Summary: KEY ISSUES Context. The economy is very dependent on natural resources. Government spending, funded by oil exports, has driven rapid non-oil GDP growth but with high inflation, a loss of competitiveness, and weak employment generation. The political situation is relatively stable with elections in 2012 and the long-term UN presence has ended but fragilities persist as poverty remains high. The Strategic Development Plan guides policies, aiming for upper middle-income status and significant poverty reduction by 2030. Outlook and Risks. Non-oil GDP growth should average around 8 percent assuming structural reforms to catalyze the private sector and a sustainable fiscal stance. Key risks are: (i) fiscal slippages risk sustainability and inflation remains high, hampering diversification and poverty reduction; (ii) no agreement on the development of a major new oil field leads to the end of oil production by 2024; and (iii) lack of inclusiveness and poverty reduction results in social discontent and pressures for expansionary policies. Policy assessment. Policy discussions focused on shifting to a higher quality and poverty reducing growth path with stability and sustainability. Policy challenges include: ? Ensuring a sustainable level of public spending that is well targeted on projects with high socio-economic returns and calibrated to reduce inflationary pressures and improve competitiveness. ? Developing an asset-liability management framework linking debt accumulation with the Petroleum Fund; avoiding off-balance sheet and non-concessional liabilities. ? Enacting structural reforms to create an enabling environment, promote access to finance, provide basic infrastructure, and investment in human capital. ? Strengthening the Banco Central de Timor-Leste’s prudential and supervisory regime, preparing a crisis management framework, and developing a strategy for the financial system to support inclusive growth. Full dollarization remains appropriate for now given limited capacity for independent monetary and exchange rate policies.

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