Mission Concluding Statement 

Islamic Republic of Afghanistan -- Concluding Statement for the Staff Visit to Discuss Developments Under the Poverty Reduction and Growth Facility-Supported Program

August 16, 2006

Despite a difficult security environment, the authorities honored all but one of their first quarter commitments under the Poverty Reduction and Growth Facility (PRGF)-supported program. While agricultural production appears to have suffered from unfavorable weather conditions, activity in the other sectors remains sustained. Inflation has declined sharply and the exchange rate remains stable. Although the first quarter revenue target was met, the mission expressed concerns regarding the authorities' capacity to meet their year-end revenue objectives if several critical revenue-raising measures are not adopted promptly. The mission was also troubled by the low level of core budget spending, especially with respect to development expenditures. Lastly, the mission emphasized that the authorities' strong track record in implementing structural reforms should not lead to complacency.

1. This statement presents the conclusions of the IMF mission that visited Kabul from August 6-17, 2006 to assess progress in implementing the recently-approved PRGF-supported program. This is the first IMF mission since the start of a new phase of the relationship between the IMF and Afghanistan, marked by the completion of a Staff Monitored Program (SMP) and the launching of a formal arrangement approved by the IMF Executive Board. The discussions focused on macroeconomic developments during the first quarter of 2006/07, the observance of the end-June 2006 indicative targets and structural benchmarks, and on policies for the remainder of the year. The mission's findings will serve as a basis for the discussions for the first review under the PRGF-supported program, scheduled for November 2006. The mission would like to thank the authorities for their assistance, hospitality, and cooperation.

I. Performance Under the PRGF

2. Building on their strong track record under the SMP, and despite a challenging security environment, the authorities' performance under the PRGF-supported program was satisfactory during the first quarter of 2006/07. The authorities met all end-June quantitative indicators, albeit narrowly for domestic revenue, but did not observe the structural benchmark related to the appointment of a new Board of Directors at Bank Pashtany (see below). With regards to economic activity, cereal production is expected to decline by 9 percent this year as a result of insufficient rainfall during the growing season. Activity remains buoyant, however, in construction and services. At the same time, and despite a significant increase in counternarcotics operations, opium production is expected to increase substantially in 2006/07. Year-on-year inflation declined from 9.5 percent in March to 5.6 percent in June in Kabul, and from 9.6 percent to 5.7 percent at the national level, reflecting essentially slowdowns in bread and cereal prices and in rents.

3. While fiscal revenue was in line with program projections during the first quarter, government spending was substantially lower than projected, reflecting the delay in approval of the budget by parliament. Revenue amounted to Af 5.4 billion, slightly exceeding the indicative target of Af 5.3 billion. Just over 14 percent of the annual operating budget and less than one percent of the annual development budget were executed during the first quarter of 2006/07.¹ This underspending was attributable to the late budget approval, as well as to delays in receiving the final expenditure reports of 2005/06, which affected allotments in the first month of 2006/07. For investment expenditures, it also reflected unrealistic projections in the national budget. On the structural front, the budget calendar for 2007/08 was approved by Cabinet and published on the Ministry of Finance website. However, the implementation of the recently adopted new tariff schedule, which is a critical policy measure in support of the program's revenue targets, was delayed following complaints from the business community.

4. Reflecting a seasonal slowdown in money demand and a further shift within broad money toward local and foreign currency bank deposits, currency in circulation declined during the first quarter of 2006/07. International reserves increased further, to more than $1.7 billion (equivalent to 4.6 months of prospective imports), owing primarily to a further accumulation of government deposits. After increasing sharply in early 2006/07, to about 8 percent, interest rates on the capital notes declined slightly, to 7.5-7.8 percent at the end of the quarter. The exchange rate was broadly stable, fluctuating between Af 49.5 and Af 50.5 per dollar.

5. The end-June structural benchmark related to the appointment of a new Board of Directors at Bank Pashtany was not observed owing to difficulties in recruiting qualified candidates. In view of these difficulties and of the complexity of restructuring two banks simultaneously, the authorities have decided to keep only one state-owned bank, which will assume the performing assets and deposits of the three existing state-owned banks. In line with their commitments under the program, the authorities have started enforcing the regulations related to the commercial banks' foreign exchange open positions, and reduced significantly the interest rate on the commercial savings accounts at DAB, from 6 percent to 2.5 percent.

6. Following the reconciliation of outstanding Russian claims of $11.2 billion, Paris Club creditors agreed on July 19 on substantial debt relief and rescheduling. In addition to the upfront cancellation of 80 percent of Russia's claims, the agreement provides for the cancellation of arrears, the rescheduling of prospective debt service, and the capitalization of moratorium interest. The Paris Club creditors also committed to writing off fully the remaining eligible debts if Afghanistan becomes eligible for the HIPC Initiative and qualifies for debt relief at the completion point.

II. Policies for the Rest of 2006/07

7. Real GDP growth is expected to be lower than initially forecast in 2006/07. Reflecting a lower-than-expected cereal output, real GDP is now projected to increase by 8 percent in 2006/07, compared with an initial projection of 12 percent.² On account of higher food prices, year-on-year inflation is expected to pick up somewhat during the remainder of 2006/07, to about 7 percent at end-March 2007.

8. IMF staff forecasts indicate that additional measures may be required to ensure the observance of program's fiscal targets. Progress has been made on priority reforms in some revenue areas, such as the preparation of information on tax liabilities and tax and customs appeal procedures, strengthening the large taxpayer office, and upgrading administrative capacity in the provinces; this progress is reflected in the recent revenue data. Nevertheless, the mission emphasized that delays in other areas could jeopardize the authorities' ability to meet the 2006/07 revenue target. In particular, the mission recommended that the authorities quickly enact legislation to remove nuisance taxes and illicit charges and to reform the business receipts tax, and welcomed the recent submission to parliament of such legislation. Most critically, decisions regarding the introduction of an excise tax on selected goods and the rationalization of the customs tariff regime need to be taken shortly, and be consistent with the authorities' revenue target for 2006/07 and the objective of fiscal sustainability. If any of these actions, which are part of the authorities economic program under the PRGF, is considered too difficult to implement, the authorities will need to adopt other revenue-compensating measures.

9. Enhancing budget implementation through better public expenditure management and improved budgeting is critical for the credibility of the fiscal program. The mission concurred with the authorities that, in light of the delayed approval of this year's budget, the scope of the midyear budget review should be limited to required adjustments. Budget changes should be consistent with the fiscal program agreed under the PRGF and should take into account: (i) delays in revenue-raising reforms; (ii) unexpected external budget expenditures coming onto the core budget; and (iii) continued uncertainty surrounding sections of the public payroll. Regarding the latter, it is important for the authorities to conclude the ongoing investigation into past lapses in manpower management and to pursue their efforts to strengthen monitoring and enforcement of employment and payroll controls.

10. The Medium-Term Fiscal Framework (MTFF) should play a key role in defining annual budget envelopes and in informing fiscal policy decisions. In particular, measures such as the tax and customs reforms or the introduction of the new pay and grading reform need to be consistent with the MTFF objectives. The mission noted progress in several areas, including the reorganization of the budget department, the piloting of simple program budgeting in select ministries, and the publication of a less compressed budget calendar. Nonetheless, the mission underscored the need to ensure greater consistency between the budget formulation process, the MTFF, and the development of a Poverty Reduction Strategy Paper (PRSP). The worryingly low level of core development spending during the first quarter of 2006/07 epitomizes the need for a more realistic development budget with effective execution.

11. The current monetary stance appears appropriate, as evidenced by the decline in inflation and the stability of the exchange rate. If warranted by economic developments (a rebound in inflation and/or an inordinate depreciation of the exchange rate), the authorities should stand ready to tighten the monetary stance, even if it translates into currency in circulation being well below the PRGF ceiling. A further slowdown in demand for money in circulation could indeed result from the slowdown in economic activity as well as from the continued financial deepening of the Afghan economy. The mission welcomed the increased interest for the capital notes and the development of interbank operations and encouraged the authorities to pursue their efforts to strengthen the monetary policy framework.

12. The mission welcomed the authorities' decision to keep only one state-owned bank, rather than two as initially envisaged, and encouraged them to implement this decision promptly. The authorities will decide shortly on the precise modalities of this operation (creation of a new bank or merger of these banks). On the basis of this decision, and consistent with the timeline agreed under the program, they will prepare a long-term restructuring plan by end-September. This plan will aim at creating a competitive bank able to contribute to the mobilization of private savings and to the financing of the economy, while laying the ground for its future privatization.

13. The authorities are confident that they will meet the end-September structural benchmarks and performance criterion, and the mission concurs that this is feasible. Notwithstanding the potential for further security-related delays, the authorities will submit to parliament Da Afghanistan Bank's (DAB) audited financial statements for 2004/05 and 2005/06 and the government's audited financial statement for 2005/06. They will also take steps to process the gold held in the palace vaults with a view to increase Afghanistan's international reserves. With broad parameters already agreed upon, the Ministry of Finance and DAB will finalize a service level agreement, which will clarify their financial relations. Lastly, the mission encouraged the authorities to intensify efforts to improve the legal framework for bank lending operations and to enhance the monetary and external sector statistics.

14. Following the July 19 Paris Club agreement, the authorities need to finalize promptly the associated bilateral agreements. They also need to reconcile their external debts with non-Paris Club creditors and seek rescheduling agreements on comparable terms. In that respect, the mission welcomed renewed contacts by the Ministry of Finance with non-Paris Club creditors.

III. Poverty Reduction Strategy

15. While welcoming the steps taken for the preparation of a full PRSP, the mission called upon the authorities to turn plans into concrete actions. De facto, much of the effort since the London conference has been devoted to form rather than substance. The authorities need to begin the participatory process and sectoral consultations to identify and quantify priority policy actions, prepare well-costed medium-term sector strategies for some key sectors, and map out a system for monitoring and evaluating the poverty reduction strategy. Also, these strategies need to be integrated into the budgetary process. The mission took note of the effort aimed at creating an information base to measure poverty in Afghanistan.

16. The mission underscored the urgent need to address impediments to private sector development, investment, and growth. While there has been some progress in enhancing the legal framework, some key laws are still being discussed. Furthermore, the divesture program of the state-owned enterprises and of government entities engaged in commercial activities should be accelerated and conducted in a transparent and fair manner. The creation of an interministerial energy working group in response to the substantial cut of emergency external financing for fuel used in electricity generation is a positive development. To date, the authorities have been slow to implement energy sector reforms, which have had significant fiscal implications and stands in the way of foreign investment and sustainable economic growth.

IV. Statistics and Other Issues

17. Further improvements in official statistics are necessary. National accounts data remain particularly weak. The lack of a reliable and timely monetary survey continues to be a challenge for monetary policy formulation. The assessment of the balance of payments remains complicated by the lack of a reporting system and further efforts are needed to create a reliable set of social indicators.

18. The mission to conduct the first semi-annual review under the PRGF program is scheduled for November 2006. It will review macroeconomic developments during the first half of 2006/07 and assess observance of the end-September 2006 quantitative and structural benchmarks and performance criteria. It will also discuss the outlook for the remainder of the year and the medium term.

¹ The Ministry of Finance's internal records showed development expenditures equivalent to 4 percent of the annual budget for the same period; the difference in the two figures is due to the fact that the record of checks issued is not entered into the financial management system until the corresponding payments are confirmed by the banks. According to the authorities, the execution of development budget was just above 10 percent for the first 5 months and there are indications of a pick up in development expenditure commitments.

² At the macroeconomic level, the impact of the decline in agricultural output on the demand for other sectors is expected to be largely offset by the anticipated increase in opium-related income.