Information about Middle East Oriente Medio
Chapter

IV Microeconomic Reforms

Author(s):
Nada Choueiri, Klaus-Stefan Enders, Yuri Sobolev, Jan Walliser, and Sherwyn Williams
Published Date:
May 2002
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In the 1960s the end of the reign of the imam in the north of Yemen brought about the establishment of a republic, which took first steps toward introducing a modern, market-oriented commercial and civil law. At the same time, the socialist government that took power in the south following the end of the British mandate established a legal regulatory system based on central planning and extensive government control over production. Thus the unification of the country in 1990 required the merging of two very different legal systems. The product was a complex and ineffective regulatory environment, combining elements of modern Western law with sharia and tribal law, and at the onset of the 1990s an array of controls covered all economic sectors. For a large set of commodities, prices were administratively fixed by the government, to keep basic consumer and input prices low and to suppress inflation.

As discussed in Section III, multiple exchange rates and interest controls were in place, the latter mainly to control credit in the economy. Quantitative import controls, such as bans and licensing, were used to protect domestic agricultural and industrial activities, while export bans (mainly on fish and unprocessed leather) aimed to maintain supply at low prices. Other laws allowed the government to enforce domestic and external trade monopolies. The Agencies Law and the Trade and Supply Law effectively protected certain monopolistic activities, and the government tolerated such private monopolistic structures as the trucking cartel (Ferzah) and the shipping agents’ cartel in Aden, or even supported such practices through entry restrictions in various forms. The Investment Law gave the government discretion to approve projects as well as wide-ranging control over their implementation. This economic and legal environment failed to attract much investment, especially foreign investment. Hence an important component of the reform program of 1995 was regulatory reform.

Foreign Exchange Regime and Foreign Trade Reforms

On July 1, 1990, the foreign exchange and trade systems of the former PDRY and the former YAR were unified using the system of the latter. However, as part of an attempt to contain growing financial imbalances through administrative controls, a complex system of segmented foreign exchange markets, ad hoc administrative measures aimed at curbing “speculative” activity, and wide-ranging trade restrictions was maintained through 1995.

The Foreign Exchange System

At the time of unification, the foreign exchange market in Yemen comprised official and parallel markets. The official market was limited to government external transactions and covered crude oil and petroleum products, official receipts and payments, and external debt-service payments. The official exchange rate applied to allocations of foreign exchange by the central bank to the private sector for imports of wheat, flour, rice, and LPG under government tender, as well as for special purposes such as officially approved medical treatment or study abroad. The central bank prepared indicative foreign exchange budgets in parallel with commodity budgets prepared by the Ministry of Supply and Trade, All other external transactions occurred through the parallel market, which was operated by money-changers and lacked legal status until January 1, 1993. At that time a law was enacted establishing regulations for money changing operations, including licensing, capital, and reporting requirements, with oversight powers assigned to the central bank. The law also established a parallel market oversight committee consisting of commercial banks, moneychangers, business community representatives, and an observer from the central bank.

Commercial banks operated in the foreign exchange market only as agents of the central bank and were permitted to buy or sell foreign exchange only for the accounts of their customers with the central bank. Their opening of foreign currency accounts for residents and nonresidents was subject to a long list of restrictions on the sources and uses of the funds. Commercial banks were prohibited from participating in the parallel market or from transacting with each other in foreign exchange and were required to use the official exchange rate in accounting and foreign exchange transactions with their customers.

At the time of unification, the exchange rate in the parallel market was YR1s 13 to the dollar, compared with YR1s 12 to the dollar in the official market. On April 1, 1991, the exchange rate for imports of wheat, flour, and rice was increased to YR1s 16 to the dollar; on January 1, 1992, the customs valuation rate for all imports (except petroleum products, wheat, flour, and at that time rice) was increased to YR1s 18 to the dollar. On May 1, 1992, an incentive rate of YR1s 18 to the dollar was introduced for purchases of rials by bilateral and multilateral assistance agencies and foreign embassies, as well as for imports by the government and public sector enterprises. All of these constituted multiple currency practices.42 On November 15, 1994, the parallel market oversight committee introduced an “official” parallel foreign exchange market for purchases of foreign exchange for self financed imports at an exchange rate of YR1s 84 to the dollar.43 The central bank enforced the official parallel market rate by mandating that commercial banks could open letters of credit only if the importer provided documentary evidence that the foreign exchange had been purchased at the official parallel rate. By the end of 1994 the free market rial had depreciated by 700 percent from its May 1990 level and stood at 103 to the dollar. In early 1995 the main official exchange rate was changed to YR1s 50 to the dollar (from YR1s 12), while the free market rate rose further to around YR1s 125 to the dollar. To limit the depreciation of the rial at the free market rate, the central bank from time to time suspended the operations of moneychangers, pushing foreign exchange transactions in the parallel market underground.

The exchange system was free of surrender requirements or taxes and subsidies on purchases or sales of foreign exchange. With the exception of local payments for hotel bills and airline tickets by foreign nationals, which had to be made in foreign currency, there were no prescriptions of currency requirements.

In January 1996 the authorities began a two-staged process of unification and liberalization of the foreign exchange market. In the first stage the official rial was devalued from 50 to 100 to the dollar, and all other official rates were eliminated (Figure 9). This rate continued to apply only to budget accounting, customs valuations, and transactions between the central bank and the Ministry of Finance. Commercial and specialized banks were allowed to participate fully in the parallel market, and foreign exchange regulations were amended to eliminate provisions inconsistent with free market operations. The prohibition on the issuing of letters of credit unless the foreign exchange was purchased in the official parallel market was eliminated, and the issuing of letters of credit for public sector enterprises and purchasing of foreign exchange from foreign oil companies was shifted from the central bank to the commercial banks. The government also eliminated the multiple currency practice related to wheat and flour imports by delinking the subsidy payment from the foreign exchange transaction.44

Figure 9.Nominal Rial-Dollar Exchange Rates

(In Yemeni rials to the dollar)

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

Following a short transition period under a dual rate system, full unification of the foreign exchange market was implemented on July 1, 1996, and an independently floating exchange rate regime was adopted. All government and central bank transactions, including customs valuations, began to use the unified market rate, thus completing the second liberalization stage by August 1, 1996. Finally, in December 1996 Yemen formally accepted the obligations under Article VIII, Sections 2, 3, and 4, of the IMF Articles of Agreement, and since then it has maintained a foreign exchange system free of exchange restrictions on current or capital account transactions.

The central bank is empowered to conduct exchange rate policy and aims to maintain an independently floating exchange rate regime by limiting its interventions in the foreign exchange market to the smoothing of volatility. If the central bank had intervened in the market between 1996 and early 2000(virtually always as a seller), it would have invited open bids from commercial banks and large moneychangers to buy dollars, and it would have sold to the highest bidder.

The Moneychangers Section of the central bank is responsible for the licensing and inspecting of moneychangers. The number of licensed moneychangers has declined from 260 in 1996 to 170 at present, of which 71 are located in Sana’a, A handful of large moneychangers account for up to 90 percent of transactions in the market. Moneychangers are not part of the banking sector, and their balance sheets are not included in the monetary survey, although their foreign exchange and rial accounts with commercial hanks are. Moneychangers are supposed to report their transactions volume to the central bank, but currently fewer than one fifth comply. Some of the moneychangers who have significant capital are reportedly involved in informal deposit taking and lending operations, which are not legal and are usually not recorded. The interest rate charged by moneychangers is estimated to include a premium of up to 15 percentage points over the lending rate quoted by commercial banks.

No firm data are available on the average daily volume of transactions in the foreign exchange market, but the underlying transactions for private current account activities are estimated by the central bank to be on the order of $1.0 billion to $1.5 billion annually on both the buy and the sell side. A fully functioning interbank whole sale market encompassing both spot and forward transactions among hanks and moneychangers has not yet developed.45 The retail spot market continues to be centered largely on the moneychangers, who provide easy and efficient transactions at very narrow spreads. According to central bank estimates, moneychangers account for about 60 to 70 percent of all transactions in the foreign exchange market; the commercial banks account for the rest. Currently there is no clearinghouse for foreign exchange transactions, but commercial banks are considering establishing one. as noncash instruments would then grow in importance, which would shift the balance in favor of commercial banks and away from the moneychangers.

All transactions, including those for budget accounting purposes, now use the market rate, although not all supply and demand for foreign exchange is channeled through the foreign exchange market; certain transactions go through the central bank. These mainly include oil export proceeds, foreign loans and grants, and public sector debt service payments, thus affecting the foreign exchange reserves of the central bank rather than the market rate. The central bank publishes its daily exchange rate by calculating an average from a sampling of rates from a group of large moneychangers and commercial banks; the central bank then uses this rate for its official transactions such as government debt service and budget accounting. Individual commercial banks usually call large moneychangers to sample the market rates that day and refer to them for their own transactions.

Both foreign and domestic banks are allowed to freely conduct all foreign and domestic currency operations. Effective January 15, 1996, commercial and specialized banks were required to observe prudential regulations regarding their currency exposure and to begin reporting their positions. Open positions (both oversold and over bought) are limited to 25 percent of the bank’s capital for all foreign currencies and 15 percent for any one currency. Banks report their daily open positions to the central bank at the end of each week, although the central bank checks only the last day’s position against the limit.

Foreign Trade

Upon unification, the foreign trade regime (adopted from the former YAR) was inward oriented, characterized by import prohibitions (through a positive import list 46 licensing, and a mean nominal tariff on the order of 27 percent. Virtually all imports required licenses from the Ministry of Supply and Trade, and the importation of certain products required the permission of particular government agencies.47 The annual commodity and foreign exchange budgets provided the basis for issuing import licenses. These budgets gave priority to imports of foodstuffs, medicines, petroleum products, and inputs for production. Imports of petroleum products were reserved for the YPC and the Aden refinery. Foreign exchange for both private and official transactions had to be purchased at the official exchange rate from the central bank, which also had to approve its availability.

Imports were subject to a customs duty under a tariff structure, which incorporated 15 bands with tariff rates ranging from 5 to 200 percent. In addition to the applicable customs duty, imports were subject to numerous taxes and surcharges, including an earthquake damage reconstruction tax, a Ministry of Finance surcharge, a Chamber of Commerce surcharge, and a Health Department surcharge.

Beginning August 1, 1990, the authorities permitted the self financing of licensed imports through foreign exchange obtained from the parallel market. A commercial bank guarantee equivalent to 2 percent of the value of the imports was required for an import license to be issued. Commercial banks were then authorized to open letters of credit for holders of import licenses, provided that the full foreign exchange value of the imports was deposited with a commercial bank. All importers holding an import license for wheat, flour, rice, or LPG could obtain the necessary foreign exchange from the central bank at the special official rate (see above), which also served as the customs valuation rate. In January 1991 the 100 percent import deposit requirement was reduced to 50 percent for commercial imports and to 25 percent for industrial imports; it was finally abolished altogether in January 1992.

In May 1993 the positive import list was replaced by a negative list, which included 63 categories of items competing with domestically produced goods. Import licensing remained in effect because of foreign exchange shortages. The government assigned priorities among import categories and granted licenses only up to a ceiling for each category. Export bans, such as the temporary ban on exports of fish in 1994, were imposed from time to time on commodities considered to be in short supply in the domestic market.

From January to March 1996, a comprehensive reform of the tariff and trade system was implemented; this was aimed at reducing effective protection, enhancing the economy’s allocational efficiency and growth prospects, and facilitating its integration into the world economy. The main elements of the reform included the following:

  • All import bans maintained for economic reasons were abolished except for those covering fresh fruit, vegetables, and coffee.48
  • All import licensing by the Ministry of Supply and Trade was eliminated except for wheat, flour, and petroleum products.
  • The 15-band tariff structure was replaced with a 4-band structure, with tariff rates of 5, 10, 15, and 30 percent ad valorem.49
  • The tariff reform was accompanied by excise tax harmonization where by excise taxes on industrial inputs and a production tax on local manufacturers applied uniformly to imported and domestic products.
  • A phaseout of import fees and surcharges was initiated, and by September 1997 all had been eliminated.
  • Duty exemptions for imports by the government and public sector enterprises were abolished.
  • No new discretionary project related import duty exemptions were to be granted except under the Investment Law.
  • All government controls over exports were eliminated except those in place for security, public health, religious, or environmental reasons.50

One month following the unification of the exchange system on July 1, 1996, the customs valuation rate was unified with the market exchange rate. To mitigate the one-lime price increase effect of the customs rate devaluation on politically sensitive imports, tariff rates were reduced at that time for imports of seven basic food items and medicines. In October 1997 the maximum tariff was further reduced by 5 percentage points, to 25 percent, and tariff rates on inputs for production were lowered from 10 percent and 15 percent to 5 percent. Tariffs for goods prone to smuggling were also reduced on a selective basis.

In March 1998 the government began a phased elimination of the remaining import bans maintained for economic reasons, replacing them with the maximum tariff. By the end of 1999 the importation of 14 categories of fruits and vegetables had been liberalized, and the remaining import bans were removed in 2000.

These trade reforms brought the trade regime closer to standard international rules. Consequently, in 1999 the government initiated the process of accession to the World Trade Organization (WTO), Following the granting of observer status at the WTO in 1999, the government is working toward full membership.

Under the reformed tariff structure, the mean tariff rate was reduced from 27 percent to 12 percent. This, together with the elimination of import bans, licensing, and other nontariff trade barriers, reduced Yemen’s trade restrictiveness index from 10 (closed or very restrictive) at the time of unification to 2(open) by the end of 1999 (Table 6).51

Table 6.Middle Eastern and North African Countries: Trade Restrictiveness Rating
Index

Rating
12345678910
OPENMODERATERESTRICTIVE
CountryDjibouti

Qatar

U.A.E
Bahrain

Yemen
MauritaniaKuwait

Oman
Saudi ArabiaJordanAlgeria

Lebanon

Pakistan
Egypt

Morocco

Sudan

Tunisia
Iran

Syria
Source: IMF, Trade Policy Information database.
Source: IMF, Trade Policy Information database.

Tax Reform

Taxes on Income and Profits

The 1991 income tax law specified an individual income tax with four brackets. Tax rates on wages, salaries, and rental income varied between 3 percent for the lowest bracket and 16 percent for the top bracket (22 percent for nonresidents). Because of high inflation, however, by the end of 1994 virtually all taxpayers were in the highest (16 percent) bracket, and the income tax had become essentially a proportional tax. Businesses were taxed at rates between 28 percent and 36 percent depending on proprietary, monopoly, and residency status.52 Under the 1991 code, individual taxpayers were taxed differently, depending on the source of income, and taxes from different sources were not aggregated. Moreover, income taxes suffered from the numerous exemptions in the 1991 Investment Law, In 1996 the income tax law was amended, and tax rates for corporations were unified at 35 percent. Single proprietors and partnerships continued to pay a flat rate of 28 percent. Further changes to the income tax law were introduced by presidential decree in early 1999. These amendments reestablished a progressive rate structure for personal income (including income from proprietorships) above YR1s 36,000. raised the top tax rate on wages and salaries from 16 percent to 20 percent, included foreign income in the tax base, simplified the depreciation schedule, and clarified the penalty regime.53 The authorities recognize that further adjustments to the income tax code are desirable to achieve a consistent treatment of income from different sources and restrict exemptions, and are therefore working toward a more comprehensive reform. Of particular importance are the integration of corporate and personal taxes to limit tax avoidance, the taxation of income from agricultural sources and rental income as regular income, the further simplification of the depreciation schedule, the clarification of international tax rules, the simplification of procedures, and the design of an effective penalty regime.

Taxes on Goods and Services

The 1991 law establishing a tax on production, consumption, and services (TPCS) consolidated numerous existing excise taxes. Despite its name, the tax originally covered only about 35 products, including qat (see Box 5 in Section VI), and tax rates varied between 5 percent and 40 percent, with imported goods taxed at double the rate of domestic goods. Specific excises were levied on petroleum products and cigarettes. In 1996 the tax base was broadened to about 100 goods and services, and the rate differentiation between domestic and imported goods was eliminated by presidential decree. The decree also established a limited tax credit mechanism to reduce cascading under the TPCS. Moreover, the specific taxes on petroleum products were converted to an ad valorem tax, mostly at a rate of 2 percent, and specific cigarette taxes were converted to ad valorem taxes at rates of 60 percent for domestic products and 80 percent for imported products.

The amendments introduced by decree were later altered by parliament (Law No. 4 of 1997), which reduced the number of goods and services covered by the TPCS. Additional minor changes in coverage were introduced by decree in January 1999. These related to the list of exempt goods, the tax base for certain imported goods, and confiscation of cigarettes.

Administration of the tax suffers from the multiple rate structure. In addition, the tax has limited revenue potential because of its restricted base. The authorities are therefore committed to replacing the TPCS with a broad-based value-added tax (to be called a General Sales Tax, or GST). A tax law providing for a 10 percent broad based GST with a strictly limited list of exemptions, a credit mechanism, and zero rating of exports was approved by the government in 1999 and is pending before parliament. The GST would originally apply only to all imports and to domestic sales of the 800 to 1,000 largest taxpayers, depending on turnover, A few excises on petroleum, tobacco products, and qat would remain in place under the cover of the TPCS.

Parliament removed stamp duties on banking and customs transactions in May 1998. Stamp duties had been applied to commercial and government transactions and based on their value. The application of customs and banking stamp duties was complicated, and the lost revenue was largely replaced by taxing services and imports.

Tax Administration

The authorities have taken several steps to improve revenue collection and lax administration. The most important was the introduction of a new taxpayer identification number (TIN) system. Although a TIN system existed before 1997, it suffered from shortcomings due to unnecessary codings. A new computerized pilot system allowing for online registration of taxpayers at several tax centers was recently introduced, and online registration was initiated in 2000. The new system will allow for a range of tax reports based on information in the taxpayer database. Customs clearance of imports now also depends on the presentation of a valid TIN. In addition, in 1997 the tax authorities introduced cigarette band rolls to improve identification of untaxed cigarettes. Moreover, through improvements in manual procedures, efficiency gains have been realized in the tax authority. Jointly with the introduction of a GST, the authority plans further reform steps. These include the creation of a large-taxpayer unit, which would handle all taxes, including income taxes and withholding taxes, paid by taxpayers above a certain turnover threshold. Further, the tax authority plans to modernize tax administration through self assess men t procedures, targeted auditing, and enhancement of services provided by the taxpayer services unit established in 1999.

Customs and Customs Administration

As previously noted, the 1990 customs law contained a complicated rate structure, with 15 rates ranging from 5 percent to 200 percent. Most imports were taxed at rates between 20 percent and 30 percent. Although the 1990 law already constituted a major simplification of preunification customs laws, it still gave rise to classification difficulties and disputes. Until the stepwise exchange rate unification in 1995–96, customs revenue was also affected by the application of the highly appreciated customs valuation rate. In 1996, as noted above, the tariff structure was simplified to four bands with rates of 5, 10, 15, and 30 percent; the top rate was reduced to 25 percent in 1997. The customs base also benefited from the step wise elimination of import bans in 1998 and 1999. Further amendments of the customs law are planned, to bring the regulations and valuation procedures in line with WTO specifications. Two of the import surcharges, the profits tax and the earthquake tax, were abolished by parliament in December 1998. Customs revenue also suffers from broad exemptions introduced through the Investment Law of 1991. That law exempts fixed assets for establishment, expansion, or upgrade of a project licensed by the General Investment Authority from all types of customs duties and taxes. It also provides for simplified customs procedures as soon as a project license is presented at the border.

Customs administration reform focused initially on procedures and regulations. Reforms covered the simplification of clearance procedures and the improvement of the functioning of the customs authority. Control of the authority over the arrival and exit of imports was strengthened, and payment of duties before release of goods was enforced. Further reforms included elimination of the deferment of customs duties, the improvement of controls over temporary admissions, and the development of new customs forms. With support from the United Nations Conference on Trade and Development, the customs authority is now working on introducing the ASYCUDA computerized customs system at three or four points of entry in 2001.

In spite of these reform efforts, enforcement of customs regulations remains difficult. The long coastline and (before the recent signing of the Jeddah border treaty) disputed borders led to major difficulties in controlling points of entry. In addition, the security situation was seen as necessitating a strong military presence at the border. To the extent that the sharing of responsibilities between the military and customs is ill defined, and because the military has little incentive to prosecute smugglers, border enforcement has been hampered. The declining share of customs revenue in imports likely reflects increasing smuggling and tax evasion.

Public Expenditure Reform

High levels of public expenditure were the root cause of unsustainable public deficits from 1990 to 1995. The major culprits were subsidies for wheat, wheat flour, and petroleum products, as well as the civil service wage bill. In the second half of the 1990s, the government took several steps to contain expenditure, particularly through changes in administered petroleum prices and the removal of subsidies for wheat and wheat flour imports.

Subsidy Reform

Until 1997, wheat and wheat flour subsidies constituted the government’s primary social safety net and transfer program. The subsidies were supposed to ensure impoverished families access to basic food items at low prices. However, according to World Bank staff estimates, only one third of the subsidies reached consumers; the rest was captured by importers, distributors, and smugglers to neighboring countries. Moreover, the poorest groups of the population benefited very little from the subsidies because they spent disproportionately less on wheat and wheat flour than did high-income groups.

Substantial petroleum product subsidies were also instituted to support the rural population. Subsidies for petroleum products other than diesel fuel have been substantially cut over time (Table 7). but diesel prices have remained unchanged since 1997, when an increase of YRI 1 a liter led to political unrest and wide spread rioting. Diesel fuel is used for rural transportation as well as agricultural machinery, particularly to pump ground water. But the diesel subsidy has caused large distortions in the Yemeni economy. Car engines designed for regular gasoline have been converted to diesel engines. Diesel-fueled pumps have depleted water tables rapidly, mostly to provide water for qat plantations, and richer households as well as many businesses have begun to generate their own power, imposing losses on the electricity company. The company has been losing its best customers, affecting its ability to cross-subsidize its poorest customers.

Table 7.Petroleum Products Prices Compared to World Market Levels (March 2000)(YRls per liter, unless otherwise slated)
Domestic

Retail

Price
Domestic

Wholesale

Price1
International

Wholesale

Price
International1

Domestic Price

Ratio
Gasoline3528.3532.130.88
Diesel106.4530.720.21
Fuel oil1310.0920.230.50
Kerosene1612.7631.800.40
Source: International Energy Agency, Oil Marker Report (March 2000); Ministry of finance; and IMF staff estimates.

Domestic wholesale price is, calculated by deducting from retail prices appropriate taxes and surcharges imposed for each product. International wholesale prices are actual average prices for February 2000, converted to rials at the current period-average exchange rate. (Gasoline prices are regular northwest Europe prices, while the other products are Mediterranean-based prices; fuel oil corresponds to the 3.5 percent sulfur type.) The International/Domestic Price Ratio is the ratio of the two wholesale prices. For example, the wholesale price for gasoline in Yemen in February 20O0 was 88 percent of the level of the international wholesale price.

Source: International Energy Agency, Oil Marker Report (March 2000); Ministry of finance; and IMF staff estimates.

Domestic wholesale price is, calculated by deducting from retail prices appropriate taxes and surcharges imposed for each product. International wholesale prices are actual average prices for February 2000, converted to rials at the current period-average exchange rate. (Gasoline prices are regular northwest Europe prices, while the other products are Mediterranean-based prices; fuel oil corresponds to the 3.5 percent sulfur type.) The International/Domestic Price Ratio is the ratio of the two wholesale prices. For example, the wholesale price for gasoline in Yemen in February 20O0 was 88 percent of the level of the international wholesale price.

From 1990 to 1994, subsidies for wheat, wheat flour, and petroleum products were implicit, resulting from the multiple exchange rate regime.54 Importers of wheat and wheat flour had access to foreign exchange at the official exchange rate, which at the end of 1994 was about one eighth the parallel rate. Likewise, imports of petroleum products and later sales to domestic refineries took place at exchange rates far removed from market rates. With the move to a unified exchange rate, those subsidies that had been implicit, reducing oil export revenue, have to be recorded explicitly on the expenditure side. Their magnitude became clear in 1996, when the explicit subsidy bill reached 13 percent of GDP after the exchange rates were unified. In addition to the explicit subsidies, there continued to be implicit subsidies through the application of non-market-based transfer prices in the domestic oil sector. In particular, the Aden refinery charged an additional $15 per ton of delivered petroleum products (raised to $17 in 1999) for transport services, part of which likely reflects a production subsidy.

Box 1.Reduction of Subsidies, 1995–99

Domestic prices of wheat, flour, and petroleum products in Yemen have traditionally been set administratively at prices well below market prices, involving large subsidies. After the unification of exchange rates in mid-1996, many of the subsidies that had been implicit, giving importers access to foreign exchange at non market rates, became explicit in the budget.

The subsidies created incentives against domestic wheal production and for the inefficient use of petroleum products (especially diesel fuel). They also encouraged smuggling of subsidized goods to neighboring countries. Moreover, the untargeted subsidies benefited all groups in society regardless of income and gave rise to rent seeking by importers and distributors.

In 1996, the government began to reduce the subsidy bill through several rounds of administered price increases. The wheat and flour subsidies, which by then had reached 7.5 percent of GDP and priced wheal and flour almost 75 percent below their world market prices (see table below), were eliminated entirely by mid-1999.

The decline in the world market price for oil in 1997 and 1998 affected oil and petroleum subsidies, which fell with the increase in administered prices, resulting in violent unrest. However, domestic prices, especially diesel fuel prices, which have been unchanged since 1997, did not keep pace with the increase in oil prices in 1999, and the subsidy rose to about 2 percent of GDP.

Republic of Yemen: Subsidies, 1995–99
19951996199719981999
Wheat and flour subsidy
In percent of market value of consumption173.765.350.59.2
In percent of GDP7.54.73.10.4
Domestic oil and petroleum subsidy2
In percent of market value of consumption185.348.912.010.627.0
In percent of GDP10.75.51.00.72.1
Sources: Ministry of Finance; and IMF staff estimates.

Evaluated at world market prices and parallel exchange rates.

Calculated as the difference between world market value at parallel exchange rates of domestic crude oil consumption and domestic oil revenue net of explicit budgetary subsidies. This calculation ignores the value-added by refining and the potential additional subsidy or tax implied by selling refined products below or above world market prices.

Sources: Ministry of Finance; and IMF staff estimates.

Evaluated at world market prices and parallel exchange rates.

Calculated as the difference between world market value at parallel exchange rates of domestic crude oil consumption and domestic oil revenue net of explicit budgetary subsidies. This calculation ignores the value-added by refining and the potential additional subsidy or tax implied by selling refined products below or above world market prices.

Reduction of subsidies has played an important role in the fiscal adjustment efforts of the government since 1995 (Box 1). Jointly with its move to unify the exchange rate, the government began to raise domestic petroleum retail prices in March 1995. Retail gasoline prices were raised by 100 percent, and fuel oil prices by 74 percent. Despite these increases, domestic whole sale prices (retail prices net of taxes and distribution fees) remained far below world market prices in 1995 (Figure 10). Gasoline prices were closest to world market levels, at about 60 percent, followed by fuel oil at 30 percent and diesel fuel and kerosene at 15 percent. Further substantial administered price increases of 58 percent (for gasoline), 100 percent (diesel fuel), 167 percent (kerosene), and 133 percent (fuel oil) took place from January through March 1996. These brought prices for gasoline close to world market levels but left diesel fuel, kerosene, and fuel oil heavily subsidized. Prices were raised again in 1997, 1998, and 1999, but the price for diesel fuel has remained unchanged since September 1997, as noted previously (Table 8). Owing to these measures, by 1998 gasoline prices were 80 percent above world market prices and allowed to cross-subsidize diesel fuel and, to a lesser extent, fuel oil and kerosene (Table 8). However, in 1999 rising world oil prices were not matched by equivalent price adjustments, leading to the reappearance of a substantial cash subsidy bill (see Table 5 in Section III). In 1999 the government also changed its transfer pricing system to charge world market prices for crude oil in its transactions with the domestic refineries, as explained in Section II. Sales to refineries are now conducted at export prices. Refineries charge world market prices to the distribution company for petroleum products (the YPC) plus a surcharge (see above). The YPC’s losses at the administered retail prices are covered by subsidy payments from the budget.

Table 8.Adjustments in Administered Retail Prices, 1994–99
Dec.Jan.Mar.Aug.Jan.Mar.Jul.Sept.Jul.Jan.Jun.
199419951996199719981999
(Percentage change in unit price)
Gasoline1005073040
Diesel10067
Fuel oil1741335718
Fuel oil232100405718
Kerosene167653157
Aviation fuel67150885
LPG2560503821
Electricity (average tariff)60161750
Wheat38150153025FL3
Flour38150112817FL3
Rice, milk, sugar, medicineFL3
Water120
Sources: Ministry of Oil and Mineral Resources; Ministry of Finance; and World Bank.

For electricity plants.

For cement plants.

FL stands for full liberalization.

Sources: Ministry of Oil and Mineral Resources; Ministry of Finance; and World Bank.

For electricity plants.

For cement plants.

FL stands for full liberalization.

Figure 10.Domestic Wholesale Prices of Petroleum Products1

(In percent of world market prices)

Sources: Data provided by the Yemeni authorities; and International Energy Agency, Oil Market Report (March 2000).

1 Wholesale prices are defined as retail prices net of taxes and distribution fees.

2 World prices are Mediterranean ex-refinery prices.

3 First quarter only.

Progress in removing subsidies in utility tariffs proceeded at a slower pace (Table 8). After a 120 percent increase in water tariffs and a 161 percent average increase in electricity tariffs in January 1996, small increases took place in 1997 and 1998 for the latter. Electricity tariffs have not been changed since then, however, despite the fact that, at the present level, the average tariff covers only about 90 percent of the average cost of production per kilo–watt-hour. The previous, opaque system of transfer prices and artificial exchange rates for domestic transactions led to implicit subsidies for consumers and utilities. Higher prices and the new settlement mechanism, combined with the price distortions favoring diesel generation of electricity, led to arrears of the electricity company in its accounts with the petroleum distributor. The government reimbursed these arrears, implying a subsidy to electricity consumption on the order of 0.4 percent of GDP in 1999.

Wheat and wheat flour subsidies were entirely phased out by mid-1999 through increases in administered prices. Small increases, ranging from 10 to 30 percent, took place between the second half of 1996 and January 1999, following a large increase (150 percent) in January 1996.55 The administration of wheat subsidies was complicated, giving rise to substantial rents for a few privileged import companies and distributors.56 The government gave importers access to foreign exchange at below-market rates such that the latter were wilting to sell at the administered prices.57 The government also negotiated distribution fees with distributors. Import contracts were distributed through a tendering system, which, however, was not transparent and generally invited bids from the same few companies. There was little competition among distributors.

As a result of the reductions in subsidies, the subsidy bill fell substantially over time, reducing pressure on expenditure. With rising domestic petroleum prices and declining differentials with world market prices, net domestic oil revenue (a measure that tracks domestic oil revenue net of explicit subsidies) rose from 1.8 percent of GDP in 1995 to 5.4 percent in 1999. Wheat and flour subsidies, which peaked at 7.4 percent of GDP in 1996, fell to 3 percent in 1998 and were completely eliminated in 2000.

Civil Service and Wage Reforms

Unification and the political and economic events that followed resulted in a large, partly redundant, and poorly paid civil service. In 1990, the civil services of the YAR and the PDRY were merged, and the pay scale for southern civil service employees was adjusted to the higher levels prevailing in the north. With the return of expatriates and reinstatement of the policy of hiring all university graduates. The civil service (excluding public enterprises) grew from 168,000 in 1990, to 322,000 in 1995, to 336,000 in 1998. As a share of the total population the civil service rose from 1.3 percent in 1990 to 1.9 percent in 1998, as estimated by the Ministry of Civil Service and Administrative Reform. An estimated additional 83,000 were working in public enterprises in 1998. Most civil servants are employed in the education sector, followed by the health sector and general administration (Table 9). High inflation eroded real civil service wages substantially from 1994 to 1997. Although this helped reduce the wage bill from almost 11 percent of GDP in 1993 to 6 percent in 1997, it also left Yemen with an under qualified, underpaid, and over staffed civil service that fell short of delivering adequate services to the population.

Table 9.Distribution of Public Employees by Sector, 1998
SectorEmployeesTotal Percent
Education223,36853
Health33,3268
General administration33,0068
Construction21,7515
Manufacturing15,8034
Other92,15322
Total419,409100
Source: MOSCAR Employee Database
Source: MOSCAR Employee Database

The government has recently initiated a comprehensive civil service reform program aimed at reducing the size of the civil service through retrenchment and retirement, to allow higher pay increases for the remaining work force. The program also envisions are structuring of public administration, beginning with six pilot ministries, the introduction of a new grade structure, and minimum qualifications for each job.

Several steps in the reform program have been implemented. In 1998 a civil service census identified all civil servants by age, occupation, length of service, and other characteristics. The census also identified possible double dippers and overage workers, to prepare the way for future reductions in staff, and it established a database allowing computer-based management of the civil service. The civil service ministry has also begun to issue employee identification numbers. A Civil Service Fund (CSF) was created by presidential decree in January 1999; supported by World Bank financial assistance, the CSF will continue to pay laid-off public workers for a certain period.

Despite these preparations, however, no progress was made in reducing staff or containing the wage bill. The retirement of overage workers (estimated at 24,000) was delayed through the end of 2000; however, in February 2001 a total of 14,000 overage workers were retired. Since the CSF was not yet operational in early 2000, the so-called at-home workers, who were supposed to be the first group transferred to the fund, remained on the government payroll. Hiring continued at a level of 20,000 people in 1999; given that there were about 2,000 retirees, this amounts to a net addition of 18,000 civil servants. Average wages continued to rise by more than 20 percent in 1998 and 1999, largely owing to a bill passed by parliament that granted a 100 percent wage increase for teachers and health workers in 1998—2000. As a result, the civil service wage bill rose from 6 percent of GDP in 1997 to 7.5 percent in 1999. Moving ahead with retrenchment and organization will therefore be essential for progress in refocusing government expenditure.

Other Expenditure Reforms

Since 1994 the Yemeni government has reduced its defense spending. At unification, total defense expenditure stood at 8.4 percent of GDP, over 80 percent of which went to pay salaries. During the first years of unification, defense spending remained high, peaking at 9.7 percent of GDP in 1994 during the civil war. Starting in 1995, however, expenditure began to fall, reaching 5.8 percent of GDP in 1999, At the same time, in parallel with the overall decline of the civil service wage bill, military wages declined as a share of total defense spending.

Development expenditure remained volatile because it served as a first resort for expenditure cuts in difficult times. In the years immediately after unification, the government spent more than 8 percent of GDP for development. However, with financial difficulties emerging in 1991, development spending made up less than 4 percent of GDP. This declined further to 2.6 percent of GDP in 1994. With budget pressures easing after the unification of exchange rates and the rise in oil revenue, the government sharply increased development spending to more than 6.5 percent of GDP in 1996 and 1997. However, because development projects are among the few discretionary items in the budget, the drop in oil prices in 1998 and continuing low prices in early 1999 led to cutbacks in spending, to 6.1 percent and 5.6 percent of GDP, respectively.

Between 1990 and 1997, government interest obligations fluctuated between 2 and 3 percent of GDP. Domestic interest payments, which in that period were recorded net of central bank profit transfers, remained between 1 and 2 percent of GDP, with the exception of 1994. External interest obligations remained in the same range. In 1996 obligations were particularly high because the first Paris Club rescheduling agreements required the settlement of some deferred interest payments. In 1998 and 1999, after the Paris Club agreements took full effect, foreign interest obligations were only about 1 percent of GDP. Domestic interest payments have been recorded on a gross basis since 1998 and rose from 2.5 percent in that year to 3 percent in 1999, reflecting rising interest rates in the wake of tight monetary policy.

Social indicators in Yemen point to major deficiencies in human development. For example, Yemen has the highest fertility rate, the highest maternal mortality rate, and the highest infant mortality rate in the Middle East and North Africa region (see Section VI). The public sector is the major provider of basic social services, particularly health services. The Ministry of Public Health (MOPH) administers more than 2,200 public health facilities, including about 100 hospitals, 500 health centers, and 1,600 health units. In addition, two hospitals outside the MOPH structure receive direct allocations from the budget. The MOPH employs more than 30,000 people, including 3,800 physicians and 9,400 nurses. However, health services are distributed unevenly among regions and between rural and urban areas.

Spending on education and health has been on the rise since 1996, the first year in which data on these expenditures were compiled. In that year education expenditure was 3.5 percent of GDP and health expenditure I percent of GDP. Seventy percent of education spending and 41 percent of health spending were for wages and salaries. Spending on education rose sharply after 1996 and reached 7.4 percent of GDP in 1999, with 61 percent going to wages and salaries. Thus, although the wage bill has grown more slowly than total allocations to the education sector, the share of wages remains high. In contrast, the share devoted to materials and services fell between 1996 and 1999, from 17 percent to 13 percent. Development expenditure, largely consisting of school construction in rural areas, therefore took an increasing share of education expenditure. Health expenditure increased much less rapidly, to 1.3 percent of GDP in 1999. Wages and salaries continue to take up about 40 percent of this spending.

Yemen appears to spend less on the military than some other countries in the region, but also less on education and health (Table 10). Some of these comparisons should be interpreted cautiously, because of different definitions across countries. Nonetheless, measured as a share of GDP, military and security expenditures in Saudi Arabia, Oman, and Jordan were much higher than in Yemen during the 1990s. Of the countries in the table, only Egypt shows a considerably lower ratio of military spending to GDP than Yemen. As a result of the sharp rise in education spending since 1996, Yemen now spends a considerably larger percentage of its GDP on education than Oman, but a smaller share than Saudi Arabia spends on educational staffing alone (including vocational training). Health spending remains quite low in Yemen in this regional comparison: Yemen’s 1 to 1.4 percent of GDP is lower than spending in Oman (2 percent of GDP) or Saudi Arabia (3 percent of GDP), but higher than that in Egypt.

Table 10.Regional Comparison of Expenditures on Defense, Education, and Health, 1994–98(In percent of GDP)
19941995199619971998
Defense
Yemen9.76.75.66.06.1
Oman115.614.512.512.412.4
Saudi Arabia29.710.08.79.710.3
Jordan13.414.415.316.017.5
Egypt3.33.23.12.92.8
Education
Yemenn.a.n.a.3.54 67.0
Oman3.13.12.93.03.4
Saudi Arabia38.47.88.08.89.9
Jordan4n.a.n.a.n.a.4.4n.a.
Egypt2.93.43.33.53.9
Health
Yemenn.a.n.a.1.01.01.4
Oman2.02.01.91.92.2
Saudi Arabia52.62.32.62.93.3
Jordan4n.a.n.a.n.a.3.0n.a.
Egypt0.60.60.70.70.8
Source: Various Recent Economic Development reports.

Includes security expenditures and capital expenditures.

Includes health expenditures.

Manpower expenditures.

The amounts reported for 1997 reflect only direct budgetary spending by the central government and exclude some transfers.

Social development, including health, social welfare, and labor affairs.

Source: Various Recent Economic Development reports.

Includes security expenditures and capital expenditures.

Includes health expenditures.

Manpower expenditures.

The amounts reported for 1997 reflect only direct budgetary spending by the central government and exclude some transfers.

Social development, including health, social welfare, and labor affairs.

Budget Management Reform

The budget management reform program attempts to address shortcomings in budget formulation, budget execution, and budget control mechanisms. Budgets were traditionally prepared without regard to a macroeconomic framework or financial limits, leading to a less-than-optimal budget process that failed to address priorities. Indeed, the Ministry of Finance did not follow macroeconomic developments or prepare a macroeconomic framework. Budget execution is cumbersome because each ministry and each independent government agency has three accounts at the central bank: one for current expenditure, one for development expenditure, and one for revenue. Until 2000 the ministry could follow account movements but had no more detailed information about expenditure. Budget control suffers from a clear system of guidelines and procedures as well as weaknesses in independent auditing.

The first phase of an IMF- and UNDP-supported technical assistance program resulted in improvements in budget preparation and accounting procedures. The 2000 budget was prepared with a revised circular and was based on a macro-economic framework. It also followed the classification of the IMF’s Government Financial Statistics Yearbook. Budget reports are now regularly requested in standardized format from budgetary units. The accounting software at the central bank, which executes the treasury functions of the Ministry of Finance, was modified to a two-level classification (budget chapter and subchapter) in 1999. Recently, a deputy minister was appointed to head the new macro-economic studies unit, and its staffing has begun. This unit will track and forecast revenue and expenditure and prepare a basis for a medium-term budget framework.

Reform of the Regulatory Environment

A number of traditional rules and practices in the Yemeni economy effectively sheltered producers from competition and protected monopolies in various sectors. Such obstacles to market entry likely contributed to relatively weak economic growth and job creation outside the oil sector. The government has recently initiated a number of reforms in this area—such as overhauling the Investment Law. The Agencies Law, and the Trade and Supply Law—but is also preparing for the privatization and liberalization of monopolistic activities in the airline and telecommunications industries. The government has also established the Aden Free Zone, where deregulation seems to have taken place at a faster pace, albeit with modest results (Box 2).

The current Investment Law (Law No. 22 of 1991) aims at regulating and promoting the investment of domestic and foreign capital in Yemen. It determines the sectors in which such investment may take place and the procedures to be followed to obtain legal authorization to undertake a business enterprise. It establishes the guarantees and benefits to be accorded to projects, including tax and customs duties and exemptions, and extensively elaborates on the rights and obligations of investors in their foreign exchange transactions. Many features of the law likely deter potential investors. For example, the General Investment Authority (GIA) is granted a high degree of control in approving projects through licensing; in having access to annual balance sheets of projects, which investors are obligated to provide; and in micromanaging aspects of the disposal of property associated with terminated projects, including controls on foreign exchange transactions related to licensed projects. The law limits the kind of commercial activities that may be undertaken within a particular project, and it provides a potential shelter for local production by allowing the imposition of additional customs duties on inputs used in the execution of some projects.

Box 2.The Aden Free Zone

Aden was once one of the world’s top ports for ship bunkering and transshipment warehousing. About 7,000 vessels a year used its facilities in the 1950s and 1960s. But the closing of the Suez Canal from 1967 until 1975, the security problems in the region that followed, and changes in international cargo routes led to a sharp decline in business and loss of prosperity. Shortly after reunification, the government decided to initiate a development program for Aden, based on creation of a free zone, to restore some of its former importance.

With Aden’s attractive location on the main shipping route between Asia and Europe, the Aden Free Zone and the Aden Container Terminal (ACT) offer a distance advantage over many other ports in the region. The free zone could provide an international gateway to businesses on three continents, provided it can compete with the several other free zones in the region. The development of modem transportation facilities and infrastructure in and around the free zone could spur regional trade, business opportunities, and economic growth.

The Yemen Free Zones Public Authority (YFZPA) was established in 1991 to develop the free zone in Aden and to grant concessions and regulate development. The free zone, covering approximately 31,000 hectares within the Governorate of Aden, was established in 1993. In 1995 Yeminvest, a joint venture between Port of Singapore Authority Corporation Ltd. (PSA) and Yemen Holdings Ltd. (a Saudi-owned company), was awarded exclusive rights to develop the ACT and the industrial estate of the free zone. PSA currently holds 60 percent of the project.

The beginning of operations of the ACT on March 19, 1999, marked the completion of the project’s first phase, which gives the port a handling capacity of 500,000 twenty-foot equivalent units (TEUs) annually. This phase included the construction of two berths and a 700-meter quay wall, as well as dredging the harbor channel and berths to 16 meters. The second phase of the project will include the construction of an additional 325 meters of quay with a terminal capacity of up to 1.5 million TEUs annually. Future plans include expansion of the Aden airport and of tourist facilities.

As of mid-1999 the YFZPA had received 653 local, Arab, and international applications to invest in the new free zone, for a total value of $1.5 billion. These applications range across the industrial, storage, commercial, and tourism industries. However, apart from shipping through the ACT, no projects in the free zone have yet started, and even in the ACT activity remains far below the terminal’s capacity.

Besides stipulating the formation of a “competent court” in the free zone, in compliance with the judiciary law in force, to settle disputes (in the spirit of commercial law in the United Kingdom), the free zone law provides various investment incentives. These include exemption from taxation on industrial and commercial profits for 15 years (with a possible additional 10 years); the possibility of 100 percent foreign ownership; free transfer of capital and profits outside the zone; and exemptions from income tax on salaries, wages, and bonuses of non Yemeni employees working on projects in the zone.

A major reform of the Investment Law was initiated in mid-1999. Amendments, to be considered by parliament shortly, aim at making the law more transparent and at streamlining the procedures for registering investment projects and carrying out related financial transactions. In particular, investment licensing by the GIA is to be eliminated and replaced by a simple registration process; equitable treatment of all investment projects is to be ensured; tax exemptions are to be streamlined and clarified; and controls on foreign exchange transactions related to projects registered under the law are to be liberalized.

Entry restrictions were also implicit in the original Agencies Law (Law No. 36 of 1992), aimed at regulating the establishment of commercial ventures between foreign companies and Yemeni representatives (which must be locally owned companies registered with the Ministry of Supply and Trade). The law made it illegal to act as an agent for a foreign supplier without a license, which must be renewed annually for a fee. Enforcement was in large part achieved through import licensing: licenses were not issued to importers who were not approved agents of foreign companies. In its original form, the law gave discretionary powers to the ministry in the granting of licenses and in allowing import activities without the agent being approved. This led to effective enforcement and protection of import trade monopolies. Amendments to this law decreed in 1997 and 1999 redefined the government’s authority and should ensure a more competitive environment for these activities.

Similarly, the original Trade and Supply Law (Law No. 24 of 1990) effectively allowed the government to mandate and enforce prices in the private sector, with the purpose of guaranteeing a stable supply of basic commodities and avoiding overpricing and monopolies. It also aimed at supervising trade activities in the private sector to avoid disruptions in supply, in the spirit of a centrally planned economy. Amendments decreed in 1998 removed the authority of the government to set prices except for a limited number of basic commodities. Moreover, a law to promote competition and prohibit monopolies and commercial fraud was recently issued by presidential decree (Decree No. 19 of 1999). It includes explicit provisions for the market determination of prices of goods and services and for preventing collusion among producers. It calls for the establishment of a Competition Promotion and Anti Monopoly Authority within the Ministry of Supply and Trade with the purpose of identifying and eliminating monopolistic practices and activities that disrupt the competitive operation of markets.

Transport and Communications

The transportation sector has long remained under the control of various state monopolies (such as the National Shipping Company in the Port of Aden, the Yemen Navigation Line, the General Land Transportation Company, and Yemenia, the state airline) and consequently plagued by inefficiency. The government set tariffs in all areas of transport services and kept the provision of all related services under its control through licensing requirements. Under the economic reform program, privatization and liberalization of land and maritime transport and, to some extent, air transport have been initiated.

In particular, a draft Surface Transportation Law, approved by the cabinet in 1999, calls for establishing a General Land Transport Authority, in charge of granting trucking licenses and posting suggested tariffs, a practice intended to replace administrative tariff setting by the government. By laws specifically regulating the trucking sector have already been issued, allowing any trucker to obtain a license for operation, valid anywhere in Yemen.58 Previously, the trucking industry was controlled by the (private) Ferzah cartel, which kept transport costs high through price fixing and preventing free entry, as well as by preventing private sector producers and traders from providing their own transport. Although the regulations recently introduced do not abolish the cartel, the government’s intention is to provide a competitive environment by allowing other truckers to enter the market.

Progress in other parts of the transport sector includes the liberalization of stevedoring and the privatization of the National Shipping Company. However, the latter led to the establishment of a cartel of shipping agents at Aden, supported by the government in exchange for the absorption of former public sector employees by these agents. In the air transport industry, privatization of ground handling operations is on hold until the exclusive right of Yemenia to provide these services expires in 2001.

Deregulation of the telecommunications industry is only at an initial stage. The Public Telephone Corporation (PTC) has a monopoly on local services. International services is another monopoly, controlled by Tele Yemen, a joint venture between PTC and a U.K. company; its status was renewed for four years in 1999. The only liberalization currently taking place is in the market of mobile services: the government recently tendered two cellular telephone (GSM) licenses, and a few offers were received, but no decision has yet been reached. Although these licenses will break the monopoly enjoyed by TeleYemen in the mobile sector, GSM providers will still have to go through TeleYemen to ensure international communications services to their customers.

Judicial Reform

Reform of the judicial system and, in particular, the functioning of the commercial courts has been initiated. Problems in the way courts were run, records kept, cases processed, and judgments enforced were increasingly recognized as important obstacles to private investment. Moreover, tribal affiliations hindered the administration of court decisions, and lack of adequate staff and judges’ absenteeism rendered the process slow and inefficient. To address these issues, the government in recent years has consolidated jurisdiction over the administrative functioning of the courts in one ministry with a view to streamlining the process to reduce the backlog of pending cases. It also created a special unit to monitor the courts, organize the training of judges, and provide technical assistance on legal issues, and in early 2000 it started publication of judgments issued and the reasoning behind them.

The current Land Law also presents obstacles to investment. The system for land registration and proof of ownership is considered ineffective, and indeed, the majority of litigation cases in Yemen are related to land ownership disputes. Yemen uses the registration of deeds system in recording land ownership: a deed, registered by a public officer and with copy held in a registry, testifies to ownership. Land registration is governed by Law No. 12 of 1976, which many experts consider ambiguous and ineffective.59 Consequently, many land sales are currently transacted without registration, partly to avoid paying the sales tax and the zakat tax (a tax funding charitable services by mosques), but also because the parties often have little confidence in the Land Registration Authority, the government body in charge of applying the law. Major problems in certifying ownership arose after unification, leading to the issuance of Decree No. 65 in May 1991 to ensure the return of land in the south to its lawful owners. The decree was not adequately implemented, however, and appears to have led to several instances of land grabbing and corruption. Steps being taken to help remedy the shortcomings in the Land Law include the formation of an interministerial committee, which is currently working to streamline procedures for proving clear title and registration for all properties that will be privatized pending a broad review of the law.

In a step to improve the overall legal environment, the authorities plan, with support from the World Bank, to carry out a diagnostic assessment of the overall legal framework governing economic activity; an awareness campaign on the importance of the law in a democratic society is also being planned. In addition, a steering committee was formed in early 1999, involving both private sector and government institutions, to review the regulatory structure and administrative procedures for trade and investment and assess the obstacles to private sector investment. This committee is expected to make recommendations on further reforms needed to increase efficiency and transparency in the regulation of private sector activity.

Privatization

In early 1995, following the end of the civil war, the government initiated the privatization of public enterprises in various sectors of the economy, including industry, tourism, agriculture, fishing, transportation, oil, trade, and finance. In order to identify the enterprises to be privatized, a census was compiled in mid 1996 listing a total of 192 enterprises, of which more than 110 were located in the formerly socialist south. These public enterprises, employing over 86,500 employees (more than 25 percent of the civil service at the time), inefficiently run and sometimes even shut down, constituted a heavy burden on the budget, as operational losses had to be covered by budget transfers or the accumulation of arrears.

Over 1994—97 nearly 70 small enterprises were privatized; these included 16 tourism enterprises (8 of which were leased to private operators, and 8 privatized by restitution to the former owners) and 53 other properties, most of them agricultural units returned to their original owners. In the absence of a general strategy and a strong institutional framework, these privatization operations were mainly conducted at the discretion of the ministries involved and in an ad hoc manner. Ministries independently established their own internal committees to privatize or liquidate some of the enterprises under their jurisdiction.

The Technical Privatization Office (TPO) was operationally established in 1996. In cases where the TPO was in charge of privatization, the ministerial committees still participated in each step of the process (such as approving the short list of consultants and the report eventually submitted by the chosen consultant). Delays were sometimes encountered in bringing the committee members together and obtaining their inputs. During 1998 and most of 1999, privatization operations were largely put on hold while the government put in place an overall legal framework to conduct these operations in a more systematic and transparent way.

After a long gestation, a Privatization Law was promulgated in November 1999, aimed at organizing and unifying privatization procedures across state owned economic units. That same month the World Bank approved a project for financial and technical assistance to the privatization program. The Privatization Law called for the establishment of a High Commission to ensure the implementation of standardized, unbiased, and transparent privatization procedures. The High Commission was established in December 1999 and held its first meeting in June 2000. It is chaired by the prime minister; other members include the ministers of planning, finance, legal affairs, and state. It is expected to provide policy oversight of the privatization program, approve transactions and program designs, and appoint temporary executive board members to the state owned units approved for privatization. A reestablished TPO is expected to act as a secretariat to the commission, coordinating the whole program. Its functions include formulating privatization strategies (mostly by way of carrying out studies and reviewing proposals) and monitoring their implementation. Monitoring operations entail, for example, the provision of advice and assistance to individual ministries in carrying out privatization transactions as well as the preparation of necessary documents and contracts and coordinating with all concerned institutions such as labor unions.

In addition to these two bodies, the law stipulates the establishment of temporary committees representing each concerned ministry and/or its economic unit approved for privatization.60 Each committee would participate in the privatization of the concerned enterprise, under the supervision of the High Commission and in coordination with the TPO. Although the sector ministries will have responsibility for carrying out the privatization of small and medium-size enterprises in collaboration with the TPO, full authority for approving large privatization transactions remains with the High Commission.

According to the Privatization Law, any person—whether a Yemeni citizen or a foreign national—is eligible to buy or lease the units offered for privatization, and sufficient land will be provided for the investor with the winning bid to conduct the activities of the privatized enterprise, either on a lease or on a sales basis. The terms negotiated between the government and potential investors will also cover the number of employees to be retained, and the conditions offered to these workers (salaries, bonuses, and other benefits) must be at least as good as those they currently enjoy. Those employees that the investors choose to keep would be guaranteed their jobs for a minimum of five years, and the remaining workers would be transferred to the CSF. Although this provision is intended to protect the workers, many observers fear that, as a result, investors will agree to take on only a small number of the existing employees, to avoid being locked into long-term contracts. Privatization proceeds are to be deposited with the central bank, in a special account earmarked to finance economic and social development projects.

Privatization strategies for each of five large enterprises have already been prepared and endorsed by the government, including implementation steps and schedules. For the Aden Refinery Company, new shares would be issued in return for capital contributions by investors, and an internationally recognized refinery operator would be attracted to ensure expert control over the enterprise. The privatization of Airport Ground-Handling Services is also projected to result in a joint shareholding and/or re venue-sharing venture between the government and the private sector. Privatization of the General Land Transport Company is expected to start with strategic restructuring, with the aim of creating a joint-stock limited liability company, partly funded by the government and potentially also by employee stock ownership. The Yemen Corporation for Cement Production and Marketing and the Yemen Drug Company will be privatized through issuing shares to strategic investors and selling government equity.

Quantitative estimates of the impact of the privatization program are available only for the fiscal impact of the large-enterprise component of the project. These estimates indicate that the privatization of these five units would result in net sales proceeds of about $20 million (about 0.3 percent of GDP) and that in the medium term an annual flow of $62 million (0.8 percent of GDP) would accrue to the budget in the form of taxes and dividends from the privatized enterprises. The emergence of new competitors in airport ground-handling services, land transport, and cement production and marketing could generate another $7 million in annual flows to the budget.

In the financial sector, all five state-owned banks are earmarked for liquidation, restructuring, or privatization under the government’s reform program. Privatization of the Housing Bank was recently turned over to the TPO.

Financial Sector Reforms

Reforms in the Banking System and in Bank Supervision

In the period between unification and the end of 1994, the authorities’ efforts regarding the financial system were focused on unifying the financial structures of the northern and southern parts of the country. (Box 3 describes the current status of the banking system.) Largely reflecting the lack of consensus and coherence in government and the civil service, little progress was made in achieving positive real interest rates and taking steps to stop financial disintermediation. Genuine financial sector reform did not begin until early 1995 as part of the economic reform program. At the start of this process, the authorities tackled interest rate reform and reform in the area of bank supervision, both of which produced quick and quantifiable results.

Interest rate reforms initiated in 1995 entailed the freeing of all lending rates, the elimination of concessional loan rates, and the establishment of minimum benchmark commercial bank savings deposit rates. The benchmark rates were set at high levels in view of the excess liquidity situation and the general reluctance by banks to attract new deposits. These rates were later adjusted in light of macroeconomic conditions, maintaining positive real rates most of the time (Section III).

Box 3.The Yemeni Banking System

The Yemeni banking system comprises the Central Bank of Yemen, 13 commercial banks, and 3 specialized state-owned development banks. The commercial banking sector is made up of three privately owned domestic banks, four privately owned foreign banks, two state-owned banks, and four Islamic banks. The structure of the banking system has been broadly maintained since unification, with the exception of the Islamic banks, which were established after 1995.

At the end of 1999 the assets of the commercial banks totaled YRls 233 billion ($ 1.5 billion), equivalent to 22 percent of GDP. The largest bank, with 37 branches and over 20 percent of commercial bank assets, is the Yemen Bank for Reconstruction and Development (YBRD), in which the government has a majority share. The YBRD is heavily undercapitalized and has a large portfolio of nonperforming loans; the bank is being restructured with the objective of bringing it into full compliance with prudential regulations. The government also fully owns the National Bank of Yemen, which was the only commercial bank in the south before unification. This bank will be put up for sale in the near future.

The four privately owned foreign banks are all fully owned branches of banks with headquarters in France, Iraq, Jordan, and Pakistan. Of the three privately owned domestic banks, one is a joint venture with Saudi Arabian banks, with the local owners holding 75 percent. The four Islamic banks began operations between 1995 and 1998, and thus far their share of commercial bank assets is about 8 percent.

The three specialized banks were established to promote agriculture, housing, and industry. All three, but especially the Industrial Bank of Yemen, have been burdened for years with a large portfolio of nonperforming loans. An interministerial committee was recently formed to liquidate this bank.

The banking system as a whole is relatively weak, as reflected at the end of 1999 in a high ratio of nonperforming loans (17 percent of the total), low capitalization (a nonweighted capital adequacy ratio, or Cooke ratio, of 5.2 percent), and significant provisioning shortfalls. These problems are particularly acute for the public sector banks, which hold about one-third of total bank assets.

A number of other problems beset the banking system. Concentration is high: almost 70 percent of both deposits and loans are with the top four banks, and banks are generally located only in a few cities. Cash is the predominant medium of exchange, as reflected in a low ratio of quasi-money to broad money. Banks have generally maintained excess reserves for years, reflecting their reluctance to lend outside of a narrow group of borrowers, in the absence of effective legal recourse for timely recovery of nonperforming loans.

A number of actions by the authorities are aimed at improving the banking environment. The Banking Law of 1998 and subsequent central bank circulars have addressed such problem areas as credit concentration, insider lending, and use of overdraft facilities. Measures have also been taken to improve the operations of the commercial courts, and the central bank is enforcing a notification system under which delinquent borrowers are disqualified from receiving new loans. The new central bank law gives the central bank more independence to perform its role as supervisor of the banking system and to resist open-ended financing of the budget. A recent World Bank assessment revealed that Yemen’s banks were either compliant or largely compliant with 10 of the 24 Basle core principles.

In order to improve financial intermediation, reform of bank supervision was also launched in 1995 (Box 3). From early 1996 on, banks were required to report their foreign currency positions, and by the end of 1997 the minimum capital requirement was doubled to YRls 500 million. During 1996–97 the central bank issued a number of circulars related to risk management, loan classification and provisioning, foreign exchange exposure, and external auditing. Provisioning requirements were set at 15 percent for substandard loans (those 90 days past due), 45 percent for doubtful loans (180 days past due), and 100 percent for bad loans (more than 365 days past due). Also, the banks were required to maintain a minimum capital adequacy ratio of 25 percent of total assets, and standards for new audit procedures and terms of reference for external auditors and risk management standards were established. The law governing the operations of moneychangers was amended so that moneychangers had to be licensed by the central bank, and provisions inconsistent with the operation of a free market were eliminated.

Adoption of a new banking law in 1998 established a more solid legal basis for the central bank to address prudential concerns, and in particular to set limits on credit concentration and insider lending. Thus in 1999 the central bank started to lay down clearer operational rules in the areas of credit concentration, insider lending, and use of overdraft facilities. To address the problem of concentration of credit among a small number of companies and groups of companies, a circular was issued limiting total credit to such entities to 15 percent (25 percent under certain circumstances) of total paid-in capital and reserves. If the central bank determines that the interests of two or more groups of persons are so intermingled that they should be considered as one, the liabilities of the two groups are combined and considered as a single liability.

To address the problem of insider lending, the central bank issued a circular that forbids lending to certain insiders and sets limits on lending for others as follows, A member of the board of directors who is not also a senior officer or manager may borrow an aggregate amount that does not exceed one-half of 1 percent of the bank’s total paid in capital and reserves. A shareholder owning 5 percent or more of the common stock or voting power of the bank may borrow an aggregate amount that does not exceed 15 percent of the bank’s total paid in capital and reserves. A senior officer, manager, or employee, including any such person who also is a member of the bank’s board of directors, may borrow an aggregate amount that does not exceed that person’s total annual wage and salary. The circular also stream lined the process of loan application by insiders.

To deal with the widespread use of overdraft facilities, which account for about 90 percent of bank credits, the central bank first introduced a new category of classification of exposures, called “special attention,” to the existing categories of substandard, doubtful, and loss. This category was intended to require banks to identify and remedy potentially weak credit relationships at an early stage. It is to be used to identify and monitor exposures that contain weaknesses or potential weaknesses that, at the time of review, do not jeopardize the repayment of the credit or reflect a potential for loss, but which, if not addressed or corrected, could result in the deterioration of the credit to a substandard or worse classification. Second, to clarify the treatment of bank guarantees, the new regulation allows banks to consider guarantees of other banks as a basis for not classifying an otherwise nonperforming credit exposure. This may be done provided that the banks issuing the guarantees have a capital adequacy ratio of 12 percent or higher, that they are rated A+ or better by a reputable international bank rating agency, and that the guarantees are unrestricted.61 However, such credits need to be returned to performing status or the guarantee called upon within a reasonable time. Third, the central bank streamlined the process to be used by banks for determining borrower performance for credit lines that are in continuous overdraft for three months or more.

Establishment of the Treasury Bills Market

To develop sources of less inflationary financing of the government budget from the nonbank sector, in December 1995 the authorities initiated central bank auctions of treasury bills to the public. The central bank started its monthly auctions with 30day treasury bills, but this instrument was discontinued in the following year in favor of three month and six month bills. By the end of 1996 the outstanding stock of treasury bills had reached YR1s 12 billion (1.7 percent of GDP), over half of which was held by the banking system. During 1997 the authorities introduced a one year treasury bill and phased out the term deposits facilities in the central bank. The treasury bills issued during 1996–97 were used mainly as monetary policy instruments for liquidity management during that period, reflecting the strengthened fiscal position in each of those years. A sharp increase in the amount of bills issued took place after banks’ reserve requirements were lowered from 25 percent to 15 percent in December 1996, in order to mop up the banks’ excess liquidity.

With the strengthening of fiscal balances in 1999, issuance of treasury bills slowed down, although in early 2000 the authorities started lo convert large amounts of outstanding government overdrafts into treasury bills. Most of these were used to provide additional bills required by banks for their own liquidity management through repurchase operations (repos), initiated in November 1999. Although the central bank offers clearing and settlement facilities, secondary trading of treasury bills has not yet developed. In part, this reflects banks’ lack of information on each other and a general mistrust of the information released by individual banks, which to date has also prevented development of an interbank market.

Other Instruments of Monetary Policy

In addition to the changes in the minimum benchmark interest rate and some use of treasury bills for monetary policy purposes, the central bank has relied on reserve requirements on rial deposits and on foreign currency deposits, intervention in the foreign exchange market and credit ceilings, and central bank credit facilities as monetary policy instruments.

Credit facilities were little used, reflecting the excess liquidity situation of the commercial banks. The central bank does not have an overdraft facility, but it can discount treasury bills held by commercial banks (and others) at a rate of 2 percentage points above the highest accepted yield on three month treasury bills at the latest auction. Throughout 1990–99 the central bank also provided a small amount of credit to public enterprises at market rates and on commercial terms. The central bank has intervened actively in the foreign exchange market, especially in late 1998, to smooth volatility in the exchange rate. Credit ceilings were used in the early post unification period but were hardly ever binding. Since 1997 the central bank has retrained from selling any ceilings.

Financial Deepening and Economic Stabilization

The need for financial deepening has been evident since the early post unification period, as commercial banks maintained excess reserve positions with the central bank, in spite of high legal reserves. This behavior reflected their reluctance to grant loans to the private sector in a regime of fixed interest rates and in the absence of effective legal recourse for the timely recovery of nonperforming loans. Consequently, commercial banks had little interest in mobilizing rial deposits and were content to place a large part of their deposits with the central bank at a rate of 1.5 percent above the banks’ average cost of funds. Negative real interest rates were, not surprisingly, accompanied by an increasing trend toward dollarization of the economy. The share of foreign currency deposits in total deposits rose steadily, from 9 percent in 1990 to 29 percent in 1999 (Figure 11), and continued to rise even after real interest rates turned positive in the last three years of the period. This may have reflected, in part, expectations of a depreciation of the rial: indeed, during 1999 holders of dollar deposits earned a real return of only 2 percent, compared with the average minimum saving deposit rate of 10 percent. In addition. Yemeni expatriate workers, reflecting their experience of several years of high inflation and political unrest, traditionally hold part of their remittances in dollar deposits. On the lending side, the growth of foreign currency loans as a percentage of total loans has been much slower, reaching only 9 percent of total loans in 1999. This reflects strict central bank regulations under which borrowers of foreign currency must also be foreign exchange earners.

Figure 11.Credit and Currency Ratios

Source: IMF, International Financial Statistics.

The economic stabilization program has so far translated into some limited progress in financial deepening. The trend increase in credit to the private sector as a share of total credit is partly the result of the government’s repayments to the banking system and the added importance of nonbank financing of the budget deficit. However, it also reflects positive real private credit growth in 1996–99, averaging 2.4 percent a year, compared with an average annual decline of 15.7 percent during 1990–95. A rising multiplier points to increasing efficiency of the banking system (Figure 12). and a rising ratio of credit to non-oil GDP (from 44 percent at the end of 1996 to 78 percent in 1999) indicates that financial deepening is taking place in the non-oil sector. Other indicators point to an opposite trend: for example, the use of currency has grown relative to that of deposits (Figure 11). A comparison of various indicators of depth and efficiency of financial markets with a selection of other countries highlights the under development of Yemen’s financial system (Figure 13 and Figure 14).62 The ratio of broad money (M2) to GDP in Yemen was the lowest among the selected countries in 1998. The same holds for the ratio of private credit to GDP, the share of private sector credit to total credit, and the share of commercial banks’ credit as a percentage of total credit; Yemen’s money multiplier is much lower than those of the other countries.

Figure 12.Money Velocities and Multipliers

(Ratio)

Source: IMF, International Financial Statistics.

1 Ratio of rial money to rial component of reserve money.

Figure 13.Republic of Yemen and Selected Comparators: Liquidity and Credit Ratios

Source: IMF, International Financial Statistics.

Figure 14.Republic of Yemen and Selected Comparators: Money Multipliers and Credit Indicators

Source: IMF, International Financial Statistics.

1 The high ratios for Saudi Arabia reflect large claims by the government on the banking system.

Soundness of the Banking System

One of the objectives of the financial reform program was the implementation of legal reforms that would enable the commercial banks to seek effective judicial recourse to deal with nonperforming assets. Such action, together with a more independent central bank implementing stricter supervision over the credit operations of banks, was expected to significantly improve the soundness of the banking system. Despite considerable progress in the central bank’s role as bank supervisor, however, implementation of the new legal framework has remained timid. Among the more effective steps was the introduction by the central bank in May 1997 of a notification system for delinquent private sector borrowers, and prohibition of new bank loans to such borrowers until they regularize their relations with their creditor banks. The notification system has yielded some results, as reflected in fewer delinquencies among large borrowers.

Despite wide spreads between lending and deposit rates (Statistical Appendix Table A.26), banks’ profitability has remained low, reflecting their large excess reserves (and their lack of interest in granting credit and in mobilizing deposits) as well as large nonperforming portfolios. Wide spreads also reflect the lack of competition from within the banking system and the lack of a non-bank financial system. Low profitability may have also contributed to some erosion of the capital base since the early post unification period, but this was only detected with the strengthening of the provisioning requirements after the reform program was implemented.

Partly reflecting the problems of judicial recourse, commercial banks in Yemen have traditionally been reluctant to lend outside of a core group of customers. The strengthening of the central bank’s supervision in these areas is therefore creating considerable friction, as banks resist or try to circumvent enforcement of prudential regulation. Although provisioning against problem loans has improved in recent years, their ratio to total loans has increased (Statistical Appendix Table A.29). Banks’ exposure to foreign exchange risk, as measured by the difference between assets and liabilities denominated in foreign exchange, is also a cause for concern, with a large part of total foreign currency exposure relating to two public sector banks. The government began in 1997 to buy back the overdue foreign obligations of one of these banks at a significant discount, and the other is scheduled to be put up for sale shortly. The private commercial banks’ exposure to foreign exchange risk is not large. Concentration of credit risk across the sectors of the economy is broadly in line with the structure of GDP, except that lending for construction accounts for only 4 percent of total credit to the non governmental sector (Statistical Appendix Table A.27), a much lower percentage than in most economies. This is probably explained by the absence of property guarantees in Yemen, with the consequence that banks extend housing loans only to their best customers. With regard to maturity structure, over 90 percent of all commercial bank loans have maturities of less than one year, reflecting alack of willingness on the part of banks to lend for investment purposes, and the importance of import and domestic trade financing in the Yemeni economy and the associated prevalence of overdraft facilities.

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