* Bank still pays salaries on both sides of civil war
* It represents last bastion of financial system
* Governor determined to maintain "economic truce"
* Dwindling foreign reserves endanger vital food imports
By Noah Browning
DUBAI, June 10 (Reuters) - As civil war engulfs Yemen, the central bank is so committed to staying neutral that it pays salaries of soldiers on both sides.
The bank distributes money to public-sector workers in both government and rebel-held areas, and guarantees payments for vital grain and flour imports.
Central banks play an important role in many economies but in Yemen, which has been plagued by a war for more than a year, it is keeping the country from financial collapse and the population from running out of food.
The Central Bank of Yemen (CBY) is based in the capital Sanaa, which isn't even controlled by the internationally recognised government. The city was seized by Houthi rebels in late 2014.
The CBY represents the last bastion of the financial system in the impoverished country and is effectively running the economy, according to central bank officials, foreign diplomats and Yemeni political sources on both sides of the war.
Its independence is not just an institutional need; to safeguard imports and forestall a looming famine, international lenders and traders must have confidence in the bank's ability to manage Yemen's riyal currency and foreign exchange reserves free of political interference, said the sources.
The country relies on imports for 90 percent of its food, but shipments have been falling since the war began; 21 million out of its 28 million people need some form of humanitarian aid and over half the population suffer from malnutrition.
"It's fair to say the central bank is certainly serious about being neutral in a very difficult political and security setting, and it has been to a large extent successful in maintaining basic financial stability throughout the conflict," said the IMF Mission Chief for Yemen, Albert Jaeger.
The CBY regularly disburses riyals to pay soldiers loyal to the Houthis and other state employees on ministry payrolls in territory held by the group.
The amounts involved are unclear, and no official statistics have been released by the CBY since the war began.
The bank also sends money to the port of Aden - declared the "temporary capital" by the government - to pay doctors, teachers and some soldiers in government-run areas in southern and eastern Yemen, the CBY sources, diplomats and political sources said.
Though no civilian flights fly the same route, every few weeks a plane from state airline Yemenia flies several million dollars in riyals from the central bank in Sanaa to Aden in the south, they added.
Central bank sources declined to be named as they are not authorised to speak publicly. A spokesman for the central bank said it had decided not to conduct interviews during the crisis.
The diplomats and political sources also asked to remain anonymous, citing the sensitivity of the situation.
The crisis began in September 2014 when the Iran-allied Houthis seized Sanaa. An Arab military alliance led by Saudi Arabia intervened last year, seeking to restore ousted President Abd-Rabbu Mansour Hadi, and has launched thousands of air strikes against the Houthis.
The fighting - which has killed more than 6,400 people and displaced 2.5 million - has also allowed al Qaeda to consolidate its presence in the country.
The conflict has hit access to basic supplies like food, fuel and medicine amid the coalition's near-blockade on ports. The central bank plays a key role in keeping vital goods coming in, guaranteeing imports of flour and grain at official rates, but it cancelled such pledges for rice and sugar in February as its dollar reserves dwindled.
Western banks have already cut credit lines for traders shipping food to Yemen due to the security chaos and fragility of the financial system, Reuters reported in March. They are increasing unwilling to offer letters of credit, which guarantee sellers will be paid on time.
Any sign that Yemen's fiscal policies and dwindling foreign exchange reserves - used to pay for imports - are being mismanaged could lead to a further fall in shipments, central bank and political sources said.
"If monetary policy had been pushed by political interests, the riyal would have lost its value, inflation would rise, public salaries could not be paid and food imports could not be guaranteed," one central bank source told Reuters.
"Even though the employees here have different political views, we're proud that the central bank has stuck to its independence in a way that has reduced the negative impact on people's lives."
The Houthis are likely to have received more central bank cash for their troops than the government, as when they seized Sanaa thousands of their militiamen were added to army rosters and became entitled to state pay, political sources say.
Many pro-government troops were recruited after the war erupted, however, so were not on existing rosters. They were therefore not eligible for official pay but instead receive salaries from the Saudi-led alliance.
Much of the credit for the central bank's survival lies with Mohammed Bin Humam, its 69-year-old governor who has cordial ties to both sides in the civil war.
When the Gulf Arab alliance intervened in Yemen, Hadi and many of his ministers fled to luxury guesthouses in Riyadh.
Bin Humam stayed in Sanaa.
Diplomats and central bank officials say an unwritten "economic truce" was agreed between the warring sides by which the CBY would remain free of political interference to avert economic collapse.
When government forces retook Aden from rebel forces in July 2015 and Hadi pledged to set up a temporary capital there, uncertainty spread over whether the CBY would shift base.
Bin Humam then suddenly left Sanaa.
"In Sanaa they (the Houthis) were afraid. They thought he defected," a senior Yemeni security official told Reuters.
"He travelled to Saudi Arabia and met government officials there. He received guarantees that the neutrality of the bank would still be respected. Then when he returned, they greeted him like a hero."
Videos posted on YouTube showed central bank employees mobbing him as he returned to its headquarters, with men kissing him on both cheeks and women ululating in joy.
Despite efforts to shore up the economy, the central bank may be running out of options.
Yemen faced daunting economic challenges even before the war, but had one saving grace: oil. Its energy industry accounted for 80 percent of its state budget and nearly half of the inflow of foreign currency.
But exports stopped over a year ago and foreign companies have pulled out; the country's largest oil export terminal was only wrested back by the government from al Qaeda fighters in late April and its main natural gas port is still in territory under the sway of the militants.
With little means of replenishing its foreign exchange reserves, the central bank has burned through its dollars to pay for imports and keep up Yemen's foreign debt obligations.
The reserves have fallen to around $1.1 billion from $4.7 billion at the end of 2014. The IMF put them at well below two months' of imports, which it told Reuters was "very, very low".
"Economic collapse is a genuine, imminent threat," a European diplomat said, adding that only a swift peace deal in floundering U.N.-backed talks in Kuwait may forestall disaster.
(Editing by Pravin Char)
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