Afghanistan: The long road ahead

The Afghanistan authorities have done an incredibly good job at sticking to its main financial targets set out in the IMF's Staff Monitored Program (SMP) and the economy has strengthened as a result. However, there is still an enormous amount of work to do. The country remains extremely reliant on external funding. Efforts to reduce the level of state involvement in the economy, via the closure/privatisation of state-owned companies, are crucial to ensure the long-term vibrancy of the economy and the sustainability of the country's public finances. However, the security situation is the make or break factor for the government's attempts to reform the economy. It is here where the bad news emanates from. Poppy cultivation is on the rise once again, after a decline in 05/06, and as a result so are security concerns. A failure to address these issues would risk a change in government and a reduction of international financing that is so crucial to the economy.


According to IMF data, the Afghan economy is doing well. In fiscal year 2005/06, real GDP, excluding opium production, is estimated to have expanded by 13.8% and is projected to grow by another 11.7% in the current fiscal year. Inflation remains high, around 10%, but is expected to decline gradually going forward with the authorities already having tightened monetary conditions in the second half of 05/06.

The IMF also appears very pleased with the progress made under the macroeconomic stabilisation program with the government having met all of its December-2005 obligations under the SMP apart from the publication of audited fiscal accounts for the year 2004/5, ultimately met in March of this year. Given that this was in the backdrop of an election campaign, where it would have been easy to temporarily backtrack on reform, it is even more impressive.

It is probably for this reason that the IMF appears confident in the government's
willingness and ability to continue to push ahead with the reform program, which includes reducing the level of government involvement in the economy via the closure/privatisation of state-owned enterprises and the encouragement of a vibrant private sector, to be boosted by increased foreign direct investment.

Despite problems in producing timely audited accounts, the fiscal performance has been impressive with the 05/06 operating deficit excluding grants expected to be around 3.7% of GDP versus a previous expectation of 4.1% and expected to fall further to 2.8% in 06/07. The 05/06 performance was helped by better than expected revenue collection efforts. On the spending side of the equation, the government kept operating expenditures broadly on track, despite the fact that many non-budgeted items hit the accounts, including security costs previously born by donors and sharply higher education costs due to a recruitment drive. This illustrates the government's commitment to meet targets and stabilise the macroeconomic situation.

That said, there are three worrying aspects to the fiscal accounts. First, the results on the spending side have partially been achieved by delays in paying public sector salaries in some provinces. Second, there is still an apparent lack of control over spending and recruitment in the country, although there is an increased focus on this now.

Finally, and most importantly, the level of development spending has been disappointing, as it is expected to reach only 40% of planned spending. Given the need to reduce the level of government involvement in the economy and establish a vibrant private sector, an accelerated implementation of the development budget spending is crucial. The main problem here is not the access to the finances - donor spending in 05/06 was projected at 29% of GDP - but a lack of the authorities' capacity to implement the programs. Even the target of development spending to the tune of 14.2% of GDP is ambitious and 'will require a considerable effort to overcome constraints hindering spending capacity', according to the authorities' Letter of Intent (LOI) with the IMF. However, its importance should not be under-estimated for a government that is
increasingly under pressure.

Of course, all the above efforts could count for nought. In its LOI, the authorities
state the following: "Sustained robust growth is predicated on improved security
and a reduction in drug-related activities, together with the establishment of an
environment conducive to private investment."

Thus, a necessary condition for the economy's long-term stability is to manage the delicate balance of reducing the economy's reliance on poppy cultivation and provide alternative sources of employment. On the former, crucial to not only the government's standing in the international community, but also to keep the opium-funded Taliban in check, last year saw a 21% decline in poppy cultivation, although good weather almost entirely offset this decline in terms of production as yields rose. Unfortunately, this year there are already reports that poppy cultivation is once again on the rise - the UN estimates a 20% increase in 2006. While rising incomes from poppy cultivation may have spillover into the licit economy via increased spending, the negative aspects on stability are there for all to see.

The key problem for the government is President Hamid Karzai appears to have declining control. Meanwhile, the security situation is deteriorating as the Taliban
is starting to gain more influence outside of Kabul. The slow pace in the increase in standards of living - GDP per capita, excluding the opium sector, is estimated to have risen to USD 294 from USD 253 a year earlier - is providing the Taliban with support as it can provide much higher income levels. This is leading some constituencies to question the government's path and suggest a sharp reduction in local taxes, measures to protect domestic businesses from international competition and increased government involvement in the economy, something that is unsustainable in the long-run.

If this trend for reduced support of the government is not arrested and the government were to be replaced, the risks to foreign funding and the country's liquidity position would increase. As well as the obvious fiscal connotations of a sharp reduction in foreign aid, external funding is also crucial from a balance of payments perspective. The current account is estimated to have posted a small surplus in 05/06, but if you exclude grants this falls into a dramatic 42% of GDP deficit.

Of course, the international community would want to maintain good relations with the new government, but it would require the incoming government to show a willingness and ability to implement reforms currently being put in place. If the Taliban's influence within the government were to rise dramatically, then this would likely be problematic. Meanwhile, under such a scenario, poppy cultivation would soar once again. Therefore, while the Afghanistan economy is currently on an upward path, there are clearly many risks to the outlook.