On behalf of our Afghan authorities, we thank staff for the high quality reports and Executive Directors and management for their continued support to Afghanistan. The authorities are highly appreciative of the Fund’s continued engagement with them in these challenging circumstances, and agree with staff analysis and recommendations.

Overview

The Afghan authorities have made significant progress over the last decade in rebuilding the economy and institutions, achieving macroeconomic stability, and improving human development indicators. As documented in the report, access to primary health, maternal health, child mortality rates, school enrollment, and universal primary education are close to the 2015 targets. However, adverse external and domestic conditions have not allowed the economy to fully reap the benefits of these advances. The drawdown of international troops, increased security concerns, and political uncertainty in the aftermath of the 2014 presidential election adversely affected confidence and held back the recovery.

Notwithstanding these challenges, the new administration of President Ghani and Chief Executive Abdullah, which took office in late 2014, moved forward to address vulnerabilities and advance the structural reform agenda in close collaboration with the Fund under a Staff Monitored Program (SMP), and other development partners. Following up on the Tokyo conference in July 2012 and the London conference in December 2014, the authorities reaffirmed their strong commitment to addressing the many challenges facing Afghanistan in the context of the Senior Officials Meeting (SOM) of September 2015.

Recent economic developments and outlook

The sharp growth deceleration that started in 2013 continued into 2014, with real GDP growth falling further to 1.3 percent, reflecting the difficult security situation and weak private investment during the political transition. In turn, subdued economic activity and rising unemployment contributed to increasing emigration. The fiscal situation also deteriorated owing to the decline in domestic revenue collection and higher operating expenditure, leading to a sharp fall in cash balances and the emergence of domestic payment arrears. Inflation fell to 1.4 percent by end–2014 and to -1.9 percent in September 2015, reflecting weak economic activity and lower global fuel and food prices. The external current account deficit, excluding official transfers, rose to 37 percent of GDP in 2014, but was more than covered by official transfers. Gross official reserves exceeded 8 months of imports and the exchange rate remained in line with medium-term fundamentals.

Afghanistan’s medium-term outlook hinges critically on lasting improvement in the security situation, steadfast implementation of reforms to address current fragilities, continued donor assistance, and execution of important mining projects. Developments in these areas going forward can tilt the balance of risks to the downside as well as the upside. In 2015, the recovery is expected to remain modest with growth picking up to 2 percent, as uncertainty dissipates, before gradually increasing to 3-5 percent from 2016 onward.

Performance under the SMP

Staff indicates that performance under the SMP for end-June and end-September 2015 has been satisfactory. All quantitative PCs have been met, except for social and other priority spending for June and September and the budget revenue target for September. The Treasury’s cash balance was replenished following the disbursement of grants in September and was above the indicative target. Pro-poor spending was below the target, but the pace of execution is expected to pick up during the last quarter. Implementation of structural reforms has been slower than expected given the time needed for technical preparation and to build consensus around these measures. Nonetheless, three out of four structural benchmarks were observed.

Against the background of lower-than-envisaged growth and inflation in 2015, and given the increasing pressure on the foreign exchange market emanating from the migration outflow, reserve money growth and international reserve accumulation targets for end-December 2015 under the SMP were revised.

Fiscal policies and debt sustainability

The fiscal situation remains challenging against the background of low revenue collection as a result of weak economic activity, high security risks, and rising spending needs. While the authorities agree with the need to strengthen revenue mobilization and prioritize spending, donor financing of development spending and part of operating expenditure will be needed for several years to come.

The authorities have taken important steps toward enhancing revenue mobilization. A number of revenue measures were introduced in 2015 under the SMP, including an increase in tariffs, overflight fees, the business receipt tax, and fuel fees collected at the customs, as well as the introduction of a telecommunications fee. These, together with improved tax compliance, are projected to yield additional revenue of about 1 percent of GDP per year in the medium-term. The authorities also made progress in strengthening tax administration and plan to enhance collection of tax arrears. While the VAT was postponed pending better preparation to ensure its successful introduction, the authorities are confident that it will help strengthen the revenue base over the medium-term, together with taxation of future mineral activities, for which a transparent fiscal regime is being developed in line with the EITI.

On the expenditure side, efforts have been directed toward containing non-priority spending, limiting increases in wages, pensions, and bonuses, and reviewing the targeting of payments to families of martyrs and disabled persons. Pro-poor spending will be maintained at 2.7 percent of GDP in line with the SMP target. Public Finance Management is being strengthened in consultation with donors and stakeholders.

Afghanistan’s debt is very low (6.4 percent of GDP at end-2014) and is sustainable under the baseline scenario of continued reform and donor financing of the gap through grants, although it would be vulnerable to security or political instability shocks.

Monetary and financial sector policies

Monetary policy will continue to adjust to an environment of slower-than-anticipated growth in money demand, weak economic activity, and lower-than-programmed inflation. DAB remains committed to a flexible exchange rate policy and intends to enhance its communication strategy to strengthen confidence. In parallel, efforts are under way to develop domestic currency-denominated instruments, including sukuks, to be used for open market operations.

Notable progress has been made in banking sector reform. The sale of New Kabul Bank (NKB) was initiated in October 2015, while asset recovery by the Bad Debt Commission has continued. The banking law was enacted in August 2015, and will help address remaining weaknesses in the banking system. Regulations on asset classification and provisioning have been revised in September 2015, and work is underway to introduce regulations on corporate governance and related-party lending. Banking supervision has been stepped up and the authorities are determined to build robust institutions and strengthen the independence of DAB. Moreover, amendments to the AML/CFT laws were approved by the President in April 2015.

Fostering high and inclusive growth

As presented at the recent donor conference and the September SOM, the authorities’ strategy to promote inclusive growth and raise productivity involves wide-ranging reforms, including reforming the public administration, strengthening governance and combating corruption, unifying trade and investment licenses, establishing one-stop shop for private businesses, and reforming land management and acquisition laws. The authorities also plan to develop strategic sectors, such as agriculture and mining, which can boost growth and increase job opportunities and tax revenue. Investment in infrastructure through PPPs could also allow Afghanistan to benefit from its position at the confluence of South and Central Asia. The authorities look forward to technical assistance from the Fund and development partners in support of their reform strategy.

Ex-post assessment of longer-term program engagement

The authorities share the candid assessment and conclusions of the EPA, which provides useful lessons for future Fund engagement with Afghanistan. Of particular interest is the report’s emphasis on the need for strong program ownership, realistic assessment of implementation capacity, well-prioritized and macro-critical structural conditionality, and effective coordination among donors, along with scaled-up capacity building. The authorities are committed to do their part in this joint effort and look forward to a follow up Fund-supported program after the expiration of the current SMP.