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Democratic Republic of Timor-Leste: Selected Issues and Statistical Appendix

Author(s):
International Monetary Fund
Published Date:
July 2005
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II. Managing Oil/Gas Wealth in Timor-Leste1

A. Introduction

1. The 2004 onset of oil/gas production in Timor-Leste marks a turning point for the impoverished and newly independent country. Oil/gas revenue from the existing Bayu Undan field is estimated at $3.2 billion (NPV terms) over 20 years, more than nine times Timor-Leste’s 2004 non-oil GDP. These prospects are uncertain: they could be higher if new projects are undertaken or lower if oil prices return to historical norms. To date the new oil revenue has contributed to a sharp improvement in the fiscal situation, with the central government surplus (including grants) moving from 10 percent of non-oil GDP in FY03/04 to 70 percent of non-oil GDP in FY04/05.2

2. Many economies with significant natural resources have suffered from the “resource curse.” Weak institutions, lack of transparency, and political pressures have often resulted in misuse and misallocation of the resources. Boom-burst cycles in oil/gas-producing countries have been at least partially caused by fiscal policies that followed oil/gas price developments. To date, many oil/gas producing countries have had difficulty achieving economic stability and high sustained growth.

3. Timor-Leste’s long-run economic prospects will thus depend on its strategy for use of its oil/gas wealth. The key challenge for the government will be the effective use of oil/gas wealth for the development of the economy by preserving the right balance between spending and saving for future generations. This chapter is organized as follows: Section B reviews the macroeconomic challenges commonly faced by oil/gas exporters, Section C discusses Timor-Leste’s oil/gas revenue outlook, Section D describes Timor-Leste’s plans for managing its oil/gas wealth through a natural resource (petroleum) fund and a saving policy, and Section E provides some conclusions.

B. Managing Natural Resources: Challenges Facing Oil/Gas Producing Countries

4. The past experience of resource-rich economies is often one of poor macroeconomic performance in the absence of good policies for managing the wealth. Studies show that resource-rich economies generally grow less rapidly than those without natural resource wealth. The challenges that arise include the following:

5. Fiscal policy in oil/gas countries may be excessively expansionary. Frequently, government spending exceeds appropriate levels given long-term considerations, without convincing signs that the higher spending has been able to lift the productive potential of the economy. This is related to volatile oil/gas prices, which may translate into pro-cyclical expenditure. In addition, the volatility may cause frequent unexpected fiscal adjustments, which are costly to private sector activity, particularly when making a downward adjustment.

6. The large inflow of oil/gas revenue may cause an appreciation of the real exchange rate. This appreciation may lead to loss of competitiveness in the non-oil/gas sector of the economy, including the manufacturing sector, which is regarded as an engine of early development and a potential source of employment and growth. This generally means that economic resources move away from the production of tradable goods to non-tradable sectors and imports would rise. The oil/gas resource inflow also affects the rest of the economy through its impact on macroeconomic aggregates. Income increases as a result of rising oil/gas revenue will likely lead to higher consumption and investment. Without proper management of aggregate demand, this would substantially raise the overall price level and may distort relative prices.

7. Given that oil/gas is a nonrenewable resource, intergenerational equity should be considered. This means that oil/gas revenue should be used in a way that will leave future generations as well off as the current one; generally this would involve some level of saving. How much saving should occur before the oil/gas reserves are fully extracted depends on the particulars of the country case. Those countries with significant development needs would arguably best use part of the resources to finance public expenditure with high social and economic returns; however, those countries with limited absorptive capacity would need to save more since the efficiency of public spending may be low.

8. From these challenges, lessons may be drawn for oil/gas producers in designing a strategy for managing natural resource wealth:

  • Fiscal policy should be set in a longer-term, comprehensive framework. This requires analyzing the government’s overall net wealth, including estimates of the value of oil/gas in the ground, and ensuring that the wealth is prudently managed and that the government’s fiscal policy is sustainable. This typically entails saving a significant share of current oil/gas revenue.
  • Pro-cyclical fiscal policy should be avoided and preparations should be made for downturns. To prevent having to cut spending sharply when oil/gas prices fall, governments need to ensure sufficient financing capacity. As many oil/gas-producing countries are credit constrained (especially when oil/gas prices are low), liquidity cushions are recommended.
  • Fiscal policy should focus on the non-oil/gas deficit as a percent of non-oil/gas GDP in developing a long-term budgetary framework. Given that national wealth is expected to derive predominantly from the non-renewable oil/gas resources, the non-oil/gas primary balance is a key variable as it strips out the impact of volatile oil/gas revenues. The non-oil/gas budget balance also reflects, to a large extent, the current and future economic developments in the domestic economy. Focusing on the developments in the non-oil/gas economy can help the government to pursue the objective of diversifying the economy and to create a tax base that does not solely rely on oil/gas revenues.
  • Transparency should be a guidepost in managing the oil/gas wealth and fiscal policy. At the same time, accumulated assets could be invested overseas to prevent real exchange rate appreciation and minimize risks to the real value of the asset.

Box II.1.Fiscal Environment for the New Oil Exporter

The fiscal sector in Timor-Leste has several unique features that, taken together, differentiate it from other low income oil/gas exporters. These include:

  • Large fiscal surpluses since oil/gas production began in 2004;
  • Administrative capacity shortfalls, which have led to shortfalls in budget execution, particularly for investment spending, notwithstanding significant large development needs;
  • A broad medium-term investment strategy, under the Sector Investment Programs, with the objective of achieving the millennium development goals;
  • A policy of refraining from either domestic and foreign borrowing, resulting in no interest burden;
  • Early establishment of a petroleum fund, expected to be operational from July 1, 2005 to avoid Dutch disease and other resource-related complications;
  • Very low level of non-oil/gas tax revenue; and
  • An officially dollarized economy, highlighting the importance of fiscal policy.

Central Government Balance, Excluding Grants

(percent of GDP)

External Public Debt

(percent of GDP)

C. Oil/Gas Sector Prospects

9. The prospects for oil/gas production in Timor-Leste are favorable, although still highly uncertain. Production of oil/gas in the Timor Sea is already providing Timor-Leste with significant revenues; updated revenue projections show petroleum revenues of around US$ 3.2 billion, more than 9 times 2004 non-oil GDP.3 Development of other fields and additional exploration for both onshore and off-shore areas are planned. The Phoenix field, adjacent to the current Bayu-Undan production area, has an estimated value of 2.26 trillion cubic feet of gas, and could extend the life of the Bayu-Undan field by around 15 years from 2023. The Greater Sunrise field has 8.3 trillion cubic feet of gas (three times that of Bayu-Undan) and around 200 million barrels of oil/gas. The allocation of revenue from Greater Sunrise will depend on the outcome of current negotiations with Australia.

10. Major oil/gas fields. Timor-Leste’s oil/gas revenue is generated from the commercial exploitation of oil/gas/resources mostly in the “Timor Gap” (Box 2). Major oil/gas fields discovered to date include the Elang-Kakatua-North (EKKN), Bayu-Undan, Phoenix, and Great Sunrise fields. The Bayu-Undan field is currently the main source of oil/gas revenue. Resources from the EKKN field were limited and are nearing exhaustion. The timeframe for the Great Sunrise field remains uncertain, pending conclusion of negotiations with Australia regarding an area of disputed sovereignty with some recent reports suggesting these negotiations are nearing conclusion.

11. Revenue sharing arrangement. The commercial exploitation of oil/gas in the Timor Gap is governed by the Timor Sea Treaty signed between Timor-Leste and Australia on May 29, 2002. Under the Treaty, the Timor Gap is partitioned into tree areas: (1) the Joint Petroleum Development Area (JPDA) (see JPDA Map below), (2) an area under Australian jurisdiction, and (3) an area under Timor-Leste jurisdiction. Oil/gas revenue in the JPDA are shared between Timor-Leste and Australia with a 90/10 split.4 The Bayu-Undan field is located entirely in the JPDA, while the Great Sunrise field straddles the boundary of the JPDA to areas that are claimed by both countries.

12. The outlook for oil/gas revenue is highly sensitive to oil/gas prices as well as production. The sensitivity analysis of the projection for revenue from Bayu-Undan is based on data provided by the authorities and is largely derived from ConocoPhillips, the oil/gas extraction company that is the principal “operator” for Bayu-Undan. Estimating oil/gas revenue is highly difficult mainly due to the non-linearity of price elasticity oil/gas revenue (profit oil/gas revenue is contingent on movements in oil/gas prices) and the volatility of world oil prices. The scenarios taken for the analysis assume prices that are $5 higher and $10 lower than the baseline series from 2005/06 onward (prices are per barrel). The asymmetrical bands were chosen because of the historically high level of current oil/gas prices. The $15 price band is modest compared to historic movements in world oil prices (prices moved within a $24 band in 2004). Figure 1 shows the large fluctuation in government revenue, varying substantially according to oil/gas prices. Operational uncertainties regarding the pace and costs of extracting oil and gas are additional risks, in particular for the period when Bayu-Undan is the only source of revenue.

Box II.2.Timor Gap

The Timor Gap was created by the 1972 seabed boundary agreement between Australia and Indonesia. It was a legacy of the fact that Australia and Portugal—then the colonial ruler of Timor-Leste—never agreed on a maritime boundary between Portuguese Timor and Australia.

Source: Timor Sea Office.

Sensitivity of Oil Revenue to Oil Prices

(Percent of Non-Oil GDP)

JPDA Map. Source: Timor Sea Office.

D. A Long-term Strategy for Oil/Gas Wealth Management

Natural Resource Funds

13. Natural Resource Funds (NRFs) may help in addressing the challenges commonly facing natural resource rich countries. Resource funds have been established in Norway, Azerbaijan, Chile, Kazakhstan, Kuwait, Oman, and Venezuela with a significant variety in design and purpose. NRFs can be classified as stabilization funds, saving funds and financing funds, based on the envisaged purpose, although in most cases the nature of the fund is mixed. Stabilization funds are designed to reduce the impact of volatile revenue inflow, saving funds emphasize the accumulation of wealth for future generations, and financing fund primarily focus on effectively financing the overall budget deficit.

14. Well-designed NRFs may help stabilize aggregate demand and dampen real exchange rate appreciation. Investing NRF assets abroad reduces the need for domestic sterilization of foreign exchange inflows. NRFs may also enable a build-up of financial savings for future generations on political economy grounds. In their absence, the large inflow of natural resources can prompt considerable political pressure to spend the higher revenues for the current generation by increasing budget expenditure or reducing taxation. Against this backdrop, establishing a NRF with clear and transparent objectives may provide support for governments in building public consensus for saving part of the revenue from natural resources.

15. The performance of NRFs across countries has been mixed. If not properly set up or managed, NRFs carry risks, including the fragmentation of the budget account, asset management losses, and lack of transparency. If the fund is abused or mismanaged by the authorities, it can often be more of a problem than a solution. For instance, the oil/gas fund in some countries may be seen as a way to avoid public scrutiny and accountability. The lack of the transparency of operations and the poor quality of management could further aggravate economic performance. An assessment of established oil/gas funds in selected countries (Fasano, 2000) shows that savings funds in Norway, Azerbaijan and Kuwait have contributed to building sizeable assets to meet needs for future generations and some stabilization funds have helped to alleviate the volatility of fiscal expenditure by making fiscal policy less driven by revenue availability. However, the experience of stabilization funds in Oman and Venezuela was less successful because of frequent changes to rules and weak commitment to the intended purpose. Success, therefore, does not hinge on the establishment of NRFs, but rather on prudent fiscal management and fiscal discipline conducted through NRFs. Indeed, some argue (Sala-i-Martin and Subramanian, 2003) that where weak institutions and governance may lead to waste and increase vulnerability to corruption, distributing natural resource wealth directly to the population would be more efficient and conducive to long-term growth on the assumption that the private sector could spend the windfall more efficiently than the public sector.

A Petroleum Fund for Timor-Leste 5

16. The Timor-Leste government has announced the intention to establish an oil/gas (petroleum) fund as of July 2005. Based on the experiences of other countries, a petroleum fund could be a useful tool for Timor-Leste to manage its petroleum wealth wisely—particularly given Timor-Leste’s petroleum revenues are large relative to the size of the economy and its limited absorptive capacity. The design of the petroleum fund draws on the Norwegian model, including the emphasis on transparent operations of the fund.

Box II.3.Experience with Petroleum Funds in Oil/Gas Producing Countries

Norway. Oil/gas wealth is managed through the State Petroleum Fund (SPF), which was established in 1990. The purpose is to preserve national wealth so that future generations inherit as large an amount of wealth as the present generation. All of the government’s net income from oil/gas revenue is fed into the SPF, from which an annual transfer is made to the treasury to meet the non-oil/gas deficit in the budget. The Fund contributes to increasing transparency in the use of oil/gas revenue. The SPF can be considered a successful institutional arrangement. It has served as a tool for managing the resources needed in connection with the increase in pension outlays and helped enhance the effectiveness of fiscal policy by facilitating the adoption of a countercyclical fiscal stance.

Azerbaijan. The State Oil/gas Fund of the Republic of Azerbaijan (SOFAZ) was established in 1999 as an extra-budgetary institution. The main objective is the professional management of oil/gas revenue for the benefit of the country and future generations. The SOFAZ receives all government revenues arising from oil/gas production. The Fund’s rules currently prohibit spending in excess of inflows in any given year. A conservative expenditure policy has ensured a steady growth of savings in the fund. The creation of an oil/gas fund in Azerbaijan has had a positive impact on fiscal discipline and contributed to better transparency and accountability of oil/gas revenue management.

Kuwait. In 1976, the Kuwaiti authorities created a saving fund, the Reserve Fund for Future Generations (RFFG), aimed at providing a stream of income for future generations. Transfers to the RFFG—10 percent of total government revenue—are made independently of budget or oil/gas market developments. Nearly all assets are managed offshore and accumulated sizeable assets helped cover government expenditure during the 1990-91 regional crisis when oil/gas facilities were damaged and helped finance a large part of the reconstruction effort.

Oman. While the initial State General Reserve Fund (SGRF) was created in 1980, several revisions including in 1990 and 1993 have adulterated well-established operational guidelines. Notwithstanding the stated objective of building assets for future generations, accumulated assets have been frequently used for budget support in the face of external shocks.

Venezuela. A 1999 revision to the Macroeconomic Stabilization Fund (MSF) may have weakened the stabilization objectives by introducing presidential discretion for withdrawals, changes to the reference values, and earmarking the use of resources for social and investment expenditure and debt repayment.

Source: Fasano (2000).

17. The Petroleum Fund is to be fully integrated into the budget process. The Petroleum Fund will operate as a government account rather than a separate institution. Annual budget formulation and reporting will focus on the consolidated presentation, including the Fund, and expenditure of Petroleum Fund assets will be executed—as with other government revenue—by the Treasury Directorate of the Ministry of Planning and Finance. In addition, the return on the Petroleum Fund’s investments will be added to the Fund. The outflow from the Petroleum Fund will depend on the government’s saving policy (described below).

18. The Petroleum Fund’s assets are to be prudently managed and invested offshore. The Petroleum Fund’s savings are to be invested securely in low risk financial assets abroad, so that they are available when there is a need to draw on them. This strategy also has the benefit of putting less pressure on the domestic economy and contributes to balanced economic development. There is also a concern that investing domestically may increase the risk of corruption and bad governance. The government will have overall responsibility for the management of the Fund and the Minister of Planning and Finance will exercise key functions and competences. The Minister of Planning and Finance will be advised by an Investment Advisory Board that includes experienced financial advisers.

19. The guidelines and operations of the Petroleum Fund are to be transparent with stringent mechanisms to ensure accountability and prevent misuse. Regular and frequent disclosure and reporting are among the key principles governing the Fund, its inflows and outflows, and its investment strategy and return on assets. The Petroleum Fund’s activities will be audited by an independent external agency, and investment performance will be periodically evaluated. These policies are consistent with the principles in the Extractive Industries Transparency Initiative.

Timor-Leste Oil/Gas Saving Policy

20. A key element of Timor-Leste strategy for managing its oil/gas wealth is the adoption of a saving policy to guide the use of its resources. From the range of strategies for managing oil/gas resources, the Timor-Leste authorities chose to follow one that draws on Friedman’s Permanent Income Hypothesis (PIH) of consumption. The oil/gas saving policy adopted by the authorities envisages the use of only the permanent income from the oil/gas wealth to finance the non-oil fiscal deficit. Accordingly, annual budget “sustainable” spending is set equal to the sum of annual domestic non-oil revenue and the estimated permanent income from the total oil/gas wealth. Under this option, the government preserves oil/gas wealth constant in real terms, which can be calculated by discounting the future value of oil/gas revenue inflows. Based on conservative projections of oil/gas revenue over the life of Bayu-Undan, permanent income from oil/gas wealth of about $100 million, together with projected domestic revenue of about $30 million, would allow “sustainable” spending of about $130 million. Central government expenditure during the period of oil/gas extraction could be maintained at around 30 percent of non-oil GDP, on average.

Box II.4.A Petroleum Fund for Timor-Leste—Key Principles

  • The fund will receive all revenue accruing to the Government of Timor-Leste from its ownership of petroleum resources.
  • The fund has strong inter-generational equity objectives.
  • A process, or mechanism, for drawing on the fund which will enable it to support fiscally responsible levels of budget expenditure over the long term.
  • The design of the fund aims to strengthen the role of the budgetary process and existing institutions, with clear lines of responsibility and maintaining democratic accountability.
  • The fund is designed to have a high degree of legislative protection from governments of the day for the objectives of the fund, including its major institutional arrangements for custody and management.
  • The investment of fund resources is to be exercised according to written and approved guidelines which emphasize a conservative, low risk, approach to the placement and management of fund assets.
  • Implementation of the investment guidelines is to be assigned to a carefully selected group of professionals, drawing on appropriate experience, advice and quality information.
  • There will be maximum transparency of fund operations to parliament and the public through frequent, easily accessible and simple reporting.
  • Institutional arrangements will incorporate a role for eminent persons who are widely trusted within the Timorese community.
Source: Public consultation paper “Establishing a Petroleum Fund for Timor-Leste” and Timor-Leste Petroleum Fund Draft Act.

21. Different oil/gas management strategies have considerably different implications for spending paths over the long term. Under one extreme of the resource management strategies, “going on a binge,” the budget is designed to spend all of the oil/gas revenue available. No saving from natural resource revenue is envisaged and budget expenditure depends on production and world oil/gas prices. Under the other extreme, the Bird-in-Hand (BIH) rule, a country saves all current oil/gas revenues in the form of income generating assets, and spends only the real projected income from the available stock of assets. One drawback of the second approach is a lower level of income generation in the initial stage of the fund primarily due to the slow initial accumulation of oil/gas wealth.

22. The non-oil/gas deficit in Timor-Leste is expected to be very large over the long term, while the overall fiscal balance should run significant surpluses during the period of oil/gas extraction. This result is driven by the dominance of oil/gas revenue and the relatively weaker production from the non-oil/gas sector. Studies indicate that higher reliance on transfers from natural resources may be harmful to fiscal sustainability over the long term. Instead, stronger non-oil revenue allows a permanently higher level of expenditure. Thus, the long-term fiscal strategy should include measures to strengthen non-oil revenue and avoid excessive reliance on oil/gas revenue.

Spending Paths Under Different Saving Policies

(Percent of Non-Oil GDP)

Non-Oil and Overall Fiscal Balance

(Percent of Non-Oil GDP)

23. The saving policy adopted allows some flexibility on the level of sustainable spending. Under a strict PIH saving rule, the level of sustainable expenditure is established. In contrast, the procedural guidelines for Timor-Leste’s petroleum fund allow expenditure to exceed the sustainable level if authorized by Parliament under a highly transparent process. Revisions are made in connection with budget preparations and the legal requirements under the Petroleum Fund law to recalculate annually the sustainable income. Parliament can authorize other deviations from the estimated sustainable level of expenditure; for example, limited capacity could suggest spending less than the expenditure guidelines, while urgent needs for infrastructure could suggest exceeding the guidelines. In sum, there is no “ceiling” on withdrawals in Timor-Leste, only a procedural threshold; in other words, the fund follows fiscal guidelines but not strict fiscal rules.

24. In theory, the difference in the rate of social return between current physical investment and savings in financial assets would be a key to determining the appropriate level of government spending. Accordingly, if the social return on physical investment is higher than that of saving, the authorities could increase the level of government spending, which otherwise the authorities would save in the form of financial assets. Recent studies suggest that economic returns on infrastructure investment are especially high in early stages of development, given the links between investment in infrastructure and improvement of social indicators such as child mortality, educational achievement, and health indicators.6 However, in practice there are many examples of countries that have invested in physical investments with low or negative rates of return. A particular problem is to estimate accurately the assets’ rate of return, particularly if institutional capacity is limited.7

25. However, capacity constraints and budget execution problems are expected to keep actual spending below the level identified under the new saving policy for the near term. Generally, given pressing needs for investing in infrastructure, human capital, and basic service delivery, quick movement toward sustainable spending would be desirable, in line with improvements in administrative and absorptive capacity. However, given existing capacity constraints which have prevented the full execution of smaller budgets in Timor- Leste, a sharp and large increase in government spending could risk a less efficient use of resources with investments directed to less productive projects and increasing inflationary pressures. Improved expenditure capacity would allow the authorities to more quickly meet worthwhile development needs by increasing expenditure to the estimated sustainable level. According to staff projections, with steady improvement in capacity building, spending could reach the sustainable spending level around FY 2011/12.

Revenue and Expected Actual and Sustainable Spending

(Percent of Non-Oil GDP)

E. Conclusions

26. Timor-Leste’s long-run economic prospects will depend on its strategy for the use of its oil/gas wealth. The government has made a promising start in meeting the challenge of ensuring effective use of oil/gas wealth for the development of the economy through the establishment of a petroleum fund and a cautious saving policy. The key for the future will be preserving the right balance between spending and saving for future generations. Given that non-oil/gas sector development will be vital to economic growth over the long term, the appropriate use of oil/gas revenue should assist by building an enabling environment for business through wisely spending on infrastructure, human capital and basic services. In addition, the authorities need to build adequate institutional capacity to manage the oil/gas wealth carefully. Overall, the authorities are to be encouraged in their policy to spend, but to spend wisely.

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1Prepared by Yitae Kevin Kim.
2The fiscal year runs July to June.
3Oil/gas revenue is based on the NYMEX forward price minus 5 dollars ($39.6, $38.2, $35.9, $34.5, $33.7, and $33.2 per barrel, 2004/05–2009/10). Future prices after 2010/11 are assumed to grow 2.5 percent a year.
4The Timor-Leste Government receives two streams of revenue from the petroleum fields in the JDPA, tax revenue and royalty payments. Tax revenue is gained by levying taxes (including income and withholding taxes and VAT) on companies (e.g., petroleum and construction companies) operating in the JDPA. The Government also gets royalty payments, called first tranche petroleum (FTP), from the Bayu-Undan field when the petroleum companies sell the Government’s share of petroleum on the Government’s behalf.
5This section draws heavily on the public consultation paper on the establishment of a petroleum fund for Timor-Leste, prepared by the Ministry of Planning and Finance (2004).
6Calderon, Easterly, and Serven (2003) estimate that infrastructure compression in the 1990s reduced longer-term growth by about 3 percentage points a year in Argentina, Bolivia, and Brazil, and by 1.5-2 percentage points a year in Chile, Mexico, and Peru.
7For example, during its post-independence development Nigeria over-invested in physical capital and subsequently suffered from poor productivity, mainly due to poor institutions and political pressures for excessive public investment (Sala-i-Martin and Subramanian, 2003).

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