## _cr08202 ## Source details **Canonical URL:** [_cr08202](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08202.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08202.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08202.pdf.json) --- ### Economic Setting - Civil unrest of the past two years interrupted Timor-Leste’s initial efforts to develop a stable and healthy economy; the security and political situation remains fragile. - Growth and macro developments: - Non-oil growth is estimated to have reached almost 8 percent in 2007 and should remain high in 2008. - Agriculture contracted in 2007 due to drought and locust infestations; output of coffee fell by an estimated 20 percent. - Private sector activity remains subdued by the security situation. - Inflation and prices: - Consumer prices increased by 8.9 percent in 2007 and are likely to stay high in 2008; food has a 60 percent weight in the CPI basket. - Excluding food prices, inflation was relatively low; demand-side price pressures are emerging in tight markets (e.g., construction materials). - Exchange rate and external price effects: - Weakening U.S. dollar and low inflation contributed to a moderate depreciation of the real effective exchange rate; on a nominal trade-weighted basis the exchange rate is unchanged relative to 2004. - Oil/gas sector and public finances: - Petroleum revenue reached 340 percent of non-oil GDP in 2007. - Petroleum Fund assets increased to $2.6 billion at end-March 2008 (about 6 times non-oil GDP). - Central government spending almost doubled in FY2006/07; merchandise imports almost doubled to an estimated 51 percent of non-oil GDP. - On a combined sources basis, total public sector expenditure in FY2008 is expected to reach 101 percent of non-oil GDP. - Budget execution and spending pressures: - Government spending to date remains far below budgeted levels, especially for investment; large stock of unspent commitments is carried forward. - MYBU includes rice purchases equal to 5.8 percent of GDP and significant increases in current spending; updated appropriations are expected to exceed the estimated “sustainable” spending level, but actual cash expenditure is likely to be significantly lower. - Financial intermediation: - Less than 2 percent of the population use banking facilities. - Non-performing loans and provisioning rose to, respectively, 28 percent and 53 percent of bank lending at end-March 2008. - Bank deposits have increased sharply but there has been little credit growth since 2006; banks placing excess funds abroad. - Structural constraints: - Civil unrest and mid-2007 general elections delayed structural reforms; critical economic legislation is pending, the court system is overwhelmed, contractual enforcement is weak, and business licensing regulations have become more complicated. ### Key Policy Issues and Recommendations - Core challenge: - How to use growing oil/gas revenue to develop a sustainable non-oil economy, while alleviating near-term social problems and maintaining macroeconomic stability. - Fiscal policy and petroleum wealth management: - Maintain long-term fiscal sustainability strategy targeting inter-generational equity through use of a petroleum fund, including identification of annual sustainable spending limits. - There is ample room under the fund’s arrangements for needed spending to address social and development needs. - Improve budget execution to enable targeted fiscal spending to rise to sustainable levels while recognizing administrative and absorptive capacity constraints that could lead to inflation pressure and poor quality spending. - Public and private investment: - Stepped up public and private investment needed, especially in infrastructure and human capital. - Fast-track updating of the national development plan (NDP) and expedite structural reforms to spur private activity. - Shift spending mix toward well-planned investment spending—bringing capital expenditure to about 30 percent of non-oil GDP—could be associated with annual growth rising to above 8 percent and less inflationary pressure than under the baseline. - Monetary and exchange rate framework: - Authorities reaffirm commitment to use of the U.S. dollar as the official currency. - Financial sector development: - Focus on creating a supportive environment for a stable financial system based on sound business practices to encourage financial deepening. - Budget composition and social support: - MYBU’s increased allocations for public works and social transfers respond to humanitarian and social pressures, but execution constraints and inflation risks warrant careful sequencing and targeting. ### Outlook and Scenarios - Baseline medium-term outlook: - Given favorable oil/gas revenue prospects and constraints on government capacity to spend, the “sustainable” spending level would be reached within a couple of years as budget execution gradually improves. - Non-oil economy growth projected to average about 5 percent annually over the medium term under current trends and slow reform. - Government expenditure will continue to drive growth, with capital outlays increasing gradually to 20-25 percent of non-oil GDP, and slowly declining inflation. - Higher-investment reform scenario: - If capital expenditure reaches about 30 percent of non-oil GDP and business environment reform succeeds, annual growth could rise to above 8 percent with less inflationary pressure than under the baseline. ### Key Risks (including Box 2 highlights) - Major identified risks: - Projections of oil/gas revenue and sustainable income are highly sensitive to global oil market developments. - A disruption at Bayu-Undan would negatively affect government finances. - If realized, the Greater Sunrise project would almost double sustainable income. - Continuing civil unrest and political uncertainty could distract from reforms, increase humanitarian assistance needs, and deter private investment. - Higher global food prices and regional market disruptions could lead to shortages and civil disturbances. - Failure to anchor government expenditure within a prioritized medium-term development plan could lead to waste, governance risks, increased inflation, and little or no reduction in poverty. - Rapid large-scale external borrowing without a prudent debt management strategy could erode fiscal sustainability. - Box 2 quantitative points: - Every $20 change in global oil/gas prices changes estimated sustainable spending by 10–15 percent of GDP annually. - Greater Sunrise revenue potential of about $10 billion or 10–15 times 2007 non-oil GDP; could commence production by 2015 and possibly double sustainable spending over the medium term. - A recent commercial discovery identified a significant new field; additional offshore exploration possible if prices remain high. ### Policy Discussions and Staff Views - Overarching themes: - Build a strong sustainable non-oil economy to create employment and reduce poverty. - Manage government spending to promote growth and address humanitarian needs without risking macroeconomic stability. - Maintain an appropriate exchange rate regime. - Promote financial deepening to encourage growth. - How to accelerate growth and reduce poverty: - Formal non-oil economy needs to expand at least 8 percent annually to support population growth and prevent deeper poverty. - Private sector potential in commercial agriculture, fisheries, and tourism requires significant public investment in infrastructure and human capital. - Population and labor metrics cited: - Population growth estimated at about 3.5 percent a year. - Youth unemployment in Dili at 40 percent. - Almost 45 percent of the population is under 15 years of age. - Staff recommendations: - Fast-track an updated and costed NDP to support the 2009 budget. - Expedite structural reforms: pass pending land law, simplify business regulations, judicial reform for commercial disputes. - Tax reform (Box 4) welcomed. - Tax Reform (Box 4 quantified elements): - Reduce income tax rates from 30 to 10 percent, with high thresholds that exempt most wage earners and full expensing of fixed assets for businesses. - Reduce import duties and sales tax rates from 6 to 2½ percent and service tax rates from 12 to 5 percent. - As a result, non-oil tax revenue is estimated to decline from about 10 percent to 5 percent of non-oil GDP. - How much should the government spend: - Staff projects a 50 percent increase in cash spending, weighted toward current expenditure. - Risks include price pressures and domestic absorptive constraints (ports, construction, skilled labor). - Staff recommendations to manage spending increases: - Temper expectations in line with implementation capacity; emphasize investment in infrastructure and human capital consistent with a prioritized NDP. - Monitor price developments; use mid-year budget reviews to manage excessive demand pressures. - Target humanitarian relief, design exit strategies to avoid long-term entitlements, support domestic agricultural production. - Consider public sector pay increases together with performance-improving reforms; note new 13th month payment and continued rice allowances represent an effective pay increase of over 20 percent to an already privileged group. - Recommendations to improve budget execution: - Enhanced budget execution through updated NDP and medium-term fiscal framework. - Streamline payment procedures, accelerate training and capacity building, increase delegation of financial management and procurement authority to line ministries. - Use cash grants for specific purposes where appropriate without weakening fiduciary standards. - Move to a cash-based budget system that limits expenditure carry-overs to major capital outlays and provide more comprehensive reporting on past budget execution. - Petroleum Fund assessment: - Arrangements appropriate to promote macroeconomic stability by separating budget spending from volatile revenue flows, mandating transparency, and investing funds abroad. - Framework flexible enough to allow spending above sustainable income in a given year if justified and presented to parliament. - Current sustainable income levels leave ample room to meet immediate social, security, and development needs. ### Investment, National Development Plan, and Petroleum Fund - An updated NDP would soon be ready, emphasizing human capital and infrastructure. - Authorities reaffirm commitment to the basic principles of the petroleum fund arrangement while planning to broaden the investment universe to increase returns. - Petroleum Fund functions: - Smoothing of budget spending. - Investment of the remainder abroad. - High level of transparency. - Flexibility to allow higher levels of spending if justified. - When revisiting the petroleum fund law to enhance expected rate of return, authorities are urged to preserve basic principles. - Operational developments: - Petroleum Fund invested in short- and medium-term U.S. government bonds tracking the Merrill Lynch US government bond index. - Global Custody Agreement signed with an internationally recognized financial services firm to act as global custodian. - BPA forming a team of finance professionals; World Bank and BIS assistance appreciated. - Timor-Leste accepted as an EITI Candidate Country in February; Secretary of State of Natural Resources responsible for EITI validation. ### Budget Execution, Capacity, and External Borrowing - Authorities expect reform efforts to improve budget execution; capital projects will rely largely on international and private sector expertise. - New government in office less than one year and faces very low administrative capacity. - External borrowing considerations: - Pros and cons being weighed. - Financial equivalence between foreign borrowing and drawing from the petroleum fund; concessional loans could be more cost effective. - Borrowing with attached technical assistance could assist implementation of major infrastructure projects. - Care to avoid unproductive investments, minimize inflation pressures, and create debt management capacity. - Staff recommendations: - Guard against unproductive spending and inflationary pressures through careful planning and monitoring. - Overall appropriations should align with implementation and absorption capacities. - Proposals to begin external borrowing should be transparently analyzed to ensure adequate concessionality, a clear net positive rate of return, and consistency with the NDP and macroeconomic stability. - Overcome impediments to budget execution via international outsourcing, realistic planning, streamlining payment procedures, and cash-based budgeting. ### Exchange Rate Regime and Competitiveness - Use of the U.S. dollar has supported macroeconomic stability by providing a credible nominal anchor and helping keep inflation in check. - Management of exchange rate and monetary policy would strain existing capabilities at the BPA. - Absence of monetary policy tools places greater importance on ensuring fiscal pressures and structural constraints do not undermine competitiveness. - REER has depreciated moderately; nominal effective exchange rate broadly unchanged from 2004. - REER depreciation mainly due to Timor-Leste’s record of relatively low inflation; structural factors are likely a greater obstacle to competitiveness. - Authorities’ views: - Existing exchange rate regime remains appropriate. - Stronger institutional capacity needed before planning introduction of a national currency. ### Promoting Financial Intermediation - Strengthened financial sector would benefit economic growth prospects. - Level of credit to the private sector not exceptionally low relative to comparators. - High level of NPLs not likely a systemic risk as all three commercial banks are branches of established foreign banks with expansion intentions. - Staff recommended actions: - Enact long-pending financial sector legislation, including law to transform the BPA into a central bank, banking, payments system, and anti-money laundering legislation. - Facilitate loan recovery and contract enforcement by finalizing land titling legislation and procedures; introduce alternative dispute mechanisms based on traditional systems. - Continue strengthening banking supervision. - Ensure public sector involvement in the financial sector be on commercial terms and supervised under domestic law. - Authorities’ plans: - Launch a central credit information registry shortly and continue enhancements in banking supervision. - Plans to take over the largest micro-finance bank and to create a National Development Bank (plans at an early stage). - Authorities emphasized preventing political influence and ensuring loans are evaluated on commercial terms. ### Data, Statistics, and Monitoring - Macroeconomic analysis hampered by absence of good quality data, particularly for national accounts. - Monetary aggregates and financial data now available in the IMF’s International Financial Statistics. - Good progress on balance of payments statistics since transfer to the BPA; first estimates will soon be published. - Staff recommended adequate resources be provided to compile the national accounts. - Timor-Leste maintains an open trade regime, with a uniform duty on imports and no quantitative restrictions. - Timor-Leste: data availability and dissemination table shows latest observations and frequencies (selected items dated between 2/2008 and 5/2008; GDP/GNP latest observation 2003). ### Key Banking Indicators (as reported) — selected exact values (percent) - Capital adequacy ratio 1/: - 2003 Q4: 227.9; 2004 Q4: 226.5; 2005 Q4: 121.2; 2006 Q4: 189.8; 2007 Q4: 189.0; 2008 Q1: 167.1; 2008 Q2: 134.8; 2008 Q3: 107.0; 2008 Q4: 87.6. - Net profit/average assets: - 2003 Q4: -0.4; 2004 Q4: 2.3; 2005 Q4: 2.6; 2006 Q4: -21.3; 2007 Q4: 0.5; 2008 Q1: 1.3; 2008 Q2: 1.6; 2008 Q3: 1.7; 2008 Q4: 0.6. - NPLs/total loans: - 2003 Q4: 6.3; 2004 Q4: 5.4; 2005 Q4: 12.5; 2006 Q4: 27.8; 2007 Q4: 29.9; 2008 Q1: 32.7; 2008 Q2: 30.4; 2008 Q3: 30.2; 2008 Q4: 28.2. - Total provisions/NPLs: - 2003 Q4: 2.2; 2004 Q4: 5.8; 2005 Q4: 23.2; 2006 Q4: 181.6; 2007 Q4: 169.6; 2008 Q1: 158.7; 2008 Q2: 165.9; 2008 Q3: 178.9; 2008 Q4: 187.2. - Liquid assets/total assets: - 2003 Q4: 74.3; 2004 Q4: 36.0; 2005 Q4: 34.8; 2006 Q4: 47.9; 2007 Q4: 55.4; 2008 Q1: 61.4; 2008 Q2: 63.0; 2008 Q3: 71.3; 2008 Q4: 69.7. ### Selected Social and Macro Indicators (selected exact values) - Gross national income per capita (US$), 2007: Timor-Leste 1,647; East Asia and Pacific 1,856; Low income countries 649. - GDP per capita (US$), 2007 (non-oil basis): Timor-Leste 378; East Asia and Pacific 4,363; Low income countries 1,884. - Total population (in millions): Timor-Leste 1.015. - Population growth (in percent) 3/: Timor-Leste 4.0. - Life expectancy at birth (years): Timor-Leste 57. - Infant mortality (per thousand live births): Timor-Leste 47. - Literacy rate (ages 15 and above): Timor-Leste 50 percent. - Population below the poverty line: Timor-Leste 40 (figure for 2001). - Households with access to electricity: Timor-Leste 26 (figure for 2001). - Population with access to improved water source 8/: Timor-Leste 58 (figure for 2004). ### Selected Fiscal, External, and Monetary Figures (selected exact series and projections) - GNI at current prices (US$ million): 2003/4 318; 2004/5 459; 2005/6 696; 2006/7 974; 2007H2 1,725; 2008 2,464. - Non-oil GDP at current prices (US$ million): 2003/4 298; 2004/5 309; 2005/6 332; 2006/7 327; 2007H2 396; 2008 473. - Real non-oil GDP growth (percentage change): 2003/4 0.1; 2004/5 4.2; 2005/6 6.2; 2006/7 -5.8; 2007H2 7.8; 2008 6.8. - Inflation (period average): 2003/4 7.2; 2004/5 3.2; 2005/6 1.8; 2006/7 4.1; 2007H2 8.9; 2008 9.0. - Current account excl. international assistance (US$ million): 2003 -479; 2004 -321; 2005 342; 2006 957; 2007 711; 2008 1,333 (Proj.). - Petroleum Fund balance (millions) 1/: ... 370; 1,012; 2,086; 3,834 (series as presented). - Medium-term baseline projections (selected): - GNI at current prices (US$ million): 2006 974; 2007 1,725; 2008 2,464; 2009 2,178; 2010 2,357; 2011 2,388; 2012 2,234; 2013 2,274. - Non-oil GDP (US$ million): 2006 327; 2007 396; 2008 473; 2009 530; 2010 584; 2011 635; 2012 684; 2013 738. - Oil/gas income (millions): 2006 637; 2007 1,309; 2008 1,974; 2009 1,632; 2010 1,757; 2011 1,738; 2012 1,535; 2013 1,521. - Real non-oil GDP growth (percentage change): 2006 -5.8; 2007 7.8; 2008 6.8; 2009 5.9; 2010 5.7; 2011 4.6; 2012 4.5; 2013 4.5. - Inflation (period average): 2006 4.1; 2007 8.9; 2008 9.0; 2009 7.0; 2010 6.0; 2011 5.0; 2012 3.5; 2013 3.5. - Oil/gas savings (stock): 2006 310; 2007 527; 2008 810; 2009 963; 2010 1,103; 2011 1,221; 2012 1,292; 2013 1,342. - Public foreign assets (end-period): 1,096; 2,316; 4,064; 5,333; 6,676; 7,981; 9,070; 10,133. ### IMF Staff Update: 2008 Mid-Year Budget Update (MYBU) — Key points - MYBU approved by Council of Ministers on June 18; will be sent to Parliament. - Revenue estimates expected close to staff’s projection of 424 percent of non-oil GDP. - Government proposes to increase spending by more than double that in the original 2008 budget, and about 50 percentage points higher than previously expected for the MYBU. - Bulk of increase reportedly for an Economic Stabilization Fund (ESF) to stabilize prices of rice and other foods, fuel, and construction materials. - MYBU implies an additional withdrawal from the Petroleum Fund of 61 percent of non-oil GDP above the estimated sustainable level, requiring special parliamentary approval. - Staff concerns: - Need for well planned and managed spending to guard against waste. - Given undefined operational details, weak administrative capacity, and timing, much of the ESF appropriation unlikely to be spent in remaining half of fiscal year. - Initial public reaction suggests significant opposition in Parliament. ### Public Information Notice (PIN No. 08/78, June 30, 2008) — Key summary points - Article IV consultation concluded on June 25, 2008. - Non-oil growth estimated to have reached almost 8 percent in 2007 and should remain high in 2008. - Consumer prices increased by 8.9 percent in 2007; food has a 60 percent weight in the CPI basket. - Petroleum revenue reached 340 percent of non-oil GDP in 2007; Petroleum Fund assets US$2.6 billion at end-March 2008 (about 6 times non-oil GDP). - Central government spending almost doubled in FY2006/07; merchandise imports almost doubled to an estimated 51 percent of non-oil GDP. - On a “combined sources” basis, total public sector expenditure in FY2008 expected to reach 101 percent of non-oil GDP. - Less than 2 percent of the population use banking facilities; NPLs and provisioning were 28 percent and 53 percent of bank lending at end-March 2008. - Medium-term outlook: under current trends and gradual budget execution improvement, non-oil economy should grow by about 5 percent annually; a shift toward capital expenditure about 30 percent of non-oil GDP plus business reforms could raise growth to above 8 percent. ### Staff Appraisal — Key findings and recommendations (selected) - Findings: - Good foundation for economic development but civil unrest caused setbacks; growth has not yet been sufficient to reduce widespread poverty. - Sound fiscal and monetary framework ensures macroeconomic stability; petroleum wealth offers potential to substantially increase living standards. - Investment is key to growth and poverty reduction; financial resources available but constrained by low administrative capacity. - Recommendations: - Fast-track update of the National Development Plan. - Encourage private investment: enact a land law, proceed with planned tax reform, simplify business regulations, improve judicial system. - Prioritize stepped-up investment given capacity constraints. - Address security and humanitarian needs with well-prioritized and carefully managed spending to avoid unproductive spending and inflationary pressures. - Overcome impediments to budget execution: international outsourcing, realistic planning, streamlining payment procedures, cash-based budgeting. - Preserve basic principles of the Petroleum Fund while enhancing expected rate of return. - Maintain the U.S. dollar regime until stronger institutional capacity is established. - Strengthen the financial sector: credit registry, banking supervision, pending legislation, alternative dispute mechanisms, ensure government participation on commercial terms and supervised under domestic banking laws. - Prioritize capacity to compile national accounts and improve monitoring of real sector activity. ### Consultation timing - Next Article IV consultation proposed to be conducted on the standard 12-month cycle. *International Monetary Fund staff report: Executive Summary and Informational Annex for the 2008 Article IV Consultation — DEMOCRATIC REPUBLIC OF TIMOR-LESTE (content unit: _cr08202).* ### Executive Summary ...................................................................................................... ### EXECUTIVE SUMMARY ### Economic Setting - The civil unrest of the past two years interrupted Timor-Leste’s initial efforts to develop a stable and healthy economy; the security and political situation remains fragile. - Growth and macro developments - Despite the domestic violence, growth rebounded in 2007, buoyed by higher public spending; non-oil growth is estimated to have reached almost 8 percent in 2007 and should remain high in 2008. - Agriculture contracted in 2007 due to drought and locust infestations; output of coffee fell by an estimated 20 percent. - Private sector activity remains subdued by the security situation. - Inflation and prices - Consumer prices increased by 8.9 percent in 2007 and are likely to stay high in 2008, driven by rising global food prices and reflecting food’s 60 percent weight in the CPI basket. - Excluding food prices, inflation was relatively low, but signs of increased demand-side price pressures are emerging in tight markets (e.g., construction materials). - Exchange rate and external price effects - The weakening U.S. dollar and low inflation contributed to a moderate depreciation of the real effective exchange rate over the past year; on a nominal trade-weighted basis the exchange rate is unchanged relative to 2004. - Oil/gas sector and public finances - The off-shore oil/gas sector has not been affected by the domestic crisis; petroleum revenue reached 340 percent of non-oil GDP in 2007. - Petroleum Fund assets increased to $2.6 billion at end-March 2008 (about 6 times non-oil GDP). - The large revenue inflows more than offset a steep increase in government expenditure; central government spending almost doubled in FY2006/07, and merchandise imports almost doubled to an estimated 51 percent of non-oil GDP. - On a combined sources basis, total public sector expenditure in FY2008 is expected to reach 101 percent of non-oil GDP. - Budget execution and spending pressures - Notwithstanding the sharp increase, government spending to date remains far below budgeted levels, especially for investment spending; budget execution is constrained by weak planning and procurement capacity and a large stock of unspent commitments is carried forward. - The planned 2008 mid-year budget update (MYBU) includes a large appropriation for rice purchases (5.8 percent of GDP) and significant increases in current spending appropriations for public works, transfers to refugees, veterans and the elderly, and higher public sector salaries. The MYBU updated appropriations are expected to exceed the estimated “sustainable” spending level defined under the Petroleum Fund arrangement, but actual cash expenditure is likely to be significantly lower. - Financial intermediation - Access to financial services remains limited; less than 2 percent of the population use banking facilities. - Non-performing loans and provisioning rose to, respectively, 28 percent and 53 percent of bank lending at end-March 2008. - Bank deposits have increased sharply but there has been little credit growth since 2006, with banks placing excess funds abroad. - Structural constraints - The civil unrest and mid-2007 general elections have delayed structural reforms; critical economic legislation is pending, the court system is overwhelmed, contractual enforcement is weak, and business licensing regulations have become more complicated. ### Key Policy Issues and Recommendations - Core challenge - How to use growing oil/gas revenue to develop a sustainable non-oil economy, while alleviating near-term social problems and maintaining macroeconomic stability. - Fiscal policy and petroleum wealth management - Maintain the authorities’ long-term fiscal sustainability strategy targeting inter-generational equity through use of a petroleum fund, including identification of annual sustainable spending limits. - There is ample room under the fund’s arrangements for needed spending to address social and development needs. - Steps to improve budget execution are encouraged to enable targeted fiscal spending to rise to sustainable levels, while recognizing administrative and absorptive capacity constraints that could lead to inflation pressure and poor quality spending. - Public and private investment - Stepped up public and private investment is needed, especially in infrastructure and human capital. - Fast-tracked updating of the national development plan is essential, along with expedited structural reforms to spur private activity. - A more appropriate and forceful shift in the spending mix toward well-planned investment spending—bringing capital expenditure to about 30 percent of non-oil GDP—would be associated with annual growth rising to above 8 percent and less inflationary pressure than under the baseline scenario. - Monetary and exchange rate framework - The authorities reaffirmed their commitment to use of the U.S. dollar as the official currency, given its success in helping keep inflation in check and the lack of capacity to manage monetary and exchange rate policy. - Financial sector development - The government should focus on creating a supportive environment for a stable financial system based on sound business practices to encourage financial deepening. - Budget composition and social support - The MYBU’s increased allocations for public works and social transfers respond to humanitarian and social pressures, but execution constraints and inflation risks warrant careful sequencing and targeting. ### Outlook and Scenarios - Baseline medium-term outlook - Given continued favorable oil/gas revenue prospects and constraints on government capacity to spend, the “sustainable” spending level would be reached within a couple of years as budget execution gradually improves. - Under current trends and slow reform of the business environment, non-oil economy growth is projected to average about 5 percent annually over the medium term. - In this baseline, government expenditure will continue to drive growth, with capital outlays increasing gradually to 20-25 percent of non-oil GDP, and slowly declining inflation. - Higher-investment reform scenario - If the spending mix shifts toward well-planned investment spending (capital expenditure about 30 percent of non-oil GDP) combined with successful business environment reform, annual growth could rise to above 8 percent with less inflationary pressure than under the baseline scenario. _International Monetary Fund staff report: Executive Summary_ ### 15. Key risks include: ### 15. Key risks include: ### Major identified risks - Projections of oil/gas revenue and sustainable income are highly sensitive to global oil market developments (Box 2). - A disruption at Bayu-Undan, the one field currently in production, would also have a negative impact on government finances. - If realized, the Greater Sunrise project would almost double sustainable income. - Continuing civil unrest and political uncertainty could: - distract from the pursuit of the reform agenda, - increase the need for short-term humanitarian assistance, - deter private investment. - Higher global food prices and regional market disruptions could lead to shortages and civil disturbances. - Failure to anchor government expenditure within a prioritized medium-term development plan in line with administrative capacity could lead to waste, governance risks, increased inflation, and little or no reduction in poverty. - Rapid assumption of large-scale external borrowing, particularly in the absence of a prudent debt management strategy, could erode fiscal sustainability. ### Box 2. Oil/Gas Sector Outlook — Key quantitative points - Every $20 change in global oil/gas prices changes estimated sustainable spending by 10–15 percent of GDP annually. - Pending agreement on a development plan, the Greater Sunrise oil/gas field (revenue potential of about $10 billion or 10–15 times 2007 non-oil GDP) could commence production by 2015, possibly doubling sustainable spending over the medium term. - A recent commercial discovery identified a significant new field, and additional oil/gas fields offshore may be explored if oil/gas prices remain high. ### III. Policy discussions — Overview themes - Building a strong and sustainable non-oil economy that would create employment and reduce poverty. - Managing government spending to promote growth and address humanitarian needs without risking macroeconomic stability. - Maintaining an appropriate exchange rate regime. - Promoting financial deepening to encourage growth. ### A. How to Accelerate Growth and Reduce Poverty? — Background and staff views - The formal non-oil economy needs to expand at least 8 percent annually to support the rapidly growing population and prevent poverty from deepening. - The private sector has potential in commercial agriculture (especially coffee), fisheries, and tourism, but significant public investment in infrastructure and human capital is required. - Timor-Leste has weak infrastructure and shortcomings in education and health; ranks especially poorly in telecommunications and transport infrastructure, and in ease of contract enforcement and property registration. - Population and labor metrics cited: - Population growth is estimated at about 3.5 percent a year. - Youth unemployment in Dili at 40 percent. - Almost 45 percent of the population is under 15 years of age. - Staff recommendations: - An updated and costed NDP should inform resource allocation, with projects prioritized according to the social rate of return, a carefully sequenced timetable, and a framework for monitoring performance. Completion of the NDP should be fast-tracked to support the 2009 budget. - Expedite structural reforms to increase productivity and spur private sector activity, including passage of a pending land law, simplified business regulations, and judicial reform for commercial disputes. - The tax reform under consideration (Box 4) is welcomed and presents an opportunity to remove tax incentives under investment laws. ### Box 4. Tax Reform — Quantified elements - Reduce income tax rates from 30 to 10 percent, with high thresholds that exempt most wage earners and full expensing of fixed assets for businesses. - Reduce import duties and sales tax rates from 6 to 2½ percent and service tax rates from 12 to 5 percent. - As a result, non-oil tax revenue is estimated to decline from about 10 percent to 5 percent of non-oil GDP. ### B. How Much Should the Government Spend to Promote Growth Without Risking Stability? — Background and staff views - Civil unrest and development needs point to the need for increased spending, but large prospective step-increases in the MYBU raise concerns regarding inflation and waste. - Staff projects a 50 percent increase in cash spending, weighted toward current expenditure. - Risks from rapid spending increases include significant price pressures and domestic absorptive constraints (ports, construction, skilled labor market). - Staff recommendations to manage spending increases: - Temper expectations and planned spending increases in line with implementation capacity; emphasize investment in infrastructure and human capital consistent with a prioritized NDP. - Closely monitor price developments for signs of emerging supply constraints; use mid-year budget reviews to manage excessive demand pressures. - Target humanitarian relief to the most needy and minimize disruptions of private markets; design an exit strategy to avoid creation of long-term entitlements; support domestic agricultural production. - Consider public sector pay increases together with performance-improving reforms; note that a new 13th month payment and continued rice allowances to civil servants represent an effective pay increase of over 20 percent to an already privileged group. - Recommendations to improve budget execution: - Enhanced budget execution through an updated NDP and medium-term fiscal framework. - Streamline payment procedures, accelerate training and capacity building, and increase delegation of financial management and procurement authority to line ministries. - Use cash grants for specific purposes where appropriate without weakening fiduciary standards. - Move to a cash-based budget system that limits expenditure carry-overs to major capital outlays and provide more comprehensive reporting on past budget execution. - Petroleum fund assessment: - Petroleum fund arrangements remain appropriate to promote macroeconomic stability by separating budget spending from volatile revenue flows, mandating transparency, and investing funds abroad. - The existing framework is flexible enough to allow the government to spend more than sustainable income in a given year if justification and consequences are presented to parliament. - Current sustainable income levels leave ample room to meet immediate social, security, and development needs. *Source: _cr08202 - 15. Key risks include:* ### 26. The authorities stressed that the long-term focus remains on investment. An ### The authorities stressed that the long-term focus remains on investment. An ### Investment, National Development Plan, and Petroleum Fund - An updated national development plan would soon be ready, emphasizing human capital and infrastructure. - Authorities reaffirmed commitment to the basic principles of the petroleum fund arrangement, while planning to broaden the investment universe to increase returns. - The petroleum fund is described as a cornerstone for sound management of the country’s resources, providing: - Smoothing of budget spending. - Investment of the remainder abroad. - A high level of transparency. - Flexibility to allow higher levels of spending if justified. - When revisiting the petroleum fund law to enhance the expected rate of return, authorities are urged to preserve the basic principles of the framework. ### Budget Execution, Capacity, and External Borrowing - Authorities expect reform efforts to soon improve budget execution; capital projects will rely largely on international and private sector expertise for design and implementation. - New government in office less than one year and faces a starting point of very low administrative capacity. - Appreciation of assistance from development partners, including the Fund and the World Bank, and donors including the AsDB providing technical assistance to infrastructure development. - External borrowing considerations: - Pros and cons are being carefully weighed. - Financial equivalence exists between foreign borrowing and drawing from the petroleum fund, but concessional loans could be more cost effective. - Borrowing with attached technical assistance could assist implementation of major infrastructure projects. - Care will be taken to avoid unproductive investments, minimize inflation pressures, and create debt management capacity. - Staff recommendations related to spending and borrowing: - Large increases in government expenditure intensify the need to guard against unproductive spending and inflationary pressures through careful planning and monitoring. - Overall appropriations should be in line with implementation and absorption capacities. - Large spending increases planned for the mid-year 2008 budget raise concerns about potential waste and pressure on prices, including large ad-hoc wage increases. - Proposals to begin external borrowing should be carefully weighed and transparently analyzed to ensure adequate concessionality, a clear net positive rate of return, and consistency with the NDP and macroeconomic stability. - Achieving good results depends on overcoming impediments to budget execution; international outsourcing, more realistic planning, streamlining of payment procedures, and a move to cash-based budgeting are recommended. ### Exchange Rate Regime and Competitiveness - Background and staff views: - Use of the U.S. dollar has supported macroeconomic stability by providing a credible nominal anchor and helping keep inflation in check. - Management of exchange rate and monetary policy would strain existing capabilities at the Banking and Payments Authority (BPA). - Absence of monetary policy tools places greater importance on ensuring fiscal pressures and structural constraints do not undermine competitiveness. - The exchange rate does not appear fundamentally out of line with its long-term equilibrium. - REER has depreciated moderately; nominal effective exchange rate broadly unchanged from 2004. - REER depreciation is mainly due to Timor-Leste’s record of relatively low inflation, implying that price competitiveness has not worsened with growing petroleum revenue. - Structural factors are likely a greater obstacle to competitiveness and growth. - Poor data quality precludes standard empirical assessment of the exchange rate level, but a broad forward view suggests policies appear consistent with long-term external stability. - Authorities’ views: - Existing exchange rate regime remains appropriate. - Stronger institutional capacity needed before planning introduction of a national currency. - Intention to address structural impediments to competitiveness and remain attentive to emerging inflationary pressures. ### Promoting Financial Intermediation - Background and staff views: - Strengthened financial sector would benefit economic growth prospects. - Level of credit to the private sector in Timor-Leste is not exceptionally low relative to comparators. - High level of NPLs is not likely a systemic risk as all three commercial banks are branches of established foreign banks with stated intentions to expand outside of Dili. - Fiscal risks appear small given high levels of provisioning and liquidity. - Staff recommended focus on building a supportive environment for a stable financial system, including: - Enacting critical long-pending financial sector legislation, including the law to transform the BPA into a full-fledged central bank, as well as banking, payments system, and anti-money laundering legislation. - Facilitating loan recovery and contract enforcement by finalizing land titling legislation and procedures, and introducing alternative dispute mechanisms based on traditional systems. - Continuing strengthening of banking supervision. - Ensuring public sector involvement in the financial sector be on commercial terms and supervised under domestic law. - Authorities’ plans and views: - Authorities agreed that the slow-down in credit growth since mid-2004 and the increase in banks’ NPLs were concerns. - Ongoing efforts include a central credit information registry to be launched shortly and continued enhancements in banking supervision. - Banks seen as reluctant to take risks and charging excessive interest; authorities expect credit to pick up with a growing economy. - Need to expand access to financial services, especially in the districts; government plans to take over the largest micro-finance bank and to create a National Development Bank (plans at an early stage). - Authorities emphasized preventing political influence and ensuring loans are evaluated on commercial terms. ### Data, Statistics, and Monitoring - Progress and remaining needs: - Macroeconomic analysis hampered by absence of good quality data, particularly for national accounts. - Monetary aggregates and financial data are now available in the IMF’s International Financial Statistics. - Good progress on compilation of balance of payments statistics since transfer to the BPA; first estimates will soon be published. - Staff recommended adequate resources be provided to compile the national accounts. - Timor-Leste maintains an open trade regime, with a uniform duty on imports and no quantitative restrictions. ### Key Banking Indicators (in percent) — Timor-Leste: Banking Indicators (as reported) - Capital adequacy ratio 1/: - 2003 Q4: 227.9 - 2004 Q4: 226.5 - 2005 Q4: 121.2 - 2006 Q4: 189.8 - 2007 Q4: 189.0 - 2008 Q1: 167.1 - 2008 Q2: 134.8 - 2008 Q3: 107.0 - 2008 Q4: 87.6 - Net profit/average assets: - 2003 Q4: -0.4 - 2004 Q4: 2.3 - 2005 Q4: 2.6 - 2006 Q4: -21.3 - 2007 Q4: 0.5 - 2008 Q1: 1.3 - 2008 Q2: 1.6 - 2008 Q3: 1.7 - 2008 Q4: 0.6 - NPLs/total loans: - 2003 Q4: 6.3 - 2004 Q4: 5.4 - 2005 Q4: 12.5 - 2006 Q4: 27.8 - 2007 Q4: 29.9 - 2008 Q1: 32.7 - 2008 Q2: 30.4 - 2008 Q3: 30.2 - 2008 Q4: 28.2 - Total provisions/NPLs: - 2003 Q4: 2.2 - 2004 Q4: 5.8 - 2005 Q4: 23.2 - 2006 Q4: 181.6 - 2007 Q4: 169.6 - 2008 Q1: 158.7 - 2008 Q2: 165.9 - 2008 Q3: 178.9 - 2008 Q4: 187.2 - Liquid assets/total assets: - 2003 Q4: 74.3 - 2004 Q4: 36.0 - 2005 Q4: 34.8 - 2006 Q4: 47.9 - 2007 Q4: 55.4 - 2008 Q1: 61.4 - 2008 Q2: 63.0 - 2008 Q3: 71.3 - 2008 Q4: 69.7 - Source: Data provided by the Timor-Leste authorities. - Note: 1/ Applies to IMFTL only as other banks are branches of foreign parents. ### Staff Appraisal — Key Findings and Policy Recommendations - Findings: - Timor-Leste has a good foundation for economic development but civil unrest caused setbacks and growth has not yet been sufficient to reduce widespread poverty. - Sound fiscal and monetary framework has ensured macroeconomic stability; petroleum wealth offers potential to substantially increase living standards. - Original National Development Plan strategy remains valid: long-term oil/gas revenue saving policy via the petroleum fund; well-targeted development spending; a monetary and exchange rate regime that preserves macroeconomic stability; a supportive environment for private investment and activity. - Investment is key to growth and poverty reduction, particularly infrastructure and human capital; financial resources are available but outcomes constrained by low administrative capacity and a difficult starting point. - Recommendations: - Fast-track update of the National Development Plan to reinforce objectives. - Encourage private investment: enact a land law this year and proceed with planned tax reform; simplify business regulations and improve the judicial system. - Prioritize stepped-up investment given capacity constraints. - Address pressing security and humanitarian needs with well-prioritized and carefully managed spending to avoid unproductive spending and inflationary pressures. - Overcome impediments to budget execution for capital projects; use international outsourcing, realistic planning, streamlining payment procedures, and cash-based budgeting. - Preserve basic principles of the petroleum fund while enhancing expected rate of return. - Maintain the U.S. dollar regime until stronger institutional capacity is established before introducing a national currency. - Continue initiatives to strengthen the financial sector: credit registry, banking supervision, pending financial sector legislation, creation of alternative dispute mechanisms, and ensure any government participation in the financial system is on commercial terms and supervised under domestic banking laws. - Prioritize creating capacity to compile national accounts and improve monitoring of real sector activity. *Source: _cr08202 - 26. The authorities stressed that the long-term focus remains on investment. An* ### 48. It is proposed that the next Article IV consultation be conducted on the standard ### _cr08202 - 48. It is proposed that the next Article IV consultation be conducted on the standard ### Consultation timing - It is proposed that the next Article IV consultation be conducted on the standard 12-month cycle. ### Regional and global comparisons (Figure 1 — key points) - Nominal GDP Per Capita, 2007 (In US$): Timor-Leste shown relative to Fuel Exporters, Developing Asia, Developing Countries, Sub-Sahara Africa, Pacific Islands (chart). - Inflation, 2005-07 Average (y/y percent change): Timor-Leste compared with Fuel Exporters, Sub-Sahara Africa, Developing Countries, Pacific Islands, Developing Asia (chart scale 0, 3, 6, 9, 12). - External Debt, 2007 (In percent of GDP): Timor-Leste compared with Fuel Exporters, Sub-Sahara Africa, Developing Asia, Pacific Islands, Developing Countries (chart scale 0, 10, 20, 30, 40). - Proven Oil Reserves, 2006 (In billions of barrels): Timor-Leste shown relative to Indonesia, Malaysia, Yemen, Equatorial Guinea, Syria, Angola (chart scale 0, 2, 4, 6, 8, 10). - Human Development Ranking, 2007 (1-177, 177 is the lowest): Timor-Leste placed relative to Developing Asia, Pacific Islands, Fuel exporters, Sub-sahara Africa (chart scale 1, 26, 51, 76, 101, 126, 151, 176). - Per-capita Oil Revenue and Public Expenditure, 2007 (In millions of US$): Timor-Leste shown relative to Indonesia, Colombia, Bolivia, Ecuador, Nigeria, Mexico, Russia, Venezuela (chart scale 0, 500, 1000, 1500, 2000, 2500, 3000). ### Summary judgments from the regional comparison text - Six years after independence, standards of living in Timor Leste remain low compared to those in other developing regions in the world. - Despite good macroeconomic management, reflected in low inflation and the absence of external public debt, living standards remain low. - Large per-capita oil reserves provide policymakers with significant opportunities to strengthen growth prospects, while maintaining a stable macroeconomic environment. 2/ ### Recent macroeconomic developments (Figure 2 — key points and descriptive findings) - External Current Account Balance, excluding International Aid (In millions of US dollars): annual series shown for 2001–2007 (est.) with values on chart scale -900, -600, -300, 0, 300, 600, 900. - Non-oil Exports (In millions of US dollars): series 2001–2007 (est.) with chart scale 0–10. - Real GNI and non-oil GDP Growth (In percent): series 2001–2007 (est.) with chart scale -10 to 15. - Consumer Prices (12-month average percentage change): Headline, Food, Non-food series from Jan-04 to Jan-08 with chart scale 0–15. - Text findings: - Civil unrest halted the nascent recovery in non-oil GDP in 2006 and has subdued the recovery. - Rising global food prices have pushed up inflation. - Growing oil/gas revenue has boosted national income and the current account surplus. - From a relatively small base, non-oil exports have continued to grow. ### Medium-term baseline scenario (Figure 3 — indicators and projections) - Growth Indicators: - Non-oil GDP growth rate and Per capita non-oil GDP (US$, RHS) projected 2005–2013 (chart scale -10 to 15 for growth; 0–2,500 for per capita levels). - Per capita GNI (US$, RHS) projected 2005–2013 (chart). - Balance of Payments Indicators (In percent of non-oil GDP): Current account excl. international aid, Current account incl. international aid, Trade balance (excl. oil revenue) projected 2005–2013 (chart scale -200 to 500). - Central Government Balances (In percent of non-oil GDP): Non-oil balance and Overall balance projected across fiscal periods 2004/5–2012 (chart scale -150 to 450). - Combined Sources Expenditure and Capital Expenditure (In percent of non-oil GDP): Donors, Government shares and projections 2004/5–2012. - Government Revenue (In percent of non-oil GDP): Oil and gas vs Non-oil and gas projected 2004/5–2012. ### Selected social indicators (Table 1 — key exact values) - Gross national income per capita (US$) 2/: Timor-Leste 1,647; East Asia and Pacific 1,856; Low income countries 649. - GDP per capita (US$) 2/: Timor-Leste 378; East Asia and Pacific 4,363; Low income countries 1,884. - Area (in thousands of square kilometers): Timor-Leste 15. - Total population (in millions): Timor-Leste 1.015; East Asia and Pacific 1,899; Low income countries 2,420. - Population growth (in percent) 3/: Timor-Leste 4.0; East Asia and Pacific 0.9; Low income countries 1.9. - Life expectancy at birth (years): Timor-Leste 57; East Asia and Pacific 71; Low income countries 60. - Male: Timor-Leste 56; East Asia and Pacific 69; Low income countries 59. - Female: Timor-Leste 58; East Asia and Pacific 73; Low income countries 62. - Infant mortality (per thousand live births): Timor-Leste 47; East Asia and Pacific 24; Low income countries 74. - Under 5 mortality rate (per thousand live births): Timor-Leste 55; East Asia and Pacific 29; Low income countries 112. - Literacy rate (in percent, ages 15 and above) 5/: Timor-Leste 50; East Asia and Pacific 91; Low income countries 61. - Male literacy: Timor-Leste 54; East Asia and Pacific 95; Low income countries 72. - Female literacy: Timor-Leste 45; East Asia and Pacific 87; Low income countries 50. - Gross primary school enrollment rate (in percent): Timor-Leste 99; East Asia and Pacific 111; Low income countries 102. - Immunization rate (percent of children aged 12 to 23 months): - Measles: Timor-Leste 64; East Asia and Pacific 89; Low income countries 69. - DPT: Timor-Leste 67; East Asia and Pacific 89; Low income countries 68. - Other indicators: - The population below the poverty line: Timor-Leste 40 (figure for 2001). - Households with access to electricity: Timor-Leste 26 (figure for 2001). - Population with access to improved water source 8/: Timor-Leste 58 (figure for 2004); East Asia and Pacific 79; Low income countries 75. - Notes: - 1/ Data are for 2006, unless otherwise indicated. - 2/ Timor Leste figures are for 2007. GDP refers to non-oil GDP at market prices. - 3/ Average growth over 2000-2006. - 4/ Figures are for 2005. - 5/ For ages 15 and above. - 6/ In percentage share of the total. - 7/ Figures are for 2001. - 8/ Figures are for 2004. ### Selected economic indicators, budgets, and fiscal data (Tables 2–4 — selected exact figures) - Aggregate national accounts and price series (2003/4–2008 columns, selected): - GNI at current prices (US$ million): 2003/4 318; 2004/5 459; 2005/6 696; 2006/7 974; 2007H2 1,725; 2008 2,464. - Non-oil GDP at current prices (US$ million): 2003/4 298; 2004/5 309; 2005/6 332; 2006/7 327; 2007H2 396; 2008 473. - Real non-oil GDP growth (percentage change): 2003/4 0.1; 2004/5 4.2; 2005/6 6.2; 2006/7 -5.8; 2007H2 7.8; 2008 6.8. - Inflation (percentage change, period average): 2003/4 7.2; 2004/5 3.2; 2005/6 1.8; 2006/7 4.1; 2007H2 8.9; 2008 9.0. - Investment-saving and fiscal aggregates (selected): - Gross investment (2003/4–2008): 2, 9, 2, 1, 2, 8, 3, 1? (table shows series in context — preserve original layout). - Gross national savings (selected): 22, 29, 10, 31, 83, 32, 3387 (table shows series; retain source presentation). - Central government budget (selected monetary values, in US$ millions): - Revenues (2003/4–2008): 35, 105, 157, 289, 350, 424. - Domestic revenues (selected): 10, 12, 10, 11, 10, 7. - Oil/gas revenues (selected): 148, 314, 627, 534, 0417 (table formatting preserved in source). - Grants (selected): 11, 10, 3, 00. - Expenditure (cash basis) (selected): 212, 226, 485, 371. - Recurrent expenditure (selected): 201, 192, 139, 4157 (source layout). - Capital expenditure (selected): 13, 59, 12, 14. - Overall balance (selected): 148, 313, 124, 229, 7352. - Cumulative oil/gas savings (selected): 4, 5, 11, 23, 105, 278, 10 (table format). - Central Government Budget, FY2004/05–2008 (Table 3 — selected) - Revenue (in millions of US dollars): 2004/05 337; 2005/6 517; 2006/7 733; 2007H2 1,045; 2008 693; 1,379; 2,005; 2,005 (table shows multiple columns). - Oil/gas revenues (in percent of non-oil GDP, memorandum): 266, 482, 993, 672, 1974. - Oil fund balance (in percent of non-oil GDP) (mem.): 22, 197, 290, 386, 527, 8, 10. - Non-oil fiscal balance (mem.): 1, -47, -121, -85, -307. - Notes: - 1/ Fiscal year: July-June until 2008, then calendar year. Central Government includes subsidies to Autonomous Agencies. - 2/ Oil gas revenue are not included as a budget revenue item and flows directly to the petroleum fund. - 3/ Oil/gas revenue is included in the line of oil fund financing. - 4/ New projects financing requested from donors; still uncommitted. ### Balance of payments overview (Table 5 — selected exact values) - Current account excl. international assistance (in millions of US$): 2003 -479; 2004 -321; 2005 342; 2006 957; 2007 711; 2008 1,333 (Proj.). - Current account incl. international assistance (in millions of US$): 2003 -232; 2004 627; 2005 353; 2006 1,111; 2007 1,168; 2008 1,689 (Proj.). - Trade balance (selected): -121, -121, -117, -114, -192, -299 (2003–2008 series). - Merchandise exports 1/ (selected): 8, 8, 9, 9, 8, 11. - Merchandise imports (selected): -130, -129, -125, -123, -200, -309. - Income (net) (selected): 20, 149, 365, 647, 1,330, 1,991. - O/w: oil/gas revenue and interest: 13, 14, 13, 54, 637, 1,974 (table shows series). - Capital and financial accounts (selected): 4195, -303, -600, -1,021, -1,689 (2003–2008 series). - Public foreign assets (end-period) (memorandum item): 72, 196, 524, 1,096, 2,316, 4,064 (2003–2008). ### Monetary developments (Table 6 — selected exact values) - Banking System Net foreign assets (millions US$): 70, 108, 184, 159, 113, 183, 305 (2002–2008 proj.). - Broad money (end-period): 44, 62, 66, 78, 100, 144, 187 (2002–2008 proj., in millions). - Narrow money (selected): 38, 33, 32, 39, 54, 75, 97. - Commercial banks: Deposits (selected): 446, 266, 779, 914, 3188 (table formatting preserved). - Memorandum items: - Petroleum Fund balance (millions) 1/: ... 370, 1,012, 2,086, 3,834 (series). - Credit to the private sector (annual percentage change): ... 309.9, 237.2, 19.8, 5.2, -9.8, 5.0. - Credit/non-oil GDP (percent): 2.2, 8.9, 28.6, 31.9, 34.1, 25.4, 22.3. - Deposits/non-oil GDP ratio (percent): 15.4, 20.7, 21.3, 23.5, 30.6, 36.3, 39.5. ### Medium-term outlook (Table 7 — Baseline Scenario, selected exact projections) - GNI at current prices (in millions of US dollars): 2006 974; 2007 1,725; 2008 2,464; 2009 2,178; 2010 2,357; 2011 2,388; 2012 2,234; 2013 2,274. - Of which: Non-oil GDP (in millions): 2006 327; 2007 396; 2008 473; 2009 530; 2010 584; 2011 635; 2012 684; 2013 738. - Oil/gas income (millions): 2006 637; 2007 1,309; 2008 1,974; 2009 1,632; 2010 1,757; 2011 1,738; 2012 1,535; 2013 1,521. - Real non-oil GDP growth (percentage change): 2006 -5.8; 2007 7.8; 2008 6.8; 2009 5.9; 2010 5.7; 2011 4.6; 2012 4.5; 2013 4.5. - Inflation (percentage change, period average): 2006 4.1; 2007 8.9; 2008 9.0; 2009 7.0; 2010 6.0; 2011 5.0; 2012 3.5; 2013 3.5. - Central government budget (percent of non-oil GDP) — Revenues: 2006 289; 2007 350; 2008 424; 2009 313; 2010 306; 2011 280; 2012 231; 2013 213. - Domestic revenue: 2006 111; 2007 0?; 2008 75; 2009 56; 2010 67 (table shows series). - Oil/gas revenue (percent of non-oil GDP): 275, 340, 417, 308, 301, 274, 224, 206 (2006–2013). - Overall balance (percent of non-oil GDP): 2006 24; 2007 29; 2008 7?; 2009 24; 2010 0? (table format retained). - Oil/gas savings (stock): 2006 310; 2007 527; 2008 810; 2009 963; 2010 1,103; 2011 1,221; 2012 1,292; 2013 1,342. - External sector: - Current account balance (millions): 2006 531; 2007 1,168; 2008 1,689; 2009 1,202; 2010 1,275; 2011 1,229; 2012 1,015; 2013 981. - Trade balance (selected percent of non-oil GDP): -114, -192, -299, -416, -458, -476, -486, -506. - Public foreign assets (end-period): 1,096; 2,316; 4,064; 5,333; 6,676; 7,981; 9,070; 10,133. - Public foreign assets (in months of imports of goods and services): 107, 139, 158, 150, 170, 196, 217, 233. ### Vulnerability indicators (Table 8 — selected exact values, 2001–2007) - Public debt (percent): 0.0 for 2001–2007. - Broad money (percent change, 12-month basis): 2001 155.5; 2002 -14.5; 2003 41.1; 2004 6.9; 2005 18.3; 2006 28.2; 2007 43.9. - Private Sector credit (percent change, 12-month basis): 2001 900.0; 2002 113.1; 2003 312.5; 2004 235.3; 2005 19.8; 2006 5.2; 2007 -9.8. - Exports (percent change, 12-month basis in U.S. dollars): 2001 230.8; 2002 48.8; 2003 21.9; 2004 0.4; 2005 3.4; 2006 7.6; 2007 -10.7. - Imports (percent change, 12-month basis in U.S. dollars): 2001 18.4; 2002 7.4; 2003 3.4; 2004 -0.2; 2005 -3.2; 2006 -1.9; 2007 63.0. - Current account balance (excl. international assistance) (percent change): 2001 -281.2; 2002 -226.1; 2003 -160.8; 2004 -103.6; 2005 10.2; 2006 90.2; 2007 195.0. - Public foreign assets (in millions of US$) 3/: 2001 31.1; 2002 50.9; 2003 71.9; 2004 196.4; 2005 523.5; 2006 1,095.5; 2007 2,316.4. - In months of corresponding imports of goods: 3.2; 4.9; 6.7; 18.2; 50.2; 107.0; 138.9. - Net foreign assets of commercial banks (in millions of US$): 41.7; 26.6; 46.7; 1.3; 5.8; 29.4; 87.9 (2001–2007). - Total external debt: 0.0 for 2001–2007. - Notes: - 1/ No external or domestic debt has been contracted. - 2/ Excludes currency in circulation on which no data are available. - 3/ Includes investments of Petroleum Fund assets overseas. ### Key substantive findings and policy implications highlighted in the content - Timor-Leste exhibits low standards of living relative to other developing regions six years after independence. - Macroeconomic management indicators are positive: low inflation in past years and absence of external public debt. - Growing oil/gas revenue has substantially boosted national income, current account surpluses, and public foreign assets (Petroleum Fund). - Large per-capita oil reserves present significant opportunities to strengthen growth prospects while maintaining macroeconomic stability. - Recent risks and challenges identified include: - Civil unrest in 2006 that halted the nascent recovery in non-oil GDP. - Rising global food prices contributing to higher inflation in 2007–08. - Dependence on oil/gas revenue flows and the need to manage petroleum wealth (Petroleum Fund balances and sustainable spending considerations). - Fiscal management challenges reflected in non-oil fiscal deficits and reliance on oil fund financing to cover non-oil fiscal deficits. - Monetary and financial conditions: rapid expansion in broad money and intermittent swings in private sector credit growth highlight financial sector dynamics to monitor. *INTERNATIONAL MONETARY FUND — DEMOCRATIC REPUBLIC OF TIMOR-LESTE, Staff Report for the 2008 Article IV Consultation—Informational Annex, Prepared by the Asia and Pacific Department, June 10, 2008.* ### ANNEX I. TIMOR-LESTE: FUND RELATIONS ### ANNEX I. TIMOR-LESTE: FUND RELATIONS (As of April 30, 2008) ### Membership and Fund Resources - Status: Joined 7/23/2002; Article VIII - General Resources Account: - Quota: 8.20 SDR Million 100.00 percent - Fund holdings of currency: 8.20 SDR Million 100.00 percent - 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 Fund: None ### Exchange Rate Arrangements - On January 24, 2000, the U.S. dollar was adopted as the official currency of then East Timor by the United Nations Transitional Administration in East Timor (UNTAET). - The arrangement has been maintained after Timor-Leste’s independence on May 20, 2002. - The monetary authority does not undertake foreign exchange transactions; commercial banks handle them on the basis of rates quoted in the international markets. ### Article IV Consultations - 2006 Article IV consultation discussions were held during October 9–20, 2006. - The last Article IV consultation was concluded on January 29, 2007. - The Public Information Note may be found at http://www.imf.org/external/np/sec/pn/2007/pn0724.htm. ### Technical Assistance — Overview - Since late 1999, the Fund has provided significant technical assistance focused on establishing key economic institutions (especially fiscal and monetary authorities) and developing local capacity. - Between late 1999 and end–2007, Timor-Leste has been one of the largest recipients of Fund technical assistance. ### FAD (Fiscal Affairs Department) Assistance - Early multi-topic FAD missions helped establish and develop the Central Fiscal Authority (CFA, February 2000), which developed into the Ministry of Planning and Finance. - Assistance provided to develop budget preparation, establish tax policy and administration, strengthen treasury and expenditure management, and advise on oil sector fiscal regimes. - Long-term resident advisors assigned to the Ministry of Planning and Finance and the Revenue Service of Timor-Leste, partly under a cost sharing arrangement with the UN. - Over August 2004–July 2005, a FAD resident advisor assisted in the design and establishment of the Petroleum Fund, which started operations in August 2005. - A FAD resident advisor to the Treasurer started work in December 2006 to strengthen expenditure management, reporting and budget execution; after a short break, a replacement will commence in June 2008. - In 2007, a FAD TA mission provided guidance for future reform of the non-oil tax regime. ### LEG (Legal Department) Assistance - LEG missions advised on fiscal and financial legislation: tax legislation, the budget and financial management law, and banking regulations (monetary authority, banking system, payments system). - Joint assistance with MFD (now MCM) to draft an AML/CFT Law. - Assistance, in collaboration with FAD, for drafting the Petroleum Fund Act and tax consolidation, and with MCM for drafting the Central Bank Law. ### MCM (Monetary and Capital Markets Department) Assistance - Numerous missions to establish and develop the Central Payments Office (CPO, January 2000), later transformed into the Banking and Payments Authority (BPA) (November 2001). - Assistance to establish a payment system, prepare banking legislation, and develop functions of the monetary authority, including banking supervision, asset management, accounting, and organization and management. - Assistance on adoption of a dollar-based currency system and issuance of domestic coins to supplement U.S. dollar coins. - Recent assistance areas: - Draft insurance law and develop insurance supervision framework. - Strengthen banking supervision. - Address money laundering and financing of terrorism. - Establish and train the investment unit responsible for managing Petroleum Fund assets (funded by Norway; resident adviser commenced March 2005; replacement expected to commence in 2008 after contract renegotiations). - Prepare for establishment of the central bank. - Design a more effective organizational structure at the BPA. - Modernize payment systems and accounting for the Petroleum Fund. - Long-term resident advisors assigned to the 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) Assistance - Multi-sector statistical mission in November 2000 assessed official macroeconomic data availability and helped establish the Statistic Division of the Ministry of Planning and Finance. - Long-term statistical advisor provided over November 2001–October 2005; a peripatetic statistical advisor appointed in 2007. - The peripatetic advisor is assisting in improving data compilation and developing local capacity to prepare balance of payments statistics—responsibility for this was transferred to the BPA in 2007. - Early 2008 monetary and financial statistics mission helped introduce standardized report forms (SRFs) for reporting monetary data to the IMF and an integrated monetary database. - Subsequently, Timor-Leste has, for the first time, been able to publish a country page in IFS. ### Resident Representative - A resident representative office was established in Dili in August 2000. - The current resident representative, Mr. Tobias Rasmussen, assumed the post in February 2006. *ANNEX I. TIMOR-LESTE: FUND RELATIONS (As of April 30, 2008)* ### introduction of the standardized report forms (SRFs). Beginning in February 2008, monetary ### introduction of the standardized report forms (SRFs) ### Monetary statistics and reporting reforms - Beginning in February 2008, monetary data are reported to the IMF for publication in the International Financial Statistics and IFS Supplement on Monetary and Financial Statistics. - SRF-based data will be used for the Fund’s operational and publication purposes. - The BPA is planning to introduce a new call report form in 2008 to obtain balance sheet information from other depository corporations. - A follow-up mission has been tentatively scheduled during FY09 to assist the authorities in this endeavor. ### Balance of payments compilation and gaps - No official balance of payments data are available, except on merchandise exports and imports (starting March 2000), but no reports are available since July 2007. - The merchandise trade series have significant gaps; they are based on customs reports with a breakdown for major commodity categories, but: - Data do not include oil and gas exports. - Trade data do not include any estimate of large unrecorded border trade. - In Fund staff estimates: - Data on oil/gas revenue are recorded as current income based on fiscal data. - All other major items in the balance of payments are estimated by Fund staff on the basis of limited information obtained from various sources, including bilateral donors and banks. - Institutional response: - The Ministry of Finance transferred responsibility for the compilation of the balance of payments to the BPA in 2007. - An STA peripatetic advisor is assisting the BPA to develop balance of payments statistics. ### Timor-Leste: data availability and dissemination (Table of Common Indicators, As of May 27, 2008) - Exchange Rates: Date of latest observation 5/2008; Date received 5/2008; Frequency of Data M; Frequency of Reporting M; Frequency of publication M. - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation 2/2008; Date received 3/2008; Frequency M; Reporting M; Publication Q. - Reserve/Base Money (excludes currency in circulation): Date of latest observation 4/2008; Date received 5/2008; Frequency M; Reporting M; Publication Q. - Broad Money (excludes currency in circulation): Date of latest observation 4/2008; Date received 5/2008; Frequency M; Reporting M; Publication Q. - Central Bank Balance Sheet: Date of latest observation 4/2008; Date received 5/2008; Frequency M; Reporting M; Publication Q. - Consolidated Balance Sheet of the Banking System: Date of latest observation 4/2008; Date received 5/2008; Frequency M; Reporting M; Publication Q. - Interest Rates: Date of latest observation 4/2008; Date received 5/2008; Frequency Q; Reporting Q; Publication A. - Consumer Price Index: Date of latest observation 4/2008; Date received 5/2008; Frequency M; Reporting M; Publication M. - Revenue, Expenditure, Balance and Composition of Financing – Central Government: Date of latest observation 12/2007; Date received 2/2008; Frequency Q; Reporting Q; Publication A. - Stocks of Central Government and Central Government-Guaranteed Debt: No debt contracted. - External Current Account Balance: Data not available. - Exports and Imports of Goods and Services: Date of latest observation 07/2007; Date received 09/2007; Frequency M; Reporting M; Publication M. - GDP/GNP: Date of latest observation 2003; Date received 10/2004. - Gross External Debt: Not applicable. - International Investment Position: (no date provided) - Notes from table footnotes (selected): - 1 Includes reserve assets pledged or otherwise encumbered as well as net derivative positions. - 2 Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds. - 3 Foreign, domestic bank, and domestic nonbank financing. - 4 The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments. For Timor-Leste it includes public spending from donors, on which data on execution are not available. - 5 Includes only goods. There are significant gaps in the series. No information on services is available. - 6 Frequency codes: Daily (D), Weekly (W), Monthly (M), Quarterly (Q), Annually (A); NA: Not Available. - 7 Includes external gross financial asset and liability positions vis à vis nonresidents. ### IMF staff update: 2008 mid-year budget update (MYBU) — Statement by the IMF Staff Representative (June 25, 2008) - Timing and approval: - The 2008 mid-year budget update (MYBU) was approved by the Council of Ministers on June 18 and will shortly be sent to Parliament for consideration. - Revenue and spending projections: - Revenue estimates are expected to be close to staff’s projections of 424 percent of non-oil GDP. - The Government proposes to increase spending by more than double that in the original 2008 budget, and about 50 percentage points higher than previously expected for the MYBU. - The bulk of the increase is reportedly for a new Economic Stabilization Fund (ESF) to stabilize the price of rice and other foods, fuel, and construction materials. - Petroleum Fund withdrawal: - To finance the higher appropriations, the MYBU implies an additional withdrawal from the Petroleum Fund of 61 percent of non-oil GDP above the estimated sustainable level, which requires special approval from Parliament. - Staff concerns and assessment: - The MYBU reinforces concerns about the need for well planned and managed spending to guard against waste. - Given undefined operational details, weak administrative capacity, and timing, it is not expected that much of the ESF appropriation could be spent in the remaining half of the fiscal year. - Initial public reaction suggests the MYBU proposal will encounter significant opposition in Parliament. ### Central Government Budget (selected figures and notes) - Table header: Central Government Budget (In percent of non-oil GDP) - Selected cells (presented in table format in source; key items shown here verbatim where provided): - Revenue: 291 350 291 423 418 - of which oil and gas: 281 340 287 417 410 - Expenditure (commitments): 555 272 105 154 - Current: 524 453 76 121 - Capital: 381 929 33 - Memorandum items: - Cash opening balance 4/: 115 115 38 38 38 - Carry-over opening balance 3/ 4/: 5959 20 20 20 - Carry-over spending 5/: 5922 20 20 20 - Total cash spending 5/: 1145 39 21 25 174 - 'Sustainable' spending: 77 ... 66 90 92 - Notes: - 1/ Preliminary, as of mid-May. Cost of rice subsidies (5.8 percent of non-oil GDP) is included in current expenditure on a net basis. - 2/ Approved by Council of Ministers June 18. Includes 51 percent of non-oil GDP for an economic stabilization fund. - 3/ Cash spending of current budget. - 4/ Figures for 2007H2 are higher because of comparing to half-year GDP. - 5/ Figures in budget columns assume full cash execution, also of carry-over. ### Public Information Notice and macroeconomic assessment (PIN No. 08/78, June 30, 2008) - Article IV consultation concluded on June 25, 2008. - Growth and output: - Following negative growth in 2006, non-oil growth is estimated to have reached almost 8 percent in 2007 and should remain high in 2008. - Agricultural production contracted in 2007 due to drought and locust infestations; coffee output fell by an estimated 20 percent. - Inflation: - Consumer prices increased by 8.9 percent in 2007 and are likely to stay high in 2008; food has a 60 percent weight in the CPI basket. - Excluding food prices, inflation was relatively low, though demand-side price pressures are emerging. - External and fiscal positions: - Petroleum revenue reached 340 percent of non-oil GDP in 2007, with petroleum fund assets increasing to US$2.6 billion at end-March 2008 (about 6 times non-oil GDP). - Central government spending almost doubled in FY2006/07, with a further increase in spending during the second half of 2007. - Merchandise imports almost doubled to an estimated 51 percent of non-oil GDP. - On a “combined sources” basis, total public sector expenditure in FY2008 is expected to reach 101 percent of non-oil GDP. - Financial sector and credit: - Less than 2 percent of the population use banking facilities. - Nonperforming loans and provisioning are, respectively, 28 percent and 53 percent of bank lending at end-March 2008. - Little credit growth since 2006; banks placing excess funds abroad. - Structural and institutional issues: - Civil unrest and mid-2007 elections delayed structural reforms. - Drafts of critical economic legislation still pending; court system overwhelmed; business licensing regulations have become more complicated. - Medium-term outlook: - Under current trends and gradual improvement in budget execution and slow reform, non-oil economy should grow by about 5 percent annually over the medium term. - A more forceful shift toward well-planned investment spending and successful business environment reform could raise annual growth to above 8 percent and reduce inflationary pressure. ### Executive Board Assessment and policy advice - Overall view: - Directors praised authorities for solid recent macroeconomic performance and maintained macroeconomic stability amid civil unrest, aided by a sound fiscal and monetary framework. - Key challenge: use growing oil and gas revenue to develop a sustainable non-oil economy while alleviating social problems and maintaining macroeconomic stability. - Endorsed strategy elements: - Long-term oil and gas revenue savings policy. - Well-targeted development spending. - A monetary and exchange rate regime that preserves macroeconomic stability. - A supportive environment for private investment and activity. - Specific recommendations and cautions: - Encourage private sector development; step up public investment in infrastructure and human capital. - Further reforms to simplify business regulations, clarify land tenure rights, and improve the judicial system. - The increase in government expenditure planned for midyear 2008 requires careful planning and monitoring to ensure productivity and avoid inflationary pressures. - Adoption of cash-based budgeting would be helpful. - Enhance administrative and absorptive capacities for efficient and timely budget operations; continued technical assistance will be needed. - Develop a medium-term fiscal framework aligned with macroeconomic stability and absorptive capacity. - Preserve Petroleum Fund principles: smooth budget spending, invest abroad resources not required for budget execution, and mandate transparency. - Preserve U.S. dollar as currency until stronger institutional capacity is developed before considering a national currency. - Strengthen the financial sector: complete pending financial sector legislation, create an alternative dispute resolution mechanism, ensure any public sector participation is on commercial terms and supervised under domestic banking laws. - Proposals for external borrowing should be weighed carefully and be adequately concessional, deliver a clear net positive rate of return, and be consistent with macroeconomic stability. - Commended progress on compilation of financial and balance of payments statistics and encouraged compilation of national accounts to better monitor real sector activity. ### Selected economic indicators (2003–08) — key figures (as presented) - GNI at current prices (US$ million): 318 459 696 974 1,725 2,464 - Non-oil GDP at current prices (US$ million): 298 309 332 327 396 473 - Real non-oil GDP growth (percentage change): 0.1 4.2 6.2 -5.8 7.8 6.8 - Including United Nations 1/: -6.2 0.4 2.3 -3.4 16.2 4.7 - Inflation (percentage change, end-period) 2/: 4.2 2.5 1.0 6.7 7.6 9.0 - Inflation (percentage change, period average) 2/: 7.2 3.2 1.8 4.1 8.9 9.0 - Investment-saving balance (In percent of non-oil GDP): - Gross investment 3/: 29 21 21 21 28 31 - Gross national savings: 22 29 103 183 323 387 - External savings: 8 -9 -82 -162 -295 -357 - Central government budget (In percent of non-oil GDP): - Revenues: 35 105 157 289 350 424 - Domestic revenues: 10 12 10 11 10 7 - Oil/gas revenues: 14 83 146 275 340 417 - Grants: 11 11 0 3 0 0 - Expenditure (cash basis): 21 22 26 48 53 71 - Recurrent expenditure: 20 19 21 39 41 57 - Capital expenditure: 1 3 5 9 12 14 - Overall balance: 14 83 131 242 297 352 - Non-oil fiscal balance: 0 0 -16 -33 -43 -65 - Public debt: 0 0 0 0 0 0 - Cumulative oil/gas savings: 4 5 112 310 527 810 - Combined sources fiscal operations (In percent of non-oil GDP): - Domestic revenue and budget grants: 23 25 13 16 12 8 - Expenditure: 68 67 64 83 88 101 - Recurrent expenditure: 52 50 47 64 66 78 - Capital expenditure: 16 16 17 20 22 23 - Overall balance: -45 -42 -51 -67 -77 -93 - Money and credit: - Broad money (end-period) 6/: 21 21 23 31 36 40 - Net domestic assets (end-period): -15 -38 -24 -3 -44 -24 - External sector (In millions of U.S. dollars): - Current account excl. international assistance: -479 -321 34 295 771 1,333 - Current account incl. international assistance: -23 26 273 531 1,168 1,689 - Merchandise exports 7/: 8 8 9 9 8 11 - Merchandise imports: -130 -129 -125 -123 -200 -309 - Overall balance: 18 121 -29 -70 147 0 - (In percent of non-oil GDP) - Current account excl. international assistance: -161 -104 10 90 195 282 - Current account incl. international assistance: -8 9 82 162 295 357 - Overall balance: 6 39 -9 -21 37 0 - Notes: - 1/ Includes locally paid compensation of UN peacekeeping mission staff. - 2/ Whole of the country CPI from 2003. - 3/ Excludes oil/gas sector investment. - 4/ Fiscal years (July-June) up to FY2006/07 (in column for 2006); Fiscal year corresponds to calendar years from 2008. - 5/ Includes autonomous agencies and quasi-fiscal expenditure programs undertaken by bilaterals and multilaterals outside the central government budget. The revenue decline in 2005 reflects the creation of the petroleum fund, to which oil revenue now accrues. Income from the fund and donor grants finance the fiscal deficit. - 6/ Excludes currency holdings by the public, for which no data are available. - 7/ Excludes oil/gas revenue, which is recorded as income, and re-exports, which primarily relate to repatriation of UN peacekeeping equipment. *Source: IMF staff report content provided in the supplied document.* ### 1. Introduction ### 1. Introduction ### Key facts and context - Timor-Leste has been gradually reinforcing its democratic institutions, but the process has not been smooth; the 2006 crisis, triggered by rivalry within the Timorese security forces that rebelled, illustrated the country's extreme fragility. - National elections: - Presidential election: April and May 2007. - Legislative elections: June 2007. - These were the first national post-independence elections organized by Timorese authorities. - Demographic and social indicators: - Population: about one million inhabitants. - Literacy: More than half is illiterate. - Labor force: most of the labor force (over 4/5) gets its subsistence from agriculture and fishery. - Population growth after independence: about 3.5 percent a year. - Age structure: About 70 percent of the population is under 30-years-old. - Life expectancy: about 56 years old. - Geographic concentration: Capital is home to about a quarter of the labor force. - Youth unemployment (ages 15 to 29) in the capital: unemployment stands at about 40 percent. - Internally Displaced Persons (IDPs): Full reintegration of some one hundred thousand IDPs is far from achieved; about 30% of them continue to reside in 58 camps, mainly in the capital. - Human Development Index: ranked 150 out of 177 countries in the 2007/2008 UNDP HDI. - Poverty: Estimates suggest that as much as 42% of the population is now below the national poverty line of $0.55 per day. - Non-oil GDP per capita: $378 in 2007 (Timor-Leste is the poorest country compared with ASEAN countries, on a non-oil basis). ### 2. Macroeconomic overview ### Output, shocks, and recovery - 2006 civil unrest led to a contraction of real non-oil GDP of about 5.8 percent. - Real non-oil GDP is estimated to have rebounded to 7.8 percent in 2007, driven largely by government and donor spending. - Adverse factors limiting recovery: unstable security conditions, drought, and locust infestations. - Coffee production decline: about 20 percent. ### Inflation and price stability - Policy measures contributing to price stability: - The USD as the currency of legal tender provides an effective nominal anchor. - Strategy to invest oil-and-gas wealth abroad. - Responsible fiscal policy tracked by sustainable spending defined by the Petroleum Fund Law. - Food-price shock in early 2007: - Higher international food prices (especially rice), poor harvests, and difficulties securing imported rice caused a hike in inflation in Q1 2007. - By end-2007 price level had fallen significantly; inflation averaged 8.9 percent over 2007. - Food share of CPI: about 58 percent. - Share of food items that are imported: about half. - Excluding food, inflation recorded a slight reduction in 2007 to under 3.5 percent on average. - Authorities' mitigation: - Government decided to import rice for resale to local retailers at subsidized prices, representing an additional cost to the budget, to mitigate pass-through of international rice prices. ### External balances and petroleum revenues - Offshore oil-and-gas sector not affected by civil unrest. - Petroleum revenue reached 340 percent of non-oil GDP in 2007. - Petroleum Fund assets: $2.6 billion at end-March 2008 (about 6 times non-oil GDP). - The Greater Sunrise oil/gas field could commence production by 2014, although serious questions remain on project financial viability. ### Fiscal execution and spending dynamics - 2007 government spending rise reflected gradual decline in donor spending; total expenditure rise was much lower than government spending rise. - Staff's financial programming for 2008 projects government cash spending: - Double that in FY2006/07. - 60 percent higher than the annual rate in the second half of 2007. - Execution rates in 2007: - Less than 60 percent of the transitional 2007 budget (second half of 2007) was spent on a cash basis. - Execution rate for capital expenditure: just 12 percent. - Carry-over of financial resources due to execution difficulties does not violate the Petroleum Fund Law; resources drawn respected annual estimated sustainable limits. - Authorities have introduced procedures to limit carry-over of obligations between fiscal years but acknowledge execution constraints will persist, though less pronounced over time. ### Financial sector - Rise in nonperforming loans and provisioning reflects deterioration from recent past security conditions. - Several commercial banks (branches of foreign banks) have expressed interest in opening new branches outside the capital, suggesting no evidence of systemic risk. ### 3. Oil and gas resources ### Petroleum Fund design and governance - Timor-Leste established the Timor-Leste Petroleum Fund in 2005 to assure inter-generational equity and fiscal sustainability; modeled after the Norwegian petroleum fund. - The Petroleum Fund is integrated into the central government budget. - Transfers to the budget are subject to a spending ceiling based on fiscal sustainability policy. - Annual sustainable spending = sum of estimated permanent (interest) income from oil-and-gas wealth and domestic non-oil revenue. - Petroleum Fund Law allows drawings to exceed the sustainable level with parliamentary approval; this option has never been used. - Petroleum Fund assets are invested abroad to limit risk and minimize real exchange rate appreciation pressures. - Governance roles: - Minister of Planning and Finance: overall management and investment strategy. - Banking and Payments Authority (BPA): operational management; submits quarterly reports to the Minister. - Ministry publishes an annual report with financial statements certified by an internationally recognized audit firm. - Investment Advisory Board: strategic investment advice to the Minister. - Independent Consultative Council: advises Parliament on Petroleum Fund issues. - International rankings: Petroleum Fund generally considered at the top for transparency and accountability. ### Investment strategy and operational developments - Current investments: short and medium-term U.S. government bonds, managed passively to track the Merrill Lynch US government bond index. - Authorities recognize the need to develop a long-term investment strategy. - Operational step taken: signing a Global Custody Agreement with an internationally recognized financial services firm to act as global custodian for Petroleum Fund assets (procured via international tender). - Contracted firm responsibilities include custody, settlement arrangement for trading instructions from external managers, monitoring external managers' performance, providing BPA with investment performance and compliance services, and Petroleum Fund financial accounting and reporting. - This supports future appointment of specialized external managers to broaden the investment mandate and achieve higher long-term returns. - BPA strategy: form a team of finance professionals to manage Petroleum Fund assets; Timorese authorities appreciate World Bank and BIS assistance for initial phase. - Extractive Industries Transparency Initiative (EITI): - Timor-Leste's Multi-Stakeholder Working Group met; Timor-Leste was accepted in February as an EITI Candidate Country. - Secretary of State of Natural Resources is responsible for undertaking the EITI validation. - Authorities are committed to complying with international best-practices in this area and for the Petroleum Fund. ### 4. Poverty reduction and structural reforms ### Short-term priorities and social cohesion - Short-term focus: food security and social cohesion. - Rice subsidization: used to shield vulnerable populations from famine risks due to supply shortages, weather disturbances, and plagues. - Pacification policy and National Recovery Strategy (endorsed December 2007) focus on: - Reintegration of petitioners from the 2006 rebellion into military and civilian life. - Reintegration of IDPs, particularly housing. - Involvement of the United Nations, development partners, and civil society. - Additional measures address severe difficulties faced by elderly and disabled people. - Strengthened measures reflected in the 2008 mid-year budget update approved by the Council of Ministers and to be sent to parliament. ### Long-term priorities and structural reforms - Long-term goal: develop a sustainable non-oil economy within a stable macroeconomic environment. - Structural legacy: public administration long employed civil servants with very low productivity; productive sectors underdeveloped; private sector remains insipient (micro and small-businesses dependent on Government contracts). - Prioritized public investment areas: - Infrastructure: road building, housing, water supply, electricity generation, using labor-intensive strategies where possible to promote employment among low-skilled population. - Human capital: strengthen education and professional qualification, including introduction of free basic education and nine years of compulsory attendance. - Institutional and regulatory framework. - Tax reform: - New non-petroleum tax system significantly reduced tax rates, lowered compliance costs, and streamlined regulations. - Expected decline in non-oil tax revenue from about 10 percent to 5 percent of non-oil GDP — a budgetary cost the authorities assume to boost a formal private sector, using sustainable fiscal space from oil-and-gas revenues. - Other bottlenecks to address: - Expand access to financial services, especially in districts, by encouraging expansion of commercial bank branches of established foreign banks and creating a National Development Bank (plans under analysis). - Implement land reform, expected to be completed by the end of the year, to create framework for land ownership, titling, and registration. - Advance judicial reform, including enforcement of judicial decisions. - Capacity needs: substantial physical and human investment and technical support required. ### External financing considerations and macro-stability measures - Timor-Leste currently has no external public debt. - If external borrowing is considered for long-term priorities, debt management expertise would need to be developed from scratch. - For the very immediate future, external financing may be less favorable compared with using Petroleum Fund resources. - 2008 mid-year budget update presents needs and justifies, as being in the long-term interest, spending above the estimated sustainability limit; execution difficulties probably will contain spending below this limit. - Inflationary risk management: - Government conscious of potential inflationary risk from higher spending in a limited absorption-capacity economy and intends to contain inflationary pressures (noted risks especially on construction materials). - Government approved establishment of a Fund for Economic Stability to contain rises in prices of food, fuels, and construction materials. - Medium-term goal of the Fund: reconstruct economic capacity and develop programs to help population deal with crisis effects, supporting short- and long-term priorities within a stable macroeconomic framework. ### Legal and transparency compliance - All decisions taken and to be sent to parliament respect the Law and transparency requirements that characterize the Timor-Leste Petroleum Fund. ### 5. Final remarks ### Overall assessment and international involvement - Post-rebellion situation: rebel attacks in February ended with surrenders; disturbances have significantly diminished and the country returned to a state of normalcy. - Fragility remains latent pending near-term consolidation of social cohesion, eradication of food insecurity, and long-term development of a sustainable formal non-oil economy. - International community involvement is essential to sustain the current juncture. - IMF role: the economic task is huge and requires permanent in situ counseling; Timorese authorities highly appreciate IMF support and request continuation of current involvement. - Authorities express deepest appreciation for the competence and personal engagement of the IMF resident representative. *Source: _cr08202 - 1. Introduction* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08202.pdf_