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A new economy: East Timor moves to establish foundations of sound macroeconomic management

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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Background

After more than four centuries of Portuguese rule, Indonesia annexed East Timor in 1975. In the mid-1990s, East Timor ranked among Indonesia’s poorest provinces, with a per capita income of about $350. Its economy grew rapidly, however, driven by capital outlays on infrastructure funded largely by transfers from the Indonesian central budget. Real GDP growth averaged about 10 percent and inflation was in single digits.

Output growth collapsed with the onset of the Asian crisis in 1997. The decline was partially off set by growth in agriculture, the financial sector, public administration, defense, and public utilities. Per capita GDP reached $424 in 1998, and inflation increased to about 80 percent (see table, page 277).

In East Timor’s small and rudimentary banking system, publicly owned banks were key players. Public finances depended heavily on transfers from Jakarta, with tax revenues amounting to only 6–8 percent of GDP (excluding revenues related to oil concessions), while expenditures represented 40–75 percent of GDP. The economy was quite open and heavily reliant on interisland trade. Exports averaged about 13 percent of GDP during 1995–98, while imports averaged about 36 percent of GDP.

After the referendum

Following an agreement among the United Nations, Indonesia, and Portugal, a referendum was held on August 30, 1999, on the future status of the territory. The referendum provided an overwhelming mandate for independence, but the outcome also triggered widespread violence that seriously disrupted East Timor’s economy and institutional structure.

The destruction affected all sectors of the economy. Real GDP is estimated to have declined by almost 40 percent in 1999 and inflation increased sharply. The banking and payments system ceased functioning, and all transactions were conducted in cash—mostly in rupiah, although other currencies also started circulating. Public administration also stopped functioning, revenue collection came to a halt, and budgetary transfers from Jakarta ceased.

The disruption in production and transportation sparked a marked decline in trade. But perhaps most crucial for the economy, the massive displacement of people led to the loss of valuable human capital, particularly key civil servants and commercial bank officials.

In mid-September 1999, a multinational peacekeeping force arrived to restore security and facilitate humanitarian assistance provided by various UN agencies and other bilateral and nongovernmental organizations. In October, the People’s Consultative Assembly of Indonesia revoked the annexation of East Timor and, subsequently, the UN Security Council issued a resolution establishing the UN Transitional Administration in East Timor (UNTAET) with broad responsibilities for administering the territory during its transition to independence.

At the request of the UN Secretary General, several official, bilateral, and multilateral agencies joined with the UN agencies and the East Timorese to assess reconstruction requirements, including external financing and technical assistance and training. The World Bank took the lead in assessing reconstruction needs and in designing the development program. IMF staff and experts focused on helping to develop a basic macroeconomic and institutional framework, with special emphasis on the immediate steps needed to ensure stability and create an enabling environment for economic recovery.

Macroeconomic framework

The IMF staff proposed a strategy centered on three essential components—the revival of the payments system, the development of a basic fiscal framework, and a comprehensive program of policy and technical advice. The most critical initial steps toward reviving the payments system were the choice of a legal tender and the establishment of a monetary authority that would design and enforce a basic regulatory framework for the operation of the foreign exchange market and the banking system.

Photo Credits: Denio Zara, Padraic Hughes, Pedro Márquez, and Michael Spilotro for the IMF, pages 273 and 279; Darren Whiteside for Reuters, page 276; and Jimin Lai for AFP, pages 282–83.

There was a consensus that conditions were not currently in place for the introduction of an East Timorese currency and that a single foreign currency would be needed to help eliminate the inefficiencies and distortions that had arisen from the ongoing use of multiple currencies. A Central Payments Office would be created to provide basic depository and payments services to the government and perform the treasury functions related to payments of stipends to civil servants.

The basic fiscal strategy featured two key elements: the establishment of a Central Fiscal Authority, which would be responsible for administering public finances as well as enforcing fiscal legislation and would ensure appropriate oversight, and the adoption of a budget underpinned by a fair, transparent, and efficient tax system that was easy to administer.

The UNTAET prepared the preliminary budget for 2000, in consultation with the IMF staff. The budget, presented to donors in Tokyo in December 1999, proposed the introduction of a 5 percent import duty, various excises, a 5 percent sales tax on commercial imports, a 5 percent service tax on selected services, and a 5 percent presumptive income tax on coffee exports.

Recent developments

The overall economic situation has improved considerably since September 1999. Real GDP is estimated to have grown at an annual rate of 15 percent in the first half of 2000, led by the reconstruction of public and residential buildings and the progressive restoration of commerce and some basic services. Prices are slowly beginning to stabilize, but unemployment remains high, particularly in urban areas. Humanitarian assistance continues to be a major source of income support for large segments of the population.

The implementation of the preliminary budget up to the end of June has been well below projections for that period. This has been primarily due to low levels of expenditures reflecting complex administrative procedures, delays in the receipt of external financing, and long-drawn-out planning stages for investment programs. Moreover, the composition of expenditures has deviated markedly from that originally envisaged. In particular, the wage bill was almost twice as large as originally projected, because public sector employment and the average monthly compensation were higher than assumed in the budget.

In the financial sector, two foreign institutions have started operations, mainly providing foreign exchange services. Progress has also been made in restoring the payments system, particularly budgetary payments. UNTAET, with the endorsement of the National Consultative Council, adopted the U.S. dollar as the legal tender in early January 2000. The use of the U.S. dollar has not been as widespread as expected, however, because of a scarcity of low-denomination notes, the absence of coins, and a lack of familiarity with the new legal tender. These problems are being addressed.

On the external front, foreign trade activity also appears to be picking up gradually. As regards external financing, generous assistance from the international community has supported East Timor’s reconstruction effort. Donor pledges in Tokyo amounted to $523 million and have been sufficient to cover the special appeal for humanitarian aid ($150 million); a three-year, $147 million reconstruction program underwritten by a Trust Fund for East Timor; recurrent and capital expenditures for civil administration and law and order ($32 million); and a number of bilateral programs. All assistance has been voluntary and has taken the form of grants or donations to avoid external liabilities. Assistance has also been provided through the UNTAET budget, financed through assessed contributions from the UN member states.

Key economic indicators
1995199619971998199920002001
Est.Proj.Proj.
GDP per capita
(U.S. dollars)1374429442424304
(percent change)
Real GDP growth9114–2–381515
Inflation rate 2851080140203
(percent of GDP)
Consumption83.479.971.074.691.9104.2112.7
Investment40.844.352.947.028.133.446.7
Domestic saving16.620.129.025.48.1–4.2–12.7
External saving–24.2–24.2–23.9–21.6–20.1–37.6–59.4
(million U.S. dollars)
Merchandise exports37445255464963
Merchandise imports311213214213582118192
Fiscal year41995/961996/971997/981998/991999/2000Jan.-Jun. 20002000/01
Budget5Prel.
BudgetEst.
(percent of GDP)
Fiscal balances
Revenues8.18.26.03.21.15.9
Recurrent expenditures13.014.613.07.45.015.1
Capital expenditures61.822.529.521.06.944.6
Overall balance (deficit)–66.7–28.8–36.5–25.2–10.8–53.8

GDP in U.S. dollars was calculated using 1996 as the base year and assuming purchasing power parity.

CPI, Dili, based on rupiah prices, except for projected 2001 figure, which is CPI, Dili, based on U.S. dollar prices.

Includes imports through foreign aid; excludes projected imports by UNTAET and Office of Coordination of Humanitarian Affairs in 1999, 2000, and 2001.

The fiscal year under Indonesia was from April 1 to March 31. There are no data on the execution of the 1999/2000 budget. The preliminary budget of UNTAET was prepared for calendar year 2000. Fiscal year 2000/01 is from July 1 to June 30.

Original Indonesian provincial budget for East Timor

Data: Indonesian authorities and IMF staff estimates

GDP in U.S. dollars was calculated using 1996 as the base year and assuming purchasing power parity.

CPI, Dili, based on rupiah prices, except for projected 2001 figure, which is CPI, Dili, based on U.S. dollar prices.

Includes imports through foreign aid; excludes projected imports by UNTAET and Office of Coordination of Humanitarian Affairs in 1999, 2000, and 2001.

The fiscal year under Indonesia was from April 1 to March 31. There are no data on the execution of the 1999/2000 budget. The preliminary budget of UNTAET was prepared for calendar year 2000. Fiscal year 2000/01 is from July 1 to June 30.

Original Indonesian provincial budget for East Timor

Data: Indonesian authorities and IMF staff estimates

On the institutional front, the two key economic institutions—the Central Fiscal Authority and the Central Payments Office—are close to becoming operational. The IMF’s Fiscal Affairs, Legal, and Monetary and Exchange Affairs Departments have provided extensive technical assistance, including identifying suitable expatriate staff for key positions.

One of the most important institutional developments has been the creation of a decision-making structure, which includes the establishment of the National Consultative Council and, more recently, the shift from a transitional administration to a transitional government in which East Timorese would assume executive positions. The IMF’s Asia and Pacific Department has provided continued policy advice to UNTAET, including helping to form a consensus at the National Consultative Council on key economic policy issues.

Outlook for the near term

Real GDP is projected to grow by at least 15 percent a year during 2001–02, led by agriculture, commerce, basic services, and construction. As supply constraints are relaxed and the U.S. dollar becomes more widely used, inflation in East Timor should start converging to that of its major trading partners.

The fiscal deficit for 2000/01 is projected at $155 million, with domestic revenues covering only 10 percent of expenditures. The deficit is projected to remain above $100 million in the following two years, with fiscal revenue more than doubling in the outer years to cover about 80 percent of expenditures. The projected increase in revenues, however, would require an additional tax effort and a broadening of the tax base. Setting an appropriate wage policy for the civil service would also be a critical policy challenge in the fiscal area.

Financing of the deficit will continue to rely fully on external grants. A donors’ meeting in late June helped to confirm the availability of funds for the reconstruction and development program funded through the Trust Fund for East Timor and provided strong indications that the funding of recurrent and capital expenditures for civil administration would be made available.

In the financial sector, urgent steps need to be taken to reestablish the banking function by enacting key prudential regulations and establishing a system of supervision of financial institutions. Finally, there will be a continued, albeit declining, need for external financial assistance as well as for further technical assistance and training for a number of years.

Challenges ahead

Despite the progress achieved so far, the tasks ahead remain monumental. As the reconstruction effort gains momentum with generous external financial support, sound economic management will be critical in preserving macroeconomic stability and providing reasonable assurances to all parties involved, including donors, that the resources made available to East Timor are being effectively used and properly accounted for.

Active participation of the East Timorese in all stages of the process—including the design, implementation, monitoring, and, if required, reformulation of objectives and policy priorities—is critical to the success of the reconstruction effort and would consolidate gains already made.

Copies of East Timor: Establishing the Foundations of Sound Macroeconomic Management, by Luis M. Valdivieso, Toshihide Endo, Luis V. Mendonça, Shamsuddin Tareq, Alejandro López-Mejía are available for $18.00 each from IMF Publication Services, Box X2000, IMF, Washington, DC 20431 U.S.A. Telephone: (202) 623-7430; fax: (202) 623-7201; e-mail: publications@imf.org.

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