Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 28192-AF

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR

A PROPOSED CREDIT IN THE AMOUNT OF SDR 54.7 MILLION

(US$SO MILLION EQUIVALENT)

TO

THE ISLAMIC REPUBLIC OF AFGHANISTAN

FOR

PROGRAMMATIC SUPPORT FOR INSTITUTION BUILDING

July 6,2004

Poverty Reduct ion and Economic Management South As ia Region

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. I t s contents may not be otherwise disclosed without Bank Authorization.

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ADB AFMIS

AHRC AIA AIAF

AISA ANA ARTF ASP ATA BPHS C A O C G cso DAB DABM D C A DDR

EPAP

GDP GOA IAB IARCSC

IDA IDP IMF ISAF

Vice President: Praful Pate1

Sector Director: Sadiq Ahmed Sector Manager: Kapi l Kapoor

Country Director: Alastair McKechnie

Country Managers: Wi l l iam Byrd, Jean Mazurelle 1

CURRENCY EQUIVALENT (as o f June 30,2004)

Currency Unit: Afghani US$1 = "48.3

GOVERNMENT FISCAL YEAR March 21 - March 20

ABBREVIATIONS AND ACRONYMS

Asian Development Bank Afghanistan Financial Management Information System Afghanistan Human Rights Commission Afghanistan Interim Administration Afghanistan Interim Administration Fund Afghanistan Investment Support Agency Afghan National Army Afghanistan Reconstruction Trust Fund Afghanistan Stabilization Program Afghanistan Transitional Administration Basic Package o f Health Services Controller and Audit Office Consultative Group Central Statistics Office D a Afghanistan Bank D a Afganistan Brishna Moassesa Development Credit Agreement Disarmament, Demobilization, and Reintegration Emergency Public Administration Project Gross Domestic Product Government o f Afghanistan Independent Appointments Board Independent Administrative Reform and C iv i l Service Commission International Development Association Internally Displaced Person International Monetary Fund International Security Assistance Force

L D P M C A T M o E M o F M o H M o J M P W MRRD

M W P NDB NDF NEEP NGO NPP NSP PFEM P M U PPA PRR PSIB PTA SMP SOE TA TISA TSA TSS UN UNDP UNHCR

Letter o f Development Policy Ministry o f Civ i l Aviation and Tourism Ministry o f Education Ministry o f Finance Ministry o f Health Ministry o f Justice Ministry o f Public Works Ministry o f Rural Rehabilitation and Development Ministry o f Water and Power National Development Budget National Development Framework National Emergency Employment Program N o n Govemmental Organization National Priority Program National Solidarity Program Public Finance and Expenditure Management Program Management Unit Performance-based Partnership Agreement Priority Reform and Restructuring Programmatic Support for Institution Building Parents-Teachers Association Staff-Monitored Program State-Owned Enterprises Technical Assistance Transitional Islamic State o f Afghanistan Treasury Single Account Transitional Support Strategy United Nations United Nations Development Program United Nations High Commission for Refugees

.. 11

FOR OF’FICLAL USE ONLY AFGHANISTAN: PROGRAM DOCUMENT

PROGRAMMATIC SUPPORT FOR INSTITUTION BUILDING

TABLE OF CONTENTS I. INTRODUCTION ........................................................................... ; ..................................... 1 II. AFGHANISTAN’S DEVELOPMENT: BACKGROUND, ACHIEVEMENTS, AND PROSPECTS .................................................................................................................................. 1

A. Background ......................................................................................................................... 1 B. Achievements .........................................................................................................

................................... 111. AFGHANISTAN’S DEVELOPMENT STRATEGY ........................................................ 9

Promoting Secur i ty and Rule of Law ................................................................................. 9 Maintaining Macroeconomic Stability ............................................................................. 10 Strengthening Fiscal Management and Public Administration .............................

A. B. C. D. Enhancing Human Development E. Promoting Private Sector Development ..................... 17

IV. BANK’S ASSISTANCE TO AFGHANISTAN ................................................................ 21 A. Investment Lending .......................................................................................................... 22 B. C. Coordination with Other Donors. ...................... 23

THE PROPOSED CREDIT ............................................................................................... 24

Analytical and Advisory Services ..................................................................................... 23

V.

A. B. C. D. E. F. G. H. I.

Reform Areas Supported by the Credits ........ Country Ownership .......................................................... 25 Prior Actions for PSIB I ........................... Triggers for PSIB I1 .......................................................................................................... 29 Monitoring and Evaluation ................................................... ...................

Poverty Implications ............................................................... 33

...................................

Credit Administration Coordination with the IMF and Other Donors .................................................................. 32

Benefits and Risks 33 ..................................................................

LIST OF TABLES

Table 1 : Macroeconomic Indicators .................................................................................... Table 2: Medium-Term Fiscal Financing Requirements, 200 1102-2006107

Table 4: Summary o f Key Achievements, Prior Actions for PSIB I and Outcomes

3 ............................... 8 ............................. 24 Table 3: Consultative Groups ......................................................................

LIST OF AILnEXES

Annex 1 : Policy Matrix: Reform Program, Prior Actions, Triggers, and Outcomes Annex 2: Relations with the Intemational Monetary Fund Annex 3: Letter o f Development Policy Annex 4: Progress in Reducing Fiduciary Risks Annex 5: Review o f 2004105 Budget Annex 6: Monitoring and Evaluation Annex 7 : Statistical Indicators

... 111

This document has a restricted distribution and m a y be used by recipients only in the performance of their official duties. I t s contents may n o t be otherwise disclosed without W o r l d Bank authorization. __

Task Team

Mano j Agrawal C h s t i n e Allison N a w a f Al-Mahamel Craig Andrews Phil ippe Auf f re t Kathleen Bannon Richard Beardmore Christophe Bosch Asger Christensen Amer Durrani Julia Fraser Soraya Goga StCphane Guimbert Rajneesh Gupta Q u a m 1 Hasan Carol L e D u c Benjamin Loevinsohn Syed Mahmood Samuel Ma imbo N i c k Mann ing Peter Middlebrook Subhash M i t t a l Ke iko M i w a Suzanne Mor r i s Akm Oduolowu Asta Olesen Satyendra Prasad V ik ram Raghavan Arlene Reyes

Ra j Nal lar i Zmarak Shalizi Andrew Wilder L inda V a n Gelder

Financial Management Specialist, S A R F M Lead Human Development Specialist, S A S H D Legal Counsel, L E G M S Lead Mining Specialist, COCPD Senior Economist, Task Team Leader, SASPR Senior Editor, ISGIS Senior Urban Specialist, SASEI Water and Sanitation Economist, SASES Senior Operations Officer, SASRD Senior H ighway Engineer, SASEI Senior Financial Analyst, SASEI Urban Specialist, TUDUR Economist, Co-Task Team Leader, SASPR Procurement Specialist, SASPS Procurement Specialist, S A R P S Senior Social Development Specialist, SASES Senior Public Health Specialist, S A S H D Senior Private Sector Development Specialist, SASFP Financial Sector Specialist, SASFP Lead Public Sector Specialist, SASPR Budget and Public Expenditures Specialist, SASPR Consultant, S A R F M Education Specialist, SASHD Senior Finance Officer, LOAG2 Lead Energy Specialist, ECSIE Senior Social Development Specialist, SASES Public Sector Specialist, SASPR Legal Counsel, L E G M S Program Assistant, SASPR

Peer Reviewers

Lead Specialist, WBIPR Senior Manager, DECRG Director, Afghanistan Research and Evaluation Unit Senior Economist, PRMPR

iv

AFGHANISTAN: PROGRAM DOCUMENT PROGRAMMATIC SUPPORT FOR INSTITUTION BUILDING

Borrower:

Implementing Agency:

Amount:

Terms:

Objective and Description:

Disbursement:

Credit Summary

Islamic Republic o f Afghanistan

Ministry o f Finance (MoF)

SDR 54.7 mi l l ion (US$80 mi l l ion equivalent)

Standard IDA terms: 40-year maturity with a 10-year grace period

The Credit o f SDR 54.7 mi l l ion (USSSO mi l l ion equivalent) i s the f i rs t o f a series o f operations aimed at supporting the implementation o f the Government o f Afghanistan’s (GOA) medium-term development strategy within the context o f a secure environment and a satisfactory macroeconomic framework. The Government’s development program, init ially formulated in the National Development Framework o f April 2002, has been reaffirmed through the 2003/04 and 2004105 National Development Budgets and the document Securing Afghanistan ’s Future presented by the Transitional Islamic State o f Afghanistan (TISA) to the international community at the donors’ conference held in Berl in in March 2004. The operations outlined here take the form o f Programmatic Support for Institution Building of which the current Credit (PSIB I) i s the f irst. They wil l provide rol l ing support to the Government’s development strategy with each operation specifying a set o f triggers which, when met, provide the basis for proceeding with the next operation.

The overall objective o f this operation i s to deepen, broaden and sustain the reforms underway in the areas o f public administration and fiscal management. The operation builds on the reforms initiated under IDA’S Emergency Public Administration Projects (EPAP) to improve GOA’S own fiduciary standards. Deepening and broadening these reforms i s critical for poverty reduction assistance to be effective. The operation supports on-going reforms to strengthen the budget process, increase the administrative capacity o f l ine ministries and sub-national governments, develop revenue policy and administration, and improve c iv i l service effectiveness.

The operation also supports the implementation o f reforms that lead to a more efficient allocation o f fiscal resources in the areas o f human development (health, basic education and social protection) and private sector development (investment climate, financial sector, and state-owned enterprises). More comprehensive, thematic reforms in human and private sector development wi l l require support through other instruments, including sectoral operations and technical assistance.

The proposed f i rs t Credit would be released in one tranche upon Credit effectiveness. All performance conditions would be met prior to Board presentation.

V

Benefits:

Risks:

The Credits provide potential benefits which wi l l all contribute to poverty reduction. First, they strengthen public administration and fiscal management, and support reforms to improve fiduciary standards. This will reduce the implementation r isks o f all projects including these Credits, and i s l ikely to translate into higher levels o f donors’ assistance. Second, they provide resources to the central Govemment to deepen i t s reform program including service delivery beyond Kabul. This will benefit the whole population including the poor. Third, they also support the implementation o f reforms leading to a more efficient allocation o f fiscal resources in the areas o f human development and private sector development, which wi l l reduce poverty. The Credits have significant country r isks (political, security and macroeconomics) and implementation r isks (fiduciary, budget execution and the implementation o f reforms). A reversal in the polit ical process set out in the December 2001 Bonn agreements or a deterioration o f the security situation constitutes the largest source o f risk for the operations. The recent conclusion o f the Constitutional Loya Jirga has somewhat reduced this risk, but the elections, currently scheduled for the fall o f 2004, remain a significant source o f uncertainty. The macroeconomic scenario i s also uncertain since donors’ assistance and the response o f the private sector are highly dependent on the political and security situation. The mitigation o f these country r isks i s largely outside the scope o f the project. However, the Credits will allow the Government to deepen the implementation o f i t s program beyond Kabul, which will contribute to the nation-building effort and will somewhat mitigate polit ical and security risks. Strengthening the Central Government could increase tensions with regional leaders, which could slow down the nation-building process. The Credits also have implementation risks. First, fiduciary standards, while improving, partially as the result o f this Credit, are not yet fully effective. Budgetary systems and mechanisms, including tax administration and collection, are s t i l l at a formative stage. Second, there i s room for improvement in the execution o f the Budget, and implementing the reform program may be a challenge during an election year. To mitigate the r isks o f implementation, prior actions and triggers focus on areas for which the authorities, under the leadership o f the MoF, have expressed ownership and have built a good track record o f reforms. Continued Intemational Development Association (IDA) support through the Emergency Public Administration Projects, together with the next Credit’s triggers, in the areas o f financial management, audit and procurement, wi l l also contribute to raising fiduciary standards. The risk o f not undertakmg these operations also i s significant. First, IDA’S support to the Government o f Afghanistan’s development strategy under the form o f PSIBs i s seen as a catalyst for other donors’ continuing support, including through the Afghanistan Reconstruction Trust Fund (ARTF). Second, the resources provided by the PSIBs wil l allow the authorities to deepen the reform program and quickly deliver services throughout the country, thereby reducing the risk o f further deterioration o f the polit ical and security situations.

Project ID Number: PO78618

vi

AFGHANISTAN: PROGRAM DOCUMENT PROGRAMMATIC SUPPORT FOR INSTITUTION BUILDING

I. INTRODUCTION

1. This document constitutes the Program Document for a proposed f i rs t Programmatic Support for Institution Building (PSIB I) to the Islamic Republic o f Afghanistan (IRA) o f SDR 54.7 mi l l ion (US$SO mi l l ion equivalent). I t i s the first o f a series o f PSIBs aimed at supporting the implementation o f the Government o f Afghanistan’s (GOA) medium-term development strategy within the context o f a secure environment and a satisfactory macroeconomic framework. In i t ia l ly formulated in the National Development Framework PDF) o f April 2002, GoA’s development strategy was reaffirmed through the 2003104 and 2004/05 National Development Budgets (NDB) and the document Securing Afghanistan ’s Future presented by the TISA to the international community at the donors’ conference held in Berl in in March 2004.’ The Credits will provide rol l ing support to the Govemment’s development strategy with each operation specifying a set o f triggers which, when met, provide the basis for proceeding with the next operation. T h e overall objective o f these Credits i s to deepen, broaden and sustain the reforms underway in the areas o f public administration and fiscal management. The implementation o f these reforms will in turn facilitate a more efficient allocation o f fiscal resources to priority activities in the areas o f human development and private sector development. PSIB I i s a one-tranche operation based on prior actions. The Country Assistance Strategy (CAS) related to this operation i s provided in the Transitional Support Strategy (TSS) o f the Wor ld Bank Group for Afghanistan (IDAR-2003-0022) discussed at the Board in April 2003.

2. The Program Document i s structured as follows. Section I1 provides background about Afghanistan’s at the end o f the Taliban regime in late 200 1, the achievements to date, and future prospects. Section I11 presents the GoA’s development strategy. Section N describes the Bank‘s assistance to Afghanistan and Bank’s coordination with other donors. Section V describes the proposed Credit including the reform areas to be supported by the Credits, the prior actions before Board presentation for PSIB I, and the triggers for PSIB 11.

11. AFGHANISTAN’S DEVELOPMENT: BACKGROUND, ACHIEVEMENTS, AND PROSPECTS

A. Background

3. The starting point for Afghanistan’s reconstruction at the end o f 2001 was unusually dire. After two decades o f conflict, interspersed with earthquakes and droughts, the new Afghan authorities confronted their task with largely defunct Government and financial institutions, weak administrative capacity, and widespread destruction o f the country’s infrastructure. Most social services and Government systems had been brought to a complete standstill. A legacy o f poor administration and lack o f human capital investment over the last twenty years had left Afghanistan with an aging c i v i l service whose sk i l l s and abilities had depreciated over time. Afghanistan’s formal financial sector was non-operational. Commercial banks were dysfunctional, lacking basic management systems, procedures, controls and s l l l e d personnel. By the end o f 2001, the conflict had resulted in the (i) disruption o f domestic and international payment systems, (ii) cessation o f formal lending within the country, (iii) cessation o f institutional deposit-taking activities, and (iv) stoppage o f most international banking

‘ See http:!!www.afirecosting!

1

relationships, particularly when the Taliban Govemment was subjected to intemational sanctions and offshore bank accounts were frozen. Afghanistan's central bank - D a Afghanistan Bank (DAB) - n o longer had the infrastructure, staff and resources to perform conventional central banking functions. In the absence o f a formal banking system, a large and vibrant informal market - referred to as hawala - which includes a domestic and intemational payment system has developed, largely organized around the money exchange dealers o f Kabul. There had also been very significant damage to infrastructure, especially to the power system, roads, telecommunications, and the stock o f private housing. Traditional irrigation systems had greatly suffered f rom destruction and lack o f maintenance. Agnculture production had collapsed, livestock herds had been depleted, and industries had ceased functioning while most slulled professionals had fled the country.

4. By the end o f 2001, Govemment services, including health care and education, had essentially stopped functioning, resulting in a dramatic decline in social indicators, particularly affecting women. In 1996, Afghanistan ranked 169" out o f 174 countries in the United Nations' (UN) Human Development Index and conditions deteriorated further in the following years. Under the Taliban, schools were religious institutions and attendance was extremely l o w while girls were barred from attending schools. Women were excluded from political and economic l i fe . The health situation was grim. Infant and under-five mortality as well as maternal mortality were estimated to be among the highest in the world and malnutntion affected about 50 percent o f children under age five. The average l i fe expectancy was l i t t l e more than 40 years.

B. Achievements

5. The Bonn process. After more than 20 years o f conflict, a new opportunity for the peaceful development of Afghanistan emerged with the fall o f the Taliban regime in late 2001. The political agreement reached between the various Afghan factions in Bonn in December 2001 provided a road map for the creation o f a peaceful and democratic state. An Afghanistan Interim Administration (AIA) was appointed and governed for six months until an Emergency Loya Jirga (Grand Council) was convened in June 2002 to elect a new Afghanistan Transitional Administration (ATA), headed by President Karzai, to remain in office for about two years. The ATA was charged with preparing a new Constitution and organizing free and fair elections to elect a fully representative Govemment. A Constitution Drafting Commission was created in late 2002 to draft the new Constitution, and a Constitution Commission was established in April 2003 to seek opinions of the Afghan population. On the basis o f this broad consultation, a draft Constitution was submitted to a Constitutional Loya Jirga in mid-December 2003. Eventually, Afghanistan's f i rs t Constitution in three decades was ratified on January 26, 2004. The UN i s working closely with the Afghan authorities to prepare for the Presidential and Parliamentary elections to be held towards the end o f the year, possibly during the fall o f 2004.

6. Following the fall o f the Taliban, a retum movement began among Afghan refugees, mainly living in the neighboring countries o f Pakistan and Iran. At the beginning o f 2002, an estimated 5.9 mi l l ion Afghans l ived outside the country and one mi l l ion Intemally Displaced Persons (IDPs) l ived inside Afghanistan making one in every three Afghans a refugee or an IDP. According to UNHCR, within two years, 2.5 mi l l ion Afghans have retumed to their home country while within Afghanistan, an additional 600,000 IDPs have moved back to their areas o f origin.

7. Security and rule of law. Actions were taken to establish security and the rule o f law. Achievements include (i) the inauguration o f an Afghan National Army (ANA) and police force, (ii) the commencement o f major reform in the Ministry o f Defense, (iii) the implementation o f a Disarmament, Demobilization, and Reintegration (DDR) program, (iv) the formulation o f a National Drug Control Strategy in M a y 2003, (v) the initiation o f a comprehensive review o f the

Refugee return.

2

country’s judicial infrastructure, (vi) the establishment o f the Afghanistan Human Rights Commission (AHRC), and (viii) steady progress in de-mining.

8. Growth. Although the dearth o f economic statistics makes i t diff icult to assess the state o f the economy, available indicators show strong signs o f recovery, albeit fi-om very l o w levels o f activity. Fol lowing an economic growth o f 30 percent in 2002, estimates indicate that real Gross Domestic Product (GDP) growth remained strong at 23 percent in 2003 (Table 1). The economic recovery reflects the end o f hostilities and i s driven by sizable donor assistance, sound economic policies, and the end o f a prolonged drought. The impact o f economic recovery i s most visible in services and construction; which are expanding rapidly in urban centers. Agricultural production rose sharply, benefiting from increased rainfall and expanded acreage under cultivation. GDP (excluding opium production) reached US$4.8 b i l l ion in 2003, equivalent to around US$200 per capita.

9 . Macroeconomic stability. Under the leadership o f the Governor o f the Central Bank and his team, a new currency was launched in late 2002. Since the completion o f this operation, whose feasibility the international organizations had viewed with skepticism, the exchange rate has been stable and inflation has been brought under control. Monetary policy has been restrained, supported by the adherence to strong fiscal discipline and a “no overdraft” rule that prohibits Central Bank financing o f the deficit.

Table 1: Macroeconomic Indicators

2001102 2002103 2003104 2004105 2005/06 2006107 Estimates Estimates Estimates Projections

A. Output GDP (US$ million, excluding opium production) 2,463 4,048 4,762 5,731 6,737 7,832 GDP (millions of new Afghani) 133,987 181,350 230,962 277,950 326,869 380,966

GDP per capita (US$) 123 186 207 243 277 313 Real GDP growth rate (%) ... 29 23 15 12 11

Opium production (metric tons) 185 3,400 3,600 ... ... ... Opium value (US$ million) ... 2,540 2,320 ... ... ... B. prices CPI (Kabul, % change from beginning to end period) -43.4 52.3 10.3 5.0 5.0 5.0 C. Exchange rates AfghaniitJS$ (period average) 54.4 44.8 49.0 ... ... ... AfghaniRiS$ (period end) 31.0 52.6 50.3 ... ... D. Monetary indicators Domestic currency in circulation (annual percentage change) ... 20.1 40.9 26.4 ... ... Gross foreign exchange reserves (US$ million) ... 426 819.5 883.6 943.6 993.6 Source: IMF.

...

10. Donor-led humanitarian relief and immediate reconstruction. Donors init ially focused on providing immediate humanitarian rel ief to vulnerable Afghan people and ensuring regular payment o f c iv i l service salaries. In the first few months o f the AIA, the international community and especially the UN system was closely involved in these efforts as the machinery o f Government had not yet recovered enough to fully lead the recovery process. The Asian Development Bank (ADB), IDA, and the United Nations Development Program (UNDP) conducted a preliminary needs assessment in January 2002, estimating the cost o f Afghanistan’s reconstruction at US$15 bi l l ion over the next ten years. Based o n this preliminary needs assessment, the UN developed a set o f emergency programs to deal with the ongoing humanitarian crisis. These programs, covering the period f rom October 2001 to December 2002, were financed by US$1.1 b i l l ion fi-om donor countries and mostly focused o n (i) the return and reintegration o f refugees and internally displaced people, (ii) food assistance, (iii) rehabilitation o f crop production, (iv) child immunization, and (v) improvement o f school enrollment. Similarly, in the f i rs t six months o f the AIA (January to June 2002), payrolls o f the c iv i l service both at the center and in the provinces were processed, controlled, recorded, and financed through a specific fund, the Afghanistan Interim Administration Fund (AIAF), set up and administered by the

3

UNDP. performed, f rom the outset, by the line-ministries and MoF’s Treasury.

1 1. Zncreasing Government ownership and accountability for development strategy. Under the leadership o f the Ministry o f Finance, the authorities progressively took the lead in the formulation o f Afghanistan’s development strategy. In April 2002, they formulated a comprehensive development strategy, the NDF, which outlined a strong agenda to rebuild institutions and implement structural reforms within a stable macroeconomic framework.’ The NDF, which was prepared through an extensive consultative process, was also a significant step taken by the Government to move away from a mostly donor-driven strategy to a tmly Govemment-led reconstruction process. The NDF provides a framework to coordinate the Govemment’s policies and donors’ assistance, and to prepare the NDB. Although the Government acknowledged from the outset that a number o f reconstruction projects would be directly implemented by donors and N o n Governmental Organizations (NGOs), without the corresponding funds being channeled through the MoF, the authorities insisted that al l development projects should be approved in the budget, as determined by the Cabinet. The NDF was endorsed by the Wor ld Bank.

12. The report Securing Afghanistan’s Future i s a revised needs assessment based on the NDF which was recently presented at the donors’ conference held in Berlin in March 2004. I t furlher enhances and underpins the Government’s development strategy as formulated in the NDF. I t also reassesses Afghanistan’s development needs to US$28 bi l l ion to cover the 7-year period 2004-10. The strategy outlined in Securing Afghanistan s Future was also endorsed by the World Bank.

13. Budget process. Under the leadership o f the Ministry o f Finance, the budget progressively became the main tool to implement the NDF and coordinate donors’ assistance. The Government budget consists o f an operating budget, which covers current expenditures and some capital expenditures aimed at quick repairs, and a development budget covering reconstruction projects and some donor-funded recurrent costs. The f i rs t operating budget (2002/03) was a f i r s t attempt at prioritizing operating expenditures under the constraint o f l imited external assistance, setting up clear benchmarks for domestic revenue collection and establishing the Govemment’s macroeconomic credibility. The bulk o f expenditures was on wages and salaries (including in the provinces), while the rest was mostly on office refurbishment and basic equipment. The actual provision o f public services was quite limited, especially outside Kabul. After a slow start, i t s execution accelerated in l ine with the development o f administrative capacity at the M o F and faster disbursements o f donor financing. Domestic revenues at US$163 mi l l ion were higher than expected (Table 2), in part reflecting exceptional revenues such as telecom licenses. The financing requirement was largely met by donor grants. However, the budget execution was hampered by the fiscal systems’ lack o f cohesion. Only a very small amount o f the revenues collected by provinces was transferred to the center. Also, n o reliable information was available on provincial non-wage expenditures. In fact, very litt le o f the extemal assistance disbursed in 2002103 went through the Treasury, reflecting largely the Govemment’s s t i l l very limited administrative capacity, particularly in line ministries.

14. The 2003104 operating budget envisaged expenditures at US$550 mi l l ion (11 percent o f non-opium GDP), with domestic revenues were expected to reach US$200 mill ion. I t reflects the enormous needs in the security, health, and education sectors, and the slow but steady increase in the Govemment’s capacity to provide public services. The 2003/04 NDB, structured around a public investment program, consisted o f a l i s t o f projects amounting to USSl.8 bi l l ion consistent with the strategic priorities expressed in the NDF, to be implemented as funding becomes available. Estimates suggest that ordinary budget expenditures in 2003/04 were around US$457

However, the preparation o f the payroll and the actual payment o f salaries were

* National Development Framework. April 2002. pp. 6-7

4

mil l ion o f which US$208 mi l l ion were financed from domestic resources. Disbursements against the NDB were approximately US$2.4 billion.

15. As the Government currently starts i t s third budget cycle (2004/05), the level o f technical sophistication and understanding has increased, and the budgets have become more comprehensive and prescriptive. T h e budgets are used more substantively to allocate funds to the Government’s highest priorities. The budget process i s also playing a major role in defining the structure o f the Government and i s the catalyst that i s forcing the discussion o f major policy and institutional issues. In addition, the Government released in June 2004 a comprehensive financial report on how the resources available to the Govemment since 2002 had been utilized.

16. Fiscal management. Improvements have also been made in budget execution and treasury functions. T h e Government has implemented a centralized computerized system, the Afghanistan Financial Management Information System (AFMIS) to issue checks and record revenues and expenditures o f the ordinary and development budgets. Parallel improvements have been made in the DAB payment systems. The ARTF has set fiduciary standards for the Govemment to be reimbursed and, over time, the Government has been improving i t s performance relative to these standards. Under IDA’S Emergency Public Administration Projects (EPAPs), significant efforts have been made to improve financial management, Government procurement, and audit, and build local capacities to hand over these functions to Afghan nationals as soon as possible. T h e Treasury has instructed provinces to open a single revenue account, which ensures that all collected revenues are periodically swept to the Treasury Single Account (TSA) at DAB. Provinces also have a single expenditure bank account, and reports and reconciliations on this account have improved markedly. Also, the Government has several times reiterated publicly i t s commitment to fiscal transparency.

17. Public administration. As a component o f the NDF, the authorities designed and started to implement a Public Administration Reform (PAR) program to strengthen public administration. The size of the c iv i l service was kept under control while its efficiency was increased. In July 2003, the Government enacted the Priority Reform and Restructuring (PRX) program to reform the most critical functions o f Government by allowing administrative departments to place staff on an elevated pay scale in exchange for organizational restructuring. In some ministries, an integrated approach combining the best available resources from the existing Government staff, senior transfers f rom outside Government (particularly f rom the N G O community), and international expertise has resulted in a significant improvement in service delivery.

18. Human development. Since the fal l o f the Taliban regime, school enrollment has continuously increased: more than 3 mi l l ion students were enrolled in Grade 1-12 in 2002, and 4.3 mi l l ion in 2003, o f which 3.9 mi l l ion were in primary schools. Progress has also been made in health. A massive vaccination program led to a reduction in confirmed pol io cases. A measles mortality reduction campaign was conducted and reached more than 90 percent o f children 6 months to 12 years o f age, and iodized salt has been provided to 300,000 malnourished women and children. Three main programs were introduced to provide a basic safety net and reduce poverty: (i) the National Emergency Employment Program (NEEP) which i s a cash-for-work program to rehabilitate rural infrastructure, (ii) the National Solidarity Program (NSP) which provides block grants for community managed small-scale reconstruction and development projects in rural areas, and (iii) the Comprehensive Disabled Afghan’s Program which delivers services to disabled and heirs o f martyred persons and transfers payments to around 300,000 disabled people and members o f martyr families. The new Constitution provides the legal basis for women to participate in political and economic affairs. There i s also a pension system for c iv i l servants which makes l o w pension payments to about 50,000 pensioners.

19. Fimmcial sector. Afghanistan’s formal financial system has been revived. N e w legislation (DAB L a w and Banking Law) was adopted in the summer o f 2003 to grant the Central Bank independence and establish the basis for a modem legal framework for a two-tier banking

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system. A number o f banks have since been licensed based on standards consistent with the new legal framework. Also, progress has been made in rebuilding the D A B .

20. The authorities have taken initial steps to support the development o f the private sector, including: (i) enactment o f the L a w on Domestic and Foreign Investment (September 2002); (ii) establishment o f the Afghanistan Investment Support Agency (AISA), a single-window clearance and advice center for domestic and foreign investors (August 2003); (iii) allowance o f private investment into the telecommunication sector, and (iv) initiation of institutional restructuring process in the Ministry o f Commerce. AISA has registered new investment projects amounting to US$435 mi l l ion from September 2003 to March 2004.

Private sector development.

C. Prospects

21. Despite the impressive economic recovery and the forceful implementation o f a development strategy based on sound economic fundamentals, the development challenges are enormous and much remains to be done. The remaining o f this section outlines a medium-term framework fully consistent with the IMF Staff-Monitored Program (SMP), which covers the fiscal year 2004105.

22. Security. The security situation remains precarious and significant expansion and acceleration o f security sector reforms are necessary. While progress has been made in rebuilding state institutions and stimulating economic growth in Kabul and some other cities, adverse security conditions have prevented such progress in other areas, particularly rural areas in the South and along the border with Pakistan. As a result, the reconstruction process has been fragmented and the pace reduced. In part due to security constraints, the GOA has met with difficulties imposing i ts presence in the countryside and exerting countrywide leadership. For the authorities, “security IS the number one issue and constraint for Afghanistan’s reconstruction. Without an adequate level o f security, the country will fa i l to achieve key national goals for economic growth, political normalization and national reconciliation, reconstruction, and social development. No t only would Afghanistan fai l to develop, but in the absence o f adequate security recent progress on al l these fronts will be reversed, and resumption o f large-scale conflict would become more l i k e l ~ . ” ~ Reforms are moving ahead as evidenced by the building up o f the Afghan National Army, the creation o f Provincial Reconstruction Teams in the provinces and the expansion o f the NATO-led International Security Assistance Force (ISAF), but recent incidents highlight increased tensions in the run-up to the elections.

23. Drug economy. W h i l e the formal economy i s recovering, so i s the production o f opium. In 2002, opium production was estimated by the United Nations Office on Drugs and Crime (UNODC) to have reached 3,400 tons, a level similar to that o f the late 1990s. Production in 2003 increased further to an estimated 3,600 tons, equivalent to about ha l f o f non-drug GDP. The drug economy has a profound negative impact o n security and ru le o f law and increases political instability. In Berlin in March 2004, the authorities made strong statements opposing opium production and outlined a strategy to interdict drug trafficking.

24. Maintaining a strong level o f economic growth i s an important challenge. Growth and security are mutually dependent. On one side, future economic growth i s highly dependent on current investments, which, in tum, depend on the security situation. As a result, maintaining security i s the main prerequisite for economic growth. O n the other side, continued growth and job creation i s likely to tip sentiment in favor o f progress thereby strengthening security. Economic growth i s also highly dependent on the performance o f the agricultural sector as agriculture accounts for ha l f o f non-opium GDP. A significant proportion o f the economic growth observed in the past two years directly relates to the recovery f rom conflict and drought.

Growth.

Securing Afghanistan Future. Govemment o f Afghanistan. March 2004. p. 71

6

Beyond this level, sustained agricultural growth will require productivity gains fkom adoption o f available technologies, rehabilitation o f imgation and investments in rural roads for better access to input and output markets. I t i s also critical to generate broad-based growth that includes the industry and service sectors.

25. Provided the authorities make progress in ensuring security and maintaining macroeconomic stability while making continued progress in implementing the NDF, economic prospects are good in the medium term. According to the Central Statistics Office (CSO), real GDP i s expected to grow by an average o f 12 percent per annum during the period 2004-06. The three major sources o f growth are expected to be in the sectors directly benefiting f rom the reconstruction effort (construction, Government and other services), the end o f the conflict (trade and small services) and the end o f four years o f drought (agnculture).

26. Human development. Despite recent achievements, Afghanistan s t i l l ranks poorly on all health indicators. The majority o f children are stunted. Infant mortality (165 per thousand l ive births), maternal health and immunization coverage at about 30 percent are o f particular concern. Access to basic health services i s s t i l l very limited particularly in rural areas. Routine immunization coverage (Diphtheria, Tetanus, Pertussis - DTP3) i s estimated to be at most 30 percent. Forty percent o f existing health facilities do not have female staff, which implies that women are very unlikely to use those facilities. In addition, large numbers o f orphans, female headed households and handicapped remain outside the social safety net. Despite progress, access to education i s also s t i l l limited. Short-term measures such as using tents as learning space and opening up second and third shifts in schools have been adopted but the overall quality o f education remains low. Whi le n o output indicators are yet available, a l l input indicators indicate a poor quality o f education. There remains stark provincial and gender disparities. In 2003, while net enrollment ratio in major cit ies i s as high as 80 percent, i t i s only 47 percent in rural areas. Nationally, female net enrollment ratio i s 40 percent while that o f boys i s 67 percent. Net enrollment ratio for girls remains as l o w as one percent in some provinces. In spite o f significant budget funding for the Livelihoods and Social Protection program (US$170 mi l l ion excluding food aid in 2003/04), the coverage o f the existing social protection programs i s l o w while their impacts remain un-assessed.

27. Revenue mobilization. Beyond their init ial focus on improving financial management, the authorities are now focusing on increasing domestic revenues. Domestic revenues are expected to increase to U S 3 0 9 mi l l ion in 2004/05 (Table 2). T o achieve this, the authorities have recently introduced an ambitious tax package that includes new customs tariffs and amendments to the Income Tax L a w which eliminate tax holidays. The authorities are also takmg measures to strengthen tax administration, with the objective to increase in compliance by 40 percent over the next three years and continue enforcing the ru les regarding full remittance o f all revenues to the TSA. A five-year plan to modernize customs has been developed, aiming at improving revenue collection while facilitating trade. I t includes facilitating the transfer o f customs revenues to the central treasury, improving customs infrastructure, re-organizing and re-building the capacity o f central and regional customs offices, building a comprehensive legal fiamework for customs, improving clearance times, and establishing effective enforcement controls. A five-year plan to modernize tax administration was also developed. A Large Taxpayer Office i s being established in the MoF to administer the taxation o f the largest taxpayers in the country. Similar offices will then be created to manage medium-size taxpayers in selected Provinces.

28. Expenditures. Ordinary expenditures are expected to increase over the next three years. Despite the pay reforms approved in 2003, the current pay and grading system remains inadequate to attract, retain, and motivate slulled c iv i l servants. The size o f the c iv i l service i s also expected to increase, but only to accommodate the need to recruit additional teachers, while non-wage expenditures are expected to increase to provide local administrations and line ministries with sufficient budget allocations to operate and maintain new investments.

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29. Development expenditures are also expected to increase in l ine with the implementation o f GoA’s development strategy. The Development Budget has been formulated around the implementation of National Priority Programs (NPP). A key element of the new budget i s that an increasing share o f the budget i s executed through the Treasury to allow the Government to directly finance and implement several NPPs. These programs include (i) the Afghanistan Stabilization Program (ASP), (provincial and district public buildings and grants to provincial governors), (ii) a bilateral entry program to attract advisors at competitive rate on short-term contracts, (iii) a national vocational training program, and (iv) the scaling-up o f the NSP (block grants to communities for community infrastructure).

30. Improving service delivery in provinces i s becoming an increasingly important element o f GoA’s development strategy. The Government recognizes that i t i s critical that resources are provided to provinces and districts to support state building efforts and enhance service delivery at the local level. These objectives are supported by the ASP and the NSP programs. The ASP extends the PRR program to provincial and district departments o f ministries, provides funds for the physical reconstruction o f province and district administration, and includes a security and stabilization component. In the future, budget allocations to provinces and districts through the ASP may be made contingent upon local performance.

Efficiency of provincial administration.

Table 2: Medium-Term Fiscal Financing Requirements, 2002/03-2006/07 (US$ million)

2002103 2003104 2004105 2005106 2006107 Actual Estimates Budget Projections

A. Domestic Revenues 163 208 309 400 500 B. Expenditures (Bl+B2) 891 1,514 2,217 2,670 3,090

B.1. Ordinary Expenditures 349 452 609 780 950 Wages ... 244 349 ... ... Debt Service ... 4 6 ... . . . Goods and Services ... 133 144 ... ... Capital Expenditures ... 61 45 ... . . . Others ... 10 64 ... ...

B.2. Development Expenditures (disbursement basis) 542 1,062 1,608 1,890 2,140 Financed through Treasury (Core Budget) ... 190 508 600 700 Financed outside Treasuw (Extemal Budget) ... 8 72 1,100 1,290 1,440

C. Budget Deficit (A-B) -728 -1,306 -1,908 -2J70 -2,590 D. Financing (Dl+DZ+D3+D4+D5) 728 1,306 1,908 2,270 2,590

D.1. Extemal Assistance for Projects (through Treasury) 111 173 293 420 590

Others 111 151 213 300 440 D.2. Extemal Assistance for Projects (outside Treasury) 511 872 1,100 1,400 1,550 D.3. ARTF (recurrent window) 79 195 252 250 250 D.4. LOTFA 17 36 48 50 50 D.5. Fast Disbursing Loans

ARTF (investment window) 0 22 80 120 150

IDA (PSIB) 0 0 80 80 80

D.6. Change in GoA’s account at DAB -86 -29 115 0 0

Expenditures on Security and Rule of Law 339 414 771 971 1,120

ADB 96 59 20 70 70

Memo: Development Expenditures (commitment basis) ... 1,592 4,256 4,000 4,000

Ordinary Budget 209 206 226 289 352 Development Budget 130 268 546 682 768

Source: Budget documents and S ta f f estimates.

3 1. In the medium-term, donors’ assistance wil l remain crucial for achieving sustainable public finance in Afghanistan. The fiscal financing gap will remain large as the increase in domestic revenues will remain insufficient t o cover Afghanistan’s fiscal expenditures need over the next three years. At the donors’ conference in Berlin, donors pledged US$4.5 bi l l ion for 2004/05 in line with the conclusions of the document Securing Afghanistan s Future and US$8.2 bi l l ion for the three-year period 2004-06. About US$1.5 b i l l ion from ARTF, L a w & Order Trust Fund Afghanistan, and fast-disbursing loans i s expected to be available for general budgetary support during the same period, translating into an expansion o f activities financed through the Treasury .

Financing.

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32. Risks. The growth targets and fiscal framework outlined above are associated with substantial risks. The scenario assumes: (i) a steady implementation o f the political process as outlined in the Bonn Agreement, (ii) a steady improvement in the security conditions allowing donors to implement programs throughout Afghanistan, (iii) steady progress on the Government’s reform program, (iv) a strong private sector response, and (v) continued, well-targeted donor support to Afghanistan, and (vi) favorable climatic conditions. Afghanistan has l itt le cushion to absorb the consequences o f any significant downward deviation in these areas. Lack o f progress on the political or security front would negatively affect both the willingness and capacity o f donors to support Afghanistan’s reconstruction effort. It could also negatively impact on the relationship between central Government and provinces, reinforcing warlordism and reducing nation-building efforts. Under this scenario, real GDP growth would be lower. A worsening o f the political and security situation would also favor the development o f poppy production with associated negative impacts on security and political stability. If the implementation o f the development strategy i s weaker than expected, private sector development would be negatively affected. Reduced external assistance would also slow down reconstruction, with an adverse impact on growth and nation-building efforts, and a potential impact on poppy culture, political situation, and security. A drought would hurt agnculture, the main source o f income, with a dramatic impact on poverty.

111. AFGHANISTAN’S DEVELOPMENT STRATEGY

33 . The Government’s strategy can be articulated around five reform areas o f de~e lopmen t :~

e Promoting Security and Rule of Law. Security and rule o f law are fundamental prerequisites for political normalization, national reconciliation, reconstruction, and social development.

e Maintaining Macroeconomic Stability. Maintaining a stable macroeconomic framework i s a prerequisite for broad-based economic growth.

e Strengthening Public Administration and Fiscal management. This key element o f the strategy includes the following areas: c iv i l service, administrative capacity, budget preparation, public sector financial management, procurement, and revenue mobilization and management. Enhancing Human Development. Building human capital through the implementation o f reforms in health, basic education and social protection i s key for long-term growth.

The strategy supports the creation o f an enabling environment for private sector development through improvement in the investment climate, provision o f infrastructure including transport, power and telecommunications, financial sector development, state-owned enterprise restructuring, trade reform, agriculture development, and development o f the oil, gas and mining sectors.

e

e Promoting Private Sector Development.

A. Promoting Security and Rule of Law

34. Key Issues. Despite significant gains made by the Government in partnership with the international community, the security sector reform process has been beset by difficulties since i t s inception. According to the document Securing Afghanistan s Future, these difficulties relate to the lack o f an overall strategic vision and framework to guide the process o f reform of the

~~

The NDF is anchored in three pi l lars o f development: (i) human capital and social protection, (ii) physical reconstruction and natural resources, and (iii) private sector development, wh ich includes security and ru le o f l a w and public administration reform and economic management. I t also includes three cross-cutting themes: (i) govemance, financial management and administrative reform, (ii) human rights, security and ru le o f law, and (iii) gender.

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security sector, which translates into l ow levels o f targeted resources, poor coordination structure and misaligned reform objectives. The police reform process has been obstructed by a lack o f coordination among stakeholders, corruption, a lack o f capacity, and shortfalls in funding. Counter-narcotics activities have been constrained by the absence o f a coherent and credible strategy as wel l as the absence o f well-targeted external support. The program to build an army meets with difficulties to attract and retain qualified recruits and suffers f rom an ethnic imbalance, although recent outreach efforts, targeted recruitment and a greater focus on retention have partially addressed these concerns. The reform o f the justice system suffers f rom the absence o f judges’ independence, the excessive concentration o f power and functions within the Supreme Court, the l o w level o f adequate correctional facilities and related resources, the limited availability o f legislation, legal texts and jurisprudence collections, the l o w reliability o f the internal security forces, perceptions o f corruption, and nepotism and a lack o f human capacity in terms o f qualified criminal justice professionals. There are also major human rights challenges including allegations o f forced conscription o f civilians, including under-aged boys, existence o f private jails, and arbitrary and politically-motivated arrests, ill-treatment, and torture o f detainees. Concerns also persist around issues related to forced marriage, abductions, and unchecked surveillance by intelligence and security agencies. T h e implementation o f the DDR program suffers f rom a lack o f security in some regions that prevents the return o f refugees and a lack o f coordination among the main stakeholders in the DDR process. A number o f challenges also remain related to de-mining.

35. Reform Strategy. The Government seeks to take the lead in effectively coordinating the security sector reform process, by fostering a consensus among the ministries and institutions involved with security, and developing their capacity through training and administrative reforms. K e y elements o f this strategy include coordinating ministries, as wel l as donor governments, by the National Security Council, ensuring civilian control over the armed forces and monitoring fiscal transparency. The Government aims to create a uniformed police force o f 50,000 supported by 12,000 border police by end-2005 and an Afghan National Army o f 20,000 members over the next three years. The National Drug Control Strategy aims at eliminating the production, consumption and trafficking o f i l l ic i t drugs into, within and from Afghanistan by 2012. I t s key elements are: (i) the provision o f alternative livelihoods for Afghan poppy farmers, (ii) the extension o f drug law enforcement throughout Afghanistan, (iii) the implementation o f drug control legislation, (iv) the establishment o f effective institutions, and (v) the introduction o f prevention and treatment programs for addicts. T o improve the judicial system and ensure i t s independence, the strategy includes efforts to rebuild the administration o f juvenile justice, prison and law enforcement systems. Among the activities to be carried out are the establishment o f new courts and the strengthening o f legal aid services within the organizational structure o f the Supreme Court. The Government also seeks to build human rights institutions and capacity, raise awareness, and seeks societal consensus around human rights issues.

B. Maintaining Macroeconomic Stability

B.l Macroeconomic Policy

36. Key Issues. The authorities have implemented a prudent economic management which, together with sizable aid and the end o f the drought, has provided an environment conducive to the resumption o f economic growth. The challenge now consists in maintaining macroeconomic stability.

37. Strategy. The authorities are committed to maintaining the implementation o f a macroeconomic framework based on a strong commitment to fiscal discipline. The implementation o f a Staff-Monitored Program with the IMF to cover the fiscal year 2004/05 provides evidence o f this commitment.

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B.2 Budget Process

38. Key Isszies. Despite significant progress made since 2002103 to improve budget preparation, the following issues remain (see para. 13), in part reflecting the challenges o f coordinating external assistance through the budget. First, the budget formulation i s based on the cost o f inputs rather than the cost o f implementing policies. The budget i s not based on a medium-term fiscal framework and does not reflect the multi-year impacts o f reforms. Second, the participation o f sub-national entities in budget preparation i s limited. Provinces have limited inputs into the budget process which decreases the budget’s ability to address local needs. Third, the budget i s not comprehensive. Until the current fiscal year (2004/05), the development budget was a partially funded public investment program formulated on a commitment basis whose implementation depends on the mobilization o f resources s t i l l to be identified. Fourth, linkages between ordinary and development budgets are s t i l l missing. The ordinary budget does not incorporate the amounts o f operations and maintenance implied by the development budget. More generally, the distinction between ordinary and development budgets i s ill defined: the development budget includes programs (like the provision o f health services) which are recurrent while the ordinary budget includes some capital expenditures.

39. Reform Strategy. In 2004105, the authorities have successfully prepared a fully funded development budget. The authorities have also submitted to the Ministry o f Justice (MoJ) a draft o f the Public Finance and Expenditure Management (PFEM) L a w and intend to enact i t in 2004/05. The PFEM L a w provides a framework for the proper management o f public resources. It specifies the budget process (including the requirement to base the budget on a medium-term economic framework) and content (including transfers to public sector enterprises). It also mandates the budget to be presented by programs, defines the standards o f transparency and financial reporting, and mandate the design and implementation o f a multi-year fiscal framework.

B.3 Revenue Policy and Administration

40. Key issues. Domestic revenues are insufficient to finance the functioning o f the Government and the delivery o f basic public services. External assistance cannot be expected to be sustained at current level over the longer term, so the authorities need to increase domestic revenues. K e y issues include an incomplete, albeit improving, voluntary remittance o f revenues to central Government by some provinces, a weak administrative efficiency to mobilize resources, an absence o f a clear tax code (several layers o f regulations accumulated since the 1960s are applied unevenly across the country), and the need to introduce new fiscal measures.

41. Reform Strategy. The Government’s strategy i s to increase domestic revenues to cover the wage bill in 5 years and ordinary budget expenditures in 9 years. Increase in tax collection efficiency i s also expected to result in a 60 percent increase in compliance over the next five years. The authorities have recently introduced an ambitious tax package that includes new customs tariffs and the elimination o f tax holidays for new investments (as amendments to the Income Tax Law), a withholding tax on high income, a streamlined corporate income tax, and a tax on selected services (see para. 27).

B.4 Statistics and Data Management

42. Key Issues. In the absence o f a functioning leading statistical agency (the CSO has very limited capacity), the information necessary to formulate policies i s provided through a number o f uncoordinated piecemeal initiatives from donors and line ministries.

43. Reform Strategy. The authorities are developing the statistical framework necessary for policy formulation. A Statistical Master Plan was drafted at the end o f 2003 (and discussed at the workshop in Kabul in M a y 2004) to provide a roadmap for the development o f a viable statistical system in Afghanistan. I t recommends the creation o f a National Statistics Council in charge o f

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identifying needs and priorities regarding statistics. I t also aims at developing the CSO’s physical and human capacity to execute data collection including a population census and surveys as scheduled in the Statistical Master Plan.

C. Strengthening Fiscal Management and Public Administration

C.l Government Structure

44. Key Issues. The administrative capacity o f the Government to formulate and implement policies i s s t i l l very limited. There i s n o systematic mechanism to adopt and coordinate policies across a large number o f ministries which have overlapping functions. Also, ministries’ capacity to develop and implement policies i s limited.

45. Reform Strategy. The authorities intend to restructure and rationalize the Central Government bureaucracy and strengthen policy design and program implementation capacity in ministries, The Government has enacted the PRR Program decree in July 2003 to initiate the process o f reforming the most critical functions o f the Government by allowing administrative departments to place staff on an elevated pay scale in exchange for organizational restructuring (see para. 17). 3,000 positions are covered by this program and the Government i s fully committed to pursue i t s implementation. The first Program Management Unit (PMU) has been created in the Ministry o f h g a t i o n to enhance project ownership by l ine ministries and strengthen implementation capacity. Such units are expected to be responsible for the preparation, procurement, financial management, supervision, and evaluation o f projects which should hasten their implementation. The authorities also intend to improve the bureaucracy o f central Government, which includes reform o f the Office o f the President. The President has also announced i t s intention to reduce the number o f Ministerial portfolios.

C.2 Personnel Management

C.2.a Legal Framework

46. Key Issue. The absence o f transparent rules for recruitment and promotion adversely affects c iv i l servants’ motivation and overall efficiency, especially in Provinces.

47. Reform Strategy. An Independent Administrative Reform and Civ i l Service Commission (IARCSC) was created in June 2003 to coordinate and manage the PAR. The IARCSC comprises (i) a Civ i l Service Management Department responsible for developing a new legal framework (including a Code o f Ethics) for the Civ i l Service and modem human resources management policies and procedures, (ii) the Independent Appointments Board (IAB), responsible to have appointments based on merit, and (iii) the Independent Appeals Board responsible for hearing complaints against unfair, il legal or discriminatory behavior in the workplace. Merit-based procedures have been adopted and the IAB has started applying them. The authorities intend to adopt an updated legislative framework that defines c iv i l service, i t s role, lays down ethical standards, and regulates c iv i l servants’ terms and conditions in line with modem employment practice. The upcoming adoption o f a C iv i l Service L a w will establish a legal framework for c i v i l service in l ine with good modem employment practices. Appointments are expected to be increasingly based on merit and progressively audited.

C.2.b Systems for Payroll

48. Key Issues. Failures with the existing arrangements for payroll (failures to pay govemment employees in time, in full amount, and with clear identification o f receiving individuals) undermine the integnty o f the process and the motivation o f c iv i l servants. These failures are: (i) delays in confirming employment and authorizing quarterly budget allotments by l ine ministries to provinces and districts and in preparing l is ts o f established positions (tashkeels), (ii) errors and

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existence o f “ghost” employees due to manual calculation o f payroll and lack o f supervision over salary distribution, and (iii) delays and payments o f less than 100 percent o f salary related to the use o f bonded trustees contracted by the budget institutions for collection o f cash from the Central Bank and for disbursement o f salaries in cash to individuals. The ARTF conducts spot checks over payroll distribution, but Govemment’s financial controls and audit are weak to rectify the problems.

49. Reform Strategy. The MoF, with IARCSC and DAB, intends to implement a verified payroll plan for government employees. The plan seeks to: (i) address the failures in the process o f timely authorization o f budget allotments and tashkeels; (ii) implement computerized payroll systems and issue Afghanistan Personal Identification Numbers and standardized picture identification cards to al l government employees; and (iii) make salary payments through banks. Improvements in the timeliness o f authorization o f allotments and tashkeels will stem from improvements in the budget process. Improvements in other aspects o f the plan will build o n the ongoing effort o f individualized salary payments, already implemented in Kabul for ten line ministries, and to be gradually extended to all govemment employees. Additional reforms on legal regulations, accounting, and audit will also support a more effective payroll system (see para. 59).

C.2.c Human Resources

50. Key Issues. There i s currently a dearth o f the core s lu l ls and competencies required to build an efficient administration, in part the result o f competition with NGOs and aid agencies. The problem is particularly severe at management level where a severe shortage o f people - especially women - with the required sk i l ls i s compounded with the absence o f merit-based appointments over many years. At middle and lower levels, generic management and such basic sk i l l s as writing, counting, planning, and using IT systems are largely missing.

51. Reform Strategy. T o enhance the level o f human resources i s by nature a long t e r m endeavor. In the short-term, the PRR program provides an opportunity to administrative departments to restructure themselves and increase salaries for key positions while accessing funds to provide significant training to retained staff. In addition, the Government i s designing a lateral entry program to hire advisors on short-term contracts at competitive rate and place them in key positions. This program would allow the Government to attract skilled employees while limiting pressures on the whole pay structure. In the longer term, the Government intends to conduct a training and development needs analysis, design and implement a Retraining, Reslulling, and Redeployment Program, and build a proper human resource management system to continuously enhance ski l ls .

C.2.d Salary and Pension

52. Key Issues. Salary and pension levels remain inadequate to attract and retain skilled public employees, and this despite recent salary and pension increases. Also, there i s s t i l l n o long-term pension policy and pension administration i s inefficient.

53. Reform Strategy. Average salaries are expected to increase as the Government pursues the implementation o f the PRR program. Beyond this, the Government intends to carry out a labor market survey to be used as a base for a c iv i l service pay and grading review. The Government also intends to reform c iv i l service pensions. The recent increase in pensions for public employees i s viewed as a temporary measure pending the overall reform o f c iv i l service compensation (salary and pension). The pension scheme i s expected to remain a contribution based, defined benefit scheme for retired public sector employees and their dependents. I t i s expected to s t i l l be administered by the Pensions Administration Office, which i s planned to undergo a modernization program.

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C.2.e Gender

54. Key Issues. Although there i s no accurate data on women‘s share o f civil employment, i t i s clear that women are seriously under-represented at all levels o f Government. There has been considerable discrimination against women especially under the Taliban regime. This has a considerable impact on the capacity to deliver health and education services to girls and women.

5 5 . Reform Strategy. The Government i s committed to correct the gender imbalance and promote the role o f women in c iv i l service. The strategy consists in establishing targets for increased level o f female employment and develop and implement a plan to achieve these targets.

C.3 Strengthening Subnational Administration

56. Key Issues. Years o f destruction and absence o f new investments combined with an absence o f operations and maintenance have left most Government offices in very poor conditions and severely under-equipped. Although improvements mostly financed from donor assistance have taken place for the central administration based in Kabul, the lack o f infiastructure severely limits the administrative capacity o f provinces and districts to deliver basic services, including health and education.

57. Reform Strategy. The authorities intend to strengthen provinces’ and provincial municipalities’ capacities to deliver basic services. The authorities are already upgrading basic office facilities in pi lot districts to improve service delivery and provide the means to connect citizens with central Government. The authorities want to progressively increase budget allotments to provinces. Modest budget grants could be provided to Provinces for public building reconstruction. The recently created ASP will finance small-scale labor-intensive construction projects (see para. 30). Modest grants could also be provided to provincial municipalities - the only administrative uni ts outside o f central Government with an independent budget process - to finance the reconstruction o f the municipalities’ own building, local roads and water and sanitation programs and some labor-intensive works. Municipalities’ capacity will require strengthening to effectively manage these resources.

C.4 Fiduciary Standards

C.4.a Financial Control Systems and Cash Management

58. Key Issues. Despite progress in financial management, several issues remain (Annex 4). First, the centralization o f the financial management system (AFMIS i s only implemented at the Treasury and in Herat mustofiat), while a necessary f i r s t step, creates delays in recording revenues and expenditures and making payments. Second, despite recent achievements in consolidating al l government bank transactions in the center and provinces, cash management needs to be strengthened. Third, budget managers have weak accountability because financial controls and paperwork are excessive, the regulatory framework i s not wel l understood and optionally applied, and there i s lack o f effective audit. Fourth, significant portions o f financial management operations are managed by an external firm.

59. Reform Strategy. First, the M o F will continue improving the timeliness and accuracy o f periodic reporting from provinces and reconciliation o f accounts with line ministries. AFMIS i s expected to be rolled out to l ine ministries and provinces. The PFEM L a w mandates the appointment o f a Chief Financial Officer in each line ministry, which will increase financial management accountability. I t i s envisaged that the l ine ministries where Chief Financial Officers are in place will be provided more financial management responsibilities, including payments, accounting, and reporting. Second, M o F will strengthen i t s cash management system. Treasury particularly wi l l promote the introduction o f direct payments f rom the TSA to vendors’ bank accounts, increasing bank intermediation in the payment process. Third, financial controls will be implemented through ongoing effort o f reducing ARFT ineligibilities and direct intervention o f

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the Treasury, where line ministries do not demonstrate due financial management capacity. The regulatory framework for financial control will be updated in line with the PFEM Law. MoF’s Internal Audit Department i s being strengthened as part of M o F reform and the legal and institutional framework wi l l be clarified. Fourth, a strategy i s in place to gradually shift a l l financial management capacities to Treasury, while external firms would focus only o n advisory and training services.

C.4.b Financial reporting

60. Key Issues. Financial reporting remains weak. Data are now available and internal reporting i s prepared for the Minister o f Finance on a weekly basis, but has only aggregated information. The capacity o f compiling informative financial statements i s lacking at a l l levels o f the government.

61. Reform Strategy. The PFEM L a w will mandate quarterly reporting on public finances, as wel l as the preparation and auditing o f annual financial accounts. Capacity will be built to develop reporting functions.

C.4.c External Audit

62. Key Issues. The external auditor, the Controller and Audit Office (CAO), has not the institutional and human capacity to conduct financial statement audits at international standards. Despite support f rom an international firm (financed by IDA’S EPAP), which facilitated the audit o f a l l IDA’S grants and credits, and ARTF for the solar year 200212003, n o financial statements has been audited for more than 10 years.

63. An update o f the legal framework, including an Audit Law, will establish a clear framework for external audit: requirement to audit annual financial accounts, requirement for the Government to respond to the Auditor’s opinion, independence o f the auditor. This will be complemented by capacity building programs.

C.4.d Procurement

64. Key Issues. Despite significant initiatives to improve public sector procurement, three main issues remain, leading donors to conduct themselves as much as fifty percent o f procurement. First, regulations are inadequate to ensure a complete, transparent, uni form and la id down process o f procurement. Procurement procedures need to address key issues such as setting out qualification criteria, specifications, evaluatiodaward criteria, post tender negotiations, and time frame for settling tenders. Second, capacity in the administration i s weak and the procurement function i s sometimes misunderstood (mindset that only major works or purchases are “procurement”). Third, the institutional framework i s weak, with n o clear procurement champion in Government.

65. Reform Strategy. First, the legal framework will be clarified by a new Procurement Law, with the procurement regulations, defining a l l the required ingredients o f the procurement as discussed above. Second, the reform strategy seeks to address the lack o f capacity through the assistance o f a central procurement consultant (currently supported by IDA through the EPAP project). While this consultant init ially provided direct procurement services, i t will gradually move towards advisory services. Third, the institutional framework will be strengthened to transfer procurement management f rom donors to l ine ministries as capacity i s built through new recruitment (by implementing PRR in procurement units) and training. A central Public Procurement Unit wil l be created to monitor and review the procurement policies.

Reform Strategy.

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D. Enhancing Human Development

D.l Health

66. Key issues. The most important issue facing the health sector i s the l o w coverage o f basic health services (see para. 18). An estimated 43 percent o f the population s t i l l do not have access to basic health services. Forty percent o f existing health facilities do not have female staff, which implies that women are very unlikely to access those facilities. Quality o f services i s also an issue. Major bottlenecks to improve service delivery and quality include: (i) overall lack o f financial resources, (ii) high inefficiencies at the central ministry level which limits the amount o f fiscal resources that are allocated to health service delivery, (iii) shortage o f skilled staff in rural areas, particularly female health staff, (iv) l ow management capacity in the Ministry o f Health (MoH) and at provincial level, and (v) absence o f a well-functioning health referral system. There are also many important cross-cutting issues that impede improvements in health status such as physical insecurity which discourages female health workers, l o w levels o f education particularly among women, l o w social status afforded to women, and lack o f physical infrastructure including rural roads, electricity, potable water, and sanitation.

67. Reform strategy. With NGOs providing more than 80 percent o f existing services, the M o H exerts a leading role in the sector, particularly in terms o f policy development. M o H developed an Interim Health Strategy for the period 2002-04 to ensure that partners focus on strategic priorities. These priorities are to: (i) ensure the nation-wide delivery o f Basic Package o f Health Services (BPHS) and expansion o f referral services, (ii) continue to strengthen vertical programs such as salty iodination, polio, measles, tetanus immunization, and vitamin A distribution, and (iii) improve the quality o f hospital services, with priority to emergency obstetrical care and trauma management. T o increase BPHS coverage, the M o H has already signed Performance-based Partnership Agreements (PPAs) with NGOs for the delivery o f the BPHS in some under-served areas. Also, the M o H plans to take a more active and direct role in the provision o f health services than under the PPAs wi th NGOs. Implementation o f this strategy will require a strengthening o f Government systems o f management, disbursement, financial management, and procurement. The overall objective o f the strategy i s to deliver the BPHS in areas that are not served by NGOs, and test whether in the long term the public sector can run services as efficiently as the private sector under contract.

D.2 Education

68. Key Issues. One o f the most important issues facing the education sector are the poor quality o f primary education and i t s l o w coverage and retention, particularly for girls (see para. 18). Major constraints include: (i) weak institutional capacity o f educational administration, including financial management (ii) weak capacity o f teachers and school principals, (iii) limited involvement o f communities in school management, and (iv) l o w quality and inadequate inputs including teaching learning materials and learning space.

69. Reform strategy. The Government’s approach to overcome the constraints in education i s as follows. First, the authorities intend to redefine the Ministry o f Education’s (MoE) role and i t s Provincial and District Departments. MoE’s capacity has already increased over the last 18 months and i ts mandate has also become more focused. M o E now emphasizes i t s role as policy maker, regulating and monitoring service delivery, facilitating the roles o f others, and contracting for services. This policy shift i s expected to be further reinforced at provincial and district levels, to make the school the point o f service delivery. Second, the authorities intend to strengthen teaching force by assessing the current status o f teachers and developing a comprehensive teacher training program. Third, the authorities intend to strengthen the role o f both communities and schools. Many communities and schools have sustained education at the local level in very challenging environment for decades in Afghanistan. Government i s strengthening the functions

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o f school principals and encouraging communities to participate in the planning, implementation and monitoring o f education services.

D.3 Social Protection

70. impact evaluation needs to be conducted to assess i t s targeting.

71. Reform Strategy. The thrust o f Government policy over the past two years has been to shift increasingly beyond pure humanitarian relief to the adoption and implementation o f a more comprehensive and sustainable integrated social protection. More effective coordination between ministnes, and stronger Government leadership o f the overall social protection program, including utilization o f food aid, i s also a priority. The strategy also consists in conducting an impact evaluation o f the existing programs. The M o H i s currently reviewing beneficiaries under the disability program. In the longer term, the authorities intend to shift f rom work-for-food to work-for-cash based systems while avoiding creating systems o f entitlements that are not financially sustainable. The authorities have also initiated the design o f a National Vulnerability Program, one o f the thirteen NPPs, including the rationalization and expansion o f a safety ne t system (see C.2.d for the c iv i l service).

Key Issues. Coverage under the existing safety net system i s l o w (see para. 18). Also, an

E. Promoting Private Sector Development

E.l Investment Climate

72. Key Issues. Private sector-led development i s the key to Afghanistan’s long-term economic development. One main issue i s to overcome the legacy o f the Soviet-type system established during the communist era. Currently, insecurity severely constrains the development o f the private sector. The lack o f infrastructure i s also a constraint, increasing operating costs (e.g. because o f the lack o f power) and reducing market opportunities (e.g. because o f a weak road system). The lack o f management capacity and the lack o f insurance, financial services, and other business services further constrain the development o f the private sector. In addition, there are two main policy and institutional issues. First, Afghanistan has inherited many laws, regulations and procedures that tend to inhibit trade and investment instead o f encouraging it. A legal framework should be in place that allows businesses to start up easily, to function efficiently while they are in operation and to exit the market in a timely and efficient manner. Second, problems caused by a weak legal framework are compounded by a host o f administrative bamers that affect entry and raise transaction costs, thereby reducing the competitive strength o f the private sector.

73. Reform Strategy. The Government i s committed to support private sector development (as outlined in the NDF). A revised “Law o n Domestic and Foreign Private Investment in Afghanistan” wi l l establish a simple, transparent and mostly automatic registration process for both domestic and foreign investment. Restrictions for foreign investment wi l l however apply to some sectors or activities. The new law will use provisions for accelerated depreciation and loss- carry forward instead o f tax holidays, as investment incentives. The registration will be undertaken by the newly established AISA, a “one-stop-shop” for investors that i s designed to cut through the red tape o f investment. The Commercial Code i s also being revised. Administrative reforms are expected to clarify responsibilities and increase capacity. These initiatives wi l l need to be followed by further legal reforms, including issuance o f implementing regulations for the investment law and enactment o f a “Companies Act” and resolution o f urban land issues. More generally, a thorough review o f the existing legal framework for PSD i s required in order to identify areas where there are serious gaps or deficiencies in the existing legal framework.

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E.2 Infrastructure

E.2.a Transport

74. Key Issues. The poor state o f the transport sector i s a key issue for Afghanistan’s development. As a landlocked country and in the absence o f railways, Afghanistan relies on road and air transport. However, road infrastructure remains in very poor conditions and only about 16 o f the country’s 21,000 km national road network i s paved. Extending access to primary, secondary and tertiary roads, which i s vital for market integration will also require a provincial investment focus. The country’s alrports and civ i l aviation infrastructure too have also suffered significant destruction and neglect through years o f war.

75. Reform Strategy. The Government’s strategy consists in (i) urgently rehabilitating the primary road network and key airports to accommodate increasing traffic volume and promote trade with neighboring counties, (ii) creating a regulatory framework to promote private sector participation and provide efficient transport services; and (iii) restructuring the institutions involved in the sector including the Ministry o f Public Works (MPW), Ministry o f Civ i l Aviation and Tourism (MCAT), and Ministry o f Transport and separate policy functions fi-om construction activities. The Govemment plans to establish a PMU in MPW to manage the entire program o f road and bridge construction. This would leave M P W with the primary task o f setting policies, planning the development o f the country-wide road network, setting standards and regulations and enforcing them, and managing the Super Corridors and National Highways for which works will be contracted out. Rural roads will continue to be under the responsibility o f the Ministry o f Rural Rehabilitation and Development (MRRD). The M C A T will focus on (i) formulating policy and strategy, (ii) planning and budgeting, and (iii) creating and maintaining databases. Specialized airport companies are expected to manage airports while the Government i s expected to severe commercial and operational ties with Ariana, the Afghan national airline.

E.2.b Power Sector Development

76. Key Issues. The power sector i s severely constraining Afghanistan’s development. An estimated 6 percent o f the population have access to power and electricity consumption per capita, at 12kWh/year, i s among the lowest in the world. Only 234,000 customers are officially connected to the public grid, o f which approximately 30 percent are in Kabul. Outside Kabul, access to power i s much more limited, and rural areas are virtually un-served. The existing power network i s dilapidated, while the D a Afghanistan Brishna Moassesa (DABM), the power utility responsible for generation, transmission, and distribution o f electricity, does not have an appropriate governance structure nor the economic resources to improve services.

77. Reform strutegy. The Ministry o f Water and Power (MWP) has adopted a Reform Road M a p and has submitted an Electricity Policy Statement to Cabinet. The vision o f the MWP i s for DABM to evolve into autonomous, financially viable enterprises providing reliable, l o w cost electric service to a l l Afghan citizens in an environmentally responsible manner. To accomplish this vision, the MWP has planned, over the next few years, projects to rehabilitate i t s existing infrastructure, increase i t s generation capacity through the participation o f the private sector where feasible, steadily increase the number o f customers it serves, establish more appropriate tariffs, and increase i t s revenue through enhanced and effective billing and collection and loss reduction procedures. The Govemment has increased tariffs (although a significant gap remains to achieve cost recovery), and several donors are providing ad hoc assistance to improve billing and collection. However, a key f i rst step to improve governance in the sector i s the creation and corporatization o f the Kabul Distribution Company to enable it to operate as a commercially and financially viable enterprise. Technical Assistance (TA) under IDA’S Power Rehabilitation Project will help the authorities reach this objective. Lastly, the MWP recognizes the pressing need to develop institutional capacity and tools to effectively manage the rehabilitation and

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reconstruction efforts o f power infrastructure. As a first step, MWP i s in the process o f creating a Project Implementation Support Unit expected to be operational by mid-2004.

E.2.c Telecommunications

78. Key Issues. The main challenge facing the telecommunications sector consists in sustaining recent successes. Telecommunications were in a dilapidated state at the end o f recent hostilities, when tele-density (telephones per 1,000 people) o f 1.6 was one o f the lowest in the world. Since the end o f conflict, the telecommunications sector has been expanding rapidly. Over the last two years, private investors and the Government supported by the donors, have played a significant role in extending the quality and reach o f telecommunications services, improving international connectivity and fixed services in major cities, and enhancing Government communications. Full mobile services have rapidly developed reaching 135,000 subscribers in December 2003 and it i s now possible to make mobile calls between all major cities. Confidence in the sector has resulted in significant private foreign investments (more than US$90 mi l l ion o f projects i s recorded by A I S A and the Ministry o f Commerce).

79. Reform Strategy. The overriding objective o f the Govemment’s national communications policy i s to achieve modernization and rapid expansion o f telecommunications networks and services, and to create universal access across Afghanistan. T o reach this objective, the Government’s strategy consists in creating a regulatory framework to promote private sector participation and restructuring o f the institutions involved in the sector to separate policy functions from service provision. A regulatory body has already been established and will be strengthened over the course o f the next few years. The regulatory framework i s expected to (i) maintain an open and technologically neutral environment, (ii) develop an open and transparent system o f licensing, and (iii) emphasize private ownership and operation. The Ministry o f Communications i s expected to reorient itself as a policy malung body while Ministry o f Communication’s telecommunications operational arm, Afghan Tel, and the postal services are expected to be corporatized. The Ministry o f Communications i s ro l l ing out wireless local loop services in major towns and cities, while undertaking a rapid and ambitious reform agenda to ensure that private services delivered on a competitive basis are the driving force behind future sector growth. Capacity development within Ministry o f Communications has already been initiated through training and TA, and needs to be sustained. The private sector i s expected to continue providing mobile phone services and play a growing role in other aspects o f telecommunications, telephone and internet access, information technology and postal services.

E.3 Financial Sector Development

80. Key Issues. Afghanistan’s financial sector face some key issues: (i) the legal and regulatory environment remains extremely weak, (ii) DAB s t i l l remains far behind basic standards o f modem central banking, and (iii) Afghanistan’s publicly-owned commercial banks (i.e. all o f them except for the new licensed banks) are virtually non functioning lacking basic management systems, procedures, contsols and skilled personnel and remain in critical need o f rehabilitation.

81. Reform Strategy. The reform strategy includes three elements. First, building on the recently passed financial sector legislation (see para. 19), the authorities intend to further strengthen the regulatory framework including the elaboration o f internationally accepted prudential regulations to clarify the legal and regulatory environment. Second, the authorities intend to continue implementing the reform o f DAB. These reforms are expected to focus on creating an organization structure and culture that enables DAB to function as a regulatory body for the financial sector and carry out key supervisory functions in Kabul and the most important cities. These reforms include (i) the development o f an effective national payment system, (ii) the introduction of management information systems, and (iii) the implementation o f accounting and auditing standards in accordance with international standards. It also includes the

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implementation o f a reorganization and operational restructuring program which includes substantial changes to human resources (including the implementation o f a PRR program), personnel management processes, and management information systems. As commercial banks develop, the Central Bank will gradually end i t s commercial banking functions. Third, the authorities intend to solve the situation o f the six state-owned banks. The banks have all applied for re-licensing and a resolution plan i s expected to be developed and implemented.

E.4 State-Owned Enterprise Restructuring

82. Key Issues. There are currently about seventy State-Owned Enterprises (SOEs) in Afghanistan. Budgeted fiscal transfers to SOEs have been discontinued, which forced SOEs to start restructuring themselves. The Government s t i l l faces the challenge o f developing and implementing a strategy to restructure SOEs and a plan to address the social impacts o f such a restructuring.

83. Reform Strategy. The authorities have been dealing forcefully with SOE restructuring. A survey o f SOEs was conducted to assess their situation including number o f workers and asset valuation particularly landholding. In April 2004, the M o F was given the institutional responsibility for SOE restructuring. The SOEs were requested to submit financial reports on a quarterly basis. A strategy to restructure SOEs was developed and i t s implementation has started while i t s completion i s programmed for 2007. As part o f this strategy, SOEs have already been classified in four categories (economically viable, candidate for merger, candidate for liquidation, and SOEs to remain under public ownership), while specific steps on how to deal with each category within Afghanistan’s existing legal framework have been developed. Also, a plan to deal with the social impacts o f SOE restructuring, including the creation o f an employment agency specifically geared to protect SOE employees, has been developed.

E.5 Trade Reform

84. Key Issues. Trade, both regional and global, will be a driving force in Afghanistan’s economic growth. Over the past 2 years, TISA has both renewed existing trade agreements, while entering into new agreements with i t s neighbors. At the recent Cancun trade meeting, Government representatives pledged to build a foreign trade regime that will allow Afghanistan to easily pass the standards required for World Trade Organization accession over the next few years. Afghanistan has also joined the Wor ld Customs Organization. W h i l e security and infrastructure are key constraints, there are policy problems related to (i) the customs code, (ii) the weakness of the transport system, combined with burdensome transit procedures, and (iii) the lack o f administrative capacity o f the Government to manage customs and transit, a responsibility fragmented amongst the Ministry o f Commerce, Finance, Interior and Transport, and the Afghan Chamber o f Commerce, creating obvious inefficiencies in securing customs and trade revenues and in facilitation o f trade and transit. In future years, it will be vital for the Government to move towards a multilateral system for trading within the region perhaps init ially based around corridor agreements. This would also allow issues such as transshipment to be addressed. The M a y 2004 meeting o f the Economic Cooperation Organization in Bishkek however symbolizes Afghanistan’s return as the hub for regional trade.

85. Reform Strategy. First, the Government has approved the revised countrywide tar i f f regime with a simplified six-band tar i f f structure, a maximum rate o f 16 percent, and one that utilizes a uniform floating exchange rate. The Government i s focusing on harmonization o f standards and procedures, and curtailing smuggling. Second, the Government intends to improve regional trade and transit issues - including development o f efficient, safe, and reliable, transport corridors. Third, the Government intends to clarify institutional responsibilities.

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E.6 Agricultural Development

86. Key Issues. The main constraints to agncultural growth include (i) limited utilization o f Afghanistan’s water resources and unsustainable water resource management and use practices, (ii) limited access to farm inputs including fertilizers due in part to l imited access to credit, (iii) limited information on available inputs and new technologies, (iv) l imited private sector involvement in input and service delivery, (v) lack o f land security and tenure, (vi) l imited access to markets, and (vii) lack o f grades and standards and certification systems which limit the scope for cash generating export oriented production. M a i n issues with livestock are widespread animal diseases and the limited access to animal health preventive services and vaccine programs.

87. Reform Strategy. The Govemment i s committed to not introduce policy distortions l ike those related to price support or direct subsidies for example. The Govemment also intends to move away from direct interventions in the sector through the provision o f fertilizers and seeds by SOEs or agricultural credit f rom the currently defunct Agricultural Development Bank. Instead, the Govemment intends to revive institutions l ike those involved in agncultural research, introduce more innovative delivery mechanisms l ike credit extension and also foster the legal and regulatory framework for water user groups and agricultural marketing. The strategy also seeks to identify viable substitutes for poppy production although this may not be achievable. In June 2004, the authorities have created an amculture program as one o f their NPPs.

E.7

88. Key Issues. Afghanistan has substantial reserves o f solid minerals, among them coal, quarry materials, marble and dimension stone, industrial minerals, some metals, and semiprecious stones, and gas. Production suffered greatly during the conflict years, and the sector i s largely outside the central Govemment’s direct knowledge or control, with most production unregulated and riskmg environmental damage. The regulatory framework i s poorly developed and public institutions in charge o f supervising these activities have limited capacity.

89. Reform Strategy. Government i s committed to focus i t s role on regulation o f the sector and development o f a policy environment for private sector participation, rather than a directed operational approach. In particular, the reform strategy emphasizes the need to regularize existing production (of quarry materials and gemstones in particular) and to streamline the regulatory framework. The policy and regulatory functions o f the Ministry o f Mines and Industries need to be separated from i t s operations. The administrative capacity (e.g. for the cadastral office) wi l l also be strengthened. The revenue procedures for this sector will be made transparent and in l ine with overall revenue policy and administration.

Oil, Gas and Mining Development

IV. BANK’S ASSISTANCE TO AFGHANISTAN

90. After a gap o f more than two decades, IDA’S re-engagement with Afghanistan began with an Approach Paper to the Board in November 2001 (IDAR-2001-23247) followed by a Preliminary Needs Assessment prepared jo int ly with the UNDP and the ADB in early 2002. A f i r s t TSS was presented to the Board on March 2002 (IDAR-2002-0035) and proposed a 9-month emergency assistance strategy to support post-conflict reconstruction and economic recovery as part o f a broader intemational effort, as well as the establishment o f the ARTF. Ini t ia l Bank interventions focused on addressing urgent public administration and fiscal management needs to enable the Government to rapidly build capacity to oversee the reconstruction process. Other assistance provided investment funding for critical short-term priorities including education, infrastructure rehabilitation and job creation.

91. A second TSS (IDAR-2003-022) was presented to the IDA Board o f Executive Directors on March 2003 to cover the next 1 %month to two-year period until Afghanistan develops a new

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Constitution and a stable, representative Govemment is established, in line with the process mandated by the Bonn Agreement. This second TSS was designed to focus IDA’s financial assistance and Analytical and Advisory Activities on supporting the Government’s vision and strategy for national reconstruction embodied in the NDF (April 2002). Following the clearance of Afghanistan’s arrears to IDA and commitments o f US$lOO mil l ion in FY02 in the form o f IDA Post-Conflict Grants, the second TSS outlined a program with up to four new operations in FY03, and additional operations in FY04, to fully realize the World Bank’s Tokyo pledge o f US$570 mill ion.

A. Investment Lending

92. As o f end-June 2004, IDA’s portfolio consists o f 13 active projects which support GOA’S development strategy. Donors’ contributions to ARTF amounted to US$185 mi l l ion in 2002/03 and US$286 mi l l ion in 2003104, to support mainly the ordinary budget, but also several investment projects. IDA’s investment projects which amount to a total commitment o f US$608 mi l l ion are as follows:

IDA also administers the ARTF created in M a y 2002.

Public Administration and Fiscal Management. The EPAP (US$lO million) and EPAP I1 (US$8.4 million) have provided funds and TA to build a payment system at the Treasury and to raise the public sector’s fiduciary standards. These projects support budget preparation and execution, expenditure accounting and reporting, procurement, and audit. EPAP I1 also supports public administration reform (PRR process and IARCSC).

0 Human Development. The Health Sector Emergency Rehabilitation Project (US$59.6 million) expands equitable delivery o f basic health services through performance-based partnership agreements with NGO service providers and the strengthening o f the Ministry o f Public Health. The Emergency Education Rehabilitation and Development Project (US$15 million) supports grants via NGOs to schools and communities to rehabilitate schools, and block grants to higher education institutes to improve student facilities, increase female enrollment and improve quality o f teaching. The Emergency Community Empowerment and Public Works Project (US$42 million) and the NEEP for Rural Access Project (US$39.2 million) aim at creating emergency short-term employment opportunities for the poor while improving rural access infrastructure. The Emergency NSP (US$95 million) aims at laying the foundations for local governance and assisting the reconstruction and development o f rural communities through the provision o f grants. Private Sector Development. The Emergency Custom Modemization and Trade Facilitation Project (US$3 1 mill ion) supports the customs reform program, including trade-related infrastructure. The Emergency Irrigation Rehabilitation Project (US$40 million) aims at rehabilitating more than 1,000 small and medium irrigation schemes. The Emergency Infrastructure Reconstruction Project (US$33 million) seeks to rehabilitate power distribution networks in Kabul and five other cities, and water supply systems in twelve provincial cities. The power component includes assistance to increase generation capacity in Kabul and prepare a power sector strategy. The project also supports municipal public works programs that have implemented over one hundred labor intensive projects. The Emergency Transport Rehabilitation Project (US$108 million) finances the rehabilitation o f the main corridor f rom Kabul to Tajiskistan, including the Salang Tunnel, and some c iv i l work in Kabul airport. The Emergency Communication Development Project (US$22 mill ion) seeks to rehabilitate communication infrastructure and provide the Govemment with communication equipment. The Power Rehabilitation Project (US$l05 mill ion) seeks to restore and expand the distribution network, rehabilitate the largest generation station supplying Kabul and the associated transmission line, and improve commercial operations o f the utility.

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B. Analytical and Advisory Services

93. Knowledge partnership i s a core element o f IDA’S assistance to Afghanistan. So far, the Bank has focused analytical and advisory services on providing quick, practical, concrete and focused technical inputs and advice on specific policy, institutional design and reform issues that are o f immediate concern to the Government. In depth technical work has been conducted in response to GOA’S requests in key sectors such as public administration, health, the financial sector, private sector development and infrastructure. The Bank has also made significant contributions to the formulation o f the Government’s strategy as outlined in the report Securing Afghanistan’s Future which was presented at the donor’s conference held in Berlin in March 2004. A variety o f vehicles have contributed to this work, including Post-Conflict Fund grants, TA components o f IDA Grants, and partner financing o f work. T h e Govemment provided strong positive feedback particularly in the areas o f public administration, private sector development, health and mining. Analytical and Advisory Activities also support the reform areas o f GOA’S strategy as follows:

Security and Rule of Law. A paper titled Afghanistan’s Drug Economy: A Preliminaly Overview and Analysis (December 2003) was prepared as an input for the Government’s report Securing Afghanistan ’s Future (March 2004). Public Administration and Fiscal Management. TA i s continuously provided in the fiduciary areas and that o f c iv i l service reform. A Workshop on Economic Management Strategy was held on April 2003. A Procurement Review was conducted in June 2003. Also, a comprehensive analysis o f the structure and work o f the administration at the sub- national level has been conducted in partnership with the Afghanistan Research and Evaluation Unit (AREU), leading to a constructive policy dialogue with the Government on public administration reform as well as a reference report A Guide to Government in Afghanistan, with a policy paper Subnational Administration in Afghanistan: Assessment and Recommendations for Action (December 2003). An Economic Report i s cu,rrently under preparation. Human Development. An Education Policy Note i s under preparation. A Poverty and Vulnerability Analysis i s also under preparation, based on a household survey recently completed in collaboration with the MRRD. A Gender Assessment in under preparation. Private Sector Development. Analysis has focused on sectors that are key for private sector development including: Trade and Regional Cooperation between Afghanistan and its Neighbors (February 2004), Afghanistan: Financial Sector Reforms (March 2003) and Afghanistan Border States Development Framework (November 200 1). Also, policy notes, industry and service studies and a comprehensive Private Sector Development Report are under preparation. IDA provided TA to prepare the Mining L a w and the O i l and Gas Law. The Report Mining as a Source of Growth (December 2003) assesses the existing mineral production and potential for development and addresses the challenges faced by the Govemment to establish an enabling environment which will regularize existing production and stimulate new investments. TA has been provided at the regional level in the area o f power trade. Some work has also been done on water issues: a study o f Amu Darya riparian issues has just been completed and another study on riparian issues involving Pakistan and Afghanistan i s being considered.

C. Coordination with Other Donors

94. The national budget i s the main instrument for donor coordination. Donors finance projects that belong to the development budget, i t s e l f structured around the NDF programs. To facilitate donor coordination, a Consultative Group (CG) has been created for each program and an Advisory Group for each cross-cutting theme (for example gender and environment). CGs are chaired by the program’s lead ministry and are composed o f representatives f rom all donors

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involved in the reform area, under the leadership o f a ‘Donor Focal Point” (Table 3). CGs have significantly improved donor coordination, information sharing, budget preparation and monitoring, despite uneven performance across programs. The Development Budget and Extemal Relations Unit under the Director General o f Budget at M o F i s responsible for coordinating and monitoring extemal assistance as well as undertalung reviews with each donor. A first jo int portfolio review prepared by IDA and the authorities has been conducted in February 2004. Similar reviews are expected to be conducted with other donors which will strengthen project implementation and development budget coordination.

95. TA i s a key component o f the development program that i s also coordinated through CGs and the NDB. To strengthen coordination, the Govemment has recently announced i t s intention to channel TA through the Technical Assistance and Feasibility Studies component o f ARTF.

Table 3: Consultative Groups

V. THE PROPOSED CREDIT

96. Starting f rom the particularly dire situation l e f t by the Taliban, the Government has made significant progress since i t came to power in June 2002. I t s main challenge now i s to deepen, broaden and sustain the reforms underway in the areas o f public administration and fiscal management while implementing reforms that lead to a more efficient allocation o f fiscal resources in the areas o f human development and private sector development. The implementation o f such reforms requires the Government to deepen i t s program beyond Kabul to eventually reach al l provinces and municipalities, including those where donors are absent.

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97. T o reach this objective, in the short to medium term, the Government requested multi-year financial support that i s not linked to specific projects, but that can support i ts entire budget including recurrent costs, as wel l as development projects that are viewed as a priority, yet not fully financed by donors including small-size rehabilitation projects, projects o f operations an maintenance or projects located in insecure areas.

98. The following section provides a description o f the proposed Credits including: (i) reform areas supported by the Credits, (ii) country ownership, (iii) prior actions to be taken before Board presentation o f PSIB I, (iv) triggers for PSIB 11, (v) monitoring and evaluation, (vi) administration o f the Credit, (vii) coordination with the IMF and other donors, (viii) poverty implications, and (ix) benefits and risks.

A. Reform Areas Supported by the Credits

99. The Government’s medium-term development strategy i s described in Section 111. The Govemment’s policy action matrix i s outlined in Annex 1. The Govemment has requested IDA to support an important subset o f the reforms outlined in i t s strategy (which excludes activities related to security and r u l e o f law as per IDA’s mandate) while other donors are supporting other reform areas. The reform program supported by the Credit i s outlined in the attached Letter o f Development Policy (LDP) (Annex 3).

100. The overall objective o f these operations i s to provide rol l ing support to the Govemment’s objective to deepen, broaden and sustain the reforms underway in the areas o f public administration and fiscal management. PSIB I builds on the reforms initiated under IDA’s Emergency Public Administration Projects (EPAP) to improve GOA’S own fiduciary standards. Deepening and broadening these reforms i s critical for poverty reduction assistance to be effective. The Credit supports on-going reforms to strengthen the budget process, increase the administrative capacity o f l ine ministries and subnational administration, develop revenue policy and administration, and improve c iv i l service effectiveness. The Credit also supports the implementation o f reforms that lead to a more efficient allocation o f fiscal resources in the areas o f human development (health, basic education and social protection) and private sector development (investment climate, financial sector, and state-owned enterprises). More comprehensive, thematic reforms in human and private sector development will require support through other instruments, including sectoral operations and TA.

B. Country Ownership

101. The overall framework for PSIB i s based around the NDF, the NDB and associated public investment programs, and the Securing Afghanistan s Future document. The pol icy and strategy framework for PSIB i s therefore driven by national priorities for state building and poverty reduction.

102. Ownership of the Credits by counterpart ministries and the Central Bank is strong. The definition o f the reform areas supported by the Credits, prior actions and triggers results fi-om a highly collaborative process between the Bank and the authorities including the Vice-president, the Central Bank and the Ministries o f Health and Education under the overall leadership o f MoF.

103. Several aspects o f the PSIBs are expected to foster and support broader country ownership. First, the PSIBs will provide incremental funding to the Central Govemment that could be used strategically to implement centrally-funded development programs country-wide. Second, the PSIBs allow the Government to establish a record o f accomplishments while adapting i t s reform program as it goes forward. For example, the number o f prior actions and triggers included in this operation reflects not only the solid achievements to date but also the level o f challenges the Govemment i s willing to confront. A s such, the PSIBs can be used strategically as they provide

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both leverage to implement core reforms and the flexibility required to adapt to unforeseen developments, which can only increase overall country ownership.

C. Prior Actions for PSIB I

104. Table 4 describes the authorities’ key achievements since January 2002, the prior actions for Board presentation o f PSIB I and the expected outputs and outcomes. The prior actions are as follows:

0 Adoption by Cabinet o f an ordinary and a development budget for i t s fiscal year 1383, which, among other things, contains: (i) an adequate financing and fiscal framework, which shows the sources o f the financing o f the deficit; (ii) an increase in aggregate allocations to provinces above allotments in fiscal year 1382; (iii) an increase in aggregate non-salary allocations to provinces above allotments in fiscal year 1382; (iv) an increase in the allocation to the Basic Package o f Health Services above fiscal year 1382; (v) an increase in the ordinary budgetary allocation to the Ministry o f Education above fiscal year 1382; and (vi) an increase in the allocation to the National Solidarity Program above fiscal year 1382.

Submission to Ministry o f Justice o f a draft o f the Public Finance and Expenditure Management Law, which includes the budget preparation process and applicable standards o f transparency and financial reporting.

Approval by the Independent Administrative Reform and C iv i l Service Commission placing 3,000 government staff positions under an elevated pay-scale in accordance with the government’s Priority Reform and Restructuring Program.

Approval by the Independent Administrative Reform and C iv i l Service Commission placing D a Afghanistan Bank’s staff under an elevated pay-scale in accordance with the government’s Priority Reform and Restructuring Program.

Adoption by Cabinet o f a tax reform package which includes: (i) wage withholding; (ii) a fixed tax (10 percent) on selected services (hotel, restaurant, telecommunication and intemational air travel); (iii) a reduction in the corporate tax rate (to 20 percent); and (iv) withholding tax on rental income (20 percent).

Adoption by Cabinet o f Income Tax L a w amendments which (i) give effect to the Decree o f 7 June 2004 which provides for the Income Tax L a w and the Customs L a w to be preferred and applied if there i s a conflict between those laws and other laws or agreements that provide for concessional tax treatment, (ii) provide altemative tax concessions (accelerated depreciation and loss cany-forward) for companies that are registered under the proposed investment law and for companies that enjoyed tax holidays under the 1381 Investment Law, and (iii) include appropriate transition rules.

0

0

0

0

0

0 Completion o f a draft procurement law and accompanying procurement regulations.

26

Table 4: Summary o f Key Achievements, Prior Actions for PSIB I and Outcomes (In Parenthesis: Prior actions included in or complementing prior actions in another reform area)

Prior Actions for Board Presentation of

PSIB I

Key Achievements (Jan. 02 -May 04) Reform Area Outputs/Outcomes

(para 37) Successful currency reform Adoption of SY 1383 Implementation o f a satisfactory Budget w t h satisfactory macroeconomic framework fiscal framework

Establishment o f national investment programs Mandatory evaluation o f recurrent costs implications o f Development Budget Formulation o f Development Budget Creation o f Consultative Groups

Satisfactory macroeconomic framework

Submission to MoJ o f draft o f PFEM Law which specifies the Budget preparation process and standards o f transparency and financial reporting

(para. 41)

Multi-year, comprehensive, transparent, and result-based budget system

I Coordination o f external assistance with Govemment's strategy and Budget I

Adoption o f a tax reform package (wage t withholding; fixed tax on

lncrease domestic revenues and certainty o f revenue system

Approval o f a new customs tariffs Development o f a 5-year plan for customs and tax administration

Preparation o f mid-year review o f 1382 Budget

A.3 Revenue Policy and Administration

(para. 43) Completion o f a Statistical Master Plan Availabil ity o f data to feed into uolicv makine

PRR Level 2 Status for Customs and Excise Department Creation o f a Large Taxpayer Office

reduction o f corporate tax rate; and rent tax)

(para. 45)

A.4 Statistical and Data Management

Enactment o f PRR decree Creation o f Program Management Unit in one ministry

Approval o f PRR-level 2 Restructured, downsized and rationalized Central Government Strengthened policy design'and implementation capacity in ministries

for 3,000 positions

Systems for payroll (para. 49)

Human resourceslsalary structurelpension (para. 51 and 53)

B. STRENGTHENING PUBLIC ADMINISTRATION AND FISCAL MANAGEMENT

Decentralization o f payroll to provinces Introduction o f Individualized Salary Payments for staff o f budget entities o f 10 ministries in Kabul issuance

Verification o f payroll against headcount database (ARTF) Adoption o f verified payroll p lan Design and implementation o f PRR Program and top-up decree Design o f lateral entry program Cap on total public employment outside education Increase in pensions for public employees

B.1 Government Structure

B.2 Personnel Management

(para. 47) Creation o f IARCSC Agreement on merit-based appointment procedures Draft o f C iv i l Service Law for Cabinet consideration

(Approval PRR-level 2 for 3,000 positions)

Updated legislative framework for C iv i l Service in line with modern practice

Payroll payments in time, with full amount and adequate controls

Human resource and pay and pension systems adequate to recruit, retain and motivate skilled c iv i l servants

27

Prior Actions for Board Presentation of

PSlB I

Key Achievements (Jan. 02 - May 04) ieform Area

5.3 Strengthening Subnational Administration

Outputs/Outcomes

para. 57)

Appointment o f new Provincial Govemors by the President

(Adoption of SY1383 Improvement of local govemments’ Budget with provincial infrastructure t allocations above SY 1382

Re-establishment of Provincial departments by a number of parent ministries (e.g. MRRD)

allotments, in particular Strengthening of local govemments ’ for non-salary

. - :para. 61)

1 Extemal audit :para. 63) 8 Procurement :para. 65)

I emendituresi I

- execution (MoF) draft of PFEM Law with

requirements on financial reporting)

inforhation and timely pGeparation and release of financial accounts

Completion of 1381 audits of IDA’S Audit o f financial accounts in l ine

Creation of a Central Procurement Completion of draft o f Procurement activities in line with grants and ARTF

Facilitation Unit Procurement Law and international standards

with international standards

procurement regulations

~

B.4 Fiduciary Standards

Pnmary and secondary education (para 69)

Financial control ;ystems and cash nanagement ,para. 59)

Issuance of Decree to create Parents- (Adoption of 1383 Progress towards universal pnmary

School improvement grants are Teachers Associations (PTAs) Budget with higher education, gender panty and

provided to PTAs in 3 Provinces as a allocation to Ministry o f Education)

completion ofpnmary schooling (Millennium Development Goals)

pilot

Implementation of AFMIS in Treasury Improvements in reporting of Provinces Creation o f a “Consolidated Fund” as mandated by the Constitution and Govemment’s operations mainly through bank accounts controlled bv

(para. 71)

Implementation of Budget with optimized cash management and appropriate controls

(Adopt 1383 Budget with increased allocation for NSP)

Improvements in social protection t Complete reform o f MRRD and development and implementation o f NEEP and NSP

1 Treasury and provincial mustofiats I* Draft annual reports on budget

I

1 Financial reporting c (Submission to MoJ o f /* Adequate financial management

Adoption of amendments to Income Tax Law (tax measures in non-tax laws and agreements have no effect; tax-holidays are I ended)

1 Preparation of an Investment Law Improved business environment, including transparency in tax payments

Basic health Development of an Interim Health (para. 67) Strategy (2002-04)

Initiate process of contracting with NGOs to further expand coverage o f 1 BPHS

C.2 Education

Services for private sector development (para. 73)

(Adoption of 1383 Budget with higher health coverage

Progress towards universal basic

morbidity rates, especially among women and children (Millennium

Creation of Afghanistan Investment Improved registration procedures Support Agency

D. PROMOTING PRIVATE SECTOR DEVELOPMENT

D.l Investment Climate

Regulatoo (para. 73)

‘ framework

28

Prior Actions for Board Presentation of

PSIB I

Key Achievements (Jan. 02 -May 04) Reform Area OutputdOu tcomes

Legal and regulatory framework Enactment of Central Bank Law (uara 81)

Enactment of Banking Law

(para. 85) Signature of bilateral and multi-lateral trade agreements

Implementation of a sound, efficient and competitive legal and regulatory environment

Development of intemational trade Increase domestic revenues

Central Bank modernization (para. 81) Commercial banking (para. 81)

Pass new Tariff Code

D.5 Oil, Gas and Miming

Connection o f key Central Bank Approval o f PRR branches program at DAB

Creation of a modem Central Bank

Licensing of new commercial banks Development o f efficient financial All state-owned banks submit re- sector licensing application to DAB

(para. 77)

D. Triggers for PSIB I1

105. Progress on several reform areas i s deemed important to the sustainability o f the Government’s program. Triggers to measure progress on these areas have been identified in collaboration with the authorities. Attainment o f these triggers would represent sufficient progress to move to the next operation.

106.

0

Triggers for PSIB I1 can be summarized as follows:

Maintenance o f a satisfactory macroeconomic framework, including progress in raising domestic revenues;

Preparation o f a Medium-Term Fiscal Framework (MTFF);

Improvement in c iv i l service efficiency as measured by: (i) maintaining the increase in number o f un-uniformed central government employees (except teachers) below 10,000 compared to end-June 2004 level, and initiating a census o f a l l government employees, (ii) gazetting o f a new C iv i l Service L a w and Code o f Ethics for government employees, (iii) making progress according to the Government’s Verif ied Payroll Plan, (iv) continuing implementation o f the PRR program to include 15,000 positions, and (v) steady increase in the percentage o f senior positions (level 2 and above) selected on a merit-basis (i.e. by IARCSC);

Preparation o f a draft Pension L a w and proposed plan o f financing;

Progress in raising fiduciary standards as reflected by: (i) steady decrease in ARTF ineligibility ratio, (ii) initiation o f ro l l ing out o f AFMIS to Provinces and l ine ministries, (iii) gazetting and implementation o f the Public Finance and Expenditure Management Law which includes public release o f quarterly reports on budget execution (including

0

0

0

0

Adoption of a Reform Road Map Increase access to electricity Submission to Cabinet of Electricity Policy Statement

29

Oil and Gas sector Draft Oil and Gas Law Increased private investments in oil (para. 89) and gas Mining sector Draft Mining Law Increased private investment in (uara. 89) mining

-

revenues and expenditures by Ministry and Province against appropriations, allocation o f contingencies), preparation and audit o f final accounts for 2003104, consolidation o f all Government’s accounts into the Treasury Single Account, and preparation o f the 2004/05 budget document in l ine with the standards outlined in the law, (iv) gazetting o f a Procurement L a w and procurement regulations, and creation o f a Public Procurement Unit, and (v) gazetting o f an Audit Law;

Proper monitoring and evaluation o f health delivery as evidenced by the completion o f a baseline evaluation o f service delivery performance by M o H and NGOs;

Assurance that budget allocation for education leads to increased provision and quality o f primary and secondary education as evidenced by (i) initiation o f a baseline assessment o f existing teachers’ number and qualification; (ii) development o f a certification program for existing and new teachers; and (iii) development o f MoE’s financial management system and strengthening o f MoE’s capacity;

Review o f legislations, regulations and procedures related to private investments in order to simplify and harmonize them in l ine with international best practice;

Continued progress on financial sector reform including strengthening the regulatory framework, modernization o f the Central Bank, and resolution o f the state-owned commercial banks:

o Regulatory Framework: Progress will be measured by the elaboration o f internationally accepted prudential regulations for all core sectors o f banking (licensing, monitoring and closure) and the strengthening o f the banking supervision function o f the Central Bank,

Central Bank modernization: Progress will be measured by (i) installation o f technical hardware and software equipment in the Central Bank and at least 6 regional Central Bank branches, (ii) implementation and completion o f the PRR program at DAB, (iii) preparation o f externally audited financial statements in accordance with international accounting standards, and (iv) steady reduction in the Central Bank’s commercial banking functions where private banks have demonstrated capacity to develop these functions,

Resolution o f state-owned commercial banks: Progress will be measured by (i) completion o f re-licensing o f commercial banks, (ii) initiation o f a resolution for the banks that have not been re-licensed;

o

o

Progress in SOE reform as evidenced by the continued implementation o f a plan for SOE restructuring.

E. Monitoring and Evaluation

107. The existing capacity o f the Government to monitor and evaluate outcomes o f and progress under i t s reform program i s limited. Currently, indicators o f progress are not produced systematically and, when they are produced, they often result f rom the monitoring and evaluation components o f donor-financed projects. However, these activities are not institutionalized and are conducted mostly on an ad hoc basis.

108. The Government i s expected to gradually strengthen i t s institutional capacity to monitor and evaluate i t s development strategy including public expenditures. One element o f the strategy consists in strengthening the CSO. IDA has contributed to the elaboration o f a Statistical Master Plan for the CSO that includes the development o f the analytical capacity necessary for pol icy making. This includes the design, implementation, and analysis o f regularly held households

30

surveys. This plan w i l l provide the framework for IDA ’s technical assistance to build capacity to evaluate and monitor outcomes related to poverty and social development. Reforms supported by this Credit, including the implementation o f the PFEM law, the completion o f a baseline study on health service delivery, and a baseline evaluation o f existing teachers, are part o f this plan to strengthen the Government’s capacity to monitor and evaluates outputs and outcomes.

109. In the short term, monitoring and evaluation wi l l focus on processes and inputs, as opposed to outcomes. Annex 6 describes monitoring and evaluation indicators, which focus on budget and reform program implementation.

110. The capacity to monitor these indicators has steadily been improving. An AFMIS i s in place in MoF, providing data on revenues and expenditures. Processes are being improved and training delivered to improve the reliability o f this system. In addition, ARTF has hred an international firm to pre-audit expenditures before reimbursements which provides additional monitoring mechanisms. Extemal audit has also started, with the audit o f ARTF’s account for 2002103. As part o f the implementation o f the PFEM law, the budget documents will be more comprehensive and quarterly reports on budget execution will be released. The Staff-Monitored Program implemented by the IMF i s expected to increase the frequency and quality o f reporting. The IMF has also posted a resident advisor to the Treasury. U S A I D provides assistance to M o F in the area o f budget formulation and salary payments and to DAB for central bank reform. UNDP provides assistance to prepare the development budget and coordinate donor assistance. IDA’s assistance with financial management, audit, and procurement i s expected to further raise fiduciary standards and improve capacity to monitor revenues and expenditures. IDA’s future work program may also include a Public Expenditure Review (FY05) and a Poverty Assessment (FY06), which will help monitor public spending as wel l as i t s impacts on poverty. This in turn will permit IDA and the authorities to intensify their dialogue on the equity impact o f public spending which will also contribute to refine the development strategy.

F. Credit Administration

111. Credit Amount, Benejiciary, Terms, and Tranching. The borrower i s the Islamic Republic o f Afghanistan, represented by MoF. The Credit i s for an amount equivalent to US$80 million, on standard IDA terms to be released in one tranche following approval o f the Credit and notification by the Association o f Credit effectiveness. The completion o f the prior actions i s sufficient to release the Credit.

1 12. Implementation, Monitoring and Supervision. During the preparation o f the Credit, IDA has assisted the authorities to ensure timely implementation o f the agreed measures. Min is t r ies responsible for monitoring progress have been identified and a plan to monitor indicators developed. To assess the impact o f the proposed operation, IDA will monitor progress in achieving the benchmarks described in the LDP.

113. Credit Management. A dedicated Deposit Account in U S Dollars will be established at DAB in the name o f the MoF. The Account will be managed by the MoF, on terms and conditions satisfactory to IDA. The only funds paid to this account would be the proceeds o f the Credit.

1 14. Disbursements. Upon notification by IDA o f Credit effectiveness, and with the submission by the Recipient o f a withdrawal application, the proceeds o f the Credit will be deposited by IDA into the Deposit Account o f the Recipient. The proposed Credit will fo l low IDA’s simplified disbursement procedures for adjustment credits. Disbursements will not be linked to specific purchases and no procurement requirements will be needed. However, the proceeds o f the Credit cannot be used for ineligible expenditures (i.e. to finance items imported from non-member countries, or goods and services f rom the IDA’s standard negative list). If, after deposit into the Deposit Account, the proceeds o f the Credit are used for ineligible expenditures, IDA will require

31

the Recipient to either (i) retum the amount to the account for use for eligible purposes, or (ii) refund the amount directly to IDA. Eligible expenditures would include payments by GOA to meet its external service obligations, provided that there are legal agreements that establish such external debt service obligations. Transactions and balances o f the Deposit Account will be fully incorporated into the Govemment’s accounting records and financial statements, via the AFMIS.

115. Fiduciary Aspects. Significant progress has been made over the last two years to reduce fiduciary risks. Under IDA’s EPAPs, financial management (implementation o f AFMIS), procurement (establishment o f a Central Procurement Facilitation unit), and audit (external audit o f a l l IDA grants and ARTF for 2002/03) have been strengthened. The IMF has just completed a mission to assess the Central Bank’s balance sheet. The Authorities have also initiated discussions with the IMF regarding a Safeguard Assessment o f the Central Bank. Overall progress in raising fiduciary standards i s evidenced by GoA’s compliance with standards set by ARTF. Annex 4 describes in more details the measures taken to reduce fiduciary r isks as well as GoA’s strategy to further reduce these risks. As GOA takes the whole responsibility for financial management, procurement, and audit (currently supported by IDA through the EPAPs and other donors), r isks might temporarily increase due to lack o f capacity. However, such temporary increase i s deemed unavoidable in order to decrease fiduciary risks in the long-term.

1 16. Reporting, Accounting and Auditing. Section 3.02 o f the Development Credit Agreement gwes IDA the right to require the Borrower to audit the deposit account. Pursuant to this provision and considering the prevailing financial management situation in Afghanistan, immediately following closure o f the Deposit Account, IDA intends to request the Borrower to have the Deposit Account audited by auditors acceptable to IDA. The terms o f reference for these auditors will be agreed at negotiations. The Borrower will send a copy o f the audit report to IDA n o later than 6 months following the date o f IDA ’s request for such an audit. In addition, IDA may also request audits o f the Deposit Account prior to i t s closure in accordance with Section 3.02 o f the Development Credit Agreement.

117. Closing Date. The expected closing date o f the Credit will be March 20,2005, which i s the end o f Afghan fiscal year 1384.

118. Environmental and Social Aspects. The proposed Credit supports a broad spectrum o f economy-wide policies and institutions. For the purpose o f Operational Directive 8.60, environmental and social assessments are not required and the Credit has been placed in category U. During implementation, the proposed Credit will fo l low the Social and Environmental Safeguards Framework applied to other IDA-financed projects. For that purpose, IDA has developed a Capacity Assessment and Building for Social and Environmental Management program, which the M o F and other implementing ministries will be invited to attend.

G. Coordination with the IMF and Other Donors

119. The achievement o f reform objectives will be supported by IDA’s close collaboration with the IMF and other donors. The authorities’ overall reform program i s designed within a satisfactory macroeconomic policy framework as evidenced by the implementation o f a 12-month S M P covering the Afghan fiscal year starting March 21, 2004 (Annex 2). The SMP’s structural benchmarks also place considerable focus on promoting fiscal discipline and further developing public financial accountability. The preparation and future implementation o f the proposed Credit i s being closely coordinated with the IMF. The PSIBs incorporate the SMP macroeconomic framework and are fully consistent with i t s structural benchmarks. The PSIBs are also consistent with the support provided by donors through the ARTF. Indeed, ARTF funding i s integrated in the medium-term fiscal framework supported by the PSIBs while ARTF provides key fiduciary standards aiming at mitigating fiduciary r isks (Annex 4).

32

120. Many donors are active in the reform program supported by the proposed PSIBs. This reform program has been discussed with other donors and will provide a platform to coordinate donor’s support around GOA’S strategy. I t s implementation requires significant TA under IDA projects (EPAP I and 11, and EPAP 111 under preparation), ARTF, and IMF and bilateral supports.

121. The authorities have initiated discussions with IDA for the preparation o f an Interim Poverty Reduction Strategy Paper which will lay the basis for future donor coordination.

H. Poverty Implications

122. The Government has demonstrated a clear concern for both economic and social issues, through the NDF and national budget. As described in i t s development strategy, the Government aims to support broad based economic growth, while designing and implementing an efficient and comprehensive social protection program. The Government has already introduced a number o f social programs (see para. 18). By increasing and allocating fiscal resources in line with the Government’s medium term priorities, the Credits will have positive impacts on poverty reduction. The Credits will also help ensure that public spending progressively be targeted more effectively in the areas o f health, basic education and social protection, while ensuring country- wide coverage.

I. Benefits and Risks

123. Benefits. The Credits provide potential benefits which will all contribute to poverty reduction. First, they strengthen public administration and fiscal management, and support reforms to improve fiduciary standards. This will reduce the implementation r i sks o f a l l projects including these Credits, and i s l ikely to translate into higher levels o f donors’ assistance. Second, they provide resources to the central Government to deepen i t s reform program including service delivery beyond Kabul. This will benefit the whole population including the poor. Third, they also support the implementation o f reforms leading to a more efficient allocation o f fiscal resources in the areas o f human development and private sector development, which wil l reduce poverty.

124. Risks. The Credits have significant country r isks (political, security and macroeconomics) and implementation r i sks (fiduciary, budget execution and reform implementation). A reversal in the political process set out in the Bonn agreements or a deterioration o f the security situation constitutes the largest source o f risk for the operations. T h e recent conclusion o f the Constitutional Loya Jirga has somewhat reduced this risk, but the elections scheduled for the fall o f 2004 remain a significant source o f uncertainty. The macroeconomic scenario i s also uncertain since donors’ assistance and the response o f the private sector are highly dependent on the political and security situation, as outlined in Section 11.

125. The mitigation o f these country r isks i s largely outside the scope o f the project. However, the Credits will allow the Government to deepen the implementation o f i t s program beyond Kabul, which wi l l contribute to the nation-building effort and will somewhat mitigate political and security risks. Strengthening the Central Government could increase tensions with regional leaders, which could slow down the nation-building process.

126. The Credits also have implementation risks. First, fiduciary standards, while improving, partially as the result o f this Credit, are not yet fully effective. Budgetary systems and mechanisms, including tax administration and collection, s t i l l need to be improved. Second, there i s room for improvement in the execution o f the Budget, and implementing the reform program may be a challenge during an election year. Third, implementation capacity, particularly at the sub-national level and across sectoral ministries, remains constrained. However, even though the commitment to the reform program o f the post-election Government remains to be evidenced, this

3 3

Government has already demonstrated i ts commitment to reforms by achieving al l benchmarks under the two tranches o f the ADB budget support operation.

127. T o mitigate the risk o f implementation, prior actions and triggers focus on areas for which the authorities, under the leadership o f the MoF, have expressed ownership and have already built a good track record o f reforms. IDA and other donors are also supporting the Government’s efforts to improve i t s implementation capacity through investments and technical assistance. The present operation also aims at strengthening the Government’s structure (para. 45), personnel management (para. 47-55) and subnational administration (para. 57). Continued IDA support through the EPAPs, together with the next Credit’s triggers, in the areas o f financial management, audit and procurement, will also contribute to raising fiduciary standards. Finally, the program design as a series o f operations based on prior actions provides IDA with a possibility to adjust subsequent operations to the security and political situation and the pace o f reform implementation.

128. The risk o f not undertakmg these operations also i s significant. First, IDA’S support to GOA’S development strategy under the form o f PSIBs i s seen as a catalyst for other donors’ continuing support, including through the ARTF. Second, the resources provided by the PSIBs will allow the authorities to deepen the reform program and quickly deliver services throughout the country, thereby reducing the risk o f further deterioration o f the polit ical and security situations.

34

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Annex 2 Page 1 of 1

ANNEX 2 RELATIONS WITH THE INTERNATIONAL MONETARY FUND

The International Monetary Fund (IMF) i s currently implementing a Staff-Monitored Program (SMP), covering the fiscal year 2004/05 (March 21,2004 to March 20, 2005). The staff report on the SMP was issued for the information o f the Executive Board on March 26, 2004, and i s available on the web at http://imf.orn/external/~ubs/ft/scr/2004/cr04 1 1 O.pdf . The IMF i s expecting to conduct i t s f i rs t SMP review in end-July 2004.

Annex 3 Page 1 of I O

ANNEX 3 LETTER OF DEVELOPMENT POLICY

Yrwm Sincerely

Annex 3 Page 2 of 10

ISLAMIC REPUBLIC OF AFGHANISTAN LETTER OF DEVELOPMENT POLICY

I. INTRODUCTION

Background

1. The Afghan Transitional Authority began i t s task o f reconstruction in an environment that was virtually unparalleled. Two decades o f conflict had reduced physical and social infrastructure to skeletal proportions. Coherent government and administration were non-existent. Social indicators were among the world’s lowest, and simply maintaining security was an immense challenge. During the f irst two years o f administration, the government’s central focus has been on emergency interventions and crisis management, along with workmg to establish or rebuild the fundamental institutions and services necessary for any state. The progress over this period i s recognized by the international community as a monumental achievement by the Government o f Afghanistan. N o w that many o f these building blocks are in place, the govemment’s goals are increasingly focused on establishing a greater sense o f economic and political ‘normalcy’, while ensuring a high degree o f government transparency and accountability.

2. Establishing the institutions and processes necessary for a peaceful political transition has been at the forefront o f the govemment’s agenda, and in line with commitments made at the Bonn Conference. The Constitution approved by the Loya Jirga in early January 2004 was signed into law by President Karzai on January 26, and i s a critical f i rs t step in reestablishing an effective democratic unified state. The new Constitution establishes a strong presidency with wide ranging powers and checks and balances through a bicameral legislative body. Although D a n and Pashto are identified as the national official languages, other languages were given official status in the areas where they are spoken. The adoption o f the new Constitution provides for national elections in 2004, and fulfills the timetable agreed upon at the Bonn Conference. Voter registration i s proceeding, although slower than hoped, partly reflecting the security conditions.

3. Rebuilding economic and financial institutions and implementing sound macroeconomic policies have been clear priorities. Important economic and institutional reforms have been undertaken. In the fiscal sector, the Government has focused on improving budgetary management, enacting some important tax policy measures, introducing an ambitious program of customs reform, and gaining control over national revenue. The budget has been guided by the “no-overdraft rule,” which will remain a pillar o f fiscal pol icy for 2004/05. A draft Public Finance and Expenditure Management (PFEM) law will be presented to the cabinet this fiscal year. In the monetary and financial sector, a new currency was successfully launched and has gained acceptance by the public. Monetary policy has been conducted with a v iew to guarding against inflation, providing a stable exchange rate, and building an adequate level o f international reserves. N e w financial sector legislation has established autonomy for the central bank and paves the way for the creation o f a modern banking sector.

4. The Government i s committed to fiscal transparency to the international community and the people o f Afghanistan. In June 2004, a comprehensive financial report on 1380-82 was released by the Government on the resources available to the Government, how they were uti l ized and detailing the modalities o f expenditure by the donor community outside the Government accounts. The Government will publicly release the budget and provide a full accounting for i t s use.

Annex 3 Page 3 of 10

Recent Economic Developments

5. During 2003104, real GDP (excluding opium) i s estimated to have grown by 23 percent, following 29 percent in 2002103, although these high figures represent growth from a very l ow base. Construction and service sectors benefited from donor assistance, while agncultural production recovered as a result o f increased rainfall, the retum o f refugees to their lands, and an expansion o f cultivated acreage. However, the government i s deeply concemed about a similarly strong recovery in opium production, which represents an estimated 40 percent o f formal GDP.

6. Consumer prices rose by 52 percent in 2002103. Whi le prices remained relatively flat during March-October 2003, prices rose by 3 percent in both November and December, mainly driven by food prices, which were associated with Ramadan and colder-than-usual weather at end- year. Pnces in January and February fell modestly, with year-over-year inflation at 10 percent at the end o f 2003104.

7. These encouraging developments reflected a monetary policy focused on maintaining price stability, in the context o f a relatively stable exchange rate. Monetary policy was executed through control over the growth o f currency in circulation. Despite the lack o f sophisticated monetary pol icy instruments, the government has had considerable success in meeting i t s monetary objectives. Increases in money demand brought about by increases in real growth and increased use o f the Afghani have been accommodated while simultaneously avoiding excessive inflationary pressure. Currency in circulation increased by 41 percent in the twelve months to March 2004. This growth was also reflected in accumulation o f foreign exchange reserves. Intemational reserves increased by $294 mi l l ion through March 2004, to a level equivalent to 3 months o f imports.

8. The enactment o f the new central bank and commercial banking laws, in 2003, paves the way for modemizing o f the D a Afghanistan Bank (DAB) and the entry o f new commercial banks. The new laws provide a framework for an independent and accountable central bank and the creation o f a sound financial system. Progress has already been achieved in reorganizing and modemizing DAB, including building an information technology (IT) system, designing a national payment network, and reestablishing communications between DAB’S headquarters and some o f i t s territorial branches. The monitoring o f monetary developments has also improved substantially. Further, consistent with the Central Bank Law, a new corporate structure has been established, including the appointment o f Supreme Council to oversee DAB’S operations and to ensure accountability. In addition, five new commercial banks were licensed in 2003104.

9. Fiscal policy in 2003104 facilitated monetary control through continued adherence to the “no-overdraft-rule,’’ which forbids monetary financing o f the budget. Domestic revenues exceeded the Af9 bi l l ion budgetary target with Af10.2 bi l l ion revenues ($209 million). Spending was slow early in the year, due to delays in budget allotments, procurement constraints, and weak financial management capacity in the Ministries. However, ministries steadily accelerated their pace o f spending through the course o f the year, and expenditures reached Af 22.1 bi l l ion ($457 million) by the end o f the financial year, compared with a budgeted amount o f Af 24.8 bi l l ion ($550 million). The lower level o f spending compared to the budget principally reflects lower outlays by the education, health, defense, interior, and foreign affairs ministries. Donor disbursements have amounted to about $239 mi l l ion in 2003104 (compared to a budgeted level o f $350 million), allowing for the financing o f the budget and a small carry-over o f available financing into the upcoming year. Donor commitments for 2003104 covered about 70 percent o f the requirements expressed in the National Development Budget adopted in March 2003. As a result, high-priority projects were able to be implemented in infrastructure, education, and other critical areas.

10. Significant progress has also been made in fiscal management, where the immediate task has been to identify and eliminate waste, and to reassert transparent control over public finances. The

Annex 3 Page 4 of 10

major achievements include: (a) the introduction o f Afghanistan’s Financial Management Information System (AFMIS), a computerized system for expenditure recording, payment processing, and financing reporting; (b) the assignment o f fiscal advisors to provincial offices o f the Ministry o f Finance (Mustofiats) as well as to a number o f l ine ministries to assist with financial management and reporting; (c) a budget process for 2004/05 which evolved from a top-down approach controlled by the M o F to one that was driven by the ministries with a strong Cabinet consensus; (d) the progressive consolidation o f government bank accounts to strengthen treasury control over cash flows; (e) init ial steps toward a modern payroll system; ( f ) the increased integration o f the operational and development budgets; and (g) comprehensive traclung o f external resources by M o F and other ministries through the Donor Assistance Database and integration with the budget preparation process. The comparatively slow progress in the provinces highlights the need for continued focus and support to bring responsible fiscal management to the country as a whole.

11. On the revenue side, a landmark customs reform package was enacted, which will in effect make Afghanistan one o f the most open economies in the region. The package includes using the market exchange rate for import valuation, streamlining the tar i f f structure, putting in place new broker processes, and lowering tar i f f rates f rom the current range o f 0 to 150 percent to six rates ranging from 2.5 to 16 percent. In addition, an important set o f new revenue measures was enacted, including a final wage withholding tax on higher-income employees, an improved income tax regime, a streamlined business establishment tax, a tax on a l imited range o f services consumed by high- income earners (e.g. hotels and restaurants), and other revenue measures (rent tax, land tax, and an airport departure fee). Considerable progress has been made in securing the transfer o f provincial revenues to the center in 2003/04 and the accounting o f these revenues. However, efforts will continue to improve revenue collection mechanisms, including verification o f the total amount o f provincial revenues and expenditures.

12. In the area of c iv i l service reform, the government designed a program to decompress the c iv i l service salary structure to help the government attract and retain qualified staff in key positions. A large proportional increase in the base salary o f c iv i l servants was decided in December 2003 (excluding the military, police, and teachers who had previously received a separate pay increase). This increase ranged from 13 percent for the lowest grade to 130 percent for the highest grade, with an overall average increase o f about 25 percent. Despite the increase, base salaries remain very low.

13. Efforts have also been made by the government to eliminate “ghost” workers f rom public payrolls. A Priority Reform and Restructuring (PRR) program was launched by decree in July 2003 and provides the primary mechanisms for promoting administrative reforms across government departments and agencies. Managed by the Independent Administrative Reform and C iv i l Service Commission (IARCSC) under the oversight o f the Ministerial Advisory Committee on public administration reforms, the PRR framework enables departments to transfer/appoint key staff in reformed units to higher salary scales. By the end o f 2003/04, thirty-six departments had been granted PRR status and approximately 3,000 c iv i l servants were transferred to the PRR scales in these departments.

14. The Government i s committed to an agenda o f public enterprise reform as an engine o f future economic growth. Init ial steps include the establishment o f a census o f state-owned enterprises (SOEs) and audits o f the assets of SOEs. Progress to date has been limited by lack o f records and absence o f foreign assistance in this area. Despite this, the Govemment expects to reform a number o f key public enterprises and put in place a strategy for implementation o f a long term reform agenda.

15. The Government considers poppy cultivation and heroin production to be one o f the most serious obstacles to developing Afghanistan into a secure, stable democracy with a prosperous economy. Many Afghan farmers have been driven into poppy production by decades o f deep poverty and lack o f alternative livelihoods. But the drug economy has benefited mostly international

Annex 3 Page 5 of 10

narcotics and terrorist networks. The Government i s deeply committed to root out this grave threat to Afghanistan’s future. I t has therefore passed broad anti-narcotics legislation, banning all opium production and trading. I t has established an Anti-Narcotics Directorate and adopted a National Drug Control Strategy that aims to reduce opium production by 70 percent by 2008, and eliminate i t altogether within ten years. An ambitious eradication program was launched that led to the destruction o f more than 20,000 hectares o f poppy fields during the 2002-2003 season.

11. THE GOVERNMENT’S STRATEGY

16. The Government has made significant progress since it came to power in June 2002. I t has demonstrated i ts capacity to implement i t s ambitious reform program. I t demonstrated achievement o f benchmarks under the two tranches o f the ADB budget support operation and received full disbursement o f the fund according to the original schedule - a momentous achievement which demonstrates the capacity o f the Government to deliver against fiscal reform targets. The Government has also entered into an ADB agriculture sector reform program and was able to fulfill a l l prior conditions on schedule. On March 2 1, 2004, the Government started the implementation o f an IMF’s Staff Monitored Program.

17. Yet, the Government’s challenge i s now to apply i t s authority nationally and to implement reforms that, beyond the init ial steps o f state building, will generate broad-based growth. For that, in the short to medium term, the Government needs multi-year financial support that i s not linked to specific projects, but that can support i t s reform program.

18. Init ially formulated in the National Development Framework (NDF) o f April 2002, the Government’s development strategy was reaffirmed in the document Securing Afghanistan s Future presented by to the intemational community at the donors’ conference held in Berl in at end-March 2004.’ Within this reform strategy, the Government i s primarily see lng support to deepen, broaden and sustain the reforms underway in the areas o f public administration and fiscal management. The proposed reform program builds on ongoing reforms to strengthen the budget process, increase the administrative capacity o f l ine ministries and sub-national governments, develop revenue policy and administration, improve c iv i l service effectiveness, and increase fiduciary standards in the areas o f financial management, procurement and audit. These reforms will also facilitate a more efficient allocation o f fiscal resources to priority activities in the areas o f human development (health, basic education and social protection) and private sector development (investment climate, financial sector, and state-owned enterprises).

19. are as follows.

The key elements o f the reform program on fiscal management and public administration

20. Revenues Collection. The Government’s strategy i s to increase domestic revenues to cover the wage bill in 5 years and ordinary budget expenditures in 9 years. Increase in tax collection efficiency i s also expected to result in a significant increase in compliance over the next five years. The Cabinet has recently introduced an ambitious tax package that includes new customs tariffs and the elimination o f tax holidays for new investments, a withholding tax on high income, a streamlined business tax, a tax on selected services, a rent tax, a land tax, and an airport departure fee.

21. Government Structure. The Government intends to restructure and rationalize the central Government bureaucracy and strengthen policy design and program implementation capacity in ministries. The PRR Program decree was enacted in July 2003 to initiate the process o f reforming the

’ See h ~ : / / ~ ~ . w . a M r e c o s t i i i ~ / . This Letter o f Development Pol icy should be read in conjunction with our commitment to implement the reform agenda agreed at the recent Intemational Conference on Afghanistan held in Ber l in in March 2004 (annex to the “Berlin Conference”).

Annex 3 Page6oflO

most critical functions o f the Govemment by allowing administrative departments to place staff on an elevated pay scale in exchange for organizational restructuring. 3,000 positions are covered by this program and the Government i s fully committed to pursue i ts implementation. The f i rs t Program Management Unit (PMU) has been created in the Ministry o f Imgat ion to enhance project ownership by line ministries and strengthen implementation capacity. Such units are expected to be responsible for the preparation, procurement, financial management, supervision, and evaluation o f projects which should hasten their implementation. The Government also intends to improve the bureaucracy o f central Government, which includes reform o f the Office o f the President.

22. Sub-national Administration. Provinces’ and provincial municipalities’ capacities wi l l be strengthened to deliver basic services. Basic office facilities have been upgraded in 6 pi lot districts to improve service delivery and provide the means to connect citizens with central Govemment. Budget allotments to provinces are gradually being increased. Budget grants could be provided to Provinces for public building reconstruction. The recently created Afghanistan Stabilization Program wil l finance small-scale labor-intensive construction projects. Modest grants could also be provided to provincial municipalities to finance the reconstruction o f the municipalities’ own building, local roads and water and sanitation programs and some labor-intensive works. Municipalities’ capacity will require strengthening to effectively manage these resources.

23. Civil Service. An Independent Administrative Reform and C iv i l Service Commission (IARCSC) was created in June 2003 to coordinate and manage the PRR. The IARCSC comprises (i) a Civ i l Service Management Department responsible for developing a new legal framework (including a Code o f Ethics) for the Civ i l Service and modem human resources management policies and procedures, (ii) the Independent Appointments Board (IAB), responsible to have appointments based o n merit, and (iii) the Independent Appeals Board responsible for hearing complaints against unfair, il legal or discriminatory behavior in the workplace. Merit-based procedures have been adopted and the IAB has started applying them. An updated legislative framework will be adopted to define c iv i l service, i t s role, lays down ethical standards, and regulates c iv i l servants’ terms and conditions in line with modem employment practice. The upcoming adoption o f a Civ i l Service L a w will establish a legal framework for c iv i l service in line with good modern employment practices. Appointments are expected to be increasingly based on merit and progressively audited.

24. The strategy to control legitimacy o f public employment and progressively reduce delays in payroll settlement i s as follows. In the short term, first, the Government i s decentralizing the processing o f payroll to Provinces. Second, individualized salary payments are piloted in ten central Ministries in Kabul and will be rolled-out to all central Ministries this year and, then, gradually to provinces. Third, a headcount database has been created to control the size o f the civ i l service. In addition, the Monitoring Agent o f ARTF conducts spot checks o n payroll distribution including individual cash payments. Also, in the longer term, the Government aims at improving personnel management and computerizing processes. This wil l contribute to speeding up the payroll process (through computerization) and validate the legitimacy o f public employment (through random audit).

25. The Government’s objective to enhance the level o f human resources i s by nature a long term endeavor. In the short-term, the PRR program provide an opportunity to administrative departments to restructure themselves and increase salaries for key positions while accessing funds to provide significant training to retained staff. In addition, the Government i s designing a lateral entry program to hire advisors on short-term contracts at competitive rate and place them in key positions. This program would allow us to attract skdled employees while limiting pressures on the whole pay structure. In the longer term, the Government intends to conduct a training and development needs analysis, design and implement a Retraining, Reskilling and Redeployment Program, and build a proper human resource management system to continuously enhance slul ls.

Annex 3 Page 7 of I O

26. The Government intends to pursue the implementation o f the PRR program and increase the number o f employees under PRR. Beyond this initial reform, the Government intends to carry out a labor market survey to be used as a base for a c iv i l service pay and grading review. The Government jus t increased the pensions o f public sector employees from about US$1 mi l l ion to an estimated US$15 mi l l ion in the 2004/05 Budget. This short-term measure i s associated with a commitment to review operations and management o f the Pension Fund Office and refrain f rom any increase in pension before the adoption o f a long-term policy regarding pension.

27. The Government i s committed to correct the gender imbalance and promote the role o f women in c iv i l service. The strategy consists in establishing targets for increased level o f female employment and develop and implement a plan to achieve these targets.

28. Public Finance and Expenditure Management. The Ministry o f Finance has completed the final draft o f the Public Finance and Expenditure Management (PEFM) Law. The PFEM L a w provides a framework for the proper management o f public resources. I t specifies the budget process (including the requirement to base the budget on a medium-term economic framework) and content (including transfers to public sector enterprises). It also mandates the budget to be presented by programs, defines the standards o f transparency and financial reporting, and mandate the design and implementation o f a multi-year fiscal framework. The PFEM L a w will mandate quarterly reporting on public finances, as well as the preparation and auditing o f annual financial accounts.

29. Four elements are key for the Government’s strategy to strengthen financial management. First, Mustofiats are being trained to reduce delays in reporting. A decentralization process i s being planned and AFMIS i s expected to be rolled out to l ine ministries and provinces. The PFEM L a w mandates the appointment o f a Chief Financial Officer in each line ministry, which will increase financial management accountability. It i s envisaged that the l ine ministries where Chief Financial Officers are in place wil l be provided more financial management responsibilities, including payments, accounting, and reporting. Second, M o F will strengthen i t s cash management system. Treasury in cooperation with DAB will fully implement the TSA. Third, a strategy i s in place to gradually shift al l financial management capacities to Treasury, while external f irms would focus only on advisory and training services. Fourth. MoF’s Internal Audit Department i s being strengthened as part o f M o F reform and the legal and institutional framework will be clarified.

30. External Audit. An update o f the legal framework, including an Audit Law, will establish a clear framework for extemal audit: requirement to audit annual financial accounts, requirement for the Government to respond to the Auditor’s opinion, independence o f the auditor. This will be complemented by capacity building programs.

31. Procurement. Three elements are key for the Government’s strategy to strengthen public procurement. First, the legal framework will be clarified by a new Procurement Law. Second, the reform strategy seeks to address the lack o f capacity through the assistance o f a central procurement consultant (currently supported by IDA through the EPAP project). Whi le this consultant init ially provided direct procurement services, it wi l l gradually move towards advisory services. Third, the institutional framework will be strengthened to transfer procurement management f rom donors to line ministries as capacity i s built through new recruitment (by implementing PRR in procurement units) and training. A central Public Procurement Unit will be created to monitor and review the procurement policies.

Financial Management.

Annex 3 Page 8 of 10

111. STRUCTURAL REFORM AGENDA UNDER PSIB I

32. The measures described in this section are considered critical to demonstrate the Government’s commitment to the reform program. The following measures have been taken before approval o f the proposed Credit:

Cabinet adoption o f an ordinary and a development budget for i t s fiscal year 1383, which, among other things, contains: (i) an adequate financing and fiscal framework, which shows the sources o f the financing o f the deficit; (ii) an increase in aggregate allocations to provinces above allotments in fiscal year 1382; (iii) an increase in aggregate non-salary allocations to provinces above allotments in fiscal year 1382; (iv) an increase in the allocation to the Basic Package o f Health Services above fiscal year 1382; (v) an increase in the ordinary budgetary allocation to the Ministry o f Education above fiscal year 1382; and (vi) an increase in the allocation to the National Solidarity Program above fiscal year 1382.

Submission to the Ministry o f Justice a draft o f the Public Finance and Expenditure Management Law, which includes the budget preparation process and applicable standards o f transparency and financial reporting.

Approval by the Independent Administrative Reform and C iv i l Service Commission placing 3,000 government staff positions under an elevated pay-scale in accordance with the government’s Priority Reform and Restructuring Program.

Approval by the Independent Administrative Reform and C iv i l Service Commission placing D a Afghanistan Bank’s staff under an elevated pay-scale in accordance with the government’s Priority Reform and Restructuring Program.

Cabinet adoption o f a tax reform package which includes: (i) wage withholding; (ii) a fixed tax (1 0 percent) on selected services (hotel, restaurant, telecommunication and international air travel); (iii) a reduction in the corporate tax rate (to 20 percent); and (iv) withholding tax on rental income (20 percent).

Cabinet adoption o f Income Tax L a w amendments which (i) give effect to the Decree o f 7 June 2004 which provides for the Income Tax L a w and the Customs L a w to be preferred and applied if there i s a conflict between those laws and other laws or agreements that provide for concessional tax treatment, (ii) provide alternative tax concessions (accelerated depreciation and loss carry-forward) for companies that are registered under the proposed investment law and for companies that enjoyed tax holidays under the 1381 Investment Law, and (iii) include appropriate transition rules.

Preparation o f a draft procurement law and accompanying procurement regulations.

IV. STRUCTURAL REFORM AGENDA FOR 2004/05

33. implemented in 2004/05:

The following actions are key elements o f the Government’s reform program to be

Maintenance o f a satisfactory macroeconomic framework, including progress in raising domestic revenues;

Preparation o f a Medium-Term Fiscal Framework (MTFF);

Annex 3 Page 9 of I O

0 Improvement in c iv i l service efficiency as measured by

o (i) maintaining the increase in number o f un-uniformed central government employees (except teachers) below 10,000 compared to end-June 2004 level, and initiating a census o f all govemment employees,

(ii) employees,

(iii) m a l n g progress according to the Government’s Verif ied Payroll Plan,

(iv) continuing implementation o f the PRR program to include 15,000 positions, and

(v) steady increase in the percentage o f senior positions (level 2 and above) selected o n a merit-basis (i.e. by IARCSC);

o gazetting o f a new Civ i l Service L a w and Code o f Ethics for government

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Preparation o f a draft Pension L a w and proposed plan o f financing;

Progress in raising fiduciary standards as reflected by:

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(iv) Gazetting o f a Procurement L a w and procurement regulations, and creation o f a Public Procurement Unit, and

(v) Gazetting o f an Audit Law;

(i) steady decrease in ARTF ineligibility ratio,

(ii) initiation o f ro l l ing out o f AFMIS to Provinces and line ministries,

o

o

0 Proper monitoring and evaluation o f health delivery as evidenced by the completion o f a baseline evaluation o f service delivery performance by M o H and NGOs;

Assurance that budget allocation for education leads to increased provision and quality o f primary and secondary education as evidenced by (i) initiation o f a baseline assessment o f existing teachers’ number and qualification; (ii) development o f a certification program for existing and new teachers; and (iii) development o f MoE’s financial management system and strengthening o f MoE’s capacity;

Review o f legislations, regulations and procedures related to private investments in order to simplify and harmonize them in l ine with international best practice;

Continued progress o n financial sector reform including strengthening the regulatory framework, modernization o f the Central Bank, and resolution o f the state-owned commercial banks:

0

0

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o Regulatory Framework: Progress will be measured by the elaboration o f internationally accepted prudential regulations for a l l core sectors o f banking (licensing, monitoring and closure) and the strengthening o f the banking supervision function o f the Central Bank,

Annex 3 Page 10 of I O

o Central Bank modernization: Progress will be measured by (i) installation o f technical hardware and software equipment in the Central Bank and at least 6 regional Central Bank branches, (ii) implementation and completion o f the PRR program at DAB, (iii) preparation o f externally audited financial statements in accordance with international accounting standards, and (iv) steady reduction in the Central Bank’s commercial banking functions where private banks have demonstrated capacity to develop these functions,

Resolution o f state-owned commercial banks: Progress will be measured by (i) completion o f re-licensing o f commercial banks, (ii) initiation o f a resolution for the banks that have not been re-licensed;

o

0 Progress in SOE reform as evidenced by the continued implementation o f a plan for SOE restructuring.

Annex 4 Page I of 5

ANNEX 4 PROGRESS IN REDUCING FIDUCIARY R I S K S

1. Significant progress has been made over the last two years to reduce fiduciary risks. A key objective o f the PSIBs i s to support the Government’s strategy to further reduce risks, a prerequisite to effectively deliver public services and implement Government’s policies. This annex describes these fiduciary risks, progress made by the Government, and i t s strategy to further reduce fiduciary r isks.

2. In the past two years, GOA, with the assistance o f a number o f international advisers, has made significant progress to reduce fiduciary r isks. First, the development o f financial management, procurement, and audit has been supported under IDA’S Emergency Public Administration Projects (EPAP). In these three areas, international f i r m s have been contracted to develop and implement fiduciary systems and build Government’s capacity. A financial management system, the Afghanistan Financial Management Information System (AFMIS) has been implemented since October 2002. A Central Procurement Facilitation unit has been set up. The Controller and Audit Office (CAO) has prepared external audits for a l l IDA grants and ARTF for the solar year 2002/03. As part o f the IDA portfolio review conducted in February 2004, progress on these projects has been rated satisfactory, although administrative capacity s t i l l needs to be enhanced. Second, disbursements under ARTF demand the application o f fiduciary standards in line with international standards. These standards have been monitored since September 2003 by the Monitoring Agent o f ARTF and their compliance i s a condition for expenditure reimbursement. The application o f these standards generates overall improvement in GOA’S practices. Third, capacity i s being built in l ine ministries as external advisors provide Technical Assistance in the area o f budget and financial management (budget advisors are funded by DfID and Chief Financial Officers by ARTF).

3. T o consolidate this progress, the Government’s strategy i s to continue to build systems and institutions, and strengthen i t s technical capacity to operate these systems (see Table below). First, in terms o f institutions, the Treasury Department and the Budget Department have undergone the PRR reform process and the Internal Audit Department will soon apply to this process. A Public Finance and Expenditure Management Law, a Procurement Law, and an Audit L a w will be adopted and implemented, creating a strong legal basis for public finance management. In terms o f systems, the AFMIS wil l be gradually rolled-out to l ine ministries and provinces, improving the effectiveness and timeliness o f the overall system. Second, to strengthen the Government’s technical capacity to operate these systems, the role o f international f i r m s in the area o f procurement, financial management, and audit i s expected to gradually shift towards training and advisory services. As a result, GOA will gradually take full responsibility in these areas. Already (as o f February 2004), payments and accounting for Kabul are largely done by M o F staff, and payments and reporting for Provinces are done by Mustofiat’s staff (MoF’s provincial departments) while the international f i r m s supported by EPAP operate a number o f coordination and reporting functions in Kabul. Finally, the IMF has just completed a mission to assess the Central Bank’s balance sheet. The Authorities have also initiated discussions with the IMF regarding a Safeguard Assessment o f the Central Bank.

4. The PSlBs support this strategy and particularly the following measures:

0 Submission to Ministry o f Justice o f a draft o f the Public Finance and Expenditure Management (PFEM) L a w constitutes a prior action for PSIB I and i t s enactment and implementation are critical triggers for PSIB 11. The law i s expected to increase standards o f financial management, by clarifying systems and accountability and establishing fundamental rules in terms o f transparency, reporting, accounting, and auditing.

Annex 4 Page 2 of 5

0 Completion o f the draft o f the Procurement L a w and procurement regulations constitutes a prior action for PSIB I and i t s enactment and the creation o f a Public Procurement Unit are critical triggers for PSIB 11. The law will establish a clear institutional framework and raise procurement rules up to international standards.

Preparation o f the Audit L a w constitutes a trigger for PSIB 11. The law i s expected to give a clear authority to the external auditor (CAO).

External assistance addressing fiduciarv risks i s also a key element o f the PSIBs. EPAP projects will continue to provide technical support for the implementation o f the Afghanistan Financial Management Information System (AFMIS) and will gradually shift their focus from operations to capacity building. Steady implementation o f the IMF Staff Monitored Program will also mitigate fiduciary r isks as the SMP includes benchmarks progress on bank reconciliation o f fiscal accounts and the implementation o f a Treasury Single Account that integrate provincial Mustofiat balances.

5. By supporting these policies, the PSIBs provide a necessary complement to the EPAP projects, which focus on technical assistance, in order to deepen, broaden, and sustain the reforms underway in the areas o f public administration and fiscal management. Supporting the Govemment’s strategy to build institutions, systems, and sk i l ls in order to gradually take over complete management o f public resources i s a key enabling factor to effectively deliver public services and a necessary component o f a long-term, sustainable approach. Three main benefits are expected from this strategy: (i) a direct positive impact on the quality o f public expenditures; (ii) a positive impact on the image o f Government and by way o f consequence on the nation-building effort; and (iii) a positive impact on donors’ willingness to mobilize more resources for Afghanistan and use the Government to manage their projects.

6. Progress on implementing this strategy and further reducing fiduciary r isks wi l l be closely monitored by IDA (see Annex 6 on Monitoring and Evaluation). A joint Public Expenditure Review and Country Financial Accountability Assessment i s scheduled for FY05.

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Annex 5 Page I of 7

ANNEX 5 REVIEW OF 2004/05 BUDGET

1. The purpose o f this annex i s to describe Afghanistan’s Budget for the solar year 1383 (March 2 1, 2004 to March 20,2005). This description will be a key base o f monitoring and evaluation during project implementation. The f i rs t two sections describe the 2004105 Ordinary and the Development Budgets. The third section outlines the execution o f the 2003/04 Budget.

2. The National Budget has two components. The Ordinary Budget includes the wage bill, most non-salary recurrent costs, and some capital expenditures. The Development Budget includes al l technical assistance, most capital expenditures, and some recurrent costs (e.g. health services contracted out). Treasury executes the Ordinary Budget, while donors largely execute the Development Budget. The Ordinary Budget i s structured around ministries, while the Development Budget i s composed of projects structured around development programs. The Ordinary Budget i s based on the principle o f annuity, while the Development Budget i s prepared for three rol l ing years. In 2004105 for the f i r s t time, the development budget i s presented in two components, the core budget, including resources f lowing through the Treasury, and the extemal budget. Also for the f i rst time, a consolidated budget, including operating expenditures and development expenditures, has been approved and the 2004/05 consolidated core budget i s fully financed.

3. 30, 2004. A description o f the Budget i s available at http://www.af./mofibudaet/index.html.

The Ordinary Budget was approved on March 18,2004 and the Development Budget o n June

I. 2004/05 ORDINARY BUDGET

4. mi l l ion fi-om domestic revenues and US$300 mi l l ion f rom extemal assistance. expenditures o f 10.9 GDP points and revenues o f 5.5 GDP points.

5. Revenues. The main source o f revenues i s import duties (54 percent, Table I). Administrative fees, which include overflight fees f rom the Intemational Air Transport Association (expected to reach US$18 mi l l ion in 2004/05) as wel l as fees on traders, are the second largest source of revenues (18 percent). Incidental sales by market establishment account for an additional 15 percent o f revenues. Overall, tax revenues account for two thirds o f the revenue and non-tax revenues for one third.

Total expenditures are set at US$609 mi l l ion and are expected to be financed by US$309 This represents

Source: MoF/Treasury, Staff estimates.

6. US$309 million, a U S $ l O l mi l l ion increase. This would be driven by four elements:

Revenues are projected to grow from an estimated US$208 mi l l ion in 1382 to a target o f

Annex 5 Page 2 of 7

Law Customs T a n f f

Corporate IncomeTax Personal Income Tax

A f i rs t assumption i s that economic growth will continue at a high level (1 WO), generating about US$20 mi l l ion additional revenue.

Second, continued progress to increase compliance at border posts would generate US$26 mill ion. The customs reform adopted in 2003 (use o f market exchange rates for import valuation, streamlined tariff structure - moving from 25 tar i f f rates ranging from 0-150 percent to 6 rates ranging 2.5-16 percent) i s under implementation since the beginning o f the fiscal year.

Third, new policy reforms enacted during the year (a final wage withholding tax on higher income employees, a tax on a l imited range o f services consumed by high income earners, and a rent tax, see Table 2) are expected to generate an additional US$14 mill ion.

Fourth, collection performance i s expected to improve, as a result o f administrative reforms, investments and technical assistance in the customs and tax administration, generating a US$41 mi l l ion increase.

Reform (1) Reduction in the number o f tar i f f rates (ii) Use o f market exchange rates for valuation Reduction o f tax rate to 20% Reinstatement o f PIT with a simpler schedule (wth exemption for

Rent Tax

income below - $500) and withholding Business receipts tax I Fixed tax (10%) o n selected services (hotel, restaurant,

telecommunication, and international alr travel) Tax (20%) on rent for rents above -$200/month

7. The IMF views this target as potentially achievable, but considers that i t constitutes a high- case scenario. I t s Staff Monitored Program i s based on an assumption o f US$256 mi l l ion revenues in 2004105.

8. Economic Classification. The wage bill accounts for 57 percent o f the ordinary budget (Table 3). Together with pensions and debt service, non-discretionary expenditures amount to 61 percent o f ordinary expenditures. Purchase o f goods and services account for 24 percent and capital expenditures for 7 percent. Other expenditures (8 percent) include transfers and contingencies.

Table 3: 2004/05 Ordinary Budget - Economic Classification

2004/05 Ordinary Budget (US$ million) (%total)

Wages 348.8 57.3 - Pensions Debt service Goods and services Transfers Contingencies

14.5 2.4 5.6 0.9

144.3 23.1 22.5 3.7 27.8 4.6

Capital 'expenditures 45.1 7.4 Total 608.6 100.0

Source: 2004/05Budget Document, Staff estimates.

9. Wage Bill. Public employment i s capped at 406,000 in the budget. Excluding Ministries of Defense and Interior and National Security, the c iv i l service i s capped at 269,200 employees. For the c iv i l service, the budgeted average salary i s around Af2,900 (around US$60) per month (this amount

Annex 5 Page 3 of 7

includes provisions for travel). allowances under the Prionty Reform and Restructuring scheme.

10. t o service debt. Current debt service i s mainly directed to international financial institutions.

11. Pensions. Civil and military pension payments are expected to reach US$14.5 mill ion. The number o f pensioners from the Government are estimated at 50,000 and, as a result o f a recent Cabinet decision, their pension i s expected to increase from US$21 to US$290 per year.

12. Other Recurrent Expenses. Other expenses f irst include the purchase o f goods and services (US$144 mill ion). Transfers also include allowances given to disabled and heirs o f martyrs, as wel l as transfers made by the Ministry o f Interior. Contingencies are set at 5 percent o f the budget. Contrary to the first two Budgets o f this administration, n o reserve has been set aside for transfers to State-Owned Enterprises (SOEs), including to pay SOE staf fs wages.

13. Capital Expenditures. The ordinary budget includes a provision for about US$45 mi l l ion o f capital expenditures. This includes small capital investments in a number o f ministries. A specific amount i s earmarked for projects seeking to improve air safety because the implementation o f such projects i s a condition to receive overflight fees.

14. Comparison with 2003/04. 2004105 Budget i s US$156 mi l l ion above 2003104 expenditures (and USS59 m i l l i on above 2003104 Budget, Table 7). US$l05 mi l l ion o f this increment reflect an increase in salaries. This i s driven by four elements:

In addition, the budget includes a US$34 mi l l ion provision for

Debt Service. Debt service (US$5.5 mill ion) includes both principal and interest payments

0

0

0

0

15.

Recruitment of and pay increase for teachers: agreed employment for the Ministry o f Education i s 162,000, a 37,000 increase o n the level at mid-year. In addition, the full-year impact o f the pay increase decided in 2003 for teachers i s included in the 2004105 Budget (US$37 million); Full-year impact of 1382 pay increase: a general pay increase was decided in December 2003 for c iv i l servants (other than policemen and teachers, who had separate pay increases). I t s annual cost was estimated at US$22 mi l l ion (incremental cost o f US$ 13 million); Funding of PRR decree: while n o c iv i l servant received PRR allowances in 2003104, it i s expected that 30,000 c iv i l servants will receive it by the end o f the year (US$34 million); Security financing: Additional funding i s provided to the Ministry o f Interior (including to cover the pay increase for policemen decided in 2003), National Security, and the Afghan National Army (the latter reflects that an increasing number o f soldiers are now on Government’s payroll). This i s partly offset by a decreased allocation to the Ministry o f Defense, reflecting the impact o f the Disarmament, Demobilization, and Reintegration program (net total cost o f US$20 million).

The rest o f the increase (VSS51 mill ion) f i rst reflects higher pension payments (US$14 million). In addition, contingency funds (by definition absent f rom expenditures) are set at US$28 mill ion.

16. Functional Classification. Education i s the largest function o f the Ordinary Budget (21 percent), while funding for health (4 percent) and social protection (1 percent) i s quite low, reflecting the use o f the Development Budget to finance a large part o f these programs (Table 4). Defense and public order functions account for 40 percent o f the Ordinary Budget. Reserve finds are quite high (16 percent) since they include special allowances (for PRR, pensions, debt service, as wel l as Martyrs and Disabled) as wel l as some contingencies (5 percent o f the Budget). Compared to 2003104, the main Budget increases are for education and public order and safety.

Annex 5 Page 4 of 7

2003/04 Budget a/ (US$ million) (%total)

Wages 172 31

Table 4: 2004/05 Ordinary Budget -

2003/04 Estimates (US million) (‘% total)

142 26

Functional Classification - 2004/05 Ordinary Budget

(US$ million) ( X total) General Public Services 34.1 5.6 Defense 119.1 19.6 Public Order and Safety 124.9 20.5 Economic Affairs 58.7 9.6

Health 25.3 4.2

Education 127.3 20.9 Social Protection 8.5 1.4 Reserves 97.0 15.9

Total 608.6 100.0 Source: 2004/05Budget Document, Staff estimates.

Housing and Communal Services 1.3 0.2

Recreation, culture, and religion 12.5 2.0

17. allocated to Provinces. allotment. previous year.

Provincial Expenditures. In 2003/04, only 29 percent o f the f i rs t quarter’s allotment was In particular, Provinces received only 7 percent of the f i rs t quarter’s

In 2004/05, the f i rs t quarter’s allotment for Provinces i s 27 percent higher than the

157 29 300 55 154 28 96 18

250 45 452 100

11. 2004/05 DEVELOPMENT BUDGET

18. The Development Budget for 2004/05 i s set at US$4,524 mill ion. This represents 74 percent of the GDP. For the f irst time, the Development Budget i s presented in two components. The Core Development Budget, set at US$1,070 million, includes al l expenditures managed by the Treasury and i s fully financed. The External Development Budget, set at US$3,455 mill ion, includes projects managed by donors directly and i s partially financed.

19. The Development Budget i s biased towards economic services (29 percent), because o f the cost o f large infrastructure investments (Table 6). Social protection (12 percent) and health (6 percent) are also significant components o f this budget because they include recurrent costs such as the provision o f a basic package o f health services (contracted to NGOs), aid to refugees and IDP, and transfer programs such as the National Emergency Employment Program and the National Solidarity Program. The Core Development Budget also includes a reserve fund to allocate to National Priority Programs and to co-financed other projects.

Annex 5 Page 5 of 7

Table 6: 2004/05 Development Budget - Functional Classification

2004/05 Development Budget (US$ million) (% total)

General Public Services 517 I 1.4 Defense 679 15.0 Public Order and Safety 495 10.9 Economic Affairs 1,315 29.1

Health 289 6.4

Education 277 6.1 Social Protection 540 11.9 Other ai 300 6.6

Housing and Communal Services 78 1.7

Recreation, culture, and religion 34 0.8

Total 4,524 100.0 ai Include funds for National Priority Programs

Source: 2004/05Budget Document, Stafjrestimates.

20. The 2004/05 Development Budget includes the new Afghanistan Stabilization Program, with expenditures expected at US$81 mill ion. The expected expenditures for the Basic Package o f Health Services (for mothers and infants, and children under 5) and for the National Solidarity Program are US$90 mi l l ion and US$168 mill ion.

111. 2003/04 BUDGET EXECUTION

21. Ordinary Budget Outcomes. The deficit on the Ordinary Budget (before extemal grants) was planned at U S 3 4 9 mi l l ion and reached US$245 mill ion, reflecting the fact that expenditures were US$98 mi l l ion below plan (Table 7). This in part reflects a depreciation o f the Afghani against the Dollar. In addition, salary payments were significantly lower than planned, a result o f an unclear picture o f the size o f the c iv i l service at the Budget was formulated and an overly ambitious plan to recruit teachers when the budget was prepared (and despite several pay increases decided during the course o f the year). Non-salary payments also tumed out much lower than planned, probably in part reflecting constraining l o w allotments in Provinces, where more was needed, and high allotments for Central Ministr ies, where capacity or need to spend was lower. Another factor could be constraints related to procurement procedures.

22. Monthly Profile. The monthly profi le o f expenditures reflects this l o w spending. After a very slow start, expenditures have steadily increased during the year. The very slow start (though offset by a lumpy, unbudgeted payment in Herat in the f i rst month) reflects two factors: (i) allotments to departments (including provincial departments) were prepared and communicated very late and (ii) cash management reforms in August 2003 created some confusion and constrained non-salary expenditures until the Treasury decided to transfer cash in advance to Provinces. The increase during the year reflects this slow start and usual year-end bunching. I t reflects also pol icy decisions, such as recruitment o f teachers and pay increases. L o w expenditures in the month o f Qaws reflect the Ramadan and the Eid Holiday.

Annex 5 Page 6 of 7

Chart 1: 2003/04 Ordinary Budget Execution (US$ million) 80

70

60

50

*Total Ordinary Expendtures +Wages and Salaries - - ,Provincial Expenditures

Source: MoF/Treasury, Staf estimates

23. Development Budget. The Government reports development expenditures for 2003/04 at US$2,373 mill ion. This i s higher than the original budget (UStSl.8 billion), but the two are diff icult to compare since the Government i s continuing i ts efforts to bring more resources under the Budget.

24. Of these disbursements, a small portion flowed through Treasury. According to the 2004/05 Budget Document, only US$190 mi l l ion has been disbursed, including grants and loans f rom IDA and ADB and grants f rom the ARTF and LOTFA.

Annex 5 Page 7 of 7

Table 7: Ordinary and Development Expenditures and Public Employment, 2002-2007

Solar year a/ 2002/03 2003104 2004105 2005/06 2006/07

Ordinary Budget (USS million) Budget Estimate Budget Estimate Budget Projections

Location b/ Center 193.1 391.7 269.4 418.4 Provinces 155.8 158.3 182.9 190.2

Total 460.3 348.9 550.0 452.2 608.6 780 950 Economic classification c/

Wages 190.4 274.8 243.5 348.8 449 549 Pensions 15.6 1.1 0.5 14.5 15 15 Debt service 6.6 6.7 4.4 5.6 6 6 Goods and services 131.0 179.1 128.1 144.3 194 244 Transfers 4.0 22.4 14.3 22.5 23 23 Contingencies 74.1 28.3 27.8 49 69

Total 460.3 348.9 550.0 452.2 608.6 780 950 Functional classification

Capital expenditures 38.7 37.5 61.3 45.1 45 45

General Public Services 14.2 42.2 41.1 34.1 Defense 115.5 128.5 122.3 119.1 Public Order and Safety 93.5 82.0 1 1 1.0 124.9 Economic Affairs 61.2 41 .O 45.3 58.7 Housing and Communal Services 0.4 1.3 2.5 1.3 Health 27.9 28.0 21.7 25.3 Recreation, culture, and religion 16.0 13.4 10.0 12.5 Education 61.6 133.0 77.0 127.3 Social Protection 4.9 7.2 16.9 8.5 Reserves 65.1 73.4 4.4 97.0

Total 460.3 348.9 550.0 452.2 608.6 780 950 Development Budget (US% million) dl

General Public Services 7.2 120.0 158.8 517.2 564 467 Defense 129.6 445.8 694.1 678.8 706 11 Public Order and Safety 77.7 173.6 190.5 494.9 184 100 Economic Affairs 109.2 403.7 591.3 1,315.3 726 490 Housing and Communal Services 2.9 35.5 89.8 78.3 59 81 Health 7.2 212.9 153.5 289.4 415 428 Recreation, culture, and religion 18.6 30.0 19.0 34.3 26 13 Education 3.5 84.7 109.9 277.0 51 27 Social Protection 185.6 448.4 365.8 539.6 850 91 1 Reserves 299.5

Total 541.5 1,954.5 2,372.7 4,524.3 3,581 2,528 Employment ('000) el

General Public Services 11.5 9.3 9.9 Defense 100.0 100.0 66.7 Public Order and Safety 78.7 77.2 88.3 Economic Affairs 43.1 29.7 34.4 Housing and Communal Services 1.1 0.8 1 .O Health 26.3 18.9 20.6 Recreation, culture, and religion 16.3 11.9 12.5 Education 172.2 129.9 166.9 Social Protection 6.1 5.5 5.9

Total 455.3 383.2 406.1 436 466 Memorandum Item

Exchange rate (Af / US$) 34.0 44.5 44.8 49.0 49.8 49.8 49.8

a/ Afghan solar year 1381 = March 21,2002 - March 20,2003 b/ 1381: based on IMF report. 1382 budget: based on first quarter allotment. c/ Based on GOA'S chart ofaccounts (differs from IMF's GFS). Wages include PRR allocation. d/ 1381 and 1382 estimates = disbursements. 1382 budget = budget. 1383 = Exp. Requirements presented in Berlin. e/ Budget = employment ceilings. 1382 Actuals = Mid-Year Review.

Source: 2004/0.5Budget Document, StafSestimates.

Annex 6 Page i of 3

ANNEX 6 MONITORING AND EVALUATION

1. This annex describes the methodology to monitor and evaluate the reform agenda on public finance management. As indicated in the Project Document, the evaluation o f PSIB I wil l largely focus on process and input indicators, which themselves can be linked to medium-term outcomes (see table below). T h i s reflects the nascent but l o w capacity o f the Govemment’s monitoring capacity. Technical assistance required for this monitoring i s provided by IMF, IDA, and USAID in these areas (see Project Document).

2. The framework was discussed with the Govemment as part as PSIB I preparation and i s therefore owned by the Govemment. The identification o f ministries and agencies responsible for monitoring each indicator will increase accountability. Overall, the fi-amework will contribute to create an evaluation culture in the Government. The framework was also discussed with other donors in order to reach a common understanding on priorities and measurement.

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Annex 7 Page I of 2

-80 1 -Exports - O - l m p o r t s I

ANNEX 7 STATISTICAL INDICATORS

Afghanistan at a glance 4/7/04

POVERTY and SOCIAL Afghanistan

2002 Population, mid-year (millions) GNI per capita (US$) GNI (US$ billions)

22.8

Average annual growth, 1996-02

Labor force (%) 2.9

Most recent estimate (latest year available, 1995.03)

Population ( O h ) 3.4

Poverty (% of population below national poverty line) Urban population ( O h of total population) Life expectancy at birth (years) infant mortality (per 1,000 live births) Child malnutrition (% of children under 5) Access to an improved water source (Oh of POPUlatiOn) Illiteracy (Oh of population age 15+) Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1981

GDP (US$ billions) 3.5

Exports of goods and serviceslGDP Gross domestic savingsiGDP 10.8

Current account balancelGDP -5.9

Gross domestic investmenVGDP 13.9 10.8

Gross national savingsiGDP 13.0

interest paymentsiGDP Total debtlGDP Total debt serviceiexports Present value of debWGDP Present value of debtlexports

1970-1980 1980-90 (average annual growth) GDP 2.4 -2.0

Exports of goods and services GDP per capita -0.1

17.5

23 43

165 49 13

36 51 21

South LOW- Asia income

1,401 2,495 460 430 640 1.072

1.8 1.9 2.3 2.3

28 30 63 59 71 81

84 76 44 31 97 95

108 103 89 87

1991 2001

1990-98 2002

4.6 30

2002

4.0 13.5 56.6

-15.9

-3.6

60 1.4 2.7

85.2

2003-06

Development diamond'

Life expectancy

T

1

Access to improved water source

- Afghanistan Low-income group

Economic ratios'

Trade

Investment Domestic savings

Indebtedness

----Afghanistan Low-income group

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Private consumption General government ConSumPtiOn imports of goods and services

Manufacturing

(average annual growth) Agriculture industry

Services

Private consumption General government COnSUmPtlOn Gross domestic investment Imports of goods and Services

Manufacturing

1975

55.4 13.7 10.5 30.9

86.1 5.7

14.3

1970-78

2.5 5.0 3.9 4.8

6.6 12.2 19.6 9.8

2001 2002

.. 52.0

.. 24.1

.. 23.9

.. 107.7 8.2

.. 86.0

2001 2002 Growth of exports and imports (Oh) I 0

40 20

-20 4 0 -60 I

Note: 2002 data are preliminary estimates. See page 3 for sources. *The diamonds show four key indicators in the country (in bold) compared with its income-group average. The diamond is incomplete

since data are missing

Annex 7 Page 2 of 2

Afghanistan

PRICES and GOVERNMENT FINANCE

Domestic prices I% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusideficit

OFFICIAL TRADE

(US$ millions) Total exports (fob)

Natural gas Fruits and nuts Carpets

Total imports (ci0 nla n/a nla

Export price index (1995=10Ol Import price index (1995=100) Terms of trade (1995=100)

BALANCE of PAYMENTS

(US$ millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, local/US$)

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Composition of net resource flows Official grants Official creditors Private creditors Foreign direct investment Potlfoiio equity

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

1981

21.5 4.4

17.5 -6.2 -0.2

I980

670 216 216 104 841

88 78

113

1981

723 1,060 -337

24 108

-206

168 38

658 49.5

FY1982

1991

166.0

1990

235

93 44

936

89 90 99

1989

26 1 727

-466

12 31 1

-143

123 20

631 50.6

FYI992

1 -1 0

-1

2001

-54.8

2001

81

554

82 82

100

2001

FY2002

100

2002

98.5

7.5 -0.6 0.0

2002

79

700

2002

2,436 3,868

-1,432

1.287

-146

-155

374 45.0

FY2003

2,429

70

215 34 23 12 6 6

-GDP deflator +CPI

I Export and Import levels (US$ mlll.)

767

384

" O2 I 1 - s3 97 98 99 00 01

I Exports Imports I

Current account balance to GDP ("/a)

Composition of 2002 debt (US$ mill.) a-IDA D-Other ) / mulblat 1 F -

E - Bilateral

A - IBRD a. IDA D - Other multilateral F - Pnvate C-IMF G - Short-ten

E - Bilateral

Note: 2002 data are preliminary estimates See page 3 for sources. 4/7/04