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

August 16, 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 staff team visited Kabul from August 2-16, 2005 to hold discussions with the Afghan authorities on the fifth review under the staff-monitored program (SMP). The discussions covered a broad range of issues, but focused on performance under the program during the first quarter of 2005/06 (April-June 2005), as well as policy priorities for the rest of this year and for 2006/07. Policies and structural reforms necessary to ensure external and fiscal sustainability over the medium-term were also discussed. We congratulate the authorities on the successful implementation of their program thus far. As on previous occasions, the mission has benefited from the authorities' assistance, hospitality, and cooperation.

2. Program performance remains solid but significant challenges are looming. Led by a rebound of agricultural production, economic activity during the first quarter of 2005/06 appears to have been consistent with program projections. Consumer price inflation declined. Budgetary and monetary developments were in line with program projections. All structural benchmarks were met, and most of the authorities' other commitments under the SMP were implemented. Looking ahead, the government must stay the course, and pursue steadfastly the implementation of sound macroeconomic policies and structural reforms. Against the background of lingering insecurity, intensified efforts to reduce opium-related activities, and the challenge of working with a newly elected parliament, the government must address the following economic issues to safeguard macroeconomic stability:

  • Diversification of sources of growth: in the immediate post-conflict environment, wheat production, construction, and some service activity have been the main contributors to economic growth. While activity in these sectors will continue to provide some impetus to growth over the new few years, it will be insufficient over the long term to sustain growth and alleviate poverty.

  • Fiscal sustainability: domestic revenue remains exceptionally low by international standards and covers only slightly more than half of operating expenditures. Unless a significant effort is made by the government to meet its objective of covering its operating costs with its own resources within a few years, donor support could wane quickly. Given the country's significant spending needs, the government also needs to prioritize its expenditures within the available domestic and donor resources.

  • External sustainability: even under the assumption of a "clean slate" for existing bilateral debts and claims, external sustainability could be at risk unless there are strong economic and revenue performances and the government financing strategy relies on grants and borrowing at highly concessional terms.

  • External competitiveness: the Afghani appreciated by 15 percent in real terms against the dollar during 2004/05. This real appreciation, along with the current high level of wages, appears largely attributable to the impact on aggregate demand of significant donor- and drug-related inflows. Unless inflows are accompanied by substantial gains in productivity, this real appreciation will weaken further external competitiveness and diminish the opportunities for exports and further growth.

  • Credit markets: a weak regulatory and institutional framework for the banking system stands in the way of the development of credit markets and ultimately the expansion of the private sector. The current favorable growth environment suggests there is room to support further reform and progress in building a resilient banking system.

3. Economic developments are broadly in line with the projections of the last review. Revised data indicate that real GDP grew by an estimated 8 percent in 2004/05 (compared with the May 2005 estimate of 7.5 percent), reflecting a stronger-than-anticipated performance of the manufacturing sector. Economic activity during the first quarter of 2005/06, which was led by a rebound in agricultural production and continued strength in the other sectors, appears to have been consistent with program projections. Year-on-year inflation declined substantially in Kabul during the first quarter of 2005/06, to 11.5 percent year-on-year at end-June from 16.3 percent at end-2004/05.1 This decline reflected essentially: the sharp slowdown in rents, which increased by 8.1 percent during the first quarter compared with 41.2 percent a year earlier; the stability of education fees, which had almost doubled during the first quarter of 2004/05; and the slowdown in food prices. Excluding rents and petroleum products prices, year-on-year inflation declined from 11.3 percent at end-2004/05 to 9.0 percent at end-June.

4. Due to a substantial reduction in cultivation, opium production appears to have declined in 2005. While explained in part by the eradication campaign, the reduction in cultivation appears to have also reflected the decision by many farmers not to plant as a result of several factors, including the anticipation of an intensification of anti-narcotics efforts, the promised opportunities through alternative livelihoods programs, and the decline in farmgate prices triggered by the 2004 bumper crop. This reduction in cultivation, observed in most provinces is expected to be only partly offset by a rebound in yields, which had fallen by 29 percent in 2004 because of low rainfall and the prevalence of diseases. Farmgate prices remained low during the first half of 2005, likely on account of large inventories and an intensification of the authorities' interdiction efforts.

5. Provisional data indicate that domestic revenues reached Af 4,757 million during the first quarter of 2005/06, slightly above the SMP indicative target (Af 4,629 million).2 This outcome represents an increase of over 75 percent, in total domestic revenues compared with the same period last year. This strong performance was attributable to both an increase in customs revenue, of around 40 percent, and the delayed transfer of about Af 794 million in overflight charges from the previous year. However, the decline in domestic tax revenues is worrisome.

6. Improvements in budget preparation helped to reduce the payment delays, notably for wages, which had occurred at the start of previous years. Core budget operating spending was Af 6.6 billion during the first quarter, compared with an annual budget estimate of Af 32.8 billion. Wages and salaries contributed around 60 percent of operating expenditures. The operating budget, including grants, recorded a small deficit over the first quarter, which was funded by a drawdown of domestic deposits.

7. Despite the substantial increase in expenditures projected in the June supplementary development budget, improvements in the rate of spending are likely to be modest. Core development expenditures are now budgeted at 16.7 percent of GDP in 2005/06, up from an outturn of 4.5 percent in 2004/05, and a preliminary budget estimate of 13.2 percent of GDP. During the first quarter of 2005/06, core budget development spending amounted to Af 3.8 billion, compared with an annual budget estimate of Af 58.6 billion. 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 lead time required to design and initiate projects; and (iii) security concerns.

8. While higher-than-projected, monetary growth during the first quarter was consistent with the SMP first quarter ceiling on currency in circulation. Currency in circulation increased by 3.4 percent, to Af 40.1 billion at end-June, compared with a projection of Af 38.8 billion and a ceiling of Af 41.2 billion. Due in part to the government's accumulation of deposits with DAB, international reserves continued to increase, to $1.3 billion at end-June (equivalent to 3.8 months of 2006/07 imports). While the interest rate on the overnight capital note remained low, at 1-2 percent, the rate on the 30-day note increased slightly, fluctuating between 5 and 6 percent during the first quarter. The 30-day note auctions are no longer systematically undersubscribed, as some private banks are now participating. The nominal exchange rate depreciated slightly, losing 3 percent against the U.S. dollar during the first quarter of 2005/06. The real exchange rate remained broadly unchanged after appreciating by around 15 percent in 2004/05.

9. Steps have been taken to further modernize the central bank. The financial statements of the 2003/04 external audit of DAB were published. The foreign exchange auctions system was modernized by moving to a standard auction system (with confidential bids; no renegotiation; and the possibility of multiple bids), and by allowing commercial banks to participate along with the money-changers. The monetary policy institutional framework was strengthened by establishing a monetary policy committee in charge of daily operational issues. Significant progress was made in transferring DAB's commercial activities in its city branches in Kabul and in its provincial branches located in provinces where at least one commercial bank operates. Lastly, a preliminary assessment of the gold and silver held in the palace vaults was conducted.

10. Little progress was made in liquidating the former state-owned banks and in restructuring the licensed ones. While the authorities indicated their intention to liquidate the three former state-owned banks, a formal decision has yet to be taken and there appears to be efforts to revive at least one of these institutions. Moreover, these former banks have still to transfer or reimburse the deposits they are keeping. Although overdue, a long-term restructuring plan for the licensed state-owned banks is being prepared by the Minister of Finance. The central bank is currently reviewing their performance under their conditional licenses. There are indications that some conditions attached to these licenses, including those related to the divestment of their real estate portfolio, the hiring of qualified management, and the submission to DAB of quarterly progress reports, were not fully met. The lack of progress in improving the operational performance of these banks has proved detrimental to the development of the Afghani banking sector.

11. The current account deficit excluding grants declined to 45.0 percent of GDP in 2004/05, down from 50.9 percent of GDP in 2003/04, due primarily to a slowdown in imports. While foreign direct investment and concessional borrowing increased, the current account deficit continued to be primarily financed by grants. Including grants, the current account surplus declined, to 0.7 percent of GDP in 2004/05 from 3.1 percent of GDP in 2003/04. External borrowing remained limited and on highly concessional terms.

II. The Program for the Remainder of 2005/06 and 2006/07

12. While the authorities have been successful in maintaining macroeconomic stability and making headway in the structural areas, Afghanistan continues to suffer from the legacy of decades of war. Limited basic infrastructure, weak capacity, red tape, the prevalence of drug-related activities, lingering insecurity, a weak and ineffective court system, the lack of enforcement powers to implement reforms, and limited transparency remain powerful deterrents to investment, sustainable growth, and improvements in the welfare of the population. Afghanistan needs to build on achievements so far and lay the foundations for faster growth and poverty reduction, as well as for the achievement of the Millennium Development Goals.

13. The authorities requested a twelve-month extension of the SMP. They view cooperation with the IMF as helpful and beneficial. With the current program due to expire in September 2005 and the work on the interim Afghanistan National Development Strategy (I-ANDS) still underway, the authorities expressed interest for a further 12-month extension of the current SMP, through end-September 2006. The mission welcomed such a request, which will provide the authorities with a framework to maintain macroeconomic stability and pursue structural reforms, especially in the areas of fiscal administration and financial sector development. Nonetheless, the IMF is ready to open negotiations on a PRGF-supported program before the SMP expires if the authorities indicate they are prepared to do so.

14. The growth outlook remains positive. In view of the recovery in agricultural output, as well as continued sustained activity in construction, telecommunications, and transport, the real GDP growth projection of 13.6 percent for 2005/06 remained unchanged. In 2006/07, as agricultural growth returns to its trend, economic growth is likely to moderate somewhat, to a projected 10.9 percent. On account of the expected slowdown in rents and food prices and of the tightening of the monetary stance, inflation is expected to decline further, to 10 percent year-on-year at end-2005/06 and 8 percent year-on-year at end 2006/07.

15. The mission encouraged the authorities to pursue steadfastly the implementation of their anti-narcotics strategy, to ensure that the decline in opium production observed this year is sustained over the medium-term. This year's sharp decline in cultivation validated the authorities' multi-pronged approach, combining eradication, interdiction and alternative livelihoods. Nonetheless, there is no room for complacency, as these gains could quickly reverse, especially if farmgate prices start increasing and sustainable alternatives are not developed. Continued efforts and new initiatives from both the government and its development partners are required on all fronts. The persistence of relatively low farmgate prices should help the authorities in pursuing their strategy.

16. While welcoming the authorities' efforts to strengthen capacity in the line ministries, the mission cautioned against creating unsustainable structures and emphasized the need to produce a more realistic budget. The focus of technical assistance towards the line ministries and the creation of a National Project Support Office may help build the capacity needed to implement development programs. However, the mission cautioned against the establishment of unsustainable institutions within government, which are often donor-funded.3 Another issue is that the budget will continue to overstate spending and inflate expectations, unless the presentation of the budget is grounded in more realistic cash-based assumptions regarding domestic revenue growth, the rate of donor disbursements (rather than pledges or multi-year commitments), and the likely rate of absorption over the medium-term.

17. The mission welcomed the maintenance of the "no-overdraft" financing commitment. It means that the core budget will continue to be funded by domestic revenues and foreign grants. The mission notes the importance of the external supplementary budget, which is executed directly by donors. For 2005/06, it is estimated to be equivalent to 44 percent of GDP, compared with estimated disbursements of 35 percent of GDP in 2004/05. Nonetheless, part of the external budget (equivalent to 21 percent of GDP) is unfunded and projects will not commence until the funding is secured.

18. The recently published Public Financial Management Law provides the basis for improving budget management. This law (whose publication was an end-June 2005 benchmark) sets out a clear and transparent budget framework and provides stricter guidelines for budget formulation, execution and financing, and a consistent framework for internal control and internal and external audit. While recognizing that it will take time to embed these new practices and build capacity throughout the public financial management system, the mission calls for an urgent revision of financial regulations and procedures to help implement the law. The mission welcomed the publication of monthly statements of fiscal performance for the core budget and the intention to produce a regular quarterly fiscal bulletin during the year, both of which should enhance fiscal transparency.

19. The mission encouraged the government to put in place an affordable and realistic Medium-Term Fiscal Framework (MTFF) to provide the budgetary link to the national sector policies that will be included in the Afghanistan National Development Strategy (ANDS). The MTFF, whose adoption is an end-December benchmark, should better integrate the macroeconomic framework with fiscal policies, assumptions and projections over the next three to five years. This framework should better articulate a path towards fiscal sustainability, including the government's significant financing requirements. Donors could then be encouraged to channel a larger share of their resources through the budget with greater multi-year predictability, assuming fiduciary standards and transparency in the use of resources continues to improve. In the interim, the external budget, which includes significant recurrent spending (such as for the ANA), will remain sizeable. In order for the government to develop comprehensive, sustainable fiscal and sectoral policies, donors need to provide more timely and reliable information on expenditures currently outside the core budget, consistent with the government's budget classification.

20. The mission stressed the need to consult with development partners prior to making budgetary adjustments in the mid-year review (MYR), scheduled for September/October 2005. The mission encouraged the authorities to coordinate this year's exercise with the development of the MTFF to improve the realism of the budget processes, to enhance the comprehensiveness of the budget, transparency in the use of resources, and to improve the links between recurrent and capital costs.

21. Any wage adjustment should be consistent with a move towards fiscal sustainability over the medium-term and with the public administration reform (PAR). In light of the current low level of wages and the fact that no wage increase has been awarded since November 2003, a nominal wage increase may be warranted at the time of the MYR. Nonetheless, the scope for a large wage increase is limited as domestic revenues cover only about 50 percent of the operating budget, and wage-related costs are expected to rise considerably as a result of the proposed PAR and the need to absorb additional security-related costs.4Nonetheless, any increase in the wage bill for non-uniformed civil servants of up to Af 600 million in 2004/05 might be affordable, if more than covered by additional domestic revenues compared to the budget estimate. It should also not undermine a realistic PAR. The mission stressed the importance of carefully quantifying and controlling any pay award (as there are currently many different allowances in the complicated pay structure) and also of discussing these proposals with key donors who finance a significant share of the budget.

22. Increasing domestic revenues over the medium term is of critical importance. The authorities concurred that the SMP revenue target for 2005/06, which is slightly higher than the budget projection but, at 5.2 percent of GDP, is still one of the lowest in the world, is achievable provided that customs and tax administration reform programs are well implemented.5 The mission emphasized the importance of strengthening the large taxpayer unit, establishing tax enforcement powers (an end-September 2005 benchmark), and improving tax and customs administration and infrastructure. At the same time, the Ministry of Finance must reduce graft and eliminate nuisance taxes, which are a real impediment to private sector activity. Formal regulations and procedures to support the customs code and the income tax law are also be required. The mission welcomed the authorities' resolve to implement the recent tax policy reforms and their willingness to consider the introduction of excise taxes in the near future.

23. Improvements in the domestic revenue administration and the payment and accounting systems are predicated on the reform of the provincial treasuries (Mustofiats). Enhancing capacity, systems and reorganizing the Mustofiats along functional lines, with separate reporting to the Treasury and General Presidency of Revenue, are critical to improving revenue collection and public financial management. The mission urged the authorities to accelerate the pilot reform and restructuring programs in the five largest regional centers.

24. Monetary policy will continue to be guided by the 2005/06 monetary program agreed on at the time of the third review. The program provides for a further tightening of the monetary stance during the remainder of the year, consistent with DAB's primary objective to bring inflation under 10 percent. The authorities agreed with the mission that they could have adopted a more restrictive approach during the first quarter so as to generate more room to accommodate the expected sharp seasonal increase in money demand during the remainder of the first semester, and therefore reduce the risk of a large appreciation because of substantial foreign exchange intervention. The authorities indicated that they had since adopted such an approach. The monetary program will remain flexible to be able to accommodate unanticipated shifts in the demand for currency. International reserves are expected to increase further, to about $1.7 billion at end-2005/06, equivalent to 4.8 months of 2006/07 imports.

25. The modernization of DAB's operations and the simplification of its balance sheet will continue. To address more effectively the commercial banks' liquidity needs, DAB will introduce, with technical assistance from the IMF, an overnight collateralized credit facility against capital notes and allow participants in the foreign currency auctions to sell, as well as to buy, dollars. If the demand for capital notes, notably from the private banks, continues to increase, DAB will introduce longer-maturity notes. DAB will discuss with the banking community ways to support this demand. Consistent with the authorities' commitment to transparency, the capital note interest rates will be published. DAB's commercial accounts in its city branches in Kabul, and in its branches located in provinces where at least one fully-licensed commercial bank operates, will be reimbursed, transferred to other entities, or frozen. Lastly, to allow DAB to increase its reserves and ensure that it is adequately capitalized, the gold held in the palace vaults should be processed into a form that qualifies as a reserve asset, and the monetary gold held in Afghanistan transferred to an international gold center.

26. The mission stressed the need to tackle the administrative and legal impediments to the development of the banking sector. The mission encouraged the authorities to work with the banking and donor communities to prioritize reforms aimed at strengthening the banking sector regulatory framework. In particular, the authorities should determine for each key law (mortgage law, insurance law, land titling and property registration law) whether it needs to be amended, and/or which measures are needed to ensure proper enforcement. The authorities are also committed to eliminate the registration fees for deeds, or at least reduce them sufficiently to bring them in line with international standards. These fees have proved to be a major deterrent to lending operations associated with immovable property, as well as a major source of corruption.

27. The mission urged the authorities to intensify their efforts to resolve the former state-owned banks and to restructure the licensed state-owned banks. As a formal decision regarding the process of the resolution of the 3 former state-owned banks has yet to be taken, and as there appeared to be pressures to revive at least one of them, the mission cautioned the authorities against such a course of action. In particular, the mission emphasized that the rural financing needs of the country would be best served by means other than the creation of a sectoral bank. The mission was therefore encouraged by the authorities' commitment to liquidate these banks. The mission was also encouraged by their commitment to assign new management teams or engage management advisors to implement the restructuring plans, due by end-September 2005, for the three licensed state-owned banks. The mission encouraged the authorities to consider all options for the banks, including the liquidation or privatization of some ,or all of them. Lastly, the mission stressed the need for DAB to ensure that the conditions attached to the relicensing of these banks are strictly met.

28. The authorities continue to make progress in their good faith efforts to complete the external debt survey as well as in formulating an external debt management strategy. The mission welcomed the initiative taken by the authorities to closely liaise with the Paris Club Secretariat to survey and reconcile any outstanding debt due to Paris Club creditors. The mission reiterated its willingness to facilitate exchanges between the government and officials of non-Paris Club creditors.

29. The mission supports the current agenda of structural reforms. It is appropriately articulated around creating an enabling environment for private investors and enhancing the efficiency of the public sector. The mission encouraged the authorities to accelerate work underway to put in place a modern and simplified tax system, an adequate legal framework for business, and simplified procedures for enterprises. The mission agrees with the government's agenda to streamline the role of government in the economy, and looks forward to the adoption by end-September 2005 of a comprehensive divestment plan and a classification of state-owned enterprises (SOEs) by planned method. Regarding work underway on a retrenchment plan associated with divesting in those SOEs, the mission emphasizes the importance of designing a plan that will be fiscally sustainable and thus set the standard for future retrenchment.

30. The mission stresses the importance of improving the reliability and timeliness of economic statistics to support the formulation and monitoring of macroeconomic and social policies. While acknowledging progress in some areas, there are still weaknesses in others including national accounts, balance of payments, and monetary statistics. The mission urged the authorities to pursue, with assistance from the donor community, their efforts and take measures to address data issues. The adoption of a statistical law would in particular provide the much-needed legal framework and help improve and strengthen data collection and processing in line with international standards. In addition, the restructuring of the Central Statistics Office (CSO) would strengthen its capacity to produce economic data, consistent with the statistical master plan adopted by the government in September 2004. In this regard, the mission considers that there is no alternative for an independent CSO, which should be provided with adequate means to carry out its mission. Regarding balance of payments data, the mission urged the authorities to continue strengthening the processes for evaluating non-recorded trade flows, extending coverage and consistency of data and grants, and securing data on financial flows from the banking community. Lastly, the mission encouraged the authorities to pursue work on the national risk vulnerability assessment survey on rural households and soon launch the integrated living standard survey on household income and expenditure and the integrated business enterprise survey (which will cover a sample of about 1000 medium and large enterprises). These surveys are critical in providing a baseline for measuring poverty and development progress.

31. Work on the ANDS is under way, and an I-PRSP is expected to be completed by end-December 2005. The mission noted that an extensive consultation process was being developed. While this is a welcome development, the mission encouraged the authorities to prioritize and focus their efforts on: (i) the determinants of poverty. (ii) the sources of growth; and (iii) on ways to integrate medium-term fiscal choices, included in a MTFF within a medium-term framework. While there is a clear need for a genuine and extensive consultative process to facilitate ownership of their development strategy and address poverty concerns, the mission recommends that the focus now be on understanding the determinants of poverty, the sources of growth, and the design of an adequate integrated macroeconomic framework highlighting the main priorities of the time. The I-PRSP process is in its early stages, but priorities can, and should be established for the upcoming donors' conference and the budget; nonetheless these priorities are expected to change as a result of a full consultative process by the time the full PRSP is completed.

32. The technical coordination committee (TCC) will continue to play a critical role in the months ahead monitoring execution of the SMP and reporting key data to the IMF. In the process, the TCC has acquired significant information and knowledge about the Afghan economy. At this juncture, it is now important that the TCC reaches out by making key economic date available to the public and government agencies to enhance ownership. At the same time, the mission recommended that the TCC focus on developing its analytical capacity.

33. The mission urged the authorities to complete the ongoing technical assistance review and address the distortions and weaknesses identified so far, establish new priorities, redeploy resources to sectors in need, and require reporting of deliverables by technical assistance providers.

34. The sixth review under the SMP will take place in November 2005. It will review observance of the end-September 2005 quantitative indicators and structural benchmarks. Policy discussions will cover the findings of the mid-year budgetary review (MYR), scheduled for September/October, fiscal and external sustainability, tax and customs reforms, and progress made in bank restructuring.

35. The mission emphasized that the IMF remains committed to helping Afghanistan build capacity a and help implement with success its program and address the significant challenges lying ahead.

1 The year-on-year increase in the national CPI, which covers five major cities in addition to Kabul, declined from 11.6 percent to 10.3 percent, due essentially to the slowdown in rents.

2 The Ministry of Finance recently introduced new procedures to reconcile revenue reports and banking data. Over time, this should enhance the integrity of fiscal reporting, although discrepancies are currently significant.

3 One recent example of this approach has been the creation of the Counter Narcotics Ministry(CBM), funded almost entirely outside of the operating budget, where salaries are reportedly significantly above approved civil service pay scales. While the issue is being addressed in the CNM, the problem is widespread in government, where the desire to improve capacity quickly has led to wage rates considerably in excess of current pay scales.

4 In order to make progress in closing the absolute gap between domestic revenue and operating costs, revenues have to grow at a considerably faster pace than operating expenditures over the medium-term.

5 The SMP revenue target is Af 18,328 million, compared to a budget target of Af 16,510 million.


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