In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.


In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

I. Overview

1. The 1990s surely must have been one of the most dramatic periods in Yemen’s rich history. Unification, rapid development of an oil sector, and a radically changed external environment fundamentally transformed the opportunities and challenges the Yemeni people face. This paper attempts to summarize economic developments in Yemen during the 1990s; to take stock of the many structural changes that took place in the economy during this decade; and to point out important reforms that are needed if Yemen were to move to a path of high and sustainable growth, to reduce rampant poverty, and to responsibly manage a highly volatile oil rent. It is hoped that this paper may provide useful input to the ongoing debate in Yemen on the appropriate development strategy for the coming years.

2. Section II summarizes the main political and exogenous events that shaped the decade. At the beginning stood the unification of the Yemen Arab Republic (YAR)—which itself had undergone dramatic change since it emerged in the 1960s as republican successor to the medieval regime of the Imam—with the People’s Democratic Republic of Yemen (PDRY), which had emerged from the struggle for independence in the British colony and protectorates around Aden in 1967. A few months after unification, with the onset of the second Gulf Crisis, Yemen experienced a major shock with the return of about three quarters of a million workers from the Gulf states, challenging a fragile socioeconomic fabric already weakened by a severe two-year drought. At the same time, the development of oil fields provided a growing source of foreign exchange earnings, and may have been the element that kept Yemen away from the brink, even if it also added a new vulnerability due to fluctuations in world oil prices.

3. However, the strains from these developments eventually led to a brief civil war in 1994, following attempted secession by elements of the former PDRY leadership. It was only after the secession was militarily defeated—and as the new constitutional system providing for a multi-party democracy, a free press, and an essentially market-based economic system took hold—that the political consensus could be forged for the urgent economic reforms that had been delayed since unification. In 1995, Yemen thus initiated an economic reform program, supported by the Fund as well as by the World Bank and other institutions and countries, aiming in its core at enhancing the foundations of a market-based and private sector-driven economy, integrated into world markets and in a context of broad financial stability. This approach underpins government policy until today.

4. The first priority of reform was obviously to restore macroeconomic stability, which was threatened by large fiscal imbalances, price distortions (including exchange and interest rate controls) resulting from the attempt to suppress excess demand through controls, and a huge debt-overhang largely, but not only, arising out of the former PDRY’s debt to the Soviet Union. The emerging macroeconomic policy mix is described in Section III. Fiscal policy was obviously key, and in light of the importance of oil for government revenue, it is assessed also from an inter-temporal perspective, given the fact that based on current information Yemen has only limited proven reserves.

5. While stabilization policy was highly successful, structural reforms faced greater difficulties and resistance and were also more severely constrained by Yemen’s limited administrative capacity. Section IV describes the progress to date, pointing to impressive success in liberalizing the exchange and trade regime and lifting price controls, but also to a huge unfinished agenda in tax and budget management reform, privatization, and civil service reform. Deep-rooted obstacles to growth, notably weaknesses in the judicial system and governance, have been barely touched so far; and reform in these areas, perhaps more than in others, will have to emerge from and be shaped by civil society itself.

6. Section V looks at some of the “formal” social safety measures that were put in place to protect the most vulnerable segments of society against adverse effects of certain reform measures (notably the reduction in generalized subsidies), but—probably more important—the often brutal exogenous shocks Yemen society had to absorb, such as the return of workers in 1990–91, the dislocations from the civil war in 1994, and the collapse of oil prices in 1998. No data exist to gauge the scope of traditional, often tribal- or religious-based, social support systems; such systems likely remain far more important than formal systems and must have been at the core of Yemen’s ability to somehow absorb the workers returning from the Gulf region.

7. Finally, Section VI looks at performance in terms of growth, inflation, social indicators, and savings and investment balances, also in comparison with other countries.1 Clearly, during the second half of the 1990s, performance improved on all three accounts, very much so for macro stability but considerably less for social indicators. This reflects the return to political stability and peace, on the whole favorable oil price sector developments, and the first fruits of reforms. But building on these achievements, an even greater focus on growth and poverty reduction will be needed. The Yemeni authorities have therefore embarked on preparing a comprehensive poverty reduction strategy in the context of the next Five-Year Plan (2001–2006) and in broad consultation with civil society to be launched in early 2001. It is hoped that this paper can contribute to the formulation of such a strategy by providing some of the needed background and by drawing some first lessons from Yemen’s adjustment experience to date.

II. The External Environment: Politics, Oil, and Debt

A. Political Developments: Unity, Gulf Crisis, Civil War, and Democracy

8. Unification of North and South Yemen in early 1990 opened a decade of dramatic sociopolitical and economic change. Similar to German unification, the YAR of North Yemen, a larger and broadly market-based economy, absorbed a smaller, centrally planned economy: the PDRY in the south.2

9. As in the German case, unification was a long-standing aspiration of the Yemeni people in both states and became possible mainly through the effects of Perestroika in the Soviet Union on the socialist PDRY. On the economic side, a reduction in financial and technical assistance from the Soviet bloc, combined with declining workers remittances—a main stay of the PDRY accounting for about half of government revenue in the late 1980s—created pressures for a rethinking of the PDRY’s development strategy in the mid-1980s. While the PDRY had achieved respectable improvements in education and other social indicators (more so than the YAR),3 the economy was in a dismal state as a result of failed socialist reforms in agriculture, fisheries, and port activity. Large Soviet-financed investments in the Shabwah oil field (discovered in 1986) added half a billion U.S. dollars to South Yemen’s staggering debt (largely to the Soviet Union and her allies), but the oil facilities were yet unfinished and production was limited to 10,000 barrels per day (bd) which were trucked to the decrepit refinery in Aden.4 On the political side, the last years of the PDRY saw some liberalization of political activity and the press, but at the same time it saw political instability within the leadership of the country with violent internal struggles in 1986.

10. The YAR, in contrast, had witnessed a measure of political stability with some consolidation of central control—even over traditional tribal areas—as well as a measure of economic development despite limited progress in education and health. Oil exploration was in private hands and, in 1984, oil strikes quickly led to development of a major oil field (Marib) starting production in 1987 with most output exported through a pipeline, reaching about 195,000 bd in the early 1990s. While the YAR was also dependent on workers’ remittances, foreign debt averaged to a more manageable 60 percent of GDP, well below PDRY’s 180 percent of GDP during 1987–89.

11. Development of oil was another important catalyst for unification. The simultaneous oil discoveries in the YAR (Marib) and the PDRY (Shabwah) were in adjacent areas, and development and exploration required settling of outstanding border issues. At first it triggered a bilateral agreement, demilitarizing the border zone in 1988, along with easing the bilateral travel restrictions and activation of common institutions, notably the Supreme Yemeni Council, formally in place since 1982. The dynamics set in motion were such that by late-1989 “historic agreement” was reached, calling for a draft constitution for a unified Yemen to be presented to both parliaments within six months and a referendum six months thereafter. A unity government was formed in early 1990 and a year later, an impressive majority in both parts of the country approved a new constitution by popular referendum. The new constitution provided for basic political freedom (inclusive of women), including the right to organize and vote, the right of private ownership, and sharia as principal (but not sole) source of law.

12. Early on, however, severe strains developed to challenge the newfound unity. Most importantly, during the Gulf crisis in late 1990, Saudi Arabia—home to the bulk of Yemeni migrant workers, made up an estimated 17 percent of the Saudi workforce—decided to end the visa and sponsorship exemptions traditionally enjoyed by Yemeni people living and working in Saudi Arabia. As a result, an estimated three-quarters of a million workers returned to Yemen.5 About 50,000 workers returned from other Gulf states. Some 60,000 returning migrants had to be put in refugee camps, most others returned to their hometowns and villages. Returnees initially ran through their savings, but the loss in remittances and official assistance from Gulf states (about US$200 million per year in the late—1980s) and the need to accommodate a million returnees contributed to a rapid deterioration in economic balances, contracting economic activity and fuelling inflation. These adverse factors were compounded by a severe drought during 1990–91.

13. Other economic (and political) strains resulted from the way the two very different economic systems were merged. The two civil services were simply added together, with 50/50 sharing of all posts between the former YAR and the former PDRY services, reflecting a similar sharing of the top leadership posts. Harmonization of wage scales at the higher level of the YAR added to pressures on the public finances. Tensions quickly arose, for example, as to what education policy to pursue. Hasty attempts to roll back the PDRY’s farmland distribution and only slow reconstitution of real estate nationalized under the PDRY to businesses who had fled the South, led to dissatisfaction among farmers and the business community. The bloated bureaucracy fueled a rise in governance problems; many Southerners were concerned about aspects of traditional YAR society such as tribal influence and greater circumscription of the role of women (and many Northerners about what was perceived as non-Islamic behavior in the South). As a result, the leadership remained largely divided among former North-South lines, with Southern representatives often abstaining from joint cabinet meetings. Each side largely preserved control over its former armed forces.

14. At the same time, the introduction of democracy led to a flourish of political parties (more than 40 political parties emerged) and newspapers across a broad political spectrum. In the first “unified” election in 1993, the electorate largely voted along the traditional North-South line.6 The General Peoples’ Congress (GPC), including much of the former YAR’s leadership, emerged as the dominant political force, winning nearly half of the available seats; the newly formed Islamic Yemeni Reform Group (YRG), or Islah, came in a distant second; closely followed by the Yemeni Socialist Party (YSP), comprised largely of the former PDRY leadership, and which won most seats in the South. There were also a large number of independents and small parties. Although a coalition government including the GPC, YRG, and YSP was formed, the election results led to growing estrangement between the Southern and Northern leadership, with each focused on the rebuilding of regional power bases. This was also fuelled by development of a Southern oilfield (Masila), which came on stream in 1993 (with 40,000 b/d trucked to Aden); output rose to 150,000 b/d as a central processing unit and a pipeline to the Indian Ocean were completed in 1994. Despite many attempts—notably by other Arab states—to mediate between the two sides, the declaration of an independent Southern state by parts of the YSP leadership in 1994 triggered a civil war that ended with the defeat of the Southern forces a few months later and at the cost of considerable destruction of lives and property.

15. In September 1994, a new constitution was adopted, providing for direct popular election of the president and making sharia the principal source of legislation. A new government comprising only GPC and Islah representatives was formed and, in 1995–96, was able to reach a broad consensus to start needed economic and administrative reforms. New elections in April 1997 were boycotted by the YSP and gave the GPC an absolute majority, with Islah again the second largest party, followed by a number of smaller parties and independents. This time the GPC alone formed the government, although the cabinet included a few independents (including the Prime Minister). However, the President also instituted the Consultative Council, including members of YRG, YSP, and GPC, along with eminent tribal leaders and other representatives of civil society. The council has no legislative or executive mandate, except for debating the major issues and submitting recommendations to the president; it plays, however, an important role in mediating, for example, differences between parliament and the executive.

16. In September 1999, President Saleh won another five-year mandate in Yemen’s first contested presidential election, running against another GPC member. The Yemeni Reform Group refrained from putting up a candidate, and other opposition parties were unable to muster the 10 percent votes in parliament, which was needed to field a presidential candidate.

B. Yemen’s Emergence as Oil Producer

17. From a regional perspective, with estimated proven oil reserves and production levels in 1998–99 at 0.6 percent and 1.8 percent of the corresponding Middle Eastern totals, Yemen is a minor player in the oil market. The oil sector in Yemen is characterized by little government intervention and dominated by the presence of large international oil companies that manage exploration and production operations. Oil production began in 1987 in the Marib concession held by a consortium of companies (including Hunt, Exxon, and Yukong). In 1993 the second major block, Masila, operated by Canadian Occidental Petroleum (CanOxy), came on stream, giving a major boost to oil GDP growth (Table 1). As oil production continued to increase at an annual average of about 3 percent throughout the rest of the decade (Chart 1), Yemen’s economy became highly oil-dependent. The share of oil in real GDP nearly doubled, from 10.7 percent in 1992 to 20.2 percent in 1999, and government crude oil export revenues as share of GDP increased eight-fold over the same period.

Table 1.

Republic of Yemen: Selected Economic Indicators, 1990–99

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Sources: Yemeni authorities; staff estimates and projections.

EBS/99/98 (6/15/99).

Gross reserves minus commercial bank foreign exchange deposits held with the central bank. Imports are for the current year, and exclude oil and gas sector imports. Short-term debt by remaining maturity; excludes private debt for which data is not available.

Public- and publicly-guaranteed debt including central bank foreign liabilities. Debt service ratios in percent of exports of goods and services and reflecting reschedulings in 1996 and 1997 under the auspices of the Paris Club.

Based on the free market rate.

Chart 1.
Chart 1.

Republic of Yemen: Crude Oil Production and Government Share 1/

(In millions of barrels per year)

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Source: Ministry of Oil and Mineral Resources; Ministry of Finance, and staff calculations.1/ Based on proven recoverable reserves as of end-1999; excluding natural gas reserves.

Inception and evolution of exploration agreements

18. While exploration activity took place in Yemen as early as in the late 1930s, it accelerated in the 1970s when 8 agreements were signed with oil companies to conduct exploration, mostly in the Hadramout and Tihama areas. Between 1982 and 1991, Yemen signed about 10 additional exploration and production agreements,7 including agreements for the 5 currently producing blocks—Marib, Masila, Jannah, Shabwah, and Ayad. The contracts in each case were fairly similar. Exploration commitments were specified,8 in addition to cost oil percentages9 and profit sharing ratios, and signing bonuses were granted in most cases. The share of cost oil was usually around 30 percent, while profit sharing was on average about 20 percent for the company.10

19. Three agreements signed in the 1980s eventually led to oil discoveries, which was quite substantial in two cases.11 The remaining agreements for the currently producing blocks were signed in the early 1990s. In the early to mid-1990s, foreign interest in the Yemeni oil sector diminished, mainly due to the civil war and a relatively low exploration success rate (primarily because of geological difficulties). As the government realized that without additional foreign investment, oil production would decline in the near future; it began to offer better financial terms for interested oil companies and eased the terms of existing contracts on a case-by-case basis. A major change implemented in the contracts was allowing the share of cost oil to be periodically revised in light of movement in world oil prices.

20. To provide better incentives to oil companies investing in small fields, the Yemeni government renegotiated deals with NPC and CanOxy in 1995–96. The new financial terms allowed oil companies to recover their initial exploration expenses in a shorter period of time.12 For the new agreements signed in 1996 and onwards, the starting point for the sliding scale of the profit-sharing formula was increased from 20 percent to 30 percent, and the share of cost oil was increased from about 30 percent to 50 percent-75 percent. That share was to be decreased, however, once the oil company had recovered its initial costs and entered into the operational phase. As a result of these better terms, the number of new companies in the oil sector increased significantly. During 1996–99, 20 exploration blocks were awarded (Statistical Appendix Table 11). As of February 2000, more than 26 oil companies were conducting exploration operations in Yemen on a total of 30 blocks. Most finished their seismic surveys and were in the process of drilling exploration wells. More recently, the authorities moved away from their traditional approach of negotiating concessions on a bilateral basis and embarked in late 1999 on road shows in London and Houston, inviting a new round of bids for the development of seven blocks. About 15 companies seemed interested but none was ready to make a formal commitment, possibly awaiting important discoveries in the current exploration operations.

Production prospects

21. According to the Petroleum Exploration and Production Board, Yemen’s remaining recoverable reserves stood at 2.8 billion barrels at end-April 2000, allowing for a production horizon of about 18 years at the current level of output.13 Yemen’s oil production is expected to increase from an average of 389,000 b/d in 1999 to about of 450,000 average in the year 2000. The main increase is expected to come from the Jannah and Shabwah blocks where large investments in infrastructure are taking place. Unless relatively large new fields come on stream, however, oil production is expected to start declining from 2001 onwards at an approximate average rate of 3 percent as fields in both Marib and Masila start drying up.14


22. Yemen has two state-owned refineries in Aden and in Marib. The refinery in Aden was constructed in 1954 by British Petroleum and nationalized by the PDRY. It is currently entirely state-owned and operated by the Aden Refinery Company (ARC). Initial capacity was about 150,000–170,000 b/d, but obsolescence of its equipment and other inefficiencies had reduced the refinery’s capacity to about 110,000 b/d by 1990, and it sustained further significant damage during the civil war in 1994. It only refines about 70,000 b/d currently, producing an array of petroleum products (including gasoline, fuel oil, kerosene, and diesel) mainly for the domestic market. The Marib refinery was constructed much later in 1986, in the Marib block, specifically to refine oil extracted there. It is operated by Yemen Hunt Oil Company. Its capacity is much lower 10,000 b/d; and it mostly supplies the local market.

23. Under pricing arrangements introduced in early 1999, refineries pay the international price for crude oil delivered out of the government’s share in production (through the Yemen Oil and Gas Corporation) and charge the Yemen Petroleum Corporation (YPC) international prices for refined products.15 The Ministry of Finance transfers the difference to the YPC between its payments to the refineries and its sales (at administratively fixed prices for most products).

24. Progress on the renovation of the Aden refinery has been plagued with problems including disagreements over how much capacity to restore. In May 1998 the Council of Ministers approved, in principle, the privatization of the Aden refinery, and in January 2000 preparations for the privatization of the plant began.

The role of crude oil in the Yemeni economy

25. The bulk of Yemeni crude oil production has always been exported which accounted for 80–90 percent of total exports over the period 1994–99 (Chart 2). Companies export their entire share, which has averaged about 43 percent of production in the second half of the 1990s; the government sells about two-thirds of its share abroad. The second half of 1999 was an exceptionally favorable period for the Yemeni government, as both the government’s oil share and oil prices increased; the former was mainly due to high oil prices allowing the government to negotiate substantially lower than usual cost oil shares for the companies.

Chart 2.
Chart 2.

Republic of Yemen: Crude Oil Comparisons, 1990–99

(Comparing Yemen to other non-major oil exporters)

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Source: Ministry of Oil and Mineral Resources.

26. Over the course of the decade, dependence on oil to generate exports and budget revenues has increased quite sharply in Yemen, also when compared to other non-major oil producing countries (Chart 2). By the second half of the 1990s, Yemen’s dependence on oil exceeded, for example, that of Syria, and it has always been higher than Egypt’s.16 A simple simulation exercise highlights the extent to which Yemen has become more vulnerable to oil price movements. Table 2 shows the effect of a unit decrease in the export price of crude oil on government and export revenues for the sample countries, assuming unchanged production levels and profit-sharing arrangements for each year. For example, an oil price lower by one U.S. dollar in 1999 would have resulted in a drop in budget revenues of 0.68 percent of GDP in Yemen, higher than those all other sample countries except Saudi Arabia; it would have also reduced exports by 1.67 percent of GDP, an impact considerably larger than the one for all other sample countries.

Table 2.

Republic of Yemen: Sensitivity to Oil Price Changes, 1990–99

(In percent of GDP)

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Source: Staff estimates.

Assumes unchanged production and sharing patterns between the government and oil companies. Because of different classifications for each country, the results should only be interpreted as broadly indicative of trends.

27. More generally, Table 3 summarizes key volatility measures of oil-related macroeconomic aggregates for Yemen and a sample of countries from the region. Terms of trade volatility in the 1990s were much higher for oil exporters than for non-oil exporting countries in the sample, clearly due to the volatility in oil prices. Yemen’s terms of trade volatility was similar to that of other oil-exporters in the region, but is associated with higher than-average income volatility. Indeed, in Yemen as in Iran, GDP volatility is not much below terms of trade volatility; while for Saudi Arabia and Egypt, GDP is far less volatile than the terms of trade.17 Yemen’s terms of trade variability is also associated with relatively larger volatility of government revenues, compared to countries such as Syria and Egypt, and high oil price variability could, therefore, have a bigger negative impact on Yemen. In part, this reflects the fact that under the cost-sharing agreements with oil companies’ oil revenues accruing to the government do not change linearly with oil prices. The lower the oil price, the more oil volume is necessary to pay for oil production costs and thus the lower the oil volume available to the government. Hence, falling oil prices also cause a fall in government oil volume. The opposite holds true for rising oil prices.

Table 3.

Republic of Yemen: Oil-Related Volatility in the Economy, Comparing with Other Oil Exporters in the Region

(In millions of Yemeni Rials)

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Source: Staff estimates.

The volatility for crude export price, terms of trade, and real GDP was calculated as the standard deviation of the natural logarithms of the corresponding annual values over the period 1990–99.

The volatility for the GDP-shares of oil exports and budget oil revenues was calculated as the standard deviation of the corresponding annual values.

28. Fluctuations in real gross domestic income (RGDI) are another way to capture the impact of oil price volatility on the Yemeni economy, adjusting fluctuations in real gross domestic product (RGDP) for terms of trade effects:18

RGDI = RGDP + ToT effect.

The terms of trade effect adjusts the volume of production, measured by RGDP, for changes in the purchasing power of income generated by such production.19 Simple calculations show that in 1990–99 the volatility of RGDI reached 0.23, more than the double of RGDP volatility. In 1998, following the large drop in oil prices, the 30 percent decline in the terms of trade for Yemen was associated with a 15 percent decline in RGDI; the 61 percent improvement in terms of trade in the following year led to a 59 percent increase in RGDI (changes in RGDP for these two years were 5.3 percent and 3.8 percent, respectively).

29. Growing budgetary vulnerability can be illustrated by recent episodes. The collapse in oil prices in 1998, for example, was accompanied by a dramatic decline in government export revenue from 15 percent of GDP in 1997 to 8.5 percent in 1998. In that instance, because of oil shares cost rising, the price decline was aggravated by a 17 percent reduction in the government share of the total volume of oil production. By the same token, with the rapid rise in oil prices and an increasing government share in oil production, in 1999 oil export revenues reached 12.7 percent of GDP. The 1998–99 swing in prices also pointed to costs in adjusting expenditures. With limited access to foreign financing, avoiding inflationary deficit financing requires sharp adjustments to expenditures in times of low oil prices. Much expenditure is already predetermined by long-term decisions and cannot be cut at short notice. In 1998, the government coped with the unexpected revenue shortfalls by stopping development projects on an ad hoc basis, not always reflecting spending priorities. Moreover, wage increases were delayed and granted only after the recovery of oil prices in 1999. While difficult to quantify, the economy likely suffered costs, such as the unavailability of unfinished schools and infrastructure as well as more indirect effects on investment and saving.

Gas production prospects

30. Yemen’s proven natural gas reserves are about 15 trillion cubic feet,20 about one percent of the Middle East total. So far, only few facilities for recovering and utilizing associated gas have been installed. About 30,000 b/d equivalent of liquefied petroleum gas (LPG) are currently produced in the Marib block, fully covering domestic consumption.

31. After the civil war, the government signed a joint contract establishing the Yemen liquefied natural gas (LNG) Company—a partnership of Hunt, Exxon, Yukong, and Total of France—with the public General Gas Corporation of Yemen, which retained 26 percent of the venture. The LNG project stipulates the construction of: (a) a two-train liquefaction plant with a capacity of 5.3 million tons per year; and (b) facilities for supplying gas to local power stations and industrial factories. The initial expenditure is estimated at about US$2.6 billion, but could reach US$5 billion if the cost of shipping the LNG to foreign markets is factored in. In addition, a 100–250 million cubic feet per day capacity gas line is to be constructed to supply Sana’a with gas for local consumption, and the maximum possible volume of LPG is to be extracted as well for both domestic consumption and for export. The agreement between the government and the foreign companies with holdings in Yemen LNG would expire 25 years from the start of exports.

32. The launching of the LNG project has been delayed so far because of the lack of secured markets in which to sell the gas. The Asian crisis in 1997–98 temporarily dimmed the prospects of finding markets for LNG in the region, and—even with the upturn of the economic situation in Asia—Yemen faces strong competition from Oman and Qatar, which already have LNG infrastructure in place with room to expand existing plants, if necessary. However, despite the fact that no definite gas sales contracts have yet been signed, Yemen LNG recently decided to invite bids for the execution of the project (including the plant, pipeline, and long-lead items) starting in March 2001. Three years would be needed to complete the construction of the plant.

C. External Debt

33. Of the many burdens unified Yemen inherited, the crushing external debt was among the heaviest. By the end of 1990, unified Yemen’s medium- and long-term external public and publicly guaranteed debt amounted to an estimated US$9.9 billion (equivalent to 106 percent of GDP) of which US$6.4 billion (valued at the official exchange rate) was debt to the members of the former Council of Mutual Economic Assistance (CMEA) with Russia accounting for 97 percent of it.21 Yemen’s debt service obligations for 1990 were estimated at US$696 million (47 percent of exports of goods and nonfactor services) on a commitment basis. However, the actual debt service payments were in the order of US$426 million as debt service to the former CMEA and certain Middle Eastern countries and financial institutions had been in abeyance since mid-1990 (Table 4).

Table 4.

Republic of Yemen: Balance of Payments, 1990–99

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Sources: Central Bank of Yemen; and Fund staff estimates and projections.

For the period until 1996, includes private capital.

Represents full settlement of overdue obligations to non-Paris Club official bilateral creditors under discussion to ensure comparable treatment and commercial debt subject to IDA debt buyback.

Includes central bank SDR holdings, foreign exchange held abroad, foreign securities, gold, silver, and foreign currencies, excludes commercial bank required foreign exchange reserves with the central bank against their foreign currency deposits.

Imports are c.i.f. for current year and exclude oil sector imports.

Public- and publicly-guaranteed debt including central bank foreign liabilities. Debt and debt service reflect the 1996 and 1997 Paris Club reschedulings, including the 80 percent upfront discount provided by the Russian Federation.

34. In 1991, the government began to explore the possibilities to normalize the arrears situation and to seek debt relief. Following the temporary interruptions in 1990, debt service payments to all regional multilateral institutions were resumed. The government’s debt-servicing policy was to fully service its contractual obligations to international multilateral creditors and to give debt-servicing priority to those bilateral and regional multilateral creditors who continued to provide resources for development.22 For the former CMEA creditors, the policy was to seek a write-off of all obligations relating to the military debt of the former PDRY and a rescheduling of principal and a write-off of interest obligations on civilian debt.23

35. In 1993, Germany forgave Yemen’s debt to the former German Democratic Republic (US$46 million), but there were no negotiations with Middle Eastern or other former CMEA countries, except Russia, to seek ways to address Yemen’s external indebtedness. While an agreement was reached with the Russian authorities in early 1993 on the magnitude of the ruble stock of debt, differences persisted over the currency and exchange rate for valuing and servicing the debt. In the end of 1994, Russia offered to cancel Yemen’s debt for a cash payment equivalent to 10 percent of the stock of debt outstanding plus the accumulated interest arrears valued at the loan contracting rate. While the Yemeni government wished to resolve the Russian debt issue, the financial resources available at the time or in prospect were not sufficient to meet those terms.

36. In 1994, all debt service to multilateral creditors became current despite shortfalls continued in debt service payments to bilateral creditors.24 By the end of 1995, Yemen’s public and publicly guaranteed external debt (including capitalized interest) had risen to about US$11.0 billion, or 170 percent of GDP, of which US$6.8 billion was debt to Russia. Over the same period, the stock of official external arrears reached an estimated US$6.4 billion of which US$4.8 billion were arrears to Russia.

37. In February 1996, the government requested debt relief from the Paris Club creditors and intensified its efforts to reach an agreement on debt relief with Russia and other bilateral official and commercial creditors. On September 24, 1996, Paris Club creditors reached an agreement with Yemen on a flow rescheduling on Naples Terms.25 The debt relief applied to medium- and long-term public and publicly guaranteed external debt contracted before the January 1, 1993 cut-off date and entailed a 67 percent reduction in the net present value (NPV) of consolidated debt, encompassing outstanding debt service arrears as of end-August 1996 and obligations falling due during the September 1, 1996–June 30, 1997 period.26 This provided a debt service relief in the amount of US$93 million for the remaining months of 1996. The participating creditor countries also agreed in principle to consider the matter of Yemen’s debt service payments falling due after June 30, 1997 and relating to loans contracted before January 1, 1993.

38. Following the September 1996 Paris Club meeting, the authorities communicated to all other bilateral creditors requests to negotiate debt relief on terms that would be at least as favorable as those granted by the Paris Club creditors. In particular, intense direct contacts with Russia were initiated in late 1996.27

39. On September 17, 1997, Russia reached an agreement with the Paris Club creditors on Russia’s participation in the Paris Club and, in line with the provisions of the agreement, agreed to provide debt relief to Yemen on Paris Club terms. The agreement applied to the totality of Russian claims on Yemen, including capitalized interest, and, for the purpose of their treatment within the Paris Club, entailed an 80 percent up front discount to be applied at the date of the signature of an Agreed Minute.28 The Agreed Minute negotiated in November 1997 between Yemen and its Paris Club creditors (including Russia) provided a 67 percent NPV reduction of consolidated public and publicly guaranteed external debt contracted before January 1, 1993, and encompassing outstanding debt service arrears as of end-October 1997 (including late interest); principal due from November 1, 1997 up to October 31, 2000; and interest obligations (excluding late interest) falling due during the July 1, 1999–October 31, 2000 period.29 This provided an immediate debt relief in the amount of US$6.0 billion of which US$5.9 billion was for arrears reduction.

40. In addition, the authorities requested assistance under the IDA Debt Reduction Facility in executing buybacks of the remaining commercial debt, which had been in default since 1991. Yemen’s total commercial debt eligible for the Facility amounted to US$695 million of which US$415 million consisted of principal and the rest of interest arrears. Of the principal, about US$342 million was owed to Russian creditors and the rest to creditors from 51 countries. Under the proposed buyback operation, all interest arrears were to be forgiven; the principal arrears were to be bought back at a fixed price after an initial reduction of 80 percent was applied to the stock of Russian commercial debt in line with the provisions of the September 17, 1997 agreement between Russia and the Paris Club on Russia’s participation in the Paris Club.30 A grant in the amount of US$15.10 million was approved in November 1999 and a buyback offer for a payment of 10 cents per U.S. dollar of outstanding principal was launched.31

41. As a result of the multiyear debt relief provided under the 1997 Paris Club, rescheduling, Yemen’s external debt burden was substantially reduced. The total official external debt declined from US$11.1 billion (173 percent of GDP) by the end of 1996, to US$5.5 billion (80 percent of GDP) by the end of 1999 while the stock of amortization and interest arrears was reduced from US$7.0 billion to US$1.2 billion.32 Over the same period, external debt service obligations declined from 32 percent of exports of goods and nonfactor services to 11 percent.

42. In early 2000, the government undertook a debt sustainability analysis (DSA) in collaboration with the Fund and Bank staffs. The analysis was based on the stock of public and publicly guaranteed external debt outstanding as of end-1999 and assumed a full use of traditional debt relief mechanisms, in particular, a stock-of-debt operation on Naples Terms in the near future. The results of the analysis indicate that Yemen’s external debt position would remain sustainable over the medium term with the stock of debt and the ratio of debt service payments to exports of goods and nonfactor services projected to decline further (after taking into account expected new borrowing), to US$5.4 billion (64 percent of GDP) and 7.8 percent, respectively, by 2005; and that Yemen would not be eligible for special assistance under the enhanced Highly Indebted Poor Country (HIPC) Initiative.

III. Macroeconomic Policy During 1990–99

A. Changing Policy Mix

43. The macroeconomic policy mix differed radically between the first and the second half of the 1990s. Unification of the YAR and the PDRY in 1990 joined two countries that already faced considerable macroeconomic policy challenges on their own in the late 1980s. The budget deficits of the YAR ranged from 15 percent to 20 percent in 1988 and 1989, of which about two-thirds were financed by the central bank, keeping inflation in double digits. In the centrally planned economy of the PDRY, the fiscal deficit reached over 50 percent of GDP in both 1988 and 1989, of which 25 percent to 30 percent were domestically financed.33 Unification added new problems which were related to the merger of the two civil services and tax systems as well as the large number of publicly operated enterprises in the southern governorates. Since unification had resulted from negotiation between two sovereign governments that received equal weight in the new joint government, many conflicts inherent in the different economic philosophies were resolved only after the civil war in 1994.34 The Middle East crisis of 1990 also added strains to both public and private financial balances in the early 1990s with the return of workers from neighboring countries and the drying up of most external financial assistance. Faced with financial crisis, following some early price liberalization efforts during 1990–91, the authorities’ macroeconomic policy mix centered in the first half of the decade around attempts to manage financial imbalances through direct control of the economy, affecting in particular imports, exchange rates, interest rates, and investment. The attempt to defend nominal exchange rates led to a sharp appreciation of the real effective exchange rate in the first half of the 1990s (Chart 3). As it became increasingly clear that multiple exchange rates and foreign exchange controls exacerbated the negative impacts of external shocks, in 1993–94 the authorities took some partial steps to achieve positive real interest rates and more realistic exchange rates.

Chart 3.
Chart 3.

Republic of Yemen: Real and Nominal Effective Exchange Rate, 1990–99

(August 1996 = 100)

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Source: International Monetary Fund, Information Notice System.1/ The weighted exchange rate was derived by applying assumptions on the shares of various external transactions taking place at either the parallel or the official exchange rates.

44. However, it was only, during the period 1995–99, that the implementation of the authorities’ reform program, with assistance from the IMF and the World Bank, slowly transformed the economy into one of the more open and market oriented systems in the region. This process was supported by rising oil revenue and the return of internal and extenral stability. Efforts to improve fiscal balances were essential to these achievements, along with the adoption of a unified floating exchange rate system that helped to broadly stabilize the real exchange rate at levels well below the earlier peaks. However, the large swing in oil prices in 1998 and 1999 served as a reminder of the fragility of macroeconomic balances in a country that depends largely on revenue from crude oil exports. The government’s ongoing reform program therefore aims at preserving a larger share of the oil revenue to cushion swings in oil prices, and enhancing growth of the non-oil economy by encouraging investment and improving education.

B. Crisis, Controls, and Stagnation—Macroeconomic Policies 1990–94

Public finances, 1990–94

45. Between 1990 and 1994, limited efforts were made to address severe structural fiscal problems in Yemen. Large and rising implicit subsidies for domestic petroleum products and wheat imports weighed heavily on public finances, the customs base was eroding; and the collection of taxes on goods and services was declining as a percent of GDP (Charts 4-5). An already large civil service was afforded large wage increases, albeit below levels of rampant inflation. The resulting financial pressures motivated the maintenance of controls, which, in turn, further aggravated fiscal imbalances and deterred private sector activity. After 1994, the newly constituted government was thus left with a large backlog of economic reforms as well as the task of repairing the physical damage of the war and mending the rift between North and South.

Chart 4.
Chart 4.

Republic of Yemen: Government Revenue, 1990–99

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Source: Data provided by the Yemeni authorities.
Chart 5.
Chart 5.

Republic of Yemen: Customs Revenue, 1990–99

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Source: Data provided by the Yemeni authorities.

46. The large fiscal deficits were at the core of the severe internal and external imbalances in 1990–94 (Table 1; and Chart 6). With the exception of 1991, the deficit on a commitment basis remained above 12 percent of GDP between 1990 and 1994. Because loan disbursements dried up almost entirely in the years after the Gulf crisis of 1990 and because the dissolution of the Soviet Union, these deficits were largely financed by the accumulation of external arrears, or were simply monetized, and inflation accelerated from 33 percent in 1990 to 71 percent in 1994.

Chart 6.
Chart 6.

Republic of Yemen: Fiscal Developments, 1990–99

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Source: Data provided by the Yemeni authorities.

47. Overall revenues dwindled from 20 percent of GDP in 1990 to 13 percent of GDP in 1994 (Table 5). Both declining oil revenue and declining tax revenue contributed to these developments. Oil revenues suffered from the decline in oil prices, the impact of the dual exchange rate system, and the rising importance of domestic refining. Oil and gas revenues, which by the time of unification were 7.5 percent of GDP and 40 percent of budget revenues, deteriorated after peaking at 9.4 percent of GDP in 1991. In 1994, oil revenues were only 3.7 percent of GDP, representing 30 percent of budget revenues. Some of the decline in oil revenue can be explained by the fall in oil prices from US$22 per barrel in 1990 to USS15 per barrel in 1994. In addition, oil production at Marib, Yemen’s major field in the early 1990s; fell by 10 percent in 1992 following technical problems. The widening gap between the market-based parallel exchange rate and the official exchange rate also contributed to the decline of oil revenues as a share of GDP.35 Receipts were credited to the budget at the official rate and thus assumed a declining share of the overall economy, in which most other external transactions took place at the parallel rate. The revenue loss to the budget resulting from use of the official rate also implied subsidies for those products whose import was financed at the official rate, particularly wheat and petroleum products. The implicit subsidies, including those for domestic petroleum product sales, reached 13 percent of GDP in 1996. Finally, following the Gulf crisis, the government increased oil deliveries to domestic refineries to substitute for previously imported petroleum products. At the same time, domestic petroleum prices were increased by 30–50 percent in 1990. As a result, domestic oil revenues surged in 1991 and continued to exceed export revenues until 1994, when exports increased because the Masila field came on stream for its first complete year and the Aden refinery was damaged during the civil war, disrupting domestic deliveries. Because domestic petroleum prices remained unchanged during 1992–94, their value dropped to about 10 percent of international prices (evaluated at the parallel exchange rate), reflecting a rising subsidy for domestic consumption of petroleum products. This policy implied increasing incentives for smuggling, further eroding the oil revenue base.

Table 5.

Republic of Yemen; Central Government Finance, 1990–99

(In percent of GDP)

article image
Sources: Ministry of Finance; Ministry of Planning; and staff estimates.

1990–95: Revenues net of subsidies.

Profit transfers from the Central Bank of Yemen were netted out against interest payments to the CBY until 1998.

Until the unification of exchange rates, subsidies were implicit by applying a preferential exchange rate to wheat and flour imports.

Revenue excluding grants, net of expenditures excluding interest obligations.

Primary cash balance excluding grants and development expenditures

Domestic oil revenue net of cash petroleum subsidies.

Comprises spending on wages, salaries, materials, services, capital in the education and health sectors, and spending by the social welfare fund.

48. The fall in indirect tax revenue as a share of non-oil GDP over time was partially compensated by rising direct tax revenue as a share of non-oil GDP. The latter reflected largely the rising government wage bill as a share of GDP and “bracket creep” in the progressive tax system in a high-inflation environment.

49. Public expenditures were dominated by the heavy weight of the civil service wage bill (Chart 6). Following unification, the public work force of the YAR and the PDRY were merged, and the pay scale in the South was adjusted to the higher level of the North. Moreover, many civil servants received allowances for moving from the former PDRY capital Aden to Sana’a, the former YAR capital and capital of the unified country. The government also reinstated a policy that guaranteed employment to all university graduates and employees of public enterprises. In 1991–94, the government afforded sizable pay raises to public employees, which kept the wage bill in the order of 10 percent to 11 percent of GDP.36 Between 1990 and 1993, the share of wages in total expenditures rose from 29 percent to 36 percent, largely at the expense of development expenditures whose share fell from 27 percent to 12 percent. Defense spending ranged between 8.4 percent and 8.9 percent of GDP between 1990 and 1993, with a sharp increase to 9.7 percent of GDP in 1994 due to the civil war. Moreover, many of the loss-making public enterprises relied on government transfers, reflected in the rise of current transfers from 1.7 percent to 2.7 percent of GDP between 1990 and 1993.

Controls in the monetary and exchange rate systems, 1990–92

50. To contain the spillovers from the fiscal imbalances to the external account, the authorities maintained a “hybrid” exchange system involving a large and relatively free parallel exchange market—with occasional ad hoc attempts to tighten control over this market—and a highly administered exchange system for certain (including official) transactions (Chart 7) involving quantity rationing and a highly appreciated exchange rate (Section IV.A).

Chart 7.
Chart 7.

Republic of Yemen: Nominal Exchange Rates, January 1990–December 1999

(Yemeni Rials per U.S. dollar)

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Source: Data povided by the Yemeni authorities; and staff estimates.

51. Thus there was little scope to formulate an independent monetary policy in the period immediately following unification. Rapid expansion of net domestic assets was driven by the need to provide financing for the budget given the absence of nonbank financing.

52. Commercial banks were reluctant to lend to the nongovernmental sector due to the absence of effective recourse within the legal system for the timely recovery of overdue loans. Accordingly, banks preferred to deposit their resources with the central bank for on-lending to the government at a remuneration of 1.5 percentage points above the banks’ average cost of funds.

53. The continued existence of separate interest rate structures after unification posed special problems for the monetary authorities. While the authorities were targeting a unified system based on the structure of the former market-based YAR, the National Bank of Yemen-the only commercial bank (state-owned) in the South-was allowed to set its own rates as an interim measure. The statutory interest rates that existed in this period were very low and highly negative real rates (Chart 8) discouraged the mobilization of savings, facilitated inefficient consumption investment choices, and added further pressures on the foreign exchange market. Indeed, the level of foreign currency deposits in 1992 doubled from the level attained in 1991, while Yemeni rial deposits increased by only 15 percent over the same period. Also, negative real interest rates continued to facilitate financial disintermediation, as the absence of controls in the parallel financial market for rials spurred growth in this market at the expense of the banking sector.37

Chart 8.
Chart 8.

Republic of Yemen: Interest Rates, 1990–99

(In percent per annum)

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Source: Data provided by the Yemeni authorities.1/ Nominal rates minus inflation (CPI).

Partial liberalization of the exchange and interest rates, 1993–94

54. During the period 1993–94, economic structures became more unified and conducive to national macroeconomic policy making, and the authorities increasingly recognized the need for strong corrective fiscal policy actions, establishment of positive real interest rates, and unification of exchange rates at a realistic level. However, initial reform efforts remained partial and extensive controls remained. In particular, the appreciation of the real effective exchange rate accelerated, undercutting efforts to contain fiscal and external imbalances. For example, faced with a growing gap between the free market parallel rate and various official rates in November 1994, the authorities introduced a “managed official parallel market rate” at YRls 84 per U.S. dollar, to be “guided” by a committee of moneychangers and commercial bank representatives under the supervision of the central bank, taking into account market indicators. This attempt to manage the parallel market failed, however, and already by end- 1994, the unofficial parallel market rate depreciated to YRls 100 per U.S. dollar.

55. To allow a greater role of market forces in financial intermediation, the authorities took some steps to improve the competitiveness in the banking sector. First, they adopted a more liberal policy towards licensing of branches of banks, removing the monopoly of the National Bank of Yemen in the south. Second, the central bank began strengthening prudential regulation and supervision (Section IV.F). In particular, the banking system’s vulnerability to exchange depreciation had to be addressed to prepare for liberalization of the exchange rate. The largest commercial bank, the Yemen Bank for Reconstruction and Development (YBRD) had built up sizable foreign currency deposits, but its net foreign assets position was negative. Unification of the exchange rate at a realistic level would thus trigger large valuation losses. This bank’s problem was addressed by the government’s assignment of most of this debt to public sector enterprises for which the (foreign) credits had been opened, shifting the vulnerability to the corporate sector. The foreign liability position of the central bank was also large, mainly reflecting deposits from foreign governments prior to unification, outstanding liabilities related to oil imports, and short-term liabilities to foreign banks.

C. Reform and the Return of Stability and Growth, 1995–99

56. A new phase of post-unification macroeconomic policy making began in early 1995. By this time, the political situation had stabilized and the new government embarked upon a macroeconomic adjustment and structural reform program with support from the World Bank and the IMF. The program included strong fiscal adjustment measures, liberalization of most interest rates, and reform of the exchange rate system, including in 1996 the elimination of the official exchange rate and unification of exchange rates at the free market level, and the adoption of a floating rate regime.

57. Fiscal improvements during the second half of the 1990s were the basis for the gradual return of some measure of macroeconomic stability to Yemen. Integrating the official and parallel exchange rates helped reduce the subsidy bill and, combined with rising government oil exports, strongly boosted revenues. As a result, the fiscal imbalance declined from 6 percent of GDP in 1995 to 2 percent in 1997. However, as a stark reminder of Yemen’s oil dependence, macroeconomic stability suffered a blow in 1998 with the collapse of oil prices, and the budgel deficit rose to 6 percent of GDP. The reverse outcome could then be observed in 1999 when a surge in oil prices led to a balanced budget and a substantial strengthening of the external position.

58. Total revenues increased from 19 percent of GDP in 1995 to 32 percent in 1999, in large part due to improving oil revenues. Following the enforcement problems of the 1994 civil war, the government also improved its tax collection and introduced several simplifying reforms to tax and customs laws, which contributed to a rising ratio of tax revenues to non-oil GDP.38

59. Rising production and prices as well as the stepwise unification of exchange rates in July 1996 raised oil export revenue accruing to the budget from 3 percent of GDP in 1994 to 15 percent of GDP in 1997. The government’s crude oil volume available for domestic deliveries and exports almost doubled between 1993 and 1997, partly because overall production rose and partly as investment costs had been recouped by concession holders, reducing the companies’ share in production. Moreover, the stepwise adjustment of the official exchange rates to the parallel market rate substantially raised the value of oil revenue recorded in Yemeni rials while eliminating the implicit subsidization of certain economic activities resulting from preferred access to foreign exchange.

60. Domestic oil revenues increased from 3 percent of GDP in 1995 to 7 percent of GDP in 1999. Exceptionally high domestic revenues in 1996 resulted from a settlement of excess cost recovery charges with an oil company yielding 2.3 percent of GDP, as well as rising international prices and the integration of the exchange rates. While the unification of exchange rates removed one source of implicit subsidization, the transactions between the government, oil refineries, and distributors remained opaque and involved nonmarket-based transfer prices and free inputs. Only in 1999 was pricing of all wholesale transactions moved to be based on world prices.39 Therefore, the domestic revenues have to be evaluated together with the subsidy payments to receive a clear picture of domestic efforts. As shown at the bottom of Table 5, the resulting measure of net domestic oil revenue rose steadily over time.40

61. Tax revenue rose strongly to 11.5 percent of non-oil GDP in 1996, but then began to erode slowly, reaching 10.7 percent of non-oil GDP in 1999. The initial strengthening of tax revenue was a consequence of exchange rate unification, economic recovery, and several tax reforms undertaken in 1995 and 1996 (Section IV.B). Higher exchange rates applied to import valuation; the recovery of the economy that was followed by higher import volumes, and the simplification of the tariff structure with concomitant improvements in customs administration led to a rebound of customs revenues to more than 9 percent of non-oil imports in 1996. Taxes on goods and services also benefited from higher economic activity, a widening of the tax base, and higher tax elasticity after some specific taxes was replaced with ad valorem taxes. Direct tax revenues rose with a simplification of corporate rates at 35 percent. After 1996, direct taxes and—until 1999—taxes on goods and services continued to rise faster than non-oil GDP, but the decline in customs revenue pulled down overall revenue growth. Direct taxes benefited from the rising share of government wages in GDP, improving business income tax revenue after the 1996 rate unification, improving economic conditions, and an increase in top tax rates in 1999. Taxes on goods and services grew strongly after their base was broadened in 1996 but fell as a share of non-oil GDP after the 1999 tax amendments changed a number of tax rates. The poor performance at customs likely reflects the rising importance of smuggling, continuing weaknesses in administration, and to a certain extent elimination of import surcharges in 1998.

62. Large swings in expenditures were driven by the move to unify exchange rates and related subsidy reform. After the unification of exchange rates over 1995–96, the implicit subsidy through below market foreign exchange rates was replaced by explicit cash subsidies for wheat, flour, and petroleum products. In 1996, these subsidies rose to 13 percent of GDP because of a widening gap between domestic and international prices. In later years, these subsidies declined when domestic prices were moved closer to world market prices, and wheat and flour subsidies were eliminated entirely by mid-1999 (Section IV.C). The civil service wage bill declined to 6 percent of GDP in 1997 as wage increases were kept below inflation and despite rising currency costs for foreign workers (mainly teachers) paid in foreign exchange. However, following large wage increases in 1998–2000, the civil service wage bill has recently been on the rise again. These wage increases largely reflected the implementation, phased over three years, of a teachers’ law passed by parliament in 1998 that granted 100 percent wage increases to workers in the education sector, where the majority of civil servants work. Similar wage increases were granted to health workers. Defense spending declined from 6.7 percent of GDP in 1995 to less than 6 percent in 1999. Development expenditures doubled as a percent of GDP in 1996, but were cut back in 1998 and early 1999 after the fall in oil prices.

63. The financing of the government deficit through central bank credit remained a critical source of macroeconomic instability. Although disbursements of foreign grants and loans in the order of 2 percent of GDP resumed in 1996, the government continued to face large amortization obligations and, hence, net external financing remained small until rescheduling agreements were reached with Paris Club creditors in 1996–97. To develop sources of noninflationary financing and deepen the financial system, a market for treasury bills was introduced in 1995 and the central bank subsequently closed its term deposit facility for banks and for pension funds to channel resources into this market (Section IV.F). Thus, in 1996 and 1997, the government reduced its indebtedness to the central bank, financing deficits with accumulation of arrears to wheat importers, as well as increasing treasury bill sales to commercial banks and nonbank. However, as oil revenue shrank dramatically in 1998, the government had to borrow 3 percent of GDP from the central bank, and the concomitant expansion in money supply resulted in an immediate spurt of inflation. Fortunes were reversed in 1999, and inflation rates fell when rising crude oil revenues led to a balanced budget, permitting the government to reimburse almost 5 percent of GDP to the central bank.

64. The use of monetary policy instruments became more flexible, responding to macrofinancial conditions. In the context of the reform program, in 1995 the central bank unified the reserve requirement at a rate of 25 percent, without remuneration, for all rial deposits to be lowered to 15 percent in December 1996 and to 10 percent in December 1997. A rate of remuneration of 5 percent on these deposits was initiated in December 1996, and rose the following year to the same level as the benchmark deposit rate. In December 1997, the reserve requirement on foreign currency deposits was lowered from 25 percent to 15 percent, and the rate of remuneration was set at half of a percentage point less than the rate received on the central bank’s deposits abroad. The higher reserve requirements for foreign currency deposits and the much lower rate of remuneration on these deposits reflected the central bank’s objective to stem the trend of increasing dollarization of the economy and to enhance the attractiveness of the rial as a store of value; undoubtedly, such discriminatory measures induced capital flight. The effectiveness of reserve requirements as an instrument of monetary policy might have been hampered by the less than full implementation of the penalties for shortfalls. While the central bank can impose a maximum daily penalty of 5 percent, in practice this figure lies in the 0.5–2.0 percent range. The central bank has used credit ceilings as an instrument of monetary policy in the early post-unification period, but this instrument was hardly effective then and subsequently lost all importance.41

65. Two sharp real exchange rate depreciations took place in early 1995 and mid-1996 (Chart 3). While the latter reflects the nominal depreciation that occurred at the time of unification of the exchange rates, the former was the result of a partial reform of the exchange rate system implemented at the time, including the elimination of special official rates and the depreciation of the only remaining official rate from YRls 12 to YRls 50 per U.S. dollar.

66. With the authorities’ move to a floating exchange rate system throughout the period, the rial broadly stabilized in real effective terms; some small appreciation in real terms between end-1996 and end-1999 partly reflected a reluctance to tolerate substantial variability in the exchange rate. Indeed, exchange rate stability remains, in the eyes of the public, the main yardstick for the success of government policy. Accordingly, through interest rate policy, moral suasion, and the regular auctioning of foreign exchange to moneychangers and banks, the central bank attempted to stabilize the exchange rate in times of turmoil. In part, intervention reflected also an attempt to smooth sharp seasonal peaks in demand for foreign exchange (especially around the Ramadan and Hajj seasons), given the limited depth of the private market. For example, reflecting the impact of low oil prices on macroeconomic performance in 1998, the central bank employed its limited monetary tools to ease the pressure on the exchange rate. It raised the official benchmark interest rate (up to 3.5 percent in real terms) and removed remuneration on foreign currency deposits at the central bank, but still had to spend half of its reserves to limit exchange rate depreciation during 1998 to 7 percent against the U.S. dollar. Only in early 1999 did the authorities allow a faster rate of depreciation, coupled with further interest rate tightening.

67. In light of sharply improved macroeconomic balances in the latter half of 1999, the Central Bank of Yemen (CBY) initiated a gradual lowering of benchmark interest rates. As a result, the real effective exchange rate showed a modest depreciation in 1999, reversing some of the appreciation of 1998.

D. Preserving the Oil Wealth—A Long-Term View of Yemen’s Fiscal Policy Stance

68. For oil exporting countries, an added complexity of fiscal policy involves the management of finite oil wealth. Yemen derives a significant share of government revenue from oil exports and oil-related economic activity. Unless further exploration activities result in new discoveries, most of the country’s proven recoverable oil resources—estimated at 2.8 billion barrels in April 2000—will be depleted within 18 years.42 Chart 1 presents the amount of crude oil accruing to the government after subtraction of cost oil and the oil producer’s share between 1990 and 2020. Under these projections, the government’s crude oil share will peak in 2000 and drop steeply after 2009 with the exhaustion of the Marib field. Unless revenue from the non-oil economy replaces oil revenue in future years, achieving long-run sustainability implies saving a portion of today’s oil revenue in the form of financial assets, human capital, or infrastructure. In practice, it is highly uncertain whether spending oil wealth on education and infrastructure will boost growth sufficiently for the tax revenue generated from additional growth to sustain government spending.43

69. Fiscal policy decisions must rely on an estimate of oil wealth, i.e., the present value of all future government revenues generated by extracting crude oil. However, calculating oil wealth at any given point in time is subject to considerable uncertainty. It depends notably on a forecast of future oil prices, oil production, and interest rates. Oil prices change in unpredictable ways. Statistical tests of their movements generally have difficulties rejecting the hypothesis that oil prices do not systematically return to a long-run average and that the current price is the best predictor of future prices.44 As a result, small changes in the current price could lead to large changes in estimated oil wealth because price changes today would lead to revisions in all future prices. New information on oil reserves, extraction rates, and discount factors as well as new technology developments also affects oil wealth and permanent income estimates. Therefore, oil wealth estimates underlying long-run policy decisions must be adapted frequently to new information regarding prices, oil reserves, crude oil extraction rates, and long-run interest rates.

70. A simple rule to ascertain the long-run sustainability of consumption out of oil wealth45 can be derived from the permanent income theory of consumption. It would prescribe that each period governments should consume at most the real interest they receive on their total wealth.46 From the perspective of consumption possibilities, the permanent income model treats oil wealth and other forms of wealth as equivalent. Hence, consumption in excess of permanent income would result in a decline in total wealth over time. In more practical terms, this concept of government wealth would proxy the ability of governments to sustain current levels of spending in real terms. Preserving wealth thus means preserving the ability to deliver to future generations the same level of public services (health, education, etc.) available to the current generation.

71. The permanent income framework can be extended to account for growth of the population. Yemen’s population growth exceeds 3 percent. If the government aims at preserving wealth per capita, it must adjust its consumption for the expanding population. The reason for maintaining per capita wealth is that it allows keeping the same per capita income stream over time and thus constant per capita government expenditures. Assuming a population growth rate of 3 percent, the government needs to save an additional 3 percent of wealth each period to keep per capita wealth at the same level. Returning to the example above, at a 4 percent real interest rate with a population growing at 3 percent, Yemen should consume only 1 percent of wealth and save the remaining 3 percent interest earnings to keep per capita wealth constant.

72. Apart from oil and financial assets, the non-oil sector provides an additional source of income for the government. Revenue generated by an expanding non-oil sector per capita could over time replace revenue from exploiting oil. In allocating consumption over time the government should thus take into account the expected future growth in non-oil revenue. However, additional non-oil revenue must be generated by growth in per capita non-oil GDP, not by increasingly heavier tax burdens. The latter would not reflect growing overall resources but simply change the distribution of wealth between the public and the private sector. Potential growth of the non-oil sector could be driven by investment into infrastructure or human capital, as well as increased factor productivity. However, as outlined earlier, such investment would have to generate tax revenue sufficient to replace oil revenue in order to sustain fiscal spending. Since the indirect impact of infrastructure and human capital investment on tax revenue is difficult to ascertain, the subsequent discussion is largely limited to the conversion of oil wealth into financial wealth.

73. To analyze past Yemeni fiscal policy from an intertemporal perspective, a few calculations based on a permanent income framework assessing sustainable consumption if the government were to keep per capita wealth derived from oil constant over time are presented below. These calculations do not consider how future growth of non-oil GDP per capita could enhance the government’s revenue base, and thus may understate sustainable consumption.47, 48 Optimal consumption is derived in each year (starting 1990) for the current and future years assuming that oil prices remain constant at current levels. For example, the optimal consumption level out of oil wealth for 1998 is derived under the assumption that oil prices from 1998 onwards remain at US$11.90 per barrel, Yemen’s 1998 average oil export price. This assumption corresponds to the hypothesis that the current price is the best predictor of future prices, i.e., oil price shocks are permanent. Furthermore, the calculations assume that the amount of proven recoverable reserves as estimated today (2.8 billion barrels) constitutes total oil wealth. Other important assumptions are a 4 percent real interest rate and a population growth rate of 3 percent in 1999 declining to 2.5 percent in 2005 and 1.5 percent in 2050. The calculations also incorporate Yemen’s initial net financial wealth, which is assumed to be equivalent to its foreign indebtedness. Under these assumptions, oil wealth at the beginning of 1999 stood at about 280 percent of the 1999 GDP, or USS1,080 per capita. Net total wealth, after subtracting external debt, was US$13.3 billion or USS765 per capita.

74. The calculations show that the level of consumption out of oil wealth as a percent of GDP consistent with preserving oil wealth per capita in the early 1990s was virtually nil. It would have been necessary to save almost the entire oil revenue to preserve wealth per capita because population growth rates partly reflecting the return of expatriates, were high and close to the assumed real interest rate of 4 percent. Moreover, the country entered unification with a debt stock of roughly US$11 billion. As a result, sustainable consumption of oil wealth was only between 0.1 percent and 0.5 percent of GDP. The rescheduling agreement of 1996 reduced external debt by about one-third and, together with declining population growth rates and somewhat higher oil prices, permitted higher consumption out of oil wealth after 1996. Sustainable consumption levels rose to 1.8 percent of GDP in 1997. However, the example of 1998 clearly shows that revaluing oil wealth with current prices would necessitate large adjustments of consumption levels. The fall in oil prices in 1998 resulted in a drop in oil wealth because future production is evaluated at current prices, and sustainable consumption fell from 1.8 percent of GDP in 1997 to 1.0 percent of GDP in 1998. Hence, following the permanent income rule would result in sizable fiscal adjustments. Under 1999 oil prices, oil wealth consumption of 2.4 percent of GDP would be sustainable. This level would rise to about 3.5 percent in the long run with the assumed decline in population growth rates to 1.5 percent.

75. The calculation of sustainable consumption out of oil wealth raises the question of how the government’s actual policies stacked up against that benchmark. For that purpose, budgetary outcomes must be translated into consumption out of oil wealth. The government budget constraint can be summarized as follows:

ORt + TRt + rAt−1CtIt = AtAt−1

where OR stands for total value of oil production accruing to the government, TR for tax revenue net of transfers (such as subsidies), A for net financial wealth, C for government consumption, and I for government net investment after subtracting the depreciation of existing capital. Transfers must include the subsidies for domestic petroleum products implied by charging less than world market prices, even if the latter do not appear directly in the budget.49 Moreover, investment figures must be adjusted for assumed depreciation. The equation can be re-written as:

TRtCt + rAt−1 = AtAt−1 + ItORt;

that is, government non-oil savings (left side) equal the change in total public wealth (including financial wealth, infrastructure, and “oil in the ground”).

76. Hence, if non-oil savings were zero, total wealth would be unchanged—as prescribed by the permanent income framework for the case of zero inflation and zero population growth. Positive non-oil savings would be required for a growing population. The major difficulty in applying the above concept lies in estimating net investment because depreciation levels are unknown. To overcome this problem, only two extreme cases are discussed, providing upper and lower bounds. The first assumes that depreciation equals investment (zero net investment), the second that depreciation is zero (gross investment equals net investment).

77. In the event, consumption out of oil wealth was much higher than can be sustained between 1990 and 1999. As presented in Chart 9, the difference between the optimal government non-oil saving and the actual such balance was large, between 10 percent and 25 percent of GDP. The results indicate that, under the assumptions made, Yemen has spent on average each year in the order of 10 percent to 25 percent of GDP more than can be sustained, and that up to today oil revenue has not been converted into sufficient amounts of wealth to sustain expenditure, even if all development expenditure are counted as net addition to wealth.

Chart 9.
Chart 9.

Republic of Yemen: Oil Balances and Wealth, 1990–99

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Sources: Data provided by Yemen authorities; and staff estimates.

78. The analysis above is subject to great uncertainty regarding future oil and gas resources, as well as the general assumptions of the analysis. Yemen still has unexplored territory and future technologies could render currently inaccessible reserves available. Moreover, the large proven gas reserves, which could last for at least 25 years of LNG production exceeding 5 million tons annually, could prove another important source of revenue. However, developing the capacity to produce LNG is expensive and may produce limited revenue for the government until potential investors in the suggested LNG project have recouped their costs. Another uncertainty surrounds non-oil growth and growth strategies: the analysis implicitly assumes that the return to the government from investing in financial assets will be higher than returns from investing in other assets. It ignores the fact that some of the government consumption, especially in health and education, has contributed to build human capital and thus potential future non-oil growth. This, in return, could boost future government revenues from the non-oil economy. Similarly, structural reforms may eventually bring about positive TFP growth. However, despite increasing budgetary allocations to the education sector, the limited progress in improving social indicators and low non-oil per capita growth may indicate that too much oil wealth has thus far been used to support current consumption rather than the building of human or physical capital.

IV. Microeconomic Reforms

79. In the 1960s, the end of the reign of the Imam in the North of Yemen brought about the establishment of a republic which took first steps to introduce a modern market-oriented commercial and civil law; at the same time, the socialist government that took power following the end of the British mandate in the South established a legal regulatory system based on central planning and extensive government control over production. Thus the unification of the country in 1990 led to the unification of two very different legal systems. The product was the establishment of a complex and at the same time ineffective regulatory environment, combining elements of modern western law with sharia and tribal law, and at the onset of the 1990s an array of controls covered all economic sectors. For a large set of commodities prices were administratively fixed by the government, with the purpose of ensuring low basic consumer and input prices and to suppress inflation.

As discussed in Section III, multiple exchange rates and interest controls were in place, the latter mainly to control credit in the economy. Quantitative trade controls, such as bans and licensing, were used to protect domestic agricultural and industrial activities, while export bans (mainly on fish and unprocessed leather) aimed to maintain supply at low prices. Other laws allowed the government to enforce domestic and external trade monopolies. The Agencies Law and the Trade and Supply Law effectively protected certain monopolistic activities and the government-tolerated private monopolistic structures for example, the trucking carte] (Ferzah), a shipping agents’ cartel in Aden—or even supported such practices through entry restrictions in various forms. The Investment Law gave the government discretion to approve projects as well as wide-ranging control over implementation. This economic and legal environment failed to attract much investment, especially foreign investment. Hence an important component of the reform program of 1995 was regulatory reform.

A. Exchange Regime and Foreign Trade Reforms

80. On July 1, 1990, the exchange and trade systems of the former PDRY and YAR were unified using the system of the former YAR; the latter system was adopted for the Republic of Yemen. However, as part of an attempt to contain growing financial imbalances through administrative controls, a complex system of segmented foreign exchange markets, ad hoc administrative measures aimed at curbing “speculative” activity, and wide-ranging trade restrictions were maintained through 1995.

Exchange system

81. At the time of unification, the foreign exchange market in Yemen was comprised of official and parallel markets. The official market was limited to government external transactions and covered crude oil and petroleum products, official receipts and payments, and external debt service payments. The official exchange rate applied to the allocations of foreign exchange by the CBY to the private sector for imports of wheat, flour, rice, and LPG under government tender, as well as for special purposes such as officially approved medical treatment or study abroad. The CBY prepared indicative foreign exchange budgets in parallel with commodity budgets prepared by the Ministry of Supply and Trade. All other external transactions occurred through the parallel market, which was operated by moneychangers and did not have a legal status until January 1, 1993. At that time a law was enacted establishing regulations for money changing operations including licensing, capital, and reporting requirements, and which assigned oversight powers to the CBY.50

82. Commercial banks operated in the foreign exchange market only as agents of the CBY and were permitted to buy or sell foreign exchange only for the accounts of their customers with the CBY, opening foreign currency accounts for residents and nonresidents only subject to a long list of restrictions on the sources and uses of funds.

83. Commercial banks were prohibited from participating in the parallel market or from transacting with each other in foreign exchange, and were required to use the official exchange rate for accounting and foreign exchange transactions with their customers.

84. At the time of unification, the exchange rate in the parallel market was YRls 13 per U.S. dollar compared to YRls 12 in the official market. On April 1, 1991, the exchange rate for imports of wheat, flour, and rice was increased to YRls 16; on January 1, 1992, the customs valuation rate for all imports (except petroleum products, wheat, flour, and at that time rice) was increased to YRls 18; and on May 1, 1992, an incentive rate of YRls 18 was introduced for purchases of rials by bilateral and multilateral assistance agencies and foreign embassies, as well as for imports by the government and public sector enterprises, all of which constituted multiple currency practices.51 On November 15, 1994, the parallel market oversight committee introduced an “official” parallel foreign exchange market for purchases of foreign exchange for self-financed imports with the exchange rate of YRls 84.52 The CBY enforced the official parallel market rate by mandating that commercial banks could open letters of credit only if the importer provided documentary evidence that the foreign exchange was purchased at the official parallel rate. By the end of 1994, the free market rate had depreciated by 700 percent compared to May 1990 and stood at YRls 103. In early 1995, the main official exchange rate was devalued to YRls 50 (from YRls 12) while the free market rate depreciated further to around YRls 125. To limit the depreciation of the free market rate, the CBY from time to time suspended the operations of moneychangers, pushing foreign exchange transactions in the parallel market underground.

85. The exchange system was free of surrender requirements or taxes and subsidies on purchases or sales of foreign exchange and, with the exception of local payments for hotel bills and airline tickets by foreign nationals which must be made in foreign currency, there were no prescriptions of currency requirements.

86. In January 1996, the authorities began a two-staged process of unification and liberalization of the foreign exchange market. In the first stage, the official exchange rate was devalued from YRls 50 to YRls 100 per U.S. dollar and all other official rates were eliminated (Chart 7). This rate continued to apply only to budget accounting, customs valuations, and transactions between the CBY and the Ministry of Finance. Commercial and specialized banks were allowed to fully participate in the parallel market, and foreign exchange regulations were amended to eliminate provisions inconsistent with free market operations. The exchange restriction entailing the prohibition on the issuance of letters of credit unless the foreign exchange was purchased in the official parallel market was eliminated, and the opening of letters of credit for public sector enterprises and purchasing of foreign exchange from foreign oil companies was shifted from the CBY to commercial banks. The government also eliminated the multiple currency practice related to wheat and flour imports by delinking the subsidy payment from the foreign exchange transaction.53

87. Following a short transition period under a dual rate system, full exchange market unification was implemented on July 1, 1996, and an independently floating exchange rate regime was adopted. All government and CBY transactions, including customs valuations, began to use the unified market rate thus completing the second liberalization stage by August 1, 1996. Finally, in December 1996, Yemen formally accepted the obligations under Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreements, and since then has maintained an exchange system free of exchange restrictions on current or capital account transactions.

88. The CBY is empowered to conduct exchange rate policy, and aims to maintain an independently floating exchange rate regime by limiting its interventions in the foreign exchange market to smooth volatility. If the CBY had intervened in the market between 1996 and early-2000 (virtually always as a seller), it would have invited open bids from commercial banks and large moneychangers to buy dollars, and it would have sold to the highest bidder.

89. The Moneychangers Section of the central bank is responsible for the licensing and inspecting of moneychangers. The number of licensed moneychangers has declined from 260 in 1996 to 170 at present, of which 71 are located in Sana’a. A handful of large moneychangers account for up to 90 percent of total transactions in the market. Moneychangers are not part of the banking sector and their balance sheets are not included in the monetary survey, although their foreign exchange and rial accounts with commercial banks are. Moneychangers are supposed to report their transactions volume to the central bank, but currently less than one-fifth complies. Some of the moneychangers who have significant capital are reportedly involved in informal deposit taking and lending operations, which are not legal; it is also not usually recorded. The interest rate charged by moneychangers is estimated to have a premium of up to 15 percentage points over the lending rate quoted by commercial banks.

90. No firm data are available on the average daily volume of transactions in the foreign exchange market, but the underlying transactions for private current account activities are estimated by the CBY to be in the order of US$1.0–1.5 billion annually on both the buy and sell side. A fully functioning interbank wholesale market encompassing both spot and forward transactions among banks and moneychangers has not yet developed.54 The retail spot market continues to be centered largely on moneychangers, which provide easy and efficient transactions with very narrow spreads. According to CBY estimates, moneychangers account for about 60 percent to 70 percent of all transactions in the foreign exchange market, while the commercial banks account for the rest. Currently there is no clearinghouse for foreign exchange transactions, but commercial banks are considering establishing one as noncash instruments would grow in importance, which would shift the balance in favor of commercial banks and away from the moneychangers.

91. All transactions, including those for budget accounting purposes, use the market rate, although not all supply and demand for foreign exchange is channeled through the exchange market; certain transactions go through the central bank. The transactions that go directly through the CBY include mainly oil export proceeds, foreign loans and grants, and public sector debt service payments thus affecting the foreign exchange reserves of the CBY rather than the market rate. The CBY publishes its daily rate by calculating an average from a sampling of rates from a group of the large moneychangers and commercial banks; the CBY then uses this rate for its official transactions such as government debt service and budget accounting. Individual commercial banks usually call large moneychangers to sample the market rates that day and refer to them for their own transactions.

92. Both foreign and domestic banks are allowed to freely conduct all foreign and domestic currency operations. Effective January 15, 1996, commercial and specialized banks were required to observe prudential regulations regarding currency exposure and to begin reporting their positions. The open positions (both oversold and overbought) are limited to 25 percent on all foreign currencies and 15 percent on one currency. Banks report their daily open positions to the CBY at the end of each week, although the central bank only checks the last day’s position against the limit.

Foreign trade

93. Upon unification, the foreign trade regime (adopted from the former YAR) was inward-oriented and was characterized by import prohibition (through a positive import list), licensing, and a mean nominal tariff in the order of 27 percent. Virtually all imports required licenses from the Ministry of Supply and Trade, and the importation of certain products required the permission of particular government agencies.55 The annual commodity and foreign exchange budgets provided the basis for issuing import licenses. These budgets gave priority to imports of foodstuffs, medicines, petroleum products, and inputs for production. Imports of petroleum products were reserved for the YPC and the Aden Refinery. Foreign exchange for both private and official transactions had to be purchased at the official exchange rate from the central bank, which also had to approve its availability.

94. Imports were subject to a customs duty under a tariff structure, which incorporated 15 bands with the tariff rate ranging from 5 percent to 200 percent. In addition to the applicable customs duty, imports were subject to numerous taxes and surcharges, including an earthquake damage reconstruction tax, a Ministry of Finance surcharge, a Chamber of Commerce surcharge, and a Health Department surcharge.

95. Beginning August 1, 1990, the authorities permitted the self-financing of licensed imports through foreign exchange obtained from the parallel market. A commercial bank guarantee equivalent to 2 percent of the value of the imports was required for an import license to be issued. The commercial banks were then authorized to open letters of credit for holders of import licenses provided that the full foreign exchange value of the imports was deposited with a commercial bank. All importers holding an import license for wheat, flour, rice, and LPG could obtain the necessary foreign exchange from the central bank at the special official rate of YRls 12 per U.S. dollar, which also served as the customs valuation rate.56 In January 1991, the 100 percent import deposit requirement was reduced to 50 percent for commercial imports and to 25 percent for industrial imports, and was finally abolished altogether in January 1992.

96. In May 1993, the positive import list was replaced by a negative list which included 63 categories of items competing with domestically produced goods. Import licensing remained in effect due to foreign exchange shortages. The government assigned priorities among the import categories and granted licenses only up to a ceiling for each category. Export bans, such as the 1994 temporary ban on exports of fish, were imposed from time to time on commodities considered to be in short supply in the domestic market.

97. Over the period January-March 1996, a comprehensive reform of the tariff and trade system was implemented in order to reduce effective protection, enhance the economy’s allocational efficiency and growth prospects, and facilitate its integration into the world economy. The main elements of the reform included:

  • All import bans maintained for economic reasons were abolished except for fresh fruit, vegetables, and coffee.57

  • All import licensing by the Ministry of Supply and Trade was eliminated except for wheat, flour, and petroleum products.

  • The 15-band tariff structure was replaced with a 4-band structure with tariff rates of 5, 10, 15, and 30 percent ad valorem.58

  • The tariff reform was accompanied by excise tax harmonization whereby excise taxes on industrial inputs and a production tax on local manufacturers applied uniformly on imported and domestic products.

  • A process of phasing out import fees and surcharges was initiated and, by September 1997, all import fees and surcharges were eliminated.

  • Duty exemptions for imports by the government and public sector enterprises were abolished.

  • Any new discretionary project-related import duty exemptions were not to be granted anymore except under the Investment Law.

  • Any government controls over exports were eliminated except for security, public health, religious, or environmental reasons.59

98. Following the unification of the exchange system on July 1, 1996, the customs valuation rate was unified with the market exchange rate on August 1, 1996. To mitigate the one-time price increase effect of the customs rate devaluation on the politically sensitive imports, tariff rates were reduced at that time for imports of seven basic food items and medicines. In October 1997, the maximum tariff was further reduced by 5 percentage points to 25 percent, and the tariff rate on inputs for production was lowered from 10 percent and 15 percent to 5 percent. Tariffs for goods prone to smuggling were also reduced on a selective basis.

99. In March 1998, the government began a phased elimination of the remaining import bans maintained for economic reasons, replacing them by the maximum tariff. By the end of 1999, the importation of 14 categories of fruits and vegetables had been liberalized and the remaining import bans were scheduled for removal in 2000.

100. These trade system reforms brought the trade regime in Yemen closer to standard international rules. Consequently, in 1999, the government initiated the process of accession to the World Trade Organization (WTO). Following the granting of observer status to Yemen at the WTO in 1999, the government is working toward full membership.

101. Under the reformed tariff structure, the mean tariff rate was reduced from 27 percent to 12 percent. This—together with the elimination of import bans, licensing, and other nontariff trade barriers—had reduced Yemen’s trade restrictiveness index from 10 (closed or very restrictive) at the time of unification to 2 (open) by the end of 1999,60 The relative ranking of Yemen in terms of trade restrictiveness among the Middle Eastern countries is below:

Table 6.

Middle Eastern and North African Countries: Trade Restrictiveness Rating

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Source: IMF, Trade Policy Information Database.

B. Tax Reforms

After unification, the parliament of Yemen passed three new tax laws to give the country a consolidated new tax structure. Law No. 31/91 regulated the taxation of incomes and profits, Law No. 70/91 introduced a tax on production, consumption, and services (TPCS), and Customs Law No. 14/90 introduced a new tariff structure. All three laws remained virtually unchanged over the period 1990–94, but between 1995 tol999 were amended several times in an initial effort to make some improvements in the tax system. However, more comprehensive reforms are underway to modernize the entire tax code.61

Taxes on income and profits

103. The 1991 law specified an individual income tax with four brackets. Tax rates on wages, salaries, and rental income varied between 3 percent for the lowest bracket and 16 percent in the top bracket (22 percent for nonresidents). Owing to the high levels of inflation, by end- 1994 virtually all taxpayers were in the highest 16 percent bracket and the income tax had become essentially a proportional tax. Businesses were taxed at rates between 28 percent and 36 percent varying for proprietary status, monopolies, and residency status.62 Under the 1991 code, individual taxpayers were taxed differently depending on the source of income, and tax from different sources was not aggregated. Moreover, income taxes suffered from the numerous exemptions contained in the 1991 Investment Law. In 1996, the income tax law was amended and tax rates for corporations were unified at 35 percent. Proprietors continued to pay a flat rate of 28 percent.

104. Further changes to the income tax law were introduced by presidential decree in early 1999. These amendments replaced previous provisions with a progressive rate structure for personal income (including from proprietorship) above YRls 36,000; raised the top tax rate on wages and salaries from 16 percent to 20 percent, included foreign income in the tax base; simplified the depreciation schedule, and clarified the penalty regime.63 The authorities recognize that further adjustments to the income tax code are desirable to achieve a consistent treatment of income from different sources and restrict exemptions, and are therefore working towards a more comprehensive reform. Of particular concern are the integration of corporate and personal taxes to limit tax avoidance, the taxation of income from agricultural sources and rental income as regular income, the simplification of the depreciation schedule, the clarification of international tax rules, the simplification of procedures, and the design of an effective penalty regime.

Taxes on goods and services

105. The 1991 TPCS law consolidated numerous excise taxes. Despite its name, the tax covered originally only about 35 products, including qat, and tax rates varied between 5 percent and 40 percent with twice the rate applied to imported goods. Specific excises were levied on petroleum products and cigarettes. In 1996, the tax base was broadened to about 100 goods and services, and the rate differentiation for domestic and imported goods, was eliminated by presidential decree. The decree also established a limited tax credit mechanism to reduce cascading under the TPCS. Moreover, the specific taxes on petroleum products were converted to an ad valorem tax, mostly at the rate of 2 percent, and specific cigarette taxes were converted to ad valorem taxes at rates of 60 percent for domestic products and 80 percent for imported products.

106. The amendments introduced by decree were later altered by parliament, which reduced the number of goods and services covered by the TPCS in 1997.64 Additional minor changes regarding coverage were introduced by decree in January 1999. These related to the list of exempt goods, the tax base for certain imported goods, and confiscation of cigarettes. The administration of the tax suffers from the multiple rate structure. In addition, it has limited revenue potential owing to a restricted base. The authorities are therefore committed to replace the TPCS with a broad based value-added tax (called General Sales Tax or GST). A tax law providing for a 10 percent broad-based GST with a strictly limited list of exemptions, a credit mechanism, and zero-rating of exports was approved by the government in 1999 and is pending before parliament. The GST would originally apply only to all imports and to domestic sales of the 800–1,000 largest taxpayers, depending on turnover. A few excises on petroleum, tobacco products, and qat would remain in place under the cover of the TPCS.

107. Parliament removed stamp duties on banking and customs transactions in May 1998. Stamp duties were applied to commercial and government transactions and based on the value of transactions. The application of customs and banking stamp duties was complicated and the lost revenue was largely replaced by taxing services and imports.

Tax administration

108. The authorities have taken several steps to improve revenue collection and tax administration. The most important was the introduction of a new taxpayer identification number (TIN). While a TIN system existed before 1997, it suffered from shortcomings due to unnecessary codlings. A new computerized pilot system allowing for online registration of taxpayers in several tax centers was recently introduced and online registration of taxpayers should begin in 2000. The new system will allow for a range of tax reports based on the taxpayer database. Customs clearance of imports now also depends on the presentation of a valid TIN. In addition, the tax administration introduced cigarette bandrolls in 1997 to improve identification of untaxed cigarettes. Moreover, through improvements in manual procedures, efficiency gains have been realized in the tax authority. Jointly with the introduction of a GST, the tax administration plans further reform steps. These include the creation of a large taxpayer unit, which would handle all taxes, including income taxes and withholding taxes, paid by taxpayers above a certain threshold for turnover. Further, the Tax Authority plans to modernize tax administration through self-assessment procedures, targeted auditing, and enhancement of taxpayer services provided by the taxpayer services unit established in 1999.

Customs and customs administration

109. The 1990 customs law contained a complicated rate structure, with 15 rates ranging from 5 percent to 200 percent. Most imports were taxed at the rates between 20 percent and 30 percent. Although the 1990 law already constituted a major simplification over the preunification customs laws, it still gave rise to classification difficulties and disputes. Until the stepwise exchange rate unification in 1995–96, customs revenue was also affected by the application of the highly appreciated customs valuation rate. In 1996, the customs tariffs were simplified to 4 bands entailing rates of 5, 10, 15, and 30 percent, with a further reduction of the top rate to 25 percent in 1997. The customs base also benefited from a stepwise elimination of import bans in 1998 and 1999. Further amendments of the customs law are planned for the future to bring the regulations and valuation procedures in line with WTO specification. Other than customs duties, Yemen also imposed a number of import surcharges such as a health department surcharge on cigarettes, a profits tax, and an earthquake tax. The last two of these surcharges were removed by parliament in December 1998. Customs revenue also suffers from broad exemptions introduced through the Investment Law of 1991. It exempts fixed assets for establishment, expansion, or upgrade of a project licensed by the General Investment Authority from all types of customs duties and taxes. Moreover, it provides for simplified customs procedures as soon as a project license is presented at the border.

110. Customs administration reform focused initially on customs procedures and regulations. Reforms covered the simplification of clearance procedures, and the improvement of the functioning of the Customs Authority. The control of the authority over arrival and exit of imports was strengthened and payment of duties before release of goods was enforced. Further reform steps included the elimination of the deferment of customs duties, the improvement of controls over temporary admissions, and the development of new customs forms. The Customs Authority is now working on introducing the ASYCUDA system with support from UNCTAD at three or four points of entry in 2001.

111. In spite of reform efforts, enforcement of customs regulations remains difficult. The long shoreline and before the recent signing of the Jeddah border treaty, the disputed borderlines led to major difficulties in controlling points of entry. In addition, the security situation was seen as necessitating a strong military presence at the border. To the extent that responsibilities between the military and customs are ill defined and the military has little incentive in prosecuting smugglers, border enforcement has been hampered. The declining share of customs revenue in imports likely reflects increasing smuggling activity and tax evasion.

C. Public Expenditure Reforms

112. High levels of public expenditures were the root cause of unsustainable public deficits from 1990 to 1995. The major elements of high expenditures were subsidies for wheat, wheat flour, and petroleum products, as well as the civil service wage bill. In the second half of the 1990s, the government took several steps to contain expenditures particularly through changes in administered petroleum prices and the removal of subsidies for wheat and wheat flour imports.

Subsidy reform

113. Until 1997, wheat and wheat flour subsidies constituted the government’s primary social safety net and transfer program. Those subsidies were supposed to ensure impoverished families access to basic food items at low prices. However, according to World Bank staff estimates, only one-third of the subsidies reached consumers, the rest was used up by importers, distributors, and by smugglers to neighboring countries. Moreover, the poorest groups of the population benefited very little from subsidies because they spent disproportionately less on wheat and wheat flour than high income groups.

114. Substantial petroleum product subsidies were instituted to support the rural population. Subsidies for petroleum products other than diesel have been substantially cut over time but diesel prices have remained unchanged since 1997, when an YRl 1 increase led to political unrest and widespread violent riots. Diesel fuels rural transportation as well as agricultural machinery, particularly to pump ground water. The diesel subsidy has caused large distortions in the Yemeni economy. Car engines have been changed from gasoline to diesel engines. Diesel fueled pumps have depleted water tables rapidly, mostly to provide water for qat plantations, and richer households as well as many businesses have begun to generate their own power with concomitant losses for the electricity company (PEC). As PEC has been losing its best customers, affecting its ability to cross-subsidize its poorest customers.

115. From 1990 to 1994, subsidies for wheat, wheat flour, and petroleum products were implicit, resulting from the multiple exchange regimes.65 Importers of wheat and wheat flour had access to foreign exchange at the official exchange rate, which at end-1994 was about one-eighth of the parallel rate. Likewise, import of petroleum products and later sales to domestic refineries took place at exchange rates far removed from market rates. With the move to unified exchange rates, those subsidies that had previously been implicit through reducing oil export revenue, have to be recorded explicitly on the expenditure side. This became clear in 1996 when the explicit subsidy bill reached 13 percent of GDP after the exchange rates were unified. In addition to the explicit subsidies, there continued to be implicit subsidies through the application of nonmarket based transfer prices in the domestic oil and petroleum sector. In particular, the Aden refinery charged an additional USS15 per ton of delivered petroleum products (raised to US$17 in 1999), from transport services, but part of this is likely to reflect a production subsidy.

116. Reducing subsidy have played an important role in the fiscal adjustment efforts of the government since 1995 (Box 1). Jointly with its move to unify the exchange rate, the government began to raise domestic petroleum retail prices in March 1995. Gasoline retail prices were raised by 100 percent and the fuel oil price by 74 percent. Despite these increases, domestic wholesale prices (retail prices net of taxes and distribution fees) remained far below world market prices in 1995 (Chart 10). Gasoline prices were closest to world market levels at about 60 percent followed by fuel oil at 30 percent and diesel and kerosene at 15 percent. Further substantial administered price increases of 58 percent (gasoline), 100 percent (diesel), 167 percent (kerosene), and 133 percent (fuel oil) took place over January-March 1996. They brought price levels for gasoline close to world market levels, but left diesel, kerosene, and fuel oil heavily subsidized (Table 7). Prices were raised again in 1997, 1998, and 1999 but the price for diesel remained unchanged since September 1997 (Table 8). Owing to these measures, by 1998 gasoline prices were 80 percent above world market prices and allowed to cross-subsidize diesel and, to a lesser extent, fuel oil and kerosene. However, in 1999 rising oil prices were not matched by equivalent price adjustments and led to the reappearance of a substantial cash subsidy bill (Table 5). In 1999, the government also changed its transfer pricing system to charge world market prices for crude oil in its transactions with the domestic refineries, as explained in Section II.

Chart 10.
Chart 10.

Republic of Yemen: Petroleum Product Wholesale Prices, 1995–2000 1/2/3/

(In percent of world market prices)

Citation: IMF Staff Country Reports 2001, 061; 10.5089/9781451840780.002.A001

Sources: Data provided by the Yemeni authorities; and various oil publicalions.1/Wholesale prices are defined as retail prices net of taxes and distribution fees.2/World prices are Mediterranean ex-refinery prices.3/Data for 2000 is for the first quarter only.
Table 7.

Republic of Yemen: Petroleum Products Prices Compared to World Market Levels (March 2000)

(YRls per liter unless otherwise stated)

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Sources: International Energy Agency, Oil Market Report (March 2000); Ministry of Finance; and staff estimates.

Domestic wholesale price is calculated by deducting from retail prices appropriate taxes and surcharges imposed for each product. International wholesale prices are actual average prices for February 2000, converted to rials at the current period-average exchange rate. (Gasoline prices are regular northwest Europe prices, while the other products are Mediterranean-based prices; fuel oil corresponds to the 3.5 percent sulfur type). The International/Domestic Price Ratio is the ratio of the two wholesale prices. For example, the wholesale price for gasoline in Yemen in February 2000 was 88 percent the level of the international wholesale price.

Table 8.

Republic of Yemen: Adjustments in Administered Retail Prices, 1994–99

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Sources: Ministry of Oil and Mineral Resources; Ministry of Finance; and World Banle

For electricity plants.

For cement plants.

FL stands for full liberalization.