A quarterly magazine of the IMF

March 2001, Volume 38, Number 1

East Timor's economy was seriously disrupted by widespread violence following the 1999 referendum in which its people voted for independence from Indonesia. With strong support from the international community, East Timor is reconstructing its economy and making the transition to managing it independently. What has been done so far to achieve these goals, and what additional challenges lie ahead?

East Timor—which had a population of about 900,000 in early 1999 and an area of 14,600 square kilometers, including the islands of Ataúro and Jaco and the enclave of Oecussi on the western half of the island of Timor—spent more than four centuries under Portuguese rule before Indonesia annexed it in 1975. Following a long period of political and social unrest, in May 1999 the United Nations (UN), Indonesia, and Portugal agreed to hold a referendum on August 30, 1999 on the future status of East Timor. The referendum produced an overwhelming mandate for independence but triggered widespread violence, which resulted in the displacement of about two-thirds of the population, the loss of many lives, the damage and destruction of property, and a serious disruption of economic activity.

The response of the international community to East Timor's suffering was unprecedented. International peacekeeping forces were deployed in mid-September 1999, rapidly reducing security concerns and facilitating the provision of humanitarian relief. In October, Indonesia's legislature revoked the annexation of East Timor, clearing the way for the UN Security Council to establish the UN Transitional Administration in East Timor (UNTAET) with broad responsibility for administering the territory until independence.

Following a request by the UN Secretary General, several multilateral and bilateral agencies joined UN agencies and the East Timorese in assessing requirements for reconstruction, including external financing, technical assistance, and training. The World Bank took the lead in assessing the country's reconstruction needs and the design of its reconstruction program, while the IMF focused on developing basic macroeconomic, institutional, and legal frameworks.

Successful reconstruction required the following:

• the restoration of law and order;
• the reestablishment of governmental structures and systems;
• the rebuilding of institutions needed to ensure the functioning of a market economy;
• the normalization of relations with Indonesia; and
• the full participation of the East Timorese.

Reconstruction was further complicated by the weak economic system the country had inherited from the Indonesian administration.

Economic system before the referendum

In the mid-1990s, East Timor ranked among the poorest provinces in Indonesia, with an annual per capita income of around $350. Inflation was in single digits and real GDP was growing fast (about 10 percent annually), driven by capital outlays on infrastructure funded largely by transfers from Indonesia's central budget (see chart).

In the wake of the Asian crisis, East Timor's output declined, although by less than the average for Indonesia; inflation and interest rates rose; and monetary velocity (how rapidly money changes hands in an economy as a result of transactions) and credit disintermediation (disruptions in the normal flows of funds between lenders and borrowers) increased. Fiscal transfers from Indonesia's central government declined sharply, forcing a reduction in capital expenditures. Nevertheless, East Timor's wage bill remained unchanged, reflecting rigidities imposed by an overstaffed provincial administration. East Timor's external current account deficit averaged almost a third of GDP during 1995-98, reflecting the extent of the public sector's savings-investment gap. Most trade was with other provinces of Indonesia. Exports were mainly agricultural goods (mostly coffee), while imports were mainly foodstuffs, petroleum, and construction materials.

The payment system and public administration were provincial versions of those in Jakarta. By mid-1999, there were eight commercial banks, half of them public, settling their payments through the local branch of Indonesia's central bank, Bank Indonesia. Budget preparation was not guided by traditional economic indicators and there was no comprehensive cash management. The province's management capacity was limited because very few East Timorese occupied managerial positions.

In sum, the economic system that emerged from the Indonesian administration lacked an indigenous managerial capacity and promoted a culture of dependence on the government as key provider of employment, subsidies, and transfers that built up an infrastructure that was very costly to maintain.

Short-term impact of the violence

The violent events of early September 1999 brought about acute shortages of goods and services, and trade was seriously curtailed by disruptions in transportation and distribution channels. Real GDP is estimated to have declined by more than a third in 1999. The supply shortage and the removal of subsidies led to sharp increases in prices. The banking and payment system ceased functioning. All bank buildings were destroyed and transactions were shifted to a cash basis, with payments made mostly in Indonesian rupiah. Some foreign currencies started to circulate, leading to distortions in relative prices in the absence of a functioning financial market. The government effectively stopped functioning. Tax and customs administrations were dismantled; office equipment and records were removed or destroyed; and revenue collections stopped. Budgetary transfers from Jakarta ceased. In addition, the widespread displacement of the population, including key civil servants and bank officials, created acute labor shortages; the UN and nongovernmental organizations became almost the only sources of employment, paying wages well above those paid before the referendum.

Against this background, the UN Office for the Coordination of Humanitarian Affairs (OCHA) launched a consolidated appeal to raise funds, initially setting a target of $199 million (approximately 90 percent of East Timor's GDP in 1999), to provide humanitarian assistance through the end of June 2000; the World Bank estimated that reconstruction would cost some $300 million over three years (World Bank, 1999), and the UN estimated that the operations of UNTAET would cost some $700 million in the period through the end of 2000. Simultaneously, the IMF helped UNTAET to develop a macroeconomic framework that would ensure the efficient use and proper accounting of the resources made available to East Timor.

Key features of the strategy

In November 1999, the IMF staff proposed a strategy that featured reviving the payment system, developing a basic fiscal framework, and providing a technical assistance program. The critical steps to be taken to revive the payment system were choosing the legal tender and establishing a monetary authority. After taking into account political and economic considerations, East Timor adopted the U.S. dollar as its only legal tender to help eliminate the distortions arising from the use of multiple currencies. The East Timorese leadership wished to eventually introduce a national currency, but the staff of the IMF, while receptive to these views, recommended that such a step be taken only once a financial market became functional in East Timor and sound financial policy and well-developed institutional and legal frameworks were in place. Initially, a monetary authority—the Central Payments Office—would be responsible for providing basic depository and payment services, mainly to the government, and facilitating the development of the foreign exchange and money markets by adopting internationally accepted bank licensing and supervisory procedures.

The fiscal strategy called for adopting a sustainable budget underpinned by a fair, transparent, efficient, and easy-to-administer tax system and an expenditure plan that would guarantee the provision of basic public services. It also called for establishing the Central Fiscal Authority, which would formulate tax policy and administer the collection of revenues, and design and coordinate the execution of the expenditure program.

Implementing the proposed strategy required a comprehensive technical assistance program. East Timor needed immediate assistance from the IMF to design and implement a macroeconomic policy framework, and establish and make operational the Central Fiscal Authority and the Central Payments Office. Substantial medium-term assistance was also needed to enable East Timor to carry out both macroeconomic management and policy design and analysis.

Developments up to November 2000

Economic activity revived strongly during 2000, led by commerce, services, and construction—activities closely linked to the international presence and reconstruction efforts in East Timor. Imports have increased, reflecting both substantial official aid flows and steadily growing private sector imports, but exports have continued to weaken. Inflation is low and price differences across districts have narrowed.

Unemployment remains high. It is becoming increasingly difficult, however, to hire and retain civil servants because of the high wages being paid to people employed by UN and international financial institutions and the inflexible wage scale of the East Timor Transitional Administration (ETTA), which stipulates the same wage for workers within each skill category regardless of their experience. The average monthly wage for civil servants has been set at $135, which is much higher than comparable wages in Indonesia and other countries with similar per capita GDPs; and despite a lean civil service (which employs only about a third as many people as the Indonesian provincial administration did), the wage bill was higher than envisaged in the preliminary budget (see Valdivieso and others, 2000; and IMF, 2000).

The preliminary budget, which was prepared by UNTAET with IMF technical support, guided public spending in East Timor in the first half of 2000. On July 1, 2000, this budget was replaced by the first consolidated budget for ETTA (covering fiscal year 2000/2001), which was prepared by the Central Fiscal Authority and was reviewed and marginally revised in November to accommodate additional expenditures.

Budget execution has proceeded more slowly than anticipated, although it started to pick up speed toward the end of the year. Efforts to raise tax revenues—principally from a 5 percent import duty; various excises; a 5 percent sales tax on commercial imports; a 10 percent service tax; and royalties from, and taxes on, the production of oil and gas—have been successful, but enforcement of user fees (especially on power) needs improvement. With the exception of wages, ETTA expenditures—including recurrent and capital expenditures related to public administration buildings and equipment—and the reconstruction expenditures funded through the Trust Fund for East Timor (administered by the World Bank) have been lower than anticipated, reflecting managerial and operational problems in spending agencies, delays in supply and procurement, and long-drawn-out planning stages of investment programs.

East Timor's fiscal deficits are expected to be fully financed by grants during the next three years. Following meetings in Tokyo (December 1999), Lisbon (June 2000), and Brussels (December 2000), donors have disbursed $150 million (thus fully meeting the target of OCHA's revised special appeal), allowing UN agencies to provide a wide range of humanitarian services. The capital expenditure program has been supported by pledges to the Trust Fund for East Timor of $166 million, enough to cover more than half of the country's estimated three-year reconstruction needs, and by pledges of bilateral assistance of $149 million up to mid-2003. Donors are also committed to providing an additional $55 million, which should be enough to meet ETTA's budget net financing requirements until mid-2001. Finally, to support UNTAET activities through June 2001, UN member states have approved expenditures of almost $1 billion, of which only a minimal fraction is likely to represent obligations for the budget of a future East Timorese government.

Progress in the financial sector has been mixed. The foreign exchange market turnover (that is, the total value of sales and purchases of foreign exchange) is growing rapidly, and the exchange rate of the U.S. dollar vis-à-vis the Indonesian rupiah is closely tracking the corresponding rate in the Jakarta market. Two foreign banks have started operations and several others are interested. Bank demand deposits have risen quickly, but no commercial bank has extended credit, except for on-lending operations under the Trust Fund for East Timor, owing to the lack of collateral. Since January 2000, all budgetary payments have been made in U.S. dollars. Use of the U.S. dollar is increasing, but the rupiah continues to be widely used as a means of payment countrywide while the Australian dollar circulates mainly in the capital, Dili.

Throughout the year, UNTAET has taken steps to progressively involve East Timorese in decision making. Five out of nine cabinet ministers are East Timorese; and the National Council, all of whose 36 members are East Timorese, is consulted on all policy decision matters. There is an ongoing effort to appoint East Timorese to management positions. Work to establish the Central Fiscal Authority and the Central Payments Office and associated regulatory frameworks has progressed on schedule. Regulations for budget execution and taxation framework were adopted (see http://www.easttimor.com for details); the treasury is functional; and there has been progress in setting up a tax administration. The Central Payments Office has issued several regulations, based on the Basel Committee on Banking Supervision's Core Principles, enabling foreign exchange bureaus and banks to operate. Licensing rules for nonbank financial institutions are being drawn up. Technical and financial assistance from the IMF, the World Bank, and bilateral sources has been critical in setting up the Central Fiscal Authority and the Central Payments Office. Finally, significant progress has been made in discussions with Indonesia, including on delineating land and maritime borders, rebuilding archives, and regularizing payments of state pensions to retired East Timorese civil servants. Several lessons are beginning to be drawn from the experience in assisting East Timor (see box).

Six lessons from assisting East Timor Although it is too early to draw firm conclusions, six main lessons are beginning to be learned from the experience of international organizations, bilateral donors, and others in assisting East Timor: It is helpful to coordinate assistance efforts from the outset, because this facilitates the assessment and prioritization of needs, and reduces demands by foreign experts on the time of a limited number of local counterparts. Early adoption of a basic and easily enforceable legal and regulatory framework helps to reduce uncertainty. The framework must be simple but sufficiently comprehensive to minimize the scope for discretion in its applicability. Clear lines of authority, responsibilities, and obligations within and between decision-making and consultative bodies expedite the implementation of policy. Establishment of key institutions must receive priority, and these must be allocated sufficient funds to ensure adequate staffing and the formation of local managerial capacity. A basic macroeconomic framework does not need to be complex to facilitate sound decision making. Resource allocation in the economy should be efficiently guided by the market, and, to that end, payment and banking facilities must be restored quickly, with due regard to efficiency and competition; a basic and sustainable fiscal framework must also be adopted and enforced at the outset. East Timorese nationals' ownership and direct responsibility for implementing the reconstruction strategy and for establishing sound macroeconomic management are essential for success and can be achieved only with their participation at all levels of government.

Challenges ahead

Looking ahead, East Timor will face the challenge of creating an environment conducive to long-term private investment, so that this can become the engine of growth. Only by attaining high and sustained rates of economic growth will East Timor be able to effectively fight unemployment and poverty, and reduce, and eventually phase out, its reliance on foreign grants.

Private investment is more likely to flourish if investors have favorable perceptions of East Timor's internal security, political and economic stability, and regulatory and institutional frameworks. To improve the security environment, additional progress needs to be made on refugee issues, delineation of borders, and free transit to the Oecussi enclave through West Timor. To foster political stability, the political transition expected to be completed by the end of 2001 needs to be supported by a broad campaign of civil education and the development of well-structured and well-funded political institutions.

East Timor's fiscal policy stance is a critical part of its efforts to achieve and maintain macroeconomic stability. Although adopting the U.S. dollar as legal tender eliminated the possibility of inflationary budget financing, ensuring fiscal stability in the face of an eventual decline of foreign grants will require East Timor to adopt measures to increase revenues and maintain strict control over expenditures. Controlling expenditures may require reductions in both the wage bill and spending on goods and services. Reducing the wage bill will be difficult because of existing distortions and the number of people likely to be needed by newly created agencies, including the army. Controlling the growth of other expenditures over the medium term will require that bilaterally funded expenditures match the government's capital expenditure priorities and that the implications of bilaterally funded expenditures for medium-term recurrent expenditures (especially maintenance) be carefully watched. This will, in turn, require development of a formal institutional process for signing bilateral agreements.

Finally, there is need to adopt a commercial legal framework, a land and property rights law, a labor code, mechanisms for the resolution and arbitration of disputes, proceedings for business bankruptcies, and a legal framework for foreign investment. Steps must also be taken to ensure that the Central Payments Office and the Central Fiscal Authority continue operating under sound principles of good governance, and to specify clearly the mandates of recently created economic institutions to avoid duplication of functions.

References:
World Bank, 1999, Joint Assessment Mission (JAM) background report, available on the World Bank's website at http://wbln0018.worldbank.org/eap/eap.nsf.
http://www.easttimor.com (This website, which is published by the East Timorese nongovernmental organization Timor Aid, provides a wide range of information on East Timor, including a list of regulations issued by UNTAET.)

Luis M. Valdivieso is an Advisor, and Alejandro López-Mejía is an Economist, in the IMF's Asia and Pacific Department.