REFORM of FINANCIAL SYSTEM in AFGHANISTAN By
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REFORM OF FINANCIAL SYSTEM IN AFGHANISTAN By KHELWATI LAILA THESIS Submitted to KDI School of Public Policy and Management In partial fulfillment of the requirements For the degree of MASTER OF PUBLIC POLICY 2008 REFORM OF FINANCIAL SYSTEM IN AFGHANISTAN By KHELWATI LAILA THESIS Submitted to KDI School of Public Policy and Management In partial fulfillment of the requirements For the degree of MASTER OF PUBLIC POLICY 2008 Professor Jin PARK REFORM OF FINANCIAL SYSTEM IN AFGHANISTAN By KHELWATI LAILA THESIS Submitted to KDI School of Public Policy and Management In partial fulfillment of the requirements For the degree of MASTER OF PUBLIC POLICY Committee in charge: Professor JIN PARK, Supervisor _____________________ Professor Younguck, KANG ______________________ Professor Dong-Young, KIM ______________________ Approval as of July , 2008 ABSTRACT REFORM OF FINANCIAL SYSTEM IN AFGHANISTAN By KHELWATI LAILA The economy of Afghanistan has improved significantly since 2002 due to the infusion of multi-billion US dollars in international assistance and investments, as well as remittances from experts. It is also due to dramatic improvements in agricultural production and the end of a four-year drought in most of the country. However, Afghanistan still remains poor for now and highly dependent on foreign aid. About half the population suffer from shortages of housing, clean drinking water, electricity and employment. The Afghan government and international donors have remained committed to improving access to these basic necessities by prioritizing infrastructure development, education, housing development, jobs programs, medical care, and economic reform over the recent years. The replacement of the opium trade - which probably makes up about one-third of the country's GDP - is one of several potential spoilers for the economy over the long term. i Reforming of financial sectors in post conflict countries face many challenges, among Damaged physical infrastructures, deskilled staff, and outdated technological capacity. Because properly functioning financial systems enhance economic development, reduce costs in the economy, promote the efficient use of financial resources, and improve financial market liquidity, it is vital that those challenges be met. The thesis of this study is that financial sector reforms in Afghanistan will take a long time to implement; further, these reforms will continue to face significant challenges. The sector had so deteriorated by the end of 2001—namely, the absence of a legal framework; poor and outdated infrastructure; lack of trained personnel; inappropriate governance and ownership structures in the state banks; inadequate collateral and bad debts; low depositor confidence; absence of clear accounting standards; and an ineffective formal payment system—that only focused and unrelenting reform efforts can help. Afghanistan banking sector is unlike in the past. In the past, we had commercial banks being part of the central bank. Now we have commercial banks that are separate from the central bank, we have private and state own commercial banks and now there is significant progress in that area, our banking system serious problem is human resources. We need qualified people for this. Commercial banks are supposed to compete with each other, and through competition, we hope they will offer better services, a more consumer friendly environment, and lower prices. This is the benefit you would expect from any privately owned, free market, and competitive economic environment. The second benefit would be that the Government ii would not be involved in any losses that these banks might incur. We would hope that we will change the banking culture from one of being dominated by bureaucratic procedures to one that is dominated by initiative, competition, and result orientation. We recognize that financial sectors in post conflict countries have varying levels of development and capacity for reform. Reform efforts must therefore continue to accommodate Afghanistan’s unique characteristics and circumstances. Specifically, the government and its development partners must bear in mind. In spite of its political progress, Afghanistan continues to face huge challenges, including extreme poverty, insecurity, weak human capacity, and gender inequality. While the country has managed to avoid a resurgence of major civil conflict, insecurity continues to hamper its reconstruction and development. Following a lull in incidents involving antigovernment elements during the winter, since May 2005 there has been an upsurge in violence, including attacks directed at foreign forces and international aid personnel. In addition, instability in some of Afghanistan’s neighboring countries poses a threat to both national and regional security. Cultivation of opium poppy has increased and now takes place in more provinces, posing a threat to Afghanistan’s long-term stability. iii TABLE OF CONTENTS CHAPTER ONE Introduction Sections Pages 1. Brief overview of Afghanistan economy 4 2. the financial sector in Afghanistan 8 3. historical background 11 CHAPTER TWO CENTRAL BANK 1. State of the central bank after the fall of the Taliban 14 2. Central banking reform in 2002-2003 15 3. The state commercial and development banks 18 4. Legal and regulatory reforms needed in Afghanistan financial sector 24 5. Retail banking activities and national payment system 37 6. FinTRACA 43 iv CHAPTER THREE AFGHANISTAN BANKS ASSOCIATION Sections 1. Goal of the association 45 2. ABA structure 46 3. Founder members of the association 47 4. Mission statement 48 5. Corporate governance and management structure 51 CHAPTER FOUR 1. Re licensing of state commercial and development banks 54 2. Legal and regulatory reforms for Afghanistan’s financial sector 55 3. Broading and deepening the financial sector 64 4. Function and powers of the supreme council 70 CHAPTER FIVE ISLAMIC BANKING 1. A global definition 107 2. Techniques 111 3. Appraisal of theory and performance 115 4. Risk-averse clients 117 5. Challenges 118 v CHAPTER SIX THE MICRO FINANCE INDUSTRY Sections 1. Micro finance institutions introduction 127 2. The micro finance support facilities for Afghanistan (MISFA) 140 3. Legal and regulatory reforms 151 CHAPTER SEVEN BUSINESS IN AFGHANISTAN 1. Market opportunities 168 2. Opportunities in Agro processing 181 3. Opportunities in carpet industry 185 4. US agency for international development (USAID) 210 5. Do’s and Don’ts in Afghanistan culture 213 CONCLUSION AND RECOMMENDATIONS 218 BIBLIOGRAPHY 243 vi CHAPTER ONE INTRODUCTION 1. BRIEF OVERVIEW OF AFGHANISTAN ECONOMY: Afghanistan’s economy is in a state of collapse. The three-year drought and resulting famine, the ban on opium production, the choking of trade via Pakistan and the massive displacement of population have exhausted what coping capacity was left among families and civil society. The key economic institutions of State—a central bank, treasury, tax collection and customs, statistics, civil service, law and order, judicial system—are extremely week or simply missing. Basic infrastructure—roads, bridges, irrigation, canals, telecommunications, electricity, markets—have been destroyed. Afghanistan, which has always been at bottom of the poverty and social indicator rankings of countries, must now be considered the poorest, most miserable state in the world. 2. There is little reliable up to date data on Afghanistan’s economy. There has never been an accurate Census or other precise data on Afghanistan’s population. In 1979 the total population of Afghanistan was estimated at 14 million, whereas at present the population in-country (not including refugees in Pakistan and Iran) is estimated at 18-20 million. Before the war about 85% of the people lived in rural areas, including 1.5 million nomads. The bulk of the total labor force was engaged in agriculture, livestock, and livestock- based handicrafts. Even before the war Afghanistan was one of the world’s least 1 developed countries. The past 20 years of conflict have exacerbated poverty, deprivation, and suffering. 3. Afghanistan’s pre-war economy was mainly based on agriculture and animal husbandry. The country has a low population density due to difficult topographical and climatic conditions (high mountains covering most of the country, extremes of temperatures, and arid to semi-arid climate). In 1978—the last year of peace— Afghanistan was largely self-sufficient in food and was a significant exporter of agricultural products. Agriculture was largely concentrated in narrow river valleys and plains where irrigation water from snowmelt was available. Manufacturing industry was largely undeveloped, with only a few plants established (in textiles, medicines, cement, etc.). Afghanistan’s strategic position during the Cold War period made it a large recipient of foreign aid, which funded the running of a centralized but relatively weak state without substantial domestic taxation. Also largely as a result of foreign aid, the country had a relatively good major road network, as well as some other infrastructure including major irrigation and hydroelectric facilities. This modern infrastructure, however, did not extend beyond the main arteries and urban centers. Social and other services (such as education and health) were largely limited to the relatively small urban sector. 4. The long drawn-out war of Soviet occupation and subsequent internecine conflict severely damaged Afghanistan’s economy. By the mid-1990s, most of the country’s limited modern