## cr17360

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---

### Recent economic developments
- Growth and inflation
  - Real non-oil GDP growth in 2016: 5.5 percent.
  - Real total GDP in 2016: -7.9 percent.
  - CPI (annual average) in 2016: -1.3 percent (y/y), largely due to lower global food and oil prices.
- Fiscal outcomes (2016)
  - Overall fiscal deficit widened to 30.8 percent of GDP in 2016 from 17.0 percent in 2015.
  - Revenue sourced from Estimated Sustainable Income (ESI) of the Petroleum Fund (PF) in 2016: 19.7 percent of GDP.
  - Domestic revenue in 2016 outperformed due to one-off increases in customs duties and corporate tax collection and improved compliance.
  - Recorded capital spending doubled in 2016, reflecting substantial additional allocations in the supplementary budget.
- External sector (2016)
  - Current account balance (percent of GDP): -18.9 (deficit) in 2016 from a surplus of 7.7 percent of GDP in 2015.
  - Trade balance (in millions of U.S. dollars): -539.
  - Petroleum revenue (in millions of U.S. dollars): 540.
  - Public foreign assets (end-period, in millions of U.S. dollars): 16,125; Public foreign assets (in months of imports): 167.
  - REER depreciated by 2.8 percent in 2016.

### Outlook and medium-term risks
- Projections and near-term outlook
  - Non-oil real GDP growth projected to moderate to 3 percent in 2017.
  - Inflation: return to positive territory amid rising global food and fuel prices.
- Medium-term risks
  - Depletion of the current oil field by around 2022 increases urgency to generate growth and fiscal revenue.
  - Significant frontloading of public investment poses large downside risks to fiscal sustainability because of envisaged large PF withdrawals.
  - Risk that large infrastructure projects may not generate sufficient social and economic returns to translate into higher tax returns and restore fiscal sustainability.
  - Risk of higher inflation due to domestic price pressures from larger government spending.
  - Finalization of the Greater Sunrise petroleum field agreement: does not materially alter the need for employment creation and economic diversification but helps alleviate long-term fiscal resource constraints.

### Executive Board assessment and policy recommendations
- Overarching challenge
  - Need for economic diversification to create employment for young labor force and adjust from high dependency on oil revenue.
- Fiscal policy recommendations
  - Maintain a fiscal position compatible with debt sustainability and preserving PF assets; adhere to the ESI.
  - Moderate and prioritize frontloading of capital spending in line with scarce resources and capacity constraints and reforms of the public investment management system.
  - Prioritize public investment on high-return projects determined through rigorous investment appraisal, cost-benefit analysis, and risk assessments.
  - Rationalize recurrent spending while protecting health and education spending and improving the efficiency of public spending.
  - Consider adopting a ceiling on primary expenditure as an expenditure rule in addition to the ESI.
- Revenue mobilization and borrowing
  - Mobilize domestic revenue; introduction of a value-added tax by 2020 and an early start in upgrading tax administration capacity are key.
  - Use concessional borrowing effectively; develop clear criteria to identify infrastructure projects to be financed by concessional loans.
- Financial inclusion and stability
  - Implement the national financial inclusion strategy 2017-22.
  - Create a well-designed and operated credit guarantee scheme for SMEs accompanied by capacity building.
  - Strengthen BCTL supervisory and regulatory framework and capacity, and bolster the AML/CFT framework.
- Structural and capacity-building reforms
  - Improve basic infrastructure, financial access, labor competitiveness, and the ease of doing business.
  - Improve external competitiveness by keeping wages competitive, raising productivity, and closing labor skill gaps through targeted vocational training.
  - Improve statistical capacity: timeliness and periodicity of national accounts data need improvement.

### Fiscal outcomes and Petroleum Fund (PF) — details and key figures
- Overall fiscal deficit: 30.8 percent of GDP in 2016 (17.0 percent in 2015).
- PF transfers and balances
  - The PF provided a transfer of US$1.24 billion to finance the 2016 budget; US$0.7 billion of this was in excess of the ESI.
  - PF closing balance for 2016: US$15.8 billion (second year of net reduction).
  - Cumulative excess withdrawals from the PF by end-2016: $3 billion.
  - PF balance as of end-September 2017: US$16.7 billion.
  - Petroleum Fund balance (closing, in millions of U.S. dollars, memorandum): 15,844.
  - Petroleum Fund balance (in percent of GDP, memorandum): 574.
- Central government operations (2016, percent of GDP)
  - Revenue: 33.7
  - Domestic revenue: 7.8
  - ESI: 19.7
  - Grants: 6.1
  - Expenditure: 64.5
  - Recurrent: 36.3
  - Net acquisition of nonfinancial assets: 22.1
  - Net lending/borrowing: -30.8

### External sector assessment and exchange rate
- Current account and financing
  - Current account balance (in millions of U.S. dollars): -523.
  - Current account balance (percent of GDP): -18.9.
  - Drivers: higher imports related to public investment and decline in oil/gas receipts as output fell with near depletion of current oil field amid lower global oil prices.
  - Financing: CA deficits financed largely by divestment from the PF, together with external borrowing and FDI inflows.
  - Projected CA deficit in medium term (2018-2022 average): 18 percent of GDP.
- REER and competitiveness
  - REER appreciated about 7 percent annually during 2010-2015; depreciated in 2016 and early 2017 but did not materially enhance export performance.
  - Staff’s EBA-lite assessment suggests substantial exchange rate overvaluation and an external position substantially weaker than implied by fundamentals.
- Reserve adequacy
  - Net international reserves (NIR) at end-2016: US$0.3 billion, equivalent to 2.9 months of imports.
  - Adequacy threshold for Timor-Leste estimated around 9.5 months of imports.
  - PF assets at end-2016: US$15.8 billion (164 months of goods and services imports).

### Banking sector, credit, and liquidity
- Private sector credit growth: -1.8 percent (y/y) in 2016 (10.5 percent in 2015).
- NPL ratio: 15 percent of outstanding loans at end-2016 (23 percent at end-2015).
- Loan-to-deposit ratio: around 29 percent in 2016.
- Banks’ overseas placements of deposits: 74 percent.
- Banking system composition: five banks — one wholly government-owned bank (BNCTL) and four foreign bank branches (ANZ, Bank Mandiri, Bank Rakyat, CGD/BNU). Bank Rakyat Indonesia started operations in March 2017.

### Public investment, DIG model scenarios, and macro implications
- 2017 Budget public investment plan
  - Planned capital spending averaging around US$1 billion annually during 2018-21, or about US$4.3 billion (156 percent of 2016 GDP) in total.
  - Expected financing: PF transfers (exceeding the ESI) of US$4.8 billion (30 percent of the PF balance) and external borrowing of US$1.3 billion.
  - Staff baseline assumes 70 percent execution rate of multi-year (2018-21) capital expenditures.
- DIG model calibration and key assumptions
  - Public investment efficiency assumed at 50 percent (Timor-Leste PIMA).
  - Return on public investment assumed to be 15 percent.
  - Depreciation rate assumed to be 5 percent.
- Scenario outcomes (quantitative highlights preserved)
  - Budget scenario (frontloaded): capital expenditure scaled up by an average of 39 percent of GDP in 2018-2021; effective public capital stock increases by 96 percent during scale up but risks erosion of 12 percent from peak within a decade without adequate O&M.
  - Baseline scenario (historical execution): effective public capital stock expands by 63 percent during scale up; later declines by 10.7 percent.
  - Reform scenario (moderate scale up + efficiency): public investment at 15 percent of GDP during 2018-2021 and stabilizing at 10 percent thereafter; efficiency improves from 46 percent to 75 percent over a decade; effective public capital stock increases by about 52 percent at end of scale up and by about 60 percent a decade after.
- Policy implications
  - Prefer gradual scale up and prioritize improvements in investment efficiency (PIMA implementation).
  - Ensure adequate operation and maintenance funding in outer years.
  - Favor concessional financing to reduce immediate PF withdrawals (reform scenario example: up to 95 percent concessional financing).

### Revenue mobilization, VAT, and borrowing strategy
- VAT and domestic revenue targets
  - Introduction of a VAT by 2020 is recommended to reach government’s domestic revenue target of 15 percent of non-oil GDP.
  - Draft VAT rate proposed in analysis: 7.5 percent; VAT expected to raise revenues up to 5 percent of GDP in the medium term with this rate and accompanied excise increases could yield an additional 3 percentage points of GDP.
  - Consider raising VAT rate to 10 percent starting from 2028 in reform scenario.
- Borrowing and PF withdrawal rules
  - Baseline: total external borrowing during 2017–37 expected to reach US$3.8 billion; outstanding debt at 22 percent of GDP in the long term.
  - Reform scenario: total borrowing projected at US$4.5 billion over 2017-37 (about 18 percent higher than baseline) in one presentation; elsewhere reform scenario projects US$2.3 billion over 2017-37 (note: figures preserved as presented across source).
  - Commitment plan: cap PF withdrawals at US$1.3 billion per annum beyond the medium term; cease PF withdrawals in excess of the ESI from 2028 under reform scenario to rebuild PF assets.

### Debt sustainability, DSA findings, and stress tests
- Main DSA conclusions
  - Net public asset position strong at US$15.7 billion at end-2016 due to PF assets and low public debt.
  - Public external debt in 2016: US$77 million (2.8 percent of GDP).
  - Under baseline, projected higher concessional borrowing and excess PF withdrawals imply moderate risk of debt distress.
  - Baseline projections: PF balance US$12 billion in 2022 (340 percent of GDP) and US$640 million (3½ percent of GDP) by 2037.
  - Reform scenario outcome: PF balance projected to reverse decline to around US$15.6 billion (468 percent of GDP) in 2022 and US$17.7 billion (93 percent of GDP) in 2037.
- Key DSA numeric highlights (selected exact figures)
  - Real non-oil GDP growth (%) 2017: 3.0; 2017-22: 5.0; 2023-37: 5.2.
  - Inflation (CPI annual average, %) 2016: -1.3; 2017: 1.0; 2017-22: 3.2.
  - Revenues (% GDP) 2016: 27.5; 2017: 24.2; 2017-22: 22.3.
  - Net lending/borrowing (% GDP) 2016: -30.8; 2017: -20.1; 2017-22: -33.3.
  - Public sector debt (percent of GDP) projections: 2016: 2.8; 2017: 3.1; 2018: 10.6; 2019: 17.8; 2020: 24.3; 2021: 27.6; 2022: 28.3.
  - PV of PPG external debt (percent of GDP) selected: 2017: 1.4; 2018: 1.6; 2019: 6.7; 2020: 11.7; 2021: 16.2; 2022: 18.7.
  - PV of PPG external debt in percent of exports (selected): 2019: 23.7; 2020: 43.0; 2021: 68.2; 2022: 83.0.
  - PPG debt service-to-revenue ratio (selected): 2019: 1.0; 2020: 1.9; 2021: 3.0; 2022: 4.0.
- Stress tests
  - Baseline does not breach DSA thresholds but stress tests breach all thresholds.
  - High vulnerability to shocks due to very small exports and revenue bases.

### AML/CFT, financial inclusion, and payments modernization
- AML/CFT status and operational challenges
  - First National Risk Assessment released in October 2016.
  - Government adopted a national strategic plan (2016-2020).
  - BCTL introduced a risk-based approach to AML/CFT in 2017.
  - Staff recommend bolstering operationalization and continued capacity building and training for commercial banks.
- Financial inclusion and payments
  - National financial inclusion strategy 2017-22 welcomed; planned measures include digital financial products, agent banking, consumer protection review, financial literacy plan, and pilot credit guarantee scheme.
  - National payments modernization: R-TiMOR automated transfer system introduced early 2016; BCTL developing national card and mobile payment switch.
- Credit Guarantee Scheme (CGS) for SMEs
  - Decree‑Law approved in May 2017; BCTL preparing regulations.
  - Decree‑Law target sizes: small enterprises 6-20 workers; midsize enterprises 21-50 workers.
  - Maximum guarantee coverage in Decree‑Law: up to 70 percent.
  - Staff recommendations: eligibility limited to new loans; clarify claim and recovery processes; limit moral hazard (partial guarantees, loss-sharing, eligibility criteria).

### Statistics, data issues, and capacity building
- Data shortcomings hamper surveillance; main weaknesses in national accounts timeliness and periodicity.
- Near 18-month lag in release of annual GDP data should be shortened; quarterly GDP availability recommended.
- Recommendations: implement enhanced GDDS (e-GDDS); improve reporting of annual and quarterly GFS in line with GFSM 2014; enhance cash-based accounting toward accrual accounting over medium term.
- Table of Common Indicators Required for Surveillance (selected entries preserved exactly):
  - Exchange Rates: Date of latest observation 10/2017; Frequency of Data D.
  - International Reserve Assets and Reserve Liabilities: Date of latest observation 09/2017; Frequency of Data M.
  - Consumer Price Index: Date of latest observation 08/2017; Frequency of Data M.
  - Revenue, Expenditure, Balance and Composition of Financing – Central Government: 2016; Frequency of Data A.
  - GDP/GNP: 2015; Date received 04/2017; Frequency of Data A.
  - External Current Account Balance: Q2/2017; Date received 8/2017; Frequency of Data Q.

### Annex highlights — reform scenario versus baseline (selected numeric comparisons)
- Baseline assumptions
  - Assumes 70 percent execution rate of multi-year (2018-21) capital expenditures.
  - Total external borrowing during 2017–37 expected to reach US$3.8 billion.
  - PF balance under baseline: US$12 billion in 2022 (340 percent of GDP) and US$640 million (3½ percent of GDP) by 2037.
- Reform scenario aggregate outcomes
  - Net borrowing/lending improves to a deficit of 6 percent of GDP in the medium term, and to about 1½ percent of GDP in the long term.
  - Over the long term, total revenue projected to be about 11 percent of GDP higher than under baseline.
  - Key reform elements and numeric targets:
    - Capital spending averaged 14½ percent of GDP in the medium term and anchored at no more than 10 percent of GDP in the long term.
    - Recurrent spending reduced to 22 percent of GDP in the medium term.
    - VAT implemented by 2020 with draft VAT rate 7.5 percent expected to raise revenues up to 5 percent of GDP in the medium term; accompanied by excise increases yielding an additional 3 percentage points of GDP in revenue.
    - Commitment to stop PF excess withdrawals from 2028 onwards.
  - Reform scenario financing and PF projections:
    - Total borrowing projected at US$4.5 billion over 2017-37 in one presentation; reform scenario also presented with US$2.3 billion over 2017-37 elsewhere in the source (figures preserved).
    - PF balance projected to reverse decline to around US$15.6 billion (468 percent of GDP) in 2022, and reaching US$17.7 billion (93 percent of GDP) in 2037.
- Selected numeric table highlights (preserved exactly as presented)
  - Total revenue: 2017 Est. 29.9; Baseline 2018 30.0; Reform Proj. 2018 29.7
  - Domestic revenue: 2017 Est. 6.8; Baseline 2018 7.6; Reform Proj. 2018 8.2
  - Tax revenue: 2017 Est. 5.0; Baseline 2018 5.4; Reform Proj. 2018 5.9
  - Estimated Sustainable Income: 2017 Est. 17.4; Baseline 2018 16.8; Reform Proj. 2018 17.0
  - Total expenditure excluding grants: 2017 Est. 44.3; Baseline 2018 65.1; Reform Proj. 2018 47.2
  - Recurrent spending: 2017 Est. 33.4; Baseline 2018 35.7; Reform Proj. 2018 32.2
  - Capital spending: 2017 Est. 10.9; Baseline 2018 29.3; Reform Proj. 2018 15.0
  - Net borrowing and lending: 2017 Est. -20.1; Baseline 2018 -40.7; Reform Proj. 2018 -22.0
  - Petroleum Fund balance (in percent of GDP): 2017 Est. 571.1; Baseline 2018 522.8; Reform Proj. 2018 548.6
  - Petroleum Fund balance (in millions of US dollars): 2017 Est. 15,784; Baseline 2018 15,044; Reform Proj. 2018 15,589
  - Real GDP growth: 2017 Est. 3.0; Baseline 2018 5.0; Reform Proj. 2018 4.7
  - Inflation: 2017 Est. 2.0; Baseline 2018 3.5; Reform Proj. 2018 2.0

_International Monetary Fund, Staff Report for the 2017 Article IV Consultation, Democratic Republic of Timor-Leste (cr17360)._

### 1.3 percent (y/y) in 2016, largely due to lower global food and oil prices.

### cr17360 - 1.3 percent (y/y) in 2016, largely due to lower global food and oil prices.

### Recent economic developments
- Growth and inflation
  - Real non-oil GDP growth in 2016: 5.5 percent.
  - Real total GDP in 2016: -7.9 percent.
  - CPI (annual average) in 2016: -1.3 percent (y/y), largely due to lower global food and oil prices.
- Fiscal outcomes (2016)
  - Overall fiscal deficit widened to 30.8 percent of GDP in 2016 from 17.0 percent in 2015.
  - Revenue sourced from Estimated Sustainable Income (ESI) of the Petroleum Fund (PF) in 2016: 19.7 percent of GDP.
  - Domestic revenue in 2016 outperformed due to one-off increases in customs duties and corporate tax collection and improved compliance through streamlined procedures.
  - Recorded capital spending doubled in 2016, reflecting substantial additional allocations in the supplementary budget to projects that advanced ahead of schedule.
- External sector (2016)
  - External current account balance turned to a deficit of 18.9 percent of GDP in 2016 from a surplus of 7.7 percent of GDP in 2015.
  - Drivers: higher imports related to public investment and a decline in oil/gas receipts as output fell with the near depletion of current oil field amid lower global oil prices.
  - Real effective exchange rate (REER) depreciated by 2.8 percent in 2016, reflecting lower inflation and U.S. dollar nominal depreciation against the currencies of Timor-Leste’s trading partners.

### Outlook and medium-term risks
- Projections and near-term outlook
  - Non-oil real GDP growth projected to moderate to 3 percent in 2017, due to lower government expenditure and the slowdown of activity due to the delayed formation of the new government after the parliamentary elections in July.
  - Inflationary pressures remain low, with a return to positive territory amid rising global food and fuel prices.
- Medium-term risks
  - The depletion of the current oil field by around 2022 increases urgency to generate growth and fiscal revenue.
  - Significant frontloading of public investment poses large downside risks to fiscal sustainability because of the envisaged large PF withdrawals required for financing.
  - Risk that large infrastructure projects may not generate sufficient social and economic returns to achieve inclusive growth, translate into higher tax returns, and restore fiscal sustainability.
  - Risk of higher inflation due to domestic price pressures from larger government spending.

### Executive Board assessment and policy recommendations
- Executive Board summary of challenges
  - Timor-Leste faces a pressing need for economic diversification to create employment opportunities for its young labor force.
  - Adjustment from high dependency on oil revenue and large infrastructure and social development needs pose a significant challenge to a fragile state with weak institutional capacity.
  - While the near-term growth outlook is favorable and inflationary pressures low, the medium-term outlook and risks depend critically on the success of fiscal and structural reforms.
- Fiscal policy recommendations
  - Maintain a fiscal position compatible with debt sustainability and preserving the assets of the PF; maintaining the PF’s assets as a sustainable revenue source should remain the fiscal anchor, achieved by adhering to the ESI.
  - Moderate and prioritize frontloading of capital spending in line with scarce resources and capacity constraints and reforms of the public investment management system.
  - Prioritize public investment on high-return projects determined through rigorous investment appraisal, cost-benefit analysis, and risk assessments.
  - Rationalize recurrent spending while protecting health and education spending and improving the efficiency of public spending.
- Revenue mobilization and borrowing
  - Mobilize domestic revenue; introduction of a value-added tax by 2020 and an early start in upgrading tax administration capacity are key to mobilization of sufficient domestic non-oil revenues.
  - Use concessional borrowing effectively; develop clear criteria to identify infrastructure projects to be financed by concessional loans, especially those that would benefit from knowledge transfer in project appraisal and implementation.
- Financial inclusion and stability
  - Implement the national financial inclusion strategy 2017-22 to achieve greater financial deepening and inclusive growth.
  - Create a well-designed and operated credit guarantee scheme for SMEs accompanied by capacity building for SMEs in business plans and financial management.
  - Strengthen BCTL supervisory and regulatory framework and capacity, and bolster the anti-money laundering/combating the financing of terrorism (AML/CFT) framework.
- Structural and capacity-building reforms
  - Implement macro-critical structural reforms to improve basic infrastructure, financial access, labor competitiveness, and the ease of doing business.
  - Improve external competitiveness by keeping wages competitive, raising productivity, and closing labor skill gaps through targeted vocational training.
  - Improve statistical capacity: timeliness and periodicity of national accounts data need improvement.
  - Further leverage technical assistance and capacity building from the Fund and other development partners.

### Key statistics (selected, as reported)
- Real sector (2016, annual percent change)
  - Real total GDP: -7.9
  - Real non-oil GDP: 5.5
  - CPI (annual average): -1.3
- Central government operations (2016, percent of GDP)
  - Revenue: 33.7
  - Domestic revenue: 7.8
  - Estimated Sustainable Income (ESI): 19.7
  - Grants: 6.1
  - Expenditure: 64.5
  - Recurrent: 36.3
  - Net acquisition of nonfinancial assets: 22.1
  - Net lending/borrowing: -30.8
- Balance of payments and external (2016)
  - Current account balance (in millions of U.S. dollars): -523
  - Current account balance (percent of GDP): -18.9
  - Trade balance (in millions of U.S. dollars): -539
  - Exports (excluding petroleum exports, in millions of U.S. dollars): 20
  - Imports (in millions of U.S. dollars): 559
  - Petroleum revenue (in millions of U.S. dollars): 540
  - Public foreign assets (end-period, in millions of U.S. dollars): 16,125
  - Public foreign assets (in months of imports): 167
- Memorandum items (2016)
  - GDP at current prices (in millions of U.S. dollars): 2,762
  - Non-oil GDP (in millions of U.S. dollars): 1,672
  - Oil GDP (in millions of U.S. dollars): 1,090
  - GDP per capita: 2,278
  - Crude oil prices (U.S. dollars per barrel, WEO): 43
  - Petroleum Fund balance (closing, in millions of U.S. dollars): 15,844
  - Petroleum Fund balance (in percent of GDP): 574
  - Public debt (in millions of U.S. dollars): 77
  - Public debt (in percent of GDP): 2.8

*International Monetary Fund, Staff Report for the 2017 Article IV Consultation, Democratic Republic of Timor-Leste.*

### 4.      The fiscal deficit has widened. The overall fiscal deficit widened to 30.8 percent of GDP in

### 4.      The fiscal deficit has widened. The overall fiscal deficit widened to 30.8 percent of GDP in 2016 from 17.0 percent in 2015.

### Fiscal outcomes and Petroleum Fund (PF)
- Overall fiscal deficit: 30.8 percent of GDP in 2016 (17.0 percent in 2015).
- Revenue sourced from estimated sustainable income (ESI) of the PF: 19.7 percent of GDP in 2016 (marginally lower).
- Domestic revenue outperformance driven by one-off increases in customs duties and corporate tax collection and improved compliance.
- Recorded capital spending doubled due to supplementary budget allocations advancing projects under the Infrastructure Fund.
- The PF provided a transfer of US$1.24 billion to finance the 2016 budget; US$0.7 billion of this was in excess of the ESI.
- PF closing balance for 2016: US$15.8 billion (second year of net reduction).
- Cumulative excess withdrawals from the PF by end-2016: $3 billion.
- PF balance as of end-September 2017: US$16.7 billion.

### External current account and exchange rate
- Current account: deficit of 18.9 percent of GDP in 2016 (surplus of 7.7 percent of GDP in 2015).
- Deterioration drivers: higher imports for public investment and decline in oil/gas receipts as output fell with near depletion of current oil fields and lower global oil prices.
- Real effective exchange rate (REER): depreciated by 2.8 percent in 2016, reflecting negative inflation and U.S. dollar nominal depreciation against trading partner currencies.
- Note: The U.S. dollar is sole legal tender in Timor-Leste.

### Banking sector, credit, and liquidity
- Private sector credit growth: -1.8 percent (y/y) in 2016 (10.5 percent in 2015).
- NPL ratio: 15 percent of outstanding loans at end-2016 (23 percent at end-2015).
- Loan-to-deposit ratio: around 29 percent in 2016.
- Banks’ overseas placements of deposits: 74 percent (reflecting excess liquidity).
- Banking system composition: five banks — one wholly government-owned bank (BNCTL) and four foreign bank branches (ANZ, Bank Mandiri, Bank Rakyat, CGD/BNU). Bank Rakyat Indonesia started operations in March 2017.

### Near-term outlook and macro indicators
- Non-oil real GDP growth projection for 2017: 3 percent (moderation due to lower government expenditure and slowdown after delayed government formation following July 2017 parliamentary elections).
- Inflationary pressures: remain low with a return to positive territory given rising global food and fuel prices.

### Medium-term risks
- Main risks centre on success of fiscal and structural reforms and economic diversification.
- Depletion of current oil field by around 2022 increases urgency to generate growth and fiscal revenue.
- Significant frontloading of public investment poses large downside risks to fiscal sustainability due to large PF withdrawals.
- Risk that large infrastructure projects may not generate sufficient social and economic returns to translate into higher tax returns.
- Risk of higher inflation from domestic price pressures from larger government spending.
- Finalization of the Greater Sunrise petroleum field agreement with Australia: does not materially alter the need for employment creation and economic diversification but helps alleviate long-term fiscal resource constraints.

### Policy recommendations — ensuring fiscal sustainability
- Fiscal anchor: preserve PF assets as a sustainable revenue source; make a clear commitment to end excess withdrawals from the PF.
- Rationalize recurrent spending by reducing current transfers to ZEESM over the medium term while protecting health and education spending.
- Moderate and prioritize frontloading of capital spending in line with resources and capacity constraints; accelerate capacity building to manage public investment projects.
- Consider adopting a ceiling on primary expenditure as an expenditure rule in addition to the ESI.
- Staff illustrative reform measures urged for the 2018 Budget:
  - More moderate levels of recurrent and capital spending, while preserving pro-poor social spending and investing in people and systems to improve public investment management.
  - Mobilize domestic revenue through the introduction of a value-added tax by 2020, accompanied by an increase in excise duties and other taxes.
  - Put an end to PF excess withdrawals from 2028 onwards to rebuild the PF asset base.
- Expected outcome if measures implemented: smaller overall deficit in the medium term and higher total revenue allowing a larger expenditure envelope while maintaining the PF balance.

### Public investment, efficiency, and absorptive capacity
- 2017 Budget envisaged planned capital spending averaging around US$1 billion annually during 2018-21, or about US$4.3 billion (156 percent of 2016 GDP) in total.
- Expected financing for this capital spending: PF transfers (exceeding the ESI) of US$4.8 billion (30 percent of the PF balance) and external borrowing of US$1.3 billion.
- Staff baseline assumes 70 percent execution rate of multi-year (2018-21) capital expenditures due to capacity constraints.
- DIG model findings:
  - Rapid scaling up of investment may not achieve desired goals due to absorptive capacity constraints and inefficiencies.
  - New investment requires significant resources for operation and maintenance; frontloading should account for these requirements.
  - Sustained improvement in investment efficiency significantly reduces resource requirements and the debt burden.
- Public Investment Management Assessment (PIMA) weaknesses should be addressed with a clear action plan and timeline before scaling up infrastructure investment.
- Priorities: rigorous project appraisal, cost-benefit analysis, risk assessments, competitive procurement, and investment in public investment management systems and capacity.

### Domestic revenue mobilization and borrowing
- Importance of passing VAT legislation and introducing VAT by 2020 to raise domestic revenue toward the goal of 15 percent of non-oil GDP.
- Establishment of customs authority and tax authority and an action plan to increase tax compliance welcomed.
- Early upgrade of tax administration capacity critical for efficient VAT implementation in a two- to three-year timeframe.
- Concessional borrowing: develop clear criteria to identify projects for concessional loans, prioritizing projects that also deliver knowledge transfer in project appraisal and implementation.

### Debt sustainability, public financial management (PFM), and monitoring
- DSA indicates moderate risk of debt distress driven by projected higher external borrowing under the baseline scenario that reflects increased concessional borrowing for frontloaded public investments.
- External debt projected to increase from 2.8 percent of GDP in 2016 to about 28 percent in the medium term under the baseline plan.
- Need to strengthen debt recording and monitoring capacity with greater utilization of external financing.
- Public financial management reforms under the “Roadmap of Budgetary Governance Reform” (approved March 2017) should be prioritized and sequenced to complement PFM practices beyond the budget process.
- Publish first phase (2011-16) SDP review and apply lessons learned; prioritize costings of the SDP for health and education aligned with SDGs.

### Financial inclusion and macro-financial stability
- Financial intermediation remains weak; retail deposit growth in foreign bank branches funds liquid investments abroad.
- National financial inclusion strategy 2017-22 welcomed; planned measures include digital financial products, agent banking, consumer protection review, a financial literacy strategic plan, and a pilot credit guarantee scheme.
- Measures to increase access to credit: enhance collateral system, bankruptcy regime, and credit registry information system.
- Credit guarantee scheme for SMEs could close financing gaps but must limit moral hazard via proper risk-sharing and minimize contingent liabilities (eligibility criteria, partial guarantees, loss-sharing, regulation and supervision). BCTL is preparing regulations for the scheme; staff recommend design best practices (eligibility only to new loans, clarified claim and recovery processes, regulatory requirements) and accompanying SME capacity building.
- National payments system modernization: automated transfer system (R-TiMOR) introduced early 2016; BCTL developing national card and mobile payment switch.
- Safeguarding financial stability: BCTL strengthening supervisory oversight, collaboration with home country regulators, strict oversight of government-owned local bank, review of prudential requirements, and MOUs with Australian Prudential Regulation Authority and Indonesian Financial Services Authority. Capacity development for regulating non-bank financial institutions and a draft credit union law are underway with MCM/PFTAC support.

*International Monetary Fund staff summary based on the source chapter.*

### 27.      More needs to be done to operationalize the AML/CFT framework. The first National

### cr17360 - 27.      More needs to be done to operationalize the AML/CFT framework. The first National

### AML/CFT framework: status and operational challenges
- The first National Risk Assessment of Money Laundering and Terrorist Financing was released in October 2016.
- The government has adopted a national strategic plan (2016-2020) to mitigate ML/TF risks.
- The introduction of the risk based approach to AML/CFT by BCTL in 2017 is commendable.
- No sign of correspondent banking withdrawal in Timor-Leste as foreign banks access correspondents through their head offices.
- Transfers are largely for trade payments and workers’ remittances are low.
- Staff recommendation / implication:
  - Bolster AML/CFT operationalization and continue capacity building and training for commercial banks.

### Financial sector and dollarization
- Use of the U.S. dollar as sole legal tender remains appropriate given institutional capacity constraints and limited financial development.
- The fully dollarized regime has worked well given high dependence on oil revenue and limited other non-oil exports.
- Long-run change in exchange rate regime would require:
  - Sound macroeconomic policies, including improved fiscal policies.
  - Further progress in financial sector and institutional developments.
- Financial sector findings:
  - Credit to private sector is relatively low compared to peers.
  - Large interest rate spread suggests low efficiency in financial intermediation.
  - Financial inclusion has improved given the increase in the number of bank branches per capita, but lags due to poor coverage by ATMs.
  - Visual/statistical indicators presented in the source include:
    - Timor-Leste: Number of Deposit and Loan Accounts (chart units: In thousands).
    - Domestic Credit to Private Sector (In percent of GDP).
    - Bank Lending-Deposit Spread (In percent).
    - Bank Branches (per 100,000 adults).
    - ATMs (per 100,000 adults).

### Authorities’ views on financial inclusion, payments, and AML/CFT
- Authorities appreciate promoting safe financial inclusion.
- Initiatives to modernize the national payment system are expected to:
  - Enhance safety of the payment system.
  - Foster financial system stability.
  - Make domestic revenue collection more efficient and support fiscal reforms.
- Expectation that the credit guarantee scheme would promote financial intermediation in a banking system dominated by foreign banks.
- Authorities agree with staff recommendations on institutional design to contain moral hazard and public contingent liabilities; design should reflect country circumstances and policy objectives.
- Emphasized that banking system is sound and that resolution of legacy NPLs would help promote private sector credit growth.
- Emphasized efforts to implement AML/CFT framework in line with global best practice, including:
  - Adoption of risk-based approach.
  - Provision of training to commercial banks.

### Facilitating economic diversification and inclusive growth
- External sector assessment:
  - Staff assesses the external sector position to be substantially weaker than suggested by medium-term fundamentals and desirable polices.
  - Current account deficit expected to remain above sustainable level financed by the ESI, due largely to falling oil exports and high imports driven by scaling up public investment.
  - For a dollarized economy, adjustment must fall on domestic price reduction.
- ASEAN accession prospects:
  - Timor-Leste applied for ASEAN membership in 2011; a decision approving accession expected in one to two years (as stated in source).
  - Integration into the ASEAN Economic Community is unlikely to have significant short-term economic implications but can create economic transformation opportunities.
  - Commitment to harmonize trade, services and investment policies with ASEAN standards and observer status in the WTO (December 2016) expected to help attract investment.
- Macro-critical structural reforms needed:
  - Improve infrastructure.
  - Enhance financial access without raising risks.
  - Improve labor competitiveness.
- Priority areas and facts:
  - Employment:
    - Unemployment at 11 percent.
    - Youth unemployment at 22 percent.
    - The National Employment Strategy 2017-30 is a good start and should be accompanied by action plans to improve vocational training and labor market institutions.
  - Investment:
    - Operationalization of the Land Law should help clarify land/property rights and facilitate land use for investment and as loan collateral.
    - Amendment of the private investment law clarifying regulation and incentives, and adoption of the National Tourism Policy, should help stimulate investment.
  - Governance:
    - Perceptions of corruption appear to have declined marginally but remain a key impediment to doing business.
    - Finalizing the national anti-corruption strategy and effective implementation could enhance governance.

### Building capacity and strengthening statistics
- Persistent institutional strengthening and capacity building are key to reducing fragility.
- Investment in human capital (education and health), aligned with the SDGs, is critical for diversification.
- Data quality and timeliness issues hamper surveillance:
  - Near 18-month lag in release of annual GDP data should be shortened.
  - Making quarterly GDP available would help economic monitoring and policy making.
  - Authorities encouraged to implement the enhanced General Data Dissemination System (e-GDDS).
  - Improve reporting of annual and quarterly government finance statistics in line with the GFSM 2014 (as recommended by PFTAC TA).
  - Enhance current cash-based accounting to pave way for accrual accounting over medium to long term in context of sustainable PFM reforms.
  - Establishment of a quarterly statistical working group (MOF, BCTL, General Directorate of Statistics) to resolve data compilation issues and facilitate data exchange is commendable.
- The Fund stands ready to provide TA and capacity building:
  - Timor-Leste is a pilot country under the Fund’s infrastructure support initiative.
  - Staff encourage requests for TA to strengthen public investment management and support tax and PFM reforms.
- Authorities value TA and training from the Fund and PFTAC and suggested on-the-ground technical experts could enhance TA traction.

### Staff appraisal: fiscal policy, reform priorities, and recommendations
- Overarching challenge:
  - Need for economic diversification to create employment for a young labor force and to adjust from high dependency on oil revenue.
  - Frontloading of public investment poses downside risks to fiscal sustainability because of envisaged large PF withdrawals for deficit financing.
- Fiscal policy recommendations:
  - Maintain fiscal position compatible with debt sustainability and preserve Petroleum Fund (PF) assets.
  - PF assets should remain fiscal anchor, achieved by adhering to the ESI.
  - Moderate and prioritize frontloading of capital spending in line with scarce resources and capacity constraints and public investment management reforms.
  - Prioritize public investment with focus on high-return projects determined through rigorous investment appraisal, cost-benefit analysis, and risk assessments.
  - Rationalize recurrent spending while protecting health and education spending and improving public spending efficiency.
- Revenue and borrowing:
  - Domestic revenue mobilization and effective use of concessional borrowing are critical for fiscal sustainability.
  - Introduce a VAT by 2020 and start upgrading tax administration capacity early to mobilize sufficient domestic non-oil revenues.
  - Develop clear criteria to identify infrastructure projects suitable for concessional loans, prioritizing projects that benefit from knowledge transfer in appraisal and implementation.
- Financial inclusion and stability:
  - Steady implementation of national financial inclusion strategy 2017-22 to achieve financial deepening and inclusive growth.
  - Create a well-designed credit guarantee scheme for SMEs accompanied by capacity building for SMEs in business plans and financial management.
  - Safeguard financial stability by strengthening BCTL supervisory and regulatory framework and capacity, and bolstering the AML/CFT framework.
- Structural reforms for competitiveness:
  - Improve basic infrastructure, financial access, labor competitiveness, and ease of doing business.
  - Improve external competitiveness by keeping wages competitive, raising productivity, and closing labor skill gaps via targeted vocational training.
- Statistics and TA:
  - Further improvements in timeliness and periodicity of national accounts data are crucial.
  - Authorities encouraged to further leverage technical assistance and capacity building from the Fund and development partners.
- Procedural recommendation:
  - It is recommended that the next Article IV consultation takes place on the standard 12-month cycle.

*International Monetary Fund — Democratic Republic of Timor-Leste staff report content as provided.*

### Box 4. External Sector Assessment

### Box 4. External Sector Assessment

### Overall assessment
- The external position is substantially weaker than that consistent with medium-term fundamentals and desirable policy settings.
- The economy is oil-dependent and facing a large structural change due to expected depletion of the current oil/gas field by 2022.
- The deterioration is driven by falling oil exports and compounded by higher imports from scaling up public investment.
- Improving external competitiveness is key to advancing economic diversification and promoting non-oil private sector development, warranting fiscal adjustment and steady implementation of structural reforms.

### Current account projections and financing
- The external current account (CA) deficit is projected to remain.
- The CA turned to a deficit in 2016, driven by a decline in oil/gas receipts amid declining output and lower oil prices.
- The current account deficit is projected to remain at 18 percent of GDP in the medium term (2018-2022 average), driven by higher imports related to capital spending, coupled with falling oil/gas receipts.
- The Petroleum Fund (PF) will provide a source of funding over the medium term.
- The CA deficit will be financed largely by divestment from the PF, together with external borrowing and FDI inflows.
- This financing mix is unsustainable over the long term as the PF balance dwindles.

### Exchange rate developments and competitiveness
- The real effective exchange rate (REER) has appreciated strongly since 2010, resulting in an erosion of external competitiveness.
- The REER has appreciated by about 7 percent annually during 2010-2015, due to high inflation differential with trading partners in 2010-13 and an appreciation of the nominal effective exchange rate (NEER) since 2013 as the U.S. dollar strengthened against trading partners’ currencies.
- REER depreciation in 2016 and early 2017 helped to moderate the loss of external competitiveness.
- Depreciation has not materially enhanced export performance because Timor-Leste’s main exports—petroleum and coffee—are denominated in U.S. dollars.
- The economy is highly dependent on imports, reflecting a very limited domestic production base.

### Staff assessment and methodology
- Staff’s assessment—based on the EBA-lite framework—suggests substantial exchange rate overvaluation compared to the level implied by fundamentals and desirable policies.
- The assessment is based on the IMF standard methodology using:
  - the CA model,
  - the REER Index model, and
  - the External Sustainability approach (ES).
- The CA gap (the difference between CA-actual and the CA norm) suggests an external position that is substantially weaker than current fundamentals and desirable policy settings.
- The REER gap from the REER model also points to a substantially weaker external position.
- These results are sensitive to sample periods and underlying assumptions.
- The estimates of the CA norm may not fully capture Timor-Leste–specific factors such as data limitations.

### Key statistics and timeline references
- Expected depletion of current oil/gas field: by 2022.
- CA turned to a deficit: 2016.
- Projected CA deficit in medium term: 18 percent of GDP (2018-2022 average).
- REER appreciation: about 7 percent annually during 2010-2015.
- Inflation differential period cited: 2010-13.
- NEER appreciation since: 2013.
- REER depreciation noted in: 2016 and early 2017.

*Source: IMF staff Box 4. External Sector Assessment (extracted content).*

### Box 4. External Sector Assessment (concluded)

### Box 4. External Sector Assessment (concluded)

### Reserve adequacy and role of the Petroleum Fund
- Net international reserves (NIR) were US$0.3 billion at end 2016, equivalent to an import coverage of 2.9 months.
- Reserve adequacy metrics for credit-constrained LICs suggest the optimal level of reserves for Timor-Leste is around 9.5 months of imports.
- The estimated adequacy threshold largely reflects the inflexibility of a dollarized economy in adjusting the exchange rate to absorb shocks.
- A fully dollarized economy does not face exchange rate fluctuation risk, but liquidity is needed to:
  - protect the financial system from liquidity shocks, and
  - serve as a fiscal buffer for the financing gap.
- The Petroleum Fund (PF) provides significant buffers:
  - foreign assets at US$15.8 billion (574 percent of GDP with allocation of 40 percent in equities and the remaining in bonds),
  - PF assets equivalent to 164 months of goods and services imports.
- Foreign liabilities were relatively small at 18.8 percent of GDP at end-2016:
  - FDI liabilities 12.8 percent of GDP,
  - concessional external debt 2.4 percent of GDP.

### External balance assessment (2016 EBA results)
- Current account (CA) and valuation gaps (percent of GDP / implied REER over(+)/under(-) valuation):
  - Actual CA: -19.3, -19.3, -15.3
  - CA norm: -8.2, -6.6, -0.3
  - CA gap: -11.1, -12.7, -14.9
  - REER gap 3/: 32.7, 37.4, 26.6, 44.1
- Notes on models:
  - 1/ With staff's recommended desirable fiscal balance equivalent to narrowing the underlying fiscal deficit by 6 percent of GDP via reducing capital expenditure by one-third.
  - 2/ For External Sustainability (ES) model, actual CA is the medium-term CA projection and CA norm is the CA that stabilizes NFA at the 2016 level.
  - 3/ Implied over(+)/under(-) valuation.
- Source of estimates: IMF staff estimates.

### External developments and trends
- Current account balance continued to deteriorate due to strong imports and declining oil and gas receipts.
- Current account deficit was financed mainly by divestment of the PF portfolio investment.
- Non-oil exports have picked up from a small base but remain volatile, reflecting fluctuations in coffee exports (the single-largest export item after oil/gas).
- Fuel and food account for about one-half of total imports.
- The depreciation of REER in 2016 reflected negative inflation and nominal depreciation of the U.S. dollar against currencies of trading partners.

### Structural competitiveness and policy recommendations
- Structural reforms remain crucial to improve external competitiveness:
  - raising productivity;
  - improving the business climate;
  - promoting non-oil private sector development.
- Minimum wage considerations:
  - The minimum wage remains relatively high compared to regional peers and could discourage FDI in labor-intensive sectors.
  - Recommendation: keep the wage level in line with productivity to help improve export competitiveness and attract foreign direct investment.
- Additional reforms to improve competitiveness:
  - addressing infrastructure bottlenecks;
  - increasing financial access;
  - closing labor skill gaps through more targeted vocational training.

*Source: IMF staff estimates.*

### Annex I. Main Recommendations of Past Article IV Consultations

### Annex I. Main Recommendations of Past Article IV Consultations

### Past staff recommendations and implementation
- Greater focus on fiscal sustainability with a front-loading strategy in line with implementation and absorptive capacity should see expenditure envelope stabilized at $1.3 billion.
  - Broadly accepted by the authorities. The 2017 budget reflects a modest expenditure envelopment of US$1.39 billion due to significant slowing of capital spending envisaged in an elections year. The multi-year budget projects a continuation of frontloaded capital spending for 2018-21.
- Improve the composition of government expenditure, including rigorous cost-benefit analysis for large scale projects, scaling back planned infrastructure for cases ahead of demand, higher recurrent budget for maintenance cost for infrastructure development, curtail rapid increase in transfer and subsidies.
  - On-going progress but challenges remain. The authorities recognized public investment plans should be subject to robust appraisal but need to build capacity.
- Mobilize non-oil domestic revenues.
  - Fiscal Reform Commission is working on the introduction of value-added tax in the medium term. Establishment of the new custom authority and tax authority would increase tax collection efficiency and raise compliance.
- Implement the Financial Sector Master Plan to strengthen financial system oversight and development. Need to strike a balance between expanding financial inclusion and safeguarding financial stability. Put in place a strategy to resolve legacy NPL.
  - BCTL is making progress in building up supervisory and regulatory capacity covering banks and non-bank financial institutions. Substantial part of the legacy NPL was resolved in 2016 with the remaining amount expected to be largely resolved in 2017.
  - The financial system in Oecusse special economic zone continues to be within the mandate of the BCTL. Accepted by the BCTL authorities.
- Vigilant to the build-up of contingent fiscal liabilities in setting up a development bank.
  - The authorities are in board agreement with staff's views and there has been no further progress in the conceptualization of a development bank.
- Faster progress in reform of the land law to improve the availability of collateral to expand lending and borrowing.
  - Early attention to be given to enable moveable property to be used as collateral; follows by the use of immoveable property such as land and building as collateral when land titles have been clarified. The Land Law has been promulgated on June 1, 2017.
- Establishing appropriate AML/CFT framework.
  - Good progress is being made with the introduction of the risk based approach.
- The use of the U.S. dollars remains appropriate given institutional capacity constraints and limited financial development.
  - The authorities agreed with the staff's views on full dollarization given competing development goals and while institutions and financial markets remain underdeveloped.
- Non-oil real GDP growth averaging around 5 percent over the medium term led by the private sector is more inclusive and sustainable.
  - Non-oil GDP growth is assumed at 6-6.5 percent  in 2018-19 with the frontloading of public investments creating a conducive environment ofr strong growth in private sector investment.
- Measures to alleviate impediments to private sector development and economic diversification.
  - Ongoing progress but challenges remain.

### Annex II — Risk Assessment Matrix (selected risks, likelihoods, impacts, and policy responses)
- 1. Weaker-than-expected global growth
  - Relative Likelihood: Medium
  - Time Horizon: Short to Medium Term
  - Expected Impacts if Realized: Medium (via lower commodity and oil prices limited by the insulating role of the Petroleum Fund (PF) and low levels of non-oil trade and capital account integration; weaker growth in trading partners may slow tourism and FDI inflows)
  - Recommended Policy Responses:
    - Government expenditure plans need to be scalable to mitigate sharp slow-down in growth.
    - Efforts to raise non-oil revenues need to be intensified and the PF should be maintained at an adequate level as an ongoing revenue source and to provide fiscal buffer.
- 2. Tighter global financial conditions
  - Relative Likelihood: High
  - Time Horizon: Short Term
  - Expected Impacts if Realized: Medium/Low (PF would gain from higher global interest rates but could incur capital losses on its PF’s bond portfolio; renewed global shocks could impact local liquidity)
  - Recommended Policy Responses:
    - The BCTL’s regulatory and supervisory framework and crisis management toolkit need to be enhanced.
    - Fostering competition among banks to appropriately increase credit supply and narrow interest rates spread.
- 3. Lower energy prices
  - Relative Likelihood: Low
  - Time Horizon: Short to Medium Term
  - Expected Impacts if Realized: Medium (lower energy prices delay investment decisions in new oil fields and reduce profit; lack of augmentation to PF saving raises fiscal risk)
  - Recommended Policy Responses: As for 1 above.
- 4. Higher inflation
  - Relative Likelihood: Medium
  - Time Horizon: Medium Term
  - Expected Impacts if Realized: Medium (high inflation adversely affects the poor; higher transfers and public sector wages add fiscal pressures)
  - Recommended Policy Responses:
    - Fiscal policy needs to be adaptable to maintain macro-stability, preserve competitiveness and better protect the poor.
- 5. Over investment in projects with low returns
  - Relative Likelihood: Medium
  - Time Horizon: Medium Term
  - Expected Impacts if Realized: High (capital-intensive projects with limited linkages deplete PF and risk fiscal sustainability)
  - Recommended Policy Responses:
    - Projects should be subject to transparent and realistic cost benefit assessments and risk analysis, and only go ahead if the social returns are higher than the opportunity costs.
- 6. Failure to secure inclusive growth
  - Relative Likelihood: Low/Medium
  - Time Horizon: Medium Term
  - Expected Impacts if Realized: High (discontent, rent seeking, pressures to raise expenditures, discouraged foreign investment)
  - Recommended Policy Responses:
    - Sound policy frameworks and governance structures to be reinforced, especially through more transparency and accountability.
- 7. Development of Greater Sunrise or other oil fields
  - Relative Likelihood: Low
  - Time Horizon: Medium Term
  - Expected Impacts if Realized: High (upside fiscal effects if production starts; expected to take 5-7 years after finalization of agreement with Australia)
  - Recommended Policy Responses:
    - Fiscal resources should be prudently spent in line with absorptive capacity to avoid overheating and focus on growth enhancing projects.

### Annex III — Expenditure Rule for Safeguarding Long-Term Fiscal Sustainability (key points)
- Historical rule: Since the Petroleum Fund (PF) Law (2005), Timor-Leste adopted the estimated sustainable income (ESI) — calculated as 3 percent of the financial assets of the PF and the net present value of future oil and gas receipts — to facilitate macroeconomic management; the ESI functions as a fiscal rule.
- 2011 amendment: Provides more flexibility in the use of PF assets with parliamentary approval, weakening the effectiveness of the ESI.
- Recommendation: Consider complementing the ESI with an expenditure fiscal rule.
  - Rationale: An expenditure rule can set permanent limits on total, primary, or current spending (absolute terms, growth rates, or percent of GDP), helping ensure long-term fiscal sustainability and shielding the economy from overheating.
  - Specifics for Timor-Leste: A ceiling on primary expenditure will help ensure a more moderate pace of spending increase to maintain macroeconomic stability and give time to strengthen public investment management to select projects supportive of economic growth.

### Annex IV — Revenue and Expenditure Reform Scenario versus Baseline Forecast (summary of scenarios and key numeric projections)
- Baseline fiscal scenario assumptions and projections:
  - Baseline assumes 70 percent (past average execution rate) of the multi-year (2018-21) capital expenditures allocation plan under the 2017 Budget will be implemented due to capacity constraints.
  - Recurrent spending expected to remain broadly at 35 percent of GDP in 2022 but decline to 18 percent of GDP in 2037.
  - In absence of tax reforms, domestic revenue expected to hover around 8 percent of GDP over the medium term, and reach 17 percent of GDP in the long term.
  - Baseline assumes a cap on the withdrawal of the PF of US$1.3 billion per annum beyond the medium term.
  - Total external borrowing during 2017–37 expected to reach US$3.8 billion, with outstanding debt at 22 percent of GDP in the long term.
  - Continued reliance on excess PF withdrawals would lead to PF balance: US$12 billion in 2022 (340 percent of GDP) and US$639 million (3.5 percent of GDP) by 2037.
- Staff’s proposed reform scenario (three-pronged strategy) — aggregate outcomes:
  - Net borrowing/lending improves to a deficit of 6 percent of GDP in the medium term, and to about 1½ percent of GDP in the long term.
  - Over the long term, total revenue projected to be about 11 percent of GDP higher than under the baseline, allowing an expenditure envelope about 7 percent of GDP larger and a rebuild of the PF assets in nominal terms.
- Key reform elements and numeric targets:
  - More moderate capital spending: scale up averaging 14½ percent of GDP in the medium term and anchored at no more than 10 percent of GDP in the long term.
  - Recurrent spending reduced to 22 percent of GDP in the medium term through lowering wages and salaries, goods and services, and public transfers, while preserving pro-poor social spending.
  - Consider operating balance target of zero, or a surplus such that budgeted recurrent spending is financed by domestic revenue and the ESI.
  - A value-added tax (VAT) implemented by 2020:
    - With the government’s proposed VAT rate of 7.5 percent (envisaged in the draft VAT law), VAT is expected to raise revenues up to 5 percent of GDP in the medium term.
    - Accompanied by an increase in excise duties yielding an additional 3 percentage points of GDP in revenue.
    - Consider raising the VAT rate to 10 percent starting from 2028.
  - Commitment plan to stop PF excess withdrawal:
    - Beyond capping PF withdrawal at US$1.3 billion over the medium term, PF withdrawals in excess of the ESI should not be permitted starting from 2028, to rebuild the PF balance.
    - Resulting financing gap could be met by external concessional borrowing.
    - Under the reform scenario: total borrowing projected at US$4.5 billion over 2017-37 (about 18 percent higher than baseline); outstanding external debt rises to 24½ percent of GDP in the medium term but declines to 8 percent in the long term.
    - PF balance projected to reverse decline to around US$15.6 billion (468 percent of GDP) in 2022, and reaching US$17.7 billion (93 percent of GDP) in 2037.

- Selected numeric table highlights (Baseline vs Reform projections; values preserved as presented):
  - Total revenue: 2017 Est. 29.9; Baseline 2018 30.0; Reform Proj. 2018 29.7
  - Domestic revenue: 2017 Est. 6.8; Baseline 2018 7.6; Reform Proj. 2018 8.2
  - Tax revenue: 2017 Est. 5.0; Baseline 2018 5.4; Reform Proj. 2018 5.9
  - VAT (Reform): entries shown as ---   ------ --3.43.83.85.0 (as presented)
  - Estimated Sustainable Income: 2017 Est. 17.4; Baseline 2018 16.8; Reform Proj. 2018 17.0
  - Total expenditure excluding grants: 2017 Est. 44.3; Baseline 2018 65.1; Reform Proj. 2018 47.2
  - Recurrent spending: 2017 Est. 33.4; Baseline 2018 35.7; Reform Proj. 2018 32.2
  - Capital spending: 2017 Est. 10.9; Baseline 2018 29.3; Reform Proj. 2018 15.0
  - Net borrowing and lending: 2017 Est. -20.1; Baseline 2018 -40.7; Reform Proj. 2018 -22.0
  - Petroleum Fund balance (in percent of GDP): 2017 Est. 571.1; Baseline 2018 522.8; Reform Proj. 2018 548.6
  - Petroleum Fund balance (in millions of US dollars): 2017 Est. 15,784; Baseline 2018 15,044; Reform Proj. 2018 15,589
  - Real GDP growth: 2017 Est. 3.0; Baseline 2018 5.0; Reform Proj. 2018 4.7
  - Inflation: 2017 Est. 2.0; Baseline 2018 3.5; Reform Proj. 2018 2.0

### Annex V — The Macroeconomic Impact of Scaling Up Public Investment (model and scope)
- Objective: Analyze macroeconomic implications of public investment scale-up under the 2017 Budget, baseline fiscal scenario, and staff’s proposed reform scenario using the Debt-Investment-Growth (DIG) model.
- DIG model features:
  - Small open economy with two production sectors, two types of households (savers and non-savers), and an active government.
  - Government collects taxes, supplements domestic income by foreign and domestic borrowings, uses revenues to finance public investment, government consumption and transfers.
  - Financing modalities include domestic borrowing, external concessional to commercial financing; taxes and transfers adjust to reasonable levels allowing debt to be paid down as painlessly as possible.

*Source: cr17360 - Annex I. Main Recommendations of Past Article IV Consultations*

### 2.      The model goes beyond comparing the rate of return on public investment and the

### 2.      The model goes beyond comparing the rate of return on public investment and the

### Model framework and calibration
- The model frames debt sustainability analysis to incorporate:
  - differences in the efficiency of public spending,
  - the response of the private sector to the investment plan,
  - the ability of the government to adjust taxes and spending.
- Calibration for Timor-Leste:
  - Public investment efficiency assumed at 50 percent (in line with Timor-Leste’s PIMA report).
  - Cross-country averages referenced: 60 percent for low-income countries and 75 percent for emerging market economies.
  - Return on public investment assumed to be 15 percent based on cross-country estimates of marginal productivity of capital.
  - Model adapts to availability of finance via drawing down savings from the Timor-Leste Petroleum Fund (PF).
  - Depreciation rate assumed to be 5 percent (no country-specific estimate available).

### Scenario analyses and macroeconomic implications
- Three scenarios analyzed: Budget (frontloaded scale up), Baseline (lower scale up), Reform (moderate scale up + efficiency gains).
- Budget (frontloaded scale up, Budget 2017 assumptions):
  - Capital expenditure scaled up by an average of 39 percent of GDP in 2018-2021.
  - Capital expenditure maintained at 11 percent of GDP thereafter.
  - Financing mix: one-third of scale up financed by concessional loan and remaining two-thirds financed through excess withdrawal of the PF.
  - Result: effective public capital stock increases by 96 percent relative to initial level during scale up, but declines after the scale up period.
  - Risk: without adequate operation and maintenance funding in outer years, public capital stock could be eroded by 12 percent compared to its peak level within a decade after the scaling up period.
- Baseline (30 percent lower than budget scenario, reflecting historical execution):
  - Post-frontloading capital spending maintained at 11 percent of GDP.
  - Financing mix: 40 percent financed by concessional loan and remaining through excess withdrawal of the PF.
  - Result: effective public capital stock expands by 63 percent (relative magnitude) during scale up but later deteriorates; effective capital stock would decline by 10.7 percent as incremental investments are insufficient to cover depreciation.
- Reform (moderate scale up with efficiency improvements):
  - Public investment increased to 15 percent of GDP during 2018-2021 and stabilizes at 10 percent of GDP thereafter.
  - Efficiency improvement: assumed to rise over a decade from 46 percent to 75 percent (the current level of emerging market countries) by implementing PIMA recommendations.
  - Financing mix: concessional loans finance about 95 percent of public investment and remaining through excess withdrawal from the PF.
  - Result: effective public capital stock increases by about 52 percent at the end of the scale up period.
  - Long-term: effective public capital stock would expand by about 60 percent—relative to its initial point—a decade after the end of the scale up period as improved efficiency more than offsets depreciation.

### Key quantitative outcomes (selected)
- Public investment efficiency: assumed 50 percent (Timor-Leste PIMA); current level cited elsewhere as 46 percent in reform scenario baseline.
- Return on public investment: assumed 15 percent.
- Depreciation rate: assumed 5 percent.
- Budget scenario scale-up: average of 39 percent of GDP in 2018-2021; maintained at 11 percent of GDP thereafter.
- Baseline scenario scale-up: 30 percent lower than budget scenario; maintained at 11 percent of GDP thereafter.
- Reform scenario: 15 percent of GDP during 2018-2021; stabilizes at 10 percent of GDP thereafter.
- Effective public capital stock changes:
  - Budget: +96 percent during scale up; potential erosion of 12 percent from peak within a decade after scale up.
  - Baseline: +63 percent during scale up; decline of 10.7 percent in outer years.
  - Reform: +52 percent at end of scale up; +60 percent relative to initial point a decade after scale up.

### Macro implications and dynamics
- Budget and baseline scenarios:
  - Real GDP growth accelerates during the scaling up period but tapers off in the long term.
  - External debt increases sharply during scale up then declines gradually afterwards.
  - Private investment increases as public capital accumulates, but pace declines over time as public capital stock declines.
- Reform scenario:
  - Moderate impact on real GDP growth during scale up.
  - External debt also accelerates but to a much lower level compared with budget and baseline scenarios.
  - Gradual scale up and efficiency improvements support private investment; long-term private investment impact marginally surpasses that under budget and baseline scenarios.
- Overall insight:
  - Frontloaded scale up can rapidly build capital stock but risks long-term erosion absent adequate maintenance and higher efficiency.
  - At 50 percent efficiency and 5 percent depreciation, long-term investment needs to be significantly higher than historical capital spending of about 11 percent of GDP to prevent deterioration.
  - Decelerating scale up while improving efficiency is desirable to save investment resources and build public capital more sustainably.

### Policy recommendations and implications
- Prefer a gradual scale up of public investment rather than a frontloaded approach to ensure sustainability.
- Prioritize improving public investment efficiency (implement PIMA recommendations) to offset depreciation and reduce long-term funding needs.
- Ensure adequate allocation for operation and maintenance in outer years to preserve capital stock gains from scale up.
- Favor concessional financing in the reform scenario (example calibration: up to 95 percent concessional loans) to reduce immediate PF withdrawals and external imbalances.

### Annex: VAT implementation lessons (selected considerations)
- Key success factors for VAT introduction: high-level political commitment, tax administration readiness, public understanding, and adequate preparation time between legislation and implementation.
- Legal framework elements: appropriate registration threshold, a single positive rate, limited exemptions, balance between taxpayer rights and tax agency powers.
- Administrative and operational recommendations:
  - Efficient organizational structure and staffing with strong headquarters, function-based design, minimal management layers, and alignment to key taxpayer segments.
  - Effective management arrangements with strategic, operational, and individual performance measures.
  - Self-assessment systems to minimize revenue official interference and focus enforcement on higher-risk taxpayers.
  - Streamlined VAT filing and payment systems to secure timely revenues with minimal compliance cost.
  - Service-oriented taxpayer support and education.
  - Risk-based audit and verification programs with effective dispute resolution.
  - Extensive use of information technology for online filing, real-time validation, inter-agency data exchange, and management support.
  - Modern human resource practices to incentivize high performance and reduce corruption.

### Annex: Credit Guarantee Scheme (CGS) for SMEs — guidance and key design points
- Rationale:
  - CGS can expand SME finance by mitigating credit risk and improving access and borrowing terms.
  - CGS typically requires relatively small initial public funding but exposes government to future cash outflows from realized credit losses.
- Risks:
  - Moral hazard if lenders or borrowers rely on guarantees and reduce risk assessment or engage in riskier lending/borrowing.
  - Potential for significant public contingent liabilities from public support to CGS.
- Preconditions and design features to maximize effectiveness:
  - Implement legal, regulatory, and institutional reforms to mitigate market failures, improve SME information availability, and improve debt recovery methods.
  - Define eligibility criteria for borrowers (firm size, assets, sales), lenders (risk management capacity), and credit types; prioritize new working and investment capital over refinancing.
  - Partial guarantees and loss sharing: avoid guarantees above 60 percent which risk increasing moral hazard; prefer shared-loss arrangements rather than full first-loss coverage.
  - Clear guarantee triggers and efficient claim management that incentivizes loan loss recovery prior to claim submission.
  - Risk-based guarantee fee pricing to maintain financial sustainability.
  - Adequate regulation and supervision by BCTL or a regulatory committee to monitor performance, capital adequacy, reporting, and corrective actions.
  - Governance: mixed public-private ownership to enhance transparency, knowledge, and financial base; consider equity endowments complemented by concessionary loans; clearly limit public fiscal support to minimize moral hazard.

*Source: IMF staff calculations; prepared by Daniel Zerfu Gurara (SPR).*

### 6.      The Decree-Law on Credit Guarantee Scheme for SMEs was approved in May 2017

### 6.      The Decree-Law on Credit Guarantee Scheme for SMEs was approved in May 2017

### Decree‑Law key features and implementation status
- The Decree‑Law was approved in May 2017.
- The BCTL is currently preparing regulations for implementation of the scheme.
- Key features defined in the Decree‑Law include:
  - Targeting SMEs: small enterprises employing between 6-20 workers and midsize enterprises between 21-50 workers.
  - Defining eligibility (e.g., for loans in priority areas for the diversification of the economy).
  - Limiting maximum guarantee coverage up to 70 percent.

### Staff recommendations and regulatory design guidance
- Staff encourages best practices to be reflected in the implementing regulations, including:
  - Eligibility only to new loans.
  - Clarification of the claim and recovery processes.
  - Regulatory requirement to be factored into the regulation.

### Context: firms’ access to finance in Timor‑Leste (selected findings from the informational annex)
- Financing from banks accounts for a relatively small portion of firms’ investment in Timor‑Leste.
- The proportion of SMEs with access to bank financing is low.
- A high number of firms consider credit access a key constraint, especially among small firms in Timor‑Leste.
- Firms are required to provide collateral for most loan applications.
- Collateral is valued about 2.5 times as high as underlying loans.
- The low quality of credit information can be an obstacle to SME financing.
- The Depth of Credit Information Index is measured on a 0-8 scale (Score 0-8; higher is better).

*Source: cr17360 - 6.      The Decree-Law on Credit Guarantee Scheme for SMEs was approved in May 2017*

### 3. Joint Work

### 3. Joint Work

### Relations with the Asian Development Bank (AsDB)
- Timor-Leste joined the AsDB in 2002; relationship evolved from rehabilitation and reconstruction to development of infrastructure and institutional capacity to support growth and poverty reduction.
- AsDB supports implementation of Timor-Leste’s Strategic Development Plan 2011-2030 (SDP).
- Country partnership strategy for 2016-2020 aims to support growth of a sustainable non-oil economy through targeted investments in infrastructure, human resources, and institutions for inclusive private sector-led growth.
- Timor-Leste first accessed the Asian Development Fund (ADF) in 2005; ADF provided grants for road rehabilitation, water supply, and technical and vocational education and training projects.
- AsDB technical assistance areas include:
  - Preparing Timor-Leste for ASEAN membership.
  - Developing a competitive financial sector.
  - Developing the coffee and forestry sub-sectors.
  - Establishing legal framework for bankruptcy and secured transactions.
  - Public financial management: fiscal policy analysis, governance assessment of autonomous public agencies, and design of a new value added tax.
  - Energy and water sector reforms: reviewing performance of water and electricity services and exploring institutional options to build capacity for efficient and sustainable service delivery.
- AsDB supported establishment of the Institute of Microfinance; in July 2011 it became the Banco Nacional Comércio de Timor-Leste (BNCTL), the country’s first locally owned commercial bank. AsDB supports BNCTL commercialization and growth.
- AsDB provided technical support for establishment of the Petroleum Fund and other core public sector management elements.
- Resource availability:
  - Reclassification as group B member in 2011 enabled access to market-based lending while retaining concessional window.
  - Merger of OCR and ADF balance sheets in 2016 further increased resource availability.
- Lending and allocations:
  - Since 2011, Timor-Leste borrowed US$91.86 million on concessional terms and US$135.63 million on market-based terms to finance upgrading of national roads.
  - Further lending for roads, urban water supply and electricity services planned for 2017–2019.
  - Indicative concessional lending allocation for 2018–2020 is US$74.28million.
  - Indicative OCR allocation for 2016–2018 is US$218.00 million.
  - Actual allocations depend on demand and portfolio performance.

### Statistical Issues — Assessment of Data Adequacy for Surveillance (As of October 2017)
- General:
  - Data provision to the Fund has serious shortcomings that significantly hamper surveillance.
  - Main weaknesses: national accounts — need to improve periodicity and timeliness of GDP data.
  - Enhancement of the General Directorate of Statistics within the Ministry of Planning and Finance is an ongoing priority.
- National Accounts:
  - GDP compiled using a contemporary base period (2015), but estimates are not timely.
  - Net exports in the Balance of Payments and national accounts diverge due to inconsistent classification of petroleum production in the Joint Petroleum Development Area (JPDA).
- Price Statistics:
  - Monthly national CPI uses expenditure weights from the 2011 Household Income and Expenditure Survey.
  - Data released monthly for Dili and regions other than Dili.
- Government Finance Statistics (GFS):
  - Annual and quarterly GFS compiled and disseminated.
  - Annual data for 2010−2015 reported for Government Finance Statistics Yearbook.
  - Quarterly data disseminated in the quarterly fiscal bulletin.
  - PFTAC currently providing capacity development support through a GFS resident advisor.
- Monetary and Financial Statistics:
  - Banco Central de Timor-Leste (BCTL) compiles monetary statistics generally following the Monetary and Financial Statistics Manual.
  - Data incomplete because of absence of official data on public currency holdings and of banks’ positions with public nonfinancial corporations.
  - BCTL reports detailed monthly monetary data for central bank and other depository corporations using SRFs.
  - Data for other financial corporations (mainly insurance companies) are not compiled.
  - An integrated monetary database meeting the needs of BCTL, APD, and STA is in operation.
- Financial Sector Surveillance:
  - Only basic market-based indicators available; coverage, valuation and timeliness vary.
  - Data insufficient to conduct stress tests or Balance Sheet Approach analysis.
  - Cross-border exposure data for financial corporations not available.
  - Financial soundness indicators not reported to STA.
- External Sector Statistics (ESS):
  - Progress made, but accurately measuring non-Petroleum Fund-related current account transactions remains work in progress.
  - Monthly merchandise trade data now regularly published, but significant gaps for 2006 and 2007.
  - Monthly merchandise exports and imports based on ASYCUDA.
  - Service transactions largely estimated; data collection largely limited to official and tourism sectors.
  - Interest revenue from oil/gas recorded as primary income.
  - Quarterly balance of payments and IIP data available for 2006–Q1/2017.
  - Further development needed to address limitations in merchandise trade statistics and service transactions and to ensure consistency with National Accounts, particularly for exports of commodities and imports of services.
  - Limited information on remittances from Timorese working abroad — estimation and compilation procedures should be improved.
  - October 2015 ESS TA Mission found important progress on coverage, periodicity, timeliness, and methodology, and on integrated IIP, treatment of the Petroleum Fund’s positions, and IMF-related accounts; but recommendations remain pending implementation.
  - Recommendation to improve coverage of direct investment survey to include JPDA companies’ equity valued at own funds at book value was not implemented.
  - Treatment in ESS of JPDA companies’ activities consistent with national accounts is still pending due to difficulty obtaining source data from the National Petroleum Authority (NPA).
- Data Standards and Quality:
  - Timor-Leste began participating in the IMF’s GDDS (now enhanced GDDS) in 2012.
  - No data ROSC is available.
- Reporting to STA:
  - GFS data available in the GFS Yearbook for 2015.
  - Timor-Leste does not report to the Quarterly Public Sector Debt database (QPSD).
  - Since February 2008, monetary data reported to IMF for publication in IFS.
  - Quarterly balance of payments and IIP data reported timely to STA for publication in IFS.

- Table of Common Indicators Required for Surveillance (As of October 31, 2017) — selected entries preserved exactly:
  - Exchange Rates: Date of latest observation 10/2017; Date received 10/2017; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D.
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation 09/2017; Date received 10/2017; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
  - Reserve/Base Money: 09/2017; 10/2017; M; M; M.
  - Broad Money: 09/2017; 10/2017; M; M; M.
  - Central Bank Balance Sheet: 09/2017; 10/2017; M; M; M.
  - Consolidated Balance Sheet of the Banking System: 09/2017; 10/2017; M; M; M.
  - Interest Rates: 09/2017; 10/2017; M; M; M.
  - Consumer Price Index: 08/2017; 10/2017; M; M; M.
  - Revenue, Expenditure, Balance and Composition of Financing – General Government: 2016; 10/2017; A; A; A.
  - Revenue, Expenditure, Balance and Composition of Financing – Central Government: 2016; 10/2017; A; A; A.
  - Central Government and Central Government-Guaranteed Debt: 2016; 10/2017; A; A; A.
  - External Current Account Balance: Q2/2017; 8/2017; Q; Q; Q.
  - Exports and Imports of Goods and Services: Q2/2016; 8/2016; M; M; M.
  - GDP/GNP: 2015; 04/2017; A; A; A.
  - Gross External Debt: 12/2016; 3/2017; Q; Q; Q.
  - International Investment Position: Q2/2017; 8/2017; Q; Q; Q.

### Debt Sustainability Analysis (DSA) — Summary and Key Findings
- Main DSA conclusion:
  - Timor-Leste’s external debt remains at moderate risk, reflecting projected increase in concessional borrowing to finance frontloaded infrastructure spending intended to moderate drawdown of Petroleum Fund (PF) assets.
- Net public asset position:
  - Net public asset position is strong at US$15.7 billion at end-2016 due to PF assets and low public debt.
  - PF balance at end-2016 stood at US$15.8 billion (574 percent of GDP), covering 164 months of goods and services imports.
  - PF balance has declined for two consecutive years due to large excess withdrawals over the Estimated Sustainable Income (ESI) and lower oil and gas receipts.
- Public external debt:
  - Outstanding public external debt stood at US$77 million (2.8 percent of GDP) in 2016.
  - External loans signed since 2012 to end-2016 totaled US$321 million (11.6 percent of GDP) across eleven loans under seven loan packages.
  - Loan profile: concessional loans from AsDB, JICA, World Bank Group, and a new loan from China EXIM Bank for roads and Dili’s drainage.
- Assessment of sustainability:
  - Staff’s baseline assessment suggests existing expenditure plans are unsustainable: PF will be depleted in the long term given large excess withdrawals.
  - Staff’s illustrative fiscal reform scenario demonstrates that revenue and expenditure reforms can ensure fiscal and debt sustainability.
- Policy reforms required to safeguard long-term fiscal and debt sustainability:
  - Maintain a more moderate level of public spending.
  - Reduce large front-loaded public investment in line with implementation capacity.
  - Raise investment efficiency.
  - Mobilize domestic revenues.
  - Commit to a medium-term plan to reduce PF excess withdrawals to rebuild PF assets.
- DSA methodological and scenario notes:
  - DSA prepared by IMF staff with input from World Bank Group staff using the debt sustainability framework for low-income countries approved by both Boards.
  - Macroeconomic assumptions maintain the broad assumptions from 2016 Article IV DSA; two scenarios considered: baseline and reform.
  - Key macroeconomic assumptions (preserved from table text):
    - Real GDP growth: expected to continue to fall in the medium term due to declining oil output; existing oil field estimated to cease production by around 2022. Non-oil real GDP growth expected to moderate in 2017; growth projected to hover in the range of 5-6 percent over the medium term, stabilizing at around 5¼ percent per annum in the long term.
    - Inflation (CPI): expected to increase steadily to about 4 percent over medium and long term.
    - Current account: expected to remain in deficit over the medium term; projected current account deficit larger compared to previous DSA due to higher imports and lower oil/gas receipts; lower in the long term due to slower import growth after frontloaded public investment completion.
    - Primary fiscal balance: projected to remain in deficit of about 33 percent of GDP (2017-22 average) over the medium term, gradually narrowing to about 5 percent in the long term.
    - Public sector revenue defined as non-oil domestic revenues plus the ESI from the PF; financing gap covered by PF withdrawals in excess of ESI and external borrowing.
    - Debt servicing projections based on creditor information; authorities do not have a system for estimating debt servicing payments.
    - Grant element of loans assumed to stabilize over the long term at about 32 percent after higher borrowing for frontloaded infrastructure projects is over.
    - Risk of natural disasters and climate change estimated to be very small and not incorporated in the DSA (empirical study estimated negative impact of natural disasters on real GDP growth in the range of 0.04 percent to 0.12 percent).
    - No off-budget debt is accumulated including by state-owned enterprises based on available information.
- Select numeric entries from the macroeconomic table (preserved exactly as in source):
  - Real GDP growth (%) 2016: -7.9; 2017: -8.0; 2017-22: -3.7; 2023-37: 5.2; 2015: -0.6; 2016: -8.8; 2016-21: -8.8; 2022-35: 5.0.
  - Real non-oil GDP growth (%) 2016: 5.5; 2017: 3.0; 2017-22: 5.0; 2023-37: 5.2; 2015: 4.3; 2016: 5.0; 2016-21: 5.7; 2022-35: 5.5.
  - Inflation (CPI annual average, %) 2016: -1.3; 2017: 1.0; 2017-22: 3.2; 2023-37: 4.0; 2015: 0.6; 2016: 1.5; 2016-21: 3.6; 2022-35: 4.0.
  - Revenues (% GDP) 2016: 27.5; 2017: 24.2; 2017-22: 22.3; 2023-37: 15.9; 2015: 30.9; 2016: 34.0; 2016-21: 27.9; 2022-35: 12.9.
  - Current expenditure (% GDP) 2016: 36.3; 2017: 33.4; 2017-22: 35.1; 2023-37: 23.1; 2015: 39.1; 2016: 49.3; 2016-21: 44.2; 2022-35: 24.0.
  - Net acquisition of non-financial assets (% GDP) 2016: 22.1; 2017: 10.9; 2017-22: 20.2; 2023-37: 5.4; 2015: 11.7; 2016: 17.4; 2016-21: 19.1; 2022-35: 5.0.
  - Net lending/borrowing (% GDP) 2016: -30.8; 2017: -20.1; 2017-22: -33.3; 2023-37: -12.9; 2015: -20.3; 2016: -32.7; 2016-21: -35.3; 2022-35: -16.0.
  - Net incurrence of liabilities (% GDP) 2016: 1.1; 2017: 0.4; 2017-22: 5.0; 2023-37: 2.1; 2015: 0.9; 2016: 5.1; 2016-21: 7.3; 2022-35: 0.7.
  - Borrowing (in millions of USD, period average) 2016: 30.6; 2017: 10.0; 2017-22: 154.2; 2023-37: 191.0; 2015: 23.8; 2016: 107.0; 2016-21: 195.6; 2022-35: 37.1.
  - Exports of G&S (y/y growth) 2016: 5.7; 2017: -1.6; 2017-22: 14.6; 2023-37: 20.8; 2015: -2.6; 2016: 15.2; 2016-21: 14.4; 2022-35: 12.0.
  - Imports of G&S (y/y growth) 2016: -11.1; 2017: -0.2; 2017-22: 6.1; 2023-37: 6.1; 2015: -3.4; 2016: 9.5; 2016-21: 5.7; 2022-35: 6.9.
  - Current account balance (% GDP) 2016: -18.9; 2017: -3.4; 2017-22: -15.9; 2023-37: -4.1; 2015: 16.5; 2016: 2.0; 2016-21: -9.0; 2022-35: -15.8.

_International Monetary Fund — cr17360: "3. Joint Work" (extracted content)_

### 4. Under the baseline, projected capital expenditure is lower than planned reflecting past

### 4. Under the baseline, projected capital expenditure is lower than planned reflecting past

### Baseline assumptions and fiscal projections
- A 70 percent implementation rate is assumed for the planned $4.3 billion multi-year (2018-21) capital spending envisaged under the 2017 Budget.
- The current total capital spending plan is about US$0.9 billion higher than that of the 2016 Budget reflected in the previous DSA.
- Domestic revenue to GDP ratio is expected to rise gradually in the absence of VAT implementation:
  - from 6 percent in 2017 to 8 percent in the medium term and 16 percent in the long run.
  - Increases are assumed to be driven by increased compliance and a broadening tax base.
- The ESI in nominal terms will decline due to a progressively lower PF balance under the baseline scenario.
- Total withdrawals from the PF are capped at US$1.3 billion per annum beyond the medium term.
  - This cap is broadly in line with the notional budget envelope proposed during the 2014 Yellow Road Workshop discussions of domestic stakeholders.
  - PF balance projections under the baseline:
    - US$12 billion in 2022 (340 percent of GDP).
    - US$640 million (3½ percent of GDP) by 2037.
- External borrowing projections:
  - Medium term (2017–22) external borrowing projected to total US$0.9 billion, assuming about 70 percent of planned borrowing disbursed.
  - This is lower than the previous DSA projection of US$1.1 billion.
  - Total external borrowing in the DSA horizon (2017–37) projected at US$ 3.8 billion.
  - Outstanding external debt projected to increase from 2.8 percent of GDP in 2016 to 28 percent in 2022.

- Key macroeconomic assumptions (selected figures from Table 2):
  - Real GDP growth (%): 2016 Est. -7.9; 2017 Proj. -8.0; 2017-22 Baseline -3.7; 2023-37 Baseline 5.2.
  - Real non-oil GDP growth (%): 2016 Est. 5.5; 2017 Proj. 3.0; 2017-22 Baseline 5.0; 2023-37 Baseline 5.2.
  - Inflation (CPI annual average, %): 2016 Est. -1.3; 2017 Proj. 1.0; 2017-22 Baseline 3.2; 2023-37 Baseline 4.0.
  - Revenues (% GDP): 2016 Est. 27.5; 2017 Proj. 24.2; 2017-22 Baseline 22.3; 2023-37 Baseline 15.9.
  - Current expenditure (% GDP): 2016 Est. 36.3; 2017 Proj. 33.3; 2017-22 Baseline 35.1; 2023-37 Baseline 23.1.
  - Net acquisition of non-financial assets (% GDP): 2016 Est. 22.1; 2017 Proj. 10.9; 2017-22 Baseline 20.2; 2023-37 Baseline 5.4.
  - Net lending/borrowing (% GDP): 2016 Est. -30.8; 2017 Proj. -20.1; 2017-22 Baseline -33.3; 2023-37 Baseline -12.9.
  - Net incurrence of liabilities (% GDP): 2016 Est. 1.1; 2017 Proj. 0.4; 2017-22 Baseline 5.0; 2023-37 Baseline 2.1.
  - Borrowing (in millions of USD, period average): 2016 Est. 30.6; 2017 Proj. 10.0; 2017-22 Baseline 154.2; 2023-37 Baseline 191.0.
  - Current account balance (% GDP): 2016 Est. -18.9; 2017 Proj. -3.4; 2017-22 Baseline -15.9; 2023-37 Baseline -4.1.

### Reform scenario: three-pronged strategy and impacts
- Main elements of the staff’s reform scenario:
  - More moderate levels of spending:
    - Capital spending averaged at 14½ percent of GDP in the medium term and anchored at 10 percent of GDP in the long term, supported by an expenditure rule.
    - Recurrent spending reduced to 22 percent of GDP in the medium term, from 36 percent of GDP in 2016, largely through lowering public transfers, and goods and services expenditure, while preserving pro-poor social spending.
  - Domestic revenue mobilization:
    - To reach the government’s domestic revenue target of 15 percent of non-oil GDP, a value-added tax (VAT) would need to be implemented by 2020.
    - VAT estimated to generate about 3¾ percent of GDP based on a VAT rate of 7.5 percent (tentative) in the medium term.
    - VAT revenue should increase to at least 5 percent of GDP in the long term.
  - A commitment plan to stop PF excess withdrawal:
    - Beyond capping PF withdrawals at US$1.3 billion over the medium term, PF withdrawals in excess of the ESI should cease from 2028 to rebuild the PF balance.
    - The resulting financing gap could be met by external borrowing.

- Fiscal and debt outcomes under the reform scenario:
  - PF balance projections:
    - PF balance increasing to about US$15.6 billion (468 percent of GDP) in 2022.
    - Stabilizing at US$17.7 billion (93 percent of GDP) in 2037.
  - External borrowing:
    - Total external borrowing projected at US$0.9 billion in the medium term (2017–22), similar to the baseline.
    - US$2.3 billion over 2017-37 under the reform scenario (lower than baseline).
  - Outstanding external debt:
    - Expected to rise to 36 percent of GDP in the medium term but decline to 11½ percent of GDP in the long term.

### Debt sustainability assessment and stress tests
- Overall assessment:
  - Timor-Leste’s risk of debt distress is moderate due to projected higher external borrowing.
  - The baseline scenario does not breach any DSA thresholds, but stress tests breach all thresholds.
- Medium-term external debt indicators (baseline reflective summary):
  - Present value of external debt projected to reach 20 percent of GDP, 86 percent of exports, and 142 percent of revenues over the medium term.
- Stress tests:
  - Include shocks to real GDP growth, exports, non-debt creating flows, and combinations.
  - The most severe shock scenarios result in breaches for all indicators.
  - High vulnerability to shocks driven by very small exports and revenue bases and exposure to debt service payment risks if positive asset position is not considered.

### Debt management, institutional capacity, and contingent liabilities
- Recommendations to accompany increased external borrowing:
  - Develop institutional framework and debt management policies and procedures and undertake capacity building.
  - Improve comprehensive debt servicing projections for existing debt in the near term.
  - World Bank TA recommendations (summarized):
    - Adoption of simple debt recording and management systems.
    - Strengthening the organization and capacity of the debt management unit.
    - Preparation of guidelines on the terms and conditions for external borrowing.
    - Preparation of a medium-term debt management strategy including cost-risk analysis.
- Risks and safeguards:
  - Increased use of concessional financing and PPPs will increase complexity of the consolidated government balance sheet and contingent liabilities.
  - PPPs should be undertaken with realistic and transparent project assessments to reduce contingent liabilities; off-balance sheet activities should be avoided.
  - State-owned companies (e.g., Timor GAP) undertaking equity positions or issuing liabilities in overseas markets increases risk.
  - Further fiscal autonomy of ZEESM could raise risks of off-budget expenditures and external debt contracting.
  - Provisions allowing the PF to guarantee government debts (up to 10 percent of the PF’s assets) are potentially risky and should be avoided.

### Authorities’ views and conclusion
- Authorities’ views:
  - Authorities consider the risk of debt distress to be contained despite higher borrowing.
  - Authorities broadly agree on the need for bold fiscal consolidation measures but emphasize accounting for the PF buffer.
- Conclusion:
  - Timor-Leste remains at moderate risk of debt distress driven by projected higher external borrowing.
  - Greater use of concessional financing reflects frontloaded infrastructure spending and strategy to preserve PF wealth.
  - Meeting the financing gap through external loans is warranted if borrowing cost is lower than the opportunity cost of tapping the PF (as measured by the PF’s expected investment return).
  - Non-concessional debt should be avoided.
  - Discipline of debt sustainability monitoring by creditors may accompany transfer of knowledge from multilateral or bilateral institutions.

*cr17360 - 4. Under the baseline, projected capital expenditure is lower than planned reflecting past*

### 13. Fiscal reforms are needed to safeguard long-term fiscal and debt sustainability. These

### 13. Fiscal reforms are needed to safeguard long-term fiscal and debt sustainability. These

### Fiscal reform priorities
- Adopt a more moderate pace of capital spending in line with implementation capacity.
- Rationalize recurrent spending.
- Mobilize domestic revenues.
- Commit to a medium-term plan to preserve the PF assets wealth as an ongoing revenue source and as a fiscal buffer to mitigate shocks.
- Prioritize government expenditure to facilitate high-return infrastructure investments to ensure medium- to long-term fiscal and debt sustainability.

### Debt indicators and scenario framework (high-level)
- Figures present indicators of Public and Publicly Guaranteed (PPG) External Debt under alternative scenarios, 2017-2037, including:
  - Baseline, Historical scenario, Most extreme shock, Threshold, Reform scenario.
- The most extreme stress test is defined as the test that yields the highest ratio on or before 2027; specific correspondences are noted across subfigures (Combination shock, Exports shock, GDP deflator shock).
- Under the historical scenario, debt-to-GDP ratio is negative after 2018 due to large current account surpluses; net debt-creating dynamics assume historical average of non-interest current account balances, which do not reflect declining oil production in future.

### Key quantitative findings and projections (selected exact figures from tables)
- External debt (nominal) PPG:
  - 2017: 3.1 (percent of GDP)
  - 2018: 10.6
  - 2019: 17.8
  - 2020: 24.3
  - 2021: 27.6
  - 2022: 28.3
  - 2017-22 Average: 25.3
  - 2027: 21.4
- Change in external debt (selected):
  - 2017: 0.4
  - 2018: 7.4
  - 2019: 7.2
  - 2020: 6.5
  - 2021: 3.3
  - 2022: 0.7
  - 2017-22 Average: -0.9
- Identified net debt-creating flows (selected):
  - 2017: 2.3
  - 2018: 13.4
  - 2019: 15.7
  - 2020: 15.1
  - 2021: 14.0
  - 2022: 14.3
  - 2017-22 Average: 3.1
- Non-interest current account deficit (selected):
  - 2017: -31.5 (percent of GDP)
  - 2018: 21.2
  - 2019: 3.4
  - 2020: 18.1
  - 2021: 19.1
  - 2022: 18.5
  - 2017-22 Average: 17.4
  - Stabilizing non-interest current account deficit: 3.1 (2017), 10.7 (2018), 11.9 (2019), 12.1 (2020), 14.0 (2021), 16.5 (2022)
- PV of external debt (selected):
  - 2017: 1.4 (percent of GDP)
  - 2018: 1.6
  - 2019: 6.7
  - 2020: 11.7
  - 2021: 16.2
  - 2022: 18.7
  - 2017-22 Average: 19.5
  - 2027: 18.2
  - 2037: 15.4
- PV of PPG external debt in percent of exports (selected):
  - 2017: 5.7
  - 2018: 4.2
  - 2019: 23.7
  - 2020: 43.0
  - 2021: 68.2
  - 2022: 83.0
  - 2017-22 Average: 86.3
  - 2027: 88.2
  - 2037: 80.4
- PPG debt service-to-revenue ratio (selected):
  - 2017: 0.0 (percent)
  - 2018: 0.5
  - 2019: 1.0
  - 2020: 1.9
  - 2021: 3.0
  - 2022: 4.0
  - 2017-22 Average: 4.6
  - 2027: 11.1
  - 2037: 8.9
- Total gross financing need (Billions of U.S. dollars) (selected):
  - 2017: -1.1
  - 2018: -0.3
  - 2019: 0.5
  - 2020: 0.1
  - 2021: 0.4
  - 2022: 0.5
  - 2017-22 Average: 0.4
- Key macroeconomic assumptions (selected exact values):
  - Real GDP growth (percent):
    - 2014: -26.0
    - 2015: 20.9
    - 2016: -7.9
    - 2017: 0.4
    - 2018: 13.5
    - 2019: -8.0
    - 2020: -0.7
    - 2021: -4.7
    - 2022: -3.7
    - 2017-22 Average: -2.6
    - 2027: -2.6
    - 2037: -3.7
    - Projections beyond: 5.2, 5.2, 5.2 (repeated)
  - GDP deflator in US dollar terms (change in percent):
    - 2014: -3.2
    - 2015: -36.5
    - 2016: -3.3
    - 2017: 3.3
    - 2018: 22.6
    - 2019: 8.8
    - 2020: 4.9
    - 2021: 8.0
    - 2022: 8.4
    - 2017-22 Average: 8.7
    - 2027: 11.1
    - 2037: 8.3
    - Projections beyond: 6.0, 6.0, 6.0
  - Effective interest rate (percent):
    - 2014–2017: 0.0
    - 2018: 0.0
    - 2019: 0.1
    - 2020: 0.3
    - 2021: 0.4
    - 2022: 0.5
    - 2017-22 Average: 0.5
    - 2027: 0.5
    - 2037: 0.5
  - Growth of exports of G&S (US dollar terms, percent):
    - 2014: -34.3
    - 2015: -37.4
    - 2016: -52.7
    - 2017: 10.5
    - 2018: 52.4
    - 2019: 60.4
    - 2020: -23.6
    - 2021: -0.9
    - 2022: -8.5
    - 2017-22 Average: 0.6
    - 2027: 8.4
    - 2037: 6.1
    - Projections beyond: 10.9, 11.7, 10.3
  - Government revenues (excluding grants, percent of GDP):
    - 2014: 13.1
    - 2015: 18.9
    - 2016: 21.4
    - 2017: 18.5
    - 2018: 18.8
    - 2019: 17.8
    - 2020: 16.4
    - 2021: 14.9
    - 2022: 13.7
    - 2017-22 Average: 9.7
    - 2027: 12.1
    - 2037: 10.7
- Grant-equivalent financing (in percent of GDP) (selected):
  - 2019: 5.8
  - 2020: 8.0
  - 2021: 8.0
  - 2022: 7.9
  - 2027: 6.0
- Memorandum items:
  - Nominal GDP (Billions of US dollars):
    - 2014: 4.0
    - 2015: 3.1
    - 2016: 2.8
    - 2017: 2.8
    - 2018: 2.9
    - 2019: 3.0
    - 2020: 3.1
    - 2021: 3.3
    - 2022: 3.5
    - 2017-22 Average: 6.1
    - 2027: 18.1
  - PV of PPG external debt (Billions of US dollars): 0.0 (2014), 0.0 (2015), 0.2 (2016), 0.3 (2017), 0.5 (2018), 0.6 (2019), 0.7 (2020), 1.1 (2021), 2.8 (2022)

### Public sector debt sustainability (selected exact figures)
- Public sector debt (percent of GDP):
  - 2014: 0.5
  - 2015: 1.5
  - 2016: 2.8
  - 2017: 3.1
  - 2018: 10.6
  - 2019: 17.8
  - 2020: 24.3
  - 2021: 27.6
  - 2022: 28.3
  - 2017-22 Average: 25.3
  - 2027: 21.4
  - 2037: 21.4
- Identified debt-creating flows (percent of GDP):
  - Primary deficit (selected): 2017: 15.6; 2018: 9.1; 2019: 25.7; 2020: 46.2; 2021: 50.1; 2022: 41.5
  - Revenue and grants (percent of GDP, selected): 2017: 24.2; 2018: 24.4; 2019: 23.4; 2020: 22.0; 2021: 20.5; 2022: 19.3
  - Primary (noninterest) expenditure (percent of GDP, selected): 2017: 49.9; 2018: 70.6; 2019: 73.5; 2020: 63.4; 2021: 57.3; 2022: 50.3
- Residual, including asset changes (percent of GDP, selected):
  - 2017: -25.4
  - 2018: -38.7
  - 2019: -42.9
  - 2020: -34.7
  - 2021: -32.6
  - 2022: -28.8
- Gross financing need (percent of GDP, selected):
  - 2017: 25.8
  - 2018: 46.3
  - 2019: 50.5
  - 2020: 42.0
  - 2021: 37.4
  - 2022: 31.7
  - 2017-22 Average: 22.6
  - 2027: 10.5

### Sensitivity analysis (overview)
- Table 1b and Table 2b present sensitivity analyses for PV of debt-to-GDP ratio, PV of debt-to-exports ratio, PV of debt-to-revenue ratio, debt service-to-exports ratio, and debt service-to-revenue ratio across multiple alternative scenarios and bound tests for 2017-2037.
- Scenarios reported include:
  - A1. Key variables at their historical averages in 2017-2037.
  - A2. New public sector loans on less favorable terms in 2017-2037 (assumes interest rate on new borrowing is 2 percentage points higher than baseline).
  - Bound tests B1–B6: shocks to real GDP growth, export value growth, US dollar GDP deflator, net non-debt creating flows, combination shocks, and a one-time 30 percent nominal depreciation in 2018.
- Memorandum item: Grant element assumed on residual financing: 30 (applies to stress scenarios except A2).

*Sources: Country authorities; and staff estimates and projections.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17360.pdf_