Islamic State of Afghanistan -- Third Review Under the Staff-Monitored Program: Concluding Statement of the IMF Mission, February 3, 2005

February 7, 2005

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

1. An IMF mission visited Kabul from January 23-February 3, 2005 to conduct the third quarterly review under the staff-monitored program (SMP). The mission discussed with the authorities recent economic developments, policy priorities for the rest of 2004/05 and for 2005/06, prospects for future relations with the Fund, and longer-term strategies for sustaining equitable growth. The team is grateful to the authorities for their hospitality and generous cooperation, and for the cordial and candid discussions with the Vice President, the Minister of Finance, the Minister of Economy, the Minister of Commerce, the Governor of Da Afghanistan Bank (DAB), other senior government officials, as well as representatives of the donor, business, and NGO communities. Key findings of the mission are as follows:

• Afghanistan's overall economic performance was strong during the third quarter. Output has continued to exhibit steady growth despite the lingering drought that affected agricultural performance, while inflation has declined. Fiscal revenue was in line with the SMP target, although it appears unlikely that revenue for the year will meet the target specified in the government budget. Structural benchmarks under the SMP have been largely met. This performance is attributable to fiscal discipline, cautious monetary policy, structural reforms, and the pursuit of policies consistent with these goals. However, the new government faces significant challenges, and the mission believes that potential downside risks should not be overlooked.

• After experiencing some early difficulties related to the reshuffling of the cabinet, the new economic team has demonstrated appropriate oversight and control over the implementation of fiscal and monetary policies. It is now facing some very difficult policy issues, however, including the need to modernize the banking system, improve on revenue collection, and maintain a sound and sustainable fiscal policy in light of pressures for new programs, possible shifts in government priorities, and in the face of uncertain donor commitments partly as a result of other pressing international needs.

• The new government recognizes that macroeconomic stability, transparency, and a long term, pro-growth structural agenda have served the country well thus far. However, as part of a shift from emergency post-conflict management to a situation of greater normalcy, the new government wants the opportunity to reassess policies to improve the delivery of government services and provide badly needed infrastructure. There has been a strong partnership with the international community, and the authorities have indicated that they will continue to work closely with donors to strike the appropriate balance between various priorities. The mission views continued donor support as critical. At the same time, the mission expressed concern over the short- and medium-term fiscal implications of some recent and prospective initiatives.

• Until a new parliament is in place, and in view of the lack of an immediate balance of payments need, the authorities reached an understanding with the mission on an extension of the current SMP until end-September 2005. The mission supports this option and encourages the authorities to take advantage of this extension to further strengthen their policy framework and administrative capacity.

• Preparatory steps are being taken to launch the work on a poverty reduction strategy (referred to as the National Development Strategy). An Interim Poverty Reduction Strategy Paper (I-PRSP) is expected to be completed by October 2005.

I. Performance Under the SMP

2. Consistent with its strong track record, the government of Afghanistan has met all quantitative indicators and structural benchmarks that were established for the third quarter of 2004/05, with the exception of the benchmark related to the publication of the central bank and banking laws.1 The mission commended the authorities for this performance, which was achieved against the backdrop of the presidential election and the subsequent formation of a new cabinet. Notwithstanding this notable achievement, economic growth remains fragile, provision of government services remains weak, drug-related activities have increased, security remains a concern, barriers to private investment are still significant, and poverty remains pervasive. In the face of such daunting challenges, the mission is of the view that there is significant room for more market-oriented reforms that would sustain equitable growth while preserving social policy objectives.

3. Current economic developments have been in line with the projections made at the time of the second review, with agricultural output declining substantially due to adverse weather conditions, but activity in transportation and other services remaining buoyant. Consumer prices in Kabul increased by 4.0 percent during the third quarter of 2004/05, reflecting a seasonal increase in food prices. Excluding food items, the consumer price index is estimated to have risen by only 0.9 percent, due in part to a decline in rents and petroleum prices, which had increased sharply over the first half of 2004/05. Overall, year-on-year inflation amounted to 11.9 percent at end-December (6.6 percent excluding rents and petroleum products), compared with 14.1 percent at end-September 2005. 2

4. Fiscal revenue for the first nine months of 2004/05 is estimated at Af 8.9 billion, exceeding the SMP indicative target of Af 8.6 billion. Following a subdued start to the third quarter, receipts rebounded sharply during the last month, essentially reflecting an increase in customs revenue.

5. On the expenditure side, the rate of spending, particularly for development programs, continued to lag budget expectations. The under-spending in the operating budget (outlays reached Af 18.2 billion during the first nine months of 2004/05, compared with the annual budgeted amount of Af 30.3 billion) was attributable to delays in the recruitment of additional teachers and in the implementation of the main civil service restructuring program.3 Over the same period, core budget development spending was Af 8.4 billion while direct donor spending was reported at $1.6 billion, compared to budget estimates of Af 37.3 billion and $3.5 billion, respectively. The slow rate of development spending was due to the lack of capacity in ministries and implementing agencies to develop and implement projects, delays in mobilizing donor funding, and the level of insecurity.

6. Monetary growth was in line with the program agreed under the SMP: currency in circulation amounted to Af 37.1 billion at the end of the third quarter of 2004/05, slightly below the SMP indicative ceiling of Af 38.1 billion. The faster than expected slowdown in currency growth appears to have resulted from the financing of the Hajj (most pilgrims financed their journey by depositing Afghanis in DAB), and from a slowdown in donor-related spending in the period leading up to the formation of the new government. Reflecting the persistent high level of liquidity of some banks, interest rates on the overnight capital notes remained low (at 1-2 percent). Foreign exchange reserves continued to increase steadily during the third quarter, to $1.3 billion at end-Decembe 2004, equivalent to 5.3 months of 2005/06 imports. The nominal exchange rate depreciated slightly, to about Af 48 per dollar at end-December—roughly the same level as at the beginning of the year.

7. While further progress was made in modernizing DAB and strengthening the commercial banking regulatory framework, the restructuring and modernization of the state-owned banks continues to be slow and uncertain. The external audit of DAB's 2003/04 financial accounts was initiated and the findings will be presented to DAB management shortly. In addition, substantial progress was made toward finalizing the transfer of DAB's commercial accounts to other entities, and new banking data reporting requirements have been implemented. The publication of the central bank law in the official gazette is another positive development. While significant progress was made in restructuring Bank Pashtany and Bank Millie, delays were incurred in restructuring the Export Promotion Bank. Moreover, a decision has yet to be taken regarding the resolution process of the three state-owned banks that were not relicensed. These banks have ceased commercial operations, but continue to pay employee salaries.

8. Balance of payments data remain of poor quality, although the mission noted the government's efforts to make improvements in this area. Preliminary data indicate that the external current account (excluding grants) deficit narrowed to 32 percent of GDP in the first three quarters of 2004/05, down from 39 percent a year before, and was primarily financed by donor support in the form of grants. The decline in the deficit appears to reflect an improvement in the trade balance, including a continued recovery in domestic exports. External borrowing, which is on highly concessional terms, remained limited, with disbursements reaching an estimated $176 million during the first nine months of the year. The authorities continue to make progress in verifying external obligations to bilateral creditors, and a survey of external debt and reconciliation with creditors is expected to be completed by end-March 2005.

II. The Program for the Remainder of 2004/05 and 2005/06

9. As recent economic developments are consistent with the projections made at the time of the second review, real GDP growth projections for 2004/05 and 2005/06 remain unchanged at 8 percent and 10 percent, respectively. The mission expects inflation to pick up slightly during the fourth quarter, reflecting recent information about higher food prices. Inflation is expected to reach about 13 percent, year-on-year, at end-2004/05. For 2005/06, due to a slowdown in rent prices and a tightening of the monetary stance, inflation would decline to 10 percent.

10. The authorities, in collaboration with the donor community, intend to step up their efforts to deal with the drug economy through the implementation of a multi-pronged strategy. To ensure the sustainability of these efforts, and to limit their potential economic impact on the most vulnerable segments of the population, this strategy will combine an intensification of eradication and interdiction with a broad strategy to introduce alternative livelihoods. There is anecdotal evidence that some poppy farmers, faced with the current low farm gate prices and the increased risks associated with government intervention, are turning voluntarily to other crops. This provides a window of opportunity to make significant progress in addressing the opium problem. If this trend is to be sustained, however, eradication of poppy crops must be accompanied by stronger interdiction of opium traffickers and decisive efforts to ensure the transition to alternative livelihoods. Otherwise the apparent move to legitimate agriculture may prove to be nothing more than a cyclical response to low farm gate prices for poppy.

11. Assuming strong implementation of the customs and tax reform programs, the authorities should meet the SMP revenue target for 2004/05, of Af 12.8 billion, but are unlikely to reach the budget target of Af 15.4 billion. The expected shortfall in domestic revenue relative to budget will be offset by savings proposed in the mid-year review, combined with additional donor funding. This shortfall (around Af 2.3 billion) is due to several factors, including a slower-than-anticipated implementation of the tax reform program. The mid-year budget review proposed the reallocation of resources from slow disbursing ministries, such as Education, to ministries facing budgetary pressures, such as Interior. In addition, Af 1.9 billion will be reallocated to the Disaster Contingency Fund (Af 190 million), and a new `Budget Safety Fund' (Af 1.7 billion). Grant funding from the two multi-donor trust funds, the Afghanistan Reconstruction Trust Fund (ARTF) and the Law and Order Trust Fund for Afghanistan (LOTFA), should also exceed the budgeted amount. Given the downside risks to domestic revenues, the mission called upon the authorities for a strict adherence to the proposed expenditure ceilings to ensure that the operating budget is fully funded.

12. The mission urged the authorities to redouble their efforts to implement the tax and customs reform programs. The mission recommended that the authorities should avoid quick fixes to provide temporary revenue gains that may prove detrimental in the long run. Rather, the mission is of the view that, in addition to the full implementation of last July's tax reform package, including the services taxes (where compliance has been poor) and the airport departure tax, priority should be given to the restructuring of the revenue headquarters and the new Kabul provincial revenue office. In this vein, a renewed commitment needs to be made to establish the large taxpayer office, as envisaged in the 5 year revenue reform plan. Policy proposals to improve tax administration law and corporate law, including establishing revenue enforcement powers, should also be given a high priority. The mission suggested that priorities in the customs area including the completion of the customs code and the roll-out of new border facilities. Both revenue and customs reform will require agreement between the Ministries of Finance, Justice, and Interior, particularly on enforcement and collection powers. To strengthen the legal framework for revenue, publication in the Official Gazette is needed for: (i) the tax reform package; (ii) the amendment that precludes the granting of tax exemptions and concessions (with the exception of those contained in revenue legislation); and, (iii) the new customs code.

13. Delays in the adoption of the 2005/06 budget should not disrupt fiscal operations. Due to the recent cabinet changes, and the need for close consultation with donors during the preparation of the budget, it is likely that the budget will be adopted shortly after the start of the fiscal year (March 21). The mission called upon the authorities to establish arrangements to ensure that payments, particularly for salaries, are not disrupted.4 The adoption of the new budget law, which will improve the fiscal framework, is likely to slip to June 2005 due to the backlog of pending legislation in the Ministry of Justice.

14. The authorities are facing considerable pressures to deliver services and provide basic infrastructure. However, the mission stressed the need for the 2005/06 budget to be based on realistic assumptions regarding domestic revenue growth and a potential decrease in the availability of donor financing over the medium-term given other demands on donor funds. The mission supports the current approach to funding the operating budget, which prohibits domestic financing and seeks to utilize only domestic revenue and external grant resources, as an appropriate means of maintaining aggregate fiscal discipline.5 The mission stressed the need for the government to demonstrate their ability to manage resources in an efficient, accountable and transparent manner if it wants to continue to attract sufficient donor funding. Donors should also be willing to progressively (and with greater predictability) support the development of the government by channeling their funds through the core budget.

15. Building an effective and affordable public administration will be a major challenge over the medium-term. The wage bill (representing around 75 percent of the operating budget) is budgeted to increase by up to 50 percent in 2004/05, due to the recruitment of additional teachers, the full-year impact of the 2003/04 pay increase, and implementation of the Priority Reform and Restructuring (PRR) program. Over the medium-term, if the wage bill increases faster than predicted, or if domestic revenues fail to increase, the government may quickly encounter problems of sustainability.6 The mission and the authorities shared the view that generalized or sector-specific wage increases would also erode the government's ability for comprehensive civil service reform. The mission discussed the authorities'strategy for containing the wage bill to achieve a more sustainable fiscal position over the long-term-initially limiting any increase in the wage bill to those stemming from the ongoing reform initiatives (mainly PRR). Staff will continue to discuss the possibility of introducing more formal arrangements to contain the wage bill during the next review of the SMP. Further, several donor-financed programs with significant recurrent costs will have substantial medium-term fiscal implications, including the wage bill in the security sector.7 The mission has expressed its concern that if this issue is not addressed immediately by the authorities and the donors, public finances may become unsustainable.

16. The lack of capacity to execute spending plans, combined with the ongoing insecurity, will continue to hamper the government and donors' ability to implement development programs. This is particularly the case for reconstruction projects, for which implementation capacity is very low. Considerable technical assistance is being provided to improve planning, financial management, procurement and audit capacity. The experience of other post-conflict countries suggests that this problem will persist over the medium-term, and would be adversely affected by a further deterioration in the security situation. Therefore, the mission encourages the government to manage public expectations and produce realistic budgets that reflect the limited absorptive capacity.

17. Monetary policy has been effective in, and will continue to be geared toward, maintaining low inflation and guarding against currency instability. In view of the slowdown in consumer prices over the last few months and the monetary tightening already implied in the program for the remainder of the year, understandings were reached on keeping the monetary targets for 2004/05 unchanged. For 2005/06, the pace of monetization of the economy is expected to slow somewhat, reflecting the now relatively high level of monetization of the Afghan economy and the expected development of the banking sector. The program will remain flexible, allowing for the accommodation, up to certain level (5 percent), of perceived shifts in monetary demand. However, the authorities should stand ready to tighten monetary policy, if warranted by price and exchange rate developments. Foreign exchange reserves are expect to increase further in 2005/06, to the equivalent to 5.5 months of prospective goods and services imports, a cushion sufficient to deal with most exogenous shocks.

18. The modernization of the central bank will continue. Several measures aimed at allowing DAB to focus on its core functions will be implemented, including: (i) the transfer of DAB's commercial accounts to other entities; (ii) the transfer of DAB's commercial holdings and potential liabilities to the MoF; and (iii) the transfer to DAB of the monetary gold and silver from the palace vaults. The mission encouraged the authorities to publish the financial statements of DAB's 2003/04 external audit and to decide on a strategy should the audit show that DAB needs to be recapitalized. At the same time, DAB should also move toward the development of interbank money and foreign exchange markets. The mission considers that the development of a money market, by facilitating the transfer of excess liquidity of the state-owned banks to the banks aiming at developing their lending activities in Afghani, would contribute to setting a relevant benchmark interest rate and thus improve the efficacy of the capital note as an instrument of monetary policy. The mission encouraged the authorities to move forward with their plan to give a more prominent role to the commercial banks in the foreign exchange market through the introduction of an automated system, and to ensure that the access of the money-changers to this market is in line with AML/CFT legislation.

19. The mission stressed the need to strengthen further the commercial banking regulatory framework and to proceed with the resolution of the unlicensed state-owned banks. It encouraged the authorities to publish promptly in the official gazette the banking law, as well as the various regulations adopted by DAB's Supreme Council over the last year. The mission also urged the authorities to ensure that the conditions attached to the relicensing of the three state-owned banks are strictly implemented. In addition, the mission cautioned the authorities against reviving the three state-owned banks that have not been relicensed, and stressed that a decision regarding their resolution process should be taken and implemented promptly.

20. Limited data render projections for the balance of payments difficult. On current trends—including continued reconstruction and economic recovery accompanied by strong donor inflows—the external current account is projected to be in surplus for 2004/05, then deteriorate to a deficit of about 2-3 percent over the next two years, before gradually improving over the medium-term, Given the large structural changes taking place in the economy, the uncertainties in external sector data, and the occasional lumpiness in donor disbursements, the mission stressed the need to remain vigilant to emerging pressures on the balance of payments. External borrowing is expected to remain relatively light, given the authorities' cautious approach to new obligations and the current availability of grant financing.

21. Poverty remains pervasive as a result of decades of war interspersed by natural disasters. Political stability as well as progress in macroeconomic management augur well for economic growth and poverty reduction. However, the government is still faced with major challenges. The mission believes that the authorities are correct to now place poverty reduction at the center of their development platform. The mission welcomed their efforts to initiate work on a poverty reduction strategy—called the National Development Strategy—and complete the I-PRSP by end-October 2005, based on a preliminary consultative process in Kabul and at the provincial level. The mission also supported their decision to create an Inter-Ministerial Committee, formed of Ministers and Deputy Ministers from a cross-section of government, including the Ministry of Finance, the Ministry of Economy, the Ministry of Foreign Affairs, and social line ministries to coordinate and conduct work on the I-PRSP. Equally welcome is the establishment of a working group of predominantly Afghan experts who will conduct the technical work, and an external advisory Group (EAG) formed of representatives from United Nations agencies, international financial institutions, key donors, and NGOs to facilitate exchanges with partners outside the government and civil society.

22. Key to this strategy will be the development of the private sector, which currently faces cumbersome administrative barriers, unclear legal constraints, poorly developed infrastructure, and high input costs. Scaling back the red tape, implementing tax reforms to modernize and simplifying procedures for enterprises, and gazetting the investment law by end-September 2005 are short-term measures that the mission believes government can effectively implement. The mission urged the authorities to send these positive signals to the business community. In the same context, the mission welcomes the authorities' intention to restructure the state-owned enterprises and adopt a classification restructuring method for these firms.

23. The Technical Coordination Committee (TCC) has been effective in helping implement the SMP and providing core data to the Fund. The mission encouraged the TCC to strengthen its analytical capacity, and reach out to other government agencies. Another issue that needs to be addressed in the months ahead is the coordination between the TCC and the other working groups expected to be put in place as part of the I-PRSP process.

24. The improvement of the statistical database, together with the strengthening of the Central Statistics Office (CSO) as an independent agency, has been on the government's agenda for the past two years and is a pillar of the SMP. The government has decided recently to place the CSO under the authority of the Ministry of Economy (instead of the Presidency). While the change in the line of reporting may have its merits, the mission urged the authorities to safeguard the independence of CSO. At the same time, the mission encouraged the authorities to prepare a work program to implement the statistical plan and seek donor support to fund it.

25. Technical assistance (TA) provided so far has helped the government make significant progress in many areas. However, there have been problems of coordination, allocation, cost, and consistency. The government is well advised to conduct an assessment of TA to address these weaknesses. The mission encourages the government to complete his reevaluation and adopt soon a comprehensive TA plan.

1 The central bank law was published but the commercial banking law is still being translated and is expected to be published soon.
2 The "national" consumer price index, which covers Kabul and five other major cities, increased by 3.4 percent during the third quarter of 2004/05. It increased by 8.4 percent over the first nine months of 2004/05, compared with 12.6 percent in Kabul.
3 Total government employment was around 375,000, including 134,000 for the police and defense force, compared to a budget estimate of 406,000. The shortfall was mainly in the education sector.
4 Severe payment delays occurred at the start of the previous two years, particularly for salaries, due to the lack of coordination between the budget allotment process and the establishment register (Tashkeel).
5 The authorities have interpreted the policy flexibly with regard to the use of loan funds for cash management purposes; they have temporarily drawn on loan funds to bridge intra-year timing mismatches between spending requirements and domestic revenue receipts and grant disbursements.
6 Under the current strategy and assumptions, which assume a rolling out of the Priority Reform and Restructuring (PRR) program, domestic revenue would cover the wage bill in five years and the operating budget within nine years.
7 The Afghan National Army (ANA) is currently funded by external grants, outside of the core budget. The incorporation of the ANA into the core budget has been proposed and would significantly increase the reported operating costs, but would further strengthen fiscal consolidation and transparency.


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