IMF Executive Board Concludes 2009 Article IV Consultation with Yemen

On January 8, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Yemen.

Background

Yemen is one of the poorest countries in the region, and progress toward meeting the Millennium Development Goals has been slow. Crude oil output—the mainstay of government revenue and exports—has been in decline since 2000. Barring major new discoveries, exploitable oil reserves could be exhausted in a relatively short period. A new liquefied natural gas (LNG) facility that began production in late 2009 will provide some cushion for dwindling oil, and recent discoveries of natural gas may prolong the life of the hydrocarbon sector as a whole. Nevertheless, the magnitude of adjustment required by continued declines in oil output is substantial, even over the medium term. Generating strong and sustainable nonhydrocarbon growth, ensuring fiscal and external sustainability, and meeting Yemen’s pressing social and development needs will be key challenges.

Recent economic performance in Yemen has raised some concerns. While direct financial contagion from the global crisis has been limited, Yemen has suffered from a range of indirect effects. The slowdown in world growth appears to have contributed to a slowdown in some areas of economic activity. Non hydrocarbon economic growth in Yemen appears to have weakened, from 4.8 percent in 2008 to an estimated 4.1 percent in 2009—reflecting slower activity in such areas as agriculture (possibly linked to Yemen’s growing water shortages), construction, manufacturing, and real estate. Inflation has hit record lows, due largely to the sharp decline in international food prices.

The heaviest impact from the global recession has come through lower oil prices. Lower production, combined with the sharp drop in average prices and lower government share of output between 2008 and 2009 has resulted in a significant decline in government oil exports. The loss of oil revenue has put pressure on the government fiscal balance. The authorities have sought to mitigate the impact through containment of the civil service wage bill and a cabinet decree to slash non-essential current expenditures, but overall the adjustment effort has not kept pace with declining oil receipts. Non-hydrocarbon revenues, meanwhile, have been stagnant. Full implementation of the General Sales Tax (GST), expected in 2009, did not materialize. The overall deficit is projected to reach 8–9 percent of GDP in 2009.

The main focus of monetary policy shifted from containing inflation to providing liquidity. With single digit inflation, declining private sector credit, and a rapidly expanding fiscal deficit, monetary policy by the Central Bank of Yemen (CBY) has been largely accommodative. In addition to reinjecting sizeable liquidity into the banking system through a repurchase of central bank CDs, the CBY also made the first adjustment to the benchmark deposit rate in nearly ten years—lowering the rate from 13 percent to 10 percent during January–May. The impact on broad money growth has been muted given the decrease in net foreign assets. However, the surge in credit to government may have contributed to lower private sector credit growth—which turned negative by mid-2009.

Pressure on the balance of payments was also visible. From September 2008 to September 2009, usable foreign exchange reserves of the Central Bank of Yemen (CBY) declined by $1.6 billion, or roughly one-fifth of the initial reserve cushion (excluding allocations of Special Drawing Rights (SDRs) in August and September), but remain comfortable at $6.6 billion or about 9 months of imports. The sharp decline in oil exports was the driving force. However, strong import demand (especially for food and fuel, which together account for 60 percent of total imports) and an apparent slowdown in foreign direct investment and inward remittances also played a role. Pressure may have eased in the last quarter of the year as oil prices rose, but the current account deficit is projected to widen from 4 percent of GDP in 2008 to about 6 percent in 2009.

Financial sector soundness indicators continue to improve. While nonperforming loans remain high, they are declining. Capital ratios are also on the rise, in line with a legal requirement to increase capital by end-2009. However, dollarization (measured as foreign exchange deposits as a share of total deposits) appears to be rising after several years of steady decline.

Given the many challenges ahead, the authorities signaled interest in Fund support—possibly under the Extended Credit Facility (ECF)—to support the design and monitoring of a Yemeni strategy to reduce macroeconomic and structural imbalances. It was agreed that program discussions could move forward early in 2010.

Executive Board Assessment

Executive Directors noted that although the global financial crisis had limited impact on economic growth and the financial sector, risks to macroeconomic stability have increased. Lower oil prices and production, coupled with weaker foreign direct investment and remittances, have put pressure on the fiscal and external accounts. These pressures are likely to continue as oil reserves dwindle. At the same time, the political and security situation has deteriorated. The immediate challenge is to restore fiscal sustainability while supporting growth and reducing poverty. Directors stressed the need for prudent macroeconomic policies and sustained structural reforms. Yemen’s medium-term prospects hinge critically on progress in enhancing competitiveness, creating an attractive investment regime and promoting non-hydrocarbon growth.

Directors underscored the urgency of reducing the fiscal deficit in 2010, while protecting social and development spending. They welcomed measures to curtail non-priority public expenditures and restrain wage increases. Given the sizable increase in domestic debt to finance the 2009 budget deficit, including use of central bank financing, Directors encouraged ambitious fiscal consolidation, focusing on aligning expenditures with revenues, reducing structural rigidities in expenditures and boosting non-oil revenue. Key priorities in this regard include full implementation of the General Sales Tax and reducing fuel subsidies. At the same time, Directors stressed the need for larger and better-targeted direct transfers to protect the poor. Continued efforts to reform the income tax regime, eliminate exemptions and strengthen public financial management are also crucial. Directors looked forward to early and full implementation of the Automated Financial Management Information System.

Directors viewed the stance of monetary policy as broadly appropriate and endorsed the decision to lower the benchmark deposit rate. They broadly considered that gradual further rate cuts could be explored with a view to eventually liberalizing Yemen’s interest rate regime, while being mindful of such key indicators as the international reserve position.

Directors emphasized the role of exchange rate flexibility, together with fiscal consolidation, in facilitating adjustment of the external accounts and protecting the reserve position. Allowing the exchange rate to adjust over time, in line with fundamentals, would help facilitate transition to a post-oil economy.

Directors welcomed the continued improvement in financial sector indicators. They supported the plans to issue Islamic financial instruments. Directors commended the authorities for the recent ratification of new legislation pertaining to Anti-Money Laundering and Combating the Financing of Terrorism and encouraged them to take more concrete actions in this area. As regards structural reforms, Directors recommended further progress in reforming property rights, contract enforcement, and the judicial system for creating an environment in which banks would be willing to expand private sector credit.

Given the significant challenges ahead, Directors welcomed the authorities’ interest in closer engagement with the Fund. They noted that any Fund-supported program would require strong government ownership, robust structural reforms, and a sustainable macroeconomic framework. Directors pointed out that along with financial support from the Fund, adequate donor support will also be critical. Close cooperation with the World Bank and other multilateral institutions is also encouraged.

Directors noted the importance of improving governance, enhancing implementation capacity, and making use of Fund’s technical assistance, including in the area of statistical data.