## HOW HAS DOLLARIZATION SERVED TIMOR-LESTE SO FAR?

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### Introduction
- Timor-Leste has exclusively used the US dollar since January 2000.
- US dollar banknotes circulate for cash transactions; the Banco Central de Timor-Leste (BCTL) issues centavo coins for local circulation.
- One centavo equals one US cent; coins are issued in denominations up to 200 centavos.
- The total stock of centavo coins in circulation was $31 million (around 2 percent of non-oil GDP) at end-2023.
- General tradeoffs of full dollarization:
  - Pros: helps stabilize prices and reduce inflationary pressures by using the US nominal anchor; reduces currency risks.
  - Cons: central bank cannot set domestic monetary policy when the capital account is open; effective exchange rate determined by global strength of the US dollar; forfeiture of potential seigniorage revenue.
- Literature context: Koráb, Fidrmuc, and Dibooglu (2023) meta-analysis across 43 studies suggests full dollarization tends to raise output volatility and reduce growth, but tends to yield lower inflation.

### Growth and inflation
- Scope: benchmark Timor-Leste against peer groups (EMDE, ASEAN) and other post-conflict economies; evaluate level and volatility of growth and inflation.
- Findings on growth:
  - Timor-Leste outperformed the average cumulative growth trajectory of 29 post-conflict economies by the early 2010s, with growth pickup starting in 2007.
  - Public spending rose rapidly, reaching close to 80 percent of non-oil GDP by 2010 (from around 50 percent in early 2000).
  - Non-oil GDP growth outturn was 2.3 percent in 2023.
  - The 2013 Article IV had envisaged non-oil GDP growth to remain above 8 percent in the medium term; that did not materialize.
  - Fiscal multiplier estimated at around 0.1 - 0.2, reflecting low quality and high import content of public expenditure (IMF 2024).
  - Growth in non-oil GDP per-capita in Timor-Leste averaged 1.2 percent during 2002-23, similar to 1 percent for a medium EMDE with a fixed exchange rate.
  - Per-capita growth was significantly lower than several Asian peers (e.g., Cambodia, Laos, Myanmar) that started with similar income levels in 2000.
- Findings on inflation:
  - Headline inflation, averaged over the past two decades, was 4.9 percent in Timor-Leste.
  - Comparative averages: other post-conflict countries 5.5 percent; EMDEs 5.1 percent; ASEAN economies 4.6 percent; EMDEs with fixed exchange rates 2.4 percent.
  - Inflation was highly volatile until about mid-2010 and influenced by global food prices; volatility fell considerably in the past decade.
  - The standard deviation of inflation in early period was 4.5 percent, which is 1 percentage point higher than in EMDEs and 2 percentage points higher than in EMDEs with fixed exchange rates.
  - Conclusion: under dollarization, Timor-Leste has achieved relatively low and stable inflation in the last decade.

### Business and financial cycle synchronization
- Rationale: synchronization determines whether US monetary policy is appropriate for Timor-Leste; synchronization arises from common shocks and trade/financial linkages.
- Key findings:
  - Correlation of Timor-Leste real GDP growth (2002-23) with the United States is -0.1.
  - US share of Timor-Leste total trade by value: 4 percent in 2023 (down from 10 percent in 2003).
  - By comparison, other dollarized economies (Ecuador, El Salvador, Panama) have US trade shares between 15 and 40 percent.
  - ASEAN’s share of Timorese total trade increased from 25 percent in 2003 to around 40 percent in 2023.
  - Growth correlations between Timor-Leste and ASEAN neighbors can be as high as 0.6 (with Indonesia).
- Transmission channels of US monetary policy:
  - Correlation of changes in the Fed Funds rate with domestic loan rate = 0.05 over December 2002 to December 2023.
  - Correlation of changes in the Fed Funds rate with domestic deposit rate = 0.04 over the same period.
  - Timor-Leste’s interest rates offered by local banks exhibit very low correlations with US interest rates, especially in the last five years.
- Structural reasons for weak interest-rate transmission:
  - Domestic structural bottlenecks in deposit and lending practices.
  - Severely underdeveloped capital markets (no tradable government or private debt securities; no local stock exchange).
- Implication: US monetary conditions are unlikely to be appropriate for Timor-Leste given weak synchronization and limited trade linkages with the US; growing ASEAN linkages would likely raise the costs of dollarization.

### Adjustment to external shocks
- Concept: flexible exchange rates can cushion shocks by adjusting relative prices when wages/prices are sticky; dollarization limits this channel and shifts adjustment burden to domestic prices/wages and fiscal policy.
- Petroleum Fund (PF) and fiscal rule as buffers:
  - Stock of savings in the PF averaged around 1,000 percent of non-oil GDP in the last ten years.
  - Withdrawals are governed by Timor-Leste’s fiscal rule based on an Estimated Sustainable Income (ESI) — 3 percent of total petroleum wealth (sum of the Petroleum Fund balance and the net present value of expected future petroleum revenue).
  - Withdrawals in excess of the ESI require Parliament approval.
  - Small share of fuel in CPI basket (a subcomponent of the ‘housing’ category), which is 6.3 percent, limits direct pass-through from fuel price swings to CPI.
- Event-study: 2014 global oil price fall (comparison with Colombia and Ecuador):
  - Ecuador experienced contraction of domestic demand and per-capita income over the subsequent three years.
  - Colombia and Timor-Leste delivered rising per-capita income after the shock.
  - Colombia: REER depreciated driven by nominal depreciation of the peso versus the US dollar, supporting net exports and domestic demand.
  - Ecuador and Timor-Leste: REER appreciated as trading partners depreciated nominally against the US dollar, limiting external adjustment and worsening real impact.
  - Fiscal response in Ecuador was pro-cyclical with sharp expenditure contraction in 2015 due to limited buffers/options.
  - Colombia and Timor-Leste applied countercyclical fiscal responses; Timor-Leste’s response included very large fiscal expansion involving excess withdrawals from PF buffers well above the ESI.
- Broader fiscal behavior:
  - Correlation between cyclical components of global oil prices and public spending in Timor-Leste over the last two decades is weak (around 0.2), suggesting an acyclical fiscal policy consistent with fiscal rule design.
  - Excess withdrawals from the PF have been common since early 2010s, generating large fiscal and external imbalances and limited growth payoff given low-efficiency public spending, but they have not been systematically procyclical with oil prices and have not been cyclical destabilizers.

### Competitiveness: evolution, drivers, and constraints
- Dollarization ties the effective exchange rate to the global strength of the US dollar; appreciation of the US dollar or relative movements of trading partners’ currencies can affect Timor-Leste’s REER and competitiveness.
- Impact of recent US dollar strength and external shocks:
  - Federal Reserve hiked interest rates aggressively by 450 basis points starting in March 2022.
  - Recent global dollar strength was the main factor behind a 15-percent appreciation of Timor-Leste’s real effective exchange rate between 2021 and 2023.
  - Over the past decade the REER in Timor-Leste has experienced a sustained appreciation of about 30 percent.
  - The oil price shock of 2014 was transitory and prices have since recovered, yet the large appreciation of the REER did not meaningfully subside, indicating a degree of downward nominal rigidity.
  - The REER appreciated further when the currencies of Timor-Leste’s trading partners depreciated against the dollar amid higher-for-longer US interest rates after 2022.
  - Fund estimates suggest that the REER has become increasingly overvalued, likely weighing on diversification and development of the non-oil economy.
  - REER overvaluation likely constrained tourism—the main services export—with tourism arrivals remaining well below their pre-pandemic levels.
  - Overvaluation may also be undermining development of new export products and of the non-oil economy by making imports relatively more affordable than locally-produced goods.
- Structural bottlenecks undermining competitiveness:
  - High costs of goods and services reflecting a small market and low economies of scale (Freedman 2020).
  - Low productivity in the non-oil economy, notably in agriculture.
  - Tourism constrained by poor infrastructure and low business and hospitality skills in the workforce.
  - Labor market constrained by the lack of a skilled work force.
  - Large current account deficits that mirror REER overvaluation reflect large fiscal imbalances and an underdeveloped export sector.
- Policy implication: Improving performance and reducing imbalances under dollarization calls for resolving fiscal imbalances and advancing reforms that address structural bottlenecks.
- Caveat: Absent these reforms, moving away from dollarization would not be sufficient to durably overcome deep competitiveness issues and lack of diversification.

### Conclusion and policy recommendations
- Summary assessment:
  - Dollarization has helped Timor-Leste achieve relatively low and stable inflation in the context of post-conflict fragility.
  - Timor-Leste has achieved relatively good performance in terms of growth and price stability compared to other post-conflict states.
  - The non-oil economy has significantly underperformed versus expectations and has stagnated in recent years.
  - The severe overvaluation of the REER following a series of external shocks in the past ten years may be a contributing factor alongside structural bottlenecks constraining private sector development.
  - As trade is increasingly oriented towards ASEAN and with oil production having come to an end, the cyclical drivers of the Timorese economy will be increasingly unrelated to the United States, raising the costs of dollarization.
- Recommendations:
  - Reduce fiscal imbalances.
  - Advance reforms addressing structural bottlenecks facing the private sector.
  - Build technical capacity at the central bank.
  - Improve the regulatory and legal framework for the financial system.
  - These measures should be seen as important to strengthen economic performance under dollarization and as pre-requisites before consideration is given to the introduction of a national currency (IMF 2022).

*International Monetary Fund — Democratic Republic of Timor-Leste (excerpts).*

### References ____________________________________________________________________________ 15

### HOW HAS DOLLARIZATION SERVED TIMOR-LESTE SO FAR?

### Introduction
- Timor-Leste has exclusively used the US dollar since January 2000. US dollar banknotes circulate for cash transactions; the Banco Central de Timor-Leste (BCTL) issues centavo coins for local circulation.
- One centavo equals one US cent; coins are issued in denominations up to 200 centavos. The total stock of centavo coins in circulation was $31 million (around 2 percent of non-oil GDP) at end-2023.
- General tradeoffs of full dollarization noted:
  - Pros: helps stabilize prices and reduce inflationary pressures by using the US nominal anchor; reduces currency risks.
  - Cons: central bank cannot set domestic monetary policy when the capital account is open; effective exchange rate determined by global strength of the US dollar; forfeiture of potential seigniorage revenue.
- Literature context: Koráb, Fidrmuc, and Dibooglu (2023) meta-analysis across 43 studies suggests full dollarization tends to raise output volatility and reduce growth, but tends to yield lower inflation.

### Growth and inflation
- Scope: benchmark Timor-Leste against peer groups (EMDE, ASEAN) and other post-conflict economies; evaluate level and volatility of growth and inflation.
Findings on growth:
- Timor-Leste outperformed the average cumulative growth trajectory of 29 post-conflict economies by the early 2010s, with growth pickup starting in 2007.
- Public spending rose rapidly, reaching close to 80 percent of non-oil GDP by 2010 (from around 50 percent in early 2000).
- Non-oil GDP growth outturn was 2.3 percent in 2023.
- The 2013 Article IV had envisaged non-oil GDP growth to remain above 8 percent in the medium term; that did not materialize.
- Fiscal multiplier estimated at around 0.1 - 0.2, reflecting low quality and high import content of public expenditure (IMF 2024).
- Growth in non-oil GDP per-capita in Timor-Leste averaged 1.2 percent during 2002-23, similar to 1 percent for a medium EMDE with a fixed exchange rate.
- Per-capita growth was significantly lower than several Asian peers (e.g., Cambodia, Laos, Myanmar) that started with similar income levels in 2000.
Findings on inflation:
- Headline inflation, averaged over the past two decades, was 4.9 percent in Timor-Leste.
- Comparisons: other post-conflict countries 5.5 percent; EMDEs 5.1 percent; ASEAN economies 4.6 percent; EMDEs with fixed exchange rates 2.4 percent.
- Inflation was highly volatile until about mid-2010 and influenced by global food prices; volatility fell considerably in the past decade.
- The standard deviation of inflation in early period was 4.5 percent, which is 1 percentage point higher than in EMDEs and 2 percentage points higher than in EMDEs with fixed exchange rates.
- Conclusion: under dollarization, Timor-Leste has achieved relatively low and stable inflation in the last decade.

### Business and financial cycle synchronization
- Rationale: synchronization determines whether US monetary policy is appropriate for Timor-Leste; synchronization arises from common shocks and trade/financial linkages.
Key findings:
- Correlation of Timor-Leste real GDP growth (2002-23) with the United States is -0.1.
- US share of Timor-Leste total trade by value: 4 percent in 2023 (down from 10 percent in 2003).
- By comparison, other dollarized economies (Ecuador, El Salvador, Panama) have US trade shares between 15 and 40 percent.
- ASEAN’s share of Timorese total trade increased from 25 percent in 2003 to around 40 percent in 2023.
- Growth correlations between Timor-Leste and ASEAN neighbors can be as high as 0.6 (with Indonesia).
- Transmission channels of US monetary policy:
  - Deposit and lending rate correlations with changes in the Fed Funds rate over December 2002 to December 2023 are low: correlation of the change in the Fed Funds rate with domestic loan rate = 0.05; with domestic deposit rate = 0.04.
  - Timor-Leste’s interest rates offered by local banks exhibit very low correlations with US interest rates, especially in the last five years.
- Structural reasons for weak interest-rate transmission: domestic structural bottlenecks in deposit and lending practices; severely underdeveloped capital markets (no tradable government or private debt securities; no local stock exchange).
- Implication: US monetary conditions are unlikely to be appropriate for Timor-Leste given weak synchronization and limited trade linkages with the US; growing ASEAN linkages would likely raise the costs of dollarization.

### Adjustment to external shocks
- Concept: flexible exchange rates can cushion shocks by adjusting relative prices when wages/prices are sticky; dollarization limits this channel and shifts adjustment burden to domestic prices/wages and fiscal policy.
- Petroleum Fund (PF) and fiscal rule as buffers:
  - Stock of savings in the PF averaged around 1,000 percent of non-oil GDP in the last ten years.
  - Withdrawals are governed by Timor-Leste’s fiscal rule based on an Estimated Sustainable Income (ESI) — 3 percent of total petroleum wealth (sum of the Petroleum Fund balance and the net present value of expected future petroleum revenue). Withdrawals in excess of the ESI require Parliament approval.
  - Small share of fuel in CPI basket (a subcomponent of the ‘housing’ category), which is 6.3 percent, limits direct pass-through from fuel price swings to CPI.
Event-study: 2014 global oil price fall (comparison with Colombia and Ecuador)
- Outcomes:
  - Ecuador experienced contraction of domestic demand and per-capita income over the subsequent three years.
  - Colombia and Timor-Leste delivered rising per-capita income after the shock.
- Mechanisms:
  - Colombia: REER depreciated driven by nominal depreciation of the peso versus the US dollar, supporting net exports and domestic demand.
  - Ecuador and Timor-Leste: REER appreciated as trading partners depreciated nominally against the US dollar, limiting external adjustment and worsening real impact.
  - Fiscal response in Ecuador was pro-cyclical with sharp expenditure contraction in 2015 due to limited buffers/options.
  - Colombia and Timor-Leste applied countercyclical fiscal responses; Timor-Leste’s response included very large fiscal expansion involving excess withdrawals from PF buffers well above the ESI.
- Broader fiscal behavior:
  - Correlation between cyclical components of global oil prices and public spending in Timor-Leste over the last two decades is weak (around 0.2), suggesting an acyclical fiscal policy consistent with fiscal rule design.
  - Excess withdrawals from the PF have been common since early 2010s, generating large fiscal and external imbalances and limited growth payoff given low-efficiency public spending, but they have not been systematically procyclical with oil prices and have not been cyclical destabilizers.

### Competitiveness (implications distilled)
- Dollarization ties the effective exchange rate to the global strength of the US dollar; appreciation of the US dollar or relative movements of trading partners’ currencies can affect Timor-Leste’s REER and competitiveness.
- Growing trade integration with ASEAN (from 25 percent to around 40 percent of trade between 2003 and 2023) and higher growth synchronization with ASEAN imply that exchange rate developments tied to ASEAN partners (often flexible versus the US dollar) can raise the economic costs of remaining dollarized.
- Restoring and improving competitiveness under dollarization requires:
  - Reduced fiscal imbalances, including adherence to the fiscal rule to limit excess withdrawals that erode PF buffers.
  - Advancement of reforms to address structural bottlenecks that impede private sector development and undermine the effectiveness of public spending.

*Italic: Source — IMF staff report extract, “HOW HAS DOLLARIZATION SERVED TIMOR-LESTE SO FAR?”*

### 18.      To further delineate the impact of external shocks on Timor-Leste’s exchange rate, we

### 18.      To further delineate the impact of external shocks on Timor-Leste’s exchange rate, we

### Impact of US dollar strength and external shocks
- After the Federal Reserve hiked interest rates aggressively by 450 basis points starting in March 2022, the US dollar appreciated substantially against most global currencies.
- The recent global dollar strength was the main factor behind a 15-percent appreciation of Timor-Leste’s real effective exchange rate between 2021 and 2023.
- As a dollarized regime, Timor-Leste’s REER has strengthened in tandem with the strength of the US dollar, with implications for competitiveness.

### Competitiveness: recent evolution and drivers
- Over the past decade the REER in Timor-Leste has experienced a sustained appreciation of about 30 percent.
- The oil price shock of 2014 was transitory and prices have since recovered, yet the large appreciation of the REER did not meaningfully subside, indicating a degree of downward nominal rigidity.
- The REER appreciated further when the currencies of Timor-Leste’s trading partners depreciated against the dollar amid higher-for-longer US interest rates after 2022.
- Fund estimates suggest that the REER has become increasingly overvalued, likely weighing on diversification and development of the non-oil economy.
- REER overvaluation likely constrained tourism—the main services export—with tourism arrivals remaining well below their pre-pandemic levels.
- Overvaluation may also be undermining development of new export products and of the non-oil economy by making imports relatively more affordable than locally-produced goods.

### Structural bottlenecks undermining competitiveness
- Dollarization imposes constraints on nominal adjustment, preventing a nominal exchange rate depreciation that could compensate for imbalances.
- Additional structural impediments include:
  - High costs of goods and services reflecting a small market and low economies of scale (Freedman 2020).
  - Low productivity in the non-oil economy, notably in agriculture.
  - Tourism constrained by poor infrastructure and low business and hospitality skills in the workforce.
  - Labor market constrained by the lack of a skilled work force.
- Large current account deficits that mirror REER overvaluation reflect large fiscal imbalances and an underdeveloped export sector.
- Policy implication: Improving performance and reducing imbalances under dollarization calls for resolving fiscal imbalances and advancing reforms that address structural bottlenecks.
- Caveat: Absent these reforms, moving away from dollarization would not be sufficient to durably overcome deep competitiveness issues and lack of diversification.

### Conclusion and policy recommendations
- Dollarization has helped Timor-Leste achieve relatively low and stable inflation in the context of post-conflict fragility, and Timor-Leste has achieved relatively good performance in terms of growth and price stability compared to other post-conflict states.
- However, the non-oil economy has significantly underperformed versus expectations and has stagnated in recent years.
- The severe overvaluation of the REER following a series of external shocks in the past ten years may be a contributing factor alongside structural bottlenecks constraining private sector development.
- As trade is increasingly oriented towards ASEAN and with oil production having come to an end, the cyclical drivers of the Timorese economy will be increasingly unrelated to the United States, raising the costs of dollarization.
- Recommendations:
  - Reduce fiscal imbalances.
  - Advance reforms addressing structural bottlenecks facing the private sector.
  - Build technical capacity at the central bank.
  - Improve the regulatory and legal framework for the financial system.
- These measures should be seen as important to strengthen economic performance under dollarization and as pre-requisites before consideration is given to the introduction of a national currency (IMF 2022).

### Annex I — Data description and additional results (selected points)
- Cross-country data sources and coverage:
  - GDP, per-capita GDP, and government expenditure from the IMF’s World Economic Outlook (WEO) Database.
  - NEER, REER, CPI, and exchange rate data from the IMF’s Information Notice System.
  - Fuel exports from the World Bank’s estimates through the Comtrade database.
  - Data are compiled at the annual frequency and cover the period 2000-2023 for most variables.
  - The sample of Emerging and Developing Economies (EMDE)— comprising 146 economies—follows the IMF classification.
- Post-conflict episodes: The list of post-conflict economies and related episodes follows UNDP (2008); in the event study the end-of-the-conflict year is taken to be year “0”.
- External Sector Assessment (ESA):
  - The ESA evaluates external positions and assigns one of seven categories: (i) substantially stronger; (ii) stronger; (iii) moderately stronger; (iv) broadly consistent; (v) moderately weaker; (vi) weaker; and (vii) substantially weaker.
  - Timor-Leste’s external position is assessed as “substantially weaker than fundamentals and desirable policies,” like many other economies with fixed exchange rate regimes.
  - Exchange rate regime classification is based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER).

*International Monetary Fund — Democratic Republic of Timor-Leste (excerpts).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2024/english/1tlsea2024003-print-pdf.pdf_