Report No. 16147-YEM Republic of Yemen Public Expenditure Review November 27, 1996 Country Operations Division Country Department II Middle East and North Africa Region Document of the World Bank This report is based on the findings of a mission which visited Yemen between March 9 and 28, 1996. The mission consisted of the following staff members and consultants: Sudhir Chitale (Mission Leader), Ishac Diwan (Adviser), Nelly Batchoun (Transfers to Public Enterprises), Sethaput Suthiwart-Narueput (Sectoral Analysis), Youssef Fuleihan (Agriculture), Sarosh Sattar (Health and Education), George Tharakan/James Reichert (Transport), Josephine Masanque (Power), Alexander McPhail (Water), Sulayman Al Kudsi, Nicholas van der Windt and Marion Eeckhout (Consultants). The report also draws on the substantial ongoing project work in the World Bank. Messrs. John Hansen, Ehtisham Ahmad and Ms. Antonella Bassani were peer reviewers for the report. Finally, we gratefully acknowledge the substantial help and hospitality we received during the preparation of this report from many officials of the Government of Yemen especially those in the Ministries of Planning and Development and of Finance. A draft of this report was discussed with the Yemeni authorities during the course of a mission to Yemen in November 1996. The suggestions and comments received have been incorporated in the present report. Vice President : Mr. Kemal Dervi, Director : Mr. Inder K. Sud Division Chief : Mr. Adil Kanaan Staff Member : Mr. Sudhir Chitale Exchange Rate As of February 3. 1995: Primary Official Exchange Rate: YR12/US$ Parallel Market Exchange Rate: YR1 15/1US$ As of September 1996: Exchange Rate for the Budget: YR100-1 15/US$ Parallel Market Exchange Rate: YR125-130/US$ ABBREVIATIONS AND ACRONYMS AREA Agricultural Research and Extension Authority BOO Build Own and Operate BOP Balance of Payments CACB Cooperative and Agricultural Credit Bank CAMA Civil Aviation and Meteorological Authority CBY Central Bank of Yemen CPI Consumer Price Index CPPR Country Portfolio Performance Review CSO Central Statistical Office ERC Economic Recovery Credit ESMAP Energy Sector Assistance Program GAEI General Authority for Educational Institutions GAREWS General Authority for Rural Electrification and Water Supply GCRB General Corporation for Roads and Bridges GDP Gross Domestic Product GLTC General Land Transport Corporation GNP Gross National Product GOY Government of Yemen GWH Giga Watt Hour HBS Household Budget Survey HTB High Tender Board IDF Institutional Development Fund IDA International Development Association IFAD International Fund for Agricultural Development IMF International Monetary Fund IMR Infant Mortality Rate KfW Kreditanstalt fir Wiederaufbau MAWR Ministry of Agriculture and Water Resources MCSAR Ministry of Civil Service and Administrative Reforms MEW Ministry of Electricity and Water MOC Ministry of Construction, Housing and Urban Planning MOE Ministry of Education MOF Ministry of Finance MOPH Ministry of Public Health MOT Ministry of Transport MW Mega Watt NGOs Non-Govermnental Organizations NWRA National Water Resources Authority NWSA National Water and Sanitation Authority O&M Operation and Maintenance PEC Public Electric Corporation PEs Public Enterprises PDRY Peoples' Democratic Republic of Yemen ROY Republic of Yemen STC Surface Transport Company YAR Yemen Arab Republic YPA Yemen Ports Authority YPC Yemen Petroleum Company YR Yemeni Riyal YR/KWH Yemeni Riyal Per KiloWatt Hour REPUBLIC OF YEMEN PUBLIC EXPENDITURE REVIEW Table of Contents page No. Preface Executive Summary (Arabic) ............................................... i-xvii Executive Summary (English) ............................................... xviii-xxix Chapter 1. Macroeconomic Developments and Fiscal Adjustment ...........................I A. Economic Developments Since Unification, 1990-96 ....................................1 B. Fiscal Deterioration .............................................2 C. Government's Reform Program ..............................................4 D. Medium Term Macroeconomic Framework ............................................. 5 E. Resource Envelope for Public Expenditure .............................................. 6 Chapter 2. Restructuring Public Expenditure ............................................... 10 A. Strategy for Restructuring ............................................. 10 B. Wage Bill and Public Sector Employment ............................................. 13 C. Subsidies and Protecting the Poor ............................................. 18 D. Budgetary Transfers ............................................. 25 Chapter 3. Sectoral Expenditure Programs ............................................... 31 A. Development Strategy and Structure of Expenditure ......... ......................... 31 B. Issues Common to all Sectoral Expenditure Programs ................................. 34 C. Agriculture ......................................... 38 D. Education ......................................... 40 E. Health ......................................... 45 F. Power ......................................... 48 G. Water ......................................... 51 H. Transport ......................................... 56 Chapter 4. Operationalizing the PER ........................................... 61 Annex 1.0 Yemen -- Country At a Glance Annex 1.1 Financing Requirements Annex 2.1 Grades and Salaries (YR/Month) for Civil Servants, 1990-1995 Annex 2.2 Average Wage According to Education and Age of Civil Servants Annex 2.3 Beneficiaries Wheat and Flour Subsidies Annex 2.4 Subsidies on Petroleum Products Annex 2.5 Subsidy on Electricity Annex 2.6 Transfers to Public Enterprises Annex 2.7 Status of Privatization Effort March 1996 Annex 2.8 Government Share of Profits from Public Enterprises Annex 3.1 Budget for 1996 Annex 3.2 Ministry of Education, Branch (1) General Budget Estimates for the Financial Year 1996 Annex 3.3 Timetable for Settling Claims Annex 3.4 Yemen - Investment Program Annex 3.5 Technical Note - Projecting Public Expenditures in the Social Sectors Preface This report is based on a mission which visited Yemen in March 1996. The estimates for 1996 and beyond contained in this report are based on data available in March 1996. They are consistent with those presented in the Bank's documentation for the Economic Recovery Credit (ERC) and the published government budget for 1996. Recent (September) data show some improvements in Yemen's economic performance compared to what was expected in March in the following two areas: * First, there has been a significant improvement in the fiscal situation. Ihx cash deficit for the whole of 1996 is estimated to be around 2.5% of GDP. including pension payments. compared to 4.5% expected in March. The budget has benefited by about a 15% increase in oil prices in the past six months. Partly as a result of this improved fiscal outturn, the annualized inflation is now estimated to be about 9% compared to about 20% anticipated in March 1996. * Second, the oil price increase has also resulted in an improved balance of payments (BOP). The official gross foreign exchange reserves at end September were about $850 million compared to a year end target of $640 million set in March. Yemen also reached an agreement on debt relief at a Paris Club meeting held in September 1996, at terms which were in line with those presented in the report. Finally, with the tight fiscal conditions, and an improved BOP situation, the unified floating exchange rate has remained stable in the range of YR 125-128/$ over July-October without Central Bank intervention. These positive developments have, however, yet to be translated into substantial growth in the non-oil sector. With the reduction in inflation, the interest rates have become substantially positive, putting a dampening effect on ne'w investments. Similarly, there has been no spurt in new foreign investments or remittances. Over the medium term, the oil production and price forecasts continue to remain in line with those contained in the report. 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L., "-ibi L..~-A^ e>SjJ&L: "S--i LL-I- JsL-J I jAl .ja zL A t. uY "I J -):6MU 2---Iwl yllr4 -Wala a i;(5LIv .4:Ajutj jul cp"SY -*JLulI+Ji L >) --------000-------- Yemen - Public Expenditure Review Executive Summary I. Overview 1. The government of Yemen is in the process of implementing a challenging economic reform program. The objectives of this are to reduce inflation, achieve a sustainable balance of payments and restore growth based on an expansion in investment. In order to meet these objectives, as per the macroeconomic framework' discussed in Section II of this executive summary, Yemen would need to restructure public expenditures as well as significantly reduce them from their present level by the year 2000. This report outlines a restructuring strategy which involves generating savings through a reduction in subsidies and transfers, and through sector specific efficiency improving policies. The savings thus generated could be deployed to increase outlays on operations and maintenance, capital expenditures, developing a targeted social safety net for the poor who may suffer, at least transitionally, from the reform and for improving the working of the civil service. Section III discusses the specific cross-sectoral policies recommended to restructure the expenditures on wages, subsidies and transfers. Section IV discusses the issues in restructuring sectoral expenditure programs including correcting the imbalance between capital and operating costs, reorganizing institutions to improve efficiency, improving the implementation of projects and implementing appropriate cost recovery measures. II. Macroeconomic Framewor Fiscal Deterioration 1990-95 2. Over 1990-94 Yemen experienced severe economic difficulties arising from a series of shocks such as the Gulf war, the collapse of the Soviet Union, problems of unification of two very different political and economic systems, and the civil war. Output fell, unemployment increased, and the economy faced severe balance of payments difficulties, including an inability to service external debt. 3. A sharp deterioration in public finances has been at the heart of Yemen's recent economic problems. This deterioration resulted from the government's response to the external shocks by a series measures such as acting as an employer of last resort to the returnees, retaining workers of public enterprises and by increasing subsidies to protect living standards. As a result: I Discussed in detail in Chapter 1 of the report. - xix - * The overall budget deficit increased to over 16% of GDP during 1992-94 from about 10% in 1991, resulting in high inflation which reached over 60% in 1995. * There was also a deterioration in the structure of budgetary expenditures in terms of their contribution to growth. Much of the increase in expenditures was due to an increase in government employment and poorly targeted subsidies at the expense of crucial outlays on operations and maintenance -- which remained at only 3% of GDP; and development expenditures which fell from 11% of GDP in 1990 to only 3.3% by 1995. This led to a deterioration in public services and long term growth potential. The Resource Envelope 4. The objectives of the government's reform program are to reduce inflation and achieve a GDP growth of almost 5% p.a. by the year 2000. The growth objective would require an acceleration in total investment from about 14% of GDP in 1996 to about 20% by 2000 on the basis of an Incremental Capital Output Ratio (ICOR) of about 4.2. This investment would be financed by foreign savings, private domestic savings and public savings. 5. Balance of payments projections consistent with such a growth target show that the availability of foreign savings2 is constrained by the high debt burden, modest prospects for oil exports and the limited availability of official concessional finance. The prospects for an increase in private domestic savings are also limited by low per capita income and the impact of a withdrawal of subsidies on incomes. This means that public savings need to be increased, or the budgetary current account deficit must be decreased from about 2% of GDP in 1996 to a surplus of at least 4% of GDP by the year 2000. Including budgetary capital expenditures, the overall budget deficit needs to decline from 6.2% of GDP in 1996 to about 2.4% of GDP by 2000. 6. The prospects for further reducing the overall budget deficit by increasing revenues are modest and therefore most of the adjustment in the future is likely to fall on expenditures. Oil revenues, estimated to be nearly 80% of budgetary revenues in 1996, cannot be increased further in the future because oil production is expected to decline beyond 1997. Non-oil revenues could only be increased by implementing a difficult tax reform centered around the introduction of a general sales tax. Even if this program was implemented, over the medium term, the fiscal revenue would remain at the 1996 level of about 31% of GDP. This means that total expenditures have to be reduced from the 1996 level of about 37.6% of GDP to about 33.5% of GDP by 2000 to meet the deficit reduction targets. Given the need to increase capital expenditures, the fall in current 2 Foreign savings are defined as the net exports of goods and services. - xx - expenditures will have to be even higher--from 33% of GDP to 27% of GDP, highlighting the need for a substantial expenditure adjustment program. Restructuring Strategy 7. A restructuring strategy to meet the objectives of the reform program would involve generating savings by: (i) replacing subsidies on wheat, petroleum and electricity by a cheaper, targeted social safety net; (ii) reducing transfers to public enterprises; and (iii) implementing sector specific efficiency improving policies. These savings could then be deployed to: (i) increase outlays on capital expenditure to develop infrastructure and strengthen the basis for long term growth; (ii) increase operations and maintenance expenditures to improve the utilization of existing facilities; and (iii) to improve the efficiency of the civil service. III. Cross Sectoral Policies Reform of Wage and Employment Policies 8. The wage bill in Yemen is very high, amounting to about 13.5% of GDP in 1995. This is due to a rapid rise in employment, especially in the lower grades, rather than a liberal wage policy. Over 1990-95 real wages for civil servants have fallen by 80% while the employment has doubled. Further, in Yemen, the compression ratio--the ratio of the highest to the lowest salary is only 3 compared to around 9-12 in more developed administrations. Such a salary structure creates disincentives amongst the senior servants. In order to improve the quality of public service the government is considering initiating a comprehensive civil service reform. It is recommended that elements of such a reform include, a freeze on gross recruitment into government service, eliminating retired and ghost workers, transferring workers from cities to provinces, and developing a menu of severance packages for excess workers. Although in the medium term such a program would result in a reduction in the wage bill, in the near term, the savings generated from the elimination of ghost and surplus workers are likely to be counter balanced by the cost of severance packages, costs associated with transferring civil servants from cities to rural areas, and the need to raise salaries of senior civil servants in order to rationalize incentives. Subsidies and Protecting the Poor 9. The current system of universal - untargeted - subsidies for wheat, petroleum and electricity is very inefficient and expensive, amounting to almost 9% of GDP in 1996. For wheat, nearly 25% of the subsidy goes to smuggling and inefficiencies in the procurement system. In addition, because the subsidy is untargeted, i.e., equally available to all consumers, of the total subsidy, only 6.7% reaches the bottom 20% of households. However, an outright elimination of subsidies would hurt the poor because wheat is an important component of their consumption basket. Therefore the elimination of subsidies needs to be accompanied by the introduction of a targeted social safety net. A possible - xxi - cheaper alternative to the present system of subsidies is the wheat voucher system described in detail in para. 2.23 in the main report. Although the voucher system could substantially reduce the outlay on subsidies, it could prove to be administratively complex. It would therefore be a good idea to test the feasibility of the voucher system by implementing a pilot project in a province before extending it to the whole country. In the medium term, the best form of assistance to the poor will be through employment creation, increased provision of social services especially in the rural areas, and encouraging NGOs to deliver assistance to the poor. Such a program is being developed by the government in the context of the proposed IDA-supported Social Fund for Development. In the short term, the safety net could consist of implementing the civil works program (being supported by an IDA credit) to generate employment, charging low tariffs for the first block of electricity consumption, cross-subsidizing kerosene and developing the wheat voucher system. Budgetary Transfers 10. Current and capital transfers, which are estimated at about 4.7% of GDP in 1996, provide one more source of potential savings. Within transfers, there are two areas where potential savings could be realized. First, are transfers to social welfare, medical grants and "other" ad hoc transfers, carried out through the Ministry of Finance amounting to 1.4% of GDP. These programs could be combined with other programs in the social sectors and redesigned to improve their efficiency and generate savings. Second, it should be possible to reduce the transfers to all public enterprises (PEs) from an estimated 1.9% of GDP in 1996. In the short term this could be achieved by increasing the prices of goods and services they produce, and over the medium term, through privatization, and where needed, liquidation. The government has launched a comprehensive privatization program supported by technical assistance from the IDA under the Economic Recovery Credit (ERC). As of March 1996, out of the 100 PEs targeted for privatization, 16 PEs have been brought to the point of sale/liquidation, work has progressed on an additional 60 enterprises while the remaining have merely been identified for sale. IV. Sectoral Expenditure Programs Intersectoral Priorities 11. Yemen's sectoral expenditure priorities are broadly evolving in the right direction. Yemen has ceased any new public investment in manufacturing, oil and gas and other purely commercial activities. Existing PEs in manufacturing inherited from the south at unification as well as agricultural farms and enterprises engaged in commercial activities are covered by the recently launched comprehensive privatization effort. The remaining public investment is in infrastructure -- mainly road construction, in human resource development and in electricity. In agriculture, the program consists of building capacity for research and extension, and projects for irrigation and water conservation -- areas normally in the domain of the public sector. - xxii - 12. The main challenge before the authorities is, however, setting priorities for public expenditures within a very tight resource envelope. At present, Yemen's needs for public expenditures are very high. In almost all sectors a strong case may be made to increase recurrent expenditures and find public investment projects with very high returns. In view of the tight resource envelope, however, hard tradeoffs have to be made at the margin between urgently needed recurrent expenditures in different sectors and further prioritize projects with high returns. 13. Section 3.1 in the main report, compares the proposed priority expenditures for 1996-98 with the resource envelope dictated by the macroeconomic framework. Priority expenditures are estimated on the assumption that the sectoral policy reforms to restructure expenditures (identified below in paras. 16 and 17) are implemented while achieving the sectoral and macroeconomic objectives of the reform program. In making the expenditure projections the first priority is given to making adequate provisions for O&M and other recurrent expenditures to fully utilize the current facilities and those coming on stream in 1996-97. The priority capital expenditures are estimated on the basis of first completing ongoing projects with high returns. New projects are few and should be initiated only if the existing capacity is fully utilized and adequate recurrent resources are available to operate new capacity coming on stream. 14. Even with the highly selective approach described above, as indicated in Table 3. 1, in the main report, the total priority expenditures for 1996-98, exceed the resource envelope dictated by the macroeconomic framework. Priority current expenditures are roughly in line with the resource envelope, while priority capital expenditures exceed the resource envelope by nearly 30%. 15. Thus further prioritization of the proposed priority investment program is necessary to stay within the overall resource envelope3. This requires increased selectivity in all sectors to ensure that only projects with highest returns are continued. On the basis of the sectoral analysis presented in sections G-H inr the main text, the following are possible candidates for realizing further savings4: * The electricity investment program could be further prioritized by protecting the investments in transmission and distribution -- which have high returns and slowing the expansion in generating capacity. The extension of the Hadramawt power station and the construction of the Marib power station 3 This assumes that the institutional problems in sectors which affect project implementation are resolved and the government is able to spend the full allocation of the capital budget. In the past, the government managed to spend only 70% of the capital budget (see section 3B). If institutional constraints are not resolved, expenditures could well remain within the envelope. However, the cuts would not necessarily fall on the lowest priority projects and could therefore adversely affect growth. This is only one possible pattern of expenditure reduction to stay within the overall resource envelope. It is possible for the government to choose to protect the investments in electricity - but this would, for example result in falling short on targets to expand education and health or water. - xxiii - could be delayed to beyond 1998. Finally further savings on public resources could also be achieved by accelerating the privatization program, the preparation of BOO schemes for foreign participation and finally implementing a faster increase in electricity prices to equal the long run marginal cost. Savings are also possible for the nearly YR2 billion p.a. (about 8% of the total investment program) GAREWS program for small water and electricity projects. * Further savings are also possible in the large road construction program. This could only be done after the detailed analysis of the ongoing projects being carried out under the transport rehabilitation project is completed. Similarly, nearly half the public resources planned for the airport reconstruction program could be saved if the privatization program is rapidly implemented. * Finally, the functional classification of the total expenditures shows that in 1996, only about 27% of the total expenditures can be identified as current and capital expenditures in specific sectors. Of the remaining, 56% are for interest payments, subsidies and defense, and an additional 17% are adhoc administrative expenditures whose developmental impact is often dubious. In short, even small improvements in efficiency/expenditures reduction in areas such as defense, administration could release large resources for increasing the growth potential of the economy. Issues Common to Sectors 16. There are three issues common to most sectoral expenditure programs. First, in almost all sectors the allocation of Operations and Maintenance (O&M) expenditures is inadequate to operate existing facilities and those coming on stream upon completion of ongoing projects. Second, the data base on projects is weak. For most projects no data are available on the original cost of the project, expenditures carried out so far and the extent of its physical completion. This makes it very hard to project investment needs into the future. Third, project implementation faces severe problems. The main reasons are a weak and low-paid though very large civil service, and the institutional constraints. A particular problem is the complex and centralized system of disbursement of funds against amounts approved in the budget which results in inordinate delays in project implementation. Addressing these problems would involve the following actions. * In all sectors, before initiating new projects which add to new capacity, additional resources must first be deployed to increase the O&M expenditures to fully utilize the existing facilities as well as those coming on stream by projects currently under implementation. - xxiv - * Improve the data base for the projects. First, a reliable data base for projects has to be developed to include the total cost of the project, amount spent so far and the financing needed for completion. This is necessary to set priorities consistent with available resources. Second, small schemes should be aggregated for planning purposes into a smaller, manageable number of expenditure programs so that their relative priorities could be assessed. Currently, the government is engaged in creating a computerized data base for all ongoing projects with the assistance of the KfW. Completion of this work would provide inputs to further work in this area. * Improve project implementation. To begin with, the civil service reform being considered by the Government would improve administrative efficiency and result in improved project planning and execution. Working closely with the authorities, IDA's Country Portfolio Performance Review (CPPR) process has already succeeded in streamlining the procedures for IDA-financed projects. Prior to this review,5 all tenders above $0.2 million were sent to the High Tender Board (HTB) which had become a bottleneck. Under the CPPR, the limit of tenders needing the HTB approval has been increased to $1 million. Further, contractors are now denominating their contracts in foreign currency rather than in Riyals and there is improved compliance with audit reporting and submission of financial statements. An IMF study carried out in April 19966 also makes a number of suggestions in the area of budget execution, expenditure control and government accounting. These include: devolving more spending powers to the spending agencies, disbursing funds to the spending agency according to a quarterly as against monthly advance schedule of work and giving greater freedom to the spending agency to reallocate expenditures between budget subitems. This report is currently being used to develop a financial management improvement program. Sector Specif c Expenditure Restructuring Policies 17. In addition to the policies common to all sectors, the expenditure restructuring policies recommended for major sectors are listed below. Agriculture Privatize agricultural parastatals which are currently engaged in purely commercial activities, to reduce the transfers from the budget as well as to improve their operational efficiency. These parastatals include, the Machinery 5 These were mainly focused on IDA projects rather than the "systemic" problem of the investment programn. 6 Republic of Yemen, "An Evaluation of Government Budgetary, Accounting, and Expenditure Control systems", IMF, April 1996. - xxv - Rental Stations, Mareb Poultry Company, the General Organization for the Marketing of Fruits and Vegetables, General organization for Drilling and the General Organization for Agricultural Services. Eliminate subsidies on wheat to remove the bias against domestic production as well as to reduce the burden on the budget. The program for the elimination of these subsidies is discussed in Chapter 2 in the main report. Substitute the current import ban on fruits and vegetables with a tariff to enhance revenues and promote efficiency in production. This policy is being supported by the Bank's Economic Recovery Credit (ERC). CACB should be exposed to market forces to improve its efficiency. The highly subsidized, negative lending rates should be raised to levels closer to market rates, and the recovery rates should be raised substantially. Administrative costs should also be reduced considerably by reducing the overstaffing. Raise the incomes of the displaced tenants and other very poor people living below the poverty line, in the four southern governorates through irrigation development and promotion of off-farm economic activities such as micro- enterprise development, fisheries and tourism related business. This priority program is expected to be supported by the proposed IDA-supported Southern Govemorates project. Improve productivity in agriculture by improving the availability of quality seeds and by upgrading extension and research services. This program is expected to be supported by the proposed IDA-assisted seeds and services project. Education Increase recurrent budgets to ensure that all the existing facilities and those coming on stream during 1996-98 are fully utilized. Make budgetary allocations to Governorates by developing a formula which accounts for differences in enrollment rates, population, migration, and unit cost differentials. Eliminate mandatory fees in elementary and secondary schools. These fees do not mobilize significant revenues, and can act as a significant barrier to enrollment, especially for girls. Upgrade physical facilities in schools especially by providing toilets and washrooms to create an environment to attract and retain more female students. - xxvi - Currently school buildings are overdesigned. Building designs could be revised to reduce costs by as much as 20%. Priority expenditures in education are estimated on the basis of an expansion in the enrollment rate of girls at primary school from 35% in 1996 to 50% by 2000 and maintaining boys rate at its comparatively high current level of 80%. (See Annex 3.6.) Health Increase O&M budget for the Ministry of Public Health (MOPH). Restrict investment in new health facilities until existing health centers and district hospitals have adequate supply of essential drugs and equipment. Increase the availability of health workers in rural areas. Retain the present model of full public finance for (a) purely preventive activities e.g. malaria control, vaccinations; and (b) catastrophic care, while moving to increased cost-sharing for other services. Develop quality secondary care facilities in major regional centers to address the dual problems of (a) providing the full-range of health services to a widely dispersed population and (b) increasing tendency to by-pass primary care facilities and go straight to tertiary facilities. These facilities could be run in partnership with the private/ NGO sector with public finance being complemented by cost- sharing with beneficiaries. Power Further prioritize the PEC program by emphasizing transmission and distribution projects and slowing generation projects. Increase electricity tariffs to allow PEC to achieve and maintain a break-even position and restrict demand growth to about 6% p.a. over 1996-2000. Settle inter-enterprise arrears between PEC, the Yemen Petroleum Company (YPC) and major consumers of electricity. Prepare the grounds for an eventual privatization of PEC. Give PEC more managerial autonomy. Create an regulatory framework to encourage private sector participation in the power sector. - xxvii - Water Expand the mandate of NWRA to include all water resource planning, assessment of water sector investments and donor coordination. To return water use to a sustainable level Support NWRA institutionally as well as financially to enable it to develop regional water management plans, with priority given to particularly vulnerable areas such as Taiz and the Sana'a basin. NWRA should begin to test the feasibility of the licensing and control of wells and drilling rigs to control the mining of groundwater. NWRA, together with the MAWR should develop a program for water conservation in agriculture. Such a program could include: further research and extension in irrigation, subsidies to maintain terraces and giving users the responsibility for spate irrigation schemes. Facilitate Transfer of Water From Rural to Urban Areas Carryout a program of exploration and development of new sources of supply for cities in the context of the regional management plans being developed by NWRA. Set up a regulatory framework which defines ownership, rights to market and rules for conservation to develop the current informal water markets to allow a sustainable transfer of water from rural to urban areas. To increase the availability of safe potable water For rural areas, expand the GAREWS program especially in the poorer Governorates such as Dhamar, Al-Beida and Al-Mahwit. In expanding the GAREWS program emphasize community participation and ownership of projects. For urban areas, implement a two stage restructuring plan for reforming NWSA. In stage 1, decentralize NWSA and grant autonomy to regional offices. In stage II, convert the regional offices into corporations and invite private capital and management to participate in these regional corporations. Create a framework for expanding the role of the private sector by passing legislation defining the rights and duties of private operators and developing a series of model concession agreements for organized private supply to towns. - xxviii - The urban program should be carefully prioritized by first focusing on towns where water is very short. Transport In the road transport sector, make the Yemen Road Fund created with IDA assistance operational to generate the financing necessary for road maintenance. In the near term, improve the working of the intracity operations of the General Land Transport Corporation (GLTC) by creating autonomous municipal authorities, contracting the services to private operators and making subsidies explicit. In parallel, privatize the intercity transport operations of GLTC. In the civil aviation sector, complete the ongoing investments for the emergency rehabilitation of Aden and Sana'a airports. Increase the overflight charges and improve their collection to make the Civil Aviation and Meteorological Authority (CAMA) profitable. In parallel, invite private participation in CAMA investments as well as operations except in the provision of air navigation services. Complete the merger of the two airlines (Yemenia and Al Yemen) and prepare them for privatization. In the port sector, invite private participation in investment as well as operations of the Aden port. The Aden port has the potential to be an independent profit center requiring no budgetary support. Some complementary public investment is, however, required for institutional strengthening and key equipment such as tugs and container handling equipment. Operationalizing the PER 18. The findings of the PER have operational implications in three areas. First, the resource envelope estimates in the PER could be used as an input into the discussion of the Five Year Plan. The macroeconomic framework could be updated to provide estimates of sustainable level of public investment to the annual budget exercise, which can be carried out within the framework of a three year rolling plan. 19. Second, The PER brings together in an integrated framework three issues which have a high priority in the government's reform effort. The analysis on the civil service, which uses civil service survey data could be used as a basis to define the elements of a civil service reform. The analysis of subsidies could be further refined to design a social safety net and as an input into the design of the food voucher scheme. The analysis of the household budget survey data could also be used in the design of the Social Fund project. Finally, the analysis of the transfers to PEs needs to be extended further to assess the implication of the government's privatization efforts to the budgetary transfers. 20. Third, the analysis of the PER needs to be extended to formulate sector strategies and expenditure programs within the overall resource envelope. First, more analysis is - xxix - needed of the issues of inadequacy of O&M budgets, poor project implementation and lack of counterpart funds. The work could be done by forming a series of working groups within the government with participation from the World Bank and other donors to identify the reasons for inadequate O&M budgets and work out the resource implications of fully meeting these needs. The lessons of the Country Portfolio Performance Review (CPR) for IDA - supported projects could be extended to all projects to improve project implementation. Second, more analysis is needed to improve the effectiveness of the sectoral expenditure programs. Better information is needed to assess the outlays needed to complete ongoing projects in health, education and road construction. Following this, the overall sectoral expenditure program could be assessed by a working group consisting of the government, the Bank and other interested donors. 000 - Chapter I Macroeconomic Developments and Fiscal Adjustment1 A. Economic Developments Since Unification, 1990-96 1.1 Beginning in 1990, the Yemeni economy was adversely affected by a series of external shocks and domestic upheavals: * Gulf war: The Gulf war led to large return migration which amounted to nearly 10% of the population and a decline in the aid from the Gulf states. Over 1990-96, workers remittances dropped from $1.5 billion in 1990 to 1.1 billion in 1996, i.e., from 100 to 50% of merchandise imports, and external assistance dropped from 40 to only 7% of merchandise imports. * Collapse of the Soviet Union: This resulted in a decline in the aid to the south and left a heavy burden of external debt. * Unification: The unification resulted in the deterioration in public finances due to the costs associated with the merger of the two civil services as well as the burden imposed by the money losing public enterprises inherited from the south. * Civil war: This led to a sharp increase in military spending, extensive damage to productive facilities and also contributed to deteriorating public finances. 1.2 Output: The adverse effects of the civil war and the break-up of the former Soviet Union, resulted in a sharp decline in GDP in 1990-91. The GDP, however, rebounded in 1992 and 1993 to about 5% p.a. on average due to favorable rains in 1992 and an increase of 19% in oil production in 1993. Although oil production increased by a further 56% in 1994 due to the coming on stream of new fields, output in the non-oil sectors declined by 5.6% due to the effects of the civil war, resulting in a stagnant overall GDP in 1994. GDP, however, is estimated to have grown by about 3.6% in 1995 and is further expected to grow by 2.5% in 1996 due to the continued increase in oil production combined with a return to normality following the civil war. 1.3 Inflation: The uneven GDP growth was accompanied by a sharp rise in urban inflation. Measured by the CPI, urban inflation accelerated from about 30% in 1990 to almost 65% by 1994, despite attempts to repress it through controlling prices of key commodities. Fiscal measures implemented beginning 1995 (see Section 1 C) reduced the This chapter focuses on the fiscal problems facing Yemen. For a more detailed description of the trends in the Yemeni economy, see: Yemen, "Country Assistance Strategy ", January 1996, and Yemen, "Report and Recommendation of the President, Economic Recovery Credit (ERC)", February 1996. -2 - inflation to about 44% in 1995 and are expected to reduce it further to about 20% by the end of 1996. Because of stagnant per capita output in recent years, and the depreciation of the exchange rate, per capita GNP for 1994 in US$ terms per Bank's Atlas methodology, is estimated at only $280. 1.4 Balance of Payments: The balance of payments continued to suffer from structural weaknesses such as a heavy dependence on private transfers, a limited export base (non-oil exports accounted for less than 10% of total exports of goods in 1994-95), and volatile crude oil export revenues. The current account deficit before grants widened from 24% of GDP in 1992 to 30% in 1993. Due to a doubling of oil export revenues in 1994 and a further increase in 1995, this deficit turned into a surplus of 5.2% of GDP in 1994 and 2.1% of GDP in 1995. These surpluses have, however, not been sufficient to finance the debt obligations falling due and contractual repayments to oil companies. This has led to the accumulation of arrears, which amounted to almost $5.2 billion by end 1995. B. Fiscal Deterioration 1.5 A sharp deterioration in public finances has been at the heart of Yemen's recent economic problems. This deterioration resulted from the government's response to the shocks in an atmosphere of intense political competition between the two political parties immediately following unification. The government took it upon itself to smooth the effects of the negative shocks through a series of populist measures. * The government acted as the employer of last resort for the returnees and new university graduates. It also retained workers of defunct pubic enterprises on the government payroll. * The government tried to protect the living standards by increasing subsidies on wheat, flour, petroleum products and electricity. * Defense expenditures increased as a result of the civil war. 1.6 The deterioration in public finances (Table 1.1) had two dimensions: * First, the overall deficit on a cash basis increased to over 16% of GDP during 1992-94. As access to external financing dried up, these fiscal deficits were financed through domestic bank financing and resulted in high inflation. * Second, there was a deterioration in the structure of the budgetary expenditures in terms of their contribution to growth. Much of the increase in expenditures was due to an increase in government employment and poorly targeted subsidies. This came at the expense of crucial outlays on operations and maintenance -- which remained at only 3% of GDP; and development expenditures which fell from 11% of GDP in 1990 to only 3.3% by 1995. - 3 - This led to a deterioration in public services and constrained growth (due to the squeeze in capital expenditures). Table 1.1: Central Government Finance, 1990-96 (% of GDP) 1990 1991 1992 1993 1994 1995 1996 Act Act Act Act Act Act Est. TOTAL REVENUES 23.7 28.5 21.9 20.4 14.2 21.7 31.4 Oil Revenue 10.1 13.4 7.1 6.5 4.3 11.5 21.1 Non Oil Revenue 13.6 15.2 14.9 13.9 9.8 10.2 10.4 TOTAL EXPENDITURES 42.0 39.5 40.7 38.2 31.7 29.7 37.6 Current Expenditures, (o/w) 29.6 32.8 34.8 34.5 29.2 26.4 33.4 Wages 20.4 22.5 24.2 24.1 19.6 13.5 11.6 Goods & Services 2.4 2.6 3.2 2.3 2.0 3.4 3.5 Defense (non-wage) 1.9 2.1 1.6 1.4 2.0 0.6 0.6 Interest 2.8 2.8 2.5 3.5 3.2 2.8 4.7 Subsidies ... ... ... ... ... 3.4 9.1 Current Transfers 2.2 2.8 3.2 3.3 2.4 2.1 3.2 Development Expenditures 12.4 6.6 5.9 3.8 2.5 3.3 4.2 OVERALL BALANCE (comm.basis) -18.3 -11.0 -18.8 -17.8 -17.5 -8.0 -6.2 OVERALL BALANCE (cash basis) -17.4 -9.9 -17.3 -16.6 -16.7 -7.0 -4.5 External Financing (net) 6.1 5.3 1.1 0.4 0.5 0.5 4.3 Domestic Financing (net) 10.3 6.0 16.0 18.6 17.5 6.5 0.3 Discrepancy 1.0 -1.3 0.1 -2.4 -1.3 ... ... Memorandum Item GDPatMarketPrices (YR Bill) 96.4 111.9 134.7 169.8 262.7 434.7 633.7 Source: Ministry ofFinance and the IMF. 1.7 The fall in the availability of operation and maintenance expenditures also affected the sustainability of projects. First, once projects were completed there were insufficient funds to operate the facilities created. Second, the nature of development expenditures changed, i.e., more and more "projects" were restructured as recurrent expenditures bunched together for additional donor financing. Donors seem to have reacted to this situation by financing more and more local costs. 1.8 The situation was exacerbated by severe implementation constraints which represents a more entrenched problem. These are: (i) Some categories of public sector employees have low salaries, which affects their efficiency. (ii) The budgetary system is complex and bureaucratic. (iii) The high inflation that had prevailed and exchange rate changes led to contracting difficulties. Civil works contractors were not willing to deliver on promises they had made when the exchange rate was much higher. This led to renegotiating the old contracts, further slowing down project implementation. In 1994, only 34% of the funds budgeted for projects were actually spent. -4 - C. Government's Reform Program 1.9 The government responded to the deteriorating economic situation by implementing a series of measures in 1995 which were further strengthened in 1996 and developed into a comprehensive reform program. The program consists of the following three main components: (a) macro-economic stabilization centered around a reduction of the fiscal deficit; (b) structural reform; and (c) social protection measures. The following section discusses the fiscal adjustment. 1.10 Fiscal Adjustment: The most pressing challenge that faced the authorities at the start of their reform effort in 1994 was the reduction of the fiscal imbalance and the resulting inflationary pressures. The government has already implemented a series of difficult fiscal measures 1995 and in 1996. As a result of these measures, the budget deficit on a commitment basis fell from 17.5% of GDP in 1994 to 8% in 1995 and is expected to fall further to around 6.2% by end 1996. 1.11 This adjustment was mainly due to increases in revenue. Of this large (nearly 11.3% of GDP) reduction in the deficit, 7.4% was due to an increase in revenue and the remaining 2.7% was due to a decrease in expenditure. Almost all the increase in revenue came from an increase in oil revenues, which multiplied nearly 12 times in Riyal terms from about 4.3 to 21.1% of GDP while non oil revenues remained at around 10% of GDP. The increase in oil revenues was mainly due to the revaluation of oil revenues going to the budget from YR1 2/$ to YR1 00/$ while oil production remained at about 340,000 barrels per day during 1994-96. Nevertheless, the additional fiscal measures implemented to merely maintain the share of non-oil revenues in GDP at about 10% of the total revenue were significant. These included: (i) depreciation of the customs evaluation rate; (ii) freeing up cement prices and increasing petroleum prices (80%); and (iii) increasing transport and communication prices. The main measure on the expenditure side was the reduction of the wage bill by almost 4 percentage points of GDP. This was, however, compensated by the increased burden of subsidies. As a result of these measures, inflation is estimated to have declined from 65% in 1994 to 44% in 1995 and is expected to fall further to 20% in 1996. 2 The government's program is being supported by a 15-month stand-by arrangement (SBA) from the IMF of SDR 132.4 million ($192 million) and a proposed IDA Economic Recovery Credit (ERC) of $80 million. Other components of the reform program, including exchange rate and monetary policies, are discussed in the documentation for the Economic Recovery Credit (ERC) and the IMF, "Staff Report for Request for Stand-By Arrangement", March 5, 1996. - 5 - Table 1.2: Macroeconomic Framework 1994 1995 1996 1997 1998 1999 2000 act act est. projected - National Accounts Real GDP growth (%/p.a.) 0 3.6 2.5 5.1 4.3 4.3 4.8 Oil Sector - 2.1 1.0 5.8 .7 .8 1.3 Non-Oil Sector - 4.3 3.7 4.8 5.2 5.4 6.0 GDP Deflator (Domestic Inflation, % p.a.) 64.6 43.4 20.0 10.0 5.0 5.0 5.0 Investment (%ofGDP) 9.7 10.1 13.7 15.6 16.6 18.5 19.7 Private 7.6 8.1 11.0 11.5 11.5 13.0 13.2 Public 2.1 2.0 2.7 4.1 5.1 5.5 6.5 Balance of Payments (% of GDP) Exports of goods andNFS 60.3 57.8 40.7 41.4 40.2 38.3 36.9 Imports of goods and NFS 65.5 65.9 52.5 54.9 54.3 53 51.6 Net exports of goods and NFS -5.2 -8.2 -11.8 -13.5 -14.1 -14.7 -14.7 Current Account Balance 5.2 2.1 -3.1 -3.2 -3.1 -3.2 -3.0 DOD/GDP (%) 196.0 185.5 115.5 115.5 118.9 120.8 121.7 Debt Services /Exports of Goods & Services(%) I/ 30.8 27.6 6.7 4.9 4.5 6.1 11.4 Public Finance (% of GDP) Revenues 14.2 21.7 31.4 31.0 31.3 31.8 31.0 Expenditures 31.7 29.7 37.6 34.0 33.8 34.3 33.5 Budget Deficit (accrual basis) -17.5 -8.0 -6.2 -3.0 -2.5 -2.5 -2.5 Budget Deficit (cash basis) -16.7 -7.0 -4.5 -3.0 -2.5 -2.5 -2.5 Financed by: Foreign Borrowing 0.5 0.5 4.3 3.0 3.0 3.0 3.5 Domestic Borrowing 17.5 6.5 0.3 0.0 -0.5 -0.5 -1.0 I/After debt rescheduling. Source: MOF, IMF, World Bank staff estimates. D. Medium Term Macroeconomic Framework 1.12 Table 1.2 outlines the macroeconomic framework underpinning the adjustment program adopted by the government. If all the policies in the program are successfully implemented and the required external financing and assumed debt relief is achieved, the economy could grow modestly by about 4.8% p.a., to the end of the decade. Most of this growth is expected to come from the non-oil sector, which is expected to reach a growth rate of 6% p.a. by 2000, while the oil production is expected to stagnate after 1997 (a discussion of the pattern of growth and public investment is presented section 3). 1.13 The prospects for Yemen's balance of payments crucially depend upon obtaining debt relief as well as additional external assistance on highly concessional terms. In response to the structural reform measures being implemented, non-oil exports are projected to grow by nearly 10% p.a., albeit from a very low base. However, since oil exports, which account for 90% of the merchandise exports, are expected to stagnate beyond 1998, exports of goods and NFS will decline as a share of GDP. Over 1996- 2000, imports are projected to grow roughly in line with overall GDP. Workers' - 6 - remittances are projected to grow from the present level of about $ 1.1 billion to about 1.5 billion by the year 2000. On this basis, the current account deficit, would remain at about 3% of GDP until the year 2000. 1.14 External Financing Requirements and Debt: Yemen's financing requirements4 arise from the initially widening current account deficit, repatriation of oil company profits, and the need to settle nearly $5.2 billion of arrears at end 1995. Yemen's future financing strategy is based on the following assumptions: (i) the arrears and additional payments falling due on Yemen's external debt are restructured at Naples terms; i.e., two thirds forgiven and one third rescheduled at market rate of interest, (ii) Yemen has access to regular financing of about $150 million p.a. consisting of the disbursement of bilateral and multilateral loans and grants; and (iii) an additional exceptional financing of around $300 million p.a. over the next three years are obtained at highly concessional terms. Under this scenario, Yemen's external debt situation would be restored to sustainable levels. The external debt service ratio and the debt/GDP ratio would decline from the 1995 (pre-restructuring) level of 36.9 and 185, to 11.4 and 122 respectively by the year 2000. E. Resource Envelope for Public Expenditures 1.15 The availability of foreign and domestic savings consistent with the macroframework indicates that the public savings need to be increased, or the overall budgetary deficit needs to be reduced from the estimated 1996 level of 6.2% of GDP to about 2.5% of GDP by the year 2000. 1.16 The sustainable level of public savings, i.e., the budgetary current account deficit, depends upon the trends in three variables: investment needed to meet the growth targets, foreign savings consistent with the balance of payments, and private domestic savings. As per the macroeconomic framework, the trends in each of these variables are constrained as follows: * Investment: The achievement of the medium term growth targets will require a steady increase in the investment/GDP ratio from about 13.7% in 1996 to about 20% by the year 2000 on the basis of an Incremental Capital Output Ratio (ICOR) of about 4.2 over the five year period 1996-20005. Future growth in Yemen is likely to arise largely from an expansion in the private sector activity in petroleum, agriculture, small and medium scale manufacturing, tourism and construction activity. Public investment is however crucial to support this growth in the private sector by providing A detailed financing plan is presented in Annex 1. 1. This is a reasonable ICOR for countries at Yemen's level of income undergoing adjustment. Comparisons with the past are not possible in the absence of a long enough time series on investment following unification. physical infrastructure, develop water resources and for human resource development. The needed public investment to support the growth is estimated to be in the range of 4-5% of GDP. Thus of the total investment, by the year 2000, about 30% is projected to be public investment and 70% is projected to be private investment. * Foreign savings: The availability of foreign savings6 is constrained by the high debt burden, modest prospects for oil exports and the limited availability of official concessional finance. The balance of payments projections presented in Table 1.2 show that under reasonable assumptions on the availability of external financing, Yemen can afford to run a current account deficit of 3% of GDP at most, in order to achieve a sustainable debt position. Including net factor income from abroad7 which, under reasonable assumptions amount to around 10% of GDP, the availability of foreign savings on average is at most around 13-14% of GDP over 1996-2000. * Private savings: The prospects for an increase in private domestic savings are quite limited. Private domestic savings are expected to remain at around only 1% of GDP during 1996-2000, much lower than about 6-7% achieved during 1994-95. There are two reasons for this decline. First, per capita incomes have considerably eroded during 1994-96 and are expected to remain stagnant during the adjustment period, thereby depressing savings. Second, in the past, the government transferred substantial income to households in the form of subsidies amounting to about 10% of GDP. The private household sector was therefore able to save (and consume) on account of this income. The net result of eliminating subsidies under the adjustment program is to transfer some of this income back to the public sector thereby increasing 8 public saving and depressing private domestic savings (and consumption) . 1.17 Given the trends in foreign and private domestic savings (Table 1.3), the public savings need to be increased or the budgetary current account deficit of about 2% of GDP in 1996 must be turned into a surplus of at least 4% by the year 2000 to meet the investment targets. Including budgetary capital expenditures, the overall budget deficit must decline from 6.2% in 1996 to about 2.4% by 2000. As indicated in Table 1.2, the 6 Foreign savings are defined as the net export of goods and services. 7 These consist of: inflows of remittances, grants and outflows on interest and repatriation of oil company profits. 8 The fact that the total domestic savings increase over 1996-2000 implies that the marginal propensity to save/invest from the income transfer due to subsidy elimination is higher in the public sector than in the private household sector. The model is not specified in sufficient detail to demonstrate this implication. Finally, this discussion applies to only private domestic savings. The foreign savings are largely private savings and will continue to increase. -8 - Table 1.3: Availability and Use of Resources (1995-2000) (% of GDP) 1995 1996 1997 1998 1999 2000 Variables Act Est. Proj Proj Proj Proj Total Investment I 10.1 13.7 15.6 16.6 18.5 19.7 Govemment Investment 1/ Ipub 3.0 4.2 4.1 5.1 5.5 6.5 Private Investment Ipvt 7.1 9.5 11.5 11.5 13.0 13.2 Financed by: Foreign Savings 2/ FS 8.2 11.8 13.5 14.1 14.7 14.7 Domestic Savings S =I-FS 1.9 1.9 2.1 2.5 3.8 5.0 Private Savings Spvt 6.9 3.9 1 -0.1 0.8 1 Public Savings Spub = 1- FS - spvt -5.0 -2.0 1.1 2.6 3.0 4.0 Revenue R 21.7 31.4 31 31.3 31.8 31 Current Expenditures Ecu = R-Spub 26.7 33.4 29.9 28.7 28.8 27.0 Capital Expenditures Ipub 3.0 4.2 4.1 5.1 5.5 6.5 Memorandum Items: Total Expenditures E = Ecu +Ipub 29.7 37.6 34.0 33.8 34.3 33.5 Total Budget Deficit DEF = R -E -8.0 -6.2 -3.0 -2.5 -2.5 -2.5 Current Expenditures (YR billion) 115 212 220 233 256 262 Capital Expenditures (YR billion) 14 26 30 41 48 63 1/ Capital Expenditures in the Budget. 2/ Defined as Net Exports of Goods and Services. Source: Table 1.2 macroeconomicframework projected budget deficits are expected to be financed essentially from external sources including project aid and exceptional financing. Recourse to domestic financing will be eliminated in 1996, thereby releasing financial resources for private sector investment, enhancing the effectiveness of the monetary policy, and providing a fiscal and monetary policy mix that would be conducive to financial sector intermediation and financial sector reform. 1.18 Revenues and Sustainable Expenditures: A recent study carried out by the IMF9 shows that the prospects for further reducing the overall budget deficit by increasing the revenues are modest and therefore most of the adjustment in the future is likely to fall on expenditures. Oil revenues are expected to account for nearly 80% of the budgetary revenues in 1996. These cannot be increased further because, as discussed above, oil production is expected to increase up to 1997 and would decline thereafter. Non-oil revenues can only be increased by implementing tax reform centered around the introduction of a general sales tax, which is not envisioned at present. Still, non-oil revenues could be increased by: rationalization of tariffs including valuations of imports at the market exchange rate, reductions in exemptions from the business income tax, and 9 International Monetary Fund, " ROY: The Tax System - Recent Developments and Possibilities for Revenue Mobilization", November 1995. -9- stepped-up efforts to collect revenue arrears. Even if these measures are implemented, over the medium term, the fiscal revenue would remain at the 1996 level of about 31% of GDP. This means that the total expenditures have to be reduced from the 1996 level of about 37.6% of GDP to about 33.5% of GDP by 2000 to meet the deficit reduction target. Given the need to have higher capital expenditures, the fall in current expenditures will have to be even higher--from 33% of GDP to 27% of GDP (Figure 1). Figure 1. Government Expenditures & Investment, 1996-2000 as%of GDP 40.0 . Total Expenditures 35.0 ll t _ 30.0 25.0 20 619719819900 5.0 0.0 L 1996 1997 1998 19'99 20'00 1.19 These projections in relation to GDP imply that, in nominal terms, the total affordable public investment can grow by almost 9% p.a. over 1996-2000; i.e., from the estimated 1996 level of YR26 billion to YR63 billion by the year 200010. Given the average projected inflation of about 7% p.a. over 1996-2000, real public investment could grow by about 2% p.a. over 1996-2000. At the same time, the current expenditures could grow in nominal terms only by about 5% p.a. as shown in Table 1.3 indicating a fall in real terms of almost 2% p.a. over 1996-2000, highlighting the need for a substantial expenditure adjustment program. 10 In dollar terms this translates into a total cumulative investment of about $1.5 billion over 1996-2000, or about $300 million p.a. -10- Chapter 2 Restructuring Public Expenditures A. Strategy for Restructuring 2.1 As discussed in Chapter 1, the expansion in public expenditures during 1990-94, was due to an increase in government employment and poorly targeted subsidies at the expense of expenditures on materials, maintenance and developmental expenditures. By 1996, subsidies are estimated to account for nearly 24% of the total expenditures and development and material expenditures only 8-9% each. This has resulted in a serious deterioration in public services and long term growth potential. 2.2 In order to lay the basis for sustainable and equitable growth in Yemen, within the total expenditure envelope dictated by stabilization considerations, a substantial restructuring of expenditure is necessary. For instance, substantial increases in outlays are required on capital expenditures, which are presently only around 4% of GDP. Urgent increases are also needed for operations and maintenance, for creating a social safety net, including improving the efficiency of the civil service, and for the provision of basic social services such as health and education given Yemen's weak social indicators. If the government has to achieve these increases in outlays necessary for growth, savings will have to be generated in the wage bill, transfers to public enterprises and by restructuring subsidies, as described below and summarized in Figure 2 and Table 2.1. Figure 2. Expenditure Restructuring Strategy 1996-2000 INCREASE REDUCE + Capital + Wage Bill + O & M + Transfers + Safety Net + Subsidies + Health & Education Areas to Increase Outlays: * Capital expenditures, to create basic infrastructure and lay the basis for longer term growth. * Operations and maintenance expenditures, to improve the delivery of government services by fully utilizing the existing facilities and those being created by the ongoing investments. * Social safety net, for protecting those who stand to lose from reforms. Specifically, poor consumers and redundant workers in public enterprises. Further, it is urgently necessary to deploy more resources towards expanding basic social services such as health and education and improve the availability of water. * Program to improve the efficiency of the civil service. This would include administrative reforms, training, a less compressed wage schedule and perhaps higher wages. Areas to Generate Savings * The high wage bill. To begin with, the restructuring program must include an elimination of ghost workers, and workers with multiple jobs. It would also involve a shift of civil servants from cities to rural areas, and perhaps some layoffs in the longer run. * The current system of subsidies, amounting to almost 9.1% of GDP, is highly inefficient and costly in meeting its objective of assisting the poor. If the policies suggested in section 2C are implemented, it should be possible to replace it by a far cheaper, better targeted social safety net. * Improving the finances of public enterprises (PEs) by liberalizing the prices of the goods and services they produce and making progress on privatization along the lines suggested in section 2D. This could result in a reduction in transfer payments on both current and capital accounts. * As deficit is reduced, reduced borrowing would reduce interest payments. * It should also be possible to generate savings through an improvement in the efficiency of resource use at the sector level by which, same outcomes could be achieved using less resources. The aggregate impact of these policies, identified in Chapter 3, are difficult to quantify. - 12 - 2.3 Table 2.1 summarizes the restructuring strategy under two scenarios. If the government fully succeeds in implementing policies identified above, it would be possible to generate savings of almost 12.6% of GDP over 1996-2000 (Case A). In this scenario, after providing for a reduction in deficit (3.7%) and a small shortfall in revenue (0.4%), resources amounting to almost 8.5% of GDP would be available to increase selected public expenditures. As shown in Table 2. 1, in this scenario, the government could expand the recurrent outlays for O&M, for improving the delivery of social services and for assisting the poor, by 6.1% of GDP as well as increase in capital outlays by 2.4% of GDP thereby meeting the growth targets of the macroeconomic framework. Table 2.1: Expenditure Restructuring Strategy (% of GDP) Case A Case B Change Change 1996 2000 2000-1996 2000-1996 Deficit -6.2 -2.5 -3.7 -3.7 Revenues 31.4 31 -0.4 -0.4 Expenditures 37.6 33.5 4.1 4.1 Kcourefq ssaed :N1 1 . -12. 6 Xi K Wages (Civilian) 1/ (6.8) (6.8) (0) (0) Defense (5.3) (5.3) (0) (0) Interest Due (4.7) (2.9) (-1.8) (-1.8) Subsidies (9. 1) (0) (-9.1) (-5) Transfers (3.2) (1.5) (-1.7) (0) Resourees Deployed 8 5 17 1J X i 2 7 Other Recurrent 2/ (4.4) (10.5) (6.1) ? Capital (4.1) (6.5) (2.4) 9 Source: Bank staff estimates. I/As indicated in section 2B, the savings will be balanced by the costs of administrative reform. 2/ 7his includes outlaysfor O&M, safety net andfor health and education. 2.4 The policies to generate savings, however, will not be easy to implement. Withdrawal of subsidies will be politically difficult and the development of an alternative safety net could prove to be complex and expensive. Similarly, while the privatization of PEs could reduce transfers in the medium term, as discussed in Section 2C, in the short term, privatization has costs which must be borne by the budget. Finally, in the near term, the costs of a civil service reform are likely exceed the savings. As indicated in Table 2. 1, as Case B, if the Government is not able to reduce subsidies and transfers to the projected levels, resources amounting to only 2.7 percentage points of GDP (vis a vis 8.5 percentage points under the Case A) would be available. This implies that resources will not be available to expand outlays on crucial operations and maintenance and capital expenditures cannot be increased as required by the macroeconomic framework. This, in - 13 - turn, means that the growth targets will not be met and delivery of social services will deteriorate resulting in a fall in standards of living. B. Wage Bill and Public Sector Employment 2.5 In 1995, the year for which the latest firm data are available, Yemen's public sector employed about 633,000 persons'1 amounting to about 17.5% of the total labor force (see Table 2.2). Of these, 322,000 were employed by the government in the civil service, about 237,000 were employed by the military and the remaining 74,000 were employed by the public enterprises (PEs). Table 2.2: Employment in Yemen in 1995 ('000 Persons) Sector Employment Share of total Civil Service 322 8.9 Military 237 6.5 Public Enterprises 74 2.0 Total Public Sector 633 17.5 Private Sector 2669 73.6 Working 3302 91.1 Unemployed 1/ 324 8.9 Total Labor Force 3626 100 Source: Civil Service Survey (1995) and Population Census (1994). 1/ Estimate. 2.6 The wage bill in Yemen is high amounting to almost 13.5% of GDP in 1995 compared to about 6% in Jordan and 8% in Lebanon. The wage bill is also the largest single category of expenditures in the budget. The share of wages (civilian and military) in total expenditures increased from about 50% in 1990 to almost 60% during 1992-94 (Table 2.3). It has since estimated to have come down to about 30% in 1996, mainly as a result of the growth in subsidies. Employment 2.7 The high wage bill in Yemen is mainly due to a rapid growth of employment rather than a liberal wage policy. The number of civilian government employees, almost doubled from about 170,000 in 1990 to about 320,000 by 1995 (see Table 2.3). This increase took place in response to external shocks in an atmosphere of rapid political I I Recent data indicate that this could be an underestimate. - 14 - changes during the period immediately following unification, for the reasons outlined below: * First, the two civil services of YAR and PDRY were joined together resulting in a great deal of duplication. Further, the combined civil service had to absorb a number of workers of the public enterprises inherited from the south which were not functioning. * Second, the government acted as an employer of last resort for the returnees following the Gulf war. • Third, the civil service also absorbed a number of retirees from the army and continued to absorb a large proportion of new college and school graduates. In Yemen, like in some other countries in the Middle East, there is a public employment guarantee scheme for university graduates. According to the CSO, about 4400 students graduate every year from universities. This means that the civilian employment could potentially grow at least by about 1.5% every year. * Fourth, because the government's pension fund'2 was insufficient to finance regular retirement pensions, the government allowed retirees to continue in service beyond the normal retirement age. 2.8 The civil service faces three problems: First, it is overstaffed. Given the resource constraints, the number of civil servants in Yemen is inconsistent with the available complementary goods and services, equipment and vehicles to make them effective in doing their job. Second, there is a skill mismatch within the civil service, with overstaffing at lower grades and understaffing at the higher grades. During the past five years, the growth in civil service employment has been concentrated in grades 3 and 4 which are typically staffed by junior college and high school graduates. Workers classified in these two grades increased from 58% of the total labor force in 1989 to 66% of the total civil service employment in 1995. Third, the civil service is highly centralized with overstaffing in urban centers such as Sana'a and Aden and understaffing in the rural areas, where the bulk of the population lives. For example, in agriculture, nearly 70% of the extension staff is based in Sana'a, while remote villages suffer form insufficient extensionists. The same problem exists in health and education sectors where teachers and health workers prefer to stay in the big cities rather than serve in rural areas. Wages 2.9 The overstaffing of the civil service combined with the pressure to reduce costs has resulted in a sharp decline in wages over the years. Between 1990 and 1995, average 12 The financial problems of the pension funds are discussed in section 2D. - 15 - (real) wages for civil servants have declined by about 85% as shown in Table 2.3. Furthermore, salaries of the civil servants do not increase sufficiently with responsibilities or grades. Not only are basic salaries not sufficiently differentiated, the final salary has a large element of cost of living allowances. As a result, the ratio of highest to lowest salaries (the compression ratio) is only about 2-3 (see Table 2.3). International comparisons indicate that an efficiently functioning civil service has a compression ratio in the range of 9 to 1213. Table 2.3: Trends in Nominal and Real Wages and in Employment 1990 1991 1992 1993 1994 1995 1996 Wage Bill Total (YR billion) 1/ 19.6 25.2 32.5 40.9 48.6 67.3 73.3 Military 8.4 10.5 16.3 18.8 23.5 28.5 29.9 Civilian 11.2 14.7 16.2 22.1 25.2 34.8 43.4 As a%ofTotal Expenditures 48.5 57.1 59.5 63 61.7 45.4 30.7 As a % of GDP 20.4 22.5 24.2 24.1 19.6 13.5 11.6 No. of Civil Servants ('000) 168 203 235 267 295 322 350 Av. Nominal Wage (YR' 000 /month) 2/ 5.56 6.03 5.74 6.89 7.11 10.04 10.33 Av. Real Wage (YR'000/month) 5.56 4.16 2.64 1.94 1.16 1.02 0.81 Compression Ratio 3/ 2.7 3 2.5 3.5 Memorandum Items CPI (1990=100) 100 145 218 355 609 987 1274 Source: Ministry of Finance, Ministry of Civil Service and Administrative Reform (MCSAR). 1/ Wages include all allowances. 27/For civil servants only. 3/ This is the ratio of the highest to the lowest salary, see Annex 2.1 for details Elements of a Comprehensive Administrative Reform 2.10 To deal with the problems of falling salaries, rising employment and low compression ratios, the Government should consider initiating a comprehensive civil service reform. The objective of such a reform would be to improve the quality of the public services by restructuring public employment and wages. Although in the medium term the program outlined below would result in a reduction in the wage bill, in the near term, the savings generated from the elimination of ghost and surplus workers are likely to be counter balanced by the cost of severance packages, costs associated with 13 Barbara Nunberg and John Nellis, 'Civil Service Reform and the World Bank', PPR working paper 422, May 1990. - 16- transferring civil servants from cities to rural areas, and the need to raise salaries of senior civil servants in order to rationalize incentives. 2.11 In order to successfully implement the reforms described below, we suggest that the President appoint a 5 - member Oversight Committee (OC) with full powers and responsibilities for the overall program. The details of the program such as matching staff to jobs and deciding the grade structure could be worked out and implemented by the head of each agency/ministry who could be made responsible for the quality of staff and work performance. Technical assistance to support the OC as well as other components of the program could be provided by the UNDP and by the IDA. Elements of a proposed civil service reform in Yemen would involve the following steps: * Carry out a civil service census. The first step is to carry out a civil service census. This would allow the reconciliation of the personnel management records in the Ministry of Civil Service and Administrative reforms (MCSAR) and payroll records in the Ministry of Finance. In parallel, a study needs to be done to compare the wages and employment conditions in the private and the government sector. Such studies would help identify surplus workers, workers who are beyond their retirement age and help design severance packages. * Freeze gross recruitment into government employment. Unless the rapid increase in public employment is arrested, the government is likely to face a greater political problem of large-scale layoffs in the coming years. A freeze would force the government to restrict critical new employment to reductions achieved through retirement or attrition. Further, within the overall ceiling, there would be scope for reallocating employees from sectors in surplus to sectors where there is a shortage of personnel. In this context, the government should reconsider the current system of job guarantees to the 4400 new university graduates new graduates amounting to 1.5% of the civilian employment every year. * Eliminate ghost and retired workers. A Civil Service Survey conducted in 1995 indicates that there are at least 28,000 workers who are eligible for retiring but have not been able (or allowed) to retire. This was either because retirement rules were not enforced or because the government was not able to pay their pensions because of the financial problems in the pension funds. As shown in Table 2.4, if only those who are above 55 years old and have studied for less than four years are retired, it would be possible to annually save the budget nearly YR4.7 billion or about 7% of the 1995 wage bill. In addition, there is a significant number of workers who hold multiple jobs and draw salaries from several government agencies. Carefully scrutinizing such double salaries would also result in additional savings. - 17 - Table 2.4: Budgetary Impact of Retiring old Workers in 1995 Age Group Number Years of Years of Wage Savings per Education Public Year (YR Million) Service 55-59 11061 4.0 23.9 -- 60-64 8596 3.21 19.9 -- 65-69 8902 3.03 29.3 -- Total 55-69 28559 - - 4,709 As a % of wage bill 7 Sowre: Civil Service Survey, MCSAR * Stop paying surplus PE workers through the budget. In the hope of expediting and simplifying privatization, redundant workers and retirees of PEs used to be transferred to the Ministry of Civil Service and their salaries were paid by the Ministry of Finance. This was done recently in the case of privatization of tourism establishments, when nearly 840 employees were transferred to the budget. This practice should be stopped and labor redundancy should be handled as an integral part of the privatization transactions. During 1996, the government plans to retire nearly 25,000 "at home" public enterprise workers, whose jobs were eliminated by past plant closings and labor shedding but who presently are provided salaries from the budget. These workers, will be eligible for suitable severance packages and pension. Further they would also be covered by the restructured social safety net described in section 2C. - Improve the finances of the pension system. (Discussed in section 2D) - Improve the regional distribution of workers. Sectoral analysis shows that substantial improvements in delivery of government services in agricultural extension, health and education is possible by transferring the excess staff from the big cities and urban centers to rural areas. * Surplus workers. A more difficult step, both politically and administratively, is the voluntary retirement of surplus workers. For this to work, it would be best to offer a menu of separation options. A typical separation package offered in other countries (e.g. Sri Lanka, Tunisia) involves 1.5 to 2 months of salary per year of service. In addition, there is also a compensation for denied service between termination and the worker's 55th birthday. The menu could also include cash offers for starting new businesses and retraining. * Improve performance over the medium term. To upgrade the public administration and to improve the efficiency of the civil service, the following steps need to be taken: - 18 - * On the basis of the civil service census and other studies to be carried out, the government needs to prepare an action plan focused on: (i) simplification of procedures, starting with the ministries of finance and planning, (ii) reforming the structure and organization of the ministries, (iii) over time, as the number of employees is controlled, resources would be available to raise wages for senior civil servants to bring the compression ratio from the present level of 3.5 to more in line with international norms of close to ten. * Establish modem personnel, information and records management systems. C. Subsidies and Protecting the Poor 2.12 Yemen currently subsidizes three main items of consumption: wheat and flour, petroleum products and electricity. The current system has three consequences. First, the subsidies place a very heavy burden on the budget. In 1996, the three subsidies are expected to amount to almost 9% of GDP. Second, the wheat'4 subsidy had a negative impact on the domestically produced wheat prices and depressed the incomes of the wheat farmers. Third, despite all the leakages, an elimination of the subsidies would reduce the income of the poorest in Yemen by as much as 18% and, therefore, calls for the development of a social safety net. The Current System of Subsidies 2.13 Wheat Subsidy: The government's stated objective of the wheat and flour subsidy program is to assist the poor by providing inexpensive food items15. Under the present system, importers of wheat and flour selected on the basis of a tendering process, are provided foreign exchange at the highly subsidized implicit food exchange rate of YR30/$ compared to the exchange rate of YRl 151$ used for most other budget transactions' . The GOY sets the retail (consumer) price for wheat and flour, allowing a margin for wholesalers (for loading, unloading and distribution) and a margin for retailers. The importers are then expected to sell the imported wheat and flour to wholesellers and the 14 The wheat subsidy refers to both wheat and flour subsidy. The subsidy on rice was phased out in 1994. 16 If 1$ of wheat is imported, the Ministry of Finance provides a cash subsidy of YR (115-30) = 85/1$ worth of wheat imported. This is the subsidy borne by the budget. The total subsidy borne by the economy is the difference between the cost of wheat at the implicit wheat exchange rate of YR30/$ and the cost at the market exchange rate of YR 135/$. See Annex 2.32 for details. - 19- wholesellers to retailers at the official prices. In the past, wheat was imported by four public sector companies but recently private sector companies have also been involved in grain imports. 2.14 The budgetary subsidy for wheat is defined as the difference between what the importer (and hence the consumer after adding the official margins) would have to pay if wheat were to be imported at the official exchange rate applicable to all budgetary transactions and what he pays because it is imported at a highly subsidized implicit food exchange rate and sold at the official retail prices. As indicated in Table 2.5, the wheat subsidy in 1995 amounted to YR1O billion which is estimated to increase to YR34 billion or 5.4% of GDP in 1996. 2.15 Petroleum Products: Government's share of crude oil which is earmarked for domestic consumption is sold to the refineries at the going export price (in dollars) converted into Yemeni Rials at a highly subsidized exchange rate of YRl2/$. The refined products are delivered from refineries to the Yemen Petroleum Company at administratively set prices (YR/Litre) determined by the government. The YPC sells the products to the consumers adding a margin for operation, transport and marketing costs. From the sales proceeds, the YPC pays the refineries for certified deliveries. The refineries then pay the government the Rial value of the crude delivered to them. If the government increased the final prices to the consumers, the YPC pays the government the difference between the new prices to the consumers and the agreed refinery delivery prices. Table 2.5: Subsidies and Price Adjustments 1995 1996 1997 1998 1999 Act Est. Proj. Proj. Proj. Subsidies (YR Bill.) 14.4 57.4 52.7 37.4 18.4 Wheat " 10.1 34.0 32.6 26.6 18.4 Petroleum 2.5 19.3 17.0 9.3 0.0 Power 1.8 4.1 3.1 1.5 0.0 GDP 434.7 633.7 735.1 814.5 889.0 Subsidies as % of GDP 3.30 9.07 7.17 4.60 2.08 Prices D Wheat (YR/50 kg bag) 3/ 1260 1526 1737 1940 2187 Petroleum4/ (YR/litre) 5.85 10.77 13.18 15.58 17.98 Power (YR/KWH) 2.09 4.6 6.81 8.83 10.56 Source: Ministry of Finance. l/lncludes wheat andflour. 2/Prices which reflect the exchange rate adjustment and would eliminate subsidies by 2000. 3/ The price is an average price assuming 20%o goes through the official channels, and 80% sold on open market. 4/ Weighted average of the domestic retailprice - the budgetprice + retail margin.. - 20 - 2.16 The subsidy to petroleum is the difference between what the government is entitled to receive if the proceeds from the sale of crude were valued at the official exchange rate of YRI 151$ (used for the rest of the budget transactions) and what it actually receives under the current system. (See Annex 2.4 for details). 2.17 In 1995, domestic prices were well below the Gulf ex-refinery prices as well as the Saudi domestic prices (encouraging smuggling to Saudi Arabia). This situation has been corrected with the latest round of price increases announced in January 1996. Yemeni prices although still below the world prices, have now been adjusted to above Saudi prices, thereby eliminating smuggling. As indicated in Table 2.5, the total subsidy on petroleum products in 1996 is estimated at YR19.3 billion. 2.18 Electricity: The subsidy for electricity arises because the electricity tariffs are not adequate cover costs of operations (See Annex 2.5 for details). In 1996 for instance, even with an increase in tariffs from YR 2.09/KWh to 4.60, operating revenues are lower than operating costs by nearly YR4.1 billion. These are covered partly by transfers from the budget and partly by running arrears to YPC. The Budgetary Impact 2.19 The estimated subsidies for 1996, YR57 billion (about 9% of GDP) are clearly unsustainable. The government's current policy is to steadily move towards a system in which all prices will be market determined in order to eliminate all explicit or implicit budgetary subsidies by 2000. Table 2.5 shows one possible time path of prices which would achieve this objective. For wheat and flour, given the potential impact on the poor, the price would be adjusted to end the subsidy within a five year period beginning 1996 (See Annex 2.3 for details). For petroleum and electricity, prices would be adjusted in line with the exchange rate so as to eliminate the subsidies frilly by 1998. The Government has already made progress towards meeting this objective. In 1996, petroleum prices were increased by 84% and the electricity tariffs were increased by nearly 120% (Table 2.5). As per the analysis, the petroleum and electricity tariffs need to be raised further by 67% and 130% respectively from their 1996 levels in order to fully eliminate the subsidies by 1998. Inefficiency of the Current System of Subsidies 2.20 In addition to its large impact on the budget, the current system of general subsidies is a highly inefficient instrument of helping the poor. In the case of wheat, for instance, a large part of the outlay is simply wasted. Of what remains, only a small portion reaches the consumer, and of what reaches the consumer, only a fraction reaches the poor. In other words, large budgetary outlays are being used to transfer a small benefit to the poor. * The wheat inport/distribution system is inefficient and therefore expensive: The government has not been efficient in importing wheat. For instance, in - 21 - 1994, government imported wheat at $166/ton, while the comparable international price was 140/ton. This price premium arose because: (i) the governemnt's inability to make timely payments (ii) the govememnt's reputation of not honouring its contracts, and (iii) Yemeni ports are very slow in unloading the wheat and there are reports of corruption which adds to the cost of importing wheat. * The system results in smuggling of wheat: In 1995, the cost of obtaining wheat was $50/ton if the importer had access to foreign exchange at the food rate, compared to the international price of wheat of around $166/ton. This large price differential provides an incentive for the wheat to be diverted from the official distribution channels and smuggled out of the country, especially to Saudi Arabia where the domestic price of wheat is higher than the world price to protect domestic production. It is estimated that smuggling and port losses amount to nearly 25% of the imported wheat. * Only a smallproportion of the subsidy reaches the consumers: The amount of subsidy reaching the poor depends upon the proportion of wheat sold at the official price. As the system is set up, wheat ownership changes four times in its path from the foreign supplier to the Yemeni consumer with the price being controlled at each point of transfer. It is our assessment that, only about 20% of the domestic supply of wheat is sold through the official channels and the remaining through the parallel market reflecting the depreciated rate. The analysis in Table 2.6 shows that in 1996, of the total subsidy of $314 million, about 42% went to traders, 25% went to smugglers and only 33% went to consumers. Table 2.6: Benefits Across Social Groups ( million) Social Groups 1994 1996 Traders 99 132 Consumers 76 104 Smugglers 58 79 Total Subsidy 233 314 Source: Ministry of Finance, World Bank staffestimates. * Only a small proportion of what reaches consumers reaches the poor: The subsidies in Yemen are not targeted, i.e., they are equally available to all consumers regardless of their income. Therefore, the subsidy on any item of consumption is distributed across different income groups in proportion to -22 - their respective expenditure on the subsidized commodity. As indicated in Table 2.7, of a general subsidy of YR 100 on wheat, about YR 31 reaches the top 10% of the households and only YR 6.7 reaches the poorest 20% of the households. A similar pattern emerges for the benefits from the subsidies on electricity and petroleum products. Table 2.7: Benefits of YR 100 General Subsidy by Commodity to Various Income Groups Petroleum Wheat Electricity products Decile Poorest 2.5 6.4 2.0 Second 4.2 7.5 3.3 Third 5.0 8.9 3.5 Fourth 6.0 9.2 5.1 Fifth 7.2 9.8 6.1 Sixth 8.2 10.9 6.8 Seventh 9.6 10.6 8.8 Eighth 11.9 11.7 12.4 Ninth 14.6 11.7 14.9 Richest 30.7 13.1 37.1 100.0 100.0 100.0 5ource: Household Budget Survey (HBS), Round 4, 1992. Impact on the Poor 2.21 Although the current system of subsidies is highly inefficient and only a small proportion of the total outlay reaches the poor, subsidies are indeed important for the welfare of the poor. Table 2.8 gives an illustrative example of the income loss for different deciles of the population over the four year period 1995-99 due to the price increases necessary for the elimination of the subsidies on wheat, electricity and petroleum products. As indicated in this table, over 1995-99, the poorest 10% of the households would suffer an income loss of about 1 8%'7 while the richest 10% would suffer a loss of about 23% of income. This loss of income is mitigated to some extent by the rise in per capita income of about 6% over 1995-99, the multiple tier pricing for electricity and the cross subsidy on kerosene. Even taking these into consideration, removal of subsidies would hurt the poor. Therefore action on subsidies needs to be accompanied by the introduction of a targeted social safety net. 2.22 The design of a targeted social safety net must distinguish between the employable poor and the unemployable poor such as old people, invalids, widows and 17 On a per capita basis they would have 18% less income in 1999 compared to 1995. - 23 - orphans. For the unemployable poor, the government already has a transfer program. According to the Ministry of Social Affairs, Social insurance and Labor (MSOL), about 31,000 households are assisted with food and cash assistance estimated at YR3 1 million in 1994. Table 2.8: Total Impact of Price Changes Loss of Income over 1995-99 (%) Income Per Capita loss over Income(1995) Decile 95 - 99 YR p.a. Poorest 17.7 6910 Second 17.7 9865 Third 16.4 11670 Eighth 18.2 19670 Ninth 18.4 27340 Richest 22.8 43645 Price increases over 1995-99 (%/6) Wheat 74 Petroleum 207 Electricity 405 Source: Household Budget Survey. Design of a Targeted Social Safety Net 2.23 For the employable poor, the best form of assistance can be given by creating employment, increased provision of social services especially in the rural areas, and developing NGOs to deliver assistance to the poor. The Government is currently engaged in creating a "Social Fund for Development" in the context of a proposed IDA project. The social fund would finance small scale labor intensive activities, deliver community services, encourage small and microenterprise development, and build capacity at the local levels to plan and execute development projects. The fund is however very much a medium term solution because its activities are not likely to begin until late 1997. In addition the proposed IDA southern governorates project which develops and distributes land to the landless also would assist the poor in the medium term. 2.24 Over the short term, designing programs that target cash or goods to the poor is difficult. Most of the poor live in small geographically dispersed communities, and therefore are difficult and expensive to reach through targeted programs especially in view of the government's weak institutional capacity. One way around this is to expand public works programs which are self targeting. If the work is sufficiently difficult and the wages are low, there is little incentive for the non poor to participate in such programs. Furthermore, the poor can be protected to some extent if the withdrawal of - 24 - subsidies on electricity and petroleum products, is accompanied by low tariffs on the first block of power consumption and by cross subsidizing kerosene, which is mainly consumed by the poor. The package of reforms to restructure social safety net can be summarized as follows: Social welfare programs * To improve coordination, the government should consider making the MSOL responsible for all social welfare programs, currently being managed by different ministries. These include: the Public Works project, the social welfare fund, the southern governorates project and the proposed IDA social fund project. * Implement a civil works program, included in the Public Works project currently being supported by the Bank, which will create jobs and assist the poor. In the 1996 budget, the Government has set aside YR1 billion, for the establishment of a Social Welfare Fund (SWF). The SWF augments the existing programs of the MSOL for assisting the poor. Further work needs to be carried out to develop transparent criterion to identify beneficiaries and ensure that there is no duplication. Restructuring subsidies * Raise prices to eliminate subsidies on electricity and petroleum by 1998 and wheat by 2000. m For electricity, have a graduated payment schedule. Cross subsidize the first block of power consumption by charging low tariffs. * Cross subsidize kerosene. As per the household budget survey (HBS) it is an inferior good i.e. it's consumption falls with income, and is therefore, self targeting. * Substantial savings could be generated by eliminating the wheat flour imports as they are costlier and no better targeted than wheat. * Substantial saving could also be realized by improving the wheat import system by: (i) reducing margins on transportation and handling by renegotiating prices with trucking unions and port handlers, (ii) complying with contracts made with importers, (iii) providing secured letters of credit for import commitments. These actions could reduce the subsidy by an estimated 30%. - 25 - * Government can reestablish its reputation in the wheat market, by installing a system to make prompt payments to importers which would lower the price of wheat. This benefit could be then passed on to the consumers. * The current subsidy could be phased out and replaced by a wheat voucher scheme. One possible design for the scheme would be to give a wheat voucher to all households for an amount of wheat equal to the per capita consumption of the poorest two deciles of the population. This would circumvent the problem of targeting using a means test and could reduce the subsidy bill by about 4% of GDP p.a. The main difficulty in introducing such a scheme are the administrative weaknesses in Yemen which would hamper the efficient operation of the voucher system and therefore would not yield the projected savings. The complexity of the proposed voucher system should not be underestimated. The vouchers, have to be distributed nationwide to all families. The distribution and redemption will have to be coordinated across Central Bank branches, offices of the Central Registration Authority and post offices. It would therefore be useful to carryout a more detailed analysis of the administrative feasibility and costs prior to launching the voucher scheme. Alternatively, the government could test feasibility of the scheme by implementing a small pilot project before extending it to the whole country. Finally, it should be made clear to the public that the voucher scheme is being introduced as an interim measure. There should be a built in sunset provision to end the scheme or gradually reduce its scope, say, over the next five years. D. Budgetary Transfers 2.25 There are two kinds of transfers taking place in the budget -- current (under Chapter 3 of the budget) and capital (under Chapter 418 ). Current transfers decreased from 3.2% of GDP in 1992 to about 1.7% of GDP in 1995 and are estimated to increase sharply to 3.2% in 1996, mainly as a result of an increase in pension payments. Nearly all the capital transfers from the budget, on average about 1.5% of GDP, are to Public Enterprises (PEs). Of the current transfers, nearly 70 to 80% is accounted for by social transfers and pension payments, and the rest are to PEs (Table 2.9). 8 Chapter 4 in the budget also contains other items such as amortization payments and govermment lending to the public sector. These have been netted out in this discussion. - 26 - Table 2.9: Current and Capital Transfers from the Budget (% of GDP) 1992 1993 1994 1995 1996 Act Act Act Act Est. Current Transfers 3.25 3.23 2.59 1.67 3.20 Public Enterprises 0.79 0.89 0.66 0.45 0.45 Social Welfare 0.87 1.08 0.74 0.61 1.00 Pension Contribution 11 0.52 0.25 0.20 0.15 1.36 Medical grants 0.18 0.12 0.05 0.07 0.11 Other 2/ 0.89 0.89 0.93 0.39 0.27 Capital transfers 1.31 1.16 0.41 1.27 1.44 Investment expenditure 4.60 2.57 2.10 2.05 2.67 GDP (YR Billion) 134.71 169.79 262.71 434.71 633.67 Source: Ministry of Finance. 1/For 1996, YR8000 Million are budgeted to supplement the pension system. 2/ Consists of transfersfor social and sports activities. 2.26 There are two areas where potential savings could be realized. First, the transfers listed in Table 2.9, under the headings social welfare, medical grants and "other" amounting to 1.4% of GDP are ad hoc transfers carried out through the Ministry of Finance. These programs should be combined with other programs in the social sector and redesigned to improve their efficiency and reduce costs. Second, it should be possible to reduce the transfers to all PEs, first by improving their finances and, second, over the medium term, through privatization where possible, or liquidation. While the transfers to the pension system could be reduced if a reform of the pension system is successfully implemented, these gains are likely to be neutralized by an increase in government's contribution to match the increased pension contribution of employees. Transfers to Pension Funds 2.27 Yemen currently has four main pension funds--one each for public sector employees (civil servants and public enterprise employees), military personnel, police, and private sector employees. All four funds are administered by the Insurance and Pension Authority. There are also some group pension schemes operated by private insurance companies. 2.28 The operations of the public sector employees' pension fund are illustrative of all state-operated funds. Participation is mandatory for all public sector employees, who are required to contribute 6 percent of their salary. This amount is matched by an equal contribution by the government. Full retirement benefits can be drawn at age 60 and after - 27 - 35 years of service. Annual retirement benefits are calculated according to a formula which takes into account the years of service and the last annual salary. 2.29 The resources of the pension fund are primarily invested in private sector companies and real estate where the returns have been relatively low. The pension fund also keeps part of its resources (about YR12.6 billion as of November 1994) in the form of deposits with the CBY, receiving currently about 9 percent per year. These negative real returns could present problems in funding future liabilities should there be a significant change in the balance between current contributors and retirees arising from large scale staff retrenchments. 2.30 Over the next two years --1996-97, the government is committed to make transfers of YR8 billion p.a. to the pension fund to cover the additional actuarial financial commitments, stemming from the retirement of the 25,000 "at home" public enterprise workers in 1996. Even with these transfers, recent analysis indicates that the pension system would make losses beginning 1998, and therefore, would require the following policies to restore its viability: - Improve compliance. Currently only 75% of the dues are collected. - Limit survivor's benefit to immediate family. - Improve the base for pension contributions by consolidating the large number of allowances of the public sector employees into the base salary. - Merge public and private pension schemes to reduce overheads. 2.31 Our analysis shows that the program outlined above would restore viability to the pension system over the next 2-3 years. In other words, the budgetary transfers to the pension funds (1.36% of GDP) are likely to continue for the next 2 years and could be gradually eliminated thereafter provided the program outlined above is successfully implemented. This decrease in budgetary transfers is, however, likely to be neutralized by an increased budgetary outlay for the government's share of pension contribution to match the increased contribution from employees. Public Enterprises 2.32 The unification of the two Yemens in 1990 brought together a large number of southern and northern public enterprises and created a PE sector consisting of about 140 entities employing some 73,000 workers. As indicated in Table 2.10, in 1995, the total current and capital transfers to the PEs in 1996 are likely to amount to around YR12 billion or about 1.5% of GDP. - 28 - Table 2.10: Transfers to Public Enterprises (YR million) 1992 1993 1994 1995 1996 Current Transfers 1075 1565 1745 1759 2844 Broadcasting and Television Corporation 233 293 314 372 1017 Al-Thawra Hospital 174 236 214 331 432 Organization for Agriculture Research 110 143 139 148 203 Touhama Development Organization 58 90 98 96 157 Yemen News Agency(Saba'a) 39 52 52 57 68 Rural Development Org. 30 61 67 70 104 Oil Exploration Organization 52 107 143 Mineral Resources Exploration Org. 89 78 151 Other Agricultural & Industrial Enterprises in trouble 249 449 262 160 240 Others 183 241 459 339 329 Capital Transfers 1225 1867 1178 8897 9281 Broadcasting & Television Corporation 59 38 29 479 518 Al -Thawra Hospital 4 9 26 166 189 Civil Aviation (CAMA) 38 52 60 194 257 Posts & Postal Service Organization 26 20 75 56 95 Rural Areas Development Organization 91 144 129 119 260 GAREWS 0 336 369 1376 1935 Public Electricity Corporation (PEC) 652 457 246 4741 4076 Water & sewage Corporation (NWSA) 191 643 198 1059 1395 Others 164 168 47 707 556 Total Transfers 2300 3432 2923 10656 12125 GDP (YR billion) 134.7 169.7 262.7 434.7 633.7 Source: Ministry of Finance. 2.33 Current transfers to PEs are small, estimated to be less than 0.5% of GDP in 1996. Moreover, these transfers are to entities such as hospitals, research organizations and broadcasting, which are likely to remain in the public sector, have no source of revenues and therefore will continue to need transfers. Four PEs, CAMA, GAREWS, PEC and NWSA are the biggest recipients of capital transfers, accounting for almost 80% of the total capital transfers in 1996 (Table 2. 10). 2.34 The current and capital transfers reported in Table 2.10 understate the true magnitude of the current and future burden of the PEs on the budget. The PEs face a number of p