Increasing Access to Investment Credit for SMEs 

In Timor‐Leste: A Review of Options 

 

 

08/13/2009 

By Consultant Lene M.P. Hansen

For the Better Business Initiative (BBI), Timor-Leste’s Public-

Private Dialogue, facilitated by the International Finance Corporation (IFC)

Table of Content

1. EXECUTIVE SUMMARY .............................................................................................................................1 2. BACKGROUND AND INTRODUCTION ..............................................................................................6 3. CLARIFYING THE CONSTRAINTS ......................................................................................................7

3.1 THE MEDIUM- AND LARGE ENTERPRISES (MLES) .................................................................................8 3.2 SMALL AND MEDIUM ENTERPRISES (SMES)...........................................................................................8 3.3 THE MICRO-SEGMENT (HOUSEHOLDS AND MES) ................................................................................10 3.4 SUMMARY OF CONSTRAINTS ...................................................................................................................11

4. THE RATIONALE FOR GOVERNMENT PARTICIPATION.......................................................12 4.1 WHETHER AND HOW MUCH TO PARTICIPATE ........................................................................................13 4.2 HOW TO PARTICIPATE..............................................................................................................................13

4.2.1. Be a Savvy Investor ..............................................................................................................................16 4.2.2. Demand must drive – it cannot be sustainably ‘created’ .....................................................................17 4.2.3 Test the Product before Institutionalization .........................................................................................18

4.3 THE OBJECTIVES OF GOVERNMENT PARTICIPATION .............................................................................20 5. OPTIONS FOR PARTICIPATION .......................................................................................................21

5.1 CO-INVESTMENT IN A MICROFINANCE APEX FUND...............................................................................21 5.2 A GOVERNMENT-OWNED BANK FOR MSMES........................................................................................23

5.2.1 Options for IMfTL ................................................................................................................................24 5.3 INCREASED INVESTMENT FINANCE TO VIABLE SME PROJECTS ............................................................25

5.3.1 A State-Owned Development Bank.......................................................................................................25 5.3.2 Credit lines ...........................................................................................................................................26 5.3.3 Credit Guarantee Institution (CGI)......................................................................................................27 5.3.4 Credit Risk Share Facility ....................................................................................................................29

5.4 THE ENABLING ENVIRONMENT – NON-FINANCIAL SUPPORT TO SMES..............................................31 5.5. THE MEGA PROJECTS – PHYSICAL INFRASTRUCTURE PPPS .................................................................32

6. CONCLUSIONS AND RECOMMENDATIONS ................................................................................34 6.1 A PRAGMATIC POLICY APPROACH ............................................................................................................34 6.2. CLEAR DIAGNOSTICS ...............................................................................................................................34 6.3 SELECTIVE AND EXPERIMENTAL, PARTICIPATIVE REFORMS...................................................................35

Annexes

1. Setting for the Financial Services Sector debate in Timor-Leste mid-2009 2. An Update on Rural Development and Rural Finance

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Acronyms and Abbreviations ADB Asian Development Bank ADR Alternative Dispute Resolution ANZ Australia and New Zealand Banking

Grp. BBI Better Business Initiative BDC Business Development Center(s) BDS Business Development Services BIDV Bank for Investment and

Development, VIE BNI Bank Negara Indonesia BOD Board of Directors BOM Bank of Maldives BOP Bottom of the (economic) Pyramid BPA Banking and Payments Authority CGD Caixa Geral de Depositos CGI Credit Guarantee Institution CIT Cash in Transit FDI Foreign Direct Investment FIF Fund for Inclusive Finance FSP Financial Service Provider GDP Gross National Product GOI Government of Indonesia HH Household IADE Institute of Business Support ICT Information and Communication

Technology IFC International Finance Corporation IFI International Financial Institution IMfTL Instituição de Microfinanças de

Timor-Leste INFUSE Inclusive Finance for the Under-

Served Economy Project JV Joint Venture LIH Low-Income Households LoC Letter of Credit LoG Letter of Guarantee MCTI Ministry of Communication, Trade

and Industry ME Microenterprise MF Microfinance

MFI Microfinance Institution MLE Medium- and Large-sized

Enterprise MoED Ministry of Economy and Development MoF Ministry of Finance MR Moris Rasik MSE Micro- and Small Enterprise MSME Micro-, Small and Medium-sized Enterprise NBFI Non-Bank Financial Institution (I)NGO (International) Non-Govern- mental Organization NPL Non-Performing Loans OPM Office of The Prime Minister PaR Portfolio at Risk (NPL for microfinance) PCG Partial Credit Guarantee PPP Public-Private Partnership PRC People’s Republic of China RMDC Rural Microfinance Development Centre, Nepal RNFE Rural Non-Farm Enterprise(s) SCIC State Capital Investment Corporation, Vietnam SEP Small Enterprise Project SHG Self-Help Group SME Small and Medium-sized Enterprise SOB State-Owned Bank SOE State-Owned Enterprise TA Technical Assistant/Assistance TFET Trust Fund for East Timor UNCDF United Nations Capital Development Fund UNDP United Nations Development Programme VBSP Vietnam Bank for Social Policy WB(G) World Bank (Group)

1. Executive Summary This report presents options for Government of Timor-Leste participation in the financial services sector that are based on a pragmatic policy approach and a careful diagnostic of actual constraints. With this approach, Government would be able to experiment with participation in limited, defined and incremental reforms in the financial sector of Timor-Leste to resolve or minimize the constraints and allow new learning to be created from effective monitoring and feedback to guide the process. Since Independence, the Government of Timor-Leste has retained a firm strategic commitment to a market-led economy with the private sector as the primary engine of growth. However, the nascent private sector of Timor-Leste has so far been unable to spur sufficient economic development for the rapidly increased population. Several years of severe budget execution problems and stagnation in the non-oil sectors (2004-06) contributed to increased poverty, serious civil unrest in 2006, and a change of government in 2007. Since then, the Government has significantly increased public expenditures to generate employment and income for the East Timorese, and the economy is now dominated by public spending. Through the IFC-supported Inisiativa ba Negosios Diak Liu (Better Business Initiative) public-private dialogue1 the business community has identified access to longer-term investment finance as a key constraint to growth but effective demand2 is much lower than stated demand and there are several other constraints that additional credit would not resolve. On the supply side, the financial service providers complain that there are very few bankable proposals from enterprises, and that the market risks are too high for longer-term lending. The constraints on the demand and supply sides are exacerbated by weaknesses in the enabling environment for the financial sector. Any government will want the maximum ‘bang for its buck’ when considering participation in a conventionally ‘private’ part of the economy. Investments under consideration must necessarily present as opportunities for comparatively high leverage and returns (whether economic or social). If the government is to invest to resolve a perceived market-dysfunction in an otherwise ‘self-funding’ sector, there has to be a good rationale and a credible and proportional return, even if it is long-term. It is not evident that participation in the financial services sector in Timor-Leste will provide the highest returns for the Government of Timor-Leste’s investment. However, since 2007, the Government has taken an interest in facilitating increased access to finance for the micro-, small and medium-sized (MSME) enterprises that make up the vast majority of the Timorese private sector and it is possible that a relatively small investment can be highly leveraged and thus presents a competitive ‘internal rate of return’. While the desired outcome has not yet been quantified, the Government of Timor-Leste agencies involved in private sector development do seem to have coalesced around four expected returns (objectives) for intervention(s) in the financial services sector that coincide with the four segments of wealth, scope and size of the demand community:

1 As expressed by the Joint Private Sector Presentation at the meeting with the Prime Minister and MCTI on 14 April 2009, for example. 2 Effective demand for credit is defined in the BBI Credit Demand Study as ability to service and repay a loan calculated based on annual net income (disposable cash), and assets. Johansson, Johanna S.: Credit Demand by Micro, Small and Medium Scale Enterprises in Timor-Leste: An Assessment, IFC Better Business Initiative Timor-Leste, August 2009.

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Sector/economic Segment3: Govt expected outcome from participation: A. Micro-level (85% of population) Rural/urban poor, low-income households and microenterprises

Increased scale (outreach) and depth of urban and rural microfinance

B. Micro- & Small level (20% of registered businesses) Rural and urban low-medium income households and micro- and small enterprises

Increased linkages between the rural and urban economies (intermediation) – increased access to capital

C. Small & Medium level (64%% of reg. businesses) Rural and urban SMEs

Increased investment finance of viable SME projects by commercial banks

D. Top level (16% of reg. businesses) Medium and large-sized enterprises, FDI companies and Government itself (PPPs)

Better informed investment decisions for government investment in public private partnerships

Governments can participate in many ways in a conventionally ‘private’ sector like financial services, and in many countries across the globe governments have done so with more or less success. Government participation in the financial sector can go well or poorly, can help meet the desired objectives or not, but it always impacts the sector significantly – either positively or negatively, and it is therefore important to understand the short- and long-term implications of any intervention. As has been documented in many countries, failed government interventions in the financial sector can be utterly devastating for the entire economy of a country, are extremely expensive, and do generally take many years to overcome. Therefore, participation is less about whether and how much the Government ‘should’ intervene for political reasons than it is about ‘how’ and ‘how smartly’ this is done. In the steep learning curve of development over the past 50 years, which is discussed in Section 4, three aspects of participation seem to be pivotal to successful government interventions in the financial sector: • Commercial awareness; • Demand-drive; and • Focus on the product. The Government of Timor-Leste is already participating as a partner in Timor-Leste’s financial services sector in two specific ways, which directly address the two first objectives (see above), and reasonably, the focus of these interventions has been to assist the poorer segments of society by: 1. Co-funding an apex institution providing capacity building and funding to

MFIs (INFUSE). INFUSE should ensure increased outreach to rural and urban microfinance through funding of MFIs, but it is equally important that product development is promoted through the funding of design, test and roll-out feasible deposit, remittance, micro-insurance, micro-leasing and agricultural finance products; and that the industry is supported by an NBFI or MFI Circular/Decree to clarify that MFIs are part of the financial sector, can register as financial service providers, and may take deposits if reasonable prudential regulation and reporting can be met. Likewise, MFIs and their clients need to be linked to relevant opportunities for training and market access; and all funders and investors in the industry need to join the Fund for Inclusive Finance to enhance coordination and coherence in the small market.

3 Around 85% of the population is self-employed, used as a proxy for poor or low-income, as per UNDP: Human Development Report 2006 A Path out of Poverty. The indicative percentages of total registered (formal) enterprises are taken from the Johansson, Credit Demand by Micro, Small and Medium Scale Enterprises in Timor-Leste, August 2009, op. cit., which

2 surveyed 2.5% of all registered/licensed businesses in the country.

2. As owner of IMfTL, providing strategic direction to the revitalization, growth and re-licensing of this quasi-bank. Whether IMfTL will focus on MSEs or poor households in future, technical and

managerial assistance is needed to clarify the mission, objectives, business operations and target markets, and to tailor the products for its target clientele and strengthen risk management systems before applying for a banking license and expanding its branch network. The Asian Development Bank is currently undertaking a strategy and business plan development process that will include a corresponding implementation plan.

With the requests for assistance increasingly voiced by the private sector and the inability of banks currently operating in the market to meet a significant portion of effective demand, the Government is now considering how to participate most effectively and viably in the sector to attain the third objective: increased SME investment credit. This report reviews the following options for participation to inform the decision making process: • An (additional) state-owned development bank

Some degree of state ownership in a bank which is allowed to operate on commercial principles and is well-insulated from political pressure through a competent and independent Board and management can be a very successful addition to a financial sector - provided that there is enough effective demand for it to charge reasonable rates and still cover at least its operational costs and retain the value of its capital. Recent research on the size of demand does not indicate that there is sufficient demand for a fully fledged new bank to meet the need of the SMEs for investment capital in Timor-Leste and this would only dilute the scarce human resources further.

• A Credit Guarantee Institution (CGI) or Fund As with state-owned banks, government funded CGIs run the risk of distorting

commercial incentives (banks with guaranteed portfolios tend to be less vigilant in their credit appraisal and client monitoring); encourage directed or ‘policy’ lending; and diminish efficiency. Due to the size of the market and the lack of support services for the financial sector such as re-guarantees, and informed by the significant losses and difficult implementation structures of Guarantee Institutions elsewhere in Asia, a formal Credit Guarantee Institution is not recommended as a viable option for the country. However, the Government can share the risk of the longer-term, larger loans that SMEs demand in a less institutionalized way such as a credit risk share facility.

• Credit lines channeled through commercial banks By directly intervening in retail credit by making subsidized credit available, a

government will usually harm rather than encourage the current providers, and may lead people to borrow or lenders to lend for more risky activities which will end up failing. As experienced also in Timor-Leste under the SEP I project channeled through BNU/CGD, the channeling of capital as risk-free credit lines almost always leads to huge defaults and results in contraction and regression, thus actually reducing the access of SMEs to credit. In addition, the government as an investor will often get no financial return on such credit lines. Credit lines work best if there is a liquidity problem in the market, which is not the case in Timor-Leste, and for credit lines to work, the lending institution needs to retain sufficient risk to subject the loan applications to the normal appraisal and approval procedures – even if the pricing may be less because the risk is shared with a third party.

3. A Credit Risk Share Facility

The best option for the Government of Timor-Leste to assist SMEs in accessing longer-term investment loans would be to participate in a tripartite Public-private partnership structured as a Credit Risk Share Facility (CRSF) for the financial services sector. A CRSF would be able to address the demand while avoiding the majority of the pitfalls experienced in similar markets and in the rest of Asia with government-funded guarantee schemes. It would also be able to under-write new products that

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may at the outset seem too risky for financial institutions to test and roll-out in the country, and could thus act as a stimulant for new product development. Funding contributions could come from Government through the Ministry of Economy and Development/Ministry of Finance; the participating financial institutions (commercial banks and IMfTL); and an International Finance Institution (IFI) with expertise in the structuring of risk sharing funds should be sought. The initial capital of the CRSF would not have to exceed US$ 10-12 million. The basic operating principles of the CRSF include scope and size of portfolios and loan types to be guaranteed; type of guarantee; and non-guarantee benefits of participation, and are outlined in section 5.3. All guarantee facilities should be structured to incentivize borrowers to graduate to guarantee-free financing. This requires non-financial support (training, mentoring, business development services) to SMEs. And it requires a well functioning financial market with credit ratings, credit bureaus and asset registries. A more enabling environment thus remains the responsibility of a supportive government and the precondition for a well-functioning and dynamic financial services sector.

4. A National Investment Center An increasing number of large public work contracts and proposals are vying for Government attention and funding under budgets that are already significantly higher than the ‘sustainable income’ generated by the Petroleum Fund. Large public infrastructure investments require differently structured finance that does the majority of the SMEs in the country. While outside of the scope of this report, it is recommended that Government considers a National Investment Unit to perform the technical analysis, selection and monitoring of large public investment projects. To reduce political risk, such a Unit could be twinned with expertise at e.g. regional universities. The Unit would be charged with the technical, financial, social and environmental impact assessment of each large-scale investment proposal received and would present its recommendations as a prioritized list of investments within the national capital budget for the decision of the Council of Ministers.

There are great benefits to being a young Nation in an interconnected world because it is no longer necessary to repeat the entire punishing cycle of learning from ‘zero’ within development. Rather, the lessons learned by other governments in similar circumstances provide a cutting-edge starting point.

With a flexible modern policy approach to ‘learning through monitoring and innovation while doing’, the Government of Timor-Leste is eminently well placed to avoid the expensive historic pitfalls of government intervention in the financial services sector and thus potentially ensure a ‘quantum-leap’ development for the small market.

Summary of options for Government participation in the financial services sector

INCLUSIVE & EXPANSIVE FINANCIAL

SECTOR DEVELOPMENT

Private sector: - Needs short-term

opportunities and capacity to participate and profit

- Structural challenges: Geo-economic location with few comparative advantages in region (low non-oil trade/export), small and young population, high population growth human resource/capacity gap, under-developed rural economy;

- Core problems: Capacity gap, low rural incomes, rapid urbanization, high unemployment, increasing poverty; inadequate physical and social infrastructure and basic services, lack of effective institutions to implement policies, absence of land rental markets.

- Vulnerabilities: emerging corruption, root causes/aftereffects of civil unrest, open economy – oil/commodity prices.

Environment: - Significant challenges and trade-offs

Government: - Needs long-term justifiable rationale for comparatively high return on budget investment

Segment: A (Micro) B (MSEs) C (SMEs) D (MLE/PPPs) Investment BOD and TA Credit Risk National Investment in Apex for IMfTL Share Facility Clearing Unit (INFUSE) divestiture w/ banks & IFI Status: Done Ongoing Structure in OPM

Demand side: - Investment (LT) credit - Business loans, leasing, - Increased rural/micro

services - Insurance, agric.

Services - Capacity building (fin.

man.)

Supply side: - Bankable projects with

realistic repayment capability

- Enforceable loan agreements

- Acceptable risk - Capacity building (SME

lending)

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2. Background and Introduction The entrepreneurs of Timor-Leste have raised their concern that medium- to long-term financing at affordable rates is not available from the country’s small financial services sector. Less of a pricing than an accessibility complaint (cost of credit is relatively high for the region, but consistent with the higher general cost level of Timor-Leste4), the private sector in the country is looking to the IV Constitutional Government of Timor-Leste to facilitate their access to: • Investment capital loans at 12-48 months terms in the range of US$ 0.25-3 million

(project finance is available); • Financial leasing products as a less expensive means of acquiring needed equipment

(currently many SMEs rent equipment at high costs); • Accounting standards, training and other business support services for staff; • For SMEs outside of Dili, increased banking network (access to financial services near-by

to reduce transport/time transaction costs); and • A land and property registry so that land assets can be pledged and accepted by the

banks as collateral. On the supply side, the small group of financial services providers in Timor-Leste acknowledge their limited lending, restrictive collateral requirements (preference for land in home countries of the banks), and interest rates above the regional average, but explain that: • Borrower experience is very limited and few of the loan applications received are

bankable (lack of financial statements, track record, business projections, documentation of repayment capacity, etc.);

• The lack of a land law and asset registries severely curtails conventional collateral options as pledged collateral (land in particular) cannot be legally liquidated in case of default;

• The lack of a credit registry (bureau), insurance, CIT and other industry support services increases the risk of lending;

• The East Timorese market is too small to merit product development and diversification without external funding; and

• The general country and security risk is assessed at the foreign head offices and at the local branch offices as very high, underscored by the non-performing loan ratios which sky-rocketed after the civil unrest in 2006.

The specialized micro-bank Instituicau de Micro-financas de Timor-Leste (IMfTL) is now formally fully state-owned after ADB transferred its share capital from the Foundation for Poverty Reduction in East Timor (FPRET) to the Government of Timor-Leste in 20085. It operates its most successful lending product (80% of the portfolio6) based exclusively on salary-guarantees, which limits access by entrepreneurs. The two leading non-bank microfinance providers Moris Rasik and Tuba Rai Metin that survived the 2006 unrest do not require physical collateral to any large extent, but like IMfTL, offer loans that are too small for SMEs. As SMEs, they themselves experience difficulties in accessing capital for on-lending. The constraints on the demand and supply sides are exacerbated by weaknesses in the enabling environment for the financial sector. While the basic legislative and regulatory framework for the financial sector has been laid, several policy, legislative and regulatory gaps remain, e.g. a bankruptcy law and regulations for the land and insurance laws. In addition, the young nation’s financial infrastructure lacks support services such as credit and property registries; CIT services; ICT, rating and audit facilities, accounting standards (e.g. for banks’ treatment of reserves and write-offs), etc. These constraints are well recognized

4 As everywhere, SMEs in Timor-Leste would like lower interest rates on their loans but cost is less important than access to credit, as confirmed by the results of an IFC-funded Assessment of Credit Demand by MSMEs in Timor-Leste, August 2009. 5 ADB maintains a position on IMfTL’s board. 6 As per annual audited accounts of September 2008. ADB informs that IMfTL’s payroll pending has decreased to 64% of the portfolio as at July 2009. Email communication with Jeremy Cleaver, 29 July 2009.

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by the Government of Timor-Leste and plans have been adopted to fill the gaps. In the human resource-strapped country, however, it will take time to establish a fully enabling and supportive environment around the financial sector. For these reasons, the Government of Timor-Leste has decided to participate in the financial services sector to facilitate the access by SMEs to investment capital. A number of models have been floated, from the founding of a Government-capitalized development and/or investment bank (along the lines of BNI in Indonesia in its current form, National Bank of Vanuatu, or TEMASEK for investment in Singapore), over government credit lines administered by commercial banks, to co-investments with donors or commercial partners in the transformation and expansion of the existing Government held financial institution (IMfTL) into a specialized SME or agricultural lender. This Options Paper seeks to present viable options for effective government participation in an otherwise market-led financial services sector to accelerate and expand the access to financial services for the relatively immature private enterprise sector while highlighting the trade-offs and avoiding the worst of the costly pitfalls that have marred government intervention in the sector worldwide. Annex 1 provides an updated summary of the context in which this debate takes place in Timor-Leste mid 2009. Given that most East Timorese are engaged in agriculture, Annex 2 provides a brief update on drivers for rural development and rural finance. A separate memo has been drafted to examine options for IFC to support recommended options for government participation in the financial services sector of Timor-Leste. The paper has been developed during a 3-week consultancy in May-June 2009 hosted by the Better Business Initiative (BBI) in Timor-Leste. The BBI is a formal dialogue mechanism established in January 2008 by the Ministry of Economy and Development and IFC to provide a platform for effective and constructive dialogue between the private sector business community (domestic and foreign), the Government of Timor-Leste, and bi- and multilateral funders; to facilitate information sharing with investors; and to identify, prioritize and address entry barriers and other constraints with the view to improve the business enabling environment. The BBI operates through a structure of Working Groups that address issues of top priority and a 6-monthly Business Forum attended by top-level government officials. The BBI Working Group on Access to Financial Services serves as the key channel to compile and clarify the private sector demands and constraints with access to finance7. Throughout the assignment, the Consultant was fortunate to meet committed professionals, who shared their insights and assessments of the current situation and constraints, and took time from a busy schedule to attend meetings and provide information and feedback. The Consultant would like to extend her sincere appreciation for the time and effort that was put into the assignment by all persons met and interviewed. This paper presents the findings and recommendations of the Consultant for the comments of IFC-BBI and East Timorese stakeholders. The views and recommendations expressed in the paper are those of the Consultant, and do not necessarily represent the views of Timor-Leste’s financial sector stakeholders, nor of IFC-BBI.

3. Clarifying the Constraints The key constraints from the demand side (MSME) perspective include a lack of access to longer-term, affordable credit for investments and working capital; convenient and safe deposit services for asset building; and credit enhancement products for trade (letters of credit, letters of guarantee, bank guarantees and remittances). But the constraints to access differ with the maturity of the enterprise and the size and scope of the investment project for which finance is sought. Similarly, the interests, concerns and constraints of the financial services providers (supply side) in the small East Timorese market also differ by type of institution and preferred

7 IFC and Government of Timor-Leste, Memorandum of Understanding: “Timor-Leste Better Business Initiative”, Feb 2008.

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market segment. There is no one-size solution to fit all. This section seeks to clarify and analyze the constraints in the market by segment in order to determine appropriate options for government participation in alleviation of the constraints.

3.1 The Medium- and Large Enterprises (MLEs) MLEs are few in Timor-Leste, and the few that are large by national standards meet the international criteria for a ‘small and medium sized enterprise’ both in terms of asset value and employees8. These, the largest of the East Timorese private businesses are looking to increase their asset base, compete for and win larger contracts and reduce overheads from rentals. To do this, they seek bank guarantees and LoCs to bid for government contracts and in particular longer-term (1-4 years) investment credit. The calculated effective credit demand for MLEs in the country ranges from $250,000 - $3 million9. This top segment of the business community is in general serviced by the three commercial banks in Timor-Leste, but only with 3-9 months project finance, which at the costs of funds in the market is too short a period to generate the profits necessary to repay a large investment loan. While the banks may be interested to lend to projects that appear viable and sufficiently collateralized, the lack of bankruptcy laws, regulations to enforce liquidation of collateral, and creditor protection in the market has made them more risk averse towards these longer loans.

3.2 Small and Medium Enterprises (SMEs) There is most definitely a perceived unmet demand for SME credit in the national private sector of Timor-Leste. SMEs clearly state a high demand for credit and consistently list access to finance as a constraint. This is consistent with most developing markets – in particular transitional markets where people have been used to a high level of state support – where a very high level of spurious demand for ‘money’ or ‘assistance’ is often expressed as a lack of credit. The larger small and medium sized enterprises (SMEs) in Timor-Leste do access credit. With sufficient project description and collateral or a government contract, most SMEs appear to receive a favorable response to a loan application for 3-12 months term project loans, which they need. Along with the working capital loans, SMEs in Timor-Leste (corresponding to micro and small enterprises by World Bank definitions) also seek credit for investments. Their demands range from $5,000 - $250,000 for start-up and expansion of business opportunities based on relatively limited business plans and projections and with little and unregistered collateral to offer as security. While 2,500 SMEs are registered with the MCTI (Sept 2008), there are many more informal businesses although the lack of data does not permit accurate quantification. Their credit demands, however, appear to fall into two major groupings: A. Small, newly established or start-up businesses with little track record and credit history,

and subsequently limited collateral and financial management experience, seeking loans of $5,000 - $50,000 primarily for trade, services and small investments. These businesses would also benefit from leasing, supplier and consumer credit products, and domestic remittances; and

B. Larger, mature and experienced (primarily services, construction and hospitality) companies that have some collateral and track record require credit in the range of $50,000 - $250,00010 to compete for governmental public works tenders, etc. In

8 For a discussion on the size of the national enterprise sector, see J. Conroy, 2006. 9 The MLE segment constituted 16% of a small, random sample of nationally-owned businesses interviewed in a recent survey. Correspondingly, 15% of the sample had a calculated effective demand for investment credit in the US$500-3000k range with an additional 5% of the sample capable of serving repayments on loans of $250-500k. Johansson, Credit Demand by Micro-, Small and Medium Scale Enterprises in Timor-Leste, Better Business Initiative, Timor-Leste, August 2009. 10 Of the random sample of 2.5% of formally registered businesses, 64% were SMEs and 10% microenterprises using WB definitions. Of these, 62% fell in Group A and 38% in Group B. Correspondingly, 78% of the total sample of MSMEs had an effective credit demand in the range of $5-250k. The effective demand was, however, much higher for Group B loan amounts (56% of sample) than for Group A loan amounts (22% of sample). Preliminary results from IFC-funded Assessment of MSME Credit Demand in Timor-Leste, August 2009, op.cit.

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addition, LoCs, LoGs, insurance, overdraft facilities and trade finance is also in demand in this segment.

However, applications for loans or expression of need in questionnaires do not constitute effective demand. Finance is a binding constraint only when all other ingredients for successful investment are available, and when finance can conveniently activate these other ingredients for positive returns on the investment. An effective demand is one backed by at least preparedness to meet requirements such as a liquidity cushion (equity); a loan purpose related to a feasible technology and economic activity (business plan), measures to contain the effects of probable risks, interest rate and collateral requirements, etc. In many countries, even a staunchly argued and widely accepted notion that lack of credit is the overriding constraint to SME development turns out to be a broader performance problem, which importantly an increase in credit funds would not resolve11. This would seem to be a relevant problem in Timor-Leste too. In a recent credit demand study, the total stated demand among respondents was US$ 123 million whereas the estimated effective demand was calculated to only $14.4 million12 or 12%. Due to historic under-exposure to business management, the occupation by a paternalistic state which did not encourage private sector development, and the general youth of the nation, Timor-Leste’s SMEs face other constraints to their effective performance which credit can do little to solve and may in fact exacerbate, but which it would be important to address in order to develop the SME sector, including: • There is no national manufacturing industry and a limited demand for potential products

(strong and cheaper neighboring markets, lack of national focus on demand); • Few comparative business opportunities and advantages (high price level, low

competitiveness); and • Very limited managerial and entrepreneurial capacity, resulting in demand for help to

develop and present more bankable projects (prepare financial statements and get them audited)13.

SME credit has been provided primarily by the financial services market leader in Timor-Leste, Caixa Geral Depositos (CGD) with its 10 branches in Dili and other major towns. After 2006, however, this bank has incurred significant losses (over 50% of the $ 82.3 million outstanding portfolio is currently provisioned14) and has adopted stricter lending practices as a result. Pending track record and (preferably) conventional collateral (land) and/or business assets in Australia and Indonesia respectively, SME borrowers are also served by ANZ Bank and Bank Mandiri, but for both these banks, non-credit facilities are vastly more important than the loan portfolio. The banks cite the weak legal system for realization of collateral; the lack of bankable projects; and the general country risk as reasons why their lending to SMEs is limited. With a total banking sector liquidity of 70% and excess liquidity of 56%15, there is not a lack of capital available for credit in the financial sector. At the same time as the banks reject a significant part of applications received, stating that lending opportunities are few, they also report high levels of non-performing loans since 2006. So, rather than a dearth of credit (funding), the problem would seem to be a shortage of viable projects that are bankable. If this is the case, demand for larger, longer term loan products which inherently carry greater risk are unlikely to be met by commercial providers, unless other measures are put in place to mitigate the perceived risks while regaining (through write-offs) and maintaining a low non-performing loan ratio in the financial services sector.

11 The issue of spurious versus real credit demand is researched e.g. in A. Gockel and A. Akoena: Financial Intermediation for the Poor: Credit Demand by micro, small and medium scale enterprises in Ghana, ILO IFLIP, 2002. 12 Johansson, SME Credit Demand Study, August 2009. 13 Ibid, and Joint Private Sector Presentation to HE the Prime Minister on 14 March 2009. 14 Interview with Mr. T Goncalves, Director General of CDG, Sucursal Timor-Leste. 15 Banking and Payment Authority: Quarterly Economic Bulletin, March 2009.

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3.3 The Micro-segment (Households and MEs) The vast majority of the East Timorese private sector consists of informal income generation projects or micro-businesses run at household level or by individual entrepreneurs, 80% of whom reside in rural areas. A key demand in this segment is for semi-liquid, interest-bearing, safe and convenient (proximity and very low entry and minimum balances) deposit services that will help them build assets. On the credit side, micro loans ($100 - $5,000) are in demand for investments, working capital and income smoothing (seasonal income fluctuations, life events, and consumption, e.g. housing repairs, schooling, medical bills, etc.). Also, in the urban informal sector, many micro-entrepreneurs are rural-urban migrants who incur travel and other transaction costs to transfer cash home. For them, cheaper and more efficient domestic remittance services are needed. Finally the limited ‘financial literacy’ of micro-entrepreneurs diminishes their capacity to make bankable proposals, use financial services effectively, and grow their businesses successfully. Training and mentoring to enable micro entrepreneurs start, manage and expand a business is therefore also needed. This – the largest – segment of the East Timorese economy is the least served by the financial sector. The two leading microfinance institutions (MFIs), Moris Rasik and Tuba Rai Metin and the specialized government-owned financial institution (IMfTL) together serve around 20,500 borrowers of the estimated total market of 290,00016. In addition, a few credit cooperatives, multi-purpose NGOs and donor-funded projects are providing credit at subsidized rates to groups and individuals. The 2 NGO-MFIs cannot remit funds or mobilize deposit from the public, but do take savings from their members (registered clients) as partial ‘surety’ for their microloans. Until Jan 2009, IMfTL had a deposit ceiling of $ 1 million which has recently been raised to $ 3 million, and does not offer term deposits. As the only commercial bank down scaling to the micro-segment, ANZ Bank has introduced a student’s savings product which displays the fastest growth of any product in the country. These institutions together hold some 39,500 savings accounts or 17% of the total estimated demand of 234,000 accounts17. CGD has the largest branch network in the country and offers remittances, as do IMfTL and Western Union but this still restricts the service to between major towns and provides no rural outreach. The MFIs, and the rural-focused Moris Rasik in particular, have demonstrated resilience and effectiveness in their provision of alternatively collateralized credit even in the face of the 2006 crisis. Moris Rasik is currently profitable and has a Portfolio at Risk ratio of 0.9% (Dec 2008)18. Contrary to the liquid commercial banks, the biggest constraint for the MFIs has been access to capital for on-lending to more clients. This has been especially critical for Moris Rasik which could have grown faster with more credit. Part of this problem could be alleviated with a (limited) non bank financial institution license allowing Moris Rasik to mobilize deposits, and facilitating its access to international sources of capital while distinguishing it clearly from risky savings schemes in the community, and ensuring increased consumer protection for its customers. As part of the preparation for a license, the smaller Tuba Rai Metin needs managerial and operational strengthening, and a mentoring partnership with the large Indian MFI BASIX under the newly established UNCDF facility Micro-Lead may provide just that. While IMfTL is already licensed, it is currently in transition to a new board of directors appointed by the Minister of Economy and Development, which needs to determine a clear business strategy for the institution.

16 Bankable Frontier Associates LLC: The Potential for New Technologies and Branchless Banking Models to Expand Access to Financial Services in Timor-Leste, ADB, January 2009 (V2.0 confidential to ADB) 17 Updated from the current population figures of 1.1m to the equivalent of 1 account per household. 18 M-CRIL: Update of Rating of Moris Rasik, December 2008.

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3.4 Summary of Constraints There is a perceived unmet demand for SME credit, primarily longer-term investment loans, in the national private sector of Timor-Leste. A recent study indicates that the demand for longer-term investment credit is real; but that effective demand is much lower than stated demand19. On the supply side, the lack of available investment credit does not relate to a liquidity problem in the financial services sector – the banks are excessively liquid. Rather, the constraint is related to the limited opportunities and capacity in the market combined with the absence of risk- mitigating services to the providers (enabling legislation on collateral; land and property registries; credit bureau, etc.). These deficiencies translate into high perceived market risk, compounded by a 30% NPL rate carried over from 2006 and not yet written off. To summarize, the segmented demand for increased access to finance are illustrated in table 1 below: Table 1: Summary of key Access to Finance demands MLEs/high end SME/mid market ME/poor Credit services 24-60 months

investment credit, ($ 250-3000k)

- 12-48m investment credit, ($ 50-250k) - 3-12m working capital loans, ($ 5-50k)

-Rural/urban micro loans (alt. collateral), 2- 12 m, ($ 100 – 5k)

Other financial services

- Credit enhancement - Trade finance

- Credit enhancement - Leasing - Overdrafts - Asset/credit insurance - Supplier credit - Agricultural finance - Trade finance

- Rural deposit services - Rural remittances - Micro-insurance (crop; health, assets) - Micro-leasing - Agricultural finance (warehouse receipts)

Non-financial services

- Land/property registry, - Deregulated business environment - Functioning courts/ADR

- Land/property registry - Credit registry/bureau - Simplified business regs - Accounting standards, audit and financial statement trng - BDS/training/mentoring - Market development

- MFI/NBFI law/license - Fin. Literacy training - Market access/rural infrastructure

The policy, legal and regulatory weaknesses in the financial services sector have been acknowledged by Government of Timor-Leste, and the missing pieces of legislation are being attended to, but at a much slower pace than the private sector would have wished, as there are many competing priorities in government. The sector as a whole (both banks and SMEs) seems to agree that Government participation is now required for changes to take place, given the perceived risk level in the market and the lack of response from the donor community since 2004. While often heard from prospective borrowers, it is unusual for a private sector-led banking industry to actually request government participation in this way. But both within the public and private sectors, there is a widespread contention that banks will not begin to lend more and longer-term to the national private sector without significant risk mitigation. Before we examine the options for Government participation in mitigating this credit risk, the overall issues related to government participation in the financial services sector will be discussed in section 4.

19 Johansson: MSME Credit Demand study, BBI, August 2009, op. cit.

4. The Rationale for Government Participation With the demand and supply side constraints segmented and clarified, we can now turn to the public side of the equation, and review the rationale for government participation in the financial services sector. Whether a government decides to intervene or not, any economy has certain structural characteristics which it serves to remember in a more pragmatic approach to ‘fixing what needs to be fixed, if anything’. As illustrated in Figure 2 below, for Timor-Leste, it is worth noting that: • The economy is small and completely open due to an almost total import dependency; • The country has no debt and the well-managed sovereign wealth (Petroleum) fund

could, if continued, provide sustainable revenue for the nation in perpetuity; • Economic growth, while solid, is currently driven by government (and UN) activity,

which keep price and cost levels at a higher than regional level; • The private sector has few opportunities and limited capacity – there are very few

comparative advantages to exploit; • The small financial sector does not (yet) display any major faults or structural problems

that would appear to require intensive government intervention; • The supply of financial services is limited, but relatively sound, willing (if risk averse),

and well segmented in the market, and could be encouraged to expand services - there would seem to be little need for Government to acquire a controlling interest in the sector;

• The Government may well be able to assist its SMEs with a temporary and facilitating intervention.

Fig. 2 Overview of the demand and constraints for financial services sector development

INCLUSIVE & EXPANSIVE

FINANCIAL SECTOR DEVELOPMENT

Private sector: - Needs short-term

opportunities and capacity to participate and profit

- Structural challenges: Geo-economic location with few comparative advantages in region (low non-oil trade/export), small and young population, high population growth human resource/capacity gap, under-developed rural economy;

- Core problems: Capacity gap, low rural incomes, rapid urbanization, high unemployment, increasing poverty; inadequate physical and social infrastructure and basic services, lack of effective institutions to implement policies, absence of land rental markets.

- Vulnerabilities: emerging corruption, root causes/aftereffects of civil unrest, open economy – oil/commodity prices.

Environment (see annex 1): - Significant

challenges and trade-offs

Government: - Needs long-term justifiable rationale for comparatively high return on budget investment

?

Demand side: - Investment (LT) credit - Business loans, leasing, - Increased rural/micro

services - Insurance, agric.

Services - Capacity building (fin.

man.)

Supply side: - Bankable projects with

realistic repayment capability

- Enforceable loan agreements

- Acceptable risk - Capacity building (SME

lending)

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4.1 Whether and How Much to Participate From the time of Karl Marx, Adams and Keynes there has been an ongoing politico-ideological debate of the respective superiority of state and market, and financial sector development has been one of the key battlefronts of this debate. Significant government participation has been particularly popular in socialist-inspired command economies, and thus in many countries under occupation, newly liberated from colonial pasts, and/or under military rule. Minimalist government intervention and a ‘laissez-faire le marché’ approach has historically been favored by more capitalist nations and the international monetary institutions they have established. In between, there are more pragmatic examples of ‘mixed economies’ leaving the market to do what it does well, i.e. allocate resources efficiently and balance prices based on demand and supply; and giving the state the responsibility for (and the right to collect taxes to pay for) public goods and welfare that are of insufficient interest to the market forces. Over the course of history, many financial sectors of nations that favored state-interventionism have faltered due to the sheer cost of the inefficiencies of command-economics as their private sectors did not become an engine of growth, and most are currently undergoing reforms. The recent global financial crisis left the financial sectors of many market-oriented countries equally in shambles and requiring state intervention. The lesson to be learned is perhaps that there are no absolute ‘right’ or ‘wrong’. Government participation in the financial sector can go well or poorly, can help meet the desired objectives or not. It is important to get it right, simply because failure in the financial sector can be utterly devastating for the entire economy of a country, is extremely expensive, and does generally take many years to overcome. Governments can participate in many ways in a conventionally ‘private’ sector like financial services (see fig 4 below). It is, however, important to understand the short-term as well as the long-term implications of any intervention; government participation impacts the financial sector significantly – either negatively or positively. But it is less about whether and how much the Government ‘should’ intervene for political reasons than about ‘how’ and ‘how smartly’ this is done.

4.2 How to Participate Box 3: Early Government participation in Indonesia Government participation to support national businesses remains a convincing model for many leaders in both the public and private sectors in Timor-Leste, the most frequently referenced being the development banking experience of Indonesia in the decades following Indonesian independence.

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Given that the early attempt at government SME support came to an inglorious end after 7 years leaving large defaults in the participating bank, this understanding may rest on less than complete information about that ‘model’ (see Box 3).

In the early 1950s, national aspirations rose for an economy which would be controlled by indigenous Indonesians (Indonesia asli) rather than by ‘foreigners’ like the Dutch and the ethnic Chinese. To promote this goal, import licenses were issued to would-be indigenous businessmen who were also given easy access to cheap credit from the state-owned Bank Negara Indonesia (BNI). The ‘Benteng’ (Fortress) program as it became known saw several thousand businesses register is a very short time – most with little business experience. By 1954 the Central Office of Imports estimated that about 90% of the registered national importers were not bonafide, and the majority also failed to repay their loans. In fact, “the ‘Benteng’ program did not foster a strong, self-reliant indigenous merchant class, but a group of licensed brokers and political fixers, in short what are now called unproductive ‘rent-seekers’ or ‘rent-harvesters’”. The program was terminated in 1957, failing to achieve its expected objectives. For more on the Benteng Program, see e.g. Kian Wie Thee: Recollections: the Indonesian economy, 1950s-1990s, Institute of Southeast Asian Studies at Australian National University, 2003 from where the quote is taken, and Yuri Sato: Post-Crisis Economic Reform in Indonesia: Policy for Intervening in Ownership in Historical Perspective, IDE Research Paper No. 4, September 2003.

Figure 4: Spectrum of government participation in financial services sector

Type of intervention

Examples of participation

Cost to Govt Risk of distortion/ failure

Return Examples

Presiding Dominating policy bank, sector corporations

High High Low

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An effective financial services sector must be able to respond to demand, allocate financial resources efficiently, and provide opportunities for people – both wealthy and poor – to manage risk prudently. In short, the sector and its service providers need to be able to function as business units seeking opportunities, responding to demand and competing for the reward of e.g. increased market shares, market expansion, recognition and profit. If a financial sector is unable to do this, it may require assistance from the state. If the state is unable to help, the economy may require international assistance (often in the past provided as ‘structural adjustments’). However, too much or too directive assistance can equally bring a financial sector to a complete halt if it disables the inherent reward structure. Inversely, the State – as most public institutions - has the common good as its key concern, and is accountable to the population for the management of the country’s development and the use of funds. As such, it does not work on the commercial principles of reward of private sector operators.

VBSP & SCIC Vietnam

SOBs to finance SOEs

High High Low BNI, until 97 RBB, Nepal

Paternal Credit Guarantee Institution

Medium/High Medium Low ASKRINDO, Indonesia

Directive credit lines through banks

Medium (low if externally funded)

Medium Low BIDV, VIE TL: SEP I

(Interim) majority owner of bank

Medium Medium/low Medium/low BOM, Maldives TL: IMfTL?

Holding company for wealth management

Medium Medium/low Medium/high TEMASEK TL: Petrol Fund

Partnering/PPPs Minority equity participation in private/ transforming bank

Low Low (transition)

Medium/low Bank of Georgia ‘94 TL: CGD?

Co-investing in apex funds

Low Low Medium RMDC, NEP TL: INFUSE

Credit Risk share facility

PCG Madag. AlRafah, PAL

Promoting Enabling environment

Medium/low Low High MFF, Uganda TL: CRIS

Non-financial enhancement of borrowers (training, business planning)

Medium/low Low Medium/high PEACBROMO TL: IADE

Max. risk and cost

Min. risk and cost

Box 5: Other regional experiences In many countries in the 1950s and 1960s, the government intervened in the financial sector with a general intent of improving access; often for the ‘indigenous people’. Typically, the response to a perceived ‘unequal’ or unmet demand for financial services was the establishment of a national (commercial or development) bank with very specific directions given about whom to serve with what and how. Most banks so created have performed very poorly and have been reformed at huge cost over the past 30 years. Many governments have been tempted to use the power of national budget funding to dictate to established institutions how they should do what the State wanted. Interest rate ceilings imposed on banks is a case in point, which has proven a misstep every time and everywhere it has been attempted: politically directed management of institutions that must operate in the commercial real economy works counter to its intended outcome. If financial institutions cease to operate commercially, they lose money. If they are required to continue, they lose their own, their depositors’ and the State’s money in rapid succession. In addition, however, any commercial competition in its environment may also stop operating, because of the unlevel playing field. Too much state intervention can bring an entire industry to a standstill20.

See more in Nimal Fernando: “A Note on White Elephants in Rural Finance in South Asia”, Ohio State University and Goethe University of Frankfurt Seminar Reader, 1999 quoted in Fernando 2008 op.cit.

The Philippines introduced a subsidized lending program in the 1970s to provide loans to rice farmers (the ‘Masagana 99’). The program so severely undermined the financial viability of the banks involved that it was closed after a few years. In Bangladesh, Nepal and Pakistan, state-owned agricultural banks continue to operate, but their very high default rates require significant and regular injections of government funds. In addition to being very expensive for the governments, the banks are not reaching the poorest, but their subsidized services crowd out sustainable microfinance institutions so the net effect is less service to those rural areas that the government banks were meant to support.

Box 6: India’s Experience

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In the steep learning curve of development over the past 50 years, three aspects of participation seem to be pivotal to successful government interventions in the financial sector:

In addition, the interventions have undermined the financial viability of the lending institutions (many SOBs are technically bankrupt) and have discouraged private sector investments in the rural financial market development. No market-based financial institution would want to try to enter a rural market in which a subsidized institution operates. Further, the credit-only approach has failed to provide savings, insurance, money transfer and other financial services demanded by farmers. It has remained a valid question whether the social benefits of these measures outweighed the substantial social costs. See more in Meyer, Richard L., and Geetha Nagarajan: Rural Financial Markets in Asia: Policies, Paradigms, and Performance. Hong Kong: Oxford University Press, 2000, quoted in Fernando 2008, op.cit.

India has used state-owned banks (SOBs) and cooperatives extensively to promote social banking – at substantial cost. In India, like in Ghana and most other markets researched, there are now clear indications that government-supported financial institutions primarily serve the richer rural households, i.e. that the target group has been displaced, and the rural poor continue to face severe access barriers.

• Commercial awareness; • Demand-drive; • Focus on the product.

20 The role of the Vietnam Bank for Social Policy in the Vietnamese micro- and MSE lending market is a good example of how directive state ownership has caused the under-development of an entire segment of the financial system.

4.2.1. Be a Savvy Investor State-owned financial institutions (banks, non-banks, development funds, credit guarantee institutions, sector corporations and enterprises) generally have a ‘bad name’ in financial sector development history because many of them have failed and dragged their industry and sometimes their government down with them, and because economies with a lot of state owned institutions have been particularly slow and expensive to revive and reform. Like any other type of institution, State-owned institutions tend to perform poorly if they are: • Politically directed (performing tasks that they would not otherwise have done or being

restricted from doing tasks that they would have done); • Guaranteed bail-out (why work harder if government will pay/capitalize you at the end

of the year anyways?); and • Under-capacitated (being required to hire more or less or less skilled employees than

necessary). Box 7: Experiences with subsidies

On the other hand, state-owned financial institutions can do well IF they are allowed to operate on commercial (market) terms and are protected from undue political influence and pressure to act differently than commercial efficiency would dictate. The issue is not so much about the owner, but about how the ownership is managed. As an owner of a financing institution, the State must act as a savvy investor in order to get the desired return. All of the Good Funding Practices painstakingly developed from experiments and mistakes in the donor world of development funding21 apply in equal measure to any public owner of a financial institution which must, to be successful, operate on commercially sound principles: • Set objectives and a strategic direction for the

institution; • Appoint skilled people to achieve the specified

results; • Protect them from undue influence and do not

restrict their management scope; • Review their performance against the stated

goals and pay them accordingly – incentivize and/or fire them if necessary; but

• Do not intervene in their management. This last point is particularly important and hard for many investors/owners to accept, given that their money is involved. However, rather than acting as business specialists, smart funders/investors find the best skilled people to run their businesses and define their return in terms of the success of the business. Smart investors may apply internal incentives for the business to serve specific sectors; test specific

new products; and serve clients in a specific way, but will never direct the business to perform in ways its management does not recommend.

India, Pakistan, China. Thailand and Viet Nam have all used subsidized credit extensively as a means for government to help reduce poverty. In all countries, significant capture by the non-poor has been noted along with very serious repayment problems for the participating institutions. Timor-Leste had a small taste of the repayment problems inherent to ‘cold’ (public) funds availed at subsidized price during SEP I. Because of their political nature – and their popularity among beneficiaries and benefactors alike, subsidy programs can become socio-politically entrenched and very difficult to remove. And in all countries, credit subsidization programs depend on the government’s ability and willingness to meet the increasing costs over time – an ability that may not always be possible, as e.g. Indonesia experienced in the late 1990s. See more in Shenggen Fan: Investment or Subsidies: Where Should China Be Heading?, 2005 quoted in N. Fernando: Rural Develop-ment Outcomes and Drivers, ADB, 2008.

Most countries have used subsidies either to lower the cost of input or to keep artificially high prices, import restrictions etc. Used and studied in depth in India, the disconcerting conclusion on agricultural subsidies is that they may have helped in the beginning, but in the 1990s most subsidies became uneconomic, i.e. the return in poverty reduction on subsidies (= number poor reduced per million of currency spent) turned negative.

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21 As compiled in CGAP: Good Practice Guidelines for Funders of Microfinance, Oct 2006.

Savvy investments by public owners in commercial sectors are about where to place the subsidy (see Box 7 above). If placed wrongly, it can distort the commercial functioning of the entire market. Intervention by government in the direct commercial transaction between buyer and seller has never been able to promote market-led private sector development anywhere. Rather, when faced with subsidized pricing or costing from a state-sponsored competitor, the private sector (domestic and/or foreign) of producers and traders will rather disengage, ultimately leaving the customers without any services. In addition, subsidies for the financial sector would directly compete with the long-term capital investments of the country, e.g. roads, health, education and environmental sustainability, which may give better (social) returns. Subsidies must therefore always be used selectively and targeted effectively, if at all. If placed right, however, interim subsidies can energize, vitalize and move a sector forward. Box 8: Direct intervention in the commercial transaction can be risky

The recent intervention in the rice market by the Government of Timor-Leste is a good example of a well intended intervention for a noble cause (cheaper food for the people) which may have unintended repercussions in terms of its effect on the market. No development partner begrudges poor East Timorese a lower price of a food stable (albeit rice being a higher-class stable than cassava and corn, the stable of the poor in Timor-Leste) or the popularity that the intervention may have given the Government. The concerns expressed – based on international experiences – are that such a direct intervention into the commercial transaction often harms the very agricultural sector that the Government seeks to develop, and which looks to the Government for support. The 24 months of rice supply now said to be in government storage can be suppressing farm production and rural incomes, as prices for domestic production will decline when supply is increased and secure. As described in ADB: Outlook for Asia, 2009, Timor-Leste.

Just like for participation in the financial services sector, savvy investment decisions are also important when governments need to prioritize limited resources and decide on the relative returns of various public investment proposals. An important aspect to consider is the ability of some sectors and services to be able to fund their own development through fees, and the inability of others to do so as effectively, even if the services are as necessary. A case in point is the relative difference in ability to cover costs between the hospitality sectors (and to an extent utilities and financial services) and the health and education sectors. There would be less comparative reason to invest scarce public resources in the self-funding hospitality sector (e.g. a resort) than in rural roads, health clinics and schools (see Section 4.5).

4.2.2. Demand must drive – it cannot be sustainably ‘created’ Within the development debate, command-economists up until the 1970s favored a notion that ‘supply not only can but must create demand’ and thus that banks should be established before demand becomes evident in order to create it. The argument maintained that proactive government interventions like institution building, interest rates caps and directed credit policies would be necessary to provide the financial impetus for economic development. The typical result of this supply-driven approach was the establishment of a national retail or development bank to ‘create demand’, often on very non-commercial terms, leading to inefficiencies and huge losses. As compelling as the argument may seem, there are no experiences that suggest that state-driven supply can foster sustainable demand. Rather, state-driven supply in the financial sector tends to fragment and cause the sector to stagnate. Fragmentation has been seen in many countries: In Ghana, specialized development banks were set up first. When it was noticed that they didn’t serve the small farmers, rural banks were established at significant cost. Similarly, in the Philippines a system of rural banks was set up when it was observed that commercial banks made little effort to penetrate the

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country side22. A certain level of specialization is beneficial in the banking system, and no one institution should be expected to serve the entire market. On the other hand, in a small economy like Timor-Leste, there simply would not be enough demand for several specialized entities. The stagnation can be even more severe, especially where government intervention is driven by credit demand targets that are unable to filter out proposals likely to lead to bad investments and therefore bad loans. Development banks ended up accumulating huge amounts of non-performing assets in many countries. Throughout Asia, painful experiments with banking systems developed as a response to perceived credit needs became very costly for governments. In the process, these failed banks negatively affected the entire financial services sector by: • Running up huge NPL and failing to follow up defaulting clients, thus instituting a poor

repayment culture among customers; • Suppressing possible expansion by (“displacing”) commercial banks due to the subsidy

levels creating an unlevel playing field; and • Creating a legacy for ‘paternalistic banking’, i.e. expectations of subsidies from the

State. As Timor-Leste knows only too well from Indonesian times, the paternalistic state may establish structures that (mean to) deliver basic services, but not without control and usually at unsustainably high costs due to inefficiencies. The transition from a supply- to a more demand-driven economy can, however, be hard on people accustomed to the paternalistic State – everywhere from Moscow to Maliana, there are nostalgic longings for the ‘good old days’ which in hindsight seem a lot better than perhaps they were. But a sustainable economy able to take care of its weakest cannot afford to provide for its entire people – the private sector must generate its share of the wealth. It does this best when it is led by demand for goods and services. Most economists today acknowledge a demand-led approach, and argue that the financial sector expands as a consequence of the demand created from growth within the “real” economy and is thus dependant on stimulation from market sources23. Equally, if government wishes to intervene, it should do so outside of the direct commercial transaction and as much as possible on the demand side of the equation, e.g. by supporting borrowers (SMEs) to present themselves and their projects more successfully to their banks and thus lower the risk of lending – rather than lowering the ‘cost’ by providing free money to the service providers. The supply side should be supported by better business services in an enabling environment.

4.2.3 Test the Product before Institutionalization In most forms of government participation, visibility is important for the political return on the investment. Perhaps this is a reason why government participation tends to involve the creation of an institution to respond to a constraint. However, creating an institution does not automatically translate into a service being offered or offered well. When both the World Bank and ADB24 caution against a state owned bank or guarantee institution in Timor-Leste, part of the concern related to this resource allocation issue.

22 A. Gockel and A. Akoena: Financial Intermediation for the Poor: Credit Demand by micro, small and medium scale enterprises in Ghana, ILO IFLIP, 2002. 23 Gerschenkron 1962, Goildsmitch 1969, Patrick 1966 quoted in A. Gockel and A. Akoena: Financial Intermediation for the Poor: Credit Demand by micro, small and medium scale enterprises in Ghana, ILO IFLIP, 2002. 24 IFC and ADB: Economic and Social Brief August 2007 states for example: “GoTL should avoid providing credit guarantees or establishing new banks: investment capital is best provided on commercial terms by established banks and microfinance agencies”.

Box 9: Experimental policies give flexibility In a small market like Timor-Leste it would be more economical to start with the design of responsive products that could then be tested by existing institutions. If pilot testing and roll-out is successful, there may be a case for ‘institutionalization’ once a product has proven financially viable (self-financing), but creating an institution will not necessarily create demand and, particularly in Timor-Leste, would dilute the scarce human resources available.

China has pursued an entrenched process of experimentation that precedes the enactment of many national policies and has served as a powerful correcting mechanism. Half of all national regulations in China in the early to mid 1980s had explicitly experimental status, meaning that regulations had e.g. provisional rules for trial implementation, etc. Dani Rodnik: The New Development Economics: We Shall Experiment, but How Shall We Learn?, John F. Kennedy School of Government - Harvard University, October 2008.

A more experimental approach of designing and prototype testing a range of services and interventions to assist the SMEs access investment credit to meet their effective demand is perhaps called for, and could – if comparatively providing a high enough return for the Government – be supported financially for a period of 3-5 years as a pilot scheme. With a positive outlook, the entrepreneurial private sector of Timor-Leste will not need further governmental support after 5 years and will have made themselves and their projects bankable. In a less rosy scenario, demand has changed or even increased in five years, and it would be feasible to review the pilot mechanism. In addition, such an approach is cheaper, more flexible and allows for withdrawal for funds should the services not deliver on the expected outcome. In spite of all its command-economic features and centralized control, the government of the PRC has actually been more experimental and flexible in its policy development over the past 10 years (see Box 9) and provides an example for other Asian economies to follow. The Government of Timor-Leste has heard the demand from the private sector for longer-term affordable credit for investment, and to address this constraint, it is natural to respond with the proposal to establish a development bank - rather than a commercial bank. A development bank would normally be dedicated to provide equity or debt finance for new economic development and would therefore not usually compete with retail commercial banks and accept savings, as opposed to a commercial bank that would have retail banking as its core service. In addition to the general concerns about any institutionalizing before having tested the product, however, the national priorities concerning the poorer segments of the population speak of a huge unmet demand for safe and convenient savings. A development bank would be unable to meet this demand – but the Government already owns a (quasi) commercial bank that could: IMfTL. For reasons of avoiding duplication costs alone, the establishment of a new institution may not be the first step necessary, if risk mitigating products can be tested by existing ones. This also holds true for another long-stated demand in the market: capital for microfinance institutions that are essentially SMEs whose commodity is money. As SMEs, the MFIs do not have the collateral required by the banks operating in Timor-Leste either and so only one (Moris Rasik) has been able to secure a - fully collateralized – bank loan. Subsequently, Moris Rasik has been able to tap into international sources of socially responsible capital, but both Moris Rasik – and eventually IMfTL – will continue to need to raise debt finance for onlending. Rather than creating an institution to manage such apex loans, wholesale lending to MFIs could well be tested in the market by IMfTL lending to MFIs to stay true to its name and meet its mandate of investing 65% of its portfolio with poor and low income people. Once fully licensed, IMfTL itself should be able to mobilize additional capital through debt finance and deposits alike.

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4.3 The Objectives of Government Participation Since Independence, the Government of Timor-Leste has retained a firm strategic commitment to a market-led economy. As His Excellency the Prime Minister said recently: “the Government is committed to working with the private sector to boost the economic growth and sustainable development of our Country. The Government must not drive growth but be a partner with a strong, competitive private sector to build a strong economy”25. As the East Timorese private sector is not yet ‘strong and competitive’, it has become evident that government will be the primary development agent in the country for some time to come. Operationally, the current government appears intent on ensuring visible, tangible and rapid development benefits for the people of Timor-Leste. Whether driven by a desire to share the newly found oil wealth or to demonstrate ability to deliver services, the Government is taking pains to be seen to be responsive to the needs and concerns of its people. Action and responsiveness is a priority not least because the perceived lack of service delivery under the previous government contributed to the civil unrest in 2006. As a partner to the nascent private sector, the Government does appear to have listened to the concerns raised by the business community about administrative barriers and limited access to finance. Four Ministries currently appear to have plans for financial services sector development: MoED, MoF, OPM, and MCTI. Without a clear ‘lead ministry’, this may not be the most effective use of limited resources and could confuse the strategic direction. It could also lead to confusion and counterproductive parallel activities in the sector. Informally, however, MoED and MoF appear comfortable as joint de facto ‘lead agencies’ and government actors seem to agree that the demand by SMEs for increased access to medium- long term affordable investment finance should be addressed, preferably by an expanding financial services sector. Within the framework of the National Priorities, Government appears particularly interested in expansion of financial services to:

- The poorer population segments (microfinance); - The rural economy (businesses and households); - The national private sector (SMEs); and - Support large-scale public-private partnerships, including FDIs, e.g. for power.

Any Government will want the maximum ‘bang for its buck’ when considering participation in a conventionally ‘private’ part of the economy. Investments under consideration must necessarily present as opportunities for high leverage and returns (whether economic or social). To gain the attention of the resource-strapped Government in Timor-Leste, arguably the investment proposal must also be justifiable comparative to all the other demands on government participation. This is particularly true for sectors of the economy that are generally ‘self-funding’, i.e. can generate revenue to cover own costs (e.g. hospitality, most utilities (electricity, water, refuse collection) and financial services)). For the government to invest to resolve a perceived market-dysfunction in an otherwise self-funding sector, there has to be a good rationale and a credible and proportional return, even if it is long-term. Among all the needs that the Government of Timor-Leste is trying to address it is not evident that participation in the financial sector is the most urgent or indeed the one that will provide the highest returns. However, it is possible that a relatively small investment can be highly leveraged and thus presents a competitive ‘internal rate of return’. The return for a (temporary) government investment in the financial services sector will be more socio-economic than financial and will not be immediate. But like all public funders, government can afford to be more patient than private investors, e.g. commercial banks. While not quantified by Government (yet), there does not seem to be much disagreement about what the expected outcomes of government intervention(s) in the financial services sector are:

25 OPM Media Release 18 Mar 2009: Victorian Employer’s Chamber of Commerce and Industry to support business development.

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1. Increased scale (outreach) and depth of urban and rural microfinance; 2. Increased linkages between the rural and urban economies (intermediation); 3. Increased investment finance of viable SME projects by commercial banks; and 4. A mechanism to help effectively prioritize, select, supervise and manage large-scale public-private partnerships (PPPs) with national and/or foreign direct investors for public infrastructure.

Any investment in these commendable objectives will need to be commensurate with the expected returns, even if the returns may not materialize in the short-term. The Government is already participating as a partner in the financial services sector in two specific ways, which directly address the two first objectives, and perhaps reasonably, the focus of these interventions has been to assist the poorer segments of society (see section 5.1-5.2 below). A budget line item of $3 million has been allocated on the national budget since FY 2006/07 for rural finance26 sometimes referred to more specifically as a ‘rural’ or ‘development bank’, but this would also only address outcome 1 and 2 in the list above. With the requests for assistance increasingly voiced by the private sector, the Government of Timor-Leste is now considering how to participate most effectively and viably in the sector to attain the third objective. Section 5.3-5.4 provide some suggestions and options to inform the debate and provide ideas for the decision making process based on examples from Timor-Leste where they exist, and from the region where Timor-Leste has not yet experimented with state participation. Simultaneously, the interest in ‘mega-investments’ drives an interest in large-scale PPP management mechanisms. While outside the scope of this report, the large public works investments signed recently are addressed briefly in section 5.5 below.

5. Options for Participation With the intent to address objectives 1 and 2 of the four objectives listed above, Government participation in the financial sector to date has focused on the poorer segments of society. As demand for government action has increased for objectives 3 and 4, i.e. SME and high-end investment projects, the Government of Timor-Leste has asked the IFC-supported Better Business Initiative for advice on how to participate effectively at these levels. Based on the general lessons learned as presented in Section 4 above, this section presents the options that seems most appropriate, viable and effective for Government participation at this time.

5.1 Co-investment in a Microfinance Apex Fund All international microfinance research documents that it is better for government to support capacity building efforts that will allow better outreach and enable MFIs to get commercial funds and operate at a sustainable level, than to displace providers by retailing subsidizing micro credit27. And this is precisely what the Government of Timor-Leste has done: To support the micro-segment of the financial sector and increase access by the poor and low-income population to financial services, the Government (MoED) with UNCDF and UNDP are implementing the 5-year, $5 million “Inclusive Finance for the Under-Served Economy” (INFUSE) Project started in 2008. The project aims to promote policy development including regulatory inclusion for MFIs; establish a financial business support infrastructure for microfinance; and directly support MFI expansion through grants and loans. An Investment committee approves loans and grants to applicant microfinance service providers from a Fund for Inclusive Finance (FIF) to which donors interested in supporting this segment of the market are invited to participate (see Figure 10).

26 International Finance Corporation (IFC): Financial Sector Diagnostic, August 2007. 27 Commercial Microfinance in South Asia, MicroCapital Institute, 2005. http://www.microcapital.org

Fig 10: Fund for Inclusive Finance of INFUSE Project28

While INFUSE has been delayed in its start-up and continues to be hampered by slow and excessively bureaucratic disbursement procedures through an under-capacitated UNDP country office, it is hoped that this apex facility will be able to move to separate offices and increase responsiveness to serve demand more effectively and better assist the microfinance industry grow and diversify. INFUSE fills the institutional gap for support to the micro-segment of the small industry and provides an easy mechanism for the channeling of additional support from donor agencies and government. The Government (MoED) has already committed to a $1.5 million investment in the project, disbursing $ 300,000 in 2009.The FIF investment forum has the potential to be a pivotal coordination and consensus generating platform for industry development, and it would be important also for the exit strategy of the Project to seek to bring all current and potential, public and private investors together in this forum, whether as observers or contributors. For the time being, INFUSE is well placed to address the constraints identified for the ME/household segment of the financial sector, by: • Increasing rural and urban microlending through funding of MFIs; • Promote product development to design, test and roll-out feasible deposit, remittance,

micro-insurance (e.g. in cooperation with RisCorp29), micro-leasing and agricultural finance products;

• Assisting the BPA in the drafting and consulting of an NBFI or MFI Circular/Decree to clarify that MFIs are part of the financial sector, can register as financial service providers, and may take deposits if reasonable prudential regulation and reporting can be met;

• Linking MFIs and their clients to relevant opportunities for training and market access; and

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28 Project Fact Sheet: INFUSE Project, Government of Timor-Leste and UNDP, September 2008. 29 RisCorp is preparing to support insurance service provision in Timor-Leste, starting with 3rd party motor vehicle cover but interested in expanding into microinsurance and asset insurance in 2010.

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• Advocating on behalf of or with the microfinance industry association AMFITIL for increased rural infrastructure and market development services to enhance rural business opportunities.

The financial sector stakeholders and the members of the INFUSE FIF in particular do need to be observant, however, that a subsidized apex fund can become a problem in the market if it competes with commercial funders to serve a few MFIs30. This is unlikely to happen in INFUSE’s lifespan, but provides a good case for the FIF to exit to commercial funders after the planned 5 years. In the process of exiting, INFUSE could facilitate the graduation of funded MFIs to wholesale loans from IMfTL, credit lines from commercial local banks, and/or access to international microfinance investment funds. INFUSE may also consider a gradual commercialization (charging of market prices) of the TA and training provided during its lifespan31. In the past 10 years, Microfinance Investment Funds have emerged in the global microfinance market as effective Private Public Partnerships (PPPs) that are able to leverage public funds by attracting private monies. Participating public institutions (e.g. development banks or Foundations) often provide the expertise, track record, critical mass, guarantee, and/or first-loss stakes in order to attract private investors to the Funds32. If problems do persist and MFIs are not able to access needed additional capital for on-lending through INFUSE, it may be worthwhile to contact existing socially responsible investors (e.g. HIVOS or Dexia); the Rural Impulse Microfinance Fund managed by Incofin; or perhaps the $30 million Global Microfinance Facility II managed by Cyrano Management on behalf of IFC and KfW among others. As an example of a PPP, IFC’s Facility provides and under-writes Letters or Guarantee and/or Credit with a guarantee structure that appeals to commercial institutional investors – the investment is safer due to subordination tranches and the return is in line with or just above investment-grade debt securities33.

5.2 A Government-owned Bank for MSMEs The history of the Instituicau de Microfinancas de Timor-Leste (IMfTL) is well documented and need not be repeated here. It is important only to recall that this specialized institution was set up by the Government and donors (ADB being the chief donor agency involved) specifically to meet the need for credit in rural Timor-Leste. After 8 years of operations, the institution is profitable, but only around 20% of its portfolio can be said to serve its original target group34 and this part of the portfolio has incurred significant losses over time. The organizational structure and set-up of IMfTL was never really well aligned with its purported mandate. Rather than a microfinance provider, the IMfTL presents as a small commercial bank with a slightly misleading name. The governance structure of IMfTL with TFET funding to an NGO Fund functioning as a holding company for the capital investments and an advisory board of the public institution has always been cumbersome. By end of 2008, ADB transferred ownership of its capital to the Government and IMfTL is now a fully government-owned financial institution, albeit with a limited banking license. ADB remains committed to fund technical assistance to the institution for a while yet. From its 7 branches, the IMfTL currently serves some 6,600 borrowers with loans totaling $4.1 million at an average outstanding balance of around $620 (for comparison, Moris Rasik’s average loan balance outstanding was $265 as at Dec 200835). IMfTL’s largest and most successful credit product is a salary-guaranteed (consumer) loan, whereas the four more typical microfinance products has fared less well, even if the portfolio at risk has

30 As is the case for some investments made by the apex funds PKSF in Bangladesh and PAF in Pakistan. 31 As was done by the small and privately funded apex fund PT Ukabima in Indonesia, which served 44 BPRs (Bank Perkreditan Rakyats or people’s credit banks) in Java. This apex fund is described by Maris C. Stephens: Rural Financial Institutions: Start-Ups. PT Ukabima Case Study. USAID BASIS-CRSP and WOCCU, 2003. 32 Patrick Goodman: Microfinance Investment Funds – Key Features, ADA/KfW, Luxembourg, Feb 2005. 33 For more on IFC’s Microfinance Facility, see www.ifc.org 34 18.7% as per annual audited financial statements of end September 2008. ADB informs that around 36% of the portfolio is now micro- or MSME loans as at July 2009. Email communication with Jeremy Cleaver, 27 July 2009. 35 M-CRIL: Update of Rating of Moris Rasik, December 2008.

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decreased from 8% to 2.1% overall as at end April 2009. With the lifting of the deposit cap from $1 million to $3 million, depositors have increased to a total of 22,000 holding $ 1.7 million at $77 per account36. A new Board of Directors (BoD) is currently being appointed by the Minister of Economy and Development who has invested an additional $ 1.5 million as equity into the institution. In order to address the key constraints from the low-end SMEs and rural segments of the market, the new BoD of the IMfTL with its management and staff need to: • Determine the target market, update the strategic business plan, and focus and

strengthen its methodology, product range and operations for significant growth; • Determine the most appropriate ownership (public, private, time-limited partnership)

for the strategic direction decided upon; and • Prepare, apply for and attain a full banking license (class C bank will suffice).

5.2.1 Options for IMfTL The selection of new BoD members is particularly important for the success of the institution. IMfTL will need to continue to operate with a clear mission, but following fully commercial principles of operations in order not to fail in the market and become a drain on the national budget. This requires a BoD that can protect the bank from political pressure and interference in its banking business. In addition, as representatives of the owners, the new BoD will need to be able to pass the ‘fit and proper’ test of the BPA as part of the bank licensing requirements. The first big question for the new BoD will be to determine if IMfTL should re-focus on its original mandate of serving the poor and low-income population segment as a rural microfinance bank OR whether it should develop a different set of products to serve the micro and small business market in the urban and peri-urban areas like a small commercial or ‘merchant’ bank. There are advantages and disadvantages associated with both option, to be addressed in on-going TA currently underway with the ADB37. . It would also be important to determine the timeline for privatization of the bank if this is indeed planned for the future. Privatization, once the bank has overcome its current impasse, would be consistent with Government’s overall commitment to market- and private sector led development, and would confirm the Government of Timor-Leste in the role as an encouraging industry facilitator. If a clear exit point and strategy is determined from the start (e.g. sale when certain targets have been achieved) this would also help reduce any confusion about the commercial mandate of the bank, as experienced by some banks during the Indonesian occupation of Timor-Leste. Once the direction has been set, the next big step for IMfTL will be to prepare and apply for a full (at least Class C) banking license which would permanently remove the deposit ceiling currently imposed and enable the institution to mobilize deposits to meet a clear market demand while contributing to future loan capital.

36 Interview with General Manager Mr. Sergio de Espirito Santos 02 June 2009. 37 ADB, Email Communication with Jeremy Cleaver, 07/27/2009.

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5.3 Increased investment finance to viable SME projects Since 2007, the Government has identified increased lending of investment capital to SMEs as a priority, based on requests for assistance from the private sector. Various models have been debated, including the establishment of a state-owned development bank; guarantees provided to commercial banks to mitigate their risk and thus enhance the credit rating or ‘bankability’ of applicant SMEs; or channeling funds as credit lines through commercial banks to farmers and rural enterprises. In this section, the options raised in the debate over the past few years will be discussed in sequence, from the government intervention with the highest cost and risk to the least risky. The section ends with a recommendation to viably support the aim of easier access to investment finance in Timor-Leste for SMEs and MLEs.

5.3.1 A State-Owned Development Bank Since 2005, there have been calls both from within the Government and the private sector to establish a national development bank in the country to offer long-term credit to national businesses at concessional rates. Such a bank could also offer short-term credit to specific sectors (e.g. agriculture, as suggested by UNDP38) or investment banking, e.g. joint venture equity investments, leasing arrangement and swaps, and should be able to float bonds on the open market to raise capital, but would not be mobilizing deposits. Most Asian governments have invested in one or more specialized development bank to support longer-term, higher-risk, sometimes also concessional lending to priority sectors. Likewise, many European donors have established development finance institutions that have become an integral part of government development policy, e.g. Swiss Investment Fund (SIFEM), the Belgian Investment Company for Developing Countries (BIO), and the Netherlands Development Finance Company (FMO), a partnership between the Dutch government (51% shares) and Dutch financial institutions like ABN Amro, ING and Rabobank39. When donor agencies therefore suggest that the Government should not invest in a development bank40, the issue is not that development banks are necessarily or always bad, or that governments should never own banks, or that Timor-Leste shouldn’t have the same development institutions as other Asian countries. It is merely a warning that recalls the tiny market of the country and questions whether the effective demand in this market can sustain a development bank without putting too much strain on the national budget. It is a warning that many state-owned commercial and development banks have not functioned well and that development banks that do not function well have a tendency to become very costly failures and to drag down other banks in their market (see Box 13). As discussed in Section 4, the important drivers of success for development banks is their ability – legally, by their BoD and management, procedurally and politically – to operate commercially based on identified demand and to remain protected from non-commercial influence. A bank which is well-insulated from political pressure, through the appointment of a strong and independent Board that sets a clear strategy and recruits experienced and commercial savvy management, who in turn is supervised on performance results (high repayment rates in addition to increased lending) can be a very successful addition to any financial sector - provided that there is enough effective demand for development credit in its real economy for it to charge reasonable rates and still cover at least its operational costs and retain the value of its capital.

38 UNDP: The Path out of Poverty, Timor-Leste Human Development Report 2006, p. 32 39 J. Rodriguez and J. Santiso: Banking on Development: Private Banks and Aid Donors in Developing Countries, OECD Development Center, Working Paper 263/2007. 40 See e.g. John Conroy: Timor-Leste Access to Finance for Investment and Working Capital, World Bank and GoTL, 2006, which states that “there is no convincing argument for a development bank in Timor-Leste”.

The size of the total effective demand in Timor-Leste remains an unanswered question, but is conservatively estimated by BBI to be in the vicinity of US$ 50 million41. It is estimated that over 90% of the businesses in the country are small42, and a recent study suggested that over half (56%) of all registered businesses have an effective credit demand within the range of $5,000 – 50,00043. If the new BoD of IMfTL so decides, its mandate could be expanded to serve the vast majority of this demand. That would leave a maximum potential market of around 1,100 registered SMEs (44% of 2500) that may demand development credit at some point in time. The investment in a fully fledged new bank to meet the need of the SMEs for investment capital does not appear justifiable, especially with the current scarcity of human resources to run a bank. Box 13: Lesson Learned from Asian SOBs However, an argument could perhaps be made for the Government to take a share in an existing commercially operated bank at this time in order to encourage competition and product diversification into e.g. investment loans, deposits, leasing and remittances specifically for SMEs and to establish the nucleus of a future national banking system.

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To benefit from a branch network and access to managerial expertise, a share in the existing CGD bank branch would be the most obvious choice, but it would not be in anyone’s interest for the Government to take a commanding (majority) share. A minority share for a period of e.g. 5-10 years would suffice to encourage product development, while the responsibility for management and the under-writing of potential losses would be shared with the current owners who have an interest in leaving a prospering bank in Timor-Leste. It may be possible to attract the interest of an International Finance Institution (IFI) like IFC in such a structured investment, if there is a clear plan to privatize the bank to East Timorese shareholders within a set timeline.

5.3.2 Credit lines Liquidity levels in the banking sector suggest that the lack of access to investment credit felt by the SMEs is not due to a lack of funds. Adding additional money to the banking system by channeling government funds through a commercial bank would likely not solve the problem – unless such funds alleviated the banks’ perceived risk. This was the intent behind the $4 million credit line extended to SMEs through the CDG under the World Bank-funded SEP I project. The result was a significant but temporary increase in lending at no cost nor risk to the bank and a predictable spike in default (up to 75% of outstanding

• Many state banks start as credit only ‘specialized’ institutions (e.g. quasi or development banks) with no/little deposit mobilization. But deposit taking often serves a widespread demand and ensures proper intermediation (if properly supervised), and makes the bank less dependent on government funding.

• Decentralization of decision making and branch structure to profit centers have in all cases created better banks

• State-owned banks become very expensive if things go wrong. The Asian financial crisis in 1997/98 cost the Government of Indonesia 50% of GDP (2000) to recapitalize and restructure its banking sector – massive amounts of liquidity has to be channeled into banks facing deposit runs and the high NPL were replaced with government bonds.

See more in GtZ: The Challenge of Sustainable Outreach. How can public banks contribute to outreach in rural areas? 5 case studies from Asia, 2003; and World Bank: Key issues on the Financial sector, Indonesia Country page, FSD.

State-owned (development) banks have inherent problems:

• Governance. Prone to political influence and interference which causes the vast bulk of loan losses (lending to unviable projects). They are often used for government debt relief in crises, which harms the bank’s business and management targets and negatively affects borrower discipline;

• Interest rates are often regulated, making it difficult for bank to ensure its own sustainability and/or select and target clients. If a government insists on interest rate capping, it must also accept ongoing subsidization of the bank. Microfinance has demonstrated the willingness and ability of even poor clients to pay for cost covering loans, so it may be better for government to subsidize other activities, e.g. rural infrastructure;

• Unsound lending practices lead to high cost for loan provisioning and often high current loan loss ratios of 10-25%;

41 Johansson, MSME Credit Demand Study, BBI, August 2009, op .cit. 42 Conroy, 2006, op. cit. 43 Johansson, MSME Credit Demand Study, BBI, August 2009, op. cit.

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portfolio as at Feb 200344) on this portfolio. If government provides free funds to a lender who then carries no risk, this will inevitably lead to less diligence in selection, appraisal and monitoring of projects. In addition, defaulting borrowers are hard to follow up on and when the lender has no ‘own’ money at risk, debt collection will often be more lax. Channeling of capital as risk-free credit lines not only distorts the banking system, but also makes access to commercial credit even more difficult for SMEs because it leads to contraction (reduced new lending and increased requirements imposed by banks); and regression (lack of commercial risk willingness) in the financial sector, and thus it sends the wrong message to new borrowers. In addition, the government as an investor will often get no financial return on such a credit line45. Direct intervention in retail credit in the financial services sector, by making subsidized credit available will harm rather than encourage the current providers, and may lead people to borrow or lenders to lend for more risky activities which will end up failing. Additional funds for on-lending should always be treated as an investment, and hence the cost, risk and the expected return from the venture of increasing the lending business should be shared among investors. For credit lines to work, the risk on each loan to be extended needs to be shared, with the lending institution retaining sufficient risk to subject the loan applications to the normal appraisal and approval procedures – even if the pricing may be less because the risk is shared with a third party, e.g. government or a donor agency. Direct credit lines are, however, most effective in response to a liquidity problem in the banking system, which is not the case in Timor-Leste. When they are used to try to develop an increased appetite among lenders for a specific segment of the SME market (targeted credit), they may work for the duration of the agreement between lender and funder. However, rarely is any longer-term effect seen – lenders often just stop the specific product when the funding dries up.

5.3.3 Credit Guarantee Institution (CGI) Institutionalized credit guarantee schemes (Institutions or ‘Funds’) catering for defaults on existing and/or future SME loans have been operating in almost 100 developed, developing and emerging economies for the past 50 years to promote SME and private sector growth; solve the SME problem of lack of collateral and high lender transactional cost; and reduce the risk and cost incurred by lenders. Credit guarantees help businesses obtain credit from banks by guaranteeing their repayment even if they may not have the required collateral. Traditionally, they have been a popular way for Governments to participate in the financial sector. Sometimes, government funders put an interest rate cap on the loans being guaranteed with the best intent - this phenomenon often leads commercial banks to withdraw and/or to lend less under the guarantee, as competition becomes unfair and commercial spreads cannot be attained. Even when under-writing financing, it is important to keep the transaction commercial. Well-designed, well-funded and well-implemented credit guarantee schemes have no doubt improved SME access to credit and their integration into formal financial markets. Unfortunately, it is very difficult to design, create and implement such schemes in a sustainable way. Often, like the SEP I credit-line in Timor-Leste, Guarantee Institutions tend to deliver short-term outreach results (many people get loans that they may or may not be able to service) followed by a prolonged period of clean up (banks needing to write off or claim for large NPLs; Guarantor needing to claim to under-writer), etc. The vast majority of existing credit guarantee institutions (CGIs) in the world are local, non-profit, relatively small, reach a limited number of existing SMEs and lack sustainability, as their fees do not cover costs. Most do not take collateral (leaving collateral requirements to the lenders they serve). Even the strong CGIs of Japan, South Korea and Taiwan require

44 World Bank: ICR for SEP, 2003. 45 World Bank: Implementation Completion Report (TF23631) on the Small Enterprises Project, Timor-Leste, June 2003.

regular and increasing government funding, and it has been particularly difficult to wean financial markets from dependence on guarantees46. Box 14: Credit Guarantee Institutions – An example

A recent cross country review from Asia suggests that credit guarantee institutions that have low leverage, provide close to 100% guarantees for loans, and/or offer a large amount of credit guarantee relative to GDP, tend to exhibit poor performance and profitability47. In fact, most Asian CGIs have posted poor performance in recent years:

Askrindo continues to require significant annual capital injections from government, partly because banks “view them as a public service, not as a business”. As an example, Niaga Bank which focuses on agriculture signed an agreement with Askrindo to insure its SME portfolio of Rp 200-700 billion in 2008 (up to $ 54 m), after it had provided cover for 10% of the SME portfolio of 1100 loans worth Rp 360bn in 2007. Borrowers pay a premium for the insurance cover. Around 50% of clients opt to do so. See more in: Ian Davies: People’s Republic of China: Development of Small and Medium-Sized Enterprise Credit Guarantee Companies. ADB Technical Assistance Consultant’s Report TA3450-PRC, January 2007 and ACSIC: Questionnaire on credit supplementation system completed by Askrindo for 21st ACSIC conference, November 2008.

Until 1990, credit insurance was compulsory for banks lending to SMEs, and the cost of premiums shared by banks (passing it on to customers) and the government. Askrindo made large losses. When a 20% SME-share of all lending by banks replaced the compulsory insurance in 1990, premium rates were liberalized, but Askrindo set theirs too low and was technically bankrupt in 1992. With additional state funds, it reopened for business in 1994 with higher premiums (1-2% p.a.) and a coverage limit of 70% of the losses. Askrindo also diversified product range to include surety bonds, LoCs, counter bank guarantees, payment guarantees and trade credit insurance to cross-subsidize the SME credit guarantee. Huge losses were incurred on the GoI LOCs and trade credit, which are stopped in 2007.

ASKRINDO of Indonesia The Asian Credit Supplimentation Institution Confederation (ACSIC) that organized the region’s SME credit insurance industry has 3 members from Indonesia, including the state-owned PT Asuransi Kredit Indonesia (Askrindo) established in 1971.

• Underwriting performance (net payments/fee income ratio similar to combined ratio for non-life insurance) was significantly above 100%, indicating underwriting loss);

• Only 1 of 5 Asian country Institutions posted a profit;

• The ratio of recovery to payments is 3 - 50%. Many CGIs have recovery incentives for participation banks;

• The higher the guarantee coverage, the lower the profitability for CGIs;

• To compensate losses, shareholders have had to continuously contribute new capital. In Korea, participating banks are now required to contribute 0.25% p.a. of their corporate loan book to the Fund48.

As for state-owned banks, government funded CGIs run the risk of distorting commercial incentives (banks with guaranteed portfolios tend to be less vigilant in their credit appraisal and client monitoring); encourage directed or ‘policy’ lending; and diminish efficiency. Conversely and again like for SOBs, good CGI performance appears to be linked to the following commercial principles: • High multiplication/leverage ratio (10-20 times outstanding guarantees to net worth of

institution); • Adequate risk management (partial guarantees and coverage ratio of less than 100%)

and strong capitalization, structured to high ratings;

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• Significant outreach (reaching 20-40% of SME market) to avoid concentration risks;

46 Ilhyock Shim: “Corporate credit Guarantees in Asia”, BIS Quarterly Review, December 2006. 47 Ibid. 48 Ian Davies: People’s Republic of China: Development of Small and Medium-Sized Enterprise Credit Guarantee Companies. ADB Technical Assistance Consultant’s Report TA3450-PRC, January 2007.

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• Strong fiscal and regulatory support from government and complementing government

policies promoting financial market infrastructure (credit rating systems, accounting standards etc.) and a private corporate credit guarantee industry; and

• Access to loss/risk compensation and re-guarantee or underwriting schemes. Due to the size of the market and the lack of support services for the financial sector in general, and re-guarantees in particular, in Timor-Leste and informed by the significant losses and difficult implementation structures of Guarantee Institutions elsewhere in Asia, a formal Credit Guarantee Institution is not recommended as a viable option for the country. However, the option of the Government sharing the risk of the longer-term, larger loans that East Timorese SMEs need access to can be implemented in a less institutionalized way for the small market.

5.3.4 Credit Risk Share Facility Supply-driving demand (excess credit chasing bankable projects) in the financial services sector generally has not been seen to improve access to finance. A less risky government intervention to support increased access to finance would be to lower the perceived risk of commercial retail lending by sharing the cost of this risk with existing providers. This approach can also be tailored more accurately to demand development so that inefficiencies from excess capacity are avoided. For SME lending, Public Private Partnerships (PPPs) have been structured but rarely at international level. FMO and Citibank have, however, recently launched a $ 540 m risk sharing facility aimed at providing loans to SMEs in LDCs49. For the small Timor-Leste market where effective demand and credit guarantee experience is limited, the best option for government participation to assist the SMEs in accessing longer-term investment loans would seem to be a tripartite PPP structured as a Credit Risk Share Facility (CRSF) for the financial services sector. The CRSF would be established with funding contributions (investments) from the Government through the MoED/MoF; the participating financial institutions (commercial banks and IMfTL); and an IFI with expertise in the structuring of risk sharing facilities, e.g. IFC. The initial capital of the CRSF would not have to exceed US$ 10-12 million, given the current estimated effective demand. Participating banks could chose whether to invest own capital in the Facility and negotiate the expected risk and profit share with the other shareholders or to respond to a competitive tender issued by the Facility manager to financial service providers wishing to expand and mitigate risk on their SME portfolio. Because investment participation is preferred, tender responses could be subject to an access fee (non-investing banks would pay to access the Facility). The basic operating principles of the CRSF would be negotiated with investors and/or participating banks, to include as a minimum: • Scope and size of portfolios and loan types to be guaranteed

o It would be preferable to leave the structure of the portfolio to the executing bank, and focus on issues of risk management, e.g. expected PaR/NPL for a given portfolio; minimum and maximum loan size and terms; appraisal and monitoring procedures, etc.;

o It would be important to resist the tendency of ‘supply driven direction’ of what loans, sectors, geographic areas, etc. to be guaranteed, and instead support the executing banks to attract increasing numbers of customers based on agreed total loan portfolio values;

o Directional intent could instead be reflected in incentives. E.g. loans to SMEs outside of Dili, in new sector, with softer than conventional collateral, and longer

49 OECD paper 263/2007.

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than usual terms could be encouraged by assigning a higher risk mitigation (i.e. lower risk share) for the bank;

o Borrowers should not be made aware that their loan may be under guarantee.

• Type of guarantee o A non-cash, partial guarantee of an estimated loss on an agreed total portfolio

would be preferable, but this may be too early in Timor-Leste, and the structure should be negotiated with each participating bank;

o Rather than negotiating the usual ‘total portfolio’ to be guaranteed, participating banks should be assisted in determining a reasonable PaR/NPL on the portfolio to be pursued under the agreement, and the maximum agreed expected PaR/NPL should be the basis for the negotiation of risk share and cost. This would increase leverage of government investment manifold and avoid some of the problems of ‘channeled credit lines’;

o A sharing of the potential loss (risk) pari-passu with each bank is the simplest way to structure the guarantee – even if it may have to start with the Facility mitigating a slightly higher share than the banks, e.g. 65-35 pari-passu. Alternatively, the Facility may be able to accept a 1st loss share of e.g. 15% of estimated default + a 50-65% share of 2nd loss shares for a first ‘cycle’ (e.g. 24 months). Pending excellent performance of the portfolio, the risk share should be revised to that the share of the executing bank increases to avoid dependence and waning vigilance;

o The IFI investor should be able to ensure a AAA rating to the portfolio under guarantee so that head offices of participating banks can assign a 0% risk to the part of the loan book under guarantee;

o If executing banks are concerned about claims processing and pay-out delays, a negotiated total of the expected maximum guaranteed loss (based on PaR/NPL on total portfolio) could be deposited in the executing bank, but should not be accessible without joint signatures of all CRSF parties;

o Standardized loan rating system, claim procedures and prerequisites should be determined and agreed;

o Performance targets should be agreed, including the possible reallocation of guarantee amounts in case of under-utilization.

• Non-Guarantee benefits

o Liaison between banks and BDS providers so that relevant training are offered to borrowers;

o Offer of TA to participating banks to better assess, appraise and monitor SME investment loans; and

o TA for the Facility Manager to ensure proper mechanism, paperwork, claims procedures and Fund management, audit etc.

Such a Guarantee Facility would be able to address the demand for longer-term investment credit by SMEs in Timor-Leste while avoiding the majority of the pitfalls experienced in the rest of Asia with government-funded guarantee schemes. It would also be able to under-write new products that may at the outset seem to risky for financial institutions to test and roll-out in the country, and could thus act as a stimulant for the existing financial institutions to engage further and test new products with perceived high risk, e.g. agricultural loans, loans for RNFEs, microinsurance, etc. One final lesson to be taken from Asian public guarantee infrastructure is that all guarantees should be structured to incentivize borrowers to graduate to guarantee-free financing – and this requires a well functioning financial market with credit ratings, credit bureaus and asset registries to document track records50. The enabling environment remains the responsibility of a supportive government and the precondition for a well-functioning and dynamic financial services sector.

50 Ilhyock Shim: “Corporate credit Guarantees in Asia”, BIS Quarterly Review, December 2006.

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5.4 The Enabling Environment – Non-financial Support to SMEs Generally, countries that develop essential financial infrastructure, support the development of retail institutional capacity, and allow for institutional diversity have seen thriving inclusive, urban and rural financial markets develop over time. Through wise public spending on labor intensive and decentralized physical infrastructure, government can positively affect employment and income generation, at least in the short-term. Since 2007, the city centers (primarily Dili) of Timor-Leste have experienced a consumption boom largely driven by public spending. For a rural economy like the East Timorese, Government can facilitate economic opportunities by improving market access for MSMEs through roads, telecommunication, electricity, water, etc. Increased incomes in turn fuel increased demand (consumption) which spurs additional supply, as discussed in Annex 2. For the financial sector to become more dynamic, self-propelled and risk-willing, its infrastructure needs strengthening. As fully recognized by the Government there is a need for a more encompassing and yet flexible legislative and regulatory framework for the sector. In particular: o Land and property registries will facilitate the pledging of collateral for SME loans; o Bankruptcy and collateral regulations will facilitate the realization of pledged collateral,

lowering the risk rating for the borrower. As will the setting up of an interim, effective alternative dispute resolution mechanism for commercial disputes, acknowledging that it will take time for the regular court system to be able to deal effectively with commercial complaints;

o A credit rating service/bureau will enable borrowers to present a track record to lenders and for lenders to check the history of new borrowers to weed out willful defaulters. It is understood that the BPA will take charge of this service, but it is recommended that BPA allow private sector participation in the further development of consumer credit information systems (CIS). Private credit bureaus have demonstrated that they are better able to manage the professional processed of bank data and retail information (from utility companies) in a format that facilitates the use of risk assessment and standardized pricing models by banks and NBFIs;

o In preparation for the credit bureau, standardized accounting procedures for the entire sector will assist in its supervision, and once determined can also serve as the basis on which to help train SME borrowers;

o There is no NBFI legislation in Timor-Leste at present. Rather than developing specialized legislation for each potential NBFI type, the Government and BPA may wish to draft a general legislation for ‘multi-finance companies” which can provide leasing, factoring, consumer finance and credit card services, etc. but do not take deposits, like it has been done in Indonesia. When drafting regulations for leasing it is important to allow lessors to depreciate the leased asset under a financial lease and include depreciation in the calculation of tax for lease transactions. This reduces the costs of leasing and therefore helps SMEs51;

o Specifically to assist the MFIs, a BPA Circular will suffice to determine the nature of business, customers and basic operating principles that microfinance institutions adhere to and which delineates these financial services providers from multi-purpose NGOs and private ‘Ponzi’ (pyramid) schemes. In addition, regulations that stipulate the registering and reporting requirements for MFIs wishing to respond to the demand for safe and convenient rural savings services would be helpful to stimulate the bottom-end of the economic sector. A full microfinance law is not necessary – and neither is a full banking license for the existing MFIs, but prudential controls of institutions intermediating consumer savings must of course be put in place;

o Overly complicated business legislation and regulations continue to present obstacles for new SMEs in particular, and the ongoing process of simplification must continue;

o In addition to the simplification of rules and regulations, MSME customers across the board demand and need more effective business development services and training.

51 For more on the Indonesian experience with NBFI legislation and leasing, see World Bank: Unlocking Indonesia’s Domestic Financial Resources: The Role of Non-Bank Financial Institutions, December 2006.

IADE trains new, primarily micro-level entrepreneurs, but advanced training, mentoring and operational services (taxation advise, legal advise, audit, financial statements review etc.) for SME customers is also needed to enhance their businesses and the bankability of their loan applications. The additional capacity needed to adequately serve SME customers may be more effectively provided by private sector, commercially based BDS providers alone or in partnerships with IADE. In addition to the cooperation with ILO ongoing under the Decent Work Programme, nearby PEAC BROMO is relevant for assistance in this field (see Box 15). Alternatively but slightly further afield, the IFC supported Mekong Private Sector Development Facility (MDFP) would also be a good resource for IADE52.

Box 15: The PEAC (credit) BROMO and MONAS Facilities in Indonesia

For more on these initiatives, see www.ifc.org and www.peacbromo.co.id

IFC supports a Program for Eastern Indonesia Small and Medium sized Enterprise Development – PENSA. IFC: PEAC BROMO- Promoting Small Medium Enterprise in East Java Access to Credit, Surabaya, Dec 16, 2008.

Under the facilities, local business service providers are trained in available banking products and bank requirements for SMEs. Once trained and certified, the providers can assist MSMEs become better bank clients. In addition, PEAC BROMO offers more general capacity building workshop packages to enterprises at different levels of maturity and experience. As a member of the supervisory Board of PEAC BROMO along with Bank Indonesia, and the government of East Java, BDS Indonesia acts as the certification body of participating business development service providers. After one year of operation, PEAC BROMO had facilitated IRp. 1.4 billion of loans to MSMEs.

PEAC BROMO is a private company providing consulting services for SME Development. It was established in 2004 in Surubaya by the Indonesian Business Development Services Association (ABDSI) and Jawa Pos Daily Newspaper, with support from SwissContact and IFC’s PENSA Program. In 2005, a similar facility – PEAC MONAS - was established for MSMEs in the Greater Jakarta area. PEAC Monas is managed by PT Penjamin Kredit Pengusaha Indonesia (PT PKPI) and TRIEKA Group. Both PEAC BROMO and PEAC MONAS aim to enhance MSMEs’ access to finance through

• training and mentoring of business service providers that can work directly with individual MSMEs to enhance their bankability;

• networking and information sharing within the business community; and

• linkages to and training of banks.

5.5. The Mega projects – physical infrastructure PPPs Traditionally, Public-Private Partnerships (PPPs) have been developed in sectors where critical public infrastructure was lacking, e.g. public housing, telecommunications (Timor Telecom is a good example of a PPP); postal services, power plans, ports, airports etc. Often, government invites tenders from private companies to execute the projects. Alternatively, government establishes an autonomous agency (‘Board’ or ‘Corporation’ for the ‘sector’) and authorizes it to partner in venture with private firms – creating subsidiary executing JVs to co-invest with private partners to share cost, risks and profits. Sometimes a development bank is given that authority. In traditional PPPs, the (typically foreign) private partner in the JV will eventually want the return on investments and will leave, and these JVs become State-owned Enterprises (SOEs), which – on the whole – have not fared well in any country and are being phased out with economic reforms, especially in Asia. Where a number of these SOEs still exist, governments have had to find a consolidated mechanism for their operation. The $87 bn TEMASEK holding company in Singapore is managing all the subsidiaries that were established by PPPs over the years in the city state and reinvests the profits, not unlike the Timor-Leste Petroleum Fund.

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52 For details on the Mekong Private Sector Development Facility, see www.ifc.org/mpdf

Box 16: The importance of comparative returns It is relevant to note, however, that a ‘TEMASEK II” proposed to focus on government assistance to SMEs has been stopped in its tracks by the Singaporean government that does want to local SMEs compete internationally but that will not force its sovereign wealth fund TEMASEK to finance them. The PM recently said that “Government wants to help companies grow […] but we don’t believe that this can be done by the government by simply pouring money, or creating a TEMASEK II” 53. His may be good advice to the Government of Timor-Leste.

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More and more frequently, PPPs are being structured as tri-partite investments with the Government, a private partner and an IFI, e.g. ADB, EIB or IFC to cost-, risk-, and profit-share investments. In such ventures, the parties involved agree to share the cost of the project (often split with capital from Government, equity stake from the IFI and technical expertise, operational funds and management responsibility by the private partner); the risk; and the expected profit in proportion to their investment for a specified period of time, following which the project reverts to private (or public) ownership.

Argument presented in ADB’s Outlook of Asia 2009, Democratic Republic of Timor-Leste.

In among all the ‘people-oriented’ national priorities, Government does appear to give a de factor priority to power generation – a sector that otherwise can be self-funding through fees. From the current electricity capacity of 40 MW supplying 20% of the population, Government has signed contracts to expand the production of electric power to 180MW, spending more than half of the capital expenditure budget of $616 m for the period of 2009-2011 without much evidence that environmental concerns have been heard. Given that an electricity demand study in 2004 suggested that 100 MW of electricity by 2025 would increase coverage to 80% of the population, this could demonstrate a ‘supply-driven’ approach to development which may not immediately meet the stated objective of serving the people. The costs involved are staggering, especially when compared to the costs – and social returns – of ‘true public goods’ such as law and order, road building and maintenance, education and health services that cannot successfully self-finance.

As discussed in Section 4, one lesson learned from the Asian experience is that any public corporation needs to be able to operate commercially without political interference in its quest to invest and supervise public and private works projects. Few Sector Investment Board or Corporations have done so successfully. However, an increasing number of large public work contracts and proposals is seeking government attention and vying for funding under the general annual budgets that are already significantly higher than the ‘sustainable income’ generated by the Petroleum Fund. It may be useful therefore, to allocate resources for the technical analysis, selection and monitoring of such projects in a National Investment Center or Unit. Such a unit would be charged with the technical, financial, social and environmental impact assessment of each large-scale investment proposal received and to ensure that all proposals were carefully analyzed and compared based on objectively verifiable criteria. The unit would then present its recommendations as a prioritized list of investments within the national capital budget for the decision of the Council of Ministers. As for any institution, the task is more important than the institutional structure and resources are few in the Government of Timor-Leste. The tasks of a National Investment Center could be performed, e.g. within the Ministry of Finance or by the recently established Investment Unit in the Office of the Prime Minister for an experimental period of 12-24 months prior to a review of performance and a decision on whether a more permanent institutional structure would facilitate the tasks. While it is hoped that the government-led development process will bring multi-facetted prosperity to Timor-Leste, it may nevertheless be prudent for the time being to treat the Petroleum Fund as the only source of national income and ensure that the revenue from investment of the proceeds is not spent faster than it can be replenished given the volatile international oil prices.

53 Reuters: Singapore PM kills “Temasek II” idea to help local firms, 27 May, 2009.

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6. Conclusions and Recommendations

6.1 A pragmatic policy approach Whether based on liberalist or socialist principles, the traditional approaches to development and in particular to government participation in private sector development have been presumptive, rather than diagnostic. They start with strong priors about the nature of the problem (“unmet need for credit”) and the appropriate fixes (e.g. “state-owned development bank” or “increased rural finance”). A new and more pragmatic policy mindset has gradually gained ground over the past few years. This new approach has the following characteristics: • It starts with relative agnosticism on what works and what doesn’t. It is explicitly

diagnostic in its strategy to identify bottlenecks and constraints; • It emphasizes experimentation as a strategy for finding out what works. Monitoring

and evaluation are essential in order to learn which experiments work and which fail; • It tends to look for selective, relatively narrowly targeted reforms. The main hypothesis

is that there usually is “slack” in poor countries, so that simple changes can make a big difference but also that not everything needs ‘fixing’; and

• It is suspicious of “best-practices” or universal remedies. It searches instead for policy innovations that provide a shortcut around local second-best or political complications.

The traditional policy model presumes that analysis and recommendations precede the stage of policy formulation and implementation. The new, experimental approach implies instead “innovating through implementation first, and drafting universal laws and regulations later”. The new development policy framework suggests that problems can be diagnosed and solutions found through pragmatic experimentation, careful monitoring of output, and innovative changes to the policies as incremental results produce new learning54. The financial sector of Timor-Leste has been analyzed in detail for the past five years, recommendations have been made in many, many reports but little has been done to actively address the problems identified, partly because of general disagreements on a given presumptive “solution”. Rather than clinging to the old paradigms, the case can be made for a change to the new development model based on the evidence accumulated to date and a continuing pragmatic experimentation with different potential policy solutions to limited development problems and choices as they present themselves in Timor-Leste. As a proponent for private sector-led growth and sound financial sector development, the Government of Timor-Leste has resisted from becoming deeply and directly involved in the sector, which - while sluggish - does not display any major dysfunctions. Progress has been made in creating an enabling environment and a stronger financial services sector framework, and the filling in of gaps is continuing. There is little evidence that the Government would desire to distort or displace the small current group of financial services providers. Rather, there is a strong desire to support, facilitate and stimulate expansion and growth in order for the sector to be able efficiently serve a much larger portion of the Timorese population. Such a pragmatic approach to the constraints of access to investment finance identified in the business community would enable the Government of Timor-Leste to experiment with participation in the financial sector to resolve or minimize the constraint and allow new learning from monitoring and feedback to guide the process.

6.2. Clear diagnostics The demand among MSMEs for easier access to investment finance is being heard, as are the constraints and risk-adversity felt among financial service providers. The Government of

54 Dani Rodnik: The New Development Economics: We Shall Experiment, but How Shall We Learn?, John F. Kennedy School of Government - Harvard University, October 2008

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Timor-Leste has long recognized that there is a problem (need) and demonstrated a willingness to respond. The diagnostic of the problem attempted here indicate that: • There is not a lack of liquidity in the market (hence no need for more external capital)

but there is an unmet effective demand for financial services (deposits, credit, remittances, etc);

• There is a need among MSMEs for training, mentoring and better project presentations to banks (and other financial institutions);

o Stated demand is unrealistically high compared to effective demand o Business planning and financial projection are generally weak o Many projects are not convincingly viable when presented to banks/MFIs

• (M)SMEs that have bankable projects cannot access longer-term investment loans; • Banks perceive the risk too great to approve longer-term loans;

o A credit bureau would be able to establish credit history o A land and property registry would facilitate the pledging of collateral o Contract/collateral/bankruptcy legislation/regulations would enable banks to

enforce contracts and realize collateral o A commercial ADR facility would offset the current dysfunction of the courts o Banks need training and mentoring to better deal with cash flow-based credit

appraisals. • The Government may wish to do too much in too short a timeframe – on the back of the

revenue from the Petroleum Fund, there is a certain sense of impatience with the market that weakens the emphasis on careful analysis of possible long-term implications and impacts of government and investors’ actions.

6.3 Selective and experimental, participative reforms

The options for Government participation in the financial services sector have been explored based on national evidence where possible and augmented with evidence from other countries where the governments have faced similar demands. With the experience in mind, and due to the size of the East Timorese market; the level of maturity of the business community as a whole; and the level of capacity - both private and public; the best approach for the Government of Timor-Leste would be a limited, temporary and targeted program of participation with the explicit aim to energize and incentivize (as opposed to displace) the private financial services sector to expand by sharing the perceived (and real) risks of doing so. This report recommends the following viable options for government participation in the financial services sector of Timor-Leste: Segment A: The majority rural and urban poor and low-income population and the micro-enterprises they operate to sustain their livelihood. As co-chair and co-funder of the microfinance apex fund INFUSE to continue the support to:

a) A light regulatory framework enabling MFIs to register and report to the BPA as non-bank financial institutions and – if able to meet prudential standards – to mobilize public deposits;

b) Easier and swifter access by MFIs to funds for institutional capacity building, technical assistance and capital for on-lending, including easier access to the INFUSE offices;

c) Increased and stronger coordination within the FIF of all funders and investors in microfinance in Timor-Leste to improve investments, performance monitoring and linkages of MFIs to the rest of the financial sector, especially banks.

Segment B: The rural and urban low-medium income population that sustain their livelihood through wage labor and micro- and small enterprises As sole owner of IMfTL, to provide interim decisive direction to appoint a capable, fit and proper Board of Directors for the stagnating bank that will be able within 1-2 months to:

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a) Provide overall strategic direction to management on the future role of the bank, either as a small MSE bank or a rural microfinance bank;

b) Facilitate the early contracting of appropriate TA as per the strategic direction; c) Ensure that the bank BoD and management retain a fully commercial

approach to its operations and is afforded protection from undue interference and political pressure;

d) Monitor progress of the BoD, management and contracted TA against the business plan targets to ensure that:

- a comprehensive and growth-oriented business plan is completed and adopted with a strategy for divestiture in 3-5 years;

- an application for at least a Class C bank license is successfully submitted; - a review and revision of products (including wholesale loans to MFIs, if

desired), staffing and procedures is conducted at all levels of the bank to ensure dynamic growth, high quality portfolio and continuing profitability.

Segment C: The rural and urban small and medium-sized enterprises that employ a growing number of people

In response to the demand for easier access to SME credit in the market, to participate in a Risk Sharing Facility with interested commercial banks to mitigate the current high perceived credit risk, by:

a) Allocating funds for a temporary Credit Risk Share Facility (CRSF) to be designed and competitively offered to financial institutions willing to lend to SMEs;

b) Negotiating IFI participation in the CRSF and contracting TA to finalize design; c) Facilitating (with TA) the establishment of an independent, competent and

reliable claims processing mechanism for participating banks; d) Promoting a more enabling environment, by supporting the efforts of BPA to

establish a functioning credit reference service for customers and the efforts of MoJ to finalize the land and property legislation and registers;

e) Ensuring that quality TA is made available to participating banks to better appraise the cash flows of East Timorese businesses;

f) Ensure that quality TA is made available to enhance the bankability of SME investment projects through a strengthening of the basic capacity building structure established with IADE and the BDCs.

If the Government would wish to invest directly in ensuring credit flow to the SME community, it could consider buying a minority share in the commercially operated bank with the largest outreach, CGD/BNU, in order to encourage competition and product diversification into e.g. investment loans, deposits, leasing and remittances specifically for SMEs. An equity investment for a period of e.g. 5-10 years would suffice to encourage product development, while the responsibility for management and the under-writing of potential losses would be shared with the current owners who have an interest in leaving a prospering bank in Timor-Leste. It may be possible to attract the interest of an International Finance Institution (IFI) like IFC in such a structured investment, if there is a clear plan to privatize the bank to East Timorese shareholders within a set timeline. Segment D: Government itself and national and international medium- and large enterprises that generate income and employment, but also require regulation and supervision Ensuring a fully informed governmental decision-making process when selecting and prioritizing public infrastructure projects of varying size and impact on the ecology, economy and social fabric of the country, by:

a) Adoption of a transparent and objectively verifiable set of minimum standards to be met by large-scale public works projects;

b) Establishing a technically, economically, financially and environmentally competent National Investment Unit or similar to assess, rate and rank all large- scale public works projects against socio-economic, fiscal and environmental impact prior to their consideration by the Council of Ministers;

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c) Ensure the independence and immunity of the Unit to political pressures and influence, by having non-resident technical experts validate the assessment results and recommendations, e.g. through agreements with technical universities in the region; d) Establishing a practical and effective monitoring, evaluation and standards

enforcement system on public contractors and their projects, enabling the Government to supervise development projects and incrementally rectify problems before its too late.

Table 17: Summary of options for Government participation Segment A-D

Demand Constraints Recommended Government action to facilitate solution

Status Mid 2009

D. MLEs, FDI, Gov’t budget

Public /PPP ‘mega’ projects

Prioritization difficult. Long-term economic, social, financial and environmental impacts unclear.

National Investment Unit backed by foreign expertise (twinning arrangements with Universities etc) to appraise, compare and prioritize investment projects for Government decision.

OPM Unit

C. SMEs Investment credit for MLEs and SMEs

No long-term loans Few bankable projects; Unrealizable collateral

Credit Risk Share Facility as PPP with IFI and possibly commercial banks for investment loans above $50k at 12-48 m term offered competitively and negotiated individually with participating banks.

C. SMEs Business loans Leasing products Asset insurance Training/mentors

Few bankable projects; Unrealizable or no collateral; High cost market; Limited product dev’t

CRS Facility may under-write products/pilot tests to stimulate new product dev’t. Support to private sector-led BDS/training. Land/property legislation to be fast tracked Credit registry to be launched Equity investment in CGD/BNU

BPA consults CGD proposal

B. MSEs, HHs, IMfTL

Increased MSE & rural deposits, Credit, Remittances

IMFTL stagnant

Careful, merit-based selection of new BoD Stakeholders meeting to determine strategic direction prior to tendering and contracting TA to prepare for full banking license and adopt new performance-based expansion plan55

With MoED TA from ADB underway; License applic. to be updated.

A. MEs, HHs, MFIs

Increased micro-finance products

MFIs capital-starved Industry in crisis-recovery (2 MFIs) Low financial literacy

Facilitation/co-funding of INFUSE CRS Facility to under-write capital investments in MFIs too. IADE to be strengthened with external, intensive support

Done, MoED ILO supports.

There are great benefits to being a young Nation in an interconnected world because it is no longer necessary to repeat the entire punishing cycle of learning from ‘zero’ within development. Rather, the lessons learned by other governments in similar circumstances provide a cutting-edge starting point for the Government of Timor-Leste. With a flexible modern policy approach to ‘learning through monitoring and innovation while doing’ and clear diagnostics of the problems that limited participation may fix, the Government of Timor-Leste is eminently well placed to avoid the expensive historic pitfalls of government intervention in the financial services sector and thus potentially ensure a ‘quantum-leap’ development for the small market.

_____________________________

55 A stakeholders meeting took place in August 2009 and ADB TA to support the process is well underway.

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Annex 1

The Setting for the Financial Services Sector Debate Mid 2009

In response to internal and private sector pressure to address limited access by East Timorese enterprises to long-term investment finance in particular, the current Government has publicly announced its intention to enter the financial services market, focusing on SME lending and investment promotion, and has requested that the IFC-supported BBI provide options on how to do this in a productive and sustainable manner. While the prioritized options for government participation are presented in the main report, this Annex provides a brief (and by no means exhaustive) contextual update for the listed options, which may be of use to new or peripheral stakeholders. 1. Historic Background East Timor was a colonial territory and overseas province of Portugal from 1520 – 1975, when the Portuguese abruptly pulled out, leaving the island vulnerable to the subsequent Indonesian invasion and annexation. The Indonesian occupation was characterized by ‘economic paternalism’ and extreme brutality towards the Timorese resistance movement which was violently suppressed by Indonesian military forces. More than 200,000 Timorese or a third of the population is reported to have died from famine, disease, and fighting during the 24 years of occupation and in the violence erupting around the 1999 referendum on self-rule, which eventually led to 3 years of UN administration (UNTAET). In 2002, after almost 500 years of foreign rule, the tiny new nation of Timor-Lorosa’e (Timor-Leste) was proclaimed. With 70% of all infrastructure in the country destroyed and 75% of the desperately poor populace displaced, the newly appointed government faced a massive job of nation-building. Since then, significant economic and social progress has been made by the four successive constitutional governments, but the progress has been slow and uneven, largely invisible to the ordinary population, and results have been mixed. The long history of violent and/or paternal occupation and the resultant Timorese inexperience in self-governance is reflected in weaknesses in the abilities of state institutions to deliver services, especially at district and local levels, and lapses in the application of the principles of democratic governance and social cohesion.56 Eruptions of violence involving the armed forces and police; and civil unrest (2002/3, 2006 and 2008) continue to demonstrate these lapses, and have lead to the return of a UN-mandated peacekeeping mission (UNMIT) in addition to a stabilization force under Australian and New Zealand command, assisting the Government of Timor-Leste with the maintenance of law and order while security sector reforms have begun. The UNMIT mandate has recently been extended till February 2010. Following their enormous sacrifices, the high expectations of the small but rapidly growing population (1.1 million in 2009) for peace, prosperity, and perceived entitlement to public support are understandable. They are, however, not easily met. 2. National political framework and context Since the 2002 National Development Plan, the twin overall objectives of the country have remained economic growth and poverty reduction. In early 2004, Government adopted a private sector investment policy which clarified the operational economic leadership role expected of the private sector, both domestic and foreign, and spelled out the primarily enabling and regulatory role of Government. The overall Government of Timor-Leste approach to economic development remains market-based and focuses on the development of the private sector as the engine of growth, explicitly wishing to avoid replicating the “paternalistic State” experienced under the

56 United Nations Development Assistance Framework, 2009-2013.

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Indonesian occupation57. While this is a sound governance approach, the transition from a controlling – but also protective and subsidizing – State to a market-led economy can be difficult for a resource-strained population. Many of the positive and necessary development outputs under the previous government (policies, laws, completion of institution-building) have been largely invisible to the population. Despite strong planning and strategic direction (e.g. through Sector Investment Programs for priority sectors), implementation and in particular budget execution remained a problem (only 25% of the central government budget had been spent by end of Q3/06-07). The perceived inactivity and the accompanying economic downward turn and disenfranchise led to civic unrest and a crisis in 2006. Better communication and more participation were necessary after the crisis to shore up popular support for the national development process. The National Priorities developed by the new government after the Election in 2007 upheld the principles of a market-economy but emphasize economic growth with government participation58. Social safety net schemes were been initiated and the security sector reforms began. Public spending on labor-intensive infrastructure programs continued along with an increased focus on agriculture and food security - agricultural extension services have increased and a major irrigation system was recently rehabilitated. In addition, the government launched an Economic Stabilization Fund (ESF) to ‘stabilize the rice supply for Timor-Leste’ subsidizing imported rice for consumption. While the 2008 priorities helped the government focus and take action to improve political and social stability, the 2009 national priorities are “geared to consolidate peace and sustain economic growth” with the restricted resources that the falling international oil prices signal for Timor-Leste’s revenue. The 2009 priorities focus on rural and “small family sector production” and include:

- agriculture and food security; - rural development; - Human resource development; - Social protection and social services including health; - Security and public safety; - Clean and effective government; and - Access to justice, including the implementation of land and property registries and a

simplified business registry, all key concerns to the private business sector59. The Government has recently approved the National Priorities for 2010 to include infrastructure; food security; human resource training; access to justice; social services and administrative decentralization; good governance; and public security.60 In prioritizing rural development, the Government of Timor-Leste stresses the importance of a strong private sector, but recognizes the need for government to also invest in rural infrastructure, agriculture and services to support a trickle down effect by raising productivity and thus incomes61. MoED and the Ministry of Infrastructure are leading the rural development priority area which includes measures to alleviate poverty, promote business initiatives and improve infrastructure. Facilitating access to microfinance is specifically mentioned along with the facilitation of cooperatives. Under the Access to Justice priority, the Ministry of Justice has begun a mapping of the cumbersome and overly complicated business registration procedures with a view to simplify them; a Land Law is being drafted; and several other important pieces of legislation appear

57 Political Transition in Timor-Leste, in Country Strategy Paper and National Indicative Programme for the period 2008-2013, European community, p. 36. 58 As planning instruments, the National Priorities are updated annually and appear to have replaced the Sector Investment Plans developed during 2004-06. 59 Government of TL: Goodbye Conflict and Welcome Development, paper for Timor-Leste Development Partners Meeting, Ministry of Finance, April 2009. 60 Democratic Republic of Timor-Leste IV Constitutional Government: “Extraordinary meeting of the Council of Ministers on 23 May 2009”, Secretariat of State for the Council of Ministers, Dili, 23 May 2009. 61 UNMIT Statement for the Timor-Leste Development Partners’ Meeting 2009 on National Priority 2: Rural Development.

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to be in process. There is a clear understanding that the work on the institutional and legal frameworks which in many ways remain incomplete and embryonic needs to continue. On the other hand, the current government is intent on providing real benefits for its people to consolidate stabilization. No doubt this was a factor in the establishment of the ESF which recently intervened in the rice market. Agricultural productivity and output remains very low (a 21% increase in 2008 output due to favorable weather resulted in domestic rice covering only 40% of demand) not least due to high post-harvest losses and lack of market access. The purchase by government of imported price and the reselling of the commodity locally at a subsidized price certainly made cheaper rice available in the local market for a short while. But the ESF appeared to lack pro-poor targeting mechanisms to channel subsidized rice to the poorest segment of the population (who often can’t afford rice at all are generally eat more corn and cassava) and distorted the local market prices sufficiently to negatively impact domestic rice production and trade. It is not clear how the Government of Timor-Leste is “engaging the private sector in enhanced domestic food production”62 by subsidizing imported commodities. 3. The Economic and Social Context

The economy of Timor-Leste is a dichotomy between two sectors that have very little in common: the oil (and UN expatriates) sector on one hand and the non-oil real sector on the other. Whereas the GNI per capital (including oil revenue) is at a middle-income country level of $ 1,51063 (2008), the non-oil per capita income has declined since Independence from $385 in 2002 to an estimated $350 – the relative oil wealth thus disguises deep poverty in the country.64 Petroleum revenue represents about 95% of total government income. It is thus critical to the present and future East Timorese economy, but it is not directly generating significant employment. The Petroleum revenue management structure established in Timor-Leste is acknowledged as a ‘good practice model’ which, if continued, could save the country many of the problems of waste and corruption experienced by other oil rich nations. Petroleum revenues are deposited in a Petroleum Fund managed by the Banking and Payments Authority (BPA)65, currently holding some US$ 4.7 bn66, which invests all of the proceeds to augment the Fund. The interest income from the investments, primarily in US Treasuries (and thus escaping losses owing to the current international financial crisis) are passed on to the national budget. At present some US$ 400 million is sustainably available for the Budget each year. Concern was expressed this year about depletion of the Fund due to the plummeting international oil prices, and the ability of the Fund to generate sufficient sustainable income for the increasing public budgets for 2009 and 201067. The Government of Timor-Leste maintains that the 2009 budget would not be gravely distorted by the international oil prices, as the baseline price for the revenue forecast used is US$ 40/barrel, and hence within range of current prices68. Just like in 2000-02, the large contingent of international personnel based in country until 2010 under the current UNMIT and ISF mandates, creates an artificial demand for housing, consumer goods and services that the local trade-based economy is quick to exploit, resulting in price and wage spirals significantly above the regional ranges.

62 Government of Timor-Leste: Goodbye Conflict and Welcome Development, paper for Timor-Leste Development Partners Meeting, Ministry of Finance, April 2009. 63 World Bank: Doing Business, Timor-Leste Country Review 2009. 64 ADB and IFC: Economic and Social Brief, August 2007 and UNDP Human Development Report 2006 and UNDAF 2009-2013. 65 ADB and IMF: Economic and Social Development Brief, August 2007. 66 BPA: Quarterly Economic Bulletin, March 2009 67 IMF: Statement at the Development Partners Meeting, April 2009. The IMNF argued that at the current price, Timor-Leste’s petroleum receipts would fall by some 60 % from the level in 2008, which would eventually mean a much tighter budget constraint. IMF advised that the 2009 budget should be reduced to reflect the lower cost of government imports and that if it was not, the 2009 budget would imply a non-oil fiscal deficit of over 100 % of non-oil GDP (97% in 2008). 68 Government of Timor-Leste: Goodbye Conflict and Welcome Development, paper for Timor-Leste Development Partners Meeting, Ministry of Finance, April 2009.

Total expenditure in 2008 including the ESF amounted to $480 m69. If this, merchandise import represented $247m against which the bumper coffee crop provided $48 m export earnings70. The yawing trade deficit is going to remain for a while, as the country really does not have much but its high-value coffee to export. Fig 1: GDP developments in Timor-Leste71 2002 – 03 Economy contracts

This was expected due to the gradual pull-out of the international UN mission/UNTAET which had caused an economic bubble in the tiny market; 2004-05 Positive economic growth The macro economic framework was stable and sound fiscal management prevailed. However, real term per capital incomes remained stagnant; 2006 -07 Economic activity ceased A virtual economic stand-still slowed social progress too. The non-oil economy stagnated, with unemployment and poverty high and rising. Consumer prices increased and the combination had bank NPL surge to

GDP composition by sector72 (2006):

Agriculture: 32.2% Industry: 12.8% Services: 55%

above 30%73. 2008-09 Economic Revival The combination of a bumper crop of coffee and a massive public sector development

program (Government expenditure more than doubled in 200874) revived the economy and GDP grew an estimated 10-12% in 2008.

Consumer prices peaked in June 2008 driven by higher food prices, but have since fallen along with international commodity prices, also reflecting government intervention in the rice market through the ESF75. The annual CPI-based inflation for Dili has decreased from 7.5% in December 2008 to 4.2% in March 2009. 76 Timor-Leste is ranked 158 of 179 countries in the UNDP Human Development Index77 as the poorest country in Asia. Poverty has increased significantly between 2001-2007 from 36% then to 50% of the population now living below the national poverty line of $ 0.55/day ($ 1.50/day in international PPP dollars), disproportionately more in the urban areas due to the inability of migrants and youth to find employment.

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69 BPA: Quarterly Economic Bulletin, March 2009. 70 ANZ Pacific Quarterly: Country Update Timor-Leste, May 2009. 71 ADB: Economic Outlook for Asia, 2009, Timor-Leste. 72 Bartleby (www.bartleby.com) 73 ADB and IFC: Economic and Social Development Brief, August 2007. 74 Government of TL: Goodbye Conflict and Welcome Development, paper for Timor-Leste Development Partners Meeting, Ministry of Finance, April 2009. 75 IMF Statement to the East Timor Development Partners Meeting 2009 in East Timor Law and Justice Bulletin, 11 April 2009 76 Government of Timor-Leste: Goodbye Conflict and Welcome Development, paper for Timor-Leste Development Partners Meeting, Ministry of Finance, April 2009 and United National Development Assistance Framework 2009-2013; and BPA: Quarterly Economic Bulletin, March 2009. 77 UNDP: Human Development Index, 2008 Statistical Update. Statistics are based on 2006 figures.

Fig 2: Illustrative segmentation of population and enterprises by size and wealth78

Est. % of Adult Population: Est. % of reg. businesses: High income segment

MLE 16% s

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20,500 MF borrowers

Mid level High End SMEs

Low end SMEs

Poverty line

The Poor and Low-Income segment

Households/MEs

Unserved: 270k

Outside cash econ: 200k

2% - 12,000

13% - 78,000 110,000 bank customers

32% 52%

85% - 510,000 80% rural

39,500 MF savers

The country faces an all-pervasive human resource dilemma of opportunity and capacity: Like people everywhere, East Timorese people want a better life and are prepared to work for this ideal. Many, however, will look to government to help them establish a business or find a job, some in a nostalgic return to the paternal care of the Indonesian state; some cashing in on a perceived entitlement from active resistance duty; and some by default, given that there are few other entities to turn to for help. While unemployment is high and job creation therefore a key concern of government, the level of training and employable skill of the available work force is extremely low, and the labor price levels remain inflated by regional standards. This is the compounded result of a history of employment in low-level positions during the Indonesian occupation and thus extremely limited managerial experience; a young population79; a very basic educational system and resultant low literacy rates (50.1% (2005)); and a significant brain-drain to the Diaspora and the resident international organizations that remunerate at double the public sector salaries. With the need for strategic planning and effective implementation of reforms in almost all areas, the scarcity of trained and experienced management skill in both the public and private sectors may constitute the single biggest constraint to development in the country, and is not easily resolved in the short term. 4. The Private Sector and the Public-Private Dialogue In the global ‘Doing Business Index’, Timor-Leste ranked 170 of 181 economies in 2009 (174 in 2005), scoring better on cross border trading as the only improvement among the 10 criteria. On all other indicators, including access to credit, performance has declined since 200880. Most urban enterprises are informal81 and more than 90% of the 2,500 formal (registered) enterprises have less than 20 employees. The largest enterprises in Timor-Leste are medium-small by international standards with up to 300 employees and comparatively small assets.

78 Figure 2 is based on data published in Human Development Report 2006: A Path Out of Poverty, updated from Hansen and Agos: Financial Services Sector Assessment in Timor-Leste, AMFITIL, 2005; and Bankable Frontier Associates: The Potential for New Technologies and Branchless Banking Models to Expand Access to Financial Services in Timor-Leste, ADB, January 2009. 79 UNICEF estimates that some 66% of the population is under 25 years of age. UNDP, Path out of Poverty, 2006. 80 World Bank: Doing Business, 2009. 81 John Conroy: Access to Finance for Investment and Working Capital, World Bank/GoTL, 2006.

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Recently, the urban business community has become more vocal and active in associations, investigating possible economies of scale from working together and to better advocate their interests. The Better Business Initiative supported by IFC is one such forum for dialogue with the Government, focusing on administrative barriers and access to finance. In addition – but largely voiceless - the private (non-state) sector of Timor-Leste comprises the 82% of the labor force (74% of the population82) depending on agriculture, forestry and fisheries for their livelihoods, producing for subsistence and selling or bartering whatever surplus they have at local markets. Most are primary small-holding producers of coffee, rice, nuts, fruit and vegetables or reef fishermen. The few larger rural enterprises are mostly processing coconut products. An estimated one third of the adult population83 remains outside of the cash economy. Market access remains very limited in most rural areas of the country. Generally the understanding of government as a service provider to the private sector is not strong, given 500 years of superiority and paternalistic economic management. Compounding the problem is the limited coordination and coherence among the many foreign advisors having been posted at request by many different countries to Timor-Leste. Most ministries have 3-10 foreign advisors. Not all speak a common language, and many do not speak the official languages of Timor-Leste. In addition, donor agencies, while meeting regularly, do not appear to be effectively coordinating the input they provide to the government, leaving a weakly capacitated national administration to sort, prioritize and decide on opposing and sometimes conflicting proposals. Whereas the most urgent pieces of legislation and regulations have now been developed and adopted, critical gaps remain, in particular the Land law, Land and property registration, leasing and collateral, bankruptcy, and business licensing84. Once these gaps have been filled by legislation, the critical challenge will be to build administrative capacity. Because the country is extremely short of skilled human resources, the institutions charged with enforcing and administering the laws and rules do not yet have the capacity to do so. Service standards would help, as would the publication of laws, rules, regulations and procedures (in languages that can be read), and general ‘customer care training’ for government officials. In terms of support to the privates sector, TITL and IADE and the district BDCs in particular need commercially and service oriented training and TA to expand and improve their services. As courts are completely over burdened, an interim and commercial Alternative Dispute Resolution mechanism would also be welcome by the private sector. From the Government, there is recognition of the constraints, and also of a tendency to over-complicate and over-bureaucratize the interface between government and private sector, as illustrated by legislation, regulations and procedures that need to be simplified for the benefit both of the private sector and the government. 5. The Financial Services Sector From a rather comprehensive Indonesian banking network before Independence, Timor-Leste now has three foreign owned commercial banks: ANZ, Caixa Geral de Depositos (CGD) and Bank Mandiri, all regulated and supervised to some extent by the Banking and Payments Authority (BPA) that also regulates the state-owned Instituicao de Microfinancas de Timor-Leste (IMfTL), established with support from ADB. With a very few exceptions, the non-bank (and thus far unregulated) microfinance service providers having signed the cutting-edge code of Conduct adopted under the auspices of the Association of Microfinance Institutions in Timor-Leste (AMFITIL) in 2004 did not fare well

82 Government of Timor-Leste: Goodbye Conflict and Welcome Development, paper for Timor-Leste Development Partners Meeting, Ministry of Finance, April 2009. 83 Bankable Frontier Associates: The Potential for New Technologies, 2009, op.cit. 84 World Bank: Timor-Leste - The business regulatory environment, June 2006.

during the crisis in 2006. All international NGOs have withdrawn from supporting microfinance NGOs in the country85, and only Moris Rasik and Tuba Rai Metin (TRM) appear to have a sustainable future. Whereas Moris Rasik has strengthened86 over the past years – a tribute to good governance, access to capital and true demand – TRM has not grown and has serious repayment problems. With an estimated 270,000 people without any bank contact, the financial sector is not yet ‘inclusive’ by international standards and the government dominates the sector. A fully inclusive financial sector would be characterized by: • Diverse institutions providing competitive and permanent access • to a wide variety of financial services • for a broad range of poor and low- income households and their enterprises, thus • opening markets to increasingly poor and geographically remote customers. Fig 3: The Financial Sector in Timor-Leste After a peak in Sept 2007, growth of broad money in Timor-Leste declined somewhat in 2008 but has recently increased to a strong 43.9% in Mar 09, primarily due to the increased international presence (the UNMIT mandate has been extended to end Feb 2010). Fig 4: Lending in Timor-Leste87

The total outstanding credit to the private sector as at March 2009 was $102.5 million, of which some 58.5 million or 57% was provided to “individuals”. The vast majority of these individuals operate businesses that bid and contract for government projects. Foreign resident deposits and savings from households and enterprises are increasingly being deposited in banks even if they attract low interest rates, but neither the excess liquidity nor this has caused banks to increase their lending to the private sector.

There is thus no evidence of a lack of liquidity in the East Timorese banking system – on the contrary. Banks agree, and argue that lending opportunities in the government-dominated economy are few and too risky. The key concern remains the high non-performing loan rate

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85 Plan International is currently scoping the market, but Opportunity International; and CRS have pulled out. 86 The MFI is profitable with Portfolio at Risk below 1% and has recently been rated by M-CRIL to a very respectable a- 87 From ADB: Outlook 2009.

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(NPL of 28% as at end 2008) from 2006 which still mars the books primarily of CDG as the BPA does not require banks to write-off bad debt (see Figure 4 above)88. There is very little intermediation in the system. Whereas banks have excess liquidity, MFIs have been suffering from a capital crunch for several years, inhibiting their expansion to serve households and provide small business credit outside of the urban centers89. It seems particularly wasteful that IMfTL has excess capital set aside for microfinance as its mandate requires its portfolio to be 65% microloans but has not yet considered wholesaling funds to e.g. Moris Rasik. The product range has not expanded much in the past years. ANZ has introduced a popular low-balance savings product for school children, and a small pilot scheme guaranteeing commercial credit lines to agricultural traders is being supported by GtZ and IFC. There are no deposit insurance mechanisms in the sector, except for what is provided by the foreign banks themselves. The absence of supplier- and consumer credit facilities continue to limit marketing and distribution, especially outside Dili. Domestic remittances/payment services remain expensive and weak, as the banking branch network is very limited. Based on the high levels of deposits recorded around Timor-Leste before Independence, it is also assumed that a geographically wider banking network (e.g. branchless banking, M-banking, sub-units or agents) would address a high demand for convenient rural deposits. No leasing companies or products have yet been introduced, as it is unclear if leasing legislation has been adopted. Deposit rates continue to linger between 0.5 – 1.35% p.a. pending the term (except for Moris Rasik’s exceptionally generous 6% p.a. deposit product), whereas lending rates have decreased slightly to 11-12% p.a. in the banking sector and remains at 18—22% p.a. among the MFIs.90 The BPA is working on a (public) credit registry information system (CRIS) which could help borrowers document their credit history to lenders and thus facilitate access to more credit. It is commendable that the largest MFI Moris Rasik is being consulted as a prospective member of the CRIS together with the banks.

88 IFC: Financial Sector Diagnostic Timor-Leste, August 2007 and BPA: Quarterly Economic Bulletin, March 2009. 89 Milissa Day and Ekkehard Esser: “Report on Options for Provision to Second Tier Microfinance Clients in East Timor”, USAID, April 2005 quoted in ‘Annex C: Financial Sector Brief for East Timor Rural Development Planning Mission, April 2008. 90 BPA: Quarterly Economic Bulletin, March 2009.

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Annex 2

Rural Development and Rural Finance – An Update Up until the 1970s, rural finance was synonymous with agricultural development and focused on increasing agricultural production. If finance was linked to rural development, it was often provided as government and/or donor money channeled directly into the agricultural sector, without any intermediation. Through the 1980s, the strategy shifted away from the exclusive growth focus and towards a broader understanding of the need for a strategy to improve economic and social life of the rural poor, which did not focus on income poverty alone. Around 2000, rural development began emphasizing even broader changes in the quality of life of rural people, including improved health, nutrition, education, environmentally safe living conditions and reduction in gender and income inequalities. Since 2003, the focus has been on “Inclusive rural development” – much like inclusive finance: “improving quality of life of all rural residents in economic, social and political dimensions”. One way to measure the extent of rural development problems is to compare the contribution of agriculture to GDP to the percentage of employment provided by agriculture. The larger the gap between these two measures, the more serious would the indications be of low productivity and lack of more productive rural business opportunities91. Table 1: Comparative rural development gaps % agric/non-oil GDP % employment/agric Rural Dev’t Gap Indonesia (1987) 29.4% 54.1% 24.7% Pakistan 23% 50 % 27% Timor-Leste (2006) 33% 74 % 41% A dynamic rural farm and non-farm economy is important for public expenditure. If development has relied too heavily on agriculture alone, it has exerted enormous pressure on governments to introduce and maintain highly protective agricultural policies and provide subsidies to farmers. Such excessive protection increases costs of future adjustments, and subsidies add to the fiscal burden of government and compete directly with budgets for public services to the poor. A smart government develops RNFEs in its rural economy together with expanding urban and global markets, i.e. with a market-driven approach. Planning for rural growth benefits from being thought of as regional hubs with rural spokes rather than ‘rural strategies’ and ‘rural regions’. A recent study92 of the outcomes of rural development from developed to developing countries in the Asia-Pacific has identified seven major drivers of inclusive rural development. In the finalization of the rural development plans for Timor-Leste, it may be useful to take note of these drivers, as presented in table 2:

91 Nimal A. Fernando: Rural Development Outcomes and Drivers, an Overview and some lessons. EARD Special Studies, ADB, 2008, from where the data for Indonesia and Pakistan has also been taken. 92 Ibid.

Table 2: Rural Development drivers in Asia

Driver Effect on rural development 1. High overall economic growth In the Asia/Pacific region, the relationship between growth

and poverty reduction is tighter than elsewhere in the world. 1% extra GDP growth results in 2% decline in poverty incidence. Growth is thus a necessary but not a sufficient precondition for rural development

2. Effective land reforms Egalitarian land distribution, secure land tenure, rent and use, as well as enforceable land laws increase the rate of rural development.

3. Rural Infrastructure Rural development is expedited when investments are made in the physical (roads, access to markets, basic services) and social (health, education) infrastructure.

4. Effective implementing institutions Even well conceived strategies will not achieve the desired goals if implementing institutions are inefficient, failing to provide opportunities to participate and benefits from growth. Four kinds of institutions are particularly important: - Those that maintain law, order, enforce laws, ensure

justice; - Effective and efficient Rural financial institutions; - Efficient providers of basic services (water, sanitation,

education, health); and - Civil Society organizations.

5. Vibrant rural financial markets Credit is not enough - the rural poor need improved access to credit, deposit services and insurance products.

6. Rural non-farm Enterprises (RNFEs)

To achieve high rural growth rates, both agriculture and RNFEs must be promoted, e.g. small, highly labor intensive enterprises in manufacturing, agricultural processing, and services including rural tourism. Their role becomes more important as economic transformation proceeds and they can make a significant contribution to employment generation, especially for youth who are not often drawn to agriculture. This in turn can reduce the pressure to migrate.

7. A dynamic agricultural sector

Agricultural productivity and efficiency continues to be important for rural development. Sluggish growth may reflect too little public investments in rural infrastructure (irrigation, roads, electrification and communication); in social infrastructure (health, education), and in agricultural research and extension services.

Rural Finance

In Asia and Europe, cooperatives have been a key driver for rural development. Where they have generally worked well in Europe, many of the rural credit societies of Asia are saddled with severe operational and financial problems. When state-owned banks have been relied upon as rural financial institutions to serve the market, they have generally been unable to allocate their financial resources efficiently or provide opportunities for poor people to manage risk prudently. Many poor people have been excluded due to capture of services by the non-poor. Following dramatic loss of capital, governments in most Asian countries have had to inject vast amounts of rural development funds into these financial institutions for recapitalization; interest rate subsidies; and the buying off of bad debt during reforms. These strategies are now widely agreed to be flawed and unsustainable, as the private sector has been crowded out. The extensive negative effects of subsidized rural credit in most countries is the background for which a majority of Rural Development experts in the mid 1980s concluded that ‘cheap credit undermines rather than promotes’ rural development (Adams 1984 quoted in Fernando 2008). Instead of attempting to run another state-owned rural financial institution, the Government of Timor-Leste would be in a much better position to support the establishment of a dynamic

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rural financial market with more depth, better diversity of services and increased scale of outreach to the poor, low-income households and micro and small enterprises. Any government intervention should induce and leverage private sector investments, and promote institutional diversity, efficiency and competition through: • Ensuring that the small market remains open to foreign investment (e.g. by preferred

entry status to a selected few, proven providers of rural financial services); • Maintaining the liberal operational environment for INGOs and easing the registration of

businesses; • Providing a ‘light’ and effective regulation and supervision framework for rural financial

institutions, but avoid introducing/remove caps or rate ceilings (e.g. through a bank licensing of IMfTL);

• Providing incentives for the commercial banks (and potential entrants) to expand operations into rural areas93.

Box 3: The beginnings of BRI Like BRI (see Box 3), the formerly state-owned Agricultural Bank of Mongolia was also struggling with significant losses until its reform when it divested all but one product, and is now a very successful rural finance institution. Similarly, the ‘modern’, market-based MFIs, e.g. Grameen Bank, Cambodia’s ACLEDA Bank and India’s Share Microfin Ltd. would testify to the feasibility of sustainable rural finance solutions in support of inclusive rural development.

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The recent interest of India’s conventional, commercial ICICI Bank along with others in the rural financial market would suggest that they have a convincing case.

But the BRI Unit Desa track record after its reform in 1984, by contrast, would suggest that market-oriented rural financial institutions can significantly and profitably contribute to rural development, particularly rural non-farm enterprise development. The would appear to be confirmed by the interest of competing bank BNI to capture its share of the profitable rural financial market since 2002 when it opened some 60 sub-branch offices. See more in Patten and Rosengard, 1991 quoted in Fernando, 2008 and GtZ: The Challenge of Sustainable Outreach – How can Public Banks Contribute to Outreach in Rural Areas – 5 Case studies from Asia, GtZ, Eschborn, 2003.

Bank Rakyat Indonesia (BRI) is now well known as a very successful financial service provider in rural Indonesia, but the start was not so rosy. The state-owned BRI began establishing unit desas (village banking units) in the early 1970s to provide credit to farmers as part of the governmental rice intensification program, BIMAS. Credit was supplied at highly subsidized interest rates. The program failed due to persistent and high default rates. The unit desa system had to be drastically reformed in 1983 to ensure its sustainability. In fact, BIMAS was completely terminated and replaced with a totally different business model with one product (KUPEDES). With KUPEDES, BRI turned profitable. It should be noted though, that the BRI Units do not explicitly target the poorest, and that BRI without its microfinance operations, up to 2003 would still be a loss making enterprise.

93 Meyer and Nagarajan, 2000, quoted in Fernando, 2008, op. cit.