Policy Issues

Fiscal Management Issues

Post-Conflict Fiscal Management

The International Monetary Fund (August 2002) studied the fiscal effects of armed conflict and terrorism in low-and middle-income countries.⁶⁴ It found that there are three main ways in which armed conflict and terrorism can affect the fiscal account: by changing the composition of government spending; adversely affecting both the tax base and the efficiency of the tax administration; and influencing real economic activity (GDP) and therefore, government revenues. More specifically, the share of government revenue in GDP tends to fall during the conflict period, and to pick up in the immediate postconflict period.

Despite the collapse of the tax base following outbreaks of armed conflict in the 1990s in two African countries, after some years of peace and normal production the tax revenues managed to even exceed pre-conflict levels. On the expenditure side, in comparison to the pre-conflict period, government expenditures and net lending as a percent of GDP appear to increase significantly during the conflict period. These fiscal consequences have repercussions on economic growth, further affecting public finances. The high defense spending during the conflict period and in the years immediately preceding it tend to come at the expense of macroeconomic stability, reflected in a higher budget deficit and higher inflation. However, if internal security is achieved, defense spending can have a positive resource mobilization effect through augmented savings and investments. Since conflict is associated with lower real GDP growth, the implication is lower real per capita government spending on education and health.

The end of armed conflict can result in several different "peace dividends," releasing fiscal resources to be used for lowering the deficit, raising the allocation for spending in social sectors, or reducing taxes. This process helps to restore macroeconomic stability. However, successful post-conflict reconstruction takes time. It involves ensuring that grievances due to perceived biases in fiscal policies will be addressed, improving trust among the formerly warring parties, renewing the social contract, and rebuilding damaged infrastructure and institutions. Consequently, it is highly critical, especially in countries that have experienced prolonged conflicts, that the involvement of the international donor community continues and not be just one-shot assistance.⁶⁵

To maximize donor impact, it is essential that the government and the donor community consider, and act, with the awareness that donors have different respective comparative advantages in providing fiscal support. Furthermore, experience in the past reconstruction efforts has shown that the preferred approach is for each donor to provide support for a well-defined project, such as tax administration, expenditure management, or customs administration. In comparison to a situation where the resources are cobbled together from a variety of donors, a single-donor approach to a specific component encourages ownership and leaves no question about oversight to ensure the desired outcome. This strategy worked very well in Kosovo, where the US government provided the resources for establishing an institution with the same function as the ministry of finance. In contrast, funding for the same institution in Timor-Leste was provided by many different sources; it was difficult to achieve sustainability, and there was always a question about responsibility.⁶⁶

In general, the reform of fiscal policies and institutions lies at the heart of structural adjustment in developing countries, with the immediate aim to reduce fiscal imbalances and achieve macroeconomic stability. Efficient revenue mobilization can help the funding of public goods and services and help cut fiscal imbalances. Making revenue mobilization efficient requires reforms of the tax and tariff systems and their administration. The tax administration is usually reformed through the wider registration of taxpayers, simplification of procedures for taxing the informal sector, establishment of large-taxpayer units, and staff training and computerization. The appropriate sequencing of tax reform is important for the overall success of the reform strategy, especially given limited administrative capacity in developing countries. An early focus on implementing a value added tax (VAT), beyond its importance for revenue, may be justified in terms of motivating necessary improvements in overall revenue administration (IMF 1998). On the expenditure side, fiscal consolidation calls for reorienting public spending toward growth-promoting investment in physical infrastructure and in social and human capital.

Rebuilding the Fiscal Infrastructure in Afghanistan

The extent to which the above general observations apply to Afghanistan will have to be tested in the next few years during the course of the initial reconstruction phase. Wars and conflicts in the last four decades in Afghanistan have led to the discontinuance of budgeting, worsened the structural and macroeconomic problems of the economy, and distorted the composition of public spending, eroding the tax base and lowering the efficiency of the tax administration. The increase in defense expenditures has had a "crowding-out effect" on the resources available for private investment, and on public spending on sectors that could have had a strong and positive impact on growth. Since the majority of defense spending was on imported armaments, there were no positive supplyside spillover effects on the non-defense sectors. Since internal security was not achieved, the focus on defense expenditures failed to boost private savings and investments or attract foreign investment, and thus had a negative effect on the long-run sustainable growth rate.

The successful reconstruction of Afghanistan's fiscal management will take time, implying the reconstruction of fiscal institutions, generation of a sense of trust among the warring parties, and addressing possible perceived biases in fiscal policies. Due to the limited established representation of the authorities in the countryside, time is needed for the transitional government to bring about an appropriate apparatus for fiscal management. Given the extension of the central government's authority over the entire country, a substantial increase of revenue collections from both direct and indirect sources will follow. An expected fiscal effect of the decrease in civil conflicts will be falling military spending and a reduction of other related expenditures. It is important, however, that the distribution of public spending and tax burden are not perceived to be unequal, as critical opinions could have negative effects on the present armed conflicts. Developing a good system of revenue collection could have a positive effect on the process of strengthening national unity. To gain taxpayers' trust, the current government will need to deliver economic results. Support for fiscal management from the donor community will not only help bring a relative economic continuity, but also political stability.

The Ministry of Finance (MOF) requires support in the areas of policy setting, training, project implementation and donor coordination.⁶⁷ A fiscal policy analysis unit should be supported as a means to project revenues, analyze revenue options, coordinate macroeconomic planning with the Central Bank and other government agencies, simulate policy changes, make recommendations on fiscal and tax policy, and provide input into the budgetary process. This unit should assume responsibility for policy coordination with international donors, in particular the IMF, World Bank and ADB. It should also encourage the efficient spending of the development budget according to the national priorities set by the NDF.

Budget Execution and Financial Control⁶⁸

An immediate priority had to be placed on upgrading budget execution and financial controls in the MOF in order to provide donors with the fiduciary assurances they requested to realize their assistance pledges. In June 2002, the World Bank provided grant support for an Emergency Public Administration Project to fund qualified international contractors in the areas of financial management, government procurement and audit. The project's financial management contractor developed, along with the MOF Treasury Department, a computerized system for expenditure recording, payment processing and financial reporting for budget spending (known as Afghanistan's Financial Management Information System or AFMIS). In order to deliver immediate results, the AFMIS did not change the procedures and functions specified in the Afghan regulations, but merely computerized the existing manual system using a simple software package. Starting in October 2002, the AFMIS has provided timely and reliable information on expenditures paid at the center, broken down by source of funding (domestic revenues or grants), spending units, and economic and functional classification. AFMIS has significantly accelerated the expenditure payments through the automation of the printing of checks.

In the initial period, however, AFMIS faced several limitations: (i) its coverage was limited to central government expenditures, and not to revenues and non-wage provincial expenditures; (ii) no budget management facilities (appropriations, allotments, transfers) were available; (iii) expenditure commitments were not recorded; and (iv) the system did not perform reconciliations between treasury information and central bank statements. The system's functionalities were significantly expanded at the beginning of 2003/04 to include revenue information, the reporting of provincial expenditures, and budget management functions. Although further improvements are still needed—especially with regard to the recording of financing sources for the operating budget, bank reconciliation and monitoring the development budget—the introduction of the AFMIS in a very short period of time critically improved expenditure management in the treasury and provided a concrete illustration of the authorities' commitment to fiscal transparency. The project has been successful in progressively transferring AFMIS operations from contractors to Afghan staff following intensive training and capacity-building.

Since the beginning of fiscal 2003/04, the MOF has given priority to resolving the fact that provinces do not report their nonwage expenditures to the center; and the center, in the absence of provincial expenditure reports, refuses to transfer resources to the provinces. Forty Afghani fiscal advisors have been trained in the MOF under USAID funding and sent to all provinces to provide assistance with financial reporting on both revenues and expenditures. Six were assigned to the six provinces, collecting the bulk of domestic revenues⁶⁹ to coordinate the activities of the other provincial advisors. Similarly, satellite communication facilities will be set up on a pilot basis in the largest provinces to facilitate the exchange of information between the central MOF and its regional offices (Mustufiats). The rolling out of AFMIS to the provinces has recently begun, and Herat's Mustufiat is expected to be the first to use the system. These initiatives have begun to yield important and tangible results. For example, while Mustufiats did not report their non-wage expenditures in 2002/03, they have started doing so in 2003/04. However, fiscal reporting still requires improvement, especially on revenues, as there are indications that the major provinces report less revenues than they collect and that most send their reports to the center only after significant delays.

Fiscal accountability is inevitably constrained by the absence of or inadequacies of the statistical system. Capacity building for the development of a minimum of statistics is therefore critical for fiscal policy formulation and monitoring. The overall framework necessary for compilation exists, but the breakdown of the manual financing reporting chain has impeded the production of statistics. Once accounting procedures have been computerized and communications with the provinces are reestablished, it will be possible to resume the production of government finance statistics. While steps are being taken to computerize the accounting system, through for instance the installation and repair of computers in provincial offices, provincial staff must first be trained in computer operations. The plan is currently to computerize in three stages, with the first phase covering 10 provinces (6 large cities and 4 areas around Kabul).

Cash Management

While in theory Afghanistan was supposed to operate with a "Treasury Single Account," as do most governments internationally, there has been in practice a proliferation of accounts, interfering with the proper consolidation of cash resources, hindering prompt information on the government's fiscal situation and leading to the fragmentation of revenues. There is a need to consolidate the government's accounts in the center and the provinces and eliminate the accounts of line ministries. In line with IMF recommendations, the authorities streamlined the number of MOF bank accounts operated at the center for domestic revenue and expenditures, managing to reduce them from 26 to 2 excluding the specific accounts to track donor funded expenditures. Most importantly, in August 2003, the MOF treasury instructed the central bank (DAB) to close all the provinces' accounts and to transfer their balances into two new accounts, one for expenditures and the other for revenues, with the latter being operated on a "deposit basis" only. This means that the provinces will no longer be authorized to draw on their revenue account to spend without explicit authorization from the MOF. The next step will involve ensuring the regular consolidation of these accounts into the central government's accounts and making timely transfers to the provincial accounts to allow provinces to make expenditures according to their budget allotments.

To address the issue of inadequate predictability of in-year cash requirements, the MOF treasury has recently established a cashmanagement unit charged with responsibility for estimating revenue inflows, forecasting future disbursements, and developing an in-year cash-plan. However, the development of a full-fledged cash planning regime can only be envisaged in the medium term, as it is a highly technical task, which will need to be supported by external assistance.

Budget Formulation

The MOF and line ministries have received significant external assistance for the preparation of the 2002/03 and 2003/04 budgets. The budget preparations for 2003/04 marked a vast improvement over the previous year, reflecting great efforts by the Cabinet, MOF, and line ministries toward information compilation, strategy formulation, prioritization, and coordination. However, further progress is needed in terms of better integration between the ordinary and development budgets, the quality of budget submissions by the line ministries, revenue projections, construction of the macro-fiscal framework to underpin the initial budget estimates, introduction of hard budget constraints at the beginning of budget preparation, and the development of a medium-term fiscal framework.

Various donors, including ADB, have assigned a number of resident budget preparation experts to the MOF, and they are providing hands-on support during the budget preparation process as well as training and restructuring of the MOF budget department. This assistance, which mainly dealt with the ordinary budget so far, has recently been expanded to the development budget, with the establishment of a development budget unit in the treasury supported by a budget resident advisor. Similarly, chief financial officers funded by the World Bank will be appointed to key line ministries to enhance their budget formulation (and execution) capacities. IMF also intends to provide short-term technical assistance for the establishment of a macro-fiscal coordination unit, which will be responsible for coordinating macroeconomic forecasting and analysis with the central bank (DAB), Central Statistics Office (CSO), and other government agencies.

Debt Management

During the two decades of war and conflict, Afghanistan fell into arrears in payments to the IFIs. Through significant international collaborative efforts, the arrears to ADB, World Bank and IMF were cleared by February 2003. Now Afghanistan has entered into new loans with these IFIs. On paper, there is a debt management unit within the Department of Treasury in MOF, but in practice, this unit has been inactive, with a U.S. Treasury budget adviser having to serve as the interlocutor with the IFIs to make sure that debt service payments are made in a timely fashion. There is an important issue of bilateral debt in arrears (especially to Russia) that must be addressed sooner or later. Capacity building in this area is an urgent issue.⁷⁰

Donor Fund Coordination

Since much of the ordinary budget and all of the development budget is currently financed externally, the coordination of donor resources is of critical importance. Afghan officials' efforts to date in this regard have been commendable. The main instrument to avoid the duplication of donor projects has been the preparation of the National Development Budget (NDB). The transitional government, led by the MOF and assisted by the Afghan Assistance Coordination Authority (AACA),⁷¹ launched a new aid coordination system in January 2003. It has streamlined previously fragmented donor consultations into a government-centered Consultative Groups (grouped by priority programs in NDF) and enhanced the country ownership of external aid. The new system is still in an experimental stage and the latest meeting was held in August 2003 in Kabul to discuss the lessons learned and improvements.

The first Afghanistan Development Forum (AfDF), held in March 2003 also in Kabul, brought various donor forums into a unified venue and was also used to announce the FY2004 (SY1382) consolidated recurrent and development budget. The AfDF is to be held in March every year. This shows the clear intent of the government to integrate all donor activities into a transparent budgeting exercise and to steer donor fund allocation according to the priorities set by the government.

In December 2002, the MOF established (with the support of the World Bank) a Grant Management Unit (GMU) within the treasury, with the responsibility for assuring that donor contributions are utilized as specified in the grant agreements and reported accordingly. The GMU will act as a repository of all grant agreements, authorize off-shore payments when government spending is not channeled through the budget, maintain payment records, and report to donors and the MOF. However, it is too early to determine what the real scope of GMU's interventions will be, as the MOF has apparently decided to merge the GMU and AACA functions into a new department to be established within the MOF.

Customs Policy and Administration

Collecting $200 million in domestic revenue in fiscal year 2003/4 will require strong and early implementation of the customs reform package. Furthermore, the MOF aims to fully finance the ordinary budget through domestic revenues by 2006. Meeting this ambitious objective will require increasing revenue collection from about $130 million in 2002/03 to $600 million in 2006/07. As customs duties account for more than half of total domestic revenue collection, improving customs policy and administration has been one of the authorities' top priorities. The key elements of the reform include using the market exchange rate for customs evaluation, streamlining tariffs, and strengthening revenue administration.⁷² Given the existence of functioning fiscal processes in the past, Afghanistan is not an institutional tabula rasa. Therefore, reforms should be built on existing institutional arrangements.

The 1974 customs law specifies the import duties, fees, and charges levied on international trade and transactions. The customs tariff includes 25 bands with rates ranging from 7 percent to 150 percent, allocated across 888 tariff headings. Duty is currently calculated on the c.i.f. Afghan value of imported goods, using artificially low exchange rates ranging between Af2 and Af4.5 per US dollar⁷³ – compared with a market rate of about Af48 per US dollar. In addition, there are a number of fees levied on imports, including in particular a 2.5 percent fee collected by the Chamber of Commerce for the valuation of imported goods. Although there is no excise tax, customs tariffs achieve the same result by imposing higher tariffs on certain goods that are not produced domestically and would normally be excised (e.g. automobiles, tobacco products). Imports of petroleum, diesel, and kerosene for transportation purposes are exempt from duty, although there appears to be a "monopoly tax" on petroleum products equal to 20 percent of the import value.

The use of different and artificially low exchange rates for customs valuation creates uncertainty for traders and confusion for customs officers and has a negative impact on revenue collection. Similarly, the extremely complex tariff structure is difficult to administer and is subject to corruption and abuse. In line with the IMF's recommendations, the MOF has prepared a draft presidential decree recommending the revision of the customs law with a view to: (i) mandating the use of the market exchange rate of the afghani in customs valuation; (ii) reducing the number of tariff bands from 25 to 4 (0, 5, 10 and 20 percent); and (iii) lowering the tariff rates from the current 0-150 percent to 0-20 percent.

The customs administration, like other government offices, is currently weakened by a lack of experienced managers, poorly trained staff, inadequate facilities and equipment, all of which create the environment for potential corruption and abuse. In particular, customs regulations are apparently not applied consistently throughout the country and, in some cases, customs duties are "negotiated'' between taxpayers and customs officers. To address this issue, the transitional government adopted on July 4, 2003 a decree to immediately simplify customs procedures including: (i) the adoption of the internationally recognized "single administrative document" for customs clearance; (ii) improved monitoring of exemptions; (iii) the progressive introduction of harmonized tariff codification for commercial goods; (iv) development of a comprehensive computerized data base for customs valuation; (v) establishment of a simplified customs regime for travelers; (vi) licensing by the MOF of "customs brokers" to assist traders with the clearance of commercial goods; (vii) the assignment of a taxpayer identification number (TIN) to each taxpayer; and (viii) the gradual phasing out of Chamber of Commerce involvement in customs valuation.

In addition, the government has designed a comprehensive 2003- 7 five-year plan, at an incentive cost of around $100 million, to strengthen the administration of customs. This strategic document calls for a complete revamping of the customs department and its regional offices, training of customs officials, reform of customs procedures (including investigation, enforcement and controls), centralization of customs revenues collected by the provinces, and progressive rehabilitation of the customs infrastructure, equipment, and communications. The opening in May 2003 at Kabul airport of a model customs house, featuring a renovated warehouse and training facilities, has been a first step towards the implementation of this strategy and the authorities plan to extend this pilot to all provinces by the end of 2004.

Effective customs administration requires assisting provincial governors with their existing structures and links to ministries, including monitoring of goods in transit and clearance procedures and merchandise dispatch. As the Afghan economy develops, there will be an increasing need to gain custom revenues from the high-value goods currently banned on the ATTA negative list by Pakistan authorities. A short-term need for the Afghan customs is to improve cooperation with their Pakistani counterparts in efforts to reduce the level of smuggling of transit back to Pakistan. Medium-term improvements such as an introduction of a simple computerized control and record system will assist in strengthening the transit control system. This measure could help to reduce the current manipulation of the transit system.

Other Tax Policy and Administration

The existing tax regime is defined by the 1965 income tax law, which provides for a progressive personal income tax, with rates varying from 4 percent to 60 percent, a flat 20 percent corporate income tax, a 2 percent business receipts tax (a form of sales tax on corporate entities' turnover), withholding taxes on imports and exports, and various fixed (presumptive) taxes (see Appendix 5, "Existing Tax Regime"). It is currently difficult to ascertain all the details of the 1965 tax law and its application, since it has been amended by 18 separate decrees and not all amendments have been included in a comprehensive consolidated version. In particular, a Taliban decree of May 1999 seems to have reformed the personal income tax to introduce three rates of taxation (1, 8, and 20 percent) together with a series of exemptions. It is unclear if these provisions are still currently enforced.

The tax law includes a number of serious deficiencies: (i) the current rule imposing taxation of worldwide income on Afghan citizens wherever they live leaves a large number of expatriate Afghans with disincentives to return to Afghanistan; (ii) the top marginal rate for personal income tax (60 percent) is high compared to international standards and cuts in at a modest annual earnings level (less than half of the average annual salary), creating incentives for tax evasion and fraud; in addition, the existing 32-tax-rate structure is complex and difficult to administer; (iii) the coverage of the business receipts tax does not include certain services provided to expatriates and other high-income earners, resulting in revenue losses for the government; and (iv) the current limitations of the loss carryover period and depreciation allowances for the payment of the corporate income tax discourage investment.

To address these deficiencies and to enhance tax efficiency, the MOF is now preparing draft decrees to: (a) impose the income tax on the basis of whether an individual is a resident or nonresident of Afghanistan; (b) reduce the top marginal tax rate on individuals from 60 to 25 percent and increase the personal exemption; (c) restore wage withholding for higher-income employees; (d) introduce a rent tax and an airport departure fee; (e) expand the business receipts tax to cover the services most likely to be provided to expatriates and other high income-earners (e.g., hotels, restaurants, telecommunications, rental vehicles); (f) extend the loss carryover period; and (g) liberalize the depreciation allowances allowed for tax purposes.

These tax policy reforms are closely linked to a program to strengthen the capacity of the revenue department in the MOF and improve tax operations in the Mustoufiats. This plan includes the establishment of a large taxpayer unit (LTU) in Kabul, which will be responsible for administering the personal income tax, the business receipt tax and the rent tax. The Kabul LTU will then be complemented by model tax offices for medium-sized taxpayers, in which new operational procedures and concepts can be piloted. Although initial steps have been taken by the authorities to reform tax policy and administration, progress has been somewhat slow, partly due to the priority given to customs reform, and partly due to the Cabinet's reluctance to adopt a tax reform with the potential for vast social implications. However, a sizeable amount of technical assistance has been recently mobilized and decisions are expected to be reached by Cabinet in this area during 2003/04.

Monetary Policy Issues

Introduction of a New Currency and Financial Stability

To help facilitate recovery and economic growth, an adequate degree of financial stability must be established as quickly as possible. One of the most important issues in this regard is whether to temporarily adopt a foreign currency as legal tender, or whether to introduce a new national currency. Under the latter option, a plan would need to be devised for the interim period prior to the completion, and the central bank would need to have a framework to conduct monetary policy. From the outset, Afghan authorities indicated a desire to introduce a new national currency as soon as possible. IMF staff recommended that the introduction of a new currency be considered at a somewhat later stage, as it would require time because of technical considerations (design, printing, etc.) and, more importantly, because of the need to establish sound and credible financial policies and an adequate institutional and legal framework to support the value of the new currency. One possible option for the interim period would be full dollarization until the new afghani was successfully launched. The temporary use of a stable foreign currency would have provided immediate monetary stability, as well as time to establish credibility and to build up the necessary capacity at DAB.

The authorities, however, decided to continue to use the existing afghani and to introduce a new currency as soon as technically possible. They viewed the afghani as an important symbol of sovereignty and unity, and were concerned that even a partial and temporary dollarization would be difficult to reverse. While they recognized the risks posed by counterfeits to financial stability, they believed that these risks had diminished, based on information received from at least some of the printers involved regarding volumes printed, and their assurances that printing had stopped. Also, it was discovered that the Taliban, while in government, had fortuitously started preparations for the introduction of a new currency and had signed a contract with a reputable banknote printer. Some work had already been done, including preliminary designs of various denominations. Because of the U.N. embargo, however, this agreement had been put on hold, but with the sanctions lifted, a significant shortening could be achieved of the technical lead-time needed to launch the new currency. As the value of the old afghani had been eroded by inflation—the largest denomination (Af10,000) was worth about 25 US cents, and people had to carry around large bundles of cash for even small transactions, it was decided that one new afghani would replace 1,000 old ones. This would make transactions much simpler and would set the stage for the central bank's monetary control.

The introduction of the new currency⁷⁴ was a crucial step in the authorities' efforts to establish financial stability. During the Taliban regime, the central government was not involved at all in the printing of money, as the Russian company responsible did not deliver it to DAB. The transitional government has now given DAB full authority over the issuance of currency. The new currency was intended to eliminate the problem of regional currencies: in northern Afghanistan, General Abdul Rashid Dostum and a former president, Burhanuddin Rabanni, printed their own version of the afghani, which was worth around Af80,000 per US dollar (before currency change), and is not legal tender outside the north. DAB announced that the northern notes could also be traded in for the new notes. The plan for the introduction of the new currency was made public on September 4, 2002, and the conversion process started on October 7, 2002 and ended on January 2, 2003. All in all, Af15.6 billion in new afghanis was issued. By early 2003, the amount of currency in circulation was somewhat over Af20 billion, reflecting both the currency conversion and government payments in the new currency.

With the completion of the currency conversion, DAB achieved full control over the printing and issuance of the national currency, and gained the ability to determine accurately the amount of currency in circulation. 12 Circulation grew by 17 percent in January-August 2003, slightly less than the 20 percent increase envisaged for that same period under the indicative monetary program. Money demand continued to be met by an accumulation of foreign exchange reserves in DAB, which reached $555 million by late August 2003, as the government maintained its adherence to the no-overdraft rule in 2003. As a result of these sound monetary (and fiscal) policies, consumer prices have been broadly stable in 2003. Moreover, in the absence of any major shocks, exchange rate stability was established, with the rate fluctuating around Af48 per US dollar. Since the introduction and float of the new currency, DAB has aimed to limit exchange rate volatility and keep the exchange rate within a range. This range, however, is not firmly set nor announced and DAB does not intend to resist persistent exchange rate pressures should these emerge, and thereby risk losing its reserves. The exchange rate regime can therefore be described more accurately as a de facto (lightly) managed float, or an intermediate regime between a pure float and a firmly fixed rate. The low degree of financial integration and market development allows DAB to pursue this approach, although the informal financial markets are such that people can quickly substitute one currency for another if they wish to do so.

Monetary Program

DAB's monetary program, which receives assistance from IMF, aims to control the domestic money supply as an intermediate target. However, the ability to target inflation through the domestic currency supply is complicated by the widespread use of foreign currencies. Inflation can be influenced by changes in the stock of foreign currency holdings as well as the supply of afghanis. The effect of changes in the stock of foreign currency holdings on inflation depends in part on what the foreign exchange is used for (savings or daily transactions). However, there is little information on the size of foreign currency holdings in Afghanistan or on their use. In the absence of a functioning banking system, the domestic money supply is limited to the stock of domestic currency in circulation. Also, without any new central bank financing by the government, changes in the amount of currency in circulation are primarily driven by changes in DAB's (net) foreign asset position. This largely reflects the government's conversion of donor assistance it receives to finance the budget into afghani, thereby increasing DAB's foreign assets. Without any action from DAB and given the size of budgetary assistance, these foreign exchange inflows would imply a doubling or more of the domestic money supply within one year.

In the absence of a functioning banking system or money market to counter this, the only market-based instrument that could be developed quickly was the selling of foreign exchange through auctions. IMF staff provided extensive assistance to DAB to establish and improve these auctions, with the (larger) informal money traders acting as auction participants.⁷⁵

The formulation of an appropriate monetary program for Afghanistan is complicated by substantial uncertainties over the country's economic prospects. Inflation could be affected by factors beyond DAB's control, including supply shocks, fluctuations in the international prices of imports, and political events. Given these uncertainties, the monetary program needs to be based on cautious assumptions regarding the strength of the economic recovery and the demand for domestic currency. In addition, the monetary target should not be pursued too rigidly. In this regard, movements in the exchange rate, the only economic indicator that is readily available, can provide an early signal of changes in the relative demand for the domestic currency that may warrant a tightening or loosening of monetary policy.

A further, more practical, complication is the lack of reliable data for the stock of afghanis in circulation and, more generally, the absence of a balance sheet for the central bank. IMF estimates of the outstanding stock of afghanis are based on information obtained from the bank note printer that printed the official afghani and another printer that printed one of the counterfeit versions. By combining the estimate of currency in circulation with estimates of DAB's foreign assets that had so far been identified, plus an estimate of the government overdrafts accumulated over the years and for which records were found, a very crude estimate of DAB's balance sheet could be put together. This estimate was used as a basis for the monetary program. The program was updated regularly as new information became available, particularly following the completion of the currency conversion when the stock of currency in circulation could finally be determined accurately. A first indicative monetary program was formulated in April 2002 for the year 2002/03, aiming for a 12-month inflation rate of somewhat below 20 percent by March 2003 and limiting money growth to less than 30 percent. A similar program was formulated in early 2003 for 2003/04, with slightly different parameters, targeting a 12-month inflation rate of about 15 percent by March 2004.

Rebuilding the Financial Sector⁷⁶

Despite the commendable efforts reviewed above, many steps must be taken before a satisfactory financial infrastructure emerges and sustains private sector led economic growth. Formulating and implementing monetary policy is difficult without a functioning and modernized banking system. Despite the commendable work to revive monetary control and central bank functions, DAB is not yet fully operational and commercial, and other banks are much less so. Much of the economy still depends on the traditional hawala system for money transfers, and the informal credit market meets the demand for liquidity. None of the existing six banking institutions (two commercial banks, one trade finance bank, one agriculture development bank, one housing bank, and one industrial bank) are performing any intermediation functions. The capital market is undeveloped and modern savings and investment instruments are almost nonexistent.

The legal basis for the central bank and the commercial banks has been the 1994 Law on Money and Banking. The law has a number of serious flaws: namely, (i) it is designed on the outdated socialist principle that the purpose of monetary policy is to direct credit; (ii) it involves a number of important conflicts of interest between the government, central bank, and commercial banks; and (iii) it omits important modern prudential standards and enforcement tools. For most of its life, however, the law was irrelevant in practice, as the Taliban largely ignored it during their rule. The law needed to be replaced in its entirety by a modern central bank law and banking law, and so new legislation was ratified by the transitional government cabinet in September 2003.

Other aspects of the legal foundations of the financial system seem, on the surface, to be less problematic, as they have been derived from Western, market-oriented laws. Afghanistan's civil code was adopted in the 1960s with assistance of the Egyptian government, and is reported to be almost identical to the civil code of Egypt, originally based on French law. The commercial code was received from Turkey, which in turn was modeled after German law. It covers general company law, transport law, insurance law, and special financial transactions. It also includes provisions on bills of exchange, promissory notes, and checks. Finally, bankruptcy law provisions can be found in both the civil code and the commercial code and apply equally to state-owned and private banks. Bankruptcies are administered by the courts. Nevertheless, for these laws to become operational, there will need to be adequate infrastructure: such as, record-keeping institutions, functioning courts and police, and an impartial and independent judicial system.

Da Afghanistan Bank

At the end of 2001, DAB was actively performing two main functions. First, it was acting as cashier to the MOF and was, in principle, responsible for salary and other budget payments, and receiving government revenues for deposit, across the country. Second, it issued bank notes and managed the stock of cash monies. DAB was also structured around many commercial banking operations that a central bank in a modern two-tier banking system would not normally do, while at the same time omitting many of the central bank functions that a modern central bank should do. On the commercial side, it offered commercial banking services, extended long-term loans to banks and enterprises, and accepted deposits from the public. Although most of these operations were discontinued in 1995, a number of DAB accounts (debit and credit) are still current.⁷⁷ Its governor remains legally the chairman of the governing boards of all the commercial and development banks. This would have involved a substantial conflict of interest with the traditional functions of a central bank, in particular with banking supervision, had DAB considered this its duty. As it was, the central banking side of DAB was minimal. It did not supervise the banking sector either by issuing prudential regulations or by checking compliance through on and offsite inspections. It did not provide or supervise an efficient payment system. Nor did it offer any lender-of-last-resort facility for illiquid but solvent banks. While best practice in central banking would require that it be granted a high degree of autonomy, combined with stringent rules for accountability, DAB is fully controlled by the government. Its ultimate decision-making organ, the Supreme Council, as well as the Monetary and Credit Committee, which drafted regulations and governed the operational aspects of DAB, both included representatives from different ministries.

DAB's organizational structure was based on the Soviet monobank system, and therefore is inappropriate for a modern central bank in a two-tier banking system. Most importantly, crucial departments were missing or did not perform the functions that their name would have suggested. For example, there was no monetary policy department, banking supervision department, or market operations department. The Planning and Research General Department did not conduct any research and the Supervision and Control of Currency Exchange General Department's main activity was to keep records on the activities of licensed exporters and importers. Finally, it had departments that do not belong in a modern central bank, such as the Savings General Department or the Foreign and Domestic Loans General Department. The latter is in charge of keeping the records of defaulted DAB-guaranteed loans extended to Afghan entities by foreign banks or governments. The last guarantee was granted 10 years ago, and the last external payment under such guarantees was made in 1997. It also had a Pension Department to hold the pensions of the entire financial sector, including commercial banks.

Although it had an Accounting General Department, this did not in fact perform the required accounting tasks. It had no formalized accounting system or chart of accounts. Its rudimentary accounting rules were incompatible with the principles of materiality, prudence, and substance. Its systems lacked headquarters-branch data reconciliation, a delineation between central bank and commercial operations, and an appropriate valuation and classification of assets and liabilities, and involved confusion between stocks and flows. There was a complete absence of automation and computerization. While the department did keep records of movements in assets and liabilities, income, and expenses, the old National Cash Registry (NCR) card journal entry posting machine that used to do this broke down six years ago. This, together with the Taliban's disinterest in financial affairs and the long delays in financial reporting by DAB's branches, meant that it failed to produce a balance sheet for seven years.

Before the Taliban regime came to power in Kabul, DAB's Planning and Research Department routinely collected statistics from banks without, however, analyzing them. The department's supposed supervisors did not have adequate understanding or capacity for meaningful supervision. The data collected were in any case mostly irrelevant, as the accounting rules under which data were produced in the commercial banks did not correspond to international practice, and much of the data collected (number of employees, their profession and gender, and number of buildings and cars) bore no relation to prudential considerations. Some functions related to supervision were also performed in other departments. For example, money changers were licensed by the Foreign Relations General Department, and on-site audits were performed by the Inspection General Department. In short, banking supervision was confused with the functions of auditing and checking the bank's activities against the rules set out in its charter, and had largely ceased.

In the original design, DAB had 89 branches across the country, but 24 of them had been closed due to local conflict. Although the branches were supposed to report monthly to the headquarters on branch activities, most stopped sending reports six years ago, reflecting the disruption in transportation and communication and the disinterest of the Taliban rulers. As a result, the headquarters no longer knew the current cash holdings of its branches. In mid-2002, despite the low level of activity and the past closure of numerous branches, the staffing level had remained generally unchanged and DAB employed 2,400 staff, of which 1,021 were at headquarters, 1,130 in branches, and approximately 250 at the tolls. A substantial number of staff had no clear responsibility, and many only showed up at work for attendance checks. There was also a conspicuous lack of modern communication tools. The difficulties at DAB's headquarters in making prompt wage payments in its branches resulted in the staff in some provinces turning to local political authorities, to whom they became accountable. In some instances, these branch employees were also called upon to perform municipal duties.

Commercial Banks

During the pro-communist and later Soviet era (1973–89), the banking system was nationalized and Soviet-style accounting, financial control, and management systems were introduced. The situation of the banks deteriorated further during the Mujahedin period and the associated civil strife, with continued government interference in bank management, directed lending, and administered interest rates.

Finally, during the Taliban period, financial institutions were forbidden to charge interest on their loans or to pay interest on deposits. The banks' loan portfolios suffered widespread defaults. Deposit mobilization collapsed and the banks discontinued lending. During this same period, registered moneychangers and the rest of the hawala system replaced the banks in providing payments and liquidity in the economy, as well as certain deposit and lending services. In summary, the commercial banks may be solvent and even have a positive cash flow, but this situation is due to the real estate they own and returns on foreign currency deposits abroad that had been frozen during the Taliban times. However, none of the banks have been effectively engaged in the banking business for many years, nor do they have a management cadre, an accounting framework, or risk management systems that remotely resemble modern banking.

As with DAB, the commercial banks do not operate according to a defined chart of accounts. While most (including DAB) are still using outmoded NCR accounting systems, others use the manual Cartotek system.⁷⁸ Neither system is adequate to determine a bank's true financial condition and is thus not appropriate as a modern management tool. The banks have no system of headquarters-branch reconciliation. The valuation and classification of assets, liabilities, expenses, and income are misleading and do not correspond to international accounting standards. There are also problems stemming from the lack of adequate financial controls and weak verification procedures and monitoring mechanisms.

Two major weaknesses in the current accounting framework are the inappropriate booking of non-performing loans and the absence of their provisioning. Some banks transfer non-performing loans together with accrued interests from "loans" to "receivables" in the balance sheet, keeping the loan at a value greater than its face value. Certain banks apply some provisioning rules and punitive interest rates for late payment, but these penalties are insignificant and do not reflect the probability of nonpayment.

In the absence of reliable data and audits, the banks' financial situation can only be guessed at. Their main assets consist of foreign currency deposits held abroad, which were frozen during the Taliban regime because of UN sanctions, and real estate, including repossessed houses and the banks' offices and branch networks. Most of the banks' loan portfolios are past due by 7 to 15 years, and many borrowers are either dead or have disappeared. While some bankers claimed that some of their loans were still recoverable, they conceded that, because of corruption or inefficiency in the court system, they would not attempt to enforce repayments but rather negotiate a settlement of the debt. On the liability side, the deposit base has been eroded substantially by high inflation rates; deposits would now likely represent only a small claim on the asset base. The income situation differs between banks. Some generate sufficient income from rents and interest on deposits abroad to cover their overhead and administrative expenses, as well as the fixed and variable costs of their liabilities. Others, however, such as the Industrial Development Bank, depend on loans from DAB to cover their expenses.

The banks' managers had not been managing their operations in a modern commercial sense for years. Interference in commercial decisions was either made directly through the managers or through the banks' governing boards, which are chaired by the governor of DAB. Furthermore, bank managers were appointed on political grounds, and often lacked any banking experience.

Interest rates were first set by a governmental committee independently of the underlying risk of the projects and later were prohibited altogether under the Taliban regime. Staff, management, and board members lack basic banking and operational experience, even in their own assigned areas. Operationally, the banks do not have any policies, procedures, or well-defined communication lines in place to guide management and staff. It is estimated that the six commercial banks together employ nearly 2,000 staff, but they are mostly unfamiliar with computers and have little or no basic bank management skills. There has been no training for many years. Staff have been regularly turned over with each political upheaval.

Toward Modernization

The transition of the Afghan economy to a modern commercial and diversified one depends greatly on the strength of the financial sector. This is a major challenge for the Afghan authorities. Reforms include replacing the 1994 Law on Money and Banking with a Central Bank Act and Banking Law (see above); introducing a new currency (see above); privatizing the commercial banking activities of DAB to establish a two-tier banking system; adopting and implementing prudential regulations;⁷⁹ implementing an effective monitoring and reporting system; establishing a modern payments system;⁸⁰ and enacting efficient laws on bankruptcy and foreclosure.

A New Legal Framework

The new Central Bank Act ratified by the transitional government cabinet in September 2003⁸¹ includes provisions giving DAB the overriding responsibility to achieve and maintain price stability, and grants it full autonomy in seeking this objective. In order to mark a clear departure from the country's socialist legacy, the law also specifies that DAB shall act in accordance with the principle of an open market economy with free competition. It further entrusts DAB with the tasks of defining, adopting, and implementing Afghanistan's monetary and foreign exchange policy, issuing bank notes and coins, holding and managing the official foreign exchange reserves, and licensing, regulating, and supervising institutions engaging in the banking business. DAB is prohibited from providing loans to commercial banks, except as a lender of last resort and to extend short-term liquidity support to solvent but illiquid banks, especially in the event of a systemic liquidity crisis.

Independence requires accountability, and this is also stipulated in the law. Accountability is to be achieved by a clear mandate and through reporting requirements to parliament and to the public on DAB's financial condition, and on the achievement of its objectives and the performance of its task. Accountability is also enhanced by prohibiting DAB senior officials from holding other government positions and by excluding them from engaging in other tasks incompatible with their duties. The law also stipulates DAB's right to be consulted on any proposed legislative or public administrative act of the government in DAB's field of competence. This provision is meant to ensure that the overall legal framework of the financial system continues to be consistent and coherent. Finally, in consideration of the difficulties involved in passing several laws at the same time, the current draft of the central bank law includes specific issues that under normal circumstances could have been covered by separate laws, including currency, cash payments, payment system issues, and securities services and securities transfer systems. Furthermore, DAB is given the power to issue regulations for hawala dealers as nonbank providers of money and payment services.

The main features of the new Banking Law, also ratified in September 2003, includes a precise definition of a bank as an entity engaged in the business of accepting deposits or other repayable funds from the public and using such funds either for extending loans or for making investments for its own account.

The Law includes the standard rules of a modern banking system with sound management, prudent risk management, and transparent and adequate accounting. Specifically, the Law includes provisions related to the banks' corporate governance and on DAB's powers to review changes in bank ownership, as well as the board and senior management level. The Law also includes requirements for credit documentation, risk management, as well as provisions that banks must maintain their accounts in accordance with international accounting standards (IAS). Banks are subject to specific auditing requirements, including the establishment of an audit committee. DAB's oversight role is strengthened through the conduct of on-site examinations. The Law grants DAB the exclusive authority to revoke licenses and to initiate insolvency proceedings, with comprehensive explicit provisions for the resolution of insolvent banks under the oversight of a financial service tribunal.

A modern central bank in a two-tier banking system

One of the most important improvements in DAB took place with the initial steps in establishing effective banking supervision. At the end of 2001, a new Supervision Department was created, a number of prudential regulations and manuals were drafted, and the training of supervisors was initiated. In the first phase, staff received training in basic balance sheet analysis and the concepts of prudential ratios. More recently, and under the supervision of a foreign expert, the staff has been conducting "real life" off-site supervisions of the operating banks and on-site supervision of Bank Millie Afghan. The licensing of money traders has been shifted from the Foreign Relations Department to the new Supervision Department. In November 2002, all licensed money traders had to renew their licenses, a process that was enforced with the help of the police. The department has now started to improve the collection of personal data on the licensed money traders.

Although there has not yet been an overall reorganization, parts of some DAB departments are being restructured individually into what corresponds to a Monetary Policy Department, Payment Systems Department, Accounting Department, Banknote Operations Department, and Banking Supervision Department with foreign experts in each of these departments. The work of the foreign experts has initially focused on the key outputs of these departments by training (and hiring new) personnel, while leaving the remaining departments untouched. The strategy is to recruit national staff from within or outside DAB to perform tasks that should be performed by DAB staff. The objective is to reintegrate these local employees into DAB once the reorganization, including the pay scale, has been implemented.

On the accounting side, DAB is in the process of introducing a new chart of accounts, as well as computerizing the function to include a general ledger software package that will ultimately enable it to produce a balance sheet on a regular basis. However, the reform agenda in the accounting area is still substantial. Accounting regulations still need to be drafted, together with operating manuals and procedures, and staff need to be trained. Furthermore, the consolidation of financial accounts will also depend on the speed of reforms made in DAB's branches. An ambitious project has been initiated to improve the connectivity of the branches with the main office. Improvements have also been made in data collection with the production of a simple quarterly Economic and Statistical Bulletin. Some essential monetary and fiscal statistical data have been collected and work has been initiated for analytical reports.

DAB has also made notable progress in the efficiency of its commercial services. Almost all banking activities of the international organizations and many of the NGOs in Afghanistan are currently being conducted by the commercial arm of DAB. Although its services include the opening of accounts, deposits, and international money transfers, this is solely to facilitate international payments for donor organizations. The efficiency of the payment service has substantially improved with the introduction of SWIFT. Improvements in the commercial area have included the development and introduction of procedures that expedite the opening of letters of credit by the MOF under grant programs. New current accounts can only be opened by moneychangers, NGOs, or international organizations, but not by the general public. With the exception of two recent small loans, one to the Ministry of Defense and another to the Industrial Development Bank, DAB has ceased to extend loans. DAB's commercial arm has been expanding rapidly over the last couple of months. Although these commercial operations do not belong in a central bank, the current vacuum in the banking system leaves DAB with little option but to fill the gap, at least until commercial banks have resumed operations in Afghanistan. It intends to divest itself of all the commercial bank activities it now undertakes as soon as possible and no later than the end of 2004.

DAB has reconnected 35 of its main provincial branches to its headquarters in Kabul. These branches have been connected by laptops with Immarsat links, and by the end of September 2003, they were able to report to the center their balances and account movements, with the capacity to do so on a daily basis.⁸² Bank branches in Kabul are already reporting to the head office on a daily basis under the existing communication system. In the near future they will be connected by a computer network. The next step will be to identify the branches that need to be rehabilitated to meet the necessary security standards. The disbursement of government salaries – the main expenditure item in the provinces – will probably require fewer operational provincial branches than existed in the past. DAB would further need to develop a physical distribution system with regional cash centers from where the distribution of cash can be made. This should also include the introduction of a software system for the management of the currency inventory and the purchase of an armored fleet or use of an aircraft for risky cash transportation. For the medium term, with the emergence of a commercial banking system, DAB plans to implement two payments systems that will be the core of the National Payment System: high value payments using a Real Time Gross Settlement (RTGS) system and low value payments using a Direct Giro Credit (GC) system.

Commercial banks still do not function in a manner consistent with a market economy. A fundamental restructuring of the currently licensed banks, together with a substantial improvement in their management, will be necessary if they are to become modern and efficient banking institutions. A good number of reforms can be imported into the banking system by opening the market to foreign banks. Such banks could be expected to have modern management and risk assessment techniques. In-house rules would require them to apply international accounting standards.

But foreign banks cannot provide all the answers. To begin with, they will most likely limit their operations to the larger cities, starting with Kabul, and to certain type of customers, namely international organizations, NGOs, the diplomatic corps, and the largest corporations, leaving small and medium-size enterprises and rural areas without services. Most banks will likely also focus their operations initially on facilitating payments and few can be expected to engage in significant domestic-lending. This indicates that there remains an important role for DAB, micro-finance institutions, and a rehabilitated domestic banking sector to deliver financial services outside of Kabul and to a client base not served by the international banks. In this regard, Afghanistan needs a comprehensive medium- to long-term financial sector development strategy, possibly including a strategy to rehabilitate part of the current domestic banking system.

Moneychangers and the hawala system

Even with the emergence of a modern banking system, the informal hawala system will likely continue to exist, as is the case in many other countries in the Middle East.⁸³Given the need to counter nontransparent, undocumented, and adverse practices, DAB will need to evaluate the options available to partly regulate and supervise this market without pushing it underground. In this context, simply extending banking regulations and supervision practices with respect to licensing requirements, customer identification, suspicious activity reporting, and record-keeping to the money dealers is not a viable option. It would not be feasible to regulate in this manner, given the huge number of traders involved. Two options might be envisaged.

First, the hawala dealers could, at least as an interim solution, subject themselves to self-regulation and supervision. This market already benefits from an association enforcing a number of unwritten rules. The association could be encouraged to draft written rules and regulations. Second, recognizing the distinct features of the hawala system would justify the development of special regulations and supervision techniques, which would mainly attempt to increase the level of transparency in the business while keeping intact the characteristics that made this market so efficient. Such regulations could include the requirement of registration but not licensing of the hawala dealers, the requirement to be able to identify customers and to keep records on their identity, and to cooperate in investigations if the need arises. The latter would also include the right of DAB to enter and inspect the money dealers' premises where there is a reasonable suspicion of an offence.

Institutional Issues

Need to Reconstruct Public Administration

The underlying arrangements for government employment stem from the 1970 law on the Status and Condition of Government Employees, as amended by the 1977 decree on the civil service. Although this legislation includes a number of sound provisions, in practice, Afghanistan's civil service faces various problems and uncertainties. First, it has been very difficult to ascertain the number of staff employed by the government, due to the absence of a nominal roll of employees and large variations in the number of staff paid each month. These difficulties have been compounded by the failure of payroll data to indicate in which ministry provincial staff worked or to distinguish between staff working in ministries and those working in SOEs. As a result, estimates for total civil service employment range widely from 240,000 to 331,000, excluding military personnel (of about 100,000) and government enterprises (about 35,000).

Second, although the size of the civil service is not large relative to the population, the low level of service reflects very weak capacities in the ministries, with overrepresentation of unskilled workers in the government's workforce and the absence of qualified senior staff, most of whom emigrated during the war. Third, the current administration inherited a situation where a large number of civil servants have been hired on the basis of their ethnicities and loyalties to political factions rather than merits. Fourth, the current pay and grading system is inadequate to attract, retain and motivate skilled civil servants. The average monthly pay for civil servants is approximately Af1,800 (about $36 at current exchange rates). This is probably higher than market rates for unskilled staff, but is clearly well below what would be needed to retain or recruit qualified senior civil servants. The wage structure is extremely compressed, as food allowances comprise the bulk of total pay (see also Appendix 7, "Sub-national Public Administration and Finance").

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. Creating the Commission was an obligation of the government undertaken in the Bonn Agreement of December 2001. The IARCSC's main responsibilities were set out in a presidential decree (June 10, 2003) and include: (i) designing and implementing civil service management policies and procedures; (ii) coordinating the public administration reform program; (iii) recruiting government senior staff on the basis of a fair, transparent, and open process; and (iv) overseeing lower level appointments in the civil service. However the specific delineation of responsibilities between the IARCSC, the MOF, the Ministry of Labor and Social Affairs, and the Office of Administrative Affairs has not yet been fully clarified.

The government presented in the 2003/04 National Development Budget (NDB) 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. This strategy has focused on the following elements: (i) drafting a new civil service law and subsidiary regulations governing civil service employment; (ii) revising the pay and grading arrangements on a pilot basis; (iii) developing a nominal roll for civil servants; (iv) introducing a comprehensive government payroll system in the treasury; (v) reviewing ministerial staff and structures; (vi) starting preparatory work for future retrenchment arrangements; and (vii) individualizing salary payments.⁸⁴ The government is also committed to improving the timeliness of provincial salary payments and implementing effective arrangements for enforcing civil service headcount ceilings mandated in the annual budget.

Despite the importance of the civil service reform in the reconstruction process, it must be carried out with caution due to its large potential for economic and social implications. In particular, any across-the-board pay reform should remain compatible with mediumterm fiscal sustainability. Moreover, detailed proposals for salary decompression remain contingent on a reliable classification of individual positions in the government, which is a lengthy and resource-demanding process that has yet to be launched. The implementation of a retrenchment program is also a highly sensitive political issue. Finally, the reform program cannot be implemented without prior development of a nominal payroll and effective establishment controls to avoid the dangers of staff leaving and then reentering the civil service.⁸⁵

Under these constraints, progress in civil service reform was on the whole modest during 2002/03. Nevertheless, important initiatives have been taken, including the approval by the Cabinet on July 10, 2003 of a presidential decree on priority restructuring and reform, 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 number of departments have already submitted applications to the IARCSC to benefit from the provisions of the new decree, including customs and treasury departments of the MOF. A second decree is soon to be submitted to the Cabinet to regulate and limit the salary top-ups granted by donor agencies.

Longer-term challenges facing the 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; and providing a social safety net that can make the retrenchment of surplus staff feasible. Responsibility for the overall management of the civil service is diffused and the division of responsibilities within and between the central and provincial governments is unclear. Many ministers and ministries have little experience in policymaking and in directing the public service. The Cabinet needs technical assistance in support of the policy and institutional reform process. Findings about subnational public administration are provided in Appendix 7.

Need to Create Market Enabling Environment

Despite an externally imposed planned economy in certain periods of its modern history, Afghanistan has a long tradition of entrepreneurship and a vibrant private sector, which has actively engaged in agricultural production, trading activities, and small-scale industrial activity over the centuries. An initial condition for restoring Afghanistan's private sector vitality is to consolidate security and political stability throughout the country. Equally important is the establishment of a strong judicial system able to effectively enforce laws and regulations with fair, transparent, and simple rules with regard to the banking system, tax and customs, competition protection, property registration, and foreign investment.

Important steps in this direction have included the drafting of the banking and central banking laws, successful implementation of the currency conversion, and formulation of a customs reform. Adding to this list of achievements, has been the enactment of a new domestic and foreign investment law. In August 2002, the government replaced the 1987 law on domestic and private investment, which had a negative impact on foreign direct investment, with a new law. 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 the law, 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. However, following IMF and other donors' recommendations against the use of tax holidays and for more transparent mechanisms for encouraging investments, such as low corporate tax rates and accelerated depreciation, the August 2002 law is now being reviewed by the Afghan authorities. The government has taken steps to attract investment in major areas, including the sale of a telecommunications license in October 2002, and the signing of public contracts with international developers to renovate two major hotels in Kabul.

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. Such a reform would eliminate the burden placed on the ordinary budget⁸⁶ and restore a level playing field between these enterprises and potential private sector competitors. Preliminary data suggest that, from the 174 public enterprises which were operated under the communist regime (and accounted for more than one-third of the revenues of the ordinary budget), only 80 have survived (or 161, including their provincial branches) accounting for a total of somewhat more than 35,000 employees. Very little information is currently available on their situation and operations.

Only a small number of SOEs seem to be viable; none are selfsufficient —let alone profitable—and for most, employee salaries are fully paid out of the government's ordinary budget. The main SOEs are the public utility companies (for example, electricity and gas production and distribution) some of which apparently have partial success in collecting utility fees, but only in major urban centers. Other important SOEs include fabric-making companies and smallscale cement industries. The government has officially indicated that that it does not intend to revive non-functioning public enterprises but plans to close them down or divest them to the private sector as soon as possible. A Commission for the Evaluation of the 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 the drafting of transparent privatization procedures. Its activities so far have been mainly limited to a census of the existing SOEs. Notwithstanding a commitment to an ambitious overhaul of the public sector, the authorities have acted cautiously in this area for the following reasons: (i) most records of SOE assets have disappeared, making it extremely difficult to design any privatization strategy; (ii) there has been some reluctance on the part of the government to enter into a privatization process which, without appropriate assurances and safeguards, could create considerable opportunities for corruption; (iii) line ministries have been reluctant to delegate the evaluation and transformation of the SOEs operating in their sectors to the newly created commission; and (iv) this is a highly technical area in which major assistance is required, but no such assistance has materialized yet.⁸⁷

Need to Strengthen Public Consultation

The Afghan government faces enormous challenges over the next two years, as it prepares for national elections, drafts and promulgates its new constitution, trains and deploys new national armed forces, demobilizes 200,000 faction-based soldiers, and implements a multibillion dollar reconstruction program. In addition, much more needs to be done to nurture national unity and participation by civil society. The government's attempts to meet these challenges are complicated by the imperatives set forth by the International Security Assistance Force (ISAF) and coalition forces in Afghanistan, whose concerns for long-term stability and participatory governance appear to be overshadowed by more immediate efforts to root out terrorism.

On the brighter side, there appears to be considerable interest in and willingness for a more participatory process. However, more needs to be done to effectively engage the emerging civil society organizations, including NGOs. Participation of these institutions in public decision-making processes is necessary to reinforce, check and decentralize modern institutions. Service delivery policies need to consider the role of civil society in providing services and in conducting social audits of services provided by the government.

Crosscutting Policy Issues

The promotion of regional cooperation could revive the historical importance of Afghanistan. Kabul might emerge once more as an international city, a melting pot and meeting point of traders and different cultures. Afghanistan could eventually play a major role in fostering the stability and economic prosperity of the entire region, extending from Iran to the People's Republic of China and India, and from the Central Asian Republics (CARs) to Pakistan.

Afghanistan is already reaping substantial revenues from fees for commercial aircraft flying over its territory, and these fees are expected to continue and increase. Surface transit trade through Afghanistan will also generate fees, as well as income from transportrelated services. However, transit fees should be set at reasonable levels to encourage transit trade through Afghanistan, particularly before its road infrastructure is fully rehabilitated, and revenue generation should not be the primary objective of these fees. Furthermore, better security guarantees are necessary, making transit visitor activities difficult in the short run, though they could be developed in the medium run starting with the safer areas.⁸⁸

Given the country's landlocked but strategic location, an open trading regime and regional cooperation should have many advantages for Afghanistan and its partners. Afghanistan has very few significant tariffs and food and goods are relatively inexpensive as a consequence. It is in its interest to maintain this system of low tariffs, as higher tariffs would largely not support domestic industries and would only result in higher costs for Afghani consumers. Furthermore, keeping an open system encourages neighbors to lower their tariffs over time (except in particularly justified categories), benefiting their economies and allowing them to take advantage of freer trade.

In the pre-war period, Afghanistan had significant exports of carpets and dried fruits like raisins, and such exports have continued and in some cases expanded through various channels, including carpet production in refugee camps, during the war. Thus, there are promising existing export channels which Afghanistan can exploit. There also appear to be good prospects for exports by air of certain fresh fruits, such as melons and grapes, to destinations such as the Middle East. Exports can be facilitated by the diaspora of expatriates and entrepreneurial networks in many of the countries of likely export destination. It is also very important that preferential access to exports from Afghanistan, offered by OECD countries, be maintained and to the maximum extent possible include Afghanistan's agricultural and agriculture-based exports.

Transit Trade Agreements ⁸⁹

As mentioned in Section I.5 above, the main transit trade agreement at present is with Pakistan, largely through the port of Karachi and Port Quasim. This agreement was established in 1965, but during 1994–96 the Pakistan authorities unilaterally banned several items from the eligible list; and since 1996, 18 items have been placed on the negative list. The ban was imposed because of concerns that a large part of these imports were being smuggled back into Pakistan.

Following a series of meetings since 1991 between the two countries, the issues of disagreement are expected to be resolved during 2003/04. Six of the banned items have recently been restored to the list and the time taken for processing and clearing procedures of transit goods has been reduced from 20 to 5 days. At the same time, it has been agreed that some categories of imports for which Afghanistan has little need and are clearly intended to be smuggled back into Pakistan will be eliminated from the eligible list. To reinforce this measure, it is expected that Afghanistan will levy punitive import tariffs on these goods. Both countries are committed to making substantial progress on lifting the ban on the remaining 12 restricted items at a meeting later in the year. In addition, agreement was reached, with the support of aid from Pakistan, that the Torkham (the railhead in Pakistan) to Jalalabad (in Afghanistan) road would be repaired and a new road parallel to the existing one would be constructed by early 2005.

A new transport agreement with Iran was signed in January 2003. Changes under the new agreement included lifting previous restrictions on the routes that could be used by Afghanistan trucks between the border and destination cities. In addition, Afghan truckers were allowed to buy Iranian fuel at the same subsidized price as Iranian truckers. Discussions on trade and transit agreements have been initiated with Kyrgyz Republic, Tajikistan, and Uzbekistan. In August 2003, a Memorandum of Understanding was signed by the Uzbek and Afghan authorities, and a draft agreement with Tajikistan is under discussion in order to establish mutually beneficial trade, transit, and railway development treaties.

In March 2003, Afghanistan and India signed a new preferential trade agreement replacing an earlier one that was little used because of the Taliban presence and strained relations between India and Pakistan. Under the new agreement, India has granted 50–100 percent tariff reductions on 38 export items from Afghanistan, and duty-free access has been given to India for eight tariff lines. In June 2002, preferential access to the European markets was obtained under the Everything But Arms agreement, and in January 2003, the United States granted Afghanistan GSP access to its domestic market. On April 10, 2003, Afghanistan applied for membership to the WTO.

Iran, India, and Afghanistan signed a Memorandum of Understanding in January 2003 to improve access to the Iranian port of Chabahar on the Indian Ocean, along the Chabahar-Malik-Zaranj- Delaram route into Afghanistan. Under this understanding, Iran will build a new transit route to connect Milak in the southeast of Iran to Zaranj inside Afghanistan including the Milak bridge over the Helmand river. For its part, India will build a new road connecting Zaranj to Delaram, which is on the main Herat-Kandahar road. These improvements will shorten the transit distance between Chabahar and Delaram by some 600–700 kilometers.

Also, India and Iran plan to build a railroad from Chabahar to the Iranian Central railway station on the railroad between Karachi and Tehran (and further west), and Iran will extend its railway to the port of Islam Qaleh. This will provide cheaper access to Chabahar and open up markets along the railroad and to Europe. In addition, Afghanistan was granted full access to the duty-free zone at the port of Chabahar. The Iranian authorities are also providing storage facilities and have permitted Afghan inspectors and trade representatives on-site. Port fees have been cut by 90 percent and warehousing and other charges by 50 percent; smaller cuts were granted for oil tankers.

Cross-Border Infrastructure

There is also a strong potential for regional cooperation in road transport and energy development.⁹⁰ Improved governance would remove corruption, which is a serious nontariff barrier to trade. Streamlining of customs and border procedures and improving the quality of information would foster regional trade. Regional cooperation in natural gas and/or natural gas-based power development and distribution has great potential. Iran and Turkmenistan are gas-rich, and the Kyrgyz Republic and Tajikistan have large hydroelectric potential. Pakistan may have a periodic power surplus. The possibilities for regional power trade include (i) the export of power from hydroelectric projects in Afghanistan; (ii) the resumption of exports of gas from Afghanistan; and (iii) exports of gas from Turkmenistan to India via Afghanistan and Pakistan and exports of power from Turkmenistan to Afghanistan. This Trans- Afghanistan Pipeline Initiative (TAPI) is a key regional cooperation project for which ADB is funding a feasibility study. This could eventually result in net revenues of $250 million per year to the Afghan government, but care must be taken to ensure that such benefits are realized in an agreed regulatory formula.

The same is true of the hydroelectricity potential. There is considerable scope for regional cooperation in water resource management, given that many rivers originate in the Afghan highlands and flow to neighboring countries. The headwater watersheds of the Indus and Amu Darya are located in the Northern highlands of Afghanistan. A beginning could be made with meteorological and hydrologic monitoring and data sharing.

The Joint Economic Commission between Pakistan and Afghanistan was reestablished in late August 2002, after a 10-year hiatus, following a meeting between the two countries' finance ministers. The ministers also discussed the Afghan Transit Trade Agreement (ATTA) and Pakistan's support in the establishment of banks, post offices and micro-credit facilities in Afghanistan.

The Economic Cooperation Organization (ECO – which comprises Iran, Pakistan, Afghanistan, Turkey as well as the 6 neighboring former Soviet Union countries: Azerbaijan, Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan and Uzbekistan)29 set up a fund to help rebuild Afghanistan following a meeting in Turkey in mid-October 2002.

Gender

According to the UNDP Human Development Report 1995,⁹⁰ Afghanistan's gender disparity index⁹¹ was the lowest in the world. Since 1994, all of these indicators seem to have worsened. For example, gross primary school enrollment ratio for female pupils was 32 percent in 1995 but declined to virtually zero by 2000, while the ratio for male pupils also declined from 64 percent to 29 percent during the same period (see Appendix 3, "Economic and Social Statistics"). A 2002 UN report found that in the 1990s, women and girls continued to have restricted access to services and employment except in teaching, medicine (doctors) and government work, and their rights to movement and freedom of association were limited.⁹²

Most of the IDPs were women who did not have access to health services. One of the key gender issues is a significant disparity in the lives and expectations of urban and rural women, and there is an important role for education and cultural sensitivity in effecting change. The history of Afghan women's emancipation can be traced back to the 1920s: by the late 1970s, Afghan women enjoyed considerable freedom of movement, educational opportunities and a relatively wide range of career choices, but there were strong contrasts with the positions of rural and uneducated women. Perhaps the single biggest failure of past development efforts was the widening gap between the cultural outlook of the urban elite and that of the rural masses.⁹³ This gender bias appears to persist, particularly outside Kabul.

The experience of war and displacement has had a profound impact on Afghan women over the past 25 years. As a result of widowhood and displacement, more households are now headed by women, while the absence of men for long periods to fight led women to take on new areas of responsibility. In addition, exposure to refugee camp health care facilities, and to education and vocational skills training, has led to changed attitudes and aspirations. It is of critical importance that agencies do not ‘reinvent the wheel', but take care to build on existing foundations. Significant numbers of women both served or were employed in existing health services, even under the Taliban regime. Energy should be focused on scaling-up investment and training of personnel in this sector as well as others and on ensuring the widest possible coverage in rural areas. The same applies to education and the civil service.⁹⁴ All three sectors traditionally employed large numbers of women and, therefore, it is important to build upon the broad acceptability that exists for women working there. Above all, through the new constitution, Afghan women must be considered as equal citizens to men. This was the state of affairs nearly 40 years ago as well as in the currently operational constitution. According to Gross, unless women's rights are protected in the constitution, any civil code of lesser authority would eventually be inadequate (Gross, 2003).

Environment

One of the critical environmental problems of Afghanistan is massive deforestation and overgrazing, which could be aggravated by the return of the refugees, especially if their livelihoods cannot be restored quickly and they employ environmentally unsound practices. Extensive deforestation took place during the hostilities of the past 20 years.

Large-scale movements of population and livestock since the late 1970s have put severe pressure on the environment, increasing deforestation and encroachment on protected parklands. More than 90 percent of rural households use wood as a source of energy. More than 40 percent of urban households use charcoal as a source of energy.⁹⁵ Forest cover has declined from 3.4 percent of total land area in the 1970s to 2.6 percent in 1991, 2.1 percent in 2000, and to less than 2 percent now. Deforestation has caused a degradation of watersheds, soil erosion, and desertification. Land degradation has also been caused by land mines, reducing access to agricultural land and irrigation. The country's 40 million hectares of pasture cover remains under threat.

Urbanization in Kabul, Herat, Mazar-i-Sharif, and Kandahar are taking place in an uncontrolled fashion. This process is making it virtually impossible for municipalities to plan for and provide even the most fundamental management of drainage, protection of groundwater supply and quality, household and commercial wastewater management, piped water supply, air pollution control, and urban zoning or land-use planning.

Certain regions of the country were subjected to intensive attacks with chemical weapons during the war with the Soviet Union. Between 1979 and 1981, chemical attacks reportedly killed more than 3,000 people. However, there is no information available as to the persistence of toxins in soil, vegetation, and animal tissues.⁹⁶

A UNEP report (February 2003) found that the environmental situation in Afghanistan is even worse than had been expected. Satellite imagery has revealed that 99 percent of the wetlands have dried up since 1998. The Helmand River, the main tributary of the wetlands which drain 31 percent of Afghanistan's land area, has run as much as 98 percent below its annual average in recent years. Four years of drought have compounded the problems caused by uncoordinated management of the river basin's dams and irrigation schemes during two decades of conflict. In the absence of a stable source of water, much of the natural vegetation of the Sistan basin has died or been collected for fuel. This has contributed to soil erosion and significant movements of sand onto roads and into settlements and irrigated areas. In central Afghanistan, the UNEP team found the national waterfowl and flamingo sanctuaries at Dasht-e-Nawar and Ab-e-Estada were completely dry.

At the regional level, Afghanistan must work harder with direct neighbors on water, forest and desertification issues. The report concludes that the collapse of local and national forms of governance during Afghanistan's two decades of conflict has been one of the main contributors to the environmental decline. It has also destroyed infrastructure, hindered agricultural activity and driven people into cities that were already lacking the most basic public amenities. The droughts have compounded a situation of lowered water tables, dried up wetlands, denuded forests, eroded land and depleted wildlife populations. And with 1.5 million refugees expected to return this year, the pressure on natural resources and environmental services will increase further. With the restoration of national-level governance, the country has an historic opportunity to create environmental laws and policies and build the capacity for the sustainable management of natural resources.

Other environmental issues include toxic residues from chemical warfare, the use of agrochemicals, and the degradation of wetlands. The approach to preservation and enhancement of the environment must be based on local traditional knowledge and people's participation. People need to have choices and the means to take rational decisions that are environmentally friendly. The costs of environmental degradation and the benefits from environmental preservation have to be made transparent. An appropriate policy and incentive framework would ensure that individuals and communities could contribute to sustainable development. Mainstreaming environmental concerns in all sector development projects would help to prevent actions threatening the environment and to put appropriate mitigation measures in place.

At the central and provincial level, one serious institutional problem is the involvement of 6 ministries in the management of water resources: MAAH; MIWRE; MMI; MWP, MRRD and MUD. In particular, the division of responsibilities between MAAH and MIWRE is unclear and not properly institutionalized. Forestry legislation has been in draft form for years, awaiting the clarification of tenure and land use rights of local tribes in many parts of the country. The lack of a legal framework clarifying tenure, user rights and oversight responsibilities, combined with the collapse of government institutions, has led to resource rents being controlled by local elites. A natural resource policy unit should be established in MAAH to ensure that policies, legislation and regulations are harmonized across sub-sectors. On the other hand, environmental concerns should be addressed through the enactment of an Environment Protection Act. MIWRE should prepare action plans for implementing environmental policies and strategies.

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