Harnessing Hydropower for Growth: Bhutan’s Next Steps for Economic Resilience

Bhutan's economic growth has been driven by hydropower, but over-reliance on this sector has limited job creation and diversification. To ensure sustainable development, the country must focus on expanding agricultural productivity, reforming the financial sector, and investing in non-hydro sectors.

Bhutan has made significant progress in reducing poverty and improving human development, thanks to strong economic growth supported by its hydropower sector. As a small landlocked country located in the eastern Himalayas, Bhutan’s economy is heavily influenced by its geography and its close relationship with India. The country has taken advantage of its mountainous terrain and abundant water resources to develop hydroelectric power, which has become a major contributor to the economy. Hydropower has played a crucial role in Bhutan’s growth, accounting for 16% of GDP, over a third of goods exports, and a large share of domestic revenues. However, despite this success, Bhutan faces several challenges, including high transportation and trade costs, a small domestic market, and the need to diversify its economy to reduce its reliance on hydropower.

Limited Job Creation Despite Rapid Growth

Over the past two decades, Bhutan has experienced rapid economic growth, with real GDP growth averaging 7% annually between 2001 and 2019. The hydropower sector has driven much of this growth, with the country’s installed capacity expanding significantly since the 1980s. However, while hydropower has provided substantial economic benefits, its capital-intensive nature has resulted in limited job creation, employing less than 1% of the labor force. This lack of employment opportunities in the hydropower sector has contributed to a slow pace of structural transformation, with many workers still reliant on low-productivity sectors such as agriculture and public services. Agriculture, which accounts for 19% of GDP, remains the main source of livelihood for about half of Bhutan’s population, particularly in rural areas. However, agricultural productivity has lagged behind other sectors, and the sector faces several challenges, including labor shortages, inadequate infrastructure, and vulnerability to climate change.

Dutch Disease and the Need for Diversification

Bhutan’s economy has also suffered from the effects of “Dutch Disease,” where large foreign currency inflows from hydropower exports have caused the local currency to appreciate, making non-hydro exports less competitive. This has hindered the growth of other tradable sectors such as tourism, manufacturing, and agriculture, contributing to the country’s over-reliance on hydropower. While the service sector, which accounts for nearly half of GDP, has grown in recent years, driven by tourism, public administration, and financial services, the private sector remains small and underdeveloped. Microenterprises dominate the private sector, and there has been little entrepreneurial dynamism, with only 2.7% of firms established in recent years. These small firms often face barriers to growth, and many have low productivity levels, which limits their ability to create jobs and contribute to economic diversification.

Agriculture and Climate Change: Opportunities and Challenges

Agricultural productivity is another critical area for Bhutan’s future development. Although agriculture remains the main source of employment for much of the population, productivity in the sector has stagnated, and traditional crops such as maize and paddy have experienced declining yields. Climate change presents both challenges and opportunities for the agricultural sector, with rising temperatures and increasing rainfall variability expected to affect crop yields. Investments in infrastructure, such as irrigation systems, as well as targeted support for farmers, are necessary to close productivity gaps and facilitate a shift toward higher-value agricultural products. This would help reduce poverty in rural areas and accelerate the structural transformation of the economy.

Reforming the Financial Sector for Private Sector Growth

The financial sector also needs reforms to support economic diversification and private sector development. Bhutan’s financial system is dominated by state-owned enterprises, and access to finance for small and medium-sized enterprises (SMEs) remains limited. Reforms aimed at deepening financial intermediation and improving access to finance are necessary to spur private sector growth and encourage entrepreneurship. This would help create jobs and reduce the reliance on the public sector and agriculture for employment.

While Bhutan has made remarkable strides in poverty reduction and human development, its reliance on hydropower has hindered the diversification of its economy. The country must now focus on managing its hydropower revenues more effectively to invest in physical and human capital, stimulate productivity growth in non-hydropower sectors, and create new employment opportunities. By doing so, Bhutan can build a more resilient and inclusive economy that is better equipped to face future challenges, including those posed by climate change and external economic shocks.