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LESSONS:

Bhutan: Financial Sector Intermediation Facility and Equity Investment in Bhutan National Bank

| country: Bhutan

Insufficient analytical underpinnings led to formal rather than substantive compliance with tranche release conditions. Joint undertakings with other donors and Royal Government of Bhutan might have strengthened the substantive analysis of policies and the robustness of the dialogue with Royal Government of Bhutan. For example, requiring that the Royal Government of Bhutan formulate an foreign direct investment policy, without engaging substantively on the substance of that policy, was not useful. A policy was written and adopted, but a new attempt was being made to formulate a workable policy in 2009. If ADB wishes to influence foreign direct investment policy in Bhutan, it needs to contribute to public and official awareness of the benefits of foreign direct investment, partly by supporting research on the experience in Bhutan to date and making known the lessons from other small economies. Other policy measures where underlying analysis was lacking included the approval of commercial legislation and interest rate liberalization.

Delays in the establishment of a credit information bureau were also partly a failure of analysis. Costs were underestimated and the problems were not fully understood. Founding a credit information bureau in Bhutan is not only a problem of coordination among the lending institutions. The challenge is more fundamental, with the essential problem being the poor data systems and practices of the lending institutions. Substantive analysis at the design stage of the Financial Sector Intermediation Facility would probably have identified this issue and allowed ADB and Royal Government of Bhutan to address it earlier. If the lending institutions do not have good records of the credit history of their own borrowers, then a joint credit information bureau is unlikely to succeed.

The failure of interest rate liberalization was also partly a failure of analysis. Removing overt administrative control of interest rates may make little difference to prevailing rates and practices if there is little competition between lenders because of the sector’s oligopolistic and closely held structure. Several factors made it unlikely that simple deregulation of rate setting would be conclusive. These included (i) the oligopolistic structure of the financial system where all financial institutions were largely government held; (ii) the close interconnections between the stakeholders of the financial institutions, resulting in a risk of informal collusive rate setting; and (iii) the 1-to-1 peg of the Ngultrum against the Rupee that complicates the relationship between Bhutanese and Indian interest rates. These factors made it likely that interest rates would be largely unchanged and price competition between financial institutions would be slow to emerge. This has in fact been the case.

The key problems and constraints of small and medium enterprises access to credit in Bhutan needed to be better understood. Problems included high interest rates, short loan amortization periods, and excessive collateral requirements. The Financial Sector Intermediation Facility loan had no effect on these.

A small equity investment can have a large impact in the right circumstances, especially if it is supported by technical assistance and policy reforms. Although ADB’s equity investment in Bhutan National Bank was largely effective in achieving its aims, it illustrates that small investments are not easy for ADB to handle within its cost structure.

Another lesson is that if ADB brings a private partner into the deal with the aim of facilitating capacity development, it should only go with a strategic investor with relevant banking experience, who will remain as a shareholder for a long time and thus play an active role in the management and corporate governance of an institution. In this particular case, the investor was not actively involved in managing the institution and acted more like a financial than a strategic investor.

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