Yemen Policy Note 2: Economic, Fiscal and Social Challenges in the early phase of a Post Conflict Yemen WOLD BANK GROUP 1 B Table of Contents Acronyms iv Acknowledgements 1 Summary – key messages 2 Toward a Shared Recovery 4 Recommendations for immediate actions post-conflict 10 Priorities to be tackled to win the peace momentum - the medium term (6-24 months) 14 Establishing the public revenue base with a view toward a revised social contract 14 Stabilization and peace building requires restoring the non-hydrocarbon sector 17 Outlook for Yemen’s Hydrocarbon Production Recovery 18 Yemen’s key policy and institutional challenges for the hydrocarbon sector 22 Fiscal policies for peace building, recovery and fomenting growth 24 Re-establishing the Public Financial Management System 24 Policy challenges for the Public Financial Management System 27 Policy recommendations for the Public Financial Management System 29 Restoring budget operations 29 Ensuring the integrity of budget controls 30 Providing information about where government funds are going 31 Launching preparations of the new budget 31 Establishing the core foundations for rebuilding PFM institutions and systems 32 Final Remarks 34 List of Tables Table 1: Oil and Gas Future Price Forecasts 19 Table 2: Yemen: Estimated Yemen’s output share in oil production, 2017 and 2018 20 i Table of Contents Annexes Annex 1: Summary of Yemen’s Current Tax Regime 37 Annex 2: Tax Reforms as Initiator of a Virtuous Cycles of Development 38 Annex 3: Oil and Gas Sector: Institutional Structure 40 Annex 4: Oil and Natural Gas Infrastructure 41 Annex 5: Republic of Yemen: Selected Economic Indicators, 2010–17 42 Annex 6: The Republic of Yemen: Growth Diagnostics Tree 43 Annex 7: A brief background information to the PFM system in Yemen 43 References 47 ii iii Acronyms iv Acknowledgements AFMIS Automated Finan- cial Management Information System CBY Central Bank of Yemen COCA Central Organiza- tion of Control and Audit IMA Independent Mon- itoring Agents IMF International Mon- etary Fund IT Information Tech- nology LGMIS Loans and Grants Management Information System NPL Non-performing Loan MAF Mutual Account- ability Framework MOPIC Ministry of Plan- ning and International Cooperation MTFF Medium-Term Fis- cal Framework PEFA Public Expendi- ture and Financial Accountability PFM Public Financial Management PIP Public Investment 1 Plan a first set of recommendations to address PIU Project Implemen- pressing needs. tation Unit RPBA Recovery and The World Bank team was led by Wilfried Peacebuilding Needs Assessment Engelke (Sr. Economist). However, many SOE State-owned en- more helped. The section on tax revenues terprise was based on a contribution received from TPSD Transitional Pro- Jan-Peter Olters (Lead Economist, Gover- gram for Security and Development nance), and Amir Mokhtar Althibah (Research TSA Treasury Single Analyst) has been very helpful in drafting the Account section on the hydrocarbon sector. The sec- tion on public financial management (PFM) topics has been based on a paper prepared by Manuel Vargas (Lead Financial Management Specialist) and his team, comprising Walid H. Al-Najar (Financial Management Specialist) and Moad M. Alrubaidi (Sr. Financial Man- agement Specialist). Further contributions and advice in preparing this note has been received from Francesca Recanatini (Sr. Pub- lic Sector Specialist), Marijn Verhoeven (Lead Economist, Public Sector Governance), Mi- chael G. Schaeffer (Sr. Public Sector Special- ist), Nadia Fernanda Piffaretti (Sr. Economist, Macro Economics & Fiscal Mgmt.), Thomas Blatt Laursen (Lead Economist), Muna Abeid Salim (Sr. Program Assistant), Suhair Al- Zubairi (Program Assistant), and Fowzia Ya- hya Musleh Al-Qobi (Program Assistant). Mr. Albert Jaeger, IMF Mission chief to Yemen, and Mr. Mohd S. M. Zaher (Senior Economist) This Policy Note 2 for Yemen has been pre- from the International Monetary Fund (IMF), pared by a team from the World Bank, led and Dr. Mohammed A. Zubair, Lead Econo- by Wilfried Engelke (Senior Economist). The mist at the Islamic Development Bank contrib- team drew on a wide pool of expertise, ex- uted with comments and specific inputs. perience, and references inside and outside of the World Bank. The decision to conduct The team is grateful for advice and guidance this work followed a discussion with the then received from the Mr. Asad Alam, Country Di- Minister of Planning and International Coop- rector, Ms. Sandra Bloemenkamp, Country eration, internal deliberations about a future Manager for the World Bank in Yemen, Mr. re-engagement with Yemen, and the realiza- Auguste Tano Kouame and Mr. Eric Le Bor- tion that coordination with Yemen’s partners gne, Practice Manager and acting Practice toward a re-engagement would need anchor- Manager, Mr. Renaud Seligmann, Practice ing around strategic themes, identification of Manager Governance who reviewed the PFM pressing priorities or policy trade-offs, and components, and Abdallah Al Dardari, Senior 2 Advisor. A special appreciation goes to the peer reviewers for this operation, Ms. Clau- Restoring a minimum stock of foreign re- dia Nassif (Lead Country Economist) and Ms. serves is a priority for allowing the private Henriette von Kaltenborn-Stachau (Sr. Opera- sector to recover and initiate economic re- tions Officer). covery. The minimal stock of initially available foreign reserves commensurate with restor- The team appreciated the close and produc- ing macro stability should amount to roughly tive cooperation with the Government of Ye- 3 months of imports1, estimated at $4.5 billion men during the preparation of these notes, under pre-conflict conditions.2 The availability with particular reference to H.E. Dr. Moham- of foreign reserves will allow to fund recovery med Saed Al-Sadi, Minister of Planning and imports and are indispensable to engage the International Cooperation (MoPIC); H.E. Mr. private sector for recovery. Mohammed Abdelwahed Al-Maitami, Minister of Trade and Industry (MoTI), Mr. Mohammed Restoring the operations of the Central Al-Hawiri (Deputy Minister for Economic Stud- Bank immediately is a sine qua non condi- ies and Forecasts, MoPIC), Eng. Mohammed tions for economic recovery and regaining M. Al-Maswari (Deputy Minister for Foreign- macro stability. The Central Bank of Yemen Financed Projects) and Mr. Abdulmajeed Al- would need to be able to assume again its Batuly (Head of Socio-economic-Forecasts). normal financial anchor functions which are (1) servicing as a lender of last resort to the We thank the team at the Word Express for Yemeni financial system, (2) balancing the an excellent typesetting job. And there were national private and public debt market, (3) many more others who would need to be ac- facilitating international trade, and (4) ensur- knowledged for their kind assistance, help, ing the viability and credibility of the Yemeni explanation of issues, or simply their kindness financial system. extended to the team during this process. Resuming trade to its full potential and Summary – key messages reviving the hydrocarbon sector requires a regularization of the external debt situ- Stabilizing the macro economy is key for ation to allow investors to have access gaining the peace and realizing the peace to currency flows. Accumulated arrears on dividend. For the short term, though, the external debt obligation will be an obstacle to prime challenges are: (1) rebuilding key eco- resuming normal trade activities, reviving the nomic stocks and central national economic private sector in general, and for entering in institutions, foremost the foreign reserves and complex financial transaction for restoring the the Central Bank, the anchor for Yemen’s fi- hydrocarbon sector, as creditors would insist nancial system, (2) restoring the fiscal reve- on meeting their claims before new inves- nues, (3) restoring the hydrocarbon sector as tors could make a claim on external currency the financial backbone of the economy with- flows. External debt obligations would need out which economic stability will be difficult to be restructured; similarly, external debt ar- to conceive over the medium terms, and (4) rears would need to be rescheduled. establishing the legitimacy of the central insti- tutions, especially through restoring the fiscal 1 Three months of import coverage is considered a mini- management system and its accountability mum level for countries to meet macroeconomic stability mechanism while delivering on reconstruction criteria. and restoring public services. 2 Which would be equivalent to about 10 percent of the conflict depressed GDP total by the end of 2016. 3 Yemen needs to restore its fiscal revenue central imperative for economic recovery and base from day one. Yemen’s reconstruc- sustainable economic stabilization in Yemen. tion, stabilization, and development path from the immediate over the medium to the longer How quickly the past production revenue term hinges critically on the ability of its fu- capacity can be restored depends on (1) ture government to raise domestic revenues the speed of investor re-engagement, (2) to fund its public expenditure program. Exter- better utilization of given investments, nal resource availability has an important role and (3) the future investment conditions to play for early stabilization, restoring of live- available to the sector, ultimately aided lihood as well as the social and institutional by a conflict resolution agreement. The fu- fabric. However, sustainable recovery, restor- ture international oil price is assumed to rally ing its own systems and its institutional fabric, around $50 a barrel, about half of past pric- requires generating own resources. es. Achieving the pre-2014 hydrocarbon rent level for Yemen’s fiscal and external balance Trade and consumption taxes have an im- going forward, would require a substantial in- portant role to play in the short term to crease in the annual production. The decline restore fiscal revenues. Yemen’s given tax in production - as observed since 2002 - could regime does not a priori represent an obsta- be reversed, if the investment climate in the cle to efforts aimed at strengthening revenue sector would allow for a more sustainable collection. However, a post-conflict situation prospection, exploration, and production path. requires some initial short term “emergency responses” to finance and support recon- Legitimacy, trust building, and effective- struction efforts. In this context, it is critically ness of any expenditure program all re- important to (1) sequence the re-establish- quire the restoration of normal budget op- ment of the tax and customs administration erations. Normal budget operations will have appropriately; and (2) minimize administra- to be restored in order to support the state tive complexities so as to permit the govern- administrative structure and to provide some ment to re-assume its core functions without degree of service delivery. This will include asphyxiating first signs of private-sector re- establishing the authorizing arrangements, covery. Trade taxes and consumption taxes as well as restarting treasury operations. As a should receive attention on a priority basis. starting point, an “emergency budget” for the post-conflict fiscal year would need to be pre- The pace of the recovery of fiscal receipts pared.3 and export earnings over the medium term (after 6-12 months) depends on the speed There is no legitimacy without restoring and depth to which the oil and gas sector budget integrity. In order to build confidence can be restored. Pre-conflict, the hydrocar- among the relevant stakeholders and to make bon industry in Yemen generated 50-60 %% efficient use of limited resources, it will be im- of the fiscal revenues and up to 85 %%of portant to ensure that fundamental controls export revenues, and nearly 50% of foreign are in place to prevent fiscal leakages. Under reserves. The sector’s share of the GDP the presumption that expenditure priority will amounted to 8-9%, and its importance for initially be placed on payments of civil servant direct employment is negligible. Yet, despite salaries, securing the integrity of payroll data of the massive decline of international hydro- and controls will be imperative. carbon prices since 2014, the recovery of the hydrocarbon sector continues to constitute a 3 Emergency budgets may be required even beyond the first post-conflict fiscal year. 4 tunities, and sustainable development Commitment to and delivery on fiscal in Yemen. Resulting capture, economic transparency will be an important trust and distortions and underperformance are confidence-building measure. Producing equally symptoms of the conflict con- timely and reliable information about the bud- text in Yemen as they are also drivers get and its execution (to start with) will help of such conflict. While it will take time to open doors for public debate. It will also to address this dead-end development facilitate accountability over the use of public path, there is no alternative to begin- resources to citizens and development part- ning to address the root causes of this ners alike. It will be particularly important for path, starting with setting the condi- the government to quickly show that spending tions for a shared recovery. The risk of is going to support reconstruction and service failure is high: Walter (2004) estimates restoration in the various areas of the country. that countries have a 40 % chance of reverting to violence within the first de- cade after peace. But identifying and The first post-emergency budget formu- addressing key risks, among others lation exercise will be constrained by the through realistic, well sequenced and presumed limited available capacity. A sim- balanced policies, can break the cycle ple mechanism for selection and allocation of violence in Yemen and allow the of funds to reconstruction capital investment country to enter a shared recovery and projects would need to be established and to outgrow deeply seated legacies. further developed over time. While these in- vestments would initially be supported largely Salient economic and social features in by development partners on the basis of a Yemen Recovery and Peacebuilding Needs Assess- Yemen’s development path has been ment (RPBA), the foundations for an institu- mixed and state dependent. In the two de- tional project “gate-keeping” process could be cades that followed Yemen’s unification in set early on. May 1990, the country enjoyed its most sta- ble period, politically as well as economically, Toward a Shared Recovery since the modern Yemen emerged from its co- This note lays out the key economic lonial period (South Yemen) or the Imamate challenges, risks and policy options governed period (North Yemen) in the 1960s. that Yemen faces during a first phase Post-unification the economic growth in Ye- of socio-economic stabilization post men from 1994-2010 was driven primarily by conflict, supporting restoration of pub- demographic change, exporting labor to the lic and social services, recovery of GCC countries, shifting out of agriculture, and economic activities, creating income since the early 1990s by the development of opportunities, overcoming economic an oil sector. The Yemeni oil sector was con- legacies and managing key risk fac- sidered small by regional standards, reaching tors. The suggested range of policy about 350,000 barrel a day at its peak (2000) options aim for a ‘shared recovery’, but delivering on average about 60 % of fis- acknowledging that unsustainable pre- cal revenues and 85 % of export revenues. A conflict policies, mixed with bad gover- large state determined private sector4, inher- nance, led to economic distortions and ited both, from the former Northern Yemen as economic capture by a few undermin- 4 Capturing more than 50% of the economy, depending on ing investment and employment oppor- the measurement applied. 5 well as from the socialist former South Yemen, Exports - except of hydrocarbon product - augmented by the oil sector, gave the central contributed close to nothing to growth while state a broad leverage about many economic domestic demand has been an overriding fac- assets, and state determined employment tor explaining growth.6 was encompassing in the modern economy. The emerging state dominated economic Non-sustainable use of resources in com- structure gave rise to a rent-seeking econo- bination with exclusion of a large part of my, where formal employment opportunities Yemenis is hindering improvements and and use of economic assets were continuous- limiting options in the future. Yemen is ly negotiated along political consideration and one of the most water-deficient Arab coun- shifting loyalties, on the local level as much tries, with declining freshwater resources due as on the national level. A competitive and to over-pumping of aquifers and the rapid productive private sector could not develop growth of the population and the development on a scale under these conditions. Large fam- of commercial agriculture. In 2010, annual de- ily based conglomerates formed the nucleus mand for water was estimated at 3.9 billion of a private sector but they, too, were depen- cubic meters (bcm) (90 % for agriculture – of dent on state granted privileges, which could which 40 % is reserved for Qat production), be withdrawn or renegotiated. The business 8 % for municipal uses, and 2 % for industry) climate in Yemen was not helpful for develop- against an estimated renewable supply of 2.5 ing a thriving and competitive private sector. bcm. The shortfall (1.4 bcm) has been met by Employment and income sources beyond the depleting Yemen’s stock of non-renewable government and a small modern sector, were groundwater, which became accessible in the largely determined by services (about 37 % 1970s because of modern diesel powered of the GDP), mostly at low productivity, and tubewell technology. The largest user of water agriculture (10 % of the GDP). is agriculture. However, ownership of land is favoring a few with large land assets, running Growth has been reliant on hydrocarbon cultivation for fruits, vegetables and Qat (30 investment. Growth per capita averaged 1.3 % of the total agricultural production)7. Opera- % annually in the two decades preceding tions of these farms were helped by (1) mis- 2011, the year which set transition in Yemen guided policies involving subsidies (diesel and into motion but ended up in the on-going open cheap pricing) for water extraction, leading to conflict. The marginal returns on fixed capital the over-extraction of water, especially for the investments were fairly high5, but reflected, cultivation of Qat, (2) a lack of legal enforce- to a great extent, investments in the hydro- ment to regulate water use; and (3) public in- carbon sector. Overall, investment has been vestment that encouraged the use of water in on a declining path since 1997, reaching 14.8 surface or spate irrigation. Most of Yemenis % during 2006-2010, while the private invest- live from small scale agricultural production ment sank to 8.8 % of the GDP in 2005-2010, that is rain fed. reflecting also the lack of profitability outside the few areas offering access to rents (hydro- Poverty and dismal social outcomes are a carbon sector). High operating costs, many direct result of a rent seeking and non-com- formal or informal restrictions, and overall low petitive, managed or negotiated economy. profitability hampered expansion of produc- Lagging productivity of the Yemen economy tion for small and medium enterprises, limit- 6 Yemen- Country Economic Memorandum, October 2015, ing employment and income opportunities. World Bank, Report no. 102151-YE, page16. 5 Yemen- Country Economic Memorandum, October 2015, 7 Qat is a Yemeni flowering plant typically chewed as a World Bank, Report no. 102151-YE; Figure 6. stimulant and to induce euphoria (amphitamine). 6 underpinned overall stagnation of livelihood A third of the student population is assessed conditions in the country prior to the con- to not attending school since the outbreak of flict, combined with a lack of opportunity. The the conflict. The school program of those at- World Bank’s 2015 Country Economic Memo- tending is in many ways adversely effected, randum (CEM) identified such a result as a undermining the quality of their learning pro- major obstacle to sustaining high growth. The gram, which was considered low already prior mutual dependence of rent seeking, a non- to the conflict. The adverse long-term effects competitive economy, bad governance, and on the economy, on the labor market, and ul- non-sustainable use of resources compound- timately on society as a whole of a generation ed sub-optimal economic outcomes and the growing up without proper schooling, formal event of poverty. Since long, Yemen had the qualifications, and limited economic options highest poverty incidence in the Middle East, will be tremendous. with about 35 % of the population living below the poverty line of US$2 (2005 PPP) a day Overview of economic, fiscal, financial, per person. Poverty is more widespread and and social challenges persistent in rural areas, where 70% of the The economy has contracted sharply since population lives. A preliminary analysis of the the open conflict erupted in early 2015 and 2014 Household Budget Survey data shows vital social and institutional functions have that poverty has been increasing between been impaired. Official reporting suggests 2005 and 2014. Initial simulations of the im- that Yemen’s GDP has contracted by approxi- pact of the ongoing conflict indicate that the mately 40 % in the two years since 2015. The poverty incidence may have almost [doubled] conflict had a devastating overall effect on the nationally, from 34.1 % in 2014 to 78 % in economy, damaging the production chain and 2016.8 In 2012, Yemen had one of the high- markets in the real sectors. The conflict-re- est malnutrition rates in the world, with almost lated losses, damages, and disruptions to in- 60 % of children under the age of five (about dustry, agriculture, livestock and fisheries are 470,000) suffering from chronic malnutrition, estimated at the end of 2015 to be in the order 13 % acutely) and 35 % underweight. of $18 billion, or higher.9 Due to the overall breakdown of access to inputs markets (en- Demographic pressures keep rising, es- ergy, labor, intermediate goods, and services) pecially young Yemenis have to deal while demand is also depressed, a quarter of with a weak economy, and a dramatically all firms suspended operations (estimations weakened access to education is going point to 35 % of the services sector, 29 % of forward. Population growth is estimated to the industrial enterprises, and 20 % of the be around 2.5-3% per annum. A third of the trading companies).10 Supply of centrally gen- population of 28 million is at school age (5- erated electricity has diminished since late 19 years). Currently, about 400,000 young 2014, and with the onset of the conflict it has Yemenis enter each year the labor market. If come to complete stop in 2015. Oil production gender balance is assumed for the labor mar- has come to a virtual halt. However, extraction ket entry, the pressure would be even higher. continued for producing liquefied gas used for The required investment in schooling has, the domestic market. Businesses face high however, been lagging earlier, and the lack operative costs, lack of input markets, and of investment is compounded by the conflict. are vulnerable to the risk of violence (see also 8 The poverty headcount is based on a national poverty line the Policy Note no. 3). Formal private sector of YER 10,913 (or about US$50) per capita per month in 2014 9 Yemen: Preliminary Damage and Needs Assessment, June prices. In terms of 2011 PPP terms, it is about US$3.52 per 15th, unpublished. person per day, or about US$105.6 per person per month. 10 UNDP SMES Rapid Business Survey, April 2016. 7 employment is estimated to have declined by system of these flows. about 50 %. This has exacerbated the pre- war premium on high-rents sector, and further Access to foreign exchange is market emphasized the lopsided structure of the Ye- driven and subjected to the political, in- meni economy. stitutional, and economic uncertainties prevailing in Yemen. With the Central of Bank of Yemen being largely absent, cur- 90 % reduction in Yemen’s hydrocarbon rency exchanges are undertaken at a market production and export income since 2014 exchange rate, which varies currently (March deprived the country from its main foreign 2017) from about 320 Yemeni Riyal per dol- exchange earning source and the state lar to 360, depending on the size and type of from 50-60 % of its fiscal income. Yemen’s transaction and whether it is a cash or paper hydrocarbon sector drives the fiscal and the transaction. Incoming cash transactions enjoy external balance of the country. Hydrocar- the most favorable exchange rate. Banks are bon production exports (oil and gas) gener- constrained by the fact that the interbank mar- ated about 60 % of fiscal revenues (11.2 % of ket has largely collapsed, given the high de- the GDP in 2014; about $5 billion) since the gree of uncertainty or risks and the absence early 2000s. They generated up to 85 % of of the Central Bank as a market actor. Banks export revenues, in 2014 roughly $7 billion. have some credit and exchange relations with Oil and gas production declined from an av- national money traders. But there are high erage equivalent to 326,000 barrels a day to transaction costs involved and the market no more than 30,000 barrels in 2016. Other is not very liquid. A transaction in the fall of sources of exports declined by around 60 % 2016 aiming to raise the equivalent of about in 2015 compared to their level in 2014. In to- $80 million for financing food imports caused tal, exports in 2016 are estimated to have de- an immediate fall of the free market exchange clined to below 10 % of their pre-conflict level. rate to 400 Yemini Riyal per dollar. The situ- ation is further compounded by the absence Yemen’s foreign reserves flows depend of a formal access to the international finan- currently largely on a dwindling flow of re- cial markets, either because of the absence of mittances. The lack of exports, lack of foreign the Central Bank or because of the de-risking assistance flows of about $2 billion annually, problem which tends to work against small fi- left only remittances as the source for foreign nancial operators like those established in Ye- exchange earnings. Remittances maintained men. initially their level up to early 2015 but have since then declined, estimated to amount cur- The official import regime has ceased rently to not more than $1.4 billion.11 The un- to operate in 2016 in the absence of the certainty in general, and in the financial mar- Central Bank and the gradual decline of ket in particular, with the Central Bank system the foreign reserve level. Imports have currently being dysfunctional, led to the fall in contracted since 2014 by about 50%. Since transfers to Yemen. If not in cash, a large part September 2016, imports are not being af- of these remittances is estimated to come to fected anymore via official channels, or sup- the country through private money trader and ported by the Central Bank of Yemen (CBY), payment houses, adding to the financial re- due to the lack of appropriate institutional ar- silience of families but depriving the financial rangements and the institutional uncertainties created in the context of moving the CBY to 11 The assessed decline is related to the dwindling trust in the Yemen financial system; the dwindling capacity to ab- Aden. Supplies, including food, are deemed sorb in the absence of the Central Bank of Yemen services. 8 to be procured informally, and by traders with level of inflation could materialize as one allegiances to conflict parties, or through hu- way to allow the state to discount the real manitarian assistance. The inefficiencies of value of accumulated arrears, which adds such an outcome results in higher prices and to the uncertainties. rationing of goods and locations, yielding lim- ited choices over quality. The United Nations • The quantitative fiscal outturn does not launched therefore a humanitarian appeal in reveal easily the forced fiscal adjustment early 2017, with the objective to bridge the that the Central Government had to im- gap in food supplies. plement since 2015. While the GDP has shrunk by about 40 % since early 2015, The financial sector suffers from the eco- the fiscal resource envelope available, nomic decline and from the in-operation including deficit financing, shrunk to less of the Yemen Central Bank system.12 The than half in percent of Gross Domestic financial sector has lost effectively its lender Product (GDP), from 23.6 % in 2014 to 11 of last resort since the CBY HQ has been % of the GDP at the end of 2016 (see also moved to Aden. As a result, the payment sys- annex 5). As a result, institutions and ser- tem among banks has virtually been brought vices reduced their functions, range, and to a standstill. The economy is largely being depth progressively during this period, if deprived of its financial sector, rendering also they did not stop to function altogether. humanitarian assistance costlier to imple- ment.13 The legitimacy of any public expenditure program in 2015 and 2016 was based – Central state institutions are undergoing broadly - on the 2014 budget, the last one their deepest crises as public finances are approved by Parliament, which formally under severe stress: served as the reference for the 2015 and 2016 budgets, in accordance with the • The assessed fiscal deficit reached 14 budget law. The tensions between main- % of the GDP in 2016 and is projected to taining a framework resembling legality be much higher in 2017 without turning to and the demands of the day for payment peace soon. Until August 2016, fiscal re- and services under the condition of a con- sources available covered mainly public flict, when revenues were dwindling, were sector salaries and wages only (in 2014: increasingly resolved in favor of short 10 % of the GDP). Public finances, which term consideration and the imperatives are under severe stress, have been un- of the conflict, with a devastating impact able to maintain a large part of their func- on service delivery, credibility (arrears), tions since August 2016. Since then, sala- and effectiveness of the central govern- ries have not been paid anymore for most ment, undermining altogether the cred- civil service officials. In addition to rising ibility of an already deemed weak budget salary arrears, arrears to suppliers are and public financial management system. also building up. While non-hydrocarbon Since August 2016, public service sala- tax collection remained in 2015 broadly ries could only be paid partially, indicating at their pre-conflict level of about 10 % of the financial stress but also the incremen- GDP, they declined dramatically during tal fragmentation of the central state’s ca- 2016. Going forward, the risk of a higher pacity and waning legitimacy. 12 See also the separate Policy Note no. 3 on this topic. 13 See also note no. 3 on the Private Sector in Yemen, • The Central Bank of Yemen first helped including the financial sector. the economy to weather the difficult con- 9 text of Yemen’s fragile transition process post conflict phase depends currently largely since 2011 and continued to do so when on external sources.14 the conflict situation deepened in early 2015. It did so by managing relative ex- Infrastructure, institutional capacity and change rate stability for the Yemeni Riyal, delivery systems are impacted adversely in line with its longstanding conservative by the conflict and hinder effective hu- economic monetary policy paths. Yet, ex- manitarian assistance delivery. Servic- change rate stability could ultimately only ing the many suffering Yemenis quickly in a be maintained at the expense of running post-conflict situation will be ineffective with- down its foreign reserves. This policy out restoring the social and economic core came largely to an end in March 2016 systems, private (e.g., financial market; pay- with the foreign reserves had fallen below ment system, delivery chains, etc.) as well the level of one month of imports. The offi- as public ones (budget and public financial cial exchange rate was consequently ad- management systems). Yet, these have suf- justed to YR250 per dollar (from YR215), fered either physical (infrastructure), conflict with a market exchange rate running cur- induced political damages, or suffer from the rently at around YR330 to 360 per dol- general decline in institutional capacity (ad- lar, depending on the transaction (cash ministrative capacity, enforcement, etc.). The or non-cash, see above). Transactions restoration of this economic and institutional at the official rate have not been affected fabric as well as delivery systems is expected since September by the market exchange to take time. The destruction having so far oc- rate. curred will therefore have a legacy effect on the speed of future recovery. The financial counter-side of this conflict caused a massive build-up of public debt Poverty and misery is pervasive in today’s and arrears, domestically as well as ex- Yemen and a challenge for building a more ternally, and weakened the financial sec- inclusive society post-conflict. Initial esti- tor. Total public debt was relatively low prior mates of the poverty dynamics suggest an in- to 2015 but the rising fiscal deficit financed crease of about 14 %age points to 78 %, from through the CBY overdrafts has increased 48 % in 2014, of Yemenis living below the na- the domestic debt by almost 30 % to 65 % tional poverty line.15/16 It is estimated that ap- of GDP by end-2016. Statuary limitations of proximately 19.4 million Yemenis lack access local banks buying state debt are exhausted. to clean drinking water and sanitation, with Additional domestic debt has been created about 8 million facing acute shortages and by accumulating payment arrears at cur- 14.1 million cannot access adequate health rently unknown levels; non-payment of civil care. Children and adults are facing significant service salaries is just one source of arrears psychological stress; severe food insecurity accumulation. Going forward, the weakened affects 8.1 million people, and an estimated financial sector is not in position to be a sig- 3.3 million are acutely malnourished, of which nificant source for public domestic financing, 14 Yemen’s Precarious External Financing Situation: What Could Donors do? IMF, unpublished, May 23, 2016. constraining domestic financing options for 15 The poverty headcount is based on a national poverty the future government and for recovery. Yet, line of YER 10,913 per capita per month in 2014 prices. In not addressing the build-up of domestic pay- terms of 2011 purchasing power parity, the national poverty ment arrears will hinder the financial sector line is equivalent to about US$3.52 per person per day based on 2014 prices. and the remaining private sector to contribute 16 Poorer households appear to be more affected by inse- to recovery. Financing space during an initial curity than better off household – see the Household Budget Survey result of 2014. 10 2.1 million are children. An estimated 2 million out to the different regions, brokers the un- children are out of school because of fighting doubtedly diverse expectations, helps to iden- and insecurity. The total number of IDPs has tify a national purpose, and allows for a broad risen to over 3 million, while 2 million of IDPs and continuous dialogue within Yemen as well remained internally displaced for longer than as with its regional and international partners. 6 months. The prospects for women-headed households, which represent 52 % of the dis- 1. Recommendations for im- placed community, are particularly challeng- ing.17 These conflict related results pose seri- mediate actions post-con- ous risks to the future of human development flict in Yemen. Stabilizing the macro economy is a key to gaining the peace and realizing the peace Recovery, regaining growth, and employ- dividend. Peace cannot win, if the economy ment all require having confidence in the continues to struggle, particularly if the war eventual arrangements for peace. Whether economy prevails. Anchoring the economy rapid external and sizeable support as well as and providing a credible perspective for re- early restoration of livelihoods, infrastructure, covery and reconstruction will be extremely and the hydrocarbon economy can translate important. Balancing the macro economy, into generating a recovery growth shock, re- essentially the external and the domestic versing the economic decline since 2014 de- economic aggregates, would be a first step. pends on: (1) whether the expected eventual Stabilizing the macro economy would initially political agreement about ending this conflict – beyond policies – require restoring the es- and resuming the political transition in Yemen sential stocks of the macro economy, with a is shared by the major political stakeholders minimum stock of foreign reserves to allow in the country and, therefore, enjoys cred- for imports and recovery, including recovery ibility, and (2) whether the external resources of the private sector, and a minimum of fiscal possibly made available by Yemen’s partners resources to begin rebuilding public services can lead to reconstruction and investment in and respective institutions, and ultimately the Yemen, leading eventually to development. central state. It would also require to endow This second condition requires continuous the state, specifically the future new Yemeni participation of Yemen’s stakeholders, will- Government with initial resources, to allow ingness and demonstration of a reversal in for salary payments, servicing accumulated traditional approaches (see above), including arrears, and beginning with service delivery.18 governance, which in turn requires a decisive The latter will be particularly important to re- degree of transparency and communication store credibility among the Yemeni population. about plans, sequencing of action, and finally Restoring a minimum stock of foreign re- also early tangible results in recovery. Finan- serves is a priority for allowing the private cial assistance has been massively available sector to recover and initiate economic for Yemen in the past but the post conflict fi- recovery. The minimal stock of initially avail- nancial assistance will not deliver the expect- able foreign reserves which commensurate ed restoration (and repair of the break with with restoring macro stability should amount past cycles) unless a peace process can be to roughly 3 months of imports19, estimated set into motion in Yemen that aims to include 18 The modality for support could have many forms but the all Yemenis at their different levels, reaches external and initial support should focus on supporting and 17 IOM (International Organization for Migration). 2015. restoring the functioning of the national budget system. Task Force on Population Movement in Yemen: 6th Dash- 19 Three months of import coverage is considered a mini- board. mum level for countries to meet macroeconomic stability 11 at $4.5 billion under pre-conflict conditions.20 important to endow the Central Bank early on Restoring the reserves to this level would be with an adequate foreign reserves level for re- a first priority. The known reserves (January building confidence in this institution. Such an 2017) amount to less than one month of im- initial foreign reserve endowment could help ports21. It is further estimated (see below) that the CBY in the short-term to return to known the potential for hydrocarbon export receipts policies, including policies of the exchange would amount during the first 2 years to maxi- rate management, which would instill confi- mum 50 % of pre-conflict export receipts be- dence and positively influence its ability to at- cause it will take time to reach the pre-conflict tract currency flows from the economy. The production volume and export prices have estimated foreign reserve gap for the initial 6 since been cut by half.22 It is estimated that months would oscillate between $2 and $3 bil- such exports could result in around $3 bil- lion, taking also into account recovery import lion of hydrocarbon export receipts per year, needs. beginning with 2018 at the earliest, if peace Restoring the operations of the Central should become possible by mid-2017. It is Bank immediately is a sine qua non condi- likely that this post-conflict export potential will tions for economic recovery and regaining require at least 6 months to emerge, so it will macro stability. While the current discus- not be available in the short term (see also sion on the Central Bank of Yemen focuses the section 2.2.1, below, on the hydrocarbon much on its ability to service public salary sector recovery). Remittances – prior to 2015 payment, its actual financial function to serve running at about $3 billion a year - would ini- as a lender of last resort to the Yemeni finan- tially be the more significant source and more cial system, to balance the national private as reliable source for restoring the stock of for- much as public debt market, to facilitate in- eign reserves than the hydrocarbon sector. ternational trade, and to ensure the viability While remittances continue to flow to Yemen and credibility of the Yemeni financial system23 (via private channels), attracting these flows are not yet the subject of this discussion. The back to the Central Bank through rebuild- Yemeni bank’s balance sheets are currently ing confidence in this institution and its poli- frozen in time. The non-performing loan rate cies, would be the immediate task. If the CBY for banks is reaching alarming levels (see can attract post-conflict a third to half of the also the Policy Note no. 3 on the private sec- current remittance flows, it could amount to tor). The $2 to $3 billion for meeting the for- maximum $750 million. It is therefore highly eign reserve gap - argued for above as a first and quick assistance to stabilize the economy criteria. - would also help indirectly, in a first step, to 20 Which would be equivalent to about 10 percent of the conflict depressed GDP total by the end of 2016. revive the financial sector services as the im- 21 Actual statistics on reserves are not available. An as- port activity could be resurrected, a business sessment made by the end of 2016 suggests that reserves area, which traditionally has been important have fallen below a critical level. The then assessed level reflects, however, the economic dimension of the dividing to Yemeni banks. The availability of a critical conflict lines in Yemen, which translates in a lack of trust by 23 The Yemeni financial system suffers deeply from the economic agents toward such an institution and its ability to impact of what is called “de-risking”, which describes a trend attract reserves. A look at the balance sheet of the Central that banks and financial institutions located at larger finan- Bank only would underestimate the actual level of available cial and capital markets which are well supervised tend to reserves in the economy. “de-link” from small banks or small or marginal financial mar- 22 The complexity of restoring the hydrocarbon sector will kets for fear of taking risks to be exposed to money laun- not only be determined by restoring the physical infrastruc- dering transactions and possible terrorists financing. The ture and contracts, including contracts with national and for- counter side of this trend is that Yemeni banks are deprived eign operators. Accommodating and balancing the political of their correspondence banks in these larger financial economy of the sector, which also has a local and regional markets, and any transaction in foreign currency becomes dimension, will be time consuming and costly. costlier, if not feasible or accessible at all. 12 amount of foreign exchange would help the garding the external arrears, could be worked Central Bank to support policies, which re- out. However, if left unresolved, accumulated vive the economy while managing inflation- arrears will adversely tax recovery efforts. So, ary pressures through sterilization, a policy it would be critical to regularize the debt situa- stance pursued with some success in 2015 tion with Yemen’s external creditors.26 (and earlier). Certainly, more resources and Similar to the external debt status, con- policy measures will be required over time (af- taining domestic debt, addressing arrears ter 6 months, or earlier) to go this route and (e.g., suppliers, salaries) and possibly re- address more structural issues with regard to structuring domestic debt would be impor- the banking sector’s portfolio of assets (see tant to (1) build the foundation for macro- also the Policy Note no. 3 on the Private Sec- economic stability, (2) create fiscal space tor Recovery). It is unclear how quickly and for recovery expenditures, and (3) build broadly the economy would respond to such confidence for the economic management assistance. Judged by past experience (2012 of the central state (reinforcing the above to 2013) the impact could be significant24 in a mentioned recommendation). Domestic debt first instance. as a share of the GDP almost doubled within Resuming trade to its full potential and the two years (end 2014 to end 2016, from reviving the hydrocarbon sector requires 34 % of the GDP to 65 %. Much of this do- a regularization of the external debt situ- mestic debt is, either with the Central Bank ation to allow investors to have access to (overdraft to fund the fiscal needs), with un- currency flows. Accumulated arrears on ex- paid suppliers, or unpaid public civil servants. ternal debt obligations will be an obstacle to Almost half of the public expenditures in 2016 resuming normal trade activities, reviving the were for salaries, and a third has been for in- private sector in general, and for entering in terest rate payments. The expenditure and complex financial transactions for restoring debt path is not sustainable and would put re- the hydrocarbon sector, as creditors would in- covery into jeopardy, as it would also crowd sist on meeting their claims before new inves- out private credit needs (see also above- the tors could make a claim on external currency need to restructure the financial sector; or the flows. External debt obligations would need Policy Note no. 3 on the Private Sector Re- to be regularized, specifically external debt covery). The accumulated domestic arrears arrears and possibly debt falling due (going are estimated to amount to 3.5 to 4 % of the forward) would need to be rescheduled. The GDP (equivalent to about $1.3 billion) by the level of the total external debt outstanding end of 2016. The 2017 fiscal deficit is likely amounted to about 21 % of the GDP by the to be in the order of the one of 2016, roughly end of 2016, and accumulated arrears on ex- 13 % of the GDP, with a primary deficit of an ternal debt obligation amount to about 2 % of estimated 8 % of the GDP, broadly equal to GDP. Both the parameters, the total outstand- the level of domestic debt interest obligations, ing debt stock and the accumulated arrears respectively a third of total expenditures (see are still relatively low by international compari- also the macro-indicator table of annex 5). son and normally bearable for Yemen25, or re- Although the relative weight of the domestic 24 Roughly 1 % of the GDP in form of external support debt reflects the precarious fiscal situation ($1 billion) would buy 3 % of growth in a first round, if the caused – among others - by the on-going con- past serves as a guide. Whether the multiplier effect can be flict and the consequently depressed state of maintained depends on the credibility of the peace arrange- ments and whether the hydrocarbon sector can be revived debt situation would be bearable, as has been the case prior with speed (after 6 months of a peace agreement) which to 2015. would serve for stabilizing expectation for economic growth. 26 The Paris Club would normally serve as the indicated 25 Under normal economic circumstances, the external international institution to help to find a solution. 13 the economy, the sheer share of the domestic social fabric is likely to take some time as will debt service – a third of total expenditures (at peace building. Both dimensions (recovery the minimum) – is an indication that the central and peace building) are, however, mutually state, fiscally speaking, is reaching its finan- supportive. In this sense, economic recovery cial boundaries. Not addressing this problem is also a part of winning the peace. Yet, the would undermine peace building and feed into central state, its institutions, and the emerging drivers of conflict, and most certainly heighten future Yemeni government will find it difficult the risk of inflation. Addressing this problem to meet expectations about restoring public is not only a question of resources, or a one- services, exert an inclusive policy coverage, time pay-off of the debt (unpaid contracts, integrating all regions, and regaining credibil- salaries etc.), but also addressing the lacking ity. The actual task appears to be daunting. fiscal legitimacy of the state, which is hinder- Nonetheless, early stabilization efforts need ing raising the required fiscal resources in the to show at the minimum the ability to (1) stop short term. Injecting fiscal resources, short- economic deterioration, (2) create an environ- term, joined by measures in support of fiscal ment for recovery, which combines security legitimacy would inject some initial confidence with taking visible steps toward restoring the in favor of peace building and institutional ca- Yemeni productive, trade, and financial sys- pacity, and thereby facilitate medium term re- tem, and (3) show how citizens across Yemen covery. All these parameters together would benefit from peace and recovery. While the help to turn around this adverse debt path. above and before-mentioned recommenda- In this regard, priority would be given in the tions for the immediate post-conflict period immediate term to cover first back payments would initiate economic recovery benefiting, (contracts, salaries), because of their (1) eco- at different pace, citizens, enterprises, and nomic (multiplier) effect, and (2) because of institutions, the many more impoverished Ye- the reassertion of the state’s authority. Sec- menis, estimated now to have doubled to a ond, arrears clearance with the private sector level of 78 % of the population as compared needs to be tackled in parallel (see also page to 200527, would also need to receive support 32 on modes for addressing arrears). Such and relief aids. While humanitarian assistance step would obviously help the liquidity of the will continue to be necessary after a peace private sector, but would also positively feed- agreement and will have to be augmented to back on the financial sector; this would send a cover areas difficult to access, it will be critical signal for recovery. Third, an inflation neutral that social safety net support to the most vul- foreign refinancing of domestic interest rates nerable Yemeni is resumed.28 Therefore, the payments at least for 6 initial months (about 4 Social Welfare Fund (SWF) and other institu- % of the GDP), would impact positively early tions29 supporting the livelihoods of many Ye- macroeconomic stabilization, and help the 27 The year of the last household budget survey preceding banking sector in two ways: (1) gaining much the one of 2014, which is not the most recent available. needed liquidity, and (2) easing the shortage 28 For an overview of social protection institutions and of foreign exchange, which would support im- policies in Yemen, please see the Joint Social Economic ports. Both are fundamental features for Ye- Assessment (JSEA) for the Republic of Yemen, 2012, and the forthcoming Poverty Assessment on Yemen: Free Fall- men’s economic recovery, as well as for the ing – Living Standards during Times of Conflict in Yemen recovery of Yemen’s financial sector (see also (chapter 4). the Policy Note no. 3 on Private Sector Re- 29 The Social Welfare Fund has suffered institutionally since end 2015. Its targeting system has been improving but covery). could not yet meet all expectations prior to 2015. However, Setting the steps toward inclusive recov- given its central role in reaching out to the most vulnerable ery. Recovery of the Yemen economy and Yemenis, partners have been working with the SWF and other stakeholders since late 2016 to design, update and 14 menis should also be a priority for early eco- be a strong signal of support, and would help nomic and social stabilization. Cash grants for to rebalance economic incentives from con- the poor could usefully be combined with nu- flict toward peace, to provide perspectives for trition/food vouchers for children’s education citizens, and to facilitate initial trust building to create more socially desirable incentives or across diverse segments of Yemeni institu- demand for restoring education services and tions and society. combat malnutrition among children (see also Policy Note no. 4). A full year of SWF fund- 2. Priorities to be tackled to ing is estimated at about $40 million, without counting for newly qualifying households and win the peace momentum additional vouchers. External funding of such - the medium term (6-24 support would equally help the Central Bank months) to restore its stocks in foreign reserves and thereby restoring the import capacity. Massive external financial assistance is Over the medium-term, making progress on required for the first 6 months to support the country’s overarching reconstruction and peace building (see above). Aside from the development objectives cannot be achieved willingness among Yemeni political leadership without ensuring a stable macroeconomic and to build peace and design policies support- fiscal path and using the country’s resources ing the above-mentioned stabilization efforts, in a sustainable and inclusive way. Rebuilding massive external financial assistance is re- the country’s institutional foundation, funding quired for the first 6 months, at the minimum, as well as providing for public services that in support of restoring the social and econom- help to give rise to a more inclusive society, ic national systems. Given the inter-linkages and help the private sector to restart and/or between peace building, service delivery, in- expand private-sector activities would require stitutional capacity, employment, and recov- work on rebuilding the domestically available ery in general, including for the private sec- fiscal resources. The focus on domestic fis- tor, the payment or regularization of arrears cal resources and the management is thus a and bringing the level of external reserves to 3 necessity but not a sufficient criterion for Ye- months of imports30 would be the first priority. men’s economic transformation and the initia- In addition, initial fiscal support is required to tion of an ultimately virtuous cycle of develop- compensate for lacking fiscal revenues, esti- ment. mated to be scarce for at least 6 months after peace agreement (see also the section on re- 2.1 Establishing the public revenue covery of oil revenues below). To accelerate base with a view toward a revised recovery and make up for the initial lack of social contract fiscal resources, external funding, provided in phases (installments) and against transparent Yemen needs to restore its fiscal revenue agreements (see also Policy Note Paper no. base from day one. Yemen’s reconstruc- 5 on Aid Coordination), of up to an estimated tion, stabilization, and development path from $5 billion dollars31, would be critical in a first the immediate over the medium to the longer phase. Such a level of external support would term hinges critically on the ability of its fu- ture government to raise domestic revenues improve the targeting system, using also the most recent to fund its public expenditure program. Ex- data on conflict impact and displacement. ternal resource availability has an important 30 Three-month coverage of imports is considered a mini- mum level for countries. role to play for early stabilization, restoring 31 Judged by today’s given knowledge – February 2017. of livelihood as well as the social and insti- 15 tutional fabric. However, sustainable recovery than the tax rate. Raising tax revenues is requires generating own resources. External not so much a question of raising tax rates aid offers, if well designed, at best acceler- – especially for a country like Yemen that is ate the county’s recovery investment and its coming out of conflict - but it is a question of eventual development program. Yet, sustain- designing a tax system that minimizes distor- ability of the country’s ability to generate inclu- tions to economic activity, contributes to re- sive recovery and growth with the help of such ducing income disparities and incorporates investments depends ultimately on whether an element of sharing or social solidarity. As Yemen can restore its own systems, its insti- such, building a domestic revenue base and tutional fabric, and whether it will be able to the underlying tax system is part of the com- claim and steer ownership. A key prerequisite ponents that strengthen mutual accountability for such an objective will be a critical level of between citizens and the state.34 own funding.32 Attaining a tax to GDP ratio of 15 % (ex- Raising fiscal revenues and reshaping the cluding the hydrocarbon rents) for Yemen social contract in Yemen are mutually in- over the medium term is deemed critical, terdependent. The ability to raise resources judged by international experience. Prior to is not only critical for financing public expen- the conflict, the non-hydrocarbon tax-to-GDP ditures but also a legitimacy test of the even- ratio has been around 8 to 10 %. A tax-to- tual post conflict peace arrangements; and GDP ratio of 15 % is judged to be a threshold the transitional governance arrangements, below which it has proven difficult to provide based on which public institutions, central or the state with both the resources and legitima- local, are to be restored to deliver the services cy to build functioning public institutions (and in need. Delivery of such services will consti- crowd in private-sector activities), and deliv- tute a central element and test for the future er the services required to sustain the social (transitional) government’s ability to reshape contract between citizens and the state.35 The the social contract between citizens and the aim should be to achieve such a level with- state.33 out the benefits from the hydrocarbon sector, which in the future is projected to achieve a The tax system design is more important maximum revenue level of 6 % of the GDP at the currently prevailing price level and at the 32 See also the Addis Ababa Action Agenda and, specifi- cally, the Addis Tax Initiative (ATI). Domestic public resourc- pre-2015 production level. es are a more stable and sustainable source of income, they also strengthen a legitimate relationship between citizens and the state and foster good governance” (Addis Tax 34 Research by academics and international organiza- Initiative Declaration, https://www.addistaxinitiative.net/docu- tions has focused on mechanisms between (effective and ments/Addis-Tax-Initiative_Declaration_EN.pdf). The July non-discriminatory) taxation and efficient, accountable, 2015 ATI is the foundation of the evolving global tax agenda responsive, and inclusive governments. The OECD (2008) aimed at strengthening countries’ abilities to collect budget- argued that, historically, the formation of accountable and ary resources in a manner that is consistent with overarch- effective states has been closely related with the emergence ing objectives of fostering socio-economic development of taxation systems, whether in Europe, North America, and improving the business climate. At this point, the ATI— Eastern Asia or among the pioneers of good governance in through which the doubling of international and multilateral Latin America and Africa (such as Costa Rica and Mauri- support for technical cooperation is foreseen over the next tius): “The concept of a ‘fiscal social contract’ is central to few years—seeks to support governments’ corresponding the explanations of how representative government and de- efforts with diagnostic work, global expertise, and the active mocracy emerged in Western Europe and the United States. connection to the global tax debate. This development focus Citizens accepted obligations to pay tax in return for rights represents an important anchor to efforts aimed at reaching to be represented in the process of decision-making about relevant Sustainable Development Goals. how public money was raised and spent” (OECD 2008:7). 33 World Bank, IDA 18, Special Theme: Governance and 35 Governance and Institutions, World Bank, IDA Resource Institutions, IDA, Washington D.C., (2016), unpublished. Mobilization Department May, 2016, unpublished. 16 Trade and consumption taxes have an im- private sector; and (3) allow for proper portant role in the short term to restore infrastructure and training that permits fiscal revenues. Yemen’s tax regime is rel- the gradual transition of responsibilities atively simple (see annex 1) and does not a back to Yemeni authorities. The experi- priori represent an obstacle to efforts aimed ence could serve as a base for further at strengthening revenue collection. How- reforms after an initial phase of resto- ever, a post-conflict situation requires some ration. initial short term “emergency responses” to finance and support reconstruction efforts. In a number of (post-conflict) coun- In this context, it is critically important to (1) tries, contracting out parts of the cus- sequence the re-establishment of the tax and tom management task has proven customs administration appropriately; and (2) cost-effective and provided for a major minimize administrative complexities so as to advance in raising revenues. Through permit the government to re-assume its core a transparent scheme and accountabil- functions without asphyxiating first signs of ity obligations, such tools added to the private-sector recovery. The following taxes country’s overarching reform agenda, should receive attention on a priority basis: and the re-establishment of essential trust between the private sector and • Trade taxes. Yemen’s import reliance the government. will increase, not least in the context of national reconstruction efforts. There • Consumption taxes. The second pol- are limited points of entry (harbors, icy priorities would cover indirect taxes, airports, and main border crossings) both for reasons of tax policy (Yemen’s through which the majority of imported general sales tax has particularly low commodities enter the country. For rates) and tax administration. In light of these reasons, Yemen would be able the need to make important institution- to ensure a relatively sizeable and reli- al investments in tax administration, able stream of revenues, which admin- Yemen might want to take advantage istratively are manageable. Tax and of the situation and consider replacing revenue raising efforts should there- its general sales tax (GST) with a mod- fore begin with the customs and the ern value-added tax (VAT),36 possibly trade flows. paired with select excise taxes for com- modities currently taxed at rates (con- The country could take advantage of siderably) above the general rate of 5 using time-bound management con- %. In most countries, including those in tracts with specialized private compa- a post-conflict situation, a modern, ad- nies for the design and implementa- ministratively not excessively complex tion of most urgently needed physical VAT has proven effective in providing and ICT investments, while ensuring the authorities with a stable revenue that customs duties fall on all traders base, while avoiding growth-inhibiting in a uniform and non-discriminatory distortions and negative effects on manner. The objectives would be to 36 More than three-quarters of countries worldwide have (1) provide government with a secure currently adopted a VAT, generally with good success. In May 2015, Ministers of Finance of member countries of the revenue stream; (2) improve gover- Gulf Cooperation Council (GCC) agreed, in principle, on the nance (reduce smuggling) and, in so introduction of a VAT in its member countries Related tax doing, establish credibility vis-à-vis the policy reform priorities which will be actively supported by international development partners; see, e.g., IMF (2015). 17 foreign direct investments (FDI) and differentiation in the application of the external trade. The case for replacing corporate income tax by sectors (apart Yemen’s GST—described by very low from extractive industries) adds unnec- standard rate (5 %), high thresholds, essary administrative complexity and and a narrow base—is even stronger should be reconsidered. in light of substantial compliance chal- lenges.37 This tax, in particular, could Using tax reform as a driver for re- allow for some increases, especially if shaping the social contract and revenues were to be shared, eventu- accelerating development (see an- ally, between the central and regional nex 2). Yemen has already devel- governments. oped important pillars for driving tax reform as an outcome of the National GCC countries have recently em- Dialogue Conference. If reconfirmed barked on VAT reform or introduction of in a post-conflict reconciliation agree- VAT system in response to lower rev- ment, Yemen has major elements in enues derived from hydrocarbon ex- place to commence a tax reform agen- ports. There exists a variety of VAT im- da, not least a draft constitution, with plementation approaches in the GCC very specific stipulations for initiating member countries, learning from which the process of administrative and fis- would be at Yemen’s benefit. cal decentralization38. In this process, it is imperative that explicit rules are • Income taxes. Contrary to neigh- defined, by law or in the constitution, boring GCC member countries, Ye- to accompany and guide the process men has levied a personal income toward decentralization. The sequenc- tax, differentiating residents from ing of assigned fiscal responsibilities non-residents. Even if effective as an as well as the distribution thereof on instrument of (implicit) tax progressiv- the expenditure and revenue sides ity, the inherent cost/benefit balance as well as the mechanisms or formu- of related administrative enforcement las for “shared resources”, like the hy- requirements by the revenue authori- drocarbon revenues. If done properly, ties—especially related to the resourc- governments on different levels of ju- es and capacities required to assess risdictions are equipped to deliver pub- residents’ global income—is unlikely lic goods more directly and effectively, to warrant this complexity. In the first earn legitimacy and credibility, and, in phase of Yemen’s post-conflict recon- so doing, contribute to the gradual in- struction, the authorities might want to crease in tax compliance. A successful consider to (i) restrict the tax base to tax reform would aim at (i) increasing domestic income; and (ii) apply a uni- collection efficiency; (ii) facilitating, ac- form tax rate. For similar reasons, the celerating, and professionalizing the private sector’s required interaction 37 Such a reform would be considerably more far-reaching with tax authorities; and (iii) establish- and ambitious than the measures agreed between the Gov- ernment of the Republic of Yemen and the IMF in 2014. In paragraph 25 of the Memorandum of Economic and Finan- 38 Fiscal decentralization constitutes a more structural and cial Policies (MEFP), dated July 1, 2014, Yemen announced longer term reform program when it comes to implementa- its intention of increasing the GST rate “from 5 percent to 10 tion. Given the topic’s significance at the onset of the current percent” and unifying 90 percent all tobacco products, while conflict in Yemen, and given the limited capacity in Yemen expanding the GST coverage “to include all imported used as well its fragmented politics post-conflict, fiscal devolution vehicles and spare parts” (IMF, 2014). would be a first step toward forms of decentralization. 18 ing taxes gradually as a “fair” price for been in the past to fund the government and socio-economic development. imports. Recovery of the hydrocarbon sector constitutes therefore a central imperative for 2.2 Stabilization and peace economic recovery and sustainable economic building requires restoring the stabilization in Yemen. non-hydrocarbon sector The hydrocarbon production capacity The pace of the recovery of fiscal re- has been affected by the conflict on the ceipts and export earnings over the me- level of infrastructure, investment, and dium term (after 6-12 months) depends on sector logistics. The ongoing conflict has the speed and depth the oil and gas sector led to numerous destructions of the hydro- can be restored to. Although crude oil pro- carbon sector infrastructure, resulting either duction has been on a gradual declining path directly from the destruction of production or since 2000, oil production reached an aver- transmission infrastructure, such as pipeline age of 175,000 and 156,000 barrels per day connecting Marib’s oil fields to the export ter- in 2013 and 2014, respectively. Gas produc- minal at the Red Sea and the refinery facilities tion which came on stream in 2009, reached Table 1: Oil and Gas Future Price Forecasts   2014 2015 2016 2017 2018 2019 2020 Net Oil Output (million b/y) 57 22 0 30 66 67 68 Net LNG Output (million 61 24 0 0 61 61 61 b/y)* WEO future $/bbl 96 51 43 55 56 56 56 Yemen price $/bbl (WEO 95 49 41 53 54 54 54 - $3) Yemen LNG $/MT (Con- 513 650 431 503 499 497 496 tract Price) Memo: Qatar LNG Price $/MT 493 498 509 530 554 578 585 Henry Hub Price $ per metric 436 291 193 226 224 223 223 ton WEO LNG Index 160 107 71 83 82 82 82 * In barrels of oil equivalent. Source: IMF and staff calculations - January 2017. in Aden, or indirectly by the halted production an equivalent of around 190,000 and 167,000 and the exodus of foreign and private opera- barrels of oil per day in 2013 and 2014, respec- tors, including the service companies, as well tively. Pre-conflict, the hydrocarbon industry as interruption of maintenance. The current in Yemen generated 50-60 % of the fiscal rev- production is limited to an estimated 10 % enues and up to 85 % of export revenues, and of capacity relying on production from Block nearly 50% of foreign reserves. The sector’s 18 in Marib, whose crude oil is mainly trans- share of GDP amounted to 8-9%, and its im- formed into (bottled) cooking gas for domes- portance for direct employment is negligible. tic sale. The operations are run by the state The hydrocarbon sector economic role has 19 owned Safer Company39, running currently at ly been explored.40 a level of about $200 million in turnover. 2.2.1 Outlook for Yemen’s Hydro- How quickly the past production revenue carbon Production Recovery capacity can be restored depends on (1) the speed of investor re-engagement (2) Oil sector recovery better utilization of given investments, and Initial post-conflict restoration of produc- (3) the future investment conditions avail- tion needs to rely on state-owned oil pro- able to the sector, ultimately aided by a duction blocks. As of 2014, the state oper- conflict resolution agreement. Although oil ated two of the 12 active blocks, represented production has been on a declining path since around 42 % of the country’s total output for early in the last decade, oil revenues were en- 2014 (Block 18 by Safer, Block 14 by Petro- hanced, over-compensating the loss in pro- Masila). However, following the Production duction through the high international aver- Sharing Agreement (PSA) expiry in 2015 of age price level for hydrocarbon products from TOTAL’s Block 10 in Hadramout and conse- 2010 up to mid-2014. The future prices are quent handover by TOTAL to the state-owned assumed to rally around $50 a barrel, about company PetroMasila the share of state half of past prices. Achieving the pre-2014 owned companies in national production in- hydrocarbon rent level for Yemen’s fiscal and creased to potentially around 65 % of current- external balance going forward, would require ly total possible production (156,000 barrels a a substantial increase in the annual produc- day in 2014). tion. The decline in production - as has been observed since 2002- could be reversed, if The government share in revenues de- the investment climate in the sector would rived from oil production will be lower go- allow for a more sustainable prospection, ex- ing forward compared to prior to the con- ploration, and production path. Also, only 12 flict. The share of the Yemen Government in blocks are currently active whereas another oil output averaged at around 60 % during the 86 onshore and 29 offshore blocks have bare- 2000-2014 period. The ratio of the govern- Table 2: Yemen: Estimated Yemen’s output share in oil production, 2017 and 2018 (in 1000 barrels) Block Operated by 2017 2018 2019 National Operators   Marib 18 SAFER 1,826 2,233 2,177 MASILA 14 PetroMasilah 2,948 5,225 4,256 )E. SHABWA (Block 10 )PetroMasilah (formerly TOTAL 3,753 8,278 9,435 Total 8,527 15,735 15,868 Foreign Operators    JANNAH 5 Jannah-Hunt 4,279 9,535 10,798 )Ulquah (Block S-2 OMV 1,368 5,031 2,868 Total 5,647 14,566 13,666 Grand Total 14,174 30,301 29,534 Source: Staff calculations - January 2017. 39 Safer Company is a state-owned company operating block 18 in the Marib governorate. 40 Yemen Ministry of Oils and Minerals. 20 ment’s share in oil output improved up to 2011 structure could be restored/maintained, the but has been declining since then, taking into country’s post-conflict oil production (2017- account the difficult operating environment 19) could be gradually restored to around 130 since 2011, which led to increasing operation thousand barrel per day during 2017/18 com- costs and in turn, are part of costs recovery pared to the pre conflict level of 156 and 59 arrangements between the operating com- thousand barrel per day in 2014 and 2015, re- panies, including the state owned ones, and spectively. The restoration scenario is based the government. Between 2000-2014, cost re- on (1) the full engagement of state owned covery averaged 17.6 % of the net output. In national operators (Blocks 18, 10, 14), which post-conflict phase, this share is to increase would secure 65 % of the estimated daily pro- because of compensation needs, damage re- duction, (2) status-quo of the oil infrastructure pairs, backlog in maintenance, and a continu- as known at end 2016 remains valid (no fur- ous high cost operating environment due to ther damage or deterioration), and (3) a quick continuous presumed conditions of insecurity. return of the large foreign operators and resto- Therefore, the net earnings for the state from ration of their production capacity. The state’s the post conflict oil production will decrease export revenues from the so restored output relatively to the pre-conflict situation for the could exceed $1 billion in 2017.41 initial years. Eventually, if conditions improve, • Full recovery of oil production: especially the overall investment conditions, the full recovery is dependent on the the ratio could improve again in favor of the speed of foreign operators returning, government share. representing around 35 % of the to- tal production. If production of the two Oil production by the nine privately operat- state companies and of all foreign op- ed blocks, could take more time to restore. erators can be fully restored in the 2nd Nine out of the country’s 13 oil production half of 2017, the estimated total oil out- sites are operated by foreign and private com- put in this scenario would be around panies, only 2 sites (Block 5 – Jannah hunt 30 million barrels in 2017, and 65 mil- & Block S2 – OMV) yield larger production lion barrels in 2018, resulting in a net potential, and thus would pose greater eco- share for the state of about 17 million in nomic incentives for a quick restoration. The 2017 and 37.5 million barrels in 2018, others are small blocks and were operated by which generate nearly $0.9 billion of small and medium sized private companies. revenues for the state in 2017 and $2 Most are not expected to return and resume billion in 2018, based on the current oil operations in the first year of post-conflict due price forecast. to weak economic incentives (i.e. low global • Partial Recovery of oil production: oil prices vs. security), revoked/expired con- 2 state companies and the 2 largest tracts that require renegotiations, damaged foreign operators resume opera- infrastructure, etc. On the other hand, the suc- tions (no return of most foreign oil cess of national or large operators in restor- operators). Given the vested interest ing the sector and its operating logistics would and potential commercial viability con- provide significant incentives (synergy effect) cerning the 5 largest production blocks for smaller operators to restore production of (18, 10, 14, 5 and S2) in Yemen, it is smaller sites. likely that the 2 largest private inves- Restoring oil production: three scenarios tors (Jannah Hunt & OMV) join the two for the post-conflict (2017-2018). If a peace settlement is reached, and the pipeline infra- 41 Based on the estimated state output share for 2017 times the future oil price for 2017. 21 state companies in restoring produc- sible reserves or on the likely cost of tion. In this scenario, the state’s output development. Indications are that size- share could reach 14 million barrels in able gas reserves might still exist in the 2017 and 30 million barrels in 2018. east of the country. However, proactive This would imply state net revenues of measures to encourage discovery and $0.7 billion in 2017, and $1.6 billion in development may be needed. 2018. Gas production and export infrastructure • Slow Recovery of oil production are managed jointly by the state and the (no return of foreign operators): If private sector. The country’s gas upstream/ production capacity by foreign opera- production is managed by the state-owned tors could not be restored in the initial company SAFER, which extracts the gas from post-conflict period (2017-2018), the its Block 18 in Marib. Safer delivers the gas expected output for the state by its two to the Yemen Liquefied Natural Gas Com- operators (block 10, 18, 14) would be pany (YLNG), which is a private consortium around 25 million barrel for period total, with 21.7 % state ownership42. TOTAL com- which would imply around $1 billion of pany operates YLNG. Although gas export state revenues. infrastructure is managed by YLNG, SAFER Gas production recovery is managing the transport of gas via a pipe- Yemen’s gas sector has played a line from Block 18 to YLNG’s liquidation built- vital economic role since it came facility (at a capacity 6.7 MBTU per year) and on stream in 2009. The Republic of export terminals at the port of Balhaf in Shab- Yemen has 430 billion cubic meters wah governorate. of proven gas reserves, mainly in the Marib basin. Two-thirds of these re- The state’s revenues derived from the gas serves (288 billion cubic meters) were sector has 2 components and are roughly allocated in 2007 to the Yemen Lique- equal to 25% of the gas export revenues. fied Natural Gas Consortium (YLNG) The government revenues from the LNG proj- under an agreement, by which 90 % ect are derived from two main sources: (i) di- of this amount would be exported and rect taxes, bounces and royalty, and (ii) indi- the remaining 10 % would be used for rectly, from the profit sharing agreement of the power generation and household con- consortium signed with the two state owned sumption in Yemen. The remaining enterprises, the Yemen Gas Company (YGC), one-third of the reserves (142 billion and the General Authority for Social Security cubic meters) has not yet been certi- Pensions (GASSP), both of which are share- fied. Of this remaining volume, around holders of YLNG (about 25% in total). The 40 % is so called near-term gas that gas off-take price was renegotiated in 2013 could be mobilized. So far, gas pro- in favor of augmenting the net revenues flow duction has been limited to Marib’s to the state. As a result, the state’s net share block 18, but a large part of the coun- from LNG exports in 2014 almost doubled to try has not yet been explored because around $0.7 billion, from $353 million in the of a lack of resources, leading to the previous years. uncertain political outlook and invest- ment conditions, which hinders inves- 42 Yemen LNG Co. which is a private consortium featur- ing Total, Canadian Nexon, Kogas, Hyundai as the private tor’s interest. Data are not available on shareholders in addition to the state, which owns 21.7 % of the potential size of probable and pos- the company through the Yemen Gas Corporation and the General Authority for Social Security Pensions. 22 of operators are likely to play a role, and will Conditions determining recovery of gas dampen the outlook for revenues from the gas production in Yemen are less dependent on sector for the first 12 to 18 months. physical infrastructure factors but more on legal or contractual considerations. While Two tentative scenarios for illustrating the restoring infrastructure for the gas export sec- possible recovery path of gas sector. It is tor would not pose a significant constraint43, assumed to be unlikely that the legal and con- the biggest challenge facing the sector recov- tractual issues of the sector allow for a quick ery would be the restoration of the revoked resumption of production, although the tech- long-term sale contracts for Yemen LNG ex- nical readiness would be relatively easy to port. As the conflict escalated early 2015, Ye- restore. As a result, gas production would re- men LNG Company announced on April 7th, sume only at the end of 2018, if peace should 2015, its decision to halt all production and emerge in mid-2017: export operations, and evacuate the site per- sonnel. In addition, TOTAL, which operated Yemen LNG, has declared force majeure44 in • Restoring full LNG export capacity relation to its various stakeholders and con- from 2018: assuming that full “contrac- tracts in Yemen. Until now, it is not clear how tual” export capacity of 6.7 million BTU the halted operations and the contractual sta- tons a year could be restored, and the tus of having declared force majeure would contract related compensation claims impact the contractual legal agreements with due to conflict related losses and dam- the company’s three principal (gas) buyers, ages are settled rather quickly, and and the feasibility for reinstating of these assuming, too, that the export price three long term sale contracts. There is also setting mechanism as renegotiated in a shift in the international gas market condi- 2012-2013 can be applied, the expect- tions through shale gas production and tradi- ed resumption of LNG export could tional producers planning to reenter the inter- generate around $3 to $3.3 billion in national gas market.45 As a result, Yemen, as annual export revenues for the first a small producer46, is likely to have a reduced post-conflict year (2018) and thereaf- relative competitive position for future re-en- ter. Consequently, the estimated total gagement scenarios, if the prospect for build- net share for the central government ing more scale cannot be established. How from of LNG export could reach around these factors of relative size, complex invest- $1.07 billion for the first year (2018) ment environment, legal legacy, and rise of with an increase to $1.1 billion in the other investment opportunities (supplies) can second year in 2019. be balanced with Yemen’s gas sector restora- tion needs is difficult to assess. Yet, financial • Restoring at 75 % export capacity in incentives to overcome compensation claims the first post-conflict year in 2018: In this scenario, full maintenance of the 43 As per a mid-2016 assessment which concludes that transmission pipeline to the YLNG liq- little infrastructure damage has been documented/reported uidation facilities in Belhaf, could not for the LNG facilities and gas transmission pipeline from Marib to Bahaf. be achieved by the end of 2017. Oth- 44 Force majeure is a legal clause meaning circumstances er technical reconstruction work and which make it impossible to meet contractual obligations. repairs took also more time as in the 45 Iran, a very large potential producer, announced to ex- first scenario, so that production and pand heavily its gas production over the next years. 46 Yemen’s share in global gas production amounted in exports set only in after the first quar- 2014 to 2.2 %. 23 ter of 2018. The total gas export rev- Yemen issued during the fourth bidding round enues could then equal around $2.5 in mid 2000s, which contained provisions that billion in 2018 and $3.3 billion for 2019. define gas sales and provide PSA holders the Consequently, the total for the central right to negotiate the development of non- government net share of LNG export associated gas fields. Using gas resources would then be around $0.8 billion for would require (i) renegotiating PSAs pre-dat- 2018, and increasing to USD 1.1 billion ing the 4th generation PSAs, or (ii) waiting until in 2019. they lapse. However, the calculations of compensation The sectors incentives and governance for economic losses and actual repair costs provisions would need to be rebalanced did not enter in the above made revenue pro- to provide a premium for the long term in- jection. It is very likely that a substantial share vestment view. Although the new generation of the estimated revenue amount will not be of PSA contracts (4th generation) allow for prof- available to the government during the first it-sharing in the development of gas, so far two years after conflict as sector operators little success has been achieved to attract in- will claim compensation from the government vestment into the sector. The pre-2015 record to resume services; and the government will has been poor with regard to this type of ex- have to finance the restoration and compen- ploration activity. Perceived weak government sation claims. The presumed large claims by capacity to commit to attractive terms, and companies will also determine their strategic deep insecurity in Yemen with related uncer- approach toward restoring the legal frame- tainty about investments, have left the current work for their operations. In short, it will be 4th generation of PSA ineffective, judged by difficult to settle sector restoration issues and market observers. Furthermore, the govern- considerations in isolation. ment’s decision to take over the Masila and Marib concessions, in 2011 and 2005, respec- 2.0.2. Yemen’s key policy and in- tively, have led investors to question the value stitutional challenges for the hydro- of investing in Yemen. Oil firms also pointed carbon sector to a lack of assurances that future govern- ments will not try to renegotiate deals (as the Yemen’s Production-Sharing Agreements government has done with the off take agree- (PSAs) are mostly outdated and require ments negotiated in 2005 for its LNG project) renegotiations to incentivize for a more ef- and push for even less attractive or simply ficient hydrocarbon resource exploitation. altered terms. As a result, investors are risk Gas has not been exploited for production adverse and prefer the short-term view, favor- in the country’s active blocks (except in the ing a quick recovery of investment. It would be state-owned block 18) because of the lack of important for a more efficient, economic, and contractual provisions in the Oil Production- more sustainable use of Yemen hydrocarbon Sharing Agreements (PSAs) permitting gas resources to change the investor’s incentive sales. So far, Yemen has issued four genera- structure, and create an investment climate, tions of PSAs three of which did not include which favors the longer term view, which pro- provisions regarding associated gas sale Ministry of Oil. Under the new deals, a joint management whereas the deficiency was partly remedied committee would oversee exploration and, if a discovery in the newest PSAs (4th generation)47, which were to be made, it would negotiate the terms of a joint venture company to manage the asset, for which the state 47 The updated PSA continued to set 20-year production would hold a 50 % stake. With the addition of the carried schedules with an option to extend production by 5 years share, the government would, in effect, have a 55–60 % while carrying an interest rate of 5–10 % granted to the share in the asset. 24 vides for a more secure “give & take”, influ- consumption uses such as being alternative enced and supported by the overall gover- source for car fueling or to generate electric- nance of the sector. ity when regular fuel supplies in 2015 became very scarce and expensive. Non-competitive Establishing performance based instru- arrangements help also to maintain implicit ments for operators, especially also for subsidies for the used gas cylinders. the large state owned operators, Safer and PetroMasila, would help to improve Establishing a stronger link between hy- the efficiency and investment path of drocarbon revenues and development these companies.48 Competing institutional expenditures. The opaqueness of the insti- arrangements have prevented the creation tutional set-up of the hydrocarbon sector in of performance-based incentives support- Yemen and the capture of its operation by ing investment, i.e. by allowing public opera- way of the universe of state owned compa- tors to own/access a share of their revenue nies would need to be addressed if the no- or to commercialize part of the hydrocarbon tion of sharing the natural resources with all output, favoring also short term financial prof- Yemeni should be meaningful. A start could its and output gains over medium or longer be made by setting up a council composed term financial viability and production capac- of the Ministries of Oil and Minerals, Finance, ity. In addition, capital expenditure cuts for the and International Cooperation and Planning, state-run oil operators ordered in the recent as well as Yemen’s Central Bank. This council past by the Ministry of Finance further distort- would then be tasked to report to the Yemeni ed the incentives of state owned operators to public the state of the production, sales and improve revenues performance and efficiency prices obtained, as well as revenues collected of their operations, favoring instead short term from operation. It would build on the Extrac- profit considerations. Creating more publicity tive Industry Transparency Initiative (EITI) to or public debate on such choices and their which Yemen had subscribed to in 2011. trade-offs would help to change these ad- verse policies. Setting up a fundamentally re- vamped governance for the sector Enhancing the governance and competive- over the medium term is unavoidable ness of the domestic gas distribution mar- for creating scale investment oppor- ket in Liquefied Petroleum Gas (LPG/cook- tunity, and enhancing transparency. ing gas) would cut rents and help meeting A review of the sector’s organizational demand with fewer subsidies. As of now, set-up is recommended, which would there is no clear governance framework to help to re-define the delineation of the regulate the private sector role in the distribu- sector’s political oversight and opera- tion and completion in the upstream or down- tions across an array of existing in- stream stages. Since 2015, the LPG sector stitutions, entities, and state owned has seen considerable expansion activities companies. Considerations should be and rising interests from local private sector given to inviting public entities (e.g., when domestic demand for LPG sales began Ministries) into the collective oversight to increase substantially, due to additional responsibilities in order to broaden the demand for transparency and align in- 48 Since 2010, reportedly, Safer did not receive capital terests in favor of transparency. The budget from the Ministry of Finance to fund its operations, which were kept alive, thanks to the gas production pay- future organizational and governance ments made “directly” to Safer by the Yemen Liquefied set-up would have to serve the sus- Natural Gas consortium. 25 tainable development of the sector, then oscillated around 4-5% of GDP, half of it to provide for more investor reassur- foreign financed. Of the roughly 6-7 % of the ances, domestic or foreign investor, GDP was spent on social expenditure about and to balance out the Yemeni region’s 2/3 were spent on education. About 80 % of share or regional shares with regard to the total social spending was due to wages the financial benefits the explorations and salaries. The structure of the expendi- of this national resource offer. One way ture program since 2015 has been further forward could be to form a national hy- compressed to comprise only (1) salaries, drocarbon holding company, which is (2) interest rate payments due to the build-up tasked to deal along commercial cri- of public debt, and (3) some consumption of teria with the national resource, as an gasoline/diesel/energy/some goods. With re- investor and operator, jointly with other covery growth reaching an assumed 5 to 10% investors or alone. The holding com- annually over the first 2 years of an initial post pany could allow for foreign strategic conflict period, the resource envelope avail- or portfolio investors to participate in able will not be much more than half of the providing for private sector incentives costs for a minimal expenditure program, im- for improved overall sector governance plying that a fiscal deficit of about 10 to 12 % and management.49 As an additional of the GDP should be counted with. The do- visionary point, the sectors’ assets mestically raised revenues are likely to cover could also, along the above-mentioned at best salaries and allow for some down pay- path, eventually form a nucleus of pri- ments on regularizing accumulated domes- vate assets traded at a stock exchange tic, and some re-initiation of social services. in Yemen or elsewhere, adding to the Employment and recovery programs are un- incentives for private sector based likely to be possible to be financed from own governance while also using the sec- resources, particularly savings, during the first tor as an entry point for revamping the two years post conflict. The limited expendi- large state owned enterprise sector in ture options risk in such a scenario to put the Yemen. peace under stress, as the future government will not be able to deliver on expectations. 2.3. Fiscal policies for peace build- Foreign financial assistance is required ing, recovery and fomenting growth for Yemen to recover and restore, and to build peace. With an estimated deficit going Rebuilding the country after agreeing forward of 10 to 12% of the GDP, additional to peace building will not be possible with resources of about 5 to 6% of the GDP are re- the fiscal expenditure program executed quired to settle with an effective deficit of about in Yemen in the past and the financial en- 5-6 % of the GDP, which is in the order expe- velope likely to be available for the next 2 rienced on average since 2000. Such deficit years (see also above). Pre-conflict expen- would require more external assistance than diture fiscal programs reached about 28 to 34 in the past, but it would also require a higher % of the GDP. Roughly a third (around 10% absorption capacity, which has been already of GDP) was reserved by the civil service, an obstacle in the past. In the decade 2000- another third (nearly) was spent over the last 2010 Yemen absorbed annually on average decade on transfers and subsidies, predomi- not more than 1.5 % of the GDP in external nately gasoline and diesel. Capital spending aid. Even if foreign aid becomes available on reached only in 2005 8% of the GDP but since the required level of up to 6 % of the GDP the 49 See also the reform of ARAMCO in the Kingdom of country’s capacity after the conflict is likely not Saudi Arabia. 26 up to delivering the needed higher absorption they can contribute to stirring up productiv- rate of aid. To facilitate such aid flows under ity. Apart from the above referred redirection the given constraints, more budget directed of public investment program, the regulatory assistance would need to be considered, framework and market conditions would be an as happened in 2012, and bolstering of for- important area to look at, and to incentivize eign reserves as a partial alternative could much needed private investment.53 The state be considered. Bolstering the reserves have owned enterprise sector and its social and the advantage to benefit the private sector via economic performance would be another im- imports they can pay for; and the bolstered portant area for gaining productivity through reserves could help to stabilize the exchange interventions and reform. The aim would not rate as well as expectation early on. Particu- be simply privatizing but first to use any pos- larly, stabilizing expectations, as a measure- sible mean to make the state owned sector ment of trust building, would be an important economically more performing, be less of a positive by-product (externality) of bolstering fiscal burden to the public, and be more enter- the foreign reserve stock. prising, ultimately more productive. Only then Fiscal policies are key for supporting re- it can fulfill its employment objective in a sus- covery and growth. Past effectiveness of the tainable and credible way. public expenditure program has been limited Fiscal policies should free space for in- in terms of its impact on growth. In fact, public vestment expenditures and should stop investment has been low and the vast share supporting private consumption (foremost of expenditures went for consumption or cur- subsidies) regardless of income brackets. rent expenditures (see also above) since the Going forward, subsidies for energy con- turn of the millennium. The Joint Social Eco- sumption should be all but abolished. In the nomic Assessment (JSEA) of 201250 laid out past, up to 8% of the GDP, up to a third of that supporting industry and service develop- the fiscal envelope, were used for subsidies, ment through public spending has the highest foremost energy subsidies. This represented growth impact, if such spending is invested much more than was spent on education or in electricity and water, public works, housing health. While subsidies were reduced in mid- and roads.51 The productivity growth in Ye- 2014, and the remaining one supports only a men has been notoriously low over the past subsidy for diesel for electricity generation, 2 decades52, which translates – among oth- the country would be better off when all en- ers - into a low per capita growth rate, low in- ergy subsidies could be clearly abolished, in come per capita, and is in general an indica- line with a general regional policy shift away tor for the relative stagnant state of Yemen’s from energy subsidies. Apart of distorting eco- economy up to 2012. Future fiscal policies nomic outcomes at the expense of the public, in Yemen will therefore have to look at how or education for that matter, energy subsidies were also a lucrative area for extracting rents. 50 The JESA was a joint assessment undertaken by the World Bank, the United Nations, the European None of these outcomes would be acceptable Union and the Islamic Development Bank to assess going forward. Eliminating all energy subsi- broadly Yemen’s priority needs in support of the dies would therefore equally reinforce better Yemen’s Transition Agreement which was signed in governance as a large source for rent distri- November 23rd, 2011. bution would be dried up, another prerequi- 51 See JSEA, page 19, table 5; “Public Spending and Elasticities”. See also Table 7 “Projected Growth site for supporting sustainable growth. The Rates by Sector”. Social Welfare Fund’s cash transfer program 52 See The Republic of Yemen: Unlocking the Poten- for poor households should instead be used tial for Economic Growth; a Country Economic Memo- randum, World Bank, Washington D.C., 2015. 53 See also Annex 6. 27 to compensate the poor for loss of income, own PFM capacity is highly important for or supporting income, while also helping to achieving recovery, stability, and ultimate- leave poverty through productivity enhancing ly peace. There are essentially three reasons programs, which could be linked to the cash why the focus on the national PFM system is transfer program. In general, the future public important: (1) the orderly flow of revenues and expenditure program should focus more on expenditures to allow the provision of public investment, including human capital invest- sector services, (2) using national systems is ment, rather than on consumption. a cost effective and sustainable way to absorb None of these fiscal policy priorities will be external assistance, and (3) rebuilding the successful or effective without rebuilding the national PFM system in an accountable and public financial management system. inclusive manner offers the opportunity to re- build trust between citizens and the state (see 2.4 Re-establishing the Public Fi- also above). The state-building impact of the nancial Management System PFM system and its reform can be significant, if it is taken as a building bloc towards form- Effective Public Financial Management ing an environment for domestic accountabil- (PFM) forms a critical prerequisite for eco- ity, joined by the development of sustainable nomic governance and supporting sus- capacity and a clear focus on supporting and tainable recovery. PFM is a basic but also a delivering services (Gill 2015). central instrument to create trust in the state A recent World Bank review of PFM re- and its public purpose through applying rig- forms in post-conflict countries underpins orously its standards, regulations, and pro- the supporting role of the PFM system in cesses in a transparent and accountable way. generating recovery, trust, and stability. It is at the center of state rebuilding efforts, Despite many legacies, including very low ca- as it matches publicly available resources pacity, continuous insecurity, and acute cases with public service delivery, Yemenis are hop- of failed development, building more effective ing for and counting with. Mastering the PFM PFM systems has been a key driver for over- system is therefore a sine-qua-non condition coming these constraints. At the same time, for restoring the central state. If mastered in a there are also tremendous risks: progress has transparent and accountable way it will help been uneven across the dimensions of the to contribute to rebuilding legitimacy. It is not budget cycle, and the sustainability of PFM an end in itself. It is meant to deliver on poli- reforms frequently remains uncertain due to cies and public services, to which all Yemenis capacity challenges, political and security rea- have access. If the system helps to deliver sons (World Bank 2012). such services based on agreed policies (e.g., While it is important for the PFM systems budget), it will also help to refocus the politi- to support immediate needs such as re- cal discussion in Yemen about resources and storing basic services, this should be services, which has been fragmented before done without compromising longer-term 2015 but is certainly heavily fragmented in the institution-building objectives. One of the immediate post conflict period.54 main challenges in post-conflict situations is finding the right balance between the urgen- Experience in post-conflict situations has cies of the day and addressing medium- to shown that rebuilding the government’s longer-term governance challenges (World 54 Letter dated 27 January 2017 from the Panel of Bank 2016). Experts on Yemen addressed to the President of the Security Council; United Nations Security Council, January 31st, 2017; document no.: S/2017/81 28 2.4.1 Policy challenges for the the absence of an approved budget in 2015 Public Financial Management Sys- and 2016, an expenditure plan using the 2014 tem budget ceilings was applied, even though the 2014 fiscal context was largely outdated in A number of contextual and structural 2015 and thereafter. In 2016, expenditures problems will shape the post-conflict PFM have been limited to parts of Chapters 1 (pay- policy priorities: the mismatch between the roll) and 4 (debt service), with the process available fiscal revenues and the pressure on controlled and largely financially serviced by expenditures, the absence of an approved the CBY. However, with the CBY running out budget for some time, the need to reconcile of tradable assets, domestic as well as exter- actions taken during the conflict by the con- nal assets (foreign reserves), its supporting flicting parties in Sana’a and in Aden, and service function stopped.56 The Hadi-admin- maybe also by local actors in other locations istration has prepared its own budget, but it in Yemen, the significant cash flow shortages has not become operational. disrupting service delivery, limited or inter- rupted chain of information about budget im- The quality of fiscal information cannot be plementation, compounded by the erosion of ascertained and the integrity of govern- PFM capacity on all levels. ment accounting records is uncertain. The Already prior to the current crisis, the use of the Automated Financial Management country has been unable to establish a Information System (AFMIS) by the spending sustainable fiscal position and depended units has apparently continued in some min- on foreign support. As a result of the dra- istries, but has been stopped in others due to matic deterioration of the fiscal situation in the ongoing conflict. The Central Organiza- Yemen, and starting in May 2015, the Minis- tion of Control and Audit (COCA) institutional try of Finance implemented expenditure con- structure seems to have remained intact and tainment measures, such as: (i) suspending staff continue to operate. However, no audited investment projects (budget chapters 4 and financial statements have been produced. In 5); (ii) reducing some recurrent expenditures addition, the PFM capacity, which has been (budget chapters 1 & 2); and (iii) limiting bud- limited before the conflict, seems to have gets of the economic units to salary and wag- been significantly deteriorated. For example, es only — except for medicines and some few staff continue working at the Ministry of operating costs for hospitals. Notwithstanding Finance premises under authorities who are these measures, a large increase in the bud- not recognized by the administration in exile. get deficit and public debt occurred.55 Salary and wages have exceeded revenues, leading Tackling PFM policy options and actions to direct financing from the central bank, and is critical for the post-conflict to be sure lately arrears. 56 In September 2016, President Hadi issued de- crees to move the CBY from Sanaa to Aden, replace The fiscal challenges have been exacer- the Bank’s Governor and reshuffle the Board of Directors. This change coincided with the depletion of bated by the political crisis, leading to national bank notes and foreign reserves. Since then, two separate authorities (in Sana’a and the CBY in Sanaa stopped paying salaries. Servicing in Aden) issuing instructions that cre- external debt stopped already earlier, in April 2016. ated uncertainty for the PFM systems. In Since March 2016, CBY rationed access to foreign re- serves in favor of critical food imports, a policy which 55 The public budget’s financing gap is estimated was discontinued in the wake of the decisions taken in at US$5.8 billion in 2016, without even considering September 2016 by the political leadership, and due reconstruction needs (Government of Yemen 2016). to the lack of foreign reserves. 29 that policy measures meet envisaged re- sults. The government and its development The short-term demands from the PFM partners are advised to place immediate post- system is to support fiscal stability, res- conflict focus on downstream budget imple- toration of service delivery, reconstruc- mentation, where funding and expenditures tion, and building of trust. Such demands produce results and accountability. Fragile would require restoring budget operations states are particularly weak in de facto (ver- quickly, ensuring the integrity of budget con- sus de jure) PFM measures that track imple- trol processes as soon as possible, providing mentation of budget transparency and execu- information on where the funds are flowing in tion, including crucial downstream processes a transparent fashion, and launching a new such as cash management, procurement, budget. payroll control and internal control (Porter et al 2010). Therefore, a focus on budget exe- In parallel, the government is advised to cution and on the ability to verify and report on start deliberations for the Medium-Term where the government is spending its money Strategy which should include further across the main stages of the budget cycle is strategically minded PFM reform. These more critical in the immediate term than up- reforms would have to strengthen the core stream processes, such as multi-year budget- foundations of the PFM institutions and sys- ing frameworks or program-based budgeting. tems in Yemen and adapt them, as needed, The former are also more likely to bear fruit to the emerging public sector administrative in improving results and accountability in gov- setup, which will likely include a wider sharing ernment spending. of power across regions. PFM policies will evolve with the political 2.5. Policy recommendations for compromise found for the post conflict in the Public Financial Management Yemen and will need to be revisited and System adapted regularly. Adaptation and precise requirements will also depend on the terms of 2.5.1 Restoring budget operations the political settlement that, at present, is still unknown. In any case, selectivity is needed to Legitimacy, trust building, and effective- avoid placing excessive demands on the weak ness of any expenditure program requires administrative capacity, which in the short the restoration of normal budget opera- term will require re-assembling a core group tions. Normal budget operations will have of local budget management experienced to be restored in order to support the state practitioners, supported by international ex- administrative structure and to provide some pertise. Evidently, the degree of political com- degree of service delivery. This will include mitment will be a critical factor for the success establishing the authorizing arrangements, as of PFM measures and their sustainability in well as restarting treasury operations. the longer run. Experience with PFM reforms in post-conflict environments shows that the i. As a starting point, an “emergency greatest progress has been achieved when budget” for the post-conflict fiscal year two factors are aligned: (i) the development of would need to be prepared.57 Its initial a close relationship between the national au- approval and subsequent adjustments thorities and the international community; and may be subject to temporary authoriz- (ii) a domestic commitment to state building ing procedures as possibly articulated in (World Bank 2012). 57 Emergency budgets may be required even beyond the first post-conflict fiscal year. 30 the post-conflict political settlement, for PFM systems. In particular, these funding instance by a “Fiscal Policy Committee” mechanisms should not be fully off-bud- with representation from the Ministries of get, i.e. they should be considered in the Finance, Planning, and Oil, the CBY, and emergency budget planning, cash flow the Prime Minister’s Office. This authoriz- programming, and budget execution re- ing body would then set the revenue and ports. In addition, they should be subject expenditure policy and procedures.58 to sunset provisions aligned with the PFM Strategy and Action Plan (see section (e) ii. In order to build cash balances for bud- below). get execution, the Ministry of Finance and the CBY would need to implement iv. An inventory of liabilities and expendi- as possible treasury consolidation, i.e. ture arrears (salaries, entitlements, do- control of central government revenue mestic debt, suppliers, etc.) would need inflows (from hydrocarbon, taxes, untied to be conducted, verified, and categorized donor aid, and so on) through the Trea- to help to inform expenditure prioritiza- sury Single Account (TSA).59 Possession tion decisions, including the identification of “own revenues” by central government of financing sources and a timetable for entities should be discouraged. Similarly, liquidation (IMF 2014b). These decisions creation of extra-budgetary funds should should be communicated by the authoriz- be restricted. ing body in a transparent manner. iii. While the principle of treasury consoli- v. Based on the revenue projections and dation should be vigorously pursued, it prioritized expenditures, a simple cash is likely that in the aftermath of conflict, flow program would need to be prepared development partners will require spe- and operationalized. The arrangements cial flow-of-fund mechanisms to mitigate for central treasury payments between fiduciary risks. These may include the the Ministry of Finance and the CBY, in use of financial intermediary agencies existence prior to the conflict, would need (including United Nations agencies) for to be reinstated. investment projects, the establishment of a recurrent cost operation to provide 2.5.2. Ensuring the integrity of for immediate stabilization and recon- budget controls struction needs,60 and the recruitment of Independent Monitoring Agents (IMAs) There is no legitimacy without restoring to provide an additional level of fiduciary budget integrity. In order to build confidence controls. These mechanisms can prove among the relevant stakeholders and to make valuable in the short-term, provided they efficient use of limited resources, it will be im- are not detrimental to the formal national portant to ensure that fundamental controls are in place to prevent leakages. 58 As a part of the preparation of the emergency bud- get, there will be a need to review the impact of the major decisions and actions taken by both administra- i. Under the presumption that expen- tions during the conflict. diture priority will initially be placed 59 This note does not address fiscal decentralization on payments of civil servant salaries, policy, including revenue-sharing arrangements. securing the integrity of payroll data 60 Examples supported by the World Bank include the Afghanistan Reconstruction Trust Fund and the and controls will be imperative. The Somalia Recurrent Cost and Reform Financing Proj- post-conflict environment might ac- ect. tually bring with it the opportunity to 31 consolidate a uniform payroll directly 2.5.3. Providing information about linked to a personnel database (to be where government funds are going computerized in due course), provid- ing the list of all staff whose salaries Commitment to and delivery on fiscal would be financed by the budget. The transparency will be an important trust list should be verified against the ap- and confidence-building measure. Produc- proved establishment and personnel ing timely and reliable information about the records.61 The system used for pay- budget and its execution (to start with) will roll calculations needs to be verified help open doors for public debate. It will also as well. Subsequent amendments to facilitate accountability over the use of public the payroll and personnel databases resources to citizens and development part- should be processed in an authorized ners alike. It will be particularly important for and timely manner, and documented the government to quickly show that spending through a monthly reconciliation report. is going to support reconstruction and service An audit trail of all payroll transactions restoration in the various areas of the country. and authorizations should be kept. i. The government would need to re- ii. The Ministry of Finance would also sume public access to budget infor- need to resume the operationalization mation, i.e., availability without restric- of other basic budget execution con- tion, within a reasonable time, with no trols for incurring commitments (which requirement to register, and free of will be important to prevent a new charge, to a basic set of budget docu- build-up of arrears), verification of re- ments, starting with: ceipt of goods and services, prepara- tion of payment orders, and issuance • Enacted budget and supporting doc- of payments. umentation, within two weeks of pas- sage. iii. In addition, the Ministry of Finance • Monthly budget execution reports, would need to exercise strict enforce- in a format consistent with that of the ment of budget appropriation ceilings. approved budget, within one month of A centralized payroll system, as sug- their issuance. gested above, should help in this re- • Annual budget execution reports, gard. As a general hard budget con- within six months of the fiscal year end. straint, no budget overruns should be • Audited annual financial statements, allowed before a transfer between or incorporating or accompanied by the within appropriations (“virements”), in- COCA auditor’s report, within twelve cluding the use of the contingency re- months of the fiscal year end.62 serve, is approved by the authorizing 62 In addition to the identified priority documents, oth- body. In the absence of an operational er elements would need to be added in due course, AFMIS, the previously used sub-ac- specifically: (i) executive budget proposal documen- count structure of the TSA, mirroring tation to be made available to the public within one the chapter and sub-chapter ceilings, week of the executive’s submission to the legislature; (ii) macroeconomic forecasts, within one week of their can facilitate effective virement control. endorsement; (iii) a Pre-budget Statement, includ- ing the broad parameters for the executive budget 61 In the case of Central African Republic, for in- proposal regarding expenditure, planned revenue, and stance, the post-conflict census of civil servants was debt, at least four months before the start of the fiscal completed in around two months. year; (iv) other external, non-confidential, audit reports 32 ii. The preparation, issuance and dis- tiation with spending entities. semination of audits by COCA would constitute an important element of ear- ii. The budget would need to be uni- ly commitment to financial accountabil- fied. While an inter-agency “gatekeep- ity. With this objective in mind, COCA ing process” for approval of capital proj- would need to develop a basic financial ects can be instituted (see next point), audit program allowing it to issue an the Ministry of Finance would lead the opinion on the annual financial state- single formulation of the capital in- ments (or at least the budget execu- vestment and recurrent expenditure tion report) soon after the end of the budgets.63 Moreover, to main budget fiscal year. Further, it would need to de- integrity, donor-financed investments velop a program of compliance audits would be incorporated into the national focused on budget execution that can budget, even if special implementation provide a minimum degree of external mechanisms are required by the do- assurance — even before the annual nors.64 accounts are closed. In conducting these activities, COCA will benefit from iii. A simple mechanism for selection collaborating with other oversight bod- and allocation of funds to reconstruc- ies such as the Supreme National Au- tion capital investment projects would thority for Combating Corruption and need to be established and further de- the Higher Council for Procurement. veloped over time. While these invest- ments would be supported largely by 2.5.4. Launching preparations of development partners on the basis of the new budget a Recovery and Peacebuilding Needs Assessment (RPBA), the foundations The first post-emergency budget formu- for an institutional project “gatekeep- lation exercise will be constrained by the ing” process can be set early on, us- presumed limited available capacity. If ing basic appraisal techniques65 and anything positive can arise from the absence 63 As one of the reform pillars under the 2012 Mutual of effective public investment planning and Accountability Framework (MAF), the Ministry of budgeting processes during the conflict, it is Finance and MOPIC made the first joint attempt at the opportunity to achieve the long-sought in- budget integration through “The Executive Plan for tegration of the capital and recurrent budgets the Harmonization of Investment Programs and State under a fiscally sustainable outlook. Public Budget.” (Government of Yemen 2012). The plan intended to solve problems resulting from dual i. The new budget formulation process budgeting and the misalignment of the budget with would need to consider the preparation the government’s economic priorities, specifically the of a basic fiscal outlook to inform bud- priorities and objectives reflected in the government’s get ceilings. These ceilings, together Transitional Program for Security and Development with the arrears liquidation and the ex- (TPSD) 2012-14, as well as with the future develop- ment plans and programs in general. penditure prioritization program, would 64 While allowing for special implementation mecha- set hard budget constraints for nego- nisms, the government and its development partners on central government entities, within six months of should prevent the emergence of enclave-type ar- submission; and (v) a Citizen’s Budget within two rangements whereby a donor agrees with a ministry weeks of the executive budget proposal’s submission on investments in the sector without reference to the to the legislature and within one month of the budget’s overall reconstruction program, development and approval (the first Citizen’s Budget for Yemen was fiscal sustainability objectives reflected in the budget prepared in 2013). (Adapted from PEFA Framework (UN and World Bank, forthcoming). 2016). 65 Investment priorities in post-conflict settings 33 involving the Ministry of Finance, need to be conducted. To this effect, MOPIC, and eventually the Cabinet. two instruments are recommended: A “clean” public investment project (i) the indicator-based, globally-recog- database would be built from scratch nized Public Expenditure and Account- for planning and monitoring purposes, ability Framework (PEFA) PFM Per- with the underlying information system formance Assessment (PEFA 2016), platform evolving over time. and (ii) a Capacity Needs Assessment to identify and measure capacity con- iv. The budget approval procedures, straints to PFM reform, such as scarce and the phasing out of the post-conflict resources, low staff skills, mandate ad hoc authorizing body would need limitations, and underdeveloped sys- to be established as soon as the new tems, among others. legislative body could be reconstitut- ed.66 The new budget approval pro- ii. Using both, PFM performance and cess could also serve as a means to capacity assessments, a PFM Strategy encourage more public debate around and Action Plan would need to be pre- the public policies reflected in the bud- pared. The plan would cover revenue get, including the public investment administration, the budget cycle, inter- program. nal control, public investment manage- ment, management information sys- 2.5.5. Establishing the core tems, and fiscal transparency. A similar foundations for rebuilding undertaking will be needed to strength- PFM institutions and systems en accountability functions, such as COCA’s external audit and Parlia- While the preceding proposed policy mea- mentary budget oversight. It would sures would take place in the immediate need to be carefully sequenced —but post-conflict context, a parallel dedicated not prescriptive in nature. Instead, it effort will be necessary to shape the PFM should seek to define the trajectory of institutions and systems for the medium reform while allowing for learning and and longer term. adaptation (Williamson 2015). The i. During the immediate term, priority plan should be developed in an inclu- should be placed on addressing con- sive manner by the government (and, crete PFM problems. Yet, as soon as as noted below, development part- the conditions on the ground are con- ners should coordinate their initiatives ducive, a broad evidence-based as- around the plan), with due attention to sessment of the PFM system perfor- empowering groups of leaders work- mance and associated resources will ing in coalitions around the key PFM normally require making distinctions between projects that should be identified and executed under special problems (Porter et al 2010). As PFM modalities suitable to their political/social objectives; reform encompasses the whole of the other projects tailored to humanitarian or damage- public sector, Cabinet discussion and control goals; and projects that should meet the approval of the PFM Strategy and Ac- standard rules of economic appraisal. (UN and World tion Plan is suggested. Bank, forthcoming). 66 Prior to the conflict, Yemen was characterized by a well-structured and vibrant parliamentary oversight of iii. The PFM Strategy and Action Plan the government’s budget estimates approval process would need to be supported by a that addressed both fiscal policy and details of the large capacity-building program, us- revenue and expenditure estimates (Arya 2010). 34 ing a combination of approaches. For framework that is expected to emerge most staff in charge of routine PFM after the conflict — including the pow- functions, including in central finance ers, roles and responsibilities for each agencies and spending line minis- level of the sub-national structure, the tries, mechanisms for capacity building fiscal risk monitoring mechanisms, and through skills development will be ap- the coherence and linkages between propriate. However, gains will be slow the central and sub-national PFM sys- and incremental, given the limited ab- tems. For instance, the public sector sorption capacity that has been further chart of accounts and budget classifi- exacerbated by the conflict. For some cation across central and sub-national specialized PFM functions, capacity government administrations should supplementation or substitution sup- remain unified. In addition, the trans- ported by development partners can fer system could include financial in- be incorporated as a short-to-medium- centives (e.g., performance grants) term measure, with built-in mecha- for compliance with PFM procedures nisms for transitioning over time. For and development of PFM skills in local coordination of PFM capacity building, administrations. Mechanisms for local a centralized unit to manage the activi- participation in budget planning and ties and associated donor funding, and oversight could also be fostered. to liaise with line ministries, could be set up at the Ministry of Finance (e.g., vi. The PFM legal framework would Liberia PFM Unit). need to be updated as needed to con- solidate reforms. However, compre- iv. One particular aspect that would hensive legal reform would be irrele- need to be tackled early in the post- vant if the capacity for implementation conflict reform period involves the bud- is not available. Therefore, revisions getary classification of public sector to the PFM legal framework should be entities. In particular, the state budget well targeted and fit to context.69 financing of economic units should be done more transparently,67 differentiat- vii. Early on, the development partners ing between non-market entities that would need to establish effective do- should form part of the central gov- nor coordination mechanisms for ana- ernment budget and procedures, and lytical and implementation support for actual public corporations (market pro- the preceding elements. Resources to ducers) that fit the definition according support PFM diagnostics, reform, and to international standards.68 capacity building should be provided v. Any PFM strategy would need to in a coherent manner, avoiding dupli- be adapted to the fiscal decentraliza- cated and/or fragmented interventions. tion and intergovernmental relationship 67 Inter-enterprise credit and commercial loans might 3. Final Remarks represent a hidden source of fiscal risk, with a number The many conflict, social, and economic chal- of SOEs amassing a substantial amount of payment lenges Yemen is facing the post-conflict arrears and incurring debts that the general budget 69 Regarding the independent audit function of may have to absorb at a later stage (Lepain, 2014). COCA, prior to the conflict the World Bank had dis- 68 See Chapter 2 of the International Monetary cussed with COCA a set of recommendations to bring Fund’s Government Finance Statistics Manual (IMF, the legal provisions closer to international standards 2014a). (World Bank, 2013). 35 phase will require time to heal and time to be drocarbon sector as the financial backbone of addressed. Although the observer to the Ye- the economy without which economic stability men case will easily point to the risks ahead will be difficult to conceive, and (3) establish- for peace building, there is no alternative to ing the legitimacy of the central institutions overcoming these challenges, in phases, well and their leadership, which is ultimately the communicated, and by practicing the open Yemeni government. Such legitimacy can be participatory approach, which Yemeni political built by delivering on reconstruction and re- traditions would suggest. While external po- storing public services. Only when Yemenis litical and financial support to peace building are able to agree individually that the public in Yemen is critical to overcome the conflict purpose of the central government makes a mode, the national political leadership’s com- difference in terms of security, economic well- mitment to peace building is more important. being, and service delivery (health, educa- In fact, willingness to build peace will gener- tion, etc.), legitimacy of the central state and ate external support, and not the other way its government can be re-established. Trust around. – as argued above – is an important building The post-conflict period, following examples block for legitimacy and can best be practiced in Europe, in Africa, and in Asia, can easily where and when it matters most: during the take up one or two decades, depending on initial peace building period, when scarce the factors at work and depending on the will- public resources, domestic or external ones, ingness of neighbouring countries or the re- are used for restoring and rebuilding legitima- gion’s ability to help and integrate the country, cy and overcoming conflict. The question of politically and economically. Yemen is unlikely how political process is facilitated and choices to be an exception. are best made, centrally or on the sub-central The reality of major conflict work-out across level, can be worked out over time, and, if the globe has shown that tremendous post- well-conceived and credible, can surely add conflict support is needed to build peace. to building legitimacy. Such support cannot content itself by just sup- Lacking inclusiveness was seen as a driver of porting a reconstruction fund, although such conflict in Yemen, for long. The problem has a fund is certainly helpful. Regional leaders only been compounded by now, with an in- should think about providing Yemen with a creasing number of households falling below perspective for integration in regional institu- the poverty line in Yemen. If the poverty rate tions and schemes, thereby sharing more hor- has been 48% in 2014, it is per end 2016 es- izontally economic and political opportunities timated at around 70% of the population. Ad- for Yemen. There should be a shared interest dressing inclusiveness in Yemen could have among regional stakeholders to build peace in many entry points but given this massive such a forward looking way, which could over scale and increase in poverty, for the immedi- time benefit all, either in terms of stability, wel- ate, successful recovery would be a base for fare, or simply by enhancing future economic facilitating more inclusiveness. opportunities. Europe and its post-World War II architecture could serve as a positive ex- ample. For the short term, though, the prime chal- lenges are: (1) rebuilding central national eco- nomic institutions, foremost the fiscal system with its budget and the anchor for the financial system, the Central Bank, (2) restoring the hy- 36 Annex 1: Summary of Yemen’s Current Tax Regime Tax base Tax rates Exemptions Direct taxes Personal income tax Worldwide income (residents) 10‒15% (Income Tax Law Domestic income (non-residents) 20% No. 17 of 2010) Net wealth tax 2.50% Corporate income tax Taxable income, 20% (standard); Micro entities; (Income Tax Law incl. capital gains, 50% (mobile phone); 2010 income tax law No. 17 of 2010) excl. dividends from public company 35% (int'l telecom, oil and abolished all incentives gas, cigarettes, importers); and exemptions; 10‒20% (SMEs); accelerated appreciation special rates for oil/gas, of 40% in first year of use. mining, and investments; 15% (investment projects). Withholding tax On payments made to non-residents 10% Dividends paid to residents; (commissions, patents, trademarks, interest paid to foreign banks copyright royalties) and on fees for (if approved by Yemeni CB) transfer/use of technology/licences. Fees paid to resident technical and 3% professional service providers. Indirect taxes Property tax Based on rental value of property. One month's rent (Income Tax Law Sale of land, constructed property. 1% No. 17 of 2010) General sales tax 5% (general rate) Services (financial, insurance, (General Sales Tax Export, int'l transport, baby milk 0% health, education, non-profit, Law No. 19 of 2001) Gold (half-manufactured) 2% land transport, renting, water, Jewellery and gold 3% clean-up, historical, religious). Telecommunication 10% Qat 20% Cigarettes, cigars, arms, ammunition 90% Social security By companies 9% of salary By employees 6% of salary Customs Assessed value of imports, Ad valorem duties of More than half the scheduled Source : Deloitte, (Law 37/1997) 2016. International Tax: CB applying Republic of Yemen exchange rate 5, 10, 15, and 25% items are taxed at ≤ 10%. Highlights 2016. MCO, 2013. Doing Business in Yemen: Tax and Business Guide. 37 Annex 2: Tax Reforms as Initiator of Virtuous Cycles of Development A potentially virtuous Increased Higher rates of cycle of development private-sector More jobs inclusive and prospects can be productivity sustainable created… and profitability growth Better prioritization … if/when governments and higher quality of succeed in embedding public investments domestic resource mobilization efforts into a broader development More framework. taxes, Improved quality of non- public institutions taxes and Increased planning and services security for the State Budget grants Tax Reform and Reconstruction Efforts fessional revenue authorities: There have been a considerable num- • Ownership and political leadership. ber of countries70 over the last decades There is no substitute to a government’s that managed to translate a popu- commitment to a (complete) break with lar “never again” mood when coming the past and a process of economic trans- out-of-conflict into root-and-branch re- formation, institutional reform, and public forms to address entrenched problems accountability. By redefining the role of in society and unresolved issues from the State, altering the balance between the past, including those related to tax promises of service delivery and means revenue reconstruction. A number of of financing, allows the authorities to common lessons can be drawn from have residents be included in shaping the public policies and accept their civic successful experiences in re-creating duties. Whether it was West Germany’s modern, efficient, transparent, and pro- post-World War II decision to build the 70 See, e.g., Müller-Armack (1956) for (post-World War II) institutional framework for a social mar- West Germany, Hacıbeyoğlu (2009) for (post-Soviet) Azer- baijan, or Land (2004) for (post-genocide) Rwanda. 38 ket economy71 or Rwanda’s commitment • Political mandate and clear objec- to anchoring its tax reform agenda in the tives. The comprehension of the urgency 2002 Poverty Reduction Strategy, these for reforms has to translate into clearly de- highly inclusive and comprehensively fined political mandates given by the high- communicated policies managed to link est political authority (President, Prime tax-related efforts to the country’s (in this Minister, and/or Parliament) to the lead im- case, Rwanda’s) overarching attempts “in plementing agency (typically the Ministry galvanizing a societal drive to pick itself up of Finance), joint with clear (monitorable) and to work towards becoming a prosper- objectives, sufficient financial resources, ous, secure and confident society” (Land, and the necessary political and manage- 2004). In 2000, Azerbaijan went as far as rial independence to implement a corre- to establish a Ministry of Taxes, with clear sponding reform agenda. mandates, specific objectives, and a com- mitted minister who wanted no less than • Reliance on information and commu- to revolutionize his country’s tax adminis- nication technologies (ICT). Increasing- tration by creating a state-of-the-art online ly, successful tax reforms worldwide have system (Hacıbeyoğlu, 2009) that trans- tended to rely on the inclusion of compre- formed the revenue authority into an effi- hensive ICT components to a tax policy/ cient, transparent, service-providing public administration reform agenda aimed at institution. In these endeavors, develop- (i) ensuring an efficient, transparent, and ment partners and international financial non-discriminatory interaction with (large) institutions can provide technical and/or fi- taxpayers; (ii) facilitating revenue authori- nancial support, but the definition of—and ties’ administrative tasks, inspections, and political commitment to—the agenda and audits; (iii) effecting a culture change with objectives has to emanate from the coun- revenue authorities to impede corruption try itself as the political leadership that and institutional arbitrariness. No country frames, guides, supports, and has to co- was more innovative than Estonia in build- finance these efforts. ing a modern public administration by im- 71 The concept of a social market economy originated in plementing a comprehensive ICT agenda, the Federal Republic of Germany after World War II—that where more than 95 % of residents are now is, during a period of time, in which the country needed filing their tax returns through the internet to look for a new start. Anchored on the conviction that a strong state, functioning institutions, and a well-defined (Estonia, 2014), thereby providing the rev- legal framework supports, constrains, and directs a market enue authority an efficient instrument for economy (called Ordnungspolitik in German). The efficiency collection, communication, and auditing of the market system was to be balanced with explicit social objectives alien to a laissez faire-type economic model. At purposes. For households and companies the time, it took eight years after statehood in 1949 be- this implies that (i) all required information fore a core consensus on development priorities started and forms can be found online; (ii) there to emerge. The then Minister of Economy Ludwig Erhard (1957) published Wohlstand für alle (prosperity for every- is no personal interaction with tax officials one), popularizing the core principles of a social market (except on hotlines), minimizing the risk of economy and succeeding in securing its gradual acceptance corruption; (iii) the time and effort required as the country’s economic anchor. Originally coined by the “Freiburg School” around Walter Eucken and Alfred Müller- to file a proper tax return is reduced to the Armack (1956), the concept of a social market economy, in absolute minimum. Of course, rebuilding which competition and free initiative were to be channeled (rather than reforming) a revenue author- by a rules-defining, rules-enforcing, and rules-adhering state toward the overarching goal of increased social equity, ity makes these types of fundamental re- aimed at combining the efficiency of a free-market economy forms easier to implement and accept. with an explicitly stated social objective of constraining mar- • International collaboration. Following ket outcomes at either end of the income distribution. 39 the strong international commitment to tax administrations. supporting demobilization and reconstruc- • Communication. Especially in a con- tion efforts, especially in the ATI context, text, in which citizens (and resident en- governments have access to comprehen- terprises) resisted tax compliance on the sive technical and/or financial support to account of sub-standard public goods re- strengthen the “hard” and “soft” compo- ceived in return, it is paramount that tax re- nents of their respective tax regimes. Lead form agendas are consulted with, and ex- agencies should not hesitate to collabo- plained and communicated to, the public, rate closely with the World Bank, the IMF, ideally in the context of the broader socio- the OECD, and other relevant institutions economic development agenda. in their efforts to build efficient and modern Annex 3: Oil and Gas Sector: Institutional Structure Source: Government of Yemen. 40 Annex 4: Oil and Natural Gas Infrastructure Source: Energy Information Agency (EIA). 41 Annex 5: Republic of Yemen: Selected Economic Indicators, 2010–17 2010 2011 2012 2013 2014 2015 2016 2017 Prel. Prel. Proj. National Income and Prices (Change in percent, unless otherwise indicated) Nominal GDP, market prices (billions of YR) 6,219.3 6,480.5 6,785.8 8,462.7 9,289.3 8,108.6 7,648.9 9,812.0 Real GDP growth 7.7 -12.7 2.4 4.8 -0.2 -28.1 -9.8 5.0 Hydrocarbon sector growth 46.9 -14.5 -11.5 13.2 -11.3 -61.0 -87.0 447.4 Nonhydrocarbn sector growth 4.4 -12.5 4.0 4.0 1.0 -25.0 -6.0 2.0 CPI (period average) 11.2 19.5 9.9 11.0 8.2 39.4 5.0 20.0 Hydrocarbon production (in thousand barrels per day) 426 364 322 365 324 126 16 90 Crude Oil 264 197 155 175 156 59 16 90 LNG (oil equivalent) 162 167 167 190 167 67 0 0 Central Government Finances (In percent of GDP) Revenue and Grants 26.1 25.3 29.9 23.9 23.6 12.9 10.8 18.6 of which hydrocarbon revenue 16.5 16.5 14.1 12.8 10.6 2.9 2.3 6.2 of which grants 1.2 1.2 6.1 0.9 2.7 0.5 0.0 3.7 Expenditure and net lending 30.2 29.8 36.2 30.8 27.8 23.5 24.4 24.6 Current, of which: 25.5 27.8 32.5 28.4 26.9 23.5 23.8 22.8 wages and salaries 8.7 10.0 11.1 10.2 10.0 11.3 11.4 10.2 subsidies 8.7 8.1 9.3 7.2 5.6 0.7 0.9 1.4 Capital 4.7 2.0 3.7 2.4 1.8 0.8 0.5 1.9 Overall fiscal balance (excl. grants) -5.3 -5.7 -12.4 -7.8 -6.9 -11.1 -13.6 -9.7 Primary non-oil fiscal balance (cash) -19.4 -17.9 -21.1 -15.2 -12.3 -6.5 -7.6 -8.7 Nonhydrocarbon primary fiscal balance (cash) excluding grants Gross Public Sector Debt 42.9 45.7 47.3 48.2 48.7 66.7 83.8 75.8 Domestic debt 23.0 27.1 29.9 33.0 34.5 51.2 63.6 56.2 External debt 19.9 18.6 17.4 15.2 14.3 15.5 20.3 19.6 Monetary data (end-of-period annual growth rate) Broad money 9.2 0.0 21.5 12.5 0.2 3.1 13.0 18.2 Reserve money 7.7 15.8 12.9 1.9 1.4 27.4 23.8 10.7 Credit to private sector 8.2 -16.9 -0.6 38.9 2.6 -22.3 1.3 15.7 Benchmark deposit interest rate (percent) 20.0 20.0 18.0 15.0 15.0 15.0 15.0 15.0 Velocity (non-oil GDP/M2) 2.4 2.3 2.4 2.4 2.4 2.4 2.4 2.4 External Sector (In millions of U.S. dollars, unless otherwise indicated) Exports (goods & services) 9,271 9,929 8,802 9,037 9,287 3,864 898 2,749 of which hydrocarbon (oil and gas) 6,279 7,731 6,332 6,537 6,774 2,440 248 1,755 of which nonhydrocarbon 1,369 931 1,017 1,102 1,132 501 125 219 of which services 1,622 1,267 1,453 1,398 1,390 923 524 775 Imports (goods & services) 10,629 10,708 12,921 12,186 12,257 8,485 6,855 8,420 of which hydrocarbon 2,073 2,578 3,840 3,265 3,094 1,278 1,373 1,711 of which for food 2,476 2,725 2,692 2,701 2,645 1,859 1,450 1,740 of which services 2,156 2,165 2,680 2,294 2,525 1,896 1,339 1,738 Current account balance (in percent of GDP) -3.4 -3.0 -1.7 -3.1 -1.7 -5.5 -6.1 -4.2 Reserves Central Bank own gross reserves (billions US$ end-period) 5.1 4.0 5.6 4.8 4.1 1.5 0.6 1.1 Central Bank own gross reserves (in months of imports) 5.7 3.7 5.5 4.7 5.7 2.6 0.9 1.2 Exchange Rate Exchange rate (per US$, official rate) 219.6 213.8 214.3 214.9 214.9 214.9 250.0 … Memo Items Nominal GDP in billion US$ 30.9 32.7 35.4 40.4 43.2 37.7 27.3 27.2 Population (in millions) 23.6 24.2 24.9 25.5 26.2 26.8 27.5 28.2 Nominal per capita GDP (US$) 1,310 1,350 1,423 1,583 1,651 1,406 993 964 Source: Yemeni authorities; and staff estimates. 42 Annex 6: The Republic of Yemen: Growth Diagnostics Tree Annex 7: A brief background information to the PFM system in Yemen Yemen’s executive power comprises the trols in accordance with the financial law and President and the Council of Ministers, regulations, as well as submitting the financial with executive authority established in the and accounting records to the Central Orga- Office of the President. The Prime Minister nization of Control and Audit (COCA), the su- is responsible for the day-to-day running of preme audit institution. The Central Bank of government affairs. The Ministry of Finance Yemen (CBY) operates the Treasury Single is responsible for the management of public Account (TSA). finances, with the Ministry of Planning and In- The multiparty Parliament votes on the ternational Cooperation (MOPIC) in charge of budget, but has no authority to directly preparing the investment budget. The Minister amend budget lines. COCA is responsible of Finance appoints Financial Officers to each for conducting external audit and special in- ministry and department with responsibility for vestigations for the Cabinet, the Minister of safeguarding the application of funds as in- Finance, and the parliamentary Public Ac- tended by Parliament in the approved budget. counts Committee. Line ministries, for their The Ministry of Finance is also responsible for part, are responsible for drafting, negotiating, maintaining financial records and internal con- and implementing their respective budgets. 43 There are two main tiers of sub-national gov- (ii) the weak cash management system — in ernment in Yemen. The first is at the Gover- spite of the existence of many requisite ele- norate level (22), each of which has an ex- ments for sound cash management (including ecutive office headed by a Governor. There a TSA and centralized payments); (iii) the non- is a local council whose members are elected uniformly implemented commitment controls; by the districts. The second tier is comprised (iv) the less than fully effective salary expen- of the district councils (303) and headed by diture controls; (v) the non-achievement of council chairmen. Both tiers have the author- value-for-money in procurement; (vi) the prac- ity to raise revenues (Arya 2010). tice of ex-post approval of the supplementary The state budget in Yemen is character- budget by Parliament; (vii) the accumulation ized by its limited credibility, a problem of arrears without proper and complete track- compounded by its fragmentation into ing; and (viii) the incomplete information on four largely independent components: the donor-funded projects. (World Bank 2008). operational budget, the subsidy budget, Following the PEFA, the government im- the investment budget, and the economic plemented a World Bank-financed PFM entities’ budget. The investment budget is Modernization Project since 2009. The based on multi-year Public Investment Plans project included the improvement of the Min- (PIPs), including on-going projects which are istry of Finance’s functional organization, neither properly documented nor monitored. implementation of an Automated Financial In this context, the PIPs are prepared with- Management Information System (AFMIS), out consideration of the Ministry of Finance’s capacity building of procurement institutions Medium-Term Fiscal Framework (MTFF). The and of the Central Organization for Controls economic entities budget is a supposedly and Audits (COCA). In 2012, donor and gov- auto-financed budget, which is not the case ernment stakeholders decided to pursue a in practice. The concept of economic enti- new, two-year PFM Intermediary Action Plan ties tends to group State-Owned Enterprises to provide strategic direction and reduce do- (SOEs) with a number of non-market bud- nor fragmentation. The new Action Plan, to get entities that nevertheless have a signifi- be implemented from 2014–2015, was meant cant volume of own-source revenue. (Lepain to define the government’s priorities and al- 2014). Some budgets are not disaggregated low donors to align their assistance based on (for example, the Ministry of Justice, Interior these priorities, including: (i) general budget and Defense), and some off-budget funds and reform; (ii) reinforcing revenue management; special accounts remain. Financial reports (iii) enhancing control and accountability; (iv) are cash-based, but are not aligned with the enhancing capacities of a financial institute pertinent international standards. to become a regional institute specialized in The 2008 PEFA assessment revealed that public finance; (v) public debt management; previous PFM reform plans did little to ad- and (vi) the institutional restructuring of the dress fiscal sustainability and budget cred- Ministry of Finance.72 ibility. The poor matching of expenditure out- PFM modernization activities were sus- turn figures to the budget estimates reflected pended since early 2015 due to the po- a lack of strict fiscal discipline exercised in litical and security crisis. While the AFMIS budget execution. Many factors contributed to system facilitated a strengthening of budget the undermining of Yemen’s PFM capacity in execution reporting and follow-up, the system terms of improving the credibility of the budget has still not sufficiently enhanced budget ex- and achieving fiscal discipline. These include: 72 PFM Reform Initiative Team, Draft Action Plan of (i) the lack of predictability in budget releases; Yemen Public Finance Management Reform Program 2014 – 2015. 44 ecution control mechanisms. In particular, the was rolled out to 38 Project Implementation critical functions of expenditure commitment Units (PIUs).74 A strategic development plan controls73 and cash management were still for COCA was prepared and a training center underdeveloped, and a comprehensive stock- established.75 taking of all state budget payment arrears was considered necessary. The AFMIS was 74 The External Aid and Grants Directorate of the deployed in 35 ministries and central agen- Ministry of Finance is responsible for the review and cies, but not in the governorates or the se- approval of disbursement requests to donors and of curity sector (Defense and Interior Ministries payment orders to the CBY for payments to suppliers and beneficiaries. This internal control process was and related agencies). In turn, the Loans and facilitated by the LGMIS, which improved the process- Grants Management Information System (LG- ing times, among other benefits. MIS) for financial management of external aid 75 COCA staff were trained on themes such as information technology (IT)-based audits, procure- 73 A commitment control trial manual system was ment laws and procedures, and budget classification, placed in 15 spending units, but only six units used it. preparation and execution, among others. 45 References Arya, Arun. (2010) PFM Reform in MENA: Lepain, Jean-Marc. (2014). PFM Reforms Yemen Country Case. Washington, DC: in Yemen: Background and Way Forward. World Bank. European Union. Collier, Paul, V. Lani Elliott, Håvard Hegre, PEFA. (2016). Framework for Assessing Anke Hoeffler, Marta Reynal-Querol, and Public Financial Management. Washing- Nicholas Sambanis, (2003). Breaking the ton, DC: PEFA Secretariat. Conflict Trap: Civil War and Development Policy. Washington, DC: World Bank. Porter, Doug, Matt Andrews, Joel Turke- witz and Clay Wescott. (2010). Managing Devarajan, Shanta, and Lili Mottaghi. 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