Dear Mr. de Rato:

1. The government of Afghanistan is pleased with the progress made under the IMF staff-monitored program (SMP) agreed to in March 2004. Through our determined efforts, and with the support of your staff, we have met all of the quantitative indicators and structural benchmarks that were established for the first review of the program, except the benchmark on licensing of commercial banks, which was only met partially due to a technical delay. Along with our development partners, we view this program as an important catalyst for our ambitious reform and reconstruction agenda. We are already seeing tangible benefits of the program, and we have been able to maintain sound macroeconomic conditions while facilitating private sector growth. Clearly, however, much remains to be done, and our goal is to build on the progress already achieved.

2. At the time the program was adopted, we indicated that we would need to decide on structural benchmarks for end-December 2004 and end-March 2005 after completing the first review. Working together with the IMF mission that visited Kabul in July 2004, we reached understandings on a revised macroeconomic framework for 2004/05, on one additional structural benchmark for end-September 2004, and on a set of structural benchmarks for end-December 2004 and end-March 2005. The new benchmarks are consistent with the original March 24, 2004 Memorandum of Economic and Financial Policies (MEFP) that described our program for 2004/05.

3. The attached memorandum, prepared in consultation with Fund staff, updates the original MEFP to reflect recent developments and highlights some of the key achievements. We hope that the continued successful implementation of the SMP will lead to a successor Fund-supported program for 2005/06.

4. The government believes that the policies and measures described in the March 2004 MEFP and in the attached update to the MEFP are sufficient to attain the 2004/05 program objectives, but we stand ready to take appropriate further measures. The government will continue to remain in close consultation with Fund staff, and will provide information that Fund staff requests to assess the implementation of the SMP, as updated.

5. In order to enhance transparency of our economic policies, we request that this letter, and the update to the MEFP, be published on the Fund's website.

Very truly yours,

Update to the Memorandum of Economic and Financial Policies

I. Introduction

1. During the first quarter of 2004/05, the government of Afghanistan began implementing the staff-monitored program (SMP) with the International Monetary Fund (IMF), covering the period March 20, 2004-March 20, 2005. We are pleased to report that all prior actions, indicative quantitative targets, and structural benchmarks for end-June were observed, except the benchmark on licensing of commercial banks, which was only met partially due to a technical delay. In particular, we adopted measures to improve financial management, licensed several banks, implemented a customs policy reform, adopted a development budget, and created a technical committee to strengthen our institutional and administrative capacity to monitor macroeconomic developments and execute the SMP.

2. In meeting the targets and benchmarks under the program, we have demonstrated our continued strong commitment to macroeconomic stabilization and structural reform. We fully expect this performance to continue through the remaining months of the SMP. Together with the IMF mission that visited Kabul during July 11-25, 2004, we have revised the macroeconomic framework for 2004/05 and for the medium term, established one additional structural benchmark for end-September 2004, and reached understandings on new structural benchmarks for end-December 2004 and end-March 2005.

3. This Memorandum of Economic and Financial Policies (MEFP) updates the MEFP dated March 24, 2004, which outlined our strategy for reform and described the government's economic program for 2004/05. By publishing this updated memorandum, the government reaffirms its commitment to keep the public informed about its policies and objectives, enhance transparency, and set the economy on an irreversible path for economic reform and growth.

II. Recent Economic Developments and Performance Under the SMP

4. Real GDP is estimated to have grown by 16 percent in 2003/04, compared with an initial estimate of 23 percent. This significant revision mainly reflects lower-than-anticipated output in the agricultural sector attributable primarily to the lingering drought affecting some regions and to a lower outturn in the hydroelectric sector, which also was adversely affected by the drought.

5. Consumer prices increased by 6.9 percent during the first quarter of 2004/05, significantly more than during 2003/04, when quarterly price increases averaged 2.5 percent. This rise in consumer price inflation reflected primarily increases in rents, education fees, and other nontradables. While partly explained by seasonal factors (return of Afghanis living in Pakistan for the summer season; poppy crop season), and tax-related factors (introduction of the rental tax), this pick up in the Consumer Price Index (CPI) may also stem from higher spending by the donor community on nontraded goods. Over the last 12 months, the prices of rents, education, health, and transportation have increased substantially faster than the overall index. Excluding these four sectors, which represent 12 percent of the overall index, consumer prices have increased by 11.3 percent over the last 12 months (compared to 15.5 percent for the overall index) and by 2.7 percent over the last three months.

6. Fiscal revenue for the first quarter of 2004/05 reached Af 2.6 billion, slightly exceeding the target level of Af 2.5 billion.¹ Similar to the pattern observed in 2003/04, the government's operating expenditures were relatively slow during the first quarter of the year, reaching an estimated Af 4.8 billion, compared with an annual budgeted amount of Af 30.3 billion (10.5 percent of GDP). This was attributed to problems in communicating budget allotments to line ministries and the government units in the provinces (moustoufiats) along with procurement constraints and weak financial management capacity.

7. In June 2004, we adopted a 'core budget' that consolidates, for the first time, the operating budget with a significant share of development spending. Total spending for the core budget is projected at Af 69 billion (24 percent of GDP) for FY 2004/05, of which Af 38 billion constitutes planned spending on development projects that is channeled through the treasury system. The development projects included in the core budget are fully funded by the government or donors. All development projects, whether included in the core budget or outside it, are classified as National Programs (NPs) or National Priority Programs (NPPs). We expect that, in addition to the financing of the expenditures currently included in the core budget, grants and concessional loans of Af 15.2 billion will be available to the core budget this year. We will use them to both augment the NPPs and help finance existing donor projects that are currently outside the core budget and only partially funded. We expect to fully allocate these funds by September this year. The government estimates that spending undertaken directly by donors outside the core budget could reach Af 172 billion, although only Af 128 billion of donor grant commitments had been confirmed by the time the core budget was presented. The development of the core budget is an important step toward a comprehensive budget that incorporates all fiscal spending.

8. During the first quarter of 2004/05, currency in circulation increased by 5.4 percent (51.0 percent year-on-year), slightly less than envisaged under the program (6.3 percent). This increase in money supply resulted from the conversion of foreign currency into Afghanis by the Ministry of Finance (MoF) and by donors, which was only partly sterilized through foreign currency auctions. Along with the accumulation of foreign currency deposits by the government, this resulted in a significant increase in international reserves, to $950 million at end-quarter (3.2 months of projected 2004/05 imports), well above the SMP floor.

9. The appreciation of the Afghani points to increasing acceptance of the domestic currency. After depreciating during the last quarter of 2003/04, the Afghani has been appreciating steadily, gaining 8 percent vis-à-vis the U.S. dollar between end-March 2004 and end-July 2004. This appreciation, at a time of increasing inflation, appears to reflect a greater willingness by the population to use the Afghani as a medium of exchange and as a store of value. This trend appears to be attributable to the relative stability of the exchange rate since the introduction of the new currency, administrative measures aimed at promoting its use, such as the requirement that shopkeepers must price goods in Afghanis. Donors are increasingly making payments in Afghani instead of U.S. dollars and this appears to be widely accepted.

10. Further steps were taken toward the modernization of the central bank and the creation of a sound financial system. A preliminary assessment of Da Afghanistan Bank's (DAB) balance sheet was finalized, paving the way toward its restructuring. DAB's Supreme Council adopted a plan for introducing a short-term capital note, designed primarily to help establish a benchmark interest rate, and thereby facilitate development of a domestic credit market. New banking licenses were granted, raising to seven the number of new commercial banks operating in Afghanistan, all of them being financed by foreign investment. Two of the six state-owned banks were relicensed, and the liquidation of three others was initiated. A final decision regarding the Export Promotion Bank (EPB) had to be delayed for three months due to a decision by its shareholders to reject a restructuring involving merger with the three other state banks. Regular reporting to DAB supervision department was initiated, and a monetary survey, including the balance sheet of commercial banks, was developed.

11. Data for the external accounts are limited. However, based on revised estimates of trade data, the external current account balance (before grants) deteriorated in 2003/04 to a deficit of 56 percent of GDP, compared to a deficit of 32 percent in 2002/03. The deterioration resulted largely from a surge in imports associated with reconstruction and rising consumer demand. Donor inflows, predominantly in the form of grants, continued to finance the deficit, along with some private inflows in the form of foreign direct investment. Disbursements of external loans remained limited and on highly concessional terms. The large and positive errors and omissions in the balance of payments suggests that unrecorded inflows (perhaps from opium exports, unrecorded foreign investments and capital flows, or remittances) continue to be present.

III. The Program for 2004/05

12. We recognize that recent movements in consumer price inflation, the appreciation of the exchange rate and the downward revision of real GDP growth for 2003/04 pose new policy challenges. Further, continued insecurity in a number of regions and the reemergence of drought in some provinces, add to the challenges we are facing. Nevertheless, we remain confident in our ability to implement the measures contained in the SMP, and believe our track record over the last two years speaks to the government's capacity to operate under difficult conditions. At the same time, we are witnessing some favorable developments, including the continued delivery of substantial external assistance following the recent Berlin conference, growing confidence in the Afghani, and several key projects in the agricultural and manufacturing sectors coming on stream.

13. Against this background, we have decided to update the macroeconomic framework for 2004/05. In light of the largely unavoidable increase in the prices of some nontraded goods in a context of large donor inflows and limited supply response, the revised program aims at containing inflation at 10 percent (compared to 5 percent in the original program). At the same time, recognizing that some of the unexpected shortfall in real output in 2003/04 was temporary, we have slightly raised the real economic growth target from 15 percent to 16 percent. We anticipate that the agriculture sector will reap the benefits of the full production cycle and better land moisture this year, and that construction will provide the additional impetus for economic growth. These outcomes, together with a stable exchange rate, are expected to translate into a rise of per capita income to $246, compared with $199 in 2003/04.

14. We estimate that the overall investment rate remains high, at 43 percent of GDP in 2004/05, largely because of continued donor assistance while the opening of several commercial banks should boost private investment. We expect our current account deficit to narrow by 7 percentage points of GDP to 49 percent of GDP, as exports continue to recover and the surge in import demand levels off, and our gross official reserves to rise by about $162 million to a level equivalent to over three months of prospective imports of goods and nonfactor services.

15. Pursuing sound fiscal and monetary policies will be critical to achieve the program's quantitative targets (Table 1). To improve the prospects for sustained economic growth, we will pursue our structural reforms (Table 2).

A. Fiscal Policy

16. The successful execution of our fiscal policy will depend on our ability to rebuild domestic tax collection. While first quarter revenue represents a significant increase (about 23 percent) over the same period last year, we recognize that the budgetary target for domestic revenue of Af 15.2 billion² for 2004/05 is ambitious and that compliance rates need to be increased (and illegitimate charges reduced), particularly at border posts where the majority of revenues are generated.

17. We remain committed to implementing our five-year reform plans for both customs and domestic tax administration. We have implemented a number of customs reforms so far this year, including (i) the introduction of the Afghan Harmonized System Tariff that reduced the number of rates to 6 from 25, classified goods according to international standards and uses the official exchange rate as published by DAB for valuation purpose; (ii) the introduction of new procedures to control and monitor exemptions; (iii) an increase in the number of licensed customs brokers; and (iv) the gradual establishment of regional customs valuation units in the major provincial centers. With regard to the reform of domestic tax administration, we have (i) adopted a tax reform package;³ (ii) created a Large Taxpayer Office (we expect to appoint a head shortly); (iii) accelerated the nationwide roll out of the Taxpayer Identification Number (TIN) to the major provincial centers; and (iv) consolidated tax legislation to clarify the status of tax and customs legislation (this should be officially published shortly). In addition, we remain committed to enacting the new Customs Code this year and to ending tax concessions and tax holidays, which further undermine the tax base.

18. We expect expenditure to pick up significantly during the remainder of the year, particularly as late salary and wage payment are cleared and ongoing payments normalized, and to be in line with budgetary projections over 2004/05.⁴ The late payment of operating expenditures was also observed at the start of the previous year and is mainly attributed to weaknesses in the public expenditure management systems, including confusion over budget allotments, employment registers, and procurement constraints. The government will implement a more modern verified payroll system over the next few years, so as to improve payments, and is currently conducting a review of outstanding salary and wage payments from 2003/04 to verify the integrity of any claims before they are discharged. At the same time, we will continue to improve public expenditure management, particularly through the strict adherence to government procedures for verifying spending on operations and maintenance. Enforcing appropriate expenditure controls will enhance accountability and is part of a package of measures aimed at reducing existing payment problems and improving fiduciary standards.⁵

19. We will continue to upgrade our public expenditure management systems. During the first quarter of the year, we have made progress in consolidating all line ministry accounts into the Treasury Single Account (TSA) and regularly transferring provincial moustoufiat balances into the TSA. This should enhance our ability to monitor and control revenue. The consolidation of accounts into the TSA and the planned improvements in the automation of the payments system, including electronic funds transfers through the DAB, should also enable the government to develop more modern, secure, and direct methods of payment for both salaries and goods and services that will greatly improve the efficiency of government operations.

B. Monetary and Exchange Rate Policy

20. DAB will maintain the current stance on monetary policy, with a view to maintaining low inflation, while guarding against currency instability. To that purpose, the central bank will be guided by the flexible monetary program developed with Fund staff in March, which will allow us to accommodate, up to a certain level (5 percent above the program target), perceived shifts in monetary demand. In view of the poor quality of consumer price statistics, particular attention will be paid to exchange rate developments. While keeping a close watch on price and exchange rate developments, should this flexibility turn out to be insufficient, we will consult with Fund staff on possible changes to the monetary targets under the SMP. Consistent with the unchanged approach to the target for currency in circulation, and given that a substantial portion of the buildup in international reserves stemmed from accumulation of government deposits, the indicative target for gross international reserves of the DAB will remain unchanged. We will, however, consult with Fund staff on this issue at the time of the second review.

21. We will actively pursue further measures deemed essential to reform the financial system. DAB's balance sheet will be restructured, including the transfer of DAB's commercial holdings to the MoF. Those commercial activities of DAB that are inconsistent with the functions of a central bank will be transferred to other entities in accordance with a memorandum of understanding between the MoF and the DAB. To minimize any potential further capital loss, this transfer will be bound to the transfer of monetary gold and silver from the palace vaults to DAB and forgiveness of DAB claims on the government. In addition, an auction process will be introduced for the short-term capital note. Finally, a decision will be taken regarding the relicensing application of the EPB.

C. External Policy and Debt Management

22. We remain committed to prudent management of external debt. Regarding the stock of debt, we have made progress in identifying debts undertaken by previous administrations, and reconciling these amounts with external creditors. More remains to be done in this area, however, as there are still a number of outstanding claims which have yet to be verified. Toward this end, we will complete by end-March 2005 a full and detailed inventory of external loans, verified with bilateral creditors. In this context, we will also continue to seek generous debt relief from bilateral creditors, which we see as essential to fiscal sustainability over the medium and long term. With regard to the flow of new loans, and as specified under the SMP, external loans contracted by the government of Afghanistan thus far in 2004/05 have been on highly concessional terms, and disbursements have been limited. To ensure that this prudent strategy remains a central pillar of Afghanistan's reconstruction and stabilization, we will make significant progress toward designing a comprehensive external debt management strategy.

D. Structural Reforms

23. There are key structural reforms that need to be implemented to achieve sustainable growth. We recognize that the agenda of structural benchmarks is extensive. However, the length and breadth of this agenda reflects both the government's desire to make real and effective reforms, and to demonstrate our commitment to establishing a track record, facilitating economic growth, and building much needed administrative capacity. Foremost, among these benchmarks are measures to address weaknesses in the regulatory environment and an inefficient public sector.

24. We have established a timetable for the closure or corporatization of the state-owned enterprises (SOE), and have completed an initial audit of their operations and assets. By end-December 2004, we will complete the assessment of their financial position and adopt a list of SOEs that will specify those slated for liquidation, privatization, or those to be maintained in the government's portfolio. Recognizing that the welfare of the employees of these firms is a crucial issue, we will also adopt an overall economic restructuring plan, which will guide the government's action in this area, for the future including efforts to retrain or reassign workers displaced by the rationalization of the state enterprise sector. Although not yet fully assessed, the fiscal cost associated with this overall exercise is expected to be small.

25. A critical element of our structural program is aimed at increasing private sector investment. Toward this end, we will prepare an action plan by end-September 2004 to address critical deficiencies in the investment climate, including revisions to the commercial code, property rights, and bankruptcy legislation.

E. Program Monitoring

26. In addition to the quarterly quantitative indicators for end-September 2004, end-December 2004, and end-March 2005 defined in the MEFP dated March 24, 2004, we have reached understandings with Fund staff on one additional structural benchmark for end-September 2004, and a set of structural benchmarks for end-December 2004 and end-March 2005. The structural benchmarks are detailed in Table 2.

27. Since it was created in early April, the Inter-Ministerial Technical Committee (TC), has been instrumental in effectively monitoring the implementation of the SMP and in providing core data to the Fund. Although the role and the specific missions of the TC were an entirely new concept, we made a lot of progress in getting this new institutional unit to work, meet regularly, and provide a forum for discussions and exchanges among staff from DAB, the MoF, and the Central Statistic Office, the key government agencies currently involved in the SMP. In the months to come, the TC will focus its efforts on the timely execution of the SMP, intensifying the dialogue between government agencies, and setting the standards for better economic management.

28. The second review of the program is scheduled to take place on or after October 15 based on performance as of September 20, 2004. At the time of that review, those quantitative indicators and structural benchmarks for end-December 2004 and end-March 2005 may be revised in light of developments.

Islamic State of Afghanistan

Amendments to the Technical Memorandum of Understanding

1. Paragraph 5 will be replaced with: "Currency in circulation is defined as total currency (new Afghani) issued by DAB. It excludes currency held in the presidential palace vault, in the DAB main vault, and in the vaults of DAB's six main branches, but includes currency in the other branches'vaults."

2. The following sentence will be inserted at the end of the second bullet point of paragraph 14: "For each individual branch, the transferred amount will have to be credited to the TSA within 30 days of the end of each solar month."

3. The following bullet point will be inserted at the end of paragraph 14:

• Publication (by the MoF) of fiscal data on a quarterly basis. The data should be at least quarterly, but whenever possible, should include monthly revenue and expenditures (center and by individual province) covered under the core budget, as well as financing. The structure of the revenue and expenditure data should be on the same classification as the approved budget. The data should also compare outturns against the budget. As information on the external budget depends on cooperation from the donors, the government should make a "best effort" to compile the data, and make ongoing revisions. Published data should also include principal and interest payments on external government and government-guaranteed debt, and disbursement of external loans. Publication of this information can be in either electronic or paper format.

4. The second bullet point of paragraph 15 will be replaced by:

• Monetary statistics, including exchange rate data (daily), government accounts with the DAB and currency in circulation (monthly) from March 20, 2004. From September 21, 2004, monetary statistics will also include a monetary survey (monthly), including balance sheets of DAB and a balance sheet of the commercial banks. This should be reported no longer than three weeks after the end of the month.