Public Information Notice No. 01/19

Public Information Notice: IMF Concludes Article IV Consultation with the Republic of Yemen

March 8, 2001

On February 28, 2001 the Executive Board concluded the 2000 Article IV consultation with the Republic of Yemen.¹

Background

Macroeconomic balances improved dramatically in 1999-2000 as a result of higher oil prices, the maintenance of high interest rates and expenditure restraint. Average annual inflation was brought down to 8 percent in 1999 and reserves rebuilt by more to the equivalent of six months of imports by end-1999. The buildup of reserves continued in 2000, to more than ten months of imports by end-2000. However, average annual inflation rate rose to 10.9 percent. Real economic growth in 1999 was below target at an estimated 3.8 percent, reflecting: (a) a lower-than-expected increase in crude oil extraction; (b) drought in the first-half of the year; (c) a decline in tourism; and (d) a continued weak investment climate. Although spring rains failed again in early 2000, growth for the year is estimated at 6.5 percent due to high oil production and a recovery in agriculture after good summer rains. Long term growth prospects have received a boost from the agreement reached in June between Saudi Arabia and Yemen on the settlement of long-standing border issues; in particular, this could help opening the door to a better integration of Yemen into the regional economy.

A dramatic improvement in public finances driven by high oil export revenue was key to the strong macrofinancial performance in 1999 and 2000. On a commitment basis, excluding grants, the 1999 fiscal cash deficit is estimated at 0.4 percent of GDP, compared with a 7.9 percent deficit in 1998. Non-oil revenues performed broadly as expected, although some categories of indirect taxes such as customs revenue fell short of expectations. Overall spending restraint in 1999 succeeded in keeping expenditure growth below the growth of GDP. Domestic oil revenue (net of cash subsidies) improved over 1998, despite continued substitution toward diesel, the most heavily subsidized product. Available data for 2000 indicate that expenditure growth remains broadly in line with GDP except for a surge in petroleum subsidies, especially diesel. This will be more than offset by increased oil revenue, and the budget is expected to show a surplus in the order of 9 percent of GDP for the year 2000.

While in response to mounting exchange market pressures the Central Bank of Yemen (CBY) had raised interest rates to 20 percent in early 1999, the turnaround in financial balances allowed the CBY in late 1999 to initiate a gradual lowering of the benchmark interest rate on deposits, to 13 percent in July 2000. The improved external position helped stabilize the exchange rate at about YRls 160 per U.S. dollar from mid-1999 through late-2000, following a 13 percent depreciation in the first half of 1999. Broad money growth has steadily accelerated since late 1999, to 25 percent in the year to December 2000, reflecting mainly the sharp expansion in net foreign assets of the central bank in the second half of the year which more than offset repayments of government credit to the banking system. At the same time, high interest rates and probably a better enforcement of prudential rules depressed private credit growth to 15 percent in 1999, while the monetary easing in 2000 helped spark a recovery to 21 percent in 2000.

Progress on the structural front slowed in 1999, albeit a number of important structural steps were taken: the privatization law was promulgated; cabinet approved time-bound action plans agreed with the World Bank for the restructuring of the three public sector specialized banks and two public sector commercial banks; and steps to improve the functioning of the commercial courts were initiated. Measures in 2000 included an adjustment of domestic fuel oil prices to close to world market levels, increased electricity charges to better cover cost, the promulgation of the reformed Central Bank Law, retirement of several thousand over-age civil servants, elimination of general import bans maintained for economic reasons, and the way was cleared for the privatization of a number of state enterprises.

The government has prepared an interim Poverty Reduction Strategy Paper (IPRSP) and has launched preparation of a full-fledged PRS in the context of elaborating the next Five-Year Plan (2001-05). As proposed in the IPRSP, the poverty reduction strategy will focus mainly on promoting private investment to achieve higher growth, while strengthening the efficiency of public expenditure in delivering basic social services and providing infrastructure needed to allow the poor to participate in, and contribute to, economic growth. The government's macroeconomic objectives for 2001 are to achieve an increase in non-oil growth to about 5 percent through higher public and private investment, containing inflation to an average annual rate of 9 percent, and to use the oil windfall gain for achieving a small external current account surplus in order to build a cushion for the future. As to the macroeconomic policy mix, fiscal policy will aim to contain the non-oil deficit to 14.9 percent of GDP, while within a flexible exchange rate system reserve money targeting will provide a nominal anchor. Structural reforms for 2000-01 will focus on further tax reform, including introduction of a value added tax, civil service reform, restructuring of public financial institutions, and other reforms of the regulatory framework to improve the environment for private investment, growth, and job creation.

Executive Board Assessment

Executive Directors welcomed the marked improvement in macroeconomic balances in 1999-2000 resulting both from the recovery in oil prices and from the authorities' efforts to restrain public expenditures in the face of rising pressures for a relaxation of the adjustment effort. The pick up in inflation during 2000, although partly attributable to drought conditions, was, however, a source of concern. Directors were disappointed that, apart from a number of recent measures, the implementation of the structural reform agenda had slowed since late-1999. While they appreciated the difficulty of building a consensus for difficult reforms in the present context of high oil prices, Directors emphasized that continued macroeconomic stability and sustained implementation of structural reforms will be the key to the expansion of the non-oil sector and a lasting and broad-based improvement in living standards. Directors endorsed the economic program planned for 2001 which aims to bring the inflation rate down to single digits, strengthen the external balance, and lay the basis for higher growth.

Directors particularly emphasized the need for current expenditure restraint in order to accommodate higher poverty-related social spending and save part of the oil windfall for leaner years ahead. They generally welcomed the planned reduction in energy-related subsidies as a share of GDP, and urged the authorities to adhere to the timetable for the diesel price increase. Directors expressed concern regarding the budgeted increases in the civil service wage bill and defense outlays, as these could weaken the civil service reform and build in higher recurrent expenditures in later years when oil prices may be lower. They noted the authorities' intention to implement the wage increase following the diesel price adjustment.

Directors highlighted the need for tax reforms in order to reduce the dependence on oil revenue and create a more investment-friendly environment. They strongly encouraged the authorities to redouble their efforts to ensure the introduction of a modern general sales tax in value-added mode covering most goods and services and based on a single rate structure.

Directors welcomed plans to tighten monetary policy in 2001 to prevent the reemergence of inflationary pressures. They observed that during 2000 one-sided intervention in the foreign exchange market, by contributing to real appreciation of the rial, has weakened incentives for tradeable goods production and diversification away from oil, and advised the authorities to allow the exchange rate to be fully market determined.

Directors took note of the recent Financial System Stability Assessment and welcomed the progress in strengthening bank supervision and reforming the commercial codes. They urged the authorities to make further progress in strengthening governance and the rule of law in this area. Directors encouraged the central bank to rapidly develop indirect instruments such as certificates of deposit to allow a phasing out of the administratively set minimum benchmark saving deposit rate.

Directors expressed strong support for the government's structural reform agenda as key to increasing growth in the non-oil sector and reducing poverty. They stressed that this would require timely implementation of the planned structural reforms to address deep-rooted weaknesses in the business and investment environment. In this regard, they noted that the implementation of the privatization law should stimulate privatization efforts and contribute to private sector development.

Directors encouraged the authorities to pursue civil service reform with renewed vigor in order to achieve a leaner and better qualified civil service that will carry out the overall reform strategy and address the governance problems that are rooted, in part, in low salaries and insufficient links between merit and pay. They also underscored the importance of moving ahead with reforms to ensure the sustainability of the pension system, by establishing stronger links between benefits and contributions, and more clearly circumscribing survivor's benefits.

Directors welcomed the authorities' intention to step up efforts to mobilize public support for the reform program. The IPRSP is an important step in this regard, and provides a good basis for preparation of a full-fledged poverty reduction strategy with broad participation of the civil society. Directors felt that the establishment of local governments offers scope for greater grassroots participation in formulating and implementing Yemen's development and poverty reduction strategy, but stressed the need to put in place safeguards to preserve fiscal responsibility.

Directors noted improvements in the quality and availability of statistics, and urged the authorities to redouble efforts in this area, particularly to ensure more timely and comprehensive fiscal and balance of payments data in order to enhance program design and monitoring, as well as public understanding and support.