Islamic Republic of Afghanistan: First Review Under the Extended Credit Facility Arrangement and Request for Modification of Performance Criteria
Author: International Monetary Fund. Middle East and Central Asia Dept.
Publication Date:
05 Jun 2017
eISBN:
9781484302972
Language:
English
Keywords:
ISCR; CR; debt; real GDP; deficit; Afghan authorities; banking sector; IMF staff calculation; development policy framework; foreign currency; Currencies; Commercial banks
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First Review Under the Extended Credit Facility Arrangement and Request for Modification of Performance Criteria

Abstract

First Review Under the Extended Credit Facility Arrangement and Request for Modification of Performance Criteria

Context

Objectives and Modalities of the ECF Arrangement1

The ECF-supported program seeks to consolidate progress on the macroeconomic and structural fronts and catalyze continued support from donors, helping to raise growth.

The program rests on two pillars:

  • Structural reforms that focus on institution building, fiscal and financial reforms, and measures to combat corruption for scaled up private sector development.

  • Prudent macro-financial policies to preserve macro-financial stability.

The first review assesses implementation of five Structural Benchmarks and eight Performance Criteria:

  • SBs on reforms to fight corruption and strengthen revenue administration; a sound budget; and measures to help complete the resolution of the 2010 Kabul Bank crisis.

  • PCs on government revenues, foreign exchange reserves, reserve money, net credit to central government from the central bank, and public debt.

1http://www.imf.org/external/pubs/cat/longres.aspx?sk=44130.0

1. The security and political landscape remains challenging.

  • 2016–17 saw several high profile insurgent attacks, with civilian casualties reaching record levels last year. Prospects for peace talks with insurgent groups are limited despite recent successes.

  • The relationship with Pakistan deteriorated because of security concerns, leading to trade disruptions and accelerated relocation of Afghan refugees (Box 2).

  • The political situation remains fragile, although cohesion within the NUG has improved; parliamentary elections are expected toward end-2017 and presidential elections in 2019. Ministers dismissed by parliament last November for budget under-execution remain in place pending a Supreme Court ruling.

2. Donor support is strong. As demonstrated at the successful Warsaw and Brussels meetings last year, the international community continues to support Afghanistan. At the Brussels conference in October, donors pledged $15.2 billion in development assistance, surpassing analysts’ expectations. The new U.S. administration’s approach to Afghanistan has not yet been articulated; however, President Trump and Vice President Pence spoke with President Ghani and expressed their support for Afghanistan.

Returning Afghan Refugees: Facts and Implications

Afghanistan is experiencing a large influx of returning refugees from Pakistan, Iran, and, to a lesser extent, Europe. UNHCR estimates that around one million returned in 2016 (620,000 from Pakistan) and projects up to one million more in 2017.

Prospects for returnees—many living abroad for decades—are difficult. Most are vulnerable and need shelter, food, jobs, education and health services. With more than one million Internally Displaced Persons and many people in poverty, the country’s capacity to cope is severely stretched.

Higher demand for food, goods, health services, and housing brought about by the returnees can put upward pressure on prices and rents, while increased supply of labor raises the already high unemployment rate. There could also be longer-term effects on economic and social development: if basic services, such as education and health, cannot keep up with increased demand, some human capital could be lost.

Increased spending by the returning refugees could, however, contribute positively to economic activity. The government is developing a strategy for reintegrating the returnees and managing the IDPs, focusing on the provision of basic services, cash transfers, documentation, land allocation, assistance with job and housing search, all with a focus on urban areas—the location of choice for many returnees.

In 2016 UNHCR provided around US$145 million in assistance (cash allowance of US$400 to returnees with proper documentation; US$200 in 2017). For 2017, UNOCHA appealed for further humanitarian assistance of US$550 million, (20.4 percent is raised so far), of which US$240 million will be allocated to assist returning refugees. The authorities’ own budget for returnees’ assistance is about US$4 million in both 2016 and 2017.

Economic Developments, Outlook, and Risks

A. Recent Developments

3. Constrained by weak confidence, growth remains feeble, and inflation has moderated.

  • Staff estimates 2016 growth at 2 percent. The pickup from 0.8 percent growth in 2015 likely reflected improved agricultural output, although the lack of high frequency indicators severely constrains the analysis.

  • Inflation moderated1 in 2016H2 before picking up to 4.1 percent in February, mostly driven by movements in global food prices.

  • Trade performance remained weak. Temporary border closing and some import substitution contributed to lower imports and thereby trade balance improvement. The pick-up in exports of goods, due to a favorable harvest and improved shipment capacity, was more than offset by a fall in exports of services.

  • Credit to the economy declined by 3.8 percent y-o-y in December, reflecting lower demand for trade credit and a DAB-mandated write-off of NPLs.

Figure 1.
Figure 1.

Islamic Republic of Afghanistan: Real Sector

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: Afghan authorities, United Nations Assistance Mission in Afghanistan, and IMF staff calculations.

4. The Afghani appreciated in 2016H2 and international reserves increased. The currency remained broadly stable against the US$ in 2016H1 before appreciating slightly, helped by the influx of returnees and an administrative ban on the use of the Pakistani rupee in border provinces. Lower imports, together with substantially lower FX sales by DAB, contributed to above-program target reserve accumulation.2 Trade and current account deficits (before grants) remain large, but FX reserves cover 11 months of imports.

5. A small overall fiscal surplus (including grants) of 0.1 percent GDP was recorded in 2016. The improvement (from a 1.4 percent deficit in 2015) was mainly on the operating budget, with security grants and domestic revenues increasing in broadly equal amounts. The operating deficit excluding grants narrowed by one percentage point of GDP to 8.4 percent. Domestic revenues were up 15.4 percent, reaching Af141.1 billion, well above the ECF target (Af132.6 billion), with around half of the over-performance attributable to policy measures introduced in 2015. A slightly lower rate of execution for development spending largely offset improved operating execution. The end-2016 discretionary cash balances of Af11.8 billion remained above the indicative target. Revenue growth continued to decelerate in 2017Q1 as the impact of the 2015 revenue measures continued to fade

Decomposition of Revenue

article image
Sources: Afghan authorities and IMF staff calculations.

One-offs are revenue sources that are not expected to be repeated.

A01ufig1

Domestic Revenues Growth

(Y-o-y percentage change, 12-month cumulative)

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: Afghan authorities and IMF staff calculations.
A01ufig2

Total Treasury Discretionary Cash Balances

(In billions of Afghanis)

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Figure 2.
Figure 2.

Islamic Republic of Afghanistan: External Sector

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: Afghan authorities and IMF staff calculations.
Figure 3.
Figure 3.

Islamic Republic of Afghanistan: Fiscal Sector

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: Afghan authorities and IMF staff calculations.

6. Financial soundness indicators improved. The NPL ratio declined to 10.8 percent in December 2016 (12.1 percent a year earlier), due to collateral repossessions and loan charge-offs in several private banks. Hence, CAR reached 28.3 percent (19.9 percent a year earlier). Asset quality remains a concern, as repossessed assets are often overvalued and illiquid. Profitability indicators also improved, while liquidity remains adequate.

B. Outlook and Risks

7. Growth is expected to rise gradually over time. Staff revised their projection for 2017 growth down to 3 percent, from 3.4 percent in the July 2016 staff report, and flattened the medium-term path to account for more persistent security challenges. The baseline scenario3 envisages a gradual increase to growth potential of 6 percent4 (predicated on improvements in security and political stability, implementation of reforms, and continued aid). Over time, extractive industries, agricultural development, and regional trade integration could support stronger growth and job creation. The influx of returning refugees could boost demand in the short run while a medium-term supply response is contingent on their absorption into the job market.

8. The outlook is subject to significant risks (Annex I). If security conditions worsen, aid falls short, or reforms stall, growth would be lower with attendant effects on unemployment and poverty. Alternatively, lasting peace with insurgents would boost private sector confidence and facilitate a shift in public spending from security to development.

Policy Discussions

A. Fiscal Policies

9. The 2017 budget is in line with the program. Under prudent assumptions for revenue collection and expenditure execution, the operating deficit excluding grants is projected to decline to 7 percent of GDP, while the overall surplus including grants—the near-term fiscal anchor—rises to 0.5 percent GDP. Revenue projections are conservative, with a near flat revenue-to-GDP ratio (¶10). Operating expenditures are envisaged to fall to 18 percent GDP as donor-funded security spending on fuel is transferred off-budget. Total grants are expected to decrease slightly. Specific budget allocations for returning refugee-related spending are minimal, with donors providing off-budget support. Staff reiterated that the overarching fiscal policy goal should be to expand the tax base, while maintaining the overall balance including grants close to zero and keeping public debt low.

Key Fiscal Indicators

(Percent of GDP)

article image
Sources: Afghan authorities and IMF staff calculations.

10. Authorities and staff concurred that the main fiscal risk in 2017 relates to the revenue projection. The authorities noted that the sustainability of the recent increase in domestic revenues is uncertain. They expressed particular concern about customs revenues: trade disruptions (due to closures of the Pakistan border) and WTO accession (with many tariffs reduced to zero) could adversely affect customs duties in the short run. Tensions with large taxpayers, who feel unfairly targeted by revenue collectors, are an additional concern. The authorities consider spending risks to be small, with donors expected to finance any unexpected refugee and security outlays. Staff encouraged the authorities to devise a contingency plan in case these fiscal risks materialize.

11. Further revenue gains are likely to come mostly from economic growth and an expanded tax base. A concurrent TA mission identified reforms that would help achieve this objective and promote a stable and attractive investment climate: strengthening anti-avoidance components of the corporate income tax (a minimum tax or higher border withholding), eliminating a proposed income tax exemption for manufacturing firms, streamlining the fragmented Large Taxpayers’ Offices, and preparing for the introduction of VAT in 2019. The authorities agreed in principle with the recommendations, however, expressed concerns that some could not be implemented under current conditions (e.g., consolidating the LTOs given the difficulties posed by travel and communication within Afghanistan).

12. Staff expressed concern about some elements of a new Income Tax Law that was approved by the Cabinet after the mission. This harmonizes tax treatment of different business and asset classes, and includes a three-year tax holiday for manufacturing firms as a way of incentivizing private investment in a difficult business environment. Staff expressed concern about the tax holiday, reiterating the TA experts’ views that such a measure is likely to be ineffective, open to abuse, and subject to fiscal risks. The authorities stressed that the incentives only apply to new firms, and that strict guidelines will be applied to prevent abuse

13. The budget formulation process is unwieldy. Large carry-overs, unrealistic expenditure estimates, imprecise costing, and premature inclusion of development projects contribute to an inflated expenditure envelope. Therefore, development expenditures suffer from low execution rates (54 percent in 2016) with political consequences (¶1). The authorities introduced a mid-year review to reallocate funds to better-performing projects and staff assumes an execution rate of 64 percent for 2017.

14. The SOEs are not effectively monitored. While SOEs do not receive explicit budgetary support, their revenues often rely on non-core operations, their financial position is uncertain, and their accounting not up to standard. The authorities concurred on the importance of closer monitoring and pointed to changes in legislation that strengthen oversight, e.g., by requiring proper audits of SOE operations.

B. Monetary and Financial Sector Policies

15. The current monetary and exchange rate regime has served Afghanistan well. Given weak monetary transmission and the high degree of dollarization, reserve money remains the nominal anchor with the objective of keeping inflation low. Staff called for continuing efforts to reduce dollarization and advocated applying reserve requirements on deposits in currencies of their denomination, rather than in domestic currency only. The authorities stressed that such a change should be implemented gradually. They concurred that the flexible exchange rate regime remains appropriate as a shock absorber.

16. External stability hinges on external aid disbursements. The current account is dominated by imports and official transfers. Exchange rate developments primarily depend on the level of foreign aid disbursements and dollarization behavior, while FX auctions aim to limit short-term volatility against the U.S. dollar. The real effective depreciation observed from early 2015 until recently has been largely driven by emigrants leaving Afghanistan increasing demand for FX, and has not yet been reflected in an improvement in export performance because of non-price factors (investors’ confidence, access to finance and energy, quality of infrastructure, and investment climate), calling for structural reforms to enhance the business environment and build competitiveness. Weak external sector statistics make the assessment of the exchange rate difficult.

A01ufig3

Real Effective Exchange Rates

(Indices, 2010=100)

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: National authorities and IMF staff calculations.

17. Despite signs of improvement, the financial sector remains vulnerable (Box 3). Banking sector assets are concentrated and related-party lending in some banks exceeds prudential limits. Overall banking system liquidity is adequate, but high concentration in large demand deposits creates significant liquidity risks. Staff urged DAB to ensure that weak banks implement time-bound restructuring and recapitalization plans, and unwind excessive related-party exposures within one year. DAB on-site inspections identified a recapitalization need for several banks, as well as the need to increase loan-loss provisions, including for off-balance sheet exposure. The authorities agreed with staff’s assessment and confirmed their commitment to implement DAB’s recently approved “Program and Strategy Dealing with Weak Banks.”

The Afghan Banking Sector: An Overview

The banking sector is composed of three SOCBs (NKB, Pashtany, and Bank Millie), nine private banks, and three foreign commercial bank branches. The SOCBs have wide retail presence across the country, and private banks have presence in most of the provinces.

Financial intermediation remains limited, even for a low-income, fragile state. Total banking sector assets constitute 24.1 percent of GDP (against 18.6 percent in deposits) and bank lending is at 3.7 percent of GDP. Lending is almost entirely done by private banks since the SOCBs focus on governance and efficiency improvements. Financial inclusion is limited: only 10 percent of adults have accounts with formal financial institutions, ATM services are available in eight of 34 provinces, credit cards are issued in six.

Total Assets

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: Afghan authorities and IMF staff calculations.

Total Liabilities

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

This level of financial intermediation can be largely explained by difficult economic and security conditions, resulting in a shortage of credit-worthy borrowers. The judicial system and legislative framework also contribute, as do banks’ weak management, lack of professional capacity, poor governance and internal controls. Low financial literacy is a further impediment.

The banking sector is marginally profitable, with few banks having incurred losses in 2016. Profitability is supported by high net interest margins and significant investment income from DAB capital notes. System-wide CAR is at 28.3 percent, although several banks require capital injections. The banking system has adequate liquidity, although prevalence of overnight deposits and high concentration of large deposits create significant risks.

DAB performs the functions of supervisor and resolution authority. It has sufficient supervisory powers but faces significant capacity constraints. With banks’ balance sheets highly dollarized and interbank activity very limited, monetary transmission is impaired.

World Bank and IMF provide TA in modernizing SOCBs, implementing proper governance, dealing with weak banks, and strengthening DAB’s supervision capacity.

Figure 4.
Figure 4.

Islamic Republic of Afghanistan: Monetary Sector

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: Afghan authorities and IMF staff calculations.1/ The drop in credit to the private sector in 2011 reflects the write-off of Kabul Bank loans.
Figure 5.
Figure 5.

Islamic Republic of Afghanistan: Banking Sector

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: Afghan authorities and IMF staff calculations.

18. The authorities concurred that the three SOCBs remain a key source of macro-financial vulnerability. They are marginally profitable, but lack viable business models. The MoF, in coordination with DAB and with World Bank support, is working on a strategy for SOCBs, addressing their business model and governance structure. The authorities agreed that, until the strategy is developed and approved, NKB and Pashtany Bank will maintain their current “no-lending” policy; Bank Millie will refrain from issuing longer-term mortgages; and the privatization of NKB will be on hold. The authorities noted plans to develop appropriate financing instruments for agriculture and housing in the “National Financial Inclusion Strategy” before the end of 2017.

19. Staff advocated the establishment of a Financial Stability Council as a crisis preparedness mechanism to facilitate operational coordination among the authorities. The FSC mandate should be spelled out in a presidential decree and a Memorandum of Understanding between the MoF and DAB and include developing contingency plans and performing crisis simulations to test the capacity to respond to severe scenarios. The authorities agreed on the importance of establishing an FSC and plan to set it up promptly.

20. Effective financial intermediation remains a challenge. The mission and authorities discussed measures to encourage credit growth while maintaining effective prudential requirements, including by promoting a broader use of the public credit registry and collateral registry, implementing prudential measures to encourage term-lending instead of overdrafts, and allowing banks with CAMEL ratings of two or better to provide unsecured lending to good quality borrowers. DAB agreed to consider these measures as long as they do not affect negatively banks’ financial position.

21. The authorities have made progress in addressing the shortcomings identified by the FATF, with TA in some areas by the Fund. Afghanistan has been subject to the FATF’s monitoring since 2012 for its “strategic deficiencies” in the AML/CFT regime, and is scheduled to receive an on-site visit before June 2017, possibly leading thereafter to a delisting. Progress was also made in relation to financial supervision, most notably in implementation of fit-and-proper regulations and the supervision of money service businesses.

C. Governance Issues

22. The authorities have made progress in anti-corruption reforms. The new provisions as part of the consolidated penal code aiming to criminalize corruption in line with UNCAC have been drafted, but submission to parliament is still pending. Progress has also been made in relation to asset declarations. A draft law to require heads and deputies of law enforcement agencies, tax authorities and customs to submit annual asset declarations was submitted to parliament. If enacted, these declarations should be available to domestic law enforcement agencies and the FIU. The proposed requirement covers assets that are legally and beneficially owned, with sanctions for non-compliance for all officials subject to declaration requirements. In addition, the authorities are drafting a new anti-corruption bill and are working towards the designation of a special court for financial crimes.

23. Nevertheless, important challenges remain. Despite recent progress, Afghanistan ranks 169 out of 176 in Transparency International’s Corruption Perceptions Index of 2016.5 The pending criminalization of corruption needs to be enacted (SB end-November 2017). Likewise, the pending legislation in relation to asset declarations of heads and deputies of law enforcement agencies, customs and tax authorities needs to be enacted (SB end-December 2017) to allow timely implementation. Asset declarations of officials listed in the constitution need to be made available in English online soon (SB end-June 2017). Beyond the new legislation, the focus of reforms will need to shift towards effective implementation of the anti-corruption and anti-money laundering framework. This includes ensuring that relevant authorities, including the recently-established Anti-Corruption Justice Center, generate prosecutions and convictions of corruption and recover assets in line with Afghanistan’s risk profile.

D. Other Issues

24. The Afghanistan National Peace and Development Framework, issued in late 2016, lays out the government’s development policy framework.6 As such, it serves as the authorities’ Economic Development Document in line with the Fund’s requirements on engagement with low-income countries.7 Progress on the two pillars of the ECF-supported program—structural reforms for private sector growth (institution building, fiscal and financial reforms, and measures to combat corruption for scaled up private sector development) and policies for macro-financial stability—is critical for the success of the ANPDF.

  • The document sets out structural reforms aimed at promoting private sector activity; developing agriculture, mineral and natural resource sectors, energy and infrastructure; advancing regional integration; increasing labor productivity and investing in human capital; and urban development. The overarching objective is to transform the import-dominated economy of small farmers into an export-oriented one of larger manufacturers.

  • The ANPDF emphasizes poverty reduction and social inclusion through The Citizens Charter, a concentrated effort to include provinces and rural communities into the development strategy. The Charter aims at improving mechanisms for service delivery in such areas as education, health, agricultural services, and infrastructure through Community Development Councils that will channel resources, identify potential beneficiaries, and help with operation and maintenance. It explicitly incorporates women’s empowerment and investment in youth opportunities.

25. Data constraints continue to hamper analysis. Staff noted that data on national accounts and the BOP suffer from weaknesses in coverage and consistency and stressed the need to develop high frequency real sector indicators. TA is being provided to strengthen statistical systems.

Program Performance and Modalities

A. Performance Under the First Review

26. Program performance has been satisfactory. All December 2016 PCs and indicative targets were met, with a sizeable over-performance on FX reserves and revenue (¶4 and ¶5).

Quantitative Performance Criteria (PC) Under the ECF, December 2015–December 2016

article image
Sources: Afghan Authorities and IMF staff calculations.

27. Three out of five SBs were met, and all requirements for one of the remaining two SBs are now implemented.

  • Anti-corruption (end-October 2016): One element of the SB—the submission to parliament of the draft amendment to the Law on Supervision and Implementation of an Anti-Corruption Strategy, requiring senior officials to declare their assets with proportionate and dissuasive sanctions for non-compliance—was completed on November 13, 2016. The other—the criminalization of acts of corruption— became part of a draft consolidated penal code, still to be enacted.

  • 2017 budget (end-November 2016): The budget is in line with the program, expected to deliver a small surplus after grants. It reflects a capital transfer to reduce DAB’s lender of last resort exposure (Af7.7 billion, plus interest payment to be agreed between the MoF and DAB) and including a payment to the Kabul Bank Receivership, to be subsequently transferred to DAB. While total transfers identified in the budget were appropriate in magnitude, the Receivership portion was lower than stipulated by the SB. The amended budget corrected this and was submitted to parliament for approval.

  • Transfers to DAB and NKB (end-December 2016): As stipulated in the SBs, Ministry of Finance transferred US$106 million to recapitalize NKB and Af6 billion to reduce DAB’s LoLR exposure.

  • Afghanistan Customs Department to review and update its risk management policy (end-December 2016): The policy has been revised and assessed positively by IMF and World Bank experts.

Islamic Republic of Afghanistan: First Review Structural Benchmarks

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B. Program Modalities

28. The program is monitored closely through quantitative targets and structural benchmarks. PCs and SBs proposed for end-June 2017 and end-December 2017 are outlined in Annex II. The authorities request the modification of three end-June 2017 PCs (central government revenues, net credit to the central government from DAB, and reserve money), which were approved by the Board in July 2016, owing to an update of the macroeconomic framework and some methodological changes affecting the monetary variables.

The authorities request the exclusion from the zero ceiling on non-concessional borrowing of two loans from the Islamic Development Bank totaling ID53.2 million (US$72 million, 0.4 percent of GDP). These loans have grant elements of 49.6 and 55.6 percent and do not meet the concessionality criterion of 60 percent stipulated by the TMU. The loans finance part of the construction of the Kabul City Ring Road, a critical infrastructure project integral to the authorities’ development program, and the improvement of local link roads and social infrastructure. These loans do not modify the conclusions of the last DSA. Given a high risk of debt distress, the authorities agree that non-concessional borrowing should remain exceptional, and reaffirm their commitment to aim for the program’s concessionality threshold (currently 60 percent).

Summary Table on External Borrowing Program

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Sources: Afghan Authorities and IMF staff calculations.

Contracting and guaranteeing of new debt. The present value of debt is calculated using the terms of individual loans and applying the 5 percent program discount rate.

Debt with a grant element that exceeds a minimum threshold. This minimum is 60 percent for Afghanistan.

29. Proposed SBs support reforms in the following areas (MEFP Tables 2 and 3):

  • Governance: improving governance and fighting corruption; enhancing transparency in the mining sector in line with the EITI Standard.

  • Fiscal: strengthening budgetary processes, cash planning, and commitment control; improving revenue collection efficiency and reducing leakages; preparing for implementation of a VAT.

  • Financial sector: strengthening independence of DAB; developing a strategy for SOCBs; overcoming the legacy of the Kabul Bank collapse. For the latter, agreed SBs stipulate that the payment to Kabul Bank Receivership ($50 million) and the capital transfer to DAB will be executed this year, as specified in the FY 2017 budget, and that such transfers will be identified transparently in the FY 2018 budget.

30. Safeguards assessment. The January 2017 update assessment found that DAB continues to face significant capacity constraints and operational risks considering the difficult security situation. Governance and external audit arrangements are nonetheless broadly sound, and work on draft amendments to the DAB Law has been initiated, with emphasis on provisions on DAB’s mandate, institutional and personal autonomy, rules of profit distribution, recapitalization, and foreign reserve management. However, progress has been slow in the work on the draft amendments, and in some other key areas such as the resolution of the Kabul Bank exposure and strengthening the internal audit function. The assessment recommended that full resolution of DAB’s exposure to Kabul Bank be anchored by a signed agreement between the MoF and DAB with explicit repayment commitments in the period 2017–19. While an agreement has not yet been signed, the authorities remain committed to resolving this by 2019. The assessment also recommended that draft amendments to the DAB Law be submitted to Cabinet and that controls over the compilation of program monetary data be strengthened.

31. The calibration of the program and the capacity to repay the Fund remain adequate.

  • There is no immediate residual BOP need, however, there are protracted BOP pressures over the medium term reflecting underlying current account imbalances.8

  • High aid dependence and associated risks call for a significant level of foreign reserves. The current and projected level of reserves remains adequate, supporting investors’ and donors’ confidence in the economy’s ability to address unexpected shocks.

  • Afghanistan’s public debt remains modest at just above 8 percent of GDP. The authorities have made progress in obtaining pledged debt relief delivery from one Paris Club creditor.9

  • Upon completion of the first review, a disbursement of SDR 4.5 million would be made.

A01ufig6

Reserve Adequacy, 2016

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2017, 144; 10.5089/9781484302972.002.A001

Sources: Afghan authorities and IMF staff calculations.

32. Risks to the program remain high. They include security conditions, the strength of aid flows, and the management of the returning refugee influx. Maintaining domestic revenue collection in line with program targets will be key to sustain donors’ confidence in the country’s ability to move towards self-reliance.

Staff Appraisal

33. Despite progress in improving socio-economic conditions over the past 15 years, Afghanistan remains poor, fragile, and heavily aid-dependent. Security and political uncertainties, the drawdown of international troops, and weak institutions adversely affect economic performance and social outcomes. The National Unity Government, which started work in late 2014, is committed to economic transformation to ensure higher inclusive growth and self-reliance over the medium term. External stability hinges on external aid disbursements, and structural reforms will be essential to diversify the economy and build competitiveness.

34. The authorities’ commitment to the program’s objectives has been commendable. With strong financial and technical support from the donor community, they are undertaking wide-ranging reforms, including those in the context of the ECF-supported program, to achieve higher inclusive growth. They have demonstrated their commitment to this process, but continued progress is contingent on sustained donor support and an eventual improvement in security conditions.

35. A modest pickup in growth is expected in 2017 and, conditional on continued donor support, steadfast reforms and improvements in security, over the medium term. This outlook is subject to significant risks. If security conditions worsen, aid falls short, or reforms stall, growth would be lower with attendant effects on unemployment and poverty. An additional risk is the large returning refugee influx. On the upside, a lasting improvement in security conditions would provide a game-changing boost to confidence and the economy.

36. The program’s policy mix aims at preserving macro-financial stability and fostering higher medium-term growth. The overall fiscal balance after grants is targeted to remain close to zero, preventing a build-up in public debt, while monetary policy is programmed to deliver moderate inflation, fostering confidence in the domestic currency and a comfortable international reserves buffer. The flexible exchange rate regime has served Afghanistan well and should remain in place.

37. A continued strong fiscal reform effort is essential. These should focus on broadening the tax base and raising the revenue intake in a fair and sustainable manner. Several specific policies could contribute to meeting these objectives: capacity should be improved, especially in the revenue and customs departments; the fragmented LTOs should be streamlined; and policies to reduce corporate income tax evasion should be introduced. The authorities’ intention to prepare a VAT implementation plan is particularly welcome. Determined efforts are also needed to improve formulation, execution and reporting of the budget; to ensure a pro-growth composition of expenditures; and to strengthen commitment control and cash management. Establishing a strong fiscal anchor and expanding the fiscal perimeter are other important objectives. The inclusion of a three-year tax holiday for manufacturing firms in the new income tax law is unlikely to be effective in boosting investment, and strict guidelines will need to be developed to prevent abuse. Further tax concessions or tax expenditures should be avoided.

38. Financial sector reforms are critical to banking system stability and economic development. Following recent progress in this area, it is important to continue strengthening DAB’s regulatory and supervisory frameworks (including in the areas of risk-based supervision, implementation of AML/CFT and fit-and-proper measures, and consolidated supervision). The authorities should closely monitor financial risks given poor asset quality, connected lending, capital shortfalls, weak profitability, and management deficiencies in several banks. A key priority remains overcoming the Kabul Bank crisis legacy and restoring DAB’s balance sheet. The authorities are encouraged to pursue the remaining asset recoveries related to this crisis. Staff welcomes the authorities’ plans to prepare, with World Bank support, a strategy for state-owned commercial banks, addressing their business model and governance deficiencies, and minimizing their operational risk.

39. Strong anti-corruption measures are critical to boost stakeholders’ confidence, and reforms in this area should be accelerated. As a priority, the authorities need to strengthen the legal and institutional framework for anti-corruption by ensuring that acts of corruption are criminalized in line with the UNCAC. The regime for asset declaration by public officials and publication of declarations is a critical tool in improving transparency and accountability of the public sector and should be enacted, supported by strong implementation and enforcement. Following the enactment of these two pieces of legislation, the authorities should focus on implementation measures and enhancing the overall effectiveness of the anti-corruption regime, including in relation of enforcement. They should also continue improving implementation of the anti-money laundering measures to protect financial stability and enable effective detection and deterrence of illegal proceeds from corruption and other macro-critical economic crimes such as illicit drug production and trafficking.

40. The quality and timeliness of economic data is a major impediment to proper analysis. Reliable statistics, particularly for real sector activity, are critical for sound economic policy-making. Offsite TA from the Fund is available to support this effort.

41. Continued strong program ownership is critical to the success of the program. The fragile security situation and political uncertainty could undermine reform implementation and derail the program, as could governance gaps and a lack of transparency. As the program proceeds toward more complex reforms, the likelihood of setbacks will rise. Together with the determination and commitment of the authorities, the support of donors is key to success.

42. Staff supports completion of the first review in light of satisfactory performance. Staff supports the authorities’ request to modify the performance criterion on non-concessional borrowing to enable two loans from the Islamic Development Bank to fund a key development project in line with the Fund’s debt limit policy. Finally, staff also supports the authorities’ request for a modification of three June 2017 quantitative performance criteria, reflecting updates of the macroeconomic framework and changes in methodology.

Table 1.

Islamic Republic of Afghanistan: Selected Economic Indicators, 2014–17

(Quota: SDR 323.8 million)

(Population: approx. 33.4 million)

(Per capita GDP: approx. US$615; 2015)

(Poverty rate: 35.8 percent; 2011)

(Main exports: opium, US$2.7 billion; carpets, US$83.4 million;2014)

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Sources: Afghan authorities, United Nations Office on Drugs and Crime, WITS database, and IMF staff estimates and projections.

Excluding the narcotics economy.

Comprising mainly current spending.

Defined as domestic revenues minus operating expenditures.

Public sector only. Incorporates committed but not yet delivered debt relief. Debt relief recorded fully at time of commitment.

Public debt (including 2016 program number) was revised to include promissory note issued by MoF to settle DAB’s Kabul Bank exposure.

In months of next year’s import of goods and services.

CPI-based, vis-a-vis the U.S. dollar.

Table 2.

Islamic Republic of Afghanistan: Medium-Term Macroeconomic Framework, 2015–22

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Sources: Afghan authorities and Fund staff estimates and projections.

Excluding the narcotics economy.

Comprising mainly current spending. It is assumed that donors’ recurrent expenditure off-budget, mostly in the security sector, is being moved onto the budget by 2031.

Defined as domestic revenues minus operating expenditures.

In months of next year’s im port of goods and services.

Public sector only. Incorporates committed but not yet delivered debt relief. Debt relief recorded fully at time of commitment.

Incorporates the 2012 revision to the UN World Population Prospects.

Table 3a.

Islamic Republic of Afghanistan: Central Government Budget, 2014–22

(In billions of Afghanis)

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Sources: Afghan authorities and Fund staff estimates and projections.

ARTF: Afghanistan Reconstruction Trust Fund; LOTFA: Law and Order Trust Fund for Afghanistan; CSTC-A: Combined Security Transition Command - Afghanistan (now NTM-A: NATO Training Mission - Afghanistan)

2015 figure includes about Af 2.85 billion arrears, which are repaid.

2015 figure includes about Af 7 billion discretionary development arrears, which are repaid.

Positive number indicates that expenditures have been recorded, but not yet executed.

Pro-poor spending covers ministries of education, labor and social affairs, martyrs and disabled, public health.

Table 3b.

Islamic Republic of Afghanistan: Central Government Budget, 2014–22

(In percent of GDP)

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Sources: Afghan authorities and Fund staff estimates and projections.

ARTF: Afghanistan Reconstruction Trust Fund; LOTFA: Law and Order Trust Fund for Afghanistan; CSTC-A: Combined Security Transition Command - Afghanistan (now NTM-A: NATO Training Mission - Afghanistan)

2015 figure includes about Af 2.85 billion arrears, which are repaid.

2015 figure includes about Af 7 billion discretionary development arrears, which are repaid.

Positive number indicates that expenditures have been recorded, but not yet executed.

Pro-poor spending covers ministries of education, labor and social affairs, martyrs and disabled, public health.

Table 4a.

Islamic Republic of Afghanistan: Central Bank Balance Sheet, 2014–22

(In billions of Afghanis, at current exchange rates, unless otherwise indicated)

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Sources: Afghan authorities and Fund staff estimates and projections.Note: Monetary indicators are calculated based on modified methodology and, thus, differ from the numbers reported in the previous staff reports.

A nonmarketable security issued to DAB by the Ministry of Finance for the cost of a lender of last resort assistance to Kabul Bank.

Includes Afghanistan’s SDR holdings (MoF is the fiscal agent for the IMF).