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Can Timor-Leste Move Away From an Oil-Based Economy?

 
 

Timor-Leste successfully held its first early election on May 12, 2018 demonstrating its growing maturity as a democratic state. The early election resulted in the formation of the Eighth Constitutional Government by the coalition AMP (Aliansa Mudansa ba Progresu, Alliance of Change for Progress), comprising three political parties – CNRT (Congresso de Reconstrução de Timor, National Congress for Reconstruction of Timor), PLP (Partidu Libertasaun Popular, People Liberation Party), and KHUNTO (Kmanek Haburas Unidade Nasional Timor Oan, Party of the Enhancement of Timorese National Unity). Political observers consider AMP to be a mix of old and new faces, a blend of experience and technical expertise – an ideal combination for the successful implementation of the programs suggested during the political campaign.

On February 11, President Francisco “Lu-Olo” Guterres promulgated the 2019 state budget, ending the utilization of the 1/12 budget employed over the last two years to finance state activities (Note: When a state budget is not yet enacted, the Budget and Financial Management Law allows spending to continue according to a duodecimal system — 1/12th of the previous year’s budget line each month). The new government, as a result, can now begin to implement its programs.

Political parties, throughout their campaigns, emphasized the need to diversify Timor-Leste’s economy, stating that economic diversification is essential to move the country away from dependency on its oil resources. The strategy lies in making significant investments in other productive sectors, particularly agriculture and tourism. Diversifying the economy is not new rhetoric, but it has become consistent campaign material for political parties, at least over the last five years. Nevertheless, there are few signs and scant results of economic diversification to date. Given this trend, is it realistic for Timor-Leste to rid itself of its oil dependency?

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Why does Timor-Leste have an oil-dependent economy?

In 2005, it was reported that Timor-Leste had around 987 million barrels of oil. Oil reserves are expected to dry up in the next five years or so unless new oil fields start to produce. Timor-Leste’s oil reserves are modest when compared to those of oil-producing majors such as Saudi Arabia (266 billion barrels), Iran (155 billion barrels), Venezuela (302 billion barrels), and Nigeria (37 billion barrels). Nevertheless, Timor-Leste is fortunate because oil prices were high during its peak production years and, based on the Quarterly Report of the Central Bank of Timor-Leste, oil revenues totaled $15.8 billion at the end of 2018. That is a significant amount for a country with only 1.3 million people. However, an oil-dependent economy is not determined by the size of a state’s oil reserves but by IMF standards. If more than 25 percent of a country’s budget comes from selling resources, the country is considered to be resource dependent. Revenues from oil account for around 90 percent of Timor-Leste’s budget and so Timor-Leste has a highly oil-dependent economy.

Policies for economic diversification

Diversification is defined in different ways, depending on the area of application. However, in general, it refers to strategies to reduce reliance on a single or limited number of commodities. Oil is a nonrenewable resource and sooner or later it will run out, although many Timorese living in rural areas are led to believe such resources are endless. Therefore, it is crucial for Timor-Leste to establish different sources of income before the oil runs out.

Studies on economic diversification in oil-producing countries show that policies to mitigate oil dependency revolve around four areas: a) fiscal and monetary discipline to control overvaluation of currency, normalize consumption, and offset economic (macro) volatility; b) investment in human capital and infrastructure to improve labor productivity, encourage innovation, and attract investment in non-oil sectors; c) improving private sector participation in economic activities; and d) policy interventions that actually respond to challenges faced by the country.

In the context of such policies, Timor-Leste has followed a similar path. For instance, it has established a 3 percent threshold for withdrawing money from the sovereign fund (known as the Petroleum Fund) and established an annual budget ceiling as part of its fiscal policy. This set a good precedent, even though in practice the annual budget has breached the 3 percent threshold over the last 10 years. In oil-rich countries, fiscal policy has shifted the focus from financing to structural adjustment, which is to widen the non-oil revenue base, rationalize government spending, and re-evaluate government subsidies and incentive programs. This kind of fiscal adjustment, in the short and medium terms, may have unfavorable effects on non-oil activities, but it is essential for long-term sustainable growth. However, there is no monetary policy in place because Timor-Leste does not yet have its own currency. Furthermore, the government of Timor-Leste has established the Human Capital Development Fund and Infrastructure Fund as investment strategies to develop human resources and infrastructure, respectively. Similarly, SERVE (Serviços de Registo e Verificação Empresarial, Business Verification and Registration Office) has also been created in parallel with other policies to facilitate the opening and support of businesses. This is definitely a positive step, but it is important to be aware that policy does not automatically translate into results.

Diversification can be approached in three ways: 1) diversification within the sector – vertical diversification; 2) further diversification in the already successful sector and; 3) the introduction of new sectors that have good potential – horizontal diversification. Countries with sizable oil reserves mostly adopt vertical diversification to add value to the product within the sector. Timor-Leste has so far applied this approach, as evidenced by the investment in the Tasi Mane Program (a cluster of projects that include a supply base, refinery, and LNG plant along the south coast of the country) to develop the petroleum industry. It is important to note that this approach will not reduce oil dependency.

Results and challenges of policies for economic diversification

So, how do policies in oil-rich countries fare in terms of diversification of the economy? Analysis in the last quarter century of countries where oil contributes significantly to per capita income shows that economic diversification has been slow and, in some cases, there has been none. Even in Gulf countries, where diversification policies have been developed and implemented over 40 years, oil still plays a major role in their economies. A similar trend is also seen in small countries where policies to move away from dependency on natural resources are unsuccessful.

Factors contributing to difficulties in moving away from oil dependency have been extensively studied. These are widely known, including the Dutch Disease phenomenon and increased economic volatility, and very little labor skill spillover to other sectors due to the specialist skills required by the oil industry. In small countries, diversification policies generally fail due to a lack of investment and the lower profitability of non-oil sectors. Also problematic are a lack of a skilled workforce and a small internal market resulting from a small population. Diversification may happen if there is a willingness to carry out political reform, decentralization of power, and sound implementation of government investment programs in meeting actual targets.

This trend is not good news for Timor-Leste, but it does not mean that diversification is impossible. The impact of the oil economy on growth varies from one country to another. However, to have a positive impact the country needs strong human capital and governance or institutional capital. Sometimes, failure to diversify the economy comes down to mismanagement, lack of accountability, and an incompetent workforce.

Discourse on investment in productive sectors

In Timor-Leste, agriculture and tourism are two productive sectors frequently mentioned in the diversification discussion. In the last five years, budget allocations to the agriculture and tourism sectors have never exceeded 10 percent of the state’s annual budget. It is necessary to allocate more money to these sectors, but it is also important to avoid the perception that this is the only solution. Prior to increasing the sectors’ budgets, it is vital to identify problems comprehensively, begin detailed program elaboration, and ensure there is adequate institutional capacity and activity prioritization is in place to ensure that money is used properly. Without these crucial preparations, relevant ministries and institutions are forced to absorb a budget they are not prepared for, resulting in money being spent with little to show for it.

On January 12, Prime Minister Taur Matan Ruak stated that income from agriculture would not be able to finance government activities in the short term. Considering the recent increases in the size of the annual budget, this statement is true because the annual income from the main export, coffee, is a mere $16 million. However, to develop these sectors in order to expand the non-oil revenue base, ground work must start now. Economic diversification does not happen overnight. It takes continuous efforts to change the mind-set, acquire adequate skills, have correct institutional structure, provide the appropriate technology, and develop the political will to transform these sectors into significant revenue generators for the state.

Moving forward

Experience shows that no oil-dependent countries have completely moved away from oil. In many ways, an economy driven by oil is not the problem; the problem is when oil money is not properly managed or invested in non-oil sectors. Consequently, the economy suffers after the oil runs out because there is no other source of revenue either to sustain government activities or to meet sufficiently market consumption demands. For this reason, more is needed to expand the non-oil revenue base to avoid post oil economic shock.

In the meantime, Timor-Leste faces several immediate challenges in terms of addressing the decreasing revenue from oil resources, creating jobs for a rapidly growing young population, economic volatility, and responding to demand for adequate basic infrastructure, especially for people in rural areas. During political campaigning, the current prime minister pledged the need to balance investment in large infrastructure with basic infrastructure to ensure that people, especially rural dwellers, have access to clean water, decent health services, and quality education. Investing in basic infrastructure is inarguably a proper use of the oil money, and now that the 2019 budget is approved, it is hoped that the government can start working to deliver on this pledge.

In the end, the question is not about how to move away from the oil economy, but rather how to capitalize on current oil revenues to strengthen the economy while the money lasts. That involves maximizing revenues from productive sectors, creating jobs through innovation and application of the latest technology, building basic infrastructure to increase private-sector participation in economic activities, and developing strong public finance management systems to ensure accountability and proper use of public money. In addition, the government must have the courage necessary to make difficult choices to trim the size of the annual budget through prioritization and assessing subsidy programs. A difficult road lies ahead, but we must never lose hope because a better future awaits.

Joao da Cruz Cardoso completed his undergraduate studies at the University of Hawaii at Hilo and acquired a Masters at the University of Illinois at Urbana-Champaign under the Fulbright Scholarship Program. He works at the Major Project Secretariat of the Ministry of Planning and Strategic Investment of Timor-Leste. This article is the opinion of the author and does not represent the institution where the author works.

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