Public Information Notice No. 08/78

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

June 30, 2008

On June 25, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Democratic Republic of Timor-Leste.¹

Background

Growth rebounded in 2007, although the civil unrest continues to undermine the economy. Following negative growth in 2006, the peak year for the civil unrest, non-oil growth is estimated to have reached almost 8 percent in 2007 and should remain high in 2008. Growth is driven mainly by the public sector, as government expenditure surges and donor spending remains high. Agricultural production contracted in 2007 due to drought and locust infestations. Output of coffee, the main non-oil export commodity, fell by an estimated 20 percent. Private sector activity remains subdued by the security situation.

Inflation has risen sharply, but remains low relative to regional comparators. 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. Fuel prices have also risen in line with international prices. While government subsidies for rice have partially shielded consumers, the threat of rice shortages looms. Excluding food prices, inflation was relatively low, although signs of increased demand-side price pressures are emerging in tight markets, e.g., in construction materials.

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. Revenue from off-shore oil/gas continues to surge, reflecting high international prices. 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).

The large revenue inflows more than offset the steep increase in government expenditure, as external and fiscal surpluses further widened. Central government spending almost doubled in FY2006/07², with a further increase in spending during the second half of 2007, as reflected in expanding non-oil deficits. Government expenditure drove a surge in merchandise imports, which also almost doubled to an estimated 51 percent of non-oil GDP.

The increase in government expenditure has more than offset a gradual decline in donor spending. On a "combined sources" basis, which includes donor spending for projects identified in the national development plan, total public sector expenditure in FY2008 is expected to reach 101 percent of non-oil GDP. Although the recent civil unrest-related humanitarian needs have led to new commitments, international assistance is expected to decline further over the coming years.

Notwithstanding the sharp increase, government spending to date remains far below budgeted levels, especially for investment spending. Budget execution remains constrained by weak planning and procurement capacity, as financial management reforms have not yet had a significant impact. In addition, a large stock of unspent commitments continues to be carried forward, despite efforts to tighten procedures.

The planned 2008 mid-year budget update (MYBU) includes a significant increase in current spending appropriations. Additional funds are being allocated for public works programs, transfers to refugees, veterans and the elderly, and higher public sector salaries. The MYBU also includes a large appropriation for rice purchases (5.8 percent of GDP) to be used for subsidized resale to local retailers, distribution to civil servants, and humanitarian assistance. The 2008 budget update 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.

Access to financial services remains limited and credit growth has stalled. Notwithstanding the rapid expansion of credit to the private sector following independence (from a small base), still less than 2 percent of the population use banking facilities. A poor credit culture and weak enforcement of creditors' rights, compounded by the recent civil unrest, has led to an increase in nonperforming loans and provisioning to, respectively, 28 percent and 53 percent of bank lending at end-March 2008. While bank deposits have increased sharply, there has been little credit growth since 2006, with banks placing excess funds abroad.

The civil unrest and mid-2007 general elections have delayed progress on structural reforms needed to support non-oil private sector activity. A draft of critical economic legislation is still pending. The court system is overwhelmed and there is no effective system to enforce contractual rights or settle disputes. Business licensing regulations appear to have become more complicated, rather than simplified as needed.

The medium-term outlook is for moderate non-oil growth. The outlook is shaped by, on the one hand, expected continued favorable oil/gas revenue prospects, and on the other, constraints on the government's capacity to spend. Given current trends, the "sustainable" spending level would be reached within a couple of years as budget execution gradually improves. Under that assumption, and based on continued slow reform of the business environment, the non-oil economy should grow by about 5 percent annually over the medium term. A more forceful shift in the spending mix toward well-planned investment spending and successful business environment reform would be associated with annual growth rising to above 8 percent and less inflationary pressure.

Executive Board Assessment

Executive Directors praised the authorities for Timor-Leste's solid recent macroeconomic performance. Despite civil unrest, macroeconomic stability has been maintained, aided by a sound fiscal and monetary framework. Looking forward, the key challenge remains to use the growing oil and gas revenue to develop a sustainable non-oil economy, while alleviating social problems and maintaining macroeconomic stability.

Directors believed that the strategy set out in the current National Development Plan remains valid. This includes the long-term oil and gas revenue savings policy, well-targeted development spending, a monetary and exchange rate regime that preserves macroeconomic stability, and a supportive environment for private investment and activity.

To ensure sustainable growth and poverty reduction, Directors stressed the need to encourage the development of the private sector. The comfortable level of resources should permit a stepping up of public investment in support of this, particularly in infrastructure and human capital development, as well as expenditures to address immediate security and humanitarian needs. Directors welcomed the tax reform, which should promote business formation, and called for further reforms to simplify business regulations, clarify land tenure rights, and improve the judicial system.

Directors observed that the increase in government expenditure planned for the midyear 2008 budget will call for careful planning and monitoring to ensure that such expenditure is productive while avoiding inflationary pressures. Adoption of cash-based budgeting would also be helpful. Directors noted the importance of enhancing Timor-Leste's administrative and absorptive capacities so that budget operations are accomplished efficiently and in a timely manner, and in full accordance with the authorities' program goals. Continued technical assistance will be needed in this regard. Looking further ahead, Directors encouraged the authorities to develop a medium-term fiscal framework that is in line with macroeconomic stability and the country's absorptive capacity.

Directors viewed the Petroleum Fund as a cornerstone for sound management of the country's resources, ensuring fiscal sustainability and macroeconomic stability. The Fund smoothes budget spending, provides for investment abroad of resources not required for budget execution, and mandates transparency in its operations. Looking forward, Directors encouraged the authorities to preserve these principles. They welcomed the acceptance of Timor-Leste as a candidate country in the Extractive Industries Transparency Initiative (EITI).

Directors agreed that the use of the U.S. dollar as the currency of Timor-Leste has served the economy well by providing a credible nominal anchor for price stability. They noted the staff assessment that the current level of the exchange rate appears broadly consistent with its equilibrium level. They observed that stronger institutional capacity will be needed before considering a move to introduce a national currency.

Directors welcomed the initiatives to strengthen the financial sector, including the progress made on a credit registry and the strengthening of banking supervision. Additional efforts are needed on pending financial sector legislation and the creation of an alternative dispute resolution mechanism. Any public sector participation in the financial system should be on commercial terms and supervised under domestic banking laws. Directors cautioned that proposals to begin external borrowing should be weighed carefully and analyzed transparently to ensure that such borrowing is adequately concessional, will deliver a clear net positive rate of return, and is consistent with macroeconomic stability.

Directors commended the authorities for the progress made on the compilation of financial and balance of payments statistics. They encouraged them to better monitor real sector activity through the compilation of national accounts.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.

² Fiscal years end in June up to FY2006/07. The government budget moved to a calendar year basis in 2008; the second half of 2007 was covered by a transition budget.