This is Part 2 of my mini-series analysing some of the challenges that the newly elected majority government in Timor-Leste faces. Yesterday, I documented how the IMF and World Bank had infused its ideological stance into the currency arrangements that Timor-Leste set out with as a new nation. That infusion is still apparent in the major commentary on Timor-Leste’s future options – specifically that the dollarisation should continue and that fiscal austerity should be pursued (relative to the current fiscal stance) because the nation will run out of money. What they mean is that the Petroleum Fund will eventually run out of money. There is a major difference in those statements although under the current currency arrangements they are identical. The ‘run out of money’ story is only applicable as long as the new government resists adopting its own currency. I also showed how the development process has been stalled by the austerity bias. In Part 2, I explore the currency issue directly and make the case for currency sovereignty which would require Timor-Leste to scrap the US dollar, convert the Petroleum Fund into its stock of foreign exchange reserves, and to run an independent monetary policy with flexible exchange rates, mediated with the capacity to use capital controls where appropriate. In Part 3, which will come out next Monday, I will discuss specific policy options that are required to exploit what is known as the ‘demographic dividend’ where the age-structure of the nation generates a plunging dependency ratio. To exploit that dividend, which historically delivers massive development boosts to nations, the shifting demographics have to be accompanied by high levels of employment. That should be policy priority No.1. I will also complete some Petroleum Fund scenarios to complement the policy advice.
The urgency of currency sovereignty in Timor-Leste
When the new nation was being set up in the late 1990s, the process was controlled by the – United Nations Transitional Administration in East Timor (UNTAET) – which in cahoots with the IMF and the World Bank pressured the new government to adopt the US dollar as its official currency.
At the time, I advised a lawyer, who had provided legal support for the resistance movement and was also aiding the transition, to strongly argue in favour of introducing their own currency and avoid dollarisation of the economy.
The neoliberals won out and the decision to dollarise has hampered the nation ever since.
I remain of the view that in the interests of Timor-Leste’s long-term development, the new government should abandon the US dollar as soon as possible.
What are the issues?
The bevy of consultants, IMF delegations etc all argue that Timor-Leste cannot cope with its own currency.
The issue came up again in January 2018 then the Institute of Business (IOB) in Timor Leste, which is a private for profit education provider in Dili hosted a workshop which considered whether Timor-Leste should have its own currency.
The speakers at that workshop all agreed that “it is too soon for Timor-Leste to implement a national currency”.
Representative of the opinion expressed was the view outlined in the IMF’s latest – Democratic Republic of Timor-Leste : 2017 Article IV Consultation-Press Release and Staff Report (December 7, 2017) which claimed that:
The use of the U.S. dollar as sole legal tender remains appropriate given institutional capacity constraints and limited financial development. The fully dollarized regime has worked well for Timor-Leste, given the high dependence on oil revenue and limited other non-oil exports. Sound macroeconomic policies, including improved fiscal policies, together with further progress in financial sector and institutional developments, would be needed over the long run to pave the way for any change in exchange rate regime.
When is the right time?
Well, according to the neoliberals, Timor-Leste “first must develop the non-oil sectors of the economy, which includes agriculture, tourism and light manufacturing” (Source).
Because the claim that “implementing a national currency now would lead to an increase in the price of imported goods, thereby worsening people’s purchasing power while domestic production remains low.”
The discussion thus always centres on two things:
1. That if Timor-Leste introduced its own currency it would quickly depreciate as the government goes crazy and spends like a drunken sailor. Hyperinflation is posed as an inevitability.
In fact, these are the same arguments that the neoliberals use against any deficit spending even in advanced nations.
2. The argument is nuanced for nations such as Timor-Leste because the structure of the economy is alleged to be such – small, open economy dependent on imports and oil revenue, few exports with volatile prices on international markets, undeveloped financial sector and a dearth of private activity – that such a depreciation would not change the real exchange rate and hence improve competitiveness.
But, note, that these arguments are always pitched in terms of external competitiveness rather than enhancing the government’s capacity to bring all idle resources into productive use, including labour resources.
There is more ways to develop a nation than through export competitiveness, the latter which has been, the IMF’s obsession for decades and has delivered poor results for nations that have tried to export their way to prosperity with a fiscal straitjacket being imposed.
Further, even within the trade-narrative, using the US dollar as its currency significantly disadvantages Timor-Leste in terms of international competitiveness.
Effectively, Timor-Leste has to take US interest rates as given (so no room to create incentives or disincentives for financial flows) and nominal movements in the US dollar drive its real exchange rate, which is the accepted indicator of international competitiveness.
Between 2010 and 2016, the real exchange rate rose by around 45 per cent, which was a combination of domestic inflation pressures and, more importantly, US dollar appreciation.
Further, the interest rate environment is clearly determined by what the US Federal Reserve Bank deems to be suitable for advancing its agenda, which certainly does not include any consideration of the impact of different interest rate choices on Timor-Leste.
Why does this matter?
If the economic cycles of the two nations are moving in different directions, then being forced to adopt interest rates that are designed for the current state of the US economy will result in ‘pro-cyclical’ policies being implemented in Timor-Leste.
So, for example, if the US is facing an inflationary surge while Timor-Leste is in recession and the Federal Reserve starts hiking interest rates, Timor-Leste will have to endure higher interest rates even though the responsible direction for policy is to relax monetary policy.
Of course, this may not matter that much given that monetary policy is not a very effective policy tool for controlling aggregate spending patterns anyway.
But usually, fiscal policy is forced into passively supporting the monetary policy stance. And then the pro-cyclicality of the policy positions becomes deeply problematic.
Fiscal policy is much more important in this regard and not having one’s own currency renders the government of the nation reliant on export revenue in order to spend on domestic policy initiatives.
While this is not problematic if export revenue is stable and sufficient, in Timor-Leste’s case the export revenue source will deplete at some point and then austerity becomes the norm given the poorly developed domestic tax base.
Further, since the creation of the new nation, inflationary episodes have been mostly due to the falling value of the US dollar (and cross-rates against the US dollar), and, to some extent, rising food prices. Timor-Leste is a net importer of food.
The nation imports a lot of essentials from Australia (food etc) and when the Australian dollar appreciated against the US dollar prior to the GFC, the prices of imported goods from Australia rose commensurately.
So the inflation generating process in Timor-Leste is in no small part driven by its decision to use the US dollar as its official currency.
But the cure for that is not to impose fiscal austerity to deflate the economy, but rather, to insulate the economy from imported inflation by allowing the exchange rate to move. That cannot happen at present as a result of the dollarisation.
Another claim by those who advocate the on-going dollarisation is that the use of the US dollar provides stability for international investors.
The fear of out-of-control depreciation resonates strongly through the debate about Timor-Leste’s currency choice.
The La’o Hatumuk (aka Timor-Leste Institute for Development Monitoring and Analysis) editorial (March 16, 2018) – 18 Years Later: Should Timor Drop the U.S. Dollar? claimed that:
A relatively stable currency makes investors confident that the value of their investment will be preserved over time.
However, the data shows that Foreign Direct Investment (FDI) has been weak and declining rapidly over the last 5 years or so.
So even if the ‘stability’ of using the foreign currency is attractive to international investors, it has not been sufficient to generate growing FDI.
But, of course, the ‘stability’ argument is really not about FDI at all. It is a smokescreen to hide the underlying agenda.
The neoliberals have an ideological bias against government involvement in the economy (unless it is lining the pockets of the elites).
But they know it is a hard argument to make in the case of Timor-Leste where the government sector is essentially THE economy.
You soon realise that the underlying reasons for these ‘commentators’ advocating for retention of the US dollar as the national currency relates to their intrinsic distrust of their own polity.
La’o Hatumuk disclose this lack of trust:
In the case of Timor-Leste, national institutions have not yet proven that they can resist the temptation to print more money during economic hard times …
One challenge often faced by newly independent countries is having inexperienced institutions. The biggest risk is the potential use of cheap and quick fixes for the economy – such as printing money to reduce a budget deficit or providing credit to banks – which could have devastating impacts on inflation and exchange rates in the future.
The question is when have the central bank of Timor-Leste, for example, demonstrated this “temptation”?
The new nation has never had its own currency to ‘print’.
On the question of capacity and experience, the new nation is around 16 years old.
It has now a generation of citizens moving through higher education (abroad). There is no shortage of PhDs floating around Dili who are taking consulting income from the government and giving all sorts of advice – spurious in the case of the currency choice.
There is ample human capacity available to the government of Timor-Leste in order that it introduces its own currency.
These arguments are the same ones that are used about an Eurozone nation like Greece contemplating exit. It is too complex, no-one would know what to do, etc.
All are just excuses for the underlying agenda.
I could assemble a team of people within weeks who have all the experience you could ask for (senior central bankers, IT experts, bankers etc).
Further, the new nation has created a central bank, which among other things takes around $US4.9 million in management fees for looking after the US bond portfolio of the Petroleum Fund, which is excessive to say the least.
As an aside, I am reliably informed that the $US14,869,835 annual Petroleum Fund ‘management’ fees the government of Timor-Leste pays out, some of which goes to Wall Street-type investment bankers, is grossly inflated and that the same task could be brought down easily to below $US1 million.
There is a challenge for the new government – clean out the parasites bleeding revenue from the nation for nothing.
Further capacity is evident in the fact that the nation now has a national statistical agency, a working Ministry of Finance and other administrative institutions.
What extra experience does it need to run a currency? How would they get that experience anyway?
How long can the distrust of national institutions continue?
The question of depreciation is also an interesting one.
Most of the arguments cite examples of currencies that have fallen in value rather sharply such after a pegged arrangement is ended (for example, Argentina).
They rarely tell readers/listeners that after enduring a sharp depreciation, it doesn’t take very long after that for the central banks to be struggling to keep the exchange rate down. This follows an improved growth profile (partly through improved trade competitiveness) and renewed capital inflow attracted to the new growth (spawned, in part, by the depreciation).
Queue Argentina and Iceland as two recent examples.
But these examples have limited relevance for Timor-Leste because there is a huge difference between introducing a new currency altogether, which has no volume in foreign exchange markets and breaking a peg of an existing currency which is already being bought and sold in the international currency markets.
In the case of Timor-Leste, as long as the government can enforce local tax obligations in the new currency, there would be a demand for that currency.
Initially, the supply of the currency would be restricted by the government spending (given that this is the way the currency would enter the monetary system).
So massive excess supplies of the currency are not likely immediately, and that is the requirement for depreciation in a floating exchange rate system.
Eventually, as the currency volumes increased in the foreign exchange markets, buying and selling on international markets would determine its value and it is likely that it would fall below parity, notwithstanding the massive oil revenue that the government generates from its Petroleum resources.
It would be a finite fall as the currency adjusted to the fundamentals of the economy.
But holding a suspected depreciation out as a reason for not introducing a national currency is spurious to say the least.
The Australian dollar does not trade at parity with the US dollar. If it was pegged at parity and the peg was dropped then it would suddenly and sharply depreciate. Does that mean Australia should dollarise?
I also consider the dollarisation to be undermining the development of a local import-competing sector. At present, Timor-Leste can import goods and services more cheaply than they can be produced locally because it uses the US dollar.
If the US dollar was abandoned and the local currency depreciated somewhat – then that cost disadvantage would probably be eliminated, thus spawning incentives to develop import-competing products. FDI would be attracted to those opportunities.
A viable import-competing sector is a bulwark against imported inflationary pressures. It also provides for skill development and a ‘market’ for non-government consumption spending.
It is clear to me that one of the important steps the new government should take is to introduce its own currency.
It cannot lead economic and social development while using the US dollar and facing declining petroleum revenue.
The struggle to rebuild the roads, water supply systems, the power supply, houses and school buildings which were targetted as a malicious last act of an illegal colonisation by the Indonesians is ongoing.
At present, the Government is using the considerable resources available from the Petroleum Fund to fulfill this task.
But those resources are finite.
Further, the petroleum sector is not linked to the local economy in any meaningful (productive) way. It doesn’t generate much local employment at all.
It is a cash cow albeit a volatile one. If the Timor-Leste government introduces its own currency, then the Petroleum Fund will become its initial store of foreign exchange, which will be important in managing its international currency affairs.
While the non-oil economy was growing strongly up to 2016 as a result of strong public infrastructure spending, huge problems still remain and they are immediate – widespread illiteracy, malnutrition, unemployment and poverty – all interrelated.
Unlike the neoliberal commentators, I consider the decision to dollarise the economy of Timor-Leste to have been a poor one.
First, the dollarisation of the economy is not only unnecessary but it has limited the scope of macroeconomic policy making in Timor-Leste.
By adopting the US dollar the nation does not have independent monetary or exchange rate policy. It cannot choose its own interest rate and the inflationary implications of that are noted above.
This means that all counter-inflation efforts have to be performed using fiscal policy, which is also entrusted with advancing the economic development, in line with the Millennium Development Goals.
There is a rule in economics that there has to be an equal number of policy tools for the policy targets. How on the one hand can the Timor-Leste government satisfy the development goals when it has to adopt tight spending policies, under the watchful eye of the masters of slash and burn, the IMF?
Any serious attack on inflation via fiscal austerity will be very costly to a nation that desperately needs increases in government spending growth not reductions.
And remember that trying to discipline the inflation process, when the origin of that process is mostly due to its currency arrangements (dollarisation) is very costly and, ultimately, doomed to fail.
The collapse in real GDP growth in 2017 was the direct result of imposing austerity and cutting the draw-down on the Petroleum Fund.
The solution, from an Modern Monetary Theory (MMT) perspective is clear.
Timor-Leste should abandon the US dollar and introduce its own currency and allow it float on the international markets. That should be a priority of the new government.
Then the nation would de-couple itself from the US monetary policy and exchange rate fluctuations and fiscal policy would be able to target public infrastructure development more fully to not only provide capacity to increase agricultural outputs (reducing its dependency on imported food) but also attract private investment in urban infrastructure (so-called crowd-in effects).
This will also allow the nation to better manage a large-scale public works program to directly address the problem of unemployment and underemployment. That will, in turn, better target poverty reduction.
I will return to the issue of the ‘demographic dividend’ in Part 2. But what we will learn is that fiscal resources need to be allocated to facilitate a major human development push to take into account the way in which Timor-Leste age structures are shifting and dependency ratios falling.
In turn, apart from investments in better educational and training outcomes, that policy agenda requires the creation of tens of thousands of jobs. That will be the only way to exploit the ‘dividend’.
While very large infrastructure projects might be appealing to the IMF and the World Bank (for example, the South Coast Highway and Industrial Zone developments), the billions that are spent on those projects would be better spent on creating jobs in rural areas and providing basic supporting infrastructure (roads, drainage, village infrastructure, sanitation, etc).
Further, introducing a new national currency will allow the central bank, which is now a coherent institution, to play the dual role of maintaining financial stability (via liquidity management) and acting as a development bank to ensure that private development was adequately funded at stable interest rates.
In my view, there is sufficient institutional structure currently developed in Timor-Leste to manage its own currency.
Clearly, the nation is already spending billions of its Petroleum revenue on developmental projects. What expertise does that require? Sufficient to manage its own currency is the answer.
Article 139 says that all natural resources “shall be owned by the State and shall be used in a fair and equitable manner in accordance with national interests”.
The Petroleum Fund Act in tandem with the dollarisation of the economy was set up in such a way that that statement of purpose was undermined from the outset.
Articles 14 and 15 of the Petroleum Act required that 90 per cent of the invested funds be placed in US dollar assets (of various types).
At the time, it prevented the Fund from investing in higher yielding, risk free non-US assets such as Australian government bonds. So it was also tied in with the fluctuations in the value of the US dollar rather than a true purchasing power measure if the PF was diversified across a range of zero-risk assets (such as the higher yielding Australian government bonds).
This requirement means that the value of the fund fluctuates with the fortunes of the US dollar and during the economic crisis, the Petroleum Fund lost up to 30 per cent of its value as the US dollar depreciated. Clearly, the loss of value is not in terms of the fund’s nominal asset value given it is denominated in US dollars. But in terms of purchasing power the fund is vulnerable from this unnecessary restriction.
More recently it diversified its portfolio to allow some 40 per cent of the fund to be held in volatile private shares, which have been dragging down returns.
At the outset, the government of Timor-Leste was pressured into accepting a constraint known as the ESI (estimated sustainable income) which is defined in the Petroleum Fund Law as:
3 percent of Timor-Leste’s total petroleum wealth that is the current Petroleum Fund balance plus the net present value of future petroleum receipts
There was no economic or financial basis for this 3 per cent rule. It was intended to be an arbitrary constraint to prevent Timor-Leste from using the wealth it possesses to advance its development goals.
It was never matched to any reasonable time profile of the development challenge.
It is a typical neo-liberal constraint on government spending. The consequences are predictable and observed by the fact that the vast majority of the population remain in an impoverished peasant state.
In its most recent ‘staff Article IV consultation’, the IMF continues to emphasise that (Source):
Maintaining the PF’s assets as a sustainable revenue source should remain the fiscal anchor, achieved by adhering to the ESI.
Pressure to conform.
The outgoing Minister for Planning and Finance told the audience at the January workshop that the ESI rule had not been respected:
… this rule isn’t in place since sizable and increasing excessive withdrawals have been made since 2014 to fund the policy of frontloading of expenditures. Excessive withdrawals have been used not only to finance the construction of infrastructures but also to finance recurrent expenditures. There is currently no constraint to public expenditures and the incentives for the efficient use of public funds are weak. Moreover, following recent trends of excessive withdrawals would lead to a more or less rapid depletion of the resources of the PF.
The facts speak clearly on this matter.
The stronger growth which has now disappeared was directly the result of the increased government spending a point I made in Part 1.
Further, the implication that the government has been ‘over-spending’ since 2014 is not consistent with the huge pool of unemployment, high poverty rates, poor regional infrastructure and low inflation.
It has been underspending!
And the scale that the government has exceeded the ESI in the last 3 years has hardly led to a “rapid depletion” of the PF.
The debate is about front-loading development spending or maintaining artificial fiscal rules imposed from outside by the IMF etc while a high percentage of the population are excluded from any hope of prosperity under the current development path.
More front-loading is required not less. But it also needs to be targetted to generating employment as above.
Having a huge Petroleum Fund is irrelevant to the hundreds of thousands who are living and dying in poverty.
The IMF has pressured the government to spend less when it should be spending more and allowing the other macroeconomic policy tools, which are currently unavailable as a result of dollarisation to lift some of the weight. They are using the inflation bogey to restrict spending when the inflation is mostly tied up with the decision to use the US dollar.
The link between macroeconomic policy and poverty reduction via development (including job creation) is obvious although usually denied by these demands for fiscal balance.
The outgoing Minister for Planning and Finance told the January 2018 Workshop (cited in Timor – challenges for the new government – Part 1) that:
… in order to ensure fiscal sustainability … A robust fiscal rule is urgently needed and should probably be enshrined in Law.
But in Timor-Leste’s context, all the notions of fiscal space that the IMF and UNDP wheel out are moot.
The idea of fiscal sustainability tied to the Petroleum Fund in Timor-Leste becomes inapplicable if the government has its own currency.
Clearly, if the government uses a foreign currency (in this case, the US dollar) and relies on exporting a commodity in US dollars for its tax base then it can run out of spending capacity should the exported resource deplete.
But, fiscal sustainability with its own currency (which it can never run out of) becomes tied to what can be purchased with that currency that is available for sale.
With the ridiculously high unemployment rate in Timor-Leste one would have to argue that these workers would not accept a new currency in return for work to maintain a position that the Timor-Leste government has limited capacity to spend its own currency.
Clearly, once the government imposes all tax liabilities in the local currency then it would not take long for people to start demanding it.
There are hundreds of developing countries that do have currency sovereignty which means they can enforce tax liabilities in the currency that the government issues. It doesn’t matter if other currencies are also in use in those countries, which is common.
For example, the USD will often be in use in a LDC alongside the local currency and be preferred by residents in their trading activities. But, typically, the residents still have to get local currency to pay their taxes. That means the government of issue has the capacity to spend in that currency.
So the point is that as long as there are real resources available for use in a less developing country, the government can purchase them using its currency power and bring them back into productive use.
The are hundreds of thousands of people in Timor-Leste who are unemployed. They are real resources which have no ‘market demand’ for their services. The government of Timor-Leste could easily purchase these services with the local currency without placing pressure on labour costs in the country.
I will return to that policy option in Part 3.
Those who might oppose such a development will claim that this policy would place further strain on the food shortage and cause inflation.
Given the strength of the current account (as a result of its petroleum exports) it is hard to see any large scale depreciation occurring in the short-run.
But all open economies are susceptible to balance of payments fluctuations. These fluctuations were terminal during the gold standard for external deficit countries because they meant the government had to permanently keep the domestic economy is a depressed state to keep the imports down.
For a flexible exchange rate economy, the exchange rate does the adjustment. There is no clear relationship in the research literature to show that fiscal deficits create catastrophic exchange rate depreciation in flexible exchange rate countries?
If one is worried that rising net spending will push up imports then this worry would apply to any spending that underpins growth including private investment spending. The latter in fact will probably be more ‘import intensive’ because most less developed countries import capital.
But as noted above, the Petroleum Fund gives Timor-Leste an abundance of purchasing power for now with which it can increase the importation of food without introducing a debilitating currency crisis.
Further, well-targetted government spending can create domestic activity which replaces imports. For example, Job Guarantee workers could start making things that the nation would normally import including processed food products.
Moreover, a fully employed economy with a skill development structure embedded in the employment guarantee are likely to attract FDI in search of productive labour.
So while the current account surplus might decline from its very heady heights as the economy grows (which is good because it means the nation is giving less real resources away in return for real imports from abroad) the capital account would move into surplus. The overall net effect is not clear but an external deficit in the short- to medium-term is highly unlikely in the the case of Timor-Leste.
Where imported food dependence exists – then there are two considerations. If the nation is not resource rich and cannot generate sufficient export earnings to allow it to import enough food, then the role of the international agencies should be to buy the local currency to ensure the exchange rate does not price the poor out of food. This is a simple solution which is preferable to to forcing these nations to run austerity campaigns just to keep their exchange rate higher.
But Timor-Leste is not in this position. It has sufficient export revenue earning capacity at present to fund vastly increased imports, including food.
In the case of Timor-Leste, dollarisation and the associated fiscal rules generate continued poverty, malnutrition and unemployment. They do nothing to develop the self-sufficiency of the agriculture – and most of Timor-Leste remains a peasant, pre-capitalist economy.
The dollarisation also leave it with little room to pursue the development goals that have been set for it.
In Part 3, which will come out next Monday, I will discuss specific policy options that are required to exploit what is known as the ‘demographic dividend’ where the age-structure of the nation generates a plunging dependency ratio.
To exploit that dividend, which historically delivers massive development boosts to nations, the shifting demographics have to be accompanied by high levels of employment.
That should be policy priority No.1. In that context, I will discuss the types of public spending that should be prioritised.
I will also complete some Petroleum Fund scenarios to complement the policy advice.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.