Islamic State of Afghanistan—Letter of Intent, Memorandum of Policies, Agreement, Memorandum of Economic Policies, Memorandum of Economic and Financial Policies

Kabul, December 29, 2004

Mr. Rodrigo de Rato
Managing Director
International Monetary Fund
Washington, D.C. 20431
U.S.A.

Dear Mr. de Rato:

The government of Afghanistan has held discussions with Fund staff in the context of the second review of the staff-monitored program (SMP) agreed to in March 2004 and is very pleased with the progress under the program. Based on these discussions, the attached memorandum of economic and financial policies (MEFP) reviews macroeconomic developments and implementation of structural policies during the first two quarters of fiscal year 2004/05 and describes the objectives and policies that the government intends to pursue during the remainder of the fiscal year 2004/05. The government’s program will continue to be guided by the macroeconomic and structural reform policies described in the MEFP of March 24, 2004, and modified by the updated MEFP of September 6, 2004. The attached technical memorandum of understanding (TMU) was also updated to reflect the adjustments introduced to some terms and conditions of the program.

With the support of your staff, we have met all of the end-September 2004 quantitative indicators and structural benchmarks, except the benchmark on the adoption of anti-money laundering/combating the financing of terrorism legislation, due to a slight delay in issuing the presidential decree. The government of Afghanistan appreciates the technical support provided by the Fund and intends to continue its reform efforts as envisaged under the SMP. Reacting to the changing circumstances, the government reached an understanding with the mission on a revised macroeconomic framework for 2004/05, and on the deferment to end-March 2005 of several of the structural benchmarks because of technical difficulties and capacity issues related to the long political transition that followed the Presidential election. We have also strengthened our program by including an additional structural benchmark for end-March 2005 on the publication in the Official Gazette of the amendments related to (i) the tax reform package; and (ii) ensuring that the revenue laws supersede all other legislation in revenue-related matters.

The government believes that the policies and measures set forth in the attached MEFP are adequate to achieve the objectives of its program, but we stand ready to take any further measures that may become appropriate for this purpose. Afghanistan will consult with the Fund on the adoption of any measure that may be deemed necessary and will provide information that Fund staff request to assess the implementation of the SMP, as updated. The government of Afghanistan authorizes the publication and distribution of this letter, the attached MEFP and TMU, and all reports prepared by Fund staff regarding the SMP.

Very truly yours,

/s/ Anwar Ul-Haq Ahady Minister of Finance Ministry of Finance	/s/ Noorullah Delawari Governor Da Afghanistan Bank
Attachments: Update to the Memorandum of Economic and Financial Policies Amendments to the Technical Memorandum of Understanding

Update to the Memorandum of Economic and Financial Policies of the Government of Afghanistan

Second Review Under the Staff-Monitored Program, 2004/05

I. Introduction

1. The positive outcome of Afghanistan’s first direct presidential election was an important step in rebuilding the nation’s institutional framework and broadening ownership of the government’s reform agenda. In this context, we will continue to pursue prudent macroeconomic policies and structural reforms, while simultaneously rebuilding administrative capacity. The government’s program for the rest of 2004/05 will continue to be guided by the policies described in the Memorandum of Economic and Financial Policies (MEFP) of March 24, 2004, and modified by the updated Memorandum of September 6, 2004.

2. This MEFP reviews performance during the second quarter of 2004/05, updates the government’s macroeconomic objectives in the context of a medium-term framework, and describes the policies and targets for FY 2004/05. Two of the quantitative indicators have been changed in accordance with an earlier agreement with Fund staff and management and consistent with the flexibility clause in the program. In addition, some minor changes to the end-December 2004 and end-March 2005 structural benchmarks are incorporated in the program to reflect circumstances that were not fully known at the time that they were originally developed, including the long political transition that followed the Presidential election.

II. Developments Under the SMP

3. Overall economic performance during the first semester of 2004/05 was broadly satisfactory despite some adverse shocks, including a more fragile security situation in the run-up to the election. The resurgence of drought conditions in some southern provinces led to lower-than-projected growth in the agricultural sector, with both cereal and livestock output declining during the main harvest season (April–July). However, output was sustained by stronger than expected growth in construction and services. After a rise of 6.9 percent in the first quarter, consumer price inflation declined to 1.3 percent during the second quarter.¹ Inflation continued to be led by rents and petroleum product prices, which increased by 26 percent and 17 percent, respectively. Rental prices increases were attributable to the imposition of the rental tax, and increased demand from donors and returning refugees. Excluding rents and petroleum products, consumer prices declined by 1.7 percent during the second quarter, reflecting a decline in bread and cereal prices. Overall, year-on-year inflation amounted to 14.1 percent at end-September (8.3 percent excluding rents and petroleum products), compared to 15.5 percent at end-June.

4. The United Nations Office on Drugs and Crimes (UNODC) has just released its official findings for the 2004 harvest. The report indicates that opium cultivation has covered 206,700 hectares during the 2004 crop season as poppy farming continued to spread to new areas of the country. However, opium production does not appear to have increased significantly, due mainly to crop diseases and adverse climatic conditions. Indications are also that farm gate prices have declined markedly and are expected to average below $100 per kilogram (compared to $283 in 2003). The market appears to be segmented as the price decline is reportedly much larger in the southern part of the country, due to intensified interdiction. As the decline in farm gate price was not reflected in export prices, it is likely that the aggregate share of opium revenues taken by traders and laboratories has again markedly risen. Overall, total export revenues from opium are tentatively estimated at $2.2 billion, of which only about $600 million went to farmers. Consistent with the increase in cultivation, it is also estimated that the number of people deriving income directly from opium has also risen to 2.3 billion.

5. Fiscal revenue for the first half of 2004/05 was Af 5,886 million, exceeding the SMP indicative target of Af 5,506 million. Revenue mobilization over the first half of the year represents a significant increase (about 33 percent) over the same period last year. This positive outcome was attributed to administrative reforms, which have yielded sharp increases in administrative fees, and taxes on goods and services (including rent), and on companies. The more timely sweeping of provincial accounts into the central government account (end-December 2004 benchmark) has also helped in regularizing revenue collection. Following some initial delays, the rate of spending for operating expenditures increased, reaching Af 12 billion by the end of the first half of the year, compared with an annual budgeted amount of Af 30.3 billion (11.3 percent of GDP). In light of the election and continuing security concerns, 51 percent of operating expenditures were directed towards security-related spending.

6. We continue to respect the no-overdraft policy and operating expenditures continued to be financed through revenue, foreign assistance and the draw down of government deposits. However, the level of reimbursements from the two multi-donor grant funds—the Afghanistan Reconstruction Trust Fund (ARTF) and the Law and Order Trust Fund for Afghanistan (LOTFA)— was less than expected and the domestic deficit during the first half of the year was covered by a draw down of both domestic deposits of Af 1.6 billion from a highly concessional loan from the Asian Development Bank (ASDB) amounting to $12 million. The resources from the ASDB loan are expected to provide only temporary financing during the year as the rate of reimbursement from the ARTF gradually picks up, compliance with financial management rules improves, and as LOTFA receives and disburses additional funds. Direct payments to vendors’ bank accounts were recently introduced and should help reduce corruption and speed up payments.

7. Core budget development spending reached Af 3.5 billion during the first half of 2004/05, compared to the annual budget estimate of Af 38.4 billion for FY 2004/05 (equivalent to 14.3 percent of GDP).² The low rate of development spending was attributed to several factors, including (i) the late approval of the core development budget;³ (ii) the poor security environment, which has hampered implementation; and (iii) the limited capacity of line ministries and other agencies to implement programs. During the first half of the year, development spending was concentrated in just a few of the National Priority Programs.

8. In consultation with Fund staff, and to accommodate the perceived increase in money demand, Da Afghanistan Bank (DAB) allowed the growth of money in circulation to exceed the second-quarter SMP indicative target. Money in circulation increased by 21.7 percent during the first half of 2004/05, exceeding by 7.6 percent the SMP indicative target. This higher-than-targeted money increase was justified by the strong appreciation of the Afghani, which along with the recent slowdown in inflation, pointed to an increase in money demand. DAB’s decision to accommodate this increase in money demand was successful in stabilizing the exchange rate. After appreciating by 20 percent in the first five months of 2004/05, including by 9 percent in the third week of August (when it reached Af 42 per dollar), the exchange rate has stabilized in the Af 45–46 per dollar range.

9. We continued to modernize the DAB and create a sound financial system. The banking regulatory framework was strengthened through enactment of the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) legislation, and the adoption of bank reserves requirements. The Export Promotion Bank, whose licensing had been delayed due to the cancellation of its merger with 3 other state-owned banks, was granted a conditional banking license. DAB also granted a preliminary license to Arian Bank, raising to eight the number of private commercial banks operating in Afghanistan. DAB introduced short-term capital note auctions. Reflecting the high level of liquidity in the banking system, overnight auctions were overbid and the interest rates on these notes declined steadily to less than 2 percent. At this early stage, demand for longer maturities remains limited. Finally, DAB started implementing the transfer of its commercial activities and the Supreme Council agreed to develop a modern payments system (electronic funds transfer).

10. Data for the external accounts are limited, but steadily improving. Based on preliminary data, the external current account balance (before grants) narrowed to a deficit equivalent to 12 percent of GDP, down from a deficit of about 22 percent during the first half of 2003/04. This decline in the deficit appears to have stemmed largely from an improvement in the trade balance, including a substantial increase in domestic exports. 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 suggest the continued presence of unrecorded inflows (perhaps from opium exports, unrecorded foreign investments and capital flows, or remittances).

11. In terms of the SMP, all quantitative indicators for end-September were observed, with the exception of the ceiling on currency on circulation. However the failure to observe this target was in accordance with the flexibility established in the program.

12. On the structural front, progress has been made, and all the structural benchmarks were met, except for the benchmark related to the issuance of a presidential decree enacting the AML/CFT legislation.⁴

III. The Program for the Remainder of 2004/05

A. Macroeconomic Objectives

13. With climatic conditions adversely affecting the short-term potential for further gains in agriculture, overall economic growth now depends more heavily on such activities as construction, transport, and other services, led by the private sector. Notwithstanding weaker prospects for agricultural production, which is likely to fall by 20 percent for the year as a whole, we expect growth to continue in 2004/05 and beyond. While somewhat slower than the brisk pace of the two previous years, real GDP growth is projected to reach about 7.5 percent for 2004/05. Downside risks include the lingering drought, volatile oil prices, and security. Inflation is expected to remain moderate during the remainder of the year as the rent prices appear to be stabilizing. Some pickup in import demand is expected to materialize in the second half of the year, associated with a post-election resumption of donor activities. Nevertheless, we expect an improvement in the overall external current account relative to 2003/04.

14. Against this backdrop, we will continue to adhere to sound fiscal and monetary policies. Strengthening our administrative capacity, accelerating structural reforms, and providing an enabling environment for private sector activity, while being mindful of poverty and social concerns, are also key priorities. At the same time, we are working very closely with our international partners to develop a five-pronged strategy to deal with the issue of opium, focused on education, alternative livelihoods, interdiction, eradication, and legal reform. We are also keenly aware that eradication of opium production cannot be accomplished in isolation, and that the economic consequences of any program will have to be carefully managed.

B. Fiscal Policy

15. The increase in revenue over the first half of the year is encouraging and we are confident that we will achieve the SMP target. However, we recognize that the budgetary revenue target for the whole year (Af 15 billion) is ambitious but achievable.⁵ Meeting this objective will require a significant improvement in revenue collection during the second half of the year—by about 55 percent over the first half of 2004/05.

16. Achievement of the core budget target will require a redoubling of our collection efforts. Customs and tax administration both have a comprehensive five-year reform plan to rebuild capacity in the Afghanistan Customs Department (ACD) and Revenue Presidency, within the Ministry of Finance. The central office of both organizations have recently been restructured under the Priority Reform and Restructuring (PRR) process. Key measures in the customs area include stronger management and coordination of domestic and donor-financed projects, and the construction of modern customs houses at key border posts. On the revenue side, the Large Taxpayer Office (LTO) is now operational and reform of the Kabul provincial revenue office (Model Office) is now underway. Parts of the tax reform package have also been implemented in Kabul, including: (i) the rental services tax; (ii) a 10 percent business receipts tax on service providers in restaurants, telecommunications, and hotels; and (iii) corporate tax rates have been harmonized at a rate of 20 percent. A simplified fixed tax on money changers and a withholding tax on wages will be gradually introduced, while legislation is pending to increase the airport departure tax. Finally, before the end of March 2005, we will publish in the Official Gazette the amendments to: (i) the income tax law relating to the tax reform package; and (ii) ensure that the revenue laws supersede all other legislation in revenue-related matters. By that time, we also intend to consolidate all recent revenue measures into the existing revenue code and to publish it as a single document.⁶ In addition, we will receive some large non-tax revenue in the fourth quarter.

17. Operating expenditures are expected to pick up significantly during the remainder of the year. Additional training is being provided to line ministries and moustoufiats in financial and procurement procedures. This should improve compliance with current expenditure controls, which should translate into better rates of non-salary spending and the associated financing from the ARTF. The government is considering paying a bonus of Af 1,000 after Ramadan to most civilian employees, at a total cost of around Af 300 million, which can be accommodated within the current budget appropriations.

18. We will continue to consolidate government operations and upgrade our public expenditure management systems. While it had, for administrative reasons related to the political transition process, to be postponed from end-December 2004 to end-March 2005, the Cabinet approval and publication in the Official Gazette of the Financial Management Law will provide the legal framework for fiscal policy. Significant progress has been made with the development of the core budget and the consolidation of government accounts into the Treasury Single Account (TSA). These reforms need to be deepened with additional efforts to: (i) further harmonize the operating and development budgets, initially by agreeing to a single Chart of Accounts; (ii) improve the payment and payroll systems and expenditure controls; (iii) strengthen macro-fiscal analysis and cash management capabilities; (iv) enhance quarterly budget reporting and budget classification; and (v) reintroduce internal and external audit functions.

19. Expenditure policy will gradually shift from security and reconstruction toward more broad-based sustainable development as improvements in the security situation allow. The budget is currently dominated by the wage bill (58 percent of the operating budget) with spending on security comprising more than 40 percent of the total. Given the limited scope for increasing domestic revenue, we envisage the medium-term role of the public service as restricted to providing only the most essential services in the most cost-efficient manner. We are just beginning more fundamental sector-based planning in the form of a Public Expenditure Review (PER), which will initially assist with the preparation of the 2005/06 budget but is also expected to become a key component in developing government priorities and monitoring performance.

C. Monetary and Exchange Rate Policies

20. The revised monetary framework will continue to be geared toward maintaining low inflation and currency stability. The revision of the monetary program was warranted given the emergence of stronger-than-anticipated money demand, the sharp appreciation of the Afghani, and the slowdown in inflation. The increase in money demand may partly reflect seasonal factors, such as the impact of the poppy harvest and the return of expatriate Afghans. However, we believe that the root cause of the increase, which coincided with weaker economic growth, is a greater acceptance of the local currency. This faster-than-expected “Afghanization” of the economy appears to have been spurred by efforts to promote the use of the Afghani by the public in daily transactions, the relative stability of the exchange rate, and the greater use of the Afghani by the donor community. We expect this process to continue, albeit at a slower rate. We therefore believe that the new monetary indicative targets, which imply a monetary tightening as compared to the current stance, will ensure a further decline in inflation.⁷ In any case, DAB will continue to closely monitor exchange rate and price developments, and stands ready to tighten its monetary policy would inflation not abate.

21. We will continue our reform of the financial system. Difficulties in identifying the owners of current and savings accounts will prevent DAB from finalizing the transfer of its commercial activities by the target date of end-December 2004. We are committed to finalize the transfer of all commercial activities from the DAB’s main office, and to start implementing the transfer in the provincial branches, by end-March 2005. As first steps, by end-December we intend to (i) complete a campaign asking customers to transfer their accounts; (ii) classify all accounts into three categories (voluntary transfer; involuntary transfer; and incapables of transfer); and (iii) initiate transfers. This, together with the transfer of DAB’s non-core assets to the Ministry of Finance, will help lay the foundations of a modern central bank. Reflecting difficulties in assigning some potential liabilities currently housed at DAB, this transfer will be initially limited to the transfer of DAB’s commercial holdings (end-March 2005 benchmark). At the same time, the findings of DAB's external audit will provide a comprehensive assessment of its financial situation and set, if needed, a framework for its recapitalization. DAB will also work toward a more market-oriented foreign exchange market, with a view to giving a more prominent role to the commercial banks and will try to deepen interest in the short-term capital note. Finally, we will decide the time frame and restructuring strategy for the three licensed state-owned banks, and the specific resolution methods of the three unlicensed ones.

D. External Policy and Debt Management

22. The government remains committed to an open trade and exchange system. The introduction of a new tariff system and the use of market exchange rates for import valuation were significant steps forward in this regard. Afghanistan is now one of the most open economies in the region, with a simple average applied tariff of only 4 percent, and very few nontariff barriers. To enhance the prospects for regional trade, the government will also continue to pursue or improve upon trade and transit agreements with neighboring countries. Consideration is also being given to membership in the World Trade Organization. On current trends, the current account balance (excluding grants) is projected to narrow to 32 percent of GDP, a 10 percentage points decline compared with the 2003/04 estimate. Such an outcome would enable us to further increase our foreign exchange reserves to about $1.1 billion, equivalent to roughly 4 months of prospective goods and services imports. In any event, we are raising our floor for international reserves to 3.5 months of imports, a sufficient level of reserves to help us face a possible external shock.

23. We remain committed to prudent management of external debt. Regarding the stock of debt, we have made further progress in identifying debts undertaken by previous administrations, and reconciling their 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. In seeking international cooperation in this area, we will also continue to look for generous debt relief from bilateral creditors. We see such relief as essential to external and fiscal sustainability over the medium- and long-term. During the first two quarters of 2004/05, and consistent with the SMP, we have contracted external loans only on highly concessional terms. Disbursements have also been limited. To ensure that this prudent strategy remains a central pillar of Afghanistan’s reconstruction and stabilization, we will seek to design and implement a comprehensive external debt management strategy in the near future.

E. Structural Reforms

24. We recognize the need to undertake reforms to unlock the potential of new growth- generating economic activities. One avenue is to press ahead with our structural reform agenda, with a particular focus on making improvements to the business and regulatory environment, as well as the public sector.

25. Notwithstanding the limited availability of detailed financial data, we have recently completed a survey of state-owned enterprises (SOEs), including a preliminary assessment of their financial situation. On the basis of this survey, we have established a preliminary classification of SOEs according to how they might be best restructured. Accordingly, we intend to maintain 10 SOEs in public ownership and at least 20 for liquidation. Currently, as many as 41 are slated for privatization, and the larger firms will be subject to an international tendering process. Further work on the financial state of these SOEs is ongoing, which will likely lead to some adjustment of the current classification. Due to delays related to the formation of new government, however, we do not expect this classification, and the related restructuring plan, to be adopted by the Cabinet by end-December 2004, as initially envisaged under the SMP. We are fully committed though to have the classification adopted by end-March 2005. In the meantime, we have already initiated the privatization process of a limited number of small SOEs, including the sale of a cotton company and a sugar beet company. In undertaking this process of privatization and reform, we remain keenly aware of the need to alleviate the social impact of the restructuring and efficiently manage the implications for current employees. Toward this end, we have compiled a comprehensive list of all employees of SOEs, which will help the government retrain or reassign workers displaced by the restructuring process.

26. With a view toward boosting nonagricultural private sector investment, we are finalizing a new private investment law and anticipate its publication in the Official Gazette before end-December. We are also making headway in putting in place a legal framework for the extractive industries—an area where we see considerable scope for new investment and growth.

27. Reform of public administration must balance the need to improve productivity with the availability of resources. To enhance control over the payroll and reduce a source of corruption, we are developing a “verified payroll plan” for ministries to normalize the payroll process and improve employee verification.⁸ Over the medium-term, this will enable us to develop a more comprehensive personnel database and computerized payroll. Over the next few years, we will aim at maintaining the size of the civil service while enhancing its productivity with major investments in capacity building and salary increases to retain and recruit professional staff. The PRR process has been the essential component in civil service reform and it has gained wide acceptance within the government.

28. We remain concerned about poverty. We have begun a dialogue with our various social counterparts both within government, including the provinces, as well as civil society and our international partners to develop a poverty reduction strategy. We expect that an interim strategy should be finalized before end-March 2006.

F. Safeguard Assessment and Statistical Issues

29. DAB has hired an international consulting firm to conduct an external audit based on internationally recognized standards. This audit will serve as a basis for the introduction, in consultation with the Fund, of a safeguard assessment—which should begin after the external audit is completed.

30. Notwithstanding the progress made so far, the statistical database remains weak. We remain committed to improving the quality, coverage, and timeliness of our macroeconomic statistics. In this context, we have adopted a statistical master plan, aimed at establishing clear work program priorities, including the introduction of institutional and legal reforms to underpin statistical capacity, promote interagency coordination, and enable the resources and technical assistance needed for the development of a comprehensive statistical database.

G. Technical Assistance

31. Technical assistance (TA) received from various donors has been instrumental in reconstructing an institutional infrastructure and achieving significant improvements in various areas. While TA needs will remain significant in some areas, they are expected to diminish in others. Consequently, TA needs must be redefined, focused, coordinated and efficiently delivered. For that purpose, we intend to conduct a comprehensive review of technical assistance, and establish a comprehensive TA action plan.

H. Program Monitoring

32. The program will continue to be monitored using the definitions, data sources, and frequency of monitoring set out in the attached Technical Memorandum of Understanding (TMU). The quantitative indicators for the third and fourth quarters of 2004/05 are included in Table 1. The structural benchmarks are detailed in Table 2. The government will make available to Fund staff all core data, appropriately reconciled and on a timely basis, as specified in the TMU.

33. The Technical Committee of Coordination (TCC) is gradually emerging as the key unit in monitoring the implementation of the SMP and in providing core data to the Fund. It is now the main body through which coordination of technical work is conducted. Notwithstanding this progress, there is still room for improvement. In particular, the government will encourage the TCC to step up its capacity-building efforts, develop a much needed analytical function, and reach out to other government agencies.

34. The third review of the program is scheduled to take place around mid-January 2005, based on performance at end-2004. At the time of that review, the quantitative indicators and structural benchmarks for end-March 2005 may be revised in light of developments.

35. The presidential election has just been completed and the composition and form of both the Cabinet and economic policy oversight is expected soon. We believe it would be premature to discuss any future Fund program until the new government is in place. However, given the need to further build administrative capacity, and given the absence of an immediate balance of payments need, we believe a follow-on SMP (either a new program or an extension of the current SMP) might be an appropriate step.

Amendments to the Technical Memorandum of Understanding

1. The following bullet points will be inserted at the end of paragraph 14:

• Complete an assessment of the financial position of the SOE. Adopt (by Cabinet) (i) the list classifying SOEs according to proposed economic restructuring method; and (ii) the Economic Restructuring Plan. For those nonfinancial SOEs with poor record keeping and scarce financial information, instead of an assessment of the financial position, the experts will make, at a minimum, an informed judgment of the state of the enterprise through in-site visits and thorough discussions with management and staff. If sufficient financial information becomes available, then a full-fledged assessment of the financial position of the SOE will be conducted prior to its restructuring. The Economic Restructuring Plan will reflect the various steps and tasks entailed by the restructuring process, and will be adopted by the Ministries in charge of the SOEs and presented to the Cabinet.
  
• Transfer to other entities all DAB commercial activities that are inconsistent with the central bank and commercial banking laws. At a minimum, this will include all commercial activities performed by DAB’s main office. Notwithstanding the transfer of other commercial activities, the transfer of commercial accounts will, at least, comprise all accounts which are not: frozen; non-cash; or requiring audit or/and legal determination.

2. The following bullet point will be inserted at the end of paragraph 15:

• Core development budget operations and their financing should be reported on a quarterly basis no more than six weeks after the end of the quarter. The data should be at least quarterly, but whenever possible, should include monthly expenditures covered under the core budget, as well as financing. The structure of the financing (grants and loans) and expenditure data should be on the same classification as the operating budget in addition to the program classification used by the budget. The data should also compare outturns against the budget.