VZCZCXRO6181
OO RUEHDT RUEHLMC
DE RUEHDT #0184/01 1961000
ZNR UUUUU ZZH
O R 141000Z JUL 08
FM AMEMBASSY DILI
TO RUEHC/SECSTATE WASHDC IMMEDIATE 4039
INFO RUEHBS/AMEMBASSY BRUSSELS 0002
RUEHLI/AMEMBASSY LISBON 1051
RUEHJA/AMEMBASSY JAKARTA 0995
RUEHBY/AMEMBASSY CANBERRA 1191
RUEHKO/AMEMBASSY TOKYO 0877
RUEHWL/AMEMBASSY WELLINGTON 0958
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHLMC/MILLENNIUM CHALLENGE CORP
RHHMUNA/HQ USPACOM HONOLULU HI
RUEHDT/AMEMBASSY DILI 3496

UNCLAS SECTION 01 OF 03 DILI 000184 
 
SENSITIVE 
SIPDIS 
 
FOR E. EEB, AND EAP/MTS; PLEASE PASS FOR INFO: USAID 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PREL TT
SUBJECT: MAJOR CHANGES IN TIMOR-LESTE FISCAL POLICY 
 
¶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 
percent. 
 
¶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. 
KLEMM