Public Information Notice No. 04/118

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Democratic Republic of Timor-Leste

October 12, 2004

On July 16, 2004, 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 has begun nation-building following its restoration of independence in May 2002. Progress has been made in consolidating the new government's administrative power and fostering a stable political environment, despite some early challenges. Further steps have been taken under the government's initiatives to reconstruct the economy from the severe destruction of 1999 that followed the national referendum overwhelmingly supporting independence from Indonesia.

Despite progress in economic reconstruction, significant economic challenges remain. These challenges center around the strengthening of medium-term growth prospects to alleviate widespread poverty. Meeting the challenges requires the authorities to address deep-rooted structural problems, including poor infrastructure, low productivity (notably in agriculture), an underdeveloped legal system for business activity, and serious institutional and capacity constraints. Added to this task is the need for the productive use of growing oil/gas revenues expected over the medium term from the exploitation of oil/gas resources in the Timor Sea.

After a strong recovery from the 1999 destruction, economic activity slowed down substantially since mid-2002. Real GDP is estimated to have declined by 3 percent in 2003, reflecting the lingering impact of a reduced international presence. Inflationary pressures, however, have been waning in recent months, with CPI inflation declining to 4 percent (year-on-year) in April 2004. The external current account excluding official transfers remains in large deficit, but the deficit is narrowing, due to a further reduction in donor-assisted reconstruction activities. The Bayu-Undan oil/gas project has come on stream, paving the way for increased oil/gas revenues over the coming years. However, in the near and medium term these revenues are projected to be substantially smaller than earlier projected due to low production in initial few years.

Fiscal policy remains prudent. The budget for FY2003/04 (July-June) was tightened during the mid-year budget review (November 2003) in response to a potential decline in oil/gas revenues. A major tightening of expenditure policy was also incorporated in budget estimates for FY2004/05 and three-year forward projections through FY2007/08, with total expenditure budgeted to be compressed by 12 percent, on average, in comparison with the estimates envisaged during the November 2003 mid-year budget review. The expenditure compression is aimed primarily at narrowing the significant financing gaps that were projected during the mid-year budget review due to a substantial weakening in the outlook of oil/gas revenues. The prudent policy stance reflects the authorities' continued avoidance of external borrowing, as well as the lack of access to domestic borrowing under the current U.S. dollar-based monetary and exchange rate arrangement.

The expansion of the banking system continues, although its activity remains largely confined to the Dili area. Bank deposits increased by more than 35 percent (year-on-year) during the 12 months ending March 2004, as a third commercial bank commenced operations in mid-2003 and micro-financing operations gained momentum. Although a substantial portion of deposits continue to be invested abroad, bank lending (mainly to the construction and trading sectors) has started to pick up since mid-2003. Despite the increase, the amount of nonperforming loans has remained modest. Steps have been taken to prepare a payments law to address risks associated with the payments system and develop an insurance law to foster insurance activities, as well as build a framework for insurance supervision.

Progress has been made in implementing structural measures relating to private sector development and institution and capacity building. A commercial code and a company law were enacted as initial steps to establish a legal and regulatory framework for business activity. A policy paper on private investment was placed for public consultation in last November and draft domestic and foreign investment laws have been submitted to the Council of Ministers. Following the enactment of a basic law for land ownership in early 2003, draft laws for (i) leasing of private and public land and (ii) land and property dispute mediation are currently being reviewed by the Council of Ministers. To strengthen institutions and capacity (particularly those relating to governance and service delivery), actions are being taken in the context of the donor-supported Second Transition Support Program. Nonetheless, Timor-Leste continues to depend heavily on international experts for its daily administrative operations, and acceleration in institution and capacity building remains a major challenge, especially in view of a further winding-down of the UN-supported capacity building program.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They commended the authorities for their prudent macroeconomic policies in a challenging environment, and for the initial steps taken to address Timor-Leste's deep-rooted structural problems. Directors noted, however, that the significant weakening in economic activity underscores the urgency of strong actions to alleviate the country's widespread poverty and serious underemployment. They agreed that the authorities will need to step up their efforts to develop a dynamic private sector, strengthen Timor Leste's institutions and capacity, and make effective use of oil/gas wealth in order to improve growth prospects and reduce poverty. They stressed that continued international assistance will be essential to support the authorities' efforts toward these objectives.

Directors commended the authorities for maintaining a prudent fiscal policy to narrow the projected large financing gaps and safeguard the budget against volatile oil/gas revenues. They stressed the importance of follow-up actions to make the budget estimates for FY 2004/05 and over the medium term credible, while minimizing the adverse economic impact of the budgeted spending cuts. In this context, Directors highlighted the need for improvements in expenditure execution, careful prioritization of spending, and maintaining the policy of restraint with respect to wages and salaries, while ensuring that critical human resource needs in the public sector are effectively met. They also encouraged the authorities to step up efforts to improve the financial position of the power authority.

Directors observed that, despite the significant expenditure compressions, some financing gaps will still remain over the medium term. In the event that these gaps are not fully closed through further donor assistance, Directors advised the authorities to consider other financing options, given the limited scope for additional fiscal adjustment. These options should include the increased use of oil/gas revenues and the prudent tapping of concessional loans to fund essential capital investments, consistent with the country's absorptive and debt management capacity.

Directors underscored the critical importance of developing a long-term fiscal strategy aimed at ensuring the productive use of the country's oil/gas wealth, while sustaining a sound fiscal position over the long run. They agreed that part of the oil/gas wealth should be used to meet pressing investment needs for infrastructure and human capital development. However, they stressed that an unduly ambitious public investment program should be avoided in view of the country's still limited absorptive capacity, and indicated that a significant portion of oil/gas wealth should be saved in financial assets for future generations. Directors shared the government's view that, over the long-term, the non-oil tax base should be broadened in order to avoid excessive reliance on oil/gas revenue.

Directors encouraged the authorities to press ahead with their plan to establish a petroleum fund by mid-2005, in response to the commencement of oil/gas production in the Bayu-Undan field. They supported the authorities' intention to base the fund on a Norwegian model designed to ensure transparency and accountability in the management of oil/gas savings, and underscored that the continuation of a prudent fiscal policy will be essential for the effective operation of this fund. They welcomed the provision of Fund technical assistance in this area.

Directors reiterated their support for the current U.S. dollar-based monetary and exchange rate regime, in view of the existing institutional and financial constraints. Given the constraints of the current regime, prudent fiscal and wage policies will be essential to help avoid an erosion in Timor-Leste's external competitiveness. Directors welcomed the recent increases in bank lending and financial intermediation, while stressing the importance of close monitoring by the monetary authority to keep bank portfolios sound. They looked forward to the enactment of legislation on money laundering and combating the financing of terrorism.

Directors underscored the critical importance of private sector development in improving Timor-Leste's growth prospects and fostering economic diversification. They looked forward to the timely enactment of legislation to establish a clear framework for business activity, steps to develop an independent judiciary, and the swift completion and implementation of the Sector Investment Programs to improve infrastructure. Directors commended the authorities for their commitment to maintain a liberal trade and investment regime, but cautioned against the introduction of tax incentives to promote investment in view of their general ineffectiveness and potentially large revenue losses.

Directors urged the authorities to intensify their efforts to strengthen Timor-Leste's institutions and capacity, and welcomed their commitment to progress in this area. Given the further scaling-back in the UN-supported capacity building program, they stressed the importance of the expeditious implementation of medium-term capacity building plans, especially for the Ministry of Planning and Finance (MOPF). They welcomed initial steps to `Timorize" senior positions at the monetary authority, and encouraged further progress in improving the capacity of local officials.

Directors noted serious weaknesses in Timor-Leste's macroeconomic data. To build on the enactment of the statistical law last year, they urged the authorities to take early steps to improve the data, especially those relating to national accounts and the balance of payments, as well as to strengthen staff resources.