MONETARY POLICY STATEMENT

Transcription

1 MONETARY POLICY STATEMENT September 2013 Designed & KUENSEL Corporation Limited Royal Monetary Authority of Bhutan

2 Royal Monetary Authority of Bhutan This Report has been prepared by the Royal Monetary Authority of Bhutan in accordance with Chapter II Section 10 of the RMA Act of Bhutan Unless specified, the source of data presented in tables and charts is the Royal Monetary Authority of Bhutan or the National Statistics Bureau. Macroeconomic projections presented in the Outlook Section of this Report have been prepared by the Multi-Sectoral Macroeconomic Framework Coordination Technical Committee composed of various government and statistical agency representatives, and led by the Ministry of Finance, Royal Government of Bhutan. Projections and assumptions adopted thereof are a representation of collective judgment. For monthly, quarterly and annual publications of the Royal Monetary Authority of Bhutan, please visit the RMA website. All rights reserved. Acknowledgement required if material is reproduced. P.O Box 154 Thimphu, Bhutan Telephone: , , Fax: rma.rsd@rma.org.bt Website: RMA Financial Literacy Webpage:

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4 CONTENTS Acronyms... i Governor s Statement... iii I. The State of the Bhutanese Economy: Recent Developments...1 II. Bhutan s International Reserve Status at a Glance...4 III. RMA Monetary Policy Operations: FY 2011/12 FY 2012/ IV. Medium Term Outlook for Bhutan: FY 2012/ /15: Risks and Challenges...19 Annex Annex Annex Annex

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6 ACRONYMS BOP Balance of Payments CAD BOP Current Account Deficit CC Convertible Currency COTI Countries other than India CPI Consumer Price Index CRR Cash Reserve Ratio CY Calendar Year (January 1 December 31) DACL Druk Air Corporation Limited FY Fiscal Year (July 1 June 30) FYP Five Year Plan FXD Foreign Exchange & Reserve Management Department, RMA GDP Gross Domestic Product GoI Government of India IMF International Monetary Fund M0 Reserve Money M1 Narrow Money M2 Broad Money MFCC Macroeconomic Framework Coordination Committee MFCTC Macroeconomic Framework Coordination Technical Committee MoF Ministry of Finance MoLHR Ministry of Labour & Human Resources NBFI Non-Bank Financial Institution NFA Net Foreign Assets NPL Non Performing Loan NPPF National Pension and Provident Fund NSB National Statistics Bureau ODA Official Development Assistance ODF Overdraft Facility OIN Other Items Net PNB Punjab National Bank, India PPI Producer Price Index QM Quasi Money Monetary Policy Statement September 2013 i

7 RBI RGOB RMA RSTLAW SBI SCF SLR T-Bill WPI y-o-y Reserve Bank of India Royal Government of Bhutan Royal Monetary Authority of Bhutan RMA Short Term Liquidity Adjustment Window State Bank of India Standby Credit Facility (also referred to as Line of Credit, LoC) Statutory Liquidity Requirement Treasury Bill Wholesale Price Index Year-On-Year Monetary Policy Statement September 2013 ii

8 GOVERNOR S STATEMENT It has been over a year since the Royal Monetary Authority of Bhutan (RMA) launched its policy measures to address the twin challenges of Rupee reserve constraints and tight financial sector liquidity. With the latter following closely at the heels of the former, the RMA in collaboration with the Royal Government has done all it can to cool external demand in the near-term, while safeguarding the health of the financial system. On the monetary front, the RMA has successfully implemented most immediate to short-term monetary measures recommended by the national Rupee Task Force, the most important of which was streamlining access to and prudent management of Indian Rupee reserves. Economic conditions in Bhutan continue to be highly challenging in Although trade tensions have somewhat eased in recent months due to exchange measures and merchandise import restrictions initiated by the Royal Government, pressures on Rupee reserves fueled by external imbalances on the balance of payments (BOP) front remain. As such, the RMA continues to avail of short-term Rupee financing through the overdraft facility with Indian commercial banks along with the Reserve Bank of India (RBI) Rupee SWAP arrangement. And in a move parallel to that of December 2011, the central bank, as depository and manager of Bhutan s official external assets, sold USD 200 million from international reserves on June 26, 2013 against the Indian Rupee, taking advantage of the appreciating USD to liquidate Rupee borrowings, invest in more lucrative instruments and to finance other BOP transactions. It is expected that Rupee pressures from domestic as well as external imbalances shall continue to persist during the medium-term as indicated in Bhutan s macroeconomic outlook (Section II) and in line with developments in neighboring India. FY 2013/14 is a critical year for the nation with the election of a new government and the commencement of the 11 th Five Year Plan (FYP). The alignment of these circumstances coupled with the past events of the year spell out a number of policy imperatives for the government and stakeholders. Today, the focus of policy makers and the newly-elected government should be on making the difficult decisions for long-term macroeconomic growth and sustainable development. First, addressing the Rupee balance of payments problem necessitates immediate policy action to tackle long-term structural constraints in the Monetary Policy Statement September 2013 iii

9 economy. Over the years, low-level of economic diversification in Bhutan beyond that of hydropower have exacerbated external pressures through the trade and current account given our over-reliance on foreign goods, services and labor. Bhutan faced tremendous pressure on its Rupee reserves last year fueled by external sector imbalances. The fact that the current account deficit in the BOP has grown rapidly and is becoming increasingly difficult to finance through sustainable flows of capital and financial flows is a growing matter of concern. And since the BOP mirrors the domestic economy, gaps in goods, services and other flows to meet public and private consumption and investment within Bhutan are then derived from India and other countries. While Bhutan s overall BOP has been positive and international reserves have grown over the last few decades, this has primarily been possible through the steady and large inflow of aid and concessional official development assistance (ODA) as opposed to export performance. Thus, along with efforts of fiscal consolidation, the Bhutanese economy must be poised to earn more. This requires sequencing of reforms to channel resources, domestic or external towards boosting domestic productive capacity and local industry in order to reduce both internal and external imbalances. Some introspection may also be useful to assess whether past capital investments have yielded desired returns and whether adequate efforts/effective investments have been made under national development plans towards providing a conducive/enabling environment for the development of the private sector since the latter has long been regarded as an engine of economic growth. While Bhutan s economic outlook appears robust for the medium-term, hydropower-led growth is expected to raise income and living standards and projected inflationary pressures in neighboring India will exert fall-through price pressures in Bhutan, with large spill-over pressures deteriorating the trade and current account. The past high credit growth and expanding external debt could nudge overheating pressures to resurface. Bhutan will need more predictable flows of long-term financing to replace costly short-term Rupee debt to finance BOP transactions, particularly with India. These expectations and looming uncertainty over ODA timing and inflows exerting pressures on international reserves (especially the Indian Rupee) pose significant challenges for Bhutan. It is true that some reprieve is expected in the final year of the plan with the commissioning of three new hydropower projects. However, in the near term, gaps are expected in the financing of our BOP transactions, consequently involving persistent draw-downs in our international reserves Monetary Policy Statement September 2013 iv

10 as an alternative, albeit unsustainable source of finance. While there is no a priori definition of what constitutes a sustainable level of the current account deficit, it is becoming clear that constantly resorting to drawdown in reserves and availing costly commercial short-term Rupee debt to finance BOP transactions on a regular basis is not a sustainable solution. During FY 2011/12, the RMA incurred a total of million as interest payment towards the overdraft facility (ODF). Further, between July 2012 and June 2013, interest payments by the RMA towards the ODF increased to million. SWAP and ODF measures are at best short-term and while borrowing to finance investment in productive ventures is good for the economy, borrowing for direct consumption entails a direct drain on reserves with no prospects of future earnings. Under the existing terms of agreement with the RBI, the SWAP financing line is only available for a maximum of 6 months (3 month period with an additional 3 months rollover), thus expiring at the end of September 2013; rolling over of the SWAP beyond this period would require Bhutan to enter into a BOP program with the IMF. Second, when it comes to coordination between fiscal and monetary policy to the extent that fiscal and other sectoral policies remain sluggish, monetary policy instruments will become ineffective.the Taskforce Report predicted that some contraction in the economy may take place during policy adjustments. Similarly it was suggested that the government would need to be mindful of the implications of fiscal expansion on fueling aggregate demand in the economy and this should be an important lesson when drawing up the 11 th FYP. Growth driven by high government spending spurred on by heavy imports and large inflows of donor funds is not sustainable in the long run. That said, hydropower investments need to be carefully paced to deal with spillover shocks to the economy since they have tremendous bearing on external pressures. Furthermore and without any more delay, additional fiscal policies need to be activated and other supporting policies reviewed and synchronized. Until then, current demand-side tools to curtail non-essential imports should be continued; this includes the RMA s temporary measures on the Rupee front as well. At this point, it is imperative to note that tools of economic policy are not limited to fiscal and monetary policy alone. Numerous cross-cutting policies impact the growth and development of the Bhutanese economy, including but not limited to labor and employment, trade and investment, policies related to hydropower, tourism, agriculture and other key economic sectors; national development plans etc. Sound macroeconomic management necessitates the synchronization and coordination of complementary sectoral policies under the guiding development principles of a forward-looking national development plan. Monetary Policy Statement September 2013 v

11 Third, the results from the RMA s monetary policy measures till date have been encouraging with a slowdown in credit that has translated into the reduction of several non-essential imports. Institutionalization of a system of monitoring trade-related flows has helped ensure greater transparency and disclosure as well as revenue collection for the government. However, temporary measures initiated by both the RMA and Royal Government should be phased out in line with the introduction of new fiscal and real economy measures to reduce aggregate demand and boost domestic production. Doing so would also alleviate liquidity constraints in the financial system by providing more predictable and regular flows of funds for investment and consumption. The government s recent fiscal austerity measures are a positive step in the right direction as is the Economic Stimulus package. At this point, the RMA would like to assure the public that the domestic financial system remains resilient and Bhutanese financial institutions under the close supervision of the RMA continue to uphold safety prudential norms and requirements. Notably, recent macro-prudential measures taken by the RMA earlier during the year to safeguard the financial institutions against over exposure to single sectors which have huge implications on the external balance have been viewed as restrictive. I would like to reassure that the measures implemented by the RMA have been reviewed in line with new information and developments and as of August 2013, the RMA has reclassified its loan categories (for more transparency and ease of prudential application) lowered several risk weight provisioning requirements for loan categories including agriculture, while those of riskier portfolios such as consumer and consumption-based loans have been left unchanged. The RMA is committed to correcting challenges associated with past rapid credit growth and the build up in asset-liability mismatches of the banking sector, while supporting financial institutions in their operations to meet sanctioned loans. Until such time investments in productive sectors such as hydropower are completed and commissioned, the RMA had recommended to the Royal Government that we must be prudent in the medium-term and to exercise austerity fiscal measures to curtail the import of non-essential merchandise. We can argue that the Rupee shortage and tight banking sector liquidity situation from 2012 can be turned into an opportunity to jump-start domestic reorientation towards more inclusive, balanced and equitable socio-economic development. The policy imperative today is to phase in targeted longterm policy measures (both demand and supply side management, fiscal and otherwise) in the real and fiscal sectors to promote and boost domestic productivity and employment.the government s economic policies need to Monetary Policy Statement September 2013 vi

12 channel investments in productive sectors, diversifying the economy and building the domestic supply and production base. Simultaneously, the RMA would then be able to phase out its temporary measures restricting Rupee access for construction and motor vehicle imports in line with the new government s fiscal response. This would also permit authorities to scale back on costly short-term debt financing through the ODF. However, should Bhutan need to continue resorting to the overdraft facility, it is advisable that this short-term policy tool be managed by the fiscal authorities. For now, the RMA shall maintain its tight monetary policy stance, and remain vigilant on trade and credit flows. We shall also continue to avail of short-term financing from India, while exercising prudent management of limited foreign exchange reserves that includes the sale of excess reserves as and when necessary and when market conditions are deemed favorable, as was recently carried out. We take this opportunity to especially thank all the financial institutions for their support in these endeavors and the media for their role in awareness building. Daw Tenzin Governor September 2013 Monetary Policy Statement September 2013 vii

13 I. The State of the Bhutanese Economy: Recent Developments 1 1. Real GDP growth for Bhutan while robust declined to 8.5% during 2011 as compared to 11.7% in While all components of the GDP recorded positive growth, the electricity and water sector, and the public administration subsector recorded a negative growth of 5.5% and 3.3%, respectively. The tertiary sector recorded the highest growth of 15.7% with a 6.5% contribution to real GDP growth. The construction subsector remained the highest contributor to nominal GDP. 2. Inflationary conditions remained consistently high during the year, largely carried over from across the border in India. As of the second quarter of 2013, food commodities now constitute 39.9% of Bhutan s CPI s basket weights, and over 90% of all food and processed foods and beverages imports are derived from India 2. Price levels in India as featured by their WPI (RBI) grew by 4.9% during the second quarter of 2013, the lowest in more than three years. Annual inflation in Bhutan after peaking at 13.5% during the second quarter of 2012 started easing recently and declined to 5.5% during the second quarter of 2013, with improvements in both food and non-food price levels. As of June 2013, food inflation decreased to 2.8% from 18.7% as of the second quarter of Growth in broad money supply (M2) 3 picked up as of June 2013 growing to 18.6% up from -1% (year-on-year growth) as of June Higher growth in M2 can be explained by the sharp increase in the growth of net foreign assets (NFA) which grew from 0.1% to 38.1% as of June Growth in other items (OIN) also grew, albeit lower at 31.8% as of June These expansions resulted in expanding the growth of other monetary aggregates including demand deposits which grew by 25.6% and quasi money by 19.2% as of June Please see Annex 1 for a summary of Bhutan s latest Key Economic Indicators and charts. Data featured is as of June As of the second quarter of 2013, the NSB has revised the weight of food in the CPI index from 31.67% to 39.92%; and that of non-food from 68.33% to 60.08%. 3 For monetary analysis, the balance sheet data of financial corporations are classified within the framework of the Monetary and Financial Statistics Manual (MFSM 2000) of the IMF. Please note that the data classification done here by the Research and Statistics Department are not directly comparable to those compiled and published by the Financial Regulation and Supervision Department of the RMA. Monetary Policy Statement September

14 4. As of the second quarter of 2013, the growth of combined assets of the financial sector 4 increased to 19.6% (Nu.79.9 billion). Of the total assets, 89.6% belonged to the commercial banks and the residual to the NBFIs. During the same period, banking sector assets alone grew by 20.1% to Nu.71.6 billion while that of the NBFIs grew by 15.4% to Nu.8.3 billion. The NPL ratio increased to 9.7% at the end of June 2013 from 7.8% in the same period last year. In particular, high NPLs were recorded in the trade and commerce, housing, personal loans, and manufacturing and industry sectors. Apart from seasonal factors in loan recovery, lack of access for ever greening of loans due to tighter credit conditions may also have contributed to the increase in the NPL. 5. Challenges associated with acute liquidity constraints of the banking sector and enduring pressure of Rupee outflows remained remarkably significant throughout In response to this, the RMA formulated several policy measures to safeguard the financial sector from unwarranted risk and vulnerabilities. Coupled with the problem of tight liquidity, the RMA lowered the CRR in a consecutive manner during 2012 and continued to restrain credit flows channeled through import oriented sectors including the transport and housing sectors. 6. In Bhutan s balance of payments, with a 20.3% increase in the net surplus in the current transfers account from Nu.10.2 billion in FY 2010/11 to Nu.12.2 billion in FY2011/12, Bhutan s current account deficit improved slightly to 20.5% of GDP from 25.7% in the previous year. The increase in the overall trade deficit was minimal during the fiscal year (1.9% growth) because of a slight improvement in the trade deficit with India. Hydropower, Bhutan s largest export declined to Nu.9.8 billion in 2011 from Nu.10.4 billion in 2010 due to a 3.5% fall in production levels; however, at 31.8% of total exports in 2011 hydropower remains Bhutan s largest export, followed by ferro alloys (21% of total exports). 7. With a fall in convertible currency loan disbursements and an increase in the principal repayments towards Rupee debt, Bhutan s capital and financial account surplus decreased by 38.7% during FY 2011/12. As a result, the capital and financial account surplus stood at Nu.13.1 billion, against a current account deficit of Nu.17.6 billion which resulted in a drawdown of reserves and a corresponding negative overall BOP of Nu.5.5 billion. Bhutan s official international reserves as of June 2012, corresponding to the decrease in the overall balance, stood at USD 770 million, a 15% decrease 4 This excludes the NPPF. Monetary Policy Statement September

15 from the previous year. Gross international reserve levels were sufficient to meet 9.6 months of merchandise imports, 9.3 months of imports of both goods and services and 20.6 months of essential imports. As of June-end 2013 Bhutan s gross international reserves totaled USD million, of which CC reserves totaled USD million (following the sale of USD 200 million). As of the same period, reserves are sufficient to finance 12.2 months of total merchandise imports and 25.1 months of essential imports (Table 1). 8. Bhutan s external debt obligations as of June 2013 totaled USD 1.5 billion, increasing by 13.7% from June Of the total, 34.2% were outstanding convertible currency loans and the remaining 65.8% as Indian Rupee denominated debt (mostly for hydropower development). As of June-end 2013, the overdraft facility from India was liquidated. Overall debt servicing for the FY 2012/13 amounted to USD 21.2 million on convertible currency debt and 83.6 billion on Rupee denominated debt (which includes a cumulative amount of 76.9 billion liquidated on overdraft availed throughout the year with a corresponding interest cost of million). Consequently, as of June 2013 Bhutan s total debt outstanding stood at 107.7% of GDP (2011 levels); the debt service ratio (excluding ODF) has increased to 20.2%. 9. Meanwhile, on the fiscal front 5, based on latest updates from the Ministry of Finance in June 2013, total revenue including grants, increased from 35.8% of GDP to 36.9% of GDP in FY 2012/13. Total expenditure also increased from 36.9% of GDP in 2011/12 to 37.8% of GDP during 2012/13. As a result, the national budget deficit was 0.9% of GDP for the FY 2012/13 from 1.1% of GDP in the previous year. At Nu.20.4 billion, domestic revenue was more than sufficient to finance all current expenditures totaling Nu.16.7 billion. Capital expenditure during the year increased to 19.6% of GDP from 18.6% of GDP in the previous year. Grant support helped finance 37.1% of total expenditure. 5 Source: Ministry of Finance, MFCTC, September Please note that since the updates are sourced from the latest MFCTC review (September 2013), these figures shall not be comparable with fiscal data published in previous RMA publications (including the March 2013 Selected Economic Indicators) that still feature fiscal figures as of the last Budget Speech Monetary Policy Statement September

16 II. Bhutan s International Reserve Status at a Glance 6 Table 1. Bhutan s CC and INR Reserve Indicators, Particulars Q1 (Mar 12) Q2 (Jun 12) (USD/INR millions) Q3 (Sept 12) Q4 (Dec 12) Q1 (Mar 13) Q2 (p) (Jun 13) 1. Total reserves Gross CC reserves Gross INR reserves 1, , , , , , Net INR position (5,805.5) (3,639.7) (7,403.8) (10,295.3) (1,250.2) 6, Gross reserves coverage (months) of total imports (goods) 4. Gross reserves coverage of total imports (goods &services) 5. Gross reserves coverage of essential imports ) Gross reserves figures are sourced from the RMA Monthly Bulletin. Net INR reserve position figures are inclusive of the ODF and sourced from the FXD, RMA. 2) Reserve import coverage (goods and including services) in months, source: RMA Monthly Bulletin. The essential import figure of USD million (2012) was used. Table 2. Timeline: GoI SCF and ODF 1993 GoI SCF INR 100 million 1994 GoI SCF enhanced to INR 250 million 1998 SBI ODF INR 800 million 1999 GoI SCF of INR 250 million liquidated 2003 SBI ODF enhanced to INR 2 billion 2007 SBI ODF enhanced to INR 4 billion (sold USD 25 million) 2009 (Mar) GoI SCF INR 3 billion fully utilized 2010 (Jul) SBI ODF enhanced to INR 5 billion 2011 (Jun) SBI ODF enhanced to INR 6 billion 2011 (Jul) SBI ODF enhanced to INR 7 billion 2011 (Aug) SBI ODF enhanced to INR 8 billion 2011 (Dec) Sold USD 200 million to liquidate SBI ODF INR 8 billion 2012 (Mar) SBI ODF enhanced to INR 10 billion 2012 (May) PNB ODF limit of INR 2 billion 6 Source: FXD, RMA. Monetary Policy Statement September

17 Table 2. Timeline: GoI SCF and ODF (contd:-) 2012 (Jun) PNB ODF enhanced to INR 5 billion Additional GoI SCF of INR 3 billion; fully utilized 2013 (Jan) Sold USD million (World Bank Development Policy Credit II received as budgetary support to RGOB); fully utilized 2013 (Mar) INR SWAP with RBI INR 5.4 billion; fully utilized Additional GoI SCF INR 4 billion; fully utilized 2013 (Jun) Sold USD 200 million Table 3. Summary of Major INR Inflows/Outflows: June 2012 to June 2013 (INR Millions) Particulars Apr-Jun 12 Jul-Sept 12 Oct-Dec 12 Jan-Mar 13 Apr-Jun 13 Inflows 20, , , , ,845.4 Commercial banks 10, , , , ,082.1 GoI grants 9, , , , ,230.7 GoI LoC & SWAP with RBI , Hydro-project export proceeds , , Outflows 16, , , , ,493.0 Industry 2, , , , ,385.7 Hydro projects 2, , , , ,916.9 Construction materials 3, , , , ,598.2 Hardware items Groceries 2, , , , ,806.9 Govt& corporations 1, , ,241.1 Garments 1, Remittances Card Payments Vehicles Auto spare parts Fuel 1, , , , ,015.9 Vegetables Interest expenses ODF GoILoC& SWAP Others Net Rupee Flows (+/-) 3, (5,254.5) 5, ,352.4 Notes: 1) Quarterly data flows sourced from the FXD, RMA. 2) (-) = data not available. 3) Hydropower projects data for December 2012 includes the Tala debt repayment of INR 2.5 billion. 4) All flows pertain to transactions only carried out through the banking system (RTGS) and therefore exclude all INR transactions in cash issued over the banking counters. Monetary Policy Statement September

18 III. RMA Monetary Policy Operations: FY 2011/12 FY 2012/ As stipulated in the RMA Act 2010, the primary function and objective of the RMA is to formulate and implement monetary policy with a view to achieving and maintaining price and financial stability (Chapter II, Section 7). Other secondary objectives that evolve around the primary objectives are to: a) formulate and apply financial regulations and prudential guidelines to ensure the stability and integrity of the financial system as empowered by the Act; b) promote an efficient financial system comparable to international best practices; c) promote, supervise and, if necessary, operate national and international payment and settlement systems including the electronic transfer of funds by financial institutions, other entities and individuals; d) promote sound practices and good governance in the financial services industry to protect it against systematic risks; and e) promote macroeconomic stability and economic growth in Bhutan. 11. It is important to note that the RMA s monetary policy works largely via its influence on aggregate demand in the economy and has a limited role in explaining the dynamics of domestic supply and structural bottlenecks. The RMA pursues a multi-faceted monetary policy strategy aimed at stability in the credit and financial markets, domestic inflation and growth. This requires the monitoring and analysis of movements in a number of macro indicators including broad money supply, interest rates, credit growth, inflation, trade, capital flows and the fiscal position, along with trends in output. Moreover, the RMA also places large emphasis on financial inclusion and financial literacy programs in collaboration with the government and international development partners including the World Bank. 12. In the pursuit of monetary policy, the RMA uses the following tools to manage and influence key macroeconomic variables that impact macroeconomic trends and development in the country. The CRR and SLR: Changes in the CRR and SLR addresses nonautonomous, structural mismatches in the liquidity conditions of the economy (such as large mismatches in the growth of domestic deposits, domestic credit and domestic investment). Policy Rate: Unlike the two facility window corridor on deposits and lending as in neighboring India, the RMA operates a single lending 7 Please see Annex 2 for supplementary data. Monetary Policy Statement September

19 facility through the Repo window. This repo facility is normally used to address autonomous frictional liquidity mismatches that occur due to (i) liquidity pressures originating from currency demand which is periodic and seasonal in nature; (ii) changes in commercial banks reserve levels and cash balances maintained with the RMA and, (iii) changes in the government cash balances at the RMA. RMA Short-term Liquidity Adjustment Window Facility (RSTLAW): The RSTLAW provides short-term funds to liquiditydeficient banks to meet daily operational requirements and short term outstanding liabilities; and not for long term lending activities; this is to ensure that liquidity injected through the RSTLAW are prudently utilized and not directed towards further credit creation. Base Rate: The base rate provides a broad framework for assessing the cost of funds for commercial banks. Changes in the monetary policy stance signaling through base rates of the commercial banks influence lending and the deposit rates of the financial sector, thereby having some impact on savings and investment levels in the economy. Open Market Operations (OMOs): OMOs are conducted through periodic auctioning of government Treasury Bills. Treasury Bills are issued (i) to help finance the short term fiscal deficit of the government and (ii) towards liquidity sterilization for monetary policy purposes. Similar to the policy rate, OMOs are more often used to meet shorter-term structural liquidity mismatches than the CRR. Macro-prudential Measures: Other instruments at the discretion of the RMA include the enforcement of macro-prudential measures and guidelines as embodied in the RMA s Prudential Regulations 2002, to influence the operations of depository institutions, as well as the prudent management of country s foreign exchange balances. Additionally, through moral suasion, the RMA appeals to financial institutions to collectively shoulder social responsibility and operate in a manner that supports the overarching economic policies of the government aimed at poverty reduction and sustainable socioeconomic growth. Monetary Policy Statement September

20 Review of Policy Measures Implemented by the RMA in the Past Year 13. During 2012, the RMA faced limited options when dealing with acute banking sector liquidity constraints and mounting Rupee outflow pressures. As remedial action, the RMA implemented several corrective policy measures to slow aggregate demand while safeguarding the financial sector (refer to paragraph 14) from unwarranted risks and vulnerabilities. Dealing with the twin problem of huge Rupee trade outflows and tight domestic financial sector liquidity, the RMA lowered the CRR twice during 2012 while at the same time restraining credit flows channeled through import-oriented sectors including the transport and housing sectors which contribute to large Rupee outflows and external sector imbalances with India. These measures were necessary at the time due to the substantial, costly and growing short-term Rupee borrowings by the central bank. Despite these measures, however, large interest payments associated with the short-term Rupee borrowing from Indian commercial banks continued to burden the RMA during the second half of The following provides an overview of recent key monetary and financial policy measures taken by the RMA since last catalogued in the 2012 MPS: Date May 2012 Measures Taken While INR cash transactions have been curtailed, INR transactions via the banking channel continue to be largely unlimited though subject to the submission of proper evidence and documentation (e.g. pro-forma invoice, travel documents, import/export license, service contracts etc.) in the interest of legitimacy and transparency. To ease Rupee pressures and to encourage Rupee inflows and retention in the country, as prescribed by the RMA under the Operational Guidelines for Indian Rupee Transactions (issued May 1, 2012), local industries with the capacity to earn Rupees through the export of goods and services are now permitted to operate Rupee Accounts with one of the authorized banks in Bhutan. 10% of their export earnings can be retained in these Rupee accounts and used for payments to India. July 2012 As part of RMA s efforts to improve the overall payments and settlement systems and in line with the introduction of the Electronic Fund Transfer and Clearing System (EFTCS), the RMA launched the Point-of-Sale (POS) Integration System in July 2012, launching the inter-connectivity of all POS terminals across different banks and Bhutan. This will benefit foreign visitors, and promote cashless transactions and hence enhance convenience and safety for both customers and merchant businesses, while promoting revenue disclosure and transparency. Monetary Policy Statement September

21 Date September 1, 2012 Measures Taken In order to strengthen the management and transmission of monetary policy, the RMA in collaboration with the financial institutions has introduced a system of the base rate to indirectly manage and influence domestic credit growth. The base rate will ensure the minimum rate below which it will not be viable for financial institutions to lend and help bring about greater transparency in loan pricing, promote lending discipline while strengthening monetary policy transmission. The base rate system is implemented in accordance with the Operational Guidelines on the Base Rate System (accessible on the RMA website). The base rate also serves as the reference benchmark rate for floating rate loan products, apart from other external market-based benchmark rates.the actual lending rates charged to the borrowers by the financial institutions shall be the base rate plus borrower-specific charges, which includes product-specific operating costs, credit risk premium and tenor premium.in order to make the lending rates more responsive to the RMA s policy rate, the financial institutions are required to periodically review and announce their base rates to the public (at least once a year). November 9, 2012 Towards the end of 2012, the RMA revised several prudential provisions pertaining to loan provisioning and gestation periods to ease liquidity stress on commercial banks as follows: (i) Loan provisioning on standard loans has been reduced from 1.5% to 1%; (ii) Loan provisioning on sub-standard loans has been reduced from 20% to 15%; (iii) Asset classification on doubtful loans has been revised from days to 181 days to 18 months; (iv) Asset classification on loss loans has been revised from more than 365 days to more than 18 months. (v) Gestation period for personal housing/construction has been raised to a maximum of 3 years; (vi) Gestation period for hotel construction has been raised to a maximum of 5 years; and (vii) Gestation period for the manufacturing and service sector has been raised to a maximum of 5 years. March 2013 Following from the March 8, 2012 RMA Circular on Foreign Currency, the RMA has (i) lowered the international credit card limit from USD 3,000 p.a. to USD 1,000 p.a., and (ii) lowered the transaction limit on point-of-sale (POS) machines in India (through debit cards) from 1 lakh per month to 15,000, to ease pressures on Rupee reserves since INR outflows from these channels were escalating. Monetary Policy Statement September

22 Date March 8, 2013 With effect from March 30, 2013 Measures Taken The RMA in collaboration with the Royal Government, entered in a Rupee Currency SWAP agreement with the RBI for a total of 5.4 billion at 5.5% p.a. for the duration of 6 months (3 month period with an additional 3 months rollover). Such financing provides short-term relief to meet immediate BOP transactions. The SWAP will fall due at the end of September Exercising the powers conferred by Section 117 of the RMA Act of Bhutan 2010, the new Foreign Exchange Regulations, 2013 was endorsed by the RMA Board of Directors and now supersedes the Foreign Exchange Regulations, 1997 (a copy of the Regulations is accessible on the RMA website) including all related past notifications, circulars and guidelines. In line with the RMA Act, this Regulation empowers the RMA to make regulations or establish limits, prescribe rules and procedures and issue notifications, orders, guidelines and clarifications with respect to foreign exchange transactions and impose administrative penalties for any contravention thereof. With effect from June 1, 2013 The RMA Financial Policy Committee of the RMA Board of Directors made amendments to the RMA Prudential Regulations on Risk Weights, identifying sector portfolios with increasing loan exposure trends and risks. To regulate credit flows to those sectors and reduce pressures on the external account, the RMA raised risk weight percentages as follows: (i) Service and Tourism 200% (ii) Housing 200% (iii) Transport 200% (iv) Personal 300% (v) Others 200% These amendments have been implemented with the additional conditions: a) Loans for education and loans against fixed deposits are excluded from the personal loan category; b) Loans to the entrepreneurship development program (EDP) are excluded from the other loan category; c) Education loans shall be disbursed directly to educational institutes; and d) Financial institutions shall not be allowed to sanction loans for the purchase of land unless the purchase of land is for investment/project purposes. Monetary Policy Statement September

23 Date With effect from December 1, 2013 Measures Taken In August 2013, the RMA made further amendments to the RMA Prudential Regulations on Risk Weights. With effect from December 1, 2013, revised risk weights shall be assigned with the new Sectoral Classification for loan portfolios designed collaboratively with the financial institutions as follows: (i) Agriculture - 50% (ii) Manufacturing/Industry 100% (iii) Services 150% (iv) Trade/Commerce 100% (v) Housing 150% (vi) Transport 150% (vii) Loan to Purchase Securities 100% (viii) Personal Loan 300% (ix) Education Loan 100% (x) Loan against Term Deposits 0% (xi) Loans to FIs 100% (xii) Infrastructure Loan 100% (xiii) Staff Loan 50% (xiv) Loan to Government Owned Corporations 20% (xv) Consumer Loans (GE) 50% These risk weights shall be assigned to each sector and reviewed after 6 months from the date of compliance. Furthermore, for sector exposures above 20%, further 50% risk weight shall apply for additional exposure. For a detailed description of the various loan sectors, please see Annex 4. Key Policy Variables, Q2, Monetary Policy Statement September

24 15. Referring to MPS 2012 and paragraph 14, over the year on the monetary front, the RMA has done all that it can to cool external demand in the nearterm, while safeguarding the health of the financial system. Of a total of 36 recommendations cited in the Rupee Task Force Report, the RMA has successfully implemented numerous monetary measures recommended by the Task Force. Now, more than a year after the RMA launched its policy measures; there have been optimistic outcomes. Overall, the RMA has attempted to juggle demand-side intervention through direct credit controls, exchange measures and prudential tools to reduce demand for and use of Rupee reserves for unproductive sectors, while keeping a close eye on liquidity levels and ensuring safety of depositors funds and financial sector soundness. 16. Demand-side management implemented by the RMA, has produced a gradual albeit marginal slow-down in the growth of key monetary aggregates along with movements of key policy variables and economic variables (table above). In summary, changes in policy variables and monetary as well as foreign exchange measures taken by the RMA have resulted in the following: (i) (ii) (iii) Lowering of the CRR helped ease financial sector liquidity constraints without resulting in an automatic pick-up in growth of credit to the private sector during FY 2012/13; Growth in broad money supply (M2) slowed down in tandem with a slowdown in growth in domestic credit levels over the year; With the introduction of the base rate system, an increase in the base rates prompted commercial banks to raise deposit rates and lending rates. 17. Unlike the past trends in sectoral credit concentration, the composition of lending of the financial institutions to the transport sector as a percentage of overall credit also declined from 9.5% in June 2012 to 6.6% as of June During first half of 2012, liquidity constraints faced by the banking sector gradually eased due to improvements in the flow of funds in the banking sector. Banking sector structural liquidity improved from Nu.3.9 billion as of June 2012 to Nu.9.4 billion as of June 2013 (Annex 2). Improvements in the liquidity situation of the banking sector were also attributed to the consecutive reduction in the CRR limit by the RMA during Q Q The implementation of the base rate system by the financial sector also revealed some signaling effect in the RMA s monetary policy. Gradual Monetary Policy Statement September

25 movements in the lending interest rates of the financial institutions were witnessed within the span of the last two to three quarters. As of June 2013, the average retail lending rate range of the financial institutions increased to 14.6% from 12.9% as of June 2012, while, the average deposit rate (all deposits with varying maturities) of the commercial banks witnessed an increase from 6.3% as of June 2012 to 7.6% as of June Besides providing a benchmark rate for lending to the financial institutions, the base rate system has helped financial institutions appropriately price their loan products while at the same time protecting themselves from financing risky investment projects. As envisaged with the base rate framework and lessons learnt from the recent Rupee circumstances, it is vital for the financial sector to channel available funds to productive economic sectors with the capacity to generate employment and address domestic supply bottlenecks besides financing import and consumption expenditures. 20. That said, RMA s measures over the past year have also had a discernible impact on the trade account. According to monthly data on banking sector transactions, Rupee imports of vehicles and construction related merchandise have steadily declined since July During the months of April to June in 2012 and 2013, the import of construction materials alone decreased from 3.4 billion for the quarter ending June 2012 down to 1.6 billion for the quarter ending June 2013 (Section II, Table 3). Despite these developments however, other Rupee-denominated imports and major outflows remain substantial. 21. Similarly, there still continues to be a huge asset-liability mismatch (using very short-term deposits to lend long-term) in the banking system posing numerous challenges for liquidity management. Banking sector liquidity has spilled over from 2012 due to (i) past and rapid growth in Indian Rupee imports, necessitating an equivalent drain on local currency liquidity; (ii) a reduction in general deposit levels held with banks due to volatility and withdrawals by corporate entities as well as direct inter-corporate transactions bypassing financial intermediaries; as well as (iii) heavy reliance on bank-loan capital to finance public and private sector investments rather than tapping alternative finance, including the capital market. 22. This explains why despite some improvement in structural liquidity of the commercial banks as of the first quarter of 2013, financial sector liquidity today remains tight and why lending activities continue to be constrained. Notably, lasting solutions to the current conundrum is tied to growth in Monetary Policy Statement September

26 economic activity, strengthening exports and inflows of foreign exchange, investment revenue and thus savings within the economy. Meanwhile, the RMA already offers access to short-term funds to liquidity deficient banks through the RSTLAW and is currently working with the banks to improve asset-liability management. Further more, to facilitate credit for priority sectors, the RMA has provided the following exemptions on the base rate framework to the financial institutions: (i) (ii) (iii) (iv) (v) (vi) (vii) Loans for the agricultural sector; Loans for small businesses and artisan schemes; Entrepreneurship Development Program (EDP) loans; Staff incentive loans; Loans against fixed deposits Loans which call for renewal, restructuring, enhancement and rescheduling; Pension membership loans of the NPPF. 23. In light of continued demand-side external account pressures warranting continued aggregate-demand policy intervention to keep prospective credit growth in check, the RMA s monetary policy stance shall continue to remain tight over the medium term. The RMA shall maintain vigil on developments in money and credit markets, with focus on effective management of demand and supply of market funds geared towards building productive capacity in the economy and priority sectors identified for development at the heart of credit policies. Meanwhile, maintaining a sustainable level of growth and minimizing external sector imbalances through prudent management of international reserves and short term Rupee debt are viewed equally critical for sustainable economic development in the medium to long-term. The RMA shall continue to use its policy tools (reserve requirements, base rate and the policy rate) to achieve its macroeconomic objectives and to support financial sector development in the country. Recent policy measures taken by the RMA, especially on the macro-prudential front shall also be subject to further change as and when the situation warrants. Monetary Policy Statement September

27 Sale of USD 200 million from Bhutan s International Reserves, June 26, 2013 On June 26, 2013, the RMA sold USD 200 million from Bhutan s international reserves against Indian Rupees at the prevailing exchange rate of per USD for a total of billion. The transaction was effected on June 28, As of June 22, 2013, Bhutan s gross CC reserve position totaled USD million (table below), while Bhutan s net INR position was negative at (12.2 billion) with the outstanding ODF balance with the SBI at (9 billion). Between June 24-26, 2013, total inflows amounting to 9 billion received by Bhutan helped liquidate the ODF with the SBI, freeing up pledged CC reserve assets (USD 190 million) against the ODF. Table 4. Bhutan Reserve Position: June 22, 2013: Particulars 1. CC Reserve Position (USD millions) Royal Monetary Authority Commercial Banks Net Rupee Position (INR millions) (12,181.5) Of which, RMA (including SBI ODF of (14,235.4) (9, % p.a., and RBI SWAP of (5, % p.a. Of which, Commercial Banks Holdings 2,053.9 The RMA s decision to sell USD 200 million was based on the following: (i) (ii) Favorable exchange rate conditions: With the strengthening of the USD against the Indian Rupee, the Rupee had fallen to an all-time low exchange rate of to the USD. Compared to the previous quarter March-end 2013 s exchange rate of to the USD (a difference of 20 bps), Bhutan earned an exchange rate gain of 1.1 billion at the time of the sale. Taking advantage of these developments and the exchange rate gain helped offset interest expenditure incurred by the RMA on the ODF, GoI line of credit and the SWAP for the FY 2012/13 (amounting to INR 1 billion). Outstanding and upcoming Rupee obligations: Although Bhutan received Rupee inflows associated with hydropower flows and the excise duty refund from India during June 2013, given uncertainty surrounding future Rupee inflows and outstanding Rupee obligations (Kurichhu and Tala hydropower debt and RBI SWAP repayments) estimated at 6.9 billion for the remainder of 2013 (July-December), selling CC reserves helps position Bhutan to make these payments including other BOP transactions on imports of goods and Monetary Policy Statement September

28 services as and when they fall due. (iii) CC reserve levels comfortable before sale: After setting aside (i) USD million reserve coverage for essential imports; (ii) USD 190 million from CC reserves pledged against the ODF; (iii) USD 31.9 million in outstanding payments due on new aircraft for DACL; and (iv) backup of currency in circulation estimated at USD 112 million (2012 average), Bhutan had an approximate CC reserve surplus of USD million prior to the sale of USD 200 million as of June 22, Part of the proceeds from the sale of CC reserves was invested in Rupee term deposits in 7.25% p.a. Following the sale of CC reserves, Bhutan s Rupee reserve position totaled million as of June 30, The estimated surplus has now been reduced to USD million. Table 6. Bhutan Reserve Position: June 30, 2013: Particulars 3. CC Reserve Position (USD millions) Royal Monetary Authority Commercial Banks Net Rupee Position (INR millions) 6,000.4 Of which, RMA (RBI SWAP of (5, , % p.a. Of which, Commercial Banks Holdings Table 7.Estimated Surplus CC Reserve Position: June 30, 2013: Particulars (USD millions) 1. CC Reserve Position Liabilities against CC reserves (outstanding payment for DACL aircraft) 31.9 CC Reserves Available (1-2) (less) back-up for domestic currency in circulation (2012 average) (less) reserve requirement for essential imports Estimated Surplus CC Reserve Balance Note: Reserves data sourced from institutional balance sheet figures as of June 30, (Source of information and data: FXD, RMA) Monetary Policy Statement September

29 Issues in Foreign Exchange Management 24. As per Chapter VI, Section 108, 111, and 114 of the RMA Act of Bhutan 2010, The Authority shall be the owner, depository and manager of the official external assets of Bhutan and the RMA shall use its best endeavors to manage the external reserves to maintain safety, liquidity and yield, in that order and maintain the external reserves at a level adequate for the international transactions of Bhutan or as may be required by law. The RMA is also empowered to adopt appropriate policy guidelines for decisions regarding the allocation and composition of reserves in accordance with international best practices. 25. By international practice, the central bank usually has sole authority in setting the overall objectives for reserve management. In Bhutan s case, to strengthen the institution of democracy, the broad goals and objectives of reserve management have been set in consultation with the government and enshrined in the law. However, operational independence is vital for the RMA in order to facilitate day-to-day management of reserves and implementation of reserve management strategies, including the choice of instruments of reserve management. 26. Notably, the RMA as custodian and manager of reserves is severely constrained in its mandate to the extent of the amount of foreign exchange reserves available for management. It is widely acknowledged that Bhutan s reserves have been largely built-up from decades of official aid and assistance (grants and concessional loans) rather than export performance. The majority of both current account and capital account inflows in Bhutan s BOP (India and other countries) are dominated by public-sector related inflows. These inflows are channeled through the domestic banking system contributing to reserve asset accumulation. However, given current supply-side constraints in the Bhutanese economy, these inflows of convertible currency and Indian Rupees are insufficient when pitted against economic requirements to meet international payment transactions (imports of goods and services from abroad). 27. The events of 2012 have taught us that Bhutan lacks domestic productive capacity to generate sufficient foreign exchange earnings. As a result, the RMA has had to undertake unconventional measures to control the demand for Rupees including availing of a costly overdraft facility. However, these measures are at best short-term and should only be treated as the last line of defense. More importantly, RMA s measures will be ineffective unless stronger long term fiscal and real sector intervention is phased in soon.the RMA undertaking and sustaining huge overdraft at high commercial rates is: Monetary Policy Statement September

30 (i) (ii) First and foremost not advisable as it places additional burden on our already limited reserves since the cost of servicing that debt is substantial and there is a corresponding pledge on CC reserves. Second, the practice of availing debt to service debt is not only unsustainable and dangerous but destroys the credibility of the central bank institution. The overdraft inflates the central bank s balance sheet liabilities reflecting the state of a deteriorating economy. (iii) Third, undertaking overdraft to finance consumption expenditure of various sectors of the economy raises serious concerns because it further deteriorates the external sector through the trade account as Bhutan is an import-dependent economy. While borrowing to finance investment in productive ventures is good for the economy, borrowing for direct consumption entails a direct drain on reserves with no promise of future earnings. 28. In the past year, it has been suggested that the central bank should revisit its reserve management policy to make the sale of convertible currency reserves standard operating procedure given the larger demand for Rupees for economic transactions. Henceforth, it should be clarified that in line with the mandate and powers of the RMA Board, the existing reserve management guidelines, the RMA shall use the reserves as a last line of defense as and when necessary, with due consultation with the fiscal authority. This shall include the sale of CC reserves to build Indian Rupee reserves as and when overall reserve levels are comfortable. 29. However, determining the level of comfort accorded by CC reserves shall also be determined after fulfilling additional parameters set by the Constitution and other requirements of the RMA (CC reserves pledged for the overdraft and back-up of Ngultrum in circulation outside banks). The overall discretionary powers as entailed in the RMA Act of Bhutan 2010 to make these assessments and decision shall lie with the RMA Board of Directors. The RMA recently received Missions from the IMF (July 2013) and the World Bank (September 2013) to review reserve management policies and operations as part of its ongoing efforts to improve reserve management practices. Monetary Policy Statement September

31 IV. Medium Term Outlook for Bhutan: FY 2012/ /15 8 : Risks and Challenges Macroeconomic forecasts for Bhutan s medium-term are prepared by the multi-sectoral Macroeconomic Framework Coordination Technical Committee (MFCTC) taskforce and endorsed by the high-level Macroeconomic Framework Coordination Committee (MFCC), chaired by the Finance Secretary, and comprising executives from various government departments and the RMA. The compilation of macroeconomic and fiscal projections involves estimating revenues, issuing a statement of strategic fiscal policy, and establishing a budget envelope for the medium-term period. Careful monitoring of possible policy changes is vital to prepare and address emerging issues in the Bhutanese context, where a few variables can have a dramatic effect on the overall macroeconomic and fiscal picture. 30. The growth outlook for Bhutan has been tempered to reflect the impact of the BOP deficit with India over the last year as well as revisions in the date of construction of several pipeline hydropower projects. While growth in the agriculture sector is expected to remain at 1.8%, there is not much pick-up expected in both the industry and services sector. Activity in construction in particular will be very sluggish, in part as a result of the credit measures that were taken and in part because construction of five new hydropower projects initially forecast to commence in 2012 have been pushed beyond As a result, the GDP growth forecast for FY 2012/13 is expected to moderate to 6.9% from 8.1% in the previous year, and remain within 7% in the medium term. 31. Globally, inflation pressures are deemed to remain contained, reflecting narrowing output gaps and the slowdown in and lower food and energy prices (IMF World Economic Outlook, April 2013). Closer to home in India however, upside pressures remain from high food prices, ongoing upward revisions in administered fuel prices and wage pressures. Upside pressures aside, inflation in India did ease significantly towards the end of FY 2012/13 with the Reserve Bank of India committed to contain headline WPI inflation at around 5% in the short-term and 3% over the medium-term (RBI Monetary Policy Statement , May 2013). With inflation in Bhutan closely tied to inflation in India, Bhutan s CPI inflation moderated from a historical high of 13.5% in the last quarter of FY 2011/12 to 5.5% in the last quarter of FY 2012/13, and is further expected to remain between 7% and 8% in the medium term. 8 Please see Annex 3 for a summary of Bhutan s macroeconomic projections from FY 2011/12. Please note that macroeconomic projections are subject to sector-wise revisions as and when new data is available, thereby potentially generating variations in different forecasts published. Monetary Policy Statement September

32 32. On the external front, the Indian rupee shortage has been a manifestation of a rapidly rising current account deficit with India spurred by the trade deficit. The current account deficit is not expected to ease in the medium term as imports continue to grow at a faster pace than exports driven by hydro-related imports. In spite of slightly higher levels of budgetary grants as compared to the past, the current account deficit is expected to increase steadily in the medium term reaching 29.7% of GDP by 2014/ The current account deficit has been traditionally financed by ODA in the form of grants for investment and concessional loans. One of the overall goals of the 11 th FYP is that of self-reliance and a gradual phasing out of ODA. In line with this goal, ODA flows into the country, especially from countries other than India are projected to gradually decline over the plan period. As a result, gaps are expected in the financing of Bhutan s BOP transactions with COTI consequently involving persistent draw-downs in our international reserves as an alternative, albeit unsustainable source of finance. On the BOP with India front, repayment obligations on account of the GoI line of credit (Rs. 3 billion) and the RBI Swap arrangement (Rs. 5.4 billion) are expected to place added pressures on reserves. 34. Consequently, Bhutan s overall balance is forecast to be negative in FY 2013/14, implying draw downs in the nation s gross international reserves. While some reprieve is expected towards the end of the 11 th FYP with the commissioning of three hydropower projects, the phasing out of ODA from COTI implies that Bhutan will continue to have to meet part of its external obligations through its reserves. Therefore, long-term measures must be initiated to reduce the trade and current account deficits. Reserves will be sufficient to finance between 6.8 and 9.3 months of total merchandise imports and an average of 24.6 months of essential imports in the medium term. 35. On the domestic front, the fiscal deficit is expected to increase to 3.7% of GDP by FY 2013/14 before falling slightly to 3.1 % of GDP in FY 2014/15. Domestic revenue receipts are expected to average 19.5% of GDP over the medium term while capital expenditure is expected to average 16.5% of GDP. 36. As a developing country, it is inevitable that for the foreseeable future, Bhutan will continue to depend on imports fueled by industry and improvements in living standards for core development activities. This will undoubtedly place increasing pressure on Bhutan s reserve levels. The recent Rupee shortage has underscored the need to build domestic capacity to meet internal demand for goods and services. Without risking a slowdown in Monetary Policy Statement September

33 economic activity, authorities must work together to seek a balance and find more sustainable solutions to financing foreign exchange transactions in the midst of rapid urbanization and development plans. Therefore, the policy imperative today is to phase in targeted long-term policy measures (both demand and supply side management, fiscal and otherwise) in the real and fiscal sectors to promote and boost domestic productivity and employment. Economic policies need to channel investments in productive sectors, diversify the economy and build the domestic supply and production base. 37. While investments in the hydropower sector remain essential to overall socio-economic development in Bhutan, it is unlikely that the current and pipeline hydropower investments are a panacea to current risks. Though it has been stated that with the completion of pipeline hydropower projects (10,000 MW vision by 2020), Bhutan will enjoy comfortable inflows of Rupees to finance its BOP, the reality is that in the build up to the commissioning of the projects, Bhutan is already up-fronting future hydropower earnings through current imports of goods and services, workers remittances and the servicing of mounting short-term Rupee debt. 38. Sustained and large deficits in the current account remain one of the biggest risks to medium and long-term growth prospects. The table (next page) outlines the revisions in the medium-term BOP projections since June 2012, while also providing an indication of where the major risks lie going forward. Revised forecasts as of September 2013 indicate a sudden increase in the current account deficit to 29.7% of GDP in FY 2013/14. This increase in the current account deficit is expected in spite of an optimistic export growth rate of 17.6% (largely exports from the Dungsam Cement Corporation Ltd.), largely because of lesser budgetary grant inflows in the year. 39. A comparison of the initial projection and provisional outcomes for FY 2011/12 indicates two major areas of downside risks and shocks to macroeconomic performance in the medium-term: timely realization of anticipated financing flows (grants and concessional loans); optimistic export performance. As recent developments have demonstrated, external risks and the pace of recovery in India could have corresponding impacts in Bhutan and compound risks moving forward since India remains Bhutan s largest development aid partner. Monetary Policy Statement September

34 Comparison of MPS 2012 Macro Projections and Latest Projections for Bhutan 2011/ / /14 I II* I II I II CAD (Nu. Mns) (% of GDP) Exports growth rate (%) Imports growth rate (%) Trade Balance (Nu. mns) (% of GDP) Budgetary Grants (Nu. Mns) Capital & Financial Account (Nu. Mns) Overall Balance (Nu. Mns) Gross International Reserves (USD Mns) Reserve cover of essential imports (months) Nominal GDP (FY) I = Projections as of June 2012; II = Latest data/projections (as of July 2013). CAD = Current Account Deficit; * = provisional. Monetary Policy Statement September

35 Outlook and Risks for India: FY 2013/14 The Reserve Bank of India anticipates a slow-paced recovery in India s growth in 2013/14 with baseline GDP growth projected at 5.7%. Economic activity is expected to improve only modestly over the last year, conditional upon a normal monsoon that would then return agricultural growth to trend levels. Meanwhile, the outlook for industrial activity remains subdued, with declining trends in new investment projects and supply bottlenecks and sluggish external demand continuing to affect both manufacturing and service activities. Growth in services and exports are also not very optimistic since global growth is unlikely to improve significantly over On the inflation front, upside pressures remain from elevated food inflation and ongoing administered fuel price revisions. Given a historical average of 5.4% and 5.8% for the WPI and CPI, respectively, during the last decade (2000s) and empirical evidence on the threshold level of inflation that is conducive for sustained growth, the RBI is committed to contain headline WPI inflation at around 5.0% in the short-term and 3.0% over the medium-term, consistent with India s broader integration into the global economy. Consequently, M2 growth for 2013/14 is projected at 13.0% for policy purposes. However, being indicative projections and not targets, the conduct of monetary policy would be eventually guided by the evolution of monetary aggregates along the indicative trajectories set out for various monetary aggregates. The current account deficit remains the biggest risk to the economy, which was at a historical high of 6.7% of GDP in Q3 of 2012/13, well above the sustainable level of 2.5% of GDP estimated by the RBI. In addition, financing the CADalso exposes the economy to the risk of sudden stop and reversal of capital flows. Subdued investment sentiments and supply constraints, particularly in the food and infrastructure sectors also pose risks to sustained recovery and efforts to contain inflationary pressures. Forecast of Selected Economic Indicators Annual Q4 Q1 Q2 Q3 Q4 Real GDP growth rate (%) Inflation, WPI (average, %) Exchange Rate (INR/USD end of period) 54.4* 54.4* ) Forecasts are based on the latest round of projections, except where * = actual figure. 2) India s fiscal year runs from April to March. Source: RBI Marcoeconomic and Monetary Developments in , May 2, 2013 and RBI Monetary Policy Statement , May 3, Monetary Policy Statement September

36 ANNEX 1 BHUTAN: KEY ECONOMIC INDICATORS Indicator 2009/ / / /13 GDP Growth and Prices (% change) GDP at Constant (2000) Price (a), (b) n/a Consumer Prices (c) Producer Price Index (d) (0.2) Wholesale Prices (India) (e) Government Budget (in millions of Nu.) (f) Total Revenue and Grants 30, , , ,648.2 Of which: Foreign Grants 11, , , ,798.6 Total Expenditure and Net Lending 29, , , ,604.4 Current Balance 6, , , ,557.4 Overall Balance 1,101.8 (1,670.7) (1,041.7) (956.2) (In % of GDP) 1.8 (2.3) (1.1) (0.9) Money and Credit (% change, end of period) Broad Money, M (1.0) 18.6 Credit to Private Sector Interest Rates (%, end of period) One Year Deposits Lending Rate (*) day RMA Bills/ Treasury Bills Balance of Payments (in millions of Nu.) Trade Balance (13,938.2) (23,544.9) (23,985.1) n/a (In % of GDP) (22.8) (32.5) (28.0) n/a With India (4,933.6) (15,160.0) (14,014.4) n/a Current Account Balance (6,634.9) (18,599.4) (17,585.2) n/a (In % of GDP) (10.8) (25.7) (20.5) n/a With India (3,493.7) (14,410.8) (12,714.0) n/a (In % of GDP) (5.7) (19.9) (14.9) n/a Foreign Aid (Concessional Loans net) 3, , ,804.1 n/a Of which: India , ,247.3 n/a Errors and Omissions 1, ,516.1 (1,006.0) n/a Overall Balance 4, ,335.4 (5,456.1) n/a (In % of GDP) (6.4) n/a Monetary Policy Statement September

37 Indicator 2009/ / / /13 External Indicators (end of period) Gross Official Reserves (in millions of USD) (In months of merchandise imports) (In % of external debt) External Debt (% of GDP) Debt-Service Ratio (including overdraft) (g) Memorandum Items: Nominal GDP (in millions of Nu.) (a), (b) 61, , ,580.6 n/a Ngultrum per USD (period average) Money Supply, M2 (end of period) 41, , , ,451.2 Money Supply, M1 (end of period) 22, , , ,794.1 Counterparts (in millions of Nu) Foreign Assets (Net) 34, , , ,566.4 Domestic Credit 23, , , ,432.3 Claims on Private Sector 25, , , ,824.6 Components (in millions of Nu) Currency Outside Banks 5, , , ,681.2 Demand Deposits 17, , , ,112.9 Quasi-Money 19, , , ,657.1 Reserve Money, M0, of which 20, , , ,997.4 Banks Deposits 14, , , ,607.6 Money Multiplier (M2/M0) Income Velocity (GDP/M2) n/a Population Growth Rate (a), (h), (i) n/a Unemployment Rate (a), (i) a) On a calendar year basis, e.g., the entry under 2011/12 is for b) Source: National Accounts Statistics 2012, NSB. c) The CPI reflected in this table is for the last quarter of each fiscal year. As of the second quarter of 2013, the NSB has increased the weight of food in the CPI from 31.67% to 39.92%, and correspondingly decreased the weight for non-food from 68.33% to 60.08%. d) The first PPI bulletin for Bhutan was released by NSB during Q2, 2012 and the data available are year-on-year inflation. e) Source: Reserve Bank of India. Wholesale Price Index of All Commodities, Base = Effective August 2010, the RBI revised the base year from to , creating a break in the continuity and comparison of data. The newly-recalculated WPI commences from April 2004; reference period same as for Bhutan CPI. f) Fiscal data for 2011/12 and 2012/13 are updates from the MoF (September 2013). g) Debt service payments in percent of exports of goods and services. h) Data on calendar year basis; sourced from NSB. i) Updates sourced from Labour Market Information System, MOLHR. (*) With effect form September 2012, the RMA introduced the base rate system. Monetary Policy Statement September

38 Monetary Policy Statement September

39 Monetary Policy Statement September

40 MONETARY AGGREGATES (y-o-y Growth in %) 2009/ / / /13 M (1.0) 18.6 Reserve Money 40.0 (4.1) (15.1) 43.3 Net Foreign Assets (% growth) Net Domestic Assets (1,232.5) (3.5) (27.2) Domestic Credit Credit to the private sector (% growth) Credit to the public sector (% growth) (85.5) Source: RMA. *) Includes only banking sector credit. MONETARY AGGREGATES (% Share of M2) End of the period Jun 13 Nu. in Millions M2 51, , , ,451.2 Domestic Credit 29, , , ,432.3 Credit to the Private Sector 30, , , ,824.6 % growth rates M Domestic Credit Credit to the Private Sector % share of M2 Domestic Credit Credit to the Private Sector CD ratio (%)* CA ratio (%)** */ CD ratio refers to credit to deposit ratio of commercial banks. **/ CA ratio refers to credit to asset ratio of commercial banks. Monetary Policy Statement September

41 Monetary Policy Statement September

42 Monetary Policy Statement September