## _cr03299 ## Source details **Canonical URL:** [_cr03299](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03299.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03299.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03299.pdf.json) --- ### I. The Political Landscape - After more than two decades of conflict, a new opportunity for peaceful development emerged with the fall of the Taliban regime in late 2001 and the political agreement reached in Bonn in December 2001. - Historical chronology and political milestones: - Soviet intervention: December 1979. - Soviet withdrawal: 1989. - Mujahedin took Kabul: 1992. - Taliban took Kabul: 1996; they eventually controlled almost 90 percent of the country. - Military intervention following September 11, 2001 resulted in the collapse of the Taliban regime in late 2001 and formation of a new government. - Post-2001 political transition and institutional steps: - Afghan Interim Administration (AIA) governed for six months. - Emergency Loya Jirga of some 1,500 delegates (June 2002) chose Afghan Transitional Administration (ATA) headed by President Karzai for two years. - Constitutional Drafting Commission created in late 2002. - Constitutional Commission established in April 2003 to prepare draft constitution for Constitutional Loya Jirga in late 2003. - Elections scheduled for 2004. - Noted challenges: logistical and security concerns; lack of basic information such as a register of voters. ### II. Coordination of Assistance and National Framework - Donor coordination and pledges: - Steering Group (SG) created fall 2001; SG co-chairs: United States, Japan, Saudi Arabia, European Union. - Tokyo conference (January 2002) pledges: $4.5 billion total; $1.8 billion in pledges for the first year. - Preliminary needs assessment by World Bank, AsDB, UNDP: $14.6 billion needed over 10 years (excluding humanitarian assistance); requirements for the first year: $1.7 billion; first 2½ years: $4.9 billion. - Including additional pledges after Tokyo: pledges for the first 15 months (2002 and Q1 2003) totaled $2.1 billion in grants. - Grants actually disbursed (Jan 2002–Mar 2003): over $1.8 billion; loans disbursed: $0.1 billion. - Institutional mechanisms: - Implementation Group (IG) established early 2002; SG/IG evolved into Consultative Group (CG) mechanism in early 2003. - First major CG meetings: March 2003 (Afghanistan Development Forum in Kabul; Afghanistan High-Level Strategic Forum in Brussels). - National Development Framework (NDF) and National Development Budget (NDB): - NDF pillars: (a) security and human development; (b) rebuilding physical infrastructure; (c) enabling private sector creation. - NDB translates NDF priorities into detailed prioritized development projects to be funded through the budget. ### III. The Role of the IMF and Technical Assistance - IMF engagement since January 2002 at authorities’ request: - Focus: policy advice and technical assistance for economic management and macroeconomic stability. - Institutional rehabilitation assistance to Ministry of Finance (MoF) and Da Afghanistan Bank (DAB). - Departmental contributions: - Fiscal Affairs Department: improving expenditure management and tax system. - Monetary and Financial Systems Department: new currency introduction, central bank modernization, financial sector legislation (with Legal Department). - Statistics Department: new framework for macroeconomic statistics. - Macroeconomic policy advice emphasized: fiscal policy formulation and execution, currency arrangement choice, monetary policy design and conduct. - Operational notes: - IMF resident representative office opened Kabul: August 2002. - Afghanistan cleared arrears to IMF: February 2003. - IMF technical assistance ongoing. ### IV. Recent Macroeconomic Developments and Outlook - Growth and GDP (CSO and IMF staff estimates): - Economic growth excluding opium: almost 30 percent in 2002/03; about 20 percent expected in 2003/04. - 2002/03 GDP (excluding opium): about $4 billion (derived from expenditure side). - Per capita GDP (excluding opium, population ~22 million): some $180–190 in 2002/03. - GDP (including opium) entries: 6,588; Per capita GDP (including opium)302 (Table II.1 entries). - Sectoral drivers: - Recovery most visible in agriculture (end of prolonged drought), construction, and services driven by donor assistance. - Agriculture supports over three-quarters of the population and accounts for over 50 percent of GDP (estimate based on early 1990s data). - Selected activity indicators: - Cereal production (metric tons): 1999: 3,144,000; 2000: 1,763,000; 2001: 1,966,000; 2002: 3,589,000; 2003: 5,372,000. - Percent change (total cereal): -16.7; -43.9; 11.5; 82.6; 49.7. - Opium production (metric tons): 1999: 4,565; 2000: 3,276; 2001: 185; 2002: 3,422; 2003: ... - Real GDP (in percent): 28.6 (Estimate for 2002/03 excluding opium). - Outlook for 2003/04: - Overall GDP expected to grow by about 20 percent in 2003/04. - Cereal production in 2003/04 increased by another 50 percent to 5.4 million tons — level needed for self-sufficiency. ### V. Opium Production, Market Structure, and Economic Impact - Scale and trends: - Share of opium sector in the economy: about half (estimated). - UNODC estimate value of opium exports in 2002: about $2.5 billion. - Accounting for opium, GDP including opium could reach as high as $6.5 billion; per capita GDP could be about $300 (distribution uneven). - Opium production history (Table AII.1 production in metric tons): 1994: 3,416; 1995: 2,335; 1996: 2,248; 1997: 2,804; 1998: 2,693; 1999: 4,565; 2000: 3,276; 2001: 185; 2002: 3,422. - Income distribution and market shares: - About half the income from opium exports probably accrues to farmers; the other half accrues to refiners and traders who likely bank profits abroad. - UNODC estimate: in Europe alone more than $20 billion was spent on Afghan opiates. - Prices and annual cycle: - Annual farm-gate price volatility noted; farm gate prices at harvest ($ per kg main bazaar prices): 1994: 69.0; 1995: 65.0; 1996: 50.0; 1997: 71.0; 1998: 65.0; 1999: 55.0; 2000: 39.0; 2001: 301.0; 2002: 350.7. - Gross income per ha (in $): 1994: 3,297.9 ... 2002: 16,207.6. - Employment and labor intensity: - Direct farm employment (person year): 1994: 77,205; 1999: 98,284; 2002: 79,987. - Persons needed at harvest time: 1994: 794,111; 1999: 1,010,922; 2002: 822,722. - Labour intensity per hectare: poppy requires about 350-person days per ha; wheat requires 41 person-days per ha; black cumin 135 person-days per ha. - Policy implications: - Reversing opium expansion requires a comprehensive, prolonged commitment beyond eradication and law enforcement—building a stable unified state, alternative livelihoods, and broad-based economic growth. ### VI. Fiscal Developments, Budgets, and Execution - Fiscal stance and principles: - Strong commitment to fiscal discipline and prohibition of central bank financing (the “no-overdraft rule”). - 2002/03 budget financing gap covered entirely by donor support; similar principle for 2003/04. - 2002/03 outcomes: - Expenditures estimated at $349 million. - Domestic revenues reported to center: $132 million (much higher than budgeted $83 million). - Budget execution: actual spending reached 95 percent of budgeted amounts in Afghani terms; expenditures in U.S. dollar terms estimated at $349 million vs. budgeted $460 million due to average exchange rate Af 44.5 per U.S. dollar (budget accounting rate Af 34 per U.S. dollar). - Composition (last five months): Wages and Salaries: 74% of spending; Purchase of Goods and Services: 16%; Capital Expenditure: 9%. - Functional classification (last five months): Defense: 26%; Public Order and Safety: 17%; Education: 19%; Health: 8%. - 2003/04 operating and development budgets: - 2003/04 operating budget expenditures envisaged: $550 million; targeted domestic revenues: $200 million. - 2003/04 development budget: $1.8 billion (to be fully financed by external assistance). - 2003/04 financing requirement for operating budget: $350.0 (64); ARTF: $250.0 (45); LOTFA and Army Trust Fund: $100.0 (18). - Memorandum items: Number of civil servants: 456,000; Of which: military: 100,000; Average monthly wage (in U.S. dollars): 50.6. - Budget execution and financing in 2002/03: - Estimated financing requirement revised to $232 million (66 percent of total spending) vs. planned $400 million. - Major sources: donor assistance grants $183 million (including $125 million from ARTF); one-off receipts $39 million; partial ADB loan $25 million. - ARTF covered 54 percent of 2002/03 operating budget funding requirement. - Conditions for full execution: - (a) Domestic revenues increase via customs and tax reforms. - (b) Revenues centralized through improved fiscal relations with provinces. - (c) Additional donor pledges obtained and materialize timely. - Key risks: - As of early September 2003, existing pledges short of requirements of both operating and development budgets; donor fatigue risk noted. ### VII. Fiscal Institutions, Revenue Mobilization, and Public Financial Management Reforms - Achievements and systems: - Significant improvements in expenditure management; AFMIS operational from October 2002 for central government expenditures and expanded at start of 2003/04 to include revenue information and provincial expenditures. - Treasury consolidated MoF central bank accounts from 26 to 2; instructions (August 2003) to close provincial accounts and transfer balances into two new accounts (one for expenditures, one for revenues). - Grant Management Unit (GMU) established December 2002 within treasury to manage donor grant agreements. - Afghan Aid Coordination Agency (AACA) established April 1, 2002 to track foreign aid disbursement. - Revenue mobilization targets and reforms: - Authorities aim to fully finance the ordinary budget through domestic revenues by 2006. - Revenue collection target: increase from about $130 million in 2002/03 to about $600 million in 2006/07. - Customs reform prioritized: current customs regime 25 tariff bands with rates ranging from 7 percent to 150 percent across 888 items; unweighted average tariff rate 43.3 percent. - Customs valuation uses artificially low exchange rates in practice (examples: Chamber of Commerce Af 3.5 per U.S. dollar; Kabul Customs Af 4.5 per U.S. dollar) versus market rate about Af 48 per U.S. dollar. - Proposal: mandate use of market exchange rate in customs valuation; reduce tariff bands from 25 to 4 with rates 0, 5, 10, and 20 percent. - Tax policy reforms: - Existing PIT progressive schedule with rates 4 to 60 percent; CIT flat 20 percent; business receipts tax 2 percent. - Draft decrees under preparation to: tax on resident/nonresident basis; reduce top PIT marginal rate from 60 to 25 percent; increase personal exemption; restore wage withholding for higher-income employees; expand business receipts tax coverage; introduce rent tax and airport departure fee; liberalize depreciation and loss carryover rules. - Large taxpayer unit (LTU) planned in Kabul by end-2003. ### VIII. Monetary Policy, Currency Reform, and DAB Modernization - Currency introduction and outcomes: - New currency introduced October 7, 2002: 1 new Afghani replacing 1,000 old ones; conversion process ended January 2, 2003. - New notes ordered: Af 27.9 billion (almost 800 million notes, about 500 tons); old official notes exchanged: Af 13.9 trillion; unofficial notes exchanged at 50 percent discount: Af 3.3 trillion; new notes issued in exchange: Af 15.6 billion; total old notes collected: about Af 19 trillion (some 5 billion banknotes or over 2,000 tons). - Consumer prices rose by a cumulative 60 percent during September–November 2002; 12-month inflation reached almost 100 percent by end-2002. - After conversion completion and relatively tight monetary policy, prices broadly stable in first 8 months of 2003; average monthly inflation close to zero; 12-month inflation fallen to 51 percent by August 2003. - Exchange rate regime and operations: - De facto (lightly) managed float since early 2003; DAB aims to limit exchange rate volatility and keep the exchange rate within a range but will not resist persistent pressures that risk reserves. - Exchange rate fluctuated around Af 48 per U.S. dollar in absence of major shocks. - Monetary program and instruments: - Indicative monetary program targeted limiting money growth and lowering inflation (2002/03 target somewhat below 20 percent 12-month inflation by March 2003; money growth target reduced from 30 percent to 24 percent). - Domestic currency in circulation grew by an estimated 20 percent in 2002/03; currency in circulation grew by 17 percent in first eight months of 2003. - DAB foreign exchange auctions used to sterilize inflows: in 2002/03 $135.4 million sold through auctions; first quarter 2003/04 $34.5 million sold. - Reserves and adequacy: - Identified assets at beginning of 2002: about $250 million (including $196 million in gold). - DAB foreign exchange reserves estimated end-August 2003: $556 million ($600 million with gold valued at market prices); alternate figure cited: $555 million by late-August 2003. - Currency in circulation as of August 2003: Af22.4 billion, equivalent to $456 million at prevailing exchange rate. - DAB reserves judged to cover some 3 months of imports (rule-of-thumb), and adequate given context but vulnerability to shocks noted. ### IX. Financial Sector: Banking, Money Traders (Hawala), and Reform Agenda - Banking sector condition and statistics: - Pre-2001: six commercial banks licensed but virtually ceased to function; DAB had become Soviet-style with monetization of deficits. - Banks’ employment and branch examples (selected): - Banke Millie Afghan: Number of Staff 800; Number of Branches 19. - Pashtany Tejaraty Bank: Number of Staff 564; Number of Branches 17. - Agricultural Development Bank: Number of Staff 230; Number of Branches 28 (of which 15 remain). - Export Promotion Bank: Number of Staff 250; Number of Branches 4. - Industrial Development Bank of Afghanistan: Number of Staff 37; Number of Branches 3. - Mortgage and Construction Bank: Number of Staff 80; Number of Branches 2. - Aggregate: the six commercial banks together employ nearly 2,000 staff. - Da Afghanistan Bank (DAB) governance and deficiencies: - Law on Money and Banking (1994) provisions politicized DAB; Supreme Council composition: nine members; meeting frequency at least four times a year. - DAB staffing (mid-2002): 2,400 staff (1,021 at headquarters; 1,130 in branches; ~250 at tolls). - Branch network originally 89 branches; 24 of 89 branches closed; DAB owns 30 branches. - Operational weaknesses: no recent balance sheet, inadequate accounting, lack of supervision, inadequate vault security, limited transport capacity (two trucks, one bus, one Land Rover). - DAB reforms in progress: creation of banking supervision department, drafting prudential regulations, AFMIS rollout, reconnection of 35 provincial branches via laptops with Immarsat (reporting daily balances). - Money dealers and Hawala: - Approximately 5,000 money traders in Kabul; about 300 have shops and are licensed. - The 30 largest traders cover about 70 percent of transactions; daily trade volumes reportedly several millions of U.S. dollars. - Transfer costs: international transfers vary between 0 and 2 percent; domestic transfers add ½ to 1 percent. - Market operates largely on reputation and trust; limited or no formal reporting requirements. - Reform pillars and strategy: - Enact new central bank law and banking law to establish DAB autonomy and modern supervisory framework. - Pillars for banking sector development: competition, good corporate governance, strong supervision, accounting reform, and capacity building. - Role for foreign banks in Kabul and for microfinance and rehabilitated domestic banks outside Kabul. - Options to regulate Hawala without pushing it underground: self-regulation by associations or special registration and targeted supervision (customer identification, record-keeping, cooperation provisions). ### X. Trade, Transit Agreements, and Competitiveness - Main transit and trade arrangements: - Main transit trade agreement with Pakistan (1965) covers imports/exports largely via Karachi and Port Quasim; processing and clearing reduced from 20 to 5 days. - Iran: new transport agreement signed January 2003; approval of trade and transit agreement expected mid-2003; subsidy element on fuel about 20 percent. - India: March 2003 preferential trade agreement; India granted 50–100 percent tariff reductions on 38 export items and duty-free access for eight tariff lines. - Iran–India–Afghanistan (Chabahar route) MoU January 2003 to improve access to Chabahar; port fees cut by 90 percent; warehousing and other charges cut by 50 percent. - Trade liberalization and market access: - June 2002: preferential access to European markets under Everything But Arms. - January 2003: United States granted Afghanistan GSP access. - April 10, 2003: Afghanistan applied for WTO membership. - Customs and tariff structure: - Current customs regime: 25 tariff bands with rates 7 percent to 150 percent across 888 items; unweighted average tariff rate 43.3 percent. - Chamber of Commerce valuation fee: 2.5 percent for nonmembers (2 percent for members); Chamber of Commerce valuation used in practice (Af 3.5 per U.S. dollar example). - Proposed reforms: reduce tariff bands to 4 and rates to 0–20 percent; mandate use of market exchange rate for customs valuation. - Direction and composition of trade (selected): - Exports official recorded (2002/03 total): 100.0 value index; principal destinations (percent of total value): India 27.4; Pakistan 26.0; Finland 9.0; Germany 5.5; United States 4.3. - Imports official recorded (2002/03 value 2,322.0): principal origins (percent and value) Japan 43.0 (999.0); Pakistan 8.9 (206.7); Korea 4.9 (113.4); Unclassified 33.1 (767.8). - Commodity composition of exports (2002/03, thousands $): Total exports 100,143 (100.0); Dried fruit 40,582 (40.5); Carpets, etc. 47,474 (47.4). - Commodity composition of imports (2002/03, thousands $): Total imports 2,322,609 (100.0); Machinery and equipment 854,842 (36.8); Household needs and medicine 622,481 (26.8); Fabrics, clothing, and footwear 345,934 (14.9). ### XI. Social Indicators and Humanitarian Response - Social indicators (exact figures): - Population (millions; 2002): 21.8. - Life expectancy at birth (2001): 42.8. - Infant mortality per 1,000 live births (2001): 165. - Under-five mortality per 1,000 live births (2001): 257. - Children underweight (percent under age 5; 1995–2001): 48. - Undernourished people (percent of population; 1998–2000): 70. - Adult literacy (percent age 15 and above; 2001): 36 (Male: 51; Female: 21). - Primary school enrollment ratio, gross (1995–99): Male: 53; Female: 5. - Population without sustainable access to an improved water source (percent; 2000): 87. - Afghanistan UN Human Development Index rank in 1996: 169th out of 174 countries. - Malnutrition affected over 50 percent of children under age five (circa 2001). - Average life expectancy circa 2001: little more than 40 years. - Humanitarian assistance (ITAPs; Oct 2001–Dec 2002): - Estimated ITAP spending: $1.0 billion (excluding civil service payments made by AIAF). - Box III.2 (ITAP achievements financed by $1.1 billion from donors): - Return and reintegration (UNHCR): nearly 1.8 million refugees and 400,000 internally displaced persons assisted; some 48,000 million tons (MTs) of food aid; 310,000 return packages; $35 million in travel grants; 40,000 shelters constructed. - Food Assistance (WFP): by December 2002, 250,000 MTs of food commodities reached over 8 million people; school feeding programs reached 150,000 children. - Health: Six million people vaccinated against polio; Nine million children vaccinated against measles. - Public Administration: $50 million worth of civil servant salary payments made with AIAF support. - Education: supplies to 1.8 million children and 70,000 teachers at 4,500 schools. - Transition to NDF and government ownership: - NDF adoption and 2003/04 NDB (Cabinet adoption March 2003) signaled government leadership; Consultative Groups (12 CGs) established to coordinate donor support and monitor implementation. ### XII. Risks, Policy Priorities, and Reform Imperatives - Core policy priorities: - Maintain fiscal discipline and uphold the no-overdraft rule. - Mobilize domestic revenues so the operating budget can be largely financed from domestic resources within a few years. - Proceed with civil service reform and improve provincial fiscal management and reporting. - Continue to focus monetary policy on maintaining low inflation by limiting monetary expansion within the present lightly managed floating exchange rate regime. - Revisit exchange rate regime choice once reconstruction structural changes evolve. - Create market-oriented regulatory framework and legal system to enable private sector-led growth and investment. - Major risks: - Restoring security nationwide remains critical; limited government control outside Kabul complicates macroeconomic management and reconstruction. - Without adequate provincial security and alternative livelihoods, poppy cultivation and opium production may dominate, risking a slide into violence and corruption. - External assistance may fall short: post-conflict patterns show assistance typically declines after a few years; Afghanistan’s reconstruction will require sizable assistance for several years. - Conditions for fiscal discipline and budget execution (2003/04 completion): - (a) fiscal relations with provinces improve and provincial compliance centralizes revenues; - (b) domestic revenue mobilization increases (customs and tax reforms implemented); - (c) large external assistance projected materializes in a timely and predictable fashion. *Source: IMF staff report covering institutional and economic achievements in Afghanistan from late 2001 up to September 2003.* ### Chapter I. Overview................................................................................................... ### CHAPTER I. OVERVIEW ### I. The Political Landscape - After more than two decades of conflict, a new opportunity for peaceful development emerged with the fall of the Taliban regime in late 2001 and the political agreement reached in Bonn in December 2001. - Historical chronology and political milestones: - Soviet intervention: December 1979. - Soviet withdrawal: 1989. - Mujahedin took Kabul: 1992. - Taliban took Kabul: 1996; they eventually controlled almost 90 percent of the country. - Military intervention following September 11, 2001 resulted in the collapse of the Taliban regime in late 2001 and formation of a new government. - Post-2001 political transition: - An Afghan Interim Administration (AIA) was appointed and governed for six months. - An Emergency Loya Jirga of some 1,500 delegates convened in June 2002 and chose an Afghan Transitional Administration (ATA) headed by President Karzai to remain in office for two years. - The ATA is charged with preparing a new constitution and free and fair elections to elect a fully representative government. - Institutional steps taken toward constitution and elections: - Constitutional Drafting Commission created in late 2002. - Constitutional Commission established in April 2003 to seek opinions of the population and to prepare a draft constitution for submission to a Constitutional Loya Jirga in late 2003. - Elections scheduled for 2004 (within two years after the Emergency Loya Jirga). - Noted challenges: logistical and security concerns, lack of basic information such as a register of voters; the United Nations is working closely with Afghan authorities to prepare for elections. ### II. Coordination of Assistance - International coordination and pledges: - Steering Group (SG) of donor governments created in the fall of 2001 to enhance international political support and provide strategic guidance; SG co-chairs were the United States, Japan, Saudi Arabia, and the European Union. - World Bank, AsDB, and UNDP produced a preliminary needs assessment requested by the SG; presented at the International Conference on Reconstruction Assistance to Afghanistan in Tokyo in January 2002. - Tokyo conference pledges: $4.5 billion total, with $1.8 billion in pledges for the first year. - Evolution of coordination mechanisms: - Implementation Group (IG) established in early 2002, chaired by the government with AsDB, UNDP, IsDB, and the World Bank as vice-chairs; IG meetings held in Kabul in March and September 2002. - SG/IG structure evolved into a Consultative Group (CG) mechanism in early 2003. - First major CG meetings held in March 2003: Afghanistan Development Forum (Kabul) and Afghanistan High-Level Strategic Forum (Brussels). - National Development Framework (NDF) and budgeting: - Authorities adopted the NDF in 2002 to strengthen coordination and management of reconstruction. - NDF focuses on three pillars: - (a) security and human development; - (b) rebuilding physical infrastructure; and - (c) enabling the creation of a viable private sector as the engine for sustainable and inclusive economic growth. - For each pillar, broad sectoral programs and individual CGs were established to identify and select projects within the resource envelope. - The National Development Budget (NDB) translated NDF priorities and programs into detailed and prioritized development projects to be funded through the budget. ### III. The Role of the IMF - IMF engagement since January 2002 at the request of Afghan authorities: - Focus: provide extensive policy advice and technical assistance to establish sound foundations for economic management and macroeconomic stability to support reconstruction and recovery. - Institutional rehabilitation assistance: - Helped rehabilitate key economic institutions, notably the Ministry of Finance (MoF) and Da Afghanistan Bank (DAB). - Departmental contributions: - Fiscal Affairs Department: improving expenditure management and the tax system. - Monetary and Financial Systems Department: assisted with introduction of the new currency, central bank modernization, and, with the Legal Department, preparation of new financial sector legislation. - Statistics Department: assistance on a new framework for macroeconomic statistics. - Macroeconomic policy advice: - A staff team from the IMF Middle Eastern, Fiscal Affairs, and Policy Development and Review Departments assisted and continues to assist in developing a macroeconomic framework aimed at achieving a sustainable, noninflationary recovery. - Policy advice emphasized formulation and execution of fiscal policy, the choice of currency arrangement, and the design and conduct of monetary policy. - Operational notes: - In August 2002, the IMF opened a resident representative office in Kabul. - In February 2003, Afghanistan cleared its arrears to the IMF. - IMF technical assistance is ongoing and will continue to be available. *Source: CHAPTER I. Overview (July 2003).* ### 7. From the outset, the Afghan authorities have been strongly committed to achieving ### _cr03299 - 7. From the outset, the Afghan authorities have been strongly committed to achieving ### Background and objectives - Authorities committed to achieving financial stability and maintaining fiscal discipline to support reconstruction and recovery. - Objectives included transparency in government operations, improved economic management, liberal and open markets led by private sector activity with low state intervention, and open external trade, payments, and exchange systems. - The authorities received support from the IMF, the AsDB, the World Bank, various UN agencies, and numerous bilateral donors. - This report provides an overview of institutional and economic achievements in Afghanistan from late 2001 up to September 2003. ### Asian Development Bank (AsDB) engagement (Box I.1) - Historical context: - Afghanistan was a founding member of AsDB in 1966. - By 1979, Afghanistan had received nine loans totaling $95.1 million from the Asian Development Fund (ADF), and grant technical assistance totaling $2.5 million. - Post-2001 commitments and disbursements: - In 2002, AsDB provided $15 million in capacity building technical assistance grants and administered a further $22 million in grant-funded pilot projects from the Japan Fund for Poverty Reduction (JFPR). - In 2003, AsDB expects to provide an additional $10 million in capacity building TA grants, and $43 million in grants from JFPR and the Kuwait Fund for Arab Economic Development. - AsDB committed a total of $300 million in two loans: a Postconflict Multisector Program Loan ($150 million) approved on December 4, 2002 and an Emergency Infrastructure Rehabilitation and Reconstruction Project (EIRRP) Loan ($150 million) approved on June 3, 2003. - Of the Postconflict Multisector Program Loan, $100 million has been disbursed; the remaining $50 million will be disbursed by end-2003 subject to policy and institutional reforms. - An agricultural sector program loan ($50 million) is under discussion. - Country Strategy and Program Update (CSPU): - CSPU approved in June 2003 for the period 2003–05 with $610 million earmarked. - CSPU covers transportation; energy; and natural resources (agriculture, irrigation, and environment). - Some $10 million per year in technical assistance is planned during 2003–05. - Loan terms and debt service: - All these loans are concessional, with a grant element equivalent to around 60 percent. - The first repayment from the loans extended since the current administration assumed office is not scheduled until 2013. - Old outstanding loans resumed generating a small debt service obligation of about $1.3 million per year during 2003–11 (with further declining amounts thereafter). ### World Bank engagement (Box I.2) - Reengagement and commitments: - World Bank reopened its office in Kabul in May 2002. - Since April 2002, the World Bank committed $186.8 million in grants and an additional $128.4 million in no-interest loans (“credits”) for development projects (roads; power supply in Kabul; municipal waste; schools; health services; public administration; national highway and civil aviation). - Trust funds and administered facilities: - Administers projects funded under a $50 Japan Social Development Fund (JSDF) and World Bank Post-Conflict Fund projects (teacher training, technical assistance, early impact projects, database of expatriate Afghan expertise). - Acts as administrator of the Afghanistan Reconstruction Trust Fund (ARTF) used to cover government recurring costs and salaries and finance projects in microfinance, telecommunications, and infrastructure. - Transitional Support Strategy (TSS): - Finalized in March 2003 to support the National Development Framework over 18 months to 2 years. - Focus areas: improving livelihoods; assisting fiscal strategy, institutional development, and management; supporting governance and public administration reform; enabling private sector development. - TSS envisages operations amounting to $470 million over FY2003 and FY2004. - Pre-Taliban loan debt service: - World Bank has some pre-Taliban loans on which debt service of approximately $3.0 millions falls due in FY2003. ### Recent macroeconomic developments (Chapter II summary) - Growth and GDP: - Economic growth, excluding opium production, is estimated to have reached almost 30 percent in 2002/03 and is expected to continue at a rate of about 20 percent in 2003/04. - Per capita GDP is estimated to have reached some $180–190 in 2002/03. - Sectoral drivers: - Recovery most visible in agriculture (end of prolonged drought), construction, and services (rapid expansion largely driven by donor assistance). - Opium production: - The share of the opium sector in the economy is estimated to be about half. - Opium production has returned to late 1990s levels after the 2000 Taliban ban; drivers include improved weather, increased area under cultivation, lack of alternative livelihoods, and limited central government control beyond Kabul. - Aid and donor assistance: - Disbursements have been high compared to pledged amounts, but pledges may have been low compared to actual needs. - Reconstruction will require sizable international assistance over the next several years, overwhelmingly in the form of grants to avoid future debt servicing difficulties. ### Fiscal developments and budgets (Chapter III summary) - Fiscal stance and principles: - Fiscal policy characterized by strong commitment to fiscal discipline and refrain from monetary financing (the “no-overdraft rule”). - 2002/03 budget financing gap was entirely covered by donor support; 2003/04 budget based on same principle. - 2002/03 outcomes: - Expenditures estimated at $349 million—mostly government salaries (including provinces) and security and social sectors. - Domestic revenues turned out much higher than expected, at $132 million. - Execution hampered by lack of unity of the fiscal system: only a very small amount of locally collected revenues transferred to the center; little information on provincial nonwage expenditures. - 2003/04 budgets: - Operating budget adopted in March 2003 envisages government expenditures of $550 million, with increase concentrated in security and education sectors. - Targets a rise in domestic revenues to $200 million. - Preliminary execution data suggest expenditures off to a slow start, mainly because of delays in payroll disbursements. - Domestic resources may reach $200 million if current trends are sustained and with customs reform. - The 2003/04 $1.8 billion development budget provides a program of reconstruction and humanitarian projects; outcome depends on donor support and implementation capacity. - Conditions for full execution: - (a) Domestic revenues increase via customs and tax reforms. - (b) Domestic revenues effectively centralized through improved fiscal relations with provinces. - (c) Additional pledges of donor assistance are obtained and materialize in a timely manner. - As of early September 2003, existing pledges were still short of requirements of both operating and development budgets. ### Fiscal institutions and revenue mobilization (Chapter IV summary) - Improvements: - Biggest strides made in improving expenditure management. - Progress toward fiscal transparency and accountability. - Efforts underway to increase central government control over provincial finances; significant amounts of revenues collected by provinces transferred to the center so far in 2003/04. - Next steps: - Focus shifted toward increasing revenue mobilization so the operating budget can be fully financed from domestic revenues within a few years. - Comprehensive reform started with customs policy and administration, to be followed by tax policy and administration reform. - Limited progress in civil service reform; restructuring of state-owned enterprises yet to begin. ### Monetary policy, currency reform, and financial sector (Chapter V–VI summary) - Currency introduction and monetary objectives: - Authorities introduced a new national currency to regain control over issuance of money and as a symbol of unity and sovereignty. - Initial difficulties led to a spike in inflation in fall 2002, but replacement of banknotes was completed sooner than many expected. - Primary objective of monetary policy: achieve and maintain price stability and restore confidence in the new national currency. - Central bank aims to control domestic money supply within a floating exchange rate regime. - Since introduction and float of new currency in early 2003, DAB has aimed to limit exchange rate volatility and keep the exchange rate within a range, without resisting persistent pressures. - Monetary policy has been restrained and supported by the no-overdraft rule; prices broadly stable in 2003. - Exchange rate fluctuated around Af 48 per U.S. dollar in the absence of major shocks. - Financial sector revival: - Pre-2001 legacy: soviet-style banking, central bank printing money to cover deficits; six commercial and development banks had virtually ceased to function; money traders (Hawala) were main banking service providers. - Since late 2001, central bank made important progress in monetary policy, payments, and supervision. - Road maps being developed to bring DAB’s organization, capacities, and functions in line with modern-day best practices. - New central bank law (providing DAB autonomy) and banking law to be enacted soon to underpin transformation and enable entry of new commercial banks. - Diagnostic studies and reform strategies for existing banks designed; implementation is next step. - Hawala system may continue to have a role alongside emerging banks. ### Risks, challenges, and policy priorities (Looking ahead, Chapters V–VI summary) - Core policy priorities to ensure fiscal sustainability: - Maintain fiscal discipline. - Mobilize domestic revenues so operating budget can be largely covered from domestic resources within a few years. - Move ahead with civil service reform. - Improve fiscal management in the provinces, requiring compliance of provincial governors to transfer revenues to the center. - Monetary policy priorities: - Continue to focus on maintaining low inflation by limiting monetary expansion within the present lightly managed floating exchange rate regime. - Revisit exchange rate regime choice once economy moves beyond early reconstruction structural changes. - Structural and institutional priorities: - Create environment conducive to sustainable private sector growth: market-oriented regulatory framework, fair and functioning legal system, rule of law, and security of property rights. - Major risks: - Restoring security nationwide remains a key priority; government control limited in many regional areas, complicating macroeconomic management and reconstruction outside Kabul. - Without adequate provincial security, poppy cultivation and opium production may dominate, risking a downward spiral of violence and corruption. - External assistance may fall short: post-conflict experience shows assistance typically declines after a few years, just when absorption capacity increases; Afghanistan’s reconstruction will continue to require sizable assistance for several years. ### Key statistics and figures (preserved exactly as in source) - Afghanistan population estimate: about 22 million currently within its borders, and up to 25 million if all refugees were to return. - AsDB historical loans and TA: nine loans totaling $95.1 million; grant technical assistance totaling $2.5 million. - AsDB 2002 support: $15 million (capacity building TA) and $22 million (JFPR pilot projects). - AsDB 2003 expected support: $10 million (capacity building TA) and $43 million (grants). - AsDB committed loans: $300 million total ($150 million Postconflict Multisector Program Loan; $150 million EIRRP Loan). - Disbursed from Postconflict Multisector Program Loan: $100 million; remaining $50 million to be disbursed by end-2003 (subject to reforms). - AsDB CSPU earmark for 2003–05: $610 million. - AsDB technical assistance planned: $10 million per year during 2003–05. - AsDB loan grant element: around 60 percent. - AsDB small debt service obligation: about $1.3 million per year during 2003–11. - World Bank commitments since April 2002: $186.8 million in grants and $128.4 million in credits. - World Bank TSS envisaged operations: $470 million over FY2003 and FY2004. - World Bank pre-Taliban debt service: approximately $3.0 millions falls due in FY2003. - Economic growth (excluding opium): almost 30 percent in 2002/03; about 20 percent in 2003/04. - Per capita GDP estimate: $180–190 in 2002/03. - Opium sector share of the economy: about half. - 2002/03 expenditures: $349 million. - 2002/03 domestic revenues: $132 million. - 2003/04 operating budget expenditures: $550 million. - 2003/04 targeted domestic revenues: $200 million. - 2003/04 development budget: $1.8 billion. - Exchange rate (2003): fluctuating around Af 48 per U.S. dollar. - Afghanistan UN Human Development Index rank in 1996: 169th out of 174 countries. - Malnutrition affected over 50 percent of children under age five (circa 2001). - Average life expectancy circa 2001: little more than 40 years. - Afghan solar year 1381: March 21, 2002 until March 20, 2003. - Afghan solar year 1382: March 21, 2003 until March 19, 2004. *Source: IMF staff report covering institutional and economic achievements in Afghanistan from late 2001 up to September 2003.* ### 25. A new opportunity for the peaceful development of Afghanistan emerged with the fall ### _cr03299 - 25. A new opportunity for the peaceful development of Afghanistan emerged with the fall ### Social indicators - Population (millions; 2002): 21.8 - Life expectancy at birth (2001): 42.8 - Infant mortality per 1,000 live births (2001): 165 - Under-five mortality per 1,000 live births (2001): 257 - Children underweight (percent under age 5; 1995–2001): 48 - Undernourished people (percent of population; 1998–2000): 70 - Adult literacy (percent age 15 and above; 2001): 36 - Male: 51 - Female: 21 - Primary school enrollment ratio, gross (in percent; 1995–99): - Male: 53 - Female: 5 - Population without sustainable access to an improved water source (in percent; 2000): 87 ### Comparison of donor assistance - Preliminary needs assessment (World Bank, AsDB, UNDP): $14.6 billion needed over 10 years (excluding humanitarian assistance). - Requirements for the first year: $1.7 billion - Requirements for the first 2½ years: $4.9 billion - Tokyo conference (January 2002) pledges: $4.5 billion for the first 5 years (most covering the first 2½ years) - Pledges for the first year (also including humanitarian assistance): $1.8 billion - Including additional pledges after Tokyo: pledges for the first 15 months (2002 and Q1 2003) totaled $2.1 billion in grants. - Disbursements during that period: - Grants actually disbursed: over $1.8 billion - Loans disbursed: $0.1 billion - Observations on aid composition and timing: - Needs assessment excluded humanitarian assistance; bulk of disbursements so far addressed humanitarian needs. - Reconstruction aid lags humanitarian aid due to longer preparation requirements. - Risk of donor fatigue: donor interest may decline after a few years, possibly sooner for Afghanistan as other post-conflict cases compete for funds. - Aid per capita comparison (January 2002–March 2003; population estimate 22 million): - Afghanistan: $67 per capita per year - Bosnia and Herzegovina (1995–97): $249 per capita per year - Timor-Leste (1999–01): $256 per capita per year - West Bank and Gaza (1994–01): $219 per capita per year - Rwanda (1994–96): $98 per capita per year - Aid as percent of GDP (annual averages): - Afghanistan (2002/03): close to 40 percent of GDP - Bosnia and Herzegovina (1995–97): similar to Afghanistan (~40 percent) - West Bank and Gaza (1994–2001): 13 percent - Timor-Leste (1999–2001): about 60 percent - Rwanda (1994–96): about 60 percent - Conclusion: So far aid flows to Afghanistan have been relatively low compared to other recent post-conflict cases on a per capita basis; pledges may have been low relative to needs. Continued and substantial foreign assistance over several years is required to avoid prolonged dependence, widespread poverty, or a slide into violence, crime, and corruption financed by opium proceeds. ### Output and prices — overview of economic developments - Data limitations: reliable statistics mostly unavailable; most data are rough estimates. - Drivers of recovery: - International assistance and spending. - Sharp rebound in agriculture following the end of a three-year drought. - CSO estimates for 2002/03 (based on agricultural production excluding poppy, cement import/production, and electricity): - Economic growth in 2002/03: almost 30 percent (CSO estimate) - 2002/03 GDP (excluding opium): about $4 billion (derived from expenditure side) - Per capita GDP (excluding opium, population ~22 million): some $180–190 - Table II.1 key entries (Estimate; in millions of U.S. dollars, unless indicated otherwise): - Private consumption (2001/02...2002/03): 4,360 - Government consumption 1/...349 - Investment...654 - Exports of goods and nonfactor services...2,290 - Own exports (excluding opium)...100 - Reexports (including smuggling)...2,190 - Imports of goods and nonfactor services...3,605 - GDP (excluding opium)24,048 - Per capita GDP (in U.S. dollars, excluding opium)0186 - GDP in billions of (new) Afghani (excluding opium)134181 - Value of opium exports2,540 - GDP (including opium)6,588 - Per capita GDP (in U.S. dollars, including opium)302 - Share in GDP — Real growth rates (in percent; excluding opium) Estimate: - Agriculture 5227.7 - Industry 2621.1 - Services 2239.5 - Real GDP (in percent): 28.6 - Sources: Central Statistics Office of Afghanistan; UNODC; and IMF staff estimates. - Note: 1/ Government spending from the operating budget. - Sectoral developments: - Services and construction expanding rapidly (visible in Kabul). - Returning refugees and improved security helped growth. - Retail trade expanded; taxicab fleet increased; reconstruction underway. - Agriculture: - Agriculture supports over three-quarters of the population and accounts for over 50 percent of GDP (estimate based on early 1990s data). - 2002 cereal production (FAO/WFP estimates): total cereal production up by 80 percent to 3.6 million metric tons (from 2 million metric tons in preceding year). - Production increases across wheat, fruits, vegetables, and livestock-related products, though orchards and livestock remain depleted by conflict and drought. - Selected indicators of economic activity (Table II.2, 1999–2003): - Cereal production, total (metric tons): 1999: 3,144,000; 2000: 1,763,000; 2001: 1,966,000; 2002: 3,589,000; 2003: 5,372,000 - Percent change (total cereal): -16.7; -43.9; 11.5; 82.6; 49.7 - Wheat: 2,500,000; 1,469,000; 1,597,000; 2,686,000; 4,361,000 - Rice: 188,000; 105,000; 122,000; 260,000; 291,000 - Barley: 216,000; 74,000; 87,000; 345,000; 410,000 - Maize: 240,000; 115,000; 160,000; 298,000; 310,000 - Opium production (metric tons): 1999: 4,565; 2000: 3,276; 2001: 185; 2002: 3,422; 2003: ... - Percent change (opium): 69.5; -28.2; -94.4; 1,749.7; ... - Electricity production (million kwh): ...; 503; 490; 557; ... - Transport of goods by road (1,000 tons): ...; 1,887; 3,688; 5,015; ... - Taxicabs: ...; 16,991; 19,209; 33,507; ... - Sources: FAO/WFP; UNODC; and CSO. ### Outlook for 2003/04 and investment needs - Agriculture in 2003/04: - With continued snow and rainfall, cereal production increased by another 50 percent to 5.4 million tons — the level Afghanistan needs to be self-sufficient. - Note: This does not automatically eliminate food assistance needs because access and distribution remain issues. - GDP growth outlook: - Overall GDP expected to grow by about 20 percent in 2003/04 (driven by agriculture, services, and construction). - Investment needs and constraints: - Alleviating poverty requires strong economic growth and large amounts of investment over many years. - Further agricultural gains require investment in (repairing) irrigation facilities. - So far, investment beyond donor-funded projects has been largely small-scale; large-scale private investment limited to telecommunications and some hotel construction. - Pre-conditions for significant large-scale private investment: adequate security, market-oriented regulatory framework, functioning and fair legal system, and a functioning banking system. - Institutional developments: new investment law adopted; Afghan Investment Support Agency opened in August 2003; sharp increase in livestock licenses issued; modern financial sector legislation under preparation. ### Opium and its economic impact - Poppy/opium dynamics: - Afghanistan became the largest illicit opium producer by mid-1990s due to lawlessness, profitability, and favorable climate. - Taliban poppy ban (July 2000) reduced production to 185 tons in 2001 (mainly northern provinces) from over 3,000 tons in 2000. - Post-2001: new government banned poppy cultivation, but limited provincial control, favorable weather, rural poverty, and lack of alternatives led to sharp recovery: - 2002 opium production: almost 3,500 tons (75 percent of record 1999 harvest) - 2003: opium production expected to have increased further - Economic magnitude: - UNODC estimate for value of opium exports (including derivatives like morphine and heroin) in 2002: about $2.5 billion — making opium Afghanistan’s largest source of export earnings. - Accounting for opium in GDP is complicated; share of opium in the economy could range from 40–60 percent depending on treatment of private consumption and imports. - Estimates for GDP including opium could reach as high as $6.5 billion, which would translate into a per capita GDP of $300 (distribution would be uneven). (Table II.1 entries show GDP (including opium)6,588 and Per capita GDP (including opium)302.) - A more detailed description of poppy and opium production and trade is provided in the annex to the chapter. ### Prices and inflation - Consumer prices largely driven by exchange rate movements. - Price data limitations: CSO maintained a consumer price index for Kabul covering 50 main items (mostly food); recently expanded to over 200 items and planned expansion to provincial cities. - Price and exchange rate volatility: wide fluctuations in late 2001 and early 2002 due to changing political and economic conditions and uncertainty. - Inflation trend: as government implemented policies and goods availability improved, inflation came down quickly. - Monthly inflation averaged 3.5 percent in the first 8 months of [text truncates in source]. *Prepared by Ron van Rooden and Louis Dicks-Mireaux; sources cited within text: Central Statistics Office of Afghanistan; UNDP; UNICEF; World Bank; FAO/WFP; UNODC; IMF staff estimates.* ### 2002. Uncertainty regarding the introduction of a new currency, however, caused the ### _cr03299 - 2002. Uncertainty regarding the introduction of a new currency, however, caused the ### Inflation, currency conversion, and price developments - Uncertainty about a new currency caused the exchange rate to depreciate in the fall of 2002, resulting in a sharp spike in prices. - Consumer prices rose by a cumulative 60 percent during September–November 2002. - The 12-month inflation rate reached almost 100 percent by end-2002. - When the exchange rate strengthened in late 2002, prices declined. - A new currency was introduced on October 7, 2002, with 1 new Afghani replacing 1,000 old ones. The conversion process ended on January 2, 2003. - After the successful completion of the currency conversion process in early January 2003, combined with a relatively tight monetary policy and an increased supply of major food staples: - Prices remained broadly stable in the first 8 months of 2003, with the average monthly inflation rate close to zero. - The 12-month rate of inflation had fallen to 51 percent by August 2003. ### Price and exchange rate indices (selected observations) - Monthly price change series (last observation: August 2003) and Price And Exchange Rate Indices (December 2001 = 100) are reported for April-01 through August-03 (figure referenced). - Table II.3 (Kabul CPI, Dec. 2002 = 100) highlights: - November 2002: Index 104.6 (CPI), Monthly percentage change 22.7, 12-month percentage changes 26.5 (General) and 15.9 (Nonfood). - December 2002: Index 100.0, Monthly percentage change -4.4, 12-month change 31.9 (General). - August 2003: Index 98.9 (General), 102.7 (Food), Monthly percentage change 0.6 (General), -0.7 (Food), 12-month 51.4 (General). - January–August 2003 monthly indices and percent changes show stabilization with monthly changes near zero and 12-month rates declining from 68.8 (Jan 2003) to 51.4 (Aug 2003). - Source for CPI table: CSO. ### Balance of payments: data constraints and 2002/03 estimates - Estimation hampered by severe lack of data; customs data believed to cover only two-thirds of total imports and only a fraction of exports because of smuggling. - Opium exports in 2002/03 were estimated in the order of $2.5 billion, equivalent to around half of GDP and roughly equal in value to estimated non-opium exports; opium exports excluded from reported balance of payments figures. - Figures exclude external flows related to U.S. military operations and most ISAF activities due to lack of information. - For 2002/03 (Table II.4, in millions of U.S. dollars, Fund staff estimates): - Trade Balance: -1,315 (2002/03 estimate) vs. -874 (2001/02). - Exports of goods: 2,290 (2002/03) vs. 1,657 (2001/02). - Own exports: 100 (2002/03) vs. 68 (2001/02). - Reexports: 2,190 (2002/03) vs. 1,589 (2001/02) — Official 100 (2002/03), Unofficial 2,090 (2002/03). - Imports of goods: 3,605 (2002/03) vs. 2,531 (2001/02). - Recorded imports: 2,322 (2002/03) vs. 1,696 (2001/02). - Commodity food aid: 94 (2002/03) vs. 719 (2001/02). - Unrecorded imports: 1,189 (2002/03) vs. 764 (2001/02). - Services: Receipts 29, Payments 133 (2002/03). - Current transfers: 1,287 (2002/03) — Public 1,081 (including commodity food aid 94), Private 206. - Current account balance (before grants): -1,419 (2002/03). - Capital financial account: 100 (2002/03) — Public loans 50 (disbursements 50), Direct investment 50. - Net errors and omissions: 188 (2002/03). - Overall balance: 155 (2002/03). - Financing: -155 (2002/03) — Change in net foreign assets of DAB: -101; Arrears: -54. - Overall, balance of payments for 2002/03 estimated to show a small surplus after grants and donor assistance. - Composition reflects donor-financed reconstruction and revival of private sector activity; a large current account deficit (before grants) funded mainly by official transfers; official loan disbursements were small. ### Opium-related flows and implications - Inclusion of opium-related exports would produce a large surplus broadly equal to the additional opium exports; this surplus would be offset by an equally large additional errors and omissions outflow. - The offsetting errors and omissions are consistent with banking abroad (and increase in foreign currency holdings within and outside Afghanistan) of illicit earnings related to opium, and with unrecorded imports related to opium. ### Trade patterns, composition, and direction - Exports are expected to grow rapidly, mostly as re-exports; own exports remain a small fraction and are primarily agricultural products boosted by return of rains. - Reexports comprise transit trade and “unofficial” (smuggling) exports, mainly to Pakistan; many such exports are imported via Iran. - Growth in unofficial reexports expected to slow as customs administration reform becomes effective. - Rapid growth of imports reflects revival of private sector activity and a more liberal environment; rapid import growth in 2002/03 includes cars, televisions, and refrigerators. - Commodity food aid expected to decline in 2003/04 with rebound in domestic cereal production. - Unrecorded imports comprise duty-exempt donor imports, transit trade, and smuggled goods. - Direction of trade (Table II.5, in millions of U.S. dollars and percent of total value, CSO): - Exports (official recorded only): Total 100.0 (2002/03 basis: value 100.0 shown in table as index); principal destinations in percent of total value (2002/03): India 27.4, Pakistan 26.0, Belgium 3.3, United States 4.3, Germany 5.5, Finland 9.0, Russia 3.5, United Arab Emirates 4.6, Unclassified 15.9. - Imports (official recorded only; includes reexports): Total 2,322.0 (2002/03); principal origins in percent of total value (2002/03): Japan 43.0 (999.0), Pakistan 8.9 (206.7), Korea, Rep. of 4.9 (113.4), Kenya 2.4 (56.5), Turkmenistan 2.2 (50.1), India 1.6 (36.5), China, People’s Rep. of 0.9 (20.3), Germany 2.1 (48.5), Unclassified 33.1 (767.8). - Commodity composition of exports (Table II.7, thousands of U.S. dollars; percent of total exports): - Total exports (2002/03): 100,143 (100.0 percent). - Major export items (2002/03): Dried fruit 40,582 (40.5 percent), Carpets, etc. 47,474 (47.4 percent), Medicinal plants 2,620 (2.6 percent), Spices 1,050 (1.0 percent), Seeds 1,006 (1.0 percent). - Commodity composition of imports (Table II.7, thousands of U.S. dollars; percent of total imports): - Total imports (2002/03): 2,322,609 (100.0 percent). - Major import categories (2002/03): Machinery and equipment 854,842 (36.8 percent), Household needs and medicine 622,481 (26.8 percent), Fabrics, clothing, and footwear 345,934 (14.9 percent), Chemical materials 172,679 (7.4 percent), Food 201,339 (8.7 percent). ### Transit trade potential and constraints - Afghanistan dependent on other countries for access to the sea; potentially important transit country for Central Asian access to the Indian Ocean and Pakistan and for west-east trade. - Current transit trade mainly with Iran and Pakistan; transit trade with northern neighbors limited. - Obstacles to transit route potential: - Poor quality transport infrastructure. - Poor security and frequent unofficial “tolls” charged by various factions. - Cumbersome border administration. - Policy actions underway or proposed: - Infrastructure improvements (e.g., Kandahar-Kabul road). - Renewing and improving existing transit trade agreements and establishing new ones with neighboring countries. - Aligning with regional initiatives such as ECO transit trade agreement. ### Exchange and trade system features - Historically (late 1980s–early 1990s) many official exchange controls: DAB maintained an official exchange rate (for government debt-service payments) and a commercial rate linked to the free rate in the money changers market, implying multiple currency practice. - Bilateral payments agreements existed with Bulgaria, China, and the former Soviet Union, with settlement in bilateral accounting U.S. dollars at rates set under the agreements. - Outside payments agreements, foreign exchange proceeds from main agricultural exports had to be surrendered immediately at the commercial rate. _Source: Fund staff estimates._ ### 1. At present, the main transit trade agreement is with Pakistan for Afghanistan’s imports and exports ### _cr03299 - 1. At present, the main transit trade agreement is with Pakistan for Afghanistan’s imports and exports ### Transit and transit-trade agreements — Pakistan - Main transit trade agreement with Pakistan (established in 1965) covers Afghanistan’s imports and exports through Pakistan, largely via the southern port of Karachi and Port Quasim. - Since 1996, 18 items have been banned from the eligible list; six of these banned items have recently been restored. - Processing and clearing procedures for transit goods reduced from 20 to 5 days. - Disagreement issues between the two countries expected to be resolved by end-2003. - Agreement to eliminate some categories of imports clearly intended to be smuggled back into Pakistan; Afghanistan expected to levy punitive import tariffs on these goods. - Both countries committed to making substantial progress later in the year on lifting the ban on the remaining 12 restricted items. - Infrastructure agreement (with Pakistan aid support) reached to repair the Torkham (railhead in Pakistan)–Jalalabad (Afghanistan) road and construct a new parallel road by early 2005. ### Transit and transport agreements — Iran, India, Central Asian neighbors - Iran: - Longstanding trade, transit, and transport agreements (since 1973) revised; new transport agreement signed January 2003; final approval of trade and transit agreement expected mid-2003. - Changes include lifting previous route restrictions for Afghan trucks and allowing Afghan truckers to buy Iranian fuel at the same subsidized price as Iranian truckers (subsidy element is about 20 percent). - India: - March 2003 preferential trade agreement with India replaced an earlier little-used agreement. - India granted 50–100 percent tariff reductions on 38 export items from Afghanistan and duty-free access for eight tariff lines. - Iran–India–Afghanistan (Chabahar route): - Memorandum of Understanding (January 2003) to improve access to Iranian port of Chabahar via Chabahar-Malik-Zaranj-Delaram route. - Iran to build a new transit route connecting Milak to Zaranj including the Milak bridge over Helmand river. - India to build a new road connecting Zaranj to Delaram (on main Herat-Kandahar road). - Improvements will shorten the transit distance between Chabahar and Delaram by some 600–700 kilometers. - India and Iran will build a railroad from Chabahar to the Iranian Central railway station on the Karachi–Tehran line; Iran will extend its railway to port of Islam Qaleh. - Afghanistan granted full access to the duty-free zone at the port of Chabahar; Iranian authorities providing storage facilities and permitting Afghan inspectors and trade representatives on-site. - Port fees cut by 90 percent and warehousing and other charges cut by 50 percent; smaller cuts granted for oil tankers. ### Trade liberalization, market access, and WTO - June 2002: preferential access to European markets under the Everything But Arms agreement. - January 2003: United States granted Afghanistan GSP access to its domestic market. - April 10, 2003: Afghanistan applied for membership to the World Trade Organization. ### Exchange and trade system (de facto liberalization) - De facto unified exchange rate system: DAB quotes an official Afghani–U.S. dollar exchange rate daily based on the early morning free market rate of money changers. - DAB calculates a simple average of the buy rate and the sell rate of ten reputable and large licensed money changers and quotes them as the official buy and sell rates. - During the first half of the year, the spread between the two rates (for cash transactions) has rarely exceeded 0.6 percent; during the latter half of 2002 spreads were usually larger and on two occasions exceeded 2 percent. - For transfers, fees are 0.25 percent of the amount, with a small minimum fee. - For letters of credit, fees are 0.25–0.5 percent of the amount. - In practice, virtually no controls are enforced on imports/exports, payments, invisibles, and capital transactions; commercial license permits exporting and importing with few additional licensing requirements. - Some imports require special licenses or are prohibited (certain pharmaceutical products, mining items, petroleum products, certain drugs, liquor, arms, ammunition; exports of opium and museum pieces prohibited). - DAB intends to replace existing rules and regulations for exchange and payments with new ones conforming with a liberal regime (assistance sought from the IMF). ### Customs, tariffs, and trade administration - Existing customs regime: - 25 customs import tariff bands with rates ranging from 7 percent to 150 percent allocated across 888 items. - Majority of items fall within the 0–50 percent range. - Unweighted average tariff rate is 43.3 percent. - Effective tariff rate lower because an undervalued exchange rate (Af 4.5 per U.S. dollar) is used to obtain the taxable value of imports. - Additional levies: Red Crescent fee of 2.5 percent and a withholding incomes tax of 4 percent (these use different exchange rates for valuing the tax base). - For exports and imports, a 4 or 2 percent withholding tax reclaimable against the income tax is levied. - Chamber of Commerce valuation fee: 2.5 percent for nonmembers and 2 percent for members (assessed on c.i.f value calculated using the customs exchange rate); in practice most valuations are carried out by customs houses (no fee). - Customs procedures not applied consistently across customs houses. - Authorities reviewing a new simplified tariff regime expected to be in place this year and have embarked on customs administration reform. ### Trade finance and foreign investment - In absence of functioning commercial banks, most trade financing done by cash or Hawala system. - Central bank DID open letters of credit in 2003: during first half of 2003 it opened 15 letters of credit for government agencies under the World Bank Donor Flow Management Program. - Foreign investment governed by Domestic and Foreign Private Investment Law of 2002: - Full foreign participation allowed; no limits on transfer of capital and profits out of Afghanistan. - Law provides tax holidays of up to seven years and a four-year exemption on export tariffs and duties. - The Law is being reviewed with consideration to eliminate tax holidays. - Investments in pipelines, telecommunications, infrastructure, oil and gas, mines, and minerals regulated under separate legislation. ### The poppy dimension — key findings and indicators (selected) - Afghanistan accounts for more than 70 percent of world opium supplies on average over the last decade (UNODC). - Historical production trends and key facts: - Annual rate of growth of opium production: - 1979–1989: on average 14 percent per year. - 1989–1994: accelerated to 19 percent per year. - Afghanistan’s share in world production: - About 20 percent in 1980. - 50 percent in 1995. - 79 percent in 1999. - Decline in real heroin street price in Western Europe: from about $300 per gram in 1987 (after adjusting for inflation) to $70 per gram in 2000. - Table AII.1. Afghanistan: Indicators of Opium Cultivation, 1994–2002 (selected annual figures exactly as presented) - Production (in metric tons): - 1994: 3,416 - 1995: 2,335 - 1996: 2,248 - 1997: 2,804 - 1998: 2,693 - 1999: 4,565 - 2000: 3,276 - 2001: 185 - 2002: 3,422 - Cultivated area (in ha after eradication): - 1994: 71,470 - 1995: 53,759 - 1996: 56,824 - 1997: 58,416 - 1998: 63,674 - 1999: 90,983 - 2000: 82,171 - 2001: 7,606 - 2002: 74,045 - Yield per ha (in kg): - 1994: 47.8 - 1995: 43.4 - 1996: 39.6 - 1997: 48.0 - 1998: 42.3 - 1999: 50.2 - 2000: 39.9 - 2001: 24.3 - 2002: 46.2 - Average farm gate price at harvest time ($ per kg): - 1994: 30.0 - 1995: 23.0 - 1996: 24.0 - 1997: 33.7 - 1998: 32.8 - 1999: 40.1 - 2000: 27.8 - 2001: 301.0 - 2002: 350.7 - Main bazaar prices (in $ per kg): - 1994: 69.0 - 1995: 65.0 - 1996: 50.0 - 1997: 71.0 - 1998: 65.0 - 1999: 55.0 - 2000: 39.0 - 2001: 301.0 - 2002: 350.7 - Gross income per ha (in $): - 1994: 3,297.9 - 1995: 2,823.2 - 1996: 1,978.0 - 1997: 3,408.0 - 1998: 2,749.1 - 1999: 2,759.6 - 2000: 1,554.9 - 2001: 7,321.2 - 2002: 16,207.6 - Direct farm employment (in person year): - 1994: 77,205 - 1995: 58,073 - 1996: 61,384 - 1997: 63,104 - 1998: 68,784 - 1999: 98,284 - 2000: 88,765 - 2001: 8,216 - 2002: 79,987 - Persons needed at harvest time (in persons): - 1994: 794,111 - 1995: 597,322 - 1996: 631,378 - 1997: 649,067 - 1998: 707,489 - 1999: 1,010,922 - 2000: 913,011 - 2001: 84,511 - 2002: 822,722 - Recent developments and prospects: - Taliban total ban (July 2000) led to a 95 percent fall in production in 2001; sowing in 2001 coincided with Taliban collapse and acreage returned to record levels. - January 17, 2002 AIA decree forbidding all poppy cultivation and trading; eradication campaign followed, along with alternative livelihood efforts. - Weak provincial authority and delays in donor assistance limited impact; 2002 harvest produced 3,422 tons. - Preliminary indications for 2003 suggest areas under cultivation remained extensive; 2003 harvest could be of similar order of magnitude to 2000 and 2002 or maybe slightly larger. *Italicized source: IMF staff summary of the PDF chapter "_cr03299 - 1. At present, the main transit trade agreement is with Pakistan for Afghanistan’s imports and exports"_* ### 58. During each year the fluctuation in opium prices tends to follow a typical annual ### _cr03299 - 58. During each year the fluctuation in opium prices tends to follow a typical annual ### Annual price cycle and storage role - Fluctuation in opium prices follows a typical annual agricultural cycle: low during the harvest period (April to June) and gradually rising until a few weeks before the next harvest period. - Opium can easily be conserved for long periods; market participants (farmers, traders, processing laboratories) rely on stock building and depletion to limit price fluctuations and stabilize incomes. - In the absence of a working financial system, opium has served as a store of value in rural areas and was often considered more liquid than other assets, including foreign currency. - There were strong incentives, even for individuals normally not involved in the trade, to hold opium. ### Regional markets, integration, and pricing disparities - Until recently, local opium markets were fragmented with large price disparities between producing regions due to: - Regional differences in opium quality. - Difficulties in arbitraging between regions during the civil war. - Regional centers oriented toward specific export routes: south → Iran and southern Pakistan (Baluchistan); east → northern Pakistan (North West Frontier Province); north → Tajikistan and Central Asia. - Prices were generally lowest in areas with the tightest border controls. - Recent reduction in factional fighting led to pronounced integration of regional markets as traders could exploit better trading routes. ### Historical price movements and shocks (selected events) - From 1994 to 2000 average farm gate prices (as monitored by UNODC at harvest time) fluctuated between a low of $23 per kg and a high of $40 per kg. - Taliban ban effects and subsequent volatility: - By April 2001 bazaar prices rose almost tenfold to $380 per kg. - Peaked at $700 per kg just prior to September 11, 2001. - In the following weeks prices crashed to $90 per kg as stocks were liquidated in anticipation of military operations. - Prices recovered over the next few months and soon exceeded $400 per kg in reaction to the transitional government’s January 2002 prohibition decree and expectations of donor assistance. - With start of eradication campaign in April 2002 prices rose further to a high of nearly $600 and after erratic fluctuations settled back after the 2002 harvest to around $400 per kg. - Indications that by the end of the 2003 harvest prices had fallen further. ### Farming the poppy: participation, returns, and income estimates - UNODC estimates number of farmers involved in opium cultivation fluctuated about 200,000 households. - Typical farm size and allocation: - Average land holdings of one and a half hectares, of which one-third is usually devoted to poppy growing. - Cash earnings are the main reason for planting poppies, but returns have varied; alternative crops sometimes yielded higher returns (example years cited: 1998/99 vs 1999/2000). - Other factors favoring opium for farmers: - Extremely labor intensive (important for large households). - Technical advantages: lower irrigation needs than wheat, weather resistance, short growing season, early harvest enabling second crops in some areas. - Easy to store, transport, and sell in damaged infrastructure contexts. - Opium is the only crop against which farmers could easily obtain credit (often at usurious rates); a 1999 UNODC study reports over 60 percent of traders interviewed made advance purchases of opium well before the harvest. - Income estimation caveats: - Many farmers sell forward at discounts usually exceeding 50 percent of the harvest price. - Pre-harvest monitored prices tend to be the lowest; better-off farmers hold production to sell later expecting higher prices. - Table AII.2 (UNODC data reproduced in source) — Afghanistan: Estimate of Farmers’ Net Income from Opium, 1994–2002 (In millions of U.S. dollars) - 1994: Gross revenue to farmers from opium production 235.7; Seed, fertilizers, tools, and other inputs 2.9; Wage bill (itinerant laborers) 47.1; Taxes and other payments (30 percnet of gross revenue) 70.7; Bazaar traders margins (8 percent) 18.9; Net income 96.1 - 1995: Gross revenue to farmers from opium production 151.8; Seed, fertilizers, tools, and other inputs 2.2; Wage bill (itinerant laborers) 30.4; Taxes and other payments (30 percnet of gross revenue) 45.5; Bazaar traders margins (8 percent) 12.1; Net income 61.6 - 1996: Gross revenue to farmers from opium production 112.4; Seed, fertilizers, tools, and other inputs 2.3; Wage bill (itinerant laborers) 22.5; Taxes and other payments (30 percnet of gross revenue) 33.7; Bazaar traders margins (8 percent) 9.0; Net income 44.9 - 1997: Gross revenue to farmers from opium production 199.1; Seed, fertilizers, tools, and other inputs 2.3; Wage bill (itinerant laborers) 39.8; Taxes and other payments (30 percnet of gross revenue) 59.7; Bazaar traders margins (8 percent) 15.9; Net income 81.3 - 1998: Gross revenue to farmers from opium production 175.0; Seed, fertilizers, tools, and other inputs 2.5; Wage bill (itinerant laborers) 35.0; Taxes and other payments (30 percnet of gross revenue) 52.5; Bazaar traders margins (8 percent) 14.0; Net income 71.0 - 1999: Gross revenue to farmers from opium production 251.1; Seed, fertilizers, tools, and other inputs 3.6; Wage bill (itinerant laborers) 50.2; Taxes and other payments (30 percnet of gross revenue) 75.3; Bazaar traders margins (8 percent) 20.1; Net income 101.8 - 2000: Gross revenue to farmers from opium production 127.8; Seed, fertilizers, tools, and other inputs 3.3; Wage bill (itinerant laborers) 25.6; Taxes and other payments (30 percnet of gross revenue) 38.3; Bazaar traders margins (8 percent) 10.2; Net income 50.4 - 2001: Gross revenue to farmers from opium production 55.7; Seed, fertilizers, tools, and other inputs 0.3; Wage bill (itinerant laborers) 11.1; Taxes and other payments (30 percnet of gross revenue) 16.7; Bazaar traders margins (8 percent) 4.5; Net income 23.1 - 2002: Gross revenue to farmers from opium production 1,200.1; Seed, fertilizers, tools, and other inputs 3.0; Wage bill (itinerant laborers) 240.0; Taxes and other payments (30 percnet of gross revenue) 360.0; Bazaar traders margins (8 percent) 96.0; Net income 501.1 - Source: UNODC. ### Employment, labor intensity, and diffusion of know-how - Labor requirements: - To cultivate and harvest one hectare of poppy requires, on average, about 350-person days. - Wheat: 41 person-days per hectare. - Black cumin: 135 person-days per hectare. - Harvest requires about 250 person-days per hectare. - Labor market impacts: - Majority of growers rely on hired help, usually six to seven itinerant harvesters per hectare, normally paid in-kind (a share of the harvest varying between one-fifth and one-sixth). - UNODC estimates about one million persons are involved in the opium harvest every year. - Production concentrated in two provinces, causing acute local labor shortages at harvest time; schools, colleges, and public works programs have been reported affected. - Skilled labor and spread of cultivation: - Lancing is a delicate, experience-dependent task; as experience spread, a pool of competent workers emerged giving Afghanistan a comparative advantage. - Itinerant harvesters, after receiving payment in opium and gaining know-how and contacts, propagated poppy growing when returning to home villages. - Number of poppy growing villages rose from 2,008 to 6,645 over the 1994–2000 period (UNODC). ### Trading structure and market functions - Estimated participants: approximately 15,000 persons participate in concentric trafficking circles funneling opiates out of Afghanistan. - Trafficking circle layers (as summarized from studies): - Outer rim: itinerant farm gate buyers — most numerous, small turnover, often better formal education than population average, sometimes teachers or government workers; provided credit and advice; trading was competitive with no significant risk premium historically. - Regional opium bazaars: shop owners buy from farmers/itinerants/other shopkeepers and sell to local consumers, clandestine laboratories, wholesale traders, foreign traders; bazaars functioned as regional commodity exchanges (up to 200 shops in some areas) though recent authority intervention curtailed these activities. - Center: bulk buyers / large-scale specialist traders — buy year-round, organize shipping to borders or abroad (sometimes several tons), relatively few in number, often family-linked, commit substantial capital, face high risks and rewards; collusion/protection payments used to reduce risks. - Cross-border trafficking: - Biggest risk and rewards are in moving opium across borders. - Large-scale international trafficking usually not undertaken by Afghan nationals; specialized traders from border tribes often conduct border crossings. - Prices highest in Iran, but penalties for interception are also far higher in Iran than in other neighboring countries. ### Clandestine laboratories and processing - Border seizure data suggest about 30 percent of Afghan opium is exported raw; the remainder transformed into morphine base or heroin. - UNODC estimates for 2000 production of 3,276 tons: - 1,081 tons exported as raw opium. - 1,146 tons transformed into base morphine. - 1,048 tons into heroin. - Processing developments: - Processing within Afghanistan began mid-1990s as laboratories moved from Pakistan into eastern Afghanistan and multiplied in border locations. - Typical refining in small to medium-scale laboratories producing about 10 kg a day of brown heroin. - Reports of a relatively small number of large-scale, heavily defended laboratories producing high-quality heroin, indicating vertical integration and growing capacity. - Domestic spread between opium prices and high-quality heroin fell significantly from 1997 to 1999. - Efficiency and input costs: - Required raw opium per 1 kg heroin reportedly lowered from 10 kg to as little as 6 kg due to efficiency gains. - Precursor chemical acetic anhydride: average cost has fallen by two-thirds in Afghanistan since mid-1990s and has fluctuated between $15 per liter and $36 per liter; approximately four liters are needed to produce one kilo of heroin. - Early interdiction measures included closing bazaars where precursor chemicals were traded. ### Taxes, levies, and the political economy - Legal or de facto rulers (warlords, local commanders, provincial administrators, tribal leaders, central government at times) benefited from the opiate industry via levies on producers and traders or direct involvement. - Opium helped finance the war against Soviet occupation and the civil war through levies and direct involvement by those in power. - Taxes levied by local authorities strengthened regional power relative to the center. - Surveys indicate most farmers continued to pay traditional agricultural taxes; acceptance of payment was often interpreted as implicit support for opium cultivation. - Small-scale and bazaar traders regularly indicated they paid taxes on their income. ### Exports, export composition, and revenue estimates - UNODC export volume and price estimates are available for 2000; 2002 breakdown between heroin and morphine is assumed in Table AII.3 to be the same proportions as in 2000. No figures available for 2001 due to Taliban ban and disarray. - Selected figures from Table AII.3 (UNODC; and IMF staff estimates) — Afghanistan: Revenues from Opiates, 2000–02 (In millions of U.S. dollars, unless otherwise indicated) - I. Farmers (2000, 2001, 2002) - Gross revenue to farmers from opium production: 127.8, 55.7, 1,200.0 - Volume (in tons): 3,276, 185, 3,422 - Price ($ per kg, bazaar price): 39.0, 301.0, 350.7 - a. Seed, fertilizers, tools, and other inputs: 3.3, 0.3, 3.0 - b. Wage bill (itinerant laborers): 25.6, 11.1, 240.0 - c. Taxes and other payments (30 percent of gross revenue): 38.3, 16.7, 360.0 - d. Bazaar and small traders margin (8 percent of gross revenues): 10.2, 4.5, 96.0 - e. Surplus to farmers: 50.4, 23.1, 501.0 - II. Traders (2000 ... 2002) - 1. Gross revenue from exporting raw opium: 425.0 ... 1,359.0 - Volume (in tons): 1,081.0 ... 890 - Price ($ per kg): 393.2 ... 1,527.0 - 2. Gross revenue from exporting morphine: 175.0 ... 651.2 - Volume (in tons): 115.0 ... 164.0 - Price ($ per kg): 1,521.7 ... 3,969.9 - 3. Gross revenue from exporting heroin: 245.0 ... 529.8 - Volume (in tons): 105.0 ... 89.0 - Price ($ per kg): 2,333.3 ... 5,954.9 - 4. Total exports: 845.0 ... 2,540.0 - Volume (in tons): 1,301.0 ... 1,143.0 - Price ($ per kg): 649.5 ... 2,222.2 - Sources: UNODC; and IMF staff estimates. - Key aggregate insight: - Estimates suggest the value of opium exports and opium derivatives increased substantially in 2002 compared with 2000 to a total of $2.5 billion, mainly due to higher prices. - Of the 2002 total, half relates to exports of raw opium and the remainder relates to exports of morphine and heroin in roughly equal amounts. - These estimates suggest opium production would represent somewhere between 40–60 percent of Afghanistan’s GDP (depending on the measure of non-opium GDP) and is roughly equal in value to Afghanistan’s legitimate (mostly transit) trade. *Source: Excerpt from IMF staff analysis drawing on UNODC/UNDCP data as presented in the original content.* ### 75. The estimates also suggest that about half the income from opium exports probably ### _cr03299 - 75. The estimates also suggest that about half the income from opium exports probably ### Opium-economy estimates and distribution - About half the income from opium exports probably accrues to farmers. - This farmers’ income is also likely to be mostly either spent or saved domestically. - The other half of the gross export earnings of opiates would then accrue to refiners and traders after payment to farmers. - Refiners and traders are probably better connected and bank their profits abroad. - The estimates do not represent the value that exports of Afghan opiates fetch on the world market; that value is probably substantially more than 10 times the value that Afghan exports of opiates fetch at the border. - UNODC estimate that in Europe alone more than $20 billion was spent on Afghan opiates. - Most of the money made from trading Afghan opiates is therefore earned by international dealers and traffickers. ### Conclusion: causes, dynamics, and policy implications - The rise of the opium economy is a relatively recent phenomenon that has occurred only over the last twenty years. - Underlying causes and enabling conditions: - Long-term failure of the Afghan state and its institutions. - Breakdown of law and order. - Degradation of agriculture. - Absence of commerce or any alternative economic opportunity. - Destruction of infrastructure. - The opium economy’s development pathway: - Poppy cultivation became one of the few viable economic activities in many areas. - The foundation was progressively built upon by raising productivity, by developing a qualified labor force, by expanding trade routes, and by investing in laboratories. - A large number of stakeholders now have vested interests in the survival of this industry. - Policy implications and required response: - Reversing this process will require a substantial and prolonged commitment by the authorities and by the international community. - The commitment must go beyond eradication and law enforcement. - It will demand a comprehensive strategy for building a stable and unified Afghan state, and for the development of a growing economy that provides alternative livelihoods throughout the country. - Absent early and visible progress, there is a dangerous potential for Afghanistan to progressively slide into a narco-state where legitimate institutions become penetrated by the power and wealth of traffickers. ### I. Overview of past fiscal developments: a slow descent into chaos - Very limited information is available on Afghanistan’s fiscal situation before the Afghan Interim Administration (AIA) took office in December 2001; the last full analysis covered the 1987–90 fiscal years. - After two decades of conflict, fiscal policy and public finance management had disintegrated: - Traditional domestic revenues steadily declined and were progressively replaced by illegal off-budget revenues, collected both by the central government and local warlords. - Actual revenue performance continually fell short of budget requirements; the central bank provided the government with unlimited overdraft facilities to cover deficits. - Monetization of the budget deficits resulted in high inflation and a rapid depreciation of the Afghani. - At the end of 2001, the government’s accumulated overdraft with Da Afghanistan Bank (DAB) was estimated by DAB to have reached almost (old) Af 15 trillion, equivalent to $300 million at mid-2003 exchange rates. - Example of price effects: the Central Statistics Office (CSO) reported prices of basic goods rose on average about 162 times between 1991 and 1995 in Kabul. - Fiscal collapse occurred in three stages, reflecting the drying up of revenues from: - Extraction and exportation of mineral resources, particularly gas. - Income transfers by state-owned enterprises (SOEs). - Customs duties, taxes on agricultural land, hotels, residential dwellings, and sales tax on real estates and cars. - These domestic revenues had been substantially supplemented by grants and external borrowing prior to the conflict. ### II. The starting point: a dismal situation but resilient structures - By December 2001 the Ministry of Finance (MoF) and provincial offices (Mustufiats) had, for most intents and purposes, ceased to function. - Most skilled and qualified MoF staff had emigrated during the war; remaining personnel largely lacked basic qualifications. - MoF infrastructure was devastated, especially regional offices and customs houses. - Basic telecommunication facilities had failed and most primary road network was impassable; there was no office automation (in early 2002, there was only one calculator available for the whole Revenue Department), and key government offices lacked regular access to electricity. - Budget policy was largely limited to payment of salaries, which were subject to delays and arrears; it is estimated that in December 2001 there was about $20 million of salary arrears corresponding to wages incurred during the Taliban period. - Fiscal practices violating law included line-ministries and provincial Mustufiats operating bank accounts outside the purview of the MoF, with no reconciliation between central bank accounts and the MoF treasury. - Despite dissolution of practice, pre-conflict fiscal laws and institutions provided a starting point for reconstruction: - The 1966 Organic Budget Law required that all revenues and grants be collected and spent through the government treasury and that full project costs be reflected in the national budget. - Accounting Regulations, the Treasury Manual, and the Control and Audit Law established procedures and a supreme audit authority. - A comprehensive tax system based on the 1965 Income Tax Law and 1974 Customs Law survived (individual and corporate income taxes, business receipt tax, fixed presumptive taxes, and indirect taxes on trade). - Government employment arrangements were based on legislation for centralized recruitment, job classification and grading. - Institutional reality versus law: - Constitutional and legislative setup provided for a highly centralized state; in practice provinces exercised de facto fiscal autonomy. - Under the law provinces are deconcentrated offices of the central government, do not have a distinct budget, and revenues collected by provinces are receipts of the national budget and must be transferred to the center (with limited exceptions for some municipalities). ### III. The reconstruction strategy: from donor-led humanitarian assistance to government-driven reconstruction - Donors and international organizations assisted Afghan authorities to assess external and technical assistance needs. - In late 2001, AsDB, UNDP, and the World Bank conducted a preliminary assessment covering 1, 2½, 5, and 10-year horizons. - These projections presented at the International Conference on Reconstruction Assistance to Afghanistan in Tokyo on January 21–22, 2002 concluded that $14.6 billion would be needed over a period of 10 years to fund Afghanistan’s recovery, excluding humanitarian assistance. - Donor pledges resulting from the assessment: - $1.8 billion in grants for the first year. - $4.5 billion mostly over the first 2½ years for Afghanistan’s reconstruction. - International agencies, including the IMF and the World Bank, sent diagnostic missions to develop technical assistance action plans addressing administrative structures, laws and regulations, staff suitability, and availability of facilities and equipment. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03299.pdf* ### 93. In the meantime, donors focused on providing immediate humanitarian relief to ### In the meantime, donors focused on providing immediate humanitarian relief to vulnerable Afghan people and ensuring regular payment of civil service salaries. ### Humanitarian relief and UN ITAPs (October 2001–December 2002) - The UN’s Immediate and Transitional Assistance Programs (ITAPs) were the main instruments addressing urgent humanitarian needs during October 2001–December 2002. - ITAPs focused on: - return and reintegration of refugees and internally displaced people; - food assistance; - rehabilitation of crop production; - child immunization; - improvement of school enrollment. - Estimated ITAP spending: $1.0 billion (excluding civil service payments made by the Afghan Interim Administration Fund (AIAF)).1/ - Box III.2 summary of ITAP achievements (October 2001–December 2002), financed by $1.1 billion from donor countries: - Return and reintegration (UNHCR): nearly 1.8 million refugees and 400,000 internally displaced persons assisted; some 48,000 million tons (MTs) of food aid; 310,000 return packages; $35 million in travel grants; 40,000 shelters constructed. - Food Assistance (WFP): by December 2002, 250,000 MTs of food commodities reached over 8 million people; school feeding programs reached 150,000 children; 1.8 million benefited from “Food-for-Asset-Creation”; over 250,000 received assistance through “Food-for-Work.” - Rehabilitation of Crop Production (FAO): 2002 spring season—1,500 MTs of wheat seed and equivalent fertilizer to 40,000 farmers; 2002 autumn season—3,800 MTs of wheat seed and 6,500 MTs of fertilizer to 80,000 farmers. - Health: Six million people vaccinated against polio; Nine million children vaccinated against measles. - Public Administration: $50 million worth of civil servant salary payments made with AIAF support. - Education: back-to-school campaign in March 2002 provided supplies to 1.8 million children and 70,000 teachers at 4,500 schools. - In the first six months of the AIA (January–June 2002) civil service payrolls were processed and financed through the Afghan Interim Administration Fund (AIAF) administered by the UNDP; line ministries and the MoF’s treasury prepared payrolls and performed salary payments. ### Transition to government leadership and the National Development Framework (NDF) - Key political and planning milestones: - Adoption of the 2002/03 operating budget and presentation of the National Development Framework (NDF) in April 2002 marked the government taking full leadership of the development agenda. - NDF prepared through consultations between the MoF, line-ministries, and government, shifting from donor-driven ITAPs to a government-led reconstruction process. - NDF structure and priorities: - Three pillars: (a) human capital and social protection; (b) physical infrastructure; (c) private sector development. - Government developed 12 National Programs, with 6 National Priority Subprograms identified for priority donor and implementation attention. - Government commitments in the NDF (five main principles): - Government leadership in formulation of development strategy; insistence that all development projects be approved in the budget and that all resources be reflected in the budget to avoid parallel budgets. - Reliance on market mechanisms and private-sector led growth rather than state intervention; role of the state limited to security, investing in human capital, assistance to the vulnerable, and enabling private-sector development. - Programmatic approach to policy-making and resource allocation to anchor investment projects in coherent programs and align donor support with national priorities. - Government transparency and accountability: commitment to fiscal transparency; contracted three reputable international companies through competitive bidding to provide interim management and build capacity in fiscal reporting and accounting, procurement and audit. - Priority on investing in security and human capital: development of national police and army, reintegration of ex-combatants, revival of the judicial system, and emphasis on education, including girls’ enrollment; achievement of getting three million children back to school. ### 2003/04 National Development Budget (NDB) and donor coordination - Cabinet adoption in March 2003 of the 2003/04 National Development Budget (NDB) translated NDF architecture into detailed development projects with precise funding sources. - Features of the 2003/04 NDB: - Marked full government ownership of the development agenda; combined operating and development budgets in a single document. - Development projects worth $815 million (the 2003/04 UN Transitional Assistance Programs succeeded the 2002/03 ITAPs). - The NDB was prepared by the MoF and approved by the Cabinet after extensive consultation and negotiation with line-ministries. - Government-donor coordination reforms: - Establishment of twelve Consultative Groups (CGs) covering the twelve major programs of the NDF to prepare budget bids, monitor operating budget implementation, report reconstruction progress, and offer policy dialogue forums; each CG chaired by a lead line-ministry and includes UN agencies, donor countries, and active NGOs. - Annual Afghanistan High-Level Strategic Forum (AHSF) convened every March to discuss the next fiscal year budget, firm up external assistance pledges to the NDB, review priorities, and assess progress; the first AHSF took place in March 2003 and endorsed the first NDB. ### Fiscal policy framework and the 2002/03 operating budget (March 21, 2002–March 20, 2003) - Fiscal context and objectives: - During 2002/03 the authorities maintained fiscal discipline and provided basic services despite low domestic revenue base and unclear fiscal relations with provinces; external assistance was key. - For 2003/04 the authorities sought to increase operating and development budgets, especially in security, education, health, and humanitarian assistance, contingent on donor support, increased domestic revenue collection, and progress toward fiscal unification. - Budget preparation and role of international institutions: - The operating budget was prepared with IMF and World Bank assistance and adopted by the Cabinet on April 6, 2002. - The operating budget covered fiscal transactions for center and provinces, relied heavily on donor financing, and aimed primarily at ensuring payment of civil service and military wages. - 2002/03 budget totals and composition (Table III.1, in millions of U.S. dollars): - 1. Wages and salaries (excl. defense, interior, national security, and SOEs): 104.3 - Of which: allocation for wage reform: 24.1 - 2. Goods and services (excl. defense, interior, and national security): 60.7 - 3. Capital expenditure (excl. defense, interior, and national security): 14.4 - 4. Defense, interior, and national security: 198.8 - Defense: 96.6 - Interior: 83.4 - National security: 18.9 - 5. Subsidies to SOEs: 34.1 - Wages: 15.9 - Other: 18.3 - 6. Social transfers: 18.8 - Of which: allocation for pension reform: 15.5 - 7. Interest: 6.6 - 8. Contingency: 22.5 - 9. Total: 460.3 - 10. Wage arrears clearance: 22.5 - 11. Revenues: 83.0 - 12. Financing need: 399.8 - 13. Foreign grants: 399.8 - Aggregate budget figures and financing: - Expenditures budgeted at (new) Af 15.7 billion, plus Af 750 million to clear pre-existing wage arrears. - Using the accounting exchange rate of Af 34 per U.S. dollar, this corresponded to $483 million (including clearance of wage arrears). - Revenue target: $83 million (17 percent of total spending), reflecting a narrow tax base and low domestic revenue collection in early AIA months. - Budget financing gap: $400 million (83 percent of the budget) to be financed by donor assistance; domestic financing of the budget was precluded by the authorities. - Civil service cap included: 240,000 civil employees (60 percent in provinces, 40 percent at center). - Composition and priorities: - Civil service wages (excluding police and army but including SOEs) projected at $120 million; military salaries estimated at $99 million—combined wage bill represented a little less than 48 percent of total spending.46 - Security-related spending (including police) amounted to close to 45 percent of total spending. - Health and education accounted for 20 percent of the total envelope, reflecting anticipated capacity constraints and expectation that most social sector development spending would be carried out by donors outside the operating budget. - Budgetary rules and safeguards: - 2002/03 budget decree prohibited central bank financing (no-overdraft rule) and limited ministerial allotments to resources actually available in government accounts. - Introduced binding headcount ceilings for each ministry’s civil service staff and required explicit authorization in the budget for all state operating expenditures. - Established specific funding for wage and pension reforms and separated SOE compensation from budgeted wage appropriations by treating it as government transfers and subsidies to SOEs. - Authorities stated intention to restrict external borrowing, to the extent possible, to financing the development budget while operating budget would mainly rely on external grants. *Italic: Source — IMF staff report content from the supplied document.* ### 103. According to preliminary estimates, actual spending in 2002/03 (including estimated ### _cr03299 - 103. According to preliminary estimates, actual spending in 2002/03 (including estimated ### Budget execution in 2002/03 — headline outcomes - Actual spending (including estimated nonwage provincial expenditures) reached 95 percent of budgeted amounts in Afghani terms (Table III.2). - In U.S. dollar terms, expenditures amounted to an estimated $349 million, compared with the $460 million initially envisaged. - The annual average exchange rate was Af 44.5 per U.S. dollar whereas the budget accounting rate was Af 34 per U.S. dollar. - Budget spending was very low in the first half of the year and picked up sharply in the second half, especially in the fourth quarter, as donor disbursements accelerated and administrative capacity improved. - Budget execution in the center during the last five months of the year focused mostly on salary payments (74 percent of total spending, versus the budgeted 48 percent) and on three priority sectors: security (43 percent), education (19 percent), and health (8 percent). ### Composition and concentration of spending - Ministries with the highest shares of spending: defense, interior, education, health, and the president’s office (presidential discretionary funds reallocated during the year). - Economic classification (last five months of the fiscal year): - Wages and Salaries: 74% - Purchase of Goods and Services: 16% - Transfers and Subsidies: 1% - Pensions: 0% - Capital Expenditure: 9% - Functional classification (last five months of the year): - General Public Services: 9% - Defense: 26% - Public Order and Safety: 17% - Education: 19% - Health: 8% - Social Protection: 2% - Housing and Communal Services: 0% - Recreation and Culture: 3% - Economic Affairs: 16% ### Domestic revenue and transfers - Domestic revenue as reported to the center is estimated at about $132 million, versus the budgeted $83 million. - More than 80 percent of reported revenues were collected in the provinces; the remainder came from line-ministries at the center. - About 60 percent of locally collected revenues were customs revenues. - Only a small proportion of reported provincial revenues were actually transferred to the central government’s accounts (about 27 percent). ### Financing requirement and financing mix for 2002/03 - Estimated financing requirement: $232 million (66 percent of total spending), compared with the initially planned $400 million. - Major sources covering the gap: - Donor assistance grants: $183 million (including $125 million from the Afghanistan Reconstruction Trust Fund (ARTF)) - One-off receipts: $39 million - Partial use of an external loan from the Asian Development Bank: $25 million - Result: positive balance of $16 million at the end of the year. ### Afghanistan Reconstruction Trust Fund (ARTF) — role in 2002/03 - ARTF covered 54 percent of the 2002/03 operating budget funding requirement. - Established in April 2002, administered by the World Bank, providing grant support to: - recurrent civil costs of government (excluding the army and national security), - priority investments, - benefits granted to returning expatriate Afghan professionals. - In 2002/03, ARTF disbursements almost entirely focused on recurrent civil costs; four investment projects were approved (commitment basis) in late 2002; no disbursement under the return-of-expatriates component. - Governance: Management Committee (ADB, Islamic Development Bank, UNDP, World Bank); day-to-day administration by the World Bank; Monitoring Agent appointed by the World Bank; Donor Committee supervises management and provides policy guidance. ### Positive features of 2002/03 execution - Authorities respected commitment to fiscal discipline; prohibition of monetary financing observed except in the third quarter when the government’s account went temporarily into overdraft. - Most of the annual budget was spent despite a slow start; budget was national in scope with more than 45 percent of estimated spending benefiting the provinces. - Actual spending reflected sectoral priorities: education, health and social protection, and security. - Domestic revenue collection as reported to the MoF exceeded budget expectations. - Expenditures were fully financed from revenues, grants, and loans, leaving a significant positive balance at year-end. ### Key implementation obstacles and weaknesses - Lack of unity of the fiscal system due to weak central control over provinces. - Provinces collected bulk of domestic revenues, reported them to the center with time lags, but remitted only about 27 percent to central accounts. - Collapse of the equalization system between “rich” and “poor” provinces due to nonremittance from rich provinces. - Incomplete or unreliable reporting: - Most provinces did not send reliable reports on nonwage expenditures; comprehensive information unavailable for 2002/03. - Authorities estimated nonwage provincial expenditures by assuming provinces spent all revenues they reported plus net transfers received. - Payroll and staffing problems: - Difficulties in preparing a nominal roll of employees countrywide. - Executed provincial payroll could not be broken down by ministry in the first half of the year. - Some SOE staff continued to be paid through government payroll contrary to provisions. - Some provinces hired and paid civil service staff out of local revenues without informing the center. - Slippages and reallocations during the year without formal budget revision: - Government employees’ food allowances raised by 37 percent in May 2002. - World Food Program in-kind food replaced by monetary allowance in September 2002. - One-month salary (“Ramadan bonus”) paid in November 2002. - Some line-ministries, including Ministry of Education, hired more staff than authorized. - These slippages financed within the overall ceiling using presidential reserve fund and wage and pension reform reserves. ### External assistance and off-budget donor spending - Total disbursements of external assistance in 2002/03 estimated at about $1.4 billion (excluding support for the operating budget). - Less than 40 percent of these funds, channeled outside the government’s budget, went to reconstruction; the remainder was allocated to humanitarian relief. - No comprehensive information was available on expenditures directly spent by donors on development projects in 2002/03. ### 2003/04 budget framework and projections - Authorities presented 2003/04 operating and development budgets totaling $2.3 billion at the first AHSF (Brussels, March 2003). - Budget decree reaffirms commitment to fiscal discipline and the no-government-overdraft rule; includes ceilings for total staff by ministry and obligations to break down headcount ceilings into sub-ceilings for center and each province. - External borrowing restricted to $300 million for the fiscal year; limited to development projects and temporary cash flow needs for the operating budget. - A Civil Service Reform Fund of $20 million established. - Reserve funds of the operating budget reduced and subject to tighter controls. ### 2003/04 operating budget specifics (Table III.3) - Domestic revenues budgeted: $200.0 - Total expenditures envisaged: $550.0 (100) - Economic classification (in million U.S. dollars and percent of total spending): - Wages and salaries: $276.6 - Goods and services: $178.4 - Capital expenditure: $39.2 - Transfers: $24.5 - Interest: $6.7 - Unallocated: $24.6 - Functional classification highlights: - General public services: $48.7 (9) - Defense: $128.0 (23) - Public order and safety: $81.7 (15) - Education: $132.5 (24) - Health: $27.9 (5) - Social protection: $24.6 (4) - Housing and communal services: $1.3 (0) - Recreation and culture: $13.3 (2) - Economic affairs: $40.5 (7) - Unallocated: $51.5 (9) - Financing requirement: $350.0 (64) - ARTF: $250.0 (45) - LOTFA and Army Trust Fund: $100.0 (18) - Memorandum items: - Number of civil servants: 456,000 - Of which: military: 100,000 - Average monthly wage (in U.S. dollars): 50.6 ### 2003/04 policy priorities and assumptions - Operating budget increase to $550 million, a 58 percent rise over 2002/03 outcome, reflecting constrained absorptive capacity in 2002/03. - Planned spending allocation: almost 40 percent to defense/public order/safety; 24 percent to education; about 10 percent to health and social protection. - Wage and salary payments account for 50 percent of the budget (a reduction from 74 percent in 2002/03 actuals). - Domestic revenues budgeted at $200 million — 52 percent higher than domestic revenues collected in 2002/03 — based on: - strong economic growth assumptions, - increased revenue collection from planned customs reform, - effective centralization of locally-collected revenues. - Projected $350 million financing gap to be covered by foreign assistance; $250 million projected from ARTF and $100 million via LOTFA and the Army Trust Fund for security-related recurrent expenditures (military and other security expenditures not eligible for ARTF). - Authorized civilian headcount ceiling: 356,000 (50 percent increase over last year’s budget). Authorities expect to hire 60,000 new staff (mainly teachers); the remainder reflects recording of staff already paid by provinces but not previously reported to the center. *Source: IMF staff summary of Afghanistan budget execution and 2003/04 budget materials contained in the provided content unit.* ### 116. The 2003/04 development budget, which is the first real development budget ### _cr03299 - 116. The 2003/04 development budget, which is the first real development budget ### Development budget size and composition - The 2003/04 development budget prepared by the ATA amounts to $1.8 billion (Table III.4), to be fully financed by external assistance. - Allocation by pillar and sector (in millions of Afghanis; percent of total): - Pillar I: Human and Social Protection — 858.3 — 48.2 - Refugee return — 162.6 — 9.1 - Education — 244.0 — 13.7 - Health and nutrition — 173.5 — 9.7 - Rural livelihoods and social protection — 248.0 — 13.9 - Culture/media/sports — 30.2 — 1.7 - Pillar II: Physical Infrastructure — 637.2 — 35.8 - Transport and telecommunications — 253.6 — 14.2 - Energy, mining — 162.4 — 9.1 - Natural resources — 146.1 — 8.2 - Urban management — 75.2 — 4.2 - Pillar III: Private Sector Development — 284.8 — 16.0 - Trade and investment — 5.5 — 0.3 - Public administration — 87.9 — 4.9 - Justice — 27.0 — 1.5 - Interior — 98.4 — 5.5 - Mine action — 66.1 — 3.7 - Total — 1,780.4 — 100.0 - Notes on donor projects: - All donor projects are supposed to be reflected in the budget, especially most of the Transitional Assistance Programs for Afghanistan (TAPA; successors to ITAPs) carried out by UN agencies. - $750 million of the $815 million envisaged for TAPAs 2003/04 is included in the development budget. - Memorandum items (items not included in the development budget): - Mine Action Program - Afghan National Army Development Costs - Counter Narcotics Program - MIGA Investement Guarantee Trust Fund - Footnote on disbursements: "Actual disbursements during the year, however, are expected to be less, depending on the disbursement pace of the various multiyear projects." ### Exclusions and confidentiality - Full comprehensiveness has not been achieved: the budget envelopes do not include development costs for the Afghan National Army, the Counter-Narcotics Program, and the preparation of the national elections to be held in mid-2004. - Footnote: "The Afghan National Army and Counter-narcotics Program development expenditures have been kept outside the budget for confidentiality reasons and because they will be planned and executed directly by specific bilateral donors. The cost of the national elections is not included in the 2003/04 budget because it was not known at the time the budget was prepared." ### Budget execution and fiscal outcomes (first five months, 2003/04) - Preliminary execution data covering the first five months show: - Revenue performance reached $31 million in the first quarter of 2002/03 — a 72 percent increase over the same period last year ($18 million). - Provinces transferred $12 million of their 2002/03 surplus revenues to the center. - If sustained, total domestic resources available to finance the operating budget could reach $150–200 million (attainment of the upper limit depends on customs reform implementation). - Spending was slow: only 24 percent of the annual budget was spent in the first five months, mainly due to large delays in payments of provincial and military salaries. - The no-overdraft rule has been observed; government accounts show comfortable surpluses at the end of the fifth month ($63 million), reflecting: - slow spending; - the positive balance remaining at the end of 2002/03; - transfers from provinces of accumulated 2002/03 revenues; - sizeable disbursements of external assistance; - a transfer of $33 million from the proceeds of a loan disbursed by the AsDB in late 2002 (initially planned for the development budget). - Development budget execution: "No comprehensive information on the execution of the development budget is currently available, although partial reports indicate that project expenditures have been much lower than budgeted." - Government action: undertaking an in-depth review of development budget execution to identify bottlenecks and capacity constraints and to reflect new donor pledges since the March 2003 AHSF. - Footnote: The U.S. administration has publicly announced its intention to allocate an additional $1 billion aid package to Afghanistan. However, the decision remains to be confirmed and the modalities of its integration with the NDB are not yet determined. ### Institutional and administrative reforms to improve fiscal performance - Agreement between central government and provincial governors to centralize provincial revenues: - National Security Council instruction (May 2003) co-signed by major provincial governors ordered that: - (a) all provincial tax and customs revenues be recorded and transmitted to the center on a regular and timely basis; - (b) provincial authorities refrain from meeting their expenditures directly out of their local revenues; - (c) provincial expenditures be limited to budget allotments received from the center. - Major challenge: ensuring provincial governors comply with the signed agreement; compliance would be an essential milestone toward fiscal unification. - Human resource support: 40 newly-trained fiscal experts will be sent to the provinces (including 6 foreign consultants stationed in the largest provinces) to enhance financial reporting and follow up on revenue centralization. ### Risks, financing gaps, and conditions for fiscal discipline - Conditions required for compatibility of the sharp budget increases with fiscal discipline: - (a) fiscal relationships with provinces improve; - (b) effective revenue centralization is achieved; - (c) increased domestic revenues are mobilized, especially through promoting private sector development; - (d) large external assistance projected in the budget materializes. - Financing gaps: - For the operating budget, pledges of external assistance are still short of about $100 million compared with budget requirements (shortfall relates mainly to army and police expenditures). - For the development budget, the AACA estimates that commitments are about $700 million short of the budgeted amount. - Donor behavior: need for donors to mobilize necessary resources and to disburse pledges in a timely and predictable fashion to ensure adequate implementation pace. ### Summary of the Twelve National Programs (Annex III.1) — program objectives and priorities - Refugee Return: improve information, registration and documentation of refugees; provide support to neediest and host communities; address winter vulnerability; build capacity of government agencies for reintegration. - Education: improve education infrastructure, teacher development, increase primary and secondary enrollment (focus on female enrollment), vocational training, early childhood development. - Health and Nutrition: decrease infant, child, and maternal mortality through basic packages of health services; build government capacity; implement safe motherhood and nutrition programs; quantify improvements in health indicators. - Livelihoods and Social Protection: focus on institutional strengthening, macroeconomic regeneration, community-based development, protection of lives and livelihoods, income generation; address needs of disabled (~4 percent of population); involve communities in reconstruction design and implementation. - Cultural Heritage, Media, and Sports: preserve cultural heritage; rehabilitate sports infrastructure; rehabilitate media with encouraged participation of women. - Transport and Telecommunications: large investments in national and secondary roads; create regulatory environment for private sector participation; improve telephone, information technology, internet, postal services; develop technology for distance education. - Urban Management: rebuild cities, provide housing services, waste water and sanitation, land acquisition for housing; address town planning, management, standards, and legislation. - Energy and Mining: secure cost effective power supplies to urban areas and expand to rural areas where cost effective; focus government role on regulation and policy environment for private sector participation. - Natural Resource Management: rehabilitate sustainable agriculture, horticulture and livestock; identify viable substitutes for poppy production; sustainable water usage; forestry protection and agro-forestry; develop environmental laws and awareness campaigns. - Trade and Private Investment: foster private sector development; assist small business development; improve governance; create laws on competition, direct and foreign investment, and standards and certification; address divestiture of state-owned enterprises. - Public Administration: establish effective civil service system; rehabilitate government physical infrastructure; develop organizational structure to deliver goods and services; rationalize number of ministries; integrate donor assistance into the budget process; reduce number of government corporations; mainstream gender in public administration. - Security and Rule of Law: activities to improve domestic justice system and independence of the judiciary; rebuild juvenile justice, prison, and law enforcement systems; establish new courts; strengthen legal aid services within Supreme Court structure. ### Comparison with sample of low-income countries (Annex III.2) - Sample: 39 low-income countries supported by IMF PRGF arrangements. - Key comparative findings for Afghanistan (2002/03) vs. sample averages: - Civilian government employment (percent of population): - Afghanistan: 1.1 - Sample average (excluding Eastern Europe in the cited breakdowns): comparable figures include Africa 1.4, overall sample 2.3 (various subgroup averages presented). - Current expenditure (percent of GDP): - Afghanistan: 11.5 - Sample average: 18.5 - Wages (percent of GDP): - Afghanistan: 7.2 - Sample average (example): 5.6 - Domestic revenues (percent of GDP): - Afghanistan: 2.1 - Sample average: 18.7 - Memorandum items for Afghanistan 2002/03: - Population: 22.0 (in millions) - GDP for FY 2002/03: 4,000.0 (in millions of U.S. dollars) *Source: Afghan authorities; Ministry of Finance; DAB; and IMF staff estimates.* ### References ### _cr03299 - References ### Bibliographic references - Afghan Interim Administration, 2002, National Development Framework (March). - Afghan Transitional Administration and Afghan Aid Coordination Agency, 2003, Analysis of Aid Flows to Afghanistan (April). - Ewans, Martin, 2002, Afghanistan. A Short History of Its People and Politics, (Harper Collins). - Gupta, Sanjeev, et al., 2002, “Expenditure Composition, Fiscal Adjustment, and Growth in Low-Income Countries,” IMF Working Paper No. 02/77 (Washington: International Monetary Fund). - Rubin, Barnett R., 2000, Fragmentation of Afghanistan. - Schiavo-Campo, Salvatore, et al., 1997, “An International Statistical Survey of Government Employment and Wages,” World Bank Policy Research Working Paper 1806, (August). - United Nations, 2002, Immediate and Transitional Assistance Program for the Afghan People, (February). - United Nations, 2003, Transitional Assistance Program for Afghanistan, (January). - World Bank, 2002, Afghanistan Support Strategy. - World Bank, 2003, Transitional Support Strategy (February 7). - World Bank, Asian Development Bank, United Nations Development Program, 2001, Preliminary Needs Assessment, (December). ### Chapter IV excerpt: Structural reforms — revitalizing fiscal institutions (selected findings and actions) - Implementation approach - The fiscal strategy in Chapter III was supported by a comprehensive technical assistance program focused on restoring essential financial capacity in the Ministry of Finance (MoF) and line-ministries through: design of detailed reform projects; hands-on implementation; and training of MoF staff. - Assistance also provided in civil service reform and private sector development to maintain fiscal sustainability. - Major international actors involved: World Bank, Asian Development Bank (AsDB), European Union, United States (USAID), United Kingdom (DFID), German agencies (GTZ), U.S. Treasury, and the IMF (monitoring and recommending). - Key principles - Rely on existing systems where sound to facilitate ownership and immediate results. - Where systems needed revamping, technical assistance aimed at basic financial system elements while preparing for gradual introduction of best international practice. - Emphasis on capacity building in the MoF via intensive training and close partnerships. ### I. Improving public expenditure management: transparency and accountability - Context and objectives - From the outset, interim and transitional authorities committed to full transparency in public resource management (articulated in President Karzai’s January 2002 Tokyo speech). - Pre-war financial regulations largely broken down: reporting and recording non-operational, internal controls and external audit ceased, banking arrangements collapsed, cash management and bank reconciliation not performed. - Surviving fiscal functions were slow, cumbersome, error-prone, and subject to abuse; legacy of deficit monetization undermined budget discipline. - Budget execution and financial management - Immediate priority: upgrade MoF budget execution and financial management to provide donors fiduciary assurances. - World Bank Emergency Public Administration Project (June 2002 grant) funded qualified international contractors for financial management, procurement, and audit with tasks to assist authorities and build local capacities. - Afghanistan’s Financial Management Information System (AFMIS): - Developed by the financial management contractor to computerize existing manual expenditure recording, payment processing, and financial reporting without changing Afghan regulations. - Operational from October 2002, AFMIS provided timely and reliable expenditure information on center-paid expenditures, broken down by source of funding (domestic revenues or grants), spending units, economic and functional classification; automated printing of checks accelerated payments. - Initial limitations: - (a) coverage limited to central government expenditures only, excluding revenues and nonwage provincial expenditures; - (b) no budget management facilities (appropriations, allotments, transfers); - (c) expenditure commitments not recorded; - (d) no reconciliation between treasury information and central bank statements. - System expanded at beginning of 2003/04 to include revenue information, reported provincial expenditures, and budget management functions. - Remaining needs: recording financing sources for operating budget, bank reconciliation, monitoring the development budget. - Major achievement: progressive transfer of AFMIS operations from contractor to Afghan staff after intensive training. - Provincial reporting and AFMIS rollout - Priority since 2003/04 to move away from provinces not reporting nonwage expenditures and center withholding transfers in absence of reports. - Forty Afghan fiscal advisors trained under USAID funding and sent to all provinces to assist with financial reporting of revenues and expenditures; six advisors assigned to provinces collecting the bulk of domestic revenues (Herat, Nangarhar, Kabul, Kunduz, Mazar-i-Sharif, and Kandahar). - Satellite communication facilities to be piloted in largest provinces to facilitate MoF–regional office information exchange. - AFMIS rollout started; Herat’s Mustufiat expected first to use the system by the beginning of October 2003. - Early results: Mustufiats began reporting nonwage expenditures in 2003/04 after failing to report in 2002/03. - Ongoing issues: fiscal reporting still requires improvement, especially on revenues; indications provinces report less revenues than they collect and send reports with significant delays. - Progressive consolidation of provinces’ accounts into central government accounts expected to address these issues. ### Cash management and banking arrangements - Treasury single account (TSA) rationale - TSA concentrates government cash in a single bank account to strengthen treasury control, reduce borrowing costs, and minimize idle cash. - Prevailing problems and reforms - In practice, proliferation of accounts interfered with cash consolidation, prompt fiscal information, and fragmented budget revenues. - IMF proposed progressive plan to consolidate government accounts in center and provinces and eliminate non-public-interest line-ministry accounts. - Authorities reduced MoF central bank accounts from 26 to 2 (excluding donor-funded expenditure tracking accounts). - August 2003: treasury instructed central bank to close all provincial accounts and transfer balances into two new accounts: one for expenditures and one for revenues. The revenue account to be operated on a “deposit basis” only (provinces no longer authorized to draw on their revenue account without explicit MoF authorization). - Next steps: ensure regular consolidation of provincial accounts into central government accounts and make timely transfers to provincial accounts to allow provinces to spend according to budget allotments. - Cash planning - Treasury did not undertake cash or financial planning, preventing MoF from informing the central bank of in-year cash requirements or requesting donors to adjust disbursement schedules; this caused unpredictability and inefficiencies in budget execution. - Treasury established a cash-management unit to estimate revenue inflows, forecast disbursements, and develop an in-year cash-plan. - Full cash planning regime requires medium-term development, full TSA introduction, and extensive technical assistance. ### Budget formulation - Progress and shortcomings - Significant support provided for 2002/03 and 2003/04 budgets; 2003/04 preparation marked a vast improvement. - Remaining needs: - Better integration of ordinary and development budgets. - Improved quality of line-ministry budget submissions. - Improved revenue projection and construction of macrofiscal framework underpinning initial estimates. - Introduction of hard budget constraints at beginning of preparation. - Development of a medium-term fiscal framework. - Capacity building - Donors assigned resident budget preparation experts to MoF for hands-on support, training, capacity building, and MoF Budget Department restructuring. - Development budget attention: establishment of a development budget unit in the treasury supported by a budget resident advisor. - World Bank-funded chief financial officers to be appointed to key line-ministries to enhance budget formulation and execution capacities. - IMF intended to provide short-term technical assistance to establish a macrofiscal coordination unit to coordinate macroeconomic forecasting/analysis with central bank and CSO, make recommendations on fiscal and tax policy, and provide input into budget process. ### Coordination of external assistance - National Development Budget (NDB) and AACA - NDB used as main instrument to avoid duplication and overlap; most donor assistance channeled through NDB. - Afghan Aid Coordination Agency (AACA) established April 1, 2002, within government to track foreign aid disbursement. Primary activities: - (a) coordinating bilateral and multilateral development efforts; - (b) reviewing and endorsing projects/programs by agencies and NGOs; - (c) developing comprehensive information system to track foreign assistance and monitor investments/programs; - (d) serving as secretariat for Consultative Groups within NDB. - Main AACA achievement: development of comprehensive donor information database recording pledges, commitments, and disbursements from all donors. - Grant Management Unit (GMU) - December 2002: MoF established GMU within treasury (with World Bank support) to ensure donor contributions used as specified in grant agreements and reported. - GMU responsibilities: repository and custodian of grant agreements; authorize off-shore payments when spending not channeled through budget; maintain payment records; report to donors and MoF. - GMU in infancy; authorities considering merging GMU and AACA functions into a new MoF department. ### II. Reforming revenue policy and administration: enhancing domestic revenue collection - Fiscal sustainability objective and targets - Authorities aim to fully finance the ordinary budget through domestic revenues by 2006. - Revenue collection target: increase from about $130 million in 2002/03 to about $600 million in 2006/07. - Reform requirements - Meeting targets requires major overhaul of tax and customs legislation and large-scale reform of tax and customs administration. - IMF assisted AIA in June 2002 to design reform program being progressively implemented with international and bilateral donor assistance. - Customs policy and administration (key details) - Customs duties account for more than half of total domestic revenue collection. - 1974 customs law specifies import duties, fees, and charges. - Customs tariff details: - 25 tariff bands with rates ranging from 7 percent to 150 percent allocated across 888 tariff headings (for an unweighted average tariff rate of 43 percent). - Duty calculation: - c.i.f. Afghan value of imported goods using artificially low exchange rates of Af 2 per U.S. dollar to Af 4.5 per U.S. dollar—compared with a market rate of about Af 48 per U.S. dollar. - Data limitations: - Due to lack of data (no historic import data sorted according to tariff codes are currently available), it is very difficult to assess the tariff structure, the extent of exemptions, and their impact on revenues. _Italic source attribution: Excerpted from _cr03299 - References and Chapter IV (STRUCTURAL REFORMS: REVITALIZING THE FISCAL INSTITUTIONS) as provided in the source content._ ### 2.5 percent fee collected by the Chamber of Commerce for the valuation of imported goods ### 2.5 percent fee collected by the Chamber of Commerce for the valuation of imported goods ### Customs valuation, exchange rates, and tariff structure - Customs valuation is currently performed by the Chamber of Commerce rather than the customs administration; a 2.5 percent fee is collected by the Chamber of Commerce for the valuation of imported goods. - Imports of petroleum, diesel, and kerosene for transportation purposes are exempt from duty. - Although there is no excise tax, customs tariffs impose higher tariffs on certain goods (automobiles, tobacco products) that would normally be excised. - Box IV.1 — Exchange rates currently used in customs valuation (all fixed at very low levels compared to the market exchange rate of about Af 48 per U.S. dollar): - Chamber of Commerce: Af 3.5 per U.S. dollar; - Herat Customs: Af 2 per U.S. dollar; - Kabul Customs: Af 4.5 per U.S. dollar; - Kandahar Custom: Af 2.5 per U.S. dollar. - Only Kabul airport appears to apply the market exchange rate but only on certain categories of goods (including TVs and clothes imported by individuals). - Use of different and artificially low exchange rates: - distorts the value of international trade; - has a negative impact on revenue collection; - creates uncertainty for traders and confusion for customs officers. ### Proposed customs law and tariff reforms - MoF draft presidential decree recommends: - (a) mandate the use of the market exchange rate of the Afghani in customs valuation; - (b) reduce the number of tariff bands from 25 to 4; - (c) lower the tariff rates from the current range of 0 to 150 percent to rates ranging from 0 to 20 percent. - Streamlining and reduction of tariff rates will partly offset the effect of adopting the market exchange rate on the average level of customs duties. - The draft decree has been extensively discussed with merchants and traders and apparently received favorably; adoption by the Cabinet is described as imminent. - Note: there appears to be a “monopoly tax” on petroleum products equal to 20 percent of the import value. - Tariff bands proposed: Zero, 5, 10, and 20 percent. ### Customs administration capacity and procedural reforms - Current weaknesses in customs administration: - lack of experienced managers; - poorly trained staff; - inadequate facilities and equipment; - outdated and cumbersome policies and procedures; - inconsistent application of customs regulations across the country; - instances where customs duties are “negotiated’’ between taxpayers and customs officers. - Decree adopted on July 4, 2003 to simplify customs procedures; provisions include: - adoption of the internationally recognized “single administrative document” for customs clearance; - improved monitoring of exemptions; - progressive introduction of the harmonized tariff codification for commercial goods; - development of a comprehensive computerized data base for customs valuation; - establishment of a simplified customs regime for travelers; - licensing by the MoF of “customs brokers” to assist traders with the clearance of commercial goods; - assignment of a taxpayer identification number (TIN) for each tax payer; - gradual phasing out of the Chamber of Commerce involvement in customs valuation, and full transfer of this function to the customs administration. - ATA five-year plan to strengthen customs administration: - calls for complete revamping of the customs department and regional offices, training of customs officials, reform of customs procedures (including investigation, enforcement and controls), centralization of customs revenues collected by the provinces, and progressive rehabilitation of customs infrastructure, equipment, and communications; - plan covers the years 2003-3007 and has an indicative cost of around US$100 million, of which two thirds would be allocated to technical assistance. - Pilot measures: - opening in May 2003 at Kabul airport of a model customs house with renovated warehouse and training facilities; - plan to extend this pilot to all provinces by the end of 2003/04. ### Tax policy and administration—structure, deficiencies, and reform proposals - Around half of domestic revenues collected in 2002/03 are noncustoms tax revenues. - Existing tax regime (defined in the 1965 income tax law, amended by 18 separate decrees) includes: - progressive personal income tax (PIT) with rates varying from 4 percent to 60 percent; - flat 20 percent corporate income tax (CIT); - 2 percent business receipts tax (a form of sales tax on corporate entities’ turnover); - withholding taxes on imports and exports; - various fixed (presumptive) taxes. - Uncertainty exists over applicability of amendments, including a Taliban decree of May 1999 that appears to have reformed PIT to introduce three rates of taxation (1, 8, and 20 percent) together with exemptions; it is unclear if these provisions are currently enforced. - Identified deficiencies in the tax law: - taxation of worldwide income on Afghan citizens wherever they live creates disincentives for expatriate Afghans to return; - top marginal PIT rate of 60 percent is too high and cuts in at a modest annual earnings level (less than half of the average annual salary), hampering voluntary compliance and leading to massive tax fraud; - the existing 32 tax rate structure is complex and difficult to administer; - coverage of the business receipts tax excludes certain services provided to expatriates and other high-income earners, resulting in revenue losses; - limitations of the loss carryover period and depreciation allowances for CIT discourage investment. - ATA draft decrees under preparation (with support of resident tax advisors) to: - (a) impose the income tax on the basis of whether an individual is a resident or nonresident of Afghanistan; - (b) reduce the top marginal tax rate for individuals from 60 to 25 percent and increase the personal exemption; - (c) restore wage withholding on higher-income employees; - (d) introduce a rent tax and an airport departure fee; - (e) expand the business receipts tax to cover certain services most likely to be provided to expatriates and other high income-earners (Hotels, restaurants, telecommunications, rental vehicles); - (f) extend the loss carryover period; - (g) liberalize the depreciation allowances allowed for tax purposes. - Tax administration reforms and capacity building: - establishment of a large taxpayer unit (LTU) in Kabul by the end of 2003, responsible for administering the personal income tax, the business receipt tax and the rent tax (As prescribed in the May 1999 Taliban decree until the tax law is amended); - Kabul LTU to be complemented by model tax offices for medium-sized taxpayers to pilot new operational procedures and concepts. - Progress in tax reform has been slower than in customs due to priority given to customs reform, limited technical expertise in the MoF, and Cabinet reluctance given potential social implications; technical assistance mobilized and Cabinet decisions expected by the end of 2003. - Revenue centralization challenge: - provinces collect most tax and nontax revenues; timely and regular transfer of these revenues to the center is essential to ease pressures on financing the ordinary budget; - agreement recently reached with provincial governors on this issue noted as important. ### Civil service and public administration reform—state, priorities, and actions - The civil service situation characterized by: - large uncertainties about the size of the public service due to absence of a nominal roll and large variations in staff paid each month; estimates for total civilian employment range from 240,000 to 331,000, excluding military personnel (about 100,000) and government enterprises (about 35,000); - serious lack of professional capacity and overrepresentation of unskilled workers; absence of qualified senior staff who emigrated during the war; - pervasive patronage: hiring based on ethnic origins and loyalty rather than qualifications; - inappropriate pay arrangements: - average monthly pay for civil servants is approximately Af 1,800 (about $36 at current exchange rates); - wage structure extremely compressed; vast majority of government staff paid approximately the same monthly salary of Af 1,800; - salary compression exacerbated by introduction of an additional flat rate food allowance on May 5, 2002; - donors and NGOs paying large “salary top-ups” to Afghan civil servants on externally supported projects have distorted pay markets and created resentment. - fragmented and duplicated government structures with remnants of centrally-planned model and overlapping functions. - Institutional steps and mandates: - Administrative Reform and Civil Service Commission (ARCSC) established in June 2002; presidential decree of June 10, 2003 sets responsibilities: design and implement civil service management policies and procedures; coordinate public administration reform program; recruit senior staff via fair and transparent processes; oversee lower-level appointments. - Delineation of responsibilities among ARCSC, MoF, Ministry of Labor and Social Affairs, and Office of Administrative Affairs not yet fully clarified; coverage of full range of civil service management tasks remains uncertain. - 2003/04 NDB short-term strategy for public administration and civil service reform focuses on: - (a) drafting a new civil service law and subsidiary regulations; - (b) revising pay and grading arrangements on a pilot basis; - (c) developing a nominal roll for civil servants; - (d) introducing a comprehensive government payroll system in the treasury; - (e) reviewing ministerial staff and structures; - (f) starting preparatory work for future retrenchment arrangements; - (g) individualizing salary payments. - Note: currently, salary checks are not cashed by individuals; managers of spending units cash treasury checks and distribute cash to staff. - Constraints and implementation considerations: - reforms must be carried out with caution due to large economic and social implications; any across-the-board pay reform should be compatible with medium-term fiscal sustainability; - salary decompression contingent on reliable classification of individual positions—a lengthy resource-demanding process not started yet; - retrenchment program is politically sensitive and requires a nominal payroll and effective establishment controls to avoid staff leaving and reentering the civil service. - Recent initiatives and pace: - progress modest in 2002/03; - Cabinet approval on July 10, 2003 of a presidential decree (“Priority Restructuring and Reform Decree”) introducing an interim additional salary allowance for specific positions in ministerial departments critical for reform (e.g., customs, tax) undergoing large-scale restructuring; - departments including customs and treasury in the MoF have submitted applications to ARCSC for additional allowances; - a second decree to regulate and limit salary top-ups by donor agencies will soon be submitted to the Cabinet; - IMF staff and donors stress need to sustain pace of civil service reform to meet 2003/04 NDB objectives. ### Private sector development and market-led economy building - Afghanistan has longstanding entrepreneurship and a vibrant private sector with activities in agriculture, trading, and small-scale industry. - Constraints to restoring business vitality: - need to consolidate security and political stability throughout the country; - establishment of a strong judicial system able to enforce laws and regulations; - building a legal framework providing fair, transparent, and simple rules for corporate operations, including banking, tax and customs, competition protection, property registration, and foreign investment. *Source: _cr03299 - 2.5 percent fee collected by the Chamber of Commerce for the valuation of imported goods* ### 158. Important steps have been taken by the authorities in this direction, including the ### Important steps have been taken by the authorities in this direction, including the ### Investment law reform and investor incentives - August 2002: the ATA replaced the 1987 law on domestic and private investment. - Key eliminations in the old law that had negatively impacted foreign direct investment: - joint venture requirements; - minimum Afghan capital requirements; - limitations on repatriation of profits. - Incentives in the August 2002 law: - three to seven year tax holidays to eligible companies, according to the type of investments; - a four-year exemption from exports tariffs and duties. - Institutional arrangements established under the law: - High Commission on Investment chaired by the Minister of Commerce and comprising the ministers of finance, justice, foreign affairs, planning and reconstruction, as well as two representatives of the private sector, is responsible for all policy decisions regarding domestic and foreign investment; - Office of Private Investment (OPI), established within the Ministry of Commerce, determines which investments qualify for tax holidays. - IMF and other donors’ assessment and recommendations: - Use of tax holidays is questionable: they reduce transparency, hamper tax administration efficiency, and significantly erode the tax base, with potential detrimental impact on revenue collection in the medium term. - IMF generally counsels against tax holidays and recommends more transparent mechanisms such as: - low corporate tax rates; - accelerated depreciation regimes; - liberal loss carry forward rules. - Following these recommendations, the August 2002 law is under review with consideration of elimination of tax holidays. ### Recent investment actions and public contracts - Government steps to attract investment: - sale of a telecommunications license in October 2002; - signing of public contracts with international developers to renovate two major hotels in Kabul. ### State-owned enterprises (SOEs): scale, condition, and reform approach - Historical and current scale: - Under the communist regime: 174 public enterprises operated (accounted for more than one-third of the revenues of the ordinary budget). - Surviving enterprises: only 80 have survived (or 161, including their provincial branches), accounting for a total of somewhat more than 35,000 employees. - Financial burden and viability: - Very little information available on SOE operations. - Only a small number of SOEs seem viable; none are self-sufficient—let alone profitable. - For most SOEs, employee salaries are fully paid out of the government’s ordinary budget. - Main SOEs include public utility companies (electricity and gas production and distribution) with partial success in collecting utility fees, but only in major urban centers; other important SOEs include fabric making companies and small-scale cement industries. - Note: Ariana Airlines, the Afghan national airline, does not have the status of a public enterprise. - Fiscal appropriation: - About $52 million has been appropriated in the 2003/04 budget to fund SOEs. - Authorities’ stance and institutional response: - The authorities indicated they do not intend to revitalize nonfunctioning public enterprises and plan to close them down or divest them to the private sector whenever possible. - Commission for the Evaluation of the State-Owned Enterprises established in June 2002 and started operating in January 2003. - Main activities: assessment of SOE operations and assets, preparing recommendations for privatization, drafting transparent privatization procedures. - Activities to date mainly limited to a census of existing SOEs. - Constraints and reasons for cautious approach: - (a) Most records of SOE assets have disappeared, making privatization strategy design extremely difficult. - (b) Reluctance to rush into privatization without appropriate assurances and safeguards to limit corruption. - (c) Line-ministries reluctant to delegate transformation of enterprises operating in their sector to the Commission. - (d) Reform is highly technical and requires major technical assistance, which has not materialized. - Prospect: - Significant progress is unlikely without strong support from the international community. ### Civil service pay structure (Annex IV.1) - Two pay scales exist: - permanent staff (karmand); - “contract” staff (agir). - Base pay and allowances: - Base pay: payable to all staff. - Food allowance: payable to all staff. - Second food allowance: introduced in May 5, 2002. Not payable to teachers. - Transport allowance: payable only to public employees in Kabul. - Professional allowance varies by education: - Af 8 for those who have completed high school; - Af 15 for a university degree; - Af 17.5 for an additional year beyond university; - Af 20 for a master’s degree; - Af 25 for a doctorate. - Additional professional allowance: only payable to permanent staff at the highest level of the pay scale. - Scientific allowances: only payable to permanent staff at the highest level of the pay scale. - Special allowances: (listed but not numerically specified in the source). ### Tax structure summary (As of August 2003) (Annex IV.2) - Corporate income tax (CIT): - Flat rate of 20 percent. - Taxable base: Net profits of corporations and limited liability companies. - Notes: - Most expenses incurred to derive gross income are deductible. - Firms are allowed to deduct losses incurred in previous years. - The CIT is mostly collected in the form of withholding taxes on imports and exports creditable against the income tax. - Personal income tax (PIT): - Progressive schedule comprising 21 brackets, with rates varying from 4 to 60 percent. - Taxable base: Income of employees (salaries and wages) and profits of noncorporate entities. - Notes: - The basis for taxation is Afghan citizenship; tax is imposed on the worldwide income of Afghan citizens wherever they live. - The wage PIT which used to be collected on government and private sector employees (wage withholding tax) seems to have disappeared at the beginning of the 1990s; most PIT is now collected in the form of fixed presumptive taxes. - Business receipts tax (BRT): - Rates: - 2 percent: gross receipts of legal persons engaged in domestic business; - 2½ percent: receipts of legal persons engaged in import and/or export operations. - Taxable base: Gross receipts (before any deductions) of corporations and limited liability companies. - Notes: - The BRT is in addition to the CIT on taxable profits. - The BRT must be paid within 6 months of the end of the fiscal year, irrespective of profit or loss. - Imports are not taxed under the BRT but exports are. - The BRT raises greater revenue than the CIT. - Fixed withholding taxes on imports and exports (creditable against the income tax): - Imports: 4 percent for licensed importers and 3 percent for unlicensed importers. - Exports: 4 percent for licensed exporters and 2 percent for unlicensed exporters. - Tax is based on the duty-paid cost of imports/exports. - For unlicensed importers/exporters, this tax is not creditable against the income tax. - Presumptive taxes in lieu of the income tax: - Retailers: based on a 170 category classification of businesses; taxation depends on type of goods sold, size and location. - Limited list of specific businesses (e.g., cinemas, theaters, mills): 10 percent on estimated turnover. - Transportation businesses (taxis, buses,...): lump sum depending on type, size, characteristics of vehicles. - Government contractors: From 1 to 8 percent of the price of goods and services purchased by the government. - Taxable base: Estimated gross receipts of corporations and limited liability companies (except importers and exporters). - Rationale: simplification, reduced compliance costs, and combating tax evasion. - Import duties: - 25 tariff bands with rates ranging from 7 percent to 150 percent allocated across 888 tariff headings. - Valuation: C.i.f. in Afghani value, using an exchange rate of Af 4.5 per U.S. dollar. - Notes: - Customs tariffs currently in use were introduced in 2000. - Imports of petroleum, diesel and kerosene for transportation purposes are exempt from duty. - The exchange rate used for valuation purposes is well below the open market rate (approximately Af 38–40 per U.S. dollar). - Fees and charges: - Chamber of Commerce license and valuation of imports/exports: 2.5 percent. - Red Crescent fee: 2.5 percent. - Ministry of Commerce’s permit fees (examples): cars $200 to $400, cigarettes $2.5 per case. - For the Chamber of Commerce and the Red Crescent: c.i.f. invoice value of exports or imports. - Numerous fees, charges, and other taxes levied on imports and exports add significantly to the cost of international trade. ### Monetary and exchange rate policy in a post-conflict environment: starting conditions and currency choice (Chapter V, excerpts) - Starting point (end-2001): - Afghanistan’s financial system had largely ceased to exist and the country was almost entirely cash-based. - Banks had essentially stopped functioning during the Taliban years; informal Hawala system remained. - Confidence in the Afghani was low after years of high inflation. - The central bank, Da Afghanistan Bank (DAB), had little or no control over issuance of currency. - At least three versions of the national currency were circulating: - official Afghani issued prior to Taliban rule and continued from central bank stocks; - duplicates issued by the internationally recognized government in exile by reruns of earlier series using same serial numbers; - two warlords issued counterfeit versions trading at a discount in Kabul money markets. - Foreign currencies (including the U.S. dollar and neighboring currencies) were widely used, especially for larger transactions and as a store of value. - Key monetary policy questions faced by the new government: - Whether to adopt a foreign currency as legal tender temporarily or introduce a new national currency; - Interim arrangements prior to introduction of a new currency and a framework for monetary policy (objectives, intermediate targets, exchange rate regime, instruments in absence of functioning banking system). - Currency options considered: - Full dollarization until new Afghani could be launched: - Pros: immediate monetary stability, time to build credibility and DAB capacity. - Cons: required upfront redemption of all existing Afghanis, considerable organization, expensive requiring significant donor assistance, potentially difficult to reverse. - IMF-recommended interim option: - Use a foreign currency to conduct government transactions until the new currency could be introduced; - Public free to use any mutually agreed currency and to hold any currency; - Existing Afghanis continue to circulate until redemption by the new currency within a floating exchange rate regime, with the central bank not issuing more Afghanis; - Government announces commitment to redeem existing Afghanis for the new currency at a later to be determined rate; - This imposes transparency and discipline on fiscal and monetary policy and contributes to financial stability. - Authorities’ chosen approach: - Continue to use the existing Afghani and introduce a new currency as soon as technically possible, viewing the Afghani as an important symbol of sovereignty and unity and concerned that dollarization would be difficult to reverse. - Authorities judged counterfeit risk had diminished based on information from printers and assurances that printing had stopped. - It was discovered the Taliban had started preparations for a new currency and had signed a contract with a reputable banknote printer (work included preliminary designs); U.N. embargo had put the agreement on hold, and sanctions being lifted shortened lead-time. - Currency redenomination mechanics: - The value of the old Afghani had been eroded by inflation—the largest denomination (Af 10,000) was worth about $0.25 and people had to carry large bundles of cash for anything other than smallest transactions. - One new Afghani would replace 1,000 old ones. - Implementation timeline and outcome: - Plan for introduction of the new currency made public on September 4, 2002. - Conversion process started on October 7, 2002. - Changeover completed successfully on January 2 (year implied in source context). *Source: _cr03299 - 158. Important steps have been taken by the authorities in this direction, including the* ### 2003. Moreover, they managed to do so much earlier than many had thought possible and ### _cr03299 - 2003. Moreover, they managed to do so much earlier than many had thought possible and ### Preconditions for a successful monetary policy - DAB’s (Da Afghanistan Bank) pre-conversion capacity: - Central bank described as “little more than an empty shell” with ample staff but “virtually none” with knowledge of modern monetary policy and banking, no computers, no recent balance sheet, and little or no communication with provincial branches. - IMF and donors (notably USAID) assisted DAB to build capacity rapidly. - Authorities’ primary objective for monetary policy: - “To achieve and maintain price stability and, thus, to restore confidence in the (new) national currency.” - Three main preconditions recognized as necessary for low inflation: - DAB must have full jurisdiction and control over the printing, delivery, and issuance of the domestic currency; authorities proceeded forcefully with introducing the new currency. - DAB must be independent and “should neither seek nor take instructions from any other authority.” IMF assisted in preparing new central bank and banking laws; draft laws discussed December 2002 and submitted to the Cabinet in August 2003; Cabinet committee reviewing laws with expectation of approval “later this year.” - The government must maintain strict fiscal discipline; DAB should refrain from financing the government budget or any government agency or government-owned enterprise. A provision prohibiting recourse to central bank financing was included in the 2002/03 budget decree and repeated in the 2003/04 budget. ### Introducing the new currency — logistics, operations, and outcomes (Box V.1) - Context and planning: - Afghanistan described as a rugged country slightly larger than France with a population of about 22 million and over 20 years of armed conflict. - Steering committee formed with central bank, MoF, and international experts; planning began early summer 2002. - Banknote printing and denomination details: - New denominations: Af 1, 2, 5, 10, 20, 50, 100, 500, and 1,000. - Initial estimate of old official notes in circulation: about Af 16 trillion (including counterfeits). - Two types of unofficial notes eligible for conversion at a 50 percent discount; taking this into account total old Afghanis to be exchanged estimated at about Af 13 trillion. - Authorities ordered new notes totaling Af 27.9 billion (with 1 new Afghani replacing 1,000 old ones), equivalent to almost 800 million notes or about 500 tons. - First deliveries received in August 2002; last shipments arrived in January 2003. - The five smallest denominations make up almost 90 percent of the total volume of notes ordered but only 15 percent of the total value. - Regional facilities, staffing, and exchange infrastructure: - DAB had 89 branches, most inadequate for secure vaults and office space. - Country divided into seven regions: Kabul, Kunduz, Mazar-i-Sharif, Herat, Kandahar, Jalalabad, and Gardez. - 47 exchange points established; an exchange point consisted of one to five units, each unit having 7 windows (5 to take in old currency, 2 to give out new currency). - Some 2,500 local staff selected; staff were paid considerably more than the typical $30 to $40 a month for bank employees. - UN and USAID provided international observers, notably for destruction of old notes. - Transportation and security arrangements: - 500 tons of new currency to be delivered countrywide, almost half to provinces. - Ground transport ruled out for distant locations; air transport via two helicopters and one Antonov 32 airplane provided by USAID; USAID set up an air operations unit handling scheduling and coordination (all flights required clearance and two-day advance notification). - Afghan Air Force provided some assistance early on. - Government and DAB provided security throughout; governor and deputy governors visited provincial governors and local commanders to secure cooperation. - Notable outcome: “there were no major security problems or serious violations of procedures during the entire three-month exchange period.” - Public information and timing: - Introduction announced September 4, 2002 by President Karzai; communication relied mainly on radio, word of mouth, speeches, village meetings, and posters depicting notes and security features. - Conversion started October 7, 2002; initially set to end December 4, 2002 (two-month period chosen to limit counterfeiting risk); currency decree issued to regulate conversion. - Money changers allowed to exchange during initial two weeks with a sampling verification procedure (only 10 percent of amounts verified by sample; sample errors proportionally discounted). - Operational experience and adjustments: - Demand from general public opened exchange to public before two weeks elapsed; many major-city exchange points opened in first two weeks. - Provincial exchange points often delayed due to air transport and operational readiness; many opened two to three weeks after planned opening at October 21. - Exchange rate depreciation in November due to public uncertainty; DAB extended conversion period by one month to January 2, 2003, after which the exchange rate returned close to initial levels. - Early exchanges dominated by large denominations (1,000, 500, 100, 50 Afghanis) reflecting money changers’ activity; later dominated by low denominations (1, 2, 5, 10 Afghanis). - Quantities exchanged and destruction: - Af 13.9 trillion of old official notes exchanged during conversion; Af 3.3 trillion in unofficial notes exchanged at a 50 percent discount. Result: Af 15.6 billion of new notes issued in exchange. - An additional Af 2 trillion in old official notes absorbed through foreign exchange auctions during conversion. - Total old notes collected: about Af 19 trillion, equivalent to some 5 billion banknotes or over 2,000 tons — almost 20 percent more than the estimated face value of banknotes based on printer information. - Possible reasons for excess: inaccurate or incomplete printer information, “last minute” printing of counterfeits, or round-tripping during conversion. - Initial plan to invalidate old notes using punchers/drills and shredders proved ineffective due to equipment delays and breakdowns; principal method switched to incineration, with local ovens constructed (did not require electricity). - A schedule for weekly or two-weekly destruction was established with both international and national observers present. - Exchange ended January 2, 2003. - Denomination distribution (Figure 1 note): - Figure caption: “Afghanistan: Currency Denominations, 2003” with data reflecting the situation per May 21, 2003. (Source: Da Afghanistan Bank.) ### Fixed or flexible: the choice of the exchange rate regime - Trade-offs in regime choice: - Fixing the exchange rate advantages: (a) reduce transaction costs and exchange rate risk; (b) provide a credible nominal anchor for monetary policy. - Floating exchange rate advantage: pursue an independent monetary policy and better absorb external and real shocks. - Intermediate regimes exist but are argued by many to be increasingly untenable. - Characteristics favoring a fixed regime for Afghanistan: - Relatively small and open economy — trade benefits from exchange rate stability. - Strong and rapid pass-through of exchange rate movements into consumer prices — fixing could stabilize prices. - History of high and variable inflation and high dollarization — a fixed rate provides a clear nominal anchor and could increase acceptance of the new currency. - Little or no economic data available publicly — exchange rate is an easily observed anchor. - Weak policy implementation capacity (particularly at the central bank) — favors simple fixed rules (e.g., currency board simplicity). - Characteristics favoring exchange rate flexibility: - Large structural changes underway; equilibrium exchange rate likely to change during reconstruction — risk of misalignment under a fixed regime. - Likely large foreign exchange inflows from donors and repatriation may cause real exchange rate appreciation. - Difficulty in determining an appropriate fixed exchange rate level given lack of reliable data (see Box V.2). - High vulnerability to external and domestic shocks (trade shocks, droughts, earthquakes, political tensions) — under fixed regime labor and product markets must absorb shocks; question whether that is desirable. ### Assessing the “right” exchange rate level (Box V.2) - Definition and concept: - Equilibrium real exchange rate defined as the rate consistent with a sustainable current account position without major reserve changes or macro policy shifts. - Data limitations for Afghanistan: - Typical information to assess exchange rate appropriateness is largely lacking. - No sensible base year due to huge changes in trade patterns over the past 20 years. - Little information on indicators of competitiveness: export/import volume growth rates, trade patterns, relative price and wage costs vis-à-vis trading partners and competitors, and level of foreign exchange reserves. ### Key statistics and dates (preserved exactly as in source) - Population: “about 22 million” - Old notes initially estimated at about Af 16 trillion - Total old Afghanis to be exchanged estimated at about Af 13 trillion (after 50 percent discount for two unofficial types) - New notes ordered: Af 27.9 billion (1 new Afghani replacing 1,000 old ones), almost 800 million notes, about 500 tons - First deliveries: August 2002; last shipments: January 2003 - Exchange start: October 7, 2002; initial end date: December 4, 2002; extended end date: January 2, 2003 - Staff typical bank earnings referenced: $30 to $40 a month - Old official notes exchanged: Af 13.9 trillion - Unofficial notes exchanged at 50 percent discount: Af 3.3 trillion - New notes issued in exchange: Af 15.6 billion - Additional old official notes absorbed via auctions: Af 2 trillion - Total old notes collected: some Af 19 trillion; equivalent to some 5 billion banknotes or over 2,000 tons; “almost 20 percent more” than estimated face value - Figure data reflect situation “per May 21, 2003.” *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03299.pdf* ### 3. A few partial indicators of international competitiveness are available. ### 3. A few partial indicators of international competitiveness are available ### Trade patterns and competitiveness - Most of Afghanistan’s own exports (that is, excluding reexports) are to India and Pakistan; these and other countries in the region are likely to be Afghanistan’s competitors in its export markets (agriculture and light manufacturing). - Major import sources: Pakistan, Korea, Japan, Iran, and, since 2002, the USA; for Iran and Pakistan available import data possibly include goods in transit from other countries. - Most imports are likely to be goods Afghanistan does not produce (e.g. cars, refrigerators, and televisions). Imports from neighboring countries are more likely to compete with domestic substitutes (e.g. agricultural goods and construction materials). - Relative labor compensation and wages: - Civil servants in the lower grades: about $38 a month in Pakistan (including food and transport allowances) compared with $35 in Afghanistan. - Wages for unskilled labor in the private sector in Afghanistan are substantially higher than in Pakistan; in early 2003, wages for unskilled labor paid by foreign companies and agencies typically are in the order of $100 per month. - Exchange rate and inflation effects on competitiveness: - A comparison of inflation rates and nominal exchange rate movements in 2001, 2002, and the first half of 2003 suggests Afghanistan has become less competitive vis-à-vis most nearby countries. - This reflects the large appreciation of the Afghani against the U.S. dollar in late 2001 and a higher rate of inflation. - Productivity and infrastructure: - Productivity is probably higher in neighboring countries because years of conflict resulted in low levels of investment and destruction of much infrastructure in Afghanistan. - Damage to roads has contributed to higher transport costs, slow traffic movement, and greater damage to goods for transit trade. ### Outlook: potential “Dutch Disease” pressures and offsets - Factors that could put upward pressure on the equilibrium real exchange rate: - Official external financial assistance expected to rise and remain at a high level relative to the size of Afghanistan’s economy for at least the next few years before settling to lower levels. - Composition of aid expected to shift from humanitarian aid (high import content) to infrastructure and project aid (lower import and higher domestic content), with a positive impact on production capacity. - Continued reflux of refugees contributing to increased domestic spending. - Resulting increase in domestic spending on nontraded goods would lead to a rise in the relative price of nontraded to traded goods (the real exchange rate) and a shift of resources from the traded goods sector to the nontraded goods sector. - Factors that could offset upward pressures: - Large underutilization of capacity (including labor and return of refugees) could allow domestic production to rise rapidly in response to increased demand, reducing upward pressure on nontraded goods prices. - Reconstruction could ease supply bottlenecks, raise productivity, and reduce some costs (for example, transportation), damping domestic price increases and loss of competitiveness. - A decline in transshipment costs would significantly improve Afghanistan’s attractiveness as a transit route, given the large share of transit trade. ### Exchange-rate anchoring and credibility issues - Authorities had yet to establish credibility in the eyes of economic agents; government had at best no track record or at worst a poor track record of high inflation. - A firmly fixed rate (e.g., a currency board) could help establish credibility, but would not be a panacea; commitment to fiscal discipline had not yet been fully tested. - No obvious anchor currency: - Large share of trade appears to be with neighbouring countries, but a significant share of trade flows seem to be denominated in U.S. dollars. - Fixing against the U.S. dollar could result in a real appreciation against neighbouring countries and adversely affect competitiveness. - Fixing against neighbouring currencies could adversely affect stability. - Authorities’ decision on regime (paragraph 176): - On balance Afghanistan’s existing economic conditions favored a floating exchange rate regime, at least for the near term. - Risks associated with a fixed peg or currency board were considered too large; defending an unsustainable exchange rate could quickly deplete foreign exchange reserves. - Once the economy moves beyond early structural reconstruction changes, the choice of exchange rate regime could be revisited. - De facto regime (paragraph 177): - Since the introduction and float of the new currency in early 2003, Da Afghanistan Bank (DAB) has aimed to limit exchange rate volatility and keep the exchange rate within a range; the range is not firmly set nor announced. - DAB does not intend to resist persistent exchange rate pressures if this would risk losing reserves. - The regime is best described as a de facto (lightly) managed float — intermediate between a pure float and a firmly fixed rate. - Low degree of financial integration and market development allows this approach, although informal markets permit quick currency substitution. ### Formulating a monetary program and operational constraints - Intermediate objective and complications: - Within the floating exchange rate regime, IMF staff assisted DAB in developing an indicative quantified monetary program aimed at achieving low inflation; the program uses control of the domestic money supply as an intermediate target. - Targeting inflation via domestic currency supply is complicated by widespread use of foreign currencies; inflation is likely influenced by changes in the stock of foreign currency holdings as well as Afghanis. - Little or no information on the size and use of foreign currency holdings. - Monetary base and sterilization needs: - In the absence of a functioning banking system, the domestic money supply is limited to the stock of domestic currency in circulation. - Without new central bank financing of the government, changes in currency in circulation are primarily driven by changes in DAB’s (net) foreign asset position. - Given the size of budgetary assistance, without action DAB foreign exchange inflows could imply a doubling or more of the domestic money supply within one year, risking renewed erosion of the Afghani. - An instrument to sterilize monetary expansion was needed; without a functioning banking system or money market, the quickly developable market-based instrument was selling foreign exchange through foreign exchange auctions (IMF staff assisted DAB to establish and improve these auctions). - Data and balance-sheet limitations: - Lack of reliable data prior to the new currency for the stock of Afghanis in circulation and absence of a central bank balance sheet complicated program formulation. - Estimates of currency stock relied on information from banknote printers and other fragmentary records. - A very crude DAB balance-sheet estimate was assembled and used as a basis for the monetary program; the program was updated regularly as new information became available, particularly after currency conversion when the stock of currency in circulation could be determined accurately. ### Foreign exchange auctions (Box V.3) — design and outcomes - Establishment and participation: - Auctions started in May, 2002; open to all licensed money changers. - Participation grew from about 10–20 in May–June, 2002 to 30–60 after July, 2002, and in the first half of 2003 participants were usually in the range of 50–80, with some provincial participation. - DAB improved transparency and operation: public advance announcements, announcement of successful bids in presence of participants, clearer explanations, and more systematic mechanics. - Measures to discourage non-settlement: temporary prohibition and “three strikes and you are out”; in April, 2003 participants required to make an advance (non-interest bearing) Afghani cash deposit equivalent to $10,000 with DAB; failure to settle could risk forfeiture. This requirement and forfeiture being formalized in a cash collateral agreement and expected to be approved later in 2003. - DAB reviewing draft rules and regulations for auctions expected to be issued later in 2003. - Auction modalities: - Since November 2002, sealed advance bids used as starting point; sealed bids inform the auctioneer (governor or deputy governor) to offer a sell price for U.S. dollars in a session to which all bidders are invited. - Auction closes when auctioneer and participants agree on a mutually acceptable single clearing exchange rate; auctioneer reserves the right not to sell. - Amounts requested in sealed bids usually exceed amount on offer; broadly equal amounts of U.S. dollars are awarded to each successful bidder to avoid cornering the market; highest bidder receives a larger amount. - Link to monetary program and volumes: - Auctions held at fairly regular 1–2 week intervals; by end of first quarter of 2003/04, 50 auctions had been held. - Amounts sold per auction: on average about $2 million for the first six months and since then usually in the range of $5–10 million. - In 2002/03, a total of $135.4 million (Af 6.2 billion) was sold through auctions and in the first quarter of 2003/04, $34.5 million (Af 1.7 billion) was sold. - The amounts and timing of auctions reflected the rate of monetary expansion (driven by pace of government spending) and the size of exchange rate movements. ### Monetary targets, developments, and reserves - Indicative monetary program targets: - First program (April 2002 for 2002/03) targeted a 12-month inflation rate of somewhat below 20 percent by March 2003. - Assuming economic growth of about 10 percent and modest strengthening of money demand, the 2002/03 program aimed to limit money growth to less than 30 percent (the target was reduced to 24 percent in the fall of 2002). - A similar program was formulated in early 2003 for 2003/04; the 2003/04 program targets a 12-month inflation rate of about 15 percent by March 2004. - Monetary and exchange-rate relationships: - Monetary developments in 2002 and 2003 suggest a fairly close relationship between domestic money growth, exchange rate movements, and inflation. - The exchange rate is very susceptible to rumors and (political) uncertainty; pass-through of exchange rate movements into prices is very strong and almost immediate. - Outcomes in 2002/03: - Currency in circulation grew by an estimated 20 percent in 2002/03, significantly less than the almost 30 percent originally targeted (later reduced to 24 percent). - Increase in money demand was entirely met by accumulation of foreign reserves at the central bank; the government largely adhered to the no-overdraft rule and ended the fiscal year with a surplus (occasional limited overdrafts occurred in Q3 2002/03). - DAB’s reserves increased by an estimated $100 million in 2002/03. - During the year, DAB received foreign exchange inflows to help finance the government budget in the amount of $215 million; DAB auctioned off $135 million of this to limit monetary expansion. - DAB paid over $16 million from its reserves to cover the cost of printing the new currency. - Part of the reserve increase reflected new information on foreign deposits rather than an actual inflow. - At the end of 2002/03, DAB’s stock of foreign exchange reserves was estimated at $426 million. This level of reserves was judged adequate for the current exchange rate regime to cushion short-term negative shocks and provide strong backing for the national currency (see Box V.4). *Source: IMF staff estimates and Da Afghanistan Bank and Central Statistics Office figures as presented in the original chapter.* ### 1. The level of external reserves held at the beginning of 2002 by DAB was uncertain. The only identified ### _cr03299 - 1. The level of external reserves held at the beginning of 2002 by DAB was uncertain. The only identified ### External reserves: levels, identification, and trend - Identified assets at the beginning of 2002 amounted to about $250 million (including $196 million in gold). - As of end-August 2003, DAB’s foreign exchange reserves were estimated at $556 million ($600 million with gold valued at market prices). - DAB continued to contact foreign banks to clarify the size and status of its foreign assets. - Drivers of the increase in identified reserves: - More assets located, primarily at banks in Europe. - Inflows of donor funds to finance the budget. ### Assessing reserve adequacy: criteria and application to Afghanistan - General observation: adequacy criteria relate to either the trade account or the capital account; adequacy is a dynamic concept that changes as country circumstances evolve. - Constraints for Afghanistan: - Little or no access to international capital markets; reliance on reserves rather than rapid international borrowing to smooth shocks. - Large potential for shocks; donor assistance may be discretionary and not promptly available. - Trade-based measure: - Rule-of-thumb: three months of imports coverage is often used; reserves generally considered low if they cover less than three months of imports. - Based on available data and estimates, DAB reserves at end-August 2003 are estimated to cover some 3 months of imports (excluding reexports, imports exempt from duties, and smuggled goods). - Interpretation: the level could be considered just sufficient, but a higher level would be warranted given vulnerability to shocks, limited market access, rising imports during recovery, and potential resumption of debt service payments. - Capital-account (monetary aggregate) measure: - Relevant where capital flight risk, weak banking systems, unstable money demand, or inflation history exist. - In August 2003, currency in circulation amounted to Af22.4 billion, equivalent to $456 million at the prevailing exchange rate. - This measure suggests Afghanistan’s level of foreign exchange reserves was more than adequate at that time. - Caveat: with economic growth and strengthening confidence in the Afghani, money demand can be expected to increase, requiring additional reserves; provided the government refrains from central bank financing of the budget and central bank rediscount window use remains limited, increases in demand for domestic currency should be met by inflows of foreign exchange reserves. ### Monetary developments, inflation, and exchange rate dynamics (2002–2003) - Very crude estimates suggest the economy grew in real terms by almost 30 percent in 2002/03, while the overall price level, measured year-on-year, increased by 5 percent (paragraph 185). - Implication: money demand may have weakened in relation to nominal GDP in 2002/03, contrary to prior assumptions. - Exchange rate history and key movements: - Late 2001: Afghani appreciated from (old) Af 70,000–80,000 per U.S. dollar to about Af 25,000 per U.S. dollar in early 2002. - By August 2002: exchange rate depreciated slowly to about Af 40,000 per U.S. dollar. - Late summer/early fall 2002: uncertainty about new currency and logistical problems led exchange rate to fall to over Af 70,000 per U.S. dollar in early November 2002. - During September–November 2002 local prices increased by a cumulative 60 percent. - Policy response: DAB resumed foreign exchange auctions in mid-November and extended banknote exchange period until January 2, 2003. - Exchange rate outcome: Afghani strengthened and stabilized at about (new) Af 46 per U.S. dollar in January 2003; subsequently fluctuated around Af 48 per U.S. dollar (late-August 2003 observation). - Currency issuance and monetary policy (2003): - With completion of currency conversion in January 2003, DAB could accurately determine currency in circulation. - Currency in circulation grew by 17 percent in the first eight months of 2003, slightly less than the 20 percent increase envisaged for that same period under the indicative monetary program. - Money demand continued to be met by accumulation of foreign exchange reserves in DAB, which reached $555 million by late-August 2003 (text also cites $556 million / $600 million with gold; $555 million appears as an operational figure). - Consumer prices were broadly stable in 2003, with an average monthly rate of inflation of minus 0.1 percent during the first eight months. - Result: exchange rate stability and notable progress toward financial stability, conditional on absence of major shocks. ### Financial sector condition at end-2001 and legal foundations - State of banking sector at end-2001: - Six commercial banks retained licenses but none were operational; virtually no loans made since 1995. - Central bank functionally transformed into a Soviet-style dirigiste institution that monetized fiscal deficits and interfered in credit allocation and interest rate setting. - Payments largely conducted via informal Hawala system. - Registered financial entities: about 300 registered money trading entities reportedly operating in Kabul with some 5,000 traders. - Assessment challenges: - Scarcity of qualified translators and poor security hampered nationwide assessment. - Communication lines with branches mostly broken down; no correspondent bank exchanges for years; assets/liabilities data unavailable or out of date; accounting based on Soviet systems incompatible with international standards. - Informal sector (Hawala and money traders) even harder to assess; information often ambiguous or contradictory. - Legal framework issues (Law on Money and Banking, 1994): - The 1994 law is a compound central bank and banking law, poorly written and at times contradictory. - Part I: defines legal tender ambiguously both in terms of gold and SDRs; defines minimum reserves DAB must hold against issued banknotes at 25 percent; reserves right of printing and issuing money to DAB. - Part II: assigns DAB responsibilities including implementation of government monetary and credit policy, maintaining Afghani value, supervising banks, regulating foreign exchange operations, setting commercial banks’ interest rates and commissions, defining liquidity and capital requirements, limits on large loan exposure. - Shortcomings: provisions are ill-defined, do not comply with international best practice, lack loan classification or provisioning requirements, and contain no enforcement provisions for regulations. - Part II also requires DAB to manage government accounts and, if necessary, finance the government budget deficit and grant loans to government institutions; DAB must check on projects’ economic and financial efficiency for government project loans. - Conclusion: the law is unsuitable for a market economy and needs to be replaced in its entirety by a modern central bank law and modern banking law; new legislation is expected to be enacted soon. *Source: Excerpt from the provided IMF document content.* ### 3. The final section of Part II defines the composition and the role of DAB’s organs, namely the ### _cr03299 - 3. The final section of Part II defines the composition and the role of DAB’s organs, namely the ### Composition and formal roles of DAB organs - Supreme Council - Composed of nine members: the Prime Minister, the ministers of finance, commerce, planning, mines and industries, agriculture and light industries and food products, the minister without portfolio (advising the Prime Minister on economic affairs), and the governor of DAB. - Supposed to meet at least four times a year and decides on all important matters of DAB or on recommendations made by the other supervisory organs. - Approves all regulations. - Monetary and Credit Committee - Charged with drafting regulations and recommending the level of interest rates to the Supreme Council. - Charged with determining the accounting principles to be used and advising the Supreme Council on monetary, banking, and credit matters. - Composition: the Governor and the First Deputy Governor of the DAB, the Treasury Director of the Ministry of Finance (MoF), the Financial and Commercial Director of the Ministry of Planning, the Foreign Trade Director of the Ministry of Trade, the President of the Chamber of Commerce and Industry, two presidents of state commercial banks, one of a private bank, and one of a specialized state bank (all four selected by the president of DAB), and a professor of economics (specialized in banking) from Kabul University. - Executive Board - Consists of the governor and his two deputies. - Upon recommendation of the Supreme Council, the governor is to be appointed by the president for three years. - Law stipulates that members of the Executive Board are not allowed, during their tenure of office, to accept any position in any other government or private institution. - Board of Supervisors - Composed of a chairman and two members to supervise DAB’s banking operations and accounting practices. - Supposed to submit monthly reports to the MoF and quarterly reports to the Supreme Council. - The control function has not been fulfilled for years. ### Legal provisions on banking in Part III of the law - Definition and establishment - A bank is defined as an establishment that accepts deposits for the purpose of granting loans or making investments. - “Private banks” defined as institutions whose operations are limited in scope and whose activities consist of “monetary and credit transactions” and the purchase and sale of movable and immovable assets. - Law defines conditions for establishing a bank, including minimum capital requirement and by-laws. - Accounting and reporting requirements - Banks required to use a double entry accounting method. - Banks must submit to DAB their annual balance sheet and profit and loss statement within four months following the end of each year, together with an audit report. - Supervisory and resolution powers - Supreme Council, upon recommendations of the governor and the Money and Credit Committee, empowered to transfer the management of a bank to DAB, take measures for the management of the bank, or close the bank (e.g., if the bank acts against the law or its by-laws). - Law allows liquidation of an insolvent bank to be carried out by a team that could include officials of the failed bank. - If a government bank is closed, all outstanding deposits, salaries, and claims of other creditors would be paid by the government. - If a private or semipublic bank is closed, outstanding claims would be paid with the 15 percent of capital the bank deposited with DAB at the time the bank was constituted, without indicating the order of priority. - Caveat on translation - Box based on an unofficial translation from Dari into English; weaknesses highlighted may stem from an incorrect translation of the Dari version. ### Findings on governance, independence, and politicization - Composition concerns - The composition of the Supreme Council and of the Monetary and Credit Committee is described as highly problematic as it politicizes decisions that should be made on purely technical grounds. - Conclusion: DAB lacks the necessary independence that a modern central bank should have. - Practical control - While best practice would require that DAB be granted a high degree of autonomy combined with stringent rules for accountability, DAB is fully controlled by the government. - The Supreme Council and the Monetary and Credit Committee include representatives from different ministries and govern operational aspects. ### DAB’s functions, operations, and infrastructure (end-2001 / early-2002 context) - Main functions performed - Acted as cashier to the Ministry of Finance (MoF): responsible for salary and other budget payments and receiving government revenues for deposit across the country. - Issued banknotes and managed the stock of cash monies. - Commercial banking operations - Structured around many commercial banking operations that a central bank in a modern two-tier system would not normally do. - Offered commercial banking services, extended long-term loans to banks and enterprises, and accepted deposits from the public (most discontinued in 1995, though some accounts remain current). - Governor legally the chairman of the governing boards of all commercial and development banks, creating a substantial conflict of interest with central bank functions. - Omissions of typical central bank functions - Omitted many typical central bank functions: no meaningful banking supervision (prudential regulations, on- and off-site inspections), no efficient payment system supervision, no lender-of-last-resort facility, and lacking a meaningful and credible monetary or foreign exchange policy. - Physical infrastructure and security weaknesses (Box VI.2) - Main currency reserve stock held in two major vaults in Kabul. - Vault area situated near counters with public access and not monitored by electronic surveillance or access technology. - During banking hours security entrusted to unarmed guards and armed military personnel; after hours patrolled by military personnel. - Lack of suitable vehicles and poor road conditions made cash transport to the provinces difficult and risky. - In early 2002, DAB had only two trucks, one bus, and one Land Rover (all old and unsuited for cash transport). - Some cash transport to provinces relied on local authorities, private cars, or, exceptionally, army air transport, causing frequent delays. ### Accounting, control, and supervision deficiencies - Accounting and financial reporting - Accounting General Department did not perform required accounting tasks: no formalized accounting system or chart of accounts. - Accounting rules incompatible with principles of materiality, prudence, and substance. - Lacked headquarters-branch data reconciliation, delineation between central bank and commercial operations, appropriate valuation and classification of assets and liabilities, and automation/computerization. - Old National Cash Registry (NCR) card journal entry posting machine broke down six years ago. - DAB had not produced a balance sheet for seven years. - Control and internal audit - Control General Department performed preemptive control requiring signatures of two representatives for each operation, leading to protracted delays and removing responsibility from mid-level managers while failing to reduce risks. - Inspection General Department performed ex-post internal control, but collected information did not conform to traditional internal audit functions. - Banking supervision capacity - Planning and Research Department previously collected statistics but did not analyze them; staff lacked necessary understanding and capacity for meaningful supervision. - Data collected were often irrelevant to prudential concerns and accounting rules used by commercial banks did not correspond to international practice, making assessment against prudential benchmarks impossible. - Money changers licensed by Foreign Relations General Department; on-site audit performed by Inspection General Department. - During the Taliban regime, the Planning and Research Department was closed and no banking data were collected; by end-2001 supervision needed to be built from scratch. ### Branch network, reporting, and employment - Branch network and status - Original design: headquarters in Kabul plus 89 branches across the country, six desks in hotels and other public places, and four toll desks on highways. - As a result of upheavals, 24 of 89 branches were closed. - Provinces without any functioning branch: Bamyan, Maidan Shar, Qala E Naw, Zabul, and Nimroz. - Provinces with only one branch: Gardez, Khost, Kapisa, Logar, Ghazni, Kunurha, Qalat, Urazghan, Ghorat, Farah, Badghis, Sar-e-Pol, Baghlan, and Taluqan. - Branch counts in select provinces: Kabul (15 official branches), Nangarhar (5), Kandahar (4), Herat (5), Mazar-i-Sharif (7), Kunduz (3). - DAB owns 30 branches; remaining properties belonged to other state institutions and private investors. - Branch reporting and cash transparency - Most branches stopped sending reports six years ago; main office in Kabul no longer knew current cash holdings in branches. - Employment and staffing - In mid-2002, DAB employed 2,400 staff: 1,021 at headquarters, 1,130 in branches, and approximately 250 at the tolls. - Substantial number of staff had no clear responsibility; lack of telephone, telex, and computer operators noted. - Difficulties in making prompt wage payments in branches led some staff to become accountable to local political authorities and perform municipal duties (examples: Ghazni and Gardez branch staff ran provincial tollbooths). ### Key statistics and exact figures reported in the text - Supreme Council membership: nine members - Supreme Council meeting frequency: at least four times a year - Governor’s appointment term: three years - Bank account statistics at DAB headquarters: 5,000 active accounts out of a total of 100,000 accounts (35,000 of which had a zero balance) - Active accounts in first 30 branches assessed in May 2002: less than 6,000 accounts - Vaults for main currency reserve stock: two major vaults in Kabul - Vehicles in early 2002: two trucks, one bus, and one Land Rover - Branch network originally: 89 branches; 24 of 89 branches closed - Kabul official branches: 15 - Nangarhar: 5; Kandahar: 4; Herat: 5; Mazar-i-Sharif: 7; Kunduz: 3 - DAB ownership of branches: 30 branches owned by DAB - Staffing (mid-2002): 2,400 staff; 1,021 at headquarters; 1,130 in branches; approximately 250 at the tolls - Liquidation provision for private/semipublic bank closures: 15 percent of capital deposited with DAB *Source: Excerpt from the PDF chapter on Da Afghanistan Bank (DAB) and the Law on Money and Banking included in the provided document.* ### 205. It is not surprising that at the end of 2001, after 23 years of military conflict, the ### _cr03299 - 205. It is not surprising that at the end of 2001, after 23 years of military conflict, the ### Background and historical evolution - After 23 years of military conflict, the financial system in Afghanistan at end-2001 bore little resemblance to a modern western banking system. - Key historical phases and effects: - Pro-communist and Soviet era (1973–89): banking system nationalized; soviet-style accounting, financial control, and management introduced. - Mujahedin period and civil strife: further deterioration with continued government interference, directed lending, administered interest rates. - Taliban period: financial institutions forbidden to charge interest on loans or pay interest on deposits; deposit mobilization collapsed; banks discontinued lending. - Informal financial sector role: - Registered money changers and the Hawala system replaced banks for payments, liquidity, and some deposit and lending services. ### Accounting and financial reporting deficiencies - No defined chart of accounts for commercial banks or DAB. - Predominant accounting systems: - Outmoded NCR accounting systems (including DAB). - Manual Cartotek system (double-entry manual bookkeeping described in footnote). - Deficiencies and consequences: - Neither system adequate to determine true financial condition or serve as management tools. - No headquarters-branch reconciliation. - Valuation and classification of assets, liabilities, expenses, and income misleading and not consistent with international accounting standards. - Inappropriate booking of nonperforming loans and absence of provisioning. - Nonperforming loans are never written off; some banks move loans with accrued interest from “loans” to “receivables” and keep value greater than face value. - Provisioning and punitive interest rules are insignificant and do not reflect probability of nonpayment. - Footnote explaining common developed-country rule: loans nonperforming for a year written down to zero with corresponding provisioning charge in income statement, while client liability remains enforceable. ### Financial situation and key statistics - General observations (end-2001): - Banks’ main assets: foreign currency deposits held abroad (frozen during Taliban times) and real estate (including repossessed houses, office and branch network). - Real estate values in Kabul likely increased due to arrival of embassies and aid organizations. - Most other assets substantially eroded by inflation or likely written down to zero. - Most banks’ loan portfolios past due by 7 to 15 years; many borrowers dead or disappeared. - Collections on nonperforming loans account for less than 1 percent of total income for banks as a whole. - Deposit base substantially eroded by high inflation; deposits likely represent only a small claim on asset base. - Outstanding debt on letters of credit generally not substantial, except Export Promotion Bank reports an outstanding debt of $5 million. - Specific historical/financial items mentioned: - AgBank received an IDA credit facility of $34 million for re-lending. - Bank-level staffing and branch counts (from Box VI.3 summary table): - Banke Millie Afghan: Date Established 1933; Public or Private (at inception) Private; Date Nationalized 1976; Number of Staff 800; Number of Branches 19 (of which 9 in Kabul and 6 international). - Pashtany Tejaraty Bank: Date Established 1955; Private; Date Nationalized 1974; Number of Staff 564; Number of Branches 17 (of which 6 in Kabul, 8 in provinces, and 3 international). - Agricultural Development Bank: Date Established 1955; Public; Date Nationalized n.a.; Number of Staff 230; Number of Branches 28 (of which 15 remain). - Export Promotion Bank: Date Established 1976; Public; Date Nationalized n.a.; Number of Staff 250; Number of Branches 4 in Kabul, Mazar, and Herat (Herat branch not functional). - Industrial Development Bank of Afghanistan: Date Established 1973; Private; Date Nationalized 1977; Number of Staff 37; Number of Branches 3 (2 in Kabul and 1 in Mazar (2 branches now destroyed)). - Mortgage and Construction Bank: Date Established 1948; Private; Date Nationalized 1976; Number of Staff 80; Number of Branches 2 in Herat and Mazar (both are closed). - Aggregate employment estimate: - The six commercial banks together employ nearly 2,000 staff. ### Management, employment, and operational capacity - Banks had not been managed in a modern commercial sense for years; managers executed government instructions aligned with social, political, and developmental objectives. - Governance and appointment issues: - Interference via managers or governing boards chaired by the governor of DAB. - Bank managers often appointed on political grounds without banking experience. - Interest rates historically set by governmental committee and later prohibited under the Taliban. - Staff competencies and operations: - Staff, management, and board members lack basic banking and operational experience; job descriptions, responsibilities, and accountability ill-defined. - Absence of policies, procedures, and communication lines. - Lack of modern automation and information technology; employees mostly unfamiliar with computers. - Deficiencies in understanding: automation technology, risk assessment, profit and loss elements, financial flows and stocks, branch management and operations, accounting, lending, deposit mobilization, and general banking operations. - No training for many years; frequent staff turnover with political upheavals. ### Payment system, vulnerabilities, and immediate needs - By end-2001, most domestic and international payments undertaken by money dealers (Hawala and related informal network). - Role and risks: - Informal network crucial for economy but vulnerable to money laundering, drug trafficking, and terrorist financing. - Urgent need for a formal payment system for government and donor payments; Hawala not best suited for these purposes. - Operational imperatives for currency conversion and government payments: - Central government needed to make salary and other budgetary payments and collect customs revenues from provinces. - Reactivating DAB’s branch system was critical for nationwide currency conversion. - In absence of a functioning banking system, responsibility fell to DAB to lead reform and development of a formal national payment system. ### Reform agenda and legal framework recommendations - Legal reform: - Existing Law on Money and Banking incompatible with a modern two-tier banking system; needs replacement by a completely new central bank law and a banking law to define separate roles of central bank and commercial banks. - Early enactment of modern central bank and banking laws crucial for development of a sound, resilient private banking sector and for macroeconomic stability and growth. - Laws necessary to attract foreign banks (technology and management know-how) by providing transparent, predictable, and sound “rules of the game.” - Central bank independence and tools: - Central bank needs proper tools to regulate and supervise banking system without government and political interference to restore public confidence and regenerate the deposit base. - Status of legal drafting: - Drafts of central bank and banking laws, prepared with IMF help and commented on by international organizations, law firms, and consulting firms, have been extensively discussed with senior Afghan officials and are now ready to be enacted as presidential decrees. *Source: Excerpt from _cr03299 (IMF staff report).* ### 1. There are approximately 5,000 money traders in Kabul, of which some 300 have shops and are ### Box VI.4. The Money Dealers in Afghanistan (concluded) ### Market structure and licensing - There are approximately 5,000 money traders in Kabul, of which some 300 have shops and are licensed by the Supervision Department of DAB. - In provincial towns, there are on average around 80–150 licensed money traders with shops and about 500 traders. - This department licenses money changers for a fee, but does not regulate or supervise them. Until early 2003, money traders were licensed by the Foreign Relations Department of DAB. - Some unlicensed money traders are affiliated to shops (which typically have two to five traders); most traders work independently and thus without a license. - The money transfer system is usually referred to as the Hawala System. - Since the Islamic revolution, when most foreigners left Afghanistan, the money exchange market has been dominated almost entirely by Afghan nationals. - The Money Dealers Association, formed by the 20–30 leading traders, provides self-regulation. The Association is directed by an Executive Committee that consists of an executive director and three assistants, meets regularly, and enforces unwritten rules of conduct (traders not respecting these rules can be expelled). ### Transfer mechanics, counterparties, timing, and costs - Funds can be transferred within 6 to 12 hours from Peshawar, Dubai, or London to Kabul; transfers to provinces usually take a little longer. - Regional money dealers are mostly located in provincial cities and organize distribution to villages through local offices or representatives; international dealers are mainly based in Kabul. - Traditional international counterparts are situated in Iran, Pakistan, India, Saudi Arabia, Qatar, the United Arab Emirates, and Oman. - Rather than transacting in cash, some clients wire funds to a correspondent account in Peshawar or Dubai; upon confirmation of receipt, the counterpart is released immediately at the desired destination. - Some 10 to 15 of the larger traders have correspondent accounts with banks abroad; affiliated traders can also benefit from this network. - Reputable customers can cash checks or require receipt of the counterpart prior to making the corresponding wire; such services are usually negotiated at a higher cost. - The cost for making international transfers varies between 0 and 2 percent of the amount transacted, depending on the amount, destination, financial relationship, the currency of exchange, and security environment. - Domestic transfers are typically more expensive with an additional charge of ½ to 1 percent. - In exceptional circumstances, such as immediately after September 11, 2001 and until early 2002, the fees have been as high as 4 percent. - Money transfers operate on a netting system with other traders in the provinces or abroad; physical transfer of cash or goods is only made when a trader has no representation in a particular town or where a net position needs to be settled. - Outstanding balances are usually settled between two dealers on a weekly or monthly basis, but at times, when the volume of transactions is high, settlement of accounts are made daily. ### Foreign exchange dealing and market concentration - Main financial service provided by money dealers is foreign exchange dealing, mainly in U.S. dollars, Pakistani rupee, and Iranian rial; virtually any currency can be traded. - The 30 largest traders cover about 70 percent of all transactions and roughly half of their trading consists of transactions in U.S. dollars. - Daily trade volumes in the Kabul foreign exchange market reportedly run to several millions of U.S. dollars, and most of this is transacted in cash. - There are no limits on transaction volumes; traders have reported that buying or selling $1 million in cash can be accommodated easily. - The main market place is in Kabul, located close to the gold and silver bazaars; it includes shops and operates as an open-cry currency exchange. - At the end of each day, dealers store their excess currency and working capital in vaults located in their shops until the next working day. ### Other services and clientele practices - Other financial services include deposit taking, granting of short-term loans, trade finance, and microfinance. - Money traders extend loans or accept deposits only to and from people they personally know and trust; most loans are between traders and are made on an intra-day basis. - Dealers offer auxiliary nonfinancial activities, including telephone (GSM and satellite) and fax services, regional and international trade services, and internet access. ### Documentation, record-keeping, and communications - Traders operate without standard documentary requirements and usually design and maintain their own documentary policies and procedures. - Transactions usually involve comprehensive and detailed records for the entire process of remittance and settlement of each money transfer; documentation is kept at least until the entire transaction and its settlement is completed. - Customers are provided with a document containing a money transfer number or code, needed for customer identification, payment, and settlement. - Some dealers require secondary identification from clients collecting funds in addition to the transfer number or code; others request photocopies of passports or identity cards from hospitals or the army. - Dealers record the date of the transaction, the name and address of the sender and recipient, identity card number, transaction number or code, and the name of the transaction counterpart dealer. - For regular customers, dealers keep customer files containing invoices and quotations, copies of receipts, transaction contracts, and agreements. - Upon request, mostly from established organizations and NGOs, dealers deliver receipt and payment confirmation documents to the sender. - The larger traders keep daily records of volumes and rates traded and balance their books at the end of each day. - Communications with banks abroad are via fax and satellite phone. - The money market is not subject to any reporting requirements or supervision and is fully based on reputation and trust. ### DAB legal and supervisory framework, and banking sector reforms - The draft central bank law includes provisions that give DAB the overriding responsibility to achieve and maintain price stability and grants it full autonomy in seeking this objective. - The law would specify that DAB shall act in accordance with the principle of an open market economy with free competition. - DAB would be entrusted with defining, adopting, and implementing Afghanistan’s monetary and foreign exchange policy; issuing banknotes and coins; holding and managing the official foreign exchange reserves; acting as advisor to and fiscal agent to the government; and licensing, regulating, and supervising institutions engaging in banking business. - The law would prohibit financing the government budget deficit and prohibit DAB from providing loans to commercial banks, with the one exception permitting DAB to act as a lender of last resort and extend short-term liquidity support to solvent but illiquid banks in the event of a systemic liquidity crisis. - Under the draft law, DAB would be granted complete legal, operational, and administrative autonomy from the state and any other person or authority; accountability would be achieved by reporting requirements to Parliament and the public on DAB’s financial condition and on the achievement of its objectives. - DAB senior officials would be prohibited from holding other government positions and from engaging in other tasks incompatible with their duties. - The governor, first deputy governor and members of the Supreme Council of DAB would be appointed, remunerated, and dismissed in accordance with procedures and conditions specified by law. - The law would stipulate DAB’s right to be consulted on any proposed legislative or public administrative act of the government in DAB’s field of competence. - The draft law includes specific issues that under normal circumstances could have been covered by separate laws, including currency, cash payments, payment system issues, and securities services and securities transfer systems. - DAB would have the powers to issue regulations for the Hawala dealers as nonbank providers of money and payment services. ### Banking law, supervision, and institutional capacity building - The draft banking law would include a precise definition of a bank as an entity engaged in accepting deposits or other repayable funds from the public and using such funds for lending or investments for its own account. - The law would introduce a two-stage process for applications of banking licenses, with only essential information submitted in the first stage, and would give DAB the mandate to issue regulations specifying necessary conditions for obtaining a banking license. - Before considering an application, DAB would apply a fit and proper test to future owners, board members, and senior managers of the bank. - The law would include standard rules of a modern banking system with sound management, prudent risk management, and transparent and adequate accounting, including provisions on corporate governance, DAB’s powers to review changes in bank ownership, credit documentation, risk management, and requirement that banks maintain accounts in accordance with international accounting standards (IAS). - Banks would be subject to specific auditing requirements, including the establishment of an audit committee; DAB’s oversight role would be strengthened through on-site examinations. - The law would specify enforcement measures, a graduated system of prompt corrective actions, power to order removal from office of board members or senior managers, explicit provisions for dealing with banks having solvency problems, exclusive authority for DAB to revoke a license and to initiate insolvency proceedings, and comprehensive explicit provisions for resolution of insolvent banks under the oversight of a financial service tribunal. ### Progress, operational reforms, and payment systems - In the first 18 months since the end of the war, DAB successfully implemented the currency exchange and gained control over the issuance of currency. - DAB created a banking supervision department, drafted prudential regulations and manuals, initiated training of supervisors, and conducted “real life” off-site supervisions and on-site supervision of Bank Millie Afghan. - The licensing of money traders has been shifted from the Foreign Relations Department to the new Supervision Department; in November 2002, all licensed money traders had to renew their licenses, a process enforced with the help of the police. The department has started to improve collection of personal data on the licensed money traders. - Restructuring of DAB has been slow, with many departments still under the original organizational chart and employing a large number of unqualified staff with no assignments; parts of some departments are being restructured into functional departments with foreign experts. - Accounting reforms are underway: introduction of a new chart of accounts, computerizing the function with a general ledger software package to enable regular balance sheet production; accounting regulations, operating manuals, and staff training still required. - DAB has improved commercial services for international organizations and many NGOs; almost all banking activities for these organizations are currently conducted by DAB’s commercial arm. - New current accounts can only be opened by money changers, NGOs, or international organizations, but not by the general public. - DAB has ceased to extend loans with the exception of two recent small loans (one to the Ministry of Defense and another to the Industrial Development Bank). - DAB intends to divest itself of all commercial bank activities no later than end-2004. - DAB has reconnected 35 of its main provincial branches to DAB’s head office in Kabul via laptops with Immarsat connections; by end-September 2003 they will be able to report balances and account movements to the center on a daily basis. - As transaction volumes increase, Immarsat connections are planned to be replaced by a VSAT network. - Bank branches in Kabul already report to the head office on a daily basis and will be connected by a computer network; branch re-opening and rehabilitation decisions will be based on needs assessments and estimated reflow of refugees and internally displaced people. - DAB plans to develop a physical distribution system with regional cash centers, introduce a software system for currency inventory management, and purchase an armored fleet or use of an aircraft for transporting cash. - For the medium term, with the emergence of a commercial banking system, DAB plans to implement two payment systems that will represent the core of the National Payment System: a Real Time Gross Settlement (RTGS) system and a Direct Giro Credit (GC) system. *Source: _cr03299 - 1. There are approximately 5,000 money traders in Kabul, of which some 300 have shops and are (PDF).* ### 227. With the assistance of a foreign expert, DAB is also unblocking and consolidating ### _cr03299 - 227. With the assistance of a foreign expert, DAB is also unblocking and consolidating ### DAB actions on foreign accounts and reserves - With the assistance of a foreign expert, DAB is unblocking and consolidating existing DAB accounts in international banks and is improving the management of its foreign reserves. - Tasks for the future include: - the removal from the DAB balance sheet of all assets and liabilities held by both the Foreign and Domestic Loans General Department and the Foreign Trade General Department, together with all records associated with them, and their transferal to a public agency designated to settle these balances. - addressing the pension department, which is responsible for the pensions of employees of both DAB and the commercial banks; options would include transferring them to an outside private agency or to a national pension system. ### Seeking the renaissance of commercial banks - Post-Taliban developments: - Since the end of the Taliban era, several of the licensed banks claim to have received a small number of new deposits and loan repayments, and to have extended some new loans. - Management practices of the licensed banks have not changed. - Commercial banks still do not function in a manner consistent with a market economy. - Despite the reemergence of some limited banking transactions, the commercial banking sector in Afghanistan remains dysfunctional. - Required response: - A fundamental restructuring of the currently licensed banks, together with a substantial improvement in their management, will be necessary if these banks are to become modern and efficient banking institutions. ### Pillars for effective banking sector development - The development of an effective banking sector will need to be based on three important pillars: competition, good corporate governance, and strong banking supervision. 108 - Legal and institutional prerequisites: - The enactment of the draft central bank and banking laws will be the first major step toward this new structure. - Passing new laws alone will not suffice without improved contract enforcement and well defined property rights. - Concurrent reforms needed: - accounting reform and training in commercial banking and risk assessment. ### Role of foreign banks and limits - Benefits of foreign banks: - Importable reforms: modern management and risk assessment techniques. - Expectation they would apply international accounting standards. - A number of international banks have already made formal applications for banking licenses, pending the passage of the draft central bank and banking laws. - Limitations and gaps: - Foreign banks will most likely limit operations to larger cities, starting with Kabul, and to certain types of customers (international organizations, NGOs, the diplomatic corps, and the largest corporations). - Small and medium-size enterprises and rural areas likely to remain unbanked. - Most banks likely to focus initially on facilitating payments; few can be expected to engage in significant domestic-lending at the outset. - Implication: - An important role will remain for DAB, microfinance institutions, and a rehabilitated domestic banking sector to deliver financial services outside of Kabul and to client bases not served by international banks. ### Comprehensive medium- to long-term financial sector development strategy - Components of a likely rehabilitation strategy: - an experienced and competent management team to make a detailed diagnostic and action strategy with voluntary retrenchment plans, training of remaining staff, and introduction of modern banking technology. - assignment of qualified and experienced people to board and management positions. - restructured organization and corporate governance. - strengthened and automated operating systems, management tools, and operating policies and procedures. - well-defined duties, responsibilities, and scope of authority at all levels of management and staff. - sufficient capitalization after full due diligence and after financial, management, and operational audits have been performed on the banks being restructured. - Outcome for non-viable institutions: - Institutions which are unable to perform should ultimately be liquidated. ### Money changers and the Hawala system - Persistence and challenges: - Even with the emergence of a modern banking system, the informal Hawala system will likely continue to exist, as is the case in many other countries in the Middle East. - Need to counter untransparent, undocumented, and adverse practices. - Regulatory options and considerations: - DAB will need to evaluate options to partly regulate and supervise this market without pushing it underground. 109 - Simply extending banking regulations and supervision practices (licensing requirements, customer identification, suspicious activity reporting, and record-keeping) to money dealers is not a viable option because: - the huge number of traders involved would make such regulation infeasible, and - such regulation would probably push the activity underground. - Two alternative options: 1. Self-regulation and supervision: - Hawala dealers could, at least as an interim solution, subject themselves to self-regulation and supervision. - The market already benefits from an association enforcing a number of unwritten rules; the association could be encouraged to draft written rules and regulations. 110 - Note: “The disadvantage of self-regulation is that it risks becoming self-serving with a high degree of regulatory forbearance.” 2. Special regulations and supervision techniques: - Recognizing distinct features of the Hawala system would justify development of special regulations and supervision techniques to increase transparency while keeping intact the characteristics that made the market efficient. - Possible regulatory measures: - requirement of registration but not licensing of the Hawala dealers; - requirement to be able to identify customers and to keep records on their identity; - requirement to cooperate in investigations if the need arises, including the right of DAB to enter and inspect the money dealers’ premises where there is a reasonable suspicion of a committed offence; - information campaigns by DAB to educate money dealers about their responsibility to report suspicious activities. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03299.pdf* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03299.pdf_