Short to Medium Term Economic Prospects

The transitional government's control of the internal security situation is still tenuous in many regions outside Kabul, which hosts about 4,500 personnel of the International Security Assistance Force (ISAF) that is now led by NATO. The influence of local Afghan commanders is still dominant in many parts of the country. It is recognized at home and abroad that security and stability will remain problematic as long as local commanders retain their own armed forces. Remnants of Taliban and Al Qaeda still seem to be very much operational, as terrorist bombs have claimed many innocent civilian lives in Kabul, Kandahar, Jalalabad and elsewhere. Efforts are under way to establish the rule of law, bring provincial and local authorities under central control, build a national army and a police force and extend the tenure and expand the role of the ISAF.⁵⁶ The improvement of security conditions in much of the county is a prerequisite for effective reconstruction and inevitably for a sustained economic performance.

Collier and Hoeffler (2002) find that super-normal economic growth tends to be seen in post-conflict countries. This follows an inverted-U pattern and is typically at peak levels from the fourth to the seventh year of peace. Hence after the initial several years, a period of catch-up growth can be expected, which dissipates over time as the economy reverts to some longer-term growth rate. The delayed onset of relatively high economic growth after the conflict probably reflects the time it takes for business and investor confidence to be restored and for the institutional and infrastructural base of the economy to be rebuilt.

In the case of Afghanistan, there may be decent prospects for a strong economic recovery even in the short run, provided that certain preconditions on security, the government's continued commitment to sound economic management, and continued donor support are met. There are positive factors to contribute to a strong recovery. First, following a long war, a sharp rebound can be expected once investments start to flow in. In this regard, a new investment law has been adopted and the Afghan Investment Support Agency was opened in August 2003. Second, while the return of large numbers of Afghan refugees puts an added burden on the urban infrastructure and environment, they bring with them essential skills and entrepreneurship. Third, reconstruction activities will generate substantial demand and provide business opportunities.⁵⁷ As seen in the previous section, FY2002/03 has seen a strong rebound at a very high estimated real growth rate. If the above preconditions are met, economic growth in the period 2003-2005 could be above 10 percent.

However, it is very difficult at this stage to predict with any degree of confidence what the macroeconomic picture will look like in the medium run, especially given the uncertainties over many noneconomic factors such as security, institutional capacity and overall governance of the central and local authorities. Projecting economic performance for any further than the next few years would require simulations under scenarios with varied assumptions on key parameters. The following scenario simulations should therefore be taken as only indicative.⁵⁸

Simulation Model and Assumptions

A spreadsheet based simple simulation model is used here. It has two components: (i) a minimal macroeconomic framework with the US dollar as an accounting unit, used to project GDP growth over the period 2003-2010 based on estimated GDP and its composition for 2002, and the evolution of sectoral growth elasticity during the projection period, and (ii) a sub-model to project future growth of exports and revenue based on their estimated current levels and future export and revenue elasticities relative to GDP. No attempt was made to model monetary variables such as exchange rates and domestic inflation. Under the current situation of scarcity in reliable macroeconomic data and uncertain relationships between real and monetary variables, a sophisticated modeling exercise seemed premature.

GDP for 2002 is taken to be $4.05 billion as estimated by CSO (Table A3.1). With the estimated population of 21.8 million, per capita GDP in 2002 is about $186.⁵⁹ The 2002 GDP is assumed to be composed of 52 percent agriculture, 24 percent industry and 24 percent services as in the CSO estimate. Macroeconomic projections are based on assumed growth elasticity by sector and exogenously derived agricultural growth rates that would be realized should the government's prioritized investment plan carry through with donor support. Agricultural growth rates and assumed elasticity give the rate of GDP growth from which growth rates of other sectors are determined by applying sector-specific elasticity. The value added of the industry sector and electricity and gas sub-sectors were calculated as residuals to close the model. The elasticity estimates were derived from fragmentary historical data for Afghanistan and the post-conflict experiences of comparable countries. Adjustments to future elasticity were made on the basis of experiences of other countries as well as likely structural changes of the Afghan economy. While GDP growth will be driven mainly by agricultural sector, growth elasticity for industry and services would be much higher than agriculture and the economy would transform gradually away from the current high share of agriculture in total value added.

Strong Growth Scenario (I)

Two growth scenarios are explored to simulate economic performance in the medium run: a strong economic growth scenario and a moderate growth scenario. Under both scenarios, rapid transformation of the economy is envisaged. However, for the strong growth scenario, the macroeconomic scenarios chosen below assume: (i) a reasonable improvement in the security situation, (ii) the government's firm adherence to sound economic management, and (iii) reasonable progress in revenue streamlining and centralization. In 2004, there will be a democratically elected government and the political environment should be conducive to sound economic management and private sector investment activities.

The strong growth scenario is based on agricultural growth of 7 percent in 2003, 6 percent in 2004, 5 percent in 2005, and 4 percent per annum in 2006-2010. By 2010, GDP composition is projected to change to 28 percent agriculture, 36 percent industry, and 36 percent services. This scenario translates into the GDP growth rates of 21 percent in 2003, 18 percent in 2004, 15 percent in 2005 and 10 percent in 2006-2010. The economy rebounds beyond the 1998 level (estimated at $6.74 billion) by 2005. This quick rebound in the first few years is not unrealistic, considering the current devastated economic base. While a direct comparison is not warranted, Timor- Leste's economy is estimated to have grown over 15 percent in the two immediate post-conflict years. The assumed long-run growth rate is higher than the experience of Cambodia, whose economy has grown at 5-6 percent during the 1990s and early 2000s. Compared with Cambodia, which lost a large portion of its productive human capital during the conflict years, Afghanistan may be in a relatively advantageous position, as it has human resources, especially returning Afghans, ready to contribute to economic development. Historically, the Afghans were skilled in trade and commerce, which they were able to conduct often under very adverse circumstances. There are strong signs of a quick revival of these activities. The initial growth would also be accompanied by industrial growth led by infrastructure rehabilitation, construction materials production, and accelerated growth of the services sector. After the rebound period, as the investment environment gradually improves, the medium-to-longterm growth would be led by manufacturing and mining sub-sectors, induced by improved infrastructure, foreign direct investments, and domestic assets, increasingly emerging and utilized for investment, and continued growth of the services sector.

Official exports (excluding re-exports) are estimated at $100 million in 2002.⁶⁰ Considering the significant level of unofficial trade flows evidenced elsewhere, it is assumed that total indigenous exports (excluding re-exports) could be about $200 million in 2002 under both scenarios, still only 4.9 percent of GDP. Under strong growth, export elasticity with respect to GDP is assumed to start from 2.5 in 2003 and gradually decline, leveling off at 1.5 during 2006-2010.⁶¹ This translates into exports growing gradually toward 13.6 percent of GDP in 2010. It should be noted that the assumed pace of export growth is far milder than what Cambodia actually experienced: its exports went from 6 percent of GDP in 1990 to around 20 percent in the mid- 1990s, and then exceeded 40 percent in 2001.⁶²

In Afghanistan's ordinary budget, general government revenues are estimated at $132 million for FY2002/03 and $200 million for FY2003/04. These amount to only 3.3 percent and 4.1 percent of GDP, respectively. Under strong economic growth, the elasticity of revenue collection with respect to GDP is assumed to be 2.2 in 2003 and 2004, 2.4 in 2005 and to decrease to 1.8 during 2006-2010. It is assumed that revenue collection will be fully centralized well before 2010 as the newly elected government in 2004 starts to gain fiscal control in the provinces. This translates into revenue growing from 3.3 percent of GDP in 2002 and 4.1 percent in 2003, and gradually increasing to 10.6 percent in 2010. The scenario here is comparable to Cambodia's experience: 3.5 percent in 1990, 8.4 percent in 1995, and 11 percent in 2000.⁶³

Moderate Growth Scenario (II)

The moderate scenario assumes: (i) a reasonable improvement in the security situation, but (ii) modest economic management performance; and (iii) a slower streamlining of revenue collection.

In this scenario, agricultural growth is assumed to be slower than in the strong growth scenario, at 4.0 percent in 2003, 3.0 percent in 2004, and 2.5 percent annually thereafter. Therefore, the transformation away from the agriculture dependence is slower. By 2010, GDP will be composed of 36 percent agriculture, 29 percent industry and 35 percent services. This scenario translates into GDP growth rates of 12.1 percent in 2003, 9.1 percent in 2004, 7.6 percent in 2005, and 6.3 percent a year thereafter.

In essence, this scenario assumes a slow pickup of the economy from the current devastated state (i.e. a slow supply response to the reconstruction investments) and a slow revival of domestic demand. Moderate growth of the type projected is possible only if exports are emphasized. Therefore, export elasticity is assumed to start from 4.0 in 2003 and gradually decline, leveling off at 2.0 during 2006-2010, which is equivalent to the estimated elasticity in the early 1990s. This translates into exports growing gradually toward 12 percent of GDP in 2010, a figure still lower than under the strong growth scenario. Correspondingly, revenue collection is assumed to respond to GDP growth more rapidly, with an elasticity of 3.6 in 2003, 3.0 in 2004, 3.0 in 2005, and to gradually decrease to 2.0 by 2010. This translates into revenue growing from 3.3 percent of GDP in 2002 and 4.4 percent in 2003, and gradually increasing to 7.2 percent in 2010. The scenario here is more conservative than Cambodia's experience: 3.5 percent in 1990, 8.4 percent in 1995, and 11 percent in 2000. Table 2 provides the two macro scenarios discussed in this section, while Tables 3 and 4 provide the parameters underpinning the two scenarios.

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