On December 6, 2017, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with the Democratic Republic of Timor-Leste, and considered and endorsed the staff appraisal without a meeting on a lapse-of-time basis. [2]

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.

The overall fiscal deficit widened to 30.8 percent of GDP in 2016 from 17.0 percent in 2015. Revenue sourced from estimated sustainable income (ESI) of the Petroleum Fund (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 substantial additional allocations in the supplementary budget to projects that advanced ahead of schedule.

The external 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. This was driven by higher imports related to public investment and a decline in oil/gas receipts as output fell with the near depletion of current oil field amid lower global oil prices. The real effective exchange rate (REER) depreciated by 2.8 percent in 2016, reflecting lower inflation and U.S. dollar nominal depreciation against the currencies of Timor-Leste’s trading partners.

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

Medium-term risks depend critically on the success of fiscal and structural reforms. The key challenge facing Timor-Leste will be achieving economic diversification. The depletion of its current oil field by around 2022 adds more 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 envisaged large PF withdrawals required for financing. Risks also lie in whether large infrastructure projects would generate sufficient social and economic returns to achieve inclusive growth that would translate into higher tax returns and restore fiscal sustainability. There is also risk of higher inflation due to domestic price pressures from larger government spending.

Executive Board Assessment

In concluding the 2017 Article IV consultation with Timor-Leste, Executive Directors endorsed the staff’s appraisal, as follows:

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.

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.

Domestic revenue mobilization and effective use of concessional borrowing are critical for safeguarding fiscal sustainability. The introduction of a value-added tax 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.

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 small and medium-sized enterprises (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 anti-money laundering/combating the financing of terrorism (AML/CFT) framework.

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.

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.

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.