The development crossroads of small island states: the case of Timor-Leste

The island nation of Timor-Leste serves as a prime example of the difficulties faced by small island developing states (SIDS) in achieving their development goals.

Based on a report to the President of Timor-Leste, Policy Analyst Mateus Labrunie from Cambridge Industrial Innovation Policy (CIIP) and Research Professor of Economics Ha-Joon Chang from SOAS delve into the situation in Timor-Leste and present potential policies that could help SIDS achieve economic transformation.

Small island developing states (SIDS) face unique economic growth challenges such as a narrow production base, undiversified economy, concentrated export and import markets, and increased vulnerability to natural disasters and climate change. It is common for them to have limited research and development activity, fragmented national innovation systems, and low tertiary education attainment.

Despite these challenges, SIDS should set their goals high in the long run. A very poor country can become rich in just a few decades. For example, in 1978, South Korea had a similar income per capita as Timor-Leste today (US$1,405 and US$1,457, respectively), but two decades later, it had increased to US$13,403 (1996) and two decades after that, it had reached US$33,436 (2018).

It is commonly believed that small countries cannot achieve development, but this is untrue. Examples of successful small countries include Mauritius, Singapore, and Finland. These countries have transformed the production structure of their economies through effective industrial policies tailored to their specific conditions. So, although small countries may require different strategies than larger ones, they can still develop successful and thriving economies.

The case of Timor-Leste

Timor-Leste, a small island nation in Southeast Asia, faces numerous challenges common to other Small Island Developing States (SIDS), but with even greater obstacles to its economic growth.

With one of the lowest incomes per capita in the world, a significant portion of the population relies on subsistence agriculture. Additionally, the country is one of the youngest in the world in two senses – it gained independence from Indonesia only in 2002, while 42% of the population was under the age of 14 in 2015.

Furthermore, Timor-Leste is highly susceptible to natural disasters, and its economy is highly dependent on oil. These factors create a vulnerable situation, highlighting the need to enhance the country’s economic, social, and environmental resilience to achieve stability and prosperity.

Timor-Leste’s situation would be like that of any other small oil-dependent country if it were not for one simple, albeit dramatic, fact: the country’s oil is ending. The available fields for exploitation are almost exhausted, and due to political tensions with Australia, it is improbable that new ones, like the Greater Sunrise field, will be exploited anytime soon. Consequently, the country’s leaders are actively seeking methods to diversify the economy swiftly.Fortunately, for the past two decades, the country has accumulated oil revenue in an Oil Fund (inspired by the Norwegian model), which today is valued at around US$20 billion. The question now is how to use these resources in the most productive way for its 1.3 million population, and for the generations to come.

Building the institutional foundations for long-term policymaking

When confronted with a challenging task, it is crucial to establish the necessary institutional foundations for sustained policymaking. Industrial policies necessitate a long-term strategy, typically requiring a minimum of ten years to achieve desired results. This is particularly important for Timor-Leste, as the Petroleum Fund provides a once-in-a-generation opportunity, and significant changes in policy direction could lead to a waste of resources. To ensure consistency and continuity, strong institutional structure and capabilities are required.

This requires two main things: mechanisms for building social consensus on the direction to be taken and organisations that can carry out long-term policies without being disturbed by political cycles. The first one can be done, as in other countries, through national congresses, councils, or committees, with wide consultation, and the writing up of a national plan. Social policies are also crucial to ensure the distribution of the development benefits to the population, thereby guaranteeing their continued support to the plan.

In terms of organisations that can drive productive development, two have historically benefited developing countries: development banks and government development agencies. In the case of Timor-Leste, these organisations should be focused on using the Oil Fund resources to develop non-oil industries and on providing extension services and technical advice to existing productive activities.

Industrial policy options for SIDS

Once the institutional foundations are laid out, governments can explore industrial policy options for the country.  There are short-term investments and medium- to long-term investments – all of which need to be done simultaneously, albeit at different scales depending on the country’s specific situation and priorities:

Short-term investments (5 years)

• Investing in basic infrastructure: investing in electrification, water, and transport, to create the minimum conditions for reliable business activity.
• Investing in digital infrastructure: building a reliable digital infrastructure, including adequate broadband and wireless connectivity, not to miss technological opportunities using digital technologies.
• Expanding production and raising the productivity of existing non-petroleum sectors: raising production volume and productivity of sectors typical of SIDS, such as agriculture, fisheries, mining, commerce, and tourism.
• Attracting Foreign Direct Investment (FDI) with conditionalities: SIDS in Asia and the Caribbean can attract FDI by taking advantage of the growing trends of near-shoring and supplier diversification. They should, however, impose conditionalities on the foreign investors, around knowledge sharing, local workforce training, technology transfer, and R&D activities. Moreover, governments of SIDS need to be proactive in “courting” foreign companies, rather than taking the usual passive approach of simply liberalising FDI.

Medium to long-term investments (5-10, 10-20 years)

• Upgrading the value chain of existing sectors: SIDS should aim to integrate existing production with backward (upstream) and forward (downstream) linkages, i.e., moving from the export of raw agricultural products to their processing or the production of inputs used in existing activities. For example, in the case of Timor-Leste, it needs to move from exporting raw coffee beans to producing the final coffee packages under Timorese brands.
• Investing in new productive sectors: SIDS should consider upgrading into higher-value segments of existing value chains (e.g., eco-tourism) or moving into completely new sectors – especially manufacturing. This requires a proactive approach in which selected sectors and activities are promoted through custom-made supports. This should not be guided by comparative advantage; it will require creating capabilities that have not existed in the country before.
• Focusing on manufacturing: manufacturing has historically proven to be the sector with the greatest transformative effects on the economy. Mauritius – a successful SIDS – has followed this path and has reaped many benefits from it.

Continuous investments:

• Investing in education, training, and research, as well as renewable energy, is necessary for economic diversification and sustainability.

The journey towards diversification may not be easy, but Small Island Developing States (SIDS) should not be disheartened. History has proven that with proper policies and dedication over time, significant economic transformations can be accomplished. Timor-Leste, in particular, is in a prime position to undergo an economic transition. The country’s leaders have a unique opportunity to reshape its economy, which will have a lasting impact on future generations.

This blog post is based on a report by Mateus Labrunie and Ha-Joon Chang for the President of Timor-Leste on industrial policy for the green transition of the country. The report was funded by Open Society Foundations and the Institute for Democracy and Economic Affairs (IDEAS).

At CIIP, we work with governments to help them realise opportunities in industrial innovation policy by providing new evidence, insights and tools based on the latest academic thinking and international best practice. We combine these with careful reviews of local contexts to identify practical policy options. Find out more about working with us.