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Islamic Republic of Afghanistan: Staff Report for the 2005 Article IV Consultation and Sixth Review Under the Staff-Monitored Program

Author(s):
International Monetary Fund
Published Date:
March 2006
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I. Overview

1. Since the inception of the staff-monitored program (SMP) in March 2004, the Afghan authorities have pursued prudent fiscal and monetary policies and have implemented a number of important institutional and structural reforms, which have contributed to the stabilization of the economy and the resumption of growth. Commendable efforts have been made to improve revenue collection, establish a transparent expenditure system with fiduciary standards, and modernize central bank operations while strengthening the banking sector regulatory framework. These efforts took place within a difficult environment, dominated by continued insecurity and a heavy political agenda. Looking ahead, the authorities face the challenges of diversifying the sources of growth; achieving external and fiscal sustainability; enhancing the competitiveness of the economy; removing institutional and structural obstacles to private sector development; and gradually eliminating opium-related activities.

2. Afghanistan’s first legislative and provincial elections took place on September 18, 2005. About 50 percent of the 12.4 million eligible Afghans voted in elections for the 249-seat parliament and 34 provincial councils. Although some leading parliamentarians are not supportive of President Karzai’s government, they indicated their intention to work in a constructive fashion with the present administration. The parliament held its first meeting on December 19, 2005.

3. The security situation remains volatile. The number of incidents increased in the period leading to, and in the aftermath of the legislative elections, likely due to a resurgence of Taliban activity and the government’s counternarcotics efforts.

4. Performance under the SMP during the second quarter of 2005/06 (the period covered by the sixth review) continued to be favorable, notwithstanding minor slippages in the implementation of structural reforms. While these slippages do not reflect a change in policy priorities, they illustrate the need for the authorities to remain focused on the reform program and strengthen ownership.

II. Background and Performance Under the Staff-Monitored Program

5. The government met all the end-September 2005 quantitative indicators and observed, albeit with some delays, all structural benchmarks, except for the publication of the audited 2004/05 core budget financial statements.1 This performance was achieved in the context of the preparations for the elections.

6. After slowing down sharply in early 2004/05, economic activity has rebounded over the last 12 months, in line with program projections (Tables 1 and 2). These swings in economic activity reflected primarily the impact of weather conditions on agricultural output: cereal production fell by 17 percent in 2004/05, before recovering in 2005/06. At the same time, the reconstruction effort continued to drive growth in construction, trade, transportation, and telecommunications. Although it is slowing, real growth remained strong at 30 percent in the industrial sector and 31 percent in services.2

Table 1.Islamic Republic of Afghanistan: Selected Economic Indicators, 2001/02–2006/07(Quota: SDR 161.9 million)(Population: 21.8 million; 2002/03)(Per capita GDP: US$253; 2004/05)(Poverty rate: n.a)(Main export: carpets, US$156 million; 2003/04)
Est.Est.Est.Est.Proj.Proj.
2001/022002/032003/042004/052005/062006/07
(Annual percentage change)
Output and prices
Real GDP (at market prices)28.615.78.013.811.7
Consumer prices (end of period)-43.452.110.216.310.08.0
Consumer prices (period average)5.023.914.312.08.9
(In percent of GDP)
Investment and saving
Gross domestic formation34.542.045.243.140.8
Of which: nongovernment7.58.110.310.911.4
Gross national savings1.1-8.90.30.70.9
Of which: nongovernment5.7-4.44.94.54.1
(In percent of GDP)
Public finances 1/
Revenue (including grants)8.49.09.810.09.2
Expenditure8.59.89.49.48.9
Budget balance (including grants)-0.1-0.80.40.60.4
Primary balance (including grants)-0.1-0.80.40.60.4
Total government debt 2/13.113.512.5
(Annual percentage change; unless otherwise indicated)
Monetary sector
Credit to the private sector
Base money20.140.937.527.822.5
Broad money20.140.937.527.822.5
Velocity of broad money8.87.87.37.27.1
One-month capital note interest rate (end-period, in percent)4.27
(In percent of GDP; unless otherwise indicated)
External sector
Exports of goods (in U.S. dollars, percentage change) 3/36.125.020.120.6
Imports of goods (in U.S. dollars, percentage change) 3/51.818.214.915.1
Merchandise trade balance-29.8-41.3-37.0-35.2-33.3
Current account balance, excluding official transfers-33.4-50.9-44.8-42.4-39.9
Current account balance, including official transfers-3.53.11.91.7-0.9
Foreign direct investment1.21.33.13.54.2
Total external debt 2/13.113.512.5
Gross reserves (in millions of U.S. dollars)4268161,2611,7302,119
In months of next year imports of goods and services 3/1.83.44.04.85.8
In percent of short-term external debt (on remaining maturity basis)
Memorandum items:
Nominal GDP (excluding opium production; in millions of U.S. dollars)2,4634,0844,5855,9717,1398,608
Opium production (in millions of U.S. dollars)2,5402,3002,8002,700
Unemployment rate (in percent)
Net imports of petroleum products (in millions of U.S. dollars)132477
Afghanis per U.S. dollar (period average)54.444.849.047.7
Real exchange rate (annual average, percentage change) 4/21.012.214.9
Stock market index
Sources: Afghan authorities; and Fund staff estimates and projections.

Operating budget. Does not include externally-financed development expenditures, which amounted to 40 percent of GDP in 2004/05.

Includes unreconciled debts. Excludes Russian claims.

Excluding reexports.

An increase in the exchange rate indices corresponds to an appreciation. The real exchange rate is estimated using the U.S. and Afghan CPIs.

Sources: Afghan authorities; and Fund staff estimates and projections.

Operating budget. Does not include externally-financed development expenditures, which amounted to 40 percent of GDP in 2004/05.

Includes unreconciled debts. Excludes Russian claims.

Excluding reexports.

An increase in the exchange rate indices corresponds to an appreciation. The real exchange rate is estimated using the U.S. and Afghan CPIs.

Table 2.Islamic Republic of Aghanistan: Savings-Investment Balances, 2002/03–2007/08
Est.Rev.

Est.
Est.Rev.

Est.
Est.

Fifth

Rev.
Est.

Sixth

Rev.
Est.

Fifth

Rev.
Est.

Sixth

Rev.
Est.

Fifth

Rev.
Est.

Sixth

Rev.
Est.

Fifth

Rev.
Est.

Sixth

Rev.
2002/032003/042004/052005/062006/072007/08
(In millions of U.S. dollars)
Domestic expenditures5,4475,4476,9196,9198,6588,64710,32610,16511,97612,04513,03613,380
Consumption4,2934,0385,3054,9926,3395,9517,4327,0878,8578,53410,2949,950
Public 1/318318429429546546661640729778826903
Private 2/3,9753,7204,8754,5625,7935,4056,7716,4478,1287,7569,4689,047
Gross fixed capital formation1,1541,4091,6151,9282,3192,6962,8933,0783,1193,5112,7423,429
Public1,1041,1041,5571,5572,0822,0822,3312,2982,4332,5261,9312,307
Private 3/50305583712376145627806869858111,122
Net exports of goods and services-1,364-1,364-2,335-2,335-2,688-2,676-3,196-3,026-3,415-3,437-3,086-3,381
Exports of goods and services (excluding reexports)328328482482564564685686825829956960
Imports of goods and services (excluding reexports)-1,691-1,691-2,817-2,817-3,251-3,239-3,881-3,712-4,240-4,266-4,042-4,341
Domestic savings-21045-720-407-36920-30353-29674-34349
Public savings-187-187-203-203-251-273-246-266-234-275-249-279
Private savings-23232-517-204-118293-57319-61349-94328
GDP at market prices4,0844,0844,5854,5855,9715,9717,1307,1398,5628,6089,9519,999
(In percent of GDP)
Domestic expenditures133.4133.4150.9150.9145.0144.8144.8142.4139.9139.9131.0133.8
Consumption105.198.9115.7108.9106.299.7104.299.3103.599.1103.499.5
Public7.87.89.49.49.19.19.39.08.59.08.39.0
Private97.391.1106.399.597.090.595.090.394.990.195.290.5
Gross fixed capital formation28.334.535.242.038.845.240.643.136.440.827.634.3
Public27.027.034.034.034.934.932.732.228.429.319.423.1
Private1.27.51.38.14.010.37.910.98.011.48.211.2
Net exports of goods and services-33.4-33.4-50.9-50.9-45.0-44.8-44.8-42.4-39.9-39.9-31.0-33.8
Exports of goods and services (excluding reexports)8.08.010.510.59.49.49.69.69.69.69.69.6
Imports of goods and services (excluding reexports)-41.4-41.4-61.4-61.4-54.4-54.3-54.4-52.0-49.5-49.6-40.6-43.4
Domestic savings-5.11.1-15.7-8.9-6.20.3-4.20.7-3.50.9-3.40.5
Public savings-4.6-4.6-4.4-4.4-4.2-4.6-3.4-3.7-2.7-3.2-2.5-2.8
Private savings-0.65.7-11.3-4.4-2.04.9-0.84.5-0.74.1-0.93.3
Memorandum items:
Real GDP growth (annual percentage change)28.628.615.715.78.08.013.613.811.211.710.710.6
Nominal GDP growth (annual percentage change)33.833.823.123.126.426.424.925.120.120.616.216.2
Sectoral shares of GDP (in percent)
Agriculture49.849.848.548.537.237.236.136.134.334.333.533.5
Industry20.120.121.321.324.424.424.824.824.724.725.125.1
Services30.130.130.230.238.338.339.239.241.041.041.441.4
GDP per capita (in U.S. dollars)182182199199253253294294344344388388
Domestic government revenue (in percent of GDP)3.23.24.54.54.54.55.25.35.26.05.56.4
Sources: Afghan authorities; and Fund staff estimates and projections.

Data originating from the fiscal accounts.

Determined as a residual.

Equivalent to foreign direct investment reported in the balance of payments, and some new private investment.

Sources: Afghan authorities; and Fund staff estimates and projections.

Data originating from the fiscal accounts.

Determined as a residual.

Equivalent to foreign direct investment reported in the balance of payments, and some new private investment.

7. The drug economy remains a major challenge for the government. Opium production declined by 2 percent in 2005, as a 21 percent reduction in cultivated areas was offset by an increase in yields due to favorable weather conditions. The sharp decline in cultivated areas was due primarily to many farmers not planting in anticipation of intensified government-led anti-narcotics activities. Increased drug seizures and eradication efforts continued to have a modest direct impact relative to the size of the problem. Opium prices fell slightly, which contributed to declines in export and farm gate values of 4 percent and 7 percent, respectively, to $2.7 billion and $560 million.

8. After rising sharply in 2004/05 on account of an acceleration of rents and petroleum product prices, inflation subsided over the first half of 2005/06, reflecting primarily a slowdown in rents (Figure 1). Year-on-year inflation declined to 12.9 percent in September 2005, from 16.3 percent in March, as envisaged in the program.3 However, excluding rents and petroleum product prices, inflation rose slightly to 12.7 percent in September, from 11.1 percent in March, owing mainly to sharp increases in bread and cereal prices. After appreciating during the first half of 2004/05, the Afghani was broadly stable in real effective terms during the 12 months ending in September 2005, the nominal depreciation of the currency being offset by a positive inflation differential.

Figure 1.Islamic Republic of Afghanistan: Price Developments, 2003–2005 1/

Sources: Central Statistics Office of Afghanistan; and Fund staff estimates.

1/ Last observation: September 2005.

9. The fiscal program is on track as the authorities remain committed to fiscal discipline and continue to improve fiscal management. The operating budget deficit, excluding grants, reached 4.9 percent of GDP in 2004/05 and 1.7 percent of annual GDP during the first half of 2005/06 (Tables 3a and 3b). This deficit was slightly lower than envisaged; combined with higher-than-expected grants, it contributed to a further build up of government deposits with Da Afghanistan Bank (DAB).

Table 3a.Islamic Republic of Afghanistan: Core Budget, 2003/04–2008/09
H1RevisedYTD
Est.Est.Est.MYR 1/Prov.Proj. 2/Proj. 2/Proj. 2/Proj. 2/
2003/042004/052004/052005/062005/062005/062006/072007/082008/09
(In millions of Afghanis)
Domestic revenue10,1685,94712,80018,7358,75218,77625,86431,97039,835
Tax revenues6,2624,4889,54613,1285,67012,70519,71724,21230,257
Taxes on income, profits and capital gains3635449953,7894281,7383,3455,6547,059
Taxes on international trade and transactions5,3693,2547,2478,9174,5739,32314,34715,63519,155
Other taxes5316911,3044226691,6432,0252,9234,043
Non tax revenues3,9061,4583,2545,6073,0826,0726,1477,7599,578
Donor assistance grants (to operating budget)10,0743,85814,98416,8788,58816,87813,73312,12210,248
ARTF (recurrent window)8,1823,37212,31913,5807,25713,58010,58010,0629,080
LOTFA1,8924042,5833,2981,3313,2983,1532,0601,168
Other grants8383000000
Donor assistance grants (core development budget)4,5692,8318,25029,0138,00820,01932,50636,04439,145
Total core budget expenditure31,60615,49939,55083,66623,58655,86570,86081,69295,575
Operating expenditure22,15112,01926,71633,60114,68033,60138,04344,09250,643
Wages and salaries14,6608,24518,90220,7889,34720,97223,91828,36433,117
Purchase of goods and services4,6532,0644,1826,6093,2336,6097,3578,2459,244
Transfers and Subsidies6523147642,29302,1092,4782,8133,186
Pensions1774698891,6597821,6591,7421,8291,920
Capital expenditure2,0099271,9791,8471,2221,8472,1322,4212,750
Interest40496404415420425
Core budget development spending3/9,4553,48112,83450,0668,90622,26532,81837,60044,933
National programs3,3393,22512,07044,3518,22820,57129,12033,48840,186
1.4 Livelihoods and Social Protection15917956013,5853,9979,99216,53319,01322,816
1.5 Culture, Media, Sport00028437106122147
2.1 Transport756592,1739,8931,9824,9544,5085,1846,221
2.2 Energy, Mining, and Telecommunications8522589327,9929312,3292,1132,4302,916
2.3 Natural Resources Management4491,9874,6092,7752153546275
2.4 Urban Management394002,2532746841,1611,3361,603
3.1 Trade and Investment950038637121417
3.2 Public Administration and Economic Management59846614,6297581,8963,4904,0144,817
3.3 Justice0802,5814124303441
3.4 National Police, Law Enforcement and Stabilization319161,1532,5122586441,1121,2791,535
3.5 Afghan National Army39900000000
National priority programs6,1152567655,7156781,6943,6974,1114,746
Education and Vocational Training289471723,1472436081,0031,1541,385
Health and Nutrition5082095791,5834211,0521,7472,0092,411
Other programs5,3180139851434947949951
Operating budget balance (excluding grants)-11,983-6,072-13,916-14,866-5,929-14,824-12,179-12,122-10,808
Operating budget balance (including grants)-1,910-2,2131,0682,0122,6602,0541,5540-560
Core budget balance-6,795-2,863-3,516-19,0401,761-1921,242-1,556-6,348
Float and adjustment4/1,6939213570-1,6300000
Sale of nonfinancial assets5/0003,98703,987000
Financing5,1021,9423,15815,054-131-3,795-1,2421,5566,348
External loans (net)4,8869,33614,75423,9462,7014,2363,8807,3517,750
Domestic (net), of which:217-7,394-11,596-8,892-2,832-8,031-5,122-5,795-1,402
Change in foreign currency deposits 6/396-8,912-10,457na-3,313-5,718-3,647nana
Change on domestic currency deposits 6/-1791,518-1,139na481-2,313-1,475nana
Memorandum item:
Domestic revenue (government medium-term targets) 7/18,84228,87334,53943,260
External budget expenditure 8/74,528100,225105,394na102,958104,67987,44983,077
GDP225,108284,504355,829429,014498,353574,883
Real GDP growth rate (in percent)15.78.013.811.710.69.9
Sources: Ministry of Finance (MoF) and Da Afghanistan Bank (DAB); and Fund staff estimates and projections.

November 2005 supplementary budget relased following the midyear budget review (MYR).

Staff projections. Operating budget expenditure is consistent with the authorities medium-term fiscal framework (MTFF) but domestic revenue, development spending and funding/financing are lower.

Government program classification.

Variation between the fiscal position recorded at MoF and DAB. This discrepancy is partially due to the difference (“float”) between checks issued and checks cashed.

For 2005/06 this includes US$80 million in revenue from the sale of telecommunications licenses.

Net transfers from government deposits with DAB. A positive sign corresponds to a decline in balances and a negative sign to an increase in balances.

Government revenue projections from the MTFF, which assume considerable policy changes and new measures.

For 2005/06 the budget estimate includes only the funded portion of expected expenditure.

Sources: Ministry of Finance (MoF) and Da Afghanistan Bank (DAB); and Fund staff estimates and projections.

November 2005 supplementary budget relased following the midyear budget review (MYR).

Staff projections. Operating budget expenditure is consistent with the authorities medium-term fiscal framework (MTFF) but domestic revenue, development spending and funding/financing are lower.

Government program classification.

Variation between the fiscal position recorded at MoF and DAB. This discrepancy is partially due to the difference (“float”) between checks issued and checks cashed.

For 2005/06 this includes US$80 million in revenue from the sale of telecommunications licenses.

Net transfers from government deposits with DAB. A positive sign corresponds to a decline in balances and a negative sign to an increase in balances.

Government revenue projections from the MTFF, which assume considerable policy changes and new measures.

For 2005/06 the budget estimate includes only the funded portion of expected expenditure.

Table 3b.Islamic Republic of Afghanistan: Core Budget, 2003/04–2008/09
H1RevisedH1
Est.Est.Est.MYR 1/Prov.Proj. 2/Proj. 2/Proj. 2/Proj. 2/
2003/042004/052004/052005/062005/062005/062006/072007/082008/09
(In percent of GDP)
Domestic revenue4.52.14.55.32.55.36.06.46.9
Tax revenues2.81.63.43.71.63.64.64.95.3
Taxes on income, profits, and capital gains0.20.20.31.10.10.50.81.11.2
Taxes on international trade and transactions2.41.12.52.51.32.63.33.13.3
Other taxes0.20.20.50.10.20.50.50.60.7
Non tax revenues1.70.51.11.60.91.71.41.61.7
Donor assistance grants (to operating budget)4.51.45.34.72.44.73.22.41.8
ARTF (recurrent window)3.61.24.33.82.03.82.52.01.6
LOTFA0.80.10.90.90.40.90.70.40.2
Other grants0.00.00.00.00.00.00.00.00.0
Donor assistance grants (core development budget)2.01.02.98.22.35.67.67.26.8
Total core budget expenditure14.05.413.923.56.615.716.516.416.6
Operating expenditure9.84.29.49.44.19.48.98.88.8
Wages and salaries6.52.96.65.82.65.95.65.75.8
Purchase of goods and services2.10.71.51.90.91.91.71.71.6
Transfers and subsidies0.30.10.30.60.00.60.60.60.6
Pensions0.10.20.30.50.20.50.40.40.3
Capital expenditure0.90.30.70.50.30.50.50.50.5
Interest0.00.00.00.10.00.10.10.10.1
Core budget development spending 3/4.21.24.514.12.56.37.67.57.8
National programs1.51.14.212.52.35.86.86.77.0
1.4 Livelihoods and Social Protection0.10.10.23.81.12.83.93.84.0
1.5 Culture, Media, Sport0.00.00.00.10.00.00.00.00.0
2.1 Transport0.00.20.82.80.61.41.11.01.1
2.2 Energy, Mining, and Telecommunications0.40.10.32.20.30.70.50.50.5
2.3 Natural Resources Management0.20.71.60.80.00.00.00.00.0
2.4 Urban Management0.20.00.00.60.10.20.30.30.3
3.1 Trade and Investment0.00.00.00.10.00.00.00.00.0
3.2 Public Administration and Economic Management0.30.00.01.30.20.50.80.80.8
3.3 Justice0.00.00.90.00.00.00.00.00.0
3.4 National Police, Law Enforcement and Stabilization0.10.00.40.70.10.20.30.30.3
3.5 Afghan National Army0.20.00.00.00.00.00.00.00.0
National priority programs2.70.10.31.60.20.50.90.80.8
Education and Vocational Training0.10.00.10.90.10.20.20.20.2
Health and Nutrition0.20.10.20.40.10.30.40.40.4
Other programs2.40.00.00.30.00.00.20.20.2
Operating budget balance (excluding grants)-5.3-2.1-4.9-4.2-1.7-4.2-2.8-2.4-1.9
Operating budget balance (including grants)-0.8-0.80.40.60.70.60.40.0-0.1
Core budget balance-3.0-1.0-1.2-5.40.5-0.10.3-0.3-1.1
Float and adjustment 4/0.80.30.10.0-0.50.00.00.00.0
Sale of nonfinancial assets 5/0.00.00.01.10.01.10.00.00.0
Financing2.30.71.14.20.0-1.1-0.30.31.1
External loans (net)2.23.35.26.70.81.20.91.51.3
Domestic (net), of which:0.1-2.6-4.1-2.5-0.8-2.3-1.2-1.2-0.2
Change in foreign currency deposits 6/0.2-3.1-3.7na-0.9-1.6-0.9nana
Change on domestic currency deposits 6/-0.10.5-0.4na0.1-0.7-0.3nana
Memorandum item:
Domestic revenue (government medium-term targets) 7/5.36.76.97.5
External budget expenditure 8/33.10.035.229.6na28.924.417.514.5
Sources: Ministry of Finance (MoF) and Da Afghanistan Bank (DAB); and Fund staff estimates and projections.

November 2005 supplementary budget relased following the midyear budget review (MYR).

Staff projections. Operating budget expenditure is consistent with the authorities medium-term fiscal framework (MTFF) but domestic revenue, development spending and funding/financing are lower.

Government program classification.

Variation between the fiscal position recorded at MoF and DAB. This discrepancy is partially due to the difference (“float”) between checks issued and checks cashed.

For 2005/06 this includes $80 million in revenue from the sale of telecommunications licenses.

Net transfers from government deposits with DAB. A positive sign corresponds to a decline in balances and a negative sign to an increase in balances.

Government revenue projections from the MTFF, which assume considerable policy changes and new measures.

For 2005/06 the budget estimate includes only the funded portion of expected expenditure.

Sources: Ministry of Finance (MoF) and Da Afghanistan Bank (DAB); and Fund staff estimates and projections.

November 2005 supplementary budget relased following the midyear budget review (MYR).

Staff projections. Operating budget expenditure is consistent with the authorities medium-term fiscal framework (MTFF) but domestic revenue, development spending and funding/financing are lower.

Government program classification.

Variation between the fiscal position recorded at MoF and DAB. This discrepancy is partially due to the difference (“float”) between checks issued and checks cashed.

For 2005/06 this includes $80 million in revenue from the sale of telecommunications licenses.

Net transfers from government deposits with DAB. A positive sign corresponds to a decline in balances and a negative sign to an increase in balances.

Government revenue projections from the MTFF, which assume considerable policy changes and new measures.

For 2005/06 the budget estimate includes only the funded portion of expected expenditure.

10. During 2004/05 and the first half of 2005/06, revenue was broadly in line with program projections. Although customs reforms and larger transfers from the provinces led to a higher-than-expected increase in customs revenue, tax administration and tax policy reforms have yet to translate into higher domestic revenues. Domestic tax revenue declined by 9 percent in the first half of 2005/06 owing to reduced compliance stemming from uncertainty over the delay in passing the amended income tax laws, which were finally approved and published in the Official Gazette in November 2005. A number of recently adopted tax measures, including a higher turnover tax rate for specific services, a wage withholding tax, and an airport departure fee, took effect in October 2005. Lastly, in response to pressure from the private sector, the government recently: (a) eliminated the withholding tax on exports, which had been implemented in July 2005; (b) removed import duties on dye and yarn to assist domestic carpet makers, while raising the import tariff on finished carpets; and (c) exempted some basic commodities and livestock from customs duty and withholding tax, with a view to encouraging imports and reducing domestic prices.

11. Government spending, especially for development purposes, remained lower than budgeted because of capacity constraints. Core development expenditure reached 2.5 percent of annual GDP during the first half of 2005/06, compared with a revised budget target of 14.1 percent of GDP for the fiscal year as a whole. Despite well structured coordination mechanisms that seek to align donor activities with the government’s priority programs, limited information is available on external budget spending (projected at 29 percent of GDP in 2005/06), which is directly implemented by donors.4

12. The midyear budget review (MYR) was concluded in October 2005. The authorities capped the increase in operating expenditure to 2.1 percent over the budget, as a 3 percent increase in compensation for civil servants—agreed under the program—and unanticipated spending for parliamentarians and pensions were partially offset by savings in other expenditures. A medium-term fiscal framework (MTFF) was approved by Cabinet at the time of the MYR, including a set of integrated macroeconomic projections and fiscal targets that outline a path towards fiscal sustainability.

13. The authorities have continued to focus on improving fiscal management and transparency. The budgetary process and transparency have been strengthened through the adoption of a new public finance and expenditure management law, the routine reconciliation of the government’s fiscal and banking records, and the publication of monthly core budget reports. A World Bank study is helping to design the computerized financial management system that will eventually be rolled out to line ministries and provinces. However, the reconciliation of fiscal and banking data remains largely manual and constrained by existing procedures and information systems, and weak capacity. The external audit of the 2004/05 core budget financial statements was delayed by uncertainty over the appropriate procedures following the introduction of the new budget law.5 To avoid a repetition of these delays, the Ministry of Finance (MoF) and the Control and Audit Office will agree on an audit plan for 2005/06 before the end of the current fiscal year. A multi-year public administration reform program is expected to be adopted during the remainder of 2005/06.

14. Monetary developments during 2004/05 and through September 2005 remained broadly in line with SMP projections (Table 4). Monetary policy continued to be guided primarily by indicative targets for currency in circulation, and implemented almost entirely through foreign currency auctions.6 As expected, there was a marked slowdown in currency growth, due in part to the development of the banking sector. Currency in circulation rose by 11 percent during the first half of 2005/06, below the SMP indicative ceiling (13 percent). As the seasonal increase in money demand during the second quarter was less marked than last year, DAB was able to contain money growth within program limits without triggering an appreciation of the Afghani, such as the one observed in August 2004. International reserves reached $1.5 billion at end-September 2005 (equivalent to 4.1 months of 2006/07 imports of goods and nonfactor services), owing partly to the accumulation of deposits by the government. Interest rates on overnight and 30-day capital notes continued to move in the 1–2 percent and 4–6 percent ranges, respectively. Commercial bank lending operations increased at a brisk pace, albeit from a low base, with the banks’ deposit base rising by 9 percent during the first half of 2005/06.

Table 4.Islamic Republic of Afghanistan: Monetary Program (Da Afghanistan Bank), 2003/04–2006/07
Est.Est.EstProj.EstProjProj.
Mar. 19Mar. 20Jun. 21Sep. 22Sep. 22Dec. 20Mar. 20Jun. 21Sep. 21Dec. 20Mar. 20
2003/042004/052005/062006/07
(In millions of Afghanis)
Net foreign assets 1/39,19961,61265,72469,64071,83479,65085,44585,43889,44096,173105,124
Foreign assets41,16963,58267,69371,61073,80381,61987,41487,40891,41098,143107,094
Foreign exchange reserves40,66562,86167,07370,65372,70380,46986,21486,13390,06096,718105,594
Gold 1/14,01514,01514,01514,01514,01514,01514,01514,01514,01514,01514,015
Other26,65048,84653,05856,63858,68766,45472,19972,11876,04582,70391,579
Other foreign assets5037216219571,1011,1501,2001,2751,3501,4251,500
Foreign liabilities-1,970-1,970-1,970-1,970-1,970-1,970-1,970-1,970-1,970-1,970-1,970
Net domestic assets-8,075-20,549-23,477-23,796-27,295-30,894-33,324-31,894-31,508-35,156-40,985
Domestic assets6,795-19,751-19,576-19,576-22,627-25,836-27,782-25,782-24,782-27,782-32,904
Net claims on general government6,795-19,751-19,576-19,576-22,627-25,836-27,782-25,782-24,782-27,782-32,904
Net claims on government before 2002/0314,9510000000000
Net claims on government in 2002/3–2004/05-8,155-19,751-19,576-19,576-22,627-25,836-27,782-25,782-24,782-27,782-32,904
Domestic currency deposits-1,984-3,123-2,000-2,000-2,686-4,188-5,436-4,436-3,436-4,936-6,911
Foreign currency deposits-6,171-16,628-17,576-17,576-19,941-21,648-22,346-21,346-21,346-22,846-25,993
Other claims00000000000
Other items net-14,870-799-3,901-4,220-4,668-5,058-5,542-6,113-6,726-7,374-8,081
Reserve money31,12441,06342,24745,84544,53848,75552,12153,54457,93361,01764,140
Currency in circulation 2/28,80138,76340,08443,82042,99746,58549,52150,67854,79957,61760,640
Banknotes and coins issued29,72641,22842,75846,59145,82349,39852,32153,57857,79960,71763,840
less cash holdings 2/9252,4652,6742,7712,8252,8132,8002,9003,0003,1003,200
Bank deposits with DAB and capital note holdings2,3232,3002,1632,0251,5412,1702,6002,8673,1333,4003,500
Memorandum items:(In percent; unless otherwise indicated)
Currency in circulation (year-to-date change)3.413.010.920.227.82.310.716.322.5
Currency in circulation (year-on-year change)40.937.535.827.725.328.327.826.425.123.722.5
Currency in circulation (SMP indicative ceiling; in millions of Afghanis)43,82046,58549,52152,09354,799
Currency in circulation (level triggering discussions; in millions of Afghanis)46,06148,91451,99753,39657,539
Gross international reserves (end-of-period level; in millions of U.S. dollars)815.91,261.31,345.81,417.61,458.71,614.51,729.81,728.21,807.01,940.62,118.7
Consumer prices in Kabul (quarterly change)-0.53.22.42.6
Consumer prices in Kabul (annual change)10.216.311.512.910.08.0
Sources: Da Afghanistan Bank (DAB) and Central Statistics Office; and Fund staff estimates and projections.

Foreign currency amounts converted into Afghani at the program exchange rate (49.84 per dollar in 2004/05–05/06). Gold figures do not include the gold held in the palace vaults and is valued at US$400 per ounce in 2004/05–05/06.

In 2003/04–04/05, cash holdings only include cash in DAB’s Treasury vaults and in DAB’s six major provincial branches. In 2005/06–2006/07, they include cash in DAB’s Treasury vaults and in all DAB’s provincial branches.

Sources: Da Afghanistan Bank (DAB) and Central Statistics Office; and Fund staff estimates and projections.

Foreign currency amounts converted into Afghani at the program exchange rate (49.84 per dollar in 2004/05–05/06). Gold figures do not include the gold held in the palace vaults and is valued at US$400 per ounce in 2004/05–05/06.

In 2003/04–04/05, cash holdings only include cash in DAB’s Treasury vaults and in DAB’s six major provincial branches. In 2005/06–2006/07, they include cash in DAB’s Treasury vaults and in all DAB’s provincial branches.

15. The authorities made significant progress in modernizing DAB’s operations and strengthening the banking sector regulatory framework. In line with Fund recommendations, DAB modernized its foreign exchange and capital note auctions, made progress toward introducing new instruments and increasing transparency, restructured its balance sheet, and improved monetary statistics. The authorities also adopted a set of regulations and administrative measures to strengthen DAB’s supervision of the banking sector and improve the environment for lending operations, including by reducing the registration fee for deeds from 6 percent to 0.5 percent.

16. The external current account deficit, excluding grants, narrowed to 45 percent of GDP in 2004/05, from 51 percent in 2003/04 (Table 5).7 This improvement essentially reflected a slowdown in imports attributable to a stabilization of foreign aid and one-off factors (i.e. purchase of airplane parts by Ariana Airlines in 2003/04). Including grants, the current account recorded a surplus close to 2 percent of GDP in 2004/05, compared with 3 percent in 2003/04.

Table 5.Islamic Republic of Afghanistan: Balance of Payments, 2002/03–2008/09
Est.Est.Est.Proj.Proj.Proj.Proj.
2002/032003/042004/052005/062006/072007/082008/09
(In millions of U.S. dollars)
Trade balance-1,217.6-1,892.0-2,210.8-2,515.1-2,863.2-2,824.1-2,904.6
Exports of goods 1/1,290.61,893.91,656.11,893.31,968.61,755.31,861.4
Domestic exports276.8376.8471.0565.5681.8797.5856.6
Reexports1,013.91,517.11,185.11,327.81,286.8957.81,004.8
Imports of goods2,508.23,785.93,866.94,408.54,831.94,579.44,766.0
Recorded imports1,142.31,688.51,993.12,328.72,829.72,900.43,183.5
Duty Free840.81,001.01,203.31,348.01,323.61,061.71,088.0
Of which: Commodity food aid94.040.9107.80.00.00.00.0
Other525.11,096.4670.5731.8678.5617.2494.5
Services-145.1-439.3-480.8-542.3-621.6-613.5-614.8
Receipts50.8105.592.5120.5146.9162.6180.8
Payments195.9544.8573.3662.8768.5776.1795.7
Income (net)-1.1-3.415.731.647.756.864.8
Interest receipts0.04.925.435.151.660.868.8
Interest payments 2/1.18.39.73.53.94.04.0
Current transfers1,221.82,475.92,787.13,148.53,361.73,138.43,057.4
Public1,170.22,420.92,477.02,806.03,018.02,708.02,648.0
Commodity food aid94.040.9107.80.00.00.00.0
Other1,076.22,380.02,369.22,806.03,018.02,708.02,648.0
Private 3/51.655.0310.1342.5343.7430.4409.4
Current account (including grants)-141.9141.2111.1122.7-75.5-242.4-397.2
Current account (excluding grants)-1,363.7-2,334.7-2,676.0-3,025.8-3,437.2-3,380.8-3,454.6
Capital and financial account144.0147.7476.7334.8453.7530.9685.7
Capital account0.00.017.60.00.00.00.0
Debt forgiveness0.00.017.60.00.00.00.0
Financial account144.0147.7459.1334.8453.7530.9685.7
Foreign direct investment50.057.8186.9253.3351.2383.4530.2
Public loans94.089.9289.881.5102.5147.5155.5
Disbursement100.296.1296.085.0106.0151.0159.0
Amortization paid 2/6.26.26.23.53.53.53.5
Net errors and omissions153.290.1-99.30000
Overall balance155.3379.0488.5457.8378.0289.0288.8
Financing-155.3-379.0-488.5-457.8-378.0-289.0-288.8
Changes in reserve assets
Foreign exchange of the DAB-101.0-389.4-499.1-468.5-388.9-300.0-300.0
Fund credit (net)0.00.00.00.00.00.00.0
Exceptional financing-54.310.410.610.710.911.011.2
Arrears-54.310.410.610.710.911.011.2
Memorandum Items:
Official foreign exchange reserves
In millions of U.S. dollars4268161,2611,7302,1192,4192,719
In months of imports 4/1.83.44.04.85.86.47.3
Exports of goods and nonfactor services1,3411,9991,7492,0142,1161,9182,042
Imports of goods and nonfactor services2,7044,3314,4405,0715,6005,3555,562
Trade balance (in percent of GDP)-29.8-41.3-37.0-35.2-33.3-28.2-24.5
Current account balance (in percent of GDP)
Including grants-3.53.11.91.7-0.9-2.4-3.4
Excluding grants-33.4-50.9-44.8-42.4-39.9-33.8-29.1
GDP (in millions of U.S. dollars)4,0844,5855,9717,1398,6089,99911,853
Source: Afghan authorities; and Fund staff estimates and projections.

Excludes opium exports, and because information is unavailable, flows associated with U.S. Army and most ISAF activities.

Debt service projections are based on recognized obligations, reconciled with creditors. Arrears shown here represent an estimate by Fund staff, on the basis of loans which have been verified with creditors, but are not being serviced.

Includes foreign transactions recently reported by licensed money changers.

In months of imports of goods and services, excluding imports for reexports.

Source: Afghan authorities; and Fund staff estimates and projections.

Excludes opium exports, and because information is unavailable, flows associated with U.S. Army and most ISAF activities.

Debt service projections are based on recognized obligations, reconciled with creditors. Arrears shown here represent an estimate by Fund staff, on the basis of loans which have been verified with creditors, but are not being serviced.

Includes foreign transactions recently reported by licensed money changers.

In months of imports of goods and services, excluding imports for reexports.

17. Further progress was made in reconciling the external debt (an end-September 2005 structural benchmark). The reconciliation process has been completed with many of Afghanistan’s creditors. However, debt reconciliation with the former Czechoslovakia and Yugoslavia is hampered by uncertainty over the claimant, while two other small creditors have yet to provide adequate documentation to validate their claims. Also, a few outstanding issues still need to be resolved to reconcile Russian claims. The Cabinet has adopted a comprehensive debt management strategy—a structural benchmark—which defines the institutional and operational guidelines for public borrowing, consistent with both fiscal and external debt sustainability.

18. Further steps have been taken to restructure public financial institutions. The authorities have made public their intention to liquidate three former state-owned banks that had not been relicensed, of which only one, the Agricultural Development Bank, keeps a deposit base. As a first step toward the transfer/reimbursement of the remaining deposits of this bank, initially expected to be completed by end-September 2005, DAB froze its correspondent accounts in November. In addition, the MoF (the main shareholder) will restructure two of the relicensed state-owned banks, Bank Millie and Bank Pashtany, and is considering the transfer of the assets of the Export Promotion Bank to one of these two institutions. Other positive developments in the banking sector included the divestiture of DAB’s commercial activities in those provinces where at least one commercial bank is active.

19. In the public enterprise area, the government adopted, with donor assistance, a classification of state-owned enterprises (SOEs) by the envisaged restructuring method.8 Out of 66 enterprises directly owned by the government, 8 are expected to remain state-owned, while 58 will be liquidated or privatized. In addition, the government amended the SOEs law to provide the MoF full authority and responsibility to privatize these enterprises. However, the detailed modalities of the privatization have yet to be developed.

20. Statistical deficiencies are being addressed. To improve balance of payments data, the authorities are putting in place a new reporting system covering trade flows, private grants, interest receipts and payments, and the international investment position. Also, a new statistical law has been adopted which provides for an independent statistical agency and defines the legal framework for collecting, processing, and disseminating economic data.

III. Policy Discussions

21. Afghanistan continues to establish a solid track record of macroeconomic policy and structural reforms. As noted above, despite concerns that low capacity would hinder the delivery of the program’s commitments, the authorities have been able to meet all the quantitative indicators and almost all the structural benchmarks set under the SMP.

22. Notwithstanding this commendable performance, Afghanistan’s outlook remains clouded by lingering insecurity, drug industry activities, weak institutions, and serious capacity constraints. Furthermore, the government remains under pressure to quickly improve public services, increase wages, and borrow at lower concessional terms to fund major infrastructure projects. Some constituencies, frustrated by the slow rise in the standards of living, dispute the government’s policies and advocate lowering or temporarily eliminating taxes to encourage investment; raising import tariffs to protect domestic industries; and increasing government interference in the economy, including through government ownership and price controls, notably in the agricultural sector. Staff advised the authorities to keep the focus on the long-term benefits of market-oriented policies, and to press ahead with medium-term policies and a reform agenda that is financially sustainable and in line with their development objectives.

23. While the SMP has served the country well, the authorities are ready to move to a more ambitious reform program. At their request, the mission initiated discussions on a successor program that could be supported by a Poverty Reduction and Growth Facility (PRGF) arrangement. The authorities view such a program as an appropriate vehicle for implementing their structural reform agenda, which is described in detail in the Interim Afghanistan National Development Strategy (I-ANDS) and has been prepared in consultation with the civil society and the donor community. Specifically, the authorities are of the view that a PRGF-supported program would help them consolidate macroeconomic stability, develop the institutions and conditions necessary for private sector development, and significantly improve social conditions. In addition, a PRGF arrangement would contribute to the resolution of outstanding debt issues with Paris Club creditors (possibly in the context of the heavily indebted poor countries (HIPC) Initiative). Further discussions on a successor program are expected to take place in early March 2006, with the view of submitting to the Executive Board a request for a PRGF arrangement in the second quarter of 2006.

24. Against this background, the discussions with the authorities focused on: (a) the policy framework for the remainder of the period covered by the SMP; and (b) the medium-term economic outlook and the reform strategy. The authorities were in broad agreement with the staff on most of the issues that were discussed, except on tariff policy, as they raised the possibility of an increase in import tariffs with a view to increasing revenue and protecting the domestic industries.

A. Macroeconomic Outlook and Policy Framework for the Remainder of the Program Period

25. The macroeconomic outlook for 2005/06 remains favorable. Real GDP growth is still projected at 14 percent, as originally envisaged, on account of a continued recovery of the agriculture sector—due to better rainfall—and sustained activity in construction and services. While there are some upside risks from second round effects of the increase in oil prices, year-on-year inflation is targeted to decline to about 10 percent by end-2005/06. The current account deficit, excluding grants, is projected to narrow further in 2005/06, while international reserves would continue to rise.

Fiscal Policy

26. In the context of the MYR, the government reaffirmed its commitment to fiscal sustainability. The operating budget deficit, excluding grants, is now projected to narrow to 4.2 percent of GDP in 2005/06, from 4.9 percent in 2004/05, owing essentially to rising revenues, while the overall deficit would be significantly lower than expected because of continued capacity constraints in executing development spending. Overall, including anticipated grants and loans, the government is expected to build up further cash reserves in 2005/06. Revenues are projected to increase to 5.3 percent of GDP in 2005/06, from 4.5 percent in 2004/05, reflecting the better-than-expected performance of customs revenue, but also the implementation of the recently adopted tax measures.9 The ratio of operating expenditures to GDP is expected to remain unchanged at its 2004/05 level of 9.4 percent.

27. For 2006/07, under the MTFF, the operating budget deficit, excluding grants, is projected to decline further to 2.8 percent of GDP. Revenues are projected to reach 6 percent of GDP (a 38 percent rise over 2005/2006), largely owing to the full impact of the recent measures and structural reforms. The authorities are committed to limiting the nominal increase in operating expenditures to 13 percent in 2006/07, thus reducing their ratio to GDP to 8.9 percent.

28. Possible budgetary pressures arising from the pension system are of a growing concern. In the MYR, the authorities increased the allocation for pensions to about 5 percent of total operating expenditures. However, a recent Supreme Court decision links military pensions directly to sizeable salary increases granted to the Afghan National Army. This decision, if implemented, would add a further 7 percent to the budget (0.6 percent of GDP) for past payments, and about half that amount annually to future budgets. The authorities have indicated that they are not in a position to fund this unexpected increase in expenditure and have appealed the Supreme Court’s decision on the grounds that (a) it would set a costly precedent given the imminent retirement of a large number of civil servants and proposed pay reforms; and (b) any payment would be outside the recently adopted budget law. The authorities and staff concurred on the need to address pension issues in a comprehensive manner in the context of their ongoing public administration reform program.

Monetary and Exchange Rate Policies and Financial Sector Reforms

29. In view of the decline in inflation, the monetary program, which caps the increase in currency in circulation to 28 percent in 2005/06, was kept unchanged. In 2006/07, pending a deepening of the financial markets (interbank market, capital notes), the authorities will continue to target currency in circulation within the context of a market-determined exchange rate. However, with upward risks to inflation from second-round effects of the increase in oil prices, DAB will stand ready to tighten the monetary stance as needed to achieve the program’s inflation target.

30. DAB is committed to pursuing the modernization of its operations and strengthening its monetary policy framework. In line with Fund recommendations, DAB will amend regulations to remunerate reserve requirements, while excluding capital notes from eligible assets. These new regulations, as well as those related to open foreign currency positions, will be enforced by end-March 2006. In addition, the authorities committed to allowing participants in the foreign exchange auctions to sell, as well as buy foreign exchange, and to establishing an overnight collaterized credit facility with capital notes eligible as collateral. DAB also intends to introduce capital notes of longer maturities. Lastly, DAB will strengthen monetary management through more reliable liquidity forecasts, publication of the capital note interest rates, and stronger oversight.

31. The authorities are committed to accelerating the restructuring of the public banking sector. They will appoint officials to oversee the liquidation of the former state-owned banks, and, by end-March 2006, they will complete the transfer/reimbursement of Agricultural Development Bank deposits. In addition, the management boards of Bank Millie and Bank Pashtany will be replaced and experts will be appointed to help restructure these banks’ operations. By end-June 2006, the new managements of both banks, in coordination with the MoF, will adopt long-term restructuring plans. In its capacity as banking supervisory authority, DAB will monitor these developments closely.

32. The authorities agreed to address several administrative and legal impediments facing the banking sector. While factors such as poor judicial enforcement hinder the expansion of bank lending operations, there appears to be a consensus between the government and the business and donor communities on the need to give priority to the enactment of a core group of enabling laws, including on secure transactions, business organization, and negotiable instruments, as well as to clarify land ownership rights. Together with several donors, the authorities are working toward the adoption of this legislation.

External Sector Policies

33. The current account deficit, excluding grants, would decline to 42 percent of GDP in 2005/06. Although foreign direct investment (FDI) is expected to increase, this deficit will continue to be primarily covered by grant financing, which is projected at $3.1 billion. Including grants, the current account is projected to record a surplus of 2 percent of GDP in 2005/06.

34. An open and transparent trade regime will help improve Afghanistan’s growth prospects. The authorities intend to pursue technical work in support of discussions on Afghanistan’s accession to the World Trade Organization (WTO), with the longer-term aim of reaping the benefits of a liberal trade regime as well as of the WTO’s dispute settlement mechanisms and technical assistance. As part of its trade strategy, Afghanistan recently joined several regional organizations, including the Central Asian Regional Economic Council and the South Asian Association for Regional Cooperation.

35. The authorities also recognized the need to establish an adequate legal framework for the exchange system, in order to pave the way for accepting the obligations under Article VIII of the Fund’s Articles of Agreement. They requested Fund assistance in this area.

Structural Reforms

36. In addition to the fiscal and financial structural reforms described above, the authorities intend to make further progress in restructuring the public sector and creating an enabling environment for private investment. In particular, they committed to: (a) publish in the Official Gazette, by end-December 2005, the amendments to the SOEs law; (b) initiate an open and transparent divestiture process for the SOEs slated for liquidation or privatization; and (c) complete by end-December 2005, an inventory of the various public entities and government agencies engaged in commercial activities but not covered by the SOEs law, with a view to preparing an appropriate divestment strategy.

Poverty Reduction

37. The I-ANDS prepared in consultation with donors and the civil society places priority on: (a) security; (b) governance, rule of law, and human rights; and (c) economic and social development. It also identifies the elimination of the narcotics industry as a vital and cross-cutting priority, includes sectoral strategies that outline objectives and constraints, and provides rough estimates of resource needs. The government and the donor community have developed a “Compact” that establishes commitments, benchmarks, and a monitoring mechanism to support the delivery of the development strategy.

Statistical Issues and Technical Assistance

38. Notwithstanding recent progress, a number of statistical weaknesses remain. The authorities are seeking assistance to improve the quality and coverage of the national accounts and CPI estimates, as well as the reliability of monetary and balance of payments data. An ongoing survey on recorded trade, which should be completed by March 2006, will improve the estimates of overall trade flows. Efforts are also being made to develop social statistics and conduct a population census in support of work on the PRSP. Lastly, DAB will coordinate closely with the MoF to improve the quality of external debt data.

39. The authorities decided to delay the completion of their assessment of technical assistance (TA) until after the International Donors’ Conference. This assessment will help identify the country’s main human capacity constraints and TA needs. It should also contribute to improving disbursement rates and the cost-efficiency of available resources, in line with the priorities set in the I-ANDS. Key areas of possible future Fund TA include tax and customs administration and policy, public expenditure management, legal assistance in the fiscal area (including provisions for extractive industries), banking supervision and liquidity management, financial markets legislation, and statistics.

Program Monitoring

40. Program implementation will continue to be guided by the definitions, data sources, and frequency set out in the Technical Memorandum of Understanding (TMU). The tables attached to the Memorandum of Economic and Financial Policies establish quantitative indicators (Table 1) and structural benchmarks (Table 2) through end-September 2006. Fund staff will be notified prior to the introduction of any policy actions and developments that might affect the program. The SMP will continue to be in effect unless a successor program is approved by the Executive Board before end-September 2006.

B. Medium-Term Outlook and Reform Strategy

41. Afghanistan’s medium-term prospects are broadly favorable. Based on preliminary projections, growth is expected to be around 10 percent a year over the medium-term. Agricultural growth is expected to return to its historical trend, while telecommunications, transport, and trade would continue to expand at a strong pace. Construction activity would increase steadily, albeit more slowly than in recent years. Further growth prospects are predicated on the emergence of new economic activities, assuming increased efficiency in the public sector, the design of an appropriate regulatory framework for private sector activity, and improvements in human capital and infrastructure. In the context of the I-ANDS, the authorities have identified four sectors that could enhance the country’s growth and exports prospects: (a) agriculture and rural industry; (b) leasing of state assets (land and buildings); (c) mining and extractive industries; and (d) regional trade and transit. Assuming continued sound monetary and fiscal polices, inflation is expected to decline further, to about 8 percent by end-2006/07, and to 5 percent a year thereafter.

42. These projections are based on the assumption of a gradual fall in opium production. A sharper decline in opium production could, at least temporarily, affect adversely the real sector (GDP growth would fall due to an income-induced decline in the demand for licit goods), and the balance of payments. However, the impact on the real sector might not be pronounced because the larger decline in income would fall on traffickers, who have a lower propensity to consume. Similarly, both the high level of drug-related capital outflows and the large import content associated with drug-related consumption could moderate the effect on the balance of payments.

43. Fiscal consolidation and continued substantial donor support are required over the medium term. The MTFF provides a good basis for medium-term fiscal consolidation and sustainability. However, it needs to be strengthened in order to ensure (a) a significant increase in revenue from its low level; (b) the implementation of a civil service reform program to contain the wage bill and pensions to affordable levels; and (c) a gradual consolidation of fiscal operations within the core budget. Based on the current reform programs, it should be possible for revenues (excluding grants) to cover the rising nominal wage bill by 2006/07, and the entire operating budget, as currently defined, within four years. Nonetheless, reliance on external funding will remain significant, even for basic activities such as the Afghan National Army and health expenditures (see Box 1).

44. The MTFF includes an ambitious program to increase tax revenue.10 Revenue is projected to rise from 4.5 percent of GDP in 2004/05 to 8.6 percent by 2009/10, through: (a) rationalization of the current tariff structure and introduction of road tolls and excises in 2006/2007; (b) implementation of the taxes introduced in 2005/06; and (c) strengthened compliance facilitated by administrative reforms, including through the operations of the large taxpayer unit. Tax simplification to remove the plethora of small nuisance taxes and procedures will continue over the medium-term, and the authorities intend to gradually transform the turnover tax into a more efficient consumption-based tax. As noted earlier, during the discussions, the authorities also raised the possibility of an increase in import tariffs, with a view to increasing revenue while protecting the domestic industries. Staff cautioned strongly against such an approach, emphasizing that protectionist measures would send a wrong signal to potential investors while raising the prices of domestic goods often needed by the poor. Instead, staff recommended giving consideration to introducing excise taxes on a group of items.

45. The primary medium-term objective of monetary policy will continue to be the reduction of inflation to single-digit levels. Accordingly, with Fund assistance, the authorities intend to: (a) strengthen DAB’s implementation capacity through new monetary instruments and the deepening of financial markets; (b) increase DAB’s policy formulation capacity by developing its analytical tools and improving monetary statistics; and (c) better manage public expectations through greater transparency. Once these building blocks are in place, the authorities intend to begin targeting a broader monetary aggregate. The authorities will also proceed with the planned restructuring of the public banks to improve their operational efficiency and maximize shareholder value. More generally, they will aim at creating an enabling environment for bank lending.

46. The pace of reconstruction and structural changes will continue to influence the balance of payments. A decline in imports relative to GDP, stemming from a progressive reduction in aid and gradual import substitution, would contribute to a steady decline in the current account deficit, excluding grants, to around 29 percent of GDP by 2008/09. While largely offset by a reduction in grant financing, this improvement in the current account, together with an increase in FDI, would contribute to maintaining a strong reserve position.

Box 1.Achieving Fiscal Sustainability 1/

Substantial external assistance will be required to fund Afghanistan’s operating expenditures for many years. The overall fiscal deficit (excluding grants) is large and predominantly funded by external grants (Tables 3a and 3b). A large part of spending, including recurrent spending, in key areas such as security, counternarcotics, elections, and infrastructure, is undertaken directly by donors through the external budget. Eventually, the recurrent costs of these activities, including military salaries and infrastructure maintenance, will have to be included in the government’s core budget. The attached chart presents a conservative projection of total recurrent expenditures in the operating and development/external budgets and domestic revenue mobilization. 2/

Government operating expenditure and revenue projections to 2011/12

(in percent of GDP)

Sources: Government of Afghanistan;World Bank; and Fund staff projections.

A strong increase in revenue is needed to move towards fiscal sustainability. Although revenue mobilization has increased rapidly in the last few years, meeting the government’s revenue target of 8.6 percent of GDP by 2009/10 will require a sustained effort to rebuild administrative capacity, with a focus on the new large taxpayer unit and customs, and a gradual move toward a coherent policy framework placing lesser reliance on trade taxes.

A first step toward fiscal sustainability would be the ability to fund recurrent expenditures from tax revenue. So far, the government has demonstrated its commitment to pursuing a prudent fiscal policy based on the funding of operating expenditures from tax revenue and grants. Expenditure restraint will have to remain a priority if the government is to achieve its medium-term objectives of using only revenue to fully fund the wage bill by 2006/07 and all other expenditures currently included in the operating budget by 2010/11. This leaves little room for a substantial pay restructuring and a significant increase in staff numbers. Also, given the expected borrowing constraints, other recurrent expenditures currently outside the operating budget will need to be funded by foreign grants (around $900 million per year).

Expenditure should be consolidated within a realistic MTFF. The MTFF should be used to articulate the path towards fiscal sustainability by elaborating strategies for domestic revenue mobilization and public service reform, and developing detailed sectoral policies consistent with the I-ANDS and future operating and maintenance costs. To assist the planning process and improve transparency, donors are being encouraged to channel their resources through the budget, with greater multi-year predictability.

1/This box draws on discussions and information supplied by the authorities and World Bank staff during the development of the I-ANDS.2/ Significant recurrent costs are currently funded by donors in the core development and external budgets, such as: the Afghan National Army; health costs; non-salary education costs; transfers under the National Solidarity Program; and costs related to the elections. The projections do not include possible increases in pensions following the recent Supreme Court ruling.

47. Afghanistan’s currency appreciated by about 20 percent in real effective terms over the 30 months ended in September 2005. To a large extent, this real appreciation results from “Dutch disease” stemming from drug- and aid-related inflows. In addition, relatively high production costs reflect the difficult security situation, cumbersome business practices, and poor infrastructure. The authorities concurred with the staff that in Afghanistan’s present context, there is little that financial policies can do to improve external competitiveness. Rather, strengthening competitiveness will require strong efforts to increase efficiency in utilizing external aid, as well as the determined implementation of structural reforms to increase productivity, including by lowering the cost of doing business. Of course, better security conditions would help improve the business climate and unlock investment opportunities.

48. The authorities concurred with the main findings of the debt sustainability analysis conducted by the staff (Appendix V). While emphasizing that Afghanistan’s medium-term program cannot be financed solely by grants, they indicated that highly concessional borrowing was key to achieving external sustainability. In addition, the government will continue to seek generous debt relief from official bilateral creditors and to pursue good faith efforts to complete the debt reconciliation process with all creditors. In this connection, the authorities have recently intensified their contacts with Russia, Afghanistan’s largest creditor, and remain confident that substantial progress can be achieved over the coming months toward the resolution of outstanding claims.11

IV. Staff Appraisal

49. Economic developments in Afghanistan have remained generally favorable, and the SMP has contributed to improving macroeconomic management and making headway in the structural area. At the same time, the country has made significant strides in its political stabilization efforts, as evidenced by the recent legislative and provincial elections. Still, Afghanistan faces formidable challenges, and its medium-term outlook is subject to the risks and uncertainties typical of a post-conflict environment. In particular, there is a need to consolidate macroeconomic stability, diversify the sources of growth, achieve fiscal and external sustainability, address institutional and structural obstacles to private sector development, and gradually eliminate opium-related activities. Addressing these challenges will require formidable coordinated efforts on the part of the government, the private sector, and the donor community for several years.

50. Fiscal policy should remain cautious over the medium term to ensure macroeconomic stability and maintain external imbalances at sustainable levels. New revenue measures and decisive efforts to strengthen the limited administrative capacity of the revenue directorate, including by targeting large taxpayers, are needed to achieve the objectives of the MTFF. In particular, the introduction of excises on certain consumption items and continued implementation of the current reform plan for the customs and tax administrations are of critical importance. The staff would caution strongly against raising import tariffs, introducing ad-hoc duty exceptions, or reducing tax rates.

51. Affordable public administration reform is a major challenge. Government policy to date has been to maintain the size of the civil service, except for the recruitment of more teachers, while enhancing its productivity through capacity building and higher salaries to recruit and retain qualified professional staff. In the medium term, a more systematic reform program is required to strike a better balance between the need for higher salaries and budgetary considerations. Furthermore, linking pensions to salary increases would constitute a costly and counterproductive policy shift that could jeopardize medium-term fiscal sustainability.

52. The MTFF needs to be progressively refined to closely link multi-year projections with policies, notably those aimed at wage reform, while ensuring proper maintenance of development budget investments. Also, critical fiscal activities presently funded off-budget by donors, such as the military, should be progressively incorporated in the MTFF in order to increase transparency and better estimate the government’s significant long-term financing needs.

53. Monetary developments should be monitored closely, and the authorities should stand ready to tighten monetary conditions as needed to achieve the targeted reduction in inflation. The modernization of the current monetary framework will contribute to strengthening DAB’s control on overall liquidity in the context of a developing financial sector. In this connection, the authorities’ intention to remunerate required reserves and introduce a collaterized credit facility and capital notes of longer maturities are steps in the right direction. Looking forward, further efforts are necessary to develop DAB’s analytical capacity and enhance the transparency of monetary management.

54. The present managed float system has been working well and should be maintained. The real appreciation experienced by the Afghani in recent years reflects, to a large extent, the impact of opium- and aid-related inflows. In this context, strengthening competitiveness requires enhancing efficiency in the utilization of foreign aid as well as a deepening of structural reforms to increase productivity, including by lowering the cost of doing business.

55. The authorities must persevere in their efforts to build a resilient banking system. In this regard, it is essential to adhere strictly to the work programs for the restructuring of state-owned banks and to speed up the adoption of an appropriate legal and administrative framework for the development of private financial institutions.

56. A vigorous implementation of structural reforms is critical to promote private sector-led growth. The authorities must continue to strengthen the legal and regulatory environment for private sector activities, focusing on financial and business regulations and increased transparency. Also, priority should be given to further reducing government involvement in the economy, including by pressing ahead decisively with the divesture of SOEs and reducing interference by public entities and government agencies not covered by the current SOEs law. Direct intervention in the agricultural sector through price controls should be avoided. More generally, the business environment could be improved by enhancing the consistency and predictability of government policies.

57. The I-ANDS is an important step forward in defining the government’s medium-term development strategy. The authorities are encouraged to broaden the participatory process as they move toward a PRSP. The main challenge will be to turn the large number of proposals in the I-ANDS into a coherent and fully sustainable set of medium-term programs and policies.

58. Continued efforts are needed to eliminate the opium economy. With the cooperation of the donor community, the government should implement vigorously the programs aimed at reducing the cultivated area and putting in place sustainable income generation activities in support of the eradication, interdiction and prevention campaigns. This would pave the way for a decline in drug activities and would create the conditions for improved security and governance.

59. Further determined efforts are required to address a number of statistical deficiencies. Particular attention should be given to improving the quality and coverage of the national accounts and CPI estimates, as well as the reliability of the monetary and balance of payments data, with donor assistance. The recent approval of a new statistical law is a welcome step that should contribute to a successful implementation of the statistical master plan.

60. The program is subject to a number of risks. In particular, insufficient progress in improving security and strengthening government control over the provinces could slow down the reform process. Political pressures could also delay the implementation of reforms, notably in the fiscal area, and limit the authorities’ capacity to meet the program’s objectives. Lastly, the fight against opium-related activities could have disruptive effects on the security situation.

61. The current SMP has been instrumental in maintaining macroeconomic stability and building a momentum for structural reform, and the authorities have continued to implement it satisfactorily. Accordingly, staff support the authorities’ request for completion of the sixth review. Staff is of the view that a successor program that could be supported by a PRGF arrangement would help the authorities consolidate the gains that have been made under the SMP, and would provide a suitable framework for the continued implementation of their ambitious reform agenda.

62. It is proposed that the next Article IV consultation with Afghanistan take place on the standard 12-month cycle.

Figure 2.Islamic Republic of Afghanistan: Monetary Developments, 2003-05 1/

Sources: Da Afghanistan Bank; and Fund staff estimates and projections.

1/ Last observation: September 30, 2005.

Figure 3.Islamic Republic of Afghanistan: Foreign Exchange Reserves and Real Exchange Rate, 2003-05 1/

Sources: Central Statistics Office of Afghanistan; Da Afghanistan Bank; and Fund staff estimates.

1/ Last observation: September 2005.

2/ An increase in the exchange rate indices corresponds to an appreciation. The real exchange rate is estimated using the U.S. and Afghan CPIs.

Table 6.Islamic Republic of Afghanistan: Millennium Development Goals, 1990–2003
19901994199720002003
Goal 1: Eradicate extreme poverty and hunger
Percentage share of income or consumption held by poorest 20 percent
Population below US$1 a day (in percent)
Population below minimum level of dietary energy consumption (in percent)
Poverty gap ratio at US$1 a day (incidence x depth of poverty)
Poverty headcount, national (in percent of population)
Prevalence of underweight in children (under five years of age)49.3
Goal 2: Achieve universal primary education
Net primary enrollment ratio (in percent of relevant age group)26.5
Primary completion rate, total (in percent of relevant age group)23.0
Proportion of pupils starting grade 1 who reach grade 5
Youth literacy rate (in percent ages 15–24)
Goal 3: Promote gender equality and empower women
Proportion of seats held by women in national parliament (in percent)4.0
Ratio of girls to boys in primary and secondary education (in percent)
Ratio of young literate females to males (in percent ages 15–24)
Share of women employed in the nonagricultural sector (in percent)17.8
Goal 4: Reduce child mortality
Immunization, measles (in percent of children ages 12–23 months)20.040.048.035.050.0
Infant mortality rate (per 1,000 live births)168
Under 5 mortality rate (per 1,000)260
Goal 5: Improve maternal health
Births attended by skilled health staff (in percent of total)12.414.0
Maternal mortality ratio (modeled estimate, per 100,000 live births)1,900..
Goal 6: Combat HIV/AIDS, malaria, and other diseases
Contraceptive prevalence rate (in percent of women ages 15–49)10.0
Number of children orphaned by HIV/AIDS
Prevalence of HIV, total (in percent of population aged 15–49)
Tuberculosis cases detected under DOTS (in percent)2.09.018.2
Goal 7: Ensure environmental sustainability
Access to an improved water source (in percent of population)13.0
Access to improved sanitation (in percent of population)8.0
Access to secure tenure (in percent of population)
CO2 emissions (in metric tons per capita)0.10.1
Forest area (in percent of total land area)2.12.1
GDP per unit of energy use (2000 PPP, U.S. dollars per kg oil equivalent)
Nationally protected areas (in percent of total land area)0.3
Goal 8: Develop a global partnership for development
Aid per capita (in U.S. dollars)7.411.1
Debt service (in percent of exports)
Fixed line and mobile phone subscribers (per 1,000 people)2.21.61.31.311.8
Internet users (per 1,000 people)1.0
Personal computers (per 1,000 people)
Unemployment, youth female (in percent of female labor force ages 15–24)
Unemployment, youth male (in percent of male labor force ages 15–24)
Unemployment, youth total (in percent of total labor force ages 15–24)
Other
Fertility rate, total (births per woman)6.9
GNI per capita, Atlas method (in U.S. dollars)197.2
GNI, Atlas method (in billions of U.S. dollars)4.3
Gross capital formation (in percent of GDP)
Life expectancy at birth, total (years)41.5
Literacy rate, adult total (in percent of people ages 15 and above)
Population, total (in millions)17.720.7
Trade (in percent of GDP)145.6
Source: World Development Indicators database, April 2005.
Source: World Development Indicators database, April 2005.
APPENDIX I Islamic Republic of Afghanistan: Relations with the Fund

(As of December 31, 2005)

I. Membership Status: Joined July 14, 1955; Article XIV.

II. General Resources Account

SDR Million% Quota
Quota161.90100.00
Fund holdings of currency161.92100.01
Reserve position in Fund0.000.00
Holdings Exchange Rate

III. SDR Department

SDR Million% Allocation
Net cumulative allocation26.70100.00
Holdings0.030.11

IV. Outstanding Purchases and Loans None

V. Financial Arrangements None

VI. Projected Obligations to Fund

(SDR million; based on existing use of resources and present holdings of SDRs)

Forthcoming
20062007200820092010
Principal0.000.000.000.000.00
Charges/Interest0.810.810.810.810.81
Total0.810.810.810.810.81

VII. Implementation of HIPC Initiative Not Applicable

Nonfinancial Relations

VIII. Exchange Arrangement

Afghanistan is an Article XIV member country. The authorities are implementing a liberal exchange system. Based on information currently available to the staff, no exchange restrictions and multiple currency practices are currently in place. The authorities intend to formalize the current liberal regime through the adoption of new laws and regulations, for which they have asked for technical assistance from the Fund. A joint LEG/MFD mission is envisaged to take place over the next few weeks. The authorities have been implementing a managed float system with no predetermined path for the exchange rate. As of February 2, 2006, the average exchange rate on the Kabul money exchange market was Af50.36 per $1.

To conduct monetary policy, the authorities rely on foreign exchange auctions since May 2002, and on short-term capital note auctions since September 2004. The foreign exchange auctions were initially open only to licensed money changers, but since June 2005 they are also open to commercial banks. The capital note auctions are open to commercial banks. Auctions are linked to the overall monetary program and are held on a regular basis (weekly for foreign exchange auctions, daily for capital note auctions).

IX. Article IV Consultation

The last Article IV consultation with Afghanistan was discussed by the Executive Board on January 19, 2005. Consultations with Afghanistan are on the standard 12-month cycle.

X. Technical Assistance, 2004-05

DepartmentDatePurpose
FADMarch 2004 (ongoing)Resident Treasury Expert
March 22–April 3, 2004Tax policy and administration
April 18–May 2, 2004Customs administration
May 19–25, 2005Seminar of reorganization of the MoF
October 18–25, 2005Tax policy
MFDFebruary 2–6, 2004Anti-money laundering legislation
March 21–30, 2004DAB capital adequacy and balance sheet structure
September 2004 (ongoing)Training coordinator
February 2–15, 2005Implementation of DAB balance sheet reconstruction and capital adequacy recommendations
May 16–25, 2005Monetary Policy and Financial Markets
October 11–20, 2005Monetary Policy
November 20–29, 2005Financial Markets
LEGFebruary 2–6, 2004Anti-money laundering legislation
March 3–21, 2004Fiscal revenue legislation
January 29–February 12, 2005Income Tax Law
STAJanuary 29–March 15, 2004Multisector statistics
April 19–May 3, 2004Balance of Payments Statistics
May 13–June 30, 2004Multisector statistics
May 17–29, 2004Consumer Price Index
January 15–February 15, 2005Multisector Statistics
March 23–June 11, 2005Multisector Statistics
July 20–August 31, 2005Multisector Statistics
October 31, 2005–January 12, 2006Multisector Statistics
MCDApril 16–20, 2005Basic Macroeconomic Accounting Relationships and Introduction to Financial Programming
METACNovember 15–20, 2005Tax policy and administration

Afghanistan is a participant in the Middle East Technical Assistance Center.

A resident treasury expert for the Ministry of Finance, Mr. Platais, was appointed in March 2004.

A resident multisector statistical advisor, Mr. Soulatha, was stationed in Kabul on July 17, 2002. STA has also provided technical assistance through a series of peripatetic multisector missions which began in January 2004. These missions were suspended in July 2004 due to the security situation. A new series of peripatetic missions commenced in January/February 2005.

During 2004, with financial support from the Sweden Technical Assistance SubAccount, the Fund sponsored a number of training activities aimed at DAB officials. A long-term training advisor, Mr. Khan, was appointed in September 2004. He is responsible for all practical matters related to the delivery of formal training to DAB staff in Kabul, as well as the coordination of training for DAB staff outside Afghanistan. Finally, Sweden has financed a monetary policy peripatetic advisor (a position currently shared by Mr. Coats and Mr. Gray) to assist DAB in developing the strategy and instruments for improving the implementation of monetary policy.

XI. Resident Representatives

During the first half of 2002, the Fund’s resident representative in Pakistan, Mr. Ghesquière, assisted in maintaining relations with the Afghan authorities. A resident representative, Mr. de Schaetzen, took up his post in Kabul on August 24, 2002. Mr. Charap succeeded him on June 13, 2005.

APPENDIX II Islamic Republic of Afghanistan: Relations with the World Bank

(As of January 17, 2006)

1. A second Transitional Support Strategy (TSS) was presented to the World Bank Board of Executive Directors in March 2003. This was due to be updated by March 2005, following the culmination of the political process outlined in Bonn. Despite a successful Presidential election in October 2004, parliamentary elections in Afghanistan were not held until September 2005. This delay in the political process, coupled with the government’s preparation of a National Development Strategy, slowed down the World Bank’s efforts to develop a new Interim Strategy Note. The World Bank continues to assist the government under the existing TSS and is now in the process of preparing an Interim Strategy Note, in line with the government’s plans for the National Development Strategy.

2. In FY 2002, World Bank staff prepared and negotiated four projects to utilize IDA grant funds for a total of $100 million. Following the clearance of Afghanistan’s arrears to the World Bank and the Fund through donor contributions, the first IDA credit for $108 million for an Emergency Transport Project was approved by the Board in March 2003. By the end of FY 2003, three additional projects—Emergency Health Sector Rehabilitation ($59.6 million), Emergency Public Administration II ($8.4 million), and National Emergency Employment II ($39.2 million) were approved, bringing to $215 million the total allocation for the year.

3. Five IDA credits/grants were negotiated for FY 2004, for a total of $293 million. These programs include the Emergency Communications Project ($22 million), the Emergency Customs Modernization and Trade Facilitation Project ($31 million), the National Solidarity Program II ($95 million), the Emergency Irrigation Rehabilitation Program ($40 million), and the Emergency Power Rehabilitation Program ($105 million).

4. For FY 2005, six projects and two supplementals were approved, for a total of $285 million: the first budget-support operation, Programmatic Support for Institution Building ($80 million); the Kabul Urban Reconstruction Project ($25 million); the Investment Guarantee Facility ($5 million), together with MIGA; the Education Quality Improvement Program ($35 million); Public Administration Capacity Building ($27 million); Strengthening Higher Education ($40 million); and supplemental financing for the Emergency Transport Project ($45 million) and the National Solidarity Program ($28 million).

5. For FY2006, six projects are planned for a total IDA grant commitment of $267 million. To date, one program has been approved by the Board–the second budget support operation: Programmatic Support for Institution Building II ($80 million), which was approved in December 2005.

6. The World Bank also administers the Afghanistan Reconstruction Trust Fund (ARTF), which became effective in May 2002 and plays a critical role in funding the recurrent costs of government. In its first year of operation (2002/03), the ARTF mobilized $185 million and disbursed $65 million. Paid-in contributions for 2003/04 amounted to $286 million, while disbursements reached $254 million. Paid-in contributions for 2004/05 amounted to $380 million, while disbursements reached $292 million. Pledges for 2005/06 have reached $470 million, with $288 million having been paid in (as of December 21, 2005). ARTF is increasing its financing of investments and has the potential to support better donor coordination, simplified processes, and fast results. Discussions are under way with donors to the ARTF to increase the focus on policy reform.

7. The World Bank is also actively engaged in providing advisory services to the government and continues to respond quickly to a range of requests. Current analytical work focuses on civil service reform, urban development and land management, education policy reform, labor market and pensions, and oil/gas infrastructure development, as well as broader regional trade work encompassing issues with Afghanistan’s neighbors. A Gender Assessment is due to be released publicly in January 2006. The World Bank has just completed a major Public Finance Management (PFM) review, which incorporates an assessment of public expenditures and fiduciary aspects, including procurement and financial management. Fund staff contributed to the PFM review, including by providing an analysis of domestic revenue prospects. The World Bank has also actively utilized the Post Conflict Fund and continues to use resources from the Japan Social Development Fund to provide on-the-ground support to the government and communities.

8. The World Bank’s program is growing quickly and, as of December 2005, has an active IDA portfolio of 18 investments and two supplementals (one project has closed). Total commitments since 2001 add up to $973 million, of which $537 million are in grants. Disbursements amount to $636.5 million. A number of projects are under preparation for the remainder of the fiscal year and total commitments for FY 2005 are expected to reach $267 million, entirely in grants.

APPENDIX III Islamic Republic of Afghanistan: Statistical Issues

General

1. The statistical system has improved since 2002; nonetheless, organizational weaknesses, poor staffing, and lack of equipment continue to hamper the compilation process. Due to security reasons and limited central government influence outside Kabul, setting up nationwide statistics has been a difficult undertaking. While the Central Statistics Office (CSO) has regional offices, staffing and communication are poor. Staffing in most agencies is inadequate both in number and expertise, and salaries remain low. Strengthening the statistical capacity is an ongoing process; greater efforts and significant institutional support will be required if further substantial improvements are to be made. STA continues to provide technical assistance through a peripatetic multisector statistics advisor as well as short-term topical missions.

2. The authorities have restructured the CSO but many key donors involved in preparing the statistical master plan (SMP) have expressed concern over the independence of the CSO, which now reports to the Ministry of National Economy; and the integrity of the statistical system. Progress on the implementation of the SMP has been delayed as the authorities have been slow in undertaking the required institutional changes and strengthening the management structure of the CSO.

3. The authorities have expressed interest in participating in the General Data Dissemination System (GDDS) and have appointed a national GDDS coordinator. The statistical agencies have started drafting the GDDS metadata with the support of STA.

Real Sector

4. The national accounts compilation process is hampered by the general lack of source data. The Asian Development Bank is providing funding for two major surveys that could supply critical source data for the national accounts; however, the survey fieldwork has been delayed until 2006. Thus, the survey data may not be available before 2007.

5. The CSO now compiles a nationwide CPI covering Kabul and the five major cities. Nonetheless, the inexperience of the price collectors has posed some early challenges to the compilation process. There is also the need to update the index weights. The CPI basket was derived from a 1987 household income and expenditure survey. In 2003, the CSO conducted a limited exercise to update the weights based on household expenditure in Kabul; however, a comprehensive exercise to obtain representative weights is required, and is predicated on the completion of the delayed integrated living standard survey.

6. Customs coverage of overland foreign trade—which is most of foreign trade—is limited at best. The CSO currently records trade at only seven of the 14 customs posts. Monthly trade data are updated manually, thereby causing delays in dissemination. Accordingly, there is an urgent need for improved computer hardware.

Government Finance Statistics

7. An Advisor from FAD has been assisting the Ministry of Finance in compiling GFS data; however, there is an acute shortage of staff to work on compilation. The FreeBalance software, which is used in many countries for budget execution and tracking and could generate some data, does not work very well in Afghanistan. The authorities have reported data on budgetary central government for publication in the 2005 Government Finance Statistics Yearbook.

Money and Banking Statistics

8. The banking sector has developed steadily over the last several years. In addition to three relicensed state-owned banks, four foreign-owned commercial banks and four foreign banks are now in operation. While there was some improvement in the scope and quality of data reporting by the central bank, there are still weaknesses in many areas. Da Afghanistan Bank (DAB) is now in the process of installing new accounting software, which is expected to be ready for use by May 2006. This new accounting software will allow DAB to produce its balance sheet at least on a monthly basis. The very limited accounting capacity of DAB, especially outside Kabul has hindered efforts to produce a complete and reliable balance sheet. Regarding the commercial banks, DAB has developed new reporting formats to provide data for bank supervision and monetary statistics, and the banks have started reporting data to DAB regularly according to these formats. STA reviewed the new report forms and found that they lacked sectorization and classification of financial assets by type of financial instrument, which are basic requirements for compiling monetary statistics in accordance with international standards. In this regard, STA provided guidance on how to incorporate these required breakdowns into the new report forms. STA plans to send a mission on monetary and financial statistics to Kabul during March 2006 to help develop source data and a data reporting system, and train staff on the methodology.

Balance of Payments

9. Like the national accounts, balance of payments compilation suffers from the paucity of source data. There are no estimates of unrecorded border trade, which constitutes a significant proportion of foreign trade. No reliable source data exist to estimate services, income, transfers, and foreign direct investment. A balance of payments statistics mission that visited Kabul during April 11–May 7, 2005 reported that while some of the recommendations from the previous mission in April 2004 had been introduced, most of the efforts regarding data generation had not materialized, as the response and cooperation from respondents was poor. The 2005 mission provided the authorities with a list of important actions that need to be implemented before a follow-up mission:

  • Estimate exports and imports based on CSO data with adjustment for illegal trade and duty free imports. The CSO should start including duty free imports according to international classifications.
  • Adjust freight and insurance at 12 and 3 percent, respectively, of c.i.f. imports from overseas to calculate imports f.o.b.
  • Introduce questionnaire to hotels and guesthouses to collect data on expenses of nonresidents to estimate travel receipts.
  • Conduct sample surveys of residents returning from travel abroad and use the immigration data to estimate travel expenses.
  • Introduce the questionnaire for collecting data from foreign embassies and other foreign organizations to estimate government receipts, compensation of employees, etc.
  • Introduce the questionnaire on foreign direct investment (FDI) to collect data from major FDI enterprises.
  • Introduce reporting forms to commercial banks (on foreign exchange transactions between residents and nonresidents) following discussions with them and with the Banking Supervision Department of the DAB.
  • Introduce questionnaire to money changers and money service providers.
  • Collect quarterly data from the Ministry of Economy on NGOs’ receipts of donations and grants.
  • Compile preliminary balance of payments on the basis of various estimation procedures discussed with and documented by the Balance of Payments Section.

10. A follow-up mission is tentatively scheduled for early 2006.

External debt

11. Many records were destroyed during the war and the authorities are slowly rebuilding their database through a reconciliation process in cooperation with the Secretariat of the Paris Club and all non Paris Club creditors. The same reconciliation process is taking place regarding Russian claims.

APPENDIX IV Islamic Republic of Afghanistan: Table of Common Indicators Required for Surveillance

(As of January 10, 2006)

Date of latest

observation
Date

received
Frequency

of

Data6
Frequency

of

Reporting6
Frequency

of

Publication6
Exchange Rates01/08/061/08/06DDD
International Reserve Assets and Reserve Liabilities of the Monetary Authorities112/21/0512/28/05WWW
Reserve/Base Money12/21/0501/08/06MMM
Broad Money09/30/0510/30/05QQQ
Central Bank Balance Sheet12/21/0501/08/06MMM
Consolidated Balance Sheet of the Banking System9/31/0511/15/05QQQ
Interest Rates201/08/0601/08/06WWW
Consumer Price Index12/0512/31/05MMM
Revenue, Expenditure, Balance and Composition of Financing3—General Government4-----
Revenue, Expenditure, Balance and Composition of Financing3—Central Government11/0512/05MMM
Stocks of Central Government and Central Government-Guaranteed Debt5-----
External Current Account Balance2004/058/15/05AAA
Exports and Imports of Goods and Services2004/0508/15/05AAA
GDP/GNP2004/058/15/05AAA
Gross External Debt2004/058/15/05AAA

Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

Foreign, domestic bank, and domestic nonbank financing.

The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

Including currency and maturity composition.

Daily (D); weekly (W); monthly (M); quarterly (Q); annually (A); irregular (I); and not available (NA).

Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

Foreign, domestic bank, and domestic nonbank financing.

The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

Including currency and maturity composition.

Daily (D); weekly (W); monthly (M); quarterly (Q); annually (A); irregular (I); and not available (NA).

APPENDIX V Debt Sustainability Analysis

1. This annex assesses Afghanistan’s external debt sustainability (DSA) using the joint World Bank–Fund’s DSA template for Low Income Countries. Data limitations notwithstanding, a sound debt management strategy remains central to the overall growth dynamics of Afghanistan, which is currently heavily dependent on external financing.1 Based on the current medium-term macroeconomic framework and outstanding stock of debt, this DSA examines Afghanistan’s annual borrowing capacity under two scenarios: one that assumes future borrowing under highly concessional terms, and another that assumes limited access to concessional borrowing. The analysis concludes that Afghanistan has relatively little scope for nonconcessional borrowing. Furthermore, Afghanistan is subject to an elevated risk of debt distress owing to the weakness of exports, the low revenue base and the country’s large reconstruction financing requirements.2

Table 1.Islamic Republic of Afghanistan: External Debt, 2004/05
(In millions of U.S. dollars)
Total external debt749
Multilateral debt455
World Bank233
Asian Development Bank222
Bilateral debt 1/294
Verified claims137
United States82
USAID57
USDA25
Former GDR40
OPEC Fund2
Kuwait Development Fund13
Unverified claims157
Bulgaria47
Saudi Arabia30
Iraq6
Former Czechoslovakia75
Memorandum item:
(In percent of GDP)
Total external debt13
Total multilateral debt8
Total verified bilateral debt2
Total unverified bilateral debt3
Sources: Afghan authorities; and Fund staff estimates.

Excludes Russian claims. Staff estimate these claims to exceed $10 billion.

Sources: Afghan authorities; and Fund staff estimates.

Excludes Russian claims. Staff estimate these claims to exceed $10 billion.

2. The main economic assumptions are the same in both scenarios. The scenarios are based on an end-2004/05 external debt stock of $749 million (see Table 1), which includes all currently acknowledged, verified or unverified debts,3 but excludes disputed Russian claims. If included, the Russian claims—preliminarily estimated at around $10.8 billion—would dramatically increase the NPV of debt-to-export ratio and the need for debt relief (possibly in the context of the HIPC Initiative). Real economic activity is projected to expand rapidly over the next 10 years, as the reconstruction effort boosts all sectors of the economy. Real GDP growth is projected to be around 10 percent a year during this period of accelerated growth, before moderating to approximately 6 percent thereafter. Assuming annual export growth of about 15 percent a year in the medium term, the trade deficit diminishes but remains significant throughout the projection period. The current account (including grants) is nevertheless generally in surplus, as transfers are expected to remain substantial.

3. The first scenario assumes that all future borrowing is contracted under highly concessional terms (i.e. with a grant element of at least 60 percent). On this basis, Afghanistan’s gross annual borrowing could reach $380 million without breaching the indicative NPV of debt-to-exports threshold.4 While this level of borrowing represents a significant increase over current levels, it may be useful to contrast it against the projected gap between total recurrent spending requirements and revenue excluding grants, estimated at around $900 million per year over the medium term.5 This highlights the need for continued grant financing for several years. Debt sustainability is maintained only in the absence of shocks affecting the economy (e.g. lower export growth of about 9 percent would raise the NPV of debt-to-exports ratio to well above the indicative sustainability threshold).

4. The second scenario assumes that Afghanistan has limited access (up to $75 million annually) to concessional borrowing and borrows all additional funds on nonconcessional terms.6 In this case, additional nonconcessional borrowing could reach about $250 million annually, without breaching the 150 percent indicative sustainability threshold. This scenario illustrates both the sensitivity of debt sustainability to export growth assumptions and the importance of continued access to highly concessional resources in meeting Afghanistan’s development needs. Although not shown in the tables and figures, the debt service-to-revenue ratio reaches nearly 24 percent under this scenario (compared to less than 3 percent in the first scenario), which is another indication of the sustainability problems that would ensue if Afghanistan were to borrow on nonconcessional terms. Also, assuming export growth of only 9 percent a year, Afghanistan’s sustainable borrowing capacity would be limited to about $150 million annually. Given the geopolitical risks in the region, lower foreign direct investment could also hinder the country’s capacity to service debt and thus would warrant a re-evaluation of the appropriate debt sustainability threshold.

Policy Implications

5. The availability of external borrowing to fund development spending will depend critically on the authorities meeting their fiscal targets. Although revenue mobilization has increased rapidly in the last few years, it remains very low, amounting to 4.5 percent of GDP in 2004/05, equivalent to about 50 percent of operating expenditures and only 28 percent of total recurrent expenditures (see Box 1 of the staff report). The medium-term framework projects revenue to cover operating expenditures by 2010, when the revenue to GDP ratio is expected to reach 8 percent. Meeting the proposed fiscal target will require both a sustained increase in revenue and expenditure restraint. Any underperformance in these two areas, or any reduction in donor grants, will require additional borrowing to fund recurrent expenditures, thereby reducing by an equivalent amount the financing available for development spending.

6. In view of the uncertainty surrounding the medium-term macroeconomic framework, the medium-term debt strategy should continue to rely primarily on grant financing and highly concessional borrowing. The DSA indicates that, even under the conservative debt stock assumptions, external shocks may severely limit new borrowings, corroborating the results of the previous DSA exercise (IMF Country Report No. 05/34). Afghanistan’s reliance on grants and donor support may also be tested under an uncertain and changing political landscape.

7. Also, the resolution of the Russian claims—not currently reconciled or acknowledged formally by Afghanistan—will have a significant impact on debt sustainability. Preliminary calculations suggest that anything short of a full write-off of these claims could result in explosive debt dynamics, impeding any future borrowing. However, given the uncertainty regarding the resolution of this issue, it would be premature to evaluate specific debt relief options.

Table 2.Islamic Republic of Afghanistan: External Debt Sustainability Framework, Baseline Scenario, 2002–25 1/(In percent of GDP, unless otherwise indicated)
ActualHistoricalStandardEstimateProjections
Average 6/Deviation 6/AverageAverage
2002200320042005200620072008200920102005–10201520252011–25
External debt (nominal) 1/13.112.311.810.710.09.99.89.79.57.84.1
Of which: public and publicly guaranteed (PPG)13.112.311.810.710.09.99.89.79.57.84.1
Change in external debt13.1-0.8-0.5-1.1-0.7-0.1-0.1-0.1-0.2-0.4-0.3
Identified net debt-creating flows-6.6-7.4-6.2-4.1-2.1-1.8-2.3-2.70.92.9
Noninterest current account deficit3.4-3.1-2.1-0.42.9-1.60.72.13.02.41.71.44.35.14.6
Deficit in balance of goods and services54.667.853.548.443.334.030.529.027.621.513.6
Exports6.87.57.47.17.17.26.76.56.35.64.7
Imports61.475.360.955.550.441.137.135.534.027.118.3
Net current transfers (negative = inflow)-29.9-49.3-43.9-30.822.1-39.6-35.1-28.2-23.8-23.8-23.8-29.1-11.9-2.5-9.1
Other current account flows (negative = net inflow)-21.3-21.7-11.6-10.4-7.5-3.7-3.6-2.9-2.1-5.3-6.0
Net FDI (negative = inflow)-1.2-1.1-2.9-1.31.2-3.3-3.8-3.4-4.1-3.9-3.7-3.7-3.0-2.0-2.7
Endogenous debt dynamics 2/-2.3-2.4-1.3-1.0-0.9-0.8-0.8-0.8-0.5-0.2
Contribution from nominal interest rate0.20.20.00.00.00.00.00.00.10.0
Contribution from real GDP growth0.0-1.7-0.8-1.3-1.0-0.9-0.8-0.8-0.8-0.6-0.2
Contribution from price and exchange rate changes0.0-0.8-1.8
Residual 3/5.86.95.13.42.11.72.22.6-1.3-3.2
Of which: exceptional financing-0.2-0.2-0.1-0.1-0.10.00.00.00.00.0
NPV of external debt 4/5.85.45.15.15.05.04.94.22.1
In percent of exports78.675.471.271.075.377.177.974.444.4
NPV of PPG external debt5.85.45.15.15.05.04.94.22.1
In percent of exports78.675.471.271.075.377.177.974.444.4
Debt service-to-exports ratio (in percent)2.63.83.41.21.10.90.91.01.12.12.7
PPG debt service-to-exports ratio (in percent)2.63.83.41.21.10.90.91.01.12.12.7
Total gross financing need (in billions of U.S. dollars)0.1-0.2-0.3-0.4-0.3-0.1-0.1-0.2-0.30.52.9
Noninterest current account deficit that stabilizes debt ratio-9.6-2.4-1.6-0.51.42.23.12.41.94.75.4
Key macroeconomic assumptions
Real GDP growth (in percent)28.615.78.017.410.413.811.710.69.99.69.410.88.15.27.2
GDP deflator in U. S. dollar terms (percentage change)4.06.417.09.26.99.98.05.05.04.64.66.24.63.84.2
Effective interest rate (in percent) 5/1.61.61.60.00.50.50.40.40.50.60.51.00.81.0
Growth of exports of G&S (U.S. dollar terms, in percent)36.125.030.67.920.120.617.07.411.311.414.610.57.59.6
Growth of imports of G&S (U.S. dollar terms, in percent)50.92.126.534.514.09.6-5.24.19.69.46.98.15.27.2
Source: Fund staff simulations.

Includes both public and private sector external debt.

Derived as [r-g - ρ(l+g)]/(l+g+ρ+gρ) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and ρ = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For proj ections also includes contribution from price and exchange rate changes.

Assumes that NPV of private sector debt is equivalent to its face value.

Current year interest payments devided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Source: Fund staff simulations.

Includes both public and private sector external debt.

Derived as [r-g - ρ(l+g)]/(l+g+ρ+gρ) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and ρ = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For proj ections also includes contribution from price and exchange rate changes.

Assumes that NPV of private sector debt is equivalent to its face value.

Current year interest payments devided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

ATTACHMENT I

Kabul, February 11, 2006

Mr. Rodrigo de Rato

Managing Director

International Monetary Fund

Washington, DC 20431

U.S.A.

Dear Mr. de Rato,

1. In November 2005, we carried out with IMF staff the discussions for the 2005 Article IV consultation and the sixth review under the staff-monitored program (SMP) agreed in March 2004.

2. Since the completion of the fifth review under the SMP, we have continued to maintain economic stability while holding, for the first time in recent history, legislative and provincial elections. During the recent discussions, we reached understandings on a revised macroeconomic framework and an updated memorandum of economic and financial policies (MEFP) covering the period through September 2006. As detailed in the MEFP, we have observed all the end-September 2005 quantitative indicators and, albeit with some delays caused by technical factors, all but one of the end-September structural benchmarks under the SMP program (Tables 1 and 2).

3. We believe that the policies and measures set forth in the attached MEFP are adequate to achieve the objectives of the program, but we will take any further measures that may become appropriate for this purpose. In accordance with IMF’s policies on such consultations, the Government of Afghanistan will consult with staff prior to adopting any such measures or revising any of the policies contained in the MEFP. We will also provide any information required to assess the implementation of the SMP.

4. Looking forward, and in view of the significant challenges facing the country, including the prevalence of drug-related activities and pervasive poverty, we intend to intensify our adjustment and structural reform efforts. To that end, we are preparing an interim national development strategy consistent with the Millennium Development Goals, which will focus on creating adequate conditions for sustainable economic growth and reducing poverty in the context of fiscal and external sustainability. In support of this strategy, we have initiated discussions with IMF staff on a formal program that could be supported by the Poverty Reduction and Growth Facility (PRGF). We expect to continue these discussions in early March 2006, with the view of requesting a PRGF arrangement in the second quarter of 2006.

5. In continuing with our policy of transparency, we consent to the publication of this letter, the attached MEFP, the technical memorandum of understanding, and the accompanying Executive Board documents on the IMF’s website.

Sincerely yours,

/s//s/
Anwar Ul-Haq AhadyNoorullah Delawari
Minister of FinanceGovernor
Ministry of FinanceDa Afghanistan Bank

Attachment:

Update to the Memorandum of Economic and Financial Policies

ATTACHMENT II Update to the Memorandum of Economic and Financial Policies of the Government of Afghanistan

Sixth Review Under the Staff-Monitored Program

November 22, 2005

I. Introduction

1. The government of Afghanistan held discussions with IMF staff in the context of the sixth quarterly review under the staff-monitored program (SMP). These discussions, which coincided with the 2005 Article IV consultation, covered: (a) developments under the SMP during the second quarter of 2005/06, as specified in our Memorandum of Economic and Financial Policies (MEFP) of September 26, 2005; (b) the macroeconomic outlook for the remainder of 2005/06 and the first half of 2006/07; (c) the structural reform agenda; and (d) the medium-term outlook.

2. This update to the MEFP reviews performance during July–September 2005 and describes policies and objectives for the remainder of 2005/06 and the first half of 2006/07. The program will continue to be guided by the macroeconomic and structural reform policies described in the MEFP of March 2004, and in the supplements of September 6, 2004; December 29, 2004; February 3, 2005; May 18, 2005; and September 26, 2005. The seventh review under the SMP is scheduled for early March 2006 and will coincide with discussions to reach understandings on a program supported by the Poverty Reduction and Growth Facility (PRGF). That review, combined with the interim Afghanistan National Development Strategy (I-ANDS), which we will present at the January 2006 Donors’ Conference in London, will provide the basis for policy discussions related to the PRGF program.

3. The government continues to attach paramount importance to the SMP. We have adhered fully to the agreed macroeconomic policies, having observed all the end-September quantitative indicators. We have also met, albeit with some delays caused by various factors, all end-September structural benchmarks, except for the benchmark related to the publication of the audited 2004/05 core budget financial statements, which we now intend to meet by end-December. Lastly, as described below, we have also taken important policy actions in the fiscal, financial, and statistical areas.

4. While much has been achieved under the SMP in terms of macroeconomic stabilization and structural reforms, we still face significant challenges, including the prevalence of drug activities and pervasive poverty. To further strengthen our reform efforts, we intend to develop a comprehensive economic program for 2006/07–2008/09 consistent with our I-ANDS and the Millennium Development Goals (MDGs). In support of these policies, the government of Afghanistan has initiated discussions with IMF staff on a three-year PRGF-supported program, with the view of requesting a PRGF arrangement in the second quarter of 2006.

A. Developments Under the SMP

5. Macroeconomic developments during the first half of 2005/06 were in line with program projections. Reflecting a rebound in agriculture output—resulting from favorable weather conditions—and sustained activity in construction, transportation, and telecommunications, economic growth remained strong during the first half of the year.

6. Consumer prices in Kabul have continued to increase at a moderate pace during the second quarter of 2005/06. They increased by 2.6 percent, up from 2.4 percent in the first quarter. Reflecting the pass-through of international prices to consumer prices, petroleum product prices increased by 26.3 percent during the second quarter. While slowing markedly, rents increased by 6.5 percent. Excluding these two items, prices increased by 1.6 percent during the first quarter, and by 3.3 percent during the first half of 2005/06. After declining sharply during the first quarter, from 16.3 percent at end-March to 11.5 percent at end-June, year-on-year inflation rebounded somewhat, to 12.9 percent at end-September.1

7. According to preliminary estimates provided by the UN Office of Drugs and Crime, opium production declined by 2 percent in 2005, as a sharp fall in area cultivated was largely offset by a rebound in yields due to favorable weather conditions. Opium cultivation declined by 21 percent, primarily due to the decision by many farmers not to plant in anticipation of intensified government-led anti-narcotics efforts but also in response to relatively low farm gate prices. The intensification of the government’s interdiction efforts led to a significant increase in seizures of opium, while eradication contributed to a reduction in the cultivation area. Due to a slight decline in prices, the production export value and farm gate value fell by 4 percent and 7 percent, respectively, to $2.7 billion and $560 million.

8. The core operating budget deficit, excluding grants, was lower than expected, reaching 1.7 percent of GDP during the first half of 2005/06. The government continued to abide by its “no-overdraft” commitment and the core operating deficit was more than covered by foreign grants, resulting in a surplus of 0.7 percent of GDP (including grants). Core budget operating and development spending during the first half of the year totaled Af 14.6 billion and Af 8.9 billion, respectively, compared with revised annual budget estimates of Af 33.6 billion and Af 50.1 billion. Compensation of employees accounted for about 64 percent of operating expenditures, while spending on livelihoods and social protection and on transport amounted to 67 percent of the core development budget.

9. Revenue, excluding grants, was estimated at Af 8.8 billion in the first half of 2005/06, exceeding the SMP indicative target (Af 8.3 billion). Revenue comprised Af 4.6 billion in customs duties, Af 1.1 billion in domestic taxes, and Af 3.1 billion in nontax revenues. While customs performed better than anticipated, increasing by 40 percent over the same period of 2004/05, tax collections declined by 9 percent. While a number of new tax polices and administrative reforms were introduced over this period, covering: the lowering of corporate tax rates (from 25 to 20 percent); the increase in turnover tax rates for specific services; the introduction of a rental tax; the removal of tax holidays; and the creation of a large taxpayer office; the expected revenue benefits from these changes, with the exception of the rental tax, are yet to be achieved. Factors which affected the revenue collections, and which have now been resolved, involved: delays in the approval of the new enforcement provisions, so over the period compliance remained voluntary; and uncertainty associated with the administration and application of the amended income tax law, as the new one was already drafted and was being discussed.

10. We have started to implement a range of recently-adopted tax measures. These measures, which have been the subject of a taxpayer education program, include: (a) an increase in turnover tax rates for specific services (hotels, restaurants, telecommunications, and airlines); (b) a wage withholding tax; and (c) an airline departure fee. As our administrative capabilities are still limited and several technical issues related to implementation and coverage need to be resolved, we are initially focusing on the larger taxpayers.

11. The new income tax law was approved after a short delay. The new law, which incorporates amendments to provide for administrative powers and additional corporate tax reform measures, was approved by the Cabinet and signed into law by the President in November 2005. The short delay was largely due to an unanticipated legal ruling that required the re-submission of the complete law, rather than only the amendments, as was originally intended.

12. The midyear review (MYR), was adopted by Cabinet in October 2005. An increase in the wages of non-uniformed public servants was required, as the last general increase was in November 2003. Importantly, the aggregate rise in the wage bill for 2005/06 was restricted to less than 3 percent over the original budget (Af 549 million). Overall, the increase in operating budget stemming from the MYR was limited to 2.1 percent, with additional unanticipated spending for parliamentarians and pensions partially offset by savings in other current and capital expenditures. This increase in operating spending should be more than offset by additional domestic revenues, projected to increase by around 14 percent over the initial budget.2

13. We have adjusted the core development budget to make it more realistic, reflecting the government’s limited spending capacity. For the remainder of 2005/06, core development spending was reduced by 14 percent to Af 50.1 billion (15 percent of GDP) as projects unlikely to be started in the current year were carried forward to 2006/07. Over the medium term, core development spending is expected to average around 8 percent of GDP and be predominantly funded by external grants. Donor-funded spending currently implemented outside the core budget is estimated at Af 105.4 billion (31 percent of GDP) in 2005/06.3 To enhance transparency, accountability, and the role of the budget as a key policy instrument, we continue to encourage donors to bring this expenditure on-budget.

14. Currency in circulation increased by 12.1 percent during the first half of 2005/06, to Af 43.5 billion, slightly below the SMP second quarter indicative ceiling (Af 43.8 billion). As expected, demand for money accelerated somewhat during the second quarter due to seasonal factors. This acceleration was, however, less pronounced than last year, allowing Da Afghanistan Bank (DAB) to contain money growth within program limits without triggering a sharp appreciation of the Afghani. Reflecting the central bank’s foreign exchange activity and the accumulation of deposits by the government, international reserves increased further, reaching $1.5 billion at end-September, equivalent to 4.1 months of prospective imports. Interest rates on the overnight and 30-day capital notes continued to move in the 1–2 percent and 4–6 percent ranges, respectively. After depreciating by 3 percent during the first quarter, the Afghani appreciated by 2 percent against the U.S. dollar during the second quarter. During the 12 months leading to end-September, the Afghani has depreciated modestly against the dollar but remained broadly stable in real terms.

15. Progress was made in restructuring the state-owned banks. The Ministry of Finance, formally notified by DAB, and made public our decision to restructure the licensed banks, and to liquidate the three former state-owned banks that had not been relicensed. As a first step toward the transfer of its remaining deposits, DAB froze the correspondent accounts of Agricultural Development Bank, the only institution among the three former banks that had kept a deposit base. Regarding the licensed state-owned banks, we have decided to restructure Bank Millie and Bank Pashtany and to finalize the restructuration plan of Export Promotion Bank. The Ministry has initiated steps to restructure the management and operation of the Bank Mille, with recruitment of a new chief executive and a management team, all with the appropriate skills and experience, which will be in charge of implementing the restructuring. At the same time, DAB has conducted a review of the performance of these banks regarding observance of the conditions attached to their licenses. Based on the findings of this review, DAB has adopted enforcement measures to improve the operational performance and governance of these banks, starting with the replacement of the top management of Bank Mille. Accordingly, consultants are being recruited to advise and assist management of the Bank. A similar approach will be taken with Bank Pashtany. Other positive developments in the financial sector include the completion of the transfer of DAB’s commercial activities, and the reduction of the registration fees for deeds from 6 percent to 0.5 percent.

16. The current account deficit, excluding grants, reached 45 percent of GDP, compared with 51 percent in 2003/04.4 Including grants, the current account recorded a surplus, which narrowed to 1.9 percent of GDP in 2004/05, down from 3.1 percent of GDP in 2003/04. In addition, there was increasing foreign direct investments, concessional loans, as well as other unrecorded flows.

17. We stepped up our efforts to improve compilation of balance of payments statistics. In line with the recommendations of the May 2005 IMF technical assistance mission on balance of payments statistics, we have started implementing a reporting system that covers trade flows, private grants, interest receipts and payments, and the international investment position. In this context, we are working closely with the banking community, money changers, nongovernmental organizations, and firms engaged in international trade.

18. We have made progress in verifying external debt owed to Paris Club creditors and to non Paris Club creditors (an end-September 2005 structural benchmark). However, despite protracted efforts, we are still to receive from some creditors a reply to our requests, or provision of adequate documentation to validate claims.

19. We have adopted a classification of state-owned enterprises (SOEs) by the envisaged restructuring method. This list comprises the 66 enterprises directly owned by the government. Eight will remain state-owned, while 58 will be divested (liquidated or privatized). We expect about two thirds of the latter to be privatized, including about seven through international tenders. To facilitate the privatization of these enterprises, many of which are no longer in operation but hold large real estate assets, we adopted amendments to the Tassidy law giving the Ministry of Finance full authority and responsibility to privatize these enterprises.

20. We have adopted a statistical law, which provides for an independent statistical agency. This law establishes the legal framework for collecting, processing, and disseminating economic data, with the Central Statistical Office (CSO) being an independent institution with a separate budget. In addition, we adopted a program of restructuring and reform to ensure that the CSO has the human capital needed to implement the statistical master plan.

II. Policies for the Remainder of 2005/06 and 2006/07

21. To ensure a continued strong economic performance, we intend to pursue prudent macroeconomic policies, consistent with the SMP objectives, and create the conditions for sustained growth and poverty alleviation.

A. Macroeconomic Objectives

22. The macroeconomic outlook for 2005/06 remains favorable. Real GDP is expected to grow by 14 percent in 2005/06, driven by the continued recovery of the agriculture sector due to better rainfall during the planting season, and sustained activity in construction and services. Year-on-year inflation is expected to decline further, to about 10 percent at end-2005/06, notwithstanding upside risks related to possible second round effects of oil prices. The current account deficit, including grants, is projected to decline to 1.7 percent of GDP in 2005/06, while international reserves are expected to increase further.

B. Fiscal Policy

23. In October, the Cabinet adopted a medium-term fiscal framework (MTFF), that will form the basis for the 2006/07 budget, which also contains projections of the main fiscal aggregates over the next four years. This MTFF, the government’s first, includes a set of integrated medium-term macroeconomic and fiscal targets and projections that set out a path towards fiscal sustainability. The MTFF will be gradually refined to strengthen the linkages between these aggregate projections and our policy priorities. Although it will take time to develop more detailed sector strategies, the I-ANDS process, combined with work in a few priority sectors, should help improve the linkages between policies and operating and development spending and contribute to a more sustainable fiscal position and improved outcomes.

24. The MTFF highlights the country’s main fiscal challenges. Fiscal sustainability is predicated on: (a) rebuilding domestic tax collection from its extremely low level; (b) implementing an civil service reform program to both contain the wage bill and pensions to affordable levels, in the face of significant cost pressures, and improve performance; and (c) gradually consolidating fiscal operations within the core budget, consistent with our limited ability to sustain such activities. In particular, incorporating the ongoing costs arising from the current reconstruction and capital investments (i.e. for maintenance) into the budget, remains a significant challenge. Over the medium-term, we will continue to rely on significant external funding, even for some core current spending (such as the Afghan National Army), while planning to enhance its predictability and effectiveness by bringing such spending into the budget, consistent with the MTFF and I-ANDS.

25. Revenue is expected to increase significantly over the medium-term. The MTFF includes an ambitious program to increase domestic revenue from 4.5 percent of GDP in 2004/05 to 8.6 percent by 2009/10. In order to achieve these ambitious revenue targets, we plan to rationalize the current tariff structure for 2006/07, expand the coverage of the taxes introduced earlier in the year, and continue to strengthen compliance through the large taxpayer office. We will also consider introducing an excise tax. In addition, following the October 2005 tax policy conference with the private sector, we are jointly reviewing the priority reforms, including the turnover tax, revenue administration, and the abolition of nuisance taxes. Before major changes are made, we will consult widely and consider the impact on the whole economy. By maintaining our competitive income tax and customs duty rates and improving administration by simplifying procedures, streamlining the number of taxes, and reducing the burden of illicit taxation and corruption, we seek to increase revenue and reinforce a positive business environment.

26. Continuing to improve fiscal transparency, accountability and the integrity of fiscal information is a priority. Fiscal reporting improved markedly over the last year, with monthly core budget data now published on our website. However, the reconciliation of fiscal and banking data (an end-September benchmark) is constrained by existing procedures, information systems and weak capacity. The audit of the financial statements for the 2004/05 core budget (an end-September 2005 benchmark), which has been delayed by uncertainty over the appropriate procedures, recent changes in the new budget law, and limited administrative capacity will now be submitted to cabinet before end-December 2005. To avoid a repeat of such delays, the Ministry of Finance and the Control and Audit Office will agree on an audit plan for the 2005/06 core budget by end-February 2006.

C. Monetary and Exchange Rate Policies and Financial Sector Reforms

27. As price, exchange rate and financial developments during the first half of 2005/06 were largely in line with SMP projections, monetary policy will continue to be guided by the program agreed during the third review. In view of the upward risks on inflation, stemming in particular from possible second-round effects of the increase in oil prices, we will closely monitor price and exchange rate developments in the coming months and stand ready to tighten the monetary stance, should inflationary pressures emerge. International reserves are expected to increase further, to about $1.7 billion at end-2005/06. In 2006/07, pending the deepening of the financial markets (interbank market, capital notes) and the development of a monetary survey in line with international standards, monetary policy will continue to target currency in circulation, and the exchange rate to be market-determined.

28. We will continue to modernize DAB’s operations and strengthen the monetary policy framework. We will adopt amendments to remunerate reserve requirements, while excluding capital notes from the eligible assets. By end-March 2006, we will enforce these new regulations, as well as those related to the foreign currency open positions, and penalize non-compliance. By end-December 2005, we will allow participants to the DAB’s foreign exchange auctions to sell, as well as to buy, dollars. By year end, with technical assistance from the IMF, we will also introduce an overnight collaterized credit facility, with capital notes eligible as collateral. We also intend to introduce capital notes of longer maturities. Lastly, we will strengthen the monetary framework, through the development of more reliable liquidity forecasts, publication of the capital note interest rates, and strengthened oversight by DAB’s Supreme Council.

29. We will pursue the restructuring of the public banking sector. By end-December 2005, we will appoint people in charge of overseeing the liquidation of the state-owned banks, and by end-March 2006, we will start implementing this liquidation and complete the transfer/reimbursement of the Agricultural Development Bank deposits. We will replace the management boards of Bank Millie and Bank Pashtany by end-December 2005 and end-March 2006, respectively. By end-June 2006, the new management teams, in coordination with the Ministry of Finance, will adopt long-term restructuring plans for these two banks.

30. We intend to tackle the administrative and legal impediments to the development of the banking sector. We will continue working with the banking and donor communities to identify the main impediments to the development of banking operations, prioritize a legal, administrative and legislative reform agenda to address impediments, and ensure better coordination between donors. One of our priorities is the adoption of essential enabling laws for lending operations, including the secure transactions law, the business organization law, and the negotiable instrument law.

D. External Policies and Debt Management

31. The overall external sector outlook remains favorable. The revised current account deficit, excluding grants, is projected to reach 42 percent of GDP in 2005/06, compared with 45 percent in 2004/05. Although foreign direct investment and concessional loans are expected to increase in the near future, the deficit will continue to be primarily supported by grant financing, as well as other flows. Including grants, the current account is expected to record a surplus of 1.7 percent of GDP.

32. We are committed to further enhance the quality and reliability of balance of payments data. The survey of non recorded trade is expected to be completed by end-March 2006. Its findings will help refine trade flow estimates. In addition to the various surveys under way on other components of the balance of payments, we will hold regular meetings with the primary providers of data on remittances, financial flows, and the international investment position. On external debt data, DAB will coordinate closely with the Ministry of Finance.

33. Our external borrowing strategy will remain cautious, relying primarily on grants and highly concessional loans to meet our financing needs. We envisage continued lending from multilaterals such as the Asian Development Bank and additional highly concessional lending from bilaterals, if need be, to fund specific projects that directly benefit the population and reduce poverty. We will continue to seek generous debt relief from existing bilateral creditors and examine the various debt-reduction options. We will pursue good faith efforts to conclude the debt reconciliation process with all our creditors.

34. We recognize that an open and transparent trade regime is critical to enhancing Afghanistan’s growth prospects. We intend to consolidate the gains made thus far through reforms of the trade regime and customs administration. We have begun discussions with the world trade organization (WTO) as a first step toward membership. Such membership will provide us with more predictability in our trade relations with other countries, and give us access to the WTO dispute settlement apparatus and to technical assistance. In addition, to enhance our role in the region, we recently became a member of the Central Asian Regional Economic Council, and are being considered for membership in several other regional organizations.

E. Structural Reforms

35. In addition to reforms in the fiscal and monetary areas, we intend to focus on further liberalizing the economy and strengthening competition. Key measures will include: (a) the publication in the Official Gazette, by end-December 2005, of the amendments to the Tassady Law; (b) the initiation of an open and transparent divestiture process of the 58 SOEs slated for liquidation or privatization; and (c) the completion by end-December 2005 of an inventory of the various public entities and government agencies engaged in commercial activities.5 The divesture will be accompanied by an equitable and affordable retrenchment plan. To enhance competition and ensure an adequate regulatory environment for investment, we will also promote land ownership rights and an insurance law.

F. Poverty Reduction Strategy

36. As part of the first step in formulating our development strategy, a draft document, the I-NDS, is being developed with broad intra-government consultation and participation of civil society and the donor community. This draft will define our strategic vision and sectoral priorities, consistent with the Millennium Development Goals, and will include broad estimates of our medium-term development needs. This draft will subsequently be discussed with our development partners, and civil society to build broader ownership before it is presented at the January 2006 International Donors’ Conference. We will continue to work closely with World Bank and IMF staffs to ensure that the I-ANDS meets the requirements of an interim poverty reduction strategy paper (I-PRSP) that could support our upcoming request for a PRGF-supported program. A final version of the I-ANDS in a format consistent with an I-PRSP, is expected to be adopted before end-March 2006.

G. Statistical Issues

37. We are committed to building our statistical capacity with support from the international community. We intend to complete the institutional statistical framework by putting in place, by March 2006, the National Statistical Council provided for by the new statistical law. At the same time, we will actively seek donor support to fully fund the action plan for rebuilding our statistical capacities. We recently notified the IMF of our commitment to join the General Data Dissemination System (GDDS), and have appointed a GDDS coordinator and started work on the metadata. Lastly, owing to some technical difficulties, the three surveys designed to measure development progress were delayed and are now expected to start in March 2006.6

H. Technical Assistance

38. An overall review of technical assistance (TA) will be completed after the Donors’ Conference. As we intend to request a PRGF-supported program, this review will be instrumental in helping us, as well as our partners, to enhance the quality of TA, ensure a better distribution of TA across government agencies, and redeploy resources in line with the priorities defined in the I-ANDS. The government of Afghanistan remains grateful for the assistance provided so far by the IMF and looks forward for its support in the months ahead to implement its reform program.

III. Program Monitoring

39. We will continue to monitor, through the Technical Coordination Committee, the implementation of the SMP. In doing so, we will refer to the definitions, data sources, and frequency set out in the technical memorandum of understanding (TMU). Table 1 includes the quantitative indicators through end-September 2006. Table 2 sets out the structural benchmarks. For reporting purposes, the government will continue to provide IMF staff all core data, appropriately reconciled and on a timely basis, as specified in the TMU. IMF staff will be notified prior to introducing any policy actions and developments that might affect the program.

Table 1.Islamic Republic of Afghanistan: Quantitative Indicators, 2005/06–2006/07(In millions of Afghanis, unless otherwise indicated; cumulative changes from beginning of fiscal year)
2005/062006/07
Jun. 21Jun. 21Sep. 22Sep. 22Dec. 20Mar. 20Jun. 20Sep. 20
Indicative

Target
EstimateIndicative

Target
EstimateIndicative

Target
Indicative

Target
Indicative

Target
Indicative

Target
Currency in circulation (ceiling) 1/2,4531,3215,0574,6937,82210,7582,5725,278
Claims of the banking system on the central government (ceiling)00000000
Gross international reserves of the central bank (floor) (in millions of dollars)-5085019810015800
Fiscal revenue of the central government (floor)4,6294,7578,3068,75212,67618,3285,56711,371
External debt
a) New medium- and long-term nonconcessional external debt (with original maturities of one year or more) contracted or guaranteed by the government (ceiling) 2/3/00000000
b) New nonconcessional debt with an original maturity of less than one year (ceiling) 3/4/5/00000000
Memorandum item:
Currency in circulation (level triggering consultation)3,5087,29810,15113,2343,8758,018
Sources: Afghan authorities; and Fund estimates and projections.

At end-2004/05, currency in circulation amounted to Af 38.8 billion.

Excluding rescheduling arrangements, but including debt with maturities of more than one year.

This benchmark will be evaluated on a continuous basis.

Concessional debt is defined as debt with a grant element of at least 60 percent calculated on the basis of currency-specific discount rates, based on the OECD commercial interest reference rates (CTRRs).

On a contracting or guaranteed basis. Excluding debt related to normal import transactions.

Sources: Afghan authorities; and Fund estimates and projections.

At end-2004/05, currency in circulation amounted to Af 38.8 billion.

Excluding rescheduling arrangements, but including debt with maturities of more than one year.

This benchmark will be evaluated on a continuous basis.

Concessional debt is defined as debt with a grant element of at least 60 percent calculated on the basis of currency-specific discount rates, based on the OECD commercial interest reference rates (CTRRs).

On a contracting or guaranteed basis. Excluding debt related to normal import transactions.

Table 2.Islamic Republic of Afghanistan: Structural Benchmarks, June 2005–September 2006
Structural BenchmarksTarget DateStatus
Adopt (by the Cabinet) and publish in the Official Gazette the financial management law.End-June 2005Implemented
Publish the financial statements of the 2003/04 external audit of DAB.End-June 2005Implemented
Reconcile the government accounting records with the government’s bank accounts.End-September 2005Implemented 1/
Publish the 2004/05 audited financial statements (core budget).End-September 2005Not implemented
Adopt (by Cabinet) a comprehensive external debt management strategy.End-September 2005Implemented 1/
Contact the Secretariat of the Paris Club to assist with the comprehensive review of, and reconciliation of, debt owed to Paris Club creditors; and continue to contact the non-Paris Club creditors for a full reconciliation of external obligations, including those that did not respond to earlier requests for debt reconciliation.End-September 2005Implemented
Publish in the Official Gazette: the proposed amendments to the income tax law to provide for administrative powers and for additional corporate tax reform measures.End-September 2005Implemented 1/
Commence implementation of recently approved tax measures, notably the business receipt tax on hotels, restaurants, telecommunications, and airlines and the wage withholding tax, accompanied by a taxpayer education program.End-September 2005Implemented 1/
Issue a statement indicating the Ministry of Finance decision, as the main shareholder, to liquidate the three former state-owned banks.End-September 2005Implemented 1/
Appoint liquidators for the three former state-owned banks and start implementing their liquidation.End-December 2005
Replace the management board of Bank Millie.End-December 2005
Adopt (by Cabinet) a Medium-Term Fiscal Framework that includes (a) a fiscal table with 3-year projections of revenues, expenditures, fiscal deficit and sources of financing, and (b) a description of the policy actions which sustain the projections.End-December 2005
Eliminate, or reduce substantially, registration fees for deeds.End-December 2005
Publish the 2004/05 audited financial statements (core budget).End-December 2005
Remunerate required reserves.End-March 2006
Identify largest taxpayers to be administered by the Large Taxpayer Unit according to agreed transparent criteria, and prepare detailed compliance profile for each taxpayer.End-March 2006
Publish estimate of revenues forgone as a result of customs exemptions, including due to international assistance, and income tax law exemptions.End-March 2006
Establish appeals process for customs and tax administrations.End-June 2006
Process gold held in the palace vaults into a form that qualifies as a reserve asset and transfer any monetary gold held in Afghanistan to an international gold center.End-September 2006
Submit to parliament the core budget’s audited financial statements for 2005/06.End-September 2006

40. Discussions on a PRGF-supported program are expected to be completed by March 2006, and the request for a program presented for consideration by the Executive Board in the second quarter of 2006. Performance under the seventh review will serve as a basis for policy discussions under the PRGF.

1The fiscal year 2005/06 runs from March 21, 2005 to March 20, 2006.
2Although it is improving, the quality of the statistical data, particularly for the national accounts and the balance of payments, remains poor as the compilation process is hampered by the general lack of reporting from primary sources (see appendix on statistical issues).
3The “national” CPI, which covers five major cities in addition to Kabul, increased by 10.8 percent during the 12 months ended in September 2005.
4Security spending continues to dominate the budget. It is projected at 26 percent of total core and external development spending in 2005/06 (implementation rates in this sector tend to be highest).
5Audits of the main multi-donor trust fund (Afghanistan Reconstruction Trust Fund) and World Bank funds, which cover a large part of the budget, were finalized by end-December.
6Afghanistan’s exchange rate system consists of a managed float with no predetermined path for the exchange rate. Foreign exchange auctions are conducted on a weekly basis.
7Current account figures exclude drug exports but include rough estimates of re-exports and unrecorded imports.
8A number of public entities and government agencies engaged in commercial activities are not covered by the SOEs law and were, therefore, excluded from this classification.
9These projections exclude $80 million (equivalent to 21 percent of total revenue) stemming from the sale of the telecoms spectrum band width (transfer of nonfinancial assets).
10In late October 2005, the MoF organized a revenue conference with the private sector and the international community to discuss both policy and administrative issues. Several working groups were established to address the issues raised during the conference.
11The governments of Russia, Germany, and the United States have indicated their intention to cancel all of the debt owed by Afghanistan through the Paris Club under the HIPC Initiative. Further details will be included in the staff statement to the Executive Board.
1While the DSA template uses 10-year averages of key macroeconomic variables to generate alternative scenarios for analytical purposes, this was not possible in the case of Afghanistan as reliable economic data exist only for the last three years. As a consequence, the present DSA does not employ the full set of stress tests typically presented in low-income country DSAs.
2A number of caveats must be noted. The World Bank has not yet assessed Afghanistan against its Country Policy and Institutional Assessment (CPIA) framework, which makes it impossible to identify a policy-dependent sustainability threshold as identified in “Operational Framework for Debt Sustainability Assessments in Low Income Countries—Further Considerations” (refer to www.imf.org). For the purposes of this exercise, it is assumed that Afghanistan is evaluated as a medium performer in the CPIA. Thus, the sustainable ratio for the NPV of debt-to-exports is assumed to be 150 percent. It is possible that the indicative sustainability thresholds for Afghanistan may be revised following its evaluation under the CPIA. This would affect the results of the DSA. Owing to these caveats, this exercise cannot propose a definitive rating of debt distress for Afghanistan.
3Unverified claims amount to roughly $157 million, which the authorities are in the process of reconciling.
4This implies that most new borrowings would need to come from concessional creditors, such as IDA and/or the Asian Development Bank.
5See Box 1 of the staff report for a full explanation. The definition of “total recurrent spending” includes a number of items, such as recurrent military costs, currently in the external budget, which are funded directly by donors outside of the government-controlled operating budget.
6This scenario is presented to underscore the importance of highly concessional resources in maintaining external sustainability. Afghanistan currently has no commercial market access, nor is it likely to have it in the near future. Nevertheless, this scenario assumes that additional debt is contracted at terms similar to those obtained in commercial markets (8 percent coupon, 1-year grace period and 6 years of maturity; the principal is to be repaid in six equal installments).
1The national CPI, which covers five major cities in addition to Kabul, increased by 10.6 percent in the twelve months ending in September 2005.
2The increase in revenue excludes $80 million (equivalent to 21 percent of domestic revenue) from the sale of telecoms spectrum band width that we expect will be received in the third quarter of the year.
3This figure reflects the funded portion of the external budget, while an additional Af 77 billion is planned but not funded in 2005/06.
4As it is now currently constructed, the current account does not include drug exports.
5This inventory will include (a) enterprises which are not fully-owned by the government (e.g. Ariana Afghan Airlines); and (b) departments—within ministries—which are engaged in commercial activities.
6These surveys are: (a) the national risk vulnerability assessment survey on rural households; (b) the integrated business enterprise survey; and (c) the integrated living standard survey or household income expenditure survey.
1/This structural benchmark was inplemented with some delay.

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