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For the first time in our history, Bhutan may be standing on the brink of an economic standstill. The central bank’s decision to stop replenishing rupee requirements of commercial banks may just have formally spelled the beginning of an economic crisis for the country. As of now, it may be quite early to call it a crisis but if adequate measures are not taken, it may not be long before we find ourselves in one. The prospect, in every possible angle, doesn’t look good.

On the same day the Royal Monetary Authority (RMA) made its decision this week, industrialists realized that they could not import raw materials from India, wholesale traders could not bring in goods, and parents could not send money to their children studying in India. The decision had virtually arrested the Bhutanese economy. On Thursday, the central bank loosened the restriction on select transactions but the issue stands far from being solved.

In retrospect, this was long overdue. It is a culmination of several factors that has gradually destabilized our economic realities. Beginning with an unscrupulous dependence on India importing almost everything from our southern neighbor coupled with a relatively negligible export base, we have failed to find a balance to define our economy. This has also been fuelled by poor legislation and weak fiscal policies that failed to see this impending problem. The finance ministry has failed to live up to its vision which states that it will strive to “steer and sustain a robust economy through a dynamic fiscal policy and strong culture of fiscal discipline”. Moreover, our monetary policy also needs to be tightened and the move of the central bank is an attempt to do it.

The issue at hand is definitely not simple. It has been in the making ever since Bhutan started its first five year plan in 1961 and began its advent of modernization with India funding the plan. The modernization era began with imports primarily from India and thus the need to have a comfortable rupee reserve had begun much before the finance ministry issued the first bank notes in 1974 and the RMA was established in 1982. Since then, the trade realities have hardly changed and India still remains the largest trading partner.

Aggravating the scenario is the virtual absence of a manufacturing base in the country which forces Bhutan to import almost everything– from matchboxes to construction materials. To add to it, we have been excessively dependent on hydropower and the new vision to export 10,000MW by 2020 to India has seen us going on a hydropower construction spree which has further drained the rupee out of the economy. This also calls for an urgent need to diversify our economy.

Over the years, the rupee crunch has only aggravated. It is worth mentioning that past governments, rather surprisingly, never made it a national issue and thus it never received national scrutiny. Thus, while we can blame the present government for shouldering the same complacency about the issue, it should be mentioned that it only inherited the issue in its entirety.

Now, less than a week after the central bank started rationalizing the rupee outflow, it has already created panic both inside Bhutan and among Indian suppliers doing business with Bhutan. We also have to understand that the move of the central bank can only address the issue in the short term. It may be able to slow down the outflow of the rupee but it will not be able to solve the issue.

The step taken by the central bank will also have its repercussions. It will encourage an informal currency exchange of the ngultrum and the rupee. Reports are already emanating that people have started charging a premium to get the rupee. This will distort the one-to-one pegging of the two currencies where the ngultrum will lose and it can lead to a currency crisis for the ngultrum. Regulating rupee outflow will also slow down the manufacturing pace for our industries which will result in slowing down exports which will in turn affect economic growth. Therefore, a sustained regulation of the rupee will trigger a bigger problem.

Overtime, the rupee crunch has also encouraged several fronting businesses. A secret government investigation in 2007 revealed that 10 companies dealing in  palm oil, copper articles and polyester yarn had exported Nu 7.51bn worth of goods from January 2006 to May 2007 but their books showed that they had received only Nu 3.73bn. This meant Nu 3.78bn had gone missing as the money had not come back from India revealing a clear case of fronting.

It is also time we debate on un-pegging the two currencies. Pegging the ngultrum to the rupee has benefits on controlling inflation by understanding prices and their stability in the market. It also makes trade between the two countries easier. But the Mundell-Fleming model says that fixed exchange rate system restricts the effectiveness of having an independent monetary policy to achieve macroeconomic stability. In our context, it means that Bhutan cannot use its monetary policy effectively without assistance from the Indian government. Moreover, with the currencies pegged, it becomes very difficult for Bhutan to assess its real economic scenario as the dependence on the pegged currency becomes inevitable.

This issue also entails that Bhutan explore all rupee generating avenues. In this light, the government can actually solve the rupee crisis by going back on their August 2011 decision to ban Bhutan lottery operations in India.

In December, the central bank sold US$ 200mn because rupee borrowing had reached an “alarming” Rs 10bn. In contrast, a special Royal Audit Authority (RAA) report says the annual turnover from the lottery business in 2007 was Nu 263.6bn (reports from India suggest the figure should be much higher). This is much higher than the revenue earning potential from the hydropower sector. If Bhutan chooses to rationalize the lottery business, the revenue can easily solve the rupee crisis in one day. In this context, the decision of the DPT government to ban lottery business is an irony at best.

Following the latest turn of events, the rupee crisis can well become the biggest challenge for the DPT government. While the RMA’s mandate limits its scope to address the issue only in the short term, it falls upon the government to find a long term solution. As of now, the government has not been able to give us any definite solutions apart from forming a task force to study the matter. While the government is keen to avoid the word “crisis” to describe the issue, it has to realize that it doesn’t have the luxury of time to act. The alarm bell has already struck.

This post appeared in Business Bhutan newspaper on March 10, 2012