Introductory History of the Country

External Sector Developments

Trade

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

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

Trade statistics have not been published by the Afghan authorities since 1992-93. According to a survey sponsored by the World Bank,⁴³ Afghanistan's total trade in 2000 was estimated at $2.5 billion, comprising about $1.2 billion in imports and about $1.3 billion in exports. However, about 90 percent of the estimated total exports comprised re-exports, implying that indigenous exports fell significantly short of financing imports. The survey suggests that Pakistan was the main trading partner for Afghanistan, accounting for 47 percent of its direct and transit imports and receiving 88 percent of its exports. Iran was next, accounting for 46 percent of direct and transit imports and 11 percent of exports. It is believed that trade has fallen sharply since, with the exception of emergency food aid and other imports and perhaps exports of opium. The Afghanistan Interim Administration (AIA) and Islamic Transitional Government of Afghanistan (ITGA) have extended the Taliban-imposed ban on poppy cultivation and opium production and eliminated $8 billion worth of drugs, but the ban has been difficult to enforce and poppy cultivation has picked up once again.⁴⁴

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

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

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

Exchange Trade System⁴⁶

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

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

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

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

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

Balance of Payments⁴⁷

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

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

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

Aid Flows⁴⁸

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

Of the $1.84 billion in grant money disbursed by the end of March 2003, only $296 million or 16 percent, was provided directly to the government budget. The rest was provided to non-budgetary expenditures and donor-designated projects through the UN system and NGOs. The breakdown of donor fund usage is as in Table 1 below.

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

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

Source: AACA (April 2003)

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

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

Debt Sustainability⁵¹

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

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

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

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

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

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