Mission Concluding Statement 

Islamic Republic of Afghanistan -- Statement by the IMF Mission at the Conclusion of the Discussions for the Second Review under the Poverty Reduction and Growth Facility Arrangement

May 10, 2007

Kabul, May 10, 2007

Afghanistan's performance during the 2006/07 fiscal year conformed broadly with the objectives of the program supported by the Poverty Reduction and Growth Facility Arrangement. Economic growth has been sustained, albeit at a lower rate than in recent years, inflation subsided, and fiscal and monetary developments remained favorable. The program remains on track, but political pressures could complicate macroeconomic management and could pose a risk to the achievement of the revenue targets. Looking ahead, continued macroeconomic discipline, effective revenue mobilization, progress in key structural reforms, policies to enhance private sector development, and political resolve to tackle difficult issues are critical to continued success.

1. An IMF staff team visited Kabul during April 25-May 10, 2007 to hold discussions on the second review under the Poverty Reduction and Growth Facility (PRGF) arrangement. Discussions focused on macroeconomic developments in 2006/07 (fiscal year ended March 20), compliance with the March 2007 quantitative performance criteria and targets, structural conditionality, and the policies for 2007/08 and the medium term. The mission also discussed Afghanistan's eligibility under the Heavily Indebted Poor Countries (HIPC) Initiative and finalized understandings on the details of the floating completion point triggers that fall within IMF's mandate. It is envisaged that the HIPC decision point document and staff report for the second review under the PRGF arrangement will be considered by the IMF Executive Board in early July 2007.

Program Performance

2. Performance under the program during 2006/07 was broadly satisfactory. All the March 2007 quantitative performance criteria and indicative targets, as well as the structural benchmarks for the second review, were observed, except for the benchmark related to state-owned enterprises (SOEs) and government agencies engaged in commercial activities (see ¶6). Real GDP growth is preliminarily estimated at 7½ percent in 2006/07, excluding opium production, which is estimated to have increased significantly. Year-on-year (end-of-period) inflation in March 2007, as measured by the consumer price index for Kabul, declined to about 4.8 percent, while "national" inflation—covering Kabul and five other cities—was 3.9 percent.

3. The overall fiscal position in 2006/07 was somewhat stronger than envisaged in the program. Preliminary data indicate that the operating budget deficit (excluding grants) was 3.6 percent of GDP, compared to a program target of 4.1 percent. Revenue collection was robust in the last quarter of 2006/07, and the March 2007 performance criterion was met comfortably. Revenue is estimated to have reached 7.0 percent of GDP in 2006/07, or about 6.6 percent above the program target. Operating expenditure was 10.5 percent of GDP, in line with the program. Over 40 percent of the operating budget was spent on defense, public order, and safety. Development budget expenditure, at 7.9 percent of GDP, was approximately half of the budgeted amount—an increase of over 50 percent compared to the previous year.

4. Monetary developments point to increased confidence in the Afghani. International reserves increased further and the exchange rate remained broadly stable (about Afs 50 per U.S. dollar), while the demand for domestic currency and deposits grew steadily. Currency in circulation increased by 12.4 percent. The end-2006/07 program targets for currency in circulation and net international reserves were met with comfortable margins. Commercial bank deposits and lending more than doubled; bank operations continued to be heavily dollarized.

5. Da Afghanistan Bank (DAB) broadened the role of capital notes in absorbing liquidity, although foreign exchange auctions remain the primary instrument of monetary policy. In the last quarter of 2006/07, the volume of 28-day capital notes (CNs) weekly auctions was increased, and 182-day CNs were launched. DAB also began preparing for introducing standard settlement procedures for secondary market trading and instructions for the recording of secondary trades.

6. The structural benchmarks related to state-owned banks and DAB accounting system were observed. However, the benchmark on adopting a comprehensive restructuring/ divestment plan for public entities, or government agencies engaged in commercial activities but not covered by the SOEs law, was not met. The World Bank document Afghanistan: Privatization Strategy Note—submitted to the authorities in May 2007—should facilitate the development of such a plan. More generally, the absence of decisive action to restructure or divest SOEs risks eroding the value of their assets—as demonstrated recently by public disclosure of the dire financial position of the national airline, Ariana.

7. Several other important commitments from the existing reform agenda are yet to be met. While the mission welcomes the steps taken to clarify and document the roles of various agencies currently operating at the borders, it is important that the document prepared to that effect be disseminated among the agencies concerned and made operational. Also, an agreement among the Ministry of Finance, the Ministry of Energy and Water, and the electricity company (DABM) to reduce energy subsidies over time is still pending. The mission hopes that the authorities will overcome the factors delaying the submission to parliament of a number of laws, including the secure transactions law, business organization laws, and negotiable instruments law.

8. While fiscal reforms have proceeded adequately, the loss of momentum in the area of tax and customs administration reform and, more generally revenue policy and collection, poses a risk to achieving the revenue targets (see below). Staff morale is low in the revenue department and there have been massive voluntary departures due to the absence of political support for tax enforcement. Staff morale in the customs department has also declined, while political pressures are distorting the tariff schedule.

9. Concessions to some manufacturers by increasing protection on final goods and lowering duty rates on raw materials have undermined the stated objective of a streamlined and transparent customs regime. Specifically (i) a new 40 percent tariff rate was introduced on soft drinks and bottled water; and (ii) a presidential decree was issued allowing producers to apply for a 1 percent rate (instead of regular tariff rates) on raw materials and intermediate goods, subject to approval by the Afghanistan Investment Support Agency. The authorities have indicated that these changes seek to offset high production costs for domestic producers and unfair competition from subsidized imports from regional trading partners.

10. The authorities have intensified efforts to regularize relations with creditors following the IMF and World Bank Boards' preliminary assessment of Afghanistan's eligibility for assistance under the HIPC Initiative. Consistent with the July 2006 Paris Club agreement, they have signed bilateral agreements with two creditors, and are close to finalizing the third and final agreement. However, there is a need to expedite discussions on the clearance of arrears to the OPEC Fund for International Development.

Policies and Prospects for 2007/08

11. GDP growth is projected to reach 13 percent in 2007/08, primarily due to a rebound in agricultural output. Kabul inflation is projected to increase slightly to about 6 percent, owing to higher food prices and transportation costs, and the current account deficit (excluding grants) is expected to decline to 40¼ percent of GDP. Foreign exchange reserves are expected to reach approximately US$2.4 billion (about 5.2 months of imports) by end-2007/08.

12. The operating budget deficit (excluding grants) is projected at 3.7 percent of GDP in 2007/08. Operating expenditure is programmed at Afs 53.6 billion (11 percent of GDP), and the development expenditure envelope approved by parliament amounts to Afs 77.0 billion (15.8 percent of GDP). However, consistent with performance in earlier years, the amount programmed for development expenditure has been set below that level, at Afs 44 billion (9.1 percent of GDP), with an automatic adjustment of the program ceiling up to the budgeted amount, if necessary. The authorities' objective of covering operating budget expenditures with operating revenue is projected to be achieved by 2012/13, implying a need for continued donor support to the recurrent budget for at least another five years. The mission encourages the authorities to use the Medium-Term Fiscal Framework, clearly anchored on a deficit target, as a tool for a disciplined approach to fiscal policy and for engaging donors to discuss the level of external support needed for the recurrent budget.

13. Further improvements in revenue performance are crucial. Revenue is targeted to increase by 24 percent in nominal terms in 2007/08, to Afs 35.7 billion (7.3 percent of GDP). To achieve this target, the mission believes that it is critical to resist political pressures in the areas of revenue policy and administration, and to muster government-wide support for reform in these areas. Additional measures to ensure adequate revenue performance would include strong backing for the customs and tax reform plans, and support to the Large Taxpayer Office (LTO) for collection enforcement and audit. The mission recommends that, looking ahead, the government intensifies its consultations with the IMF on a new tax policy framework.

14. The mission is concerned about recent changes to the customs tariff schedule. The new 40 percent tariff rate could protect inefficient industries, put upward pressure on domestic prices, and increase the incentives for smuggling, resulting in lower customs collections. The discretionary application of the 1 percent rate to selected producers is of particular concern, as it could lead to distortions and lack of transparency. The mission encourages the authorities to take timely steps to reverse these changes, recognizing that this issue will need to be addressed at the highest political level. It is also critical that the government refrains from granting further concessions and reclassifying additional goods into the three top tariff bands.

15. The operating budget ratified by parliament conforms with the program for 2007/08. However, non-security expenditure pressures may emerge later in the year and may need to be addressed in the context of the midyear review of the budget and third review under the PRGF. The scope for expanding the expenditure envelope will be linked closely to the revenue performance.

16. Given Ariana's acute financial weaknesses and the lack of a comprehensive restructuring plan, the mission urges the government not to use its scarce resources to support it. In particular, the government should not (i) assume payment obligations for liabilities contracted by Ariana without government guarantee; (ii) provide government guarantees for new obligations; or (iii) pressure banks, particularly state-owned banks, to provide loans or guarantees. Any possible budget support for Ariana should be funded from within the existing operating expenditure envelope (implying difficult choices of prioritization for the government) and be contingent on a robust restructuring plan.

17. Monetary policy remains appropriate but rapid growth in commercial banks' activities calls for further strengthening of the regulatory and supervisory framework. The mission would like to stress the need to continue improving bank supervision and to put in place regulations on credit risk management, including lending standards and credit monitoring processes. Regulations are also needed on setting limits on sectoral loan concentration. To enhance transparency and disclosure, banks should be required to publish their audited annual financial statements.

18. The mission's discussions confirmed the need to reinvigorate the momentum for structural reforms to enhance private sector development, investment and growth. This includes legislative and regulatory reforms and restructuring/divestment plans for state-owned banks, SOEs, and government entities engaged in commercial activities. In this connection, the government should intensify its divestment efforts, or risks a further erosion of the value of these enterprises.

19. The mission welcomes progress toward preparing the Afghanistan National Development Strategy, as reported to development partners at the Afghanistan Development Forum in Kabul on April 29-30, 2007.

20. Afghanistan' s technical assistance (TA) needs remain extensive. The mission urges the authorities to continue working closely with development partners to build administrative capacity and implement recommendations of TA providers. However, there is a need for better coordination among donors and multilateral institutions to improve TA effectiveness. The Fund stands ready to support the authorities in its areas of expertise.

21. The mission to conduct the discussions for the third annual review under the PRGF-supported program is scheduled for October/November 2007. It will benefit from the findings of a staff visit planned for July 2007.

22. As on previous occasions, the mission appreciated greatly the open and frank dialogue with the authorities and other public and private sector representatives. We would like to thank all of them for the hospitality, time and effort put into the discussions.