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Islamic Republic of Afghanistan

Author(s):
International Monetary Fund
Published Date:
November 2011
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I. Introduction: Afghanistan’s Main Challenges

1. Afghanistan has made important achievements in recent years. The authorities have taken steps to lay the foundation for economic stability and growth, despite a very difficult security situation and the challenges associated with building political and economic institutions (Box 1). As a result, economic activity has been robust, with real GDP growth averaging more than 10 percent annually over the past five years. The government has increased revenue collection to 11 percent of GDP in 2010/11 from 8 percent in 2008/09, though current collection levels cover only about two-thirds of central government operating expenditures and less than 20 percent of total public spending (defined as central government spending plus off-budget donor spending).1, 2

Box 1.The Authorities’ Response to Past Fund Advice

Past Fund advice focused on tax reforms toward a more efficient tax system, including transforming the Business Receipt Tax (BRT), a cascading sales tax, strengthening the capacity of the revenue administration, enhancing the monetary policy instruments by expanding the role of capital notes, and strengthening banking supervision in light of identified deficiencies in risk management at financial institutions.

The authorities have made progress toward a more efficient tax system. A main achievement was transforming the BRT, a cascading sales tax, into a broad-based consumption tax. Continued engagement in revenue administration has strengthened the capacity of the Afghan revenue and customs departments. These measures have included changes to the income tax law (including the collection of BRT on imports at the border), a strengthening of the large taxpayers office, and a tighter monitoring of fuel imports. Most recently, the ministry of finance has piloted a one-stop-shop customs border post in cooperation with other ministries, following Fund advice.

The authorities have strengthened the public financial management (PFM) systems. PFM reforms are essential for increasing the transparency and effectiveness of public spending as well as enhancing fiduciary controls. At the 2010 Kabul Conference, international donors restated commitments to bring 50 percent of development aid on budget. The government in turn pledged to strengthen PFM systems to facilitate such a transfer. Therefore, continued achievements in program budgeting and other PFM systems are an integral part of the Kabul process. At present, treasury, budgeting, and tax administration are fully functional, and the Afghanistan Financial Management Information System (AFMIS) has been rolled out to all provinces and line ministries.

The authorities have also made some progress towards enhancing monetary policy operations. The use of capital notes by the central bank has increased, but more is needed to contain inflation. The supervisory capacity of the central bank did not keep pace with a fast-growing financial sector.

2. Some poverty indicators have improved over the last decade, but Afghanistan remains one of the poorest countries in the world. Per-capita income was US$530 in 2010/11. The national poverty rate was 36 percent in 2007/08, as measured by the National Risk and Vulnerability Assessment, and the rates are higher in rural and mountainous areas that account for about 80 percent of the population. Afghanistan ranks in the bottom 10 percent of countries with the lowest score in the 2010 UN Human Development Index. The authorities have made inroads toward achieving some of the Millennium Development Goals. For example, child mortality was reduced and school enrollment increased, albeit from very low levels—the enrollment rate for primary schools is less than 40 percent. The latest Annual Progress Report also acknowledges that achievements in some areas are below expectations: more than 40 percent of children under the age of five are underweight and progress in increasing access to potable water and sanitation remains slow. The literacy rates for men and women aged 15 to 24 are 51 and 22 percent respectively. Overall, the low execution rate of only 40 percent of the development budget reflects a generally limited absorption capacity, and impedes more rapid progress toward poverty reduction.

3. Poor governance and corruption are endemic and take a heavy toll. With decades of war and extreme poverty and the absence of social safety nets, localized patronage has become reinforced as the main element of social protection. The emergence of a vibrant illicit narcotics sector has further distorted economic incentives Box 2). This has many negative consequences for the evolution into a rules-based market economy, including significant rent-seeking behavior and high levels of crime and corruption.

4. Last year’s crisis at Kabul Bank, the largest bank in Afghanistan, exposed the country’s serious governance problems, and highlighted the devastating effects of endemic corruption. The initial intervention by the central bank and a full deposit guarantee prevented a full-blown banking crisis (Box 3). However, the subsequent crisis management was slow and somewhat reluctant to tackle some important but politically difficult issues such as asset recovery and filing charges against the main architects of the fraud. As a result, the financial system has been severely weakened and is not playing its role in facilitating private sector-led growth.

5. Over the coming three to five years, Afghanistan will face additional challenges as the international military presence is wound down and the government has to take over spending currently financed by donors. Foreign troops are expected to gradually withdraw by 2014. As a result, Afghanistan’s security forces will have to take over more responsibility, leading to higher spending. At the same time, the government may lose revenues related to spending by foreign troops in Afghanistan. Moreover, it is likely that the donor footprint will gradually shrink, with total grants projected to decline from an estimated more than 40 percent of GDP in 2010/11 to less than 30 percent of GDP in 2013/14. These developments will weigh heavily on economic activity and require difficult decisions to ensure fiscal survival.

Box 2.The Illicit Economy in Afghanistan

Afghanistan’s illicit sector is estimated to be in the range of one third to one half of the country’s GDP. The largest illicit activities in Afghanistan are narcotics and corruption.1 Smuggling, fraud, extortion and arms trading are also known to generate signification proceeds. These activities are all crimes in Afghanistan.

Narcotics

  • Opium exports2 were US$2.8 billion (about 23 percent of GDP) in 2010, and are estimated to reach up to US$4 billion in 2011.3 Opium from Afghanistan supplies about 90 percent of the US$68 billion global retail market in opiates.
  • Opium cultivation provided income for 5 percent of the Afghan population in 2011.4 The decision to cultivate opium is strongly correlated with conflict and access to markets; however, there is also a price correlation mainly with the subsistence crop wheat. In addition, cannabis is extensively cultivated in Afghanistan and yields income of up to US$94 million.5
  • The large profits earned by producers and traffickers are spent both inside and outside the country. In addition to funding regular consumption and investment spending, they are also used to buy patronage, influence and services, to reinvest in illicit cultivation and to finance investments outside the country. Antigovernment elements and terrorist networks often collect a share of narcotics revenue akin to a tax (ushur).
  • Cross-border flows related to the opiate economy are not recorded in the official balance of payments statistics, and are reflected as unrecorded inflows (errors and omissions) or they finance equally unrecorded imports, i.e., smuggling, over and above the estimates included in the balance of payments.

Corruption

  • Afghans paid an estimated US$2.5 billion in bribes in 2010 (20 percent of GDP).6 One out of every two Afghans is thought to have to pay at least one bribe to a public official per year, with the request coming from the official more than 56 percent of the time.7
  • The scale of corruption, combined with the large illicit sector, has undermined governance and development in the country.
1 Afghanistan is a signatory to all three international drug control conventions as well as the United Nations Convention against Corruption.2 The International Monetary Fund does not include the illicit sector in official estimates of GDP, or in other macroeconomic measures. The drug economy is excluded from the output and prices measurements of “Table 1. Islamic Republic of Afghanistan: Selected Economic Indicators,” where opium production is listed as a memorandum item.3 United Nations Office on Drugs and Crime (UNODC) and Islamic Republic of Afghanistan Ministry of Counter Narcotics, Afghanistan Opium Survey 2011, Summary Findings, October 2011, p 4. 2011 export value is Fund staff estimate.4 United Nations Office on Drugs and Crime, World Drug Report 2010.5 United Nations Office on Drugs and Crime, Afghanistan Cannabis Survey 2009.6 UNODC, “Corruption in Afghanistan, Bribery as Reported by the Victims,” January 2010. Note: This survey did not deal with grand corruption it only looked at bribes under US$1,000 (those likely to affect Afghans on a daily basis). Total payments related to corruption therefore are likely to be far higher.7 Ibid. p. 4.

Box 3.The Kabul Bank Crisis

Based on evidence available so far, it appears that Kabul Bank shareholders and top management had abused their position to engage in criminal activity, including fraud and money laundering, by manipulating the bank’s loan book. Concerns over the soundness of Kabul Bank caused a run on the bank in early September 2010 during which the bank lost about half of its US$1.3 billion deposits. With one-third of the system’s assets of US$4 billion, the crisis threatened the stability of the financial system. The authorities removed the management of the bank, putting the bank into conservatorship, and guaranteed all deposits. This helped stem the initial panic and stopped the run. When the dust had settled, the government had to shoulder US$825 million for the cost of the lender-of-last-resort facility loans that covered the deposit guarantee (about 5 percent of GDP).1 Kabul Bank was subsequently put into receivership, revoking shareholders’ rights altogether.

Aside from the fiscal costs, the Kabul Bank crisis has had a negative impact on intermediation, as it had by far the largest and most effective branch network in the country and an effective payments system. These helped bring individuals into the formal sector and supported the government’s program of automating employee records and salary payments.

Kabul Bank has been split up into a good bank and a bad bank. The bank’s deposits and good assets were transferred to a bridge bank, New Kabul Bank. For the time being, New Kabul Bank cannot extend loans and is envisaged to be privatized in 2012. The bad assets have been retained by the receiver, appointed and overseen by the independent Financial Dispute Resolution Commission (FDRC). Based on current estimates, about US$935 million (principal and interest) in the asset portfolio are sought for recovery. This amount is likely to increase as additional illegal expenses and other charges continue to be discovered by an ongoing audit. The receiver, the FDRC, the central bank, and the Attorney General, have begun the work on asset recovery and sorting out the disputed assets with the help of the audit firm. In parallel, the government has started an investigation of criminal misconduct and has brought formal charges in nine cases so far.

The Kabul Bank crisis has magnified the risks of rapid banking sector growth with inexperienced supervision and weak rule of law. Moreover, it has undermined confidence in the banking sector (preference for cash increased and deposit growth came to a halt) and further overburdened banking supervision. On the other hand, it has provided the authorities with valuable lessons and experience, if they are able to build on them. Only fit and proper persons should be allowed to own and manage banks and prudential norms should be diligently enforced.

1 To cover the hole created in the central bank’s balance sheet by the issuance of the lender-last resort loan to Kabul Bank, the ministry of finance issued a promissory note, which would yield a regular flow of payments to the central bank over an eight-year period. The annual payments on this promissory note have to be approved by Parliament as part of the budget.

6. Against this background, the authorities seek Fund support under the ECF for their three-year economic program. In the near term, they are focusing on resolving the problems that emerged from the collapse of Kabul Bank and ensuring the stability of the banking system. In parallel, they intend to proceed with key reforms in revenue and expenditure management, and strengthen the business environment for private sector-led growth, while improving social conditions and protecting the poor. None of these reforms will succeed in the long term unless the authorities are able to deliver on their plans to enhance governance, address endemic corruption, and prevent economic and financial crimes.

7. The authorities’ program provides a basis for continued engagement with donors on Afghanistan’s development strategy, including at the December 5 Bonn Conference. Afghanistan has extensive development needs in building its physical and institutional infrastructure, and requires continued support in transforming its economy into a competitive and vibrant market-based system. Donor assistance and a new ECF arrangement can help the government make progress toward Afghanistan’s development objectives. However, such support needs to be matched by bold domestic reform, including further bolstering of government revenues, and strengthening governance, not least in the financial sector.

8. The program is subject to two significant types of risks. First, there are risks that program implementation falls short, especially due to inadequate political will or capacity constraints, undermining macroeconomic stability and possibly leading to further large-scale economic crime and corruption. Second, exogenous shocks, such as deterioration in the security situation, regional instability, trade disruptions, or volatility in the agriculture sector, could thwart the success of the program, even if fully implemented.

II. Recent Developments: Growth Amidst Civil Strife

9. A standoff between the legislature and the executive over the legitimacy of last year’s parliamentary elections has stymied the political process. President Karzai has not yet been able to confirm his cabinet in full and a number of legislative acts have been significantly delayed. Recently, a compromise has been reached, and Parliament has restarted its work, although individual parliamentarians are still protesting.

10. The security situation remains precarious and holds back economic activity.

Ongoing conflict affects the majority of Afghans. While the campaign against anti-government elements in the South has reportedly made progress, the area remains broadly insecure. Also, there are some signs that anti-government elements in the central and eastern parts of the country are gaining power, while attacks in Kabul have increased in recent months.

11. Economic growth continues to be strong, but inflation has ratcheted up.3 Real GDP growth exceeded 8 percent in 2010/11, thanks to buoyant manufacturing and services. In 2011/12, growth is expected to slow to less than 6 percent, due mainly to a drought. Headline and core inflation have moderated slightly, but remain relatively high at about 10 percent year-on-year in September, owing to an expansionary monetary policy and higher international food and fuel prices. Confidence in the banking sector is low, as reflected in listless deposit growth since the September 2010 collapse of Kabul Bank. Liquidity remains high because there are few lending opportunities (Box 4). Favorable external current account developments have allowed a further buildup of international reserves to about seven months of imports. Donor support was strong, and exports were boosted by coalition forces purchases of domestic goods and services. The Afghani has depreciated by 5 percent against the U.S. dollar since late March, but has stayed broadly stable in nominal and real effective terms over the past year.

Box 4.The Evolution of the Afghan Banking System and its Regulation

Modern banking, and the credit culture that accompanies it, is new to Afghanistan. For centuries, and to this day, the population has relied on informal money service providers to transfer cash and provide limited lending and deposit services. These so-called hawala dealers operate on the basis of personal relationships. The central bank currently licenses and regulates 320 money service providers, and some of these have several hundred agents.

Since 2002, the government and the international community have promoted the formalization of financial services. This encouraged a rapid growth of the formal banking sector with assets and deposits increasing over 50 percent annually since 2006, as banks competed vigorously to collect deposits of newly employed civil servants and to intermediate the inflow of foreign aid. Such rapid growth has generally been problematic wherever it has occurred.

Aside from five branches of foreign banks, which largely service the donor and international sector, Afghanistan’s 12 domestic banks struggled to develop normal banking practices and skills. The legal and accounting infrastructure to support nonrelationship lending was nonexistent, weak, or untested, as were the procedures and skills of the banks’ staffs. An ineffective judiciary and corruption hamper establishing or recovering collateral and enforcing contracts. In a country where most births are unregistered, normal documentation of all sorts is generally nonexistent. In such an environment, bank lending tends to be based on relationships rather than loan (risk) assessments. Indeed, many local banks have been established around business groups and loans are being channeled to related businesses. But when investments go wrong, the interests of the groups tend to supersede those of depositors. As the banking system in Afghanistan grew in size and political influence, asset quality and governance suffered.

Supervisory capacity was almost nonexistent and has struggled to catch up. After 30 years of protracted war it was almost impossible to find enough supervisors and regulators, even with minimal education. Talented and motivated young Afghans were and are being recruited but currently lack experience. In recognition of this problem the central bank issued a moratorium on new licenses and introduced caps on lending for the many low-rated banks. Critically, banking supervision has lacked political support for enforcing compliance with rules and regulations. This failure in governance must be addressed so that a robust financial sector can support the country’s long-term development objectives.

12. Fiscal developments were characterized by strong revenue performance combined with expenditure restraint. Revenue effort increased by 0.7 percent of GDP between 2009/10 and 2010/11, following the introduction of tax and administrative measures in early-2009 and the consolidation of earlier reforms; and continue to outperform in 2011/12 with a 25 percent year-over-year increase for the first half of the year, while operating expenditures grew by 27 percent over the same period. Security spending rose by 1.3 percent of GDP from 2009/10 to 2010/11 as recruitment to Afghan National Security Forces grew by over 30 percent. Nonsecurity operating spending dropped by 0.7 percent of GDP between 2009/10 and 2010/11, notwithstanding the advance of civil service pay and grade reforms and the hiring of additional teachers. As a result, the operating budget deficit excluding grants remained broadly stable at 4 percent of GDP. Development spending fell by 1.7 percent of GDP due to continued low execution rates stemming from capacity constraints, difficulties in public financial management, and a worsening security situation.

III. Policies to Put Afghanistan on a Path of Growth and Sustainability and Strengthen the Financial Sector

13. The authorities’ program aims to lay the basis for fiscal and external sustainability as well as financial sector stability.

  • The authorities recognize that restoring governance in the banking sector is a necessary condition to safeguard economic stability and convince donors to stay engaged, and they have made progress on the prior actions that address the issues that have come to the fore in the aftermath of the Kabul Bank crisis.
  • In the context of the Article IV consultations, discussions focused on a strategy to move toward fiscal and external sustainability and maintain macroeconomic stability as a precondition for progress towards Afghanistan’s broader development objectives.
  • Against this background, the authorities have put forward an economic program for the period 2011/12 through 2013/14 that deals with the aftermath of the Kabul Bank crisis, strengthens the financial sector, and initiates reforms to ensure fiscal survival as a prerequisite for fiscal sustainability.

A. Prior Actions: Strengthening Governance and the Financial Sector

14. The authorities have taken the necessary steps to deal with the immediate aspects of the Kabul Bank crisis. The bank has been put under receivership, its license has been revoked, and shareholders’ rights and interests have been extinguished. The authorities have established a bridge bank, New Kabul Bank, and developed a business plan to put it up for sale in 2012. An audit of Kabul Bank is ongoing to establish the amounts owed by the bank’s shareholders and related parties, and to provide information for any legal actions the government may take; the inception report and the interim report have been delivered. After a slow start and while available administrative, civil, and international tools have yet to be fully applied, about US$75 million in cash (of which US$34 million from regular performing loans) and US$153 million in assets available for sale were recovered as of October 30, 2011 out of an estimated total amount of assets sought for recovery of US$935 million (of which US$80 million are regular performing loans). In parallel, repayment agreements of US$270 million have been signed, with a repayment period of three to nine years.4 The ministry of finance has issued an eight-year bond to recapitalize the central bank for the costs of the Kabul Bank crisis, and parliament approved the first amortization payment on October 15, 2011.

15. The authorities have also taken actions in the case of Azizi Bank, the second largest bank. Following an intensive on-site examination of Azizi Bank, the supervisor identified a number of areas needing improvement. An audit by a reputable international audit firm is ongoing and will provide information to the bank’s management and the supervisor on the degree with which laws or regulations were breached and how to further strengthen the bank. The final audit report is expected in the first quarter of 2012. In light of the on-site examination and the preliminary audit findings, the bank and the supervisor have agreed on a path for increasing the bank’s capital and reducing its large exposures. The bank’s largest shareholder has stepped down as chairman of the board to address conflict-of-interest problems, as have the large shareholders of other banks in accordance with central bank regulations. Continued vigilant supervision will be needed to ensure that banks fully comply with the banking law and regulations.

B. Addressing Social Needs While Moving Toward Fiscal and External Sustainability

16. Transition and transformation will pose significant challenges over the coming three to five years. The growth outlook will be shaped by how these prospective developments play out and what they imply for public investment and propoor spending. The speed at which the authorities can move toward fiscal and external sustainability will depend on the future path of revenue efforts and donor engagement. There is also a trade-off with the pace of progress toward Afghanistan’s development objectives.

17. Real GDP growth over the three-year program period (2011/12 to 2013/14) will be significantly lower than the average of 10 percent over the past five years. The slowdown will be driven by the withdrawal of foreign troops and the decline in grant-financed spending. A projected recovery in agriculture from this year’s drought could temporarily boost growth in 2012/13. In addition, the nascent mining sector could also provide a positive growth impulse and would be associated with significant foreign direct investment. To fully realize the potential from mineral resources, a strong fiscal regime needs to be in place that ensures good governance. The World Bank and the Fund can advise in this area.

18. Over the medium term, fiscal policy and the level of donor engagement will be important factors driving growth. The baseline scenario for the medium-term macroeconomic framework describes a cautiously optimistic outlook. Grant-financed spending declines as a share of GDP after 2012/13, leading to a slowdown of real GDP growth to a range of 4-6 percent annually beyond 2013/14. Fiscal revenues receive a boost from the mining sector and the introduction of a VAT starting in 2014/15, reaching 15 percent of GDP in 2017/18. Expenditures are expected to average 25-26 percent of GDP, assuming a gradual and restricted takeover of externally financed expenditure, and a very conservative level of operations and maintenance (O&M) spending for projects handed over by donors to the government. Annex I explores alternative scenarios. For example, by assuming a faster decline in grants and higher operations and maintenance spending, public investment is compressed, and real GDP growth could be as low as 2 percent per annum over the medium term.

19. The authorities emphasized their commitment to the Afghanistan National Development Strategy (ANDS) as their overarching policy framework. The ultimate objective of the ANDS is to generate sustained, inclusive growth that reduces the high incidence of poverty. The authorities noted that poverty and limited opportunities outside the illicit sector provide a fertile ground for insurgent activities. The authorities’ strategy is to ensure that economic growth is broadly based and beneficial both across different tiers of society and across different regions of the country. Therefore, social programs have an important place among the government’s fiscal priorities. The transition and transformation process will affect how the government can pursue its ANDS objectives.5

20. The international presence has underpinned the Afghan economy beyond security. Quantifying the impact with any precision is difficult because of a lack of data on spending by foreign troops in Afghanistan. Available evidence suggests that consumption spending in Afghanistan by foreign troops, in combination with military spending on civilian activity, is likely to have added about 2-3 percentage points to real GDP growth in recent years. The planned withdrawal by 2014 is thus expected to have an adverse net impact on growth, reducing growth by an estimated 2½ percentage points over the next three years. In addition, external inflows will be reduced, negatively affecting the international reserves position. Some offset could come from a reversal of “Dutch disease” effects associated with large-scale foreign inflows. Indeed, Afghanistan will need to gain competitiveness to facilitate the necessary external adjustment. An important factor in this adjustment process will be how much of the spending by the military and donors in the past has fallen on nontraded goods, and what the adverse demand shock for the nontraded sector implies for the real exchange rate. In the end, the adjustment could benefit the traded sector, albeit at the cost of rising foreign currency-denominated debt service payments.

21. The expected gradual decline of donor assistance and activity over the medium term will further complicate policy-making. In 2010/11, the overall fiscal deficit (excluding grants) was 10 percent of GDP. If we include estimated off-budget development spending by donors, the fiscal deficit could be as high as 23 percent of GDP. Aside from donor support, Afghanistan has very limited scope for market financing. Of course, once domestic government securities are available, local banks could provide some financing, but this would be insufficient to replace external grant financing and there are clear limits from the need to preserve fiscal sustainability. Moreover, the government will have to shoulder security spending currently paid for by the international community as well as the recurrent cost implications of donor-financed infrastructure projects.6 Again, incomplete data on the local content of donor spending prevents precise estimates of these cost implications. Nevertheless, Annex II discusses possible trajectories for key fiscal aggregates.

22. There will be a struggle for fiscal survival for years to come, with fiscal sustainability being a more distant goal. The authorities welcomed donors’ intention to channel an increasing share of their support through the budget, even if the overall envelope would shrink. They noted that donor support above and beyond the working assumption would provide fiscal space for propoor and development spending which is severely constrained in the current medium-term budget framework. They stressed that achieving fiscal sustainability, defined as revenues covering operating expenditures, remains their fiscal goal, though this has been complicated by the drawdown of the international presence in Afghanistan. Under the program, the authorities target the operating budget balance excluding grants with a view to keeping the deficit broadly unchanged.

23. The expected decline in donor inflows also has implications for external stability. The stability of the exchange rate in the medium to long term will depend critically on the continued flow of donor assistance. In 2010/11, the current account deficit excluding official transfers registered 40 percent of GDP. Foreign grants estimated at just over 40 percent of GDP financed this deficit. The other side of the coin is that a large share of grants—estimated at 70 percent—is spent on imports of goods and services; thus grants do not only finance the trade deficit, they also contribute to it. A decline in grant inflows and inflows related to spending by foreign troops would put pressure on the exchange rate and require a corresponding adjustment of the macroeconomic policy mix, including the exchange rate. Given the uncertainties regarding the local component of grants and military spending, it is difficult to estimate precisely the impact of the withdrawal on the exchange rate. The authorities have skillfully created international reserves buffers to manage pressures in the short term. However, they will need to maintain their flexible exchange rate regime to allow for the necessary external adjustment to occur.

24. The shrinking of the donor footprint will ultimately need to be met with competitiveness gains. To ensure that external adjustment can occur in an orderly fashion, a gradual and well-planned reduction in foreign aid would allow the exchange rate to adjust without undermining macroeconomic stability.7 Competitiveness gains will also need to come from strengthening the business environment (Box 5). Areas where improvements can be made include: investor protection; property rights; collateral and property registration; enforcement of contracts; free trade across borders; access to financing; and general red tape combined with corruption. For instance, Transparency International’s Corruption Perception Index for Afghanistan in 2010 was 1.4 on the scale from 0 (highest perception) to 10 (lowest perception), making it second to worst on the ranking of 178 countries. Moreover, the government needs to adequately support the development of small and medium-sized businesses, which can be a source of job creation, in addition to promoting large-scale mining enterprises. The authorities caution that the challenging security situation is a key obstacle to quick wins in the business environment.

25. Afghanistan remains at high risk of debt distress, recent debt relief notwithstanding. Debt relief under the Heavily Indebted Poor Countries initiative and the Multilateral Debt Relief Initiative reduced the net present value (NPV) of Afghanistan’s debt-to-GDP ratio from 12 percent to 6 percent in 2009/10. Nevertheless, risks to the macroeconomic outlook and large financing needs, currently met by donor support, underscore the importance of substantial and long-term grant financing, in combination with a strong reform agenda and progress in security and governance. Should donors decide to reduce aid rapidly, security fail to stabilize, or delays arise in structural reforms and governance improvements, Afghanistan’s debt burden could become unsustainable (see the accompanying debt sustainability analysis).

26. Public financial management reforms are expected to improve the execution of the development budget. Low execution rates reflect capacity constraints, unrealistic multiyear budget and spending patterns with significant front-loading of spending, and poor procurement planning and contract management. The government has developed a road map to address most of these issues and its implementation will improve the execution of development projects. The overarching aim is to facilitate the transfer of additional aid through the development budget as envisaged under the Kabul Process.

Box 5.Exchange Rate Assessment

Afghanistan’s exchange rate arrangement is classified as floating. A quantitative exchange rate assessment using CGER-based methodologies is rendered difficult by data constraints and uncertainty about medium-term current account developments, including the prospective path for donor financing and earnings from mineral resources.

Since 2004/05, exports have risen steadily, and the current account deficit excluding grants has declined from 71 percent of GDP in 2006/07 to below 40 percent in 2010/11. In August 2011, the Afghani was slightly below its five-year average in real terms, reflecting a spike in 2008 (due to high domestic inflation) and a decline in the following period.

Structural impediments seem more binding for Afghanistan’s competitiveness than exchange rate developments. The World Bank’s Doing Business 2012 indicators rank Afghanistan 160th out of 183 countries (falling from 154th place in the previous year), diagnosing particular challenges in investor protection. In 2010, the World Bank’s Country Policy and Institutional Assessment index, measuring the quality of public policies and institutions, assigned a rating of 2.6 to Afghanistan, below the average of 3.3 for all IDA countries. While Afghanistan compared favorably with other IDA countries on macroeconomic management and budgetary and financial management, the country ranks in the bottom decile for most other components of the index, including property rights, governance, and the quality of public administration.1

Afghanistan: Effective Exchange Rates

(Index, March 2007 = 100)

Sources: IMF, Information Notice System; and Fund staff calculations.

Recorded Exports, 2007-2010, Excluding Transit Trade

(In million US dollars)

Sources: Da Afghanistan Bank (DAB), Direction of Trade, IMF.

1http://www.doingbusiness.org/reports/global-reports/doing-business-2012 and http://go.worldbank.org/S2THWI1X60.

C. The Authorities’ Request for Fund Support for their 2011/12-2013/14 Economic Program under the Extended Credit Facility

27. The authorities’ program for the next three years outlines a realistic strategy to start addressing the challenges discussed above. The main goals of the new program are to make significant progress toward a stable and sustainable macroeconomic position, move toward fiscal sustainability, strengthen the financial sector, and improve the transparency and effectiveness of public spending while protecting the poor, and strengthening the governance framework in the financial and economic sphere. The envisaged policies and reforms focus on keeping inflation low, strengthening banking supervision, achieving sustained increases in tax collection, gradually taking over externally-financed recurrent spending, improving public financial management, keeping spending aligned with ANDS priorities, improving the capacity to deal with economic crime, and reducing fiscal risks from public enterprises. The program includes a technical assistance agenda.

28. The focus of fiscal policy will be to make further progress on revenue generation to meet the many and growing spending needs. Revenue measures include ongoing administrative reforms in the customs and revenue departments (medium and large taxpayers’ offices), and steps toward the introduction of a VAT in March 2014. Still, the targeted increase in the revenue-to-GDP ratio amounts to only 0.6 percent of GDP over the program period—which is basically achieved this year. In addition, political and security risks could undermine revenue collection at the border.8 If the planned reforms do not indeed yield more revenue gains, the authorities will have to consider additional measures. For example, previous Fund technical assistance recommended an excise on petroleum products.

29. On the expenditure side, the authorities need to continue to exercise tight control over nonsecurity spending. The ongoing public financial management reforms are essential in this context to ensure effective prioritization of spending. In particular, the authorities are in the process of identifying propoor spending within the central government budget, with the aim of improving integration of priority poverty reduction policies within line ministries’ budgets (indicative target). However, due to fluctuating development budget execution rates, the pilot phase was aimed at identifying propoor operating expenditures only. In 2011/12, propoor budgeting was piloted in two ministries—the Ministry of Education and the Ministry of Labor, Social Affairs, Martyrs, and Disabled. In 2012/13, the pilot will be extended to include the ministry of public health.9 The list will be further expanded in the coming years to better reflect all propoor spending. For consistency, the indicative target on propoor spending reported in Tables 3a and 3b covers all three ministries for both years. The overall level of propoor spending is low compared to the need and is budgeted to decline as a percent of GDP in 2012/13; the authorities will explore options for further increases to support its social and development objectives.

30. To exercise budget control, the Ministry of Finance closely monitors its cash balances in the treasury single account. These balances represent the government’s primary resources to fund the operating budget and its own discretionary development priorities. Earlier in 2011/12, the government cut spending in anticipation of liquidity shortages from a temporary loss of resources from the Afghanistan Reconstruction Trust Fund (ARTF). Assuming the full reinstatement of funds from the recurrent window of the ARTF, balances are projected to end the year at just short of two months worth of cover for operating expenditures, the authorities’ informal prudential target. However, there is a risk that cash balances could be drawn down by more than targeted if additional transfers are made to pay for development spending carried over from the previous fiscal year. Should discretionary cash balances fall too low in 2011/12, a cash crunch could occur in the following year.10 The government would need to monitor all outgoings very closely, rigorously prioritizing discretionary development spending while maintaining a strong revenue effort. By 2013/14, the government plans to issue securities (sukuks) which will diminish its cash and liquidity risks.

31. The nominal anchor of monetary policy is inflation. To this end, the central bank steers reserve money and currency in circulation through the use of its own paper, so-called capital notes, and the accumulation of foreign exchange reserves. With inflation running in the double digits, the authorities, therefore, see a need to tighten monetary policies in the course of 2011/12 to achieve their inflation target of 4-6 percent by reducing money growth from 30 percent in August 2011 to less than 20 percent. They note that volatile commodity prices, including food and oil, high inflation in neighboring countries, and large inflows of aid have complicated the conduct of monetary policy. In addition, due to concerns about its income and balance sheet, the central bank has been hesitant to use its capital notes and foreign exchange auctions to the full extent. The forthcoming agreement between the central bank and the Ministry of Finance regarding central bank capitalization and responsibilities for the costs of monetary policy should alleviate these constraints and strengthen central bank independence. The new marketable government securities (sukuks), to be introduced by 2013/14, will add a useful monetary policy instrument, contribute to the development of the domestic money market, and could gradually lessen the need for the central bank to issue capital notes.

32. Efforts to manage the Kabul Bank crisis continue. The ministry of finance and the central bank are committed to securing maximum asset recovery from Kabul Bank, and the government will bring legal charges where appropriate. It will be important to ensure that the repayment agreements that have been signed, and which the authorities consider to be legally binding, are being honored. Where this is not the case, they should use all available asset recovery options. Failure to do so would send the signal that economic and financial crimes pay, in particular if committed by well-connected individuals. Moreover, every dollar recovered by the government ultimately lowers the fiscal cost of the bailout and will free scarce resources for priority spending needs.

33. The authorities intend to put New Kabul Bank up for sale by mid-2012 to a qualified investor who brings sound banking sector experience. This is somewhat later than anticipated, mainly because it is taking longer to clean up the balance sheet of New Kabul Bank to a point where it can be presented to potential investors. One of the objectives of the sale is to reinvigorate Afghanistan’s stagnant banking sector by bringing international experience and fostering competition. If the sale does not succeed, the bank would be downsized further and either merged into other financial institutions or liquidated by March 2013. In the case of liquidation, salary and other payment services will be migrated to other banks. To provide choice to government employees, migration will start in 2012 independent of privatization or liquidation.

34. Supervision and central bank independence have been weakened in the aftermath of the Kabul Bank crisis. The central bank regrets that its supervision department has been under aggressive investigation in the context of Kabul Bank while prosecution of Kabul Bank shareholders and officers appears to have proceeded more slowly. This has lowered morale and the effectiveness of supervision which has also been eroded by the redeployment of some critical staff to the bridge bank and the receivership. Nevertheless, the supervision department has undertaken a number of measures to strengthen its supervision, including regular reviews of bank compliance with earlier recommendations and the issuance of time-bound enforcement letters when appropriate. Moreover, audits by reputable international firms—supported by the United Kingdom’s Department for International Development and the World Bank—are ongoing to provide a better view of the financial health of ten banks, including systemically important institutions. Still, the supervision department remains significantly understaffed and is ill-prepared should another banking crisis emerge. The crisis also highlighted the need to build capacity in areas related to the prevention of fraud and economic crime.

35. To address these deficiencies and ensure strong competition in the banking sector, the authorities are in the process of better enforcing and revising the existing banking law and regulations. The process of overhauling the banking law and regulations has been informed by an initial review of the Kabul Bank events by the central bank and will benefit from a forthcoming report by the independent Monitoring and Evaluation Committee. The revisions will aim to bring important provisions in line with the Basel Core Principles and Financial Action Task Force recommendations, in particular, strengthening provisions on corporate governance, beneficial ownership, capital, large exposures, related parties, enforcement, and bank resolution.

Box 6.Key Findings and Main Recommendations of the Assessment of the Anti-Money Laundering and Combating the Financing of Terrorism Regime

IMF staff conducted the first detailed assessment of Afghanistan’s Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) framework in early 2011 using the updated 2004 assessment methodology. The Detailed Assessment Report was adopted by the Asia/Pacific Group on Money Laundering (APG) on July 21, 2011.

Afghanistan faces major money laundering and terrorist financing threats. The value of proceeds of crime generated by drug production and trafficking and corruption in the country is significant, in both relative and absolute terms. Smuggling and fraud also generate considerable amounts of illegal funds. In addition, terrorism and its financing remain a major concern both in terms of the security of Afghanistan and of the funding of terrorist individuals, organizations, and terrorist acts domestically and abroad.

Structural elements make the effective implementation of AML/CFT preventive measures challenging. They include ongoing conflict, lack of security, vested interests and corruption, capacity constraints, nascent and weak regulatory environment, porous borders, and low human capital. In addition, with a large share of economic activity taking place in the informal sector and within the context of a cash-based economy, the combination of rudimentary financial transactions and the formal sector banks, connected internationally through correspondent accounts and Society for Worldwide Interbank Financial Transactions (SWIFT), poses significant risks of money laundering and terrorist financing. Also, with the rapid expansion of the banking sector over the last decade, the lack of qualified and experienced supervisory and compliance staff resulted in critical failures in preventive measures.

The Detailed Assessment Report highlights significant deficiencies in Afghanistan’s AML/CFT regime and notes that current domestic efforts are not commensurate with the high risk of both money laundering and terrorist financing in the country. Afghanistan has taken measures to fight crime, including financial crime, and to lay the foundations for an AML/CFT regime. However, Afghanistan has been rated noncompliant or partially compliant in all but one of the 49 Financial Action Task Force recommendations. Despite the authorities’ efforts, there have been few investigations into money laundering and terrorist finance and none has resulted in charges being brought before the courts.

The report sets out a number of recommendations for improvement, which should be prioritized to mitigate the most serious risks that Afghanistan faces. The implementation of these recommendations will be an important element in strengthening the institutional framework for governance. Recommended actions include tightening and effectively implementing the legal and institutional framework regarding customer due diligence, supervision of financial institutions, reporting of suspicious transactions to a sufficiently independent and skilled financial intelligence unit, confiscation of criminal assets and implementation of mutual legal assistance in asset recovery. In light of the magnitude of cross-border drug trafficking and laundering of its proceeds, special attention should be given to the recommendations which address cross-border cash couriers and money service providers. The scale of corruption calls for the implementation without delay of recommendations regarding customers who are politically exposed persons. In light of the recent financial fraud, adequate fit and proper testing of financial institutions’ beneficial owners should also be prioritized. Finally, due to the high terrorist financing risks, the framework for freezing terrorist funds should be revised and implemented effectively. The authorities will submit an action plan to the APG in the context of the follow-up process on their assessment.

36. The program also includes measures to strengthen governance in the economic and financial sphere in general. The government’s first priority is to ensure that the rule of law prevails throughout the country and is protective of people, nascent institutions, the economy and the financial sector. It plans to improve its ability to deal with economic crime, and to increase transparency and accountability by tightening the application of the rule of law in the financial sector so that it can face the extreme risks posed by criminality and corruption. As part of the Kabul Process, the government has committed to a tight deadline of critical anticorruption and governance reforms. It has established a dedicated “governance cluster” in the ANDS and reports regularly to the international community on achievements in this area. Given their criticality to governance and financial sector stability, staff encourages accelerated progress on these commitments which have slowed over the course of the last year (Box 6).

37. The authorities plan to address delays in public enterprise reform. With a view to strengthening the financial oversight of public enterprises and thus limiting the possibility of contingent liabilities hitting the budget while maintaining an arms-length relationship, the authorities intend to revise the existing legal framework to bring such entities under the ownership and effective control of the ministry of finance. With respect to the four largest public enterprises (airline company, power utility, fuel and gas company, and telecommunications firm), the authorities will proceed with the implementation of the restructuring and business plans to improve their financial situation and limit fiscal risks. While these are important steps, they may not go far enough to address the large contingent fiscal liabilities from these public enterprises. Building an effective state-owned enterprise monitoring capacity in the Ministry of Finance, exercising strict financial control, and properly regulating the existing public enterprises (exposing them to full competition where possible), are needed to address the risks from this sector.

IV. Program Modalities, Risks, Technical Assistance, and Data Issues

38. Access under the program is proposed at 52.5 percent of quota (SDR 85 million, about US$134 million) phased in seven disbursements over three years (Table 8). The conclusion of the debt sustainability analysis that Afghanistan continues to be at high risk of debt distress supports the case for moderate access. Donor inflows, on which Afghanistan is highly dependent, can be uncertain and volatile, thus calling for a sufficiently high level of foreign reserves. During 2011/12-2013/14, the projected balance of payments gap before grants amounts to US$19 billion, of which the Fund would contribute 0.7 percent (Table 9). The proposed access should be sufficient to cover residual financing gaps and contribute to reserves equivalent to about nine months of imports (excluding transit trade). Given Afghanistan’s high dependency on aid, any sudden decline in aid could put pressure on reserves, especially if coupled with other external or security shocks. In the absence of broad and sustainable export opportunities, Afghanistan will require a longer adjustment period during which the reserves need to be maintained at higher levels. Debt service obligations to the Fund, including the new program disbursements, will remain moderate (Table 10).11 Quantitative performance criteria have been set for March 2012 and September 2012, and indicative targets for December 2011 and June 2012 (MEFP, Table 4).12

39. An update safeguards assessment of the central bank is largely complete. The central bank has strengthened elements of its safeguards framework since the 2008 assessment, but risks remain. In particular, there has been limited progress in establishing an effective internal audit function, and governance oversight should be strengthened. New risks have also emerged over the past year as a result of the Kabul Bank crisis, not least due to capacity constraints, resignation of the governor and strains on central bank autonomy. Previous safeguards recommendations on the central bank’s legal structure and autonomy remain valid, including the need to gain clarification over coverage and calculation of its capital shortfall. It will also be important for the central bank to address outstanding audit recommendations and to sustain earlier progress made. The central bank is working with IMF staff to complete the assessment and is committed to implementing its recommendations thereafter, some of which could be integrated into program conditionality.

40. The program is subject to significant downside risks. First and foremost, vested interests and mixed ownership in the government at large could delay or thwart urgently needed reforms. An important test case in this regard will be the envisaged maximum asset recovery from Kabul Bank and bringing New Kabul Bank to the point of sale. Second, the government’s ability to deal with the governance aspects of the Kabul Bank crisis in accordance with Afghan laws will be a litmus test of its commitment to the rule of law and sound economic management. Fiscal risks arise from (i) the possibility that revenue-raising reforms such as the introduction of a VAT get delayed beyond March 2014—it is not clear that this measure has yet garnered full ownership within the government; and (ii) the large uncertainties over future spending needs as well as future donor support, and contingent liabilities from poorly managed state-owned enterprises. Other risks stem from the volatile security situation that weighs on economic activity and limits the policy space for reforms. On the upside, Afghanistan’s mineral resources and large potential for transit trade between Central Asia and Iran and South Asia could support growth in the coming years.

41. A technical assistance agenda will support the program. Technical assistance from the Fund will focus on revenue administration and tax policy reforms, public financial management (including ongoing assistance on program budgeting and on implementing the public financial management road map), monetary operations and treasury securities, banking regulation and supervision, as well as improving the national accounts, price, monetary, and external statistics.

42. Economic data are adequate for program monitoring and surveillance, but there are significant shortcomings. The quality and timeliness of monetary and fiscal data are broadly adequate, although coverage is still deficient. Other data also suffer from weaknesses, especially data on prices, national accounts, balance of payments, and social indicators. Fund technical assistance is being provided to strengthen statistical data systems. In 2012, it will be useful to prepare a Report on the Observance Standards and Codes (ROSC) on data to help develop an economic statistics plan.

V. Staff Appraisal

43. In a difficult environment, the authorities have made important progress in a number of areas over the past few years. Most importantly, the government managed to raise revenues through revenue administration and tax policy reforms. Moreover, average annual real GDP growth exceeded 10 percent over the past five years, leading to an increase of per-capita GDP to US$530 in 2010/11 from US$250 in 2005/06; this increase was also helped by an appreciation of the exchange rate that could easily reverse. At the same time, as these levels show, further reforms are needed in these and other areas for Afghanistan to achieve its development objectives. The authorities have also taken politically difficult but important steps to strengthen governance in the financial sector, including initiating audits of Kabul Bank, Azizi Bank, and ten other banks, and establishing a path for asset recovery from Kabul Bank, with some down payments having been received.

44. The planned drawdown of foreign troops by 2014 and the expected gradual decline of donor support pose very difficult macroeconomic challenges for the authorities. Growth is likely to be adversely affected; fiscal revenues could suffer, while spending pressures will mount as the government takes over expenditures currently being financed by donors. Data limitations on the local impact of foreign troops and donor spending result in considerable uncertainties about the magnitudes of these effects. To be prepared, the authorities need to build buffers, and their targeted buildup of international reserves is an important element of this. Exchange rate flexibility will be critical to facilitate the necessary external adjustment as donor inflows slow. Donors can also contribute to building buffers by considering what level of support they can continue to provide to Afghanistan over the medium term.

45. The authorities’ fiscal program is moving in the right direction, but could be more ambitious. Fiscal policy appropriately aims for revenue increases; however, these are modest compared to recent achievements. Introducing a VAT is by March 2014 the very latest is essential to achieve the authorities’ medium-term revenue objectives, and they should consider accelerating this measure and be more ambitious in this reform area. The government’s emphasis on propoor spending is welcome, but the level of spending is low and the planned increases are too little in light of the country’s poverty situation. More generally, the intention of maintaining a tight spending envelope—for example, keeping nonsecurity wages constant in real terms over the forecast horizon—will be difficult to sustain, even though it simply reflects a lack of fiscal space. Additional pressures on the government purse will come from the need to assume an increasing amount of security spending and recurrent expenditures related to donor-financed projects that the government will have to gradually take over; the projections in this report are conservative, reflecting the lack of fiscal space. Additional spending would help Afghanistan to make faster progress toward its development objectives if grant financing can be secured. Indeed, fiscal sustainability is an issue and will require continued donor support, given Afghanistan’s development needs and the limited scope to raise domestic resources.

46. The intended monetary tightening should help return inflation to the single digits. The degree of tightening in the authorities’ program for the next 12 months seems appropriate, but may need to be revisited in light of inflation developments. The central bank will have to continue relying on capital notes to steer reserve money growth. Consequently, it is important that the government and the central bank reach an agreement on the capital requirement of the central bank and modalities for addressing shortfalls. This will strengthen the independence of the central bank, make it less susceptible to possible government interference, and put it in a better position to ensure a low-inflation environment and preserve financial and external stability.

47. The authorities seek to address the major shortcomings in the financial sector, and put it in a better position to play its role in fostering private sector-led growth. Strengthening the legal and regulatory environment as well as ensuring effective supervision are important pillars of the plan. In this context, the ongoing prudential audits of banks will provide an independent view of the health of these financial institutions and insights into whether there are other cases of large-scale violations of regulations and the laws. These audits should be completed as quickly as possible and be followed up with any necessary supervisory action, including a close monitoring of related-party lending. Staff agrees with the authorities’ intention to sell New Kabul Bank to an investor who would bring capital and thorough banking experience. Failing to find such an investor, New Kabul Bank should be liquidated by March 2013 and not become a state bank. This would, inter alia, require migrating the government salary payments to other banks.

48. Progress in the implementation of the ANDS is mixed. The authorities have made inroads toward achieving some of the Millennium Development Goals, but much remains to be done. At the same time, increasing fiscal pressures are likely to threaten the delivery of core social services. Efforts to prioritize the development objectives with the National Priority Programs, which were initiated at the Kabul conference in July 2010, will, therefore, be necessary to plan a development program in an increasingly resource-restricted environment. World Bank and Fund staffs recommend a careful review of current proposals for the National Priority Programs and to further balancing of the objectives in the ANDS within a viable financing approach.

49. Weak governance and endemic corruption are among the biggest risks to the success of the authorities’ program. The Kabul Bank crisis and the many difficulties in effectively dealing with the crisis have exposed the weakness of Afghan institutions in enforcing the rule of law. Moreover, Afghanistan has a large illicit sector that perpetuates criminal activity and one of the highest rates of corruption in the world. Significant improvements in governance and strong measures to root out corruption are needed if a vibrant private sector is to develop and provide opportunities for the whole population and be the source of sustained inclusive growth. Vested interests have the means and the potential to throw the authorities’ reform program off-track and ultimately put into question Afghanistan’s political and economic viability. It is imperative for the government to control these vested interests, including by fully applying Afghan law in every case of economic crime and ensuring that all those who derived benefits from such crimes pay back in full their unlawful gains.

50. In addition to possible shortfalls in implementation, there are a number of other risks to the success of the authorities’ program. A main risk stems from a possible deterioration of the security situation as the international troops withdraw. In this scenario, economic activity is likely to suffer, leading to additional fiscal pressures on the revenue and spending side and possibly a liquidity squeeze. State-owned enterprises constitute a significant contingent fiscal liability, which the authorities’ program does not address sufficiently due to capacity constraints. More generally, low capacity—and the corresponding dependence on international advisors—could lead to reform delays that could ultimately undermine fiscal and external sustainability. While most risks are clearly to the downside, there is also a possibility that growth (and fiscal revenues) may come in more strongly if the nascent mining sector develops faster and more vigorously than currently expected. This will require a strong fiscal regime for mineral resource development that promotes good governance.

51. On balance, staff supports the authorities’ request for a program, though it notes the significant risks. Staff believes that the program stands a good chance of providing an effective macroeconomic anchor for managing the transition and transformation while initiating important structural reforms, essential for Afghanistan’s economic viability. In particular, a Fund-supported program could strengthen the hand of the economic team and provide the necessary momentum to take difficult but necessary actions while ownership in the government at large is mixed. Staff expects that the program will have to be adjusted as the withdrawal of foreign troops and any decline in donor support take effect.

52. The next Article IV consultation will be held in accordance with the relevant decision on the consultation cycle for members with a Fund arrangement.

Figure 1.Afghanistan: Real Sector

Sources: Afghan authorities; IMF, WEO; United Nations Department of Safety and Security; and Fund staff estimates.

Attacks and serious beating incidents perpetrated by anti-government elements throughout Afghanistan. They include suicide and stand off attacks; bombings; attacks on district centers, aid and military convoys and their contractors; night letters; assasinations; illegal check points and beatings.

Figure 2.Afghanistan: Fiscal Sector

Sources: Afghan authorities; and Fund staff estimates.

Due to data limitations, the size of the external budget can only be estimated; staff take a conservative approach that aims to take out the share of donor spending that does not impact the local economy.

Figure 3.Afghanistan: Monetary Sector

Sources: Afghan authorities; and Fund staff estimates.

The sharp drop in credit to the private sector reflects the write-off of Kabul Bank loans.

Figure 4.Afghanistan: External Sector

Sources: Afghan authorities; United Nations Office on Drugs and Crime; and Fund staff estimates.

Figure 5.Afghanistan: Social and Governance Indicators

Sources: World Bank WDI; ILO.

Table 1.Islamic Republic of Afghanistan: Selected Economic Indicators, 2006/07-2013/14

(Quota: SDR 161.9 million)

(Population: approx. 30 million; 2010/11)

(Per capita GDP: US$530; 2010/11)

(Poverty rate: 36 percent; 2007/08)

(Main export: dried fruit, US$210 million; 2009/10)

2006/072007/082008/092009/102010/112011/122012/132013/14
Prel.Projection
Output and prices 1/(Annual percentage change, unless otherwise indicated)
Real GDP5.613.73.621.08.45.77.15.8
Nominal GDP (in billions of Afghanis)3524365346157308629681,074
Nominal GDP (in billions of U.S. dollars)7.18.710.512.515.918.419.621.0
Consumer prices (period average)5.113.026.8−12.27.710.54.65.0
Food3.519.237.6−19.57.38.14.7
Non-food7.34.79.91.98.314.24.6
Consumer prices (end of period)4.820.73.2−5.116.67.75.05.0
Investment and savings(In percent of GDP)
Gross domestic investment43.640.636.431.726.322.621.921.6
Of which: Private8.28.69.08.78.58.68.99.5
Gross domestic savings38.141.937.328.927.922.620.919.0
Of which: Private5.712.214.07.59.28.69.38.5
Public finances
Domestic revenues and grants18.319.917.520.522.023.723.724.0
Domestic revenues8.27.77.810.311.011.511.311.6
Grants10.212.39.810.211.012.212.412.4
Expenditures21.522.021.722.121.123.825.325.7
Operating 2/12.311.613.114.515.117.618.618.7
Development9.210.38.67.65.96.26.67.0
Overall balance (including grants)−3.1−2.0−4.1−1.60.90.0−1.6−1.7
Operating balance
Including grants 3/1.31.40.21.23.31.60.40.2
Excluding grants 4/−4.2−4.0−5.3−4.2−4.1−6.1−7.4−7.1
Monetary sector(Annual percentage change, unless otherwise indicated)
Reserve money22.314.464.917.121.318.817.116.2
Currency in circulation13.317.030.428.534.217.816.816.0
Broad money31.035.939.322.618.315.117.1
Interest rate, 28-day capital note (end-period, in percent)7.614.98.94.32.4
External sector 1/(In percent of GDP, unless otherwise indicated)
Exports of goods (in U.S. dollars, percentage change) 5/1.41.833.02.112.72.5−8.8−3.4
Imports of goods (in U.S. dollars, percentage change)10.015.614.8−0.83.00.40.00.6
Merchandise trade balance−69.7−67.9−61.9−50.9−39.6−34.1−33.3−31.7
Current account balance
Excluding official transfers−71.1−68.1−59.6−51.3−39.8−34.3−33.2−31.5
Including official transfers−5.61.30.9−2.81.70.1−1.1−2.6
Foreign direct investment2.72.82.92.42.12.12.32.9
Total external debt 6/169.623.019.79.28.07.98.69.1
Gross international reserves (in millions of U.S. dollars)2,0402,7843,5914,2095,3216,1216,6277,178
(Import coverage) 7/3.44.15.36.07.48.49.09.5
(Relative to external debt service due)7943215213425425298165
Afghanis per U.S. dollar (average)49.949.851.049.345.8
Real effective exchange rate (average, percentage change)−2.03.114.3−17.013.9
Memorandum items:
Opium statistics (wet opium)
Production (in tons)6,1008,2007,7006,9003,600
Price (in U.S. dollars per kilogram)94867048128
External budget grants (in percent of GDP) 8/55.457.449.339.930.522.119.716.5
Source: Afghan authorities; United Nations Office on Drugs and Crime; and Fund staff estimates and projections.

Excluding the narcotics economy.

Comprising mainly current spending.

Defined as domestic revenues plus operating grants minus operating expenditures.

Defined as domestic revenues minus operating expenditures.

Includes official recorded exports, estimates of smuggling, reexports and sales to nonresidents.

After HIPC and MDRI debt relief, as well as debt relief beyond HIPC relief from Paris Club creditors. Debt includes obligations to the IMF.

Gross reserves in months of next year’s imports of goods and services, excluding imports for reexport.

Estimated direct expenditures by donors on public projects not included in the government budget.

Source: Afghan authorities; United Nations Office on Drugs and Crime; and Fund staff estimates and projections.

Excluding the narcotics economy.

Comprising mainly current spending.

Defined as domestic revenues plus operating grants minus operating expenditures.

Defined as domestic revenues minus operating expenditures.

Includes official recorded exports, estimates of smuggling, reexports and sales to nonresidents.

After HIPC and MDRI debt relief, as well as debt relief beyond HIPC relief from Paris Club creditors. Debt includes obligations to the IMF.

Gross reserves in months of next year’s imports of goods and services, excluding imports for reexport.

Estimated direct expenditures by donors on public projects not included in the government budget.

Table 2.Islamic Republic of Afghanistan: Medium and Long-Term Macroeconomic Framework, 2010/11-2029/30
Projection
2010/11Medium TermLong Term
Prel.2011/122012/132013/142017/182019/202021/222024/252026/272029/30
(Annual percentage change, unless otherwise indicated)
Output and prices 1/
Real GDP8.45.77.15.86.65.65.43.94.04.0
GDP per capita (in U.S. dollars)5285916126377588028609189691,062
Consumer prices (period average)7.710.54.65.05.04.84.54.14.04.0
Investment and savings(In percent of GDP, unless otherwise indicated)
Gross domestic investment26.322.621.921.623.625.625.123.222.321.0
Of which: Private8.58.68.99.513.716.216.115.014.613.8
Gross domestic savings27.922.620.919.019.021.822.421.821.521.1
Of which: Private9.28.69.38.510.714.715.715.916.016.0
Public finances
Domestic revenues and grants22.023.723.724.023.422.122.522.822.823.0
Domestic revenues11.011.511.311.615.615.516.417.417.918.5
Grants11.012.212.412.47.76.66.15.44.94.5
Expenditures21.123.825.325.725.124.625.125.325.425.5
Operating 2/15.117.618.618.717.416.516.717.417.718.2
Development5.96.26.67.07.78.18.48.07.77.3
Overall balance (including grants)0.90.0−1.6−1.7−1.7−2.5−2.6−2.6−2.6−2.5
Operating balance
Including grants 3/3.31.60.40.20.9−0.9−0.30.00.20.3
Excluding grants 4/−4.1−6.1−7.4−7.1−1.7−1.0−0.30.00.20.3
External sector 1/
Exports of goods 5/17.815.813.512.217.317.520.120.320.220.1
Imports of goods57.450.046.843.936.232.531.227.826.324.3
Merchandise trade balance−39.6−34.1−33.3−31.7−18.9−15.0−11.1−7.6−6.0−4.2
Current account balance
Excluding official transfers−39.8−34.3−33.2−31.5−21.3−17.3−14.1−10.4−8.5−6.3
Including official transfers1.70.1−1.1−2.6−4.6−3.7−2.8−1.4−0.80.1
Gross reserves (in millions of U.S. dollars)5,3216,1216,6277,1786,8776,7326,4105,9285,8305,691
Memorandum items:
External budget grants 6/30.522.119.716.59.06.95.23.62.82.0
Total external debt 7/8.07.98.69.110.611.612.614.916.317.8
Public sector debt8.012.113.715.213.414.717.321.023.326.1
Source: Afghan authorities; and Fund staff estimates and projections.

Excluding the narcotics economy.

Comprising mainly current spending.

Defined as domestic revenues plus operating grants minus operating expenditures.

Defined as domestic revenues minus operating expenditures.

Includes official recorded exports, estimates of smuggling, reexports and sales to nonresidents.

Estimated direct expenditures by donors on public projects not included in the government budget.

After HIPC and MDRI debt relief, as well as debt relief beyond HIPC relief from Paris Club creditors. Debt includes obligations to the IMF.

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

Excluding the narcotics economy.

Comprising mainly current spending.

Defined as domestic revenues plus operating grants minus operating expenditures.

Defined as domestic revenues minus operating expenditures.

Includes official recorded exports, estimates of smuggling, reexports and sales to nonresidents.

Estimated direct expenditures by donors on public projects not included in the government budget.

After HIPC and MDRI debt relief, as well as debt relief beyond HIPC relief from Paris Club creditors. Debt includes obligations to the IMF.

Table 3a.Islamic Republic of Afghanistan: Central Government Budget, 2008/09-2013/14(In billions of Afghanis)
2008/092009/102010/112011/122012/132013/14
Act.Act.Act.Proj.
Revenues and grants93.6126.4160.4204.4229.3257.3
Domestic revenues41.463.580.498.8109.0124.1
Tax revenues28.851.566.482.193.0106.2
Income, profits, and capital gains8.215.619.423.727.131.0
International trade and transactions12.821.827.733.837.642.0
Goods and services6.312.316.321.024.227.9
Other1.51.83.03.64.15.2
Nontax revenues12.612.014.016.716.017.9
Grants to operating budget29.532.854.565.975.078.3
Afghanistan Reconstruction Trust Fund (ARTF)15.910.915.49.412.111.2
Law and Order Trust Fund for Afghanistan (LOTFA)9.914.324.428.031.331.9
NATO Training Mission - Afghanistan (NTM-A) and other grants3.77.614.628.531.635.2
Grants to development budget22.730.125.539.645.354.9
Total expenditures115.7136.1153.8204.8244.4275.6
Operating expenditures69.689.1110.5151.4180.3200.6
Of which: Security30.043.761.386.4104.1116.7
Wages and salaries47.464.386.5113.7133.0148.0
Of which: Security26.637.955.373.990.1101.2
Purchases of goods and services14.214.917.223.326.229.0
Transfers, subsidies, and other2.73.03.33.84.34.7
Pensions3.45.31.96.111.912.9
Capital expenditures1.81.51.63.43.84.2
Interest0.10.10.11.01.11.8
Development expenditures46.147.043.453.464.175.0
Of which:
Governance, rule of law, and human rights2.02.61.51.92.22.6
Infrastructure and natural resources19.717.420.725.530.635.8
Education4.46.15.26.47.69.0
Health3.33.74.35.36.37.4
Agriculture and rural development12.214.69.111.213.415.7
Economic governance and private sector development3.71.52.02.53.03.5
Operating balance including grants1.37.224.413.43.61.8
Operating balance excluding grants−28.2−25.5−30.1−52.6−71.3−76.5
Overall budget balance including grants−22.1−9.76.5−0.4−15.1−18.3
Augmented overall budget balance, including grants−22.1−9.76.5−34.5−11.4−15.7
Of which: Central bank capitalization−34.13.72.6
Float and discrepancy9.912.75.5
Sale of nonfinancial assets 1/4.11.30.12.30.10.0
Financing8.0−4.3−12.132.211.315.7
External loans (net)3.73.42.87.49.39.9
Domestic (net)4.3−7.7−14.924.81.95.8
Central bank4.3−7.7−14.924.81.9−39.3
Change in government deposits3.4−18.8−14.9−7.56.0−35.9
Change in foreign currency deposits3.8−16.5−16.4−6.45.14.9
Change on domestic currency deposits−0.5−2.31.4−1.10.9−40.9
Change in central bank claims on government0.911.10.032.3−4.0−3.3
Of which: Central bank capitalization bond issuance37.60.00.0
Recoveries−3.5−3.7−2.6
Amortization of central bank capitalization bond−2.6−2.1−2.5
Commercial banks 2/45.1
Nonbank Sector
Memorandum items:
Domestic revenues as percent of operating expenditure597173656062
Central bank capitalization bond (end-of-period stock)31.525.720.6
Security forces (National Army and Police), end of period, thousands143187275343382400
Indicative floor on propoor spending 3/18.019.4
Discretionary cash balances 4/6.19.523.420.45.633.4
External budget 5/263.0245.4222.9190.7190.8177.7
Source: Afghan authorities; and Fund staff estimates and projections.

For 2011/12 and 2012/13, reflects signature bonus payments for the Aynak Copper Mine equivalents to US$53m and US$109m, respectively.

By 2013/14 government will start to issue sukuk debt instruments.

Propoor spending covers the Ministry of Education, the Ministry of Labor and Social Affairs, Martyrs, and Disabled, and the Ministry of Public Health.

Government deposits at the central bank exclude earmarked grants.

Estimated direct productive expenditures by donors on public projects not included in the central government budget.

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

For 2011/12 and 2012/13, reflects signature bonus payments for the Aynak Copper Mine equivalents to US$53m and US$109m, respectively.

By 2013/14 government will start to issue sukuk debt instruments.

Propoor spending covers the Ministry of Education, the Ministry of Labor and Social Affairs, Martyrs, and Disabled, and the Ministry of Public Health.

Government deposits at the central bank exclude earmarked grants.

Estimated direct productive expenditures by donors on public projects not included in the central government budget.

Table 3b.Islamic Republic of Afghanistan: Central Government Budget, 2008/09-2013/14(In percent of GDP)
2008/092009/102010/112011/122012/132013/14
Act.Act.Act.Proj.
Revenues and grants17.520.522.023.723.724.0
Domestic revenues7.810.311.011.511.311.6
Tax revenues5.48.49.19.59.69.9
Income, profits, and capital gains1.52.52.72.82.82.9
International trade and transactions2.43.53.83.93.93.9
Goods and services1.22.02.22.42.52.6
Other0.30.30.40.40.40.5
Nontax revenues2.42.01.91.91.71.7
Grants to operating budget5.55.37.57.67.77.3
Afghanistan Reconstruction Trust Fund (ARTF)3.01.82.11.11.21.0
Law and Order Trust Fund for Afghanistan (LOTFA)1.92.33.33.33.23.0
NATO Training Mission - Afghanistan (NTM-A) and other grants0.71.22.03.33.33.3
Grants to development budget4.34.93.54.64.75.1
Total expenditures21.722.121.123.825.325.7
Operating expenditures13.114.515.117.618.618.7
Of which: Security5.67.18.410.010.810.9
Wages and salaries8.910.411.813.213.713.8
Of which: Security5.06.27.68.69.39.4
Purchases of goods and services2.72.42.42.72.72.7
Transfers, subsidies, and other0.50.50.40.40.40.4
Pensions0.60.90.30.71.21.2
Capital expenditures0.30.20.20.40.40.4
Interest0.00.00.00.10.10.2
Development expenditures8.67.65.96.26.67.0
Of which:
Governance, rule of law, and human rights0.40.40.20.20.20.2
Infrastructure and natural resources3.72.82.83.03.23.3
Education0.81.00.70.70.80.8
Health0.60.60.60.60.70.7
Agriculture and rural development2.32.41.21.31.41.5
Economic governance and private sector development0.70.20.30.30.30.3
Operating balance including grants0.21.23.31.60.40.2
Operating balance excluding grants−5.3−4.2−4.1−6.1−7.4−7.1
Overall budget balance including grants−4.1−1.60.90.0−1.6−1.7
Augmented overall budget balance, including grants−4.1−1.60.9−4.0−1.2−1.5
Of which: Central bank capitalization−4.00.40.2
Float and discrepancy1.92.10.7
Sale of nonfinancial assets 1/0.80.20.00.30.00.0
Financing1.5−0.7−1.73.71.21.5
External loans (net)0.70.60.40.91.00.9
Domestic (net)0.8−1.3−2.02.90.20.5
Central bank0.8−1.3−2.02.90.2−3.7
Change in government deposits0.6−3.1−2.0−0.90.6−3.3
Change in central bank claims on government0.21.80.03.8−0.4−0.3
Of which: Central bank capitalization bond issuance4.40.00.0
Recoveries−0.4−0.4−0.2
Amortization of central bank capitalization bond−0.3−0.2−0.2
Commercial banks 2/4.2
Nonbank Sector
Memorandum items:
Domestic revenues as percent of operating expenditures597173656062
Central bank capitalization bond (end-of-period stock)3.72.71.9
Indicative floor on propoor spending 3/2.12.0
Discretionary cash balances 4/1.11.53.22.40.63.1
External budget 5/49.339.930.522.119.716.5
Nominal GDP (in billions of Afghanis)5346157308629681,074
Source: Afghan authorities; and Fund staff estimates and projections.

For 2011/12 and 2012/13, reflects signature bonus payments for the Aynak Copper Mine equivalents to US$53m and US$109m, respectively.

By 2013/14 the government will start to issue sukuk debt instruments.

Propoor spending covers the Ministry of Education, the Ministry of Labor and Social Affairs, Martyrs, and Disabled, and the Ministry of Public Health.

Government deposits at the central bank exclude earmarked grants.

Estimated direct productive expenditures by donors on public projects not included in the core budget.

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

For 2011/12 and 2012/13, reflects signature bonus payments for the Aynak Copper Mine equivalents to US$53m and US$109m, respectively.

By 2013/14 the government will start to issue sukuk debt instruments.

Propoor spending covers the Ministry of Education, the Ministry of Labor and Social Affairs, Martyrs, and Disabled, and the Ministry of Public Health.

Government deposits at the central bank exclude earmarked grants.

Estimated direct productive expenditures by donors on public projects not included in the core budget.

Table 4a.Islamic Republic of Afghanistan: Central Bank Balance Sheet, 2009-2012(at market exchange rates)
2009201020112012
Mar. 20Mar. 20Mar. 20June 21Sep. 22Dec. 21Mar. 19June 20Sep. 21Dec. 22
Act.Act.ActualProj.Projections
(In billions of Afghanis, unless otherwise indicated)
Net foreign assets184.2194.8233.4265.4282.5288.9289.4298.1306.9315.8
Foreign assets188.8209.9248.2280.8297.9305.4305.8315.6324.5334.5
Foreign exchange reserves181.0204.0241.4274.2289.2296.5297.0306.5315.2324.9
Other foreign assets7.85.96.76.68.88.98.89.19.39.6
Foreign liabilities−4.6−15.2−14.8−15.3−15.4−16.5−16.4−17.4−17.6−18.7
Net domestic assets−77.9−70.3−82.4−99.0−114.9−122.9−110.1−122.7−121.0−120.7
Domestic assets−53.5−52.6−55.5−51.0−60.7−65.4−53.9−64.4−59.6−56.8
Net claims on general government−31.2−36.7−48.9−21.3−27.2−35.1−27.2−37.7−32.6−40.2
Gross claims on government4.615.114.753.150.850.347.847.446.145.7
Of which: Capitalization bonds37.835.433.931.530.028.627.1
Domestic currency deposits−8.3−10.6−9.2−4.0−7.1−11.7−10.3−11.6−10.7−11.6
Foreign currency deposits−27.5−41.2−54.4−70.3−70.9−73.8−64.7−73.4−68.1−74.4
Other claims, of which:−22.3−15.9−6.6−29.7−33.4−30.3−26.6−26.7−27.0−16.6
Capital notes−19.3−10.9−16.1−20.5−23.9−21.3−17.7−17.8−18.0−7.6
Lender of last resort loans18.10.00.00.00.00.00.00.0
Other items net−24.4−17.7−26.9−48.1−54.2−57.4−56.2−58.3−61.4−63.9
Reserve money106.2124.4151.0166.4167.7166.0179.4175.4185.9195.1
Currency in circulation76.898.7132.4133.7143.7149.0156.1157.5168.8174.4
Bank deposits (Afghani denominated)29.425.718.532.724.017.023.317.917.120.7
Memorandum items:
Reserve money
Year-to-date percentage change10.211.09.918.8−2.23.68.8
Year-on-year percentage change64.917.121.334.523.619.018.85.410.917.5
Currency in circulation
Year-to-date percentage change1.08.512.517.80.98.211.7
Year-on-year percentage change30.428.534.230.821.421.317.817.817.517.0
(In millions of U.S. dollars, unless otherwise indicated)
Gross international reserves3,5914,2095,3215,8595,9846,0636,1216,2576,3746,510
Interest rate, 28-day capital notes (percent)14.54.32.42.42.2
Source: Afghan authorities; and Fund staff estimates and projections.
Source: Afghan authorities; and Fund staff estimates and projections.
Table 4b.Islamic Republic of Afghanistan: Central Bank Balance Sheet, 2009-2012

(at program exchange rates 1/)

2009201020112012
Mar. 20Mar. 20Mar. 20June 21Sep. 22Dec. 21Mar. 19June 20Sep. 21Dec. 22
Act.Act.ActualProj.Projections
(In billions of Afghanis, unless otherwise indicated)
Net foreign assets179.3196.1233.4252.8258.4261.1263.7269.2274.7280.2
Foreign assets183.5210.8248.2267.6273.2276.7279.3285.7291.2297.5
Foreign exchange reserves176.5205.2241.4261.2264.9268.5271.1277.3282.6288.7
Other foreign assets7.05.66.76.48.38.38.38.48.68.8
Foreign liabilities−4.3−14.7−14.8−14.7−14.7−15.6−15.6−16.5−16.5−17.3
Net domestic assets−73.0−71.6−82.4−86.4−90.7−95.1−84.4−93.8−88.8−85.1
Domestic assets−50.7−50.7−55.5−49.0−56.8−61.3−50.7−60.3−55.5−51.8
Net claims on general government−28.6−35.1−48.9−19.6−23.9−31.0−24.1−33.6−28.5−35.2
Gross claims on government4.214.714.752.550.149.447.046.445.044.4
Of which: Capitalization bonds37.835.433.931.530.028.627.1
Domestic currency deposits−8.3−10.6−9.2−4.0−7.1−11.7−10.3−11.6−10.7−11.6
Foreign currency deposits−24.5−39.1−54.4−68.1−66.8−68.7−60.8−68.4−62.8−68.1
Other claims, of which:−22.1−15.6−6.6−29.5−32.9−30.3−26.6−26.7−27.0−16.6
Capital notes−19.3−10.9−16.1−20.5−23.9−21.3−17.7−17.8−18.0−7.6
Lender of last resort loans18.10.00.00.00.00.00.00.0
Other items net−22.3−20.9−26.9−37.4−34.0−33.8−33.6−33.5−33.4−33.2
Reserve money106.2124.4151.0166.4167.7166.0179.4175.4185.9195.1
Currency in circulation76.898.7132.4133.7143.7149.0156.1157.5168.8174.4
Bank deposits (Afghani denominated)29.425.718.532.724.017.023.317.917.120.7
Memorandum items:
Reserve money
Year-to-date percentage change10.211.09.918.8−2.23.68.8
Year-on-year percentage change64.917.121.334.523.619.018.85.410.917.5
Currency in circulation
Year-to-date percentage change1.08.512.517.80.98.211.7
Year-on-year percentage change30.428.534.230.821.421.317.817.817.517.0
(In millions of U.S. dollars, unless otherwise indicated)
Net international reserves (at program rates)3,7604,3155,0175,4685,5325,5895,6475,7645,8815,998
Gross international reserves (at market rates)3,5914,2095,3215,8595,9846,0636,1216,2576,3746,510
Interest rate, 28-day capital notes (percent)14.54.32.42.42.2
Source: Afghan authorities; and Fund staff estimates and projections.

Program exchange rates as of March 20, 2011 applied to evaluate foreign currency-denominated components. The Afghani per U.S. dollar rate for that day was 45.3740.

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

Program exchange rates as of March 20, 2011 applied to evaluate foreign currency-denominated components. The Afghani per U.S. dollar rate for that day was 45.3740.

Table 5.Islamic Republic of Afghanistan, Monetary Survey, 2008-12 1/
20082009201020112012
Mar. 19Mar. 20Mar. 20Mar. 20Mar. 19
Act.Act.Act.Act.Proj.
(In billions of Afghanis)
Net foreign assets162.2187.7225.6272.2337.2
Foreign assets171.5222.9257.7298.2367.2
Central bank148.0188.8209.9248.2305.8
Commercial banks23.634.147.850.161.3
Foreign liabilities−9.4−35.2−32.1−26.0−29.9
Central bank−5.0−4.6−15.2−14.8−16.4
Commercial banks−4.4−30.5−16.9−11.3−13.5
Net domestic assets−42.6−25.20.75.4−8.9
Net domestic credit5.217.429.731.512.3
Nonfinancial public sector−33.7−32.9−39.4−51.6−30.0
Central bank−34.9−31.2−36.7−48.9−27.2
Commercial banks1.2−1.7−2.7−2.7−2.7
Private sector 2/38.449.869.783.142.3
Other financial institutions0.50.5−0.60.00.0
Capital account−52.5−49.8−57.5−23.7−64.3
Other items net4.87.328.5−2.543.2
Broad money M2119.6162.5226.4277.5328.4
Narrow money M1114.9158.4212.6261.2309.5
Currency outside banks57.573.892.5126.3149.2
Currency in circulation58.976.898.7132.5156.1
Currency held by banks1.43.06.16.26.8
Demand deposits57.484.5120.1134.9160.3
Other deposits 3/4.74.213.716.318.9
(12-month percentage change)
M231.035.939.322.618.3
M128.737.834.322.818.5
Currency outside banks16.028.425.336.518.2
Currency in circulation17.030.428.534.217.8
Net credit to the private sector 2/78.329.839.719.3−49.2
(In percent of GDP)
M227.530.536.838.038.1
M126.429.734.635.835.9
Memorandum items:
M2 velocity4.03.53.02.82.7
Reserve money multiplier1.91.51.81.81.8
Banking sector
Loan dollarization (percent)75.373.374.473.177.0
Deposit dollarization (percent)79.158.767.565.566.4
Currency-to-deposit ratio (percent)94.886.673.887.687.1
Source: Afghan authorities; and Fund staff estimates and projections.

Data underlying the survey are not fully consistent because the central bank and the public banks use

the solar calendar, while commercial banks use the Gregorian calendar.

The decline in 2012 reflects a write-down of bad loans in the banking sector.

Comprising all claims, other than transferable deposits.

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

Data underlying the survey are not fully consistent because the central bank and the public banks use

the solar calendar, while commercial banks use the Gregorian calendar.

The decline in 2012 reflects a write-down of bad loans in the banking sector.

Comprising all claims, other than transferable deposits.

Table 6.Islamic Republic of Afghanistan: Balance of Payments, 2008/09-2013/14
2008/092009/102010/112011/122012/132013/14
Prel.Projections
(In millions of U.S. dollars, unless otherwise indicated)
Current account (including grants)92−34726718−207−536
Current account (excluding grants)−6,244−6,402−6,343−6,293−6,508−6,621
Trade balance−6,480−6,354−6,303−6,266−6,524−6,672
Exports of goods (f.o.b.) 1/2,4652,5172,8362,9082,6512,560
Official exports547476571657749836
Unofficial exports1,9182,0412,2652,2511,9021,724
Smuggling180141152157161162
Transit trade1,4381,4001,4631,4441,2911,263
Sales to nonresidents300500650650450300
Imports of goods (f.o.b.)−8,945−8,872−9,139−9,174−9,174−9,232
Services and income, net−240−370−408−423−394−372
Of which: Interest due 2/−16−19−11−12−14−17
Current transfers6,8126,3776,9786,7076,7106,508
Public (program grants)6,3376,0546,6106,3116,3016,085
Private475323368396409424
Capital and financial account338−287612734760929
Capital account000000
Financial account338−287612734760929
Debt forgiveness0−1,0610000
Foreign direct investment300303329386447604
Other investment38471283348313326
Official loans (net)96286133156188194
Disbursement 3/97287134158190206
Amortization due 2/−1−1−1−2−2−13
Other inflows−57185151192125132
Errors and omissions (including short-term capital)541190−81−116−78−11
Overall balance972−445797636475382
Financing−972445−797−636−475−382
Changes in central bank’s gross reserves (increase = -)−993−621−797−653−506−404
Use of Fund resources (net)1700173022
Disbursements (PRGT)1700183636
Repayments0001614
Exceptional financing51,0660000
Arrears 4/−8400000
Debt rescheduling 5/3250000
Debt forgiveness561,0610000
HIPC04420000
MDRI0350000
Financing gap000000
Memorandum items:
Gross international reserves3,5914,2095,3216,1216,6277,178
(Import coverage) 6/5.36.07.48.49.09.5
(Relative to external debt service due)215213425425298165
(In percent of GDP, unless otherwise indicated)
Trade balance−61.9−50.9−39.6−34.1−33.3−31.7
Current account balance, including grants0.9−2.81.70.1−1.1−2.6
Excluding grants−59.6−51.3−39.8−34.3−33.2−31.5
Source: Afghan authorities; and Fund staff estimates and projections.

Excludes opium exports; includes official exports, estimates of smuggling, reexport, and sales to nonresidents.

Debt service projections are based on the total stock of external debt (including estimates of unverified arrears). Interest on overdue obligations represents estimates by Fund staff.

Includes allocation of SDR 128.6 million in 2009/10.

Arrears shown represent Fund staff estimates of debt service due, but not paid, on estimated overdue obligations.

Debt rescheduling includes the capitalization of interest falling due to Paris Club creditors until the completion point, interim assistance from multilateral creditors, and HIPC debt relief from multilateral creditors after the completion point.

Excluding imports for reexport.

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

Excludes opium exports; includes official exports, estimates of smuggling, reexport, and sales to nonresidents.

Debt service projections are based on the total stock of external debt (including estimates of unverified arrears). Interest on overdue obligations represents estimates by Fund staff.

Includes allocation of SDR 128.6 million in 2009/10.

Arrears shown represent Fund staff estimates of debt service due, but not paid, on estimated overdue obligations.

Debt rescheduling includes the capitalization of interest falling due to Paris Club creditors until the completion point, interim assistance from multilateral creditors, and HIPC debt relief from multilateral creditors after the completion point.

Excluding imports for reexport.

Table 7.Islamic Republic of Afghanistan: Main Socioeconomic Indicators, 2000-09
200020052006200720082009
Labor market
Employment-to-population ratio, (in percent, ages 15+)54.754.254.954.655.554.2
Youth employment-to-population ratio, ages 15-24, (in percent)42.241.742.642.243.341.6
Unemployment, total (in percent of total labor force)8.5
Female (in percent of female labor force)9.5
Male (in percent of male labor force)7.6
Labor participation rate, (in percent of total population, ages 15+)58.959.359.459.659.759.8
Income, inequality and poverty
Income share held by lowest 20 percent (in percent)9.0
Income share held by highest 20 percent (in percent)38.7
Gini index29.4
Poverty rate (headcount at the national poverty line, in percent of population)33.042.036.0
Gender equality and empowerment
Proportion of seats held by women in the parliament (in percent)27.327.327.327.727.7
Ratio of female to male school enrollment (in percent)
Primary59.563.662.765.167.3
Secondary32.936.838.043.349.0
Tertiary23.9
Population, female (in percent of total)48.248.248.248.248.348.3
Share of women employed in the nonagricultural sector (in percent)
Education and health
Health expenditure (in percent of GDP)
Public health expenditure (in percent of GDP)2.32.12.11.81.61.6
Public health expenditure (in percent of government spending)2.84.14.33.73.73.7
Hospital beds (per 1000 people)0.40.40.4
Life expectancy at birth (in years)45.346.646.947.247.547.9
Female45.446.747.047.347.748.1
Male45.246.546.847.147.447.8
Sources: World Bank World Development Indicators (WDI) database, ILO LABORSTA database, UN MDG indicators.
Sources: World Bank World Development Indicators (WDI) database, ILO LABORSTA database, UN MDG indicators.
Table 8.Islamic Republic of Afghanistan: Proposed Schedule of Reviews and Disbursements Under New ECF Arrangement
Amount of disbursement
DateMillions of SDRsPercent of quota 1/Conditions
November 21, 201112.07.4Approval of arrangement
May 20, 201212.07.4First review and March 19, 2012 performance criteria
November 20, 201212.07.4Second review and September 21, 2012 performance criteria
May 20, 201312.07.4Third review and March 20, 2013 performance criteria
November 20, 201312.07.4Fourth review and September 22, 2013 performance criteria
May 20, 201412.07.4Fifth review and March 20, 2014 performance criteria
November 6, 201413.08.0Sixth review and September 22, 2014 performance criteria
Total85.052.5
Source: Fund staff estimates.

Percentages do not add up to the total due to rounding.

Source: Fund staff estimates.

Percentages do not add up to the total due to rounding.

Table 9.Islamic Republic of Afghanistan: External Financing Requirement and Sources, 2010/11-2013/14
2010/112011/122012/132013/14
Projections
(In millions of U.S. dollars)
I. Total financing requirement7,1426,9497,0227,052
Current account (excluding grants)6,3436,2936,5086,621
Amortization13827
Of which: IMF01614
Prepayment of debt0000
Change in reserves (increase = +)797653506404
Reduction in arrears0000
II. Available financing7,1426,9497,0227,052
Current transfers6,6106,3116,3016,085
Foreign direct investment329386447604
Short-term private financing flows151192125132
Official medium- and long-term loans134158190206
IMF disbursements0183636
Debt forgiveness0000
Debt rescheduling0000
Other−81−116−78−11
Financing gap0000
Sources: Afghan authorities; and Fund staff estimates and projections.
Sources: Afghan authorities; and Fund staff estimates and projections.
Table 10.Islamic Republic of Afghanistan: Indicators of Capacity to Repay the Fund, 2010-18
201020112012201320142015201620172018
Projections
Fund obligations based on existing credit
(in millions of SDRs)
Principal0.00.02.58.312.814.515.112.66.8
Charges and interest0.10.00.30.30.20.20.20.10.1
Total obligations based on existing and prospective credit 1/
In millions of SDRs0.10.02.88.713.214.915.416.615.5
In millions of U.S. dollars0.10.04.413.821.023.624.426.124.5
In percent of Gross International Reserves0.00.00.10.20.30.30.30.40.4
In percent of exports of goods and services0.00.00.41.01.31.00.80.70.7
In percent of debt service10.71.923111080269220241222
In percent of GDP0.00.00.00.10.10.10.10.10.1
In percent of quota0.10.01.75.38.29.29.510.29.6
Outstanding Fund credit
In millions of SDRs75871091251371221079176
In billions of U.S. dollars0.10.10.20.20.20.20.20.10.1
In percent of Gross International Reserves2.22.32.62.83.02.62.42.11.8
In percent of exports of goods and services12.112.914.414.913.67.85.24.13.2
In percent of debt service8,9428,2399,0401,5798292,2061,5311,3241,087
In percent of GDP0.70.80.90.91.00.80.60.50.4
In percent of quota46.554.067.377.084.575.566.256.246.8
Net use of Fund credit (millions of SDRs)5.712.021.615.712.2−14.5−15.1−16.2−15.2
Disbursements5.712.024.024.025.00.00.00.00.0
Repayments and Repurchases0.00.02.58.312.814.515.116.215.2
Memorandum items:
Nominal GDP (in millions of U.S. dollars)15,92818,36419,60321,01522,47724,27326,17028,13229,626
Exports of goods and services (in millions of U.S. dollars)9521,0741,2061,3301,5982,4733,2523,4963,719
Gross International Reserves (in millions of U.S. dollars)5,3216,1216,6277,1787,2787,3497,0596,8776,626
Debt service (in millions of U.S. dollars) 2/1.31.71.912.526.28.811.110.911.0
Quota (millions of SDRs)161.9161.9161.9161.9161.9161.9161.9161.9161.9
Sources: IMF staff estimates and projections.

Includes prospective ECF disbursements of SDR 85 million (52.5 percent of quota).

On accrual basis. Total debt service includes IMF repurchases and repayments.

Sources: IMF staff estimates and projections.

Includes prospective ECF disbursements of SDR 85 million (52.5 percent of quota).

On accrual basis. Total debt service includes IMF repurchases and repayments.

Appendix I. Islamic Republic of Afghanistan: Letter of Intent

November 1, 2011

Ms. Christine Lagarde

Managing Director

International Monetary Fund

Washington, DC 20431

Dear Ms. Lagarde:

We would like to thank the International Monetary Fund (IMF) for its advice and support over the last year as the government of Afghanistan and Da Afghanistan Bank dealt with the crisis at Kabul Bank that came to the fore in September 2010 and its consequences. In response to the crisis, we have taken important steps to mitigate its adverse effects, minimize the fiscal costs, and safeguard good governance and the rule of law over the last 12 months.

Against this background, we entered into discussions with IMF staff on a new program that could be supported under the Extended Credit Facility (ECF). The three-year program through 2013/14 establishes a macroeconomic framework that will support our efforts at economic stabilization and implementation of structural reforms. In particular, the ECF arrangement will help us make significant progress toward a stable and sustainable macroeconomic position, while managing the challenges of the withdrawal of the international presence in Afghanistan, as well as strengthening the financial sector. These are key pillars of our development strategy that aims at sustained poverty reduction. Given our large dependence on donor support, we require external assistance to build a more resilient and self-sustaining economic structure as well as reinforce our balance of payments position.

We hereby kindly request the approval by the Executive Board of a three- year ECF arrangement in an amount equivalent to SDR 85 million (52.5 percent of Afghanistan’s quota). To monitor progress in implementing our reform agenda, the program includes a set of prior actions, quantitative performance criteria, indicative targets, and structural benchmarks, outlined in the attached Memorandum of Economic and Financial Policies (MEFP) and the Technical Memorandum of Understanding (TMU).

The government believes that the policies set forth in the attached MEFP are adequate to achieve the objectives of its program, but it will take any further measures that may become appropriate for this purpose. We will consult with the Fund on the adoption of these measures and in advance of any revision to the policies contained in the MEFP, in accordance with the Fund’s policies on such consultation. We intend to remain in close

consultation with Fund staff and provide timely information necessary for monitoring economic developments and implementation of policies under the ECF-supported program. In addition, the government stands ready to take any further measures that might be required to ensure that the overall objectives of the program are attained.

In line with our commitment to transparency, we hereby request that the staff report, this letter of intent, and the attached MEFP and TMU (including all annexes and attachments), as well as all other ECF-related documents, be published on the IMF website.

Sincerely yours,

/s//s/
Omar ZakhilwalMohibullah Safi
Minister of FinanceActing Governor
Da Afghanistan Bank

Attachments:

Memorandum of Economic and Financial Policies

Technical Memorandum of Understanding

Attachment I. Afghanistan: Memorandum of Economic and Financial Policies

1. This memorandum reviews recent economic developments and summarizes the government’s economic objectives and policy framework for 2011–14, for which we are seeking support under a new three-year arrangement with the IMF.

2. The government of Afghanistan and Da Afghanistan Bank (DAB) have made a number of important achievements under our economic program for 2006—10. In January 2010, we fulfilled the conditions for reaching the completion point under the Enhanced Heavily Indebted Poor Countries (HIPC) initiative, bringing together four years of important and successful efforts despite an increasingly challenging security situation. We strengthened basic economic institutions, made strong progress in restoring fiscal control and improving public financial management, fostered trade and growth, and managed inflation well. Tax collection, which was relatively weak during the first two years of the program, has improved significantly since early-2009. We also improved the monitoring of the four largest public enterprises, although the problems at Kabul Bank that came to the fore in the fall of 2010 highlighted the costs of weak corporate governance and the need to tackle vulnerabilities and prevent abuse in the financial system.

3. Looking ahead, much remains to be done. In particular, we will focus our efforts on safeguarding financial stability, strengthening the banking system, promoting responsible lending for investment and growth, improving the business environment for the private sector, moving decisively toward fiscal sustainability, and improving fiscal planning and expenditure management. We believe this will complement commitments by donors to channel additional support through the budget and allow us to raise spending in line with our development objectives.

I. Recent Developments

4. Growth and inflation. Economic activity remains robust, with projected real GDP growth of about 6 percent in 2011/12, following a growth of 8 percent in 2010/11. While agriculture has suffered from fluctuations, growth outside agriculture has been strong due to increased security spending and expansion of construction and trade. Inflation has increased again owing to rising international food prices, adverse conditions in neighboring countries, and an accommodative monetary policy. The 12-month rate of inflation peaked at 18 percent in January-April 2011, rising from 2 percent in June 2010. It has since moderated again to 11 percent in August. During the same period, core inflation (which excludes cereals, fats, and transportation) rose from 5 percent to 13 percent.

5. Fiscal performance. Fiscal performance in 2010/11 remained strong. The overall fiscal deficit including grants fell from 1.6 percent of GDP in 2009/10 to about balance in 2010/11. The improvement came mainly from a decline in development spending and a tight control over nonsecurity spending, but also from improved domestic revenue collection which was up by about 1 percent of GDP in 2010/11. Revenues in 2011/12 remain buoyant, with a 25 percent increase in the first half over the same period in 2010/11. We continued implementing pay and grade reforms, and recruited almost 60,000 personnel in the security sector leading to an increase in security spending of 1.5 percent of GDP in 2010/11.

6. Development spending. Development spending fell by 1.7 percent of GDP in 2010/11, the third year of consecutive decline. This was a result of the combined effect of earmarked donor funding that could not be reallocated, worsening security that prevented the execution of projects in some regions and capacity constraints at line ministries. Other problems include ambitious multi-year spending plans (with large carry-overs), incentives for the donors and line ministries to “front-load” the budget, difficulties with procurement planning and execution, slow approval processes, and poor contract management. We are addressing these issues through the Public Financial Management Road Map, which was prepared in consultation with IMF staff. In addition, we are working closely with line ministries to enhance their budget execution capacity and we will continue to engage with donors to increase flexibility of funding according to their bilateral and multilateral commitments.

7. Fiscal reforms. We have made progress with structural reforms in the fiscal area. First, the Medium and Large Taxpayer Offices now report directly to headquarters in Kabul instead of to the Ministry of Finance’s provincial offices, an important measure in our goal to create a national tax administration organized along functional lines. Second, we simplified the chart of accounts to reduce risks associated with the implementation of program budgeting reform. Third, with the implementation of the Afghanistan Financial Management Information System (AFMIS) in Nuristan in 2010, we completed the AFMIS roll-out across the country. This is a significant achievement, which provides timely information on budget expenditures and subjects them to a high degree of fiduciary control. Fourth, the implementation of the Automated System of Customs Data at the Nimroz customs post has begun. A business model for border controls in line with best practice (a critical measure to fight corruption at customs) was introduced in September 2011 at the Hairatan Border Crossing Post. The model envisages the presence of only two ministries at the border (Interior and Finance). Following successful implementation of the pilot, the model will be rolled out to additional border crossing posts by end-March 2012.1

8. Public enterprises. Financial reviews and business plans by four key public enterprises—Ariana (an airline), Da Afghanistan Breshna Sherkat (DABS, a power utility), Afghan Telecom, and The Afghanistan Fuel and Liquid Gas Enterprise (FLGE)—were finalized in 2010. The financial reviews revealed a number of shortcomings, such as a lack of management and financial reporting systems in the companies, over-staffing (Ariana), lack of competitiveness (Ariana, Afghan Telecom, FLGE), collection problems (DABS), and serious corporate governance issues (FLGE). The business and restructuring plans that are now being implemented address these deficiencies.2

9. Financial sector and Kabul Bank. Over the past four years, the central bank has strengthened its capacity for banking supervision. Still, the rapid growth of the banking sector proved challenging as illustrated by the Kabul Bank crisis that came to the fore in the fall of 2010. In August/September 2010, due to concerns over operation of Kabul Bank, the largest commercial bank, we removed the two major shareholders from management, put the bank into conservatorship and suspended shareholder rights. However, public concern over its stability caused a run on the bank. With one-third of the system’s assets of US$4 billion, the run threatened the stability of the whole banking system. In order to prevent further instability we promptly announced that its deposits would be guaranteed. This action contained the run and prevented contagion. Nonetheless, Kabul Bank lost about one-half of its deposits and the central bank had to extend a lender-of-last-resort (LoLR) facility for US$825 million. Subsequently, Kabul Bank was put into receivership, revoking shareholders’ rights altogether. Its deposits and good assets were transferred to a bridgebank—New Kabul Bank—which is being prepared for sale. It was established that about US$865 million (principal and interest) in the asset portfolio of the bank are questionable.

10. Monetary developments. We responded to the initial run at Kabul Bank in September 2010 with sufficient cash notes to repay depositors. At the same time, by sterilizing the impact of the LoLR loan to Kabul Bank with a fraction of our foreign reserves, we prevented the bank’s crisis from destabilizing the exchange rate. The interest rate on 28-day capital notes remained at around 3 percent. However, monetary aggregates grew by more than envisaged, mainly reflecting the increased preference for cash by the public in the aftermath of the Kabul Bank crisis, but also high aid inflows.

11. External current account. The external current account balance was favorable, facilitating a further buildup of international reserves to about 7 months of imports. After reaching the HIPC completion point in 2010, we are following up with Paris Club creditors on their debt relief commitments, and carrying out negotiations with other creditors on comparable terms.3

12. Structural reforms. While there were delays in the implementation of the structural measures agreed under the previous program for implementation by March 2010, all but one of those measures have been implemented (Table 1). The pending benchmark on the protocol for border controls is being carried over to the new program.

Table 1.Islamic Republic of Afghanistan: Structural Benchmarks for the Seventh Review of the ECF Arrangement, December 2009-March 2010
Target DateStatus as of September 25, 2010
Begin publication of four-month reports and forecasts for financial flows and other key variables for Da Afghanistan Breshna Moassessa/Sherkat (DABM/S).Dec. 31, 2009Delayed. Implemented in July 2010. Most data were provided in March 2010 and the remaining data were submitted in July 2010.
Finalize a comprehensive review of the financial situation of Afghan Telecom, ARIANA, DABS, and the Liquid Fuel and Gas Enterprise (FLGE) and their fiscal relations with the government in terms of tax owed, subsidies (if applicable), and other payables or receivables. The review will include regularization of tax payments and other cross debts and reduction of subsidies (if applicable); closure of unauthorized bank accounts; review of corporate governance procedures; business plans; and plans for divestiture, restructuring, of privatization for these enterprises.Mar. 30, 2010Partially delayed. Review of all SOEs (except FLGE) was implemented by March 2010. The review of FLGE was completed in October 2010.
Transfer the directorate responsible for monitoring and managing public enterprises in the MOF from the Administration Department to the Finance Department or the Office of the Minister.Feb. 28, 2010Delayed. Implemented in April 2010.
Adopt and implement the business model of border controls clarifying the role of each ministry at the border consistent with internationally accepted best practices in consultation with other stakeholders (Ministry of Commerce and Industry and Ministry of the Interior) for better customs controls at the border.Feb. 28, 2010Not implemented. The delay is due to difficulties in clarifying the roles of various ministries and ensuring good governance. Measure has been reformulated and included in the program to be supported under the new ECF arrangement.
Implement the Automated System for Customs Data (ASYCUDA) transit module along Zaranj-Nimroz axis and declaration processing module at Nimroz.Mar. 30, 2010Delayed. Implemented in June 2010.

II. The Economic Program For 2012—14

13. The program. Our three-year economic program is a key component of the government’s development strategy going forward. It is an integral part of the comprehensive framework for security, development, and governance presented at the Kabul Conference in July 2010 and it establishes the economic parameters for Afghanistan’s transition, which is to be agreed at the Bonn Conference in December 2011. Within this broader development agenda, the program aims at consolidating the gains achieved so far and invigorating reforms to foster growth and poverty reduction. To this end, the key objectives of the program will be to: (i) make significant progress toward a stable and sustainable macroeconomic position while managing the challenges of the withdrawal of the international presence in Afghanistan; (ii) strengthen the banking system and address the governance and accountability issues highlighted by the Kabul Bank crisis; (iii) move toward fiscal sustainability; and (iv) improve the transparency and efficiency of public spending and services to protect the poor. We will pursue policies to keep inflation low, improve banking supervision and financial integrity, amend the banking law, and strengthen the framework to deal with financial crime. In addition, we intend to achieve sustained increases in domestic revenues (with proper focus on the extractive industries sector), prioritize public spending and improve expenditure management, and reduce fiscal risks from public enterprises.

14. Macroeconomic outlook. Despite an expected decline in overall donor assistance, our goal is to sustain annual real GDP growth at about 6—7 percent over the next three years, supported by an expansion in the nonagricultural sector and mining investment. Cognizant of the negative effects of inflation, particularly on the poor, and in line with our goal to protect vulnerable segments of our population, we will strive to bring inflation down. Sustained donor funding and a stable economy will support the balance of payments. We intend to keep international reserves at around 7 months of imports.

15. Prioritizing development spending. In early 2010, we developed the cluster approach to better prioritize the Afghanistan National Development Strategy (ANDS) and improve coordination and implementation.4 We grouped line ministries in six clusters (security, governance, infrastructure, agriculture and rural development, human resource development and private sector development) that focus on the delivery of selected large-scale national priority programs which, combined, account for over 80 percent of the development budget through 2013/14. We are also taking steps to address bottlenecks in the execution of the development budget. The objective is twofold: for the government to improve the delivery of services; and for donors to align development assistance with our national priorities and channel more resources through the budget. The government believes that improvements in governance will give donors the confidence to increase the proportion of these funds channel through the budget, and we have steadily implemented Kabul conference commitments on governance and corruption and maintain a matrix of achievements.

16. Poverty reduction. Our policies are guided by the ANDS and based on low inflation, propoor budgeting, and economic growth. Although it will be necessary to allocate increasing amounts of spending to security, we will also allocate adequate resources to help the poor. To monitor results, we will improve the collection and analysis of poverty indicators. In 2011/12, we will update the ANDS poverty profile using the 2007/08 National Risk and Vulnerability Assessment as a baseline, and integrate the allocation and tracking of propoor outlays into the budget process. Based on the existing poverty profile, propoor operating spending in the 2011/12 budget is programmed to be about Af 16.3 billion (25 percent of nonsecurity operating spending) compared with Af 13.6 billion in 2010/11 (25 percent of nonsecurity operating spending) (indicative target).5

A. Monetary and Exchange Rate Policy

17. Low inflation, an exchange rate regime capable of absorbing shocks to the economy, and effective coordination of monetary and fiscal policies are key ingredients for macroeconomic stability. To this end, we will continue to promote price stability, strengthen monetary policy operations, and improve coordination between the central bank and the ministry of finance.

18. Monetary and exchange rate policies. Monetary policy will aim to lower core inflation to about 4 to 6 percent, while still recognizing that many drivers of inflation are external and beyond our control. To this end, we will regularly monitor leading indicators of inflation, including monetary aggregates and headline inflation, to steer monetary policy. We will maintain a floating exchange rate system that will allow the rate to reflect market fundamentals, while intervention will aim at smoothing out volatility and achieving our international reserves targets. We remain committed to an independent central bank that sets monetary policy with a view to maintaining low inflation and managing shocks or persistent changes in foreign exchange inflows without overburdening fiscal policy.

19. Monetary program. In line with improved operational capacity at the central bank, we switched in 2010 to reserve money targeting. Given our estimate for money demand growth and the recent rise in inflation, we target reserve money growth of 19 percent during 2011/12. We also intend to slow the growth of currency in circulation from 34 percent in 2010/11 to 18 percent in 2011/12.

20. Foreign exchange risk. We will adopt measures to reduce the central bank’s exposure to foreign exchange risk. Currently, large foreign currency inflows from coalition forces are converted to Afghanis by the central bank. These inflows remain in a dollar account, except for an appropriate working balance in Afghanis. We will move towards a system in which foreign currency will be exchanged on an open market, with sales to the central bank as a last recourse. To this end, the central bank has been reducing its role in providing currency through foreign exchange auctions by raising minimum bid amounts in these auctions and charging service fees for cash transactions.

21. Monetary operations. By January 2012, we will restore the averaging of required reserves that was in effect before the introduction of the blocked account system. This will facilitate banks’ liquidity management, stabilize interbank rates, and foster the development of the interbank market. We will also increase the stock of the central bank’s capital notes to facilitate monetary policy implementation and to enable open market operations. To prevent the capital note market from being dominated by a few participants, we have introduced a percentage ceiling on the amount of capital notes that a successful bidder can obtain.

22. Ministry of finance and central bank coordination. The cost of monetary policy over the past few years has negatively affected the equity of the central bank. This has highlighted the need to implement the framework for central bank capitalization in a manner that ensures autonomy of the central bank, safeguards its resources, adheres to international accounting standards and best practices, and is fiscally sustainable. To this end, the ministry of finance and the central bank will reach agreement by December 2011 on the central bank’s capital requirements and its calculations, possible amendments to the central bank law, and modalities for addressing the central bank’s capital shortfalls or surpluses. Subsequently, the ministry of finance will recapitalize the central bank as required. To strengthen the conduct of monetary policy, facilitate public fiscal cash management, and promote market development we will finalize legislation—with timely IMF assistance—to set up a sukuk (Sharia compliant treasury bill) market with a view to submit the bill for parliamentary approval by September 2012.

B. Financial Sector

23. We have designed and started implementing a comprehensive strategy to strengthen the banking system, to lower fiscal costs associated with Kabul Bank’s failure, and to address governance issues (Table 3). This strategy, outlined in the attached action plan, includes resolving Kabul Bank, drawing lessons from its failure, promoting transparency, governance and the framework for protecting the financial system from economic crime, as well as addressing moral hazard, and strengthening banking supervision, and safeguarding a financial system based on integrity and the rule of law.

Table 3.Islamic Republic of Afghanistan: Banking System Action Plan
ObjectiveMeasuresTarget Date
Minimize fiscal costs and protect the banking system1. Kabul Bank will be placed in receivership and its banking license revoked. All shareholder share ownership and related rights and interests will be extinguished. The receiver will split assets and liabilities into a good bank and the remaining Kabul Bank estate. The good assets, the legitimate deposits, the DAB current account liability, and the salary payments services will be transferred to a bridge bank, aka the good bank, which will be a newly incorporated entity with a new banking license.Done in April 2011
2. The central bank will issue a banking license for the bridge bank and its shares will be temporarily owned by the Ministry of Finance. The FDRC will approve an asset/liability split from the balance sheet of the receivership, which will include the transfer of a current account position with the central bank held by the former Kabul Bank and the assumption of its legitimate deposit liabilities. This current account balance will include the proceeds of a lender-of-last-resort facility agreed upon by the conservator prior to the decision of receivership.Done in April 2011
3. Enforce the regularization and repayments of Kabul Bank loans extended to shareholders and major borrowers via legally binding agreements for the full amounts attributed to them as of date. Agreements should identify collaterals, including real estate title deeds or physical assets—and cash repayments. Agreements will not preclude collection of additional debt, should such debt be identified during subsequent audits, nor will they preclude prosecution in case of violation of the Afghan law. Registration and perfection of security interests in all identified collateral will occur within a reasonable period from the date of the agreements. Those failing to comply with the attributed amounts will be pursued through the legal system.See Table 5.
4. Finalize an 18-month fully-funded business plan for the bridge bank, focused on its rapid downsizing. The plan, together with related official documentation, will contain the following elements: (i) preparation for sale within 5 months and, if the sale fails, a provision that the bank will be liquidated no later than September 2012; (ii) quarterly budgets; (iii) strict limits on operations with no new lending; (iv) semi-annual targets for the reduction of staff and branches and shedding of business products, including credit card business to reduce costs and the systemic importance of the bank; (v) migration of Kabul Bank’s salary payments activities to other banks capable of performing the service, beginning with the allocation of some salary payments contracts to other banks in an open bidding to be conducted as soon as possible. Request for proposals for the bidding will be aligned with sound practice to ensure that banks that are not sufficiently qualified to perform the service will not be included; (vi) to ensure legitimate remaining deposits will be honored, deposits affiliated with shareholders and related interests will be excluded and deposits larger than $500,000 will be reviewed; (vii) prepare monthly activity reports including management accounts; and (viii) impose service charges and reduce interest rates on deposits effective May 1, 2011. The plan will also mention a commitment to have the bank audited on an annual basis by an external audit firm.Done in April 2011
5. The authorities will publicly announce the government’s overall strategy to enforce the laws of Afghanistan with respect to ensuring accountability for economic crimes, including any crimes found to have been committed at Kabul Bank or associated with the Kabul Bank crisis that are prosecuted by the authorities. Among other things, the strategy will outline key steps to be taken and establish a timeframe for these steps. The Government will include reference to the approach and timeline that will be taken by this team in the public statement issued by DAB. Any crimes committed at Kabul Bank or associated with the Kabul Bank crisis that are prosecuted by the authorities, will be handled by a prosecution task force/team within the Anti Corruption Unit of the AGO appointed by the attorney general. The team will operate according to its defined work procedures and timelines, and shall have the roles, powers and independence given to its office under the relevant Afghan law; documentation describing this shall be provided to the IMF. The team will be supported by members who possess knowledge and expertise on financial issues.Pending (prior action)
6. The receivership management team, supported by an asset management specialist, will work on the recovery of the receivership’s assets and other assets collected from shareholders and non-performing loans with the primary purpose of realizing maximum recoverable value for claimants. All related parties’ loans even if restructured or collateralized will be included in the assets to be recovered by the asset management team. The receiver will produce monthly activity reports, including management accounts, and be audited on an annual basis by an external audit firm.Ongoing
7. The authorities will pursue through mutual legal assistance the possibility of identifying, freezing, seizing and confiscating laundered property and proceeds used or intended for use in money laundering and other offenses related to Kabul Bank. The authorities will seek advice from the audit firm on the format of the requests.Ongoing
8. A legally binding agreement between the Ministry of Finance and the central bank will be executed to capitalize the central bank for the amount of the lender of last resort (LOLR) loans needed to finance Kabul Bank resolution. Under the agreement, the Ministry of Finance will issue a debt instrument to the central bank with net present value of 37.6 billion Afghani, equivalent to $825 million, with an eight year maturity and quarterly payments totaling 3.4 billion Afghani in the first year ($73 million), which will increase over time as required to fulfill the commitment. Annual payments will be explicitly recorded in the budget and the medium-term fiscal framework, beginning with an approved attachment to the 2011/12 budget, to be passed during the current fiscal year. The agreement will specify that its purpose is to fund the deposit guarantee extended to Kabul Bank depositors, explain the exceptional nature of such support, and commit the Ministry of Finance to make amortization payments to the central bank as required in the future.Done in October 2011
9. Final resolution.
i. The bridge bank will be offered for sale in a transparent way, involving a pre-qualification process to ensure that controlling shareholders, beneficial owners, directors and management of intending bidders are fit and proper (which implies, inter alia, that an intending bidder is subject to a high standard of corporate governance, including risk management and internal controls, and that an intending bidder is in a sound financial and risk management state), and that the intending bidder controls adequate resources and has the necessary capacity and capability to ensure the ongoing provision of the relevant salary payments services. There will be a request for expressions of interest locally and internationally for the sale of the bridge bank. Interested parties will be given four weeks to respond with intention to participate in the bid. Once the central bank has vetted potential buyers, it will give them a deadline for sealed bids.

ii. If there is no interest from a suitable buyer or the sale fails, salary and other payment services will migrate to other banks as a part of branch closings and deposit migrations. Unwanted branches will be offered at negative prices or be closed. By end-March 2013, all remaining deposits will be transferred to other banks and the bridge banks’ license will be revoked.
End-June 2012 July 2012 to End-March 2013
10. In consultations with Fund staff, the Ministry of Finance and the central bank shall agree on the interpretation to be accorded to the framework for central bank’s capital requirements and on the possible amendments to the central bank law in this regard, in a manner that ensures the financial autonomy of the central bank in conducting monetary policy, safeguards central bank’s resources (including the use international reserves and the provision of the lender of last resort facility), adheres to international accounting standards and best practices, and is fiscally sustainable. The Ministry of Finance and the central bank shall sign a memorandum of understanding that will, accordingly, spell out the modalities of and procedures for the ministry’s interventions in addressing potential central bank’s capital shortfalls. Subsequently, the Ministry of Finance will recapitalize the central bank as required.End-December 2011
Promote transparency, reduce moral hazard, and address banking system vulnerabilities11. Issue a detailed public statement describing (i) key events leading to the run at Kabul Bank; (ii) actions taken and to be taken to protect depositors and the financial system; (iii) the condition of the bank; (iv) actions taken and to be taken to address suspicions or evidence of fraud, misreporting, money laundering, and corruption; (v) the envisaged resolution strategy, and (vi) the way in which the insolvency will be funded (including the responsibility of the Ministry of Finance and the intention to pay with government revenue) and efforts to recover the bank’s assets.Done in April 2011
12. Initiate an audit of Kabul Bank and Azizi Bank to be carried out by a reputable international audit firm. The work will focus on investigations aimed at determining the presence of accounting or other irregularities, as well as compliance with prudential and other regulations and laws. In relation to ECF conditionality, the firm chosen to conduct the audit (the “Auditor”) and the terms of reference will be agreed with IMF staff and all communications and reports including management letters will be shared promptly with IMF staff. The Auditor will have unrestricted access to the banks, their records, their shareholders, management, and staff. The Auditor will also be authorized to communicate with third parties to gather information on matters related to the audit and the central bank will authorize the Auditor to communicate with IMF staff. The Auditor will issue interim reports within 30 days of commencing work. The audits will include, but not be restricted to, an assessment of (i) the banks’ management; (ii) the quality of the banks’ assets, (iii) the completeness of liabilities, including off-balance sheet commitments; (iv) liquidity position and use of the lender of last resort facility from the central bank (if any); (v) the accuracy of reports and information submitted to the central bank since 2005; (vi) compliance with prudential regulations; and (vii) any illegal activity, including, but not exclusive to, related party lending, fraud and compliance with AML/CFT law and regulations.Done in August 2011
13. Audit company issues inception reports.Done in September 2011
14. An independent in-depth public inquiry into the Kabul Bank crisis will be launched, with terms of reference to be agreed with IMF staff. The inquiry will cover the period from the licensing of Kabul Bank to February 2012 and will focus on the appropriateness, effectiveness, and timeliness of the response of the government, the central bank, and the justice system for the purposes of safeguarding the financial sector, deal with governance issues, and implement Afghan law. The independence of the body conducting the inquiry will be described and guaranteed in the terms of reference, and the budget for the inquiry, including salaries, should be independently administered. The body conducting the inquiry will have the right to determine its own agenda and the powers to enquire under Afghan law. The goal is to increase awareness, transparency and draw lessons that could be used to protect the financial sector and prevent similar events in the future.End-September 2012
15. In line with the authorities’ desire to protect the financial system from abuse, the government will produce a roadmap with a strategy to build capacity and improve the institutional framework to respond promptly to economic crime. This roadmap will address issues related to the prosecution system to reinforce its independence to ensure accountability for economic crimes and build capacity for investigation and prosecution of these crimes as well as determine the most appropriate institutional framework going forward.End-March 2012
16. Reputable international firm/s will initiate financial audits of 10 additional banks.End-October 2011
17. Audit reports are finalized and issued.End-March 2012
18. The report of the public inquiry will be published.End-September 2012
Strengthen banking supervision19. Drawing on the February 2010 on-site inspection of Kabul Bank and on the experience of central bank staff involved in Kabul Bank’s conservatorship, the central bank will prepare an operational note, including a summary of lessons learned and a checklist of key procedures for use during future on-site inspections of banks.Done in December 2010
20. The central bank’s enforcement committee will

  • i. review all banks’ compliance with previous enforcement measures and issue supervisory orders with timetables for compliance and sanctions for failure to comply with the key corrective actions previously recommended;
  • ii. after that, the committee will review on a monthly basis progress with compliance and impose sanctions in line with the Enforcement Regulation (e.g., fines, suspension of profit distribution, restriction on bank branching or lending, conservatorship, and bankruptcy).
Done in September 2011 Ongoing
21. The central bank will enforce in full banking regulations and circulars by

  • i. removing shareholders from serving as Chairman and CEO of the bank they own;
  • ii. continuing the evaluation of the qualifications of shareholders and management and removing those who are not “fit and proper” as they become apparent.
Done in October 2011 Ongoing
22. The central bank will issue an enforcement letter to Azizi Bank based on an ongoing on-site examination with a strict timetable and enforcement actions for non compliance. The actions will include i) specific capitalization requirement; ii) budget and business plan requirements for improvement in profitability; and iii) detailed plan for reduction of overlimit business lines.Done in August 2011
23. As part of off-site supervision, the central bank will compile quarterly reports based on the data submissions from banks, including Financial Stability Indicators, including banks’ prudential ratios, capital adequacy ratio, liquidity ratio, concentration ratio, related loan ratio, and other relevant information statistics, such as loan and deposit amounts for largest borrowers and depositors for each bank.Throughout, beginning June 2011
24. The central bank will review the existing Enforcement Regulation in light of amendments to the Banking Law as submitted to Parliament (supervisory warnings, orders, plans to take corrective action, and orders to take prompt corrective action by commercial banks). The central bank will prepare revisions of the Enforcement Regulation so as to be ready for implementation of the revised Banking Law when enacted.End-April 2012
Improve legal and regulatory framework25. Submit to Parliament the amended or new banking law, prepared in consultation with the Fund, that will strengthen provisions on corporate governance, capital, large exposures, related parties, consolidated supervision, early intervention, enforcement, and bank resolution, where appropriate in line with the Basel Core Principles. Specifically, the law should enable the authorities to enforce upon a bank—going concern—all necessary resolution measures and strengthen corporate governance requirements for banks (including fit and proper requirements as set by the FATF standards).End-September 2012
Accounting standards, insolvency and creditors’ rights, AML/CFT26. Implement plan to address bulk cash movement at Kabul airport (all passengers including VIP to complete serialized inbound/outbound currency declaration forms and space for the central bank to process forms and conduct identifications and checks) with a view to deterring transfers of proceeds of crime and fraud.End-December 2012
27. Request an insolvency and creditor rights assessment (ICR ROSC) from the World Bank to identify remaining weaknesses and design action plan to resolve them, including legislative proposals for foreclosure of collateral and loan recovery.End-June 2012
28. Following IMF assessment of the AML/CFT regime in 2011 and presentation to and adoption by the Asia Pacific Group, the central bank will devise and begin implementing an action plan with a timeframe (involving relevant authorities), to address the findings and recommendations of the assessment.End-September 2012
29. The central bank will prepare and distribute guidance and training materials to financial institutions along with a schedule of on-site training for 2011/2012, with a view to ensuring that key money laundering and terrorist finance risk and lessons learned from Kabul Bank are properly reflected in those materials.End-March 2012
30. Establish a government-led National Steering Committee (NSC) to coordinate, supervise and direct financial reporting and auditing reforms. The NSC will develop an action plan (including short, medium and long-term measures) to develop accounting and auditing capacity in Afghanistan in line with the recommendations of the 2009 ROSC.End-May 2012

24. Resolution of Kabul Bank. We are proceeding to resolve Kabul Bank to lower fiscal costs and protect the banking system. The bank has been put under receivership and its license has been revoked. Shareholders’ rights, including ownership rights, have been extinguished. Moreover, shareholders that have been found not fit and proper according to the banking law and central bank regulations will be banned from future ownership of any bank in Afghanistan. The bad assets of Kabul Bank (along with the US$825 million LoLR liability) remain with the receiver, which, with the help of an asset management specialist, will continue to effectively pursue their recovery domestically and internationally through all available legal, regulatory, and administrative means, in accordance with Afghan law and relevant international treaties. A bridge bank was established by transferring to it Kabul Bank’s remaining deposit liabilities of US$633 million, remaining good assets of about US$208 million (consisting of physical assets and the remainder from the first LoLR loan) as well as US$425 million of new financing (funded by a second LoLR loan of that amount extended to Kabul Bank before its receivership). The bridge bank, New Kabul Bank, will be put up for sale by June 2012. The sale will be conducted in a fully transparent manner, and only “fit and proper” qualified applicants will be considered. If the sale does not materialize, the bank will be downsized and merged into other financial institutions or liquidated by March 2013. A share of salary and other payment services will be migrated to other banks to allow government employees a choice of bank starting in 2012. In case privatization fails, the migration would be accelerated in line with the objective of merging or liquidating the bank by March 2013. The receiver and New Kabul Bank will produce monthly reports including management accounts to allow the ministry of finance and the supervisor to monitor their financial performance.

25. Financing of Kabul Bank’s insolvency. To compensate the central bank for the costs of resolving Kabul Bank, the ministry of finance issued a zero-coupon government bond with net present value of Af 37.6 billion (equivalent to US$825 million), taking over DAB’s lender of last resort claim on Kabul Bank. The bond has an 8-year maturity and a quarterly increasing amortization schedule. It will yield a regular flow of payments to the central bank and allow the government to honor this obligation with fiscal resources. The characteristics of this zero-coupon bond are equivalent to a financial instrument with a two percent yield. The first amortization installment will be paid immediately after the financing has been approved by parliament. In addition, over time, the amounts recovered from Kabul Bank’s impaired assets will be paid to the central bank and reduce the outstanding amount of the bond. Request for payment of the first year’s installment of US$73 million through the national budget was initially rejected by parliament because parliamentarians wanted to better understand the issue. After a period of engaging with parliament, a bill was resubmitted to parliament for a payment of US$51 million, with the remaining US$22 million having been transferred to the central bank from the receiver out of asset recoveries. The bill was approved by parliament on October 15, 2011, and the government made the payment on October 24, 2011.

26. Moral hazard. Governance problems and fraud are the causes of Kabul Bank’s failure. The government is investigating and will prosecute any criminal acts related to the bank’s failure and will pursue maximum asset recovery using all appropriate legal and regulatory mechanisms. To this end, we have implemented a strategy for prosecution of crimes committed at Kabul Bank and a prosecutorial team has been formed in the Attorney General’s Office, equipped with the necessary mandate, expertise and resources. Evidence of wrongdoing at Kabul Bank has been and continues to be referred to law enforcement authorities according to the Afghan law. Lastly, in order to promote stability in the financial sector, in cooperation with development partners, we will prepare by March 2012 a roadmap with a medium-term strategy to build capacity and strengthen the institutional framework to deal promptly and effectively with economic crime.

27. Asset Recovery. An audit is expected to be completed by end-March 2012 to establish the financial liabilities of the shareholders and provide the basis maximum asset recovery (below); the auditor has requested some additional time compared to our earlier understandings because the analysis of the group loans is taking longer than expected. We received the interim report for Kabul Bank on September 20, 2011 and shared it subsequently with IMF staff. The interim report for Azizi Bank is expected for November and will also be shared with staff. As criminal investigations into Kabul Bank have commenced, the legal system will be used to facilitate asset recovery domestically and internationally, including through the use of relevant international treaties and mutual legal assistance provisions. To date, asset recovery efforts resulted in US$75 million recovered in cash—including from performing loans, under legally binding agreements with cooperating shareholders and related parties, and outside such agreements—along with physical assets available for sale valued at about US$153 million, and we are working to make further progress on asset recovery in the coming weeks. We have also initiated legal proceedings, including in the field of asset recovery, where appropriate and where shareholders were not cooperating. We have requested training in asset recovery and are tasking an audit firm currently working in Kabul to advise on how to make asset recovery more effective, both domestically and internationally.

28. Transparency and accountability. DAB issued a written public statement explaining the events leading to the collapse of Kabul Bank, the action taken, and the envisaged resolution strategy; the statement was posted on DAB’s website (http://www.centralbank.gov.af/) in May 2011. In addition, to draw on the lessons from the collapse of Kabul Bank, the ministry of finance and DAB have referred the case to the independent Monitoring and Evaluation Committee (which was set up as part of the Kabul Process) to conduct an in-depth public inquiry. This inquiry will examine the events leading to the Kabul Bank crisis, starting with the inception of the bank, and look into the operations of the bank, activities of its shareholders, the role of supervisory and auditing bodies, and the subsequent effectiveness of the government and the criminal justice system in dealing with any crimes committed. The final report will be published by September 2012.

29. Identifying vulnerabilities. We have started audits by internationally reputable audit firms of all banks in the system with a CAMEL (Capital, Asset Quality, Management, Profitability, and Liquidity) rating of 3 or worse, beginning with systemically important banks. The terms of reference for the audits of Kabul Bank and Azizi Bank have been agreed with the IMF. For Kabul Bank, the aim is to document accounting irregularities and possible crimes, such as fraud and money laundering—the results will also serve to support prosecution and asset recovery. For Azizi Bank, the audit is expected to identify potential problem areas and help develop additional corrective measures if needed—ultimately contributing to strengthening banking supervision. We are committed to having the audits finalized by end-March 2012.

30. Banking supervision. To improve banking soundness, the central bank is stepping up monitoring of banks and enforcing previous supervisory orders. Our approach to strengthening supervision began with a detailed “lessons learned from Kabul Bank” operational strategy to strengthen supervision. In addition, the central bank established an interdepartmental committee to review compliance with regulations by banks and issued supervisory orders to all banks with weak CAMEL ratings regarding corrective actions previously recommended. The committee is responsible for monitoring enforcement orders and imposing sanctions for noncompliance (e.g., fines, suspension of profit distribution, restriction on bank branching or lending, conservatorship, and bankruptcy), and monitoring enforcement orders and supervisory measures, including on AML/CFT recommendations. We are also working to improve capacity for off-site supervision that has been lagging. We also seek to restore the capacity and effectiveness of the banking supervision department that have been weakened, including because some staff moved to the receiver.

31. Regulatory framework. We have reinforced the governance framework for banks. The central bank has published a circular clarifying the criteria that banks’ shareholders and managers must meet in order to be “fit and proper.” In addition, we have fully enforced a circular meant to prevent conflict of interests and governance issues that arise when shareholders hold management positions.

32. Legal framework. We intend to improve governance in the banking system by strengthening the banking law and encouraging consolidation through higher capital requirements. We will finalize a replacement or amendments to the banking law by end-March 2012 with a view to strengthening provisions on corporate governance, capital, large exposures, related parties, consolidated supervision, early intervention, enforcement, and bank resolution.6 We will submit the law or the amendments to parliament by September 2012. We have already started reviewing the existing central bank regulation in light of these changes to speed up their implementation once they become law. To strengthen the banking system’s capacity to absorb losses and encourage consolidation of small banks, we have doubled the minimum capital requirement to US$20 million and the central bank will request a recapitalization plan for the banks that have not been able to increase their capital to the new ratio by September 2012 while encouraging them to consider merging with another bank. In addition, a moratorium on increasing the number of banking licenses is in place.

33. AML/CFT. Cognizant of the threat that corruption, drug trafficking, and the financing of terrorism poses to our financial system and our security, we will strengthen our AML/CFT regime by implementing an action plan based on the recommendations of the February 2011 assessment. To this end we will submit to parliament amendments to our AML/CFT legislation as necessary, strengthen the capacity of the financial intelligence unit (FinTRACA), publish its annual report, implement (by enforcement where there is electricity and security and by encouragement in areas where there is not) the reporting arrangements for money service providers (MSPs) via dedicated software. This year we have strengthened our AML/CFT regime by increasing the intensity of the training FinTRACA gives to financial sector compliance officers, we have completed the registration of roughly 80 percent of the MSPs outside of Helmand and Kandahar, we have encouraged the use of dedicated reporting software for all MSPs, and we have issued terms of references for AML/CFT interagency coordinating bodies (at the working and high level).7

C. Fiscal Policy and Governance

34. Going forward, our objectives in the fiscal area are to achieve sustained increases in revenue collection, a gradual takeover of externally-financed operating spending, and an expenditure allocation consistent with ANDS priorities in line with improvements in public expenditure management, fiscal policy formulation, and accountability in public enterprises. To this end, the program envisages actions to broaden the tax base, deepen tax and customs reforms, strengthen budget processes, program budgeting, and the Medium-Term Fiscal Framework, and increase transparency, governance and efficiency in public enterprises (Table 2).

Table 2.Islamic Republic of Afghanistan: Fiscal Measures
MeasureTiming
1. Tax Policy
VAT
a) Finalize a VAT implementation plan;End-December 2011
b) Submit VAT legislation to Ministry of Justice’s Taqnin;End-December 2011
c) Submit VAT legislation to Parliament following Cabinet approval;End- December 2012
d) Begin implementation of VAT.End-March 2014
Mining
a) Review the consistency of mining and tax laws;End-November 2011
b) Develop MoF’s capacity for medium-term projections of mining-related revenue;End-March 2012
c) Ensure a transparent mechanism for licensing, contracting, and collecting taxes, royalties, and fees;End-March 2012
d) Prepare a medium- to long-term strategy to restructure and corporatize public enterprises in the mining sector.End-March 2012
2. Tax and Customs Administration
Resourcing
Specialized units will be created at ARD and ACD to enhance their capacity to use budgets strategically and consistently with reform plans. These units will report directly to the Director General of Revenue and the Director General of Customs and will be in charge of budgeting, procurement, personnel planning, and monitoring budget execution.End-March 2012
Implement SIGTAS in the LTOCompleted
Establish pilot of a Border Management Model at Hairatan Border Crossing Point (BCP), based on a ‘two-agency’ approach which restricts border presence to the Afghan Border Police (ABP) and the Afghan Customs Department (ACD). Under this model, the ABP will continue to fulfill immigration and security responsibilities, with ACD fulfilling all other commercial and trade-related duties.Completed
Border Management Model to be rolled out to at least two additional Border Crossing Points—three if the security situation permits.End-March 2012
Improve post-clearance audits by improving the unit resources and introducing risk management.End-March 2012
Finalize (End-September 2011) and approve (End-December 2011) the new organizational structure of ACD along best international practices in consultation with IMF staff.End-December 2011
Introduce risk management to cargo verification.End-June 2012
3. Budget and Treasury Departments—PFM Roadmap
Program budgeting
Prepare a single common program-based budget presentation integrating the operating and development budgets across all budgetary units. For Budget Statement purposes, submit to the Cabinet and Parliament a program-based presentation, along with the traditional line-budget basis presentation until such time as appropriations are done on a program basis (not to happen until, at least, 1392).Completed
MoF develops and implements a communication strategy consistent with commitments under the PFM roadmap.Implementation underway.
Conduct a full review before a decision is made to transition to program based appropriations, which is unlikely before the 1392 Budget at the earliest.End-September 2012
FPU
Start developing a tax policy capacity at the FPU in line with IMF staff recommendations.End-December 2011
Enhance the MTFF and other budget documents by:
a. Analyzing explicitly the medium-term security related operating spending, including various assumptions, to assess the impact on the resource envelope available for non-security spending;End-December 2011
b. Including robust extractive industry revenue projections;End-March 2012
c. Updating projections of existing and new major fiscal pressures;Ongoing
d. Costing fiscal pressures of new reforms.Ongoing
Budget execution and fiscal reporting
Enhance AFMIS functionality to meet the requirement for commitment control of all commitments approved by the Special Procurement Committee based on allotments issued.Completed
Prepare financial plans for the Ministries of Interior and Defense taking into account their procurement plans. Annual allotments with monthly breakdown based on these financial plans will be issued on a pilot basis for operating budget expenditures for the rest of the year. Based on a successful implementation for these two ministries, we intend to extend this pilot to as many ministries as possible during the next fiscal year, 2012/13.End-November 2011
Issue 2001 GFSM-based biannual reports on the financial operations of the general government, including extra-budgetary agencies, and estimated disbursements by donors through the External Budget (based on information provided by donors). For municipalities, the reports will be annual. The reports will be quarterly for the centre after a year and remain biannual for the remainder.TBD
4. Audit
Internal audit
The Internal Audit Department of the Ministry of Finance will perform internal audits in accordance with Article 61 of the PFEM law and strengthen the internal audit departments in four line ministries (Ministry of Public Health, MoTCA, MRRD, and Ministry of Energy and Water) by reviewing their institutional arrangements, methodologies, procedures and staff capacity.Completed
The Internal Audit Department of the Ministry of Finance will perform internal audits in accordance with Article 61 of the PFEM law and strengthen the internal audit departments in an extra ten line ministries.End-March 2012
The Internal Audit Department of the Ministry of Finance will perform internal audits in accordance with Article 61 of the PFEM law and strengthen the internal audit departments in all remaining line ministries.End-March 2013
External audit
Submit to parliament the new audit law.Completed

35. We will take further steps to move toward fiscal sustainability. Fiscal sustainability will depend on sustained increases in revenues together with prioritized spending reflecting development and security priorities. The program envisages an increase in domestic revenues of 0.6 percent of GDP in the next three years. Looking beyond the program period, the planned introduction of a VAT in March 2014 is expected to raise an additional 2 percent of GDP, and we are aiming for a revenue-to-GDP ratio of about 16 percent of GDP by 2017/18.

36. Expenditures. On the spending side, the baseline scenario projects an increase in the size of security forces (national army and police) from 275,000 in March 2011 to a planned maximum of 400,000 by April 2014. In 2011/12, wages will increase by 1.4 percent of GDP, of which security accounts for 1 percent of GDP.8 We plan to continue reforms in education, the civil service and other ANDS priorities. Other spending pressures, emanating from the security transition and the gradual takeover of operations and maintenance of capital projects, will lead to an increase of 0.8 percent of GDP in nonsecurity spending as a share of GDP. Development spending is projected to increase by 0.3 percent of GDP. Given the agreement with donors to gradually phase out ARTF grants to the operating budget by US$25 million per year, we will increase the domestic financing of the operating budget accordingly. The large increase in security spending in nominal terms means that the share of operating spending financed by domestic revenues is expected to first increase and then fall in the third year.

37. Tax administration. Our goal is to further increase the efficiency and equity of tax collection. To this end, we intend to implement additional measures to strengthen the medium and large taxpayers’ offices (MTOs and LTOs) including the consistent application of these offices’ selection criteria. In addition, the Standard Integrated Government Tax Administration System was implemented in July in the LTO, allowing for automated collection systems. Lastly, specialized units will be created in the Revenue and Customs departments to use budgets strategically and in a manner consistent with reform plans. These units will report directly to the Directors of Revenue and Customs and will be in charge of budgeting, procurement, personnel planning, and monitoring budget execution.

38. Customs administration. In September we started implementing a new business model of border control at the Hairatan customs post in line with best practice. The new model envisages only two agencies at the border (Afghan Customs Department and Afghan Border Police), streamlining the number of agencies involved to improve collections and reduce opportunities for corruption. We will roll out this new business model to two additional border posts March 2012—three if the security situation permits. In addition, we will move forward with post-clearance audits and set up risk management approaches to cargo verification by June 2012. These two reforms will limit interaction between taxpayers and customs officials thus facilitating trade, improving efficiency, and reducing opportunities for corruption.

39. Tax policy. We will initiate a major tax policy reform centered on the introduction of a VAT by March 2014, with the aim of broadening the tax base significantly and achieving our long-term goal of raising revenue-to-GDP ratio to levels comparable with similar countries. We will move forward with the VAT legislation by preparing an implementation plan with support by IMF staff, sending a draft law to the Ministry of Justice (“Taqnin”) for review by end-December 2011, and submitting the law for parliamentary approval by end-December 2012. Lastly, we will set up an effective and transparent fiscal regime for mining, and seek full compliance with the Extractive Industries Transparencies Initiative (EITI) by September 2012.9

40. Public financial management. We plan to strengthen our public financial management systems with a view to ensuring that (i) policies reflect social needs; (ii) the budget is used to assign responsibilities for development outcomes, (iii) resources are allocated in an efficient manner; and (iv) officials are accountable and services are delivered with a focus on helping the poor. In this connection, donors signaled their willingness to increase the share of development aid delivered through the budget over the next few years, including through multi-donor trust funds. For our part, we will implement the Public Financial Management Road Map with priority reforms in budget preparation, budget execution, and transparency and accountability.

41. Budget presentation and execution. We will improve the capacity and involvement of provincial authorities in budget planning and project implementation, reduce procurement delays by ensuring that key line ministries adhere to the revised legal framework, and incorporate financial and nonfinancial performance targets in budget submissions. We will also improve financial planning and reporting, including reports on the financial operations of the general government (extra-budgetary agencies, municipalities, and estimated disbursements by donors through the “external” budget).

42. Transparency and accountability. To increase the transparency and accountability of public spending, we will continue to implement Article 61 of the Public Finance Expenditure Management Law. The Internal Audit Department of the Ministry of Finance performed audits on four key line ministries in the past year. We will audit 10 additional line ministries in 2011/12. External audits will be enhanced by strengthening the independence of the Control and Audit Office under a new audit law which was submitted to parliament on May 10, 2011.

43. Governance. To improve governance and strengthen anti-corruption measures, we have established an Anti-Corruption Unit in the Attorney General’s Office and the Anti-Corruption Court within the Supreme Court, enhancing our ability to investigate and prosecute corruption-related offenses. We also adopted a detailed “strategy and policy for anti-corruption and administrative reform,” and have ratified the United Nations Convention against Corruption in August 2008. In July 2008, the President issued a Decree establishing a High Office for Oversight and Anti-Corruption (HOO) as the highest office for the coordination and monitoring of the implementation of Afghanistan’s anti-corruption strategy and for the implementation of administrative procedural reform in the country. Despite delays including some beyond government control, an independent Monitoring and Evaluation Committee was inaugurated on May 11, 2011.

44. Program budgeting. We will continue the program budgeting reform by creating a simple results framework directly linked to line ministries’ performance indicators, as defined in the ministries’ budget submissions. This will allow linking public spending to intended results and increasing the efficiency and effectiveness of spending (particularly propoor spending). Furthermore, we have introduced in the 2011/12 budget a common presentation of the operating and development budgets across all budgetary units. Parliamentary appropriations on a program basis will take place in subsequent years after sufficient progress is achieved. During this year, we will also develop and implement a communication strategy to explain this reform to key stakeholders.

45. Medium-Term Fiscal Framework. We have been strengthening our medium-term fiscal framework by preparing short- and medium-term policy trade-offs and financing constraints to make it a more effective tool for fiscal policy formulation. Going forward, we plan to (i) improve revenue projections through sensitivity analysis and plausible macroeconomic assumptions; (ii) incorporate line ministries’ estimates of future spending; and (iii) improve the analysis of security spending. Ultimately, our objective is to move toward a medium-term budget framework including projections of spending by line ministries in line with the priorities of a multi-year framework.

46. Public enterprises. We are taking steps to strengthen the financial oversight of public enterprises to contain fiscal risks, reduce opportunities for corruption, and foster reforms; and will seek donor assistance to build capacity. We are ensuring the implementation of the restructuring and business plans of the four large public enterprises. Specific actions include finalizing HR reforms at Ariana by June2012, ensuring a continued reduction of subsidies for DABS, and developing a timebound plan by June 2012 for the reform and rationalization of FLGE into a commercial entity—including an asset inventory and audited financial statements—that does not require any subsidies or special treatment, and discontinue its current monopoly and unauthorized collection of fees. Finally, we will strengthen capacity at the Department of State-Owned Enterprises and, by end March 2012, submit to the Ministry of Justice changes to the legal framework governing public enterprises that will bring such entities under ownership and effective control of the Ministry of Finance.

D. Program Modalities and Monitoring

47. We will continue monitoring our reform agenda through our Technical Coordination Committee (TCC). The first year of the new three-year economic program to be supported by the ECF arrangement will be monitored through quantitative performance criteria for March and September 2012, indicative targets for December 2011 and June 2012; as well as selected structural benchmarks. The first and second reviews of the program could be completed in May 31, 2012 and November 30, 2012, respectively. The central bank will work with IMF staff to ensure timely completion of the update safeguards assessment and is committed to implementing its recommendations thereafter. Quantitative targets and structural measures are specified in Tables 45 and defined as needed in the attached Technical Memorandum of Understanding (TMU).

Table 4.Islamic Republic of Afghanistan: Quantitative Targets, 2011-13 1(on a cumulative basis from the beginning of the respective fiscal year, unless otherwise indicated)
Mar. 20, 2011 StocksFY 2011/12FY 2012/13
June 21, 2011Sep. 22, 2011Dec. 21, 2011 IndicativeMar. 19, 2012 PerformanceJune 20, 2012 IndicativeSep. 21, 2012 PerformanceDec. 20, 2012Mar. 20, 2013
ActualActualtargetscriteriatargetscriteriaProjectionProjection
(In billions of Afghanis)
Floor on revenues of the central government22.246.771.698.823.850.478.2109.0
Indicative target (ceiling) on currency in circulation132.41.311.316.623.61.512.718.326.2
Ceiling on net central bank credit to the central government-48.929.325.017.824.8-9.5-4.4-11.21.9
Indicative target (ceiling) on the operating budget deficit of the government, excluding grants0.512.033.852.610.129.244.771.3
Indicative target (floor) on social and other priority spending4.59.013.518.04.89.714.519.4
Ceiling on reserve money151.015.416.715.028.4-4.06.515.730.6
(In millions of U.S. dollars)
Floor on net international reserves of DAB5,017450514572630117234351468
Ceiling on contracting or guaranteeing new medium- and long-term nonconcessional external debt by the public sector 20.00.00.00.00.00.00.00.0
Ceiling on short-term external debt owed or guaranteed by the public sector 20.00.00.00.00.00.00.00.0
New external payments arrears, excluding interest on preexisting arrears 20.00.00.00.00.00.00.00.0
Ceiling on lending from state-owned banks or the central bank to public enterprises in need of restructuring or government guaranteeing borrowing by these enterprises 20.00.00.00.00.00.00.00.0
Memorandum items:(In billions of Afghanis)
Operating budget balance of the government, including grants17.119.318.413.45.14.89.83.6
Reference projections for the adjustors
Core budget development spending5.316.733.553.44.223.941.764.1
External financing of the core budget and sale or transfers of nonfinancial assets21.143.685.4115.322.855.794.7129.8
Asset recovery from banking sector institutions in liquidation0.00.91.83.50.91.92.83.7
Recapitalization, profit distribution and revaluation of MoF securities at DAB0.00.00.00.00.00.00.00.0
Externally financed expenditures transferred to the core operating budget0.00.00.00.00.00.00.00.0
Source: Afghan authorities

The performance criteria and indicative targets under the program, and their adjustors, are defined in the Technical Memorandum of Understanding.

These targets apply on a continuous basis.

Source: Afghan authorities

The performance criteria and indicative targets under the program, and their adjustors, are defined in the Technical Memorandum of Understanding.

These targets apply on a continuous basis.

Table 5.Islamic Republic of Afghanistan: Prior Actions and Structural Benchmarks
Prior ActionsStatus
Kabul Bank will be put under receivership and its banking license revoked. All shareholder ownership and related rights and interests will be extinguished. The receiver will split assets and liabilities into a good bank (bridge bank) and the remaining Kabul Bank estate.Done in April 2011
Finalize an 18-month business plan for the bridge bank.Done in April 2011
Issue detailed public statement about the events leading to the collapse of Kabul Bank and the actions taken and to be taken to deal with the crisis.Done in April 2011
Finalize legally binding agreements with cooperating Kabul Bank shareholders for the repayment of the full amounts attributed to them as of date. Agreements should identify collaterals, including real estate title deeds or physical assets—and cash repayments.As of October 30th, we estimate the assets sought for recovery at US$935 million, including US$80 million in regular loans to parties other than the shareholders and related parties. Legally binding agreements for US$270 million have been signed so far with cooperating shareholders and related parties, pledging collateral of US$232 million. Under these legally binding agreements, US$36 million in cash has been collected. In addition, US$153 million in ceded assets are available for sale by the receiver. Including the regular loans, payment plans and ceded assets indicate a recovery of US$483 million is possible—US$350 million from legally binding agreements and performing loans plus assets ceded to the receiver not covered by the legally binding agreements. Of this, total cash receipts since August 31, 2010 amount to US$75 million taking together payments under the legally binding agreements, payments made outside an agreement framework and from the performing loans. The Government acknowledges that complexity of the fraud has slowed recovery effort; however, based on improved cooperation by bank executives and the work of the forensic auditors, it is confident that legally binding agreements for additional recoveries will be reached. In parallel, formal charges have been brought against 2 shareholders representing over 50 percent of assets sought for recovery and 7 officers of the bank. Negotiations over additional legally binding agreements are ongoing.
Ministry of Finance to issue 8-year bond to capitalize the central bank to cover the cost of Kabul Bank’s resolution ($825 million) and obtain parliamentary approval for a budget appropriation to service the bond.Done. An US$825 million promissory note was issued on April 10, 2011, and Parliament approved the budget appropriation for FY2011/12 on October 15, 2011.
Formulate and announce strategy to enforce Afghan laws in relation to any financial crimes committed at Kabul Bank. The strategy will include steps and a timetable as well as documentation on the roles, powers, qualifications, and independence of the prosecution team.Authorities have shared draft strategy with staff.
Complete inception report for audits of Kabul Bank and Azizi Bank.Done. Report for Kabul Bank completed in July 2011, for Azizi Bank—in September 2011.
The central bank will issue an enforcement letter for Azizi Bank (in consultation with Fund staff) based on a recent on-site examination listing key actions to be undertaken, a timetable, and penalties and sanctions for non-compliance.Done in August 2011.
The central bank will issue supervisory orders to selected banks with timetables for compliance and sanctions for failure to comply with key corrective actions previously recommended.Done in September 2011.
The central bank will enforce in full conflict-of-interest regulations and circulars in the banking sector by removing shareholders from serving as Chairman and CEO of the bank they own.Done as of October 31, 2011.
Structural Benchmarks for the First ReviewRationaleStatus/Comments
In consultations with Fund staff, the Ministry of Finance and the central bank will agree, in a memorandum of understanding, on the central bank’s capitalization needs and a schedule for recapitalizing the central bank as needed.Financial sector stability, central bank independence and ability to conduct monetary policyEnd-December 2011
Submit VAT law—consistent with IMF advice—aimed at raising the revenue to GDP ratio to the Ministry of Justice (“Taqnin”) for review with a view to submitting it to parliament by end-December 2012.Support fiscal sustainabilityEnd-December 2011
Submit to the Ministry of Justice (“Taqnin”) legislation bringing public enterprises under effective monitoring and oversight of the Ministry of Finance.Support fiscal sustainability and macroeconomic stability by enhancing controls and reducing fiscal risksEnd- March 2012
Roll out to at least two additional Border Crossing Points the new Border Management Model piloted at Hairatan Border Crossing Point. The model is based on a ‘two-agency’ approach which restricts border presence to the Afghan Border Police and the Afghan Customs Department. Under this model, the ABP will continue to fulfill immigration and security responsibilities, with ACD fulfilling all other commercial and trade-related duties.Improve efficiency and lower corruptionEnd-March 2012
Reduce number of branches at bridge bank (New Kabul Bank) by 20 according to the updated business plan.Minimize fiscal costsEnd-March 2012
In line with our desire to protect the financial system from abuse, the government will produce a roadmap with a strategy to build capacity and improve the institutional framework to respond promptly to economic crime. This roadmap will address issues related to the prosecution system to reinforce its independence to ensure accountability for economic crimes and build capacity for investigation and prosecution of these crimes as well as determine the most appropriate institutional framework going forwardFinancial sector stability and integrity, reduce moral hazardEnd-March 2012
Structural Benchmarks for the Second ReviewRationaleStatus/Comments
The bridge bank (New Kabul Bank) will be offered for sale in a transparent way, involving a pre-qualification process to ensure that controlling shareholders, beneficial owners, directors and management of intending bidders are fit and proper (which implies, inter alia, that an intending bidder is subject to a high standard of corporate governance, including risk management and internal controls, and that an intending bidder is in a sound financial and risk management state), and that the intending bidder controls adequate resources and has the necessary capacity and capability to ensure the ongoing provision of the relevant salary payments services. There will be a request for expressions of interest locally and internationally for the sale of the bridge bank. Interested parties will be given four weeks to respond with intention to participate in the bid. Once the central bank has vetted potential buyers, it will give them a deadline for sealed bids.Advance Kabul Bank resolutionEnd-June 2012
The independent Monitoring and Evaluation Commission will conduct an in-depth public inquiry to examine the events leading to the Kabul Bank crisis, starting with the inception of the bank, and look into the operations of the bank, activities of its shareholders, the role of supervisory and auditing bodies, and the subsequent effectiveness of the government and the criminal justice system in dealing with any crimes committed.Strengthen financial sector stability, transparencyEnd-September 2012
Submit to Parliament the amended or new banking law, prepared in consultation with the Fund that will strengthen provisions on corporate governance, capital, large exposures, related parties, consolidated supervision, early intervention, enforcement, and bank resolution, where appropriate in line with the Basel Core Principles. Specifically, the law should enable us to enforce upon a bank - going concern - all necessary resolution measures and strengthen corporate governance requirements for banks (including fit and proper requirements as set by the FATF standards).Promote financial sector stability by strengthening independence of bank regulators, reducing risks from bank lending, and ensuring swift processes for bank resolutionEnd-September 2012
Strengthen our AML/CFT regime by implementing an action plan based on the recommendations of the February 2011 assessment by: (i) submitting amendments to the AML/CFT law to parliament as necessary; (ii) increasing the capacity of FinTRACA, including by hiring additional staff as needed; (iii) expanding MSP registration and implementation of reporting to MSPs in areas currently inaccessible for security reasons if and when the security situation allows; and (iv) enforcing MSP reporting by dedicated software in all reporting areas where it is technically and logistically feasible..Promote financial sector stability and integrity and strengthen AML/CFT frameworkEnd-September 2012
Submit legislation to Parliament for the introduction of marketable debt instruments by the Ministry of Finance.Develop financial marketsEnd-September 2012

48. During the program period, we will not impose or intensify restrictions on the making of payments and transfers for current international transactions, or introduce or modify multiple currency practices, or conclude bilateral payments agreements inconsistent with Article VIII, or impose or intensify restrictions for balance of payments purposes.

Attachment II. Technical Memorandum of Understanding

1. This memorandum reflects understandings between the Afghan authorities and Fund staff in relation to the monitoring of the ECF-supported program during 2011—12. It specifies valuation for monitoring quantitative targets under the program (Section I), quantitative performance criteria and indicative targets (Section II), adjustors (Section III), and data reporting (Section IV).

I. Program Exchange Rates and Gold Valuation

2. Program exchange rates are used for formulating and monitoring quantitative targets. All foreign assets and liabilities denominated in U.S. dollars will be converted into Afghanis at a program exchange rate of 45.3740 Afghanis per U.S. dollar, which corresponds to the cash rate of March 20, 2011. Gold holdings will be valued at US$1,418.90 per troy ounce, the price as of March 20, 2011. Assets and liabilities denominated in SDRs and in foreign currencies other than the U.S. dollar will be converted into U.S. dollars at their respective exchange rates of March 20, 2011, as reported in the following table.

Exchange RateProgram Rate
U.S. dollars / Canadian dollar1.016000
U.S. dollars / U.A.E. dirham0.272300
U.S. dollars / Egyptian pound0.168600
U.S. dollars / euro1.418200
U.S. dollars / Hong Kong dollar0.128200
U.S. dollars / Indian rupee0.022160
U.S. dollars / Pakistani rupee0.011715
U.S. dollars / Polish zloty0.348800
U.S. dollars / Iranian rial0.000097
U.S. dollars / Saudi Arabian riyal0.266600
U.S. dollars / Russian ruble0.035180
U.S. dollars / Swiss franc1.109800
U.S. dollars / pounds sterling1.623400
U.S. dollars / SDR1.585700

II. Quantitative Performance Criteria and Indicative Targets

3. The quantitative performance criteria for March and September 2012 specified in Table 4 of the MEFP are:

  • Floors on revenue of the central government and net international reserves (NIR); and
  • Ceilings on reserve money; net central bank credit to the central government (NCG); contracting and/or guaranteeing new medium- and long-term nonconcessional external debt by the public sector, (continuous); short-term external debt owed or guaranteed by the public sector (continuous); accumulation of external payment arrears, excluding interest on preexisting arrears (continuous); lending from stateowned banks or the central bank to, or government guaranteed borrowing by, public enterprises in need of restructuring (continuous).

4. The above variables also constitute indicative targets for December 2011 and June 2012. In addition, the program includes the following indicative targets for the four above-mentioned dates:

  • Ceilings on currency in circulation and on the operating budget deficit of the central government excluding grants; and
  • Floor on social and other priority spending.

5. The central government consists of the Office of the President, the ministries and other state administrations and governmental agencies, including the Attorney General’s Office; the National Assembly; and the judiciary, including the Supreme Court.

6. Reserve money is defined as currency in circulation plus Afghani-denominated commercial bank deposits at the central bank, including balances maintained by the commercial banks in the DAB’s overnight facility.

7. Currency in circulation is defined as total currency issued by the DAB. It excludes currency held in the presidential palace vault, in the DAB main vault, and in the vaults of all provincial and district branches of the DAB.

8. Net central bank credit to the government is defined as the difference between the central bank’s claims on the government and government deposits at the DAB. These deposits exclude deposits held at the DAB’s branches because of the unavailability of reliable and timely data from the DAB’s branches.

9. Net international reserves (NIR) are defined as reserve assets minus reserve liabilities of the DAB, both of which are expressed in U.S. dollars.

  • Reserve assets of the DAB, as defined in the fifth edition of the Balance of Payments Manual (BPM5), are claims on nonresidents denominated in foreign convertible currencies controlled by DAB, and are readily and unconditionally available for DAB to meet balance of payments financing needs, intervention in exchange markets, and other purposes. They include DAB holdings of monetary gold, SDRs, Afghanistan’s reserve position in the IMF, foreign currency cash (including foreign exchange banknotes in the vaults of the DAB, but excluding cash held in the DAB’s branches), and deposits abroad (including balances on accounts maintained with overseas correspondent banks). Excluded from reserve assets are any assets that are pledged, collateralized, or otherwise encumbered; claims on residents; precious metals other than monetary gold; assets in nonconvertible currencies; illiquid assets; and claims on foreign exchange arising from derivatives in foreign currencies vis-à-vis domestic currency (such as futures, forwards, swaps, and options).
  • Reserve liabilities are defined as short-term (original maturity) foreign exchange liabilities of DAB to nonresidents (held at DAB headquarters); all credit outstanding from the IMF; foreign currency reserves of commercial banks held at DAB headquarters; commitments to sell foreign exchange arising from derivatives (such as futures, forwards, swaps, and options); and all arrears on principal or interest payments to commercial banks, suppliers, or official export credit agencies.

10. Revenues of the central government are defined in line with the Government Financial Statistics Manual (GFSM 2001) but on a cash accounting basis, excluding grants. Revenue is an increase in net worth of the central government (including its units in the provinces and agencies) resulting from a transaction.

  • Revenues of the central government include taxes and other compulsory transfers imposed by central government units, property income derived from the ownership of assets, sales of goods and services, social contributions, interest, fines, penalties and forfeits and voluntary transfers received from nongovernment other than grants. The definition for program monitoring excludes grants and other noncompulsory contributions received from foreign governments and international organizations; such transfers between central government units would be eliminated in the consolidation of the fiscal reports and not recorded as revenue. Receipts collected by central government on behalf of noncentral government units should not be counted as revenue (e.g., Red Crescent fees). Receipts from the sale of nonfinancial assets, such as privatization, and transactions in financial assets and liabilities, such as borrowing but excepting interest payments, are also excluded from the definition of revenue.
  • Revenues should be recognized on a cash basis and flows should be recorded when cash is received. The official Afghanistan Government Financial Management Information System (AFMIS) reports will be used as the basis for program monitoring. Exceptional advanced payments will be treated as if received on the normal due date. All revenue must be supported by the relevant documentation and revenue receivables, where a cash sum has been recorded but the revenue item has not yet been accounted for, and revenues payable, where the revenue has been reported but the cash has yet to be recorded should be separately reported on a gross basis.

11. Social and other priority spending is defined as the sum of pro-poor spending identified in accordance with the ANDS poverty profile by the Ministry of Education, Ministry of Public Health, and Ministry of Labor, Social Affairs, Martyrs, and Disabled within the central government’s operating budget for a particular fiscal year.

12. For program purposes, the definition of external debt is set out in Executive Board Decision No. 12274, as revised on August 31, 2009 (Decision No. 14416-(09/91)).

(a) The term “debt” will be understood to mean a current (i.e., not contingent) liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows:

  • (i) loans (i.e., advances of money) to the obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans and buyers’ credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements);
  • (ii) suppliers’ credits (i.e., contracts where the supplier permits the obligor to defer payments until sometime after the date on which the goods are delivered or services are provided); and
  • (iii) leases (i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property), while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.

(b) Under the definition of debt set out in paragraph 12 (a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt.

13. Long term and medium term external debt. A ceiling applies to the contracting and guaranteeing by the public sector of new nonconcessional borrowing debt with nonresidents with original maturities of one year or more. The ceiling applies to debt and commitments contracted or guaranteed for which value has not yet been received. This applies to private debt for which official guarantees have been extended and which, therefore, constitute a contingent liability of the public sector. Excluded from the limits are refinancing credits and rescheduling operations, credits extended by the IMF, and credits on concessional terms as defined below. Consistent with the Public Finance and Expenditure Management (PFEM) Law, the MOF should have sole responsibility for the contracting and guaranteeing of external debt on behalf of the government.

  • The definition of “government” includes the central government (including government departments), as well as official agencies that do not seek profit and whose budgets are issued independent of the annual operational or development budgets. The public sector comprises the government as defined above, the DAB, and nonfinancial public enterprises. Public enterprises are defined below in paragraph 16.
  • For program purposes, the guarantee of a debt arises from any explicit legal obligation of the public sector to service a debt in the event of nonpayment by the debtor (involving payments in cash or in kind), or from any implicit legal or contractual obligation of the public sector to finance partially or in full any a shortfall incurred by the debtor.
  • For program purposes, a debt is concessional if it includes a grant element of at least 60 percent, calculated as follows: the grant element of a debt is the difference between the present value (PV) of debt and its nominal value, expressed as a percentage of the nominal value of the debt. The PV of debt at the time of its contracting is calculated by discounting the future stream of payments of debt service due on this debt.1 The discount rates used for this purpose are the currency specific commercial interest reference rates (CIRRs), published by the Organization for Economic Cooperation and Development (OECD). For debt with a maturity of at least 15 years, the ten-year-average CIRR will be used to calculate the PV of debt and, hence, its grant element. For debt with a maturity of less than 15 years, the six-month average CIRR will be used. To both the ten-year and six-month averages, the same margins for differing repayment periods as those used by the OECD need to be added (0.75 percent for repayment periods of less than 15 years, 1 percent for 15 to 19 years, 1.15 percent for 20 to 29 years, and 1.25 percent for 30 years or more).

14. The zero ceiling on short-term external debt applies on a continuous basis to the stock of short-term external debt owed or guaranteed by the public sector (as defined in paragraph 13 of this memorandum), with an original maturity of up to and including one year.

  • It applies to debt as defined in paragraph 12 of this memorandum.
  • Excluded from the limit are rescheduling operations (including the deferral of interest on commercial debt) and normal import-related credits.
  • Debt falling within the limit shall be valued in US dollars at the exchange rate prevailing at the time the contract or guarantee becomes effective.

15. A continuous performance criterion applies to the nonaccumulation of new external payments arrears on external debt contracted or guaranteed by the central government or the DAB. External payment arrears consist of external debt service obligations (principal and interest) falling due after March 20, 2011 and that have not been paid at the time they are due, as specified in the contractual agreements. Excluded from the prohibition on the accumulation of new arrears are (i) arrears arising from interest on the stock of arrears outstanding as of March 20, 2011 and (ii) external arrears that are subject to debt rescheduling agreements or negotiations.

16. Lending to, or guaranteeing borrowing by, public enterprises. The zero ceiling on new lending from state-owned banks or the central bank to, or government guaranteed domestic borrowing by public enterprises in need of restructuring applies on a continuous basis.

  • For the purposes of this performance criterion (i) “state-owned banks” refers to those banks that are wholly or majority owned by the government (as defined in paragraph 13 of this memorandum), including Bank Millie, Bank Pashtany and New Kabul Bank; (ii) “public enterprises in need of restructuring” refers to enterprises that meet either of the following: (a) public enterprises that have not had an audited balance sheet in the past two fiscal years, (b) public enterprises that have been identified by the Ministry of Finance for liquidation, or (c) public enterprises that do not have cabinet-approved restructuring plans; and (iii) “public enterprises” refers to enterprises wholly or majority owned by the government, including those covered by the State-Owned Enterprise (Tassady) Law, and all state-owned corporations and any other public entities and government agencies engaged in commercial activities but not covered by the Tassady Law.
  • It applies to any new loans (or financial contributions) extended directly from the central bank or state-owned banks to public enterprises in need of restructuring, and also to any explicit government guarantees for borrowing undertaken by these public enterprises (including loan agreements and guarantees for which value has not been received).

17. Operating budget deficit of the central government excluding grants is defined as revenues of the central government minus operating budget expenditure recorded in AFMIS.

III. Adjustors

18. The floor on NIR and the ceiling on the NCG are consistent with the assumption that core budget development spending will amount, on a cumulative basis from March 20, 2011, to:

December 21, 2011Af 33.5 billion
March 19, 2012Af 53.4 billion
June 20, 2012Af 4.2 billion
September 21, 2012Af 23.9 billion

Should core budget development spending exceed these projections, the NIR floor will be adjusted downward and the NCG ceiling will be adjusted upward by the difference between the actual level (up to the appropriated amount) and the projected level of development spending.

19. The NIR floor and NCG ceiling are defined consistent with the assumption that the external financing of the core budget and receipts from the sale or transfer of nonfinancial assets will amount, on a cumulative basis from March 20, 2011, to:

December 21, 2011Af 85.4 billion
March 19, 2012Af 115.3 billion
June 20, 2012Af 22.8 billion
September 21, 2012Af 55.7 billion

Should external financing of the core budget (including that associated with off-budgetary spending coming on budget) and the receipts from the sale or transfer of nonfinancial assets collectively exceed (fall short of) these projections, the NIR floor will be adjusted upward (downward) and the NCG ceiling will be adjusted downward (upward) by the difference between their actual level and the projected level. The overall downward adjustment to the NIR floor will be capped at $500 million and the overall upward adjustment to the NCG ceiling will be capped at Af 25 billion.

20. The NIR floor and NCG ceiling are defined consistent with the assumption that the asset recovery from banking sector institutions in liquidation applied towards MoF assets or liabilities at DAB will amount, on a cumulative basis from March 20, 2011, to:

December 21, 2011Af 1.8 billion
March 19, 2012Af 3.5 billion
June 20, 2012Af 0.9 billion
September 21, 2012Af 1.9 billion

Should such asset recovery exceed (fall short of) these projections, the NIR floor will be adjusted upward (downward) and the NCG ceiling will be adjusted downward (upward) by the difference between the actual recovery and its projected level.

21. Should DAB be recapitalized by the MoF, the NCG ceiling will be adjusted upward by the amount of this recapitalization.

22. Should MoF receive profit distribution from DAB, the NCG ceiling will be adjusted downward by the amount of this profit distribution.

23. Should some expenditure currently financed directly by donors outside the budget be moved on to the operating budget, the NIR floor will be adjusted downward, and the NCG ceiling and the indicative targets (ceilings) for the operating budget deficits of the central government, excluding grants, will be adjusted upward, by the actual amount of these expenditures on the conditions that (i) the moving on budget of these expenditures is justified by a statement from donors indicating their decision to stop financing them outside the budget and (ii) they are subject to a supplementary appropriation approved by parliament. The overall downward adjustment to the NIR floors will be capped at $300 million.

IV. Provision of Information to the Fund

24. To facilitate monitoring of program implementation, the government of Afghanistan will provide the Fund through the office of the Resident Representative of the IMF in Afghanistan, the information specified below and summarized in the list of reporting tables provided to the Technical Coordination Committee.

25. Actual outcomes will be provided with the frequencies and lags indicated below.

  • DAB net international reserves: weekly, no later than two weeks after the end of each week.
  • Monetary statistics, including exchange rates, government accounts with the DAB, currency in circulation, reserve money, and a monetary survey: monthly and no later than three weeks after the end of the month. The monetary survey will include the balance sheet of the DAB and a consolidated balance sheet of the commercial banking sector.
  • Core budget operations and their financing: monthly and no later than four weeks after the end of the month. The official reports for program monitoring will be the monthly financial statements from the Afghanistan Financial Management Information System. The structure of financing (grants and loans should be separately identified) and expenditure data should be on a consistent cash basis. Core operating expenditures should be reported on a monthly basis using the budget appropriation economic (object) and administrative classification in addition to the program and functional classification as reported in the budget documents. Core development expenditures should also be reported separately on a monthly basis using the budget program classification in addition to the economic (object), administrative and functional classification consistent with the operating budget. All the data should also compare outturns against the approved budget. Core operating and development revenues and expenditures should also be reported by province, separately on the same monthly basis.
  • External budget operations and their financing (i.e., donor funded spending outside the core budget treasury systems): semiannually (more frequently if possible) and no later than eight weeks after the end of the period. External development expenditures should be reported on a disbursement basis (as currently defined in budget documents) using the budget program classification (and an administrative, functional and provincial classification where possible).
  • External debt data: quarterly and no later than six weeks after the end of the quarter. These will include: (i) details of new loans contracted or guaranteed during the quarter, including the terms of each new loan; (ii) the stock of debt at the end the quarter, including short-term debt, and medium- and long-term debt; (iii) loan disbursements and debt service payments (interest and amortization) during the quarter; (iv) debt relief received during the quarter; (v) information on all overdue payments on short-term debt, and on medium- and long-term debt, including new external arrears (if any); and (vi) total outstanding amount of arrears.
  • National accounts data: annually and no later than eight weeks after the end of the year. Merchandise trade data should be reported quarterly and no later than eight weeks after the end of the quarter.
  • Monthly consumer price indexes (CPIs) for Kabul and other major cities (“national” CPI) with a lag of four weeks after the end of each month.
  • Four-monthly and with a three-month lag, financial flows and other key variables of the state electricity company (DABS), aggregated as well as disaggregated by regional hubs, for the preceding 12 months and (in the last four-monthly period of the year) a forecast for the following fiscal year. The report will use the template agreed with Fund staff, with all lines filled in, but excluding the disaggregation of loses into technical and nontechnical for regions outside Kabul, which is expected by March 20, 2013.
  • Financial Stability Indicators for each commercial bank: quarterly and with a one-month lag after the end of each quarter. These indicators will include banks’ prudential ratios, capital adequacy ratio, liquidity ratio, portfolio quality indicators (e.g., nonperforming loans, provisions as percentage of classified loans), concentration ratio, related loan ratio, information on open foreign exchange positions, large loan and deposits statistics and other relevant information.
  • Lending to public enterprises from each commercial bank: quarterly with a one-month lag after the end of each quarter share a report on the following balance sheet items and operations for each bank: (i) aggregate value of outstanding loans to all public enterprises; (ii) disaggregated value of outstanding loans by public enterprise for each bank’s top 10 borrowers; (iii) indicators of the quality of these loans. For this reporting requirement, public enterprises refer to those defined in point (iii) in the first bullet of paragraph 16.
  • Monthly activity and cost reports from the Kabul Bank receiver, including the status and financial details of asset recovery.
  • Monthly progress reports, interim reports, and final reports by the auditor conducting the forensic audits of Kabul Bank and Azizi Bank.
  • Monthly detailed balance sheet and income statement for the bridge bank (with a two weeks lag) as well as quarterly reports on bridge bank’s progress against its business and financial plans (staffing, branches, etc.)
  • Quarterly, details on the amortization payments for the promissory note issued by the Ministry of Finance to recapitalize the central bank.
  • Monthly details of the discretionary cash balances held in the Ministry’s Afghani and U.S. dollar treasury single accounts (TSA), and the discretionary development 27232 account. In addition, an update of the monthly summary report of funds under operating budget, summaries of expenditure for both the operating budget and discretionary development budgets, and the updated cash projections for the current and following fiscal years.

26. The Technical Coordination Committee (TCC) will send to the IMF reports by the end of each quarter documenting progress in implementing structural benchmarks under the program. These reports will include appropriate documentation and explain any deviations relative to the initial reform timetable, specifying expected revised completion date. Other details on major economic and social measures taken by the government that are expected to have an impact on program sequencing (such as changes in legislation, regulations, or any other pertinent document) will be sent in a timely manner to IMF staff for consultation or information.

Appendix II. Estimating the Impact of Military Transition and Transformation

Economic development over the medium term will depend on the impact of the envisaged draw-down of large-scale foreign military (transition) and civilian engagement with Afghanistan (transformation), beginning in 2012 and expected to be largely finalized by 2014.1 The baseline scenario for macroeconomic projections optimistically assumes that security will stabilize throughout the phase of the military withdrawal, and that civilian foreign assistance will be phased out gradually over the long term.2 Alternative scenarios explore possible outcomes if these optimistic assumptions, while clearly desirable, are not met.

Framework for transition and transformation

1. The impact of foreign withdrawal from Afghanistan will reverse the economic effects of large-scale military and civilian foreign presence over the past decade. The presence added to aggregate demand; provided budget resources and took over directly certain spending; supported the exchange rate and, potentially lowered competitiveness; provided civilian employment; and the affected sector-specific allocation of resources. The economics of withdrawal of foreign entities are determined in good measure by the local content of their expenditure and procurement and their employment of local staff.

2. The reduction in foreign presence affects the Afghan economy through the following transmission channels:3

  • Income effects would come from lower aggregate demand are a function of lower local expenditure of foreign civilian organizations and staff; the associated decline in local procurement; and lower numbers of local employees of foreign civilian organizations.
  • The fiscal impact will mainly result from higher on-budget security spending from the transfer of Afghan National Security Forces (ANSF) expenditures to the operating budget under the Law and Order Trust Fund Afghanistan (LOTFA) and the NATO Training Mission - Afghanistan (NTM-A), higher on-budget operations and maintenance spending, and lower revenues reflecting the adverse impact on growth. With external development spending being reduced, there will be increasing pressure to finance development spending through the budget. In addition, expenditure for operations, equipment, and maintenance are likely to be substantially higher as projects are brought on budget as part of the transformation.
  • The external sector will be affected by a possible reduction or reversal of the terms-of-trade effects of foreign presence “Dutch disease;” and trade balance effects resulting from lower imports by foreign civilian missions.
  • Labor market effects could include higher unemployment, due to lay-offs of local staff by foreign civilian organizations; lower employment in sectors closely linked to the presence of foreign entities; and, as a result, downward pressure on local wages.

Baseline Scenario

3. Real GDP growth declines over the long term and stabilizes at around 4 percent per annum, periodically peaking as a result of the mining sector production cycle (Figure 1). The expected withdrawal of foreign troops would contribute 2—3 percentage points to the decline in overall growth. The baseline scenario assumes that foreign military presence will be reduced from currently 139,000 troops to 68,000 by October 2012, and a minimal presence by 2014. In parallel, the ANSF will grow from about 304,000 at present4 to 400,000 by end-2014 under current government projections.5 In 2011, total appropriation by ISAF is estimated at US$160 billion, out of which the United States accounts for US$118 billion. With an assumed local content of this ISAF expenditure of 1.7 percent, the withdrawal would reduce GDP by 2½ percent per year over the period 2012—14. Sectors most likely to be affected include construction, wholesale and retail trade, and transport and storage.

Figure 1.Afghanistan: Alternative Growth Scenarios

Source: IMF staff simulations

4. The withdrawal raises fiscal pressures and pushes back fiscal sustainability—defined as domestic revenues covering total operating expenditures—to 2024/25. The fiscal impact of transition and transformation will mainly come from increasing pressure to take over externally-financed operating expenditures (security and nonsecurity); decreasing grants to the development budget; and a continuing decline in the external budget with certain expenditures being brought on-budget. As the fragility of the country’s economy is likely to be most acute during this phase, the baseline scenario (Table 2) assumes a stable donor presence over the period of the program. However, by 2020, a reduction in donor grants to the budget by about 50 percent (to 27 percent of central government expenditure) is envisaged. Shifts in budgetary allocations to national security could have negative implications for social indicators, due to more limited poverty reduction-related expenditure.

5. An improvement in basic security could generate a “peace dividend” for economic activity. With improved security, activity across sectors should benefit, foreign direct investment (including in telecommunications) could increase, and there is a possibility that tourism picks up. Moreover, a “brain gain” for the local economy (both private and public sectors) could result from the reversal of the “brain drain” seen over the past decade. These domestic factors could be complemented by external developments, despite the decline in exports to nonresidents entailed by transition and transformation. Over the longer term, exports could get a boost from enhancing regional trade, including through the development of regional transportation links. Government imports will continue to be aligned with import-related fiscal expenditures, reflecting the decline in these aggregates.

Alternative Scenarios

6. Two alternative scenarios illustrate the sensitivity of the baseline scenario to its main assumptions. The sequential transition and transformation periods represent two phases in Afghanistan’s future economic development that can be shocked. The first alternative scenario examines the sensitivity of the framework to a lower growth outlook, with the negative impact of transition/transformation on growth being larger than assumed in the baseline. The second alternative scenario evaluates the economy’s prospects under more rapid donor grant withdrawal than during the transformation phase.

7. In a “lower growth” scenario, transition and transformation could have a more negative effect on growth than assumed in the baseline. Given the limited information on local content and multipliers, there is considerable uncertainty about the impact of transition and transformation on growth. The “lower growth” scenario traces the macroeconomic effects of transition and transformation, reducing growth by an additional 4—5 percentage points compared to the baseline. This would lead to lower fiscal revenues which would reduce the government’s resource envelope, putting crucial security and development spending at risk, potentially leading to further adverse growth effects. In response to this, donors are assumed to increase grants to the development budget in subsequent years.

8. In a “faster donor withdrawal” scenario, a swifter donor exit in the transformation period compromises development spending and ultimately growth. In this case, grants to the external and development budgets decrease at a faster rate than in the baseline, while the handover of security expenditures remains the same. The assumption is that donors maintain the funding of national security forces while divesting resources in the broader economy. Part of this process of withdrawal involves moving large operations and maintenance expenditures onto the budget. This leads to rapidly rising fiscal deficits, reflecting spiraling expenditures and lagging revenue efforts due to a loss of donor support for vital reforms. Pressures will mount rapidly as the government will be forced to choose between its security and various development priorities.

9. In both alternative scenarios, the government can create some fiscal space through borrowing, but this is unlikely to provide a full offset. Once the government has introduced domestic securities (sukuks), it can tap the domestic banks for financing, though the cumulative scope is limited even under a regime of financial repression. Access to external borrowing is also likely to be limited, though it is not constrained for the sake of exposition in the alternative scenarios. As the debt sustainability analysis shows, Afghanistan is at high risk of debt distress, and should restrict any borrowing to highly concessional financing for specific projects with a clearly identified economic return.6 There will also be risks to the monetary outlook should pressure be applied to the central bank to monetize government deficit (“fiscal dominance”).

10. Lastly, a scenario in which security deteriorates rapidly could have devastating economic consequences, but this is not modeled here. A destabilization in security represents the worst possible equilibrium for Afghanistan. Adequate and effective levels of security spending are a necessary condition for maintaining stability and potentially generating improvements which would spillover to economic development.

An Upside Scenario: “Transition Dividend”

11. Donors can provide additional stimulus to the Afghan economy by moving support on budget. Donors could transfer part of the funds spent on maintaining their contributions to the ISAF military architecture to development within Afghanistan. A number of donors are also considering channeling a larger share of their support through the budget even as the overall grant envelope declines. Taken together, a “transition dividend” could be generated leading to higher growth. According to case studies, the local content of donor spending is in the range of 20—25 percent, while the local content of on-budget development spending is 30—35 percent. Thus, by moving a share of the external budget (both security and development)—currently about 30 percent of GDP—on budget, donors would provide an extra stimulus to the local economy. For example, shifting 5 percent of GDP in grants on budget would boost GDP growth by ½ of a percentage point or more, depending on the size of the multiplier. Such a shift may imply a somewhat lower quality of the built capital stock. At the same time, operating and maintaining a more indigenous capital stock would be more affordable in light of the government’s limited resources.

Appendix III. Fiscal Survival and Fiscal Sustainability

This annex discusses alternative fiscal scenarios as the government takes over donor financed activities and certain recurrent costs of donor financed investments. In the near term, fiscal survival is likely to become the key operating principle as the government takes over spending currently financed by donors and balances this with development spending needs while exploring options of how to generate additional fiscal space. Indeed, the need to take over donor-financed spending is likely to push back fiscal sustainability—defined as domestic revenues covering total operating expenditures—to 2024/25.

1. Afghanistan remains heavily reliant on donor grants within multiple budget streams (Figure 1). As of 2010/11, the central government’s operating budget is 49 percent grant-financed, and the development budget is 59 percent grant-financed. This is in addition to a large donor-funded external budget estimated at 30 percent of GDP in 2010/11. Domestic revenues at present pay for only 52 percent of central government expenditures.

Figure 1.Afghanistan: Sources and Uses of Funds

1This category covers spending on education, health and all other nonsecurity sectors across government.

2Development expenditures include significant non capital security spending, e.g. private protection companies.

3 Estimated local spending content (‘cash impact’) of external budget. 100 percent donor-financed.

2. The government faces a tough balancing act as international engagement gradually declines to more normal levels. Over the next five years and beyond, fiscal policy needs to find ways to balance the takeover of externally-financed security spending and other expenditures, while increasing propoor and development outlays within a tight budget constraint.1 In this context, the concept of fiscal sustainability is reduced to one of fiscal survival in the short term as the limited availability of government resources will dictate the capacity to absorb operating expenditures, while continuing to fund necessary development priorities.

3. Revenue effort is the backbone of fiscal survival. The government has achieved impressive improvements in revenue collections in the space of five years (a quadrupling in absolute terms between 2005/06 and 2010/11). Realizing further gains depends heavily on the speed and determination with which the fiscal reform agenda is implemented as well as exogenous political and economic developments, e.g., border disputes with neighbors. Two key future sources of revenues include the introduction of a Value Added Tax (VAT) and the opening of the Aynak and Hajigak mines, both of which are projected to generate additional revenues by 2014/15. The VAT, in particular, is estimated to boost revenue effort by close to 2 percent of GDP at inception, while the mining sector will eventually add an additional 1 percent of GDP per year to revenues once the mines become fully operational.

4. The speed and extent of the transition process is the key determinant of the need to finance security spending from budget resources. At present, security-related grants are assumed to peak in 2013/14 in absolute terms, but peak as a percentage of total security expenditures in the current fiscal year. Given the overarching importance of maintaining and improving security, the government will have to dedicate significant resources in this area. The exact trajectory of support from the international community, including via grants from the NATO Training Missions - Afghanistan (NTM-A) and the Law and Order Trust Fund Afghanistan (LOTFA), will—in the short run—determine how much fiscal space the government has for other spending priorities.

5. Given the expected security spending needs, the government believes that it will have to contain nonsecurity expenditure growth to 10 percent per annum over the three years of the program. As a result, nonsecurity wages (in critical propoor areas such as education and health) are set to decline as a percentage of GDP from 4.6 percent in 2011/12 to 4.3 percent in 2013/14. Though clearly undesirable, whether this is a feasible trajectory depends partly on the interplay between pay and grade reforms (covering also pensions) and the rate of recruitment in to the civil service (“Tashkeel”).2

6. Growing operations and maintenance (O&M) costs constitute another source of spending pressures. As donor-financed development projects are surrendered to the Afghan government, the tight resource envelope means that the government will have to evaluate the viability of the existing capital stock (e.g., roads, schools, hospitals, bridges, etc.) put in place by donors.3

7. Taken together, these developments suggest that fiscal sustainability can be achieved only by 2024/25 in the baseline scenario. Grants to the central government budget are projected to peak in percent of GDP in FY2012/13, and decline thereafter, together with an ongoing gradual decline in the external budget.4 The government is assumed to take over some minimal O&M, but many donor projects would be allowed to depreciate.5 The baseline assumes that the significant O&M costs from the security sector will continue to be borne by donors. There is insufficient information to quantify these security-related O&M costs which cover a number of categories, including vehicle and equipment maintenance, training, utilities for military bases, fuel costs, etc. ISAF continues to evaluate the overall cost of operations that would need to be transferred to the government. Recent estimates have seen downward revisions from US$7 billion to US$3.5 billion.

8. Alternative scenarios are modeled to gauge the sensitivity of these projections to key assumptions. First, the decline in donor grants to both the development and external budgets is accelerated. The resulting profile for O&M is plotted in Figure 2. O&M costs are seen to decline faster (as the number of projects that generate O&M expenses declines). As can be seen, in each case fiscal sustainability is delayed from 2024/25 to beyond the long-term horizon.

Figure 2.Afghanistan: Operations and Maintenance Costs under Baseline and Alternative Scenario with Rapid Decline in Donor Grants

(In percent of GDP)

Source: Fund staff estimates.

9. In the case of declining grants, it is possible that development expenditures could also decline as donor funds dry up and the government is unable to take them over. The result would be a premature halt in infrastructure investment. On the other hand, should development spending be maintained and increasingly financed by the government as donors withdraw, government borrowing would increase beyond levels needed to cover O&M as well as any existing government overhang from the operating budget. This could trigger a potentially dangerous debt dynamic (see the accompanying debt sustainability analysis).

10. In a second scenario, the rate of depreciation of capital is raised to reflect the fact that donor-financed projects, which are further away from the central government budget, are less likely to be maintained. Figure 3 shows again how operating expenditures increase significantly, delaying fiscal sustainability to beyond 2030/31.

Figure 3.Afghanistan: Operations and Maintenance Costs under Alternative Baselines with 5 Percent, 10 Percent, and 20 Percent Depreciation

(In percent of GDP)

Source: Fund staff estimates.

11. Fiscal survival translates into the government ensuring that their revenue and spending paths are consistent with a predictable, and ideally gradual, reduction of grants to both the central government and external budgets. However, as the medium-term strategy for transition and transformation remains unclear, the overall nature of the donor footprint remains unpredictable.6 As the simulations show, even conservative estimates for O&M costs from the nonsecurity sector alone will require difficult decisions from the government dictated by the constraints of fiscal survival.

BOX 1.Estimating Operations and Maintenance Costs

The potential impact of taking on budget O&M related to donor projects is modeled based on assumptions about the accumulation of a public sector capital stock.1 The trajectory of capital accumulation over time depends on assumptions about grants and the central government and external budgets.

Investment in year t, It, can be viewed as a function of the capital expenditure components of the operating, development and external budgets as follows:

where OBKt is the capital expenditure component (code 25) of the operating budget for year t; DBt, is development spending in year t (covering spending on all ANDS priorities), and EBt captures the external budget in year t. θ1 and θ2 are parameters which determine the proportion of the development and external budgets which goes toward building the public capital stock. The reason for assuming only a fraction is that it is very likely that these budgets include several noncapital expenditures, in particular related to the provision of security for donor projects. In addition, donor-financed spending is typically priced at international prices rather than Afghan price levels, such that actual costs are inflated. Ministries have also been known to use the development budget for some elements of current spending, while other unwanted costs could include wages and salaries of consultants hired to oversee projects. Therefore it is necessary to make adjustments to strip out these recurrent costs.

Investment then feeds in to a standard dynamic capital accumulation equation:

Where δ captures the rate of depreciation of the capital stock, in this case the donor projects established in Afghanistan. The final step of the estimation involves an assumption as to the proportion, γt, of these capital outlays each year that needs to be financed in order to keep them running (operations and maintenance costs):

The parameters δ and γt capture assumptions about the rate at which the capital stock will erode and those assets which are actually needed by the country respectively. In the case of depreciation, the further away projects are from the oversight and control of the Afghan budget, i.e., the less ‘ownership’ by the government, the higher the rate of depreciation that can be assumed. For example, maintenance on projects executed under the external budget are more likely to be neglected, compared to those undertaken at the discretion of the government. The proportion of capital expenditure that actually accounts for O&M is related to the needs of the country. The higher the variable, γt, the higher the perceived need for the existing project. However, there are question marks over whether donor-determined needs for Afghanistan, and those determined by the authorities will always coincide.

1 The framework used was developed by Steven Symansky under projects financed by FS Share/USAID, the US Treasury, and Adam Smith International/DFID.
1“Public” spending is carried out by the central government “on-budget” (also known as “core budget”) and by donors “off-budget.” In this report, the off-budget spending by donors is referred to as the “external budget” or “external development budget.” Due to data limitations, the size of the external development budget can only be estimated with staff taking a conservative approach that aims to take out the share of donor spending that does not affect the local economy. Figure 1 of Annex II illustrates the relative importance of the central government budget and the external budget and their financing sources.
2The fiscal year follows the solar calendar and runs March 21-March 20, most of the years.
3See Figures 1 through 5 and Tables 1 through 7.
4The cash recoveries of US$75 million have been used as follows: US$41 million was collected during the conservatorship and used to pay depositors and operating expenses. US$22 million was transferred to the central bank as part of this year’s amortization payment for the promissory note issued by the ministry of finance to the central bank for the cost of the Kabul Bank crisis. US$5 million paid for expenses of the receivership, and the remainder is being held at the central bank in reserve.
5The next Annual Progress Report will be circulated to the IMF’s Executive Board by the time of the second review of the ECF.
6Current projections of security costs assume that the Afghan National Security Forces will grow to 400,000 personnel by 2014/15 as envisaged by ISAF, but discussions about the necessary troop levels are ongoing and the final ceiling could be as low as 352,000 which would be more manageable in terms of recurrent costs.
7A simple back-of-the-envelope calculation suggests that the Afghani is overvalued by 20 percent or more in real effective terms. This is calculated as the real effective exchange rate depreciation necessary to bring about the external adjustment that would offset the assumed decline in donor support, net of grant-related imports, in the baseline scenario.
8Customs collections over the first six months in 2011/12 grew at only 15 percent compared to the same period in 2010/11, slower than total revenue growth.
9These three ministries were chosen as their operating budgets have the highest impact on poverty reduction and strong links to ANDS priorities. The remaining ministries being targeted have propoor spending components primarily within their development budgets, which are harder to monitor and verify.
10Cash shortfalls would manifest most acutely intra-year, as monthly balances could come close to zero due to seasonality in spending and revenues.
11The relatively low level of obligations suggests that Afghanistan should not have trouble in servicing its debt to the Fund.
12The authorities consider switching from the current solar fiscal year (March 20-March 19) to a calendar fiscal year starting in 2013. Once that decision is finalized, program monitoring and phasing will be adjusted accordingly.
1In addition, we had the largest positive increase in Public Expenditure and Financial Accountability (PEFA) scores of any country with two assessments. We remain committed to increases in budget transparency. Although still low in absolute terms, we had a 160 percent increase in our Open Budget Index score from 8 to 21 percent and have committed to at least 30 percent in the next review.
2At Ariana, the ministry of finance-appointed implementation team has installed a new chief financial officer, the amendments of the charter of the company is in process, and an advisor was recruited to work on maintenance, safety, and quality assurance. In the past year, DABS has improved revenue collection and introduced a procurement manual and new human resources’ procedures. Afghan Telecom has been expanding its capacity. As for FLGE, the company no longer enjoys an effective monopoly on fuel storage.
3A 100 percent debt forgiveness agreement with the United States in the amount of US$109 million came into effect in September 2010, and we signed a final debt forgiveness agreement with Germany in the amount of US$17 million in January 2011. Saudi Arabia, Iraq, and Croatia also provided 100 percent debt relief. We are still discussing debt restructuring and relief with Non-Paris Club creditors, namely Bulgaria, Iran, Kuwait and OPEC.
4The cluster process is not a new strategy for development nor does it substitute the budget process. It is a way to better prioritize activities for the purposes of budget planning, with an emphasis on improving governance, job creation and the delivery of public services.
5Separately, we also estimate that around 45 percent of the development budget is propoor spending, but this will not be yet included in the program because of uncertain execution rates.
6Corporate governance and consolidated supervision amendments are intended to address weaknesses that leave the banking sector vulnerable, including risks from mismanagement and bad accounting. Amendments related to the enforcement of supervision orders are being put forward to increase the efficacy of bank supervision and legal implementation, while amendments regarding problem bank resolution are designed to limit the costs to the government and damage to the financial sector in the event of bank failure.
7The financial intelligence unit of the central bank will also continue training counterpart institutions in AML/CFT regime implementation, including the filing of suspicious transaction reports.
8Security forces will increase by 60,000 in 2011/12
9Afghanistan became an EITI candidate country in February 2010. In addition to the four sign-up criteria that were met to achieve EITI candidate status, the Afghanistan EITI (AEITI) Multi-Stakeholders Group and National Secretariat have been established to run and oversee EITI implementation. Currently AEITI stakeholders are undertaking EITI training and capacity building activities.
1The calculation of concessionality will take into account all aspects of the loan agreement, including maturity, grace period, payment schedule, upfront commissions, and management fees.
1Following authorization by UN Security Council Resolution 1386 on December 20th, 2001, the International Security Assistance Force (ISAF) has been operating in Afghanistan for almost 10 years.
2According to the “Declaration by the Heads of State and Government of the Nations contributing to the UN-mandated NATO-led International ISAF at the 2010 Lisbon Summit, “ISAF and the Government of Afghanistan are entering into a new phase of our joint effort, which allows us to help set the conditions for irreversible transition to full Afghan security responsibility and leadership … by the end of 2014.”
3Due to data constraints, the analysis does not take into account possible macroeconomic effects of more limited technical assistance on capacity building in public administration and the associated path for structural reforms.
4As of mid-October, 2011: consisting of 169,000 members of Afghanistan National Army, and 135,000 members of Afghanistan National Police and the Afghan Air Force. (Source: NTM-A)
5However, the Joint Coordination and Monitoring Board recently capped the final force size to 352,000. This number is under discussion with the government.
6In all scenarios, the interest rate on domestic borrowing is held constant at 5 percent throughout whole period.
1Due to the magnitude of on- and off-budget contributions, the government would only take over a fraction of total externally-financed spending. This is likely to comprise ongoing support to existing projects alongside new priority spending.
2There are significant costs in the pipeline in the nonsecurity sector. Apart from the structurally important pay and grade reforms, there are the potentially large replacement costs of the “second civil service”—the absorption onto the government payroll of those civil servants paid for by donors (e.g., UNDP, World Bank, etc.) at wages many multiples higher than the standard Tashkeel salaries. This would be on top of existing pressures from the natural and targeted recruitment rates for the civil service, particularly in the health and education sectors.
3Projects have been undertaken across Afghanistan by both military and civilian assistance teams. In the case of the former, ISAF’s Provincial Reconstruction Teams and Commanders’ Emergency Response Programs have invested significant resources in the local communities by providing a mixture of assets. These projects are designed to generate ‘goodwill’ but can sometimes produce assets which the provincial communities are unable to maintain.
4The latter assumption encapsulates the continued impetus to move certain expenditures onto the central government budget, while the former captures the government’s growing requirement to finance domestic expenditures on its own terms, be it revenues or additional borrowing.
5O&M costs eventually decline as a proportion of GDP as development expenditures fall and capital accumulation declines. In this way, O&M is “self-limiting” in the long run.
6Donor support is typically uncertain, as plans are established on an annual basis and depend on national appropriations processes, in consultation with the Afghan government. However, the economic and political uncertainty surrounding transition has lowered predictability of the donor stance to an even greater extent.

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