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Birth of a nation: East Timor gains independence, faces challenges of economic management, poverty alleviation

International Monetary Fund. External Relations Dept.
Published Date:
January 2002
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East Timor’s independence comes after centuries of colonial rule, a 24-year annexation, and, more recently, a 2½-year transitional administration. After more than 400 years of Portuguese rule, East Timor was annexed by Indonesia in 1975. An independence struggle ensued, resulting in an agreement among the United Nations, Indonesia, and Portugal in 1999 to hold a referendum to determine the territory’s future status. About 80 percent of the voting-age population opted for independence.

The outcome of the 1999 referendum triggered a violent reaction by pro-Indonesian forces, resulting in widespread destruction and loss of life. An estimated two-thirds of the territory’s physical infrastructure was destroyed, and over three-fourths of the population was displaced in the weeks following the ballot. The disruption caused a more than 30 percent drop in GDP in 1999, a sharp acceleration in inflation, and a breakdown of the fiscal, financial, and legal systems. In the ensuing chaos, a multinational peace-enforcement mission arrived to restore security and begin relief efforts. In October 1999, East Timor was brought under the authority of a United Nations Transitional Administration for East Timor (UNTAET), which was charged with administering the territory during the transition to independence.

Over the next 2½ years, and with the assistance of the international community, UNTAET succeeded in establishing the legal and institutional conditions for independence. A constituent assembly was elected in August 2001 to draft and approve a constitution; a self-governing structure was established under the Second Transitional Government; and an election was held for East Timor’s first president in April 2002. These events culminated in East Timor’s independence on May 20, 2002, when the constituent assembly was transformed into a parliament, and the new government was sworn into office.

Rebuilding the economy

International financial institutions and bilateral donors have played an important part in helping East Timor reconstruct its economy. Following the first donors’ meeting held in Tokyo in December 1999, a multidonor Trust Fund for East Timor (TFET) was established to provide grants for economic reconstruction and development. Total pledges eventually amounted to over $170 million. TFET, which is expected to wind down its operations in 2003, is coadministered by the World Bank and the Asian Development Bank, which have disbursed these funds to finance infrastructure and sectoral programs. Since late 1999, donors have also disbursed more than $60 million in grants to support recurrent budgetary expenditures, as well as additional amounts in project aid.

Real GDP has been recovering while inflation has been falling sharply

Data: Indonesian and East Timor authorities; and IMF staff estimates

The IMF’s involvement in East Timor began in October 1999, at the request of the UN Secretary-General. The thrust of the IMF’s role—facilitated through a resident representative office in Dili (East Timor’s capital and largest city) since August 2000—has been to support economic institution building and provide policy advice in support of sound macroeconomic management. With respect to institution building, the IMF has played a principal role in establishing the Central Fiscal Authority (now the country’s Ministry of Finance) and the Banking and Payments Authority (BPA, a precursor to a fullfledged central bank). The IMF is also assisting the authorities in establishing a central statistical office. With respect to policy advice, a key area has been the establishment of an appropriate currency arrangement, under which East Timor adopted the U.S. dollar as its official currency in early 2000 (in the absence of sufficient institutional and economic management capacity to issue its own currency). On the fiscal side, the IMF has helped the authorities develop a tax system and prepare annual budgets.

East Timor has recovered significantly from the chaos of 1999. Real GDP is estimated to have recovered to close to precrisis levels (see chart, this page), rising by 15 percent in 2000 and a further 18 percent in 2001. During much of this period, growth was fueled by an expansion in the service and construction sectors in Dili, associated with the presence of the international community. Recently, the recovery has become more broad-based, with a restoration of agricultural production.

At the same time, inflation, which rose to 140 percent in 1999, has been declining steadily, turning negative at the end of last year and reaching–2 percent (on a 12-month basis) in April. This trend reflects the increased availability of goods and is also indicative of the ongoing real exchange rate adjustment to the winding down of the international presence, which had driven prices and wages to unsustainable levels (well above those on neighboring islands).

Development of the financial sector has been advancing but remains limited, with access to banking services largely confined to Dili. In addition to the BPA, the financial system consists of two commercial banks and a microfinance institution recently established with the assistance of the Asian Development Bank. Deposits in the banking system have been rising steadily, although the extension of bank credit has been weak, reflecting the absence of adequate collateral and other risk factors. Although use of the U.S. dollar for transactions got off to a slow start (given the widespread use of the Indonesian rupiah), the dollar has, in recent months, become the principal means of payment throughout the country.

East Timor has had to rely heavily on external grants for its public finances. In the current fiscal year, grants are expected to finance some 80 percent of total public sector spending. The tax system remains appropriately simple, given the early stage of economic development and limited administrative capacity. The tax base is narrow, with most revenues derived from indirect taxes levied on imported goods and selected services. Income taxes are levied on a relatively small number of workers and businesses.

Challenges ahead

Notwithstanding recent progress, the near-term economic outlook remains difficult. The winding down of the international presence, albeit gradual, is expected to dampen economic activity. With private sector growth being held in check by impediments to investment, overall output is likely to decline this year and next.

Over the medium term, sustainable GDP growth could rise substantially to 5–6 percent a year if appropriate policies are implemented, in line with the authorities’ recently drafted National Development Plan. Significant oil and gas revenues in the Timor Sea—conservatively estimated at about $3 billion over the next 20 years—are expected to lift the economy as they materialize over the next few years. The recent signing of the Timor Sea Treaty with Australia has facilitated prospects for these inflows, shifting the revenue share in favor of East Timor to a 90:10 split for fields within a Joint Petroleum Development Area. There are prospects for much higher revenues, pending the development of other oil and gas fields and the outcome of maritime boundary issues.

Joining the IMF

In anticipation of independence, in March 2002, the East Timorese authorities applied for membership in the IMF. Membership would facilitate East Timor’s entrance into other financial institutions and foster the new country’s integration into the global economy. The IMF’s staff, management, and Executive Board worked quickly to process the application, enabling the Board of Governors to approve East Timor’s membership resolution on May 29, 2002. Membership will become effective upon the authorities’ acceptance of the Articles of Agreement, expected shortly, and enable East Timor to become the IMF’s 184th member.

Although East Timor has made impressive strides in restoring stability and can look ahead to significant oil and gas revenues, many of the most difficult challenges of nation building and economic management lie ahead. The economy suffers from low productivity—the result of weak investment, shortages of management skills, and inadequate infrastructure. East Timor remains a very poor country, with more than 40 percent of the population, according to a recent household survey, living below the poverty line. Much of the population has only limited access to social services, including health care and education, and unemployment remains high.

The IMF has played a principal role in establishing the Central Fiscal Authority (now the country’s Ministry of Finance) and the Banking and Payments Authority (BPA, a precursor to a full-fledged central bank).

A major task for the new government will be to sustain the progress made during the transitional period. It will be particularly important to maintain and strengthen the institutions that have been established. This will require significant efforts to build local capacity through training and technical assistance.

Achieving significant reductions in poverty will require sustained high economic growth over the medium term. The National Development Plan lays the basis for a sound poverty reduction strategy. The plan envisions a market-based approach to economic development, underpinned by a strong and dynamic private sector. It will be important to maintain open trade and investment policies. It will also be crucial to eliminate impediments to investment, among them the lack of a business regulatory framework, and problems relating to land and property rights (competing land claims are the legacy of Portuguese and Indonesian rule, exacerbated by the destruction of land and property records in 1999).

East Timor remains a very poor country, with more than 40 percent of the population living below the poverty line.

Future prospects will also depend on maintaining sound fiscal policy. Given the limited scope for domestic revenue mobilization, and the authorities’ desire to refrain from borrowing, the government will need to rely on donor support for at least the next few years, until the country can benefit from oil and gas revenue inflows. It will therefore be important for the government to prioritize development goals and channel donor resources efficiently.

Once oil revenues come on stream, the challenge will be to maintain expenditure at a level consistent with the government’s capacity to use financial resources effectively. For this purpose, the authorities are seeking to develop an appropriate savings and investment strategy to manage oil inflows. Such a strategy would help insulate the economy from the volatile oil market and foster the growth of the other sectors of the economy.

The challenges facing the new country are significant. To meet them, East Timor will need the continued support of the international community and the commitment of the East Timorese leadership to setting the country on a sound policy path. While the challenges are difficult, prospects are bright. At the most recent donors’ meeting, held in Dili on May 14–15 just prior to independence, the international community reaffirmed its commitment to assisting East Timor. With the East Timorese people having demonstrated an ability to overcome unspeakable difficulties in the past, expectations are high that they will now be able to meet the challenges that come with their long-awaited independence.

The primise of oil and gas

East Timor is situated on the island of Timor, located at the eastern extremity of the Indonesian archipelago. A mountain chain runs along the middle of the island, which has narrow coastal plains and relatively poor soil quality. Agriculture—mainly subsistence farming—accounts for one-fourth of total output (see chart) and about three-fourths of employment. The underdeveloped manufacturing sector is constrained by poor infrastructure and a limited supply of skilled workers. The island has long been known for its sandalwood, and more recently for its high-quality coffee, which constitutes its principal export. Looking ahead, the exploitation of oil and gas resources in the Timor Sea is expected to alter significantly East Timor’s export profile and economic prospects. Given the island’s natural beauty, tourism is also a sector with development prospects.

In 2000, agriculture and public administration accounted for the bulk of GDP

Data: East Timor authorities

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