Public Information Notice No. 05/40

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with the Republic of Yemen

March 24, 2005

On March 14, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Yemen.¹

Background

An expected rapid decline in oil production poses serious long-term economic challenges for Yemen. The authorities have carried out a public information campaign to highlight the risks of inaction and to facilitate the political and public acceptance of reform measures, some of which are now part of the 2005 budget.

Economic growth slowed in 2004 due to a sharp contraction in the oil sector. Oil production declined by 5.9 percent, reflecting diminishing recovery from aging large oil fields as well as the absence of significant new discoveries. Given the slowdown in oil production, real GDP growth is estimated to have declined to 2.7 percent in 2004 compared with 3.1 percent in 2003. Non-oil GDP growth is estimated to have reached 4.1 percent in 2004, supported by stronger activity in the construction, transportation, and trade sectors, and fueled by domestic demand stemming from continued fiscal expansion and higher public sector wages.

The end-year core CPI inflation (excluding qat) increased from 12.1 percent in 2003 to 14.5 percent in 2004, owing largely to expansionary fiscal and monetary policies, as well as higher food prices caused by adverse weather conditions. The nominal exchange rate remained stable vis-à-vis the U.S. dollar in 2004, and the real effective exchange rate appreciated by 3.5 percent over the 11 months ending November 2004.

The 2004 fiscal deficit was estimated at 4.5 percent of GDP, about 1 percent higher than the original budget. The larger than expected deficit was due to higher development spending and larger petroleum subsidy due mainly to higher oil prices and the postponement of the envisaged increase in petroleum prices. An increase in imports and strong capital inflows mitigated most of the export gains resulting from higher oil prices, leaving the current account balance broadly unchanged. Because of higher oil exports and strong capital inflows, international reserves increased to about $5.1 billion or 16.4 months of imports at end-2004.

Money grew by 15 percent in 2004. It was largely driven by the accumulation of net foreign assets as well as a sharp rise in private sector credit (33.5 percent mainly to finance trade). The benchmark interest rate on saving deposits, the anchor of other interest rates, has remained constant since 2001 at 13 percent.

Some progress has been made in structural reforms. The revised General Sales Tax (GST) law submitted to parliament in late 2004 included several improvements designed to protect the integrity and simplicity of this tax. On public expenditure management, the authorities used, for the first time, macroeconomic indicators and indicative ceilings in the preparation of the 2005 budget, but very little has been done to improve internal expenditure control mechanisms, or to improve budget execution or fiscal reporting. The ministry of civil service continued to lay strong foundations for civil service reform and completed the civil service database. In light of the amnesty granted to multi-dippers (those collecting more than one salary) several hundreds of those came forward voluntarily.

Executive Board Assessment

Executive Directors considered that Yemen is at a crucial crossroads, facing the long-term challenges arising from the expected rapid decline in oil production. While noting the slow pace of reform in recent years, Directors welcomed the authorities' plans to develop a comprehensive strategy aimed at promoting growth and diversifying the productive base. They also welcomed the authorities' renewed efforts to mobilize public support for reforms-including through a public information campaign-and to make the reform package part of the 2005 budget. Directors underscored the importance of strengthening fiscal adjustment and deepening structural reforms to ensure fiscal and external sustainability, with macroeconomic policies guided by long-term considerations, as well as to strengthen the non-oil sector.

Directors noted that, while the short-term outlook remains manageable, without policy adjustments, the long term fiscal and external positions are clearly unsustainable. They observed that an indicative target for debt-to-GDP could provide a useful long-term anchor for fiscal policy. Several Directors took note of the staff's estimate that, to maintain the debt-to-GDP ratio at its current level, a fiscal adjustment of more than 20 percent of GDP in the non-oil primary fiscal deficit will be required over the next 12 years. Directors concurred that, to achieve an adjustment of such magnitude, there will be a need for strong and front-loaded fiscal adjustment, along with a range of structural reforms to facilitate Yemen's smooth transition to a non-oil economy. They welcomed the authorities' recognition of the challenges ahead and their commitment to undertake the necessary policy response, which is also important for attracting additional donor assistance and foreign investment. Some Directors also encouraged the authorities to further explore the country's natural gas reserves as part of their efforts to meet the challenges posed by the declining oil sector.

Directors underscored the need for a strong, credible, and comprehensive fiscal strategy, and recommended the implementation, without delay, of critical measures, such as the General Sales Tax, the removal of the petroleum product subsidy, and the reduction in the wage bill through retrenchment rather than a wage freeze. They also emphasized the importance of improving public expenditure management and strengthening tax and customs administration for the success of the reform effort.

Directors emphasized that public expenditure management reforms should aim mainly at strengthening expenditure controls and enhancing fiscal transparency. Recognizing the large number of needed measures, Directors expressed strong support for clear prioritization and sequencing. They underscored that policies to dissolve extra budgetary accounts and "special funds" leading to the creation of a fully-fledged Treasury Single Account (STA) will be essential. Directors also emphasized the importance of enhancing expenditure discipline by developing a commitment control system to help contain budgetary overcommitments. Poverty reduction strategy priorities should be reflected in the national budget to ensure that the envisaged sectoral plans can be implemented. Efforts should also be made to adopt a functional classification of expenditures and to improve tracking of poverty-related spending.

Directors welcomed the latest amendments to the GST law-now in parliament-intended mainly to limit exemptions and to simplify the GST structure, and expressed hope that it will be adopted soon. Directors called for strengthening the Large Tax Payers Office (LTO) as an important step in mobilizing more tax revenue. They also welcomed the authorities' intention to phase out the petroleum product subsidy and suggested that this be done on the basis of an automatic price adjustment formula. Some Directors noted that the introduction of the excise tax on petroleum products following the elimination of the subsidy might need to be phased in gradually.

In view of the planned adjustment in petroleum prices, Directors underscored the importance of strengthening social protection mechanisms to mitigate the impact on the poor. They supported policies that would improve the targeting and the coverage of the Social Welfare Fund (SWF), which distributes cash subsidies directly to poor families. They also called for further efforts to protect the most vulnerable groups from the long term adjustment required for achieving sustainability. An explicit link between the dividend of oil price reform and increased pro-poor spending was considered beneficial in this connection.

Directors noted that fiscal adjustment alone will not be sufficient to achieve long-term sustainability. Complementary macroeconomic and structural policies to stimulate growth and diversify the production base away from oil will also be required. Particular attention should be given to sectors with a strong potential comparative advantage and large job creation prospects, including fisheries, transshipment activities, and tourism.

In this context, Directors called on the authorities to adopt policies that would improve the business environment, including reducing costs of business startups and streamlining procedures to encourage private sector investment. They also considered that addressing governance issues and tackling corruption should enhance the climate for both domestic and foreign investment. Directors welcomed the continued civil service reform efforts, but stressed that ad hoc wage increases, which are not part of the national wage strategy, may undermine these efforts.

Regarding recent macroeconomic and policy developments, Directors expressed support for the authorities' fiscal policy in the context of the 2005 budget. Directors particularly welcomed the planned significant reduction in the petroleum product subsidy and the improvement in tax revenue expected from the introduction of the GST by mid-year. However, they noted that the adjustment target under the 2005 budget, equivalent to about 9 percent of GDP in the non-oil primary deficit, may be ambitious. They stressed that, under all circumstances, if a supplementary budget is to be adopted later in the year, it should be subject to stringent budgetary discipline and be designed to respond only to unforeseen developments or external shocks.

Directors expressed concern about the surge in prices and considered that monetary policy should be geared to containing inflationary pressures. They called for a tightening of monetary policy, and took note of the authorities' readiness to closely monitor the situation and intervene when necessary. While recognizing the occasional need for the central bank to balance multiple objectives, Directors emphasized that price stability should remain the primary focus of the monetary authorities, especially when macroeconomic stability is in the balance. To enhance the role and effectiveness of monetary policy, they called on the monetary authorities to liberalize the minimum benchmark rate on saving deposits. Directors encouraged the authorities to make further progress in implementing the recommendations of the 2001 Financial Sector Assessment Program, and in strengthening the AML/CFT framework.

Directors emphasized the importance of exchange rate flexibility to achieve long-term sustainability. With the expected decline in oil production and international reserves, the central bank should not resist signals in the foreign exchange market emanating from changes in underlying economic fundamentals. A flexible exchange rate policy, supported by structural reforms, should improve external competitiveness and boost growth in non-oil sectors, easing the transition to a post-oil economy.

Directors took note of the efforts under way to improve the quality and availability of statistics. However, they emphasized the need for further improvements in national accounts and price statistics, balance of payments data, and government finance statistics, to enhance the quality of economic analysis.