## Democratic Republic of Timor-Leste: Staff Report for the 2006 Article IV Consultation (_cr0779) ## Source details **Canonical URL:** [Democratic Republic of Timor-Leste: Staff Report for the 2006 Article IV Consultation (_cr0779)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr0779.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr0779.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr0779.pdf.json) --- ### Executive summary — economic and policy developments - Mid-2006 violence and political instability disrupted private and public sector activity; real non-oil GDP growth in 2006 is estimated to be negative. - Sharp rebound in growth expected in 2007 due to end-year re-escalation of donor activity and higher public spending. - High oil and gas prices and production led to sizeable twin surpluses of 111 percent (fiscal) and 93 percent (current account) of non-oil GDP in 2006. - Petroleum Fund assets should exceed 250 percent of non-oil GDP; petroleum fund assets noted as $847 million (240 percent of non-oil GDP) at September 2006 in budget chapter. - Progress on reforms to encourage non-oil private sector activity stalled after the crisis; business environment weak, legislative structure incomplete and judicial system fragile. - Medium-term prospects highly sensitive to oil-and-gas developments, unsettled political environment, and large-scale donor activity. ### Key policy issues and authorities’ strategy - Core challenge: how best to use oil-and-gas wealth to lift the non-oil economy onto a higher growth path and reduce poverty. - Authorities affirmed commitment to a strategy comprising: - stepped up public investment; - adherence to an oil-and-gas saving policy and Petroleum Fund; - continued macroeconomic stability (U.S. dollar as currency). - Immediate needs: - Address physical damage from civil unrest and restore law and order. - Implement the 2006/07 budget to sharply increase spending on infrastructure, human capital, and humanitarian assistance while guarding against unproductive spending and inflationary pressure. - Private sector: stronger and more coordinated effort needed to improve business environment. ### Recent developments and macro indicators - Non-oil activity: - Real non-oil growth estimated at 2 percent in 2005 but below population growth of 3 percent; non-oil GDP estimated to be negative in 2006 (about 6 percentage points lower than projected before the unrest). - Coffee production declined by 20 percent following unrest. - Inflation and exchange rate: - CPI inflation jumped to above 6 percent in the year to June 2006 and remains at about that level (other passages cite about 7 percent to June 2006 and CPI end-period entries include "5.7 5.0"). - REER remains close to previous lows in 2003 after real depreciation was partly offset by inflation. - Fiscal and external: - Oil-and-gas revenue was 128 percent of non-oil GDP in 2005/06; central government surplus reached 103 percent of non-oil GDP (commitments basis) in one passage and elsewhere 111 percent of non-oil GDP is cited. - Central government expenditure (commitments) 34 percent of non-oil GDP in 2005/06; estimated “sustainable” spending level around 86 percent (authorities’ saving policy) or conservatively 76 percent in some tables. - Current account surplus of 93 percent of non-oil GDP (excluding international assistance) reported for 2006 in Executive Summary; other passages note current account surpluses of 116 percent or 125 percent of non-oil GDP in different tables. - Net foreign assets of the BPA combined with petroleum fund foreign assets rose to US$957 million by September 2006 (equivalent to 7 years of merchandise imports). ### Petroleum Fund policy and outlook - Policy design: - Inter-generational equity and fiscal sustainability: annual “sustainable” spending equals estimated permanent (interest) income from oil-and-gas wealth plus domestic non-oil revenue. - Petroleum Fund integrated into central government budget; transfers limited by spending ceiling based on fiscal sustainability policy; assets invested abroad to limit risk and REER appreciation. - Oversight: Consultative Council, Investment Advisory Board, independent audits; participation in Extractive Industries Transparency Initiative. - Outlook: - High global oil prices and improved extraction prospects (notably Greater Sunrise field revenue potential estimated at about 10 billion U.S. dollars commencing in 2013) could significantly raise “sustainable” budget spending over the long term. ### Fiscal policy, 2006/07 budget, and execution - 2006/07 budget objectives: - Emergency assistance, housing reconstruction, quick-disbursing rural grants, rise in civil servants’ compensation, increased electricity subsidy. - Nearly triple capital spending via accelerated SIPs—especially roads, education, and power generation. - Budget execution constraints: - Central government cash spending in 2005/06 estimated at 26 percent of non-oil GDP with large poorly monitored cash carryover. - Financial management reforms have not significantly eased execution constraints; capital expenditure budgeted to rise to 32 percent of GDP in 2006/07. - Staff estimate for cash expenditure (2006/07) 212 / 640 (table note). - Central government budget (2006/07; Act./Prelim./Budget amounts as shown): - Revenue: 98 / 137 / 173 - of which oil and gas: 77 / 128 / 161 - Expenditure (commitments): 213 / 473 - Current: 182 / 241 - Wages and salaries: 77 / 11 - Goods and services: 91 / 319 - Subsidies and transfers: 22 / 6 - Capital: 31 / 232 - Overall balance: 76 / 103 / 100 - Memo: - Non-oil balance: -1 / -24 / -61 - 'Sustainable' expenditure: ... / 86 / 76 - Cash expenditure 1/: 212 / 640 - Combined sources: on a combined (government cash + donor) basis, total 2006/07 expenditure should increase only slightly compared to pre-2005/06 levels as higher government spending is largely offset by declining donor spending. ### Banking sector, credit, and vulnerabilities - Bank loan quality: - NPLs were 30 percent of total bank lending at end-September 2006. - Credit to the private sector fell by 10 percent year/year. - Banking indicators (selected series as presented): - NPLs/total loans: 6.3 5.4 6.9 7.8 9.6 12.8 16.3 21.8 29.8 - Total provisions/NPLs: 2.2 5.8 14.4 20.2 22.5 23.2 24.1 24.2 64.8 - Liquid assets/total assets: 74.3 36.0 31.6 33.5 32.7 34.8 33.3 36.3 41.7 - Capital adequacy ratio (IMFTL only): 227.9 226.5 188.1 140.3 125.5 121.2 119.1 140.3 176.1 - Risks and policy: - Weak enforcement of creditors’ rights and contract enforcement; displacement of Dili residents worsened loan repayments. - Unless run commercially, a proposed state-owned rural development bank could quickly run into NPL and solvency issues and create fiscal liabilities. - Authorities plan a credit registry, strengthened supervision, and resumption of off-site supervision with Fund assistance; Central Bank, Payments, and Anti-Money Laundering laws still pending. ### Business environment, structural reforms, and capacity building - Business environment constraints: - Onerous property and business registration, pending bankruptcy law, overwhelmed court system, incomplete implementing regulations. - World Bank ranks Timor-Leste among the most difficult countries for doing business (Doing Business Survey, 2007). - Poor infrastructure and limited human capacity. - Priorities and recommendations: - Pass pending land law, finalize commercial code and contract enforcement mechanisms. - Streamline business licensing procedures and avoid binding minimum wage that could hinder employment. - Create a government coordination unit to guide legislative and regulatory agenda. - Expand donor-supported Planning and Financial Management Capacity Building Program; staffing the Ministry of Finance’s macroeconomic unit is a priority. ### Near-term projection and medium-term scenarios - Near-term (2007): - Rebound expected: surge in economic growth by over 30 percent (20 percent excluding the UN) in 2007 due to UN mission buildup and increased government spending. - Prices expected to decline as security stabilizes, particularly after spring 2007 elections. - Moderate policy implementation scenario: - Civil service wages rise from 7 percent to 11 percent of non-oil GDP. - Public investment increase by 14 percent of non-oil GDP. - Economic growth (excluding UN activities) of 4–5 percent per annum. - Total investment peak at 40 percent of non-oil GDP during 2008–11. - Non-oil GDP growth remains insufficient to significantly reduce poverty if business environment improves slowly. - Strong policy implementation scenario: - Total investment could rise to around 50 percent of non-oil GDP if infrastructure and human capital spending executed effectively. - Annual non-oil GDP growth (excluding UN mission decline) could reach 7-8 percent. - Inflation higher than baseline but still moderate. ### Fiscal strategy, risks, and crisis-response guidance - Fiscal strategy: - Adhere to saving guideline and keep spending within “sustainable” levels; prudent Petroluem Fund management should smooth spending and invest remainder abroad. - Fund governance: Consultative Council, reporting, audits, Investment Advisory Board to ensure accountability. - Risks to outlook: - Upside: agreement with Australia on Greater Sunrise revenue and new exploration could double long-term oil-and-gas inflows. - Downside: - A 20 percent or steeper decline in oil-and-gas prices from budget assumptions would reduce annual “sustainable” spending and constrain investment. - Continued political instability and 2007 elections could distract reforms, increase inflationary spending pressures, and discourage private investors. - Rapid large-scale external borrowing without prudent debt-management could erode fiscal sustainability. - Crisis response and prioritization: - Well-targeted public investment with high import content can support growth without increasing inflation. - Fast-disbursing emergency cash grants should be carefully targeted and transparently provided to crisis-affected populations. - Avoid across-the-board wage increases for unskilled staff; greater wage differentiation needed to attract qualified senior staff. ### Data, statistical capacity, and surveillance limitations - Data provision not adequate for effective surveillance; significant weaknesses in balance of payments and national accounts. - Historical disruption: pre-1999 statistics compiled by Indonesian agencies; post-1999 turmoil destroyed databases. - National accounts: BIDE estimates for 2000–2003 rely on limited source data; Fund staff prepared some GDP estimates due to gaps. - Monetary statistics: BPA compiling monthly series; test SRF data reported for December 2004; no regular reporting to STA yet. - Availability snapshot (selected): - CPI for Dili: latest observation 9/2006; received 11/2006; frequency M. - GDP/GNP: latest observation 2003; received 10/2004. - Balance of payments: official data largely unavailable; responsibility transferred to BPA in 2006. ### Selected key numerical indicators (as presented in source tables) - GNI at current prices (millions US$): 352 349 507 692 847 1,375 - Non-oil GDP (millions US$): 343 336 339 350 356 493 - Oil/gas income (millions US$): 9 13 168 342 492 882 - Real non-oil GDP growth (percentage change): -6.7 -6.2 0.3 2.3 -1.6 32.1 - CPI (Dili, end-period, percentage change): 9.5 4.2 1.8 0.9 5.7 5.0 - Central government budget (cash basis, percent of non-oil GDP) Revenues: 24 31 98 137 172 202; Expenditure: 20 20 21 26 40 43; Overall balance: 4 11 77 111 132 158 - Petroleum Fund balance (end-period, selected entries): 184 247 285 395 533 649 (table entries) - Net foreign assets (BPA + petroleum fund) US$957 million by September 2006 (7 years of merchandise imports). ### Staff and Executive Board recommendations (condensed) - Maintain U.S. dollar regime until institutional capacity and financial markets justify a national currency. - Continue adherence to long-term fiscal saving rule and prudent Petroleum Fund management. - Improve budget execution: adopt public finance law, strengthen commitment monitoring and cash controls, and expedite procurement reforms. - Carefully assess external borrowing; ensure projects align with SIP priorities and concessionality is adequate. - Implement tax policy reforms: simplify tax structure, increase minimum thresholds, reduce rates, and consolidate tax law. - Strengthen banking supervision, establish a loan registry, finalize bank- and payments-related legislation, and avoid noncommercial state bank interventions. - Prioritize passage of land law, streamline licensing, develop mediation/arbitration alternatives, and create a coordination unit for legislative/regulatory agenda. - Intensify efforts to strengthen statistical capacity and produce reliable national accounts and balance of payments statistics. *Source: Staff Report for the 2006 Article IV Consultation (IMF), Approved by Daniel Citrin and Mark Plant, December 27, 2006 (content unit _cr0779).* ### 2006. The views expressed in the staff report are those of the staff team and do not ### INTERNATIONAL MONETARY FUND — DEMOCRATIC REPUBLIC OF TIMOR-LESTE: Staff Report for the 2006 Article IV Consultation ### Executive Summary — Economic and Policy Developments - The mid-2006 outbreak of violence and political instability disrupted private and public sector activity; real non-oil GDP growth in 2006 is estimated to be negative. - A sharp rebound in growth is expected in 2007 due to end-year re-escalation of donor activity and higher public spending. - High oil and gas prices and production led to sizeable twin fiscal and current account surpluses of 111 percent and 93 percent of non-oil GDP, respectively, in 2006. - Petroleum fund assets should exceed 250 percent of non-oil GDP. - Progress on reforms to encourage non-oil private sector activity stalled following the crisis; the overall business environment remains weak, the legislative structure incomplete and the judicial system fragile. - Medium-term macroeconomic prospects have become more uncertain; outlook is highly sensitive to oil-and-gas sector developments, the unsettled political environment, and large-scale donor activity. ### Key Policy Issues - Core challenge: how best to use oil-and-gas wealth to lift the non-oil economy onto a higher growth path and reduce poverty. - The new government affirmed commitment to the long-standing economic strategy, supported by staff, comprising: - stepped up public investment; - adherence to an oil-and-gas saving policy and petroleum fund; - continued macro-economic stability. - Authorities need to address physical damage from recent civil unrest and restore law and order. - The 2006/07 budget targets a sharp jump in spending focused on infrastructure, human capital, and humanitarian assistance. Staff welcomes innovations to address bottlenecks constraining capital spending, while emphasizing the need to guard against unproductive spending and increasing inflationary pressure. - A vibrant private sector is essential for long-term growth; a stronger and more coordinated effort is needed to improve the business environment. - Authorities reaffirmed commitment to the U.S. dollar as Timor-Leste’s currency, given its role in maintaining macroeconomic stability and still limited institutional capacity. ### Introduction — Context and Institutional Setting - Timor-Leste had made good progress in establishing a stable and healthy economy prior to the civil unrest in 2006, though remaining one of the poorest countries in the world. - Real non-oil GDP rose in 2004–05 after contracting for two years following the end of the post-conflict reconstruction boom. - Macroeconomic stability was achieved through early adoption of prudent fiscal and monetary policies. - Progress toward National Development Plan (NDP) objectives and Millennium Development Goals (MDGs) was limited. - The April 2006 violence introduced new risks; security situation and domestic institutions remain fragile. International security forces arrived in May; periodic violence and large numbers internally displaced persist. - The government endorsed the pre-existing development strategy set out in the NDP and related documents comprising the Poverty Reduction Strategy (PRSP), focusing on: - a long-term oil-and-gas revenue saving policy supported by a petroleum fund; - well-targeted development spending under sector investment programs (SIPs); - a monetary and exchange rate regime preserving macroeconomic stability; - a private-investment-friendly environment. - In the aftermath of the unrest, the government plans a new Compact with donors to reinvigorate the development strategy. ### The Current Economic Setting — Recent Developments and Indicators - High world oil-and-gas prices and increased output raised projected revenue inflows; projections used for the 2006/07 budget imply a $3 billion improvement in revenue over 2005/06–2009/10 compared with the 2005 Article IV consultation projections. - Non-oil activity began to recover in 2005; real non-oil growth was estimated at 2 percent in 2005, but remained below the population growth rate of 3 percent. - Inflation: - CPI inflation jumped to above 6 percent in the year to June 2006 and remains at about that level. - Exchange rate: - The rise in inflation offset some real depreciation since mid-2005; the real effective exchange rate (REER) remains close to previous lows in 2003. - Impact of mid-2006 civil unrest: - The unrest paralyzed the government and disrupted private sector activity; coffee production, the main non-oil export commodity, declined by 20 percent. - Real non-oil GDP growth is estimated to be negative (about 6 percentage points lower than projected before the unrest), despite an end-year boost from public spending and international aid. - The oil sector is off-shore and was not affected. - Fiscal and external balances: - Oil-and-gas revenue was 128 percent of non-oil GDP in 2005/06, lifting the central government surplus to 103 percent of non-oil GDP. - Central government expenditure (commitments basis) of 34 percent of non-oil GDP was 13 percentage points higher than in 2004/05, but well below the annual “sustainable” spending level determined by the authorities’ saving policy, estimated at 86 percent of non-oil GDP. - A current account surplus of 93 percent of non-oil GDP (excluding international assistance) emerged in 2006. - Net foreign assets of the Banking and Payments Authority (BPA), combined with foreign assets of the petroleum fund, rose to US$957 million by September 2006 (7 years of merchandise imports). ### Oil Sector Policy and Outlook (Box 1) - Policy features: - Inter-generational equity and fiscal sustainability are objectives of the long-term fiscal expenditure and saving policy; annual “sustainable” spending equals the sum of estimated permanent (interest) income from oil-and-gas wealth and domestic non-oil revenue. - The petroleum fund is integrated into the central government budget and transparently managed; transfers are subject to a spending ceiling set on the basis of the fiscal sustainability policy. Fund assets are invested abroad to limit risk and minimize real exchange rate appreciation pressures. Designated oversight bodies monitor operations and internationally recognized accounting firms conduct annual audits. All oil revenue is paid into the petroleum fund. - Outlook: - High global oil prices have boosted current and potential revenue inflows. - The recently improved outlook for new oil extraction under the new treaty with Australia on the Greater Sunrise field—where the revenue potential is estimated at about 10 billion U.S. dollars (commencing in 2013)—and from newly tendered offshore blocks and promising onshore areas could further significantly raise “sustainable” budget spending over the long-term. ### Fiscal Policy and 2006/07 Budget - The 2006/07 budget: - Steep increase in spending approved in August, designed largely to respond to the crisis with outlays for emergency assistance, repair of damage including housing reconstruction, quick-disbursing grants for rural communities, rise in civil servants’ compensation, and increased electricity price subsidy. - The budget seeks to nearly triple capital spending by accelerating implementation of SIPs projects—especially roads, education, and power generation. - Although more than doubling spending relative to 2005/06, budgeted expenditure remains just within the estimated “sustainable” level prescribed under the saving policy; actual spending (cash basis) is expected to be much lower. - Central Government Budget (2006/07; Act./Prelim./Budget amounts shown in source table): - Revenue: 98 / 137 / 173 - of which oil and gas: 77 / 128 / 161 - Expenditure (commitments): 213 / 473 (table format preserved in source) - Current: 182 / 241 - Wages and salaries: 77 / 11 - Goods and services: 91 / 319 - Subsidies and transfers: 22 / 6 - Capital: 31 / 232 - Overall balance: 76 / 103 / 100 - Memo items: - Non-oil balance: -1 / -24 / -61 - 'Sustainable' expenditure: ... / 86 / 76 - Cash expenditure 1/: 212 / 640 (1/ Staff estimate for 2006/07) - Combined sources: - On a ‘combined source’ basis (central government cash spending plus donor spending), total expenditure in 2006/07 should increase only slightly compared to pre-2005/06 levels as increased government spending is largely offset by declining donor spending. ### Institutional and Data Issues - Timor-Leste uses the U.S. dollar as its official currency and has accepted the obligations of Article VIII, Sections 2, 3, and 4; maintains an exchange system free of restrictions on payments and transfers for current international transactions. - Data provision to the Fund is not adequate for effective surveillance; significant weaknesses remain in macroeconomic data, especially in the balance of payments and the national accounts (Appendix II, Annex IV). - Authorities indicated their intention to publish the staff report and background documents; a press statement was issued by the Resident Representative office at the end of the consultation. *Source: Staff Report for the 2006 Article IV Consultation, Approved by Daniel Citrin and Mark Plant, December 27, 2006.* ### 8. Central government budget ### 8. Central government budget ### Budget execution and public spending - Central government budget execution remains constrained by weak capacity, resulting in cash expenditure falling short of commitments. - Central government spending on a cash basis in 2005/06 is estimated at 26 percent of non-oil GDP and resulted in a large and poorly monitored cash carryover. - Financial management reforms have not yet significantly eased spending constraints, particularly for capital projects, due to weak planning and procurement capacity. - Capital expenditure is budgeted to rise to 32 percent of GDP in 2006/07. ### Petroleum Fund and fiscal framework - The petroleum fund became operational in July 2005, with an expenditure and saving policy targeting intergenerational equity and long-term fiscal sustainability. - Assets in the fund reached $847 million (240 percent of non-oil GDP) at September 2006. - Institutional arrangements for the Fund are largely completed, with the first meeting of the Consultative Council in November; transparent reporting, independent audits, and an Investment Advisory Board have been established. - The Fund’s investment strategy is defined within an asset management framework; MCM is providing support to strengthen BPA capacity to manage the Fund’s assets. - Authorities consider a conservative investment strategy appropriate in the initial years, with plans to initiate use of multilateral institutions’ fund managers over time. ### Banking sector performance and private credit - Bank loan quality deteriorated further post-crisis; nonperforming loans (NPLs) were 30 percent of total bank lending at end-September 2006. - Banks more aggressively provisioned for potential losses; given weak enforcement of creditors’ rights, banks were increasingly reluctant to extend new loans. - Credit to the private sector fell by 10 percent on a year/year basis. - The displacement of a large number of Dili residents to outlying districts following the crisis expanded the number of borrowers failing to make payments. ### Business environment and administrative capacity - Reforms to spur non-oil private sector activity gained some momentum prior to the crisis, but significant legal and institutional gaps remain. - The World Bank ranks Timor-Leste as one of the most difficult countries for doing business (Doing Business Survey, 2007). - Specific constraints: onerous property and business registration, pending bankruptcy law, overwhelmed court system, failure to amend related legislation or adopt needed regulations. - Poor infrastructure and lack of human capacity compound development difficulties. - Administrative capacity is improving slowly but remains low; technical staff skilled in policy implementation remain limited. - A donor-supported Planning and Financial Management Capacity Building Program aims to strengthen capacity; progress at the BPA is encouraging but government-wide capacity remains limited. ### Policy discussions and Fund advice - Discussions focused on policies to lift growth to a higher sustainable path and alleviate poverty over the medium term while responding to the crisis short term. - Fund advice highlights: - Maintain the current monetary and exchange regime until institutional capacity is built and financial markets are sufficiently developed for a national currency. - Establish a long-term fiscal strategy to ensure productive use of oil/gas wealth and long-term fiscal sustainability. - Legislation to establish the Petroleum Fund and a saving/spending policy was enacted and Petroleum Fund operations started. - Remove obstacles to budget execution to allow faster increases in well-prioritized development spending without creating inflationary pressures. - Establish a clear legal and regulatory framework for non-oil private activity; strengthen capacity for effective macroeconomic management. ### Near-term outlook and 2007 projection - The near-term outlook will be volatile after the crisis. - The buildup of the new UN mission and increased government spending, along with a gradual return to normal business conditions and rebound from depressed conditions in 2006, should contribute to a surge in economic growth by over 30 percent (20 percent excluding the UN) in 2007. - Prices are expected to decline as the security situation stabilizes, especially after the spring 2007 elections. ### Medium-term scenarios and projections - Moderate policy implementation scenario: - Civil service wages would rise from 7 percent to 11 percent of non-oil GDP within the pay structure expected to be introduced in 2007. - Public investment would increase by 14 percent of non-oil GDP. - Economic growth (excluding UN activities) of 4–5 percent per annum. - Total investment would peak at 40 percent of non-oil GDP during 2008–11. - Slow progress in improving the business environment would keep non-oil GDP growth below levels needed to significantly reduce poverty. - Strong policy implementation scenario: - Total investment could rise to around 50 percent of non-oil GDP if development spending in infrastructure and human capital is executed effectively. - Annual non-oil GDP growth (excluding the expected decline in the UN mission) could reach 7-8 percent, contributing to a significant reduction in poverty. - Inflation would be higher than under the baseline but still moderate. ### Fiscal strategy and sustainability - Adherence to the saving guideline and keeping spending within “sustainable” levels, along with prudent management of the Petroleum Fund, should help shield Timor-Leste from the “oil curse” by smoothing spending and investing the remainder abroad while financing increased development spending. - The Fund participates in the Extractive Industries Transparency Initiative. - The Fund’s Consultative Council, reporting, audits, and Investment Advisory Board are intended to ensure accountability. ### Risks to the outlook - Upside: an agreement with Australia on revenue-sharing from the Greater Sunrise field and new exploration prospects could double long-term oil-and-gas revenue inflows. - Downside: - A 20 percent or steeper decline in oil-and-gas prices from current budget assumptions would reduce annual “sustainable” spending and constrain investment spending over the medium term. - Continued political instability and the 2007 elections could distract from reforms, increase pressure for potentially inflationary public spending, and discourage private investors. - Rapid assumption of large-scale external borrowing without a prudent debt-management strategy could erode fiscal sustainability. ### Crisis response, prioritization, and risks from fiscal expansion - The crisis increased the need for stepped-up development spending, particularly in human capital and infrastructure. - Well-targeted public investment with a high import content could support higher growth without increasing inflation. - The 2006/07 budget appropriation is just within “sustainable” levels; cash spending is likely to be lower than appropriated due to execution problems. - Fast-disbursing emergency cash grants should be carefully targeted and transparently provided to those affected by the crisis to minimize long-term fiscal, inflation, and growth impacts. - Greater wage differentiation is needed to attract qualified senior staff; across-the-board increases for unskilled staff (e.g., cost-of-living subsidy) could put upward pressure on private sector wages and reduce competitiveness. Box 2 — Fiscal Expansion: Benefits and Risks - Development needs are significant; Timor-Leste is one of the poorest countries in the world, and the mid-year crisis increased damage and humanitarian problems. - Notwithstanding needs, rapid fiscal expansion carries risks: - Much higher public expenditure could build pressure on non-tradeable goods’ prices and impair non-oil private sector competitiveness. - Under the SIPs, expected benefits: - SIPs investment in infrastructure and human capital are complementary to private investment, should support growth, absorb employment, and raise factor productivity. - Expenditure is likely to be on traded goods (imported capital equipment) or on unskilled labor and services not in limited domestic supply, and therefore less likely to trigger rapid price and wage increases. - Aggregate public spending is not expected to increase overall relative to the reconstruction period as Timor-Leste’s own resources replace donor financing. - Experience in other open, low-income, oil-producing economies with fixed exchange rates shows large expenditure increases may be absorbed without a major inflationary impact. ### Financing Sectoral Investment Programs (SIPs) - SIPs financing reflects a transition in which project financing committed by donors, additional requests for donor financing, budget support grants, and Timor-Leste own revenue interact across years; the SIPs continue to guide budget planning and increased execution of development spending. *Source: _cr0779 - 8. Central government budget* ### 18. As weaknesses in the budget process continue to constrain needed development ### 18. As weaknesses in the budget process continue to constrain needed development spending ### Budget execution reforms and constraints - The 2006/07 budget incorporates new measures to raise execution levels, including greater use of rural development and education cash grants; international outsourcing of design, implementation, and monitoring of capital projects; and procurement decentralization with technical support from donors. - Adoption of the pending public-finance management law (including improved commitment monitoring and controls) would strengthen the fiduciary framework, expenditure execution, and the medium-term budget framework. - Authorities’ views: - Authorities are optimistic that technical assistance from the new IMF treasury advisor and other donors will boost budget planning, execution, and monitoring capacity. - They acknowledged that the effect of the measures to improve budget execution could take time to be fully realized given the low level of capacity. - They plan to limit the growing carryover to capital expenditure in addition to instituting re-appropriation requirements. ### External borrowing: caution and criteria - It will be important to carefully weigh borrowing opportunities to ensure that the project to be financed is consistent with SIP priorities, the absorptive capacity of the economy, and debt management capacity within the government. - A rigorous cost-benefit analysis should be undertaken to carefully assess the concessionality of the terms and conditions of the proposal to ensure that these do not prejudice future economic growth or resource management. - Consideration of external borrowing projects should also be handled in a fully transparent manner in line with normal budget procedures. - Authorities’ views: - Authorities agreed with the need to look closely at the terms and conditions of any borrowing opportunity, as well as its potential macroeconomic impact. - They viewed concessional borrowing as a means to finance priority infrastructure projects necessary for raising economic growth. ### Tax policy reform opportunities - The favorable outlook for oil-and-gas revenue provides a good opportunity to update the tax policy regime and reduce non-oil taxes without compromising fiscal sustainability. - Key observations and recommendations: - The current tax policy regime acts as a drag on the narrow base of the non-oil sector, encouraging noncompliance and being a challenge to administer. - Simplifying the tax structure—including by increasing minimum thresholds and reducing rates, and streamlining tax procedures—would be investment-friendly, reduce incentives for avoidance, and better suit the continued low administrative capacity. - New oil-and-gas operations require stepped-up capacity to audit tax compliance. - A consolidated tax law, which has been pending for over a year, would improve taxpayer awareness and remove ambiguities. - Authorities’ views: - Authorities agreed that tax policy reform is a high priority. - They welcomed the initial FAD tax-policy review and indicated that substantive actions would follow the full TA mission planned for January. ### Monetary and financial sector: exchange regime and banking developments - Exchange regime: - The use of the U.S. dollar as legal tender has supported macroeconomic stability by providing a credible nominal anchor for low inflation. - Authorities reaffirmed their commitment to the current monetary and exchange arrangements. - Staff and authorities agree the current level of the exchange rate does not present concerns for competitiveness, but vigilance is needed to ensure fiscal pressures do not undermine competitiveness in the future. - Stronger institutional capacity and well-functioning financial markets are prerequisites to the introduction of a national currency. - Banking sector developments and risks: - The deceleration in credit growth since mid-2004 and the increase in banks’ nonperforming assets are concerns, given the importance of finance for growth, but do not appear to reflect a systemic problem. - The initial rapid expansion of bank credit to the private sector in the first half of 2004 in part represented a re-intermediation of the financial sector as the macroeconomic and political situation stabilized. - The more recent deceleration in credit growth parallels developments in non-oil activity and the rising share of NPLs. The latter largely reflects weak credit assessment policies at one commercial bank (which have been addressed), combined with difficulties in contract enforcement and loan recovery, exacerbated by the recent civil unrest. - Timor-Leste: Banking Indicators (in percent) — 2003–2006 series (as presented) - Capital adequacy ratio 1/: 227.9 226.5 188.1 140.3 125.5 121.2 119.1 140.3 176.1 - NPLs/total loans: 6.3 5.4 6.9 7.8 9.6 12.8 16.3 21.8 29.8 - Total provisions/NPLs: 2.2 5.8 14.4 20.2 22.5 23.2 24.1 24.2 64.8 - Liquid assets/total assets: 74.3 36.0 31.6 33.5 32.7 34.8 33.3 36.3 41.7 - Sources: Data provided by the Timor-Leste authorities, and Fund staff estimates. - Note: 1/ Applies to IMFTL only as other banking institutions are branches of foreign banks. - Additional points and risks: - The worsening quality of banks’ portfolios is unlikely to pose serious risks for depositors given that all three banks in Timor-Leste are branches of established foreign banks. - A slowdown in financial intermediation could reduce credit availability and hamper the recovery. - Unless operated on a commercial basis, a state-owned rural development bank as now under consideration could quickly run into NPL and solvency issues, leading to fiscal liabilities and further undermining development of the formal banking sector. - Given current difficulties in enforcing loan contracts, an alternative means of resolving disputes is needed. Land-registration legislation and commercial code regulations need finalization. - Other key legislation, including the Central Bank, Payments, and Anti-Money Laundering laws, are still pending. - Authorities’ views: - Authorities emphasized the need to continue monitoring credit developments closely and to strengthen the environment for financing in the future. - The BPA has taken steps to establish a credit registry to help screen creditor quality; enhance bank supervision, including the resumption of off-site supervision with assistance from the Fund; and push for submission of the Central Bank Act to Parliament. - Authorities are considering introduction of an alternative commercial dispute mechanism. ### Private sector development and institutional capacity - To make private non-oil activity the source of long-term growth and job creation, the business environment needs considerable strengthening. - Priorities and recommendations: - Pass the still-pending land law and address the absence of effective contract enforcement. - Streamline cumbersome business licensing procedures. - Develop institutions for mediation and arbitration to provide alternatives for settling commercial disputes while law courts are being reinforced. - Greater consultation with the private sector in developing and implementing laws and regulations could help ensure their effectiveness. - Avoid setting a binding minimum wage and adopting costly hiring and firing provisions given high levels of unemployment. - Create a government coordination unit to guide the legislative and regulatory agenda to ensure: (a) appropriate consideration of laws’ economic and social impact, (b) adoption of needed implementing regulations and amendments, (c) easy access to laws and regulations for the general public, and (d) adequate training of officials to implement the new framework. - Authorities’ views: - Authorities are committed to intensifying ongoing programs to improve the business climate and encourage private investment. - Foreign investors have supported the proposals for the long-term leasing of state-owned land. - Consultation with the business community is identifying areas for reducing red tape and new training programs for civil servants should improve service provision. - Proposed changes to labor legislation will be carefully evaluated to avoid hindering employment creation. - Options are advancing for more effective handling of commercial disputes, but other action on laws and regulations is likely to remain constrained by low capacity. ### Other institutional and data issues - Macroeconomic analysis remains hampered by weak capacity and poor data availability. - Lack of qualified candidates hinders recruitment for national accounts compilation and the macroeconomic unit in the finance ministry. - In the absence of national accounts and balance of payments statistics, authorities have begun producing quarterly macroeconomic indicators of non-oil activity based on existing data available in various parts of the administration. - Formal responsibility for balance of payments statistics has been transferred to the BPA, where capacity is stronger. - Trade regime: - Timor-Leste maintains an open trade regime, with a uniform 6 percent duty on all imports and no quantitative restrictions. ### Staff appraisal: key conclusions and recommendations - Progress and challenges: - Timor-Leste has made good progress in stabilizing the macroeconomy and establishing a foundation for future growth, but growth is not yet high enough to reduce poverty and recent civil unrest has heightened risks to the outlook. - The authorities’ development strategy focuses on: a long-term oil-and-gas revenue saving policy supported by a petroleum fund; well-targeted and prioritized development spending; maintenance of a monetary and exchange regime that preserves macroeconomic stability; and an appropriate environment for private investment and activity. - Fiscal policy and spending: - By targeting long-term fiscal sustainability and intergenerational equity, the saving rule and Petroleum Fund should help shield Timor-Leste from the “oil curse” by smoothing spending and investing the remainder abroad, while leaving sufficient resources to finance the needed increase in development spending. Authorities are encouraged to continue transparent reporting of its activities. - A significant stepping up of investment spending is needed and feasible given the absence of a binding financing constraint. Large increases in government spending intensify the need to guard against unproductive spending and inflation pressures through careful planning and monitoring. - The increase in public sector wage levels could put upward pressure on private sector wages for unskilled workers. Subsidies should be monitored carefully to ensure effectiveness. - Budget process and borrowing: - Measures to strengthen budget execution are welcome, but further reforms are necessary, including an effective public finance law and improved monitoring and control on a cash basis. - Proposals to borrow externally should be carefully weighed. Rigorous and transparent analysis should be undertaken to ensure the project’s consistency with SIP priorities and macroeconomic stability, and the adequate concessionality of its terms. - Tax reform: - The increase in oil revenues enables wide-ranging tax reforms. A simplified tax regime, including a reduction in tax rates and an increase in minimum thresholds, could help to encourage the private sector. Tax procedures should also be streamlined to better fit limited administrative capacity. - Monetary and financial sector: - Maintenance of the current monetary and exchange regime provides a credible anchor for maintaining macroeconomic stability. The current level of the exchange rate is not a threat to medium-term competitiveness, though vigilance is needed to ensure expansionary fiscal and wage policies do not increase price pressures. - The weakening in banks’ loan portfolios does not appear to present a systemic risk but may reduce credit availability and undermine the economic recovery. Staff welcomes plans to further strengthen supervision, create a loan registry, introduce an alternative means of resolving commercial disputes, and finalize banking sector legislation. A state-owned rural-development bank could further weaken the fragile financial system, if not operated on a commercial basis. - Private sector and capacity: - Greater efforts are needed to create an environment that encourages private investment and growth. Passage of the pending land law would support private investment, while amendments to the labor legislation under preparation should encourage greater labor market flexibility. The creation of a coordination unit to guide the legislative and regulatory agenda would be useful. - The recently launched donor-supported capacity building program is welcome and should help improve financial management. Staffing the Ministry of Finance’s macroeconomic unit is a priority. Given data are not adequate for effective surveillance, intensified efforts are needed to strengthen statistical capacity to compile basic macroeconomic data. *Source: IMF staff report text as provided.* ### 37. It is proposed that the next Article IV consultation be conducted on the standard 12- ### _cr0779 - 37. It is proposed that the next Article IV consultation be conducted on the standard 12-month cycle. ### Regional and global comparisons (Figure 1) - Standards of living three years after independence remain low relative to other developing regions. - Despite low standards of living, macroeconomic management indicators show: - Low inflation (see Figure 1 "Inflation, 2003-05 Average"). - Absence of external public debt. - Timor-Leste has relatively large per-capita oil reserves creating opportunities to strengthen growth while maintaining macroeconomic stability. - Proven oil reserves context: - Bayu Undan field only; Greater Sunrise field production will increase total reserves significantly. - Timor-Leste petroleum fields have significant gas reserves. - Select comparative levels (as presented in figures): - Nominal GDP Per Capita, 2005 (US $) — Timor-Leste compared with Fuel Exporters, Developing Asia, Developing Countries, Sub-Sahara Africa, Pacific Islands (charts show levels up to 4,000). - Human Development Ranking 2006 (1-177, 177 is the lowest) — Timor-Leste positioned alongside Developing Asia, Pacific Islands, Fuel exporters, Sub-sahara Africa. - 2005 Per-capita Oil Revenue and Budget Spending (US$ millions) — Timor-Leste shown relative to Rep. of Congo, Chad, Cameroon, Nigeria, Angola, Gabon, Equatorial Guinea (scales to 2,500). ### Recent macroeconomic developments (Figure 2) - Civil unrest in 2006: - Halted nascent recovery in non-oil GDP that had begun in 2004. - Halted decline in inflation that had been occurring since 2004. - Disrupted non-oil export performance in 2006. - Oil revenue effects: - Revenue from oil boosted real national income. - Current account turned into a surplus in 2005, reflecting high tax and royalty payments from foreign oil companies. - Selected indicators (as plotted): - Consumer Prices (12-month percentage change): charts show Headline and Food series across Mar-04 to Sep-06 with ranges -2 to 10. - External Current Account Balance, excluding International Aid (millions of US dollars): series 2001–2006 with values spanning negative to positive hundreds (chart scale -350 to 350). - Non-oil Exports (millions of US dollars): series 2001–2006 with levels up to 10 (chart scale 0–10). - Real GNI and non-oil GDP Growth (In percent): series 2001–2006 shows GNI and Non-oil GDP with ranges -10 to 80 in charting (reflecting axis choice and plotted series). ### Medium-term moderate policy implementation scenario (Figure 3; 2005–11) - Growth indicators and fiscal/BoP dynamics under a moderate policy implementation scenario: - Non-oil GDP growth rate shown 2005–2011 with series from -5.0 to 35.0 (chart axes). - Per capita non-oil GDP and per capita GNI (US$) plotted (RHS) with levels 300 to 1,500 (chart axes). - Fiscal balances (in percent of non-oil GDP) plotted for 2005/6–2011/12: - Overall budget balance and Non-oil fiscal balance series with chart axis from -100 to 250. - Balance of payments indicators (in percent of non-oil GDP) plotted 2005–2011: - Current account excl. international aid, Current account incl. international aid, Trade Balance with axis -100 to 200. ### Millennium Development Goals progress snapshot (Table 1, 1990–2005) - Goal 1 (Eradicate extreme poverty and hunger): - Prevalence of underweight in children (under five) entries show "46 46 ..". - Prevalence of undernourishment (% of population) entries include "9 .. 88 ..". - Goal 2 (Universal primary education): - Net primary enrollment ratio: missing data (".............."). - Goal 3 (Gender equality): - Proportion of seats held by women in national parliament (%) entries include "26 26" and "25.3". - Share of women employed in the nonagricultural sector (%) shows "19 ............". - Goal 4 (Reduce child mortality): - Immunization, measles (% of children ages 12-23 months) shows "55 55 55". - Infant mortality rate (per 1,000 live births) entries: "130 .... 80 .. 64 64". - Under 5 mortality rate (per 1,000) entries: "172 .... 102 .. 80 80". - Goal 5 (Improve maternal health): - Births attended by skilled health staff (% of total) entries include "25.8 .. 18 18 ..". - Maternal mortality ratio (modeled estimate, per 100,000 live births): "......660......". - Goal 6 (Combat HIV/AIDS, malaria, other diseases): - Contraceptive prevalence rate (% of women ages 15-49): "........1010..". - Tuberculosis cases detected under DOTS (%) entries include "......49.7 45.8 45.8". - Incidence of tuberculosis (per 100,000 people) entries include "555.5........555.5 555.5". - Goal 7 (Environmental sustainability): - Forest area (% of total land area) entries: "65 .... 57 .... 54". - Access to an improved water source (% of population): "..58". - Access to improved sanitation (% of population): "..36". - Goal 8 (Global partnership for development): - Aid per capita (current US$) entries: "0.1 0.3 0.6 297.1 176.8 165.2 165.2". - Other indicators: - Fertility rate, total (births per woman): "........7.8....". - GNI per capita, Atlas method (current US$): "........420 550 750". - GNI, Atlas method (current US$) (billions): "........0.4 0.5 0.7". - Gross capital formation (% of GDP): "......41.3 31.3 28.4 32". - Population, total (millions): "0.7 0.8 0.8 0.8 0.9 0.9 1.0". - Note: figures in italics refer to periods other than those specified; ".." indicates data not available. ### Key recent and projected macroeconomic indicators (Tables 2–7) - Aggregate national accounts and prices (selected lines, 2002–07 and projections): - GNI at current prices (in millions of U.S. dollars) entries include "352 349 507 692 847 1,375" (table rows across years). - Non-oil GDP entries include "343 336 339 350 356 493". - Oil/gas income entries include "91 316 834 249 2882" (note formatting as in source tables). - Real non-oil GDP growth (percentage change) series includes "-6.7 -6.2 0.3 2.3 -1.6 32.1". - Inflation (percentage change, end-period) (CPI for Dili) entries include "9.5 4.2 1.8 0.9 5.7 5.0". - Investment, saving, and fiscal aggregates (percent of non-oil GDP and levels): - Gross investment entries across periods: "31 26 19 19 28" and in projections "19 28 34 37 39". - Gross national savings entries include "-6 150 103 135 168" and projections "135 168 196 184 168 170". - Central government budget (cash basis) revenues and expenditures (in millions of US dollars) examples: - Revenues across FYs: "243 198 137 172 202" and later budget lines "337 395 485 733 731 1,032 1,121 1,090". - Domestic revenues entries include "69 199 98" and later "37 34 33 39 37 39 42 45". - Oil/gas revenues entries include "91 277 128 161 192" and projected "683 983 1,079 1,045". - Overall balance (cash basis) entries include "41 17 71 11 11 32 158" and projected overall balances in later tables such as "132 158 161 142 136 133". - Non-oil fiscal balance examples: "-5 -10 -17 -29 -34" and projections "-1 -25 -24 -61 -41 -39 -43 -44". - Petroleum Fund and sustainable spending: - Net allocation to the petroleum fund entries: "......111100132158161142". - Petroleum Fund balance (end-period) entries: "......184247285395533649". - Sustainable spending ratio entries include "... 66 86 77 76 65 61 59". - Balance of payments (Table 5 and Table 7 projections): - Current account excl. international assistance series (in millions US$): "-244 -208 -151 93 329 296 17" (2002–2007 Proj.). - Current account incl. international assistance series: "-128 -85 10 32 92 411 688". - Trade balance (in millions US$): "-211 -186 -154 -127 -133 -219". - Oil/gas revenue memorandum: "913 168 342 492 882" (2002–06) and projections "492 882 1,086 1,070 1,023 1,103". - Gross foreign assets (end-period) entries include "446 118 252 310 061 692" and in projections "1,006 1,692". - Monetary and financial sector indicators (Table 6 and Table 8): - Broad money (end-period, millions US$): "72.3 83.0 97.2 107.3 113.8 145.7". - Net foreign assets (banking system, millions US$): "108.3 186.0 161.0 133.2 136.0 146.0". - Net domestic assets series and claims on government and private sector are reported with large negative government claims beginning 2003–06 (e.g., Claims on government (net) "-49.7 -168.6 -128.5 -85.1 -79.1 -78.1"). - Banking sector composition: includes three commercial banks (branches of foreign banks) and one micro-finance institution. - Banking and payments authority (BPA) net foreign assets and off-shore petroleum fund investments noted. - Medium-term outlook (Table 7, 2006–11 projections): - GNI at current prices (in millions US$) projections: "847 1,375 1,616 1,627 1,609 1,721". - Non-oil GDP projections: "356 493 530 558 586 618". - Real non-oil GDP growth (percentage change) projections: "-1.6 2.1 3.5 1.8 1.9 2.4". - Excluding United Nations growth series: "-6.7 19.9 5.6 4.8 4.3 4.4". - Inflation (CPI for Dili, end-period) projections: "5.7 5.0 3.7 3.4 3.2 3.0". - Investment and public finance projections include Gross investment "19 28 34 37 39 39", public investment "15 23 27 29 30 29", gross national saving projections "135 168 196 184 168 170", external saving projections "-116 -140 -162 -147 -129 -132". - Central government revenues (percent of non-oil GDP) projections: "172 202 206 191 185 182"; expenditures "40 43 45 49 49 50"; overall balance "132 158 161 142 136 133". - Combined sources fiscal operations overall balance (percent of non-oil GDP) projected around "-58 -58 -62 -63 -62 -61". - External sector projections (in millions US$): Current account balance "411 688 859 818 755 813"; Trade balance "-133 -219 -241 -259 -271 -288"; Merchandise exports "8 10 12 13 15 17"; Merchandise imports "-141 -229 -252 -272 -286 -306"; Oil income and transfers "492 882 1,086 1,070 1,023 1,103". - Overall balance projections (in millions US$): "482 686 843 844 814 830". - Vulnerability indicators (Table 8): - Public debt: "0.0 0.0 0.0 0.0 0.0 0.0". - Broad money (percent change, 12-month) series: "6.9 32.4 14.7 17.1 17.1 28.0". - Private sector credit (percent change, 12-month) series: "117.4 324.4 218.1 21.0 -3.6 15.5". - Gross official reserves (in millions of US$) series: "4 46 118 252 31,006 1,692" and months of imports series "2.4 3.8 13.4 46.0 85.4 88.5". - Total external debt and debt-service indicators reported as "0.00" across years (no external or domestic debt contracted). ### Extracted policy-relevant observations and implications (from source text) - Oil revenues have materially altered national income and external balances: - High tax and royalty payments from foreign oil companies produced a current account surplus in 2005. - Petroleum Fund implementation and sustainable income policy adopted in FY 2005/06: oil revenue accrue to the petroleum fund and sustainable income is transferred to the budget to finance the non-oil fiscal deficit. - Fiscal sustainability and public expenditure management implications: - Non-oil fiscal balances show sizable deficits in multiple years (e.g., non-oil fiscal balance entries -29, -34, etc.), indicating dependence on petroleum fund transfers to finance non-oil deficits. - Net allocation to petroleum fund and Petroleum Fund balances are substantial (e.g., end-period balances shown as "184 247 285 395 533 649"). - Sustainable spending measures and net allocation rules are central to medium-term fiscal projections (sustainable spending entries shown). - Vulnerabilities and risks: - Civil unrest (2006) caused a setback to recovery, disrupted non-oil exports, and interrupted disinflation trends. - Large swings in private sector credit growth and broad money (e.g., private credit growth 324.4 percent in one year) indicate financial-sector dynamism and potential volatility. - Banking system indicators show substantial government-related claims shifts and significant net domestic asset swings linked to oil-related deposits and petroleum fund movements. - Medium-term outlook hinges on: - Continued moderate policy implementation, management of petroleum-derived income via the Petroleum Fund framework, and restoration of non-oil growth following disruptions. *Italic: Extracted from IMF staff report content in the provided PDF content unit.* ### APPENDIX I. SUMMARY OF ANNEXES ### APPENDIX I. SUMMARY OF ANNEXES ### Fund Relations — overview and institutional arrangements - Timor-Leste joined the Fund on 7/23/2002; Article VIII status. - Currency arrangement: - On January 24, 2000, the U.S. dollar was adopted as the official currency. - Foreign exchange transactions are handled by commercial banks on the basis of rates quoted in the international markets. - The monetary authority does not undertake foreign exchange transactions. - Resident representation: - A resident representative office was established in Dili in August 2000. - The current resident representative, Mr. Tobias Nybo Rasmussen, assumed the post in February 2006. - Article IV consultation: - Discussions with the authorities were held during March 10–25, 2005. - The Executive Board concluded the consultation on June 15, 2005. ### Fund Relations — financial and quota statistics (As of November 30, 2006) - Quota and holdings: - Quota: 8.20 SDR Million 100.00 percent of quota. - Fund holdings of currency: 8.20 SDR Million 100.00 percent of quota. - Reserve position in Fund: 0.00 SDR Million 0.01 percent. - SDR Department: - Net cumulative allocation: None. - Holdings: None. - Outstanding purchases and loans: None. - Financial arrangements: None. - Projected obligations to the Fund: None. ### Fund technical assistance (scope and chronology) - General: - Since late 1999, the Fund provided significant technical assistance focused on establishing key economic institutions and developing local capacity for macroeconomic management. - Between late 1999 and end–2006, Timor-Leste has been one of the largest recipients of Fund technical assistance. - FAD (Fiscal Affairs Department): - Early multi-topic missions to establish and develop the Central Fiscal Authority (CFA, February 2000) which became the Ministry of Planning and Finance. - Assistance provided on budget preparation, tax policy and administration, treasury and expenditure management, and oil sector fiscal regimes. - Long-term resident advisors assigned to the Ministry of Planning and Finance and the Revenue Service of Timor-Leste (cost-sharing with the UN). - Over August 2004–July 2005, a FAD resident advisor assisted in design and establishment of the Petroleum Fund (started operations in August 2005). - A FAD resident advisor to the Treasurer started in December 2006 to strengthen expenditure management, reporting and budget execution. - LEG (Legal Department): - Missions advising on customs law and directives, income tax legislation, the budget and financial management law, and banking regulations. - Assistance, jointly with MFD/MCM, on drafting an AML/CFT Law. - Assistance, with FAD and MCM, on drafting the Petroleum Fund Act and the Central Bank Law. - MCM (Monetary and Capital Markets Department): - Missions to establish and develop the Central Payments Office (CPO, January 2000), later transformed into the Banking and Payments Authority (BPA, November 2001). - Assistance on payment systems, banking legislation, banking supervision, asset management, accounting, organizational design, dollar-based currency system, and issuance of domestic coins. - Recent assistance on: drafting insurance law and supervision framework; strengthening banking supervision; money laundering and financing of terrorism; establishment and training of investment unit for Petroleum Fund (resident adviser commenced March 2005); preparation for establishment of the central bank; organizational design at the BPA; modernization of payment systems and accounting for the Petroleum Fund. - Long-term resident advisors on banking supervision, payments, and accounting assigned to the CPO and BPA under a cost-sharing arrangement with the UN. Since early 2005, a long-term advisor has assisted the BPA general manager. - STA (Statistics Department): - A multi-sector statistical mission visited in November 2000 to assess data availability and quality and to help establish the Statistical Division of the Ministry of Planning and Finance. - A long-term statistical advisor served November 2001–October 2005. - A peripatetic statistical advisor was expected to be appointed in 2007 to assist in improving data compilation and developing capacity for national accounts and balance of payments statistics (responsibility for the latter transferred to the BPA in 2006). ### Relations with the World Bank Group (As of December 19, 2006) - Membership and lending stance: - Timor-Leste joined the World Bank Group on July 23, 2002. - Became eligible for IDA assistance on October 9, 2002. - To date, there has been no lending, reflecting the authorities’ policy to avoid external borrowing, including concessional loans. - Timor-Leste joined IFC in September 2004; an IFC office, together with the Pacific Enterprise Development Facility, was opened in Dili in 2006. - Trust Fund for East Timor (TFET): - The World Bank co-managed TFET (established December 1999) with the AsDB. - World Bank-administered TFET projects total funding reached $112 million, of which $105 million was disbursed by mid-December 2006. - Budget support programs: - Transition Support Program (TSP), FY 2003–2005: about $30 million in budget support annually, with about $5 million financed by IDA and the balance by 9 bilateral partners. - Consolidation Support Program (CSP), FY 2006–2008: about $10 million in budget support annually, with about $0.5 million financed by IDA. - TSP and CSP thematic focus: (1) good governance; (2) service delivery for poverty reduction (education and health); (3) job creation (private sector development, agriculture, basic infrastructure). - CSP I approved by the Board in October 2005. - CSP observations: procurement is a major bottleneck for expanding government expenditures; law to harmonize legislation pending approval; private sector development needs greater emphasis. - Analytical and advisory support: - Provided a Country Economic Memorandum, a Poverty Assessment, a Public Expenditure Management and Accountability Note, a Public Expenditure Review, an Education Sector Review, and a Paper on Strengthening the Institutions of Governance in Timor-Leste. - The “Doing Business” report for 2006 featured Timor-Leste for the first time. - Additional support: financial and private sector development, health sector development including population growth challenges, youth issues, and contribution to the FIRST Initiative's Technical Assistance Project for a Credit Registry. - Country Assistance Strategy (CAS) FY 2006–08: - Focus areas: (i) delivering sustainable services; (ii) creating productive employment; (iii) strengthening governance. - CAS includes new programs in education, health, energy, and public finance capacity building, with IDA grants of about US$ 25 million. - The Planning and Financial Management Capacity Building Project approved in March 2006: $37 million total; $7 million from IDA and $30 million from development partners. - Timor-Leste awarded $8.2 million from the Education For All Fast Track Initiative (FTI) Catalytic Fund. - Donor coordination: - The World Bank co-chaired the Timor-Leste and Development Partners Meeting (TLDPM) with the Government; meetings held in December 2002, June 2003, December 2003, May 2004, April 2005 and April 2006. - The sixth TLDPM concluded: (i) Timor-Leste can sustainably increase spending on services; (ii) well-targeted public investments offer near-term job creation and poverty reduction potential; (iii) private sector enabling environment improvements are needed for longer term growth. ### Relations with the Asian Development Bank (As of December 15, 2006) - Membership and lending: - Timor-Leste joined the AsDB on July 24, 2002. - To date, there has been no AsDB lending to the country. - TFET involvement and projects: - The AsDB co-managed TFET with the World Bank. - AsDB-managed projects: six projects with total funding of $51.7 million. - Project focus: rehabilitation of physical infrastructure (urban and rural power, national roads, ports, water and sanitation) and microfinance. - At mid-December 2006, disbursements for AsDB-managed projects totaled $50.8 million. - Most projects were completed at the end of 2004; only one project (EIRP-2) was ongoing with completion expected by February 2007. - AsDB “consolidation” phase program: proposed $16 million in Asian Development Fund grants over 4 years and about $4 million in technical assistance over 4 years, focused on main roads and urban water supply and sanitation. - Technical assistance: - AsDB approved 27 technical assistance programs totaling $12.2 million. - Technical assistance focused on project preparation and sector-specific capacity/institution building, regulatory and legislative frameworks, sectoral policy analysis, poverty assessment and statistics, and development planning. - As of end-January 2006, 16 technical assistance programs were completed and 10 programs continued. ### Statistical Issues — data quality, capacity, and historical context - Overall assessment: - Data provision to the Fund is not adequate for effective surveillance; significant weaknesses remain in macroeconomic data, especially balance of payments and national accounts. - Institutional capacity is very limited; availability and quality of data are very weak. - Historical context: - Prior to 1999, macroeconomic data were compiled by Indonesian agencies (Badan Pusat Statistik, BPS, and the Central Board of Statistics of the East Timor Province). - Balance of payments statistics were almost nonexistent because Timor-Leste was treated as an Indonesian province. - Data compilation was seriously disrupted in 1999 due to post-referendum turmoil destroying databases and the collapse of institutional capacity after most Indonesian statistical officers left. - Post-1999 assistance and developments: - International financial institutions and bilateral donors provided technical assistance during reconstruction. - A multi-sector Fund statistics mission visited Dili in November 2000 to assist authorities in restoring economic statistics and setting up a Statistical Division in the Ministry of Planning and Finance. - Responsibility for balance of payments statistics was transferred to the BPA in 2006. - A peripatetic statistical advisor was expected to be appointed in 2007 to assist in improving data compilation and developing local capacity to prepare national accounts and balance of payments statistics. *Timor-Leste — Annexes to the 2006 Article IV Consultation Staff Report (appendices I–IV, as presented in the source document).* ### 2001. A long-term resident statistical advisor assisted the Statistical Division during ### _cr0779 - 2001. A long-term resident statistical advisor assisted the Statistical Division during ### Statistical capacity and data quality - Institutional capacity remains very limited, and availability and quality of data are very weak. - A long-term resident statistical advisor assisted the Statistical Division during November 2001–February 2004, and was succeeded by a new resident advisor until September 2005. - Progress has been minimal due to insufficient resources at the Statistical agency. - The authorities have secured a commitment from the World Bank for continued support on national accounts. ### National accounts - Under a World Bank-financed project, national accounts data for 2000 (both sector and expenditure basis) were estimated by the Boston Institute for Developing Economies (BIDE). - In late 2004, BIDE produced GDP estimates for 2001-2003 that suffer from limited source data and substantial extrapolation. - The Division of Statistics has not been able to replicate the BIDE estimation exercise for 2004. - Consequence: estimates of GDP (including for the oil sector) have been prepared by Fund staff. - To improve national accounts data, appropriate staff and substantial efforts at data collection and elaboration are needed. ### Prices, employment, and wages - Since 1999, a consumer price index has been compiled monthly for Dili and quarterly for the whole country, with April 2000 as a base period. - The commodity basket and the weighting scheme were revised in mid-2003; a new monthly index for Dili has been compiled with December 2001 as the base period. - A further update of CPI weights based on detailed consumption patterns is not expected before 2007 because the authorities are focusing on the conduct of a World Bank living standards measurement survey for 2006. - Annual data on public sector employment and wages are available through fiscal records. - No official data are compiled regularly on private sector employment and wages, except partial data from household surveys conducted jointly by UNDP, ADB, and the World Bank. ### Government financial statistics (GFS) - Official data on central government revenue and expenditure are published semi-annually. - Audited annual financial statements of the executed budget are made available to APD as soon as they are released, normally three months after the end of the fiscal year. - Monthly data are available on request through the budget, treasury, and revenue services. - Compilation follows the classification of the Manual on Government Finance Statistics (GFSM 1986) (including expenditure based on both functional and economic classification). - Data on execution of expenditure carried over from past fiscal years are not yet compiled and reported regularly. - Only partial data are available on fiscal and quasi-fiscal activities undertaken by bilateral donors outside the central government budget. - Four non-financial public enterprises are treated as government agencies and data on their operations are available in the audited annual financial statements. - No data are currently reported for the GFS Yearbook and the International Financial Statistics. ### Monetary accounts and banking statistics - Monetary statistics are compiled by the Banking and Payments Authority (BPA), generally following the classification recommended by the Fund. - Data are incomplete because of the absence of official data on public currency holdings under the current currency regime. - The BPA publishes a quarterly bulletin and an annual report with key monetary aggregates; detailed monthly monetary data are available to Fund staff on request. - Comprehensive compilation of data on interest rates and bank lending and investment has begun only recently. - Availability of these data is extremely limited because the BPA is concerned about revealing confidential information given the very small number (four) of banks in the economy. - No monetary data are currently reported to STA for publication in the International Financial Statistics. - Work is ongoing for BPA to start reporting monetary statistics to STA using the standardized report forms (SRF) on a monthly basis; test data for December 2004 have been reported, and efforts are underway to derive monthly data for 2005 and 2006. - At end-September 2006, nonperforming loans (NPLs) accounted for 30 percent of total bank lending. - Credit to the private sector fell by 10 percent on a year/year basis (post-crisis). ### Balance of payments - No official balance of payments data are available except merchandise exports and imports (starting March 2000) based on customs reports; these exclude oil and gas exports and do not include estimates of large unrecorded border trade. - Data on oil/gas revenue are currently recorded as income (for royalties) and transfers (for tax revenue) based on fiscal data. - All other major items in the balance of payments are estimated by Fund staff using limited information from various sources, including bilateral donors and banks. - Ministry of Finance has taken steps to transfer responsibility for compilation of the balance of payments to the BPA. ### Timor-Leste — Data availability snapshot (selected items as of December 14, 2006) - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation 9/2006; Date received 10/2006; Frequency of Data M; Frequency of Reporting M; Frequency of Publication Q. - Reserve/Base Money (excludes currency in circulation): 9/2006; 10/2006; M; M; Q. - Broad Money (excludes currency in circulation): 9/2006; 10/2006; M; M; Q. - Central Bank Balance Sheet: 9/2006; 10/2006; M; M; Q. - Consolidated Balance Sheet of the Banking System: 9/2006; 10/2006; M; M; Q. - Interest Rates: 9/2006; 10/2006; Q; Q; A. - Consumer Price Index: 9/2006; 11/2006; M; M; M. - Revenue, Expenditure, Balance and Composition of Financing – Central Government: 3/2006; 11/2006; Q; Q; A. - Exports and Imports of Goods and Services (includes only goods; no information on services is available): 03/2006; 05/2006; M; M; M. - GDP/GNP: 2003; 10/2004. - External Current Account Balance: Data not available. - Stocks of Central Government and Central Government-Guaranteed Debt: No debt contracted. - Gross External Debt: Not applicable. ### Economic developments, outlook, and key projections - Non-oil GDP is estimated to have contracted by around 6 percent in 2006, but is expected to rebound by 32 percent in 2007. - Inflation: crisis-related supply disruptions pushed inflation to about 7 percent in the year to June 2006; prospects for inflation are brightening as supply returns to normal. - Petroleum/oil-and-gas revenue impact: - Oil-and-gas revenue was estimated at 128 percent of non-oil GDP in 2005/06. - The 2005/06 budget surplus reached 103 percent of non-oil GDP (commitment basis) in one part of the report; elsewhere central government surplus was noted as 111 percent of non-oil GDP. - The current account surplus is estimated at 116 percent of non-oil GDP in 2006 (in one passage), and 93 percent of non-oil GDP (excluding international assistance) in another summary passage. - Net foreign assets of the BPA combined with the foreign assets of the petroleum fund rose to US$957 million by September 2006, equivalent to almost 7 years of merchandise imports. - Budget and spending: - Central government expenditure was 26 percent of non-oil GDP in 2005/06. - The budget for the 2006/07 fiscal year allows for spending to rise to 73 percent of non-oil GDP (commitments basis), from an estimated 34 percent in 2005/06. - Total revenues are expected to reach 173 percent of non-oil GDP in 2006/07. - The level of expenditures deemed sustainable under the oil and gas savings rule is conservatively estimated at 76 percent. - On a ‘combined source’ basis (government and donor spending), total expenditure should increase only slightly compared to pre-2005/06 levels. ### Oil and gas management framework - The Petroleum Fund Law was promulgated in August 2005 and the framework became operational in the second half of 2005. - Related institutions established: Consultive Council, Investment Advisory Board, independent auditor selected by international open tender, participation in the Extractive Industries Transparency Initiative. - Transfers from the Petroleum Fund can only be made into a specific Treasury account and up to an annual expenditure ceiling equal to the sum of non-oil domestic revenues and the estimated permanent income from invested oil and gas revenues (the savings rule). - The framework remained robust and unaffected during the mid-2006 civil unrest; revenues continued to accumulate in the Petroleum Fund. ### Fiscal policy analysis and recommendations - Authorities prioritize improving public service delivery via higher and faster-executed public investment to consolidate social stability and promote private sector development. - The Sector Investment Programs (SIP) framework was designed to preserve the quality of public investment, foster complementarities with private investment, and maximize returns. - Budgeted increase in current expenditures is largely non-recurrent and aimed at bridging the transition to a new efficiency-oriented wage structure (no pay rises since 2002). - Authorities have an outstanding track record of fiscal soundness and currently have no public debt; they may consider concessional financing options in the future. - Tax policy: authorities are keen to explore simplifying the tax structure and reducing burdens on the non-oil economy; FAD mission is addressing the issue. ### Monetary policy and banking sector recommendations - Official dollarization remains the monetary framework and provides an effective anchor for price stability. - The framework is judged well suited to the country’s needs and constraints; scarce human resources reinforce keeping the current framework. - Banking sector: the increase in NPLs since mid-2006 mainly reflects civil unrest and is to some extent reversible. - Systemic impact is limited because local branches of solid foreign banks dominate the system. - Steps taken/planned: stepped-up provisioning, implementation of a credit registry by the BPA, and continued efforts to finalize Payments, AML and Central Bank laws and take them to Parliament. ### Structural reforms and private sector development - Authorities plan decisive action to improve the environment for private activity: tax system reforms, streamlining legislation, regulation and administrative procedures for domestic and foreign investment. - Reported increase in foreign investment since July 2006: about 30 new projects approved since July 2006, amounting to about USD 180 millions (almost half of non-oil GDP), against 12 projects in the previous 12 months. - Remaining constraints: business registration, land development, missing key legislation, overwhelmed court system, poor infrastructure, and lack of human capital. ### Executive Board assessment — key messages and recommendations - Directors commended authorities for stabilizing the economy and establishing a foundation for future growth. - Main challenge: use oil-and-gas resources and stable macroeconomic environment to lift the non-oil economy onto a higher growth path and reduce poverty. - Directors endorsed the authorities’ development strategy emphasizing: - Maintain a monetary and exchange regime that preserves macroeconomic stability. - Forceful progress to secure well-targeted and prioritized development spending. - Far-reaching reforms to encourage private activity and investment. - Directors supported sustainable stepping-up of government investment spending over the medium term but stressed careful planning and monitoring to guard against unproductive spending. - Welcomed measures to strengthen budget execution: small education and community grants, international outsourcing of large infrastructure projects, improved cash and commitment controls, and procurement decentralization. - Commended establishment of the petroleum fund and the saving rule; welcomed transparent reporting and participation in the Extractive Industries Transparency Initiative. - Supported the current monetary and exchange regime and urged fiscal restraint in wages, subsidies and other recurrent costs to contain price pressures. - Agreed that stronger institutional capacity and a well-functioning financial market are prerequisites before considering changes to the monetary framework. *IMF Executive Board concludes 2006 Article IV Consultation with the Democratic Republic of Timor-Leste (Public Information Notice No. 07/24).* ### introduction of a national currency. ### introduction of a national currency. ### External borrowing and fiscal stance - Directors urged the authorities to limit external borrowing to ensure consistency with the government’s investment priorities, the sustainable spending framework, and macroeconomic stability. - Directors emphasized that terms of external borrowing should be adequately concessional. ### Tax reform and non-oil sector development - Directors agreed that favorable oil revenue developments provide an opportunity to put in place wide-ranging tax reforms in the non-oil sector to help spur private economic activity. - Directors considered that a simplified, streamlined tax regime, with low tax rates and higher minimum thresholds, would better fit the limited administrative capacity. ### Banking sector risks and policy responses - Directors considered that the weakening in banks’ loan portfolios is unlikely to present a systemic risk, but noted it may reduce credit availability and slow the economic recovery. - Directors welcomed plans to: - further strengthen banking supervision; - create a loan registry; - introduce an alternative means of resolving commercial disputes; and - finalize banking sector legislation. - Directors cautioned that a state-owned rural-development bank—as being considered—must be operated on a strict commercial basis to avoid further weakening of the fragile financial system. ### Private investment, structural reform, and capacity building - Directors stressed the need for greater efforts to create an environment conducive to more private investment and growth. - Directors urged the authorities to expedite passage of critical legislation, such as the pending land law. - Directors noted that proposed amendments to labor legislation should encourage greater labor market flexibility. - Directors encouraged intensified efforts to strengthen capacity to compile and analyze basic macroeconomic data. ### Selected Economic Indicators, 2002–07 - GNI at current prices (in millions of U.S. dollars): 352 349 507 692 847 1375 - Non-oil GDP (in millions of U.S. dollars): 343 336 339 350 356 493 - Oil/gas income (in millions of U.S. dollars): 9 13 168 342 492 882 - Real non-oil GDP growth (percentage change): -6.7 -6.2 0.3 2.3 -1.6 32.1 - Inflation (percentage change, end-period) (CPI for Dili): 9.5 4.2 1.8 0.9 5.7 5.0 Central government budget (cash basis) (In percent of non-oil GDP): - Revenues: 24 31 98 137 172 202 - Domestic revenues: 6 9 11 9 9 8 - Oil/gas revenues: 9 12 77 128 161 192 - Grants: 10 10 10 0 2 2 - Expenditure: 20 20 21 26 40 43 - Recurrent expenditure: 17 18 18 20 33 29 - Capital expenditure: 3 3 3 7 7 14 - Overall balance: 4 11 77 111 132 158 - Non-oil fiscal balance: -5 -1 0 -17 -29 -34 Public debt: 0 0 0 0 0 0 Combined sources fiscal operations: - Revenues: 17 21 23 12 13 12 - Expenditure: 71 70 68 62 71 70 - Recurrent expenditure: 54 55 52 47 53 44 - Capital expenditure: 18 15 15 15 18 25 - Overall balance: -54 -50 -45 -50 -58 -58 Money and credit: - Broad money (end-period): 15.9 21.5 24.8 27.8 32.0 29.5 - Net domestic assets (end-period): -10.3 -10.7 -30.1 -17.7 -6.2 -0.1 External sector (In millions of U.S. dollars): - Current account excl. international assistance: -244 -208 -15 193 329 617 - Current account incl. international assistance: -128 -85 103 292 411 688 - Trade balance: -211 -186 -154 -127 -133 -219 - Merchandise exports: 6 8 8 9 8 10 - Merchandise imports: -218 -194 -163 -137 -141 -229 - Overall balance: 20 18 121 341 482 686 External sector (In percent of non-oil GDP): - Current account excl. international assistance: -71 -62 -4 55 93 125 - Current account incl. international assistance: -37 -25 30 84 116 141 - Trade balance: -62 -55 -46 -36 -38 -44 - Merchandise exports: 2 2 2 3 2 2 - Merchandise imports: -63 -58 -48 -39 -40 -46 - Overall balance: 6 5 36 97 136 139 *Sources: Data provided by the Timor-Leste authorities; and IMF staff estimates.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr0779.pdf_