Statement at Donor Meeting

Statement by Mr. Luis Valdivieso, Advisor, Asia & Pacific Department of the IMF at the donors conference for East Timor. Brussels, December 6, 2000

December 5, 2000

1. It is a great pleasure for me to represent the International Monetary Fund in this meeting today and have the opportunity to present this statement. The thrust of my remarks follow on the macroeconomic assessment contained in the background paper prepared by IMF staff, in close collaboration with the World Bank.

2. After just over a year since the unfortunate events of September 1999, East Timor is entering a new phase in its road towards self-rule. For most of the past year, the concerted efforts of the East Timorese and the UN Transitional Administration, supported by generous assistance of the international community, have been instrumental in:

• Restoring peaceful and secure conditions throughout most of the territory;

• Providing basic needs through humanitarian assistance for the majority of the population;

• Getting the East Timorese progressively involved in policy decision-making and, more recently, in executive decisions; and,

• Taking the first steps to establish the foundations of sound macroeconomic management to guide economic decision-making and provide all parties involved, especially the East Timorese and Donors, with reasonable assurances that the resources being made available to East Timor will be efficiently used and appropriately accounted for.

3. There has been significant progress to date, but much more remains to be done. Looking ahead, it is appropriate for this meeting to focus on areas that require immediate attention such as political, administrative, sectoral and fiscal sustainability. However, as we discuss these issues in detail and continue our work, we must not lose sight of the broader objective of ensuring that the right environment is created to enable the private sector to become the engine of growth. The ongoing recovery of economic activity is driven mainly by sectors that may be too closely linked to the transitory international presence and do not have a long run perspective. We know, however, that only a favorable and sustained domestic supply response by the private sector will permit East Timor to address effectively problems of unemployment and poverty while reducing, and eventually phasing out, its reliance on foreign grants.

What therefore are the key features of an enabling environment for private sector development, and where do we stand on this?

4. First and foremost, there must be a strong sense of internal security and political stability. It is clear that private investment and savings decisions in East Timor are affected by the occasional outbreaks of violence (particularly at the border) as well as by the political activity associated with the approach of elections and independence. There is no doubt that the security conditions will improve as the CNRT and UNTAET continue discussions with Indonesia on the issue of refugees, delineation of borders, and transit access to Oeccusi through West Timor. The international support provided through the offices of the UN Security Council should contribute to expedite this process. On the political front, the firming up of a timetable for the political transition is a step in the right direction. The international community can assist in ensuring that the political institutions are well structured, technically equipped, and appropriately funded so as to elicit the broadest degree of political participation in the period leading to independence and beyond.

5. Second, there must be a general climate of sustained economic stability. As described in the background papers, there are clear signs of a revival in economic activity and low consumer price inflation, but unemployment remains high. In order to sustain high growth and price stability and start reducing unemployment, there is a need to:

• Develop well functioning and efficient markets where market-clearing prices should guide the allocation and utilization of resources; and,

• Design and implement sound macroeconomic policies that provide the right incentives for production and assure an adequate degree of control of aggregate demand.

6. As regards market developments, the Dili foreign exchange market appears to be operating well and is gaining depth. The use of the dollar as a means of payment and store of value is still low, but appears to be gradually picking up. By contrast, the credit market has yet to be restored. Despite the steady growth of bank deposits, there is no commercial bank credit, mainly due to lack of collateral, and the only credit available to the private sector is that funded by Trust Fund for East Timor (TFET). There are also some distortions and rigidities affecting the functioning of the labor market. Despite sizable unemployment, there is strong upward pressure on wages. The pressure appears to be stronger in urban areas than in rural ones and driven mainly by the wages being paid to the locally hired employees of the UN, IFIs and other foreign institutions. There are also rigidities in ETTA's current wage scale, which are making it difficult to retain civil servants. Indeed, as we anticipated in Lisbon, it is becoming increasingly apparent that the most experienced civil servants cannot be retained if the wages paid to civil servants within the same skill category are the same regardless of their previous experience. It is encouraging to learn that these problems will be addressed prior to the discussions of next year's budget.

7. As regards macroeconomic policies, the crucial area is fiscal policy as East Timor surrendered its monetary independence when it adopted the U.S. dollar as the legal tender. In general, the fiscal stance of the budget this year is consistent with maintaining short-term economic stability and there are mechanisms in place to ensure adequate budgetary control and accountability. The main areas of concern are the pace of implementation of the budget and the sustainability of the fiscal effort over time.

8. As we will discuss in the afternoon session, the implementation of the East Timor Administration (ETTA) budget continues to be well below projected levels. On the revenue side, tax collections appear to be on track but the enforcement of user fees, particularly for power and water, needs improvement. Overall expenditures levels, both on a commitment and cash basis, are well below pro-rata targets, reflecting mainly delays in making spending agencies operational, management deficiencies in many agencies, and problems in supply and procurement. It is encouraging that the November review of the budget included measures to strengthen revenue performance (including the introduction of a wage withholding tax, an income tax, a reduction in exemptions from customs duties, excises and the sales tax, and an increase in the number of goods subject to excise taxes), and that the new expenditure proposals (e.g., on defense and security, higher education, foreign relations) were accommodated while keeping the overall expenditure target virtually unchanged.

9. Looking ahead, the recent budget review has disclosed that ETTA will face difficult challenges to ensure fiscal sustainability. The current tax system will not yield sufficient revenue to meet the projections presented in Lisbon, even after taking into account revenues from the Timor Gap. As a result, additional revenue measures will be required. It is important that revenue decisions be taken in the context of next year's budget discussions, including a policy on the use of Timor Gap revenues. On the expenditure side, the medium-term implications of the changes recently made will require offsetting reductions in wages and salaries and goods and services to remain within the targeted expenditure envelope. Achieving the reduction in the wage bill will not be an easy task given existing problems in the labor market. The expenditure cuts in goods and services will also be difficult because of the need to allow for recurrent expenditures associated with the quasi-fiscal expenditures currently funded by bilateral sources. There is no comprehensive analysis of the recurrent fiscal implications yet, but there is the possibility that they might be significant. It is important that this analysis be completed as soon as possible and that a clear line of authority for signing bilateral agreements be established and a formal institutional process be developed to ensure that expenditure priorities identified by the NCC are met and fully funded.

10. Third, there must be a credible institutional framework. The two key economic institutions, the Central Fiscal Authority (CFA) and the Central Payments Office (CPO), have been established and are close to being fully operational. The CFA has successfully developed the first consolidated budget for East Timor and more recently a combined sources budget. The Treasury is functional and the Tax Administration is making significant progress. The CPO has developed its bank licensing function, and there is a well functioning payments system, mainly to support the settlement of ETTA payments. The CPO will soon need to expand its role in the payments system, but it is becoming increasingly apparent that it cannot continue being financed from the budget, and options to provide it with some degree of financial autonomy should be explored. Both the CFA and the CPO are operating under very sound principles of good governance, and steps must be taken to ensure that these precepts are passed on to future administrations. More recently, ETTA has created a Ministry of Economy and a National Planning and Development Agency. It will be important to define clearly their respective roles to avoid a duplication of functions with the CFA and the CPO. Another institutional pillar of key importance is the judiciary, especially to ensure that laws and regulations are enforced, and that a forum for the resolution of disputes exists. Reportedly, there is important progress in this area.

11. Finally, the legislative and regulatory frameworks must be comprehensive, easy to administer, predictable and equitable. The regulatory framework in the financial sector has progressed on schedule. Regulations for a budget and taxation framework were adopted, allowing a transparent execution and development of the budget, and empowering the East Timor Revenue Service (ETRS) to collect taxes and fees. The CPO is finalizing a prudential regulatory framework based on Basle Core Principles and instructions on bank licensing, capital requirements and liquidity have been adopted. However, further progress is required to reduce a number of impediments currently hampering private investment. The most commonly acknowledged legislative and regulatory impediments to investment are the lack of a commercial legal framework, a land and property rights law, a labor code, mechanisms for the resolution and arbitration of disputes, proceedings for the bankruptcy of business, and a legal framework for foreign investment. In addition, investors attach great importance to the frequency of changes in regulations and to a level playing field.

12. In all of the areas mentioned above, there is a need to develop an indigenous administrative and managerial capacity. The task ahead in this area is indeed monumental and must be significantly accelerated. The needs in the macroeconomic area are significant and will require continued comprehensive technical assistance and effective coordination.

13.It will take some time for ETTA and the future elected government of East Timor to create an enabling environment for private sector development and obtain a positive response in terms of higher income and savings. Accordingly, there will be a need for continued external financial support for years to come. Although this meeting is not a pledging meeting, let me close my statement by providing some preliminary indications of East Timor's external financing requirements beyond FY01/02. As stated in the background reports, if revenue targets are met, the financing gap would reach $29 million in FY01/02 and $22 million in FY02/03. However, on current policies, in which the revenue targets are not met, the ETTA budget financing gap would be expected to reach $33 million in FY 01/02 and $37 million in FY 02/03. The rehabilitation and reconstruction program under TFET is also likely to need additional support. In particular, if commitments are to reach $218 million by the end of FY02/03, the uncovered financing needs for TFET would reach about $46 million, so that additional support will be required from Donors.