Public Information Notice No. 03/147

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the Islamic State of Afghanistan

December 22, 2003

On November 21, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Islamic State of Afghanistan.¹

Background

The starting point for Afghanistan's reconstruction at the end of 2001 was unusually dire. After more than 20 years of conflict, interspersed with earthquakes and drought, the new Afghan authorities confronted their task with a largely defunct government and financial institutions, weak administrative capacity, and the widespread destruction of the country's infrastructure. Social indicators were among the worst in the world.

The authorities have made solid progress in rebuilding institutions and implementing sound economic policies. Fiscal policy has been characterized by a strong commitment to respect fiscal discipline and refrain from monetary financing. Big strides were made in improving expenditure management. An ambitious customs policy reform package is about to be approved and is to be followed by a reform of tax policy and administration. A new currency was launched in late 2002 and monetary policy has been restrained since then. As a result, prices and the exchange rate have been broadly stable in 2003. New financial sector legislation was adopted in the summer of 2003, granting the central bank autonomy and paving the way for establishing a modern banking sector.

The economy shows strong signs of recovery, albeit from very low levels of activity, reflecting not only the end of major hostilities, but also the end of a prolonged drought and the impact of sizable donor assistance and sound economic policies. Real GDP, excluding opium production, is estimated to have grown by almost 30 percent in 2002/03, driven by donor assistance and the end to a prolonged drought.² The impact of international assistance (and also of opium revenues, see below) is most visible in services and construction, which are expanding rapidly in urban centers. Agricultural production rose sharply in 2002/03, benefiting from increased rainfall and expanded acreage under cultivation. Agricultural production continued to increase this year, and combined with further strong growth in services and construction, GDP is expected to grow by 20 percent in 2003/04.

But while the formal economy is recovering, so is the production of opium. In 2002, opium production was estimated by the United Nations Office on Drugs and Crime (UNODC) to have reached 3,400 tons, a level similar to that of the late 1990s. Production in 2003 increased further to 3,600 tons. The opium sector has a profound impact on the economy and may account for about half of overall GDP.

Executive Board Assessment

Directors welcomed the opportunity to assess Afghanistan's economic performance and prospects for the first time in 12 years. They were strongly encouraged by Afghanistan's important progress over the past 18 months in rebuilding key institutions and restoring macroeconomic stability. Directors were particularly encouraged by the authorities' strong commitment to prudent macroeconomic policies and management, which, together with sizable international aid and the end of the drought, had provided an environment conducive to the resumption of economic growth. They expressed strong concern that any worsening in the fragile security situation might jeopardize the progress achieved so far and emphasized the need for the international community to continue to play a key role in the reconstruction process.

Directors noted that the government would require substantial resources in the period ahead in order to address more aggressively the many basic needs in the areas of security, health, education, and institutional reforms. They viewed progress in these areas as a necessary condition for promoting sustainable economic growth. In this regard, Directors underscored the importance of maintaining substantial donor assistance.

Directors supported efforts to put in place revenue-raising measures to reduce the dependence of the operating budget on donor assistance in due course. They supported measures to broaden the sources of revenue through tax policy and customs reform and improved collection, particularly from the provinces. Although significant strides have already been made in improving fiscal management, Directors looked forward to further progress in improving revenue transfers from the provinces to the central government, and budget formulation and execution.

Directors encouraged a process of meaningful civil service reform, including to the civil service wage system. They welcomed the progress toward the integration of donor projects into the development budget, which would facilitate the comprehensive monitoring of projects, and ensure their consistency with the authorities' overall strategy, as outlined in the National Development Framework, and thus promote a greater contribution of the authorities to the "ownership" of these projects. They emphasized the importance of this process, especially as donor assistance gradually shifts from budgetary support to development and reconstruction.

Directors commended the authorities on the successful introduction of the new currency and noted that introducing a new currency in a post-conflict environment such as in Afghanistan was a major accomplishment. They regarded prudent monetary policy supported by strong fiscal discipline, including the "no-overdraft" rule for budget financing that prohibits central bank financing of the deficit, as instrumental in ensuring the stability of the exchange rate of the new currency. On the exchange rate regime, Directors saw merit in a "lightly managed" float for a country which remains vulnerable to shocks, and is undergoing structural changes and reconstruction, though a few Directors cautioned against using a narrow or rigid target range for the exchange rate.

Directors welcomed the authorities' commitment to a liberal trade and exchange regime and urged them to act swiftly to clarify the regulatory environment. They supported the provision of Fund technical support to draft the appropriate laws and regulations needed for the acceptance by Afghanistan of the obligations under Article VIII, Sections 2, 3, and 4.

Directors commended the creation of a supervision department in the central bank, and emphasized the importance of further developing regulatory and supervisory capacities, and restructuring and privatizing state banks. They urged tighter control of informal mechanisms of financing, and the introduction of anti-money laundering and controlling the financing of terrorism legislation.

Directors considered that the authorities faced major challenges and risks in their efforts. They concurred that one of the most prominent risks is a lack of security and the limited rule of law, highlighted by the government's limited control over the provinces. They considered that restoring adequate security throughout the country remains a key priority to facilitate the implementation of reforms and projects, as well as the resumption of private economic activity and the provision of basic public services beyond Kabul. In this regard, Directors stressed the need for the international community to support the government in its efforts.

Directors were concerned about the serious risks posed by the rise in poppy cultivation and the production of opium in Afghanistan to levels of the late 1990s. In this regard, they urged the authorities to intensify eradication programs with the help of the international community, and to provide farmers with alternative livelihoods to avoid a downward spiral of violence and corruption.

Directors considered that poverty alleviation in Afghanistan will require strong economic growth for many years to come, as per capita GDP remains one of the lowest in the world. They observed that a key support in sustaining economic growth, and reconstruction and development, will be maintaining a high level of donor support, predominantly in the form of grants, in view of Afghanistan's limited debt servicing capacity. Directors welcomed the debt relief that had already been provided by some countries and encouraged the authorities to pursue debt cancellations from other major creditors and regularization of relations with all creditors. They welcomed the formation of a debt management unit.

Looking ahead, they emphasized the importance of Afghanistan attracting substantial private investment to eventually take the place of official assistance and in general of developing a solid private sector. They also encouraged the authorities to prepare the ground for privatization of state-owned companies. Directors saw several key areas of reform as preconditions, including putting in place a functioning financial system, a market-oriented regulatory framework, and a functioning and fair legal system to firmly establish the rule of law and the security of property rights.

Directors stressed that the process of maintaining macroeconomic stability and moving the reform program ahead will require sustained efforts to strengthen and maintain the political and public consensus for the reforms, strong policy actions, the support of the international community, and a strengthened administrative capacity. To this end, Directors supported Afghanistan's intention to undertake a staff-monitored program in the period ahead. They viewed this as an appropriate framework for improving policy formulation capacity, strengthening economic management, and better coordinating and targeting technical assistance, and an important step for the preparation for a Poverty Reduction and Growth Facility arrangement. They encouraged the authorities to make full use of donors and Fund technical assistance. In this context, some Directors referred to the possibility of a post-conflict arrangement.

In view of the poor quality of Afghanistan's macroeconomic statistics, Directors welcomed recent improvements in the quality of fiscal and monetary data and indicated that substantial efforts will be needed to bring the data quality to levels adequate for surveillance and program monitoring.