Islamic Republic of Afghanistan: Fourth Review Under the Extended Credit Facility Arrangement, Request for Modification of Performance Criteria, and Request for Extension and Rephasing of the Arrangement—Press Release; and Staff Report

Fourth Review Under the Extended Credit Facility Arrangement, Request for Modification of Performance Criteria, and Request for Extension and Rephasing of the Arrangement-Press Release; and Staff Report

Abstract

Fourth Review Under the Extended Credit Facility Arrangement, Request for Modification of Performance Criteria, and Request for Extension and Rephasing of the Arrangement-Press Release; and Staff Report

Context

Objectives and Modalities of the 2016–19 ECF Arrangement

The ECF supports macroeconomic and structural reforms, catalyzes donor support, and rests on:

  • Structural reforms for institution building, fiscal and financial reforms, and measures to combat corruption for scaled-up private sector development;

  • Policies to preserve macro-financial stability.

The fourth review covers seven structural benchmarks (SBs) and eight performance criteria (PCs):

  • SBs on: fiscal risks reduction via approval of a supplementary budget in line with the ECF’s macroeconomic framework; fighting corruption and strengthening revenue administration, including through establishment of a national LTO; reducing the central bank’s lender of last resort exposure to Kabul Bank; and improving fiscal risk oversight and corporate governance through adoption of PPP and state-owned entities’ legislation conforming with good international practice.

  • PCs for end-June 2018 on: government revenues, net credit to central government from the central bank, reserve money, FX reserves, and government’s borrowing and lending.

1. The first parliamentary elections since 2010 took place in October amid violence and severe operational challenges. Voter turnout estimated at 45 percent was high considering the violence, with especially strong participation by women. Final election results will be available in December 2018, after which the focus will shift to the presidential election scheduled for April 2019.

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Civilian Deaths and Injuries

(Thousands, January to September 2009 – 2018)

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Source: United Nations Assistance Mission in Afghanistan.

2. The armed conflict rages on, but there is a new impetus for peace. Civilian casualties remain near record levels, most recently related to the election, including targeting of candidates. Increased attacks by Islamic State militants have added another dimension to the violence. Nevertheless, peace efforts continue through multiple channels involving global and regional powers. A prominent U.S. envoy was appointed as a special adviser to Afghanistan tasked with bringing the Afghan government and the Taliban to the negotiating table.

3. A severe drought risks setting off a major humanitarian crisis, possibly compounded by returning Afghan migrants. Afghanistan’s worst drought in decades is leading to a collapse in agriculture in northern and western Afghanistan, with two-thirds of the country affected. A humanitarian crisis is unfolding, with increasing numbers of Afghans displaced from rural areas to cities. In addition, the slowdown in economic activity in Iran in the context of the re-imposition of U.S. sanctions is driving Afghan migrants back with nearly 600,000 returnees as of late September.1 Meanwhile, some 1.4 million Afghan refugees in Pakistan have had their residency permits extended until end-June 2019.

4. The upcoming Geneva donor conference will once again put the international spotlight on Afghanistan. The goal of the November 27–28, 2018 conference is to confirm the international community’s support of Afghanistan and for the Afghan government to showcase the progress it has made over the past several years, while renewing its commitment to development and reform. The conference will also be an opportunity to measure results against the $15.2 billion of grants committed in 2016 by the international community for Afghanistan. The Geneva conference is held between two pledging conferences, Brussels 2016, and the next pledging conference expected to be held in 2020.

Recent Developments

5. In 2017, growth picked up marginally, but remained slow given weak confidence and political uncertainty, while inflation was low. Real GDP growth at 2.7 percent, 0.5 percentage point above 2016 growth, reflected stronger services and agriculture.2 In the first half of 2018, prices declined mostly due to lower food prices, as imports have substituted for domestic food shortages, and the demand effect of lower rural incomes owing to the drought. Starting in August, and partly reflecting the Afghani’s depreciation, inflation returned to positive territory, picking up to 0.2 percent y/y in September (2.3 percent excluding food).

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Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Source: Afghanistan authorities.
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CPI Inflation

(Y-o-y change, in percent)

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Source: Afghanistan authorities.

6. The Afghani has depreciated against the U.S. dollar in 2018 amid regional currency presures. Depreciation peaked at over 9 percent in early October versus end-2017, with the Afghani reaching a record low against the U.S. dollar. On a nominal trade-weighted basis, the Afghani appreciated modestly reflecting the sizeable currency depreciations in Iran and Pakistan. To counter increased exchange rate volatility, Da Afghanistan Bank (DAB) raised sales of U.S. dollars by some 30 percent over the corresponding 2017 volumes. The pressure on the exchange rate partly reflects dollar outflows to Iran. The trade and current account deficits (before grants) remain very large despite efforts to increase exports via diversification of export destinations. Reflecting the latter, exports have risen by 30 percent in the first half of 2018, albeit from a low base.

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Nominal Exchange Rate

(Period average, LCU/USD)

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Source: Haver, Afghanistan authorities.
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Gross International Reserves and Exchange Rate

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Source: Afghanistan authorities.
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Exchange Rate

(Index 2010=100; +=appreciation)

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Sources: Afghan authorities and IMF staff calculations.

7. Fiscal performance has generally been good. As expected, revenue growth has moderated in 2018, as the impact of stronger revenue administration waned. Nevertheless, the June program revenue target was met and in September revenues grew by nearly nine percent over the last year. At end-June, operating grants exceeded the program forecast due to a large disbursement by the donor fund administered by the World Bank. Consequently, the treasury’s cash balance was Af 42 billion, well above the program floor of Af 10 billion and remained above Af 40 billion in September. The operating deficit (excluding grants) at end-June exceeded the program’s indicative target by Af 3 billion primarily due to increased spending, including traditional bonus payments to civil servants before Eid. In September, the deficit was below the indicative target by nearly Af 10 billion.

uA01fig07

Domestic Revenues Growth

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

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Sources: Afghan authorities and IMF staff calculations.
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Total Treasury Discretionary Cash Balances

(In billions of Afghanis)

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Sources: Afghan authorities and IMF staff calculations.

8. Monetary aggregates have grown in line with the program. Reserve money in local currency at end-June was below the program’s ceiling (and below the indicative target at end-September), mainly because of larger-than-expected dollar sales by DAB. Credit to the economy has grown by 3.5 percent over the last year, albeit in part due to depreciation of the Afghani. As of end-August, the loan-to-deposit ratio was low at 16 percent. To incentivize credit growth, DAB reduced its interest rate on capital notes—which has constituted the lion’s share of banks’ income—to almost zero.

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Credit to Economy

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Source: Afghanistan authorities.

9. Most financial soundness indicators are broadly stable but there are concerns about the health of a few private banks. Nonperforming loans declined in 2018Q2 compared to a year earlier and profitability improved relative to Q1. A small number of private banks are assessed by DAB as facing serious problems, but DAB’s supervisors are closely monitoring the implementation of corrective action plans.

Outlook and Risks

10. The near-term growth outlook has weakened. Reflecting the impact of the drought on agricultural output, the 2018 real GDP growth forecast was lowered to 2.3 percent from 2.5 percent previously. In 2019, agricultural output is expected to recover from the drought and with political uncertainty gradually declining following the presidential election the baseline scenario envisages a modest growth rebound to 3 percent. It assumes growth reaching 5 percent in 2023 conditional on no significant deterioration in security, continued reforms, and aid inflows. Over time, extractive industries3 and regional trade integration could support growth and job creation. Still, under current projections, Afghanistan would not make much progress in reducing poverty (MEFP ¶13). Given developments so far and favorable regional food prices, the 2018 inflation forecast was reduced to 3 percent (compared to 5 percent in third review), and to 4.5 percent on average during 2019–20. The external position should remain comfortable with international reserves covering about 10 months of imports as aid inflows continue (albeit at reduced levels).

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Growth Scenarios

Citation: IMF Staff Country Reports 2018, 359; 10.5089/9781484389539.002.A001

Source: IMF staff calculations.

11. The baseline scenario faces considerable downside risks. In the near term, increased political instability due to the electoral cycle and violence raises uncertainty and may dampen economic activity.4 The authorities emphasized that the uncertain impact and duration of the ongoing drought presents another risk. The domestic risks are compounded by mounting external risks. The re-imposition of U.S. sanctions on Iran5 and economic difficulties in Pakistan may have adverse trade and financial spillovers, including via lower remittances and exports. On the upside, a durable peace agreement, boosting private sector confidence and investment and allowing re-composition of spending towards pro-growth investments in human and physical capital, would improve growth prospects significantly.

Policy Discussions

A. Fiscal Issues

12. The implementation of the 2018 supplementary budget approved by parliament in July (fourth review benchmark) is on track. Staff and the authorities agreed an end-year deficit target (including grants) of 0.4 percent of GDP in line with the program. It was agreed that any deviations from the deficit target should be small and occur only in case of emergency expenditure needs that cannot immediately be grant-financed.

  • Revenues and grants: Despite increased economic risks, the supplementary budget raised the forecast for domestic revenues relative to the initial budget. Staff favors the more conservative program target given the weaker outlook for growth and significant downside risks (see paragraph 13). On grants, the budget envisages increased operating and development grants, mostly from the World Bank and EU. These projections appear consistent with donor intentions, provided reforms continue.

  • Expenditures: The revised projection envisages increased operating and development spending explained by higher security as well as higher pensions and civil service wage spending. Election-related spending is mostly off-budget and financed by grants. The increase in development spending, much of it new nondiscretionary projects commitments by donors, is for schools, hospitals, health care facilities, and other infrastructure projects including Af 0.3 billion for drought relief. Much of the drought relief is financed by donors. Recently, the EU and the UN’s Central Emergency Response Fund announced respective allocations of US$23 million and US$35 million.

13. In 2018, the main fiscal risks relate to the revenue projection. The authorities emphasized downside risks to this year’s revenue collections because of the elections and related political tensions, as well as disruptions caused by increased violence. They saw less potential for expenditure slippages, since risks due to drought or unexpected refugee and security outlays appeared contained as donors are financing these. The authorities noted that, in the event revenue risks materialize, they would be prepared to quickly rationalize discretionary spending as part of the budget implementation mandate. They agreed that any expenditure cuts should be undertaken while preserving priority social spending.

14. The authorities emphasized that 2019 will be a very challenging year for the country’s public finances.6 They noted that revenue collections will come under pressure from the uncertainties caused by the presidential elections, while grants are expected to be lower in 2019 because some of the donor programs that ended in 2018 have not yet been replaced with new commitments. Given these factors, revenue is conservatively projected to grow in line with nominal GDP, and grants are assumed to decline by 3.3 percentage points of GDP relative to 2018. Reflecting these constraints, and with expenditures 2.9 percentage points of GDP lower than the projected 2018 outcome, staff and authorities agreed a revised overall deficit (including grants) target of 0.8 percent of GDP. While this implies a fiscal loosening compared to the deficit expected for 2018, the operating deficit excluding grants remains at 6.7 percent, a substantial tightening relative to the 2018 projected deficit of 7.5 percent. To counter any unfavorable revenue or grants developments next year, the authorities are prepared as part of a contingency plan to implement additional spending cuts of about 0.5 percent of GDP (from lower bonuses and cuts in operation and maintenance expenditures), while preserving priority social spending (MEFP ¶15).

15. Staff and the authorities discussed progress on structural fiscal reforms.

  • Adoption of the value-added tax (VAT): The VAT is to be adopted at end-2020. The authorities have advanced towards this goal and will establish the VAT Steering Committee and the VAT Implementation Team before end-2018 (fifth review benchmark). The Committee is responsible for the strategic issues of the VAT implementation, and the VAT Team will manage VAT implementation and operation (MEFP ¶15, 19).

  • Reforms of large taxpayers’ office (LTO): The authorities have prepared a strategic implementation plan to establish a single national LTO (fourth review benchmark). In accordance with this plan, the authorities will establish a fully functional Single LTO and transfer cases from the existing provincial LTOs by end-October 2019 (sixth review benchmark, MEFP ¶19).

  • Improvement in budget execution and management: Staff welcomed the higher execution rate of the development budget of 49 percent (32 percent a year ago) at end-September. The authorities agreed to continue efforts to make the budget an effective policy tool, including through improved execution, supported by realistic multi-year development programming. Staff welcomed the authorities’ intention to strengthen public investment management, including implementation of forward baseline estimates along with effective project appraisal and selection (MEFP ¶22).

  • Improvement of the legal framework for the state-owned corporations (SoE/Cs): Staff welcomed adoption of a new SoC law (fourth review benchmark). The new law provides the Ministry of Finance (MoF) with a clear mandate to monitor and oversee potential fiscal risks emanating from the SoCs. Staff encouraged further progress building on the revised legislation and the recommendations of Fund TA. The September 2018 FAD TA mission proposed inter alia: including fiscal risk statements in the Fiscal Strategy paper; constituting a new SoC Oversight Board; establishing a system for managing contingent liabilities; and amending the Public Financial Management (PFM) act to adequately manage issuance of guarantees (MEFP ¶17).

  • Development of a Public Private Partnership (PPP) framework: The government plans to increase its reliance on PPPs to improve infrastructure financing and delivery. The PPP legislation was brought in line with good international practices (fourth review benchmark). The new law will be helpful for recognizing financial implications including contingent liabilities of the PPPs. In this context, staff advocated strengthening PFM including effective project appraisal, selection, and implementation.7 The September 2018 FAD TA mission proposed inter alia: preparing pre-feasibility studies for projects in energy, agri-business, and public works; completing the portfolio review for all major capital projects; and setting up a technical committee to evaluate all large and major projects before any funding is allocated to them (fifth review benchmark; MEFP ¶15, 17, 22, 23).

  • Strengthen debt management: Staff urged development of procedures for collecting and disseminating external borrowing plans as soon as they materialize. In that context, it is important to strengthen public debt monitoring and management, and planning for development projects to establish a project financing/borrowing program which includes possible public guarantees. When borrowing externally, the authorities should remain committed to seeking the concessional terms as agreed under the program after a careful assessment of their implications for debt sustainability (MEFP ¶23).

Text Table 1.

Public Private Partnerships Signed Projects (Power Plants) 1/

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Source: 2018 National Budget Document and the authorities’ revisions in October 2018.

The government guarantees purchase of energy from these projects and provides a partial risk guarantee backed by the World Bank with IDA funding (pending World Bank Executive Board’s approval) to Mazar/Bayat IPP and provides a sovereign guarantee to Kajaki project. Budget investment, from the Viability Gap Fund, covers 36 percent of costs of Kandahar Solar. Projects not listed above are in very early stages of development and estimates of the required financing are not available.

B. Monetary and Financial Sector Policies

16. Staff encouraged DAB to remain committed to exchange rate flexibility. The authorities explained that both domestic (political uncertainty, drought) and external (general U.S. dollar strength, developments in neighboring countries) factors had complicated monetary and exchange rate policy making over the past few months. They noted that they had sought to dampen excessive exchange rate volatility by increasing foreign exchange sales, while eschewing administrative measures, in the broader context of letting the Afghani move with market trends. Staff acknowledged the need to dampen excessive volatility, while allowing the exchange rate to act as shock absorber, especially given low inflation (MEFP ¶12, 16).

17. Considering the financial sector’s vulnerability, staff welcomed DAB’s continued efforts to address shortcomings among the weak private banks. The authorities noted that they have been strictly enforcing the corrective action plans agreed with the weak banks, and that the implementation rate of these plans is 70 percent on average. The weaknesses among private and publicly-owned banks generate some contingent fiscal liabilities, albeit limited due to the low level of financial intermediation. These risks should remain contained provided that close supervision continues. On August 1, 2018, Afghanistan Commercial Bank was placed under liquidation and its license was cancelled. DAB stressed that there had not been any contagion from this closure to other banks, that depositors had been repaid, and that asset recovery was proceeding. Going forward, staff encouraged continued efforts to strengthen the crisis prevention framework, with the authorities requesting the Fund’s assistance on crisis management legislation. In this context, the forthcoming Financial Stability Committee (FSC) will provide a vehicle for DAB and MoF to cooperate on crisis preparedness and management. The authorities confirmed that the establishment of the FSC by end-2018 (fifth review benchmark; MEFP ¶33) is on track.

18. Staff encouraged further progress in improving the performance of the state owned commercial banks (SOCBs) through a new corporate governance framework and individualized operational reform plans. Progress had slowed temporarily in 2018Q3 owing to capacity constraints but is now regaining momentum. The World Bank is providing continued support in line with a strategy agreed with the authorities. Staff stressed the importance of adhering to the agreed strategy. A sound corporate governance framework for the SOCBs is to be established by end-2018 (fifth review benchmark; MEFP ¶28).

19. The authorities noted that the recovery of Kabul Bank’s stolen assets should be revived. To this end, a structural benchmark for the sixth review was agreed that supports an accelerated process of asset recovery with the help of an internationally reputable forensic auditor. Progress with recovery of Kabul Bank’s assets would help offset the fiscal cost of repayment of the lender of last resort exposure incurred by DAB, while signaling the authorities’ commitment to fight corruption and strengthen credit discipline.

20. Implementation of the “National Financial Inclusion Strategy,” with World Bank support, due in May 2019, is on track. The authorities confirmed their commitment to further promote financial inclusion and improve financial intermediation and the quality of financial services. They plan to introduce mobile money taking advantage of the high rate of ownership of mobile phones. Staff welcomed DAB’s intention to increase demand for financial services by lowering their cost through the ongoing modernization of the payment systems and supported ongoing efforts to prepare a legislative and institutional framework for issuance of sukuk. (MEFP ¶34, 35, 36).

21. Revival of system-wide correspondent relationships with global banks remains a challenge. Afghanistan exited the Financial Action Task Force’s monitoring in June 2017. However, this was not followed by a system-wide revival of correspondent banking relationships as global banks remain concerned about low profitability of transactions and regional cross-border risks. These concerns, according to the authorities, make Afghan banks reluctant to serve certain customers, and could drive those transactions into the informal sector. Staff encouraged the authorities to monitor the situation, engage with foreign regulators, and ensure effective application of risk-based AML/CFT measures (MEFP ¶30).

C. Anti-Corruption Reforms

22. The ECF arrangement supports the authorities’ anti-corruption efforts, in particular criminalizing corruption and strengthening asset declaration requirements for public officials. The legal frameworks have been upgraded with the new penal code criminalizing corruption, entering into force in February 2018, and the Law on Declaration and Registration of Assets of Officials and Government Employees, enacted and entering into force in September 2017. The high- ranking officials who have not declared their assets for 2018 have been reported and sanctioned as required by the law (MEFP ¶39). The authorities will advance implementation of these frameworks. They plan to publish the results of the Anti-Corruption Justice Center (ACJC)’s activities, including prosecutions and convictions of major corruption cases that fall under its jurisdiction by end-January 2019 (fifth review benchmark; MEFP ¶40). They also plan to publish information on the implementation of the enhanced asset declaration framework among senior officials by end- October 2019 (sixth review benchmark). In addition, DAB continues its efforts to promote effective implementation of risk-based AML/CFT measures to detect potential proceeds of corruption. A draft anti-corruption law8 has been approved by cabinet and the authorities are working towards its enactment. During the mission, staff made a presentation on the Fund’s new governance framework and discussed its potential implications for Afghanistan.

D. Debt Sustainability Analysis

23. Afghanistan’s risk of debt distress remains high. Public external debt is expected to remain low in the medium term given continued substantial grants from donors. In the long term, as loans replace grants, sustainability indicators would breach the relevant thresholds. The authorities agreed with the DSA analysis and requested TA on debt management and the new debt sustainability framework for low income countries.

Fourth Review

24. All end-June 2018 PCs were met (Table 11), with some over-performance on domestic revenue and net international reserves (NIR).9

Table 1.

Islamic Republic of Afghanistan: Selected Economic Indicators, 2016–19

(Quota: SDR 323.8 million)

(Population: approx. 34.7 million; 2016)

(Per capita GDP: approx. US$570; 2017)

(Poverty rate: 54.5 percent; 2016–2017)

(Main exports: fruits and vegetables, US$ 216.2 million; carpets, US$ 39.0 million, 2016)

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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. Opium exports in 2015 amounted US$ 2.0 billion.

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 includes 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. Positive – real appreciation of the Afghani.

Table 2.

Islamic Republic of Afghanistan: Medium-Term Macroeconomic Framework, 2015–23

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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 import 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, 2015–23

(In billions of Afghanis)

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Source: Afghan authorities and Fund staff estimates and projectionsNote: Government Finance Statistics Manual 1986 presentation Overall budget balance including grants for 2018 revised budget excludes repayment to DAB and treasury cash balance.

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)

Some of the grants to development budget can finance operating expenditures.

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, 2015–23

(In percent of GDP)

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Source: Afghan authorities and Fund staff estimates and projectionsNote: Government Finance Statistics Manual 1986 presentation Overall budget balance including grants for 2018 revised budget excludes repayment to DAB and treasury cash balance.

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)

Some of the grants to development budget can finance operating expenditures.

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, 2015–23

(In billions of Afghanis, 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).

International reserves for Dec 2016 were revised relative to June 2017 report.