Reconstructing AFGHANISTAN

Adam Bennett, Editor Bruno de Schaetzen Louis Dicks-Mireaux Felix Fischer Thierry Kalfon Ron van Rooden

International Monetary Fund

Production: IMF Multimedia Services Division Cover design: Massoud Etemadi Figures: Theodore F. Peters, Jr. Typesetting: Alicia Etchebarne-Bourdin

Cataloging-in-Publication Data

Reconstructing Afghanistan/Adam Bennett, editor—[Washington, D.C.]: International Monetary Fund, 2004. p. cm. Includes bibliographical references. ISBN 1-58906-324-4 1. Afghanistan—Economic policy. 2. Afghanistan—Economic conditions. 3. Fiscal policy— Afghanistan. 4. Monetary policy—Afghanistan. I. Bennett, Adam. HC417.R43 2004

Mackenzie, G.A. (George A.), 1950–

Price: US$25.00

Please send orders to:

International Monetary Fund, Publication Services 700 19th Street, N.W., Washington, D.C. 20431, USA Tel.: (202) 623-7430 • Telefax: (202) 623-7201 E-mail: [email protected] Internet: http://www.imf.org

©International Monetary Fund. Not for Redistribution Contents

Preface vii

List of Acronyms ix

Map x

1. Overview Ron van Rooden 1 The Political Landscape1 Coordination of Assistance1 Role of the IMF2 Economic Developments and Achievements3 Looking Ahead5

2. Recent Macroeconomic Developments Ron van Rooden and Louis Dicks-Mireaux 6 Comparison of Donor Assistance6 Output and Prices9 External Sector 12 Appendix 2.1. Poppy Dimension in the Afghan Economy 20 References 27

3. Fiscal Framework and the Budget Thierry Kalfon 28 A Slow Descent into Chaos 28 Dismal Situation but Resilient Structures 29 Reconstruction Strategy 31 Fiscal Policy Framework: Postconflict Budgeting 34 Appendix 3.1. Programs of the National Development Framework 42 Appendix 3.2. Comparing Afghanistan’s 2002/03 Operating Budget with Low-Income Countries’ Budgets 45 References 46

4. Structural Reforms: Revitalizing Fiscal Institutions Thierry Kalfon 47

Improving Public Expenditure Management 47 Reforming Revenue Policy and Administration 50 Revitalizing the Civil Service 52 Developing the Private Sector: Building a Market-Led Economy 54

iii

©International Monetary Fund. Not for Redistribution CONTENTS

Appendix 4.1. Pay Structure for Government Staff and Tax Summary 55

5. Monetary and Exchange Rate Policy in a Postconflict Environment Ron van Rooden and Louis Dicks-Mireaux 59 Choice of Currency 60 Preconditions for a Successful Monetary Policy 62 Fixed or Flexible: Choosing the Exchange Rate Regime 64 Formulating a Monetary Program 66 Monetary and Exchange Rate Developments in 2002–04 69 Reference 71

6. Financial Sector Development in Afghanistan: Seeking a Renaissance Felix Fischer 72 After the Taliban: Financial System at the End of 2001 72 Modernizing the Financial Sector in Afghanistan 77 References 82

Text Boxes 1.1 Asian Development Bank in Afghanistan4 1.2 World Bank in Afghanistan5 2.1 Social Indicators7 2.2 Trade, Transit, and Transport Agreements 18 2.3 Exchange and Trade Arrangements 19 3.1 Public Sector and The Relationship Between the Center and Provinces 30 3.2 UN Immediate and Transitional Assistance Programs, 2001–02 32 3.3 Afghanistan Reconstruction Trust Fund 39 5.1 Introducing the New Currency 61 5.2 What Is the Right Exchange Rate Level? 65 5.3 Foreign Exchange Auctions 67 5.4 Considerations on the Level of Foreign Exchange Reserves 70 6.1 The Law on Money and Banking of the Islamic State of Afghanistan 74 6.2 Physical Infrastructure and Security of Da Afghanistan Bank 75 6.3 Six Licensed Banks in Afghanistan 76 6.4 Money Dealers in Afghanistan 78

Text Tables 2.1 Gross Domestic Product 10 2.2 Selected Indicators of Economic Activity 10 2.3 Balance of Payments 13 2.4 Direction of Trade 1 14 2.5 Direction of Trade 2 16 2.6 Commodity Composition of Trade 17 3.1 General Government Current Budget, 2002/03 36 3.2 Budget Execution, Center and Provinces, 2002/03 37 3.3 Operating Budget, 2003/04 41 3.4 Development Budget, 2003/04 42 5.1 Monetary Developments (Da Afghanistan Bank) 68

©International Monetary Fund. Not for Redistribution Contents

Figures 2.1 Foreign Assistance to Postconflict Countries8 2.2 Price and Exchange Rate Developments 11 3.1 National Development Framework: Relationship Between Pillars, National Development Programs, and National Priority Subprograms 33 3.2 Budget Execution: Economic Classification, 2002/03 38 3.3 Budget Execution: Functional Classification, 2002/03 38 5.1 Exchange Rates 71

Appendix Box A4.1 Civil Servant Salaries 56

Appendix Tables A2.1 Indicators of Opium Cultivation 21 A2.2 Estimate of Farmers’ Net Income from Opium 23 A2.3 Revenues from Opiates 26 A3.1 Afghanistan’s 2002/03 Budget Compared with Budgets of Selected Low-Income Countries 44 A3.2 Sample of Low-Income Countries Used for Comparison 45 A4.1 Tax Summary 57

The following symbols have been used throughout this paper: . . . to indicate that data are not available; — to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist; – between years or months (for example, 2002–03 or January–June) to indicate the years or months covered, including the beginning and ending years or months; / between years (for example, 2002/03) to indicate a crop or fiscal (financial) year. “Billion” means a thousand million. Minor discrepancies between constituent figures and totals are due to rounding. The term “country,” as used in this paper, does not in all cases refer to a territorial entity that is a state as understood by international law and practice; the term also covers some territorial entities that are not states, but for which statistical data are maintained and provided internationally on a separate and independent basis.

©International Monetary Fund. Not for Redistribution This page intentionally left blank

©International Monetary Fund. Not for Redistribution Preface

his study was prepared by an IMF staff team headed by Adam Bennett. Team T members included Louis Dicks-Mireaux, Felix Fischer, Thierry Kalfon, Ron van Rooden, and Bruno de Schaetzen. Reconstructing Afghanistan reflects the staff’s work in Afghanistan beginning in early 2002, with the establishment of the interim administration headed by President Hamid Karzai, through the first quarter of 2004. During this period, the staff focused on helping (often under difficult circumstances) the Afghan authorities quickly establish a basic framework for economic management and policies, including rebuilding key institutions, notably the Ministry of Fi- nance and the central bank, Da Afghanistan Bank. A preliminary version of this study was first published during the Annual Meetings of the IMF and the World Bank in Dubai in the fall of 2003, in the context of the IMF’s 2003 Article IV Con- sultation with Afghanistan. The authors are grateful for the excellent cooperation received from the Afghan authorities. In particular, our thanks go to Ashraf Ghani, Minister of Finance of Afghanistan (2002–04); Anwar Ul-Haq Ahady, Governor of Da Afghanistan Bank (2002–04); and Michael Carnahan, Larry Seale, and Martin Dinning, three key advisors in the Ministry of Finance and the central bank. The authors are also grateful to the United Nations Office on Drugs and Crime, which provided valuable information on and useful insights into the illicit drug sector in Afghanistan. The study covers the key areas in which the IMF staff has made important contributions toward the reconstruction of Afghanistan. In this regard, the authors would like to acknowledge the work of Paul Chabrier, Jean Le Dem, and Milan Zavadjil, who respectively led the staff team before Adam Bennett took over in the spring of 2003. The authors also acknowledge the work of the staff members of the IMF’s functional departments who have provided technical assistance to the Afghan authorities in their various areas of expertise, especially Steven Symansky and Emil Sunley of the IMF’s Fiscal Affairs De- partment, Ake Lönnberg of the Monetary and Financial Systems Department, Tobias Asser of the Legal Department, and Adriaan Bloem and Vilay Soulatha of the Statis- tics Department. The authors are also grateful for helpful comments and suggestions received from our colleagues in the IMF’s Middle East and Central Asia Department, especially George Abed and Mohammad Shadman-Valavi. The authors are indebted to Sheila Tomilloso for providing invaluable secretarial assistance, both at the IMF headquarters in Washington and in Kabul, and to Archana Kumar of the IMF’s Exter- nal Relations Department for editing this book and coordinating its publication. The views expressed here are those of the authors and do not necessarily reflect those of the IMF, its Executive Directors, or the Afghan authorities.

vii

©International Monetary Fund. Not for Redistribution This page intentionally left blank

©International Monetary Fund. Not for Redistribution List of Acronyms

AACA Afghan Aid Coordination Agency AFMIS Afghanistan’s Financial Management Information System AIA Afghan Interim Administration AIAF Afghan Interim Administration Fund ARCSC Administrative Reform and Civil Service Commission ARTF Afghanistan Reconstruction Trust Fund AsDB Asian Development Bank ATA Afghan Transitional Administration CG Consultative Group CIRR Commercial Interest Reference Rates CIT Corporate income tax CSO Central Statistics Office DAB Da Afghanistan Bank ECO Economic Cooperation Organization FAO Food and Agriculture Organization GMU Grant Management Unit IAS International Accounting Standards ICMP Illicit Crop Monitoring Program IDA International Development Association IG Implementation Group ISAF International Security Assistance Force IsDB Islamic Development Bank ITAPs Immediate and Transitional Assistance Programs LOTFA Law and Order Trust Fund for Afghanistan LTU Large taxpayer unit MoF Ministry of Finance NCR National Cash Registry NDB National Development Budget NDF National Development Framework PRGF Poverty Reduction and Growth Facility PIT Personal income tax RTGS Real time gross settlement SG Steering Group SOEs State-owned enterprises TAPAs Transitional Assistance Programs for Afghanistan TIN Taxpayer identification number USAID United States Agency for International Development UNDCP United Nations International Drug Control Program UNDP United Nations Development Program UNODC United Nations Office on Drugs and Crime WFP World Food Program

©International Monetary Fund. Not for Redistribution ©International Monetary Fund. Not for Redistribution Source: United Nations: Management Service. Afghanistan Information

x 1

Overview

Ron van Rooden

fter more than two decades of conflict, a new An Afghan Interim Administration (AIA) was A opportunity emerged for the peaceful develop- appointed and governed for six months until an ment of Afghanistan when the Taliban regime fell Emergency Loya Jirga (grand council) of some 1,500 in late 2001 and a political agreement was reached delegates could be convened in June 2002. The Loya between the various Afghan factions in Bonn in De- Jirga chose a new Afghan Transitional Administra- cember of the same year. The years of fighting had tion (ATA), headed by President Karzai, that was started with the former Soviet Union’s intervention scheduled to remain in office for two years. The ATA in Afghanistan in December 1979 to support the was charged with preparing a new constitution and communist regime that had taken power in a mili- holding free and fair elections to elect a fully repre- tary coup in the previous year. The following 10 sentative government. Following broad consultation years saw fierce fighting, until the Soviet forces with the Afghan people, a new constitution was withdrew in 1989. In 1992, the Mujahedin took adopted by a Constitutional Loya Jirga in late 2003, over Kabul and installed a new government. How- and signed into law in January 2004. Presidential ever, much of the country remained under the con- elections were held in October 2004—a little over trol of local warlords and it was in response to the two years after the convening of the Emergency Loya growing lawlessness and increased factional fighting Jirga. This was a challenging task, made even more that the Taliban movement emerged. The Taliban difficult by the logistical and security concerns, in- took over Kabul in 1996, following heavy fighting cluding the need to establish a register of voters. The between the various factions that left much of the United Nations worked closely with the Afghan au- city destroyed, and eventually controlled almost 90 thorities to prepare for this major undertaking. percent of the country. They made little effort, however, to form a functioning civilian government or provide adequate public services. The U.S.-led mili- Coordination of Assistance tary intervention in Afghanistan, following the tragic events of September 11, 2001, resulted in the The enormous task of rebuilding Afghanistan has collapse of the Taliban regime in late 2001 and the required the strong support of the international formation of a new government. community. Even before the AIA came to office, the international community had organized a number of meetings on Afghanistan’s reconstruction, The Political Landscape starting in the fall of 2001. This included the creation of a Steering Group (SG)—cochaired by the The 2001 Bonn agreement provided a road map United States, Japan, Saudi Arabia, and the Euro- for the creation of a peaceful, democratic state. pean Union—of donor governments to enhance in-

©International Monetary Fund. Not for Redistribution OVERVIEW

ternational political support for the reconstruction Role of the IMF process and provide strategic guidance. In Novem- ber 2001, the SG requested the World Bank, the Starting in January 2002, at the request of the Asian Development Bank (AsDB), and the United Afghan authorities, the IMF began to provide ex- Nations Development Program (UNDP) to produce tensive policy advice and technical assistance in its a preliminary needs assessment for Afghanistan’s re- areas of expertise.1 The focus of this assistance was construction. This assessment was presented at the on ensuring the early establishment of sound foun- International Conference on Reconstruction Assis- dations for economic management and macro- tance to Afghanistan in Tokyo in January 2002. The economic stability in order to support a sustained conference generated pledges of assistance for economic recovery and facilitate the process of re- Afghanistan’s reconstruction totaling $4.5 billion, construction. This assistance included helping the with $1.8 billion in pledges for the first year. The authorities to rehabilitate key economic institu- Afghan government presented an updated needs tions, in particular the Ministry of Finance (MoF) assessment at a donors’ conference held in Berlin in and the central bank, Da Afghanistan Bank (DAB). March 2004. This conference generated pledges to- The IMF Fiscal Affairs Department has focused on taling $8.2 billion in support for the period March improving expenditure management and the tax 2004–March 2007, including pledges of $4.4 billion system. The IMF Monetary and Financial Systems for the period March 2004–March 2005. Department assisted with the introduction of the In the two years that followed the establishment of new currency, central bank modernization, and, to- the AIA, the leadership and ownership of the recon- gether with the IMF Legal Department, the prepara- struction process were steadily transferred to the tion of new financial sector legislation. The IMF Afghan authorities. In early 2002, an Implementa- Statistics Department provided assistance on a new tion Group (IG) was established, chaired by the gov- framework for macroeconomic statistics. In addi- ernment and with the AsDB, the UNDP, the Islamic tion, a staff team from the IMF’s Middle East and Development Bank (IsDB), and the World Bank as Central Asia, Fiscal Affairs, and Policy Develop- vice-chairs, to facilitate the coordination of assis- ment and Review Departments assisted the authori- tance. The Implementation Group meetings were ties in developing a macroeconomic framework to held in Kabul in March and September of 2002. The guide economic decision making aimed at achieving SG/IG structure evolved in early 2003 into a normal a sustainable, noninflationary recovery. Policy ad- Consultative Group (CG) mechanism and the first vice centered on issues crucial to a quick restoration major CG meetings—Afghanistan Development of macroeconomic stability, including the formula- Forum and Afghanistan High-Level Strategic tion and execution of fiscal policy, the choice of cur- Forum—were held in March 2003 in Kabul and Brus- rency arrangement, and the design and conduct of sels, respectively. monetary policy. In early 2004, the authorities re- The authorities strengthened their responsibility quested closer involvement from the IMF and an to coordinate and manage the reconstruction effort agreement was reached on a staff-monitored pro- by adopting a National Development Framework gram (SMP), which provided a more detailed frame- (NDF) in 2002. The NDF focused on three pillars of work for economic policies for 2004/05. The main development: (1) security and human development; objectives of the SMP were to maintain macro- (2) rebuilding physical infrastructure; and (3) en- economic stability and strengthen Afghanistan’s in- abling the creation of a viable private sector as stitutional and administrative capacity to implement the engine for sustainable and inclusive economic policies. The SMP was announced in the context of growth. For each of these pillars, broad sectoral pro- the donors’ conference in Berlin in March 2004.2 grams have been developed, and individual CGs, which provide the framework for identifying and se- lecting individual projects within the overall resource envelope, have been established. This process 1In August 2002, the IMF opened a resident representative office in Kabul, and in February 2003, Afghanistan cleared its culminated in the creation of the National Develop- arrears to the IMF. ment Budget (NDB), which translated the broad pri- 2The SMP is described in the Afghan government’s Memoran- orities and programs of the NDF into detailed and dum of Economic and Financial Policies, which was posted on the IMF’s website on March 24, 2004. The IMF Staff Report on the prioritized development projects that are to be SMP was also posted on the IMF’s website (www.imf.org/External/ funded through the budget. NP/LOI/2004/afg/01) on April 16, 2004.

©International Monetary Fund. Not for Redistribution Economic Developments and Achievements

Economic Developments and countries suggests that aid flows to Afghanistan Achievements during 2002 and 2003 were relatively low. Disburse- ments were high compared with pledged amounts, From the outset, the Afghan authorities proved but pledges were low compared with actual needs. strongly committed to achieving financial stability Putting the country back on its own feet will con- and maintaining fiscal discipline to support the re- tinue to require sizable international assistance over construction and recovery of the economy. They the next several years. This assistance will need to be also sought to establish transparency in government overwhelmingly in the form of grants to avoid possi- operations and to improve economic management. ble future debt-servicing difficulties. The economy would be based on liberal and open Chapter 3 traces the formulation and implemen- markets, led by private sector activity with low state tation of the government’s budgetary policy. intervention. Also, the external trade, payments, Afghanistan’s fiscal policy, as embodied by the and exchange systems would be open and liberal; 2002/03 and 2003/04 operating and development and private sector investment would be promoted. budgets, was characterized by a strong commitment In their efforts to achieve all these goals, the author- to respect fiscal discipline and refrain from mone- ities received the support of the IMF, the AsDB tary financing (the “no-overdraft rule”); the (Box 1.1), the World Bank (Box 1.2), various UN 2002/03 budget financing gap was entirely covered agencies, and numerous bilateral donors. This book by donor support and the 2003/04 budget was based provides an overview of the institutional and eco- on the same principle. In 2002/03, expenditures are nomic achievements in Afghanistan from late 2001 estimated to have reached $349 million—mostly to early 2004. for government salaries, including those of the Chapter 2 describes the strong economic recovery provinces, and for the security and social sectors— that took place during 2002 and 2003. Economic while domestic revenues turned out much higher growth, excluding opium production, is estimated to than expected, at $132 million. The execution of have reached almost 30 percent in 2002/03 and to the 2002/03 budget was, however, seriously ham- have continued at a rate of about 16 percent in pered by the breakdown of the fiscal system. Only a 2003/04.3 This recovery was most visible in agricul- very small amount of the locally collected revenues ture, reflecting the end of prolonged drought, and in were transferred to the center, and little information the construction and services sectors. Per capita was available on provincial nonwage expenditures. GDP is estimated to have reached about $200 in The 2003/04 operating budget adopted in March 2003/04 (although it was still one of the lowest lev- 2003 constituted a major improvement in proce- els in the world). dures compared with the previous year. It envisaged As the formal economy recovered, so did the pro- a considerable increase in government expenditures, duction of opium. This has had a profound impact to $550 million, with the increase concentrated in on the economy, with the share of the opium sector the security and education sectors. It also targeted a in the economy estimated to be about half. The ban sharp rise in domestic revenues, to $200 million. In on poppy cultivation imposed by the Taliban in the event, expenditures are estimated to have 2000 was very successful, but opium production reached $451 million in 2003/04, while domestic re- quickly returned to the levels of the late 1990s. sources are estimated to have reached $207 million. Apart from improved weather conditions and an in- The $1.8 billion development budget of 2003/04 crease in area under cultivation, the reemergence of provided a program of both reconstruction and hu- poppy cultivation reflected the lack of alternative manitarian projects, whose outcome would depend livelihoods and the limited control of the central on the availability of donor support and the authori- government beyond Kabul. ties’ implementation capacities. Although donor assistance has been sizable, a com- Chapter 4 offers more detail on the progress made parison of aid levels with other recent postconflict in rebuilding fiscal institutions. The biggest strides were made in improving expenditure management—the area where it was most needed, so the 3Afghan solar year 1381 ran from March 21, 2002, until March government could execute the budget and provide a 20, 2003, while the solar year 1382 ran from March 21, 2003, still very basic level of public services to the popula- until March 19, 2004. The fiscal calendar runs according to the solar year. The solar year 1381 corresponds to the fiscal year tion. The authorities also made progress toward 2002/03. fiscal transparency and accountability. Difficulties

©International Monetary Fund. Not for Redistribution OVERVIEW

Box 1.1. Asian Development Bank in Afghanistan

Afghanistan was a founding member of the Asian gram Loan ($150 million), approved on December 4, Development Bank (AsDB) in 1966. By the time of 2002, and an Emergency Infrastructure Rehabilitation the Soviet occupation in 1979 and the suspension of and Reconstruction Project (EIRRP) Loan ($150 mil- AsDB operations, Afghanistan had received nine lion), approved on June 3, 2003. The EIRRP is assisting loans from the Asian Development Fund (ADF) to- the government in restoring key infrastructure in taling $95.1 million and grant technical assistance Afghanistan’s transport (roads) and energy (electric (TA) totaling $2.5 million. power and gas) sectors. The AsDB resumed operations when the Afghanistan The AsDB approved a Country Strategy and Pro- Interim Administration was installed in December gram Update (CSPU) for Afghanistan in June 2003 2001. Since then, it has been substantially engaged in for 2003–05, for which $610 million was earmarked. assisting Afghanistan. During 2002, AsDB provided The CSPU covered three broad sectors: (1) trans- $15 million in capacity-building technical assistance portation (roads and civil aviation); (2) energy grants, and administered a further $22 million in grant- (power, gas, and petroleum); and (3) natural resources funded pilot projects from the Japan Fund for Poverty (agriculture, irrigation, and environment). Some $10 Reduction (JFPR). In 2003, AsDB planned to provide million per year in technical assistance is planned in an additional $10 million in capacity-building TA various areas during 2003–05. grants, and $43 million in grants from JFPR and the Kuwait Fund for Arab Economic Development. All these loans were concessional, with a grant ele- Through September 2003, the AsDB had committed a ment equivalent to about 60 percent and principal re- total of $300 million in a Postconflict Multisector Pro- payment starting only in 2013.

remained in fiscal management of the provinces, but difficult endeavor sooner than many had thought efforts were made to increase the central govern- possible. The introduction of the new currency was ment’s control over provincial finances. These a crucial step in the authorities’ efforts to establish efforts were rewarded and significant amounts of financial stability. revenues collected by the provinces were transferred At the same time, the central bank needed a to the center in 2003/04. framework to conduct an independent monetary After improving financial management, the policy. The authorities decided that the primary ob- focus of reform shifted toward increasing revenue jective of monetary policy should be to achieve and mobilization, with the objective that the operating maintain price stability and thus to instill confi- budget should eventually be fully financed from do- dence in the new national currency. To do so, the mestic revenues. To achieve this, the authorities central bank aimed to control the domestic money embarked on a comprehensive reform of customs supply, within the context of a floating exchange policy and administration, as well as a reform of tax rate regime. While Afghanistan’s existing economic policy and administration. Only limited progress conditions favored a floating exchange rate regime, was made in the difficult area of civil service re- the authorities nonetheless saw benefits in at least form, while the restructuring of the state-owned some degree of exchange rate stability to instill con- enterprise (SOE) sector had yet to begin. fidence in the new currency and to support price Chapter 5 provides an overview of the chal- stability. Therefore, following the introduction and lenges and issues that the authorities faced in the float of the new currency in early 2003, DAB aimed area of monetary and exchange rate policy. To re- to limit exchange rate volatility and keep the ex- gain control over the issuance of money, the au- change rate within a range, but without intending thorities decided early on to introduce a new na- to resist persistent exchange rate pressures should tional currency, which would also be an important these have emerged. Monetary policy was re- symbol of national unity and sovereignty. Replac- strained, supported by the no-overdraft rule for the ing all banknotes in a postconflict country such as budget. As a result, inflation remained low in 2003 Afghanistan within a fairly short period posed and early 2004. Moreover, in the absence of any tremendous logistical challenges. Nevertheless, major shocks, exchange rate stability was estab- after some initial problems that led to a spike in in- lished with the exchange rate fluctuating at about flation in the fall of 2002, they succeeded in this Af 48 per U.S. dollar.

©International Monetary Fund. Not for Redistribution Looking Ahead

The renaissance of the financial sector will be vital to Afghanistan’s economic development. Chapter 6 describes the parlous state the financial sector had reached by the end of the Taliban period, Box 1.2. World Bank in Afghanistan and the progress that was made during 2002 and Following the end of the Taliban era, the World 2003. The central bank had inherited the legacy of Bank quickly resumed its long-standing relation- Soviet-style banking and its sole function had be- ship with Afghanistan, and in May 2002, it offi- come to print money to cover budget deficits. The cially reopened its office in Kabul. Between April existing six commercial and development banks had 2002 and September 2003, the World Bank com- virtually ceased to function and they had lost the mitted $186.8 million in grants and an additional public’s confidence. With a dysfunctional banking $128.4 million in no-interest loans (“credits”) for system, money traders—that is, hawala service development projects that included improving roads; increasing the power supply in Kabul; clean- providers—had become the only providers of most ing up municipal waste; repairing schools; and im- banking services. During 2002 and 2003, the central proving health services. These funds are also being bank made important progress in restoring some key used to strengthen public administration, and de- functions, especially in the areas of monetary policy, velop the national highway and civil aviation. payments, and supervision. To underpin DAB’s In addition, the World Bank administered a transformation and to enable the entry of new com- number of activities financed through separate mercial banks, a new central bank law, which pro- trust fund facilities. These included projects vided DAB with autonomy, and a banking law were funded by a $50 million grant from the Japan So- enacted in September 2003. cial Development Fund (JSDF)—including community rehabilitation, local infrastructure development, and capacity building within the Ministry of Health. A number of projects were also funded Looking Ahead by the World Bank Post-Conflict Fund, including teacher training programs implemented by non- Overall, the Afghan authorities made solid governmental organizations (NGOs), technical progress in the two years since the Bonn Agreement assistance in key areas requested by government, in improving economic management and achieving early impact projects and technical assistance in a macroeconomic stability under very difficult cir- range of priority sectors, and a database of expatri- cumstances. Of course, difficulties and risks remain ate Afghan experts. The World Bank has also acted as the administrator of the multilaterally in a number of areas. Restoring security throughout supported Afghanistan Reconstruction Trust Fund the country remains a key priority. To a large extent, (ARTF), which is used to cover recurring govern- this has been achieved for Kabul and its immediate ment costs and salaries as well as finance a number surroundings with the help of the International Se- of new projects in areas such as microfinance, curity Assistance Force (ISAF), but the govern- telecommunications, and infrastructure. ment’s control over many regional areas is still very In March 2003, the World Bank finalized its limited. This situation complicates macroeconomic Transitional Support Strategy (TSS) for Afghan- management and prevents reconstruction from tak- istan, designed to support the government’s Na- ing place outside Kabul. Without security, and tional Development Framework. The TSS outlined progress in reconstruction, the country could be- the World Bank’s assistance to Afghanistan over come dominated by poppy cultivation, sending a period of 18 months to 2 years. The strategy Afghanistan back into a downward spiral of vio- focused on four key areas: improving livelihoods; assisting with the government’s fiscal strategy, lence and corruption. Another key priority is to institutional development, and management; maintain the engagement of the international com- supporting governance and public administration munity. This will be important both for the restora- reform; and helping to enable private sector devel- tion of security and the reconstruction process. opment in Afghanistan. The TSS envisaged opera- Donor support will continue to be needed for some tions amounting to $470 million over 2003/04 and time. It is to be hoped that the impressive progress 2004/05. in reconstructing Afghanistan over the past two years will serve to persuade the international community that its contribution has been, and will continue to be, more than worthwhile.

©International Monetary Fund. Not for Redistribution 2

Recent Macroeconomic Developments

Ron van Rooden and Louis Dicks-Mireaux

fghanistan is a landlocked, mountainous, and stopped functioning, which particularly affected A arid country, with considerable ethnic diversity. women and resulted in a dramatic decline in social Its population was estimated in 2003 at about 22 mil- indicators (see Box 2.1). In 1996, Afghanistan lion within its borders, and up to 25 million if all ranked 169 out of 174 countries in the UN’s Human refugees were to return. Afghanistan’s prewar econ- Development Index, and conditions deteriorated omy was mainly based on agriculture and animal further in the following years. The health situation husbandry; some light industry; and some natural re- was grim. Infant and under-five mortality was esti- sources, mainly gas and minerals. The country was mated by UN agencies to be among the highest in largely self-sufficient in food and was even an ex- the world in 2001, and malnutrition affected over porter of agricultural products. Agriculture was 50 percent of children under age five. The average largely concentrated in narrow river valleys and life expectancy was little more than 40 years. plains where irrigation water from snowmelt is avail- A new opportunity for the peaceful development able. Afghanistan experienced a modest degree of of Afghanistan emerged with the fall of the Taliban economic development until the late 1970s, when regime in late 2001 and the political agreement the country was still at peace. Modernization was reached between the various Afghan factions in largely concentrated in major cities, and government Bonn in December 2001. This chapter describes services had limited reach in rural areas. macroeconomic developments since then, as well as By the end of 2001, however, Afghanistan was a the main features of the country’s external sector. country ravaged by war and natural disasters. More The chapter opens with an overview of the large than two decades of conflict, as well as droughts and amounts of foreign assistance Afghanistan has re- earthquakes, had resulted in widespread destruction ceived so far, and without which the country would of Afghanistan’s social and economic structures, not be where it is today. But it also puts this assis- and human suffering. Most of the country’s infra- tance in a broader perspective, comparing it to the structure had been severely damaged and traditional levels of assistance received by other recent post- irrigation systems had greatly suffered from the de- conflict cases. struction and lack of maintenance. Agricultural production had collapsed, livestock herds had been depleted, and industries had ceased functioning. Most Comparison of Donor Assistance skilled professionals had fled the country. The breakdown of the state and civil society and the ero- Afghanistan’s reconstruction would not be possi- sion of institutions, both modern and traditional, ble without strong support, including financial assis- were similarly dramatic. Government services, in- tance, from the international community. At a cluding health care and education, had essentially donor meeting in November 2001, the World Bank,

©International Monetary Fund. Not for Redistribution Comparison of Donor Assistance

period, virtually all of these pledges were committed Box 2.1. Social Indicators and over $1.8 billion in grants were actually disbursed, plus $0.1 billion was disbursed in loans. Population (millions; 2002) 21.8 At a first glance, the size of disbursements during Life expectancy at birth (2001) 42.8 this period appears to have been well in line with Infant mortality per 1,000 live the pledges made by donors and with the prelimi- births (2001) 165 nary needs assessment. However, the needs assess- Under-five mortality per 1,000 live ment excluded humanitarian assistance, while the births (2001) 257 bulk of the disbursements went to meet humanitar- Children underweight (percent under ian needs. Aid flows targeted toward reconstruction age five; 1995–2001) 48 were only just beginning to gear up. To some extent, Undernourished people (percent of this pattern mirrored other recent postconflict cases population; 1998–2000) 70 and fitted reasonably well with the country’s early Adult literacy (percent age 15 and needs and capacity.1 In a typical postconflict case, above; 2001) 36 donors first strive to address the immediate humani- Male 51 tarian emergency, providing shelter to displaced Female 21 people and ensuring minimum levels of consump- Primary school enrollment ratio, gross tion to those unable to fend for themselves. This is (in percent; 1995–99) followed by reconstruction aid, as donors aim to re- Male 53 pair or rebuild the destroyed infrastructure and insti- Female 5 tutions and restore the provision of basic public ser- Population without sustainable access to an vices, such as security, health care, and education, improved water source (in percent; 2000) 87 which were disrupted by the conflict. The reconstruction aid typically takes longer to materialize be- Sources: Central Statistics Office (CSO) of Afghanis- cause it needs more preparation (e.g., feasibility tan; UNDP, Human Development Indicators (2003); studies, design, more complex procurement proce- UNICEF, The State of the World’s Children (2003); and dures, and so on) than humanitarian aid. Experi- World Bank, World Development Indicators (2003). ence shows that early attention to critical elements of infrastructure—primary roads and telecommunication—and capacity building within the govern- the Asian Development Bank, and the United Na- ment is crucial to get the reconstruction process tions Development Program were asked to produce going. Over time, as the reconstruction process gets a preliminary needs assessment for Afghanistan’s re- under way and institutions are restored, a country’s construction. These agencies presented their find- capacity to absorb reconstruction aid will quickly ings at the International Conference on Recon- increase. Donors and country authorities need to struction Assistance to Afghanistan held in Tokyo find the right balance between speed and capacity in January 2002. According to this assessment, to effectively absorb aid. But a country must also be- $14.6 billion would be needed over a period of 10 ware of donor fatigue. As has been observed in other years in external assistance to support Afghanistan’s postconflict cases, donor interest often declines economic and social recovery, excluding humanitar- sharply after a few years, just when a country’s ca- ian assistance, with requirements for the first year pacity to absorb reconstruction aid actually starts to estimated at $1.7 billion and, for the first two and a increase significantly. half years, at $4.9 billion. This assessment was well The level of foreign assistance that Afghanistan received by donors and the Tokyo conference gener- received through March 2003 appears to have been ated pledges totaling $4.5 billion for the first five on the low side compared with other recent post- years, but with most of these covering the first two conflict cases, particularly when looking at the level and a half years and $1.8 billion in pledges for the of aid per capita (Figure 2.1).2 Using a population first year. These amounts also included humanitarian assistance, however. Some additional pledges were made following the Tokyo conference: for the 1See Demekas, Kosma, and McHugh (2002). first 15 months (covering 2002 and the first quarter 2This was first pointed out by CARE International (2002). See of 2003), the grants totaled $2.1 billion. During that also Dobbins and others (2003).

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS

1994–96, received much less assistance than these Figure 2.1. Foreign Assistance to other countries, but still more than Afghanistan Postconflict Countries did in 2002–03. One could argue that the price level in places such as Bosnia and Herzegovina or West Bank and Gaza is much higher, so that $1 in 300 Aid per Capita (In U.S. dollars; annual averages) assistance “buys” less relief there than in 1995–97 1999–2001 250 Afghanistan. But this is only partly true, because 1994–2001 many items, including foreign staff, are procured 200 internationally. Moreover, the cost of transportation and providing adequate security for relief and 150 reconstruction efforts appear to be at least equally 100 1994–96 high, if not higher, in Afghanistan compared with 2002–031 other cases. 50 An alternative approach would be to compare levels of foreign assistance expressed in percent of 0 Afghanistan Bosnia Rwanda Timor- West Bank estimated GDP, although such estimates are highly and Leste and Gaza Herzegovina unreliable. However, according to available information, Afghanistan received close to 40 percent 80 of GDP in aid in 2002–03, which is similar to the Aid in Percent of GDP (Annual averages) percentage of GDP aid received by Bosnia and 70 Herzegovina during 1995–97, and much higher 1994–96 1999–2001 60 than the 13 percent that West Bank and Gaza re- 50 ceived during 1994–2001. On the other hand, aid 1995–97 40 2002–031 to Afghanistan expressed in percent of GDP remained below the ratio for Timor-Leste and 30 Rwanda, both of which averaged about 60 percent 20 1994–2001 per year during 1999–2001 and 1994–96, respec- 10 tively. One could argue that Afghanistan’s GDP 0 may be low, and thus the ratio of aid to GDP high, AfghanistanBosnia Rwanda Timor- West Bank and Leste and Gaza because the economy has been destroyed to a much Herzegovina greater extent than in the comparator countries. In Sources: Afghan authorities;World Bank, World Development Afghanistan, the fighting has been going on for Indicators (2003). over 20 years and has destroyed most of the coun- 1January 2002–March 2003. try’s economic capital, both human and physical. Bringing the country back to a level where it can successfully sustain itself will therefore require high levels of assistance and most likely for a longer pe- estimate of 22 million, the total amount of assis- riod of time. tance that Afghanistan received over the period All in all, it does appear that, through 2003, aid January 2002–March 2003 translated into $67 per flows to Afghanistan were relatively low compared capita per year. This is far less than the assistance re- with other recent postconflict cases. While disburse- ceived by Bosnia and Herzegovina, which was on ments were high compared with pledged amounts, average $249 per capita per year in aid during pledges were low by the standards of comparator 1995–97; Timor-Leste received $256 per capita per countries. It was therefore appropriate that the at- year during 1999–01; and West Bank and Gaza re- tention of the international community should have ceived $219 per capita per year during 1994–01.3 been refocused on Afghanistan in the context of the Rwanda, with $98 per capita per year in aid during Berlin donors’ conference in March 2004. Against a revised needs assessment of $27.5 billion over seven years, donors came up with additional pledges of $8.2 billion to cover the period 2004–07, of which 3Data from World Bank’s World Development Indicators $4.4 billion was to be available for the fiscal year (2003). 2004/05.

©International Monetary Fund. Not for Redistribution Output and Prices

Output and Prices 2002/03, agriculture benefited not only from increased rainfall but also from an increased availabil- On the Road to Recovery ity and better quality of seeds, fertilizers, and other inputs. The Food and Agriculture Organization In 2002, the Afghan economy began the process of (FAO) and the World Food Program (WFP) esti- recovery.4 This recovery was driven by the interna- mated that total cereal production (mostly wheat) tional community’s assistance as well as by a sharp re- in 2002 was up by over 80 percent, reaching 3.6 mil- bound in agriculture following the end of a three-year lion metric tons, compared with 2 million metric drought. A strong rebound was to be expected be- tons in the preceding year (Table 2.2). The produc- cause the economy started from extremely depressed tion of fruits, vegetables, and livestock-related prod- levels of activity. The Central Statistics Office ucts, such as dairy items, meat, wool, and hides, also (CSO) of Afghanistan estimated the country’s eco- increased. However, it will take some time for the nomic growth in 2002/03 to have reached almost 30 production of these items to reach preconflict levels. percent, based on indicators of agricultural produc- The total livestock population in Afghanistan was tion (excluding poppy production), construction (im- significantly depleted because of the many years of port and production of cement), and electricity pro- armed conflict and prolonged droughts, and the as- duction (Table 2.1). According to the CSO, GDP sociated distress selling. Similarly, many orchards rose to about $4 billion in 2002/03, again excluding were cut down for firewood during harsh winters or opium production. This GDP estimate was derived destroyed during fighting. from the expenditure side, making crude assumptions Agriculture is estimated to have expanded again regarding consumption, investment, and exports and considerably in 2003/04. With continued snow and imports. Using a population estimate of almost 22 rainfall, cereal production increased by another 50 million, this implied per capita GDP of some percent, reaching 5.4 million tons, the level $180–$190, still one of the lowest in the world.5 Afghanistan needs to be self-sufficient.7 The use of The impact of international assistance was most many land plots that had been left unused during visible in the services and construction sectors, which the drought contributed to this increase. By putting appear to have expanded rapidly (based on observa- virtually all of these plots back in use at the same tions in cities, especially Kabul). The improvement time, cereal production reached an upper limit in security and the large number of returning refugees within the current production capacity. With the also helped promote economic growth. Many de- continued strong growth in agriculture, as well as in stroyed buildings were rebuilt. Returning refugees services and construction, overall GDP is estimated tried to reclaim and rebuild their former homes. Re- to have grown by about 16 percent in 2003/04. tail trade expanded significantly, as did the number of Alleviating poverty in Afghanistan will require taxicabs. Traffic jams, unheard of during the Taliban strong economic growth for many years to come. era because of scarcity of motor vehicles, became a Donor inflows will continue to contribute to eco- commonplace rush hour phenomenon. nomic growth in the coming years, but sustained Notwithstanding the recovery in trade, services, growth will require large amounts of investment. Fur- and construction, Afghanistan remained primarily ther increases in agricultural production, for example, an agricultural economy. The agricultural sector is will require investment in repairing irrigation facili- estimated to support over 75 percent of the popula- ties. Apart from donor-funded projects such as road tion and to account for over 50 percent of GDP.6 In reconstruction, investment in Afghanistan during 2002 and 2003 has been mostly on a small scale: for example, rebuilding damaged stores, repairing farms, 4It should be stressed that the analysis of economic develop- or importing taxicabs. Large-scale private investment ments in Afghanistan in this early period of recovery is very difficult because reliable data are mostly unavailable. Most data pre- has been limited to telecommunications and the re- sented here are rough estimates at best and should be interpreted construction of hotels. A significant increase in large- as such. 5For comparison: average per capita GDP in 2002 in Iran was $1,610; Pakistan, $446; Yemen, $437; Sudan, $418; Mauritania, $355; and Ethiopia, $89. 6This estimate is based on data for the early 1990s. The share 7This does not automatically mean that Afghanistan would no of agriculture in Afghanistan’s GDP may well be even larger, longer require food assistance. While sufficient grains may be given the level of destruction of the country’s infrastructure and available, not every Afghan will have access to it. Many Afghans industries. remain dependent on food aid.

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS

TABLE 2.1 Gross Domestic Product (In millions of U.S. dollars, unless indicated otherwise)

______Estimates 2001/02 2002/03 2003/04 Private consumption . . . 4,344 4,875 Government consumption1 . . . 318 407 Investment . . . 800 1,248 Exports of goods and nonfactor services . . . 129 459 Imports of goods and nonfactor services . . . –1,542 –2,404 GDP (excluding opium) 2,463 4,048 4,585 Real GDP growth (in percent, excluding opium) . . . 29 16 Per capita GDP (in U.S. dollars, excluding opium) 134 186 199 GDP in billions of (new) Afghanis (excluding opium) 134 181 225 Value of opium exports . . . 2,540 2,320 GDP (including opium) . . . 6,588 6,905 Per capita GDP (in U.S. dollars, including opium) . . . 302 300

Sources: Central Statistics Office of Afghanistan; United Nations Office on Drugs and Crime (UNODC); and IMF staff estimates. 1Government spending from the operating budget.

TABLE 2.2 Selected Indicators of Economic Activity

1999 2000 2001 2002 2003 Cereal production, total (metric tons) 3,144,000 1,763,000 1,966,000 3,589,000 5,372,000 Percent change –16.7 –43.9 11.5 82.6 49.7 Wheat 2,500,000 1,469,000 1,597,000 2,686,000 4,361,000 Rice 188,000 105,000 122,000 260,000 291,000 Barley 216,000 74,000 87,000 345,000 410,000 Maize 240,000 115,000 160,000 298,000 310,000 Opium production (metric tons) 4,565 3,276 185 3,400 3,600 Percent change 69.5 –28.2 –94.4 1,737.8 5.9 Electricity production (million kwh) . . . 503 490 557 . . . Percent change ...... –2.6 13.8 . . . Transport of goods by road (1,000 tons) . . . 1,887 3,688 5,015 . . . Percent change ...... 95.4 36.0 . . . Taxicabs . . . 16,991 19,209 33,507 . . . Percent change ...... 13.1 74.4 . . .

Sources: Food and Agriculture Organization (FAO);World Food Program (WFP); United Nations Office on Drugs and Crime (UNODC); and Central Statistics Office of Afghanistan.

scale private investment will require a functioning Against this background, investment sentiment im- and fair legal system, and a functioning and efficient proved strongly in 2003, as measured by the number banking system. In this context, a new investment of business licenses issued. law was adopted and the authorities also established an investment agency. The Afghan Investment Sup- Rebound in Opium Production port Agency was opened in August 2003. Modern financial sector legislation has been enacted that al- Poppies have again become a major cash crop for lows for the emergence of new commercial banks. Afghanistan. Although Afghanistan was not a tradi-

©International Monetary Fund. Not for Redistribution Output and Prices tional poppy-growing country, the increasing lawlessness in large parts of the country during the Figure 2.2. Price and Exchange Rate many years of conflict, the high profitability of Developments opium production, plus the fact that poppies flourish in the Afghan climate resulted in the country 30 becoming the largest producer of illicit opium in the Monthly Price Change world by the mid-1990s. In July 2000, the Taliban 20 (In percent) introduced a ban on poppy cultivation, which was 10 brutally enforced. As a result, only very small quan- 0 tities of opium—185 tons—were produced in 2001, mainly in the northern provinces, compared with –10 over 3,000 tons in 2000. The new government that –20 came to power in late 2001 also banned poppy culti- –30 vation, but the authorities’ limited control over the –40 provinces and favorable weather conditions, as well –50 as rural poverty and lack of alternative livelihoods, 2001 2002 2003 2004 led to a sharp recovery in poppy production in 2002, 280 yielding almost 3,500 tons of opium or 75 percent of Price and Exchange Rate Indices the record 1999 harvest. Opium production in- (December 2001 = 100) creased further in 2003. 230 The impact of the poppy and opium sector on the CPI Afghan economy is large. The value of Afghanistan’s 180 opium exports, including derivatives like morphine Exchange rate and heroin, in 2002 was estimated by the United 130 Nations Office on Drugs and Crime (UNODC) to have been about $2.5 billion. This would make 80 opium Afghanistan’s largest source of export earnings. Accounting for opium exports in GDP esti- 30 mates is complicated because estimates for private 2001 2002 2003 2004 consumption and imports are likely to already re- Sources: Central Statistics Office of Afghanistan; Da Afghanistan flect, to some extent, the proceeds from opium ex- Bank. ports. Depending on these considerations, the share of opium in the Afghan economy could be up to about half. Estimates for GDP including opium could reach as high as $6.5 billion. This high-end estimate widely in late 2001 and the first few months of would translate into a per capita GDP of $300, but 2002, reflecting the rapidly changing political and obviously this would not be spread evenly across the economic conditions and large uncertainties. But as population. Appendix 2.1 contains a more detailed the new government started to steadily implement description of Afghanistan’s poppy and opium pro- its economic policies and more goods became avail- duction and trade. able, inflation came down quickly. Monthly inflation averaged 3.5 percent in the first eight months of 2002. Uncertainty regarding the introduction of a Toward Low Inflation new currency, however, caused the exchange rate to Consumer prices in Afghanistan are strongly in- depreciate in the fall of 2002.8 This resulted in a fluenced by exchange rate movements (Figure 2.2). sharp spike in prices. Consumer prices rose by a cu- Price data are limited, but the CSO has maintained mulative 60 percent during September–November a consumer price index covering 50 main items, 2002 and the 12-month inflation rate reached al- mostly food, for Kabul. This index was expanded to most 100 percent by end-2002. When the exchange cover over 200 items in 2003, and it is intended to expand the collection of price data beyond Kabul to 8A new currency was introduced on October 7, 2002, with 1 include major provincial cities by late 2004. Domes- new Afghani replacing 1,000 old ones. The conversion process tic prices—and the exchange rate—fluctuated ended on January 2, 2003. For more details, see Chapter 5.

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS

rate strengthened in late 2002, prices came down as of private sector activity. A large current account well. With the successful completion of the cur- deficit before grants is funded mainly by official rency conversion process in early January 2003 and transfers; official loan disbursements were small. a relatively tight monetary policy, as well as an in- Exports are expected to grow rapidly over the creased supply of major food staples, prices remained medium term, although mostly in the form of broadly stable in the first eight months of 2003, with re-exports. Afghanistan’s own exports are a small the average monthly inflation rate close to zero. In- fraction of its total exports; these include primarily flation picked up in late 2003, mainly driven by ris- agricultural products and have been boosted by the ing food prices because of Ramadan and unusually return of rains after several years of drought. Re- cold weather. Prices fell modestly in early 2004, exports comprise transit trade and “unofficial” with year-on-year inflation reaching 10 percent by (smuggling) exports. Transit trade is expected to in- the end of 2003/04. crease steadily with the reopening of normal trade relations with transiting countries and the signing of new transit and trade agreements. The bulk of re- External Sector exports are unofficial and are mainly to Pakistan; these exports are largely imported, officially and un- Balance of Payments officially, via Iran. The demand in Pakistan for smuggled imports from Afghanistan exists because of the Estimation of the balance of payments for opportunity to avoid relatively high import tariffs Afghanistan has been hampered by lack of data. Es- and domestic sales taxes. Future growth in these un- timates presented here are based on available cus- official re-exports is expected to slow as the reform of toms data, partner country trade data, information customs administration becomes effective. The rapid supplied by international donors, and a trade survey growth of imports reflects both the revival of private conducted in 2000 by the UNDP and the World sector activity and the more liberal environment— Bank.9 Customs data are believed to cover only two- areas of particularly rapid growth have been cars, thirds of total imports and only a fraction of exports televisions, and refrigerators. Unrecorded imports because of smuggling. As such, while the broad comprise duty-exempt donor imports, transit trade, structure and trends of the estimates are likely to be and smuggled goods. correct, the magnitude of the flows is subject to Service receipts and payments in 2002/03 and greater uncertainty than usual for a low-income 2003/04 mostly reflected donor activities. Receipts country. Moreover, the figures do not include an es- comprised donor payments of local staff salaries as timate of opium exports, which in 2002/03 were well as expatriate accommodation and restaurant very large—in the order of $2.5 billion (as discussed expenses. In addition, tourist travel and the local above and in Appendix 2.1) and equivalent to staff cost of ISAF and local expenditures of ISAF around half of GDP and roughly twice the value of personnel were included. Payments comprised expa- estimated nonopium exports. When compared with triate salaries, travel abroad, and the cost of em- Afghanistan’s nonopium exports—that is, excluding bassies abroad. Interest payments on AsDB and the re-exports—opium exports are the overwhelming International Development Association (IDA) source of export revenues generated with domestic loans resumed in 2003/04. Current transfers were resources. The balance of payments figures also ex- mainly official donor grants to fund the budget and clude external flows related to the U.S. military op- national development plan. Private transfers in- erations and most of those related to the Interna- cluded remittances from Afghans living abroad, net tional Security Assistance Force (ISAF) activities of the remittance of expatriate salaries not spent do- for which there is no available information. mestically. Net errors and omissions were small and Overall, the balance of payments for 2002/03 is positive. While by its very nature the combination estimated to have shown a small surplus, after grants of flows captured in this term is unknown, it could and donor assistance were taken into consideration reflect transactions related to military operations for (Table 2.3). The composition of the balance of pay- which information is not available and changes in ments and its evolution reflect in large part the the holdings of foreign currency by residents, which donor-financed reconstruction effort and the revival may have been significant given the large amounts of U.S. dollars and Pakistani rupees, in particular, 9See World Bank (2001). that circulate in Afghanistan.

©International Monetary Fund. Not for Redistribution External Sector

TABLE 2.3 Balance of Payments (In millions of U.S. dollars)

______Estimates 2001/02 2002/03 2003/04 Trade balance –936 –1,159 –1,595 Exports of goods1 709 1,248 1,820 Own exports 85 277 377 Re-exports 624 972 1,443 Imports of goods 1,645 2,408 3,415 Services . . . –146 –346 Receipts . . . 51 87 Donor-related . . . 46 71 Other . . . 5 16 Payments . . . 197 433 Donor-related . . . 196 429 Wages of expatriates . . . 131 355 Other . . . 65 74 Interest paid . . . 1 4 Current transfers . . . 1,222 1,864 Public . . . 1,170 1,809 Commodity food aid 71 94 41 Other . . . 1,076 1,768 Private . . . 52 55 Other . . . 0 0 Current account balance . . . –84 –81 (before grants) . . . –1,306 –1,945 Capital financial account . . . 144 154 Public loans . . . 94 96 Disbursements . . . 100 96 Amortization paid . . . 0 0 Direct investment . . . 50 58 Net errors and omissions . . . 101 312 Overall balance . . . 155 389 Financing . . . –155 –389 Change in net foreign assets of DAB . . . –101 –389 Arrears . . . –54 0

Source: IMF staff estimates. 1Excludes exports related to opium and opium derivatives, which would imply a large trade surplus in 2002/03 and 2003/04.These would be offset by opium-related imports and other external payments, as well as the banking abroad of illicit earnings. The data also do not include flows associated with U.S. Army and most International Security Assistance Force (ISAF) activities. Interest and amortization reflect amounts actually paid.

If exports related to opium and opium deriva- which have not been included in the estimates re- tives were to be included, the balance of payments ported in Table 2.3. would have shown a large surplus broadly equal in size to the additional opium exports. This surplus Pattern and Composition of Trade would have been offset by an equally large additional errors and omissions outflow. The latter Based on data from partner countries, Afghan- would be consistent with the banking abroad, in- istan’s direction of export trade appears to have crease in foreign currency holdings within and out- been relatively stable over the past five years. The side Afghanistan of illicit earnings related to pattern of imports has changed in recent years with opium, and likewise related unrecorded imports, the effects of reconstruction since 2001 felt in 2002.

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS 2002/03 2002/03 In Millions of U.S. DollarsValue Total of In Percent ______1997/98 1998/99 1999/2000 2000/01 2001/02 (estimate) 1997/98 1998/99 1999/2000 2000/01 2001/02 (estimate) ©International Monetary Fund. Not for Redistribution 2.4 includes re-exports) 604.3 462.5 1,012.0 1,176.0 1,696.0 2,322.0 100.0 100.0 100.0 100.0 100.0 100.0 BelgiumFinlandFranceGermanyIndiaPakistanRussiaUnited Arab EmiratesUnited KingdomUnited StatesUnclassified 13.3 4.4 10.5 2.7 7.6 9.4 5.4 24.7 29.8 4.4 3.6 3.2 6.8 7.7 10.2 7.5 24.0 25.4 1.3 21.6 16.9 3.8 3.6 49.2 5.7 16.0 1.071.0 6.5 13.0 0.3 4.4 28.9 4.5 2.6 5.1 52.0 8.4 6.3 5.8 0.4 8.0 11.6 23.0 3.3 4.8 6.6 26.0 2.6 10.0 9.0 4.9 30.1 0.8 0.2 9.2 4.6 26.0 5.5 0.6 27.4 2.5 5.6 3.0 0.4 7.3 20.6 1.9 5.1 6.5 4.3 15.9 2.2 3.5 3.6 16.5 3.1 16.9 4.6 2.4 4.5 34.0 7.0 14.4 14.5 5.2 42.8 0.8 12.3 2.5 2.2 3.4 19.2 7.8 10.6 0.7 38.0 4.3 0.2 1.6 6.5 13.8 3.3 3.7 5.0 38.2 5.8 9.3 3.5 0.6 3.3 8.5 21.9 7.1 26.0 14.7 9.6 1.9 9.0 3.6 0.2 1.1 8.2 27.4 4.6 5.5 0.9 3.7 15.9 0.4 4.3 3.5 PakistanSingaporeTurkmenistanUnclassified 23.0 100.9 20.8 190.6 22.4 13.6 41.5 168.3 45.0 13.8 89.8 422.0 135.4 228.7 41.8 6.6 157.0 643.6 46.2 2.8 206.7 767.8 50.1 1.5 31.5 3.4 3.8 16.7 36.4 9.0 4.9 41.7 2.9 8.9 4.4 19.4 1.4 11.5 37.9 3.6 0.6 9.3 33.1 2.7 0.2 8.9 2.2 0.1 China, Rep. People’s ofGermanyIndiaJapanKazakhstan, Rep. ofKenyaKorea, Rep. of 35.7 26.8 18.4 17.2 9.5 21.9 15.7 25.5 8.4 96.7 46.2 35.0 13.6 16.4 38.3 12.5 67.1 43.6 20.3 16.1 38.8 30.9 64.4 292.0 33.0 15.9 5.9 491.0 30.5 41.0 19.9 92.5 594.0 48.5 25.0 47.2 104.5 21.6 5.8 999.0 52.1 36.5 113.4 2.8 1.8 1.6 16.0 56.5 4.2 7.6 3.4 1.9 1.8 14.5 6.3 3.5 9.4 1.3 28.9 2.1 1.2 8.4 3.1 3.3 41.8 1.4 0.9 5.5 4.1 35.0 2.6 7.9 0.9 1.2 43.0 4.0 1.5 6.2 2.1 0.9 3.1 1.6 4.9 2.4 Source: Central Statistics Office of Afghanistan. ABLE Exports only) (official recorded Total 144.4 150.3Imports 166.0Total only; (official recorded 137.0 68.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 T ofDirection 1 Trade

14 External Sector

Further changes in this respect are very likely. Part- trade with its northern neighbors was very limited ner country trade data and data from the CSO show during the Taliban period, and continued to be similar patterns of exports but differ for imports small in 2003. The poor quality of transport infra- (Tables 2.4 and 2.5).10 Export data cover official structure, poor security, and cumbersome border ad- trade only and exclude a large amount of smuggled ministration are important obstacles to realizing unofficial exports, primarily to Pakistan, which are Afghanistan’s potential as a transit route, especially imported officially and unofficially, largely across for its northern neighbors. For example, imports the Afghanistan-Iran border. The UNDP/World destined for Kabul and other eastern provinces from Bank survey of trade in 2000 estimated that of total Iran are often routed through Uzbekistan, rather exports of about $1.2 billion, about $1 billion worth than directly across the Iran-Afghanistan border, in were unofficially exported. Exports to Iran and Pak- order to bypass a long stretch of travel in istan account for about one-half of total exports, Afghanistan. This is motivated by the poor road with Iran’s share rising during 2001–02. Other ex- conditions and by the frequent unofficial “tolls” that port destinations that each account for 5 percent or are charged by various factions in Afghanistan. To more of exports are Belgium, Germany, Russia, the help overcome these obstacles to trade, several in- United Arab Emirates, and the United States. The frastructure improvements are under way, such as source of one-third of imports is unclassified. In the Kandahar-Kabul road, and more are being 2002, imports from Japan and the United States in- planned. To improve conditions for transit trade, creased sharply, reflecting the reconstruction and re- the Afghan authorities are renewing and improving juvenation of the economy. Much of the increase is existing transit trade agreements and establishing accounted for by cars, televisions, refrigerators, and new ones with neighboring countries (see Box 2.2). other electrical appliances. The main origins of im- These initiatives would also be consistent with a ports are Japan, Korea, and Pakistan, together ac- number of regional ones, including improving re- counting for about 40 percent of imports, of which gional trade among members of the Economic Co- most in 2002 came from Japan. Other significant operation Organization (ECO) under the existing sources of imports, which in total account for about ECO transit trade agreement.11 15 percent of imports, are Germany, India, Iran, Kenya, Turkmenistan, and the United States. The Exchange and Trade System major import categories of goods are machinery and equipment, household items, fabrics and footwear, During the late 1980s and early 1990s, Afghan- and food. Most of Afghanistan’s own exports are istan had many official controls in the exchange sys- agricultural goods and carpets (Table 2.6). tem. Da Afghanistan Bank (DAB) maintained an official exchange rate—largely for government debt-service payments—and a commercial rate that Transit Trade: A Corridor for Growth was linked to the free rate in the money changers’ Afghanistan is dependent on other countries for market on which the authorities did not impose any access to the sea and to other markets. But it is also controls. This implied a multiple currency practice. a potentially important country for transit trade, Reflecting the orientation of trade, Afghanistan had higher volumes of which could generate consider- bilateral payments agreements with Bulgaria, able revenues. Afghanistan could provide access to China, and the former Soviet Union, with settle- the Indian Ocean via Pakistan for the Central ments made in bilateral accounting U.S. dollars at Asian countries on Afghanistan’s northern borders, rates set under the agreements. Outside of the pay- and could also be an important transit country for ments agreements, foreign exchange proceeds from West-East trade. In 2003, most of Afghanistan’s the main agricultural exports had to be surrendered transit trade was with Iran and Pakistan. Transit immediately at the commercial rate. The bilateral payment agreements have now lapsed. There were some restrictions on invisible payments, primarily 10The customs data, as reported by CSO, differ from the Direc- tion of Trade (DOT) data beginning in 1999. For exports, CSO data show a slightly higher amount destined for Pakistan and India, which is reflected in a slightly higher value of total ex- 11The ECO members are Afghanistan, Azerbaijan, Iran, ports. For imports, the CSO data show much larger imports from Kazakhstan, Pakistan, Tajikistan, Turkey, Turkmenistan, and Japan, with the discrepancy rising. Uzbekistan.

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS In Millions of U.S. DollarsValue Total of In Percent 3.3 0.1 0.4 1.1 0.7 . . . 2.3 0.1 0.4 0.7 0.8 . . . 14.5 3.8 11.8 39.7 36.5 . . . 2.4 0.8 2.4 6.3 6.1 . . . 604.3 462.5 490.3 635.5 599.8 880.1 100.0 100.0 100.0 100.0 100.0 100.0 144.4 150.3 122.0 145.8 94.3 96.9 100.0 100.0 100.0 100.0 100.0 100.0 1997 1998 1999 2000 2001 2002 1997 1998 1999 2000 2001 2002 ______©International Monetary Fund. Not for Redistribution ; and UN Statistics Division. Direction of Trade Statistics Trade of Direction 1 1 2.5 The UN provided data for Iran. data for The UN provided FinlandGermanyIndiaIran, I. R. of 4.4 9.4 5.3 3.1 6.8 21.6 5.4 5.7 20.8 8.8 5.1 22.9 6.3 6.6 25.2 6.3 5.5 27.4 3.0 6.5 2.2 3.6 14.4 4.5 17.0 4.4 4.7 15.7 6.0 3.5 26.8 6.7 7.0 28.3 6.5 5.7 NetherlandsPakistanRussiaTurkmenistanUnited States Rest of world PakistanRussiaUnited Arab EmiratesUnited States 4.5Rest of world 23.0 20.7 2.9 12.5 20.6 12.4 22.4 41.5 4.3 7.6 14.9 16.8 45.0 89.8 4.2 19.8 14.6 14.1 135.4 41.8 2.7 –12.2 157.0 12.2 12.3 3.9 46.1 206.7 –8.5 29.8 3.6 6.6 8.5 19.8 10.2 50.1 7.5 25.4 4.9 44.5 3.4 87.9 26.0 16.0 3.6 0.7 3.8 36.0 6.5 6.8 2.0 4.5 2.1 9.0 3.4 8.4 36.0 0.6 4.9 5.8 4.7 18.3 4.8 3.6 2.6 23.7 1.6 3.2 0.9 9.2 4.9 4.0 21.3 2.9 0.6 4.6 22.7 4.0 3.0 0.7 2.5 6.6 26.2 5.4 –1.9 20.6 4.3 1.9 1.9 1.9 23.5 0.6 7.7 3.5 5.2 –1.4 16.9 7.1 1.1 2.4 1.4 2.2 5.7 5.2 5.1 3.4 29.5 10.0 10.6 3.0 3.0 24.7 4.3 4.5 6.9 3.1 25.1 4.8 3.9 1.8 5.1 23.4 3.4 2.8 0.7 4.7 2.7 5.7 4.4 3.6 5.4 China, Rep. People’s ofFranceGermanyIndiaIran, I. R. of 35.7 26.8 18.3 20.0 17.2 21.9 14.0 15.7 25.4 19.0 13.6 16.4 7.0 20.3 16.1 30.9 6.2 5.9 15.9 30.5 5.2 5.8 48.5 33.7 10.2 3.7 36.5 2.8 3.3 3.4 4.2 3.4 3.0 3.2 3.5 2.8 1.4 2.3 6.3 2.5 1.0 4.8 2.7 0.9 5.6 5.5 1.2 4.2 JapanKazakhstan, Rep. ofKenyaKorea, Rep. of 9.5 8.4 96.7 46.2 38.3 12.5 67.1 43.6 38.8 64.4 72.7 33.0 41.0 19.9 56.9 92.5 47.2 104.5 21.6 49.4 52.1 113.4 84.9 1.6 56.5 7.6 16.0 1.8 6.3 14.5 9.4 2.6 14.8 8.4 6.7 10.1 8.4 8.9 14.6 3.3 17.4 8.2 7.4 2.5 12.9 9.7 8.7 6.4 Sources: IMF, 1 ABLE Total exports Total T ofDirection 2 Trade imports Total

16 External Sector In Thousands of U.S.In Dollars Exports Total of In Percent 159,235 166,241 137,312 68,541 100,143 100.0 100.0 100.0 100.0 100.0 462,077 1,012,262 1,175,896 1,696,525 2,322,609 100.0 100.0 100.0 100.0 100.0 1997/98 1998/99 1999/2000 2000/01 2002/03 1997/98 1998/99 1999/2000 2000/01 2002/03 ______©International Monetary Fund. Not for Redistribution 2.6 Fresh fruits Fresh Dried fruit Medicinal plants Spices 176Seeds 0Animal skins 700Wool 64 385SausageCarpets 154,782 1,266 147,036 170 88 904 99,571 518 21,503 198 2,967 1,050 47,474 1,006 651 97.2 0.1 0.0 2,919 0.4 57 9 88.4 0.0 9,282 0.2 5,797 195 0.8 72.5 539 16,381 0.1 8,403 0.1 23,328 669 2,116 31.4 0.7 4,269 0.8 40,582 1,935 10,841 53 0.3 4.3 47.4 5,587 13,678 2,620 1.8 100 1.0 1.0 1,172 0.0 0.7 0.0 5.6 285 0.3 3.5 0.1 11.9 144 1.3 6.1 34.0 0.5 1 7.9 6.2 40.5 2.8 0.0 20.0 5.6 2.6 0.1 1.2 0.2 0.2 0.0 Machinery and equipment and oilPetroleum MetalsChemical materialsConstruction materialsPaperClothing materialsFood and drinksCigarettes Fabrics, clothing, and footwearHousehold needs and medicine 6,029 993,307 71,870 512,382 805 854,842 96 12 2,875 451,807 1,747 1,303 1.3 10,160 3,112 396 446 28 110 357,110 905 12,328 536 98.1 392,231 3,865 478,521 648 14,444 335 472,638 622,481 4,276 39,728 0 0 5,077 6.1 997 345,934 172,679 48,420 3,727 97.8 0.2 1,358 3,557 40 23,111 2,293 30.2 21,793 0.4 0.0 0.0 1.0 250,675 0.3 46,636 6,751 214,433 9,024 45 36.8 0.1 0.0 0.1 201,339 30.4 0.0 0.1 0.3 0.0 48 40.7 23.1 0.2 0.3 0.0 0.0 0.7 0.1 0.0 27.9 59 2.3 26.8 0.2 0.3 0.3 0.6 0.4 0.1 14.9 0.0 21.3 7.4 2.1 1.4 0.2 1.3 12.6 0.0 2.0 0.3 0.4 0.0 8.7 0.0 0.0 Source: Central Statistics Office of Afghanistan. ABLE Total exports Total T Commodity Composition of Trade Total imports Total

17 RECENT MACROECONOMIC DEVELOPMENTS

Box 2.2. Trade,Transit,and Transport Agreements

As of 2003, the main transit trade agreement was under discussion toward establishing mutually benefi- with Pakistan so that Afghanistan’s imports and ex- cial trade, transit, and railway development treaties. ports largely go to and from the southern ports of In March 2003, Afghanistan and India signed a new Karachi and Port Quasim in Pakistan. This agreement preferential trade agreement, which replaced an ear- was established in 1965, but during 1994–96 the Pak- lier one that was little used because of the Taliban istan authorities had unilaterally banned several items presence and strained relations between India and from the eligible list (since 1996, 18 items have been Pakistan. Under the new agreement India granted banned). The ban was imposed because of concerns 50–100 percent tariff reductions on 38 export items that a large part of these imports were being smuggled from Afghanistan and duty-free access was given to back into Pakistan. Following a series of meetings India for eight tariff lines. In June 2002, preferential since 1991 between the two countries, the issues of access to European markets was obtained under the disagreement were expected to have been resolved by Everything But Arms agreement, and, in January end-2003. Six of the banned items were restored to 2003, the United States granted Afghanistan general the list and the time taken for processing and clearing system of preferences (GSP) access to its domestic procedures of transit goods was reduced from 20 to 5 market. On April 10, 2003, Afghanistan applied for days. At the same time, it was agreed that some cate- membership in the World Trade Organization. gories of imports for which Afghanistan has little need and which were clearly intended to be smuggled In January 2003, Iran, India, and Afghanistan signed back into Pakistan would be eliminated from the eli- a Memorandum of Understanding to improve access gible list. To reinforce this measure, it was expected to the Iranian port of Chabahar on the Indian Ocean, that Afghanistan would levy punitive import tariffs along the Chabahar-Malik-Zaranj-Delaram route into on these goods. Both countries were committed to Afghanistan. Under this understanding, Iran will making substantial progress on lifting the ban on the build a new transit route to connect Malik in the remaining 12 restricted items. In addition, agreement southeast of Iran to Zaranj inside Afghanistan, includ- was reached, with the support of aid from Pakistan, ing the Malik bridge over Helmand river.2 For its part, that the Torkham (the railhead in Pakistan) to Jalal- India will build a new road connecting Zaranj to De- abad (in Afghanistan) road would be repaired and a laram, which is on the main Herat-Kandahar road. new road, parallel to the existing one, would be con- These improvements will shorten the transit distance structed by early 2005. between Chabahar and Delaram by some 600–700 kilometers. Also, India and Iran will build a railroad A number of trade, transit, and transport agreements from Chabahar to the Iranian central railway station with Iran dating from 1973 have been revised. A new on the railroad between Karachi and Tehran (and fur- transport agreement was signed in January 2003, and ther west), and Iran will extend its railway to the port final approval of the trade and transit agreements of Islam Qaleh. This would provide cheaper access to were expected in mid-2003. Under these new agree- Chabahar and open up markets along the railroad and ments, changes included lifting previous restrictions to Europe. In addition, Afghanistan was granted full on the routes that could be used by Afghanistan access to the duty-free zone at the port of Chabahar. trucks between the border and destination cities, and The Iranian authorities are also providing storage fa- Afghan truckers were allowed to buy Iranian fuel at cilities and have permitted Afghan inspectors and 1 the same subsidized price as Iranian truckers. Discus- trade representatives to be present on-site. Port fees sions on trade and transit agreements were initiated have been cut by 90 percent and warehousing and with Kyrgyzstan, Tajikistan, and Uzbekistan. By Au- other charges by 50 percent; smaller cuts were granted gust 2003, a Memorandum of Understanding had for oil tankers. been signed by the Uzbekistan and Afghanistan authorities, while a draft agreement with Tajikistan was 2At present, a main highway connects Chabahar and Malik (in Iran, south of Zaranj) with only a secondary road 1Previously, Afghan truckers had to pay the unsubsidized connecting to Zaranj. The bridge will significantly shorten fuel price; the subsidy element is about 20 percent. the time taken to travel between Malik and Zaranj.

limits on foreign exchange cash to be taken abroad direct investment required prior approval and own- for personal travel, and foreign employees had to ership could not exceed 49 percent. Capital could convert 60 percent of their foreign currency salaries be repatriated only after five years and at an annual into Afghanis at the official exchange rate. Foreign rate of 20 percent of total registered capital.

©International Monetary Fund. Not for Redistribution External Sector

In recent years, the exchange and trade system has radically changed and in effect is now liberal Box 2.3. Exchange and Trade and open (see Box 2.3). Many of the rules and regu- Arrangements lations that applied during the Taliban and pre- Taliban eras are formally still in place, but in prac- Under the authority of the ATA, Afghanistan has tice a liberal exchange and trade system has been operated a de facto unified exchange rate system. DAB quotes on a daily basis an official Afghani- applied by the ATA. Given the disrupted financial U.S. dollar exchange rate based on the early morn- system, the erosion of capacity in customs and trade ing rate in the free market of the money changers.1 administration, and a relatively sophisticated This rate is used for all transactions, including with hawala system, controls would have been difficult to the government. DAB exchange rates for other enforce. The authorities are committed to formaliz- currencies are based on cross-rates with the U.S. ing the de facto liberal regime with revised rules and dollar. DAB uses the buy and sell rate from the free regulations consistent with liberal and open ex- market rather than applying a fixed spread around a central rate. During the first half of 2003, the change, payments, and trade systems. spread between the two rates for cash transactions In early 2004, the government enacted a sweep- rarely exceeded 0.6 percent while, during the latter ing reform of trade taxes, including the use of mar- half of 2002, spreads were usually larger than in ket exchange rates for import valuation, a stream- 2003 and on two occasions exceeded 2 percent.2 In lined tariff structure (moving from 25 tariff rates to addition, a small commission is charged on trav- 4), a reduction in tariff dispersion (the old system eler’s checks and on international transfers. For had rates ranging from 0 percent to 150 percent, transfers, fees are 0.25 percent of the amount, with while the new system ranges from 0 percent to 20 a small minimum fee, and for letters of credit, fees are 0.25–0.5 percent of the amount. percent), and the establishment of new, more effective broker processes (see Chapter 4). In practice, virtually no controls are enforced or In principle, the Chamber of Commerce was sup- are in place on imports and exports, payments, in- posed to carry out the valuation of imports, which is visibles, and capital transactions. Traders, who for the most part carry out other domestic commercial to be used as the basis for customs tariff charges, activities and are thus classified and licensed as charging a fee of 2.5 percent for nonmembers and commercial businesses, are required to hold a com- 2 percent for members. The fee was assessed on the mercial license, which is also required for all busi- c.i.f. value calculated using the customs exchange nesses; under this license exporting and importing is rate, which is much more depreciated than the mar- permitted, and no further export or import license is ket exchange rate, and as a result the effective fees required. However, a few imports are subject to li- are currently much lower.12 But, in practice, only a censes and quotas. These comprise certain pharma- ceutical products, mining items, and petroleum small part of imports have been valued by the products for which a special license is required. The Chamber of Commerce and the majority of valua- import of certain drugs, liquor, and arms and ammu- tions are carried out by the customs houses, for nition is prohibited on grounds of public policy or which no fee is charged. for security reasons; special permission is required In the absence of functioning commercial banks, for these imports. Exports of opium and museum most trade financing is done by cash or through the pieces are prohibited. Imports and exports should be hawala system. The central bank did not open let- registered with the Ministry of Commerce for ters of credit in its own name before 2003. In 2003, recording and statistical purposes, and to establish their eligibility for export incentives. pending the arrival of new commercial banks, DAB opened several letters of credit for government 1Each morning, DAB calculates a simple average of the agencies under the World Bank Donor Flow Man- buy rate and the sell rate of 10 reputable and large li- agement Program.13 Earlier limits on the amounts censed money changers and quotes them as the official that can be taken out of the country for tourist and buy and sell rates. DAB quotes rates for cash and transfer transactions. 2The IMF considers a spread greater than 2 percent in official transactions to be a multiple-currency practice. 12Following the customs policy reform (see Chapter 4), customs valuation will use the market exchange rate. 13The World Bank provides a special commitment letter to the business travel have been eased, and the require- correspondent bank in which it commits to guarantee payments made under the letter of credit; this obviates the need for the ment that foreign employees convert 60 percent of usual advance collateral deposit. their foreign currency salaries into Afghanis and

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS

limits on payments for medical treatment abroad are accelerated to 19 percent per year between 1989 and no longer enforced. 1994. Afghanistan’s share in world production grew Foreign investment is required to conform to the accordingly from about 20 percent in 1980 to 50 per- new Domestic and Foreign Private Investment Law cent in 1995, just prior to the Taliban takeover, and of 2002. Foreign and domestic investment require to 79 percent in 1999.15 Opium became the coun- prior approval, and investments in construction of try’s largest cash crop and its only significant source pipelines, telecommunications, infrastructure, oil of illicit export earnings. Two decades of expanding and gas, mines, and minerals are regulated under Afghan production have contributed to the dramatic separate legislation. Full foreign participation is al- decline in the street price of heroin in real terms in lowed and there are no limits on the transfer of cap- Western Europe, which fell from the equivalent of ital and profits out of Afghanistan. The law provides about $300 per gram after adjusting for inflation in tax holidays of up to seven years and a four-year ex- 1987 to $60 per gram in 2001.16 emption on export tariffs and duties. However, the In spite of the illicit nature of the opium economy, law is being reviewed with consideration being a wealth of information is available. This is mainly given to eliminating the tax holidays. thanks to the dedicated work of the UNODC that, as part of its global Illicit Crop Monitoring Program (ICMP), operates a poppy crop monitoring system in Appendix 2.1. Poppy Dimension Afghanistan, now in close cooperation with the in the Afghan Economy country’s new transitional government. As part of this monitoring, regular opium surveys are con- Afghanistan is by far the largest producer of opium ducted that combine satellite imagery with cross- in the world, accounting for more than 70 percent of checking on the ground to produce a detailed world supplies on average over the last decade, ac- mapping of poppy cultivation. The surveys are com- cording to the United Nations Office on Drugs and plemented by in-depth interviews with farmers and Crime (UNODC).14 About 10 million people con- traders, the collection of comprehensive price data, sumed opiates of Afghan origin in 2003 even though and studies of seizure data in neighboring countries. Afghanistan has not been a traditional opium-ex- The results are published annually, normally a few porting country. The cultivation of the poppy on a months after the end of the April–June harvest sea- large scale is a relatively recent phenomenon, dating son, and supplemented by interim reports. Most of back to the early 1980s when strict bans on opium the analysis presented in this appendix is based on production in Turkey, Iran, and Pakistan pushed up information from the 2002 and 2003 surveys. the world price of opium. At the same time, governments in Afghanistan were progressively losing con- Growing Production trol over rural areas. Faced with strong international demand and virtually no legal or social impediments, From 1994 to 2000, annual opium production is poppy cultivation flourished. It did not take long for estimated to have averaged around 3,000 tons per Afghanistan to replace the so-called Golden Triangle year (Table A2.1). During this period, the acreage (Thailand, Lao P.D.R., and Myanmar) as the main under cultivation fluctuated between about 53,800 supplier of opiates to Europe and the Middle East. hectares and 91,000 hectares. On average, this repre- The almost complete collapse of any form of cen- sented less than 1 percent of the country’s arable tral government after the Soviet withdrawal, the land. But yields per hectare in Afghanistan in the warring parties’ needs for alternative sources of fi- areas cultivated with poppy are, on average, more nancing, and the fact that opium was a crop well than three times higher than in Myanmar, the adapted to the prevailing circumstances greatly world’s second largest producer.17 With virtually no added momentum to this trend. Opium became restrictions on poppy growing at the time, year-on- firmly entrenched in the economy. While the annual year fluctuations reflected the normal pattern of an rate of growth of opium production had been, on av- annual agricultural crop affected by changes in cli- erage, 14 percent per year between 1979 and 1989, it matic conditions, and the supply response to price

14Appendix prepared by Bruno de Schaetzen. For a detailed 15UNODCCP (2002b) and UNODC (2003e). discussion of world’s illicit opiate markets, see United Nations 16UNODC (2003d). Office on Drugs and Crime (UNODC, 2003e). 17UNODCCP (2001 and 2002b).

©International Monetary Fund. Not for Redistribution Appendix 2.1

TABLE A2.1 Indicators of Opium Cultivation

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Production (in metric tons) 3,416 2,335 2,248 2,804 2,693 4,565 3,276 185 3,422 3,600 Cultivated area (in ha after eradication) 71,416 53,759 56,827 58,417 63,672 90,909 82,033 7,606 74,045 80,482 Yield per ha (in kg) 48 43 40 48 42 50 40 24 46 45 Average farm gate price at harvest time ($ per kg, fresh) 30 23 24 34 33 40 28 301 351 283 Main bazaar prices (in $ per kg) 69 65 50 71 65 55 39 301 351 283 Gross income per ha (in $) 3,300 2,823 1,978 3,408 2,749 2,762 1,557 7,321 16,208 12,659 Direct farm employment (in person years) 77,147 58,073 61,387 63,105 68,781 98,204 88,616 8,216 79,987 86,940 Persons needed at harvest time 793,511 597,322 631,411 649,078 707,467 1,010,100 911,478 84,511 822,722 894,244

Source: United Nations Office on Drugs and Crime (UNODC).

changes typically lagged one year. Production was 2002, a decree forbidding all poppy cultivation and mainly concentrated in two provinces, Helmand (40 trading, although this was too late to prevent the percent of total production in 2002) and Nangarhar sowing of poppies, which had already taken place. (27 percent of total production in 2002), but has An ambitious eradication campaign soon followed been rising more rapidly in the north, particularly in this decree together with efforts to provide alterna- Badagshan.18 These provinces have some of the most tive livelihoods to farmers. But the government’s productive agricultural land in the country. still weak authority over the provinces, and delays Excess rain in 1998 caused crop damage during in donor assistance for alternative crops and farmer the harvest, and production sagged. In 1999, excep- support, made progress difficult. With favorable cli- tionally favorable climatic conditions together with matic conditions, the 2002 harvest produced 3,422 a rise of acreage under cultivation led to a record tons, similar to the 2000 harvest. harvest of 4,565 tons. In September of that year, the During the 2002–03 season the government fur- Taliban, in an effort to stave off looming interna- ther expanded its interdiction activities. The target tional sanctions, ordered poppy growers to reduce was set as part of the National Drug Control Strategy their planting by one-third. This decree had little to reduce opium production by 75 percent in five effect because it was weakly enforced, although pro- years and to completely eliminate all commercial duction was, in the event, reduced to 3,276 tons in production in Afghanistan within 10 years. Some 2000 because of a drought. In July 2000, now faced 21,430 hectares were eradicated during that season, with the prospect of severe international repercus- mainly in the traditional opium-growing provinces of sions, the Taliban issued a total ban on poppy culti- Helmand and Kandahar where production fell by 49 vation that was soon resolutely enforced. Virtually percent and 29 percent, respectively. These efforts no poppies were planted in the region under their nonetheless were insufficient to stem continued control. Production fell by 95 percent and only growth in production, which rose overall by 6 per- small quantities of opium were harvested in 2001, cent to 3,600 tons. But while there was progress in re- mainly in the northern provinces. The 2001 sowing ducing planted acreage in the south, the proliferation season coincided with the collapse of the Taliban to other areas accelerated. The UNDCP reported regime. The resulting power vacuum incited wide- that, in 2003, opium production could be found in 28 spread replanting, and acreage under cultivation of Afghanistan’s 32 provinces, up from 18 provinces soon returned to the record levels of the late 1990s. in 1999. Even more striking was the fact that nearly One of the first acts of the new Afghan Interim one-tenth of the cultivation occurred in districts Administration (AIA) was to issue, on January 17, where opium had previously not grown.19

18UNODCCP (2002a). 19UNODC (2003a and 2003b).

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS

Development of Prices The Taliban ban started a sharp increase in opium bazaar prices, which by April 2001 had risen almost During each year the fluctuation in opium prices tenfold to $380 per kilogram, before peaking at $700 tends to follow a typical annual agricultural cycle, per kilogram just prior to September 11, 2001. In reaching a low during the harvest period and then the following weeks prices crashed to $90 per kilo- gradually rising until a few weeks before the next gram, as stocks were quickly liquidated in anticipa- harvest period. Opium can easily be conserved for tion of military operations. Prices recovered over long periods; therefore, all market participants, in- the next few months and soon exceeded $400 per cluding farmers, traders, and processing laboratories, kilogram in reaction to the transitional govern- have relied on stock building and depletion to help ment’s January 2002 prohibition decree and expec- limit price fluctuations and stabilize incomes.20 In tations of substantial donor assistance to help en- the absence of a working financial system, opium force it. With the start of the eradication campaign also played a significant role in rural areas as a store in April 2002, prices rose further to a high of nearly of value. In remote locations it was often considered $600 and after a period of erratic fluctuations settled more liquid than any other asset, including foreign back after the 2002 harvest to around $400 per kilo- currency. There were strong incentives, therefore, gram. On average, the price received by farmers in even for individuals otherwise not involved in the 2002 rose by 17 percent to $350 per kilogram. trade, to hold opium. Higher production in 2003, however, pushed down Until recently local opium markets were frag- the average price to $283 per kilogram (Table A2.1) mented, with large price disparities persisting be- and gross income of farmers from opium conse- tween producing regions. These price disparities re- quently fell by 15 percent. flected a combination of regional differences in the quality of opium and difficulties in arbitraging between regions during the civil war. Regional opium Incentives for Poppy Farming centers therefore tended to be oriented toward spe- The UNODC estimates that about 264,000 cific export routes with the local price level reflect- households were involved in growing poppies during ing a specific route’s costs and risks. Opium centers the 2002–03 season, up from about 200,000 at the in the south turned to Iran and southern Pakistan end of the past decade. These households tend to be (Baluchistan), those in the east to northern Pak- representative of the general farming population in istan (North West Frontier Province), and those in their region with landholdings of 1–1.5 hectares, of the north to Tajikistan and Central Asia. Prices which one-third is usually devoted to poppy grow- generally were the lowest in areas with the tightest ing. Cash earnings are the main reason why farmers controls at the border. But since the fall of the Tal- plant poppies. But surveys have revealed that, until iban, there has been a pronounced integration of re- the recent tenfold increase in prices took place, regional markets as the reduction in factional fighting turns were not irresistibly high compared with other has made it easier for traders to exploit the best trad- cash crops and often fluctuated widely. With few re- ing routes. strictions on cultivation during the civil war period, From 1994 to 2000, average farm gate prices, as markets were fairly competitive. Other crops can monitored by UNODC at harvest time, fluctuated sometimes turn out to be more attractive. A between a low of $23 per kilogram and a high of $40 UNODC study shows that, for example, in the per kilogram (Table A2.1). With international de- 1998–99 season opium was by far the most prof- mand for opium growing relatively steadily, price itable crop because of a combination of high prices, fluctuations have reflected mainly domestic supply a bumper harvest, and poor yields and prices for factors. Downward pressures also occurred when competing crops. But this situation reversed in trafficking networks or laboratories in the region 1999–2000, when the return per hectare on several were dismantled, creating temporary gluts on the alternative crops, including grapes, onions, black Afghan markets. By contrast, large-scale purchases cumin, and other fruits, comfortably exceeded that by traders occasionally caused temporary spikes. of opium.21 Market expectations have also played an important role in price formation.

20UNDCP (1998). 21UNODC (2003c and 2003e).

©International Monetary Fund. Not for Redistribution Appendix 2.1

TABLE A2.2 Estimate of Farmers’ Net Income from Opium (In millions of U. S. dollars) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Gross revenue to farmers from opium production 235.7 151.8 112.4 199.1 175.0 251.1 127.8 55.7 1,200.1 1,018.8 Seed, fertilizers, tools, and other inputs 2.9 2.2 2.3 2.3 2.5 3.6 3.3 0.3 3.0 3.2 Wage bill (itinerant laborers) 47.1 30.4 22.5 39.8 35.0 50.2 25.6 11.1 240.0 203.8 Taxes and other payments (30 percent of gross revenue) 70.7 45.5 33.7 59.7 52.5 75.3 38.3 16.7 360.0 305.6 Bazaar traders’ margins (8 percent) 18.9 12.1 9.0 15.9 14.0 20.1 10.2 4.5 96.0 81.5 Net income 96.1 61.6 44.9 81.3 71.0 101.8 50.4 23.1 501.1 424.7

Sources: United Nations Office on Drugs and Crime (UNODC, 2003); and IMF staff estimates.

A number of other factors also made opium well before each harvest. However, the accuracy of this suited to the needs of farmers during the difficult measure of farmers’ income is compromised by two years of the civil war, and at times provided stronger problems, each pulling in the opposite direction. On incentives to produce opium than mere cash re- the one hand, many farmers sell their crop forward turns. First, as discussed in more detail below, opium at a discount usually exceeding 50 percent of the production is extremely labor intensive. The harvest price. On the other hand, prices tend to be UNODC surveys reported that this was an impor- the highest just before harvest time. Better-off farm- tant consideration for farmers supporting a large ers generally hold on to their production with the household in relation to the size of their land hold- intention to gradually sell it in subsequent months ings. Second, a poppy crop presents a number of in the expectation of higher prices. technical advantages. It does not require as much attention to irrigation as, say, wheat. It is relatively Poppy Farming: Employment and weather resistant with a short growing season, giv- Know-How ing it an advantage over a crop such as black cumin, which needs three years to come to maturity. The Opium is by far the most labor-intensive cash early harvest frees resources to harvest other crops crop in Afghanistan. To cultivate and harvest one later, and even makes it possible in semitropical hectare of poppy requires, on average, about 350 areas to plant a second crop. Third, opium is easy to person-days. This compares with 41 person-days for store, transport, and sell. The destruction of the wheat and 135 person-days for black cumin, the sec- transportation infrastructure in many areas has ond most labor-intensive crop in the country. Even often made it virtually impossible for farmers to more significant, most of this labor is needed at har- grow other cash crops in remote districts. Fourth, vest, which requires about 250 person-days per opium is currently the only crop against which farm- hectare. The majority of growers therefore have to ers in Afghanistan can easily obtain credit, albeit at rely on hired help, usually six to seven itinerant har- usurious rates. A 1999 UNDCP study reports that vesters per hectare. They are normally paid in-kind over 60 percent of traders interviewed made ad- a share of the harvest that has varied between one- vance purchases of opium well before the harvest.22 fifth and one-sixth. Because of this high labor re- As there is no reliable information on the actual quirement, UNODC estimates that about one mil- price at which farmers sell their opium crop, it is dif- lion persons are involved in the opium harvest every ficult to accurately estimate the gross income they year. Since production is concentrated in two derive from it, but broad estimates can be con- provinces, this has a very pronounced effect on local structed. Table A2.2 shows the value of production labor markets. Acute labor shortages have been at the prices monitored by the UNODC a few weeks reported at harvest time in poppy-growing areas, with schools and colleges emptying and public works programs coming to a standstill due to lack of 22UNDCP (1999a). manpower.

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS

Two further considerations are important to un- workers among them. Indeed, respondents who derstanding the role of labor in the development of had received an intermediate level of formal ed- the opium industry—skilled labor and itinerant ucation often cited the lack of alternative em- workers. In the earlier years, availability of qualified ployment opportunities as an important consid- labor was a limiting factor in poppy cultivation. eration for going into opium trafficking. They Lancing of poppies is a delicate task that requires ex- especially bemoaned the lack of government perience and knowledge because it can greatly affect jobs that pay living wages. Until recently profits the final yield. As experience was acquired, this con- from small-scale trading were not substantial in straint was progressively lifted and a vast pool of absolute terms but were attractive in relation to competent workers emerged. This human capital alternative sources of income. This suggests stock now undoubtedly gives Afghanistan a large that trading was competitive and that there was comparative advantage relative to other potential no significant risk premium. producers. But it only makes eradication efforts more • Further toward the center of trafficking circles difficult. The itinerant workforce has contributed, in are the shop owners in the regional opium turn, to the rapid propagation of poppy growing. bazaars. They buy directly from farmers, itiner- Having acquired know-how to cultivate poppies and ant traders, or other shopkeepers. They sell to having established the necessary contacts to sell the local consumers, clandestine laboratories, opium that they usually receive as a payment, itiner- wholesale traders, other shop owners, foreign ant laborers, once back in their home village, started traders, or anyone interested in opium trade. to experiment with opium production. As a result, They may pool resources and put together large from the mid–1990s onward, cultivation gradually shipments when there is demand. Therefore, expanded from the core areas of Helmand, Nan- opium bazaars, which in some areas had as garhar, and Badakshan to neighboring districts and many as 200 shops, effectively operated as provinces. Consequently, according to UNODC, the thriving regional commodity exchanges where number of poppy-growing villages in Afghanistan opium was openly and actively traded. Recent rose from 2,008 to 6,645 villages over the 1994–2000 intervention by the authorities has greatly period.23 curbed these activities.

Trading and Commodity Markets • Finally, at the center of the opium trade are the bulk buyers or large-scale specialist traders who Traders are the essential link between opium pro- buy opium throughout the year and organize duced in remote, nearly inaccessible Afghan villages shipping to border areas or directly abroad, and heroin sold on the streets of Europe. The sometimes amounting to several tons. This is UNODC estimates that approximately 15,000 per- the backbone of the narcotics industry, which sons participate in the concentric trafficking circles consists of a relatively small number of traders that funnel opiates out of Afghanistan. It is much who are often linked by family ties and willing more difficult and dangerous to obtain information to commit substantial capital. They can reap on this segment of the opium economy, but UNDCP phenomenally large rewards, but also face sub- and UNODC studies suggest the following:24 stantially higher risks. Until recently, these in- • On the outer rim are the itinerant farmgate cluded shipments being stolen, ransomed, lost buyers. They buy from farmers and push them to interdiction or deception, and the sometimes to produce by providing advice and incentives rapidly fluctuating price of opium. Not surpris- such as credit. These traffickers are the largest ingly, one way to reduce these risks was to col- in number and have a relatively small average lude with or pay protection money to those in turnover. Surveys have found that they have power. generally received a longer formal education The biggest risks (and therefore rewards) are for than the population average and it is not un- moving opium across the borders. Large-scale traf- common to find teachers and government ficking by Afghan nationals has usually been limited to trade within Afghanistan and the country’s im- 23UNDCP (1999b, 1999c, 2000a, and 2000b). mediate neighbors. Afghans do not generally partic- 24UNDCP (1998) and UNODC (2003e). ipate in lucrative international trafficking. Special-

©International Monetary Fund. Not for Redistribution Appendix 2.1 ized traders, who are members of tribes living on largest cost for producing heroin is that of the pre- both sides of the border, often undertake the actual cursor chemical acetic anhydride. Since the mid- border crossings. The deeper those traders are able 1990s a thriving market has developed in acetic an- to get into the neighboring country, the higher is hydride, with imports reportedly coming from the profit. Prices are highest in Iran, but the penalty Europe and Russia, often via Turkmenistan. Its aver- associated with being intercepted with drugs in Iran age cost has fallen by two-thirds in Afghanistan is also far higher than in other countries neighbor- since then, and has fluctuated in recent years being Afghanistan. tween $15–$36 per liter. Approximately 4 liters are needed to produce 1 kilogram of heroin. One of the first steps that the new authorities took at the start Clandestine Laboratories of their interdiction campaign was to close several Data from border seizures in neighboring coun- bazaars where precursor chemicals were traded. tries suggest that in recent years only about 30 percent of Afghan opium is exported raw, and that the Taxes and Other Levies on Opium remainder is transformed into either morphine base or heroin. The UNODC estimates that, in 2000, out The legal or de facto rulers of the areas in which of a 3,276-ton total production, 1,081 tons were ex- opium was cultivated or through which it transited ported as raw opium; 1,146 tons were transformed have also likely benefited from the opiate industry. into base morphine; and 1,048 tons into heroin.25 These may have included, at various times and This is a relatively new development indicative of places, warlords, local commanders, provincial ad- the maturing of the opium industry in Afghanistan. ministrators, tribal leaders, and even the central Processing within Afghanistan began in the mid- government until the fall of the Taliban regime. 1990s when laboratories moved from Pakistan into Opium is believed to have played an important role eastern Afghanistan and progressively multiplied in in financing the war against the Soviet occupation, other border locations. This development appears to and thereafter the civil war, either indirectly have been prompted by a more supportive environ- through levies on producers and traders or directly ment for trafficking in Afghanistan, the desire to through the active and personal involvement of lessen cost and risk by transporting less bulky and those in power. Taxes levied on opium by local au- more easily concealed heroin, and the higher profit thorities have also helped to strengthen the power margins associated with heroin trade. It is difficult to of the regions vis-à-vis the center. Surveys report obtain precise information on these activities but re- that most farmers continued to dutifully pay the tra- fining seems to take place typically in small- to ditional agricultural taxes. Acceptance of this pay- medium-scale laboratories producing about 10 kilo- ment by the local authorities was often interpreted grams a day of brown heroin. There are reports of a by the farmers and itinerant workers as implicit sup- relatively small number of large-scale laboratories, port for the cultivation of opium. Small-scale and located in heavily defended strongholds, becoming bazaar traders have also indicated that they regularly dominant in the industry and producing top-quality paid taxes on their income. heroin. This suggests a move toward vertical integration and growing capacity. One indication of rising Exports of Opium and Its Derivatives processing capacity is that the domestic spread between opium prices and high-quality heroin has At the time of writing this report, UNODC esti- fallen significantly from 1997 to 1999. mates for export volume and prices of raw opium, The recent large increase in the price of raw morphine, and heroin were available only for 2000 opium is likely to have been a strong incentive for and there was no breakdown between heroin and laboratories to improve the efficiency of their morphine for 2002. In Table A2.3, it is assumed processes. While it used to take 10 kilograms of raw that the same amount of heroin and morphine were opium to produce 1 kilogram of heroin, efficiency exported in 2002 as in 2000. No figures are avail- gains have reportedly lowered the required input to able at all for 2001 because the Taliban ban, the as little as 6 kilograms. Aside from raw opium, the disarray resulting from the collapse of their regime, and the unsettled security situation made it impossible to obtain meaningful estimates for that year. It 25UNDCP (2001) and UNODC (2003e). is likely, however, that exports were substantially

©International Monetary Fund. Not for Redistribution RECENT MACROECONOMIC DEVELOPMENTS

TABLE A2.3 Revenues from Opiates (In millions of U.S. dollars, unless otherwise indicated) 2000 2001 2002 2003 Farmers Gross revenue to farmers from opium production 128 56 1,200 1,019 Volume (in tons) 3,276 185 3,422 3,600 Price ($ per kg, bazaar price) 39 301 351 283 Seed, fertilizers, tools, and other inputs 3 0 3 3 Wage bill (itinerant laborers) 26 11 240 204 Taxes and other payments (30 percent of gross revenue) 38 17 360 306 Bazaar trading (8 percent of gross revenue) 10 4 96 82 Surplus to farmers 50 23 501 425 Traders Gross revenue from exporting raw opium 425 . . . 1,359 . . . Volume (in tons) 1,081 . . . 890 . . . Prices ($ per kg) 393 . . . 1,527 . . . Gross revenue from exporting morphine 175 . . . 651 . . . Volume (in tons) 115 . . . 164 . . . Prices ($ per kg) 1,522 . . . 3,970 . . . Revenue from exporting heroin 245 . . . 530 . . . Volume (in tons) 105 . . . 89 . . . Prices ($ per kg) 2,333 . . . 5,955 . . . Total exports 845 . . . 2,540 2,320 Volume (in tons) 1,301 . . . 1,143 . . . Prices ($ per kg) 649 . . . 2,222 . . .

Sources: United Nations Office on Drugs and Crime (UNODC, 2003); and IMF staff estimates.

higher than the small quantities produced because traders after payment to farmers. These agents are stocks accumulated in earlier years were likely to probably better connected and bank some of their have been liquidated. profits abroad. While these estimates provide an in- These estimates suggest that the value of opium ex- dication of the probable magnitude of revenue accru- ports and opium derivatives increased substantially in ing to Afghanistan, they do not represent the value 2002, in comparison with 2000, to a total of $2.5 bil- that exports of Afghan opiates fetch on the world lion, mainly on account of higher prices. There was a market. The latter is probably substantially more slight drop in 2003 to $2.3 billion mainly because the than 10 times the value that Afghan exports of opi- decline in price more than offset a higher volume. Of ates fetch at the border.26 International dealers and these values, approximately half relates to exports of traffickers therefore earn most of the money made raw opium and the remainder relates to exports of from trading Afghan opiates. morphine and heroin, in roughly equal amounts. These estimates suggest that opium production could Conclusion be up to about half of Afghanistan’s GDP, depending on the measure of non-opium GDP (itself subject As the foregoing analysis makes clear, the rise of to uncertainty) and is roughly equal in value to the opium economy is a relatively recent phenome- Afghanistan’s legitimate, mostly transit, trade (see non that has occurred only over the last 20 years. discussion in this chapter). The long-term failure of the Afghan state and its in- The estimates also indicate that about half the institutions, the breakdown of law and order, the come from opium exports accrues to farmers. This income is also likely to be mostly either spent or saved domestically. The other half of the gross export 26UNODC estimates that, in 2003, about $30 billion will be spent worldwide on Afghan opiates by some 10 million users, for earnings of opiates then accrues to refiners and an average of $3,000 per person per year.

©International Monetary Fund. Not for Redistribution References degradation of agriculture, the absence of commerce Coping Strategies of Opium Traders (October). or any alternative economic opportunity, and the All UNDCP reports available via the Internet: destruction of infrastructure made poppy cultivation www.unodc.org one of the few viable economic activities in many ———, 1999a, Afghanistan Strategic Studies No. 3: The Role areas of Afghanistan. This foundation was progres- of Opium as a Source of Informal Credit (January). sively built upon by raising productivity, developing ———, 1999b, Afghanistan Strategic Studies No. 4: Access to Labor: The Role of Opium in the Livelihood Strategies a qualified labor force, expanding trade routes, and of Itinerant Harvesters Working in Helmand Provinces investing in laboratories. A large number of stake- (June). holders now have vested interests in the survival of ———, 1999c, Afghanistan Strategic Studies No. 5: An this industry. Analysis of the Process of Expansion of Opium Poppy Reversing this process will require a substantial to New Districts in Afghanistan, Second Report and prolonged commitment by the authorities and (November). the international community. This commitment ———, 2000a, Afghanistan: Opium Poppy Survey. will have to go beyond efforts at eradication and law ———, 2000b, Afghanistan Strategic Studies No. 7: An enforcement. It will also demand a comprehensive Analysis of the Process of Expansion of Opium to New strategy for building a stable and unified Afghan Districts in Afghanistan, Final Report (November). state and developing a growing economy that pro- ———, 2001, Afghanistan: Annual Poppy Survey. vides alternative livelihoods throughout the coun- United Nations Office on Drugs and Crime (UNODC), try. If early and visible progress is not made in these 2001, Global Illicit Drug Trends. All UNODC reports areas, a dangerous potential exists for Afghanistan available via the Internet: www.unodc.org. to progressively slide into a narco-state where all le- ———, 2002a, Afghanistan: Opium Survey 2002 gitimate institutions become penetrated by the (October). power and wealth of traffickers. ———, 2002b, Global Illicit Drug Trends. United Nations Office for Drug Control and Crime Preven- tion (UNODCCP), 2003a, Afghanistan: Opium Rapid Assessment Survey. All UNODCCP reports available References via the Internet: www.unodc.org. ———, 2003b, Afghanistan: Opium Survey 2003 CARE International, 2002, Rebuilding Afghanistan: A Lit- (October). tle Less Talk, a Lot More Action (policy brief; Lon- don), October. ———, 2003c, Afghanistan Strategic Studies No. 9: Opium Poppy Cultivation in a Changing Policy Envi- Demekas, Dimitri G., Jimmy McHugh, and Theodora ronment, Farmers’ Intentions for the 2002/2003 Kosma, 2002, “The Economics of Post-Conflict Growing Seasons. Aid,” IMF Working Paper 02/198 (Washington: International Monetary Fund). ———, 2003d, Global Illicit Drug Trends. Dobbins, James, and others, 2003, America’s Role in Nation- ———, 2003e, The Opium Economy in Afghanistan: An In- Building: From Germany to Iraq (Stanta Monica, Cali- ternational Problem, 2nd ed. fornia: Rand Corporation). Available via the Internet: World Bank, 2001, Afghanistan’s International Trade Rela- www.rand.org/publications/MR/MR1753. tions with Neighboring Countries (Washington: World United Nations International Drug Control Program Bank). (UNDCP), 1998, Afghanistan Strategic Studies No. 2: ———, 2003, World Development Indicators (Washington: The Dynamics of the Farmgate Opium Trade and the World Bank).

©International Monetary Fund. Not for Redistribution 3

Fiscal Framework and the Budget

Thierry Kalfon

ery limited information is available on Afghan- get deficits resulted in high inflation and a rapid de- V istan’s fiscal situation before the Afghan In- preciation of the Afghani.2 For most of this period, terim Administration (AIA) took office in Decem- budget spending was focused on security expendi- ber 2001. The last time fiscal developments in tures and government salaries, with very limited Afghanistan were analyzed was during the 1991 Ar- amounts allocated to reconstruction and develop- ticle IV consultations between Afghanistan and the ment. In sum, the national budget became a residual IMF, which covered the 1987/88–90/91 fiscal years instrument in public policies, which were mainly and provided preliminary projections for the 1991 conducted—and illegally financed—by warring local budget. There is no comprehensive source for fiscal leaders according to their own factional interests. data in the subsequent periods, including the civil The collapse of fiscal management and policy war (1992–96) and the Taliban regime (1996–2001). over the past 20 years took place in three stages. Traditionally, before the period of conflict began, government revenues were derived from three main A Slow Descent into Chaos sources: (1) extraction and exportation of mineral resources, particularly gas; (2) income transfers by Partial information and empirical evidence con- state-owned enterprises (SOEs), whose production firm, however, that after two decades of conflict, fis- mostly focused on cement, fabric (especially wool), cal policy and public finance management had disin- fertilizer, and agricultural goods; and (3) customs tegrated. With continuous fighting and deteriorating duties; taxes levied on agricultural land, hotels, and economic conditions, traditional domestic revenues residential dwellings; and sales tax on real estate and steadily declined, together with inflows of external cars. These domestic revenues were substantially assistance, and were progressively replaced by illegal supplemented by grants and external borrowing off-budget revenues, collected both by the central from diverse sources. government and by local warlords. Actual revenue With the communist coup in April 1978, the new performance continually fell short of budget require- government sought to impose unpopular reforms, ments and the central bank provided the govern- including land redistribution, and there was wide- ment with unlimited overdraft facilities to cover the spread unrest. This led to the invasion by the former resulting budget deficits.1 Monetization of the bud- Soviet Union in December 1979, and with the 10

1At the end of 2001, the government’s accumulated overdraft 2The Central Statistics Office released a report in 1996 show- with Da Afghanistan Bank (DAB) was estimated by DAB to ing that the prices of basic goods—such as flour, sugar, and cook- have reached almost (old) Af 15 trillion, equivalent to $300 mil- ing oil—rose on average about 162 times between 1991 and 1995 lion at mid-2003 exchange rates. in Kabul.

©International Monetary Fund. Not for Redistribution Dismal Situation but Resilient Structures years of conflict that followed, the government’s tra- hampered the collection of official domestic rev- ditional revenue sources began to dry up. Fiscal enues, and the government increasingly returned to management by the Soviet-supported communist monetary financing of the budget deficit. government in Afghanistan relied heavily on the printing press and on Soviet financing. Following the retreat of the Soviet troops, and Dismal Situation but Resilient the subsequent fragmentation of political authority Structures and civil war between opposing military factions, provincial warlords gained control of the mineral In December 2001, when the AIA took office, and productive resources in their territories, divert- the Ministry of Finance (MoF) at the center and its ing the associated revenues from the central govern- provincial offices (Mustufiats) had, for most intents ment to themselves, and started collecting large and purposes, ceased to function. amounts of off-budget taxes and fees. Natural gas exports stopped, foreign assistance inflows substan- • Most of the skilled and qualified staff of the tially decreased, and the income of SOEs declined MoF had emigrated during the war. Except for a sharply because of large-scale armed confrontations limited number of senior staff who returned to in industrial areas, resulting in a severe loss of rev- Kabul after the conflict, the vast majority of enue for the central government.3 Despite this fall MoF personnel still in situ lacked the basic in revenue, expenditures increased significantly, re- qualifications to conduct even rudimentary fis- flecting rising defense spending, successive pay in- cal functions. Tasks still being performed in the creases for government employees, and subsidies, MoF were mostly of a clerical nature and car- mainly on food and utilities. The resulting deficits ried out by the different MoF divisions in com- were covered entirely by printing money. plete isolation from each other. After the Taliban regime took power in 1996, it is • The MoF’s infrastructure had been devastated reported to have initially succeeded in collecting by years of war and neglect. This was especially sizable revenues from import duties on trade, agri- true of a number of MoF regional offices and cultural taxes, municipality surcharges, and various customs houses in the provinces, whose build- fees on transportation. The tax revenue base was ings were literally falling into ruins. also broadened to include some Islamic taxes, such as zakat (wealth tax) and ushr (tax on agricultural • Basic telecommunication facilities had failed, products). In the first years of their administration, and most of the primary road network was im- the Taliban also received foreign assistance from passable, resulting in the breakdown of fiscal re- Pakistan (about $10 million in 1998) and Saudi lationships between the center and provinces. Arabia, the latter providing subsidized fuel and di- There was no office automation—in early 2002, rect grants.4 In addition to these official revenues there was only one calculator available for the and grants, the regime benefited substantially from whole Revenue Department—and key govern- 5 unofficial off-budget revenues from taxes on poppy ment offices lacked regular access to electricity. cultivation and duties on opium exports, and on Budget policy was limited to the payment of smuggling of consumer goods from the United Arab salaries, and even these were subject to considerable Emirates to Pakistan. In northeast Afghanistan, delays and arrears.6 Budget preparation consisted of controlled by opposition movements to the Taliban, adding a large central reserve to the previous year’s the main source of income came from the gem trade appropriations, which was drawn down during the (lapis lazuli and emeralds) through collection of ushr on mine owners and zakat on traders. By the end of the 1990s, however, the misrule and increased isola- 5This was the situation in the entire country. The December tion of the Taliban regime, together with four years 2001 World Bank, Asian Development Bank (AsDB), and of drought and continued fighting, had seriously United Nations Development Program (UNDP) preliminary needs assessment estimated that only 6 percent of Afghans had access to electricity in 1993 and Afghanistan had only 2 tele- phones per 1,000 people, compared with 24 in Pakistan, 35 in 3In 1991, the ratio of revenues to estimated net material prod- Tajikistan, and 68 in Uzbekistan. uct fell to 3 percent, according to IMF staff estimates. 6It is estimated that, in December 2001, about $20 million of 4This aid was stopped in the summer of 1998 to protest the salary arrears corresponded to wages incurred during the Taliban Taliban’s refusal to expel Osama Bin Laden (Rubin, 2002). period.

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

in the MoF. The reporting system between the cen- Box 3.1. Public Sector and The Relationship ter and the Mustufiats had broken down completely. Between the Center and Provinces The last annual government accounts prepared by the MoF accounting department related to 1989/90 According to the 1964 Constitution and the and no government accounts had been put together 1966 Organic Budget Law, the public sector in since then. Most files and fiscal data were missing, Afghanistan is composed of ministries, provinces, districts, municipalities (provincial and rural), including all records of the government’s external more than 170 nonfinancial public institutions, debt. and several public financial institutions. The fiscal institutional framework featured a Under the law, provincial and district govern- sharp contrast between the constitutional and leg- ments are deconcentrated offices of the central islative setup—providing for a highly centralized government rather than subnational levels of gov- state with very limited deconcentration—and the ernment. They comprise the provincial offices of reality on the ground was characterized by de facto the different central ministries and are adminis- fiscal autonomy of the provinces (see Box 3.1). For tered by a governor, who is a civil servant directly most of the 1990s, the central government had very appointed by the center. These provincial offices limited control over the provinces, especially in the report both to the governor and to the correspond- fiscal area. The revenues collected by provincial ing line-ministries.1 Provinces neither have a dis- tinct budget nor do they collect their own rev- governors were neither reported nor remitted to the enues. At the request of the local office of each center and were spent off-budget, on expenditure line-ministry, provincial expenditures are made by items that were decided on the basis of local and Mustufiat against the ministry’s annual budget ap- factional interests. The Taliban regime apparently propriations. Similarly, the revenues collected by had some success in bringing the provinces under the provinces are receipts of the national budget the rule of the center in the territories that they and can only be used by the provinces to finance controlled. But, at the end of 2001, the provincial the expenditures included in the line-ministries’ budget; any surplus between centrally budgeted governors were, at the outset, very reluctant to com- expenditures and locally collected revenues must ply with the country’s centralized institutional be transferred to the center. The only exception to framework. these rules concerns certain provincial and rural Notwithstanding the dissolution of the system, a municipalities, which have very limited expendi- workable national fiscal process dating from before ture and revenue assignments, such as trash collec- the conflict remained nominally in place, contrary tion and park services, directly financed through to many other postconflict situations, where pre- the proceeds of local service charges. existing fiscal arrangements were either very weak or nonexistent (e.g., Kosovo and Timor-Leste). The existing fiscal laws and regulations, although imper- 1For instance, there is a Mustufiat in each province (provincial office of the MoF), placed under the authority fect and ignored for many years, provided a starting of both the governor and the central MoF—and reporting point for the reconstruction effort. There was no to both. need to discard all past arrangements and invent completely new ones; the immediate challenge was rather to reactivate and reform a basically sound sys- year, depending upon the political pressures exerted tem, which had not been applied for many years. by line-ministries. In violation of the budget law, The 1966 Organic Budget Law, for example, pro- line-ministries and provincial Mustufiats had opened vided elements of good practice, such as the require- a number of bank accounts in the regional branches ment that all revenues and grants be collected and of the central bank and state-owned banks, which spent through the government treasury, and the were operated outside the purview of the MoF.7 No obligation that the full cost of government projects reconciliation was performed between the govern- be reflected in the national budget. The entire pub- ment’s accounts in the central bank and the treasury lic expenditure management system was compre- hensively documented in the Organic Budget Law, the Accounting Regulations, and the Treasury Man- 7It has even been reported that the real Taliban treasury and ual, and a number of senior officers in the MoF were central bank consisted of a couple of tin trunks in the house of Mohammad Omar, the leader of the Taliban regime, outside still familiar with the procedures. Although often Kandahar (Ewans, 2002). complex, obsolete, cumbersome, and in need of re-

©International Monetary Fund. Not for Redistribution Reconstruction Strategy view, these procedures provided the legal and ad- sistance.11 This assessment led to donor countries ministrative basis for the delivery of basic financial pledging $1.8 billion in grants for the first year and functions, including payment and recording of fiscal $4.5 billion mostly over the first two and a half years transactions, reporting, control, and rudimentary for Afghanistan’s reconstruction (see Chapter 2). accounting.8 The Control and Audit Law also es- Also, international agencies, including the IMF and tablished a supreme audit authority responsible for the World Bank, sent a number of diagnostic mis- the external audit of the whole government. sions to the country to take stock of the existing sit- In spite of major weaknesses (see Chapter 4) and uation—administrative structures, laws and regula- an urgent need for overhaul, a comprehensive tax tions, suitability of staff, availability of facilities and system had also survived, based on the 1965 Income equipment—and to develop appropriate technical Tax Law and 1974 Customs Law, which includes in- assistance action plans. dividual and corporate income taxes, a form of sales In the meantime, donors focused on providing im- tax (business receipt tax), fixed presumptive taxes, mediate humanitarian relief to vulnerable Afghan and indirect taxes on trade (Table A4.1). people and ensuring regular payment of civil service Finally, the underlying arrangements for govern- salaries. In the first few months of the AIA, the inter- ment employment stemmed from basically sound national community, especially the UN system, was legislation providing for a system of centralized re- closely involved in these efforts because the machin- cruitment, and job classification and grading.9 ery of government had not yet recovered enough to fully lead the recovery process. During this intermediate stage, the UN’s Immediate and Transitional As- Reconstruction Strategy sistance Programs (ITAPs)—covering October 2001 to December 2002—were the main instruments With the support of the international community, through which UN institutions addressed the most the AIA and its successor, the Afghan Transitional urgent humanitarian needs of the Afghan popula- Administration (ATA), progressively outlined a tion. These programs mainly focused on (1) the re- government-led development agenda to address the turn and reintegration of refugees and internally dis- humanitarian and reconstruction challenges facing placed people; (2) food assistance; (3) rehabilitation the country. This process involved a number of dif- of crop production; (4) child immunization; and ferent steps. (5) improvement of school enrollment, with esti- First, donor governments and international orga- mated spending of $1 billion12 (Box 3.2). Similarly, in nizations helped the Afghan authorities to assess the the first six months of the AIA (January to June external and technical assistance required to sup- 2002), the payrolls of the civil service both at the cen- port the country’s economic and social recovery ter and in the provinces were processed, controlled, over the short and medium term. In this context, in recorded, and financed through a specific fund, the late 2001, the AsDB, the UNDP, and the World Afghan Interim Administration Fund (AIAF), set up Bank conducted a preliminary assessment of the and administered by the UNDP. However, from the funding requirements for the Afghanistan recon- outset, the payroll was prepared and the salaries paid struction program, covering horizons of one, two by the line-ministries and the MoF’s treasury. and a half, five, and ten years.10 These projections, The Afghan authorities progressively took the presented at the International Conference on Re- lead in formulating the reconstruction strategy and construction Assistance to Afghanistan in Tokyo on put forward their vision for the country’s future. The January 21–22, 2002, concluded that $14.6 billion adoption of the 2002/03 operating budget and the would be needed over a period of 10 years to fund presentation of the National Development Frame- Afghanistan’s recovery, excluding humanitarian as- work (NDF) in April 2002 were turning points in this regard: they marked the government taking a full leadership role in the development agenda and 8 For instance, the different stages usually found in most public an increased focus on reconstruction over humani- expenditure management systems (appropriations, apportion- ment of appropriation, commitments, payment orders, and payments process) are satisfactorily defined in the Accounting Regu- lations and Treasury Manual. 11The financing required for the first year was estimated at 9See World Bank (2002). $1.7 billion and for the first two and a half years at $4.9 billion. 10The horizon of two and a half years corresponds to the com- 12Excluding the civil service payments made by the Afghan In- bined expected terms of the AIA and the ATA. terim Administration Fund.

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

Box 3.2. UN Immediate and Transitional Assistance Programs, 2001–02

On the basis of the AsDB, the World Bank, and the grams had reached 150,000 children; 1.8 million peo- UNDP January 2002 preliminary needs assessments, ple had benefited from food aid provided through the United Nations developed a set of emergency pro- “Food-for-Asset-Creation” and over 250,000 received grams—Immediate and Transitional Assistance Pro- assistance through “Food-for-Work.” grams (ITAPs) for the Afghan People—to deal with the ongoing humanitarian crisis facing Afghanistan. 3. Rehabilitation of crop production and food security These programs, covering October 2001–December (Food and Agriculture Organization). During spring 2002, were financed by $1.1 billion from donor coun- 2002, 1,500 MTs of wheat seed and an equivalent tries and achieved the following main results.1 amount of fertilizer were distributed to 40,000 farmers. During autumn 2002, 3,800 MTs of wheat seed 1. Return and reintegration of refugees and internally and 6,500 MTs of fertilizer were distributed to 80,000 displaced persons (United Nations High Commission for farmers. Refugees). Nearly 1.8 million refugees and 400,000 internally displaced persons were assisted in returning 4. Health. Six million people were vaccinated home, in part under the government’s voluntary repa- against polio, preparing for total polio eradication by triation program. Some 48,000 million tons (MTs) of 2003. Nine million children were vaccinated against food aid, 310,000 return packages, and $35 million in measles. travel grants were provided to returning families. 5. Public administration. Some $50 million worth of About 40,000 shelters were constructed in areas of re- civil servant salary payments were made with the sup- turn all over the country. port of the AIAF. 2. Food assistance (World Food Program). By Decem- 6. Education. The Ministry of Education, with UN ber 2002, 250,000 MTs of food commodities had and NGO support, launched a back-to-school cam- reached over 8 million people, and school feeding pro- paign in March 2002, providing basic educational supplies, such as student kits, teacher kits, and black- 1This list is incomplete and includes only the most salient boards, to 1.8 million children and 70,000 teachers at features. 4,500 schools.

tarian assistance. In particular, the first operating the formulation and implementation of the devel- budget adopted on April 6, 2002, by the AIA was an opment framework: important step in establishing the government’s macroeconomic credibility, by prioritizing operating • Government leadership in the formulation of the de- expenditures under the constraint of limited exter- velopment strategy. The authorities have pro- nal assistance and setting up clear benchmarks for gressively succeeded in making the budget the domestic revenue collection. In addition, the NDF, central instrument for policymaking. Although through extensive consultations between the MoF, the government acknowledged from the outset line-ministries, and the government, outlined the that a number of reconstruction projects would key principles underpinning the government’s strat- be directly implemented by donors and NGOs, egy. It was also a significant step taken by the gov- without the corresponding funds being chan- ernment to move away from the mostly donor- neled through the MoF, the authorities insisted driven strategy underpinning the UN ITAPs to a that all development projects, including those truly government-led reconstruction process. The independently implemented by donors, should NDF focuses on three pillars of development: be approved in the budget, as determined by the (1) human capital and social protection; (2) physi- cabinet. In parallel, the authorities obtained cal infrastructure; and (3) private sector develop- the donors’ agreement that all available re- ment. Under these pillars, the government devel- sources, whatever their sources, be reflected in oped 12 National Programs, of which six National the budget. This principle sought to avoid the Priority Subprograms have been identified to reemergence of parallel budgets, thereby ensuring ceive priority attention from donors and implemen- a proper prioritization of expenditures and tation agencies (Figure 3.1). In the NDF, the gov- putting the government in the driver’s seat in ernment has committed to five main principles in the reconstruction process.

©International Monetary Fund. Not for Redistribution Reconstruction Strategy

Figure 3.1. National Development Framework: Relationship Between Pillars, National Development Programs, and National Priority Subprograms

Pillar 1 Pillar 2 Pillar 3 Human Capital and Social Protection Physical Infrastructure Private Sector Development

1.1 Refugee and Internally Displaced 2.1 Transport 3.1 Trade and Investment Persons Return National Transport Subprogram (roads and airports)

1.2 Education and Vocational Training 2.2 Energy, Mining, and 3.2 Public Administration Telecommunications National Primary Health and Education National Governance Infrastructure Subprogram Subprogram

1.3 Health and Nutrition 2.3 Natural Resource Management 3.3 Security and Rule of Law National Water Resource Investment Subprogram

1.4 Livelihoods and Social Protection 2.4 Urban Management

National Solidarity Program and Emergency National Urban Infrastructure Public Works Subprogram Subprogram

1.5 Cultural Heritage, Media, and Sports

6 National Priority Subprograms (NPSPs)

Cross-Cutting Issues: Governance, Financial Management and Administrative Reform, Human Rights, Gender

• Reliance on market mechanisms and private sec- strong belief, confirmed by international expe- tor–led growth rather than state intervention. The rience, that investment projects would not be authorities have always made it clear that the sustainable unless anchored in coherent pro- state should not be involved in the production grams. This strategy also aims at aligning donor of goods and services, or directly manage the support with the national priorities identified economy. They see the private sector as the by the government and avoiding duplication of main engine of growth and consider that the donor efforts. role of the state should be limited to providing • Government’s transparency and accountability. security, investing in human capital, offering as- Recognizing that accountable and transparent sistance to the most vulnerable, and enabling a public expenditure management is critical for se- suitable environment for the development of curing donor funding, the government publicly the private sector. reiterated its commitment to fiscal transparency • Programmatic approach to policymaking and re- several times. It contracted three reputable inter- source allocation. Underlying the NDF, there is a national companies through competitive bidding

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

to provide interim management and build gov- (CGs), covering the 12 major programs of the ernment capacity in the key areas of fiscal report- NDF, were established and charged with the ing and accounting, and procurement and audit tasks of (1) preparing budget bids for MoF con- (see Chapter 4). sideration during the preparation of the NDB; (2) monitoring the implementation of the oper- • Priority on investing in security and human capital. ating budget; (3) reporting on the progress of Without security, development efforts have lit- the reconstruction strategy; and (4) offering a tle chance of taking hold. In this regard, the au- forum for general policy dialogue in the various thorities’ priorities included the development of sectors. Each CG is chaired by a lead line- a national police force and army, reintegration ministry and includes all the UN agencies, of excombatants, and revival of the judicial sys- donor countries, and NGOs that are the most tem. The authorities also put strong emphasis active in the program area. In addition to the on immediate enhancement of the education CG structure, an Afghanistan Development system and school enrollment, especially of Forum is convened every year in March, with girls, given that quality education is the founda- the participation of all the cooperation partners tion for economic development. One of the to the NDB, to review priority areas and policy major achievements of the government in this objectives, assess progress made in the previous area over the past year included getting three year, and firm up external assistance pledges. million children back to school. This process culminated with the adoption by the cabinet, in March 2003, of the 2003/04 National Fiscal Policy Framework: Development Budget (NDB), translating the high- Postconflict Budgeting level architecture of the NDF into detailed development projects, with precise identification of funding During the first fiscal year of the new government sources for each project: (2002/03), the authorities succeeded in maintaining • The 2003/04 NDB marked full ownership by fiscal discipline and providing basic services to the the government of the development agenda population despite the very difficult circumstances, and made the budget the focal point for deci- including the continued lack of a satisfactory fiscal sion making on government policy and the al- relationship between the center and the provinces, location of domestic and external resources. In and a very low base for domestic revenues. Avail- particular, the NDB combined in a single docu- ability of external assistance during the year was a ment the 2003/04 operating and development key factor in achieving this positive outcome. budgets, which comprised most of the projects In fiscal year 2003/04, the authorities sought to financed by the donor community, including increase the operating and development budgets, the 2003/04 UN Transitional Assistance Pro- especially in the areas of security, education, grams (these projects, worth $815 million, suc- health, and humanitarian assistance. Ensuring that ceeded the 2002/03 ITAPs). This represented a this fiscal strategy remained compatible with the significant improvement over 2002/03, when authorities’ commitment to fiscal discipline re- most of the development projects (including quired that (1) the strong support pledged by the ITAPs) were carried out by donors outside the international community materialized; (2) domes- budget. This document was prepared by the tic revenue collection increased to the ambitious MoF and approved by the cabinet after exten- level set out in the budget; and (3) significant sive consultation and negotiation with line- progress could be made toward the fiscal unification ministries, including information compilation, of the country. strategy formulation, prioritization, and cutoffs to observe resource constraints. Budget for 2002/03: A Positive • The adoption of the first NDB was accompa- Outcome nied by a significant reform of coordination between the government and donors, aimed at The operating budget for 2002/03 (March 21, enhancing the effectiveness of government- 2002–March 20, 2003) was prepared with the assis- donor interaction. Twelve Consultative Groups tance of the IMF and the World Bank staff, and

©International Monetary Fund. Not for Redistribution Fiscal Policy Framework: Postconflict Budgeting adopted by the cabinet on April 6, 2002.13 The pas- country. The low share of spending on health and sage of this first budget was both a difficult challenge education, 20 percent of the total envelope, resulted and a significant achievement, given the total ab- from anticipated capacity constraints in the recruit- sence of reliable fiscal data from previous periods. ment of new teachers in the first year, and the as- This operating budget, covering the entire state’s sumption that most development spending in the fiscal transactions for both the center and the social sectors would be carried out by donors outside provinces, relied heavily on donor financing, and the operating budget. aimed primarily at ensuring the payment of civil ser- Comparing Afghanistan’s 2002/03 operating bud- vice and military wages.14 get with the operating budgets of a sample of low- Expenditures were budgeted at (new) Af 15.7 bil- income countries (Appendix 3.1) shows that, in lion, plus an additional Af 750 million to clear wage 2002/03, budgeted current expenditure was, in per- arrears accumulated prior to the new government’s centage of GDP, much lower in Afghanistan than tenure. This corresponded to a dollar amount of the sample average (11 percent compared with 18 $483 million, including clearance of wage arrears, percent). Similarly, the civil employment caps in- using the exchange rate prevailing at that time of cluded in the 2002/03 budget placed Afghanistan at Af 34 per U.S. dollar as an accounting rate. This the low end of public civil employment relative to budget included a modest revenue target—$83 mil- population. lion or 17 percent of total spending—reflecting the The budget decree for 2002/03 included a strong narrow tax base and the low domestic revenue col- commitment to fiscal discipline by explicitly pro- lection observed in the first three months of the hibiting the government from taking recourse to AIA. This left a gap of $400 million—83 percent of central bank financing (no-overdraft rule) and by the budget—to be financed by donor assistance limiting ministerial allotments to the amount of re- (Table 3.1), because the authorities precluded do- sources actually available in the government’s ac- mestic financing of the budget. This budget also in- counts.16 Other elements of sound public expendi- cluded a 240,000 cap on civil employees, of which ture management included the introduction of 60 percent were in the provinces and 40 percent at binding headcount ceilings for each ministry’s civil the center, broken down by ministry. This allowed, service staff, provision that all state operating ex- in theory, all employees that were on the payroll penditures should be explicitly authorized in the prior to the Taliban regime to continue working. budget, and the establishment of specific funding for In terms of composition of expenditures (Table wage and pension reforms. The decree also sepa- 3.1), civil service wages, excluding the police and rated SOEs from the rest of the civil service, by re- army but including the SOEs, were projected at moving the compensation due to SOE employees $120 million and military salaries were estimated at from the budgeted wage appropriations, making this $99 million, for a total estimated wage bill repre- instead part of the government’s transfers and subsi- senting a little less than 48 percent of total spend- dies to SOEs. The authorities also publicly stated ing.15 Together with the police, security-related that they intended to restrict, to the extent possible, spending amounted to about 45 percent of total external borrowing to the financing of the develop- spending, a proportion considered justified given ment budget, that is, the operating budget would the need to reestablish security throughout the mainly rely on external grants. According to preliminary estimates, actual spending in 2002/03, including estimated nonwage 13Although preliminary development expenditure numbers provincial expenditures, reached 95 percent of bud- were submitted to the international community in October geted amounts in Afghani terms (Table 3.2). In U.S. 2002, there was no development budget as such in 2002/03 and dollar terms, expenditures amounted to an esti- development expenditures were directly carried out by donors. The authorities made progress toward better integration of the mated $349 million, much less than the $460 mil- operating and development budgets in the preparation of the lion initially envisaged, due to the depreciation of 2003/04 NDB by presenting both budgets together. the Afghani during the year (the annual average ex- 14In a break from past practice, under the new budget, the wages of the provincial civil service were henceforth to be paid change rate was Af 44.5 per U.S. dollar whereas the by the center. 15Sum of the rows “wages and salaries” and “subsidies to SOEs wages” and half of the total appropriations for defense, interior, and national security in Table 3.1 (excluding the clearance of 16In the absence of a parliament, presidential decrees signed by wage arrears). the head of the AIA and ATA have the force of law.

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

TABLE 3.1 General Government Current Budget, 2002/03 (In millions of U. S. dollars) 2002/03 1. Wages and salaries (excluding defense, interior, national security, and SOEs) 104.3 Of which: allocation for wage reform 24.1 2. Goods and services (excluding defense, interior, and national security) 60.7 3. Capital expenditure (excluding defense, interior, and national security) 14.4 4. Defense, interior, and national security 198.8 Defense 96.6 Interior 83.4 National security 18.9 5. Subsidies to SOEs 34.1 Wages 15.9 Other 18.3 6. Social transfers 18.8 Of which: allocation for pension reform 15.5 7. Interest 6.6 8. Contingency 22.5 9. Total 460.3 10. Wage arrears clearance 22.5 11. Revenues 83.0 12. Financing need 399.8 13. Foreign grants 399.8

Sources: Afghan authorities; and IMF staff estimates.

budget accounting rate was Af 34 per U.S. dollar).17 spending were defense, interior, education, health, In the first half of the year, budget spending was very and the president’s office, which dispenses presiden- low, reflecting limited administrative capacity, a tial discretionary funds that were reallocated to di- lack of financing, and a shortage of banknotes in the verse expenditure items during the year. central bank before the currency conversion. Ex- Domestic revenue as reported to the center penditures, however, picked up sharply in the sec- reached about $132 million, significantly higher ond half of the year, especially in the fourth quarter, than the budgeted $83 million. More than 80 per- as donor disbursements accelerated and administra- cent of the reported revenues were collected in the tive capacity improved, and there was no longer a provinces, with the remainder coming from the shortage of banknotes. Figures 3.2 and 3.3 show that line-ministries at the center. About 60 percent of budget execution at the center during the last five the locally collected revenues were customs rev- months of the year focused mostly on salary pay- enues (a breakdown of noncustoms revenues into ments (74 percent of total spending, significantly the different categories of revenues is not available). more than the budgeted 48 percent) and on three But only a small proportion of the reported provin- priority sectors: security (43 percent), education (19 cial revenues were actually transferred to the central percent), and health (8 percent).18 Accordingly, the government’s accounts. ministries that accounted for the highest shares of These combined factors have limited the financing requirement to an estimated $232 million (66 17Expenditures excluding the clearance of wage arrears. percent of total spending), considerably less than the 18No comprehensive information on the composition of ex- initially planned $400 million. This gap was mainly penditures is available for the first seven months of the year, nor met through (1) donor-assistance grants ($184 mil- in the provinces. Sixteen percent of spending also related to “economic affairs,” but this category lumps together highly differ- lion), including support ($125 million) from the ent items. Afghanistan Reconstruction Trust Fund (ARTF; see

©International Monetary Fund. Not for Redistribution Fiscal Policy Framework: Postconflict Budgeting

TABLE 3.2 Budget Execution, Center and Provinces, 2002/03 (In millions of U.S. dollars)

Comp. ______2002/03 Q1 Q2 Q3 Q4 Period Budget7 Adj.8 Act.7, 8 Domestic revenue 18.0 26.9 41.0 46.1 . . . 83.0 64.0 131.9 Customs revenue1 9.9 14.3 21.2 22.3 ...... 67.8 Central ministries 0.6 2.3 13.4 7.1 ...... 23.3 Noncustoms provincial1 7.5 10.3 6.3 16.7 ...... 40.8 Expenditure 36.0 69.3 102.1 131.7 9.8 482.8 369.2 348.9 Center 18.0 34.1 68.0 67.7 5.7 ...... 193.1 Provinces (payroll only)2 3.0 11.0 14.8 33.6 4.1 ...... 66.5 Net presumptive provincial expenditures3 15.0 24.2 19.8 30.3 ...... 89.3 Balance (MoF) –18.0 –42.4 –61.1 –85.6 –9.8 –399.8 –305.7 –217.0 Float and adjustment4 0.4 –0.7 –0.9 –6.4 –7.1 ...... –14.8 Balance (DAB) –17.7 –43.1 –62.1 –92.0 –16.9 –399.8 –305.7 –231.8 Donor assistance grants 26.3 39.0 37.9 60.8 19.9 ...... 183.5 Bilaterals 10.0 10.0 6.4 0.0 0.0 ...... 26.4 UNDP 16.3 10.0 0.0 0.0 0.0 ...... 26.3 ARTF 0.0 18.5 30.3 56.3 19.7 ...... 124.9 LOTFA 0.0 0.0 1.2 4.5 0.0 ...... 5.7 Others 0.0 0.0 0.0 0.0 0.2 ...... 0.2 Donor assistance loans 0.0 0.0 0.0 25.0 0.0 ...... 25.0 Other financing5 0.0 22.8 4.2 12.0 0.0 ...... 39.0 Exchange rate adjustment6 –6.4 –7.4 4.0 8.4 1.5 ...... 0.1 Surplus/deficit net 2.2 10.8 –16.0 14.2 4.5 ...... 15.8

Sources: Afghanistan’s Ministry of Finance; DAB; and IMF staff estimates. Note: All arrears to the World Bank, AsDB, and IMF were cleared in 2002/03 through grants ($51.2 million) and Afghanistan’s reserve tranche with the IMF ($5.7 million). 1As reported to the MoF. However, a small part of this money is remitted to the center (transfers received by the MoF). 2Provincial salaries were paid by the center except for Herat province, which paid the salaries of its government staff out of the revenues it collected. 3Because no reliable data on nonwage provincial expenditures are available at the center at this date, these expenditures are assumed to equal the provincial revenues reported to the center plus net transfers from the center. 4Variation between the fiscal position recorded at MoF and DAB. This discrepancy is because of the difference (“float”) between checks issued and cashed and the fact that the provinces’ accounts in DAB branches were not consolidated into the government’s central accounts at the end of the year. 5International Air Transport Association (IATA) accumulated overflight fees, sale of a telecommunications license, one-off transfer from the Min- istry of Commerce, and transfer of previous year’s provincial surpluses. 6This adjustment reflects the difference between the exchange rate used for donor grants (effective exchange rate at the time of deposit in the government’s accounts) and the average exchange rate used to convert into U.S. dollars the other components of the table (Af 44.46 = $1). 7Including Af 750 million for the clearance of wage arrears related to payrolls incurred before the interim administration took over in January 2002. 8The approved budget was expressed in Afghanis and was converted into U.S. dollars at the time of its adoption (March 2002), using an accounting exchange rate of Af 34 = $1.The depreciation of this rate to an annual average exchange rate of Af 44.46 = $1 results arithmetically in a downward adjustment of the U.S. dollar amount of the budget.

Box 3.3); (2) one-off receipts19 ($39 million); and positive balance of $16 million at the end of the year (3) partial use of an external loan extended by the (Table 3.2).20 Asian Development Bank ($25 million), leaving a The execution of the first operating budget of the AIA/ATA included a number of positive features. 19Including $22 million from the International Air Transport Association in accumulated overflight rights; $5 million from the sale of a telecommunications license; $7 million of customs valu- 20This figure includes the external assistance deposited by ation fees accumulated in the past few years; $4 million of last donors in the central bank’s account in the U.A.E. but not yet year’s provincial surpluses. transferred to the government’s accounts.

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

First, the authorities respected their commitment to Figure 3.2. Budget Execution: Economic fiscal discipline. The prohibition of monetary fi- Classification, 2002/03 nancing of the budget (no-overdraft rule) was ob- (Last five months of the fiscal year) served, except in the third quarter, when the government’s account went temporarily into overdraft because of time lags in donor disbursements and a Pensions Capital Expenditure 0% 9% lack of communication between the MoF and the Transfers and central bank. Second, despite a slow start, most of Subsidies 1% the annual budget was spent, and the budget was truly national in scope since more than 45 percent of the estimated spending benefited the provinces.21 Purchase of Goods and Services Third, actual spending reflected the government’s 16% sectoral priorities for education, health and social protection, and security. Fourth, domestic revenue collection as reported to the MoF was much higher than envisaged in the budget. And, fifth, expenditures were fully financed from revenues, grants, and loans, and the government ended with a significant positive balance at the end of the year. These achievements were all the more significant Wages and Salaries 74% given that the execution of the 2002/03 operating budget—and its monitoring—was undertaken in the context of a number of obstacles. The main ob- Sources: Afghanistan’s Ministry of Finance; Afghanistan’s Financial Management Information System. stacle was the lack of unity of the fiscal system because of weak central control over the provinces. Although provinces collected the bulk of domestic revenues and reported these revenues to the center—albeit with considerable time lags—only very limited amounts of these revenues were actually transferred to the central government’s accounts Figure 3.3. Budget Execution: Functional during 2002/03 (about 27 percent).22 The reluc- Classification, 2002/03 (Last five months of the fiscal year) tance of most provinces to transfer local revenues also led to the collapse of the equalization system between “rich” provinces (border provinces collect-

Economic Affairs ing large customs revenues) and “poor” provinces 16% (inland provinces). In the absence of revenue remit- Recreation and General Public Services Culture 9% tances from the rich provinces, the government Housing and 3% Communal found itself unable to allocate to the provinces the Services transfers budgeted in the budget decree. In addition, 0% contrary to the existing fiscal regulations, most Social Defense Protection 26% provinces did not send to the MoF reliable reports 2% Health on their nonwage expenditures, for which compre- 8% hensive information was therefore unavailable for 2002/03. This missing information seriously complicated the monitoring of the execution of the budget Education 19% Public Order and Safety 17% 21Including “presumptive nonwage provincial expenditure.” 22It is also likely that revenues reported by the provinces were Sources: Afghanistan’s Ministry of Finance; Afghanistan’s well below the revenues actually collected by the provinces. The Financial Management Information System. 1964 Organic Budget Law requires that any positive balance between locally collected revenues and budgeted expenditure should be promptly sent to Kabul.

©International Monetary Fund. Not for Redistribution Fiscal Policy Framework: Postconflict Budgeting at both the center and the provinces. To compare actual spending with the budget, the authorities had Box 3.3. Afghanistan Reconstruction to estimate the provinces’ unknown nonwage ex- Trust Fund penditures by assuming that all revenues collected by each province were entirely spent by the same The main source of funding for the 2002/03 oper- province.23 Furthermore, it was only during the sec- ating budget was the Afghanistan Reconstruction Trust Fund (ARTF), which covered 54 percent of ond half of the year that it became possible to get a the funding requirement. Established in April clear and reliable picture of spending by ministry 2002, the ARTF is a coordinated funding mecha- and by economic or functional categories, and this nism administered by the World Bank, which pro- was only for the center, following the introduction vides financial grant support to the Afghan govern- of a computerized system of expenditure recording ment in three main areas of expenditures: recurrent at the MoF. civil costs of the government (excluding the army There were also problems in estimating the and national security), priority investments, and benefits granted to returning expatriate Afghan number of permanent staff employed by the gov- professionals. In 2002/03, ARTF disbursements fo- ernment in 2002/03 and enforcing the recruitment cused almost entirely on the first component; ceilings included in the budget decree. This was for under the second component, only four investment the following reasons: (1) the preparation of a projects were approved (on a commitment basis) in nominal roll of employees for the whole country late 2002; and no disbursement had yet taken place was a long and resource-demanding process, which under the third component (return of Afghan ex- the authorities were not able to complete during patriates). The ARTF is governed by a manage- 2002/03; (2) the executed provincial payroll could ment committee, which consists of representatives of the Asian Development Bank, Islamic Develop- not be broken down by ministry in the first half of ment Bank, UNDP, and World Bank, with day-to- the year; (3) contrary to the provisions of the bud- day administration of the fund performed by the get decree, a part of the staff working in the SOEs World Bank. A monitoring agent has been ap- continued to be directly paid through the govern- pointed by the World Bank to ensure proper fidu- ment payroll and not through transfers to the ciary management; a donor committee supervises SOEs; and (4) a number of provinces apparently the management and administration of ARTF and hired and paid a significant number of civil service provides policy guidance. staff directly out of their local revenues without in- forming the center. Although the overall initial budget ceiling was respected, important reallocations between expen- get were financed within the overall budget ceiling diture items were made during the fiscal year with- through the use of the substantial 2002/03 presi- out the budget being revised accordingly: (1) gov- dential reserve fund and the wage and pension re- ernment employees’ food allowances were raised by form reserves. (No such reforms took place in 37 percent in May 2002 to increase government 2002/03.) wages from their very low levels; (2) food in-kind No detailed information is available on expendi- distributed to civil service staff by the World Food tures directly spent by donors on development pro- Program was replaced in September 2002 by a new jects in 2002/03 because the Afghanistan Aid Co- monetary allowance; (3) civil servants received in ordination Agency (AACA) has not yet received November 2002 a salary bonus corresponding to comprehensive information on donors’ project fi- one-month salary (“Ramadan bonus”) to ease the nancing. It is estimated, however, that total dis- social tension stemming from the depreciation of bursements of external assistance reached about the Afghani during the currency conversion (see $1.4 billion, excluding support for the operating Chapter 5); and (4) a number of line-ministries, budget. Less than 40 percent of these funds, which including the Ministry of Education, apparently were channeled outside the government’s budget, hired more staff than authorized in the budget de- went to reconstruction; the remaining were allo- 24 cree. These slippages in the execution of the bud- cated to humanitarian relief.

23Nonwage provincial expenditures are thus estimated as equal to provincial revenues reported to the center plus net transfers received from the center. 24ATA and AACA (2003).

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

Budget for 2003/04: Increasing more than domestic revenues collected in 2002/03— Domestic Revenues was based on the assumptions of (1) strong economic growth (see Chapter 2); (2) an increase in revenue The authorities presented both the 2003/04 oper- collection expected from the planned customs re- ating and development budgets—for a total of $2.3 form (see Chapter 4); and (3) the effective central- billion—to the donor community during the first ization of locally collected revenues. Afghanistan High-Level Strategic Forum (AHSF) This revenue assumption left a $350 million fi- held in Brussels in March 2003. nancing gap to be covered by foreign assistance, of The budget decree for 2003/04 reiterated the au- which $250 million was projected to be financed thorities’ strong commitment to fiscal discipline. through the ARTF. Military and other security ex- The decree explicitly reaffirmed the government’s penditures, which are not eligible for financing commitment to the principle of no government through the ARTF, were expected to be financed overdraft with the central bank. It also included, as through domestic revenues and by $100 million in in the previous year, ceilings for total staff by min- donor assistance channeled through the Law and istry but, unlike before, the authorities had the ca- Order Trust Fund for Afghanistan (LOTFA) and the pacity to meaningfully monitor, and effectively Army Trust Fund. (These two trust funds, managed enforce, these ceilings.25 The budget decree fur- by the UN, were established in 2002 to channel thermore restricted external borrowing to $300 mil- donor assistance to support military and security re- lion for the entire fiscal year and limited its use to current expenditures.) The authorized headcount the funding of development projects and meeting ceiling for civilian employees was set at 356,000, temporary cash flow requirements for the operating which represented a 50 percent increase over the budget. The decree specifically mentioned the pas- previous year’s budget (whose civil employment cap sage of a customs reform package and ranked the was low by international standards, see Appendix centralization of revenues as one of the govern- 3.1), mainly concentrated in the Ministry of Educa- ment’s priority tasks for the year. A Civil Service tion, growing from an authorized level of 72,000 in Reform Fund ($20 million) was established to ac- 2002/03 to 166,000 in 2003/04. Only 60,000 new commodate the much-needed reforms of the civil staff (mainly teachers) would actually be hired; the service (see Chapter 4). The reserve funds of the remainder of the increase would result from the operating budget were reduced and were subject to recording of staff who were already paid by the tighter controls.26 provinces in 2002/03 from local revenues, but whose The 2003/04 operating budget envisaged expendi- payroll was not reported to the center. tures equivalent to $550 million, an increase of 58 The 2003/04 development budget, which was the percent compared with the previous year’s outcome, first real development budget prepared by the ATA, reflecting the fact that in 2002/03 government spend- amounted to $1.8 billion (Table 3.4),27 to be fully fi- ing was constrained by limited absorptive capacity. nanced by external assistance. Over one-third of the Almost 40 percent of planned spending was allocated development budget was to be spent on the rehabili- to defense, public order, and safety; 24 percent to edu- tation of infrastructure; another one-third on health, cation; and about 10 percent to health and social pro- social protection, and humanitarian assistance; and tection (Table 3.3). Wage and salary payments ac- 14 percent on education. All donor projects were counted for 50 percent of the budget, which supposed to be reflected in the budget, especially represented a significant reduction in the weight of most of the Transitional Assistance Programs for wages in the operating budget, compared to actual Afghanistan (TAPAs; successors to ITAPs) carried spending in 2002/03 (74 percent). out by UN agencies—$750 million of the $815 mil- Domestic revenues were budgeted to reach $200 lion envisaged for TAPAs in 2003/04 was included million. This ambitious revenue target—52 percent in the development budget. However, full compre- hensiveness was not yet achieved because the budget envelopes did not include the development costs for 25This is because the budget decree included an obligation for each ministry to break down its headcount ceilings into “sub- ceilings” for the center and each province, which was not the case in 2002/03. 27Actual disbursements during the year, however, were ex- 26 “Unallocated items” in the economic and functional classifi- pected to be less, reflecting the disbursement pace of the various cation of expenditures in Table 3.3. multiyear projects.

©International Monetary Fund. Not for Redistribution Fiscal Policy Framework: Postconflict Budgeting

TABLE 3.3 Operating Budget, 2003/04 (In millions of U.S. dollars)

______Outturn (Estimates) Budget Q1 Q2 Q3 Q4 2003/04 Domestic revenue1 200 44 47 42 75 207 Center . . . 3 7 12 26 49 Provinces . . . 41 40 30 49 159 Expenditure2 550 80 91 114 167 451 Central government3 . . . 35 58 61 90 244 Provinces4 . . . 45 33 53 77 208 Economic classification 550 80 91 114 165 451 Wages and salaries 277 33 63 83 120 299 Purchase of goods and services4 178 39 16 16 23 94 Transfers and subsidies 25 3 4 3 2 12 Pensions . . . 0 3 0 1 4 Capital expenditure 39 5 5 12 19 41 Unallocated 31 Functional classification 200 80 91 114 167 451 General public services 49 7 10 9 16 41 Defense 128 18 20 31 53 123 Public order and safety 82 13 23 30 39 105 Education 133 5 18 23 31 77 Health 28 3 5 7 7 22 Social protection 25 0 3 1 4 8 Housing and communal services4 12600127 Recreation and culture 13 1 2 3 4 10 Economic affairs 41 6 9 10 14 38 Unallocated 52 Balance (MoF) –350 –36 –44 –72 –92 –244 Float and adjustment5 . . . 18 –25 14 27 35 Balance (DAB) –350 –18 –68 –58 –65 –209 Donor assistance grants 350 50 27 60 77 214 ARTF 250 46 11 50 69 175 LOTFA and Army Trust Fund 100 4 16 10 9 39 Bank balance . . . –32 41 –2 –11 –4

Sources: Afghanistan’s Ministry of Finance; DAB; and IMF staff estimates. 1As reported to the MoF. However, a small part of this money is remitted to the center (transfers received by the MoF). 2Checks issued by the MoF. 3Provincial salaries are paid by the center except for Herat province, which pays the salaries of its government staff out of the revenues it collected. 4Including $25.2 million paid in the first month by the Ministry of Reconstruction in Herat province for the purchase of services (advance payments to contractors). 5Variation between the fiscal position recorded at MoF and DAB.This discrepancy is because of the difference (float) between checks issued and cashed, and the fact that the provinces’ accounts in DAB branches are not yet consolidated into the government’s central accounts at DAB.

the Afghan National Army, the Counter-Narcotics Preliminary budget execution data indicate that Program, and the preparation of the national elec- the authorities adhered to their commitment to fiscal tions to be held in 2004.28 discipline and effectively enhanced domestic revenue mobilization (Table 3.3). Revenue performance 28The Afghan National Army and Counter-Narcotics Program reached an estimated $207 million—higher than the development expenditures were kept outside the budget for con- targeted $200 million and most of these reported rev- fidentiality reasons and because they were planned and executed enues, still mainly collected in the provinces, were directly by specific bilateral donors. The cost of the national elections was not included in the 2003/04 budget because it was transferred to the government’s central accounts. In- not known at the time the budget was prepared. cluded in this were transfers by the provinces of their

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

TABLE 3.4 Development Budget, 2003/04

______2003/04 In millions of Afghanis In percent Pillar I: Human and social protection 858.3 48.2 Refugee return 162.6 9.1 Education 244.0 13.7 Health and nutrition 173.5 9.7 Rural livelihoods and social protection 248.0 13.9 Culture/media/sports 30.2 1.7 Pillar II: Physical infrastructure 637.2 35.8 Transport and telecommunications 253.6 14.2 Energy, mining 162.4 9.1 Natural resources 146.1 8.2 Urban management 75.2 4.2 Pillar III: Private sector development 284.8 16.0 Trade and investment 5.5 0.3 Public administration 87.9 4.9 Justice 27.0 1.5 Interior 98.4 5.5 Mine action 66.1 3.7 Total 1,780.4 100.0

Source: Afghan authorities. Note: Items not included in the development budget: Mine Action Program, Afghan National Army development costs, Counter Narcotics Program, and MIGA Investment Guarantee Trust Fund.

2002/03 surplus revenues to the center. Spending got and customs revenues be recorded and transmitted to off to a slow start in 2003/04—because of delays in the center on a regular and timely basis; (2) provin- budget allotments and procurement difficulties—and cial authorities refrain from meeting their expendi- amounted to an estimated $450 million for the year tures directly out of their local revenues; and as a whole, substantially lower than envisaged in the (3) provincial expenditures be limited to budget al- budget. The no-overdraft rule was observed through- lotments received from the center. A major challenge out the year. While donor grant disbursements were was to ensure that provincial governors complied lower than had been envisaged in the budget, they with their signed agreement. In parallel with this ini- were more than sufficient to finance the budget tiative, 40 newly trained fiscal experts were sent to deficit, allowing some carryover of available financ- the provinces—including six foreign consultants sta- ing for the 2004/05 budget. Donor commitments for tioned in the largest provinces—to enhance financial 2003/04 covered about 70 percent of the require- reporting from the provinces on their revenues and ments expressed in the NDB. As a result, the govern- expenditures, and to follow up locally on the agreement was able to implement high-priority projects in ment on revenue centralization (see Chapter 4). infrastructure, education, and other critical areas. During 2003 the authorities made important progress toward addressing the serious weaknesses Appendix 3.1. Programs of the that hampered the execution of the 2002/03 budget. National Development Framework The most significant step in this regard was an agreement concluded between the central government The following provides a summary of the 12 na- and provincial governors to enforce effective central- tional programs of the government’s National Pro- ization of provincial revenues. In May 2003, the Na- gram for Reconstruction.29 Information has been tional Security Council chaired by President Karzai issued an instruction cosigned by the major provincial governors, ordering that (1) all provincial tax 29See World Bank (2003).

©International Monetary Fund. Not for Redistribution Appendix 3.1 taken from government documents including the their communities. This program will also address is- National Development Framework and the Na- sues of the disabled, who comprise nearly 4 percent tional Development Budget. of the population. Refugee return: With an unprecedented number of Cultural heritage, media, and sports: Recognized as refugees returning to Afghanistan and settling in a key element in consolidating a common Afghan urban centers, facilities and services—already se- identity, particularly during the transitional period, verely pressed to serve current residents—have been this program will promote a number of activities, in- stretched beyond capacity. This program aims to im- cluding the preservation of Afghan cultural her- prove information, registration, and documentation itage, rehabilitation of sports infrastructure, and re- of refugees, and provide support to the neediest and habilitation of the media, with participation of their host communities. Specific measures are de- women encouraged in all areas. signed to cater to the needs of the most vulnerable Transport and telecommunications: The vital role during the cold winter months. The program will also of good communication and transport networks in address policy and institutional issues and develop economic development and national integration the capacity of government agencies charged with as- form the basis of this program. Having suffered sig- sisting refugees and coordinating their reintegration. nificant destruction and neglect through years of Education: Given the appalling conditions of the war, large investments are planned in these net- education system in the country, evidenced by the works. In addition to building physical infrastruc- population’s education indicators—among the worst ture for both national and secondary roads, this in the world—and the destruction of many of the program will also create a regulatory environment country’s educational institutions, development of to promote private sector participation in the trans- the education system is a vital need for future port sector and address other policy and institu- growth and development in Afghanistan. The edu- tional issues. In the areas of telecommunications, cation program covers a range of essential areas, in- telephone, information technology, Internet, and cluding improving education infrastructure, teacher postal service, improvements will be addressed, as development, increased primary and secondary will the regulatory environment for private sector school enrollment with a particular focus on female involvement and the development of the technol- enrollment, as well as vocational training and early ogy for distance education in priority areas. childhood development. Urban management: With Afghanistan’s urban Health and nutrition: Infant, child, and maternal population estimated at about 30 percent of the mortality rates in Afghanistan are very high and total population, this program aims to create cities there is widespread prevalence of communicable dis- as viable economic hubs around the country. The eases and poor nutrition. The health and nutrition program will address rebuilding in cities that have program will therefore focus on decreasing mortality been destroyed during the war, the provision of ser- rates through the provision of basic packages of vices to housing areas, wastewater and sanitation health services, increasing the capacity of govern- services, new land acquisition for housing as well as ment to develop necessary systems and policies, as attention to policy issues such as town planning well as implementing a number of specific interven- and management and standards, procedures, and tions, including safe motherhood and nutrition pro- legislation. grams. The expected results are quantifiable improve- Energy and mining: As in other areas, the power ments in health indicators as well as improvements in and mining sectors have suffered severe neglect after health infrastructure and institutional capacity years of war. The energy and mining program, which within relevant agencies. recognizes the significant role of the private sector in Livelihoods and social protection: Aimed to address this area, aims to secure cost-effective power supplies the risk and deprivation experienced by large parts to urban areas and the expansion of these power sup- of the rural Afghan population, this program will plies to rural areas where it is cost-effective and prac- focus on five areas: institutional strengthening, tical. The role of government will focus on regula- macroeconomic regeneration, community-based de- tion and development of a policy environment for velopment, protection of lives and livelihoods, and private sector participation, rather than a directed income generation. It is hoped that communities operational approach. will be empowered by being directly involved in de- Natural resource management: Focusing on com- signing and implementing reconstruction efforts in munity management of natural resources and

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

TABLE A3.1 Afghanistan’s 2002/03 Budget Compared with Budgets of Selected Low-Income Countries

1 ______Low-Income Countries Afghanistan Eastern Latin 2002/03 Average Africa Asia Middle East Europe America General government employment (in percent of population)2 . . . 3.8 1.7 2.9 3.8 8.2 2.6 Civilian government employment3 1.14 3.3 1.4 2.1 3.5 7.2 2.3 Armed forces . . . 0.5 0.3 0.8 0.3 1.0 0.3 2002/03 budget (in percent of GDP) Total revenues . . . 21.6 22.6 17.3 20.5 18.7 28.8 Revenues, excluding grants 2.1 18.7 16.8 14.2 18.5 18.0 25.8 Tax revenues . . . 16.1 14.5 11.5 15.0 15.8 23.6 Nontax revenues . . . 2.6 2.3 2.8 3.5 2.2 2.3 Grants . . . 2.9 5.8 3.1 2.0 0.7 3.0 Total expenditures . . . 27.2 26.7 20.5 30.5 23.4 35.1 Current expenditures 11.55 18.5 16.1 10.9 22.0 19.6 23.8 Of which: wages 7.2 5.6 5.8 3.5 . . . 4.9 8.4 Capital expenditures . . . 8.7 10.6 9.6 8.5 3.8 11.3 Memorandum items Population in 2002/03 (in millions) 22.0 GDP for 2002/03 (in millions of 4,000.0 U.S. dollars)

Sources: Employment data: Schiavo-Campo, de Tommaso, and Mukherjee, 1997; budget data: Gupta and others, 2002. 1Based on a sample of 39 low-income countries in these regions (see list of countries in Table A3.2). 2Data from a 1997 World Bank Study, mostly based on 1995 and 1996 numbers. Excludes state-owned enterprises. 3Central and local governments excluding defense and state-owned enterprises. 4Including the police but excluding national security and army. 5Operating budget for 2002/03, excluding clearance of wage arrears.

improvements in livelihoods, this program will re- Public administration: The public administration habilitate and enhance the development of sus- program focuses on three key areas: the establish- tainable agriculture, horticulture, and livestock ment of an effective civil service system, the reha- production, including the identification of viable bilitation of the physical infrastructure of govern- substitutes for poppy production. Resource protec- ment, and the development of an organizational tion measures will include sustainable water usage structure that permits the government to deliver and protection of existing forests as well as new the needed goods and services to the Afghan pub- planting through agro-forestry programs. Addition- lic in an effective manner. The program will also ally, environmental laws and policies will be devel- aim to rationalize the number of ministries, ensure oped and awareness campaigns conducted to reach that donor assistance is integrated into the budget out to the population. process, and reduce the number of government Trade and private investment: Private sector devel- corporations. Within this program, an important opment lies at the heart of the government’s devel- subprogram will focus on mainstreaming gender opment plans, and the trade and investment pro- through public administration. gram will lay the basis for developing an Security and rule of law: Specific activities relating environment conducive to foreign and domestic in- to security remain under discussion. To address the vestment. Activities will include assistance for small rule of law, activities will improve the domestic jus- business development, efforts to improve gover- tice system to ensure independence of the judiciary nance, creation of laws in areas such as competition, and will include efforts to rebuild the administration direct and foreign investment, and standards and of juvenile justice, and prison and law enforcement certification. The challenging issues of divestiture of systems. The activities to be carried out include es- state-owned enterprises will also be included. tablishing new courts and strengthening legal aid

©International Monetary Fund. Not for Redistribution Appendix 3.2

TABLE A3.2 Sample of Low-Income Countries Used for Comparison

Africa Asia Middle East Eastern Europe Latin America Benin Cambodia Yemen Albania Bolivia Burkina-Faso Lao P.D.R. Armenia Guyana Cameroon Vietnam Georgia Honduras Central African Republic Kyrgyz Republic Nicaragua Chad Macedonia Djibouti Moldova Ethiopia Tajikistan Gambia, The Ghana Guinea Guinea-Bissau Kenya Lesotho Madagascar Malawi Mali Mauritania Mozambique Niger Rwanda São Tomé and Príncipe Senegal Tanzania Zimbabwe

Sources: Employment data: Schiavo-Campo, de Tommaso, and Mukherjee, 1997; budget data: Gupta and others, 2002.

services within the organizational structure of the of the population) and compares it with those of Supreme Court. other countries in the sample. Consistent with international standards, the general government concept used in this analysis includes both central and Appendix 3.2. Comparing local governments, and extrabudgetary funds, such Afghanistan’s 2002/03 Operating as pension schemes, but excludes state-owned enter- Budget with Low-Income prises. For all the countries in the sample, except for Countries’ Budgets Afghanistan, for which reliable data on the military are not available, civil and military employments This appendix compares the operating budget of are identified separately. Afghanistan for fiscal year 2002/03 with the budgets Data on Afghanistan’s operating budget and em- of 39 low-income countries—24 in Africa, three in ployment levels are drawn from the 2002/03 operat- Asia, one in the Middle East, seven in Eastern Eu- ing budget as approved on April 6, 2002. For the rope, and four in Latin America—supported by an other countries, the employment data come from a IMF Poverty Reduction and Growth Facility 1997 World Bank Study and the budget numbers are (PRGF) arrangement (Table A3.1).30 Budget num- based on an IMF working paper.31 The main find- bers are expressed in percentage of GDP and sepa- ings are the following: rately show revenue, grants, current expenditure (with identification of the wage bill), and capital General Government Employment expenditure. • The civil government employment ratio in Table A3.1 also shows the size of the general Afghanistan (1.1 percent of the population), ex- civilian government in Afghanistan (in percentage

30Appendix prepared by Thierry Kalfon. See Table A3.2 for a 31See Schiavo-Campo, de Tommaso, and Mukherjee (1997); list of these countries. and Gupta and others (2002).

©International Monetary Fund. Not for Redistribution FISCAL FRAMEWORK AND THE BUDGET

cluding the army and national security, is compa- References rable to that of low-income African countries (1.4 percent), but lower than the average for the Afghan Interim Administration, 2002, National Develop- countries in the sample, excluding Eastern Euro- ment Framework (March). pean countries (2.3 percent).32 Afghan Transitional Administration and Afghan Aid Co- ordination Agency, 2003, Analysis of Aid Flows to • Data on the size of Afghanistan’s national army Afghanistan (April). and national security are not available. How- Ewans, Martin, 2002, Afghanistan: A Short History of Its ever, for the other low-income countries in the People and Politics (New York: HarperCollins). sample, the weight of armed forces in percentage Gupta, Sanjeev, and others, 2002, “Expenditure Composi- of the population is shown as reference. tion, Fiscal Adjustment, and Growth, in Low- Income Countries,” IMF Working Paper 02/77 (Washington: International Monetary Fund). Budget Expenditure and Revenues Rubin, Barnett R., 2002, Fragmentation of Afghanistan: State Formation and Collapse in the International System • Current expenditure in percentage of GDP is (New Haven, Connecticut: Yale University Press). much lower in Afghanistan than the sample’s Schiavo-Campo, Salvatore, Giulio de Tomasso, and Amitabha Mukherjee, 1997, “An International Sta- average (11.5 percent compared with 18.5 per- tistical Survey of Government Employment and cent). However, the weight of wages in GDP is Wages,” World Bank Policy Research Working Paper larger in Afghanistan (7.2 percent). No. 1806 (Washington: World Bank), August. • Regarding budget revenue, Afghanistan’s bud- United Nations, 2002, Immediate and Transitional Assis- tance Program for the Afghan People (February). get is characterized by a very low level of do- ———, 2003, Transitional Assistance Program for Afghan- mestic revenues, which, in percent of GDP (2.1 istan (January). percent), is about one-tenth of the average of World Bank, 2002, Afghanistan Support Strategy (Washing- the selected countries (18.7 percent). ton: World Bank). ———, 2003, Transitional Support Strategy (Washington: World Bank), February 7. World Bank, Asian Development Bank, and United Na- tions Development Program, 2001, Preliminary Needs 32Including the police. Assessment (December).

©International Monetary Fund. Not for Redistribution 4

Structural Reforms: Revitalizing Fiscal Institutions

Thierry Kalfon

he implementation of the fiscal strategy de- in both establishing the civil service commission T scribed in Chapter 3 was underpinned by a and reviewing the civil service aspects of the over- comprehensive technical assistance program, which all fiscal strategy. Private sector development is an aimed at restoring essential financial capacity in the area where there is still considerable scope for fur- Ministry of Finance (MoF) and line-ministries ther progress and support, especially in relation to through the design of detailed reform projects, the much-needed transformation of the large public hands-on implementation of these reforms, and enterprise sector. training of MoF staff. Specific assistance has also Structural fiscal reforms have relied as much as been provided in the areas of civil service reform possible on the existing systems, whenever they and private sector development, which are key to were found to be sound and reasonably well oper- maintaining fiscal sustainability. ated, in order to facilitate ownership of the reforms A large number of international organizations and yield immediate results. In the areas where re- and donors were involved in these efforts. In partic- vamping the existing system was required, technical ular, following early diagnostic missions in 2002, assistance efforts primarily focused not only on get- the IMF outlined specific action plans to establish ting the basic elements of the financial system right financial management capacity in the MoF and im- but also on preparing the ground for gradually intro- prove revenue mobilization. The government en- ducing best international practice over the medium dorsed these proposals, which were subsequently to long term. Similarly, particular emphasis has been carried out on the ground by the World Bank, the put on building capacity in the MoF through inten- Asian Development Bank (AsDB), the European sive training and close partnership between the Union, the United States Agency for International MoF departments and implementing agencies. Development (USAID), the United Kingdom’s De- partment for International Development (DfID), Germany’s Gesellschaft für Technische Zusamme- Improving Public Expenditure narbeit (GTZ), and the U.S. Treasury. The IMF Management also assisted the authorities with monitoring progress in the reforms and suggesting further im- From the outset, Afghanistan’s interim and transi- provements, while hands-on implementation was tional authorities committed themselves to full being undertaken by other international organiza- transparency in managing public resources. This tions and bilateral donors. In the area of civil ser- theme was articulated in President Karzai’s speech vice reform, the World Bank played a leading role during the Tokyo conference in January 2002 and

©International Monetary Fund. Not for Redistribution STRUCTURAL REFORMS: REVITALIZING FISCAL INSTITUTIONS

has repeatedly been reaffirmed as a pillar of the re- (AFMIS). In order to deliver results immediately, construction strategy since then. AFMIS did not change the procedures and func- Public expenditure management, as performed tions specified in the Afghan regulations but only when the Afghan Interim Administration (AIA) computerized the existing manual system using a took office, was far from meeting these objectives. simple software package. Since October 2002, Most of the financial management procedures in AFMIS has provided timely and reliable informa- place before the war and still documented in the fi- tion on expenditures paid at the center, broken nancial regulations had broken down: (1) reporting down by the source of funding (domestic revenues and recording of government expenditure was non- or grants), spending units, and economic and func- operational because of the absence of any office au- tional classification; and it has also significantly ac- tomation and communication with the provinces; celerated the expenditure payments through the au- (2) budget internal controls and external audit had tomation of the printing of checks. In the initial ceased functioning; (3) banking arrangements for period, however, this system suffered from important government operations had collapsed; and (4) cash limitations: (1) its coverage was limited to central management and bank reconciliation were no government expenditures only, excluding revenues longer performed. The fiscal functions that had sur- and nonwage provincial expenditures;1 (2) budget vived, such as budget execution, some aspects of management facilities, such as appropriations, allot- budget formulation, and management of budget ap- ments, and transfers, were not available; (3) expen- propriations and payroll, were mostly slow, cumber- diture commitments were not recorded; and (4) the some, and subject to both errors and abuse. Apart system did not perform reconciliation between trea- from the disruptions caused by the conflict, these sury information and central bank statements. To weaknesses were also the legacy of years of deficit address these issues, the system’s functionalities were monetization, which removed the discipline of a significantly expanded at the beginning of 2003/04 budget constraint and hence precluded the develop- to include revenue information, provincial expendi- ment of effective financial management procedures. tures, and budget management functions. Although Against this background, a comprehensive program further improvements were still needed—especially of technical assistance was designed to restore basic with regard to recording financing sources for the financial functions in the MoF. operating budget, bank reconciliation, and monitoring the development budget—the introduction of AFMIS in a very short period of time critically im- Budget Execution and Financial proved expenditure management in the treasury and Management gave a concrete illustration of the authorities’ com- Immediate emphasis had to be put on urgently mitment to fiscal transparency. One of this project’s upgrading budget execution and financial manage- major achievements has been the progressive trans- ment in the MoF in order to provide donors with fer of AFMIS operations from the contractor to the fiduciary assurances that they requested for real- Afghan staff following intensive training and capac- izing their pledges. ity building. At the request of the AIA, in June 2002, the In addition to the support provided to the MoF World Bank provided grant support for an Emer- under the World Bank Emergency Public Adminis- gency Public Administration Project to fund the hir- tration project, the authorities have taken impor- ing of qualified international contractors in the areas tant steps to improve budget execution and report- of financial management, government procurement, ing in the provinces. This task, which has received and audit, with the tasks of (1) assisting the authori- priority attention since the beginning of 2003/04, ties in performing these functions and (2) building aimed at moving away from the existing impasse local capacities in order to hand over these functions where (1) provinces did not report their nonwage to the authorities as soon as possible. expenditures to the center and (2) the center, in the The financial management contractor, hired by absence of provincial expenditure reports, refused to the government under the World Bank project, developed for the treasury a computerized system for expenditure recording, payment processing, and fi- 1Although the system had the technical capacity to record and account for nonwage provincial expenditures, no reliable infor- nancial reporting for budget spending—Afghanis- mation was received at the center on this category of expendi- tan’s Financial Management Information System tures in 2002/03.

©International Monetary Fund. Not for Redistribution Improving Public Expenditure Management transfer resources to the provinces. In this context, get revenues. The IMF submitted to the authorities 40 Afghan fiscal advisors were trained in the MoF a progressive plan to consolidate the government’s under USAID funding and sent to all provinces to accounts in the center and the provinces and elimi- assist them with financial reporting on both their nate the accounts of line-ministries that do not revenues and expenditures. Six of them were as- serve the public interest. In line with these recom- signed to the six provinces collecting the bulk of do- mendations, the authorities streamlined the number mestic revenues to coordinate the activity of the of the MoF’s bank accounts operated at the center other provincial advisors.2 Similarly, satellite com- for domestic revenue and expenditures.3 Most im- munication facilities were set up on a pilot basis in portantly, in 2003 they undertook a complete over- the largest of these provinces to facilitate exchange haul of the government’s banking arrangements in of information between the MoF and its regional of- the provinces to improve revenue centralization. In fices (Mustufiats). The rolling out of AFMIS to the August 2003, the treasury instructed the central provinces started in mid-2003. These initiatives bank to close all the provinces’ accounts and trans- yielded important and tangible results: in particular, fer their balances into two new accounts, one for ex- whereas the Mustufiats did not report on their non- penditures and one for revenues, the latter being op- wage expenditures in 2002/03 (see Chapter 3), they erated on a “deposit basis” only, meaning that started doing so in 2003/04. However, fiscal report- provinces will no longer be authorized to draw on ing still requires improvement, especially on rev- their revenue account to spend without explicit au- enues, as there are indications that major provinces thorization from the MoF. The next step will in- report less revenue than they collect and most volve ensuring regular consolidation of these ac- provinces send their reports to the center with sig- counts into the central government’s accounts and nificant delays. The progressive consolidation of the making timely transfers to the provincial accounts provinces’ accounts into the accounts of the central to allow provinces to make their expenditures ac- government will help to address these issues (see cording to their budget allotments. next section). The treasury does not currently undertake cash or financial planning. As a result, the MoF cannot in- form the central bank of its in-year cash require- Cash Management and Banking ments, nor can it request donors to adjust their dis- Arrangements bursement schedule according to government cash Cash management is a critical element of public projections. This results in a lack of predictability in resource management, especially in environments the resources made available to line-ministries, lead- characterized by high demands on scarce public rev- ing to delays and inefficiencies in budget execution. enues. Government banking arrangements exert a To address this issue, in 2003 the treasury estab- strong influence on the ability of the treasury to effec- lished a cash-management unit charged with the re- tively discharge its cash management responsibilities. sponsibility of estimating revenue inflows, forecast- Learning from international experience, most gov- ing future disbursements, and developing an in-year ernments have opted for concentrating all govern- cash plan. However, developing a full-fledged cash ment cash resources in a single bank account (the planning regime can only be envisaged in the Treasury Single Account, or TSA) to strengthen medium term because this is a highly technical task, treasury control over cash flows, reduce the cost which will first require full introduction of a TSA of borrowing operations, and minimize idle cash and will need to be supported by extensive dedi- balances. cated technical assistance. While, in theory, Afghanistan was supposed to operate with a TSA, there had been, in practice, a Budget Formulation proliferation of accounts in recent years that inter- fered with proper consolidation of cash resources, Significant support was offered to the MoF and hindered prompt information on the government’s line-ministries for the preparation of the 2002/03 fiscal situation, and led to fragmentation of the bud- and 2003/04 budgets. The budget preparation for

3The number of these accounts was reduced from 26 to 2, 2These provinces are Herat, Nangarhar, Kabul, Kunduz, excluding the specific accounts opened to track donor-funded Mazar-i-Sharif, and Kandahar. expenditures.

©International Monetary Fund. Not for Redistribution STRUCTURAL REFORMS: REVITALIZING FISCAL INSTITUTIONS

2003/04 marked a vast improvement over the proce- set up within the NDB. Since its creation the dures followed in 2002/03 reflecting major efforts by AACA’s main achievement has been the develop- the cabinet, MoF, and line-ministries toward infor- ment of a comprehensive donor information data- mation compilation, strategy formulation, prioritiza- base recording the pledges, commitments, and dis- tion, and coordination. However, further progress is bursements from all donors.4 needed in terms of better integration between the In addition, in December 2002, the MoF estab- ordinary and development budgets, quality of bud- lished, with the support of the World Bank, a Grant get submissions by the line-ministries, revenue pro- Management Unit (GMU) within the treasury that jection, construction of the macrofiscal framework is responsible for assuring that donor contributions to underpin the initial budget estimates, introduc- are utilized as specified in the grant agreements and tion of hard budget constraints at the beginning of reported accordingly. The GMU is intended to serve budget preparation, and development of a medium- as the repository and custodian of all grant agree- term fiscal framework. ments, authorize offshore payments when govern- Various donors assigned a number of resident ment spending will not be channeled through the budget preparation experts to the MoF. Their budget, maintain payment records, and report to tasks—in addition to hands-on support during the donors and the MoF. The functions of the GMU budget preparation process—focused on training, and AACA may be merged into a new department capacity building, and restructuring of the MoF to be established in the MoF. Budget Department. This assistance, which initially dealt mainly with the ordinary budget, was expanded in 2003 to include the development budget, Reforming Revenue Policy and with the establishment of a development budget Administration unit in the treasury supported by a budget resident advisor. Similarly, chief financial officers funded by Improving revenue mobilization will be a key fac- the World Bank were to be appointed to key line- tor in attaining fiscal sustainability. Afghanistan’s ministries to enhance their budget formulation and operating expenses cannot be expected to be funded execution capacities. by donors’ grants indefinitely. Over time external assistance will be increasingly allocated to develop- Coordination of External Assistance ment expenditures. The authorities’ medium-term objective is therefore to fully finance the ordinary In a context where budget financing comes budget through domestic revenues. Meeting this mainly from external sources and where a large ambitious objective would not be possible without a number of multilateral and bilateral donors are in- major overhaul of the tax and customs legislation volved in the reconstruction efforts, coordination of and a large-scale reform of tax and customs adminis- donor resources is of critical importance. The main tration. At the request of the AIA, the IMF helped instrument used by the authorities to avoid duplica- the authorities in June 2002 to design a reform pro- tion of efforts and overlapping of donor projects is gram in these areas, which is being progressively im- the National Development Budget (NDB), through plemented with the assistance of international and which most of the donor assistance has been chan- bilateral donors. neled (see Chapter 3). In addition, in April 2002, the authorities established the Afghan Aid Coordi- nation Agency (AACA) as a public body within Customs Policy and Administration the government, to track the disbursement of for- As customs duties account for more than half of eign aid. The AACA’s primary activities include total domestic revenue collection, improving cus- (1) coordinating development efforts from bilateral toms policy and administration has been one of the and multilateral donors; (2) reviewing and endorsing authorities’ top priorities. The 1974 customs law projects and programs carried out by multilateral/ specified the import duties, fees, and charges levied bilateral agencies and nongovernmental organiza- on international trade and transactions. The cus- tions; (3) developing a comprehensive information system for tracking foreign assistance and monitoring development investments and programs; and 4This database is publicly available and can be accessed at the (4) serving as secretariat for the Consultative Groups following website: http://www.af/dad.

©International Monetary Fund. Not for Redistribution Reforming Revenue Policy and Administration toms tariff included 25 tariff bands with rates rang- tion of the internationally recognized “single admin- ing from 7 percent to 150 percent allocated across istrative document” for customs clearance; (2) im- 888 tariff headings (for an unweighted average tariff proved monitoring of exemptions; (3) progressive in- rate of 43 percent).5 Duty was calculated on the troduction of the harmonized tariff codification for c.i.f. Afghan value of imported goods, using artifi- commercial goods; (4) development of a comprehen- cially low exchange rates of Af 2 per U.S. dollar to sive computerized database for customs valuation; Af 4.5 per U.S. dollar—compared with a market (5) establishment of a simplified customs regime for rate of about Af 48 per U.S. dollar. In addition to travelers; (6) licensing by the MoF of “customs bro- the customs duties, there were a number of fees kers” to assist traders with the clearance of commer- levied on imports, especially a 2.5 percent fee col- cial goods; (7) the assignment of a taxpayer identifi- lected by the Chamber of Commerce for the valua- cation number (TIN) for each taxpayer; and tion of imported goods (customs valuation was not (8) gradual phasing out of the Chamber of Commerce performed by the customs administration but by the involvement in customs valuation.8 In addition, the Chamber of Commerce). Although there is no ex- authorities designed a comprehensive five-year plan cise tax, customs tariffs achieve the same result by to strengthen the administration of customs. This imposing higher tariffs on certain goods, such as au- strategic document calls for a complete revamping of tomobiles and tobacco products, which are not pro- the customs department and its regional offices, train- duced domestically and would normally be excised. ing of customs officials, reform of customs procedures Imports of petroleum, diesel, and kerosene for trans- (including investigation, enforcement, and controls), portation purposes were exempt from duty.6 centralization of customs revenues collected by the In early 2004, a customs reform package was en- provinces, and progressive rehabilitation of customs acted that included (1) the use of the market ex- infrastructure, equipment, and communications. This change rate of the Afghani in customs valuation; plan covers the years 2003–07 and has an indicative (2) the reduction of the number of tariff bands from cost of around US$100 million, of which two-thirds 25 to 4;7 and (3) a lowering of the tariff rates from would be allocated to technical assistance. The open- the previous range of 0 to 150 percent to rates ranging in May 2003 of a model customs house, featuring ing from 0 to 20 percent. The streamlining and re- a renovated warehouse and training facilities at Kabul duction of the tariff rates partly offset the effect of airport, was a first step toward the implementation of the adoption of the market exchange rate on the av- this strategy. erage level of customs duties. These customs policy reforms, which are key to Tax Policy and Administration enhancing revenue collection, would not be successful unless enforced by a capable and effective cus- Around half of the domestic revenues collected in toms administration. However, customs administra- 2002/03 were noncustoms tax revenues. Therefore, tion has been weakened by a lack of experienced improving revenue mobilization will require—in ad- managers, poorly trained staff, inadequate facilities dition to reforming customs—the establishment of a and equipment, and outdated and cumbersome poli- fair, transparent, and easy to administer tax system. cies and procedures, all of which have created av- The existing tax regime was defined in the 1965 enues for potential corruption and abuse. In particu- income tax law, which provides for a progressive lar, customs regulations have not been applied personal income tax (PIT) with rates varying from consistently throughout the country and, in some 4 percent to 60 percent, a flat 20 percent corporate cases, customs duties are “negotiated’’ between tax- income tax (CIT), a 2 percent business receipts tax payers and customs officers. In July 2003, the author- (a form of sales tax on corporate entities’ turnover), ities adopted a decree to simplify customs procedures. withholding taxes on imports and exports, and vari- The provisions of this decree included the (1) adop- ous fixed (presumptive) taxes (Appendix 4.1). It is difficult to ascertain all the details of the 1965 tax law and its application, since the law was amended 5The lack of data (historic import data sorted according to tariff codes are currently not available) makes it very difficult to as- by 18 separate decrees and not all amendments were sess the tariff structure, the extent of exemptions, and their impact on revenues. 6However, there appears to be a “monopoly tax” on petroleum products equal to 20 percent of the import value. 8As well as full transfer of this function to the customs 7Zero, 5, 10, and 20 percent. administration.

included in a comprehensive consolidated version. wage withholding tax on higher-income employees; In addition, tax administrators in the MoF and its fi- and (4) shifting the nexus of taxation from citizen- nancial regional offices (Mustufiats) had different ship to residence. Similarly, the business receipts tax views about the applicable tax provisions, which rate was increased to 10 percent on a limited range were not applied consistently throughout the coun- of services consumed by high-income earners (ho- try. In particular, a Taliban decree of May 1999 re- tels, restaurants, international airline services, and formed the personal income tax by introducing telecommunications services) and new taxes were three rates of taxation (1, 8, and 20 percent) to- introduced including a tax on rental incomes, a gether with a series of exemptions. But it is unclear snuff tax, and an airport departure fee. The system if these provisions were ever enforced. of fixed and presumptive taxes was also streamlined The tax law included a number of serious to simplify tax administration and reduce distortions deficiencies: between similar businesses. These policy measures • The rule imposing taxation of worldwide in- were accompanied by specific administrative provi- come on Afghan citizens wherever they live sions including introduction of self-assessment prin- meant that expatriate Afghans intending to re- ciples, provisions for tax ruling, and new collection turn to Afghanistan would be met by a poten- enforcement powers and penalty provisions. tially crippling legal tax liability on all the in- These tax policy reforms were closely linked to a come they earned abroad. This tax provision program to strengthen the capacity of the revenue created disincentives for these individuals to re- department in the MoF and improve tax operations turn to Afghanistan and participate in the in the Mustufiats. This plan included the establish- country’s reconstruction. ment of a large taxpayer unit (LTU) in Kabul in 2004. The LTU will be responsible for administering • The top marginal rate for PIT (60 percent) was the personal income tax,9 the business receipt tax, high even compared with international stan- and the rent tax. The Kabul LTU will then be com- dards and cuts in at a relatively modest annual plemented by model tax offices for medium-income earnings level (less than half of the average an- taxpayers, in which new operational procedures and nual salary). This hampered voluntary tax com- concepts would be piloted. pliance and likely led to tax fraud. In addition, the existing tax rate structure, consisting of 32 different rates, was complex and difficult to Revitalizing the Civil Service administer. • The coverage of the business receipts tax did The underlying arrangements for government not include certain services provided to expatri- employment stem from the 1970 law on the “Status ates and other high-income earners, resulting in and Condition of Government Employees” as revenue losses for the government. amended by the 1977 decree on the civil service, which provides for a system of centralized recruit- • Limitations of the loss carryover period and de- ment, job classification, grading, and pay. Although preciation allowances for the payment of the this legislation included a number of sound provi- CIT discouraged investment. sions, in reality Afghanistan’s civil service emerged In view of these deficiencies, the authorities pre- from the Taliban era in a state of profound crisis. Its pared, with the assistance of resident tax advisors, situation could be characterized as follows: an important set of tax policy reforms to improve • Large uncertainties about the size of the public ser- the efficiency and the equity of the tax system. vice. It was very difficult to ascertain the num- These measures, which conformed with the IMF’s ber of staff employed by the government be- recommendations, were enacted by presidential de- cause of the absence of a nominal roll of cree on March 18, 2004, and included the following employees and large variations in the number of provisions. staff paid each month. These difficulties were The income tax regime was improved through compounded by the failure of payroll data to in- (1) aligning the corporate and top personal tax rate (at 20 percent); (2) allowing a significant personal exemption to replace the previous complex individ- 9As prescribed in the May 1999 Taliban decree until the tax ual and dependent deductions; (3) restoring a final law is amended.

dicate the specific ministry in which the nizations to pay large “salary top-ups” to provincial staff worked or to distinguish be- Afghan civil servants working on externally tween staff working in ministries and those supported projects. This distorted the public working in government enterprises. As a result, and private sector pay market and created re- 2003 estimates for total civilian employment sentment from staff not benefiting from these ranged widely from 240,000 to 331,000, exclud- arrangements. ing military personnel (about 100,000) and • Fragmented and duplicated government structures. government enterprises (about 35,000). In ad- A number of public institutions were remnants dition, little was known about the status, com- of the old centrally planned economic model petence, and efficiency of the civil service. and their existence was no longer justified in a • A serious lack of professional capacity. Although market-based economy. Similarly, in the past, the size of the civil service did not appear large the rationale for creating a number of govern- relative to the population (1.4 percent of the ment bodies was based on the need to grant of- population excluding state-owned enterprises ficial positions to powerful individuals and fac- and military), numbers were still out of propor- tions rather than to provide specific public tion to the minimal services actually delivered. services to the population. This resulted in The low level of service reflected the very weak the fragmentation of government structures and capacities in the ministries, with overrepresen- the unnecessary overlapping of many public tation of unskilled workers in the government’s functions. workforce and the absence of qualified senior staff, most of whom emigrated during the war. In view of all these problems, reform of public administration and civil service is critical for • Pervasive patronage. The AIA inherited a situa- Afghanistan’s development and has therefore been tion where a large number of civil servants had made a priority in the reform agenda by both the au- been hired on the basis of their ethnic origin thorities and donors. The World Bank has provided and loyalty to the successive factions that ruled the authorities with significant technical assistance the country, rather than their proven profes- in this area. sional qualifications. An important step in the modernization of the • Inappropriate pay arrangements. The pay and civil service was the establishment, in June 2002, of grading system was inadequate to attract, re- the Administrative Reform and Civil Service Com- tain, and motivate skilled civil servants: mission (ARCSC), the creation of which was an obligation of the government under the Bonn agree- ◆ The average monthly pay in 2003 for civil ment. The commission’s main responsibilities were servants was approximately Af 1,800 (about set out in a presidential decree in June 2003. These $36), which was probably higher than market responsibilities include designing and implementing rates for unskilled staff but clearly well below the civil service management policies and proce- what would be needed to retain or recruit dures; coordinating the public administration reform qualified senior civil servants. Low salaries for program; recruiting government senior staff on the public servants increase their vulnerability to basis of a fair, transparent, and open process; and corruption, especially among those dealing overseeing lower level appointments in the civil ser- with the private sector (e.g., customs). vice. However, at the time of writing the specific de- ◆ The wage structure was extremely compressed lineation of responsibilities between the ARCSC, the because food allowances comprised the bulk MoF, the Ministry of Labor and Social Affairs, and of total pay. The vast majority of government the Office of Administrative Affairs was not fully staff was paid approximately the same clarified. In particular, it was unclear whether the monthly salary of Af 1,800. The salary com- ARCSC responsibilities would cover all—or only pression was recently exacerbated by the in- part of—the tasks usually assigned to a civil service troduction of an additional flat rate food al- management agency, including the establishment of a lowance in May 2002. register of government-sanctioned positions; over- ◆ The government’s ability to manage its work- sight of personnel records; development and mainte- force was hampered by the extensive practice nance of a human resource database; workforce plan- by some donors and nongovernmental orga- ning; job classification and grading; and pay policy.

The authorities presented in the 2003/04 NDB a cree—Priority Restructuring and Reform Decree— detailed short-term strategy for public administra- introducing an interim additional salary allowance tion and civil service reform, aiming at creating a for specific positions in ministerial departments that lean, capable, and motivated civil service dedicated are considered critical for reform (e.g., customs, tax) to supporting the country’s national interests. This and are undergoing a large-scale restructuring of strategy focuses on the following elements: (1) draft- their functions. A number of departments have al- ing a new civil service law and subsidiary regulations ready submitted applications to the ARCSC to ben- governing civil service employment; (2) revising the efit from the provisions of the new decree, including pay and grading arrangements on a pilot basis; customs and treasury in the MoF. A second decree (3) developing a nominal roll for civil servants; was adopted in late 2003 to regulate and limit the (4) introducing a comprehensive government pay- salary top-ups granted by donor agencies. roll system in the treasury; (5) reviewing ministerial staff and structures; (6) starting preparatory work for future retrenchment arrangements; and (7) individ- Developing the Private Sector: ualizing salary payments.10 The government also Building a Market-Led Economy committed to improving the timeliness of provincial salary payments and implementing effective Afghanistan has a long tradition of entrepreneur- arrangements for enforcing civil service headcount ship and a vibrant private sector, which has actively ceilings mandated in the annual budget. engaged in agricultural production, trading activi- Although the authorities are fully aware of the ties, and small-scale industrial activity for centuries. central role of the civil service reform in the recon- In the 1980s, the development of the private sector struction process, they have emphasized that this re- was hampered by the preference given to an eco- form is faced with considerable difficulties. It will nomic model based on state intervention and was take time and will need to be carried out with cau- further undermined by subsequent war, devastation, tion because of its potentially large economic and and neglect. The first condition to restoring social implications. In particular, any across-the- Afghanistan’s business vitality is to consolidate se- board pay reform will need to remain compatible curity and political stability throughout the country. with medium-term fiscal sustainability. Moreover, Equally important is the establishment of a strong detailed proposals for salary decompression remain judicial system able to effectively enforce laws and contingent on a reliable classification of individual regulations. Energizing the private sector also re- positions in the government, which is a lengthy and quires the building of a legal framework that would resource-demanding process that has not yet started. provide for fair, transparent, and simple rules for the The implementation of a retrenchment program operations of corporate entities, especially with re- would be a highly sensitive political issue because gard to the banking system, tax and customs, com- civil service employment continues to serve as a so- petition protection, property registration, and for- cial safety net for a large part of the urban popula- eign investment. tion; also, this program cannot be implemented Important steps have been taken by the authori- without prior development of a nominal payroll and ties in this direction, including enactment of new, effective establishment controls to avoid the dan- modern banking and central banking laws (see gers of staff leaving and then reentering the civil Chapter 6), successful implementation of the cur- service. rency conversion (see Chapter 5), large-scale cus- Under these constraints, progress in the civil ser- toms reform, and enactment of a new domestic and vice reform has been slow.11 However, important foreign investment law. initiatives have been taken, including the approval In August 2002, the ATA replaced the 1987 law by the cabinet in July 2003 of a presidential de- on domestic and private investment with a new law dropping the provisions of the previous system, which had negatively affected foreign direct invest- 10Currently, salary checks are not cashed by the individuals: ment, including joint venture requirements, mini- the manager of a spending unit cashes a check issued by the trea- mum Afghan capital requirements, and limitations sury, accounting for the salaries of his subordinates, and distrib- on repatriation of profits. The new law also provided utes the cash to his staff. 11Apart from the decrees establishing the civil service commis- three- to seven-year tax holidays to eligible compa- sion and its functions. nies, according to the type of investments, as well as

©International Monetary Fund. Not for Redistribution Appendix 4.1 a four-year exemption from export tariffs and duties. 35,000 employees. Only a small number of SOEs Under the law, a High Commission on Investment, seem to have been viable; none was self-sufficient— chaired by the Minister of Commerce,12 became let alone profitable—and most of their employee responsible for all policy decisions regarding domes- salaries were fully paid out of the government’s ordi- tic and foreign investment, and an Office of Private nary budget. The main SOEs in 2003 were the pub- Investment (OPI), established within the Ministry lic utility companies, such as electricity and gas pro- of Commerce would determine which investments duction and distribution, some of which have had qualify for tax holidays. The authorities’ decision to partial success in collecting utility fees, but only in scrap the obsolete 1987 law was a critical step to- major urban centers.14 Other important SOEs in- ward the development of foreign private investment clude fabric-making companies and small-scale ce- in Afghanistan. However, the use of tax holidays as ment industries. a tool for encouraging capital inflows was question- The authorities have indicated that that they do able. International experience has shown that such not intend to revitalize nonfunctioning public en- exemptions reduce the transparency of the tax sys- terprises and plan to close them down or divest tem, hamper the efficiency of tax administration, them to the private sector whenever possible. A and significantly erode the tax base, all of which Commission for the Evaluation of the State-Owned may have a detrimental impact on revenue collec- Enterprises was established in June 2002 and started tion in the medium term. The IMF generally coun- operating in January 2003. Its main activities in- sels against the use of tax holidays and recommends clude assessing SOE operations and assets, preparing instead more transparent mechanisms for encourag- recommendations for privatization, and drafting ing investment, such as low corporate tax rates, transparent privatization procedures. Its activities so accelerated depreciation regimes, and liberal loss far have been primarily limited to a census of the ex- carryforward rules. Following these recommenda- isting SOEs. Notwithstanding their commitment to tions and those from other donors, the August 2002 an ambitious overhaul of the public sector, the au- law was redrafted in 2004, and a revised law is to be thorities have acted cautiously in this area for the enacted. following reasons: (1) most records of SOE assets The government has taken steps to attract invest- have disappeared, making it extremely difficult to ment in major areas, including the sale of a telecom- design any privatization strategy; (2) there has been munications license in October 2002 and the signing reluctance on the part of the government to rush of public contracts with international developers to into a privatization process that, without appropri- renovate two major hotels in Kabul. ate assurances and safeguards, could create consider- In addition to stimulating foreign investment, the able opportunities for corruption; (3) line-ministries transformation—through partial/total privatization have been reluctant to delegate the transformation or closing down—of the extensive SOE network is a of the enterprises operating in their sector to the critical element of Afghanistan’s transition to a newly created Commission for the Evaluation of market economy. Such a reform would eliminate the SOEs; and (4) this is a highly technical area in burden placed on the ordinary budget to support which major technical assistance is required and no these enterprises,13 restore a level playing field be- such assistance has materialized yet. Significant tween these enterprises and potential private sector progress in this area is unlikely without strong sup- competitors, and reduce the scope for corruption. port from the international community. As of 2003, preliminary data suggest that, of the 174 public enterprises that operated under the communist regime (and accounted for more than one-third Appendix 4.1. Pay Structure for of the revenues of the ordinary budget), only 80 Government Staff and Tax had survived (or 161, including their provincial Summary branches), accounting for a total of more than As of August 2003, there were two pay scales for government staff in Afghanistan—one for perma- 12The commission comprises the ministers of finance, justice, foreign affairs, and planning and reconstruction, as well as two representatives of the private sector. 13About $52 million has been appropriated in the 2003/04 14Ariana Airlines, the Afghan national airline, does not have budget to fund SOEs. the status of a public enterprise.

Box A4.1. Civil Servant Salaries

Base pay Payable to all staff. Food allowance Payable to all staff. Second food allowance Introduced in May 5, 2002. Not payable to teachers. Transport allowance Payable only to public employees in Kabul. Professional allowance The amount of this allowance varies according to the level of education: • Af 8 for those who have completed high school; • Af 15 for a university degree; • Af 17.5 for an additional year beyond university; • Af 20 for a master’s degree; • Af 25 for a doctorate. Additional professional allowance Only payable to permanent staff at the highest level of the pay scale. Scientific allowances Only payable to permanent staff at the highest level of the pay scale.

nent staff (karmand) and one for contract (agir) staff. whether karmand or agir, did not receive the second Karmand were regular, permanent public employees, food allowance introduced on May 5, 2002. The dif- whereas agir were hired on fixed-term contracts. ferent elements of the civil servants’ salaries are out- The base pay scales were very similar. The same lined in Box A4.1. monetary allowances applied to both, but teachers, The tax summary is presented in Table A4.1.

TABLE A4.1 Tax Summary (As of August 2003) Tax Rate Taxable Base Remarks Corporate income Flat rate of 20 percent. Net profits of corporations • Most expenses incurred to tax (CIT) and limited liability companies.1 derive gross income are deductible. • Firms are allowed to deduct losses incurred in previous years. • The CIT is mostly collected in the form of withholding taxes on imports and exports creditable against the income tax (see below). Personal income Progressive schedule comprising Income of employees (salaries • The basis for taxation is Afghan tax (PIT) 21 brackets, with rates varying and wages) and profits of non- citizenship. The tax is imposed from 4 to 60 percent. corporate entities. on the worldwide income of Afghan citizens wherever they live. • The wage PIT that used to be collected on government and private sector employees (wage withholding tax) seems to have disappeared at the beginning of the 1990s. Most of the PIT is now collected in the form of fixed presumptive taxes levied on individuals (see below). Business receipts Two rates: tax (BRT) • 2 percent: gross receipts of Gross receipts (before any de- • The BRT comes in addition to legal persons engaged in ductions) of corporations and the CIT on taxable profits. domestic business. limited liability companies. • The BRT must be paid within six •2!/2 percent: receipts of legal months of the end of the fiscal persons engaged in import year, irrespective of whether the and/or export operations. business makes a profit or a loss. • Imports are not taxed under the BRT but exports are. • The BRT raises greater revenue than the CIT.

Fixed withholding • Imports: 4 percent for licensed • Unincorporated exporters taxes on imports importers and 3 percent for or importers.4 and exports unlicensed importers.2 • The tax is based on the duty- (creditable against • Exports: 4 percent for licensed paid cost of imports/exports. the income tax) exporters and 2 percent for unlicensed exporters.3 Presumptive taxes • Retailers: Based on a 170 Estimated gross receipts of The major reasons for using in lieu of the category classification of corporations and limited presumptive taxation in lieu of income tax businesses. Taxation depends liability companies (except income tax are simplification, on the types of goods sold and importers and exporters). reducing compliance costs for the size and location of the taxpayer and the tax businesses. administration, and combating • Limited list of specific businesses tax evasion.5 (e.g., cinemas, theaters, mills): 10 percent on estimated turnover. • Transportation businesses (e.g., taxis, buses): Lump sum depending on the type, size, and characteristics of the vehicles used. • Government contractors: From 1 to 8 percent of the price of the goods and services purchased by the government.

TABLE A4.1 (concluded)

Tax Rate Taxable Base Remarks Import duties 25 tariff bands with rates ranging C.i.f. in Afghani value, using an • Customs tariffs currently in use from 7 percent to 150 percent exchange rate of Af 4.5 per were introduced in 2000. allocated across 888 tariff headings. U.S. dollar. • Imports of petroleum, diesel, and kerosene for transportation purposes are exempt from duty. • The exchange rate used for valuation is well below the open market rate (approximately Af 38–40 per U.S. dollar). Fees and charges • Chamber of Commerce license For the Chamber of Commerce In addition to customs duties, and valuation of imports/exports: and the Red Crescent: c.i.f. there are numerous fees, and 2.5 percent. invoice value of exports or other taxes levied on imports and • Red Crescent fee: 2.5 percent. imports. exports that add significantly to • Ministry of Commerce’s permit the cost of international trade. fees (e.g., cars $200 to $400, cigarettes $2.5 per case).

Source: Afghanistan’s Ministry of Finance. 1A type of partnership. 2For unlicensed importers, this tax is not creditable against the income tax. 3For unlicensed exporters, this tax is not creditable against the income tax. 4If they are incorporated, they only pay the CIT. 5In a presumptive tax, the concept of income tax base is replaced by indicators that are more easily measured.

Monetary and Exchange Rate Policy in a Postconflict Environment

Ron van Rooden and Louis Dicks-Mireaux

t the end of 2001, Afghanistan’s financial sys- guished from those already in circulation. Further- A tem had largely ceased to exist. The country more, two warlords had issued their own counterfeit had become almost entirely cash based. Banks had versions of the official currency. While these coun- essentially stopped functioning during the Taliban terfeits were very similar to the official currency, years and whatever financial infrastructure had sur- they did have some distinguishing features and were vived the many years of conflict was in a very poor typically traded at a discount in the Kabul money condition. What remained was the informal hawala markets. Reflecting the limited confidence in the system that people could use to exchange and trans- national currency, foreign currencies were also fer money.1 Confidence in the national currency, widely used, including the U.S. dollar and the cur- the Afghani, was low, because it had lost much of its rencies of neighboring countries. Foreign currencies value following years of high inflation. Moreover, were used especially for larger transactions and as the Afghan central bank, Da Afghanistan Bank store of value. (DAB), had little or no control over the issuance of Against this background, the new government currency. At least three versions of the national cur- that came to office in late 2001 faced a number of rency were circulating in the country. First, there key questions in the area of monetary policy. To help was the official Afghani, which had been issued facilitate recovery and economic growth, an ade- prior to the Taliban rule and which the Taliban had quate degree of financial stability would need to be continued to issue from the remaining stocks in the established. The question was how best to achieve vaults of the central bank. In addition, duplicates of this as quickly as possible. One of the most impor- the official banknotes had been put into circulation tant and pressing issues in this regard was whether to during the Taliban years by the then internationally temporarily adopt a foreign currency as legal tender recognized government in exile, which had ordered or whether to introduce a new national currency. reruns of earlier issued series from the country’s reg- Under the latter option, which would take time to ular printer and had issued these in the northern implement, a plan would need to be devised for the parts of the country. By using the same serial num- interim period prior to completion. Also, under the bers as used in earlier years, the government in exile latter option, the central bank would need to have a ensured that the new notes could not be distin- framework to conduct monetary policy. What would be the objectives and intermediate targets of monetary policy? Would it be better to fix the exchange 1See Chapter 6 for a description of the state of the financial rate or to let it float? In the absence of a functioning system in Afghanistan in 2001 and its development thereafter. banking system, which instruments could be used to

implement monetary policy? This chapter discusses late until redemption by the new currency took these issues, the various options that were open to place, within a floating exchange rate regime, but the authorities, and the choices they have made, as the central bank would not issue more Afghanis. well as the actual conduct of monetary and exchange The government would have announced its com- rate policy during 2002–03. mitment to redeem existing Afghanis for the new currency at a rate that would be determined later. The risk of counterfeits would have remained, but Choice of Currency would have had less impact. This approach would have imposed a substantial degree of transparency It was clear that financial stability could not be and discipline on both fiscal and monetary policy, achieved under the prevailing circumstances, with thus contributing to financial stability. little or no control over the issuance of money. In ad- The authorities, however, decided to continue to dition, donors were looking for reasonable assurances use the existing Afghani and to introduce a new cur- that the effectiveness of their assistance would not rency as soon as if was technically possible. The au- be eroded by high inflation. Thus, one of the first thorities viewed the Afghani as an important symbol critical economic issues facing the new government of sovereignty and unity and were concerned that was the choice of currency that would serve as legal even a partial and temporary dollarization would be tender. From the outset, the authorities indicated difficult to reverse. While the authorities recognized their desire to introduce a new national currency as the risks posed by the various counterfeits to financial soon as possible. IMF staff, however, recommended stability, they believed that these risks had dimin- that the introduction of a new currency be consid- ished. This view was based on information received ered at a somewhat later stage because of technical from at least some of the printers regarding volumes considerations, as the design and printing would take of earlier issued series of Afghanis printed so far, and time and, more importantly, because of the need to their assurances that such printing had stopped. Also, establish sound and credible financial policies and an it was discovered that the Taliban, while in govern- adequate institutional and legal framework to sup- ment, had started preparations for the introduction of port the value of the new currency. Several options a new currency and had signed a contract with a rep- could be considered for the interim period, ranging utable banknote printer. Some work had already been from adopting a stable foreign currency as legal ten- done, including preliminary designs of various de- der to the continued use of the existing Afghani, nominations. However, this agreement had been put leading up to the introduction of the new currency. on hold because of the UN embargo; but with the One possible option for the interim period was a sanctions lifted, this allowed for a significant shorten- full dollarization until the new Afghani could be ing of the technical lead-time needed to launch the successfully launched. The temporary use of a stable new currency. As the value of the old Afghani had foreign currency would have provided immediate been eroded by inflation—the largest denomination monetary stability as well as time to establish credi- (Af 10,000) was worth about $0.25 and people had to bility and build up the necessary capacity at DAB. carry around large bundles of cash for anything other Full dollarization, however, would have entailed an than the smallest of transactions—one new Afghani up-front redemption of all existing Afghanis, which would replace 1,000 old ones. would have required considerable organization. The introduction of the new currency was a crucial Moreover, this approach would have been expen- step in the authorities’ efforts to establish financial sive, requiring significant additional donor assis- stability and create an environment that was con- tance. Also, full dollarization might have been po- ducive to restoring sustainable economic growth in tentially difficult to reverse. Afghanistan. The plan for the introduction of the An alternative option, recommended by IMF staff new currency was made public on September 4, 2002, that was based on pragmatic economic and techni- and the conversion process started on October 7, cal grounds, was to use a foreign currency to conduct 2002. Replacing all banknotes in a postconflict coun- government transactions until the new currency try such as Afghanistan within a fairly short period could be introduced. Meanwhile, the public would posed tremendous logistical challenges (details of the have been free to use any mutually agreed-upon cur- currency conversion are provided in Box 5.1). Never- rency for any transaction and to hold any currency. theless, the authorities, assisted by the international Existing Afghanis would have continued to circu- community, managed to complete the changeover

Box 5.1. Introducing the New Currency

The introduction of the new currency was a difficult 1 task. Afghanistan is a rugged country slightly larger Afghanistan: Currency Denominations, 2003 than France, with a population of about 22 million, that had been ravaged by over 20 years of armed con- Distribution of notes ordered flict. Roads were in a very poor condition, there was Distribution of notes in circulation little or no secure ground transportation between 30 Number of Notes major cities, and there was a lack of communication (In percent of total notes) facilities. To reach all holders of the old currency 25 within a limited period of time posed enormous logistical challenges. To address these vast challenges, a 20 steering committee was formed, which comprised senior officials from the central bank and the Ministry of 15 Finance (MoF), and was assisted by international experts from the IMF, USAID, the Bundesbank, and the 10 UN. Planning for the exchange started in earnest in 5 the early summer of 2002 with the formation of a task force, comprising mainly senior officials from the cen- 0 tral bank and several international advisors. 1 2 5 10 20 50 100 500 1000 Denominations The first stages included the ordering, printing, and 40 delivery of the new banknotes. DAB contracted the Value of Notes (In percent of total value) printing of the new currency in denominations of 35 Af 1, 2, 5, 10, 20, 50, 100, 500, and 1,000 to two rep- 30 utable banknote printers, building upon the work that 25 had already been done for the Taliban regime. The new notes included several advanced security features 20 to deter future counterfeiting. It was difficult to deter- 15 mine how many new banknotes would be needed. The authorities only had a crude estimate of the existing 10 number of old notes in circulation. Including the vari- 5 ous counterfeits, the face value of the old Afghanis in 0 circulation was initially estimated at about Af 16 tril- 1 2 5 10 20 50 100 500 1000 lion. For political reasons, it was decided that two Denominations types of unofficial notes would be eligible for conver- Source: Da Afghanistan Bank. sion, but at a 50 percent discount (close to the actual 1Data reflect the situation on May 21, 2003. discount at which these counterfeits traded in the Kabul money market). Taking this discount into account, the total value of old Afghanis to be exchanged was estimated at about Af 13 trillion. The authorities 89 branches, but most of them did not meet even the realized, however, that running out of new banknotes most basic requirements in terms of secure vaults and before all old ones would be converted would fatally office space. With assistance from international donors, undermine the public’s confidence in the new cur- DAB urgently set out to refurbish or construct a mini- rency. Because of this, and to be able to accommodate mum of one currency distribution facility in each an increase in money demand at least in the first year province. The country was divided into seven regions, following the new currency’s introduction, the author- each the responsibility of an area manager. In addition ities ordered a total value of the new notes of Af 27.9 to Kabul, the regions were Kunduz, Mazar-i-Sharif, billion (with 1 new Afghani replacing 1,000 old ones), Herat, Kandahar, Jalalabad, and Gardez. Each region equivalent to almost 800 million notes or about 500 had a number of exchange points, depending on esti- tons. The first deliveries were received in August 2002 mates of population size and levels of economic activ- and the last shipments arrived in January 2003. The ity. All in all, 47 exchange points were established five smallest denominations make up almost 90 per- where the public could exchange their old notes for cent of the total volume of notes ordered, but only 15 new ones. An exchange point consisted of one to five percent of the total value (see the figure). units, with each unit having seven windows: five win- The first problem to overcome was the extremely dows to take in the old currency and two to give out poor condition of DAB’s regional facilities. DAB had the new currency. With communication still difficult,

Box 5.1 (concluded)

the success of the whole program depended signifi- rency. The government, together with DAB, provided cantly on the work of the area managers and exchange all the security during the currency conversion point managers, who often had to act on their own to process. The governor and deputy governors of DAB deal with problems in their regions. Some 2,500 local visited the governors and local commanders in the staff were selected to carry out the operation. Staff were provinces to ensure their cooperation. It is notable selected from the most experienced and skilled person- that there were no major security problems or serious nel in the banking sector. In order to motivate staff and violations of procedures during the entire three- to establish reliable operations, staff were paid consid- month exchange period. erably more than the $30–$40 a month that a bank The introduction of the new currency was made employee would normally earn. In addition, the UN public on September 4, 2002, by President Karzai. and USAID provided international observers to over- This was followed by a broad public information cam- see the process, notably the destruction of old notes. paign to ensure that most, if not all, Afghans would be Transportation was another obstacle to tackle. The aware of the conversion. With large parts of the popu- 500 tons of new currency had to be delivered to ex- lation being illiterate and with hardly anyone owning change points throughout the country, with almost half a television, the campaign relied mainly on radio of this to be transported to the provinces. Ground broadcasts and dissemination by word of mouth, transport for the more distant locations was ruled out through speeches, village meetings, and so on. Also, a for security reasons. Air transport was seen as the best large number of posters were distributed, depicting the approach, but the facilities available were very limited. new notes and specifying their main security features. The bulk of the need for air transport was met by two The conversion process started on October 7, 2002, helicopters and one airplane, an Antonov 32, provided and was initially set to last two months, ending on De- by USAID, who also set up an air operations unit that cember 4, 2002. The authorities opted for a relatively handled the scheduling and coordination of flights (all short changeover period to limit the risk of new coun- flights required clearance from the regional military air terfeit printing. A currency decree was issued to en- command and a two-day advance notification). The able and regulate the implementation of the currency Afghan Air Force provided some assistance, particu- conversion. larly in the early stages of the conversion period, when During the first two weeks of the exchange period, difficulties in obtaining aircraft and crews that were only the money changers would be allowed to ex- willing to operate in Afghanistan led to delays in the change their old notes. This way DAB aimed to arrival of the helicopters and the airplane. collect large volumes of old notes early on. In order to Adequate security was yet another requirement, be able to handle the large volumes that were with security needed at all stages: from the delivery of expected to be exchanged this way, a sampling the new currency to the destruction of the old cur- procedure was agreed on with the money changers,

successfully on January 2, 2003. Moreover, they man- the interim created the need to rapidly develop ca- aged to do so much earlier than many had thought pacity at the central bank to ensure that it would be possible and without any major incidents. There was able to conduct monetary policy. DAB’s capacity to no last-minute rush or queues during the last days of perform key central bank functions was extremely the exchange period, nor were there any late shows weak. The central bank was little more than an after the closing of the exchange points. The ex- empty shell, with ample staff but virtually none that change rate of the Afghani remained broadly stable had any knowledge of modern monetary policy and following the completion of the conversion process, banking, no computers, no recent balance sheet, reflecting not only sound financial policies but also and little or no communication with its many the population’s confidence in the new currency. branches in the provinces. The IMF and several other donors, notably USAID, assisted DAB in its Preconditions for a Successful efforts to quickly build adequate capacity. The authorities decided that the primary objec- Monetary Policy tive of monetary policy should be to achieve and The authorities’ decision to introduce a new cur- maintain price stability and, thus, to restore confi- rency and to continue to use the existing Afghani in dence in the (new) national currency. Furthermore,

whereby only 10 percent of the total amount pre- nis) were exchanged. Old official notes worth Af 13.9 sented was verified to make sure that the count was trillion were exchanged during the conversion process correct, the denominations were correct, and the for new notes, plus Af 3.3 trillion in unofficial notes notes were indeed eligible for exchange. If the sample at a 50 percent discount. Thus, new notes worth count found, for example, 2 percent to be incorrect, Af 15.6 billion were issued in exchange. An addi- this proportion would be discounted from the entire tional Af 2 trillion in old official notes were absorbed amount that a money changer was presenting. through the foreign exchange auctions during the conversion period. All in all, some Af 19 trillion in Demand from the general public to exchange their old notes were collected, equivalent to some 5 billion old banknotes was such, however, that the exchange banknotes or over 2,000 tons, almost 20 percent more was opened to the general public before the first two than the estimated face value of banknotes based on weeks were over. Thus, almost all of the exchange the information received from the printing compa- points in the major cities opened in the first two nies. This difference may reflect inaccurate or incom- weeks. Many exchange points in the provinces had de- plete information received from the printers, “last- lays in opening, not only because of delays in the ar- minute” printing of counterfeits, or round-tripping of rival of air transport but also because many exchange old notes during the currency conversion process. To points were simply not yet operational until two to address the problem of round-tripping, initially old three weeks after their planned opening on October banknotes were to be invalidated, using punchers and 21. In November, uncertainty grew among the general drills, and to be subsequently destroyed, using shred- public about whether everyone would be able to con- ders. However, this approach quickly proved to be in- vert their old notes into new ones on time. As a result, effective because the arrival of equipment was delayed the exchange rate started to depreciate sharply. To ease and, once it arrived, had a tendency to break down. these pressures, DAB announced in mid-November The solution to the destruction problem was to use in- that the conversion period would be extended by one cineration as the principal method. Difficulties in month to January 2, 2003. Following this announce- transportation and security meant that the best ap- ment, the exchange rate quickly returned to levels proach was to incinerate the notes locally. The con- close to those at the start of the exchange. struction of ovens was relatively simple and inexpen- In the initial period, large denomination banknotes sive. Also, ovens did not require electricity, which was of 1,000, 500, 100, and 50 Afghanis dominated the not available in many exchange points. A schedule exchange, reflecting the early and active role of was established for the weekly or two-weekly destruc- money changers. This also meant that the weight of tion of the old banknotes, with both international banknotes, relative to their value, was much less than and national observers present to assure the integrity in the last month of the exchange, when primarily of the process. The exchange ended quietly on Janu- low denomination banknotes (1, 2, 5, and 10 Afgha- ary 2, 2003.

to ensure that monetary policy could be successful IMF to assist in preparing new central bank and in achieving low inflation, the authorities recog- banking laws to this effect. Draft laws were dis- nized that the following three main preconditions cussed at a seminar held in Delhi in December would need to be met: 2002 and were adopted in September 2003. The new legislation granted DAB autonomy • DAB would need to have full jurisdiction and and paved the way for establishing a modern control over the printing, delivery, and issuance banking sector.2 of the domestic currency. To achieve this, as noted above, the authorities pressed ahead • The government would need to maintain strict forcefully with the introduction of the new fiscal discipline. In particular, DAB should re- currency. frain from financing the government budget, any government agency, or any government-owned • DAB would need to be independent from any enterprise to break with the previous practice of other authority in the pursuit of its objectives automatic and unlimited overdraft financing and the performance of its tasks. DAB should neither seek nor take instructions from any other authority. The authorities requested the 2See Chapter 6 for a discussion of these laws.

that had resulted in high inflation and a sizable • Inflation pass-through: The openness of the depreciation of the exchange rate. Adopting a economy is reflected by the strong and rapid simple and straightforward rule to this effect pass-through of exchange rate movements into would signal an unambiguous commitment to consumer prices. Fixing the exchange rate fiscal discipline. The authorities therefore in- could be a simple and straightforward way to cluded in the 2002/03 budget decree a provision stabilize prices. that prohibited the government from taking re- • Nominal anchor: Afghanistan has a history of course to central bank financing. This provision high and variable inflation, and the economy is was repeated in the 2003/04 budget. highly dollarized. A fixed exchange rate would The next step was to define the appropriate provide a clear nominal anchor for monetary framework for monetary policy. What would be the policy. Acceptance and use of the new currency intermediate target for monetary policy? A first step would be greater if its exchange rate were to re- in this regard was to determine the appropriate ex- main fairly stable. If the exchange rate would change rate regime for Afghanistan. continue to be highly volatile and the currency would again lose its value, dollarization could be expected to increase further. Fixed or Flexible: Choosing • Credibility: The capacity to implement eco- the Exchange Rate Regime nomic policies, in particular, at the central bank, was at the outset weak, favoring simple, In choosing an exchange rate regime, a country fixed rules. A currency board, for example, is has to trade off the advantages of more exchange rate simple to administer as it does not require a full- stability against the advantages of more flexibility. fledged central bank. Two big advantages of fixing the exchange rate for a country are (1) it reduces transaction costs and ex- The characteristics that favored flexibility change rate risk, which can discourage trade and in- included vestment, and (2) it provides a credible nominal anchor for monetary policy. The big advantage of a • Structural change: Afghanistan’s economy is un- floating exchange rate regime, on the other hand, is dergoing large structural changes and the equi- the ability to pursue an independent monetary pol- librium exchange rate will change as a result. icy. Moreover, a floating regime enhances a country’s Thus, there would be a considerable risk of an ability to absorb external and real shocks. Several exchange rate misalignment in a fixed regime. countries choose something in between rigid fixity The reconstruction phase would likely be ac- and free-floating, although many argue that interme- companied by large foreign exchange inflows, diate regimes are no longer tenable because of the in- both from donors and repatriation of funds by creasing integration of financial markets.3 Afghanis, which may cause the real exchange In deciding the exchange rate regime for rate to appreciate. A more practical matter is Afghanistan’s new currency, the authorities took that in present-day Afghanistan, it would be into account a number of relevant characteristics of very difficult to get a firm idea as to what the the Afghan economy. Some of these characteristics appropriate exchange rate level would be in a favored a fixed rate regime; others favored flexibil- fixed regime, not least because of the lack of re- ity. Not all these characteristics would necessarily be liable data (see Box 5.2). permanent; some may change over time. This may • Vulnerability: Afghanistan was (and will remain) have a bearing on the choice of exchange rate vulnerable to shocks, both external and domes- regime in the future. The characteristics that fa- tic, and both real and financial. These shocks in- vored exchange rate stability included clude inter alia trade shocks, droughts, earth- • Openness: Afghanistan is a relatively small and quakes, and political tensions. Under a fixed open economy. Trade would benefit from ex- regime, labor and product markets would need to change rate stability. have a high degree of flexibility to absorb such shocks. While these markets could be expected to have considerable flexibility, the question 3See Frankel (1999). would remain whether it would be desirable to

Box 5.2. What Is the Right Exchange Rate Level?

Since the collapse of the Taliban regime there have food and transport allowances, the equivalent of been significant changes in Afghanistan’s economy, about $38 a month compared with $35 in including its trading patterns. The exchange rate has Afghanistan. However, compared with Pakistan, meanwhile fluctuated widely. Is it possible to make a data suggest that, in Afghanistan, wages for unskilled judgment about the appropriate “equilibrium” level labor in the private sector are substantially higher; in of the exchange rate for the Afghani? The equilib- early 2003, wages for unskilled labor paid by foreign rium real exchange rate (or nominal rate after ad- companies and agencies were typically about $100 justing for inflation differentials) would be the rate per month. A comparison of inflation rates and that would be consistent with a sustainable current nominal exchange rate movements in 2001, 2002, account position, without the need for major and the first half of 2003 suggests that Afghanistan changes in international reserves or shift in macro- has become less competitive vis-à-vis most nearby economic policies.1 countries in the region. This reflects the large appreciation of the Afghani against the U.S. dollar in late Information typically used to assess the appropriate- 2001 and a higher rate of inflation. In addition, pro- ness of the exchange rate level is notably lacking for ductivity is probably higher in neighboring countries Afghanistan. There is no sensible base year against than in Afghanistan because the years of conflict re- which to compare the current level of the real ex- sulted in low levels of investment and a destruction change rate. There have been huge changes in the of much of its infrastructure. In the case of transit pattern and composition of trade in the past 20 years trade, the damage to roads has contributed to higher and consequently a base year during this period would transport costs, slow traffic movement, and greater not be relevant to Afghanistan’s current circum- damage to goods. stances. Moreover, there is very little information available on indicators used to assess competitiveness, Looking ahead, there may be a so-called Dutch Dis- such as growth rates of export and import volumes; ease effect that could put upward pressure on the equi- the pattern of trade, relative price, and wage costs vis- librium real exchange rate. Official external financial à-vis trading partners and competitor countries; and assistance is expected to rise and remain at a high the level of foreign exchange reserves. level relative to the size of Afghanistan’s economy for at least the next few years, before settling to lower lev- A few partial indicators of international competi- els. The composition of aid is expected to shift from tiveness are available. Most of Afghanistan’s own ex- humanitarian aid, with a high import content, to in- ports—that is, excluding re-exports—are to India frastructure and project aid, with a lower import and and Pakistan. These and other countries in the re- higher domestic content, and have a positive impact gion are likely to be Afghanistan’s competitors in its on the production capacity of the economy. There export markets (agriculture and light manufactur- will also be a continued reflux of refugees that will ing). For imports, the major sources appear to be contribute to increased domestic spending. The re- Pakistan, Korea, Japan, the Islamic Republic of Iran, sulting increase in domestic spending on nontraded and, since 2002, the United States; for the Islamic goods would lead to a rise in the relative price of non- Republic of Iran and Pakistan, available import data traded to traded goods (the real exchange rate) and a possibly include goods in transit from other coun- shift of resources from the traded goods sector to the tries. Most of the imports are likely to be goods (e.g., nontraded goods sector. However, there are also sev- cars, refrigerators, and televisions) that Afghanistan eral factors that could offset these effects. The econ- does not produce. Imports from neighboring coun- omy is operating at a low level and given the existing tries, however, are more likely to compete with do- underutilization of capacity, including labor and the mestic substitutes, such as agricultural goods and return of refugees, domestic production could rise construction materials. As regards competitiveness, rapidly in response to increased demand and reduce in Pakistan, Afghanistan’s largest bilateral partner, upward pressures on the price of nontraded goods. civil servants in the lower grades are paid, including Also, as the reconstruction effort moves forward, supply bottlenecks could be eased, productivity could rise, and some costs could decline (e.g., transportation), all of which would dampen increases in domes- 1The real exchange rate can be defined as RER = ePD/PF, tic prices and improve competitiveness. Moreover, where PD is the domestic price level, PF the level of foreign prices, and e is the nominal exchange rate (measured in units given the large share of transit trade in Afghanistan’s of foreign currency per unit of domestic currency). The prices trade, a decline in transshipment costs would signifi- used are typically those of imports and exports, or tradable cantly improve the attractiveness of Afghanistan as a and nontradable goods. transit route.

let these markets absorb these shocks rather than Formulating a Monetary Program to let the exchange rate adjust. Within the context of Afghanistan’s floating ex- • Fiscal discipline not guaranteed: The government change rate regime, IMF staff assisted DAB in de- had no track record in terms of underlying eco- veloping an indicative quantified monetary pro- nomic policies. The viability and credibility of gram, aimed at achieving low inflation. The a firmly fixed rate, such as in a currency board program aimed to control the domestic money sup- arrangement, would depend on the credibility ply as an intermediate target. The ability to target of supporting policies. But the authorities’ com- inflation through the domestic currency supply was mitment to fiscal discipline had not yet been complicated, however, by the widespread use of for- put fully to the test. eign currencies. Inflation was likely to be influ- • Lack of an obvious anchor currency: Should enced by changes in the stock of foreign currency Afghanistan peg to the U.S. dollar or the cur- holdings as well as the supply of Afghanis. The ef- rency of one of the neighboring countries? Fix- fects of changes in the stock of foreign currency ing the rate against the U.S. dollar might result holdings on inflation and the exchange rate de- in a real appreciation against neighboring coun- pended in part on what the foreign exchange is tries, adversely affecting Afghanistan’s competi- used for—savings or daily transactions. However, tiveness. On the other hand, fixing the rate there was little information on the size of foreign against the currencies of neighboring countries currency holdings in Afghanistan or on their use could adversely affect exchange rate stability (for savings or transactions). against “hard” currencies, which might under- In the absence of a functioning banking system, mine the Afghani as a savings medium. the domestic money supply was limited to the stock of domestic currency in circulation. Also, The Afghan authorities decided that, despite the without any new central bank financing of the advantages of a fixed rate regime (such as a currency government, changes in the amount of currency in board), on balance Afghanistan’s existing economic circulation were primarily driven by changes in conditions favored a floating exchange rate regime, DAB’s net foreign asset position. In practice, this at least for the near term. The risks associated with a largely reflected the government converting the fixed peg or currency board arrangement were con- donor assistance it receives to finance the budget sidered too large in the prevailing circumstances. at DAB into Afghanis, thereby increasing DAB’s Defense of an unsustainable exchange rate would foreign assets. Without any action from DAB and run the risk of a quick depletion of the country’s for- given the size of budgetary assistance, these foreign eign exchange reserves. However, as the economy exchange inflows would have implied a doubling progresses beyond the early structural changes in- or more of the domestic money supply within one herent in the reconstruction process, the choice of year, which would undoubtedly have resulted in a exchange rate regime could be revisited. renewed erosion of the value of the Afghani. To While ruling out a fixed peg, the authorities still prevent this, an instrument to sterilize the mone- saw benefits in maintaining a degree of exchange tary expansion was needed. However, without a rate stability. In particular, a degree of stability was functioning banking system or money market, the considered important to instill confidence in the only market-based instrument that could be devel- new currency. Therefore, following the introduction oped quickly was selling foreign exchange through and float of the new currency in early 2003, DAB foreign exchange auctions. IMF staff provided aimed to limit exchange rate volatility and to keep extensive assistance to DAB to establish and im- the exchange rate within a range. This range, how- prove these auctions (see Box 5.3), with the infor- ever, was neither firmly set nor announced and mal money traders acting as participants in these DAB did not intend to resist persistent exchange auctions. rate pressures, should these emerge, and thereby risk The formulation of a monetary program for losing foreign exchange reserves. This exchange rate Afghanistan was complicated by the substantial regime could therefore be described more accurately uncertainties that surround the country’s overall as a de facto (lightly) managed float, that is, an in- economic prospects and economic relationships. termediate regime somewhere between a pure float Inflation could be affected by factors beyond the and a firmly fixed rate. central bank’s control, including supply shocks,

Box 5.3. Foreign Exchange Auctions

With IMF staff assistance, DAB began undertaking quently, in April 2003, those wishing to participate foreign exchange auctions in May 2002. These auc- in auctions were required to make in advance a non- tions were open to all licensed money changers. Ini- interest-bearing Afghani cash deposit equivalent to tially, only the larger money changers participated, $10,000 with DAB. Failure to settle a successful bid but as money changers became more familiar with the would risk forfeiture of the deposit. This requirement auctions, the number of participants soon increased and forfeiture were later formalized in new regulations from about 10–20 in May–June 2002 to 30–60 after for the auctions that were issued in early 2004. July 2002. In the first half of 2003, the number of par- The modalities of the auction were adjusted over ticipants was usually in the range of 50–80, with a few time. Beginning in November 2002, sealed advance money changers in the provinces also participating. bids were used as the starting point by the auction- DAB has progressively taken measures to improve the eer—the governor or deputy governor of DAB—to transparency and operation of the auctions. These offer a selling price for U.S. dollars to participants in measures included public announcements of the auc- an auction session where all bidders are invited. tions in advance in local newspapers and on radio, the Under this system, the auction closes when the auc- announcement of successful bids at the auction in the tioneer and participants agree on a mutually accept- presence of the participants, and a clear explanation able single clearing exchange rate. The auctioneer, of auction procedures and any changes to be intro- however, reserves the right not to sell. duced at the outset of auctions. The mechanics of the auctions also became more efficient and were system- The amounts auctioned were linked to the overall atically applied. For example, on several occasions, monetary program. Auctions were held on a fairly reg- money changers who had made successful bids did not ular basis at one- to two-week intervals. The amounts settle. To discourage this behavior, DAB began pro- sold per auction were on average about $2 million for hibiting these money changers from participating in the first six months and afterward in the range of the auctions on a temporary basis and declared that $5–$10 million. In 2002/03, a total of $135 million repeated offenses would result in a permanent ban on was sold through the auctions and in 2003/04, $155 participation (“three strikes and you are out”). Subse- million was sold.

fluctuations in the international prices of imports, tained from the banknote printer who had printed and political events. Given these large uncertain- the official Afghani and another printer who had ties, the monetary program needed to be based on printed one of the counterfeit versions. By combin- cautious assumptions regarding the strength of the ing the estimate of the amount of currency in circu- economic recovery and the demand for the domes- lation with estimates of DAB’s foreign assets that tic currency. In addition, it was clear that the tar- had so far been identified, plus an estimate of the get should not be pursued too rigidly, but that DAB government overdrafts that had been accumulated would need to monitor developments closely and, over the years and for which some records were if necessary, adjust the monetary program when found, a very crudely estimated balance sheet could needed to remain consistent with its inflation ob- be put together for DAB (Table 5.1). This estimate jective. In this regard, movements in the exchange was used as a basis for the monetary program. The rate, which is the only economic indicator that is program was updated regularly as new information readily available, could provide an early signal of became available, particularly following the comple- changes in the relative demand for the domestic tion of the currency conversion when the stock of currency that may warrant a tightening or loosen- currency in circulation could finally be determined ing of monetary policy. accurately. A further, more practical, complication in formu- A first indicative monetary program was formulating a monetary program was the lack of reliable lated in April 2002 for the year 2002/03. The pro- data (at least prior to the introduction of the new gram targeted a 12-month inflation rate of some- currency) for the stock of Afghanis in circulation what below 20 percent by March 2003. Assuming and, more generally, the absence of a balance sheet economic growth in the order of 10 percent and a for the central bank. Estimates of the outstanding modest strengthening of money demand, the mone- stock of Afghanis were based on information ob- tary program for 2002/03 aimed to limit money

©International Monetary Fund. Not for Redistribution MONETARY AND EXCHANGE RATE POLICY IN A POSTCONFLICT ENVIRONMENT 2001/02 (SY 1380) wage expenditures. issuance of new Afghanis during October 7, issuance of new 2002–January 21, Af 46 = $1; valued at $279 per ounce. gold (In percent, unless indicated otherwise) (In millions of new Afghanis, (In millions of new unless indicated otherwise) 0 0 –93 –574 . . . 133 –501 –4,410 –3,607 –6,650 –7,813 ...... 10,727 11,053 12,567 12,893 12,436 12,762 ...... 17,951. 18,392 . . 19,602 –11,483 19,602 24,031 –12,819 24,031 –12,108 26,158 26,158 32,653 32,653 . . .. . 33,607 . 33,607 –13,888 –13,376 . . . –14,232 –14,400 . . . –14,587 –11,604 ...... 20.1 ...... 40.9 2001/02 Estimates 2002/03 Estimates 2003/04 Estimates ©International Monetary Fund. Not for Redistribution 14,577 14,525 14,951 14,95113,475 13,769 . . . 14,606 14,951 14,704 14,951 18,384 14,951 19,146 14,951 20,676 14,951 20,340 14,951 23,102 26,367 29,140 December 21 20 March 21 June September 22 September 22 December 21 20 March 21 June September 22 December 21 20 March ______8 5, 6 2, 3 4, 5 7 3 1 2002/03 (SY 1381/1382) 2002/03 (SY 1381) Net claims on government after Net claims on government Net claims on government before before Net claims on government 5.1 Banknotes and coins issuedless cash holdings 13,509 13,809 14,718 34 14,718 40 . . . 19,831 112 21,302 14 21,302 23,302 . . . 27,392 29,726 684 626 962 200 1,025 586 Claims on nonbank public institutions banksClaims on deposit money Other items net ...... 0 0 0 0 0 0 ...... 0 0 0 0 0 0 0 0 0 0 0 0 GoldOtherNet claims on general government 14,577 14,525 14,857 . . 14,376 . . . . 6,674 4,379 . . . 6,674 6,219 15,084 6,674 14,450 6,087(millions of U.S. dollars) 10,541 ...... 11,344 9,030 9,362 8,301 9,030 10,572 7,138 15,001 9,030 17,128 9,030 23,623 9,030 24,577 9,030 Foreign currency amounts converted into Afghani at an exchange rate of Af 34 = $1 until September 2002;Afghani at an exchange rate of at a rate of thereafter into amounts converted currency Foreign accounts abroad. plus recovered (net) flows reflect Increases In Q3 2002/03 (SY 1381), currency. the new of $16 million in costs for DAB by includes payment the 2001/02 (SY 1380) budget. for booked made and revenues expenditures Changes in Q1 2002/03 (SY 1381) reflect Accounts 600100, 701101, funding of to 2001/02 (SY 1380) for of 2002/03 (SY 1381) revenues reallocation for and 731001 corrected funds (accounts 701102 and 731002). AIAF,ARTF, and LOTFA Including disbursed September 22, 2002, calculated as January 21, in circulation stock of currency 2003, net minus Afghanis in circulation stock of new changes. quarterly percentage multiplying in 2002/03 (SY 1381) calculated by increase percentage Annual Reserve money growth (quarterly) growth Reserve money (annual) growth Reserve money . . . 2.2 6.1 0.7 . . . 4.1 8.0 –1.6 13.6 14.1 10.5 Bank reserves 0 0 0 0 . . . 0 0 0 0 0 0 Foreign exchange reserves Foreign liabilitiesForeign Domestic assets . . .Afghanis in circulation . . . –326 14,525 –326 14,857 –326 14,376 international reserves Gross .Inflation (quarterly; . Kabul) . . .Inflation (12-month; Kabul) . –441 15,084 . . . 14,450 –36.8 0 325.1 10,541 . . . 25.2 11,344 379.2 0 –43.4 8,301 375.3 1.6 –35.3 7,138 0 . . . 18.3 –4.9 . 0 . 399.8 . . . . 426.1 0 31.9 98.5 522.4 –4.0 52.3 568.7 709.9 2.0 52.9 730.6 32.6 2.6 6.6 6.0 10.3 –0.6 Source: All figures are IMF staff estimates based on available data from Da Afghanistan Bank and the Central Statistics Office. Source: Da data from IMF staff estimates based on available are All figures 1 2 3 4 5 6 7 8 ABLE Memorandum items Net domestic assets .Reserve money . . 3,041 2,038 2,268 13,475 . . . 13,769 1,196 14,606 14,704 1,074 18,384 –3,691 19,146 –3,056 20,676 –6,286 20,340 –4,466 23,102 26,367 29,140 T Afghanistan Bank) (Da Monetary Developments 2003, 1,000) during September 23,Afghanis (divided by of old plus net withdrawal 2002–January 21, 2003. Net foreign assets Net foreign

68 Monetary and Exchange Rate Developments in 2002–04 growth to less than 30 percent. A similar program Monetary developments in 2002/03 demonstrated was formulated in early 2003 for 2003/04, with only the difficulty of predicting money demand in slightly different parameters. The 2003/04 program Afghanistan. The economy is estimated to have targeted a 12-month inflation rate of about 15 per- grown in real terms by almost 30 percent in 2002/03, cent by March 2004 and aimed to limit money while the overall price level, measured year-on-year, growth again to 30 percent.4 increased by 5 percent. This suggests that money demand may have actually weakened in relation to nominal GDP in 2002/03, instead of strengthening Monetary and Exchange Rate as had been assumed when formulating the program. Developments in 2002–04 This underscores the uncertainties surrounding even the most basic economic relationships in a post- Monetary developments in 2002 and 2003 sug- conflict situation and the need, therefore, to make gested that a fairly close relationship exists between cautious assumptions, to remain pragmatic, and to be domestic money growth, exchange rate move- willing to make adjustments as one goes along, tak- ments, and the rate of inflation. Developments, ing into account all available information. particularly in 2002, also showed that the exchange After a period of sharp volatility in 2002, the ex- rate was very susceptible to rumors and political un- change rate of the Afghani proved remarkably sta- certainty and, furthermore, that the pass-through of ble during 2003. The exchange rate strengthened exchange rate movements into prices was very dramatically in late 2001, during the collapse strong and almost immediate. of the Taliban regime, appreciating from (old) During 2002/03, currency in circulation grew by Af 70,000–80,000 per U.S. dollar to about an estimated 20 percent, significantly less than the Af 25,000 per U.S. dollar in early 2002 (Figure almost 30 percent targeted in the original monetary 5.1). The exchange rate depreciated slowly in line program (in the fall of 2002, the target was reduced with inflation to about Af 40,000 per U.S. dollar to 24 percent).5 The rate of monetary expansion in August 2002. In the late summer and early fall varied widely from quarter to quarter, reflecting of 2002, however, uncertainty about the introduc- both the volatility of money demand, as well as tion of the new currency and logistical problems more practical constraints, such as the availability of during the first weeks of the conversion period sufficient volume of the old banknotes prior to the caused the exchange rate to fall to over Af 70,000 introduction of the new currency. The increase in per U.S. dollar in early November. People had be- money demand during the year was entirely met by come increasingly nervous about whether they an accumulation of foreign reserves at the central would be able to convert their old notes into new bank; the government adhered to the no-overdraft ones in time; initially, the changeover period was rule and ended the fiscal year with a surplus. DAB’s planned to last only eight weeks. DAB had also reserves increased by an estimated $100 million in temporarily suspended its foreign exchange auc- 2002/03. At the end of 2002/03, DAB’s stock of for- tions after the start of the exchange because it eign exchange reserves was estimated at $426 mil- lacked qualified staff to handle both operations at lion.6 This level of reserves would appear to have the same time. The sharp depreciation of the been adequate in the context of the prevailing ex- Afghani was passed through quickly to local prices, change rate regime as a cushion against negative which increased by a cumulative 60 percent during shocks, as well as backing for the national currency.7 September–November 2002. To ease the exchange (See Box 5.4.) rate pressures, DAB resumed foreign exchange auctions in mid-November and announced an ex- tension of the banknote exchange period until Jan- 4The staff-monitored program (SMP) for the year 2004/05 also uary 2, 2003. The Afghani immediately strength- included an indicative monetary program. ened and eventually stabilized at about (new) Af 46 5Due to the break in series—because of the introduction of the per U.S. dollar in January. With the strengthening new currency—the annual growth rate is calculated by multiplying estimated quarterly growth rates. of the Afghani consumer prices came down as well, 6Including $196 million of gold valued at $279 per ounce. although somewhat less than the appreciation of 7These reserves covered approximately three months of im- the Afghani. ports (excluding re-exports, donor-financed exports, and smuggled goods) and were roughly equal in value (at the prevailing With the completion of the currency conversion exchange rate) to the amount of currency in circulation. in January 2003, DAB achieved full control over the

Box 5.4. Considerations on the Level of Foreign Exchange Reserves

The level of external reserves held at the beginning cover some three months of imports, excluding re- of 2002 by DAB was uncertain. The only identified exports; imports exempt from duties that are largely assets were those held (frozen) with the Federal Re- externally financed, for example, by donors; and serve Bank of New York and a few other banks, smuggled goods. Thus, the level of reserves could be which amounted to about $250 million, including considered to be just sufficient, although a higher $196 million in gold. Since then, the level of identi- level of reserves would be warranted, given the fied reserves has steadily increased as more assets country’s vulnerability to various shocks and its lim- have been located, primarily at banks in Europe, and ited access to capital markets, to provide a crucial because of inflows of donor funds to finance the bud- cushion. Also, the recovery and reconstruction of get. As of end-August 2003, DAB’s foreign exchange the economy could be expected to generate a rapidly reserves were estimated at $556 million ($600 mil- rising level of own imports, and thus a higher level of lion with gold valued at market prices). DAB is con- desired reserves. The resumption of debt service pay- tinuing to contact foreign banks to clarify the size ments would also have a bearing on the adequacy of and status of its foreign assets. As a more reliable es- reserves. timate of DAB’s reserves emerged and the authorities established a framework for macroeconomic and A capital-account-based measure captures the po- exchange rate policy, the question of what would be tential for capital flight by residents. Typically, such an adequate level of external reserves needed to be a measure relates the level of reserves to relevant addressed. monetary aggregates, often the monetary base, and is relevant especially for countries with a (quasi) Criteria to assess the adequacy of reserves can gen- pegged exchange rate, weak banking systems, and an erally be related to the trade account or the capital unstable money demand or a history of high infla- account of the balance of payments. It should be rec- tion. Afghanistan has a history of high inflation that ognized that, when applying any criteria, the ade- resulted in low confidence in the Afghani and the quacy of reserves is a dynamic concept: as the cir- widespread use of foreign currencies. While confi- cumstances of a country change over time, so will dence in the national currency has improved with the desirable amount of reserves. For the moment, the introduction of the new currency, the potential Afghanistan has little or no access to international for large shifts between the Afghani and foreign cur- capital markets and thus would have to rely more on rencies still exists and points to using a monetary its own resources (reserves) than on international aggregate–based measure in assessing the adequacy borrowing to smooth adjustments to shocks. The po- of reserves. In the absence of a functioning banking tential for such shocks in Afghanistan is large and is system, the relevant monetary aggregate is the stock thus a key factor in determining reserve goals. Donor of domestic currency in circulation; as and when the assistance, either in the form of lending or grants, banking sector is reestablished, the relevant mone- could be available, but access to these would be at tary aggregate could be expanded to include bank the discretion of the donor and may not be available deposits in domestic currency. In August 2003, quickly enough to offset the immediate impact of a currency in circulation amounted to Af 22.4 bil- shock. lion, equivalent to $456 million at the prevail- When using a trade-based measure one looks at ing exchange rate. This measure suggests that how many months of imports a country can finance Afghanistan’s level of foreign exchange reserves was with its reserves. Conversely, it shows how rapidly a more than adequate. Again, with economic growth country or its exchange rate might need to adjust to resuming and confidence in the national currency an external shock. Three months of imports cover- strengthening, money demand can be expected to age is often used as a rule of thumb to assess reserve increase, requiring additional reserves. But as long as adequacy. Reserves are generally considered low if the government refrains from central bank financing they cover less than three months of imports. As of the budget and there is limited use of a central noted in Chapter 2, the availability of reliable trade bank discount window by commercial banks, any data is limited for Afghanistan. However, based on increase in the demand for the domestic currency available data and estimates, the stock of reserves would be met by an inflow of foreign exchange held by DAB at end-August 2003 was estimated to reserves.

printing and issuance of the national currency and it 1 Figure 5.1. Exchange Rates was now able to determine accurately the amount of currency in circulation.8 While monetary policy continued to be restrained during 2003/04, the rate of 90 Monthly Average Afghani/U.S. Dollar Rates monetary expansion accelerated somewhat by com- 80 parison to 2002/03. Currency in circulation grew by an estimated 41 percent in 2003/04, exceeding the 70 30 percent increase envisaged under the indicative monetary program. Money demand continued to be 60 met entirely by the accumulation of foreign exchange 50 reserves at DAB (which reached over $700 million by late-March 2004), while the government contin- 40 ued to adhere to the no-overdraft rule. As a result of these sound monetary (and fiscal) policies, inflation 30 remained low in 2003/04, with an average monthly rate of inflation of less than 1 percent. Moreover, in 20 1999 2000 01 02 03 04 the absence of any major shocks, exchange rate sta- 75 bility was established with the exchange rate fluctuat- Daily Average Afghani/U.S. Dollar Rates ing around Af 49 per U.S. dollar. 70 65 60 Reference 55 50 Frankel, Jeffrey A., 1999, “No Single Currency Regime Is Right for All Countries or at All Times,” NBER 45 Working Paper No. 7338 (Cambridge, Massachu- 40 setts: National Bureau of Economic Research), September. 35 30 25 8The amount of currency in circulation could be calculated 2002 03 04 simply as the amount of currency delivered by the printer, less the amounts remaining in DAB’s vaults. But little or no informa- Source: Da Afghanistan Bank. tion was available on a timely basis on amounts held in the vaults 1In new Afghanis; last observation: March 31, 2004. of DAB’s branches. Until adequate communications have been established with the branches, currency that may be held there must be assumed to be in circulation.

Financial Sector Development in Afghanistan: Seeking a Renaissance

Felix Fischer

fter more than two decades of war and conflict, investment in infrastructure, collect taxes and cus- A regional tensions, and endemic security con- toms duties efficiently, and make the best use of the cerns, very little was left of Afghanistan’s financial substantial donor funds destined for Afghanistan’s system when the Taliban departed at the end of reconstruction, a rudimentary payment system and 2001. Although six commercial banks still retained basic financial services were essential. It was thus banking licenses, none of them was operational. paramount for the Afghan authorities to quickly ini- Virtually no loans had been made since 1995 and tiate reforms to move away from cash as the sole banks had lost their credibility as deposit-taking in- medium of exchange and to lay down the enabling stitutions. The central bank had been changed into framework for an efficient commercial banking sys- a Soviet-style dirigiste institution, interfering in the tem to develop and flourish. For all this to be done allocation of credit and the setting of interest rates, while safeguarding against fraud and bank failure, it and abrogating its responsibility to undertake the was necessary to rebuild a modern central bank, traditional functions of a central bank. Its financial with a supervisory capacity in line with interna- role was reduced to monetizing successive govern- tional standards to oversee the operations of the ments’ fiscal deficits. The banking system could no new banking system as it develops.2 The passage, on longer provide a payment system, which was instead September 16, 2003, of a modern central bank law taken over by the informal hawala system. and a modern banking law and the subsequent The speed at which Afghanistan’s economy could granting of banking licenses to a number of foreign be rebuilt, sustainable economic growth achieved, banks have laid the groundwork in this endeavor. and widespread poverty reduced depended crucially on a rapid and sound redevelopment of its financial sector.1 For the government to pay the wages of its After the Taliban: Financial civil servants, procure goods and services, undertake System at the End of 2001

At the end of 2001, there was no functioning 1See Holden and Prokopenko (2001) for a literature review on banking sector in Afghanistan, notwithstanding the the linkages between the financial sector growth, economic existence of a number of financial institutions with growth, and poverty. See also Levin, Loayza, and Beck (2000) for an econometric analysis showing the positive link between financial intermediation and growth. The study also confirms that legal and accounting reforms that strengthen creditor rights, 2Banking supervision does not necessarily have to be per- contract enforcement, and accounting practices can boost finan- formed by a central bank. Some countries have chosen to set up a cial development and accelerate growth. separate institution for this purpose.

©International Monetary Fund. Not for Redistribution After the Taliban: Financial System at the End of 2001 a banking license and a roster of staff on the payroll. rious flaws. First, it was designed on the now out- Most of what remained of the financial system was dated socialist principle that the purpose of mone- based in Kabul. Although not much is known about tary policy was to direct credit. It was therefore un- the state of the financial system in the provinces, it suitable for a market economy. Second, it involved a is not believed to have been extensive, let alone op- number of important conflicts of interest between erational. The Afghan financial system comprised, the government, the central bank, and commercial in principle, Da Afghanistan Bank (DAB), a hybrid banks. Third, it omitted important modern pruden- institution with central banking and commercial tial standards and enforcement tools. During the banking functions; two state-owned commercial Taliban era, this law was largely ignored. Although banks; and four state-owned special purpose devel- this law has recently been replaced by modern legis- opment banks. In addition, there were about 300 lation, it is still instructive to recall its main ele- registered money trading entities reportedly operat- ments because they help comprehend the dismal sit- ing in Kabul with some 5,000 traders. uation of the financial system encountered at the Assessing the conditions of the financial sector in end of 2001. Box 6.1 summarizes some of the main Afghanistan that prevailed at the end of 2001 issues and shortcomings of the Law on Money and proved in itself to be a major challenge. Qualified Banking. translators were few and the difficult security situa- Other aspects of the legal foundations of the fi- tion, particularly outside of Kabul, seriously ham- nancial system seem, on the face of it, to be less pered a systematic and rapid assessment of the finan- problematic, because they were derived from West- cial sector on a nationwide scale. Communication ern market-oriented laws and thus do not bear the lines between most of the branches of the central communist legacy.3 Afghanistan’s civil code was bank or commercial banks and their headquarters adopted in the 1960s with assistance from the had largely broken down. In most cases, there had Egyptian government, and is reported to be almost been no exchanges with correspondent banks abroad identical to the civil code of Egypt, which was origi- for years and accurate information on assets and lia- nally based on French law.4 The commercial code of bilities, either domestic or external, was unavailable. Afghanistan, in turn, was received from Turkey The books kept at the banks in Kabul were com- where it had been modeled after German law. It pletely out-of-date and, moreover, had been prepared covers general company law, transport law, insur- according to Soviet accounting systems that were in- ance law, and special financial transactions. It also compatible with internationally accepted account- includes provisions on bills of exchange, promissory ing standards. At the aggregate level, meanwhile, notes, and checks. Finally, bankruptcy law provi- the databases of international institutions, such as sions can be found in both the civil code and the the IMF, on Afghanistan’s financial sector had not commercial code and apply equally to state-owned been updated for more than a decade. A proper as- and private banks. Bankruptcies are administered by sessment of the informal financial system, the regis- the courts. For these laws to be made operational, tered money traders, and the rest of the hawala was, however, there needs to be the necessary infrastruc- by its nature, even harder to make. As a result, infor- ture: record-keeping institutions, functioning courts mation collected was often ambiguous or contradic- and police, and an impartial and independent judi- tory and it was impossible to properly assess the cial system. Given the difficult environment in soundness of the banking sector, let alone to conduct Afghanistan, many of these elements are either not any due diligence of reported data. It thus took con- yet in place or are in a state of substantial disrepair. siderable time to assess the post-Taliban conditions of the financial sector and even today the assessment remains approximate. 3However, a detailed assessment of the old legal framework would be necessary to determine the adequacy and mutual con- Legal Foundations sistency of the laws. Given the variety of origins that the legal framework has been built on, it is likely that at least parts of the Until the enactment of the new central bank law laws could be contradictory or incompatible. and the banking law in September 2003, the legal 4Based on the very rudimentary information available, the basis for the central bank and for the commercial property law and the law of obligations could, in principle, be adequate for supporting banking transactions in Afghanistan. banks was the Law on Money and Banking. This Again, a more thorough review of the laws would be necessary to law, which was enacted in 1994, had a number of se- determine their adequacy for banking activities.

Box 6.1.The Law on Money and Banking of the Islamic State of Afghanistan1

The 1994 Law on Money and Banking was a com- governor of DAB. The Supreme Council was sup- pound law of a central bank law and a banking law for posed to meet at least four times a year and to decide the period 1994–September 2003. The law was poorly on all important matters of DAB or on recommenda- written and at times contradictory. Part I defined the tions made by the other supervisory organs. It notably legal tender, the Afghani, and its value, ambiguously had to approve all regulations. The Monetary and in terms of both gold and SDRs. It also defined the Credit Committee, in turn, was charged with drafting minimum reserves DAB had to hold against issued regulations and recommending the level of interest banknotes at 25 percent. rates to the Supreme Council. It consisted of the governor and the first deputy governor of DAB, directors Part II of the law related to DAB, its objectives, re- of three different ministries, the president of the sponsibilities, powers, and organizational structure. It Chamber of Commerce and Industry, two presidents stated that DAB was responsible for the implementa- of commercial banks, and a professor of economics. tion of the government’s monetary and credit policy The composition of the Supreme Council and of the and that it had to maintain the value of the Afghani Monetary and Credit Committee was highly problem- in order to facilitate banking and commercial transac- atic because it politicized decisions that should have tions. It also empowered DAB to supervise operations been made on purely technical grounds. DAB thus of banks and credit institutions and to regulate and lacked the necessary independence that a modern carry out foreign exchange operations. It mandated central bank should have. The Executive Board con- DAB to determine the commercial banks’ interest sisted of the governor and his two deputies. Finally, a rates for deposits and loans and to set minima and Board of Supervisors with a chairman and two mem- maxima on their commissions. DAB was also man- bers was supposed to supervise DAB’s banking opera- dated to define liquidity and capital requirements and tions and accounting practices, and submit monthly limits on large loan exposure. However, these provi- reports to the MoF and quarterly reports to the sions were mostly ill defined and did not comply with Supreme Council. This control function had not been international best practice. There were no loan classi- fulfilled for years. fication or provisioning requirements. Furthermore, the law only empowered DAB to define ratios and to Part III of the law related to banking, including the collect information, but no provisions existed on the definition of a bank, a “private bank,” and the condi- enforcement of the regulations. Part II further re- tions for establishing a bank. The law required banks quired DAB to manage government accounts and, if to use a double-entry accounting method and to sub- necessary, to finance the government budget deficit, mit to DAB its annual balance sheet and profit and as well as to grant loans to government institutions, loss statement within four months following the end agencies, and municipalities. of each year, together with an audit report. The law empowered the Supreme Council to transfer the man- The final section of Part II defined the composition agement of a bank to DAB, to take measures for the and the role of DAB’s organs, namely the Supreme management of the bank, or to close the bank (if, for Council, the Monetary and Credit Committee, the example, the bank acted against the law or its by- Executive Board, the Board of Supervisors, and the laws). For the liquidation of an insolvent bank, the Banknote Reserves Supervision Board. The highest law envisaged the possibility of including officials of organ was the Supreme Council, which consisted of the failed bank in the liquidation team. The involve- eight ministers, including the prime minister, and the ment of the management of the closed bank is particularly problematic if a bank failed for fraudulent reasons. If a government bank is closed, all outstanding 1The contents of this box are based on an unofficial trans- deposits, salaries, and claims of other creditors would lation of the law from Dari into English. be paid by the government.

Da Afghanistan Bank the country. Second, it issued banknotes and managed the stock of cash monies. The bank was also At the end of 2001, DAB was actively performing performing many commercial banking operations two main functions. First, it was cashier to the Min- that a central bank in a modern two-tier banking istry of Finance (MoF) and was, in principle, re- system should not, while at the same time it was not sponsible for salary and other budget payments, and carrying out many of the typical central bank func- receiving government revenues for deposit, across tions that a modern central bank should. Mean-

©International Monetary Fund. Not for Redistribution After the Taliban: Financial System at the End of 2001 while, DAB was fulfilling its tasks with a totally inadequate physical infrastructure and security fea- Box 6.2. Physical Infrastructure and tures (see Box 6.2). Security of Da Afghanistan Bank On the commercial side, DAB offered commercial banking services, extended long-term loans to A critical weakness of DAB was the design of the main office, which was not adequate for a central banks and enterprises, and accepted deposits from bank. The security features associated with the the public. Although most of these operations were storage of cash were most disturbing. DAB’s main discontinued in 1995, a number of DAB accounts currency reserve stock was held in two major (debit and credit) were still current.5 Under the old vaults in Kabul. Although there were well- Law on Money and Banking, the governor of DAB established procedures for accessing the vault, re- remained legally the chairman of the governing quiring two certified key holders and a witness, the boards of all the commercial and development vault area was situated near counters to which the banks. This role involved a substantial and undesir- general public had access and was not monitored by electronic surveillance or access technology. able conflict of interest with the traditional func- During banking hours, the security of the premises tions of a central bank, in particular with banking was entrusted to unarmed guards and armed mili- supervision. By late 2001, however, the governor of tary personnel. After working hours, the exterior DAB refrained from exercising this role. As it was, of DAB was patrolled by military personnel. the central banking side of DAB was minimal. DAB DAB’s lack of suitable vehicles and the poor and did not supervise the banking sector either by issu- insecure road conditions made transporting cash ing prudential regulations or by checking compli- to the provinces very difficult and highly risky. In early 2002, DAB had only two trucks, one bus, and ance through on- and off-site inspections. DAB did one Land Rover. All these vehicles were old and not provide or supervise an efficient payment sys- unsuitable for transporting cash. Only exception- tem. Nor did it offer any lender-of-last-resort facility ally could DAB benefit from air transport provided for illiquid but solvent banks. Finally, DAB lacked a by the army to deliver cash to the provinces. As a meaningful and credible monetary or foreign ex- result, cash delivery was often delayed. This forced change policy (see Chapter 5 for a discussion of some branches to rely on their local provincial au- monetary and exchange rate policy). thorities and private sources to transport cash from While best practice in central banking would re- Kabul to the provinces. quire that DAB be granted a high degree of autonomy, combined with stringent rules for accountability, under the old law DAB was fully controlled by Soviet-style accounting, financial control, and man- the government. DAB’s ultimate decision-making agement systems were introduced. The situation of organ, the Supreme Council, as well as the Monetary the banks deteriorated further during the Muja- and Credit Committee, which drafted regulations hedin period and the associated civil strife, with and governed the operational aspects of DAB, both continued government interference in bank man- included representatives from different ministries. agement, directed lending, and administered interest rates. Finally, during the Taliban period, financial institutions were forbidden to charge interest on Commercial Banks their loans or pay interest on deposits. The banks’ After 23 years of military conflict, the financial loan portfolios suffered widespread loan defaults, re- system in Afghanistan at the end of 2001 bore little flecting one of the effects of constant warfare. De- resemblance to a modern Western banking system. posit mobilization collapsed and the banks discon- During the procommunist and later the Soviet era tinued lending. During this same period, the (1973–89), the banking system was nationalized and registered money changers and the rest of the hawala system replaced the banks in providing payments and liquidity in the economy, in addition to providing certain deposit and lending services. 5In DAB’s headquarters there were only 5,000 active accounts out of a total of 100,000 accounts (35,000 of which had a zero Box 6.3 summarizes each bank’s history and par- balance). In the first 30 branches assessed in May 2002, fewer ticularities. Briefly, the commercial banks may still than 6,000 accounts were found to be active. Active accounts are have been solvent in 2002 and even had a positive defined as those that had any movements since the beginning of the year or that had a customer who declared an interest for his cash flow, but that was because of the real estate or her account. they owned and returns on foreign currency deposits

Box 6.3. Six Licensed Banks in Afghanistan

The Banke Millie Afghan (BMA) was established and export. During the Soviet period, the bank’s ac- in 1933 as a private bank and is the oldest and largest tivities declined, concentrating on importing and sell- commercial bank in Afghanistan. Until the establishing Russian equipment. After the Soviets left, the ment of the central bank, DAB, in 1939, BMA is be- bank essentially became inoperative. lieved to have undertaken certain core central bank- The Export Promotion Bank (EPB), was established ing activities. During the first 40 years, the bank in 1976 by MoF, the Chamber of Commerce, and sev- expanded aggressively, both domestically and interna- eral local producer cooperations. Despite its name, the tionally. BMA was nationalized in 1974, and since EPB mainly financed import letters of credit. Apart then has been fully owned and managed by DAB. from trade finance, no other loans were offered. The Since its nationalization, the bank has suffered from bank’s operations continued during the Soviet period, political interference and consequently weak corpo- but they fell back drastically after 1992 and were effec- rate governance and management structure. Follow- tively suspended under the Taliban regime. ing a serious deterioration of the bank’s financial condition, it effectively ceased all forms of financial The Industrial Development Bank of Afghanistan intermediation in 1992. (IDBA) was founded in 1973 as a private financial institution by domestic shareholders and six foreign in- The Pashtany Tejaraty Bank (PTB) was set up in vestors, including Chase Manhattan Bank, First Na- 1955 mainly to provide financial services to the grow- tional City Bank of New York (predecessor of ing trade business community. Although the bank was Citicorp), the International Finance Corporation of majority owned by the government through DAB, the the World Bank Group, National Westminster Bank of MoF, and the Ministry of Commerce (together with London, Industrial Bank of Japan, and Credit Lyonaise 58.3 percent of shareholdings), its 12-member board of France. The bank provided short- and long-term se- had an equal representation from both the private cured and unsecured loans to the private sector, state- sector and the government. Until its full nationaliza- owned enterprises, and joint private-government en- tion in 1974, the bank performed relatively well. terprises. Most projects that were financed were for Thereafter, the shrinking private sector reduced lend- production of alcohol, carpets, shoes, medical products, ing opportunities, and political interference made the and textiles in Kabul. With its nationalization in 1977, bank entirely dependent on DAB for policy direction its new owners became DAB, the MoF, Pashthany Te- and operational instructions. By the early 1990s, the jaraty Bank, Bank Millie Afghan, and the Afghanistan bank’s operations were limited to receiving payments Chamber of Commerce. The bank’s activities were dis- of government utilities and small-value deposits. rupted during the Soviet and Mujahedin periods and The Agricultural Development Bank (AgBank) totally halted with the arrival of the Taliban in 1996. was established in 1954 as the Agricultural and Hand- The Mortgage and Construction Bank (MCB) was icraft Bank by the MoF, DAB, and Banke Millie established in 1948 to finance residential and com- Afghan, and has not changed its ownership structure mercial construction in Afghanistan. From its incep- since then. The bank’s objective was to provide finan- tion, the bank was majority state-owned. The compo- cial services to small farmers and handicraft produc- sition of the private shareholders is not known as the ers. After an unsuccessful start, the bank was reorga- bank’s records were destroyed. After nationalization nized and renamed in 1969. The restructured bank in 1974, the bank’s share structure was divided be- successfully refocused its business on financing the tween DAB, the Afghan Chamber of Commerce, agricultural supply chain from producers to processing MoF, and Banke Millie Afghan. The MCB extended its last loan in 1995. As of 2003, MCB’s main activity is to collect rents of repossessed buildings and interest Sources: Interviews in February and July 2002 and May rates on some 300 loans, the principal of which had 2003; diagnostic studies conducted by the World Bank. already been collected during the Taliban regime.

abroad that had been frozen during the Taliban era. peared. On the liability side, the deposit base had Most of the banks’ other assets had been substan- been eroded substantially by the high inflation rates tially eroded by inflation and/or could probably be that prevailed until the end of the war. However, written down to zero. For example, most of the none of the banks had been effectively engaged in banks’ loan portfolio was past due by 7–15 years and the banking business for many years, nor did any of many borrowers were either dead or had disap- them have a management cadre, an accounting

©International Monetary Fund. Not for Redistribution Modernizing the Financial Sector in Afghanistan framework, or risk management systems that would the modern central bank and banking law through a remotely resemble modern banking. As such, the six presidential decree has been a crucial first step for banks should probably be characterized as shell the development of a sound and resilient private banks, that is, institutions that may have assets and banking sector and more generally for macroeco- a banking license but cannot become operational nomic stability and growth in Afghanistan. The without a fundamental restructuring and a substan- laws have opened the doors for foreign banks, with tial improvement of their management. their much-needed technology and management know-how, to set up businesses in Afghanistan. Im- mediately following the enactment of the new laws, Payment System DAB issued banking licenses to Standard Chartered With the decline of the commercial banking sys- Bank, the National Bank of Pakistan, and the First tem to a near-moribund state at the end of 2001, MicroFinance Bank, which was established by the most domestic and international payments in Aga Khan Fund for Economic Development. For Afghanistan came to be undertaken by the money such banks, investing in Afghanistan offers poten- dealers (see Box 6.4). As the only viable payment tially lucrative opportunities, but—given the low system, this informal financial network had become institutional development—they have substantial crucial for the functioning of the Afghan economy. risks. Under the new laws, investors are given trans- But it was also vulnerable to money laundering, drug parent, predictable, and sound “rules of the game.” trafficking, and terrorist financing.6 At the end of At the same time, the central bank has been given 2001, there was an urgent need for a formal payment the proper tools to regulate and supervise the bank- system for payments by the government and by the ing system without government and political inter- donor community. These payments, for a variety of ference. With the basic legal foundations for the fi- reasons, were not best suited to be made under the nancial sector in place, the next step is for hawala payment system. Not only did the central authorities to press ahead with creating the neces- government need to make salary and other bud- sary institutional framework, including the govern- getary payments to and collect customs revenues ing bodies of DAB, and the technical capacities to from the provinces, but the success of the currency be able to effectively perform the duties prescribed conversion critically depended on being able to re- by the laws. Furthermore, complementary laws activate DAB’s branch system for the conversion to should also be enacted soon, including a modern take place nationwide. In the absence of a function- payment system law and a law on anti-money laun- ing banking system, therefore, the responsibility fell dering (AML) and combating the financing of ter- to DAB to provide leadership in the reform and de- rorism (CFT). This would help to restore the confi- velopment of the formal national payment system. dence of the public in the banking system and regenerate the deposit base that banks need to be able to extend credit. Modernizing the Financial Sector The central bank law includes provisions that give in Afghanistan DAB the overriding responsibility to achieve and maintain price stability, and grants it full autonomy New Legal Framework in pursuing this objective. In order to mark the clear departure from its socialist legacy, the law also speci- A completely new central bank law and a bank- fies that DAB shall act in accordance with the prin- ing law, properly defining the separate roles of the ciple of an open market economy with free competi- central bank and commercial banks, replaced, on tion. It further entrusts DAB with the tasks of September 16, 2003, the Law on Money and Bank- defining, adopting, and implementing Afghanistan’s ing, which was outdated and incompatible with a monetary and foreign exchange policy; issuing bank- 7 modern two-tier banking system. The enactment of notes and coins; holding and managing the official foreign exchange reserves; acting as advisor and fis- 6Afghanistan remains the largest opium producer in the world. cal agent of the government; and licensing, regulat- See Chapter 2 (Appendix 2.1) for an account of opium production in Afghanistan. 7Drafts of the central bank and banking laws were prepared firms. The draft laws had been extensively discussed with senior with the help of the IMF and benefited from comments from a officials in the Afghan government at a legal seminar in Decem- number of international organizations, law firms, and consulting ber 2002.

Box 6.4. Money Dealers in Afghanistan

In 2003, there were approximately 5,000 money for making international transfers varies between 0 traders in Kabul, of which some 300 had shops and and 2 percent of the amount transacted. Domestic were licensed by DAB.1 DAB licensed money chang- transfers are typically more expensive with an addi- ers for a fee, but did not regulate or supervise them. tional charge of !/2 –1 percent. In exceptional circum- Some of the unlicensed money traders are affiliated stances, such as immediately after September 11, 2001, with shops, which typically have two to five traders. and until early 2002, the fees have been as high as 4 Most traders, however, work independently and thus percent. In principle, money transfers operate on a without a license. In provincial towns, there are on netting system with other traders in the provinces or average around 80–150 licensed money traders with abroad. Physical transfer of cash, or at times in legal or shops and about 500 traders. The Afghan people have illicit goods, is only made when a trader has no repre- relied on this informal sector for hundreds of years. sentation in a particular town, or where a net position The money transfer system is usually referred to as the needs to be settled. Outstanding balances are usually hawala system.2 settled between two dealers on a weekly or monthly basis, but at times, when the volume of transactions is Funds can be transferred within 6–12 hours from Pe- high, settlement of accounts is made daily. shawar, Dubai, or London to Kabul, and with improving communication, the transfer time continues to di- Besides the transfer of funds, the other main finan- minish. Transfers to provinces usually take a little cial service provided by the money dealers is foreign longer. While regional money dealers are mostly lo- exchange dealing, mainly in U.S. dollars, Pakistani cated in provincial cities, from where they organize the rupees, and Iranian rials. Virtually any currency can distribution to villages through their local offices or be traded. The 30 largest traders cover about 70 per- representatives, the international dealers are mainly cent of all transactions and roughly half of their trad- based in Kabul. For international transfers, the tradi- ing consists of transactions in U.S. dollars. Daily trade tional counterparts are situated in the Islamic Repub- volumes in the Kabul foreign exchange market report- lic of Iran, Pakistan, India, Saudi Arabia, Qatar, the edly run in to several millions of U.S. dollars, and United Arab Emirates, and Oman. Rather than con- most of this is transacted in cash. There are no limits ducting transactions in cash, some clients wire funds to on transaction volumes. Traders have reported that a correspondent account in Peshawar or Dubai, and buying or selling $1 million in cash can be accommo- upon confirmation of receipt of funds, the counterpart dated easily. Other financial services include deposit is released immediately at the desired destination. taking, granting of short-term loans, trade finance, Some 10–15 of the larger traders have correspondent and microfinance. However, money traders extend accounts with banks abroad. Affiliated traders can also loans or accept deposits only to and from people benefit from this network. Reputable customers can whom they personally know and trust. cash checks or require receipt of the counterpart prior The money traders operate without standard docu- to making the corresponding wire. Such services are mentary requirements and usually design and main- usually negotiated at a higher cost. Depending on the tain their own documentary policies and procedures. amount, destination, financial relationship, the cur- Transactions generally involve comprehensive and rency of exchange, and security environment, the cost detailed records for the entire process of remittance and settlement of each money transfer. The documen- Sources: Maimbo (2003); El Qorchi, Maimbo, and Wilson tation is kept at least until the entire transaction and (2003), and meetings held with money changers in its settlement are completed. The money market is Afghanistan in February and July 2002 and May 2003. not subject to any reporting requirements or supervi- 1Until early 2003, money traders were licensed by the for- sion. It is fully based on reputation and trust, but also eign relations department of DAB. benefits from self-regulation by the Money Dealers 2 The term “hawala” is used throughout the Middle East Association formed by the 20–30 leading traders. The and means “transfer.” Equivalent informal transfer systems exist in other countries under a different terminology: fei- association has unwritten rules of conduct and prac- ch’ien (China), hui kuan (Hong Kong), hundi (India), tices. Traders who do not respect these rules can be padala (Philippines), and phei kwan (Thailand). expelled from the market.

ing, and supervising institutions engaged in banking and high inflation might otherwise emerge. DAB is business. The law prohibits financing the govern- also prohibited from providing loans to commercial ment budget deficit, thereby closing one important banks. The one exception to this rule is that DAB is channel through which macroeconomic instability permitted to act as a lender of last resort and to ex-

©International Monetary Fund. Not for Redistribution Modernizing the Financial Sector in Afghanistan tend short-term liquidity support to solvent but illiq- extending loans or for making investments for its uid banks, especially in the event of a systemic liq- own account. The law introduces a two-stage process uidity crisis. for filling out applications of banking licenses with The new central bank law grants DAB complete only essential information to be submitted in the legal, operational, and administrative autonomy first stage. It gives DAB the mandate to issue regula- from the state and any other person or authority, in tions to further specify the necessary conditions for the pursuit of its objectives and the performance of obtaining a banking license. The law stipulates that its tasks.8 Independence requires accountability, and before an application is considered, DAB would this is also stipulated in the law. Accountability will need to conduct a fit and proper test of future own- be achieved by a clear mandate and by reporting re- ers, board members, and senior managers of the quirements to the Parliament and to the public on bank. The draft law defines the banking activities DAB’s financial condition, on its success in achiev- that banks are allowed to pursue. They are further ing its objectives, and on how it performed its tasks. detailed in their banking licenses.10 Accountability will increasingly also be enhanced The law includes the standard rules of a modern by prohibiting DAB senior officials from holding banking system for sound management, prudent risk other government positions and by excluding them management, and transparent and adequate ac- from engaging in other tasks incompatible with counting. Specifically, the law includes provisions their duties, which would create a conflict of inter- related to the banks’ corporate governance and on est.9 The governor, first deputy governor, and mem- DAB’s powers to review changes in bank ownership, bers of the Supreme Council of DAB are appointed, the board, and senior management. The law also in- remunerated, and dismissed in accordance with cludes requirements of credit documentation, risk specified procedures and conditions. management, as well as provisions that banks should The law also stipulates DAB’s right to be con- maintain their accounts in accordance with interna- sulted on any proposed legislative or public adminis- tional accounting standards (IAS). Furthermore, trative act of the government in DAB’s field of com- banks will be subject to specific auditing require- petence. This provision ensures that the overall ments, including the establishment of an audit com- legal framework of the financial system continues to mittee. DAB’s oversight role will be strengthened be consistent and coherent. In consideration of the through the conduct of on-site examinations. The difficulties involved in passing several laws at the last part of the law is dedicated to specifying DAB’s same time, the central bank law already includes enforcement measures to address infractions by specific basic issues that under normal circum- banks and situations where a bank’s capital declines. stances would have been covered by separate addi- It defines a graduated system of prompt corrective tional laws, including currency, cash payments, pay- actions to be imposed by DAB, including the power ment system issues, and securities services and to order the removal from office of board members securities transfer systems. Some of these issues or senior managers of banks, and explicit provisions should, however, be further extended by separate for dealing with banks undergoing solvency prob- legislations. Furthermore, DAB has the powers to lems. Finally, the law grants DAB the exclusive au- issue regulations for the hawala dealers as nonbank thority to revoke a license and to initiate insolvency providers of money and payment services. proceedings, with comprehensive explicit provisions The main features of the banking law include a pre- for the resolution of insolvent banks under the over- cise definition of a bank as an entity engaged in the sight of a financial service tribunal. business of accepting deposits or other repayable funds from the public and using such funds either for Modern Central Bank in a Two-Tier Banking System

8For a period of three years after the enactment of the law, the In the two years since the fall of the Taliban, Minister of Finance can, however, nominate one member of the DAB has made important progress in a number of Supreme Council of DAB, other than the governor and the first vice governor (transitional provisions of the central bank law, areas. Most importantly, it has successfully imple- Article 133). 9The transitional provision of the central bank law (Article 135) allows, however, for political activities to be continued 10The draft law also provides DAB with the powers to specify until a successor administration of the Transitional Islamic State by regulation additional activities for banks to the extent not of Afghanistan is in place. specifically restricted by law.

mented the currency exchange and gained control structured individually into what corresponds to a over the issuance of currency, which is a prerequisite monetary policy department, a payment systems de- for an effective monetary policy (see Chapter 5). It partment, an accounting department, a banknote has also created a banking supervision department operations department, and a banking supervision and thereby addressed one of the key weaknesses of department, with foreign experts assisting each of DAB. Progress in other areas, in particular the re- these departments. structuring of the central bank, has been slower. Basic training in the business of banking will be a Accounting Reform crucial prerequisite for successfully reforming the financial sector. At the end of 2001, there existed a On the accounting side, DAB began working to- fundamental misunderstanding by both the banks ward the introduction of a new chart of accounts, as and the supervisors regarding the role that banks well as a general ledger software package that would and banking supervision had to perform. In the fu- enable it to produce its balance sheet on a regular ture, supervisors will have to be concerned about basis. However, by end-2003, the reform agenda in the safety of the banks’ depositors, rather than about the accounting area remained substantial. Account- any social, political, or developmental agenda. Bank ing regulations still needed to be drafted, together managers, in turn, will need to be concerned about with operating manuals and procedures, and staff proper pricing of risk, risk management, and return needed to be trained. Furthermore, the consolida- on equity. tion of financial accounts could not be completed without reforms in DAB’s branches. An ambitious project was initiated to improve the connectivity of Banking Supervision DAB’s branches with the main office (see below). One of the most important improvements in Improvements were also made in data collection DAB took place with the initial steps in establishing with the production of a Quarterly Economic and Sta- effective banking supervision. By the end of 2003, a tistical Bulletin. new supervision department had been created, a number of prudential regulations and manuals had Commercial Operations been drafted, and the training of supervisors had been initiated. In the first phase, staff received DAB also made notable progress in the efficiency training in basic balance sheet analysis and concepts of its commercial services. Almost all banking activ- of prudential ratios. This was soon followed by “real ities for the international organizations and for life” off-site staff supervision of the operating banks many of the NGOs in Afghanistan during 2002 and and on-site supervision of Banke Millie Afghan, 2003 were conducted by the commercial arm of under the supervision of a foreign expert. DAB. Although DAB’s services included the open- The licensing of money traders was shifted from ing of accounts, deposits, and international money the foreign relations department to the new supervi- transfers, this was solely to facilitate international sion department. In November 2002, all licensed payments for international organizations, including money traders had to renew their licenses, a process USAID, World Bank–funded programs, NGOs, as that was enforced with the help of the local police. well as the U.S. army. The efficiency of the payment In 2003, the department began the process of im- service was substantially improved with the intro- proving the collection of personal data on the li- duction of SWIFT. Improvements in the commer- censed money traders. cial area included the development and introduction of procedures that expedited the opening of letters of credit by the MoF under grant programs. Restructuring New current accounts could only be opened by Apart from the new supervision department, money changers, NGOs, or international organiza- progress in other areas of the reorganization of DAB tions, but not by the general public.11 DAB ceased started more slowly. By end-2003, DAB still ran to extend loans. DAB’s commercial arm expanded under its original organizational chart and contin- rapidly in 2003. Although these commercial opera- ued to employ a large number of unqualified staff with no assignments. Pending an overall reorganiza- 11In early 2002, DAB resumed paying interest on the savings tion, parts of some departments were instead re- accounts.

©International Monetary Fund. Not for Redistribution Modernizing the Financial Sector in Afghanistan tions did not belong in a central bank, the prevail- troduction of a software system for the management ing vacuum in the banking system left DAB with of the currency inventory and the purchase of ar- little option but to fill the gap, at least until com- mored cars and/or use of an aircraft suited for the im- mercial banks have resumed operations in portant, yet risky, task of transporting cash within Afghanistan. When that time comes, DAB intends and outside Kabul. For the medium term, with the to divest itself of all the commercial bank activities emergence of a commercial banking system, DAB it now undertakes as soon as possible and no later plans to implement two payment systems that will than September 2005.12 A conscious effort is being represent the core of the National Payment System. made to develop the commercial activities in such a These payment systems will provide the clearing and way that they can be easily split off from the core settlement of both high and low value payments, operations of DAB at a later stage. using a real time gross settlement (RTGS) system and a direct giro credit (GC) system. Domestic Payment System Other Changes Developments in the payment area by commercial banks will likely be limited for some time. In the With the assistance of a foreign expert, DAB is meantime, by late 2003, DAB had reconnected 35 of also in the process of unblocking and consolidating its main provincial branches to DAB’s head office in existing DAB accounts in international banks, and Kabul. These branches were connected by laptops is improving the management of its foreign reserves. with Immarsat connections, which allowed them to Tasks for the future include the removal from the report to the center their balances and account DAB balance sheet of all assets and liabilities held movements on a daily basis.13 Bank branches in by both the foreign and domestic loans general de- Kabul were to be connected by a computer network. partment and the foreign trade general department, The next step will be to identify the branches that together with all records associated with them, and need to be rehabilitated to meet the necessary secu- their transferal to a public agency designated to set- rity standards. The decision about which branch to tle these balances. DAB will also need to address the reopen or to rehabilitate will need to be taken based pension department, which is responsible for the on a needs assessment, including an estimate of the pensions of employees of both DAB and the com- reflow of refugees and internally displaced people. mercial banks. Options would include transferring The disbursement of government salaries, the main these pension accounts to an outside private agency expenditure item in the provinces, would probably or to a national pension system. require fewer operational provincial branches than existed in the past.14 DAB would further need to de- Seeking the Renaissance of velop a physical distribution system with some re- Commercial Banks gional cash centers from where the distribution of cash could be made. This would also include the in- The development of an effective banking sector in Afghanistan will need to be based on three important pillars: competition, good corporate governance, and 12See transitional provision (Article 129) of the central bank law. strong banking supervision.15 The enactment of the 13As the volume of transactions increases, it is planned central bank and banking laws has been the first that the Immarsat connections would be replaced by a VSAT major step toward this new structure. But the passing network. 14Facilitating the Ministry of Rural Development’s scheme to of these new laws is not a sufficient basis for the rede- make grant payments to 7,000 villages commencing end-Septem- velopment of the banking system without improved ber 2003 and using the DAB branch network outside Kabul repre- contract enforcement and well-defined property sents one of DAB’s biggest immediate tasks. As regards the MoF individual salary payment requirements, this is still in the plan- rights. Reforms will be needed simultaneously on a ning stage by a task force at the ministry. Retail salary payments in number of different fronts, including accounting Afghanistan are currently made by cash payments at the employ- reform and training in commercial banking and risk ees’ place of work in the municipalities, rather than by bank transfers to commercial banks (which are not possible) or through assessment. individual payments at DAB’s branches around the country. The number of DAB branches required to undertake this operation is limited by the fact that, after the money has been sent to the local DAB branch, provincial payments are thereafter the responsibil- 15For experience gained in banking sector reform in Central ity of the local representative of the MoF (Mustufi). and Eastern Europe, see Bokros (2001).

A good number of reforms can be imported into tinue to exist, as is the case in many other countries the banking system by foreign banks. The recent in the Middle East. Given the need to counter un- granting of banking licenses to a number of foreign transparent, undocumented, and adverse practices, banks represents an important window of opportu- DAB will need to evaluate the options available to nity for the development of an efficient banking sys- partly regulate and supervise this market without tem. These new banks are expected to have modern pushing it underground.16 In this context, simply management and risk assessment techniques. In- extending banking regulations and supervision prac- house rules will require them to apply international tices with respect to licensing requirements, cus- accounting standards. However, foreign banks can- tomer identification, suspicious activity reporting, not provide all the answers. To begin with, foreign and record keeping to the money dealers is not a vi- banks will most likely limit their operations to the able option. It would not be feasible to regulate in larger cities, starting with Kabul, and to certain this manner, given the huge number of traders in- types of customers, namely international organiza- volved, and this level of regulation would probably tions, NGOs, the diplomatic corps, and the largest push the activity underground. But two alternative corporations, leaving small and medium-size enter- options might instead be envisaged. First, the prises and rural areas unbanked. Most banks will hawala dealers could, at least as an interim solution, likely also focus their operations initially on facili- subject themselves to self-regulation and supervi- tating payments and few can be expected to engage sion. This market already benefits from an associa- in significant domestic lending at the outset. This tion that enforces a number of unwritten rules. The indicates that there remains an important role for association could be encouraged to draft written DAB, microfinance institutions, and a rehabilitated rules and regulations.17 Second, recognizing the dis- domestic banking sector to deliver financial services tinct features of the hawala system would justify the outside of Kabul and to a client base unlikely to be development of special regulations and supervision served by the international banks. techniques, which would mainly attempt to increase Afghanistan needs a comprehensive medium- to the level of transparency in the business while keep- long-term financial sector development strategy, ing intact the characteristics that made this market possibly including a strategy to rehabilitate part of so efficient. Such regulations could include the re- the existing domestic banking system. Such a strat- quirements of (1) registration but not licensing of egy would likely require an experienced and compe- the hawala dealers, (2) the ability to identify cus- tent management team to make a detailed diagnos- tomers and keep records on their identity, and tic and action strategy with voluntary retrenchment (3) cooperation in investigations if the need arises, plans, training of remaining staff, and introduction which would include the right of DAB to enter and of modern banking technology. Domestic bank re- inspect the money dealers’ premises when there is a structuring will only bear dividends if qualified and reasonable suspicion of a committed offense. Finally, experienced people are assigned board and manage- through information campaigns, DAB could seek to ment positions; if the organization and corporate educate the money dealers about their responsibility governance are well restructured; if the operating to report suspicious activities. systems, management tools, and operating policies and procedures are strengthened and automated; if the duties, responsibilities, and scope of authority at References all levels of management and staff are well defined; and if the bank is sufficiently capitalized after full Asian Development Bank, 2003, National Payments Sys- due diligence and after financial, management, and tem for the Islamic Republic of Afghanistan (draft (B) is- operational audits have been performed on the sued August 19), Final Report TA 3874-AFG, pre- banks being restructured. Institutions that are un- pared by Schlumberger Sema. able to perform should ultimately be liquidated.

Money Changers and the Hawala 16For a detailed discussion of regulatory options for the hawala System system, see Maimbo (2003); and El Qorchi, Maimbo, and Wilson (2003). Even with the emergence of a modern banking 17The disadvantage of self-regulation is that it risks becoming system, the informal hawala system will likely con- self-serving with a high degree of regulatory forbearance.

El Qorchi, Mohammed, Samuel Munzele Maimbo, John F. able via the Internet: http://www.imf.org/external/ Wilson, 2003, Informal Funds Transfer: An Analysis of np/mae/ferm/eng/index.htm. the Hawala System, IMF Occasional Paper No. 222 Maimbo, Samuel Munzele, 2003, “The Money Exchange (Washington: International Monetary Fund). Dealers of Kabul—A Study of the Hawala System in International Monetary Fund, 2001, Guidelines for Foreign Afghanistan,” World Bank Working Paper No. 13 Exchange Reserve Management (Washington). Avail- (Washington: World Bank).