indicators) A report on the completion of first stage pilot ARMS Assumptions and Risks Adoption of internal audit manuals in major spending departments by 2014 (baseline: audit manuals not available) Achieved: MOF submitted the approved internal audit manual and the report on training of internal auditors on 18 April 2014 with Office Order No. MoF/CCA- Gen/ /114. Approved internal audit manual and a comprehensive report on training of the internal audit staff Activities with Milestones Inputs 1. Improved budget and debt management systems implemented ADB: $35 million 1.1. Develop a draft public debt management strategy by February Grant: $20.81 million 1.2. Complete the staffing of debt management division by February Loan: $14.19 million 1.3. Prepare an integration plan for Treasury management and debt management divisions by Q Improved revenue effort and revenue management system implemented 2.1. Prepare system requirement specifications for the revenue administration management information system by February Prepare the draft rules and regulations for property valuation by Q Improved macro-prudential management framework implemented 3.1. Prepare the road map for the liquidity management system, based on proposed policy actions under the program, by Q Prepare the regulatory and supervisory structure for a credit rating agency by Q Prepare the draft of the capital market master plan by Q Improved external and internal audit operations implemented 4.1. Complete auditing module software by Q Complete the implementation of the audit resource management system by Q Approve an internal audit manual and complete training of all the staff recruited for internal audit by Q DMD = Debt Management Division, DRC = Department of Revenue and Customs, FY = fiscal year, GDP = gross domestic product, IT = information technology, MOF = Ministry of Finance, MOWHS = Ministry of Works and Human Settlement, MTDS = medium-term debt strategy, MTEF = medium-term expenditure framework, PAVA = Property Assessment and Valuation Agency, PVM = property valuation methodology, RAA = Royal Audit Authority, RAMIS = revenue administration management information system, RMA = Royal Monetary Authority, TMD = Treasury Management Division. Source: Asian Development Bank. This consultant s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s design.]

30 24 Appendix 3 PROGRAM ASSURANCES AND CONDITIONS Item Source Achievement Covenants Section 4.02 (b) The Beneficiary shall enable ADB's representatives to inspect any relevant records and documents referred to in paragraph (a) of this Section. Financing Agreement (FA), Article IV, Particular Covenants Complied with. The executing agency, the Department of Public Accounts (DPA) of the Ministry of Finance (MOF), has cooperated fully with each ADB mission by providing relevant documents as Section (a) As part of the reports and information referred to in Section 6.05 of the Loan Regulations and Section 6.04 of the Grant Regulations, the Beneficiary shall furnish, or cause to be furnished, to ADB all such reports and information as ADB shall reasonably request concerning the implementation of the Program, including the accomplishment of the targets and carrying out of the actions set out in the Policy Letter. Section (b) Without limiting the generality of the foregoing or Section 6.05 of the Loan Regulations and Section 6.04 of the Grant Regulations, the Beneficiary shall furnish, or cause to be furnished, to ADB semi-annual reports on the carrying out of the Program and on the accomplishment of the targets and carrying out of the actions set out in the Policy Letter. Implementation Arrangements 1. (a) The Beneficiary shall be responsible for the coordination and execution of the Program with the various concerned departments and agencies of the Beneficiary. (b) The DPA shall be the Program Executing Agency and shall be responsible for the overall implementation of the Program, including compliance with all policy actions, facility administration, disbursements and maintenance of records. DPA shall also be responsible for overseeing and coordinating the timely implementation of agreed policy actions to be implemented by the implementing agencies. (c) The DPA, RMA, DRC and RAA shall be the Implementing Agencies. DPA shall be FA, Article IV, Particular Covenants FA, Article IV, Particular Covenants FA, Schedule 4, Program Implementation and Other Matters requested by ADB. Complied with. The DPA and the implementing agencies have provided ADB with reports and other information concerning the program. Complied with. On 13 February 2014, Mr. T. Dorji, Chief Program Officer, Debt Management Division, DPA, submitted an executing agency progress report on the SEMP policy action status, as liaised with the respective implementing agencies. The other progress report was submitted earlier on 21 September Complied with. The DPA has been responsible for the overall implementation of the program, in coordination with the various implementing agencies. A steering committee meeting was held on 6 March 2014 to discuss completion of second-tranche policy actions. The DPA has consistently and fully cooperated with the project team and consultants during several technical assistance (TA) grants that supported the implementation of the SEMP. a

31 Appendix 3 25 Item Source Achievement responsible for delivering the policy actions relating to budget and debt management. RMA shall be responsible for the delivery of policy actions relating to macroprudential and financial sector management component. DRC shall be responsible for the delivery of the policy actions relating to strengthening revenue mobilization, and RAA shall be responsible for the delivery of the policy actions pertaining to improve external and internal audit component. (d) The Beneficiary shall (i) use its best endeavor to ensure that critical Program staff shall remain in their position on a fulltime basis for a reasonable duration to ensure continuity in the implementation of the Program; and (ii) ensure that all Implementing Agencies shall be adequately staffed and provided with the necessary financial, technical, and other resources to perform their functions under the Program. Policy Actions and Dialogue 2. The Beneficiary shall ensure that all policies adopted and actions taken under the Program, as set forth in the Policy Letter and the Policy Matrix, continue to be in effect for the duration of the Program. 3. The Beneficiary shall keep ADB informed of policy discussions with other multilateral and bilateral aid agencies that may have implications for the implementation of the Program and shall provide ADB with an opportunity to comment on any resulting policy proposals. The Beneficiary shall take into account ADB s views before finalizing and implementing any such proposal. FA, Schedule 4, Program Implementation and Other Matters Complied with. The DPA and implementing agencies have confirmed that all policies adopted and actions taken under the Program, as set forth in the Policy Letter and the Policy Matrix, continue to be in effect and committed to the continuation of the policy actions throughout the program, as recorded in each aide-mémoire following an ADB mission. The DPA has informed ADB missions of ongoing and planned activities of other multilateral and bilateral aid agencies and facilitated meetings with the resident representative office of the World Bank. Counterpart Funds Complied with. 4. The Beneficiary shall ensure that the FA, Schedule 4, The DPA has provided Counterpart Funds are used to finance the Program Implementation information to ADB on the use local currency cost relating to the and Other Matters of counterpart funds as and implementation of the Program and other when needed. activities This consultant s consistent report with does the objectives not necessarily of reflect the views of ADB or the government concerned. [For the PPTAs: Program Also, and all shall of the provide views the expressed herein may not be incorporated into the proposed project s necessary design.] budget appropriation to finance costs relating to the implementation of reforms under the Program.

32 26 Appendix 3 Item Source Achievement Governance and Anticorruption 5. The Beneficiary, the Program Executing Agency, and the Implementing Agencies shall: (a) comply with ADB's Anticorruption Policy (1998, as amended to date) and acknowledge that ADB reserves the right to investigate directly, or through its agents, any alleged corrupt, fraudulent, collusive or coercive practice relating to the Program; and (b) cooperate with any such investigation and extend all necessary assistance for satisfactory completion of such investigation. FA, Schedule 4, Program Implementation and Other Matters Program Review 6. The Beneficiary shall undertake periodic reviews during Program implementation period to evaluate the scope, implementation arrangements, progress and achievement of the objectives of the Program. In addition to the periodic reviews, a mid-term review shall take place during fourth quarter of The Beneficiary shall ensure that ADB shall have the opportunity to participate in these reviews. Program Performance Monitoring and Evaluation 7. Within 3 months of the Effective Date, the Beneficiary shall establish and maintain a performance evaluation system, to monitor the implementation and outcomes of the Program, using a set of indicators and targets that has been agreed between the Beneficiary and ADB to assess progress towards meeting the objectives of the Program. For each of the agreed indicators, progress shall be measured against a baseline in FY The responsible Implementing Agencies shall review the agreed frameworks every 3 months to determine progress and identify constraints. Records of Accounts and Reporting 8. The Beneficiary shall maintain separate records of account for the Program. To ensure proper fund management, ADB retains the right to audit the use of Grant proceeds. The accounts shall be managed, operated, and liquidated in accordance with terms satisfactory to ADB. The Beneficiary shall prepare a semiannual consolidated progress report on policy and institutional reforms implementation and shall forward the same to ADB. The reports shall describe progress made in the Program and any changes to the implementation schedule, and shall also identify any problems FA, Schedule 4, Program Implementation and Other Matters FA, Schedule 4, Program Implementation and Other Matters FA, Schedule 4, Program Implementation and Other Matters Complied with. The DPA under MOF is the executing agency. The project team has not received allegations of corrupt, fraudulent, collusive, or coercive practices relating to the program. Complied with. The DPA conducted periodic reviews throughout the program, and provided ADB with the minutes of a review meeting held on 6 March In addition, ADB conducted a midterm review mission in November 2013, and other periodic reviews in February, April, and May Complied with. A performance evaluation system was established in September 2013 to monitor implementation and outcomes of the program. This was recorded in the first executing agency progress report. Program targets and indicators are listed in the design and monitoring framework. The DPA as the executing agency has recorded the status of each target in the progress report. Complied with. There were consolidated progress reports in September 2013 and in January 2014.

33 Appendix 3 27 Item Source Achievement encountered and remedial actions taken. The Beneficiary shall submit a Program completion report not later than 3 months after Program completion. ADB = Asian Development Bank, DPA = Department of Public Accounts, DRC = Department of Revenue and Customs, FA = Financing Agreement, MOF = Ministry of Finance, RAA = Royal Audit Authority, RMA = Royal Monetary Authority, SEMP = Strengthening Economic Management Program, TA = technical assistance. a The TA grants that supported the implementation of the SEMP are: (i) ADB Technical Assistance to Bhutan for Strengthening Audit Resource Management. Manila (TA 7723-BHU); (ii) ADB Technical Assistance to Bhutan for Strengthening Public Management in Bhutan. Manila (TA 7724-BHU); (iii) ADB Technical Assistance to Bhutan for Developing a Revenue Administration Management Information System. Manila (TA BHU); (iv) ADB Technical Assistance to Bhutan for Capital Market Development. Manila (TA 8280-BHU); and (v) ADB Technical Assistance for Supporting Financial Stability in Bhutan and the Maldives. Manila (TA REG). Source: Asian Development Bank This consultant s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s design.]

34 28 Appendix 4 ANALYSIS OF MACROECONOMIC DEVELOPMENTS 1. Growth slowed in Bhutan from 8.6% in fiscal year (FY) 2012 to 4.6% in FY2013, well below the average growth rate of over 8% during the last decade since This deceleration was in part engineered by the authorities through targeted policy measures to cool down an overheated economy and avoid the risk of a hard landing. The slowdown reflected (i) credit restrictions in 2012 and an import ban, particularly in import-heavy activities such as construction and transport that required large rupee payments, to alleviate the balance of payment crisis with India and the rupee liquidity shortage; (ii) delays in the construction of new hydropower projects; and (iii) a slowdown in tourist arrivals. 2. Figure 1 shows that, with the economic slowdown, inflation decelerated to 5.5% in FY2013 from its peak at 13.5% a year earlier, due in particular to the price developments in India, Bhutan s major trading partner, but also to domestic monetary tightening measures adopted in 2012 to alleviate growing shortages of Indian rupee reserves. Targeted measures such as restrictions on imports, 2 growth of credit, 3 and explicit recognition by the Royal Monetary Authority (RMA) of convertibility under the currency peg of the ngultrum to foreign currencies 4 have lowered import-driven consumption and moderated the demand for rupees. 5 1 The latest key economic indicators are given in Appendix 5. 2 With such measures, merchandise import growth contracted from soaring levels of around 40% in FY2010 and FY2011 to 9.5% in FY2012 and 6.5% in FY Growth of credit to the private sector declined from 30.1% in FY2012 to 7.1% in FY This served to curtail the perception that rupees would always and everywhere be redeemed by the monetary authorities. 5 Recent issuance of notification on suspension of housing and vehicle loans; revised risk weights with effect from 1 June 2013 (from 100% to 300% on personal loans, and to 200% on housing and transport sector loans); and an increase in banks capital adequacy ratio to a minimum of 10% have limited credit expansion in the banking system. The RMA further revised the prudential regulations on risk weights in August 2013, with effect from 1 December 2013, by reducing the risk weights on housing and transport sector loans from 200% to 150%.

35 Appendix 4 29 Other steps taken in FY2013 to improve rupee liquidity management included the smoothening of debt payments for hydropower plants to two installments in July and December instead of one payment in January. 6 In March 2013, the RMA entered into a 6-month swap agreement with the Reserve Bank of India for a total of Rs5.4 billion, which fell due in September 2013, so as to get short-term relief for immediate balance of payment transactions. The RMA also sold $200 million to convert it to rupees in June 2013, to liquidate the overdraft facility with State Bank of India. As a consequence of these measures, and as displayed in Figure 2, reserves increased sharply in FY2013 to $916.9 million, from $674 million in FY2012, equivalent to 12.6 months of imports, providing a more comfortable cushion for cross-border payments On the fiscal side, the government has been pursuing an austerity program through expenditure rationalization. 8 Government spending cuts and inflows of substantial grants helped improve the ratio of fiscal deficit to gross domestic product (GDP) from 1.2% in FY2012 to 0.9% in FY2013 despite the slowdown in revenue collection. The reduction in public spending is also believed to reduce pressure on the current account given the large import dependence of public spending. The government also issued treasury bills and used its overdraft facility with the central bank to finance cash shortages and rupee requirements. The government has increased import duties on vehicles (by 100%), furniture, and alcohol. The temporary ban on imports has 6 This was a recommendation of Asian Development Bank (ADB) in its policy dialogue with the government during the processing of the first tranche of Strengthening Economic Management Program (SEMP). Installation of a debt payment schedule once in January every year has been one of the major contributing factors to the rupee liquidity crunch, while rupee revenue from electricity exports accumulates mostly during the rainy season. 7 As of the quarter ending in December 2013, reserves stood at $934.5 million. Of the total reserves, $833.8 million This were consultant s convertible report currency does reserves not necessarily and 6.2 billion reflect were the Indian views rupee of ADB reserves. or the Reserves government were concerned. sufficient to cover [For 13.4 months of merchandise imports at the end of December (Source: RMA Selected Economic Indicators, PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project s December 2013) 8 design.] The government s austerity measures target rationalization of expenditures on vehicle purchases, construction of staff quarters, and other non-essential operating expenses, and do not have any negative implications for operation and maintenance of existing infrastructure and spending on the social sectors.

36 30 Appendix 4 led to marginal improvements in import duty receipts in FY2013, but more lasting fiscal measures are needed to reduce the budget deficit. 4. The external sector continued to be driven in large part by hydropower-related trade, accounting for nearly one-third of exports in FY2013. As the country s large import bill fell, reflecting the administrative restrictions that curtailed imports of vehicles and construction materials, the trade deficit narrowed to 19.5% of GDP, even as the current account deficit widened from 23% to 25% of GDP on sharply lower current transfers and increased interest payments (Figure 3). Capital transfers, foreign direct investment, and foreign loans (including those earmarked for hydropower) funded the large current account deficit. The overall balance of payments moved to a surplus of 9.3% of GDP, which marked a sharp turnaround from a deficit of 10.6% of GDP since the liquidity crisis a year earlier. 5. In terms of the economic prospects, 9 GDP growth is expected to rebound to 6.0% in FY2014 and to 6.8% in FY2015 as hydropower construction projects under the Eleventh Five- Year Plan ( ) get under way and the Dagachhu plant starts operation. The service sector anchored mainly in tourism and tourism-related services is also predicted to expand with the improvement in economic conditions in major tourist source countries. Growth is expected to receive a further boost from the government s economic stimulus plan, which will inject liquidity into the banking system, targeted toward lending to small and medium-sized enterprises, agriculture, and other priority areas. Funding for the stimulus plan came from a grant of Nu5 billion (corresponding to 4.4% of GDP or 14% of total expenditures in the FY2014 budget) provided by the Government of India. Inflation is anticipated to rise just over 10% in 9 The figures for Bhutan are obtained from: ADB Asian Development Outlook Manila.