March 6, 2006

1. This statement contains information on recent economic developments in Afghanistan that has become available since the staff report was circulated to Executive Directors on February 16, 2006. This information does not alter the thrust of the staff appraisal.

2. Preliminary data indicate that all end-December 2005 quantitative indicators and all but one of the structural benchmarks under the SMP have been observed. The authorities appear to have failed again to meet the benchmark on the publication of the 2004/05 core budget’s audited financial statements, which had initially been set for end-September. The statements have been submitted to the Auditor-General, who still has to certify them.

3. Inflation (year-on-year) declined further to 12.2 percent in December, reflecting a slower increase in food prices that was partly offset by an acceleration in rents and petroleum product prices.

4. The operating budget deficit, excluding grants, reached 1.9 percent of annual GDP during the first nine months of 2005/06, a level lower than envisaged in the program, owing to a better-than-expected performance of customs revenue. Domestic tax collection remained somewhat below last year’s outcome, as weaker compliance appears to have offset the gains from new tax measures. Operating budget spending was broadly in line with the program, but core budget development spending was only 25 percent of the estimate for the whole fiscal year, owing to weak implementation capacity and security concerns. The operating budget surplus, including grants, was equivalent to 1.2 percent of annual GDP.

5. The government has not yet finalized the budget for 2006/07, as the authorities are still discussing changes in budget coverage with the staff and the donor community. Staff expect the budget to be consistent with a reduction in the operating deficit to 3.5 percent of GDP in 2006/07, from 4.2 percent now projected for 2005/06, owing mainly to an increase in revenue. Operating expenditure is expected to remain broadly unchanged relative to GDP, after the inclusion of security and other outlays previously financed outside the budget. Staff are working closely with the authorities to ensure that the budget is consistent with medium-term fiscal sustainability.

6. Faced with some pressure on the exchange rate, Da Afghanistan Bank tightened its monetary stance by keeping currency in circulation virtually unchanged during the third quarter of 2005/06. International reserves increased further, to more than $1.5 billion at end-December 2005 (4.2 months of prospective imports of goods and services). The Afghani gradually rescinded the 3-percent gain against the U.S. dollar it had made during the second quarter, before stabilizing in January. Reflecting the inflation differential with the United States, this resulted in a real appreciation of about 2 percent against the U.S. currency during the third quarter.

7. At the International Donors’ Conference held in London from January 31–February 1, 2006, the authorities presented their Interim Afghanistan National Development Strategy. By mid-March 2006, they intend to send the final version of this strategy to the Fund and the World Bank as well as their Interim Poverty Reduction Strategy Paper. The authorities and the donor community have also agreed on a “Compact” that includes time-bound benchmarks on security, governance, rule of law, and economic development, and encourages donors to deliver aid more effectively by pledging multiyear support and channeling it through the budget.

8. At the London Conference, donors made pledges of financial assistance amounting to about $10.5 billion over the next five years. In addition, Germany, Russia, and the United States (Afghanistan’s three Paris Club creditors) indicated their intention to provide 100 percent debt relief.