2011 Article IV Consultation and Request for a Three-Year Arrangement Under the Extended Credit Facility-Staff Report; Staff Supplement-A Joint World Bank/IMF Debt Sustainability Analysis; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Islamic Republic of Afghanistan
Afghanistan has made important achievements in recent years. The 2011 Article IV Consultation highlights that authorities have taken steps to lay the foundation for economic stability and growth, despite a very difficult security situation and the challenges associated with building political and economic institutions. Directors agreed that the Extended Credit Facility (ECF)-supported program, accompanied by a technical assistance agenda, provides an appropriate framework for addressing the considerable challenges lying ahead and a basis for continued engagement with the donor community.
Afghanistan has made important achievements in recent years. The 2011 Article IV Consultation highlights that authorities have taken steps to lay the foundation for economic stability and growth, despite a very difficult security situation and the challenges associated with building political and economic institutions. Directors agreed that the Extended Credit Facility (ECF)-supported program, accompanied by a technical assistance agenda, provides an appropriate framework for addressing the considerable challenges lying ahead and a basis for continued engagement with the donor community.
I. Introduction: Afghanistan’s Main Challenges
1. Afghanistan has made important achievements in recent years. The authorities have taken steps to lay the foundation for economic stability and growth, despite a very difficult security situation and the challenges associated with building political and economic institutions (Box 1). As a result, economic activity has been robust, with real GDP growth averaging more than 10 percent annually over the past five years. The government has increased revenue collection to 11 percent of GDP in 2010/11 from 8 percent in 2008/09, though current collection levels cover only about two-thirds of central government operating expenditures and less than 20 percent of total public spending (defined as central government spending plus off-budget donor spending).1, 2
The Authorities’ Response to Past Fund Advice
Past Fund advice focused on tax reforms toward a more efficient tax system, including transforming the Business Receipt Tax (BRT), a cascading sales tax, strengthening the capacity of the revenue administration, enhancing the monetary policy instruments by expanding the role of capital notes, and strengthening banking supervision in light of identified deficiencies in risk management at financial institutions.
The authorities have made progress toward a more efficient tax system. A main achievement was transforming the BRT, a cascading sales tax, into a broad-based consumption tax. Continued engagement in revenue administration has strengthened the capacity of the Afghan revenue and customs departments. These measures have included changes to the income tax law (including the collection of BRT on imports at the border), a strengthening of the large taxpayers office, and a tighter monitoring of fuel imports. Most recently, the ministry of finance has piloted a one-stop-shop customs border post in cooperation with other ministries, following Fund advice.
The authorities have strengthened the public financial management (PFM) systems. PFM reforms are essential for increasing the transparency and effectiveness of public spending as well as enhancing fiduciary controls. At the 2010 Kabul Conference, international donors restated commitments to bring 50 percent of development aid on budget. The government in turn pledged to strengthen PFM systems to facilitate such a transfer. Therefore, continued achievements in program budgeting and other PFM systems are an integral part of the Kabul process. At present, treasury, budgeting, and tax administration are fully functional, and the Afghanistan Financial Management Information System (AFMIS) has been rolled out to all provinces and line ministries.
The authorities have also made some progress towards enhancing monetary policy operations. The use of capital notes by the central bank has increased, but more is needed to contain inflation. The supervisory capacity of the central bank did not keep pace with a fast-growing financial sector.
2. Some poverty indicators have improved over the last decade, but Afghanistan remains one of the poorest countries in the world. Per-capita income was US$530 in 2010/11. The national poverty rate was 36 percent in 2007/08, as measured by the National Risk and Vulnerability Assessment, and the rates are higher in rural and mountainous areas that account for about 80 percent of the population. Afghanistan ranks in the bottom 10 percent of countries with the lowest score in the 2010 UN Human Development Index. The authorities have made inroads toward achieving some of the Millennium Development Goals. For example, child mortality was reduced and school enrollment increased, albeit from very low levels—the enrollment rate for primary schools is less than 40 percent. The latest Annual Progress Report also acknowledges that achievements in some areas are below expectations: more than 40 percent of children under the age of five are underweight and progress in increasing access to potable water and sanitation remains slow. The literacy rates for men and women aged 15 to 24 are 51 and 22 percent respectively. Overall, the low execution rate of only 40 percent of the development budget reflects a generally limited absorption capacity, and impedes more rapid progress toward poverty reduction.
3. Poor governance and corruption are endemic and take a heavy toll. With decades of war and extreme poverty and the absence of social safety nets, localized patronage has become reinforced as the main element of social protection. The emergence of a vibrant illicit narcotics sector has further distorted economic incentives Box 2). This has many negative consequences for the evolution into a rules-based market economy, including significant rent-seeking behavior and high levels of crime and corruption.
4. Last year’s crisis at Kabul Bank, the largest bank in Afghanistan, exposed the country’s serious governance problems, and highlighted the devastating effects of endemic corruption. The initial intervention by the central bank and a full deposit guarantee prevented a full-blown banking crisis (Box 3). However, the subsequent crisis management was slow and somewhat reluctant to tackle some important but politically difficult issues such as asset recovery and filing charges against the main architects of the fraud. As a result, the financial system has been severely weakened and is not playing its role in facilitating private sector-led growth.
5. Over the coming three to five years, Afghanistan will face additional challenges as the international military presence is wound down and the government has to take over spending currently financed by donors. Foreign troops are expected to gradually withdraw by 2014. As a result, Afghanistan’s security forces will have to take over more responsibility, leading to higher spending. At the same time, the government may lose revenues related to spending by foreign troops in Afghanistan. Moreover, it is likely that the donor footprint will gradually shrink, with total grants projected to decline from an estimated more than 40 percent of GDP in 2010/11 to less than 30 percent of GDP in 2013/14. These developments will weigh heavily on economic activity and require difficult decisions to ensure fiscal survival.
The Illicit Economy in Afghanistan
Afghanistan’s illicit sector is estimated to be in the range of one third to one half of the country’s GDP. The largest illicit activities in Afghanistan are narcotics and corruption.1 Smuggling, fraud, extortion and arms trading are also known to generate signification proceeds. These activities are all crimes in Afghanistan.
Opium exports2 were US$2.8 billion (about 23 percent of GDP) in 2010, and are estimated to reach up to US$4 billion in 2011.3 Opium from Afghanistan supplies about 90 percent of the US$68 billion global retail market in opiates.
Opium cultivation provided income for 5 percent of the Afghan population in 2011.4 The decision to cultivate opium is strongly correlated with conflict and access to markets; however, there is also a price correlation mainly with the subsistence crop wheat. In addition, cannabis is extensively cultivated in Afghanistan and yields income of up to US$94 million.5
The large profits earned by producers and traffickers are spent both inside and outside the country. In addition to funding regular consumption and investment spending, they are also used to buy patronage, influence and services, to reinvest in illicit cultivation and to finance investments outside the country. Antigovernment elements and terrorist networks often collect a share of narcotics revenue akin to a tax (ushur).
Cross-border flows related to the opiate economy are not recorded in the official balance of payments statistics, and are reflected as unrecorded inflows (errors and omissions) or they finance equally unrecorded imports, i.e., smuggling, over and above the estimates included in the balance of payments.
Afghans paid an estimated US$2.5 billion in bribes in 2010 (20 percent of GDP).6 One out of every two Afghans is thought to have to pay at least one bribe to a public official per year, with the request coming from the official more than 56 percent of the time.7
The scale of corruption, combined with the large illicit sector, has undermined governance and development in the country.
1 Afghanistan is a signatory to all three international drug control conventions as well as the United Nations Convention against Corruption.2 The International Monetary Fund does not include the illicit sector in official estimates of GDP, or in other macroeconomic measures. The drug economy is excluded from the output and prices measurements of “Table 1. Islamic Republic of Afghanistan: Selected Economic Indicators,” where opium production is listed as a memorandum item.3 United Nations Office on Drugs and Crime (UNODC) and Islamic Republic of Afghanistan Ministry of Counter Narcotics, Afghanistan Opium Survey 2011, Summary Findings, October 2011, p 4. 2011 export value is Fund staff estimate.4 United Nations Office on Drugs and Crime, World Drug Report 2010.5 United Nations Office on Drugs and Crime, Afghanistan Cannabis Survey 2009.6 UNODC, “Corruption in Afghanistan, Bribery as Reported by the Victims,” January 2010. Note: This survey did not deal with grand corruption it only looked at bribes under US$1,000 (those likely to affect Afghans on a daily basis). Total payments related to corruption therefore are likely to be far higher.7 Ibid. p. 4.
The Kabul Bank Crisis
Based on evidence available so far, it appears that Kabul Bank shareholders and top management had abused their position to engage in criminal activity, including fraud and money laundering, by manipulating the bank’s loan book. Concerns over the soundness of Kabul Bank caused a run on the bank in early September 2010 during which the bank lost about half of its US$1.3 billion deposits. With one-third of the system’s assets of US$4 billion, the crisis threatened the stability of the financial system. The authorities removed the management of the bank, putting the bank into conservatorship, and guaranteed all deposits. This helped stem the initial panic and stopped the run. When the dust had settled, the government had to shoulder US$825 million for the cost of the lender-of-last-resort facility loans that covered the deposit guarantee (about 5 percent of GDP).1 Kabul Bank was subsequently put into receivership, revoking shareholders’ rights altogether.
Aside from the fiscal costs, the Kabul Bank crisis has had a negative impact on intermediation, as it had by far the largest and most effective branch network in the country and an effective payments system. These helped bring individuals into the formal sector and supported the government’s program of automating employee records and salary payments.
Kabul Bank has been split up into a good bank and a bad bank. The bank’s deposits and good assets were transferred to a bridge bank, New Kabul Bank. For the time being, New Kabul Bank cannot extend loans and is envisaged to be privatized in 2012. The bad assets have been retained by the receiver, appointed and overseen by the independent Financial Dispute Resolution Commission (FDRC). Based on current estimates, about US$935 million (principal and interest) in the asset portfolio are sought for recovery. This amount is likely to increase as additional illegal expenses and other charges continue to be discovered by an ongoing audit. The receiver, the FDRC, the central bank, and the Attorney General, have begun the work on asset recovery and sorting out the disputed assets with the help of the audit firm. In parallel, the government has started an investigation of criminal misconduct and has brought formal charges in nine cases so far.
The Kabul Bank crisis has magnified the risks of rapid banking sector growth with inexperienced supervision and weak rule of law. Moreover, it has undermined confidence in the banking sector (preference for cash increased and deposit growth came to a halt) and further overburdened banking supervision. On the other hand, it has provided the authorities with valuable lessons and experience, if they are able to build on them. Only fit and proper persons should be allowed to own and manage banks and prudential norms should be diligently enforced.
1 To cover the hole created in the central bank’s balance sheet by the issuance of the lender-last resort loan to Kabul Bank, the ministry of finance issued a promissory note, which would yield a regular flow of payments to the central bank over an eight-year period. The annual payments on this promissory note have to be approved by Parliament as part of the budget.
6. Against this background, the authorities seek Fund support under the ECF for their three-year economic program. In the near term, they are focusing on resolving the problems that emerged from the collapse of Kabul Bank and ensuring the stability of the banking system. In parallel, they intend to proceed with key reforms in revenue and expenditure management, and strengthen the business environment for private sector-led growth, while improving social conditions and protecting the poor. None of these reforms will succeed in the long term unless the authorities are able to deliver on their plans to enhance governance, address endemic corruption, and prevent economic and financial crimes.
7. The authorities’ program provides a basis for continued engagement with donors on Afghanistan’s development strategy, including at the December 5 Bonn Conference. Afghanistan has extensive development needs in building its physical and institutional infrastructure, and requires continued support in transforming its economy into a competitive and vibrant market-based system. Donor assistance and a new ECF arrangement can help the government make progress toward Afghanistan’s development objectives. However, such support needs to be matched by bold domestic reform, including further bolstering of government revenues, and strengthening governance, not least in the financial sector.
8. The program is subject to two significant types of risks. First, there are risks that program implementation falls short, especially due to inadequate political will or capacity constraints, undermining macroeconomic stability and possibly leading to further large-scale economic crime and corruption. Second, exogenous shocks, such as deterioration in the security situation, regional instability, trade disruptions, or volatility in the agriculture sector, could thwart the success of the program, even if fully implemented.
II. Recent Developments: Growth Amidst Civil Strife
9. A standoff between the legislature and the executive over the legitimacy of last year’s parliamentary elections has stymied the political process. President Karzai has not yet been able to confirm his cabinet in full and a number of legislative acts have been significantly delayed. Recently, a compromise has been reached, and Parliament has restarted its work, although individual parliamentarians are still protesting.
10. The security situation remains precarious and holds back economic activity.
Ongoing conflict affects the majority of Afghans. While the campaign against anti-government elements in the South has reportedly made progress, the area remains broadly insecure. Also, there are some signs that anti-government elements in the central and eastern parts of the country are gaining power, while attacks in Kabul have increased in recent months.
11. Economic growth continues to be strong, but inflation has ratcheted up.3 Real GDP growth exceeded 8 percent in 2010/11, thanks to buoyant manufacturing and services. In 2011/12, growth is expected to slow to less than 6 percent, due mainly to a drought. Headline and core inflation have moderated slightly, but remain relatively high at about 10 percent year-on-year in September, owing to an expansionary monetary policy and higher international food and fuel prices. Confidence in the banking sector is low, as reflected in listless deposit growth since the September 2010 collapse of Kabul Bank. Liquidity remains high because there are few lending opportunities (Box 4). Favorable external current account developments have allowed a further buildup of international reserves to about seven months of imports. Donor support was strong, and exports were boosted by coalition forces purchases of domestic goods and services. The Afghani has depreciated by 5 percent against the U.S. dollar since late March, but has stayed broadly stable in nominal and real effective terms over the past year.
The Evolution of the Afghan Banking System and its Regulation
Modern banking, and the credit culture that accompanies it, is new to Afghanistan. For centuries, and to this day, the population has relied on informal money service providers to transfer cash and provide limited lending and deposit services. These so-called hawala dealers operate on the basis of personal relationships. The central bank currently licenses and regulates 320 money service providers, and some of these have several hundred agents.
Since 2002, the government and the international community have promoted the formalization of financial services. This encouraged a rapid growth of the formal banking sector with assets and deposits increasing over 50 percent annually since 2006, as banks competed vigorously to collect deposits of newly employed civil servants and to intermediate the inflow of foreign aid. Such rapid growth has generally been problematic wherever it has occurred.
Aside from five branches of foreign banks, which largely service the donor and international sector, Afghanistan’s 12 domestic banks struggled to develop normal banking practices and skills. The legal and accounting infrastructure to support nonrelationship lending was nonexistent, weak, or untested, as were the procedures and skills of the banks’ staffs. An ineffective judiciary and corruption hamper establishing or recovering collateral and enforcing contracts. In a country where most births are unregistered, normal documentation of all sorts is generally nonexistent. In such an environment, bank lending tends to be based on relationships rather than loan (risk) assessments. Indeed, many local banks have been established around business groups and loans are being channeled to related businesses. But when investments go wrong, the interests of the groups tend to supersede those of depositors. As the banking system in Afghanistan grew in size and political influence, asset quality and governance suffered.
Supervisory capacity was almost nonexistent and has struggled to catch up. After 30 years of protracted war it was almost impossible to find enough supervisors and regulators, even with minimal education. Talented and motivated young Afghans were and are being recruited but currently lack experience. In recognition of this problem the central bank issued a moratorium on new licenses and introduced caps on lending for the many low-rated banks. Critically, banking supervision has lacked political support for enforcing compliance with rules and regulations. This failure in governance must be addressed so that a robust financial sector can support the country’s long-term development objectives.
12. Fiscal developments were characterized by strong revenue performance combined with expenditure restraint. Revenue effort increased by 0.7 percent of GDP between 2009/10 and 2010/11, following the introduction of tax and administrative measures in early-2009 and the consolidation of earlier reforms; and continue to outperform in 2011/12 with a 25 percent year-over-year increase for the first half of the year, while operating expenditures grew by 27 percent over the same period. Security spending rose by 1.3 percent of GDP from 2009/10 to 2010/11 as recruitment to Afghan National Security Forces grew by over 30 percent. Nonsecurity operating spending dropped by 0.7 percent of GDP between 2009/10 and 2010/11, notwithstanding the advance of civil service pay and grade reforms and the hiring of additional teachers. As a result, the operating budget deficit excluding grants remained broadly stable at 4 percent of GDP. Development spending fell by 1.7 percent of GDP due to continued low execution rates stemming from capacity constraints, difficulties in public financial management, and a worsening security situation.
III. Policies to Put Afghanistan on a Path of Growth and Sustainability and Strengthen the Financial Sector
13. The authorities’ program aims to lay the basis for fiscal and external sustainability as well as financial sector stability.
The authorities recognize that restoring governance in the banking sector is a necessary condition to safeguard economic stability and convince donors to stay engaged, and they have made progress on the prior actions that address the issues that have come to the fore in the aftermath of the Kabul Bank crisis.
In the context of the Article IV consultations, discussions focused on a strategy to move toward fiscal and external sustainability and maintain macroeconomic stability as a precondition for progress towards Afghanistan’s broader development objectives.
Against this background, the authorities have put forward an economic program for the period 2011/12 through 2013/14 that deals with the aftermath of the Kabul Bank crisis, strengthens the financial sector, and initiates reforms to ensure fiscal survival as a prerequisite for fiscal sustainability.
A. Prior Actions: Strengthening Governance and the Financial Sector
14. The authorities have taken the necessary steps to deal with the immediate aspects of the Kabul Bank crisis. The bank has been put under receivership, its license has been revoked, and shareholders’ rights and interests have been extinguished. The authorities have established a bridge bank, New Kabul Bank, and developed a business plan to put it up for sale in 2012. An audit of Kabul Bank is ongoing to establish the amounts owed by the bank’s shareholders and related parties, and to provide information for any legal actions the government may take; the inception report and the interim report have been delivered. After a slow start and while available administrative, civil, and international tools have yet to be fully applied, about US$75 million in cash (of which US$34 million from regular performing loans) and US$153 million in assets available for sale were recovered as of October 30, 2011 out of an estimated total amount of assets sought for recovery of US$935 million (of which US$80 million are regular performing loans). In parallel, repayment agreements of US$270 million have been signed, with a repayment period of three to nine years.4 The ministry of finance has issued an eight-year bond to recapitalize the central bank for the costs of the Kabul Bank crisis, and parliament approved the first amortization payment on October 15, 2011.
15. The authorities have also taken actions in the case of Azizi Bank, the second largest bank. Following an intensive on-site examination of Azizi Bank, the supervisor identified a number of areas needing improvement. An audit by a reputable international audit firm is ongoing and will provide information to the bank’s management and the supervisor on the degree with which laws or regulations were breached and how to further strengthen the bank. The final audit report is expected in the first quarter of 2012. In light of the on-site examination and the preliminary audit findings, the bank and the supervisor have agreed on a path for increasing the bank’s capital and reducing its large exposures. The bank’s largest shareholder has stepped down as chairman of the board to address conflict-of-interest problems, as have the large shareholders of other banks in accordance with central bank regulations. Continued vigilant supervision will be needed to ensure that banks fully comply with the banking law and regulations.
B. Addressing Social Needs While Moving Toward Fiscal and External Sustainability
16. Transition and transformation will pose significant challenges over the coming three to five years. The growth outlook will be shaped by how these prospective developments play out and what they imply for public investment and propoor spending. The speed at which the authorities can move toward fiscal and external sustainability will depend on the future path of revenue efforts and donor engagement. There is also a trade-off with the pace of progress toward Afghanistan’s development objectives.
17. Real GDP growth over the three-year program period (2011/12 to 2013/14) will be significantly lower than the average of 10 percent over the past five years. The slowdown will be driven by the withdrawal of foreign troops and the decline in grant-financed spending. A projected recovery in agriculture from this year’s drought could temporarily boost growth in 2012/13. In addition, the nascent mining sector could also provide a positive growth impulse and would be associated with significant foreign direct investment. To fully realize the potential from mineral resources, a strong fiscal regime needs to be in place that ensures good governance. The World Bank and the Fund can advise in this area.
18. Over the medium term, fiscal policy and the level of donor engagement will be important factors driving growth. The baseline scenario for the medium-term macroeconomic framework describes a cautiously optimistic outlook. Grant-financed spending declines as a share of GDP after 2012/13, leading to a slowdown of real GDP growth to a range of 4-6 percent annually beyond 2013/14. Fiscal revenues receive a boost from the mining sector and the introduction of a VAT starting in 2014/15, reaching 15 percent of GDP in 2017/18. Expenditures are expected to average 25-26 percent of GDP, assuming a gradual and restricted takeover of externally financed expenditure, and a very conservative level of operations and maintenance (O&M) spending for projects handed over by donors to the government. Annex I explores alternative scenarios. For example, by assuming a faster decline in grants and higher operations and maintenance spending, public investment is compressed, and real GDP growth could be as low as 2 percent per annum over the medium term.
19. The authorities emphasized their commitment to the Afghanistan National Development Strategy (ANDS) as their overarching policy framework. The ultimate objective of the ANDS is to generate sustained, inclusive growth that reduces the high incidence of poverty. The authorities noted that poverty and limited opportunities outside the illicit sector provide a fertile ground for insurgent activities. The authorities’ strategy is to ensure that economic growth is broadly based and beneficial both across different tiers of society and across different regions of the country. Therefore, social programs have an important place among the government’s fiscal priorities. The transition and transformation process will affect how the government can pursue its ANDS objectives.5
20. The international presence has underpinned the Afghan economy beyond security. Quantifying the impact with any precision is difficult because of a lack of data on spending by foreign troops in Afghanistan. Available evidence suggests that consumption spending in Afghanistan by foreign troops, in combination with military spending on civilian activity, is likely to have added about 2-3 percentage points to real GDP growth in recent years. The planned withdrawal by 2014 is thus expected to have an adverse net impact on growth, reducing growth by an estimated 2½ percentage points over the next three years. In addition, external inflows will be reduced, negatively affecting the international reserves position. Some offset could come from a reversal of “Dutch disease” effects associated with large-scale foreign inflows. Indeed, Afghanistan will need to gain competitiveness to facilitate the necessary external adjustment. An important factor in this adjustment process will be how much of the spending by the military and donors in the past has fallen on nontraded goods, and what the adverse demand shock for the nontraded sector implies for the real exchange rate. In the end, the adjustment could benefit the traded sector, albeit at the cost of rising foreign currency-denominated debt service payments.
21. The expected gradual decline of donor assistance and activity over the medium term will further complicate policy-making. In 2010/11, the overall fiscal deficit (excluding grants) was 10 percent of GDP. If we include estimated off-budget development spending by donors, the fiscal deficit could be as high as 23 percent of GDP. Aside from donor support, Afghanistan has very limited scope for market financing. Of course, once domestic government securities are available, local banks could provide some financing, but this would be insufficient to replace external grant financing and there are clear limits from the need to preserve fiscal sustainability. Moreover, the government will have to shoulder security spending currently paid for by the international community as well as the recurrent cost implications of donor-financed infrastructure projects.6 Again, incomplete data on the local content of donor spending prevents precise estimates of these cost implications. Nevertheless, Annex II discusses possible trajectories for key fiscal aggregates.
22. There will be a struggle for fiscal survival for years to come, with fiscal sustainability being a more distant goal. The authorities welcomed donors’ intention to channel an increasing share of their support through the budget, even if the overall envelope would shrink. They noted that donor support above and beyond the working assumption would provide fiscal space for propoor and development spending which is severely constrained in the current medium-term budget framework. They stressed that achieving fiscal sustainability, defined as revenues covering operating expenditures, remains their fiscal goal, though this has been complicated by the drawdown of the international presence in Afghanistan. Under the program, the authorities target the operating budget balance excluding grants with a view to keeping the deficit broadly unchanged.
23. The expected decline in donor inflows also has implications for external stability. The stability of the exchange rate in the medium to long term will depend critically on the continued flow of donor assistance. In 2010/11, the current account deficit excluding official transfers registered 40 percent of GDP. Foreign grants estimated at just over 40 percent of GDP financed this deficit. The other side of the coin is that a large share of grants—estimated at 70 percent—is spent on imports of goods and services; thus grants do not only finance the trade deficit, they also contribute to it. A decline in grant inflows and inflows related to spending by foreign troops would put pressure on the exchange rate and require a corresponding adjustment of the macroeconomic policy mix, including the exchange rate. Given the uncertainties regarding the local component of grants and military spending, it is difficult to estimate precisely the impact of the withdrawal on the exchange rate. The authorities have skillfully created international reserves buffers to manage pressures in the short term. However, they will need to maintain their flexible exchange rate regime to allow for the necessary external adjustment to occur.
24. The shrinking of the donor footprint will ultimately need to be met with competitiveness gains. To ensure that external adjustment can occur in an orderly fashion, a gradual and well-planned reduction in foreign aid would allow the exchange rate to adjust without undermining macroeconomic stability.7 Competitiveness gains will also need to come from strengthening the business environment (Box 5). Areas where improvements can be made include: investor protection; property rights; collateral and property registration; enforcement of contracts; free trade across borders; access to financing; and general red tape combined with corruption. For instance, Transparency International’s Corruption Perception Index for Afghanistan in 2010 was 1.4 on the scale from 0 (highest perception) to 10 (lowest perception), making it second to worst on the ranking of 178 countries. Moreover, the government needs to adequately support the development of small and medium-sized businesses, which can be a source of job creation, in addition to promoting large-scale mining enterprises. The authorities caution that the challenging security situation is a key obstacle to quick wins in the business environment.
25. Afghanistan remains at high risk of debt distress, recent debt relief notwithstanding. Debt relief under the Heavily Indebted Poor Countries initiative and the Multilateral Debt Relief Initiative reduced the net present value (NPV) of Afghanistan’s debt-to-GDP ratio from 12 percent to 6 percent in 2009/10. Nevertheless, risks to the macroeconomic outlook and large financing needs, currently met by donor support, underscore the importance of substantial and long-term grant financing, in combination with a strong reform agenda and progress in security and governance. Should donors decide to reduce aid rapidly, security fail to stabilize, or delays arise in structural reforms and governance improvements, Afghanistan’s debt burden could become unsustainable (see the accompanying debt sustainability analysis).
26. Public financial management reforms are expected to improve the execution of the development budget. Low execution rates reflect capacity constraints, unrealistic multiyear budget and spending patterns with significant front-loading of spending, and poor procurement planning and contract management. The government has developed a road map to address most of these issues and its implementation will improve the execution of development projects. The overarching aim is to facilitate the transfer of additional aid through the development budget as envisaged under the Kabul Process.
Exchange Rate Assessment
Afghanistan’s exchange rate arrangement is classified as floating. A quantitative exchange rate assessment using CGER-based methodologies is rendered difficult by data constraints and uncertainty about medium-term current account developments, including the prospective path for donor financing and earnings from mineral resources.
Since 2004/05, exports have risen steadily, and the current account deficit excluding grants has declined from 71 percent of GDP in 2006/07 to below 40 percent in 2010/11. In August 2011, the Afghani was slightly below its five-year average in real terms, reflecting a spike in 2008 (due to high domestic inflation) and a decline in the following period.
Structural impediments seem more binding for Afghanistan’s competitiveness than exchange rate developments. The World Bank’s Doing Business 2012 indicators rank Afghanistan 160th out of 183 countries (falling from 154th place in the previous year), diagnosing particular challenges in investor protection. In 2010, the World Bank’s Country Policy and Institutional Assessment index, measuring the quality of public policies and institutions, assigned a rating of 2.6 to Afghanistan, below the average of 3.3 for all IDA countries. While Afghanistan compared favorably with other IDA countries on macroeconomic management and budgetary and financial management, the country ranks in the bottom decile for most other components of the index, including property rights, governance, and the quality of public administration.1
C. The Authorities’ Request for Fund Support for their 2011/12-2013/14 Economic Program under the Extended Credit Facility
27. The authorities’ program for the next three years outlines a realistic strategy to start addressing the challenges discussed above. The main goals of the new program are to make significant progress toward a stable and sustainable macroeconomic position, move toward fiscal sustainability, strengthen the financial sector, and improve the transparency and effectiveness of public spending while protecting the poor, and strengthening the governance framework in the financial and economic sphere. The envisaged policies and reforms focus on keeping inflation low, strengthening banking supervision, achieving sustained increases in tax collection, gradually taking over externally-financed recurrent spending, improving public financial management, keeping spending aligned with ANDS priorities, improving the capacity to deal with economic crime, and reducing fiscal risks from public enterprises. The program includes a technical assistance agenda.
28. The focus of fiscal policy will be to make further progress on revenue generation to meet the many and growing spending needs. Revenue measures include ongoing administrative reforms in the customs and revenue departments (medium and large taxpayers’ offices), and steps toward the introduction of a VAT in March 2014. Still, the targeted increase in the revenue-to-GDP ratio amounts to only 0.6 percent of GDP over the program period—which is basically achieved this year. In addition, political and security risks could undermine revenue collection at the border.8 If the planned reforms do not indeed yield more revenue gains, the authorities will have to consider additional measures. For example, previous Fund technical assistance recommended an excise on petroleum products.
29. On the expenditure side, the authorities need to continue to exercise tight control over nonsecurity spending. The ongoing public financial management reforms are essential in this context to ensure effective prioritization of spending. In particular, the authorities are in the process of identifying propoor spending within the central government budget, with the aim of improving integration of priority poverty reduction policies within line ministries’ budgets (indicative target). However, due to fluctuating development budget execution rates, the pilot phase was aimed at identifying propoor operating expenditures only. In 2011/12, propoor budgeting was piloted in two ministries—the Ministry of Education and the Ministry of Labor, Social Affairs, Martyrs, and Disabled. In 2012/13, the pilot will be extended to include the ministry of public health.9 The list will be further expanded in the coming years to better reflect all propoor spending. For consistency, the indicative target on propoor spending reported in Tables 3a and 3b covers all three ministries for both years. The overall level of propoor spending is low compared to the need and is budgeted to decline as a percent of GDP in 2012/13; the authorities will explore options for further increases to support its social and development objectives.
30. To exercise budget control, the Ministry of Finance closely monitors its cash balances in the treasury single account. These balances represent the government’s primary resources to fund the operating budget and its own discretionary development priorities. Earlier in 2011/12, the government cut spending in anticipation of liquidity shortages from a temporary loss of resources from the Afghanistan Reconstruction Trust Fund (ARTF). Assuming the full reinstatement of funds from the recurrent window of the ARTF, balances are projected to end the year at just short of two months worth of cover for operating expenditures, the authorities’ informal prudential target. However, there is a risk that cash balances could be drawn down by more than targeted if additional transfers are made to pay for development spending carried over from the previous fiscal year. Should discretionary cash balances fall too low in 2011/12, a cash crunch could occur in the following year.10 The government would need to monitor all outgoings very closely, rigorously prioritizing discretionary development spending while maintaining a strong revenue effort. By 2013/14, the government plans to issue securities (sukuks) which will diminish its cash and liquidity risks.
31. The nominal anchor of monetary policy is inflation. To this end, the central bank steers reserve money and currency in circulation through the use of its own paper, so-called capital notes, and the accumulation of foreign exchange reserves. With inflation running in the double digits, the authorities, therefore, see a need to tighten monetary policies in the course of 2011/12 to achieve their inflation target of 4-6 percent by reducing money growth from 30 percent in August 2011 to less than 20 percent. They note that volatile commodity prices, including food and oil, high inflation in neighboring countries, and large inflows of aid have complicated the conduct of monetary policy. In addition, due to concerns about its income and balance sheet, the central bank has been hesitant to use its capital notes and foreign exchange auctions to the full extent. The forthcoming agreement between the central bank and the Ministry of Finance regarding central bank capitalization and responsibilities for the costs of monetary policy should alleviate these constraints and strengthen central bank independence. The new marketable government securities (sukuks), to be introduced by 2013/14, will add a useful monetary policy instrument, contribute to the development of the domestic money market, and could gradually lessen the need for the central bank to issue capital notes.
32. Efforts to manage the Kabul Bank crisis continue. The ministry of finance and the central bank are committed to securing maximum asset recovery from Kabul Bank, and the government will bring legal charges where appropriate. It will be important to ensure that the repayment agreements that have been signed, and which the authorities consider to be legally binding, are being honored. Where this is not the case, they should use all available asset recovery options. Failure to do so would send the signal that economic and financial crimes pay, in particular if committed by well-connected individuals. Moreover, every dollar recovered by the government ultimately lowers the fiscal cost of the bailout and will free scarce resources for priority spending needs.
33. The authorities intend to put New Kabul Bank up for sale by mid-2012 to a qualified investor who brings sound banking sector experience. This is somewhat later than anticipated, mainly because it is taking longer to clean up the balance sheet of New Kabul Bank to a point where it can be presented to potential investors. One of the objectives of the sale is to reinvigorate Afghanistan’s stagnant banking sector by bringing international experience and fostering competition. If the sale does not succeed, the bank would be downsized further and either merged into other financial institutions or liquidated by March 2013. In the case of liquidation, salary and other payment services will be migrated to other banks. To provide choice to government employees, migration will start in 2012 independent of privatization or liquidation.
34. Supervision and central bank independence have been weakened in the aftermath of the Kabul Bank crisis. The central bank regrets that its supervision department has been under aggressive investigation in the context of Kabul Bank while prosecution of Kabul Bank shareholders and officers appears to have proceeded more slowly. This has lowered morale and the effectiveness of supervision which has also been eroded by the redeployment of some critical staff to the bridge bank and the receivership. Nevertheless, the supervision department has undertaken a number of measures to strengthen its supervision, including regular reviews of bank compliance with earlier recommendations and the issuance of time-bound enforcement letters when appropriate. Moreover, audits by reputable international firms—supported by the United Kingdom’s Department for International Development and the World Bank—are ongoing to provide a better view of the financial health of ten banks, including systemically important institutions. Still, the supervision department remains significantly understaffed and is ill-prepared should another banking crisis emerge. The crisis also highlighted the need to build capacity in areas related to the prevention of fraud and economic crime.
35. To address these deficiencies and ensure strong competition in the banking sector, the authorities are in the process of better enforcing and revising the existing banking law and regulations. The process of overhauling the banking law and regulations has been informed by an initial review of the Kabul Bank events by the central bank and will benefit from a forthcoming report by the independent Monitoring and Evaluation Committee. The revisions will aim to bring important provisions in line with the Basel Core Principles and Financial Action Task Force recommendations, in particular, strengthening provisions on corporate governance, beneficial ownership, capital, large exposures, related parties, enforcement, and bank resolution.
Key Findings and Main Recommendations of the Assessment of the Anti-Money Laundering and Combating the Financing of Terrorism Regime
IMF staff conducted the first detailed assessment of Afghanistan’s Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) framework in early 2011 using the updated 2004 assessment methodology. The Detailed Assessment Report was adopted by the Asia/Pacific Group on Money Laundering (APG) on July 21, 2011.
Afghanistan faces major money laundering and terrorist financing threats. The value of proceeds of crime generated by drug production and trafficking and corruption in the country is significant, in both relative and absolute terms. Smuggling and fraud also generate considerable amounts of illegal funds. In addition, terrorism and its financing remain a major concern both in terms of the security of Afghanistan and of the funding of terrorist individuals, organizations, and terrorist acts domestically and abroad.
Structural elements make the effective implementation of AML/CFT preventive measures challenging. They include ongoing conflict, lack of security, vested interests and corruption, capacity constraints, nascent and weak regulatory environment, porous borders, and low human capital. In addition, with a large share of economic activity taking place in the informal sector and within the context of a cash-based economy, the combination of rudimentary financial transactions and the formal sector banks, connected internationally through correspondent accounts and Society for Worldwide Interbank Financial Transactions (SWIFT), poses significant risks of money laundering and terrorist financing. Also, with the rapid expansion of the banking sector over the last decade, the lack of qualified and experienced supervisory and compliance staff resulted in critical failures in preventive measures.
The Detailed Assessment Report highlights significant deficiencies in Afghanistan’s AML/CFT regime and notes that current domestic efforts are not commensurate with the high risk of both money laundering and terrorist financing in the country. Afghanistan has taken measures to fight crime, including financial crime, and to lay the foundations for an AML/CFT regime. However, Afghanistan has been rated noncompliant or partially compliant in all but one of the 49 Financial Action Task Force recommendations. Despite the authorities’ efforts, there have been few investigations into money laundering and terrorist finance and none has resulted in charges being brought before the courts.
The report sets out a number of recommendations for improvement, which should be prioritized to mitigate the most serious risks that Afghanistan faces. The implementation of these recommendations will be an important element in strengthening the institutional framework for governance. Recommended actions include tightening and effectively implementing the legal and institutional framework regarding customer due diligence, supervision of financial institutions, reporting of suspicious transactions to a sufficiently independent and skilled financial intelligence unit, confiscation of criminal assets and implementation of mutual legal assistance in asset recovery. In light of the magnitude of cross-border drug trafficking and laundering of its proceeds, special attention should be given to the recommendations which address cross-border cash couriers and money service providers. The scale of corruption calls for the implementation without delay of recommendations regarding customers who are politically exposed persons. In light of the recent financial fraud, adequate fit and proper testing of financial institutions’ beneficial owners should also be prioritized. Finally, due to the high terrorist financing risks, the framework for freezing terrorist funds should be revised and implemented effectively. The authorities will submit an action plan to the APG in the context of the follow-up process on their assessment.
36. The program also includes measures to strengthen governance in the economic and financial sphere in general. The government’s first priority is to ensure that the rule of law prevails throughout the country and is protective of people, nascent institutions, the economy and the financial sector. It plans to improve its ability to deal with economic crime, and to increase transparency and accountability by tightening the application of the rule of law in the financial sector so that it can face the extreme risks posed by criminality and corruption. As part of the Kabul Process, the government has committed to a tight deadline of critical anticorruption and governance reforms. It has established a dedicated “governance cluster” in the ANDS and reports regularly to the international community on achievements in this area. Given their criticality to governance and financial sector stability, staff encourages accelerated progress on these commitments which have slowed over the course of the last year (Box 6).
37. The authorities plan to address delays in public enterprise reform. With a view to strengthening the financial oversight of public enterprises and thus limiting the possibility of contingent liabilities hitting the budget while maintaining an arms-length relationship, the authorities intend to revise the existing legal framework to bring such entities under the ownership and effective control of the ministry of finance. With respect to the four largest public enterprises (airline company, power utility, fuel and gas company, and telecommunications firm), the authorities will proceed with the implementation of the restructuring and business plans to improve their financial situation and limit fiscal risks. While these are important steps, they may not go far enough to address the large contingent fiscal liabilities from these public enterprises. Building an effective state-owned enterprise monitoring capacity in the Ministry of Finance, exercising strict financial control, and properly regulating the existing public enterprises (exposing them to full competition where possible), are needed to address the risks from this sector.
IV. Program Modalities, Risks, Technical Assistance, and Data Issues
38. Access under the program is proposed at 52.5 percent of quota (SDR 85 million, about US$134 million) phased in seven disbursements over three years (Table 8). The conclusion of the debt sustainability analysis that Afghanistan continues to be at high risk of debt distress supports the case for moderate access. Donor inflows, on which Afghanistan is highly dependent, can be uncertain and volatile, thus calling for a sufficiently high level of foreign reserves. During 2011/12-2013/14, the projected balance of payments gap before grants amounts to US$19 billion, of which the Fund would contribute 0.7 percent (Table 9). The proposed access should be sufficient to cover residual financing gaps and contribute to reserves equivalent to about nine months of imports (excluding transit trade). Given Afghanistan’s high dependency on aid, any sudden decline in aid could put pressure on reserves, especially if coupled with other external or security shocks. In the absence of broad and sustainable export opportunities, Afghanistan will require a longer adjustment period during which the reserves need to be maintained at higher levels. Debt service obligations to the Fund, including the new program disbursements, will remain moderate (Table 10).11 Quantitative performance criteria have been set for March 2012 and September 2012, and indicative targets for December 2011 and June 2012 (MEFP, Table 4).12
39. An update safeguards assessment of the central bank is largely complete. The central bank has strengthened elements of its safeguards framework since the 2008 assessment, but risks remain. In particular, there has been limited progress in establishing an effective internal audit function, and governance oversight should be strengthened. New risks have also emerged over the past year as a result of the Kabul Bank crisis, not least due to capacity constraints, resignation of the governor and strains on central bank autonomy. Previous safeguards recommendations on the central bank’s legal structure and autonomy remain valid, including the need to gain clarification over coverage and calculation of its capital shortfall. It will also be important for the central bank to address outstanding audit recommendations and to sustain earlier progress made. The central bank is working with IMF staff to complete the assessment and is committed to implementing its recommendations thereafter, some of which could be integrated into program conditionality.
40. The program is subject to significant downside risks. First and foremost, vested interests and mixed ownership in the government at large could delay or thwart urgently needed reforms. An important test case in this regard will be the envisaged maximum asset recovery from Kabul Bank and bringing New Kabul Bank to the point of sale. Second, the government’s ability to deal with the governance aspects of the Kabul Bank crisis in accordance with Afghan laws will be a litmus test of its commitment to the rule of law and sound economic management. Fiscal risks arise from (i) the possibility that revenue-raising reforms such as the introduction of a VAT get delayed beyond March 2014—it is not clear that this measure has yet garnered full ownership within the government; and (ii) the large uncertainties over future spending needs as well as future donor support, and contingent liabilities from poorly managed state-owned enterprises. Other risks stem from the volatile security situation that weighs on economic activity and limits the policy space for reforms. On the upside, Afghanistan’s mineral resources and large potential for transit trade between Central Asia and Iran and South Asia could support growth in the coming years.
41. A technical assistance agenda will support the program. Technical assistance from the Fund will focus on revenue administration and tax policy reforms, public financial management (including ongoing assistance on program budgeting and on implementing the public financial management road map), monetary operations and treasury securities, banking regulation and supervision, as well as improving the national accounts, price, monetary, and external statistics.
42. Economic data are adequate for program monitoring and surveillance, but there are significant shortcomings. The quality and timeliness of monetary and fiscal data are broadly adequate, although coverage is still deficient. Other data also suffer from weaknesses, especially data on prices, national accounts, balance of payments, and social indicators. Fund technical assistance is being provided to strengthen statistical data systems. In 2012, it will be useful to prepare a Report on the Observance Standards and Codes (ROSC) on data to help develop an economic statistics plan.
V. Staff Appraisal
43. In a difficult environment, the authorities have made important progress in a number of areas over the past few years. Most importantly, the government managed to raise revenues through revenue administration and tax policy reforms. Moreover, average annual real GDP growth exceeded 10 percent over the past five years, leading to an increase of per-capita GDP to US$530 in 2010/11 from US$250 in 2005/06; this increase was also helped by an appreciation of the exchange rate that could easily reverse. At the same time, as these levels show, further reforms are needed in these and other areas for Afghanistan to achieve its development objectives. The authorities have also taken politically difficult but important steps to strengthen governance in the financial sector, including initiating audits of Kabul Bank, Azizi Bank, and ten other banks, and establishing a path for asset recovery from Kabul Bank, with some down payments having been received.
44. The planned drawdown of foreign troops by 2014 and the expected gradual decline of donor support pose very difficult macroeconomic challenges for the authorities. Growth is likely to be adversely affected; fiscal revenues could suffer, while spending pressures will mount as the government takes over expenditures currently being financed by donors. Data limitations on the local impact of foreign troops and donor spending result in considerable uncertainties about the magnitudes of these effects. To be prepared, the authorities need to build buffers, and their targeted buildup of international reserves is an important element of this. Exchange rate flexibility will be critical to facilitate the necessary external adjustment as donor inflows slow. Donors can also contribute to building buffers by considering what level of support they can continue to provide to Afghanistan over the medium term.
45. The authorities’ fiscal program is moving in the right direction, but could be more ambitious. Fiscal policy appropriately aims for revenue increases; however, these are modest compared to recent achievements. Introducing a VAT is by March 2014 the very latest is essential to achieve the authorities’ medium-term revenue objectives, and they should consider accelerating this measure and be more ambitious in this reform area. The government’s emphasis on propoor spending is welcome, but the level of spending is low and the planned increases are too little in light of the country’s poverty situation. More generally, the intention of maintaining a tight spending envelope—for example, keeping nonsecurity wages constant in real terms over the forecast horizon—will be difficult to sustain, even though it simply reflects a lack of fiscal space. Additional pressures on the government purse will come from the need to assume an increasing amount of security spending and recurrent expenditures related to donor-financed projects that the government will have to gradually take over; the projections in this report are conservative, reflecting the lack of fiscal space. Additional spending would help Afghanistan to make faster progress toward its development objectives if grant financing can be secured. Indeed, fiscal sustainability is an issue and will require continued donor support, given Afghanistan’s development needs and the limited scope to raise domestic resources.
46. The intended monetary tightening should help return inflation to the single digits. The degree of tightening in the authorities’ program for the next 12 months seems appropriate, but may need to be revisited in light of inflation developments. The central bank will have to continue relying on capital notes to steer reserve money growth. Consequently, it is important that the government and the central bank reach an agreement on the capital requirement of the central bank and modalities for addressing shortfalls. This will strengthen the independence of the central bank, make it less susceptible to possible government interference, and put it in a better position to ensure a low-inflation environment and preserve financial and external stability.
47. The authorities seek to address the major shortcomings in the financial sector, and put it in a better position to play its role in fostering private sector-led growth. Strengthening the legal and regulatory environment as well as ensuring effective supervision are important pillars of the plan. In this context, the ongoing prudential audits of banks will provide an independent view of the health of these financial institutions and insights into whether there are other cases of large-scale violations of regulations and the laws. These audits should be completed as quickly as possible and be followed up with any necessary supervisory action, including a close monitoring of related-party lending. Staff agrees with the authorities’ intention to sell New Kabul Bank to an investor who would bring capital and thorough banking experience. Failing to find such an investor, New Kabul Bank should be liquidated by March 2013 and not become a state bank. This would, inter alia, require migrating the government salary payments to other banks.
48. Progress in the implementation of the ANDS is mixed. The authorities have made inroads toward achieving some of the Millennium Development Goals, but much remains to be done. At the same time, increasing fiscal pressures are likely to threaten the delivery of core social services. Efforts to prioritize the development objectives with the National Priority Programs, which were initiated at the Kabul conference in July 2010, will, therefore, be necessary to plan a development program in an increasingly resource-restricted environment. World Bank and Fund staffs recommend a careful review of current proposals for the National Priority Programs and to further balancing of the objectives in the ANDS within a viable financing approach.
49. Weak governance and endemic corruption are among the biggest risks to the success of the authorities’ program. The Kabul Bank crisis and the many difficulties in effectively dealing with the crisis have exposed the weakness of Afghan institutions in enforcing the rule of law. Moreover, Afghanistan has a large illicit sector that perpetuates criminal activity and one of the highest rates of corruption in the world. Significant improvements in governance and strong measures to root out corruption are needed if a vibrant private sector is to develop and provide opportunities for the whole population and be the source of sustained inclusive growth. Vested interests have the means and the potential to throw the authorities’ reform program off-track and ultimately put into question Afghanistan’s political and economic viability. It is imperative for the government to control these vested interests, including by fully applying Afghan law in every case of economic crime and ensuring that all those who derived benefits from such crimes pay back in full their unlawful gains.
50. In addition to possible shortfalls in implementation, there are a number of other risks to the success of the authorities’ program. A main risk stems from a possible deterioration of the security situation as the international troops withdraw. In this scenario, economic activity is likely to suffer, leading to additional fiscal pressures on the revenue and spending side and possibly a liquidity squeeze. State-owned enterprises constitute a significant contingent fiscal liability, which the authorities’ program does not address sufficiently due to capacity constraints. More generally, low capacity—and the corresponding dependence on international advisors—could lead to reform delays that could ultimately undermine fiscal and external sustainability. While most risks are clearly to the downside, there is also a possibility that growth (and fiscal revenues) may come in more strongly if the nascent mining sector develops faster and more vigorously than currently expected. This will require a strong fiscal regime for mineral resource development that promotes good governance.
51. On balance, staff supports the authorities’ request for a program, though it notes the significant risks. Staff believes that the program stands a good chance of providing an effective macroeconomic anchor for managing the transition and transformation while initiating important structural reforms, essential for Afghanistan’s economic viability. In particular, a Fund-supported program could strengthen the hand of the economic team and provide the necessary momentum to take difficult but necessary actions while ownership in the government at large is mixed. Staff expects that the program will have to be adjusted as the withdrawal of foreign troops and any decline in donor support take effect.
52. The next Article IV consultation will be held in accordance with the relevant decision on the consultation cycle for members with a Fund arrangement.
Islamic Republic of Afghanistan: Selected Economic Indicators, 2006/07-2013/14