Worker at a sweets factory in Kabul: Afghanistan has the potential for strong growth over the medium term, the IMF says (Sabawoon/EPA/Newscom)
MIDDLE EAST AND CENTRAL ASIA
Afghanistan’s program, endorsed by the IMF’s Executive Board on November 14, contains measures to start addressing corruption, strengthen the banking system, and improve revenue collection. The three-year arrangement under the Fund’s Extended Credit Facility also aims to make tangible progress on improving social conditions in the country, one of the world’s poorest.
The IMF hopes that the program will strengthen the hand of the economic team to push forward with difficult reform, but there are clear risks, including from vested interests that may have an interest in derailing reforms.
One key objective of the program is to help allay growing fiscal pressures. International troops are scheduled to withdraw from the country by 2014, which means that the government will have to shoulder more of the spending on security, and the economy will no longer benefit from the associated foreign spending. Over the medium term, donor support is also expected to gradually decline, adding to already high fiscal pressures stemming from the country’s vast social spending needs and limited revenues.
“Going forward, the authorities will have to make determined efforts to strengthen governance and root out corruption. Progress in these two areas is the prerequisite for the success of their reform program,” said Axel Schimmelpfennig, IMF mission chief for Afghanistan. “They also need to improve tax collection, prioritize spending, and engage with donors. In the absence of these measures, the country will struggle hard to make ends meet as the international presence and support gradually declines.”
A second key objective of the program is to promote a sound and effective financial sector that can facilitate private sector activity. This will be important to create the environment for high and inclusive growth. The authorities’ program thus emphasizes steps to effectively manage the Kabul Bank crisis and strengthen the financial sector based on the lessons learned from the crisis.
Kabul Bank crisis
Afghanistan’s recent banking crisis has highlighted dramatically the need to strengthen governance and the rule of law and build a more stable banking system that fosters productive lending. The new program focuses on achieving these ends.
Concerns about the soundness of Kabul Bank, the country’s largest financial institution, caused a run on the bank in September 2010, leading to the withdrawal of about half of its $1.3 billion in deposits. As the bank represented nearly a third of the financial system’s assets, the crisis threatened its stability.
Over the past year, the authorities have taken some initial steps to deal with the crisis. The bank has been put under receivership, its license has been revoked, and shareholders’ rights and interests have been extinguished. The authorities have established a bridge bank—New Kabul Bank—and developed a business plan to put it up for sale in 2012. In addition, a comprehensive audit of Kabul Bank by an independent, internationally recognized firm is now under way.
Restoring stability
The authorities recognize that enforcing the rule of law in the banking sector is a necessary condition for economic stability as well as for donor engagement, and their program spells out steps to strengthen bank governance and supervision to address the underlying flaws in the system that led to the crisis.
“The initial actions of the central bank and the government after the Kabul Bank crisis erupted prevented a full-blown financial crisis,” said Enrique Gelbard, former IMF mission chief for Afghanistan who led the work in earlier rounds of the program discussions.
“Going forward, they need to make faster progress on asset recovery and apply Afghan laws in cases where crimes have been committed. Moreover, the central bank needs to be free from political interference to take the measures it considers necessary to safeguard the banking system,” he added.
One important objective of the program is to revise the existing banking law and regulations. These revisions should bring important provisions in line with the Basel Core Principles and Financial Action Task Force recommendations—in particular, strengthening corporate governance, beneficial ownership, capital, large exposures, related parties, enforcement, and bank resolution.
The authorities’ program also includes measures to strengthen governance in the economic and financial sphere. A key priority is to ensure that the rule of law prevails throughout the country, and the government plans to improve its ability to deal with economic crime and tighten the application of the rule of law in the financial sector. The Afghan authorities have also reaffirmed their commitment to critical anti-corruption and governance reforms.
“If the reform program is implemented as envisaged, the financial sector should be in a position to play an important role in supporting investment and economic activity in coming years,” said Schimmelpfennig.
Fiscal progress
“Despite a difficult security situation, the authorities have made much progress in recent years on administrative and governance reforms to strengthen tax collection. Although domestic revenue only amounts to about 11 percent of GDP, this is a considerable improvement from about 6½ percent of GDP collected in fiscal year 2005/06,” said Gelbard.
Over the next five years, the authorities intend to increase revenues by another 4 percentage points of GDP, including by introducing a value-added tax in 2014, Schimmelpfennig said.
Increasing tax revenues to levels achieved in countries similar to Afghanistan will be crucial for fiscal survival. “The government cannot borrow to cover the financing gap. This would just lead to a fast and unsustainable buildup of debt,” said Schimmelpfennig. “This also highlights the importance of continued donor support to the budget for many years.”
In early 2010, Afghanistan received $1.6 billion in debt relief from its official creditors under the Enhanced Heavily Indebted Poor Countries (HIPC) Initiative, a joint program between the IMF and the World Bank’s International Development Association.
Growth potential
Afghanistan has the potential to grow by around 6 to 7 percent over the medium term, but this assumes a stable security situation and is subject to considerable uncertainty.
Much depends on the economic impact of the troop withdrawal as well as the evolution of the security situation, which in turn affects the business environment. Risks are clearly to the downside, and, if security does not stabilize or the negative impact of the troop withdrawal is larger than currently estimated, economic activity could easily come to a standstill or worse. The performance of the agriculture sector, which represents about 30 percent of GDP, is also hard to predict because of weather fluctuations.
The mining sector offers some hope as a future contributor to growth. Afghanistan has rich mineral deposits that have not yet been exploited. In order to attract the needed large foreign investment to develop mining, the country must first stabilize the security situation and improve the legal framework. But if Afghanistan succeeds in doing so, the growth of this sector could benefit its economy more broadly, for example, if the roads and electricity infrastructure built to service the mines are also be available to other business.
“As Afghanistan develops the mining sector, it will be important to have a strong fiscal regime in place that allows the country to harness the benefits from these resources,” says Schimmelpfennig, noting that robust governance structures would need to be in place to ensure that the government reaps the full benefits of such investment.
Policy priorities
Under the new program, the government aims to achieve the following goals:
• Put Afghanistan on a medium-term path toward fiscal sustainability, including by increased domestic revenue mobilization;
• Contain inflation and ensure adequate central bank capitalization to allow it to follow its mandate;
• Improve governance to enhance the investment climate and lay the foundation for high and inclusive growth;
• Strengthen the financial sector by revising the legal and regulatory framework, including in the area of anti-money laundering, and enhancing supervision and enforcement; and
• Achieve maximum recovery of Kabul Bank losses and apply Afghan law, as appropriate, in dealing with financial crimes.
