The Stagnant Policy Context of Economic Diversification in Timor-Leste

Economic diversification and potential in Timor-Leste

Economic diversification, according to United Nations Climate Change (UNFCCC) is “the process of shifting away from a single income source toward multiple source of income through growing range of sectors and markets.” It is a key element to toward resilience to external shock, equitable growth, job creation, poverty reduction. Empirical evidence suggests that countries with more diversified economies have higher GDP per capita, while lack of economic diversification is associated with poor development outcomes. Economic diversification is closely associated with economic structural transformation, where the latter refers to changes in the way industry or the market functions. Economic diversification becomes a common discourse for oil-dependent countries, as it is presented as a way of reducing commodity price volatility, job creation outside of the mineral sector, and preparing for resource depletion.

As one of the highest oil-dependent countries, economic diversification is a major policy issue in Timor-Leste. It primarily refers to efforts to reduce the state’s dependence on petroleum revenues, and broadening the tax base. Beyond this, it is critical for the country’s long-term development, job creation, and sustainable and inclusive growth. Economic diversification together with structural transformation are the keys to achieving Timor’s aspiration to be an upper middle-income country with a healthy and educated population and no poverty in all forms of dimension by 2030.

Four sectors identified to be essential for economic diversification are agriculture, tourism, petroleum, and manufacturing. Agriculture is the key sector for Timor-Leste, given that currently, around 60% of households are engaged in this sector; and the growth of agriculture is a determinant to poverty reduction, food security, and rural development. Tourism will facilitate job creation and regional balance. The petroleum sector in particular has been the backbone for Timor-Leste’s economy, as it is the only source of revenue for the state. The development of this extractive sector focuses on the South Coast Petroleum Corridor, consisting of a supply base, refinery and petrochemical industry and LNG (liquefied natural gas) plant. This is expected to drive the development of other sectors, primarily agriculture and services, to grow through backward linkage. Manufacturing, although small, has the potential to develop into a small-scale sector with a home-based industry.

Since 2008, restoring peace and stability has become the primary goals, reflected in the ‘Buying Peace’ strategy. Following that, the government’s investment in physical infrastructure increased significantly, reaching up to 50% of non-oil GDP in 2011. Improving human capital is also an essential part and since 2015, the government launched the Economic Diversification Strategy, focusing on key reforms to address some of the bottlenecks for private sector investment. This includes legislative reforms, economic reforms, fiscal reforms, business environment reform, among others. In recent years, the government has also introduced soft loan schemes to support MSMEs (micro, small and medium-sized enterprises) in agriculture, tourism and a home-based manufacturing sector. In general, economic diversification has become a long-term policy goal that has guided Timor-Leste’s policy development over the past decade.

Assessing the results so far

Judging from statistical evidence, the results so far in Timor-Leste has not been encouraging. While front-loading fiscal policy worked at the initial stage (2008–2012) to restore peace and stability, and to generate economic growth, in the long-run it has not been sufficiently effective to generate economic growth, drive economic diversification, nor offer employment opportunities. Although Timor-Leste has the highest public spending among Southeast Asian countries in term of its proportionality relative to non-oil GDP, its non-oil GDP growth rate is the lowest in the region. Between 2008–2019 (before COVID-19), the average of annual growth rate of Timor-Leste is 4.5%, compared to 7.45% for the East Asia Pacific, 7.3% for Lao, and 6.4% for Cambodia. During the COVID-19 period, Timor-Leste had one of the biggest economic contractions in the world, where its economy declined by -8.3% in 2020 compared to -3.1% in Cambodia and -2.1% in Indonesia. Graph 1 compares Timor-Leste’s GDP growth rate with regional trends and other respective countries.

The key sectors to economic diversification underperformed. Although the agriculture sector is key for economic diversification and overall development strategy, according to the most recent World Bank report, agriculture production has been declining substantially over the last decade and the value added of the agriculture sector has been declining, and lower than other sectors. As indicated in Graph 2, between 2008–2022, the average annual growth rate of Timor-Leste’s agriculture was around 1.5% , compared to 9.3% percent in public administration, 16.3% in construction, and 12.6% percent in information and telecommunication. The share of agriculture in overall GDP has been declining as well, from 25% in 2010 to 20% in 2021. Manufacturing, another important sector for economic diversification, has shown high growth rate in terms of value added (6.5%), but nonetheless, its contribution to GDP is very small;  lower than 2%. 

Alongside economic diversification, job creation is another pressing issue, particularly for the country with one of the highest young populations in the world. The results, however, have not been positive. Excluding agriculture, the public sector is the biggest source of employment. Formal employment in the private sector is very low, and has been stagnant, reflecting underdeveloped private sector investment in the economy. Compared to other countries in the region, Timor-Leste has the lowest labor force participation rate in the region, as seen in Graph 3.

On the state’s finance side, lack of economic diversification deepens the state’s dependence on the Petroleum Fund. By 2021, domestic revenues contributed less than 20% of the total state’s spending. The majority of the state’s annual spending are derived from the Petroleum Fund.

Lack of economic diversification contributes to other social and economic problems such as lack of employment opportunities, dependency on imported goods and services, the gap between rural and urban regions, and social vulnerability to external shocks, among others. Timor-Leste’s economy is also highly vulnerable to external shocks; as experienced over the last five to six years. Political impasse since 2017 and COVID-19 caused three years of negative growth – negative growth by 3.9% in 2017 and 0.8% in 2018 and 8.6% in 2020 – with high inflation due to war in Europe. At present, Timor-Leste is facing long-term uncertainty as the Petroleum Fund is drying up. Ongoing fiscal policy faces the alarming risk of a fiscal cliff.

The growth trends, and other social problems that the country is facing, in some ways is a historical legacy and are also symptoms of a ‘Resource Curse,’ a “failure of many resource-rich countries to benefit fully from their natural wealth, and for the government in these countries to respond effectively to the public welfare needs.” Economists identified hinderance toward economic diversification for oil-dependent countries, namely: Dutch disease, economic volatility, limited labor with skilled labor spillover to other sectors, and lack of investment in non-oil sectors due to its low profitability.

Policy failure and Timor-Leste’s high spending

The Resource Curse is not merely due to the presence of commodities; but also due to the policy options pursued by policymakers. To great extent, policy failures or misguided policies not only fails to address the structural problems that Timor-Leste is facing, but perpetuates them. Timor-Leste’s fiscal policy is one of them. Regardless of the political party’s affiliation, successive governments since 2008 have adopted the same fiscal policy approach, which is high government spending and running non-oil high fiscal deficits. During 2008 and 2012, Timor-Leste was only behind  Zimbabwe in term in terms of budget growth. According to the World Bank, adjusting for inflation, between 2008–2016, the total expenditure grew by 12% every year –  twice that of non-oil GDP growth.

Timor-Leste’s government defends high public spending based on the necessity for better infrastructure. Nevertheless, as the state’s bureaucracy continues to expand, the cost of maintaining it also rapidly increases. This includes payments to the high number of public employees, and the operational costs to maintain the functioning of public administration. A large proportion of the state’s spending is also to finance subsidies, notably veteran payments, payments to the elderly, the Bolsa da Mae program supporting mothers and children’s access to school, and Bolsa da Mae Jerasaun Foun for children nutrition, social housing programs, and so on. Consequently, the proportion of public investment in overall state expenditure is declining. Simultaneously, the budget allocation for the key sectors for economic diversification such as agriculture, tourism, and human capital is very small by regional and international standards. 

Economically, high public spending drives the public sector to grow, and crowds out the private sector. The large size of public spending relative to the domestic economy – between 80–120% – keeps domestic economic activities revolving around petroleum money, which recycles through the state’s annual spending. Public administration and the construction sectors are directly linked with public spending, and therefore have experienced significant growth in the last few years. The service sector is also growing, largely concentrated in Dili, to satisfy rising domestic demand in Dili. Private sector activities concentrate in Dili; and a large proportion of the private sector activities are involved in construction and retail. This is a typical characteristic of the private sector to be found in a rentier state. Rising domestic demands, from public or private, has been satisfied with the influx of imported goods from Indonesia, China, Vietnam, and even Brazil or Cyprus. Inflation, driven by high spending, coupled with poor infrastructure, low labor skills, high regulatory costs, and a dollarized economy (with currency substitute in US dollars), makes the cost of producing goods and services expensive. Domestically produced goods, including agriculture products, are hardly competitive in the domestic market.

While agriculture’s share is declining overall, non-oil GDP can be viewed as a normal process as the economy is moving towards becoming more modern and urbanized; the policy failure is responsible for its low productivity. It is the result of rising urban wages, particularly in the public sector wage, the rural-urban divide, low budget allocations, and availability of alternative income from government subsidies.

The policy setting of a rentier state

Heavy reliance on Timor-Leste’s Petroleum Fund is not only unsustainable, but also ineffective to tackle some of the social and economic problems and diversify the economy. The call to revisit government’s overall development strategy, rationalizing its spending, increase efficiency in terms of resource allocation, more attention toward productive sectors, and more investment in human capital are echoed by everyone, including inside the government. The World Bank’s Public Expenditure Review called for “changing course” in Timor-Leste’s government’s spending. The Ministry of Finance already noted that if the current budget growth trend continues, the government will have to cut its spending by 80% in 2034. Nevertheless, successive governments opt for the same policy approach, regardless of political affiliation or composition.

The persistence of certain policy choices in Timor-Leste, therefore, needs to be comprehended beyond merely economic rationales. It is critical at this point to understand the institutional setting and the political economy which is sustained by petroleum rent. By its very definition, Timor-Leste is a type of rentier state, where the basic feature of a rentier state is that the state survives upon external rent, and not from taxing its citizens. Around 80% of the state’s revenues are derived from selling its natural resources to external markets, and the return of investment of its Petroleum Fund in the international market. It is argued that high dependence on rents tend to have “dysfunction state behaviors” and produce bad budgetary policies. It produces a “distinctive type of institutional setting, which encourages the political distribution of rents.” While petroleum makes it easier to finance development programs, it also limits the policy choices to be centered around money. This limits the framework of thinking and undermines the efforts to explore other policy choices which are more sustainable, inclusive and less costly in terms of financing. It places pressures on the government to deliver as quickly as possible through public spending. Because of limited institutional capacity and weak check and balances, this drives misallocation of resources and foments spending without thinking behavior. These institutional settings sustain and even reinforce existing policy choices.

One example of this is giving handouts or subsidies. Over the years, the government’s spending on cash transfer programs – either conditional or unconditional – have increased and consumes a significant portion of the state’s budget. This is an example of how the government resorts to giving handouts and subsidy as the primary policy instruments to many structural issues, such as poverty, maintaining peace and stability, generating growth, job creation, incentivizing domestic economic activities, and even buying political loyalty. Aside from contestation about its effectiveness and efficiency issues, the prominence of subsidies as a prominent policy tool can be comprehended on how the presence of petroleum money makes this choice cheap. This choice would not be a viable choice if there is not enough revenue.

Regardless of the intention, spending oil money alone cannot provide solutions to such a complex challenge. It displaces the incentives from production to consumption, making locally produced goods less competitive, and incentivizes people to migrate to urban areas. According to the World Bank, “public spending perpetuates vicious cycles of resource misallocation, which is fueling large fiscal and trade deficits, and weighing on economic growth, which is then offset with further unproductive spending.” These are common features of Dutch disease.

Easy money from petroleum also shapes the interests and incentives of political elites, governance strategy, and political strategy. For them, winning the election and being part of government means having direct access to most of the economic resources in society, and the decisions on how to distribute the resources through whichever channels. Political parties increasingly resort to patronage as the way of facilitating resource distribution through awarding public contracts via political clientelism, creating positions in public offices to party members, making laws that benefit party members, and similar.

Resisting easy money and making harder policy choices

Oil money also provides a comfort zone to politicians and society in general. It discourages policymakers from taking tough choices, even when the country is facing the risk of a fiscal cliff  and a large current account deficit. Instead of taking the difficult path by cutting unnecessary spending, and finding different approaches to diversify the economy, the country is rushing to find more oil. Furthermore, given large revenues that oil promises, the oil industry attracts more attention from society, including the media. Despite rhetoric on economic diversification, the oil-related sectors receives significantly more resources than agriculture, tourism, and human capital.

Economic diversification requires policy changes, including making some difficult choices. Yet the presence of easy money displaces the necessity and the urgency of changing the policies – and perpetuates existing ones, which have proven to be ineffective to drive economic structural change and economic diversification.

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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.