Islamic Republic of Afghanistan -- Seventh Review Under the Staff-Monitored Program and Discussions on a PRGF-Supported Program, Concluding Statement

April 6, 2006

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.

March 26, 2006

This statement presents the conclusions of the IMF mission that visited Afghanistan from March 12-26, 2006 to conduct the seventh review under the staff-monitored program (SMP) and discuss a successor program that could be supported by an arrangement under the Poverty Reduction and Growth Facility (PRGF).1

1. Over the past few years, the Afghan authorities have made significant progress toward building a foundation for macroeconomic stability and development. The political and institutional framework envisaged under the 2001 Bonn Agreement was brought to fruition with the recent parliamentary elections. The authorities continued to demonstrate strong performance under the two-year SMP; macroeconomic stabilization has been largely achieved and there has been clear progress in areas that are central to the program. Building on these gains, the Interim Afghanistan National Development Strategy (I-ANDS)—submitted to the International Donors' Conference held in London—provides a strategic medium-term vision to foster sustainable growth, create jobs, and tackle poverty.

2. Notwithstanding these achievements, the challenges remain formidable and the risks have become more apparent. Persistently high levels of insecurity and drug-related activities represent direct threats to continued stability and social harmony, and add to the already significant fiscal burden of the government. At the same time, as they seek to deliver on the goals and policies of the I-ANDS, the authorities need to address a number of implementation weaknesses. In this context, extensive, but targeted, donor support and technical assistance will be required to address weak administrative capacity and build needed infrastructure. In particular, the ability of the civil service to play an effective role in policy development and the delivery of public services needs to be strengthened. Perhaps of more concern are developments that threaten the reform momentum such as widespread allegations of corruption, a fragile social consensus, and heightened and unrealistic expectations of immediate improvements in economic and living conditions for a population severely effected by years of war and conflicts.

3. The medium-term program, for which the authorities are seeking support under the PRGF, is designed to address these challenges by providing a framework for implementing consistent and predictable macroeconomic policies. Over the medium- to long-term, the necessary diversification of the sources of growth will depend crucially on establishing a stable macroeconomic environment through consistent and predictable policies that focus on achieving: (a) fiscal sustainability; (b) a stable monetary policy framework and effective banking system; (c) external sustainability; (d) an environment conducive for sustained private sector-led growth; (e) external competitiveness of the economy; and (f) further liberalization of the economy to stimulate competition and productivity. Moreover, transforming the objectives and policies of the I-ANDS into a well prioritized and achievable reform program should be underpinned by comprehensive institutional reform. Continued technical and highly concessional financial support by the donor community will also be essential to implement the authorities' strategy.

4. Our comments focus on: (a) recent economic performance, including under the SMP; (b) medium-term fiscal and external sustainability; (c) the monetary policy framework and banking system; and (d) the structural agenda to support broad-based and sustainable growth.

I. Performance Under the SMP and Economic Assessment

5. The authorities met all end-December 2005 quantitative indicators and observed all structural benchmarks, except for the publication of the audited 2004/05 core budget financial statements.2 Fiscal and monetary developments were broadly in line with program projections, with domestic revenue expected to be above the 2005/06 target.

6. Our assessment of the economy remains broadly unchanged since the IMF Executive Board concluded the 2005 Article IV consultation and sixth review under the SMP in early March.3 As expected, real GDP is estimated to have grown by 14 percent in 2005/06, as agricultural output recovered on account of better precipitation, while momentum in the reconstruction effort sustained activity in manufacturing, construction, and services. Inflation continued to decline, to 12.6 percent in February 2006, owing primarily to a slowdown in food prices, which was partly offset by an acceleration of rents and petroleum product prices.

7. Looking ahead, Afghanistan's medium-term growth prospects are favorable. Sustained reforms aimed at improving the investment climate should facilitate growth at an average of 10 percent a year over the medium term. While agricultural growth would return to trend, telecommunications, transport, and trade would provide further impetus for growth. Construction activity would increase steadily, albeit at a slower pace than in recent years. Per capita income would rise to more than $400 by 2008/09, from $299 in 2005/06. Assuming the pursuit of sound monetary and fiscal polices, inflation would decline further to 9 percent by end-2006/07, and to 5 percent a year thereafter.

II. Medium-Term Fiscal and External Sustainability

8. Fiscal sustainability is predicated on implementing durable reforms aimed at (a) rebuilding domestic tax collection; (b) managing expenditures as fiscal operations are gradually consolidated within the core budget; (c) effectively implementing an affordable public administration reform program; and (d) prudently managing external resources. The government's reputation for fiscal responsibility reflected in past budgets has been reinforced by the publication of a Medium-Term Fiscal Framework (MTFF) in November 2005, the I-ANDS in January 2006, and more recently, extensive discussions with donor partners in producing the 2006/07 budget. This has helped to secure significant financial assistance from the donor community, who committed to increasingly use the national budget as its key policy tool. In the months to come, it is important that the authorities adhere to policies agreed upon with the IMF and the international community, which call for strong revenue performance and prudent expenditure management.

9. A strong revenue effort is needed to underpin the move towards fiscal sustainability. While revenue is projected to increase to 6 percent of GDP in 2006/07 from 5.5 percent in 2005/06, the authorities must accelerate the reform program to reach the "Compact" target of over 8 percent by 2010/11. The mission recommended that the government focus its efforts in 2006/07 on priority reforms that include: (a) strengthening the large taxpayers' office; (b) improving transparency, including through the publication of tax and customs guides and an appeals process; (c) upgrading physical and human administrative capacity, particularly in the provinces; (d) introducing an excise tax on selected goods; (e) removing the plethora of small, low-yielding "nuisance" taxes and illicit charges; and (f) prepare a consultative paper to reform the current cascading business receipts tax into a more efficient consumption tax.

10. The MTFF provides a framework for assessing future policy challenges and options, including the definition of macro-fiscal constraints in the context of the annual budget. While the departure of the 2006/07 budget from the MTFF is due partly to the incorporation of expenditures previously contained in the external budget, as well as genuinely unforeseen expenditures, the mission emphasized the need to strengthen the MTFF as a more effective guide for budget formulation. Deviations from the MTFF need to be reviewed carefully, taking into account their medium-term implications and well justified in budget documents and in discussions with development partners. Accordingly, the mission welcomed proposed measures to improve budget formulation, such as the publication of a less compressed budget calendar and the reorganization of the Budget Department to better assess and support more realistic development plans by line ministries to reduce the inflated development budget. Again in 2005/06, the execution will be far below its budgeted level.

11. Improvements in expenditure management are essential to contain the budget deficit. In particular, careful management and control over staff levels and the wage bill are needed to ensure that the proposed administration reforms both improve performance and ensure fiscal sustainability. The mission expressed concern over recent lapses in control that resulted in new staff being hired in excess of budgeted manpower ceilings and at times in the inappropriate use of non-salary payments. This has reportedly resulted in salary payment arrears and undermines the long-term administrative reform effort. In this regard, the mission welcomed the authorities' commitment to investigate personnel management issues in key sectors and to strengthen the monitoring and enforcement of manpower and payroll controls. The proposed tightening of expenditure controls, particularly on staff numbers and remuneration, should lead to savings, which, combined with a strong revenue effort, should help contain the operating deficit, excluding grants, to no more than 3.0 percent of GDP for 2006/07.

12. The mission supported the consolidation of fiscal operations but recognized that absorbing additional responsibilities into the Core Budget, if not accompanied by more funding, reduces available fiscal space, particularly over the medium-term. In this context, a well executed public administration reform program is essential to raise public sector productivity while containing costs to affordable levels. The mission welcomed the authorities' commitment to avoid general pay increases, which, even if justified on the basis of recent inflation and the low level of pay, do not provide incentives for better performance and leave less room for sustainable pay reforms. The proposed pay and grading reforms (and pay and rank reforms for the police) appear affordable, but only if well managed. While recognizing the scarcity of skilled labor, the mission urged the authorities to closely work with the donor community to accelerate the design of their implementation strategies, to build required capacity, and to accelerate the extension of the verified payroll and personnel management systems to all line ministries and to the provinces.

13. To ensure external sustainability, the authorities' reform strategy should be supported by prudent debt management, enhanced grant management, and the timely regularization of relations with creditors. To that end, and given Afghanistan's large development financing needs, the mission underscored the need for the government to continue to focus on increasing its capacity to spend resources productively while relying predominantly on grant financing and utilizing highly concessional borrowing only for development expenditures after careful review of project soundness. The mission welcomed the authorities' initiatives to improve grant resource management by monitoring project performance more closely and enhancing the financial management capacity of line ministries and in the provinces. In line with the Public Expenditure and Financial Management Law and the new debt management strategy, the operational effectiveness of this policy depends upon ensuring that the Ministry of Finance has sole responsibility for all borrowing and loan guarantees on behalf of the government.

14. The unverified external debt overhang is an impediment to private investment and growth. The mission welcomed progress in reconciling claims with bilateral creditors, but noted that efforts appear to have waned recently. While acknowledging that the process is in part in the hands of creditors, the mission urged the authorities to reinvigorate their efforts. Ensuring sustained good faith efforts toward resolving outstanding claims with all creditors will be a vital step toward securing a PRGF arrangement. The debt sustainability analysis undertaken in the context of the 2005 Article IV consultation highlighted the need for forgiveness of most (if not all) of Afghanistan's outstanding bilateral liabilities to ensure sustainability.

III. The Monetary Policy Framework and the Banking System

15. The monetary program for 2006/07 is consistent with the targeted decline in inflation to 9 percent at end-2006/07. The mission agreed with the authorities that, in view of the current weaknesses of banking statistics and the shallowness of financial markets, the monetary program will continue to target currency in circulation in the context of a flexible exchange rate. As was the case in 2005/06, currency in circulation is expected to increase at a slower pace than nominal GDP, owing largely to the anticipated growth of the commercial banking sector, which is expected to be accompanied by a shift from currency in circulation to deposits. In view of the uncertainty surrounding money demand, the authorities should monitor price and exchange rate developments and stand ready to tighten the monetary stance, should inflationary pressures emerge. The expected increase in international reserves to the equivalent of 5 months of 2007/08 imports of goods and services would provide a much-needed cushion to support the Afghani.

16. Efforts to modernize DAB's operations and to strengthen the monetary policy framework are commendable and should be sustained. The mission was encouraged by the gradual implementation of regulations on reserve requirements and foreign exchange open positions. It also welcomed the authorities' commitment to adopt measures to deepen the capital note market and introduce credit and deposit standing facilities which will contribute to strengthening DAB's control over liquidity. The mission advised the authorities to clarify the financial relations between the government and DAB through a service level agreement that includes an appropriate structure of charges for financial services provided by DAB and the remuneration of government deposits. In view of the uncertainty surrounding future balance of payments developments, it welcomed the authorities' decision to process the gold held in the palace vaults into a form that qualifies as a reserve asset, and recommended that it be transferred to an international gold center. The authorities' commitment to submit to Parliament the external audits of DAB for 2004/05 and 2005/06 is a welcome step, particularly in light of the need to complete a safeguard assessment by the time of the first review under the PRGF. These audits will help to determine more accurately DAB's current capital position. To facilitate program monitoring, the mission fully supports the authorities' objective to improve the monetary statistics through the development of a monthly balance sheet of DAB and a monthly monetary survey in line with international standards.

17. Progress in restructuring state-owned banks has been disappointing and the mission urged the authorities to intensify their efforts. The authorities' decision to liquidate the Export Promotion Bank or to merge it with Bank Pashtany and Bank Millie, and to complete the transfer of its deposits by end-September is a step in the right direction. At the same time, the mission raised concerns regarding the appointment of new Board of Directors at Bank Millie and Bank Pashtany. While acknowledging the difficulty in recruiting sufficiently qualified staff, the mission emphasized the need to appoint Directors that meet the qualification requirements set by DAB in its capacity as bank supervisor. The mission also urged the authorities to develop and adopt long-term restructuring plans for Bank Millie and Bank Pashtany, aimed in particular at improving their operational performance and ensuring their financial sustainability over the long term.

18. The mission underscored the need to address the administrative and legal impediments to the development of the banking sector. It encouraged the authorities to work with the banking community toward the establishment of an interbank money market. This will contribute to a more efficient allocation of banking system resources in Afghanis, as this would help channel the state-owned banks' liquidity surplus to other commercial banks. The mission called for an intensification of efforts to adopt a group of enabling laws and the clarification of land ownership rights. Lastly, the mission urged the authorities to reduce substantially the rate of remuneration of private savings accounts held with DAB in the provinces where no commercial bank operates, as the current rate constitutes a strong disincentive for commercial banks to expand outside of Kabul and a few other large cities.

IV. The Structural Agenda and Growth

19. Structural reforms will play a central role in enhancing productivity and improving the external competitiveness of the economy. With substantial donor- and drug-related inflows pushing upward the real exchange rate, productivity growth is essential to improve competitiveness. In this context, the authorities need to intensify their efforts to tackle the impediments to private sector investment, including issues related to: land tenure, business regulations, transparency, the political and security climate, infrastructure, the trade framework, and human resources. In all these areas, there are significant weaknesses that add to the cost of doing business. Furthermore, all business surveys also point toward widespread corruption as a critical obstacle to investment. In the mission's view, actions to address these issues would enhance greatly the overall effectiveness of the authorities' reform strategy. The mission encouraged the authorities to pursue the implementation of their restructuring strategy for the state-owned enterprises and to extend it to public entities and agencies involved in commercial activities not covered by the Tassady Law.

20. A rationalization of the tariff structure should be consistent with a liberal and transparent trade regime. Maintaining a simple tariff structure will have administrative benefits, thereby supporting the government's efforts to strengthen customs administration. Correcting the anomalies in the classification of goods according to their stage of production would also help to minimize investment distortions. However, a general ratcheting up of the average tariff or the introduction of specific tariffs should be avoided, as they could undermine reforms aimed at removing investment distortions and establishing a level playing field for investment and growth. Moreover, the mission favors introducing an excise tax as the most appropriate means of raising revenue from specific goods.

V. Statistics, Technical Assistance, and Other Issues

21. Reliable statistics are key to effective policy formulation and analysis and program monitoring. Notwithstanding improvement in some areas over the past months, substantial data shortcomings continue to affect the national accounts, balance of payments, and monetary and social sector data. In this regard, the mission welcomed the establishment of a National Statistical Council to better coordinate the development of the statistical system. Now that the independence of the Central Statistics Office has been established, the mission encouraged the authorities to work closely with the donor community to implement the statistical master plan.

22. The mission welcomed the authorities' intention to publish the letter of intent and Memorandum of Economic and Financial Policies, as well as the staff report for the seventh review under the SMP and the request for a successor program supported by an arrangement under the PRGF. We wish the authorities every success in their efforts.

1 The mission held constructive discussions with the authorities, as well as with members of Parliament, and representatives of the private sector and diplomatic and donor communities. The mission would like to thank the authorities for their hospitality and excellent cooperation at all levels, in particular the Minister of Finance and the Governor of Da Afghanistan Bank (DAB).

2 The audited financial statements were only published in March 2006.



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