Islamic Republic of Afghanistan -- Fourth Review Under the Staff-Monitored Program, Concluding Statement of the IMF Mission

May 18, 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 May 8-19, 2005 to conduct the fourth quarterly review under the staff-monitored program (SMP). Discussions with the authorities covered performance under the program during the fourth quarter (January-March 2005) of 2004/05, policy priorities for 2005/06, and longer-term strategies for growth and external and fiscal sustainability. The team is grateful to the authorities for the preparatory work they undertook, for their warm hospitality, and for cordial and candid discussions with 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.

2. Afghanistan's performance under the SMP was strong in 2004/05. Output continued to grow steadily. Core inflation remained limited. Money growth and fiscal revenue were in line with program projections. All structural benchmarks but one were met. This performance bodes well for the long-term course of the economy. There is however no scope for complacency or inaction as major challenges continue to loom, including security concerns, a pervasive drug economy, a weak enabling environment for private sector development, poor infrastructure, significant fiscal pressures, a very high level of poverty, an underdeveloped financial sector, and low administrative capacity with governance concerns. A forceful policy agenda of sustainable reforms is needed to make room for private investment, preserve competitiveness, increase employment, reduce poverty, and enhance external and fiscal sustainability. Against this background, we are pleased to have reached understandings with the government on a set of quantitative indicators, structural benchmarks, and a policy framework in support of their agenda.

3. Economic developments are consistent with projections made at the time of the third review. Real GDP grew by an estimated 7.5 percent in 2004/05. The sharp decline in agricultural output was offset by the expansion of telecommunications and construction. Year-on-year inflation reached 16.3 percent at end-2004/05, compared with 10.2 percent at end-2003/04.1 This increase in inflation was essentially attributable to the acceleration of rents, education fees, and petroleum product prices. Excluding these items, which account for less than 10 percent of the consumer basket, inflation declined slightly in 2004/05, to 10.3 percent from 10.8 percent at end-2003/04.

4. Revenue met the SMP indicative target for 2004/05 but remained below the budget forecast. The SMP indicative target was met despite the fact that overflight charges accrued in 2004/05 were only collected in May 2005, and thus were excluded from 2004/05 revenue. Customs duties exceeded their budget target by around 20 percent, to constitute about half of domestic revenue, while tax and nontax revenues were lower-than-expected. The shortfall in revenue relative to the budget target was more than offset by lower-than-expected operating expenditures. Reflecting continued delays in recruiting teachers and in implementing the main civil service restructuring program, spending reached Af 26.7 billion in 2004/05, well below the mid-year review projection of Af 29.1 billion. Overall, the operating budget, including grants, recorded a surplus of Af 1.1 billion for the year. While improving, the rate of development spending was also below budget expectation. Development spending continues to be hampered by: (i) the lack of capacity in line ministries and implementing agencies to develop and implement projects; (ii) the long lead time required to design and initiate projects; and (iii) security concerns.

5. The recently promulgated new customs code and income tax amendments provide for more efficient customs regime and tax system, including more efficient tax incentives to private investors. The publication of estimates of the revenue forgone as a result of the previous regime of tax exemptions and concessions also demonstrated the authorities' commitment to transparency. The potential revenue loss is estimated conservatively at $14.6 million for 2005/06, equivalent to 4.4 percent of budgeted domestic revenue, and at over $30.2 million since 2003/04. A key element of the government's findings is that the previous regime favored particularly some sectors, such as construction, that should not have been the main beneficiaries of such investment incentives.

6. Monetary growth was in line with SMP projections: currency in circulation amounted to Af 39.6 billion at end-year, slightly below the SMP indicative target (Af 39.8 billion). To meet this target, DAB stepped up its foreign currency auctions during the fourth quarter, so as to partly offset the monetary expansion resulting from the increase in government spending. This increased spending was partly financed through a drawdown of government's deposits with DAB, leading to a slight decline of foreign exchange reserves during the fourth quarter, to $1.3 billion (equivalent to 3.9 months of projected 2005/06 imports). The interest rate on the overnight capital note remained low, at 1-2 percent, while the one-month auctions continued to be undersubscribed. The nominal exchange rate was stable during the fourth quarter.

7. Further progress was made in restructuring DAB's balance sheet and in strengthening the banking sector regulatory framework. The cessation of DAB's headquarters-based commercial activities was completed by end-March. The ownership of the silver and gold held in the palace vaults was transferred to DAB, and a local independent expert has started working on their valuation. DAB's financial participation in state-owned banks and enterprises was also transferred to the Ministry of Finance. The audit of DAB's end-2003/04 financial statements has been finalized and the commercial banking law was published in the Official Gazette. A set of new banking regulations was adopted by DAB's Supreme Council. Finally, DAB has started enforcing its reserve requirements.

8. The restructuring of the state-owned banks continues to be slow. Although the licensed state-owned banks made some progress in modernizing their internal regulations, no significant progress was made in hiring qualified staff and toward divesting real estate investments. This appears partly due to insufficient government involvement as the shareholder. The authorities have also to take a decision regarding the specific resolution process of the three former state-owned banks that were not relicensed.

9. The current account deficit, excluding grants, reached 45.7 percent of GDP in 2004/05, down from 50.9 percent in 2003/04. While foreign direct investment (FDI) and concessional borrowing increased, this deficit continued to be essentially financed by grants. Including grants, the current account was broadly balanced in 2004/05, compared with a 3.1 percent of GDP surplus in 2003/04. This deterioration essentially reflected an increase in imports not associated with reexports. External borrowing remained limited and at highly concessional terms.

II. The Program for 2005/06

10. The mission considers the performance of the Afghan economy during 2004/05 as a significant step toward meeting the government's medium-term objectives of sustainable growth, poverty reduction, and fiscal and external sustainability. Staff note that the government economic program for 2005/06, based on prudent fiscal and monetary policies and wide-ranging structural reforms, should allow for further progress toward these objectives.

11. The mission expects growth to increase to 13.6 percent in 2004/05, largely reflecting a rebound in agricultural output due to better precipitation. While slowing down, activity in construction, transport, and telecommunications will continue to grow steadily. The tightening of the monetary stance should contribute, along with the expected slowdown in food prices and rents, to a decline in inflation, to 10 percent year-on-year at end-2005/06.

12. Poppy cultivation appears to have declined significantly in early 2005. This was due in part to the authorities' anti-narcotics campaign and to the decline in farmgate prices triggered by the 2004 bumper harvest. It is uncertain, however, whether this will translate into a significant reduction in opium production, as the decline in planted areas is expected to be, at least partly, offset by an increase in yields stemming from better weather conditions. In any case, any sustainable progress in reducing opium production will depend on protracted efforts by the authorities. The mission therefore encouraged the authorities to pursue vigorously the implementation of their multi-pronged anti-narcotics strategy, built upon eradication, interdiction, alternative livelihoods, and education. As a successful implementation of this strategy could have substantial macroeconomic consequences, Fund staff are assisting the authorities in assessing the possible impact and corrective policies.

13. The operating budget for 2005/06 is prudent and should provide a solid base for developing a medium-term budgetary framework. The budget was approved before the start of the fiscal year (March 21), which will help the authorities avoid a repeat of the payment delays that occurred at the start of previous years. Despite significant pressures for additional spending, operating expenditures are budgeted to grow broadly in line with nominal GDP.2 Given the uncertainty about the level of donor financing, the mission welcomed the authorities' commitment to continue to follow the no-overdraft financing rule and to fund the operating budget from domestic revenue and grants.3

14. The authorities were well advised to adopt an `interim' development budget at the start of the fiscal year, as some donors could not fully confirm their commitments. Core development spending, which is financed through the treasury, is budgeted to increase from 4.5 percent of GDP in 2004/05 to 13.2 percent of GDP in 2005/06. However, the government's ability to increase spending will largely depend on an improvement in implementation capacity and security. To further consolidate the budget as the main fiscal policy tool, the mission supports the government's request that donors channel funds through the budget, particularly via the multi-donor trust funds, and provide more predictable multi-year commitments based on continuing improvements in accountability and transparency. Staff cautioned that the proposed new Counter Narcotics Trust Fund (CNTF), which will be used to elicit donor financing for the antinarcotics effort, should be fully integrated into the core budget. The mission welcomed the authorities' assurances that any new resources flowing to the core budget will be introduced through a supplementary budget and will not be used to inflate the cost of existing operating budget programs. This should reinforce the growing credibility of the budget as one of the government's main policy instruments.

15. Improving the consistency of the budget presentation and developing a realistic medium-term fiscal framework will help manage growing expectations. The current presentation of the core budget combines cash and commitment concepts, and therefore significantly overstates the actual amount of spending within the year. In order to better manage domestic expectations for additional spending, and to reflect a realistic rate of absorptive capacity over the medium term, the authorities must continue to enhance the transparency and realism of the budget. The mission welcomed the authorities' commitment toward a more standard and consistent cash-based presentation of the budget, within a medium-term framework, and to publish more timely quarterly core budget reports.

16. Afghanistan faces major challenges in developing a sustainable fiscal position. Salary costs currently represent about 75 percent of operating expenditures and are expected to increase significantly over the medium term due to the ongoing public administration reforms and the gradual absorption of the Afghan National Army (ANA), which was previously funded by donors, into the budget.4 The mission reiterated the need to contain pressures for generalized or sector specific pay increases that might undermine a more comprehensive reform effort. Specific measures to manage the wage bill should be considered in the context of comprehensive medium-term public administration reform program. Developing such a reform program is an urgent priority.

17. Even with strong revenue mobilization efforts and expenditure restraint, significant external assistance will continue to be required over the medium-term, including for the wage bill and other operating costs. The government should therefore set "stretch targets" for accelerated revenue mobilization and maintain expenditure discipline. The budget revenue forecast is appropriately conservative, but as the 2004/05 SMP target was achieved without the overflight charges, the program target for domestic revenues for 2005/06 has been revised upwards.5 To bolster the credibility of the budget spending plans, prior to the mid-term review any additional domestic revenue collected above the budget forecast will be used to either: (i) offset shortfalls in budgeted grant resources for the operating or development budgets; or (ii) build the Government's prudential cash reserves. Any allocation of such additional revenue at the time of the mid-term review will have to be consistent with medium-term fiscal sustainability and public administration reforms.

18. The mission urged the authorities to give tax and customs reforms their highest priority. Only an intensive and sustained effort to improve revenue collection will lead to a sustainable fiscal balance. The government's strategy should focus on medium-term reforms rather than on quick fixes that may prove detrimental in the longer-term. New regulations are urgently required to support the customs code, which, combined with the planned improvements in customs infrastructure, the rollout of a computerized customs management information system and the introduction of a new customs police service, should yield significant additional revenue. The government will also be well advised to give priority to (i) ensuring that the large taxpayer office identifies and starts to work with its main clients and (ii) restructuring the revenue headquarters and new provincial revenue offices. New tax revenue enforcement powers should be put in place by end-September 2005. At the same time, the number of `nuisance' taxes (notably the fixed taxes) need to be rationalized and illicit charges removed. The mission welcomed the authorities' request for IMF technical assistance to help review and prioritize their customs and tax reform programs.

19. Staff welcomed the commitment to promulgate the public financial management law by end-June 2005 and to develop the accompanying financial regulations shortly thereafter. The timetable for the submission of the audited financial statements to the executive before end-September 2005 should also be strictly adhered to.

20. Monetary policy will continue to be guided by the monetary program developed at the time of the third review. This program provides for a substantial tightening of the monetary stance, while allowing for a further monetization of the economy. The mission emphasized the need for a flexible exchange rate and for DAB not to resist persistent pressures on the exchange rate, especially when such resistance is not consistent with the objective of reducing inflation. The mission acknowledged however that DAB might have to intervene to smooth short-term exchange rate fluctuations. The monetary program will remain flexible, allowing for a revision of the monetary stance in consultation with the Fund when warranted by exchange rate and price developments.

21. Further progress will be made in restructuring DAB's balance sheet and improving monetary reporting. By end-June, DAB will publish its audited 2003/04 financial statements. The preliminary estimate of the gold and silver held in the palace vault will allow the authorities to determine whether DAB is adequately capitalized. In the unlikely event of an undercapitalization, the authorities stand ready to take remedial action. By end-September, DAB's commercial activities in its Kabul's city branches, and in its branches located in provinces where at least one commercial bank operates, will be transferred to other entities. In collaboration with the commercial banks, the authorities will work toward improving the timeliness and reliability of monetary reporting.

22. The modernization of the banking sector will continue. So as to strengthen DAB's control over liquidity, and based on the findings of the IMF technical assistance mission on monetary policy, the authorities will work toward broadening DAB's monetary instruments. The authorities also intend to tackle some of the administrative impediments to the development of the banking sector, including the absence of laws supporting financial market development (e.g. bankruptcy and corporate laws) and high fees (e.g. property registration).

23. The mission urged the authorities to intensify their efforts to restructure the state-owned banks. While the three licensed state-owned banks, which are highly capitalized, do not currently represent a systemic risk, there is much room for improving their operational performance. The government will prepare, by end-September 2005, a long-term strategic plan for the restructuring of these banks. The government also reiterated its commitment to take a decision regarding the specific resolution process for each of the former state-owned banks that were not relicensed and to start implementing it by end-June.

24. The staff emphasized the need for a complete accounting of external debt in designing an external debt management policy. The authorities agreed to continue their good faith efforts to complete the external debt survey. The staff welcome the intention of the authorities to seek assistance from the Paris Club Secretariat in contacting Paris Club creditors regarding outstanding debt obligations. The mission indicated its willingness to facilitate exchanges between the government and officials of non-Paris Club creditors.

25. The business environment remains challenging for private sector development. Private entrepreneurs have to deal with complex and time-consuming regulations, high registration fees, and burdensome bureaucracy. A wide range of reforms is under way to make Afghanistan's business environment more attractive to investors. The mission encourages the authorities to continue their work on a modern and simplified tax system, an adequate legal framework for business, simplified procedures for enterprises, and endeavor to publish in the official gazette a new investment law. Equally important are the reforms of the state-owned enterprises (SOEs). The adoption by the cabinet of a classification of the SOEs by envisaged restructuring method and an economic restructuring plan by end-September 2005 would represent a welcome step in that direction.

26. The authorities intend to prepare by end-October 2005 an interim poverty reduction strategy paper (I-PRSP), which will be based on their National Development Strategy (NDS). The mission urges the authorities to speed up the establishment of an institutional framework to coordinate the NDS/I-PRSP process. Establishing the Inter-Ministerial Committee and the working group of predominantly Afghan experts that will conduct the technical work would help launch the NDS/I-PRSP process. The mission also encourages the authorities to build bridges with the other partners in the process, notably the United Nations agencies, the international financial institutions, key donors, and civil society through the creation of the External Advisory Group.

27. While the institutional mechanism to monitor macroeconomic developments and report core data and information on the implementation of the SMP is in place and working well, there is room for improvement. The mission is of the view that the technical coordination committee(TCC) has now built up enough capacity to take upon more ambitious tasks, including the development of an analytical role in the macroeconomic area. The next major task is to reach out to other government agencies, to help strengthen the ownership of the reforms.

28. Although some economic legislation has recently been adopted, sometimes with delays, the staff has serious concerns about the bottlenecks constraining the process, including the capacity of the Ministry of Justice to pass needed legislation in due time. The staff urged the government to coordinate better, prioritize legislation, and actively seek additional resources from the donor community to address this issue.

29. Technical assistance (TA) has been instrumental in the progress made so far by Afghanistan in various areas. TA will remain indispensable in the years ahead to build capacity and carry out the ambitious reform agenda. While the international community responded well to those needs, there still remain areas of concern. The allocation of this technical assistance has at time been unevenly distributed among the government agencies. The mission encourages the authorities to expedite this assessment of TA and much-needed redeployment of resources to strengthen capacity. The mission reiterated the IMF's willingness to continue to provide technical assistance in support of the authorities' economic reforms.

30. The authorities continue to make progress in strengthening their statistical database but should press ahead in completing pending reforms. While commending the authorities for taking action to resolve various data weaknesses, staff noted that the statistical law is still not adopted, and the reform of the central statistics office (CSO) has not even started. These reforms need to be reinvigorated as they are key to establishing an adequate legal and institutional framework. Together with continued TA from donors, they will help the authorities collect, process, and produce data in line with international standards. The staff considers that there is no alternative to an independent CSO, and urges the government to take steps in that direction.

31. The fifth review under the SMP will take place in August 2005. It will review observance of the end-June 2005 quantitative indicators and structural benchmarks. The policy discussions will focus on some key issues, including economic growth and the income of farmers, medium-term fiscal and external sustainability, and the modernization of the banking system.

32. Afghanistan has undergone significant changes during the initial period of the SMP (March 2004-March 2005), weathering in the process a challenging presidential election, a change in administration and lingering insecurity. The smooth transition is testimony of the resolve of its leadership and its people and also of the constant support of the donor community. However, a consensus within the government and the donor community is still needed that identifies the policies that will deliver fiscal sustainability while addressing the acute needs of the population. The mission wishes the current leadership and authorities well in their endeavors. Consistent with their transparency policy, the staff welcome the authorities intention to publish the SMP documents once they have been approved by IMF management and the government.

1 Inflation continued to be lower in the provinces than in Kabul: the "national" consumer price index, which covers five major cities in addition to Kabul, increased by 2.7 percent during the fourth quarter and by 10.9 percent year-on-year at end-2004/05.

2 The operating budget provides for a 15 percent increase in recurrent spending over the mid-year review projections for 2004/05, but the lower-than-expected 2004/05 outturn implies an increase of around 23 percent.

3 Grants from the Afghanistan Reconstruction Trust Fund (ARTF) and the Law and Order Trust Fund for Afghanistan (LOTFA) are expected to increase to cover over 50 percent of operating budget expenditures in 2005/06. Indications of donor commitments suggest that the ARTF and LOTFA will have sufficient funds to cover the operating budgets' requirements.

4 According to government, $520.9 million was reportedly spent directly by donors on the ANA during the first seven months of 2004/05. The salary structure of the ANA is considerably higher than the civil service and troop numbers are projected to grow significantly in the coming years, which is likely to place a significant burden on the Government's resources.

5 The updated forecast for 2005/06 accounts for the payment of two overflight charges (one paid in May 2005 but accrued in 2004/05 and one accrued and paid before the end of 2005/06), and is based on the higher-than-expected 2004/05 outturn. Revenue is projected to increase by 43 percent over this outturn.


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