Background

2. A series of wide-ranging macroeconomic and structural reforms undertaken over the past decade helped engender an economic transformation in Yemen. Chief among these are the unification of the exchange rate, fiscal reforms, trade liberalization, privatization of public sector enterprises, and financial sector reforms. The Fund has played a critical role in assisting and promoting this process, which helped the country achieve steady progress. These deep structural reforms have been pursued alongside efforts to democratize the political process. Admittedly, tensions could sometimes arise between the desirability of an ambitious pace of economic reforms and the need to ensure their broader acceptance in the context of high levels of poverty and unemployment. From this perspective, the introduction of the General Sales Tax (GST) in 2007, as well as important structural reforms undertaken in various areas are notable accomplishments since last year’s consultation.

3. Notwithstanding these accomplishments, the authorities are intent on deepening the economic transformation in order to address the challenges emanating from the prospective depletion of oil reserves and the weaknesses in human and physical capital. In view of the significant development needs, intensified donor support will be critical in sustaining the authorities’ efforts to tackle problems of widespread poverty and limited institutional and implementation capacities. In this respect, the Consultative Group (CG) meeting in November 2006 in London was an important milestone, with pledges of about $5 billion financing about 85 percent of the government’s Public Investment Program for 2007-2010.

Recent Developments

4. Economic performance in 2006 continued to be broadly positive. Real GDP growth is estimated at 4 percent, with growth in the non-hydrocarbon sector more than offsetting a sizable contraction in oil production. Notwithstanding the latter, buoyant oil prices helped keep the overall budget broadly in balance, although the non-oil primary deficit registered a limited increase. Moreover, the external current account continued to register a modest surplus, and the surplus in the overall balance of payments contributed to a further increase in foreign exchange reserves, which reached almost $6.8 billion at end-2006, covering about 11 months of imports. Both gross public debt and public external debt continued on a downward trajectory, declining to 40 percent and 27 percent of GDP, respectively. Nonetheless, average core inflation accelerated to 20 percent, in part reflecting higher world food prices, as well as domestic demand-induced pressures owing to higher government spending out of larger than projected oil revenues. Given pressing spending needs, additional oil revenues have been channeled essentially toward greater development expenditures, in addition to fuel subsidies to shield vulnerable groups from higher oil prices. With the abatement of seasonal pressures on inflation, due to a sharp drop in prices of basic food commodities and below-budget government spending, core inflation declined steeply to 12 percent in May 2007.

Prospects and Policies

5. The recent positive performance has not detracted the authorities’ attention from the challenges in the period ahead. While the near-term outlook is broadly manageable, the authorities are aware of the need for tightened financial policies to bring core inflation down within the range of 12-14 percent by end-2007. Given the heavy weight of food components in the consumer price index, and the onset of food stocking for the religious month of Ramadan, the current juncture of persistent strength of world food prices would not realistically allow for an inflation rate below 10 percent in the period immediately ahead, as suggested by staff.

6. The authorities are also cognizant of the challenges posed by the prospective depletion of proven oil reserves over the medium and longer term. The coming on-stream of liquefied natural gas (LNG) production will partly mitigate the negative drag on growth from declining oil output, and the implications for the fiscal and external accounts will only be modest. The outlook on oil production, however, could surprise on the upside, given the intensification of exploration and recovery efforts. Nevertheless, the authorities are committed to maintain fiscal and external sustainability by formulating fiscal policy within conservative estimates of proven reserves. Sustainability considerations, however, would need to be carefully balanced against the imperative of sustaining a minimum level of economic growth to facilitate diversification and support labor absorption and poverty reduction. Achieving these objectives could call for maintaining relatively high spending levels, at least over the medium term. Policy makers are thus confronted with competing pressures on government resources that require a delicate balancing act in the policy mix.

Fiscal Policy and Reforms

7. The 2007 budget initially envisaged an increase in the overall deficit to 6 percent of GDP, reflecting the persistence of spending pressures against a background of a sharp decline in oil revenues. Nonetheless, given inflationary pressures, the authorities have effected some degree of fiscal tightening from the initial plans. In this respect, implementation of the announced wage increase has been delayed until mid-2008 to coincide with the introduction of biometric cards. Additionally, non-wage current spending will be streamlined, while development spending financed by CG pledges will help offload some capital expenditure from the budget. Together these measures are expected to result in a reduction in the overall budget deficit by about 2 percent of GDP from the initial estimates.

8. The authorities share the view that a sizable consolidation effort is needed to ensure fiscal and debt sustainability over the medium and longer term as oil revenues taper off. They are in broad agreement with the balance of measures proposed by staff that emphasize increasing non-oil revenue intake and trimming government expenditures. On the revenue side, the GST has been successfully introduced in January 2007, with only limited exemptions, at the rate of 5 percent. The authorities remain committed to full implementation of the GST at 10 percent by 2009 as proposed by staff. However, they are of the view that it is important to ensure that the tax is effectively implemented and administered before proceeding with a rate increase. Moreover, a large tax payer unit has been established. Further efforts are contemplated to expand the revenue base, including the reduction of the corporate income tax rate from 35 percent to 20 percent to harmonize it with regional levels, and the elimination of exemptions in the income, customs, and investment laws.

9. On the expenditure side, the authorities are cognizant of the need to phase out fuel subsidies, although progress in this area is affected by political considerations. Fuel price increased in July 2005 had led to social unrest and considerable loss of life. Nonetheless, the authorities are committed to link the elimination of fuel subsidies with progress on measures to protect vulnerable groups from its adverse effects. In this vein, a revised social assistance law will be submitted to parliament before end-2007, as part of ongoing efforts to strengthen the targeting and coverage of the Social Welfare Fund, and to broaden the subsidy reduction and render it more politically acceptable.

10. Importantly, the authorities have taken decisive measures to address weaknesses in budget formulation and execution by embarking on a comprehensive two-year public financial management reform program, with the assistance of a group of donors. In this respect, a Medium-Term Expenditure Framework will be introduced, starting with the 2008 budget. Moreover, discussions are ongoing with a FAD technical assistance mission regarding the establishment of a single treasury account at the Ministry of Finance, which should further enhance control over spending.

11. The authorities appreciate the staff’s debt sustainability analysis (DSA), which incorporates the updated information on LNG revenues and export receipts, and accounts for new disbursements pledged during the 2006 CG meeting. The DSA underscores the fragility of debt dynamics in Yemen. Even under the assumption of full implementation of the adjustment scenario proposed by staff, highly concessional financing would still be required to avert debt distress over the projection period. In this connection, and while pledges from the GCC countries, accounting for half of total pledges at the CG, are predominantly in grant form, the authorities are hopeful that disbursement of remaining pledges would be mindful of the need for a high degree of concessionality.

Monetary and Financial Sector Policies

12. The Central Bank of Yemen (CBY) remains committed to the maintenance of price stability. However, the attempts at effecting a steady depreciation of the Yemeni rial, consistent with the gradual depletion of oil reserves, have resulted in an accommodative monetary stance in 2006. To help alleviate emerging inflationary pressures in 2007, the authorities have agreed to tighten monetary policy. In this respect, and consistent with staff’s advice, they have slowed the rate of depreciation of the rial and even allowed for a modest appreciation. Nevertheless, the authorities are mindful that reserve accumulation and competitiveness considerations would prevail once inflationary pressures subside, with the exchange rate resuming a market-determined path.

13. The CBY is aware of the limitations of the present monetary framework that aims at controlling inflation through the targeting of monetary aggregates. Given the shallow financial intermediation and relatively high deposit dollarization, there is limited scope for a more active interest rate policy as an effective instrument to control inflation. The authorities recognize that deepening financial intermediation and removing structural impediments to private sector credit growth are essential to promote non-oil sector activities. To help identify vulnerabilities and develop an agenda for reforms, they have expressed interest in a Financial Sector Stability Update. In addition, a revised Anti Money Laundering law, prepared partly under the assistance of the Fund, is to be submitted to parliament for approval.

Other Structural Reforms

14. With oil production on a declining trend, the Yemeni government has stepped up efforts to diversify the economy and promote alternative sources of growth and employment generation. While the gas sector is of major strategic importance for Yemen, there is concurrent focus on strategies to promote the development of the country’s tourism and maritime activities, to capitalize on the coastal location and cultural heritage. The authorities are aware that significant levels of investment are required for the effective development of these sectors. To this end, a number of initiatives have been undertaken to strengthen the investment climate. In particular, tax and administration reforms which resulted in the elimination of production taxes on businesses have earned Yemen the title of top reformer in 2005/06 according to the 2007 Doing Business Report. Moreover, and to further strengthen transparency in the oil sector, the authorities intend to join the Extractive Industries Transparency Initiative. Efforts will also be directed at strengthening the economy’s regional linkages, particularly with the GCC countries, and global integration, through ongoing discussions on accession to the World Trade Organization.