Afghanistan Economic Update

April 2015 Public Disclosure Authorized Afghanistan Economic Update Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Macroeconomics and Fiscal Management Global Practice The World Bank

Disclaimer This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work.

Table of Contents Executive Summary... 5 1. Recent Economic Developments... 6 2. Economic Outlook and Medium-Term Prospects... 19 3. Structural Policies for the Immediate and Medium Term... 21 Box 1: The impact of declining oil prices on the Afghan economy... 10 Annex 1: World Bank Group Program in Afghanistan... 24 Annex 2: Afghanistan Data Sheet... 26 This report was prepared by Omar Joya (Economist, GMFDR), under the guidance of Faruk Khan (Lead Economist, GMFDR). Useful inputs were received from the wider country team. The author gratefully acknowledges comments and suggestions received from Claudia Nassif, Guillemette Jaffrin, Pedro Olinto, and other members of the country team. This report was prepared under the overall guidance of Shubham Chaudhuri (Practice Manager, GMFDR) and Robert Saum (Country Director). The author also gratefully acknowledge the cooperation and suggestions received from the Afghan authorities.

Executive Summary The political and security transition continues to take a heavy toll on Afghanistan s economy. Economic growth is estimated to have fallen further to 2 percent in 2014 from 3.7 percent in 2013 and an average of 9 percent during 2003-12. Political uncertainty combined with weak reform progress dealt a further blow in 2014 to investor and consumer confidence, already in a slump from uncertainty building since 2013. As a result, growth in the non-agricultural sectors (manufacturing, construction, and services) is estimated to have fallen further in 2014. The agricultural harvest in 2014 was strong for the third year in a row, but was up only marginally from the bumper year of 2012. Agriculture benefited from robust cereals production thanks both to well distributed, timely rainfall and an increase in irrigated area for wheat cultivation. The growth outlook for 2015 remains weak. Continued uncertainty and the difficult environment for reforms mean that investor and consumer confidence show no signs of picking up, while unfavorable weather conditions point toward a slight contraction in agriculture. Growth is projected at 2.5 percent in 2015. Afghanistan has been in the midst of a fiscal crisis, with declining revenues leading to financing difficulties in 2014. Domestic revenues fell from a peak of 11.6 percent of GDP in 2011 to 8.4 percent in 2014, because of the economic slowdown and weaknesses in tax and customs enforcement. The decline in revenue collection took place across all sources, including tax revenues, customs duties, and non-tax revenues. As a result, in spite of measures to restrain expenditures, the authorities faced a financing shortfall in excess of $500 million in 2014. This was proactively managed under difficult circumstances by drawing down cash reserves, accumulating arrears, and exceptional donor assistance. The authorities curtailed civilian operations and maintenance (O&M) and discretionary development expenditures, although overall expenditures increased in 2014 because of higher security and mandated social benefit spending. Restoring fiscal stability will require accelerating revenue enhancing reforms, additional discretionary assistance, and prioritizing expenditures. The government began 2015 with a weak cash reserve position and significant arrears, while reforms to improve revenues continued to stall through the first three months of 2015. Afghanistan thus faces a financing gap in 2015 that is potentially as large as last year, against the backdrop of a weaker cash position. The authorities reached agreement in March on a nine-month IMF Staff Monitored Program (SMP) to address macroeconomic vulnerabilities by mobilizing revenue and strengthening the financial sector. The macroeconomic framework also envisions rebuilding cash reserves by year end. Successful implementation of the agreed reform agenda will be key to reining in macroeconomic risks which remain high. Afghanistan faces the dual challenge of restoring confidence in its economic prospects and addressing formidable medium term development challenges. The new government articulated its development vision and a bold reform program through its paper Realizing Self Reliance: Commitments to Reforms and Renewed Partnership presented at the London Conference on Afghanistan in December 2014. The paper presents the government s plans for tackling corruption and building better governance, restoring fiscal sustainability, bolstering private sector confidence, promoting growth, and improving security and political stability. Successful implementation of this bold reform program under difficult circumstances is the major challenge facing Afghanistan. 5 P a g e

Percent Percent 1. Recent Economic Developments The sharp slowdown in economic growth has continued in parallel with the protracted political uncertainty and weak reform progress Economic growth fell to an estimated 2 percent in 2014 as the protracted political transition and weak reform progress dealt a further blow to confidence in the non-agriculture sectors. Economic growth is estimated to have fallen to 2 percent in 2014 from 3.7 percent in 2013 and an average of 9 percent during 2003-12 1. Protracted political uncertainty and weak reform progress dealt a further blow to investor and consumer confidence, which were already in a slump from uncertainty building since 2013 due to the political and security transition. Anecdotal evidence and proxy data indicate that private investment dropped further in 2014. The economy also faces headwinds from the drawdown in aid. As a result, growth in the non-agricultural sectors (manufacturing, construction, and services) is estimated to have fallen further in 2014. Furthermore, agricultural production was robust, but up only marginally from the bumper year of 2012. This helped buoy economic activity, particularly in light of the strong links between agriculture and the rest of the economy, but was not strong enough to outweigh the confidence slump. Finally, restrained spending on operations and maintenance (O&M) and discretionary development projects due to the fiscal crisis would tend to put a damper on growth, although higher nondiscretionary development spending helped support economic activity. Figure 1: Growth of real GDP and output sectors 45.0 35.0 25.0 15.0 5.0-5.0-15.0 Figure 2: Sector contributions to GDP growth 25.0 20.0 15.0 10.0 5.0 0.0-5.0-10.0 Real GDP growth Services growth Agriculture growth Industries growth Agriculture Industries Services Source: CSO and Bank staff estimates The agriculture harvest in 2014 was strong for the third year in a row, but was up only marginally from the 2012 bumper year. Agriculture growth (estimated at 1.9 percent in 2014, compared to -0.2 percent in 2013 and 18.2 percent in 2012) benefited in large part from robust cereals production thanks both to well distributed, timely rainfall and an increase in irrigated area for wheat production. Cereals production grew 3.6 percent in 2014 reaching 6.7 million metric tons. Production of wheat, Afghanistan s most 1 Estimated growth for 2014 is based on a preliminary projection since national accounts figures for 2014 have not yet been released. Estimated growth of 3.7 percent for 2013 is for the calendar year, for the non-opium economy, and also incorporates a number of adjustments based on supplementary indicators of economic activity. It is thus different from the growth rate reported by the Central Statistics Organization (CSO) for the 1392 solar year. 6 P a g e

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Metric tonnes Thousand Hectares Thousand metric tonnes Number of firms important staple crop, increased by nearly 4 percent. Nonetheless, despite the strong harvest, Afghanistan has not yet reached self-sufficiency in cereals, with the Ministry of Agriculture, Livestock and Livelihoods (MAIL) estimating that 0.24 million tons of imported cereals were required to meet the domestic demand. MAIL also reported increases in the production of fruits, horticulture and livestock in 2014, although other agricultural products declined. Figure 3: Cereals production (thousand tons) Figure 4: New firm registrations, 2012-2014 7,000 6,000 6,000 5,000 5,000 4,000 3,000 4,000 3,000 2,000 1,000 2,000 Wheat Other crops - 2012 2013 2014 Manufacturing Construction Services Agriculture Source: MAIL Source: AISA New investment activity dropped sharply again in 2014 across all sectors. The number of new firm registrations dropped 26 percent to a total of 2,470 companies in 2014 (see Figure 4). This is on top of the 36 percent drop in 2013 after several years of rising numbers of new firm registrations during 2008-11. The further decline in new firm registrations occurred across all sectors including construction, manufacturing, and services, and also across both domestic and foreign investments. In the absence of higher frequency national accounts data, new firm registrations can serve as a proxy for business confidence and new investment activity in the private sector. While not a perfect indicator, it can help track investment decisions that are sensitive to market conditions and political developments as potential investors delay investments in the face of higher risks. Opium production grew strongly in 2014 for the second year in a row, although the farm-gate price of opium declined by 20 percent. According to data from the United Nations Office on Drugs and Crime (UNODC), opium production grew strongly to 6,400 metric tons in 2014 from 5,500 metric tons in 2013 and 3,700 metric tons in 2012. While this is still down from the recent peak production of 8,200 metric tons in 2007, area under poppy cultivation reached a high of 224,000 hectares in 2014. The UNODC reports that the vast majority of opium cultivation took place in 9 provinces in the Southern and Western regions, which are the most Figure 5: Opium production and area under poppy cultivation 8,000 6,000 4,000 2,000 - Source: UNODC Opium production 300 200 100 Cultivated land - 7 P a g e

2006 2007 2008 2009 2010 2011 2012 2013 2014 insecure in the country. On the other hand, the farm-gate price of opium dropped by 20 percent in 2014. As such, the total farm-gate value of opium production declined from US$950 million in 2013 to $850 million in 2014. This is about 4 percent of GDP, although the total export value of opiates is likely twice as large. A number of factors could have contributed to the recent increase in poppy production, including (i) the introduction of new production technologies (e.g. irrigation); (ii) fewer livelihood opportunities or the expectation thereof; and (iii) the rollback of international forces and associated counternarcotic efforts from the provinces. Although opium s importance in GDP has been declining over time, it is likely an important source of livelihood for a segment of the rural population. Security continues to pose a significant risk for private investment and public service delivery, with the number of conflict related civilian deaths rising in 2014. Although elections in 2014 were held without major security incidents, according to figures reported by the United Nations Assistance Mission in Afghanistan (UNAMA), the number of Figure 6: Number of civilian deaths, conflict related 4,000 conflict-related civilian deaths increased by nearly 25 percent in 2014, reaching unprecedented levels. 3,000 Lack of security is perceived as the most important constraint for private investment in Afghanistan. It is also one of the biggest challenges for public service delivery. Insecurity directly impacts growth and poverty by damaging human capital, 2,000 1,000 constraining productive economic activities, increasing social unrest, promoting unequal access - to basic services, and increasing political instability. Poverty is high and persistent in Afghanistan. Poverty incidence nationwide was 35.8 percent in 2011-12, compared to 36.3 percent in 2007-08, with no statistically significant change in spite of rapid growth and improved social outcomes and service delivery. A number of factors appear to be responsible for this pattern. First, poverty incidence in the Northeast Region increased sharply during this period: without the Northeast, poverty declined from 36.3 percent in 2007-08 to 33.4 percent in 2011-12. Second, climactic shocks impacted the country, with two consecutive years of negative agricultural growth prior to the 2011/12 survey (and the climactic shocks appear to have Figure Source: 7: UNAMA Poverty and Inequality 2 Source: NRVA (CSO) been more prevalent in the Northeast). Third, inequality nationwide increased during this period, with percapita consumption growth of top quintile significantly greater than that of bottom quintile, with the latter 36.3 Poverty and Inequality 35.8 2007/08 2011/12 7.9 8.4 29.7 31.6 Poverty rate (%) Poverty gap (%) Gini index (%) 2 The poverty rate is the share of the population below the poverty line. The poverty gap measures the depth of poverty using the average shortfall from the poverty line. The Gini index is an indicator of income inequality. 8 P a g e

Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Percent Percent actually negative. Finally, Afghanistan faces a daunting demographic challenge, with around 400,000 new entrants into the labor force each year and underemployment pervasive. Inflation dropped significantly in 2014, driven by both domestic factors and global price trends Consumer price inflation dropped in 2014, as both food and non-food inflation softened. Period average inflation was recorded at 4.6 percent in 2014 compared to 7.4 percent in 2013. Both food and nonfood prices contributed to the drop in inflation. End-year numbers show an even larger decline, with headline inflation dropping from 7.3 percent in December 2013 to 1.4 percent in December 2014. In fact, end-year inflation in Kabul was actually negative at -1.1 percent in December 2014. Figure 8: Headline and core inflation, monthly trend 12.0 10.0 8.0 6.0 4.0 2.0 0.0-2.0 Figure 9: Headline, food and non-food inflation 12.0 10.0 8.0 6.0 4.0 2.0 0.0-2.0 Headline Core inflation (excl. fuel & cereals) Headline Food Non-Food Source: Central Statistics Organization Both domestic factors and global price trends have driven the decline in CPI inflation. Food prices in Afghanistan are driven by a mix of domestic agriculture sector performance and global food prices, with imports still playing a significant role in meeting domestic demand of main food staples (including wheat, wheat flour, rice, and vegetable oil). Given strong domestic agriculture performance in 2014, as well as softening global food prices, particularly of grains, food price inflation closed the year at 2.9 percent in December 2014 compared to 9.8 percent in December 2013. On the other hand, non-food price inflation declined from 4.8 percent in December 2013 to -0.3 percent in December 2014. The drop in non-food prices was driven in large part by falling housing prices. Rental prices dropped nearly 10 percent in December 2014 compared to 12 months earlier. Furthermore, prices of communication services have also been declining since 2013. As a result of the expansion in internet services, access to fiber-optic network, and increased competition in the market, the price for 1 megabyte of internet usage has dropped from $300 in 2012 to $35 in 2014. The pass through from falling global oil prices to lower transport prices in Afghanistan has been evident since January 2015. Global oil prices started to decline since September 2014 from above $100 per barrel to around $60 by the end of the year. The effects of declining global oil prices on domestic prices in Afghanistan passed through with some time lag, starting in January 2015. Transport price inflation (which includes oil prices) dropped from 19.5 percent in September 2014 to 2.5 percent in January 2015 9 P a g e

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 US$ per barrel Million US$ and further to -8.1 percent in February 2015. Although the weight of transport in Afghanistan s overall consumer basket is relatively small (4.7 percent), lower transportation costs also indirectly affect the prices of most other consumer goods, particularly those that are imported to this landlocked destination. Box 1 provides a more detailed discussion of the impact of lower global oil prices on the real sector and fiscal outlook for Afghanistan. Box 1: The impact of declining oil prices on the Afghan economy Oil prices started to decline in mid-2014 from over $100 a barrel to around $60 by the end of the year the lowest since 2009. It is expected to remain at $70 or less in 2015 and to linger well below $100 over the next five years. Reports show that supply surplus, together with lower demand in the global economy, have led to the collapse in oil prices. While this represents an adverse shock to oil exporters, it may entail favorable results for a number of oil-importing countries. Impact on the real economy Afghanistan is an oil-importing economy. Its import bill for oil and gas amounts to around US$1.5 billion annually, almost a quarter of total imports. The overall impact of declining oil prices on the real economy in Afghanistan is likely to be positive at least in the short-term. Given that Afghanistan is landlocked and mountainous, transportation costs are significant. Lower energy prices and thus lower transportation costs not only favor in-country movement of goods but also reduce the import bill for other items too. This not only benefits the poor through lower food prices but also reduces costs for local producers who mostly import their intermediate and primary goods by land from Pakistan, Iran and Central Asia. The moderation in domestic prices improves welfare for the poor and increases the purchasing power of consumers which in its turn increases private consumption and domestic demand. Figure 10: Crude oil prices 2010-2014, $/bbl Figure 11: Fuel imports in Afghanistan, 120.00 2,500 2,167 100.00 2,000 1,842 80.00 1,500 1,156 60.00 1,000 500 40.00-2012 2013 2014 Source: World Bank Source: CSO On the other hand, with Afghanistan a potential natural resource exporter, a sharp and prolonged decline in oil and commodity prices could negatively impact the incentives for investment in extractives. 10 P a g e

While the short-term impact of declining oil prices is favorable, the impact over the medium term could thus be negative, particularly with the fall in oil prices coinciding with declining global commodity prices. In particular, subdued energy prices over the long-term could discourage investments in oil extraction. Two oil basins, namely the Amu Darya and the Afghan-Tajik, -- both multi-billion-dollar foreign investments have already been tendered. The Amu Darya project started operations in 2012, but suspended oil production in 2013 due to security concerns. Currently, three oil basins (Tripul and Kushka, in the northwest, and Katawaz in the south-east) could potentially come in the pipeline for tender over the next 3-5 years. While a long term decline in prices would have an impact on the prospects for potential investments, current forecasts suggest that oil prices will gradually recover through 2020 and are set to increase over a 10-year horizon. Impact on fiscal sustainability The decline in oil prices is likely to have limited, if not neutral, impact on the budget. Unlike other countries in the region, where fuel subsidies are a major transmission channel for price changes, the Afghan government does not subsidize oil prices in any way. The impact on duties and taxes, both levied on basis of a fixed price per unit, will depend on the extent to which demand will react to the softening of prices. Custom duties on oil and gas imports, are an important source of government revenue: In 2013, the government collected $140 million in customs duties on oil and gas, representing about a quarter of total customs revenues or 7 percent of domestic revenues that year. The slowdown in economic growth and the withdrawal of international troops 3 resulted in a decline of fuel imports by over 30 percent in volume and an associated loss in customs revenue of nearly $50 million in 2014. The tax take from the newly introduced fuel fee, on the other hand, has been relatively low at around Afs 1.3 billion (equivalent to US$22.5 million) in 2014. The decline in fuel prices could potentially spur demand and consequently have a positive impact on taxes of higher sales and imports. However, economic developments, the decline in aid and the reduction of presence of foreign troops could contain this effect. Finally, on the public procurement side, benefits from savings are unlikely to materialize since fuel contracts are typically structured as multi-year commitments or financed by non-fungible donor assistance. 3 Fuel imports for the security forces are duty exempted and are not reflected in the official import statistics. However, there is indication that some of the security-related fuel imports are actually sold for local consumption by traders, implying a a positive correlation between security-related fuel imports and local consumption. 11 P a g e

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 in billion Afs in percent of GDP In Percent of GDP As the revenue decline intensified, a fiscal crisis unfolded in 2014, leading to accumulating arrears and exceptional financing needs The decline in domestic revenues intensified in 2014. Domestic revenues fell sharply to 8.4 percent of GDP in 2014 from 9.7 percent in 2013 and a peak of 11.6 percent in 2011 (see Figure 12). As such, 2014 was the third consecutive year with declining revenue performance. In fact, the intensity of the decline is underscored by the fact that domestic revenues fell even in nominal terms to Afs 100.1 billion in 2014 from Afs 109.4 billion in 2013 (a decline of 8.5 percent), which represents the first time since 2003 that revenues have actually fallen in nominal terms. The decline in revenues took place across all sources of revenue. Tax revenues, customs duties, and non-tax revenues are each down by about 1 percentage point of GDP or more since 2011. Figure 12: Revenues by sources of collection, in percent of GDP Source: AFMIS, MoF 5.3 4.9 4.7 4.3 The sharp decline in revenues is a result of both the economic slowdown and increased weaknesses in enforcement and compliance in both tax and customs administration. While the economic slowdown is part of the explanation, weaknesses in tax and customs enforcement are a large part of the problem, particularly given that the decline in Figure 13: Domestic revenues, 2003-2014 collections began in 2012 when economic growth 120 14.0 was very strong. Even with a growth slowdown, 100 12.0 domestic revenues should generally remain flat as a 10.0 80 share of GDP, with a decline in revenues by more 8.0 than 3 percentage points of GDP a compelling sign 60 6.0 of increased weakness in enforcement and 40 4.0 compliance. Increased uncertainty surrounding the 20 2.0 political and security transition has likely 0 0.0 encouraged greater rent-seeking and tax evasion activity. There have also been indications that some in nominal value (bn Afs) taxpayers withheld payments in light of the in percent of GDP protracted political impasse. On the other hand, lower imports and a shift in the structure of imports Source: AFMIS, MoF away from luxury and other higher tariff items toward lower tariff items has also impacted customs revenues. As revenues fell far short of the target, the authorities curbed certain expenditures and accumulated arrears. As the government s cash position deteriorated toward the second half of 2014, a number of austerity measures were introduced, including putting on-hold new discretionary development projects, curtailing asset acquisitions under the operating budget, limiting overtime payments to civil servants, and 14.0 12.0 10.0 8.0 6.0 4.0 2.0-2.8 3.6 2.7 2.5 2.7 2.5 1.9 2.2 2011 2012 2013 2014 Tax revenue Non-tax revenues Customes duties 12 P a g e

suspending bonuses and other benefits. Furthermore, the authorities accumulated arrears in operations and maintenance (O&M) and discretionary development expenditures. The Ministry of Finance estimated total arrears at the end of 2014 at about $205 million, of which around $50 million were accumulated under the recurrent budget. Overall civilian O&M spending (chronically low and far below economic needs) declined from Afs 18 billion in 2013 to Afs 16.3 billion in 2014. In addition, discretionary development spending in 2014 was only half the amount recorded in 2013 (see Table 1). Table 1: Expenditures 2013-2014 (in billion Afghanis) 2013 2014 Total recurrent 198.0 228.3 Security 119.3 137.4 Civilian 78.6 91.0 Wages & salaries 47.9 52.7 Operations & maintenance 18.0 16.3 Capital expenditures 1.7 1.9 Social transfers 11.1 20.0 Discretionary development 18.9 9.9 Recurrent + Disc development 216.9 238.2 Non-discretionary development 61.2 72.6 Total core expenditures 278.1 310.8 Source: AFMIS, MoF Despite restraining civilian O&M and discretionary development spending, overall expenditures increased in 2014 due to higher security and mandated social benefit spending. On-budget security expenditures increased from Afs 119.3 billion in 2013 to Afs 137.4 billion ($2.4 billion) in 2014, driven by higher spending in areas financed out of domestic resources as well as some on-budgeting of items that were previously financed off-budget. The fiscal crisis has had little impact on security spending, which is treated as a first priority and has thus been inflexible to resource constraints. Domestically-financed security expenditures increased from Afs 31.8 billion ($575 million) in 2013 to Afs 43 billion ($750 million) in 2014. Security grants are restricted to Ministry of Defense (MoD) and Ministry of Interior (MoI) expenditures, while other security costs (particularly the National Directorate of Security) have increased substantially over the past few years. Furthermore, the legislation on social benefits for families of martyrs and disabled was amended in 2013 to revise certain benefits to almost threefold their previous rates. The authorities have also indicated that increased conflict-related casualties resulted in higher payments of death benefits to the families of security personnel in 2014. As such, social transfers almost doubled to Afs 20 billion in 2014. Overall, total discretionary spending (including recurrent and discretionary development) increased by nearly 10 percent to Afs 238 billion in 2014, with higher security and social benefit spending crowding out civilian O&M and discretionary development spending. With lower revenues and higher expenditures, the fiscal crisis in 2014 was proactively managed under difficult circumstances by drawing down cash reserves, accumulating arrears, and exceptional donor assistance. As discretionary resources fell below discretionary expenditures, the fiscal crisis unfolded over the course of the year with the authorities running through their cash reserves and accumulating arrears. At the beginning to 2014, the opening cash balance was about Afs 21 billion or $370 million. This was essentially drawn down to zero by the end of the third quarter, although some grants disbursed at the very end of the year allowed the end-2014 cash position to recover to some extent. Despite the difficult environment for managing cash flows, the authorities were generally successful in maintaining payments 13 P a g e

In Billion Afghanis In Billion Afghanis for salaries and domestic contributions for security financing. Nonetheless, significant arrears in O&M and discretionary development expenditures were accumulated in the second half of the year, with total outstanding arrears at end-2014 of about $200 million. In light of the fiscal crisis, the authorities made multiple requests for exceptional assistance during the second half of the year and received around $190 million in such funds, although not all was disbursed prior to the closing of the fiscal year. Even after the exceptional assistance and not counting arrears (which are not booked as actual expenditures), the discretionary deficit for 2014 amounted to about Afs 19 billion ($337 million), equivalent to about 1.6 percent of GDP. Figure 14: Discretionary resources, 2013-2014 Figure 15: Discretionary expenditures, 2013-2014 160.0 160.0 140.0 140.0 9.9 120.0 100.0 80.0 60.0 40.0 17.7 109.4 24.5 100.1 120.0 100.0 80.0 60.0 40.0 18.9 78.6 91.0 20.0 20.0 31.8 43.0-2013 2014-2013 2014 Civilian discretionary development Domestic revenues Civilian discretionary grants Civilian recurrent Security (financed by domestic revenues) Source: AFMIS (MoF), and Bank staff estimates Fiscal vulnerabilities remain high in 2015. The authorities started 2015 with a significantly lower level of cash reserves. Furthermore, arrears in the recurrent and discretionary development budget need to be repaid. On top of this, the authorities envision a fiscal gap of about Afs 8 billion ($136 million) in the 2015 budget, with an ambitious target of Afs 125.5 billion for domestic revenues. Unless revenue performance improves dramatically compared to 2014, the financing gap for 2015 is likely to be much higher than budgeted, with the authorities having a much smaller cash buffer on which to draw. Furthermore, with the economy still in a sharp slump and the growth outlook weak, the scope for further expenditure austerity is limited. As such, Afghanistan could well require additional discretionary financing in 2015, although this would need to be combined with structural reforms to improve growth and revenue prospects in order to chart a path toward sustainability. The authorities reached agreement on a nine-month IMF Staff Monitored Program (SMP) in March 2015. The reforms supported by the program are intended to address macroeconomic vulnerabilities by mobilizing revenue, strengthening the financial sector, and improving growth prospects. The reforms envision a number of revenue measures, to be implemented by mid-2015, which are intended to generate 14 P a g e

Million US$ In Million US$ additional revenues for 2015. The macroeconomic framework also envisions rebuilding cash reserves by year end. Successful implementation of the agreed reform agenda will be key to reining in macroeconomic risks which remain high. Figure 16: 2015 Budget: expenditures, resources, and financing gap 3,500 2,500 1,500 500 3,246 1,642 492 2,625 454 2,164-136 (500) Source: MoF Trade deficit narrowed, thanks to strong exports growth and declining imports Official exports increased for a second consecutive year, likely due to higher agriculture output as well as improved recording. Official exports in 2014 were recorded at $621 million, up from $500 million a year earlier. The increase in exports was primarily led by higher exports of agricultural products. Exports of dried fruits and fresh fruits increased by more than 60 percent. Afghanistan s exports basket is principally comprised of agriculture-related products and commodities. Dried fruits and carpets are the two major export items, which respectively make 35 percent and 14 percent of total exports, followed by medicinal plants (9 percent) and fresh fruits (5 percent). The strong agricultural harvest for the third year in a row in 2014 is thus responsible in part of the increase in exports. Furthermore, the real exchange rate depreciated by 3.5 percent in 2014, which would also encourage an increase in exports. At the same time, a good part of exports in Afghanistan have been estimated to be unrecorded and informal, so that part of the increase in exports during 2014 could well have been due to improved recording. Figure 17: Official exports, 2013 and 2014 700 600 500 400 300 200 100-2013 2014 Source: CSO Other Cotton Oil seeds Animal byproducts Fresh fruits Medicinal plants Carpets Dried fruits 15 P a g e

Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Million US$ The trade deficit narrowed in 2014. The total estimated trade deficit declined from 41.9 percent of GDP in 2013 to 37.9 percent in 2014. This was a result of higher total exports (including unofficial and smuggling) by an estimated 13.4 percent and lower total imports (incl. unofficial and smuggling) by an estimated 5.7 percent in 2014. The decline in imports comes about as a result of lower demand in the economy, as both consumer and business confidence was hit by the prolonged political uncertainty. Estimates indicate that 15-20 percent of all trade in Afghanistan is unrecorded and smuggled. As such, official trade statistics fall short of capturing all trade flows. While official statistics indicate a decline of official imports by about 20 percent in 2014 (see Figure 18), a good part of this was likely due to poorer recording and increased smuggling. The total merchandise trade deficit remains large and is fully financed by large aid inflows (i.e., current official transfers), so that the estimated current account is a surplus of 5.6 percent of GDP in 2014. After depreciating in 2013, the exchange rate remained relatively stable in 2014. The exchange rate of the Afghani versus the US dollar remained relatively stable during 2014, depreciating only marginally by 2.4 percent during the year, compared to depreciation by 9.9 percent during 2013. These trends are likely due to similar trends for regional currencies including the Pakistani Rupee. At the same time, as the Euro fell globally against the US dollar, the Afghani appreciated by 9 percent against the euro during 2014. On the other hand, the real exchange rate depreciated by 3.5 percent in 2014 as domestic price inflation was lower than in trading partners. Figure 18: Official imports, 2013 and 2014 10,000 Source: CSO Figure 19: Current account balance for 2014 (in percent of GDP) Source: Bank staff estimates Figure 20: Afghani exchange rate against the US dollar and the euro 60 57.5 55 52.5 50 47.5 8,000 6,000 4,000 2,000 45 - -41.8 2013 2014 Exports Imports Merchandise trade balance Net income Current transfers, net Current Account balance US dollar (left axis) 4.0-37.8 0.9 5.6 Other Cement Vegetable Oil Metal products Wheat and wheat flour Textile and clothing Vehicles, machinery and equipment Fuel and oil 39.9-60.0-40.0-20.0 0.0 20.0 40.0 60.0 Euro (right axis) 85 80 75 70 65 60 Source: Da Afghanistan Bank 16 P a g e

Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Million US$ Foreign exchange reserves remained at Figure 21: Foreign exchange reserves (million US$) US$7.4 billion, equivalent to around 8 months of imports. Gross international reserves closed the year at $7.4 billion, nearly the same level as in December 2013. Since 2002, foreign exchange reserves have 7,500 7,250 7,000 increased consistently. While this 6,750 accumulation of reserves has continued, a higher degree of fluctuations has been observed since the start of 2013. This is not unexpected in light of less steady capital flows 6,500 6,250 6,000 during periods of higher uncertainty as has been the case over the course of the 2013-14 political and security transition. In case of Source: DAB more abrupt swings in foreign grants and capital flows, prudent management of foreign exchange reserves will be important. Monetary and banking performance already in a slump from the Kabul Bank crisis has weakened further from the economic slowdown Broad money (M2) growth continued to be sluggish in 2014, as a result of slowing growth in commercial banks deposits. Despite the strong growth of currency-in-circulation, growth in banking sector deposits slowed in 2014. Currency-incirculation grew on an annual basis by 16.7 percent in December 2014, compared to 13.4 percent in the same period previous year. Total deposits of the banking sector declined, however, through most of the year and only picked up towards the end of 2014 (see Figure 23). Commercial banks deposits closed the year with a 2.8 percent growth rate, much lower than the 5.9 percent growth in December 2013 and 15.8 percent in December 2012. Total deposits stand at $3.5 billion as of December 2014 (while they stood at $3.4 billion as of December 2013). The slowdown in deposits growth reflects the fact that confidence in the economy continues to be suppressed. The political uncertainty and economic slowdown in 2013 and 2014 seem to have exerted strong impact on monetary performance indicators. Figure 22. Growth in monetary aggregates and reserve money 25.0 20.0 15.0 10.0 5.0 0.0-5.0-10.0 Broad money (M2) Reserve money Currency in circulation Source: Monetary and Financial Statistics, Dec 2014, Da Afghanistan Bank 17 P a g e

Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Lending to the private sector slumped further in 2014, as economic activity continued to slow. Commercial banks lending declined by 7.3 percent in December 2014 (year-over-year), compared to growth of 7.6 percent in December 2013. Total banking sector loans stood at $757 million in December 2014, down from $826 million in December 2013. The loan to deposit ratio declined from 23.7 percent at end-2013 to 21.6 percent at end-2014 (see Figure 24). In addition, asset quality has deteriorated, with the reported Non Performing Loans (NPL) rate at 8.1 percent in December 2014, up from 5.1 percent in December 2013. The drop in banks lending can be attributed both to the slowdown in economic activity and to banks appetite for lending. With heightened perceptions of uncertainty, anecdotal evidence suggests that private investment has stalled and thus borrowing from the banking sector has dropped. Furthermore, the banking sector appears to have become more risk averse since the Kabul Bank crisis. While the large drop in bank lending in 2011 was due to the removal of Kabul Bank bad loans from the banking sector balance sheet, lending has not only failed to pick up since then but appears to have been affected further by the recent economic downturn. Figure 23: Growth in commercial banks deposits and loans to private sector 30.0 25.0 20.0 15.0 10.0 5.0 0.0-5.0-10.0 Source: MFS, Dec 2014, Da Afghanistan Bank Figure 24: Lending to deposits ratio 80.0 60.0 40.0 20.0 0.0 Deposits Source: MFS, Dec 2014, DAB Loan 2006 2007 2008 2009 2010 2011 2012 2013 2014 The Central Bank suspended the overnight deposits facility to encourage bank lending, while preserving the capital notes as an alternative monetary policy instrument. In June 2014, Da Afghanistan Bank suspended the overnight deposits facility for an undetermined period of time. The decision was driven by the fact that the commercial banks were not lending enough, and instead deposited their excess cash in the overnight facility to receive risk-free interest income. The overnight rate was 1 percent below the 28-day capital notes cut-off rate. With the suspension of the overnight deposits facility, the Central Bank now relies on capital notes and foreign exchange auctions as instruments to manage liquidity in the economy and to target the reserve money. The capital notes are short-term securities issued by the Central Bank in the primary market to commercial banks and certified money dealers on a weekly basis. In addition to the capital notes of 28-day and 182-day maturities, the DAB introduced a new capital note with 1 year maturity in April 2013 and a 7-day capital note in January 2015. Total outstanding amount in capital notes reached Afs 39.2 billion (equivalent to $675 million) in December 30, 2014. 18 P a g e

2. Economic Outlook and Medium-Term Prospects The growth outlook for 2015 remains weak. In light of the continued uncertainty and sluggish reform progress, investor and consumer confidence in the non-agricultural sectors show no signs of picking up before at least the second half of the year. Economic reform momentum has not yet picked up, and parliamentary elections are scheduled for the near future which could further disrupt the political consolidation process. Furthermore, unfavorable weather conditions point toward a contraction in agriculture this year. Growth is thus projected to remain weak at 2.5 percent in 2015 before recovering to about 5 percent during 2016-18. The growth projections remain highly fluid. With the economy stalled, the timing and strength of any growth pickup depends on a reduction of the political uncertainty and improvement in the pace of reforms. Furthermore, public development expenditures on essential infrastructure and service delivery will need to play an important role in propping up economic activity through the period of uncertainty. Restoring fiscal stability without sharp cuts in O&M and development expenditures will be critical. Table 2: Medium-term Macroeconomic Framework, 2015-2018 (Tentative Staff Projections) 2012 2013 2014 2015 2016 2017 2018 Actual/Estimates ------------------ Tentative Staff Projections ---------------- - Real GDP growth 14.4 3.7 2.0 2.5 5.0 5.1 5.3 Nominal GDP (bn US$) 20.5 20.3 20.8 22.2 24.1 26.0 28.2 CPI inflation (period average) 6.4 7.7 4.4 5.0 5.5 5.0 5.0 Fiscal Percent of GDP Revenues and grants 23.2 24.2 23.5 26.7 28.1 30.3 32.6 Domestic revenues 10.3 9.7 8.4 9.3 9.8 10.5 11.6 Foreign grants 13.0 14.5 15.1 17.4 18.3 19.8 21.0 Total core expenditures 23.8 24.7 26.0 29.2 30.1 32.6 35.1 Recurrent expenditures 17.1 17.6 19.1 20.4 21.9 24.1 26.3 Development expenditures 6.7 7.1 6.9 8.8 8.2 8.5 8.8 Overall balance (incl. grants) -0.5-0.5-2.5-2.5-2.0-2.3-2.5 External Trade balance -45.8-41.9-37.9-38.0-36.4-37.2-34.2 Current acct balance (incl. grants) 6.2 7.5 5.6 3.0 0.5-2.6-3.3 External debt 6.2 6.7 6.5 6.1 5.9 5.7 5.6 Source: Staff estimates, tentative and subject to revision In the medium term, post-transition growth is projected at about 5 percent per year during 2016-18. This is less than the average growth of 9.4 percent per year during 2003-12 that was fueled by the surge in international aid and security spending. The post-transition growth outlook is contingent upon a relatively stable political and security environment, with agriculture and services likely to be among the key drivers, and extractive industries playing an increasing role in the medium term. Agriculture accounts for about a quarter of GDP and is also linked closely to other parts of the economy, such as food and beverages (which account for almost all of manufacturing), and parts of transport and retail. Afghanistan has the potential to build on this foundation by reviving its historical position as an important exporter of fruits, nuts, vegetables, and other higher value-added products. This will require investments in irrigation and extension services to improve capacity, as well as efforts to build and improve downstream agro-processing activities. On the other hand, extractive industries sector currently account for a very small share of GDP, but have significant potential in light of Afghanistan s deposits of copper, iron ore, and hydrocarbons. Unlocking 19 P a g e

this potential will require progress on the legislative framework as well as securing financing for the necessary infrastructure. The medium term growth outlook is subject to serious risks which will need to be carefully managed. The fragile political and security environment has been a considerable constraint to private investment and growth. Continued violence, economic crime and systemic corruption also have often undermined progress in Afghanistan s governance and state-building agenda. Much will depend, therefore, on Afghanistan s success in achieving peace, stability and reconciliation. A number of factors are likely to have affected poverty incidence since 2011-12. First, the sharp slowdown in growth during 2013-15 would put pressure on underemployment and thus consumption across the board. Second, agriculture experienced a bumper year in 2012 (growing by 18.2 percent, likely postdating the 2011-12 household survey), although subsequent growth in the sector during 2013-14 has remained relatively flat and unfavorable weather conditions points toward a contraction in 2015. Poverty incidence in 2015 is thus projected at 38 percent. In the medium term, Afghanistan faces headwinds from declining aid and a demographic youth bulge. In this context, making progress on poverty reduction will require not only a pickup in overall growth, but also achieving steady growth in the agriculture sector, reducing underemployment, mitigating climactic shocks, addressing regional disparities. Poverty incidence is thus projected to decline only modestly to 35 percent by 2018, but is subject to a high degree of uncertainty. In light of the fiscal crisis, restoring fiscal stability will require accelerating revenue enhancing reforms, additional discretionary assistance, and prioritizing expenditures. Reforms to improve revenues continued to stall through the first three months of 2015 and a long delayed VAT appears to have been further delayed. Afghanistan likely faces a financing gap in 2015 that is as large as last year, against the backdrop of a weaker cash position. This would thus require additional discretionary assistance and expenditure prioritization to mitigate impact on development outcomes. In the medium term, contingent on improvements in tax and customs administration and additional tax measures, revenues are projected to improve from 8.4 percent of GDP in 2014 to 11.6 percent by 2018. The natural resources sector also has the potential to contribute to revenues in the medium term, but the timeline for this has become more uncertain in light of weak progress in recent years. While the projected increase in revenues is ambitious, it will still leave Afghanistan with an unfinanced fiscal gap of about 2 percent of GDP during 2015-18 (in excess of the 20 percent of GDP gap already financed by existing commitments during this period). If additional resources are not forthcoming to cover this gap, a more aggressive expenditure austerity path would result, which would compromise development prospects and social outcomes as Afghanistan struggles to restore stability. Budget expenditures are projected to rise, with higher security and social benefit spending, so that more aggressive austerity would squeeze essential development spending. Total budget expenditures are projected to rise from 26 percent of GDP in 2014 to 30 percent in 2016. This increase is largely a result of more security and development spending moving on budget from previously being undertaken directly by donors. Afghanistan has considerable public expenditure needs in the areas of security, service delivery, building essential infrastructure, and operations and maintenance (O&M). For example, delivering on goals to improve education outcomes will require hiring increasing numbers of teachers. Prioritizing these 20 P a g e

expenditure needs within the limited resource envelope will be critical to maintaining a pro-development stance. With social benefits for martyrs and disabled increasing significantly in 2014, the authorities will need to limit any further increases going forward. Although more detailed analysis of public expenditures in needed, there appears to be limited space to adjust expenditures without adversely affecting growth prospects and social outcomes. In light of mandatory increases in security spending, a more aggressive expenditure consolidation path would directly squeeze essential civilian operating and development spending. The resulting financing needs of the budget are, therefore, likely to remain substantial for the foreseeable future. Moreover, channeling a greater share of development assistance through on-budget expenditures is expected to enhance the medium term economic impact. Donors have committed to considerable assistance for Afghanistan contingent on satisfactory reform progress, although an acceleration of reforms and additional resources will be needed in light of recent developments. At the December 2014 London Conference, the international community reaffirmed its Tokyo commitment of providing $16 billion in development assistance for Afghanistan over 2012-15, sustaining support through 2017 at or near the levels of the past decade, and providing continuing but declining support through the Transformation Decade. These funds, contingent on satisfactory reform progress under the Tokyo Mutual Accountability Framework (TMAF), would allow Afghanistan to progress toward sustainability and its development and infrastructure targets. Together with earlier pledges on the security side, this means annual aid of about $8 billion roughly equally divided between civil and security aid. In light of the recent fiscal crisis, returning to a path of sustainability will require an acceleration of reforms as well as additional on-budget assistance. Domestic revenue is an important indicator in the TMAF, so that any additional resources will require a clear turnaround in revenue performance by broadening the tax base, strengthening enforcement, fostering private sector development, and developing the mining sector. Afghanistan may also need to explore its options on security expenditures: current projections are based on a drawdown in ANSF personnel size from 352,000 to 228,000 between 2015 and 2017, although security experts indicate that this drawdown is no longer likely to take place within that timeframe. 3. Structural Policies for the Immediate and Medium Term Afghanistan faces the dual challenge of restoring confidence in its economic prospects and addressing formidable medium term development challenges. Growth has stalled and a deteriorating fiscal crisis has emerged. In addition, medium term development challenges are formidable in the areas of aid dependence, job creation for 400,000 new entrants into the labor force each year, high and persistent poverty, low levels of human development and female labor force participation, and high levels of corruption. Furthermore, fragility and conflict remain pervasive and undermine economic prospects as well as social cohesion and stability. Addressing these challenges will require reforms from the new government of Afghanistan in three areas: (i) restoring fiscal stability; (ii) restoring confidence and creating privatesector jobs; and (iii) strengthening social cohesion and service delivery. Above all, high level commitment to tackle corruption and strengthen governance across the board will be critical to delivering on the success of reforms in these priority areas. The new government articulated its development vision and a bold reform program through its paper Realizing Self Reliance: Commitments to Reforms and Renewed Partnership presented at the London Conference on Afghanistan in December 2014. The paper presents the government s plans for 21 P a g e