Islamic Republic of Afghanistan -- Sixth Review Under the Staff-Monitored Program and 2005 Article IV Consultation, Concluding Statement of the IMF Mission

November 22, 2005

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.

This statement presents the conclusions of the IMF mission that visited Afghanistan from November 8-22, 2005, to conduct discussions with the authorities for the 2005 Article IV consultation and the sixth quarterly review under the staff-monitored program (SMP).1 The authorities' performance since the inception of the SMP in March 2004 has been commendable. In a challenging environment, they have implemented sound macroeconomic policies and an ambitious reform agenda, which have contributed to sustained growth and to the stabilization of the economy.

However, during the period covered by the sixth review (July-September 2005), there have been some slippages in the implementation of structural reforms. While these slippages did not reflect a change in policy priorities, they epitomized the need for the authorities to remain focused on the reform program. Afghanistan still faces formidable challenges, such as lingering insecurity, the effects of the illegal opium industry activities, and poor infrastructure and institutions. To overcome these challenges, the authorities, in collaboration with the donor community, will have to develop a medium-term macroeconomic framework and a reform agenda that are both consistent with their development objectives and financially sustainable. The IMF intends, through a program that could be supported by the Poverty Reduction and Growth Facility, to continue to assist the authorities in this endeavor.

1. The Afghan economy continues to perform satisfactorily. The first half of 2005/06 witnessed a rebound of output, coupled with moderate inflation. Fiscal and monetary developments remained in line with program projections. The government met all end-September quantitative indicators and observed, albeit with some delays, all structural benchmarks, except for the publication of the audited 2004/05 core budget financial statements. This performance was achieved in the context of the preparation of Afghanistan's first legislative and provincial elections, which were held on September 18.

2. Economic activity was in line with program projections, as agriculture output rebounded on the basis of good rainfall and the reconstruction effort continued to drive growth in construction, trade, transportation, and telecommunications. In spite of a sharp rise in petroleum product prices, inflation remained relatively moderate during the second quarter of 2005/06. After declining sharply during the first quarter, year-on-year inflation in Kabul rose to 12.9 percent at end-September.2 Rents, which were a very important inflation factor last year, slowed markedly.

3. Preliminary estimates by the United Nations Office on Drugs and Crime show a 2-percent decline in opium production in 2005. A 21 percent decline in cultivation was largely offset by a rebound in yields due to favorable weather conditions. The decline in cultivation was due primarily to intensified government-led anti-narcotics efforts and relatively low farm gate prices. Increasing drug seizures and eradication efforts continued to have a modest impact, relative to the size of the problem. Cultivation declined sharply in the five highest-producing provinces, while it increased significantly in the other provinces, reflecting in part the versatility of the drug economy in response to anti-narcotics efforts. Due to a slight decline in prices, the export and farm gate values declined by more than production, falling by 4 percent and 7 percent, respectively, to $2.7 billion and $560 million,.

4. Fiscal performance remained prudent, with the core operating budget deficit, excluding grants, amounting to 1.7 percent of annual GDP during the first half of 2005/06, slightly lower than expected. The government maintained its `no-overdraft' rule and the core operating deficit was more than covered by foreign grants. While core operating budget expenditure was broadly on track, development spending amounted to around 2.5 percent of GDP during the first half of the year, compared with the June budget annual estimate of 16.4 percent of GDP. Lower-than-expected development spending reflects longstanding capacity constraints, unrealistic expectations on the pace of implementation, weaknesses in budget formulation, and security concerns. Domestic revenue in the first half of 2005/06 exceeded somewhat the SMP indicative target. While customs revenue was greater than anticipated, increasing by 40 percent over the same period of 2004/05, the mission expressed its concern about the absolute decline in tax revenues, which occurred despite strong economic growth, the introduction of new measures, and administrative reforms. A number of these measures have yet to generate the expected benefits, with the exception of the rental tax, whose collection has increased markedly. Revenue collection has also been negatively affected by: (i) delays in the approval of the new enforcement provisions, meaning that compliance remained voluntary; and (ii) uncertainty over the administration of the March 2005 amended income tax law pending the adoption of a new law (the law was approved in November 2005).

5. The mission welcomed the introduction of new tax measures, taxpayer education, and the approval of the new income tax law. Revenue should also be boosted by the introduction of a higher turnover tax rate for specific services (mainly luxuries), a wage withholding tax, and an airport departure fee. However, given that the existing tax coverage is partial and with limited administrative capacity, the mission supported the government's initial focus on large taxpayers. Publication of a revised income tax manual should enhance public awareness and compliance.

6. Monetary developments were in line with SMP projections. The mission noted that the increase in currency in circulation during the first half of 2005/06 remained below the SMP second quarter indicative ceiling. The seasonal acceleration in the demand for money during the second quarter was less marked than last year, allowing DAB to contain money growth within program limits without triggering a sharp appreciation of the Afghani. DAB's foreign exchange activity and the accumulation of deposits by the government contributed to a further rise in international reserves, to $1.5 billion at end-September, in line with the balance of payments projections for 2005/06, characterized by a stable current account deficit and a positive, although declining, capital account surplus. Interest rates on the overnight and 30-day capital notes continued to move in the 1-2 percent and 4-6 percent ranges, respectively. Against this background, commercial bank lending operations increased at a brisk pace, albeit from a low base, while their deposit base rose by 9 percent during the first half of 2005/06, to 2.2 percent of GDP. During the 12 months leading to end-September, the real exchange rate was broadly stable, the nominal depreciation of the Afghani being offset by a positive inflation differential.

7. Some progress was made in restructuring the state-owned banks. The mission welcomed the authorities' public announcement of their intention to liquidate the three former state-owned banks that had not been relicensed. Also, in a move to accelerate the transfer/reimbursement of its remaining deposits, which was initially to be completed by end-September, DAB froze the correspondent accounts of Agricultural Development Bank-the only former state-owned bank to have kept a deposit base. The mission welcomed the Minister of Finance's intention, as the main shareholder, to restructure the relicensed state-owned banks, Bank Millie and Bank Pashatny, and to consider the transfer of Export Promotion Bank's assets to one of these two banks. Other positive developments in the banking sector included the divestiture of DAB's commercial activities in the provinces where at least one commercial bank is active, and the reduction, from 6 percent to 0.5 percent, of the registration fee for deeds, whose high level constituted a major deterrent to lending operations.

II. Economic and Financial Policies for the Rest Of 2005/06

8. Discussions on the program for the next twelve months centered on the need to: (i) maintain macroeconomic stability; (ii) strengthen institutional and administrative capacity; and (iii) accelerate structural reforms. In support of a reform agenda consistent with these objectives, the authorities requested a comprehensive IMF program under the Poverty Reduction and Growth Facility (PRGF); the PRGF could start as early as the beginning of the next fiscal year.

9. The mission maintained the 2005/06 GDP growth projection at around 14 percent, as favorable weather conditions should sustain a boost in agriculture output, and as construction and other services remain buoyant. Notwithstanding some upside risks, related to developments in the oil market and rents, year-on-year inflation is expected to decline further during the second half of 2005/06, to about 10 percent by year-end.

10. The government reaffirmed a commitment to fiscal sustainability during the mid-year review (MYR). In the absence of a comprehensive public administration reform program, the increase in the wages of non-uniformed civil servants appears appropriate, as the budgetary impact for 2005/06 was contained to less than 3 percent over the original budget. Overall, the operating budget increase stemming from the MYR was restricted to 2.1 percent, with additional unanticipated spending for parliamentarians and pensions offset by savings in other current and capital expenditures. Domestic revenues are also projected to increase, by around 14 percent over the budget.3 The operating balance, including grants from the two dedicated trust funds, should record a small surplus in 2005/06. While the modest reduction in the core development budget in the MYR, to 14.1 percent of GDP, reflects a move toward more realistic assumptions, the mission is of the view that actual spending is likely to be significantly lower given the current pace of spending.

11. Reform of the fragmented and largely uncoordinated pension system is a concern, as the fiscal burden remains uncertain but continues to grow. The MYR rightly increased the allocation for pensions in the operating budget to about 5 percent of total operating expenditures. However, there is considerable uncertainty about actual pension liabilities. The situation may be exacerbated by a recent Supreme Court decision on military pensions that, if upheld upon appeal, would add $45 million to the current budget for past payments, and about half that amount annually in future obligations. The decision appears to link pensions to recent salary increases, which would set a worrying precedent given the imminent retirement of a large number of civil servants and proposed pay reforms. The mission advised the authorities to quickly resolve the immediate issue of military pensions and address the policy issue within the broader public administration reform.

12. The relative stability of inflation and the Afghani during the first half of 2005/06, suggests that the monetary policy agreed upon during the third review remains appropriate. However, in view of the upward risks to inflation, stemming in particular from possible second-round effects of the increase in oil prices, the mission emphasized the need for the authorities to follow closely price and exchange rate developments and to stand ready to tighten the monetary stance, should inflationary pressures intensify. In 2006/07, pending a deepening of the financial markets (interbank market, capital notes), monetary policy will continue to target currency in circulation with a market-determined exchange rate.

13. The mission welcomed DAB's commitment to pursue the modernization of its operations and strengthen its monetary policy framework. In line with IMF technical assistance recommendations, DAB will amend reserve requirements regulations to provide for their remuneration, while excluding capital notes from eligible assets. The authorities are expected to start enforcing these new regulations, as well as those related to open foreign currency positions, and to start penalizing non-compliance by end-March. By end-December 2005, DAB will allow participants in the DAB's foreign exchange auctions to sell, as well as to buy dollars, and introduce an overnight collaterized credit facility, with the capital notes eligible as collateral. The mission supported the authorities' intention to introduce capital notes of longer maturities and emphasized the need for interest rates to remain market-determined, even if longer maturities translate into higher rates. Lastly, it will be essential for DAB to strengthen the monetary framework through the development of more reliable liquidity forecasts, publication of the capital note interest rates, and strengthened oversight by its Supreme Council.

14. The mission commended the authorities' commitment to accelerate the restructuring of the public banking sector. It supports the move to appoint, by end-December, officials to take charge of the liquidation of the former state-owned banks, and to complete, by end-March 2006, the transfer/reimbursement of Agricultural Development Bank deposits. In addition, the authorities will replace the management boards of Bank Millie by end-December 2005 followed by Bank Pashtany. Experts will also be used to help the new managements restructure these banks and develop their operations. By end-June 2006, the new management teams, in coordination with the Ministry of Finance, will adopt long-term restructuring plans. It is essential that the authorities adhere strictly to the agreed work programs to assure the emergence of a resilient banking system.

15. The authorities and the business and donor communities concurred on the importance of addressing the administrative and legal impediments facing the banking sector. While other factors, such as poor judicial enforcement, also contribute to the limited size of the banking sector lending portfolio, there appears to be a consensus regarding the need to enact a core group of enabling laws, including secure transactions, business organization, and negotiable instrument laws, and to clarify land ownership rights.4 The mission encouraged the authorities to continue working closely with the banking and donor communities to prioritize and expedite the legal, administrative and legislative reforms to address these rigidities. More efforts are needed to create a business climate that is conducive to private investment, a crucial element for sustainable growth and poverty alleviation.

16. A more comprehensive understanding of external sector developments is essential to improving the formulation of sound monetary and exchange rate policies. The mission called upon the authorities to continue improving their database and coordinate efforts between the Central Statistical Office, the Ministry of Finance, and DAB. Provision of sustained technical assistance to facilitate an adequate reporting system is critical.

17. Efforts towards a speedy reconciliation of bilateral external claims should continue so as to provide a comprehensive framework for a debt reduction strategy. The authorities have made good efforts in contacting all creditors and the secretariat of the Paris Club. The mission welcomed progress made so far in reconciling a significant amount of debt. However, some creditors have not yet replied to the government's requests or provided adequate documentation to validate their claims. This highlights the need for sustained effort to mobilize concerned parties to resolve this process.

18. Public debt sustainability requires not only a prudent fiscal policy and the favorable resolution of bilateral claims and debts currently outstanding, but also a sound debt management strategy. The mission encouraged the government to continue to rely predominantly on grants to finance its development needs. Also, to maintain debt dynamics consistent with sustainability, the government should avoid loan agreements that entail nonconcessional terms and/or implicit or explicit government guarantees. Any borrowing or guarantees should be highly concessional and adhere strictly to the policies and procedures described in the recently adopted Public Expenditure and Financial Management law and the Cabinet-approved external debt management strategy.

19. The mission initiated discussion on a IMF-supported program that could provide a medium-term macroeconomic framework to support the ambitious reform agenda. The fiscal and monetary stances and progress in the structural reforms are of critical importance for a program that could be supported by the PRGF. It is expected that discussions will continue during the next IMF mission,with a view to having a program in place by April 1, 2006.

20. Delays in implementing some structural measures agreed under the SMP highlight the need to revitalize the Technical Coordination Committee (TCC) that monitors implementation. This is especially true as Afghanistan prepares to undertake a PRGF program. Strengthening leadership and key membership of the TCC will assist this process, as will representation from the Ministries of Economy, Commerce, and Justice, as they all have a stake in economic reform. Once the PRGF is in place, representatives from key social ministries might also be included. The mission encourages the authorities to formalize the TCC as a way to enhance its effectiveness.

III. Medium-term Outlook

21. The authorities have made great strides in stabilizing the economy, but the challenges remain formidable. The commendable achievements to date are due, in no small measure, to the government's sound macroeconomic and structural policies since March 2004, in the context of an SMP framework that has emphasized macroeconomic stability, economic reform, capacity building, and transparency. However, lingering insecurity, illicit drug industry activities, the poor state of infrastructure, and weak institutions remain the key constraints to investment, sustainable growth, and improvements in social welfare. Crucial legislation still needs to be adopted. Capacity constraints and poor data management continue to impede the pace of reform, requiring more focused technical assistance, stronger donor coordination, and careful prioritization.

22. In the case of Afghanistan, as for other post-conflict countries, building a medium-term framework is challenging. For Afghanistan, the challenges include: (i) the real appreciation of the Afghani resulting from large aid- and drug-related inflows; (ii) the potential vulnerability to external shocks; (iii) the reliance on significant amounts of grants to help ensure fiscal sustainability as the country rebuilds; and (iv) limited infrastructure and water and energy supplies, which constrain productivity and growth.

23. The mission applauds the government's intention to present an Interim Afghanistan National Development Strategy (I-ANDS) at the London donors conference in January. The I-ANDS will detail the authorities' approach for a secure and sustainable Afghanistan, based on medium-term development strategies reflecting key priorities, and intersectoral resource allocations to support economic growth and livelihood improvement. The identification and prioritization of the sources of growth, key poverty factors, the removal of impediments to private investment, and sectoral strategies will serve as a basis for updating the macroeconomic framework and the discussions on a PRGF program. While the development of the I-ANDS involved considerable consultation, it should be seen as the first step in a process to formulate a comprehensive development strategy with broad ownership. IMF staff will work closely with the authorities and the World Bank to ensure that the I-ANDS meets the requirements of an interim poverty reduction strategy paper (I-PRSP) that is needed in order to enter into a PRGF arrangement.

24. Under the assumptions of continued reform, donor support, and the gradual improvement of energy and infrastructure, the medium-term framework envisages growth of about 10 percent on average for the next three years. This scenario is consistent with a return to trend of agricultural growth, and sustained, albeit decelerating, activity in construction and services.

25. The medium-term fiscal framework (MTFF) provides a good basis for the 2006/07 budget and for strengthening budget management and fiscal policy. The MTFF currently includes a set of integrated, medium-term macroeconomic and fiscal targets and projections that outline a path towards fiscal sustainability—the wage bill continues to increase, due to the public administration reforms, but is expected to be covered by domestic revenue in 2006/07, and the entire operating budget could almost be covered within four years. Over time, the MTFF should be progressively refined so that the multi-year projections are more clearly linked to policies, such as revenue and pay reform, before seeking to integrate more detailed sectoral strategies. The MTFF should also provide a framework for integrating the development and operating budgets into a truly unified budget, that considers the ongoing costs of maintaining current investment.

26. There are significant fiscal risks over the medium-term. Fiscal sustainability is predicated on: (a) rebuilding domestic tax collection from its extremely low levels; (b) implementing a civil service reform program to contain the wage bill and pensions to affordable levels, in the face of significant cost pressures;5 and (c) gradually consolidating fiscal operations within the core budget, consistent with the limited ability to sustain such activities. Over the medium term, the reliance on external funding will remain significant, even for core fiscal activities, such as the Afghan National Army and health expenditures. The inclusion of such spending in the core budget and MTFF in a more predictable way could enhance its effectiveness, assuming improvements in transparency and accountability.

27. While revenue mobilization is a priority, significant new measures must be considered within the broader economic and revenue reform context. The MTFF includes an ambitious program to increase domestic revenue, from 4.5 percent of GDP in 2004/05 to 8.6 percent of GDP by 2009/10, through: (i) the rationalization of the current tariff structure6 and the introduction of road tolls and excise taxes for 2006/07; (ii) expanded coverage of the taxes introduced in 2005/06; and (iii) strengthened compliance arising from administrative reforms. The mission cautioned against introducing piecemeal reforms, such as the recent duty exemptions and some tariff proposals, and emphasized the need for new measures within a comprehensive revenue policy and administrative reform framework. This would include the proposed transition of the turnover tax into a more effective consumption-based tax, possible tariff reform, revenue and customs administration reform and the abolition of nuisance taxes. The mission also urged the authorities to consult widely before introducing major new initiatives, to reinforce a positive business environment.

28. Fiscal reporting, accountability and transparency should remain a high priority. The authorities are encouraged to focus more resources on continuing to improve the integrity and timeliness of fiscal information. The mission welcomed the agreement between Ministry of Finance and the Control and Audit Office to expedite completion of the audit of the core budget financial statements, by end-February 2005 (originally an end-September benchmark), but urged them to agree to an audit plan for 2005/06, to ensure compliance with the new legal timetable.

29. Monetary policy's primary objective will remain the reduction of inflation to low levels. To meet this objective, and with the assistance of the IMF, the authorities intend to: (i) strengthen DAB's implementation capacity, through the development of new monetary instruments and the deepening of financial markets; (ii) increase DAB's policy formulation capacity, through the improvement of monetary statistics and the development of its analytical tools; and (iii) better manage public expectations through greater transparency. They also need to proceed with the restructuring of the public banks to improve their efficiency and maximize shareholder value.

30. The structural reform agenda is focused on improving governance and transparency, enhancing the efficiency of the public sector, and improving the business environment. The mission welcomed the plan to publish in the Official Gazette the revised Tassady Law, covering state-owned enterprises (SOEs), and launch an open and transparent divestiture process for the 58 identified SOEs, and to conduct a survey of the various public entities and government agencies (not covered by the revised Tassidy Law) that are engaged in commercial activities.

31. Improving the availability, reliability, and timeliness of economic statistics would support the formulation and monitoring of macroeconomic and social policies. While acknowledging progress, there continues to be serious deficiencies in data availability and coverage, in particular with regard to national accounts, the external sector, and labor market statistics. Weaknesses should be addressed through implementation of the statistical master plan. In this context, the mission welcomed the recent adoption of the statistical law, which should facilitate external funding to support this area. The mission also welcomed the authorities' recent decision to participate in the general dissemination data system.

32. The mission emphasized the IMF's commitment to help build capacity in Afghanistan to ensure program implementation. Key areas of possible future technical assistance include tax and customs administration and policy, public expenditure management, banking supervision, liquidity management, and the quality of statistics.

33. The mission welcomed the authorities' intention to publish the updated letter of intent and Memorandum of Economic and Financial Policies, as well as the staff report for the sixth review under the SMP and the 2005 Article IV consultation. We wish the authorities every success in their efforts.

1 The mission team would like to thank the authorities for their excellent cooperation and sincere exchange of views, in particular the Vice President, the Minister of Finance, the Minister of Foreign Affairs, the Minister of Commerce, and the Acting Governor of Da Afghanistan Bank (DAB). The mission also met with some recently elected parliamentarians, senior government officials, the donor and business communities, and with nongovernmental organizations.

2 The `national' consumer price index, which covers five major cities in addition to Kabul, increased by 10.8 percent over the twelve months through end-September.

3 The increase in revenue excludes $80 million (equivalent to 21 percent of domestic revenue) from the sale of telecoms spectrum band width-a nonfinancial asset-that will be received in the third quarter.

4 The mission organized a roundtable on the legal and administrative impediments to financial sector development with representatives of the government, the donor community, and the banking and private sectors where these issues were discussed.

5 As highlighted previously, recent proposals to retrospectively adjust existing pensions based on current pay increases could have significant cost implications. There are also proposals to significantly increase pay rates for selected public servants, such as the police, that could raise expectations elsewhere.

6 Various proposals, which would shift the current concentration of imports in very low duty bands, have been put forward on the assumption that it will increase the effective tariff, and hence revenues, considerably. The mission considers that a move towards a more uniform tariff would be preferable to increasing the top rate or the dispersion, while excises may be more appropriate for raising revenue from specific goods.


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