On behalf of our Afghan authorities, we thank management and staff for their unrelenting efforts to bring this program to the Board, which will pave the way for Afghanistan to make further progress in implementing its stabilization and structural reform strategy with the needed support from the international community. Staff dedication and hard work have been instrumental in helping the authorities deal with the difficulties caused by the near collapse of Kabul Bank and the critical need to strengthen the financial system. The authorities have now taken key measures to address the Kabul Bank crisis, identify and address the remaining risks to the financial system, and are determined to vigorously pursue Afghanistan’s stabilization and development objectives, even though the anticipated withdrawal of foreign troops and decline in grants will make their task more challenging.
Building on the achievements in recent years, the authorities have developed a medium-term program for which they have requested Fund support under a successor Extended Credit Facility (ECF) arrangement. The reform agenda will seek to strengthen the foundations of growth and poverty reduction in line with the objectives set out in the Afghanistan National Development Strategy (ANDS), while preparing to manage the impact of reduced international presence in Afghanistan. Implementation of all prior actions, despite the many hurdles involved, attests to the authorities’ determination in this regard.
Afghanistan has made important progress toward achieving its development and poverty reduction objectives. The economy has been growing by 10 percent on average since 2006/07, with non-agriculture sectors exhibiting strong performance; per-capita GDP has doubled since 2005/06; inflation declined significantly during the past two years, although it has picked up in 2010/11 in part due to higher international food and fuel prices; and some key poverty indicators have improved: child mortality has decreased, and school enrollment has increased, in particular for females. These achievements, which are detailed in the staff report and the Memorandum of Economic and Financial Policies (MEFP), must be seen against the difficult and deteriorating security situation and the volatile global and regional environment. This progress notwithstanding, further reducing poverty which is unacceptably high, while achieving security and ensuring macroeconomic stability and fiscal sustainability in an environment conducive to private sector-led growth, remains central to the authorities’ program.
Fiscal performance improved in 2010/11, including from continued progress in revenue mobilization and public financial management (¶ 7.MEFP). Building on the tax measures and administrative reforms introduced earlier, domestic revenue increased by 3.2 percent of GDP since 2008/09, and has remained buoyant, as evidenced by the 25 percent increase in revenue collection during the first half of 2011/12. Tight control on non-security spending has been maintained, thereby keeping the lid on the operating budget deficit despite implementation of necessary pay and grading reforms and hiring of new teachers. However, while spending on security has increased, development spending has been on a downward trend since 2008/09, reflecting difficulty with some donors in reallocating funding, the deteriorating security situation, and under-execution mainly related to capacity constraints in line ministries.
The impact of the Kabul Bank crisis on financial sector development has been contained. The staff report covers how the Kabul Bank crisis unfolded and rightly points to the rapid growth in banking services in an environment of nascent regulation and supervision as a key contributing factor (Boxes 3 and 4). Recognizing the risks to the stability of the financial system, the authorities moved decisively on several fronts to contain a run on Kabul Bank and prevent a run on other banks by guaranteeing bank deposits and putting Kabul Bank into conservatorship. Subsequently, the authorities placed Kabul Bank into receivership, which resulted in the revocation of all shareholders’ rights and the extinction of their interests in the bank. The major shareholders were removed from management of this and other banks. In addition, a comprehensive forensic audit of Kabul Bank by an independent, internationally recognized firm commenced in June 2011.
Despite the magnitude of the crisis, critical banking transactions were never disrupted. Payment of government wages and salaries in particular continued without interruption. While the immediate aftermath of the crisis saw a withdrawal of funds from the banking system as a whole, much of it has been reversed. The central bank extended a lender-of-last resort facility to repay Kabul Bank depositors, which was subsequently made up through recapitalization of the central bank by the government. Further progress is underway in resolving the crisis by splitting Kabul Bank into a good bank (the New Kabul Bank) and a bad bank, as highlighted in Box 3, accelerating the recovery of assets, and preparing the New Kabul Bank for privatization.
The medium-term outlook hinges on a wide range of factors and risks. Steadfast implementation of reforms, together with improved security and regional stability and cooperation, would support investment and growth, including in the promising mining sector. Conversely, the withdrawal of international presence in Afghanistan and a possible decline in donor support are likely to curb growth and adversely affect macroeconomic stability, as highlighted in the staff scenarios (Appendix II). While it is difficult to know at this stage how these factors will play out, the authorities are firmly determined to act on the factors that are under their control, namely continue to increase domestic revenue, to implement their strategy under the ANDS and the proposed program supported by the ECF arrangement, while seeking to manage the downside risks. They look forward to the forthcoming Bonn Conference in December 2011, which is expected to establish the economic parameters for Afghanistan’s transition.
Following debt relief under the HIPC initiative and MDRI, the updated DSA concludes that while debt burden indicators will improve over the near term, the risk of external debt distress remains high, potentially stemming from financing with loans instead of grants, and the withdrawal of large-scale foreign presence and increased domestically-financed security expenditures that would reduce available resources for investment and growth. The authorities agree with these findings and will rely primarily on grants to finance development spending while increasing the share of domestic resources in the financing of operating budget expenditure. They will also sustain their broad-based reform agenda, as envisaged under the ANDS.
The economic program for 2011/12-2013/14
Growth and poverty reduction
The program aims at anchoring growth and poverty reduction objectives in macroeconomic stability while strengthening the financial system and better preparing the transition to the withdrawal of foreign presence in Afghanistan. The economy is expected to grow at about 6-7 percent in 2011/12, underpinned by an expansion in the non-agricultural sector and mining investment. High priority will continue to be given to pro-poor spending, which is expected to account for 25 percent of non-security operating spending in 2011/12.
The program aims at further strengthening domestic revenue collection, aligning expenditure with the ANDS priorities, gradually integrating externally-financed operating expenditure in the national budget, and further improving fiscal management, accountability, and good governance. A broad range of fiscal measures aimed at moving toward fiscal sustainability are planned. Domestic revenue is to increase by 0.6 percent of GDP over the program period, underpinned by sustained efforts to improve tax administration and ongoing implementation of a business model of border customs control that would improve collection and reduce the opportunities for corruption. Even though the envisaged improvement in revenue over the program has already been achieved this year, the authorities are working towards ensuring that revenue performance will be better than programmed.
The authorities also plan to launch a major tax reform with Fund technical assistance, including the introduction of a VAT by March 2014, which would raise additional revenue, estimated at 2 percent of GDP. Moreover, development of the mining sector is expected to boost revenue, and the authorities are preparing a strong and transparent fiscal regime in this area with assistance from the World Bank and the IMF. This, together with further steps to enhance the efficiency of tax administration, would help achieve the authorities’ goal of bringing domestic revenue to 15.6 percent of GDP by 2017/18.
The planned security transition and gradual takeover of operations and maintenance of capital projects will put pressure on spending plans, which must also accommodate the need to increase wages to attract better qualified staff and pro-poor expenditure. Stepped up efforts will be made to strengthen public financial management, by implementing the Public Financial Management Road Map, with a particular focus on budget preparation and execution, and increased transparency and accountability, as highlighted in the MEFP. The expected channeling of an increasing share of donor support through the budget, and development of a government securities market, should ease financing constraints and budget implementation.
Monetary and financial sector policies
The authorities will seek to reduce inflation to about 4 to 6 percent in 2011/12. In an effort to enhance effectiveness of monetary policy, the central bank started in 2010 using reserve money as its operational target, while maintaining a flexible exchange rate system that allows the rate to reflect market fundamentals. Further efforts will aim at improving banks’ liquidity management and developing the secondary market for the central bank’s Capital Notes to facilitate the conduct of open market operations, pending issuance of government securities (sukuks).
The authorities are moving forward to complete the resolution of Kabul Bank. As detailed in the MEFP and the Banking System Action Plan (Table 3), New Kabul Bank will be put up for sale by June 2012, or if the sale does not materialize, be downsized and merged into other financial institutions, or liquidated. Asset recovery continues to be vigorously pursued and evidence of wrongdoing has and will be referred to law enforcement authorities.
Drawing lessons from this crisis, the authorities’ strategy seeks to strengthen the supervision of the financial system. Wide ranging efforts are being carried out to identify vulnerabilities in the banking system, including through onsite inspections and audits by internationally reputable firms. An onsite inspection and audit of another large bank are being carried out and actions have been taken to strengthen the bank’s capital, reduce its large exposure, and address conflict-of-interest issues. Moreover, the central bank is strengthening bank supervision and reinforcing the regulatory framework (¶ 30 and 31 of the MEFP). Efforts to improve governance will be stepped up by strengthening the banking law, encouraging consolidation of small banks, and upgrading the provisions on corporate governance, large exposure, and consolidated supervision.
The authorities are committed to strengthening their AML/CFT regime, as part of their broader efforts to rid the economy of corruption, drug trafficking, and the financing of terrorism. An action plan based on the recommendations of the February 2011 assessment will be implemented; amendments to the AML/CFT legislation will be submitted to parliament; and the capacity of the financial intelligence unit will be strengthened.
The authorities will move forward in implementing the restructuring plans of the four largest state-owned enterprises, and clarifying the legal framework governing these enterprises to bring them under the ownership and effective control of the Ministry of Finance. Steps will be taken to improve reporting and strengthen the capacity at the Department of State-Owned Enterprises (¶ 46 of MEFP).
Consistent with the ANDS and the program outlined in the Kabul Conference Communiqué of June 20, 2010, the authorities have taken wide-ranging measures to strengthen governance and the rule of law, improve transparency and accountability, and fight corruption. Major steps include the establishment of the Anti-Corruption Unit in the Attorney General’s Office and the Anti-Corruption Court with the Supreme Court, as well as the issuance of the President’s Decree establishing a High Office for Oversight and Anti-Corruption for coordination of the authorities’ strategy. Monitoring of the anti-corruption strategy will be carried out by an independent Monitoring and Evaluation Committee, which was inaugurated in May 2011.
Afghanistan’s path toward macroeconomic stability, growth and poverty reduction has been strewn with formidable obstacles, including security, global and regional volatility, governance issues, and low implementation capacity. Yet, progress has been achieved in many areas as outlined above, which should not be overshadowed by setbacks, such as the Kabul Bank crisis. The reform agenda in the years ahead is ambitious and will require perseverance, flexibility, and sustained donor support, within the framework of partnership that has demonstrated its effectiveness in serving agreed objectives. The authorities highly appreciate Fund advice and assistance, and are determined to deliver on their commitments under the new program.