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p. 62 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions I. Developing Asia and the world II. Economic trends and prospects in developing Asia East Asia Southeast Asia South Asia Central Asia The Pacific Cook Islands Fiji Islands Kiribati Republic of the Marshall Islands Federated States of Micronesia Nauru Republic of Palau Papua New Guinea Samoa Solomon Islands Democratic Republic of Timor-Leste Tonga Tuvalu Vanuatu III. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia

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Democratic Republic of Timor-Leste

The economy contracted in 2002-2003 but there are indications of an increase in activity in 2004. A rapid rise in petroleum revenues has helped generate a substantial fiscal surplus that is expected to grow over the medium term and to provide the basis of a large intergenerational investment fund. Prospects for the local economy remain dominated by the public sector, with the private sector continuing to face significant hurdles to achieving international competitiveness.

Macroeconomic assessment of 2004

The country’s first multiyear national accounts were finalized in 2004. They show an overall contraction in the economy from 2000 to 2003, attributable to a reduction in the contribution from the UN (excluding military and diplomatic expenditures) and, to a lesser extent, from the oil and gas sector (due to the natural depletion of a small field operational since 1998). Non-oil, non-UN GDP is estimated to have increased by 22% over the period, though most of the growth was in 2001.

The latest official projections are for a decline in GDP over FY2004 (12 months ended 30 June 2004) and again in FY2005, on the basis of the continued winding-down of the operations of the UN and the peacekeeping forces ahead of their scheduled pullout in May 2005, and a decline in expenditures by some bilateral aid programs. These negative factors are projected to outweigh an expected improvement in the agriculture sector underpinned by better weather conditions and ongoing rehabilitation of the sector.

These forecasts may prove pessimistic. The growth projections were prepared before the consequences of an early start-up in a major new petroleum project, the Bayu-Undan field, were fully appreciated. Gas recycling to extract liquids began in February 2004 and the project will provide a substantial boost to GDP during 2004. The available indicators suggest that the local economy improved over 2004.

Deposits with commercial banks have risen strongly since 2000, with a 16% increase in 2004 to $84 million by end-December. The commercial banking sector aggressively pursued new loans, and lending to the private sector grew from $22 million to $70 million in 2004. This is a release of funds equivalent to 16% of non-oil, non-UN GDP. New vehicle registrations rose by almost 50% to 7,000 vehicles in 2004, a contributory factor being the greater availability of credit. With most vehicles limited to Dili district, with its population of 170,000, the large increase in registrations points to considerable spending power in the capital.

Preliminary data indicate an 11% rise in taxable imports during 2004, only a minor share of which was attributable to higher petroleum prices. Domestic revenue collections also went up, assisted by improved enforcement.

Non-oil exports picked up but remained very low. Preliminary data suggest that coffee, which accounts for almost all non-oil exports, increased from $4.0 million in 2003 to $6.6 million in 2004. This compares with a preliminary estimate of imports for the year (excluding for aid or peacekeeping activities) of $113 million. The large trade deficit will be offset by inflows of international assistance and petroleum revenues.

Inflation remained low at 3.2% in the 12 months to December 2004, with the largest price rises recorded in transportation (12%) and food (4%).

The major fiscal development during the year was a substantial upward revision in petroleum revenues to the Government. The combination of higher world oil prices, a change in tax treatment favorable to the Government, and an early start-up of the Bayu-Undan field increased petroleum revenue collections for FY2004. Revenues rose from the budgeted level of $31 million to $41 million, and expected collections for FY2005 have nearly tripled from $44 million to $130 million. Even without these upward revisions, the central government budget was projected to be in surplus in both FY2004 and FY2005. The sound fiscal position has now been entrenched. As of end-December 2004, the Government was holding net deposits of $168 million with the Banking and Payments Authority.

Macroeconomic policy developments

The key macroeconomic issue to be resolved over the medium term is the management of the considerable petroleum revenues now coming in. Receipts from the Bayu-Undan field are projected to peak in FY2011 at $380 million and, over the 20-year life of the project, to total $3.8 billion ($2.2 billion in net present value terms). There are also other petroleum developments in prospect, notably the Greater Sunrise field. In comparison, non-oil, non-UN GDP was estimated at $300 million for 2003.

The Government has adopted a policy of pursuing intergenerational equity by maintaining the real value of petroleum wealth. This is to be achieved by limiting spending to the “sustainable income,” i.e., the amount of petroleum revenues that could be spent every year indefinitely. Based on current projections, the sustainable income from the Bayu-Undan field is $70 million. Spending this amount would allow government expenditures to grow from the FY2005 level of $75 million to $113 million by FY2008.

The new savings policy marks a substantial shift in fiscal management. The previous intention was to spend petroleum taxes and save only the “first tranche petroleum” (a de facto royalty payment). The previous policy would have seen annual expenditures increase to the order of $500 million within 10 years and savings accumulate to $1.5 billion by 2030. The new policy will instead lead to lower annual expenditures and is projected to result in approximately $4.5 billion being accumulated in the investment fund by 2030.

Achieving the objective of maintaining the real value of petroleum wealth rests on the overall fiscal surplus being large enough to allow for sufficient savings. This in turn rests on the future financial support of the international donor community.

Grants fund more than $150 million in annual public expenditures. UN expenditures were estimated at $77 million in FY2004, but most financial support is scheduled to cease in FY2005. Current commitments to budget support of $30 million-$35 million made under the Transitional Support Program are also scheduled to end then. Multilateral and bilateral projects are budgeted at $135 million-$155 million for FY2005-FY2007.

The Government has the fiscal capacity to replace much of the existing grants and to self-fund most, if not all, essential activities. This is because revenues and grants to the government are projected to be substantially above the current budget for expenditures and net lending (Figure 2.33). However, self-funding by Timor-Leste of all or much of the essential expenditures currently funded from grants would be at the expense of saving petroleum revenues.

The Government has proposed saving petroleum revenues in a petroleum fund based on the Norwegian model. Funds would be invested abroad in low-risk assets and be subject to accountability and transparency measures. A public discussion paper was released in late 2004 and enabling legislation is to be passed in time for the fund to be operational from FY2006.

Continued progress was made during 2004 in reducing electricity subsidies to the main urban areas. A new management team and the introduction of prepaid meters are projected to reduce subsidies by more than half by FY2008, from their current level of approximately 10% of government expenditures.

Outlook for 2005-2007 and medium-term trends

As the ratio of public expenditures to GDP approaches 100% and the formal private sector is still emerging, developments in the local economy will continue to be dominated by the public sector.

The UN presence was to have ceased in May 2004. A further extension beyond May 2005 is unlikely, and the pullout will in itself have a negative effect on economic activity in the short term. But there is a large carryover of public expenditures from FY2004, and the budget provides for a 17% increase in spending under bi- and multilateral programs during FY2005. The greatest short-term risk is that long-standing delays in implementing public programs arising from difficulties in procurement and capital project planning will continue, so damping the potential fiscal stimulus.

The medium-term fiscal projection is for only slightly higher government expenditures by FY2008, though this projection was made before petroleum revenues were revised substantially upward. In late 2004, the Government declared its intent to spend some of these additional revenues and to raise the level of spending beyond those currently budgeted. It also indicated that the rate of increase in expenditures would be constrained by capacity for the funds to be spent well. A 19% rise in expenditures from currently budgeted levels could be funded while still meeting the objective of only spending the sustainable income from petroleum revenues.

The ability of the Government to secure donor funding will play a major role in determining the GDP outcome over the medium term. The FY2005 budget projected that bi- and multilateral aid programs will fall by almost half to $81 million by FY2008, but this projected decline is in part a consequence of the limits of the planning cycle and may be reversed as budget planning proceeds. Sector investment programs are being prepared to help orient expenditures toward implementation of the National Development Plan and achievement of the Millennium Development Goals; the Government is seeking substantial donor support to help implement these programs. In addition, Timor-Leste is expected to become eligible for the US government-financed Millennium Challenge Accounts in 2006 (if not late 2005), a source that could provide as much as $20 million-$30 million a year in grants.

The private sector continues to face significant hurdles to achieving international competitiveness. Wages in Timor-Leste are substantially higher than in neighboring countries, and the state of infrastructure is poor in general. Low productivity of key sectors and gaps in the regulatory environment, such as a few unresolved issues with business registration and customs administration, have made it difficult for new private sector activities to emerge. The rapid expansion in commercial bank lending in 2004 suggests that at least some industries are ready to grow despite these obstacles. With local financing provided by domestic deposits now largely committed, the private sector will increasingly need to rely on foreign investment to grow.

Considerable progress has been made in developing the regulatory environment that foreign investors usually require. A Law on Commercial Societies is in place, and draft laws on domestic and foreign investment, insurance, and bankruptcy have been prepared. However, the draft investment legislation carries the downside of a potential loss of substantial revenues through the provision of concessions. Such legislation, if implemented, may reduce the initial economic stimulus from additional investment.

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