Islamic Republic of Afghanistan -- Statement of the IMF Staff at the Conclusion of the Staff Visit

February 1, 2007

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

Islamic Republic of Afghanistan
Statement of the IMF Staff at the Conclusion of the Staff Visit
February 1, 2007

This statement presents the findings of the IMF mission that visited Kabul from January 21-February 1, 2007. Discussions focused on the authorities' preparations for an assessment of Afghanistan's eligibility for the Heavily Indebted Poor Countries(HIPC) Initiative, including possible measures in support of obtaining HIPC debt relief. The mission also examined recent progress in implementing the authorities' economic and financial program, which is supported by the IMF's Poverty Reduction and Growth Facility (PRGF).

1. Performance during the third quarter of 2006/07 was broadly satisfactory. The authorities met all December 2006 quantitative indicative targets agreed on during the November 2006 mission with the exception of the revenue target. The authorities also established the certified monthly payroll system and have made progress in other reforms. The nominal Afghani-U.S. dollar exchange rate remained within a narrow band around Afs 50 per US$ reflecting mainly central bank foreign exchange intervention. The decline in international energy prices and rents in Kabul contributed to lowering year-on-year inflation to less than 4 percent at end-2006. Also, timely distribution of essential foodstuffs by the World Food Program prevented the rise in food prices usually observed during the winter.

2. The political environment surrounding the program is becoming increasingly complex. Multiple and competing demands pose a challenge for the authorities and complicate policy decisions. At the January 30-31 Joint Coordination and Monitoring Board conference in Berlin, the Minister of Finance noted that "IMF conditionality on the one hand, and our security and Millennium Development Goals and the Compact requirements, on the other hand, are subjecting us to conflicting pressures." Despite significant donor support, rising public discontent reflects the scarcity of employment opportunities and slow improvement in living conditions. The mission is concerned that, in this environment, the authorities' determination to deliver on commitments under the IMF-supported
program-notable in the past-might be waning. For example, just as the government is facing mounting expenditure pressures, they were unable, for the first time, to achieve a revenue target under an IMF program. Moreover, changes in the custom tariff regime appear to be moving in the wrong direction as it appears that additional items are slipping into the upper rate brackets and new exemptions have been introduced.

3. The mission would like to reiterate that prudent fiscal policy remains the key anchor to sustain macroeconomic stability. Accordingly, responding to immediate expenditure measures should give regard to revenue performance as well as medium- and long-term fiscal sustainability. In the financial sector, establishing the appropriate legal and institutional frameworks will support the development and stability of a vibrant financial system required for private sector development.

4. The mission welcomed the authorities' steady progress toward preparing for the assessment of Afghanistan's eligibility for the HIPC Initiative. They worked closely with the Fund mission compiling a reconciled debt database that will form the basis of the HIPC debt sustainability analysis. There was also a wide ranging dialogue about possible measures that the authorities could pursue as a basis for eventually receiving HIPC debt relief. The authorities agreed that these measure should help them avoid accumulating an unmanageable debt burden in the future, and facilitate efforts to promote growth and tackle poverty. The mission noted the authorities' interest in moving forward quickly with the HIPC process and underscored the immediate priority of reconciling the relevant debt.

5. Weaker than expected revenue performance in the third quarter could be worrisome. Domestic revenue at the end of the third quarter stood at Afs 17.9 billion (4.3 percent of GDP)-about Afs. 0.8 billion below the indicative program target for December 2006. The reasons for the revenue shortfall remain to be clarified and will need to be credibly addressed if the end-year fiscal revenue target (6.4 percent of GDP) is to be met. The uncertainty of recurrent expenditures and the dependency on donor grants underscore the importance of focusing on revenue measures. The authorities need to adopt a strategic approach toward developing a modern tax and customs administration to meet the longer term revenue objectives. Also, they need to undertake administrative reforms to improve compliance and efficiency, such as transferring accountability for administration of all large- and medium-size taxpayers directly to the revenue department. In this connection, the mission welcomed the recent draft revenue plan that is meant to clarify the revenue framework. Additional revenue would provide the budget with the fiscal space needed to respond to unforeseen pressures.

6. Nonetheless, the operating deficit excluding grants was below the indicative ceiling for December 2006 due to the continued effects of slow operating budget execution in the first quarter. Recorded development expenditures have picked up significantly as the authorities improved implementation and reporting. Although lower than budgeted, development expenditures are expected to be significantly higher than in 2005/06.

7. Fiscal policy for the remainder of 2006/07 is likely to be in line with the program, but increased security pressures on the 2007/08 budget will challenge fiscal sustainability. While the authorities and the mission were aware of rising security expenditure pressures at the start of 2007/08 budget preparations, subsequent consultations between the government and security partners revealed that further outlays would be necessary to strengthen adequately the security forces. While necessary to tackle the volatile security situation, these additional expenditures will delay the government's stated objective of covering all core operating expenditures from domestic revenues by 2010/11. The mission is particularly concerned by the difficulties posed for adhering to a targeted budget path given these pressures and growing needs in the non-security sector. Spending pressures need to be prioritized to achieve fiscal sustainability. The authorities should also resist the expansion of recurrent expenditures without corresponding increases in revenue or at least assurances of durable donor support. Priorities need to be clarified and publicly articulated in order to make effective trade-offs within the budget constraint. Continued progress in producing the Afghanistan Development Strategy should play a key role in that regard.

8. Monetary policy remains appropriate, as witnessed by the decline in inflation, and conditions for expanding the central bank's (DAB) policy instruments are improving. Preparations are under way for opening a secondary market for capital notes and introducing capital notes of longer maturities. Combined with increased volumes of capital notes auctions, these steps will facilitate the development of financial markets and enhance banks' ability to manage their liquidity efficiently. DAB will gain flexibility in liquidity management and a longer term yield curve will develop.

9. DAB must resist pressure to introduce regulations that conflict with the key principles of commercial banking. In particular, the mission recommends that DAB's Supreme Council rescind its October 2006 resolution that will force commercial banks to invest 80 percent of their deposits in the domestic market. The mission is of the view that this measure will impact negatively the development of the banking sector, particularly in the absence of viable domestic investment opportunities. Rather, the key to developing the domestic financial sector is to ensure that the appropriate legal, regulatory, and enforcement frameworks are in place to facilitate domestic lending by banks.

10. Data reporting is key for program monitoring and the quality of policy advice that Fund staff can deliver. The mission notes the difficulties in tracking public expenditure executed outside the government budget with donors' support. It is also imperative to rectify weaknesses in the central bank's financial reporting. To this effect, the mission urges DAB to improve the coordination of financial information among its various departments, including through implementing the automated accounting system at DAB's headquarters.

11. The mission will return to Kabul in late April/early May to conduct discussions for the second review under the PRGF program and continue the ongoing work related to the HIPC Initiative.

12. As on previous occasions, we very much appreciated the open and frank dialogue with the Afghan authorities and other public and private sector representatives. We would like to thank them for the time and effort that they put into the discussions.


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