EXECUTIVE SUMMARY Context: Political and security uncertainties and an inadequate policy response led to lower growth and emergence of important fiscal and banking vulnerabilities in 2014. The establishment of a national unity government and the December 2014 London Conference has helped build confidence and reconfirmed donor support for Afghanistan. The proposed staff-monitored program (SMP) will foster continued close engagement with Afghanistan, address vulnerabilities, and help manage risks. An independent staff team is preparing an ex post assessment of the Funds’ engagement with Afghanistan since 2006 and its report will be sent to the Executive Board separately. Focus of the SMP: In the attached Letter of Intent, dated May 6, 2015, the authorities requested a new SMP covering the period April 1, 2015–December 31, 2015. The SMP will aim to mobilize revenue and address urgent banking vulnerabilities. Successful performance under the SMP would support a future request for an IMF financial arrangement, foster macroeconomic stability and inclusive growth. Policy recommendations: Fiscal policy will focus on mobilizing domestic revenue and rebuilding the treasury’s cash balance. Monetary policy will aim to preserve low inflation and maintain exchange rate flexibility to protect international reserves and competiveness, and avoid excessive volatility. Structural reforms will focus on: (i) revenue mobilization, expenditure control and repayment of arrears; (ii) financial sector reforms to deal with weak banks, promulgate the new banking law, amend the central bank law, strengthen banking supervision, and address weaknesses in state banks including New Kabul Bank; and (iii) improving economic governance by strengthening the anti- corruption, anti-money laundering, and countering the financing of terrorism regimes. Risks to the SMP: Risks, mostly on the downside, are related to adverse security developments, inadequate implementation of economic policies, political instability, and donor fatigue. Large security and development expenditure needs mean that Afghanistan will remain dependent on donor financing for an extended period. On the upside, a political agreement that improves security conditions, stronger domestic demand and early development of mining projects would result in faster growth.

Abstract

EXECUTIVE SUMMARY Context: Political and security uncertainties and an inadequate policy response led to lower growth and emergence of important fiscal and banking vulnerabilities in 2014. The establishment of a national unity government and the December 2014 London Conference has helped build confidence and reconfirmed donor support for Afghanistan. The proposed staff-monitored program (SMP) will foster continued close engagement with Afghanistan, address vulnerabilities, and help manage risks. An independent staff team is preparing an ex post assessment of the Funds’ engagement with Afghanistan since 2006 and its report will be sent to the Executive Board separately. Focus of the SMP: In the attached Letter of Intent, dated May 6, 2015, the authorities requested a new SMP covering the period April 1, 2015–December 31, 2015. The SMP will aim to mobilize revenue and address urgent banking vulnerabilities. Successful performance under the SMP would support a future request for an IMF financial arrangement, foster macroeconomic stability and inclusive growth. Policy recommendations: Fiscal policy will focus on mobilizing domestic revenue and rebuilding the treasury’s cash balance. Monetary policy will aim to preserve low inflation and maintain exchange rate flexibility to protect international reserves and competiveness, and avoid excessive volatility. Structural reforms will focus on: (i) revenue mobilization, expenditure control and repayment of arrears; (ii) financial sector reforms to deal with weak banks, promulgate the new banking law, amend the central bank law, strengthen banking supervision, and address weaknesses in state banks including New Kabul Bank; and (iii) improving economic governance by strengthening the anti- corruption, anti-money laundering, and countering the financing of terrorism regimes. Risks to the SMP: Risks, mostly on the downside, are related to adverse security developments, inadequate implementation of economic policies, political instability, and donor fatigue. Large security and development expenditure needs mean that Afghanistan will remain dependent on donor financing for an extended period. On the upside, a political agreement that improves security conditions, stronger domestic demand and early development of mining projects would result in faster growth.

Relations with the Fund

(As of March 31, 2015)

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 Fund2

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

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

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 cannot 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. The authorities are implementing a liberal exchange system. Based on information currently available to the staff, no exchange restrictions and multiple currency practices are in place. The authorities have provided documents to Fund staff related to laws and regulations on the exchange regime and have requested technical assistance from the Fund to formalize the current liberal regime. They have been implementing a managed float system with no predetermined path for the exchange rate. On April 21, 2015, the average of the buying and selling exchange rates in cash transactions on the Kabul money exchange market was 57.88 Afghanis per U.S. dollar.

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 May 16, 2014. 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 authorities plan to submit amendments to the DAB law to parliament by end-December 2015 to implement the Memorandum of Understanding and make new capitalization framework operational. 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, 2011–15

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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 25, 2015)

1. The World Bank Group’s program in Afghanistan is governed by the joint Interim Strategy Note (ISN) for FY12–FY14, which focuses three themes: (i) building the legitimacy and capacity of institutions; (ii) equitable service delivery; and (iii) inclusive growth and jobs. The process for preparing the next country strategy–Country Partnership Framework for Afghanistan has been launched, with work on the Systematic Country Diagnostics (SCD) in progress.

2. Since 2002, IDA has committed a total of $2.77 billion in grants (83 percent) and credits (17 percent) in Afghanistan. In addition, the Afghanistan Reconstruction and Trust Fund (ARTF) has generated $7.99 billion from 33 donors, and committed $3.61 billion for the government’s recurrent costs and $3.79 billion for government investments programs. At end of January 2015 the active IDA portfolio totaled $835.98 million and the active ARTF investment portfolio totaled $2.46 billion.

3. The Bank administers the ARTF—the World Bank Group’s largest single-country multi-donor trust fund. The ARTF provides grant support to Afghanistan based on a 3-year rolling financing strategy. Together, International Development Association (IDA) and the Afghanistan Reconstruction Trust Fund (ARTF) provide close to $1 billion per year in grant resources (about $150 million from IDA and about $800–US$900 million from the ARTF). The ARTF is a key vehicle for providing government with predictable and transparent on-budget financing and provides a platform for policy dialogue between government and donors.

4. 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).

5. In fiscal year 2014, the World Bank Board approved two new IDA-financed projects and additional financing for an existing project totaling $106.7 million, plus the CASA-1000 regional project. The new projects included $50 million for the Development Policy Grant and $50 million for Access to Finance; the Financial Sector Rapid Response project received $6.7 million in additional financing. CASA-1000 was approved in March 2014 by the World Bank Group’s Board of Executive Directors for total grant and credit financing of $526.5 million. Of the total project financing for CASA-1000, Afghanistan receives $316.5 million in the form of an IDA grant. The FY14 IDA commitments fully utilized IDA-16.

6. In addition, in fiscal 2014 the ARTF approved $419.56 million in recurrent cost financing (of which $125 million was for recurrent cost baseline financing, $113.70 million for the Incentive Program, $146.96 million for AHP payment and O&M $33.90 million, and $580 million for Investment Window financing, including the Second Education Quality Improvement Program ($125 million), the Third Emergency National Solidarity Project ($200 million), the CASA Community Support Project ($40 million), the Nonformal Approach to Training, Education and Jobs in Afghanistan ($15 million), Kabul Municipal Development Project ($110 million), and Kabul Urban Transport Efficiency Improvement Project ($90.50 million).

7. The World Bank has continued to engage in rigorous analytical work and placed increased emphasis on policy dialogue. These nonlending activities have been supportive of the Bank’s lending program and have played a crucial role in informing government of its strategic choices and advancing dialogue between the Government of Afghanistan and its international development partners. In this regard, four pieces of analytical work stand-out; Transition Economics, Resources Corridors, Poverty Analysis, and Agriculture Sector Review. The Bank also prepared Policy Notes on key sectors of the economy to help guide its policy dialogue with the new administration.

8. IFC’s portfolio in Afghanistan has more than doubled since FY08—from around $8 million to about $135 million to date. IFC is following an integrated advisory and investment strategy focused on improving the investment climate, building capacity, and supporting selective investments in sectors with high development impact and job creation. Currently, IFC’s portfolio includes two investments in the telecommunication sector and two operations in the financial markets. Going forward, IFC is looking to expand its investment program in Afghanistan, in the areas of infrastructure, finance, manufacturing, agribusiness and services.

9. MIGA has $155 million of gross exposure in Afghanistan, supporting telecoms and agri-business projects. MIGA recently launched its “Conflict Affected and Fragile Economies Facility,” which will boost the agency’s exposure in Afghanistan. MIGA is currently supporting three projects in Afghanistan, of which one is a joint effort with IFC in the telecoms sector (MTN). The other two are MIGA-only dairy and cashmere production projects.

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

(As of March 25, 2015)

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) have been in constant touch and teams held formal consultations in June, September, October, and December 2014, as well as March 2015. 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 was a challenging year for economic management. Political and security uncertainties resulted in lower economic activity and important vulnerabilities. Fiscal vulnerabilities emerged as the authorities acquiesced to spending pressures, despite a significant revenue shortfall. The treasury cash balance was eroded with payment arrears and unfunded allotments emerging during the second half of 2014. Banking sector vulnerability increased because of lax enforcement, forbearance, and delays in financial sector reforms. 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 nonpriority 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, and reaffirmed in September at the Wales Summit and December 2014 London Conference. The government’s delivery on its commitments under the Staff-Monitored Program 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 further in 2014 and restoring Afghanistan’s revenue trajectory will be critical. Teams therefore agree on the need to emphasize timely implementation of revenue-enhancing measures in their dialogue with authorities. In order to improve our understanding for the scope of reforms, especially in the medium term, the teams agree to cooperate on relevant analysis.

  • 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, implementation of the authorities’ plan to deal with weak banks including public banks and the planned sale of the New Kabul bank are 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. Development expenditure 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 policy recommendations for 2015 should focus on revenue mobilization, addressing vulnerabilities in the financial sector, and strengthening AML/CFT framework as well as tackling corruption.

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 2014 and continuing into 2015, 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 Bank’s team is preparing a new Incentive Program (IP) that will provide funds 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 2015 with financing amounting to up to $300 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 2012–December 2015)

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Timing is tentative.

5. The Fund’s work program focuses on close engagement following the ECF-supported economic program expiration. The first ECF program review was completed in June 2012. Subsequent reviews were delayed. In late 2013, the authorities and the Fund agreed on a set of informal quantitative targets and structural measures for 2014. These targets and measures aimed at maintaining macroeconomic stability and structural reform momentum. However, performance under the agreed quantitative framework in 2014 was mixed. The Fund focused its efforts on helping the authorities advance important pieces of legislation, including AML and CFT laws. It has also provided advice on the monetary policy and banking supervision. Technical assistance was provided on VAT implementation, external sector statistics and AML/CFT issues. In 2015, the Fund plans to help the authorities with revenue mobilization, further strengthening banking supervision, improving economic governance, advancing structural reforms, central bank capitalization framework, new banking law, developing a fiscal regime for natural resources, and improving macroeconomic statistics. The Fund will continue its close engagement with Afghanistan to ensure the stability of macroeconomic framework and lay the ground for sustainable inclusive growth.

Relations with the Asian Development Bank

(As of March 24, 2015)

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. This included the transition period (2012–14) and in the transformation period (2015-24) 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), 2015–2017. 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 natural resources sectors, including management, governance, and further institutional and human capacity development. From 2009 to 2013, ADB’s operations were underpinned by the Country Partnership Strategy (CPS). In 2014–2015, ADB’s operations are based on the Interim CPS. The CPS 2009-2013 was aligned with the Afghanistan National Development Strategy (2009–2013). The Interim CPS is aligned with NPPs and the government’s development strategy—Towards Self Reliance—A Strategic Vision Beyond 2025.

3. By end-December 2014, ADB’s total assistance comprising grants and loans reached $4.03 billion, of which $3.8 billion for the public sector, and $198.1 million for the private sector. As of December 31, 2014, total cumulative lending stood at $920.28 million consisting of sovereign ($722.18 million) and nonsovereign ($198.10) loans. ADB is one of the largest donors to the government of Afghanistan. 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, 2014, 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, 2014, the total amount received was $300.92 million from Japan (Embassy of Japan, $123.0 million), United States (USAID, $105.0 million out of a total commitment of $180.3 million), and United Kingdom (DFID, $72.92 million).

5. ADB is one of the largest donors in the transport sector. As of December 31, 2014, ADB has provided $2.1 billion to construct or upgrade over 1,500 km of regional and national roads and to rehabilitate four regional airports. All four are fully operational, with usage more than doubled. Travel times decreased by more than half as a result of ADB-assisted projects completed in 2014. ADB funded the first ever railway line between Uzbekistan and Afghanistan, which became fully operational in 2012. To date, about 7.5 million tons of goods have been transported. 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 $921.31 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 5 million people. Ongoing projects will generate an additional 4.5 megawatts of power, add 500 km of transmission lines, and provide 100,000 new power connections. ADB is 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 2014, total investment reached $600 million to rehabilitate and establish new irrigation and agricultural infrastructure, 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, a rise in agricultural productivity, and improved farm livelihood.

8. ADB 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-2014, cumulative approvals in 6 projects have 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 nonsovereign portfolio as of December 31, 2014. 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 nongovernmental organizations with regard to project design and implementation.

Statistical Issues

(As of March 19, 2015)

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Afghanistan: Table of Common Indicators Required for Surveillance

(As of April 20, 2015)

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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).

The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.