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p. 36 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions I. Developing Asia and the world II. Economic trends and prospects in developing Asia East Asia Southeast Asia South Asia Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Central Asia The Pacific III. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : South Asia

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Afghanistan

After 2 years of double-digit growth, expansion slowed in 2004 as agriculture was hit by another drought. In contrast, the opium economy has grown to record levels. The Government has implemented many structural reforms, but formidable challenges remain. Long-term sustainable development will require new drivers of growth, continued commitment to the ambitious reform agenda, sustained international support, and tackling the opium economy.

Macroeconomic assessment of 2004

In 2004, another drought worked to bring down cereal production by an estimated 25%, substantially lowering GDP growth for FY2004 (ended 20 March 2005) to an estimated 7.5%, from 15.7% and 28.6%, respectively, in the 2 previous years. GDP for FY2004 is estimated at $5.4 billion, exclusive of illicit opium (poppy) production, which is estimated at $2.8 billion. (Calculations in this chapter generally refer to non-drug GDP.) Apart from agriculture, which accounts for about half of GDP, other sectors, especially services and construction, continued to show strong performance as they are mainly linked to the reconstruction effort financed by external assistance and the private spending of international personnel. Per capita GDP is estimated to have risen from $199 in FY2003 to $228 in FY2004.

According to the United Nations Office on Drugs and Crime (UNODC), opium cultivation in 2004 increased by 64% to record levels, despite falling farm gate prices (down 67%) and lower yields due to bad weather conditions and disease. Value added in the opium economy has amounted to about 50-60% of the country’s (non-drug) GDP over the past 3 years. Expenditures stemming from drug-export income have generated substantial demand, production, and income in the non-drug economy, and alternative livelihood opportunities will need to be developed alongside stronger eradication efforts.

Social indicators, while improving, are still very low. Delivery of essential services still depends heavily on continued donor support and faces extreme difficulty. Particularly in remote areas and areas affected by continued unrest, even basic services are largely absent. Reliable figures for unemployment are nonexistent, but qualitative information suggests that it is significant, especially among the young, and is exacerbated by extremely low human resource capacity, a continuing influx of returning refugees, and high population growth rates. A National Risk and Vulnerability Survey conducted in 2003 estimated that per capita expenditure in rural areas amounted to $165 per year. The data also suggest that 3.5 million of the 17.5 million Afghans living in rural areas suffer from extreme poverty and another 10.5 million are vulnerable to it. In 2004 widespread crop failure, caused by localized drought and plant and animal diseases--particularly in the west, southwest, and south--led to severe food shortages.

The Government’s operating budget for FY2004 was set at $609 million, with $300 million to be generated through domestic revenues and $309 million to be covered by foreign assistance. The target for domestic revenues under the IMF staff-monitored program (SMP) was set more conservatively at $256 million. It is expected that the Government will meet or exceed the SMP targets but fall short of the budget targets. The development budget increased from $1.8 billion in FY2003 to $4.2 billion in FY2004. Following patterns similar to the previous year, operating expenditures, as well as “core” budget development spending, which includes those donor-funded projects that are administered through government accounts, were slow through the first 9 months of FY2004. The rate of spending is estimated to have picked up during the last quarter. Budget development spending has been very slow and remains hampered by the volatile security situation and capacity constraints, particularly in line ministries.

Inflation in FY2004, as measured by the CPI in Kabul, rose sharply in the first quarter, primarily due to higher housing rents and petroleum prices, but it decreased again in the second. Year-on-year inflation at end-December was 11.9% (6.6% excluding housing rents and petroleum), slightly above the 10.5% rate for FY2003.

The afghani remained relatively stable, trading in the range of AF45-49/$1 over most of 2004, reflecting widespread acceptance of the new currency, prudent macroeconomic policies, and a government commitment to keep broadly within the SMP targets for monetary growth. Currency in circulation is expected to have shown 38.0% growth by end-FY2004.

Balance-of-payments data are weak. Exports in FY2004 are estimated to have reached $2.0 billion (including reexports of $1.5 billion). Total imports are put at $3.4 billion (including items for reexport). The principal exports are carpets and dried fruits; imports consist mainly of machinery and equipment, fuel, food, clothes, and medicine. Most reexports--primarily electronic goods, cosmetics, toiletries, and auto parts--are destined for the Pakistan market. The current account deficit (excluding grants) is estimated at $1.7 billion (about one third of GDP) in FY2004. The deficit is largely covered by grants; FDI is estimated at about $100 million and net disbursements of public loans at about $141 million for the year.

Foreign reserves are expected to have increased to $1.1 billion at end-FY2004 from $814 million a year earlier. A debt management unit in the Ministry of Finance is currently identifying and reconciling outstanding obligations to bilateral creditors. Several countries have provided generous debt relief on old claims. Much of the outstanding claims are from the Russian Federation and date back to the Soviet era.

Macroeconomic policy developments

The encouraging growth performance of the last few years has been supported by the Government’s commitment to an ambitious reform agenda and the achievement of several political milestones. The country’s first-ever democratic presidential elections in October 2004 were met by high voter turnout without major security incidents, and confirmed the incumbent interim president as Afghanistan’s first democratically elected president. These developments laid strong foundations for further political stabilization.

The Government has been implementing the SMP since March 2004. The program aims to maintain macroeconomic and financial stability, pursue essential structural reforms, and build statistical capacity. SMP performance during the first 3 quarters of FY2004 was strong and most of the targets and structural benchmarks were met. However, bottlenecks in the legal system, mainly due to a lack of capacity within the Ministry of Justice, are postponing the introduction of key laws such as those on financial management, investment, and statistics.

Budget preparation and execution have improved significantly, particularly with the introduction of a “core” budget in June 2004 that consolidated the operating budget with the development budget. Also, various government accounts have been consolidated into the Treasury Single Account.

Domestic revenue generation strengthened, from $208 million in FY2003 to an estimated $256 million in FY2004. Yet despite these improvements, donor support will remain crucial to sustaining the reform momentum and to ensuring the delivery of basic services over the medium term. Tax reform measures were enacted in early 2004, including a final wage withholding tax on higher-income employees, an improved income tax regime, and a limited range of consumption taxes on services such as telecommunications, air travel, hotels, and restaurants. However, tax administration and enforcement remain a great challenge and require substantial improvement. Furthermore, the use of market exchange rates in customs valuation and a new streamlined tariff structure (from 25 tariff rates of 0-150% to six rates of 2.5-16%) came into effect in March 2004. Provinces have begun to regularly transfer government revenues collected in their areas to the Treasury Single Account.

Reform of the civil service is only slowly moving forward. A main pillar is the Priority Reform and Restructuring (PRR) program, which enables government departments to transfer or appoint key staff to a higher pay scale for a fixed term. This has become necessary, particularly since the heavy presence of international and nongovernment organizations distorts the local labor market, which already suffers acutely from a scarcity of qualified personnel. By end-2004, 10 ministries and two independent entities had been granted PRR status and 8,017 positions had been transferred to the PRR scales. The initial target for FY2004 was for 30,000 civil servants to have moved to these scales, including 6,000 at the provincial level. The Government’s target is for domestic revenues to cover the wage bill by FY2008--a very challenging objective.

Monetary policy continues to focus on keeping inflation under control and on ensuring a relatively stable exchange rate. There is an increasingly regular regime of foreign exchange auctions. The Da Afghanistan Bank, the central bank, introduced a short-term capital note in September 2004 and a system of bank reserve requirements has been adopted. Afghanistan’s financial infrastructure, including savings and investment instruments, is still largely undeveloped. Eleven national and foreign banks have been granted operating licenses by the central bank, which is gradually disengaging from its commercial banking functions. In late-2004, the Government introduced antimoney laundering legislation.

The volatile security environment, unclear and insecure property rights, inadequate and unreliable power supply, and poor communications and transport infrastructure are key deterrents for private investors. Most investments to date have focused on the hotel and restaurant businesses that cater to the large international presence, and on the rapidly growing telecommunications sector. An Afghan Investment Guarantee Facility was set up in September 2004 to provide political risk guarantees to attract further foreign investment. An industrial park has been established outside Kabul and more are to be set up in other cities. Rationalization of SOEs has started, with an audit of their financial positions. A preliminary assessment proposes that, out of a total of 71 enterprises, 41 could be privatized, 20 liquidated, and 10 kept in government hands.

The Government and its development partners consider the opium economy--with its linkages to insecurity, warlords, poverty, and poor governance--a key issue for a successful development effort. The challenge, however, is daunting, especially given the still limited capacity to deal with governance and security problems facing the Government and the opium economy’s strong economic incentives.

According to UNODC estimates, the number of families involved in poppy cultivation rose by 35% to 356,000 in 2004, representing approximately 2.3 million people or 10% of the population. This is largely because opium production remains far more profitable for farmers than legitimate crops. Despite the fact that the yearly gross income of opium-growing families declined sharply by 63% from $4,600 to $1,700 in 2004 according to UNODC, mainly due to weaker prices, this income was still many times higher than the gross income from wheat cultivation ($390). Also, many poor farmers are deeply involved in opium-related debt or sharecropping arrangements, which forces them to continue cultivating poppies. There are, though, early indications that farm gate prices have been falling and that eradication measures are showing signs of progress, most likely leading to a reduction in the 2005 harvest.

Outlook for 2005-2007 and medium-term trends

At the Berlin Donor Conference in March 2004, the Government outlined its program of action in the document, Securing Afghanistan’s Future: Accomplishments and the Strategic Path Forward, based on the country’s National Development Framework. The document stresses the importance of the private sector as an economic driver and emphasizes investments in human capital, physical infrastructure, security, and good governance. It argues that an average of 9% growth a year of the non-drug economy (10-15% in the short term and 7-9% in the long term) is needed to assure a visible improvement in economic and social conditions while the drug economy is gradually eliminated. Total financing of $31.8 billion is needed until 2010 to raise Afghanistan to an annual per capita GDP of about $500, including an external financing requirement of $27.6 billion over 7 years. Donors pledged $8.2 billion for March 2004-2007 at the Berlin conference, the equivalent of 69% of the $11.9 billion government target for this period.

The high growth rates seen since the end of the conflict have been fueled primarily by donor-supported assistance and construction activities as well as by some relief from the drought. Reconstruction-related activities and growth in the services sector are also likely to sustain overall growth levels of about 10% annually in FY2005-FY2007. However, to achieve the Government’s own growth targets over the medium term and to gradually replace opium production, there is a need to shift to broader-based and sustainable development and to identify new drivers of growth. This is particularly important in light of the Government’s counter-narcotic efforts. Abrupt efforts to eradicate opium production could well have severe social and political consequences and adversely affect the overall economy and poverty reduction. Considering the size of the opium economy, a comprehensive strategy that creates alternative livelihoods in the rural economy--combined with eradication measures and legal reform--is required, supported by broad-based economic growth and sustained donor commitment.

Substantial continued donor assistance will be required for the recurrent budget over the medium term. There are serious concerns about the fiscal sustainability of the PRR program, the government payroll, and security expenditures. Revenue measures and tax enforcement will have to improve significantly to meet ambitious targets for covering recurrent expenditures. In early 2005, the Government started to develop an interim poverty reduction strategy paper, which will update and integrate various ongoing strategies and programs for reducing poverty, sustaining rapid economic growth, and promoting social inclusion. The 15-month formulation process is to include widespread consultation with civil society and the development of a 3-year macroeconomic framework.

Any future growth scenario will depend on the continuation of political reforms, sound economic policies, and the security situation. This remains volatile and could deteriorate in the run-up to the parliamentary elections originally scheduled for April 2005 but recently postponed until September. The scenario is also highly dependent on developments in the agriculture sector. With very high growth rates in cereal production of 84% in 2002 and 50% in 2003, even accounting for the 2004 shortfall, cereal production is nearing its natural ceiling on irrigated land. The frequency and duration of drought over the past 7 years are a serious concern and are partially attributable to deforestation and soil degradation. Through the expansion of irrigation and improvements in irrigation efficiency, productivity levels and the proportion of land under cultivation can still be significantly increased.

For the private sector to be the primary engine of growth and to create employment opportunities, support mechanisms will have to be strengthened, and the legal foundations for property rights, contract enforcement, and bankruptcy legislation strengthened; in addition, a legal framework for the extractive industries needs to be introduced. Currently, the exploitation of Afghanistan’s mineral resources, including coal, copper, gems, and gold, is very limited. Another potential growth area is the carpet industry--traditionally one of the main exporting industries--particularly in rural areas and for women.

Significant growth potential also lies in the exploitation of Afghanistan’s geographic position between Central and South Asia. Currently there is very limited trade between Afghanistan and the Central Asian republics (CARs) as tariff and nontariff barriers remain significant. If these barriers could be substantially eliminated with trade and transit linkages established, this would create new markets for Afghan exports, while transit trade from the CARs to South Asia through Afghanistan would benefit all parties substantially.

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