IMF Executive Board concludes 2006 Article IV Consultation with the Democratic Republic of Timor-LestePublic Information Notice (PIN) No. 07/24
February 28, 2007
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2006 Article IV Consultation with Timor Leste is also available.
On January 29, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Democratic Republic of Timor-Leste.1
Timor-Leste had made good progress in establishing the basis for a stable and healthy economy prior to the civil unrest in 2006, though it remains one of the poorest countries in the world. Real non-oil GDP growth turned positive in 2004-05 after contracting for two years following the end of the reconstruction boom of the initial post-conflict years. Macroeconomic stability was achieved through the early adoption and maintenance of prudent fiscal and monetary policies. However, progress toward the country's National Development Plan (NDP) objectives and Millennium Development Goals (MDGs) was limited. Further, the violence that erupted in April 2006, although now largely quelled, has introduced new risks to the outlook. Nonetheless, the onset of large oil-and-gas revenue inflows and prospects for sizable additional revenue from new fields could still, if properly managed, transform the economy.
The security situation and domestic institutions remain fragile. The unrest, combined with persistent poverty and high unemployment amid rising expectations highlight the continuing vulnerabilities in the country's institutional capacity, notwithstanding considerable nation and capacity building over recent years.
Against this background, increased urgency is placed on meeting the challenge of how best to use the new oil-and-gas wealth to lift the non-oil economy onto a higher growth path and reduce poverty. The new government endorsed the pre-existing development strategy, set out in the NDP and related documents that comprise the Poverty Reduction Strategy. This strategy focuses on reforms to promote growth, including: a long-term oil-and-gas revenue saving policy supported by a petroleum fund; well-targeted development spending under the sector investment programs (SIPs); a monetary and exchange rate regime that preserves macroeconomic stability; and a private-investment-friendly environment. However, progress on the strategy has been stronger on some elements than others and non-oil growth still falls short of that needed to reduce poverty. In the aftermath of the recent unrest, the government plans a new Compact with donors to reinvigorate implementation of the development strategy.
High world oil-and-gas prices are providing a boost to Timor-Leste's fortunes by raising current and potential revenue inflows. Non-oil activity began to recover in 2005 as stable macroeconomic conditions and improved policies offset a scaling down of donor activity, though it had not yet risen above the population growth rate. However, the civil unrest in 2006 setback the growth momentum. As a result, real non-oil GDP growth is estimated to be slightly negative for the year, despite an end-year boost from public spending and international aid. Driven by crisis-related supply disruptions, inflation jumped to about 7 percent in the year to June 2006, although the impact on external price competitiveness has been muted by the recent depreciation of the exchange rate.
Large oil-and-gas revenue inflows have led to sizeable surpluses in the external current account and in the fiscal position, notwithstanding sharply increased government spending. Oil-and-gas revenue was estimated at 128 percent of non-oil GDP in 2005/06, lifting the central government surplus to 111 percent of non-oil GDP. Central government expenditure of 26 percent of non-oil GDP remained well below the sustainable spending level determined by the authorities' saving policy. The steep increase in budgeted spending for 2006/07, to 73 percent of non-oil-GDP, is designed in large part to respond to the recent crisis. However, budget execution is likely to remain constrained by weak capacity, resulting in cash expenditures continuing to fall short of commitments. On a `combined source' basis, which includes actual government and donor spending, total expenditure should increase only slightly compared to pre-2005/06 levels as increased government spending largely offsets lower donor financing.
The authorities have maintained a policy of avoiding domestic or external borrowing, hence there is no public sector debt. A current account surplus of 93 percent of non-oil GDP (excluding international assistance) emerged in 2006. Net foreign assets of the Banking and Payments Authority (BPA), combined with the foreign assets of the petroleum fund, rose to US$957 million by September 2006, equivalent to almost 7 years of merchandise imports.
Loan quality deteriorated further, post-crisis, while private credit contracted. At end-September 2006, nonperforming loans (NPLs) accounted for 30 percent of total bank lending, with banks now more aggressively provisioning for potential losses. Given still weak enforcement of creditors' rights, banks are increasing reluctant to extend new loans and credit to the private sector fell by 10 percent on a year/year basis.
Reforms needed to spur non-oil private sector activity gained some momentum prior to the crisis, but significant legal and institutional gaps remain a burden. The investment and export promotion agency became operational in late 2005 and projects in the fishery, coffee, and tourism sectors have begun. However, business registration and land development remain difficult, some key legislation is not yet in place, and the overwhelmed court system has not been able to address commercial disputes. Poor infrastructure and lack of human capital are additional difficulties faced in developing the non-oil economy.
Executive Board Assessment
Executive Directors commended the authorities for their progress in stabilizing the economy and establishing a foundation for future growth, while recognizing the need to address the immediate economic and humanitarian consequences of the recent civil unrest. Looking ahead, Directors considered that the main challenge is to use the oil-and-gas resources and stable macroeconomic environment to lift the non-oil economy onto a higher growth path and reduce poverty.
Directors endorsed the authorities' development strategy, which focuses on core reforms needed to promote growth. In this respect, they underscored the need to maintain a monetary and exchange regime that preserves macroeconomic stability, forceful progress to secure well-targeted and prioritized development spending, and far-reaching reforms to encourage private activity and investment.
Directors supported a sustainable stepping-up of government investment spending over the medium term to address Timor-Leste's considerable development needs. They pointed, however, to the need for careful planning and monitoring to guard against unproductive spending and welcomed measures to strengthen budget execution, including the introduction of small education and community grants, international outsourcing of large infrastructure projects, improved cash and commitment controls, and procurement decentralization.
Directors commended the authorities for the establishment of the petroleum fund, which along with the saving rule, will help achieve fiscal sustainability and intergenerational equity. They welcomed the authorities' continued policy of transparent reporting of petroleum-related activities, and the participation in the Extractive Industries Transparency Initiative.
Directors supported the current monetary and exchange regime, which provides a credible nominal anchor for macroeconomic stability. While the current level of the real exchange rate is not a threat to medium-term competitiveness, Directors called on the authorities to ensure that fiscal policies—in particularly for wages, subsidies and other recurrent costs—reflect the need to contain price pressures. Directors agreed with the authorities that stronger institutional capacity and a well-functioning financial market need be in place before considering the introduction of a national currency.
Directors urged the authorities to limit external borrowing to ensure consistency with the government's investment priorities, the sustainable spending framework, and macroeconomic stability; and to ensure that terms are adequately concessional.
Directors agreed that favorable oil revenue developments provide a welcome opportunity to put in place wide-ranging tax reforms in the non-oil sector to help spur private economic activity. They considered that a simplified, streamlined tax regime, with low tax rates and higher minimum thresholds, would also better fit the limited administrative capacity.
Directors considered that the weakening in banks' loan portfolios is unlikely to present a systemic risk, but noted that it may reduce credit availability and slow the economic recovery. They welcomed plans to further strengthen banking supervision, create a loan registry, introduce an alternative means of resolving commercial disputes, and finalize banking sector legislation. Directors cautioned that a state-owned rural-development bank—as is being considered by the authorities—has to be operated on a strict commercial basis to avoid a further weakening of the fragile financial system.
Directors stressed that greater efforts are needed to create an environment conducive to more private investment and growth. They urged the authorities to expedite the passage of critical legislation, such as the pending land law, while noting that proposed amendments to labor legislation should encourage greater labor market flexibility.
Directors encouraged the authorities to intensify their efforts to strengthen capacity to compile and analyze basic macroeconomic data.