US embassy cable - 05SANAA1875

C O N F I D E N T I A L SECTION 01 OF 02 SANAA 001875 
 
SIPDIS 
 
PLEASE PASS TO MICHAEL GRIFFERTY, US TREASURY REGIONAL 
OFFICE ABU DHABI. 
 
E.O. 12958: DECL: 07/11/2015 
TAGS: ECON, EFIN, EINV, YM, ECON/COM 
SUBJECT: YEMENI RIYAL SHOWS SIGNS OF INSTABILITY 
 
Classified By: CDA Nabeel Khoury for reasons 1.5 b and d. 
 
1. (U) Summary.  The Yemeni Riyal has fluctuated dramatically 
in recent months, and the Central Bank of Yemen (CBY) 
intervened on at least two occasions to combat devaluation. 
Despite these efforts, for the first time in three years a 
black market has emerged for buying foreign currency, and the 
falling Riyal has led to rising commodity prices and 
increasing uncertainty for the average Yemeni.  IMF and World 
Bank analyses indicate that the Riyal is overvalued, and 
recommend gradual depreciation to encourage Yemen's non-oil 
production and export capacity.  Nevertheless, the ROYG 
appears committed to a strong currency and the import economy 
it supports.  The CBY's interventionist policy may buy 
short-term stability during upcoming economic reforms, but 
could easily spin out of control.  End summary. 
 
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Cracks Appear in Yemen's Monetary Policy 
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2. (U) Spring came to Yemen with an air of instability. 
Recent conflict in Sa'ada and declining economic indicators 
(septel), undermined confidence in the value of Yemeni 
currency.  At the beginning of April, the exchange rate stood 
below 190 YR to the US Dollar, but by late June had fallen to 
197 and appeared headed for a rate of 200 YR to the Dollar. 
The press reported that the devaluation was causing hardship 
for low-income Yemenis due to higher prices for food and 
construction commodities.  According to al-Ayyam newspaper, 
wholesalers raised their prices by 20-30 percent.  (Note: 
Yemen's inflation, as measured by the consumer price index, 
was already averaging an annual rate of 12 percent, and has 
recently reached as high as 15 percent.  End note.)  Other 
reports indicate that distributors of such products as Coca 
Cola are hoarding supplies, awaiting clear indication of the 
direction of the Riyal. 
 
3. (U) On July 1, the Riyal rebounded to 190 and the official 
rate appears to be holding steady for the time being (the 
current rate is 192.25).  There are reports that a black 
market for currency has emerged in Sanaa, and that the USD is 
fetching 194 YR or higher on the street.  (Note:  The absence 
of such a black market until now indicated that the official 
exchange rate represented the true market value of the Riyal. 
 This is no longer the case.  End note.)  The Riyal slipped a 
total of 0.7 percent against the USD in 2004.  In contrast, 
before the Riyal rebounded this month, it had fallen 6.6 
percent.  Devaluation on this scale is considered a severe 
threat by the Ministry of Finance (MOF).  According to Dr. 
Mohamed al-Mansoub, Assistant Deputy MOF, the MOF instructs 
the CBY to restrict the Riyal's depreciation against the USD 
to a maximum of five percent per year. 
 
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Devaluation:  Good or Bad for Economy? 
-------------------------------------- 
 
4. (U) Current devaluation appears severe to many Yemenis, 
but may actually be necessary for the health of Yemen's 
economy.  A strong Riyal supports imports and discourages the 
development of new export sectors.  Strategic devaluation 
could assist infant industries and prevent a sudden and 
painful correction in the value of the Yemen's currency in 
relation to the domestic economy.  The IMF reports that when 
measured against inflation rate differentials of Yemen's 
major trading partners, the real exchange rate of the Riyal 
actually appreciated by 3.5 percent in 2004, meaning the 
Riyal is significantly over-valued.  The World Bank contends 
in its Spring 2005 Yemen Update that a managed devaluation is 
necessary for developing the Yemeni export market and 
diversifying the economy.  The IMF adds that pursuing such a 
policy now will help avoid sudden and drastic devaluations in 
the future, brought on by declining oil and foreign currency 
reserves. 
 
5. (C) Despite this advice, the ROYG appears intent on 
maintaining the strength of its currency against the USD. 
According to Abdulaziz Tarmoom, Professor of Finance at Sanaa 
University, the ROYG allocated USD 100 million from its 
foreign reserves in two July installments as part of an 
effort to curb rapid devaluation.  In its March report on 
Article IV consultations with the CBY, the IMF wrote that the 
CBY "strongly contested any suggestion that they were 
pursuing a managed float."  According to the CBY, the ROYG's 
policy was to intervene only to "dampen exchange rate 
volatility."  An intervention on the scale described by 
Tarmoom indicates that the CBY is pursuing a more activist 
approach to monetary policy than indicated to the IMF.  On 
July 9, a CBY spokesperson was quoted in the government daily 
al-Thawra, saying:  "The Bank will...intervene in the 
currency market whenever necessary."  In reality, the CBY is 
responding directly to political pressures from the ROYG, 
rather than pursuing a course of independent monetary policy 
for Yemen's long-term economic health. 
 
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Crude Tools to Support Riyal 
---------------------------- 
 
6. (C) In another effort to control devaluation, on June 14, 
the ROYG instituted a new requirement that banks keep thirty 
percent of foreign reserves at the CBY (up from 20 percent). 
The apparent goal of this move, which met with the outrage of 
commercial bankers and the businesses, was to tie up foreign 
currency liquidity in the market, making it more expensive to 
borrow in dollars and reducing flight from the Riyal.  The 
business community, on the other hand, contended that such a 
move would slow economic activity and make it more difficult 
for banks to meet their obligations to the market and 
investments.  The CBY already follows a strong Riyal policy. 
It offers treasury bills at high rates to soak up liquidity 
and create demand for the Riyal, and offers negligible 
interest rates for foreign currency and high rates for Riyal 
accounts to encourage savings in Yemeni currency. 
 
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Decline of Riyal Could Contribute to Unrest 
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7. (C) Comment:  During a recent visit to Yemen, US Treasury 
Department Regional Representative Michael Grifferty reported 
that a shock to the currency, "Could lead to a sudden 
adjustment to lower purchasing power and higher real external 
debt service, likely with social implications."  The more the 
CBY attempts to stabilize the currency, the more vulnerable 
it appears to such a shock, which would likely accompany any 
deterioration in Yemen's security situation or a fall in oil 
prices.  Until now, Yemen's single greatest economic strength 
has been the accumulation of USD 5.5 billion of foreign 
currency reserves from oil sales, considered by the World 
Bank to equal about 17 months of imports.  The ROYG's 
reserves allow it to ride out fiscal crises, but they may be 
quickly exhausted if used continuously to support an 
overvalued currency.  The more the ROYG intervenes, the more 
it undermines confidence in its currency, creating the need 
for more intervention. 
 
8.  (C) Comment continued:  Yemen is nearing implementation 
of painful economic reform policies, including the 
introduction of a sales tax already adopted by Parliament, 
civil service reform, and the lifting of diesel subsidies 
(septel).  These measures already controversial on their own, 
would be exacerbated by the simultaneous devaluation of the 
currency and may lead to significant social unrest.  The ROYG 
is likely unwilling to entertain a much-needed gradual 
devaluation at this time.  As a result, the CBY is resorting 
to increasingly blunt instruments to support the Riyal, and 
may be running out of policy options.  Ironically, the lack 
of investment in Yemen may have prevented a more extensive 
monetary crisis, as there are few foreign investors looking 
to sell Riyals.  Nevertheless, the CBY's current monetary 
policies are short sighted and could lead to a real currency 
crisis as they undermine confidence in the Riyal and tap into 
valuable reserves.  Many of Yemen's business elite make their 
profits from imports, and average Yemenis depend on cheap 
imports for basic staples such as wheat.  A currency collapse 
would be devastating to nearly every segment of society and 
would likely lead to civil unrest.  End comment. 
Khoury