Documentof The World Bank FOROFFICIALUSEONLY ReportNo.41141-YE INTERNATIONALDEVELOPMENTASSOCIATION PROGRAMDOCUMENT FORA PROPOSEDGRANT INTHEAMOUNT OF SDR32.8 MILLION (US$50.93 MILLION EQUIVALENT) TO THE REPUBLICOF YEMEN FORAN INSTITUTIONALREFORMDEVELOPMENTPOLICYGRANT November 6,2007 Finance andPrivate Sector Development Social andEconomic DevelopmentDepartment MiddleEastNorthAfrica Region This document has a restricteddistribution and maybe used byrecipients only inthe performance o ftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization. REPUBLIC OF YEMEN GOVERNMENT - FISCALYEAR January 1-December 31 CURRENCYEQUIVALENTS (Exchange Rate Effective as of September 2007) Currency Unit Yemeni Rial (YR) US$1.oo 198.2 US$l.55 SDR 1 WEIGHTS AND MEASURES Metric System ABBREVIATIONAND ACRONYMS CAS Country Assistance Strategy CSMP Civil Service ModernizationProject DPPR Socio-economic DevelopmentPlan for Poverty Reduction DPR DevelopmentPolicy Review EITI Extractive Industries Transparency Initiative GDP Gross Domestic Product GNP Gross National Product IBRD InternationalBank for Reconstruction and Development ICA Investment Climate Assessment IDA InternationalDevelopment Association IFC InternationalFinance Corporation IMF InternationalMonetary Fund IRDPG InstitutionalReformDevelopment Policy Grant LDP Letter o f Development Policy MGGM Matrix o f Good Governance Measures MDGs Millennium Development Goals MCSI MinistryofCivil Service andInsurance MOF Ministryof Finance MOPIC Ministryo fPlanningandInternational Cooperation MTEF Medium-Term ExpenditureFramework NRA National ReformAgenda PEFA Public Expenditure and Financial Accountability PIP Public Investment Program PRSP Poverty Reduction Strategy Paper PRSC Poverty Reduction Support Credit SDR Special Drawing Rights UNDP United Nations DevelopmentProgram Vice President: Daniela Gressani Country Director: EmmanuelMbi Sector Director: Mustapha K.Nabli Country Manager: Mustapha Rouis Sector Manager: Zoubida Allaoua Task Team Leader: Andrew H.W. Stone FOR OFFICIAL USEONLY YEMEN INSTITUTIONAL REFORMDEVELOPMENT POLICYGRANT TABLEOFCONTENTS GRANTANDPROGRAMSUMMARY ....................................................................................................... i I INTRODUCTION ........................ .................................................................................................. 1 I1 .. COUNTRYCONTEXT ................ .................................................................................................. 1 RECENT MACROECONOMIC DEVELOPMENTS ......................................................................... 1 MACROECONOMIC ANDDEBTSUSTAMABILITY OUTLOOK .................................................... 4 DEBT SUSTAMABILI TY ........................................................................................................... 8 I11 . THEGOVERNMENT'SPROGRAM ....................................................................................................... 8 IV . BANKSUPPORT To THEGOVERNMENT'S STRATEGY ...................................................................... 14 LINKToTHECAS................................................................................................................. 14 COLLABORATION WITH THEIMFANDOTHERDONORS ........................................................ 15 RELATIONSHIPToOTHERBANKOPERATIONS....................................................................... 16 LESSONS LEARNED ..................................................................................................... ...... 17 ANALYTICALUNDERPINNINGS ............................................................................................... 18 V . THEPROPOSED INSTITUTIONAL REFORMDEVELOPMENTPOLICYGRANT................................... 19 OPERATION DESCRIPTION ...................................................................................................... 19 POLICYAREAS ....................................................................................................................... 19 VI . OPERATIONIMPLEMENTATION ......................................................................................................... 33 POVERTYANDSOCIALIMPACTS ............................................................................................ 33 IMPLEMENTATION, MONITORING EVALUATION............................................................. 36 AND FIDUCIARYASPECTS 38 DISBURSEMENT AUDITMG............................................................................................. .............................................................................................................. AND 40 ENVIRONMENTAL ASPECTS .................................................................................................... 41 RISKS ANDRISKMITIGATION ................................................................................................ 42 TEAMMEMBERS .................................................................................................................... 43 ANNEXES ANNEX1:LETTERDEVELOPMENT ............................................................................................ OF POLICY 44 ANNEX2: OPERATIONPOLICYMATRIX ................. ............................................................................ 53 ANNEX3: FUNDRELATIONS NOTE .............................................................................................................. 58 ANNEX4: COUNTRYATA GLANCE (INCLUDES COUNTRY MAP) ................................................................. 61 BOXES 4 Box 2: Subsidies and the Poor inYemen ..................................................................................................... Box 1:Progress inPoverty and Social Outcomes ............................................................................................ 7 Box 3: Civil Service Modernization........................................................................................................... 26 Box 4: AFMIS ............................................................................................................................................ 28 Box 5: The EITI Criteria ............................................................................................................................ 28 FIGURES Figure 2: Top constraints (of 18 categories) identifiedby Yemeni enterprises inICA enterprise survey .20 Figure 1: From Country Assistance Strategy: Republic o f Yemen (2006) ............................................... 16 TABLES Table 1:Recent Macroeconomic Indicators. 2004-06.................................................................................. 3 Table 2: Medium-term Projections. 2007-12................................................................................................ 6 Table 3: Summary of Matrix of Good Governance Measures and Achievements..................................... 10 This document has a restricted distribution and maybe usedby recipients only inthe performance o f their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Acknowledgments This Institutional Reform Grant Program Document was prepared by a core IDA team comprising: Andrew Stone, Sameh Wahba, Mikael Mengesha, Ali Al-Abdulrazzaq, T.G. Srinivasan, Giulio de Tommaso, Hisham Waly and Akram El-Shorbagi. Guidance has been provided by Gaiv Tata (during his tenure as country program coordinator) and by Ms. Daniela Gressani, Vice President for the. Middle East and North Africa Region; Emmanuel mi,Country Director, Mustapha K. Nabli, Sector Director; Mustapha Rouis, Country Manager; and Zoubida Allaoua, Sector Manager. Expert assistance in preparation was provided by Dr. John Bruce (Land) and Mr. Ashraf Al-Arabi (Taxation). Helpful comments or contributions have been received from Miria Pigato, Robert Beschel, Naji Abu-Hatim, David Biggs, Arun Arya, Sherif Arif, Sahar Nasr and Saad Sabrah (IFC). The team wishes to thank H.E.Mr.Abdulkareem Al-Arhabi, Deputy Prime Minister and Minister o f Planning & International Cooperation; H.E. Mr. Hamoud Al-Soufi, Minister o f Civil Services and Insurance; H.E. Noman Taher Al-Sohaibi, Minister o f Finance and former Chairman o f the Tax Authority; Dr. Yahia Al- Mutawakel, now Minister o f Trade and Industry; Dr. Mutahar Al-Abbasi, Deputy Minister for Development Plans, MOPIC; Mr. Nabil Shanson, Deputy Minister o f Civil Service and Insurance for Management, Personnel Affairs Sector; Mr.Nasr Al-Harbbi, Deputy Minister o f Finance for International Cooperation; Mr. Tarek A. Alsharafi, Director General. of External Financial Relations Department, Ministry o f Finance; Mr. Ahmed Ghaleb, Chairman o f the Tax Authority; Dr.Mohammed Al-Maitami, General Manager, Federation o f Yemen Chambers o f Commerce and Industry;H.E. Dr. Seif Al-Asali, former Minister o f Finance; Dr.L o t fH. Barakat, Deputy Chairman, Customs Authority; Mr. Jalal Omar Yaqoub, Assistant Deputy Minister, MoPIC; Dr.Mohammed M.Al-Sabbry, Secretary General, General Secretariat for Cabinet o f Ministers; Mr.Ibrahim Alnahari, Minister's Office Director, Ministryo f Finance; and countless other individuals from the public and private sector who have contributed to the preparation process. GRANT AND PROGRAMSUMMARY Republic of Yemen INSTITUTIONAL REFORMDEVELOPMENT POLICY GRANT Borrower IRepublic o f Yemen Implementing Ministry o f Planning and International Cooperation Agency Amount SDR 32.8 million (approximately US$50.93 million equivalent) Terms IDA Grant Tranching Two equal tranches o f SDR 16.4 million (approximately US25.47 million equivalent) each. The first tranche to be disbursed upon effectiveness and the second one at the latest 18 months after effectiveness, which is the period over which agreed measures are expected to be finalized as per the financing agreement. Description The Institutional Reform Development Policy Grant (IR DPG) will support the Government's Reform Strategy, as discussed in the country assistance strategy (CAS). It emphasizes two key elements: Supporting non-oil growth through investment climate reforms through: 9 Rationalizing the incentive framework (by harmonizing treatment of income, expenses > and investment with international standards) Strengthening property rights (by reducing ambiguity o f land titling and improving public management of land registration). Strengthening governance and public financial management through: 9 Reforming procurement as part o f public financial management reforms to increase transparency and accountability and to separate the policy-making hnctions from the > administrative function. Supporting the public administration reform strategy, inparticular through wage policy, retrenchments and a biometric database on public employees as part o f broader civil > service reform. Increasing revenue transparency through Yemen's accession to the Extractive Industries Transparency Initiative (EITI). Benefits The project should contribute to accelerate growth, poverty alleviation and improved governance through its provisions, which comprise key parts o f the Government's overall growth strategy. Risks The key risks are: (i)A risk ofpolicyreversals or loss ofmomentumdue to changes inGovernment or domestic political conflict. (ii)Failure to implement key policies supported by the loan due to weak institutional capacity. (iii) andmacroeconomicrisksduetoexogenousshocks,suchasregionalconflictora Fiscal decline inoil prices, which could create fiduciary risks. Other risks include the potential for deficits from poor enforcement o f taxes or weak expenditure management. Operation ID P101453 INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAMDOCUMENTFORA PROPOSED INSTITUTIONAL REFORMDEVELOPMENT POLICY GRANT TO THE REPUBLIC OF YEMEN I. INTRODUCTION 1. Yemen's extreme poverty demands an urgent response. Yemen is a World Bank Group IDA recipient country, with per capita GNI o f US$760. It has a population o f 21 million, with nearly half age 15 or below. The recently concluded poverty assessment estimated 34.8 percent o f the population as living inpoverty, sharply divided between an urbanrate o f 20.7 percent and a rural rate o f 40.1 percent.' Yet, growth has been slow, barely outpacing population. The investment climate remains constrained, while the economy remains vulnerable to energy prices and regional political insecurity. Also, Yemen's energy, transport, and water and sanitation infrastructure are underdeveloped. The economy is highly dependent on a dwindling oil sector that i s weakly linked to local industry and capacities, yet accounts for almost 93 percent o f all exports. Unemployment is estimated to be 16.3 percent,* while agriculture (comprising only 10 percent o f GDP) continues as the main source o f income for the vast majority o f the population. At the same time, Yemen, with signifcant water-scarcity, continues to rapidly deplete its groundwater. The Government, in recognition o f the urgency o f reform, launched a comprehensive program with the third five-year development plan (PRSP) and subsequent National Reform Agenda. Donor support i s critical to the success o f these reforms. The Institutional Reform Development Policy Grant (IR DPG) forms one part o f the Bank's overall strategy to support poverty reduction, specifically by supporting reforms aimed at stimulating non-oil growth and strengtheninggovernance. 11. COUNTRYCONTEXT RECENT MACROECONOMIC DEVELOPMENTS High oilprices underpinned thefavorable macroeconomic outcomes in recent years. The fiscal deficit narrowed and the current account stayed in surplus. GDP growth has been sustained at about 4 percent per year (higher than the population growth rate of about 3 percent) despite falling oil production because of offsetting growth in non-oil sectors. But, inflation and long-term fiscal sustainability have emerged as key policy concerns. The percentage of thepoor has droppedfrom 40.1 in 1998 to 34.8 in 2005/06. 2. Decliningoil production restrained GDP growth in 2006. Real GDP grew at 4 percent in2006, slightlylessthanthe 4.6 percent increasein2005. The slowdown largelyreflected the sharp loss in oil output, estimated at more than 8 percent. Oil production had hit a peak in 2003 and has ' TheCAS refers to the results of the 1998 householdbudget survey, which placed the poverty rate at 42% of the population. Basedon census 2004. beendeclining except for abriefpausein2005. Increasingly Yemenhashadto relyonpromisingnon- oil sectors for growth. On the expenditure side, growth was primarilysustainedby the expansion in public final consumption. Investment spending, on the other hand, remained stagnant, with the bulk o factivity takingplace inthe energy andinfi-astructuresectors. 3. Dynamism in promising non-oil sectors such as fisheries and tourism helped to sustain non-oil growth. Fisheries and trade sectors showed improvement, with the former expanding by 16.4 percent (compared to 10.1 percent in 2005) and the latter by 8.3 percent (compared to 3.5 percent a year ago). Tourist arrivals have increased greatly since 2003, as the number o f arrivals more than doubled to 382,000. Revenues have also doubled since 2003, from $139 million to $309 million in 2006. Growth in manufacturing, however, slowed to 5 percent from 8.1 percent. 4. Inflation in 2006 surged to 18.4 percent, driven primarily by higher food prices. After staying inthe range o f 10-12 percent for many years, inflation surged inthe aftermatho fan increase in the administered prices o f petroleum products. The jump in food prices, however estimated at 28.6 percent, has largely reflected the 45 percent price escalation in fruit and vegetable prices. This increase was sustained by domestic supply factors, the surge in international food prices, and higher domestic demand linked to the award o f a pay rise in the public sector in 2006. The effect o f the partial removal o f domestic-oil price subsidies in July 2005 has also continued to ripple through various sectors in the economy in 2006, including agriculture, which is heavily dependant on diesel fuel for irrigation. 5. High internationaloil prices helpedto create a small surplusin the fiscal balancein 2006 for the first time since 2001. Preliminary data for 2006 indicate improved fiscal position relative to the 2005 outcome and in relation to the forecasted budget. The improvement was sustained by a higher-than-expected rise inrevenue to 38.3 percent o f GDP and moderate growth inexpenditure to 37.4 percent o fGDP. Revenue was boostedby strong oil income, which despite declining production, increased by some 35 percent on account o f higher prices and a larger government share in total output. Meanwhile, expenditure witnessed a 20 percent increase boosted by rising expenditure on wages and salaries and subsidies. As a result, the overall fiscal balance recorded a small surplus o f 0.9 percent o f GDP compared to a deficit o f 1.8 percent a year before. However, the non-oil primary balance, the major indicator o f fiscal sustainability, continued to show deterioration, reaching about 25 percent o f GDP in2006, up from about 15 percent in2000. 6. The current account balance for 2006 recordeda surplus of about US$200 million, equivalent to 1 percent of GDP. The surplus was sustained by record oil revenues, which increased by 14 percent to US$6.7 billion despite an 8 percent fall in production. With the continuing current account surplus for the eighth consecutive year and large inflows o f direct investment in recent years, the country's foreign reserves climbed by end o f 2006 to US$7.6 billion equivalent to 11months o f imports. - 3 - Table 1:Recent MacroeconomicIndicators, 2004-06 (Percent change; unless otherwise indicated) Real GDP 4.0 4.6 4.0 Oil -5.O -0.8 -8.3 Non-oil sectors 5.4 5.3 5.7 Inflation (CPI, Period Change) 12.5 11.4 18.4 Crude oil production(Inthousandbarrels per day) 396 394 357 Average oil export price (US$ per barrel) 36.6 51.5 63.0 General government finances (Percent o f GDP) Revenue 31.7 34.7 38.3 Ofwhich :oil 19.7 23.5 28.9 Expenditure 33.8 36.5 37.4 Current 24.1 26.6 28.4 Of which : wages and salaries 9.2 9.1 10.3 Subsidies 5.9 8.9 8.2 Capital 9.8 9.8 9.1 Overall fiscal balance (deficit -) -2.2 -1.8 0.9 Primary non-oil balance -19.8 -23.2 -25.7 Balance of payments (Billions o f U.S. dollars) Exports o f goods 4.7 6.4 7.3 Ofwhich: petroleum 4.3 5.9 6.7 Imports o f goods 3.9 4.7 5.9 Services balance -0.7 -0.9 -1.3 Current account balance 0.2 0.6 0.2 Current account (as percent o f GDP) 1.6 3.8 1.o Net direct investment -0.1 0.3 -1.1 Reserves (Billions o f U.S. dollars) Gross official reserves (end period) 5.7 6.1 7.5 Inmonths o fimports o fgoods &non-factor services 11.5 9.4 11.1 Exchange rates Exchange rate (per US$, period average) 184.8 191.4 197.1 Source: Yemen, Live Data Base, October, 2007. 7. The nominal exchange rate continued to depreciate; while high domestic inflation caused a real appreciation.In 2006, the rial depreciated by 2.9 percent, below the 3.6 percent recorded in 2005, and the near 4 percent average rate during the period 2000-2004. The real appreciation that has occurred i s not indicative any serious misalignment o f the exchange rate (as per IMF Article IV consultation, August 2007) in the current circumstances. However, in the futurewhen oil is depletedcompletely, the exchange ratewill haveto depreciate. - 4 - Box 1:ProgressinPovertyand Social Outcomes Poverty in Yemen reduced: the percentageof poor fell from 40.1 in 1998 to 34.8 in 2005/06. It is creditable that this reduction has been achieved in the context o f a highpopulation growth o f 3 percent per year. Most o f the improvement has occurred in the urban areas, with poverty rate falling from 32.2 to 20.7 percent. Inrural areas, where 73 percent o f the total population lives, the decline was much less noticeable as poverty headcount declined from 42 to 40.1 percent. Yemen has made great strides in improving access to education, but it has a long way to go to achieve universalprimary completion and gender parity. In 2003, gross primary enrollment was 83.5 percent (up from about 65 percent in 1990), and net primary enrollment reached 72 percent (compared with 52 percent in 1990). Between 1995 and 2000, total enrollment rates inbasic education increased by 30 percent, while secondary education rates increased by 50 percent. However, the primary completion rate was only about 65 percent and had fallen short o f the two-thirds o f population o f the relevant age group by 2003. The adult literacy rate was only 49 percent, and more than 70 percent o f women were illiterate. The health status of the Yemeni population has improved but is still very low. Women have increased their life expectancy from 52.6 years in 1990 to 58.1 in 2002. The infant mortality rate for every 1,000 births decreased from 98 in 1990 to 83 in 2002. However, maternal mortality rate (570 per 100,000 live births) and total fertility rate (6.0 children per woman) are the highest in the Middle East and North Africa region. Child malnutrition i s also the highest in the region, and almost half o f the Yemeni children suffer from stunting. High rates of gender inequality stubbornly persist, although some progress has been made. Yemen ranks 121 out o f 140 countries on the Gender Development Index (UNDP, 2005). Female gross primary enrollment rate has doubled from 34 percent in 1990 to 68 percent in 2002. Female net primary enrollment has also shot up from 28 percent to 59 percent over the same period. This increase compares favorably to the male percentage, which has moved up from 74 percent to 84 percent. Although in 1990 female literacy was as low as 12.9 percent, compared with 55.2 for males, by 2002 the female rate had increased to 28.5 percent, compared with 69.5 percent for males. Only 33 percent o f rural girls were enrolled in school, compared with 73 percent o f rural boys and 78 percent o f urban girls. Female adult illiteracy (at 78 percent in rural areas and 40 percent in urban areas) i s more than twice that o f males (32 percent in rural areas and 15 percent in urban areas). Young and relatively educated women (age 15-29) have a higher rate o f unemployment than their male counterparts: 56 percent o f all female unemployment i s among young women compared with 47 percent for young men (World Bank 2004). P _p__ _c MACROECONOMIC ANDDEBTSUSTAINABILITY OUTLOOK Yemenfaces formidable challenges in the medium to long-term as known oil reserves are exhausted and the already scarce water resources deplete even as demand mounts. The government has indicated its commitment to carry out dgficult reforms to restore fiscal sustainability and spur alternative sources of growth in its PRSP and national reform agenda. Unfortunately, Yemen willface high external debt stress even if it carries out all the identi3ed reforms and borrows on concessional terms. Donor support is thus critical to sustain long-term development in impoverished Yemen. - 5 - 8. The current year (2007) outlook is mixed. While GDP growth is expected to be about the same as the last year, inflation i s expected to decline to the 12-14 percent range following active use o f monetary policy instruments and reining in o f public expenditures on wages and salaries. The signs o f active monetary policy are already evident as the use o f T-Bills for mopping up liquidity has resumedand the inflation inthe first half o f 2007 has declined. Internal and external balances are, however, expected to turn to a deficit. The declining oil production (down by 10 percent from the previous year) and high import requirements for the YemLNG plant are the factors behindthe swingto deficits. 9. Yemen faces dauntingchallenges as oil andwater resources continueto depleteeven as the population grows briskly at 3 percent annually. At current rates o f crude-oil production and domestic consumption, Yemen could be a net importer by 2015, and will cease production by 2018. Since exports and public finances rely heavily on oil, the impending oil depletion will stress macroeconomic management. 10. The medium-term outlook suggests that GDP growth will gradually improve to secure a 5 percent growth per year until 2012. Though GDP growth in the current year is expected to be around 4 percent, the same as the last year, the outlook is modestlypositive (Table 2). Rising non-oil GDP growth to about 6 percent by 2012 will offset the contraction in the oil output. The commencing o f LNG production and exports in 2009 will temporarily create a growth spike in that year. Growth in the non-oil sector (fisheries, tourism, agricultural products) will be sustained by new public investment projects, supported by pledges from Consultative Group donors, and ongoing projects (including Yemen Liquid Natural Gas (YLNG), Marib Power, and the first private-sector refinery). Private investmenti s also expected to start picking up in response to recent legislative and administrative reforms aimed at improving the investment climate. 11. The medium-tem outlook is optimistic despite the continuing depletion of oil, conditional on the government implementing significant reforms. Hydrocarbon export revenues o f the government are set to decline by 30 percent between 2006 and 2012, even after allowing for the new source o f gas exports which i s expected to come on stream in 2009. To keep the fiscal deficit capped below 3 percent a year in the wake o f shrinking hydro-carbon revenues will require strong adjustments efforts that will result in slashing expenditures every year by one percentage o f GDP. The macroeconomic framework also requires strict monetary discipline to contain inflation under 10 percent by 2012 despite the cost-push coming from fuel subsidy removal and application o f indirect taxes. The adverse impact on poverty (Box 2) i s expected to be cushioned by effective social transfers through a reformed social welfare fund. The non-oil primary deficit should be cut nearly by 10percent points improving long-term fiscal sustainability. 12. The medium-termoutlook builds on several policy assumptions.The key adjustment efforts envisaged in the medium-term are shared by the World Bank and IMF. The proposed reforms are: ending o f fuel subsidies by 2010 and in-lieu imposing o f a fuel tax, full implementation o f the General Sales Tax (GST) with the doubling o f the rate to 10 percent in 2009, curtailing wages and salaries by 1.6 percent o f GDP, putting in place a social transfer - 6 - mechanism that will protect the poor from adverse effects o f fuel price reforms. Helped inpart by foreign financing, public capital spending will increase in this period to 9 percent o f GDP supporting an overall GDP growth of 5 percent a year. 13. Implementingmeasures to secure fiscal sustainability require strong political will. The authorities understand the importance o f securing fiscal sustainability but there could be difficulties inimplementationinthe political context o f Yemen. Inthe past, fuel prices have been raised infrequently (1999, 2001, and 2005) and painfully, causing violent riots. The World Bank and IMFhave proposed to the government a gradual, pre-announced, but not abrupt, increase in fie1 prices, accompanied by cash-transfers to the poor. The increase in GST also faces tough opposition from the private sector. The successful introduction o f GST in 2005 followed a decade long process. Table 2: Medium-termProjections,2007-12 (Share of GDP unless stated otherwise) Real GDP Growth, percent per year 4.0 3.6 4.3 8.0 5.3 4.7 4.9 5.0 Non-hydrocarbon 5.7 5.2 4.9 5.0 5.1 5.7 5.8 5.3 Hydrocarbon -8.3 -10.1 -1.2 39.7 7.0 -3.2 -3.1 4.9 Inflation (consumer price index), percent per year 18.2 12.5 12.1 10.5 9.5 8.8 8.3 10.3 General Government Revenue and grants 36.4 30.9 30.7 30.2 28.9 27.8 26.6 29.2 Hydrocarbon export revenue 27.5 11.3 10.2 7.8 6.6 5.4 4.3 8.3 Tax revenue (non hydrocarbon) 8.9 7.1 7.6 10.2 10.4 10.7 10.9 9.5 General Government Expenditure and net lending 35.6 35.6 35.2 33.1 31.5 30.0 29.3 32.5 Subsidies 7.8 7.6 6.4 4.2 2.3 0.1 0.1 3.5 Wages and salaries 9.3 9.0 9.0 8.1 7.8 7.6 7.4 8.2 Capital spending 7.3 8.1 8.0 8.9 8.9 9.4 9.0 8.7 Social spending 7.0 8.1 9.0 9.8 10.5 10.9 10.9 9.9 Overall Fiscal balance 2.1 -2.6 -2.5 -1.4 -0.8 -0.6 -1.1 -3.3 Non-oil primary balance -25.4 -24.9 -23.4 -19.4 -17.2 -15.5 -14.6 -19.2 Trade Balance (f.0.b inmillions of US$) 1,395 -741 -193 691 401 -386 -1,217 -240.8 Exports, 7,285 6,377 6,740 7,688 7,760 7,334 6,895 7,132.3 Hydrocarbon exports 6,733 5,814 6,144 7,056 7,089 6,617 6,128 6,474.7 Imports 5,890 7,118 6,933 6,997 7,359 7,720 8,112 7,373.2 Current account balance (% o f GDP) 1.0 -3.8 -1.3 0.6 0.0 -2.2 -3.8 1.8 Source: IMFArticle IV consultations, August 2007. 14. The government's reform commitments are in the right direction. The authorities agree with the need to reform the Social Welfare Fundto improve targeting o f the poor, eliminate fuel subsidies, raise more non-oil revenue by higher GST, and implement the National Wage Strategy only after cleaning up the payroll and other institutional reforms. The commitment given - 7 - by the authorities on inflation management by active use of monetary and exchange rate policies i s also reassuring. Unswerving commitment to inflation containment will b e critical in the medium-term. Further, the reforms supported by the proposed IRGinthe area of governance and anti-corruption, public administration, and private and financial sector development will also help in creating an environment conducive to public trust inreforms, a leaner and more efficient bureaucracy and a better business environment for the private sector. Box 2: Subsidies andthe Poor inYemen Subsidies to petroleum products burden the budget and benefit mostly the non-poor. Yemen subsidizes retail prices o f petroleum products between 16 percent (petrol) and 70 percent (LPG). The subsidy outlay is, however, highest on diesel which is subsidized at a rate o f about 50 per~entIn . ~ 2006, these subsidies amounted to about 8 percent of GDP and 22 percent o f general government expenditure. The outlay on subsidies exceeded government's capital spending and its social spending. The direct benefits o f subsidies on final petroleum products are reaped mostly (about 80 percent) by the non-poor. In the past ten years, the authorities have revised the petroleum prices infrequently (1999,2001, and 2005). Poverty rates in Yemen would be significantly higher without petroleum subsidies. Without the current petroleum subsidy (taking into account only the price increase on gas, LPG and kerosene), the poverty rate would have been roughly 2.5 percentage points higher. The impact would have been higher for urban areas, where poverty would go up by 3.6 percentage points, versus 1.5 .percentage points for rural areas. Petroleum subsidies have a spillover effect by keeping the price o f other goods low. When this indirect effect o f petroleum subsidies is accounted for, the poverty rate without subsidies would be 9.2 percentage points higher. The rates are 7.6 percentage points for the urban versus 9 percentage points for the rural. Therefore, accounting for indirect affect, the impact o f current petroleum subsidy removal will be higher on rural areas than urban ones. Current petroleum subsidies are keepingroughly 1.5 million people from slippinginto poverty. Yemen can protect the poor while eliminatingthe untargetedpetroleum subsidies. The refom o f the government's cash-transfer program currently underway with the help o f EU is a step in the right direction. By moving to proxy means testing to identify the poor instead o f categorical targeting at present, as done in the EU supported pilot project in three governorates, the impact on poverty can be improved significantly. Also, by usingdistrict level poverty rather than the governorate level poverty to allocate funds, the impact on poverty i s more equitable between the rural and urban areas. For poverty not to increase when subsidies are eliminated, roughly half the saved budget on subsidies may have to be redistributed to the cash-transfer mechanisms. DEBTSUSTAIN ABILITY 15. Yemen's total outstanding external public debt was about US$5 billion (26 percent of GDP) by year-end 2006, a significant reduction from the US$11.4 billion in 1996. Three 3 As ofJanuary, 2007. Since then, the rates of subsidies have gone up higher as international prices have risenbut domestic prices have remained unchanged. - 8 - Paris club restructuring rounds have helped Yemen secure external debt relief inthe past (1996, 1997 and 2001). All official debt i s concessional, reflecting a grant element o f about 65 percent. 16. Yemen debt management policy has been consistently sound. Yemen publishes monthly and quarterly updates on external debt usingDMFAS (Debt Management and Financial System) and a yearly update regarding Debt Sustainability using DSM+ (Debt Sustainability Model). Yemen scores the highest rating in the World Bank's Debtor Reporting System. The increase in debt risk is beyond the control o f government as oil resources deplete. Reflecting the long-term concerns, the cabinet has approved and sent to the parliament a new debt law with a ceiling on total public sector debt (external and internal) set at 80 percent o f GDP, with either component not to exceed 60 percent o f GDP. 17. The recentdebt sustainabilityanalysis carried out jointly by the Bank andthe Fund in August 2007 found Yemen to face a high risk of external debt stress. Even with the baseline scenario that assumed full implementation o f a comprehensive set o f reforms, one o f the four performance appropriate4 thresholds - NPV o f external debt-to-exports ratio - will be breached by 2018 exceeding the threshold level o f 150 percent, and the threshold o f NPV o f debt-to-GDP approached. The risks are exacerbated if either the oil price falls or debt-terms harden. 18. Macroeconomicrisk factors. The main downside risk is the ability o fthe authorities to improve fiscal sustainability in time. Ifthe proposed gradual elimination of fuel subsidies is not initiated for reasons o f political expediency, the fiscal deficit will widen considerably putting pressure on inflation, curtailing capital expenditures and harming long-term growth and worsening poverty. Another downside risk i s a lower than expected production o f oil, which could precipitate a revenue crisis for the government. On the upside, if the oil prices stay consistently higher in the coming years, the government will have more resources to promote non-oil growth and makethe path o f adjustment less painful. 111. THEGOVERNMENT'SPROGRAM 19. The Government's medium-tern strategy is embodied in the Yemen Third Socio- economic Development Plan for Poverty Reduction (2006-10) (DPPR), which also serves as its PRSP. Inthis document, the Government identifies its strategic goals (or "pillars"), namely to: 0 Achieve a steady improvement in economic growth; 0 Reduce poverty andraise the quality o f life; 0 Promote good governance; 0 Reduce regional and gender disparities; 0 Enhance decentralization; and Broaden the participation o f civil society. 4For a medium performer under the World Bank's Country Policy and Institutional Assessment rating, the indicative thresholds are: N P V o f debt -to-exports o f 150 percent, NPV o f debt-to-GDP o f 40 percent and a debt-to-export ratio o f 20 percent, and debt-service to revenue ratio o f 30 percent4 - 9 - 20. It also identifies several "priorities" for achieving poverty reduction and growth, including: 0 Reforming the economic structure; Improvingthe investment climate; 0 Boosting the private sector; and IntegratingYemen speedily into the global market through accession to the Gulf CooperationCouncil andthe World Trade Organization. 21. The DPPR identifies a number o f broad reforms to macroeconomic policy, governance practices, trade policy, infrastructure development, and sectoral policies to realize poverty reduction. It also lays out an ambitious agenda for human resource development, including measures to improve education and health, improve and augment public services, and strengthen social protection. Finally, the DPPR broadly lays out measures to improve and conserve water supply, protectthe environment and strengthen basic infrastructure. 22. By all accounts, government commitment to and progress on reforms has strengthened in the recent past. To operationalize its growth and poverty reduction goals in the short-run, in early 2006 the Government (with strong donor support) put into place its National Reform Agenda (NRA), an ambitious reform program aimed to address a number o f the key development challenges. The stated overall objective o f this agenda is to improve Yemen's investment climate and strengtheningits governance and democratic institutions. It was done inexplicit recognition o f key priorities: "Effective development requires high and sustained economic growth, and in theface of declining oil revenues, Yemen must urgently reorient its economy to non oil-based sectors, thus promoting export diversiJication and labour-intensive segments of the economy. This hinges on Yemen's ability to stimulate domestic private investment as well as foreign direct investment by improving its overall business environment. Bolstering investments, in turn, is conditional on enhancing the governance structure, fighting corruption and removing signiJicant obstacles to investment and growth. '' 23. To make the reform agenda concrete, in January 2006, the Government approved a six month "Action Plan" and a "Matrix o f Good Governance Measures" (MGGM) which together mapped out a set o f discrete, short- and medium-term activities for advancing the reform agenda. The action plan described concrete measures designed to reform procurement, public audit, corruption, debt policy, fiscal policy, the financial sector, public financial management, and the business regulatory environment. The Good Governance Measures organizes concrete measures thematically under the headings o f (i) establish rule o f law, (ii) corruption, (iii) fight improve business enabling environment and government effectiveness, and (iv) increase political participation. 24. Since the approval o f these key elements o f the National Reform Agenda, significant progress has been realized on the planned activities, including a number o f measures designed to strengthen governance and public service delivery, ease regulation and tax burden as a - 10- disincentive to investment, and strengthen infrastructure. Table 3 summarizes some o f the key accomplishments within the "good governance" agenda and makes clear the impressive pace and scope o freform compared to that o f first halfo fthe decade: 0bjective Targeted Activity Achievements/Status Improving Courts Efficiency and Achieve separation o f powers Government o f Yemen has amended Effectiveness (functional and budgetary), the law o f Judicial Authority to independence o f Supreme replace the President o f the Republic Judicial Council from as head o f Supreme Judicial Council Executive; strengthened criteria (SJC) and instead establish a for selection o f judges; separation o f powers. Judicial improved accountability. independence was strengthened and EstablishAdministrative Courts reforms in the judiciary gained Develop an action plan to considerable momentum. The SJC achieve improved court was restructured and i s now headed performance, increase by the head o f the Yemeni Supreme transparency to ensure more Court. In addition, judicial public access to justice services accountability was emphasized as 22 and boost public confidence. Judges were retired and 4 were referred to the Accountability and were ultimately suspended for judicial misconduct. Two new commercial appeals courts were established. A networked, computerized case monitoring system was established in 25 courts (5 appeals, 10 commercial, 10 public funds) which was to be launched in November 2006. Enhance the protection o fproperty Harmonize the functions o f agencies To improve land management, rights dealing with lands by consolidating Government recently consolidated these agencies into one government three public bodies into a single authority. General Authority for Lands, Survey and Urban Planning (GALSUP). [nstitutional and legislative reforms Introduce law on anti-conuption Anti-corruption law was ratified by setting up an independent national Parliament in December 2006. It entity empowered to: establishes a National Supreme Anti- Reduce conflict o f interest. Corruption Authority made up o f Enforce commitments under the figures from the public sector, UN Convention Against private sector and civil society, and Corruption. having political and financial Introduce a National Corruption independence, investigatory powers Record and implement an and the authority to seize and information system. confiscate corrupt proceeds. A 0 Establish a "Hot Line" to report national corruption awareness corruption; protect "whistle campaign was h m h d . Ample blowers". donor sumort i s available for I . implementation. - 11- Table 3: Summary Matrix of GoodGovernanceMeasi !s and Achievements Objective Targeted Activity Achievements/Status Restructure Central Organization for Removed President as head o f Control and Audit (COCA), expand COCA to enhance its independence its mandate and upgrade its and constituted a working group to mechanism to ensure its design measures to improve it. independence; enhance the role of Work on strengthening COCA is control and audit offices in the proceeding o n schedule under ministries and government agencies CSMP, as well as implementation o f under COCA. the accounting and financial management system Establish the Higher Council for Accounting & Audit. Amend Public Tenders Law inorder In 2006, Government approved a to: national procurement manual and Restructure the HighTender standard bidding documents; created Board (HTB) to redefine its role a system for online disclosure o f as an independent entity and procurement-related information and separate its policy and submitted a new procurement law for regulatory functions from its parliamentary approval removing all oversight role. ministerial representation from the Disclose all information on High Tender Board, establishing a public procurement online. new procurement monitoring board Require disclosure o f income made up o f technical experts and and assets of individuals who civil society and allowing non-voting have any role to play inYemen's observers to attend board meetings. public procurement. Require allbidders to disclose A procurement management existing relationship with information system was being relevant decision-makers in introduced, requiring online public procurement process. disclosure o f procurement-related Establish in the HTB and line information. ministries a tender monitoring and tracking system. Submit to the Cabinet the National Procurement Manual and Standardized Bidding Documents rransparency Publish manualdguides for In June 2006, under CSMP, 23 government services and fees related government agencies published to these services through the Manuals o f Government Services different means o f publication providing a list o f their services and including the websites o f each including: government agency. a. requirements to obtain services; b. procedures required to obtain the services; C. length o f processing time and d. required fees The manuals were approved by Cabinet in May 2006, and an - 12- Table 3: Summary o Matrix of GoodGovernanceMeasu s and Achievements Objective Targeted Activity AchievementsIStatus electronic version was published on the website of Ministry o f Planning & International Cooperation (http:/lwww.mpic-yemen.org). Passage o f Financial Disclosure Bill Parliamentary ratification in July bythe Parliament. 2006 o f a Financial Disclosure Law requiring high-ranking public officials (including the President, the Vice-president and the Prime Minister) and public officials overseeing large financial transactions to file a financial disclosure statement. Take necessary actions for Yemen to In December 2006, the President join the Extractive Industries committed Yemen to join the EITI. Transparency Initiative (EITI) In early 2007, the Cabinet followed this up with its own commitment and formal notification was made by the Minister o f Planning (now DPM). Strengthening Public Administration Prepare an action plan that aims to: As part o f its progress on Civil Put in place well-defined Service Modernization, inM a y 2006 requirements for public posts the Government began and increase focus on implementation o f a biometric performance evaluation identification system aimed to Continue civil service eliminate "ghost workers" and modernization according to "double dippers". The first phase adopted strategies. started in Sana'a, Hodeidah and Aden and the second phase, launched early October, included Taiz and Mukalla. The process will continue through 2007, and has already identified a number o f ineligible workers. In addition, internal reviews have identified thousands of double dippers who have already been eliminated from the public payroll. ImprovingFinancial Management Start implementation o f Public In May 2006, the Ministry o f Finance Management strategy. Finance initiated the first phase o f Complete work on Accounting and the Public Finance Management Financial Management Information Strategy. An Action Plan and a System (AFMIS). Partnership Agreement were signed Design a system for a simple between the government and donors, publication o f the budget. outlining a clear agenda with specific Draft a new bill for debt requirements for fill1 management which should indicate implementation. ceilings for public external and internal debt. - 13 - Objective Targeted Activity AchievementsIStatus StrengtheningServices: Imprl ingBusinessEnablingEnvironment and Government Effectiveness Strengthen Tax Administration By replacing hidden turnover taxes with a 5% sales tax, Yemen has reduced the total tax that businesses pay from 170% of gross profit to 48% o f gross profit. Improve Public Services and The Government has launched a Partnership withthe Private Sector project with PEP-MENA (IFC) to simplify, accelerate and reduce the cost ofbusiness registration. Take actions required to cut in half Revise and change the existing The unweighted tariff rate has fallen the time taken for customs clearance procedures and submit a report to the and the number o f tariff bands has and inspection, i.e. from 8 to 4 days Cabinet. been reduced from 4 to 3. An Automated System for Customs Data (ASYCUDA) has been expanded to almost all entry points covering 90% o f imports. The CSMP subcomponent o n civil service has reviewed customs procedures and efficiency. Procedural simplification in context o f reengineering o f Customs Agency under CSMP. IncreasePolitical Participation Enhance the role o f the press in The Government o f Yemen has raising transparency suspended a controversial draft Press law, initiated consultations with civil society on a new draft press law that seeks to protect journalists' rights, and lifted the suspension o f three newspapers. I I 25. However, soon after launching this initiative the Government realized that the time frame for implementing these ambitious plans would have to be extended, and that supplemental assistance would be required to implement them. The IR DPG encourages and rewards key selected actions associated with this recently initiated and dynamic reform eff01-t.~ In January 2007 the Cabinet considered a further Executive Matrix of the Required Short-term Policies and Procedures to Improve Investment Environment inYemen which was expected to be approved. This matrix and the accompanying report embodied a number o f measures identified through consultation with the private sector aimed to increase investment and non-oil growth. - 14- IV. BANKSUPPORT To THEGOVERNMENT'S STRATEGY LINKToTHECAS 26. The Bank's Country Assistance Strategy for 2006-09 is explicitly based on the Government's PRSP for 2006-10. The CAS pillars are consistent with the key focal areas in the PRSP (Le. diversifying growth; human development; and fiscal sustainability). Further, the CAS emphasized the issue o f resource sustainability by elevating it to be a fourth pillar. Each pillar associated with a set o f outcomes arising from the Bank's experience, analytic work and policy dialogue: CAS Pillar One: Diversifying growth through better governance and better delivery of publicservices focuses on four outcomes: i. Improvingthebusiness regulatory environmentincluding: newbusinessregistration, .. tax policy and administration, customs and inspections, and landtitling and registration; 11. Improving road and power infrastructure - this outcome would also support the human development pillar; iii. Improving skills through technical education and vocational training and higher education; and iv. Improving regulatory frameworks and making appropriate public investments in key sectors (rainfed and irrigated agriculture; fisheries; manufacturing; and gas sector). CAS Pillar Two: Improving human development through more efficient service delivery and improvedsafety nets focuses on four outcomes: i. Improvingaccess,equityandqualityofbasiceducation; .. 11. ... Improving access and quality o fhealth; 111. Improving safety net programs; and iv. Improving water supply and sanitation. CAS Pillar Three: Increasing fiscal sustainability through improved public expenditure management focuses on five outcomes: i. Improvingrevenuetransparency; .. 11. ... Improving expenditure management (including through reducing fuel subsidies); 111. Public Sector Reform; iv. Improving public procurement; and v. Improving public financial management. CAS Pillar Four: Increasing resource sustainability through improved management of water resources and reduced populationpressurefocuses on two outcomes: i. Improvedwaterresourcemanagement;and .. 11. Improved control over population growth. - 15 - 27. The CAS places short-term priority on economic governance, in order to create the basis for medium-termactions. Inparticular it highlights: Improved oil revenue transparency to ensure better use o f oil revenues and also lead to increase willingness to be taxed. 0 Improved expenditure management - to ensure efficient expenditure management that upholds safety nets, the delivery o f basic services and public investments needed to support private sector development while controlling waste. 0 Improved business regulatory environment including improving predictability in macro- economic management, regulation, taxation and inspections. 0 Improved institutional arrangements and public service delivery mechanisms for groundwater resource management and controlling population growth. 28. The CAS identifies thirteen instruments o f lending assistance for the 2006-09 period, including the proposed institutional reform grant. It identifies the IR DPG as addressing two o f the four pillars: accelerating non-oil growth and increasing fiscal sustainability. The IR DPGis strategically sequenced as part o f an effort to strengtheneconomic management in anticipation o f a subsequent sector wide or programmatic type o foperation (e.g. PRSC). The CAS envisions the IRDPGas reinitiating policy-based lendingto Yemen andhelpingto establish the conditions for a subsequent three-part programmatic PRSC, intended to launch inthe third year o f the CAS. In this context, it envisions the IRDPGas follows: "To assist the Government in dealing with the immediate reform agenda, theInstitutional Reform Grant would primarily support the Government's National Agenda for Reform (including actions on governance, public sector reform and private sector development actions) as well as sector-specijk actions supporting improved governance. The emphasis will be on a credibleprogram of prior actions and establishment of speciJicJinancing needsfor theprogram (e.g. with regard to the costs of retrenchment in support of the civil service reform program)". 29. The CAS further emphasizes four sources o f fiduciary risks in Government systems that Yemen should work to reduce: budget transparency; internal auditing; preparation o f final accounts; and external auditing. The ongoing public financial management strategy (see paragraph 39) is working to strengthen all o f these elements, and the IR DPG i s specifically designed to complement the existing Government partnership with donors. Further, work to strengthen public administration reform and the investment climate under the IR DPG should contribute to reducing fiduciary risk, both by helping to contain the overall wage bill and strengthen service delivery, and by contributing to non-oil growth, hence medium- and long-term revenue. To inform decisions about the readiness for subsequent programmatic lending, upcoming economic and sector work (the PER, CFAA and CPAR) would assess progress and challenges inpublic financial management. COLLABORATIONWITH THEIMFANDOTHERDONORS 30. The International Monetary Fund has been the leading actor in advising the Government on reform o f its tax system and stabilizing revenue in the face o f declining oil revenues. It has - 16- earlier focused technical assistanceprimarily on the implementation o f the General Sales Tax and the collection o f taxes from large taxpayers. The IMF's recent Article IV mission concluded in June provided an up-to-date view on inflation and macroeconomic policy. Its conclusions formed the basis for renewed Government attention to both fiscal and monetary policy, and a working agreement between the Government and the Bank on actions that will help to restore an acceptable macroeconomic policy framework. The task team and country economic team have consulted the IMF team on inflation, monetary and fiscal policies, and this dialogue will continue. Clearly, there is concern about the elevated inflation, but measures already agreed to are projected to restrain it to 12-14 percent for 2007. In addition, the IMF has advised the Government that corporate income tax reform should only take place within the context o f broader tax incentive reform, so that lower rates can be compensated for by a broader tax base. This advice has been embraced bythe Ministryo fFinance. The Bank collaborated with the IMF on updating its Debt Sustainability Assessment (DSA). The task team has also met with other key donors to coordinate the investment climate and governance elements, including UNDP, GTZ, DFID, EU and DFID. These meetings have been positive and highly constructive and a number o f complementarities between the IR DPG and ongoing or planneddonor activities have been identified. RELATIONSHIPTo OTHERBANKOPERATIONS 31. The IRDPGis one project in a program o f lending and non-lending assistance defined in the CAS to support the Government's PRSP. This agenda includes the IR DPG, the future programmatic operation, and a number o f other operations summarized inthe table below (from the CAS) that support each o f the four pillars. While the IR DPG focuses on the pillars o f non- oil growth and fiscal sustainability/govemance; a number o f other operations complement it in attaining these goals, while still other operations focus on human development and resource sustainability. Inall, 13 operations are envisioned for the CAS period (Figure 1). Figure1: FromCountryAssistance Strategy: Republicof Yemen (2006) - 17- LESSONS LEARNED 32. The Country Assistance Evaluation for the period FY99-2005 reported inthe CAS drew a series o f lessons and recommendations from that experience.6 These include that future Bank program should: Learn local conditions by conducting adequate research and developing issue-specific knowledge to have country specific solutions (e.g. as inthe water sector); Moderate optimism by making more realistic assessments o f ownership, speed o f implementation and likely outcomes; Upgrade governance as a central constraint to delivering public services and as a cross- cutting theme inits program'; 33. As noted below, the IR DPG is based on considerable prior analysis and dialogue, including about the realism o f its objectives. Governance i s a central theme. 34. The CAS completion report added lessons on selectivity, long-term partnerships, strengthening state capacity and accountability, and a greater focus on implementation. The IR DPG builds on the growing and successful reform partnership established between the Government and donors. Great selectivity was required to find a valuable, attainable and realistic set o f actions associated with its two tranches. The second tranche focuses entirely on implementation o fpolicy reforms. 35. The 2006 DPL Retrospective drew specific lessons and conclusions applicable to future development policy lending. Paraphrased, the major findings include the following: The need to express clearly the Bank staffs assessment o f the macroeconomic policy framework and growth estimates for the short and medium-term, as part of the debt sustainability and risk analysis. The need to clearly document the analytical underpinnings o f selected policy actions supported by the operation or the expected results. The need to systematically document the participatoryprocessesusedby Governments to define their programs. The need to document the distributional effects o fthe operation. The need for upstream screening for potential negative environmental impact. The need to systematically track progress inPFM(including procurement), including with PEFAindicators, as a means to monitor the fiduciary environment. The need to carefully monitor the size o fthe policy matrix and number o fbenchmarks, and the need to motivate Governments to take the lead insetting out the details o f their policy program. The limited progress achieved during this period was reflected inthe Bank's programunder the previous two CASs being rated as moderately unsatisfactory by the Independent EvaluationGroup (IEG). 'Country Assistance Strategy, Op. Cit., p. 19. The list also included the need to save water, counteract Qat and improve populationpolicy. - 1 8 - (viii) The needto make consistent use o f a results framework, choosing results that are possible to influence inthe short-to-medium term yet not trivial, associated with quantifiable outcomes, and inline with the CAS.' 36. Development Policy finance starts from a satisfactory macroeconomic policy framework. Both the Bank's country economic team and the IMF were consulted or engaged in its preparation. Through broad consultations, the preparation process countered some o f the weaknesses in existing participatory processes. The analytic underpinnings are discussed below. In the consideration of social and environmental safeguards, potential adverse social and environmental consequenceswere carefully considered. ImprovedPublic Financial Management (PFM) is actively promoted by the project and its policy matrix. The policy matrix, while ambitious, i s limited and will be actively monitored. The actions associated with the operation are believed to be closely associated with positive results, and the elements o f the results framework are identifiedinthis Program Document. ANALYTICALUNDERPINNINGS 37. The IR DPG components are based on both prior analytic work and extensive dialogue with key Government counterparts, local stakeholders (including members o f civil society), country experts, and other donors. Key analytic underpinnings to the IR DPG include the following: 0 Republic o f Yemen, Ministry o f Planning and International Cooperation. The Socio- Economic Development Planfor Poverty Reduction (2006-2010) October 2006. 0 The World Bank. YemenEconomic Monitoring Report (Washington: August 2006) 0 World Bank. Country Assistance Strategv -- Republic of Yemen (May 17,2006). e World Bank. Republic of Yemen -- Investment Climate Assessment: Priorities and Recommendationsfor Accelerating Private-Led Growth (May 12,2006) 0 World Bank. Development Policy Review (March 2006) 0 World Bank Group, Doing Business 2007 (Washington: World Bank Group, 2006) 0 World Bank. Yemen Urban Land Policy and Administration Policy Note (2006) 0 United States Department o f Commerce US. Department of State, Investment Climate Statement -- Yemen (Washington, DC: 2006) 0 World Bank. Economic Growth in the Republic of Yemen: Sources, Constraints and Potentials (Washington, DC: World Bank. 2002) 0 World Bank. Comprehensive Development Frameworkfor Yemen (2000) 0 World Bank. Project Appraisal Documentfor a Civil Service Modernization Project (March 23,2000) 0 World Bank.Country Financial Accountability Assessment (CFAA) (2003) 38. The IR DPG builds on these underpinnings and on the ongoing dialogue on the investment climate, fiscal reform, land policy, governance, public financial management, and public administrative (civil service) reform. A final analytic input, recommended by the ICA, i s DevelopmentPolicy Lending Retrospective:Key Findings And Recommendations (World Bank, 2006) - 19- the FIAS tax incentive stud?, conducted in January and delivered to the Government in May, which provides important context for the corporate tax reform component. v. THEPROPOSEDINSTITUTIONALREFORM DEVELOPMENT POLICY GRANT OPERATIONDESCRIPTION 39. The Institutional Reform Development Policy Grant (IR DPG) is a development policy operation intended to support the implementation o f key elements of the Government's reform program as specified in the Yemen Country Assistance Strategy (CAS). As specified in the CAS, the IR DPG focuses on two pillars o f the broader country strategy: (i) increasing non-oil growth (with special attention to recommendations included from the recent investment climate assessment); and (ii)strengthening governance. Actions were selected for support by the IR DPGdue to three criteria: 0 They should have a substantial beneficial impact on their designated objective (either non-oil growth or strengthened governance). There should be a high likelihood o f success in achieving prior actions as indicated by Government commitment and progress towards completion o f each designated action. 0 They should be readily monitorable, short-term actions that can be achieved within the one-year lifespan o f the IRDPG. 40. The team believes that the grant will need to be disbursed over two tranches, with a first tranche requiring legislative achievements as prior actions, and the second focused on the implementation o f approved reform measures within 12 months o f signing to assure that supported measures are implemented. The potential components and actions associated with each tranche are discussed inthe following sections. POLICY AREAS A. StrengtheningPropertyRightsand the IncentiveFrameworkto encourage Non-Oil Growth 41. The first two components o f the IR DPG address two key challenges to private investment and non-oil growth: (i) structure o f incentives confronting investors; and (ii) the the security o fproperty rights underpinningmarkets are each critical to a sound investment climate." These elements were selected from a range o f recommendations inthe 2006 Investment Climate FIAS. Yemen: A Study into the Impact of Tax Policy and TaxAdministration on the Investment Climate 2007. I OIt is important to note that a number o f other investment climate reforms are underway, including streamlining o f business start-up procedures (with IFCFEP-MENA support), process reviews o f tax and customs administration under the CSMP, and support for customs and tax administrative reform under the PFM Action Plan, from the IMF, and from other donors. - 20 - Assessment, based on the experience and priorities o f investors. It is important to note why some other key constraints identifiedinthe I C A (Figure2) are not addressedhere: 0 Macroeconomic policy i s addressed through country dialogue and as a precondition for the entire IRDPG and subsequently plannedprogrammatic PRSC. 0 Trade regulation and customs performance was investigated during identification but were not pursued due to the likely lengthy timefi-ame o f policy reforms and the sensitive stage of public administration reform within the Customs Authority under the Civil Service Modernization Project (CSMP). Electricity supply issues are being addressedby the 2006 Power Sector Project. 1 Figure 2: Top constraints (of 18 categories) identified by Yemeni enterprises inICA enterprise survey Yemen: LeadingInvestmentClimate Constraints I 0 10 20 30 40 50 60 70 80 % of Firm IdentifyingConstraintas "Major" or "Very Severe" 42. Component 1: Income Tax Reform. Taxation is central to the incentive regime for investment which, in the past, has served as a deterrent to efficient investment in non-oil activities. The ICA found that companies in Yemen face high marginal income tax rates; nonstandard treatment o f income, investment and expenses, and discretionary implementation mar the incentives and add uncertainty for firms operating in Yemen. An ongoing FIAS review o f incentives created by the Yemeni tax system shows tremendous distortions created by the tax and investment incentive system, substantial disincentives for formality and formal bookkeeping, nonstandard treatment o f investments (exemplified by the depreciation rules) and pervasive corruption and irregularities in tax administration. With the guidance of the IMF, the Government has introduced a value added tax as o f January 1, 2007, which replaces the general sales tax that had been inplace the previous two years. (It has also been buildingthe capacity o f tax administration, creating a large taxpayers unit.) However, the introduction o fthe value added tax provoked a strong reaction from the private sector, both because it extends the tax to a large number o f firms and activities that formerly did not need to comply and because it requires -21 - accounting which the private sector finds onerous, exposes it to the 35 percent corporate income tax, and could leave it exposed to unreasonable demands and harassment fi-om the tax authority. To address these concerns, the Government agreed to ease initial implementation o fthe V A T and to lower the income tax rate. 43. The Government's Matrix o f Good Governance Measures under the National Reform Agenda (NRA) includes a plan to "review and amend [the] tax code to be in conformity with international norms and the outcomes o f adopted relevant ~tudies.'~"The output i s specified as the submission o f draft legislation. The IR DPG team found during identification missions that the Tax Authority has drafted the elements o f a new corporate income tax law. The Government proposal encompasses many o f the provisions generally sought in good tax systems - low rates, elimination o f many exceptions, more standardized treatment o f investment and costs, and self- assessment enforced through risk-based audits. Inorder to assure that the provisions o f the new law are in compliance with international norms and that they facilitate improved administration and compliance, the Tax Authority agreedthat an international expert could review its provisions and advise the authority on the law, as part o f preparation for the IR DPG. This occurred in March and the final draft was reviewed in May 2007. Among key measures associated with the project, this component would support: Preparation, approval by the Ministry o f Finance and submission to Cabinet o f a new corporate income tax law, reflecting international n o m s o f treatment o f income, investments and expenses, as a prior action. 0 Implementation o f the new corporate income tax law as a second tranche release action, as indicated by the issuance o f executive regulations in accordance with international norms. 44. To follow up, the team recruited appropriate regional expertise and reviewed and contributed to the Yemeni draft law, working carehlly with the Yemeni Tax Authority to bring the treatment o f income, expenses and investment, into conformity with international norms. As part o f this work, a workshop was organized with the Tax Authority on the Egyptian experience in corporate tax reform and features of international good practice. At the same time, it is recognized that for the tax system to be sustainable, lower rates must be accompanied by fewer exceptions. This will require Government to carefully consider the recommendations o f the recently-completed FIAS tax incentive study, including the unification tax incentives (some o f which exist under the investment law or the customs code) under the tax code and Tax Authority. The existing structure o f sector-specific tax holidays and incentives has created substantial distortions and an inefficient system perceived by many taxpayers as unfair. Other features o fthe tax system may encourage evasion or administrative discretion. The FIAS report lays out suggestions for a simplified and unified system relying on broad incentives (such as accelerated depreciation and a possible investment tax credit) that would encourage investment but remove distortions, and allow for lower rates while preservingthe tax base. IIThe simultaneous "Action Plan" had a near identical provision to "harmonize corporate tax code to be in conformity with international norms." - 22 - 45. Component 2: Land Titling and Registration Regulatory and Institutional Reform. The property rights regime is a fundamental underpinning o f any market economy. Access to land i s a key constraint to new investors locating a business, given pervasive insecurity o f property rights. It i s estimated that no more than 5-10 percent o f all urban land and property i s registered, using a process that i s highly ineffective. The supply o f commercial land with secure legal title has been very constrained, with many investors having to pay twice for land (to the State and to individual or tribal claimants). According to a recently-completed World Bank Policy Note, up to half o f all licensed investment projects incities such as Mukalla and Aden did not materialize due to land-related problems. A recent General Investment Authority study found that 2,330 licensed investment projects (roughly 45% o f the total) did not materialize, and land availability was the most important reason (electricity and other institutional constraints came second and third).I2 The land registration law i s rudimentary, and the deed registration system relying on a person-based approach (called sejel shakhsee in Arabic) i s imprecise; the result is that land titles are subject to much fraud and land disputes clutter the courts (some 50% o f the caseload in primary courts is over land and property rights, and most require over 5 years to settle). The weakness o f administrative title registration procedures contributes to a widespread perception that registration i s a complex and costly process with little benefit, which inherently limits the use o f the registry. This in turn distorts the landmarket, since buyers o f landtend to acquire land only from trusted sources and thus pay a significant premiumdue to highrisks and transaction costs. Buyers also resort to the courts to authenticate transfer deeds, a process which does not offer secure title. 46. The Matrix o f Good Governance Measures (MGGM) calls for steps to "enhance the protection o f property rights" as a key measure to strengthen the rule o f law. In parallel, the Yemen 2006-09 CAS recommends revision of the land registration law to make the act o f registration legally conclusive, strengthening the administration o f land registration (and allocation o f public land), and pilot efforts to systematically title land in specified areas. The Bank has been advising the Government since 2004 in the land sector to strengthen the administration o f property rights and the management o f public land assets, working with a government-designated Land Policy Task Force comprised o f senior officials from all concerned ministries and agencies, private sector representatives (federation of chambers o f commerce and industry, lawyers syndicate, andnotary publics), as well as members from the Parliament and the judiciary. The resulting detailed recommendations including to strengthen the regulatory framework for land registration, and implementation action plan are found in the "Urban Land Policy andAdministration PolicyNote" (World Bank, 2006). 47. In an attempt to better coordinate public authorities with responsibility for land, the Government recently consolidated three public bodies into a single General Authority for Lands, Survey and Urban Planning (GALSUP). To make this structural consolidation effective in the area o f land registration, it is understood that further reform is needed to revise the land registration law to make it legally conclusive and to strengthen the administration o f land registration. A new land registration law (and executing regulations) will help to remove ambiguity and reduce conflict about land ownership and to authorize improved administrative 12As reported in Sabanet, February27,2007 - 23 - mechanisms for regulating land ownership and use. Further, by creating a legally independent registrar, political influence and discretion can be reduced in the establishment and transfer o f property rights. This measure i s also critical to address the perceived conflict o f interest resulting from placing under one roof the registry-as adjudicator o f property rights to land, and State land management-one o f the land owners and thus a potential party inproperty rights disputes. It is proposed that the IRC support two further measures: The development and presentation to Parliament o f a new land registration law as a prior action for the release o f the first tranche. The basis for the revision o f the land registration law i s the draft preparedin 2004 by the Ministry o f Legal Affairs (MOLA), which represents a significant improvement over the current law o f 1991. The revised law, based on the 2004 draft by MOLA, takes into account the recommendations o f the Land Policy Task Force (LPTF), as detailed in the World Bank's "Yemen Urban Land Policy and Administration Policy Note", as well as the implications o f the institutional reorganization. Dialogue concluded by the Bank with the Government assured that specific provisions were incorporated to reflect these recommendation^.'^ On September 11, the Council o f Ministers approved the draft law and forwarded the revisions to Parliament. Inthe recent dialogue with the Government, it was agreed that by second tranche release, several actions would be complete to ensure that the land registration law can be effectively implemented and the implementing authority can function effectively to execute its full mandate. The following are all critical measures to enable the achievement o fthese objectives: - Approval and implementation o f the executing regulations o f the new land registration law in accordance with the underlying principles and recommendations o fthe LPTF and the PolicyNote. - Appointment o f a legally independentregistrar. - Completion and endorsement by Cabinet o f an organizational decree for the authority that organizes and clarifies its mandate and functions vis-&vis other authorities and agencies. This especially important since the creation o f the new authority has brought about a confusion regarding land use planning responsibilities and the respective roles o f central and local government. 48. The specific prior action associated with the second tranche release would be the third o f these actions - completion o f an organizational decree to clarify the mandate and functions o f the landauthority. The policymatrix would also support the other two actions. 49. The Bank has beendeeply engaged inpolicy dialogue with the Government as well as the private sector and civil society (through the LPTF) on land issues over the past two years. For this component it has mobilized top international legal expertise on land and property law, to advise the Government on finalizing the draft land registration law and on the Executive Regulations. 13Sameh Wahba, Institutional Reform Credit (IRC), Aide Memoire for the Land Component Mission, February 3- 13, 2007, and Aide Memoire o f IRC Appraisal Mission, March24-28,2007. - 24 - B. Strengthening Governance through improved public financial management and public administrativereform. 50. Governance poses a substantial challenge in Yemen. Without good governance, government credibility i s weak and other reforms are hard to enact and implement. Yet, international and survey indicators suggest governance quality in Yemen i s low. In the Investment Climate Assessment (ICA) survey and interviews, businesses reported frequent requests for bribes and corruption in public procurement and reports o f arbitrary administrative behavior. The PRSP puts strengthened governance at the top o f its priorities. A number o f analyses have concluded that Government cannot deliver the economic reforms and social services required to fulfill its Poverty Reduction Strategy without substantial public sector reform. As noted inTable 3, under its Good Governance Matrix, the government has committed to a broad agenda o f reforms to strengthen governance and has made significant progress on many fronts. 51. Two central components o f governance reform where the Bank and other donors are focusing attention are strengthening public financial management (PFM) and conducting broad- based civil service/public administrative reform. With regardto the first o f these, earlier work on public financial management suggests serious weaknesses in Government oversight o f public resources. 52. The 2004 Country Financial Accountability Assessment (CFAA) and the Public Expenditure Management (PEM) reports included a number o f recommendations to reduce fiduciary risk and improve PFM. These recommendations were discussed and agreed with the Ministry of Finance and provided the basis o f the PFM Action Plan approved by the Cabinet (Cabinet Decree, Resolution 9 August 2005, No. 253) in2005 with the endorsement o f all active donors inYemen. The Cabinet later approved the P F MReform Strategy and resolved to establish a Ministerial committee chaired by the DeputyPrime Minister to oversee PFM reform. Then, in January 2006, the President approved a PFM Policy Matrix with an action plan tackling short term reforms. In 2005, the Government approved, in consultation with key donors, a Public Financial Management Action Plan (Cabinet Decree, Resolution 9 August 2005 # 253). Multiple donors then entered a partnership agreement to assure coordinated support through a program o f technical assistance and capacity building to underpin the Government's plan. Among the aims o f this technical assistance are to: 0 Modernize internal fiscal oversight, by strengthening budget procedures, revenue administration (including tax and customs) and transparency, and pension administration. 0 Strengthen management o f macroeconomic policy, including the balance o f payments, debt management, and foreignreserve management. Strengthen monetary and financial systems by improving the use o f monetary policy instruments,strengthening bankingsupervisionand restructuringpublic sector banks. Create capacity to produce and use high quality statistical information for economic policy making. - 25 - 53. The Government's PFM Reform Strategy i s being operationalized through the vehicle o f annual PFM reform action plans agreed between the GOYand the PFM donor group. The 2007 Action Plancomprises the following main components: a Reviewing current budget practices, utilizing a public expenditure and financial accountability (PEFA) framework. a Embarking on the development o f a Medium Term Expenditure Framework (MTEF) to improve financial planningand resource allocation. a Strengthening public internal financial control, including the internal audit function. 0 Establishingand strengthening the treasury function within the Ministry o fFinance. a Strengthening the public procurement function, including by establishing a Public FinancialManagement Advisory Unit. a Drafting a new organic budget law designed to set broad regulations for preparing and implementingthe budget. 54. This Action Plan is being supported by a consortium o f donors that includes the UK, the - _ _ Netherlands, Germany, the US and the UNbP, who provide supportive technical assistance. Also in 2007, the World Bank will be financing an assessment o f the performance o f the PFM system employing the Public Expenditureand Financial Accountability (PEFA) framework. This will provide the baseline against which progress inPFMrefomwill be tracked. 55. Complementary to public financial management reform i s civil service and public administrative reform. Without a well-skilled, well motivated, and adequately paid staff to underpin improved systems, the benefits o f improved public financial management and the goal o f improved service delivery will not be achieved. Currently, Yemen's public administration i s overstaffed and inefficient. Proportional to its economy, its wage bill is high by international standards, yet the individual compensation o f civil servants i s inadequate, with monthly wages for some employees near the poverty line. Average civil service wages have declined by over 90 percent in real terms since 1990. The existence o f a large, underpaid civil service creates widespread opportunities and incentives for corruption, with little means to motivate highquality delivery o f public services. The large size o f the corps creates fiscal constraints to improving incentives. 56. The country's unification compounded staffing problems in the Civil Service and in public administration. The administrations o f North and South Yemen were united without rationalizing its structure and staff. The civil service i s suffering from severe excesses in certain geographic areas and functions (e.g. high administrator to teacher ratios) and severe shortages in other areas, such as information technology. 57. In this context, public administration reform has become central to the Government's reform program. Over the past several years, the government has worked on developing a multi- faceted strategy aimed at moving to a more performance-based, professionalcivil service through the development o f development o f clear processes, procedures, and policies for the - 26 - government's core systems. The Bank, through its Civil Service Modernization Program, has led the dialogue on these reforms.14 As noted under Component 5, Government has progressed on several fronts in developing and beginning to implement a comprehensive human resource management strategy. The IR DPG will support actions which are, at this stage, critical to the credibility and further progress o fthis initiative. ~~~ ~~ ~______ Box 3: The Civil Service Modernization Project The context for the civil service component o f the IR DPG i s an ongoing effort at public administrative reform. The Government strategy supported by the Civil Service Modernization Project focuses on the creation o f institutions, capacity, and systems, for sustained human and financial resources development. The project has five components: i.Improvementsincoresystemsrequiredtechnicalassistancefortheselection,andpreparationof priority reforms, to be implemented later inthe project. Computerization o f core systems was to be established, and extensive training provided, through specific modular courses on new core systems and skills. Sub-components include financing and training for human resources, and personnel information management development, including payroll, and accounting information management best practices; ii.Technicalassistancehasbeenprovidedtocreate acivilservicefund,andestablishitspolicy framework regardingretirement, redundancy, and severance options; iii.A re-engineering process is aimed to streamline, and rationalize organizational structures, simplify businessprocesses, and establishbasic information systems; iv. A capacity buildingcomponent is focused on the a) skills needed to sustain the reformprogram, and, b) management slulls to administer civil service; and v. A program management structure component uses technical support to accomplish standard supervision, and performance audits. 58. Thus to strengthen governance, components three, four and five o f the IR DPG support critical actions under the Public Financial Management (PFM) plan and public administration reform. They include strengthening public procurement, improving revenue transparency and key elements of public administration reform focusing on human resource management. These were elements found during identification both to make a strong contribution and to complement other work under the PFM actionplan, CSMP and other donor-financed initiatives. Component3: StrengtheningPublicProcurement 59. Strengthening public procurement forms a central part o f the public financial management and governance challenge. This aspect i s central to building the capacity o f Government to manage public resources in support o f private-led growth. The MGGM calls for a series o f measures to strengthen governance, including already approved financial disclosure and anti-corruption laws, and a variety o f procurement reforms. As noted, a substantial 14The CSMP has also supported key PFM-related reforms, including the introduction o f AFMIS, a computerized accounting and financial management information system; implementation o f internal audit across Government ministries; and re-engineering o f the Government's external audit office, COCA. - 27 - partnership with donors i s already inplace to support PFM reform. Under the first pillar o f the NRA, procurement reform is identified as a central component o f measures to enhance transparency and fight corruption. The Bank has led donor dialogue about and support o f procurement reform and it i s appropriate to continue this role through the IR DPG. As one part o f its procurement reform, the Government has already approved a standard procurement manual and procurement documents to be used in public sector transactions. The next centerpiece o f relevant reform is the new procurement law15and executing regulations. Another keypart o fthis reform i s the strengthening o f institutional capacity to oversee and monitor procurement. The MGGMdescribes two keyactions inthis regard: 0 Submit to Parliament a new Procurement draft law consistent with international standards after consultations with the Bank and Cabinet endorsement 0 Restructure the High Tender Board (HTB) by redefining its role as an independent institution. Separate the HTB's policy and regulatory functions from its oversight role as the apex body o fprocurement operations inYemen's public procurement system 60. To do this, within the framework o f the draft procurement law, the Government is planning to restructure the High Tender Board (HTB) by redefining its role as an independent technical institution. The legislation would also move HTB's policy and regulatory functions to a newly established Procurement Policy Monitoring Board with a procurement tracking system under its authority. The tracking system has already been introduced, and would be transferred from the HighTender Board to the Procurement Policy MonitoringBoard once it is established. This would give the Government a systematic means o f overseeing and regulating procurement, and a dedicated body handling policy and monitoring. The Government's reform program calls for several measures to strengthen public procurement, including: 0 Submit to Parliament a new Procurement draft law consistent with international standards. 0 Restructure the High Tender Board (HTB) by redefining its role as an independent institution. Separate the HTB's policy and regulatory functions from its oversight role as the apex body o fprocurement operations inYemen's public procurement system. The new Procurement Law was approvedby Parliament inJuly. 61. The program further calls for the introduction o f a tender monitoring system, approval by Cabinet o f a National Procurement Manual to be used across all line ministries, and new requirements for disclosure. The Government has been working closely with donors to develop all o f these elements and i s close to introducing a new public tender law. To support this work the IRDPGwould support two actions, as first and second tranche measures, respectively: 0 Approval o f the executing regulation for the new procurement (public tender law) as a prior action. This legislationwas explicitly identifiedas the next step inprocurement reform inthe Government's update on the NationalReformAgenda delivered at the Donors' Consultative Group meetinginLondoninNovember 2006. - 28 - The establishment o f a separate Procurement Policy Monitoring Board with a procurement tracking system under its authority as a second tranche release action. 62. The accompanying IR DPG policy matrix will describe complementary actions to strengthen public financial management. The Bank has actively engaged in dialogue with the Government on its reform of procurement and tender procedures, i s coordinating the dialogue on these actions. I Box4: AFMIS Under the Bank-financed CSMP, the Government o f Yemen is introducing a computerized Financial and Accounting Management Information System (AFMIS) that i s supervised by the Ministry o f Finance (MOF), through a Project Implementation Unit (PIU). AFMIS i s designed to address three major parts of public finance management reform; those are budget preparation, budget execution and accounting. AFMIS supports of reforms in the public expenditure process, both at the Central and Local Authority Levels. In its first stage, the system will be rolled out to three large government spending units, and ultimatelyto all other governmental spending units. Component4: ImprovingRevenueTransparency 63. Strengthening revenue transparency has been a major objective of Public Financial Management reform efforts. Given the centrality of oil and, now, natural gas revenue to the budget, transparency about these revenues i s a vital part o f achieving this objective. The first action listed under the MGGMto fight corruption i s "join the Extractive Industries Transparency Initiative (EITI) to improve accountability in the oil and gas sector." Government's reform strategy (NRA) also calls for Yemen to j o i n the EITI, an international compact of resource- exporting nations willing to abide by agreed international standards. Box 5: The EITI Criteria 1. Regular publication of all material oil, gas and mining payments by companies to governments ("payments") and all material revenues received by governments from oil, gas and miningcompanies ("revenues") to a wide audience ina publicly accessible, comprehensive and comprehensible manner. 2. Where such audits do not already exist, payments and revenues are the subject o f a credible, independent audit, applying international auditing standards. 3. Payments and revenues are reconciled by a credible, independent administrator, applying international auditing standards and with publication of the administrator's opinion regarding that reconciliation including discrepancies, should any be identified. 4. This approach i s extended to all companies including state-owned enterprises. 5. Civil society i s actively engaged as a participant in the design, monitoring and evaluation o f this process and contributes towards public debate. 6. A public, financially sustainable work plan for all the above is developed by the host government, with assistance from the international financial institutions where required, including measurable targets, a timetable for implementation, and an assessment o f potential capacity constraints. - 29 - 64. In the Bank's view, the Government has already published most of the required information for compliance with the initiative and a number o f cabinet officials have approved o f accession to EITI. InNovember 2006, the President confirmed Government's intention to join the EITI. Taking the necessary steps for Yemen to join the EITIwould therefore be identified as a prior action for the IR DPG. The mission determined that a great deal o f preparatory work has already been achieved. The work o fthe country team and two missions by the World Bank's Oil, Gas and Mining Policy and Operations Unit EITI team have established a high quality dialogue and technical assistance relationship with Government's designated counterparts, focusing on the Ministryof Oil andMinerals (MOM). InMay, a World Bank mission concluded that there is a "high degree of commitment ofthe Government o fYemen to implement EITI" and laid out five initial implementation steps to take place in coming months: (i)establishing EITI secretariat functions within MOM; (ii) completing EITI sign-up steps; (iii) convening EITI stakeholders; (iv) assuring that there are no legal obstacles; and (v) convening an EITIworkshopAaunch event with relevant stakeholders. Following these steps, additional actions would be taken to fklfill EITIdata reporting and reconciliationrequirements, public dissemination, and other aspects. 65. The first tranche condition requires Yemen to formally declare its adherence to the Initiative's principles and specify the procedures it will follow to implement those principles (see Box 5). This has been achieved by two means: (i) the President has already announced Yemen's adherence, and (ii) the Cabinet approved accession and notified all 3 partners (the Bank, the IMF and DFID) o f Yemen's adherence to EITI, with a copy sent to the International EITI Secretariat for inclusion on its website. Compliance will next require adherence to EITI's principles, including: Publication o f independently audited accounts documenting all material oil, gas and miningpayments by companies to governments ("payments") and all material revenues received by governments from oil, gas and mining companies ("revenues") in a publicly accessible, comprehensive and comprehensible manner. Payments and revenues are reconciled by a credible, independent administrator, applying international auditing standards and with publication o f the administrator's opinion regardingthat reconciliation including discrepancies, should any be identified. 0 This approach is extended to all companies including state-owned enterprises. 0 Civil society i s actively engaged as a participant inthe design, monitoring and evaluation o fthis process and contributes towards public debate. A public, financially sustainable work plan for all the above is developed by the host government, with assistance from the international financial institutions where required, including measurable targets, a timetable for implementation, and an assessment o f potential capacity constraints. 66. The first o f these actions, the publication o f independently audited accounts, would constitute the prior action for second tranche release. - 3 0 - Component5: ReformingCentralGovernment-PublicAdministrationReform 67. As noted above, public administration reform is regarded bothas a fiscal necessity (dueto the hugeburden o f the wage bill and related obligations) and as a vital component o f reforms to promote good governance. The existence o f a large, unfocused administration and a bloated yet underpaid civil service creates widespread opportunities and incentives for corruption, with little means to motivate highquality delivery o fpublic services. The MGGMenvisions continuing the reforms aimed at achieving a modern, professionalized and well-performing civil service. Since 2000, the Government's reform efforts have been supported by a Bank-funded Civil Service Modernization Project (CSMP) supporting institutional, proceduraland incentive reforms. 68. The Government o f Yemen has made HumanResource Management a central pillar o f its multifaceted public administrative reform. The Government's strategy i s centered on four mutually reinforcing objectives. They are: (i) Create an adequate Human Resource Management System capable to adequately track and oversee the evolution o f its workforce and reduce the incidence o f ghost workers and double dippers; (ii)Develop a medium term strategy regarding new employment to ensure that new employees address specific needs o f public administration; (iii)Implementawagestrategytoimprovecompensationofitscivilservantsinafiscally sustainable manner; and (iv) Operationalize the Civil Service Fund, a redundancy scheme aimed to process redundant civil servants. 69. To achieve the first o f these, with the support o f the IDA-financed CSMP Project, the Government has undertaken a Civil Service Census, which enabled the Government for the first time to get an accurate count o f its HumanResources inthe aftermath o funification and the Civil War. With this data, the Government has developed a Civil Service database which has captured for each individual civil servant all the required data to accurately track its HR evolution. Data includes vital information, academic credentials, current functions, career development, and training received. This data base will be strengthened with the inclusion o fbiometric data which will enable matching o f every HR file with one employee and thus reduce the incidence o f double dippers and Ghost workers. Impressive strides have been made in biometric identification over the past year. This has included extending the biometric system to the Military, the Judiciary and the Police to ensure that there will remain no opportunity for double dippers to perceive two government salaries. Underthe biometric identification program, almost 200,000 employees have been fingerprinted. The development o f this database has allowed the government to move forward inrationalizing its labor force, by: (i) enforcing its retirement rules; and (ii)removing payroll entries for persons that do not exist (ghost workers) and those collecting multiple salaries. According to Government records, payroll entries for the civil service have been reduced by over 34,000 entries in 2006 alone. (An impressive 14,000 people have come out so far and voluntarily relinquishedjobs for fear o f being identified through the biometric technology.) Inthe final phase of the Civil Service Modernization Project (CSMP), the pace o f biometric identification is being rapidly accelerated with a goal o f complete coverage - 31 - by the end o f calendar year 2007. Ifthe current pace were maintained for the entirety of public employees, as many as 135,000 payroll entries could be removed from the payroll. 70. On the second objective, development o f a medium-term strategy for new employment, over the past year the Government has worked on the one hand to decentralize public sector employment to the governorate level and on the other hand maintain tight control o f the hiring process under the responsibility o f the Ministry o f Civil Service and Insurance. A Government decree passed on May 15, 2007 further strengthened control o f new hiring, by linking new hiring to departure o f employees from public employment starting with the 2008 budget. This measure will encourage public agencies to more aggressively work to identify ghost workers and more carefully assess their new hiring needs prior to advancing requests for new employees. The Government decree is targeted to further discourage the hiring o f unskilled new workers and to significantly limit discretionary hiringbyministers and heads o f agencies. 71. Additionally, it has moved forward on developingjob descriptions andjob classifications for each position in the Government, thus defining specific academic profiles for each position and also specifying levels o f experience and career paths for individual employees in each ministry. Thanks to these tools the Government was able to produce a medium-termhiring strategy for the period 2005 -2010 which has identified skill based needs within the Government and has focused its hiring on these specific needs. As a result o f these measures, new hiringin the Government has declined from 34,000 in2004 to 10,000 in2007, a level only slightly above the attrition rate in the Government. It is expected that as a result o f the hiring procedures encompassed in from the new government decree, the levels o f new hiring will be below the attrition rate starting in2008. 72. The Government's wage strategy, adopted in 2005, links wage increases to systemic reform. It has focused on improving base salaries for civil servants, rationalizing allowances to increase transparency in the salaries o f the public servants, decompressing the salary scale (to motivate performance and recruitment o f skilled workers) and tying new wages to compliance on the part o f individual agencies with the new HR measures undertaken by the Government. This strategy i s articulated in four phases. For example, the first phase has increased the minimum base salary o f public servants from YR 11,000 per month to YR 20,000 per month (the poverty line), while reducing the number o f allowances from over ninety to just three. As a result o f this first wage increase, public servants have a starting salary closer to the poverty line and the compression ratio between the minimum and the maximum salary has beenimproved to three to one. The reduction o f allowances partially mitigated the budgetary impact, while increasing the transparency o fthe wage scale. 73. Further mitigating the budgetary impact of the wage increases, accessing the new salary scale for phase 1 has been connected to the identification on the part o f individual agencies inthe government of those people who are actually coming to work every day and are known by their supervisors. The first phase o f the wage strategy allowed identification o f ghost workers, double dippers and employees due for retirement in advance o f biometric identification. This reduction inemployees has meant aYR 10billion savings from budgetedwage increases. - 32 - 74. Subsequent phases are tied in the law to other forms o f compliance, and no salary increases are permitted to occur outside o f this framework. Any wage increase outside o f this framework will negate the very purpose o f this important reform agenda, so the IRDPG supports Government adherence. For 2007, the Government has allocated an additional YR 80 billion to wage increases. This corresponds to the allocation for Phase 11o fthe reformprogram, associated with agencies fulfilling the Phase Iconditions specified by the law. The Minister o f Civil Service has confirmed that unless the actions identified inthe law are achieved, no wage increase will be given. 75. Finally, the Government has focused on redundancies. The magnitude o f the personnel problem in Yemen is such that the Government will not be able to rely exclusively on the identification o f ghost workers and double dippers to bring it into control. It must utilize a retrenchment andpre-retirement scheme as an additional instrument inthis endeavor. To achieve this aim, through the Civil Service ModernizationProject, the Government has created the Civil Service Fund. The Fund enables the Government to sever its ties with redundant employees. Work in this area has focused on the identification o f surplus workers, the transfer o f these workers to the Civil Service Fund and the design o f assistance packages, taking into account targeting, the level and nature o f compensation, and implementation regulations governing the payment o f such compensation. The creation o f the Civil Service Fund, its policy framework regarding retirement, redundancy, and severance options are all embodied in the Civil Service FundLaw approvedby Parliament in 2003. The Civil Service Fundbegan accepting redundant workers in the middle o f 2005 and by early 2007 had received over 14,000 applications. The pace o f the reforms i s likely to increase over the next several years, accordingly it i s important that the fund's budgetary allocations remain consistent with its work stream in order to achieve the ambitious results sought bythe government 76. To support this process, the Government, in close cooperation with the Bank has developed a work program for the Civil Service Fund. The work program takes a comprehensive look at the Government Human Resource actions and evaluates their impact in terms o f redundancies. This plan provides the framework which will contribute to better manage the Government's public resources. 77. To support the achievement o f public administrative reform goals, the IR DPG would support the following actions: The first tranche prior action is the approval, by the Council o f Ministers, o f a Civil Service Fund (CSF) program for 2007-10 and alignment o f the budgetary allocation for 2008 to that program. This program already exists in draft and highlights the number o f people that are coming out as redundant as a result o f the different ongoing workstreams. In accordance with this action, the letter of development policy will incorporate the quantitative targets established inthe program. The second tranche action would require, consistent with government mandate studies, reengineering studies, and other analyses, continuing implementation o f the CSF program and quantitative fulfillment o f Civil Service Fund workstream by transferring the programmednumber o f staff from selected line departments to the CSF. - 33 - 0 Another second tranche action is the continued adherence, throughout 2007 and 2008 (untilthe release of the second tranche) to the 2005 wage law requiringagencies to meet defined reform criteria before making any future salary increases. 0 A final second tranche action is the completion o fthe biometric identification system and computerized employee databases, so that they are fully populated and functioning, with coverage extended to all civil servants, military, police andjudiciary employees. This, by law, requires the redundancy o f all identified"double dippers". 78. The idea o f these conditions i s first, to encourage the Government to base personnel actions on a clear and fully financed plan; second, to ensure that the Government's wage policy remains consistent with the framework reflected inthe wage law; and third, that the government complete the process o f creating the information basis for human resource management. The Bank, through the preparation o f IR DPG and through the CSMP, has been a key advisor to Government on this component. VI. OPERATIONIMPLEMENTATION POVERTYANDSOCIAL IMPACTS 79. The IR DPG should have a generally beneficial impact by encouraging investment and improving the management o f public resources. Generally, the initiatives supported are aimed at encouraging growth and employment, which have been identified repeatedly as necessary concomitants to poverty alleviation. Nonetheless, some project preparation explored two potential social safeguard concerns with potential distributional impacts o f reforms envisioned. 80. A first concern is the potential negative impact o f land registration for the poor and powerless. This concern is especially associated with large-scale, systematic land-titling initiatives that have sometimes dispossessed the poor o f land to which they held traditional tenure or on which they were squatting. The IR DPG does not envision or support such a program and the team i s not aware o f any Government plans to implement one. 81. The intention o f the reform is in fact the opposite - to establish rule o f law to defend claims o f the less influential and wealthy against those who can now use power and corruption to challenge and undermine legitimate land claims. This reduces the transactions costs and risks associated with new investment. Further, having a clear law and politically independent (and institutionally capable) registrar o f lands should have a positive effect to minimize the impact o f opportunities for corruption and political meddling (in which the poor tend to lose). Currently, very high transaction costs and risks puts investable land at a premium, making land markets dysfunctional and segmented, to the detriment o f all, but especially disadvantaging the poor. Improved titling could be anticipated to greatly broaden formal land markets, and to reduce legal and violent conflict over property rights (again where the poor and the politically weak would usually be expected to lose). 82. The major innovation inthe proposed new law on land registration would be provision o f - 34 - an adequate legal framework for systematic recognition and registration o fproperty rights.Under such an approach, the state provides tenure to rich and poor alike (at no cost in the case o f systematic registration and at a minimal cost to cover administrative expenses in the case o f voluntary registration). It has been used in many countries and many World Bank projects to regularize the informal occupation o f state land by the poor. It can reduce the ambit o f informal, non-transparent transactions in land rights, in which the poor are usually disadvantaged. In Yemen, there i s substantial informal occupation of state land by the poor, and some customary land occupation. The potential o f the law for poverty-alleviation in this respect i s substantial. Further, appointment o f an independent registrar and an organization degree for GALSUP that organizes and clarifies its mandate and fbnctions should have an indirect but generally positive effect upon the quality and transparency o f land administration through a reduction o f corruption and political interference in land administration and through greater clarity and less confusion regarding the responsibility o fpublic sector agenciesdealing with land. 83. This positive result depends entirely on the policy and law o f the state toward regularization o f informal and customary occupation o f land.Registrationitself does not create or change the nature o f rights; it simply records and confirms those which exist. But where regularization i s desired, it can be implementedthrough the systematic registrationprocess. 84. The Civil Code sets out the framework governing property rights. The Islamic Shari'a- inspired Code recognizes the regularization o f property rights to land based on adverse possession through the notions o f "Ehyaa" (Le. valorization through building, planting, etc, of "moyat" land, non-valorized or literally dead land, such as desert lands, etc) and "Tahagor" (i.e. demarcation o f land, which grants the demarcating person a three-year window to valorize land). The state can therefore regularize the cases o f land occupation, possession and valorization, should it chose to do so. The State Land and Real Estate Law o f 1995, promulgated by Republican Decree, defines desert (normally moyat) land as State-owned, and does not permit adverse possession on state land. This contradicts with the Civil Code; both from a legal basis and in terms o f what the courts apply in practice, it is the Civil Code's provisions governing adverse possession that apply. At the same time, the State Land Law sets out basic norms and procedures regarding State land allocation, which give government the authority to recognize and regularize such land occupation, should it choose to do so. 85. There i s a further issue concerning the land rights o f women. The experience in other countries has shown that inpractice, existing rights o f women can be lost inthe process o f land registration through faulty implementation; pro-active strategies are needed to ensure that their rights are infact registered. There have also beeninstances noted insome countries where inthe context o f systematic registration either the state or powerful individuals have secured registration for themselves o f communal landresources, such as pasture or wetlands. This usually occurs because the legal system does not recognize the communities involved as legal personalities with the capacity to hold registered landrights. 86. In the development policy reform context, these issues require an authoritative clarification o f government policy. The Letter of Development Policy (LDP) commits the Government to carefully monitor any negative social impacts and take "proper safeguards against - 35 - associated negative social consequences." The Letter clearly states that Government intends to "take measures to mitigate the impact o f the new land titling system on poor people, and women in particular, who might not possess the adequate means and resources to access formal registration. For this, we will seek to facilitate their registration andto amend the State Landand Real Estate Law and other laws the extent that it is necessary to eliminate any disadvantages to this segment o f the society.'' Inconsultations with Government, the project team has discussed with Government how it could pursue systematic registration in a fashion and at a cost to beneficiaries that will allow for the broad regularization o f informal and customary occupations in accordance with the Civil Code provisions. Where occupations violate fundamental public policies, such as environmental regulations (e.g. occupancy o f landslide or flood-prone areas), they may be legitimately refusedregistration; inthis case, the situation o f those occupants will be neither improved nor worsened by systematic registration. Interms o f cost, the revised draft Law exempts beneficiaries from payment o f registration and surveying fees in case o f systematic land registration, which ensures that systematic registration, does not constitute a financial burden on poor people. The team also discussed with Government the need for studies to develop strategies for gender-sensitive systematic registration and for registration o f communal landrights. 87. The development o f the implementing regulations for the new land low pose an opportunity to mitigate any risk o f its use to undermine customary or tribal land claims. The procedures adopted should address settlement o f customary land rights disputes through a transparent and rule-based process to ensure that landregistration does not adversely affect tribal groups with legitimate claims. The process and procedures for making such claims and the basis on which these claims would be need to be made explicit, particularly in executing regulations relating to the section o f the law relating to "sigel shakhsi" clause. 88. A second social concern raised by the operation concerns the reform o f the corporate income tax. Inthis regard, it must be noted that the reach o f the corporate income tax system is not broad, leaving most poor people outside its ambit. On the other hand, many o f the key beneficiaries o f the existing system's exceptions are influential and/or well-financed investors. The FIAS study suggests that reform o f the existing system by lowering rates and reducing exceptions could prove beneficial to groups which may include many lower income participants -includingSMEtraders. IntheLDP,Government commitstomonitoringtheimpactofreforms on vulnerable groups, so that any negative impact can be addressed by appropriate safeguards. 89. Finally, perhaps the clearest potential for distributional impact lies in the public administration reform. Clearly, wage reform, which improves wages for all public employees, benefits poverty reduction. The first phase o f the implementation o fthe wage strategy provided a one-time increase o f 55 percent to the minimumwage o fpublic employees. 90. However, implementingthe Civil Service Fundwork program will entail retrenchment o f civil servants, hence the loss a steady source o f revenue for many individuals. The appraisal mission reviewed the provisions o f this program, including its poverty mitigation features. The retrenchment package, estimated on average at roughly seven years o f salary (i.e. US$11,000 per person) i s quite generous by international standards. By providing a large enough package, the Government intends to mitigate the likelihood that civil servants will succumb to poverty. - 36 - 91. The Civil Service Fund work program provides that a certain number o f employees identifiedthrough approved procedures be transferred to it. Ifthe employee is close to retirement age, as described in the law, the Fund will transfer the employee to the Pension Authority and compensate the Authority for those years o f service for which the employee did not contribute. Inthe event the employee falls inthe category below this, where the employee is eligible for pensioning but is between 5 and 10 years from retirement, the employee may either opt for the retrenchment package or for the pre-retirement. To date, most employees have chosen the pension option, which provides them their last year's salary in perpetuity (without allowances). For an employee beyond ten years o f service from eligibility for the pension, the civil servant i s only eligible for the package. 92. Initial retrenchments have indicated that, to date, only six percent o f public employees have chosen the package. On average, public employees who have been terminated through the civil service fund appear to have lost 13 to 15 percent o f their purchasing power as a result o f retrenchment/pre retirement. Those individuals who have opted for the package seem to be able to maintain an adequate level o f revenue just from the interest that banks will provide on the package. It appears therefore that the retrenchment scheme, through generous benefits, substantially mitigates its potential to create poverty. The project requires full budgetary commitment for these benefits. 93. The Civil Service Fundhas developed a system to monitor samples of civil servants and follow them through time to ensure that the Government keeps track o f the impact o f this program on poverty. In addition, the ongoing poverty assessment is evaluating the potential poverty impact o f civil service redundancies, which will inform the Government and project team o f the implications and any need for further mitigation o f negative impact. In the LDP, Government commits to "maintain the severance payments at levels that will ensure adequate compensation to retrenched employees and establish a monitoring system to follow up on their economic and social status afterwards." IMPLEMENTATION, MONITORING EVALUATION AND 94. Overall implementation, coordination and monitoring for the proposed IR DPGprogram will be done by the Ministry o f Planningand International Cooperation (MOPIC). The Bank will request the Government to form a core IR DPG team, to be chaired by the Deputy Minister o f Planning and International Cooperation (Deputy Prime Minister). He will be supported by a technical committee from concerned Ministries and Agencies. This team will be responsible for ensuringthat key actions occur inaccordance with the agreed prior and subsequent actions under the IRDPG. - 37 - 95. Inthemedium-term, several indicators maybe useful inmonitoringimpact: Component Indicators IncomeTax Reform. Enterprise survey: frequency o f identification o f taxation as a constraint; reported percent o f sales reported for tax purposes; reported number o f tax inspections and related level o f corruption in future ICA enterprise survey. Doing Business indicators for "paying taxes". (Impact: Increased investment and employment; improved efficiency o f tax collection, increase intax base.) LandTitlingandRegistrationReform Rate o f realization o f investment projects; identification o f land as a constraint in investor surveys; number o f land transactions and titles issued; incidence o f court disputes on land title. (Impact: increased investment and more efficient land use.) StrengtheningPublicProcurement Appointment o f Procurement Policy Monitoring Board; transfer o f procurement tracking system from the High Tender Board to the Policy Monitoring Board, number and percentage o f procurement transactions included in tracking system, level o f monitoring and enforcement activities by the two boards. (Impact: reduction in incidence o f corruption, improvement in efficiency o fpublic expenditure.) ImprovingRevenueTransparency Receipt o f letter declaring adherence to EITI, publication o f externally audited accounts o f oil and natural gas revenues. (Impact: Greater government credibility, higher public evaluation o f Government, and reduced "leakage" o frevenues.) Public AdministrativeReform Quantitative fulfillment o f Civil Service Fund workstream; monitoring o f incidences o f agency wage increases; physical evidence o f completion o f biometric identification system and public employee database. (Impact: Leaner and more effective public workforce, resulting in improved public service delivery.) 96. The Bank team will focus on monitoring outcomes. It will directly verify that required actions for first and second tranche release have taken place. The set o f six prior actions for first tranche release have been fully achieved. At the same time, the policy matrix sets out actions for the subsequent tranche release, to assure that policyreforms are implemented and the momentum o f reform progress i s maintained. Appropriate impact indicators for each o f the components of the IR DPGwill b e applied so that the effect of reforms (which is likely to b e realized fully only after the brief lifespan of the operation) can b e appropriately evaluated. - 38 - FIDUCIARYASPECTS FiduciaryRisk 97. As noted above, the GOY has been actively engaged in improving its Public Financial Management (PFM) systems since 2005. A number o f key PFM weaknesses have been addressed while many are still pending, including some measures supported by the IR DPG. The 2004 Country Financial Accountability Assessment (CFAA) and the Public Expenditure Management (PEM) reports included recommendations that, when implemented, will help improve the assessment o f the fiduciary risk in Yemen that is currently rated as "high". The PFM Action Plan measures (supported by the partnership agreement) that can help to reduce fiduciary risk include: (i) Reforming budgeting, which includes (a) improving the level o f priority setting and the basis ofbudget decision making (Budget Preparation), (b) improving Budget Execution, and (c) developingPFMinformation system-AFMIS; (ii)Enhancingcontrolandfinancialaccountability; (iii)Reformingthesystemofbidsandprocurement;and (iv) Improving competence and skills o fPublic Finance staff, and the other staff in government. 98. The CFAA report emphasized four pillars o f the PFM system: internal controls; internal audit, accounting and reporting and external audit. Eachhas been the subject o freform actions. (i) InternalControl. - CFAA: The existing internal control framework is highly centralized, with substantial and strong ex ante and ex post controls exercised by the MOF over all spending. The focus, however, i s on compliance with the legal use o f appropriations, with little recognition o f the other risks present in current PFM processes. These risks include a weak management environment, complex and opaque financial approval processes, poorly documented financial procedures, and a lack o f administrative penalties. Recent Actions Taken: Much of the background work which will form the basic foundation for implementing the P F M Reform Program has already begun and is on going. Notably, the AFMIS project which will soon become operational, the introduction o f a comprehensive GFS 2001 based on functional and economic classification in the preparation o f the 2007 budget, development o f New Procurement Manuals (NPM) and Standard Bidding Documents (SBDs) to improve the procurement process. A Project document that spells out government support by UNDP, DFID and the Netherlands was signed on September 11th, 2006 and became operational, effective February2007. (ii) InternalAudit. - CFAA: There i s no effective internal audit function present in the GOY today. At - 39 - present, there are two separate ex post internal control and inspection functions operating in MOF and in all budget entities, and there is considerable confusion in the ministries about the conflicting roles and responsibilities o f these two units. Neither o f them meets the requirements o f a modem internal audit function. The only audit feedback management now receives is compliance audit information from the internal control units and the external auditor. RecentActions Taken: An extension has been granted to complete this study under the present arrangements o fthe Civil Service Modernization Project. The steering committee, in charge o f this study, has been strengthened and now includes four members representing the Ministry o f Finance. The report from the Consulting firm (PWC) finalizing the process work has been received, but to date, no agreement has been reached on some o f the thorniest issues, including who is responsible for this function and under whose authority. (iii) AccountingandReporting. - CFAA: The GOY does not have an automated financial management information system in operation today. One is under development (AFMIS), however, until AFMIS is fully functional, M O F will not have accurate and timely budget execution information from its budget entities. Full adoption o f GFS 2001, Commitment accounting, non-tax revenue accruals and cash management activities will be challenging. The nature and extent o f the arrears situation will remain unknown. It was also noted that extra-budgetary and special fundsposerisks. RecentActions Taken: AFMIS activities related to FinalAccounts are now identifiedin the Budget Execution portion, Cash Management activities have not yet been identified. Additionally, specific activities related to the Accounts Payable, FinalAccounts and Cash Management had not been specifically identified in the plan. Training i s being provided to users on the AFMIS Budget Preparation and Budget Execution in the Financial Training Institute. Almost half o f the staff o f the people who are scheduled to receive training has completed the training. The Institute i s housed in a new building and i s well equipped to provide continuing benefit to the project as well as to others inthe MOF and to other government department and agencies. (iv) - ExternalAudit. CFAA: The Central Organization for Control and Auditing (COCA) performs the function o f external auditor for the Government. COCA constitutes another important element in contributing to effective internal controls and in detecting fraud and corruption. COCA and the Government should move quickly to comply fully with all INTOSAI standards for its independence and for the conduct o f its audits. Recent Actions Taken: In this context and as part o f the Civil Service Modernization Project a consulting firm (PWC) was hired to assess in the re-engineering process o f - 40 - COCA. The consultant has finalized the work pertaining to COCA's Procedures and Standards Manual, needed changes in bylaws 26 and 39 pertaining to the Audit Profession and COCA respectively, amended hierarchy restructure as well as COCA's job descriptions and institutional capacity reform. DISBURSEMENT ANDAUDITING 99. The proposed IR DPG will follow the Bank's disbursement procedures for development policy lending. The Recipient is the Republic o f Yemen, represented by the Central Bank o f Yemen (CBY), which currently carries out its treasury functions. The proceeds o f the grant will be made available to Yemen following the enactment o f the Financing Agreement. This operation i s a two-tranche grant o f SDR 16.4million each (approximately US$25.47 million equivalent). The first tranche of grant proceeds would be made available to the Borrower upon the effectiveness o f the Financing Agreement between the Bank and Yemen, while the second would be made available upon certification o f the filfillment o f second tranche conditions, at the latest 18 months after effectiveness, which i s the period over which agreed measures are expected to be finalized. 100. Flow of funds (including foreign exchange) i s subject to normal FMprocesses. It is not possible to track the ultimate use o f the foreign exchange provided by the IR DPGproceeds, but the grant proceeds flow into a sub-account at the CBY and from it to Yemen's budget, and are thus subject to normalpublic financial management processes and CBY procedures. Byway o f a letter, the Government will provide confirmation to the Bank when the grant amount has been - credited to an account used to finance budgeted expenditures. The diagram below depicts the envisaged flow o f funds arrangements: World CBY MOF Budget Bank US$ YR YemenPFM I Dedicated Bank GeneralAccount - Account CBY 101. The IMF's most recent safeguards assessment report goes back to May 2001 which significantly limits its value to this exercise specially that it mainly focused on the external audit mechanism for the CBY (risk at the time was found to be "low"). Saying that, some o f the significant issues identified inthe IMFreport match those included inthe external auditor's latest Management Letter. 102. An audit o f the financial statements o f the CBY for the year ending December 31, 2005 was conducted by Deloitte & Touche. The auditors rendered a cleadunqualified opinion on the Financial Statements. The auditors also issued a Management Letter (ML)that included various accountability issues. The quality and the level o f details inthe MLclearly show that the external auditors did a comprehensive assessment o f CBY's internal control systems. The ML observations range from those relating to the soundness of the bank's internal controls, staff capacity to handle the bank's MIS, reliability o f the chart o f accounts to issues that do not have a - 4 1 - direct impact on the IRC. The ML did not identify issues in relation to Foreign Exchange Management at the CBY. The team met with CBY staff and agreed on arrangements to ensure that the IRC proceeds will have special arrangements interms o f recording and reporting. 103. The Bank will request the auditors o f the CBY, Deloitte and Touche, to conduct an audit o f the dedicated account established in the CBY. The audit will cover the accuracy o f the summary o f transactions o f the dedicated account, including accuracy o f exchange rate conversions; including obtaining confirmations from corresponding banks involved inthe finds flow. The first audit should be conducted and delivered to the Bank before the release o f the second tranche. An additional audit is to be conducted no later than one year after the release o f the second tranche. The time period for submission o f the audit report to the Bank i s three months. ENVIRONMENTAL ASPECTS 104. The team's determination was that the IR DPG will not have significant effects on the country's environment, forest and other natural resources. However, some potential risks were identified in consultation with the regional safeguards team. The two elements o f first pillar o f the project have been identified as having a potential for adverse environmental impact. First, reform o f tax policy was identified as having the potential for adverse impact if it encouraged investment in sectors especially associated with environmental degradation (e.g. mining). The recent FIAS study has looked at the sectoral impact o f the existing tax regime and concluded that existing incentives heavily favor investment in the mining sector while (relative to other sectors) discouraging tourism. Insimulations o f the effect o f reducing the corporate income tax rate from 35 percent (whether to 15%, 20% or 25%), the impact i s to reduce the distortion o f the incentive regime by somewhat lowering the burdenon tourism and sharply reducing the effective subsidy for mining investments.16 Such a reduction i s projected to have a neutral marginal incentive effect with regard to agriculture and have a slightly positive incentive effect for manufacturing. Inadditionto this analytic reassurance, the Government, inits Letter ofDevelopment Policy, has reassured the Bank that [environmental] considerations will be given in the design o f income tax reform, whereby we intend to ensure that the new system will not provide incentives for the rapid development environmentally harmfulprojects." 105. A second concern relates to land titling reform. Environmental concerns include the possibility that such a reform would encourage rapid conversion o f agricultural land to industrial use, or the development in environmentally fragile areas. Inthis regard, it should first be noted that international experience suggests that, if systematic land registration ensue the reform o f the registration law, it should have a generally positive impact on sustainable landuse, since it makes more effective the incentives for good husbandryprovided by property rights, increasing security o f tenure and minimizing externalities. This is true regarding both private and public lands. Further, an improved land registration law will reduce the haphazard occupation o f environmentally sensitive land due to ambiguous property rights. Nonetheless, to ensure mitigation against the negative environmental impacts that could result from better land titling, 16Foreign Investment Advisory Service. Yemen: A Study into the Impact of Tax Policy and Tax Administration on the Investment Climate: Background document (Washington: March 2007) - 42 - better land use planning and regulations are also needed. The Government's letter o f development policy takes explicit cognizance o f these risks. It expressed the Government's commitment to "protect environmentally sensitive land by undertaking a clear classification, demarcation and registration o f these areas as communal land resources (where appropriate such as pastures or wetlands) or as part o f the State's public domain that i s inalienable." It also commits Government to protect the rights o f poor people, those with informal occupancy-based rights and women, who may hold customary or informal claims to landbut not possessthe means to attain formal registration, all users who may make less intensive use o f land than those who might otherwise usurpthose claims. RISKS ANDRISK MITIGATION 106. Risksof reversal or loss of momentum: As with any reform strategy, there is always a risk o fpolicy reversals or loss o fmomentum. Changes inGovernment always bringuncertainty. Negative public reaction to certain reform moves (like the reaction to the 2005 diesel fuel subsidy reduction) can change the political calculus. The ongoing conflict in the north risks diverting Government attention from reforms, and may contribute to higher spending. Nonetheless, the Government's relatively recent focus on reform does appear firm, and was reinforced bythe Cabinet shuffle earlier this year. The Government has affirmed its commitment to IRDPGgoals and actions. The Government's recent reform achievements signal a sea change infavor ofrapid reform and a real sense of urgency to put the country on a firmer financial and fiscal footing as oil revenues decline. The newly appointed Cabinet further reinforces the Government's commitment to reform and improves the confidence o fParliament. 107. The risk o f reversal is primarily a risk for the second tranche actions, since the first tranche actions have been achieved prior to final negotiations. Changes in key counterparts, public reaction, parliamentary opposition, domestic conflict, civil strife or exogenous regional events could each detract from full commitment to the reform program. These risks will be mitigated by strong dialogue throughout the life cycle o f the financing to assure the maximum understanding, ownership and engagement with the reforms supported by the project, donor coordination in support o f the project, and civil society understanding o f the project. Careful monitoring will further mitigate risk by sounding alarms ifprogress waivers on any key action. 108. Capacity concerns: A central danger for achievement o f the prior actions for second tranche release i s the relatively weak administrative capacity in the Yemeni Government. Since several o f the second tranche actions concern implementation o f supported policy reforms, it i s here that capacity weaknesses may pose a threat. To help mitigate this risk, the project team will mobilize appropriate technical assistance resources as required, either directly or through donor coordination, to strengthen and supplement Government capacity. 109. Macroeconomic stability: Macroeconomic instability i s clearly a potential risk. One key factor is the price o f oil which, if it falls below projections, may limit the Government's ability to finance key reforms. Another i s tax policy and collections, which has been the subject o f contention between the Government and private sector inrecent months. The introduction o f the VAT (known as the General Sales Tax) in January 2007 brought a strong adverse reaction - 43 - from the business community, and required Government to agree to a grace period in its enforcement and a lowering o f the corporate income tax rate. While these measures may enhance ultimate compliance and sustainability and broaden the tax base, in the short run they may dampen revenue collection. A final concern i s expenditure discipline. It is hoped that the PFM measures, which are designed to dramatically strengthen both revenue and expenditure management will contribute to the solution. Government's demonstrated commitment to implementation o f the NRA is another mitigating factor. In some dimensions, budget and expenditure planningand discipline are improving already. The Government shared with donors inNovember 2006 its first Public Investment Program (PIP), now under revision to account for donor commitments. Under the PFM, a process for preparing a Medium-Tern Expenditure F r a m e ~ o r khas been drafted, and procedures are expected to be approved in the first half o f ' ~ 2007. After a suitable period o f piloting, the Government will develop the capacity to apply the MTEF under the guidance o f the Ministry o f Finance. These internal reforms, along with continued carefbl macroeconomic monitoring by the country economist and the IMF, and agreed actions following the Article N consultations, will help to mitigate this risk. TEAMMEMBERS Andrew Stone Team Leader Ghada Youness Sr. Counsel HyacinthBrown Sr. Finance Officer Hisham Waly Sr. Financial Management Specialist Akra, El-Shorbagi Sr. Financial Management Specialist Ali Al-Abdulrazzaq Sr. Economist T.G. Srinivasan Sr. Economist Sameh Wahba Urban Specialist Mikael Mengesha Sr. Procurement Specialist Giulio de Tommaso Sr. Public Sector Management Specialist Steve Wan Sr. Program Assistant 17The MTEFalso encompasses the Medium-Term Fiscal Framework and the Medium-TernBudget Framework. - 44 - ANNEX1:LETTER DEVELOPMENT OF POLICY1s Letter of DevelopmentPalicy Mr. RobertZoellick The President-The Worfd Bank Washington, D.C., USA Dear Mr.Zoeilick Since 1995, Yemen has been implementing a comprehensive macroeconomic and structural reform program with support frarn the World Rank and the International Monetary Fund, Eo strengthen fiscal discipline and mate a market economy conducive to investmentand growth. The proposed Znstitutional Reform Development Policy Credit (XRDYC) is another instance where the Rank's support could play an instrumental role in enstiring the continuity and succcsso four structural reformsprogram. Structural ReformProgram: Objectives and Progress Foilowing a period of slocc-dwn caused by internal and external security challenges, our reform elfofis accelerated beginning in fate 20et5, as underscored by the adoption of the Third Sacio-Economic Devetopment PEan for Poverty Reduction (DPPR) for 2006-10 (which is also our PRSP). The government's reform program, as articulated by the DPPR, focuses an six core areas: bringing steady improvement in economic growth; reducing poverty and raising the qu r of fife; promoting good govcrnance; rcducing regional and gender disparities; enhanc dmentmlisation; and broadening the participation of civil society. ln addition, it emphasizes efficient mobilization o f resaurces; stressingt h need for ~ the completion of the Economic, Financial, and Administrative Reform Program cornbatingcorruption; limitingthc role af thc state, and enhancingthe regulatoryen for thc private sector to take n lead. In the financial secror, it sets focus an promoting open market policies and strengthening!he intermediating role o f the financial institutions. it also intends to support arid modernize the banking sector and financial institutions at central and local levcis. To tackle poverty, the DPFR identifies a number of reforms in the areas of macroeconomic poficy, governancepractices, trade policy, and ssctorrtl policies. It also lays out an ambitious agenda for human rcsowce devctopment, including measures to improve education and health, improve and augment public services, and strengthen social protection. Finally, the DPPK broadly lays out measures to improve and ConServe water srtppiy, protect the environment and strengthenbasic infrastructwe, To attain ULIT ~ F C J Rand~ poverty reduction goals in the short-run, in early 2006 the ~ Government ong support from donors) put into place its N (NRA), an a reforin program aimed to address a number 18 In a letter datedNovember 5, 2007, the government confirmed that all references in the Letter of Development Policy associated with the IR DPC should be understood as now referring to IR DPG and any references to the financing as a credit shouldbe understoodas referringto the grant. "..._.--.-.........._.....49 - ". ...-.......-..".............-.-...*$Ltl ..... _............lap31 .I." "._......I challenges. The stated overall objective of this agenda is to improve Yemen's investment climateand strengthen its governance and democratic institutions. The NRA encompasses concrete measures designed to improvepublic financial management and reform procurement, public audit, governance, debt management, fiscal policy, and the business regulatory environment. Since the adoption of the NRA, we have embarked on and accomplished reforms in the many areas, some of which have been directly supported by the Institutional Reform Development Policy Credit (IRDPC). These reforms include: Simplification and reductionof tariffs, and the introductionofASYCUDA. Simplification of the tax system and introduction of a General SalesTax. Separation of thejudiciary from the executivebranch Introduction of various anti-corruption measures, including an anti-corruption law, a national anticorruption authority (Supreme National Authority to Combat Corruption-- SNACC), and a financial disclosurebill for public officials. e Introduction of a national procurement manual, standard bidding documents governing public tenders, and a new public procurement law consistent with internationalstandards. e Strengthening our Public Financial Management through the launch of a comprehensive strategy (PFM Action Plan) and Partnership Agreement with donors. e Initiating a Public Administrative Reform program, including a re-engineering program in pilot Ministries, a strategy to rationalize wages and link them to institutional reforms and a biometric identification program aimed to eliminate ghost workers and doubledippers. Strengtheningof electoral democracy and press freedom. Accession to the Extractive IndustriesTransparency Initiative. Iampleasedtosaythatoureffortshavebeensuccessfulinaddressingeitherfullyorpartially some of the most difficult and unpopular issues, particularly with regards to implementingthe new sales tax system, reducingfuel subsidies, reformingtrade tariffs, and moving ahead with the biometric identification system o f civil servants, which can ensure a smoothtransition to a sustainable development path. A significant number o f the items on the NRA agenda have been completed, while others are progressing satisfactorily. The annex table highlights our current reform program, covering measures completed over the last two years, and those planned over the next twelve months The IRDPC will come at a critical time by providingthe government with the resources and flexibility neededto ensure that the momentum for reform is sustained and rapid progress can continue. It will signal the World Bank's confidence in our reform program to investors, donors and our citizens. 2 ___." .......................... G@!l ................................ I.. "--...I aalwl I ^- Macroeconomic Framework The Government's PRSP establishesambitious goals for macroeconomic policy, including: ' An annual average rate of economic growth of 7.1% (10.1% for the non-oil GDP). Maintaining monetary stability with the annual inflation rate below 13.8% and the broad money supply growth below 22% on average. Maintainingthe fiscal deficit at less than 3% of the GDP; while raisingpublic non-oil revenues on the order of 40-45% of total revenues; and increasing investment ' spendingto reach30% of total public expenditure. Reducing poverty rates at the end o f the planning period to about 19.8%, lowering unemploymentto 12%, and increasingthe share offemale labor to 15%of the total. Macroeconomicperformance in 2006, the first year of the Plan, fell short of these objectives. Several factors negatively influenced performance, including a sharper-than-expected decline in domestic oil production, continued geopolitical tensions in the region, regional drought conditions that drove up the price of some agricultural commodities, and continued internal conflicts in the North of Yemen. As a result, GDP grew by a moderate 4% during 2006, while inflation increased unexpectedly well beyond our target. On the other hand, the year 2006 witnessed an improvement in our overall fiscal position, where we realized a small surplus for the first time since 2001. In addition, the balance of paymentsrecordeda surplus of about 1 percentof GDP, despite asurge in importsofcapital goods. In2007, we expect real GDP growth to slow to 3.3 percent, owing to a sharp fall in oil productionof morethan 12percent. Despitethe overall moderation in growth, the non-oil sector will maintain its strengthat about a 5.5 percent growth rate, reflecting the sustained increase in capital spending, both from private and public sources. Meanwhile, inflation is expected to ease to less than 13 percent, which despite the improvement, remains above the average for the years 2000-2005of 10.6 percentand raises concerns over its negative implicationsfor growth and the standardsof living ofthe poor. The fiscal balance for 2007 is expectedto show a deficit ofaround 5 percentof GDP, primarily reflecting the continued decline in oil productionand the rising cost of remainingfuel subsidies. Controlling inflation and improving fiscal sustainability. Macroeconomicstability is critical to reapingthe benefitsof the Government's ongoingreform program. With inflation in 2006 and 2007 climbingwell above our targeted level, and the primary non-oildeficit exceeding 25 percent of GDP, the Government agrees with the Bank and Fund that Yemen today faces two key macroeconomicchallenges: 0 Controlling inflation; 0 Ensuringfiscal sustainability. 3 I ....... ............................. - +!I ................................. "*&iD -....-.....-.--.-....-..I ......tal41 The Government is committed to tackle these challenges through tighter fiscal and monetary policies. On the monetary side, this will require more active policies and with more diverse instruments. On the fiscal side, it will necessitate prudence in expenditures policies, particularly subsidies and wages, and increasenon-oilrevenues. To control inflation, and in consultation with the IMF Article IV mission of June 2007, the Government will take the following steps: Resume the issuance of T-bills, beyond the needs to finance the government's budget deficit, in order to absorb excess liquidity. This will help to moderate moneysupply growth. Continue to issue Central Bank CDs, as an additional measure, to control money supply growth. Adhere strictly to the National Wage Strategy Phase 11, which requires completion o f specified public administrative reforms as a prerequisite to the next round of salary increases. 0 Explore optionsto streamline budgeted capital spending following the start of(off- budget) development projectsfinanced from last year's CG donors' pledges. Finally, the Central Bank will review internationalexperience and consider the use of foreign exchange interventions as an instrument to curb inflation while preservinglong-term competitiveness and buildingreserves. To meet the challenge of fiscal sustainability and prepare for the impending depletion of our oil reserves, we will need to make large adjustments in terms of both expenditures and revenues, including the followingsteps: Re-engineer and reform the Social Welfare Fund, and merge other funds with similar mandates,to improve its targetingofthe poor. . Once the redesign of the social safety net is completed, gradually move to eliminatethe petroleumsubsidy. 0 Modernizetax administrationto improve complianceand efficiency. Use tax policy to increase non-oil revenues substantially, including through the gradual increase of the GST in the mediumterm. 0 Substantially reduce exemptions and tax holidays from the corporate income tax, while lowering the rate to 20 percent, so that it could be made broader and more equitable. With these measures, we will establish a stable and sustainable basis for growth and poverty alleviation. Additional measures, supported by the IRDPC, will further enhance conditions for growth through investment climate reforms, public administrative reforms and strengthened public financial management. 4 "..- _.............................. +u' ........"".._.".......... ........+JWl " ........................................ l@l$J' Commitments under the proposedInstitutional Reform Credit In specific relation to our current dialogue with the Bank, we would like to confirm that we will be undertaking measures aimed at improving public administration and enhancing the climate for private sector development, by pursuingfollowing reforms: Public financial management and public procurement. We have given central priority to the modernization of public financial management (PFM). In this area, we will undertake reforms to improve budget preparation and implementation, with related actions that will bring a new Financial Law and restructurethe Ministry of Finance in line with international standards. We will also seek to strengthen the budgetary control through more effective internal and external auditing functions, with related actions including the establishment of a road map to implement internal audit in the GOY, and the passing of a new legislation to improvethe governance and transparency of COCA, the externalaudit body. We recognize the continuedreform o f budget managementand information systems isvital to reducingfiduciary risk and strengtheningperformance. New planningand managementtools, including our first ever Public Investment Program (PIP) and the planned Medium-Term Expenditure Framework (MTEF), will strengthen coherence and discipline in the use of public resources. We will continue to strengthen the capacity of the Ministry of Finance's budget functions, as well as the institutional basis and functioning of external and internal audit functions. In addition to the foregoing, we will undertake reforms to enhance the public procurement system in the following areas: a. The Minister of Finance has already issued a directive requiring key spending ministries to L I S ~of the National Procurement Manual and Standard Bidding Documents (SBDs) for all public tenders. This will subsequently be extended to all public agencies. b. Consistent with the Government's commitment, a new procurement law that conformsto international standards has been approved by Parliament in July 2007, and efforts are currently underwayto draw and implement its executive by-law. c. To implement the provisions of the new procurement law, Government will restructurethe High Tender Board (HTB) to assure its independence as a technical body overseeing government contracts above a defined threshold. In parallel, under the new law, we will create a separate procurement policy and monitoring board to address policy, monitoring, dispute resolution, and capacity building issues. I t will utilize the new procurement tracking system (PMIS) as a monitoringtool. All these reforms are to be in place by Nov. 30,2008 5 ....."....... ...................... - PJ!!l ..... ......._....*AI21 - _._.I I " ....-......... ......-.-...."....-1aIdl - Public Administration Reform. Strengthening public administration, improving service delivery, and reducingcorruption and waste form an integral part of our program. Under the Civil Service Modernization Program, good progress has been achieved. However, further reform and re-engineering of institutions, incentives, staffing and oversight systems will be required, both to motivate better performance and attract skilled workers, and to maintain fiscal restraint. Our agenda in this area will focus on the following issues: Enact a civil service program, with adequate budget allocations to support the Civil Services Fund (CSF) over the period 2008-2010. This step has already been completed in July 2007, with the Cabinet approvingthe Civil Service Fund program and its necessarybudget allocation. Continue to implement, throughout the period to Nov. 30, 2008, the CSF work program, that includes the transfer of the programmed number of staff from selected line ministriesto the Fund. Continue rigorous adherenceto the National Wage Strategy (under the Wage Law of 2005), that requires agencies to meet defined institutional reform criteria before making future salary increases. Continue efforts to build a comprehensive and operational computerized database for public sector employees based on the biometric civil servant identification system, by December2007. Hydrocarbon revenue transparency. Given the significance of hydrocarbonrevenue to the budget, transparency in this area is a vital to achieving better governance and accountability and improving the general performanceof public financial management. In this regard, we will seek to implement internationalstandards through the following sequence of measures: a. Join the Extractive Industries Transparency Initiative (EITI), which we have already announced our commitment to its principles, through a public letter to its management. b. Achieve, with the support from international donors, the institutional and procedural measiires prescribedby EITI that include: Publishing, in publicly accessible, comprehensive, and understandable manner independently audited accounts that document all significant revenues and payments to the Government or State enteritis from oil, gas, and mining companies operatingin Yemen. Establishing, in consultationwith the oil and gas companies and civil society organizations, an ongoing process for full verification and publication of payments and revenues relatedto extractive industries. Reconcilingpayments and revenues data for extractive industriesby a credible independent administrator that uses international audit standards, and subsequently publishing the reconciliation report, with any discrepancies identified. 6 ..................I.."............. +!' I ................................ _._.I +,WI .^..I.... .- ...................... :*jSlgJc ~ Income tax and incentive reform. The Government of Yemen is committedto reforming the taxation system in order to create a better investment climate and strengthen non-oil fiscal revenues. We have already introduced a modern General Sales Tax (VAT), which is being phased in. We will now reform the corporate income tax system to lower rates and eliminate most exemptions; to apply international norms in the treatment of income, expenses, and investments; and to introduce self-assessment and risk-based auditing. To achieve these objectives, we are adoptinga strategy that has three major components: a. We have conducted, with the technical support of FIAS, a comprehensive review of our current tax and incentive system. This will improve tax efficiency and equity, and strengthen incentivesfor investment. b. The Ministry of Finance has drafted and submitted to Cabinet a new Corporate Income Tax (CIT) Law that reflects international norms of treatment of income, investment,and expenses. c. Upon its enactment, we will subsequently implement the CIT Law by Nov. 30, 2008, as evidence by issuanceof its executive regulations. We plan to accompany this with a comprehensive review of investment incentives following the recommendations of the tax and incentivestudy. d. We will continue to work to strengthen the capacity of the tax administration, in order to reduce discretionand abuse, and enhance revenue collection. Land titling and registration reform. The weakness of property rights in Yemen is one of the most critical challenges to a better investment climate. We intend to create a system of secure and enforceable property rights, and remove ambiguity in titling which has led to investor uncertaintyand legal conflict. Our efforts will target the following issues: a. The Council of Ministers has approved and submitted to Parliament a new land registration law reflecting the recommendations of the Land Policy Task Force, by September 2007. b. Pending Parliamentary approval of the Law, we expect to finalize the design and implementationofthe executiveby-laws by Nov. 30, 2008. c. Next, we will appoint an independent Registrarof Land. d. Finally, the Council of Ministers will issue an organizational decree defining the mandate and functions of the General Authority for Lands, Survey and Urban Plan (GALSUP). Socialand Environmental Safeguards As we pursue the reforms described above, we recognize the importance of taking proper safeguards against any associated negative environmental and social consequences. Any negative impacts will be carefully monitored and further mitigating measures considered if results suggest the need for them. 7 O . " .-..................... ...... I+$' ."..l...-.." +4WI ".....-.........._.."".." .......I$l&l For example, concerning land titling, we recognize that while a "etter land registration law will reduce the haphazardoccupation of land, it could also bring some negativeenvironmental impacts from more intensive land development or the conversion of agricultural and/or environmentallysensitiveland. To this effect, we will seek to improve land use planning and regulations. We will protect environmentally sensitive land by undertaking .a clear classification, demarcation and registrationof these areas as communal land resources (where appropriate such as pastures or wetlands) or as part of the State's public domain that is inalienable, on the basis of environmental assessment procedures. We will also take measures to mitigate the impact of the new landtitling system on vulnerablegroups, includingthe poor, those with informal perspective acquisition, occupancy-based rights to public land, and women in particular, who may not possessthe adequate means and resoiirces to access formal registration. For this, we will facilitate their registrationand will amend the State Land and Real Estate Law and other laws the extent that it is necessaryto eliminate any disadvantages to this segment of the society. In addition, we will monitor the impact of changes in land registration on vulnerable groups, and, as required, take remedial measures to ensure their welfare. The executiveregulationsof the land registrationlaw will include a requirementthat any systematic registrationeffort be preceded by: 0 an analysis of the social and environmental impacts -- including base line surveys as appropriate, an identification of environmentallysensitiveareas, and an identification of land occupancy patterns and vulnerable and affected populations within those areas. Then mitigation measures would be designed to protect environmentally sensitive areas and vulnerableand affected groups. Similar considerationswill be given to the design of income tax reform, whereby we intendto ensure that the new system will not provide incentives for the rapid development of environmentallyharmful projects. We plan, in this respect, to carefully monitor the effect of tax reform on the pattern of investment and its environmental consequences, and, if required, take remedialmeasuresto address any negativeconsequences. Finally, concerningcivil services reform, we will maintainthe severancepayments at levels that will ensure adequatecompensation to retrenchedemployeesand establisha monitoring system to follow up on their status afterwards. Already, the first phase of the implementation o f the wage strategy has increasedcivil servant's minimum wages dramatically, lifting many out of poverty. 8 .-.... ...................-..:+!I ".I I " ..................I+>Ul "..."........I" I ...... ......................... I I@@ Conclusion In conclusion, we would like to note that there is a new spirit in Yemen with a clear commitment to economic and institutional reforms that are necessary to achieve our development goals. In this respect, a new Cabinet was formed in April 2007 with the aim of _. accelerating and deepeningreforms. Overall, and as shown in the annex table, our efforts over the next two years will aim to achievethe following objectives: Monitoring the implementation o f new laws that were passed, as well as expediting the ratification of lawsunder review. 8 Continuing to deepen structural reforms, particularly in the areas of public financial management, regulatory business environment and competition, civil services and fiscal policy. Continuingto strengthen anti-corruptioninstitutions and raise awarenesson ethics and corruptionissues amongst public officials and citizens as awhole. Improving political participation and public accountability by enacting elections of governorsas well as membersofthe second chamber ofthe legislativebranch. Inthis regard, we remain firmly committedto implementthe measuresspelled out in the main body of this document and in the attached policy matrix - - by the specified dates. We also remain committed to maintain macroeconomic stability and fiscal sustainability over the medium-term through prudent fiscal and monetary management of the economy. Our commitment also means that we will not reverse policy reforms already achieved under the National Reform Agenda. We would like to ask the Bank's support, through this first development policy credit and beyond, so that our efforts continue and that the benefits of growth and goodgovernance are sharedby all the citizens of Yemen. Yours sincerely, Dr.Ali MohamedMojawar c , l L 7 PrimeMinister 9 Annex 1. Current Reform Program in Yemen: Objectives and Progress (As of 09/30/07) Reform Structural reforms that were done/ will Status of implementation Link to Area be done IRC I. GOVERNANCE AND ANTI-CORRUPTION Yemen is placing strong emphasis on improving its ranking in governance indictors (WBI, TI), including rule of law, political stability and security. Targeting areas such as the rule of law, contract certainty, transparency in public procurement and the legal system, is expected to improve the investment climate and promote growth. Conducting a national anti-corruption Done. Campaign undertaken in June 06. . awareness campaign. .Establishing an autonomous anti-corruption Done. Stlpreme National Authority to e commission with broad mandates. Conzbat .-0 Corruption (SNACC) was Ya established in June 07 following the 1 L selection of its members by Parliament L S.- .Adopting a new disclosure policy to address Done. Parliament passed a Disclosure Law the perception of conflict of interest (COI) in July 2006, but application has been Y 4 in the handling of public procurement in the delayed pending the formation of SNACC. country The law, though a step in the right direction, requires further revision to meet international GAC standards .Joining the Extractive Industries .Done. GOY has formally joined the EITI in Trigger /TRl Transparency Initiative (EITI), through August 2007, and started to implement the the establishment of firm commitments initial required measures. for adherence to its principles. Adherence to the EIT principles, including: publishing an independently reconciled =Ongoing. Ministry of Oil and Minerals has Trigger /TR2 report of all significant revenues and been designated to lead the EITI effort and a payments transactions from oil and gas consultant has been appointed to help with between the government and companies, the implementation issues. The publishing and in a publicly accessible, the first EITI Report is expected by Nov. comprehensive, and comprehensible 2008. manner. * Establishing, in consultation with the oil Ongoing. Process is under development by Action /TR2 and gas companies and civil society the newly formed multi-stakeholder group organization, an ongoing process for full for Yemen EITI. verification and publication of payments and revenues related to extractive industries. [Reconciling payments and revenues data by .Ongoing. A sustainable reconciliation Action /TR2 a credible independent administrator, and process will be established by the Yemen using international standards. This EITI group. approach to be extended to significant payments from all oil and gas companies including SOEs. Oct. 6,07 . .Eliminating the influence of the Executive Done. Amendments passed in June 2006 Branch from the Supreme Judicial Coi~ncil (SJC), and creating the Judicial Inspection Authority. ! .Strengthening the oversight role SJC. Ongoing. SJC brought several disciplinary C) 2 actions against corrupt judges in 2006 and K' .-Q I 2007. .- 0 Improving the capacity of the judges .Done. Revised the law of the High Judicial aa Institute, and updated its curricula in 2006. b .Improving court administration through Ongoing. Phased introduction of automation computerized court management system is underway. 11.PUBLIC ADMINSTRATION Public administration needs strengthening in two major areas: public financial management (PFM) and civil service. In PFM, reforms aim to make the budget function more effectively; strengthen and decentralize the financial controls, and improve and increase the independence of the external auditing system. In the civil service sector, reforms aim to improvethe delivery of public services and keep salaries within a range that is fiscally sustainable. Im~stablishin~a Civil Services Fund (CSF) Im~one.Fund was established in 2005. =Establishing for the Civil Service Fund 'Done. Completed and approved by Cabinet Trigger /TR1 (CSF) a program for 2007-2010, and in June2007. aligning the budgetary allocation for 2008 to the proposed program. .Establishing a computerized employee 'Ongoing. Work on track with 80% percent Trigger iTR2 E a2 database including a biometric already covered. Completion expected by z C) identification system, that covers all endof2007. (I) employees on the state payroll in all 3 .-0 sectors k .Continuing to implement the CSF by 'Ongoing. Planned to continue Trigger /TR2 -.- a2 K' transferring of the programmed number implementation throughout 2007-2008 > of staff from selected line ministries to i2 CSF, in accordance with existing studies on this issue. .Continuing to adhere to the 2005 Wage .Ongoing. Planned to continue Trigger /TR2 Law requiring agencies to meet defined implementation throughout 2007- 2008 reform criteria before making any future salary increases. .Improving the governance of the Central .Ongoing. A proposal was made for . - Office of Control and Auditing (COCA) in changes in COCA'S law to comply with C) u accordance with the INTOSAI guidelines. INTOSAI, including its reporting to 2 E Parliament and the terms of its president. A I Q) Q * new law is expected to pass by Nov. 2008. 6 8 .Making COCA's audit reports publicly .Done. * 2 available. .Exposing COCA to peer reviews by .Planned Review is expected to take place reputable SAI by Nov. 2008. Oct. 6 , 07 =Establishing a Public Financial .Done. Management Advisory Unit at MOF. .Issuing Budget Implementation guidelines .Done. Guidelines issued in early 2007. for 2007 budget. .Monitoring the implementation of budget .Planned. A progress report will be issued guidelines. by Nov. 2008. .Reviewing current budget practices, .Ongoing. Work have commenced, and is utilizing a public expenditure and financial expected to be completed by October 2007. accountability (PEFA) framework .Improving budget classification and .Ongoing. GFS2001 system adopted for preparation and introducing forward economic classification. estimates .Consolidating the Extra Budgetary Funds .Ongoing. Draft a law is expected to be in the State Public Budget. approved by Nov. 2008. =Establishing a treasury fimction in the .Ongoing. The IMF and US Treasury are C 5 Ministry of Finance providing technical assistance on this issue. =Introducing a new Financial Law to .Ongoing. Draft Law was prepared, and M 2 Parliament designed to set broad expected to be ratified in early 2008. 1 regulations for preparing and implementing the budget. .-Q I u =Reviewing the Public Investment Plan .Done. MOPIC revised PIP in Aug. 2007, c Q (PIP), and linking its process to the fiscal ensuring fuller reflection of the DPPR and c tZ budge, in order to improve resources establishing a systematic process for the .- U allocation. regular updating of the rolling 4-year PIP. 5; s L .Preparing a Medium Term Expenditure .Ongoing. MOF is planning to introduce Framework (MTEF) to strengthen the MTEF by Nov. 2008. allocation of resources in line with DPPR objectives. .Improving public internal financial control .Ongoing. The government is expected to and automation roll out AFMIS in the first quarter of 2008. =Improving internal audit f~~nctions .Ongoing. GOY is expected to finalize plans to implement the new arrangements for internal audits function before the end of 2007. .Restructuring MOF in line with .Ongoing. MOF has initiated a process to international norms. engage with the Ministry of Civil Service to restructure in line with international norms. Restructuring plans expected to be finalized , bv Nov. 2008. Oct. 6,07 =Enacting a new procurement law !Done. Completed. Revised law was passed Trigger /TR1 consistent with international standards. by Parliament in July 2007. =Implementing the National Procurement done. Completed. Manual and SBDs were Action ITR1 Manual and standard bidding documents approved in April 2006. Training was held (SBDs), first on pilot level, and then by all in July 2006 in pilot ministries. In Feb. government agencies. 2007, HTB circulated instructions for compliance to spending ministries. MOF has issued similar circular for contracts below HTB threshold. =Establishing executive regulations for the ong going. Completion expected by Nov. Action /TR2 e a new procurement law. 2008. =Restructuring the High Tender Board IOngoing. Restructuring plans have been Action /TR2 L z (HTB) by redefining its role as an provided for in the new Law. Full 2 independent institution with an oversight implementation is expected before Nov. -.- k role over all government contracts, 2008 0 -Establishing the procurement and tracking ong going. Feasibility /needs assessment n 3 system (PMIS) for transactions in the High study completed. Next phase requirements L Tender Board (HTB) and line ministries analysis on selected IT option to be completed by Nov.2007. Donors' funding for IT package earmarked 1 .Establishing Procurement Policy ong going. Restructuring plans have been rigger /TR2 Monitoring Board to address policy, provided for in the new Law. Full regulatory and capacity building issues, implementation is expected by Nov. 2008. and apply and utilize the procurement tracking system (PMIS) for monitoring. =Initiatingonline disclosure of procurement- ~0ngolng.Website is under construction. related information 111. MACROECONOMIC MANAGEMENT OY is focusing on growth as a precondition for reducing poverty, and reducing inflation from its recent high level, more prudent monetary and fiscal management. Budget deficits need to be maintained under control. is targeted to reduce dependence on oil, in the face of impending depletion of country's oil reserve. =Reducingfile1 subsidies =Planned Domestic fuel subsidies were reduced once in July 2005. Further reductions are awaiting reforms to strengthen social protection schemes -[ntroducing a transparent formula for .Planned. regular price adjustment of petroleum prodi~ctand LPG. =Settingup a clear goal to save on oil and gas = Planned revenues with the aim of controlling the primary non-oil deficit I . I I =Replacingthe sales tax system with a VAT =Done. The GST Law was passed in July g system that lowers the rate to 5% and limits 2005. Implementation has been gradual, but 1 exemptions to a few basic consumption expected to be fully deployed by end of L items. 2008. u =Strengtheningthe tax authority. =Ongoing. Increased staffing and training 4" for tax authority was undertaken in 2006. -Simplifying and reducing custom tariffs to =Done. Changes made in July, 2005, is - bring the average down to less than 7 %. reducing the bands from 4 to 3, with 71 V, a2 percent of the commodities attracting only Q m 5% tariff rate, and the LI~-weightedtariff rate falling to 6.6% Oct. 6, 07 iv =Conducting a comprehensive review of =Done. Completed in May 2007 Action ITR 1 current corporate income tax with the aim of improving efficiency of revenue generation and strengthening incentives for r + investment w =Formulatinga new CIT Law that reflects =Done. Completed in May 2007, and rigger ITR1 i3" international norms of treatment of currently before Cabinet for approval. g income, investment, and expenses. 8c I" =Strengthening the capacity of tax =Ongoing. ction /TR2 Y administration to reduce discretion and corruption =Implementing the new CIT law, through the issuance of executive by-laws that =Ongoing. Expected completion by Nov. meet international standards. 2008. =Introducing a new debt policy that sets =Planned t? .c) ., ceilings for public external and internal s g debt. IV. PRIVATE AND FINANCIAL SECTOR DEVELOPMENT The government continues to dominate economic activity in Yemen. There is a need to create a better enabling environment in order to allow the private sector to lead growth and employment creation. =Enactinga new land registration law that =Done. Law approved by Parliament in Trigger /TR1 takes into account the recommendations September 07. of the Land Policy Task Force. -X -.- =Appointingan independent registrar Ongoing. Expected to finalize Action /TR2 M c implementation by Nov. 2008. u i=; =Implementing the executive regulations of =Ongoing. Expected to finalize Action /TR2 uc the Land Registration Law implementation by Nov. 2008. 2 =Establishing an organizational structure 'Ongoing. An organizational decree is Trigger ITR2 for the authority that sets up its mandate expected to be issued by Nov. 2008. and functions vis-a-vis other authorities and agencies. =Improving the licensing and registration =Ongoing. An action plan based on the i? system of business establishments. findings of the ICA study has been 9 = o Y developed. Several measure were taken % g =Establishing a clear, consistent, fair system .Ongoing. 2 $ of inspections of business establishments. .z z 2 V) .le w =Reducing costs and delays of customs =Ongoing. Introduced phased customs V) & processing, through automation automation in May 2006 - =Enforcing compliance of Basel prudential .Ongoing. nr * standards .I 0 L .Establishing the Securities Market along .Ongoing. Expected to finalize in 2008 = rn P) with its legislative, institutional, regulatory, and technical requirement Key: Action =Tranche action, Trigger =Tranche trigger, TR1 =Tranche 1,TR2= ~ranche2 * New reforms not included under NRA; - 53 - ANNEX2: OPERATIONPoLicvMATRIX Matrix of Actions Associated with Yemen Institutional Reform Grant (Actions in Botd are Mandatory for `Tranche Release u n d e r the L e g a l Agreement) Govt. p r o g r a d FirstTranche Actions Second Tranche Actions DPGobjective PILLAR 1: STRENGTHENING PROPERTY RIGHTSANDTHEINCENTIVE FRAMEWORKENCOURAGETo NON-OIL GROWTH __ Component I: IncomeTax Reforn Rationalized incentives 0 A comprehensive review of 0 The Executive Regulations facing private investors corporate tax policy and incentives, for the newly enacted through standard with an aim to rationalizing taxes, corporate income tax law, treatment of income, improving the efficiency o f revenue compliant with investment and generation, strengthening incentives international norms and expenses. and a sharp to invest and operate formally in satisfactory in substance to reduction in the Yemen, and reducing opportunities the Association, have been discretionary for discretionary application. issued. implementation that A new corporate income tax law, 0 Strengthening capacity of tax has marred the reflecting international norms o f administration to reduce incentives and added treatment o f corporate income, discretion, corruption. uncertainty for firms investments and expenses has been operating in Yemen. submitted to the Recipient's Council o f Ministers. COl ponent 2: Land Titling and Kegistratia Reform. , , , , Creation of a system o f 0 A new land registration law Approval and implementation secure and enforceable encompassing the of the executing regulations property rights, with recommendations o f the L a n d of the new land registration unambiguous title. Policy Task Force has been law in accordance with the submitted to Parliament. underlying principles and recommendations of the Land Policy Task Force and the Policy Note. Appointment of an independent registrar. The Council o f Ministers o f the Recipient has issued a decree whose substance i s satisfactory to the Association, defining the mandate and functions o f the General Authority for Lands, Survey and Urban Planning of the Recipient. - 54 - Matrix of Actions Associated with Yemen institutional Reform Grant (Actions in Bold are Mandatory for Tranche Release under the Ixgai Agreement) Govt. p r o g r a d FirstTranche Actions Second Tranche Actions DPGobjective PILLAR 2: STRENGTHENING GOVERNANCE THROUGH IMPROVED PUBLICFINANCIAL MANAGEMENT ANDPUBLIC ADMINISTRATION REFORM. PFM: Reduce Fiduciary Risk Strengthening o f the key Issue budget implementation Issue implementation areas of public financial guidelines to ensure conformity and progress report on the budget management with better consistency in executing the annual implementationguidelines. control environment and budget. Submit for approval draft law financial reporting quality. Draft a law to allow for the on the consolidation o f Extra consolidation o f Extra Budgetary Budgetary Funds in the State Fundsinthe State Public Budget. Budget. Develop draft restructuring MOF to initiate the formal process plans of MOF including MOF to engage with Ministry o f goals and criteria of the Civil Service to restructure MOF in restructuring. Iine with internationalnorms. Develop amended COCA's COCA to prepare a proposal to law to restrict the term o f better comply with INTOSAI in COCA's president to 5 years terms of reporting to the Parliament, renewable only once and limitingthe tenure o f its president to have COCA reporting to 5 years renewable once and Parliament. publishing its reform plans and Engaging with an SA1 to annual report in COCA's magazine conduct a peer review as per and lor website. INTOSAI standards and agree on a time frame for COCA to agree on undergoinga peer implementation. review by experienced SA1 in Ministry o f Finance to conducting peer reviews and prepare a Medium Term twinningarrangements. Expenditure (MTEF) to Ministry o f Planning has prepared a strengthen alignment of Public Investment Program(PIP) allocation o f resources for poverty reduction in the Budget 2008 (onwards) with the Socio-Economic Development Plan for Poverty Reduction (2006- 2010) (PRSP) - 55 - __ -_.- -.... . . . - _I-- M a t r i x of Actions Associated with Yemen Institutional R e f o r m G r a n t (Actions in Bold a r e Mandatory for Tranche Release u n d e r the Legat Agreement) Govt. p r o g r a d First Tranche Actions Second Tranche Actions DPGobjective Component 3: I! rengthening Public Financial Mana; m e n t -Procurement Strengthened public The procurement law has been Approve executing financial management and revised to align it with regulations to implement governance with regard to international best practice, and procurement law. public expenditure has been submitted to Parliament Restructure the High Tender through procurement by the Recipient's Council o f Board (HTB) by redefining reform. As a first step, Ministers. its role as an independent Government approved a institution. standard procurement Ministry of Finance to require key Focus HTB's on its oversight manual and procurement spending Ministries to apply role as the apex body o f documents to be used in procurement manual and utilize procurement operations in public sector transactions. standard biddingdocuments. Yemen's public procurement New legislation system. professionalizes (de- The Recipient has taken all politicize) the high tender action necessary, including board and creates a regulatory action, to separate Procurement establish a procurement Policy Monitoring Board policy monitoring board to with a procurement monitor procurement tracking system under its policy and undertake its authority. This gives the regulatory functions Government a systematic utilizing a procurement means o f overseeing and management information regulating procurement, system satisfactory to the and a dedicated body Association. handling policy and monitoring. CO ponent 4: ImprovingRevenueTrar parency Committed to and The Recipient has declared Adherence to EITI principles, achieving transparency commitment to the Extractive including: with regard to revenues Industries Transparency Initiative from oil and natural gas, (EITI) principles by virtue of a letter The Recipient has complied which provide the submitted by the Recipient to the with the EITI principles largest share o f the EITISecretariat. and criteria by publishing Government's income, the independently audited though accession to and accounts of the Recipient documenting all material adherence to Extractive payments made to the Industries Transparency Recipient by oil, gas and Initiative (EITI), an mining companies international compact of operating in the Republic o f resource-exporting Yemen ("payments") and - 5 6 - Matrix of Actions Associated with Yemen InstitutionalReformGrant (Actionsin Boldare Mandatoryfor Tranche Release underthe LegalAgreement) Govt. p r o g r a d FirstTranche Actions Second Tranche Actions DPGobjective - nations willing to abide all material revenues by agreed international received by the Recipient standards for the full from such oil, gas and publication and mining companies verification o f company ("revenues") in a publicly payments and government accessible, comprehensive revenues from oil, gas and and comprehensible mining.. manner. Payments and revenues are reconciled by a credible, independent administrator, applying international auditing standards and with publication o f the administrator's opinion regarding that reconciliation including discrepancies, should any be identified. This approach i s extended to all companies including state- owned enterprises. Civil society i s actively engaged as a participant in the design, monitoring and evaluation o f this process and contributes towards public debate. A public, financially sustainable work plan for all the above is developed by the host government, with assistance from the international financial institutions where required, including measurable targets, a timetable for implementation, and an assessment of potential capacity constraints. - 57 - .___ .- - M a t r i x of Ac ons Associated with Yemen lnstituti ma1 Reform Grant (Actions in Bold ai Mandatory for `lranche Release un !rthe Legal Agreement) - Govt. p r o g r a d F i r s t Tranche Actions Second Tranche Actions DPGobjective c wming Central Government- Publi 4dministration R e f o r m Reform o f the civil The Recipient's Council of The Recipient has service, both as a fiscal Ministers has approved the Civil completed the necessity (due to the Service Fund program for 2008- implementation o f the huge burdeno fthe wage 2010 and the alignment o f the Recipient's civil service bill and related budgetary allocation for 2008 to fund program for the obligations) and as a the said program. period June 2007-May vital component of 2008. public administrative The Recipient has reforms to promote consistently applied the provisions o f the 2005 good governance and Wage Law which requires effective service government agencies o f the delivery. Recipient to meet defined reform criteria before making any future salary increases. The Recipient has taken all action necessary for the establishment o f a computerized employee database, including a biometric identification information system, all satisfactory to the Association with coverage extended to all employees on the state payroll in all sectors. - 58 - ANNEX3: FUNDRELATIONSNOTE IMF Executive Board Concludes 2007 Article I V Consultation with the Republic of Yemen Public Information Notice (PIN) No. 07/120 September 27, 2007 On September 17, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Yemen.' Background Despite recent progress in poverty reduction, Yemen remains one of the poorest countries in the region and is far from achieving the Millennium Development Goals. Oil production has been declining since 2000, and in the absence of major discoveries, proven oil reserves could be depleted in some 10 years time. The start of a large liquefied natural gas project from 2009 will offer only partial compensation. Yemen faces considerable challenges to generate strong (nonhydrocarbon) growth to absorb the rapidly growing labor force and raise living standards, while ensuring fiscal and external stability in the context of declining oil reserves. Economic performance in 2006 was generally favorable, but was accompanied by an increase in inflation. Overall real GDP growth reached 4 percent in 2006, with a 6 percent non-oil growth offsetting an 8 percent decline in oil production. After a decade of relatively stable rates in the 10- 12 percent range, core inflation (excluding the volatile prices of the narcotic qat) increased to over 20 percent. This was partly due to higher world food prices, but buoyant domestic demand driven by increased government spending and rapid money growth, played a major role. High oil prices helped reduce the overall budget deficit to about '/z percent of GDP in 2006, but spending remained high. As in previous years, a large supplementary budget was issued at the end of the year to validate spending overruns that had already taken place. Fuel subsidies continued to absorb a large part of the budget (8 percent of GDP) and the wage bill rose to over 9 percent of GDP, while the non-oil tax ratio fell further to less than 7 percent of GDP. Without corrective actions, the overall deficit would significantly widen in 2007 (to 5-7 percent of GDP) as the approved budget maintains high spending levels despite lower oil revenues due to declining production and prices. Monetary policy was accommodative in 2006. With sizable government spending out of high oil revenues, the real exchange rate appreciated by 10 percent in 2006. The Central Bank of Yemen (CBY) continued its policy of targeting a slow and steady depreciation of the exchange rate, so the real appreciation manifested itself through higher inflation. Money growth accelerated to 28 percent in 2006, twice the rate of the previous two years. The external account surplus remained broadly unchanged at over 3 percent of GDP in 2006, with record-high oil receipts partially offset by imports related to sizable investments in the gas sector. With the latter financed trough foreign direct investment, the high oil revenues resulted in a large reserve accumulation by the CBY. Gross reserves at the CBY increased by $1.5 billion to $6.8 billion by year end, the equivalent of about 11months of imports. Relations with the international community have strengthened. A Consultative Group meeting held in November 2006 in London succeeded in generating almost $5 billion in pledges (about one-fourth of 2006 GDP), underwriting a large part of Yemen's Public Investment Program for 2007-10. Half of the pledges came from Gulf Cooperation Council countries. Also, Yemen was reinstated in the U.S.3 Millennium Challenge Corporation's threshold program. The Yemeni authorities recently committed to join the Extractive Industries Transparency Initiative. ! 1:ndcr i'wticlc I\' of the IMYs ,Wicks oi'rigrcerrieiit. tlic 1MIholdsbilateral discussions witli rncriihzrs, usuallycvery year. A stal'i'tcam \,isits the country. collects economic and financial inforiiiation, arid disci Is the counrry's economic dwclopments and policies. On relurn to lieadquarters, tlie stairprepares a report. wliicli form5 the on by the Pxeculive 13u:irii. At the conclusion ofthe discussirm. thc Mariagiiig Director, its (:hnii?iianof the Board, s u n thc views ol'Ewcuti\,c Dircctors, and this summary i s tranmittcd to tlic country's autliwitics. - 59 - Executive Board Assessment The Executive Board welcomed Yemen's generally favorable recent economic performance, including the decline in the poverty rate, as well as the progress being made on a number of structural reforms. Nevertheless, Directors concurred that the authorities face considerable macroeconomic and structural policy challenges to promote strong economic growth, create ample employment opportunities, and reduce poverty, while ensuring fiscal and external sustainability. In this regard, Directors welcomed the authorities' strategy of basing policies on existing hydrocarbon reserves, while recognizing that the country's economic outlook could be significantly altered by the discovery of new oil and gas resources. Directors, noting that inflationary pressures have not fully abated, were encouraged by the authorities' commitment to reducing inflation. They agreed that monetary policy should focus closely on price stability and welcomed the CBY recent efforts to keep the exchange rate of the rial vis-a-vis the U.S. dollar broadly stable, which should help limit imported inflation. Given the limitations of monetary policy in Yemen, Directors generally considered it to be appropriate for the CBY to continue to rely substantially on the exchange rate as a nominal anchor, in order to achieve lower inflation. While the exchange rate currently appears to be broadly in line with fundamentals, over time and in view of the expected decline in oil production, it will be important for the exchange rate to reflect evolving economic conditions. Directors observed that the shallow financial intermediation, along with a relatively high level of dollarization, is limiting the effectiveness of monetary policy. They viewed that the removal of the minimum interest rate for rial deposits would allow the CBY to conduct a more active interest rate policy and enhance financial intermediation. Directors noted that fiscal restraint, including public sector wage restraint, should provide an important complement to monetary policy in reducing inflationary pressures. They also underscored that frontloading fiscal adjustment will be needed, given the prospective decline in oil production and revenues. Directors agreed that the gradual phasing out of domestic fuel subsidies will be central to fiscal adjustment, while recognizing that this will require political support. They noted that raising fuel prices should go hand-in-hand with strengthening the social safety net, in order to cushion the impact on the poor, including through persevering with ongoing efforts aimed at improving the Social Welfare Fund. Directors also were of the view that, if the authorities wished to cushion the impact of high wheat prices on the poor, it would be preferable to do so through the SWF. Strong efforts will also be needed to increase the government's non-oil revenues, reorient spending towards priority areas, and improve the quality and effectiveness of capital spending. Directors supported the progress being made towards strengthening the budgetary framework and improving fiscal transparency. Directors underscored the importance of productivity-enhancing reforms to strengthen Yemen's competitiveness in non-oil exports. Further efforts are needed to improve the investment climate and the quality of labor, enhance governance and reduce red tape, including in tax and customs administration. Directors stressed that deepening financial markets will be essential for ensuring strong non-oil performance, and also recommended further strengthening of banking supervision. In this regard, they encouraged the authorities to request an Financial Sector Assessment Program update, which would help to assess potential risks in the financial system and to develop an agenda for financial sector reforms. Directors welcomed the revised Anti-Money Laundering law, and looked forward to its approval by parliament. Directors looked forward to further efforts to improve the quality and timeliness of macroeconomic statistics, to better facilitate the formulation and monitoring of economic policies. Public Information Notices (PlNsJ form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINSare issued after Executive Board discussions of Article IV consultations with member countries, of its surveillanceof developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINSare also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particularcase. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2007 Article IV Consultationwith Irelandis also available. - 60 - Republic of Yemen: Basic Economicand Financial Indicators, 2003-07 Quota = SDR 243.5 million Population = 21.6 million (2006) Per capita GDP: US$ 927 (2006) 2003 2004 2005 2006 2007 (Change in percent) National Income and Prices Real GDP 3.7 4.0 4.6 4.0 3.6 Real nonhydrocarbon GDP 4.8 5.4 5.3 5.7 5.2 Real hydrocarbon GDP -2.1 -5.0 -0.8 -8.3 -10.1 Core consumer price index (end-of-period) 12.1 14.5 20.2 22.0 12.0 (In millions of U.S. dollars) External sector Exports, f.0. b 3,924 4,676 6,413 7,285 6,377 of which : hydrocarbons 3,417 4,303 5,952 6,733 5,814 Imports, f.0.b 3,557 3,859 4,713 5,890 7,118 Current account, incl. official transfers (in percent of 1.5 1.6 3.8 3.2 -3.8 GDP) Overall balance (deficit-) 583 556 264 1,353 1,104 (In percent of GDP) Fiscalvariables Overall balance (cash basis) -5.3 -1.7 -0.3 -0.2 -4.6 Nonhydrocarbon primary fiscal balance (cash) 21 -25.7 -22.1 -24.4 -25.4 -24.9 Debt ratios Net public debt 52.2 45.5 37.1 31.4 32.0 External debt 45.0 38.5 30.8 27.3 25.8 (12-month change in percent) Broad money 20.0 15.0 14.4 28.8 25.0 Credit to private sector 26.3 33.5 21.3 16.7 12.5 Benchmark deposit interest rate (percent per annum) 13.0 13.0 13.0 13.0 ... Central bank own gross foreign reserves 3! I n millions of U.S. dollar 4,449 5,068 5,338 6,798 7,975 I n months of next year's imports of goods and services -- -15.2 15.0 11.0 10.8 12.6 - Source: Yemeni authorities; and staff estimates and projections. ' '/Core CPI is defined as the overall CPI less the CPI for qat. Includes statistical discrepancy. Gross reserves minus commercial bank and pension fund foreign exchange deposits held with the central bank. - 61 - ANNEX4: COUNTRYATA GLANCE (INCLUDES COUNTRY MAP) Yemen, Rep. at a glance 9/28/07 M. East POVERTYand SOCIAL B North LOW. Yemen Africa income Developmentdiamond' 2006 Population,mid-year (millions) 21.6 311 2,403 GNI per capita (Atlas method, US$) 760 2,461 650 Life expectancy GNI (Atlas method, US$ billions) 16.4 771 1,562 Average annual growth, 2000-06 T Population (%J 3.1 1.8 1.9 Laborforce (%) 4.2 3.5 2.3 GNI Gross per + primary Most recent estimate (latest year available, 2000-06) capita enrolimenl Poverty (% ofpopulationbelownationalpovertyline) Urbanppulation (% of totalPOpUlatiOfl) 28 57 30 Lifeexpectancyat birth (years) 62 70 59 Infant mortality (per 1,000live births) 76 43 75 Childmalnutrition (% ofchildren under5) 46 15 Access to improvedwater source Access to an improvedwater source (% ofpopulation) 67 m 75 Literacy(% ofpopulationage 15+J 54 73 61 Gross primaryenrollment (% of schwl-ape population) 89 103 102 -Yemen, Rep. Male 101 106 108 Low-incomeurouv Female 75 99 96 KEY ECONOMICRATIOS and LONG-TERMTRENDS 1986 I996 2005 2006 Economlc ratios. GDP (US%billions) 5.8 16.7 19.1 Gross capital formationlGDP 23.0 Exports of goods and servicedGDP 42.3 Trade Gross domestic savings/GDP 16.1 Gross national savingdGDP 25.1 26.3 T Cunent accountbalancelGDP I.8 4.2 InterestpaymentdGDP 0.4 0.3 Total debVGDP 109.8 32.0 Total debt service/exports 2.4 2.6 Presentvalue of debVGDP 22.5 I Present value of debtlexports 46.4 Indebtedness 1966-96 1996-06 2005 2006 2006-10 (average annualgrowth) - GDP 5.7 4.3 4.6 3.3 Yemen, Rep GDP per capita 1.0 1.0 1.3 0.2 Low-incomegroup Exports of goods and services 34.5 6.3 STRUCTUREof the ECONOMY (% of GDPJ Agriculture 16.9 Industry .... 41.5 Manufacturing 10.8 Services .... 41.6 Householdfinal consumption expenditure 70.8 General gov't final consumption expenditure 13.1 Importsof goods and services ...... 49.2 1966-96 1996-06 2005 2o06 (average annualgrowth) Growthof exports and imports (%) Agriculture 4.5 4.2 45 Industry 7.7 4.8 .. 30 Manufacturing 5.2 9.0 Services 5.2 4.4 15 Householdfinalconsumption expenditure 2.6 2.1 0 General gov't final consumption expenditure 0.1 8.6 .. -15 Gross capital formation 15.0 2.5 Exports -O'lrnports importsof QWdSand services ~ 21.1 2.3 Note: 2006 data are preliminaryestimates. This table was produced from the DevelopmentEconomics LDB database. * The diamonds show four key indicators in the country (in bold)comparedwith its income-groupaverage. If data are missing,the diamondwill be incomplete. - 62 - Yemen. Reo. PRICES and GOVERNMENTFINANCE 1986 1996 2005 2006 Domestic prices (% change) Consumer prices 30.7 ImplicitGDPdeflator 35.9 19 7 13.3 Government finance (% of GDP, includescurrent grants) Current revenue 01 02 03 04 28.8 34 5 05 06 Current budget balance 4.0 6 2 ODP dPfinlnr - 4 - = C P I Overallsurplusideficit -0.9 -2 2 TRADE 1986 1996 2005 2006 (US$ millions) Export and import levels (US$mill.) Total exports (fob) 2,263 6,624 CNde oil (government share) 958 Crude oil (company share) 1,018 Manufactures 24 6,333 Total imports (cif) 2,294 4,538 Food 974 Fueland energy 192 Capitalgoods 433 1,560 1 Export priceindex (2000=10OJ 76 177 00 01 02 03 04 05 W Import priceindex (2000=1OOj 115 113 Terms of trade (2000=100J 66 157 BALANCE of PAYMENTS 1986 1996 2005 2006 (US$millions) 1 Currentaccount balanceto GDP ("/e) h Exports of goods and services 2,448 6,908 Importsof goods and services 2,849 5,694 Resourcebalance -400 1,214 Net income -634 -1,676 Net current transfers 1,141 1,171 Current account balance 106 709 Financingitems(net) -400 -169 00 01 02 03 04 05 06 Changes in net reserves 294 -539 Memo: Reservesincludinggold (US$ millions) 1,036 6.198 Conversionrate (DEC,local/US$) 1282 1915 197.1 EXTERNALDEBT and RESOURCEFLOWS 1986 1996 2005 2006 (US$ miliionsj omposition of 2005 debt (US$ mill.) Total debt outstandingand disbursed 3,882 6,362 5,363 IBRD 0 0 0 0 G 353 IDA 407 893 1,689 1.894 c 1. Total debt service 173 87 211 IBRD 0 0 0 0 IDA 5 15 42 45 Compositionof net resource flows Official grants 146 109 151 Officialcreditors 162 106 131 Privatecreditors 129 0 24 Foreigndirect investment (net inflows) 6 6 0 -266 Portfolioequity (netinflows) 0 0 0 World Bank program Commitments 47 207 40 0 , IBRD E Bilateral Disbursements 47 95 129 160 ,-- D Other mltilateral - F Private Principalrepayments 1 9 27 31 :- IDA IMF G Short-te --- Netflows 45 86 102 130 Interest payments 4 6 15 15 Net transfers 42 80 87 115 Note: This table was producedfrom the DevelopmentEconomicsLDB database. 9/28/07 MAP SECTION REPUBLIC OF 46E 48E 50E 52E 54E This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information YEMEN shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any endorsement or acceptance of such boundaries. SELECTED CITIES AND TOWNS 20N 20N GOVERNORATE CAPITALS REP. OF S A U D I A R A B I A NATIONAL CAPITAL YEMEN RIVERS MAIN ROADS GOVERNORATE BOUNDARIES INTERNATIONAL BOUNDARIES O M A N 18N 42E To Abha 44E Sanaw Sanaw To Thamarit A L - H A D R A M O U T M A H RRA H M A H AT Habarut Habarut ThamudThamud S A A D A H Saadah Saadah A L - J O W F WadiMakhun M a h r a t To Mirbat M t n s . ZamakhZamakh Damqawt Maydi HuthHuth ¸- Wadi Al Jiz Al Hazm Al Hazm ab'atayn Dese eserrt Mar'ayt Mar'ayt Al Ghaydah 16N HAJJAHHAJJAH AMRAN AMRAN Wadi Wadi Jawf 16N Al Ghuraf Al Ghuraf Al Luhayyah HajjahHajjah Sab'ata Hadramout Nishtun Amran Amran as M A R I B Ramlat lat Hawra Hawra Salif Al Mahwit Al Mahwit SANAASANAA MaribMarib ShabwahShabwah AL- uw tt Qishn MAHWIT S H A B WA a o Red SANA'ASANA'A a m Sayhut Al Hodeidah r Dhamar NuqubNuqub HODEIDAH DAHDAH DHAMAR DHAMAR HaribHarib a d (3199 m) (3199 m) NisabNisab Ataq Ataq Shihr Sea RAIMHRAIMH H Dhamar Dhamar Rida Rida Al Mukalla Wadi Zabid A L - B E I D A 14N I B B AL-AL- Al Beida Al Beida Al Huwaymi Al Huwaymi 14N IbbIbb DHALE'EDHALE'E (3227 m) (3227 m) Al Dhale'e Al Dhale'e Bir Ali Taiz aiz Wadi A B YA N Mocha TA I Z TA Bana Ahwar Shaqra ERITREA At Turbah At urbah LahejLahej Zinjibar Gulf of Aden At L A H E J Turbah ADENAden Qalansiyah Qadub Socotra 'Abd al Kuri OCTOBER DJIBOUTI Samha 0 50 100 150 Kilometers Darsa IBRD 12N The Brothers 12N 33513 2005 0 50 100 Miles 42E 44E 46E 48E 50E 52E 54E