Addressing Institutional Constraints toward Economic Diversification in Timor-Leste

Institutions matter for economic development

Institutional reform is imperative for economic diversification, boosting economic productivity in the non-oil sector, and restructuring the economy. These are expected to reduce Timor-Leste’s dependence on petroleum. ‘Institution’ is defined as the rules of the game in a society that is devised by humans, that shapes human interaction. Some examples of institutions are contract enforcement, protection of property rights, rule of law, and efficient and effective bureaucracy. It also involves “habits and belief, norms, social cleavages, and traditions in education.” The imperative role of institutions is widely recognized by economists like Douglass North and Daron Acemoglu, with Acemoglu and James Robinson convincingly arguing that institutions play determinant roles to define why certain countries are more prosperous over others. In terms of economic development, institutions are central since they define the economic incentives in society. 

The challenges faced by oil-dependent countries are the fact that oil not only changes economic structures, but also the institutional foundation itself. Many academics argue that natural resources undermine the quality of institutions whereby elite groups try to capture economic rents from the exploitation of natural resources. This shapes the characteristics of political elites, the private sector, and the society in general.

In the context of Timor-Leste, the impact of petroleum goes beyond the state’s finance structure and economic structure. It easily attracts attention from society in general – and the political elites. It shapes the vision of the society, the incentives in the market, and the functioning of democratic institutions. These institutions in itself are not merely constraining economic diversification, but also maintaining the existing status quo and deepening the dependency on petroleum. For these reasons, addressing institutional constraints is critical for economic diversification, and economic development in general. Changing economic structures to diversify the economy requires changing the policy direction, and that requires changing the institutional setting where the policy is taking place. This refers to changing the rules of the games that affects interactions between members of the society. In an economic sense, it refers to rules that governs laws, policies, and regulations that defines the economic agents in the society. In this respect, several policy directions are needed to change the institutional setting. 

Building a conducive environment for the private sector

The role of the private sector is widely recognized, and it is an integral part of strategic development plans, economic diversification, and job creation. Over the years, the Timor-Leste government’s approach has been on infrastructure. This is also the underlying argument for front-loading fiscal policy. Despite that, statistical data confirm that the private sector in Timor-Leste continues to be small, particularly the registered business sector. According to the National Account report, private sector investment has been stagnant. By 2022, the total private sector investment in the non-oil sector is only USD $16 million, representing only 5% of total investment. Low private sector investment in the economy of Timor-Leste has also been contributing to high dependence on the public sector, low economic productivity, and lack of job opportunities.

Public discussion, and several reports identify several institutional issues that hinder private sector development. Business licenses continue to be one of the issues that is widely discussed. According to the World Bank’s report, the proliferation of business licenses incurs high regulatory costs for the private sector. Lack of access to land and uncertainty over land ownership are also other constraints to attracting private sector investment, particularly foreign direct investment. Limited access to land also affects access to credit, as lack of collateral is the main constraint for firms to access loans from the private sector. Bureaucratic hurdles are also consistently mentioned as one of the impediments toward the private sector, where sometimes bribes are offered to public officials in order to get things done. Additionally, weak law enforcement is also frequently mentioned as one of the constraints toward private sector investment.

For these reasons, it is important that the government of Timor-Leste revise its strategy regarding the private sector. While rural roads, water and sanitation, fiber optic, irrigation, and airports are still important, the government needs to balance these with addressing the institutional impediments mentioned.

Improving the efficiency of public finance

Another important aspect to diversifying the economy is by addressing inefficiency and ineffectiveness of public spending. Since its independence in 2002, due to absence of monetary policy, fiscal policy is the only policy instrument available for Timor-Leste’s government. More specifically, public spending has been the most important part of fiscal policy. Nonetheless, high public spending does not seem to be an effective instrument to generate economic growth, to drive economic structural change, nor to address other social and economic problems such as employment, malnutrition, and poverty.

Conversely, high public spending is widely criticized for lacking fiscal discipline, undermining fiscal sustainability over the long run. Without massive adjustment to its current spending level, and with uncertainty over the GreatParliaer Sunrise liquefied natural gas (LNG) development, Timor-Leste is heading toward a fiscal cliff and current account deficit. Specific to economic diversification, existing fiscal policy approaches have been increasingly ineffective tools to diversify the economy, as it displaces the incentives in society, by incentivizing short-term consumption and promoting laziness in finding other solutions. 

There have been calls coming from the public for the government to improve the efficiency and effectiveness of public spending. One way of improving efficiency is by reducing the government’s spending – particularly unnecessary spending. Some examples of these are overseas travel for public officials, salaries for public employees, and costs for maintaining public administration, among others. At the same time, there is demand to increase the budget allocation for critical sectors such as health, education, water and sanitation, rural infrastructure, agriculture, and tourism. This will reduce the government’s withdrawal from the Petroleum Fund, which will improve budget sustainability and the credibility of government spending as a policy instrument.

Another approach is to impose certain fiscal discipline through fiscal rules. This is very critical for Timor-Leste, to limit the temptation posed by easy money, by limiting numerical limits on budget aggregates. On a broader scale, budget rules can help to correct distorted incentives and contain pressure on high spending. Although the provision of the Petroleum Fund on Estimated Sustainable Income (ESI) should have served this purpose, it has not been relevant since the government ignored this provision in the budget discussion.

A different way of doing politics

Changing institutions is not merely a technical exercise, but requires political buy-in from high-level political elites and political leadership. This is not only the tasks of government or the executive body, but requires collaboration with different state sovereign bodies such as the President of the Republic, Parliament, as well civil society in general.

Political certainty is critical for economic development in general, and particularly economic diversification. Timorese society in general have learned from its experiences that political uncertainty since 2017 incurred an extremely high cost for the country. As a Business Enterprise survey revealed, political uncertainty is seen as the biggest constraints for the business sector. Beyond that, political uncertainty coupled with COVID-19 have killed momentum for economic diversification.

The positive side however, is that the 2022 presidential elections, the 2023 parliamentary election, and the peaceful transition of power already set positive momentum for the country to return to normalcy. With the return of two figureheads in Timor’s politics into key positions – Jose Ramos Horta as the President of the Republic and Xanana Gusmao as the Prime Minister – there is a feeling of returning to normalcy. The dynamic in Parliament has also changed. For example, when the government submitted its five-year programs for the Parliament to be approved, the opposition parties also voted in confidence for the government’s program.

There is some trust for the current government and the future of Timor-Leste. One indication of that trust is the visits of high-level dignitaries to the country, namely Australia’s Prime Minister and Foreign Minister respectively, the Prime Minister of Portugal, and Singapore’s Foreign Minister, among others. In the meantime, the response from the private sector has also been positive so far.

Thirdly, long-term political certainty and economic diversification requires some level of mutual understanding among major political forces in the country on the sectorial priorities, and that should reflect on the budget allocation. Although all political parties agree on the importance of economic diversification and all the political parties sell these to the voters during the campaign, such political rhetoric has not been supported in terms of budget allocation when they govern. The same applies to critical issues such as fiscal sustainability, efficiency in public spending, job creation, poverty, improving the quality of education, and more. These issues cannot be addressed within one government’s mandate, but it is a national cause that requires a long-term approach.

The challenge that Timor-Leste is facing, like other democratic countries, is that the government changes according to the electoral cycles. As a result, the new government comes up with new priorities and new approaches, and even reverses the trend. This makes it difficult to address complex challenges that require a long-term approach. The political leadership can reduce this through building constructive dialogues and communication among political parties and having some mutual understanding on major issues. This would provide certainty over the long run on the policy direction and improve the effectiveness of the policy instruments to address some of the major development issues facing the country. The roles of Parliamentary members are very critical in this process.

Finally, part of the changing political setting is by recognizing the contextual changes, either domestically or globally. At the domestic level, Timor-Leste’s demographic structure is changing, and this brings development challenges. With the growing number of youth, many young people have been able to overcome the odds and establish themselves and become a role model in society. They are taking the benefits of technology, including social media, to play positive roles in society, such as being social influencers, social media motivators, social entrepreneurs, trainers and educators, writers, and advocates.

Ongoing innovation challenges for Timor-Leste

At the international level, the COVID-19 pandemic, ongoing war in Europe, and climate change already imposed various dimensions of vulnerability and incurred high cost for Timor-Leste. This sequence of events should remind Timorese society in general about the challenges in governing society in the current context. On the one side, having a windfall from petroleum is important but it alone cannot be sufficient to address delicate and multifaceted societal problems. It requires the government to be adaptive to a rapidly changing environment and being innovative to address these challenges.

Economic diversification is an urgent policy issue in Timor-Leste. Although it has been part of policy discussions over the past decade, existing institutional settings do not support economic diversification to take place. Henceforth, changing the institutional setting is a critical issue to diversify Timor-Leste’s economy, and drive economic structural change. This will require leadership at the political level.

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Guteriano Neves is an independent policy analyst Based in Dili, Timor-Leste. He has worked in different institutions, such as the President’s Office, the Office of Prime Minister, Ministry of Foreign Affairs, La’o Hamutuk Institute. His areas of expertise are political economy, “resource curse” and petroleum dependency, and foreign aid.

This article is a personal opinion and does not represent the opinion of any institutions that the author is affiliated with.

The views expressed by the author are not necessarily those of Heinrich Böll Stiftung.

This article is a chapter from Neves, da Silva, Gomes, and Cardoso (2023), “Timor-Leste´s Economic Diversification: Challenges and the Way Forward”, Bangkok: Heinrich Böll Stiftung Southeast Asia Regional Office.