How will East Timor manage its economy?

Helder da Costa

Can tiny impoverished East Timor emerge as a viable, independent and stable state? This question mattered greatly as the Fretilin-dominated government took over the running of the nation, its institutions and economic policies on 20 May 2002.

Like Bosnia and Herzegovenia, South Africa, Rwanda and Cambodia before it, East Timor is a nation emerging from trauma. It is only now experiencing its first years of peace and the beginnings of political, economic, and social recovery after the 24-year occupation and the mass destruction of September 1999. The initial period of reconstruction needs to place a priority on meeting basic needs (food, shelter, water, health, education), as well as on maintaining political stability and personal security, while encouraging reconciliation and economic recovery.

If it is to meet the aspirations of its citizens, moreover, the reconstruction program must happen quickly and extend throughout the country. Institutional and policy foundations must be laid firmly and swiftly to prepare East Timor for sustainable recovery and growth. They must increasingly enable the country to rely on its own resources to design and implement the policies and institutions required for long-term development. An essential ingredient to provide that firm foundation is effective macroeconomic stability, so as to encourage foreign trade and investment and foster the private sector.

As a small half-island economy, East Timor is characterised by a large traditional sector, producing primarily for subsistence. East Timor�s development is constrained by bad roads and mountainous terrain, a shortage of skilled labour, and the proximity of the highly efficient economies of East Asia.

Social development indicators lag behind those of other small Micronesian states. When East Timor became independent, it took its place as one of the twenty poorest countries in the world. Its GDP per capita is just US$478, and its human development rating places it in the same category as countries such as Angola, Rwanda, Bangladesh, Guinea-Bissau and Mozambique. Life expectancy in East Timor is just 57 years. Nearly half the population live on less than US$0.55 per day. Very few people have received an adequate education - more than half the population is illiterate (55%). Over 50% of infants are underweight. And the country is still suffering from the destruction and trauma that followed the national vote for independence on 30 August 1999.

Bubble

The capital Dili appears to be bustling. But most restaurants, hotels, vehicles and apartment rentals are part of a bubble economy fed by the huge foreign presence. The official currency, the US dollar, has displaced its major rivals, the Indonesian rupiah and Australian dollar. There was considerable profiteering at the changeover over the past year when many traders simply rewrote prices from Australian dollars to US dollars, effectively doubling them at a stroke.

Aid and related spin-offs dominate much of the economy. This is an artificial economy that is not sustainable. It grew by 18 percent in 2001-02, but this was from a base of almost zero, and fuelled mainly by reconstruction, development and humanitarian aid. These factors were supplemented by the local coffee industry, where world prices are improving after several miserable years.

Independence will initially have a devastating effect on the bubble economy that developed under the two-year UN administration. Peace-keeping forces will be reduced from more than 8,000 to about 5,000, while the number of highly paid UN officials will fall from 850 to less than 300. The departure of these well-paid foreigners will burst the bubble of affluence in the capital. Estimates in Dili are that about 1,700 local people will either become under-employed or entirely jobless when the UN administration winds down.

It is indeed a tough year ahead. For 2002-03 it seems likely that growth will sink to zero. Thereafter a more balanced and sustainable form of development could set the country on a stable upward path.

The majority of Timorese derive their welfare from agriculture, and this will be the case for many years to come. Overall, East Timorese policy makers will face agricultural challenges. These range from the immediate issues of the substantial population movements after the September 1999 crisis, with their connected land ownership disputes, to infrastructure rehabilitation, reactivating rural markets and the agricultural extension service, and re-establishing commercial ties across the border to Indonesian West Timor. Development of off-farm, seasonal income generating activities is also important.

The new government�s economic policies are pro-poor oriented but still untested. Its economic instincts are 'dirigiste' (meaning that the state must be involved in every aspect of social life). It will have to develop and maintain disciplined long-term fiscal policies in the face of the nation�s grim poverty and its competing social and economic needs.

Besides the promised oil and gas, and the already noted coffee, tourism is also an important potential income-earner. However, it is seriously constrained by the weak infrastructure, limited international air links and lack of skilled personnel.

There will be a three-year gap in financing the government�s budget between the end of current assistance programs and the beginning of significant revenue from the oil and gas in the Timor sea. So far, East Timor aid has been solely through grants. Although there is a willingness to offer more grants, these international donors may not be able to cover the full budget gap that is emerging. This will probably force the new country to accept loans, albeit at concessional rates.

Once the oil and gas starts to bring in large income flows, some of the earlier problems of the 'artificial' economy will reemerge. Combined with continuing aid, this will give rise to a broader challenge. When even a part of this money is spent in the so-called 'non-traded' sector (such as food) it will cause inflation, which in turn will harm the exchange rate and thereby reduce the country's competitive ability. There will also be the danger of an urban elite appropriating the benefits of commercial opportunities and budgetary allocations.

One of the major determinants of East Timor�s long term economic future will be the way it uses revenues from the oil and gas in the Timor Sea. Under the 90-10 percent split wrestled out of Australia, this will provide a total income of US$7 billion over twenty years. However, even here there is a problem. The deal has hit a hitch with the decision by US-owned Phillips Petroleum and its partners to defer exploitation of the biggest field because of East Timor's decision to raise an extra US$1 billion in royalties.

Guard the oil

How should oil and gas revenue be managed? An endowment fund would save them in a trust fund that would store up some of the value for the next generation. This could act as a stabilising force. It would safeguard income from resource sales that rightly belong not only to East Timorese citizens of today but to those of the generation to come. There is clearly a balance to be struck here. Saving too high a proportion would mean foregoing some development opportunities and perhaps increasing the risk of the savings leaking away through corruption. Saving too little, on the other hand, might expose the country to financial problems in the future � especially given the uncertainties in oil prices and the finite reserves under the seafloor. East Timor could consider a four-part fiscal strategy:

Control public expenditure � Give priority to spending on health and education so as to expand people�s capacities and stimulate human development.

Avoid subsidising the wealthy � Fund at least some public services such as telecommunications partly from user fees.

Build donor confidence � Maintain a stable social, economic and political environment and a respect for human rights. This is vital for human development. It also encourages donors who want concentrate their resources on the poorest countries, but only those that have a supportive environment where aid can be used well.

Guard oil and gas revenues � Use them sparingly, and mostly for investment, since they are a one-off opportunity that will only last around twenty years.

All this means that East Timor�s economic growth will be incremental rather than rapid. The challenge for East Timor is to maintain sufficient fiscal discipline to ensure essential investment in human development and to stimulate private enterprise, while resisting the temptation to spend oil and gas revenues on current consumption. East Timor now has the opportunity to set out on a new path, pursuing labour-intensive, pro-poor growth. This will mean opening up opportunities for the poor, using micro-finance schemes that increase employment opportunities for women and other groups who are outside the formal labour force.

East Timor should actively engage in trade with its neighbouring countries if it wishes to develop its economy rapidly. An independent East Timor will welcome sound investment by firms that wish to operate in an environment free of artificial barriers to trade. A secure investment climate will need appropriate laws protecting property rights and contracts, establishing a fair commercial code, codifying labour relations, and minimising the cost of doing business.

A major and early priority of the infant government has to be to demonstrate to the East Timorese, to international donors and to potential investors the importance of sound economic management, and sound law and order and judicial arrangements.