Islamic Republic of Afghanistan: Staff Report for the 2014 Article IV Consultation—Informational Annex

KEY ISSUESContext. Over the past decade, Afghanistan has made enormous progress in reconstruction, development and lifting per capita income. Security and political uncertainties, and weak institutions have constrained growth and weighed on social outcomes. With significant reform efforts and donor support, Afghanistan has maintained macroeconomic stability, implemented important structural reforms, and built policy buffers, but significant vulnerabilities remain. The IMF has been supporting Afghanistan through technical assistance and a three-year Extended Credit Facility (ECF) arrangement. Reviews under the ECF arrangement have been delayed.Outlook and risks. 2014 is a crucial year in the political and security transitions and the run-up to the “transformation decade” (2015–24). Assuming smooth political and security transitions, continued reform and donor financing, the outlook should be positive. Large security and development expenditure needs and a limited domestic revenue capacity mean that Afghanistan will remain dependent on donor financing for an extended period. Macroeconomic stability, structural reforms, and political and security stability are needed to ensure inclusive growth. Risks, mostly on the downside, are related to adverse domestic or regional security developments, political instability, inadequate implementation of economic policies, and donor fatigue.Policy recommendations. The authorities’ economic strategy (maintaining macroeconomic stability, strengthening the financial sector, improving economic governance, and moving toward fiscal sustainability) remains appropriate and needs strengthened implementation. Sustained implementation of this strategy will safeguard growth and build buffers to help manage shocks. Policies should continue to aim at strengthening revenue collection, managing money growth to control inflation while preserving exchange rate flexibility, strengthening bank supervision, and quickly enacting anti-money laundering (AML), countering financing of terrorism (CFT), banking,central bank, and value-added tax legislation.

Abstract

KEY ISSUESContext. Over the past decade, Afghanistan has made enormous progress in reconstruction, development and lifting per capita income. Security and political uncertainties, and weak institutions have constrained growth and weighed on social outcomes. With significant reform efforts and donor support, Afghanistan has maintained macroeconomic stability, implemented important structural reforms, and built policy buffers, but significant vulnerabilities remain. The IMF has been supporting Afghanistan through technical assistance and a three-year Extended Credit Facility (ECF) arrangement. Reviews under the ECF arrangement have been delayed.Outlook and risks. 2014 is a crucial year in the political and security transitions and the run-up to the “transformation decade” (2015–24). Assuming smooth political and security transitions, continued reform and donor financing, the outlook should be positive. Large security and development expenditure needs and a limited domestic revenue capacity mean that Afghanistan will remain dependent on donor financing for an extended period. Macroeconomic stability, structural reforms, and political and security stability are needed to ensure inclusive growth. Risks, mostly on the downside, are related to adverse domestic or regional security developments, political instability, inadequate implementation of economic policies, and donor fatigue.Policy recommendations. The authorities’ economic strategy (maintaining macroeconomic stability, strengthening the financial sector, improving economic governance, and moving toward fiscal sustainability) remains appropriate and needs strengthened implementation. Sustained implementation of this strategy will safeguard growth and build buffers to help manage shocks. Policies should continue to aim at strengthening revenue collection, managing money growth to control inflation while preserving exchange rate flexibility, strengthening bank supervision, and quickly enacting anti-money laundering (AML), countering financing of terrorism (CFT), banking,central bank, and value-added tax legislation.

Relations with the Fund

(As of February 28, 2014)

Membership Status: Joined July 14, 1955; Article XIV.

General Resources Account

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SDR Department

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Outstanding Purchases and Loans

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Latest Financial Arrangements:

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Formerly PRGF.

Projected Payments to Fund 1

(SDR million; based on existing use of resources and present holdings of SDRs)

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Implementation of HIPC Initiative:

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Assistance committed under the original framework is expressed in net present value (NPV) terms at the completion point, and assistance committed under the enhanced framework is expressed in NPV terms at the decision point. Hence these two amounts can not be added.

Under the enhanced framework, an additional disbursement is made at the completion point corresponding to interest income earned on the amount committed at the decision point but not disbursed during the interim period.

Implementation of MDRI Assistance: Not Applicable

Implementation of PCDR: Not Applicable

Nonfinancial Relations

Exchange Arrangement

Afghanistan is an Article XIV member country, and maintains an exchange system free of restrictions on payments and transfers for current international transactions, discriminatory currency arrangements or multiple currency practices. Staff is currently undertaking a review of government policies in the context of Afghanistan’s future accession to Article VIII status. The authorities informed staff that no exchange restrictions imposed for security reasons were in place.

To conduct monetary policy, the authorities rely on foreign exchange auctions since May 2002, and capital note auctions since September 2004. The foreign exchange auctions were initially open only to licensed money changers, but since June 2005 they are also open to commercial banks. The capital note auctions are open to commercial banks. Auctions are linked to the overall monetary program and are held on a regular basis.

Article IV Consultation

The last Article IV consultation with Afghanistan was discussed by the Executive Board on November 14, 2011. Article IV consultations with Afghanistan are held in accordance with Decision No. 14747-(10/96) on consultation cycles adopted on September 28, 2010, as amended.

Safeguards Assessment

Under the Fund’s safeguards assessment policy, the Da Afghanistan Bank (DAB) was subject to a safeguards assessment with respect to the ECF arrangement approved on November 13, 2011. An initial safeguards assessment of the DAB was completed on June 12, 2006, updated on March 18, 2008, and then in December 2011. The latest update for the safeguards assessment found that while most of the previous safeguards recommendations had been implemented, an effective internal audit mechanism had still not been established and governance oversight was weak. The assessment also made recommendations to address new risks emerging as a result of the Kabul Bank crisis including with respect to central bank autonomy. Since the assessment, some recommendations have been implemented, albeit with delay. In particular, a Memorandum of Understanding on central bank capitalization has been signed and an external auditor has been appointed. The DAB is committed to implementing the remaining safeguards recommendations, with priority assigned to development of the internal audit function (with external support) and strengthening of Audit Committee oversight.

Technical Assistance, 2011–14

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METAC Advisor participated to the mission.

Afghanistan is a participant in the Middle East Technical Assistance Center.

Resident Representatives

Mr. de Schaetzen; August 2002–June 2005

Mr. Charap; June 2005–June 2008

Mr. Abdallah; June 2008–January 2014

Relations with the World Bank

(As of March 17, 2014)

1. IDA has committed a total of over $2.72 billion to Afghanistan since 2002. To date, 25 development and emergency reconstruction projects including 4 development policy grants have been implemented. IDA’s active portfolio comprises 19 investment projects with combined net commitment of over $787 million, of which almost 40 percent has been disbursed.

2. The Bank’s involvement in Afghanistan extends to its role as administrator of the Afghanistan Reconstruction Trust Fund (ARTF). The ARTF has developed into the primary multi-donor funding mechanism, financing part of the essential running costs of government as well as key investments, including national programs in health, education, rural access, irrigation rehabilitation, microfinance, and the National Solidarity Program. Since early 2002, 33 donors have contributed over $6.96 billion to this fund, making it the largest contributor to the Afghan budget for both operating costs and development programs.

3. In January 2010, the World Bank’s IDA and the International Monetary Fund (IMF) agreed to support debt relief for Afghanistan. The Boards of both institutions agreed that Afghanistan had taken the necessary steps to reach the completion point under the enhanced Heavily Indebted Poor Countries (HIPC) Initiative. This will generate total debt service savings of $1.6 billion, which include $1.3 billion from the HIPC Initiative, $260 million from Paris Club creditors beyond HIPC, and $38.4 million from the Multilateral Debt Relief Initiative (MDRI).

4. The International Finance Corporation (IFC), the World Bank Group’s private sector development arm, continues to work with its investment partners in Afghanistan. It is following an integrated advisory and investment strategy focused on the enabling environment for private sector activity and supporting selective investments in sectors with high development impact and job creation. On the investment side, IFC now has a portfolio totaling more than $131 million in five companies. This includes commitments in the financial, telecom, and hospitality sectors. The advisory services program, consisting of 8 active projects with a budget of $5.7 million, focuses on access to finance, investment climate, SME capacity development, agribusiness and Public–Private Partnerships (PPPs).

5. Next to investment in health, education, rural development and infrastructure, one of the primary focuses of the Bank’s assistance has been to help the Afghan government with legal and regulatory reform, establishing fiscal authority (incl. customs), and developing systems and human resources for public financial management and the civil service as a whole. The performance of the Ministry of Finance regarding alignment of budgetary allocations with the country’s priority needs, fiscal discipline, cash control, and aggregate transparency has contributed to macroeconomic stability and sustained external donor assistance.

6. ARTF and IDA projects are managed with the same attention. All projects are eligible for processing under the Bank’s Special Considerations for fragile states and emergencies. In practice this has proved most useful to improve flexibility post-approval as all projects are processed under regular review procedures in order to ensure quality at entry. All Bank (IDA and ARTF) funds are channeled through the government’s budget and project accounting and reporting occurs at the central level.

7. In fiscal year 2014, the World Bank Board has so far approved two IDA-financed projects totaling $100 million. The new projects included $50 million for the Development Policy Grant and $50 million for Access to Finance.

8. In addition, the ARTF approved $74.8 million in recurrent-cost financing and $325 million for Investment Window financing, including the Second Education Quality Improvement Program ($125 million) and Third Emergency National Solidarity Project ($200 million).

9. For fiscal year 2014, planned commitments are $200 million from IDA, ensuring that the full IDA-16 is fully utilized. The first project, Development Policy Grant for Promotion Economic Growth and Fiscal Sustainability, was approved on August 8, 2013 for $50 million. In addition, $1 billion are planned for operations under the ARTF including both the Investment and Recurrent Cost Windows.

Implementation of the Joint Management Action Plan on Bank-Fund Collaboration

(March 17, 2014)

1. Joint Management Action Plan (JMAP). The Afghanistan country teams of the World Bank (led by Mr. Saum, country director) and the IMF (led by Mr. Ross, mission chief) held consultations in January, May, and September 2013 and in March 2014. The teams exchanged views on the recent economic developments and their outlook, identified the macroeconomic priorities and challenges facing Afghanistan and discussed ways to coordinate their respective work programs.

2. 2014 will be a challenging year for economic management. The uncertain security transition and the upcoming election could affect confidence, weigh on growth and slow or distract the reform agenda. The following areas are critical from the macroeconomic perspective in the short and medium terms:

  • Sustaining macroeconomic stability. Policies should focus on revenue mobilization, improving the effectiveness of public expenditures, containing non-priority spending and controlling the money growth to manage inflation. A flexible exchange rate and international reserves should help accommodate shocks. The success of this strategy is predicated to a large extent on the continued donor flows, as pledged at the 2012 conferences in Chicago and Tokyo. The government’s delivery on its commitments under the IMF-supported program as well as the ARTF Incentive Program and the IDA-financed Development Policy Grant will be critical towards sustaining donors’ confidence.

  • Advancing fiscal sustainability and strengthening efforts to mobilize domestic revenues.

    The revenue effort faltered in 2013 and the momentum should be restored. Teams therefore agree on the need to emphasize the introduction of the VAT and more far-reaching customs reforms in their dialogue with authorities as measures to reverse the current trend. In the medium term, harnessing Afghanistan’s mineral resources for development would be very important as the big mines come on stream—a robust fiscal framework for mineral revenues must already be in place.

  • Safeguarding the financial sector. Macroeconomic policies must be complemented by prudential measures to safeguard financial stability. The banking sector is weak and should be strengthened to be able to meaningfully contribute to economic development. Improving banking supervision at the central bank is critical to this effort.

  • Strengthening economic governance. The high level of corruption and deficiencies in the rule of law are serious constraints on growth and—in the case of Afghanistan—have the potential to destabilize the economy.

  • Improving absorption capacity and government effectiveness. Budget execution rates linger around 50 percent. Increasing on-budget aid, especially through the transfer on-budget of security expenditures previously managed by donors, is challenging absorption capacity. More efforts need to be undertaken in advancing public financial management (PFM) reforms, improving the capabilities of the civil service and lifting constraints to service delivery and the implementation of public infrastructure projects.

3. Prioritizing reforms. Teams agreed that given the election year and the political uncertainties of transition, 2014 will be challenging for economic reform. Hence, reforms need to be consolidated and prioritized, along the lines discussed above.

4. The Bank’s work program is guided by the Interim Strategy Note (ISN). The ISN, approved by the Bank’s Board in March 2012 and spanning 2012–14, envisages that the Bank will continue to expand its support to institutions and processes associated with transparent economic and financial management and community-level governance, especially through the National Solidarity Program. Regarding economic management, in 2013 and continuing into 2014, the Bank has supported the government with technical assistance in the areas of customs reforms, mineral resource management, and economic statistics. Under the ARTF, the Incentive Program (IP) will provide funds ($175 million) for achievements in revenue mobilization, strengthening of PFM systems, investment climate improvements, and custom reforms. Since January 2013, the IP has also supported the government’s operation and maintenance expenditures. This support will continue during 2014 with financing amounting to $80 million. A Development Policy Grant Series ($100 million, half of which was disbursed in August 2013) focusing on strengthening sources of economic growth and fiscal revenues is currently under implementation (Table 1).

Table 1.

Afghanistan: Bank and Fund Planned Activities in Areas of Joint Interest, October 2011–March 2014

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Timing is tentative.

5. The Fund’s work program focuses on close engagement in the context of the ECF-supported economic program. Discussions on the second review of the program were not concluded because key program targets were missed and implementation of some structural benchmarks was delays. In addition, performance in early 2013 was significantly weaker than planned and not all prior actions were implemented, so completion of the reviews could not be recommended.

6. In 2013, the Fund focused its efforts on helping the authorities privatize New Kabul Bank, and advance important pieces of legislation, including the new banking law, the central bank law, the VAT law, AML and CFT laws, law on sukuk marketable securities, and companies’ law. The Fund has also provided advice on the monetary policy, liquidity forecasting, VAT implementation, and customs reform. Extensive technical assistance has been provided to the central bank’s supervision department, including to implement their new organizational structure and revise regulations. In 2014, the Fund plans to help the authorities build on these achievements, including through strengthening economic governance, central bank capitalization framework, developing a fiscal regime for natural resources, preparing for VAT implementation, further strengthening banking supervision, and improving macroeconomic statistics. The Fund will continue its close engagement with Afghanistan to ensure the stability of macroeconomic framework.

Relations with the Asian Development Bank

(As of March 16, 2014)

1. Afghanistan is a founding member of Asian Development Bank (ADB), established in 1966. After a hiatus from 1980 to 2001, ADB resumed partnership with the Government of Afghanistan in 2001. In the London and Kabul conferences in January and July 2010, respectively, and in the Chicago (May 2012) and Tokyo (July 2012) conferences, ADB reaffirmed its long-term development partnership with Afghanistan in the transition period (2012–14) and in the transformation period (2015–2025) based on the government’s development strategies, which along with national priority programs (NPPs) will remain the agreed basis for partnership in the next decade.

2. Current ADB operations in Afghanistan are based on the Country Operational Business Plan (COBP), 2014–15. The COBP is fully aligned with NPPs and the government’s priorities in the infrastructure sector—the backbone of economic and social development—with ADB’s investments contributing to Afghanistan’s socio-economic development in the transition and transformation period. The COBP continues ADB’s focus on Afghanistan’s energy, transport, and agriculture and irrigation sectors, including economic management, sector governance, and further institutional and human capacity development. From 2009 to 2013, ADB’s operations were underpinned by the Country Partnership Strategy, aligned with the Afghanistan National Development Strategy (2009–2013).

3. By end-December 2013, ADB’s total assistance comprising grants and loans reached $3.90 billion, of which $3.7 billion for the public sector, and $198.1 million for the private sector. As of December 31, 2013, total cumulative lending stood at $1.02 billion consisting of sovereign ($817.28 million) and non-sovereign ($198.10) loans. ADB is the sixth largest donor according to the government’s 2012 Donor Cooperation Report. Since 2007, ADB has provided assistance for the public sector on a 100 percent grants basis. Grants make more than 70 percent of ADB’s overall assistance to Afghanistan. In the July 2012 Tokyo Conference, ADB committed another $1.2 billion to support Afghanistan through 2016.

4. ADB supports co-financing of its projects to increase synergies by combining the strengths of development partners, governments, and ADB itself. As of December 31, 2013, the cumulative direct value-added official co-financing since 2002 amounted to $76.7 million for six investment projects and $10.5 million for 11 TA projects. The ADB managed the Afghanistan Infrastructure Trust Fund (AITF)—a co-financing modality that allows development partners to meet the pledge of 50 percent on-budget and 80 percent alignment with NPPs as agreed in the 2010 Kabul Conference. As of December 31, 2013, the total amount received was $271.2 million from Japan (Embassy of Japan, $110.0 million), United States (USAID, $105.0 million out of a total commitment of $180.3 million), and United Kingdom (DFID, $56.2 million).

5. ADB is one of the largest donors in the transport sector. As of December 31, 2013, it has provided $1.9 billion to construct or upgrade over 1,500 km of regional and national roads and $31 million to rehabilitate four regional airports. All four are fully operational, with usage more than doubled. Travel time decreased by more than half as a result of ADB-assisted projects completed in 2013. The ADB funded the first ever railway line between Uzbekistan and Afghanistan, which became fully operational in 2012. To date, over four million tons of goods have been transported through it. ADB supported the establishment of the Afghanistan Railway Authority to regulate and ensure the sustainability of the railway sector.

6. ADB is the largest on-budget donor in the energy sector. To date, ADB has invested around $883 million in Afghanistan’s energy sector, and committed an additional $950 million to strengthen the country’s energy supply chain. ADB-assisted projects have added 590 km of transmission lines, providing electricity to more than five million people. Ongoing projects will generate an additional 6.8 megawatts of power, add 470 km of transmission lines, and provide 99,320 new power connections. ADB is also financing the power and gas sector master plans of the government. ADB also supports the Turkmenistan, Afghanistan, Pakistan and India (TAPI) gas project as well as the Turkmenistan, Uzbekistan, Tajikistan, Afghanistan and Pakistan (TUTAP) electricity project.

7. The natural resources sector is another government priority sector assisted by ADB. In 2013, total investment reached $543 million to rehabilitate and establish new irrigation and agricultural infrastructures, and strengthen the institutional environment to facilitate economic growth and improve water resources management. Around 140,000 hectares of irrigated land have been rehabilitated and upgraded. The investments have led to a more efficient use of water resources and a rise in agricultural productivity.

8. In economic management, ADB’s assistance has improved fiscal management through policy, institutional and capacity-building reforms covering expenditure and revenue management, civil service management, provincial administration, and transparency and accountability in the public sector.

9. ADB’s private sector operations in Afghanistan began in 2004. As of end 2013, cumulative approvals in 6 projects amounted to $198.1 million. Total outstanding balances and undisbursed commitments to private sector projects amounted to $9.3 million, representing 0.1 percent of ADB’s total non-sovereign portfolio as of December 31, 2013. One of the major private sector projects is the Roshan Cellular Telecommunications Project. ADB provided financial assistance in the form of direct loans totaling $70 million for Phase 1 and 2 of the project, as well as B loans and a political risk guarantee. In 2008, ADB approved a direct loan of $60 million to finance Roshan’s Phase 3 expansion. In 2012, this project received an award for Excellence in Fragile States Engagement from the U.S. Treasury. In the financial sector, ADB has invested $2.6 million in Afghanistan International Bank (AIB), thus establishing the first private commercial bank in the post-Taliban regime.

10. ADB is an active member of the Joint Coordination Management Board (JCMB) and the Afghanistan’s Reconstruction Trust Fund Management Committee. ADB plays an active part in other donor coordination activities, including the JCMB Social and Economic Development Standing Committee, the Ministry of Finance’s High Level Committee on Aid Effectiveness, and the Inter-Ministerial Committee on Energy. ADB strongly supports all international policy dialogues on Afghanistan. Furthermore, it takes the lead in the infrastructure sector and regional corporation-related policy dialogues. ADB is a member of the core donor group (5+3) to ensure coordination and harmonization among donors and the government over policy reforms and development programs. ADB consults continuously with civil society and non-governmental organizations with regard to project design and implementation.

Statistical Issues

(As of March 19, 2014)

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Afghanistan: Table of Common Indicators Required for Surveillance

(As of March 31, 2014)

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Any reserve assets that are pledged of otherwise encumbered are specified separately.

Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

Daily (D), Weekly (W), Monthly (M), Quarterly (Q), Annually (A); Not Available (NA).

1

When a member has overdue financial obligations outstanding for more than three months, the amount of such arrears will be shown in this section.