Public Information Notice No. 02/88

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the Republic of Yemen

August 12, 2002

On July 31, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Yemen.¹

Background

A stabilization of oil production and a decline in non-oil GDP growth caused total GDP growth to slow down from 5.1 percent in 2000 to 3.3 percent in 2001. The decline in the growth of non-oil GDP (about 2/3 of total GDP) reflected weaker-than-expected performance in the agriculture, manufacturing, and electricity sectors. Large increases in the prices of diesel (70 percent increase) and electricity (about 30 percent increase) in July-August 2001, and inadequate rainfall led to a sharp rise in the consumer price index (CPI) and the 12-month CPI inflation rate reached 22 percent by end-December 2001. Core inflation has, however, remained in the single digits.

The budget surplus narrowed from 8.5 percent of GDP in 2000 to 2.8 percent in 2001, on account of weaker oil prices, lower central bank profit remittances (due to lower earnings on foreign reserves) and higher expenditure, notably for wages, defense, and border demarcation. The increase in the domestic price of diesel led to a substantial reduction in government fuel subsidies, from 6 percent of GDP in 2000 to 4 percent in 2001.

Gross foreign reserves of the central bank rose by US$747 million in 2001 to reach US$3.6 billion by year-end. Rising imports and falling exports caused the current account surplus to narrow relative to 2000.The rial has been depreciating by about 4 percent a year vis-à-vis the U.S. dollar, but the increase in inflation has caused substantial real appreciation in 2001. Broad money growth decelerated markedly relative to 2000, to around 19 percent by end-2001.

The outlook for 2002 appears relatively stable: non-oil growth is expected to pick up to around 5 percent and, on present trends, inflation should return to single digits by year-end. A deceleration of monetary growth has been targeted to support disinflation, and the central bank remains committed to a flexible exchange rate regime.

The weakening of oil prices compared to 2001 should cause the budget surplus to narrow to a near balanced position in 2002. Total government expenditure and non-oil revenue are expected to remain roughly unchanged in percent of GDP relative to 2001. Anticipated increases in wage and defense spending are to be offset by a containment of development spending. In order to enhance the effectiveness of government spending, responsibility for health, education, and new development projects has been transferred to the newly elected local councils. In all, about 20 percent of expenditure is to be transferred to local governments to meet their new responsibilities in 2002.

Consistent with its intention to make 2002 "the year of civil service reform", the government plans to take a number of measures in 2002 to improve payroll control, and accelerate the retirement and retrenchment of excess civil servants. These measures will include the issuance of biometric cards to government employees to help identify ghost workers and double dippers, the retirement of remaining over-age civil servants, and the removal from the payroll of some 11,000 civil servants who are to be transferred to the Civil Service Fund for a transitional period of two years. At the same time, restructuring plans for seven pilot agencies and ministries are expected to be submitted in 2002.

On other structural issues, a General Sales Tax (GST) was signed into law in early 2002, but implementation has been deferred pending a general review of the indirect tax system. Although problem loans remain, the quality of banks' loan portfolio has continued to improve. However, access to bank credit remains limited. Privatization has resumed, notably for small- and medium-sized enterprises, for which tenders are under way. The privatization of larger public enterprises, such as the National Bank of Yemen, the Aden refinery, and cement factories is still under discussion.

Widespread poverty (42 percent of population in 1998), inadequate per capita growth and a projected steady decline of oil revenues starting in 2003 constitute core challenges for the medium term. To address these challenges, the government has prepared a Poverty Reduction Strategy Paper (PRSP) that presents a comprehensive and coherent strategy for poverty reduction in Yemen for the period 2003-2005. The PRSP identifies the need for improvements in governance and structural reforms to reach higher and sustained growth. It sets medium-term budgetary targets aimed at maintaining sustainable fiscal and external positions as oil revenues decline, and targets a marked improvement in the composition of spending with a compression of non-productive spending and increases in development and social spending.

Executive Board Assessment

Executive Directors welcomed the authorities' efforts at maintaining macroeconomic stability, and recognized the difficult challenges faced by the government in their determination to make the transition to a market economy, diversify the economy away from oil, and reduce poverty.

Directors expressed concern with the outturn for 2001—in particular, the sharp increase in prices, the deterioration in the fiscal position, and the slow progress in structural reforms. They recognized however that the increase in inflation reflected essentially one-off factors, such as the adjustment in diesel and electricity prices and also inadequate rainfall. At the same time, they observed that the fiscal outturn stemmed from the accommodation of higher wage and defense spending.

Directors were encouraged by the indications of more stable macroeconomic conditions in the first half of 2002, and the good performance under the staff monitored program (SMP). Inflation has significantly declined and the fiscal balance is now projected to be in a surplus for 2002. They emphasized the importance of adhering to the SMP for the rest of the year, and implementing their undertakings regarding reforms, particularly in the tax system and the civil service.

Directors emphasized that significant adjustment will be needed over the medium term to maintain stability in the face of a possible decline in oil revenues. For 2003, Directors urged the adoption of a stronger budget aimed at reducing the non-oil deficit and improving the composition of expenditure. It would be important for the budget to include measures to contain the growth of the wage bill and defense spending. In this connection, Directors urged a cautious approach to fiscal decentralization pending the establishment of effective monitoring and control of decentralized expenditures.

Directors commended the authorities for the diesel and electricity price adjustments of 2001, which had led to a significant reduction in fuel subsidies. However, they noted that energy subsidies remain a heavy burden on the budget, and encouraged the authorities to continue phasing out these subsidies through further adjustment in energy prices. Directors emphasized the importance of linking these measures to a strengthening of the social safety net in order to mitigate the impact on the poor.

Directors underscored the need to press ahead with efforts to expand the tax base—following the recent, welcome decision by the government to postpone the implementation of the general sales tax law (GST). They recommended that the authorities take this opportunity to redouble their efforts to introduce promptly a broad-based and efficient tax system.

Directors indicated that ensuring a sound fiscal position requires a stepping up of efforts to institute reforms in the public sector. They stressed the importance of making rapid progress in rationalizing the civil service in order to improve efficiency and reduce the size of the wage bill. Directors also urged the authorities to modernize budget preparation, execution, and control systems to improve transparency, strengthen the medium-term orientation of policies, and link budget allocations more closely to government priorities.

Directors expressed support for the authorities' commitment to reassert control over monetary growth in order to reduce inflation. They cautioned that developments through June 2002 warranted close monitoring of the situation and suggested that adjustment in interest rates may need to be considered to achieve the inflation objectives for 2002. Directors encouraged the authorities to approve the banking law amendment and to strengthen enforcement of rules governing lending to related parties and provisioning. They welcomed the efforts against money laundering and the financing of terrorism, and called for continued implementation of the U.N. resolutions in these areas.

Directors supported the authorities' flexible management of the exchange rate, and their commitment to limit intervention in the foreign exchange market to smoothing operations. Directors considered that the exchange rate should play an important role in adjusting to lower oil revenues and other external shocks as well as maintaining competitiveness, and they stressed the importance of not resisting sustained pressures on the currency.

Directors highlighted the need for more rapid progress in the implementation of the government's structural reform agenda as key to increasing growth in the non-oil sector and reducing poverty. They observed that private investment remains limited as a result of structural impediments—particularly poor governance and weak law enforcement. They encouraged the authorities to address these issues more forcefully to strengthen private sector and donor confidence. In this regard, they welcomed the recent steps taken toward judicial and civil service reforms. Directors commended the authorities for restarting the privatization program for small and medium-sized enterprises, and encouraged them to move ahead with the privatization of larger public enterprises.

Directors welcomed the completion of the Poverty Reduction Strategy Paper (PRSP) following broad consultations. They noted that the PRSP provides a timely and comprehensive framework for poverty reduction, but cautioned that effective implementation of the strategy will require clearer definitions of programs and priorities and a strengthening of institutional capacity. Directors suggested also that greater transparency of the budget would help ensure that adequate resources are available for spending on the priorities identified in the PRSP and improve expenditure monitoring.

Directors took note of the efforts under way to improve the quality and availability of statistics. They emphasized the importance of statistics for sound policy decisions and effective monitoring of the programs and targets of the PRSP.