It is written by IMF in an assessment letter for the World Bank. It says that Bhutan’s medium-term outlook was favorable, as growth should remain strong at around 8–9 percent over the medium term, driven by developments in the hydropower sector, manufacturing, and domestic services.

The current account deficit has widened to an estimated 23 percent of GDP in 2011/12 driven in part by strong imports related to the hydropower sector, but the overall balance of payments deficit was 5 percent of GDP due to sizable grants and loan disbursements. Strong growth in domestic demand has fueled the demand for Indian rupees (since about 80 percent of Bhutan’s imports are from India), contributing to a rupee shortage. Convertible currency reserves, however, are broadly adequate (US$723 million in July 2012).

Challenges in the banking sector caused by high credit growth have come to the fore. While credit growth has remained high at 26.2 percent year-on-year in June, it has moderated since March—contracting in sequential terms in June—as a result of tight liquidity and policy measures. Loan concentration, particularly in real estate/construction and personal loans, is significant. Interest rates, albeit low, have started to increase. Financial stability indicators are generally adequate, but concerns about a prospective deterioration in asset quality have intensified as nonperforming loans (net) have risen to 5.9 percent from 3.1 percent of total loans a year earlier.

Current policy settings are broadly appropriate, and overheating pressures are being addressed.

Monetary conditions need to continue to be recalibrated to ensure that prospective credit growth remains in check and liquidity conditions are appropriate. The Royal Monetary Authority of Bhutan has taken appropriate steps to address high credit growth and improve its ability to manage liquidity, particularly with the introduction of the policy rate and base rate as well as liquidity adjustment facility, though the policy rate has been set at a low level. Financial sector supervision should be strengthened and prudential tools should continue to be used proactively.

Greater financial intermediation in recent years may have increased systemic vulnerabilities stemming from rapid credit growth.

Fiscal policy has generally been prudent, but the widening of the fiscal deficit in 2011/12 has contributed to overheating. The budget deficit, estimated to have reached 4.3 percent of GDP, has led to greater demand for imports, putting pressure on the demand for Indian rupees and exacerbated the rupee shortfall. Strong commitment to the 2012/13 budget deficit target of 1.6 percent of GDP is welcome, as current expenditure declines as a share of GDP on the back of spending restraint and tax revenue is expected to improve slightly. While public debt is sustainable over the long term, the risk of debt distress stems from the possibility of shortfalls in aid-based foreign financing. Public debt has increased significantly since 2009/10 as a result of investments in the hydropower sector and is projected to exceed 93 percent of GDP in 2014/15, putting Bhutan at high risk of debt distress.

However, risks are mitigated by the concentration of debt in commercially viable hydropower projects, which account for nearly two-thirds of external debt.

The rupee shortage reflects a structural imbalance in Bhutan’s economy, but overheating has also contributed. The spending on hydropower projects in the pipeline and volatile exports to India (due to the strong seasonality in electricity generation) continue to contribute to volatility in net rupee inflows. While the hydropower projects are financed by rupee loans and grants, ancillary private sector development (particularly construction) and aid inflows have fueled imports.

However, loose aggregate demand policies (high credit growth and a widening of the fiscal deficit) have also contributed to the balance of payment pressures. Measures to curb credit growth are expected to alleviate the rupee shortage and fiscal restraint will also help.