March 6, 2006
- In an exceptionally challenging environment, the Afghan authorities have persevered with the implementation of prudent financial policies and bold structural reforms, and have observed all of the quantitative indicators and the structural benchmarks for end-September under the SMP, except for the publication of the audited 2004/05 core budget financial statements.
- The budget deficit is expected to be lower than envisaged in 2005/06. Revenue exceeded the program target during the first half of 2005/06, while spending remained lower than budgeted because of capacity constraints.
- Monetary policy remained focused on inflation control, and inflation subsided over the first half of 2005/06.
- Important regulatory and judicial reforms are underway, including preparatory work for laws aimed at enhancing governance, property rights, and competition.
- The authorities recognize that an open and transparent trade regime is vital for growth prospects, and they intend to pursue discussions on Afghanistan’s accession to the WTO.
- The authorities have expressed strong interest in continued Fund involvement, and the progress made so far under the SMP has paved the way for discussions on a program that could be supported by the PRGF.
The Afghan authorities would like to thank management and staff for the constructive policy dialogue and support, particularly over the last two years of the Staff Monitored Program (SMP). They value highly their collaborative relationship with the Fund and recognize the important role of this engagement in support of their efforts to stabilize and transform the economy. The staff report reflects in a comprehensive and balanced way the progress made under the SMP, while highlighting the remaining challenges. The topics selected for analysis in the Selected Issues paper are relevant, and the discussion is informative, providing the analytical underpinnings for policy formulation.
In an exceptionally challenging environment dominated by security issues and adverse shocks—but with significant support from the international community—the authorities have persevered with the implementation of prudent financial policies and bold structural reforms. Although the security situation in some parts of the country remains difficult, with the number of incidents increasing in the period surrounding the legislative elections and despite concerns that low capacity would hinder the delivery of the program’s commitments, the authorities observed all of the quantitative indicators and the structural benchmarks for end-September in the SMP, except for the publication of the audited 2004/05 core budget financial statements. The budget statements have been submitted to the Auditor-General, but administrative capacity constraints have led to delays in their certification. The progress so far achieved in the adjustment of the economy finds strong expression in the high rate of economic growth and reduced inflation. Economic growth moderated in 2004/05, attributed primarily to the impact of adverse weather conditions on agricultural output, but real GDP rebounded in 2005/06, with the reconstruction effort continuing to drive growth in construction, trade, transportation, and telecommunications. After rising sharply in 2004/05 on account of petroleum prices, inflation subsided over the first half of 2005/06: year-on-year inflation declined to 12.9 percent in September 2005, from 16.3 percent in March, as envisaged in the program. Opium production declined by 2 percent in 2005: the decline could have been significantly larger, as many farmers did not plant in anticipation of intensified government-led anti-narcotics activities, but the sharp drop in cultivation was largely offset by higher yields owing to favorable weather conditions.
The authorities have continued to focus on improving the budgetary process and transparency, which were strengthened through the adoption of a new public finance and expenditure management law. The authorities recognize that fiscal policy should remain cautious over the medium term to ensure macroeconomic stability, and have demonstrated their commitment to fiscal discipline in the steadfast implementation of the SMP. The budget deficit is expected to be lower than previously envisaged in 2005/06, which should contribute to a further build-up of government deposits with Da Afghanistan Bank (DAB). The operating budget deficit, excluding grants, was 4.9 percent of GDP in 2004/05 and 1.7 percent of annual GDP during the first half of 2005/06. Revenue has increased rapidly in the last few years and exceeded the program target during the first half of 2005/06. Nonetheless, the authorities plan to take new measures because they are well aware that a broad tax base and a reduced reliance on trade taxes, as well as a strengthened administrative capacity of the revenue directorate, are a sine qua non to achieve fiscal sustainability. They have initiated a reform plan for the customs and tax administrations, with immediate focus on the new large taxpayer unit for improving compliance. They are also contemplating the introduction of excises on certain consumption items.
Current government spending remained close to budgeted but capital expenditure was lower because of capacity constraints. Core development expenditure reached 2.5 percent of annual GDP during the first half of 2005/06, compared to a revised budget target of 14.1 percent of GDP for the fiscal year as a whole. In the midyear budget review (MYR) 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. As for rationalizing the civil service, given the relatively large public employment level, the authorities believe that reform in this area should be gradual and in line with employment developments in the private sector to avoid social disruptions. To this end, the modest wage increase in 2005 was undertaken to reduce the large gap between public and private sector wages. They have chosen to keep wage increases low so as to leave room for a more fundamental reform. Recognizing that a systematic reform program is required to strike a better balance between the need for higher salaries and budgetary considerations in the medium term, a medium-term fiscal framework (MTFF) was approved by Cabinet at the time of the MYR, which includes integrated macroeconomic projections and fiscal targets.
Monetary and exchange rate policies
Monetary policy remained focused on inflation control, guided primarily by indicative targets for currency in circulation. The growth of monetary indicators during 2004/05 and through September 2005 was in line with, or lower than SMP projections, which included a marked slowdown in currency growth. DAB made significant progress in modernizing its foreign exchange and capital note auctions, as well as in strengthening the banking sector regulatory framework. 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, and the reduction, from 6 percent to 0.5 percent, of the registration fee for deeds, whose high level had constituted a major deterrent to lending operations. The authorities consider that the new regulations and administrative measures to strengthen DAB’s supervision of the banking sector will result in higher public confidence in banks, thereby encouraging depositors to invest in longer-maturity instruments, which in turn should improve the environment for lending operations.
The managed float system has served the country well. The real appreciation experienced by the Afghani in recent years reflects, to a large extent, the impact of drug- and aid-related inflows. The authorities agree with the staff that, in this context, strengthening external competitiveness requires enhancing efficiency in the utilization of foreign aid and deepening structural reforms to increase productivity, and they view the maintenance of competitiveness through these measures as a constant challenge. They are anxious about the upward risks to inflation, stemming in particular from possible second-round effects of the increase in oil prices. They have been following closely price and exchange rate developments, with a view to tighten the monetary stance if there were to be any intensification of inflationary pressures.
In recent years, the foundation of the economy has been strengthened significantly due to the structural reforms that have been undertaken. In addition to modernizing DAB’s monetary operations and strengthening bank supervision, the authorities took further steps to advance the reform agenda, including removing distortions and addressing structural weaknesses in the economy, which should encourage private investment and diversify the growth and export bases. Important regulatory and judicial reforms are underway, including preparatory work for laws aimed at enhancing governance, property rights, and competition. In particular, the authorities, with donor support, are working toward the adoption of a core group of enabling laws—including on secured transactions, business organization, and negotiable instruments—that would strengthen judicial enforcement. Regarding state-owned enterprises (SOE), the government adopted a classification for the envisaged restructuring in which only a few will remain in the public sector: out of 66 SOEs, eight are expected to remain state-owned, while 58 will be liquidated or privatized. In the restructuring of public financial institutions, the authorities have made public their intention to liquidate three former state-owned banks that had not been relicensed. The authorities recognize that an open and transparent trade regime is vital for growth prospects, and they intend to pursue technical work in support of Afghanistan’s accession to the World Trade Organization (WTO).
In the Interim Afghanistan National Development Strategy (I-ANDS), which was presented during the international donors’ conference in London in January, the authorities have articulated a medium-term development strategy, which will be underpinned by growth-boosting reforms, focused on reducing the role of the government in the economy and improving the investment climate. The I-ANDS process has been conducted through broad-based consultations with key stakeholders and civil society, which has enabled the authorities to develop a broad and credible agenda of reforms and establish their priorities, taking into account the competing demands on the limited resources. The I-ANDS places priority on: (a) security; (b) governance, rule of law, and human rights; and (c) economic and social development. The elimination of the narcotics industry is identified as a top priority in the quest for sustained rapid growth and poverty alleviation. They will exercise expenditure restraints as dictated by the MTFF, especially in nonpriority areas that have been identified. The government and the donor community have developed a “Compact” that establishes commitments, benchmarks, and a monitoring mechanism. There will be improvement in monitoring and evaluation, which will help to identify capacity constraints in the public sector. While moving toward a full ANDS, the authorities will broaden the already extensive participatory process of the I-ANDS, and will clearly define the goals and link them to specific policy actions.
The authorities recognize that the medium-term outlook is subject to various risks, but with the support of the population in the new environment shaped by the first legislative and provincial elections in 35 years, they stand ready to face the formidable challenges and make further progress in reducing poverty. Under the assumptions of continued reform, donor support, and the gradual improvement of infrastructure, the medium-term framework envisages growth of about 10 percent on average for the next three years. This scenario is consistent with a return to trend of agricultural growth, and sustained, albeit decelerating, activity in construction and services. The MTFF will serve as a key anchor for sound macroeconomic policies; it outlines a clear path toward fiscal and external sustainability, including an ambitious program to increase domestic revenue from 4.5 percent of GDP in 2004/05 to 8.6 percent of GDP by 2009/10, through, inter alia, the rationalization of the current tariff structure and the introduction of road tolls and excise taxes in 2006/07. Considerable progress has been made in reconciling the external debt, which was an end-September 2005 structural benchmark, including the completion of the reconciliation process with many of the creditors. A major milestone was reached in the aftermath of the recent donor’s conference when the governments of Russia, Germany, and the United States indicated their intention to cancel the entire debt owed by Afghanistan through the Paris Club under the HIPC Initiative. It was heartening to read in the public statements of the donors on 100% debt cancellation that this achievement reflected the hard work of the government and the people of Afghanistan to build a stable economy, despite many challenges, and that the solution of the debt problem will strongly contribute to the further development of Afghanistan’s trade, investment and other economic ties with its major creditors and with the rest of the world.
Poverty reduction and growth facility
The authorities have taken appropriate measures to ensure achievement of macroeconomic objectives under the SMP. These successes can hardly be overestimated in light of the difficult and severely constrained circumstances under which they were achieved and the variety of adverse shocks that have complicated program implementation. At the same time, the authorities are very much aware that there is a long way to go towards self-sustained growth and completing the ambitious program of reforms required to finish the tasks of economic reconstruction, eliminating opium production and providing alternative income opportunities, strengthening productive efficiency, and reducing poverty. As indicated in the staff report, the authorities have expressed strong interest in continued Fund involvement, and the progress made so far under the SMP has paved the way for discussions on a program that could be supported by the PRGF. The current SMP has been instrumental in maintaining macroeconomic stability and building a momentum for structural reform, and a successor program would help the authorities to consolidate these gains, reinforce the implementation of the ambitious policy agenda, including the critical task of developing the institutions and conditions necessary for private sector development, and significantly improving social conditions. In addition, a PRGF arrangement would contribute to the resolution of outstanding debt issues with Paris Club creditors in the context of the HIPC Initiative.
The authorities plan to continue the laborious process of restructuring the economy, improving governance and transparency, and enhancing efficiency through greater reliance on market forces with reduced government intervention in the economy. Their adjustment record since the inception of the SMP in March 2004 should give confidence in their ability to pursue such a strategy in a pragmatic way within the existing economic and political constraints. The record is all the more commendable because of a difficult environment, which has been dominated by lingering insecurity, poor state of infrastructure, weak institutions, and other myriad uncertainties typical of a post-conflict environment.