POLICY BRIEF

Enhancing Factor Productivity to Drive Growth in Timor-Leste

Education can help drive growth in productivity by spurring innovation and improving labor skills.
Education can help drive growth in productivity by spurring innovation and improving labor skills.

Published: 25 January 2021

A coordinated policy approach toward improving market efficiency, education outcomes, and infrastructure will enable the highest possible growth.

Introduction

Timor-Leste attained the status of a lower middle-income country in 2007 with rapid growth and expansion from offshore petroleum income. The rising government expenditure has since underpinned the growth in gross domestic product (GDP).[1] However, economic growth progressively slowed down over the last decade.

Despite receiving oil and gas revenues since 2005, poverty levels are high with almost 70% of the population living below $1 per day and there is a wide economic gap with ASEAN countries.[2]

Timor-Leste has a narrow economic base. Besides government spending, small-scale wholesale and retail activities, subsistence agriculture, construction, and real estate activities are the major contributors to GDP. The contribution of manufacturing, although increasing, remains negligible, accounting for roughly 25% of GDP in 2018. Agriculture represents about 14% of GDP, but 66% of households are involved in some form of agriculture activity. The country exports a narrow range of products and services. Agricultural products, mainly coffee, make up the bulk of exports. Tourism is the second largest source of non-oil foreign exchange, but Timor-Leste’s tourism potential remains largely untapped.

Taking a structural perspective to disentangle growth in Timor-Leste, this policy brief traces the potential sources or drivers of output growth. Growth modeling points to existing structural weaknesses and the need to improve total factor productivity (TFP) for the country to achieve upper middle-income status. We briefly describe different growth scenarios which underline the imperative for the government to accelerate reforms toward addressing gaps in education, institutional capacity, and infrastructure to improve the productivity in the economy. Ultimately, only the simultaneous and coordinated execution of strategies in these three areas of constraint will allow Timor-Leste to take the highest possible growth path.

This paper, based on the Solow–Swan Growth Model, summarizes the background analysis done for the government’s Economic Recovery Plan, which tackles the economic downturn caused by the coronavirus disease (COVID-19) crisis.

Recent Developments

During the first half of the last decade, Timor-Leste enjoyed a 5.6% average GDP growth. The Strategic Development Plan 2011–2030 set the goal to sustain double-digit growth rate during 2010–2020 and achieve upper middle-income status by 2030 at an average growth rate of 8.3%. However, GDP growth fell under 10% in 2010 and has seen a steadily decreasing trend since. In 2017–2018, political uncertainty constrained public spending, resulting in a sharp contraction of GDP in 2017 and flat growth in 2018. The elections in May 2018 ended the year-long political impasse and the economy was expected to gradually recover in 2019. However, a new political stalemate led to a rejection of the 2020 Budget which aggravated the economic downturn already brought by the COVID-19 pandemic and caused a contraction of the economy for the third time in 4 years.

The successive economic downturns highlighted the fragility of the economy, and in particular its high reliance on government expenditure to fuel growth. Notwithstanding impressive progress since independence in 2002, Timor-Leste remains a fragile, post-conflict nation with weak human and institutional capacity and large infrastructure gaps, and the young nation’s challenge remains to effectively manage its petroleum wealth to reduce public-sector dependence, diversify the economy, generate jobs for a young and rapidly growing population, and raise living standards (IMF 2019).

The Importance of Increasing Total Factor Productivity

GDP has been largely driven by government current and capital spending and is for the most part underpinned by economic activities in construction and public administration. Petroleum production from active fields is projected to end in 2022, and it is unclear when Timor-Leste will be able to receive revenue from the new Greater Sunrise field currently under exploration. Enabling the young and rapidly growing population to secure quality jobs, reforming institutions to establish the “software” requirements of efficient markets,  and fast-tracking “hardware” support through utilities and connectivity infrastructure development, are among the main challenges faced by the country. In the realm of growth accounting, these binding structural constraints are akin to a TFP deficit.

Using a growth accounting framework, the Asian Development Bank (2011) estimated the key inputs required by the Timor-Leste economy to narrow its income gap with the upper middle-income economies by 2030 and also estimated the required accumulation of human and physical capital and improvements in productivity. On replicating the simulations with updated data, we compare Timor-Leste’s baseline growth path with four scenarios of factor productivity growth to disentangle the potential structural sources of output growth improvements.

The Baseline. In the baseline scenario, the GDP per capita growth path plateaus at 2.5-3% during 2022–2050. Figure 1 shows that human capital accumulation is the primary contributor to GDP per worker growth, followed by capital per worker accumulation, while the contribution of TFP to GDP per worker growth is extremely limited. This provides an important insight as to why the path of GDP per capita flattens; growth is not able to “take off” because of the very weak improvements in factor productivity. While accumulating physical capital is important as the country transitions from lower to upper middle-income status, Timor-Leste will eventually experience diminishing marginal returns. Additionally, maximizing benefits from the “demographic dividend” through education outcomes needs to supplement by accelerated improvements in labor productivity that are realized outside schooling. The limited improvements in TFP are exemplified by low labor productivity.

Figure 1: Drivers of GDP per Worker Growth

GDP = gross domestic product, TFP = total factor productivity.
Note: Contribution of capital per worker accumulation includes effects of demographics and labor market variables that work though capital per worker growth.

TFP improvement, or growth in productivity, has played an increasing role in growth for the middle-income economies; even as they accumulate more physical and human capital, the focus progressively shifts to areas with more positive productivity spillover, such as advanced infrastructure and higher education, to be able to sustain higher levels of growth. Figure 2 shows that Timor-Leste’s historical TFP growth has been below regional average.

Figure 2: TFP Index Historical Change

TFP = total factor productivity.
Source: World Bank Long Term Growth Model (LTGM) estimates.

The Four Scenarios

We identify five drivers of productivity growth:

  1. innovation to create and adopt new technologies;
  2. education to spread these new technologies through the economy and develop the capacity of the workforce;
  3. market efficiency to promote the effective and flexible allocation of resources across sectors and firms;
  4. infrastructure in transport, telecommunication, energy, and water and sanitation to support and facilitate economic activity; and
  5. institutions in the regulatory, justice, policy, and political systems to provide socioeconomic stability, defend property rights, and safeguard civil rights.

These five components are interrelated. To assess the impact of specific productivity improvement scenarios on Timor-Leste per capita income growth, we look at a range of possible TFP growth trajectories through different scenario simulations.[3]

Scenario 1: Improving market efficiency. In the first scenario, constraints to market efficiency and public institutions are loosened, allowing Timor-Leste to achieve efficiency gains in doing business and governance indicators. Increased efficiency in allocation of resources across firms and sectors and good governance have positive effect on economic productivity. We find that Timor-Leste can substantially improve its overall TFP growth path to as high as 0.6%. Levels of market efficiency indicators, such as doing business scores, women employment-to-wage earning jobs, and financial development index, can serve as guideposts in designing policies aimed at addressing bottlenecks in the domestic market. Paths of institutional indicators, especially those reflecting regulatory quality and government effectiveness, can also serve as guidelines toward proper phasing of policy actions in institutional reform and capacity building.

Scenario 2: Improving education outcomes. In the second scenario, constraints to education outcomes are lifted with Timor-Leste achieving higher levels of labor skills. Education, defined as the knowledge and skills of the population, is essential to generate new technologies, as well as to disseminate, adapt, and implement them throughout the economy. The number of schooling years and the completion rate of secondary and tertiary education of the population are associated with output growth through both TFP improvements and through the direct contribution of human capital. It also enables countries to adopt new technologies from frontier countries more quickly. Timor-Leste could substantially improve its overall TFP growth path in such a scenatio to as high as 0.62% in the high-end spectrum case and achieve GDP per capita levels of $2,836 by 2050. With a young and growing working labor force, the country needs to continue to invest in policies and strategic actions geared toward increasing the attendance rates in secondray eduction and toward improving the quality of education, which remains low.

Scenario 3: Improving infrastructure. The constraints to infrastructure development are lifted in the third scenario by allowing Timor-Leste to achieve higher investments in connectivity infrastructure, which provide timely and cost-effective access to input and output markets, workplaces, and knowledge and information sources, thus supporting various economic activities. Expanding public infrastructure could improve overall TFP growth path to 0.46% and attain GDP per capita levels of $2,716 by 2050. This is lower than the two previous scenarios, as physical capital factor accumulation is considered subject to faster diminishing returns. It nonehtless highlights the immediate need to improve access to high-quality connectivity infrastructure and provision of basic utilities.

Scenario 4: A combined effort to improving TFP. Finally, we allow for a simultaneous improvement of market efficiency, education outcomes, and infrastructure. Under this fourth scenario, Timor-Leste improves its TFP path by up to 3.0% and realize a real GDP per capita value of $3,470.60 by year 2050 and an average GDP per capita growth of 4.0%. It is noticeably clear that a coordinated policy approach generates the biggest push to per capita output growth. Ultimately, only the simultaneous and coordinated execution of policies and strategies in the three constraint-areas will let Timor-Leste achieve the highest TFP growth path possible, as high as 1.2%.

The four scenarios compared to the baseline case is in Figures 3 to 5 and summarized in Table 1.

Figure 3: Growth Paths of TFP Sub-Componants under the Four Scenarios

TFP = total factor productivity.
Source: ADB estimates.

Figure 4: Contribution to Growth under the Four Scenarios

Source: ADB estimates.

Figure 5: Annual TFP Growth Rate under the Four Scenarios

TFP = total factor productivity.
Source: ADB estimates.

Table 1: Findings from the Different Scenario Simulations

   

Scenarios

 

Baseline

1. Market Efficiency

2. Education

3. Infrastructure

4. Combined Effort

Average GDP per capita growth rate (2021–2050)

2.39%

2.97%

3.01%

2.86%

4.00%

Real GDP per capita at year 2050 (constant US dollars)

2,370.50

2,807.00

2,835.50

2,716.40

3,470.60

GDP = gross domestic product.
Note: Upper middle-income status (in a non-petroleum GDP case) is not realized during 2020–2050.
Source: ADB estimates.

Policy Recommendations

The decline in TFP growth in Timor-Leste, observed before the COVID-19 crisis, reflects not only the stagnation of resources to sectors where productivity growth was slower (e.g., in agriculture) but also declining productivity growth within those sectors that increasingly account for the bulk of employment and economic activity. Alongside savings, investment, labor participation, and human capital formation, harmonized TFP improvements should continue to figure prominently in the country’s development agenda. Identifying the key sectors and intervention that are most likely to lead to increase in the productivity of the economy is key to ensure the highest possible growth.

Achieving double-digit growth in GDP as targeted by the Strategic Development Plan 2011–2030 would require extraordinarily strong performance across all key sources of economic growth and is unlikely to be achieved. A lower growth rate of GDP in the low single digit would be more firmly within the bounds of expectations and would still put Timor-Leste in close to similar footing as the fast-growing economies in developing Asia over the period 2020–2050. The growth projections are supportive of the current emphasis on public investment in physical and human capital and efforts to put in place the enabling environment required for private sector-led growth. The Strategic Development Plan presents important initiatives in these areas. Faster rate of implementation of these initiatives will enhance the prospects for economic growth, in particular:

  • Structural reforms. Reforms to increase labor productivity and enable diversification will be key to generate much-needed job growth and private sector investment. Efforts should continue to focus on improving quality of and access to education and healthcare, reduce skill gaps, encourage business formation, and promote private investment.
  • Financial sector development.  Additional efforts to develop the financial sector should help channel domestic savings to productive investments, while expanding access to financial services will be essential to facilitate diversification and promote inclusive growth. Ensuring a strong and effective regulatory and supervisory framework will be important to safeguard financial stability as the financial sector develops.
  • Capacity building. Ongoing efforts to strengthen public financial management and promote good governance are crucial to ensure public investment efficiency and enhance the quality of public services. Ongoing reforms addressing capacity gaps in fiscal management, financial regulation and supervision, and statistics is crucial to support reform efforts.

This policy brief was prepared by Kavita Iyengar, Anthony Baluga, and Claire Potdevin.


[1] GDP refers to non-petroleum GDP.

[2] Timor-Leste ranks 144 out of 186 on GDP per capita (IMF 2020 estimates).

[3] Policy interventions on the specific factors of TFP growth were projected. In these scenarios, we assume Timor-Leste would replicate the trajectory of the East Asia and Pacific benchmark country, the Republic of Korea, which has increased its overall TFP determinant index the most in 1985–2014 over all countries in the region.

References

Asian Development Bank. 2011. Economic Growth to 2030 in Timor-Leste. Manila.

International Monetary Fund. 2019 Article IV Consultation: Staff Report. Country Report No. 19/124. Washington D.C.

Y.E. Kim and N.V. Loayza. 2019. Productivity Growth: Patterns and Determinants across the World. WPS 8852. Washington, D.C.: World Bank.

World Bank. 2020. Timor-Leste Economic Report: A National Under Pressure. Washington D.C.

Ask the Experts

  • Kavita Iyengar
    Country Economist, Southeast Asia Department, Asian Development Bank

    Kavita Iyengar is country economist at ADB’s Timor-Leste Resident Mission. Previously, she was focal for regional cooperation and knowledge management at the India Resident Mission for over a decade.  Kavita has varied work experience in teaching, environment consulting, and publishing. She has a Ph.D. from Clark University in the United States.

  • Asian Development Bank (ADB)

    The Asian Development Bank is committed to achieving a prosperous, inclusive, resilient, and sustainable Asia and the Pacific, while sustaining its efforts to eradicate extreme poverty. Established in 1966, it is owned by 68 members—49 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance.

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