Mission Concluding Statement 

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

April 30, 2008

An IMF staff team visited Kabul during April 19─May 1, 2008. Discussions with the Ministry of Finance (MOF) and Da Afghanistan Bank (DAB) focused on maintaining macroeconomic stability and other reform priorities, including steps to address the revenue slippage in the second half of 2007/08. The mission reached understandings with the authorities on prior actions that will need to be implemented before the completion of the fourth review under the PRGF program. Looking ahead, continued macroeconomic discipline, effective revenue mobilization, progress in key structural reforms, policies to enhance private sector development, and political support for the reform agenda are critical for Afghanistan to keep the program with the IMF on track and to achieve the growth potential and poverty reduction objectives spelled out in the Afghanistan National Development Strategy (ANDS).

Program Performance

1. Performance under the PRGF program in the second half of 2007/08 fell short of expectations. The authorities met all quantitative performance criteria and indicative targets for end-2007/08, with the notable exception of the floor on domestic revenue, which was missed by a 6 percent margin. Nonetheless, preliminary data suggest that expenditure restraint permitted observance of the targets on the operating budget deficit and central bank financing of the government. Real GDP growth in 2007/08 was revised downward to 11.5 percent, mainly because the drought in 2006/07 was less severe, and the ensuing 2007/08 rebound in agriculture weaker than previously thought. Higher prices of imported fuel and foodstuffs led to an increase in consumer prices, with 12-month (end-of-period) inflation reaching 20.7 percent in March 2008.

2. Domestic revenue declined as a share of GDP from 7.5 percent in 2006/07 to 7.0 percent in 2007/08, but the operating deficit target excluding grants has been attained. While lower than projected imports may have contributed to the revenue shortfall, key factors behind the disappointing revenue performance were policy inertia, inadequate enforcement efforts, and undervaluation of petroleum imports by customs. Nevertheless, the operating budget deficit excluding grants is estimated to have narrowed from 3.8 percent of GDP in 2006/07 to 3.6 percent in 2007/08 (slightly better than programmed). Development expenditures are estimated to have been broadly in line with program projections at Af 45 billion, or 9.4 percent of GDP.

3. Despite the effect of higher inflation on money demand and a surge in government spending during the last months of 2007/08, the central bank observed the ceiling on currency in circulation in the program. Currency in circulation grew by 18.5 percent in 2007/08—significantly below the growth of nominal GDP (24 percent).

4. DAB is gradually improving its capacity to supervise the banking sector, but there is an urgent need to strengthen enforcement procedures further. To contain emerging risks in the banking sector, DAB continues to restrict credit growth of weak banks to 5 percent per quarter, and has refrained from issuing any licenses for new branches to these banks.

5. Despite important steps taken to restructure the state-owned electricity provider (DABM), its relations with the MOF are yet to be put on a sustainable footing. In March 2008, Cabinet adopted the articles of incorporation of the state-owned electricity provider (transforming DABM into DABS), thereby allowing it to operate on a commercial basis. However, the authorities missed the structural benchmark on the conclusion of an agreement between the MOF and the DABM on quarterly reform benchmarks in exchange for subsidy disbursements.

6. Performance in a number of areas has been mixed. The authorities met the structural benchmarks on the: (i) submission of the core budget to parliament; (ii) publication of the schedule of fees charged by the state-owned petroleum enterprise (FLGE); (iii) establishment of a system for automatic monitoring of the central bank's six regional branches from DAB's headquarters; and (iv) repeal of the requirement for commercial banks to invest 80 percent of their deposits in the domestic economy. However, policy inertia and the lack of a consensus among key stakeholders further delayed preparation of a comprehensive restructuring plan for non-Tassady enterprises. Other commitments, ranging from a review of fiscal relations between the government and key state-owned enterprises to the passage of important pieces of legislation aimed at improving the business climate and strengthening the financial sector, have not yet been fulfilled.

Policies and Prospects for 2008/09

7. For 2008/09, real GDP growth is projected to moderate to 7.5 percent due to a downward revision of the growth projection for agricultural output on account of drought during the Spring germination period. Inflation is projected to decelerate to 13 percent at year-end. The external position is projected to strengthen further due to strong export growth, mining-related FDI, and aid inflows in excess of 50 percent of GDP.

8. With the prospect of scaled-up aid flows in the context of the ANDS, the authorities' need to ensure the implementation of fiscally sustainable policies. The quantitative fiscal program for 2008/09 seeks to rebuild a track record in revenue performance and maintain expenditure discipline. The revenue target of Af 42.9 billion (7.3 percent of GDP) includes policy measures estimated to yield additional revenue equivalent to 0.4 percent of GDP. The operating expenditure envelope remains as programmed at Af 63.4 billion, plus an adjuster (Af 1.9 billion) for a security contingency to enable acceleration of ANA recruitment. Following the receipt of in-kind donations for Ministry of Interior fuel, the authorities reallocated the cash set aside for that purpose to increase the food allowances for the army and police, in response to food price increases.

9. Improvements in revenue performance are crucial to maintaining the PRGF program on track. Corrective measures to bring the revenue performance in line with the program are feasible but their implementation will require resolve and diligence. The mission agreed with the authorities on several measures to be implemented before the IMF Executive Board discussion for the fourth review of the program.

10. Monetary policy will remain focused on containing inflationary pressures. To that end, DAB will need to strengthen its cooperation with the Ministry of Finance in preparing liquidity forecasts and will need to develop a framework for timely monitoring of commercial banks' liquidity. The mission welcomed DAB's intention to increase the role of capital notes auctions and to develop the secondary market for these instruments. However, volumes of capital notes auctions should be commensurate with market conditions to avoid unnecessary interest rate volatility.

11. Rapid growth in commercial bank activities calls for further strengthening of regulatory and enforcement procedures. The mission stressed the importance of strict and prompt corrective measures when warranted by bank examinations.

12. The mission urged the authorities to move forward with structural reforms to enhance private sector development, investment, and growth. This includes following up on commitments to improve transparency in the domestic petroleum sector and preparing for the privatization of FLGE. Regarding state-owned enterprises, the mission urged the authorities to accelerate the restructuring/privatization of the most important non-Tassady enterprises. The mission also stressed the need to clarify the relationship between the budget and key public enterprises.

13. The mission welcomed the completion of the ANDS and looked forward to its implementation. A Joint Staff Advisory Note is currently being prepared by staffs of the World Bank and the IMF and will be discussed, together with the ANDS, at the Boards of the two institutions in early June, 2008.

14. The Government has decided to purchase about US$50 million of wheat from neighboring countries to sell in the domestic market. The mission urged the Government to sell the imported wheat at a price consistent with full cost recovery, and in a manner that would minimize distortions in the domestic wheat market. The government plan is unlikely to allay social concerns about the increase in food prices. The mission recommended instead that the government work with donors to develop mechanisms to provide assistance to the needy and argued that additional efforts by the government should rely on targeted cash transfers to vulnerable households, instead of direct wheat imports.

15. The mission stressed the importance of improving data collection, particularly in the areas of national accounts, trade, and poverty indicators. The authorities will need to seek donor support in these areas and be prepared to mobilize funding, as necessary, from discretionary development expenditure to revamp and equip properly the Central Statistics Office (CSO) and strengthen its professional capacity.

16. The mission will return to Kabul in July 2008 for a staff visit to discuss performance under the program. 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.