On 22 May, Yemen marked two decades of unity between the former communist south and republican northern states. Many in the country might question what, exactly, there is to celebrate.

The past 20 years have not been kind to the Arab world’s poorest state. A bloody civil war in 1994 between its Sanaa-based government and the southern Yemen Socialist Party almost tore the country in half. Ali Abdullah Saleh, president of the north since 1978 and of the combined Republic of Yemen since 1990, has spent much of the intervening period performing a high-stakes balancing act to maintain unity, which he has likened to “dancing on the heads of snakes”.

The World Bank estimated that 40 per cent of the population were living in poverty in 2008

The challenges the country faces have become increasingly well-documented over the past year, thanks largely to a six year-old war between the government and Houthi tribesmen in the northern Sadaa province, which spilled over the border into Saudi Arabia in summer 2009, and the attempted bombing of Northwestern Airlines flight 253 over Detroit on 25 December by a young Nigerian man who had allegedly been radicalised in Yemen.

The problem

A lot attention has subsequently been paid to the rise of the extremist Islamic group Al-Qaeda in the Arabian Peninsula and the threat it poses to the wider world. With secessionist sentiment again growing in the south, and the ceasefire brokered in Sadaa in February seen by many as a stop-gap solution, security is viewed by many of Yemen’s international partners as its top priority.

After a January meeting in London to address the country’s problems, the newly formed Friends of Yemen group, made up of Western and Gulf governments, trumpeted the need for better security, economic development and governance. Yet over the next year Sanaa will face a far more serious issue: its mounting cash crisis. Where security threats are longer-term, the government’s current account could reach critical levels in the coming 12 months.

“Despite the inevitable day-to-day focus on terrorism, the sense of urgency underpinning the debate about Yemen’s future stems from an economic tailspin forced by dwindling oil production and the devaluation of the riyal,” says Ginny Hill, an expert on Yemen and an associate fellow at UK think-tank Chatham House’s Middle East and North Africa programme.

The government is aware of the problem. “The fiscal situation is critical,” says Fouad Ali al-Kohlany, executive director of Yemen’s Finance Ministry’s modernisation programme. “[Although] the challenges are not just fiscal.”

The government ran a current account deficit of 9.3 per cent of gross domestic product (GDP) in 2009 – around $2.2bn – and the Finance Ministry has forecast a 7.7 per cent deficit for 2010, likely to be a similar dollar figure given prospective economic growth of more than 7 per cent this year.

To date, Sanaa has been able to raise debt from internal Yemeni sources to cover the deficit, largely the Central Bank of Yemen and low-yield treasury bills. Meanwhile, external national debt stood at $6.7bn at the end of 2009, 24.2 per cent of GDP. But government sources say that both routes are now largely exhausted.

The Central Bank’s foreign currency reserves fell to $6.2bn in March 2010, their lowest level since 2005. More worryingly, where five years ago the bank’s reserves were enough to cover up to 14 months of imports, they can now barely cover seven – the lowest level on record.

And imports remain a huge problem, for both the government and its people in a country which saw a trade deficit of 10.7 per cent of GDP in 2010. Despite having a non-oil economy which is largely based on agriculture, Yemen imports 90 per cent of its wheat and, according to senior government officials, 100 per cent of its rice – major staples in the national diet.

The demand for foreign goods is exacerbated by the falling value of the riyal, which tumbled fromYR200 against the US dollar to YR225 in the six months from October 2009 to April 2010, pushing up the price of imported goods. This is bad news in a country where the World Bank estimated that 40 per cent of the population were living in poverty in 2008 when the riyal averaged YR200 against the dollar.

Sanaa sold more than $850m in US dollars between January and April 2010 to shore up the value of the currency, but this has left its foreign currency reserves even more depleted and has done little to increase the value of the riyal, which fell back to YR225 against the dollar on 22 May from Y217 four days earlier.

Bankers say that even before the Eurozone debt crisis, which has seen EU member states put together a $953m fund to back distressed sovereign debt, a Yemeni debt issuance on international markets would be unlikely to attract much interest.

A January 2009 report by the Washington-headquartered International Monetary Fund (IMF) suggests that government debt would be best avoided. With oil production – which helped make up 76 per cent of overall export revenues in 2009 – forecast to dry up by 2021 and non-oil growth unlikely to top 5 per cent, the current account deficit could hit anything between 50 and 70 per cent of GDP by 2028.

As oil revenues dry up, further devaluation of the riyal is all but inevitable, economic advisers to the government say. If the fiscal situation is not arrested, then security will suffer even more.

“Increasing numbers of Yemeni families are struggling to cope with the rising cost of living, especially the high price of imported food staples, which adds to social discontent and the sense of frustration with the government,” says Hill, although the solutions to the country’s cash crisis are not much better.

To cut the deficit, the government needs to increase – and better enforce – taxation, increase the price of subsidised commodities like diesel, and cut reliance on the government as an employer.

“[This] will increase grassroots pressures in the short-term,” Hill says. “But the government has no choice if it wants to put the economy on a better long-term footing.”

In February 2010, the government did make some moves in the right direction. It increased the price of diesel from YR35 to YR39 a litre; the price of gasoline from YR60 to YR65 a litre; and kerosene from YR35 to YR40 a litre. Sanaa also plans to finalise a new law covering sales taxes, which it has planned since 2005.

But while these developments will likely help cut the deficit, they will not provide the much-needed cash to see the government through its next year, let alone the next decade. This will likely come from international financial institutions like the World Bank, the IMF and, Sanaa hopes, from the neighbouring states of the Gulf Cooperation Council (GCC).

MEED reported in May that the IMF is advising Sanaa on the issuance of an Islamic bond, or Sukuk worth YR60bn-plus, in the third quarter of 2010, to be collateralised against existing government assets or goods like oil. The fund is also talking to the government about other instruments and direct loans to help ease its debt burden over the next year.

The way ahead

Meanwhile, government officials say that they hope that GCC member states can turn pledges for aid and investment made at a 2006 London conference, which have largely gone unused, into direct budgetary support.

But, the Gulf states are unlikely to favour direct injections of cash into the government’s budget. The GCC has experimented with budget additions in the past, says one senior official, and it “didn’t go well”.

According to Abdel Aziz abu Hamad Aluwaisheg, director general of international economic relations at the GCC’s secretariat general, the GCC states planned to spend $3.7bn on development schemes in Yemen between 2007 and 2010, though government and GCC sources indicate that only a fraction of this amount has actually been used because of a combination of stringent donor stipulations for the way the money is spent and a lack of technocrats within the government capable of meeting them.

Both sides will need to work fast to overcome their differences if the hole in the Yemeni budget is to be plugged.

Despite additional revenues from the country’s recently inaugurated liquefied natural gas (LNG) project, Yeme LNG, officials from the Yemeni government, the GCC, and international development agencies say that the next year will be crucial to the country’s fiscal stability. If the country’s finances fail, then the security situation will deteriorate further.