Islamic Republic of Afghanistan: Request for Disbursement under the Rapid Credit Facility—Press Release; Staff Report; and Statement by the Executive Director for the Islamic Republic of Afghanistan

Request for Disbursement Under the Rapid Credit Facility-Press Release; Staff Report; and Statement by the Executive Director for the Islamic Republic of Afghanistan

Abstract

Request for Disbursement Under the Rapid Credit Facility-Press Release; Staff Report; and Statement by the Executive Director for the Islamic Republic of Afghanistan

Context

1. The post-election political impasse poses a risk to policymaking and peace efforts. President Ghani was declared the winner of the elections held last September, but former Chief Executive Abdullah has rejected the results and declared himself the winner. International efforts to end the impasse continue. The impasse has complicated intra-Afghan peace talks which were initiated following the U.S.-Taliban agreement in late February. The U.S. agreed to withdraw its troops in 14 months, starting with a 4,000-troop reduction within 135 days, in exchange for the Taliban’s commitment to reduce violence and negotiate an end to the conflict.

2. Macroeconomic performance was broadly satisfactory in 2019 despite the strained security situation. Buoyed by the recovery of agriculture from a drought in 2018, growth rebounded to an estimated 3 percent in 2019. Inflation rose to 2.3 percent in 2019, in part reflecting the earlier depreciation of the Afghani. Although tax revenue faltered due to election-related uncertainty, the operating balance excluding grants improved thanks to a large transfer of Da Afghanistan Bank’s (DAB) profits in December.1 However, declining grants and rising development spending shifted the overall balance to a 1 percent of GDP deficit from a 1.5 percent of GDP surplus in 2018. While the external current account surplus fell to 8.6 percent of GDP due to lower grants and exports, a large improvement in the financial account (including errors and omissions) led to a strengthening of the overall balance of payments in 2019.

3. Weak capacity, limited resources, and the armed conflict make Afghanistan highly vulnerable to COVID-19. With daily migrant returns from neighboring countries, at their peak, close to 10,000—well in excess of the authorities’ testing capacity—controlling the pandemic has been difficult. To slow the spread of the virus, the authorities initially imposed screening at ports of entry, strict quarantine for those tested positive, social distancing, and closure of public places for gathering. As confirmed cases continue to grow at an alarming speed, the authorities have tightened containment measures hoping to flatten the curve ahead of its peak. In late March, they placed Kabul and subsequently other major urban centers under lockdown, which remains in place, and restricted movements to those deemed essential.

COVID-19 Confirmed Cases

Citation: IMF Staff Country Reports 2020, 143; 10.5089/9781513542591.002.A001

Source: Johns Hopkins CSSE (April 20, 2020) and IMF staff calculations.

Impact of the Shock

4. The COVID-19 pandemic is inflicting severe economic damage. The pandemic and the efforts to contain it are already inhibiting domestic activity—most visibly in cities under the lockdown. Transport and trade have been disrupted by the intermittent border closures, and workers’ remittances are set for a sharp decline. Investor confidence, already depressed by the armed conflict and political uncertainty, is likely to wane.

5. Output will contract this year, and a mid-year inflation spike is likely (see the panel below). The economy has likely entered a recession. Assuming that the pandemic starts retreating by late July and activity returns to pre-shock levels by the fourth quarter, GDP is forecast to contract by 3 percent this year. The lockdowns, social distancing, and border closures have reduced domestic and export markets for services. Industry is suffering from weak domestic demand and import disruption—roughly 60 percent of imports were for industrial purposes in 2019.2 Agriculture, having already lost access to key export markets, could take another hit if the planting is hamstrung by shortages of labor or inputs, some imported. Food shortages due to border closures led to a temporary price spike,3 and staff now expects end-June inflation to rise above 5 percent. As unemployment rises, remittances fall, and household budgets are stretched by higher health spending, social indicators are likely to deteriorate and poverty to increase.

6. The fiscal position is set to worsen. The fiscal balance excluding new grants for fighting the pandemic is expected to widen to a 5.0 percent of GDP deficit as the economic contraction hits revenue and the budget takes on pandemic-related spending. Revenues fell by 10 percent in the first quarter compared to last year, and the government has already allocated Af 8 billion (0.5 percent of GDP) for emergency pandemic response.

7. An estimated $857 million balance of payments deficit has opened up. Border closures and disruptions, including of air corridors, have hit exports, which will decline further as the economies of India and Pakistan slow. Remittance inflows could fall by as much as 50 percent due to the return of Afghan workers from host countries, many of which are oil exporters whose economic prospects have worsened due to the pandemic and the sharp drop in oil prices.4 Despite the downturn, imports are projected to hold up, reflecting increased demand for medicines, new consumption due to the returnees, and the economy’s high dependence on foreign supplies. The financial account is likely to deteriorate, with larger portfolio outflows and sharply lower FDI.

8. The economic impact of the pandemic remains subject to a high degree of uncertainty. Risks to the outlook are high and to the downside. If the impact of the pandemic lasts through the end of the year, Afghanistan would suffer a deeper than currently projected output loss and face a much larger fiscal deficit. Dissatisfaction with the policy response to the pandemic and its economic fallout, including shortages of essentials and higher unemployment and poverty, could inflame social discontent and instability. If pandemic-prompted export controls in the region remain in place and deteriorating economic conditions reignite broader protectionist measures, the post-pandemic recovery could be tepid. The outlook is also clouded by significant uncertainty about the prospects for peace talks; the political dispute regarding the election outcome; and regional tensions and security risks. Uncontained, these risks would cause socio-economic and political disruption, disorderly migration, confidence shock, and harm development prospects.

Islamic Republic of Afghanistan: Economic Outcomes Under Baseline and Severe Scenarios

Citation: IMF Staff Country Reports 2020, 143; 10.5089/9781513542591.002.A001

Policy Discussions

The authorities are ramping up pandemic-related spending and accommodating tax revenue shortfalls by boosting nontax revenue, curtailing non-essential spending, and allowing the fiscal deficit to widen. Monetary policy will remain focused on price stability, while financial sector policies will aim to preserve the stability and resiliency of the financial sector. Looking beyond the pandemic, the authorities are committed to reversing the fiscal loosening and increasing self-reliance to prepare for the projected decline in aid. They have reaffirmed their commitments to reforms of state-owned commercial banks and corporations, public financial management, and governance.

A. Fiscal Policy

9. Staff supports boosting spending to contain the pandemic and its social impact. Even though Afghanistan fares somewhat better on health security and preparedness than its fragile peers, its health infrastructure lags that of its neighbors and comparators. The authorities plan to spend about 2 percent of GDP for critical pandemic-related spending during the year, with about one third directed to health. In addition, with the support of the World Bank, other development partners and humanitarian agencies, they are developing a relief package, in cash or in kind, to support food security among vulnerable households. The package could be delivered through community-based development institutions of the Citizens’ Charter National Priority Program, local municipalities, and, in remote areas, the village councils. With 54 percent of the population below the national poverty line there is a pressing need for wide coverage. Preliminary estimates put the cost of such a nationwide scheme for two months at $300 million (1.5 percent of GDP), potentially up to $400 million with greater coverage and size of assistance. Total pandemic-related spending therefore would conservatively amount to 3.5 percent of GDP in 2020, of which nearly half is expected to be funded by donors.

10. Staff urged the authorities to ensure full transparency and good governance in managing pandemic-related spending. Staff cautioned about corruption risks associated with a rapid execution of unplanned spending and encouraged the authorities to put in place robust measures to ensure transparency and suppress corruption opportunities. To that end, the authorities have committed to publish quarterly reports on pandemic-related spending, including information on beneficial ownership of companies awarded procurement contracts. In addition, the Supreme Audit Office will undertake audits of selected spending and publish reports by end-December. The authorities indicated that close involvement and oversight of donors provides additional comfort about the quality of spending.

Islamic Republic of Afghanistan: Health Infrastructure and Preparedness

Citation: IMF Staff Country Reports 2020, 143; 10.5089/9781513542591.002.A001

11. The fiscal deficit is expected to widen to accommodate pandemic-related spending and revenue shortfalls. The authorities intend to limit the fiscal deficit after grants for fighting the pandemic to about 3.5 percent of GDP. To that end, they transferred to the budget DAB’s profits amounting to 0.8 percent of GDP, based on its 2019 audited financial report, and are curtailing security and nonpriority spending, especially the discretionary component of the development budget. If the fiscal cost of the pandemic turns out to be larger than expected and additional donor financing is not forthcoming, further cuts in non-essential spending may be needed.

Text Table 1:

Central Government Revenues and Expenditures

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12. The authorities are committed to reverse the fiscal deterioration after the crisis. As the pandemic abates and the economy recovers, tax revenue should rebound and pandemic-related spending will phase out, improving the fiscal balance. The authorities aim to bring the fiscal deficit down to about 1 percent by 2022, aided by VAT introduction planned for 2021. Given the expected decline in aid over the medium term, they plan to gradually reduce the operating deficit before grants to increase self-reliance.

Aid Dependence 1/2/

(3-year averages, 2017–2019)

Citation: IMF Staff Country Reports 2020, 143; 10.5089/9781513542591.002.A001

Source: WEO and IMF staff calculations.1/ Grants include all noncompulsory current or capital transfers to the country.2/ Size of the bubbles shows aid in percent of GDP.3/ CA inflows include exports of goods and services and inflows of current transfers.

13. Afghanistan’s risk of debt distress is expected to remain “high” (see Debt Sustainability Analysis). Even with additional borrowing due to the pandemic, public debt is expected to remain low, rising to 9 percent of GDP by end-2020. Given the projected improvement in the fiscal balance and the authorities’ commitment to borrow only on highly concessional terms, public debt is expected to stay below 25 percent of GDP in the long term. The high risk of debt distress stems from the vulnerability of public debt to switching from grant- to loan-based financing. A sustained and faster-than-expected replacement of grants with loans would lead to a breach of the debt service-to-exports threshold.

B. Monetary and Exchange Rate Policy

14. The DAB faces the challenge of delivering price stability in a highly unsettled environment. This puts the onus on flexibly using policy instruments at its disposal, including capital notes and foreign exchange auctions, to respond to developments. While supply disruptions or panic-buying could cause prices of individual goods to spike, core inflation is likely to be kept in check as demand wanes and global inflation stays low. Given the large share of imports in the consumption basket, domestic prices could rise if the Afghani depreciates. The DAB should accommodate a temporary increase in inflation owing to a weaker exchange rate and stand ready to tighten its stance to ward off sustained broad-based price increases above its target range. The DAB and staff agreed on the importance of transparent communication and continued efforts to strengthen monetary policy transmission and develop debt markets.

15. The DAB reiterated its commitment to exchange rate flexibility. It plans to let the Afghani depreciate in response to balance of payments pressures and limit foreign exchange interventions to addressing disorderly market conditions.

C. Financial Sector Policy

16. Financial stability risks have risen. The underdeveloped banking sector has a small loan portfolio and should be able to use its ample capital and liquidity buffers to absorb expected losses. The DAB informed staff that its stress tests showed that bank capital and liquidity would remain above regulatory requirements under plausible scenarios. The pandemic could however cause strains—as borrowers’ incomes are squeezed and they struggle to service debt—in unregulated financial institutions, mainly hawalas, where 90 percent of financial transactions takes place.

17. The DAB and staff agreed on the need to intensify financial sector monitoring. Staff supported the initial steps taken by the DAB, including increasing the frequency of Financial Stability Committee meetings, proactively anticipating early signs of liquidity stress, and scrutinizing banks’ daily liquidity reports and business continuity plans. The DAB’s decision to suspend administrative penalties and fees and postpone the IFRS-9 implementation to June 2021 will ease the costs of adjustment, while freezing loan classifications at the pre-pandemic cutoff of end-February for viable borrowers will support their restructuring, where needed, and limit the burden of provisioning. Banks will report to the DAB granular information on restructured loans subject to the credit classification freeze. Staff encouraged the DAB to calibrate its stress tests to ongoing developments, further enhance its surveillance of money service providers and hawalas, and continue efforts to bring them into the formal sector.

Modalities, Access, Capacity to Repay, and Safeguards

18. The authorities plan to cover the balance of payments deficit with a combination of reserve drawdown and external financing. Reserves are currently broadly adequate given a host of idiosyncratic downside risks facing Afghanistan, including a faster-than-expected drop in aid,5 instability and violence, and political uncertainty.6 Using only reserves to cover the deficit could amplify these risks, lead to a further loss of confidence, and trigger a destabilizing shift to safe assets with attendant implications for the exchange rate and macro-financial stability. To ensure a balanced financing mix, the authorities are mobilizing assistance from the World Bank, other IFIs, and bilateral donors. They expect to receive about $315 million this year, including a $100 million grant for emergency pandemic response disbursed by the World Bank in April. In addition, the U.S. and EU have allocated new grants.

19. The authorities have requested a disbursement under the RCF to help close the external financing gap and to catalyze donor financing. The $220 million RCF disbursement would be channeled directly to the budget to help cover the fiscal financing gap and create room for pandemic-related spending. There is limited scope for using government’s deposits at the DAB since a significant portion is encumbered and prudent treasury management in the high-risk environment of Afghanistan demands holding adequate cash buffers. There is virtually no scope for domestic financing—the government has not borrowed domestically for years and the local debt market remains undeveloped.

20. Capacity to repay remains adequate. Debt service obligations to the Fund, including the proposed disbursement, remain low, while the authorities’ track record of servicing liabilities to the Fund is strong. The authorities have reiterated their interest in an Extended Credit Facility, which they and donors would like to have in place before the next pledging conference currently scheduled for November.

21. A safeguards assessment has been initiated. The DAB has authorized its external auditors to hold discussions with staff and will provide to the Fund its most recent external audit reports once finalized. With the proposed disbursement channeled to the budget, the DAB and the Ministry of Finance authorities plan to sign a Memorandum of Understanding to clarify responsibilities for holding funds and repaying Fund resources.

Staff Appraisal

22. The pandemic is taking a heavy toll on Afghanistan’s fragile economy. A weak health system, the domestic conflict, and a large influx of returning Afghan migrants make the country vulnerable. Intermittent border closures have led to a significant drop in exports and disrupted imports, and inflows of remittances are dropping as migrants return from host countries, all affected by the pandemic. As the authorities implemented needed measures to control the virus, domestic activity has slowed sharply, putting at risk livelihoods of thousands of Afghan families. As a result, the economy is expected to contract by 3 percent this year.

23. Afghanistan is facing urgent external and fiscal financing needs. The fiscal position is set to worsen as domestic revenue plummets while the budget takes on urgent pandemic-related expenditure, currently estimated at about 3.5 percent of GDP. The shock has also opened a large balance of payments deficit amounting to about $857 million. Should the pandemic have a more severe and protracted impact than currently assumed, Afghanistan’s need for financing, and therefore donor support, would increase.

24. The authorities’ immediate priorities are appropriately focused on mitigating the social and economic fallout of the pandemic. A temporary fiscal loosening and substantial donor support are needed to fund critical health and social mitigation spending and accommodate a revenue shortfall. Limiting the widening of the fiscal deficit to 3.5 percent of GDP by taking one-off revenue measures and cutting non-essential outlays will also help contain the deterioration of the balance of payments. The authorities have committed to full transparency and good governance in executing pandemic-related spending and to commission its independent audit. The DAB remains appropriately focused on its goal of price stability, with a flexible exchange rate, and preserving the resiliency of the financial sector. Beyond the immediate response, the authorities remain committed to safeguarding macroeconomic stability, advancing governance and structural reforms, and promoting inclusive growth.

25. Staff supports the authorities’ request for a disbursement under the RCF in the amount of SDR 161.9 million (50 percent of quota). The authorities are facing an urgent balance of payments need arising from a sudden exogenous shock. While their existing and prospective policies aim to tackle its implications, including resolving the balance of payments difficulties, an upper-credit tranche quality program cannot be put in place owing to the urgency of the need against the backdrop of the evolving pandemic and the baseline fragilities. The RCF disbursement is expected to catalyze financing from development partners. Afghanistan will receive debt service relief under the Catastrophe Containment and Relief Trust, and the authorities also plan to seek relief under the recent G20 debt service moratorium initiative. The capacity to repay the Fund is adequate, and debt is sustainable albeit with a high risk of debt distress due to the vulnerability of public debt to the switching from grant- to loan-based financing.

26. Discussions on a new arrangement could start soon subject to how the pandemic evolves. The authorities have reiterated their request for a new IMF arrangement to support their economic reforms. They informed staff that should the pandemic’s shock prove worse than expected, they will seek additional resources from development partners and also from the Fund in the context of a prospective program or through a request for another RCF disbursement.

Figure 1.
Figure 1.

Islamic Republic of Afghanistan: Real Sector

Citation: IMF Staff Country Reports 2020, 143; 10.5089/9781513542591.002.A001

Sources: Afghan authorities, United Nations Assistance Mission in Afghanistan, and IMF staff calculations.
Figure 2.
Figure 2.

Islamic Republic of Afghanistan: External Sector

Citation: IMF Staff Country Reports 2020, 143; 10.5089/9781513542591.002.A001

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

Islamic Republic of Afghanistan: Fiscal Sector

Citation: IMF Staff Country Reports 2020, 143; 10.5089/9781513542591.002.A001

Sources: Afghan authorities and IMF staff calculations.
Figure 4.
Figure 4.

Islamic Republic of Afghanistan: Monetary Sector

Citation: IMF Staff Country Reports 2020, 143; 10.5089/9781513542591.002.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 2020, 143; 10.5089/9781513542591.002.A001

Sources: Afghan authorities and IMF staff calculations.1/ NPL’s include loans 121 to 481 days or more past due for payment of principal and/or interest. This differs from the IMF’s FSI Guide which recognizes loans 90 days or more past due payment of interest or principal as NPLs.2/ Adversely classified loans include loans classified as substandard, doubtful and loss – 60 to 481 days or more past due for payment of principal and/or interest.
Table 1.

Islamic Republic of Afghanistan: Selected Economic Indicators, 2017–21

(Quota; SDR 323.8 million)

(Population; approx. 34.7 million; 2016)

(Per capita GDP; approx. US$554; 2018)

(Poverty rate; 54.5 percent; 2016–2017)

(Main exports; dried and fresh fruits and vegetables, medical seeds, 2018)

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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 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, 2017–25

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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, 2017–25

(In billions of Afghanis)

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Source: Afghan authorities and Fund staff estimates and projectionsNote: Government Finance Statistics Manual 1986 presentation

ARTF: Afghanistan Reconstrudion Trust Fund; LOTFA: Law and Order Trust Fund for Afghanistan; CSTC-A: Combined Security Transition Command – Afghanistan (now NTM-A; NATO Training Mission – Afghanistan) ARTF and other grants are reclassified into the grants to development budget.

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

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, 2017–25

(In percent of GDP)

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Source: Afghan authorities and Fund staff estimates and projectionsNote: Government Finance Statistics Manual 1986 presentation

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) ARTF and other grants are reclassified into the grants to development budget.

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

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 4.

Islamic Republic of Afghanistan: Central Bank Balance Sheet, 2017–21

(In billions of Afghanis, unless otherwise indicated)

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Sources: Afghan authorities and Fund staff estimates and projections.

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).

Table 5.

Islamic Republic of Afghanistan: Monetary Survey, 2017–21 1/

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Sources: Afghan authorities and Fund staff estimates and projections.

End of period (Dec.21). Data underlying the survey are not fully consistent because DAB and the public banks use the solar calendar, while commercial banks use the Gregorian calendar.