Public Information Notice No. 05/9

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with the Islamic State of Afghanistan

January 27, 2005

On January 19, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Islamic State of Afghanistan.¹

Background

During 2001-03, after more than 20 years of conflict, interspersed with earthquakes and drought, the authorities of Afghanistan focused on crisis management by establishing or rebuilding fundamental institutions, providing basic government services, and restoring economic stability. In 2004, with most of these tasks largely achieved, the authorities articulated, and started implementing, a long-term strategy aimed at building a financially self-sustaining state with the capacity to meet basic social needs and address poverty through: increasing security; promoting private sector-led growth; increasing revenue efforts to allow funding of recurrent costs within a medium-term horizon; eliminating the drug economy; and strengthening further the institutions. This strategy, entitled "Securing Afghanistan's Future", was endorsed by the donor community at the Berlin conference in March 2004. A one-year staff-monitored program (SMP) was adopted in March 2004 that focuses on capacity building and establishing a track record, providing the basic economic underpinnings for many of the government reforms. Overall, the authorities have successfully implemented this program.

The authorities have made further progress in rebuilding institutions and implementing sound economic policies. They have maintained their commitment to fiscal discipline, evidenced by their observance of a "no-overdraft" financing rule prohibiting government borrowing from Da Afghanistan Bank (DAB), and have continued to improve fiscal management. Important tax policy measures, combined with ambitious tax and customs administration reforms, are helping the central government to regain control over revenue collection. Further, for the first time, the authorities adopted in 2004/05 a `core budget,' to improve coordination and control over donor flows. Expenditure management has improved, although, as in many post-crisis countries, the level of expenditures have significantly lagged behind budget projections because of weak implementation capacity.

Despite a paucity of monetary instruments, DAB's flexible approach to monetary policy, in the context of a "managed float," has been largely successful in limiting both inflation and exchange rate volatility. While monetary policy is guided primarily by indicative targets for currency in circulation, DAB, uses all available indicators to assess changes in the demand for domestic currency given the substantial uncertainties surrounding relationships between key macroeconomic variables, and stands ready to adjust its monetary stance when necessary to preserve macroeconomic stability. Modernization of the central bank and reform of the financial system are progressing, although the banking sector is still in its infancy.

Real GDP growth has been relatively strong, albeit from a very low base, and has slowed over the past 18 months, due primarily to the negative impact of adverse weather conditions on agricultural production. Growth remained strong in the other sectors, especially in construction and services, which continued to benefit from a buoyant aid-related, and possibly opium-related, demand. Real GDP growth is now projected at 8 percent in 2004/05, compared with 16 percent in 2003/04 and 29 percent in 2002/03. While there was some improvement in social indicators, including in school enrollment and food security, the social challenges remain daunting. After increasing during the first half of 2004 as a result of sharp increases in rents and petroleum products prices, inflation has moderated somewhat. Reflecting a strong balance of payments, the nominal and real exchange rates vis-à-vis the U.S. dollar appreciated through September 2004, but have recently depreciated.

Current efforts by the authorities and the donor community in addressing the opium economy have not been very successful so far. The latest report of the United Nations Office on Drugs and Crimes indicates that poppy production continued to rise in 2004, with cultivation spreading to new areas of the country and involving an increasing share of the population. Illicit drug revenue is estimated to have risen to US$2.8 billion, equivalent to about 60 percent of nondrug GDP. The government and the international community are developing a common medium-term strategy to abate the drug economy. The manner in which this strategy is implemented will be critical in maintaining social, economic, and political stability.

Executive Board Assessment

Directors commended the Afghan authorities for their continued pursuit of sound macroeconomic and structural reforms despite a challenging security environment. Directors noted that prudent fiscal and monetary policies have helped to contain inflation and facilitate relatively high levels of growth, and were encouraged by the continued successful implementation of the staff-monitored program. Although budget execution has not met expectations, a core budget has been introduced that consolidates all the government operations channeled through the Treasury, revenue collection has continued to improve, and significant progress has been made in the implementation of structural reforms. Directors noted, however, that notwithstanding these achievements, daunting economic and social challenges remain, and poverty is widespread, calling for continued skilful economic management and strong implementation of further structural reforms, with continued donor support.

Directors commended the authorities for the successful conduct of Afghanistan's first direct presidential election, and viewed the forthcoming legislative elections as an opportunity to broaden the ownership of economic reforms. Directors encouraged the new government to continue to pursue the economic reforms, capacity building, and rehabilitation of physical infrastructure. Directors stressed the importance of improving security conditions, including through a vigorous disarmament, demobilization, and reintegration process.

Directors expressed concern about the continuing rise in opium-related activities, which they saw as jeopardizing security as well as macroeconomic stability. Agreeing that eradication by itself will be insufficient to address the issue, Directors supported recent efforts by the government and its international partners to develop a multi-pronged strategy to deal with the opium economy. Directors advised establishing safeguards to alleviate any significant adverse economic impact of opium eradication, particularly for the most vulnerable segments of the population. In this connection, they stressed the need to create broader economic opportunities and alternative livelihoods for farmers, expand the formal economy, and promote pro-poor growth.

Looking ahead, Directors supported the continued implementation of the SMP, which they saw as providing a framework for maintaining the reform momentum and building a solid foundation for a possible transition to a Fund program that could be supported by the Poverty Reduction and Growth Facility. In this regard, Directors were encouraged by the authorities' decision to initiate work on an Interim Poverty Reduction Strategy Paper to frame their policy agenda.

Directors observed that widespread shortages of skilled civil servants and very low administrative capacity continue to pose significant challenges for policy implementation. They considered that, in many instances, these capacity constraints have lessened the effectiveness of reforms envisaged under the program. They called on the authorities to tackle these issues, so as to support macroeconomic stability and promote private investment. Directors welcomed the intention to press ahead with planned public administration reforms.

Directors considered that the thrust of macroeconomic policies in the current staff-monitored program strikes an appropriate balance between supporting growth during this period of transition and the need to remain vigilant with regard to potential risks. Looking ahead, they encouraged the authorities to continue to develop a comprehensive medium-term budget framework that lays the ground for fiscal sustainability. This will require redoubled efforts to enhance revenue and strengthen expenditure management. Directors attached particular importance to stepping up the implementation of the planned reform of tax and customs administration, including at the level of the provinces. Directors expressed some concern about under spending on social programs, and encouraged the implementation of an expenditure framework that would increasingly support more broad-based and sustainable development, especially as progress is made in meeting the immediate security and reconstruction needs. They also cautioned the authorities to undertake only those public investments that generate an adequate rate of return.

Directors agreed that the success of the government's reform strategy is predicated on continued donor support and well coordinated technical assistance, and urged the donor community to do its part in fulfilling their financial commitments and pledges. They urged the authorities to work with donors to integrate progressively their spending into the government's medium-term budget framework, which would in turn enhance ownership and coordination of the reform program. In this context, Directors noted that direct donor support to the budget would simplify fiscal management and help coordinate donor funds. This will require continued improvement in fiduciary standards and the mechanisms for promoting accountability.

Directors noted the results of the debt sustainability analysis and the need for the authorities to maintain a cautious approach toward new external obligations. In this context, Directors supported the authorities' efforts to obtain external financing on only the most concessional terms, but also emphasized the need for the authorities as well as creditors to resolve the issues of outstanding bilateral claims. It was recognized that mobilization of grant financing has helped meet pressing social and development needs. Directors also recommended that the authorities adopt an explicit strategy to guide external debt management over the medium term.

Directors viewed the current framework for monetary policy, based on a monetary anchor, as adequate to ensure low inflation while avoiding unwarranted exchange rate fluctuations. They agreed that the flexibility embedded in the monetary program has allowed DAB to react promptly to shifts in money demand, while keeping inflation in check and limiting exchange rate volatility. Directors encouraged the authorities to remain vigilant to price developments and to stand ready to tighten monetary policy if warranted. They encouraged the authorities to work toward improving their monetary and banking data so as to better inform their monetary policy decisions, and gradually expanding the range of instruments for liquidity management.

Directors considered that further structural reforms will be crucial in improving the business climate, and in helping to sustain economic growth, employment opportunities, and export prospects. In this regard, they welcomed the new investment law. Directors also highlighted several other key elements of the reform agenda that should be pursued, including property rights, bankruptcy laws, contract enforcement, and a transparent and effective judicial system. Directors emphasized that the cooperation of all government ministries and agencies, along with political commitment at the highest levels, will also be required to create a clear and level playing field for business, and spur private sector-led growth.

Directors supported the authorities' efforts to rationalize the public enterprise sector. While agreeing that the state-owned banks may not represent a systemic risk, Directors urged the authorities to take measures to restore the profitability of those which were relicensed, and to resolve those which were not relicensed.

Directors emphasized the need for a strengthened legal system as key to the success of Afghanistan's economic reform program and medium-term outlook. They observed that the status of key economic legislation remains uncertain owing to low capacity at the Ministry of Justice. Directors urged the authorities to seek external support to address this issue. They welcomed the enactment of a legislative framework for anti-money laundering and combating the financing of terrorism actions, while underscoring the critical importance of effective implementation.

Directors noted that the creation of a technical committee of coordination for the Staff Monitored Program has facilitated program implementation and ownership. They advised the authorities to take steps to enable the committee to develop and strengthen much needed analytical and policy capacities.

Directors emphasized that, notwithstanding progress made so far, much remains to be done with respect to improving governance. They regretted indications that widespread corruption, the rise in drug activities, and the lack of transparency in many areas may have undermined the business environment.

Directors welcomed the steady progress in trade liberalization, and the authorities' commitment to a liberal foreign exchange regime. They looked forward to further advances, including through development of a supporting legal framework that will pave the way for accepting the obligations under Article VIII of the Fund's Articles of Agreement.

Directors welcomed the authorities' continuing efforts to improve the statistical framework. At the same time, they noted that the current provision of data falls short of international standards in terms of quality, frequency, and dissemination. They were encouraged by the recent adoption of a statistical master plan and urged the authorities to put in place a realistic work program and mobilize the resources needed for implementation.