Yemen's foreign currency rating raised to 'B'

The upgrade follows a re-assessment of Yemen's ratings in light of ongoing improvements in fiscal transparency and data quality. The change in the foreign currency rating reflects the significant decrease in government external debt ratios over recent years, as well as the accumulation of international reserves to levels that provide a comfortable cushion to deal with temporary shocks, and Yemen's light external debt service burden.

The ratings weigh these current credit strengths against the vulnerability of the public and external finances to oil price swings and, more importantly, to falling output from the country's maturing oil fields. The ratings also take into account the challenges posed by rapid population growth and political and security risks associated with Yemen's position as an emerging democracy and a comparatively fragile state. Limited fiscal flexibility, a weak investment climate and low GDP per capita are among the other factors that constrain Yemen's ratings.

Capital Intelligence judges Yemen's external repayment capacity to be currently good and the direct impact of the current dislocation in global financial markets to be small, owing to the country's modest gross external financing needs relative to international reserves and limited exposure to foreign banks and capital markets. Official foreign exchange reserves of around $8bn (about 26% of GDP) at end-2008 are nearly $2bn higher than the stock of public external debt and 13 times as high as external debt falling due in 2009.

Real GDP growth is projected to rise sharply to around 8% in 2009 from 5% in 2008, provided liquefied natural gas (LNG) production comes on stream as expected in May, and to drop back to 4.9% in 2010. On the downside, lower oil prices will dampen the growth of nominal GDP and contribute to sizeable fiscal and external current account deficits.

Assuming an average oil price of $40/bbl in 2009 and $50/bbl in 2010, Capital Intelligence forecasts a budget deficit of 10% of GDP next year, declining to 7.9% in 2010, and a current account deficit of 4%, narrowing to 1% in 2010. Net government debt, of which more than 60% is in foreign currency, is expected to reach 40% of GDP by end-2010, up from 31% at end-2007.

The outcomes could be less pronounced if the government take steps to reduce public expenditure and broaden the tax base, but fiscal adjustment could prove challenging in the near term given a rigid expenditure structure - with wages, interest payments, subsidies and transfers accounting for almost two-thirds of total spending - and parliamentary elections in April.

The fiscal position should nevertheless remain manageable in the short term provided oil prices do not fall sharply from current levels. However failure to substantially reduce the budget deficit beyond 2010 could lead to the emergence of funding problems and recourse to potentially destabilising deficit monetisation as Yemen's capacity to sustain significantly higher debt ratios is constrained by the small size of its underdeveloped financial system and limited access to external financing.