Mission Concluding Statement 

Islamic Republic of Afghanistan--Statement by the IMF Mission at the Conclusion of the Discussions for the 2007 Article IV Consultation and Third Review under the Poverty Reduction and Growth Facility Arrangement

November 15, 2007

An IMF staff team visited Kabul during October 30-November 15, 2007. Discussions with the government and Da Afghanistan Bank (DAB) focused on maintaining macroeconomic stability, reform priorities under the IMF-supported program, and preparations for the Afghanistan National Development Strategy (ANDS). The program remains on track, but waning commitment to market-based development and political interference are hampering effective economic management and posing risks to investor confidence. Looking ahead, continued macroeconomic discipline, commitment to economic reform-underpinned by decisive actions to strengthen governance and implement structural reforms-will be essential for Afghanistan to achieve its growth and poverty reduction objectives and to keep the program with the IMF on track.

Program Performance

1. Performance under the program during 2006/07 was broadly satisfactory. All September 2007 quantitative performance criteria and indicative targets, as well as structural benchmarks for the second review, were observed, except for the benchmark related to state-owned enterprises (SOEs) and government agencies engaged in commercial activities. For 2007/08, real GDP growth, excluding opium production, is projected to reach 13½ percent, mainly as a result of a strong rebound in agricultural production from the drought-triggered decline in 2006/07. Rising prices of imported fuel and foodstuffs caused the Kabul CPI to increase by 8 percent in the first seven months of 2007/08, with 12-month (end-of-period) inflation peaking at 12 percent. Despite rising inflation, the exchange rate of the Afghani against the U.S. dollar has remained stable.

2. Fiscal performance during the first half of 2007/08 was stronger than programmed. The revenue target for the first half of 2007/08 (equivalent to 3.1 percent of annual GDP) was met, and operating expenditure was below the programmed level by 1.1 percent of GDP, in part due to delayed budget approval. As a result, the operating budget deficit (excluding grants) for the first half of 2007/08 is estimated at 1 percent of GDP, compared to an indicative program target of 2 percent. Development core budget expenditure was in line with the program at 3.4 percent of GDP.

3. Monetary policy has remained broadly consistent with the program, despite difficulties with liquidity management experienced during and after Ramadan. Growth of currency in circulation surged from 8.5 percent during the first half of 2007/08 to 18 percent in October. Continued exchange rate stability throughout this episode suggests that the temporary excess supply of Afghanis—related to an acceleration of government expenditure—was met with increased demand, reflecting a combination of Ramadan-related seasonality and steep increases in the prices of imported fuel and essential foodstuffs.

4. All structural benchmarks within DAB's area of responsibility were implemented. A new accounting system has been introduced at DAB headquarters, with six regional hubs. Nevertheless, the system still remains in a trial phase and the operations of the regional hubs are not yet automatically monitorable from the headquarters. DAB has completed a summary report on commercial banks' compliance with prudential regulations based on the full round of on-site inspections, and followed through with targeted supervisory actions. DAB also instructed banks to publish their audited financial statements.

5. The external position is expected to strengthen in 2007/08, owing mainly to increased inflows of official grants. First quarter data show a rapid growth of exports. Afghanistan has also benefited from increased debt relief from bilateral creditors, notably Russia, and interim assistance under the HIPC Initiative. Efforts are continuing to regularize remaining external arrears (mainly to non-Paris Club bilateral and commercial creditors) and to improve public debt management. The central bank has also made progress in improving balance of payments statistics, although significant shortcomings remain.

6. Structural reforms and progress in reforming the legal framework for the business environment have been slow. In particular, the government has not submitted to parliament laws on partnership and corporations, secure transactions, and negotiable instruments. These delays constrain private sector investment and development of the financial market.

7. The preparation of the ANDS has reached an advanced stage. The ANDS document is expected to be submitted to the Boards of the IMF and the World Bank by end-March 2008. The authorities sounded out donors as to their likely contributions to the core and external budget over the next five years. They are preparing proposals on broad sectoral priorities and will engage government entities and the international community to reach agreement on the ANDS expenditure envelopes.

Policies and Prospects for the Remainder of 2007/08, 2008/09, and Beyond

8. With continued donor assistance, the near-term macroeconomic outlook remains favorable. Growth in agriculture in 2008/09 is expected to moderate to its pre-drought trend. Nonetheless, GDP growth is likely to exceed 9 percent, reflecting the strengthened fiscal impulse from increased donor contributions in support of the ANDS. Assuming that fiscal and monetary policy remain prudent, inflation is expected to drop below 10 percent.

9. Economic growth over the medium term will depend critically on confronting corruption, overcoming infrastructure bottlenecks, and structural reforms in support of private entrepreneurship. While growth is likely to fall from around 9 percent in 2008/09 to 7 percent in 2012/13, higher growth rates would be attainable if structural reforms were implemented decisively and public investment targeted key areas of infrastructure, notably transport and electricity, which would mitigate constraints on private sector growth.

10. The budget for the remainder of 2007/08 is broadly in line with medium-term fiscal policy objectives. The midyear review of the budget is consistent with the program for the remainder of the fiscal year. Revenue should reach Af 35.7 billion (8.2 percent of GDP), in line with the program, and operating expenditures are projected at Af 53.3 billion (12.2 percent of GDP). Core budget development expenditures are expected to reach about Af 45.5 billion (10.4 percent of GDP).

11. The mission welcomed the government's intention to clarify the relationship between the budget and key public enterprises. In this connection, the mission encouraged the authorities to conduct a review of the financial relations between key SOEs, line ministries, and the Ministry of Finance (MoF) in advance of the 2008/09 budget discussions. The review should focus on: (i) payment by the government of all bills and service charges; (ii) payment of taxes by SOEs; (iii) transfer of profits to the MoF; and, (iv) closure of unauthorized bank accounts. The outcome of this review should reduce the pressure to subsidize SOEs. SOEs should be required to present audited financial statements for the period of claims to be eligible for settlement of unpaid government bills.

12. The government will seek to reduce the operating budget deficit excluding grants from 4.0 percent of GDP this year to 3.6 percent in 2008/09. This is consistent with the authorities' objective of covering operating expenses from domestic revenue-a target that anchors fiscal policy and is expected to be reached by 2012/13. The revenue assumptions underlying the fiscal outlook reflect primarily the consolidation of administrative reforms in preparation for tax policy decisions slated for 2009/10. On the expenditure side, preparation of the 2008/09 budget focuses on the costing of programs underpinning the ANDS.

13. Monetary policy will remain focused on containing inflationary pressures. To that end, there is a need for DAB—in cooperation with the MoF—to improve its liquidity forecasting to ensure smooth monetary policy execution. It is also important that DAB's management strengthen the internal consultation mechanism over liquidity forecasts and intervention policy by endowing the Monetary Policy Department with greater ownership and accountability for its policy advice. The mission welcomed the intention of DAB to expand the volume of capital notes auctions with a focus on managing bank liquidity and developing the yield curve.

14. The mission recommended that DAB finalize the external audit of its accounts for 2006/07 and publish the audit report on its external website by December 31, 2007. To provide assurances regarding the level of DAB's reserve assets, the DAB will request its external auditors to conduct a special audit of its foreign exchange holdings as at September 22, 2007.

15. The mission agreed with the stated intentions of DAB to strengthen bank supervision and to take strong steps to curb non-compliance with prudential regulations. While a system of automatic supervisory actions is in place, including fines for each day of failure to comply with DAB orders, the effectiveness of supervision continues to be limited by the absence of political support for bank supervisors, which is crucial to enforce prudential regulations.

16. The mission welcomed the stated commitment of the government to a trade regime that minimizes distortions and does not discriminate across importers. In this connection, the mission reached agreement with the authorities to repeal Presidential decree No. 5016 that allows selected businesses to import raw materials at a preferential tariff rate. The mission agreed with the government that goods eligible for the 1 percent rate would be incorporated in the tariff schedule at rate(s) to be decided with due consideration for government revenue. Similarly, the mission welcomed the decision to repeal by end-July 2008 the Presidential decree (No. 96) that raised the tariff rate on soft drinks from 20 to 40 percent and to reduce the tariff rate to 20 percent by end-March 2009.

17. There is a need to clarify the role of the government in the petroleum sector. The mission stressed that a private sector-led petroleum sector, regulated by the government, is the most effective way to ensure that the petroleum market develops and that prices are maintained at appropriate levels through competitive forces in the market. Accordingly, the mission recommended that the government's Fuel and Liquid Gas Enterprise (FLGE) limit its role to the provision of key services that are not provided by the private sector. The mission welcomed the authorities' commitment, as highlighted in the Afghanistan Compact, to withdraw from the petroleum sector and privatize the FLGE by March 2009. As a first step toward that objective, the government has stated its commitment to increase the transparency of FLGE's fee structure and operations and to complete an external audit of FLGE accounts for 2007/08 by November 2008.

18. The mission is concerned by the lack of a vocal constituency for economic reform. A debate focused on interventionist or protectionist measures that could undermine prospects for sustainable growth has filled the ensuing policy vacuum. Moreover, sentiment against reform appears to have become self-fulfilling: disappointment over slow reform has encouraged interest groups opposed to reform.

19. Progress toward creating the infrastructure and legislation necessary for private sector development has stalled. There is still no reliable electricity in Afghanistan, in particular in Kabul. Meanwhile, waning political support is undermining divestment of state assets and thereby perpetuating a misallocation of resources. On the legislative front, steps toward building the legal framework for a market economy continue to falter. In the absence of a reinvigorated effort to advance structural reform, growth rates will fall short of potential, undermining poverty alleviation efforts.

20. As on previous occasions, the mission appreciated the open and frank dialogue with the Afghan authorities and other public and private sector representatives. The mission thanks them for the time and effort that they put into the discussions.