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.

Islamic Republic of Afghanistan—Statement of the IMF Staff at the Conclusion of the Mission for the First Review Under the Poverty Reduction and Growth Facility

Kabul, November 26, 2006

Despite a difficult security environment and persistent expenditure pressures from domestic constituents and donors, Afghanistan's performance during the first six months of the fiscal year conformed broadly with the objectives of the program supported by the Poverty Reduction and Growth Facility. Growth has been sustained, albeit at a rate lower than in recent years, inflation subsided, and fiscal and monetary developments remained favorable. However, the government has no room for complacency and must press ahead with its reform agenda to address daunting challenges, including limited job opportunities and widespread poverty. Weak administrative capacity, rising drug activities and persistent insecurity are the aggravating factors. Continued macroeconomic discipline, progress in key structural reforms, improved conditions to facilitate private sector development (including the state disengaging from economic activity), and political resolve to tackle difficult issues are critical to continued success. Should fiscal pressures mount further, the government's capacity to deliver on its future program commitments will depend critically on revenue mobilization as continued external support in some key areas is not assured.

1. An IMF staff team visited Kabul during November 12-26, 2006 to hold discussions on the first review of the program supported by the arrangement under the Poverty Reduction and Growth Facility (PRGF). Discussions focused on macroeconomic developments in the first half of 2006/07, compliance with the end-September 2006 quantitative performance criteria and targets, as well as structural conditionality, and the policies for the remainder of 2006/07, 2007/08, and over the medium term.

I. Program Performance During the First Half of 2006/07

2. Program performance during the first half of 2006/07 was broadly satisfactory. The authorities met all end-September quantitative performance criteria and indicative targets, the structural performance criterion and most structural benchmarks, except those related to the three state-owned banks (see below). Real GDP growth is expected to reach 8 percent, as continued activity in construction and services offset a 9 percent decline in cereal production. Despite a significant increase in counternarcotics operations, opium production is estimated to have increased substantially in 2006/07. Year-on-year inflation, as measured by the consumer price index for Kabul, declined to about 5.4 percent by September 2006, as a slower increase in rent prices largely offset a faster rise in food and energy prices. "National" year-on-year inflation, which covers Kabul and five other cities, was 5.2 percent in September.

3. The structural benchmarks related to the state-owned banks were not met because the authorities were considering alternative reform strategies. They did not: (i) appoint a new Board of Directors at Bank Pashtany; (ii) initiate the liquidation of the Export Promotion Bank or its merger with another bank; and (iii) adopt long-term restructuring plans for Bank Millie and Bank Pashtany. Instead they shifted their strategy in favor of merging all three into one state-owned bank, which was prompted by the banks' limited operational capacity and the dearth of qualified managers. This was a position supported by the IMF staff. The mission regrets that this decision was subsequently reversed, creating uncertainty as to commitment of the authorities to tackle the restructuring of these banks.

4. Domestic revenue continued to grow, exceeding the end-September program target of Af 10.6 billion. The revenue performance led to a lower than projected operating budget deficit. Higher receipts from income and profits taxes, and the business receipts tax (BRT) offset the shortfall in customs receipts resulting from delays in the introduction of a new tariff schedule and concessions to traders. Operating expenditures reached 4.1 percent of GDP, compared with 4.5 percent of GDP in the program. Core development budget expenditures as recorded in Afghanistan Financial Management Information System (AFMIS), reached only 8.2 percent of the annual core development budget. However, the backlog of expenditures pending AFMIS registration suggests that actual development spending was higher, possibly as much as twice the recorded figure.

5. Fiscal reforms have proceeded at a good pace. The 2005/06 core budget audited financial statements were submitted to parliament. The appeals process for customs and revenue has been established and the training of officials is underway. Draft procedures for implementing a certified monthly payroll system have been circulated for comments. A draft law to eliminate nuisance taxes and introduce collection of BRT on imports was submitted to Parliament, but was returned to the government, partly because of procedural issues. The government is currently reviewing ways to move forward with this law.

6. Monetary developments point toward increased confidence in the Afghani. International reserves increased further and the exchange rate remained broadly stable, fluctuating between Af 49.5 and Af 50.5 per U.S. dollar, while demand for domestic currency and deposits grew steadily. Currency in circulation increased by nearly 7 percent—somewhat less rapidly than expected, as money demand has been shifting from cash toward deposits. Interest rates on capital notes declined from about 8 percent in early 2006/07 to 5-6 percent in recent months, reflecting banks' rising liquidity in Afghanis. A corresponding decline was observed in other interest rates, while spreads between bank deposit and lending rates narrowed, reflecting growing competition in banking services. In line with their program commitments, the authorities also started enforcing regulations related to commercial banks' foreign exchange open positions, and encouraged a transfer of private accounts from Da Afghanistan Bank (DAB) to commercial banks.

7. The authorities have actively worked to resolve outstanding issues with their external bilateral creditors. Following the July 2006 Paris Club rescheduling agreement, they have made progress toward finalizing the relevant bilateral agreements. They have also made significant progress toward compiling the external debt database required for the IMF and World Bank to assess Afghanistan's eligibility for the Heavily Indebted Poor Countries (HIPC) Initiative.

8. The mission welcomed the authorities' efforts to address cases of negative effective protection through the new tariff schedule introduced in August. However, the number of tariff bands has risen from six to nine, with two new rates above the previous maximum rate. While recognizing the revenue benefits, the mission is concerned about the magnitude of the increase in effective protection.

II. Policies for the Remainder of 2006/07 and 2007/08

9. Growth is expected to reach 12 percent in 2007/08 and 10 percent from 2008/09 onwards, assuming a rebound of agriculture and sustained activity in construction and services. Inflation is expected to subside further. Timely imports of wheat have helped offset the cereal shortage and broadly stabilize food prices; at the same time, rents and energy prices are projected to rise moderately. With sustained appropriate monetary policy, inflationary pressures should remain under control, and the increase in the consumer price index should be limited to 6 percent by year-end, and 5 percent in 2007/08 and beyond.

10. The overall fiscal strategy for the remainder of 2006/07 and for 2007/08 strikes a reasonable short-term compromise, but delays fiscal sustainability. It targets a reduction of the projected operating budget deficit, excluding grants, from 4.2 percent of GDP this year to 2.8 percent at end 2007/08. Nevertheless, a disciplined approach is needed to maintain fiscal credibility:

Revenue mobilization requires a strategic approach. The authorities have reaffirmed their commitment to a pragmatic definition of medium-term fiscal sustainability, which includes an ambitious objective of covering all core operating expenditures from domestic revenues by 2010/11. While ad hoc revenue measures envisaged by the authorities may be sufficient to meet the revenue target for 2007/08, the authorities need to adopt a strategic approach to developing a modern tax and customs administration to meet their longer term revenue objectives. To this effect, they need to clarify the tax policy framework and carry out administrative reforms to improve compliance and efficiency, such as transferring accountability for administration of all large and medium-size taxpayers directly to the revenue department.

Spending pressures are mounting. The program of public financial management reforms is critical for maintaining fiscal discipline. The authorities face considerable pressures to accommodate: (i) expenditures previously funded by donors that have come on budget, namely the cost of fuel to operate several electricity generation plants; (ii) additional spending associated with the deteriorating security situation; (iii) the cost of additional teachers identified in a headcount inquiry; (iv) clearing of arrears to teachers, police, and utility companies; and (v) the inclusion of higher operating costs from the development budget. Addressing these pressures requires further improvements in budget formulation, chiefly through consolidating operating and development budgets. Program budgeting pilots in a few ministries and restructuring the budget department should enable better channeling of resources to the achievement of key policy priorities. The authorities also need to (i) conclude the ongoing investigations into past lapses in personnel management, particularly in the ministry of interior; (ii) redouble their efforts to strengthen monitoring and enforcement of the public sector payroll; (iii) build financial management capacity in line ministries; and (iv) promptly eliminate the backlog of development budget payments unrecorded in AFMIS.

Medium-term approach needs strengthening. The principal role of the medium-term fiscal framework is to identify macro-fiscal constraints. A public macro-fiscal strategy, closely linked to policy decisions, consistent with the PRGF-supported program, and endorsed by Cabinet, will assist in defining realistic envelopes for the annual budgets. It will provide clarity to donors and local stakeholders on the government's medium-term objectives, and be essential for effective implementation of the prospective Afghanistan National Development Strategy (ANDS). It will also demonstrate more transparently the fiscal impact of security-related expenditure pressures and transfers to the core budget of expenditures currently financed directly by donors outside the budget.

11. The current monetary stance remains appropriate, but DAB must remain vigilant lest banks' growing liquidity gives rise to unchecked credit expansion. In the very near term, the volumes of capital notes auctions should be raised gradually to maintain appropriate balance between money demand and money supply and forestall undue pressures in the foreign exchange market. Looking forward, as money demand is expected to rise in the second half of the year, partly reflecting the expected increase in government spending, DAB should be ready to engage in open market operations in capital notes to gain flexibility in achieving price and exchange rate stability and international reserve objectives. Development of a secondary capital notes market will be instrumental in this respect.

12. Decisive actions are required to determine the future of the state-owned banks. The banking sector is rapidly changing with private banks registering a robust growth in their deposit base and expanding their lending, which reduces the possible role for the state-owned banks. In this connection, it is imperative to either (i) accelerate the restructuring of the two state-owned banks that are still deemed potentially viable; or (ii) liquidate/privatize these banks. At present, neither bank meets the licensing requirements, which DAB's Bank Supervision Department should enforce fully. The mission is of the view that unless these banks can meet the licensing requirements and thus prove their viability DAB should take action to avoid a further dissipation of public capital.

13. The authorities need to finalize the bilateral Paris Club rescheduling agreements and preparations for assessing HIPC eligibility. They need to obtain outstanding data responses from some non-Paris Club creditors and complete the external debt database expeditiously to facilitate an assessment of HIPC eligibility in early 2007. The authorities should also work to enhance their debt management capacity. This will be vital to ensuring that Afghanistan's investment and reconstruction needs are financed in a sustainable manner and in managing the prospective HIPC process.

14. The authorities should avoid further changes that could undermine their liberal and transparent trade regime. In the near term, they should avoid reclassifying more goods into the two new top tariff bands and refrain from introducing ad hoc tax concessions that could erode the revenue base and distort the trading system, undermining efforts to enhance Afghanistan's growth prospects. Over the medium term, the authorities should aim to introduce excise taxes on selected goods while simultaneously rolling back the recent customs tariff increases that were introduced in lieu of excises.

15. The mission's discussions confirmed the need to reinvigorate the momentum for structural reforms to enhance private sector development, investment, and growth. Besides security concerns, the private sector continues to identify the lack of reliable electricity, an unclear legal framework together with the difficulties in securing land tenure, and widespread corruption as the main obstacles to doing business in Afghanistan. While steps have been taken to address some of these issues, including the creation of a one-stop shop for business licensing, they remain insufficient. The mission encourages the authorities to accelerate the adoption of business organization laws. This will go a long way toward updating, modernizing, harmonizing and simplifying legislation, regulations and procedures related to private investment. Equally welcome is the commitment to further disengaging the state from economic activities by liquidating or corporatizing 11 additional SOEs covered by the Tassady law. Nonetheless, the divestiture of government entities excluded from the Tassady law should also proceed. While the mission agrees that technical assistance could help facilitate progress, the authorities ought to step up their own efforts so that a comprehensive restructuring plan for these entities is prepared.

III. Poverty Reduction Strategy

16. The mission welcomes the authorities' efforts to build the institutional framework for the participation of stakeholders in the PRSP discussions. Equally welcome is the ongoing work to ensure that the medium-term fiscal framework is aligned with the country's PRSP objectives. There remain, however, important areas where further work is needed to enhance the efficiency of the PRSP process:

• Action is still needed to carry forward the analysis on alternative sources of growth and on the limits of the role of government in the economic area;

• Given the limited availability of social data, the mission is of the view that the findings of the second national risk vulnerability assessment (NRVA 2005) can provide sufficient input to define a reasonable poverty profile and assess poverty trends. Although the survey is not perfect, the authorities should concentrate their efforts on sectoral strategies and enhancing the participatory process.

17. Firm and vigorous implementation of the statistical master plan would help address current data weakness in national accounts, monetary statistics, and balance of payments statistics. The Fund will continue to support the authorities' efforts. The authorities should also ensure continued support from other donors.

18. The mission to conduct discussions for the second annual review under the PRGF program is scheduled for May 2007. It will benefit from the findings of a February 2007 staff visit to assess developments under the program and Afghanistan's HIPC eligibility. The second review mission will discuss developments during 2006/07 as a whole, and assess adherence to the quantitative and structural conditionality through end-March. It will also discuss the outlook for 2007/08 and beyond.

19. As on previous occasions, we very much appreciated the open and frank dialogue with the Afghan authorities and other public and private sector representatives. We would like to thank them for the time and effort they put into the discussions on the first review of the PRGF-supported program.



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