Public Information Notice No. 06/27

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Islamic Republic of Afghanistan

March 8, 2006

On March 6, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Islamic Republic of Afghanistan.¹

Background

Since its inception in March 2004, the Staff Monitored Program (SMP) has been instrumental in maintaining macroeconomic stability and contributing to the implementation of the government's reform agenda.

Over the last 12 months, the Afghan authorities have made further progress in rebuilding institutions and stabilizing the economy. In a challenging environment, dominated by the difficult security situation and parliamentary elections, the authorities have continued to pursue prudent fiscal and monetary policies and have implemented a number of important institutional and structural reforms that have contributed to strong growth, moderate inflation, a stable exchange rate, and fiscal consolidation. The government met all the end-September 2005 quantitative indicators under the SMP and observed, albeit with some delays, all structural benchmarks, except for the publication of the audited 2004/05 core budget financial statements.

After slowing down to 8 percent in 2004/05, economic activity has rebounded over the last 12 months, owing primarily to a weather-related recovery of agricultural output. Opium production declined by 2 percent in 2005, as a sharp reduction in the cultivated area was largely offset by an increase in yields due to good rainfalls. After rising sharply in 2004/05 on account of an acceleration of rents and petroleum product prices, year-on-year inflation declined to 12.9 percent in September 2005, owing to a slowdown in rents. At the same time, the external current account deficit, excluding grants, narrowed to 45 percent of GDP in 2004/05, from 51 percent in 2003/04.

The operating budget deficit is expected to decline significantly in 2005/06, mainly because of an increase in revenue. During 2004/05 and the first half of 2005/06, revenue was broadly in line with program projections, as higher-than-programmed customs receipts offset a lower-than-envisaged domestic tax collection. Government spending, especially for development purposes, remained lower-than-budgeted because of capacity constraints.

Monetary developments during 2004/05 and through September 2005 remained broadly in line with SMP projections. Monetary policy continued to be guided by indicative targets for currency in circulation, within the context of a managed float exchange rate system, and was implemented through mainly foreign currency auctions. International reserves continued to increase steadily.

On the structural side, the Afghan authorities have carried out major reforms to improve revenue collection, and have started to establish a transparent public expenditure system with fiduciary standards. The authorities have also modernized central bank operations and reinforced its supervision capacity, while strengthening the banking sector regulatory framework. Moreover, the authorities have adopted a debt management strategy and a medium-term fiscal framework consistent with their continued commitment to fiscal and external sustainability. Further steps have also been taken to restructure the public sector.

Building upon the progress made so far under the SMP, and with a view to addressing vigorously the country's important challenges, the government has initiated discussions on a successor program that could be supported by the IMF's Poverty Reduction and Growth Facility (PRGF). The Interim-Afghanistan National Development Strategy that the authorities presented at the London International Donors' Conference in late January will form the basis of an interim poverty strategy paper, in support of such a program.

Executive Board Assessment

Executive Directors commended the authorities for the continued implementation of sound macroeconomic policies, which have contributed to Afghanistan's strong economic performance over the last year. Directors noted Afghanistan's record of sustained growth and moderate inflation and viewed the short-term economic outlook as favorable, notwithstanding some downside risks. They were also encouraged by the fact that the recent legislative and provincial elections took place without any major disruption.

Directors observed that Afghanistan faces formidable medium-term challenges, which are compounded by lingering insecurity. The most pressing tasks are to consolidate macroeconomic stability while pursuing vigorously the government's reform agenda in support of sustained growth and poverty alleviation. Directors were encouraged by the authorities' commitment to address these challenges, as articulated in the Interim Afghanistan Development Strategy (I-ANDS). This strategy focuses on diversifying the sources of growth, ensuring fiscal and external sustainability, addressing institutional and structural obstacles to private sector development, and gradually eliminating opium-related activities.

Directors welcomed the authorities' fiscal consolidation efforts and their adoption of a medium-term fiscal framework (MTFF). Adherence to this framework will be critical to achieving fiscal sustainability, especially as significant expenditure pressures for both existing and new programs are likely to develop. Directors encouraged the authorities to refine the MTFF over time to link closely multi-year projections with policies. Also, fiscal activities presently funded off-budget by donors need to be progressively incorporated into the core budget in order to increase transparency and estimate better the government's long-term financing needs.

Directors welcomed the continued growth in revenue, which consistently exceeded the targets set under the Staff Monitored Program. New revenue measures and decisive efforts to strengthen tax administration, including by targeting large taxpayers, will be crucial to achieving the MTFF's objectives. Directors called for the introduction of excises on certain consumption items and the continued implementation of the reform plans for the customs and tax administrations, in order to enhance long-term fiscal sustainability. They cautioned against raising import tariffs for protectionist purposes, introducing ad-hoc duty exemptions, or reducing domestic tax rates.

Directors noted that, while recurrent spending has been broadly in line with budget estimates, development expenditures have remained significantly lower than budgeted. They encouraged the authorities to prepare more realistic development budgets, taking into account capacity constraints. Directors recognized, however, that this task is complicated by the large amount of spending implemented directly by donors. In this regard, they hoped that the Compact recently adopted by the government and the donor community—as well as the I-ANDS—will help to improve aid delivery and the process of economic reconstruction.

Directors supported the authorities' efforts to enhance the productivity of the civil service through capacity building. They emphasized the need to implement, in due course, a reform of the public administration that will provide adequate compensation to government employees while ensuring fiscal sustainability and broad social harmony. Directors cautioned the authorities against linking pensions to salary increases, as this would have serious budgetary implications.

Directors regarded the current monetary program as broadly consistent with the program's objectives, and welcomed the authorities' commitment to tighten monetary conditions further, if necessary to reduce inflation. They supported the central bank's efforts to strengthen the monetary policy framework, including through the introduction of new monetary instruments, the development of its analytical capacity, and increased transparency in monetary management.

Directors were of the view that the present managed float exchange rate system has worked well and should be maintained. They noted that the real appreciation of the Afghani in recent years stemmed, to a large extent, from the impact of opium- and aid-related inflows, and that monetary policy could do little in this context to enhance competitiveness. Directors emphasized that future efforts to strengthen competitiveness should focus primarily on enhancing the effectiveness of foreign assistance and deepening structural reforms in order to increase productivity.

Directors emphasized the importance of moving forward with reforms aimed at building a resilient banking system. In particular, they stressed the need for decisive action to address the situation of the state-owned banks, and encouraged the authorities to adopt an appropriate legal and administrative framework for the development of the commercial banking system.

Directors called for the establishment of an enabling environment for private sector activities. They urged the further liberalization of the economy through a careful and well-sequenced divestiture of the state-owned enterprises and of commercial activities currently performed by public agencies. They emphasized that enhancing the consistency and predictability of government policies would contribute to improving the business climate.

Directors considered that the I-ANDS meets most of the requirements for an Interim Poverty Reduction Strategy Paper. However, much needs to be done to turn the large number of proposals in the I-ANDS into a coherent and sustainable set of medium-term programs and policies. Directors encouraged the authorities to strengthen the participatory process and broaden the involvement of stakeholders as they work on their poverty reduction strategy.

Directors called on the authorities to continue implementing vigorously, with donor support, the programs aimed at eliminating the drug economy. In particular, they underscored the importance of developing sustainable income generation activities in support of the eradication, interdiction, and prevention campaigns. Success in this area would also help improve security and governance.

Directors noted that, notwithstanding recent progress, further efforts are necessary to address a number of statistical weaknesses. Looking ahead, they encouraged the authorities to implement, with donor assistance, the statistical master plan, which aims at tackling data deficiencies. Directors welcomed the recent adoption of a new statistical law.

Taking into account Afghanistan's solid track record of policy implementation under the SMP, Directors supported the authorities' intention to open discussions on a successor program that could be supported by a three-year arrangement under the Poverty Reduction and Growth Facility. Such a program would help the authorities consolidate macroeconomic stability, provide a suitable framework for the continued implementation of their ambitious reform agenda, and contribute to resolving outstanding debt issues. Directors were encouraged by the announcement by Paris Club creditors that they would offer 100 percent debt relief to Afghanistan if it meets the eligibility criteria for the enhanced HIPC Initiative.

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.