Introductory History of the Country

Afghanistan was a monarchy from 1747 to 1973; however, the legitimacy of the state was always somewhat precarious. The country's present borders were established when the so-called great powers sought to establish a buffer state between the then British and Russian empires. Afghanistan was virtually left out of the 19th century's globalization relative to its heyday during the Silk Route. It did, however, go through a period of state building and "modernization." Starting with Abdur Rahman Khan, this effort culminated in the reign of Amanullah (1919-1929), when Afghanistan fought a successful third war against the British, built up modern institutions of government, developed secular education, and encouraged women to remove their veils, among other reforms.

However, social conflict existed between modernizers and more conservative Afghan factions, complicated by rivalries between the Pashtun and non-Pashtun ethnic groups. Although those who held power claimed to represent the majority, their principal policy was one of 'divide and rule'. Most of the reforms were rolled back, and there was a brief period of chaos before the rule of the royal family was restored by Nader Shah (1929-1933), with a much more conservative approach to social change. Nader Shah was assassinated and succeeded by his son Zahir Sharh (1933-1973), who had a long, generally peaceful reign before being deposed by his cousin Mohammad Daoud in a bloodless coup. The Daoud government was itself overthrown by a violent communist uprising in 1978, which ushered in a long period of conflict.

From late 1979 to February 1989, Soviet military forces occupied Afghanistan, during a period marked by fierce resistance from Afghan fighters, know as the Mujaheddin, backed by the US and Pakistan intelligence services. This period witnessed a large-scale erosion of rural Afghan society and its institutions, as villages emptied and existing village hierarchies were broken down by massive displacements. As a result, authority was derived principally from the wealth and power of local warlords, a situation that was perpetuated by the Peshawar-based 'aid industry'. During the Soviet occupation, the Afghan state expanded and attempted to transform traditional society, but with disastrous results. Centralized planning and controls were superimposed on the state apparatus, and many public enterprises were established. The government structure expanded and proliferated on paper, but it became increasingly ineffective due to the protracted conflict and loss of human resources as many civil servants, particularly in the upper echelons, fled or were killed. Further declines in government capacity and effectiveness occurred after the Soviet withdrawal, and patronage-based recruitment into the civil service became the norm. Hyperinflation largely erased the value of civil service salaries, exacerbating these adverse trends.

After nearly a decade of Soviet occupation, the Geneva accords of 1988 led to the withdrawal of all Soviet forces in early 1989, but the accords failed to adequately address the issue of the post-occupation period and the future governance of the country. In 1992, UN negotiated plans for President Najibullah, the last communist-era president, to step down and for a transitional authority to take over, were thrown into disarray. Mujaheddin groups formed an alliance with a renegade government commander in the north. They entered Kabul and seized power but with no united or coherent strategy for running the government. What began as a struggle against Soviet forces mutated into internal power struggles, and the institutions that were left continued to disintegrate, creating an institutional vacuum that became entrenched.

It was into this vacuum that the Taliban stepped towards the end of 1994, as the conflict mutated still further. The Taliban fighters were largely drawn from Pashtun youths who had spent most of their lives in the refugee camps of Pakistan. The Taliban movement was seen as a way of asserting Pashtun power, to counter the Tajik, Uzbek and Hazara/Shia forces of the Northern Alliance. In addition, it was perceived as a vehicle for assessing the conservative Pashtun values they had absorbed in the madrassas that had given them what little education they had. Large numbers of foreign nationals, from Pakistan and many Arab countries came to Afghanistan, attracted by the Taliban's particular brand of radical Islam, and with plans to undertake military training in camps run by Al Quaeda.

Beginning with the catastrophic events of September 11, 2001, the world witnessed the forcible removal of the Taliban from power; the signing of a power-sharing agreement calling for a "broad-based, moderate and unitary Afghan state" by representatives of the major Afghan factions in Bonn in December 2001; the installation of an interim administration; the preparation of an ordinary budget, strategy for recovery and reconstruction, as outlined in the National Development Framework (NDF, April 2002) and National Development Budget (NDB, October 2002)²; and the convening of an Emergency Loya Jirga (traditional council of elders) in June 2002, allowing for a smooth and orderly transfer of power to a legitimate transitional government led by Hamid Karzai, to rule Afghanistan for a further two years.

A draft constitution prepared by a 35-member Constitutional Commission was reviewed by the government and a "constitutional Loya Jirga" held in December 2003 and in early January 2004 approved the new constitution which is characterized by designating Islam as the national religion, centralizing power in the presidency, and setting gender equality in principle. With the help of the United Nations Population Fund (UNFPA), the government is carrying out the first national population census in over two decades to pave the ground for national elections to be held by June 2004.

Throughout this tumultuous period, Afghan authorities have sought to assert their own leadership in the recovery and reconstruction effort. Various statements made by government leaders indicate a strong commitment to political, economic, and social development; to a free and competitive economic system, and privatesector- driven growth harnessing domestic and foreign investment — to create jobs and increase income; and, to this end, to undertaking a series of necessary policy and institutional reforms.

This section relies mainly on Barakat and Wardell (December 2001) and Byrd (October 2002). See further Appendix 1, "Historical Review of the Afghan Economy".

Recent Economic Developments

Economic Growth and Structure

The Afghan economy is one of the poorest in the world. The United Nations (UN) designates Afghanistan as a least developed country. Prior to the conflict in the late 1970s, its economy was characterized by food self-sufficiency, a predominance of agricultural exports, macroeconomic stability, a free-floating exchange rate, and a low debt burden. Over the past two decades, however, the economy has been devastated as infrastructure was destroyed, institutions and civil society weakened, and productive activities interrupted through war and conflict. The economy stabilized for a few years in the mid-1990s but later contracted, primarily due to drought, a reduction of unofficial trade, a deterioration of infrastructure, macroeconomic imbalances, and the misrule and increasing international isolation of the Taliban regime. In particular, the 4-year drought seriously affected agricultural, horticultural, and livestock production.

Analysis of the Afghan economy continues to be problematic due to the lack of reliable statistics.³ An official but rough estimate by the Central Statistics Office (CSO) puts the 2002/03 GDP⁴ at $4.05 billion, with per capita GDP at about $186 using a population estimate of 21.8 million. This GDP estimate was derived from the expenditure side, with crude assumptions regarding consumption, investment, and exports and imports. Government consumption and investment make up a modest 8.6 percent and 16.2 percent of GDP, respectively. Nonetheless, the real GDP growth rate compared with 2001/02 was estimated to be 28.6 percent, a significant but understandable rebound from the earlier economic base, with the estimated per capita hitting a bottom at $123 in 2001/02 (Table A3.1 in Appendix 3). Similarly strong economic growth is expected in 2003/04.⁵ By industry, it is estimated that agriculture grew by 27.7 percent, industry by 21.1 percent, and services by 39.5 percent.⁶ In agriculture, production recovered after years of drought. In industry, a construction boom is under way in certain urban activities (especially in Kabul), obviously driven by the international community's spending and emergency assistance efforts. In services, hotels and guesthouses have been renovated or newly opened since the beginning of 2002. Retail establishments, auto repair shops and restaurant businesses have expanded visibly, and an increased number of taxi vehicles as well as donor vehicles now clog the streets of Kabul during rush hours.

The economy remains, however, primarily agriculture-based (crop production, horticulture, and livestock), accounting for about 52 percent of GDP and an estimated 80 percent or so of the economically active population. Industry and service each make up about 24 percent of GDP, (Table A3.1), although the employment in industry and services may have risen due to increased urban activities. Agricultural production was adversely affected by the prolonged drought, land losses through mines, degradation of irrigation systems and natural resources (cultivation of steep hillsides, stripping of brushwood for fuel, and reduced productivity due to the use of animal dung for fuel rather than fertilizer), population displacement, and fighting.

However, the FAO/WFP (August 2002) estimated that the 2002 agricultural production was 82 percent higher than in 2001. The sharp gain was attributed to somewhat better rainfall than in 2001 and the increased availability and higher quality of seeds, fertilizers and other key inputs. FAO/WFP (August 2003) assessed 2003 production as seeing a continued strong recovery, mainly due to improved and well distributed precipitation in major agricultural areas. The increased use of fertilizers and improved seeds has resulted in a record cereal crop in both rain-fed and irrigated sectors. The exceptions were provinces in the south and southwest where drought conditions have persisted. Effective control and the low occurrence of pests, together with the timely distribution of agricultural inputs in needy areas, has also had a positive impact on crop yields. Favorable precipitation has benefited other crops such as vegetables.

Improved pasture and better availability of feed augur well for the livestock sector. However, reductions in veterinary services and vaccination programs have resulted in widespread animal diseases, particularly foot-and-mouth disease. The supply of livestock and livestock products is yet to recover to the pre-drought levels. This is reflected in increased animal prices and continued imports of animals from neighboring countries.

Expected good harvests and lower prices, coupled with improved employment opportunities in both urban and rural areas arising from increased economic activities, are expected to improve food access for most households. However, depressed cereal prices, especially if they continue to fall below the cost of production, may serve as a disincentive to farmers and may push them further into debt. The limited storage and financial capacity of private traders observed in surplus producing areas and the lack of banking and credit facilities, coupled with inadequate infrastructure such as roads, may hinder the storage of grain for long periods and the flow of produce from surplus to deficit areas (FAO/WFP August 2003).

A significant feature of the Afghan economy is opium poppy production. After the Taliban regime's ban on poppy cultivation ended in July 2000, the practice has become a major cash income source for rural farmers in certain provinces, and Afghanistan once again became the world's largest producer of illicit opium. The current government's ban on poppy cultivation has limited effect over the producing provinces, mainly in the north. Above all, ready profitability and the easy transportability of poppies present poor farmers with few other alternatives for making a livelihood.

The share of poppy production in the economy is large. The value of opium exports in 2002 has been estimated by the United Nations Office on Drugs and Crime (UNODC) at about $2.5 million, making them Afghanistan's single largest export item. IMF (September 2003) indicates that with a high-end estimate of its contribution to GDP, the share of opium in the economy could range from 40-60 percent, making per capita GDP jump to $302. More details on poppy cultivation are provided in Appendix 4, "Sector Descriptions and Sector Policy Issues."

The available information on non-agriculture sectors is still patchy, as no recent surveys are available. Nonetheless, broad descriptions of sectors and policy issues by sector are provided in Appendix 4.

Poverty

Reliable statistics on poverty are not available for Afghanistan. In terms of the frequently used international poverty line of $1 a day consumption, equivalent to FAO's minimum requirement of 2,453 kilocalories a day per capita, poverty incidence range from 60 to 80 percent. Based on a more conservative estimate, the poverty line, corresponding to 2,100 kilocalories, is about 40 cents a day. While no income/expenditure surveys are available ⁷ and, therefore, poverty incidence based on this estimated poverty line is not possible, it seems that the majority of the population falls into poverty.⁸ The average civil service salary is $40-45 per month or $1.33-$1.5 per day for a family of six. While the latest observation (FAO/WFP August 2003) was that the average daily wage rate across the country ranges from Af90 (US$1.9) to Af250 (US$5.2) per day depending on the location and type of work, reflecting a significant recovery in crop production, labor demand in rural areas is mostly seasonal and the rural wage is lower than in the cities and areas close to the centers of the districts. The overall poverty level in the country still seems very high.

There are also social indicators of poverty in Afghanistan. Average life expectancy is about 40 years; nearly two thirds of adults, and close to four-fifths of women, are illiterate; 70 percent of the population is malnourished; and in 1999 less than one third of Afghan children were enrolled in school.⁹ Particularly vulnerable are those without any source of production, employment, or income. The vulnerable groups, which lack food security, include small farmers, landless laborers, sharecroppers, debtors, the internally displaced persons (IDPs) (1.1 million), returnee refugees, ex-combatants, war widows, war orphans, the abandoned, and the disabled (800,000, of whom 200,000 are mine victims¹⁰). Nonmaterial poverty as reflected in physical and social insecurity; isolation; and marginalization; alienation; and ethnic, religious, and gender discrimination, pushes many Afghanis deeper down the poverty ladder.

While no systematic study is available on correlates of poverty in Afghanistan, information suggests that it is associated with low economic growth and the collapse of employment opportunities due to the long period of war. Other factors pertain to the agro-ecological environment, state of resource degradation, land ownership, land tenure status, livestock ownership, access to water and inputs, access to off-farm employment opportunities, access to poppy cultivation, refugee/displaced status, gender, ethnicity, head of household status (education, skill, female head of household, etc), and physical disability. Available social indicators are compiled at the end of Appendix 3 (Table A3.14).

Labor Market Developments

The estimated population in 2002 was 21.8 million, including returned refugees, nomads and IDPs, with about 11.2 million being male and 10.6 million female.¹¹ A few more million refugees are poised to return once the security situation normalizes, thereby raising total population significantly. Kabul is by far the most populous city with a population of about 2.7 million. The age structure of the population is very young, with about 70 percent of the population under 30. The 1999 population density was 33 per square kilometer (km2). The population growth rate is 1.9 percent per annum and the total fertility rate is 6.8, the highest in South Asia (with a regional average of 3.3).¹² Close to four-fifths of the population is rural. The ethnic composition of the population identified by Wardak (1998) is 41 percent Pashtun, 20 percent Tajik, 9 percent Hazara, 8 percent Uzbek, and 22 percent others. Tajiks are mainly farmers by occupation with many having migrated to urban areas to benefit from increased educational and economic opportunities. Hazara people live predominantly in the central mountain regions, known as Hazarajat. The other ethnic groups include nomads such as the Kuchi.

No official labor market surveys have been conducted. There seems to be almost no formal sector labor market in Afghanistan at the moment. Other than the subsistence population, notable labor markets seem to be segmented into family businesses, reconstruction labor markets and donor employment. The findings from the only specialized survey recently available (Agnew, September 2003)¹³ are as follows:

• The typical business is owned by the family (55 percent) and employs 1 to 2 workers (69 percent).
• The most commonly observed business types in urban bazaars were cloth shops (10 percent), general mechanic shops (9 percent), grain retailers (8 percent), general shops (7 percent), fruit/vegetable retailers (6 percent), tailors (6 percent), carpenters (5 percent) and drugstores (5 percent). Those in rural bazaars were fruit/vegetable retailers (21 percent), bakeries (8 percent), general shops (7 percent), butchers (6 percent), carpenters (6 percent), tailors (6 percent), and carpet shops (6 percent).
• On average, urban businesses generated $131 per month, while rural businesses generated $83 per month. Business expectations were very high, with 97 percent of those interviewed expecting their businesses to grow over the coming year. One ubiquitously expressed business constraint was financial credit services.
• Farmers' income level was $49 per month on average, with northern region farmers showing the highest average earnings and western region farmers the lowest.
• 70 percent of the families interviewed relied upon a second or third source of income. The most common sources of secondary incomes were: money from relatives (72 percent), unskilled labor work (41 percent), specific occupations (29 percent) and overseas work (11 percent).
• 13 percent of the female interviewees were widows.
• Women's current income generation occupations were carpet weaving (49 percent), tailoring (19 percent), embroidery (8 percent), mora weaving/sewing (7 percent), and gleam weaving (5 percent).
• The average income earned by women was $16 per month, representing a potential average contribution of 32 percent towards household income.

Unemployment

Those within the 15-60 age group who are able to work constitute the economically active population or labor force. On this basis, the estimated 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 this 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.¹⁴ UN agencies and NGOs have been supporting employment programs and food- or cash-for-work programs.

Reviving and sustaining economic growth is the most sustainable step for employment generation. In order to minimize social unrest arising from unemployment and underemployment, reconstruction process must include some targeted employment services, public works programs, youth and adult vocational training, enterprise development and social protection.

While official unemployment data are not available, findings by Agnew (September 2003) indicate the following:

• When local shura leaders were asked to estimate the unemployment rates within their communities, the average figure across all regions and age groups was 32 percent.¹⁵
• Youth (16-25 age group) unemployment was 26 percent on average while that for the 25-65 age group was highest at 42 percent.
• When businesses were asked to measure the annual time they spent being idle or "waiting for customers," the average figure indicating underemployment was 33 percent. By season, 37 percent underemployment was identified in winter and 29 percent in summer.

Returning Refugees

Afghanistan has seen one of the world's largest repatriation movements: with the facilitation by the Ministry of Refugees and Repatriation and UNHCR, more than 1.8 million refugees and some 600,000 IDPs have returned voluntarily in 2002 from Pakistan, Iran and other countries such as those of Central Asia.

By August 2003, an additional 420,000 returned, with a steady pace of inflow at more than 10,000 returnees a week during July – August 2003. The top five return provinces are Kabul (755,875), Nangarhar (370,481), Baghlan (136,078), Parwan (113,112), and Kunduz (112,289). Kabul district alone, meaning mostly Kabul city, has received 453,942 returning refugees, or 21 percent of the total (UNHCR source).¹⁶14 CSO projects that about 1.9 million refugees will have returned to Afghanistan in 2003, and 1.2 million and 0.5 million in 2004-5, respectively.

Fiscal Developments

There are no comprehensive sources of fiscal data during the civil war (1992–96) and the Taliban regime (1996–2001). With continuous fighting and deteriorating economic conditions, traditional domestic revenues steadily declined together with inflows of external assistance, and were progressively replaced by illegal off-budget revenues, collected both by the central government and local warlords. Actual revenue performance continually fell short of budget requirements and the central bank provided the government with unlimited overdraft facilities to cover the resulting budget deficits. The monetization of the budget deficits resulted in high inflation and a rapid depreciation of the afghani currency unit. For most of this period, budget spending was focused on security expenditures and the payment of government salaries, with very limited amounts allocated to reconstruction and development. In sum, the national budget became a residual instrument of public policies, which were mainly conducted—and illegally financed—by warring local leaders according to their own factional interests. By the end of the 1990s, the misrule and growing isolation of the Taliban regime, together with four years of drought and continued fighting, had seriously hampered the collection of official domestic revenues, and the government increasingly returned to monetary financing of the budget deficit. (See further Appendix 1, "Historical Review of the Afghan Economy").

In December 2001, when the interim administration took office, the Ministry of Finance (MOF) at the center and its provincial offices (Mustoufiats) had, for most purposes, ceased to function. Most of the skilled and qualified staff of the MOF had left the country during the war. With the exception of a limited number of senior staff who returned to Kabul after the conflict, the vast majority of the existing MOF personnel lacked the basic qualifications to conduct even rudimentary fiscal functions. The tasks still being performed in the MOF were mostly of a clerical nature and were carried out by different divisions in complete isolation from each other. The MOF's infrastructure had been devastated by years of war and neglect. This was especially true of a number of regional offices and customs houses in the provinces, whose buildings were literally falling into ruins. Basic telecommunication facilities had failed, and most of the primary road network was impassable, resulting in the breakdown of fiscal relationships between the center and provinces. There was no office automation, and key government offices lacked regular access to electricity.

In violation of the budget law, line ministries and provincial Mustoufiats had opened a number of bank accounts in the regional branches of the central bank and state-owned banks, which were operated outside the purview of the MOF. No reconciliation was performed between the government's accounts in the central bank and the treasury in the MOF. The reporting system between the center and Mustoufiats had broken down completely. The last annual government accounts prepared by the MOF accounting department related to 1989/90; no government accounts had been put together since then. Notwithstanding the dissolution of the system, a workable national fiscal process dating from before the conflict remained nominally in place, in contrast to many other post-conflict areas, where pre-existing fiscal arrangements were either very weak or nonexistent (for example, in Kosovo and Timor-Leste).

The structuring of Afghanistan's state budget by the Ministry of Finance is based on a comprehensive concept of general government. The State budget includes: (1) the budget for the central government (recurrent and development budget); and (2) the budget for local governments (districts). All activities, including those financed by foreign loans and grants, are included in the State budget and financed through the Treasury Single Account. There are 29 provincial offices, or Mustoufiats, that coordinate fiscal operations. Reports have to be submitted from the Mustoufiats to the headquarters, or the General Revenue Administration. The tax offices at the local and provincial levels also collect some non-tax revenue. Most fees and charges are collected by the ministries, departments and agencies, and periodic reports are required to be submitted to the provincial revenue administrations.

The efficiency of any tax system, and concomitant administrative organization, is based and dependent on the tax legislation with its underlying laws and codes. The present Afghan tax system is mainly based on the 1965 Income Tax Law and the 1974 Customs Law. These laws are considered to be generally operational, despite having been altered by several administrative directives and decrees. The public administration is currently collecting revenue based on these laws, including individual and corporate income taxes, gross receipts, fixed presumptive taxes, and customs duties. The tax and customs organizational structure, with its predominantly manual procedures, is considered to remain intact, though on paper. ¹⁷ The existing tax regime is summarized in Appendix 5.

The 2002/3 Ordinary Budget and its Execution

The Afghan authorities have progressively taken the lead in the formulation of the reconstruction strategy and in putting forward their vision for the country's future. The adoption of the 2002/03¹⁸ "ordinary" (operating) budget and the presentation of the National Development Framework (NDF) in April 2002 were turning points in this regard. On April 6, 2002, the Afghanistan Interim Administration (AIA) adopted an ordinary budget for 2002/03 of $483 million, of which $22.5 million was to be spent on clearance of wage arrears.¹⁹ This left a gap of $400 million (83 percent of the budget) to be financed by donor assistance (Table A3.2), since the authorities precluded domestic financing of the budget. It also included a 240,000 cap on civil employees (of which 60 percent were in the provinces and 40 percent at the center).

In terms of composition of the budget, civil service wages (excluding the police and army but including the SOEs) were projected at $120 million and military salaries were estimated at $99 million. Together with the police, security-related spending amounted to close to 45 percent of the total budget, a proportion considered as justified given the need to reestablish security throughout the country. The low share of spending on health and education (20 percent of the total budget) resulted from anticipated capacity constraints on the recruitment of new teachers in the first year, and the assumption that most development spending in the social sectors would be carried out by donors outside the operating budget. In terms of the budget size relative to the economy, this first post-conflict budget, at about 12 percent of GDP, was considered to be modest compared with other low-income countries (at average 18.5 percent of GDP).²⁰

The budget decree for 2002/03 included a strong commitment to fiscal discipline by explicitly prohibiting the government from central bank financing (the no-overdraft rule) and by limiting ministerial allotments to the amount of resources actually available in the government's accounts.²¹ Headcount ceilings for each ministry's civil service staff were imposed. The decree also separated SOEs from the rest of the civil service, by removing the compensation due to SOE employees from the budgeted wage appropriations, making this instead part of the government's transfers and subsidies to SOEs. The authorities also publicly stated that they intended to restrict, to the extent possible, external borrowing to the financing of the development budget. In other words, the operating budget would mainly rely on external grants. According to preliminary estimates, actual spending in 2002/03 (including estimated non-wage provincial expenditures) reached 95 percent of budgeted amounts in afghani terms (Table A3.3).

Actual expenditures amounted to an estimated $349 million, much less than the $460 million initially envisaged, due to the depreciation of the afghani during the year (the annual average exchange rate was Af44.5 to the US dollar whereas the budget accounting rate was Af34 per US dollar).²² In the first half of the fiscal year, budget spending was very low, reflecting limited administrative capacity, a lack of financing, and a shortage of bank notes in the central bank before the currency conversion starting in October 2002. However, the expenditures picked up sharply in the second half of the fiscal year, especially in the fourth quarter, as donor disbursements accelerated and administrative capacity improved, and there was no longer a shortage of bank notes. Budget execution focused mostly on salary payments (74 percent of total spending, significantly more than the budgeted 48 percent), and on three priority sectors: security (43 percent), education (19 percent), and health (8 percent). Accordingly, the ministries accounting for the highest shares of spending were defense, interior, education, health, and the President's office.²³

Domestic revenue, as reported to the center, is estimated to have reached about $132 million, significantly higher than the budgeted $83 million. More than 80 percent of the reported revenues were collected in the provinces, with the remainder coming from the line ministries at the center. About 60 percent of the locally collected revenues were customs revenues. But only about 27 percent of the reported provincial revenues were actually transferred to the central government's accounts.²⁴ In addition, contrary to the existing fiscal regulations, most provinces did not send to the MOF reliable reports on their non-wage expenditures. These factors have limited the financing requirement to an estimated $232 million (66 percent of total spending), considerably less than the initially planned $400 million. This gap was mainly met through (a) donor assistance grants ($183 million), including support ($125 million) from the Afghanistan Reconstruction Trust Fund (ARTF); (b) one-off receipts²⁵ ($39 million); and (c) partial use of ADB's first loan disbursement in December 2002 ($25 million), leaving a positive balance of $16 million at the end of the year.²⁶

There were problems in estimating the number of permanent staff employed by the government in 2002/03 and enforcing the recruitment ceilings included in the budget decree for the following reasons: (i) the preparation of a nominal payroll of employees for the whole country was a long and resource-demanding process, which the authorities were not able to complete during 2002/03; (ii) the executed provincial payroll could not be broken down by ministry in the first half of the fiscal year; (iii) contrary to the provisions of the budget decree, some of the staff working in the SOEs continued to be directly paid through the government payroll and not through transfers to the SOEs; and (iv) a number of provinces apparently hired and paid a significant number of civil service staff directly out of their local revenues without informing the center.

Although the overall initial budget ceiling was respected, important reallocations between expenditure items were made during the fiscal year without the budget being revised accordingly: (i) government employees' food allowances were raised by 37 percent in May 2002 to increase government wages from their very low levels; (ii) food in-kind distributed to civil service staff by the World Food Program was replaced in September 2002 by a new monetary allowance; (iii) civil servants received in November 2002 a salary bonus corresponding to one-month salary ("Ramadan bonus") to ease the social tensions stemming from the depreciation of the afghani during the currency conversion; and (iv) a number of line ministries apparently hired more staff than authorized in the budget decree. These were financed within the overall budget ceiling through the use of the substantial 2002/03 presidential reserve fund and the wage and pension reform reserves (no such reforms took place in 2002/03).²⁷

The 2003/04 Ordinary Budget and its Execution

The National Development Budget (NDB) announced in March 2003 combined in a single document the 2003/04 ordinary (operating) and development budgets. The 2003/04 operating budget envisages expenditures equivalent to $550 million, an increase of 58 percent compared to the previous fiscal year's outcome, reflecting the expected improvement in the government's capacity. Almost 40 percent of the planned spending is allocated to defense, public order, and safety, 24 percent to education, and about 10 percent to health and social protection (Table A3.4). Wage and salary payments account for 50 percent of the budget, representing a significant reduction compared to the actual spending in 2002/03 (74 percent).

Domestic revenues are budgeted to reach $200 million. This seemingly ambitious revenue target is based on the assumptions of strong economic growth, an increase in revenue collection expected from the planned customs reform, and the effective centralization of locally-collected revenues.²⁸ 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).²⁹ Military and other security expenditures, which are not eligible for financing through the ARTF, are expected to be financed through domestic revenues and by $100 million in donor assistance channeled through the Law and Order Trust Fund for Afghanistan (LOTFA) and the Army Trust Fund. The authorized headcount ceiling for civilian employees was set at 356,000, a 50 percent increase over the previous year's budget and mainly concentrated in the Ministry of Education, growing from an authorized level of 72,000 last year to 166,000 this year. According to the authorities, however, only 60,000 new staff (mainly teachers) will be hired, with the remainder of the increase resulting from the recording of staff who were already paid by the provinces in 2002/03 from local revenues, but whose payroll was not reported to the center.³⁰

The budget decree for 2003/04 reiterates the authorities' strong commitment to fiscal discipline and explicitly reaffirms the principle of no government overdraft with the central bank. It also includes ceilings for total staff by ministry. But unlike the previous year, the authorities supposedly have the technical capacity to meaningfully monitor, and effectively enforce, these ceilings.³¹ The decree furthermore restricts external borrowing to $300 million for the entire fiscal year and limits its use to the funding of development projects and meeting temporary cash flow requirements for the operating budget. It specifically mentions the passage of a customs reform package and ranks the centralization of revenues as one of the government's priority tasks for the year. A Civil Service Reform Fund ($20 million) has been established to accommodate the much needed reforms of the civil service. The reserve funds of the operating budget have meanwhile been reduced and made subject to tighter controls.

Preliminary budget execution data, covering the first five months of the fiscal year, provide positive indications that the authorities have adhered to their commitment to fiscal discipline and have effectively enhanced domestic revenue mobilization (Table A3.5). Revenue performance reached $31 million in the first quarter of 2003/04, a large increase over the same period the previous year of $18 million, with most of the revenues (still mainly collected in the provinces) transferred to the government's central accounts. In addition, the provinces transferred $12 million of their 2002/03 surplus revenues to the center. If this trend is sustained, the total domestic resources available to finance the operating budget could reach the intended $200 million provided the customs reform package is implemented as planned.³²

On the other hand, spending has been off to a slow start with only 24 percent of the annual budget spent in the first five months, mainly due to large delays in payments of provincial and military salaries. The no-overdraft principle has been adhered to so far and the government's accounts show comfortable surpluses at the end of the fifth month at $63 million. No comprehensive information on the execution of the development budget is currently available, although partial reports indicate that project expenditures have been much lower than budgeted. The government is currently undertaking an indepth review of the execution of the development budget in order to identify bottlenecks and capacity constraints in project implementation and to reflect new pledges that donors have made since March 2003.

The 2003/04 Developmental Budget

The 2003/04 development budget, the first real development budget prepared by the government,³³ amounts to $1.8 billion (Table A3.6), to be fully financed by external assistance. It comprises most of the projects financed by donors, including the 2003/04 UN Transitional Assistance Programs for Afghanistan (TAPA), worth $815 million, which succeeded the 2002/03 Immediate and Transitional Assistance Programs (ITAPs). It represents a significant improvement over 2002/03 when most of the development projects (including ITAPs) were carried out by donors outside the budget. Over one-third of the development budget is expected to be spent on the rehabilitation of infrastructure, another third on health, social protection, and humanitarian assistance and 14 percent on education. All donor projects are supposed to be reflected in the budget, including those carried out by UN agencies. However, full comprehensiveness has not yet been achieved since the budget envelopes do not include the development costs for the Afghan National Army, the Counter- Narcotics Program and the preparations for the national elections to be held in mid-2004.³⁴

Monetary Developments

At the end of 2001, based on the Law of Money and Banking 1994, Afghanistan's formal financial system consisted of the central bank (Da Afghanistan Bank or DAB), two state-owned commercial banks (Bank Millie Afghan and Pashtany Tejaraty Bank) and four stateowned special purpose development banks (Agricultural Development Bank, Export Promotion Bank, Industrial Development Bank, and Mortgage and Construction Bank).³⁵ In addition, there were about 300 registered money trading entities reportedly operating in Kabul with some 5,000 traders. However, they existed only nominally with little or no functions of financial intermediation. The country had become almost entirely cash-based. The banks had essentially stopped functioning during the Taliban years and whatever financial infrastructure had survived the many years of conflict was in very poor condition. What remained was the informal hawala system that people could use to change and transfer money.

Confidence in the national currency, the afghani, was low, as it had lost much of its value following years of high inflation. Moreover, the Afghan central bank, Da Afghanistan Bank (DAB), had little control over the issuance of currency. At least three versions of the national currency were circulating in the country. There was first the official afghani which had been issued prior to Taliban rule and which the Taliban had continued to issue from the remaining stocks in the vaults of the central bank. The Taliban put duplicates of the official banknotes into circulation by ordering reruns of earlier issued series from the country's regular printer and issued these in the northern parts of the country. By using the same serial numbers as in earlier years, the Taliban ensured that the new notes could not be distinguished from those already in circulation. Furthermore, two warlords had issued their own counterfeit versions of the official currency. While these counterfeits were very similar to the official currency, they had some distinguishing features and typically traded at a discount in the Kabul money markets. Reflecting the limited confidence in the national currency, foreign currencies were also widely used, including the US dollar and the currencies of neighboring countries. Foreign currencies were used especially for larger transactions and as a store of value. This is the background against which the new Afghan interim and transitional governments came into office and managed monetary developments.

Prices

No reliable data on price movements exist for the 1990s. In October 2002, Central Statistics Office (CSO) resumed compilation of the consumer price index (CPI) and released its first monthly report since 1987, but it only covered Kabul for the time being. According to its reports, the months following the ouster of the Taliban saw sharp deflation reflecting the appreciation of the afghani, followed by sharp inflation in the first quarter of 2002, and then followed by a fairly stable price increase in the second quarter of 2002 at 1 percent monthly, well below the 4.5 percent envisaged in the monetary program.³⁶ The CPI increased by 16 percent in September, 12.4 percent in October and 22.7 percent in November 2002.

The significantly higher inflation rates during these months were mainly due to the depreciation of the afghani and high food prices due to drought and the end of the growing season. However, in December 2002 and January and February 2003, the CPI decreased by 4.4 percent, 3.8 percent, and 1.4 percent, respectively, reflecting the turnaround appreciation of the new afghani currency by December 2002. In March and April, there were moderate pick-ups in CPI growth of 2.3 percent and 1.8 percent, respectively, due to increases in the prices of meat products and oils and fats. Then the CPI fell by 0.7 percent in May and picked up again by 1.0 percent, 0.3 percent and 0.6 percent in June through August 2003, respectively (see Tables A3.7 and A3.9).

Money Aggregates

According to an International Monetary Fund estimate (IMF, September 2003), currency in circulation grew by an estimated 20 percent from 2001/02 to 2002/03, a significantly smaller figure than the almost 30 percent targeted in the original monetary program (in the fall of 2002, the target was reduced to 24 percent).³⁷ The rate of monetary expansion varied widely from quarter to quarter, reflecting both the volatility of money demand and more practical constraints, such as the availability of the old bank notes prior to the introduction of the new currency. The increase in money demand during 2002/03 was entirely met by an accumulation of foreign reserves at the central bank; the government adhered to the no-overdraft rule and ended the fiscal year with a surplus.³⁸ DAB's reserves increased by an estimated $100 million in 2002/03. During the year, DAB received foreign exchange inflows of $215 million to help finance the government budget. DAB auctioned off $135 million of this to limit monetary expansion. DAB also paid over $16 million from its reserves to cover the cost of printing the new currency. In addition, a part of the increase in reserves reflects new information on foreign deposits that became available during the year, rather than an actual inflow of foreign exchange. At the end of 2002/03, DAB's stock of foreign exchange reserves was estimated at $426 million, (including $196 million of gold, see Table A3.7). In August 2003, currency in circulation amounted to Af22.4 billion, equivalent to $456 million at the prevailing exchange rate. This level of reserves was more than adequate in the context of the current flexible exchange rate regime to cushion the short-term impact of negative shocks.

It is very difficult to predict money demand. As mentioned above, very crude estimates suggest that the economy grew by almost 30 percent in 2002/03, while the overall price level increased by 5 percent. This implies that money demand may have actually weakened in relation to nominal GDP in 2002/03. This underscores the large uncertainties surrounding even the most basic macroeconomic relationships. In any case, with the attainment of economic growth and increasing confidence in the new national currency, money demand can be expected to increase, requiring additional reserves. But as long as the government refrains from central bank financing of the budget, there will only be limited use of a central bank rediscount window by commercial banks, and any increase in the currency demand will be met by an inflow of foreign exchange reserves.

Exchange Rates

Historically, the official exchange rate of Af45 to the US dollar set in 1963 was adjusted to Af3,000 per dollar in April 1996, reflecting, among other factors, a weakening of monetary discipline under the Jamiat regime. During the late 1990s, further depreciations of the currency occurred as a result of market forces. By 2000, the foreign exchange market became more fragmented and volatile, with wide divergences between official, spot, and black market rates and also between rates in the Taliban and opposition-controlled areas. By September 2001 the rate had depreciated to Af79,000 per dollar. Following the start of the war on terrorism in Afghanistan, the currency appreciated significantly, to under Af30,000 per dollar by December 2001. Beginning then, the afghani weakened to Af35,000– Af40,000 to the dollar, and by September 2002, plunged to Af58,000 per dollar or lower, as a result of the announcement that the Government would introduce new afghani currency, worth 1,000 old afghani per unit.

The exchange rate depreciated immediately after the introduction of the new currency from Af45-48/$ to Af70$ in early November. People had become increasingly nervous about whether they would be able to convert their old notes into new ones in time. DAB suspended its foreign exchange auctions temporarily after the start of the currency exchange because it lacked qualified staff to handle both operations at the same time. The sharp depreciation of the afghani was passed through quickly to local prices, which increased by a cumulative 60 percent during September–November 2002. To ease the exchange rate pressures, DAB resumed foreign exchange auctions in mid-November and announced an extension of the bank note exchange period by about two weeks until January 2, 2003. The afghani immediately strengthened and eventually stabilized at about Af46 (new) per US dollar in January 2003. With the strengthening of the afghani, consumer prices came down as well, although somewhat less than the appreciation of the currency. After deteriorating slightly to Af51/$ by early March 2003, possibly reflecting the situation in Middle East, it came back to a stable level of around Af48.5/$ in May- August 2003 (See Table A3.8.)

Afghanistan now has a de facto unified exchange rate system. DAB provides quotes on a daily basis for an official Afghani-US dollar exchange rate based on the early morning rate in the free market of the money changers.³⁹ This rate is used for all transactions including those with the government. DAB's exchange rates for other currencies are based on cross-rates with the US dollar. DAB uses the buy and sell rates from the free market rather than applying a fixed spread around a central rate. During the first half of 2002, the spread between the two rates (for cash transactions) has rarely exceeded 0.6 percent, while during the latter half of 2002 spreads were usually larger than those in 2003 and on two occasions exceeded 2 percent. In addition, a small commission is charged on travelers checks and on international transfers. For transfers, fees are 0.25 percent of the amount, with a small minimum fee; and for letters of credits, fees are 0.25–0.5 percent of the amount.⁴⁰

External Sector Developments

Trade

The largest receivers of Afghanistan's exports in late 1970s were the Soviet Union, Pakistan, India, and Western European countries. Exports to the East European countries experienced a sharp increase during the 1980s. In 1981, the Soviet Union and Afghanistan concluded a mutual trade agreement for the period 1981-85. In return for industrial equipment and machinery from the Soviet Union, Afghanistan agreed to supply its partner with natural gas, food products and raw materials. During this period, trade between the two countries increased sharply. A further five-year agreement was signed in 1986, under which bilateral trade expanded further. By 1985, Afghanistan's trade with the Soviet Union constituted the majority of its total trade both in exports and imports.

After the withdrawal of the Soviet military and the corresponding decline in bilateral official trade with the Soviet Union, the unofficial economy expanded during a period of internal factional fighting and the Taliban regime that followed, with the smuggling of drugs constituting a key component. The drug trade constituted the main source of unofficial revenue, and taxes from the export of opium constituted a pillar of the Taliban war economy. The annual revenues from the opium tax amounted to at least $20 million. The Taliban is reported to have levied a 20 percent zakat from drug dealers on exports of opium.⁴¹ The Afghan-Pakistan Transit Trade Agreement (ATTA) is considered to have induced the smuggling trade.⁴² Besides hindering formal revenues for the Taliban administration, the extensive illegal trade of goods, food and fuel hurt domestic industries' production. Unofficial trade takes place across the porous borders of Afghanistan simply because of the convenience of the route, since customs houses do not necessarily exist. On the Afghanistan side, customs checkpoints are usually not at the border but at the first major town inland across from a range of border crossings in the area. Customs duties and taxes in Afghanistan have been applied at low "effective rates" through the use of an overvalued exchange rate for valuation purposes. This gives little incentive for traders to avoid taxes and monitoring in Afghanistan. Thus unofficial trade in neighboring countries may be quite official in Afghanistan. The albeit fragmentary available information indicates that the Taliban regime was incapable of even rudimentary management of the economy, let alone fiscal management.

Trade statistics have not been published by the Afghan authorities since 1992-93. According to a survey sponsored by the World Bank,⁴³ Afghanistan's total trade in 2000 was estimated at $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 comprised re-exports, implying that indigenous exports fell significantly short of financing imports. The survey suggests that Pakistan was the main trading partner for Afghanistan, accounting for 47 percent of its direct and transit imports and receiving 88 percent of its exports. Iran was next, accounting for 46 percent of direct and transit imports and 11 percent of exports. It is believed that trade has fallen sharply since, with the exception of emergency food aid and other imports and perhaps exports of opium. The Afghanistan Interim Administration (AIA) and Islamic Transitional Government of Afghanistan (ITGA) have extended the Taliban-imposed ban on poppy cultivation and opium production and eliminated $8 billion worth of drugs, but the ban has been difficult to enforce and poppy cultivation has picked up once again.⁴⁴

CSO (2003) recently compiled trade statistics, as shown in Tables A3.10-3.12. These tables confirm that the level of indigenous exports is only a very small part of total exports, on the order of $100 million, while imports are on the order of $1-2 billion, implying a significant level of re-exports. Export data cover official trade only and exclude a large amount of smuggled "unofficial" exports, primarily to Pakistan. The major destinations of Afghanistan's exports are neighboring countries such as Pakistan and India. While cross-border trade with Iran is believed to be significant, it is not captured in the official statistics. The major sources of Afghanistan's imports have fluctuated and their relative positions have been changing. While Pakistan continues to be an important source of imports, other important partners include Japan and Korea, followed by Kenya, Turkmenistan and Germany. In particular, a surge of imports from Japan and Korea in recent years seems to reflect the effects of reconstruction activities.⁴⁵

The country's exports consist primarily of carpets, dried fruits, nuts, sheepskins and precious stones. Its imports, excluding those for re-exports, consist mainly of food items, fuel, transport and agricultural equipment. The re-export trade consists of electronics, cosmetics, toiletries, crockery, auto parts, etc. Most of the re-exported goods find their way into Pakistan. As indicated in these tables, the increase in imports has been more rapid than the increase in exports in the latest years, primarily because the previously closed economy under the Taliban regime has now opened up to international exchanges and the new inflow of foreign funds has allowed imports to expand. This trend is likely to continue during the initial reconstruction period.

The Afghan government announced on September 24, 2002 that it would temporarily forego customs tariffs on exports in order to boost trade. The Finance Minister held talks with several countries, including the United States, to try to increase exports. On January 13, 2003, the US government signed a proclamation that makes Afghanistan a beneficiary of the Generalized System of Preferences (GSP), eliminating US tariffs on approximately 5,700 Afghan products imported into the United States. Although many untapped mineral and energy sources could be exploited, the Afghan government's more immediate concern is to regain control of the country's huge trade in imported goods where local leaders control the main access routes to Afghanistan. At present, local leaders raise huge revenues for themselves by imposing duties. There is a long process ahead to normalize the customs revenue collection in the hands of the central government.

Exchange Trade System⁴⁶

During the late 1980s and early 1990s, reflecting the orientation of trade, Afghanistan had bilateral payment agreements with Bulgaria, People's Republic of China, and the former Soviet Union, with settlement made in bilateral accounting US dollars at rates set under the agreements. Outside of these payment agreements, foreign exchange proceeds from the main agricultural exports had to be surrendered immediately at the commercial rate. The bilateral payment agreements have now lapsed. There were some restrictions on invisible payments, primarily limits on foreign exchange taken abroad for personal travel, and foreign employees had to convert 60 percent of their foreign currency salaries into afghanis at the official exchange rate. Foreign direct investment required prior approval and ownership could not exceed 49 percent. Capital could be repatriated only after five years and at an annual rate of 20 percent of total registered capital.

In recent years, the exchange and trade system has radically changed and in effect is now very liberal and open. Many of the rules and regulations that applied in the past are still in place formally, but in practice a liberal exchange and trade system is now being applied by the authorities. In any event, given the disruption of the financial system, the erosion of capacity in customs and trade administration, and a relatively sophisticated hawala system, controls would be difficult to enforce. There are virtually no controls in effect on imports and exports, payments, invisibles, and capital transactions. Traders (who for the most part carry out other domestic commercial activities and are thus classified and licensed as commercial businesses) are required to hold a commercial license, which is required for all businesses; under it, exporting and importing is permitted, and no further export or import license is required. However, a few imports are subject to licenses and quotas. These comprise certain pharmaceutical products, mining items, and petroleum products for which a special license is required. The import of certain drugs, liquor, arms, and ammunition is prohibited on the grounds of public policy or for security reasons and, therefore, special permission is required for these imports. Exports of opium and museum pieces are prohibited. Imports and exports are supposed to be registered with the Ministry of Commerce for recording and statistical purposes and to establish eligibility for export incentives.

Under the existing customs regime, there are 25 customs import tariff bands with rates ranging from 7 percent to 150 percent, allocated across 888 items. The majority of items fall within the 0–50 percent range and the unweighted average tariff rate is 43.3 percent. The effective tariff rate is much lower because an undervalued exchange rate (Af4.5 per US dollar) is used to obtain the taxable value of imports. Customs procedures are not applied consistently across customs houses. The authorities are reviewing a new simplified tariff regime, which is expected to be in place 2004, and have embarked on a reform of customs administration (see Section III). In principle, the Chamber of Commerce is supposed to carry out the valuation of imports (which is to be used as the basis for customs tariffs charges) and charges a fee of 2.5 percent for nonmembers and 2 percent for members. The fee is assessed on the c.i.f value calculated using the customs exchange rate, which is much lower than the market exchange rate, and as a result the effective fees are currently much lower. But in practice, only a small part of imports are valued by the Chamber and the majority of valuations are carried out by the customs houses, with no fee charged.

In the absence of functioning commercial banks, most trade financing is done by cash or through the hawala system. The central bank did not open letters of credit in its own name before 2003. During the first half of 2003, it opened 15 letters of credit for government agencies under the World Bank Donor Flow Management Program. Earlier limits on amounts that can be taken out of the country for tourist and business travel have been eased, limits on payments for medical treatment abroad are no longer enforced. The same is true for the requirement that foreign employees convert 60 percent of their foreign currency salaries into afghani.

Foreign investment is required to conform to the Domestic and Foreign Private Investment Law of 2002. Foreign and domestic investments require prior approval. Investments in the construction of pipelines, telecommunications, infrastructure, oil and gas, mines, and minerals are regulated under separate legislation. Full foreign participation is allowed and there are no limits on the transfer of capital and profits out of Afghanistan. The Law provides tax holidays of up to seven years and a four-year exemption on export tariffs and duties. However, the Law is being reviewed with consideration being given to eliminate the tax holidays.

Balance of Payments⁴⁷

BOP estimates (Table A3.13) are based on customs data to the extent available, partner country trade data, information supplied by international donors, and a trade survey conducted in 2000 by the UNDP and the World Bank (World Bank 2001). These data are believed to cover only two-thirds of total imports and only a fraction of exports because of smuggling. As such, while the broad structure and trends of the estimates are likely to be correct, the magnitude of the flows is subject to greater uncertainty than usual for a low-income country. Moreover, the figures do not include an estimate of opium exports, which in 2002/03 were very large, on the order of perhaps $2.5 billion (as discussed above). When compared with Afghanistan's own non-opium exports (that is, excluding re-exports) opium is the overwhelming source of export revenues generated with domestic resources. The figures in the table also exclude external flows related to U.S. military operations and most of those related to the International Security Assistance Force (ISAF) activities, for which there is no available information.

The overall BOP for 2002/03 is estimated to have shown a small surplus, after grants and donor assistance. The composition and evolution of the balance of payments reflect in large part the donorfinanced reconstruction effort and the revival of private sector activity. A large current account deficit (before grants) has been funded mainly by official transfers; official loan disbursements were small. Exports are expected to grow rapidly, although mostly in the form of re-exports. Transit trade is expected to increase steadily with the reopening of normal trade relations with transiting countries and the signing of new transit and trade agreements. However, future growth in these unofficial re-exports is expected to slow as the reform of the customs administration becomes effective. The rapid growth of imports reflects both the revival of private sector activity and the more liberal environment.

The bulk of service receipts and payments are a function of donor activities. Receipts include the donor payments of local staff salaries, as well as expatriate accommodation and restaurant expenses. In addition, tourist travel and the local staff costs of ISAF and local expenditures of ISAF personnel are included. Payments comprise the payment of expatriate salaries, travel abroad, and the cost of embassies abroad. Interest payments on ADB and IDA loans resumed in 2003/04. Current transfers (inflows) are mainly official donor grants to fund the budget and national development plan. Private transfers include remittances from Afghans living abroad net of the remittance of expatriate salaries not spent domestically. Errors and omissions could reflect transactions related to military operations for which information is not available, and changes in the holdings of foreign currency by residents which may be significant given the cocirculation of, in particular, the US dollar and Pakistani rupee in Afghanistan.

Aid Flows⁴⁸

According to the Chairman's summary of the Afghanistan High Level Forum held in Brussels on March 17, 2003, Afghanistan's total reconstruction needs amount to $15 billion over five years, nearly $5 billion above the estimate of the earlier preliminary needs assessments (ADB, UNDP and World Bank, January 2002). At the International Conference on Reconstruction Assistance to Afghanistan in Tokyo in January 2002, US$5.2 billion in reconstruction assistance was pledged to cover the first two and half years—$3.8 billion in grant money and $1.4 billion as potential loans. In addition to this total pledge, fifteen donors have made a further $670 million in grant money available, putting the updated grant pledges for reconstruction effort at $4.47 billion. Some donors made multi-year pledges and commitments with various timeframes.⁴⁹ Total commitments as of May 15, 2003 were $2.6 billion, of which $2.1 billion has been disbursed. Total disbursements for reconstruction projects were $1.6 billion, excluding humanitarian assistance. About 90 percent of the grant money (about $1.9 million) has been disbursed, while only 30 percent, or $100 million in loan money has been disbursed (the latter is out of the ADB loan for the Postconflict Multisector Program).

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 expenditures and donor-designated projects through the UN system and NGOs. The breakdown of donor fund usage is as in Table 1 below.

Table 1: Use of Donor Grants Disbursed (in $ million)

* Includes: (1) direct bilateral contributions to the ordinary budget, (2) contributions to the Afghan Interim Authority Fund (AIAF), and (3) contributions to the Afghanistan Reconstruction Trust Fund (ARTF).
** Represents contributions to the Law and Order Trust Fund (LOTFA).
*** Clearance of arrears to ADB, World Bank and IMF during Dec 2002-Feb 2003. This was coordinated among these IFIs and supported by the governments of Italy, Japan, Norway, Sweden and the United Kingdom.

Source: AACA (April 2003)

While the disbursement rate against pledges is high, disbursements per capita are far lower in Afghanistan than in other recent post-conflict settings, and a significant amount of the funds have been used to meet humanitarian and relief needs, leaving fundamental reconstruction efforts at a frustratingly slow pace for the government. Per capita aid inflow is estimated at $66 in FY2002/2 and $90 in FY2003/4, but at the moment is projected to taper off to $41, $22, and $17 for the subsequent three years. Using a population estimate of 22 million, the amount of aid per capita received over the period of January 2002–March 2003 translates into $67 per capita per year. This compares with Bosnia and Herzegovina's $249 during 1995- 97, Timor-Leste's $256 during 1999-2001, the West Bank and Gaza's $219 during 1994-2001, and Rwanda's $98 during 1994-96. There is an urgent need to accelerate program delivery to meet Afghanistan's nation-rebuilding needs. From a donor's perspective, however, the extent to which the central government can exercise its authority over local commanders will determine the credibility and continued viability of the government. Increased centralization is also vital to ensure continued aid flows – many donors will remain hesitant to make any quick disbursement of funds until they see a visible improvement in the security and governance situation.

In this regard, a notable bright spot is the Afghanistan Reconstruction Trust Fund (ARTF), administered by the World Bank, and co-managed by ADB, IsDB, UNDP and the World Bank, which is proving to be an efficient and effective channel for flexible funding to support the Afghan government's recurrent budget and also selective technical assistance and investment projects. As of July 2003, 22 donors have pledged $430 million to the fund, $276 million has been received, and $188 million has been disbursed to the government.⁵⁰

Debt Sustainability⁵¹

Investment requirements for reconstruction and development in postconflict economies are normally higher than initial estimates, and the expectation of a large amount of assistance in grants usually does not materialize. Since November 2001, funding agencies have provided substantial humanitarian relief support through UN agencies and nongovernment organizations (NGOs) to Afghanistan on a pure grant basis. Only limited grant financing has been available for reconstruction and development. The Government is very keen to start major reconstruction work, but this has been difficult under bilateral development aid, which tends to be fragmented, tied, and small in scale. While the Government continues to mobilize grant financing from bilateral sources,⁵² the resumption of concessional lending by international financial institutions (IFIs) to Afghanistan will be an essential part of global support for reconstruction and development.

After considerable reflection, in December 2002, the Government decided to borrow from ADB for a Postconflict Multisector Program to support key policy and institutional reforms to underpin future reconstruction efforts. The loan terms are more favorable than standard concessional Asian Development Fund (ADF) loans. This was followed by a similarly concessional loan from International Development Association (IDA) and a further loan from ADB in 2003.⁵³

It is essential to ensure that appropriate amounts are borrowed at appropriate times and on appropriate terms, and that these funds are utilized effectively to have the maximum impact on economic growth, exports and revenues to make the debt burden sustainable over the medium term.

A preliminary analysis was carried out by ADB based on the information it had available on the existing debts to various creditors, consultations with the IMF and IDA, and projections on the likely restructuring of the existing debt, new borrowings, and macroeconomic scenarios. As at the end of 2002, Afghanistan's public and publicly-guaranteed debt to bilateral and multilateral lenders was estimated at $2,445 million, consisting of official bilateral debt of $2,319 million and multilateral debt of $86 million. Total debt obligation to non-IFI lenders consists of ODA and non-ODA loans. ODA debt obligations were estimated at $432 million in 2002 and non-ODA obligations at $1,927 million, representing claims by Russia at a certain assumed discount under its participation in the Paris Club as a creditor.⁵⁴

The analysis concludes that Afghanistan's external debt sustainability depends primarily on assumptions regarding the treatment of the existing stock of debt and macroeconomic growth. With generous restructuring of existing debt and strong-to-moderate growth, Afghanistan can sustain the level of borrowings planned by the IFIs over the medium term of about $325 million annually in 2002-2010, $313 million in 2011-2015 and $260 million a year thereafter.⁵⁵ However, the available information is still sketchy. Furthermore, the analysis presumes some political and institutional context: an improvement in the security situation, the government's committed efforts to sound economic policy management, and revenue streamlining. The results presented here should be treated with caution, as relevant factors must be closely monitored to update all assumptions in the future analysis.

The results depend very much on the assumptions made on macroeconomic scenarios and debt rescheduling arrangements. While precise conclusions cannot be drawn from the preliminary analysis, general implications are: (i) the achievement of debt sustainability will probably require debt relief that goes beyond the normal terms of debt restructuring; (ii) debt indicators will appear to worsen in the initial period, the duration of which will depend on the macro scenario, before leading to a robust improving trend; and (iii) debt sustainability is sensitive to positive or negative shocks to output and export growth. The macroeconomic situation needs close monitoring over the medium term before it can be said with any degree of certainty whether the Afghan economy is on a desirable path.

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