Timor_Leste_Growth_Diagnostic.pdf

Timor-Leste Growth

Diagnostic

An assessment of the binding constraints to growth

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The Growth Diagnostic working group is composed of the following main contributors:

Mark Gellerson, Senior Regional Program Economist USAID/RDMA

Whitney Dubinsky, Regional Program Economist USAID/ RDMA

Brandon Fenley, Program Economist USAID/ Indonesia

Kishore K.C., Program Economist USAID/ Nepal

With additional assistance from the USAID/Timor-Leste staff of:

Rick Scott, Mission Director

Ryder Rogers, Economic Growth Officer

Candido Conceicao, Program Management Specialist

Angela Da Cruz, Program Management Specialist

Jessica Snaza, Economic Growth Officer

Special thanks to the following contributors for their additional assistance in data procurement and editing:

USAID Economic Analysis & Data Service Team (with special thanks to Cristobal DeBrey and Adriana Harvey)

Alefia Merchant Agriculture Development Officer USAID/ RDMA

Greg Leon Private Enterprise Officer USAID/ RDMA

James Gilman Economic Growth Officer USAID/Ukraine

John Thurow Agriculture Development Officer USAID/ India

Marika Olsen Agriculture Development Officer USAID/ Indonesia

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Table of Contents

Chapter 1 Executive Summary

Chapter 2 HRV Methodology, Comparators & Growth Diagnostic Roadmap

Chapter 3 Timor-Leste Overview

Historical Context

Macroeconomic Performance

Poverty

Social Indicators

Chapter 4 Microeconomic Risks

Land Tenure & Property Rights

Current Situation in Timor-Leste

Land Tenure and Property Rights as a Binding Constraint

Regulatory Environment for Private Business

Current situation in Timor-Leste

Enforcing Contracts

Starting a business

Chapter 5 Infrastructure

Roads

Power

Chapter 6 Human Capital

Education and Skills

Education Supply – Quantity

Education Supply – Quality

Education Demand and Firm‘s Perception of Education

Education Demand – Unemployment and Labor Force Participation

Education Demand – Firm‘s Perceptions of Education

Health and Human Capital

Chapter 7 Expanded Agricultural Sector

APPENDIX A: Macroeconomic Risks

APPENDIX B: High Cost of Finance

Access to Capital (Foreign and Domestic)

International Capital

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Domestic Capital

Financial Intermediation

Lack of Lending

Why Banks Are Not Lending

APPENDIX C: Non-Binding Microeconomic Risk

Taxes and Tax Administration

Tariffs and Non-Tariff Barriers to Trade

Corruption

Current situation in Timor-Leste

Is Corruption a Binding Constraint?

Insecurity

Political Insecurity

Crime

APPENDIX D: Market Failures

Self-Discovery and Innovation

Lack of Diversity of the Export Basket

Gross Dependence on Spending

Coordination Failure

Works Cited

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Tables

TABLE 3-1 GENERAL FACTS AND FIGURES FOR TIMOR-LESTE

TABLE 4-1 REGISTERING PROPERTY DOING BUSINESS SCORES FOR COMPARATOR COUNTRIES

TABLE 5-1 GLOBAL COMPETITIVENESS REPORT 2011

TABLE 5-2 ROAD CONDITION OF NATIONAL AND DISTRICT ROADS

TABLE 6-1 HUMAN CAPITAL DEVELOPMENT FUND IN $ MILLIONS

TABLE 6-2 ENROLLMENT RATES FOR TIMOR-LESTE AND COMPARATORS

TABLE 6-3 HIGHEST LEVEL OF EDUCATION

TABLE 6-4 ESTIMATED SCHOOL INFRASTRUCTURE NEEDS

TABLE 6-5 KEY LABOR INDICATORS FROM ILO LABOR SURVEY

TABLE 6-6 MEAN MONTHLY WAGES, RECEIVED BY MALE AND FEMALE PAID EMPLOYEES, BY SECTOR OF ACTIVITY OF THEIR

MAIN JOB

TABLE 6-7 PERCENTAGE OF UNEMPLOYED PERSONS (ILO ‗RELAXED‘ DEFINITION) BY SEX, LOCALITY, AND EDUCATION LEVEL

(2010)

TABLE 6-8 EMPLOYED PERSONS BY LEVEL OF EDUCATION AND USUAL WORKPLACE (2010)

TABLE 6-9 PERCENTAGE OF CHILDREN UNDER 5 CLASSIFIED AS MALNOURISHED (BELOW 3 STANDARD DEVIATIONS) TABLE 6-10 2004 DALY RATES PER 100,000 POPULATIONS, BY CAUSE (FOR ALL DISEASES THAT HAVE EFFECT TIMOR-LESTE

MORE SO THAN LOW-INCOME COMPARATORS)

TABLE 6-11 TOP TEN NATIONAL BURDENS TO TIMOR-LESTE BASED ON 2004 DALY RATES PER 100,000 POPULATIONS, BY

CAUSE

TABLE 7-1 RICE FARMERS BY DISTRICT (2000)

TABLE 7-2 TIMOR-LESTE'S MERCHANDIZE EXPORTS, 2004-2008 ($ MILLION)

TABLE 7-3 TIMOR-LESTE: FOOD BALANCE SITUATION

TABLE 7-4 VOLUME OF IMPORTED FRUITS AND VEGETABLES (TONS), 2010

TABLE 7-5 IRRIGATION AREAS AND REHABILITATED SCHEMES BY DISTRICTS (HA)

TABLE 7-6 NUMBER OF TRACTORS IN TIMOR-LESTE BY DISTRICT

TABLE A-1 CURRENT AND CAPITAL EXPENDITURES

TABLE A-2 GOVERNMENT REVENUE AND EXPENDITURE

TABLE B-1 PERCENTAGE OF FIRMS WITH A BANK LOAN OR LINE OF CREDIT

TABLE C-1 WORLD ECONOMIC SURVEY CORRUPTION RELATED RESPONSES

TABLE D-1 EXPORT BASKET

Figures

FIGURE 1-1 BINDING CONSTRAINTS TO BROAD-BASED, MARKET-LED ECONOMIC GROWTH

FIGURE 2-1 HRV METHODOLOGY

FIGURE 2-2 SUSTAINED, BROAD-BASED GROWTH METHODOLOGY

FIGURE 2-3 COMPARATOR COUNTRIES BY WORLD BANK INCOME CLASSIFICATION

FIGURE 3-1 GDP PER CAPITA (CONSTANT 200 US$)

FIGURE 3-2 GDP GROWTH RATES (ANNUAL %)

FIGURE 3-3 INFLATION RATE

FIGURE 3-4 POPULATION PYRAMID

FIGURE 3-5 INVESTING IN PEOPLE RADAR

FIGURE 3-6 GOVERNING JUSTLY AND DEMOCRATICALLY RADAR

FIGURE 4-1 PROPERTY RIGHTS FACTOR, HERITAGE FOUNDATION

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FIGURE 4-2 WORLD BANK DOING BUSINESS SCORES

FIGURE 4-3 BUSINESS FREEDOM INDEX, HERITAGE FOUNDATION

FIGURE 4-4 ENFORCING CONTRACTS SCORES, WORLD BANK DOING BUSINESS

FIGURE 4-5 ENFORCING CONTRACTS: COST (% OF DEBT), WORLD BANK DOING BUSINESS

FIGURE 4-6 STARTING A BUSINESS, WORLD BANK DOING BUSINESS

FIGURE 6-1 PRIMARY GROSS ENROLMENT RATIO

FIGURE 6-2 PERCENTAGE OF REPEATES IN PRIMARY SCHOOL, UNESCO

FIGURE 6-3 PERCENTAGE OF MALES AND FEMALES WITH NO PRIMARY EDUCATION, DHS

FIGURE 6-4 PUBLIC EXPENDITURE ON EDUCATION (PERCENTAGE OF GNI), UNESCO

FIGURE 6-5 ADULT LITERACY RATE, UNESCO & DHS

FIGURE 6-6 QUALITY OF PRIMARY EDUCATION, THE GLOBAL COMPETITIVENESS REPORT 2011-2012

FIGURE 6-7 QUALITY OF MATH AND SCIENCE, THE GLOBAL COMPETITIVENESS REPORT 2011-2012

FIGURE 6-8 QUALITY OF EDUCATION, THE GLOBAL COMPETITIVENESS REPORT 2011-2012

FIGURE 6-9 LABOR FORCE PARTICIPATION RATE, WDI & DHS

FIGURE 6-10 THE MOST PROBLEMATIC FACTORS OF DOING BUSINESS, THE GLOBAL COMPETITIVENESS REPORT 2011-2012

FIGURE 6-11 PERCENT OF UNDER-FIVES SUFFERING FROM MODERATE & SEVERE WASTING AND STUNTING, UNICEF

FIGURE 6-12 PREVALENCE OF UNDERNOURISHMENT, WDI

FIGURE 6-13 ESTIMATED PREVALENCE OF TB PER 100 000 POPULATION, WHO

FIGURE 6-14 BUSINESS IMPACT OF TUBERCULOSIS, THE GLOBAL COMPETITIVENESS REPORT 2011-2012

FIGURE 6-15 MALARIA SITUATION IN TIMOR-LESTE, 2010: AT A GLANCE

FIGURE 6-16 BUSINESS IMPACT OF MALARIA, THE GLOBAL COMPETITIVENESS REPORT 2011-2012

FIGURE 7-1 EXPANDED METHODOLOGY

FIGURE 7-2 LAND USE IN TIMOR-LESTE

FIGURE 7-3 RICE YIELD (HG/HA), FAOSTAT

FIGURE 7-4 MAIZE YIELD (HG/HA), FAOSTAT

FIGURE 7-5 BASIC FOOD SUPPLY AND DEMAND IN 2010 AND PROJECTION

FIGURE 7-6 FOOD SECURITY SITUATION IN TIMOR-LESTE

FIGURE A-1 ECONOMIC TRENDS, IMF ARTICLE IV REPORT

FIGURE A-2 PETROLEUM FUND, IMF ARTICLE IV REPORT

FIGURE A-3 TIMOR-LESTE‘S ANNUAL PETROLEUM REVENUES

FIGURE B-1 PERCENT OF FIRMS IDENTIFYING THE PROBLEM AS THE MAIN OBSTACLE, WB ENTERPRISE SURVEY

FIGURE B-2 PERCENT OF FIRMS IDENTIFYING THE PROBLEM AS THE MAIN OBSTACLE, FIRM SIZE, WB ENTERPRISE SURVEY .. 92

FIGURE B-3 TOTAL DEPOSITS AS A PERCENTAGE OF TOTAL ASSETS, CENTRAL BANK OF TIMOR-LESTE

FIGURE B-4 TOTAL LOANS AS A PERCENTAGE OF TOTAL ASSETS, CENTRAL BANK OF TIMOR-LESTE

FIGURE B-5 SOURCE OF FIRM INVESTMENT IN FINANCE, WB ENTERPRISE SURVEY

FIGURE B-6 DEPOSIT AND INTEREST RATES, WDI

FIGURE B-7 PRIVATE CREDIT VS INTEREST RATE SPREAD, WDI

FIGURE B-8 NON-PERFORMING LOANS AS A PERCENTAGE OF TOTAL LOANS, CENTRAL BANK OF TIMOR-LESTE

FIGURE B-9 LOAN LOSS PROVISIONING AS A PERCENTAGE OF TOTAL LOANS, CENTRAL BANK OF TIMOR-LESTE

FIGURE C-1 PAYING TAXES, WB DOING BUSINESS

FIGURE C-2 TRADING ACROSS BORDERS: EXPORT, WB DOING BUSINESS

FIGURE C-3 TRADING ACROSS BORDERS: IMPORT, WB DOING BUSINESS

FIGURE C-4 CORRUPTION PERCEPTION INDEX, TRANSPARENCY INTERNATIONAL

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FIGURE C-5 PERCENTAGE OF FIRMS EXPECTED TO PAY INFORMAL PAYMENT TO PUBLIC OFFICIALS, WB ENTERPRISE SURVEY

FIGURE C-6 POLITICAL STABILITY AND ABSENCE OF VIOLENCE ESTIMATE, WB GOVERNANCE INDICATORS

FIGURE C-7 STATE FRAGILITY: SECURITY, CENTER FOR SYSTEMIC PEACE

FIGURE C-8 POLITICAL STABILITY AND ABSENCE OF VIOLENCE ESTIMATE AGAINST GNI PER CAPITA, WB GOVERNANCE INDICATORS &

WDI

FIGURE C-9 SECURITY COSTS (PERCENTAGE OF SALES), WB ENTERPRISE SURVEYS

FIGURE C-10 LOSSES DUE TO THEFT, ROBBERY, VANDALISM AND ARSON AGAINST THE FIRM (% OF SALES), WB ENTERPRISE

SURVEYS

FIGURE C-11 PERCENTAGE OF FIRMS PAYING FOR SECURITY, WB ENTERPRISE SURVEYS

FIGURE D-1 GLOBAL COMPETITIVE, INTELLECTUAL PROPERTY SCORE

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Chapter 1 Executive Summary

This report, created solely by economists employed by USAID, explores the constraints to growth experienced by the private sector in Timor-Leste and attempts to identify those constraints that are presently most critical or ―binding.‖ This Growth Diagnostic study, coupled with previous studies and assessment, is meant to help the USAID Timor-Leste mission frame and build its Country Development

Cooperation Strategy (CDCS) by identifying key impediments to economic growth across all sectors in

Timor-Leste.

Methodology The study, conducted from November 2011 to April 2012, applies a growth diagnostic methodology developed by USAID that expands upon the original growth diagnostic methodology developed by

Haussmann, Rodrik, and Velasco (HRV). This methodology focuses on identifying the principal constraints to broad based economic growth rather than to growth per se. In addition to looking at the constraints to private investment as in HRV, this expanded methodology also focuses on factors that either limit the growth of agriculture and other rural economic activities or reduce the labor-intensity of production or the employability of the labor force. In the end, however, we had to simplify this expanded methodology to make it more consistent with the rudimentary nature of Timor-Leste‘s economy and relative lack of economic data.

Using this expanded methodology, and through detailed statistical analysis, a literature review of existing studies, and interviews with private sector business owners and public officials, the team identified three key constraints to growth in Timor-Leste. When doing so, the USAID team of analysts sought a medium-term growth path that focuses on improving productivity in, and commercializing, the agricultural sector.

Analysis of Constraints to Timor-Leste’s Growth The analysis itself looked at two broad sets of possible constraints—those limiting the growth of non-farm production and employment and those limiting the growth of agricultural production and employment.

Non-farm constraints:

Macroeconomic: Timor-Leste‘s current macroeconomic position is relatively solid. The Government has a large fiscal surplus, no debt, a sustained inflow of petroleum revenues over at least the next 10 –

15 years, a substantial current account surplus (thanks again to petroleum revenue inflows and despite the fact that merchandise imports far exceed merchandise exports), and a stable currency. Because the macroeconomy is relatively stable, instability is not imposing significant costs on the economy, and individuals have little need to take ―evasive actions‖ to minimize or avoid altogether the costs associated with such instability. Timor-Leste‘s economy does face several macroeconomic challenges or risks, including: a) achieving an acceptable balance between growth and inflation; b) increasing resource mobilization from domestic taxation so as to provide a sustainable base for government spending in the post-petroleum era; and c) making public spending more effective by strengthening public financial management systems. At the moment, however, none of these risks comes even close to being a binding constraint to Timor-Leste‘s growth.

High Cost of Finance: If the cost of finance is high, enterprises are unable to afford the funds they need to operate, start, or expand their businesses, which is hindering growth and employment generation. Timorese firms lack access to finance. In fact, according to the 2009 Enterprise Survey, access to finance was the third most frequently cited business obstacle that firms identified, while among small Timorese firms (5-19 employees) access to finance was the second most frequently identified obstacle

9 | P a g e

There are several reasons why access to finance is a significant problem in Timor-Leste. For one thing, the relatively high interest rate spreads (the difference between deposit and lending rates) suggests that competition and efficiency is relatively low in the financial sector and that financial intermediation is not carried out effectively. Another important factor involves the general reluctance of banks in Timor-Leste to lend. Banks are not experiencing a shortage of capital, but there is a scarcity of available loan funds.

For example, the average loan to asset ratio for Timor-Leste Banks is only about 30 percent. Several factors explain banks‘ reluctance to lend. These include the current high level of non-performing loans

(around 40 percent of total loans), the lack of legal recourse for lenders if borrowers default (mainly related to difficulties with contract enforcement), and uncertainties associated with land tenure that make it difficult for potential borrowers to use land as collateral for a loan.

Without a doubt, the high cost of finance—specifically the difficulty of accessing finance—is a serious constraint to growth in Timor-Leste. However, the root cause of this constraint lies not with the financial sector itself and the banks that comprise it, but with problems with the business enabling environment, which are considered separately under Microeconomic Risks. Thus, we do not consider the high cost of finance per se to be a binding constraint for Timor-Leste.

Microeconomic: Microeconomic risks associated with private sector investment can lead to the inability of private entrepreneurs to adequately appropriate returns. They are impediments to the efficient functioning of private enterprises and typically relate to the policies, rules, regulations, and institutions that impact firms or factors of production.

In Timor-Leste, a variety of key perception surveys, including World Bank‘s Doing Business and

Enterprise Surveys, Transparency International‘s Corruption Perception Index, the Global Integrity

Index, and Heritage Foundation‘s Economic Freedom Survey, highlighted several important microeconomic barriers to growth. The first is the lack of secure land tenure and property rights, which has been exacerbated in Timor-Leste by repeated periods of conflict and multiple changes in land tenure systems. Since property rights are not formalized, citizens, business owners, and would-be investors fear that their ownership rights will be challenged or that their property will be taken away by government or other individuals. This lack of security is a major disincentive to long-term investments in land, capital, and enterprise. At the same time, banks or microcredit lenders are unable to use land titles as collateral due to insecure property rights and inconsistent claims registries and are often either unwilling to make loans or charge much higher interest rates as a result. Such constraints on investment and credit availability clearly hinder growth.

Another microeconomic constraint relates to the weak business enabling environment in Timor-Leste.

The World Bank‘s ―Doing Business‖ survey, other similar studies of Timor-Leste‘s business and policy environment, and the team‘s own interviews and research consistently identified problems, high costs, and long delays associated with such processes as starting a business or enforcing contracts. Once again, these problems reduce the returns to private investment and clearly impede the development of Timor-

Leste‘s private sector. Corruption and lack of political security are also often cited as hindering Timor-

Leste‘s growth and development. However, there is mixed evidence concerning the significance of this impact.

In summary, we conclude that certain microeconomic constraints are important enough that they rise to the level of binding constraints to the growth of output and jobs in Timor-Leste. Specifically, weak land tenure and difficulties associated with starting a business and enforcing contracts reduce the potential returns to private investment and significantly impede firms‘ access to capital.

Infrastructure: Infrastructure is the backbone of any economy. Without minimally adequate infrastructure, no country can realistically hope to grow and prosper since the lack of sufficient infrastructure services raises costs, lowers productivity, undermines competitiveness, and impedes

10 | P a g e service delivery. Roughly 70 percent of Timor-Leste‘s infrastructure was destroyed in the 1999 conflict, and the country is ranked below all but a few other countries in the Global Competitiveness Report when it comes to the provision of adequate infrastructure.

Timor-Leste‘s medium-term growth prospects depend heavily on increasing productivity and commercialization in the agriculture sector. In this context, the adequacy of Timor-Leste‘s road network—especially district and rural roads—is particularly important. The same is true, but to a lesser extent, for access to reliable rural electricity supply and irrigation (in selected areas of Timor-Leste).

Roughly 70 percent of freight and 90 percent of passengers travel by road in Timor-Leste. In 2008, roughly 91 percent and 100 percent of national and district roads respectively were assessed to be in either poor or very poor condition. This was due to a variety of factors, including inadequate design, landslides and road failure resulting from heavy rains and insufficient drainage, and underinvestment in road maintenance. It will be exceedingly difficult for Timor-Leste‘s agricultural sector to progress beyond the subsistence level in the absence of significantly improved road networks.

Electricity is another roadblock to development for Timor-Leste. Progress has been slow in expanding the national electric utility‘s (EDTL) service coverage across Timor-Leste, improving the reliability of service, and strengthening EDTL‘s financial performance. Currently, Timor-Leste‘s power system is composed of about 58 isolated local distribution diesel powered generators, and only about one third of the population has access to electricity, generally for roughly six hours per day. Only the central parts of

Dili and Baucau have 24-hour access to electricity. As a result, many of the larger electricity consumers have invested in their own standby generators. The Government of Timor-Leste does have ambitious power sector development plans and is taking steps to build two new power plants plant and an accompanying transmission system. In late November 2011, the first unit came on line at the Hera plant, thereby significantly increasing generating capacity available for the Dili district. However, work on the high voltage transmission network continues to be delayed, and general problems of power system access and reliability continue. Once the new generating units are completed and online, Timor-Leste will have more than enough generating capacity to meet prospective growth in demand resulting from either increased electrification of the island or growth of the economy. Nevertheless, supplying that capacity to a predominantly rural population will remain a major challenge for some time to come.

In summary, Timor-Leste has infrastructure problems across the board, and these problems clearly constrain the growth of output and jobs. A major effort backed by significant government resources is already well underway to strengthen Timor-Leste‘s power grid, and significant progress has already been made in addressing generating capacity shortages. In contrast, relatively little progress has been made in improving the country‘s road network, which will make it exceedingly difficult to develop Timor-Leste‘s agricultural sector and overall economy in the medium-term. Weak infrastructure—especially roads—is judged by the team of economists to be a binding constraint for Timor-Leste.

Human Capital: The 1999 crisis had a great impact on Timor-Leste‘s education sector when nearly 90 percent of the country‘s schools were either damaged or destroyed. Additionally, qualified Indonesian teachers fled the country, leaving many classrooms without instructors. The changing political situation also required schools to drastically alter their textbooks and curricula, leaving even experienced teachers struggling to meet their students‘ educational goals. The 2006 crisis caused additional damage to educational institutions.

The overall educational enrollment ratios in Timor-Leste are generally higher than for comparator countries, especially at the primary and tertiary levels, and they have increased in recent years. At the same time, enrollment rates are relatively low for females and children in rural areas. Despite fairly respectable enrollment rates, levels of actual educational attainment are low. For example, only about 50 percent of adults older than 15 years old in Timor-Leste are literate, which is a lower rate than nearly

11 | P a g e all of the low middle and upper middle comparators, as well as many low income countries. For example, East Nusa Tenggara, Indonesia, has a literacy rate over 80 percent. Similarly, in the Global

Competitiveness Report, Timor-Leste has the lowest score against competitors in the Quality of

Primary Education indicator and scored 139th out of 142 countries overall.

There is clearly a strong demand for well educated workers in Timor-Leste. Unemployment rates are relatively low at seven percent for individuals with a polytechnic or university degree. Also, surveys suggest that an inadequately educated work force is one of the biggest problems facing businesses in

Timor-Leste. This same view was found in interviews carried out with the private sector for this study.

Despite setbacks, the Timorese government has displayed a commitment to education. Educational funding as a percent of the national economy has increased in recent years; the Government has established a Human Capital Fund and the Government has laid out ambitious plans for strengthening

Timor-Leste‘s educational system in its ―Strategic Development Plan for 2010 – 2030.‖ Nevertheless, human capital shortages continue to significantly constrain the growth of Timor-Leste‘s economy in a variety of ways. The private sector cannot obtain the skilled workers it needs, government capacity and effectiveness is limited by skills shortages, and the lack of basic knowledge and skills impedes efforts to enhance productivity and commercialization in the agricultural sector. For these reasons, the lack of high quality human capital is a binding constraint to Timor-Leste‘s development.

The team spent additional time researching, at the request of the mission, the relation between ongoing health concerns and human capital. Since human capital is a binding constraint to growth in Timor-Leste, the team explored some of the issues directly impacting the labor force and ability of the Timorese population to maximize their cognitive development. It is clear that malnutrition hinders the population‘s educational attainment and labor productivity. Also, based on business surveys and the burden of disease from mortality and morbidity, diseases like tuberculosis and malaria are dramatically affecting the workforce in Timor-Leste. The status of health remains a major hindrance to labor force productivity and the overall educational level of the Timorese population.

Market Failures: Market failures are generally situations in which decisions made in a free market context (without government intervention) lead to inefficient outcomes. They are typically caused by externalities, the presence of public goods that are difficult for markets to provide and allocate, and the lack of information that would allow firms and consumers to make reasonable decisions on operating a business or buying goods. In the expanded growth diagnostic model used for this study, many market failures are addressed in the microeconomic and macroeconomic risk sections, such as governments failing to establish adequate property rights or effective rule of law. Market failures considered here relate to self-discovery and coordination externalities.

There are two types of self-discovery: 1) firms discover that producing a particular good in a particular location is profitable (comparative advantage), or 2) firms discover that producing something new or in a new way is worthwhile (technological innovation). Self-discovery is less likely in a country without intellectual property rights or in countries with low barriers to entry since either or both reduce the incentives for firms to innovate or enter new markets. Timor-Leste ranks very low when it comes to protecting intellectual property and is characterized by significant market entry barriers. The characteristics of Timor-Leste‘s economy--including low export volumes, the complete dominance of a single export product (coffee), and the gross over-reliance on government spending to drive the economy—suggests a lack of self-discovery.

Coordination failures occur when firms fail to cooperate with each other even though cooperation could increase their profits and lower costs. Interviews with farmers, entrepreneurs, and development

12 | P a g e partners in Timor-Leste suggest that coordination failure most frequently results from the lack of market information that can provide adequate signals up and down value chains. Particularly in the agriculture sector, which employs 80% of the population, value-chains are very poorly connected.

Farmers do not always know what the market wants in terms of the mix of produce, how much, and how often; the buyers do not know farmers‘ abilities to grow certain produce in certain quantities and times. Furthermore, supply chains themselves are extremely underdeveloped.

Overall, market failures relating to lack of self-discovery and poor coordination are surely present in

Timor-Leste. However, given the very rudimentary nature of the economy, such market failures are not critical or binding constraints to its growth.

Agricultural Constraints

Timor-Leste is a predominantly agricultural economy with about 77 percent of the people living and working in the sector. There is a heavy reliant on traditional agricultural practices such as slash-and-burn cultivation (primarily in corn), the lowland cultivation of rice (both rainfed and irrigated), household gardens, harvested forest products (like tamarind, candlenut and fuel wood) and livestock production; and most agricultural outputs meet subsistence needs with relatively little being marketed commercially. The yields for the main crops are consistently very low by international norms. And

Timor-Leste currently experiences a significant food deficit which is projected to last until 2020 at a minimum.

There are a number of factors which underlie the relatively weak performance of Timor-Leste‘s agricultural sector and ultimately hinder growth and employment generation in the overall economy. For example, while the Government has recently recruited a significant number of new agricultural extension workers, the quality of extension services remains very poor and this has recently been identified by the World Bank as an important constraint on achieving a more productive agricultural sector. Another major problem farmers face is poor access to credit. Farmers in Timor-Leste significantly lack access to credit. The three major banks in Timor-Leste operate almost entirely in Dili.

Thus rural areas are served only by microfinance institutions. However, such institutions typically do not lend to agriculture (Reis, 2012) (Abel & Sequeira, 2008) because of cash flow problems and the riskiness of agriculture. Another related factor is the lack of linkages up and down the agricultural value chain, such as input suppliers, wholesalers, and processors. Because of the lack of input suppliers, wholesalers, and processors, there aren‘t opportunities for farmers to receive credit from these firms through ―value chain financing‖ schemes by which these firms offer credit to farmers with whom they conduct business

(DAI, 2006).

A third factor hindering the performance of the agricultural sector is weak rural infrastructure— especially poor quality or non-existent rural roads—which make it difficult and more expensive to obtain agricultural inputs and market outputs. Finally, land use and tenure issues patterns help to explain the difficulties of doing agribusiness in Timor-Leste. The lack of modern land-use protocols deters agribusiness actors from leasing land and participating in commercial agriculture. The World Bank argues that without contract enforcement and secure land tenure in rural Timor-Leste, rural development by the private sector will not grow. ―[T]he potential benefits of the private sector will be more easily harnessed if investors and rural communities can be provided with a land access negotiation framework that supports the development of productive and equitable rural development partnerships and reduces the likelihood of crippling land disputes‖ (World Bank, 2009).

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Figure 1-1 Binding Constraints to Broad-Based, Market-Led Economic Growth

Infrastructure Business Enabling

Environment Human Capital

Agriculture Agriculture is a cross-cutting theme, with the greatest near-term potential for achieving broad-based economic growth.

Land Tenure

Contract Enforcement

Registering a Business

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Chapter 2 HRV Methodology, Comparators & Growth Diagnostic

Roadmap

The objective of this growth diagnostic analysis is to identify the most critical (or most binding) constraints to broad based growth to Timor-Leste at present, where broad based growth is defined as

―growth that includes all major income groups, ethnic groups and women, and that significantly reduces poverty" (USAID, 2008). To achieve this end, an ―expanded‖ version of the growth diagnostic methodology developed by Haussmann, Rodrik, and Velasco (HRV) was utilized (Hausmann, Rodrik, &

Velasco, Growth Diagnostics, 2004).

The original HRV methodology starts with an objective of private sector growth and analyzes demand and supply side constraints to private investment, which is considered to drive private sector growth.

Figure 2-1 below, demonstrates the decision tree originally developed by Haussmann, Rodrik, and

Velasco for identifying binding constraints to growth. In order to determine these constraints, an analyst looks at each level and determines if an input, like innovation, is holding back an economy.

Figure 2-1 HRV Methodology

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In contrast, the methodology employed in this study takes as an objective sustained broad based economic growth and then analyzes constraints that can impede such broad based growth. Such constraints include: 1) the demand and supply side constraints to investment as addressed in HRV, 2) constraints to small scale agriculture and agro-processing/marketing, and 3) constraints relating to the labor intensity of production and the ―employability‖ of the labor force.1

To apply the broad based growth diagnostics in practice, the analyst starts at the top of the decision tree and first assesses the likelihood as to whether or not there is apt to be one or more binding constraints further down a particular ―branch‖. If the answer is ―no‖ then one concludes that the factors covered by this branch are not among the most important impediments to a country‘s growth and one moves on to another branch. However, if the answer is ―yes‖ then the analyst moves down to the various sub-branches and assesses the evidence as to where the most serious constraints to grow are.

The end result is the identification of what, in the analyst‘s view, are the most serious constraints or impediments to a country achieving sustained broad based growth. This does not mean that other policies or issues do not constrain the country‘s broad based growth, just that they are not judged to be among the most serious constraints.

In principle, at each decision node, four tests are applied to distinguish between a binding constraint to growth and one that is not binding: First, if a constraint is binding, the shadow price associated with that constraint should be high. For example, if limited access to finance is a binding constraint, interest rates should be particularly high compared with rates in other countries. Second, a particular constraint is more likely to be binding if relaxing that constraint results in observably faster growth. Third, private agents should be making efforts to circumvent a binding constraint to growth. For example, if lack of reasonable quality rural roads is a binding constraint to growth, farmers should be observed finding alternative ways to get their products to market. Fourth and finally, the firms that survive in the face of a binding constraint to overall growth should consist disproportionately of those firms that do not depend on that constraint. For example, in an economy where finance is particularly costly, there will be relatively few firms operating in industries that rely heavily on external finance (Hausmann, Klinger, &

Wagner, Doing Growth Diagnostics in Practice: A ‗Mindbook‘, 2008).

Once on the ground in Timor-Leste, it became clear that the expanded growth diagnostic methodology for broad based growth described above would need to be modified to make it appropriate and practical. For example, and as reflected in the technical sections on Timor-Leste to follow, the

See USAID, Growth Diagnostics Analytic Guide for Sustained, Broad-based Economic Growth, December 2011 (draft) for more details.

Figure 2-2 Sustained, Broad-Based Growth Methodology

16 | P a g e agricultural sector proved to be so rudimentary and overwhelmingly subsistence based that it was not necessary or meaningful to separately consider both the ―on-farm productivity‖ branch and the

―processing and marketing‖ branch. Instead, a single branch assessing, in effect, constraints to subsistence level agriculture was used. It was also quickly determined that there was little in Timor-

Leste‘s policy environment that discouraged labor intensive production techniques—either via a distorted domestic factor cost structure that made the use of labor relatively costly or a restrictive trade regime that reduces the cost competitiveness of Timor-Leste‘s exports. Thus the branch relating to ―labor intensity of production‖ was not worked through in detail. Finally, the branch relating to the

―employability of the labor force‖ was not utilized since—for such a rudimentary economy--it was felt that factors relating to employability (health, education, and labor mobility) were adequately captured by the human capital node in the HRV branch of the overall methodology.

Finally, constraints analyses typically rely on comparisons between conditions in the country of interest and those in relevant comparator countries – including a set of countries at a roughly similar level of development as well as other countries that have already achieved a level of development to which the country aspires. In the case of Timor-Leste, finding meaningful comparator countries was no easy task given Timor-Leste‘s rather unique characteristics—a small remote island nation, undeveloped in most ways and yet with a very significant inflow of petroleum revenue, and with a recent history of conflict. In the end, a number of comparators were identified

In order to properly gauge the current state of Timor-Leste, this analysis compares Timor-Leste against other developing nations in all sectors. The comparator countries fall into three separate economic income levels2. At the time of this analysis, Timor-Leste was classified as a low middle income country.

Low income countries are included in this analysis in order to have an understanding of the countries

Timor-Leste should be outperforming.