Bhutan Country Economic Memorandum, September 2024

Maximizing Bhutan’s Potential for EconomicDiversification and Structural Transformation © 2024 The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet:www.worldbank.org Some rights reserved This work is a product of the staff of The World Bank. The findings, interpretations, and conclusions expressed in this workdo not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent.The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denomina-tions, and other information shown on any map in this work do not imply any judgment on the part of The World Bankconcerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, thiswork may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Attribution—Please cite the work as follows: “World Bank. 2024. XXX” All queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The WorldBank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail:pubrights@worldbank.org. Cover picture:©2017 Sabine Hortebusch/Shutterstock. No use without permission.Design: Alejandro Espinosa / sonideas.com BhutanCountry EconomicMemorandum Maximizing Bhutan’s Potential for EconomicDiversification and Structural Transformation Macroeconomics, Trade and Investment (MTI) Global Practice Contents Acknowledgementsx Abbreviations and Acronymsxi Executive Summary1 1.1.Introduction23 1.2.Bhutan’s hydro and non-hydro growth nexus25 1.2.1.Past growth has been drivenby the publicly led and capital-intensive hydrosector251.2.2.The private sector has remained small,with limited employment opportunities281.2.3.Economy-wide effects of the hydro sectorand symptoms of the Dutch Disease31 1.3.Economic diversification in Bhutan: a framework for managinghydropower rents37 1.3.1.The casefor investing domestically371.3.2.Current policiesfor economic diversification in Bhutan411.3.3.A suitable institutional frameworkfor effectively channeling hydropowerrents towards productivity enhancing assets in Bhutan.45 1.4.Policy priorities54 1.4.1.Hydropower development to leveragethe current comparative advantageand ensure future hydro rents541.4.2.Policies to lay the foundationfor (new) comparative advantages in thenon-hydropower sectors551.4.3.Institutional setup to frameand implement sector-specific policies57 2.Structural Transformation ThroughAgricultural Productivity60 2.1.Introduction612.2.Structural shifts in the agricultural sector612.2.1.Agriculture continues to be Bhutan’s main employer,especially in rural areas61 2.2.2.Agricultural value-added has fallenbehind other sectors and comparators632.2.3.The slow growth in agricultural value-addedis driven by the reducedproduction of Bhutan’s traditional crops652.2.4.The agricultural sector is gradually transitioningfrom traditional to highervalue products67 2.3.Productivity as a kick-starter of structural transformation69 2.3.1.Within Bhutan there is a statistical relation betweenmore productiveagriculture and the release of labor702.3.2.Agricultural productivityin Bhutan is below its potential712.3.3.Productivity gaps can be closedby alleviating production constraints722.3.4.Closing productivity gapscan accelerate structural transformation75 2.4.Climate change may increase agricultural output but also lead toyield variability79 2.4.1.Climate change is expectedto raise both temperatures and precipitationlevels792.4.2.The impacts of climate changeare expected to alter Bhutan’s yield structure812.4.3.Short-term climate-induced yield changes can temporarily increase output,but risk distracting from longer-term diversification opportunities84 2.5.Policy priorities86 2.5.1.Strategic infrastructureinvestments872.5.2.Policyreforms882.5.3.Targeted supportto farmers89 3.Bhutan’s Financial Sector: Issues and theWay Forward 3.1.Introduction923.2.Concentration and credit allocation in the financial sector933.3.Financial sector challenges and recent measures973.4.Policy priorities1033.4.1.Financial stabilityand governance of FIs1033.4.2.Deepeningfinancial intermediation1053.4.3.Bolsteringclimate finance106 Reference List109 Annexes112 Figures Figure 1: Impact of hydropower on GDP (percent), 1985-20212Figure 2: Growth rates of hydropower and non-hydropower sectors (percent), 2001-20192Figure 3: Hydro and non-hydro sector growth decomposition (contribution to growth), 2001-20194Figure 4: Spillovers from hydro to non-hydro sector, 2001-20194Figure 5: Bilateral real exchange rate with India (Index average 1980-2021 = 1), real power exportsand real capital inflows from India, 1980-20214Figure 6: Change in sectoral produ