Statement at Donor Meeting

Donors' Meeting on East Timor, June 2000

June 22, 2000

1. It is a great pleasure and honor for me to represent the International Monetary Fund in this meeting today and have the opportunity to present this statement. My presentation consists of three parts. First, I will provide an overview of economic and financial developments during the first six months of the year. Second, I will briefly present the key features of the macroeconomic outlook for the coming fiscal year and provide our general assessment of the budget prepared by the administration. Finally, I will discuss budgetary external financial requirements and financing gaps for the next fiscal year and beyond.

I. Recent Developments

2. Economic activity has started to pick up led by the initial reconstruction of public and residential buildings and the progressive restoration of commerce and some basic services. Prices are slowly beginning to stabilize, although they remain volatile across regions thus failing to provide clear signals for resource allocation. Unemployment remains high, particularly in urban areas reflecting immigration from the countryside, and social tensions are surfacing. Humanitarian assistance continues to be an important source of income support for important segments of the population.

3. The implementation of the East Timor Administration (ETA) budget has been well below projected levels. The overall fiscal deficit (on a cash basis) in the first half of 2000 is projected to reach about 11 percent of GDP, less than half the amount projected in the preliminary budget. This has been mainly due to lower levels of expenditures arising from a number of factors, including (i) complex administrative procedures for the use of UN Trust Fund resources; (ii) lack of mechanisms to ensure adherence to and timely execution of the expenditure allocations in the budget; and (iii) protracted process for translating pledges into actual contributions combined with long-drawn-out planning stages of investment programs.

4. Total revenues in the first half of 2000 are expected to reach slightly over 1 percent of GDP, or about one-third the budgeted amount, mainly because user fees for public utilities have not been introduced yet. Overall tax collections are likely to be close to the budget projection but they cannot be used for budgetary support until the legislation permitting their use is approved. This is expected to take place in conjunction with the approval of the budget for FY 2000/01.

5. Overall cash outlays (including expenditures that are budgetary in nature, such stipends and fuel, but paid for by donors, the UN agencies, NGOs, or from the UN peacekeeping budget) are expected to reach about 12 percent of GDP in the first half of 2000, or about 40 percent of the amount budgeted. Recurrent expenditures are projected to be lower than anticipated in the preliminary budget. However, expenditure on labor compensation is projected to be twice as much as budgeted, because both the level of public sector employment and the average monthly compensation were higher than originally envisaged.. Capital expenditures are projected to reach about $9 million (including those financed bilaterally) compared to about $29 million in the preliminary budget.

6. Some important policy measures have already been put in place and others are in the making. One of the first key decisions endorsed by the National Consultative Council (NCC) was to adopt early in the year the US dollar as the legal tender replacing the Indonesian Rupiah. However, the use of the dollar is still limited mainly because (i) the execution of the budget (the main official window for injecting dollars in the economy) has been slower than anticipated; (ii) there has been a scarcity of low denomination U.S. notes and absence of coins reflecting logistical problems in providing secure storage of cash; and (iii) continued lack of familiarity of the population with the legal tender despite UNTAET's information campaign. In the fiscal area, the authorities have introduced a uniform 5 percent customs duty and a 5 percent sales tax on commercial imports, excise taxes on selected imports, and a temporary 10 percent presumptive income tax on the coffee sector. Regulations introducing a tax on services and user charges for electricity, port and airports are expected to be enacted at the time of approval of the FY00/01 budget.

7. Progress has also been made in institution building in the area of economic and financial management. The Central Payments Office (CPO) and the Central Fiscal Authority (CFA) are close to becoming operational. The CPO, designed to be the embryo of a future monetary authority, has begun to provide basic depository and payment services to the government and is also performing the treasury functions related to the payment of stipends to civil servants. A number of regulations for the restoration of the banking and payments system have already been enacted. The CFA, which is responsible for the overall fiscal strategy and the execution of the budget, has already started tax collection and has contributed to the formulation of the budget for FY00/01 that is before you today. The Fund has provided technical assistance in setting up these two institutions. Financial support for hiring qualified expatriate staff for key positions of the two institutions have been provided by the Fund, the World Bank and bilateral donors, particularly Australia and Japan.

II. Macroeconomic outlook and the budget for fiscal year 2000/01

8. The recovery of economic activity is expected to gather pace in the next fiscal year led by agriculture, construction and basic services. Although damage to infrastructure, essential services and property delayed planting of certain crops, the overall consequences on agricultural output are likely to be less pronounced than might have been expected. In particular, the output of maize and rice is expected to be satisfactory and certainly better than the severely reduced crop in 1997/98. Coffee output is also reported to be better than expected as weather conditions have been favorable. The construction sector is expected to grow strongly reflecting an expected acceleration in the pace of reconstruction. Inflationary pressures as well as price differentials across districts should also decline as the rehabilitation of infrastructure continues thereby facilitating the functioning of markets.

9. The draft budget for FY 00/01 (July 2000-June 2001) endorsed by the NCC envisages a deficit of about $155 million (or about 54 percent of GDP). Revenues are projected to reach $17 million (close to 6 percent of GDP) and are expected to cover about 40 percent of recurrent expenditures projected at $44 million (about 15 percent of GDP). Capital expenditures are projected to reach $128 million (about 45 percent of GDP), of which about $15 million would correspond to capital expenditures related to the public administration. The revenue projections assume that by July 1, additional revenue measures expected to generate about $7 million will enter into effect. These include a 10 percent tax on selected services, comprehensive user fees for airports and ports, and cost recovery electricity tariffs for large consumers. The fiscal deficits for FY01/02 and FY02/03 are projected to remain above $100 million. Fiscal revenues are projected to more than double in the outer year to cover about 80 percent of recurrent expenditures. Capital expenditures are projected to come down as a percent of GDP as the reconstruction program starts folding down.

10. Some of the policies underlying the budgetary projections give rise to serious concerns about sustainability. First, on wage policy, the budgetary projections for FY00/01 have been made using a weighted average monthly wage for civil servants of $135 which is much higher than wages prevailing in neighboring countries with comparable GDP per capita. In addition, it has been decided that all civil servants within the same skill category will be hired at the same initial wage regardless of their previous experience. It is likely that the government will have to accommodate pressures to introduce wage differentials within the same skill category sooner rather than later; otherwise it will not be able to retain the most experienced personnel. Setting an appropriate wage scale for each skill category in the years to come will therefore be a critical policy challenge for the period ahead.

11. Second, on taxation, the projected increase in revenues in FY01/02 and FY02/03 could not be achieved on the basis of tax policy currently in place and the additional tax and user fees expected to be approved with the budget for next fiscal year. Hence, there will be a need for a more comprehensive tax system, including both a higher tax burden and a broadening of the tax base.

12. The Fund staff has had extensive discussions with both the UNTAET administration and the East Timorese leadership on these policy issues, and believes that they are aware of the risks inherent in the policy strategy chosen. The Fund staff is encouraged by the decisions taken to (i) postpone for a year the adoption of wage scales for each skill category; (ii) keep the size of the civil service under control and below the estimates of the Joint Assessment Mission for FY01/02 and FY02/03 (10,500 in the last year instead of 12,200); and (iii) set up a sub-committee to look into the issue of tax policy and provide recommendations for the possible introduction of a wage withholding tax in 2001. The Fund would strongly recommend that UNTAET and the East Timorese intensify the monitoring of fiscal developments and stand ready to take remedial actions, if needed.

13. The process of institution building in the area of economic and financial management will continue in the coming year. The new management of the CPO will take urgent steps for the re-establishment of banking function through the enactment of key prudential regulations and establishing a system of supervision of financial institutions. A licensing and regulatory framework for non-bank financial institutions would also be put in place to facilitate the provision of basic financial services to rural and agricultural communities. In the fiscal area, a treasury is being set up and some basic treasury functions have already been undertaken. The recent endorsement by the NCC of the budget and financial management regulation should provide the basis for the CFA to enforce proper public expenditure management. Additional staffing is required before the tax administration can become operational and begin collecting domestic revenue. In addition, a tax code, now under consideration, that includes both tax policy and tax administration will need to be in place. The CFA has a detailed plan to facilitate a smooth hand over of the treasury functions from the United Nations to the East Timorese Administration which is necessary for a more efficient control over budget implementation. The Fund will continue to provide technical assistance in these areas.

III. External Financing Requirements and Concluding Remarks

14. Mr. Chairman, before closing may I make a few remarks regarding East Timor's budgetary external financing requirements and financing gaps.

15. On the basis of current projections, the budgetary external financing requirement for FY00/01 is projected at $155 million, but the financing gap would be $78 million since some resources have already been secured. The financing gap for FY00/01 comprises about $23 million for the UN Trust Fund to finance recurrent expenditures and capital expenditures related to public administration, and US$55 million to finance the reconstruction program through the Trust Fund for East Timor (TFET) and bilateral sources.

16. The UN Trust Fund is expecting to receive soon about $10 million from pledges made in Tokyo and would therefore require additional contributions of $13 million to close its gap. It should be noted, however, that UNTAET's request from donors for additional assistance in FY00/01 is $16 million, because they would require an additional $3 million to ensure that cash flow problems are not encountered at the end of the fiscal year.

17. The financing gap for the reconstruction program includes a gap of $11 million for TFET and $44 million from bilateral sources. As for the TFET program, if previously planned contributions were to be realized on time, they would be sufficient to cover the gap for FY00/01. However, it would be important to reconfirm the availability and timing of these contributions. In addition, as indicated in the Joint UNTAET/World Bank paper, TFET will require cash contributions against new commitments in the first half of 2001 to enable TFET to commit programs for FY01/02 and beyond. As regards bilaterally financed reconstruction programs for FY00/01, it will be necessary to secure $44 million.

18. The cumulative external financing gap for FY01/02 and FY02/03 is estimated at $260 million, of which $40 million would be for the UN Trust Fund and the remainder for the reconstruction program to be financed through TFET and bilateral sources.

19. The Fund supports UNTAET's request for financial support for the East Timorese consolidated budget for FY00/01 as well as the request for budgetary financing and reconstruction program put forward by the UNTAET and the World Bank for FY01/02 and FY02/03. The Fund also recommends that the responsibility for the management of external resources for budgetary support be transferred from the UN Trust Fund to the CFA and the CPO as soon as possible within the next fiscal year, provided treasury procedures are in place, the tax administration recruits a minimal staff, and the CPO has secure arrangements for handling cash. These actions should help address the budget implementation difficulties encountered earlier this year. The Fund stands ready to work in close coordination with other national and multilateral agencies to provide policy advice and technical assistance in institution building and the formulation of macroeconomic policies in the period ahead. In this connection, the Fund will maintain a permanent presence in East Timor through sequential staff visits until August 2000, when a Senior Resident Representative is expected to be stationed in Dili.