Fiscal Policy Challenges in Timor Leste: Is the Resources Curse on the Horizon?

By Doraisami, Anita

I. Introduction With a per capita non-oil GDP of US$348 (2007), Timor Leste which emerged as a sovereign nation in 2002, is one of the poorest countries in the world. Human development indicators are also low with literacy rates at 50 per cent, a longevity rate of 57 years, and high infant and maternal mortality rates. A high birth rate of 4 per cent per annum means that the population will double in less than twenty years. High rates of population increase combined with widespread poverty and a history of civil disturbances has created substantial pressures for the nation to deliver on employment generation and greater prosperity for the majority of the population.

Development challenges in Timor Leste are considerable, but they are not insurmountable. The main reason for this optimism is that Timor Leste has access to large revenues coming on stream from oil and gas deposits in the Timor Sea. Timor Leste 's overarching challenge is to employ its oil revenues to develop and create jobs in the non-oil economy while maintaining macroeconomic stability. However the international experience of resource revenue management is not encouraging. The resource curse has stymied development in numerous oil-rich economies, and there is widespread recognition of this in Timor Leste.

Timor Leste has sought to ensure that oil revenues, which started to be realized in 2004 and expected to last for another twenty years, is used in line with the absorptive capacity of the economy, as well as to preserve inter-generational equity. A Petroleum Fund Law was passed in 2005 to ensure that withdrawals from this fund which is the major source of revenue for government budgets are in Une with the estimated sustainable income of the fund. This principle has been adhered to until the recent mid-year budget update, which was passed in July 2008, which seeks to spend in excess of 150 per cent of GDP drawing on amounts far in excess of the sustainable income.

This paper aims to assess whether the current fiscal policy stance is one which leads to sustainable development or puts the economy on the path of succumbing to the resource curse. Section ? of this paper provides a brief outline of the structure and macroeconomic performance of the Timor Leste economy since independence. Section IQ discusses the resource curse literature in the Timor Leste context. Section IV outlines the fiscal policy stance adopted by the mid-year budget update. Section V provides an assessment of the mid-year budget. Section VI comprises concluding remarks.

II. Structure and Macroeconomic Performance of the Timor Leste Economy

At the time of independence in 2002, the presence of the UN buoyed the economy. Growth slowed significantly to 0.1 per cent of GDP when UN operations were wound down significantly in 2003. The non-oil economy began to recover slightly in 2004 and 2005, growing at 4.2 per cent and 6.2 per cent, respectively, led by increases in food production and public spending. However, this recovery was short-lived and was quickly reversed by the social and political turmoil which erupted in April/May 2006. The economy contracted by an estimated 5.8 per cent in real terms in 2006, with non-oil GDP declining to US$296 million in constant 2000 prices - approximately the same level registered in 2004. In 2007, the non-oil economy grew at an estimated 7.8 per cent due to a rebound in industry and services that cater to the international community and further increases in public spending.

Inflation in Timor Leste has generally been contained. The consumer price index (CPI) rose at an annual average rate of 4.2 per cent during 2002-2006 (see Table 1). The good record on inflation can be attributed to the adoption of the U.S. dollar in early 2000, which has helped to provide an effective nominal anchor. The drawdown of the initial UN peacekeeping mission and decline in donor assistance after 2002 further mitigated the emergence of price pressures by softening aggregate demand despite slowly increasing government expenditure. However the civil disturbance that erupted in mid-2006 led to widespread supply disruptions and spikes in transportation costs as many businesses closed down for extended periods.

Higher food prices account for most of the increase in the CPI in 2006-2007. Food prices rose by 13.1 per cent in 2007, explaining most of the 8.9 per cent increase in the overall CPI in 2007. More recent increases in food prices have had a muted effect as subsidies have limited passthrough to consumers (see IMF 2008).

The use of the dollar as its currency means that Timor Leste is unable to pursue independent monetary policy, but it has provided an effective nominal anchor. Moreover, the IMF (2008) states that the overall exchange rate does not appear fundamentally out of line with its long-term equilibrium. In addition, institutional capacity constraints at the Banking and Payments Authority may be another factor in favour of using the U.S. dollar as the national currency.

Growth in Timor Leste has been driven by consumption (see Table 2). Private investment as a percentage of GDP, which declined sharply after the scaling down of the UN presence, remains stagnant at very low levels. Public sector expenditure as percentage of GDP has been increasing as oil prices and revenues have surged. The marginal propensity to import remains high, while export performance has not shown any improvements.

Timor Leste is highly dependent on imports and has run a persistent deficit in its balance of merchandise trade since 2002. Its major non-oil export of coffee has not even financed 10 per cent of imports. At the time of independence in 2002 Timor Leste was highly dependent on international assistance to finance its current account deficits. With this source of funding Timor Leste was able to run small sustainable deficits (see Table 3).

With the advent of increasing oil and gas revenues and in particular with the higher oil prices, Timor Leste is now able to run large current account surpluses which have increased from 82 per cent of non-oil GDP to 255 per cent of GDP inclusive of international assistance.

Growth rates in Timor Leste have averaged about 2.5 per cent from 2002 to 2007. As the population growth rate has been about 4 per cent per annum, on a per capita basis the real income of the population has declined. It is anticipated that a growth rate of around 8 per cent per annum will be needed to reduce poverty (IMF 2008). The news is not all negative however; on the bright side Timor Leste does not suffer from high inflation, runs a current account surplus, and has no external debt.

TJI. Resource Curse Literature and the Timor Leste Context

Comprehensive surveys of the literature on resource curse have been undertaken by several researchers (see, for example, Rosser 2006 and the World Bank 2005a). The World Bank (2005a, p. 304) makes a distinction between the economic and institutional causes of the resource curse.

The economic causes consists of reduced competitiveness of the non-mining tradeable sector during the booms (Dutch disease), inadequate savings during the booms, the establishment of unsustainable patterns of consumption and investment during booms and tardy adjustment to post-boom swings (see GeIb 1988).

The Dutch disease occurs when large increases in revenues from the export of natural resources results in high domestic absorption and appreciation of the exchange rate. The exchange rate appreciation then renders the non-resource sector of the economy less competitive (see Corden and Neary 1982). Thus the Dutch disease can reinforce resource dependence and impede a more sustainable development path based on industrial diversification.

Currently the risk of Dutch disease is low in Timor Leste. The use of the U.S. dollar as its currency and the near non-existence of other sectors and private sector activity means the impact on other sectors of the economy are minimal in the medium term. However the risks of the other three critical problems identified by GeIb (1988) remain high.

The institutional literature consists of three strands: rent- seeking and corruption, resource related conflict, and natural resource waste. Lane and Tornell (1995) suggest in a formal model that national policies in resource-rich countries are oriented to grabbing the rents earned by natural resource endowments. Windfall profits can lead to a "feeding frenzy" in which competing factions fight for natural resource rents and end up inefficiently exhausting the public good. This is supported by case studies in GeIb (1988) and Auty (1993).

The literature also contains numerous studies that suggest that natural resource abundance is associated with the onset of civil war and influences the duration and intensity of civil war (see Collier and Hoeffler 2000). A major source can be a conflict over ownership and property rights and how resources are distributed. At other times this has led to secessionist conflicts.

Weak institutional capacity and poor planning may simply result in a waste of resource revenues. When there is an abundance of resource revenues available to be expended, there may be public pressure to spend the revenues and politicians respond to this pressure because of a short-term political perspective. This spending is then undertaken rashly without much thought given to the absorption capacity of the economy and longterm goals with the result that resource revenues are simply wasted. The risks of wasting resource revenues and the three critical problems identified by GeIb (1988) now appear to be encompassed in the mid-year budget update. There is widespread recognition of the resource curse in Timor Leste. A Petroleum Fund Law was passed in 2005 to ensure that oil revenues are used in a sustainable and efficient manner. Under the Petroleum Fund Law, all oil/gas revenue is paid into the Petroleum Fund and transfers from the Fund to the budget are subject to a spending ceiling. The Fund is integrated into the central government budget with its resources only spent through the budget following Parliamentary approval.

The "sustainable" spending ceiling is set to preserve the real value of the petroleum wealth for future generations and to reduce the impact of volatile oil/gas revenue. The annual "sustainable" spending ceiling is equal to the sum of domestic non-oil revenue and the estimated "sustainable" permanent interest income from the estimated long-term oil wealth (including oil/gas still in the ground).

The Petroleum Fund Law defines estimated sustainable income as 3 per cent of total petroleum wealth assets, with wealth estimated using prudent production (90 per cent probability) and price (U.S. government's Energy Information Administration low case scenario) projections, discounted using U.S. government securities' yields.

Currently petroleum fund assets are invested according to options recommended by the Investment Advisory Board. The Banking and Payments Authority then implements it. However there are now plans to outsource part of the portfolio as well as to amend the Petroleum Fund Law to widen the scope of the investments beyond U.S. government securities.

It is envisaged that Timor Leste will continue to benefit from oil revenues coming on stream from other fields. However the magnitude of the revenues is uncertain for a number of reasons. These include the uncertainty over the price of oil, the exact amount of oil reserves in Timor Leste territory and the size of the territory itself is a source of dispute with Australia (see Lundahl and Sjoholm 2006).

IV. The 2008 Mid-year Budget Update

The 2008 State budget approved last December was the first budget of the Parliamentary Majority Alliance (AMP) government, a coalition of three parties. A total of US$347.8 million was approved, and this was to be funded by withdrawing US$294 million, the maximum allowed according to the Petroleum Fund Act and the Estimated Sustainable Income (ESI) calculations. The rest of the funds were to come from domestic revenues and existing cash reserves.

Since December, amid political uncertainty and rumours that the former Fretilin government might make a bid for power, the mid-year budget update included a "rectification" to increase the 2008 budget to US$773.3 million, of which US$686.8 million will come from the Petroleum Fund. This means that the budget increased by more than double the original and an additional US$290.7 million will be needed to be withdrawn from the Petroleum Fund (see Table 4).

The largest expenditure item envisaged in the 2008 mid-year budget update is to set up an Economic Stabilisation Fund worth US$240 million. This is subsumed under Goods and Services category (see Table 5). It represents over 30 per cent of the total 2008 budget and more than half of the increased expenditure from the budget approved in December 2007. According to the Ministry of Finance (2008) the Fund will seek to stabilize prices by market intervention to enable the supply of critical commodities at affordable prices. Items which will be included here are food and construction materials. There is little information on how the market intervention will be conducted, how much the subsidies will be or why over 50 per cent of the GDP of Timor Leste is required for this purpose. The lack of details provided on the use of these funds is disconcerting particularly given the perception that corruption is widespread and increasing. The Transparency International (2008) report stated that Timor Leste is now ranked 145 out of 180 countries in terms of corruption and this represents a fall of 22 places from last year.

In contrast to allocating 30 per cent of the budget to a stabilization fund, the budget allocates approximately 3.98 per cent to the agricultural sector where over 80 per cent of the population is employed. The same proportion is also devoted to the health sector while education received 6.64 per cent. While these sectors received increases in absolute dollar terms, it is more than likely that a prioritized medium-term development plan would have delivered larger increases of spending in these sectors and reaped a better outcome in terms of poverty reduction in the long run.

There were also substantial increases in public transfers with the higher amounts allocated to veterans, old age pensioners, internally displaced persons, petitioners and children and vulnerable groups. Salaries and wages also rose, with civil servants receiving a 13-month salary payment, which together with continued rice allocations amount to salary increases of almost 20 per cent. Aside from an increase in capital development of around US$100 million, the majority of this budget is allocated to current expenditure, which does little to enhance the future productive capacity of the economy.

V. An Assessment of the Mid-year Budget Update

As already stated, the mid-year budget update is the first time that an amount greater than the estimated sustainable income was withdrawn from the Petroleum Fund. However the availability of revenue has never been a constraint for the government. To date the government has been unable to spend the revenues designated by the estimated sustainable formula and the cash execution of the budget has in fact declined as budgets have increased. This is particularly so for capital and development spending. In addition, a large stock of unspent commitments continues to be carried forward (see Table 6).

The reasons for the chronic expenditure shortfalls have been attributed to inadequate budget planning/execution systems and poor implementation capacity both in government and the private sector. See World Bank (2005&). Making withdrawals above the estimated sustainable income levels when the government has never been able to fully execute a budget in the past may raise expectations that cannot be delivered and cause the government to lose credibility, particularly as carryovers mount in the future.

The magnitude and focus of expenditures is also likely to have adverse macroeconomic impacts. High increases in salaries and transfer payments are likely to increase consumption and because of the high marginal propensity to import, large increases in imports can also be expected. Inflationary pressures may also ensue. Higher growth rates based on increases in investment and private sector employment will be needed to reduce unemployment and poverty. Currently the elasticity of growth with respect to employment is low in Timor Leste. This is primarily a result of the fact that there is no linkage between the major driver of growth which is oil revenues generated offshore and the domestic economy. Private sector investment is unlikely to increase unless the competitiveness of the business environment improves. Timor Leste is the most poorly performing country in the world in terms of registering a property, enforcing contracts and closing a business. Overall it ranks among 168 out of 178 countries in terms of business environment (see Table 7).

Timor Leste also has weak infrastructure and shortcomings in education and health. In global surveys, it ranks especially poorly in telecommunications and electricity generation. Following the Indonesian withdrawal in 1999, the telecommunications and electricity infrastructure was destroyed in the ensuing violence. The current telecommunications market structure is a monopoly with Timor Telecom holding a fifteenyear monopoly in the form of a Build Operate Transfer (BOT) concession contract. According to AusALD (2008) the BOT concession defines exclusivity but is weak in outlining obligations, and the nature of the agreement where the provider is required to transfer assets to the government at the end of the concession period is a disincentive to long-term investment and encourages short-term profit.

Timor Leste is ranked 133 out of 134 countries in the world in terms of overall network readiness index (World Economic Forum 2008). It has low teledensi ties with 6.8 mobile lines per 100 persons and 0.21 main telephone lines per 100 persons. Costs are also among the highest in the world, with a one time residential connection charge costing 8.23 per cent of annual per capita GDP. A monthly residential telephone subscription consumed 39 per cent of monthly per capita GDP, while a three-minute local call during peak hours consumed 2 per cent of monthly GDP per capita (World Economic Forum 2008).

There are also serious problems with the energy sector. Only 32 per cent of households have access to electricity. It is high cost with nearly all of its electricity generated by imported diesel resulting in the highest electricity prices. Diesel imports are a huge drain on the budget and a regressive subsidy. There is also a culture of non-payment for services, erratic electricity supply, and low human capacity and lack of institutional structure where operations and management is concerned (World Bank 2009).

Currently high levels of expenditure are not in line with the economy's absorption capacity, and it is unlikely to increase private sector activity or employment. The reasons for this includes the high costs mentioned above, poor transportation networks, continued political uncertainty, high wage costs in comparison with Indonesia, low levels of literacy and numeracy, a small and poor domestic market, and lack of access to credit. Private credit growth rates, which started to decline in 2006, remains negative while nonperforming loans remain high at 30 per cent of total loans (see IMF 2008). There is a risk that expenditure increases will have little or no impact on poverty and could lead to waste and inflation. Intensified microeconomic reform needs to be implemented to increase the supply side response, and the policy focus should be on ensuring that growth is based on increases in productive capacity and employment.

Timor Leste has ambitions of becoming one of the more prosperous countries in Asia. However, the most successful countries in the East Asian region have been resource-poor and generated wealth and employment using a high investment, manufactured export-oriented strategy and also emphasized investment in human capital. None started on their growth trajectory with budgets that allocated high levels of expenditure to subsidies and transfers. Currently Timor Leste has ambitions to be a successful Asian economy but lacks the strategy to achieve this vision.

VI. Conclusion

The mid-year budget update 2008 passed by the Timor Leste parliament is the first which has sought to spend more than the sustainable income from the Petroleum Fund and amounts to more than 150 per cent of GDP In the improbable event that this budget is fully executed it is unlikely to enhance the future economic growth and prosperity of Timor Leste.

The major constraint that the government faces currently is not revenues. The challenge is planning and execution as well as ensuring that expenditure is in line with the absorption capacity of the economy. Once absorption capacity is improved, higher levels of spending can be used productively. Currently the risks of waste, increased inflation and little growth in employment and reduction in poverty remain high.

Many resource-rich states also find it a challenge to manage their resource wealth effectively and foster the development of their non-resources sector. As Luciani (1987, p. 74) observes, rentier states do "not need to formulate anything deserving the appellation of economic policy: all [they need] is an expenditure policy". Expenditure based on increases in transfers and subsidies may be based on a genuine concern to alleviate hardship but its impact is likely to be short-term at best. Throwing money at a problem cannot make in go away; formulating and implementing good economic policy is crucial if Timor Leste is to avoid the resource curse.

Copyright Institute of Southeast Asian Studies Aug 2009

(c) 2009 ASEAN Economic Bulletin. Provided by ProQuest LLC. All rights Reserved.

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