THE ECONOMIST INTELLIGENCE UNIT 30 May 2002

East Timor: Economy: News analysis

The morning after

COUNTRY BRIEFING

At midnight on May 19th-20th, the UN Secretary General, Kofi Annan ceded UN authority over East Timor to its new government, making this former Portuguese colony and Indonesian province the first new nation of the 21st century. As East Timor emerges into the cold light of its independent dawn, it must grapple with a daunting set of economic, political, social and security problems. Prospects are anything but encouraging.

The legacy of Portuguese neglect and, more recently, Indonesian occupation, has consigned East Timor to poverty. GDP per head was less than US$480 in 2001, and more than 40% of the population lives below a poverty line set at 55 US cents a day. The literacy rate is around 40% and life expectancy is just 57 years. These social indicators translate into a UN Human Development Index ranking that places East Timor in the company of Rwanda, Bangladesh, Angola and Mozambique.

Despite the country's oil and natural gas riches in the Timor Sea, there is no prospect of a quick turnaround for the East Timorese economy. Startling annual average GDP growth in excess of 20% in the last two years was enough to bring GDP close to 1998 levels. These growth rates were possible because of the boosts given to the economy by reconstruction in the wake of the devastation that surrounded the Indonesian withdrawal in September 1999 and by the massive international presence. Neither will be sustained.

The bubble created by the international presence has already burst. There is still much reconstruction to be done, but budgetary constraints and limited absorptive capacity are expected to put a sharp brake on reconstruction over the next few years. The government expects GDP to contract by 0.5% this year and by 2% in 2003. Earlier projections that natural gas revenues from the Timor Sea would transform the country's economic prospects after 2006 have now been scaled down. There is scope for growth in other sectors, particularly agricultural processing and tourism, but a number of fundamental issues - foremost among them the confusion surrounding land and property rights that is another legacy of colonialism and occupation - will have to be tackled first. Growth in these sectors will only come with substantial new investment.

In the coffee industry, for example, which is likely to be the country's leading non-oil/gas export earner for some time, productivity is extremely low (the World Bank believes that there is scope for doubling current yields of 150-200kg/ha) and costs are high. Investment in replanting, infrastructure, transport and marketing would not only increase yields and reduce costs but would also help East Timor ensure that more of its production reaches the niche market for high-quality organic coffee. At present only about one-third of the 10,000 tons of coffee that the country produces is suitably processed to be sold in this market, and only about one-third of that amount is actually sold as high-quality organic coffee because of a paucity of buyers.

The energy sector continues to be an area of special focus in East Timor. In a move that will have important long-term implications for the country's economic future, on May 20th, East Timor's first day as an independent state, the Australian prime minister, John Howard, and his East Timorese counterpart, Mari Alkatiri, signed the Timor Sea Treaty. The treaty assigns revenues from hydrocarbons exploitation in the area known as the Timor Gap, the portion of the Timor Sea left undefined since 1972 when Australia and Indonesia, but not Portugal, agreed their maritime boundaries. Under a treaty concluded in 1991, Australia and Indonesia agreed to create a Zone of Co-operation and to share the revenues generated by its resources on a 50:50 basis. After lengthy and often rancorous negotiations between the Australian government and the UN transitional administration, in July 2001 the two parties initialled an agreement that changed the split, in what is now known as the Joint Petroleum Development Area (JPDA), to 90:10 in East Timor's favour. This was the basis of the treaty signed on May 20th.

The agreement covers the Bayu Undan field in the Timor Gap, operated and 58.6% controlled by the US company, Phillips Petroleum, and the 20% of the Greater Sunrise field which lies in the JPDA. The Bayu Undan's estimated reserves of 400m barrels of condensate and 3.4trn cubic feet of natural gas are expected to yield revenues of up to $3.2bn for East Timor over its 17-year life span. Revenues from Bayu Undan will start to flow in 2004 as condensate comes on stream, but the more lucrative gas production from the project is not expected to start until late 2005 or early 2006, and will not peak until many years later. On present (admittedly conservative) assumptions, East Timor will receive estimated revenues of $32.7m in 2004/05 (July-June), rising to $99.1m in 2007/08. To put these figures into perspective, even by 2007/08 East Timor is expected to have a budget deficit equivalent to 16% of GDP, which will have to funded almost entirely by foreign aid.

The government that confronts these economic problems is untested. The pool of local expertise that it can draw on is limited. A last-minute truce between the country's two leading political figures - the president, Xanana Gusmao, and the prime minister, Mari Alkatiri -cobbled together on the eve of independence, could easily break down. Mr Alkatiri's party, Fretilin, has a parliamentary majority and dominates the Council of Ministers (cabinet). Mr Gusmao, the national hero who rebuilt the resistance to Indonesia during the 1980s as a broad-based movement of national unity, is seen as a more conciliatory and inclusive figure than the partisan prime minister. Clashes are possible over a number of issues, including some that have already emerged: lack of government transparency, the politicisation of the civil service, recruitment into the East Timor Defence Force (ETDF) and the relative weights to be given to justice and reconciliation in dealing with the crimes committed by Indonesians and East Timorese during the occupation.

Two large questions dog the new nation's external security: How durable will Indonesia's commitment to normalisation with East Timor prove to be? How far can East Timor rely on the backing of the international community? After much hesitation, the Indonesian president, Megawati Sukarnoputri, did come to Dili for independence day. At the same time her armed forces conveyed their displeasure at her decision by putting on a show of belligerence that included the deployment of a warship in Dili harbour. The ultimate fear is a scenario in which a nationalist military takes power in Jakarta and joins forces with hard-core East Timorese ex-militia based in West Timor to foment trouble across the border. Less dramatic, but more likely, is the possibility of lower-level destabilisation exploiting local East Timorese grievances.

A staple of the dignitaries' speeches on the night of May 19th were pledges not to abandon East Timor. The UN will retain a presence in the form of a much-reduced civilian component, providing advice and filling some of the capacity gaps, and sizeable police and military contingents. The UN Peacekeeping Force's (PKF) strength on East Timor's borders with Indonesia is to be maintained at current levels for now, but joint US and French pressure is likely to ensure that it will be wound up by the end of 2004.

Meanwhile, dwindling international attention on East Timor will have diminished further. Already, with the new government of Jose Manuel Durao Barroso facing its own budgetary constraints, Portugal's assistance to East Timor is being cut, while other less directly interested parties, such as the EU, have announced their own reductions in aid. The commitment of Australia, the country with the greatest strategic interest in a stable East Timor, is not limitless either.

A mixture of self-interest and uneasiness with a Fretilin-led government could well lead Australia to lower its profile in East Timor. Australia's interests dictate that it places high priority on putting its relationship with Indonesia back on course. For that reason, it has made it clear that it does not intend to maintain a military presence in East Timor once the UN PKF withdraws, preferring some kind of informal trilateral security arrangement that would include Indonesia.

A confrontation is already looming between Australia and the new government over the maritime boundaries between the two countries. East Timor is seeking to have the boundaries redrawn on the basis of the principle enshrined in the UN Convention on the Law of the Sea that sets the midpoint between two countries separated by less than 400 miles of sea as the recognised maritime boundary. It is estimated that bringing all of the 9.2trn cubic feet of gas reserves in the Greater Sunrise field and the already producing Laminaria/Corallina oil fields (all of these are operated by Woodside Petroleum of Australia) under East Timorese control would quadruple East Timor's oil and gas revenues. Australia rejects the median-point principle, and has said that it will not accept jurisdiction of the international court should East Timor try to bring a case.

Among the many international agreements to which East Timor has signed up since independence is the ASEAN Treaty of Amity and Co-operation. Although membership is still probably five years away and the sheer cost of full participation looks like being an obstacle to full participation, East Timor's security may well be best guaranteed by its gradual embedding in ASEAN. Several ASEAN countries, most prominently Thailand, the Philippines and Singapore, all of which have contributed troops to the UN PKF, are open to giving East Timor observer status. Ultimately, East Timor's external security will depend on such diplomatic arrangements rather than on explicit defence agreements.

SOURCE: ViewsWire London

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