Executive Summary

Encouraging Start for Nation Building

Afghanistan's nation rebuilding and reconstruction process has come a long way in a short time. An interim administration was installed following the Bonn Agreement in December 2001. The first recurrent (ordinary) budget was announced together with the National Development Framework in April 2002. The Emergency Loya Jirga was held in June 2002 followed by the installation of the transitional government led by President Hamid Karzai. A new constitution was prepared by November 2003, went through difficult deliberations at the "constitutional Loya Jirga" starting in December 2003, and was finally approved in early January 2004. The new constitution is notable, among other things, for designating Islam as the national religion, the centralized power of the presidency, and gender equality in principle. The first national population census is being carried out to pave the way for national elections to be held by June 2004.

Throughout this period, Afghan authorities have demonstrated a strong ownership in the recovery and reconstruction effort. Despite the still overall uncertain security situation in the country, the authorities represented by President Karzai have so far demonstrated a strong commitment to a free and competitive economic system, and private-sector-driven growth.

The present reconstruction effort is two-pronged: it is focused on rebuilding critical physical infrastructure on the one hand, and also on rebuilding public sector institutions from the remnants of Sovietstyle planning to ones that promote market-led development. But macroeconomic planning and management at present is hampered by poor information, weak systems of service delivery, and laws and regulations that need to be reviewed and, if need be, revised. Therefore, this volume aims to covers the efforts being made in this context.

Strong Economic Rebound

Starting from a devastated economic base of the conflict years, the Afghan economy has shown an estimated 28.6 percent real growth from FY2001/2 to FY2002/3. The main contributions to the high growth rate included recovered agricultural production after years of drought, a construction boom in urban areas and increased service establishments driven by the international community’s spending and emergency assistance efforts. Continued strong growth in agriculture, as well as in services and construction, is expected for the rest of 2004.

Evident Unemployment/ Underemployment Problem

The estimated population is 21.8 million, including returned refugees, nomads and internally displaced peoples (IDPs), with about 70 percent of the population under 30. The total fertility rate is 6.8, the highest in South Asia (with a regional average at 3.3). The economically active population in 2002 was about 11 million. While there are no official unemployment rate estimates, it is evident that youth unemployment rates are high. The number of unskilled young people is estimated at 3 million and the number will rise by some 300,000 per annum.

There is also evidence of high underemployment in rural areas and increasing unemployment in the urban areas. While the total fertility rate is among the highest in the world, so are the rates of maternal mortality, infant mortality, and under-5 mortality. The human resource potential of the population must be raised over the long run through investments in human capital.

Demonstrated Commitment to Fiscal Discipline

The central government is focusing on improved revenue collection and public sector expenditure discipline. In terms of revenue generation for the recurrent (ordinary) budget, most revenue is being generated from customs, as the income and corporate tax bases are negligible. However, one major difficulty is the low remittance of customs revenue from the provinces. Centralizing revenue collection is a major priority for fiscal management and measures are being taken toward that end.

The government is strongly committed to no central bank financing. The 2002/03 budget decree imposed headcount ceilings for each ministry's civil service staff, while the compensation due to SOE employees was removed from budgeted wage appropriations. According to preliminary estimates, actual spending in 2002/03 amounted to an estimated $349 million, much less than the $460 million initially envisaged, due to the depreciation of the afghani during the year. Budget execution focused mostly on salary payments (74 percent of total spending) and three priority sectors: security, education, and health. Domestic revenue as reported to the center is estimated to have reached about $132 million, significantly higher than the budgeted $83 million. But only about 27 percent of the reported provincial revenues were actually transferred to the central government’s accounts. The budget financing gap of $232 million was mainly met through donor assistance grants and partial use of the ADB’s first loan disbursement in December 2002.

The FY2003/04 operating budget envisages expenditures equivalent to $550 million, an increase of 58 percent compared to the previous fiscal year. Wage and salary payments account for 50 percent of the budget, a significant reduction compared to the actual spending in 2002/03 (74 percent). The “right-sizing” of the civil service and rationalization of state-owned enterprises are the two important priorities for expenditure management. Domestic revenues are budgeted to reach $200 million. This still leaves a $350 million financing gap to be covered by foreign assistance, of which $250 million is projected to be financed through the Afghanistan Reconstruction Trust Fund (ARTF). The budget decree for 2003/04 reiterated the authorities’ strong commitment to fiscal discipline and explicitly reaffirmed the principle of no government overdraft with the central bank. It also included ceilings on total government staff by ministry.

The 2003/04 development budget, which is the first real development budget prepared by the government, amounts to $1.8 billion, and will be fully financed by external assistance. It comprises most of the projects financed by donors. This represents a significant improvement over 2002/03, when most development projects were carried out by donors outside the budget. Over onethird of the development budget is expected to be spent on the rehabilitation of infrastructure, another one-third on health, social protection, and humanitarian assistance, with 14 percent on education.

Need to Strengthen Revenue Mobilization

One of the urgent fiscal policy issues is the centralization of revenues and expenditures. In August 2003, the Ministry of Finance (MOF) in Kabul instructed the central bank to close all the provinces’ accounts and transfer their balances into two new accounts -- one for expenditures and one for revenues -- so that provinces will no longer be authorized to draw on their revenue accounts without explicit authorization from the MOF.

Another urgent fiscal issue is the strengthening of customs administration and collection. In July 2003 a decree to simplify customs procedures and calling for the training of customs officials and rehabilitation of customs infrastructure was issued. The Afghan customs faces the short-term need to improve cooperation with their Pakistani counterparts to reduce the level of smuggling and transit back to Pakistan. A medium-term goal is to introduce a simple computerized control and record system to strengthen the transit control system.

Monetary Development under Reasonable Control

Price data are limited to the CPI in Kabul. The index increased in the first quarter of 2002, followed by a fairly stable increase in the second quarter of 2002 at 1 percent monthly. It rose by double digits in October and November 2002, mainly due to the depreciation of the afghani after the introduction of the new notes (which replaced 1,000 old afghani by 1 new afghani). However, prices stabilized and even decreased between December 2002 and February 2003, reflecting the turnaround appreciation of the new afghani currency. Since then, the index has indicated stability, with a moderate increase toward late 2003.

Currency in circulation grew by an estimated 20 percent from FY2001/02 to FY2002/03, a significantly smaller figure than the almost 30 percent targeted in the original monetary program. The rate of monetary expansion has varied widely from quarter to quarter, reflecting both the volatility of money demand and the volume of the old bank notes prior to the currency changeover. The increase in money demand during 2002/03 was entirely met by an accumulation of foreign reserves at DAB, estimated at $100 million. At the end of 2002/03, the central bank’s stock of foreign exchange reserves was estimated at $426 million. This level of reserves was more than adequate to cushion the short-term impact of negative shocks.

The introduction of the new currency was a crucial step in the Afghan government’s efforts to establish monetary control by eliminating regional currencies in northern Afghanistan. The plan for the introduction of the new currency was made public on September 4, 2002, the conversion process started on October 7, 2002 and ended on January 2, 2003. Af15.6 billion in new afghanis were issued. By early 2003, the amount of currency in circulation was over Af20 billion. Since the introduction and float of the new currency, DAB has aimed to limit exchange rate volatility and to keep the exchange rate within a set range. This range, however, is not firmly set or announced, and DAB has no intention to resist persistent exchange rate pressures should they emerge, risking the loss of its reserves. The exchange rate regime can therefore be described more accurately as a de facto (lightly) managed float. The low degree of financial integration and market development allows DAB to pursue this approach.

By September 2002, the afghani had weakened to 35,000–40,000 old afghani to the US dollar, and the exchange rate depreciated immediately after the introduction of the new currency from Af45- 48/$ to Af70$ in early November 2002. The sharp depreciation of the afghani was quickly transferred to local prices, which increased by a cumulative 60 percent during September–November 2002. However, after a successful currency changeover, the afghani strengthened and eventually stabilized at about Af46 per US dollar in January 2003. After depreciating slightly to Af51/$ by early March 2003, possibly reflecting the situation in Middle East, it rebounded to a stable level of around Af48.5/$ in May-August 2003.

Large Re-exports and Illicit Trade

Trade statistics have not been published by Afghani authorities since 1992-93. According to an ad-hoc survey, the country’s total trade in 2000 was $2.5 billion, comprising about $1.2 billion in imports and about $1.3 billion in exports. However, about 90 percent of the estimated total exports were re-exports, implying that indigenous exports fell significantly short of financing imports. The survey suggests that Pakistan was the main trading partner, followed by Iran. Because of smuggling, customs data are believed to cover only twothirds of total imports and only a fraction of exports. Moreover, the official figures (only recently compiled in CSO, 2003) do not include an estimate for opium exports, which were very large in 2002/03, possibly in the order of $2.5 billion. Dwarfing Afghanistan’s own nonopium exports, opium exports are the overwhelming source of export revenues from domestic resources.

Other than this, the country's exports consist primarily of carpets, dried fruits, nuts, sheepskins and precious stones while its imports, excluding those destined for re-exports, consist mainly of food items, fuel, transport and agricultural equipment. The re-exports consist of electronics, cosmetics, toiletries, crockery, auto parts, etc. Most of the re-exported goods find their way to Pakistan. It is likely that the opening up of the economy will cause imports to increase more rapidly than exports in the initial years of reconstruction.

Current Account Deficit Financed by Inflow of Donor Money

The overall balance of payments for 2002/03 is estimated to have shown a small surplus, after including grants and donor assistance. The composition of the balance of payments and its evolution reflect in large part the donor-financed reconstruction effort and the revival of private sector activity. A large current account deficit (before grants) was funded mainly by official transfers. The bulk of service receipts and payments come from donor activities. Service receipts include donor payments for local staff salaries, as well as expatriate accommodation and restaurant expenses. In addition, this includes visitor travel and the local staff costs of ISAF and local expenditures of ISAF personnel. Current transfers (inflows) are mainly official donor grants to fund the budget and national development plan.

Of the $1.84 billion in grant money disbursed by the end of March 2003, only $296 million or 16 percent, was provided directly to the government budget. The rest was provided to non-budgetary expenditure and donor-designated projects through the UN system and NGOs. While the disbursement rate against pledges is high, disbursements per capita are far lower in Afghanistan than in other recent post-conflict countries.

Need to Rebuild the Financial Sector

Many steps must be taken before a satisfactory financial infrastructure can emerge to sustain private sector-led economic growth. DAB’s role must be properly redefined and its regulatory functions strengthened. None of the existing banks is operational. Much of the economy still depends on the traditional hawala system for money transfers, and the informal credit market has met the demand for liquidity, at least prior to the influx of new aid money since 2002. The capital market is undeveloped and modern savings and investment instruments are almost nonexistent.

The new Central Bank Act that was ratified by the transitional government cabinet in September 2003, gives DAB the overriding responsibility and full autonomy to maintain price stability and implement monetary and foreign exchange policies. The new Banking Law, ratified at the same time, includes the standard rules of a modern banking system with sound management, prudent risk management, and transparent and adequate accounting. The Banking Law also includes requirements of credit documentation, risk management, as well as provisions that banks should maintain their accounts in accordance with international accounting standards (IAS). Following ratification of this legislation, the DAB issued its first operating licenses to foreign commercial banks: Afghanistan International Bank, a consortium of investors led by ING; the First Microfinance Bank led by the Aga Khan Foundation, the National Bank of Pakistan, and Britain’s Standard Chartered Bank. This set an important milestone for modernizing the financial sector. For the first time in the country's history, DAB will disengage from commercial banking and just focus on its central banking role.

Need to Reconstruct the Public Administration

An important step in the modernization of the civil service was the establishment of the Independent Administrative Reform and Civil Service Commission (IARCSC) in June 2002. In the 2003/04 national development budget, the government presented a detailed short-term strategy for public administration and civil service reform, aiming at creating a lean, capable and motivated civil service dedicated to supporting the country’s national interests. Despite various constraints, important initiatives have been taken, including the approval by the Cabinet in July 2003 of a presidential decree introducing an interim additional salary allowance for specific positions in ministerial departments which are considered critical for reform (e.g., customs, tax) and are undergoing a large-scale restructuring of their functions. A second decree is to be submitted to the Cabinet to regulate and limit the salary top-ups granted by donor agencies.

Many ministers and ministries have little experience in policymaking and in directing the public service. The longer-term challenges facing public administration include defining and implementing sound relationships between central, regional, provincial, and district governments; creating a sustainable fiscal management process including issues concerned with budget revenues; rationalizing the role and number of institutions and ministries, and retraining and reducing staff accordingly.

Need to Create Market Enabling Environment

A sound private sector environment is important for a market-led economy. In August 2002 the government replaced the 1987 law on domestic and private investment, which was having a negative impact on foreign direct investment. The new law provides 3-7 year tax holidays to eligible companies, according to the type of investments, as well as a 4-year exemption from exports tariffs and duties. Under it, a High Commission on Investment, chaired by the Minister of Commerce and comprising the ministers of finance, justice, foreign affairs, planning and reconstruction and two private sector representatives, is responsible for all policy decisions regarding domestic and foreign investment. The Office of Private Investment (OPI), established within the Ministry of Commerce, determines which investments qualify for tax holidays.

The transitional government has taken a number of steps to attract foreign investment into private sector development, particularly in the energy (oil and gas), minerals and precious stones markets, but with limited success. This may be partly due to security concerns in the country. Most investments to date have been in the hotel, restaurant, and telecommunications businesses.

The partial or total privatization or closing down of the extensive SOE network is also a critical element of Afghanistan’s transition to a market economy. Preliminary data suggest that, from the 174 public enterprises, which were operated under the communist regime, only 80 have survived, accounting for a total of somewhat more than 35,000 employees. A Commission for the Evaluation of State-Owned Enterprises was established in June 2002 and started operating in January 2003. Its main activities include the assessment of SOE operations and assets, preparing recommendations for privatization, and drafting transparent privatization procedures. Its activities so far have been mainly limited to a census of the existing SOEs. Notwithstanding their commitment to an ambitious overhaul of the public sector, the authorities have acted cautiously in this area.

Short to Medium-Term Economic Prospects

10 There may be decent prospects for a strong economic recovery in the short run, provided certain preconditions are met, principally on Executive Summary security improvements, the government’s continued commitment to sound economic management, and continued donor support. There are positive factors that will contribute to a strong recovery: (i) a sharp rebound can be expected once investments flow in; (ii) returning Afghans can bring in skills and entrepreneurship; and (iii) reconstruction activities will generate substantial demand and provide business opportunities. If the preconditions are met, economic growth in 2003-2005 could be above 10 percent.

However, it is very difficult to predict at this stage with any degree of confidence how the macroeconomic picture would look in the medium run, especially given the uncertainties over many noneconomic factors such as security, institutional capacity and overall governance of the central and local authorities. Projecting economic performance for any period beyond the coming few years would require simulations under scenarios with different assumptions on key parameters. While only indicative, a strong growth scenario translates into GDP growth rates of perhaps 21 percent in 2003, 18 percent in 2004, 15 percent in 2005 and 10 percent in the period 2006-10. Under this, the economy could rebound beyond the 1998 level (estimated at $6.74 billion) by 2005. Exports will grow gradually toward 13.6 percent of GDP by 2010. Government revenues will grow from 3.3 percent of GDP in 2002 and 4.1 percent in 2003, and gradually increase to 10.6 percent in 2010. A moderate growth scenario translates into GDP growth rates of 12 percent in 2003, and a gradual slowing to 6.3 percent a year in 2006-10. Exports will grow gradually toward 12 percent of GDP in 2010. Government revenues would increase gradually to 7.2 percent by 2010.

Comment(s)

There are [0] comment(s) for this entry. Post a comment.