Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 55649-YE

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR A PROPOSED GRANT

IN THE AMOUNT OF SDR 45.0 MILLION (US$70 MILLION EQUIVALENT)

TO THE

REPUBLIC OF YEMEN

FOR A

PRIVATE SECTOR GROWTH AND SOCIAL PROTECTION

DEVELOPMENT POLICY GRANT

November 12, 2010

Social and Economic Development Department Middle East and North Africa Region This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made publicly available in accordance with the Bank’s Policy on Access to Information.

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CURRENCY AND EQUIVALENTS (Exchange Rate as of Septemberr 30th, 2010)

Currency Unit = Yemen Riyal (YR) US$1 = YR 215 SDR1 = US$1.55619

FISCAL YEAR January 1 – December 31

ABBREVIATION AND ACRONYMS

AAA AFMIS

Analytic and Advisory ActivitiesAutomated Financial Management System

BSA Board of Supreme Audit CAS CBY

Country Assistance StrategyCentral Bank of Yemen

COCA Central Organization for Control and Auditing

COFOG CPIA

Classification of the Functions of Government Country Policy and Institutional Assessment

DPG Development Policy Grant DPPR ECF

Socio-Economic Developemnt Plan for Poverty Reduction Extended Credit Facility

GALSUP GDP

General Authority for Land, Survey and Urban Planning Gross Domestic Product

GFS Government Finance StatisticsGIA GoY

General Investment AuthorityGovernment of Yemen

HATC High Authority for Tender Control

HTB

Independent Evaluation GroupHigh Tender Board

IFC International Finance CorporationIMF International Monetary FundLIW Labor Intensive Work ProgramMENA Middle East and North AfricaMDGs MFI MOF

Millennium Development Goals Microfinance Institution Ministry of Finance

MOITMOLSA

Ministry of Industry and Trade Ministry of Labor and Social Affairs

MOPIC MTEF

Ministry of Planning and International Cooperation Medium Term Expenditure Framework,

NPV Net Present Value OP Operational Policy PEFA Public Expenditure and Financial

Accountability PFM Public Financial ManagementPRS Poverty Reduction StrategyPSDPWP SAI SEZs

Private Sector DevelopmentPublic Works Projects Supreme Audit Institution Special Economic Zones

SFD Social Fund for DevelopmentSME Small and Medium EnterprisesSOE State-Owned EnterprisesSPS Social Protection StrategySP Social Protection SSN Social Safety Net SWFTA

Social Welfare Fund Technical Assistance

UNHCR United Nations High Commissioner for Refugees

USAID YNLG YR

United States Agency for International Development Yemen Liguified Gas Group Yemen Riyal

Vice President: Country Director:

Sector Director: Sector Manager:

Task Team Leader:

Shamshad Akhtar A. David Craig Ritva Reinikka Bernard Funck Wilfried Engelke

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TABLE OF CONTENTS

ACKNOWLEDGMENTS ............................................................................................................................................ V 

I.  INTRODUCTION.............................................................................................................................................. 1 

II.  COUNTRY CONTEXT ...................................................................................................................................... 3 

A.  RECENT ECONOMIC AND POLITICAL DEVELOPMENTS ......................................................................... 3 B.  MACROECONOMIC OUTLOOK .............................................................................................................. 4 C.  EXTERNAL FINANCING NEEDS AND DEBT SUSTAINABILITY ................................................................ 9 D.  POVERTY AND SOCIAL DEVELOPMENT .............................................................................................. 10 

III.  THE GOVERNMENT’S REFORM PROGRAM ................................................................................................. 14 

A.  ACHIEVING FISCAL SUSTAINABILITY ................................................................................................. 15 B.  ENHANCING THE PRIVATE SECTOR FRAMEWORK .............................................................................. 18 C.  ENHANCING FINANCIAL INTERMEDIATION AND IMPROVING ACCESS TO FINANCE ............................ 20 D.  IMPROVING PUBLIC FINANCIAL MANAGEMENT ................................................................................. 22 E.  IMPROVING EQUITY AND EFFICIENCY OF THE SOCIAL PROTECTION SYSTEM .................................... 24 

IV.  BANK SUPPORT TO THE GOVERNMENT PROGRAM .................................................................................... 26 

A.  OBJECTIVES AND RATIONALE ............................................................................................................ 26 B.  LINK TO THE COUNTRY ASSISTANCE STRATEGY (CAS) .................................................................... 27 C.  COLLABORATION WITH THE IMF AND OTHER DONORS ..................................................................... 28 D.  RELATIONSHIP TO OTHER WORLD BANK GROUP OPERATIONS ......................................................... 29 E.  ANALYTICAL UNDERPINNINGS .......................................................................................................... 30 F.  LESSONS LEARNED ............................................................................................................................ 31 

V.  THE PROPOSED PRIVATE SECTOR GROWTH AND SOCIAL PROTECTION DEVELOPMENT POLICY GRANT34 

A.  OPERATION DESCRIPTION .................................................................................................................. 34 B.  POLICY AREAS ................................................................................................................................... 36 

B.1. Private Sector Growth and Employment ................................................................................. 36 B.2. Enhancing Financial Intermediation and Improving Access to Finance ................................. 37 B.3. Public Financial Management and Governance ..................................................................... 38 B.4. Improving the Efficiency and Equity of the Social protection system ...................................... 39 

C  PROGRAM FEATURES ......................................................................................................................... 40 VI.  OPERATION IMPLEMENTATION .................................................................................................................. 41 

A.  POVERTY AND SOCIAL IMPACT .......................................................................................................... 41 B.  CONSULTATIONS................................................................................................................................ 42 C.  ENVIRONMENTAL ASPECTS ............................................................................................................... 44 D.  IMPLEMENTATION, MONITORING AND EVALUATION ......................................................................... 44 E.  FIDUCIARY ASPECTS .......................................................................................................................... 45 F.  DISBURSEMENTS AND AUDITING ....................................................................................................... 48 G.  VALUE-ADDED AND BENEFITS .......................................................................................................... 49 H.  RISKS AND RISK MITIGATION ............................................................................................................ 49 

ANNEX 1. LETTER OF DEVELOPMENT POLICY ................................................................................................... 52 

ANNEX 2. POLICY MATRIX .................................................................................................................................. 62 

ANNEX 3. POVERTY AND SOCIAL IMPACT ANALYSIS OF THE OIL PRICE SUBSIDY REDUCTION IN YEMEN ..... 67 

ANNEX 4. FUND RELATIONS NOTE ...................................................................................................................... 70 

ANNEX 5. DEBT SUSTAINABILITY ANALYSIS ...................................................................................................... 73 

CONCLUSION ........................................................................................................................................................ 78 

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FIGURES FIGURE 1: SHORT AND MEDIUM TERM ASPECTS OF THE PRIVATE SECTOR GROWTH AND SOCIAL PROTECTION DPG . 27 FIGURE 2: LINK TO THE CAS ........................................................................................................................................ 28 FIGURE 3: FLOW OF FUNDS .......................................................................................................................................... 48  TABLES TABLE 1: YEMEN: KEY MACROECONOMIC INDICATORS ................................................................................................ 8 TABLE 2: YEMEN SUMMARY TABLE OF EXTERNAL FINANCING NEEDS ....................................................................... 10 TABLE 3: PETROLEUM PRICE INCREASES AND THE REDUCTION IN ENERGY SUBSIDIES ................................................ 17 TABLE 4: PUBLIC VS. PRIVATE INVESTMENT IN YEMEN (CENTRAL STATISTICAL OFFICE) ........................................... 20 TABLE 5: YEMEN’S NET OF SOCIAL PROTECTION INSTITUTIONS .................................................................................. 24 TABLE 6: SOCIAL WELFARE FUND CASELOAD ............................................................................................................. 25  BOXES BOX 1: PETROLEUM SECTOR OVERVIEW AND PETROLEUM REVENUES .......................................................................... 6 BOX 2: POVERTY IMPACT ANALYSIS OF THE REDUCTION OF ENERGY SUBSIDIES ........................................................ 13 BOX 3: INVESTMENT CLIMATE IN YEMEN: CHALLENGES AND PROGRESS .................................................................... 19 BOX 4: REFORM IN PUBLIC FINANCIAL MANAGEMENT IN YEMEN SINCE 1995 ............................................................. 23 BOX 5: INSTITUTIONAL REFORM DEVELOPMENT POLICY GRANT: PROGRESS, CHALLENGES AND LESSONS LEARNED32 BOX 6: PRIOR ACTIONS FOR DPG ................................................................................................................................ 35 BOX 7: GOOD PRACTICE PRINCIPLES FOR CONDITIONALITY ........................................................................................ 41 

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ACKNOWLEDGMENTS

This DPG was prepared by an IDA team led by Wilfried Engelke (MNSED); and comprised Trina S. Haque (MNSHH); Afrah A. Al-Ahmadi (MNSSP); Sabine Beddies (MNSSO); Sibel Kulaksiz (MNSPR); Andrew Stone (MNSFP); Arun Arya (MNSPS); Danielle Malek (LEGEM); Moad M. Alrubaidi (MNAFM); Steve Wan Yan Lun (MNSED); Amir M. Althibah (MNCYE); and Luis Alvaro Sanchez (Consultants). Linda van Gelder (EASPR); Gaiv M. Tata (CFIFP); and Clemens Breisinger (International Food Policy Research Institute, IFPRI) were the peer reviewers for this operation. Bernard Funck (Sector Manager); Simon Bell (Sector Manager); Guenter Heidenhof (MNSED); Roberta V. Gatti (MNSHD); Ritva Reinikka (Sector Director); Benson Ateng (Counrty Manager); and A. David Craig (Country Director) provided constant guidance and internal oversight. Excellent administrative support was provided by Naseema Salem Saeed (MNCYE); and Inosha P. Wickramasekera (MNSED). The team wishes also to express its special appreciation to the IMF team comprised by Messrs. Al-Atrash (Head), Tigran Poghosyan, and Ms. Dragana Ostojic (all MCD), for a constructive cooperation and numerous useful policy discussions. The team is grateful for the close and productive cooperation of the Government of Yemen during Grant preparation, with particular reference to H.E., Mr. Abdulkarim Ismail Al-Arhabi, Deputy Prime Minister for Economic Affairs, H.E.Mr. Noaman Taher Al-Suhaibi, Minister of Finance; H.E. Mohammed Awadh bin Hamam. Governor of the Central Bank of Yemen, Dr. Mutahar. Al-Abassi, Deputy Minister for Development Plans (MoPIC); Eng. Abdulla H. Al-Shatter, Deputy Minister for Project Programming (MoPIC), Dr Mohamed Ahmed Al-Hawri, Deputy Minister for Economic Studies (MoPIC); Dr. Fadhl Abdulkareim Al-Shoaiby, Deputy Minister for the Budget Ministry of Finance (MoF); Ali M. Al-Shatter, Deputy Minister for Planning and Statistics (MoF); Jalal Omar Yaqoub, Deputy Minister for Foreign Financial Relations, Ali Gubran Mohammed Al-Shamahi Director-General of the Budget (MoF); Ghalib bin Taleb Legal Counsel, (MoF)., Nabil M. Al-Montaser, Sub-Governor at the Central Bank of Yemen for Banking Supervision, Mansour Al-Fayadhi, Executive Director of the Social Welfare Fund; and Abdulkarim A. Salah, Director General of Policies at the Social Welfare Fund. .

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GRANT AND PROGRAM SUMMARY REPUBLIC OF YEMEN PRIVATE SECTOR GROWTH AND SOCIAL PROTECTION DEVELOPMENT POLICY GRANT

Recipient

Republic of Yemen

Implementing Agency

Ministry of Planning and International Cooperation

Financing Data

IDA Grant Amount: SDR 45 million (US$70 million equivalent).

Operation Type

The proposed Grant would be disbursed in a single tranche upon effectiveness of the Financing Agreement

Main Policy Areas

This Development Policy Grant will provide support for: (i) private sector employment and growth, (ii) financial sector development, (iii) strengthening budget management and prioritization; and (iv) improving the efficiency of the social protection system.

Key Outcome Indicators (by Decemberr 2011)

This DPG reflects some of the key achievements of Yemen’s reform agenda as of September 2010. The prior actions under this DPG are expected to generate the following outcomes by the time this grant closes:

I. Private Sector Growth and Employment

Streamlining of investment incentives: The investment incentive system has been rationalized and is rule or law based. The General Investment Authority has been transformed into an investment promotion Authority providing investor facilitation services, investor services and advocacy;

Simplification of business entry procedures, including the launch of a one-stop shop for business entry procedures, registration and building permitting, has been introduced in the governorates of Aden, Taiz, Al-Hodeidah, Hadhramout and Ibb. The improved business climate in the governorates of Aden, Taiz, and, Al-Hodeida has led to an increased registration of companies.

II. Enhancing Financial Intermediation and Improving Access to Finance

Effective launch of a credit registry: The credit registry is fully operational, and contributes effectively to the risk management of the Banks in Yemen;

Completion of the framework for micro finance: The microfinance segment has grown fast in 2011 and access to credit as well as to saving services could be widened. Microfinance has become a financial service segment of broad interest for financial service companies.

III. Public Financial Management and Governance

Introduction of a Medium Term Expenditure Framework (MTEF): The country continues to improve its planning framework for allocation of public resources and for strengthening the link between resources and development policies;

Introduction of expenditure Commitment Control Systems (CCS): The Commitment Control System is operational, and potential arrears are captured, recorded and monitored in pilot ministries (Public Works, Education, Health and Finance);

Automation of the government financial accounts (AFMIS): Transparent and timely reporting of budget outcomes has been enhanced.

IV. Efficiency and Equity of the Social Protection System

Establishment of a Targeting Method to operationalize the Law on Social

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Welfare of 2008 (Law No. 39): The SWF has improved its service efficiency and contributes to the effectiveness of the social safety net in Yemen;

Approval of the by-laws to the Social Welfare Law, No. 39, of 2009: The SWF is effectively applying and administering the testing and eligibility criteria for SWF support.

Program Development Objective(s) and Contribution to CAS

The main objective of the proposed Development Policy Grant is to foster private sector growth in the non-hydrocarbon part of the economy, to improve key aspects of the public financial management system, and to mitigate the impact of the ongoing fuel subsidy reduction on the poor by creating a more inclusive and more equitable cash transfer system.

This DPG is fully consistent with the Country Assistance Strategy (CAS) FY10-13 presented to the Board of Executive Directors in May 2009, and will help implement and achieve CAS objectives. The four DPG pillars are linked as follows to the CAS themes: (i) creating conditions for private sector growth and diversification is clearly supporting the first CAS theme; (ii) improving budget management is a key part of the second theme; and (iii) strengthening the social safety net is helping implement the third CAS theme. In all three areas of the CAS themes the DPG contributes also to ongoing Bank-supported investment and technical assistance operations being implemented in Yemen as well as past, current or planned AAA work.

Risks and Risk Mitigation

The Program faces significant risks, which include: Political and economic performance risks. The ability of the Bank Group to engage with Yemen would be affected by a reversal of recently negotiated truce and on-going dialogue with rebels in the north, and a widening of political unrest in parts of southern governorates as well as a widening of the activities of Al-Qaeda in Arabian Peninsula (AQAP). A deteriorating political environment in Yemen would affect the Bank’s ability to implement its assistance program. The DPG could also be affected by risks related to the Government’s commitment to an ambitious reform program in an electoral year. Given these political uncertainties, the operation has been designed as a single tranche DPG, as a first comprehensive step towards supporting the government’s reform program. A mitigating factor is also that this DPG supports a reform agenda that has been adopted by the current Government, and is receiving support through ongoing technical and financial assistance programs by the Bank, IMF and other donors. Risk of underperforming investment response. Even if Yemen brings its security situation under control, and even if fundamental reforms advance, investor perceptions may only change with a lag. In this case, PSD reforms might bring little private investment response. To some extent, building the strategic capacity of the General Investment Authority with its new focus on image building and strategic targeting of investors may help to mitigate this perceptual lag. Oil revenue volatility risks: Yemen has been subject to significant changes in its oil revenues, reflecting its dependence on crude oil exports. This makes it challenging to conduct fiscal policy with a medium-term orientation, while maintaining adequate levels of public spending. To help mitigate this risk, this operation aims to support reforms that would help reduce Yemen’s fiscal and socio-economic exposure to abrupt changes in oil prices and revenues, as explained elsewhere in this document. Security risks: As in many conflict-affected countries, a deterioration of the security situation constitutes a large source of risk for the operation. The capacity of the

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Yemeni Government to maintain security will be a determinant of the extent of risk that persists. However, the financing from this DPG, and the fact that it is part of a wider effort that includes substantial IMF resources, would provide the external financing needed to shore up macroeconomic weaknesses. This would help the Government maintain its recurrent and investment spending while still providing essential services to the population in a fragile and volatile environment, which may help to mitigate some domestic security risks.

Fiduciary risks: The fiduciary risk is rated high on the basis of the analytical work conducted in the area of public financial management. The 2005 CFAA rated the fiduciary risk as high; the 2008 PEFA report pointed to continuous weaknesses but noted positive improvements and reforms, including the issuance of new legislation's and laws supporting the enhancement of the Bank is, however, supporting the Yemeni Government in strengthening its public financial management system through a comprehensive PFM Reform Project, which will help to improve the Government’s fiduciary environment by supporting budget preparation, execution, transparency and accountability. The Bank continues to strengthening the Supreme Audit Institution’s independence and building its auditing capacity to ensure a broadened accountability and transparency in the use of public funds as key elements for mitigating the fiduciary risk.

Technical capacity risk: Limited technical capacity of the civil service to implement the reform program. Recent reforms and the companion technical assistance projects in each of the three pillars of this DPG are designed to help build the requisite capacity.

Operation ID P122414

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INTERNATIONAL DEVELOPMENT AGENCY PROGRAM DOCUMENT FOR A PROPOSED PRIVATE SECTOR

GROWTH AND SOCIAL PROTECTION DEVELOPMENT POLICY GRANT TO THE REPUBLIC OF YEMEN

I. INTRODUCTION

1. This program document proposes a Development Policy Grant (DPG) in the amount of SDR 45 million (US$70 million equivalent) to support the Government of Yemen promoting non-hydrocarbon private sector growth and employment, strengthening public financial management, and improving the targeting of the social protection system in light of the oil subsidy reform affecting especially the poor. The objective of the proposed DPG is to assist the Government’s economic reform program, jointly with the support from the IMF under the Extended Credit Facility (ECF), and foster private sector growth to create news sources of revenues and employment while oil revenues are declining, and aim to mitigate the impact of the ongoing fuel subsidy reduction on the poor by creating a more inclusive and more equitable cash transfer system. The supported reform program is medium- and longer term in nature and requires sustained assistance, including through a more programmatic approach towards which this operation could bridge.

2. As a result of the international financial crisis and subsequent declining oil prices, Yemen lost 8 percent of GDP in revenues since 2008 because of decreasing production and lower international oil prices. The fiscal revenues from oil peaked in 2008 when the international price for petroleum peaked. The revenue loss incurred since then amounts to 8 percent of GDP, or about 50 percent of 2008 oil revenues. Hence, after running a balanced budget (cash basis) in 2008, the country suffered a fiscal deficit (cash basis) of 8 percent of GDP in 2009. The authorities have adopted and are implementing a fiscal adjustment package that will reduce the fiscal deficit down to 5.6 percent of GDP in 2010.

3. An important component of the adjustment is the reduction in the subsidies for domestic energy prices, which required over the past 5 years on average 20 to 25 percent of public expenditure. By contrast, in 2009 expenditure for education were 6.4 percent of GDP and expenditure for health reached 2.1 percent of GDP. Apart of the fiscal angle, this measure is also welcome because the experience with energy subsidies in Yemen suggests that they induce bad governance, are a main source for corruption, and encourage an unsustainable use of resources, for energy as much as for water.1 However, the removal of the subsidies will require a reform of the current social assistance system to target and help those most in need during the adjustment period.

4. The Government program sets the basis for diversification and growth of the non-hydrocarbon economy (see also Annex 1). Although Yemen will continue to rely on the oil and gas sector, Yemen is forecast to become a net-importer of petroleum product in 4 to 5 years, if no new oil is found and current policies, including subsidizing domestic energy consumption, are maintained. Therefore, the government is accompanying its efforts at fiscal consolidation with measures that improve the business environment, especially targeting the non-oil sector. These measures include the reform of the investment code, the overhaul of the investment related tax incentive systems, the restructuring of the special economic zones regime, and measures to improve the availability of credit. Such reform policies are complemented by investments in infrastructure. It is expected that the continued growth of the non-oil economy will generate income and employment opportunities as well revenue for the public sector.

1 The impact on water resources is leveraged through cheap diesel which runs pumps going down more than 1000m below the surface, with energy being the main production costs.

2

5. The proposed operation focuses on reforms critical to setting the conditions for non-hydrocarbon growth in Yemen, while protecting the poor (see also Annex 2). Strengthening non-hydrocarbon growth and governance provides the common goal for the operation that focuses on: (i) improving the investment climate for non-hydrocarbon growth; (ii) widening access to credit; (iii) strengthening of public financial management; and (iv) making the social protection system more efficient. First, private sector reforms will generate non-hydrocarbon growth, broader employment opportunities, and will eventually offer fiscal revenue alternatives. A functioning banking system will facilitate economic diversification and non-oil growth. Second, strengthening budget management and governance is critical to ensure aggregate fiscal discipline and reduce waste and unproductive expenditures and favoring public investment. Third, a social protection system can only be truly efficient, if it is fiscally sustainable and equitable, which can be achieved through a retargeting of the beneficiary base of the Social Welfare Fund and a strengthening of its operations.

6. The four reform areas are supported by ongoing technical assistance by the Bank, the IMF, and other donors. Companion Bank Group projects are under implementation in the areas of public financial management, private sector reform (IFC led), and social protection. These projects have been closely coordinated with the IMF and donors, including DFID, the European Commission, USAID, the UN, GTZ/KfW, and CSOs/NGOs (e.g., OXFAM). In addition, the proposed operation is closely coordinated with the IMF arrangement under the ECF.

7. This DPG provides a timely response to Yemen’s financing needs and opens the door for a comprehensive dialogue and partnership with the country. This one tranche DPG offers the Bank the opportunity to launch a well-conceptualized dialogue for the medium term with the Government in support of continuous policy reforms based on Yemen’s upcoming new Development Strategy for Poverty Reduction, 2011 to 2015. The actions taken under this program and the complementary IMF operation contain important legislative initiatives and confirm the commitment of the authorities for a fiscal and structural reform program that moves to reduce the oil-dependency of the economy. Commitments made to international financing institutions will help lock in the appropriate reform measures, especially as the country faces legislative and presidential elections.

8. This World Bank operation complements the IMF ECF arrangement approved on July 30th 2010.2 The government is currently financing the fiscal deficit primarily with domestic resources. As one of the consequences of this constraint, international reserves have fallen considerably since 2008. The Board of the IMF approved on July 30, 2010, an arrangement under the Extended Credit Facility (ECF) for Yemen in support of its reform program which aims at regaining fiscal sustainability and accelerating non-hydrocarbon growth. Together with the ECF arrangement, building on lessons learned in fragile states, the Bank’s intervention aims to ensure that critical and poverty relieving public spending is maintained, contributing to stability in the country. This operation would offer external budget support amounting to 0.2 percent of GDP.

9. This DPG would add value to the portfolio of existing Bank operations in Yemen and help achieve the objectives laid out in the Bank’s strategy to support Yemen. In particular, it brings together different elements of Bank assistance under a consolidated, coherent reform package; lays out prior actions in areas not directly addressed in previous operations, such as the links between the Yemen’s Poverty Reduction Strategy and the state budget as well as the rationalization of the social protection system; and helps accelerate policy decisions in a number of reform areas, thereby energizing the reform agenda and providing synergy with the implementation of the investment and technical assistance project portfolio (e.g., PFM modernization, social protection projects, and private sector reforms). This selection

2 IMF, Republic of Yemen, Request for a Three-Year Arrangement Under the Extended Credit Facility, Country Report No. 10/300.

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is consistent with the thematic areas of the Bank’s Country Assistance Strategy 2010-2013 for Yemen. The prior actions focus largely on institutions and processes. This is because many of Yemen’s institutions are weak and have limited capacity.

II. COUNTRY CONTEXT

A. Recent Economic and Political Developments

10. Since 2000, income growth has been low and the needed reform have been stymied by weak governance and unresolved conflicts in the country. During the 1990s, Yemen had achieved annual GDP growth rates allowing for an acceptable 2 percent per-capita growth. GDP growth declined as security concerns gained prominence after September 11, 2001, and the conflict in the Sa’ada governorate led to a series of six domestic wars since 2004, with the last ending by a truce agreement in February 2010.3 The quality of governance has remained weak over this period and important structural reform initiatives like the privatization process, civil service reform and judicial reforms stalled. An increasing concentration of economic and political power alienated citizens, lowered the state’s legitimacy, and weakened the traditional systems of social cohesion, governance and accountability, while “modern” rules to guarantee good governance and accountability are not yet fully operational.

11. Until 2008 oil revenues rose steadily, blocking incentives to reform. Despite the decline in oil production since 2001, pressures for fiscal prudence were not strong as oil revenues increased due to the steady increases of international oil prices from 2000 to 2008.

12. Despite decreasing production, Yemen’s oil sector remains the main source for foreign reserves and is key for the fiscal balance. The production peaked in 2001 and has since been declining at a rate of about 3 to 4 percent per annum On average, 85 percent of exports and 65 percent of fiscal revenues were derived from oil exports and domestic oil trade since 2000. Hydrocarbon export constitutes about 85 percent of exports and generates about 60 to 70 percent of the government revenues, including domestic trade in oil products. Oil production accounts for 10 percent of the country’s GDP. The non-hydrocarbon revenues run at about 8 to 9 percent of GDP. This is unusually low for a country like Yemen.4

13. While oil production was declining, non-hydrocarbon sector growth averaged 5 percent per year during 2001-09. However, this non-hydrocarbon growth rate is not sufficient to provide economic opportunities for a young and rapidly growing population, increasing currently at the rate of 3.6 percent per annum since 2001, with more than 50 percent of the population under 25 years. Most importantly, in rural areas where most of the population resides, agriculture is constrained by limited rainfalls.5 Agricultural production contributes about 10 percent to GDP. Rural population earns on average 50 percent of monetary income from Qat cultivation. While government services stand for a large share of GDP (19 percent), non-hydrocarbon growth has been largely driven in recent years by transport, retailing and some manufacturing.

3 Tribal affiliation is an important basis for social organization in some parts of the Northern Highlands and Eastern Plains where tribes continue to wield significant power in the economy, politics and society. Tribes are territorially-based groups with shared values formalized through customary law. Some rural areas in the highlands and Eastern plains are controlled by tribal leaders with limited Government intervention. 4 Typically the tax rate of country at the development level of Yemen could be around 14 percent of GDP. 5 Yemen is one of the most water scarce countries in the world, with only about 135 m3 per annum compared to the 1,000m3/c/a water scarcity threshold (WHO), and compared to 2,500m3/c/a in the MENA region.

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14. Public expenditures grew rapidly after 2000, reaching a peak of 41 percent of GDP in 2008, largely because of energy subsidies. The largest single cost item of public expenditure is the subsidy for domestic energy consumption, which required over the past 5 years on average 20 to 25 percent of public expenditures. Even if subsidies for energy products are higher or lower depending on higher or lower international prices for oil, subsidies in 2009, when the price dropped, amounted to 8 percent of GDP, or 22 percent of public expenditures (2008: 14 percent of GDP, and 34 percent of expenditures). In comparison, expenditures in 2009 for education reached 6.4 per cent of GDP and expenditures for health 2.1 percent.

15. The most pronounced impact of the global slowdown in 2009 and 2010 has been through lower oil prices and was compounded by the emerging decline in oil production. A sharp drop in average prices since the peak in mid 2008 and lower government share of output oil production resulted in a significant decline of government oil revenues by about 50 percent since 2008. Fiscal revenues went from 16 percent of GDP in 2008 to 7.4 percent of GDP in 2009. Although the average export price per barrel of oil Yemen is projected to obtain in 2010 is 20 percent higher than in 2009, oil production declined since 2008 by 18 percent. As a consequence, after running a balanced budget (cash basis) in 2008, the country suffered a fiscal deficit (cash basis) of 8 percent of GDP in 2009. Yemen is expected to run an overall fiscal deficit of about 5.6 percent of GDP in 2010 on commitment basis, taking into account the measures agreed upon under the ECF arrangement with the Fund.

16. Besides the impact through oil, Yemen has suffered from the global crisis only indirectly.6 The financial sector is isolated from international markets and was not affected by the global financial crisis. The slowdown in world growth, however, contributed to a slowdown in non-hydrocarbon economic growth that weakened to an estimated 4.1 percent in 2009, mainly because of a reduction in investment. Due largely to the sharp decline in international food prices, inflation hit a record low in 2009 reaching an average of 3.7 percent. Also remittances, on which Yemen depends, declined by 23 percent in 2009 and have not yet reached the level of 2008.

17. Declining export volumes and values are driving down reserves. Gross foreign exchange reserves of the Central Bank climbed from US$3.6 billion in 2001 to US$7.3 billion in 2008, amounting to an average reserve cover of over 9-months of imports. However, reserves have been declining since 2008 and stood at US$6.2 billion at end 2009. They are projected to reach US$4.6 billion at end 2010, due to the combination of declining oil prices, declining oil production, and an increasing dollarization. In 2010, the combination of a political uncertainty, security concerns, the fading relevance of the oil sector and the large fiscal deficit have brought pressure on the exchange rate, whose depreciation path has become more volatile. Given Yemen’s dependence on food imports, a rapid and sudden depreciation of the Riyal, would accelerate inflation, adversely affecting the 60 percent of the population who are poor.

B. Macroeconomic Outlook

18. Yemen faces significant economic challenges. Although the immediate crisis is primarily a fiscal problem due to the sudden decline in oil revenues, the reduced oil production, and the difficulty to adjust the expenditure level at a time of crisis, addressing the fiscal challenge requires a comprehensive reform program to generate economic growth, employment opportunities, and fiscal resources beyond the hydrocarbon part of the economy. 19. Against this background, the IMF Board approved an arrangement with Yemen under the Extended Credit Facility (ECF) on July 30th, 2010. Implementation of the ECF supported reform program aims to restore fiscal sustainability over the medium term through primarily strengthening the 6 Central Bank of Yemen at a seminar held on July 4th, 2010.

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revenue base (application of the General Sales tax, elimination of tax exemptions) and reducing energy subsidies. The program is expected to maintain price inflation and help to stabilize the depreciation path of the Yemeni Riyal to adjust to the gradual reduction in oil exports. This DPG complements the program under the ECF through its focus on private sector development and improved coverage by the social protection net in Yemen. 2010 Fiscal Adjustment Program 20. The Government is addressing the fiscal challenges from the dwindling oil revenues through a reform program supported by the IMF that includes the gradual reduction of energy subsidies. The government program reduces the fiscal deficit in fiscal year 2010 (calendar year) from about 8 percent of GDP (budget 2010) to 5.6 percent of GDP and targets for the medium-term a budget deficit of around 4 percent of GDP. The main components of the government’s fiscal adjustment are (i) a gradual reduction in the energy subsidy on diesel, kerosene, and gasoil, amounting to savings equivalent to about 1.4 percent of GDP in 2010, and successive reductions from 2011 to 2013; (ii) full implementation of the General Sales Tax (a value–added tax), which had so far only applied at imports through the custom administration but not along the value adding chain up to the consumer; (iii) application of a new income tax law which will bring lower corporate and personal tax rates (from 35 percent to 20 percent, and from 20 to 15 percent) but will also eliminate numerous tax exemptions (except for capital investment) and rationalize the regime for tax exemptions; (iv) improved customs administration procedures, also to align better with WTO adherence; and (v) creating fiscal space through a more efficient use of energy by substituting diesel with natural gas in electricity generation. The reform program will be complemented by reforms supported through this operation in the areas of private sector and financial market development, public financial management system, and social protection. 21. The fiscal adjustment program of the government, however, protects investment and priority spending (Table 1). A sharp fiscal adjustment has reduced total public spending from 41 percent of GDP in 2008 to a projected 33 percent of GDP in 2010, aided by cuts in almost all expenditure categories, but mostly due to a reduction in energy subsidies (minus 6 percent of GDP, partly aided by a drop in international oil prices). The Government aims to contain other current spending by refraining from public sector wage increases in 2010, exercise constraint thereafter, by limiting public sector hiring. However, capital spending and social transfers are projected to increase in 2010 compared with 2009. Larger social spending will compensate the poor and vulnerable for the increase in domestic energy prices as a result of reducing energy subsidies.

22. IMF projections indicate a fiscal deficit for 2010 in the order of US$1.6 billion for Yemen after taking into account the above referred to fiscal adjustment measures for 2010. The financing of the deficit relies almost exclusively on domestic sources, except for about $200 million, including this operation, which makes a small contribution to meet the financing need and relieving the small domestic financial market. As a result, domestic public debt has increased substantially since 2008. The measures now taken by the government to contain the fiscal deficit will help to drive down the domestic debt build up over the medium term.

Medium Term Prospects

23. Yemen’s medium-term prospects depend on the hydrocarbon sector for the short–term and on the identification of new sources of economic growth over the medium–term. Oil production is expected to continue to decline, with exploitable reserves running out perhaps as early as 2021, in the absence of new oil finds and developments. The production and export of liquefied natural gas (LNG) via the Yemen LNG project (YLNG) will offer some cushion, but cannot compensate for the loss of oil given the government’s relatively small share in the LNG project. The start of a $4.5 billion green field

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investment project to extract and export Yemen’s natural gas reserves (YLNG project) late October 2009 and indications of additional gas reserves may prolong the life of the hydrocarbon sector, and could possibly be used for power generation (reducing the need to import refined fuel products and for subsidies). The predominant trend, however, indicates that Yemen will shift from being a net fuel exporter to a net fuel importer within just a few years (2014/2015).

Box 1: Petroleum Sector Overview and Petroleum Revenues The Ministry of Oil and Minerals (MOM) manages and regulates the hydrocarbon sector in Yemen through its various public subsidiaries. The Ministry of Finance (MOF), assisted by the Central Bank, has the responsibility of handling and overseeing all financial transactions between the government and the state-owned operating subsidiaries. The management of the sector is administered through three public subsidiaries: Yemen Company for Investment in Oil and Mineral (YICOM), Yemen Oil and Gas Cooperation (YOGC), and the Petroleum Exploration and Production Authority (PEPA), which negotiates petroleum exploration contracts and administers them. YOGC is the key vehicle for managing Yemen’s petroleum downstream activities, composed of mainly the Yemen Petroleum Company (YPC), which supplies the domestic market, the Yemen Gas Company (YGC), and the Aden Refinery Company (ARC), which also oversees the crude exports operations. Yemen depends heavily on oil; on average, 85 percent of exports and 65 percent of fiscal revenues were derived from oil exports and domestic oil trade since 2000. Oil production peaked in 2001 reaching 440,000 bbl/d, and has since been declining at a rate of about 3 to 4 percent, annually. Daily production is expected to drop by 6 percent over the period of 2010-13, ending at around 256,5 thousands bbl per day compared with about 274 thousands bbl in 2009. As a result, the government’s share in revenues is expected to decline due to the decline in net production, price forecasts, and the relative increase of so called cost oil, the quantity of oil needed by the companies to recover their investment costs - past and on-going investment costs – whose share increase with declining production. While the annual production is forecasted to decline during the period 2010-13, the government’s share is estimated to decline by 2.3 percentage points, reaching an average of 53.3 million bbl/year compared to 59.2 million bbl/year in 2009.

24. Given the current structural constraints, non-hydrocarbon growth is estimated to hover around 5 percent annually over the medium term. Factor costs for any industrial operation in Yemen are high, partly because basic services, including electricity supplies, are unreliable, governance is weak, and human capacity is low while the formal labor market is subject to significant constraints. While the government is addressing these issues, it will take time to show an impact.

25. As oil production declines, the government is establishing the basis for alternative sources of economic growth. The government has rightly focused on improving the investment climate and aims to diversify private sector growth. The overhaul of the income tax and investment regime, (applying GST, streamlining the tax exemptions and establishing the General Investment Authority as an investment promotion agency, in accordance with best international practices) is a first step in this direction. Yemen is very advanced in its negotiations to become a member of the World Trade organization. It is expected that the country’s adhesion to the WTO, coupled with its traditionally open trade regime, would provide for added private sector and investment incentives.7 Future growth is expected to be derived from manufacturing, fishery, tourism, improved infrastructure. Productivity gains and access to technology shall be for the immediate future mainly leveraged through foreign direct investment. The significant gains made in education on all levels need to be sustained to underpin growth with improved technical capacity.

7 It is possible that Yemen would become a member of the WTO later in 2011.

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26. Fiscal consolidation is a key step toward allowing more space for the private sector. At present, the fiscal deficit has driven up interest rates to 23 percent, an obstacle to investment. Reducing the fiscal deficit and therefore reducing the pressure on the domestic financial market is a prerequisite for improving the conditions for private sector development. The Fund’s program includes measures to strengthen financial sector development and widen financing options over the medium: (i) developing of Islamic financial instruments (Sukuk), which would also offer a new financing options and source to the government beyond the traditional T-Bills; (ii) enforcing prudential regulations on concentration of credit; (iii) improving the functioning of commercial courts and judicial processes for recovery of bank and other debts; and (iv) further encouraging microfinance. 27. Monetary policy will focus primarily on price stability and ensuring a sufficient level of private sector credit to support non-hydrocarbon economic growth. The Central Bank of Yemen (CBY) will continue to target reserve money growth in line with non-hydrocarbon sector economic activity, while keeping a close watch on excess liquidity in the banking system or signs of upward pressure on prices from domestic sources. To enhance the efficacy of monetary policy, the CBY will move to enhance both liquidity forecasting in conjunction with the Ministry of Finance. Furthermore, greater use of indirect instruments of monetary policy will made to minimize central bank financing of the budget and avoid inflationary pressure.

28. Yemen’s heavy reliance on food imports makes domestic prices sensitive to movements in the exchange rate. With regard to exchange rate policy, the CBY seeks to strike a balance between enhancing external competitiveness and limiting inflation. At the same time, the expected decline in oil exports makes exchange rate flexibility necessary to ensure external competitiveness and a sustainable external position. However, CBY will continue – as in the past – to auction foreign exchange in order to meet market needs and smooth out short-term volatility, while maintaining a sufficient cushion of foreign exchange reserves, which recently increased partly due to well implemented liquidity management by the CBY. 29. The balance of payments will remain under stress unless alternative sources of external financing are found (Table 2). The reforms implemented in 2010 to improve the investment climate and other reforms in this area under preparation are crucial to attract non-hydrocarbon investments, which are key in financing the current account deficit. However, more is needed in a sustained way, to compensate for the loss of investment in the oil sector. While recovery of regional economic activity would improve the outlook for employment of Yemeni migrant workers, and increase the remittance flow, remittances alone are unlikely to expand significantly unless regional integration is furthered. The tools available to the government in the short term beyond import demand management are limited, also given the high dependence on food imports. Reducing domestic oil consumption through the initiated reforms could prolong Yemen’s oil exports and provide some additional relief. However, given the very fragile outlook for the Balance of Payments, the country needs to work on sustained efforts to implement structural reforms conducive to non-hydrocarbon growth and employment. But Yemen also needs sustained assistance, including through programmatic approaches, which can mobilize the financing required and provides for the momentum to the policy dialogue (see also Annex 4)

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Table 1: Yemen: Key Macroeconomic Indicators

Source: GOY, IMF staff, and staff calculations.

prel. proj. proj. proj.2006 2007 2008 2009 2010 2011 2012

(In percent, unless otherwise indicated) National income and prices Nominal GDP, market prices (billions of US$) 19.1 21.7 26.9 25.1 25.1 25.1 25.1Real GDP 3.2 3.3 3.6 3.9 8.0 4.1 4.2 Hydrocarbon -8.3 -13.1 -8.1 1.6 51.0 -1.4 -4.1 Non-Hydrocarbon sectors 4.7 5.3 4.8 4.1 4.4 4.8 5.1Crude oil production (In thousand barrels per day) 357.0 310.0 284.0 274.0 275.0 269.0 250.1LNG production (oil equivalent) … … … 16.0 162.0 162.0 162.0Average oil export price (US$ per barrel) 62.8 72.3 95.5 60.3 73.5 … …Consumer price index (annual average) 10.8 7.9 19.0 3.7 9.8 8.9 10.2

(In percent of GDP) Central government financesRevenue 38.6 33.2 36.7 25.0 26.8 25.2 23.9

Hydrocarbon revenue 28.9 22.6 27.8 14.6 16.2 14.6 12.9Of which oil exports: 16.3 11.8 15.9 7.4 7.6 6.3 4.9Of which: LNG … … … 0.0 0.5 0.5 0.5

Tax revenue 7.1 7.3 6.8 8.0 6.9 6.7 7.2Custiom revenues 1.0 1.0 0.9 1.1 1.0 1.0 1.0Taxes on goods and services 2.7 2.7 2.2 2.7 2.5 2.6 2.8Income taxes 3.3 3.4 2.9 3.9 3.3 3.0 3.2

Grants 0.4 0.3 0.3 0.4 1.2 … …

Expenditure 37.4 40.3 41.2 35.2 32.4 30.1 28.6Current 28.2 31.4 34.5 28.7 25.7 22.9 20.6

Wages and salaries 9.9 10.9 10.0 11.0 8.9 8.7 8.5Subsidies 8.2 9.5 14.0 8.2 8.7 5.2 2.8

Of which: petroleum product subsidies (incl. LNG) 8.1 9.3 13.8 7.7 8.2 4.7 2.3Transfers 2.9 2.9 3.5 2.6 2.6 3.0 3.2

Of which: cash transfers by the Social Welfare Fund 0.5 0.5 0.6 0.8 0.9 1.4 1.6Investment 7.3 7.2 5.9 6.5 6.7 7.2 8.0

Overall fiscal balance (commitment) 1.2 -7.2 -4.5 -10.2 -5.6 -5.0 -4.7Primary non-oil primary fiscal balance (cash) -27.2 -26.1 -28.6 -22.3 -19.5 -17.1 -15.1

MonetaryCredit to the Government (annual percentage change)Credit to the Privte sector (annual percentage change) 16.7 35.7 17.5 -4.8 18.0 … …CPI (period average) 10.8 7.9 19.0 3.7 9.8 … …

(In millions of dollars, unless otherwise mentioned) Balance of PaymentsExports 7,865 7,773 10,182 7,097 9,080 9,552 9,685Imports -7,781 -9,357 -11,681 -10,126 -10,512 -11,021 -11,631Workers remittances 1,242 1,281 1,362 1,112 1,269 1,357 1,507Current account balance 206 -1,508 -1,251 -2,685 -1,565 -1,572 -1,648Current account balance (in percent of GDP) 1.1 -7.0 -4.6 -10.7 -5.2 -4.8 -4.6Non hydrocarbon current account (in percent of GDP) -19.5 -20.7 -23.3 -23.3 -20.2 -19.1 -17.0

Terms of Trade 103.3 101.9 110.7 88.8 98.8 98.8 100.1

ReservesGross official reserves (billions of U.S. dollars-end period) 6.8 7.0 7.3 6.2 4.7 4.1 3.3In months of imports of goods & non-factor services 10.2 8.0 9.3 7.5 5.3 4.4 3.4

Public DebtExternal debt (in billion of U.S. dollars) 5.4 5.8 5.9 6.1 6.4 7.0 7.7External debt (in percent of GDP) 28.9 26.9 21.9 24.8 21.7 21.7 21.8Domestic debt (in percent of GDP) 12.0 13.5 14.5 25.3 23.7 24.6 24.1

Exchange ratesExchange rate ( per US$, period average) 197.1 199.0 199.8 202.9 223.3 … …

Memo ItemsGDP in billion Rial 3,760 4,309 5,376 5,098 6,737 7,710.8 8,877.7GDP in billion US$ 19.1 21.7 26.9 25.1 30.2 33.0 36.2Population (in millions) 21.7 22.4 23.1 23.7 24.4 25.1 25.9

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C. External Financing Needs and Debt Sustainability

30. Meeting Yemen’s external financing needs requires more sustained efforts by external partners and enhancing non-concessional flows. The medium term financing need continues to be substantial (Table 2). Most of the need is currently financed through reductions in reserves, which are estimated to amount to s about 3 month in 2012, even assuming strengthened aid and remittances, substantial non-concessional inflows are required while the disinvestment of the oil sector bears heavily on the capital balance.

31. The updated debt sustainability analysis undertaken in December 2009 shows that Yemen’s risk of debt distress remains high (Annex 5). Although all indicators remain below their policy-dependent thresholds in the medium term, the PV of debt-to-exports ratio is projected to breach its threshold substantially over the long term (by over 30 percentage points annually during 2022–29) due to declining oil production. While the other indicators remain below their respective thresholds, the outlook is expected to worsen as debt accumulates and resources to service it are projected to decline due to the loss of oil exports. The high risk of debt distress underscores the importance of limiting external borrowing to concessional loans, implementing a prudent fiscal policy, and making continued efforts to diversify and increase exports. Sensitivity tests revealed that the debt outlook was vulnerable to export growth and persisting large fiscal deficits.

32. Although the Government is making efforts to lower the risk of debt distress by continuing to seek grants or highly concessionary financing, the need to promote private sector growth is likely to add to the pressures on the Balance of Payments in the short- and medium term. Although the increase in domestic and external financing to cope with the impact of exogenous shocks in 2008 did not lead to a significant deterioration of the debt indicator, debt sustainability continues to guide the authorities’ expenditure policy, particularly its public investment program. The Government is committed to continuing its conservative borrowing policy, with the aim of maintaining external debt on a sustainable footing. Moreover, the Government intends to remain selective regarding its investment projects, focusing on their impact on economic growth while seeking to provide basic services, particularly to the most vulnerable segments of the population, and select investment projects based on clear positive economic rate of return. This will ensure that higher domestic indebtedness in the medium-term would translate into faster growth and declining debt ratios over the long-term. The larger role sought for the non-hydrocarbon private sector is to add to demand on reserves and debt instruments in the short and medium term, however. In the longer term, a larger private sector and the value added attached with it will help is projected to sustain the external balance.

33. While macroeconomic risks are significant, the macroeconomic policy framework is satisfactory for the purposes of this proposed operation. A key macroeconomic risk is the dependence on declining and volatile oil revenues compounded by the little diversification of the Yemen economy. The fiscal program agreed with the IMF provides, however, for some reassurances and indicates the commitment by the authorities to address the adjustment needs. It is of utmost importance to improve the non-hydrocarbon economy and revenue base and give more space to the private sector initiative, a policy direction supported by this operation. But, sustainability requires further engagement, including through programmatic instruments and preferably on a broad base.

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Table 2: Yemen Summary Table of External Financing Needs

Source: GoY, IMF staff, and staff calculations.

D. Poverty and Social Development

34. Poverty is relatively high and primarily a rural phenomenon. Yemen is predominantly a rural8 country and poverty is by and large a rural phenomenon: 73 percent of the population, and 84 percent of the poor, live in rural areas.9 Between 1998 and 2005, the percentage of poor in urban areas declined by 11.6 percentage points (from 32.2 percent to 20.7 percent); rural poverty remained at approximately 40 percent.10 Poverty is estimated to have worsened since 2005. Estimates put the increase of the number of Yemenis who fell below the poverty line as a result of the food crisis, followed by the financial crisis and its impact on the real economy, at some 10 percentage points, with the poverty incidence rising again to about 32 percent of the population. It is estimated, that now half of the rural population lives below the poverty line.11 In urban areas, almost one fifth of Yemen’s 6.7 million urban dwellers live below the poverty line, with over half of them living in informal settlements without access to basic urban services.12 Almost three quarters of the urban poor are concentrated in the five cities of Sana’a, Aden,

8 Rural is defined as any agglomeration of less than 5000 habitants. 9 World Bank (2007), Poverty Assessment Report. Poverty is measured on the basis of household consumption, not income. Household expenditures were collected during a one month survey, with interviews four times a week with household members, recording their weekly as well as infrequent expenditures. 10 The decline is a meager 2.4 percentage points (from 42.5 percent to 40.1 percent), which is actually not statistically significant Impacts of the triple global crisis on growth and poverty in Yemen. IFPRI, Discussion Paper # 955. 11 Urban poverty is also estimated to have gone up to 31.1 percent. Breisinger, C., M.H. Collion, X. Diao, and P. Rondot (2010). The analysis uses a CGE model to trace the effects of the three crises. 12 Yemen Poverty Assessment Report, World Bank, 2007.

prel. proj. proj. proj.2006 2007 2008 2009 2010 2011 2012

Current account balance 206 -1,508 -1,251 -2,685 -1,565 -1,572 -1,648Trade balance 1,390 -441 -357 -2,201 -626 -722 -1,358Services, net -1,306 -1,143 -1,142 -828 -806 -747 -588Income -1,234 -1,350 -1,915 -1,171 -1,913 -1,973 -1,868Transfers 1,356 1,426 2,163 1,515 1,781 1,870 2,166

of which remittances 1,242 1,281 1,362 1,112 1,269 1,444 1,639

Capital & financial account balance 710 1,220 567 -252 -193 916 760FDI, net 1,121 1,148 470 -171 -724 -381 -660Medium & long term loans, net 236 238 108 247 395 599 722Other , net -647 -166 -10 -327 136 698 698Errors 536 584 1,124 1,815 … … …

Balance of payments 1,452 296 440 -1,122 -1,758 -656 -888

Financing Change in gross reserves 1,462 304 467 -1,117 -1,756 -528 -759Exceptional financing 10 8 27 6 2 0 0

Financing gap 0 0 0 0 0 -128 -129

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Taiz, Hodeidah and Mukalla.13 Increasing inequality and socio-spatial exclusion of the rural and urban poor add to the fragile cohesion of Yemen’s society. Many poor people depend on social safety nets supplementing their income, either in the form of labor intensive public works program, or in the form of cash transfers (estimated to be about 23 percent of the population).

35. Though improving, Yemen’s social indicators rank low. The country ranks 140 out of 182 countries in the 2009 Human Development Index. Average life expectancy rose from 41.6 years in 1970 to 62 in 2006 with women's life expectancy mirroring the overall trend.14 Although there has been a significant increase in enrollment rates in basic education (up from 3 million in 1996 to 4.1 million in 2004), yet female literacy rates stood at only 28.5 percent in 2002. Food insecurity and malnutrition levels in the country have reached alarming levels. Yemen is among the 10 countries in the world with the highest rates of food insecurity, with the country ranked third for the highest malnutrition in the world: 58 percent of children under 5 are stunted, and more than 1 in 10 children is acutely malnourished. A recent Comprehensive Food Security Survey (2009) conducted by the World Food Program’s (WFP) concluded that 7.5 million persons are caught in a chronic poverty trap. The situation is further compounded by climate change, increasing influx of refugees from the Horn of Africa, high population growth, and low literacy. Vulnerable groups, suffering from limited access to services, information, political and economic participation and voice, mainly include women, the physically and mentally challenged, street children, and a small group of landless people who often face extreme poverty and social exclusion. With only 5-10 percent of all urban land and properties registered with the General Authority for Land, Survey and Urban Planning (GALSUP), insecurity of land tenure in rural and urban areas is pervasive throughout the country, as the institutional and legal framework for land and real estate management remains fragmented and incomplete. Private appropriation of communal land, especially in northern governorates, is becoming an increasing problem both regarding access to land and access to increasingly scarce water resources. Insecure land tenure is an obstacle to economic development and social cohesion.

36. Health services have trouble reaching many Yemenis. Despite achievements over the last three decades, major challenges remain. Those most prominent are: (i) high and stagnated maternal, infant, and child mortality; (ii) high prevalence of malnutrition particularly for children under 5; (iii) high prevalence of malaria and Schistosomiasis. Given these challenges, it is unlikely that Yemen will achieve the 4th (reduce child mortality) and 5th (improve maternal health) Millennium Development Goals (MDGs) by 2015. The lower social status of women and girls, and their restricted mobility have negative effects on their health status and ability to get care when ill. Moreover, there is evidence that HIV/AIDS prevalence is rising, more than 3.0 million are infected with Schistosomiasis (Bilharziasis), 1.2 million Yemenis are suffering from malaria, and about 20,000 people are infected by tuberculosis. The health situation might be compounded by the perverse effects of Qat chewing.

37. The government’s efforts in education have been generally positive. The most remarkable achievement in the past three decades is the expansion of the education system at all levels and the halving of the illiteracy rate from 90 percent to 45 percent. Yet, many challenges remain. Between 1977/78 and 2007/08, gross enrollment in basic education grew 6-fold, reaching an enrollment rate of 74.3 percent. During the same period enrollment in secondary education grew 22-fold; and university enrollment grew 35-fold. Between 1998/99 and 2007/08 alone, the gross enrollment for girls improved from 49 percent to 76 percent, whereas those for boys improved from 85.6 percent to 94.5 percent; secondary enrollment (schools only) grew by 2.5 percent only; and university enrollment grew by 40

13 According to the Yemen Census (2004), Sana’a has 1.8 million inhabitants or about 30 percent of the urban population, Aden has an urban population of 0.59 million people, Taiz has 0.46 million people, Hodeidah has 0.41 million people, and Mukalla has 0.23 million urban inhabitants. In fifteen years, by 2025, these five cities together are expected to have a combined population of about 10 million. 14 Human Development Index, UNDP, 2009 Statistical Update.

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percent. Since 2000, technical education and vocational training (TEVT) expanded the fastest, increasing enrollment in post-secondary TEVT 15-fold, despite 3 percent annual population growth during the last decade. However, low quality and inadequate availability of teachers undermine the success of expansion. Forty percent of the current pool of basic and secondary school teachers do not have adequate qualifications. Most of these teachers are found in rural schools (76 percent) and are teaching in basic education (91 percent). Absenteeism among teachers is high, averaging 19 percent, and is even higher in rural areas.

38. Youth unemployment in Yemen is rising. About 50 percent of the population is younger than 15 years. Yemen’s estimated unemployment rate increased by 5 percentage points within five years, to a rate of 16 percent in 2004. More recent estimates vary but consistently put this number much higher. Unemployment is higher in urban areas, affecting 19 percent of the urban population, compared with 10 percent of the rural population.15 In addition, many more are underemployed. Most of the young Yemenis have to emigrate to make a living, a phenomenon, which for centuries was more limited to the Hadhramout but became now a necessity for young Yemenis in all regions of Yemen.

39. Furthermore, the number of refugees, predominantly from Somalia and internally displaced person from the conflict affected Sa’ada continue rising and affect the coastal zones. The United Nations High Commissioner for Refugees (UNHCR) estimates that more than 155,000 refugees, 95 per cent of which are Somalis have been granted prima facie refugee status by the Government. Other refugees in the country include Iraqis, Ethiopians and Eritreans, most of them living in Sana'a and Aden. It is estimated that a comparable amount of refugees lives illegally in Yemen. In addition, the five-year-old conflict between the authorities and the Al-Houthi tribe escalated in August 2009 for the 6th time to an open war, leading to the displacement of some 150,000 people.

40. Yemen aims to give greater voice to regions, traditional structures and citizen through decentralization. While decentralization would be a way to bridge the tension between the old and the new political structures as well as between the regions and the center, the process of decentralization has just begun. Fiscal decentralization in Yemen still needs to be largely defined, and weak human capacity of local governments limits the ability of regional and local entities to provide public services to meet the need of the citizens and fulfill their expectations about decentralization.

41. While the modern state is emerging, its weaknesses in the delivery of services and accountability are evident. Although Yemen has not a fledgling civil society, there is a large number of civil society and non-governmental organizations (CSO/NGO) that addresses needs not satisfied by the state.16 There is substantial need for capacity building of civil society organizations, and for the building of partnerships with CSOs/NGOs for the development of and demand for good governance.17

42. Energy subsidies cause a considerable waste of resources. The 2008 Yemen Social Protection Strategy highlights that energy subsidies are inefficient. First, they are costly and divert significant resources from alternative investments, including social programs and infrastructure. Second, large subsidies distort the use of subsidized commodities, encouraging underproduction for domestic markets and overconsumption. Third, critical from a safety net perspective, they are very inefficient in terms of delivering benefits to the poor. It is estimated that more than 77 percent of the direct subsidies on

15 Estimates of the GOY, World Bank, United Nations Development Program, 2007. 16 MoSAl reports over 7000 registered NGOs/ CSOs, of which an estimated 2000 are considered inactive, and only a few hundred NGOs/CSOs are considered as fully operational. 17 The World Bank refers to Demand for Good Governance as the ability and extent of citizens, civil society organizations, and other non-state actors to hold the state accountable and to make it responsive to their needs. See also Yemen Country Social Analysis (World Bank, 2006)

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petroleum products accrues to the non-poor, while only 23 percent goes to the poor, since wealthier individuals and households consume more of these goods. A conservative estimate of the economic waste incurred because of energy subsidies for the year 2008 concludes losses amounting to about YR110 billion, equal to three-quarters of all social transfers. This arises mostly from budgetary costs exceeding the gain to consumers.18

43. While removal of fuel subsidies will increase poverty in Yemen in the short term, more sustainable use of resources will benefit all Yemenis in the medium to long term. Despite its poor targeting, petroleum subsidies have protected, according to estimates, 3 percent of the population from falling into poverty, through the direct and indirect effects of keeping prices lower than they otherwise would have been. This document offers below in Box 2 a Poverty and Social Impact Analysis19 on the oil subsidy reduction (related data are shown in Annex 3).

Box 2: Poverty Impact Analysis of the Reduction of Energy Subsidies

The oil subsidy reform is estimated to raise poverty levels by up to 3 percentage points. An accelerated reform scenario (scenario 1: reduction of subsidies within one year) raises the poverty level up to 3.0 percentage points, and a gradual scenario (scenario 2: reduction of subsidies within 3 years) raises poverty by about 2.6 percentage points above baseline values during the reform process. Rural households, particularly farm households, are most affected, especially those that rely on irrigation intensive crops for their incomes. However, it is important to keep in mind that the second most affected group - rural nonfarm households - are higher in number and have higher initial poverty levels (Annex 3, Table A5). Urban households, which represent about 30 percent of the population, are most affected in terms of real income change due to their higher consumption levels of fuel/energy, but least affected in terms of poverty impact due to their relatively high initial incomes. Although, the poverty impact will decline for all households after reform sets in, yet higher than initial poverty levels are likely to persist after reform, if no additional action is taken.

The impact of the energy subsidies reforms on poverty is, however, mitigated through better targeted social assistance, while the trade-off between fast and phased removal of subsidies are being considered carefully. Timing and design of the reform matter: rapid subsidy reduction leads to a sharper spike in poverty and faster return to pre-reform income levels, while gradual reduction smoothens the poverty effect. Slow phasing out is preferable from a growth enhancing and poverty reduction perspective. A gradual approach inflicts a less pronounced growth shock on agriculture and total household incomes losses are about one fifth less than with in the case of a rapid subsidy reduction. However, slow reform comes at a higher fiscal cost since subsidies effectively need to be financed for two more years compared to the 1 year phase-out, amounting to additional costs. Thus, the faster the subsidy reduction is implemented the more fiscal space exists for the government to compensate households and to invest.

Both approaches towards fuel subsidy reform provide the Yemeni government with the leeway to reduce the budget deficit and to invest in generating new growth, employment and income opportunities. Both basic reform scenarios are analyzed in a sub Scenario (see annex 3, table A5, Scenario 1 A/B/C and Scenario 2 A/B/C) which combines budget deficit reductions, transfers and investments and assesses how investing in economic and social infrastructure can accelerate growth and reduces poverty.20 The results show that using all savings for direct transfers strongly smoothens the negative impacts on households, yet growth impulses for

18 Also called “dead-weight loss”. 19 Conducted by the International Food Policy Research Institute (IFPRI). 20 Under the accelerated reform scenario 1B, we assume that only 50 percent of the oil subsidy savings are used for the fiscal deficit reduction, which would leave a YR215 billion to spend. Under the gradual reform scenario 2B, the deficit is reduced over 3 years due to continued expenditure for subsidies. Note that scenarios 1B/C and 2B/C compare fast versus slow compensation/investment effects on growth and poverty given the same amount of resources available. However, they are not fully comparable from a fiscal point of view as the overall deficit will be higher under 2B/C due to the fact that subsidies continue to be paid during the reform process.

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sustainable development are likely to be limited.

Therefore, the preferred scenario is one where only the poor are compensated consistent with annual requirements, calculated for the period 2011-2015. If after fiscal consolidation, the remaining subsidy savings are invested in utilities, transport, trade and construction,21 improved infrastructure and basic services are likely to lower transaction costs for economic operators, offer the opportunity to integrate economic spaces in Yemen, and create the platform for a restructuring of productive, industrial and service along the value chains, which could be exploited by enabling domestic and foreign private investment. Results from model simulations show that this type of generated growth has strong poverty reducing effects and in addition to its long term growth effect can more than mitigate the negative short-term income effects of subsidy reform.

III. THE GOVERNMENT’S REFORM PROGRAM

44. The Government is in the process of mapping out an ambitious vision for the country’s development. While the 5 year development plan for the period 2006-2010 is coming to end, preparations for a new plan covering the period 2011 to 2015 have advanced. The new plan sets a greater emphasis on diversifying the economy (through private sector-led activities), enhancing governance, improving social conditions, and managing natural resources in a more sustainable way. The deterioration in the global environment has further heightened both the need to implement this ambitious agenda and the difficulties in doing so.

45. Attaining fiscal sustainability is the foremost macroeconomic concern of the government in the short term. The sudden and sharp decline of oil prices since 2008, compounded by a gradual decrease in production led the government to abandon the policy status quo of the past decade. Supported by a reform program agreed with the IMF, the Government aims to widen the non-hydrocarbon revenues. A big step forward in implementing this strategy was achieved when the Parliament approved the income tax and investment law reform package (prepared in 2008) in the Parliament in early August 2010, following the earlier commitment to begin full implementation of the General Sales Tax on July 1, 2010. In addition, the authorities have begun on February 2, 2010, to gradually reduce energy subsidies.

46. The Yemen Government’s growth strategy aims to reduce oil dependency through the promotion of economic diversification and by fostering private sector-led growth and investment. The approval in early August 2010 by Parliament of the income tax and investment law reforms and the amendments to the customs code offer a largely improved enabling framework for private domestic and foreign investment, in accordance with international best practices. The reforms in the financial sector which target widening access to credit, including through developing a micro credit market, complement the improvements for private investment. Such are moves in the right direction, however, they are likely to be constrained by the fragile security situation in the country. However, there are long standing impediments to private sector development, chief among which are electric power supply and governance challenges. A coherent growth strategy, using Yemen’s potential, can only fully unfold, if the security situation stabilizes and governance can be improved. The Government has therefore renewed its efforts to form a national dialogue.

21 It would be imported that this gained fiscal space is accompanied by an appropriate development strategy to ensure a maximum scaling up of these public investments. We assume investment-growth elasticity of 0.5, i.e. a 1 percent increase in investment leads to 0.5 percent growth in these sectors.

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47. To support the needed redeployment of public resources, the Government has initiated improving the efficiency of the pubic financial management system. Assisted by the World Bank and others (GTZ, French Cooperation, USAID, Dutch Development Assistance, and UNDP), the government aims to implement the priority reforms identified in the National Reforms Agenda, which essentially focuses on improving three sets of issues: improving (1) transparency, (2) public financial management (PFM), and (3) administrative capacity. It is anticipated that the new 5 year Development Plan for 2011-2015 will continue to highlight the criticality to steadily improve the public financial management system through financial and technical support.

48. The Government is conscious that given the widespread poverty in the country the impact of the energy subsidy reform on the poor and vulnerable requires special mitigating measures. The Social Protection Strategy (SPS) for Yemen seeks to assist the country in achieving its poverty reduction goals as well as supporting avenues out of poverty. The three major pillars of Yemen’s safety net system include the Social Welfare Fund (entirely funded out of Government budget), the Social Fund for Development (largely donor funded), and the Public Works Project (funded by the World Bank and other donors). While all Funds will contribute to mitigating the impact of the energy subsidy reform on the poor, a major burden will be put on the Social Welfare Fund (cash transfers) whose efficiency need to be improved to combine safety net demands, equity, and fiscal sustainability.

A. Achieving Fiscal Sustainability

49. Following the rapid decline of international oil price in mid 2008, Yemen suffered a revenue shock, losing about 8 percent of GDP in hydrocarbon revenues within 2 years. Faced with a rising deficit and an erosion of a key revenue pillar, the Government adopted a 4-pronge approach in line with the National Reform Agenda of 2006: (1) reviewing public expenditure, especially expenditure of energy subsidies and (2) containing current expenditures, especially wages and salaries, (3) protecting investment expenditures to facilitate non-hydrocarbon growth, and (4) widening the revenue base. The government’s urgency to act was underlined by the 10 Points Priority Plan issued in mid 2009 and which focused on immediate fiscal gains. The structural component of both plans, the NRA and the 10 Point Priority Plan, have in common (1) using Yemen’s natural gas reserves for energy generation and substitute diesel and diesel subsidies, (2) accelerating non-hydrocarbon growth, and (3) improving the attractiveness of Yemen as a location for investment, including in the mineral sector.

50. The gradual reduction of energy subsidies has begun in early 2010. The reduction in subsidies is expected to bring 1.4 of GDP in 2010. Petroleum product prices have been increased twice since February 2010 (see also Table 3). A reform of the electricity tariffs, a sector which continues to consume significant amount of diesel (mazout) at subsidized prices, is also envisaged but requires further consultations.

51. Additional measures to reduce and contain current expenditures were decided upon in late 2008. While salaries were protected in nominal terms, budgets for bonuses, over-time payments, financial assistance package including for medical treatment, embassy costs and staff, and for goods & services were at various degrees reduced, in some cases to nil. The effective execution of the saving program was delayed by the outbreak of armed conflict in the Sa’ada governorate.

52. Despite the fiscal pressure the government protected investment spending and social transfers. Investment spending rose since 2008 in terms of GDP, indicating the government’s preference is not to jeopardize important infrastructure and poverty reduction expenditures, including for the education and health sector. Recognizing the need to compensate the poor for the income loss of energy price increases

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due to the reduction in subsidies, the government increased transfers to the Social Welfare Fund in 2010 by 0.3 percent of GDP.

53. Revenue measures touched upon the whole tax and customs administrative system and stricter enforcement of existing laws. This policy emphasized especially reducing the backlog of tax claims, strengthening of the role of controls and audits, and applying the law on the General Sales Tax (GST), whose full application was finally publicly announced in mid-June 2010, implemented beginning July 1. In addition, Parliament finally approved the revised income tax law and investment law. This reform package, jointly with the GST, will eliminate many discreet exemptions, widen the non-hydro tax revenue potential, and bring investment and tax laws in line with international best practices.

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Table 3: Petroleum Price Increases and the Reduction in Energy Subsidies

Source: GoY, and staff estimates

2009 2010 2010Q1 (Feb.) price

increaseQ2 (May). June price increase

Q3 . projected price increase

Q4 . projected price increase

LPGDomestic price in YR / liter 23 30 42 47 52 43Price at the Yemen border (incl. tax, freight etc ) 52 70 64 67 67 74Subsidy as a percenatge of import prices 55.3 56.8 35.3 30.2 23.4 42.7Total Annual LPG subsidy (in billion YR) 41 17 11 10 9 47Total Annual LPG subsidy (in million of US$) 202 82 55 50 42 229Total Subsidy Reduction (savings) YR/Liter 0 7 11 5 5 28

DieselDomestic subsidized price 35 38 41 47 52 44Price at the Yemen border (incl. tax, freight etc ) 158 123 134 129 129 129Subsidy as a percentage of import prices 77.8 69.5 69.4 63.7 59.8 65.6Total annual Diesel subsidy (in billion YR) 264 90 95 99 95 379Total annual Diesel subsidy (in million of US$) 1303 420 423 420 396 1,659Total subsidy reduction (savings) YR/Liter 0 3 3 6 5 17

GasolineDomestic price 60 63 68 72 77 70Price at the Yemen border (incl. tax, freight etc ) 87 121 130 126 126 126Subsidy as a percentage of import prices 31.2 47.7 47.6 43.0 39.0 44.3Total annual gasoline subsidy (in billion YR) 55 31 33 29 26 119Total annual Gasoline subsidy (in million of US$) 271 145 148 123 110 525Total subsidy reduction (savings) YR/Liter 0 3 5 3 5 17

KeroseneDomestic price 36 38 41 46 51 44Price at the Yemen border (incl. tax, freight etc) 112 121 134 127 127 123Subsidy as a percentage of import prices 67.8 68.5 69.6 64.1 60.2 63.9Total annual kerosene subsidy (in billion YR) 15 1 3 3 2 9Total annual Kerosene subsidy (in million of US$) 76 4 13 11 10 38Total subsidy reduction (savings) YR/Liter 0 2 3 5 5 15 Jet FuelDomestic price 36 39 43 47 52 45Price at the Yemen border (incl. tax, freight etc) 97 123 136 129 129 129Subsidy as a percentage of import prices 62.8 68.6 68.0 63.9 60.0 65.1Subsidy (in billion YR) 9 3 4 3 3 13Subsidy (in million of US$) 45 16 16 14 13 58Total subsidy reduction (savings) YR/Liter 0 3 43 8 8 16

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B. Enhancing the Private Sector Framework

54. Both the National Agenda for Reform (NAR) of 2006 and the 10-Points Priority Plan of 2009 recognize the need to attract private investment and spur private sector development (PSD). PSD is considered the pivotal means for employment generation, economic diversification and growth, and long-term fiscal sustainability. The government has been working on various levels to implement reforms reducing the cost of doing business and improving the regulatory framework:

Reforms of business registration to reduce time and cost (supported by an IFC PEP-MENA project) resulted in a massive improvement in Yemen’s rating for the time and cost of business start up in Sana’a in Doing Business 2009, thought it still needs to be institutionalized and implemented nationwide. Licensing reform and streamlining of building permits are been part of this ongoing effort to streamline regulations.

Harmonization of the tax code with international standards, rationalization of incentives in the tax, investment and customs laws, combined with improved tax administration practice (supported by the World Bank Group through the Institutional Reform Development Policy Credit (IRDPG), and ongoing FIAS/DFID/WB technical assistance. Following Parliament’s approval of the investment law and the income tax law reforms, the marginal tax rate on corporate income has been reduced by 15 percentage points to 20 percent, and modern, fair, general incentives for investment were introduced. A major technical assistance program is designed to help Yemen implement a modern VAT and income tax through self-assessment and risk-based auditing, with a simplified regime for smaller enterprises.

Revision of the land registration law and related institutions to make land title and transfer of tile legally conclusive (supported by the IRDPG).

Preparing for accession to the Extractive Industries Initiative to enhance revenue transparency

(supported by the IRDPG).

Reduction by 50 percent of the time it takes for customs processing, including through the application of the ASYCUDA system, allowing