Public Information Notice No. 05/92

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Democratic Republic of Timor-Leste

July 20, 2005

On June 15, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the 2005 Article IV consultation with Timor-Leste.¹

Background

Five years after the international community stepped in to assist Timor-Leste in the aftermath of post-referendum violence, the country is successfully transitioning from post-conflict status to relative calm. Security has been broadly restored and macroeconomic stability re-established and maintained through the adoption of the U.S. dollar as legal tender and through cautious fiscal management. However, the economy remains fragile. Cumulative growth over the last three years was near zero—mainly reflecting the drawdown in the presence of international agencies. Unemployment is high, 40 percent of the population lives below the poverty line, and social indicators are poor. At the same time, human capital remains scarce, physical infrastructure inadequate and financing opportunities limited. The winding down of international financial and technical support at a time when domestic capacity is still weak and large oil and gas revenue is coming on stream present new challenges and opportunities.

Looking ahead, the pace and quality of economic development will depend on Timor-Leste's ability to manage its new oil/gas wealth effectively, and on the establishment of the environment needed for investment and growth in the non-oil sector. The authorities have designed a development strategy, with the objectives set out in the 2002 National Development Plan (NDP) and subsequent documents, that is incorporated in the Poverty Reduction Strategy Paper and assessed in the Joint Staff Advisory Note of the IMF and World Bank.

More recent developments indicate a modest recovery in non-oil economic activity in 2004, subdued inflation, and large oil/gas revenue inflows. Despite a further decline in donor activity, non-oil GDP growth recovered, reflecting a post-drought rebound in the agriculture sector and expansion in banking sector activity. Inflation declined over the course of 2004, leveling off at about 2 percent since August 2004 (year-over-year), in response to moderate domestic demand and stable non-oil import prices. The external current account surplus (including international assistance) widened sharply to 35 percent of non-oil GDP in 2004, due to large oil/gas tax and royalty income. Coffee exports rose, mainly reflecting a supply response to higher world prices. Measured against Indonesia and Australia, Timor-Leste's main trading partners, overall external price competitiveness deteriorated somewhat through March 2005, reflecting the significant depreciation of the rupiah against the U.S. dollar (Timor-Leste legal tender). In the absence of labor market data, anecdotal evidence suggests that Timor-Leste wages remain well above those in Indonesia, continuing to reflect the impact of the international presence.

The fiscal outcome for FY 2004/05 is now expected to be stronger than envisaged, due not only to better-than-expected oil/gas revenue but also stronger non-oil tax administration and weak expenditure execution. A central government surplus (including grants) of 68 percent of non-oil GDP is now expected, compared with the surplus of 33 percent of non-oil GDP expected in the revised FY04/05 budget. On a "combined sources" basis (the authorities' broad estimate of the total public sector including off-budget donor activities), the fiscal balance will move into a surplus of 29 percent of GDP in FY04/05.

The government is making good progress with the measures necessary to handle its new oil/gas wealth responsibly. The Norwegian-style petroleum fund is on track to be operational by July 2005 and a long-term fiscal savings policy has been adopted. Under the new savings policy, annual budget "sustainable" spending is set equal to the sum of non-oil revenue and the estimated permanent income from the oil/gas wealth. The government has indicated its commitment to transparency and accountability principles in line with the Extractive Industries Transparency Initiative (EITI). Finally, the preliminary Sector Investment Programs (SIPs) set out a public investment strategy for Timor-Leste's long-term economic development to be financed by domestic revenue and donor funds.

Bank lending to the private sector increased rapidly during 2004. As a share of non-oil GDP, credit tripled to 21 percent at end 2004. Financial intermediation remains concentrated in Dili, while access to financing in rural areas is limited to the operations of a few rural cooperatives and microcredit institutions. Net foreign assets of the Banking and Payment Authority (BPA) rose sharply, reflecting the sizable accumulation of government deposits from strong oil/gas revenue. At end-March net foreign assets reached US$284 million, more than 15 months of projected imports for 2005. Capacity building at the BPA progressed over the past year. A central bank law, and payment system and anti-money laundering legislation are in final stages of preparation, and a financial intelligence unit is planned for the BPA by the end of the year.

The pace of establishing the necessary environment to encourage private sector activity has accelerated; nonetheless, the agenda ahead remains heavy. Over the past six months good progress has been made in some areas, with key land legislation, the insurance law, and the domestic and foreign investment laws all either approved or submitted to Parliament. However, the overall legal framework is still incomplete, and complex regulations, an ineffective administration and weak judiciary continue to discourage private activity. Finally, while administrative skill levels are improving slowly, local capacity remains thin.

Executive Board Assessment

Executive Directors welcomed the progress that Timor-Leste has made towards establishing the basis for a stable and healthy economy. In particular, Directors commended the authorities for maintaining prudent macroeconomic policies at a time when the country is transitioning from post-conflict status, donor support is declining, and oil/gas revenue is coming on stream. While a moderate recovery in the non-oil economy is underway, Directors stressed that stronger performance will be needed to reduce poverty and create sufficient jobs for a rapidly increasing labor force.

Directors agreed that the pace and quality of Timor-Leste's economic development will depend on the effective management of its new oil/gas wealth and creation of an environment conducive to private investment and activity in the non-oil economy. They concurred that the authorities' long-term strategy based on a fiscal sustainability policy, a sound public investment strategy as set out in the Sector Investment Programs (SIPs), and the productive use of the oil/gas resources, including through the establishment of the petroleum fund, provides a solid basis for addressing these challenges and making progress towards achieving the Millennium Development Goals.

In light of Timor-Leste's considerable development needs, Directors supported the authorities' budgetary objective of moving quickly toward the sustainable spending level, without creating inflationary pressures or undertaking non-priority expenditure. The proposed spending increase for fiscal year 2005/06 appears nevertheless ambitious, given still limited administrative capacity and limited absorptive capacity in the domestic economy. While welcoming recent measures to remove obstacles to smooth budget execution, Directors called for early additional steps to eliminate remaining bottlenecks, particularly for capital spending. They welcomed the provision of Fund technical assistance in this area. Consideration might also be given to spreading out the spending commitment over a somewhat longer period. Directors also encouraged further efforts to shift spending toward improving human capital and basic infrastructure, and welcomed the authorities' intention to maintain the restraint on the wage bill.

Directors saw the SIPs as providing an appropriate framework linking Timor-Leste's development needs, available donor assistance, and the budget process. While the SIPs will help ensure that donor support is in line with the government's priorities, it will be important to strengthen SIP prioritization further in light of the still large amount of uncommitted external financing, and Directors welcomed the authorities' assurances in this regard.

Directors commended the progress made in establishing the legislative framework needed to make the petroleum fund operational by the beginning of the new fiscal year. They saw the establishment of the investment advisory board and the petroleum fund consultative council as key steps, and especially welcomed the intention to operate the fund in a transparent and accountable manner consistent with the Extractive Industries Transparency Initiative. They cautioned the authorities to carefully weigh the costs and benefits of the intended creation of a national oil company. Directors also noted the favorable developments in non-oil revenue. They encouraged a further strengthening of the tax and customs administration, and stressed the need for careful administration of the tax incentives in the new investment laws.

Directors endorsed the authorities' plan to maintain the current monetary and exchange rate regime, which provides a credible nominal anchor and continues to serve the country well. They agreed with the authorities' view that stronger institutional capacity and a well-developed foreign exchange market are essential preconditions to the introduction of a national currency. Going forward, continued cautious fiscal and wage policies will be key to preserving external competitiveness.

Directors welcomed progress at the Banking and Payments Authority in developing a strong supervisory and regulatory environment, particularly in light of the recent increase in financial intermediation. They encouraged continued vigilance over bank portfolios and looked forward to the early approval of central bank, payment system, and anti-money laundering legislation. The authorities were also encouraged to support the expansion of financial institutions to rural areas.

Noting that strong, sustainable growth and poverty alleviation require a dynamic labor-intensive private sector, Directors urged the authorities to accelerate efforts aimed at establishing an environment conducive to private investment and non-oil private sector activity. They welcomed the maintenance of a liberal trade and investment regime, and called for early enactment of pending economic legislation and the issuance of regulations that are transparent and simple to administer. Directors stressed in particular the importance of finalizing bankruptcy legislation, developing a strong and independent judiciary system, and establishing a comprehensive land-titling system. Given that local capacity and strong institutions will be critical for effective economic management and rapid economic development, Directors urged the prompt implementation of the new planning and capacity building program. Close coordination with, and continued technical assistance from, the donor community will be key in this respect.

To address weaknesses in macroeconomic data, Directors encouraged the authorities to seek additional assistance to strengthen domestic capacity, particularly for the compilation of national account and balance of payments statistics.