Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

1. Building on the achievements realized under the EFF/PRGF program that was completed in October 2001, our plans for 2002 are to consolidate the gains made in terms of macroeconomic stability and to sustain the reform effort in key areas. On the fiscal front, our 2002 program aims at containing public expenditure growth so as to preserve fiscal sustainability over the medium term when oil revenues are expected to decline. On the monetary front, we have set a monetary growth target that is consistent with the achievement of single digit inflation by year-end. As concerns structural issues, we plan to maintain the momentum of reform, with particular emphasis on civil service reform and tax reform. In order to prepare for implementation of the PRSP, we are also committed to establishing a system to better plan and track poverty-related spending starting in 2003. Improved planning and monitoring systems will also be helpful in the transfer of budgetary responsibilities to the local authorities.

2. We believe that the policies targeted for 2002 will prepare the ground for implementation of the Poverty Reduction Strategy now under preparation. As such, our 2002 program should be seen a precursor to a successor PRGF arrangement which, we hope, would come into effect in 2003. In order to build a track record of sound performance towards a successor PRGF arrangement, we wish to request that the staff of the IMF monitor performance under our 2002 program, which is described in the attached Memorandum of Economic and Financial Policies (MEFP).

3. The Government and Central Bank of Yemen believe that the policies outlined in the MEFP are adequate to achieve the program objectives. The main risk to the program objectives arises from the expenditure pressures that have built up as a result of higher oil prices, particularly for the financing of development projects. We stand ready, nonetheless, to take additional measures, as necessary, to meet the program objectives, and we will discuss with IMF staff any changes in the program objectives that may occur in the course of the year.

Republic of Yemen
Memorandum of Economic and Financial Policies

August 3, 2002

1. The main budgetary and financial objectives for 2002 are to consolidate the gains made in terms of macroeconomic stability, protect these gains against the risks of volatile oil prices, and maintain policies that are fiscally and externally sustainable over the medium term. At the same time, the government intends to pursue actively its structural reform program with the objective of mobilizing additional non-oil revenues over the medium term, rationalizing and improving the quality of spending, as well as strengthening the economic and financial management of the country. The pursuit of these objectives is consistent with the objectives of the Poverty Reduction Strategy Paper.

2. The government believes civil service reform to be a core element of the reform process. Without it, little progress can be expected in the quality of public government services and private sector development. Thus, a number of specific measures in the civil service area are targeted for 2002. The 2002 program will also target actions in the areas of tax and customs reform, and expenditure management.

Public finances

3. Fiscal policy is guided by the objective of maintaining expenditure restraint in 2002, so as to place public finances on a sustainable medium-term path consistent with the projected decline in oil revenues starting in 2003. Based on current proven reserves and making some allowance for the coming on line of new oil fields starting in 2004, government oil revenues are expected to decline from US$2.4 billion in 2001 to US$1.6 billion by 2005. Unless steps are taken to mobilize alternative sources of revenues and rationalize spending, the resulting deficits will threaten macroeconomic stability. In the absence of such measures it will also be difficult for the government to find the resources to finance its poverty reduction strategy.

4. In line with the above objectives, the 2002 fiscal program targets the containment of overall expenditures at YRls 574 billion, or 35.9 percent of GDP. This target reflects the 2002 budget approved by parliament in February as well as some expenditure carryover from last year (on account of border demarcation and electricity repairs), but also makes allowances for additional spending that is expected in the following areas: defense, due to the cost of the anti-terrorism campaign; education, due to court-ordered increases in the salaries of teachers; transfers to the Public Electricity Company to support its restructuring; diesel fuel subsidies, owing to the higher price of oil relative to the budget assumption; and development spending, due to the need to cover the cost of ongoing projects which, following a clarification of the local authorities law, will fall on the central government. The Government has also agreed to proceed with the implementation of the road tax on fuel and will do so at the earliest opportunity.

5. On the revenue side, we are targeting a stabilization of non-oil revenues in relation to GDP. To the extent that the recent rise in oil prices will be sustained, oil revenues should exceed budgeted amounts by a significant margin. On the basis of an average oil price assumption of just under US$22 per barrel for Yemeni crude in 2002, the overall budget would register a deficit of 0.6 percent of GDP in 2002.

Civil service and pension reform

6. The real value of government wages and salaries in Yemen remains grossly inadequate, particularly at the higher grades of the civil service, and the quality of the civil service has suffered as a result. At the same time, at over 8 percent of GDP in 2002, the government wage bill continues to weigh heavily on the budget. Overemployment and inadequate control over the civil service payroll have over time contributed to these problems. The government is committed to addressing these shortcomings through a comprehensive civil service reform program which aims to create a leaner, better paid and more effective civil service.

7. Progress has already been made in this direction with the completion of a census of the civil service, the establishment of a computerized data base of civil servants, the launching of restructuring plans in 6 pilot ministries and agencies, and the establishment of the Civil Service Fund. In the course of 2002, the Government has set for itself a number of additional targets, including:

• Completing the transfer of at least 11,000 civil servants into the Civil Service Fund by end-2002,
  
• Retiring all remaining (15,478) overage civil servants by end-2002,
  
• Issuing biometric cards to at least 200,000 civil servants by end-2002, with the objective of identifying double dippers and ghost workers and removing them from the payroll by end-2002,
  
• Adding the customs administration to the list of pilot agencies for civil service reform, and
  
• Containing gross recruitment by the ministry of civil service at 9,700 in 2002, as agreed in the budget.

Expenditure management

8. Effective budgeting and expenditure monitoring systems are essential to improving the quality of public spending and to the transfer of budgetary responsibilities to the local authorities. Advances have been made in the area of budget preparation and execution under the SEFM project. However, with the preparation of a poverty reduction strategy, a strengthening of these practices is needed to effectively translate government priorities into budgetary objectives and to monitor outputs.

9. To that end, the following actions will be targeted in 2002:

• Establishment of an explicit linkage between the civil service data base and the budgeted wage bill for the 2003 budget and
  
• Establishment of a system to plan and track poverty-related spending, starting with the 2003 budget.

Tax and customs reform

10. In order to modernize the tax system and improve revenue collection over the medium term, a number of important initiatives will be undertaken in 2002. We have decided to postpone implementation of the General Sales Tax (GST) that was signed into law in January 2002 in order to address its shortcomings in consultation with the business community. Successful tax reform requires effective administration. With this goal in mind, we will complete, by end-June 2002, a reorganization of the Large Taxpayer Unit (LTU) along the lines of a function-based organization. In accordance with the presidential decree establishing the LTU, we will also create a taxpayer service division within the LTU in September 2002.

11. Meanwhile, with the assistance of the IMF's Fiscal Affairs Department, we will conduct a broad review of the indirect tax system with a view to developing a more integrated approach to tax reform that takes more explicitly into consideration the tax losses caused by widespread smuggling. The results of this review will help map out a reform program for indirect taxation, which will include the strengthening of the GST law.

12. With imports exceeding 30 percent of GDP, an efficient customs administration is central to successful revenue collection. Considerable progress has been made in modernizing the customs administration, as witnessed by the implementation of the first phase of the ASYCUDA project at the Sana'a airport. In 2002, we plan to fully introduce the ASYCUDA system in Hodeida and Haradh, as well as to begin its introduction in Aden. We will also begin to develop a valuation data base for a sample of 20 goods.

Monetary and exchange rate policy

13. We believe that broad money targeting continues to be the most appropriate nominal anchor for Yemen. Consistently with our objective of reducing inflation to single digits by end-2002, we have targeted broad money growth of 16 percent for this year. This target corresponds to a reserve money growth target of 13.7 percent, taking into account the trend increase in the money multiplier. Given the additional increase in government deposits at the central bank, the reserve money target is to be backed by an increase in central bank net international reserves of US$394 million in 2002.

14. We will continue to manage the exchange rate flexibly. We will allow the exchange rate to float freely, but will intervene in the foreign exchange market when temporary pressures develop.

Program monitoring

15. The program to be monitored by the staff of the IMF is based on quarterly structural and quantitative targets. The structural targets are listed in Annex II and the quantitative targets in Annexes III and IV. The targets and the conditions under which they will be adjusted in the course of the program are defined and explained in Annex V.