## sipea2024042

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---

### A. Introduction
- Timor-Leste has exclusively used the US dollar since January 2000; US dollar banknotes circulate for cash transactions while the Banco Central de Timor-Leste (BCTL) mints coins in denominations of centavos (one centavo equals one US cent), with coins issued up to 200 centavos.
- Total stock of centavo coins in circulation was $31 million (around 2 percent of non-oil GDP) at end-2023.
- Dollarization — pros and cons:
  - Pros: helps stabilize prices and reduce inflationary pressures by using the nominal anchor of the United States; 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 seigniorage revenue.
- Meta-analysis cited (Koráb, Fidrmuc, and Dibooglu (2023), 43 studies) finds full dollarization tends to raise output volatility and reduce growth but lowers inflation relative to non-dollarized economies.

### B. Growth and Inflation
- Benchmarking approach: comparisons against EMDE, ASEAN, EMDE with fixed exchange rates, and post-conflict economies; examine growth, inflation level and volatility, cyclical and structural aspects.
- Growth performance and fiscal context:
  - Growth pickup from 2007; by early 2010s Timor-Leste outperformed average cumulative growth trajectory of 29 post-conflict economies analyzed.
  - Public spending reached close to 80 percent of non-oil GDP by 2010 (from around 50 percent in early 2000).
  - 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.
  - Non-oil GDP growth outturn was 2.3 percent in 2023.
  - 2013 Article IV had envisaged non-oil GDP growth to remain above 8 percent in the medium term.
  - Fiscal multiplier estimated around 0.1 - 0.2 due to low quality and high import content of public expenditure (IMF 2024).
- Comparative underperformance:
  - Per-capita growth significantly lower than Asian comparators (e.g., Cambodia, Laos, Myanmar).
  - Economic activity stagnated particularly since 2017.
- Inflation outcomes:
  - Headline inflation average over past two decades in Timor-Leste: 4.9 percent.
  - Comparison group 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 high until about mid-2010 and influenced by global food price swings; more moderate in past decade.
  - Volatility: 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 achieved relatively low and stable inflation in the last decade.

### C. Business and Financial Cycle Synchronization
- Rationale: synchronization determines whether US monetary policy is appropriate for Timor-Leste.
- Correlations and trade linkages:
  - Real GDP growth correlation between Timor-Leste and the United States during 2002-23: -0.1.
  - US share of Timor-Leste’s total trade by value: 4 percent in 2023 (down from 10 percent in 2003).
  - Other dollarized economies’ trade with US (Ecuador, El Salvador, Panama): range between 15 and 40 percent of total trade value.
  - ASEAN share of Timorese total trade: increased from 25 percent in 2003 to around 40 percent in 2023.
  - Growth correlation with neighboring Indonesia: as high as 0.6 (correlation of real GDP growth with TLS real non-oil GDP growth; 2002-2023).
  - Implication: US monetary conditions are unlikely to be appropriate for Timor-Leste; ASEAN orientation raises the costs of dollarization.
- Transmission channels and structural constraints:
  - Transmission of US monetary policy affects Timor-Leste mainly through exchange rate channel rather than interest rate channel.
  - Correlation of change in Fed Funds rate with change in domestic loan and deposit rates: 0.05 and 0.04, respectively, over December 2002 to December 2023.
  - Local deposit and lending rates exhibit very low correlations with US interest rates, particularly in the last five years.
  - Structural constraints: no tradable government or private debt securities, no local stock exchange; underdeveloped capital markets; deposit and lending practices constrained by domestic structural bottlenecks.
  - Practical implication: interest rates are decoupled, so cyclical stabilization cost of dollarization appears limited in practice.

### D. Adjustment to External Shocks
- Conceptual point: flexible exchange rates can act as shock absorbers; dollarization requires adjustment via domestic prices and wages, increasing premium on product and labor market flexibility.
- Buffers and fiscal framework:
  - Petroleum Fund (PF) balance averaged around 1,000 percent of non-oil GDP in the last ten years.
  - Oil and gas revenues accumulate into PF, not recorded as state budget revenues; withdrawals governed by fiscal rules.
  - Fiscal rule: annual withdrawal based on 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 (subcomponent of ‘housing’ category): 6.3 percent, limiting fuel-price transmission to CPI.
- 2014 oil price fall event study (Timor-Leste compared with Colombia and Ecuador):
  - Ecuador experienced contraction of domestic demand and per-capita income over the subsequent three years; Colombia and Timor-Leste saw rising per-capita income.
  - REER responses:
    - Colombia: REER depreciated driven by nominal depreciation of the peso vs. USD supporting net exports and domestic demand.
    - Ecuador and Timor-Leste: REER appreciated as trading partners depreciated nominally against USD, limiting external adjustment and aggravating real economy impact.
  - Fiscal responses:
    - Ecuador: pro-cyclical fiscal policy with sharp expenditure contraction in 2015 due to limited buffers/options.
    - Colombia and Timor-Leste: countercyclical fiscal response supported per-capita income.
    - Timor-Leste: very large expansion of fiscal expenditure involved excess withdrawals from PF well above ESI.
- Broad fiscal behavior:
  - Correlation between cyclical components of global oil prices and public spending in Timor-Leste during last two decades: around 0.2, indicating weak (acyclical) fiscal policy consistent with fiscal rule design.
  - Excess withdrawals have been common since early 2010s, generating large fiscal and external imbalances and not delivering strong growth given low-efficiency public spending; excess withdrawals have not been systematically procyclical with respect to oil prices.

### E. Competitiveness
- External conditions and REER dynamics:
  - 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.
  - 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, but the large appreciation of the REER did not meaningfully subside, indicating a degree of downward nominal rigidity in the economy.
  - The REER appreciated further when the currencies of Timor’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.
  - The External Sector Assessment (ESA) has consistently indicated that the external position is substantially weaker than warranted by fundamentals (Annex I).
- Implications for the non-oil economy and structural bottlenecks:
  - REER overvaluation likely constrained tourism—with tourism arrivals remaining well below their pre-pandemic levels—and may 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 reflect a small market and low economies of scale in production (Freedman 2020).
    - Low productivity in the non-oil economy, notably in agriculture.
    - Tourism constrained by poor infrastructure and low business and hospitality skills.
    - 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.
  - Dollarization prevents the nominal exchange rate from depreciating to compensate for these imbalances.
- Policy implication:
  - Improving economic performance and reducing imbalances under dollarization calls for resolving fiscal imbalances and advancing reforms that address structural bottlenecks.
  - Absent these reforms, moving away from dollarization would not be sufficient to durably overcome deep competitiveness issues and lack of diversification.

### F. Conclusion and Policy Recommendations
- Assessment of dollarization:
  - Dollarization has helped Timor-Leste achieve relatively low and stable inflation in the context of post-conflict fragility.
  - Since independence, Timor-Leste has achieved relatively good performance in terms of growth and price stability compared to other post-conflict states, and made progress with improved institutions, incipient political stability, and access to ample resources from oil and gas revenues.
  - 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 to non-oil underperformance, in addition to structural bottlenecks.
  - 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.
- Recommendation: Improving performance under dollarization calls for:
  - Reduction of fiscal imbalances.
  - Advancement of reforms that address structural bottlenecks facing the private sector.
  - Building technical capacity at the central bank.
  - Improving the regulatory and legal framework for the financial system.
- Preconditions for considering a national currency:
  - These reforms should be seen both as important for strengthening the economy’s 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
- Cross-country data:
  - GDP, per-capita GDP, and government expenditure sourced from the IMF’s World Economic Outlook (WEO) Database.
  - NEER, REER, CPI, and exchange rate data sourced from the IMF’s Information Notice System.
  - Fuel exports from the World Bank’s estimates through the Comtrade database.
  - Data compiled at the annual frequency covering the period 2000-2023 for most variables.
  - Sample of Emerging and Developing Economies (EMDE) comprises 146 economies, following 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 as year “0”.
  - List includes: Angola 2002; Azerbaijan 1994; Bosnia and Herzegovina 1995; Burundi 2002; Cambodia 1991; Congo, Republic of 1999; Côte d'Ivoire 2004; Croatia 1993; El Salvador 1991; Eritrea 1991; Ethiopia 1991; Georgia 1994; Guatemala 1995; Guinea-Bissau 1999; Indonesia 2006; Liberia 2003; Mozambique 1992; Namibia 1989; Nepal 2006; Nicaragua 1990; Papua New Guinea 1996; Rwanda 2001; Sierra Leone 2001; Solomon Islands 2003; Somalia 1991; Sudan 2002; Tajikistan 1997; Timor-Leste 1999; Uganda 1991.
- External Sector Assessment (ESA):
  - ESA classifies external positions into 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,” similar to many other economies with fixed exchange rate regimes.
  - ESA and FX regimes table (counts by category and regime) as presented in source table order:
    - Fixed: 3 5 2 1 1 1 0 6 7
    - Managed: 0 6 1 1 6 2 1 1 9
    - Floating: 0 3 3 1 5 7 7 3
  - Sources: AREAER; IMF staff.

*Source: sipea2024042 (Selected Issues Papers, IMF).*

### References ____________________________________________________________________________ 15

### sipea2024042 - References

### A. Introduction
- Timor-Leste has exclusively used the US dollar since January 2000; US dollar banknotes circulate for cash transactions while the Banco Central de Timor-Leste (BCTL) mints coins in denominations of centavos (one centavo equals one US cent), with coins issued up to 200 centavos.
- Total stock of centavo coins in circulation was $31 million (around 2 percent of non-oil GDP) at end-2023.
- Dollarization pros and cons noted:
  - Pros: helps stabilize prices and reduce inflationary pressures by using the nominal anchor of the United States; 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 seigniorage revenue.
- Meta-analysis referenced (Koráb, Fidrmuc, and Dibooglu (2023), 43 studies) finds full dollarization tends to raise output volatility and reduce growth but lowers inflation relative to non-dollarized economies.

### B. Growth and Inflation
- Benchmarking approach: compare Timor-Leste against EMDE, ASEAN, EMDE with fixed exchange rates, and post-conflict economies; examine growth, inflation level and volatility, cyclical and structural aspects.
- Post-independence growth performance:
  - Growth pickup from 2007; by early 2010s Timor-Leste outperformed average cumulative growth trajectory of 29 post-conflict economies analyzed.
  - Public spending reached close to 80 percent of non-oil GDP by 2010 (from around 50 percent in early 2000).
  - 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.
- Comparative underperformance:
  - Per-capita growth significantly lower than Asian comparators (e.g., Cambodia, Laos, Myanmar).
  - Economic activity stagnated particularly since 2017.
  - Non-oil GDP growth outturn was 2.3 percent in 2023.
  - 2013 Article IV had envisaged non-oil GDP growth to remain above 8 percent in the medium term.
  - Fiscal multiplier estimated around 0.1 - 0.2 due to low quality and high import content of public expenditure (IMF 2024).
- Inflation outcomes:
  - Headline inflation average over past two decades in Timor-Leste: 4.9 percent.
  - Comparison groups: 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 high until about mid-2010 and influenced by global food price swings; more moderate in past decade.
  - Volatility: 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 achieved relatively low and stable inflation in the last decade.

### C. Business and Financial Cycle Synchronization
- Rationale: synchronization determines whether US monetary policy is appropriate for Timor-Leste.
- Correlation with US:
  - Real GDP growth correlation between Timor-Leste and the United States during 2002-23: -0.1.
  - US share of Timor-Leste’s total trade by value: 4 percent in 2023 (down from 10 percent in 2003).
  - Other dollarized economies’ trade with US: Ecuador, El Salvador, Panama range between 15 and 40 percent of total trade value.
  - Implication: US monetary conditions are unlikely to be appropriate for Timor-Leste; raises costs of dollarization.
- Linkages with ASEAN:
  - ASEAN share of Timorese total trade: increased from 25 percent in 2003 to around 40 percent in 2023.
  - Growth correlation with neighboring Indonesia as high as 0.6 (correlation of real GDP growth with TLS real non-oil GDP growth; 2002-2023).
  - ASEAN accession roadmap likely to deepen trade linkages and raise costs of dollarization, since ASEAN currencies are generally flexible versus US dollar.
- Transmission channels:
  - Transmission of US monetary policy affects Timor-Leste mainly through exchange rate channel rather than interest rate channel.
  - Correlation of change in Fed Funds rate with change in domestic loan and deposit rates: 0.05 and 0.04, respectively, over December 2002 to December 2023.
  - Local deposit and lending rates exhibit very low correlations with US interest rates, particularly in the last five years.
  - Structural constraints: no tradable government or private debt securities, no local stock exchange; underdeveloped capital markets; deposit and lending practices constrained by domestic structural bottlenecks.
  - Practical implication: interest rates are decoupled, so cyclical stabilization cost of dollarization appears limited in practice.

### D. Adjustment to External Shocks
- Conceptual point: flexible exchange rates can act as shock absorbers; dollarization requires adjustment via domestic prices and wages, increasing premium on product and labor market flexibility.
- Buffers and fiscal framework:
  - Petroleum Fund (PF) balance averaged around 1,000 percent of non-oil GDP in the last ten years.
  - Oil and gas revenues accumulate into PF, not recorded as state budget revenues; withdrawals governed by fiscal rules.
  - Fiscal rule: annual withdrawal based on 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 (subcomponent of ‘housing’ category): 6.3 percent, limiting fuel-price transmission to CPI.
- 2014 oil price fall event study (Timor-Leste compared with Colombia and Ecuador):
  - Ecuador experienced contraction of domestic demand and per-capita income over the subsequent three years; Colombia and Timor-Leste saw rising per-capita income.
  - REER responses:
    - Colombia: REER depreciated driven by nominal depreciation of the peso vs. USD supporting net exports and domestic demand.
    - Ecuador and Timor-Leste: REER appreciated as trading partners depreciated nominally against USD, limiting external adjustment and aggravating real economy impact.
  - Fiscal responses:
    - Ecuador: pro-cyclical fiscal policy with sharp expenditure contraction in 2015 due to limited buffers/options.
    - Colombia and Timor-Leste: countercyclical fiscal response supported per-capita income.
    - Timor-Leste: very large expansion of fiscal expenditure involved excess withdrawals from PF well above ESI.
- Broad fiscal behavior:
  - Correlation between cyclical components of global oil prices and public spending in Timor-Leste during last two decades: around 0.2, indicating weak (acyclical) fiscal policy consistent with fiscal rule design.
  - Excess withdrawals have been common since early 2010s, generating large fiscal and external imbalances and not delivering strong growth given low-efficiency public spending; excess withdrawals have not been systematically procyclical with respect to oil prices.

*Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2024/english/sipea2024042.pdf*

### 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

### E. Competitiveness
- 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 has been the main factor behind a 15-percent appreciation of Timor-Leste’s real effective exchange rate between 2021 and 2023.
- A dollarized regime means that Timor-Leste’s REER has strengthened in tandem with the strength of the US dollar, with implications for its competitiveness.
- 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, but the large appreciation of the REER did not meaningfully subside, indicating a degree of downward nominal rigidity in the economy.
- The REER appreciated further when the currencies of Timor’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.
- The External Sector Assessment (ESA) has consistently indicated that the external position is substantially weaker than warranted by fundamentals (Annex I).
- REER overvaluation likely constrained tourism—with tourism arrivals remaining well below their pre-pandemic levels—and may 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 reflect a small market and low economies of scale in production (Freedman 2020).
  - Low productivity in the non-oil economy, notably in agriculture.
  - Tourism constrained by poor infrastructure and low business and hospitality skills.
  - 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.
- Dollarization prevents the nominal exchange rate from depreciating to compensate for these imbalances.
- Policy implication: Improving economic performance and reducing imbalances under dollarization calls for resolving fiscal imbalances and advancing reforms that address structural bottlenecks. Absent these reforms, moving away from dollarization would not be sufficient to durably overcome deep competitiveness issues and lack of diversification.

### F. Conclusion
- Dollarization has helped Timor-Leste achieve relatively low and stable inflation in the context of post-conflict fragility.
- Since independence, Timor-Leste has achieved relatively good performance in terms of growth and price stability compared to other post-conflict states, and made progress with improved institutions, incipient political stability, and access to ample resources from oil and gas revenues.
- 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 to non-oil underperformance, in addition to structural bottlenecks.
- 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.
- Recommendation: Improving performance under dollarization calls for:
  - Reduction of fiscal imbalances.
  - Advancement of reforms that address structural bottlenecks facing the private sector.
  - Building technical capacity at the central bank.
  - Improving the regulatory and legal framework for the financial system.
- These reforms should be seen both as important for strengthening the economy’s 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
- Cross-country data:
  - GDP, per-capita GDP, and government expenditure sourced from the IMF’s World Economic Outlook (WEO) Database.
  - NEER, REER, CPI, and exchange rate data sourced from the IMF’s Information Notice System.
  - Fuel exports from the World Bank’s estimates through the Comtrade database.
  - Data compiled at the annual frequency covering the period 2000-2023 for most variables.
  - Sample of Emerging and Developing Economies (EMDE) comprises 146 economies, following 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 as year “0”.
  - List of post-conflict economies includes Angola 2002; Azerbaijan 1994; Bosnia and Herzegovina 1995; Burundi 2002; Cambodia 1991; Congo, Republic of 1999; Côte d'Ivoire 2004; Croatia 1993; El Salvador 1991; Eritrea 1991; Ethiopia 1991; Georgia 1994; Guatemala 1995; Guinea-Bissau 1999; Indonesia 2006; Liberia 2003; Mozambique 1992; Namibia 1989; Nepal 2006; Nicaragua 1990; Papua New Guinea 1996; Rwanda 2001; Sierra Leone 2001; Solomon Islands 2003; Somalia 1991; Sudan 2002; Tajikistan 1997; Timor-Leste 1999; Uganda 1991.
- External Sector Assessment (ESA):
  - ESA evaluates external positions and classifies an economy at a point in time into seven categories: (i) substantially stronger; (ii) stronger; (iii) moderately stronger; (iv) broadly consistent; (v) moderately weaker; (vi) weaker; and (vii) substantially weaker.
  - For this analysis, latest available ESA assessments compiled for Timor-Leste and other EMDEs and grouped by exchange rate regime (based on AREAER).
  - Timor-Leste’s external position is assessed as “substantially weaker than fundamentals and desirable policies,” similar to many other economies with fixed exchange rate regimes.
  - ESA and FX regimes table (counts by category and regime):
    - Fixed: 3 5 2 1 1 1 0 6 7 (as presented in the source table order)
    - Managed: 0 6 1 1 6 2 1 1 9
    - Floating: 0 3 3 1 5 7 7 3
  - Sources: AREAER; IMF staff.

*Source: sipea2024042 - 18. To further delineate the impact of external shocks on Timor-Leste’s exchange rate, we (Selected Issues Papers, IMF).*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2024/english/sipea2024042.pdf_