East Timor: Development Challenges for the World's Newest Nation 9789812305824

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Development Challenges for the World's Newest Nation

The Institute of Southeast Asian Studies (ISEAS) was established as an autonomous organization in 1968. It is a regional research centre for scholars and other specialists concerned with modern Southeast Asia, particularly the manyfaceted problems of stability and security, economic development, and political and social change. The Institute's research programmes are the Regional Economic Studies (RES, including ASEAN and APEC), Regional Strategic and Political Studies (RSPS), and Regional Social and Cultural Studies (RSCS). The Institute is governed by a twenty-two-member Board of Trustees comprising nominees from the Singapore Government, the National University of Singapore, the various Chambers of Commerce, and professional and civic organizations. An Executive Committee oversees day-to-day operations; it is chaired by the Director, the Institute's chief academic and administrative officer.

Of! Development Challenges for the World's Newest Nation Edited by Hal Hill 8: Joao M. Saldanha

I5EIII Institute of Southeast Asian Studies, Singapore

First published in Singapore in 2001 by Institute of Southeast Asian Studies 30 Heng Mui Keng Terrace Pasir Panjang Singapore 119614 http://www.iseas.edu.sg/pub.html All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Institute of Southeast Asian Studies. © 2001 Institute of Southeast Asian Studies, Singapore.

The responsibility for facts and opinions in this publication rests exclusively with the editors and contributors and their interpretations do not necessarily reflect the views or the policy of the Institute, the Asia Pacific Press, or their supporters.

ISEAS Library Cataloguing-in-Publication Data East Timor: development challenges for the world's newest nation/ edited by Hal Hill and Joao M. Saldanha. (!SEAS current economic affairs series, 0218-2114) I. Timor Timur (Indonesia)-Economic conditions. 2. Timor Timur (Indonesia)-Economic policy. 3. Timor Timur (Indonesia)-Politics and government. I. Hill, Hal, 1948II. Saldanha, Joao M. Ill. Series sls200 I 025053 2001 HC448 T5E132 ISBN 981-230-140-2 (soft cover) ISBN 981-230-141-0 (hard cover)

For North America and Europe, a hardcover edition is eo-published by Palgrave Publishers Ltd, United Kingdom. Copy-edited, typeset, and indexed by Beth Thomson, Japan Online. Printed in Singapore by Seng Lee Press Pte Ltd.

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Contents

List of Tables List of Figures List of Maps List of Contributors Acknowledgments Preface by Xanana Gusmao Preface by Carlos Belo Preface by José Ramos Horta Preface by Asian Development Bank PART I 1

viii x xi xii xiii xvi xix xxii xxv

Introduction

The Key Issues Hal Hill and João M. Saldanha

PART II

3

Managing the Macroeconomy

2

Currency and Monetary Arrangements for East Timor Gordon de Brouwer

39

3

Folly or Foresight: Strategic Options for Fiscal Policy in East Timor Jay K. Rosengard

52

PART III 4

International Economic Relations

Trade and Commercial Policy Hal Hill

71

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Contents

5

East Timor’s Economic Relations with Indonesia Hadi Soesastro

PART IV

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Agriculture and the Rural Economy

6

Food Policy in East Timor: Linking Agriculture, Economic Growth and Poverty Alleviation to Achieve Food Security C. Peter Timmer

7

The Rural Economy and Institutions in East Timor Colin Barlow

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8

Coffee and the Economy in East Timor Jacqueline Pomeroy

125

9

Agriculture, Comparative Advantage and the Macroeconomy Helder da Costa

10

Diversity and Differential Development in East Timor: Potential Problems and Future Possibilities James J. Fox

PART V

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140 155

Institutions

11

Property Rights in East Timor’s Reconstruction and Development Daniel Fitzpatrick

177

12

Future Political Structures and Institutions in East Timor J.A.C. Mackie

193

PART VI

Banking and Finance

13

Finance Policies for East Timor Ross H. McLeod

209

14

Transport and Power Chris Cheatham and Sirpa Jarvenpaa

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PART VII 15

Social Policy

Poverty, Equity and Living Standards in East Timor: Challenges for the New Nation Anne Booth

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Contents 16

Social Policy Issues in East Timor: Education and Health Gavin W. Jones

vii 256

PART VIII Lessons from International Experience 17

Country Size and Economic Performance: A Commentary with Implications for East Timor João M. Saldanha and José Tavares

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18

Reconstruction of War-torn Economies: Lessons for East Timor Jonathan Haughton

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19

Lessons for Development from Pacific Island Countries Satish Chand

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20

The Papua New Guinea Experience: Some Issues for the Early Years of East Timor Andrew Elek

321

21

Aid, Shocks and Trade: What East Timor Can Learn from African Experience Paul Collier

336

References Author Index Subject Index

351 369 373

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Tables

1.1 3.1 3.2 3.3 7.1 8.1 8.2 8.3 9.1 9.2 10.1 10.2 10.3 14.1 14.2 15.1 15.2 15.3 15.4 15.5

Economic Indicators for East Timor, 1997–2001 Public Spending and Growth, 1980–97 Consolidated Budget for East Timor, FY2000/01 Composition of East Timor’s Income, FY1994/95 Agriculture in East Timor, 1970–95 The Role of Coffee in the East Timorese Economy, 2001 Coffee Output of the World’s Main Coffee Producers and East Timor, 1998 Coffee Exports from East Timor, 1995–2001 Economic Development Policy in East Timor, 1958–99 Land Area, Population and Relative Resource Endowments of East Timor and 13 other Economies, 1998 Agro-climatic Zones of East Timor East Timorese Population Distribution by Regency from West to East, 1990 Irrigation Systems of East Timor: Estimated Design Capacity and Functioning Area Road Maintenance Budget Estimates, 2000/01–2002/03 Port Sector Recurrent Budget Estimates, 2000/01–2002/03 Population below the Official Poverty Line, 1993 and 1996 Consumption Expenditure, Headcount Poverty and Relative Poverty in Urban and Rural Areas of Eastern Indonesia, 1993 and 1996 Gini Coefficient of per Capita Consumption Expenditure, 1993 and 1996 Agricultural Productivity Indicators, 1995 Agricultural Holdings by Size Category, 1993

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8 56 58 59 112 126 129 129 142 150 157 161 167 226 229 242 243 244 245 247

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Tables 15.6 15.7 16.1 17.1 17.2 18.1 18.2 19.1

Agricultural Labour Force by Employment Category, 1995 Sources of Farm Household Income, 1993 Educational Attainment of Population Aged 15–69 Living in Household with Head Born in East Timor, 1995 Small Countries and Economic Growth Indicators for East Timor and Other Small Countries East Timor Compared with Other War-torn Economies Economic Change during the Move from War to Peace Basic Indicators for 14 Pacific Island Countries and East Timor

248 249 258 282 284 290 292 308

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Figures

9.1 9.2 9.3 16.1 19.1

Taxonomy of Foreign Aid Inflows to a Developing Country A General Equilibrium Model of Aid Inflows Relative Endowments of Natural Resources, Labour and Capital in 14 Economies, 1998 Age and Sex Distribution of Population Living in Household with Head Born in East Timor, 1995 Hysteresis and Lock-in

x

143 145 149 259 312

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Maps

10.1 10.2 10.3

The Agro-climatic Zones of East Timor Regional Divisions of East Timor A Linguistic Map of East Timor

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156 160 162

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Contributors

Hal Hill, Australian National University, Canberra João M. Saldanha, East Timor Study Group, Dili, and University of California, San Diego Colin Barlow, Australian National University, Canberra Anne Booth, School of Oriental and African Studies, University of London, London Satish Chand, Australian National University, Canberra Chris Cheatham, Asian Development Bank, Suva Paul Collier, World Bank, Washington DC, and University of Oxford, Oxford Helder da Costa, East Timor Study Group, Dili Gordon de Brouwer, Australian National University, Canberra Andrew Elek, University of Tasmania, Hobart Daniel Fitzpatrick, Australian National University, Canberra James J. Fox, Australian National University, Canberra Jonathan Haughton, Suffolk University, Boston Sirpa Jarvenpaa, Asian Development Bank, Manila Gavin W. Jones, Australian National University, Canberra J.A.C. Mackie, Australian National University, Canberra Ross H. McLeod, Australian National University, Canberra Jacqueline Pomeroy, World Bank, Jakarta Jay K. Rosengard, Harvard University, Cambridge Hadi Soesastro, Centre for Strategic and International Studies, Jakarta José Tavares, University of California, Los Angeles C. Peter Timmer, University of California, San Diego

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Acknowledgments

It is a great pleasure to thank the many people and institutions who have contributed to this volume, and to the Dili Economic Forum on which it is based. We began to plan this exercise seriously at a conference on East Timor in Washington DC in August 2000. The basic rationale then was that East Timor was moving swiftly towards independence, that there was likely to be plenty of international goodwill and support, and that what was critically important was the development of a coherent set of development policies to guide the new nation forward. We therefore began to identify what we considered to be the key development policy challenges, and to invite a group of leading thinkers and practitioners to set out the policy options and issues under each topic. We wanted to cast the net widely, examining not just ‘mainstream’ economic issues but the political and legal framework, social policy and the special challenge of relations with Indonesia. Moreover, we thought it highly relevant for East Timor, as a latecomer, to absorb the lessons from other countries and regions. We began talking to potential donors and contributors shortly thereafter. The Asian Development Bank (ADB) expressed interest in our proposal and quickly provided the necessary support. We are most grateful to the ADB for its funding and flexibility, and for giving us a completely free hand in organization and implementation. In particular, Etienne van de Walle was with us all the way in this endeavour, sharing our vision and providing unswerving support. We also wish to single out the head of the ADB’s East Timor mission, Robin Boumphrey who, despite many onerous duties, provided staunch support throughout. Although this enterprise is funded by the ADB, it will be obvious that it does not necessarily share or endorse any of the views expressed in the volume. Our authors made this volume what it is. We wish to thank them all for their participation. They are all busy people. They were contacted at very short notice

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– many as they were about to take their summer vacation! – and given an exceptionally tight deadline. They all prepared high-quality, thoughtful and policy-relevant pieces for the Dili Forum, and they all revised their papers promptly for the book. The majority of contributors had not been to East Timor before, but all had extensive knowledge of the region and shared a commitment to wanting to help the new nation. Planning for the Forum, held in Dili on 26–28 March 2001, was a major logistical challenge. We thought initially of holding it nearby, in Darwin, which would have been easier. But this would have lacked the immediate local impact. In addition we thought that the Forum could be an exercise in institution building, to show the world what East Timor could do in difficult circumstances. The East Timor Study Group assumed responsibility for organizing the Forum, and we wish to place on record our debt to the many individuals who, in very difficult circumstances, together made the Forum a great success. The core planning was in the hands of Helder da Costa, Francisco da Costa Guterres and Francisco da Costa Soares – all members of the East Timor Study Group. Their commitment, efficient organization and generous hospitality made all the difference, and we appreciate very much their good work. Two other members of the East Timor Study Group, Edmundo Viegas and João Cancio Freitas, were also instrumental in organizing the Forum. We spent much time working over the plan for the Forum and the volume with Helder da Costa and Jay Rosengard, whose wise counsel was always invaluable. We feel greatly honoured that several distinguished Timorese supported the Forum, and took time out from busy schedules to address the gathering. These include Xanana Gusmao, Bishop Carlos Ximenes Belo and José Ramos Horta, whose speeches to the Forum are reproduced in modified form as prefaces to this volume. In addition, Bishop Basilio do Nacimento, Minister Mari Alkatiri, Mrs Maria Federer and Mr Mariano Lopes da Cruz all addressed the Forum at some stage, and contributed much with their insights. We also wish to thank the many Timorese and others who chaired sessions and acted as commentators. These include José Abel, Rui Maria Araujo, Benjamin Corte Real, Manuel Countinho, Jan van Houten, Felipe Mesquita, Domingos Sousa, José Teixeira and Sofia Borges. Our appreciation goes to the National Council of Timorese Resistance (CNRT) for allowing us to use its conference facilities, and for the strong support we received from its leadership and staff. Mr Virgilio Smith and his team from the Secretariat helped to ensure strong logistical support. Beth Thomson managed the production of this volume, working well beyond the call of duty, and to a very tight timetable. As always, she edited the papers with her customary care and efficiency. She also prepared the indexes. It is always a pleasure to work with Triena Ong and her friendly and capable editorial staff at the Institute of Southeast Asian Studies. We also thank our

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co-publishers – Asia Pacific Press (Canberra) and Palgrave (London/New York) – for their interest in and support of this volume. It is obvious that events are changing very quickly in East Timor, and so inevitably parts of this volume will begin to date almost immediately. However, while the very short term is critically important, we are also looking beyond it in this exercise, by attempting to draw attention to major elements of a coherent long-term development strategy for the new nation. It is also obviously the case that the country’s socio-economic database is seriously deficient (though not to the extent that is sometimes assumed), and that political parameters are in the process of being formed, and institutions developed. We could have waited several years for all this to be worked out. But that would have resulted in a very different kind of volume. Vital decisions are being made now, and we thought it important to participate in the process. As was mentioned by one of the participants, in a remark attributed to Lord Keynes, ‘it is better to be approximately correct than precisely wrong’. We have approached the many complex and delicate issues addressed in this volume with such a proposition in mind. Our audience is first and foremost a Timorese one: the politicians, officials, academics and students, and anybody with an interest in policy issues. To maximize local impact, this volume will be translated into Portuguese and Bahasa Indonesia, and summary policy briefs of all the chapters are being prepared. In addition, East Timor attracts much more international attention than is common for such a small, poor and isolated country. We hope that this volume will also be of service to the international community with an interest in the country. We take this opportunity to thank several international friends, from Japan, Sweden, Portugal, Indonesia, Australia and the United States, for contributing to the Forum. The people of East Timor are about to embark on the huge task of nation building. If, in some very small way, this volume helps to make this journey a success, we will all feel very satisfied. Bon voyage in the new millennium. Hal Hill and João M. Saldanha Canberra and Dili/San Diego May 2001

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Preface Xanana Gusmao

Since the dreadful destruction of September 1999, East Timor has been undertaking the task of economic reconstruction under the guidance of the United Nations Transitional Administration in East Timor (UNTAET) and with the assistance of the multilateral and bilateral development agencies. It is obvious that this process, which literally began from scratch, is a gigantic task for UNTAET and for the Timorese people. Amidst the difficulties – ranging from communication between international staff and East Timorese nationals to the slowness of the reconstruction process itself – have emerged some initiatives that will establish the basis for the democratic governance of our country. Other initiatives have also emerged to help us achieve quick economic recovery. These include the rehabilitation of essential infrastructure and the transportation network, the provision of basic health care, the re-opening of schools and, very importantly, the resumption of markets and economic activities. But a lot more will need to be done to address four important economic and social problems we currently face: poverty, unemployment, inflation and illiteracy. The per capita income of East Timor was already very low, and sank still lower with the destruction of September 1999. Unemployment, mainly in Dili, is very high. Our country has had to cope with high inflation due to the shortages of goods and services and the high transport costs resulting from the remoteness of East Timor from the main international routes. Looking to the future, one of the main goals of our development will be to create a fair society with an equitable distribution of income, in which those East Timorese with lower incomes have their basic needs for education, health care and public transport met. At the political level, we aim for stability through democratic and orderly elections, and for good governance, with no corruption and with transparency in the decision-making process. The National Council of Timorese Resistance/National Council (CNRT/CN) and UNTAET agreed on the

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date of 30 August 2001 for the first Constitutional Assembly elections. The new assembly will have as its main task the framing of the constitution of a democratic East Timor, prior to the proclamation of our independence. CNRT will dissolve itself in June to give more room for the political parties to organize themselves and compete against each other in the elections. As the main UNTAET interlocutor and partner, CNRT has accomplished part of its task in ensuring that East Timorese have an increasingly important role in the transitional process to independence. We hope that all this is a positive signal for national and international investors, to attract their involvement in mutually beneficial economic activities in East Timor. To this end, it is important to provide security, to clearly define and publish laws on land and property rights, and to simplify the administrative procedures for investment. We will develop an appropriate fiscal and tax policy to give additional incentives to investment. In this rehabilitation process, we recognize that our technical capabilities are limited. Despite the best intentions and all the goodwill, the process of Timorization is still too slow. This will pose problems for the future administration of an independent East Timor. At the CNRT/CN Congress of August 2000 several economic issues were discussed, including strategies for development, investment, the environment and natural resources. Let me share with you some issues that worry us, in the hope that your suggestions may help us find alternatives for the future of an independent East Timor. We still debate – though in a limited way for the moment – the options regarding the creation of a national currency. Should we have our own currency or should we maintain the present situation of using the American dollar? What other options do we have, considering our small size and other characteristics? We are concerned about fiscal policy, namely the budget, and whether it should be balanced. This again involves the issue of a national currency. Besides this, what are our options for offering fiscal incentives to investment? Another important discussion has been about the income from the Timor Gap, and the (so-called) ‘good life’ that it can bring to us. Will it be possible to rely only on oil revenues, or will we need to develop other resources that can complement these? Of course, we would like to have a good living standard, relying on our own resources. But the main issue will be to find a way to avoid the bad experiences of other countries and to ensure that our resources will in fact be a blessing for our country and not a source of even worse problems. We acknowledge that for the time being, during this transitional process, we are living off other countries’ taxpayers. We believe that for at least some time to come, we will benefit from the sympathy and support of the international community. But this support will diminish in the future because we recognize that there are other countries in the world which ask for the attention and sup-

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port of the international community – support which, just like that given to East Timor, is well deserved. For all these reasons we wish to develop our non-oil income, thereby ensuring our long-term growth. We have considered the creation of a 'free economic zone'. Its objective would be to stimulate new jobs for Timorese through the development of an ‘offshore’ facility that would include a modern financial centre. What would be the consequences of this for the East Timorese people? Is this a viable option for us, considering our geographic position in the world? Given our small production units, we also confront the problem of the commercialization of agricultural production in several regions of our country. We need to know how best to provide access to markets for small producers, including access to credit. Some micro-finance initiatives are available, but they are still very limited. In considering all this, I salute the Dili Economic Forum and this book as an initiative to help us identify our economic challenges and give us some alternative ideas in our efforts to overcome poverty, unemployment, inflation and illiteracy. I wish the Forum and this book every success, and extend my warmest regards to the organizers – the East Timor Study Group, the Australian National University and the Asian Development Bank (ADB) – for undertaking this important work. Kay Rala Xanana Gusmao President, Concelho Nacional de Resistencia Timor April 2001

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Preface Carlos Belo

Poor economic management in East Timor has resulted in hunger, poverty, unemployment and social instability. Hunger refers to the shortage of food, which is the most fundamental need of human life. Hunger is also a general indicator of a people’s backwardness. The solution requires the development of a broad-based economic development strategy. Poverty refers to the condition of those human beings who are deprived of what they require to live with dignity. There are various dimensions to poverty – economic, cultural and legal. The most alarming consequence of economic recession in developed countries is unemployment. In underdeveloped countries like East Timor, this is the lack of economic means. Unemployment causes humiliation and depression, leading to drug use, delinquency, family crisis and despair. It causes psychosomatic illnesses, psychological changes and personality disorders. Job creation is the key to addressing all social issues (John Paul II). Hunger, poverty and unemployment contribute to dehumanization. This often results in social instability, which is one of the major human costs of an economic crisis. The social life of any country cannot function without economic stability. How are these economic and social ills to be overcome? They have to be tackled by a free and unified people. The core moral solution entails reconstructing human solidarity, both in theory and in practice, given that true economic development must be guided by the criterion of solidarity. In the words of Vatican Council II: ‘The economic activity regulated by its own methods and laws has … exercised itself within the limits of moral order to fulfil God’s designs of human beings’ (GS, 64). Economic activity affects all human activities.

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Today, more than ever, there are strong reasons to increase our efforts to raise agricultural and industrial production, as well as the level of services, in order to meet the needs and growing aspirations of an expanding human population. Greater efforts should be made to enhance technological progress, foster a spirit of initiative, create and expand business opportunities, and adapt production methods – in sum, develop all the factors that contribute to development. But the fundamental goal of production is not the mere increase in products, revenues or power, but rather the service of the human being; of the human being in its integrity, that is, taking into account the order of his material needs and the demands of his intellectual, moral, spiritual and religious life. This is true for any individual or group of people, of any race or religion in the world (GS, n.64). The human being is the protagonist, the centre and the end of the whole of economic and social life (cf. GS, n.63). In view of this, we believe the economy of the new nation of East Timor has to be a planned one. What kind of planning are we talking about? Democratic planning. In order to be truly democratic, planning requires the presence of all social groups in the formulation, implementation and control of economic processes. The different points of view, the tensions and conflicts, require the presence of organizations that represent different interests, even those that might be regarded as exploitative. Participation in economic life requires adequate information and data. Economic development must be under human control; it should not be in the hands of an economically strong few individuals or groups, one political party or a few powerful countries. On the contrary, there is a need to involve as many people as possible, at all levels. Equally important is the need for coordination and harmonious organization between private initiatives and public institutions. The economy of East Timor is small scale. Most of the population still rely on agriculture, much of it subsistence. Hence there is a need for agricultural planning. In addition, we have been witnessing a flow of people from rural areas to the main towns, particularly Dili, causing labour shortages in agriculture. These outflows are motivated by several factors: the desire to escape from an environment regarded as without future and narrow-minded; the thirst for novelty and adventure; the hope of sudden wealth; the fantasy of a ‘free life’ with the means and facilities available in the city. What can be done to attract the population back to the villages? It is essential that the authorities provide basic services in rural areas, such as roads, transportation, communications, safe drinking water, housing, health facilities, primary, technical and professional education, and recreational facilities (cf. Mater et Magistra, n.127). There is no industry in East Timor. Efforts are under way to establish small industry. Support should be lent to this sector as well. Commerce can be understood from various perspectives, and it is in reality a complex phenomenon. Broadly defined, the ‘market’ constitutes one element of an economic system. Commerce is one of the fundamental processes of eco-

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nomic activity, as it helps to distribute the flow of goods. It is also an important social activity, fundamentally related to the distribution of wealth and the regulation of the economic cycle. Ethics and morality need to underpin commercial activity, in order to eradicate fraud, speculation and ‘free-riding’. The price of an economic good is a quantitative expression of the value of exchange, through the medium of money. According to the traditional Christian morality, a price is considered ‘just’ when it is determined by the ‘law of equivalence’ between the goods being exchanged; that is, when the price is equal to the cost of production plus a ‘reasonable’ margin for the seller. But in addition to this simple commercial dimension, prices have a social dimension. The question of prices is a moral issue, and therefore raises questions of social justice. How should the government address the question of prices? Its regulatory function needs to be balanced in a way which ensures that the economy facilitates the community’s access to basic needs, and also prevents speculation in, for instance, housing. Pricing policy therefore needs to take account of the purchasing power of individuals, including that of the disadvantaged groups in the society. Fiscal policy is one of the most important aspects of economic policy. Here, attention needs to be given both to the structure of the fiscal system (its clarity, simplicity, coherence and legal certainty) and to fiscal objectives. Social and distributional issues are also important. A similar set of ethical and political judgements applies to the expenditure side of the budget. Here, too, clarity and transparency are fundamentally important to ensure equity in the eyes of taxpayers. Finally, expenditure decisions have to be consistent with the broader development objectives discussed above. Taxation legislation must be subject to moral scrutiny and considerations of justice. Thus, for example, direct taxes should be favoured over indirect ones, and certain products and activities should be exempt (for example, schools and social institutions). On grounds of equity, a progressive tax structure should be developed, including exemptions for those with incomes below a certain level. Finally, there needs to be a public campaign and moral education to encourage taxpayers to fulfil their obligations and not to regard laws merely as punitive devices. Within this framework, I welcome the Dili Economic Forum. I am glad to know that the proceedings will be published in this book, which should prove useful for anyone interested in the development of East Timor. Carlos Filipe Ximenes Belo, SDB Apostolic Administrator, Dili Diocese Nobel Laureate July 2001

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Preface José Ramos Horta

East Timor opened a stormy new chapter in its history on 30 August 1999 when its people voted overwhelmingly for independence from Indonesia. More than 98 per cent of registered voters defied intimidation to cast their ballots in an orderly and peaceful manner. The people of East Timor won the world’s admiration for their commitment to democracy. The discipline, patience and dignity displayed on that day will be a hallmark of East Timor as it moves towards recovery and independence. Implementation of the results of the ballot should have been an occasion for celebration. Instead, the people of East Timor were forced to watch the birth of their country with tears. The reconstruction that will accompany the journey towards independence in East Timor, while arduous and painful, will also provide a genuine opportunity to establish appropriate infrastructure, institutions and economic policies at the outset. That will facilitate the rebuilding of this small and devastated land into a viable, self-sufficient, democratic state for the 21st century. In order to establish a sound macroeconomic framework for East Timor, more hard choices will need to be made. These pose formidable challenges for future policy-makers in this country. The Transitional Cabinet has endorsed policies establishing a framework for macroeconomic stability. This needs to be supplemented by appropriate structural and social policies to increase investment and employment in both the private and the public sector. Growth based on attracting private investment, both national and foreign, requires public policies and investment to provide better infrastructure, well-established property rights, effective governance and the rule of law. Parallel with this, a future independent East Timor must begin to show its commitment to sustainability by building a sound fiscal framework underpinned by a stable, credible currency. Initiatives to establish a national currency in the

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future will include efforts to ensure it has strong financial backing and the credibility necessary to be welcomed by international financial markets. An urgent task in this newly emerging country is to establish a small, competent and transparent government from the beginning. Given the experience of previous administrations, East Timor will have a lean and cost-effective government that will seek to keep aggregate expenditures aligned with the country’s absorptive capacity. Domestic revenue sources are expected to provide a solid foundation for financing the country’s recurrent budget without resource to donor assistance. Equally fundamental are sound management of public resources and maintenance of a good economic and regulatory environment conducive to efficient private sector activities. While many doubt the country’s economic viability, East Timor is arguably well endowed on a per capita basis with natural resources both on-shore and offshore. The projected oil and gas revenues for the medium term from the Timor Sea are promising. This export income will be supplemented by earnings from marble, coffee and other agricultural produce as well as tourism, since East Timor has a comparative advantage in these activities. There are strong reasons to believe that the revenues generated from oil and gas will be allocated appropriately. An endowment fund could act as a stabilizing force, safeguarding income from resource sales that rightly belongs not only to the East Timorese citizens of today but also to generations to come. Given that three-quarters of East Timorese are engaged in agriculture, a future independent East Timor will need to strengthen traditional agriculture by using appropriate technology inputs to increase crop yields. Providing access to rural banking and micro-credit facilities will also help to increase the sector’s output growth while improving its ability to market surpluses and build linkages with the private sector. Appropriate policies can provide a sound basis for sustained economic growth and poverty alleviation via export-oriented primary activities. With its small natural resource base and limited domestic financial resources, East Timor will need to engage actively in trade if it wishes to develop its economy rapidly. Again, a future independent East Timor will welcome sound investment by firms that wish to operate in an environment free of artificial barriers to trade. East Timor’s magnificent landscape will be matched by an attractive investment climate, with appropriate laws protecting property rights and contracts, establishing a fair commercial code, codifying labour relations and minimizing the cost of doing business. After all, this strategy is aimed at laying the foundation for good governance based on democracy, accountability, transparency and human rights so as to build East Timor into a modern civil society run by efficient institutions based on the rule of law. My fervent hope is that this book will contribute in some practical ways to

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help East Timor reduce its heavy reliance on foreign aid, achieve sustained economic growth and fight unemployment and poverty effectively. José Ramos Horta Cabinet Member for Foreign Affairs, East Timor Transitional Administration Nobel Laureate July 2001

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Preface Asian Development Bank

It is recognized that sound economic policies are critical to the socio-economic development of a country. This is a complex task. The policies and strategies need to be ‘owned’ by stakeholders, including government and civil society. It is challenging to implement them and to monitor their developmental impact. Such policies and strategies need to be flexible; they must be able to respond to the changing needs of the society and the economy. East Timor needs to build the capacity and skills required to put it on the desirable socio-economic development path. The papers presented and discussed at the Dili Economic Forum deal with a comprehensive framework of economic policy and strategy options which are relevant to the emergence of a national poverty reduction strategy for East Timor. Such a strategy needs to be designed and owned by the country. The critical importance of social development goals in underpinning economic policies needs to be emphasized. Such goals are best pursued by integrating and mainstreaming social development concerns into development planning, and into economic growth and other strategic objectives. This is best done by promoting equality of opportunity, security and empowerment; by bringing social concerns into the mainstream of development interventions; and by mitigating the negative social impacts of development policies. Therefore, economic policies and strategies need to be underpinned by adequate social analysis and assessment of the causes of vulnerability. Vulnerability and poverty are closely linked. Well-directed social development efforts are the backbone of sound economic policies and strategies. They will help to promote social responsiveness to, and the sustainability and ownership of, policies, strategies, programs and projects. The economic forum publication is just one step in the process through which the East Timorese people will prepare and formulate their development

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policy and strategy – not following the usual top-down approach so often practised in the past, but in a truly participatory manner, through an intensive and long-term dialogue with societal groups and organizations. This is a daunting task – and one that will take some time, as the civil society landscape and human resources potential in government agencies will need to be built up. We recommend that working groups be set up under East Timorese stewardship, not only to fine-tune macro and sectoral policies but, perhaps equally important, to formulate shorter-term action programs and concrete projects that would quickly demonstrate progress and have an impact on the ground. The Asian Development Bank stands ready to provide assistance to the East Timorese people in the realization of a consultative approach. We are committed to facilitate such a process in a sustained manner. Basudev Dahal Director, Office of Pacific Operations Asian Development Bank, Manila May 2001

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The Key Issues Hal Hill and João M. Saldanha*

This volume offers a forward-looking perspective on the economic development of East Timor. It traces the country’s ‘initial conditions’, assesses and adapts the lessons of international experience, and contains detailed discussions and recommendations across a broad range of subjects. Very few countries are commencing the long march towards economic development in such an ill-prepared state. Centuries of Portuguese colonial occupation and neglect were followed by almost one-quarter of a century of troubled and sometimes brutal Indonesian rule, though with quite rapid economic development for a period. Then, in the wake of the August 1999 vote for independence, there was massive destruction on the part of the militias and departing Indonesian military. The country reverted temporarily to UN administration, with an impossibly ambitious timetable for independence. The country’s starting point could hardly be more difficult. •

• •

• •

It is an extremely poor country, with a per capita income of about $300.1 This is broadly equivalent to the income of the poorest states of mainland Southeast Asia, and that of Portugal’s former African colonies, but well below that of most small Pacific Island and Caribbean nations. About 70 per cent of its building stock was substantially or partially destroyed in September–October 1999. In that tragic year, East Timor’s GDP was estimated to have declined by about one-third. There was massive population resettlement and dislocation in that year. At the time of writing (May 2001), about 10 per cent of the country’s pre-1999 population still resides abroad, mostly in squalid refugee camps across the border in West Timor. Much of the commercial expertise fled in 1999 and is unlikely to return. The country lacks high-level bureaucratic capacity. During the Indonesian

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• • •

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Hal Hill and João M. Saldanha period, senior echelons were dominated by non-Timorese; currently, UN officials occupy most senior positions. The country doesn’t have a constitution or a legal system; land ownership disputes are rife. Serious political fissures are emerging as the 30 August 2001 election approaches. East Timor must reach an accommodation with Indonesia on a complex array of economic, social and political issues. Yet, Indonesia is distracted with its own crises, and significant elements of its military and foreign policy establishments are either indifferent to or hostile towards the new nation. But there are rays of hope, and the country is not without potential.

• • • • • • •

There is the unifying presence of its three key political/religious figures – Xanana Gusmao and Nobel Laureates Bishop Carlos Belo and José Ramos Horta. Notwithstanding the political tensions, we are not going to see an Angolanstyle civil war erupt. In fact, East Timor is recovering more quickly than practically any other war-torn economy in the recent past. There is much international goodwill, and aid flows are very large. There is a sizeable diaspora with skills and money. A sense of pragmatism on economic policy pervades much of the putative Timorese leadership, as evidenced by its willingness to adopt some tough macroeconomic policy decisions. There is significant export potential, including for oil and gas, coffee and tourism. As a ‘latecomer’, there is much to learn from the mistakes of other newly independent states.

One fact which is beyond dispute is that East Timor is a tiny and extremely poor country. Its measured GDP is about equivalent to that of a few suburbs in an affluent country (with the obvious caveat that such comparisons need to make allowance for purchasing power parity adjustments). At $300 per capita, even with rapid growth it will remain poor for many years to come.2 Development is a long-term process in which there are no ‘quick fixes’. It is clear, then, that East Timor needs economic growth that is both rapid and ‘high quality’, the latter denoting inclusive socio-economic outcomes and sustainable management of its natural resources. Economic policy in East Timor is a tabula rasa. Everything is urgent and demands attention. Crucial decisions on the eve of nationhood will go a long way towards determining Timor’s future development trajectory, and how quickly its people are lifted out of poverty and socio-economic deprivation. In

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other words, a coherent economic policy is absolutely critical to the future course of development. One of the key lessons of economic development is that there is a big dividend from getting a few major economic policy decisions more or less ‘right’. Conversely, a failure to get the basics right would result in a squandering of the large aid and gas flows, render irrelevant much of the detailed sectoral work, and diminish the value of well-intentioned micro-level initiatives. In important respects, it is not an overstatement to characterize the development policy choices facing an independent East Timor as the ‘East Asian’ and ‘South Pacific’ routes. That is, and to oversimplify, it could aspire to being a dynamic, outward-looking country, with a well-managed macroeconomy, in which its natural resource wealth is invested wisely for the betterment of all its people and there is a broad-based improvement in living standards. To mix geographic metaphors, in this scenario it might become the ‘Mauritius’ of the region. A much less attractive scenario is however present, to Timor’s east. This is represented by the more typical situation in the small South Pacific Island states, which share many common features with East Timor. Here the outcomes are more commonly socio-economic stagnation, an aid and remittance-dependent economy, a bloated public sector, a paucity of footloose private investment, and a society in which the best and brightest vote with their feet and seek a more promising future abroad. Although it faces formidable challenges, East Timor’s development trajectory is not path-dependent. One of the key lessons of development over the past half-century is that, with good economic policies, countries need not be consigned to the status of perpetual basket cases. In the 1960s, Mauritius was seen as a case study in Malthusian economics, compounded by the problem of geographic isolation. Yet, it has been one of the star performers of Africa. Following its civil war, South Korea had ‘South Asian’ living standards and was regarded by many as a hopeless case. Sukarno’s Indonesia in the mid-1960s was characterized as a ‘chronic economic dropout’, and yet for the following three decades, up to the crisis of 1997, it achieved historically unprecedented growth rates.3 The chapters in this collection take as their starting point the premise that rapid economic development for East Timor will be a difficult but by no means impossible task. Together, they sketch the key elements of a forward-looking development policy agenda that embraces macroeconomic policy, the management of large aid and natural resource flows, commercial policy, relations with Indonesia, the special case of agriculture, finance and infrastructure, social policy, political and legal institutions, and the general lessons of international experience. Where relevant, the papers take as their starting point East Timor’s past economic and social development. Notwithstanding the tragic events of 1999, this

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past is better documented than is commonly supposed. For example, we have a quite comprehensive picture of agricultural development, education and health, poverty incidence, demographic trends, regional development and physical infrastructure. In other instances history is not much of a guide to the future, and broader lessons of international development, rooted in a Timorese context, are more useful. Examples here include exchange rate and monetary policy, the fiscal framework, trade policy and political structures. In yet other cases, history is at once murky but will also provide something of a road map to the future. The most obvious example here is the legal system, and in particular the thorny question of property rights. The following section takes stock of the country’s ‘initial conditions’: its complex historical legacies and the course of development during the period of rehabilitation and transition to independence, 1999–2001. This is followed by the major section, which summarizes the principal themes and issues developed in this volume. Together, these constitute the elements of a development policy agenda for the new nation state. It is important to emphasize that we are dealing with highly complex and politically delicate issues in a number of instances. Inevitably, our space constraint dictates that we are not able to explore all the nuances, and attach all the caveats, that one would ideally want to. But we hope that this broad-brush approach will at least capture the principal challenges, and outline the key elements of a coherent policy framework.

‘INITIAL CONDITIONS’ AND THE TRANSITION TO INDEPENDENCE East Timor’s past will inevitably shape its future economic development. But how does one define East Timor’s ‘initial conditions’? With reference to a range of imperfectly measured socio-economic variables in 2001, on the eve of independence? Or its shattered economy and infrastructure in late 1999? Or its comparatively buoyant economy for much of the 1980s and 1990s? Or its troubled political history and occupation by outside powers? All of these elements are relevant in providing a composite picture of the past, and in this section we draw attention briefly to them.4 Formal quantitative measurement of the East Timorese economy began only in the early 1980s during the Indonesian period. Before that, there was fragmentary evidence (pieced together by, for example, Saldanha 1994) from a range of social, commercial and agricultural indicators. But we have little by way of a comprehensive picture of economic development during the centuries of Portuguese colonial rule, other than a presumption of prolonged socio-economic stagnation at a very low level of income. Similarly, we lack substantial evidence of trends during the first few years of Indonesian rule, except that all

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anecdotal information suggests a very sharp economic contraction and a severe dislocation of economic life. By the early 1980s, when Jakarta’s rule was firmly established, and dissent was confined mostly to the brave but isolated resistance fighters and the underground movement, we begin to get a picture of the economy. This is provided in comparative Indonesian context, since data for East Timor appear in the provincial socio-economic statistics, alongside the other 26 provinces over this period. This is not the place to evaluate Indonesia’s development record, and in any case many would argue that broader political and human rights considerations should dominate such an assessment. But the following observations do seem pertinent, especially as we look forward and assess East Timor’s economic potential. Along with the Nusa Tenggara provinces, East Timor, with a per capita income of about 30–36 per cent the national average, was always one of the poorest regions of Indonesia.5 Nevertheless, its economy grew quite strongly: from 1983 to 1997, real per capita gross regional product (GRP) increased by 5.6 per cent per annum, marginally faster than the Indonesian figure of 5.1 per cent. It is probably the case that this was the most sustained period of economic expansion in Timor’s history. Much of this growth was propelled by the public sector, and in particular by direct grants from Jakarta. Rosengard (Chapter 3) provides some approximate quantification of these flows. In the mid-1990s, for example, they were worth about $150 million per year, equivalent to some 60 per cent of provincial GRP. This figure is broadly consistent with the estimates presented in Table 1.1, which, treating East Timor as an independent entity, suggest fiscal and current account deficits of about two-thirds and one-third of GDP respectively. We lack detailed data on the distribution of these benefits, and in particular on how much the Timorese themselves benefited from this growth. The circumstantial evidence suggests a mixed picture. On the one hand, the improvements in income and expenditure, agricultural production and education (and probably health, although accurate measurement here remains problematic) were so large that they must have percolated through to all socio-economic layers. In education, for example, there is a marked increase in age-specific school enrolment ratios, following, with a lag, the Indonesian occupation (Jones, Chapter 16). The gini ratio for household expenditure, though quite high by Indonesian standards (Booth, Chapter 15), was low enough to suggest reasonably broad-based benefits. The road network expanded dramatically (Cheatham and Jarvenpaa, Chapter 14). While this undoubtedly served military purposes, it also benefited small farmers and the economy as a whole. But there can be no doubt that non-Timorese benefited disproportionately from Jakarta’s largesse and the high growth rates. The military budget was

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Table 1.1 Economic Indicators for East Timor, 1997–2001 a

GDP ($ million, nominal) GDP growth (real, %) Consumption (% of GDP) External savings (% of GDP)

1997

1998

1999

2000

2001

383 4

375

228

263

303

–2

–38

15

72

15

74

93

114

111

25

21

21

52

55

Fiscal balance (% of GDP)

–67

–29

–36

–55

–35

Current account I (% of GDP)

–33

–29

–23

–52

–55

Current account II (% of GDP)

–6

–4

–2

–52

–55

a All figures are very approximate. Those for 2000 are estimated projections, while those for 2001 are simply projections. The data on fiscal balances refer to fiscal years, thus, for example, ‘1997’ refers to 1997/98. Current account ‘I’ and ‘II’ refer to estimates excluding and including official transfers respectively. Source: Data provided by the East Timorese authorities.

large, especially in the first decade of occupation. There was rampant corruption associated with all public sector transactions. Non-Timorese occupied most senior positions in the public sector (although Timorese governors became the norm from the late 1970s), while outside contractors procured most of the lucrative government contracts. Some indication of the unequal distribution of benefits is indicated in the gini ratio for household expenditures (Table 15.3). The ratio for East Timor was well above that of the two Nusa Tenggara provinces, and approaching that of West Papua/Irian. We have a fairly comprehensive picture of the East Timorese economy and its natural resource base in the late Indonesian period. As da Costa (Chapter 9) emphasizes, East Timor’s comparative advantage lies in land and unskilled labour-intensive activities. Its population density is below the norms of densely settled East Asia, and also less than that of the neighbouring Nusa Tenggara provinces of eastern Indonesia. Much of its agriculture is subsistence in nature, although commercialization has spread as the physical infrastructure, particularly roads, has expanded. The livestock and fishing industries are important, as they are in much of eastern Indonesia (Barlow, Chapter 7). Coffee is the major cash crop, and the key to much of rural welfare. According to Pomeroy (Chapter 8), as much as 25 per cent of the population is partially dependent on coffee, while for about 16 per cent coffee constitutes a significant proportion of their income.

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East Timor’s land area is small, approximately 14,610 square kilometres. But, as Fox (Chapter 10) emphasizes, there is great ecological diversity, and this has to be factored into any development planning. Any attempt at zonal classification is arbitrary, the more so in the wake of the major disruptions of 1999. But Fox identifies at least six different ‘agro-climatic’ zones (Map 10.1). Parallel to these are three major linguistic/demographic regions: the western (border) region, including the enclave of Oecussi, with 24 per cent of the population (and 23 per cent of the land area); the central region with 45 per cent of the population, of which Dili has about one-third; and the eastern region with 31 per cent of the population (and 46 per cent of the land area). The regional accounts data during Indonesian times support this notion of diversity, registering considerable variations in per capita GRP. Dili’s figure, for example, was more than 70 per cent above the provincial average. Table 1.1 provides a summary description of economic trends during the critical years, 1997–2001. The economy began to slow in 1997, as Indonesia’s economic crisis impacted. In addition, East Timor was particularly affected by the El Niño-induced drought of that year. However, it appears that East Timor was cushioned from its major effects, since the contraction in 1998, of just 2 per cent, was merely one-seventh of the Indonesian figure. Thus Timor was spared the ‘twin crises’ – of 1998 and 1999 – from which it might have been expected to suffer. Several factors explain the absence of a major crisis in 1998. First, the sectors that collapsed in the urban economy of Java – finance, import-substituting manufacturing, private construction – were not present to the same degree in Timor. Second, although Timor was highly government-dependent, there appears to have been some attempt to insulate it from the most severe expenditure reductions, perhaps in the knowledge that sharp cuts might trigger local unrest. Finally, Timor’s two key agricultural components, subsistence food crops and export-oriented coffee, were largely immune from the modern sector collapse and were the beneficiary of a much weaker rupiah. In this respect it shared something in common with much of Indonesia’s Outer Island provinces. It is impossible to estimate with any precision the economic cost of the massive dislocation that occurred in September–October 1999. For what it is worth, the economy is estimated to have declined by almost 40 per cent. We will never know how much of the capital stock was destroyed or damaged, although the estimate that 70 per cent of the housing stock was partially or completely destroyed seems to be widely accepted. Dili lost about one-third of its electricity-generating capacity, while losses in most district capitals were higher still (Cheatham and Jarvenpaa, Chapter 14). Modern sector commerce came to a halt. There was a huge disruption to human settlements, with perhaps up to half the population affected as the Indonesian military withdrew, and as much as 25 per cent being forcibly shifted across the border into West Timor. Almost one-

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half are still there, more than 18 months after the cessation of active hostilities. One immediate consequence of this sizeable population displacement was the disruption to the agricultural cycle. In late 1999, following pacification, an international rescue effort was mounted under the auspices of the United Nations, which established UNTAET, the United Nations Transitional Administration in East Timor. Initially the relief effort focused on encouraging the populace to move back to their homes, and on providing adequate food supplies, basic humanitarian assistance and the most urgently needed infrastructure. By early 2000, and with independence quickly looming, the focus began to shift to medium-term issues associated with the foundation of a new state. These included establishing a functioning bureaucracy, defining a new nation’s political, legal and constitutional arrangements, adopting a monetary and exchange rate system, and laying down the beginnings of a fiscal policy framework. In 2000 and 2001, economic recovery has proceeded quite quickly, probably more so than in almost all other war-torn economies (Haughton, Chapter 18). The growth of the construction and trade sectors has been particularly fast. Economic activity has yet to regain pre-crisis levels, although on present indications there is a reasonable prospect that it will do so within two or three years. It is impossible to estimate per capita living standards over this period, since the number of East Timorese residing in Indonesia, by force or by choice, is not known. It may be that living standards for the average Timorese have recovered to pre-crisis levels, at least in rural areas, owing to a succession of good agricultural harvests in the wake of plentiful rainfalls in recent years. The rudimentary consumption estimates in the national accounts (Table 1.1) do support this hypothesis. However, these figures are extremely approximate, and any measure of cautious optimism needs to take account of the huge population resettlements and very high urban unemployment evident since 1999. International assistance has been critical to East Timor’s economic recovery. Donor meetings from the one held in Tokyo in December 1999 onwards have pledged very large funds. Most, but not all, foreign aid has taken the form of official flows to the interim administration. Rosengard (Chapter 3) provides some indicative orders of magnitude from the first formal budgeting exercise, for FY2000/01. UNTAET has targeted a public sector of some 20 per cent of GDP, equivalent to about $60 million, of which about 30 per cent is to be raised from domestic sources. Aid flows are projected to be very large, about $160 million in 2000/01. This does not include still larger amounts (about $600 million) in the form of UN Assessed Contributions, which cover peacekeeping operations and the costs of the United Nations’ international staff. Thus aggregate aid flows ‘exceed’ the size of the East Timorese economy by a very large margin. Much of this aid effectively does not enter the Timorese economy, since (for example) UN salaries are paid into bank accounts abroad. Making

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some plausible back-of-the-envelope calculations, Rosengard suggests that the public sector presence, almost entirely aid-financed, accounts for at least 45 per cent of GDP, and possibly substantially more. These estimates are broadly consistent with the ‘public sector deficit’ figures for 2000 and 2001 presented in Table 1.1. They also accord with the magnitudes prevailing during the Indonesian period.6

ELEMENTS OF AN ECONOMIC POLICY FRAMEWORK This section develops a policy framework that offers the prospect of East Timor achieving rapid, broad-based and sustainable economic development. It draws on the literature on the determinants of growth, in which several key variables appear to be consistently important in diverse contexts and circumstances. These include sound macroeconomic policies, openness to the international economy, social progress and a set of institutions which, inter alia, provide secure property rights and political structures that are responsive to community pressures and preferences. The discussion obviously has to be cognizant of East Timor’s special circumstances. These include, at a minimum, the massive challenges of physical and institutional reconstruction, building peace and achieving reconciliation, forging a viable relationship with Indonesia, and managing a very small economy in the context of very large aid flows and (in prospect) royalties from natural resources. Some of these issues are immediate and urgent, while others are longer term in nature. The contributions to this volume reflect these perspectives and priorities. They draw where relevant on the lessons of international experience. There is much that is pertinent in the 50 years of post-war development, particularly from economies which share some similarities with East Timor’s initial conditions. One clear lesson from this experience is that, although East Timor starts with many severe handicaps, its small size per se is not one of them. As Saldanha and Tavares (Chapter 17) demonstrate, and as has been confirmed by several other authors,7 the cross-country empirical evidence suggests a weakly inverse relationship between size and economic performance; that is, if anything, very small economies tend to do better. The explanations for this outcome are not fully understood, but may have something to do with the fact that small economies have less scope for getting economic policy seriously wrong. They have little choice but to be open, for example, and they are more likely to hitch their macroeconomic policy framework onto that of a larger, well-managed economy. The choice of comparators obviously matters in these exercises. East Timor needs to be compared with the poorest South Pacific and Caribbean island

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states rather than a country like Singapore. Moreover, it is possible that it is not size but related characteristics which pose a major development challenge – for example, geographic isolation or being landlocked. However, as Collier (Chapter 21) points out, in the African context, among the very few success stories are isolated Mauritius, landlocked Botswana and the emerging post-independence economy of Eritrea. Managing the Macroeconomy A well-managed macroeconomy is an essential prerequisite for successful economic development. It is difficult to think of a single instance of sustained economic development in the third world without good macro management. We consider here in turn monetary and exchange rate policy, fiscal policy, and maximizing the benefits from international aid and potentially large naturalresource earnings. Some of these issues, of course, go well beyond a narrow definition of macroeconomic management, particularly issues associated with aid and natural resource management. Monetary and Exchange Rate Policy De Brouwer (Chapter 2) provides a very clear analysis of the options with respect to monetary and exchange rate policy for an independent East Timor. It makes little sense for such a small economy, with practically nonexistent bureaucratic resources or formal financial sector, to attempt to run an independent monetary policy. The obvious option is for it to link its currency, and therefore its monetary policy, to that of a larger, well-managed economy, either by simply using the latter’s currency or by the adoption of a ‘hard peg’ in the form of a currency board. The second option might be politically more acceptable in a country anxious to build its national symbols. In a strictly economic sense, the first is preferable, principally because, being more difficult to dismantle, it further reduces uncertainty about the future course of monetary policy. Which currency is selected is a matter of political and economic judgement. The US dollar would appear to be the most attractive, all things considered.8 If the parting with Indonesia had been amicable, and that country’s good macroeconomic management for most of the Soeharto era were still present, the use of the rupiah might have been an option. However, its use has to be ruled out on both grounds. Nevertheless, managing commercial relations with its probable major trading partner, whose currency may well be volatile, will pose a challenge for East Timor. In particular, there will need to be sufficient flexibility in factor and goods markets and distribution channels to be able to adjust quickly to considerable uncertainty. The signs of rigidity in the small, urban and public-sector-based labour market are therefore cause for concern. De Brouwer and others at the Economic Policy Forum (held in Dili in

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March 2001) generally endorsed UNTAET’s decision of early 2000 to adopt the US dollar as the official currency. They also emphasized the importance of the currency meeting the everyday transaction needs of the East Timorese community, especially for typical, small-scale exchanges. Currently, the rupiah continues to play this role. While, in principle, there is no reason why several currencies cannot continue to be widely used, specific measures are needed to address the ‘small change problem’.9 One is simply better education. Another might be the production of special low-denomination coins (fully backed by reserves) which can circulate alongside the US dollar notes. Fiscal Policy This will be one of the most complex areas of public policy, since so many issues impinge on budgetary processes and outcomes. These include a huge array of pressing public-sector expenditure priorities, a weak bureaucracy, public sector management and remuneration, the limited economic-policy literacy among much of the political leadership, very little tradition of, or infrastructure for, local taxation, very large aid and (in prospect) natural resource flows, and the question of how quickly the country should aim to be fiscally self-reliant. The early political signs are moderately encouraging. Officially at least, the East Timorese leadership appears to recognize the importance of developing a viable fiscal-policy framework. For example, two key East Timorese figures recently stated that: ‘An independent East Timor will have a lean, cost-effective government that will seek to keep aggregate expenditures aligned with the economy’s absorptive capacity’ (Ramos Horta and Pires 2001: 22). Addressing these issues, Rosengard (Chapter 3), as noted, provides some important historical perspective from the Indonesian period, as well as tracing the current transitional arrangements of very large aid dependence. There is of course nothing scientific about the size of the public sector. It is ultimately a question of community choice, expressed through the political process. A reasonable target on the basis of other countries’ experience might be a government sector of around 20 per cent of GDP, implying a budget at the outset of independence of some $60 million, excluding aid flows. Given the relatively high average civil-service salary selected by the interim Timorese leadership, such a budget implies a very sharp contraction in the size of the civil service, from about 32,000 in the late Indonesian period to approximately 12,000. Moreover, this civil service will have vastly increased responsibilities: running a nation, rather than a distant outpost of a highly centralized regime. Just how quickly can and should an independent East Timor aspire to fiscal self-reliance? This will be one of the most difficult public policy choices. Fiscal conservatives at home and abroad correctly emphasize that it is crucially important to develop a framework for expenditure and revenue flows, to educate the community not to expect across-the-board subsidies (especially to

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better-off urban dwellers) and to inculcate the expectation that taxes are necessary and have to be paid. This is especially so since: • • • •

the large subsidies which were a part of life during the Indonesian period have suddenly disappeared; donor fatigue could – and probably will – set in quickly, and aid flows will be difficult to predict long term; the framework needs to be intact before the large natural-resource revenue flows commence; and UNTAET has been very slow to institute user-pays principles. For example, by April 2001, nearly 18 months into its administration, it was still not charging for electricity.

Conversely, within a coherent fiscal framework, there is a case for running a very large short-term fiscal deficit (for example, in this and the next two or three financial years) and a significant one medium-term (in the three or so financial years beyond that). This is provided the deficit can be aid-financed and relies minimally (if at all) on gas, and any subsidies are transparent and earmarked as short term. The rationale for such a strategy includes the following. • •

• •

•

•

There is a large task of national reconstruction, especially of the stock of dwellings. Also, up to 80,000 refugees across the border may have to be reabsorbed into Timorese society and its economy. It takes time to adjust from a period of large subsidies of the type applicable during the Indonesian period. Moreover, while one would want to avoid as much as possible aid dependence of the type found in the Pacific Islands, it is a reality that tiny, very poor countries do receive considerable long-term aid flows. There is, as noted, a massive public sector adjustment to be made. In the transition period, major policy and institutional challenges have to be sorted out, and national institutions established. These include, for example, defining the legal system, including land and property ownership; developing institutions to deal with the rest of the world (not least a diplomatic corps); and setting up a range of national institutions. There is also the major problem of dealing with so many aid agencies and programs. In a country with a particularly traumatic recent history, deficiencies in core areas such as basic education and health need to be addressed more quickly than is usually the case, as the basis for constructing a viable and harmonious civil society. It takes time to establish effective tax collection procedures. As Haughton (Chapter 18) observes, in war-torn economies with shattered institutions,

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getting domestic revenues up to even 10 per cent of GDP takes time. The achievement of the interim administration in collecting about 7 per cent of GDP in FY2000/01 is therefore creditable. It remains unclear just how long this transitional fiscal period can and should last, and how large the subsidies and hence the deficit should be in the next three to five years. This in turn requires some assessment of the capacity of the emerging political system to get off the ‘subsidy drip’ after the transition period. The more pessimistic the assessment on this issue, the stronger is the case for pushing quickly for a tough fiscal stance to be taken by independence. As Rosengard (Chapter 3) emphasizes, it is important to cast the tax net as widely as possible, and to educate the community to expect to pay at least some tax, however low this may be for the poor. Similarly, the community will quickly need to become accustomed to the notion that government services are not costless, that even when they are free of charge, there is a cost associated with their provision.10 Which services should be subsidized, and by how much, are also large and complex issues, which revolve around social and distributional priorities. There seems little case, on either equity or efficiency grounds, for subsidizing electricity. By contrast, the case for heavily subsidized, or perhaps even free, basic public health and education, and some agricultural extension services, is surely a powerful one. We return to this issue shortly. One point is very clear: there will inevitably be pressures – from genuine nationalists to blatant rent-seekers – to establish national commercial symbols of ‘nationhood’ such as a national development bank, oil company and airline. These proposals will need to be scrutinized rigorously, cognizant of the overwhelming international experience that such enterprises almost always end up becoming vehicles for patronage, corruption and the inefficient use of scarce fiscal resources. Could anybody seriously argue, for example, that it is preferable to allocate government funds to a loss-making national airline than to nationwide anti-malarial and tuberculosis programs? Is it possible to somehow institutionalize a cautious approach to fiscal policy? Several well-managed East Asian economies have sought to achieve this through some sort of ‘balanced budget’ requirement. This might involve the budget being balanced over the course of a business cycle, or over some predetermined period (for example, five years). Alternatively, the government could simply be permitted to spend resources at its disposal, treating aid as a currentyear revenue item in the context of an overall balanced budget.11 In this context, adopting another country’s currency has the advantage that the government would not be able to fund a fiscal deficit through a monetary expansion authorized by the central bank. Finally, Rosengard touches on the issue of regional finance. Although small

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and geographically compact, East Timor will obviously want to develop some sort of provincial and/or local government network. This accords with the reality of geographic diversity adumbrated above, and with providing an important antidote to the alarming Dili bias evident in both the Indonesian and the UN periods. The obvious point to make here is the need for a suitable division of central and local government responsibilities, on the grounds of efficiency, equity and capability. Rosengard suggests that a guiding principle in these allocations would be to ‘follow the money’, thereby ensuring also that significant vertical fiscal imbalances do not emerge. Some sort of notion of fiscal equalization will also be necessary for national unity. Here, too, Timor has much to learn from other countries that have embarked on radical and ill-prepared decentralization initiatives. Regrettably, most of these examples are negative ones, none more so than Papua New Guinea (Elek, Chapter 20). Maximizing the Benefits from Aid Aid is about much more than macroeconomic management, but the discussion of fiscal policy provides a useful point of departure. Timor is currently receiving exceptionally large aid flows. While, as noted above, much of this actually accrues abroad, significant volumes are entering the domestic economy. These aid flows will begin to taper off as the immediate transition to independence is completed. But judging from the experience of other small and poor countries, the flows are likely to be large – perhaps as much as 10 per cent of GDP – for many years to come. There is an understandable Timorese ambivalence towards aid. On the one hand, it is obviously essential in the reconstruction effort and in establishing a viable nation state. Yet many worry that centuries of outside control and funding have resulted in a ‘providential mentality’, and an expectation of continued external funding. Inevitably, there is also frustration at the slow pace of Timorisasi, that UN staff are performing quite menial tasks which could easily be accomplished by Timorese, that UN administrative procedures are complicated and unwieldy, that there are huge salary differentials, and that there is slow progress in the preparation of Timorese bureaucrats for senior government positions. How can the value of aid flows be maximized? There is a large literature on this subject,12 from which at least the following factors emerge as highly relevant to East Timor. As Collier (Chapter 21) shows from African experience, it is possible for very well-managed economies to absorb productively up to 15 per cent of GDP, a figure that is indicative of magnitudes for Timor in its first decade of independence. As much as possible, East Timor needs a medium-term time-path over which some minimum level of aid flows needs to be guaranteed. This will provide the basis for planning major investment projects, and it will also provide

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enough confidence to incorporate some of these flows into the formal budgetary framework, the more so if some of the aid takes the form of direct budget support. Large annual swings in aid flows will be particularly difficult to manage, and ought to be discouraged. The three probable major bilateral donors to an independent East Timor – Australia, Japan and Portugal – thus have important responsibilities in this regard. While the East Timorese can reasonably expect the international community to be generous for some time to come, there is no certainty of this. In particular, as in Papua New Guinea, these flows could begin to wane quite quickly, just as they have been built into budgetary assumptions, especially if or given: • • • •

Timorese political squabbles intensify in the prelude to independence; there is a perception of really massive oil/gas revenues coming on-stream very soon; stories proliferate of UN waste and inefficiency; or other international crises erupt (including, not inconceivably, some nearby, such as in West Papua/Irian).

A second key issue is that the Timorese community needs to be in control of aid flows and priorities. This is to ensure that, notwithstanding an element of fungibility, funds are allocated to projects which the Timorese community desires, and for which it is willing to assume responsibility. This too is one of the key lessons of the African experience. The danger of aid is that it dilutes the government’s responsiveness to the community, and it may result in the deferral of tough policy decisions. But a genuine partnership, with the recipients in control, can be very effective. Aid projects that explicitly or implicitly require large local funding (either at present or in the future) need to be assessed very carefully, especially in light of donors’ well-known preference for tangible investment projects, which may often be very expensive to maintain. As a corollary, it makes sense for East Timor to be open to advice, perhaps on a large scale in the early years, which inevitably entails a significant expatriate advisory community. This makes sense in countries with limited bureaucratic capabilities and human capital. The skill requirements will obviously vary considerably across sectors. In some areas – primary education and health, local agriculture and infrastructure – the major need is simply funding to employ locally available skills. In tertiary education, fiscal management and financial supervision, Timor will need to rely on imported skills. The key points are to ensure that indigenous skills are being developed as quickly as possible and that expatriate advisors are fully accountable, and subordinate, to Timorese officials.13 It will probably be desirable to maintain a foreign peacekeeping force for quite some time, until the refugees are resettled, relations with Indonesia are normalized and the problem of the militias is resolved.

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Although there is much donor goodwill and cooperation, there are inevitable concerns about donor competition and overlap. Donors are cooperating in principle, and no doubt substantially in practice. But there are also worrying signs of incipient rivalry, from the Joint Assessment Mission of late 1999 onwards. All the donors want to have their own programs recognized and prioritized. They all have a tendency to favour capital works over maintenance. They all want access to the top echelons of the overstretched, tiny, internationally educated Timorese elite. Finally, large aid flows have intersectoral implications of the sort referred to in the ‘booming sector’ or ‘Dutch disease’ literatures. Since these effects are in principle the same as those resulting from a natural resource boom, they are discussed together in the next subsection. Managing a Natural Resource Boom Timor could derive undreamed-of wealth from its off-shore reserves of oil and gas (principally the latter). It is difficult to obtain anything remotely approaching a consensus estimate of what government royalties are likely to be. This is in part understandable. The reserves have not been fully prospected. The border with Australia over the Timor Gap has yet to be settled, and negotiations are proving complicated, with an 85:15 split in Timor’s favour now emerging as a likely outcome. Moreover, future price trends are difficult to project, and a Timorese taxation regime has to be formulated. But it is disturbing how wide the range of quasi-official estimates appears to be – from about $50 million per year after about seven years, trailing off quite quickly, to $300 million per year within 10 years, lasting two decades or more. If one takes a conservative midpoint between these figures, the relative magnitudes are large. Government revenues equivalent to about 25 per cent of GDP for at least a decade appear plausible. How should these funds be managed for the betterment of all the Timorese people? The range of international experiences is diverse, with the most common outcomes being waste and corruption on a very large scale.14 As Collier (Chapter 21) points out, Nigeria demonstrates perhaps the worst of all outcomes: over more than three decades it received about $280 billion from its oil, more than the total of all aid to Africa over this period, but real per capita income actually declined. The key issue is whether a fragile, competitive, probably unstable political system, in which there are tremendous pent-up expenditure pressures, can manage these flows effectively, however well intentioned its political leaders. One especially dangerous strategy would be to develop a budgetary strategy – or, even worse, borrow – on the assumption that anything like the amounts mentioned above will quickly become available. As Elek (Chapter 20) shows for the case of post-independence Papua New Guinea, resource revenues were always less than expected, and the increase in these revenues never matched the decline

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in aid flows. Related to the latter point, it will be important to ensure that donors do not impose, in effect, tax rates in excess of 100 per cent on these revenue flows through a sharp withdrawal of aid. While East Timor will no doubt do better than Nigeria, there is no reason to presume that it will perform above the average unless explicit measures are enacted to ensure that the funds are invested wisely. One strategy which commends itself is the approach adopted by Botswana to the management of its diamond resources (Collier, Chapter 21; Leith 1999). A poor, landlocked country consisting mostly of desert, it may serve as a viable model for East Timor. This approach involves treating natural resource royalties as a capital item and investing them abroad in an off-shore escrow account. The result is a revenue stream which is obviously much smaller than the direct proceeds during the lifetime of the gas fields, but which lasts for considerably longer. It removes the temptation for massive corruption; absorptive capacity is much less of a problem; and it is intergenerationally fairer. Encouragingly, there are early indications that East Timor may embark on such an approach to managing its natural resources.15 Nevertheless, good intentions alone are not enough. There needs to be a broad community consensus in favour of this policy, rooted in the political parties and the bureaucracy. An intensive public campaign of education and information at the outset of independence will be required if there is to be any hope of success. As noted, given pressing reconstruction needs in infrastructure, education and health, there may be a case for using some of the revenue directly in the early years – if aid flows fall short of what is expected, and if there is confidence that the politicians and bureaucrats can be trusted to deliver effectively.16 One inevitable consequence of the gas (and aid) booms will be the phenomenon known as the Dutch disease. In other words, large capital inflows will have important intersectoral implications, by increasing the returns to non-tradables as compared with tradable sectors. In most economies, this operates through both exchange rate and domestic expenditure effects.17 Adjustment to these changes will occur through a nominal appreciation (if the country has a floating exchange rate regime) or higher inflation rates relative to the country’s trading partners, or both. The effect will be to squeeze non-gas tradable industries such as traditional agricultural exports (for example coffee), nascent import-substituting manufactures, and service exports (for example tourism). It is important to emphasize that these intersectoral effects are an inevitable consequence of the structural changes in the economy that a resource boom implies. However, several measures can be taken to ameliorate the effects. One is an open labour market. A resource boom of the magnitude being contemplated in East Timor will have massive implications for the labour market. A closed market, in the context of a small stock of skilled workers, would inevitably result in huge wage increases, the primary beneficiaries of which

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would be a small urban elite. To spread the benefits, and thereby ensure that both the escalation in non-tradables is contained and that government programs are more expenditure-efficient, it would be desirable to ensure that the labour market is internationalized as much as is politically and socially possible. An obvious constraint here is that large numbers of workers suddenly appearing from Indonesia – the immediate source – would probably cause social tensions. The Philippines might be a politically preferable source of labour, especially as it has a long-established tradition of labour export and is religiously compatible. Skilled workers will presumably be sourced from a more diverse group of countries, most especially Australia, and thus the same sensitivities will not be present. It will also be important not to use wage policy as a means of appropriating the benefits of the natural resource boom, so that the spending boom is not dissipated in escalating wages or confined to an urban labour aristocracy.18 Another important strategy will be to invest in social and physical infrastructure, to spread the benefits more evenly through the community and to enhance supply-side capacities. Much of this investment would take place in the countryside, in public works employment projects, and in urgently needed education and health programs. Trade, Commerce and Relations with Indonesia Trade Policy As Hill (Chapter 4) puts it, three lessons from economic development should inform commercial policy in East Timor: • • •

outward-oriented economies outperform inward-looking ones; in small economies the costs of trade intervention are large and quickly evident; and by dint of geography, it is sometimes observed that ‘God made archipelagic Southeast Asia for free trade’.

East Timor has very little choice but to maintain an open trade regime, where the lower boundary is obviously free trade, and the upper limit is Indonesia’s (now very open) trade regime. East Timor’s sea and land boundaries with the rest of eastern Indonesia are so porous that high trade barriers would almost certainly be circumvented by smuggling. Relative to its land area, East Timor has a long coastline, and a long land boundary (of approximately 170 kilometres) with Indonesia. Much of it is impossible to police and, as relations with Indonesia are normalized, informal trade will simply become a matter of course. In addition, non-tariff barriers to trade should be avoided owing to their

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lack of transparency, their corruption-prone nature, and the fact that their rents invariably accrue to individual beneficiaries rather than the public purse. It might be argued that, in the absence of effective income and expenditure tax-collection procedures, tariffs are necessary for revenue-raising purposes. This is the approach of the interim administration: there is a 5 per cent acrossthe-board import duty plus a fairly widespread 5 per cent surcharge. The latter applies principally to ‘luxury’ goods and services. While it might be tempting to fine-tune the tariff structure to meet equity objectives, the more complex the system, the more it will impose on a very limited bureaucratic capacity. Over time, and notwithstanding the administrative difficulties, it would seem desirable to shift towards some sort of turnover tax as quickly as possible, so as to avoid the temptation of using duties as protective devices. East Timor’s major trading partners will inevitably be Australia and Indonesia. Assuming that it maintains a policy of open frontiers, no special policy initiatives will be required to develop these relationships other than measures to ensure customs harmonization, to promote trade perhaps, and to provide competitive transport services. Preferential trading arrangements would be irrelevant if East Timor opted for free trade, and should be avoided if the uniform tariff option is adopted. There would be obvious benefits for East Timor in joining the Association of Southeast Asian Nations, ASEAN. Membership would give it access to an influential regional grouping and help to broaden its Southeast Asian ties beyond Indonesia. It would connect it commercially to several strong, outward-looking economies, from which it could also learn much in the area of development policy and practice. The Commercial Environment A major development challenge for an independent East Timor will be how to achieve strong and durable private sector growth. Currently, as Hill (Chapter 4) observes, it is not an attractive destination for footloose investment. Not surprisingly, most investment is going into quick-yielding construction, hotel and restaurant projects. Different types of investors will obviously face varied sets of challenges. But among the problems common to virtually all investors are: • • • •

highly insecure ownership arrangements, especially for land (Fitzpatrick, Chapter 11); higher cost structures than those of potential competitors (that is, competitors for footloose investment), such as Indonesia and Vietnam – wages are much higher in Timor; acute shortages of skilled and semi-skilled labour; poor infrastructure, uncertain and expensive (when finally billed!) power supplies, and poor telecommunications;

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22 • •

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These problems are perhaps inevitable in the early transition period. But they will need to be addressed quickly if rapid economic development is to be achieved, and if East Timor is not to avoid the common Pacific Islands pattern of ‘FIFO’ (fly-in, fly-out) investment (on which see Chand, Chapter 19). Relations with Indonesia Managing relations with its erstwhile ruler and giant neighbour will be one of the most difficult challenges for the new East Timorese leadership. While the focus here is on economic issues, the relationship is about much more than trade and commerce. East Timor will need to forge a practical development partnership while also managing the complex political issue of reconciliation, and legal action against elements of the Indonesian military who perpetrated some of the worst human rights violations in 1999. As Soesastro (Chapter 5) emphasizes, East Timor will have to live with an unstable and unpredictable Indonesia. It will hardly register on Jakarta’s radar screen, as its political leadership is engulfed in daily crises. And, while President Abdurrahman Wahid seems quite well disposed towards Timor, many Indonesian ‘nationalists’ are not. A Megawati presidency, for example, could usher in considerable additional uncertainty for Timor. But there are also great opportunities in the relationship. Indonesia can, as Soesastro puts it, make a major contribution towards alleviating Timor’s ‘highcost’ economy and diversifying its current heavy reliance on expensive northern Australia. It will be important, in this context, for transborder and maritime shipping services to be able to operate in an unhindered manner as relations are normalized. It is also important that East Timor has access to a wide range of Indonesian services and skills, ranging from agricultural extension and research to tertiary education. The latter is especially urgent for the thousands of East Timorese university students whose studies were interrupted in 1999. In addition, there will need to be cooperation across a wide range of activities, including shipping (East Timor is simply unable to police its large international maritime zone) and cross-border infrastructure. Finally, there are many residual, complex issues in the wake of the abrupt termination of relations that need to be sorted out. These include Timorese accounts with (now-departed) Indonesian banks, payments of pensions to Timorese who worked for the former provincial government, Timorese living in Indonesia who wish to return home, and the treatment of Indonesian property. Putting relations between East Timor and Indonesia into a broader context, two immediate issues will require attention. One is the special case of

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East–West Timor relations. The events of 1999 have created numerous challenges for this relationship. Traditional cross-border flows of people and goods have been severely disrupted. The western region of East Timor, whose commerce is closely integrated with that of West Timor, has been particularly affected. West Timor has had to carry much of the burden of the displaced East Timorese refugees. More generally, and as relations normalize, there will be continuing tensions between the east and the languishing, neglected west as international largesse is lavished on East Timor, whose living standards in consequence could rise quite quickly. Already one of the poorest regions in Indonesia, located in the poorest province of Indonesia (East Nusa Tenggara), West Timor’s economic prospects are jeopardized not only by Indonesia’s sluggish and erratic recovery, but also by the fact that it will almost certainly lose resources as part of the major decentralization initiative currently under way. It will be important for steps to be taken – again, once relations are normalized – to allow West Timor to participate in the east’s growth. Returning to historically unrestricted cross-border trading arrangements will be an obvious place to start. The second challenge will be the management of the trilateral Indonesia– Australia–East Timor relationship. Indonesia and Australia will dominate Timor’s political, strategic and commercial life. A diffident Australia–Indonesia relationship, which was seriously strained in the wake of the events of September–October 1999, would pose great difficulties for Timor. Any tensions would almost certainly spill over to Timor, complicating its path towards peaceful reconstruction and its entry into the international community. This would particularly be the case if, as seems quite possible, the insurrection and secessionist pressures in nearby West Papua/Irian intensify.19 Independent of how this triangle takes shape, Australia’s role in East Timor will be critical. It played the major role in restoring peace and security in 1999 and subsequently in the peacekeeping force. It will probably be the major bilateral donor, and it is providing much technical assistance to the Transitional Administration. Nearby Darwin is the gateway for much international movement of goods and people, and was the lifeline during the critical months after September 1999. The Timor lobby in Australia is small but vocal. But the relationship will have its limits. Australia does not want to have to take prime and long-term responsibility for what some see as another ‘mendicant state’ in the region. The government does not want its still-rocky relationship with Indonesia to be dominated by the Timor issue. The Timor Gap treaty negotiations have proved more difficult than expected. There is even concern that East Timor could become a major conduit for illegal migration to Australia. The northern regions of Australia constitute less than 5 per cent of the national population; they are distant from major centres and heavily subsidized; and the economy is a high-cost one. There will therefore need to be skilful management of a diverse array of

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economic, social and security issues on both sides. While development assistance and security cooperation will always be significant, it will be important for both sides to look beyond these elements, which have naturally dominated the picture in the early years. The two countries’ proximity and their huge economic differentials do create opportunities, and practical cooperation may in time ameliorate some of the ‘dependency’ concerns. Business and social ties between Timor and north Australia are likely to expand, based upon spin-offs from the exploitation of Timor’s natural resources, cooperative ventures in tourism, the provision of education and business services, and possibly some labour-intensive investments in Timor. Agriculture and Rural Development The five chapters on this topic provide a comprehensive survey of the past record, development potential and future policy challenges. They are also nicely complementary. Fox (Chapter 10) stresses regional and ecological diversity. Da Costa (Chapter 9) examines the bases of East Timor’s likely future comparative advantage, and the implications of a resource boom. Timmer (Chapter 6) defines the key elements of a food policy for East Timor. Pomeroy (Chapter 8) looks at the special and important case of coffee. Barlow (Chapter 7) provides a broadranging analysis of past developments and future issues, focusing in particular on measures to make rural markets and institutions work effectively. Agriculture will be the key to East Timor’s development and social progress. Its share may appear to be quite low for such a poor country. During the late Indonesian period it contributed about one-third of GDP, being overshadowed by the inflated government sector. Currently, aid and related spinoffs dominate much of the economy, while oil and gas could soon loom large. But the majority of Timorese derive their welfare from agriculture, and this will be the case for many years to come. The turbulence of 1999 affected agriculture, but less so than it did the modern urban economy. Planting activities were interfered with, but only moderately so. Limited damage was inflicted on crops, trees, livestock and rural infrastructure. Subsistence agriculture displays a resilience to these kinds of events, just as it did to the economic crisis of 1997–98. The most serious effects appear to have been the massive, forced relocation of the population in late 1999 and the destruction of marketing channels. Some 200,000 people were evacuated by the Indonesian military. Almost half of them are estimated to remain across the border, while many have migrated to urban areas, in search of employment opportunities or for security reasons. As a result, the rural areas have been considerably depopulated. Rural dwellers need to be able to return home, not least to take the pressure off the high-unemployment urban areas and to re-energize agriculture.

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Rural markets appear to have been considerably disrupted. The Indonesian food-marketing system, while interventionist and distorted, at least ensured that buyers and sellers were connected. This system collapsed immediately in late 1999, and many of the non-Timorese traders fled. In consequence, a serious problem of ‘incomplete markets’ appears to have emerged. In 2000 and 2001, sizeable spatial price differentials have been reported, alongside surpluses in some regions and deficits in others. In addition, the sharp increase in prices since 1999 for (mainly Indonesian-sourced) basic consumer goods such as soap, cooking oil and salt has affected the price-setting behaviour of farmers. At least in the short run, the agriculture–manufacturing terms of trade has turned against farmers. The danger in such circumstances of great uncertainty is that risk-averse farmers will revert to traditional practices and technologies, eschewing modern varieties and thus foregoing the opportunity for significant yield increases. In a well-managed environment, these could be considerable. Barlow (Chapter 7), for example, suggests that whereas agricultural output grew by a quite respectable 3 per cent per annum in Indonesian times, it could increase by more than this in the future. Yields of maize, the Timorese staple, could double on a sustainable basis. There is much potential in coffee if the reforms advocated by Pomeroy (Chapter 8) are introduced. Fox (Chapter 10) suggests that rice yields could increase substantially with improved irrigation. The policy challenges to get agriculture moving again are diverse. Timmer (Chapter 6) draws attention to the key elements of a viable food policy, including agricultural extension services, reasonable certainty concerning price/cost margins, adequate price and market information, competition among traders, openness to international markets (especially Indonesia) and investments in physical infrastructure. As long as markets remain poorly developed, there is in principle a case for a more activist intervention regime in the short to medium term. However, it is not obvious that an independent East Timor will have either the resources or the capacity to manage such a regime. For one thing, under the current, very tight, fiscal regime, the agricultural extension service has been trimmed severely.20 In these circumstances, as Barlow (Chapter 7) emphasizes, the key will be to work with local institutions and communities. The ‘top-down’ approach favoured during Indonesian times is neither feasible nor desirable. As he emphasizes, many of the required extension services need not be capital-intensive – better mulching, improved coffee pruning, local irrigation systems and basic road maintenance can all be developed through local community organizations, combined with judicious extension inputs. In sum, agriculture faces many challenges. These range from the immediate issues of providing incentives and opportunities for rural dwellers to return home, infrastructure rehabilitation and land ownership, to reactivating rural

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markets and the extension service, and re-establishing cross-border commercial ties. Although the majority of rural households obtain most of their livelihood from agriculture, the importance of off-farm rural activities will also need to be recognized. Broader challenges include coping with, and adjusting to, the intersectoral implications of large aid and, imminently, gas flows, and more generally the danger of an urban elite appropriating the benefits of commercial opportunities and budgetary allocations. Finally, there is likely to be a sharp reduction in funding for a range of government services. How an independent East Timor manages these issues will have a large bearing on the livelihood of its predominantly rural populace. Finance and Infrastructure: Making Markets Work Finance and physical infrastructure are two key elements in making markets work better. There are special challenges in both areas for East Timor. Financial Development There was a complete collapse of formal financial institutions in East Timor following the hasty departure of the Indonesian banks in 1999. The exodus entailed not just the institutions, but also much of the human capital expertise and the financial records. It is difficult to determine how much the informal financial channels were also affected, but the damage must have been considerable given the widespread general disruptions. There is now much impatience at the slow recovery of the finance industry. Australian and Portuguese banks have been established in Dili, but they function simply as deposit-taking institutions. Outside the capital, no formal financial institutions exist. The obstacles to financial development are substantial: there is uncertainty regarding the status of the formal legal code, and there is no financial supervisory capacity. Owing to the confused state of land ownership – the principal form of collateral in the formal sector – lenders are unable to obtain secure title for their loans. Even though collateral arrangements are more informal for smaller borrowers, this uncertainty still affects them adversely. As McLeod (Chapter 13) observes, the government will need to move cautiously and deftly in this area. It will make sense to leave the formal sector initially to foreign banks, since this relieves an overtaxed government of the complex task of financial supervision and regulation. It is to be hoped that Indonesian banks can be re-established quickly. This would help resolve the problem of the Timorese who have accounts with Indonesian banks and would also facilitate Timor–Indonesia commerce. Over time, it may be possible for bank executives with knowledge of Timorese business from Indonesian times to be able to return. Well-established exporters should be able to obtain credit from international

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customers. In time local banks can be expected to develop. As this occurs, the government will then need to formulate a regulatory environment which will ideally feature simple, easy-to-implement, transparent rules that ensure prudent behaviour on the part of financial institutions (for example, by requiring very high capital adequacy ratios). As McLeod stresses, it will be dangerous to push this process too quickly, before the regulatory and business skills are in place. He also argues, plausibly, that a national development bank, or subsidized credit programs, would be risky strategies, as they invariably become instruments of corruption and patronage, and a drain on scarce fiscal resources. Rural, informal credit markets may be recovering more quickly. This process will continue as normal life begins to resume in rural communities, agricultural output continues to recover, and product and factor markets are reestablished. Some non-government organizations (NGOs) with international funding are now active, with encouraging results. It will be very important here too that the government eschews a heavy-handed regulatory approach in favour of one which emphasizes getting markets to work. In this respect, Timor would have much to learn from Indonesia’s successful Kupedes small credit program (on which see Patten and Rosengard 1991), which also operated in the thenprovince of East Timor. For formal and informal financial institutions alike, the importance of resolving the land ownership issue is critical.21 In the absence of such a resolution, it is difficult to envisage much formal financial development occurring. A comprehensive land-titling exercise may not be so vital for the development of informal rural credit markets, but resolving the current high level of land disputation is crucial. Infrastructure Infrastructure rehabilitation and development are equally vital. Here, in contrast to the case of finance, the public sector will have to play the key role, as provider at the national, and probably also provincial, level, and also as regulator. As Cheatham and Jarvenpaa (Chapter 14) observe, as a consequence of large investments during the Indonesian period, East Timor’s road network is quite comprehensive for an economy of its size. Roads, and more importantly bridges, were left intact by the Indonesian military, although usage by security forces has been heavy since 1999. The primary issue is therefore whether it is possible to preserve and maintain the network, not whether to expand it.22 East Timor, they point out, will always be a challenge for road works, owing to its difficult terrain and ‘spongy’ soils. Cheatham and Jarvenpaa estimate that the annual road maintenance bill will be about $18–20 million, equivalent to about 32 per cent of the budget and 6–7 per cent of GDP. Clearly this is well beyond Timorese capacities. The difficulty is how to fund the shortfall or, if this is impossible, what to cut. Aid and in time

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gas revenues may help, although there will be many other claims. User charges – such as a fuel tax and vehicle registration fees – are another option to at least partially close the gap. Perhaps there will also be trade-offs for quality (for example, these estimates are for ‘international-quality’ roads). Local communities may have to assume responsibility for feeder roads. Much power infrastructure was destroyed in 1999, including 30 subdistrict power stations. Little institutional capacity remains from the former PLN (Indonesian) system. A large backlog in maintenance has to be cleared. Repairs have proceeded most quickly in urban areas, with the result that the system is now very Dili-based.23 Power supplies are erratic and illegal connections proliferate. Up-country fuel distribution remains a major challenge. The Indonesian state oil company, Pertamina, continues to supply fuel to East Timor. Extraordinary though it may seem, almost 18 months into its administration the interim government is still not charging for electricity. Apart from the obvious immediate fiscal implications (namely the cost, plus encouraging consumption of a currently ‘free good’), such negligence will make the task for the maiden Timorese administration of enforcing user-pays principles that much more difficult. There can surely be little justification for electricity subsidies on either equity or efficiency grounds. Cheatham and Jarvenpaa observe that electricity will probably always be expensive in East Timor, as it is in the South Pacific, owing to its small, scattered market and inability to exploit scale economies. Its topography is such that it will probably make sense to aim for a national power grid only to the provincial capitals and more accessible regions. More isolated localities may have to rely on local generators. Solar or hydro power could be feasible in such locations, and perhaps even on a wider scale. Social Policies As noted above, East Timor faces a daunting array of social policy challenges. These are addressed in some detail by Booth and Jones (Chapters 15 and 16) and include the following. Demographics East Timor has high levels of fertility, which contribute to high population growth. Owing to its poverty, and probable Church-centred resistance to contraception, sustained and rapid population growth is in prospect. This is likely to slow the rate of economic development. Jones (Chapter 16) points to the urgent challenge resulting from everincreasing cohorts of young people moving into and through school-age groups. One clear lesson of economic development is that the stock of human capital is

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central to progress (Mankiw, Romer and Weil 1992). These young Timorese need to be well educated, healthy and well nourished if Timor’s growth ambitions are to be realized. Health We lack precise estimates, but East Timor undoubtedly has high infant mortality rates and low life expectancy compared with most of Southeast Asia. Malaria is prevalent, especially on the wet south coastal plains, as are respiratory diseases (including a very high incidence of tuberculosis) and gastrointestinal infections. Education Although age-specific education enrolment ratios increased significantly during the Indonesian period, they are still quite low and standards are poor. An additional challenge is that a chronically underfunded system now has to come to terms with a new official language, Portuguese (albeit with substantial Portuguese-government funding), reportedly spoken by just 5 per cent of the population. Gender Differentials The official statistics seem to suggest that the gender bias in education is modest, and much improved as compared with the late Portuguese era. But casual observation does not always support this conclusion, especially at senior secondary and tertiary levels. Poverty and Inequality In the late Indonesian period, East Timor had one of the highest incidences of poverty in the region. There was also quite high household and spatial inequality, at least compared with neighbouring regions. Rural poverty was apparently ameliorated somewhat by low levels of landlessness. Urbanization, Dili Bias and Population Resettlement As noted, the events of 1999 resulted in very large population resettlement and unsustainable levels of urbanization. By early 2001, although no systematic population census had been undertaken, Dili was thought to have about 20–25 per cent of East Timor’s population, and urban areas in total about 40 per cent. This is creating a social time-bomb, given the huge income differentials in Dili, especially between the expatriate community and the mass of underemployed Timorese. There are also serious labour shortages in agriculture. If the problem is not addressed quickly, then as the aid-driven recovery boom subsides, young unemployed migrants will be ‘trapped’ in Dili, with serious social consequences.24

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Labour Market Disequilibrium Wage levels have risen sharply since 1999, and in urban areas and cash crop agriculture are now about double the comparable levels in Indonesia.25 Several factors explain this: a high cost structure, with basic Indonesian goods about twice the price prevailing in Surabaya; a high minimum wage in the public sector, which has in effect set a floor for wages in the formal urban labour market; and a sudden, sharp increase in the demand for labour as aid has poured in. The danger is that if these ‘disequilibrium’ levels become entrenched – as there is every prospect they will – East Timor’s international competitiveness will be jeopardized, and there will be high unemployment for the majority of job-seekers who cannot join the ranks of the emerging labour ‘aristocracy’. Faced with these daunting challenges, it is hard to know where to begin. But, as both Booth and Jones emphasize, prioritizing will be critically important. Mass public health programs will surely deserve a high priority, in preference to government funding of the expensive, capital-intensive, urban-based, ‘modern-sector’ hospital sector. The latter is best left to the market, with the elite paying for treatment abroad. Similarly, investments in mass primary, and possibly also vocational, education will have a higher social return than subsidies to the tertiary sector.26 A particular challenge here too is that the tight fiscal framework dictates a reduction in the number of teachers and paramedics as compared with the Indonesian period. Female autonomy will be a critical element of the development process, not just for fundamental reasons of equity, but also to ensure the success of programs in family planning, child nutrition, rural credit markets and much else. More broadly, these social sectors will, it is hoped, be funded in preference to subsidies for electricity and fuel (which primarily benefit the better-off) and any proposed commercial investments. The most important anti-poverty weapon is of course sustained, labourintensive economic growth. It is surprising how often this fundamental proposition is overlooked, even though 40 years of East Asian development has demonstrated its veracity. In addition, and especially during the rehabilitation phase, there would seem to be a strong case for public sector employment programs. They provide immediate employment relief, and could help with national reconstruction. Perhaps they could form part of a broader, rudimentary social safety net whose key components might be essential foodstuffs, basic public health and employment. Increasing agricultural productivity is likely to have a particularly important anti-poverty edge, as Timmer (Chapter 6) emphasizes. In this context, it will be imperative to avoid the current Dili bias becoming embedded as a permanent feature of budget decisions, the labour market, social priorities and political power.

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Finally, an open, competitive labour market will be of critical importance. The objective ought to be to achieve rising real wages through increased productivity rather than administrative fiat. If Timor develops a rigid labour market, with a high-wage urban enclave, the social and economic consequences could be disastrous. This is especially so if, as seems likely, it opts for dollarization or a currency board, which thereby removes the option of achieving relative price flexibility though the exchange rate. As noted, with a natural resource boom on the horizon, an open labour market will be an important means of mitigating the Dutch disease consequences. Politics and Institutions Political Structures The contributors to this volume do not address domestic political developments and scenarios, but the political backdrop is ever-present. The emerging political parties are likely to be predominantly personality driven and focused, and there is unlikely to be a major economic policy divide between them. Fortunately, most are nationally, not regionally, based. It is unclear whether parties associated with Indonesian-era political leaders, who nevertheless attempted to promote Timorese interests, will attract more popular support than those led by ‘diaspora politicians’. In any case, the divide between the two groups is often not all that clear. There also appears to be some concern that the wealthy families from the Portuguese colonial era may seek to reassert their dominant commercial and political position. Timorese society has changed radically in the ensuing quarter-century. The populace is much better-educated. It has more international experience, mainly in Indonesia, which a surprising number of younger Timorese have visited, worked in or studied in for extended periods. Quite a few of them tasted rising prosperity for two decades, albeit under highly authoritarian circumstances. After Tetun, this generation’s principal language is Bahasa Indonesia, not Portuguese or English. And it is a much more politicized generation than the one before it. Mackie (Chapter 12) sketches some of the key considerations as East Timor moves quickly to develop its political and constitutional architecture. He emphasizes that the Northeast Asian model of an ‘insulated state’, in which economic policy ‘technocrats’ – protected by their political masters – can adopt ‘first-best’ solutions, is unlikely to be operative in East Timor for several reasons. On political structures, he maintains that a ‘winner-takes-all’ presidential system is dangerous, since it would disenfranchise a significant proportion of the population. The Westminster system also has its drawbacks. Some sort of hybrid model – which, coincidentally, Portugal also has – may be preferable. Whatever the case, political parties need to have reasonably deep roots in

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society, to avoid, for example, the problems of chronic political instability and turnover that have plagued Papua New Guinea. In drafting the constitution, Mackie’s principal advice is that a balance needs to be struck that enables change to be neither too difficult nor too easy. What can East Timor do to place checks on corruption? There is of course no simple solution, and much depends on the political leadership showing the way. In addition, a combination of measures commend themselves. Civil service remuneration needs to be broadly competitive with private sector alternatives. Strict auditing procedures need to be instituted, and harsh penalties put in place for offenders. Regulations need to be simple, transparent and as non-discretionary as possible. Broader societal checks and balances, such as the press and NGOs, need to be encouraged. Above all, administrative overload, not least among the donors, should be avoided.27 There was some debate about whether a new Timorese administration, with tough decisions to make, should blame ‘others’ as a politically expedient means of convincing parliamentarians and the general community of the need for reform. For example, when electricity and fuel subsidies are removed, perhaps attention should be drawn to the United Nations for its waste and inefficiency. Indonesia might be singled out for numerous shortcomings. Such a strategy has appeal but may be risky. East Timor needs friends everywhere, and it especially needs to adopt a pragmatic working relationship with Indonesia. Attacking Indonesia, the more so if a ‘nationalist’/Megawati regime were in power, could easily backfire. Land Ownership Land tenure and titling are among the most highly complex and politically sensitive issues to be addressed by an independent East Timor. Currently, land and property can be claimed under four separate jurisdictions: traditional, Portuguese-era, Indonesian-era and post-1999 arrangements. Land disputes are rife and, after so much suffering and conflict, the Timorese people will not be at peace with themselves until clear rules are established. The transitional UN administration is, perhaps understandably, deferring to the Timorese on this, but decisions will have to be reached as a matter of urgency. Fitzpatrick (Chapter 11) emphasizes that, while there are no simple solutions or quick fixes, workable compromises can be devised. It is not feasible, he stresses, to go back to the pre-1975 arrangements; not surprisingly, some of the powerful old families advocate this option. There is a common assumption that all property transactions conducted during the Indonesian era were fraudulent. While many were, particularly those related to the military and the Jakarta elite, quite a few were not, and these latter transactions cannot be dismissed summarily. Nor is it feasible to start from scratch, as some have advocated, with interim nationalization of all land pending the drawing up of a new code.

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The issue is as much political as it is technically legal. At all costs, Timor needs to avoid the problem common in the Pacific Islands of extravagant compensation claims suddenly surfacing when any major development project – even a road for the benefit of a local community! – is proposed (see Chand, Chapter 19, on this point). Fitzpatrick suggests, as a basic starting point, that it would make sense to register as much land as possible that is not subject to competing claims. Then, where competing parties are present, he presents the main elements of a framework for moving forward. Much case-by-case work will inevitably be required.28

CONCLUSIONS The people of East Timor finally have control over their own destiny. They have inherited a small, war-torn, extremely poor economy. As they contemplate future options, two key messages would seem to be paramount. First, development is a slow, long-term process. There are no quick fixes. Going from practically the bottom of the development ladder, with a per capita income of around $300, to middle-income developing country status will take decades, even under the most optimistic scenarios. Second, policies are the key to development success. Looking forward, East Timor’s prospects are finely balanced. It is possible to construct both a pessimistic and an optimistic scenario, as alluded to earlier. The future for the country is not path-dependent. The right policies, of the type outlined in the contributions to this volume, will result in an increasingly prosperous and dynamic economy. However, it is just as easy to envisage serious policy mistakes leading to socio-economic stagnation of the kind that afflicts much of the third world. It will be a matter of decades, not years, before we can be sure that East Timor is on the road to development success. Indeed, one of the lessons from other countries’ experiences is that some of the most daunting challenges appear after the first decade of independence. Initially progress may be rapid. There is the enthusiasm and idealism associated with nation building and reconstruction; the ‘generation of struggle’ possesses great moral authority and constitutes a powerful check on abuses; and there is plenty of international aid and expatriate policy advice available. The real problems may begin to occur subsequently, as these factors fade. It is important, finally, to stress once again that one of East Timor’s great advantages is that it can learn from others’ mistakes. The country’s leadership has had one-quarter of a century to witness the mistakes of others. They have seen nearby, in Papua New Guinea, a promising experiment in nationhood disappoint. Many have first-hand experience of the desperate socio-economic

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conditions in Portugal’s former African colonies. It is to be hoped that these valuable lessons, combined with a commitment to national development, will launch the country on the path to development success.

NOTES *

1 2

3

4

5 6

7 8

9

In preparing this overview, we have drawn freely on the contributors and on general Economic Policy Forum discussions. We are particularly indebted to Helder da Costa, Jay Rosengard and Etienne van de Walle for many useful discussions and comments on an earlier draft. All figures throughout this book are given in US dollars unless stated otherwise. Some simple arithmetic is perhaps the clearest means of illustrating this point. Even with very rapid growth, of (say) 5 per cent per capita GDP, it would take 12 years to catch up to Indonesia’s current (and very depressed) level of GDP per capita, and 53 years to Malaysia. Slower growth, of 2 per cent per capita – higher than most of Timor’s usual comparators – would stretch these periods to 55 and 131 years respectively. Morawetz (1977) remains one of the most useful volumes in reminding us of the poor track record of ‘development experts’ in picking likely future development success stories – and failures. Major studies of the East Timorese economy include da Costa (2000), Saldanha (1994), Saldanha and da Costa (1999), and Soesastro (1989). The most detailed study of the early post-Indonesia period is Valdivieso et al. (2000). See also UN/World Bank (1999) and Hill (2001b). Pederson and Arneberg (1999) provide a very comprehensive compendium of bibliographic material through until the end of the Indonesian period. See Hill (2001b: Table 1), from which the figures in this paragraph are taken. One has to be extremely cautious in using these figures, and in comparing the Indonesian and UN regimes. It is impossible to estimate the ‘leakages’, the funds that effectively do not enter the East Timorese economy – salaries paid to foreign bank accounts, profits accruing to foreign contractors, or simply corruption. Similarly, the pricing of services rendered is difficult to estimate. Presumably services provided during the Indonesian period were more ‘expenditure-efficient’, owing to much lower salaries. Conversely, corruption and overstaffing were more widespread during the Indonesian period. There is a large literature on this subject. See, for example, Armstrong and Read (2000), Briguglio (1995) and Easterly and Kraay (2000). The Australian dollar also meets most of the technical requirements. However, its adoption could well complicate the shaky triangular Australia–Indonesia–East Timor relationship. This problem was becoming increasingly acute in March–April 2001, in part owing to Bank Indonesia’s decision in January 2001 to limit the off-shore trading in rupiah. The measure was directed at the Singapore market, but unfortunately East Timor got caught up in the backwash.

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10 Elek (Chapter 20) draws attention to this problem in the case of Papua New Guinea: an inadequate appreciation of the cost of providing public services such as education and health led eventually to funding cut-backs and consequently a serious deterioration in quality. 11 Foreign borrowings are another matter. In principle it makes sense to borrow if the rate of return on borrowed funds exceeds the interest rate, and East Timor can expect to be able to borrow at highly concessional rates for the foreseeable future. Moreover, there may be occasions when the borrowed funds are indivisibly attached to required technologies. However, one would want to counsel great caution on public sector borrowings, at least for the first decade of independence: plentiful grant funding should be available, large natural-resource revenues are in prospect, and it is doubtful that East Timor will have the bureaucratic or absorptive capacity to manage such borrowings. There is no reason in principle for any restriction on private foreign borrowings. The government may want to monitor such borrowings, in case these flows became large and volatile enough to complicate macroeconomic management. It will of course be imperative to ensure that private borrowings abroad do not attract implicit or explicit government guarantees. 12 For lessons from international experience see, for example, Burnside and Dollar (2000), and the papers in this volume on Africa (Collier, Chapter 21), Papua New Guinea (Elek, Chapter 20) and the Pacific Islands (Chand, Chapter 19). A salutary, though depressing, study emphasizing the difficulties small and weak states have in effectively absorbing large aid flows is provided by Morss (1984). 13 It needs to be emphasized that, in view of East Timor’s isolation, rigorous recruitment procedures should be put in place. The danger otherwise is that it could be saddled with second-rate advisory quality, a feature already emerging in the transition period. 14 The best cross-country examination of the effects and management of resource booms remains Gelb and Associates (1988). It is worth recalling that, in this multicountry study, Indonesia emerged as the only country outside the Middle East that had managed its resource boom reasonably effectively. 15 For example, in a speech to the Economic Policy Forum, the Minister for Economic Affairs in the transitional government, Mari Alkatiri, indicated his in-principle support for something like the ‘Botswana model’. 16 In passing, it might be noted that international experience strongly suggests that the most effective way of maximizing returns from natural resource investments is through an effective taxation regime, rather than investing in a state-owned oil company. One only has to look as far as Indonesia, which otherwise managed its 1970s oil boom revenues reasonably effectively, to understand this proposition. On the mid-1970s debacle surrounding the state-owned oil company, Pertamina, see McCawley (1978). 17 See Corden (1984) for a synthesis of the literature, and da Costa (Chapter 9) for discussion in an East Timorese context. 18 In an earlier version, Elek (Chapter 20), for example, recounts the disastrous effects of Papua New Guinea’s 1974 minimum wage case, with wages set at the height of world copper prices (which fell sharply thereafter), and urged on by an Australian

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19

20 21

22

23 24

25

26

27

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Hal Hill and João M. Saldanha labour view of what constituted a ‘decent wage’. The decision bequeathed a legacy of high urban unemployment and attendant social problems for a decade or more. Against this backdrop, President Wahid’s proposed ‘Western Pacific Forum’ might have merit. The forum is controversial – it was announced in Singapore apparently as a coded attack on that country’s indifference to Indonesia’s current difficulties – and remains ill defined. But it could provide a sort of institutional umbrella under which the relevant parties (these three countries, plus perhaps Papua New Guinea, New Zealand and the Philippines) would be brought together to discuss regional issues. For example, the Department of Agriculture staff establishment has been reduced from over 3,000 to just 125. This is an important consideration even in relatively well-functioning societies such as Thailand where, for example, research by Feder et al. (1988) showed that clearer land titles led to better-functioning rural markets. The one exception to this statement might be the development of the road network along the southern belt of East Timor. This would reduce the region’s traditional isolation, open up pockets of fertile land and contribute to national integration. In March 2001, Dili accounted for about 72 per cent of East Timor’s power consumption, up from 50 per cent in late Indonesian times. Fortunately, however, owing to its compact geography and good road network, East Timor should not face the grave problems experienced in nearby Port Moresby, where the absence of cheap transport networks to the hinterland has meant that many migrants to the capital simply cannot return home. This in turn has contributed to the city’s calamitous urban decay and lawlessness. This is the case for coffee (Pomeroy, Chapter 8) and at the lower levels of the civil service. It also applies in the building industry. In March 2001, for example, it was reported that building contractors in Bacau had difficulty recruiting labour at Rp 50,000 (about $5) per day. Politics of course works in the opposite direction. This was already evident in 2000 when, in the face of tertiary students protesting against unsuccessful entrance applications, the government decided to reallocate part of the primary school budget into the tertiary sector. The latter is emphasized by Elek (Chapter 20) as one of the key lessons from the PNG experience. Expecting a weak bureaucracy and political system to deliver effectively across a wide range of policy areas is invariably an invitation to failure. Priorities are the key: deciding on the really important tasks which only a government can achieve. It might be noted in passing that there is a danger in the current uncertain commercial climate of investors attempting to bypass the rules. Already one prominent project, a hotel established by Singaporean investors, has run foul of the administration and been forced to put a very large and substantially completed investment on hold. Without commenting on the specifics of the case, it obviously sends an extremely negative message to the international business community. It reinforces the perception that only quick-return, highly liquid projects should be contemplated in East Timor.

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Currency and Monetary Arrangements for East Timor Gordon de Brouwer*

An important decision in the design of macroeconomic policies in any country is the choice of currency and monetary regime. Not surprisingly, there is an enormous literature on currency and monetary regimes. This chapter sets out a policy menu for East Timor based on this literature, constructed in a way that suits the country’s characteristics and needs. There are two basic decisions to be made in choosing a currency and monetary regime. The first is whether to have a fixed or a flexible exchange rate. The decision to fix or float depends on weighing the advantages of one against the other, and assessing which works in practice. The second decision concerns the detail of the arrangements. The chapter is structured in the following way. The following section looks at the first decision: whether to fix or to float the exchange rate, and what this means for monetary policy. The third section assesses different types of fixed exchange rate regimes, namely the standard peg, currency board and ‘dollarization’. The fourth section looks at which countries would be suitable pegging partners for East Timor. The chapter concludes by offering an assessment.

FIX OR FLOAT? The first decision in selecting a currency and monetary regime is whether to fix or to float the currency. For a small economy like East Timor, there are two main issues to consider in making this choice. Which Regime Is More Stabilizing? The first is to assess the relative merits of having a fixed or flexible exchange

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rate. This decision ultimately turns on whether an independent exchange rate provides a country with a means to stabilize its economy as the external economic circumstances it faces change. If being able to change the exchange rate helps stabilize the economy, then having a more flexible regime is, in principle, helpful and preferable.1 The exchange rate is a relative price – the value of a country’s currency relative to that of another. As circumstances change, it may be appropriate that these changes are reflected in the exchange rate. There are two types of ‘circumstances’ that warrant consideration. Changing Economic Circumstances Changes in a country’s external economic environment can have implications for the exchange rate. For example, if the prices of a country’s exports fall substantially, then the country suffers a fall in export income and GDP. If the exchange rate depreciates in response to this ‘shock’, then the value of exports does not fall by as much in terms of local currency, and export income and GDP are stabilized. In principle, this is relevant to East Timor because its export base is concentrated in a few commodities – coffee, oil, sandalwood and marble – most of which have volatile prices. If policy-makers want to stabilize export income, then they would need to either depreciate the currency when commodity prices fall, or fix to a currency which also depreciates when commodity prices fall. While this suggests that some flexibility in the currency regime may be helpful, there are two serious obstacles to a country like East Timor being able to adopt an independent currency in practice. The first is that it is too small to be able to rely on the foreign exchange market to set the exchange rate. A freely floating exchange rate is not a viable option for a very small country because its foreign exchange market lacks liquidity, making the currency vulnerable to sharp erratic movements (de Brouwer 2000). This means that a floating exchange rate would need to be highly managed, which leads to the second obstacle. Managing a floating exchange rate is challenging. It requires a large number of staff with substantial expertise, as well as a clear policy framework, sufficiently developed financial markets and no political interference. East Timor has scarce staff resources to support the administration of any currency and monetary regime. It has a very small population of about 800,000 people, and its labour force is estimated at less than half that, about 340,000, most of whom are not well educated. Even with foreign aid and future oil revenue, it will have at best only modest financial resources to support an administration. Changing Political Circumstances The second set of circumstances that can affect the exchange rate is political

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uncertainty and instability. Of particular concern here is the potential for political uncertainty and instability to destabilize the exchange rate. Even in very developed markets, political uncertainty can at times put downward pressure on the exchange rate. But when political tensions and instability are high, the cost in exchange rate instability can be substantial, as shown by the recent experience of some Pacific Island nations (de Brouwer 2000). Political instability affects both floating and fixed exchange rates, but the effect is probably felt more quickly in the case of floating regimes. The only fixed exchange rate regime that insulates a small country’s exchange rate from political instability is dollarization, because a separate currency does not exist. The Exchange Rate and Monetary Policy The second issue is the relationship between currency regime and monetary regime. The monetary regime is largely a consequence of whether a country fixes or floats its currency. The general principle is that a country where capital can move in and out cannot have both a fixed exchange rate and an independent monetary policy. If capital is mobile and the country fixes its exchange rate, then generally it has to accept the interest rates of the country to which it fixes its currency. In this case, the authorities lose their discretion to set interest rates. If the country pegs to a low-inflation currency, its inflation rate and economic cycle will tend to converge towards that of the target economy. Labour market flexibility is important because it provides a ‘shock absorber’ to reduce the adverse impact of economic disturbances on output and employment. If a country floats its currency, then in theory it can choose its own interest rates, although the evidence is that most developing countries are not able to do this in practice (Hausmann et al. 1999). In theory, the freedom to choose its own interest rates means that a country can choose its own inflation rate, although often many of the factors that affect inflation are global and it is hard for countries to resist global trends in inflation. At least for Latin American countries, the evidence is that countries with more flexible exchange rate arrangements have performed worse than those with less flexible arrangements. Labour market flexibility is also important under a flexible exchange rate. The challenge for a country that wants to set its own interest rates is to ensure that it has infrastructure adequate to the task. This is complex. The country needs to have a clear monetary policy framework in place, with a coherent, consistent set of aims and the necessary tools and markets to be able to achieve them. It also needs to have the staff, expertise and facilities (buildings, structures and capital equipment) in place to decide and implement policy. In either respect, East Timor does not appear at the moment to have the necessary resources to conduct an independent monetary policy (McLeod 2000).

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One crucial condition for a stable monetary system under both fixed and floating exchange rate regimes is the separation of monetary management from the budgetary process. The monetary authority should not be called on to print money to fund government expenditure. The consequence of making the monetary authority fund a fiscal deficit is inflation – and sometimes hyperinflation. The system needs to be robust enough to withstand the array of political and social pressures that arise in all countries, but which can be particularly fierce in developing countries. The experience of Papua New Guinea since independence in 1975 provides some valuable insights into the sorts of serious pressures and problems that can arise. When Papua New Guinea gained independence in 1975, it established its own currency, the kina, and its own monetary authority, Bank Papua New Guinea (BPNG). From 1975 to 1994, the kina was fixed to a basket of the currencies of its major trading partners and was revalued from time to time to contain inflation. The system came undone in 1994 in a serious fiscal crisis, and the fixed exchange rate regime collapsed and shifted to a managed float. The currency has since lost three-quarters of its value against the Australian dollar. The integrity of the central bank has also been undermined. While BPNG has had some excellent staff over time, it has also suffered a continual and serious shortage of skilled staff, something that Heinz Arndt warned about well in advance of Papua New Guinea’s independence (Arndt 1971). More seriously, BPNG has been forced to finance the government’s fiscal budget, which fed already-widespread corruption and created substantial inflationary pressures (Duncan and Xu 2000). This is not meant to cast doubt on the integrity of East Timor’s political leaders. Rather, it is meant to show that the system that is put in place needs to be resilient to a whole range of pressures, including political ones, long after independence has been achieved. Papua New Guinea’s system worked well until the 1990s but it came undone because it was not robust to intense rentseeking behaviour and political pressure (Duncan 1999).

HOW TO FIX? If East Timor fixes its exchange rate, the next question is, how should the currency be fixed? The degree of fixity is a matter of choice. There are three options: a standard peg, a currency board or dollarization. Under a standard peg, East Timor would have its own currency and would fix its value to another currency or basket of currencies. It would retain the option of changing the rate as economic circumstances changed. East Timor would need a stock of foreign exchange reserves to support this system. Under a currency board, East Timor would have its own currency and

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would fix its value to that of another currency. Under a currency board, a country has to back all of its currency in circulation with reserves of the target currency (and usually there are excess reserves). A currency board would tie East Timor’s interest rates to be at least equal to those of the target country, although, in reality, its interest rates would most likely be higher than US interest rates because of a risk premium. It is very difficult to change the fixed exchange rate under a currency board system because such a change would undermine the credibility of the system and likely destroy it. For that reason too, currency boards are seen as a rigid or strong form of fixed exchange rate arrangement. Dollarization means that a country officially uses the currency of another country as its own. It is called ‘dollarization’ because most of the current debate is about countries using the US dollar, but it could involve the use of any currency. Under dollarization, the country’s exchange rate is permanently fixed to that of the other country. It is difficult to exit dollarization since it takes time, money and effort to set up an alternative system, and so it is seen as the most credible of fixed exchange rate systems. Each of these ways to fix the exchange rate has relative merits. The advantage of the standard peg is that it can be adjusted as economic circumstances change. A currency board and dollarization do not allow the authorities such a degree of discretion to change the exchange rate. The main disadvantage of the standard peg is the flipside of its advantage. Because it is more flexible, it is also substantially less credible, and so interest rates under standard pegs are typically higher than under currency boards or dollarization.2 Rivera-Batiz and Sy (2000) find that standard pegs perform less well over the long term than currency boards: interest rates and inflation are higher, and economic growth lower, under a standard peg. Institutional detail does matter to performance. While a standard peg provides more discretion to deal with changing economic circumstances than the other fixed exchange rate alternatives, the general evidence suggests that this discretion has not been used well. The key advantage of a currency board and dollarization over a standard peg is credibility. This credibility means that countries that want to stabilize inflation by targeting to a low-inflation country are more likely to achieve their aim by setting up a currency board or by dollarizing to a low-inflation country. This is enhanced by the fact that the fiscal authorities cannot require the monetary authority to print money to fund a budget deficit under either a currency board or dollarization. This is particularly important for countries coming out of a crisis or in transition. A number of countries adopted currency boards in the 1990s – Argentina in March 1991, Estonia in June 1992, Lithuania in April 1994 and Bulgaria in July 1997 – and their decision was based on the desire to gain credibility. The evidence suggests that they were mostly successful (Rivera-Batiz and Sy 2000). The other advantages of a currency board and dollarization over a standard

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peg are that they are easier to run, since they reduce the discretion of policymakers, and that they require substantially less administration and support. Dollarization is the least expensive option, since it does not provide for any local policy discretion and requires no local administration. The other crucial difference between a currency board and dollarization concerns the credibility of the regime. Dollarization is more credible than a currency board. While the exchange rate is less likely to be changed under a currency board than under a standard peg, there is still the possibility that the rate will be changed under a currency board because the authorities retain the power to change the rate at their discretion. The exchange rate under dollarization, however, is not subject to immediate change by the authorities, since the authorities would need to design, print and distribute a local currency before it could replace the existing currency and change the exchange rate. The authorities can reverse dollarization, but if they want to do so they have to plan well in advance, making an unexpected change in the exchange rate an extremely unlikely event. This means that in periods of uncertainty, such as when pressures emerge for a devaluation, a currency board will be tested by speculators. The most recent examples are the intense speculative pressures Hong Kong and Argentina experienced during the Asian financial crisis. Their currency board arrangements remained in place, but speculation about whether or not they would hold, at times pushed interest rates up to extreme levels. This cannot happen under dollarization because there is nothing to speculate on. Because it is so difficult to change the exchange rate under dollarization, it is a serious policy option for small countries that want to limit both the discretion of future policy-makers and the sorts of problems that have occurred in Papua New Guinea (Xu 1999; Duncan and Xu 2000; de Brouwer 2000). There are three potential disadvantages to dollarization, none of which are insurmountable. •

•

•

The authorities cannot bail out banks unless they have the necessary excess foreign exchange reserves. This is not a problem in East Timor, at least for the foreseeable future, since all the banks operating there are foreign owned and supervised. The authorities lose seignorage, that is, the revenue earned by making currency. Governments profit from making currency, because the cost of producing it is less than its face value. Because the government is not printing its own notes if it dollarizes, the target country makes the seignorage. This is not a problem if the target country agrees to transfer seignorage. It may be interpreted as a loss of sovereignty. Having a local currency often tends to be seen as a symbol of a nation’s independence, and its replacement by the currency of another country may be seen as a loss of economic sov-

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ereignty. It is important to note that in many instances this is not the case. The European Union’s 15 members, for example, have been able to agree to replace 14 national currencies with the euro. Some other European countries are eager to join. Twenty-eight countries, most of them in Latin America, already officially use the US dollar, and others, including Argentina, are on the public record as saying that they want to follow suit. Closer to home, Nauru, Kiribati and Tuvalu are independent Pacific Island nations but use the Australian dollar. Many countries feel able to dollarize without loss of sovereignty or prestige, and indeed welcome the economic benefits that it can confer.

WHICH CURRENCY TO FIX TO? If East Timor chooses to fix its currency, in any of the forms outlined in the previous section, which currency should it fix to? One option is to peg to a basket of the currencies of the countries that are important to the country concerned. For example, when a number of countries are important trade partners, pegging to a basket of their currencies helps on average to stabilize the exchange rate. But in East Timor’s case, there are no trade data and matters are in a state of flux. The exchange rate under a basket peg would be subject to frequent realignment for a number of years, reducing transparency, raising uncertainty and increasing the risk of the ‘PNG problem’ arising. If dollarization is the preferred option, a basket peg is irrelevant. There are four serious possible currencies that East Timor could peg its currency to or use to dollarize. In no particular order, they are the euro, the rupiah, the US dollar and the Australian dollar. To be a suitable target, the foreign currency would need to meet four key criteria: it would need to be a reliable low-inflation anchor; have a meaningful economic connection to East Timor; be an internationally usable and stable currency; and, in the case of dollarization, be acceptable and practical as a medium of exchange. Based on these criteria, the four currencies listed above have different relative strengths. While the euro does not currently exist, it will come into circulation from January 2002 and replace the escudo. The euro basically meets the criteria listed above for a suitable currency target. It would provide a solid anchor for inflation since, in the tradition of the Bundesbank, the European Central Bank is an avowed inflation fighter. Its connection with East Timor is that the European Union and Portugal are the main bilateral aid donors and that East Timor is a former colony of Portugal. The euro is a major world currency. But there are reservations about its use. While the European Union and Portugal are the main aid donors to East Timor, this aid is administered by the

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United Nations and denominated in US dollars rather than euros, although the denomination may change in the future. Moreover, most of East Timor’s aid money is used for the purchase of equipment overseas and payment of UN salaries rather than for current local expenditure; the currency denomination of aid money does not seem to be so relevant to the choice of currency peg. Also, Europe is a long way from East Timor. This would make logistical support difficult and expensive, especially if East Timor were to dollarize using the euro, since the freight of coins is expensive. The distance from Europe also raises the issue of commitment. It is natural to ask whether the European Union will at some time in the future reduce its focus on East Timor, as Portugal did in the 1960s and 1970s. The rupiah is currently the currency most widely used by East Timorese themselves. Its main advantage as the target currency is that Indonesia’s proximity, common border and close connections are likely to make Indonesia East Timor’s main trading partner once relations are normalized. If East Timor were to dollarize, the rupiah would be a very easy logistical choice because it is already widely accepted and is relatively cheap to transfer. But there are several obvious disadvantages to the rupiah. It is not a stable currency. Indonesia is neither politically nor economically stable, and it cannot offer the prospect of low and stable inflation. The historical relationship is such that pegging to the rupiah, let alone using it, would be a difficult political choice. While economic relations with Indonesia will likely continue to be very important to East Timor, there is a wider need and desire to assert East Timor’s independence from Indonesia. The US dollar meets all the criteria of a target currency. It is the world’s most important currency and an increasing number of countries are pegging to it or using its currency as their own. The world prices of commodities, including oil and coffee, are all denominated in US dollars. Strategically, fixing to, or using, the US dollar may help retain a US focus on East Timor, although this should not be overemphasized. While people are free to use any currency they wish in private transactions, the US dollar became legal tender in East Timor under Regulation 2000/7 for all transactions from 24 January 2000.3 There are two problems with the US dollar. If East Timor were to use the US dollar as its own currency, one problem would be the logistics and cost of transporting notes and coins from the United States. Low-denomination currency is especially important for small transactions by the East Timorese; a bunch of bananas, for example, costs about 3,000 rupiah or 30 US cents. American coins are not widely used in East Timor – currently rupiah notes and Australian coins are used for change – but the US dollar cannot be used without an accessible set of low-denomination currency. The problem is not with US dollar notes but with the coins, which are very difficult and expensive to move, and many of which are given names but not numbered.

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One way around this is for East Timor to use its own coins so long as they are fully backed by reserves of US dollars. The precedent for this is Panama, which is officially dollarized but uses its own coins (Schuler 1999). These coins could be minted for the East Timorese government in a country close to East Timor, such as at the Australian mint in Perth. Apart from providing a low-denomination currency and reducing logistical difficulties, minting East Timorese coins for denominations below one dollar has a number of advantages. Coins are much more durable and long-lasting than notes and, if clearly numbered and properly sized, are easy to use. They are likely to be easier to read and use than most of the rupiah notes in circulation in East Timor, especially in the remoter parts of the country. It would also enable East Timor to have some localization of its currency without serious risk of loss of monetary control. The second problem is that the US dollar is very strong, which some fear would price East Timorese products out of the market, especially in comparison to Indonesian goods. This is a legitimate concern but needs to be kept in perspective. The US dollar is widely thought to be overvalued and so has substantial scope to depreciate in the future, which would help exports and importcompeting goods. There is also scope for domestic prices to fall in East Timor, once better transport and information infrastructure is established outside Dili, and as trade with West Timor is normalized and the number of foreigners falls after the United Nations Transitional Administration in East Timor (UNTAET) is disbanded. Moreover, while international competitiveness is obviously important, monetary policy must ultimately be directed at domestic price stability, and the exchange rate regime needs to support this (Drake 1983). An implication of this is that the authorities need to ensure that East Timor’s labour markets are flexible enough so that wages can fall when prices fall, and so that labour costs can fall when adverse economic disturbances occur, to minimize their negative effects on output and employment. The final alternative is to fix to the Australian dollar. The Australian dollar also fits all the criteria. It meets the inflation anchor requirement. Australia’s central bank has in place a robust but flexible medium-term inflation target regime, and inflation has averaged about 2 per cent since 1990. The Australian dollar is the seventh most traded currency in the world, and it is straightforward to hedge Australian-dollar currency risks. While the Australian dollar does fluctuate substantially, its volatility is similar to that of the major currencies. Australia also has a meaningful economic connection to East Timor. Observers suggest that many of the foreign goods and services available in East Timor are sourced from Australia and are denominated in Australian dollars. While Australia’s share of trade is expected to decline as things normalize in East Timor, Australia will remain one of its most important partners. After the

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rupiah, the Australian dollar is the most widely used currency for private transactions. Australia is also close to East Timor, so there are not the same logistical problems and costs involved in pegging to, or using, its currency. The Australian dollar is widely regarded as a commodity currency, tending to appreciate as commodity prices rise and to depreciate as they fall. This is an important stabilizing influence on inflation and economic growth in Australia, because it tends to constrain aggregate demand when world trading conditions are good and boost it when world trading conditions are poor (BlundellWignall 1993). This is potentially relevant to East Timor because its main exports are likely to be commodities, specifically crude oil and coffee. Pegging to the Australian dollar may then offer the prospect of stabilizing East Timor’s GDP in the event of price changes to its commodity exports, so long as the movement in these commodities is related to movements in commodity prices in general and the Australian dollar in particular. The Australian dollar typically depreciates when oil prices fall (and appreciates when oil prices rise), but there is little obvious relationship between the Australian dollar and coffee prices: in the 1990s, the correlation of the Australian dollar and oil prices is a statistically significant 0.5, but is an insignificant 0.1 for coffee prices, which is hardly surprising given that Australia is a net exporter of energy but a net importer of coffee. While the correlation between oil prices and the Australian dollar held in the 1990s, it has not been evident in the past few years; the correlation tends to be unstable. There are three downsides to pegging to, or using, the Australian dollar. The first is the importance of exchange rate stability in the first few years of the regime. The Australian dollar is currently worth about 50 US cents, which most observers would say is excessively depreciated. It is likely that it will appreciate over the next year or so. The second downside is that pegging to, or using, the Australian dollar could adversely affect East Timor’s relations with Indonesia, as well as those between Australia and Indonesia. Indonesia may resent such a link with Australia, and may (incorrectly) perceive it as an attempt by Australia to extend its sphere of influence at Indonesia’s cost. From a strategic point of view, East Timor has substantial interest in seeing the normalization of relations with Indonesia. Australia wants to regularize its relationship with Indonesia and would not appear at this stage to welcome formal use of the Australian dollar. Finally, pegging to, or using, the Australian dollar may contribute to a mentality of dependence in East Timor. Given the closeness to Australia and the experience of the past few years, Australia is likely to extend considerable aid and other resources over many years to come, even as the contribution of other donors wanes. From East Timor’s perspective, it is important to keep as many other countries interested in, and aware of, its circumstances as possible. Using a currency other than the Australian dollar may help this.

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AN ASSESSMENT East Timor is a small, low-income developing economy with limited financial and human resources and a narrow commodity export base. While the decision about which currency and monetary regime to adopt is obviously a matter for East Timor, the country’s economic and social features suggest that the set of feasible choices is relatively narrow. Flexible currency and monetary arrangements allow the authorities the discretion to tailor policy settings to the needs of the domestic economy. But there are two important constraints on the adoption of discretionary currency and monetary policies in East Timor. The first constraint is the country’s limited financial, infrastructure and human resources. This is such that it is probably not practical for East Timor to run its own discretionary currency and monetary policies. East Timor would probably be better off fixing its exchange rate to that of a low-inflation economy and adopting that country’s monetary policy as its own. This should enable it to secure a stable, low-inflationary macroeconomic environment. The second constraint is the need to ensure that the system is robust in the face of stress and changing circumstances over time. This is no small matter. The experience of Indonesia, Papua New Guinea and other Pacific Island nations suggests that, despite the best of intentions, discretionary systems in developing countries can come undone over time due to political pressures and corruption. This is not to question the integrity of East Timorese policy-makers or to suggest that East Timor is fated to go down this path. But it is too powerful a lesson to ignore. If this is right, East Timor should adopt a ‘strong form’ of fixed exchange system, such as a currency board or dollarization. While a currency board has the advantage of allowing East Timor to have its own currency, its interests may be served better by dollarizing. The argument is two-fold. First, dollarization is more likely to result in lower interest rates on average than a currency board, since currency boards are invariably tested in difficult times to see if the authorities will keep their resolve. This cannot happen when a country uses the currency of another. Second, under a currency board, the authorities have the discretion to change arrangements at any time they wish; the ‘PNG problem’ can still occur. Under dollarization, the authorities can change the regime if they want to, but they cannot do so easily or without proper planning. If East Timor is to fix its currency to that of another country, it has four choices: the euro, the rupiah, the US dollar or the Australian dollar. All of these have advantages and disadvantages, but the two most likely contenders are the US dollar and the Australian dollar. The choice between these two is a matter of economic and political judgment. The US dollar is attractive because it is the key world currency, can provide

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a stable low-inflation anchor, and is already in official use in East Timor. But it has two problems. First, the denomination of US dollar notes is too high for them to be used for many of the smaller transactions that take place in East Timor. US coins are too expensive to move, and too hard to understand since they are not all numbered. This can be solved by East Timor having its own coins so long as they are fully backed by US notes. The second problem is that the US dollar is very strong, which some fear would price East Timorese products out of the market, especially in comparison to Indonesian goods. This is a serious concern but needs to be kept in perspective. The US dollar is widely thought to be overvalued and so has substantial scope to depreciate. Such a depreciation would be beneficial to exports and import-competing goods. There is also scope for domestic prices to fall in East Timor, once better transport and information infrastructure is established outside Dili, as trade with West Timor is normalized and as the expatriate community gets smaller when UNTAET is disbanded. Moreover, while international competitiveness is obviously important, monetary policy must ultimately be directed at domestic price stability, and the exchange rate regime needs to support this. The Australian dollar is attractive because Australia is an important trading partner; because the currency can provide a stable low-inflation anchor; because it is a ‘commodity currency’ and so suits East Timor’s commodity export orientation; and because it is already relatively well accepted in East Timor. The main problems with fixing to the Australian dollar are the current low cycle in the Australian dollar, how fixing to the Australian dollar would affect East Timor’s (and Australia’s) relationship with Indonesia and whether it would create a mentality of dependence on Australia. This assessment has focused on the importance of limiting policy discretion in the currency and monetary system. This should not be interpreted as meaning that policy-makers should have no discretion. Indeed, as economic circumstances change it is essential that policy-makers have some tools to respond to them. The issue is whether it is better to do this with the exchange rate and monetary policy, or through fiscal policy. A tight currency and monetary system is more likely to secure better inflation and economic growth outcomes, but it also needs to be backed by a discretionary, yet disciplined, fiscal system to deal with serious economic disturbances as they occur.

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NOTES *

1 2

3

I am grateful for comments from Manuel Coutinho, Peter Drake, Mardi Dungey, Hal Hill, Jan van Houten, Bob Rankin, Klaus Rohland and Antonio de Almeida Serra. All errors are mine. See Isard (1995) and Mussa et al. (2000) for arguments on the pros and cons of fixed and floating exchange rates. The best recent example of dollarization leading to a reduction in interest rates to those of the target country is the lowering and convergence of European short and long-term interest rates to German levels in the lead-up to the introduction of the euro in 1999. An important transitional issue is the logistics of replacing the rupiah with the US dollar. This has a range of dimensions. It would require a proper education and exchange program, as well as obtaining the agreement of Bank Indonesia to replace existing rupiah with US dollars. This is complicated not only by the sensitive politics and negotiations required for such agreement, but also practical issues such as the illegibility and poor condition of rupiah notes in circulation in East Timor; the continuing use of notes that have been taken out of circulation in Indonesia but which are still widely used in East Timor (such as 500 and even 100 rupiah notes); counterfeiting; and the legitimacy of rupiah notes thought to have been stolen by the Indonesian military from Bank Indonesia and laundered in East Timor.

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Folly or Foresight: Strategic Options for Fiscal Policy in East Timor Jay K. Rosengard

phoe • nix (f e′niks), n. a mythical, beautiful bird that lived for hundreds of years, consumed itself in fire, and rose renewed from the ashes: a symbol of immortality Pocket Webster School & Office Dictionary

PHOENIX RISING East Timor is starting over. It is very much like the mythical phoenix, rising from the ashes of its recent destruction to become the newest member of the world’s family of nations. Most of East Timor’s physical infrastructure has been destroyed. Its service delivery and marketing networks are not functioning, families and communities have been decimated by internal displacement and the absence of unrepatriated refugees, and much of East Timor’s non-indigenous skilled labour has fled. But calamity also offers opportunity. After spending a generation in exile, the East Timorese diaspora is coming home to help with nation building, those who never left can now realize their full potential, and the world is offering unprecedented support to the stabilization and rebuilding of East Timor. One of the critical development challenges facing East Timor as nation building proceeds is the formulation and implementation of an appropriate fiscal policy. It has before it several dramatically different strategic options. The leaders of East Timor will have to make difficult choices between these options, notwithstanding the advice of noted philosopher and baseball coach Yogi Berra, ‘when you come to a fork in the road, take it’. Fortunately, East Timor can benefit from being a ‘late bloomer’ – it can learn from the mistakes of others as it evaluates the trade-offs between its 52

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strategic policy options, and better anticipate the results of the fiscal policy path that it chooses. Key fiscal policy dilemmas include: the role and size of the public sector; fiscal balance; resource mobilization, including dependency on commodity-based revenue and foreign aid flows; expenditure efficiency and effectiveness; and intergovernmental fiscal relations. The remainder of this chapter is devoted to an examination of the major strategic options for these critical components of fiscal policy, with an assessment of the strengths and weaknesses of each. The presentation is diagnostic, not prescriptive. The objective is to facilitate an informed dialogue among East Timorese leaders, not to advocate a particular fiscal strategy. Ultimately, it is they and their constituencies who will have to select the fiscal policy that best meets their needs.

THE ROLE AND SIZE OF THE PUBLIC SECTOR A fundamental precept that will provide the general parameters for fiscal policy formulation in East Timor is the desired role and size of the public sector in the economy.1 The government’s perception regarding its appropriate role and size will have significant implications for all other fiscal policy decisions, and public sector expectations will guide private commercial firms, non-profit organizations and community-based institutions in pursuing their respective responsibilities as partners in development. Role of the Public Sector There are two main alternatives regarding the role of the public sector: it can lead in development planning and implementation, and assume a dominant position in the economy; or it can facilitate and complement the economic development initiatives of others. In the short run, it is clear that the public sector, assisted by external resources, will have to take the lead in rebuilding East Timor’s economy – there are simply no viable alternatives. However, once the existing infrastructure has been repaired and former basic services restored, probably within the next three to five years, economic policy will shift from reconstruction to the fostering of sustainable growth. The public sector can either maintain its role as the principal agent of development in East Timor, or it can become more of an economic development enabler and catalyst. Based on an analysis of documents prepared by both the Central Fiscal Authority of the United Nations Transitional Administration in East Timor (UNTAET) and the International Monetary Fund (IMF), and after discussions with key East Timorese leaders, the government has embarked on the latter path

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(Central Fiscal Authority/UNTAET 2000; IMF 2000). That is, in keeping with global trends over the past decade and despite the tendency of some to favour a centrally planned, state-directed model of economic development, East Timor is trying to create the foundation for a market-based economic development strategy. This is encouraging, as governments have demonstrated quite consistently over the past 50 years that they have neither the resources nor the capacity to substitute for competitive markets. Their strength is in creating enabling environments that facilitate the initiatives of others, and in complementing these initiatives with the provision of public goods and services when market failures make this the only reasonable alternative. Size of the Public Sector If the expected role of the public sector is clear, at least in the medium to long term, then the question arises: how much is enough? There are three ways to try to determine the appropriate size of the public sector in East Timor: international norms; current and anticipated government spending; and government spending under Indonesian rule. A good rule of thumb is for total government expenditures to be between 20 and 30 per cent of GDP. This is confirmed by the observations for the countries in Table 3.1 comparing percentage average annual growth of GDP between 1990 and 1997 with total central government expenditure as a percentage of GDP in 1996.2 •

•

• •

The world average for total central government expenditure is 29.8 per cent of GDP, whereas the average for low-income countries is 17.4 per cent of GDP – world growth averaged 2.4 per cent, while the growth of low-income countries averaged 3.9 per cent. East Timor’s ASEAN neighbours (the Philippines, Thailand, Malaysia, Singapore and Indonesia) all had expenditures totalling between 14.6 and 21.9 per cent of GDP, and all but one (the Philippines) had an average annual growth rate of 7.4 per cent or greater. East Timor’s neighbour with a similar natural-resource economic base, Papua New Guinea, had expenditures equal to 29.4 per cent of GDP, accompanied by a growth rate of 5.7 per cent. Other countries with similar small, natural-resource-based economies, such as Ecuador (oil) and Chile (copper), spent 15.7 per cent and 21.0 per cent of GDP respectively, while experiencing growth rates of 3.1 and 8.3 per cent.3

While the 20 per cent rule is reasonable over the long term, given East Timor’s special circumstances it makes little sense over the short to medium

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term, and is unattainable unless forced on East Timor in the worst of all worstcase scenarios. As noted below, this is vividly demonstrated when examining both East Timor’s point of departure, current and anticipated government spending, as well as the immediate antecedent, government spending under Indonesian rule. UNTAET’s target for total government expenditures via the Consolidated Fund for East Timor (CFET) is 20 per cent of GDP, or roughly $60 million – GDP is estimated to be approximately $300 million. CFET is financed by onshore and off-shore resources raised by East Timor, supplemented by unrestricted donor funds. About three-quarters of the CFET budget covers recurrent expenditures, while the remainder is for capital expenditures. However, this greatly understates present public sector expenditures in East Timor (Table 3.2). Another $159 million in development assistance is budgeted in 2000/01, made up of $63 million in multilateral donor funding for development projects from the Trust Fund for East Timor (TFET), and $96 million in bilateral donor development assistance. When combined with the CFET budget, the total equals roughly three-quarters of GDP (Central Fiscal Authority/ UNTAET: 1). These figures do not yet include the UN Assessed Contributions Budget, estimated to be approximately $600 million. The Assessed Contributions Budget covers the peacekeeping force, Civilian Police (Civpol), UN international staff and a variety of other miscellaneous activities. Although a good deal of donor funds is spent off-shore, even a small portion of a figure more than twice the size of East Timor’s GDP is sure to have an impact on the domestic economy. This is vividly demonstrated by the wide range of small businesses that have been created to serve the expatriate community in East Timor. For example, if only 10 per cent of multilateral, bilateral and Assessed Contributions assistance is spent in East Timor ($76 million of $759 million), when combined with CFET expenditures ($60 million), the total ($136 million) is 45 per cent of GDP. These figures do not yet include the cost of most services delivered by UN agencies, nor do they include the cost of services delivered by non-government organizations (NGOs). Furthermore, while many of these services are temporary, at least a portion of long-term development assistance will take the form of concessional loans when East Timor becomes fully independent, and debt service will certainly affect the size and nature of public sector expenditures in East Timor. How does 45 per cent of GDP compare with the role of the public sector under Indonesian rule? If one were to construct a national budget for East Timor for fiscal year 1994/95, the last year for which full data are available, it would total $168.9 million, or 68.0 per cent of the estimated provincial GDP of $248.5 million, as follows (see Table 3.3).

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Table 3.1 Public Spending and Growth, 1980–97 Country

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48

China Congo, Democratic Republic of Myanmar United Arab Emirates Cameroon Argentina Indonesia Sierra Leone Mexico Dominican Republic Ecuador India Peru Thailand Venezuela Madagascar Nepal Philippines Korea, Republic of Chile Singapore Zambia Mongolia Malaysia United States Mauritius Bolivia Iran, Islamic Republic of Pakistan Syrian Arab Republic Canada Russian Federation Lithuania Australia Switzerland Turkey Panama Burundi Sri Lanka Trinidad and Tobago Kenya Papua New Guinea Algeria Costa Rica Albania Latvia Romania Uruguay

Total Expenditure (% of GDP)

GDP (% average annual growth)

1980

1996

1980–90

1990–97

n.a. 12.4 15.8 12.1 15.7 18.2 22.1 26.5 15.7 16.9 14.2 13.3 19.5 18.8 18.7 n.a. 14.3 13.4 17.2 28.0 20.0 37.1 n.a. 28.5 22.0 27.2 n.a. 35.7 17.5 48.2 21.1 n.a. n.a. 22.7 19.2 21.3 30.5 21.5 41.4 30.9 25.3 34.4 n.a. 25.0 n.a. n.a. 44.8 21.8

8.0 8.3 10.1 11.8 12.7 14.0 14.6 14.8 15.5 15.6 15.7 15.8 16.5 16.5 16.9 17.3 17.5 18.5 18.6 21.0 21.0 21.4 21.6 21.9 22.2 22.4 22.8 23.2 23.8 23.8 24.2 24.7 25.0 26.3 26.3 26.9 27.4 27.7 27.7 28.3 28.9 29.4 29.7 30.6 31.0 31.0 31.4 31.4

10.2 1.6 0.6 –3.5 3.4 –0.4 6.1 0.3 0.7 3.1 2.0 5.8 –0.3 7.6 1.1 1.1 4.6 1.0 9.4 4.2 6.6 1.0 5.4 5.3 3.0 6.2 –0.2 1.7 6.3 1.5 3.3 n.a. n.a. 3.4 2.0 5.4 0.5 4.4 4.0 –0.8 4.2 1.9 2.7 3.0 1.5 3.5 0.5 0.4

11.6 –6.0 6.3 n.a. –0.1 5.4 7.5 –4.4 2.2 5.1 3.1 6.0 6.2 7.4 2.2 0.9 5.1 3.3 7.2 8.3 8.5 1.0 –0.6 8.6 3.0 5.0 4.1 4.0 4.2 6.3 2.2 –7.7 –7.1 3.6 0.2 4.1 4.8 –3.6 5.3 1.2 2.1 5.7 0.8 3.8 1.8 –8.5 –0.3 4.0

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Folly or Foresight: Strategic Options for Fiscal Policy 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85

New Zealand Tunisia Greece Yemen, Republic of Nicaragua Morocco Germany Brazil Estonia Belarus Egypt, Arab Republic of South Africa Jordan Czech Republic Norway Spain Lebanon Ireland Botswana Finland Denmark Portugal Austria United Kingdom Poland Oman Hungary Kuwait Sweden Croatia France Netherlands Bulgaria Belgium Israel Italy Lesotho

38.3 31.6 29.3 n.a. 30.4 33.1 n.a. 20.2 n.a. n.a. 50.3 22.1 41.3 n.a. 34.4 26.5 n.a. 45.1 31.8 28.1 38.6 33.1 36.6 38.3 n.a. 38.5 56.2 27.7 39.3 n.a. 39.5 52.9 n.a. 50.1 72.8 41.3 45.3

31.9 32.6 32.8 32.8 33.2 33.3 33.7 33.8 33.8 33.9 34.3 34.7 35.0 36.4 36.8 36.8 37.9 38.1 39.4 40.1 41.4 41.6 41.7 41.7 42.2 42.4 43.2 45.2 46.1 46.7 46.9 48.0 48.1 48.2 48.7 49.5 55.2

1.8 3.3 1.8 n.a. –2.0 4.2 2.2 2.7 2.2 n.a. 5.4 1.2 2.5 1.7 2.8 3.0 n.a. 3.2 10.3 3.3 2.3 3.1 2.2 3.2 1.8 8.4 1.3 1.3 2.3 n.a. 2.3 2.3 3.4 2.0 3.5 2.4 4.4

3.4 4.3 1.6 3.7 4.1 1.9 1.4 3.4 –3.8 –6.1 4.0 1.5 6.3 –0.2 4.0 1.6 8.3 7.0 4.5 1.4 2.5 2.1 2.0 2.0 4.1 5.9 –0.2 n.a. 0.9 –1.0 1.3 2.4 –3.3 1.4 5.8 1.1 7.8

149

World

25.4

29.8

3.2

2.4

150

Low income

14.8

17.4

4.4

3.9

151 152 153

Middle income Lower middle Upper middle

n.a. n.a. 20.1

19.9 17.1 27.9

2.9 4.9 1.8

2.8 2.3 3.4

154 155 156 157 158 159 160

Low and middle income East Asia and Pacific Europe and Central Asia Latin America and Caribbean Middle East and North Africa South Asia Sub-Saharan Africa

n.a. n.a. n.a. 19.1 n.a. 14.3 22.5

19.5 11.6 29.9 25.6 n.a. 17.4 n.a.

3.1 7.5 n.a. 1.6 2.1 5.6 1.8

3.0 9.4 –4.3 3.8 2.9 5.6 2.0

161 162

High income European Monetary Union

26.2 n.a.

32.1 41.7

3.2 n.a.

2.2 1.6

Source: World Bank, 1999 World Development Indicators.

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Table 3.2 Consolidated Budget for East Timor, FY2000/01 ($ million) Expenditure/Revenue Planned expenditure Consolidated Fund for East Timor Recurrent Capital

Amount

60.80 45.55 15.25

Other donor assistance Trust Fund for East Timor Bilateral donors

158.84 63.15 95.69

UN Assessed Contributions (estimate)

600.00

Total

819.64

Estimated East Timor Transitional Administration revenue On-shore revenue Timor Sea revenue

19.00 6.00

Total

25.00

Source: Central Fiscal Authority/UNTAET (2000), and interviews.

• • • • •

$2.6 million (1.5 per cent) in discretionary funds from own-source revenue (local taxes and user charges, profits from local government enterprises and miscellaneous income); $19.3 million (11.4 per cent) in national taxes (income, value-added, property, and miscellaneous taxes) originating in East Timor;4 $33.5 million (19.8 per cent) in regional autonomy grants (SDOs) to cover civil service salaries; $54.0 million (32.0 per cent) in Inpres block grants for development expenditures; and $59.5 million (35.2 per cent) in sectoral project grants (DIPs).

While a large portion of Indonesia’s central government development grants for East Timor was spent on contractors from elsewhere in Indonesia, much like foreign assistance is often spent off-shore, and the SDO salary grants went to a bloated local civil service, these figures still provide a helpful comparison for estimating a reasonable size for future public expenditures in East Timor. Thus, based on an assessment of total current and anticipated spending in East Timor, combined with an evaluation of expenditures in East Timor under Indonesian

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Folly or Foresight: Strategic Options for Fiscal Policy Table 3.3 Composition of East Timor’s Income, FY1994/95 Income Component

I National taxes originating in East Timor Individual and corporate income tax (PPh) Value-added tax (PPN) Property tax (PBB) Other taxes (PLL) Total

Rupiah (million)

US Dollars % of Total (1994 average) Income (Rp 2,161 = $1.00)

15,277.0 17,387.0 8,377.8 719.3 41,761.1

7,069,412 8,045,812 3,876,816 332,855 19,324,896

4.2 4.8 2.3 0.2 11.4

2,662.6 513.9 538.4 730.2 1,153.2 5,598.3

1,232,115 237,807 249,144 337,899 533,642 2,590,606

0.7 0.1 0.1 0.2 0.3 1.5

Total (I + II)

47,359.4

21,915,502

13.0

III Transfers from central government SDO Grants Dati I (provinces) Dati II (districts/municipalities) Subtotal

17,900.0 54,400.0 72,300.0

8,283,202 25,173,531 33,456,733

4.9 14.9 19.8

Inpres Grants Dati I (provinces) Dati II (districts/municipalities) Desa (villages) Sekolah dasar (primary schools) Kesehatan (health) Jalan propinsi (provincial roads) Jalan kabupaten (district roads) Perhijauan (regreening) Desa tertinggal (poor villages) Subtotal

25,900.0 14,500.0 3,300.0 19,200.0 4,800.0 26,900.0 17,300.0 1,500.0 3,400.0 116,800.0

11,985,192 6,709,857 1,527,071 8,884,776 2,221,194 12,447,941 8,005,553 694,123 1,573,346 54,049,051

7.1 4.0 0.9 5.3 1.3 7.4 4.7 0.4 0.9 32.0

Sectoral project grants (DIPs) Total

128,600.0 317,700.0

59,509,486 147,015,271

35.2 87.0

Total population (no.) 827,219 Grants/transfers per capita 0.4 Estimated provincial GDP (ex. oil & gas) 537,000.0 Estimated per capita provincial GDP (ex. oil & gas) 0.6

827,219 178 248,496,067

365,059.4

168,930,773

II Own-source revenue in East Timor (PAD) Local taxes Local user charges Profits from local government enterprises Income from technical service departments Other income Total

IV V VI VII

Total income

300 100.0

Source: Unofficial data provided by the Agency for Financial and Monetary Analysis and the Directorate General of Tax, Ministry of Finance, Government of Indonesia.

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rule, it appears that although 20 per cent of GDP is a reasonable long-term goal to conform with international norms, 30–40 per cent of GDP is a more realistic medium-term objective. How this might be financed is discussed in the following section.

FISCAL BALANCE The issue of fiscal balance revolves around two key questions: should East Timor adopt a balanced budget strategy; and, if some sort of deficit is allowed, should it be debt-financed? Balanced Budget There are compelling reasons for East Timor to balance its budget. Most importantly, this provides an external, objective means of de-politicizing hard fiscal decisions in the allocation of scarce resources. Rather than succumb to the temptation of overspending and eventually trigger a fiscal crisis, it allows leaders to place an overall ceiling on budget expenditures, and thus force an internal rationing process for alternative uses of public resources. Not only does this promote economic efficiency, but it also exerts fiscal discipline and thus complements a prudent monetary policy. Finally, a balanced budget increases the consistency and predictability of public expenditures. However, there are also strong reasons not to adopt a balanced budget strategy. If domestic revenue is projected to increase dramatically in the medium to long term, as is the case with expected Timor Gap income, sometimes current revenue constraints place an artificial ceiling on expenditures when compared with real needs. This could result in critical investments being postponed, causing a delay in economic development and fomenting political and social unrest. Judicious application of two factors might help East Timor to resolve this dilemma: budget component and time frame. It often helps to distinguish between recurrent and capital expenditures when determining fiscal balance. For example, until the East Asian financial crisis, Indonesia operated under a system it described as a ‘dynamic balanced budget’. All recurrent (‘routine’) expenditures and a portion of capital (‘development’) expenditures were covered by domestic revenue; the capital budget was ‘balanced’ by foreign assistance. Although total government expenditures exceeded total domestic revenue, the recurrent budget was balanced and extra capital spending was not financed by the issuance of domestic debt. This is one successful model that bears further evaluation by East Timor. Another model East Timor might wish to consider is setting a multi-year, medium-term balanced budget target, with a plan to progressively phase out

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budget deficits as anticipated domestic revenues are generated. The ‘equilibrium’ limit on government expenditures is one that can be sustained when East Timor’s fiscal capacity is realized. While this allows the government to invest when the need is most urgent and the cost is least, it entails two significant risks: anticipated revenues might never be realized; and a temporary budget deficit can easily evolve into a perpetual budget deficit. At present UNTAET is employing a combination of these two models: East Timor is spending considerably more for both recurrent costs and capital investments than it can now finance with domestic revenues (the difference being covered by foreign assistance); and there is a multi-year plan to bring at least the CFET budget into balance. The most critical untested assumption in this strategy is the speed at which East Timor can achieve a balanced budget for recurrent expenditures. Deficit Financing It appears that East Timor will inevitably run some sort of a budget deficit, at least for the next several years. Should this deficit be debt-financed? The primary attraction of financing the budget deficit through government borrowing is that leveraging of debt allows the public sector to make fuller utilization of current assets. Future revenues justify the present incurring of debt, because anticipated income streams will be used to service the debt as it matures. The main drawback to debt financing of budget shortfalls is that future revenue is often overestimated, and the government’s low repayment capacity leads to the diversion of scarce resources to service debt. In addition, a large amount of public sector borrowing can ‘crowd out’ the private sector, as the government either bids up the price of capital to prohibitive levels or denies private sector access to capital by mandate. Finally, overborrowing penalizes future generations, which eventually must generate the income to retire debt incurred earlier. Given the trade-offs of debt financing, the government of East Timor may wish to evaluate specific opportunities to borrow against the following criteria. • •

•

Source of debt. Foreign debt tends to appreciate in local currency terms, but domestic debt can be inflationary not only when the funds are utilized (like foreign borrowing), but also when the debt is paid off to domestic creditors. Terms of debt. East Timor qualifies for concessional terms, being among the world’s poorest nations. The only attraction of non-concessional lending is the potential for access to private capital markets and proprietary technology. Use of debt. One way to mitigate potential revenue shortfalls with which to

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•

Jay K. Rosengard service debt is to channel loans into cost-recovery investments, relying on grants for investments in social infrastructure and services. Non-debt sources. Two alternatives to debt, especially to finance capital expenditures, are foreign grants and private sector investment. Debt should only be incurred when these two options are unavailable or inappropriate.

In sum, foreign borrowings make sense if the rate of return on borrowed funds exceeds the interest rate – and East Timor can expect to borrow at highly concessional rates. Moreover, there may be occasions where the borrowed funds are indivisibly attached to key technologies, or access to foreign privatecapital markets or expertise. However, East Timor should exercise great caution in public sector borrowings, at least for the first decade of independence: plentiful grant funding should be available; large natural-resource revenues are in prospect; and it is doubtful that East Timor will have the bureaucratic or absorptive capacity to manage borrowings. Private overseas borrowing is prudent, as long as the government does not provide implicit guarantees.

RESOURCE MOBILIZATION Given the tremendous pressures for the government to generate revenue, the challenge is to meet this objective in a fair and efficient manner. This applies both to taxes and to user charges, at all levels of government.5 Tax Regime Common features of a sound tax regime are low tax rates, a large tax base and design simplicity. Low tax rates impose a relatively light tax burden. This is efficient in economic terms, as low tax rates have a small behavioural effect on taxpayers. Low tax rates are also a major incentive for voluntary taxpayer compliance, because it simply is not worth the cost of evading or avoiding the tax. The major drawback of low tax rates is that they can lead to revenue shortfalls and budget deficits, at least until the tax base is large enough and economic activity robust enough to generate sufficient revenue. The most attractive antidote to this, higher tax rates, tends to decrease revenue in the long run by shrinking the tax base through taxpayer non-compliance, and either discouraging economic growth or driving economic activity underground. A large tax base contributes to public perceptions of equity, and thus to political acceptability. While few citizens take pleasure in paying taxes, most are more likely to tolerate a tax if they know the burden is shared by all. The main disadvantages of a large tax base are the administrative difficulties of

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dealing with a large population and the political difficulties of having an unpopular measure affect so many people. Design simplicity enhances administrative efficiency and institutional transparency. The simpler a tax regime, the easier it is to administer and the more difficult it is to defraud. Nevertheless, a relatively simple tax regime can create perceptions of inequity because it is not fine-tuned to address subtle differences between taxpayers. Others are unhappy that simple tax regimes cannot accommodate the pursuit of non-revenue objectives such as individual investment and consumption decisions. In deciding how to balance the trade-offs entailed in designing a sound tax regime, East Timorese leaders should take note of a tax regime’s dynamic and interdependent nature. •

•

•

Tax rate versus tax base. The key to balancing these is sequencing. Revenue objectives are usually secondary at the beginning of a new tax regime, with the main objectives being to get people accustomed to paying taxes and to develop a complete and accurate tax roll. Over time the tax rate can be increased, but not to the point where further increases are counterproductive. Simplicity versus complexity. Again, sequencing is the key. Most new tax administrations have very weak institutional capacity, so systems that can be implemented consistently and fairly must be simple – it is better to be approximately right than precisely wrong. As the tax administration increases its capacity, the tax regime can become more sophisticated, but it should not become so complex that the average citizen finds it incomprehensible. Revenue versus regulation. The primary objective of a mature tax regime should be revenue mobilization, not regulation. It should be designed to generate the most revenue with the least expenditure, and to be buoyant enough to reflect changes in the fiscal capacity of the tax base.

User Charges The application of user charges is essential in East Timor, under the ‘user pays’ principle: you use it, you pay for it. This is equitable, as people pay in accordance with the benefits they derive from consuming a government good or service. User charges are also a key component of a cost-recovery business strategy. In addition, consumption-based payments encourage the conservation of scarce public resources. One of the most cost-effective ways to close a government’s investment gap is to decrease the amount of required investment through conservation. It will be a challenge to introduce user charges in East Timor. UNTAET is

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now providing most utilities free of charge to most households and businesses, so consumers are becoming accustomed to not paying for public services. Furthermore, most East Timorese have very low incomes, which could lead to lack of access to basic services if user charges are adopted. The government of East Timor can reconcile this trade-off in the introduction of user charges by designing them in the following manner. • • •

Rate structure. Progressive tariffs with a ‘lifeline rate’ are usually employed to ensure access for all to a minimum level of essential public services, while at the same time encouraging conservation by large consumers. Time frame. User charges are usually phased in at very low rates and increased over time in small increments to minimize both financial hardship and political and social dissatisfaction. Goods differentiation. The government is now providing goods and services with different characteristics, and user charges should reflect this. Some are quasi-private goods, like power and telecommunications, and should be priced commercially. In contrast, something that has a large positive impact on society as a whole (‘positive externality’), such as basic health care, might be offered almost for free to encourage consumption.

EXPENDITURE EFFICIENCY AND EFFECTIVENESS One of the most-often overlooked ways to close a government’s fiscal gap is to increase expenditure efficiency and effectiveness.6 While attention is usually focused on the mobilization of more resources, less revenue would have to be raised if existing resources were better utilized. The guiding principle is ‘value for money’. Expenditure Efficiency Expenditure efficiency, sometimes referred to as cost efficiency, is the measurement of production costs. Much can be learned about expenditure efficiency simply by looking at budget expenditures (usually in monetary terms) in terms of the total amount spent on a budget category; the unit cost of any input or group of inputs; and the relative costs of different budget items. The analysis is especially useful if budget expenditures are looked at over time and across jurisdictions. Trends, whether global, seasonal or cyclical, can be determined by examining budget expenditures for several reporting periods in the form of a time series. Efficiency in terms of relatively good, average or bad performance can be determined by comparing budget expenditure effi-

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ciency for units of government with similar characteristics. At the national level, the unit of comparison is other countries. Expenditure Effectiveness Expenditure effectiveness, or cost effectiveness, is the measurement of production results. Expenditure effectiveness is determined by looking at budget figures in terms of the total quantity of outputs produced; the quality of outputs produced when compared with performance standards; and the outcome of outputs produced, when compared with clearly articulated public policy objectives or benchmarks. As with expenditure efficiency, expenditure effectiveness should also be measured over time and across jurisdictions. Unfortunately, while it is relatively straightforward to assess expenditure efficiency by quantity and quality of outputs, it is extremely difficult to determine whether or not a policy objective has been achieved. Implications for East Timor East Timor has just begun to establish systems and processes for budget preparation and analysis, so capacity for sophisticated budget tracking and assessment is still quite weak. However, as budget expertise develops, the monitoring and evaluation of expenditure efficiency and effectiveness should become a critical decision-making tool for government leaders. It would provide senior government managers with an objective way to determine which expenditures produce the most ‘bang for the buck’, that is, are most cost-effective when compared with the alternatives. Wise use of these budget tools could save the people of East Timor a lot of money; failure to use them would greatly decrease government’s transparency and accountability.

INTERGOVERNMENTAL FISCAL RELATIONS Even though East Timor has not yet decided on the form of government it will adopt, some degree of decentralization will inevitably be part of the model.7 Central government fiscal constraints, when coupled with the central government’s limited span of control, will make it impossible to finance and manage all public sector activities from Dili. There are also expectations among the people of East Timor that victory in their hard-fought struggle for independence will empower them to have more control over their destinies. Participatory, decentralized democracy is part of this expectation.

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There are two key questions for East Timor with respect to intergovernmental fiscal relations: what are the strategic options for a decentralized state; and how will East Timor’s leaders know if their decentralization strategy is working? Decentralization Options Most of the debate surrounding intergovernmental fiscal relations in East Timor puts decentralization in absolute terms: will the country be decentralized or not? It would be more helpful to think about decentralization in relative terms: which sectors, functions and locations should be decentralized, and what form will this decentralization take? Some sectors are clearly the responsibility of the central government, for example national defence and security, national highways and national social entitlements. In contrast, subnational levels of government are usually responsible for sectors that do not transcend local boundaries, such as primary education, primary health care, tertiary roads, tertiary irrigation canals, and water, wastewater and solid waste services. Within these sectors, local government could be responsible for any or all of the following functions: planning, financing, implementation, monitoring and evaluation. For example, the central government might initially perform all functions related to the production and provision of potable water, but as local capacity increased, local government might assume responsibility for these functions incrementally, beginning with retail distribution. During this initial phase of decentralization, potable water production, treatment and transmission would remain the responsibility of higher levels of government, perhaps in partnership with the private sector. The responsibilities of local government can also vary considerably by location: geographic region, degree of urbanization and/or size. These are often shorthand ways to differentiate local capacity. For example, sparsely populated, relatively remote districts tend to develop local capacity more slowly than large municipalities. Finally, decentralization is a general term covering a wide spectrum of institutional models: de-concentration within a central ministry through the opening of regional or local field offices; delegation to semi-autonomous or quasi-public corporations, such as special water and power authorities; devolution to subnational governments; and transfer to NGOs or private commercial businesses. East Timor’s leaders may wish to defuse the decentralization debate by developing a matrix with sector, function and location on one axis and type of decentralization institutional model on the other. This would allow them to map out more systematically and precisely the nature and degree of decentralization most appropriate for East Timor now and in the future, keeping in mind the dan-

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gers of ‘over-government’ for a small nation with extremely few people experienced in public administration. The results should allow both advocates and opponents of decentralization to claim victory. Measuring Decentralization While political rhetoric about community empowerment may be uplifting and decentralization legislation may be encouraging, the most objective way to measure a country’s degree of decentralization is to follow the money: who generates revenue, and who decides how these resources will be spent? Expenditure assignments without the resources to meet these responsibilities, referred to as ‘unfunded mandates’, simply result in a degradation in the quality of local public goods and services. The same can happen with the automatic allocation of significant national budget resources amid confusion over the respective roles and responsibilities of different levels of government. East Timor’s leaders may wish to set up a database to monitor both the amount of resources mobilized by subnational levels of government and the discretion of local governments to utilize central government grant and subsidy transfers. Own-source revenue generated by local governments should be evaluated with respect to local fiscal capacity (potential) and local fiscal effort (performance); the standard with which to assess expenditure authority should be the specificity of conditions attached to central government funds spent at subnational levels.8

FOLLY OR FORESIGHT? East Timor is truly at a crossroads. It can ignore the extremely painful lessons of failed fiscal policies learned by emerging nations with profiles and circumstances similar to its own, particularly the small island nations of the Pacific and the Caribbean. Try to plan and direct the economy from central ministries in Dili. Deny the private sector and community-based organizations true partnerships in the development of East Timor. Pursue deficit spending and debt financing with great enthusiasm. Spend commodity-based revenue at a rate that exceeds the absorptive capacity of the country to use these resources wisely. Be a spendthrift, without regard for cost efficiency or cost effectiveness. Not relinquish revenue-generating or resource-allocation authority to subnational levels of government. Savour the moment. Take the ‘folly’ fork in the road. Or East Timor can benefit from the mistakes of others and avoid the costly misery they endured. Try to construct an enabling environment that creates incentives for private sector businesses and local community organizations to invest in East Timor’s future. Do not spend beyond the country’s means. Incur

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debt with extreme caution. Save temporary surpluses or short-term revenue windfalls for future development needs. Maximize expenditure efficiency and effectiveness. Allocate expenditure assignments, and the authority to generate sufficient revenue for financing these expenditures, to subnational levels of government in accordance with their administrative and fiscal capacity. Think ahead. Take the ‘foresight’ fork in the road.

NOTES 1

2

3

4

5 6 7

8

A recent comprehensive review of the role of the state can be found in World Bank (1997b). The specific issues summarized in this paper are debated at length in Buchanan and Musgrave (1999). All data are from World Bank (2000a), 1999 World Development Indicators, which in turn is based on the IMF’s Government Finance Statistics Yearbook, 1998 and IMF data files. Each country’s accounts are reported using the system of common definitions and classifications found in the IMF’s (1986) Manual on Government Finance Statistics. However, this is just a general guideline. There are notable exceptions: Botswana, a small natural-resource-based economy (diamonds), had expenditures equalling 39.4 of GDP, with a 4.5 per cent growth rate; several Middle Eastern countries (Jordan, Lebanon, Oman and Israel) spent 35–49 per cent of GDP, but had growth rates exceeding 5 per cent; Ireland spent 38.1 per cent of GDP with a 7.0 per cent growth rate, and Lesotho spent 55.2 per cent with a 7.8 per cent growth rate. If we assume that all East Timor-sourced national revenue were reallocated to East Timor through central government transfers, we would be double counting. An alternative assumption, used here, is that central government transfers were redistributive: East Timor would have received the same level of transfers regardless of national taxes generated, so the revenue is additive (used for national public goods), not duplicative. The classic text on public finance is Musgrave and Musgrave (1984). ‘Fiscal gap’ is the difference between required expenditures and available resources. Two standard texts on intergovernmental fiscal relations and local government finance are Fisher (1996) and Bahl and Linn (1992). The first focuses on the United States, while the second has a more international perspective. A good example is the interministerial, 12-year time series developed in Indonesia to monitor and evaluate decentralization (Ministry of Finance 1997).

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Trade and Commercial Policy Hal Hill*

Trade and commercial policy is one of the keys to a prosperous and viable East Timor. Along with macroeconomic and social policies, and institutional development, no set of policy issues is more important. ‘Openness’, variously defined, consistently emerges as a significant and positive factor in the large ‘determinants of growth’ literature (see, for example, Barro and Sala-i-Martin 1995). Two lessons from more than 50 years of development experience stand out: open economies grow more quickly than closed ones; and high levels of savings and investment – the engine of development – will occur only if economic agents, from rural cottage enterprises to multinational corporations, can operate in a secure, stable and conducive commercial environment. These propositions provide the unifying themes of this chapter. We develop here the bare bones of an approach to trade and commercial policy which focuses in turn on the specifics of trade policy, trade and industry policy, measures to promote an efficient private sector, and policy issues and options for the state enterprise sector. These are of course large and complex issues, and one paper cannot discuss all of them in detail.

TRADE POLICY Some General Considerations Three lessons from economic development should inform commercial policy in East Timor: • •

outward-oriented economies outperform inward-looking ones; in small economies the costs of trade intervention are large and quickly evident; and 71

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72 •

Hal Hill by dint of geography, it is sometimes observed that ‘God made archipelagic Southeast Asia for free trade’.

East Timor has very little choice other than to maintain an open trade regime, where the lower boundary is obviously free trade, and the upper limit is Indonesia’s (now very open) trade regime. Protecting one sector entails taxing others, and it is not obvious that any particular sector deserves protection over any other. Assuming they (deservedly) receive a high priority, rural and agricultural activities can be promoted through direct productivity-enhancing investments in such areas as roads, irrigation and agricultural extension. In addition, East Timor’s sea and land boundaries with the rest of eastern Indonesia are so porous that high trade barriers would almost certainly be circumvented by smuggling. Relative to its land area, East Timor has a long coastline and lengthy land boundary (of approximately 170 kilometres) with Indonesia. Much of it is impossible to police and, as relations with Indonesia are normalized, informal trade will simply be a matter of course, as it has been for centuries. Already by late 2000, it was evident that there was extensive, unofficially sanctioned trade across the East–West Timor land boundary, even though officially this boundary was sealed off. Non-tariff barriers to trade should generally be avoided owing to their lack of transparency, their corruption-prone nature and the fact that their rents invariably accrue to individual beneficiaries rather than the public purse. It might be argued that, in the absence of effective income and expenditure tax-collection procedures, tariffs are necessary for revenue-raising purposes. This is the approach of the interim administration: there is a 5 per cent acrossthe-board import duty plus a fairly widespread 5 per cent surcharge. Customs procedures are now fairly simple and straightforward. This approach is, theoretically at least, a second-best policy strategy as compared with an expenditure tax, which is neutral between imports and domestically produced goods. Therefore, notwithstanding the difficulties, it would seem desirable to shift towards some sort of turnover tax as quickly as possible, so as to avoid the temptation of using duties as protective devices. The current rates at least have the advantage that they are set low enough so as not to encourage the proliferation of protectionist pressures. In addition, there may be a case on both equity and efficiency grounds for levying duties on selected luxury goods consumed mainly by expatriates, and for which local substitutes do not exist (and are not likely to for the foreseeable future). External commercial relations East Timor’s major trading partners will inevitably be Australia and Indonesia.1

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Assuming that it maintains a policy of open frontiers, no special policy initiatives will be required to develop these relationships, other than measures to ensure customs harmonization, perhaps some trade promotional initiatives2 and the provision of competitive transport services. Preferential trading arrangements would be irrelevant if East Timor opted for free trade, and should be avoided if the uniform tariff option is adopted. While Australia and Indonesia will always be East Timor’s dominant trade partners, a note of caution should be injected. In both cases, the immediate point of geographic contact is with regions that are rather isolated from the national economy – namely the islands of eastern Indonesia, and northwest Australia. In each case, these subregions amount to less than 5 per cent of the national economy. Owing to distance, their cost structures are high. And because of egalitarian political pressures, the government sector is disproportionately large in both cases. Thus, while East Timor is proximate to two much larger economies, it is some distance from the major centres of commerce in each. There would be obvious benefits for East Timor in joining the Association of Southeast Asian Nations, ASEAN. Membership would give it access to an influential regional grouping and help broaden its Southeast Asian ties beyond Indonesia. It would connect it commercially to several strong, outward-looking economies from which it could learn much in the area of development policy and practice. It would also help to lock in a liberal trading regime, under ASEAN Free Trade Agreement (AFTA) commitments, especially as in practice (if not in principle) ASEAN is a non-discriminatory trading group. Finally, membership would give it a voice in international issues on a scale far greater than such a small nation state could normally hope for. Although there exists no precedent for dual memberships, the South Pacific Forum would most likely be open to East Timor. There is a danger that the country’s tiny diplomatic resources would be stretched too thinly by joining several international and regional organizations, and the South Pacific offers few commercial opportunities. But, given shared Melanesian interests, there are affinities with several South Pacific nations, and membership of the Forum might also confer trade and aid advantages. Export promotion and processing zones In an open and undistorted economy, no particular importance attaches to exports over any other activity. That is, a dollar of value-added earned from exports is identical to that earned elsewhere. It is therefore important not to ‘overdo’ export promotion strategies at the cost of other sectors. Moreover, the most effective way of promoting exports is through a competitive and efficient domestic economy, rather than special initiatives. Within this general context, however, there may be scope for limited and

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targeted promotional work, perhaps through private-sector, joint-venture initiatives. Outward orientation may facilitate technology transfers from abroad, to the extent that exposure to world markets introduces some positive externalities (for example, new skills and products). In addition, a strong export sector helps to focus a government’s attention on the imperative of supply-side efficiencies, and it provides a buffer against protectionist pressures at home. One popular export promotion instrument in developing countries is exportprocessing zones, or EPZs (Warr 1989). This involves establishing a free trade area in a specific geographical location (although duty drawback facilities can in principle be operated anywhere). Some zones include special provision of infrastructure facilities; tax and labour regulations may also be zone-specific. It needs to be recognized immediately that these zones are second-best instruments. Singapore doesn’t need them because it is completely free trade. That is, they are generally introduced when governments wish to promote exports, which are penalized by the presence of import barriers in the home economy. There may be a case for such zones as a temporary measure if it is judged that the option of free trade cannot be achieved immediately. If East Timor opts for free trade, or a uniform tariff regime (the latter with a rebate for exporters), then an EPZ is redundant on this ground. There may still be a desire to establish an industrial zone for exporters, adjacent to a port or airport, to coordinate the provision of physical infrastructure. Such an initiative does not involve any customs or trade policy issues. One hears of such proposals in East Timor for Atauro and Oecussi, for example. Here the principal policy issues relate to efficient locational considerations and the pricing of infrastructure. It is important in particular to be clear about the objective: is it to facilitate industrial growth, or to promote the development of a particular region? If it is the latter, it is important not to introduce ‘locational diseconomies’ by forcing firms to locate in other than least-cost regions. If the government wishes to develop a particular region, this will be achieved most effectively through direct grants and programs, rather than pushing up costs for firms. It will make sense for East Timor to appropriate the rents from any special export opportunities. For example, there are implicit aid flows from the European Union to African, Caribbean and Pacific (ACP) countries under the Lome Convention, which East Timor will presumably be able to avail itself of on independence. Duty-free access to Australia (and New Zealand) may be extended to East Timor under the Spartaca facility, which currently is open to South Pacific nations. There will also be export quota entitlements under the Multifibre Agreement (MFA), which regulates the international trade of textiles and clothing. However, it would be unwise to lock in resources on the assumption that these are permanent arrangements. They provide at best a short-term window

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of opportunity. Most such facilities will be phased out quite soon, or the margins of preference will decline. For example, the MFA will be abolished shortly, and trade in textiles and clothing will be integrated within normal World Trade Organization rules. Thus the rents associated with country quotas will disappear. Similarly, the benefits of Spartaca are diminishing as Australia and New Zealand move closer to a free-trade regime. It may be possible to attract investors on the basis of these short-term export rents, then build up competence and efficiency to the point where these firms will choose to stay in a fully competitive environment. This will be achieved by addressing the obstacles to business efficiency adumbrated below. A strategy of short-term rent dissipation, followed by fiscal incentives when the special export access disappears, would be very costly. Attempts to interfere with export channels, markets and prices almost invariably backfire. East Timor has no market power in any of its exports (very few countries ever do beyond the short run), and thus any notion of an optimal tax on exports is irrelevant. Similarly, attempts by governments to set up ‘orderly marketing boards’ for exports have been almost uniformly disastrous. Inevitably, in the early stages of its development, East Timor’s exports will be narrowly based, around coffee, other cash crops, a few minerals and manufactures, and tourism. As gas comes on-stream, this concentration is likely to narrow still further. This is a fact of life with which East Timor will simply have to deal, as is the case in many other very small economies. It will be important to develop the flexibility in fiscal policy, and in product and factor markets, to be able to adjust to sudden changes in the terms of trade, in particular to build up reserves during periods of high international prices. Government and business will also need to be on the look-out for profitable export diversification opportunities, while avoiding the temptation to promote particular industries or products simply on the grounds that they may facilitate export diversification. Foreign Investment and Labour Foreign direct investment (FDI) and international labour flows both involve a complex set of economic and political considerations. In both cases, too, owing to a substantial East Timorese diaspora around the world, the definition of ‘foreign’ is problematic. Indeed, as in many other countries, this diaspora could become an asset for East Timor, as it provides a bridge to international trade and investment opportunities. East Timor will need to attract foreign investment, not so much for the capital it brings as for the accompanying benefits of technology and international market connections. This applies to the mining sector, tourism projects, possibly to some cash crops (although buying networks rather than investment may be more critical) and potentially to some labour-intensive investments. FDI will

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be especially important, moreover, in weaning the economy off a very heavy initial reliance on the government sector and international aid flows. The principal FDI policy challenges concern the regulatory and fiscal regimes. Both should be guided by simplicity and transparency. It is probable that a special taxation regime will need to be instituted for the mining sector. Elsewhere, in order to attract foreign investors, there will be pressures to offer foreign investors fiscal incentives, especially as a means of establishing the country’s commercial reputation abroad. Such an approach carries with it considerable risks. Surveys generally show that foreign investors value a simple and clear regulatory framework and an attractive business-friendly environment more highly than incentives. A uniform and low general tax rate, as in Hong Kong, would almost certainly be preferable to a regime of higher rates combined with concessional incentives. Moreover, incentives can quickly degenerate into a de facto and costly form of industry policy, as policy planners attempt to employ them in an exercise of picking winners. Worse still, incentives are often corruption-prone. Whether particular sectors or activities should be closed to FDI is principally a political question. The economic case for such restrictions is weak. It might not be politically possible to allow foreign ownership of land, but in such a case it would be imperative that clearly defined, transparent and long-term leases be available for land-intensive activities such as tourism and export-oriented cash crops. This is especially so given the great uncertainty that currently exists about land ownership (see Fitzpatrick, Chapter 11). East Timor could learn much from the early days of Singapore’s Economic Development Board (EDB). Especially after its separation from Malaysia, Singapore set out aggressively to attract FDI by lowering the costs and uncertainties of establishing and running a business in the country: it provided simple and clear regulations; an efficient and corruption-free bureaucracy; ready availability of good-quality and competitively priced infrastructure; a predictable policy regime; and a generous but efficiently administered tax regime.3 The question of international labour movements similarly involves balancing a range of economic and political considerations. This is emerging as a major policy issue in East Asia, as millions of workers migrate to more prosperous countries and regions (Athukorala and Manning 1999). As one of the poorest countries in the world, East Timor is more likely to be a source than a recipient of such flows, and thus no special policy initiatives need to be instituted. The principal exception concerns the transitional period of very high aid dependence. Here, as noted above, as far as possible it will be important to avoid embedding in the economy a heavy dependence on internationally priced labour, except in certain high-skill areas where international remuneration levels will apply in any case. Since the government will be a direct employer of much of this potential labour force – teachers, nurses, engineers – its own wage

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policies will have a major influence on the economy-wide wage structure. To the extent that it is politically possible, Indonesia (and possibly the Philippines) could well become a significant source of middle-level skilled labour in the economy. However, to ameliorate local grievances, it is obviously critically important that the indigenous skill base be developed to the point where East Timorese themselves are qualified for most labour market opportunities. Industrialization It is often argued, fallaciously, that industrialization is the sine qua non of development; that without a large industrial sector it will be impossible to raise a country’s living standards. There is little theoretical or empirical support for such a proposition. It will therefore be important for policy-makers to resist the temptation to pursue particular industrialization targets. During the Indonesian period, manufacturing generated about 3 per cent of the then-province’s gross regional product, equivalent to about one-eighth of the national Indonesian share. The major manufacturing centre was Dili, with about 23 per cent of the industrial workforce. Simple food manufacturing and agricultural processing dominated the sector, accounting for almost two-thirds of manufacturing valueadded. Textiles (16 per cent of the total) and wood processing (14 per cent) made up most of the rest. With nationhood, the size and diversity of the industrial sector might be expected to expand somewhat. Agricultural processing opportunities may emerge. Some ‘home goods’ may develop to service the small urban markets, including aid and oil-related activities. There may also be some export opportunities, particularly those which accrue to sovereign entities. As discussed above, the latter might include export quota privileges and opportunities. But the expansion will most likely be quite modest. For example, in nearby Papua New Guinea, which is larger and more developed, manufacturing accounts for just 8 per cent of GDP. Should the government develop some sort of industrial extension activities? The main point to emphasize in this context is that the major determinants of industrial success are almost invariably economy-wide factors: competitiveness (that is, relative prices and productivity), macroeconomic management, physical infrastructure, the skills base and the legal system. Microeconomic, industry-specific interventions will always be of minor importance, especially in a country like East Timor at such a low starting point. We do of course know that markets for innovation and technology do not always work well. That is, technologies (in production processes, management, marketing and so on) are available and would be economically efficient, but for various reasons are not adopted. This may be because of ignorance, risk aversion, imperfections in the capital market, an inability to appropriate investments

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in R&D, or non-economic constraints and behaviour. In these circumstances, governments may be able to play a role in hastening the pace of innovation and productivity growth. Bearing in mind the East Timorese context, international experience suggests that the following considerations are important in any such industrial extension program. • • •

•

Programs need to be demand-driven, that is, the ultimate users must really want them. Too often, it is bureaucrats who make the decisions, with the result that the schemes do not take root. Programs should have clearly defined ‘sunset’ clauses, after which they are reviewed against the option of closure. There also needs to be a timetable for phasing out – or at least reducing – subsidies over time. The private sector should be engaged in all aspects, and especially in delivery. International aid programs may be a mixed blessing, since donor interests may (intentionally or otherwise) skew the program or be excessively ‘high-tech’. In addition, donors may be sporadic in their support. There is a tendency to think of international transfers of technology as consisting of grand, large-scale initiatives. However, for East Timor, apart from a few special cases of large investments (for example, the oil and gas industry), the most effective transfers will probably be informal and ad hoc. A prime requirement for success here is that the country be an attractive and comfortable place for foreigners to visit, reside and do business.4

Small and Medium-sized Enterprises Practically all manufacturing in East Timor is small-scale, and likely to remain so for the foreseeable future. In 1996, for example, there were a little under three workers per industrial ‘establishment’. Thus no special policies are required for this class of firms. But since one hears everywhere the argument that small and medium-sized enterprises (SMEs) are deserving of special assistance, it will be useful to review briefly some of the key points in the literature. Depending on definitions, SMEs dominate much of industry in the less developed countries (LDCs).5 The general presumption is that these firms become less important over the course of industrialization. The empirical evidence on this issue is mixed, however. Declining SME shares may simply indicate industrial dynamism, that is, firms ‘graduating’ to larger size groups, as some studies show, rather than SMEs falling by the wayside. One interesting twist to this debate is that, for various reasons, these firms appear to have fared well during the recent East Asian crisis. The policy approach to SMEs has changed over the past decade, based on the gradual realization that, for all the government rhetoric concerning their importance, public policies have often actually discriminated against them.

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Trade policies have been biased against SMEs to the extent that they have offered above-average protection to large-scale intensive industries. Fiscal incentives have had a similar effect. Interest rate ceilings have often affected SMEs adversely, since banks cannot recoup the higher per-unit administrative costs of dealing with such firms. Complex regulatory regimes, which are frequently fixed-cost in nature, add an additional cost penalty for SMEs. Transport Networks Transport infrastructure is examined in detail by Cheatham and Jarvenpaa in Chapter 14, but it is useful in passing to link it briefly to trade policy issues. This is because sometimes transport costs may drive a larger wedge between international and domestic prices than trade policy barriers. This applies to landed costs in a country’s major port, and to an even larger degree to intracountry differentials. International transport networks to East Timor have been restored, although currently there is a lack of competition in most cases. That is, all the providers are monopolists (though in principle the markets should be contestable). For example, there is only one operator flying to Dili from each of the the two international gateways (Den Pasar and Darwin, serviced by Merpati and Air North respectively) and air travel is very expensive. Likewise, in the case of sea transport, there is just one shipping line each from Surabaya and Darwin. Informal small-scale shipping networks are thought to be developing again, and there is quasi-legal cross-border trade across the land boundary. Prices in Dili, let alone up-country, appear to be substantially higher than what might be expected on the basis of some reasonable allowance for transport costs. This raises the possibility of monopolistic pricing by transport providers, or regulatory impediments at the point of origin. The problem is probably more serious in the case of the Indonesian transport connections, underlining the importance of ensuring that there is contestability in the case of these transport services. In turn, this highlights the broader issue of normalizing relations between the countries as quickly as possible.

A CONDUCIVE INVESTMENT ENVIRONMENT A major development challenge for an independent East Timor will be how to achieve strong and durable private sector growth. There is considerable potential here, with a sizeable Timorese diaspora interested in returning to the country and commercial opportunities spinning off from aid and oil-related projects. Fostering a dynamic private sector is crucial if the country is to avoid the problems evident in so many other tiny, newly independent nation states: a heavy

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and protracted dependence on aid flows, a bloated government sector, and private investments concentrated in short-term investments with a quick pay-off.6 In the short to medium term, East Timor will not be an attractive destination for footloose investments, that is, outside the government, cash crops, gas and aid-related sectors. Early data on business approvals support such a contention: through to 20 March 2001, 71 per cent of the cases approved were in retail trade and commerce. The only other sectors of any significance were construction (11 per cent), transport (5 per cent), and hotels, cafes and restaurants (4 per cent). These figures of course reflect the early phase of reconstruction, and the response to the sudden and massive expatriate presence. But there is a danger that they may be setting the pattern of things to come. The key challenges and obstacles in establishing a conducive business environment can be summarized as follows. First, ownership arrangements are highly insecure, especially for land (see Fitzpatrick, Chapter 11). More generally, legal and investment codes have yet to be developed, and there is no effective form of investment protection. Second, cost structures are higher than those of potential competitors (that is, competitors for footloose investment) such as Indonesia and Vietnam. For example, unskilled wages are very high by regional standards. In the coffee estates, daily wages are reportedly about $3, or two to three times those in Indonesia (see Pomeroy, Chapter 8). Minimum daily wages in the public sector have been set at more than $4, and the public sector in turn will be a major determinant of wages in the small, urban, formal labour market. Moreover, while it would be expected that prices in the ‘expatriate economy’ would be based on those prevailing in Darwin, the Timorese economy is also very expensive. Partly, there are general cost–push pressures resulting from the expatriate presence. But even for Timorese markets, goods are expensive. Dili was always expensive in Indonesian times, with a differential of 20–40 per cent above Java. But impressionistic evidence suggests that this differential may now be as much as 100 per cent for many simple consumer goods. Third, relative prices are rigid. While the use of the US dollar makes sense as a means of securing macroeconomic policy objectives, Timor is linked to a strong currency, and will most likely have a fairly rigid labour market. Thus the option of boosting competitiveness through a nominal depreciation which ‘sticks’ (that is, a real effective depreciation) is not available. Fourth, there are acute shortages of skilled and semi-skilled labour (electricians and mechanics, for example), for which Darwin prices – which are in turn high by Australian standards – apply. To avoid relying on the expensive northern Australian labour market, East Timor will need to tap into more competitive East Asian labour markets, as noted above. As a longer-term strategy, there will need to be significant investments in skilled and semi-skilled labour. Fifth is the problem of poor infrastructure: power supplies are uncertain (a

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generator is essential as a back-up), and there is heavy reliance on the (expensive) Telstra mobile telephone network. Sixth is the absence of a modern financial sector. The foreign banks now present, from Portugal and Australia, are obviously reluctant to accept any local collateral in connection with loan applications. Effective rural financial networks will also be stymied as long as land titles and ownership remain unclear. Finally, and inevitably, there is uncertainty about post-independence policy directions. It is easy enough to point to these and other daunting problems. In a country that lacks effective public administration and legal institutions, and has yet to chart its future, these obstacles are perhaps inevitable. But they do highlight many of the key development challenges. The key point to emphasize is that these obstacles need to be tackled at their source, rather than developing new institutions and grand programs to overcome them.

STATE ENTERPRISES Nowhere are the benefits of East Timor’s latecomer status likely to be more evident – in the sense that the lessons of international experience are so obvious – than in policies towards state-owned enterprises (SOEs). The country is unlikely to inherit a large SOE sector, but it could in time become quite sizeable. Apart from the utilities, there may be some Indonesian property, the unresolved status of which results in it becoming de facto state-owned. With very large oil and gas flows in prospect, the temptation will be to develop grandiose development projects. Sections of the new political leadership will probably be sympathetic to the notion of a state-directed economy, particularly if import protection is effectively excluded from the policy menu. The record of SOEs in developing countries is almost invariably disappointing. Their commercial performance is poor. They are often large claimants on the government budget, thus squeezing resources for desperately needed social goods. Not infrequently they receive additional benefits from governments, such as tax exemptions, credit guarantees and protection from competition. Moreover, there are rarely positive externalities (such as training and better environmental management) to compensate for this poor commercial record. In the worst examples, SOEs become an endemic source of corruption and political patronage. Privatization of SOEs is often implemented corruptly, as tendering processes lack transparency, and assets are sold cheaply to the politically well-connected. Of course, much depends on the general quality of public sector administration and accountability. Singapore has a large, apparently well-managed SOE sector in the context of a very open economy. But even a country such as

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Malaysia, with comparatively good standards of governance, has had difficulty ensuring adequate SOE performance (Gomez and Jomo 1997, Ch. 4). Given that East Timor’s ‘initial conditions’ will be far below these examples, it is difficult to envisage an efficient SOE sector emerging. Most SOEs will likely be in infrastructure. The challenges facing them will be to: • • • • •

develop a regulatory framework that ensures that natural monopolies do not engage in anti-competitive behaviour; especially in the case of SOEs producing non-tradable goods and services, develop internationally comparable ‘benchmarks’ for pricing and operational efficiency; provide enough operational independence for these enterprises to ensure that political pressures are minimized; specify clear, simple and non-conflicting performance criteria; and explicitly cost and transparently fund any social obligations that SOEs are expected to perform (for example, the provision of subsidized electricity).

It will probably be the case that core SOEs (for example, utilities) will remain in public hands, because any potential private suppliers would likely demand a prohibitive risk premium before entering such long-gestation, capital-intensive activities in a country like East Timor. There may be some scope for cross-subsidies (on power pricing, for example, so that very small consumers pay a lower rate). But this would need to be controlled carefully, both to avoid abuse and so that larger consumers are not paying rates well above international norms. Ideally, the subsidies would be paid directly from the budget to electricity providers and appear as a clear budget item.

NOTES *

1

2

I am most grateful for helpful comments and discussion at the Dili Forum. Some of the issues alluded to in this paper are developed in more detail in Hill (2001b). See also da Costa (2000). It is obviously not possible to verify this proposition with data from the Indonesia period, and post-1999 trade statistics have not been assembled. In the case of investment, through to 20 March 2001, Australia and Indonesia were the major foreign investors, accounting for 39 and 24 per cent of total registered foreign investments respectively (by number of cases; value data are not yet available). Other forms of commercial cooperation may develop in time. One often-mooted possibility, for example, concerns the tourism industry, and envisages joint promo-

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tional efforts and transport facilities between Bali, East Timor and northern Australia. The fascinating history of the EDB is recounted comprehensively in Low et al. (1993). The one major reservation I have concerning its otherwise brilliant record of achievement concerns fiscal incentives, as noted above. Of course, with a high-quality bureaucracy and minimal corruption, there is more scope for a country like Singapore to experiment with such incentives. One thinks in this case of some of the recent SME success stories in Indonesia, and the important role that informal foreign inputs have played in connecting these firms to international market outlets and in providing technical inputs in areas such as quality control and consumer tastes. See, for example, the case studies of the Jepara (Central Java) furniture industry and Bali’s clothing exports, by Sandee et al. (2000) and Cole (1998) respectively. For a general review of SMEs in East Asia, see Berry and Mazumdar (1991). The Indonesian experience is surveyed by Thee (1994), while Sandee et al. (2000) provide an interesting case study of the impact of the recent crisis. Such a pattern in the Pacific Islands is aptly analysed by Duncan, Cuthbertson and Bosworth (1999). See also Chapters 19 and 20 in this volume by Chand and Elek.

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SETTING THE RIGHT POLICIES President Abdurrahman Wahid’s visit to East Timor in February 2000 paved the way for an important process of reconciliation between Indonesia and East Timor. This process may bring about more far-reaching results than reconciliation, namely Indonesia’s constructive role in the development of East Timor as an independent state. Following that visit, an agreement was reached between Indonesia and the United Nations Transitional Administration in East Timor (UNTAET) to initiate structured discussions covering a broad range of issues. These will help lay the foundation for relations between Indonesia and a postUNTAET East Timor. As stipulated in the Joint Communiqué between the Republic of Indonesia and UNTAET, dated 29 February 2000, the discussions would include: 1 the repatriation and resettlement of East Timorese refugees currently in West Timor; 2 the scope for mutual assistance in legal, judicial and human rights matters; 3 the delineation of land and maritime borders and regulation of cross-border relations, including a transit corridor between Oecussi, East Timor’s enclave in West Timor, and the main territory of East Timor; 4 the orderly settlement of mutual claims and liabilities, including extending access to East Timorese to their deposits in Indonesian banks; 5 the regularization of payments of state pensions to retired East Timorese employees of the Indonesian government, as well as the determination of the status of the cumulative contributions of East Timorese public servants to the Indonesian state pension system up to August 1999;

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6 the maintenance of educational opportunities and scholarships for East Timorese students in Indonesian educational institutions; 7 the definition of the trade regime, which will affect bilateral commercial relations and the re-establishment of trade relations; 8 the establishment of agreements to develop aviation, commercial transport and communications links between Indonesia and East Timor; and 9 the rebuilding of East Timor’s archives and records, such as property titles, the taxpayers’ registry, judicial and police records, and census and civil records. The fourth meeting between the government of Indonesia and UNTAET under the Joint Communiqué was held in February 2001. A separate memorandum of understanding between Indonesia and UNTAET provides a framework for cooperation on military issues, including steps to improve security conditions at the border and in refugee camps in West Timor. Discussions in greater detail on the above border issues are undertaken within the Joint Border Committee. It has four subcommittees, dealing with traditional border crossing, regular border crossing, police cooperation and security cooperation. These committees met for the first time in March 2001. It is perhaps too early to assess the success of these discussions and negotiations. Progress has been achieved in some areas, but certain issues will be discussed only after East Timor has gained full independence. Some issues can be resolved readily but others may require a lengthy process of negotiation. However, the overall climate is likely to be characterized by goodwill and a determination to reach outcomes that are to the satisfaction of all parties concerned. This is the brief given to Indonesia’s negotiating team, as told to the author in an interview, and as stated by Musma Musa Abbas, the head of the Indonesian delegation to the Donors’ Meeting on East Timor in Lisbon, in June 2000 (Abbas 2000). Support for promoting good relations between Indonesia and East Timor has been aired within the two countries as well as in Portugal and Australia. An editorial in Kompas called for Indonesia’s support for East Timor’s development (25 February 2000). The Portuguese Foreign Minister, Jaime Gama, stated that the reconstruction of East Timor would require Indonesia’s assistance (Suara Pembaruan, 27 May 2000). Similarly, Mario Carrascalao, former governor of East Timor and currently one of East Timor’s leaders, argued that East Timor had no choice but to strengthen its relations with its two closest neighbours, Indonesia and Australia. Richard Woolcott (2001), former Australian Ambassador to Indonesia, has espoused the same view. Development of economic and business links are seen as key to this relationship. As described by Abbas, the Indonesian government’s policy will focus

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on the promotion of trade and investment as well as cooperation in the sociocultural field to establish ‘durable and wide-ranging and mutually beneficial links with East Timor’ (Abbas 2000). Trading relations between Indonesia and East Timor are inevitable. Sergio de Mello, head of UNTAET, has argued that ‘East Timor is still tied economically to Indonesia’ and that West Timor, Surabaya and Den Pasar will become East Timor’s main trading partners (Jakarta Post, 7 January 2000). The word ‘tied’ is perhaps politically incorrect but also does not describe the situation properly. It would be more appropriate to describe East Timor as being ‘integrated’ with Indonesia economically. For political reasons or otherwise, East Timor may opt to loosen this integration, but this would be achieved at the cost of its becoming a ‘high-cost’ economy. Reports from East Timor have recorded views about the importance of trade relations with Indonesia in securing the supply of basic necessities (Suara Pembaruan, 16 February 2001). The World Bank has stated that trade between East Timor and Indonesia makes economic sense, especially as the rupiah is the de facto currency of legal tender there (Jakarta Post, 7 January 2000). Although Indonesia could become East Timor’s main trading partner, the World Bank also notes that there are political issues that may prevent this: economics cannot be separated from politics. The political problems between Indonesia and East Timor are not insurmountable, however. Indonesia has been able to mend and develop its relations with the Netherlands. It is true that having no common borders with the Netherlands made this easier. Therefore, managing the problems that relate to the common border is of utmost importance and the Joint Border Committee mechanism is a necessity. A speedy resolution of the problem of refugees in West Timor will remove a major, and dangerous, political obstacle in the long-term relations between the two countries. Such a resolution is critical to alleviating the fear of Indonesian intentions to regain or reincorporate East Timor in the future. Some wishful thinking of this type may exist, but a democratic Indonesia cannot harbour such intentions. The need for some kind of reparation from Indonesia to East Timor was raised by Lt. Gen. Jaime de los Santos, the first Commander of the Peacekeeping Force of UNTAET, in an interview in October 2000 (Pattugalan 2000). This issue may not arise in future negotiations with an independent East Timor if satisfactory agreements can be reached on the various issues stipulated in the Joint Communiqué referred to above. For instance, Indonesia should not use the claims on assets in East Timor as a negotiating lever. The question of the individual assets of Indonesians, mostly civil servants, who have left East Timor should be settled between the government of Indonesia and those individuals. It should also not bring to the negotiating table the issue of foreign debt associated with the development of infrastructure and other development projects in the former province of East Timor. This should be discussed between the government of Indonesia and the respective creditors.

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Indonesia may face real constraints in assisting East Timor’s development. As stated by Abbas (2000), ‘[s]ince our capacity to contribute is limited by constraints of Indonesia’s financial resources, our focus today is on policies that are helpful to East Timor’s development’. This suggests that financial transfers should not be seen as the centrepiece of Indonesia’s relations with East Timor. Instead it is critical to the relationship that Indonesia puts the right policies in place. This proposition applies equally to the East Timorese side (Hill 2000a).

DIRECTION OF EAST TIMOR’S DEVELOPMENT Can Indonesia influence the direction of East Timor’s development? It should not try to do so, but it does need to be aware that some of its policies may affect the structure and nature of its relations with East Timor. A recognition of this possibility suggests that Indonesia should not determine such policies unilaterally but should engage in consultations, either formally or informally, with the leaders of East Timor. Indonesia may also have to adjust its policies to take account of the direction of economic and political developments in East Timor. It should therefore monitor such developments closely. Internal discussion and debate on development in East Timor is at present open and transparent as different models and concepts are being contemplated. It is important for Indonesian policy-makers to begin to assess the economic and political implications of adopting any of the different models on East Timor’s relations with Indonesia. It is equally important to take note of the selfperceptions or expectations about East Timor’s present and future development that are prevalent among the leaders and people. The Economy East Timor is a small economy, a ‘mini-state’ that is dwarfed by its immediate neighbours, Indonesia and Australia. This is a fact that it cannot change. In 1997, as a province of Indonesia, East Timor’s GDP was less than 0.2 per cent of Indonesia’s total GDP. But being a small economy is not always a disadvantage (Hill 2000b). A small economy can be either poor or rich; it can be either isolated or integrated with its neighbours (or the world economy). There are thus five possibilities for East Timor, namely to be: (1) poor and isolated; (2) poor and integrated with its neighbours; (3) rich and isolated; (4) rich and integrated with its neighbours; or (5) rich and integrated with the world economy. Options (4) and (5) may not be mutually exclusive, as East Timor could be integrated both with its neighbours and with the world economy at the same time. It should be noted that a poor East Timor cannot hope to be integrated with the world economy.

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It is unlikely that East Timor would opt to become a small and poor economy that isolated itself from its neighbours, especially Indonesia. This would happen only if the East Timorese polity decided to cut off relations with Indonesia totally. In such a case, Indonesia would not need to concern itself with adopting policies that promoted economic and trade relations with East Timor. Would a small but rich East Timor opt to isolate itself from its neighbours? Such a scenario should not be discarded out of hand. Its policy could be to conduct normal economic relations with any country in the world because it saw no necessity to develop special or close relations with particular countries. If wealth were relatively evenly distributed, so that all citizens enjoyed a fairly high standard of living, East Timor could adopt such a posture. The ‘Brunei’ model comes to mind here. The Brunei model is not far-fetched, at least in the perception of some. The model relies for its credence on the huge stream of income from oil and natural gas that East Timor may receive through successful renegotiation of the Timor Gap Treaty. Optimistic projections based on calculations provided by UNTAET’s Political Minister, Peter Galbraith (Suara Pembaruan, 16 February 2001), have been cited widely. In November 1999, Phillips Petroleum Co. and four partners agreed to invest $1.4 billion to exploit the Bayu-Undan oilfield. Phillips already operates the smaller Elang oilfield and pays royalties and taxes on the oil to East Timor based on the rate it pays to Indonesia. The Bayu-Undan oilfield is estimated to produce 400 million barrels of crude oil and 3.4 trillion cubic feet of natural gas annually. Taxes are expected to reach $300 million a year once production begins in 2004. Royalties are projected to amount to $700 million (Suara Pembaruan, 16 February 2001). Mari Alkatiri, East Timor’s transitional Economics Minister, believes that those royalties and taxes could help quintuple annual per capita income to $1,000 by 2009. According to the calculations of the World Bank mission in East Timor, those revenues could fuel an annual economic growth rate of 15 per cent for nine years (Shari and Gaylord 2000). Implicit in the Brunei model is the overdependence of the economy on a single export commodity, oil and natural gas. East Timor’s current main export is coffee, but income from coffee exports would be overshadowed by the huge revenues from oil and gas. Coffee is a critical crop for East Timor: it is the most important source of cash income for a sizeable portion of the rural poor, and coffee processing is an important source of seasonal employment (Pomeroy 2001). Pomeroy calculates that exports of 8,000 tons of coffee (as in 2000) would bring in revenue of roughly $14 million. Galbraith believes that the proceeds could amount to as much as $50 million. Tourism may bring in an additional $100–200 million annually (Suara Pembaruan, 16 February 2001). Based on these developments, East Timor would have a budget of about $1 billion, or $1,250 per capita, which would be about seven times that of Indonesia.

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Being so much better off than its larger neighbour, East Timor may feel that it does not need to develop a special relationship with Indonesia. However, a rich East Timor could attract the attention of job-seekers in Indonesia (Suara Pembaruan, 16 February 2001), bringing new problems that would necessitate consultation and cooperation with Indonesia. It is also realistic to assume that the new wealth from oil and gas may not be distributed evenly, and that a significant portion of the rural population will remain poor. This would require the provision of basic necessities, a need that could best be met through supplies from Indonesia. If East Timor can indeed expect substantial income from oil and gas, it should use this new wealth to restructure its economy in anticipation of the eventuality that it can no longer rely on the oil industry to fuel its growth and development. Two further models of relevance to East Timor in this respect have been proposed for consideration (Moghe 2001). The first is the ‘Singapore’ model of a ‘free zone’ or open economy that would attract investments in financial services and distribution activities for the region. However, East Timor’s location is much less strategic than that of Singapore, or the United Arab Emirates. Eastern Indonesia and northern Australia are not huge hinterlands in terms of population and economic activities, and it is not clear how East Timor (Dili) could compete with Darwin, Makassar or Surabaya. The second model, the ‘Macao’ model, is for East Timor to become a ‘leisure centre’ in Southeast Asia, attracting investors such as Stanley Ho, whose gambling licence in Macao will soon expire. The main requirements for success, according to Moghe (2001), would be proper infrastructure, security, efficient police and the ability to make potential patrons feel that they are on ‘neutral territory’. Both models imply a small, rich economy that is integrated with the region and with the world. They both call for investment, trained manpower and a service orientation. Some investment from Indonesia, as well as from other parts of East Asia and Australia, would be drawn into the development of a leisure industry in East Timor. The criticism made of models of this sort is that they would force East Timor to adopt a new form of economic colonialism – to become just an outpost of global capitalism (Aditjondro 2001). The models referred to so far are derived from experiences in East Asia. There are other models with relevance for East Timor derived from experiences in Africa and the South Pacific islands. The context of these models is dependence either on a single primary commodity or on foreign aid. In these latter models there would be some scope for Indonesian involvement in cooperation with the donor community. East Timor should try to diversify its economic base. In the near and longer term, it will need to allocate resources to building infrastructure, agricultural

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and rural development, education and health, and the development of community economic enterprises (Saldanha 2000). This is the more realistic plan for East Timor. In this model there would be considerable scope for Indonesian involvement. Such involvement would not be confined to the government and the public sector at large, but could perhaps come mainly from the private sector and civil society (non-government organizations or NGOs). The Indonesian government, through the adoption of the right policies, can encourage and facilitate the developmental activities of private business and NGOs in East Timor. The Polity It is widely assumed that the East Timorese polity will develop along liberal democratic lines (Kingsbury 2000) and adopt a plural political framework. One model under consideration is a multi-party parliamentary system, in contrast to a one-party, presidential system, which would not provide room for adversarial party processes. East Timorese remain divided on this issue but will soon have to decide on the new nation’s political system (Soares 2000). Indonesia can have no influence in this decision, although the lessons of internal political developments in Indonesia may be instructive for East Timor’s leaders. In the spirit of reconciliation, Indonesia has urged East Timorese leaders to seek rapprochement with pro-integration groups, and suggested that they be invited to participate in the political process. Whatever system East Timor opts for, Indonesia will have to develop the necessary mechanisms to strengthen its relations with East Timor. These relations should be broad-based, involving people from all walks of life and diverse actors, including private business and civil society.

STRUCTURING THE RELATIONSHIP WITH INDONESIA The foundation for the new relationship between Indonesia and an independent East Timor has been laid down in the Joint Communiqué of 29 February 2000. In the context of discussions and negotiations between the government of Indonesia and UNTAET, a number of the problems that have been identified in the Joint Communiqué are treated as ‘residual’. Repatriation of Refugees One of the most important residual problems is the repatriation and resettlement of East Timorese refugees currently in West Timor. Agreement was reached in July 2000 to speed up this process. The Atambua incident of September 2000, in which UNHCR personnel were killed, proved a major setback to this. The

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Indonesian side has since proposed a comprehensive plan of action. Although much larger numbers have been cited in the media, the Indonesian side estimates that a total of 70,000–80,000 refugees remain to be processed (interview in early March 2001with Hasan Wirajuda, the chief negotiator). Pressure from the international community may still be necessary to speed up the return of refugees, but it is equally important that the UN Security Council dispatch security experts immediately to reassess the security situation. Complications on the Indonesian side arise from internal political problems that weaken the control of the civilian, political leadership over the military. The military must, once and for all, accept the fact of East Timor’s separation. Unless this problem is resolved satisfactorily, it will remain a thorn in the side of relations between Indonesia and East Timor for some time to come. Settlement of Claims Another residual problem is the settlement of mutual claims and liabilities. A number of specific agreements can only be finalized with the government of independent East Timor. However, the main principles can be drawn up now, and preparations can be made for their eventual implementation. It should not be difficult to reach agreement on giving citizens of East Timor access to their deposits in Indonesian banks that no longer operate in East Timor. This may be the main issue on the East Timor side. On the Indonesian side, the main issue relates to the status of the four types of Indonesian assets in East Timor, namely government assets, assets of state-owned enterprises, assets of private companies and assets of Indonesian individuals. Realistically, a settlement should be reached that would not require financial compensation to be paid on the part of East Timor. Assets of individuals relate mostly to the homes of civil servants, and responsibility for reaching a settlement with the individuals concerned should rest with the Indonesian government. Private sector assets should be written off unless the company intends to return to East Timor as a foreign investor. The complication here is that there may be counterclaims by East Timorese, including the East Timorese diaspora. Claims on buildings and equipment will be easier to resolve than those on land, which is currently subject to claims under four different jurisdictions, namely customary law and pre-1975, 1975–99 and post-1999 law (Hill 2001a). Indonesian private investments in East Timor, previously undertaken as domestic investment (Penanaman Modal Dalam Negeri, or PMDN), could be turned into foreign direct investments. This should be decided by the investors concerned, without the government of Indonesia acting or negotiating on their behalf. According to Indonesia’s Investment Coordinating Board (Badan Koordinasi Penanaman Modal, or BKPM), realized PMDN in East Timor as of 15 June 1999 involved 10 projects with a total investment of Rp 189.5 billion

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(Business News, 27 August 1999). The main investors were PT Siera Beta Pranasakti (cultured pearls), PT Sunaplo Agung Sejahtera (housing estates), PT Wisesa Nugrahatama (transportation), PT SCTV (television) and PT Multi Perona Maya (hotels) (Republika, 7 September 1999). State-owned enterprises should be given the same option. Pertamina, the state oil company, continues to operate in East Timor to supply fuels. It does not have much in the way of assets except for its two distribution depots (Suara Karya, 30 October 1999). Perhutani claims to have invested Rp 24 billion in the development of community forestry, and intends to continue to operate as a foreign investor (Bisnis Indonesia, 8 November 1999). Telkom, the state telecommunications company, values its investment in East Timor at Rp 45 billion. It intends to claim compensation and says that if it is unsuccessful it will dismantle its facilities (Suara Karya, 13 November 1999). Telkom should, however, consider continuing to operate in the country as a foreign investor, or sell its assets to another foreign company. PT Pegadaian, the state pawn-broking agency, has buildings in East Timor but is unlikely to continue to operate there. Buildings owned by PT Pos are valued at Rp 5.5 billion (Business News, 29 March 2000). It, too, is unlikely to stay. These assets will have to be written off and handed over to the new East Timorese government. Banks such as the State Bank of Indonesia (Bank Negara Indonesia, or BNI) may return to East Timor at a later date. Apart from their physical assets, the banks have given out credit and have deposit liabilities. While they may be able to provide access to deposits, the extent to which they will be able to recover their loans is questionable. In the case of BNI, outstanding loans amount to Rp 140 billion (Kontan, 8 November 1999). Anwar Nasution, Senior Deputy Governor of Bank Indonesia, is in favour of Indonesian banks continuing to operate in East Timor. He puts this forward as one concrete way for Indonesia to help East Timor in its development. In an interview with the author, he said that the use of Indonesian currency by these banks should be allowed because this ‘limited internationalization’ of the rupiah would not have a significant effect on monetary policy. Indonesia should neither encourage nor discourage the use of the rupiah in East Timor. Recently, UNTAET adopted the US dollar as the official currency in East Timor. However, the use of the rupiah is still widespread, a situation that is likely to continue until it can be withdrawn totally from the system. Indonesian government assets in East Timor should logically be handed over to the country’s new government. The Department of Public Works claims that its assets, consisting of roads, bridges and equipment, amount to Rp 2.2 trillion. The department does not have a position of its own on the disposition of these assets, leaving this to the ultimate decision-maker in the government. Unfortunately, it is not clear as yet who, or where, the ultimate decision-maker

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is. Perhaps this explains why negotiations on this matter have been postponed until there is a new government in East Timor. The payment of state pensions to retired East Timorese employees of the Indonesian government and related issues are being resolved for former government employees in East Timor who are now in Indonesia, but some issues remain pending for legal or other reasons (IMF 2000). The problem of delineation of land and maritime borders remains to be tackled, as the Joint Border Committee has not established a subcommittee to undertake this task. Transit between Oecussi and the main territory is being negotiated. Indonesia does not want to establish a corridor but has proposed instead that East Timor set up and operate a transportation system to link the two parts. Cross-border Relations and Other Issues Issues of cross-border relations, bilateral commercial relations and the development of aviation, transport and communication links are not residual problems. Similarly, educational exchange and scholarships should be made a permanent feature of the relationship. Cooperation in education and human resources development should be given priority. Many Indonesian teachers will wish to return and teach in an independent East Timor. Bahasa Indonesia is still the medium of instruction, although efforts to change this are under way. While this is a sensitive issue for East Timor, there should be recognition of the value of maintaining Bahasa Indonesia as at least one of the languages in East Timor. Cross-border relations will be an ongoing matter as efforts continue to make cross-border movements and transactions easier and more free. Links between East and West Timor are of critical importance to East Timor’s development and to the East Timorese people themselves. Border trade is essential, especially to the East Timorese. When border barriers are erected, smuggling activities at the border are likely to emerge, and this will cause problems for border trade. The imposition of essential import duties as part of the tax measures introduced in early 2000 is intended to raise government revenues without the need to have complex administrative arrangements. The wisdom of this measure can be questioned in light of the importance of keeping the borders as open as possible. Indonesia’s trade with East Timor will not be affected by the 5 per cent import duty on goods, but prices in East Timor will rise enough to encourage smuggling. Open and free border trade must be coupled with effective control of the border. Indonesia will need to allocate sufficient resources to achieve this objective. At this juncture it may be useful to examine Indonesia’s objectives in promoting closer relations with East Timor. Indonesia must recognize its gross mishandling of the territory for 24 years and contribute actively to the healing of the

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deep wounds between the two countries. Indonesia and East Timor are bound by geography to live together, and share a common border. The management of the border is therefore critical for Indonesia, East Timor and the wider region. The Joint Border Committee will play an important role in that management. On the Indonesian side, as the decentralization process continues to provide greater regional autonomy, a mechanism for intensive consultation between Jakarta and the local governments in West Timor will need to be developed. Another fundamental objective of the relationship is to contribute to East Timor’s viability as an independent state and thereby enhance its capacity to govern itself. This objective will also be served by guaranteeing effective management of the border. It is not in Indonesia’s interest to see East Timor develop into an unstable state of chronic dependency. Towards a Framework for Bilateral Relations Indonesia needs to establish a focal point in the government to formulate policies towards East Timor and coordinate effectively the many aspects of the relationship. At present, the Ministry of Foreign Affairs is in charge of conducting overall negotiations with UNTAET. The Ministry of Interior Affairs manages the Joint Border Committee and the subcommittees that are interdepartmental in nature. But the conduct of the relationship cannot remain solely at the working level and will need to be elevated to the policy level as well. Many critical issues will have to be addressed at this level to produce the right policy mix. Given the historical baggage in the relationship, the formulation of such policies should not be taken for granted. Non-government actors will need to form an effective lobby, both in Jakarta and in West Timor, to help promote the adoption and implementation of the right policies. The principles outlined above should guide the promotion of bilateral economic relations between Indonesia and East Timor. This framework should contain the following five elements. 1 A unilateral initiative by Indonesia to conduct open and free trade with East Timor, possibly accompanied by the provision of simple and liberal rules of origin. 2 Joint development of transportation infrastructure, especially to link East and West Timor, and East Timor and major regional centres such as Surabaya, Den Pasar and Makassar. 3 Provision of agricultural extension services to East Timor, with joint rural infrastructure and agricultural development projects being developed along the border on both sides. 4 Enhanced cooperation between the business sectors of the two countries, particularly in undertaking larger (including infrastructure) development

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projects. Whereas most of these projects were previously undertaken by the government, a public–private partnership scheme involving public and private actors from both sides could be developed. 5 Cooperation in the development of East Timor’s human resources. Public and private universities in Indonesia, in cooperation with donor agencies and foundations, should provide education, training and scholarships to a sizeable number of students from East Timor each year.

THE REGIONAL COOPERATION DIMENSION From the outset, President Abdurrahman Wahid’s policy towards East Timor has had a regional cooperation dimension. Unfortunately, it was not well articulated when he proposed the establishment of a Western Pacific Forum during the informal ASEAN Summit in Singapore in November 2000. The proposed forum would involve Indonesia, East Timor, Australia, New Zealand, Papua New Guinea and the Philippines. While the idea has yet to be fleshed out, the essence of it is to establish a high-level forum of regular consultation. Having such a regional forum in place could raise the level of comfort on the part of Indonesia and East Timor in dealing with each other, for the simple reason that in case of difficulties they could bring issues to the forum. A similar forum, BIMSTAC, involving some South Asian countries (Bangladesh, India, Sri Lanka) and some Southeast Asian countries (Cambodia, Myanmar, Thailand), is being formed and will hold its first ministerial meeting in June 2001. Being in the Western Pacific Forum would not preclude East Timor from joining ASEAN or the South Pacific Forum. Independent East Timor will change the map of the region, although it may take some time and preparation to accommodate this newly independent state in the existing regional architecture. East Timor’s membership in regional organizations could strengthen its security. It is in Indonesia’s interest to encourage an independent East Timor’s early participation in the many regional processes.

A CONCLUDING NOTE East Timor will become independent at a time when Indonesia is undergoing a difficult and tumultuous transition to democracy that may involve a lengthy period of instability. Under such circumstances, Jakarta is not going to be able to give a great deal of attention to East Timor. At the minimum, what needs to be done is to ensure that the issue of relations with East Timor does not become an internal political commodity. The Indonesian policy establishment should

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not be captured by the narrow interests of pro-integration groups, let alone the militias. There are a number of risks in the bilateral relationship, including some that originate from within East Timor. These should be identified properly, and their sources should be insulated as far as possible. The residual problems in the relationship should be resolved as early as possible and a framework for the relationship formulated. As East Timor must have shared ownership of this framework, it cannot be formulated by the Transitional Administration. Neither should the process of crafting a framework be left to the governments alone – non-government groups from both sides must have an input into and participate in the process. On the ground, the management of an ‘open’ border will have to be strengthened and closely monitored. Some Indonesian NGOs are interested in contributing to this task. Finally, a regional framework can complement and strengthen the bilateral relationship. The active regional involvement of East Timor and the development of healthy relations with its neighbours should be made a constitutional pursuit.

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Food Policy in East Timor: Linking Agriculture, Economic Growth and Poverty Alleviation to Achieve Food Security C. Peter Timmer

No country can survive for long without reasonable guarantees of food security for the vast majority of the population, and East Timor is no exception. There are multiple ways of achieving food security, but a guarantee of stable food supplies in urban markets is a quite separate concept – and governmental task – from guaranteeing that each household has adequate access to food, even in rural areas. Stabilizing market supplies requires little more than a competent government with reasonable access to foreign exchange. Ending hunger at the household level requires the elimination of poverty, which even the most effective government can only hope to accomplish over decades or generations. Integrating these two tasks and coping with the vastly different time horizons involved is one of the central roles of government. This effort will define its approach to food policy.

FOOD POLICY AND FOOD SECURITY The links connecting food policy, food security and the role of government depend to a high degree on the nature of the economy and the set of institutions embedded in the society and political economy. From this perspective, East Timor faces an extraordinary challenge. The conclusion of the Joint Assessment Mission to East Timor sponsored by the World Bank in 1999 emphasized both the difficulties and the importance of these linkages: Defining priorities amongst so much destruction is a difficult task. Yet two areas stand out as requiring urgent attention if East Timor’s economy and society are not to flounder. 51. The first is agriculture. Without agricultural recovery, East Timor’s population will remain dependent on food aid for some time to come. Aside from causing

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immediate suffering, this may also produce long-term economic distortions in the shape of irreversible rural–urban migration, and a culture of dependency amongst rural households … 52. The second urgent priority is to reconstitute capacity in the state. This is critical to prevent a situation of complete laissez-faire caused by the absence of civil regulations, taxation, dispute-resolution mechanisms and non-military law and order functions. It is also a key pre-requisite to the sustainability of developmental initiatives in the longer-term (World Bank 1999d: 15).

Integrating food security into the role of government is the task of food policy. The perspective offered here on how to do that draws heavily on Food Policy Analysis by Timmer, Falcon and Pearson (1983). This volume provides an encompassing and complex framework, drawing together models by decisionmakers in the producing, consuming and trading sectors of the food economy. It then sets these models in a macroeconomic context designed to achieve rapid economic growth and reductions in poverty. Although complex, the links are obvious: food security in a market economy requires households to be productive enough to grow or buy adequate food for their families. When hunger has been eliminated, the first stage of absolute poverty will have been eliminated, although many other dimensions of poverty may remain. But no economy can succeed with malnourished workers, and no democratic political system can leave vast numbers of citizens in acute poverty. Reducing hunger and poverty are at the top of East Timor’s priorities, and an articulated food policy is the place to start. Such a policy must have two time frames. One deals with the long-run process of equitable and rapid economic development in which the needs and contributions of the food system are part of the strategic design. The other focuses on the more immediate day-to-day management of food policy and programs. Food policy analysis seeks to bridge the gap between the two time frames by designing programs to cope with the short-run consequences of policy while retaining a consistent long-run vision of economic transformation. … With political commitment, good analysis and careful implementation, food policy offers developing countries an important vehicle for reconciling short-run equity with long-run growth and efficiency. This is no modest claim, of course. The analysis that makes it possible lies ahead (Timmer, Falcon and Pearson 1983: 16–17).

The purpose of this chapter is not to design short-run programs to deal with the massive suffering in East Timor. That is a task for specialists in the field with a much clearer sense of local circumstances and opportunities. The contribution here has a broader intent: to explain why the agricultural sector is so important to growth of the economy as a whole in East Timor, what the role of the government needs to be to make linkages as effective as possible, and why those linkages matter to food security. Considerable attention is given to explaining the connections between a rural growth strategy and the elements of

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a strategy for rapid poverty alleviation. The importance of putting both strategies squarely in the context of a market economy – and the role of government in building such an economy in a way that supports agriculture – is stressed. The conclusion focuses on the mutual interaction between a successful food policy and a growing capacity for effective governance. In a democracy, no economic development strategy is sustainable unless the people will support it. This basic fact of political economy is a major reason for urging the new government to place a high priority on designing and implementing an appropriate food policy.

THE CONTRIBUTION OF THE AGRICULTURAL SECTOR TO FOOD SECURITY What should East Timorese leaders expect from their agricultural sector with respect to food security? What policies and investments are needed to realize the full potential of the rural economy? Realistically, growth in agriculture can provide food security for the rural population and make a substantial contribution to growth in the rest of the economy. This contribution can come about directly, through rural savings and foreign exchange earned through the export of agricultural commodities, and indirectly through more efficient operation of the economy. It should be possible to improve food security at the household level measurably and to speed up the pace of poverty alleviation significantly compared with the years of Indonesian control. To realize these goals, however, the agricultural sector will need a favourable policy environment and massive investments in rural infrastructure. Rural households are close to the resource base. They know the peculiarities of each plot of land and can judge quickly when irrigation water is needed, when fertilizer should be spread or when weeds need to be cleared. Because the key constraints on raising agricultural output are highly heterogeneous and geographically dispersed, only household decisions that are equally decentralized can optimize the use of these resources. Rural households are often poor, but they are also efficient (Schultz 1964). Communal or collective decision making with respect to agricultural production cannot achieve this high level of efficiency. Placing more resources at the disposal of carefully calculating households usually leads to increases in production. If new technology and knowledge are required, a learning process will be needed, and an educated rural workforce speeds this process. There is clear evidence that inadequate knowledge, lack of access to appropriate technology and scarcity of modern inputs have constrained crop yields in East Timor. But with proper incentives, access to resources and effective extension agents, rural households can be counted on to

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gain maximum economic advantage from every unit of input. Large-scale firms, especially when operated by the state or managed cooperatively, seldom face such intense pressures to be efficient. Any growth strategy or economic reform that places a greater share of economic resources and decision-making authority in the hands of rural households and enterprises will inevitably increase the efficiency of resource allocation for the whole economy. Because poor countries typically invest so little in rural areas, substantial human resources are underutilized. Short working days at formal jobs, disguised unemployment and long hours spent on low-productivity tasks suggest that the marginal productivity of rural labour is often very low, perhaps close to zero in certain off-seasons in the agricultural calendar. Where access to the market for wage labour is constrained by demand, households – quite rationally – use family labour for tasks with a low marginal productivity. Their goal is to maximize total production for shared consumption by the entire household, not to equate marginal productivity with the market wage, especially when the wage is not reliably available. In such circumstances, accessible resources are used intensively. The marginal productivity of a new resource is very high, whether it be capital to build local irrigation systems or rural roads, new agricultural technology that raises yields, or simply more income in the hands of rural households to spend and invest where they find the highest returns. Placing more income in the hands of poor households, with the expectation that productive investments will result, is often seen by government officials as hopelessly wasteful. When the prevailing development model argues that only modern factories are productive, such an attitude is understandable. But when the development model argues that improving total factor productivity is the route to rapid economic growth, investments that mobilize underutilized resources become very attractive. In most developing countries, a historically prolonged and deep urban bias has led to a distorted pattern of investment (Lipton 1977). Typically, too much public and private capital is invested in urban areas and too little in rural areas. Too much capital is held as liquid and non-productive investments that rural households use to manage risk. Too little capital is invested in raising rural productivity. With a government committed to enhancing food security by investing in rural growth and poverty alleviation, East Timor has an opportunity to reverse this traditional urban bias and bring the rural economy into the growth process.

THE ROLE OF GOVERNMENT IN ENSURING FOOD SECURITY The two fundamental tasks of government in fostering food security are to ensure stable supplies of the basic food staples in domestic markets, and to provide access to those supplies on the part of all households, rural and urban, on

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a sustainable basis. The first task is accomplished through a combination of domestic production by the country’s own farmers and international trade. For East Timor, where agronomic conditions are not especially well suited to rice cultivation but where a substantial proportion of the population consumes rice on a daily basis, regular imports from the world market are likely to be the cheapest and most effective way of ensuring regular supplies, at least in urban markets. Very cheap rice is available from many Asian markets and the outlook is for this price environment to last for some time (Dawe 2001). Thus the role of the agricultural sector is at least as much one of income generation as it is one of food production. Because such a large proportion of the population still lives and works in rural areas, this distinction is crucial in the government’s efforts to ensure adequate access to food on a regular and sustainable basis. The difficult task for government planning is to separate commodity approaches from income approaches. The commodity approach is traditional in departments of agriculture, but in East Timor food security is more likely to be achieved by a combination of domestic production, food imports, and a cash-crop and export orientation in agriculture. It will be important for the East Timorese government to consider a number of strategies to link agriculture, economic growth and food security. These would include development of a strategy for poverty alleviation; maintenance of a growth-oriented macroeconomic environment; investment in agricultural technology and rural infrastructure, including irrigation, at levels that call forth private investments in the rural economy; and development of the physical and institutional foundations for a competitive market economy, including a free flow of information, rapid communications, and effective policies to lower transaction costs, especially transportation costs.

DESIGNING A POLICY FOR POVERTY ALLEVIATION For maximum impact on poverty alleviation, the growth strategy should target particular sectors whose development reaches the poor most effectively, and backward regions where large numbers of poor people live. Experience in several countries with excellent records of poverty alleviation has identified the key sectors that should receive special priority: smallholder agriculture, especially food crops, because of the double impact of higher productivity on rural incomes and food availability; labour-intensive construction because of the jobs it creates for unskilled labour; small-scale rural financial services because of the large multiplier effects from new enterprises started; and, ultimately, export-oriented services (such as tourism) and manufacturing as the long-run vehicle for absorbing large quantities of labour at progressively higher real wages.

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In the early stages, agriculture is the key to poverty alleviation. In virtually every developing country, an additional dollar of GDP created in the agricultural sector has a significantly larger impact on the alleviation of poverty than the same dollar earned elsewhere in the economy (Ravallion and Datt 1996; Timmer 1997). The fact that it is often far cheaper to create a dollar of GDP in the rural sector than in industry or urban services makes poverty alleviation a bargain in the process of economic growth.

MACROECONOMIC POLICY For government policy to stimulate agriculture, it must be set in a broad context that includes macroeconomic and international trade policies. It must promote an export orientation through a competitive exchange rate, and a long-term investment horizon through stable macro prices. In a country as poor as East Timor, most agricultural prices must be determined by conditions in world markets. Obviously, in rural communities with few connections to urban markets and ports, local price formation will dominate and thus prices will depend almost entirely on local conditions of supply and demand. Even in these circumstances, the exchange rate is the single most important price influencing decisions by East Timorese farmers, traders and consumers. In the short run, East Timor has access to aid resources that should be adequate to get the growth process under way. Soon, however, a very substantial gap will exist between the government’s development needs and its revenue. Agriculture must make a sizeable contribution to closing this gap, but great care should be taken to have the growth process well under way in rural areas before direct taxation and pricing policy are used to divert resources to public uses outside of agriculture. Investing now will pay far higher returns than will heavy, immediate taxation of agriculture. For East Timorese policy-makers, it will be tempting to make use of the tax base that is most readily available – taxes on land and on agricultural exports, especially coffee – as this will be the easiest way to raise government revenues. But important opportunities for growth may be sacrificed if agriculture is taxed heavily at this crucial juncture.

RURAL INVESTMENT STRATEGY It is widely agreed that governments should invest in public goods and that they need to correct important market failures in order for market-oriented economies to function efficiently. The debate is over levels of funding, the appropriate institutional organization, and the relative roles of public agencies and private firms and households. The major focus in stimulating agricultural

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development is on government support and organizations for research, irrigation and the infrastructure that supports rural marketing (Timmer 1991). The absolute necessity for new technologies to generate higher income streams for traditional farmers was stressed by Schultz (1964), who set out the analytical foundations for an entirely new approach to agricultural development. It is only in those countries with the capacity to fund and conduct the agricultural research which yields these new technologies that agricultural development can take place at a rapid enough pace for the sector to play its broader role in stimulating the entire development process. The difficulty for East Timor is its extremely limited human capital in agricultural sciences and its extraordinarily complex ecological diversity. Government efforts to improve agricultural technology will probably be limited to partnerships with international agricultural research centres such as the Consultative Group for International Agricultural Research (CGIAR), an international coordinating body with its secretariat at the World Bank, and cooperation with Indonesian agricultural scientists specializing in the crops and livestock systems found in eastern Indonesia.

DEVELOPMENT OF A MARKET ECONOMY The rural economy of East Timor is already relatively open to private trade, and policy should seek to enhance that openness. But the capacity of the private marketing sector is limited, its facilities are primitive, and many rural regions remain relatively untouched by the opportunities that a dynamic market economy should stimulate. For the rural economy to reach its potential, policy initiatives are needed in three areas: improved communications facilities and rural infrastructure; an effective trade and competition policy that will limit the scope for monopolistic practices among traders; and establishment of the infrastructure for a rural financial system that would provide short-term liquidity credits to traders (and farmers), investment credits to food processors, trucking companies and other market participants willing to invest in rural infrastructure, and a secure home for rural savings. Communications and Marketing Costs Low marketing costs are the secret to narrow margins between farmers and consumers, foreign or domestic. Marketing costs include transportation, storage and processing costs, as well as the costs of searching out information on available supplies and potential markets, and on the risks involved in buying at one time and place and selling at another. When marketing costs are high – and thus farmers are receiving low prices for their goods while consumers are paying high prices – part of the reason may be such factors as the high cost of gasoline,

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trucks and highway travel, high interest rates for liquidity credit, and antiquated processing facilities with poor recovery rates. These real and visible costs of marketing can be brought down only through investment in rural infrastructure and processing facilities, along with commensurate investment in an improved rural credit system that can lower the real cost of capital to traders. Some of the high marketing costs are invisible, however. The search for information about trading opportunities is crucial to the efficiency of price formation in market economies, but without reliable telephones, faxes (and email), trade newspapers and price information from central markets, this search is very haphazard, expensive and subject to abuse. In particular, established families or networks of traders have a large advantage over new entrants, thus limiting competition, when information about market opportunities is not readily and cheaply available. Furthermore, the marketing of commodities is risky in a market economy, because there is no guarantee that what is bought can ultimately be sold at a profit – prices must be free to go both up and down. Traders, not the government, should face the risks of such price movements, as these are simply part of the process of doing business and thus part of the cost of marketing. The government should not eliminate these risks. To do so is to prevent the marketing sector from playing one of its most important allocative roles. But the government should not increase the risks either. Arbitrary and capricious interventions by governments are one of the major risks of commodity trading in both developing and developed countries. Beyond providing clear signals on its own policies, the government has a key role to play in making market information widely available and in improving rural infrastructure to lower the physical costs of marketing. Systematic improvements in rural roads, in the availability of electricity and telephones, and in docks and port facilities must have high priority for new budgetary resources. But some improvements require coordination more than money, and some could draw on local revenues generated by the increases in the tax base arising from improved agricultural productivity. Without doubt the most important step the government can take to lower marketing costs and improve the efficiency of the marketing system is to articulate clearly the policy itself, and the government’s determination to spread market information, as widely and fairly as possible. A short-run investment strategy can then emerge automatically. Where marketing bottlenecks exist, margins are high. These locations can be identified readily by low farm prices (relative to other areas) and high consumer prices. After investigation, the cause of the high marketing margin can be identified and the road repaired, the ferry fixed, a bridge built or additional competition brought into the market, possibly in the form of government offers to buy. The point emphasized here is that policy-makers need to identify the most pressing problems and fix them, rather than draw up a comprehensive plan to rehabilitate the country’s entire rural

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infrastructure. Such a plan will be needed when the budget can support the work. In the meantime, the emphasis must be on lowering the costs of marketing in the most pressing locations. It will not be hard to find such locations in rural areas of East Timor. Local surpluses of rice and corn are already being reported, while deficit areas are too costly to reach with existing marketing infrastructure. Marketing Infrastructure For a rural marketing system to work efficiently, an entire set of interlinked components must be in place and mesh relatively smoothly. The system needs farm-to-market roads, regional highways, railways, trucks and rolling stock. Communications networks involving telephones and radios are needed to improve information-gathering capacity. Rural areas must have reliable supplies of electricity for lighting, to operate office equipment and to power rural industries (a point apparently lost on California’s utility regulators). Market centres and wholesale terminals with convenient access to both transport facilities and financial intermediaries need to be established. The government must institute a set of accepted grades and standards for traded commodities that permits reliable, arms-length contracts to be written and enforced at low cost. Each individual component of a well-functioning marketing system offers a major role for private sector involvement, perhaps even to the exclusion of a public role. Trucking companies, warehouse operators, and rural and regional banks can be entirely in the private sector; indeed, the empirical record suggests that they should be if reasonable efficiency standards are to be maintained. But a marketing system is more than the sum of these private firms, partly because the links that connect these firms – the roads, railways, telephone networks and so on – have important public-good dimensions or problems of coordination that markets alone would have difficulty solving. A further part of the story involves the substantial economies of scale and externalities in the construction and operation of the marketing system itself. No individual private firm can hope to capture the full economic benefits accruing to an efficient marketing system, even when the firm’s own investment is a crucial component needed to make the system work at all. The existence of these externalities, and of system-wide scale economies that are not appropriable by individual private firms, creates an important role for the public sector in guaranteeing that the basic rural infrastructure is in place and operates efficiently. Direct public investment, ownership and operation is neither necessary nor even desirable in many contexts. Regulation, indicative plans and appropriate investment incentives may well be sufficient. However, a direct public role may also be needed in many circumstances, especially in the building of roads, ports and communications networks.

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Investment in infrastructure has several important economic pay-offs. First, rural infrastructure – in the form of irrigation and drainage works, roads, ports and waterways, communications, electricity and market facilities – provides the base on which an efficient rural economy is built. Much of the investment needed to provide this base will come from the public sector, even when the private sector is playing the predominant role in agricultural production and marketing. Without this public investment, rural infrastructure will be seriously deficient in stimulating greater production of crops and livestock. Investment by the private sector is also less profitable in the absence of adequate rural infrastructure, thus further reducing rural dynamism. Second, public sector investment in rural areas has a ‘crowding-in’ rather than a ‘crowding-out’ effect on private investment. For this reason, the main purpose of investments in infrastructure is this longer-run stimulation of agricultural production, which has important positive effects on rural employment and income distribution. Third, the investments in infrastructure themselves can generate substantial rural employment directly. This potential has not been lost on planners seeking both long-run employment creation and short-run work programs to alleviate rural poverty or even famine conditions. ‘Food for work’ and ‘employment guarantee’ schemes almost always are designed to build rural infrastructure using low-cost or unemployed workers. Large-scale irrigation and road construction projects offer the potential to employ vast numbers of unskilled rural labourers, if project designers are sensitive to employment issues in the choice of technique and are willing to address the managerial problems that arise from labour-intensive techniques in construction.

POLICY ISSUES AND DIRECTIONS IN EAST TIMOR The rural economy in East Timor is the focus for growth initiatives, because it is more responsive in the short run to new economic incentives, has significant untapped potential to increase productivity, and is the home of most of the country’s citizens, including its poorest. However, no country will get rich by focusing all its resources on agriculture, and eventually East Timor must shift its attention to building a modern urban economy based on export-oriented industry, and technology or tourism-based services. By then, however, the rural strategy will have reduced poverty and stimulated the development of a much more effective array of linkages from farms to rural industry and then to the urban economy. The rural economy will decline in relative importance, not out of neglect or because of heavy taxation, but because its performance will have laid the foundations for the rest of the economy. Managing this process will take wise governance and careful analysis. In an

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earlier essay, I speculated on the size and nature of the new East Timorese government that could handle these tasks. Real tensions are going to erupt over the need for foreign resources for faster growth and control of the country’s destiny. Part of these tensions will be over the size of government itself. There is surprising diversity in both the developed and developing world on the scale and scope of government. If the neo-liberal consensus argues for a small government focused on tasks unique to the need for collective action (and commensurate with the human capital available to staff a civil service), a political economy perspective would argue that the institutions supporting a larger role for the private sector and civil society are conspicuous by their absence in East Timor, and they take a long time to build. A competent government can be built more quickly, especially since it starts from zero and thus faces little hostility from an entrenched bureaucracy. From the beginning, then, a larger and more aggressive role for government may be both popular and successful (Timmer 2000: 247–8).

The effective implementation of a free trade regime in East Timor does restrict the degree of freedom for policy interventions. In particular, free trade with Indonesia means de facto free trade with the major rice exporters in the region, including Thailand and Vietnam. Although rice prices are, thus, not a policy instrument, government investments in rural areas to stimulate income growth remain an effective way to enhance food security. Furthermore, an open trade regime is almost certainly the best route to overall economic growth, in which the rural economy has a major stake.

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The Rural Economy and Institutions in East Timor Colin Barlow

The rural economy is pre-eminent in East Timor, and must necessarily underpin future economic advances there. This chapter examines that economy, looking especially at the possibilities for technical improvement and ways to implement changes so as to enhance economic growth and social welfare. It also makes recommendations on government policies that would promote these goals.

BACKGROUND CONDITIONS East Timor’s dry but variable climate, mountainous topography, soils and modes of agricultural activity in East Timor are discussed by Fox in Chapter 10. The physical conditions of the territory are difficult, but usually well managed by an adaptable and resilient people living in scattered villages and with generally plentiful land. These people have evolved modes of living and farming suited to their circumstances, but still have problems of food security owing to the unpredictability of the climate. Such problems were exacerbated by the destruction accompanying the Indonesian withdrawal in late 1999. Agriculture Data on East Timorese agriculture in 1970–95 are presented in Table 7.1. While approximate, they help to denote the underlying capacity of the sector using existing technologies. The data indicate increases up to 1995 in area under cultivation, exports of coffee and numbers of cattle and pigs, but declines in land planted with coconut and rice. Exports of copra fell, mainly due to rising local consumption, while rice imports grew strongly owing to the inability of local production to keep up with rising demand.

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While maize, cassava and sweet potatoes were grown largely for home consumption, rice produced good returns for growers. Coffee, copra, some root crops and vegetables, live fattened cattle, pigs, goats and chickens were all significant earners of cash for certain groups of farmers in particular locations. Returns from these items supplemented the basically subsistence livelihood of farm households, bringing in revenue that could be used to buy consumer items and production inputs. However, the Indonesian forces as they left in 1999 killed many livestock, whose numbers will take long to recover. More details of past and present agricultural production in East Timor are given by Fox in Chapter 10. A good account of the country’s geography, climate and agriculture is provided by Metzner (1977). Further useful information on agriculture and rural society is supplied by Mubyarto et al. (1991), Simpson and Larsen (1999), Chapman (2000) and AusAID (2000). The climate and associated cropping systems of East Timor are examined by Keefer (2000), and agricultural development is scrutinized in the broader national context by Saldanha (1994) and Barlow (2000). Rural Trade and Credit The primary emphasis on subsistence means trade is often minimal, with barter frequently being more common than exchanges of money (see, for example, Forge 1991). Markets are ‘incomplete’, in the sense that information about commercial opportunities is limited and there is often little opportunity to sell products or buy necessities. Trade fell substantially during the recent troubles, with many dealers departing and marketing networks, including links with West Timor, being disrupted. Yet even in ‘normal’ times, the prices obtained by farmers for their produce have been low because of the high costs of transport on East Timor’s poorly maintained roads (see Chapter 14, this volume). Wide fluctuations in prices and the vagaries of a changeable climate also affect farmers’ revenue. In March 2001, for instance, the world price of coffee was about half what it had been a year previously, and this change was amply reflected at the village level. Shortages of cash are accordingly a major constraint to introducing improvements in rural areas. There are virtually no local lenders of money, chiefly because repayment is not feasible. The rural population restricts cash purchases to essential foods and key items such as kerosene and salt, again paying high prices owing to the cost of transport. Thus, even apart from considerations of information, skills and risk, farmers find it hard to adopt new cultivation techniques if this involves buying special equipment. Without credit and help in acquiring skills, it will take decades for profitable new techniques to be used widely in rural communities, in a slow ‘bandwagon’ process whereby the innovative few are watched and ultimately copied by those around them.

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Table 7.1 Agriculture in East Timor, 1970–95 1970

1990

1995

n.a. n.a. n.a. n.a. n.a. 33 a

19.1 9.5 7.6 0.3 0.4 36.8

17.3 7.9 3.1 0.5 0.7 29.4

3,027 1,707 15,600

7,059 445 29,664

n.a. n.a. 25,000

Area under cultivation c (thousand ha) Rice

25.2

Maize

42.1

Cassava

28.3

22.4 (2.5) 64.8 (1.3) 8.2 (3.8)

18.7 (3.5) 61.7 (1.9) 18.3 (3.5)

Agriculture in GDP (%) Food crops Tree crops Livestock and associated products Forestry Fisheries Total Exports/imports (tonnes) Coffee exports Copra exports Rice imports b

a The figure is for 1962. b The figure given in column 1 is for 1980. The figure in column 3 is an estimate. c Figures for food crops in column 1 are for 1973. Figures in parentheses are estimated yields per hectare. The ‘other’ category consists of peas, peanuts and soybeans.

Social Systems The peoples of East Timor have well-developed and closely interlinked social, religious and legal systems and modes of governance, organized by traditional leaders operating within local kinship groups. Like the local agricultural techniques, these systems are well adapted to the physical environment and local ways of life, but are capable of flexible adaptation to changing circumstances – a feature it is vital to recognize. The key to facilitating change is therefore to

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The Rural Economy and Institutions in East Timor Table 7.1 (continued)

Area under cultivation (continued) Sweet potatoes

1970

1990

1995

14.0

2.0 (3.6) 4.5 101.9

4.8 (3.8) 8.3 111.8

Other Total (food crops)

n.a. 109.6

Coffee Coconut Areca palm Kapok Candlenut Other d Total (tree crops)

n.a. n.a. n.a. n.a. n.a. n.a. n.a.

50.3 53.0 36.6 10.2 4.1 7.2 161.4

56.7 45.1 1.8 1.9 4.3 8.6 118.4

Total (all crops)

n.a.

263.3

230.2

No. of animals e (thousand) Cattle Buffalo Pigs Horses Goats and sheep

67 123 203 107 242

73 48 287 25 136

115 75 343 n.a. 204

d The ‘other’ category comprises cinnamon, cocoa, cloves, cashews and asam. e Figures for animal numbers given in column 1 are for 1969. Sources: Esmara (1979); Indonesia: Kantor Statistik Propinsi Timor Timur (1991–96); Reparticao Provincial dos Servicos de Veterinaria de Timor (1970); Saldanha (1994).

work out new approaches within the collective action paradigm, rather than trying to impose the individual emphasis common in Western and other societies. The Roman Catholic Church is another important East Timorese institution affecting the behaviour of many rural peoples, in a country where most people are at least nominally religious. Here, catechists or leaders of local religious schools are well placed to facilitate social and economic change, acting in close cooperation with traditional and other leaders. The catechists, together with the parish priests to whom they are responsible, have the advantage of exposure to

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a rather different world, and thus have a readier understanding of potentials for betterment in village circumstances.

POTENTIALS FOR IMPROVEMENT IN AGRICULTURE There is much scope for improvement in East Timorese agriculture. Critically, this rests on better research, extension and marketing, as well as advances in roads, education and health. Research Research and trials to develop new agricultural and supporting technologies are crucial to any program of rural advancement, and vitally necessary for East Timor. New technologies can both enhance food security by raising yields of subsistence crops, and raise household revenue by boosting marketed outputs. Research in a small country like East Timor must essentially be adaptive, building on technologies generated by institutions in other countries facing similar agricultural challenges. It thus entails selecting, from international sources, suitable varieties of pertinent crops, ways of supplying key inputs, and management methods. These elements must then be fashioned to needs and conditions in East Timor’s agro-climatic zones, with actual performance being explored through trials in appropriate locations. Such work is best carried out through technology research centres staffed by research workers with links to the international scene. In the case of East Timor, it would seem appropriate to set up three such centres, each with some 10 scientists plus supporting staff, to cover the main features of the six climatic zones described by Fox in Chapter 10. This is imperative if local agriculture is to advance beyond its present low technological stratum. Research arrangements of the type described, with their wider social purpose of promoting the economic activities of numerous poor farmers, are a ‘public good’. They are profitable for society as a whole but beyond the ability of individual consumers to pay for, and are thus appropriately paid for by government. In East Timor, as in other countries with little alternative administrative capacity, they are also best organized and operated by government. A similar public goods argument applies to government participation in extension, marketing and the provision of basic infrastructure and services. Extension Extension crucially complements research, both in passing on useful techniques to farmers and in obtaining feedback from them so that further research can be

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undertaken. Large numbers of extension workers are needed for this process to be successful, and several hundred are required in East Timor. But much of this force could be selected from progressive local farmers, who would be given further training. Such individuals have proved highly effective in undertaking extension in similar contexts elsewhere. East Timor would need perhaps another 30 senior extension officers as top-level staff, to liaise with researchers, control the rest of the advisory force and work out precise strategies. They would need to be supported by accounting staff to organize the provision of credit. Such a disposition of extension staff would be well placed to carry out extension work under the auspices of non-government organizations (NGOs) and local groups, as is now discussed. Under the Indonesian administration, East Timor’s extension was mainly undertaken through a government extension service. One major exception was the effective work carried out by the National Cooperative Business Association (NCBA) in assisting the production and marketing efforts of small coffee farmers. Some local NGOs were also active in helping to implement water supply schemes. Many others have been formed since independence (or Merdeka, literally, ‘freedom’), and some foreign NGOs are also now working in East Timor. World Vision (2000) provides a good example of a broad-based extension effort in a particular district by a large and well-funded organization. While government needs to facilitate the public good of extension, the actual extension task is judged best carried out by NGOs and other local groups. NGOs have proved adept at in-depth contacts and the promotion of new technologies and other rural social improvements since they began offering technical assistance to developing countries around the world in the early 1970s (Riddell and Robinson 1995). The NGO organizational form is thought especially suited to the difficult task of adjusting programs to the collective institutional arrangements predominating in East Timor. Again, Abel (2001) has suggested that a ‘cluster’ system – based on groups of local individuals working from a centre in a particular village and going from there to surrounding hamlets – is likely to prove effective in providing extension and marketing. It seems that in practice a combination of such groups and NGOs would be a good approach to filling the current extension vacuum in East Timor. Government will nevertheless still have a key role to play in facilitating the access of NGOs and other local groups to credit, in dividing the country into zones with specialties of operation for each of these groups, in ensuring they use research services properly, and in generally supervising their extension activities. Smaller NGOs in particular have a well-recognized deficiency in their command of more advanced technologies, and consequently need special guidance from the research sector. None of the agencies likely to become involved in East Timor is large enough to undertake much research of its own, which means

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they will all need to use the research services available from government. NGOs are also notorious for their independence, and will require official monitoring to ensure they keep within the boundaries allocated to them. Such supervision will likewise involve cutting out agencies and groups that perform badly or inappropriately in allotted tasks. Yet it should also be noted that competition among agencies – a feature related to NGO independence and likely to emerge in East Timor – can be a positive factor in stimulating them to secure better performance. The ‘Dispersal’ Approach Village extension undertaken by NGOs and local groups is considered best directed through a large number of small promotional activities. Each of these would be centred around a simple application of a new technology or other improvement, requiring small purchased inputs in each instance and focusing on groups of 10–50 farmers scattered widely throughout the communities concerned. One activity might, for example, entail members of a target group receiving guidance on the dry seeding of an improved rice variety, where seed and minimal fertilizer are also supplied. Another project might be to provide piping and cement for reticulating water from a spring at a higher elevation to a place where it can irrigate cash crops. All such activities must provide for the supply of small amounts of credit in cash or kind. A good principle here is to match the existing practice of many Timorese communities, where group members repay credit to a rotating fund which they manage themselves. Activities should also entail local control, with an elected leader supervising the project, and with all labour and all locally available inputs including land being provided voluntarily by group members. The role of the extension agent is to act as facilitator, providing information, outside inputs and training. This model of extension – which Tomich, Kilby and Johnston (1995: 112) label a ‘broad-based’ strategy and the author calls a ‘dispersal’ approach (Barlow 1997: 1,606) – has the advantage of securing good spread effects. It is also within the competence of rural East Timorese and organizing groups to handle and sustain, and hence less susceptible to failure. It is useful as well in that dynamic improvement can be secured through the ‘learning by doing’ of the people concerned. Once one small activity is managed successfully, extension personnel can introduce another, more complex, one, building on the first. Thus once the dry seeding of rice has been mastered, improved methods of water control and weeding that build on this technique can be introduced. It becomes feasible to move slowly up a ‘gradient’ of progressively more sophisticated technology and management. This is a slow process, but nevertheless decades faster than the belated adoption which occurs in the absence of such facilitation.

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The ‘Focused’ Approach The broad-based dispersal approach to extension may be contrasted with the ‘focused’ promotion of larger initiatives in a few locations, each entailing far more elaborate organization and the application of complex technologies making intensive use of purchased inputs. One example is the establishment of a new cattle farm, where farmers residing in a village form a cooperative and take part in an improvement package controlled, at least initially, by outside management. The package might comprise the mechanized clearing of land, which is then planted with higher-yielding forages, and the accompanying provision of cattle held in a large pen and fattened on forages and other special feeds. All this is carried out under the supervision of outside technical specialists, with farmers supplying mainly labour, for which they are paid directly or through shares in returns from the fattened animals. Farmers have to repay the substantial credit involved in such a package, probably for several years after the outside organizers have departed. The output and quality secured under a focused regime is likely to be higher than that initially obtained through a dispersal project. However, there are also disadvantages to this approach. It probably results in lesser spread effects, in that farmers not receiving substantial outside support find the activity hard to replicate. In addition, the venture may be difficult to sustain once outside intervention is withdrawn. Such focused projects are more vulnerable to failure owing to the problems inherent in maintaining a complex operation. No black and white conclusions about the dispersal and focused approaches can be drawn – what is suitable depends on the context, and the costs and benefits of each project must be reviewed carefully. The dispersal approach does nevertheless seem more suited to village conditions in rural Timor, and has been used successfully in West Timor for many years (Nusatenggara Association, 1992–2001). The focused approach, with its high level of inputs and complex organization, is more difficult for small NGOs or community organizations to implement, and is more appropriate for implementation by an official agency or business contractor. Interaction with the Traditional Framework As mentioned, a key element in village-level extension – and the sine qua non of effective efforts to spread new technologies in rural East Timor – is close interaction with traditional institutions and prominent personalities including the Catholic catechists. The high likelihood of attaining such interaction is one of the main advantages of village-based extension of the type proposed, and particularly of the dispersal approach of working with small groups of people. Such groups will often be made up of members of a particular clan, facilitating

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collaboration both with the extension agent and between individual group members. People in small groups usually feel much freer to express their opinions; the consensual group decisions resulting from their discussions are likely to reflect the efficient use of available resources characterizing family-based decisionmaking (Roumasset 1981). The comments and feedback secured by extension facilitators in such circumstances are likely to be very realistic, and hence highly relevant when adjustments need to be made at research-centre level. Marketing and Other Facilities Ensuring a competitive and efficient system of marketing is another critical aspect of rural improvement, without which raising the output and quality of existing products, or introducing new ones, is of little avail. Experience in many countries demonstrates that the capability of both government and non-government organizations in this sphere is limited, and attempts to intervene directly in marketing have generally proved unhelpful or disastrous. Effective marketing invariably involves private sector traders vying with one another to purchase outputs from and provide inputs to producers (Tomich, Kilby and Johnston 1995). Establishing such a system in East Timor is by no means easy, however. Even before the recent difficulties, many areas had a primitive marketing system dominated by single dealers paying low prices for products and charging high prices for purchases. Yet government can play a significant part in enabling the public good of efficient markets to be realized, most importantly by providing the political stability needed for effective commercial operations to take place. The government must also engineer the restoration of vital trading links, by promoting cross-border contacts with Indonesia and by establishing shipping connections with the primary regional trading centre of Surabaya. Official action may also be necessary to stimulate local trade in particular sectors, and the example of NCBA’s successful coffee-marketing initiatives could be applied to other products in potentially high demand. One such product would be live cattle, whose technical possibilities are discussed below. Government is best placed to take the main role in both financing and implementing crucial infrastructure such as roads and other basic communications facilities, with their vital effects on lowering transport costs and facilitating information flows. It must also provide health and education, which have a critical influence on capacities to implement and sustain improvement. These issues are addressed by Cheatham and Jarvenpaa in Chapter 14, and by Jones in Chapter 16.

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NEW TECHNOLOGIES Some new technologies provided through research and extension systems of the type just described would seem particularly important for uplifting the East Timorese rural economy. The low yields for almost all crops suggest that this is an area with much room for improvement. However, the situation on the ground involves numerous difficulties that need to be addressed before progress can be made. Maize As the basic subsistence crop, maize is a key target for technological improvement. Nearly all land planted with maize in East Timor (see Table 7.1) appears to be under traditional varieties grown since the distant past. The current yields of 700–1,500 kilograms per hectare are low, and could easily be doubled using hybrid maizes already tested under local conditions. Yet the main problems with hybrids are their requirement for fertilizers that are neither widely available nor affordable, their vulnerability to drought and pests, and the deterioration of corn cobs harvested from them after only a few months in storage. Hybrid seed is also expensive, and must be made available to farmers from outside sources on an annual basis. Existing local varieties, in contrast, do not need fertilizer, are resistant to stress, produce cobs storable for several years, and can be planted from free seed saved from the previous crop. These advantages explain their continued popularity despite long-standing attempts to introduce new maize varieties. The need in East Timor’s circumstances is to find a variety that will do well using minimal outside inputs, is palatable and is storable for a longer period. This is a classical problem facing plant breeders as they endeavour to cater for those living in subsistence conditions. It is possible that better cultivars are available internationally, but they need to be brought in, tried out and, if promising, adapted to local conditions. Improving yields of maize, subsistence root crops and legumes is directly pertinent to strengthening food security, thus enabling farmers to turn their attention to and obtain greater benefit from cashearning items. This should be a high priority for East Timor’s crop technology program, and is explored by Chapman (2000). Rice Rice is important both as a subsistence and as a cash crop. Ways to improve rice grown on irrigated land have been canvassed by Simpson and Larsen (1999), and are treated by Fox in Chapter 10. However, despite considerable extension in the last decade, there is still much room for improvement in this area.

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Advances in production have been held back by farmers’ shortage of cash and their rational preference for low-input systems. Despite the penetration of improved rice varieties, padi cultivation still mainly employs traditional practices such as animal trampling or rencah, zero or minimal use of fertilizer and high seeding rates to guard against losses. Irrigated rice is still largely grown as one crop per year, owing to water shortage and the disrepair of the irrigation system. Great improvements in output of rice and associated crops could be secured by repairing irrigation infrastructure, introducing animal and hand-tractor drawn methods of cultivation and adopting more advanced practices, including fertilizer use. But this requires access to credit, and the adjustment by local communities to what for them are radically new techniques. The key to securing adoption of new practices is intensive extension of the type already canvassed. Although it has been suggested that irrigated rice land could be expanded much further, doing this demands a careful weighing of net economic benefits. The availability of cheaper, good-quality rice from other countries suggests that East Timor is not an efficient producer. A better option is probably to import most additional rice required and to use the resources thus freed up for other, more promising, agricultural areas. Coffee and Coconut Coffee, yielding around one tonne of cherry per hectare, is another crop with a comparatively small output. The predominant variety is Hybrida da Timor, a locally developed cross of Arabica and Robusta that has largely replaced the Arabica wiped out by coffee rust in the early 1900s. While low yielding, it is tolerant to most coffee diseases. The smallholder coffee gardens of East Timor are characteristically overgrown, with excessive plant populations due to selfseeding. Little pruning or mulching is carried out, and farmers’ main attention is directed at harvesting the berries. These are often picked while still unripe, and processed poorly by the farmers themselves. Lack of water, which is necessary for wet fermentation, is a main obstacle to better processing. A first step in improving coffee crops is to persuade farmers to pay more attention to mulching and pruning, and to encourage them to deliver unprocessed beans to more centralized and efficient processing plants. This would materially improve quality and returns at the farmgate, but would require effective means of transport. Such a strategy has been criticized, however, for compressing the returns from coffee to just one time of year, the harvesting season, compared with the better distributed returns from traditional processing, where the crop is stored and sold in small quantities to meet farmers’ ongoing cash requirements (Simpson and Larsen 1999). Probably the approach actually taken by extension staff should be adjusted to local circumstances.

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The NCBA in conjunction with local cooperatives has been instrumental in encouraging improvements in coffee production, and in developing export links for organic coffees produced by certified growers. Such initiatives need to be undertaken more widely. In the longer run, it may be possible to introduce better and higher-yielding coffee varieties, accompanied by improved management and inputs, including advanced disease control. These advances would further serve to enhance yields and profitability, but are a relatively distant possibility at a higher level of the gradient discussed earlier. There is similar potential for improvement in coconut and other tree crops. Most coconut-bearing trees in East Timor are old and low-yielding, presenting the opportunity to replace them with modern varieties sometimes grown in conjunction with cocoa. Copra and coconut oil production could be upgraded, and coconut products utilized in livestock feed. Coconut has the potential to become an important cash earner, thus deserving the active attention of planners at this initial stage of development. Cattle and Pigs Cattle promises excellent possibilities for improvement, especially in view of the present low numbers. The usual technique with the robust Bali cattle that have shown themselves to be well adapted to Timorese conditions is to allow them to graze freely on the huge areas of collective land under native pasture, and then after two years to tether and fatten them for a year until ready for live export. One important step forward would be to replace the currently predominant native pasture with improved dry-condition grasses, legumes and the Leucaena forage tree, all of which give far higher and more palatable yields. This is technically feasible and should be started relatively soon. It could initially be done in special enclosures supplying food to tethered animals, but later expanded to cover replacement of pastures on a wider scale. Once they became widely established, the new forages could at least double the production of livestock feed and support quite a large cattle industry. Improved mixes of forage feeds securing higher growth rates could again be introduced and, together with hormone administration and other management advances such as disease control, considerably raise yields from cattle. There is scope too for improving the currently inferior stock of village pigs by introducing improved breeding stock and better-controlled feeding methods. Such measures would both augment subsistence incomes and raise cash returns to farmers. Testing It should be stressed once more, in relation to food crops in particular, that a key

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component of any strategy entailing adoption of superior seeds is first to test them under the range of conditions obtaining in East Timor. One significant, and already operational, project of this nature comprises the checking of better varieties and types of maize, padi, cassava, sweet potato and other significant food crops at six trial sites around the territory (ACIAR 2001). These varieties are being observed for several years, with the intention of eventually distributing the seeds of those proving most suitable. Early results indicate that some imported maizes and sweet potatoes are doing particularly well at some sites, and have good potential for later distribution. This principle of scattered experimental sites – which under the plan proposed above would be linked to the operations of the three technology research centres – can also usefully be applied to animal forages and tree crops. Constraints While acknowledging the exciting potentials for improved agricultural technology in East Timor, it is important to recognize the many constraints to implementation and the considerable efforts needed to enable such potentials to be realized. Experience in Timor and elsewhere shows that far more time than might be anticipated is required for farmers to understand and appreciate the new techniques. Hence, sustained extension and training over many years are probably necessary before a later, more dynamic and independent, stage of adoption can be reached. Credit is an indispensable adjunct to introducing all new systems (Nusatenggara Association 1992–2001), even when the farmers themselves supply labour and local materials. Where credit is inadequate, no progress will occur. Thus building the provision of cash-or-kind credit into the dispersed activities already canvassed is an essential element needing due attention. It should likewise be recognized that adverse climatic conditions and price fluctuations can greatly delay the process of change, stripping farmers of alreadylimited assets and presenting major setbacks to adoption. All these aspects reinforce the argument presented above for sustained, in-depth extension to local communities, for without careful attention to building this link little progress can be made.

PROGNOSIS AND CONCLUSIONS The simple rural development model presented in this chapter is felt well suited to current conditions in East Timorese agriculture. This model and the technical improvements that have been suggested emphasize the vital importance of research and detailed extension, both of which are frequently neglected in the

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process of agricultural improvement. The adoption of the recommendations made here could enable the annual agricultural growth rate of some 3 per cent per year in the Indonesian period prior to Merdeka to be substantially augmented, positioning the rural sector as the engine of economic expansion in East Timor. The model described in this chapter is in line with UN and World Bank recommendations for small government in East Timor, and would place rural improvement firmly in the hands of those benefiting most from it. It fits well with the general prescription for agricultural development presented by Timmer in Chapter 6, and with the approach recommended by well-informed outsiders such as Tanter, Selden and Shalom (2000: 192), who suggest that ‘a critical question will be the extent to which economic approaches will be rooted in indigenous social structures and based on forging close bonds with rural producers’. But it must also be realized that considerable pressures are ranged against the proposed model, not least from supporters of the ‘bureaucratic’ approach to development. This latter approach, which is widely adopted by foreign aidgivers, entails a more centralized and integrated approach to improvement, with extension being entirely conducted by government personnel, and control firmly in the hands of government administrators. Even when foreign aid is implemented by private sector contractors, projects tend to be carried out within a bureaucratic straitjacket imposed by giving and receiving governments, and to lean towards adoption of the generally less-suitable ‘focused’ implementation described earlier. The bureaucratic model was used by the previous Indonesian administration, and is applied in many similar contexts around the world. It tends to contain standardized prescriptions for project organization and supporting facilities such as credit, embodying a high-cost system apt to be pushed regardless of the locality’s particular development and social circumstances. Since bilateral and international funders dominated by government contribute most or all of the necessary finance in East Timor, and thus have the commanding role, it is likely that their funding guidelines will be inclined towards pressurizing East Timor to adopt such a model. Given that the East Timorese authorities are more inclined to the kind of alternative rural development strategy advocated in this chapter, they will have to resist such outside pressures strongly. That will not be easy. If development along the lines proposed here does take place, the task of government, although small, will need to be exercised closely and intensively. It is crucial to ensure that the three research centres carry out high-calibre and relevant work. The allocation of extension among NGOs and local groups will need to be done with care and monitored closely, with quick attention to emerging difficulties and changes. Again, the opening up of rural markets and launching of targeted activities to improve certain market segments will have to be

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pursued rigorously. All these considerations argue for a high-quality and professional, albeit small, government agricultural administration, open to review and advice from qualified outsiders. East Timor is a very poor country. Even with increased revenue from improved agricultural activity – swelled by expected returns from oil and other items – it will take years for the extremely low incomes of its rural peoples even to double. The rural development model proposed here offers a promising means of achieving progress, and should be feasible at a time when the national development program is being entirely reconsidered. It is hoped that this model will be examined carefully, and that at least some of its elements will be adopted by the new East Timorese administration.

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Coffee and the Economy in East Timor Jacqueline Pomeroy

Coffee is a critical crop for East Timor, for three reasons: it is East Timor’s most important export (at least until gas production begins in the Timor Gap); it is the most important source of cash income for a significant portion of East Timor’s impoverished rural population; and coffee processing is an important source of seasonal employment. This chapter outlines the role of coffee in the East Timorese economy; the main characteristics of the world coffee market and their implications for East Timor; features of coffee production in East Timor; and key short-term and longer-term issues that will need to be addressed by government and industry participants in order to obtain the maximum benefits the coffee industry can provide to the people of East Timor.

THE ROLE OF COFFEE IN EAST TIMOR’S ECONOMY Coffee brings good news and bad news for East Timor in 2001. The good news is that the trees are holding a bumper crop, with an estimated 10,000 metric tons of green beans waiting to be picked, processed and exported. The bad news is that international coffee prices are at a historic low: the New York ‘C’ contract price (to which most East Timor coffee prices are linked) is expected to average only $0.60/lb compared with last year’s already low $1.00/lb. In calculating the value of the crop (Table 8.1), we assume that 30 per cent of this year’s crop is wet-processed and will sell for an average premium of 12 cents on the market, and that 70 per cent of the crop is dry-processed and will sell at a 25 cent discount.1 We also assume that the crop is sold at an estimated New York ‘C’ price of $0.60 per pound and that 100 per cent of the crop is exported. Under these assumptions, the international value of coffee exports from East Timor could surpass $10 million.2 However, not all of this value will be added in East

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Table 8.1 The Role of Coffee in the East Timorese Economy, 2001 a Crop yield (estimate) Wet process (estimate) Dry process (estimate) Parchment to green bean yield Crop estimate (parchment) Exports (estimate) Premium portion of crop b Value of premium c Discount portion of crop Value of discount c Exchange rate New York ‘C’ price (estimate) Weighted average contract price

10,000 g.b.e. tons 3,000 g.b.e. tons 7,000 g.b.e. tons 79 per cent 12,658 tons 100 per cent 30 per cent $0.12 70 per cent $0.25 Rp 10,000/$1 $0.60 Rp 10,160/kg ($0.4610/lb)

International value of crop (c.i.f.) Parchment price d Farmgate cost of green beans Local transport and processing Domestic value (f.o.b.) Total payment to farmers Total local transport and processing Total domestic value

$10.2 million Rp 4,000/kg ($0.18/lb) Rp 5,696/kg ($0.26/lb) Rp 500/kg ($0.02/lb) Rp 6,196/kg ($0.28/lb) $5.1 million $1.2 million $6.2 million

Coffee-farming families Members per family Total coffee-farming population Parchment per family Cash income per family Wet process employment

40,000 families 5 members 200,000 people 316 kg Rp 1.3 million ($127) 875 people per thousand tons g.b.e. (2,625 people) 875 people per thousand tons g.b.e. (8,750 people) 11,375 people

Dry process employment e Total employment (seasonal)

c.i.f = cost, insurance and freight; f.o.b = free on board; g.b.e = green bean equivalent. a Due to current and expected volatility of the Rp/US dollar exchange rate, the estimates in the table should be treated with caution. b Based on previous years’ output, and World Bank and private producers’ estimates. c Based on private producers’ negotiated contract values for the crop year 2001. d This was the purchase price for dry-processed coffee in April 2001 and is estimated to be the rough predictor of this season’s purchase price. This price covers the cost of capital but results in roughly zero profit above that. e Washed coffee requires labour inputs for both wet and dry processing.

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Timor because the New York ‘C’ price is a cost, insurance and freight (c.i.f.) price, delivered into licensed warehouses in North America and Europe. Reliable estimates of recent past production costs indicate that the value of coffee purchased from the farmers could total about $5.1 million, with local transport and processing adding an additional $1.1 million for a domestic free-on-board (f.o.b.) value of roughly $6.2 million. If we assume that the government collects income taxes from exporters equivalent to a 5 per cent export tax based on the f.o.b. value,3 coffee can be expected to generate about $300,000 in government revenue this year. The income from this crop will have a considerable impact on an alreadypoor rural economy that has suffered widespread destruction and trauma. An estimated 40,000 farm families derive their income from coffee production. Perhaps 25,000 of these rely on coffee for a substantial proportion of their income, while another 15,000 use coffee to supplement their income. If the average family size is five persons, this means that the welfare of roughly 200,000 people in East Timor – or 25 per cent of the population – is at least partially dependent on coffee, with about 16 per cent of East Timorese relying on the crop for a significant proportion of their income. If exports amount to 10,000 tons of green beans this year, this translates to 12,600 tons of parchment beans, or an average of 316 kilograms per coffeefarming family. At a parchment price to farmers of Rp 4,000/kg,4 the average cash income would be about $127 per family. Coffee also employs large amounts of seasonal off-farm labour to transport and process the crop. At the peak of the season, washed coffee employs about 875 people per thousand tons of green beans produced just in the wet-processing factories; processing from dry parchment to export employs an equal amount of labour.5 Thus 10,000 tons of coffee would generate seasonal employment for over 11,000 people, not including transport workers.

COFFEE AND THE WORLD MARKET Types of Coffee There are two basic types of commercially produced coffee, Robusta and Arabica. Robusta is grown at all elevations and generally has a lower price. Arabica is grown at altitudes above 700 metres and has a higher price. The Arobusta variety (or mocha/moka) is a mutant mix of the two. It has Arabica characteristics but grows at somewhat lower altitudes. Most Arabicas are in fact hybrids. Pure Arabicas are commonly found only at very high elevations, typically above 1,700 metres. Robusta trees tend to be stronger and more resistant to disease and are able to grow at practically all elevations.

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Arabica trees are more vulnerable to diseases such as leaf rust, especially at lower elevations. The Arobusta hybrid results in trees that are stronger but which produce coffee beans with many of the desirable Arabica characteristics. Most coffee sold at the retail level in North America and Europe is a blend of Robusta and Arabica. Tastes vary somewhat, but generally Robusta makes up 35–65 per cent of the total (Americans prefer more Arabica in their blend whereas Europeans prefer a blend dominated by Robusta). Soluble coffee, the technical term for instant coffee, is made exclusively from Robusta coffee beans – the harsh process of making soluble coffee destroys so many of the more subtle qualities of Arabica that it would not be worth paying the higher price for the beans. World Production Levels In 1998 the world produced about 105 million bags of coffee beans, or about 65 million tons of coffee. A breakdown for the world’s major producers is given in Table 8.2. East Timor’s coffee crop in 1998 was much smaller than usual (4,250 tons) because of El Niño. However, even an excellent crop of 10,000 tons would have accounted for only 0.00015 per cent of the world’s output (Table 8.3). The important point here is that although coffee is important to East Timor, the country is so small in terms of the world market that it has no influence at all on the market or the world price. Whether East Timor produces nothing or as much as 10,000 tons, the world market will not be affected. World Coffee Markets Coffee is traded on two major world exchanges. Robusta coffee is traded in London on the London International Financial Futures Exchange (LIFFE). Prices are quoted in US dollars per ton. Arabica coffee is traded in New York on the Coffee, Sugar & Cocoa Exchange (CSCE). Prices are quoted in US dollars per pound.6 The contract is called the New York ‘C’, and the quoted price is for grade 1 coffee in contract units of 37,000 pounds (about 16.8 metric tons). The NY ‘C’ price quotation is for coffee received in registered Arabica warehouses in New York, New Orleans, London and Rotterdam. The quoted price is for delivered coffee, including all costs, insurance and freight. There is a relatively small market in Tokyo (mainly for Arabica), but the prices follow those of the two major exchanges exactly. Large volumes of coffee are traded on each of the principal exchanges every day, but not all coffee is physically traded there – for example, East Timorese Arabica would not be sold physically on the New York exchange. But the volumes of Arabica coffee that are traded every day in New York are so large that

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Coffee and the Economy in East Timor Table 8.2 Coffee Output of the World’s Main Coffee Producers and East Timor, 1998 Country

Brazil

Total Coffee Production (million tons)

Share of World Production (%)

(million tons)

16

Arabica Production (%)

22.75

35

Columbia

8.45

13

8.45

100

70

Indonesia

4.55

7

0.46

10

Vietnam

3.90

6

0

0

Mexico

3.25

5

0

0

East Timor

0.004

0.00006

0.003

80

Sources: World Coffee Almanac, 1999; World Bank estimate for East Timor.

Table 8.3 Coffee Exports from East Timor, 1995–2001 Year

Estimated Harvest (tons)

Denok/ Batara Indra/Salazar (%)

Nusra Timor (%)

Coperativa Café Timor (%)

Small Traders (%)

1995

7,000

19

57

1

23

1996

8,000

46

18

12

24

1997

4,500

38

0

11

51

1998

4,250

32

0

32

36

1999 a

10,000

0

0

25

75

7,000

0

0

33

67

2000 2001 (estimate) a

10,000

The 1999 harvest ceased mid-season. Procurement was severely disrupted by the violence before and after the popular consultation in August 1999.

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they determine the daily world price, or the benchmark price. Thus, while coffee from East Timor would most likely be traded through private contracts with buyers, the price specified in the contract would always take the New York ‘C’ price as a reference point. The actual contract price is usually made at a discount or at a premium to the exchange price, based on quality or other special factors. How Coffee Contracts Work Coffee contracts can be written to trade on a specified date either in the future (a futures contract) or immediately (a spot contract). Futures contracts are the most common way to sell coffee, particularly specialty coffees such as East Timor Arabica. Top-quality coffee is usually sold long before it is harvested. Many specialty producers have regular buyers who buy their entire output before the harvest begins. For example, a specialty coffee buyer in the Netherlands might negotiate a contract in April with an East Timorese exporter under the following terms: for an October delivery in Rotterdam, he agrees to pay the New York ‘C’ price plus a premium of 12 cents per pound, fixable on the date of shipment. If the exporter chooses to ship the buyer’s coffee on, say, 27 August, the actual price would be based on the quoted international market price on that date, plus the agreed-on premium. When coffee prices are low, producers may prefer to hold onto their physical stocks in the hope of selling them later at a higher price. There are risks to this strategy, however: the quality of coffee deteriorates as it gets older, making it less valuable, and there is always the possibility that the market price may fall rather than rise. Coffee contracts can also be made in the spot market for immediate trade. Spot prices generally tend to be lower than futures prices – buyers know that sellers have the product and need to sell it right then, and so can bargain for a lower price.

COFFEE IN EAST TIMOR Types of Coffee Grown and Elevations About 20 per cent of coffee grown in East Timor is Robusta and about 80 per cent is Arabica. Arabica is grown only at elevations above 700 metres. The major coffee production areas are found in Ermera, Liquica, Ainaro and Aileu, although all districts produce some coffee. East Timorese Arabica is called Hybrida da Timor and comes from a mutation that occurred around 1917. In fact it is an Arobusta, or mocha hybrid, making it a tougher tree and more resistant to leaf rust. This hybrid is also better

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able to adapt to marginal soil conditions and can withstand frequent droughts – important attributes in the environment of East Timor. Arabica coffee varies in quality depending on the altitude at which it is grown and other factors. In East Timor, the lower zone is 700–900 metres, the middle zone is 900–1,200 metres and the best coffee is grown above 1,200 metres. At higher elevations, the growing season is longer and the beans are harder, producing a better-flavoured (and more valuable) coffee. A portion of the Arabica coffee grown in East Timor’s higher elevations is unique and can be of very high quality (if processed properly), enabling it to command a higher price in the niche market for specialty coffees. But there are advantages and disadvantages to this uniqueness. For East Timorese producers to be able to exploit this niche market effectively, they must understand the requirements of specialty buyers. Before adding a particular coffee to their line, buyers need to be satisfied on two essential points: will they be able to get a regular supply in the volumes their customers demand, both from month to month and from year to year; and will the quality be consistent? This points to the disadvantages of the unique nature of East Timorese coffee. First, total crop levels are small and variable, meaning that the total supply to the international market is not always reliable. The size of the coffee crop is strongly influenced by climate and can range from 4,000 to 12,000 tons. East Timor is particularly vulnerable to El Niño weather patterns, which resulted in very small crops (4,500 tons or less) during the drought of 1997 and 1998, followed by very good crops in 1999 and 2000 of about 8,000 tons (Table 8.3). If a commercial coffee supplier in, say, Europe, invested in developing a popular profile for East Timorese coffee, he would have to be certain that he could provide the coffee to his customers on an ongoing basis. Second, the processing of coffee in East Timor can be very uneven, resulting in highly variable quality. Again, specialty coffee buyers need to know exactly what they will receive before they will promote this coffee to their customers. As a result, buyers in the high-value specialty market will nearly always buy from processors/exporters with whom they have a solid, established relationship. Types of Processing Dry-processed Coffee Dry processing is the technical term for coffee produced in the traditional manner in East Timor. Typically, farmers gather the ripe cherries from the trees together with those that have fallen to the ground. These are dried in the sun, with the pulp generally being removed once it is at least partially dry, and bagged for sale as parchment beans. Coffee beans can often be seen drying on the asphalt, where passing vehicles help break up the drying pulp and

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USEFUL FACTS, DEFINITIONS AND CONVERSION FACTORS Stages of coffee processing Cherry Parchment

Silver skin Green bean

When the ripe fruit is picked. When the fruit is removed and the nut inside is dried, but the thin white shell remains around the bean. Also called kulit kering or asalan in Indonesian, or pergamino in Spanish. After the hard white parchment shell is removed, leaving the thin, papery silver skin. After the silver skin is removed in a process known as polishing.

Processing ratios for East Timorese beans dried to obtain a 12 per cent moisture content (the standard for international sales contracts) Cherry to parchment Cherry to green bean

5:1 (5 kg of cherries yields 1 kg of parchment beans) 6:1 (6 kg of cherries yields 1 kg of green beans)

Useful conversion formulas $/lb × 2.204 = $/kg $/lb × 2.204 × Rp/$ = Rp/kg

Example $0.60/lb = 0.60 × 2.204 = $1.32/kg $0.60/lb = 0.60 × 2.204 × 10,000 = Rp 13,224/kg

parchment. This makes manual processing easier. Unfortunately, it also introduces dirt and foreign matter, and tends to break the beans. This type of traditional processing will yield lower-quality beans. Wet-processed or ‘Washed’ Coffee Wet-processed coffee is technically more complicated but generally produces a coffee of higher quality and value. Ripe cherries begin to ferment as soon as they are picked or fall from the tree, and the coffee bean absorbs those flavours. This is why two bags of coffee may look the same but be of very different quality. In wet processing, the fruit is removed from the bean (pulped) as soon as possible so that it does not ferment around the bean; the highest-quality coffee is pulped within 12 hours of being picked. After the cherry has been pulped, it is soaked for a period of time to soften the mucus surrounding the bean, and then this is removed (or washed). The resulting parchment is dried in the sun (to obtain an average moisture content of 12 per cent) before being bagged for further processing.

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INTERNATIONAL QUALITY STANDARDS The basic physical condition of coffee beans determines its grade. Coffee is classified from grades 1 to 4, with grade 1 being the highest. There are four criteria for grading coffee: level of defects, moisture content, foreign matter and bad beans. Grade 1 coffee must have: • • • •

a level of defects of less than 8 per 300 grams of green beans; a moisture content of less than 12 per cent; no foreign matter; and no bad beans or ‘stinkers’.

This coffee is termed ‘8-12-zero-zero’. In comparison, most Indonesian coffee is grade 4, which can have up to 80 defects per 300 grams and an occasional bad bean. The grade of coffee describes its physical condition, but is not the sole determinant of the price. There are also other factors determining whether a particular coffee will sell at a premium or discount to the New York ‘C’ price, including the particular flavour characteristics of the coffee, which can be affected by the method of processing. This is discussed further in the text.

Further Processing Parchment coffee still requires further processing before it can be sold and exported. The first step is to place the beans in bags and ‘cure’ or ‘condition’ them in the parchment for two months or more. Curing allows the moisture content to equalize within each coffee bean, producing an even colour and better consistency when roasted. After curing, the thin white shell is removed by a mechanical huller. At this point, the green beans are sorted into various qualities. Coffee beans can be sorted either by machine or by hand, although the highest-quality coffee is almost always sorted by hand. Machine sorting uses an ultraviolet light to detect off-colour or defective beans moving in a narrow stream through a tube. A blast of air removes them from the good beans. This labour-saving device is sometimes used in Indonesia and can generally be expected to produce grade 4 coffee. In hand sorting, the workers sit at a large table covered with coffee beans. They pick out defective or irregular beans and place them in a bag, sweeping the remaining ‘good’ beans into a separate bag. For very particular buyers who require a double hand-sort, the bag of ‘good’ beans might then go onto the table of a second sorter, who again picks out any substandard beans and sets them aside, placing the ‘better’ beans in a bag. These ‘best’ beans from a double handsort command a large premium in the high-value specialty market.

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Depending on the buyer’s requirements, the beans may be put through a polishing machine to remove all traces of the silver skin. Japanese buyers for the top-grade market usually require very clean beans, although buyers for the North American and European markets tend to be less particular. The silver skin evaporates into ash during the roasting process. Organic Coffee The organic market is a separate niche in the high-value specialty coffee market. There are many misperceptions about the term ‘organic’ – many people believe (incorrectly) that organic coffee is ‘wild’ coffee, or that all coffee in East Timor is organic. In reality, in order to sell coffee in this market, the coffee must be tested and certified to be free of pesticides and fertilizers. There are several international organizations (many based in North America and Europe) that certify agricultural products as organic. Initially, certification requires thorough documentation of the producer’s growing and processing steps. This is followed by a field visit from a technician of the organization, who verifies that the producer’s documentation is accurate and takes samples of the product all along the line. These samples are then chemically evaluated in the agency’s home laboratory for any traces of pesticides or fertilizers. These field visits are repeated periodically, usually at least once a year, in order to maintain certification. As part of the certification process, the holdings of each individual farmer from whom the producer buys coffee must also be inspected to verify that no added inputs are used. During the harvest season, the certification must be noted and verified for each purchase of cherries from every individual farmer. Clearly this is a very labour-intensive process and requires extensive administrative capacity. Production Levels in East Timor Most coffee from East Timor is dry-processed coffee. Up to the 2000 harvest season, there were only two producers of washed coffee. The first of these was Coperativa Café Timor (CCT, formerly Puskud), which produces only washed coffee and usually does not buy or sell dry-processed coffee.7 Much (but not all) of its washed coffee is organically certified. The second is Salazar, which produced some washed coffee originating from its own plantation up through the 1998 season. None of this coffee was certified organic. Salazar also traded significant amounts of dry-processed coffee. Therefore, roughly 30 per cent at most of East Timor’s coffee production is washed coffee (Table 8.3), and only a portion of that is certified organic.

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The Market in 2001 The key to ensuring that farmers obtain the best possible price for their coffee (especially important in view of the currently depressed international prices) is to have enough buyers in East Timor to provide a competitive market environment. Recent survey work in Dili indicates that there will probably be the minimum number of buyers required in the market this season to generate a competitive price to farmers. (The harvest season runs from late May to end August.) In addition to CCT, a Portuguese-based firm last year purchased an estimated 150 tons of (mainly dry-processed) coffee. Other planned foreign entries into the market for dry processing did not materialize for various reasons, and few if any new entrants are expected this year. Out of the group of processors/exporters from the pre-consultation period, neither the Batara Indra group nor Nusra Timor is expected to be active in the market this year. Much of last year’s dry-processed crop was purchased by a number of small traders out of Dili, who traditionally buy up to half the crop. These traders will play an important role during this year’s season as well, and efforts should be made to facilitate their activities. In the aggregate, these traders should provide minimally adequate demand for this year’s crop, as long as solutions are found for the key constraints noted in the following section. A failure to address these issues will jeopardize the industry’s ability to support economic recovery in the medium term. This would limit processing capacity and threaten seasonal employment opportunities for thousands of Timorese.

POLICY IMPLICATIONS Clearly, coffee is already an important part of the economy in East Timor and can contribute to future growth if managed appropriately. This section outlines a number of elements in an effective development strategy. Short-term Constraints and Recommendations 1 A number of important coffee-processing facilities in Dili are not operational. Some have been taken over by non-government organizations (NGOs) or international agencies such as the Organization for the Coordination of Humanitarian Activities (OCHA). The military is restricting access to others, and some have been damaged or destroyed. The government must make a coordinated effort to ensure that property rights are respected and that all facilities are made available and usable immediately. 2 Many key roads in coffee-producing areas are damaged or impassable. The maintenance efforts of the United Nations Transitional Administration in

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East Timor (UNTAET) have focused almost exclusively on repairing primary roads. Special attention should be given to ensuring that secondary and tertiary roads in coffee-producing areas are functional so that farmers can get their coffee to market. The higher value-added (and increased employment benefits) of washed coffee is especially vulnerable to road blockages. Production costs increase (thus reducing prices to farmers) when repairs have to be undertaken privately. 3 Farmers need access to information about prices and the industry in general. Radio UNTAET should continue to provide information about prices and industry activities. It could perhaps organize a feature presentation for the weekly agriculture program, and prices should be broadcast weekly throughout the harvest season. Staff will need to consult with local industry participants to tailor program needs. Some Recommendations for the Medium and Longer Term 1

Develop a practical, market-driven extension program adapted to the local culture, focusing on basic needs, targeted to the village level, and with clearly defined goals. Such a program might include the following elements. • A pruning system that is appropriate for the type of coffee grown and the social environment. A suitable pruning system would increase the volume of coffee picked while also increasing bean size and flavour. • Education of farmers on ways to produce a better product (and thus increase their incomes), including picking, pulping, fermenting, washing, drying and storage techniques. The focus should be on how to add value in order to get a better price. • Communication with farmers on price and quality issues through quality-assurance training. • Supply of basic hand tools to farmers, and training in their most effective use. • Rehabilitation of existing coffee farms. • Introduction of intensification programs. Currently there are about 600 trees per hectare whereas 2,000 could be supported with proper cultivation. • Shade tree diversification and propagation to protect existing coffee trees, aid extensification and help retain shallow soil. • Introduction of coffee breeding and testing programs. • Promotion of improved planting techniques for higher yield. • Introduction of disease and pest control strategies, including for berry borer disease (usually found below 1,000 metres). • Learning from the lessons of Indonesian-era attempts to increase farm production.

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Support the development of a full-service commercial banking sector that is capable of providing the complete range of services necessary for business, especially currency conversion at competitive international rates. The farmers’ desire to be paid in rupiah, the shortage of low-denomination US coins, the inability to maintain rupiah bank deposits in Dili and the enormous margins being applied to currency exchange all raise the cost of doing business and directly reduce the prices paid to farmers. Establish a system of quality, grading and standards for coffee exports. The variety of systems in use internationally should be reviewed and a system adopted that (a) complements the structure of East Timor’s target markets and makes it easier for international buyers to purchase East Timorese coffee, and (b) will facilitate the development of a coffee-purchasing system that rewards farmers for good coffee. Price differentiation is crucial to encouraging farmers to improve quality, and to increasing their incomes. Apply extreme care in regulating the organics industry that has developed. If appropriate, a national organic strategy could be developed to allow the organic sector to exist in parallel with non-organic rice and food-crop production. Any organic strategy should be coordinated closely with other agricultural programs to develop protocols for fertilizer and chemical use. The opportunities for expansion into the organic industry by other coffee producers – and producers of other crops such as vanilla – should be evaluated. Increased production of semi-washed and washed coffee with higher valueadded requires an adequate water supply, which is often not available in rural areas. Community-based water supply projects should be coordinated regionally and linked closely to extension programs. These activities could facilitate semi-washed coffee production by smallholders through increased utilization of small pulping machines. Rationalize labour laws and take care to establish a general pay scale that will enable East Timor’s coffee to be competitive on international markets. Wages have tripled since the consultation and, combined with significantly higher transport costs and lower productivity due to the deterioration in law and order, have resulted in production and export costs that are among the highest in the world. Markedly increased levels of violence in solving labour disputes will quickly discourage investment in coffee processing. Extend and improve the farm-to-market road system, and create a locally based road maintenance system. It is important to establish ‘ownership’ of road maintenance plans by farmers in local communities to ensure timely service delivery and long-term success. Develop a rational long-term tax policy that provides equitable treatment for all business activities in East Timor, and that does not include export taxes. In a highly competitive international environment, any export tax

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will simply reduce the price paid to farmers. Coffee farmers are part of the rural poor in East Timor and generally do not have access to government services such as health and electricity that are being provided elsewhere. Despite this, they are currently providing a large portion of the tax revenue in the country. 9 Quickly resolve land ownership issues concerning the large coffee estates and any possible transfer of abandoned estates to smallholder production. Most of these estates have been abandoned, and their coffee is picked – if it is picked at all – by farmers on adjoining properties. These estates could provide the nucleus for providing assistance to smallholders through targeted extension and improved management techniques. 10 Encourage the government and NGOs to use local coffee. Roasting and packaging in East Timor for the export market is generally not a good strategy because roasted coffee does not store well and buyers in the specialty market prefer to do their own roasting. However, there is a limited local market for perhaps 50 tons of coffee per year, primarily to serve the needs of international residents, and this market should be encouraged to develop. 11 Encourage the formation of a coffee association to enhance the ability of all parties to contribute to the development of the industry. The organization should be industry-driven and private sector-based (not government-mandated). It should focus on enabling farmers to participate in the industry’s development, including establishing a purchasing system that would reward farmers for producing good coffee. It should be the primary instrument for the industry to provide input on government policies. 12 Improve the status of farmers in East Timor. The Faculty of Agriculture should be made the cornerstone of the university, and young educated people should be encouraged to enter agriculture. An open and progressive coffee industry could lead the way for agricultural efforts in other areas. Modernize it and link it to other industries such as tourism. Communicate with farmers so they know they are the backbone of life in East Timor and are encouraged in their work. Use the print media and broadcasting to give them the information they need on prices and quality.

NOTES 1

The value of the premium depends generally on the altitude at which the coffee is grown and whether or not it has organic certification. These average prices are based on the principal private processor’s commitments for this season. The extremely low market prices are tending to push up the premium specialty buyers are willing to pay – the premium during the 2001 season averaged only 5 cents per pound.

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This should be considered a high-end estimate, since Robusta will sell at a lower price and some coffee will be consumed domestically. Last year’s 5 per cent ad valorem (f.o.b.) export tax on coffee has been modified this year. Exporters will now pay the 5 per cent export tax to offset their income tax liability. In April 2001, traders in Dili were buying dry-processed parchment for Rp 4,000/kg. As detailed later, washed coffee requires labour inputs for both wet and dry processing. Robusta prices from the London market are listed daily and can be found at . New York ‘C’ prices from the CSCE are listed daily on the New York Board of Trade at . A good summary of daily coffee market activity (including the Tokyo market) and detailed supply and demand conditions can be found in Best Investments Daily Coffee Newsletter at . Because activities during the 1999 harvest season were disrupted and farmers and traders were unable to complete normal processing and sales, CCT bought dryprocessed coffee throughout 2000. If there are not enough buyers in the market during the 2001 harvest period, CCT says it may again buy dry-processed coffee.

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Many years of colonization without real development, followed by a deliberate wave of looting and destruction, form the backdrop for the rehabilitation and development work now under way in East Timor. Agriculture cannot be regarded in isolation from its wider context, which includes transport, markets and sustainability. Employing over 80 per cent of the population, contributing 40 per cent of GDP and accounting for 90 per cent of foreign exchange, agriculture is of vital importance to East Timor in all respects. In addition to the tremendous human costs visited upon the country in September 1999, marketing systems and general economic and commercial life were seriously disrupted. A return to normal economic activity continues to be hampered in many areas by disruption to internal markets, the absence of small traders and merchants, poor roads, and decimated commercial and private transport systems. In spite of all the setbacks caused by the destruction of late 1999 (World Bank 2000e), agriculture is the activity that depends most on the Timorese themselves and is also the area that is now showing the clearest signs of recovery. Given that the vast majority of the poor still live in rural areas, the effects on agriculture of future structural and policy changes will have a major impact on real income, growth, poverty alleviation and the state of the environment. The purpose of this chapter is to examine the intersectoral implications of macroeconomic and exchange rate policy for agricultural development. A brief explanation of agriculture as the engine of economic growth is followed by an analysis of the effects on agriculture of a boom in other sectors of the economy. The chapter then discusses factor endowments using the ‘Leamer Triangle’ approach (focusing in particular on East Timor’s position relative to that of other economies), before drawing some specific lessons for East Timor.

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AGRICULTURE: THE ENGINE OF GROWTH The agricultural sector is not only relied on to enhance rural incomes and expand export earnings, it is also expected to manage ecological processes sustainably, provide environmental services and economic goods, and achieve an increase in the quantity and quality of yields. Building a dynamic agricultural sector requires that some of these resources be devoted to agriculture itself. In East Timor, the sector will have to continue to provide much-needed services and act as the ‘engine for economic growth’ for some time to come (Timmer 1988). This has been stated clearly by the United Nations Transitional Administration in East Timor (UNTAET), particularly the Division of Agriculture Affairs. Its mission statement is ‘to structure a lean and efficient Agriculture Department, build a sustainable agricultural production and marketing system, establish and empower communities to increase productivity and ensure food security, build human and institutional capacity so as to improve the overall economic and social well-being, while ensuring a sustainable and ecologically sound agricultural production system in East Timor’.1 Clearly, these specific objectives for agriculture were set primarily to increase nutrition levels; improve the quality of agricultural commodities, livestock and fisheries for local consumption; provide valuable agricultural products for regional markets; and improve the quality of commodity – especially coffee – traded on both national and overseas markets. East Timor’s economy has been dominated by agriculture for the last halfcentury or more, as shown in Table 9.1. Given the strong link between the growth of the agricultural and the non-agricultural sector, it is important that adequate resources be channelled into agriculture to get the economy moving. This would allow the economy to correct the present inefficient concentration of labour in agriculture in favour of industry and services.

BOOMS AND THEIR IMPLICATIONS FOR AGRICULTURE Government policies often have unintended effects on agriculture.2 Industrial protection policies, exchange and interest rate policies, and other fiscal and monetary policies can strongly influence the incentives for agriculture vis-à-vis other sectors. For example, border protection has often been used to protect domestic manufacturing; but restrictive trade policies of this type, accompanied by fiscal deficits, often result in exchange rate misalignment, and thus have an adverse impact on agriculture (Schiff and Valdes 1998). Agriculture is also affected indirectly by exogenous changes in the world prices of non-agricultural commodities such as oil and minerals, and by foreign capital flows. Two reasons why an economy-wide view of returns is necessary to understand the

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Table 9.1 Economic Development Policy in East Timor, 1958–99 Period

Economic Activity

1 The plantation economy (1958–60)

Agricultural development • Opening up of coffee plantations • SAPT founded • Introduction of new seeds

2 The ethical economy (1960–75)

Plano de Fomento (Five-year Development Plan) Priorities: • Introduction of new plants (cinnamon, cacao and other fruits) • Infrastructure (transportation and communication), agriculture, education and health

3 The war economy (1975–80)

War period • Destruction, rehabilitation, consolidation and restructuring

4 Uncertain development (1980–99)

Short-term development plan Five-year Development Plan (Pelita) Priorities: • Agriculture, education, health, the public sector, transportation and communications, rural development

5 Reconstruction and development (1999 – present)

Rehabilitation, recovery and development in various sectors

Source: Saldanha and da Costa (2000).

dynamics of agricultural growth and employment are, first, that sectoral growth is affected by resource flows between sectors, and second, that these flows adjust to the relative opportunities offered by different sectors over time. A conceptual taxonomy, devised by Mosley, showing how aid inflows may affect a recipient economy is given in Figure 9.1 (Walker 1996). The diagram shows that aid used primarily to transfer additional resources to a recipient country can have a positive impact on growth. It can, for example, provide extra resources to supplement domestic savings; or ease a specific constraint within the economy, such as a balance of payments constraint; or be used to increase investment in the country. Overall, this suggests that foreign aid can be an important contributor to equity and the reduction of poverty, and that it has the

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Figure 9.1 Taxonomy of Foreign Aid Inflows to a Developing Country

Improved education system

1 Direct effects

2 Indirect effects on public sector of developing country Releases equivalent value of resources in public sector

Improved infrastructure

Effects on government deficit and exchange rate

Alters income as direct consequence of project

Cuts in taxation INJECTION OF AID Cuts in borrowing

3 Indirect effects on private sector of developing country

Increases in non-development expenditure, e.g., military spending

Alters relative prices facing sector

Increases consumption by private sector

Changes saving rate

Increases in development expenditure on, e.g., education and health

Source: Adapted from Walker (1996).

potential to put the developing economy on a positive growth path. However, the success of foreign aid, and the absorption of higher levels of aid in particular, is likely to depend to a large extent on the capacity of governments to use it effectively. It is conceivable that once the absorptive threshold of foreign assistance has been reached, additional inflows of foreign aid may become counterproductive. Numerous models have been developed to deal with various aspects of the phenomenon known as the ‘Dutch disease’ (discussed below).3 One branch has noted that large inflows of foreign aid have indirect, intersectoral impacts on

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overall economic performance (Corden 1982; Corden and Neary 1982; Garnaut and Baxter 1984; White 1991; Edwards and van Wijnbergen 1989). A general equilibrium effect of aid inflows is that, when a part of foreign aid is spent in the non-traded goods sector, the ensuing upward pressure on the domestic price of such goods causes the equilibrium real exchange rate to appreciate, thereby harming external competitiveness – Corden’s (1984) ‘spending effect’. Moreover, the resulting improvement in the profitability of the non-traded goods sector induces labour to move out of tradable sectors and into non-tradable sectors such as services (Corden’s ‘resource movement effect’). The consequent out-migration of farm labour puts upward pressure on labour costs in agriculture, thus reducing the profitability of this sector. Empirical studies, such as that of Vos (1990) on Pakistan, are confirming the positive relationship between foreign aid and real exchange rate appreciation. Younger’s (1992) analysis of the aid boom in Ghana suggests that aid can lead to a crowding out of private investment, when the government tries to contain real exchange rate appreciation through tight monetary policies to counteract the aid-financed increase in demand. In the case of the South Pacific, Lapaglane (1997) reports that the reception of large inflows of rent income inevitably results in the crowding out of traditional exports and private manufacturing. The simplest intersectoral effects of an aid-financed capital inflow can be seen with the help of Figure 9.2. The figure assumes that a small, open economy competitively produces both internationally tradable products and nontradables. The relative price of non-tradables to tradables (whose composite price in this small economy is determined by conditions in international markets) is given by (the negative of the) slope of the price line p at the equilibrium production/consumption point E. If the capital inflow is used to expand output of the two types of products, the production possibility curve AB would shift out further from the point of origin. Even if the shift was equiproportional – to, for example, A'B' – the new equilibrium point would be on ray OE extended to the new production possibility curve only if the income elasticity of demand for the two types of products were the same, that is, equal to unity. It is usually assumed, however, that demand for services, which makes up the bulk of nontradables, is greater than unity. If this is the case, the new equilibrium point E' will fall on A'B', to the left of the extended ray OE. Hence the relative price of tradables falls to the slope of line p', and the quantity of tradables produced increases less than the quantity of non-tradables. Both changes ensure that the share of non-tradables in GDP at domestic market prices rises at the expense of the share of tradables. But what if the shift in the production possibility curve is not equiproportional? If tradables are more capital-intensive in production than non-tradables, as is typically assumed for developing countries, then B' would be further to the right and A' lower, say at A''B''. If A''B'' was tangential to the community indif-

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Agriculture, Comparative Advantage and the Macroeconomy Figure 9.2 A General Equilibrium Model of Aid Inflows Non-tradables

A' E' A'' A

E''

E

p'

p''

p

0

B

B'

B''

Tradables

Source: Adapted from da Costa (2000).

ference curve through E', as at E'', then aggregate welfare would be the same as at E', but the change in the composition of GDP may not be as skewed against tradables (depending on whether the relatively lower price ratio at p'' as compared with p' compensates more, or less, for the relatively larger quantity of tradables produced). Hence the impact of an aid flow on the intersectoral composition of production (and the pattern of consumption) is not certain; it would depend on the income elasticities of demand, the capital intensities of production, and the elasticities of substitution in both production and consumption between tradables and non-tradables. But the likelihood is that non-tradables will be the sector most likely to boom, in the short run at least, as aid begins to flow in. The above conclusion is more likely when one takes into account the distinction between consumption and investment goods. Corden’s (1982) investment boom framework, which involves, first, an inflow of foreign capital, and second, increased investment spending, assumes that there is no intervention in the foreign exchange market so that the current account deficit must be equal to the capital account surplus. For the moment we assume that: (1) the inflow of capital is exactly equal to the extra investment spending, and (2) initially there is full employment of domestic resources. We

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also assume that a substantial part of the extra investment spending leads to increased demand for goods and services. A current account deficit equal to the capital inflow has to be generated. Given initial full employment in the sector that is the recipient of the investment funding, a real appreciation is expected. This real appreciation will increase the demand for imports so as to generate the required current account deficit, while at the same time reducing demand for home-produced products to the level of the total supply available. Domestic prices of import-competing goods and of exportables will fall relative to the prices of non-tradables. This adverse effect on tradables is termed the Dutch disease. It has two structural effects on the pattern of domestic output, namely: (1) the output pattern will shift from consumption goods and services to investment goods and services, and (2) it will switch from tradables to non-tradables. Thus, these two shifts may have further effects on the regional and skill patterns of the demand for labour, and on the demand for public infrastructure (Corden 1982). Three implications for the short run may be identified. First, an increase in investment spending will lead to a real appreciation, at least provided that the rise in expenditure leads initially to some rise in demand for home-produced goods. Second, an increase in investment spending will then lead to a real depreciation, at least provided that the rise in expenditure leads initially to some rise in demand for imports. Combined with a rise in capital inflow and real income, the real exchange rate could go either way. And third, with the rate of inflation increasing, a constant real exchange rate will require continuous depreciation of the nominal rate. Thus, according to Corden (1982), the net short-run outcome might involve real appreciation but nominal depreciation. Applied to the case of East Timor, the argument runs as follows. As it sets up in East Timor, the UN mission will require equipment and services, not all of which can be purchased internally but must be drawn from outside. Equipment such as office equipment, office supplies and communications equipment will typically be purchased externally and imported to the country. This will push up the prices of urban non-tradables. As the prices of non-tradables rise, the change in relative prices will create an incentive for capital and labour to move to the sectors of the economy that are booming. Entrepreneurs will run restaurants and service businesses. Workers will move from rural to urban areas. At the aggregate level, the impact is similar to that of a commodity windfall, although differences may occur in the distribution of windfall benefits. Of key importance, particularly in a post-conflict situation, is how easily reversible are the structural changes generated in the local economy (World Bank 1999c). If labour and capital can move back easily into tradable sectors after the UN mission withdraws, then the overall effect will simply be a positive boost to national income. Most of the countries hosting a UN mission – Rwanda, Bosnia–Herzegovina and Eritrea, for example (World Bank 1996) –

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have had low levels of per capita income, and the necessary adjustment as the United Nations withdraws has often been into agriculture. However, one aspect of such an adjustment is likely to be particularly sticky, namely the ease of reverse labour migration from urban to rural areas. Workers who have moved to urban areas to take up new employment opportunities are often unwilling to move back due to social factors. In some cases, the period of the UN mission also sees the rise and fall of rural settlement and land allocation initiatives, making it difficult for young workers to get a foothold in rural areas at the end of the urban employment boom. The sharp increase in unemployment precipitated by the withdrawal of a UN administration may therefore be far more persistent than would be the case with perfect mobility. This may carry with it long-term adverse social impacts in urban areas through increased crime and other social problems. Particularly important is the interaction of this effect with the effects of the conflict that brought about the presence of the UN administration in the first place. Severe conflicts often result in a sharp drop in agricultural and manufacturing output, due to the destruction of crops and physical infrastructure, population displacement, and the death or displacement of skilled personnel. Whereas economic recovery in these sectors may take some time, service sectors are likely to recover more quickly due to their low capital intensity. The presence of a UN administration is likely to reinforce this effect by increasing the opportunity cost of resuming agricultural production compared with the short-term income opportunities associated with the presence of the mission. There is another opportunity cost potentially associated with the failure to boost tradable sectors during a UN mission period. The presence of large numbers of expatriates and foreign firms catering to the needs of the mission creates an opportunity for increased information flows, skills transfer and network effects in trade, as it gives local entrepreneurs the chance to extract information about technologies and business opportunities. However, the sectoral distortion caused by the pull into urban services means that few entrepreneurs or workers are likely to focus on the production of tradables. These effects together imply that countries may experience difficulty in restarting export industries to generate the foreign exchange earnings that will be needed to replace the aid inflow linked to the presence of the UN mission. This, according to the World Bank (1999c), will create a balance of payments problem, resulting in either rationing of imports or rapid real exchange rate depreciation, and causing a redistribution of income from factors employed in non-tradables to producers in the tradable sectors.

COMPARATIVE ADVANTAGE AND AGRICULTURE The sources of a country’s comparative advantage may include its relative

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factor endowments, technologies and consumer tastes.4 However, in the case of East Timor, which is relatively poor and very small, the key determinant will be relative factor endowments. We use the Leamer (1987) endowment triangle to analyse the determinants of East Timor’s comparative advantage in 1998 relative to that of other countries (Figure 9.3). Capital endowment per person (proxied by per capita GDP) and natural resources per person (proxied by per capita land area) are shown in Table 9.2 for East Timor and a sample of 13 other countries. Figure 9.3 presents in graphic form these countries’ relative endowments of three factor of production, denoted N for natural resources, L for labour and C for produced capital (human capital, physical capital and knowledge).5 These ratios are measured as logs along the LN and LC sides of the triangle. The world average for each factor endowment ratio is shown by the mid-point, W, which is taken as the numeraire. Under the assumption that all countries have equal access to available technologies, the comparative advantage of a poor country with little capital will be determined largely by its natural resources per person (shown in the graph by its position on the line LN). The higher (lower) an economy’s L/N ratio relative to the rest of the world, the stronger its comparative advantage (disadvantage) in unskilled, labour-intensive manufactures relative to primary products, ceteris paribus. Should labour skills and stocks of physical capital per person expand faster in this poor country than in the rest of the world, the capital intensity of its production would raise its comparative advantage in manufacturing and services, and the country would gradually move to more capital-intensive production. The most important property of the endowment triangle is that straight lines emanating from one corner have the same ratio as that of the other two factors. For example, in Figure 9.3, countries located along any one line emanating from the capital corner, C, have the same natural resources per person. That common ratio is measured by the point at which the ray emanating from C intersects the left-hand side of the triangle along LN. According to this standard theory, East Timor’s comparative advantage is currently likely to be slightly more in labour-intensive manufactures than in primary products because, in addition to being relatively scarce in capital, East Timor is located a little below the line AC and within the area AWL in Figure 9.3. Under the above assumptions of identical consumption patterns and technologies across countries, the economies located in the space BWC, namely Japan, Hong Kong, Portugal, Mauritius and Singapore, have above-average per person endowments of capital and below-average per person endowments of natural resources. They therefore tend to have a comparative disadvantage in primary products and unskilled labour-intensive manufactures and a comparative advantage in skill and knowledge-intensive products. On the other hand,

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Figure 9.3 Relative Endowments of Natural Resources, Labour and Capital in 14 Economies, 1998 a Land N 55 20 •

MA

7.5

• AU

2.7 A

1.0

0.37

D • ET

EP •

0.14

• FJ • IN

• NZ

W

• US PT

0.05

• •

• JM

MR

0.02 L Labour

0.02

0.05

0.14

0.37

1.0 B

JP • HK •

2.7

SG •

7.5

20

55

C Capital

a The line LN measures land area per person (in square kilometres) in each country as a ratio of the world average (21 square kilometres). The distance along LC measures GNP per person as a ratio of the world average ($3,039). Both scales are in logs. Along any ray from C to the line LN, land per person is constant; the same applies for rays emanating from the other two corners of the triangle. W is the world endowment point. Countries are represented as follows: East Timor (ET), Australia (AU), Ethiopia (EP), Fiji (FJ), Hong Kong (HK), Indonesia (IN); Jamaica (JM), Japan (JP), Malta (MA), Mauritius (MR), New Zealand (NZ), Portugal (PT), Singapore (SG) and the United States (US). The relative endowments of five small island economies observed by Findlay and Wellisz (1993) – namely Hong Kong, Jamaica, Malta, Mauritius and Singapore – are also represented in the triangle. Sources: da Costa (2000), adapted from Leamer (1987) and Anderson (1999) for log scales using data from World Bank (2000a).

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Table 9.2 Land Area, Population and Relative Resource Endowments of East Timor and 13 other Economies, 1998 Country

Land Area (thousand sq. km)

Population (thousand)

GDP ($ million)

Per Capita GDP ($)

Per Capita Land Area (sq. km)

Australia Ethiopia Fiji Hong Kong Indonesia Jamaica Japan Malta Mauritius New Zealand Portugal Singapore United States

7,682 1,000 18 1 1,812 11 377 320 2 268 92 1 9,159

18,532 59,750 782 6,502 200,390 2,554 126,091 375 1,148 3,761 9,945 3,104 267,744

404,251 6,380 2,100 173,609 215,747 4,134 4,197,439 3,339 4,177 64,959 101,286 95,138 7,844,000

21,814 107 2,685 26,701 1,077 1,619 33,289 8,904 3,639 17,272 10,185 30,650 29,297

415 17 23 0 9 4 3 853 2 71 9 0 34

East Timor a

15

884

424

503

18

109,672

5,093,175

15,479,175

3039

21

World

a East Timor’s land area was obtained from Pedersen and Arneberg (1999). GDP was obtained from World Bank (2000a). Sources: Adapted from da Costa (2000) using data from World Bank (2000a).

East Timor’s companions in the area AWL – Indonesia and Ethiopia – as well as Jamaica in the area BWL, are much less well endowed with capital per person, while still exceeding the ratio for East Timor. The triangle concept could be generalized by adding further dimensions to distinguish different types of natural resources, for example by separating out natural resources such as minerals and forests from farm land. It appears that the more abundant a country’s per person endowment of other natural resources compared with farm land and industrial capital, the stronger will be its comparative advantage in non-agricultural primary products. If there were to be a new discovery of minerals, or an increase in the international price of minerals and energy, such a country’s comparative advantage in mining would strengthen and its comparative advantage in farm and other goods would weaken.

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It is important to recognize that domestic and foreign savings can be invested to enhance the stock or improve the quality not only of industrial capital but also of labour or natural resources, in addition to providing capital specific to the non-tradables sector. Any such increase in the nest stock of produced capital per person would place upward pressure on real wages, encouraging, in all sectors, the use of more labour-saving techniques and the development and/or importation of new, less labour-intensive, technologies (Anderson and Pangestu 1995). Which type of capital would expand fastest in a free-market setting depends on the expected rates of return. The more densely populated and poor in natural resources a country is, the greater the likelihood that the highest pay-off would be in expanding its capital stocks for non-primary sectors. As indicated by Anderson and Pangestu (1995), in such a country with a relatively small stock of natural resources per person, at early stages of development wages would be very low and the country would have a comparative cost advantage in unskilled, labour-intensive, standard-technology manufactures; as the stock of industrial capital grew, more capital and skill-intensive manufactures would expand. Countries with abundant natural resources, on the other hand, would enter manufacturing at a later stage of development. Such countries would be likely to remain fully self-sufficient in agricultural products for longer, and their first industrial exports would be comparatively capital-intensive. According to Corden (1984), a resources boom would encourage mobile resources to move into the production of non-tradables as demand for them strengthened and their prices rose, further reducing farm and industrial protection. For East Timor, inheriting part-ownership in the Timor Gap6 will be very similar in impact to a new discovery of minerals and energy. The question this raises is, what lessons can be learned for application to the forthcoming resources boom expected from the Timor Gap? To help understand the effects of a resources boom on the local economy, we turn to Garnaut and Baxter’s (1984) work on Papua New Guinea. Their basic argument runs as follows. Consider a small economy with internal and external balance that suddenly experiences a massive investment in oil and gas financed by capital inflows. The new mining operation uses some indigenous labour in construction and production, but all other inputs must be imported. There is an increase in demand for labour, which raises wages and hence the cost of producing non-tradables. The boom in wage spending that follows further raises the prices of non-tradables by shifting out the demand for non-tradables. The higher labour incomes and (prospectively at least) the royalties from the mining operation raise government revenues. The trade balance moves into deficit, both because imports are required in construction, and because the consumption of tradables has increased and production of them fallen as a result of the increase in demand for labour in the non-tradables sector and at the mine site.

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The payments surplus is equal to the difference between the capital inflow on the one hand and the increase in imports and reduction in traditional exports on the other. The increased surplus allows an increase in domestic expenditure consistent with external balance; to the extent that the government uses this opportunity to expand expenditure, there will be a further increase in demand for labour, and in wages and the prices of non-tradables. This causes production in some export and import-competing industries to become less profitable. Producers in these industries may reduce their output. The resource boom has hurt them, even if it raises the incomes or services available to others in the economy. The consequences of the mining development would be different if real wages were rigid and there were unemployment prior to construction (Garnaut and Baxter 1984). The mining development would then reduce unemployment, and production of non-tradables would increase. In East Timor, unemployment of relatively unskilled labour exists alongside shortages of skilled labour. Increased domestic demand for skilled labour bids up its price, raising the costs and reducing the profitability of other industries using skilled labour. But the large excess supply of relatively unskilled labour means that there would be non-marketplace pressures for increases in their wages. This ensures that the adverse effect of mining development on other industries, and especially on labour-intensive industries, would be small. In short, Garnaut and Baxter conclude that rising wages and increases in the prices of non-tradables relative to the average price level are symbols of economic performance, so long as they are the product of strong demand for labour at full employment levels, and with a sound balance of payments. While rising wages can damage established tradable-goods industries, this cost to some is outweighed by the wider benefits.

SPECIFIC LESSONS FOR EAST TIMOR The analysis presented in this chapter has suggested that foreign aid inflows have indirect intersectoral impacts and affect overall economic performance. This occurs when a part of foreign aid is spent in the non-traded sector; the ensuing upward pressure on the domestic price of non-traded goods causes the equilibrium real exchange rate to appreciate, thereby harming external competitiveness. In addition, the resulting improvement in the profitability of exportoriented activities (such as export agriculture) brings about an expansion of service-oriented activities. A fall in labour supply in agriculture places upward pressure on labour costs, thus lowering the profitability of the sector. However, the general equilibrium effects of an aid inflow on the intersectoral composition of production, and the pattern of consumption, are not certain. As modelled in Figure 9.2, this would depend on the income elasticities of demand, capital intensities of production and elasticities of substitution in both production and

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consumption between tradables and non-tradables. One of the lessons for the future government of East Timor appears to be to concentrate on investment, and on education and technical assistance. In the context of East Timor, there are both pitfalls and opportunities resulting from an aid-financed capital inflow. In other post-conflict countries, the presence of a large UN mission typically brings about a Dutch-disease phenomenon. With additional demand for urban services and other non-tradables, labour costs increase. This hampers the competitiveness of the tradable sectors of the economy and leaves them with less capacity to earn or save foreign exchange. The resulting change in income distribution becomes particularly serious when the UN mission withdraws. The presence of a temporary UN administration is analogous to a short-lived commodity boom for the local economy, in terms of the scale of the shock and the sectoral effects it produces. The relevance of this for East Timor is the low impact it has on poverty alleviation and the difficulty of reversing sectoral distributional effects. The Leamer triangle helps to explain East Timor’s endowment position relative to that of other countries. Theory suggests that countries tend gradually to alter their comparative advantage from land and other natural-resource-based industries to ones that are more capital-intensive, as produced capital accumulates from abroad. This can be expected to happen in East Timor, too, as investments in human capital, physical capital and infrastructure begin to bear fruit. East Timor’s overall development strategy and use of macroeconomic policies – fiscal, monetary and trade – will affect demand and investment in agriculture-related activities both directly and indirectly. There is therefore an imperative need for East Timor’s policy-makers to address carefully the overall economic, social and environmental implications of policy choices and public investment decisions. Sound economic policies and an innovative private sector are critical if the economy is to be shifted onto a sustainable development path. The government of East Timor can nurture the growth of the private sector through the provision of competitive tenders to local firms, by encouraging joint ventures with foreign companies and by developing extension services to advise farmers and exporters on market opportunities. More specifically, export programs should be adopted by various industries at an early stage. The government should also ensure that economical programs to encourage backward linkages, skills development and technical assistance are in place. This will encourage domestic industries to produce inputs for export activities and to confine themselves to low-cost and high-quality production. East Timor’s agricultural strategy should be geared towards rural development. This could include encouraging manufacturing sector activities in rural areas in order to generate employment opportunities, and the processing of raw materials to increase value-added and contribute to export revenues and poverty

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reduction. Efforts to emphasize investment in rural infrastructure would have benefits not only for agricultural production. With better transport and communications infrastructure and better-educated workers, East Timor’s rural areas would be more attractive to investors in low-skill, intensive manufacturing and related service activities. This would boost the off-farm earnings of farm households, allowing a more efficient and fuller use of the rural workforce, particularly during non-peak seasons. In agricultural areas with fertile soils and favourable climatic conditions (such as exist on the southern coast of East Timor), intensification will require competitive markets, good management practices and timely information. Complementary improvements can also be made through public and private investments in agricultural research to encourage new technologies for sustainable development.

NOTES 1 2 3

4 5

6

See . This section draws heavily on da Costa (2000), Chapter 2. The term ‘Dutch disease’ was inspired by the case of the discovery of gas at Slochteren in the Netherlands in the 1960s, which adversely affected parts of the Dutch economy (van Wijnbergen 1986). This section draws heavily on da Costa (2000), Chapter 4. Particular attention is paid to selected small island economies as depicted in the Leamer Triangle. Anderson (1995) explains that although crude proxies are used here to represent the natural resource to labour ratio and the produced capital to labour ratio, more sophisticated indexes would be unlikely to alter greatly the relative positions of the country groups. For a more detailed discussion, see Pederson and Arneberg (1999) and Valdivieso et al. (2000).

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10 Diversity and Differential Development in East Timor: Potential Problems and Future Possibilities James J. Fox East Timor is a remarkably diverse territory. It is certainly as diverse in ecological terms as it is in its linguistic and ethnic make-up. A long history of human settlement has contributed to this diversity, shaping the environment as it has the cultures of the territory. Any planning for the development of East Timor as a nation must take into account this significant diversity. In this chapter, I want to outline some of the main features of East Timor’s environmental, demographic and ethno-linguistic diversity. This outlining process is inevitably an exercise in simplification but it does provide a framework within which to examine issues of development. I then want to consider how historical developments have contributed to the patterning of livelihood strategies across the territory. Finally, I want to look at recent changes that have occurred in East Timor, strengthening certain of these local patterns and altering others. In this section of the chapter, I want to focus on the contemporary situation and on the problems and possibilities of differential local development.

THE AGRO-ECOLOGICAL ZONES OF EAST TIMOR Given its relatively small size, East Timor is comprised of a surprisingly diverse ecology. Much of this diversity is a product of the territory’s complex landscape and variable seasonal rainfall. Based mainly on factors of altitude and rainfall, East Timor can be divided into six different ‘agro-climatic’ zones.1 Although further differentiation among these zones is possible, and indeed necessary, to a proper understanding of local agriculture, recognition of these zones provides a first step to comprehending East Timor’s diversity. The structure of these zones takes account of the fact that East Timor is

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Map 10.1 The Agro-climatic Zones of East Timor

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Diversity and Differential Development in East Timor Table 10.1 Agro-climatic Zones of East Timor Zone

1

North coast lowlands Maubara, Dili, Manatuto (147,045 ha: 10%)

2

Northern slopes Atabae, Dare, Baucau, Lautem (336,627 ha: 23%)

3

Altitude (m)

Rainfall Months of (mm per annum) Rain

1,500

6–7

4

Southern uplands Lolotoe, Same, Soibada, Ossu (215,021 ha: 15%)

>500

>2,000

9

5

Southern slopes Hatu-Udo, Baguia, Alas, Los Palos (304,981 ha: 21%)

100–500

1,500–2,000

8

6

South coast lowlands Suai, Natabora, Betano, Viqueque (166,700 ha: 11%)

5% GDP Govt tax revenue 100% GDP Adequate budget information Adequate NIPA ODA 10% GDP p.a.? Investment