Islamic Republic of Afghanistan: Selected Issues

Fiscal sustainability is one of several policy objectives that Afghanistan is expected to achieve in the context of the Poverty Reduction Growth Facility-supported program. There is a need to develop a comprehensive financial sector strategy aimed at deepening financial intermediation and reducing key vulnerabilities. The aim of this paper is to analyze the conduct of monetary and exchange rate policy in Afghanistan. This paper also discusses the current monetary policy framework in Afghanistan, reviews its implementation, and recommends measures to improve its effectiveness.

Abstract

Fiscal sustainability is one of several policy objectives that Afghanistan is expected to achieve in the context of the Poverty Reduction Growth Facility-supported program. There is a need to develop a comprehensive financial sector strategy aimed at deepening financial intermediation and reducing key vulnerabilities. The aim of this paper is to analyze the conduct of monetary and exchange rate policy in Afghanistan. This paper also discusses the current monetary policy framework in Afghanistan, reviews its implementation, and recommends measures to improve its effectiveness.

III. The Exchange Rate and the Conduct of Monetary Policy in Afghanistan1

A. Introduction

1. During the last five years, Afghanistan has made significant progress towards a stable macroeconomic environment. In 2006/07 inflation declined to single digits, and since then the nominal exchange rate has been broadly stable despite large aid inflows. Improvements in the ability of DAB to effectively conduct monetary policy have been an important contributing factor to this progress, and since mid-2005 they have been a focal point for Fund technical assistance (TA).

2. The aim of this paper is to analyze the conduct of monetary and exchange rate policy in Afghanistan. Section B provides a brief summary of the operational framework for monetary policy, while Section C looks at the implementation of monetary policy over the past year. Section D presents conclusions and a summary of recommendations.

B. The Monetary Policy Framework

3. The 2003 central bank law states that the primary objective of monetary policy in Afghanistan is to maintain domestic price stability. As a secondary objective, DAB aims to foster the proper functioning of the financial system and promote a sound national payment system. Operationally, DAB has been maintaining price stability by basing its policy decisions on a growth rate target for currency in circulation (CiC). When consistent with its target for CiC, DAB has also aimed at smoothing short-term exchange rate fluctuations, given the large impact such fluctuations can have on inflationary expectations and inflation itself. Monthly targets for CiC, consistent with the ceiling on CiC agreed on in the context of the PRGF-supported program, are set on the basis of expected real GDP growth, the velocity of CiC, the target for inflation, and seasonal variations in the demand for liquidity.

4. A high degree of substitutability between afghanis and u.s. dollars appears to be a key characteristic of the afghan economy. As pointed out by Agénor and Montiel (1999, p. 105) currency substitution—the process whereby foreign currency substitutes for domestic money as a store of value, unit of account, and medium of exchange—has become a pervasive phenomenon in many developing countries. After several years of instability—when the authorities raised the majority of their revenue from money creation and foreign currency was preferred to domestic currency—confidence in the Afghani appears to have increased to a point where there is indifference (at least for transaction purposes) between the Afghani and some other currencies, notably the U.S. dollar and the Pakistani rupee. In fact, it seems probable that the elasticity of substitution between domestic and foreign monies is higher in Afghanistan than in other countries.2

5. DAB conducts monetary policy primarily through interventions in the foreign exchange market, but also through the sale/purchase of domestic securities (capital notes). Open-market operations (OMO) in foreign currency and in domestic securities affect base money. In countries with managed floats and more developed financial systems, it is common for the central bank to rely on foreign exchange interventions to meet its foreign reserve objectives, and on OMO in domestic securities to achieve base money or short-term interest rate operational targets. In Afghanistan, however, the market for capital notes (CNs) is still too thin for CNs to become the primary instrument of monetary policy, and DAB has been unwilling, until recently, to expand the CNs volume because of concerns about the associated higher interest costs. Currently, DAB aims to sell up to Af 400 million worth of 28-day notes and up to Af 100 million worth of 182-day notes in weekly auctions.3 This compares with average weekly sales of foreign exchange of US$18 million (equivalent to approximately Af 900 million) in the foreign exchange auctions to date in 2007/08. DAB also operates standing credit and deposit facilities and maintains a reserve requirement for commercial banks.

6. The conduct of foreign exchange auctions has undergone substantial changes, in line with the recommendations of successive TA missions. Until mid-2005, weekly auctions were only open to Kabul-based nonbank foreign exchange dealers and were conducted using an open-outcry process, where dealers responded to an exchange rate proposed by DAB. Bids at the auction were settled over the three following days. Banks were excluded from auctions, but they were allowed to trade foreign exchange directly with the central bank at a price involving a relatively high spread. This setup not only encouraged collusion among dealers, but also discouraged genuine price discovery and made the process of deciding how much foreign exchange to sell—especially in the event of a trade-off between the CiC target and exchange rate volatility—unclear to both the market and the senior management of DAB. At present, foreign exchange auctions, which take place twice a week, are conducted as a first-price sealed bid auction with a two-day settlement period, as in most other countries. They have also been broadened to include foreign exchange dealers in the provinces as well as commercial banks. In addition, the secondary objective of smoothing out exchange rate fluctuations has been formalized. DAB manages the foreign exchange auctions to avoid exchange rate movements in excess of ± 5 basis points from the previous auction, when this does not imply unacceptable departures from the CiC target.

7. Currency substitution undermines the effectiveness of foreign exchange auctions as a tool of monetary policy. Because of currency substitution, the quantity of money which matters for transaction purposes also includes those foreign monies that are close substitutes to Afghanis. As a result, interventions by the central bank through foreign exchange auctions change the currency composition of the stock of money, not its overall size. This implies that the impact of foreign exchange auctions may be limited. This supports the need to develop a more effective instrument of monetary policy, such as CNs to affect overall liquidity.

8. Significant improvements have taken place in the capital notes program since its inception in late 2004. The 1-day capital notes have been replaced by a standing deposit facility for banks, while 30-day notes have been supplemented by 56-days notes. This maturity structure was modified again in March 2006 with the introduction of 28-day notes to facilitate refinancing and reinvestment, and 182-day notes in early 2007 to encourage secondary trading and the development of a yield curve. At the same time, DAB moved to the more typical structure of capital notes as zero coupon, rather than interest-bearing bills, to facilitate price calculation, especially for secondary market trades. The stock of outstanding capital notes rose from Af 0.4 billion at end-2005 to Af 2.5 billion as of January 1, 2008, in line with increased interest among commercial banks, although the large amounts of overnight deposits and low interest rates on capital notes (slightly negative in real terms) suggest that the market can absorb higher amounts of capital notes.

9. The implementation of monetary policy has also benefited from improvements in DAB’s ability to forecast liquidity, although further progress is necessary. In a largely cash-based economy, where the government and other major entities such as the U.S. Army and NGOs rely primarily on transfers from abroad for funding, being able to forecast accurately the autonomous factors affecting the central bank’s balance sheet—such as spending by the donor community and the government—is crucial for accurately forecasting liquidity. Figure III.1 provides a stylized flow-chart of cash flows in Afghanistan. Liquidity forecasts have been improved to take into account projected liquidity injections by the MOF and the U.S. military. However, liquidity forecasts do not take into account government spending in the development budget, and the coverage of spending by donors and NGOs remains weak.

Figure III.1.
Figure III.1.

Islamic Republic of Afghanistan: Simplified Flow-Chart of Cash Flows in Afghanistan

Citation: IMF Staff Country Reports 2008, 071; 10.5089/9781451800340.002.A003

10. Further reforms to the foreign exchange auctions are needed to improve the effectiveness of monetary policy. Although they have been opened up to commercial banks, auctions continue to be dominated by foreign exchange dealers. For DAB this is inefficient, as it requires interacting with a relatively large number of small foreign exchange dealers who typically settle their bids in cash and in numerous tranches, rather than with a relatively small number of commercial banks that could use their accounts at the central bank. It also reduces transparency, given the authorities’ limited oversight over foreign exchange dealers. 4 To address these issues, DAB should foster the development of the wholesale foreign exchange market.

11. The effectiveness of monetary policy would also benefit from significantly increasing the volume of CNs. The outstanding volume of CNs as of January 1, 2008 (Af 2.5 billion) is insufficient to have an impact on CiC, as they have been settled using banks’ excess reserves. As a result, DAB has been unable to employ CNs as an effective tool of monetary policy. Increasing the volume of outstanding CNs would help overcome this problem and would improve the effectiveness of monetary policy.

12. Developments in financial intermediation and liquidity forecasting suggest that there may be scope to consider moving to base money as the primary operational target. The choice of CiC as the primary operational target for monetary policy reflects DAB’s inability to monitor broader monetary aggregates. This problem is related to the rapid growth of, and lack of timely data on, the financial sector in Afghanistan. While CiC can be controlled directly by DAB, it has the drawback that its link to DAB’s ultimate target, inflation, is relatively weak. This is true not only because of the rapid increase in financial intermediation but also because of currency substitution. Recent improvements in liquidity forecasting may allow DAB to move to an operational target more closely related to inflation, such as base money.

C. Monetary Policy Developments in 2007/08

13. The conduct of monetary policy in Afghanistan in 2007/085 can be divided intofive distinct periods, which yield useful insights into the challenges being faced by DAB. For 2007/08, DAB’s target growth rate for CiC is 15.2 percent, compared to a ceiling under the PRGF-supported program of 19.0 percent. DAB’s target for CiC assumes a broadly stable nominal exchange rate and incorporates the information available on seasonal variations in money demand. The evolution of CiC until end-November 2007 and the forecast for the remainder of the year, together with movements in the daily exchange rate, are depicted in Figure III.2.

Figure III.2.
Figure III.2.

Islamic Republic of Afghanistan: Daily Currency in Circulation and Nominal Exchange Rate, 2007/08

Citation: IMF Staff Country Reports 2008, 071; 10.5089/9781451800340.002.A003

Source: Da Afghanistan Bank.

14. During the first period (March 21 to April 21, 2007) and second period (April 22 to June 28), DAB successfully kept CiC close to its targeted level. During the first period, DAB targeted a gradual decline in CiC in line with relatively low liquidity injections by the MOF (consistent with the budget cycle) and the U.S. Army. As shown in Figure III.3, the lower liquidity injections into the economy led to a reduction in the volume of U.S. dollars sold in the auctions. During the second period, DAB stepped up its interventions in the foreign exchange market to mop up liquidity due to higher spending by the MOF and the U.S. Army. The increased interventions led to a gradual appreciation of the Afghani (by 1.5 percent). While DAB’s monetary policy was successful at keeping CiC close to its target, these two periods were characterized by increased daily volatility in exchange rates (in excess of DAB’s target of ± 5 basis points).

Figure III.3.
Figure III.3.

Afghanistan: Daily DAB Foreign Exchange Auction Sales and Exchange Rate, 2007/08 1/

Citation: IMF Staff Country Reports 2008, 071; 10.5089/9781451800340.002.A003

Source: Da Afghanistan Bank.1/ Period average exchange rate of cutoff (or marginal successful) bid.

15. During the third period (June 29 to September 3), the target level for CiC was exceeded, suggesting that concerns about a nominal appreciation of the Afghani may have influenced monetary policy. The volumes of foreign exchange sold during this period were significantly below the amounts projected at the beginning of the year, despite higher than projected liquidity injections by the U.S. army. As a result, CiC exceeded DAB’s target, although it remained comfortably below the program ceiling. At the same time, the appreciation of the Afghani was halted.

16. During the fourth period (September 4 to October 22), the implementation of of monetary policy was hampered by serious difficulties with liquidity management. Because of delays in shipments of Afghanis from abroad, domestic currency checks presented to DAB by the government, the U.S. Army and others could not be cashed. In an attempt to satisfy the government’s demand for Afghanis, DAB increased the sale of foreign exchange, with the result that CiC started to fall below its target. When Afghanis did arrive, DAB was not prepared for the sudden increase in liquidity, and because it had intervened heavily to buy Afghanis for the government, did not have sufficient amounts of foreign currency in cash to sterilize. As a result, CiC surged above both its target and the implied ceiling under the program, and the nominal exchangerate depreciated by close to 1 percent.6

17. During the fifth period (October 22 to end-November) DAB intervened heavily to bring CiC below the PRGF ceiling. The volume of foreign exchange sold at auctions was dramatically increased, from a yearly average of approximately US$15 million per week, to US$30 million per week in November, and was accompanied by a gradual appreciation of the nominal exchange rate. In addition, a new path for CiC was introduced to bring CiC back to its original target by the end of the year. The efforts of DAB to bring CiC back down to target during this period reflect its commitment to the CiC target over the exchange rate stabilization target when these two objectives are in conflict.

18. In sum, DAB has actively used foreign exchange auctions to smooth out volatility when this was consistent with the ceiling on CiC under the PRGF arrangement. There are, however, limits to the degree of flexibility associated with the deviations from the CiC target. On the upside, the limit to this flexibility coincides with the PRGF ceiling. On the downside, the limit is less clear, but could be interpreted as the level of CiC consistent with the floor on net international reserves in the program.

D. Conclusion and Summary of Recommendations

19. This paper discussed the current monetary policy framework in Afghanistan, reviewed its implementation, and recommended some measures to improve its effectiveness. Over the past two years substantial changes—most of them based on recommendations provided by TA from the Fund—have been made to both the instruments and the implementation of monetary policy These changes have improved substantially the ability of DAB to meet its ultimate goal of stabilizing inflation and to formalize the operational framework for monetary policy. The successful implementation of monetary policy during the first half of 2007/08 was testament to these improvements, with currency in circulation close to target, low inflation, and a broadly stable exchange rate. During this period, there was no protracted conflict between the CIC target under the PRGF-supported program and the authorities’ objective of limiting exchange rate volatility.

20. Despite the improvements to the monetary policy framework that have taken place over the course of the last two years, a number of areas require the attention of the monetary authorities:

  • DAB should work with the MOF to incorporate spending through the development budget in the liquidity forecast, and with donors and NGOs to improve the coverage of their operations.

  • The volume of CNs should be increased to allow them to gradually become the primary instrument of monetary policy.

  • DAB should clarify the degree of flexibility in its CiC target.

  • DAB should consider the possibility of using base money as the primary operational target of monetary policy.

21. Reforms aimed at implementing these measures, some of which are being considered in the context of the PRGF-supported program, will be crucial for DAB to meet its ultimate goal of low inflation.

References

Agénor, Richard, and Peter Montiel, (1999), Development Macroeconomics, (Princeton: University Press).

1

This paper was prepared by Magnus Saxegaard.

2

A formal evaluation of the importance of currency substitution in Afghanistan relative to other countries is the subject of a forthcoming Working Paper.

3

Since late December 2007, DAB has doubled the issuance of CNs in primary auctions. Interest rates on CNs, which were previously below 10 percent, increased to 11–12 percent in January 2008.

4

Some progress has been made in licensing Hawalla dealers, who are now expected to report their operations by using forms that have been developed for purposes of combating money laundering and financing of terrorism.

5

Until end-November 2007.

6

The ceiling on CiC under the program applies on a quarterly basis. The deviation relative to the implied ceiling occurred after the September 21 test date, and therefore does not constitute a breach of a performance criterion under the Fund program.

Islamic Republic of Afghanistan: Selected Issues
Author: International Monetary Fund
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    Islamic Republic of Afghanistan: Simplified Flow-Chart of Cash Flows in Afghanistan

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    Islamic Republic of Afghanistan: Daily Currency in Circulation and Nominal Exchange Rate, 2007/08

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    Afghanistan: Daily DAB Foreign Exchange Auction Sales and Exchange Rate, 2007/08 1/