Republic of Yemen
2008 Article IV Consultation: Staff Report; Staff Statement and Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Yemen
Author: International Monetary Fund
Publication Date:
24 Mar 2009
eISBN:
9781451840834
Language:
English
Keywords:
ISCR; CR; WEO oil price baseline; adjustment scenario; debt; deficit; oil; balance of payments; core inflation; monetary policy; medium term; capital expenditure; Currencies
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Recent economic performance in Yemen has been mixed. A sharp decline in oil production, coupled with inflexible government expenditure and only marginal improvement in the tax-to-GDP ratio led to an overall fiscal deficit of 5.8 percent in 2007. Executive Directors have noted that Yemen’s non-oil GDP growth has been solid in recent years, and progress has been made on a number of structural reforms. Directors have welcomed the authorities’ commitment to reduce expenditure in the event that oil prices remain below the benchmark price in the 2009 budget.

Abstract

Recent economic performance in Yemen has been mixed. A sharp decline in oil production, coupled with inflexible government expenditure and only marginal improvement in the tax-to-GDP ratio led to an overall fiscal deficit of 5.8 percent in 2007. Executive Directors have noted that Yemen’s non-oil GDP growth has been solid in recent years, and progress has been made on a number of structural reforms. Directors have welcomed the authorities’ commitment to reduce expenditure in the event that oil prices remain below the benchmark price in the 2009 budget.

I. Introduction

1. Yemen is one of the poorest countries in the Middle East.1 An estimated 35 percent of the population lives below the poverty line. Oil reserves are expected to be depleted in about 10–12 years. Yemen has few other natural resources and is also facing depletion of its groundwater. These challenges are compounded by an expanding population, poor infrastructure, weak institutional capacity, a fragile security situation, and the widespread use of qat—a mild narcotic accounting for over one–third of agricultural production and about a quarter of total water resource use.

2. Economic reforms slowed after the 1990s, and urgently need to be reinvigorated. Although a number of reform initiatives emerged in recent years—including civil service and public financial management (PFM) reforms, a major adjustment to fuel subsidies in 2005, a new general sales tax (GST), an anticorruption drive, and improvements to the social safety net—most have been only partially implemented and with significant delays. Fund advice on preparing for the transition to a non-oil economy has had limited traction, particularly in the context of record world oil prices and increasing political and security constraints. However, recent developments—the sharp decline in oil output in 2007 and the even sharper decline in oil prices in late 2008—are bringing a new sense of urgency to the debate on economic reform.

II. Recent Economic Developments

3. Recent economic performance in Yemen has been mixed. Oil production continues to decline. Non-oil economic activity has grown at a reasonable rate but is likely to have slowed moderately in 2008. Inflation has been a key concern. Pressures related to the global slowdown and the falling price of oil began to materialize in late 2008.

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Yemen: Oil Output, Government’s Share and Exports, and Domestic Consumption, 2000–08

(In million barrels per year)

Citation: IMF Staff Country Reports 2009, 100; 10.5089/9781451840834.002.A001

  • Overall real GDP grew by about 3.3 percent in 2007, reflecting real non-oil growth of 5.3 percent and a 13.1 percent decline in oil output.2 Overall growth should pick up in 2008, with somewhat lower non-oil growth of 4.8 percent compensated for by a smaller decline in oil output.

  • Core inflation (excluding qat) rose to 27 percent by May 2008—reflecting the surge in global commodity prices. Inflation has since declined to about 18 percent in October. Some spillover to nonfood items may have emerged. Inflation excluding qat and food reached a record 18 percent by June—mainly due to the cost of services, clothing, housing, and fuels (Box 1).

  • A sizeable fiscal deficit emerged in 2007, and another is likely for 2008. A sharp decline in oil production, coupled with inflexible government expenditure, led to an overall fiscal deficit of 5.8 percent in 2007. For 2008, a deficit of around 5–6 percent of GDP is possible in the wake of the recent drop in international oil prices, continued rigid expenditures, and limited non-oil revenue improvements.

  • Monetary policy in 2008 focused on exchange rate stability and controlling excess liquidity in the domestic banking system. The rial has remained steady against the U.S. dollar since mid-2007, helping to mitigate imported inflation. In real effective terms, the rial appreciated by 9.5 percent in the 12 months to October. The Central Bank of Yemen (CBY) used its full allowance of Treasury bills to absorb domestic liquidity in the first nine months of the year, and has since relied on central bank certificates of deposit (CDs) and additional foreign exchange auctions. Broad money and reserve money growth through October were 15.5 percent and 10.9 percent, respectively. The benchmark deposit rate remains fixed at 13 percent.

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Yemen: Exchange Rate Developments, 2000–08

Citation: IMF Staff Country Reports 2009, 100; 10.5089/9781451840834.002.A001

Inflation Developments in Yemen and the Policy Response

Inflation developments: Inflation in Yemen has been extremely volatile in the past year. During January-July 2008, 12-month core inflation (i.e., excluding qat) averaged 19 percent. Food prices have been the main impetus, with food inflation averaging 22 percent during the first two quarters of 2008—in line with the most vulnerable net food importing countries in the region. While non-tradables have not generally been a major source of inflation—due at least in part to administered domestic fuel prices—some of the recent push from commodity prices seems to be feeding into other components of the CPI (such as housing and related items). Though the worst of the food crisis appears to be over, recent developments underscored Yemen’s vulnerability to commodity shocks.

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Yemen: Twelve-Month Core Inflation by Component January 2005 to Present

Citation: IMF Staff Country Reports 2009, 100; 10.5089/9781451840834.002.A001

Standard Deviation of Monthly Food Inflation January 2006–June 2008

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Social and macroeconomic impact: The surge in commodity prices is likely to have aggravated poverty, particularly for small farmers and the landless. Increasing poverty and food prices also appear to have contributed to growing social tensions. Record international fuel prices for the first half of 2008 also raised the fuel subsidy bill and added to the 2008 government fiscal deficit.

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Twelve-Month Food Price Inflation January 2006–June 2008

Citation: IMF Staff Country Reports 2009, 100; 10.5089/9781451840834.002.A001

Policy response and external assistance: The government has sought to mitigate the impact of surging prices through direct support to consumers and increasing the supply of commodities. In March 2008, the government increased wages, pensions, and social welfare benefits—at an estimated cost of YRL 60 billion in 2008. The government also intervened in the wheat market through direct sales to the public. International donors have increased their support to Yemen through a mix of loans, grants, and direct food aid. The central bank has meanwhile maintained a prudent monetary policy and suspended the practice of steadily depreciating the rial in favor of exchange rate stability in order to mitigate the extent of imported inflation.

  • The external current account shifted to a deficit of 7 percent of GDP in 2007, compared with an average surplus of about 2.4 percent during 2002–06. This shift reflected mainly FDI-financed imports for a liquefied natural gas (LNG) plant. The external accounts benefited from record oil prices during the first part of 2008, but pressures appear to be emerging in the wake of declining oil prices. The current account is projected to remain in deficit (about 2 percent of GDP) in 2008. CBY foreign exchange reserves look to remain roughly the same as at end-2007.

  • Financial intermediation is deepening but remains shallow compared to the region. Nonperforming loans (NPLs) remain high but have fallen steadily as a share of total loans in recent years. Capital adequacy improved in mid-2008 compared to end-2007. Further improvements in capital adequacy are expected by end-2009, in line with revised minimum capital requirements for banks in Yemen. Dollarization has declined steadily in the past few years.

  • Yemen maintains close cooperation with the donor community, but a substantial portion of the 2006 Consultative Group (CG) pledges have yet to be translated into actual disbursements or commitments.

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Yemen: Asset Side of Broad Money

(12-month change, in percent)

Citation: IMF Staff Country Reports 2009, 100; 10.5089/9781451840834.002.A001

Cross-Country Comparison of Financial Intermediation

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Source: IFS and WEO databases; all data end-2007.

Yemen: Indicators of Banking System Financial Soundness, 2004–08 1/

(In percent; unless otherwise indicated)

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Source: Central Bank of Yemen.

Data refer to all banks, except for the Housing bank and CAC bank. 2006 data included CAC

III. Policy Discussions

4. Discussions focused on (i) risks to the outlook from the global slowdown and the dramatic drop in oil prices; (ii) appropriate fiscal and monetary policies to keep inflation on a downward path and address the recent and prospective deterioration in public finances; and (iii) macroeconomic and structural reforms to ensure fiscal and external sustainability.

A. Outlook and Risks

5. Yemen remains relatively insulated from the financial side of the current world economic crisis (Box 2). Yemeni banks have relatively low exposure to private foreign lending, which centers around trade flows. Portfolio investment is quite limited, given the absence of a domestic stock market or commercial credit market. Yemen’s main foreign asset—the CBY’s reserves—are highly liquid and kept predominantly in the form of deposits in international banks. While Yemen could suffer from a decline in external financing (either through lower remittances, FDI, or official financing flows), these risks have yet to materialize, and would move more slowly than financial contagion.

6. Yemen remains vulnerable to commodity shocks and the effects of slower regional and world economic activity. Although government revenue and the balance of payments benefited from the high price of oil during the first half of 2008, the economy suffered from higher imported food and input prices. With the global slowdown and sharp decline in crude oil and other commodity prices, these risks have essentially reversed. Pressures expected to materialize over the medium term with declining oil production have become near-term considerations. Without substantial expenditure and revenue reforms, the fiscal deficit will become increasingly difficult to finance, and balance of payments pressures will mount (notwithstanding the CBY’s substantial reserve cushion). Slower regional growth is also projected to bring lower levels of non-oil foreign investment than might have been expected (contributing to lower growth), as well as lower inward remittances from expatriate Yemeni workers in the Gulf and elsewhere.

B. Policies for 2008–09: Reducing Inflation, Containing the Deficit

7. The authorities recognized the need to further reduce inflation and address emerging imbalances. Recent data suggest that the worst of the turbulence in international food prices has passed. Price pressures in Yemen should continue to ease with lower world commodity prices (and falling transport costs). Nevertheless, the authorities agreed additional efforts would be necessary to bring twelve-month inflation to 15 percent or less by end-year. The authorities also concurred that the risks to public finances and external sustainability had increased considerably since the end of the oil-price boom and that fiscal and monetary policy would need to be carefully coordinated to meet this challenge.

Impact of the Global Financial Crisis on Yemen

The risk of financial contagion from the global economic turbulence appears low. Yemen is not closely integrated with international financial and capital markets. The small size of the domestic banking system and low level of financial intermediation would also contain the direct impact, even if access to bank credit is restricted. Liquidity risk to the foreign exchange reserves of CBY also appears low, as these assets are mainly in the form of deposits at large commercial banks in Europe. The CBY increased foreign exchange auctions in September to maintain a stable exchange rate and calm market jitters about the availability of foreign exchange, but no additional action has yet been necessary.

Yemen does remain vulnerable to a real shock through lower oil prices. Oil exports account for a large share of government revenue and the bulk of foreign exchange receipts. The fiscal impact could be softened by a corresponding decline in fuel subsides (even with unchanged domestic fuel prices). A further drop in international oil prices would increase pressure on Yemen’s fiscal and external accounts. For each $10/bbl decline, the overall fiscal balance and current account would deteriorate by almost 1 percentage point of GDP. Pressure on the external accounts may be partly alleviated if international commodity prices continue to decline.

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Yemen: Sources of Government Revenue, 2008

(Proj.)

Citation: IMF Staff Country Reports 2009, 100; 10.5089/9781451840834.002.A001

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Yemen: Main Sources of Foreign Exchange, 2008

(Proj.)

Citation: IMF Staff Country Reports 2009, 100; 10.5089/9781451840834.002.A001

Softer growth and financial distress in partner countries may also negatively impact Yemen’s access to external financial resources—namely remittances, foreign direct investment (FDI) and concessional donor financing. While the likelihood or potential magnitude of these secondary effects are difficult to gauge (especially given data limitations in Yemen), stress tests prepared by staff suggest that:

  • A 50 percent decline in non-oil FDI would likely soften growth, and reduce import demand and the current account deficit (each by around 0.5 percent of GDP).

  • A 50 percent fall in remittances could widen the current account deficit by over 0.5 percent of GDP, notwithstanding some import compression, and marginally lower real GDP growth.

  • Fifty percent lower donor disbursements would marginally widen the overall fiscal deficit and, assuming capital spending is maintained to avoid a negative impact on growth, domestic debt would increase by 1.2 percent of GDP.

Absent alternative financing, each of these scenarios could result in a loss of foreign exchange reserves of up to ½ a month of imports. Under a combined loss of non-oil FDI, remittances, and donor financing, the fiscal and current account deficits would deteriorate by 1–1½ percent of GDP, public sector domestic debt would rise by around 2½–3 percent of GDP, and international reserves would drop by one month of imports.

Fiscal policy

8. The authorities indicated that they would seek to compress spending during the remainder of 2008 to reduce upward pressure on prices. They noted that some fuel subsidies were reduced in August, when pressures began to emerge.3 Spending under the supplementary budget was largely constrained to the additional cost of the fuel subsidy, but also covered the ad hoc increase in wages, pensions, and social welfare transfers granted in March. Additional compression of some spending commitments under the original budget may be possible.

9. The authorities concurred that the risks to public finances will be more pronounced in 2009. Based on an oil price of $55 per barrel, the approved government budget implies an overall deficit of about 8.6 percent of GDP—the highest since the oil price shock of 1998. Staff and the authorities agreed that a deficit of this magnitude would be difficult to finance and that additional actions would be necessary to preserve the credibility of public finances. With a view to keeping the overall deficit below 6 percent of GDP (consistent with domestic financing of 4.5 percent of GDP4), the staff offered a fiscal scenario based on a set of adjustment measures and the most recent WEO oil price ($54.25 per barrel). Most significant among the adjustment measures were (i) a reduction in fuel subsidies by mid-year; (ii) a nominal freeze on the public sector wage bill;5 and (iii) overdue actions to boost tax revenues. The staff also urged the authorities to follow up on earlier pledges of donor support, and to seek concessional external financing, where possible.

Monetary and exchange rate policy

10. Given the priority of reducing inflation, the CBY indicated it would continue to focus on exchange rate stability in the short term. In addition to alleviating imported inflation, stability vis-à-vis the U.S. dollar appears to have helped confidence in the rial and lowered dollarization. The mission noted that the monetary stance and focus on exchange rate stability had been broadly appropriate, but that there remained some risk of inflation becoming entrenched. The CBY indicated it would remain vigilant in mopping up excess liquidity in the banking system. Given that it has already exhausted its yearly allowance of Treasury bills, the CBY would continue to issue CDs and conduct further foreign exchange auctions—even at the cost of international reserves. The CBY also indicated that other options, such as increasing the benchmark deposit rate, increasing reserve requirements, or using Islamic financial instruments,6 were also under discussion.

11. While there is no evidence of current misalignment, the rial is probably moderately overvalued from a medium-term perspective. The prospective decline in oil production over the next 10–12 years suggests that the real exchange rate will need to decline over the medium term in order to render the economy more competitive and thereby generate non-oil export growth for Yemen. The current policy of maintaining broad stability for the rial seems appropriate for the short term given the need to keep inflation down. If fiscal consolidation proceeds as envisioned and inflation continues to fall, greater flexibility in the rial should be considered as the economy and the fiscal accounts adjust to lower oil revenue. (Box 3).

C. Macroeconomic Policies for the Medium Term

12. Yemen’s medium-term outlook remains dominated by the expected depletion of oil reserves. The latest information suggests that total recoverable oil (proven reserves plus a portion of probable and possible reserves) is about 1.1 billion barrels. Assuming oil production declines gradually (an average annual drop of about 5 percent per year), oil reserves will be exhausted by 2021. Starting in 2009, LNG production will help alleviate the impact on government revenue and exports, but will not make up for the loss of crude oil.

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Yemen: Medium-Term Projections for Total Hydrocarbon Output by Crude Oil and LNG, 2008–21

(million barrels per year)

Citation: IMF Staff Country Reports 2009, 100; 10.5089/9781451840834.002.A001

13. There was broad consensus among government agencies that current policies are not sustainable. The staff presented a scenario of unchanged macroeconomic policies to highlight the risks of inaction. Under this scenario, external financing and non-oil growth would be lower. The fiscal deficit would expand quickly to 15 percent of GDP by 2012; reserve cover would decline as the external current account deficit widened—raising the risk of a sharp adjustment in the exchange rate. Assuming that domestic and external financing gaps could be filled (which is doubtful given the limited appetite for domestic debt, Yemen’s lack of access to international capital markets, and tighter conditions for official financing), public debt would rise from 38 percent of GDP in 2008 to over 65 percent in the medium term.

14. The authorities acknowledged the need for a comprehensive adjustment to fiscal policy to ensure medium-term stability. They agreed that the centerpiece of this adjustment lies in addressing the two largest components of current expenditure—the fuel subsidy and the public sector wage bill, which together account for about 50 percent of total spending. Staff prepared an adjustment scenario (Tables 1-6) to illustrate the extent and magnitude of actions necessary to maintain macroeconomic stability and prevent debt distress. The exercise was guided by a debt sustainability analysis (DSA) geared around keeping the public debt-to-GDP ratio below 50 percent over the medium and long term.

Table 1.

Republic of Yemen: Selected Economic Indicators, 2005–13

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Sources: Yemeni authorities; and Fund staff estimates and projections.

The core CPI is defined as the CPI excluding qat.

Includes statistical discrepancy.

In percent of non-hydrocarbon GDP; includes statistical discrepancy.

The price of Yemeni oil differs from the WEO price because it sometimes trades at a discount.

Gross reserves minus commercial bank and pension fund foreign exchange deposits held with the Central Bank of Yemen.

Table 2.

Republic of Yemen: General Government Finances, 2005–13

(In billions of Yemeni rials)

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Sources: Ministry of Finance; Ministry of Planning; and Fund staff estimates.

The 2009 budget estimates are based on the Yemeni authorities’ oil price (US$55/barrel) and volume assumptions.

The 2009 budgeted wage bill is based on the original 2008 budget figure. Staff estimates also include a one-month Ramadan bonus and account for the wage increases announced in March 2008.

Based on overall (cash) balance and statistical discrepancy, with relevant exclusions.

Consists of education, health, social assistance, and social welfare fund transfers; covers central and local government units.

Refers to central and local governments.

Table 3.

Republic of Yemen: General Government Finances, 2005–13

(In percent of GDP)

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Sources: Ministry of Finance; Ministry of Planning; and Fund staff estimates.

The 2009 budget estimates are based on the Yemeni authorities’ oil price (US$55/barrel) and volume assumptions.

The 2009 budgeted wage bill is based on the original 2008 budget figure. Staff estimates also include a one-month Ramadan bonus and account for the wage increases announced in March 2008.

Based on overall (cash) balance and statistical discrepancy, with relevant exclusions.

Consists of education, health, social assistance, and social welfare fund transfers; covers central and local government units.

Refers to central and local governments.

Table 4.

Republic of Yemen: Monetary Survey, 2005–09

(In millions of Yemeni rials)

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Sources: Central Bank of Yemen and Fund staff estimates.

The increase in credit to public enterprises reflects primarily a new revolving credit line to finance the importation of refined fuel products.

Gross reserves minus commercial bank and pension fund foreign exchange deposits held with the Central Bank.

Table 5.

Republic of Yemen: Balance of Payments, 2005–13

(In millions of U.S. dollars)

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

Hydrocarbon sector includes oil and LNG exports less corresonding imports, expenses and repatriation.

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 and pension fund reserves.

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

Public external debt, including central bank foreign liabilities. There is limited information on private external debt, which is deemed to be modest.

Table 6.

Republic of Yemen: Millennium Development Goals, 1990–06

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Sources: World Bank; and Yemeni authorities.