Public Information Notice No. 03/90

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the Democratic Republic of Timor-Leste

July 28, 2003

On July, 14, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Democratic Republic of Timor-Leste.¹

Background

Timor-Leste gained independence on May 20, 2002, which also marked the end of the 2½-year rule of the United Nations Transitional Administration in East Timor (UNTAET). The establishment of the transitional administration followed the widespread violence and destruction that erupted in reaction to a national referendum held in August 1999, which overwhelmingly supported then East Timor's independence from Indonesia. Notwithstanding some early political challenges, the new government has endeavored to consolidate its administrative reach in the context of a reduced international presence, while taking initial steps toward nation-building as set out in the National Development Plan (NDP). Timor-Leste joined the Fund and the World Bank Group on July 23, 2002.

With poor infrastructure, limited administrative capacity, and nascent institutions, Timor-Leste is one of the most underdeveloped economies in the region. Per capita GDP is estimated at about US$470 in 2001, and underemployment is widespread. Key social indicators, including life expectancy, and health and education indices, are also low. The economy is marked by subsistence agriculture (accounting for one-fourth of GDP and three-fourths of employment) and a limited foreign exchange earning capacity. Over the medium term, however, Timor-Leste is expected to benefit significantly from the commercial exploitation of oil/gas resources in the Timor Sea, which is projected to increase government revenues sharply.

The economy is still in the process of reconstruction from the turmoil of 1999. During the turmoil, two-thirds of the physical infrastructure is estimated to have been destroyed, and key economic institutions collapsed as a result of the departure of civil servants and experts, leading to a sharp fall in output (by more than 30 percent). Under the UNTAET, the reconstruction process began with significant financial support from the international community. With substantial technical assistance from the IMF, the fiscal and monetary authorities were reestablished and initial steps were taken to develop a statistics office. Also, the U.S. dollar was adopted as the official currency in January 2000. However, these institutions are still in their infancy, relying heavily on international experts, and their further development remains a major challenge for the authorities.

The NDP covering FY2002/03-2006/07 (fiscal year: July-June), prepared on the basis of a nationwide consultation process, lays out the attainment of higher growth (about 5 percent over the medium term) and the alleviation of poverty as two major principal objectives. The NDP recognizes that the development of a dynamic private sector and the building-up of institutions and local capacity, together with the maintenance of a stable macroeconomic environment, are critical for the realization of the growth target. To flesh out the NDP in operational terms and incorporate actions set out under a short-term priority program (the "stability program," focusing on good governance and job creation), a medium-term action plan (the Road Map) covering four years through FY2006/07 was worked out in early 2003.

Economic activity initially exhibited a strong recovery from the post-referendum destruction. Real GDP reached close to pre-crisis levels, aided by the large international presence and a rebound in agricultural production. However, growth has moderated substantially since mid-2002 as a result of a winding-down of the international presence. CPI inflation fell from 140 percent at end-1999 to 7 percent at end-April 2003 (on a year-on-year basis) in response to the increased availability of basic goods, as well as the adoption of the U.S. dollar-based currency system. The external current account has been in large deficit, reflecting substantial imports associated with donor-assisted reconstruction activities. The deficit, however, has been more than financed by official transfers, and the external current account inclusive of these transfers has been in surplus.

Central government budgetary operations have been marked by large deficits, reflecting pressing needs for reconstruction expenditures in the face of limited revenues. The deficits have been financed mostly through cash grants from donors, due to the lack of access to domestic borrowing and the authorities' cautious approach to external borrowing. Progress has been made in restoring the banking system, which now comprises the monetary authority, three foreign-owned commercial banks, and a microfinance institution. Deposits also increased substantially over the last three years. Nonetheless, the banking system is still at an early stage of development, with financial intermediation limited by the lack of viable domestic lending opportunities and an underdeveloped legal framework.

Executive Board Assessment

Executive Directors extended a warm welcome to Timor-Leste as the Fund's newest member. Directors commended Timor-Leste's impressive strides in recovering from the turmoil of 1999 under a reconstruction program supported by the international community. Real GDP has rebounded, inflation has moderated, and basic institutions for economic management have been restored. However, Directors stressed that the successful recovery from the turmoil is only the initial step toward addressing the enormous economic challenges facing the country, particularly poverty reduction. Noting the slowdown in business activity due to a winding-down of the international presence, they underscored the critical importance of strengthening growth prospects over the coming years while maintaining a stable macroeconomic environment. They considered the National Development Plan, which was prepared with the wide participation of the civil society, to be an appropriate basis for achieving these objectives.

Directors stressed that fiscal policy should bear the major burden of sustaining macroeconomic stability in view of the dollarization of the economy. Supporting the cautious external borrowing policy, they agreed that the thrust of fiscal policy in the short term should be to adjust overall expenditure in accordance with available fiscal resources, while meeting essential development and social needs. They welcomed the adoption of this principle in the budget for fiscal year 2003/04. To make the budget credible, they underscored the importance of improving expenditure execution and further strengthening tax administration to realize budgeted revenues.

Directors expressed concern about the financial problems facing the power authority, which have necessitated substantial budgetary transfers. They welcomed the authorities' decision to address poor management and bill collection through the introduction of an external management contract, and the adoption of a prepaid meter system. They urged prompt implementation of these reforms, as part of a longer-term strategy for the management of the power utility, in order to keep the budget on a sustainable path.

Directors stressed that a major challenge for fiscal policy in the medium term is how best to use the growing oil and gas revenues to promote growth and alleviate poverty, while safeguarding macroeconomic stability and a sound fiscal position. They encouraged development of a medium-term fiscal strategy that addresses the issue of the appropriate size of drawdowns on oil and gas wealth. While acknowledging that increased investment in infrastructure and human capital is needed, Directors advised the authorities to tailor the investment program to the country's absorptive capacity. In addition, they stressed the importance of domestic revenue mobilization to reduce the excessive dependence on oil and gas revenues, which are subject to volatile price fluctuations.

Against this background, Directors supported the authorities' plan to introduce a petroleum fund, noting that the principal objective of such a fund should be to enhance transparency and accountability in the management of oil and gas revenue so as to avoid corruption and mismanagement. They stressed that the key to effective functioning of a petroleum fund is the maintenance of a prudent fiscal policy. They welcomed the authorities' intention to follow the recommendations made by the technical assistance mission from the Fund's Fiscal Affairs Department regarding the operations of such a fund.

Directors endorsed the authorities' plan to maintain the current monetary and exchange rate regime and avoid introduction of a national currency for the time being. They observed that the current regime has contributed to financial stability, and is a workable framework given limited institutional capacity and lack of financial and market development. Directors welcomed the banking sector's steady recovery from the 1999 turmoil, but observed that financial intermediation needs to be improved in order to reduce interest rate spreads and make adequate credit available to the private sector. Directors were encouraged by the authorities' efforts to combat money laundering and terrorism financing, and urged enactment of legislation in this area compatible with international standards.

Directors considered private sector development to be crucial to Timor-Leste's growth prospects. They stressed the urgency of establishing a proper legal and regulatory framework for business activity, especially an independent judiciary, and encouraged early preparation and parliamentary approval of legislation for this purpose. They commended the authorities' intentions to maintain a liberal trade and investment regime, and to avoid administrative interference in the free functioning of the market mechanism, which are especially important for attracting foreign investment.

Directors emphasized that capacity building is a prerequisite for economic development in Timor-Leste. They noted the progress in institutional development over the last three years, especially in the area of economic management, but stressed that considerable work remains to be done. They therefore encouraged early development of a medium-term capacity-building program for the Ministry of Planning and Finance, and strengthening of the autonomy of the monetary authority.

Directors noted significant weaknesses in Timor-Leste's macroeconomic database, especially in the areas of the national accounts and the balance of payments. They welcomed the Fund's technical assistance in this area, and urged enactment of a statistical law as the first step toward improving the database.