Press Release No. 08/20

Press Release No. 08/20

An International Monetary Fund staff team visited Kabul during January 26-February 5, 2008. Discussions with the Afghan authorities and other donor partners focused on measures to deal with the domestic revenue shortfall, inflationary pressures, and measures to mitigate the impact of high wheat prices on vulnerable households. The mission also discussed the reform prioritiesof the program supported by the IMF under the Poverty Reduction and Growth Facility (PRGF) and progress towards completing the Afghanistan National Development Strategy (ANDS). Political support to bolster revenue performance will be crucial to keep the program on track.

1. Performance under the IMF-supported program during the third quarter of 2007/08 fell short of expectations. The indicative floor on fiscal revenue and the ceiling on currency in circulation (CiC) were both missed by approximately Af 1 billion. Higher prices of imported fuel and foodstuffs led to an increase in consumer prices, with 12-month (end-of-period) inflation reaching 17 percent in December 2007. Following an increase in foreign exchange and capital notes (CNs) auction volumes in late December 2007, the Afghani has appreciated by nearly 1 percent against the U.S. dollar.

2. The domestic revenue shortfall over the first three quarters of 2007/08 raises concerns about revenue reform and fiscal sustainability. The Ministry of Finance's (MOF's) efforts to enhance revenue collection have been hindered by lack of political support, and the measures to bolster revenue collection agreed on during the November 2007 IMF mission have not yet been implemented. In the absence of renewed political support, it will be difficult to bring revenue back on track.

3. Prudent execution of the core operating budget permitted the observance of the December 2007 indicative targets on the operating budget deficit and central bank financing of the government. Core operating expenditure has been below projections due, in part, to slower than expected increases in security outlays. Expenditure in the core development budget was broadly in line with program projections but, consistent with previous years, is expected to increase substantially in the fourth quarter. Nonetheless, it is likely to be significantly below the budgeted amount.

4. The MOF submitted the draft core budget for 2008/09 to Parliament within the timeframe specified by the Public Finance and Expenditure Management Law. The mission notes that the operating budget deviates somewhat from understandings reached with Fund staff in November 2007. The overall envelope exceeds agreed expenditure by Af 2 billion (0.4 percent of GDP) on account of a contingency for accelerating the recruitment by the Afghan National Army. Also, the authorities reallocated Af 1.5 billion in cash set aside as a fuel allowance for the Ministry of Interior, following commitments of in-kind donations for the same purpose. More generally, the reallocation of expenditure from operation and maintenance to salaries undermines the government's capacity to maintain infrastructure. The operating budget envelope will be reevaluated at the time of the fourth review.

5. The mission welcomed the repeal of the Presidential decree that allowed selected businesses to import raw materials at a preferential tariff rate. There have been, however, further ad hoc changes to the tariff schedule that have been implemented without prior consultation with Fund staff.

6. The authorities continue to make good progress in preparing the ANDS, which they expect to complete in March/April 2008. The mission commended the authorities for completing the politically difficult process of intersectoral prioritization, and welcomed the integration of the three priority sectors that have been fully costed into the 2008/09 budget.

7. Growth of CiC surged in December 2007 on account of unexpectedly high injections of liquidity, compounded by difficulties in conducting mopping up operations during bank holidays. Subsequently, DAB increased foreign exchange interventions and successfully reversed the surge in CiC in early January. The mission encouraged DAB to engage the MOF in efforts to improve the projection of the government's cash-flow needs for the remainder of 2007/08.

8. DAB's decision to increase the issuance of capital notes (CNs) is commendable, but efforts are needed to integrate CNs into the overall monetary policy framework. To that end, the mission encouraged DAB to proceed prudently with its plans to increase the volume of CNs, in order to prevent unnecessary fluctuations in bank liquidity. The mission also welcomed progress toward the development of a secondary market in CNs.

9. The mission commended DAB for the successful outcome of the special audit to confirm the existence and the availability of its foreign reserves, as reported to the IMF at the September 2007 test date. It also welcomed the early appointment of an internationally-reputable accounting firm to audit DAB's annual financial statements for 2007/08, and urged DAB to follow up on its commitments to improve the accounting system, which underpins data reliability.

10. In line with program understandings, DAB proceeded with measures to strengthen banking supervision and the regulatory framework for the banking sector. The mission welcomed the issuance of regulations on credit-granting standards and the credit monitoring process, and on sectoral loan concentration. It also commended DAB for the expeditious issuance of two circulars informing banks of changes to the minimum capital requirement and repealing the requirement to invest 80 percent of deposits domestically. Regarding Bank Pashtany, the mission noted the imminent completion of an external audit and urged the authorities to integrate its findings into the restructuring plan of Bank Pashtany.

11. The mission welcomed the authorities' intention to accelerate reforms in the electricity sector. It held constructive discussions with the MOF on an agreement that would link explicitly the disbursement of subsidies to the state-owned electricity company, DABM, with reform benchmarks. It will require a high degree of pragmatism and political will to carry out the necessary reforms.

12. The mission recognized the importance of mitigating the effects of rising wheat prices on vulnerable households. The authorities are already involved, together with the World Food Program (WFP), in a joint appeal to distribute wheat to the worst-affected areas. The mission consulted with the authorities, the WFP, and other donors on government plans for further assistance to vulnerable groups. In that context, the mission argued that additional efforts by the government should be complementary to the existing programs and rely on targeted cash-transfers to vulnerable households, instead of direct wheat imports. This approach would help avoid further distorting the market and ensure that support can be made available promptly. In any event, the mission urged the authorities to source the funds for these purposes from within the existing budget envelope and to ensure that the assistance is well targeted.

13. The mission will return to Kabul in April/May 2008 to conduct the discussions for the fourth review under the PRGF-supported program.

14. As on previous occasions, the mission appreciated the open and frank dialogue with the Afghan authorities, parliamentarians, and other public sector representatives. The mission thanks them for the time and effort that they put into the discussions.