Yemen Economic Update – summer 2008 [Archives:2008/1181/Business & Economy]

August 14 2008

Yemen Economic Update is a quarterly report issued by the World Bank consisting several sections, highlighting major political and social and macroeconomic developments. It also covers structural reforms and developments and conferences and donors activities in Yemen.Here are some extracts of the lates report for summer 2008.

Recent global increase in food prices is jeopardizing political stability and aggravating the poverty situation in Yemen.

Yemen, which is a large net food importer (about 75% of food is imported), is facing severe political and social consequences as a result of rising global food inflation. With an estimated 35% of Yemen population living below poverty line, the increase in global food prices, estimated by 60 percent between 2007 and 2008, is likely to have aggravated the poverty situation, particularly for the poor in urban areas, and the landless and small and marginal farmers. Estimates put the number Yemeni who have fallen below the poverty level as a result of recent price increase by at least 6 percent. Spiraling prices and increased poverty is also feeding into increased social tensions and instability in Yemen, with implications ranging from curtailed political freedoms to reactionary measures that will undermine the reform agenda, particularly with respect to reducing public spending on wages, and subsidies on food and fuel.

Macroeconomic performance was mixed in 2007

The performance largely reflects the falling crude oil output (by more than 12 percent) which affected overall growth, fiscal outturn, and balance of payments. Overall growth for 2007 is estimated at 3.6 percent, compared to 3.2 percent in the previous year. The non-oil output witnessed a relative improvement over the previous year to 5.5 percent supported by public spending and private investment. In the fiscal area, despite higher than budgeted tax revenue and earlier savings in spending, the budget has shown a widening deficit of about 6 percent of GDP. The external sector showed deterioration as the current account balance reverted to a deficit of more than 5 percent of GDP, and the reserve accumulation eased to US$170 million, compared to US$1,460 million in 2006. A reduction in the inflation rate was the main positive outcome in 2007 reflecting tighter public spending in the early part of the year and good seasonal rains. As result, the average inflation rate for 2007 fell to 12.5 percent, a significant drop from 18.5 percent in 2006.

The outlook for 2008 calls for moderate improvement

The slower decline in oil production combined with record high international oil prices are expected to help Yemen's growth rate to improve to 4.2 percent in 2008. Higher oil revenue is expected to reflect positively on the fiscal and external sectors, though some of these gains will be wiped away by rising inflation and higher cost of imported goods. On

the fiscal side, higher oil revenue and improved tax are expected to bring a slight improvement in fiscal balance narrowing the deficit to 3.8 percent of GDP. Similarly, the current account deficit is expected to shrink to about 1 percent of GDP, compared to 5.6 percent in 2007. Needless to say, this outlook could worsen if oil production declined faster than the anticipated rate of 3 percent. Other negative factors include a further worsening in security conditions, which could affect public spending, private capital flows and growth in the non-oil sector.

Yemen's inflation rate rose sharply in the first four months of 2008.

For the period January-April 2008, all-items price index increased by 9 percent (or about 27 percent on annualized basis) over the pervious four months (i.e. Sept-Dec 2007) and by about 20 percent over the same period last year. The sharp turnaround in inflation in 2008, follows a relative slow-down in 2007 to 12.6 percent. The resurfacing of inflation in 2008 has been propelled by global factors such as rising food and fuel prices, a weakening US dollar, and by local factors such as drought conditions, and possibly the weakened effects of earlier government intervention in the wheat market through direct marketing. The high inflation rate in Yemen, though largely imported, needs to be augmented with an active monetary policy to maintain sufficiently high positive real interest rates ( nominal deposit interest rates are fixed but lending rates are not). Otherwise, low or negative real interest rates could intensify credit growth and raise demand in the economy, thus ratcheting up inflationary pressure further.

The monetary authorities in Yemen do not compile and publish data on bank lending rates to various class of borrowers. Meanwhile, bank deposit rates have been fixed since December 2000.

Oil prices witnessed a sharp rise during the first half of 2008, reaching a record high of more than US$145 per bbl in early July. Rising oil prices to these levels, which in real terms exceed the historical highs of 1981, has led to mounting global inflation and concerns for world-wide economic slowdown.1 The steady price increase, particularly in the second quarter of 2008 was supported by continued tensions in the Gulf and tight supply conditions, which were reflected on low inventories in major consuming countries. As a result, average future prices in July also increased for 2008 and 2009 to US$122.7 and US$138.4, respectively. Upside risks in these projections include factors such as the lack of surplus capacity, low inventories, accelerated reserve depletion, higher cost of production (due to credit crisis, extraction from unconventional sources), unexpected growth in demand supported by fuel subsidies, US dollar weakness, increased speculation, lower interest rates, shortage of investment in developing new oil fields and expanding or maintaining refineries and pipelines. Meanwhile, downside risks include easing of political tensions in the Gulf, deepening global recession, increased refinery capacity, rising inventories, cuts in fuel subsidies, and increased non-OPEC production. Based on official data, the price of Yemeni crude exports averaged US$73.4 per bbl in 2007, compared to US$84 per bbl projected for 2008.

The value of oil exports for the first five months of 2008 has more than doubled in relation to the same period a year ago.

Yemen does not publish comprehensive monthly data on oil transactions. Data in the monthly publication of the Central Bank pertain to three items: government share of exports (in bbls) (including exports of crude by Marib Refinery and the share of state oil companies), domestic consumption of crude in Aden and Marib refineries (in bbls), and value of exports (in US$). According the CBY report, Jan-May figures for government exports, domestic refined products consumption and total exports value show changes over the same period of last year by about 16, -20, and 107 percent, respectively.

Yemen experienced a notable shortage in diesel fuel in May,

With the owners of agricultural machinery, trucks and bakeries suffering the most. In the capital city, trucks and cars using diesel had to form long lines at fuel stations. Prices shot up in some regions with a premium of 50% above its official price. The recent diesel crisis in Yemen reflects the limited refining capacity (and subsequent reliance on imported diesel) and the growing domestic demand (which includes smuggling to neighboring countries) fueled by subsidized domestic prices. Currently, domestic diesel prices in Yemen are set at two levels: for general users at 0.36 $/liter and for power generation purposes at 0.17 $/liter. Current international reference price is more than 1.40 $/liter. The recent shortage episode was caused by management shortfalls and logistical delays of imported diesel consignments, and further aggravated by speculations that the government was preparing to raise the domestic prices.

The crisis, though later resolved, served to highlight the vulnerability of the country to fuel disruptions despite being a net oil exporter. Yemen has oil refining capacity of 120,000 b/d from two ageing plants, Aden Refinery with a capacity of 110,000 b/d and Ma'rib refinery of 10,000 b/d capacity Much of the local production is exported by Aden refinery, which, owing to the mismatch between the production and domestic consumption profiles, also imports some products to satisfy domestic needs. Among the chief items imported is diesel (and fuel oil), which is used for electric power generation, agriculture, and transport. Both refineries are publicly owned and under the control of the Ministry of Oil and Mineral Resources (MOMR). The government has backed away from a 2001 plan to privatize the Aden refinery. Plans to establish private-owned refineries, such as in Ras-Essa and in Hadramout, seem to be put on-hold due to lack of progress in negotiations. In this regard, Yemen continues to suffer from the lack a comprehensive strategy for the downstream petroleum sector, with respect to both public owned operations and the role of the private sector. Efforts to encourage international private investors continue to be hampered by the inadequate policy framework, weak regulatory capacity, and insufficient transparency. Preliminary estimates indicate that GDP growth in 2007 reached 3.6 percent, a slight improvement from 3.2 percent in the year before.

This came with the backdrop of good performance in the non-oil GDP at 5.5 percent (compared to 4.7 percent in 2006) which offset the sharp contraction in the oil output estimated at more than 12 percent. New public investment projects supported by pledges from CG donors, ongoing projects including Yemen Liquid Natural Gas (YLNG), Marib Power, and investments in housing and tourism projects sustained growth in the non- oil sector.

Structural reforms and policies

Foreign direct investment in Yemen's services sectors continues to face a number of legal restrictions.

According to a recent World Bank survey, current policies with respect to foreign competition in the provision of services in Yemen appear to be highly restrictive. In most sectors, majority-owned FDI is not permitted and there are limitations on the ability of investors to employ foreign workers (including at management level). In the area of internal transport services, only joint ventures are allowed, and foreign firms are not permitted to own facilities to provide maritime auxiliary services. Fixed line telecommunications is closed to competition, while mobile services are limited to minority ownership. Compared to other low-income countries, with the exception of professional services, Yemen has a more restrictive regime towards foreign competition on services markets. Yemen also has a more restrictive policy stance than the neighboring GCC.4 Distribution (retail), transport and professional services are more restrictive than in Saudi Arabia, Oman and Qatar. The GCC countries in turn tend to have more restrictive policies on foreign participation in services markets than do countries with similar levels of per capita incomes in the rest of the world. The surveys focus primarily on policy barriers to cross border trade in services and commercial presence or FDI and cover five key sectors: finance, telecom, retail distribution, transportation, and professional services. Some of the sectoral restrictions apply equally to both local and foreign investors (e.g. the public monopoly of fixed lines in telecom), while others aim specifically towards foreign investors. Yemeni legislations related to foreign investment in services sectors fall primarily under the Investment Law 22 of 2002.5. The Law does not cover sectors such as finance, trade, importing, wholesale and retail trade, which are governed by separate laws, (e.g. banking and commercial companies' laws). Other relevant legislations include the Land Law, and FDI-related provisions of the Customs and Tax Laws.

Yemen's financial sector plays a limited role in the economy.

According to a recent World Bank study, weaknesses in the legal and judicial framework, lack of proper accounting standards and disclosure practices, and scarcity of banking and financial skills remain major impediments to the development of an effective financial sector. The banking system dominates Yemen's small financial systems, although some non-bank initiatives are underway, such as leasing and microfinance.

Outside the banking sector, key supporting institutions are either nonexistent or play a very limited role. Leasing is beginning, but needs appropriate tax treatment and a registry for leased properties.

The financial sector is undergoing important reforms.

Recent reforms in the financial sector include the introduction of the Leasing Law in 2007, which aims to increase access to finance, particularly for micro and SME enterprises, and more recently the establishment of an independent insurance agency to protect small depositors. Legislation, currently under preparation, is the Micro financing Law that provides the legal framework for the operation of non-banking financial institutions in offering services to the poor. Other current plans call for the establishment of a credit bureau, a corporate governance code, and a stock exchange and a securities and exchange commission.

The government is taking new steps to enhance microfinance.

In a country like Yemen, where the vast majority of the population does not use formal financial services, microfinance development may represent an effective approach to enhance access to the banking system. A recent study noted that there are 13 active microfinance institutions in Yemen, most of which were created by the government's Social Fund for Development (SFD).8 Total outreach was estimated at approximately

31,000 clients, a combined loan portfolio of US$ 6.9 million, and an average loan size of US$ 97. Efforts to promote microfinance in Yemen are spearheaded by SFD, which in 2003 began providing financial and technical assistance to the Small Enterprise Development Fund (SEDF), as the only specialized institution to finance small enterprises. The SFD also took charge of formulating The National Strategy for the Development of Small and Micro, which was finalized in 2005. The Strategy was further revised in 2007 with the sole focus on microfinance business.

Efforts to promote microfinance has led to the establishment of one specialized microfinance bank while another is under consideration.

Al-Amal Bank, the country's first microfinance bank for the poor, was established in July 2007, with a capital of US$ 10 million. The Bank is expected to begin operations in summer 2008. Currently, the government is undertaking another initiative to establish another microfinance bank by inviting an experienced microfinance operator to join in the establishment of a green-field commercial microfinance bank. In tandem with the efforts to establish microfinance banks, the government is introducing the Law on Microfinance Banks that would facilitate the establishment and the licensing by CBY of microfinance banks. Legislation in the area of microfinance, however, needs to be supplemented with other measures to addresses constraints to starting a business, as well as accessing licenses, resources and information so that small enterprises can flourish. In the absence of large numbers of credible enterprises to lend to, increased supplies of finance may not result in the desired increase in economic activity. One particular measure that will ensure success of microfinance credit is brining improvements the credit registry. Efforts by the CBY to upgrade and automate its credit registry appear to be proceeding satisfactorily, with the revised registry expected to exempt the microfinance banks from the US$2500 fee imposed on beneficiary firms.

The recent increase in global food prices is bringing agricultural sector policies under renewed scrutiny.

Traditionally, Yemen agriculture sector has been an important source of growth, employment and foreign exchange earning During the period 2000-2005, for example, the sector was the main direct source of income for 74 percent of the population, making up 21 percent of the GDP, 30 percent of employment and 57 percent of non-oil exports. However, there are evidence that this role has been gradually diminishing over the last few years owing to a number of factors that include the scarcity of water resources, the insufficient public investment in the sector, and the growing cultivation of water intensive crops such as qat. The recent increase in global food prices and the need to enhance domestic food security has revived interests in the sector, both from the public and private sectors. Yemen relies heavily on food imports for domestic consumption. In 2007, Yemen imported close to 3.7 million tons (MT) of cereals to support domestic needs. Cereal imports included three main items: wheat (2.8 MT), rice and corn (with 0.4 MT each). Locally produced wheat accounts for a small proportion of domestic needs. In 2007, despite the 47 percent increase over the pervious year, local production of wheat could only cover 7 percent of domestic consumption. To encourage the expansion of food production, the government announced at late 2007 a new initiative under the National Program for the Expansion of Cereal Crops. The Program includes the allocation of new investment funds of about YR1 bln (through the Fund for Agricultural Development), measures to strengthen capacity for agricultural extension and research and plans to issue new legislations to limit the cultivation of qat.

Out look

With expectations of continued high oil prices and modest decline in domestic crude output for the rest of the year, the economic outlook in 2008 calls for moderate improvement.

Yemen's overall growth rate in 2008 is likely to improve by less than one percentage point to 4.2 percent, reflecting the continued good performance in the non-oil sector of about 5 percent and the slower decline oil production to about 3.3 percent (compared to 12.6 percent in the previous year). The non-oil sector should benefit from reforms taken in the previous two years and the higher flows of foreign capital, particularly from the Gulf. Improved outlook in the oil sector in Yemen is expected to reflect positively on the fiscal and external sectors. The government fiscal revenue should see modest improvement owing to higher oil revenue and continued progress in tax collection efforts. In the external sector, the current account deficit is expected to shrink to about 1 percent of GDP as compared to 5.6 percent in 2007. Needless to say, this outlook could worsen if oil production declined faster than the anticipated rate of 3 percent. Other negative factors include a further worsening in security conditions, which could affect public spending, private capital flows and growth in the non-oil

Inflation will pose the main threat in 2008.

With the annualized rate for the first four months of the year approaching 27 percent, the average inflation for the year 2008 is expected to run above 20 percent, surpassing its 2007 and 2006 levels. The likelihood of high inflation in 2008 is supported by expectations of continued global inflationary pressures, and the possibility of fiscal easing towards the year-end in association with upcoming elections. The exchange regime is not likely to see a sharp adjustment in order to curb inflation, as the government is expected to maintain the informal peg of the rial to the dollar at its current level of about 200 YR/$. In order to minimize the political and social consequences of rising inflation, the government is likely to put more efforts on strengthening the social safety nets, while tackling the sources of inefficiency in some areas of public expenditure such as energy subsidies.

Reforms are expected to continue in 2008.

A midterm review of the DPPR is already underway. The revision will cover the first two years and set the planning targets for the remaining period (i.e. until 2010). The revised plan will consider the changing circumstances that have emerged since the inception of the DPPR (such as the persistence of poverty incidence, the outlook of oil production, and the continued rise of global inflation) and revise its scope accordingly. Special emphasis is expected to be placed on strengthening economic diversification, improving energy efficiency, and strengthening social safety nets. Reform efforts will particularly focus on the areas of financial sector development governance and anticorruption, decentralization, and the general investment climate.

Medium-term outlook will continue to be uncertain.

Though the macroeconomic outcome in 2008 is expected to show some improvement, the medium-term outlook continues to face the same serious challenges, particularly in view of the fast decline in oil production, rapid population growth, and slow, uneven progress in reducing poverty. Rising global prices for food products, coupled with domestic supply bottlenecks in food production and distribution will continue to keep inflation high. These results reinforce the need to tackle the structural weaknesses of the economy, particularly fostering non- oil growth that needs to be led by the private sector. It also calls for more efforts to enhance fiscal sustainability through increased reliance on non-oil revenue, as well as lower and better targeting of expenditures, which is currently burdened by inefficient fuel subsidies (about 11 percent of GDP) and a large wage bill.