January 19, 2005
1. My authorities highly appreciate the continuous dialogue with staff that has been instrumental in the successful implementation of their Staff-Monitored Program (SMP). They are also grateful for the assistance from the donor community in support of Afghanistan’s security and reconstruction needs. Against the background of a difficult security and political environment, the authorities have persevered with prudent financial policies and structural reforms. All quantitative and structural benchmarks of the SMP for end-September were observed on time, with the exception of the benchmark relating to the AML/CFT legislation, which was implemented with a slight delay.
2. The recent direct presidential election—with large voter participation and a strong mandate to President Karzai—was a milestone in rebuilding the institutional framework and broadening policy ownership. The new cabinet is dominated by technocrats and the economic team is expected to continue the current successful policies. The authorities recognize the challenges ahead, including maintaining security, stemming the growing drug economy, sustaining non-inflationary growth, and reducing poverty. In addressing these challenges, they count on continued strong financial and technical support from the international community as they strive toward mobilizing domestic resources and building institutional capacity.
3. Despite the adverse effect of the persistent drought on the agricultural sector, real GDP growth remained strong, bolstered by robust activity in construction and services. Inflation, which had been fueled by sharp increases in rents and petroleum products prices, has slowed recently. Reflecting an improved trade balance, driven by a marked increase in domestic exports, the current account deficit is expected to narrow significantly and to be financed mainly from grants, highly concessional loans, and foreign direct investment.
4. The authorities have demonstrated strong commitment to fiscal discipline and to improving budget management. In the first half of FY 2004/05, revenue exceeded the SMP indicative target and registered a significant increase over the same period last year, reflecting administrative reforms and improved transfer of provincial collections into the central government account. The rate of current spending, most of it security-related, increased after initial delays, while core development budget spending fell substantially short of expectations due to combination of late budget approval, the security situation, and capacity constraints. The no-overdraft policy, a strong signal of fiscal discipline, was maintained, with operating expenditures financed through revenue, foreign assistance, and the temporary draw down of government deposits in the face of lower-than-expected reimbursements from the two multi-donor grant funds. A system of direct payment to vendors’ bank accounts has been recently initiated and is expected to accelerate payments and to improve fiscal discipline.
5. While remaining anchored on targets for currency in circulation and carried out through foreign currency auctions, monetary policy continued to be implemented flexibly. Hence, the higher-than-expected increase in money demand, reflected in the strong appreciation of the Afghani and the growing “Afghanization,” a testimony to rising confidence in the economy, has been accommodated. Monetary policy flexibility, buttressed by the managed float, has contributed to the containment of inflation, reduction of exchange rate volatility, and building of reserves. The Da Afghanistan Bank (DAB) successfully introduced a short-term note and will work toward developing additional monetary policy instruments.
6. Despite capacity constraints, significant progress has been made in structural reforms, including introduction of major initiatives in the banking and fiscal areas. Bank legislation and regulatory framework have been reinforced along with the licensing of several state- and foreign-owned banks. Further reform of the state banks will be undertaken in the period ahead to bolster competition and efficiency. Computerization of expenditure and revenue operations, and the adoption of five-year plans to improve customs and tax administrations, are expected to significantly improve budget management.
7. For the second half of 2004/05 and over the medium term, the program will focus on maintaining fiscal and monetary discipline, accelerating structural reforms, improving the environment for private sector activity, strengthening administrative capacity, and addressing poverty and social concerns. The goal is to foster broad-based growth as well as a more efficient and resilient economy.
8. The short-term outlook is overshadowed by a weaker prospect for the agricultural production due to persisting adverse weather conditions that threaten food security for up to 3.5 million people (15 percent of the population). Growth in other sectors is expected to continue, perhaps at a slower pace, spearheaded by private sector-led activities in construction, transport, and other services. Downside risks to this outlook, aside from the effects of prolonged drought, include volatile oil prices, the spread of opium activities, and the uncertain security situation. Inflation is expected to remain moderate as rents stabilize. The external current account is also expected to improve, notwithstanding a projected pickup in import demand, reflecting post-election resumption of donor activities and, as the staff suggest in BUFF/05/3, reserves increased to about US$1.3 billion, equivalent to 4.8 months of imports at end-November.
9. In the fiscal area, the strong revenue collection for the first half of 2004/05 bodes well for performance over the year. While the pace of revenue collection slowed down somewhat in October and November, this reflected a reasonable pattern, and possibly the effect of the elections, and revenue performance is expected to strengthen thereafter. The tax system is being simplified, and its base broadened, along with efforts to consolidate revenue laws into a single code. On the expenditure side, government operations are to be consolidated and expenditure management systems upgraded. Operating expenditures are projected to pick up significantly, and compliance with expenditure regulations is expected to improve as additional training of personnel is provided in financial and procurement procedures. Reforms aimed at developing the core budget and consolidating the government accounts into the Single Treasury Account will be strengthened. As improvements in the security situation allow, the expenditure policy will shift gradually from security and reconstruction to more broad-based development objectives. The outcome of a public expenditure review, currently being undertaken by the World Bank and other donors, should help in establishing priorities for next year’s budget.
10. Low inflation and currency stability remain the primary goals of monetary policy. The DAB will closely monitor price and exchange rate developments and will take prompt action in adjusting policy as necessary, in close consultation with Fund staff. A more market- determined exchange rate policy will be fostered, with an increased role for commercial banks, which should bolster the nascent export sector. Financial sector reform will continue to be geared to restructuring the state-owned banks and DAB operations. The restructuring strategy for the three licensed state-owned banks will be finalized, as will the resolution plan for the three unlicensed banks. The process of transferring DAB’s commercial activities and its non-core assets, a challenging task, will continue, as it is aimed at laying the foundations for a modern central bank. DAB’s recapitalization needs are expected to be determined by its external audit, which will also form the basis for a safeguards assessment.
11. In the structural area, reforms will be accelerated to unlock the potential of new growth-generating activities and to expand employment opportunities. A recently undertaken survey of state-owned enterprises (SOEs) will form the basis for their privatization, restructuring, or liquidation. The SOEs classification and reform plan is expected to be adopted by Cabinet by end-March 2005. In the meantime, privatization of a number of small SOEs, including a cotton company and a sugar beet company, has already been initiated. The adverse employment impact of SOEs reform will be alleviated through retraining and reassignment of displaced workers. Public administration reform will seek to balance the need to improve service delivery with resource availability. In this connection, an employee and payroll verification system is being developed to ensure effective expenditure control and will be transformed into a more comprehensive personnel database and computerized payroll over the medium term. Civil service capacity will be strengthened and remuneration improved to assist recruitment and retention of skilled staff. The government attaches high importance to private sector investment and is finalizing the requisite legal and regulatory framework. In this regard, the importance of clarifying property rights, contract enforcement, and bankruptcy laws is duly recognized. Moreover, governance concerns, including those relating to perception of corruption, are to be forcefully addressed to enhance business confidence.
12. The authorities recognize, and are committed to, the benefits of an open and transparent trade and exchange system. The introduction of a new tariff system with just a few rates and estimated average tariff of 4 percent as well as the use of market exchange rates for import valuation are important steps in this regard. Due emphasis is being placed on promoting regional trade, where the potential is significant, including through agreements on trade and transit with neighboring countries. At the multilateral level, WTO membership is a future goal once the requisite legal reforms are introduced. Long-term debt sustainability is a priority for the authorities who are committed to prudent debt management and intend to design and implement a comprehensive strategy to that end. Furthermore, steps are being taken to reconcile and verify existing debts, while limiting borrowing to highly concessional terms. The staff report duly emphasizes the need for very generous treatment of pre-war claims to ensure long-term fiscal and debt sustainability. Consequently, the authorities will continue to seek generous debt relief from bilateral creditors.
13. The growing drug-related activities pose a daunting challenge. The authorities recognize that relying solely on eradication without considering potential economic consequences, especially for the poor, will not be successful. While the government is determined to reduce opium production markedly in the years ahead, sustained donor financial and technical assistance is needed to create, in particular, alternative livelihoods for rural population. The authorities are working with international partners to develop a five- pronged strategy involving education, alternative livelihoods, interdiction, eradication, and legal reform. The “Securing Afghanistan’s Future” strategy seeks, inter alia, to sustain high growth in the nondrug economy, exploiting alternative sources of growth, including in agriculture, extractive industries, construction, and transportation. Alleviating poverty exacerbated by the war and meeting basic social needs are central to the strategy. In furtherance of this goal, a dialogue with social and development partners is underway to develop an interim poverty reduction strategy that is expected to be finalized by end-March 2006.
14. Considerable scope exists for improving the quality, coverage, and timeliness of the statistical database. In this regard, a statistical master plan to prioritize a work program and coordinate resources and TA for the development of a comprehensive database has been adopted. To maximize the benefits of TA, redefinition, focus, and coordination are critical, and, for that purpose, a comprehensive review and the establishment of an action plan are contemplated.
15. The authorities are resolved to forge ahead with their reform agenda. They recognize the risks associated with the security and the political situation, which should to be handled cautiously to maintain the necessary social stability and cohesion. Afghanistan will need significant donor assistance, including substantial debt relief, to support its reconstruction and development efforts. Until a new national assembly is in place, and given the need for more time to build a solid administrative capacity and for the new government to become fully functional, the authorities have expressed their preference for a follow-on SMP before embarking on a formal program relationship with the Fund. The SMP should continue to focus on maintaining macroeconomic stability and building a track record of policy implementation while supporting the authorities’ capacity building efforts. They are grateful to staff, management, and the Board for their advice and support.