Part 1 - Executive Summary
The Combined Sources Budget
The Combined Sources Budget for 2006-07 is estimated to be $451.9m, this consists of $315.5m in expenditure proposed by the State Budget and $136.4m in confirmed donor financing by development partners. In the following for years from 2006-07 to 2009-10 the total expenditure on a combined sources basis is estimated to be $1,328.9m, $1,103.5 from the State Budget and $225.4m including confirmed financing from development partners.
Table 1.1 clearly illustrates the total funding required by Timor-Leste as identified in the Sector Investment Packages (SIP) and that an amount in excess of $843.3m in relation to the same period to guarantee that Timor-Leste stays on the path to achieve the objectives of the National Development Plan.
Table 1.2 illustrates clearly that increase in financing of the increase in expenditure is primarily due to the increase in the Timor-Leste State Budget. The increase in available sustainable income from the high level of petroleum receipts provided for an increase in $173.2m in expenditure by the State, an increase of 122% in relation to the previous year. Confirmed financing by development partners increased by $31.3 m (30%)
Expenditure on a combined sources basis shows a decline after 2006-07, this is basically the result of the decline in confirmed donor financing in the future. At the time of publication confirmed donor financing for 2009-10 was $10.3m.
General Budget of the State for Timor-Leste
Table 1.3 shows the fiscal position of the Budget of the State of Timor-Leste for 2005-06 is estimated at $334.2m in 2005-06 rising to $423.7m in 2006-07, and reaching $826.6m in 2009-10. In 2005-06 the non petroleum fiscal estimated is expected to be a deficit of $84.6m which will be financed by cash balances held in the Treasury account, the Consolidated Fund of Timor-Leste (CFET). The non petroleum fiscal balance for 2006-07 is estimated to be a deficit of $259.7 m which will be financed by the Petroleum Fund.
As of 31 March 2006 the market value of the Petroleum Fund was $508.1m. The opening balance of the fund transferred at the beginning of September 2005 was $204.6m. For the period September 2005 through March 2005 payments from the petroleum operations total $300.5m, where as the return from the investments in this period was $3.2m. The estimated balance of the fund at the end of 2005-06 is estimated to be $623.4m.
Financing of the Budget for 2006-07 will require a transfer from the Petroleum Fund to the Treasury Account (CFET) of $259.7m.
The petroleum wealth, including that estimated to be in the petroleum fund as at 30 June 2006 is calculated at $9.4 billion, the sustainable level of petroleum income for the 2006-07 fiscal year is estimated at $283m. The withdrawal of $259.7m is below the sustainable petroleum income level, the estimates of the Government show that financing required for the period 2006-07 to 2009-10 is below the level of sustainable income. This is illustrated in Table 1.5 and Chart 1.1
Part 3 – Economic Overview
The state of the world economy is generally good. Even if growth in 2005 was somewhat lower than the previous year the world output grew at close to 5 per cent which is above trend. Growth is expected to remain at this level in 2006 and 2007.
The sustained strong global growth, in particular in Asia, has led to higher commodity prices. Demand for petroleum has been particularly strong and markets seem to have priced in a structural change in the balance between demand and supply, bringing the futures prices up to unprecedented levels. The International Energy Agency assesses both upstream and downstream investments to be below desirable levels. Recently increased geopolitical uncertainties in Iraq and Iran, and threats to oil production in Nigeria have contributed to high and volatile oil prices. Contracts of West Texas Intermediate in 2011 were (beginning of May) traded at about $US68 per barrel.
Global imbalances are increasing. The current account of the United States of America has continued to rise, whereas some of the major Asian economies continue to run significant surpluses. These imbalances are not sustainable and rebalancing of demand across regions might have significant consequences for exchange rates, with the U.S. dollar depreciating from current levels and currencies in surplus countries, such as some Asian countries, may appreciate.
Unlike previous periods of high growth, the inflationary impact has been modest and monetary policy has been accommodating. Recently interest rates in a number of countries have, however, been increased. In the United States short term interest rates are 2 percentage points higher than in the beginning of 2005. Interbank rates (3 months) were 5 per cent at the beginning of May 2006. Long term interest rates are more stable and the yields on 10 year US Government bonds were 5 per cent at the beginning of May 2006.
There is continued strong development in our part of the world. Growth in China this year is expected to be close to 10 per cent, which is the same level as in 2004 and 2005. GDP in ASEAN-4, Indonesia, Thailand, the Philippines and Malaysia, grew slightly more than 5 per cent in 2005, a level that is expected to be maintained in 2006. Primarily due to higher energy prices inflation in these countries is expected to increase from a relatively high level of 7.5 per cent to closer to 9 per cent in 2006. Inflation in Indonesia, which was 10.5 per cent in 2005, is expected to be about 14 per cent in 2006. Growth in Australia is expected to be relatively good, about 3 per cent in 2006, and inflation is expected to remain around 2.7 per cent. At the beginning of May Australia’s central bank increased its official interest rate a quarter percentage points to 5.75 per cent, as strong growth and rising price pressures threatened to accelerate inflation.
The strong performance of the world economy has a substantial positive impact on Timor-Leste. Not only are petroleum revenues affected, growth in demand and increasing prices for raw materials may have an impact on the development of Timor-Leste’s other natural resources.
The development of the international financial markets has an impact on the Timor-Leste economy. As the US dollar is the legal tender of Timor-Leste, the domestic credit market is affected when there is a change in US interest rates, and the international value of the US dollar. As discussed above US interest rates have increased, in particular for short term loans and deposits. This has lead to increased cost of borrowing in Timor-Leste. On the other hand the Petroleum Fund is invested in US government bonds with 0-5 year maturity, and the return on these investments are somewhat higher than a year ago.
The international value of the US dollar has been fairly stable, but - because of the high inflation in Indonesia - the real exchange rate of Timor-Leste has depreciated.
Over the past two years, there has been a steady improvement in the macroeconomic framework of the country and encouraging signs of a recovery from the sharp economic contraction in 2002 and 2003 that stemmed from the withdrawal of UN personnel. As Table 2 indicates, non-oil GDP is estimated to have increased by about 2% in real terms last year. The recovery has been helped by a strong performance in food production in the agriculture sector following the drought in FY2002/03, and substantial growth in bank lending to the private sector. Credit to the private sector rose from 2% of non-oil GDP at end 2002 to 25% at end 2005, made possible by a notable increase in demand and time deposits in the banking system. This measure of broad money supply has increased from $20 million in 2000 to about $95 million at end 2005, equivalent to about 28% of non-oil GDP. The past year has also seen a significant increase in recurrent spending by the Government that has stimulated domestic economic activity. Macroeconomic stability has been further strengthened by a decline in domestic inflation, with the consumer price index for Timor-Leste increasing by a total of less than 3% in the past three years. External competitiveness has also improved with the depreciation of the $US in real terms. The real effective exchange rate vis-à-vis Timor-Leste’s main trading partners, Australia and Indonesia, is now at the same level as it was at end 2002.
However, the pace of recovery has been restrained by a sharp decline in the level of fixed investment in the past four years. From the peak of $145 million in 2001 (equal to 40% of non-oil GDP), fixed capital formation is estimated to have declined to about $60 million in 2004 – equivalent to about 18% of non-oil GDP. Last year saw the beginnings of a recovery in capital spending as the Government placed increased emphasis on the role of construction activity as a means of creating employment throughout the economy and a number of new private investment projects got underway.
But the fact is that non-oil GDP per capita is still very low. From the peak of $435 per capita in 2001, non-oil value added per person declined to about $365 in 2004-2005. The contraction in economic activity and sharp reductions in capital spending have led to increased under-employment and unemployment. Although there are no up-to-date surveys of the incidence of income poverty in the country, the weak growth performance, together with an annual increase in population of 3%, has almost certainly led to a rise in the incidence of income poverty. Surveys in 2001 indicated that about 40% of the population – almost 335,000 people – was below the income poverty line. Informal estimates suggest that perhaps 41% of the population may now be below the poverty line – an increase of some 50,000 people since 2001.
Part 4 – Revenue
The Petroleum Sector
Petroleum Production and Exploration
Currently there are two fields in operation, both of them in the Joint Development Area. The Elang Kakatua North is expected to be in its final stages of production whereas production on the Bayu-Undan field is in its early stages. The pipeline from Bayu-Undan to Darwin is in operation and the first cargo of LNG was shipped from the Darwin plant in February 2006. Compared to the assumption in the 2005/06 Budget the operator has increased the reserve estimate by about 45 per cent and the field is expected to produce for another 20 years, or even longer.
The government has signed an agreement with Australia where the revenues from the Greater Sunrise field will be split evenly between Timor-Leste and Australia. This agreement will be submitted to Parliament for ratification. Licenses of acreages on the exclusive Timor-Leste offshore jurisdiction are planned to be awarded in May and further licenses in the Joint Development Area will be awarded later in the year. The government also plans to award licenses for exploration onshore.
Petroleum Revenues, Petroleum Wealth and Sustainable Income
Due to higher oil production and high oil prices petroleum revenues in the current fiscal year will be higher than assumed in the Mid-Year Budget Update. Assuming that oil prices (West Texas Intermediate) will average $58 during 2006/07 fiscal year the oil revenues are estimated at $643m, and will remain high during the coming four year term.
Review of methodology
Oil price assumption in the 2005/06 budget papers were based on the futures prices observed in the market. Prices in the Bayu-Undan contracts are, however, not related to these prices but to the highly volatile spot market prices. Futures prices are at an all time high, reflecting the fact that growth in demand for energy for a while has been higher than growth in production. Geopolitical uncertainty has also had an impact on these prices. For 2006 the highly respected International Energy Agency (IEA) has forecast a higher growth in production than in demand, and it expects a better balance between supply and demand in the years ahead than seen over the past year. If the perceived geopolitical uncertainty is lower, a significant downwards adjustment of oil prices should not be ruled out. IEA forecasts oil prices in 2010 at $44 , whereas the futures prices are about $69 (prices at the beginning of May). Against this background the Ministry of Planning and Finance uses the IEA prices for calculating the Petroleum Wealth.
The operator on the Bayu-Undan field, ConocoPhillips, has submitted three scenarios for production on this field. In the “base” case the chances of a higher production are approximately in line with the chances of a lower production. In the “high” case the chances of a higher production are 10 per cent, whereas the chances of a lower production are 90 per cent. In the “low” case the chances of a lower production are estimated to be 10 per cent. Against the parameters specified in the Petroleum Fund Act for calculating the Petroleum Wealth (in particular the interest rate for discounting the cash flow) it seems prudent to use the low case production when calculating the cash flow.
In calculating the Petroleum Wealth only fields in production are included. As there is no development plan for Greater Sunrise yet, potential Timor-Leste revenues from this field are not included in the Petroleum Wealth, nor are potential revenues from the acreages currently being offered for exploration.
The Petroleum Fund Act presupposes that the nominal yield on a US Government bond should be used when calculating the present value of the future cash flow from the petroleum sector. At the beginning of the budget process (beginning of February) this rate was about 4.5 per cent. These rates have, however, increased by about ½ a percentage point to about 5 per cent. The calculations in this document are based upon the markets at the beginning of the budget process.
The Petroleum Wealth, including the estimated value of the Petroleum Fund at 30 June 2006, is estimated at $9.4 b, and sustainable use of petroleum revenues for 2006/07 fiscal year is estimated at $283m.
There is a risk, however small, of a major disruption in the production, and hence TL revenues. Against this background we should be cautious in taking expenditures up to sustainable income levels as long as Timor-Leste has only one field in production.
There are a range of risks and uncertainties in any forecast of petroleum revenues. The most sensitive assumption is oil price, meaning that the forecast of petroleum revenues changes substantially even from a relatively small change in assumed oil prices. Other uncertainties include LNG contract volume and pricing terms, condensate and LPG spot sales prices relative to oil prices, operating costs and inflation. The MOPF has endeavoured to adopt prudent assumptions in all cases. The following table shows how petroleum revenues, petroleum wealth and Sustainable income would change for three alternative cases
Part 5 Petroleum Fund
The Petroleum Fund was established by an initial transfer of $205m in September 2005. The Petroleum Fund is the Government’s vehicle for a prudent, transparent and long-term management of Timor-Leste’s petroleum revenues. A good management of petroleum revenues is critical for ensuring sustained economic growth to alleviate poverty. The Petroleum Fund builds on international best practice and is a tool that contributes to sound fiscal policies.
The Government has responsibility for the overall management of the Petroleum Fund, and the Minister of Planning and Finance exercises key functions and competences. The operational management is delegated to the Banking and Payments Authority in accordance with a management agreement. The Fund is currently invested through the Federal Reserve Bank of New York in US Government Bonds. The Banking and Payments Authority issues quarterly reports on the management of the Fund. These reports are available at http://www.transparency.gov.tl.
As of 31 March 2006 the market value of the Petroleum Fund was $508.1m. The opening balance of the Fund, transferred in the beginning of September 2005, was $204.6m. For the period September 2005 through March 2005 payments from the petroleum operations total $300.5m, where as the return from the investments in this period was $3.2m. The return for this period is adversely affected by unrealized market revaluations, reflecting increases in the US interest rates in this period. The Banking and Payments authority has in accordance with the Management Agreement with the Ministry of Planning and Finance debited the Petroleum Fund account with $180,000 in management expenses.
The Investment Advisory Board has been established and advises the Minister of Planning and Finance on the management of the Petroleum Fund. The Investment Advisory Board will among other things consider the investment mandate given in the Management Agreement. Currently, the investment mandate defines a very narrow range of investment alternatives. As the Banking and Payments Authority builds up competencies in the management of the Petroleum Fund it may be appropriate to amend the Management Agreement to include more of the qualifying instruments listed in the Petroleum Fund Act (article 15).
The Ministry of Planning and Finance is in the final stages in the process of appointing an independent auditor in accordance with the Petroleum Fund Act. It is expected that an internationally recognized audit company will start its work in June.
In the 2005/06 fiscal year the government will finance the budget by non-oil revenues and withdrawals of the CFET cash account. In 2006/07 fiscal year the government plans to withdraw up to $259.7m. As discussed above the estimated Sustainable Income from the Petroleum Sector is estimated at $283m. Prior to transfer of funds from the Fund the Government will in accordance with article 8 of the Petroleum Fund Act provide Parliament with reports from the independent auditor certifying the amount of estimated sustainable income.
The Timor-Leste Institute for Development Monitoring and Analysis (La’o Hamutuk)