Islamic Republic of Afghanistan
2007 Article IV Consultation and Third Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criterion: Staff Report; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Islamic Republic of Afghanistan
Author: International Monetary Fund
Publication Date:
20 Feb 2008
eISBN:
9781451800371
Language:
English
Keywords:
ISCR; CR; authority; operating budget; government; financing; exchange rate; monetary policy; banking system; trade regime; Budget planning and preparation; Exports; Commercial banks; Currencies
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Afghanistan has made substantial progress toward macroeconomic stability, but structural reforms need to be accelerated. The uncertainty affecting the fiscal outlook warrants a prudent expenditure policy. Monetary policy has been instrumental in reducing inflation and safeguarding external stability, but it needs to be strengthened. The government should resist pressures for expanding its role in the economy and focus on fostering competition and improving economic governance. The current exchange rate level appears in line with fundamentals. The government should increase its efforts to improve Afghanistan’s statistical database.

Abstract

Afghanistan has made substantial progress toward macroeconomic stability, but structural reforms need to be accelerated. The uncertainty affecting the fiscal outlook warrants a prudent expenditure policy. Monetary policy has been instrumental in reducing inflation and safeguarding external stability, but it needs to be strengthened. The government should resist pressures for expanding its role in the economy and focus on fostering competition and improving economic governance. The current exchange rate level appears in line with fundamentals. The government should increase its efforts to improve Afghanistan’s statistical database.

I. Economic Developments: From Postwar Recovery to Macro-Stability

A. Overview

1. Economic developments since the fall of the Taliban regime, at end-2001, have resulted in high real GDP growth and progress toward macroeconomic stability (Table 1). Real GDP growth during 2002/03—06/07 averaged around 15 percent a year. It dropped in 2006/07 owing to drought, but is expected to exceed 13 percent in 2007/08, reflecting a post-drought rebound in agricultural output (Figure 1a). Inflation declined to single-digit levels in 2006/07, but it returned to double-digits in 2007/08 because of sharp increases in the prices of imported fuel and foodstuffs owing to worldwide commodity price pressures and the depreciation of the U.S. dollar (Figure 1b).

Table 1

Islamic Republic of Afghanistan: Selected Economic Indicators, 2005/06–2012/13

(Quota: SDR 161.9 million)

(Population: 25.7 million; 2005/06)

(Per capita GDP: US$250; 2005/06)

(Poverty rate: n.a.)

(Main export: carpets, US$186 million; 2006/07)

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Sources: Data provided by the Afghan authorities; and Fund staff estimates and projections.

National accounts numbers were revised to reflect the authorities’ data, excluding the drug economy.

For Kabul.

Does not include core budget development spending and externally-financed development expenditures, which amounted to 9.2 percent of GDP and 55.4 percent of GDP, respectively, in 2006/07.

After HIPC and MDRI relief as well as debt relief beyond HIPC relief from Paris Club creditors. Debt also includes obligations to the IMF. The debt stock includes the capitalization of interest to Paris Club creditors until completion point under the Enhanced HIPC Initiative. The large increase in the debt in 2005/06 reflects principally the recognition of Russia’s claims (that were subsequently restructured), and the reconciliation of all March 2006 debt stocks for the HIPC Initiative.

The 2007/08 number is for January 1, 2008.

Figures have been revised as a result of more reliable data on public grants.

Includes official recorded exports plus staff estimates of smuggling; excludes reexports.

Excludes reexports.

In months of imports of goods and services, excluding imports for reexports and duty free imports by donors.

An increase in the exchange rate indices corresponds to an appreciation.

Figure 1.
Figure 1.

Islamic Republic of Afghanistan: Growth and Inflation

(In units as indicated)

Citation: IMF Staff Country Reports 2008, 076; 10.5089/9781451800371.002.A001

Sources: Central Statistics Office of Afghanistan; and Fund staff estimates.1/ CPI data for Kabul only.

2. Postwar reconstruction, funded by donors, and the return of many skilled and entrepreneurial individuals have stimulated economic activity. Additional impetus came from several large foreign direct investment projects. Nevertheless, the cost of doing business remains high and economic activity is subdued in several areas of critical importance for growth and external sustainability. In particular, no new exports outside the traditional base (carpets, minerals, and horticulture products) have been developed, owing to low capacity, the high cost of capital, and lack of electricity.

3. The volatile security situation and the persistence of the drug economy are weakening attempts at broadening economic development. These two phenomena are intertwined as the resurgence of the Taliban and other anti-government elements is deemed to be fuelled by opium exports. The drug economy (Box 1), while being a source of livelihood for many households, continues to be a major obstacle for Afghanistan to regain its comparative advantage in traditional exports.

Afghanistan’s Opium Economy

Opium remains, by far, the largest cash crop in Afghanistan. Opium production has increased steadily from 185 metric tons in 2001 to 8,200 metric tons in 2007. As a result, Afghanistan has become the world’s largest opium producer, with its share of the total world supply increasing from 52 percent in 1995 to 93 percent in 2007. The increase in production has resulted in a decline in the farm-gate price of fresh opium at harvest time. Although opium prices declined in 2004—07, they were still three times higher than in 1994—2000. In 2007, about 81 percent of the opium production was located in the south and south-west regions of Afghanistan, where anti-government elements are most active.

The impact of opium cultivation on the economy has been substantial. About 12 percent of the population (or 3.3 million people) were involved in opium poppy cultivation during the 2007 season, with the farm-gate value of the opium harvest amounting to $1 billion (11 percent of projected licit GDP). The United Nations Office on Drugs and Crime estimates that the total value of the opium harvest (accruing to farmers, laboratory owners, and traffickers) was about $4 billion in 2007, compared with $2.7 billion in 2005.

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Source: United Nations Office on Drugs and Crime.1/ Export value for 2001 is not available.

4. The recommendations of the previous Article IV consultation focused on the need to broaden the revenue base, prepare more realistic development budgets, strengthen the banking system, and establish an enabling environment for private sector activities. The authorities made good progress in key policy areas. They stepped up revenue efforts through tax reforms and capacity building, and strengthened the Medium-Term Fiscal Framework (MTFF), and the implementation of the development budget. They also continued to develop the monetary policy framework and improve banking supervision. With regard to the broader reform agenda, however, policies have been subject to conflicting influences. Proposals favoring interventionist and protectionist measures are currently dominating the domestic economic debate, while the laws critical for private sector development continue to linger in the administrative pipeline and the privatization of state owned enterprises (SOEs) proceeds at a disappointing pace. At the same time, there have been allegations of corruption and growing frustration with the slow progress on structural reforms.

B. Macroeconomic Policies and Debt Issues

5. Despite continued reliance on donor financing for public spending, revenue efforts have played a central role in improving the underlying fiscal position. Domestic revenues increased markedly from an extremely low base of 4.7 percent of GDP in 2003/04 to 8.2 percent in 2006/07 (Tables 2a and 2b, and Box 2). This increase, combined with a prudent policy toward operating expenditure under the core budget, has led to a gradual reduction in the core operating budget deficit (excluding grants) since 2004/05 (Figure 2).2 During the same period, core budget development expenditures grew significantly, still mostly with donor support. However, the bulk of public expenditures, notably outlays on security and development, continue to be undertaken in the context of the external budget (i.e., outside the core budget), which is executed and financed directly by donors (Figure 3).

Table 2a.

Islamic Republic of Afghanistan: Core Budget, 2005/06–2012/13 1/

(In millions of Afghanis)

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

Core budget includes central government domestic revenues, grants, operating and development expenditure, and financing.

Funding for operating budget from the multi-donor trust funds: The Afghanistan Reconstruction Trust Fund (recurrent window) and the Law and Order Trust Fund (LOTFA).

Interest due (cash only) reflects rescheduling under enhanced HIPC Initiative.

Government’s current program classification based on a simple aggregation of administrative units.

Variation between the fiscal position recorded at MOF and DAB. This discrepancy is partially due to the difference (’’float") between checks issued and checks cashed.

In 2005/06 and 2006/07 includes $40 million receipt from sale of telecommunications spectrum bandwidth and late overflight payment. From 2007/08 includes sale of land and buildings and privatization receipts.

Net change in government deposits with DAB (excluding provincial branch balances). A positive sign corresponds to a decline in balances.

Estimates from MOF and donors.

Table 2b.

Islamic Republic of Afghanistan: Core Budget, 2005/06–2012/13 1/

(In percent of GDP)

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

Core budget includes central government domestic revenues, grants, operating and development expenditure, and financing.

Funding for operating budget from the multi-donor trust funds: The Afghanistan Reconstruction Trust Fund (recurrent window) and the Law and Order Trust Fund (LOTFA).

Interest due (cash only) reflects rescheduling under enhanced HIPC Initiative.

Government’s current program classification based on a simple aggregation of administrative units.

Variation between the fiscal position recorded at MoF and DAB. This discrepancy is partially due to the difference (’’float") between checks issued and checks cashed.

In 2005/06 and 2006/07 includes $40 million receipt from sale of telecommunications spectrum bandwidth and late overflight payment. From 2007/08 includes sale of land and buildings and privatization receipts.

Net change in government deposits with DAB (excluding provincial branch balances). A positive sign corresponds to a decline in balances.

Estimates from MoF and donors.

Figure 2.
Figure 2.

Islamic Republic of Afghanistan: Fiscal Balance, 2003/04–2007/08

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 076; 10.5089/9781451800371.002.A001

Sources: Ministry of Finance (MoF); Da Afghanistan Bank (DAB); and Fund staff estimates and projections.
Figure 3.
Figure 3.

Islamic Republic of Afghanistan: A Challenging Expenditure Structure Dependent on Donor Funding, 2007/08

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 076; 10.5089/9781451800371.002.A001

Sources: Ministry of Finance; Da Afghanistan Bank; donors; and Fund staff estimates.1/ Consists of external loans (50 percent) and use of government deposits (50 percent).

Rebuilding Domestic Revenue

Key implemented revenue measures include

  • rationalizing the customs schedule;

  • simplifying the corporate and personal income tax;

  • repealing nuisance taxes; and

  • withholding tax on imports, which is creditable against final income tax liabilities.

Steps taken on tax and customs administration include:

  • establishing a large taxpayer office (LTO) in the revenue department;

  • piloting a medium taxpayer office (MTO) in Kabul; and

  • enacting a customs code.

uA01box2fig01

Domestic Revenue

(In millions of Afghanis)

Citation: IMF Staff Country Reports 2008, 076; 10.5089/9781451800371.002.A001

Sources: Ministry of Finance; and Fund staff estimates.

6. The fiscal sector has undergone important reforms over the last few years, but the public finances remain fragile. Reforms have concentrated on: (i) creating a legal framework; (ii) establishing fiscal authority; and (iii) strengthening revenue administration and public financial management (PFM). In 2007/08, the government initiated program budget pilots with a view to consolidating the budget preparation process and facilitating the alignment of expenditures with its priorities under the Afghanistan National Development Strategy (ANDS). Also, the MOF has begun to articulate Afghanistan’s medium-term fiscal policy objectives and challenges by using the MTFF. Nevertheless, continued postwar reconstruction needs and escalating security demands are putting pressures on the public finances and perpetuating donor dependence.

7. Monetary policy management has proved challenging, owing to the high degree of dollarization and large inflows of foreign exchange. DAB has continued to rely on currency in circulation (CiC) targets and foreign exchange auctions to conduct monetary policy. Following the introduction of a new currency in October 2002, it was assumed that stabilizing the nominal exchange rate would bring about price stability, strengthen the demand for Afghanis, and thus reduce dollarization. Inflation, however, turned out to be more persistent than originally expected, due mainly to large inflows of foreign aid and opium export receipts. With ample foreign exchange at its disposal, DAB tightened the CiC targets and stepped up foreign exchange interventions. In the event, inflation declined (albeit temporarily) to single-digit levels in 2006/07, but “afghanization” has stalled since 2004/05 (Figures 4a and 4b). Dollarization, which was originally driven by the increased demand for foreign currencies as a hedge against exchange rate risk, continues to be supported by the abundance of foreign exchange, which strengthened currency substitution, with foreign currencies and Afghanis used interchangeably for domestic transactions.3

Figure 4.
Figure 4.

Islamic Republic of Afghanistan: Monetary Policy Indicators, 2002/03-2007/08

Citation: IMF Staff Country Reports 2008, 076; 10.5089/9781451800371.002.A001

Sources: Da Afghanistan Bank (DAB); Central Statistics Office of Afghanistan; and Fund staff estimates and projections.1/ For 2007/08, program ceiling for currency in circulation and program projection for NFA and CPI.2/ For 2007/08: program ceiling for currency in circulation, for other variables: projection based on data through October 2007.

8. The rapid development of the banking sector has created an enabling environment for new monetary policy instruments. In mid-2004/05, DAB launched auctions of capital notes (CNs) with a view to developing them as the primary instrument for monetary policy. Thus far, however, the role of CNs has been limited with the stock outstanding at end-November 2007 not exceeding Af 2 billion (US$40 million). Interest rates on CNs are negative in real terms, and DAB remains reluctant to expand the volume of the CN auctions and assume the associated interest cost.

9. Afghanistan’s exchange regime continues to fit the definition of a managed float. While the monetary policy conduct resulted in the stability of the Afghani vis-à-vis the U.S. dollar, the authorities have made no commitment to maintaining any particular level of the exchange rate. DAB has conducted the foreign exchange auctions in a manner consistent with the CiC targets and sought to smooth short-term fluctuations in the nominal rate only when this has been consistent with the CiC ceilings under the program. The foreign exchange market is highly decentralized and the spread between the market rate and the auction rate is negligible (Figure 5).

Figure 5.
Figure 5.

Islamic Republic of Afghanistan: Exchange Rates, Jan 2005-Nov 2007 1/

Auction Cutoff & Hawala Dealers (DAB); in Afghani per U.S. dollar

Citation: IMF Staff Country Reports 2008, 076; 10.5089/9781451800371.002.A001

Sources: Afghan authorities; and Fund staff calculations.1/ Last observation is December 1, 2007.

10. Afghanistan’s external position continues to depend on large aid inflows (Table 3). Official transfers increased to 66 percent of GDP in 2006/07 from 53 percent in 2003/04, reflecting mainly higher security spending by donors, with a predominant import content. Large official transfers, foreign direct investment, and debt relief helped improve the import coverage of gross international reserves (excluding imports financed by donors) from 2.8 months of imports in 2002/03 to 9.3 months in 2006/07.

Table 3.

Islamic Republic of Afghanistan: Balance of Payments, 2005/06–2012/13

(In millions of U.S. dollars; unless otherwise indicated)

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

Numbers have been revised as a result of more reliable data on public grants.

Excludes opium exports and, due to limited data availability, flows associated with U.S. Army and most ISAF activities.

Debt service projections are based on the total stock of external debt (including estimates of unverified arrears). Given lack of data on the rate of penalty interest and ongoing bilateral negotiations, interest on overdue obligations was estimated by Fund staff.

Assumes that Afghanistan will reach the completion point under the enhanced HIPC initiative and receive MDRI relief from IDA in 2009/10. Paris Club creditors are assumed to go beyond HIPC and provide 100 percent stock reduction on eligible debts and capitalized interest at completion point.

Includes foreign transactions recently reported by licensed money changers.

Arrears shown represent Fund staff estimates of debt service due, but not paid, on estimated overdue obligations. The 2006/07 and 2007/08 reduction in arrears corresponds principally to the July 2006 rescheduling of Paris Club debt on Naples terms, including the upfront cancellation of the majority of Russian claims consistent with Paris Club practice.

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

In months of imports of goods and services, excluding imports for reexports and duty free imports by donors. The definition of imports used for the calculation of reserve coverage has been changed to exclude duty free imports by donors that are fully financed.

After HIPC and MDRI relief as well as debt relief beyond HIPC from Paris Club creditors. Debt includes obligations to the IMF. The debt stock includes the capitalization of interest to Paris Club creditors until completion point of the enhanced HIPC initiative.

Exports exclude reexports.

11. Afghanistan’s debt sustainability has improved significantly as a result of debt relief from its bilateral creditors and interim debt relief under the HIPC initiative. In July 2006, Paris Club creditors agreed to cancel more than US$10 billion of debt, thereby reducing Afghanistan’s external debt by nearly 90 percent, and capitalized all debt service payments falling due until March 31, 2009.4 At the HIPC decision point, in July 2007, they committed to cancelling all remaining claims once Afghanistan reaches its completion point under the HIPC initiative. Additional interim debt relief under the HIPC initiative is being provided by the World Bank. The authorities are actively pursuing debt relief agreements with the OPEC Fund for International Development (OFID) and non-Paris Club bilateral and commercial creditors (MEFP ¶15), and continue to make progress towards meeting the HIPC completion point triggers (MEFP ¶47).

12. Afghanistan still has a high risk of debt distress, notwithstanding significant traditional debt relief from bilateral creditors. The Debt Sustainability Analysis (DSA) conducted in the context of the HIPC decision point in July 2007 highlights that Afghanistan’s external position is particularly vulnerable to a deterioration in the concessionality of new borrowing and to slower export growth. Nevertheless, full delivery of debt relief under the HIPC initiative and assistance under the Multilateral Debt Relief Initiative (MDRI) would be sufficient to reduce Afghanistan’s debt burden indicators to sustainable levels.

C. Financial Sector Developments and Risks 5

13. Banking sector activities have expanded considerably over the last few years (Box 3). According to information provided by DAB, as of September 2007, the banking system was well-capitalized (32 percent, compared with the minimum capital adequacy requirement of 12 percent), and the ratio of classified and watch assets to total assets was about 4.6 percent. There are, however, considerable differences among individual banks. In particular, two large private banks that recently experienced significant growth in their loan portfolios have occasionally fallen below the minimum capital adequacy requirement. Also, the low ratio of classified assets to total assets reflects, to some extent, the widespread practice of rolling over loans. In addition, a recent report by DAB on its first full-scale onsite examination of banks indicates that five banks with more than 60 percent of total banking system assets were given a CAMEL rating of 4, on a 1—5 scale.6 The report reveals serious deficiencies, including a lack of fit and proper management, violations of regulations on connected lending, and significant currency mismatch in some bank.

Banking System

Afghanistan’s banking system has been growing rapidly since the fall of the Taliban regime in 2001. As of end-2007, there were 16 licensed banks (compared with 6 banks in 2001), including three state-owned banks and five branches of foreign banks. After a long period of slow growth, the total assets of the banking system more than tripled over the last couple of years, from $388 million (7 percent of GDP) in March 2005 to $1.3 billion (about 15 percent of GDP) in September 2007. This increase has been mainly due to the expansion of private banking, whose share of total assets increased from 21 percent to 60 percent. In fact, the assets of two domestic private banks constitute about 50 percent of total banking sector assets. On the liability side, banking sector deposits have grown almost fivefold since March 2005, constituting about 78 percent of the total balance sheet (deposits plus capital) of the banking system as of end-September 2007.

The bulk of activities of the banking sector remains in foreign currencies. As of September 2007, about 77 percent of the total deposits and loans were denominated in U.S. dollars; a proportion slightly higher than in March 2005. Also, all interbank deposits were in non-Afghani currencies, with about 80 percent being denominated in U.S. dollars. About 35 percent of the deposit base of state-owned banks and 55 percent of their loans at end- September 2007 were denominated in U.S. dollars, implying a considerable currency mismatch for these banks.

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Source: Da Afghanistan Bank (DAB); and Fund staff estimates.

14. The rapid growth in commercial bank activity has prompted DAB to strengthen bank supervision. DAB has recently completed a self-assessment against the Basle Core Principles for Effective Bank Supervision. The assessment yielded a roadmap for addressing weaknesses in DAB’s supervisory framework, including noncompliance with the Basle Principles on the management of credit, and on operational and market risks.

15. Some progress has been made regarding the restructuring of state-owned banks. Following the completion of its external audit, Bank Millie has taken a number of steps to restructure and improve its financial status. Moreover, the Cabinet approved the restructuring plan for Bank Pashtany in August 2007, but the audit of its financial statements has not yet been completed. The client accounts of the Export Promotion Bank have been transferred to Bank Pashtany, but the merger of the two banks is yet to be finalized. To preserve the value of state-owned banks, the MOF continues to prohibit lending from these banks to enterprises that do not have audited balance sheets and cabinet approved restructuring plans

D. Structural Reforms, ANDS (PRSP), and AML/CFT

16. Structural reforms and the preparation of the legal framework for the business environment have advanced slowly, and the government still plays a major role in key sectors. Little progress has been made in preparing for the restructuring/privatization of government enterprises that are not covered by the law on SOEs and the government has not yet submitted to parliament laws on partnership and corporations, secure transactions, and negotiable instruments. In the petroleum sector, the government continues to be involved in importation, storing, and wholesale trade of petroleum products. While reportedly refraining from employing price controls, the government influences retail petroleum prices through market interventions and the imposition of fees on private importers.7

17. A tariff reform implemented in 2006 sought to balance trade policy liberalization and revenue considerations, but discretionary protectionist measures have subsequently crept in (Box 4). The 2006 reform intended to address instances of negative protection, but higher tariff bands on certain products were also introduced to safeguard fiscal revenue in light of political resistance to the introduction of excise taxes.8 Subsequently, in the first half of 2007, several ad hoc protectionist measures were introduced because of concerns about unfair competition from neighboring countries and the high cost of doing business in Afghanistan. One of these changes, the discretionary application of the 1 percent tariff rate, was removed in January 2008.

Summary Import Tariff Schedule 1/

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Source: Ministry of Finance.1/ Based on information up to January 10, 2008.2/ The 3.5 percent tariff band was created in 2006 on a temporary basis and will be reduced to 2.5 percent in 2008.3/ To be eliminated by March 31, 2009.

18. The authorities are implementing the interim ANDS (I-ANDS) and have made substantial progress in preparing the full ANDS (Afghanistan’s PRSP) 9 The ANDS preparation status report appropriately highlights the efforts made by the authorities to broaden the consultation on the ANDS and clearly articulates the steps toward its completion. The authorities intend to submit the full ANDS document to the Boards of the Fund and the World Bank by March 2008, as envisaged at the HIPC decision point in July 2007. This timetable may prove challenging, however, given the need for political decisions on key issues, including intersectoral prioritization. To avoid delays in completing the ANDS, the authorities have decided to limit the costing exercise to three sectors (health, education, and roads) whose expenditure envelopes will be aligned with the MTFF and the 2008/09 budget. The full costing of all sector strategies will be reflected in the first annual report on ANDS implementation.

19. The authorities continue to develop controls against money laundering and financing of terrorism (AML/CFT). Currently, all 16 banks in Afghanistan submit monthly reports on large cash and suspicious transactions to a specialized unit which was established in early 2006.10 The full-scale on-site examination of banks has revealed that most banks fell short of their obligations regarding the implementation of AML/CFT laws and regulations. These included staff’s lack of access to internal regulations, insufficient training, and lack of communication of AML/CFT policies to branches. The authorities have directed banks to strengthen controls against money laundering and correct the observed deficiencies. Also, Hawala dealers (money changers) are now expected to report their operations using forms that have been developed for AML/CFT purposes.

II. Medium -Term Outlook: Creating Conditions for Sustainable Growth

A. Overview

20. The consultation discussions with the authorities focused on Afghanistan’s medium-term policies and prospects in light of the expected decline in foreign The medium-term scenario assumes that the key obstacles to growth (including lack of electricity in Kabul and the precarious security environment) will be removed gradually. Main sources of growth would include: (i) licit agriculture benefiting from rural development programs and the implementation of the donor-supported strategy to eliminate poppy cultivation in favor of alternative crops; (ii) mining, supported by foreign direct investment; and (iii) concomitant broad-based growth in trade and services. Real GDP growth is projected to moderate from 9 percent in 2008/09 to 7 percent in 2012/13, reflecting a gradual decline in the investment-to-GDP ratio to about 30 percent in 2011/12.11 Donorfunded public investment is expected to remain critical for economic growth (Box 5), but its relative importance will diminish over time as private investment and foreign direct investment play increasing roles.

Macroeconomic Effects of Donor Assistance

Nonsecurity grants for the external budget are expected to drop, as a percentage of GDP, from an estimated 30 percent this fiscal year to 9 percent in 2012/13, as immediate reconstruction needs recede and the government takes increasing responsibility for expenditures. At the same time, grants to the core budget would decline from 13.6 percent of GDP to 10.6 percent of GDP over the same period.

The significant level of security expenditures in the external budget reflects the cost of training, equipping, and supporting the increase in the national army and the police. This support is expected to decline as force levels stabilize and security improves.

Automatic sterilization due to the large import content of donor expenditures will help mitigate the potential “Dutch disease” effect of donor inflows on competitiveness. Also, it is expected that aid-financed investments in infrastructure and security will enhance productivity and competitiveness, thus offsetting potential pressure on the exchange rate from the sustained foreign aid to the core budget.

Medium-Term Implications of Donor Assistance

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Sources: Data provided by the Afghan authorities; and Fund staff estimates and projections.

Includes MDRI and HIPC assistance.