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III Macroeconomic Policy During 1990–99

Author(s):
Nada Choueiri, Klaus-Stefan Enders, Yuri Sobolev, Jan Walliser, and Sherwyn Williams
Published Date:
May 2002
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The macroeconomic policy mix in Yemen in the first half of the 1990s differed radically from that in the second. Unification of the YAR and the PDRY in 1990 joined two countries each of which already faced considerable macroeconomic policy challenges of its own in the late 1980s. The budget deficits of the YAR ranged from 15 to 20 percent of GDP in 1988 and 1989, about two-thirds of which were financed by the central bank, keeping inflation in double digits. In the centrally planned economy of the PDRY, the fiscal deficit exceeded 50 percent of GDP in both 1988 and 1989, of which 25 to 30 percent was domestically financed. (Price controls kept official inflation subdued, however.) Unification added new problems related to the merger of the two civil services and tax systems as well as the large number of publicly operated enterprises in the southern governorates. Since unification had resulted from negotiation between two sovereign governments, each of which received equal weight in the new joint government, many conflicts inherent in the different economic philosophies were resolved only after the 1994 civil war.29 The Gulf crisis of 1990 also added strains to both public and private financial balances in the early 1990s, with the return of workers from the Gulf countries and the drying up of most external financial assistance. Faced with financial crisis, after some early price liberalization efforts during 1990–91, the authorities centered the macroeconomic policy mix in the first half of the decade around attempts to manage financial imbalances through direct control of the economy, affecting in particular imports, the exchange rate, interest rates, and investment. The attempt to defend the nominal exchange rate led to a sharp appreciation in terms of the real effective exchange rate in the first half of the 1990s (Figure 3). As it became increasingly clear that multiple exchange rates and foreign exchange controls were intensifying the negative impacts of external shocks, in 1993—94 the authorities took some partial steps to achieve positive real interest rates and more realistic exchange rates.

Figure 3.Real and Nominal Effective Exchange Rates

(Index, August 1996 = 100)

Source: IMF, Information Notice System.

1 Derived by applying assumptions about the shares of various external transactions taking place at either the parallel or the official exchange rate.

However, it was only during 1995–99 that the implementation of the reform program, with assistance from the IMF and the World Bank, slowly transformed the economy into one of the more open and market oriented in the region. This process was supported by rising oil revenue and the return of internal and external stability. Efforts to improve fiscal balances were essential to these achievements, as was the adoption of a unified floating exchange rate system, which helped to broadly stabilize the real exchange rate at levels well below the earlier peaks. However, the large swing in oil prices in 1998 and 1999 served as a reminder of the fragility of macro-economic balances in a country that depends heavily on revenue from crude oil exports. The government’s ongoing reform program therefore aims at preserving a larger share of the oil revenue to cushion swings in oil prices, and at enhancing growth of the non-oil economy by encouraging investment and improving education.

Crisis, Controls, and Stagnation: Macroeconomic Policies During 1990–94

Public Finances

Between 1990 and 1994, limited efforts were made to address Yemen’s severe structural fiscal problems. Large and rising implicit subsidies for domestic petroleum products and wheat imports weighed heavily on public finances, the customs base was eroding, and taxes collected on goods and services were declining as a percentage of GDP (Figures 4 and 5). An already large civil service was granted large wage increases, albeit below levels that would generate rampant inflation. The resulting financial pressures motivated the maintenance of controls, which in turn further aggravated the fiscal imbalances and deterred private sector activity. After 1994 the newly constituted government was thus left with a large backlog of economic reforms as well as the task of repairing the physical damage of the war and mending the rift between north and south.

Figure 4.Government Revenue from Oil and Taxes

Source: Data provided by the Yemeni authorities.

1 Net of petroleum subsidies

Figure 5.Customs Revenue

(In percent)

Source: Data provided by the Yemeni authorities.

The large fiscal deficits were at the core of the severe internal and external imbalances in 1990–94 (Table 1; Figure 6). With the exception of 1991, the deficit on a commitment basis remained above 12 percent of GDP between 1990 and 1994. Because loan disbursements dried up almost entirely in the years after the Gulf crisis of 1990 and the dissolution of the Soviet Union, these deficits were hugely financed by the accumulation of external arrears or were simply monetized, and inflation accelerated from 34 percent in 1990 to 71 percent in 1994.

Figure 6.Fiscal Balance and Civil Service Wage Bill

Source: Data provided by the Yemeni authorities.

1 On a commitment basis, excluding grants.

Overall revenue dwindled from 20 percent of GDP in 1990 to 13 percent in 1994 (Table 5), Both declining oil revenue and declining tax revenue contributed to these developments. Oil revenue suffered from the decline in oil prices, the impact of the multiple exchange rate system, and the rising importance of domestic refining. Oil and gas revenue, which by the time of unification amounted to 7.5 percent of GDP and 40 percent of budget revenue, deteriorated after peaking at 9.4 percent of GDP in 1991, In 1994 oil revenue was only 3.7 percent of GDP and represented only 30 percent of budget revenue.

Table 5.Central Government Finance, 1990–99(In percent of GDP)
Prel.
1990199119921993199419951996199719981999
Total revenue and grants19.823.116.114.912.819.535.932.826.431.8
Total revenue18.722.015.814.712.619.235.632.226.030.9
Oil and gas revenue7.59.44.74.23.79.325.122.113.819.8
Crude oil exports4.93.71.61.53.16.514.115.18.512.7
Domestic oil and gas12.65.73.12.70.52.911.07.05.27.1
Non-oil revenue11.212.611.110.58.99.810.510.112.211.1
Tax revenue8.29.28.88.56.98.08.48.29.28.0
Direct1.92.32.42.52.42.02.12.23.13.0
Indirect6.36.96.46.04.66.06.35.96.15.0
Nontax revenue3.03.52.32.01.91.92.12.03.03.0
Grants (cash)1.11.00.30.10.30.30.30.60.40.9
Total expenditure and net lending32.330.128.929.529.025.639.834.732.732 1
Current expenditure23.626.125.526.026.422.533.227.926.626.5
Civilian wages and salaries9.210.210.010.79.77.36.86.17.57.4
Materials and services1.92.02.41.71.81.52.32.93.03.1
Development O and M0.00.00.00.00.00.00.00.20.20.2
Agriculture and road maintenance funds0.00.00.00.00.00.10.30.30.30.2
Defense8.48.98.98.39.76.75.66.06.15.8
Interest obligations22.42.91.92.62.91.53.32.33.74.1
Transfers and subsidies1.77.22.42 72.34.914.69.35.25.1
Subsidies0.00.00.00.00.03.413.07.73.02.5
Petroleum cash subsidies11.05.32.92.0
Wheat and flour subsidy30.00.00.00.00.02.37.44.53.00.4
Financial support electricity0.00.00.00.00.00.00.30.30.00.0
Current transfers1.72.22.42.72.31.51.61.62.22.7
Other current expenditure0.00.00.00.00.00.40.30.70.50.6
Development expenditure8.74.03.43.52.63.16.66.86.15.6
Net lending0.00.00.00.00.00.00.00.00.00.0
Overall balance (commitment)−12.4−7.0−12.8−14.7−16.2−6.1−3.9−1.9−6.3−0.2
Overall balance (commitment, excluding grants)−13.6−8.0−13.1−14.8−16.4−6.4−4.2−2.5−6.7−1.2
Overall balance (cash)−11.7−5.6−11.7−13.9−15.7−5.20.6−1.8−7.9−0.4
Financing11.56.011.914.115.85.2−0.71.87.90.0
External (net)2.71.60.20.20.1−0.20.40.31.22.3
Domestic (net)8.84.411.713.915.75.3−1.11.56.7−2.3
Bank8.84.411.713.915.75.1−1.5−0.13.3−4.4
Central bank9.14.111.314.016.14.6−2.5−3.43.1−4.8
Commercial banks−0.30.30.4−0.2−0.40.50.93.20.20.4
Nonbank0.00.00.00.00.00.20.41.63.42.1
Pension funds0.00.00.00.00.00.00.00.03.31.2
Public enterprises0.00.00.00.00.00.00.00.00.00.6
Others0.00.00.00.00.00.20.41.60.20.3
Discrepancy−0.30.40.20.20.20.0−0.10.00.0−0.4
Memorandum items:
Primary balance (commitment)4−11.2−5.1−11.2−12.2−13.5−4.9−0.9−0.1−3.02.9
Public sector savings5−4.9−4.1−9.7−l1.3−13.9−3.32.44.3−0.64.4
Non–oil balance (commitment, excluding grants)−18.5−11.7−14.7−16.3−19.6−12.9−18.3−17.6−15.2−13.9
Tax revenue, as percent of non-oil GDP9.510.29.59.07.49.311.511.411.010.7
Direct2.22.62.62.72.52.32.93.13.74.0
Indirect7.37.76.96.34.97.08.78.37.36.7
Taxes on goods and services2.32.32.42.21.62.43.03.54.13.1
Custom duties, as percent of non-oil imports12.315.411.110.34.46.79.49.38.77.5
Average oil price for government exports ($/bbl)15.517.318.318.213.116.3
Net domestic oil revenue62.65.73.12.70.51.85.74.15.25.1
GDP (at market prices in billions of YR1s)122.1144.8183.9227.7292.3488.5702.1852.9855.91,063.6
Social expenditures (in percent of GDP)74.65.88.89.3
Sources: Ministry of Finance; Ministry of Planning; and IMF staff estimates.

1990-95: Revenues net of subsidies.

Profit transfers from the Central Bank of Yemen were netted out against interest payments to the CBY until 1996.

Until the unification of exchange rates, subsidies were implicit by applying 3 preferential exchange rate to wheat and flour imports.

Revenue excluding grants, net of expenditures excluding interest obligations.

Primary cash balance excluding grants and development expenditures.

Domestic oil revenue net of cash petroleum subsidies.

Comprises spending on wages, salaries, materials, services, capital in the education and health sectors, and spending by the social welfare fund.

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

1990-95: Revenues net of subsidies.

Profit transfers from the Central Bank of Yemen were netted out against interest payments to the CBY until 1996.

Until the unification of exchange rates, subsidies were implicit by applying 3 preferential exchange rate to wheat and flour imports.

Revenue excluding grants, net of expenditures excluding interest obligations.

Primary cash balance excluding grants and development expenditures.

Domestic oil revenue net of cash petroleum subsidies.

Comprises spending on wages, salaries, materials, services, capital in the education and health sectors, and spending by the social welfare fund.

Some of the decline in oil revenue can be explained by the fall in oil prices from $22 a barrel in 1990 to $15 a barrel in 1994. In addition, oil production at Marib, Yemen’s major field in the early 1990s, felt by 10 percent in 1992 following technical problems. The widening gap between the market-based parallel exchange rate and the official exchange rate also contributed to the decline of oil revenue as a share of GDP.30 Receipts were credited to the budget at the official exchange rate and thus assumed a declining share of the overall economy, in which most other external transactions took place at the parallel rate. The revenue loss to the budget resulting from use of the official rate also implied subsidies for those products whose importation was financed at the official rate, particularly wheat and petroleum products. The implicit subsidies, including those for domestic petroleum product sales, reached 13 percent of GDP in 1996.

Finally, following the Gulf crisis, the government increased oil deliveries to domestic refineries to substitute for previously imported petroleum products. At the same time, domestic petroleum prices were increased by 30 to 50 percent in 1990. As a result, domestic oil revenue surged in 1991 and continued to exceed export revenue until 1994, when exports increased as the Masila field came on stream for its first complete year and the Aden refinery was damaged during the civil war, disrupting domestic deliveries. Because domestic petroleum prices remained unchanged during 1992–94, their value dropped to about 10 percent of international prices (evaluated at the parallel exchange rate), reflecting a rising subsidy for domestic consumption of petroleum products. This policy implied increasing incentives for smuggling, further eroding the oil revenue base.

The fall over time in indirect tax revenue as a share of non-oil GDP was partially compensated by rising direct tax revenue as a share of non-oil GDP. The latter largely reflected the rising government wage bill as a share of GDP as well as bracket creep in the progressive tax system in a high-inflation environment.

Public expenditure was dominated by the heavy weight of the civil service wage bill (Figure 6). As noted earlier, the public workforces of the YAR and the PDRY were merged upon unification, and the pay scale in the south was adjusted to the higher level of the north. Moreover, many civil servants received allowances for moving from the former PDRY capital of Aden to Sana’a, the former YAR capital and capital of the unified country. The government also reinstated a policy that guaranteed employment to all university graduates and employees of public enterprises. In 1991–94 the government conceded sizable pay raises to public employees, which kept the wage bill on the order of 10 to 11 percent of GDP 31 Between 1990 and 1993 the share of wages in total expenditure rose from 29 percent to 36 percent, largely at the expense of development expenditure, whose share fell from 27 percent to 12 percent. Defense spending ranged between 8.4 percent and 8.9 percent of GDP between 1990 and 1993, with a sharp increase to 9.7 percent of GDP in 1994 due to the civil war. Moreover, many of the money-losing public enterprises relied on government transfers, reflected in the rise of current transfers from 1.7 percent to 2.7 percent of GDP between 1990 and 1993.

Monetary and Exchange Rate Controls

To contain the spillovers from the fiscal imbalances to the external account, the authorities maintained a “hybrid” foreign exchange system. This involved a large and relatively free parallel exchange market—with occasional ad hoc attempts to tighten control over it—and a highly administered exchange system for certain (including official)transactions involving quantity rationing and a highly appreciated currency (see Section IV). Thus there was little scope to formulate an independent monetary policy in the period immediately following unification. Rapid expansion of net domestic assets was driven by the need to provide financing for the budget, given the absence of nonbank financing.

Commercial banks were reluctant to lend to the nongovernmental sector, given the absence of effective recourse within the legal system for the timely recovery of overdue loans. Accordingly, banks preferred to deposit their resources with the central bank for on-lending to the government, at a remuneration of 1.5 percentage points above the banks’ average cost of funds.

The continued existence of separate interest rate structures after unification posed special problems for the monetary authorities. Although the authorities were seeking to establish a unified system based on the structure of the market-based former YAR, the National Bank of Yemen—the only commercial bank (state owned) in the South—was allowed to set its own rates as an interim measure. Statutory interest rates in this period were very low, and real rates were highly negative (Figure 7). This discouraged the mobilization of savings, facilitated inefficient consumption and investment choices, and put further pressure on the foreign exchange market. Indeed, foreign currency deposits doubled from 1991 to 1992, while Yemeni rial deposits increased by only 15 percent. Also, negative real interest rates continued to encourage financial disintermediation, as the absence of controls in the parallel financial market for rials spurred growth in this market at the expense of the banking sector.32

Figure 7.Interest Rates

(In percent a year)

Source: Data provided by the Yemeni authorities.

1 Nominal rates minus inflation, as measured by the consumer price index.

Partial Liberalization of the Exchange and Interest Rates

During 1993–94 economic structures became more unified and conducive to national macroeconomic policymaking, and the authorities increasingly recognized the need for strong corrective fiscal policy action, establishment of positive real interest rates, and unification of exchange rates at a realistic level. However, initial reform efforts remained partial, and extensive controls remained. In particular, the real appreciation of the currency accelerated, undercutting efforts to contain the fiscal and external imbalances. For example, faced with a growing gap between the free market parallel rate and various official rates in November 1994, the authorities introduced a “managed official parallel market rate” at YRls 84 to the dollar, to be “guided” by a committee of moneychangers and commercial bank representatives under the supervision of the central bank, taking into account market indicators. This attempt to manage the parallel market failed, however, and already by the end of 1994 the rial had depreciated on the unofficial parallel market to 100 to the dollar.

To allow a greater role of market forces in financial intermediation, the authorities took some steps to improve competitiveness in the banking sector. First, they adopted a more liberal policy toward licensing of bank branches, removing the monopoly of the National Bank of Yemen in the south. Second, the central bank began strengthening prudential regulation and supervision (see Section IV). In particular, the banking system’s vulnerability to depreciation of the rial had to be addressed to prepare for liberalization of the exchange rate. The largest commercial bank, the Yemen Bank for Reconstruction and Development (YBRD), had built up sizable foreign currency deposits, but its net foreign assets position was negative. Unification of the exchange rate at a realistic level would thus trigger large valuation losses. This bank’s problem was addressed by the government assigning most of this debt to the public sector enterprises for which the (foreign) credits had been opened, thus shifting the vulnerability to the corporate sector. The foreign liability position of the central bank was also large, mainly reflecting deposits from foreign governments prior to unification, outstanding liabilities related to oil imports, and short term liabilities to foreign banks.

Reform and the Return of Stability and Growth During 1995–99

A new phase of post unification macroeconomic policymaking began in early 1995. By this time the political situation had stabilized, and the new government embarked upon a program of macroeconomic adjustment and structural reform with support from the World Bank and the IMF. The program included strong fiscal adjustment measures, liberalization of most interest rates, and reform of the exchange rate system, including in 1996 the elimination of the official exchange rate and unification of exchange rates at the free market level, and the adoption of a floating rate regime.

Fiscal improvements during the second half of the 1990s were the basis for the gradual return of some measure of macroeconomic stability to Yemen. Integrating the official and parallel exchange rates helped reduce the subsidy bill and, combined with rising government oil exports, strongly boosted revenue. As a result, the fiscal imbalance declined from 6 percent of GDP in 1995 to 2 percent in 1997. However, as a stark reminder of Yemen’s oil dependence, macroeconomic stability suffered a blow in 1998 with the collapse of oil prices, and the budget deficit rose once again to 6 percent of GDP. The reverse outcome was then observed in 1999, when a surge in oil prices led to a balanced budget and a substantial strengthening of the external position.

Revenue

Total revenue increased from 19 percent of GDP in 1995 to 32 percent in 1999, in large part because of improving oil revenue. Following the enforcement problems encountered during the 1994 civil war, the government also improved its tax collection and introduced several simplifying reforms to tax and customs laws, which contributed to a rising ratio of tax revenue to non-oil GDP, Because of the rising oil share in GDP, the ratio of taxes to total GDP remained roughly flat.

Rising production and prices as well as the stepwise unification of exchange rates in July 1996 raised oil export revenue accruing to the budget from 3 percent of GDP in 1994 to 15 percent of GDP in 1997. The volume of crude oil available to the government for domestic deliveries and exports almost doubled between 1993 and 1997, partly because overall production rose, and partly because concession holders had recouped their investment costs, reducing their share in production. Moreover, the step-wise adjustment of the official exchange rates to the parallel market rate substantially raised the value of oil revenue recorded in Yemeni rials, while eliminating the implicit subsidization of certain economic activities resulting from preferred access to foreign exchange.

Domestic oil revenue increased from 3 percent of GDP in 1995 to 7 percent in 1999. Exceptionally high domestic revenue in 1996 resulted in large part from a settlement of excess cost recovery charges with one of the oil companies, yielding an amount equivalent to 2.3 percent of GDP. Rising international prices and the unification of the exchange rates also contributed. Although exchange rate unification removed one source of implicit subsidization, transactions among the government, oil refineries, and distributors remained opaque and involved non-market-based transfer prices and free inputs. Only beginning in 1999 was pricing of all wholesale transactions based on world prices.33 Therefore domestic revenue has to be evaluated together with the subsidy payments to arrive at a clear picture of domestic efforts. As the memorandum item in Table 5 shows, the resulting measure of net domestic oil revenue has risen steadily over time.

Tax revenue rose strongly, to 11.5 percent of non oil GDP in 1996, but then began to erode slowly, reaching 10.7 percent of non-oil GDP in 1999. The initial strengthening of tax revenue was a consequence of exchange rate unification, economic recovery, and several tax reforms undertaken in 1995 and 1996 (see Section IV). Higher exchange rates applied to import valuation, and the recovery of the economy was followed by higher import volumes; these factors, together with the simplification of the tariff structure and concomitant improvements in customs administration, led to a rebound of customs revenue to more than 9 percent of non-oil imports in 1996. Taxes on goods and services also benefited from increased economic activity, a widening of the tax base, and a higher tax elasticity after some specific taxes were replaced with ad valorem taxes. Direct tax revenue rose with a simplification of the corporate income tax at a single 35 percent rate. After 1996, direct taxes and—until 1999—taxes on goods and services continued to rise faster than non-oil GDP, but a decline in customs revenue pulled down overall revenue growth. Direct taxes benefited from the rising share of government wages in GDP, improving business income tax revenue after the 1996 rate unification, improving economic conditions, and an increase in top tax rates in 1999. Taxes on goods and services grew strongly after their base was broadened in 1996, but fell as a share of non-oil GDP after the 1999 tax amendments changed a number of tax rates. The poor performance at customs likely reflects the rising importance of smuggling, continuing weaknesses in administration, and to a certain extent the elimination of import surcharges in 1998.

Expenditure

Large swings in government expenditure were driven by the move to unify exchange rates and by related subsidy reform. After the unification of exchange rates over 1995–96, the implicit subsidies on wheat, flour, and petroleum products through the below-market exchange rate were replaced by explicit cash subsidies. In 1996 these subsidies rose to 13 percent of GDP because of a widening gap between domestic and international prices. In later years, however, these subsidies declined when domestic prices were moved closer to world market prices, and wheal and flour subsidies were eliminated entirely by mid-1999 (see Section IV). The civil service wage bill declined to 6 percent of GDP in 1997 as wage increases were kept below inflation, and despite rising currency costs for foreign workers (mainly teachers) paid in foreign exchange. However, following large wage increases in 1998–2000, the civil service wage bill has recently been on the rise again. These increases largely reflected the implementation, phased in over three years, of a teachers’ law passed by parliament in 1998 that granted 100 percent wage increases to workers in education, where the majority of civil servants are employed. Similar wage increases were granted to health workers. Defense spending declined from 6.7 percent of GDP in 1995 to less than 6 percent in 1999. Development expenditure doubled as a percentage of GDP in 1996, but was cut back in 1998 and early 1999 after the fall in oil prices.

Fiscal Balance

The financing of the government deficit through central bank credit remained a critical source of macroeconomic instability. Although disbursements of foreign grants and loans on the order of 2 percent of GDP resumed in 1996, the government continued to face large amortization obligations; hence net external financing remained small until rescheduling agreements were reached with Paris Club creditors in 1996–97. To develop sources of noninflationary financing and deepen the financial system, a market for treasury bills was introduced in 1995. and the central bank subsequently closed its term deposit facility for banks and pension funds in order to channel resources into this market (see Section IV). Thus, in 1996 and 1997 the government reduced its indebtedness to the central bank, financing its deficits by accumulating arrears to wheat importers as well as through increasing treasury bill sales to commercial banks and nonbanks. However, as oil revenue shrank dramatically in 1998, the government had to borrow 3 percent of GDP from the central bank, and the concomitant expansion in the money supply resulted in an immediate spurt of inflation. Fortunes were reversed in 1999, and inflation fell as rising crude oil revenues led to a balanced budget, permitting the government to reimburse almost 5 percent of GDP to the central bank.

Monetary and Exchange Rate Policy

The use of monetary policy instruments became more flexible, responding to macrofinancial conditions. In the context of the reform program, in 1995 the central bank unified the reserve requirement at a rate of 25 percent, without remuneration, for all rial deposits. This requirement was lowered to 15 percent in December 1996 and to 10 percent in December 1997. A rate of remuneration of 5 percent on these deposits was initiated in December 1996 and rose the following year to equal the benchmark deposit rate. In December 1997 the reserve requirement on foreign currency deposits was lowered from 25 percent to 15 percent, and the rate of remuneration was set at half a percentage point less than the rate received on the central bank’s deposits abroad. The higher reserve requirements for foreign currency deposits and the much lower rate of remuneration on these deposits reflected the central bank’s objective to stem the trend of increasing dollarization of the economy and to enhance the attractiveness of the rial as a store of value. Undoubtedly, however, such discriminatory measures induced capital flight. The effectiveness of reserve requirements as an instrument of monetary policy might have been hampered by the less than full implementation of the penalties for shortfalls. Although the central bank can impose a maximum daily penalty of 5 percent, in practice this figure lies in the 0.5 to 2.0 percent range. The central bank used credit ceilings as an instrument of monetary policy in the early postunification period, but this instrument was hardly effective then and subsequently lost all importance.34

Two sharp real depreciations took place in early 1995 and mid-1996 (Figure 3). The second of these reflects the nominal depreciation that occurred at the time of unification of the exchange rates. The first, however, was the result of a partial reform of the exchange rate system implemented at the time, including the elimination of special official rates and the depreciation of the only remaining official rate from YR1s 12 to YR1s 50 to the dollar.

With the move to a floating exchange rate system, which was maintained throughout the period, the rial broadly stabilized in real effective terms; some small appreciation in real terms between the end of 1996 and the end of 1999 partly reflected a reluctance to tolerate substantial variability in the exchange rate. Indeed, exchange rate stability remains, in the eyes of the public, the main yardstick of the success of government policy. Accordingly, through interest rate policy, moral suasion, and the regular auctioning of foreign exchange to moneychangers and banks, the central bank attempted to stabilize the exchange rate in times of turmoil. In part, its intervention also reflected an attempt to smooth sharp seasonal peaks in demand for foreign exchange (especially around the Ramadan and Hajj seasons), given the limited depth of the private market. For example, reflecting the impact of low oil prices on macroeconomic performance in 1998, the central bank employed its limited monetary tools to ease the pressure on the exchange rate. It raised the official benchmark interest rate (to 3.5 percent a year in real terms) and ended the remuneration on foreign currency deposits at the central bank, but still had to spend half of its reserves to limit the rial’s depreciation during 1998 to 7 percent against the dollar. Only in early 1999 did the authorities allow a faster rate of depreciation, coupled with further interest rate tightening.

In light of sharply improved macroeconomic balances in the latter half of 1999, the central bank initiated a gradual lowering of benchmark interest rates. As a result, the rial showed a modest depreciation in real terms in 1999, reversing some of the appreciation of 1998.

Preserving the Oil Wealth: A Long-Term View of Yemen’s Fiscal Policy Stance

For oil-exporting countries, the management of finite oil wealth adds to the complexity of fiscal policymaking. Yemen derives a significant share of government revenue from oil exports and oil-related economic activity. Unless further exploration activities result in new discoveries, however, most of the country’s proven recoverable oil resources—estimated at 2.8 billion barrels in April 2000—will be depleted within 18 years.35Figure 1 in Section II showed the amount of crude oil accruing to the government, after subtraction of cost oil and the oil producer’s profit share, between 1990 and 2020. Under these projections, the government’s crude oil share was expected to peak in 2000 and drop steeply after 2009 with the exhaustion of the Marib field. Unless revenue from the non-oil economy replaces oil revenue in future years, achieving long-run sustainability implies saving a portion of today’s oil revenue in the form of financial assets, human capital, or infrastructure. In practice, it is highly uncertain whether spending the country’s oil wealth on education and infrastructure will boost growth sufficiently for the tax revenue generated from additional growth to sustain government spending.36

Fiscal policy decisions must rely on an estimate of oil wealth, that is, the present value of all future government revenue to be generated by extracting crude oil. However, calculating oil wealth at any given point in time is subject to considerable uncertainty. It depends notably on forecasts of future oil prices, oil production, and interest rates. Oil prices change in unpredictable ways. Statistical tests of their movements generally have difficulty rejecting the hypothesis that oil prices do not systematically return to a long-run average and that the current price is the best predictor of future prices.37 As a result, small changes in the current price could lead to large changes in estimated oil wealth, because a price change today would lead to revisions in all future prices. New information on oil reserves, extraction rates, and discount factors as well as technological developments also affect estimates of a country’s oil wealth and permanent income. Therefore, oil wealth estimates underlying long-run policy decisions must be adapted frequently to new information regarding prices, oil reserves, crude oil extraction rates, and long-run interest rates.

A simple rule to ascertain the long-run sustainability of consumption out of oil wealth can be derived from the permanent income theory of consumption.38 This rule prescribes that, in each period, governments should consume at most the real interest they receive on their total wealth.39 From the perspective of consumption possibilities, the permanent income model treats oil wealth and other forms of wealth as equivalent. Hence consumption in excess of permanent income would result in a decline in total wealth over time. In more practical terms, this concept of government wealth proxies the ability of governments to sustain current levels of spending in real terms. Preserving wealth thus means preserving the ability to deliver to future generations the same level of public services (health, education, and other services) available to the current generation.

The permanent income framework can be extended to account for growth of the population. Yemen’s annual population growth exceeds 3 percent. If the government aims at preserving wealth per capita, it must adjust its consumption for the expanding population. The reason for maintaining wealth per capita is that it allows keeping the same stream of income per capita over time and thus constant government expenditure per capita. If it is assumed that the population will continue to grow at 3 percent a year, the government needs to save an additional 3 percent of wealth each year to keep wealth per capita at the same level. Returning to the example above, at a 4 percent real interest rate with a population growing at 3 percent a year, Yemen should consume only 1 percent of its wealth each year and save the remaining 3 percent interest earnings to keep wealth per capita constant.

Apart from oil and financial assets, the non-oil sector provides an additional source of income for the government. Revenue generated by a non-oil sector that is expanding in per capita terms could over time replace revenue from exploiting oil. In allocating consumption over time, the government should thus take into account the expected future growth in non-oil revenue. However, additional non-oil revenue must be generated by growth in non-oil GDP per capita, not by an increasingly heavy tax burden. The latter would not reflect growing overall resources but would simply change the distribution of wealth between the public and the private sector. Growth of the non-oil sector could be driven by investment in infrastructure or human capital, as well as by increased factor productivity. However, as outlined earlier, such investment would have to generate tax revenue sufficient to replace oil revenue in order to sustain fiscal spending. Since the impact of infrastructure and human capital investment on tax revenue is indirect and therefore difficult to ascertain, the subsequent discussion is largely limited to the conversion of oil wealth into financial wealth.

To analyze past Yemeni fiscal policy from an intertemporal perspective, this section concludes with a few calculations, based on a permanent income framework, to estimate sustainable consumption on the assumption that the government keeps wealth per capita derived from oil constant over time. These calculations do not consider how future growth of non-oil GDP per capita could enhance the government’s revenue base (rather, they implicitly assume that non-oil revenue per capita remains constant), and thus they may understate sustainable consumption.40 Optimal consumption is derived in each year (starting in 1990) for the current and future years, assuming that oil prices remain constant at current levels. For example, optimal consumption out of oil wealth for 1998 is derived under the assumption that oil prices from 1998 onward remain at $11.90 a barrel, Yemen’s 1998 average oil export price. This assumption corresponds to the hypothesis that the cur-rent price is the best predictor of future prices, that is, that oil price shocks are permanent. Furthermore, the calculations assume that Yemen’s oil wealth is limited to the amount of proven recoverable reserve estimated today (2.8 billion barrels). Other important assumptions are a 4 percent real interest rate and a population growth rate of 3 percent in 1999, declining to 2.5 percent in 2005 and 1.5 percent in 2050. The calculations also incorporate Yemen’s initial net financial wealth, which is assumed to be equivalent to its foreign indebtedness. Under these assumptions, oil wealth at the beginning of 1999 stood at about 280 percent of 1999 GDP, or $1,080 per capita. Net total wealth, after subtracting external debt, was $13.3 billion, or $765 per capita.

The calculations show that, in the early 1990s, the level of consumption out of oil wealth, as a percentage of GDP, consistent with preserving oil wealth per capita was virtually nil. It would have been necessary to save almost the entire oil revenue to preserve wealth per capita, because population growth rates, partly reflecting the return of expatriates, were high and close to the assumed real interest rate of 4 percent. Moreover, the country entered unification with a debt stock of roughly $11 billion. As a result, sustainable consumption of oil wealth was only between 0.1 percent and 0.5 percent of GDP. There rescheduling agreement of 1996 reduced external debt by about one-third and, together with declining population growth rates and some what higher oil prices, permitted higher consumption out of oil wealth after 1996. Sustainable consumption levels rose to 1.8 percent of GDP in 1997. However, the example of 1998 clearly shows that revaluing oil wealth at current prices would necessitate large adjustments of consumption levels. The fall in oil prices in 1998 resulted in a drop in oil wealth, because future production is evaluated at current prices, and thus sustainable consumption fell to 1.0 percent of GDP in that year. Hence following the permanent income rule would result in sizable fiscal adjustments. At 1999 oil prices, oil wealth consumption of 2.4 percent of GDP would be sustainable. This level would rise to about 3.5 percent in the long run with the assumed decline in population growth rates to 1.5 percent.

The calculation of sustainable consumption out of oil wealth raises the question of how the government’s actual policies stacked up against that benchmark. For that purpose, budgetary outcomes must be translated into consumption out of oil wealth. The government budget constraint can be summarized as follows:

where OR stands for the total value of oil production accruing to the government, TR for tax revenue net of transfers (such as subsidies), A for net financial wealth, C for government consumption, and I for government net investment after subtracting the depreciation of existing capital. Transfers must include the subsidies for domestic petroleum products implied by charging less than world market prices, even if these subsidies do not appear directly in the budget.41 Moreover, investment figures must be adjusted for assumed depreciation. The equation can be rewritten as:

that is, government non-oil saving (the left hand side of the equation) equals the change in total public wealth (including financial wealth, infrastructure, and oil in the ground).

Hence, if non-oil saving were zero, total wealth would be unchanged—as prescribed by the permanent income framework for the case of zero inflation and zero population growth. Positive non-oil saving would be required for a growing population. The major difficulty in applying this concept ties in estimating net investment, because depreciation levels are unknown. To overcome this problem, only two extreme cases are discussed, providing upper and lower bounds. The first assumes that depreciation equals investment (that is, that net investment is zero), and the second that depreciation is zero (that is, that gross investment equals net investment).

In the event, consumption out of oil wealth between 1990 and 1999 was much higher than can be sustained. As Figure 8 demonstrates, the difference between optimal government non-oil saving and actual saving was large, between 10 percent and 25 percent of GDP. The results indicate that, under the assumptions made, Yemen has spent on average each year some 10 percent to 25 percent of GDP more than can be sustained, and that, up to today, oil revenue has not been converted into sufficient amounts of wealth to sustain such expenditure, even if all development expenditure is counted as net addition to wealth.

Figure 8.Government Non-Oil Saving and National Wealth

Sources: Data provided by the Yemeni authorities; IMF staff estimates.

Again, the analysis above is subject to great uncertainly regarding future oil and gas resources, as well as in its general assumptions. Yemen still has territory whose oil and gas potential remains unexplored, and future technologies could render currently inaccessible reserves available. Moreover, the large proven gas reserves, which could last for at least 25 years at a rate of LPG production exceeding 5 million tons annually, could prove another important source of revenue. However, developing the capacity to produce LPG is expensive and may produce limited revenue for the government until potential investors have recouped their costs. Another uncertainty surrounds non-oil growth and growth strategies: the analysis implicitly assumes that the return to the government from investing in financial assets will be higher than returns from investing in other assets. It ignores the fact that some government consumption, especially in health and education, has contributed to building human capital and thus potential future non-oil growth. This, in return, could boost future government revenue from the non-oil economy. Similarly, structural reform may eventually bring about positive TFP growth. However, despite increasing budgetary allocations to the education sector, the limited progress to date in improving social indicators, and low non-oil per capita growth, may indicate that too much oil wealth has thus far been used to support current consumption rather than the accumulation of human or physical capital.

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