Islamic State of Afghanistan -- Concluding Statement for the Second Quarterly Review Under the IMF Staff-Monitored Program and the IMF 2004 Article IV Consultation

November 3, 2004

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

An IMF mission visited Kabul from October 20 to November 3, 2004 to review performance under the staff-monitored program (SMP) and conduct the 2004 Article IV consultation. The mission received excellent cooperation from the authorities and benefited from constructive discussions and exchange of views with the Vice President, the Minister of Finance, the Minister of Reconstruction, the Minister of Foreign Affairs, the Governor of Da Afghanistan Bank, other senior government officials, as well as representatives of the donor and business communities. In addition, the IMF mission organized a roundtable discussion on the potential sources of economic growth with representatives from the government, the donor community, and the private sector.

I. Performance Under the SMP

As was the case for the first review, the government of Afghanistan has again largely met the quantitative indicators and structural benchmarks that were established for the second review under the SMP. The staff view this as a notable achievement especially in light of the volatile security situation and the resources the government had to devote to its first direct election. However, there is no room for complacency. Afghanistan faces a large reform agenda in the remainder of the program, and there are a few areas where progress has lagged. Bottlenecks in the legal system also continue to prove problematic.

Notwithstanding a fall in agricultural production, the Afghan economy continued to perform strongly. While lingering drought conditions led to a 25 percent fall in cereal production during the first half of 2004/05, growth remained strong in other sectors, particularly construction, power, and transportation. After a sharp rise in inflation in the first quarter, the rate of inflation abated during the second quarter. While slowing down somewhat, rents and petroleum prices continued to increase sharply in the second quarter. Excluding these two items, consumer prices declined, primarily reflecting a fall in food prices. Year-on-year inflation amounted to 14.1 percent at end-September (8.3 percent, excluding rents and petroleum products). Indications are that, despite a decline in yields resulting from crop diseases and adverse climatic conditions, poppy production has continued to increase, with poppy farming spreading to new areas of the country.

Fiscal revenue for the first half of 2004/05 was Afs 5.9 billion, exceeding the SMP indicative target of Afs 5.5 billion. Based on current projections, and with full implementation of the tax and customs reform plans, the staff anticipate that the government should achieve the SMP targets for the remainder of 2004/05. After a very slow start, the rate of spending for operating expenditures increased during the second quarter of the year, reaching a total of Afs 12 billion by the end of the first semester, compared with an annual budgeted amount of Afs 30.3 billion. The government continued to abide by its "no-overdraft rule" for financing the operating budget deficit. However, delays in securing sufficient grant resources from the Afghanistan Reconstruction Trust Fund (ARTF) and the Law and Order Trust Fund (LOTFA) meant that to fully finance its operations the authorities had to draw down domestic deposits and temporarily transfer funds provided through a concessional loan. Core budget development spending, which includes donor-funded projects that run through government accounts, was very low during the first half of the year, at Afs 3.4 billion, compared to an annual budget estimate of Afs 38 billion. The underspending was attributed to a delay in the development component of the core budget which was not approved until the end of the first quarter, the poor security environment, and the limited capacity of line ministries and other agencies to implement programs.

On the monetary side, in consultation with Fund staff, Da Afghanistan Bank (DAB) exceeded the SMP target for currency in circulation target during the second quarter. This was necessary to accommodate the perceived increase in money demand and to limit the strong appreciation of the Afghani. DAB's decision was instrumental in stabilizing the exchange rate in the Afs 45-46 per dollar range. Reflecting DAB's foreign exchange activity, its international reserves increased sharply during the second quarter, to over four months of imports—a level sufficient to help the central bank avoid major exchange rate disruptions in the event of an adverse external shock. The external current account deficit (before grants) narrowed to 12 percent of GDP in the first half of 2004/05, down from 22 percent during the first half of 2003/04, and was primarily financed by donor inflows, predominantly in the form of grants. The decline in the deficit appears to have stemmed largely from an improvement in the trade balance, including a substantial increase in domestic exports, but also a slowdown in imports likely attributable to the delay in the implementation of development projects.

All the structural benchmarks were met, except the presidential decree enacting Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) legislation, which was delayed by a few weeks. Other reforms include the implementation of the tax reform package, the extension of the CPI to five additional cities, the more timely transfer of provincial revenue to the central government accounts, the preliminary classification of the state-owned enterprises by envisaged restructuring method, and the drafting of a private investment law and the legal framework for extractive industries. In the financial sector, progress has been mixed. On the one hand, a preliminary license was granted to the Export Promotion Bank, DAB successfully introduced a short-term capital note, and reserve requirements were adopted. On the other hand, the restructuring of the state-owned commercial banks and the resolution of those that did not receive licenses appears stalled, and while commercial banks were allowed to participate in foreign exchange auctions, there is considerable scope for making the process more market-oriented.

Discussions with the authorities on the program for the remainder of the year focused on: (i) maintaining macroeconomic stability in a period of political transition and persistent insecurity; (ii) strengthening capacity building; and (iii) stepping up structural reforms necessary to spur private investment and improve government delivery of services. On the macroeconomic side, understandings were reached on a revised macroeconomic framework and a revised monetary program. In the structural area, the discussions focused on the need to step up revenue collection, strengthen expenditure management, and make improvements to the business environment and regulatory framework. One issue related to the transfer of assets and liabilities between the Ministry of Finance (MoF) and the DAB (an end-March 2005 structural benchmark) has yet to be resolved.

The macroeconomic framework has been revised to reflect weaker growth in the agricultural sector. Adverse climatic conditions are expected to adversely affect the fall harvest, resulting in a 20 percent fall in cereal production in 2004/05. However, fueled by strong activity in the construction, transportation, and service sectors, economic growth is expected to reach 7.5 percent in 2004/05—albeit somewhat lower than initially projected. This would contribute to a rise in per capita income to $228, up from $199 in 2003/04. The inflation target of 10 percent, which is consistent with a further slowdown in consumer prices, was left unchanged.

In view of the perceived higher-than-expected increase in money demand, the authorities and the staff agreed on a revised monetary program. It was also agreed that, in view of the vulnerability of the Afghan economy to external and domestic shocks, a flexible exchange rate remained appropriate and that monetary policy should remain anchored on targets for currency in circulation. In this context, and on account of the faster-than-expected pace of monetization, the monetary targets for the remainder of the year were revised upward. Notably, the revised targets represent a tightening, by end-year, of monetary policy relative to the current stance. This should accommodate the anticipated further increase in demand for Afghanis without feeding inflation. As future money demand still remains surrounded by uncertainty, it was agreed that the program would remain flexible and would be carefully monitored. The authorities reiterated their commitment to closely follow price and exchange rate developments and to tighten the monetary stance should prices accelerate. Finally, in light of the foreign exchange accumulation during the first half of the year, the authorities agreed to raise the indicative target for international reserve growth.

While the increase in the rate of revenue collection over the first half of the year is encouraging, a significant improvement is still required to meet the government's budget target—which is more ambitious than the SMP target. The authorities emphasized their determination to fully implement a wide range of planned customs and tax reforms, which should enhance collection. The rate of spending for operating expenditures is expected to pick up during the remainder of the year as more ministries participate in the administrative restructuring process, and financial management capacity continues to improve. The mission cautioned that salary increases (and proposed bonus payments) should be constrained within existing budget appropriations and considered as part of an affordable medium-term public administration reform program. Core budget development spending is likely to remain constrained over the near-term by the security situation and the lack of capacity to implement large development programs.

The immediate priorities for fiscal management include measures to further: (1) integrate the operating and development components of the core budget; and (2) upgrade core public expenditure management systems. Budget management has been enhanced considerably with the introduction of the "core" budget, with increasing amounts of development spending executed through the Treasury, and the consolidation of government accounts into the Treasury Single Account. The mission continues to support the strict enforcement of expenditure controls, which is gradually improving the government's ability to utilize essential foreign assistance. Nonetheless, these reforms need to be deepened with additional measures, including: (i) the further integration of operating and development operations; (ii) the gradual introduction of a verified payroll; (iii) the strengthening of cash management; (iv) the gradual development of an internal audit function within government; and (v) enhanced quarterly fiscal reporting. A Public Expenditure Review, which is being supported by the World Bank in collaboration with other donors, should assist with the preparation of the 2005/06 budget and a medium-term budget framework.

The mission stressed the need for further progress in modernizing the legal framework and in addressing deficiencies in the investment climate. In this respect, the mission welcomed the intention to create a more attractive business environment and the authorities' commitment to publish in the Official Gazette before the end of December 2004 several revenue measures that have been adopted by a Presidential decree. There are a number of new laws that also need to be enacted quickly. These include laws and regulations pertaining to public financial management (budget law), audit, procurement, and customs.

A fuller and more timely understanding of developments in the external sector is necessary to facilitate the formulation of sound monetary and exchange rate policies. In this context, the authorities must build on the progress already made in developing a statistical database for the balance of payments. In this regard, the provision of sufficient technical assistance—to facilitate the development of data sources and surveys—to guide the work of DAB staff is critical.

A speedy reconciliation of bilateral external claims and, if possible, a resolution of these claims is needed. Substantial progress has been made in this area by the MoF, but cooperation by counterpart agencies in identifying and resolving pre-war claims is necessary. A number of countries have already stepped forward in this regard and several have provided generous debt relief on old claims. This process needs to be accelerated in order to meet the end-March 2005 benchmark for completion of a survey and reconciliation of external claims. In order to achieve fiscal and external sustainability, generous debt relief is needed.

The modernization of the central bank will continue. The transfer of its commercial activities and of its non-core assets will allow the central bank to focus on its primary functions. Of critical importance in this regard, there are a range of potential liabilities housed in the DAB which will need to be investigated and either accepted or rejected by the government before a transfer off the central bank balance sheet can be effected. The resolution of this issue is proceeding slower than originally envisaged in the program. In the meantime, however, the commercial banking regulatory framework will be strengthened through the adoption of regulations related to enforcement activities, open foreign exchange positions, and financial reporting. Measures will be taken to enable the banking sector to play a more prominent role in the foreign exchange market.

The mission encouraged the authorities to intensify efforts to rationalize the public enterprise sector. Substantial progress has been made since the last review toward restructuring nonfinancial state-owned enterprises. The restructuring of the state-owned banks, however, appears to be lagging. While these banks may not represent a systemic risk, measures should be taken promptly to restore the profitability of the three which were relicensed and to resolve the three that were not relicensed.

The main risks to the program, and in particular to the fiscal objectives, arise from: (i) the political transition, which could negatively affect the pace of the reform process; (ii) the poppy eradication program, which if not done properly, could cause major macroeconomic disruption; and (iii) the security situation, which could deteriorate in the run-up to the parliamentary and general elections tentatively scheduled for April 2005.

The third review is scheduled to take place in mid-January 2005, based on performance at end-2004.

II. Medium-Term Outlook

Afghanistan's current economic and institutional environment presents a number of positive features. The institutional and political frameworks are increasingly becoming stable and economic reforms are making headway in tackling obstacles to economic management and higher long-term growth. The enactment of important tax policy measures, together with an ambitious program of tax and customs administration reforms, are helping the central government to regain control over national revenue. A financial management law, soon to be adopted, will set up an adequate legal framework for fiscal policy. After introducing a new currency and adopting central bank and commercial bank laws, modernization of the central bank and reform of the financial system is on track. The regulatory framework for private investment is expected to receive a boost from the upcoming new private investment law and the establishment of a legal framework for extractive industries—an area of potential for new investment and growth. Private investment should also benefit from the privatization program underway.

Initial successes should not breed complacency and postpone difficult decisions. Afghanistan still faces major challenges in a rapidly changing global and domestic environment, including a volatile security situation, a fragmented political environment, a growing drug economy, the continued strength of warlords who still threaten the government's reform agenda, an ineffective legal system, a bureaucracy that continues to be riddled by poor governance at many levels, and widespread poverty. These challenges call for fundamental policy measures and strong political will to make Afghanistan attractive for investment and ensure durable economic growth over the long term. Collaboration and partnership between the government and donors will be a key pillar in this regard.

Political stability, national solidarity, and social cohesion are the foundations for economic progress. In this regard, the mission was encouraged by the positive outcome of Afghanistan's first direct presidential election, which represents an important milestone in rebuilding the nation's institutional framework and in broadening ownership of the government's reform agenda. The mission looks forward to further progress on the reform program with the new government.

Wide-ranging, long-term policy initiatives will be instrumental to address Afghanistan's many challenges. The staff welcome the authorities' broad-based reform strategy, which is consistent with the 2015 Millennium Development Goals and articulated around (i) a return of security; (ii) private sector-led growth; (iii) strong revenue efforts to allow funding of recurrent costs within a medium-term horizon; (iv) eradication of the drug sector; and (v) strong institution-building efforts. In the process of implementing this strategy, the public's attitude toward the central government and the need to rebuild trust in key institutions are central challenges. Deepening confidence is critical for future development. Many of the reforms are well defined, but successful implementation will prove challenging.

The drug economy threatens the very fabric of Afghan society. The authorities need to forcefully address this issue. The mission supports recent efforts by the government to work closely with international partners to develop a broad strategy to deal with the opium issue that focuses on education, alternative livelihoods, interdiction, eradication, and legal reform. At the same time, the staff recognize that eradication of opium production cannot be accomplished in isolation, and that it could have a significant economic impact—particularly on some of the most vulnerable segments of the population. An assessment of these effects will be made over the next few months.

As regards the thrust of macroeconomic policies, the authorities and staff must remain vigilant with regard to potential risks, but flexible to ensure that policies are tailored to support growth during a time of transition. Fiscal policy will continue to play a central role. In this context, a move toward developing a comprehensive medium-term budget framework that maintains fiscal discipline is desirable. The authorities should continue in their efforts to enhance revenue and strengthen expenditure control.

Monetary policy will continue to be geared toward maintaining low inflation and currency stability. To that purpose, the central bank will continue to extend its arsenal of market-based instruments and, as the banking sector develops and more reliable monetary data become available, will base its monetary policy decisions on a broader set of monetary indicators, including reserve money and broad money. The authorities will work with the banking sector toward strengthening the legal framework—currently viewed as the main impediment to bank financing of the private sector.

Over the medium term, expenditure policy needs to gradually shift from security and reconstruction toward more broad-based sustainable development. The operating budget remains heavily skewed toward wages and security—which is probably appropriate at this juncture. There are endemic delays in the implementation of the development budget. While there has been steady progress, especially in light of the post-conflict setting, improvement is needed in the face of widespread frustration related to the tangible delivery of services and poverty reduction. Given the limited scope for increasing domestic revenue, the government appropriately envisages its medium-term role as restricted to providing only the most essential services in the most cost-efficient manner. Entrenching a politically viable, stable, efficient, and responsive center-provincial fiscal system will also be a priority over the medium term (e.g., addressing issues of taxing powers, revenue-sharing, and expenditure assignment).

While the collection of domestic revenue has increased at a relatively fast rate, there are clear constraints, and donor support is key to ensure the success of the government's reform strategy. To enhance ownership and coordination of the reform program and to strengthen the government, donor funding should be integrated into one consolidated medium-term budget framework (moving away from a collection of donor-implemented programs). A move toward more direct donor grant support to the budget would represent a simplification of fiscal management and of the coordination of donor funds. This will require continued improvement in fiduciary standards and the mechanisms for promoting accountability, such as independent audit and transparency.

Growth, employment, and export prospects hinge critically on creating an environment conducive to investment—both foreign and domestic. The new investment law is laudable in this regard, and a valuable step forward. However, a number of critical elements—such as property rights, bankruptcy laws, contract enforcement, and a transparent and effective judicial system—will need to be addressed if the government's strategy of creating private sector-led growth is to have any chance of success. The cooperation of all government ministries and agencies will be key, along with a political commitment at the highest levels to creating a clear and level playing field for business.

Strengthening legal capacity is essential to promote economic reforms. The drafting, passage, and publication in the Official Gazette of key economic legislation has been constrained by low levels of capacity at the Ministry of Justice. Mindful that the success of the reform process is predicated on the establishment of solid legal foundations, the staff urges the government to mobilize donor aid and technical support to the benefit of the Ministry of Justice.

Afghanistan's statistical framework is improving but substantial weaknesses remain. The mission welcomed the progress made in compiling basic real sector data, extending the coverage of the consumer price inflation to five major additional cities, and producing reliable core fiscal and monetary data. Nevertheless, the statistical system falls short of international standards in terms of quality, frequency, and dissemination. External sector data are particularly weak, although the authorities have demonstrated a laudable commitment to making improvements. These deficiencies hamper policy analysis and monitoring. A first positive step in this direction is the recent adoption of a statistical master plan. The mobilization of the needed resources and the determination of a clear work program to implement this master plan should be undertaken soon.

Much remains to be done in the governance area. The authorities are keenly aware of this problem and they are determined to address it forcefully. At the same time, they consider that this issue is not exclusive to the public sector and that there are problems of accountability throughout society.

In sum, the authorities must continue to meet the challenges of a fast transforming society. A broad-ranging policy agenda of structural reforms, and external support should enable Afghanistan to build upon its strengths and progress made so far.

The mission supports the government's intention to publish the updated Letter of Intent and Memorandum of Economic and Financial Policies, as well as the staff report for the second review under the SMP and the 2004 Article IV consultation.

We wish the authorities every success in their efforts.

Kabul, November 3, 2004


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