Mission Concluding Statement 

Islamic State of Afghanistan -- Concluding Statement of the First Quarterly Review, Under the IMF Staff-Monitored Program

August 5, 2004

Over the past two weeks, a staff team from the International Monetary Fund (IMF) held extensive discussions with the authorities to assess developments in the Afghan economy, conduct the first quarterly review under the 2004/05 staff-monitored program (SMP), and set indicative targets and structural benchmarks for the remainder of the year. The mission also met with representatives of banks, private sector, NGOs and donors. Presented below is the mission's assessment.

I. Performance Under the SMP

1. A staff team from the IMF visited Kabul during the period July 11-25 to review performance under the SMP for the first quarter of the program (April-June 2004). Performance during this period has been in line with the commitments made under the program. The staff's assessment is that the authorities have met all of the indicative quantitative targets set out under the SMP, and virtually all the structural benchmarks. The only exception was the benchmark on licensing of commercial banks, due to what the staff view as a fully justified technical delay. The mission also agreed with the authorities on targets and policies for the remainder of the year.

2. The IMF staff view the authorities' performance in the first quarter as a notable achievement, but are cognizant that meeting the objectives established for the remainder of the program will take a continued major effort. The results achieved so far were due largely to the determined efforts of the Ministry of Finance and the Central Bank to deliver on an ambitious reform agenda. Meeting the quantitative targets and structural benchmarks set out for the remainder of the program, however, will require diligence and cooperation from the government as a whole. Therefore, the staff view as essential that ownership of the program be broad-based, and that the program receives the support required for continued success.

II. Recent Economic Developments

3. There have been significant revisions to key economic indicators, which make the interpretation of the overall economic picture difficult. Of particular significance is the downward revision in GDP growth for 2003/04, from 23 percent to 16 percent, largely reflecting lower-than-anticipated output in the agricultural sector. Inflation has been somewhat higher than expected during the first quarter of 2004/05, reflecting primarily increases in rents and the prices of other non-tradable goods.

4. Fiscal revenue for the first quarter of 2004/05 is estimated to have reached Afs 2.64 billion, slightly exceeding the SMP target level of Afs 2.59 billion. Similar to the pattern observed in 2003/04, the government's operating expenditures during the first quarter(Afs 4.8 billion) were well below what might have been expected for the first quarter given a budgeted amount of Afs 30.3 billion (10.5 percent of GDP) for all of 2004/05. The slow pace of spending during the first quarter was largely attributed to problems in communicating budget allotments and the employee register to line ministries and the provincial government units (moustoufiats), ongoing procurement constraints and weak financial management capacity. Given the high demands for improved security, reconstruction and poverty reduction, the mission emphasized the need for the government to try and meet its spending objectives in these priority areas while ensuring that appropriate expenditure controls are in place to safeguard and account for these resources.

5. Monetary growth was lower than projected, and the rise in international reserves exceeded the program target. The Afghani has remained strong through the first quarter of 2004/05, which appears to reflect an increased willingness by the population, particularly in rural areas, to accept the new currency as a medium of exchange and a store of value. The strength of the Afghani was also supported by prudent macroeconomic policies including strict application of a `no-overdraft rule' by the Ministry of Finance and adherence by the Central Bank to the SMP monetary growth target.

6. Reliable balance of payments data are not yet available, although efforts to build statistical capacity in this area are underway. Best estimates, however, indicate that the external current account (excluding grants) deteriorated significantly in 2003/04, due largely to a surge in imports associated with reconstruction and rising consumer demand.

III. Macroeconomic Outlook and Policy Framework

7. The discussions with the authorities focused on maintaining macroeconomic stability in a period of massive economic change, along with capacity building and the structural reforms necessary to support successful performance under the SMP. While staff remain concerned about potential downside risks to the macroeconomic outlook because of continued insecurity in a number of provinces and the reemergence of drought, these appear balanced by the continuous delivery of external assistance following the recent Berlin Conference, the growing confidence in the Afghani, and the expected coming on stream of several projects in the agricultural and manufacturing sectors. Also encouraging has been the pace of structural and policy reform over the last two years. Critical measures, such as licensing of commercial banks, passage of key customs and revenue reforms, improved financial and fiscal reporting, adoption of a comprehensive current and development budget, improved public expenditure management, and some initial steps in dealing with civil service pay reform and state owned enterprises are laying a strong basis for future performance

8. The significant revision of key economic indicators for 2003/04 warranted a revision of the medium term macroeconomic framework. The recent pickup in inflation is a concern, and will be monitored closely. The revised program aims at containing inflation to 10 percent compared with a 5 percent target under the original framework, which is now viewed as unrealistic considering the first quarter outcome. The staff believe that the unexpected shortfall in agricultural production is temporary and that climatic conditions and improvements in agricultural infrastructure will allow for gains in this area. The construction sector is also expected to perform strongly. Overall, GDP growth is now projected at 16 percent in 2004/05, compared with 15 percent under the original projection. This, together with a stable exchange rate, is expected to lead to a rise of per capita income to $246, compared with $199 in 2003/04.

9. Against this background, the government and the staff agreed on a revised macroeconomic framework for 2004/05, and on a set of structural benchmarks for end-December 2004 and end-March 2005 which continue to support macroeconomic stability and the government's structural reforms. The staff view these targets and benchmarks as ambitious, but achievable. Much will depend on intragovernmental cooperation, and mustering political support for the program.

Fiscal Issues

10. Meeting the revenue targets set out under the program will require concerted efforts by the authorities to address deficiencies in collection and transfer. Fiscal revenue (excluding grants) during the first quarter of FY2004/05 was significantly higher than during the same period last year but only slightly above the target set out in the SMP, which is consistent with an annual projection that is far less ambitious than the budget forecast. Reaching the budgeted revenue target for the year will therefore be a challenge. Aware of this, the government reiterated its commitment to fully implement a wide range of planned customs and tax reforms, step up collection efforts, particularly in the provinces for customs, and eliminate tax holidays and concession agreements. The mission warned that success will require an intense cooperation among ministries and the provincial authorities. The mission also urged the authorities to address the legal and institutional bottlenecks and to clarify the policy issues that have delayed a considerable amount of economic legislation.

11. Expenditure management must be improved if development objectives are to be met. The mission welcomed the adoption in June 2004 of a `core budget', that consolidated the operating budget with development expenditures that are financed by donors but reported through government systems. This should significantly enhance fiscal coordination and transparency. Continued adherence to the `no-overdraft rule' will ensure that fiscal policy is designed to avoid inflationary financing. At the same time, actions to make full use of available grants and concessional financing should substantially increase the resources available for priority spending. In spite of the slow pace of operating budget spending during the first quarter of the year, the staff strongly support the authorities efforts to enforce appropriate expenditure controls to ensure accountability but acknowledge that, until capacity is further developed throughout government, there may be further payment delays in non-salary expenses. Nonetheless, there are reasons to believe that there will be a significant pick up in spending during the remainder of the year as public expenditure management systems and capacity improve. The government is also encouraged to continue its efforts to work more closely with donors to enhance the pace and effectiveness of development expenditures.

Monetary Policy

12. The built-in flexibility mechanism in the monetary program developed with IMF staff in March 2004 will help the Da Afghanistan Bank to continue to effectively implement a monetary policy stance aimed at lowering inflation, while guarding against currency instability. As designed, the monetary program allows the central bank some room to accommodate apparent shifts in money demand. Should this flexibility prove insufficient, however, the IMF stands ready to discuss with the authorities the need for an adjustment of the monetary policy framework, in view of developments in key indicators. As the current consumer price index—which is limited to Kabul—is still a weak indicator for inflation across the country, particular attention will be devoted to exchange rate developments. Furthermore, it is the intention of the authorities and the staff to improve their understanding of the factors driving monetary conditions in Afghanistan. Monthly cash flow projections from the Ministry of Finance will be one crucial element in this exercise.

Structural Reforms

13. The authorities have taken welcome steps to begin rationalizing the public enterprise sector. They are conducting an assessment of the financial situation of state-owned enterprises (SOEs) which will help them decide whether each SOE will be liquidated, privatized, or will remain in the government's portfolio. To address critical deficiencies in the business investment climate, an action plan is being prepared. It will include reforms of the commercial code, property rights, and bankruptcy legislation.

14. The authorities intend to continue their efforts to create a sound financial system. In this context, the Central Bank will work toward improving the payments system, which is an essential element in extending the delivery of government services outside of Kabul. The Central Bank will also proceed with bank licensing and strengthen its supervision. Finally, an auction process for a short-term capital note will be introduced, which the staff see as the first step in establishing a money market.

15. The mission recognizes that, since its inception, the Inter-Ministerial Technical Committee (TC) has been instrumental in effectively monitoring the implementation of the SMP and in providing core data to the IMF. Looking ahead, the mission encourages the TC to focus its efforts on the timely execution of the SMP, intensifying the dialogue between government agencies, and setting the standards for better economic management.

16. The staff continue to see capacity building—in a broad range of areas—as the foundation of sustainable macroeconomic management and perhaps the single-most important precursor to a formal IMF arrangement. Intergovernmental cooperation is one key area. The collaborative approach embodied in the TC is certainly one element in this regard, and the staff hope to see this level of intergovernmental cooperation and communication expand. Building Afghanistan's statistical capacity is another key element. Expansion of the CPI to five additional cities will provide a sounder basis for the evaluation of monetary policy, while regular publication of quarterly fiscal data will aid putting macro-fiscal coordination on a sound footing. Implementing a plan to record duty-exempt imports should aid in evaluating the impact of donor spending on the external accounts. Finally, work on debt reconciliation and the development of a coherent government-backed strategy on debt management must also continue to ensure medium- and long-term external sustainability.

IV. Concluding Remarks

17. Despite a difficult security environment, the government of Afghanistan has demonstrated a high level of performance during the first three months of the SMP. It is clear, however, that the remaining three quarters of the current year will be no less difficult than the first. Both the authorities and the staff must demonstrate diligence to ensure that key program targets and benchmarks are met. At the same time, the paucity of reliable economic data and the rapidly changing economic environment imply that flexibility and a willingness to reevaluate previous assumptions will continue to be necessary. Continued close consultation with the IMF will be the critical element in this regard. Continued satisfactory progress under the SMP would lay the foundations for a comprehensive successor program for 2005/06.

18. The mission supports the government's intention to publish the updated Letter of Intent and Memorandum of Financial and Economic Policies, which clarify and elaborate on the changes in the government's program with the IMF.