IMF Executive Board Concludes 2010 Article IV Consultation with the Democratic Republic of Timor-Leste

On January 28, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with Timor-Leste.

Background

The Timorese economy has grown fast over the past three years in an environment of improved security following the 2006 civil unrest. Driven by higher oil-financed public spending and a rebound in agriculture from the 2007 drought, non-oil growth averaged 11 percent during 2007–09. A recent estimate by the World Bank also shows a decline of poverty incidence from 50 percent in 2007 to 41 percent in 2009. With increased public spending, domestic price pressures have recently been rising and are particularly high in some segments of the economy, such as housing and construction.

The fiscal position strengthened in 2009, the non-oil fiscal deficit declined by 17 percentage points to 92 percent of non-oil GDP. This reflected a moderation of spending growth to 8 percent following a sharp increase of 130 percent in 2008. A supplemental 2010 budget raised the spending envelop by more than 30 percent to US$838 million, to be financed by withdrawals of US$811 million from the Petroleum Fund (PF). However, due to procurement delays actual public spending is expected to be around US$729 million, and the non-oil fiscal deficit is projected at about 100 percent of non-oil GDP.

Timor-Leste stands out as the most oil-dependent economy in the world. In 2009, petroleum income accounted for about 95 percent of total government revenue and almost 80 percent of gross national income (GNI). The PF assets reached US$6.8 billion or about ten times non-oil GDP in October 2010. The current account surplus has been driven by large oil income.

The financial sector remains at an embryonic stage of development. Three foreign bank branches dominate the financial sector, in addition to a small state-owned microfinance institution. A first insurance company has been established. Despite high bank deposit growth, private sector credit has remained stagnant, hampered by a large share of non-performing loans, weak contract enforcement, and unclear property rights.

The near-term outlook remains positive, supported by social and political stability and government spending. Preliminary data provided by the authorities indicate that GDP growth in 2010 is likely to be higher than the estimate in the Staff Report of 6 percent and closer to the government’s estimate of 9½ percent, potentially pointing to a higher growth projection in 2011. Staff expects GDP growth to stay high in the medium term. Inflation is projected to increase from 4½ percent to 6 percent in 2011, higher than the average of neighboring countries. Large uncertainties surround the medium-term outlook, including the path of oil prices and production, the magnitude and quality of public spending, and progress in business-enabling structural reforms.

Executive Board Assessment

Executive Directors welcomed Timor-Leste’s economic performance over the last three years and the progress made on poverty reduction and other social indicators. Following a slowdown caused by adverse weather, the medium-term outlook for growth is positive. Going forward, Timor-Leste’s key challenge remains to use its petroleum wealth wisely to build a strong non-oil economy and raise living standards.

Directors welcomed the government’s resolve to push ahead with its development policies. They noted that carefully selected infrastructure investment could have sufficiently high returns to justify temporary withdrawals from the PF in excess of the estimated sustainable income (ESI), and that the upward revision in the ESI has created room for additional capital expenditure. Most Directors observed, however, that spending at a slower-than-planned pace, consistent with the absorptive capacity of the economy, would stand a better chance of realizing high quality projects and crowding in private investment.

Directors praised the government’s emphasis on raising the country’s ability to plan, evaluate, and implement spending programs, so that any expansion of public works does not overwhelm administrative capacity. They supported plans to create a new agency, reporting directly to the Prime Minister, which will be in charge of major project evaluation and approval. Further improvements in public financial management and budget execution will also be important.

Directors welcomed the government’s efforts to make the regulatory environment more business-friendly. They noted that the introduction of a one-stop-shop for start-ups is a step in this direction. Accelerated reforms to enhance property rights, such as the pending land law, would also make it easier for the financial sector to extend credits to local businesses.

Directors observed that the official dollarization has helped keep inflation under control and should be maintained, supported by a fiscal policy that is mindful of external stability. Productivity-enhancing structural reforms and efforts to build labor skills would improve competitiveness in non-oil industries and services. Directors also noted that a slower-than-envisaged pace of public spending growth would help contain inflation pressures as supply-side limitations are approached.

Directors called for an intensification of the engagement between Fund staff and the authorities. Noting differences between the official and the more conservative staff’s growth projections, they encouraged a closer policy dialog and greater use of technical assistance, including to strengthen Timor-Leste’s economic statistics. A number of Directors also saw merit in reopening the resident representative office.