This paper discusses key findings of the Fourth Review Under the Poverty Reduction and Growth Facility (PRGF) for Afghanistan and a Request for Waiver of Performance Criterion. Program performance during the second half of 2007/08 fell short of expectations. The performance criterion on fiscal revenue was missed, and the authorities fell behind on several program commitments. For 2008/09, real GDP growth is projected to moderate to 7.5 percent and inflation to decelerate to 15½ percent by year’s end.

Abstract

This paper discusses key findings of the Fourth Review Under the Poverty Reduction and Growth Facility (PRGF) for Afghanistan and a Request for Waiver of Performance Criterion. Program performance during the second half of 2007/08 fell short of expectations. The performance criterion on fiscal revenue was missed, and the authorities fell behind on several program commitments. For 2008/09, real GDP growth is projected to moderate to 7.5 percent and inflation to decelerate to 15½ percent by year’s end.

The external low-income country debt sustainability analysis (LIC DSA) reveals that Afghanistan has a high risk of debt distress, underlining the need for debt relief under the HIPC Initiative and the Multilateral Debt Relief Initiative (MDRI).1,2 Under the alternative scenario which assumes full delivery of HIPC, MDRI, and beyond-HIPC debt relief at the completion point of the HIPC Initiative, debt burden indicators fall below the country-specific indicative thresholds. The public debt LIC DSA suggests that Afghanistan’s overall public sector debt dynamics will remain manageable, despite rapid increase in domestic borrowing toward the end of the projection period. Further fiscal consolidation (or more external grants) should be considered in order to stabilize the debt burden indicators.

A. Introduction

1. The external and public debt sustainability analyses presented here are based on the common standard LIC DSA framework, with a modification to the stress tests to address the volatility of aid inflows.3,4 The DSA presents the projected path of Afghanistan’s external and public sector debt burden indicators, and draws some conclusions on the forward-looking sustainability of debt. The baseline scenario assumes continued delivery of HIPC interim debt relief during the life of the PRGF arrangement (no irrevocable debt relief at completion point), while an alternative scenario assumes the delivery of debt relief, including MDRI and beyond-HIPC debt relief, at the HIPC completion point, which is assumed to occur in mid-2009.

2. Two key changes to the baseline scenario explain the differences between the current analysis and the previous DSA included in the HIPC decision point: (i) aid inflows are significantly higher (about seven percentage points of GDP higher in the long-term), reflecting the upward revision to the size of the donor-funded external budget; (ii) real GDP growth is projected to average about one percentage point more in the long-run than at the time of the decision point, reflecting the higher aid flows and public investment coupled with the direct and indirect effects of the Aynak copper mine.

B. Baseline Scenario

3. Average annual real GDP growth is expected to moderate over the projection period, from 7.8 percent in 2008/09–2012/13 to the long-run average of 6.1 percent in 2013/14–2030/31. This pattern reflects the projected decrease in the investment-to-GDP ratio from short-to medium-term exceptional levels of around 30 percent, to a still high, yet markedly lower, long-term level (around 17½ percent). The latter is necessary to sustain an acceptable pace of growth in per capita consumption. Continued donor support for reconstruction and public investment is likely to be the main driving factor during the earlier years. The contribution of donor-led investment is expected to decline over the medium-term, with private investment gaining in prominence and eventually playing the lead role. Inflation is projected to ease over time from about 20.7 percent in 2007/08 to 5 percent starting in 2012/13 and during the remainder of the projection period. The nominal exchange rate is assumed to remain stable over the projection period, leading to a continued real exchange rate appreciation.

4. Continued macroeconomic stability is predicated on sustained fiscal discipline, with the government’s overall deficit (including grants) improving from a peak of 3.0 percent of GDP in 2009–10 to about 1.2 percent of GDP by the end of the projection period. Underlying this, revenues are assumed to increase gradually from 7 percent of GDP in 2007/08 to 11.6 percent of GDP in 2028/29, while expenditures (channeled through the national budget) are expected to decline in the short term before rising gradually to just over 19 percent of GDP with the mounting costs of maintaining new investments.

5. The external position is expected to remain comfortable with continued donor support and increasing mining-related FDI over the medium-term. Over the long-term, the current account deficit (excluding grants) is projected to decrease gradually from 66.9 percent of GDP in 2007/08 to just under 9 percent in 2028/29, in line with an improvement in the trade balance relative to GDP as imports relating to post-war reconstruction decline and the export sector, in particular mining, rebounds. The negative effects of the continued real exchange rate appreciation on exports and real economic activity are expected to be offset by continued productivity gains. External grants are expected to remain the predominant form of financing, but would decline relative to GDP from 63.2 percent in 2006/07 to 6.9 percent in 2028/29.5

C. Debt Sustainability Analyses

External Debt Sustainability

6. The baseline scenario indicates that Afghanistan has a high risk of debt distress (Table 1 and Figure 1). Although the NPV of external debt-to-GDP ratio remains well below the threshold (30 percent), the NPV of external debt-to-exports ratio remains above the 100 percent threshold until 2010/11, reflecting Afghanistan’s very narrow export base. As exports are expected to grow in US$ terms at 15 percent on average over the projection period, the NPV of external debt-to-exports ratio declines rapidly and is expected to approach 20 percent toward the end of the projection period. The relatively comfortable debt service ratios (to export and revenue) reflect in part the very high degree of concessionality on the outstanding stock of debt from multilaterals (mainly on IDA or IDA-like terms).

Table 1.

Country: External Debt Sustainability Framework, Baseline Scenario, 2005/06-2028/29 1/

(In percent of GDP, unless otherwise indicated)

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Source: Staff simulations.

Includes both public and private sector external debt. Debt service figures are presented on a cash basis and do not take into account debt relief to be delivered at the HIPC completion point (currently projected for March 2009) and therefore may differ from those in Table 4 of the accompanying Staff Report.

Derived as [r - g - p(l+g)]/(l+g+p+gp) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and ρ = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Assumes that NPV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the NPV of new debt).

Figure 1.
Figure 1.

Afghanistan: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2008/9-2028/29

Citation: IMF Staff Country Reports 2008, 229; 10.5089/9781451800401.002.A003

Source: Staff projections and simulations.

7. The alternative scenarios and stress tests indicate that the evolution of Afghanistan’s external debt position is subject to considerable vulnerabilities (Table 2, Figure 1). Most debt indicators deteriorate significantly under the bound tests (temporary shocks) and in the face of a permanent worsening in the terms of new borrowing. The debt ratios also deteriorate significantly under the historical scenario, where the main macroeconomic variables are kept at their historical averages over the projection period.6 This reflects mainly a projected improvement in the current account excluding grants—which is not captured in the historical scenario—from higher export growth, higher mining-related FDI, and a slow-down in imports related to post-war reconstruction.

Table 2.

Country: Sensitivity Analyses for Key Indicators of Public and Publicly Guaranteed External Debt, 2008/09-28/29

(In percent)

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Source: Staff projections and simulations.

Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.

Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline., while grace and maturity periods are the same as in the baseline.

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels).

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent.

Applies to all stress scenarios except for A2 (less favorable financing) in which the terms on all new financing are as specified in footnote 2.

8. The bound tests and the alternative scenarios underscore the vulnerability posed by Afghanistan’s heavy reliance on official transfers. If official transfers in 2009/10–-2010/11 were 25 percent lower than in the baseline, the NPV of external debt-to-exports would rise to 276 percent by 2010/11 and would not fall below the threshold until 2019/20.

9. The bounds tests also demonstrate that an improvement in Afghanistan’s external debt indicators depends heavily on an expansion of its very narrow export base. If export growth during 2009/10 and 2010/11 were to fall to a level one standard deviation below the historical average, the NPV of external debt-to-exports would rise to 184 percent in 2010/11 and would not fall below the 100 percent threshold until 2015/16.

10. Debt relief under the HIPC and Multilateral Debt Relief Initiatives (MDRI) is expected to significantly improve Afghanistan’s debt situation. Assuming the full delivery of HIPC and MDRI assistance at completion point, all three debt-burden indicators (NPV of debt-to-GDP ratio, NPV of debt-to-exports ratio, and debt service-to-exports ratio) would fall significantly below the indicative thresholds.

Public Sector Debt Sustainability

11. Under the baseline scenario, Afghanistan’s public debt (including domestic debt) is expected to decline steadily relative to GDP until 2012/13, before increasing thereafter (Table 3 and Figure 2). In the short term, the government is expected to draw down its significant deposits at Da Afghanistan Bank (the central bank) which, together with generous grant financing, explains the initial decline in the public debt ratios. However, the availability of external grants (channeled through the national budget) is expected to decline as a share of GDP over the projection period, from a high of around 9.5 percent of GDP in 2008/09 to about 6.2 percent in 2028/29.

Table 3.

Alghanistan: Public Sector Debt Sustainability Framework, Baseline Scenario, 2005/06-2028/29

(In percent of GDP, unless otherwise indicated)

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

[Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.]

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium and long-term debt.

Historical averages and standard deviations are derived over the past 5 years.

Figure 2.
Figure 2.

Afghanistan: Indicators of Public Debt Under Alternative Scenarios, 2008/09-2028/29 1/

Citation: IMF Staff Country Reports 2008, 229; 10.5089/9781451800401.002.A003

Source: Staff projections and simulations.1/ Most extreme stress test is test that yields highest ratio in2/ Revenue including grants.

12. The medium-to longer-term decline in external grant financing is expected to be offset by a combination of increased revenue and domestic borrowing. By 2028/29, the domestic debt is projected to reach 11.3 percent of GDP from a zero base in 2008/09, under the expectation of a gradual development of the domestic debt market. While the level of public debt over the projection period will not endanger fiscal sustainability, the average long-run primary deficit, at 1.1 percent of GDP, would be above the level that stabilizes the debt to GDP ratio.

13. Debt dynamics remain manageable under the various stress tests, but nonetheless vulnerable to a reduction in foreign grants. (Table 4 and Figure 2). The most extreme stress test (scenario that produces the largest deterioration in a debt burden indicators after 10 years) is linked to a 10 percent of GDP shock in debt creating flows. The above scenario could be interpreted as a negative shock to foreign grants, which confirms the vulnerability posed by the heavy reliance on official transfers that is seen in the external DSA. The no reform scenario (no improvement in the primary balance) also produces significant deterioration in all debt burden indicators, which highlights the need for adherence to the medium-term fiscal framework.

Table 4.

Afghanistan: Sensitivity Analysis for Key Indicators of Public Debt 2008/09-2028/29

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

Assumes that real GDP growth is at baseline minus one standard deviation divided by the square root of 20 (i.e., the length of the projection period).

Revenues are defined inclusive of grants.

14. As in the external DSA, debt relief under the HIPC and Multilateral Debt Relief Initiatives (MDRI) is expected to significantly improve Afghanistan’s public debt situation.

D. Conclusion

15. The LIC DSA reveals that Afghanistan continues to face a high risk of debt distress. The baseline path of the NPV of external debt-to-exports remains above the LIC DSA threshold (100 percent) until 2012/13, while the sensitivity analysis indicates that Afghanistan’s external debt sustainability is heavily dependant on the continued availability of official grant financing supplemented by highly concessional loans. The emerging role of domestic debt financing over the longer term does not pose an immediate risk to the debt outlook, but it does underscore the need for a cautious approach to fiscal policy as the government builds the domestic revenue base, and given the uncertainties about the pace at which donor expenditures would be brought on budget. While the level of public debt remains manageable over the projection period, the government will need additional grant financing and/or fiscal consolidation to contain the debt dynamics beyond that horizon.

1

These DSAs have been produced jointly by Bank and Fund staffs.

2

Usually, the country-specific indicative thresholds for the LIC DSA are determined using a three-year average of the country’s rating under the World Bank’s Country Policy and Institutional Assessment (CPIA). However, the CPIA for Afghanistan is available only for 2006 and 2007. In both years, Afghanistan was rated a weak performer. Accordingly, the thresholds for the LIC DSA are 30 percent for the NPV of debt-to-GDP ratio, 100 percent for the NPV of debt-to-exports ratio, and 15 percent for the debt service-to-exports ratio.

3

See “Debt Sustainability in Low-Income Countries: Proposal for an Operational Framework and Policy Implications” (http://www.imf.org/external/np/pdr/sustain/2004/020304.htm and IDA/SECM2004/0035,2/3/04) and “Debt Sustainability in Low-Income Countries: Further Considerations on an Operational Framework and Policy Implications” (http://www.imf.org/external/np/pdr/sustain/2004/091004.htm and IDA/SECM2004/0629, 9/10/04).

4

The volatility of aid flows over the past five years makes a shock to non-debt creating flows based on historical data difficult to interpret. Hence, we follow the approach in the 2007 LIC DSA of assuming grant financing 25 percent below the baseline projection (or 12.5 percent in the combined test) for 2009/10-10/11. (See “The Decision Point Document on Assistance to the Islamic Republic of Afghanistan under the Enhanced Initiative for Heavily Indebted Poor Countries,” IDA Report No. 39922-AF and IMF Country Report No. 07/253).

5

Official borrowing is assumed to continue to be on concessional terms.

6

Due to lack of data, five-year averages are used rather than the standard ten-year averages.