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Democratic Republic of Timor-Leste: Staff Report for the 2017 Article IV Consultation

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
December 2017
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Context

1. Timor-Leste has achieved significant progress in securing peace, nation building, and economic development over the past fifteen years. Adjustment from high dependency on oil revenue and large infrastructure and social development needs poses a significant challenge to a fragile state with weak institutional and human capacity. The country also faces a pressing need for greater economic diversification and for creating jobs given the large cohort of youths in the population. This underscores the need for the new minority government, formed following parliamentary elections in July, and amid difficult political circumstances to invest in building capacity, improve public investment management system and ensure sufficient social and economic returns from such investment to safeguard fiscal sustainability and secure inclusive growth.

2. Progress has been made on past IMF recommendations in several areas, but challenges remain. The authorities have made good progress in implementing recommendations from previous Fund surveillance and intensive technical assistance (TA) in the first decade of nation building (2002–12), including the setting up of the Petroleum Fund (PF), and development of the financial sector and statistics. Nonetheless, policies in moderating the scale-up of public investments and addressing weaknesses in public investment management to restore long-term fiscal sustainability are not adequate (Annex I).

Recent Economic Developments and Outlook

3. Growth picked up in 2016 accompanied by low inflation. Non-oil real GDP growth in 2016 is estimated at 5.5 percent, supported by a near doubling of government capital spending, albeit with large import leakages. However, real total GDP declined by 7.9 percent in 2016, owing to a sharp fall in oil production. The CPI declined by 1.3 percent (y/y) in 2016, largely due to lower global food and oil prices (Figure 1).

Figure 1.Timor-Leste: Real Sector Developments

Sources: General Directorate of Statistics; and IMF staff estimates and projections.

4. The fiscal deficit has widened. The overall fiscal deficit widened to 30.8 percent of GDP in 2016 from 17.0 percent in 2015.1 Revenue sourced from estimated sustainable income (ESI)2 of the PF was marginally lower at 19.7 percent of GDP while domestic revenue outperformed due to one-off increases in customs duties and corporate tax collection as well as improved compliance through streamlined procedures. Recorded capital spending doubled, reflecting additional allocations in the supplementary budget to projects under Timor-Leste’s Infrastructure Fund that advanced ahead of schedule (Figure 2).3

Figure 2.Timor-Leste: Fiscal Developments

Sources: Ministry of Finance of Timor-Leste; IMF staff calculations and estimates.

Notes: ESI= Estimated Sustainable Income; PF= Petroleum Fund.

5. The external current account position has deteriorated. The current account turned to a deficit of 18.9 percent of GDP in 2016 from a surplus of 7.7 percent of GDP in 2015. The deterioration was driven by higher imports for public investment and a decline in oil/gas receipts as output fell with the near depletion of current oil fields amid lower global oil prices. The real effective exchange rate (REER) depreciated by 2.8 percent in 2016, reflecting negative inflation and U.S. dollar nominal depreciation against the currencies of Timor-Leste’s trading partners (Figure 3).4

Figure 3.Timor-Leste: External Developments

Sources: Central Bank of Timor-Leste; and IMF, Integrated Monetary Database.

6. Dissaving from the PF financed the fiscal deficit. The PF provided a transfer of US$1.24 billion to finance the 2016 budget, of which US$0.7 billion was in excess of the ESI. The PF closing balance for 2016 declined to US$15.8 billion, a second year of net reduction. By end-2016, cumulative excess withdrawals from the PF totaled $3 billion, which in the absence of offsetting inflows would lower future ESI. As of end-September 2017, the PF balance stood at US$16.7 billion.

Petroleum Fund Dynamics

(In millions of US dollars)

Sources: Banco Central de Timor-Leste; and IMF staff calculations.

Petroleum Fund: Nominal Investment Returns

(In percent)

Sources: Banco Central de Timor-Leste; and IMF staff compilation.

7. Slowing credit growth. Private sector credit growth declined sharply to −1.8 percent (y/y) in 2016 from 10.5 percent in 2015. This slowing is largely due to the resolution of legacy non- performing loans (NPL), together with underlying weaker growth, as the NPL ratio declined to 15 percent of outstanding loans at end-2016, down from 23 percent at end-2015. The loan-to-deposit ratio declined to around 29 percent in 2016 and excess liquidity in the banking system pushed banks’ overseas placements of deposits up to 74 percent (Figure 4).

Figure 4.Timor-Leste: Monetary and Financial Developments

Sources: Central Bank of Timor-Leste; and IMF, Integrated Monetary Database.

8. The near-term outlook is generally favorable. Non-oil real GDP growth is projected to moderate to 3 percent in 2017, due to lower government expenditure and the slowdown of activity following the delayed formation of the new government after parliamentary elections in July 2017. Inflationary pressures remain low, albeit with a return to positive territory given rising global food and fuel prices.

9. Medium-term risks relate mainly to the success of fiscal and structural reforms. The key challenge facing Timor-Leste is achieving greater economic diversification. The depletion of its current oil field by around 2022 adds urgency to the need to generate growth and fiscal revenue. Significant frontloading of public investment poses large downside risks to fiscal sustainability due to the large PF withdrawals required for financing. Risks also lie in whether large infrastructure projects will generate sufficient social and economic returns to achieve inclusive growth that would translate into higher tax returns and support fiscal sustainability. There is also risk of higher inflation due to domestic price pressures from larger government spending. The recent finalization of the Greater Sunrise petroleum field agreement with Australia does not materially alter the need for employment creation and economic diversification but will help alleviate fiscal resource constraints in the long term (Box 2 and Annex II).

Authorities’ Views

10. The authorities broadly shared the staff’s assessment of the outlook and risks. They agreed with the staff on the importance of ensuring the sustainability of public finances by setting well-defined policy targets and ensuring a prudent allocation of scarce resources. They expressed a commitment to expediting structural reforms to promote economic diversification and inclusive growth.

Policy Discussions

A. Ensuring Fiscal Sustainability Through Revenue and Expenditure Reforms

11. Government expenditure is driven by the frontloading of public investment. Capital spending has increased rapidly in the past three years. Public investment in priority projects such as roads, ports, airports, and the oil sector, under the 2011–30 Strategic Development Plan (SDP), are being scaled up to attract private investment and facilitate economic diversification but the impact on crowding-in investment is unclear. The 2017 Budget envisaged that planned capital spending will average around US$1 billion annually during 2018-21, or about US$4.3 billion (156 percent of 2016 GDP) in total. This high level of capital spending is expected to be financed by transfers from the PF (exceeding the ESI) in the amount of US$4.8 billion (30 percent of the PF balance), and external borrowing (US$1.3 billion). Staff’s baseline scenario assumes that 70 percent (past average execution rate) of the multi-year (2018-21) capital expenditures allocation plan under the 2017 Budget will be implemented due to capacity constraints. With current policies under this scenario, the economy will face a fiscal cliff as continued reliance on excess PF withdrawals would lead to rapid reduction in the PF balance over the long term.

12. A bold fiscal reform strategy to ensure long-term fiscal and debt sustainability is needed. Fiscal policy should be guided by the overall objective of maintaining a fiscal position compatible with debt sustainability and the preservation of PF wealth as an ongoing revenue source. Preserving the PF’s assets as a sustainable revenue source should remain the fiscal anchor. This implies a need to make a clear commitment to end excess withdrawals from the PF. Recurrent spending should be rationalized by reducing current transfers to ZEESM5 over the medium term as the economic zone’s living standards catch up. Nonetheless, health and education spending should be protected and more should be done to improve spending efficiency. While recognizing the need to close infrastructure gaps, any frontloading of capital spending should be moderated and prioritized in line with the country’s resources and capacity constraints. Building capacity to manage public investment projects should be accelerated before scaling up. The authorities could consider the merits of adopting a ceiling on primary expenditure as an expenditure rule in addition to the ESI (Annex 3). Staff provided an illustrative reform scenario (text table and Annex IV) and urged the government to incorporate the following reform measures in the upcoming 2018 Budget:

  • More moderate levels of recurrent and capital spending, while preserving pro-poor social spending and investing in people and system to improve public investment management.

  • Mobilize domestic revenue through the introduction of a value-added tax by 2020, accompanied by an increase in excise duties and other taxes.

  • Put an end to PF excess withdrawals from 2028 onwards to rebuild the PF asset base.

If these measures are implemented, a smaller overal deficit is expected in the medium term and higher total revenue will allow for a larger expenditure envelope while maintaining the PF balance.

Timor-Leste: Health and Education Spending

(In percent of GDP)

Sources: Timor-Leste Transparency Portal, 2017 Budget; and IMF staff estimates.

Timor-Leste: Health and Education Spending

(In percent of total budget)

Sources: Timor-Leste Transparency Portal, 2017 Budget; and IMF staff estimates.

Timor-Leste: Illustrative Revenue and Expenditure Reform Strategy vs. Baseline Forecast
Baseline ScenarioReform Scenario
20162017201820222037201820222037
Est.Proj.Proj.
Total revenue33.729.930.024.921.629.733.032.6
Domestic revenue7.86.87.68.416.78.214.325.2
Tax revenue5.95.15.56.111.86.012.019.8
Direct tax2.72.22.42.77.42.93.69.0
VAT3.85.0
Other indirect tax2.92.73.03.34.33.04.55.8
Estimated Sustainable Income19.717.416.810.80.217.014.22.8
Total expenditure64.549.970.650.926.751.838.734.0
Recurrent spending36.333.435.735.217.932.221.619.4
Wages and salaries6.56.67.37.37.36.66.36.0
Goods and services12.712.213.713.35.113.27.65.4
Public transfers17.014.514.614.15.012.37.17.2
Capital spending22.110.929.310.15.415.012.510.0
Gross operating balance−8.7−9.2−11.4−15.90.3−7.06.88.6
Net borrowing and lending−30.8−20.1−40.7−26.0−5.1−22.0−5.7−1.4
Financing:
PF excess withdrawal25.319.733.123.23.414.44.20.0
Borrowing1.10.47.62.81.77.71.51.4
Outstanding public debt0.10.10.40.80.10.51.10.1
Petroleum Fund balance (in millions of US dollars)15,84415,78415,04412,04663915,58915,60217,729
Sources: Timor-Leste authorities; and IMF staff calculations.
Sources: Timor-Leste authorities; and IMF staff calculations.

13. Public investment should focus on high-return projects determined by rigorous investment appraisal. Areas of weaknesses identified by the recent Public Investment Management Assessment (PIMA) TA should be addressed (Box 3) with a clear action plan and timeline before scaling up infrastructure investment. Strengthening the project appraisal and selection processes are near-term priorities. More public investment projects need to be selected through a rigorous appraisal process, cost-benefit analysis, and risk assessments. More competitive public procurement processes should also help. Some of the resources intended for scaling up public investment should be spent in improving the public investment management systems and capacity, which will thereby provide benefit in terms of public resource saving. These savings from increasing investment efficiency will reduce the need for excess withdrawal from the PF and thereby increase compliance with the ESI.

14. Investment efficiency and absorptive capacity are important for growth and debt sustainability. Staff’s analyses using the Debt-Investment-Growth (DIG) model (Annex V) highlighted that:

  • Scaling up investment rapidly (as envisaged in the authorities’ medium-term budget) may not achieve the desired goals due to absorptive capacity constraints and inefficiencies.

  • New investment requires significant resources for operation and maintenance once projects are completed. The extent of any frontloading should take these resource requirements into consideration to effectively utilize the newly-built up public capital.

  • A sustained improvement in investment efficiency cuts the resource requirements significantly and reduces the debt burden.

15. Domestic revenue mobilization remains critical. Staff welcomes the establishment of the customs authority and tax authority, and the formulation of an action plan to increase tax compliance. Passing the VAT legislation and the introduction of a VAT by 2020 that sufficiently mobilizes domestic revenue would be crucial for achieving the government’s goal of raising domestic revenue to 15 percent of non-oil GDP. An early start in upgrading Timor-Leste’s tax administration capacity is critical for an efficient implementation of the VAT in a two- to three-year timeframe (Annex VI).

16. Concessional borrowing should be effectively utilized to reduce the size of PF withdrawals. A set of clear criteria should be developed to identify projects to be financed by concessional loans, especially projects that would benefit from knowledge transfer in project appraisal and implementation.

17. The debt sustainability analysis (DSA) suggests a moderate risk of debt distress driven by projected higher external borrowing. The assessment, based on the baseline scenario,6 reflects the government’s plan to increase concessional borrowing to help finance frontloaded public investments. External debt is projected to increase from 2.8 percent of GDP in 2016 to about 28 percent in the medium term. Debt recording and monitoring capacity need to be strengthened with the greater utilization of external financing.

18. Public financial management needs further strengthening. The objectives set out in the “Roadmap of Budgetary Governance Reform” paper approved in March 2017 will need to prioritize and sequence reforms that complement public financial management (PFM) practices beyond just the budget process. The first phase (2011-16) review of the SDP should be published and lesson learned be applied. Costings of the SDP, should be prioritized to the key service delivery areas of health and education, in line with the long-term objectives set out in the Sustainable Development Goals (SDG).

Authorities’ views

19. The authorities concurred with the staff on the need to preserve the Petroleum Fund. The government’s policy program for the next five years, supported by the consolidation of public finances, are broadly in line with staff’s recommendations. The program emphasizes the need to have quality public investment based on cost-benefit analysis and to link basic infrastructure projects to rural development. The authorities also intend to reduce current expenditures over the coming years. Social spending will focus on eliminating malnourishment and raising human capital. At current market conditions, the authorities recognized that the cost of borrowing at concessional rates is lower compared to the rate of investment return foregone when drawing down PF assets.

20. The authorities agreed that public investments should be better prioritized. This includes increasing the efficiency of capital investment in public infrastructure projects and implementing basic infrastructure projects that would increase productivity in priority sectors. In particular, priorities will be on improving road connectivity centered on increasing productivity in the coffee and tourism industries, investing in value-added agri-business, and decreasing rural isolation.

21. The authorities plan to implement reforms that strengthen public financial management. Reintegrating the planning function in the Prime Minister’s Office back to the new Ministry of Planning and Finance should increase the effectiveness of planning and prioritizing. They also plan to strengthen the budgeting process through program budgeting and improving the multi-year budgeting framework.

B. Fostering Financial Inclusion and Macro-Financial Stability

22. Financial intermediation remains weak. For foreign bank branches, growth in retail deposits has largely funded liquid investment abroad through loans to banks’ headquarters.7 These dollar-based deposits provide low-cost funding to international banks given low dollar interest rates. The continued decline in the loan-to-deposit ratio suggests banks are falling short of their role in providing financial intermediation to the domestic economy. Despite progress in resolving legacy NPLs, major challenges lie in expanding bank credit while ensuring the soundness of banks’ lending.

Selected Financial Soundness Indicators (FSIs), 2014–17(In percent)
Dec-14Dec-15Dec-16Jun-17
Asset Quality
Capital adequacy ratio 1/42.432.932.4
Non-performing loans to total grass loans26.823.015.315.2
Provision for loan losses to total gross loans31.629.821.919.3
Earnings and Profitability
Return on assets1.10.71.01.0
Return on equity 1/3.56.67.7
Liquidity
Liquid assets to total assets82.883.684.581.9
Memorandum items (In millions of U.S. dollars):
Total assets80532311491074
Total loans177191133197
Source: Central Bank of Timor-Leste.

Cavers BNCTL only.

Source: Central Bank of Timor-Leste.

Cavers BNCTL only.

23. Expanding financial inclusion is a priority. Staff welcomes the national financial inclusion strategy 2017-22, which includes plans to promote digital financial products and agent banking arrangements; review the regulatory framework for consumer protection; publish a financial literacy strategic plan; and introduce a pilot credit guarantee scheme.

24. Increasing access to credit can help support private sector growth. Efforts to enhance the collateral system, bankruptcy regime, and improving the credit registry information system are important to achieve greater financial deepening and inclusion. Creating a credit guarantee scheme for small and medium-sized enterprises (SMEs) could help to close the SME financing gap and support economic diversification.8 However, the scheme should be designed and operated to limit moral hazard through a proper risk-sharing mechanism and to minimize contingent liabilities through features such as clear eligibility criteria, partial guarantee, loss-sharing, and adequate regulation and supervision (Annex VI). The Central Bank of Timor-Leste (BCTL) is currently preparing regulations for the implementation of the scheme. Staff encouraged best practices on design and operation such as eligibility only to new loans, and clarification of the claim and recovery processes, and regulatory requirement to be adopted. Staff highlighted that the success of this initiative would be enhanced by providing accompanying capacity building to SMEs in formulating better business plans and improved financial management.

Timor-Leste: Number of Deposit and Loan Accounts

(In thousands)

Source: Central Bank of Timor-Leste.

25. Developing the national payment system is important. There is ongoing progress in modernizing the national payments system to bring affordable financial payment services to the population. The implementation of the automated transfer system (R-TiMOR)—a hybrid system that combines a Real Time Gross Settlement and a Clearing House System—was introduced in early 2016. BCTL is currently developing the national card and mobile payment switch to connecting the core banking system and payment networks.

26. Safeguarding financial stability needs continued vigilance. The continued efforts by BCTL to strengthen its supervisory oversight of banks—including through close collaboration with home country regulatory authorities and strict oversight of the government-owned local bank, and implementation of a plan to review prudential requirements―is commendable. BCTL has signed a memorandum of understanding with the Australian Prudential Regulation Authority and Financial Services Authority of Indonesia last year and various joint programs have been implemented including joint examination of financial institutions. Further, developing capacity to adequately regulate the non-bank financial institutions—credit unions and micro-finance institutions—would help mitigate financial sector vulnerability. The BCTL is preparing a draft credit union law with support from MCM/PFTAC.

27. More needs to be done to operationalize the AML/CFT framework. The first National Risk Assessment of Money Laundering and Terrorist Financing was released in October 2016, and the government has adopted a national strategic plan (2016-2020) to mitigate its ML/TF risks. The introduction of the risk based approach to AML/CFT by BCTL this year is commendable. There is no sign of the withdrawal of correspondent banking materializing in Timor-Leste as foreign banks have access to correspondents through their head offices. Transfers are largely for trade payments and workers’ remittances are low.

Timor-Leste: Financial Sector Developments

28. The use of the U.S. dollar as sole legal tender remains appropriate given institutional capacity constraints and limited financial development. The fully dollarized regime has worked well for Timor-Leste, given the high dependence on oil revenue and limited other non-oil exports. Sound macroeconomic policies, including improved fiscal policies, together with further progress in financial sector and institutional developments, would be needed over the long run to pave the way for any change in exchange rate regime.

Authorities’ Views

29. The authorities appreciated the importance of promoting safe financial inclusion. They emphasized that initiatives to modernize the national payment system would enhance the safety of the payment system and foster financial system stability. They added that upgrading the payment system is also important for the successful implementation of fiscal reforms as it will make domestic revenue collection more efficient. They expect the credit guarantee scheme would promote financial intermediation, which is currently weak in a banking system dominated by foreign banks. They agreed with the staff’s recommendations on institutional design principles to contain moral hazards and public contingent liabilities, while noting that the scheme’s specific design should reflect the country’s circumstances and policy objectives (such as promoting growth in specific sectors). They also noted that the banking system is sound and the resolution of legacy NPLs would help to promote private sector credit growth. They emphasized their efforts to effectively implement AML/CFT framework in line with the global best practice, including the adoption of risk-based approach and the provision of training to commercial banks.

C. Facilitating Economic Diversification and Inclusive Growth

30. Staff assesses the external sector position to be substantially weaker than suggested by medium-term fundamentals and desirable polices. The current account deficit is expected to remain above the sustainable level financed by the ESI, due largely to falling oil exports and high imports driven by the scaling up of public investment. Improving external competitiveness is key to economic diversification and job creation, warranting further fiscal adjustment and steady implementation of structural reforms (Box 4). For Timor-Leste with a dollarized regime, the burden of the adjustment necessarily falls on domestic price reduction.

31. Potential ASEAN accession poses economic opportunities and challenges. Timor-Leste applied for ASEAN membership in 2011 and a decision approving its accession is expected in one to two years. Integration into the ASEAN Economic Community9 is unlikely to have significant short-term economic implications, but can create economic transformation opportunities. Timor-Leste’s commitment to harmonize trade, services and investment policies and regulatory frameworks with ASEAN standards, and acquired observer status in the WTO in December 2016, will help raise its attractiveness as an investment destination.

Economic Linkages Between Timor-Leste and ASEAN

32. Macro-critical structural reforms are needed to support economic diversification. These include improving infrastructure, enhancing financial access without raising risks, and action to improve labor competitiveness. Relatively high wages—underpinned by high public sector minimum wage levels—could offset Timor-Leste’s advantage of having a young labor force. It is critical to keep wages competitive, which can be addressed by setting wages in line with labor market fundamentals, raising productivity and closing labor skill gaps with better targeted vocational training. In addition, it is important to move forward in the following priority areas:

  • Employment. Significant challenges remain in creating jobs for youth entering the labor force (unemployment at 11 percent and youth unemployment at 22 percent). The adoption of the National Employment Strategy 2017-30 is a good start and should be accompanied by action plans to improve the quality of vocational training and labor market institutions.

  • Investment. The operationalization of the Land Law passed recently should help clarify land/property rights, and facilitate land use for investment and as loan collaterals. The amendment of the private investment law which clarifies investment regulation and incentives, as well as the adoption of the National Tourism Policy, should help stimulate investment.

  • Governance. Perceptions of corruption appear to have declined marginally, but remain a key impediment to doing business. Finalizing the national anti-corruption strategy and its effective implementation could enhance governance.

Timor-Leste: Labor Force Participation and Unemployment Rates

(In percent of each age group population)

Sources: Timor-Leste Labor Force Survey 2013.

Timor-Leste: Governance Indices

(Indices rescaled: 0 = worst, 10 = best)

Sources: World Bank Governance Indicators (Control of Corruption);

Maplecroft (Corruption Index); Transparency International (Corruption Perceptions Index)

Authorities’ Views

33. The authorities stressed their commitment to accelerate the implementation of structural reforms to facilitate economic diversification. They emphasized their focus lay on the development of basic and high quality infrastructure that would generate higher economic returns (based on rigorous cost-benefit analysis), improving connectivity and help develop agri-business and tourism. The government is currently preparing an industrial policy (which focuses on FDI to promote knowledge and technology transfer) and is working on improving the business environment, including through the operationalization of Land Law to promote the commercial use of land and as collateral in borrowing/lending. They also stressed their policy priorities to reduce the unemployment rate to single digits over the medium term, and improve food security by promoting domestic production.

D. Building Capacity and Strengthening Statistics

34. Persistent efforts in institutional strengthening and capacity building are key to reducing fragility. For Timor-Leste, investment in human capital, through education and health aligned to long-term objectives set out in the SDGs, will help build the foundation for economic diversification. More specifically, government analytical and policy-making capacity need rapid strengthening.

35. Data quality and timeliness continue to hamper surveillance. Efforts to strengthen statistics should be continued. In particular, the near 18-month lag in the release of annual GDP data should be shortened. Making quarterly GDP available would help economic monitoring and policy making. The authorities are encouraged to implement the enhanced General Data Dissemination System (e-GDDS), which recommends dissemination of a key set of macroeconomic statistics in a National Summary Data Page based on an advance release calendar. Improving the reporting of annual and quarterly government finance statistics in line with the GFSM 2014, as recommended by the recent Pacific Financial Technical Assistance Centre (PFTAC) TA mission, would strengthen fiscal analysis. Enhancing the current cash-based accounting system will pave the way for moving to an accrued accounting system over the medium to long term, in the context of a sustainable PFM reforms. The establishment of a quarterly statistical working group comprising representatives from MOF, BCTL and General Directorate of Statistics to resolve data compilation issues and facilitate data exchange and monitoring is commendable.

36. The Fund stands ready to provide TA and capacity building to assist the government’s reform efforts. Timor-Leste is a pilot country under the Fund’s infrastructure support initiative. Staff encourage the authorities to request TA to strengthen Timor-Leste’s public investment management. The Fund also stands ready to provide support on progressing tax and PFM reforms.

Authorities’ Views

37. The authorities are appreciative of the TA and training provided by the Fund and PFTAC. However, they reiterated their view that having on-the-ground technical experts could enhance TA traction. They concurred with the recommendations on the need to further improve the quality and timeliness of statistics.

Staff Appraisal

38. Timor-Leste faces a pressing need for economic diversification to create employment opportunities for its young labor force. Adjustment from high dependency on oil revenue and large infrastructure and social development needs pose a significant challenge to a fragile state with weak institutional capacity. While the near-term growth outlook is favorable and inflationary pressures low, the medium-term outlook and risks depend critically on the success of fiscal and structural reforms. Significant frontloading of public investment poses considerable downside risks to fiscal sustainability, due to the envisaged large PF withdrawals required for deficit financing. Public infrastructure projects need to generate sufficient social and economic returns to achieve inclusive growth that would then translate into higher tax returns that would help restore fiscal sustainability.

39. Bold fiscal reforms are needed to ensure long-term fiscal sustainability. Fiscal policy should be guided by the objective of maintaining a fiscal position compatible with debt sustainability and preserving the assets of the PF. Maintaining the PF’s assets as a sustainable revenue source should remain the fiscal anchor, achieved by adhering to the ESI. Frontloading of capital spending to close Timor-Leste’s large infrastructure gap should be moderated and prioritized, in line with its scarce resources and capacity constraints. It should also be in line with the reforms of public investment management system. Public investment should be prioritized with a focus on high-return projects determined through rigorous investment appraisal, cost-benefit analysis, and risk assessments. Recurrent spending should also be rationalized, while health and education spending need to be protected and the efficiency of public spending improved.

40. Domestic revenue mobilization and effective use of concessional borrowing are critical for safeguarding fiscal sustainability. The introduction of a VAT by 2020 and an early start in upgrading the tax administration capacity are key to mobilization of sufficient domestic non-oil revenues. Clear criteria should be developed to identify infrastructure projects to be financed by concessional loans, especially projects that would benefit from knowledge transfer in project appraisal and implementation.

41. Expanding financial inclusion would support inclusive growth, while continued vigilance is needed to safeguard financial stability. A steady implementation of the recently adopted national financial inclusion strategy 2017-22 would help to achieve greater financial deepening and inclusive growth. Creating a well-designed and operated credit guarantee scheme for SMEs should be accompanied by capacity building to SMEs in formulating business plans and financial management. At the same time, safeguarding financial stability requires further strengthening of BCTL supervisory and regulatory framework and capacity, and bolstering the AML/CFT framework.

42. Macro-critical structural reforms are needed to support economic diversification and job creation. These reforms should aim to improve basic infrastructure, financial access, labor competitiveness and the ease of doing business. Staff’s assessment of the external position to be substantially weaker than suggested by medium-term fundamentals and desirable polices in a fully dollarized economy also points to the importance of improving external competitiveness by keeping wages competitive, raising productivity, and closing labor skill gaps by more targeted vocational training.

43. Further efforts are required to improve statistical capacity, as data limitations continue to hamper surveillance. Improvements are needed in timeliness and periodicity of national accounts data, which are crucial to policy formulation.

44. The authorities are encouraged to further leverage technical assistance and capacity building. Well-coordinated support from the Fund and other development partners would help strengthen institutional and human capacity.

45. It is recommended that the next Article IV consultation takes place on the standard 12-month cycle.

Box 1.A More Pragmatic Fiscal Presentation1

The new Summary Operation of the Central Government (Table 2b), in addition to adopting the format mostly in compliance with the GFSM2014, improves the presentation of the central government’s fiscal position to help analysis of fiscal sustainability.

The Petroleum Fund (PF) Law requires that all petroleum revenues are transferred to the PF and invested in financial assets. The PF is only transferred to the state budget through the Estimated Sustainable Income (ESI) and excess withdrawals after parliamentary approval. Petroleum revenues—oil and gas receipts and the PF investment returns—are not included in central government revenue.

The ESI is included as a revenue item. In contrast, excess withdrawals from the PF is presented as a financing item. These treatments reflect that ESI represents budget financing consistent with long-term PF viability, whereas the excess withdrawals lead to a reduction in PF assets. In this context, a zero balance in net lending/borrowing which included the ESI as a revenue item will imply zero requirement on net financial transactions.

In preparation for the migration to GFSM2014, a PFTAC/GFS TA mission in February 2017 assisted the authorities in reviewing the compilation, and clarified statistical and presentation issues that may impact the data reporting for Fund surveillance.

1 Prepared by Fazurin Jamaludin.
Table 1.Timor-Leste: Selected Economic Indicators, 2014-2022
201420152016201720182019202020212022
Est.Proj.
(Annual percent change)
Real sector
Real total GDP−26.020.9−7.9−8.0−0.7−4.7−3.7−2.6−2.6
Real non-oil GDP4.34.05.53.05.05.75.55.55.2
CPI (annual average)0.70.6−1.31.02.73.63.83.94.0
CPI (end-period)0.3−0.60.02.03.53.73.84.04.0
(In percent of GDP, unless otherwise indicated)
Central government operations
Revenue26.533.233.729.930.028.927.526.124.9
Domestic revenue4.25.57.86.87.67.98.08.08.4
Estimated Sustainable Income (ESI)15.620.619.717.416.815.513.912.410.8
Grants6.77.26.15.75.65.65.65.65.6
Expenditure39.850.264.549.970.673.863.957.850.9
Recurrent22.633.236.333.435.735.836.036.235.2
Net acquisition of nonfinancial assets10.59.922.110.929.332.422.316.010.1
Donor project6.77.26.15.75.65.65.65.65.6
Net lending/borrowing−13.3−17.0−30.8−20.1−40.7−44.8−36.3−31.7−26.0
(Annual percent change, unless otherwise indicated)
Money and credit
Deposits19.676.711.936.141.529.835.835.733.8
Credit to the private sector5.510.5−1.84.810.29.79.79.911.4
Lending interest rate (percent, end-period)12.913.514.2
(In millions of U.S. dollars, unless otherwise indicated)
Balance of payments
Current account balance 1/1,093239−523−95−523−574−585−585−630
(In percent of GDP)27.07.7−18.9−3.4−18.2−19.4−18.9−17.9−17.8
Trade balance−603−635−539−548−797−834−815−823−835
Exports 2/161820122327323745
Imports618653559559820861847861879
Services (net)−594−580−527−516−543−547−504−484−567
Petroleum revenue2,1171,281540965696672583554585
Overall balance−376220−157−3−4−5−7−6−9
Public foreign assets (end-period) 3/16,85016,65516,12516,06215,31814,42213,66712,92212,292
(In months of imports)15715316716612611411110491
Exchange rates
NEER (2010=100, period average)106.8120.2120.0
REER (2010=100, period average)134.9150.1145.9
Memorandum items (in millions of U.S. dollars):
GDP at current prices:4,0423,1022,7622,7642,8772,9603,0903,2733,541
Non-oil GDP1,4511,6071,6721,8432,0852,3712,6953,0693,541
Oil GDP2,5911,4961,0909217925903952040
GDP per capita3,4922,6192,2782,2282,2672,2802,3252,4092,549
(Annual percent change)−30.1−25.0−13.0−2.21.70.62.03.65.8
Crude oil prices (U.S. dollars per barrel, WEO) 4/965143494950525355
Petroleum Fund balance (in millions of U.S. dollars) 5/16,53916,21715,84415,78415,04314,15313,40512,66612,045
(In percent of GDP)409523574571523478434387340
Public debt (in millions of U.S. dollars)224677873045277499021,002
(In percent of GDP)0.51.52.83.110.617.824.327.628.3
Population growth (annual percent change)2.52.42.32.32.32.32.32.22.2
Sources: Timor-Leste authorities; and IMF staff estimates and projections.

Excludes trade in goods and services of entities located in the Joint Petroleum Development Area, which are considered non-resident.

Excludes petroleum exports, the income of which is recorded under the income account.

Includes Petroleum Fund balance and the central bank’s official reserves.

Simple average of UK Brent, Dubai, and WTI crude oil prices based on July 2017 WEO assumptions.

Closing balance.

Sources: Timor-Leste authorities; and IMF staff estimates and projections.

Excludes trade in goods and services of entities located in the Joint Petroleum Development Area, which are considered non-resident.

Excludes petroleum exports, the income of which is recorded under the income account.

Includes Petroleum Fund balance and the central bank’s official reserves.

Simple average of UK Brent, Dubai, and WTI crude oil prices based on July 2017 WEO assumptions.

Closing balance.

Table 2a.Timor-Leste: Summary of Central Government Operations, 2014-2017 1/
2014201520162017
Rectification BudgetIMF estimateBudgetProjection
(In millions of U.S. Dollars)
Revenue2,555.01,673.71,908.3925.01,469.11,309.3
Petroleum revenue2,116.71,280.81,593.5540.41,106.3965.5
Oil/gas receipts1,817.0978.9718.7223.9263.4300.0
Interest299.8301.7874.8316.2842.9665.5
Domestic revenue168.0170.2176.0215.4206.2187.2
Taxes123.8119.7116.4157.7145.7138.4
Taxes on income, profits, and capital gains53.053.352.374.764.961.9
Taxes on goods & services57.354.152.165.965.561.2
Taxes on international trade & transactions13.412.111.814.214.814.8
Non-taxes44.250.555.053.156.945.2
Grants270.3222.7143.4169.2156.6156.6
Expenditure1,607.71,558.72,096.31,780.21,543.41,379.8
Expenditure excluding donor projects1,337.41,336.01,952.91,611.01,386.81,223.2
Current expenditure912.71029.01106.91001.51025.9922.5
Wages and salaries162.5173.4181.9179.0208.8183.7
Current transfers291.5432.4476.0470.6421.3400.2
o/w ZEESMn.a.133.4217.9217.9171.9171.9
Goods and services458.7423.1449.0352.0395.8338.4
Capital expenditure424.6306.9846.0609.5360.9300.7
Donor project270.3222.7143.4169.2156.6156.6
Overall balance947.4115.0−188.0−855.2−74.3−70.6
Non-oil overall balance−1169.4−1165.7−1781.5−1395.6−1180.6−1036.0
Financing:1191.21148.11781.51428.31180.51036.0
Petroleum Fund withdrawals732.01278.51674.51244.81078.71026.0
ESI632.3638.5544.8544.8481.6481.6
Withdrawals above ESI99.7640.01129.7700.0597.1544.4
Change in cash balance (increase=“-”)443.3−154.40.0152.80.00.0
Borrowing15.924.0107.030.6101.810.0
(In percent of GDP)
Revenue63.253.969.133.553.247.4
Petroleum revenue52.441.357.719.640.034.9
Oil/gas receipts45.031.626.08.19.510.9
Interest7.49.731.711.430.524.1
Domestic revenue4.25.56.47.87.56.8
Taxes3.13.94.25.75.35.0
Taxes on income, profits, and capital gains1.31.71.92.72.32.2
Taxes on goods & services1.41.71.92.42.42.2
Taxes on international trade & transactions0.30.40.40.50.50.5
Non-taxes1.11.62.01.92.11.6
Grants6.77.25.26.15.75.7
Expenditure39.850.275.964.555.849.9
Expenditure excluding donor projects33.143.170.758.350.244.3
Current expenditure22.633.240.136.337.133.4
Wages and salaries4.05.66.66.57.66.6
Current transfers7.213.917.217.015.214.5
Goods and services11.313.616.312.714.312.2
Capital expenditure10.59.930.622.113.110.9
Donor Project6.77.25.26.15.75.7
Overall balance23.43.7−6.8−31.0−2.7−2.6
Non-oil overall balance−28.9−37.6−64.5−50.5−42.7−37.5
Financing29.537.064.551.742.737.5
Borrowing0.40.83.91.13.70.4
(In percent of non-oil GDP)
Non-oil revenue30.224.518.823.019.718.7
Expenditure110.897.0125.4106.583.774.9
Expenditure excluding donor projects92.283.2116.896.375.266.4
Current expenditures62.9−39.6−47.4−36.9−36.0−31.4
Capital expenditures29.319.150.636.419.616.3
Donor funded expenditures18.613.98.610.18.58.5
Non-oil overall balance−80.6−72.6−106.5−83.5−64.1−56.2
Memorandum items:
Funding gap 2/−537.1−527.2−1236.7−850.8−699.0−554.4
Petroleum Fund balance16,53916,21717,96715,84415,78415,043
Non-oil GDP at current prices1,4511,6071,6721,6721,8431,843
GDP at current prices4,0423,1022,7622,7622,7642,764
Sources: Timor-Leste authorities; and IMF staff estimates.

This presentation of government operations as well as the related comments in the main text of the report do not follow the GFSM 2001 format.

Funding gap is the deficit as per the fiscal rule, and equals ESI plus domestic revenue less expenditure.

Sources: Timor-Leste authorities; and IMF staff estimates.

This presentation of government operations as well as the related comments in the main text of the report do not follow the GFSM 2001 format.

Funding gap is the deficit as per the fiscal rule, and equals ESI plus domestic revenue less expenditure.

Table 2b.Timor-Leste: Summary of Central Government Operations, 2014-2022 1/
201420152016201720182019202020212022
EstProjection
(In millions of U.S. dollars)
Revenue1,070.61,031.4929.4825.4861.9856.6850.2852.6880.1
Domestic revenue168.0170.2215.4187.2219.2233.3248.0263.4299.1
Taxes123.8119.7157.7138.4155.4165.9177.0188.8213.4
Of which: Taxes on income, profits, and capital gains53.053.374.761.969.173.578.183.096.8
Taxes on goods and services57.354.165.961.270.075.080.285.994.6
Taxes on international trade and transactions13.412.114.214.815.816.918.119.321.3
Non-tax revenue44.250.553.145.260.063.566.970.481.5
Estimated Sustainable Income632.3638.5544.8481.6482.7458.7430.4407.2384.1
Donor Projects270.3222.7169.2156.6160.0164.6171.8182.0196.9
Expenditure1,607.71,558.71,780.21,379.82,032.62,183.31,973.11,890.61,801.5
Expenditure excluding donor projects1,337.41,336.01,611.01,223.21,872.62,018.71,801.31,708.61,604.6
Expense1,183.01,251.71,170.71,079.11,188.51,223.91,282.61,366.91,444.5
Recurrent912.71,029.01,001.5922.51,028.51,059.31,110.81,184.91,247.6
Compensation of employees162.5173.4179.0183.7210.1215.2225.3237.4256.8
Goods and services458.7423.1352.0338.4394.2404.4422.4450.0471.1
Current transfers291.5432.4470.6400.2421.4432.0450.5480.7500.0
o/w ZEESMn.a.133.4217.9171.9168.6172.8180.2192.3200.0
Interest payment0.00.00.00.12.77.712.716.919.7
Donor projects270.3222.7169.2156.6160.0164.6171.8182.0196.9
Net acquisition of NFA424.6306.9609.5300.7844.1959.4690.5523.7356.9
Gross operating balance−112.4−220.3−241.3−253.7−326.6−367.3−432.4−514.3−564.5
Net lending/borrowing−537.1−527.2−850.8−554.4−1,170.7−1,326.7−1,122.9−1,038.0−921.4
Statistical discrepancy21.8−17.732.70.00.00.00.00.00.0
Net financial transactions−558.9−509.6−883.5−554.4−1,170.7−1,326.7−1,122.9−1,038.0−921.4
Net acquisition of FA−543.0−485.6−852.8−544.4−953.2−1,104.1−900.5−885.3−821.4
Foreign0.00.00.00.00.00.00.00.00.0
Domestic (net)−543.0−485.6−852.8−544.4−953.2−1,104.1−900.5−885.3−821.4
Equity−99.7−640.0−700.0−544.4−953.2−1,104.1−900.5−885.3−821.4
of which, Excess withdrawal from PF−99.7−640.0−700.0−544.4−953.2−1,104.1−900.5−885.3−821.4
Change in cash/deposit−443.3154.4−152.80.00.00.00.00.00.0
Net incurrence of liabilities15.924.030.610.0217.5222.6222.5152.7100.0
Foreign15.924.030.610.0217.5222.6222.5152.7100.0
Domestic0.00.00.00.00.00.00.00.00.0
(In percent of GDP)
Revenue26.533.233.729.930.028.927.526.124.9
Domestic revenue4.25.57.86.87.67.98.08.08.4
Taxes3.13.95.75.05.45.65.75.86.0
Of which: Taxes on income, profits, and capital gains1.31.72.72.22.42.52.52.52.7
Taxes on goods and services1.41.72.42.22.42.52.62.62.7
Taxes on international trade and transactions0.30.40.50.50.50.60.60.60.6
Non-tax revenue1.11.61.91.62.12.12.22.22.3
Estimated Sustainable Income15.620.619.717.416.815.513.912.410.8
Expenditure39.850.264.549.970.673.863.957.850.9
Expenditure excluding donor projects33.143.158.344.365.168.258.352.245.3
Expense29.340.342.439.041.341.341.541.840.8
Recurrent22.633.236.333.435.735.836.036.235.2
Compensation of employees4.05.66.56.67.37.37.37.37.3
Goods and services11.313.612.712.213.713.713.713.713.3
Current transfers7.213.917.014.514.614.614.614.714.1
o/w ZEESMn.a.4.37.96.25.95.85.85.95.6
Donor projects6.77.26.15.75.65.65.65.65.6
Net acquisition of NFA10.59.922.110.929.332.422.316.010.1
Gross operating balance−2.8−7.1−8.7−9.2−11.4−12.4−14.0−15.7−15.9
Net lending/borrowing−13.3−17.0−30.8−20.1−40.7−44.8−36.3−31.7−26.0
Statistical discrepancy0.5−0.61.20.00.00.00.00.00.0
Net financial transactions−13.8−16.4−32.0−20.1−40.7−44.8−36.3−31.7−26.0
Net acquisition of FA−13.4−15.7−30.9−19.7−33.1−37.3−29.1−27.0−23.2
Domestic (net)−13.4−15.7−30.9−19.7−33.1−37.3−29.1−27.0−23.2
Equity−2.5−20.6−25.3−19.7−33.1−37.3−29.1−27.0−23.2
of which, Excess withdrawal from PF−2.5−20.6−25.3−19.7−33.1−37.3−29.1−27.0−23.2
Change in cash/deposit−11.05.0−5.50.00.00.00.00.00.0
Net incurrence of liabilities0.40.81.10.47.67.57.24.72.8
Memorandum item
Nominal GDP4,042.03,102.32,761.92,763.72,877.32,960.23,089.83,272.93,540.6
Petroleum Fund
Opening balance14,952.116,538.616,217.415,844.115,783.515,043.314,152.513,404.512,665.7
Comprehensive investment income2,318.5957.3871.6965.5695.7672.0582.8553.7585.1
Oil and gas receipts1,817.0978.9223.9300.080.285.330.930.991.1
Investment returns325.6326.7340.9665.5615.6586.7552.0522.8494.0
Valuation gains/losses201.8−323.3331.40.00.00.00.00.00.0
(Minus) Expenses and withholding tax25.825.024.60.00.00.00.00.00.0
Withdrawal732.01,278.51,244.81,026.01,435.91,562.81,330.81,292.51,205.5
ESI632.3638.5544.8481.6482.7458.7430.4407.2384.1
Excess withdrawal99.7640.0700.0544.4953.21,104.1900.5885.3821.4
Closing balance16,538.616,217.415,844.115,783.515,043.314,152.513,404.512,665.712,045.3
(In percent of GDP)409.2522.8573.7571.1522.8478.1433.8387.0340.2
Sources: Timor-Leste authorities; IMF staff calculations.

This table is in accordance with the GFS format, with some modifications, to facilitate policy discussion and analysis.

Sources: Timor-Leste authorities; IMF staff calculations.

This table is in accordance with the GFS format, with some modifications, to facilitate policy discussion and analysis.

Box 2.The Greater Sunrise Gas Field Agreement1

On October 15, 2017, the Permanent Court of Arbitration announced that Timor-Leste and Australia had agreed on a draft treaty relating to the Greater Sunrise gas field. The bilateral agreement addresses issues related to the maritime boundary, and the gas field’s legal status, development strategy, and revenue sharing.

Details of the agreement remain confidential. The parties will be discussing the development of the resources through the Greater Sunrise Joint Venture with an aim to sign the agreement by end 2017 or early 2018.

The 2006 Treaty on Certain Maritime Arrangements in the Timor Sea divides revenue from the Greater Sunrise 50:50 between Timor-Leste and Australia. Both governments announced the termination of this treaty on January 9, 2017 in the context of the conciliation proceedings which resulted in the current agreement.

Estimates from Woodside, the largest shareholder in the Greater Sunrise Joint Venture, suggest that the field holds 5.13 trillion cubic feet of gas and 225.8 million barrels of condensate. The value of the resources was reportedly worth between US$40 billion to US$50 billion.

1 Prepared by Racha Moussa.

Box 3.Public Investment Management Assessment (PIMA)1

The July 2016 PIMA mission recommended a prioritized action plan to strengthen public investment management institutions and processes.

Near-term measures

  • Budget unity: Consolidate capital and current budget preparation, including project selection, in the Ministry of Finance, while retaining project appraisal in the Ministry of Planning and Strategic Investment (MPSI). 2

  • Medium-term capital budget ceilings: Based on a binding resource envelope, ministerial ceilings for capital budget need to be determined at the start of the budget process.

  • Project appraisal: MPSI should strengthen the project appraisal process by developing a standard methodology for project appraisal, publishing this methodology and verifying that it is consistently applied by the line ministries.

  • Project selection: Strengthen the capital project selection process for the annual budget (and, in future years, for the multi-year investment plan and budget) by developing better targeted selection and prioritization criteria and by improving the information provided to decision makers.

Medium-term measures

  • Full cost disclosure: Ensure that budget documents provide comprehensive information on full capital project costs and eventually lifecycle costs of projects.

  • National and sectoral planning: Prepare Strategic Development update and sectoral strategies with indicative costing.

  • Protection of investment: Create a mechanism to enable parliament to review and authorize commitments beyond the budget year in the annual budget law; and establish the legal authority to enable automatic carry-over of unspent appropriations within strict limits.

  • Project management: Task an appropriate agency to develop government project management standards and promote a comprehensive approach to project management across ministries that have ownership of capital projects.

1 Prepared by Eliko Pedastsaar (FAD).2 Under the Seventh Constitutional Government, MPSI ceased to exist and almost all functions of the MPSI are transferred to the new Ministry of Development and Institutional Reform.

Box 4.External Sector Assessment1

The external position is substantially weaker than that consistent with medium-term fundamentals and desirable policy settings. The oil-dependent economy is facing a large structural change due to expected depletion of the current oil/gas field by 2022. The deterioration is due to falling oil exports and is compounded by higher imports driven by the scaling up of public investment. Improving external competitiveness is key to advancing economic diversification and promoting non-oil private sector development, warranting fiscal adjustment and steady implementation of structural reforms.

The external current account (CA) deficit is projected to remain. The CA turned to a deficit in 2016, driven by a decline in oil/gas receipts amid declining output and lower oil prices. The current account deficit is projected to remain at 18 percent of GDP in the medium term (2018-2022 average), driven by a higher imports related to capital spending, coupled with falling oil/gas receipts.

The Petroleum Fund (PF) will provide a source of funding over the medium term. The CA deficit will be financed largely by divestment from the PF, together with external borrowing and FDI inflows. However, this is unsustainable over the long term as the PF balance dwindles.

The real effective exchange rate (REER) has appreciated strongly since 2010 resulting in an erosion of external competitiveness. The REER has appreciated by about 7 percent annually during 2010-2015, due to high inflation differential with trading partners in 2010-13 and an appreciation of the nominal effective exchange rate (NEER) since 2013 as the U.S. dollar strengthened against trading partners’ currencies. The REER depreciation in 2016 and early 2017 helped to moderate the loss of external competitiveness. Nevertheless, this has not been conducive to enhancing export performance as Timor-Leste’s main exports–petroleum and coffee–are denominated in U.S. dollars. The economy is also highly dependent on imports, reflecting its very limited domestic production base.

Balance of Payments

(In percent of GDP)

Staff’s assessment—based on the EBA-lite framework—suggests substantial exchange rate overvaluation compared to the level implied by fundamentals and desirable policies.2 This assessment is based on the IMF standard methodogy using the CA model, the REER Index model, and External Sustainability approach (ES). The CA gap, the difference between CA-actual and the CA norm, suggests an external position that is substantially weaker than current fundamentals and desirable policy settings. The REER gap from the REER model also points to substantially weaker external position. Nonetheless, these results are sensitive to sample periods and underlying assumptions. Further, the estimates of the CA norm may not fully capture Timor-Leste specific factors such as data limitations (e.g., no output gap), the availability of financing from the PF, and rapid structural change the country is undergoing.

Effective Exchange Rates

(2010=100)

Sources: Country authorities; and IMF staff calculation.

International reserves adequency is met due to the significant buffer from the PF. NIR was US$0.3 billion at end 2016 or an import coverage of 2.9 months. Reserve adequacy metrics for credit-constrained LICs suggest that the optimal level of reserves for Timor-Leste is around 9.5 months of imports, much higher than the traditional metric of 3 months. The estimated adequacy threshold largely reflects the inflexibility of a dollarized economy in adjusting the exchange rate to absorb shocks.3 While a fully dollarized economy does not face exchange rate fluctuation risk, liquidity is needed to protect the financial system from liquidity shocks and as a fiscal buffer for the financing gap. In this context, the PF provides significant buffers, with foreign assets at US$15.8 billion (574 percent of GDP with allocation of 40 percent in equities and the remaining in bonds) equivalent to 164 months of goods and services imports. In contrast, foreign liabilities remain relatively small, at 18.8 percent of GDP at end-2016, mostly consisting of FDI liabilities and concessional external debt (12.8 percent and 2.4 percent of GDP, respectively).

2016 External Balance Assessment Results
CA modelCA model* 1/REER modelES model 2/
Actual CA−19.3−19.3−15.3
CA norm−8.2−6.6−0.3
CA gap−11.1−12.7−14.9
REER gap3/32.737.426.644.1

With staff’s recommended desirable fiscal balance equivalent to narrowing the underlying fiscal deficit by 6 percent of GDP via reducing capital expenditure by one-third.

For External Sustainability (ES) model, actual CA is the medium-term CA projection and CA norm is the CA that stabilizes NFA at the 2016 level.

Implied over(+)/under(-) valuation.

Source: IMF staff estimates

With staff’s recommended desirable fiscal balance equivalent to narrowing the underlying fiscal deficit by 6 percent of GDP via reducing capital expenditure by one-third.

For External Sustainability (ES) model, actual CA is the medium-term CA projection and CA norm is the CA that stabilizes NFA at the 2016 level.

Implied over(+)/under(-) valuation.

Source: IMF staff estimates

Structural reforms remain crucial to improve external competitiveness. Structural reforms such as raising productivity, improving the business climate, and promoting non-oil private sector development are warranted to enhance external competitiveness. The minimum wage remains relatively high compared to regional peers, which could discourage FDI in labor-intensive sectors. Keeping the wage level in line with productivity will help improve export competitiveness and attract foreign direct investment. Addressing infrastructure bottlenecks, increasing financial access and closing labor skill gaps by more targeted vocational training would also help improve competitiveness.

Monthly Minimum Wage

(USD, 2015)

Sources: Timor-Leste authorities; ILOSTAT; and IMF staff calculations.

1 Prepared by Tadaaki Ikoma.2 See IMF (2016), Methodological Note on EBA-Lite.3 See IMF (2015), Assessing Reserve Adequacy – Specific Proposals.

Figure 5.Timor-Leste: Business Environment and Governance

Sources: World Bank Doing Business 2018; Labor Market Survey, 2013; Worldwide Governance Index, 2016; Natural Resource Governance Institute, Resource Governance Index 2017; the World Economic Forum Global Competitiveness Index 2014–2015; World Bank Enterprise Survey, 2015 and World Bank Development Indicators, latest available data.

Figure 6.Timor-Leste: Challenges to Growth – Comparison with Regional Peers

Sources: World Bank Development Indicators; World Bank Doing Business 2018; World Economic Forum Global Competitiveness Index 2014–2015; ILO STAT latest data available; and IMF staff calculations. Note: CLMV denotes Cambodia, Lao PDR, Myanmar, and Vietnam.

Figure 7.Timor-Leste: Social Economic Development

Sources: Human Development Report, 2017; World Bank Development Indicators, latest available data; and IMF staff calculations.

Table 3.Timor-Leste: Balance of Payments, 2014-2022
201420152016201720182019202020212022
Est.Projections
(In millions of U.S. dollars)
Current account balance 1/1,093239−523−95−523−574−585−585−630
Trade balance−603−635−539−548−797−834−815−823−835
Exports 2/161820122327323745
of which: Coffee151719102022252832
Imports−618−653−559−559−820−861−847−861−879
Services (net)−594−580−527−516−543−547−504−484−567
Receipts7474778492104120148171
of which: Travel35515865718091104118
Payments−668−653−603−600−635−652−624−632−738
Income (net)2,1341,290543961689665576548580
of which: Investment income316311320661609580546518490
Other primary income (oil/gas)1,8179792243008085313191
Current transfers (net)156164−18128142158174191
Capital and financial accounts−1,3645851592519569578578620
Official capital transfers142930222222222222
Financial account−1,3782948570497547556556598
of which: Oil/gas savings−1,3851516907261,3561,4781,3001,2621,114
FDI3730−737137122137147147
Inflow4943550150135150160160
External debt (net)28115721421921914997
Errors and omissions (net)−105−77−149000000
Overall balance−376220−157−3−4−5−7−6−9
Financing
Change in net foreign assets376−220157345769
(In percent of GDP)
Current account27.07.7−18.9−3.4−18.2−19.4−18.9−17.9−17.8
Trade balance−14.9−20.5−19.5−19.8−27.7−28.2−26.4−25.2−23.6
Exports0.40.60.70.40.80.91.01.11.3
Imports−15.3−21.0−20.2−20.2−28.5−29.1−27.4−26.3−24.8
Services (net)−14.7−18.7−19.1−18.7−18.9−18.5−16.3−14.8−16.0
Income (net)52.841.619.734.824.022.518.716.816.4
Current transfers (net)3.95.30.00.34.44.85.15.35.4
Capital and financial accounts−33.81.918.73.318.119.218.717.717.5
Overall balance−9.37.1−5.7−0.1−0.1−0.2−0.2−0.2−0.3
(In millions of U.S. dollars, unless otherwise indicated)
Memorandum items:
Public foreign assets (end-period)16,85016,65516,12516,06215,31814,42213,66712,92212,292
(In months of imports of G&S)15715316716612611411110491
(In percent of GDP)417537584581532487442395347
of which: Central bank reserves311438281278274270263256247
Petroleum Fund balance 3/16,53916,21715,84415,78415,04314,15313,40512,66612,045
(In percent of GDP)409523574571523478434387340
Sources: Data provided by the Timor-Leste authorities; and IMF staff estimates.

Excludes trade in goods and services of entities located in the Joint Petroleum Development Area which are considered non-resident entities.

Excludes petroleum exports, the income of which is recorded under the income account.

Closing balance.

Sources: Data provided by the Timor-Leste authorities; and IMF staff estimates.

Excludes trade in goods and services of entities located in the Joint Petroleum Development Area which are considered non-resident entities.

Excludes petroleum exports, the income of which is recorded under the income account.

Closing balance.

Table 4.Timor-Leste: Monetary Developments, 2014-2018
201420152016201720172018
JuneProjections
(In millions of U.S. dollars)
Banking system 1/
Net foreign assets 2/7571,0161,0961,0271,0401,036
Gross reserves311438281281278274
Other foreign assets521661876799823823
Foreign liabilities768361536161
Net domestic assets−157−373−362−355−248−131
Net credit to central government−207−339−420−403−420−420
Net credit to state and local government−100−600
Net credit to public nonfinancial corporations00−1−200
Credit to private sector192212208227218240
Other items (net)−142−246−149−171−4648
Broad money600642734672793905
Narrow money343398464383501572
Currency in circulation 3/101215161618
Transferable deposits333386450367486555
Other deposits257245270289291333
Central Bank
Net foreign assets2/300427271270268264
Gross reserves311438281281278274
Foreign liabilities111110111010
Net domestic assets−154−214−179−179−179−179
Net credit to central government−181−238−215−131−215−215
Net credit to other depository corporations717590159090
Other items (net)−44−50−54−63−54−54
Monetary Base14721391928885
Currency in circulation101215161618
Other liabilities to depositary corporations13720177767367
Others 3/000000
(12-month percentage change)
Broad money growth19.97.114.316.68.014.2
Reserve money growth71445.4−57.251.4−3.1−4.3
Credit to the private sector growth5.510.5−1.87.54.810.2
Memorandum items(In percent, unless otherwise indicated)
Credit/non-oil GDP13.213.212.412.311.811.5
Broad money/non-oil GDP41.340.043.936.543.043.4
Credit/deposits 4/32.533.628.935.427.526.8
Amounts of non-perfoming loans (in millions of U.S. dollars)47.443.728.0
Non-performing loans/total loans26.822.915.3
Loan rate 5/12.913.514.2
Deposit rate 6/1.11.01.0
Sources: Central Bank of Timor-Leste; and IMF staff estimates.

Includes the Central Bank, four commercial banks (including three branches of foreign banks).

An oil fund was created in September 2005 and the deposits were moved off-shore and onto the Government balance sheet.

Includes only coinage issued by the Central Bank. No data is available for notes due to dollarization of the financial system.

Excludes government deposits.

Rate charged by other depository corporations on loans in U.S. dollars. The rate is weighted by loan amounts.

Rate offered by other depository corporations on three-month time deposits in U.S. dollars. The rate is weighted by deposit amounts.

Sources: Central Bank of Timor-Leste; and IMF staff estimates.

Includes the Central Bank, four commercial banks (including three branches of foreign banks).

An oil fund was created in September 2005 and the deposits were moved off-shore and onto the Government balance sheet.

Includes only coinage issued by the Central Bank. No data is available for notes due to dollarization of the financial system.

Excludes government deposits.

Rate charged by other depository corporations on loans in U.S. dollars. The rate is weighted by loan amounts.

Rate offered by other depository corporations on three-month time deposits in U.S. dollars. The rate is weighted by deposit amounts.

Table 5.Timor-Leste: Medium-Term Scenario, 2014-2022
201420152016201720182019202020212022
EstProjections
Real sector
GDP at current prices (in millions of U.S. dollars)404231022762276428772960309032733541
Non-oil GDP145116071672184320852371269530693541
Oil GDP259114961090921792590395204
Real non-oil GDP growth (percentage change)434.05.53.05.05.75.55.55.2
CPI (percentage change, period average)0.70.6−1.31.02.73.63.83.94.0
CPI (percentage change, end-period)0.3−0.60.02.03.53.73.84.04.0
Private sector credit (annual percent change)5.510.5−1.84.810.29.79.79.911.4
Central government operations(In percent of GDP)
Revenue26.533.233.729.930.028.927.526.124.9
Domestic revenue4.25.57.86.87.67.98.08.08.4
Estimated Sustainable Income (ESI)15.620.619.717.416.815.513.912.410.8
Grants6.77.26.15.75.65.65.65.65.6
Expenditure39.850.264.549.970.673.863.957.850.9
Recurrent22.633.236.333.435.735.836.036.235.2
Net acquisition of nonfinancial assets10.59.922.110.929.332.422.316.010.1
Donor project6.77.26.15.75.65.65.65.65.6
Net lending/borrowing23.43.7−31.0−2.6−33.3−37.6−31.4−27.2−20.3
(In percent of non-oil GDP)
Revenue176.1104.255.371.051.645.137.232.630.5
Domestic revenue11.610.612.910.210.59.89.28.68.4
Petroleum revenue (incl. PF interest)145.979.732.352.433.428.321.618.016.5
Grants18.613.910.18.57.76.96.45.95.6
Expenditure110.897.0106.574.997.592.173.261.650.9
Recurrent expenditure62.964.059.950.149.344.741.238.635.2
Capital expenditure29.319.136.416.340.540.525.617.110.1
Donor project18.613.910.18.57.76.96.45.95.6
Overall balance65.37.2−51.1−3.8−45.9−47.0−36.0−29.0−20.3
Non-oil overall balance−80.6−72.6−83.5−56.2−79.3−75.3−57.6−47.1−36.9
(In millions of U.S. dollars, unless otherwise indicated)
Current account balance 1/1,093239−523−95−523−574−585−585−630
Trade balance−603−635−539−548−797−834−815−823−835
Exports 2/161820122327323745
Imports618653559559820861847861879
Services (net)−594−580−527−516−543−547−504−484−567
Petroleum revenue (incl. PF interest)2,1171,281540965696672583554585
Petroleum Fund balance16,53916,21715,84415,78415,04314,15313,40512,66612,045
(In months of imports)15414916416312411210910289
(In percent of non-oil GDP, unless otherwise indicated)
Current account balance 1/75.314.9−31.3−5.2−25.1−24.2−21.7−19.1−17.8
Trade balance−41.6−39.5−32.2−29.7−38.2−35.2−30.3−26.8−23.6
Exports 2/1.11.11.20.61.11.11.21.21.3
Imports42.640.633.430.439.336.331.428.024.8
Services (net)−40.9−36.1−31.5−28.0−26.0−23.1−18.7−15.8−16.0
Public external debt
(In millions of U.S. dollars)224677873045277499021,002
(In percent of GDP)0.51.52.83.110.617.824.327.628.3
Memorandum items:
Petroleum Fund balance (in millions of U.S. dollars) 3/165391621715844157841504314153134051266612045
(In months of imports)15414916416312411210910289
(In percent of GDP)409523574571523478434387340
Crude oil prices (U.S. dollars per barrel, WEO) 4/965143494950525355
Sources: Timor-Leste authorities; and IMF staff estimates and projections.

Excludes trade in goods and services of entities located in the Joint Petroleum Development Area which are considered non-resident entities.

Excludes petroleum exports, the income of which is recorded under the income account.

Closing balance.

Simple average of UK Brent, Dubai, and WTI crude oil prices; July 2017 WEO assumptions.

Sources: Timor-Leste authorities; and IMF staff estimates and projections.

Excludes trade in goods and services of entities located in the Joint Petroleum Development Area which are considered non-resident entities.

Excludes petroleum exports, the income of which is recorded under the income account.

Closing balance.

Simple average of UK Brent, Dubai, and WTI crude oil prices; July 2017 WEO assumptions.

Annex I. Main Recommendations of Past Article IV Consultations
Past Staff RecommendationsImplementation
Fiscal Policy
Greater focus on fiscal sustainability with a front-loading strategy in line with implementation and absorptive capacity should see expenditure envelope stabilized at $1.3 billion.Broadly accepted by the authorities. The 2017 budget reflects a modest expenditure envelopment of US$1.39 billion due to significant slowing of capital spending envisaged in an elections year. The multi-year budget projects a continuation of frontloaded capital spending for 2018–21.
Improve the composition of government expenditure, including rigorous cost-benefit analysis for large scale projects, scaling back planned infrastructure for cases ahead of demand, higher recurrent budget for maintenance cost for infrastructure development, curtail rapid increase in transfer and subsidies.On-going progress but challenges remain. The authorities recognized public investment plans should be subject to robust appraisal but need to build capacity.
Mobilize non-oil domestic revenues.Fiscal Reform Commission is working on the introduction of value-added tax in the medium term. Establishment of the new custom authority and tax authority would increase tax collection efficiency and raise compliance.
Financial Sector
Implement the Financial Sector Master Plan to strengthen financial system oversight and development. Need to strike a balance between expanding financial inclusion and safeguarding financial stability. Put in place a strategy to resolve legacy NPL.BCTL is making progress in building up supervisory and regulatory capacity covering banks and non-bank financial institutions. Substantial part of the legacy NPL was resolved in 2016 with the remaining amount expected to be largely resolved in 2017.
The financial system in Oecusse special economic zone continues to be within the mandate of the BCTL.Accepted by the BCTL authorities.
Vigilant to the build-up of contingent fiscal liabilities in setting up a development bank.The authorities are in board agreement with staff’s views and there has been no further progress in the conceptualization of a development bank.
Faster progress in reform of the land law to improve the availability of collateral to expand lending and borrowing.Early attention to be given to enable moveable property to be used as collateral; follows by the use of immoveable property such as land and building as collateral when land titles have been clarified. The Land Law has been promulgated on June 1, 2017.
Establishing appropriate AML/CFT framework.Good progress is being made with the introduction of the risk based approach.
The use of the U.S. dollars remains appropriate given institutional capacity constraints and limited financial development.The authorities agreed with the staff’s views on full dollarization given competing development goals and while institutions and financial markets remain underdeveloped.
Structural Reforms
Non-oil real GDP growth averaging around 5 percent over the medium term led by the private sector is more inclusive and sustainable.Non-oil GDP growth is assumed at 6–6.5 percent in 2018–19 with the frontloading of public investments creating a conducive environment ofr strong growth in private sector investment.
Measures to alleviate impediments to private sector development and economic diversificationOngoing progress but challenges remain.
Annex II. Risk Assessment Matrix1
Sources of RisksRelative Likelihood

(high, medium or low)
Time HorizonExpected Impacts if Realized

(high, medium or low)
Recommended Policy Responses
1. Weaker-than-expected global growthMedium

(i) Significant China slowdown and its spillover which would lower commodity prices, roil global financial markets, and reduce global growth.

Medium

(ii) Turning of the domestic credit cycle generating disorderly deleveraging in large emerging economies and potential spillbacks to advanced economies.
Short to Medium Term

Short Term
Medium/Low

The impact via lower commodity and oil prices is limited by the insulating role of the Petroleum Fund (PF) and low levels of non-oil trade and capital account integration. Nonetheless, weaker growth in Timor-Leste’s trading partners may slow the growth in tourism and FDI inflows, hampering economic diversification.
Government expenditure plans need to be scalable to mitigate sharp slow-down in growth. Efforts to raise non-oil revenues need to be intensified and the PF should be maintained at an adequate level as an ongoing revenue source and to provide fiscal buffer.
2. Tighter global financial conditionsHigh

Fed normalization, and tapering by ECB increase global rates, strengthens the U.S. dollar and the euro vis-à-vis other currencies, and corrects market valuations. Adjustments could be disruptive if there are policy surprises.
Short TermMedium/Low

PF would gain from higher global interest rates but could incur capital losses on its PF’s bond portfolio. Renewed global shocks that affect international banking operations could impact local liquidity conditions. No crisis management or contingency planning frameworks are yet in place.
The BCTL’s regulatory and supervisory framework and crisis management toolkit need to be enhanced. Fostering competition among banks to appropriately increase credit supply and narrow interest rates spread.
3. Lower energy pricesLow

Driven by stronger-than-expected U.S. shale production and/or recovery of oil production in the African continent.
Short to Medium TermMedium

Lower energy prices delay investment decisions in new oil fields and reduce profit. The lack of augmentation to PF saving raises fiscal risk in the medium and long term.
As for 1 above.
4.Higher inflationMedium

Inability to moderate the scaling up of public expenditures raises inflation as the absorptive capacity of the economy is limited.
Medium TermMedium

High inflation adversely affects the poor and vulnerable. Higher transfers to compensate and higher public sector wages add to fiscal pressures.
Fiscal policy needs to be adaptable to maintain macro-stability, preserve competitiveness and better protect the poor.
5.Over investment in projects with low returnsMedium

This could arise due to the implementation of capital-intensive projects with ambitious cost-benefit analysis.
Medium TermHigh

Capital-intensive projects that have limited economic linkages would have limited impact on job creation and poverty reduction while depleting PF and risk fiscal sustainability.
Projects should be subject to transparent and realistic cost benefit assessments and risk analysis, and only go ahead if the social returns are higher than the opportunity costs.
6.Failure to secure inclusive growthLow/Medium

Discontent could be triggered by public perception of low growth dividend, that oil wealth is not trickling down and not reducing poverty.
Medium TermHigh

Higher rent seeking behavior and pressures to raise expenditures may lower the expected return and quality of public investments. Foreign investment, vital for private sector growth and economic diversification, may be discouraged.
Sound policy frameworks and governance structures to be reinforced, especially through more transparency and accountability.
7. Development of Greater Sunrise or other oil fieldsLow

Upside risk if production at Greater Sunrise which is expected to take 5–7 years after finalization of agreement with Australia starts generating receipts early in the medium term.
Medium TermHigh

Higher fiscal spending could be supported and to some extent help enhance long-term growth prospects.
Fiscal resources should be prudently spent in line with absorptive capacity to avoid overheating and focus on growth enhancing projects.
Annex III. Expenditure Rule for Safeguarding Long-Term Fiscal Sustainability1

1. Since the Petroleum Fund (PF) Law was introduced in 2005, Timor-Leste adopted the estimated sustainable income (ESI)—calculated as 3 percent of the financial assets of the PF and the net present value of future oil and gas receipts—to facilitate its macroeconomic management. The ESI functions as a fiscal rule, as the implied limitations on the use of fiscal resources help to ensure long-term sustainability. The ESI has served Timor-Leste well, especially during the asset accumulation phase of the PF.

2. Following the amendment to the Petroleum Fund Law in 2011 that provides more flexibility in the use of PF assets to finance the country’s development needs with parliamentary approval, the effectiveness of the ESI has been weakened by the need to balance preserving fiscal sustainability and increasing the country’s growth potential through financing investments in infrastructure. In this context, consideration should be given to complementing the ESI with an expenditure fiscal rule.

3. Expenditure rules usually set permanent limits on total, primary, or current spending in absolute terms, growth rates, or in percent of GDP. An expenditure rule therefore helps to ensure long-term fiscal sustainability by limiting fiscal spending. Furthermore, it helps shield the domestic economy from overheating due to sudden surges in government spending. While capital expenditure (the golden rule) has in practice been frequently excluded from targeted fiscal aggregates because such spending contributes to growth over the long run, there are concerns that not all capital expenditure is necessarily productive and health and education expenditures may raise productivity more.2 In the context of Timor-Leste, a ceiling on primary expenditure will help ensure a more moderate pace of spending increase to maintain macroeconomic stability. This would also give time to strengthen the public investment management process to ensure the right projects that are most supportive to economic growth are selected.3

Annex IV. Revenue and Expenditure Reform Scenario versus Baseline Forecast1

1. The baseline fiscal scenario reflects lower capital spending in line with implementation capacity when compared to the 2017 Budget. The government net borrowing and lending is projected to remain in deficit while narrowing to 26 percent of GDP by the end of the medium term (2018-22), and gradually narrowing to 5 percent of GDP in the long term (2023-37).

  • Given capacity constraints, the baseline scenario assumes that only 70 percent (past average execution rate) of the multi-year (2018-21) capital expenditures allocation plan under the 2017 Budget will be implemented. Recurrent spending is expected to remain broadly at 35 percent of GDP in 2022 but decline to 18 percent of GDP in 2037 due to compression of public transfers and goods and services expenditures when confronted with a fiscal cliff caused by a depleting PF balance (see below).

  • In the absence of tax reforms, domestic revenue is expected to rise marginally, hovering around 8 percent of GDP over the medium term, and reach 17 percent of GDP in the long term.

  • The baseline scenario also assumes a cap on the withdrawal of the PF of US$1.3 billion per annum beyond the medium term, broadly in line with the notional budget envelope proposed during the 2014 Yellow Road Workshop discussions of domestic stakeholders that will help ensure fiscal sustainability.

  • Total external borrowing during 2017–37 is expected to reach US$3.8 billion, with outstanding debt at 22 percent of GDP in the long term. Continued reliance on excess PF withdrawals would lead to rapid reduction in the PF balance to US$12 billion in 2022 (340 percent of GDP) and to US$639 million (3.5 percent of GDP) by 2037.

2. The staff’s proposed reform scenario entails a three-pronged strategy to safeguard long-term fiscal sustainability. Under this scenario, net borrowing/ lending is expected to improve to a deficit of 6 percent of GDP in the medium term, and further narrow to about 1½ percent of GDP in the long term. Over the long term, total revenue is projected to be about 11 percent of GDP higher than that under the baseline scenario which would allow an expenditure envelop of about 7 percent of GDP larger and a rebuild of the PF assets in nominal terms.

  • More moderate levels of spending. Capital spending should be scaled up at a lower level averaging 14½ percent of GDP in the medium term and be anchored at no more than 10 percent of GDP in the long term. This more moderate and even-paced capital spending level would be better aligned with the country’s implementation and absorptive capacity while still meeting the government’s objective of frontloading capital expenditure. This level in the medium term is also still higher than the average of about 8 percent of GDP among developing economies in Asia. Recurrent spending should be reduced to 22 percent of GDP in the medium term, through lowering wages and salaries, goods and services, as well as public transfers (including to ZEESM as it completes its initial stage of major development), while preserving pro-poor social spending. An operating balance target of zero, or a surplus such that budgeted recurrent spending is financed by domestic revenue and the ESI, could be considered.

  • A value-added tax (VAT) implemented by 2020. A VAT which replaces the sales and service taxes, should be introduced by 2020, accompanied by an increase in excise duties yielding an additional 3 percentage points of GDP in revenue. With the government’s proposed VAT rate of 7.5 percent (envisaged in the draft VAT law), VAT is expected to raise revenues up to 5 percent of GDP in the medium term. The authorities should further consider raising the VAT rate to 10 percent—in line with IMF past TA recommendation—starting from 2028, to coincide with the cessation of excess withdrawal of the PF (see below). Moreover, tax administration reforms that broaden the tax base and increase compliance would raise direct taxes and other indirect taxes.

  • A commitment plan to stop PF excess withdrawal. Beyond capping PF withdrawal at US$1.3 billion over the medium term, PF withdrawals in excess of the ESI should not be permitted starting from 2028, to rebuild the PF balance. The resulting financing gap from lower PF withdrawal could be met by external concessional borrowing. Total borrowing is projected at US$4.5 billion over the long term (2017-37), about 18 percent higher than that under the baseline given the lower reliance on PF withdrawal. Outstanding external debt is expected to rise to 24½ percent of GDP in the medium term but should decline to 8 percent in the long term. A combination of lower medium-term spending and lower long-term PF withdrawal is expected to reverse the decline in the PF balance to around US$15.6 billion (468 percent of GDP) in 2022, and reaching US$17.7 billion (93 percent of GDP) in 2037.

Capital Spending, 2013–15

(In percent of GDP)

Source: World Economic Outlook

Petroleum Fund Dynamics (flow): Baseline Scenario

(In millions of US dollars)

Sources: Banco Central de Timor-Leste; IMF staff calculations

Petroleum Fund Dynamics (flow): Reform Scenario

(In millions of US dollars)

Sources: Banco Central de Timor-Leste; IMF staff calculations

Petroleum Fund Dynamics (stock): Baseline Scenario

(In millions of US dollars)

Sources: Banco Central de Timor-Leste; IMF staff calculations

Petroleum Fund Dynamics (stock): Reform Scenario

(In millions of US dollars)

Sources: Banco Central de Timor-Leste; IMF staff calculations

Timor-Leste: Illustrative Revenue and Expenditure Reform Strategy vs. Baseline Forecast(In percent of GDP)
BaselineReform
201520162017201820192020202120222037201820192020202120222037
Est.Proj.Proj.
Total revenue33.233.729.930.028.927.526.124.921.629.729.733.833.533.032.6
Domestic revenue5.57.86.87.67.98.08.08.416.78.28.613.313.814.325.2
Tax revenue3.95.75.05.45.65.75.86.011.75.96.210.911.411.919.8
Direct tax1.72.72.22.42.52.52.52.77.42.93.03.13.13.69.0
VAT3.43.83.85.0
Other indirect tax2.12.92.73.03.13.23.23.34.33.03.24.44.44.55.8
Nontax revenue1.61.91.62.12.12.22.22.34.92.12.32.32.32.25.4
Estimated Sustainable Income20.619.717.416.815.513.912.410.80.217.016.515.915.214.22.8
Donor grants7.26.15.75.65.65.65.65.64.84.64.64.64.64.64.6
Total expenditure50.264.549.970.673.863.957.850.926.751.847.644.742.838.734.0
Total expenditure excluding grants43.158.344.365.168.258.352.245.323.347.243.040.138.234.129.4
Recurrent spending33.236.333.435.735.836.036.235.217.932.228.025.123.221.619.4
Wages and salaries5.66.56.67.37.37.37.37.37.36.66.66.66.56.36.0
Goods and services13.612.712.213.713.713.713.713.35.113.211.09.18.17.65.4
Public transfers13.917.014.514.614.614.614.714.15.012.310.29.08.07.17.2
Interest payment0.00.00.00.10.30.40.50.60.50.20.40.60.80.80.3
Capital spending9.922.110.929.332.422.316.010.15.415.015.015.015.012.510.0
Gross operating balance−7.1−8.7−9.2−11.4−12.4−14.0−15.7−15.90.3−7.0−3.04.15.86.88.6
Net borrowing and lending−17.0−30.8−20.1−40.7−44.8−36.3−31.7−26.0−5.1−22.0−18.0−10.9−9.2−5.7−1.4
Primary balance−17.0−30.8−20.1−40.6−44.6−35.9−31.2−25.5−4.6−21.8−17.6−10.3−8.4−4.9−1.1
Financing:
PF excess withdrawal20.625.319.733.137.329.127.023.23.414.410.33.44.34.20.0
Borrowing0.81.10.47.67.57.24.72.81.77.77.77.54.91.51.4
Petroleum Fund balance522.8573.7571.1522.8478.1433.8387.0340.23.5548.6537.3524.3502.4467.893.1
Outstanding public debt1.52.83.110.617.824.327.628.321.914.824.032.336.935.811.5
Memorandum items
Petroleum Fund balance (in millions of US dollars)16,21815,84415,78415,04414,15313,40512,66612,04663915,58915,51015,57315,60515,60217,729
Real GDP growth4.05.53.05.05.75.55.55.25.24.74.84.84.84.86.5
Inflation−0.60.02.03.53.73.84.04.04.02.02.03.03.04.04.0
Current account balance (in percent of GDP)7.7−18.9−3.4−18.2−19.4−18.9−17.9−17.8−1.5−8.0−6.5−10.2−12.3−15.0−1.2
Sources: Timor-Leste authorities; and IMF staff calculations.
Sources: Timor-Leste authorities; and IMF staff calculations.
Annex V. The Macroeconomic Impact of Scaling Up Public Investment1

This Annex looks at the macroeconomic implications of the proposed public investment scale up outlined under the 2017 Budget, baseline fiscal scenario, and staff’s proposed reform scenario described in Annex IV, all using the Debt-Investment-Growth (DIG) model.2

The DIG Model

1. The DIG model considers a small open economy with two production sectors, two types of households (savers and non-savers) and an active government. The government collects taxes, and supplements domestic income by foreign and domestic borrowings. Revenues are used to finance public investment, government consumption and makes transfer payments to households. Financing modalities for the government to finance public investment can range from domestic borrowing, external concessional to commercial financing. With financing options set, taxes and transfers adjust to reasonable levels allowing debt to be paid down as painlessly as possible.

2. The model goes beyond comparing the rate of return on public investment and the cost of funding. It frames debt sustainability analysis in a framework that incorporates differences in the efficiency of public spending, the response of the private sector to the investment plan, and the ability of the government to adjust taxes and spending.

3. The DIG model is calibrated for Timor-Leste using specific macroeconomic and microeconomic data. Public investment efficiency is assumed at 50 percent, in line with the findings in Timor-Leste’s public investment management assessment (PIMA) report. This is broadly consistent with the average efficiency level of 60 percent for low-income countries and 75 percent for emerging market economies. The return on public investment is assumed to be 15 percent based on the cross-country estimates of marginal productivity of capital.3 The assumed rate of return is also close to the average rate of returns on the Timor-Leste’s public investment projects financed by the World Bank and evaluated by the Independent Evaluation Group. The model is also adapted to reflect the availability of finance via drawing down of savings from the Timor-Leste Petroleum Fund (PF).

Macroeconomic Implications

4. The model analysis highlights the sustainable outcome from a more gradual scaling up of public investments, along with efforts to improve public investment efficiency. Panels A and B of the Figure present key results for the following three scenarios:

  • Under the frontloaded scale up plan as envisaged in Budget 2017, capital expenditure is scaled up by an average of 39 percent of GDP in 2018-2021 and maintained at 11 percent of GDP, the historical level, thereafter. The model assumed one-third of the scale up investment is financed by concessional loan and the remaining two-thirds financed through excess withdrawal of the PF. Under this scenario, the model suggests a large increase in effective public capital stock (96 percent relative to its initial level) but declines after the scale up period. Without the allocation of adequate resources for operation and maintenance in the outer years to maintain the large built-up in the ramp up period,4 public capital stock could be eroded by 12 percent compared to its peak level within a decade after the scaling up period (see Panel B).

  • The baseline scenario considers a lower level of scale up, 30 percent lower than the budget scenario based on the historical execution rate of capital spending and post frontloading capital spending is maintained at 11 percent of GDP, similar to the budget scenario. In terms of the financing mix, the model assumed 40 percent of the investment is financed by concessional loan and the remaining through excess withdrawal of the PF. The model under the baseline suggests that effective public capital stock expands at a lower magnitude (63 percent of GDP) as compared to the budget scenario but also suffers a similar deterioration of effective public capital stock in the outer years. Effective capital stock would decline by 10.7 percent as the incremental investments in the outer years are not sufficient to cover capital depreciation.

  • The reform scenario considers a moderate scaling up along with improvement in efficiency. Public investment increased to 15 percent of GDP during 2018-2021 and stabilizes at 10 percent of GDP thereafter. By implementing recommendations outlined in the PIMA report (Annex 3), the efficiency of public investment is assumed to improve over a decade from its current level of 46 percent to 75 percent—the current level of emerging market countries. Concessional loans are assumed to finance about 95 percent of the public investment and the remaining through excess withdrawal from the PF. The model under this scenario suggests that effective public capital stock increases by about 52 percent at the end of the scale up period. The assumed improvement in public investment efficiency would more than offset assumed capital depreciation. In contrast to the budget and baseline scenarios, effective public capital stock would expand by about 60 percent—relative to its initial point—a decade after the end of the scale up period.

5. The model results also highlight a more even and sustainable growth and debt trajectory with a more gradual scale up of public investments. In both the budget and baseline scenarios, real GDP growth would accelerate in the scaling up period but tapper off in the long term.5 Similarly, external debt level would increase sharply before declining gradually after the scale up period. Private investment would increase over the medium term as public capital accumulates although its pace declines over time as public capital stock declines. In contrast, the reform scenario suggests a moderate impact on real GDP growth, external debt would also accelerate but to a much lower level as compared to the budget and baseline scenarios (Panels C-F). The gradual scale up would support private investment and, over the long term, its impact on private investment would surpass marginally those under the budget and baseline scenarios.

Conclusion

6. The frontloaded public investment scaling up plan could build-up capital stock rapidly but runs the risk of public capital erosion in the long term due to the high-level of resources needed for maintenance. At the current level of public investment efficiency of 50 percent and assuming a public capital stock depreciation rate of 5 percent, the long-term investment level would need to be significantly higher than the historical average capital spending level of about 11 percent of GDP to protect the public capital stock from deterioration. As it is difficult for most countries to rapidly scale up and improve efficiency simultaneously, it would be desirable to decelerate the pace of the scale up to save investment resources. As the reform scenario illustrates, decelerating the pace of scale up while improving public investment efficiency over time could more sustainably build up public capital.

Macroeconomic Impact Under Three Scenarios of Public Investment Scale Up

Source: IMF staff calculations.

Annex VI. Other Countries’ Experiences in Value-added Tax (VAT) Implementation1

Success of the implementation of VAT in Timor-Leste would hinge on the design and modalities of implementation of the VAT law.

Based on the experiences of IMF member countries, a successful introduction of a VAT depends on high-level political commitments, implementation readiness of tax administration, and ensuring full public understanding. Adequate preparation time is needed between enacting legislation and implementing the tax.

Overall, a legal framework for VAT administration that comprises a well-designed VAT law (including an appropriate registration threshold, a single positive rate, and limited exemptions) and provides an appropriate balance between the rights of taxpayers and the powers of the tax agency is crucial to ensure success in VAT implementation. In this context, some considerations that could be contextualized to meet Timor-Leste’s specific needs include:2

  • Efficient organizational structure and staffing arrangements, featuring strong headquarters; function-based organizational design; minimal management layers and appropriate spans of control; streamlined field operations; organizational alignment to key taxpayer segments (e.g., a focus on large taxpayers); and sufficient numbers of staff assigned to each level and function of the organization.

  • Effective management arrangements, including an appropriate set of strategic, operational, and individual performance measures that create accountability for results.

  • A system of self-assessment that minimizes interference by revenue officials in the actions by complying taxpayers while concentrating enforcement initiatives on those representing a higher risk.

  • Streamlined VAT filing and payment systems and procedures aimed at securing timely revenues without imposing undue compliance costs and inconvenience on the business sector.

  • Service oriented approaches whereby the tax administration operates as a trusted advisor and educator, ensuring that taxpayers have the information and support needed to understand and meet their obligations voluntarily.

  • Risk-based audit and other verification programs aimed at detecting taxpayers who present the greatest risks to the tax system, supported by effective dispute resolution process.

  • Extensive use of information technology to assist taxpayers to file tax returns accurately online using real-time validation, gather and process taxpayer information, undertake selective checking based on risk analysis, automatically exchange information between government agencies, and provide information to support management planning and decision making.

  • Modern human resource management practices that provide incentives for high performance and non-corrupt behavior among tax officers as well as developing staff skills and professionalism.

Annex VII. Credit Guarantee Scheme for SMEs in Timor-Leste1

The Central Bank of Timor-Leste is planning to establish a credit guarantee scheme (CGS) of small-and medium-sized enterprises (SMEs) to support financial inclusion and inclusive growth. International experience suggests that CGSs generally increase credit access for targeted groups, but their effectiveness and sustainability depend on design and operation.

1. Public credit guarantee schemes are widespread globally. CGS are mechanisms in which a third party—the guarantor—commits to repay the entire or part of the loan to the lender in case the borrower defaults. It provides credit risk mitigation to lending financial institutions to improve credit availability for targeted groups or financially constrained firms, typically SMEs. CGS targeting SMEs are widespread in both developed and developing countries. Public sector is often involved in the establishment and financing of CGS with the aim of increasing credit access to SMEs as they often face limited access to credit or unfavorable borrowing terms due to high transaction costs relative to loan sizes, information asymmetry, and lack of collateral.2

2. Timor-Leste SMEs have limited access to finance. Notwithstanding their growing economic importance, the financing gap for SMEs is large in Timor-Leste, with a small portion of SMEs having access to bank loans (text figure). A lack of access to credit is often cited as one of major business constraints.

3. CGS can be useful and efficient when appropriately targeted and managed. CGS can contribute to the expansion of SME finance by mitigating credit risk for financial institutions, resulting in increased access to credit and more favorable borrowing conditions (e.g., lower collateral requirement, longer maturities, and lower rates), which is generally corroborated by international experience. CGS is considered more cost effective than more direct public intervention, such as subsidies, if lending decisions under the scheme are made by market-based financial institutions.3 CGS also normally requires relatively small public funding or cash outlays at the initial phase, but expose the government to future cash outflows as credit losses materialize.

4. CGSs however may create moral hazard and contingent liabilities. First, CGS may generate little additional credit if financial institutions provide loans to SME borrowers which could gain credit even without CGS. Second, CGS can increase moral hazard on the part of lenders if substantial credit risks are transferred to CGS, reducing lenders’ incentives to adequately conduct risk assessment and monitoring, and encourage lending to high-risk borrowers with high interest rates and on the part of SMEs as they face a smaller cost in case of default. Third, public sector support to full or even partial CGS could create significant public contingent liabilities and therefore greater fiscal risks.

5. Maximizing CGS effectiveness requires that the CGS be well designed and operated. To achieve the aim of broadening credit access to economically viable SMEs in a financially sustainable way, appropriate design and operation are key. Among them, special attention should be paid to the following issues:

  • Preconditions. Legal, regulatory and institutional reforms to mitigate market failures related to SME credit market, including improving the availability of SME information4 and efficient methods for recovering debt, should be implemented.

  • Eligibility on borrowers, lenders, and credit types. Typical eligibility criteria on borrowers include firm size, defined by maximum number of employees, value of assets, and sales, lending institutions are evaluated based on their compliance with risk management capacity and practices. Priority should be given to new working and investment capital rather than refinancing of existing loans without credit guarantee.

  • Partial guarantee and loss sharing. Proper sharing of credit risk among all parties is essential to minimize moral hazard. Guarantee coverage ratio should reflect an appropriate balance between ensuring lenders retain sufficient credit risk and attracting lenders to the scheme. A guarantee of more than 60 percent would risk increasing moral hazard and financing requirement. It is also likely to be more effective if losses are shared rather than guarantee covering fully the first tranche of losses.

  • Guarantee triggers and claim management. CGS would need to set clear triggers for payout. Also, the establishment of efficient claim management process in case of borrowers’ default, in a form that generates incentives for loan loss recovery before submitting claim payments, is important.

  • Risk-based fee pricing. Similarly, guarantee fees should be charged based on risk level of lending and sufficiently high to keep the scheme financially sustainable.

  • Adequate regulation and supervision. The BCTL or a regulatory committee should evaluate CGS’s performance on a regular basis, set adequate regulation/supervision to ensure that the CGS is financially sustainable including capital adequacy and reporting requirements, and take corrective actions when necessary.

  • Governance. Ensuring sound governance is also key to achieve efficient operation of the scheme. Mixed ownership between public and private sectors would help establish sound governance by making the decision process more transparent, as well as add to its knowledge and financial base. Consideration could be given to funding the CGS by equity endowments which can be complemented by concessionary loans. Limits on public fiscal support should be made clear to minimize moral hazard.

6. The Decree-Law on Credit Guarantee Scheme for SMEs was approved in May 2017 and the BCTL is currently preparing regulations for implementation of the scheme. Key features defined in the Decree-Law include, targeting SMEs (i.e., small enterprises employing between 6–20 workers and for midsize enterprises between 21–50 workers), defining eligibility (e.g., for loans in priority areas for the diversification of the economy), and limiting maximum guarantee coverage up to 70 percent. Staff encourages best practices listed above, such as eligibility only to new loans, and clarification of the claim and recovery processes, and regulatory requirement to be factored into the regulation.

Timor-Leste: Firms’ Access to Finance

The fiscal table has been migrated to the GFS format, with some modifications to facilitate fiscal analysis (see Box 1 and Table 2b).

The ESI—a form of fiscal rule—is set at 3 percent of petroleum wealth, which consists of the PF balance and the projected net present value of future petroleum revenues. The PF—a sovereign wealth fund—was established in 2005 under the Petroleum Fund Law to fulfil the constitutional requirement for the management of Timor-Leste’s petroleum-based revenue.

This included the transfer of the government’s contribution to the Tibar Bay PPP-project in the amount of US$131.3 million (4.8 percent of GDP) to an escrow account, which will be paid-out as the project advances.

The U.S. dollar is sole legal tender in Timor-Leste.

Government grant transfers of US$171.9 million to ZEESM (the Special Zone of Social Market Economy of Oecusse and Atauro) accounted for 40 percent of public transfers or 6.2 percent of GDP under the 2017 Budget.

However, the risk of debt distress will be higher if the higher level of external borrowing over the medium term as envisaged in the 2017 Budget is implemented.

The banking system consists of five banks, a wholly government-owned bank, BNCTL, and four branches of foreign banks incorporated in Australia (ANZ), Indonesia (Bank Mandiri, Bank Rakyat), and Portugal (CGD/BNU). Bank Rakyat Indonesia started operations in Timor-Leste in March 2017.

The Decree-Law on Credit Guarantee Scheme for SMEs was approved in May 2017.

The Association of Southeast Asian Nations (ASEAN) Economic Community (AEC) allows the free flow of goods, services, investments, and skilled labor, and the freer movement of capital across the region. Under the AEC, individuals in eight professions (physicians, dentists, nurses, architects, engineers, accountants, surveyors, and tourism professionals), who are licensed in both their home and host countries, are free to work in any ASEAN country.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent; “medium” a probability between 10 and 30 percent; and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities.

Prepared by Fazurin Jamaludin.

IMF (2009) Fiscal Rules—Anchoring Expectations for Sustainable Public Finances.

IMF (2015) Making Public Investment More Efficient.

Prepared by Racha Moussa and Fazurin Jamaludin.

Prepared by Daniel Zerfu Gurara (SPR).

Buffie, E., A Berg, C Pattillo, R Portillo, & L-F Zanna. 2012. Public Investment, Growth, and Debt Sustainability: Putting Together the Pieces. IMF Working Paper No. WP/12/144. International Monetary Fund. Washington D.C.

IMF (2014). Solomon Islands: Third Review Under the Extended Credit Facility Arrangement and Request for Modification of Performance Criteria—Staff Report. IMF Country Report No. 14/170. IMF, Washington D.C.

Historical capital spending at 11 percent of GDP assumed in the both the budget and baseline scenarios is not sufficient to cover the assumed 5 percent depreciation of capital stock due to high inefficiency rate. The model assumed a depreciation rate of 5 percent as there is no estimate of the actual depreciation rate for Timor-Leste.

The growth and debt forecasts of the DIG model are different from the macro-framework owing to differences in the structure of the model and some underlying assumptions.

Prepared by Fazurin Jamaludin and Margaret Cotton (FAD).

Sources: Keen, Michael and Victor Thuronyi (2005), “The Challenges of Value-Added Taxes,” May, IMF Survey Vol. 34, No. 9, Fiscal Affairs Department, IMF; Toro, Juan; Junji Ueda, John Brondolo, Ricardo Fenochietto, and Stephen Howlin (2016), “Thailand: Improving the Performance of the Value-Added Tax,” March, Fiscal Affairs Department; IMF (2015), Malaysia: Selected Issues; and Williams, David (1996), “Value-Added Tax,” in Tax Law Design and Drafting (Volume 1), Victor Thuronyi (Ed.).

Prepared by Tadaaki Ikoma.

This Annex benefitted from World Bank (2015) “Principles for Public Credit Guarantee Schemes for SMEs”; and Gozzi, J.C. and Schmukler, S. (2016) “Public Credit Guarantees and Access to Finance” (Warwick Economics Research Paper Series).

Gozzi and Schmukler (2016) argued that even if temporary subsidies to encourage lending into a new market are deemed necessary, the government could provide a direct subsidy to financial institutions and the public sector would face no credit risk.

World Bank Doing Business (2017) shows that depth of credit information in Timor-Leste lags regional peers.

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