Public Information Notice No. 08/24

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with the Islamic Republic of Afghanistan

February 20, 2008

On February 13, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Islamic Republic of Afghanistan.¹

Background

Since its approval by the Executive Board in June 2006 the three-year Poverty Reduction and Growth Facility (PRGF) arrangement (amounting to SDR 81 million) has helped maintain macroeconomic stability and has contributed to the implementation of the government's reform agenda. The arrangement supports the authorities' economic program through March 2009 and Afghanistan's participation in the enhanced Heavily Indebted Poor Countries (HIPC) Initiative.

The authorities have made good progress in the key policy areas covered by program conditionality. They have strengthened the Medium-Term Fiscal Framework, enhanced revenue efforts through tax reforms and capacity building, and improved implementation of the development budget. They also continue to strengthen the monetary policy framework and banking supervision. With regard to the broader reform agenda, however, performance has been mixed. There have been pressures for protectionist measures, while laws critical for private sector development have not yet been approved and the privatization of state-owned enterprises has proceeded at a slow pace. Moreover, the volatile security situation and the increasing importance of the drug economy are weakening attempts at broadening economic development.

While the PRGF-supported program remains on track, it has been strengthened to address the risks emerging from: (i) government involvement in the domestic petroleum market; (ii) potential fiscal drains stemming mainly from the government's relations with public enterprises; and (iii) a weak supervisory and regulatory framework for the banking system.

Real GDP growth (excluding the drug economy) dropped to 6.1 percent in fiscal year 2006/07 owing to drought, but is expected to exceed 13 percent in 2007/08, reflecting a post-drought rebound in agricultural output and strong growth in other sectors, particularly construction. Inflation averaged 5.1 percent in 2006/07 but returned to double-digit levels in 2007/08 owing to sharp increases in the prices of imported fuel and foodstuffs. The Afghani has remained broadly stable against the U.S. dollar.

Revenue efforts have played a central role in improving the underlying fiscal position. Domestic revenues have increased markedly from an extremely low base of 4.7 percent of GDP in the fiscal year 2003/04, and are projected at 8.2 percent in 2007/08. This increase, combined with a prudent expenditure policy under the core budget (covering operating and development expenditures of the central government) have led to a gradual reduction in the core operating budget deficit (excluding grants) since 2004/05. The bulk of public expenditures, however, continue to be undertaken in the context of the external budget, which is executed and fully financed by donors.

Monetary policy has remained broadly consistent with the program and continues to be guided by indicative targets for currency in circulation, within the context of a managed float exchange system. With ample foreign exchange at its disposal, the Da Afghanistan Bank (DAB) relies primarily on foreign exchange auctions for managing liquidity. Limited use has been made of DAB's capital notes, which were introduced in mid-2004/05, as a liquidity absorption instrument. Foreign currencies and Afghanis continue to be used interchangeably in domestic transactions.

The external position remains dependant on large aid inflows. Official transfers were estimated at 66 percent of GDP in 2006/07, reflecting mainly higher security spending by donors. Afghanistan's debt sustainability has improved significantly as a result of debt relief from its bilateral creditors and interim debt relief under the HIPC Initiative. International reserves have increased steadily.

Banking sector activities have grown considerably over the last few years, mainly due to the expansion of private banking. This rapid growth has prompted DAB to strengthen its bank supervision capabilities. The bulk of activities of the banking sector are in foreign currencies.

The preparation of the Afghanistan National Development Strategy (ANDS) has reached an advanced stage. The authorities intend to submit the full ANDS document to the Boards of the IMF and the World Bank by March 2008.

Executive Board Assessment

Executive Directors commended the authorities for Afghanistan's continued satisfactory performance under the Poverty Reduction and Growth Facility (PRGF)-supported program, despite a difficult security environment. They emphasized that, to improve Afghanistan's sustainable growth and poverty alleviation prospects, the authorities need to accelerate structural reforms to enhance governance, overcome infrastructure bottlenecks, and promote private sector activities while reducing the government's involvement in the economy.

Directors noted the revenue shortfall that emerged in the third quarter of the current fiscal year, and stressed the need for revenue enhancing measures to move Afghanistan toward fiscal sustainability. They encouraged the authorities to muster political support to implement measures aimed at bolstering revenue collection, in particular by expanding the revenue base of medium and large tax payers.

Directors welcomed the progress made in strengthening expenditure control, and considered that continued efforts were needed to meet the government's medium-term objective of covering operating expenses from domestic revenue. Directors underscored the need to prioritize the use of scarce resources in line with Afghanistan's development objectives. They also highlighted the importance of clarifying the government's relations with state-owned enterprises with a view to stemming potential fiscal drains.

Directors welcomed the authorities' efforts to improve the effectiveness of monetary policy by broadening the central bank's policy instruments, especially in light of the recent rebound in inflation. In that context, they supported the increased reliance on capital notes and the development of a secondary market for these instruments. They recommended managing the volume of capital notes prudently in order to prevent unnecessary fluctuations in liquidity.

Directors commended the Da Afghanistan Bank (DAB) for the successful outcome of the special audit on the availability of foreign reserves. Looking forward, they encouraged the authorities to improve the DAB's accounting system.

Directors welcomed the measures recently taken by DAB to strengthen bank supervision and the regulatory framework for banks, as well as DAB's decision to proceed expeditiously on implementing changes to the minimum capital requirement and investment regulations for banks.

Directors noted that the current exchange rate regime had served Afghanistan well, and that the exchange rate level appeared to be broadly in line with fundamentals. They stressed the need to maintain a transparent and liberal trade regime to improve external competitiveness. In this regard, they welcomed the elimination of the discretionary preferential import tariff for selected businesses.

Directors welcomed the progress made toward completing Afghanistan's National Development Strategy. They noted that, to achieve maximum effectiveness of public investment, the authorities needed to align their sectoral strategies with the government's growth objectives, while taking proper account of the absorptive capacity of the economy. They also stressed the importance of securing debt relief agreements on comparable Paris Club-terms with all remaining creditors.

Directors noted the authorities' intention to link explicitly the disbursement of subsidies to the state-owned electricity company to progress in its restructuring. They indicated that addressing the shortage and high cost of electricity in Afghanistan will have a major positive impact on the business environment and the well-being of the population.

Directors stressed the need for improvements in Afghanistan's statistical database, in particular in the areas of the national accounts and the balance of payments. They encouraged the authorities to strengthen the Central Statistics Office in order to improve coordination among data providers.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.