IMF OFFERS GLOOMY PROGNOSIS FOR YEMEN'S ECONOMY

C O N F I D E N T I A L SECTION 01 OF 03 SANAA 000835

SIPDIS

SIPDIS

E.O. 12958: DECL: 03/23/2016
TAGS: PGOV EFIN ECON EPET EINV KALR KMCA KMPI YM
SUBJECT: IMF OFFERS GLOOMY PROGNOSIS FOR YEMEN'S ECONOMY

REF: A. SANAA 2005 2957

B. SANAA 2005 1976

C. SANAA 2005 1919

D. SANAA 146

E. SANAA 647

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Classified By: DCM Nabeel Khoury for reasons 1.4 (b) and (d).


1. (C) SUMMARY: On March 20, the International Monetary Fund
(IMF) completed its Article IV Consultation for Yemen. In a
briefing for donors, the Fund's macroeconomic projections
were decidedly bleak, emphasizing an impending fiscal crisis
caused by declining oil reserves and increased spending.
This analysis largely confirms existing studies, and will
mean a series of tough choices for the ROYG in the next five
years. The IMF's remedy includes cutting subsidies, reducing
the civil service, new taxes and partially devaluing the
currency, all likely to bring a period of instability. There
is some indication that the IMF may be willing to become more
engaged with the ROYG in implementing these reforms. The
Fund's representatives also diverged from the usual script to
support donor reform objectives to improve governance and the
investment climate. END SUMMARY.

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"One of the Toughest Outlooks I've Ever Seen"
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2. (U) A delegation of the International Monetary Fund
recently completed its 2005 Article IV Consultation on
Yemen's macroeconomic health. The report will likely be
published at the end of May. On March 20, USAID Director and
Econoff attended a donor meeting at which the IMF offered a
summary of their findings.


3. (C) Lorenzo Perez, Deputy Director for the Middle East and
Central Asia, estimated steady GDP growth of four percent for
2005, with 4.5 percent non-petroleum growth. The overall
macroeconomic picture presented by the IMF, however, was very
negative. According to Perez, the combination of three
percent population growth and declining oil reserves will
place enormous pressure on the budget in the near future.
Privately, Perez told Econoff: "Yemen's outlook is one of
the toughest I've ever seen." (NOTE: 80 percent of annual
revenues in Yemen are derived from oil sales. END NOTE.)

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Declining Oil Will Bring Fiscal Crisis
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4. (U) Declining oil production will dominate this year's
report, warned Perez. After collecting data from both the
ROYG and private companies, the IMF predicts a drop in
production from 390,000 barrels per day to 260,000 within
five years. Without a major new discovery, Yemen may run out
of oil reserves by 2016. The ROYG is currently tendering a
number of new blocks for exploration, but most experts
predict additional production of only 20-30,000 barrels per
day. Liquid natural gas exports are expected to begin in
2009, generating USD 1 billion a year, but even this will not
significantly offset declines in oil. (Septel) These negative
trends will ultimately put pressure on Yemen's foreign
currency reserves, which recently exceeded USD 6 billion.


5. (SBU) The IMF warned that the ROYG's budgeting practices
were dangerously expansionary. In a year of record high oil
prices, Yemen is expected to show a deficit of three percent
of GDP in its 2006 budget. With declining oil revenues, this
could increase to a deficit of 20 percent by 2010. Yemen
routinely underestimates oil revenues (this year it projects
prices at USD 40 per barrel),requiring supplementary budgets
to allocate additional funds. (Ref A) According to the IMF,
however, this revenue is likely to be largely consumed by
fuel subsidies. Despite a significant reduction in the
subsidy last July, rising oil prices have largely negated
these gains, with the cost for this year's subsidy running at
approximately USD 800 million (more than five percent of GDP).

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An Eye on Inflation
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6. (U) Maintaining a stable exchange remains the Central
Bank's highest priority, said IMF representatives. Currently
trading at 196 YR to the dollar, the riyal has lost less than
five percent of its value against the dollar over the past
year. The ROYG regularly intervenes to bolster the riyal,
most recently in January, when it pumped USD 215 million from
foreign currency reserves into the local market.


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7. (U) The Fund is more concerned with inflation, however,
which has fluctuated between 10 and 13 percent in recent
years. Some contacts at the Central Bank predict that
overall inflation for 2005 will be closer to 20 percent, but
this includes a one-time inflationary spike caused by the
partial lifting of oil subsidies. (Ref B) Nevertheless, the
IMF predicts a steady increase in inflation rates, due
largely to high oil prices. Ultimately, Perez said the ROYG
must allow for a more flexible exchange rate, which would
likely result in a significant devaluation of the riyal.
(NOTE: This would be a serious blow to average Yemenis, who
are largely dependent on import commodities. END NOTE.)

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Fund Offers Bitter Medicine
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8. (U) The Article IV report will note several positive
developments in the ROYG's efforts to increase revenue. The
long-delayed value-added tax is expected to go into full
effect by January 2007. (Ref C) Combined with more effective
methods of tax collection and customs fees, this could
generate as much as three percent of GDP in new revenues.
Perez also warned that the ROYG must restrain growth in the
wage bill, which doubled the minimum wage this year. Despite
low salaries for civil servants, the IMF contends that the
ROYG simply cannot afford a spending increase of this size.
If implemented, civil service reform could also reduce
expenditures. The ROYG claims it will issue biometric cards
to government employees within two months, in order to cut
down on "ghost workers" and those drawing more than one
salary. Perez also suggested that the rising defense budget,
approximately seven percent of GDP, was high for the region.


9. (SBU) All of these reforms combined, however, would not
have the same impact as eliminating fuel subsidies, which
amount to nine percent of GDP. Perez recognized that
removing subsidies is painful for average citizens, as
evidenced by last July's riots, and recommended a more
gradual approach. (Ref B) Fuel prices could be adjusted to
international prices over a period of three years, said
Perez. Without such measures, said Perez, not only will
Yemen face declining revenues, but debt levels (mainly
domestic) will also become unsustainable, perhaps rising to
100 percent of GDP within five years. This would almost
certainly cause a crisis of confidence in Yemen's economy,
leading to a currency collapse and capital flight.

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IMF Joins Call For Governance Reforms
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10. (SBU) The Article IV delegation diverged this year from
strict monetary policy to address broader issues affecting
Yemen's investment climate. These issues are more difficult
to address from a macroeconomic standpoint, as there are few
available statistics for unemployment, poverty levels and
other key measures of standard of living. Perez stressed
that the IMF was committed to pro-growth policies, and noted
problems in the banking sector, accounting standards and rule
of law as impediments to investment. In general, Perez
expressed strong support for the donors' coordinated approach
to governance reform, and stressed the importance of such
measures for Yemen's business climate. (Ref D) "Ultimately,"
said Perez, "Yemen must clean up its own house." (NOTE: This
defense of the Fund's pro-growth position was a direct
response to the UN, which has charged that the IMF does not
sufficiently emphasize job creation and poverty reduction in
Yemen. END NOTE.)


11. (C) The team was somewhat encouraged by the new Minister
of Finance, Seif Al-Asali, and his outspoken commitment to
reform. (Ref E) Asali recently replaced the Ministry's budget
director and is reportedly eager to replace a large number of
middle managers who have become complacent or corrupt. Perez
was cautious about a number of Asali's specific initiatives,
however, describing him as "a man in a hurry." Some of
Asali's more dubious priorities include setting up a stock
market and reducing the corporate tax, which stands at a
relatively high 35 percent. IMF analysts were concerned that
despite the potential of a tax cut to stimulate growth, it
could deprive the ROYG of critical revenue when it needs it
most. The IMF was willing to contemplate such a move only if
accompanied by the elimination of some of Yemen's multiple
tax exemptions.

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Comment: Desperate Times Call For Enhanced IMF Role
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12. (C) This year's Article IV Consultation does not come as
a shock to close observers of Yemen's economy, and confirms
many of the more dire predictions of the World Bank and
others. Declining oil reserves lie at the heart of the
problem, and replacement revenues cannot be found without
major changes in Yemen's economic and fiscal policies. IMF
representatives do not expect any of these difficult
decisions to be made before the September elections, but they
hope to engage the ROYG immediately thereafter with another
visit in October. The IMF currently has no presence in Yemen
and essentially cut its program in 2001 when reforms stalled.
The Fund said it cannot return in force without an
invitation from the ROYG, but some in the donor community
feel that the time is ripe for full engagement. Many of the
IMF's recommended macroeconomic reforms will likely bring
serious instability, and require the Fund's expert guidance
to be implemented effectively.
Krajeski