Cablegate: Major Changes in Timor-Leste Fiscal Policy

DE RUEHDT #0184/01 1961000
O R 141000Z JUL 08




E.O. 12958: N/A

1. Action requested - see para 13 below.

2. (SBU) Summary. The Timor-Leste National Parliament will
begin debate this week on a massive supplementary budget that
marks a departure from the country's historically conservative
fiscal policy. If enacted and fully implemented, the government
would outspend in 2008 what it spent in the eighteen months to
December 2007 by more than 2-1/2 times. Given the Timorese
government's weak executive capacity, it is not likely to spend
but a fraction of its planned budget, but the new framework is
nevertheless worrisome. It includes withdrawals from the
country's modest Petroleum Fund at a rate that exceeds its
sustainability; it establishes a fund to finance a potential
enormous growth in subsidies for fuel, food and construction
materials; and it foresees substantial increases in both
consumption and investment programs that will severely test the
government's weak capacity to execute programs. The intent is
deliberate, however. The government believes the country
continues to face a serious danger of instability. To assure
stability and have any hope of long term development, the
government is choosing now to boost both public sector
investment and consumption. We and several other development
partners (Australia and the EC most prominently) are concerned
about the risks, both to the sustainability of the country's
only significant source of mid-term revenue (the petroleum fund)
and likely invitation to corruption that aspects of the budget
may represent. We should encourage the government to fully
consider the risks and better explain its policy to its
development partners and Timorese civic society. End summary.

3. (U) The national parliament will begin debating in plenary
the week of July 14 the government's proposed 2008 supplemental
budget. This budget represents a major shift in Timor-Leste's
fiscal policy. In 2002-2006, the country adopted a very
conservative fiscal policy due to weak revenues and a decision
not to borrow. More recently, disciplines contained in the law
governing the country's Petroleum Fund (a sovereign wealth fund
that collects revenues from exploitation of Timor's modest oil
and natural gas reserves) limited spending. The 2008
supplemental budget, however, will introduce an aggressively
expansionary fiscal policy. Planned expenditures in the
supplementary budget of $426 million will more than double the
government of Timor-Leste's (GoTL) original 2008 budget of $348
million. If fully obligated, government spending will equal
160% of forecast non-oil GDP in 2008, versus only 80% in 2007.
The new level of planned expenditures in 2008, $773 million,
will exceed all money spent by all of the previous budgets since
independence in 2002 combined. While the rise in world oil
prices has increased the estimated sustainable income (ESI) that
can be withdrawn from the Petroleum Fund to $396 million in
2008, the supplementary budget will require a withdrawal from
the Fund that exceeds the limit implied by ESI by nearly 75

4. (U) The supplemental budget includes large increases in
spending on arguably productive programs by the ministries of
agriculture (extension programs and tractors), infrastructure
(power generation), social solidarity (the introduction of an
old-age social welfare program), the prime minister's office
($20 million for IDP reintegration) and elsewhere. Their
implementation will be tested by Timor-Leste's weak
administrative and executive capacity. Indeed, the GoTL has
proven able to execute only 50-60 percent of its planned
expenditures in recent years and less than 20 percent of its
capital development budget. In fact, it is highly unlikely that
the GoTL could execute the proposed supplementary budget without
exposing itself to a greater risk of corruption. Examples may
be emerging already - several suspicious procurement actions
were recently revealed, including for patrol boats, rice, and
power infrastructure.

5. (U) Even more troubling, the budget proposes the
establishment of a $240 million Economic Stabilization Fund
(ESF) to address recent and potential future price rises in
commodities such as rice, fuel, and construction goods. At
present, there are very few disciplines surrounding the ESF.
Indeed, the GOTL's July 2008 Budget Document suggests the ESF
could be tapped to intervene in markets for a wide variety of
goods. How it might do so and under what circumstances are not
specified. As a result, the scope for oversight is limited, and
the risk of abuse is high.

DILI 00000184 002 OF 003

6. (SBU) The GOTL's capacity to administer a program to
intervene in a potentially wide-ranging set of markets is
extremely limited and therefore also presents a risk of
corruption. In recent history, the GoTL has failed to maintain
a steady supply of rice imports, manage a strategic food
reserve, develop a targeted food assistance program, and even
collect world price data on key commodities in a systematic
manner. Interventions in the markets for the goods widely
suspected of being initially targeted by the ESF - rice, fuel,
and construction materials - reflect a strong urban bias,
whereas indicators of socio-economic well-being are almost
universally worse in rural areas, where three-quarters of the
population lives.

7. (SBU) Depending on how the ESF is implemented, it could
very well undercut the incentive for farmers to increase rice
production and be a drag on private sector activity more
generally. Higher prices provide the incentive to produce,
whereas the GOTL's intervention in markets, particularly the
rice market, would reduce the prices producers receive for the
goods. As such, subsidizing rice would undercut the GOTL's
objective of increasing domestic food production and negate the
impact of investments it is making to do so, such as the $5
million allocated for the purchase of tractors in the 2008
budget. And, once introduced, subsidies are typically
politically difficult to remove and therefore could, in the
longer-term, result in increased strain on the GOTL's fiscal
position if they are maintained.

8. (SBU) Although key parliamentarians suggest minor
alterations may be made by the parliament, the government is
believed to have the necessary votes to pass the supplementary
budget in close to its original form by July 25 or 28. The GOTL
has no debt and the supplementary budget will require no
borrowing. In violating the Petroleum Fund's ESI provisions,
however, the budget poses the danger of setting a pattern in
future where the fund repeatedly is raided by amounts exceeding
the ESI. If the Petroleum Fund's financial sustainability is
undermined, so goes the government's sole meaningful source of
revenue for the foreseeable future.

9. (SBU) The Finance Minister, in an extended discussion with
the ambassador on July 11, explained that the decision to shift
to a more expansionary fiscal policy was deliberate with an
over-riding goal of promoting social and political stability.
In a post-conflict state such as Timor-Leste, stability must be
the government's highest priority. Noting that the country has
been repeatedly wracked by instability in its short history of
independence, including a near total collapse in 2006, the
finance minister stated the country simply cannot afford another
crisis - "this is our last chance; the international investor
community will not allow us to fail again." The government sees
possible sources of serious instability in the country's high
rates of poverty and unemployment, in the not-yet fully
reintegrated IDPs, and in the recent spikes in prices for rice,
fuel and other commodities (indeed, rice shortages sparked
violence in 2007). Consequently, it decided to act to counter
these and other sources of instability by expanding
infrastructure projects (the capital investment budget will
total $150 million in 2008), widening programs to assist
farmers, introducing and funding a welfare program for the
elderly, and establishing the ESF to provide a buffer against
price shocks. The supplemental budget as a whole is designed to
meet the "people's needs while not losing sight of medium and
long term development objectives," said the minister.

10. (SBU) The finance minister told us that she hopes never to
have to utilize the ESF, although its use is likely at minimum
to continue a rice subsidy. It is being created to provide a
fiscal buffer just in case "something serious goes wrong" with
key commodity prices, with a primary goal to provide food
security. When pressed on the government's weak administrative
capacity, a shortcoming she is quick to acknowledge, the
minister nevertheless believes the government now has systems in
place to effectively manage the ESF if needed. Alternative
policy responses to the rising price level such as a cash grant
program are "morally and politically unacceptable" to Timorese.
The minister defended the supplemental budget as providing an
appropriate mix of spending on consumption and investment given
Timor's state of development. Given a notably weak private

DILI 00000184 003 OF 003

sector and continuing obstacles to inbound foreign investment,
the public sector must act as the driver of growth at this stage
of Timor's development. She also supported increased spending
on programs that have failed in the past due to weak executive
capacity, such as a project to provide tractors to communities
of farmers. It should not be assumed that this government's
ministers will fail just because the last government's did, the
minister stated.

11. (SBU) The ambassador, noting serious concerns with many
aspects of the supplemental budget, urged that the finance
minister, or the prime minister, at minimum fully explain the
change in direction of the government's fiscal policy. The
government's intentions are not well understood within the donor
community, or by civil society in Timor-Leste. A discussion
with the donor community could address shortcomings regarding
absorptive capacity, the sustainability of the Petroleum Fund
(the finance minister reconfirmed that the government is moving
to change the fund's investment strategy to include instruments
other than U.S. treasury bonds to raise its returns), incentives
to corruption, and the government's ability to implement subsidy
programs without doing major harm to the country's private
sector. The finance minister twice replied that she would
seriously consider the proposal to open a dialogue with the
donor community and the ambassador offered to assist in
arranging a meeting.

12. (SBU) We have shared our concerns with the ambassadors
from Australia, New Zealand, and the European Commission, as
well as the charges of Portugal and Japan. The Australian
ambassador expects to receive instructions from Canberra soon;
the EC ambassador has raised concerns with the budget in public
fora and is eager to coordinate a joint approach. We have also
discussed GOTL fiscal policy-making with the UN SRSG, who is
concerned that the GOTL leadership is not taking sound advice.
We understand the local reps of the Bank/Fund have weighed in
with the government, but the finance minister suggested a
serious loss of confidence in these institutions has occurred.

13. (SBU) Action requested: Embassy Dili requests instructions
to approach senior GOTL leaders, including the prime minister,
to convey concerns with recent GoTL fiscal policy. The purpose
of an intervention should not be to halt or seek major changes
in the purposed 2008 supplemental budget - we anticipate this
legislation will be passed by the national parliament within two
weeks. We instead should emphasize our strong support for the
government's effort to provide stability; indeed, that stability
is paramount to the economic and social development of
Timor-Leste. We should highlight, however, the risks that the
government's expansionary fiscal policy creates, especially
given the country's weak absorptive capacity, to include
providing additional incentives to corruption as well as raising
the already high inflation rate of 10%. We should note the
debilitating role public subsidies have had in the creation of a
vibrant private sector in many developing countries. We should
encourage the government to better explain its policy to both
Timorese civic society and its development partners. Finally,
we should encourage the government to move promptly on its
anti-corruption agenda, including the creation of an
anti-corruption commission with strong investigatory and
enforcement powers. (Note: The latter point offers one bright
note: the government will hold a large public consultation with
civic society on July 14 on its proposed creation of a strong
anti-corruption commission.) We will share proposed talking
points by email with State EAP/MTS.

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