Islamic State of Afghanistan: Staff Report for the 2004 Article IV Consultation and Second Review Under the Staff-Monitored Program

This paper focuses on Afghanistan’s 2004 Article IV Consultation and Second Review Under the Staff-Monitored Program. The authorities have made further progress in rebuilding institutions and implementing sound economic policies. They have maintained their commitment to fiscal discipline. Real GDP growth has been relatively strong, albeit from a very low base, and has slowed over the past 18 months, owing primarily to the negative impact of adverse weather conditions on agricultural production. Growth remained strong in the other sectors, especially in construction and services.

Abstract

This paper focuses on Afghanistan’s 2004 Article IV Consultation and Second Review Under the Staff-Monitored Program. The authorities have made further progress in rebuilding institutions and implementing sound economic policies. They have maintained their commitment to fiscal discipline. Real GDP growth has been relatively strong, albeit from a very low base, and has slowed over the past 18 months, owing primarily to the negative impact of adverse weather conditions on agricultural production. Growth remained strong in the other sectors, especially in construction and services.

I. Background and Overview

1. Afghanistan’s first direct presidential election, which took place on October 9, 2004, represents an important milestone in rebuilding the nation’sinstitutional framework. President Hamid Karzai was elected with 55 percent of the vote. Following his inauguration on December 7, and after a lengthy consultative process, President Karzai appointed a new cabinet on December 23, 2004, giving more prominence to technicians to the detriment of regional factions. The new economic team, who signed the attached Letter of Intent, is expected to pursue the current agenda of economic reforms.1 Parliamentary elections are currently scheduled for April 2005.

2. While economic policies have been essentially in line with Fund staff recommendations and the SMP (Section III), further progress could have been made inimplementation. In many instances, the authorities complied with the rogram benchmarks, but follow-through has been weaker than envisaged—often due to weak administrative capacity, security concerns, or political considerations.

3. The security situation remains unpredictable but generally calm. The longer-term implications of the kidnapping (and release) of UN staff members remain a matter of concern among security experts. Although the situation is expected to remain volatile until the general elections, the international community remains actively involved in the country.

4. The foremost challenge facing the authorities is the drug economy. Drug activities have continued to increase, and there is a substantial risk that Afghanistan will (or already has) become a narco-state. The latest United Nations Office on Drugs and Crimes (UNODC) report indicates that poppy production continued to rise in 2004, with cultivation spreading to new areas of the country and involving an increasing share of the population. Drug revenue is estimated to have risen to $2.8 billion, equivalent to about 60 percent of nondrug GDP.2 Despite a higher export value, a steep drop in the average farm gate price cut farmers’ gross drug income by 40 percent to about $600 million, while proceeds to traders and laboratories rose sharply (more than 70 percent) to $2.2 billion. The government and the international community are developing a common strategy to abate the drug economy. The manner in which this strategy is implemented will be critical in maintaining social, economic, and political stability.

5. The return of peace and the ensuing resumption of economic growth have led tosome improvement in Afghanistan’s social indicators, which are among the lowest in the world. Refugees have returned to their lands; school enrollment has increased; vaccination campaigns against some deadly diseases were conducted; and food security has improved. Nonetheless, the challenges remain daunting as infant and maternity mortality are still among the highest in the world. Illiteracy still affects 57 percent of men and 87 percent of women, and only 40 percent of the population are reported to have access to drinking water. Electricity is provided to only 17 percent of the rural households. Poverty remains widespread, especially in rural areas.

6. While still relatively strong, real GDP growth has slowed over the past18 months, and was lower than expected (Table 1 and 2). This slowdown reflects primarily the negative impact of adverse weather conditions on agricultural production, which notably led to the 25 percent fall in cereal production during the first half of 2004/05. This fall was only partially offset by expansion in other sectors. Increased opium activity, together with the heavy reliance on external support, highlights the fragility of Afghanistan’s economic recovery. Increases in rent and fuel prices led to a rise in inflation over the last 12 months, but moderated somewhat during the second quarter of 2004/05 (Figure 1). Year-on-year inflation amounted to 14.1 percent at end-September. Excluding rents and petroleum products, it amounted to 8.3 percent. Reflecting a strong balance of payments, the nominal and real exchange rates vis-à-vis the U.S. dollar have appreciated.

Table 1.

Islamic State of Afghanistan: Basic Data, 2001/02–2004/05 1/

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

The fiscal year 2004/05 runs from March 20, 2004 until March 20, 2005.

First review under the staff-monitored program (IMF Country Report No. 04/364; November 9, 2004).

Table 2.

Islamic State of Afghanistan: Savings-Investment Balances, 2002/03–2007/08

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

Data originating from the fiscal accounts.

Determined as a residual.

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

Figure 1.
Figure 1.

Islamic State of Afghanistan: Price Developments, 2003-04 1/

Citation: IMF Staff Country Reports 2005, 033; 10.5089/9781451800197.002.A001

Sources: Central Statistics Office of Afghanistan; and Fund staff estimates.1/ Last observation: September 2004.

7. The authorities have maintained their commitment to fiscal discipline and have continued to improve fiscal management. The government continues to observe the “no-overdraft” financing rule prohibiting borrowing from Da Afghanistan Bank (DAB), as the operating budget continues to be financed by donor grants and concessional disbursements (Table 3). Central government control of provincial revenue and expenditure has sharply improved. Further, the authorities adopted, for the first time in 2004/05, a ‘core budget,’ to improve coordination and control over donor flows.3 Over the last 18 months, domestic revenues have exceeded program projections, while expenditures were constrained by delays in recruitment and general procurement. All line ministry accounts have been consolidated into the Treasury Single Account (TSA) and revenue from provincial accounts are now regularly deposited into the TSA. These measures bolstered the central government’s ability to monitor and collect revenue, of which 70 percent is collected in the provinces.

Table 3.

Islamic State of Afghanistan: Operating Budget (in millions of Afghanis), 2002/02–2007/08

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

Staff estimates. The budget adopted by the government projects revenue of about Af 15 billion.

The first half of 2003/04 includes a $18 milhon lump-sum transfer from Herat province. Revenue in the fourth quarter of 2003/04 were affected by the disruptions in collection that accompanied the aborted introduction of the customs reform in January 2004.

The sharp increase in revenue from the center reflects transfers of overflight revenue from IATA (Af 800 milhon) and of passport fees from the Ministry of Foreign Affairs (Af 300 milhon).

The functional, economic and center/provinces classifications of expenditures reported in 2004/05 reflects IMF staff projections and do not reflect Government Finance Statistics (GFS). These projections are based on assumptions regarding unallocated expenditures amounting to Af 5.3 billion.

The first quarter of 2003/04 includes $25.2 million paid by the Ministry of Re construction in Herat province for the purchase of services.

Variation between the fiscal position recorded at MOF and DAB. This discrepancy is due to the difference (“float”) between checks issued and checks cashed and the fact that the provinces’ accounts in DAB branches are not consohdated into the government’s central accounts.

This financing is assumed to be temporary and bridges temporary shortfalls in financing due to delays in securing the reimbursement of submitted expenditures from the ARTF. A positive sign corresponds to a decline in balances and a negative sign to an increase in balances.

Refers to changes in the domestic government accounts with DAB.

In 2002/03, includes one-off transfers of overflight revenue and customs valuation fees accumulated over several years and the sale of telecommunication licenses.

8. Despite a paucity of monetary instruments, DAB’s flexible approach to monetary policy, in the context of a “managed float,” has been largely successful inlimiting both inflation and exchange rate volatility. Monetary policy continues to be implemented almost entirely through foreign currency auctions, the only market-based instrument until the recent introduction of short-term capital notes. Monetary policy is guided primarily by indicative targets for currency in circulation (as set out in the SMP). However, in view of the substantial uncertainties surrounding relationships between key macroeconomic variables, DAB uses all available indicators to assess changes in the demand for domestic currency. As illustrated by the recent revision of the monetary program (paragraph 22), DAB stands ready to adjust its monetary stance when necessary to preserve macroeconomic stability.

9. The government introduced a number of important structural reforms. Following the adoption of commercial banking legislation, the regulatory framework has been strengthened further through DAB’s adoption of banking regulations. Three state-owned commercial banks were granted conditional licenses, while eight private banks—all foreign-owned—were licensed and are now operating. However, only limited progress has been made in restructuring the relicensed state-owned banks, and in resolving the three that were not relicensed. Considerable trade regime reforms have been implemented. As a result, Afghanistan is now one of the most open economies in the region (Box 1). Other important structural reforms include: the introduction of a computerized system for expenditure and revenue operations; the simplification of customs clearance procedures; and the adoption of five-year plans to improve customs and tax administrations.

II. Performance Under the Staff-Monitored Program

10. All end-September 2004 quantitative and structural benchmarks under the SMP were observed, with the exception of the benchmark related to the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) legislation, which was enacted with a short delay. This strong performance was achieved despite a volatile security situation and the mobilization of considerable resources for the presidential election.

11. After consultation with Fund staff, DAB allowed money growth to exceed its second quarter SMP indicative target (Table 4). Currency in circulation increased by 22 percent during the first half of 2004/05, compared with an objective of 13 percent (Figure 2). This increase was justified by the sharp appreciation of the Afghani, which, along with the slowdown in inflation, pointed to an increase in money demand (Box 2). DAB’s decision to accommodate this increase was instrumental in stabilizing the exchange rate. After appreciating by 20 percent in the first five months of 2004/05, reaching Af 42 per dollar in the third week of August, the exchange rate stabilized in the Af 45–46 per dollar range. Reflecting its foreign exchange activity and a further increase in government foreign currency deposits, DAB’s accumulation of international reserves exceeded its indicative floor for the first half of 2004. At end-September, the international reserves were equivalent to over four months of imports (Figure 3).

Figure 2.
Figure 2.

Islamic State of Afghanistan: Monetary Developments, 2003-05 1/

Citation: IMF Staff Country Reports 2005, 033; 10.5089/9781451800197.002.A001

Sources: Central Statistics Office of Afghanistan, Da Afghanistan Bank; and Fund staff estimates.1/ Last observation: September 2004.
Figure 3.
Figure 3.

Islamic State of Afghanistan: Foreign Exchange Reserves and Real Exchange Rate, 2003—04 1/

Citation: IMF Staff Country Reports 2005, 033; 10.5089/9781451800197.002.A001

Sources: Central Statistics Office of Afghanistan, Da Afghanistan Bank; and Fund staff estimates.1/ Last observation: September 2004.2/ An increase in the exchange rate indices corresponds to an appreciation. The real exchange rate is estimated using the U.S. and Afghan CPIs.
Table 4.

Islamic State of Afghanistan: Monetary Program (Da Afghanistan Bank), 2002/03–2004/05

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

The first column reports the March 19 outcome using the 2003/04 program exchange rate for estimating foreign assets and liabilities; the second reports the same outcome using the 2004/05 program exchange rate. The difference in currency in circulation, government deposits and banks’ claims on DAB correspond to changes in definitions (see footnotes 3, 5, 6), as new data have become available. The difference in Other items net between the two columns reflects the capital gains implied by using a higher value of the dollar vis-à-vis the Afghanis in 2004/05 than in 2003/04 and these changes in definitions.

Foreign currency amounts converted into Afghani at the program exchange rate (Af 46 per dollar in 2003/04 and Af 49.84 per dollar in 2004/05); gold valued at $279 per ounce in 2003/04 and $400 per ounce in 2004/05.

In 2003/04, includes only Ministry of Finance deposits.

The revised projections are consistent with the revised indicative ceilings on the changes in currency in circulation (Table 1) of the MEFP).

In 2002/03–03/04, cash holdings only include cash in DAB Treasury vaults. In 2004/05, they also include cash in DAB’s six major branches.

The differences as compared to the first review (IMF Country Report No. 04/364; November 9, 2004) corresponds to the fact that reliable data on bank deposits and capital note holdings have become available and are now reported.

Afghanistan’s Trade Regime

Establishment of an open and transparent trade regime has been a consistent priority of the Afghan authorities— moving in tandem with sweeping reforms to the tariff regime and customs administration. The result has been a significant improvement in transparency and simplicity, leaving Afghanistan as one of the most open economies in the region, although significant work remains to eliminate informal barriers and address governance issues.

Under the trade regime inherited by the transitional government, there were 25 tariff bands, with rates ranging from 7 to 150 percent—with a simple average of about 43 percent (although the effective tariff was much lower, due to the use of a lower exchange rate in import valuation). An overhaul of the tariff system brought the number of rates to six (2.5, 4, 5, 8, 10, and 16 percent), with a relatively low level of dispersion. By virtue of this rationalization, the average tariff also declined to 4 percent. Even with the addition of a range of “fees” (both legitimate and illegitimate), the estimated average applied tariff is only 5.3 percent—the lowest in the region. The effective tariff rose considerably, however, given the authorities’ decision to use market exchange rates in import valuation. Afghanistan maintains bans on only a few products (largely for religious purposes), and imposes no seasonal restrictions, quotas, or other nontariff barriers. Further, licensing requirements— reformed effective April 2004—have been drastically simplified. The import license application process, which previously involved 42 steps, 58 signatures, and several weeks of processing, now involves only three steps, six signatures, and 48 hours to process.

Figure 1.
Figure 1.

South and Central Asia -- Trade Restrictiveness

Citation: IMF Staff Country Reports 2005, 033; 10.5089/9781451800197.002.A001

A number of problems remain, however. Some provincial governments reportedly prohibit the use of foreign trucks. There are also other ad hoc fees imposed by local governments, warlords, and commanders, but these appear to be evenly applied to all transport, and not just on imported goods. Customs clearance in some areas (for example, in some of the more problematic areas on the border with Pakistan) can also be cumbersome. From a government policy perspective, however, substantial progress is being made to simplify customs administration—including computerization and the introduction of a customs single administrative document.

With regard to international trade policy, the emphasis thus far has been regional—reflecting the large potential for immediate gains from facilitating transit trade with such countries as India, Pakistan, and Iran. This process is expected to continue, with the Afghan authorities seeking to codify relationships with other neighboring economies. On the multilateral level, Afghanistan has recently requested observer status from the World Trade Organization (WTO). Accession to the WTO is a future goal, although the authorities have indicated that a significant number of legal reforms will be required to meet WTO requirements.

The Deepening of the Domestic Currency Market or “Afghanization”

Since the introduction of the new Afghani in late 2002, currency in circulation has increased substantially faster than nominal GDP. Afghanis in circulation rose by 41 percent during 2003/04 and by 22 percent during the first six months of 2004/05, while nominal GDP growth amounted to 23 percent in 2003/04 and is projected at 19 percent in 2004/05. Overall, the velocity of currency in circulation is estimated to have declined by 13 percent in 2003/04 and by an additional 10 percent during the first six months of 2004/05 (Figure 2).

This decline in velocity, at a time of moderate inflation and an appreciating currency, points to an increase in demand for the Afghani. While year-on-year inflation has increased during the first part of 2004/05, from 7 percent at end-December 2003 to 14 percent at end-September 2004, this largely reflects non-monetary factors. Excluding petroleum products, rents, and education, inflation has remained moderate, at 7 percent at end-September 2004 (compared with 6 percent at end-2003). At the same time, the Afghani has steadily appreciated since end-2003, gaining 7 percent vis-à-vis the dollar during the first nine months of 2004.

This higher demand for the Afghani seems to result from both a monetization and a dedollarization of the economy.1/ The use of the local currency as a means of exchange has benefited from: (i) administrative measures aimed at encouraging its use (DAB has insisted that all goods and services be priced in Afghani); (ii) its increasing use by the donor community, such as the U.S. Army for the payment of contractors and Afghan National Army salaries, which has contributed to its diffusion, notably in the rural areas; and (iii) an increased confidence resulting from its stability over the recent period. There is anecdotal evidence that the Afghani is now the preponderant currency for transactions. However, the U.S. dollar remains widely used in a few sectors, such as the telecommunication sector, the trade sector, and the opium economy.2/ Hence, preliminary data for end-August 2004 indicate that 91 percent of deposits at private commercial banks were in U.S. dollars, reflecting the preferences of their depositors, mostly traders and large companies.

With a level of monetization similar to that of other least-developed economies, the financial deepening of the Afghan economy is expected to come from the development of the banking sector (Figure 4). The ratio of reserve money to GDP, at 13 percent at end-September, is slightly higher than that observed in other least-developed countries. This is partly explained by the low level of development of the banking sector, which until recently provided few investment opportunities. Deposits with commercial banks and lending activities represented 1.8 percent and 0.4 percent of GDP, respectively at end-August (these numbers include foreign currency deposits and dormant accounts). As a result, Afghanistan’s broad money to GDP ratio was significantly lower than in similar developing countries. As the banking sector develops, this ratio should increase substantially, while the ratio of currency on circulation to GDP may decline somewhat.

Figure 4.
Figure 4.

Islamic State of Afghanistan. Reserve Money to GDP Ratio 2003-04 1/

Citation: IMF Staff Country Reports 2005, 033; 10.5089/9781451800197.002.A001

Sources: WEO; Da Afghanistan Bank; Central Statistics Office of Afghanistan; and Fund staff estimates.1/ Latest data: 2003 or latest available; end-September 2004 for Afghanistan.
1/

Due to the lack of reliable data on cash holdings in U.S. dollars, it is not possible to estimate the respective contribution of financial deepening (i.e. increase in the broad currency in circulation, including foreign currency holdings) and dedollarization (i.e. decline in currency substitution).

2/

The use of the Pakistani rupee and the Iranian rial, which was sizeable in some of the provinces, now appears marginal.

12. Domestic fiscal revenue for the first half of 2004/05 reached Af 5.9 billion, exceeding the program target of Af 5.5 billion. The sharp increase in revenue over the same period last year was attributed to more timely sweepings of provincial revenue into the TSA and to the gradual implementation of customs and domestic tax reforms. Operating budget spending reached Af 12 billion during the first half of 2004/05, compared with the annual budgeted amount of Af 30.3 billion. The rate of security-related spending, representing 51 percent of total operating expenditures, was in line with the budget, while spending on education and social services remained significantly under budget, mainly due to problems in recruiting qualified staff. Core budget development spending reached Af 3.5 billion during the first half of 2004/05, compared with the budgeted Af 38.4 billion, reflecting the late approval of the core budget, the poor security environment, and the limited implementation capacity of line ministries and other agencies.4 For similar reasons, external budget spending was also quite low, as donors reported disbursements of $103 million during the first half of 2004/05, compared with annual commitments of $2.6 billion.

13. The authorities maintained their “no-overdraft” financing rule but drew down a significant amount of government deposits to finance the operating budget deficit. As reimbursement from the multi-donor trust funds were lower than expected during the first half of 2004/05, the operating budget deficit was partly financed by a draw-down of domestic deposits, of Af 1.6 billion, and funds from a highly concessional loan, amounting to $12 million.

14. Balance of payments data remain of very poor quality. Nevertheless, preliminary data indicate that the current account deficit narrowed to 12 percent of GDP in the first half of 2004/05, down from 22 percent a year before, and was primarily financed by external grants (Table 5).5 The decline in the deficit appears to reflect an improvement in the trade balance, including an increase in domestic exports but also a slowdown in imports, likely attributable to delays in project implementation. External borrowing, which is on highly concessional terms, remained limited, reaching an estimated $104 million during the first semester. The authorities continue to make progress in verifying external obligations to bilateral creditors, and a survey of external debt and reconciliation with creditors is expected to be completed by end-March 2005.

Table 5.

Islamic State of Afghanistan: Balance of Payments, 2001/02–2007/08 1/

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Source: Fund staff estimates and projections.

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

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

In months of prospective imports of goods and services, excluding imports for re-export.

15. Progress was made in implementing structural reforms under the SMP. Efforts have focused on implementing tax reforms, extending the consumer price index (CPI) coverage, ensuring a more timely transfer of provincial revenue to the central government accounts, restructuring the state-owned enterprises (SOEs), drafting a private investment law, and establishing a legal framework for extractive industries. In the financial sector, bank regulation was strengthened through enactment of AML/CFT legislation and the adoption of bank reserves requirements. DAB also successfully introduced a short-term capital note (end-December benchmark), a significant step toward establishing a benchmark interest rate. Progress in other areas, however, remained slow. The restructuring of the three relicensed state-owned banks (a requirement under their relicensing) and the resolution of the other state-owned banks appear stalled. Moreover, the recent opening of the foreign exchange auctions to the commercial banks has not been satisfactory as the banks only have access to a fixed allocation, sold on a noncompetitive basis after each auction.6

16. The overall process of drafting, adopting, and giving force of law to key reform legislation has encountered a number of bottlenecks in the intergovernmental process, including the limited capacity of the Ministry of Justice. As a result, publication in the official gazette has been delayed for key economic legislation. While a dialogue is underway to remove these obstacles, the process is far from complete.

III. Macroeconomic Outlook and Policy Framework for the Remainder of 2004/05

17. Discussions with the authorities on the program for the remainder of 2004/05 focused on: (i) maintaining macroeconomic stability in a period of political transition and persistent insecurity; (ii) strengthening capacity; and (iii) stepping up structural reforms to spur private investment and improve delivery of government services. The macro-framework was updated and understandings were reached to step up revenue collection, strengthen expenditure management, and improve the business regulatory framework.

18. Modifications were made to the structural benchmarks for the rest of the year. Several end-December 2004 benchmarks were moved to end-March 2005: the benchmark related to the transfer to other entities of all DAB commercial activities, because of difficulties in identifying and contacting the owners of commercial accounts opened at DAB; the benchmark related to the piloting of a system to pay salaries and vendors directly, mainly resulting from the limited coverage of the banking system; and the benchmarks related to the publication in the official gazette of the financial management law, to the consolidation of all recent revenue measures into the revenue code, and to the adoption of a list classifying the SOEs according to proposed economic restructuring method, due to administrative delays linked to the lengthy political transition period between the presidential election and the appointment of a new Cabinet. In addition, the end-March 2005 benchmark for asset transfers between the DAB and the Ministry of Finance (MoF) now covers only DAB’s commercial holdings, which will be transferred to MoF, and the gold and silver in the Presidential palace vaults, which will be transferred to DAB.7 The two institutions will work together to resolve issues related to remaining liabilities, mostly related to Russian claims, currently housed at DAB. Finally, an end-March 2005 benchmark related to the publication of tax amendments in the official gazette was added. The delay in the publication of the revenue laws should not affect significantly the SMP revenue target.8

A. Macroeconomic Framework

19. The authorities and staff agreed on a revised short-term outlook, with substantially lower growth, and unchanged inflation. The downward revision of growth, from 16 percent to 8 percent, reflected the sharp reduction in agricultural output during the first half of the year and lingering drought in the southern provinces. At the same time, growth in other sectors was revised upward, as their better-than-anticipated performance during the first half is expected to continue.

B. Fiscal Policy

20. Staff concurred with the authorities that the budget revenue target for the year remains ambitious but achievable. Meeting the budget target for domestic revenue, which, at Af 15 billion (5.6 percent of GDP), is higher than the program target (Af 12.8 billion), will require a significant improvement in revenue collection, including from the provinces, during the second half of the year and is contingent on the implementation of customs and tax reforms and the collection of sizeable over flight charges near the end of the fiscal year (paragraph 16 of MEFP).

21. Donor funding should be sufficient to finance the core budget in 2004/05. Budgeted revenue, grants, and program loans for the approved core budget exceed projected expenditures by $305 million. The government initially planned to allocate this ‘surplus’ funding to specific development projects at the time of the mid-year review. However, due to the postponement of this review on account of the elections, and given the slow pace of core budget development spending, this additional funding will likely be carried over to subsequent years.

C. Monetary and Exchange Rate Policies

22. In view of Afghanistan’s vulnerability to external and domestic shocks, it was agreed that a flexible exchange rate remained appropriate and that monetary policy should continue to be anchored on targets for currency in circulation. Flexibility remains key, however, and, given the tronger-than-expected money demand, the monetary targets for the remainder of the year were revised upward. The revised targets still imply a significant tightening of monetary policy in the coming months, as year-on-year money growth is expected to decline from more than 50 percent at end-September 2004 to a maximum of 38 percent at end-March 2005. The revised program should allow DAB to accommodate the anticipated further increase in demand for Afghanis without feeding inflation. As money demand is highly uncertain, the program will remain flexible and will be carefully monitored. In particular, the authorities reiterated their commitment to closely follow price and exchange rate developments and to tighten the monetary stance, should prices accelerate. Finally, in light of the foreign exchange accumulation during the first six months, the authorities agreed to revise upward the indicative floors for international reserve growth for the remainder of the year, to levels consistent with import coverage of 3.5 months at end-2004/05.9

D. External Sector

23. While limited data render projections for the balance of payments difficult, continued reconstruction and relatively strong economic recovery would suggest a 2004/05 outcome similar to that estimated in 2003/04. The current account deficit including grants (currently projected at 3.4 percent of GDP) would be more than adequately financed by inward flows, allowing for a continued accumulation of reserves—keeping coverage in terms of imports constant at about four months. Given the large structural changes taking place in the economy, however, staff stressed the need to remain vigilant to emerging pressures on the balance of payments. External borrowing is expected to remain relatively light, given the authorities’ cautious approach to new obligations and the current availability of grant financing.

E. Structural reforms

24. The authorities recognize the continued presence of structural impediments to private sector activities and investment, and are pursuing reforms to eliminate these obstacles. In addition to ongoing fiscal and financial reforms, they are pressing ahead with measures to reform public enterprises, and improve governance and transparency, and the legal and institutional environment for private sector investment.10

25. Developing a more robust legal framework is an important component of the strategy to reestablish the rule of law and promote a market-based economy. A significant amount of economic legislation is at various stages of preparation, including a public financial management law and a customs code (both of which should be approved within the current fiscal year), revisions to the income tax law, and laws to regulate the mining, oil, and gas sectors.

26. Key public expenditure management reforms are being implemented with donor support. They include: (a) automating the payments system, with electronic funds transfer and a verified payroll (initially for Kabul-based ministries only); (b) improving general compliance with financial management procedures; (c) combining operating and development spending in line with a single new chart of accounts; and (d) reestablishing internal and external audit functions.

27. Donors are also funding a number of programs to restructure ministries and attract appropriately skilled and experienced Afghan professionals to core managerial and technical positions (see paragraph 27 of MEFP). Recognizing that these programs are likely to increase the already high share of the operating budget devoted to salaries over the medium term, the authorities intend to undertake a comprehensive pay and grading review which should be linked to the goal of achieving sustainable fiscal position within a few years (see Selected Issues Paper, “Medium-Term Structural Fiscal Reforms,” (www.imf.org)).

28. The authorities continue to modernize and reform the banking sector. The transfer of DAB’s commercial activities and noncore assets to the MoF will allow the central bank to focus on its primary functions. Taken together with an external audit, this will help clarify DAB’s financial situation and facilitate an assessment of whether it is adequately capitalized. Also, the commercial banking regulatory framework will be further strengthened. The authorities are also committed to allowing private banks to play a more prominent role in the foreign exchange market, and to deepen interest in DAB’s short-term capital notes.

F. Technical Assistance

29. Afghanistan’s track record of implementing Fund technical assistance (TA) recommendations is satisfactory. The Fund’s priority has been to provide policy advice and TA to help Afghanistan establish a sound foundation for economic management and macroeconomic stability. In many areas, where institution building requires extensive resources, the Fund approach has been to set the overall framework, leaving other partners to deliver detailed TA (paragraph 6 of IMF Country Report No. 03/299; September 10, 2003). Recent TA from the Fund under the SMP helped the authorities pass AML/CFT legislation, extend CPI coverage, prepare a balance sheet for DAB, and provide training for DAB officials. However, progress in implementing Fund TA recommendations in customs has thus far been slow. While the authorities praised Fund’s assistance and reiterated their interest in continuing to receive TA, they also expressed disappointment that the Fund has not always been able to deliver, because of security concerns, on TA that was promised in key areas— delaying implementation of structural reforms.

G. Data Issues

30. Afghanistan’s statistical framework is improving but substantial weaknesses remain. The mission welcomed the progress made in compiling basic real sector data, extending CPI coverage, and improving the reliability and timeliness of fiscal and monetary data. Although broadly adequate for surveillance and program monitoring, the current provision of data falls short of international standards in terms of quality, frequency, and dissemination. Staff welcome the recent adoption of a statistical master plan and encourage the authorities to establish a clear work program and mobilize the needed resources.

H. Program Monitoring

31. The Technical Committee of Coordination (TCC) is playing an important role by improving collaboration between the MoF, DAB, and the Central Statistics Office, which has enabled close monitoring of the targets and benchmarks. The program will be monitored through the quantitative indicators and structural benchmarks specified in Tables 1 and 2 of Attachment II.

IV. Medium-Term Outlook and Reform Strategy

32. Afghanistan’s current economic and institutional environment present a number of positive features. The institutional and political frameworks are broadly in place and economic reforms are progressing. Important tax policy measures combined with ambitious tax and customs administration reforms are helping the central government to regain control over revenue. A financial management law, soon to be adopted, will provide an adequate legal framework for fiscal policy. Modernization of the central bank and reform of the financial system are progressing, although the sector is still in its infancy. The regulatory framework for private investment is expected to receive a boost from the new private investment law and the establishment of a legal framework for extractive industries—an area of potential for new investment and growth. Private investment should also benefit from the privatization of SOEs.

33. These achievements notwithstanding, Afghanistan still faces major challenges, including a volatile security situation, a fragmented political environment, a growing drug economy, the continued strength of warlords, an ineffective legal system, poor governance, and widespread poverty. Against this background, staff welcome the government’s formulation of a broad-based strategy. This strategy is articulated around: (a) increased security; (b) private sector-led growth; (c) strong revenue efforts to allow funding of recurrent costs within a medium-term horizon; (d) eliminating the drug economy (Box 3); and (e) institution-building. If appropriately followed, this strategy should contribute toward the accomplishment of the 2015 Millennium Development Goals (MDGs).

34. Against this background, staff engaged the authorities in discussions on their medium-term policies only in broad terms as their limited capacity currently precludes a more in-depth discussion. Generally, however, the authorities concurred that Fund staff policy advice was consistent with their long-term strategy as envisioned in the Securing Afghanistan’s Future.

Key Elements and Macroeconomic Impact of a Strategy to Fight the Drug Economy

The 2005 campaign

The authorities adopted in early 2003 a multiyear anti-narcotics strategy, which aims at completely eliminating opium production by 2012. Although current efforts, including the 2004 eradication campaign, have not been very successful, the expansion of the drug economy would have likely been even more vigorous without them. With the support from donors, the government intends to focus on five key areas during the 2005 campaign:

  • An information campaign that will reemphasize the illegal nature of these activities.

  • A broad alternative livelihood strategy, focusing especially on rural rehabilitation and development (see (Box 4).

  • Centralization and intensification of eradication under the responsibility of a newly created department in the Ministry of the Interior.

  • Intensification of interdiction actions aimed at traffickers and laboratories.

  • Strengthening of the laws, courts, and penal systems to work against production and trading.

In addition, counter-narcotics efforts are being mainstreamed in the government’s overall development and reconstruction program. This takes into account the complexity of the drug issue and aims at limiting the social and economic disruptions caused by eradication (physical elimination of the poppy fields) and/or interdiction (legal action against the producers, processors, and traffickers).

Macroeconomic impact The drug economy, which is excluded from GDP, adds to the demand for domestic products and improves the balance of payments. It impacts the nondrug economy primarily through the income it generates, and the use of this income varies according to the economic actor. Farmers, who accounted for less than 25 percent of the estimated $2.8 billion of drug income in 2004, consume a large part of their earnings, mostly on domestic goods. Processors and traffickers, while consuming some domestic and imported goods, probably save, or spend, much of their income outside the country. This group imports raw materials and drug-related capital goods (for transport, processing, and security), and also invests part of its savings domestically (the current construction boom appears to be partly financed through drug revenue). As opium is exported, and as long as some income is spent domestically, the drug economy contributes positively to the balance of payments. However, the drug economy negatively affects the competitiveness of other domestically produced goods through high wage rates and a higher real exchange rate (similar to “Dutch disease”). The macroeconomic effect of a counter-narcotic campaign will depend on the method used. Eradication tends to raise farm gate prices due to lower production, while interdiction tends to lower farm gate prices due to lower demand by traffickers. Thus, these policies create different incentives and rates of return for farmers and traffickers.

A successful campaign could adversely affect GDP growth, the balance of payments and government revenue. Due to a highly inelastic demand, an eradication campaign could result, at least temporarily, in higher incomes for farmers, but also for the traffickers, which would be able to sell their stocks at higher prices.1/ A multi-pronged strategy, if successful, should however result in a lower drug income, leading to a slowdown in real growth in the nondrug economy and a deterioration of the balance of payments, putting downward pressure on the exchange rate. The relative magnitude of this shock to GDP would be less to the extent that the burden falls on traffickers. On the external side, the high foreign savings and import content associated with drug revenue suggest that the impact on the balance of payments would be substantially less than the total decline in drug revenue. However, this impact could be temporarily accentuated by capital flight, as some traders and traffickers may want to protect their assets from increased scrutiny. The slowdown in growth and the decline in imports will in turn affect negatively government revenue.

Overtime, the reallocation of resources to the nondrug sector will allow higher recorded growth. Cetibus paribus, the real depreciation of the exchange rate resulting from lower demand and the deterioration of the balance of payments, will contribute to the reallocation of resources to the export sector. Depending on monetary policy, this depreciation will come from a nominal depreciation and/or a relative decline in domestic prices. The current level of international reserves will allow the central bank, through a tightening of its monetary stance, to avoid unwarranted exchange rate depreciation.

1/

While the overall impact on farmers revenue would be positive, the social impact could be substantial, as the farmers directly touched by the eradication campaign would lose their main source of revenue.

A. Macroeconomic Framework

35. While recognizing that recent growth rates will be difficult to maintain, the authorities expect an average annual growth rate of 9 percent over the medium term will be needed to address poverty and unemployment and meet the MDGs (Box 4). In support of this target, investment is expected to average about 25 percent of GDP over the next five years, reflecting: (a) continued donor support averaging about 29 percent of GDP; (b) a gradual rise in foreign private sector investment (mostly in the form of foreign direct investment); and (c) higher levels of productivity from accelerated structural reforms. Fiscal policy targets a level of current spending averaging about 12 percent of GDP, while capital spending would decline to 17 percent of GDP by 2007/08, facilitating an expansion of private sector investment. Consumption, reflecting structural changes underway, is projected to fall to 100 percent of GDP over the same period, down from 110 percent of GDP in 2004/05. As structural reforms take hold, the gray economy shrinks, the banking system develops, and security improves, income is expected to rise and alter the household’s expenditure and savings patterns. As a result, private savings are projected to rise to 4.1 percent of GDP in 2007/08, up from -5.3 percent of GDP in 2004/05.

36. This outcome is predicated on: (a) efficient public spending that supports development and creates an enabling environment for private investment while maintaining fiscal stability; (b) public enterprise reform; and (c) accelerating market reform and promoting the rule of law and greater transparency. But even more important, the government must overcome deeply rooted problems impeding reform (paragraph 33). Furthermore, although official statistics are not available, there is evidence that wage rates have become relatively high for the region, largely driven by the aid and drug economies.

B. Medium-Term Fiscal Policy

37. The authorities are committed to promote fiscal sustainability over the medium term. Their fiscal policy is designed to ensure that the government achieves its policy objectives within the resources available, deliver basic government services efficiently, and facilitate budget execution and monitoring. The authorities intend to continue implementing a broad structural fiscal reform agenda centered around (a) continuing to consolidate fiscal management; (b) rebuilding and broadening the domestic tax base; and (c) developing an effective public administration and public expenditure management system (see Selected Issues Paper, “Medium-Term Structural Fiscal Reforms” (www.imf.org)).

C. Monetary and Exchange Rate Policies

38. Monetary policy will be implemented under a managed float. It will continue to be anchored by a target for currency in circulation but will avoid large and unwarranted changes in the exchange rate, as long as such policy is consistent with maintaining low inflation. The central bank will develop its arsenal of market-based instruments to strengthen its capacity to implement monetary policy. As the banking sector develops and more reliable monetary data become available, DAB will base its monetary policy decisions on a broader set of indicators, including reserve money and broad money. The authorities will work to strengthen the financial sector legal framework — which currently hinders bank financing of the private sector.

The Sources of Growth in Afghanistan

Following two years of crisis management, the government adopted in early 2004 a broad-based strategy called “Securing Afghanistan’s Future”. The strategy aims at building a financially self-sustaining state, with the capacity to meet basic social needs and address poverty reduction. Central to this strategy is the need to sustain an annual growth rate in the nondrug economy of at least 9 percent to raise per capita income from $135 by end-2001 to $350 by 2015 and to reduce unemployment.

Over the past three years, growth has rebounded—reflecting sound macroeconomic policies, sizable aid flows, favorable weather conditions, reconstruction efforts, and essential structural reforms. Non-opium GDP growth reached 29 percent in 2002/03, and almost 16 percent in 2003/04. Agriculture, which represents 48 percent of GDP, was the main engine of this growth. The strong performance in this sector was due largely to the return of some 3 million refugees to farmlands, the timely availability of fertilizers and other inputs, and a temporary end to drought conditions. Other sectors that fueled growth, albeit to a lesser extent, included construction and services, which represent respectively 5 percent and 30 percent of GDP.

Growth is now expected to slow as various factors that supported the economy in the immediate post-conflict period gradually diminish. Agricultural growth will be limited by the lingering drought, which is expected to continue as a result of a long-term pattern, and the low potential for a further rise in yields under current techniques (yields are now similar to those in neighboring countries). Value-added in livestock will also suffer from the drought. The boom in construction and services is expected to continue, but will not be sufficient to support the economy. Afghanistan will therefore need to exploit the full potential of existing sectors and identify other leading sources of economic growth.

Assuming the country addresses the structural impediments constraining private sector investment, including insufficient power and a difficult regulatory environment, economic expansion could be secured not only from some existing sectors but also from new sectors:

  • In the agricultural sector, expansion could come from: (a) extension of the irrigated areas (presently only 40 percent of the cultivated area is under irrigation) to break the total dependence on erratic winter snows and spring rains for water; (b) use of machines, chemical fertilizers, and pesticides to improve the yields and the quality of the grain and other staples; (c) strengthening transportation networks to ensure distribution of food and other goods; and (d) growing staples with more value added, including cotton and sugar beet on an industrialized scale.

  • Other sectors with significant scope for growth are trade, construction, and transportation. Trade links are expected to grow over time with neighbors as the country slowly builds its transportation network. The highway system requires total reconstruction, and regional road are in total disrepair.

  • New sectors that can contribute to sustained growth include extractive industries. The country is endowed with natural resources, including extensive deposits of natural gas, petroleum, copper, coal, chromites, talk, barites, sulfur, lead, zinc, iron, salt, and precious and semiprecious stones.

D. External Policy and Debt Sustainability Analysis

39. The external accounts will likely be driven by the pace of reconstruction, the availability of new trade opportunities and the impact of recent changes to trade policy. Over the medium term, as the external impact of donor projects lessens and the domestic supply of goods and services gradually supplants imports, the current account is projected to improve, reaching a deficit of 2.6 percent of GDP by 2008/09. This should facilitate a similarly gradual accumulation of foreign exchange reserves—to about five months of imports. While conservative, these projections are subject to downside risks, stemming notably from the high share of exports linked to agriculture and animal husbandry products, and from the positive impact of unrecorded capital inflows.

40. The current cautious approach to external borrowing will remain a key component of economic policy for the near term. This reflects Afghanistan’s fragile economic position, its relatively scarce foreign exchange earnings (excluding donor flows and drug-related trade), extremely low level of domestic revenue, and lack of clarity regarding the status of some pre-existing bilateral claims. Staff emphasized the need to adopt an explicit strategy to guide external debt management over the medium term. A debt sustainability analysis (see Selected Issues Paper, “Debt Sustainability Analysis,” (www.imf.org)), conducted as part of the current Article IV consultation, highlighted the potential risks and vulnerabilities associated with external borrowing under different scenarios. The results indicate that, assuming a “clean slate” with regard to old bilateral claims, and reasonably strong economic and revenue performance, there is a comfortable margin with regard to key sustainability thresholds. Through successive macroeconomic and other shocks outlined in the various scenarios, however, this margin quickly diminishes, leading to situations where Afghanistan’s debt and debt service burden would be deemed unsustainable.

41. The authorities recognized the need to provide the legal framework that conforms to their liberal trade and exchange rate regime to pave the way for accepting the obligations under Article VIII of the Fund’s Articles of Agreement. This would send a positive signal to investors. Staff reiterated the Fund’s willingness to provide TA in this area.

V. Fund Relations

42. The authorities view a formal arrangement with the Fund as one possible pillar in the strategy to fight poverty and unemployment. However, until a new parliament is in place, and in the absence of any immediate balance of payments needs, they favor continuing with an SMP to sustain the reform momentum, improve policy formulation, and strengthen administrative capacity. Staff were encouraged by the decision to initiate, in cooperation with the donor community, work on an Interim Poverty Reduction Strategy Paper.

VI. Staff Appraisal

43. Under the current SMP, Afghanistan is making headway in macroeconomic management and structural reform. Prudent fiscal and monetary policies have helped to contain inflation and facilitate relatively high levels of growth. Afghanistan’s performance during the first semester of the SMP is encouraging. Notwithstanding an array of challenges and demands, the authorities implemented a demanding program, more heavily focused on structural reforms than on quantitative targets, and have largely met every benchmark.

44. At the same time, there is a need for a forceful response to the rise in opium production, which threatens the very fabric of Afghan society. Staff support recent efforts by the government and its international partners to develop a multi-pronged strategy to deal with the opium economy. However, staff recognize that eradication cannot be accomplished in isolation, and could have a significant economic impact—particularly on some of the most vulnerable segments of the population.

45. In addition, Afghanistan is still faced with significant challenges in policy implementation due to serious capacity constraints and weak institutions. The widespread shortages of skilled civil servants and weaknesses in the public administration hinder the absorptive capacity. In many cases, these capacity constraints have meant that the effectiveness of reforms was less than envisaged under the program, particularly with regard to revenue administration, and restructuring of the banking system. Failure to address these issues will hinder efforts to attract private investment which is the backbone of Afghanistan’s future growth prospects. Staff welcome the authorities intention to press ahead with planned reforms, and urge them to strengthen these efforts. Staff look forward to further progress in the reform program with the new government. The forthcoming general elections constitute another step toward broadening ownership of economic reforms.

46. The thrust of the macroeconomic policies in the current SMP strikes an appropriate balance between the requirement to support growth during this period of transition and the crucial need to remain vigilant with regard to potential risks. As the fiscal program will be a key component, staff urge the authorities to develop a comprehensive medium-term budget framework that maintains fiscal discipline. The authorities should continue in their efforts to enhance revenue and strengthen expenditure management. The high share of wages and security-related outlays might have been appropriate until now. A gradual shift away from security and reconstruction is the most desirable avenue for expenditure policy to support more broad-based sustainable development in the medium term.

47. Continued donor support is key to ensuring success of the government’s reform strategy. To enhance ownership and coordination of the reform program, donor funding should be integrated into one consolidated medium-term budget framework (moving away from a collection of donor-implemented programs). More direct donor grant support to the budget would simplify fiscal management and help coordinate donor funds. This will require continued improvement in fiduciary standards and the mechanisms for promoting accountability.

48. The current framework for monetary policy, based on a monetary anchor and aimed at ensuring low inflation and currency stability, appears appropriate. The flexibility imbedded in the monetary program has allowed DAB to react promptly to shifts in money demand, ensuring moderate inflation and limiting exchange rate volatility. DAB needs to remain vigilant with respect to inflation and exchange rate developments. Looking beyond 2004/05, staff encourage the monetary authorities to extend their set of market-based instruments and improve monetary statistics. As the banking sector expands and more reliable monetary data become available, DAB should base its monetary policy decisions on a broader set of monetary indicators.

49. Sustained economic growth, employment opportunities, and export prospects will require further structural reforms to improve the business climate. The new investment law is a valuable step forward. Staff advised the authorities to now focus on introducing property rights, bankruptcy laws, contract enforcement, and a transparent and effective judicial system. Staff also view the cooperation of all government ministries and agencies, along with a political commitment at the highest levels in creating a clear and level playing field for business, as the cornerstone of the government’s strategy of creating private sector-led growth.

50. The mission encouraged the authorities to intensify efforts to rationalize the public enterprise sector. While the state-owned banks may not represent a systemic risk, staff urge the authorities to take measures to restore the profitability of those which were relicensed and to resolve those which were not relicensed.

51. Failure to strengthen the legal system could undermine Afghanistan’s economicre form program and medium-term outlook. Key economic legislation remains in limbo due to low capacity at the Ministry of Justice. Staff have urged the government to elicit donor aid and technical support to the benefit of the Ministry of Justice.

52. Building on the achievement of the TCC, staff encouraged the authorities to consolidate program ownership further and enable the TCC in making inroads into policy and analytical roles.

53. Notwithstanding progress so far, particularly in the fiscal area, much remains to be done in the governance area. The perception of widespread corruption, the rise in drug activities, and the lack of transparency in many areas have undermined the business environment. Staff welcome the authorities’ determination to address these issues forcefully.

54. There are a number of risks to the program. The security situation and the limited control of the government over the provinces constrain reconstruction. Political risks remain substantial and, especially in the run-up to the parliamentary elections, could complicate program implementation. The eradication of drug activities, if not handled properly, could cause major macroeconomic and social disruptions, especially in rural areas already affected by the lingering drought. All these factors could cloud Afghanistan’s future. However, the government’s track record so far is testimony of its resolve to move forward in its reform agenda. The authorities’ program for 2004/05, aimed at strengthening macroeconomic stability and Afghanistan’s long-term prospects, therefore deserves continued support from the Fund. Staff recommend completion of the second review and concur with the authorities strategy to continue within an SMP.

55. It is proposed that the next Article IV consultation with Afghanistan be held on the standard 12-month cycle.

APPENDIX I Islamic State of Afghanistan: Relations with the Fund

(As of November 30, 2004)

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

II. General Resources Account

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III. SDR Department

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IV. Outstanding Purchases and Loans None

V. Financial Arrangements None

VI. Projected Obligations to Fund

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

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Nonfinancial Relations

VII. Exchange Arrangement

Afghanistan is an Article XIV member country. The authorities are implementing a liberal exchange system. Based on information currently available to the staff, no exchange restrictions and multiple currency practices are currently in place. The authorities intend to formalize the current liberal regime through the adoption of new laws and regulations, for which they have asked for technical assistance from the Fund. At least since end-2001, the Afghani has been floating, and more recently the authorities have been implementing a managed float with no predetermined path for the exchange rate. As of December 1, 2004, the average exchange rate on the Kabul money exchange market was Af 47.26 per $1.

To conduct monetary policy, the authorities rely on foreign exchange auctions since May 2002. Auctions are open to all licensed money changers. To ensure transparency, DAB has progressively introduced measures, including public announcements of the auctions in advance in local media outlets, and clear instructions on how the auctions are conducted. Over the years, DAB has also improved the mechanics of the auctions to ensure that settlements are made after successful bids. Auctions are linked to the overall monetary program and are held on a fairly regular basis at 1–2 week intervals.

VIII. Article IV Consultation

The last Article IV consultation with Afghanistan was discussed by the Executive Board on November 21, 2003. Consultations with Afghanistan are on the standard 12-month cycle.

IX. Technical Assistance, 2002-04

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

A resident multisector statistical advisor, Mr. Soulatha, was stationed in Kabul on July 17, 2002. STA has provided technical assistance through a series of missions under a peripatetic multisector statistics assignment which began in January 2004. These missions were suspended in July 2004 due to the security situation. A new series of peripatetic missions will commence during January/February 2005. They are expected to resume in late-2004/early-2005.

A resident MFD expert was posted during July-October 2002 at DAB as an accounting adviser. In addition, from April 2002 to February 2003, several experts visited Kabul to provide advice on payment systems, restructuring of DAB, and bank supervision. A mission to provide advice on foreign exchange and short-term capital note auctions is scheduled for the first half of 2005.

During 2004, with the financial support provided by the Sweden Technical Assistance Sub Account, the Fund has sponsored a number of training activities aimed at DAB officials and is now engaged in preparing a full-scale training program for DAB. A long-term advisor has been appointed in Kabul since mid-October, 2004. The training coordinator will be responsible for all practical matters related to the delivery of formal training to DAB staff in Kabul, as well as the coordination of training for DAB staff outside Afghanistan. Finally, Sweden has agreed to finance during the period December 2004 to December 2005 a monetary policy peripatetic advisor to assist DAB in developing the strategy and the instruments for the implementation of the next stage of monetary policy—setting and advising on options to replace the existing exchange rate auctions.

X. Resident Representatives

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

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

(As of November 30, 2004)

1. A second Transitional Support Strategy (TSS) was presented to the World Bank Board of Executive Directors in March 2003. The TSS outlines a strategy for World Bank operations over the subsequent 18 months to 2 years until the establishment of a stable, representative government. The strategy focuses on four strategic areas: improving livelihoods, fiscal strategy, institutions and management, governance and public administration reform, and enabling private sector development. In collaboration with the new government and other stakeholders, the World Bank intends to update its country strategy for Afghanistan in 2005. Based on the preparatory work toward the I-PRSP, a country assistance strategy, covering a three-year period, could be finalized in FY 2006.

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

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

4. For FY 2005, four projects have been approved in July 2004, for a total of $145 million: the first budget-support operation, Programmatic Support for Institution Building ($80 million), the Kabul Urban Reconstruction Project ($25 million), the Investment Guarantee Facility ($5 million), together with MIGA, and the Education Quality Improvement Program ($35 million). Four other projects are planned, for an additional commitment of $140 million, including the Emergency Public Administration III, a supplemental financing for the Emergency Transport, the Programmatic Support for Institution Building II, and the Strengthening Higher Education project.

5. The World Bank also administers the Afghanistan Reconstruction Trust Fund (ARTF), which became effective in May 2002 and plays a critical role in funding the recurrent costs of government. In its first year of operation (SY 1381—March 21, 2002 to March 20, 2003) the ARTF mobilized $185 million and disbursed $65 million. Paid-in contributions for SY 1382 (March 21, 2003 to March 20, 2004) amounted to $286 million, while disbursements reached $254 million. Pledges for SY 1383 (March 20, 2004 to March 20, 2005) amount to $426 million. ARTF is increasing its financing of investments and has the potential to support tighter donor coordination, simplified processes, and fast results.

6. The World Bank is also actively engaged in advisory services to government and continues to respond quickly to a range of requests. In September 2004, the World Bank has released a country economic report “State Building, Sustaining Growth, and Reducing Poverty.” Current analytical work includes work on the civil service reform, urban development and land management, education policy reform, labor market and pensions, a gender assessment and oil/gas infrastructure development, as well as broader regional trade work encompassing issues with Afghanistan’s neighbors. The World Banks has notably initiated a major Public Expenditure Review (PER), which incorporates fiduciary aspects, including procurement and financial management. Fund staff are contributing to the PER, including through providing an analysis of domestic revenue prospects. The World Bank has also actively utilized Post Conflict Fund and continues to use the Japan Social Development Fund resources to provide on-the-ground support to the government and communities.

7. The World Bank’s program is growing quickly and has an IDA portfolio of 17 projects as of December 2004. Total commitments add up to $753 million, of which 44 percent has been disbursed. The World Bank’s office in Kabul is fully functional and growing rapidly to take on increasing demands. A country manager, as well as several other international staff, and a growing number of national staff are now in place.

Appendex III

Islamic State of Afghanistan: Survey of Reporting of Main Statistical Indicators

(As of November 30, 2004)

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Q=quarterly; M=monthly; and D=daily.

ATTACHMANT I

Kabul, December 29, 2004

Mr. Rodrigo de Rato

Managing Director

International Monetary Fund

Washington, D.C. 20431

U.S.A.

Dear Mr. de Rato,

The government of Afghanistan has held discussions with Fund staff in the context of the second review of the staff-monitored program (SMP) agreed to in March 2004 and is very pleased with the progress under the program. Based on these discussions, the attached memorandum of economic and financial policies (MEFP) reviews macroeconomic developments and implementation of structural policies during the first two quarters of fiscal year 2004/05 and describes the objectives and policies that the government intends to pursue during the remainder of the fiscal year 2004/05. The government’s program will continue to be guided by the macroeconomic and structural reform policies described in the MEFP of March 24, 2004, and modified by the updated MEFP of September 6, 2004. The attached technical memorandum of understanding (TMU) was also updated to reflect the adjustments introduced to some terms and conditions of the program.

With the support of your staff, we have met all of the end-September 2004 quantitative indicators and structural benchmarks, except the benchmark on the adoption of anti-money laundering/combating the financing of terrorism legislation, due to a slight delay in issuing the presidential decree. The government of Afghanistan appreciates the technical support provided by the Fund and intends to continue its reform efforts as envisaged under the SMP. Reacting to the changing circumstances, the government reached an understanding with the mission on a revised macroeconomic framework for 2004/05, and on the deferment to end-March 2005 of several of the structural benchmarks because of technical difficulties and capacity issues related to the long political transition that followed the Presidential election. We have also strengthened our program by including an additional structural benchmark for end-March 2005 on the publication in the Official Gazette of the amendments related to (i) the tax reform package; and (ii) ensuring that the revenue laws supersede all other legislation in revenue-related matters.

The government believes that the policies and measures set forth in the attached MEFP are adequate to achieve the objectives of its program, but we stand ready to take any further measures that may become appropriate for this purpose. Afghanistan will consult with the Fund on the adoption of any measure that may be deemed necessary and will provide information that Fund staff request to assess the implementation of the SMP, as updated. The government of Afghanistan authorizes the publication and distribution of this letter, the attached MEFP and TMU, and all reports prepared by Fund staff regarding the SMP.

Very truly yours,

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