AFGHANISTAN TO 2030 PRIORITIES FOR ECONOMIC DEVELOPMENT UNDER FRAGILITY This document is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the Governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. This report was prepared by a team led by Claudia Nassif and Tobias Haque and including Omar Joya, and Aman Farahi. Rebekah Smith provided substantive inputs to the section on labor mobility. The report draws from background papers prepared by Andras Bordor, Silvia Raedelli, Christina Weiser, Nandini Krishnan, Michael Stanley, Yaw Nyarko, Carole Chartouni, Rebekah Smith, Daniel Sanchez, Fanny Missfeldt-Ringius, Jie Li, Ahmed Rostom, Subika Farazi, Rishabh Sinha, Leila Aghabarari, Matthew Morton, Nadia Rocha, Carmen Estrades, Robert Holzman, Nathalie Lahire, Patrick Asea, Joshua Blumenstock, Tarek Ghani, Sylvan Herskowitz, Ethan Kapstein, Thomas Scherer, and Ott Tommet. Useful review comments were provided by Martin Rama, Vinaya Swaroop, Shantayanan Devarajan, Kevin Carey, Gladys Lopez-Acevedo, Nadia Piffaretti, and Wilfried Engelke. The report was prepared under the overall guidance of Shubham Chaudhuri, Robert Saum, and Manuela Francisco. The authors are grateful for close cooperation and collaboration with officials of the Government of the Islamic Republic of Afghanistan during all stages of preparing this analysis. The report has benefited from comments and inputs from a wide range of experts from government, development partner agencies, and the World Bank. Background papers were subject to extensive consultation, including through a seminar series at the World Bank office in Kabul throughout 2016-17. Emerging conclusions from this work were presented at the Brussels Conference on Afghanistan in September, 2016. All background papers and accompanying policy notes will be made available from: www.worldbank.org/afghanistan THIS REPORT PRESENTS ECONOMIC DEVELOPMENT PRIORITIES FOR A FRAGILE AFGHANISTAN Sixteen years after the fall of the Taliban regime This report identifies economic development options Afghanistan is still characterized by conflict and for Afghanistan in the context of likely ongoing insecurity. fragility. Increasing violence and insecurity is deterring In the short-term, Afghanistan needs to escape the investment and imposing enormous human costs. Over current slowdown despite a difficult fiscal and security half of the population lives in poverty. Unemployment situation. Public expenditure needs to be directed to the rates are high. Population growth poses challenges to highest priorities in order to spur demand, and further public service delivery capacity, while a youth bulge reform progress is required to build confidence and means that the number of young Afghans joining the increase investment. If the right choices are made, gains labour force radically outstrips the number of available achieved now can lay the foundations for future growth. jobs. Over the longer-term, Afghanistan urgently needs a A deep economic slowdown, triggered by the 2012 broad-based growth model that not only produces drawdown of international security forces, the decline in growth and jobs, but also generates sufficient domestic international aid, and political instability following the revenue and foreign exchange to sustain government 2014 elections are now threatening to reverse past activities and macroeconomic stability. This model must development gains. reflect the reality that some level of fragility and institutional weaknesses will likely persist. Any growth While much progress has been made, Afghanistan’s strategy must be achievable in the context of tight institutions remain incapable of mediating contestation constraints on fiscal resources and expected declines in over resources, protecting property rights, or providing aid. security to citizens. International evidence – and Afghanistan’s own experience – shows that strong Taking continued fragility as the start-point, this report institutions take many years to emerge and that such answers the following questions: emergence is not inevitable even over the long-term. How can Afghanistan escape the Overall, the current combination of protracted conflict, current slowdown? weak institutions, and poor economic development creates a vicious circle that will be difficult to break. How can Government, firms and households best manage the risks associated with fragility? What growth model can achieve development needs under the context of ongoing fragility and resource constraints? How can economic development priorities be financed? “We must plan to move our country beyond its history of war and poverty and begin the long journey to prosperity” Afghanistan National Peace and Development Framework (ANPDF) 2017-2021 INTRODUCTION 4 QUESTIONS OF SECURITY AND DEVELOPMENT ARE INEXTRICABLY LINKED Accelerating Improving Security Development Improving security is vital for improved development outcomes: HUMAN CAPITAL Conflict imposes huge direct human costs. Conflict and insecurity is also a major constraint to service delivery, undermining the improvements in human capital that are required to drive economic growth. INVESTMENT Private investment is directly deterred by conflict, which increases business costs and undermines confidence. Major extractives projects have been delayed partly due to ongoing conflict and insecurity, while evidence shows that business activity is reduced in areas where security incidents are most common. FISCAL SPACE Security requirements are imposing large and unsustainable costs on the Government of Afghanistan. A large proportion of the budget is absorbed by security expenditures, squeezing out required investment in social services and infrastructure. Though channels are complex and mediated by many factors, progress against development can help improve security: INCOMES Insurgents do not fight primarily to make money. But international evidence shows that participation in insurgent groups declines when opportunity costs increase – opportunity costs are higher when alternative income-generating opportunities exist or become more profitable. OPPORTUNITIES There is strong evidence that violence increases in the context of youth bulges and limited opportunities. Ensuring faster job creation is vital for managing the security risks associated with Afghanistan’s upcoming youth bulge. INSTITUTIONS There is strong evidence that perceptions of exclusion, victimization, and corruption spur violence. Stronger institutions are vital to address these underlying drivers of conflict, especially in relation to the justice sector and management of land and water rights. INTRODUCTION 5 KEY MESSAGES Improve efficiency of public expenditure. 1 • Move expenditures towards activities that have the greatest economic impact • Strengthen the budget process to free up fiscal space and reallocate resources towards growth priorities. To escape slowdown: Support increased investor confidence. • Continue to remove unnecessary regulatory constraints to investment • Demonstrate commitment to policy reforms to build credibility. Prioritize limited political capacity towards reforming the public sector 2 institutions that matter most for growth. Pursue policy measures that mitigate fragility-related risks facing households and firms. • Introduce a broad cash-transfer scheme to help households mitigate the To manage the long-term costs of security and other shocks impacts of fragility: • Reduce unnecessary regulatory constraints, improve access to financial services, and introduce new financial instruments to help firms better deal with insecurity. 3 Pursue a balanced growth strategy that addresses Afghanistan’s multiple economic development challenges. • Pursue extractives development to mobilize required revenues and foreign exchange receipts • Invest in agriculture to reduce poverty, generate jobs, and improve To achieve inclusive livelihoods long-term growth: • Increase investment in human capital so that future growth opportunities can be captured. 4 Align all available resources around a coherent growth strategy. • Align planning processes around a coherent growth strategy so that limited available resources have greatest possible impact • Bring a greater share of aid on to the budget to ensure alignment with policy priorities and maximize the local economic impact To finance growth • Strengthen public investment management processes to ensure all priorities: . expenditure is of high quality and aligned with policy priorities. INTRODUCTION 6 STRUCTURE OF THE REPORT Despite substantial gains against many indicators, Afghanistan remains a Part 1: poor, fragile country. Afghanistan since Developments since “Transition” – the 2012-2014 drawdown of “Transition” Page 8 international security forces – have driven a deep, sustained slowdown. The strong government response to recent challenges is cause for cautious optimism. Part 2: Economic In the short-term, Afghanistan faces a deep slowdown with very few policy levers available to drive growth. Development Challenges Page 17 In the longer-term, Afghanistan requires a growth strategy that addresses multiple pressing economic development challenges, including the need for increased growth, jobs, foreign exchange receipts, and revenues. Part 3: Immediate improvements in public resource allocation and business environment reform can help escape slowdown. Addressing Economic Development Policy measures are needed to shield households and firms from the Challenges Page 25 impacts of fragility. A balanced long-term growth strategy can meet Afghanistan’s different economic development needs, including focus on agriculture, extractives, and human capital. Investment required for growth is affordable if resources are tightly Part 4: prioritized. Financing Economic Development Increasing the share of aid on budget is vital for realizing growth Priorities potential. Page 64 Afghanistan will continue to rely on elevated levels of international assistance. INTRODUCTION 7 1. AFGHANISTAN SINCE “TRANSITION” Despite substantial gains on many indicators, Afghanistan remains a poor, fragile country. Developments since “Transition” – the 2012-2014 drawdown of international security forces – have driven a deep, sustained slowdown. The strong government response to recent challenges is cause for cautious optimism. 1. Economic Context and Current Challenges Development outcomes have improved substantially since 2001 but Afghanistan remains a poor, fragile country. Impacts of “transition” were worsened by realization of security risks. Poverty and humanitarian risks are increasing 8 DEVELOPMENT OUTCOMES HAVE IMPROVED SUBSTANTIALLY SINCE 2001 GDP PER CAPITA REVENUE LIFE EXPECTANCY SCHOOL ENROLMENT from $120 to $580 from 3.3 percent to 11.9 from 44 to 61 years from 0.8 million to over 8 percent of GDP million MATERNAL MORTALITY GENDER EQUITY INFRASTRUCTURE PFM from 1600 to 327 from 0 percent to 27 from almost none to over stronger PFM system than (per 100,000 births) percent of seats in 18 million mobile phone other fragile states Parliament held by women subscriptions Sources: World Bank Afghanistan Development Update October 2016, World Development Indicators 2016, Ministry of Education Management Information System, AMS health survey 2010, MICS 2011 health survey, Afghanistan PEFA 2013 AFGHANISTAN SINCE TRANSITION 9 BUT AFGHANISTAN REMAINS A POOR, FRAGILE COUNTRY HUMAN DEVELOPMENT AID DEPENDENCE 169th Human Development Index 37% Grants as percent GDP /188 Ranking • More than half of the population lives below the • Aid finances around 60 percent of the poverty line. government budget. • Limited access to services lead to poor living • Aid inflows finance a trade deficit of 32 percent standards for the majority of the population. of GDP. ECONOMIC STRUCTURE INSTITUTIONS Agriculture share of total 177th Corruption Perceptions 56% employment /180 Index Ranking • Years of conflict have eroded governance • Low levels of private investment. systems and fuelled corruption and patronage. • Aid inflows and public sector investment drive a • Active conflict persists, with large areas of the large share of economic growth. country beyond the control of government. • Economic production is concentrated in • The rule of law is extremely weak, especially agriculture and services. outside of main urban centres. Sources: World Bank data, UNDP Human Development Index 2017, Transparency International Corruption Perceptions Index 2017. AFGHANISTAN SINCE TRANSITION 10 DEVELOPMENT PROGRESS SLOWED FROM 2014, REFLECTING A SERIES OF NEGATIVE SHOCKS The drawdown of international security forces The outcome of the election led to much greater coincided with Presidential elections. disruption for a much-longer period than was expected. Following the fall of the Taliban regime in 2001, Afghanistan received massive international development The outcome of the election was disputed, among and security assistance. More than 100,000 NATO allegations of electoral fraud. Conflicts and negotiation troops were stationed in Afghanistan until 2014, of formal and informal power-sharing arrangements supporting operations against the on-going insurgency between the two branches of the National Unity and assisting in building and training a national defence Government caused major delays in the appointment of force. ministers to key ministries. Security and civilian aid amounted to an estimated 112 Divisions within the new government also led to long billion between 2002 – 2015, peaking in 2011 at delays in filling senior civil servant posts, with less approximately US$15.7 billion, equivalent to 97 percent suitable candidates often selected on the basis of percent of GDP, making Afghanistan one of the most aid- acceptability to both parties. The existence of parallel dependent countries in the world. bureaucracies under both leaders exacerbated co- ordination problems and led to contestation and In order to ensure a path toward self-reliance, the bargaining over decisions made at every level. Government of Afghanistan and NATO partners agreed in 2010 on a gradual handover of security Insurgent violence increased, driven by competition responsibilities to be completed by end-2014. between rival anti-government factions. Civilian casualties increased to a post-2001 high of 11,418 in At the same time, the country prepared for a highly 2016, while an increasing proportion of Afghanistan’s anticipated presidential election in 2014. Together with land area remains under the control of anti-government the drawdown of international troops, the elections elements. were widely seen as an opportunity for a fresh start with an administration that could revitalize a peace process, act more independently, and move the economy away from heavy dependence on aid. THERE HAS BEEN A SHARP INCREASE IN CIVILIAN CASUALTIES SINCE 2014 12,000 10,000 Civilian casualties 8,000 6,000 4,000 2,000 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: UNAMA AFGHANISTAN SINCE TRANSITION 11 “TRANSITION” AND POLITICAL UNCERTAINTY NEGATIVELY IMPACTED AID, GROWTH, AND REVENUES The drawdown of international MILITARY AND CIVILIAN AID ALMOST HALVED OVER 2009-2014 troops was also associated with a Security grants Civilian grants On and off-budget aid (% of GDP) 100% significant decline in military and 80% civilian aid. 60% The combination of political 40% uncertainty, greater insecurity and the decline in international aid 20% adversely affected consumer and 0% 2009 2010 2011 2012 2013 2014 2015 2016 investor confidence, leading to a sharp reduction in aggregate GROWTH FELL TO THE LOWEST RATES SINCE 2001 demand. Impacts were 25 Services exacerbated by poor weather 20 Industries Agriculture conditions and a decline in 15 Real GDP growth Real Growth agricultural production. 10 5 Domestic revenues fell amid 0 political uncertainty and increasing -5 corruption, while security -10 spending increased in the face of 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 increasing violence. AFTER A PERIOD OF STRONG GROWTH , REVENUES DECLINED 14% The ensuing fiscal crisis 12% necessitated additional donor 10% support and left treasury reserves 8% % GDP depleted. 6% 4% 2% 0% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Direct taxes Sales tax (BRT) Customs duty Non-tax revenues Source: World Bank data AFGHANISTAN SINCE TRANSITION 12 PRIVATE SECTOR CONFIDENCE AND INVESTMENT DECLINED New firm The number of new investment activities declined by more than half from registrations 2012 to 2016. The value of commercial loans to the private sector declined from 4.9 Commercial percent of GDP in 2011 to 3.4 percent of GDP in 2016 with bank liquidity loans increasing, reflecting weak demand for loans. Mining activities, which gained momentum in the pre-transition years, Mining were suspended by government on the basis of perceived large Investment governance risks. NEW FIRM REGISTRATIONS DECLINED RAPIDLY ACROSS MOST SECTORS 9,000 Services 8,000 Other industries 7,000 Construction New Firm Registrations Manufacturing 6,000 Agriculture 5,000 4,000 3,000 2,000 1,000 - 2012 2013 2014 2015 2016 Source: Ministry of Commerce and Industry AFGHANISTAN SINCE TRANSITION 13 POVERTY AND UNEMPLOYMENT INCREASED National Unemployment and underemployment have increased. The number of Afghan males aged +20.8 %pts 25-50 in full-time employment as a share of the population has declined from 76.3 percent in 2011/12 to 53.1 percent in 2013/14 to 67.6 percent in 2016/17. 07-08 11-12 16-17 33.7% 54.5% National poverty increased from 38.3 percent in 2011-12 to Urban 54.5 percent in 2016-17. Over 18 million Afghans now live in poverty +15.89 %pts and many more are at risk at falling into poverty. Poverty is concentrated in rural areas but the difference is becoming less pronounced over 07-08 11-12 16-17 time due to an upward trend in 25.71% 41.60% rural-urban migration. With the majority of Afghans living in or Rural close to urban centres, it is likely that poverty will increasingly +22.83 %pts become an urban phenomenon. 07-08 11-12 16-17 35.72% 58.55% Source: NRVA and ALCS data AFGHANISTAN SINCE TRANSITION 14 RETURN MIGRATION AND DISPLACEMENT EXACERBATED HARDSHIP AND RISKS Returnee flows have accelerated since 2014 and are now reaching unprecedented levels. Nearly one million Afghans are thought to have returned to Afghanistan during 2016, mostly due to THE NUMBER OF INTERNALLY DISPLACED PEOPLE intensifying push factors in Pakistan. The total 2017 INCREASED RAPIDLY number of internally displaced is currently around 1.2 488k million. With push factors now playing the dominant role, there are concerns that returnees will have limited 2012 human capital, few resources, and limited 103k connections to help manage transition. Districts that have – on average – received more returnees since 2002 are likely to experience higher levels of conflict. This may reflect pressure on land and other resources generating conflict in the context of large returnee populations. Previous experience is cause for concern given emerging evidence of declining absorption and “reintegration” capacity. Recent survey evidence shows increasing incidence of repeated-displacement among returnee populations. This is likely to reflect both higher levels of conflict within Afghanistan and potentially exhaustion of resources available to accommodate returnees at the community level. DISTRICTS AFFECTED BY CONFLICT TEND TO HOST MORE RETURNEES 30 25 Share returnees/pop, average by district 20 15 10 5 0 Low Medium Low Medium Medium High High Quantiles Conflict Severity Index Source: ALCS data, World Bank analysis AFGHANISTAN SINCE TRANSITION 15 GOVERNMENT REFORM EFFORTS HAVE SEEN A REBOUND IN CONFIDENCE The National Unity Government (NUG) has pursued Reforms are driving increased confidence. a number of key reforms to boost investment and strengthen institutions. Business sentiments, as measured by a quarterly survey conducted by the Afghanistan Chamber of Measures have been introduced to: Commerce, have been improving since mid-2015. While business owners still appear less optimistic • Strengthen leadership and governance in the than in the decade prior to the transition, the results military. Senior military leadership has been indicate a change in attitudes of domestic investors. revamped and professionalized training introduced for officers. Civilian controls have been According to the Asia Foundation’s Survey of the introduced over core support functions such as Afghan People citizens are showing more optimism procurement, financial management, and audits. about the future of their country. The number of Afghans who say the country is moving in the right • Combat corruption. An anti-corruption justice direction has increased from 29 percent to 32.8 center has been established, and a new anti- percent, while the number who say the country is corruption strategy has been introduced. Progress moving in the wrong direction has declined to 61.2 has been made in identifying and sanctioning percent, down from a record high of 65.9 percent in corrupt behavior, including through new asset 2016. The two most frequently cited reasons for declaration requirements for civil servants. optimism relate to rebuilding the country (51.0 percent) and, counterintuitively, improved security • Reduce regulatory constraints. Business (50.6 percent). environment reforms have been progressed, including a one-stop shop for issuance of BUSINESS SENTIMENT HAS IMPROVED construction permits. Business Sentiment • Strengthen public procurement. A centralized procurement unit has been established to better Index control and safeguard expenditures. • Strengthen revenues. A range of revenue policy and administration measures have seen revenues rebound from 8.7 percent of GDP in 2014 to over 11.9 percent of GDP in 2017. SURVEYS SHOW INCREASED OPTIMISM • Support regional integration. Afghanistan is collaborating with every one of its immediate and % Respondents who believe country is moving in… near neighbors to achieve increased commerce, transit trade, and investment, including cooperation on major projects: TAPI, Chabahar Port; TAP500; CASA-1000; and a number of multi- national railways. • Support communities. The “Citizens’ Charter” Right Direction Wrong Direction program will provide guaranteed minimum service Don't Know standards to participating communities, through Community Development Councils. Sources: Afghanistan Central Business Registry, Asia Foundation Survey of the Afghan People AFGHANISTAN SINCE TRANSITION 16 2. ECONOMIC DEVELOPMENT CHALLENGES In the short-term, Afghanistan faces a deep slowdown with very few policy levers available to drive recovery. In the longer-term, Afghanistan requires a growth strategy that addresses multiple pressing economic development challenges. 1. Economic Context and Current Challenges Development outcomes have improved substantially since 2001 but Afghanistan remains a poor, fragile country. Impacts of “transition” were worsened by realization of security risks. Poverty and humanitarian risks are increasing 17 THERE IS NO EASY WAY OUT OF THE CURRENT SLOWDOWN OPTIONS TO STIMULATE GROWTH THROUGH FISCAL AND MONETARY POLICY ARE LIMITED Financial systems in It would be difficult Reducing taxes or Afghanistan are to finance increased granting exemptions underdeveloped and expenditures without will unlikely override monetary additional external other binding transmission on-budget aid. constraints to channels are weak. In Increasing taxes on investment such as the current situation, the existing tax base insecurity – and may it is unlikely that could be erode fiscal stability increased money counterproductive, objectives or supply would lead to given that major undermine much lower commercial taxpayers are already needed public interest rates or relatively highly investment. compensate for weak taxed. credit demand. Fiscal space is limited by 2013-2017 FUNDING FOR ON-BUDGET EXPENDITURES imperatives for security spending and costs of providing basic Total Revenue funded services to a growing population. 52% Aid covers almost 60 percent of Afghanistan’s on-budget civilian ODA funded 58% expenditures and 80 percent of on- budget development expenditures. ODA Operating Development funded Revenue In the absence of new sources of 37% funded 20% revenue, more on-budget aid Revenue funded would be needed to finance an 63% effective fiscal stimulus. ODA funded 80% ECONOMIC DEVELOPMENT CHALLENGES 18 SCOPE TO FURTHER INCREASE REVENUES IS LIMITED Taking account of Afghanistan’s economic structure and population dynamics, Afghanistan’s tax potential is estimated at up to 17 percent of GDP. This estimate assumes optimal tax policy and administration. Revenues could be increased to around 15 percent of GDP by fully enforcing existing tax policy settings and eliminating leakages. With changes to Afghanistan's economic structure, such as through the mobilization of extractives, total revenue could expand beyond 17 percent of GDP. The Government is working on further reforms to tax administration and plans to introduce a VAT in 2019. By 2020 these reforms could show tangible impact. Regulating illegal mining and improving collection of royalties from licensed mines could also help, but this would require much stronger enforcement capacity. In the meantime, scope to quickly and significantly increase revenues is limited. Afghan firms in the formal sector are already relatively highly taxed. Further tax increases on the current narrow base of tax payers would exacerbate already-high costs of doing business, deter investment, and place much- needed economic growth and job-creation at risk. EVEN WITH OPTIMAL TAX POLICY AND ADMINISRATION, REVENUE POTENTIAL IS LIMITED 18% 16% 14% Revenue as % GDP 12% 10% 8% 6% 4% 2% 0% Current revenues Revenue potential with existing Revenue potential with optimal policies and full enforcement policies and full enforcement Source: World Bank analysis ECONOMIC DEVELOPMENT CHALLENGES 19 THE VICIOUS CYCLE OF CONFLICT AND FRAGILITY IS HARD TO BREAK Despite impressive progress in some areas, Fragility is likely to persist. Afghanistan’s institutions remain weak. Global evidence has demonstrated that countries are While a huge amount has been achieved in building more likely to experience conflict when exposed to state institutions from a very low base, government many of the stressors that Afghanistan is currently capacity and resources remain constrained in vital trying to manage. These stressors include: i) external areas. State power is contested by different actors at support for domestic insurgents; ii) illicit cross border multiple levels, and sometimes misused, increasing flows; iii) high unemployment and low incomes; iv) uncertainty for the private sector. Formal rules severe corruption; v) ethnic rivalry; and vi) perceived remain very unevenly enforced in key sectors, discrimination on behalf of the state. While peace including mining, land, taxation, and justice. deals and other political advances may reduce violent conflict, it is likely that some level of violence will Afghanistan is ranked among the most-corrupt persist for as long as these stressors continue to exist. countries in the world by Transparency International, while Afghanistan is among the lowest two percent of Global evidence is also clear that strong formal countries in terms of rule of law, as measured by the institutions emerge only under particular political World Governance Indicators. Violence is a cause and circumstances and over a period of decades. The consequence of weak institutions. Violent insurgency 2011 World Development Report found that in the – fueled by the illicit economy and international best case it takes fragile states 20 years to achieve actors – has placed a huge burden on government the institutional quality that could be considered finances and capacity, slowing institutional “good enough” to provide the minimal conditions for strengthening efforts. development. At the same time, poor perceptions of government Any growth strategy for Afghanistan therefore needs are an important driver of conflict: consistent with to be robust to ongoing institutional weaknesses and international experiences, Afghan insurgents some level of violent conflict, rather than rely on any frequently cite corruption of the state, ethnic assumption that such weaknesses can be quickly or partisanship of state institutions, and direct or easily addressed. indirect exposure to unfair or disrespectful treatment or violence at the hands of security forces as primary reasons for joining opposition groups. International evidence shows that such factors are often as important as unemployment or limited access to economic opportunities in driving conflict. AFGHANISTAN LAGS FRAGILE STATES AGAINST INSTITUTIONAL INDICATORS AND PROGRESS HAS BEEN UNEVEN 0.0 Governance Score -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 Control of Government Pol stab/No Regulatory Quality Rule of Law Voice and Corruption Effectiveness violence Accountability Source: World Governance Indicators 2004 2016 LIC FCS ECONOMIC DEVELOPMENT CHALLENGES 20 DEMOGRAPHICS EXACERBATE CHALLENGES Afghanistan’s high population growth rate creates challenges for service delivery and savings. Afghanistan’s fertility rate is among the highest in the A YOUTH BULGE IS APPROACHING world. On average, Afghan women have 5.3 children. The annual population growth rate is close to 3 [65+] percent which means that the population will double [60-64] over the next 25 years. [55-59] [50-54] The population of Afghanistan is very young. By [45-49] 2020, the number of school-age children will grow to [40-44] 5.5 million– 2.5 million more than the education [35-39] system can currently absorb. High dependency ratios [30-34] undermine savings. 47.5 percent of the population is [25-29] aged 15 or below and economically dependent. This [20-24] means households use their incomes predominantly [15-19] for consumption and reserve little for savings. Lower [10-14] savings limit Afghanistan’s capacity to grow, with fewer resources available to finance investment. [5-9] [0-4] An approaching youth bulge presents employment 2014 2030 and conflict challenges. YOUTH UNEMPLOYMENT IS ALREADY HIGH The labor force is expected to increase by 4 million by 2025. This means that every year between 480,000- Millions Unemployed 60 2.5 Unemployment rate 600,000 new entrants will potentially seek jobs – many more than then economy can absorb. Around 50 500,000 young males are already unemployed, most 2 of whom reside in rural areas (72 percent) and have either no (43 percent) or only primary education (26 40 1.5 percent). 71 percent of young people cite unemployment as the biggest problem they face. 30 1 Most empirical research finds a positive association 20 between youth bulges and higher risks of conflict. Several researchers have suggested that a large 10 0.5 supply of labor within a given age cohort can overwhelm available opportunities, leading to 0 0 frustrated expectations and loss of status among – Female Female Female Total Total Male Male Male Total especially – young men, leading to increases in violence or the emergence of insurgencies. Youth bulges in the presence of slow growth and limited job National Urban Rural opportunities can be particularly perilous, especially if migration channels are limited. Youth Total # Youth Unempl # Total Unempl Source: ALCS (2013/14 and 2016/17) data and World Bank analysis ECONOMIC DEVELOPMENT CHALLENGES 21 THE CURRENT ECONOMIC STRUCTURE CONSTRAINS FUTURE OPTIONS Afghanistan’s economy remains undiversified. Afghanistan is likely to remain reliant on agriculture and natural resources over the period of analysis. The needs of the post-conflict reconstruction process, financed largely by foreign aid, shifted the economy Education levels and manufacturing capabilities are away from agriculture towards services. However, too low to expect rapid expansion of manufacturing services remain largely unsophisticated, dominated and services. Prospects for manufacturing are further by wholesale, retail and transportation. At 12 percent worsened by heavy reliance on imported inputs and of GDP, manufacturing accounts for only a small share the prohibitive cost of trade. As primary production of production and has contributed little to growth expands, opportunities will emerge for construction, over the past 15 years. The recent decline of aid upstream and downstream industries, and – possibly reduced the demand for services and construction, – manufacturing. and magnified the relevance of agriculture. Transformation is also constrained by likely limited 93.5 percent of manufacturing and most exports investment. On-going fragility and low savings rates depend on agriculture. Private aggregate demand is will limit private sector investment over the next 15 highly correlated with agriculture output, as it years. At the same time aid is expected to further constitutes a source of income for nearly half of the decline and the potential for borrowing will remain population. Nevertheless Afghanistan is not yet fully limited. Revenue potential, even under the best case able to meet its food needs and depends on imports scenario, is constrained, requiring tough choices in in most years. the allocation of public resources. AFGHANISTAN’S ECONOMY REMAINS UNDIVERSIFIED AND RELIANT ON AGRICULTURE Civil Service, 6.4 Agriculture, 21.7 Government, 13.6 Manufacturing, 12 ICT and Transport, 26.2 Extractives, 0.7 Construction, 10.4 Wholesale and Retail, 9 Source: Central Statistics Office ECONOMIC DEVELOPMENT CHALLENGES 22 AFGHANISTAN NEEDS A GROWTH STRATEGY THAT ACHIEVES MULTIPLE OBJECTIVES AND IS ROBUST TO FRAGILITY Short-Term Impact To escape the current slowdown, some short-term measures are required to build confidence and spur growth. Job Creation With 480,000-600,000 Afghans reaching working age each year, generation of substantial new employment opportunities is vital. Revenue Generation Aid currently finances 60 percent of the government budget – new sources of growth have to generate sufficient revenue to compensate for declining aid. Foreign Exchange Generation With aid relied upon to finance a trade deficit equal to around 40 percent of GDP, export growth is vital for sustainability. Poverty Reduction With persistently high rates of poverty and growing inequality, growth has to provide broad opportunities to the poor. ECONOMIC DEVELOPMENT CHALLENGES 23 IN FOCUS: AFGHANISTAN’S ECONOMIC GEOGRAPHY Afghanistan's internal geography continues to shape The best opportunities for urban job creation are development. likely to be in the service sector. Aid-driven growth over the past decade has Public sector employment and procurement disproportionately benefited cities and exacerbated opportunities will remain concentrated in urban areas regional disparities. The poverty rate in urban areas is and Afghans will continue to travel to cities to ten percentage points lower than in rural areas. The purchase goods and services. Larger urban poorest areas in Afghanistan are often geographically populations offer service businesses larger markets isolated both from government services and markets. and scope for specialization. Improving the business regulatory environment and addressing land and Afghans are increasingly urban. infrastructure constraints to the growth of service industries should be the highest priority for urban job Consistent with the experience of other developing creation. countries, Afghanistan is experiencing rapid urbanization as rural populations seek access to the Population concentration offers opportunities for perceived broader range of economic opportunities improving access to services. that cities provide. The relative growth of urban populations has accelerated with migration, with While scope for productivity benefits from internally displaced and returnee populations seeking urbanization may be limited, important gains might access to services and economic opportunities in and still be achieved in terms of improving access to around cities – especially Kabul. services. Economies of scale mean that services and infrastructure can be provided at lower cost in urban Cities are unlikely to drive growth. centers, allowing improved quality and access. Such gains are not automatic, however, and require Unlike in many developing countries, however, the adequate urban planning and public investment. economic benefits of urbanization may be limited. In Reforms should immediately focus on ensuring that the absence of a substantial manufacturing sector, it municipal authorities have the authority and capacity will be difficult for the economy to generate sufficient to raise and manage revenues to deliver vital urban good quality jobs for urban arrivals. There is little infrastructure and services. Ensuring that urban reason to believe that population concentration arrivals can access land and establish secure land would, itself, drive major growth of manufacturing property rights is also vital for realizing potential given human capital, infrastructure, and security economic and social benefits of an increasingly urban constraints. population. 3. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES Immediate improvements in public resource allocation and business environment reform can help escape slowdown. Policy measures are needed to shield households and firms from the impacts of fragility. A balanced long-term growth strategy can meet Afghanistan’s different economic development needs. 1. Economic Context and Current Challenges Development outcomes have improved substantially since 2001 but Afghanistan remains a poor, fragile country. Impacts of “transition” were worsened by realization of security risks. Poverty and humanitarian risks are increasing 25 IMMEDIATE IMPROVEMENTS IN PUBLIC RESOURCE ALLOCATION AND BUSINESS ENVIRONMENT REFORM CAN HELP ESCAPE THE SLOWDOWN. 26 IMPROVING THE QUALITY OF PUBLIC EXPENDITURE CAN HELP SPUR SHORT-TERM RECOVERY Afghanistan’s economic situation is precarious. With limited public resources available for new demand -side measures, economic management should focus on increasing the impact of existing spending, containing negative impacts of insecurity, and safeguarding livelihoods. Options include: Reorienting budget expenditures towards labour-intensive and community-based programs that directly reach the population with the greatest needs and spur consumption, driving economy-wide benefits Improving budget execution, including by scaling down large infrastructure project that have not yet reached implementation stage and re-allocate towards basic education health service delivery. Continuing to improve quality of spending for basic service delivery Working with business groups to identify possible measures to address binding business environment constraints, including cooperative arrangements for security Implementing investment climate reforms to reduce the cost of doing business ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 27 BUSINESS REGULATORY CONSTRAINTS CAN BE SUBSTANTIALLY REDUCED Mobilizing growth sectors will Agriculture and extractives development are heavily dependent on private require private sector investment. investment decisions. Achieving growth will require active private sector engagement and adequate private sector confidence. The impact of agriculture and extractives on employment and broader Generating broad opportunities growth depends on the capacity of firms to take advantage of new markets from growth sectors will require a and consumer demand, including in service sectors and ancillary industries. vibrant private sector. An improved business environment Developing growth sectors and ensuring that benefits are maximized is vital to realize growth potential. depends on creating an environment as conducive as possible to new investment. Business surveys show that regulatory and administrative processes continue to constrain investment. While some problems facing investors are tightly tied to broader issues of Simple measures could have a large fragility, other constraints could be relatively easily addressed through impact on firms. removing red tape and reducing opportunities for corruption within administrative processes – especially business licensing and construction approvals. REGULATORY CONSTRAINTS ARE HEAVY INVESTORS CITE A RANGE OF CONSTRAINTS Ranking on 2017 Doing Business Indicators (of 190) Main constraints cited in Enterprise Survey (2014) 0 Political instability 20 Corruption 40 60 Access to land 80 100 Access to finance 120 Electricity 140 160 Crime, theft, and disorder 180 200 Tax rates Transportation Inadequately educated workforce Customs and trade regulation 0 10 20 30 ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 28 IN FOCUS: PRIORITIES FOR PRIVATE SECTOR DEVELOPMENT Government is currently in the process of developing a National Priority Program for Private Sector Development. While work on the document is ongoing, the following strategic priority areas and specific policy recommendations are currently being considered: Strategic Priority 1: Restoring confidence and creating an enabling environment Short-term: • Facilitate collective approaches to security and crime-prevention between businesses • Appoint an ombudsman to help firms facing corruption at government agencies • Streamline business start-up processes and reduce fees Medium-term: • Implement online business registration • Introduce expedited construction permitting for low-risk structures • Automate systems for monitoring electricity outages and allow for online applications for electricity connection and services • Introduce e-payment for all taxpayers Strategic Priority 2: Increasing access to key inputs for business Short-term: • Finalize the Financial Inclusion Strategy • Identify Public-Private Partnership (PPP) opportunities and pilot different PPP models • Identify land under ownership of defunct SOEs which can be used for serviced industrial parks Medium-term: • Remove legal and regulatory constraints to Islamic banking • Pilot Special Economic Zone (SEZ) development • Develop an infrastructure master plan for industrial parks, SEZs, and connective infrastructure. Strategic Priority 3: Sharing risks and crowding in investment Short-term: • Clarify organization responsibilities for investment promotion • Undertake a rapid review of state-owned enterprise performance using existing analysis Medium-term: • Streamline the foreign investment approval process • Issue visas for skilled foreign staff as part of investment approval processes • Wind down moribund state-owned enterprises while improving governance and performance of those that are viable and serving a public purpose Strategic Priority 4: Securing and facilitating trade and transit Short-term: • Develop an action plan for coordinated implementation of existing trade-related strategies and policies • Review the Afghanistan Pakistan Transit Trade Agreement and consider expanding to other countries • Negotiate improved visa arrangements with UAE and other key partners Medium-term: • Implement the Customs Reform program and Trade Facilitation Agreement • Expand the operations of the one-stop export shop to include air-freight exports POLICY MEASURES ARE NEEDED TO SHIELD HOUSEHOLDS AND FIRMS FROM THE IMPACTS OF FRAGILITY. 30 POLICY MEASURES ARE REQUIRED TO MANAGE FRAGILITY RISKS FACING HOUSEHOLDS AND FIRMS Given ongoing fragility, policies are needed to: Mitigate the aspects of fragility that are imposing the greatest constraints on growth; Support the private sector in managing the impacts fragility to allow continued investment. STRENGTHEN INSTITUTIONS Government lacks the capacity and resources to enforce compliance with all formal rules and institutions. A selective approach is therefore required, focusing on establishing “good enough” institutions in areas that matter most for development. MITIGATE RISKS FOR HOUSEHOLDS Households in Afghanistan are exposed to negative shocks to a unique extent, with insecurity constraining available responses. Social transfer systems could help households manage risk and avoid reliance on harmful coping strategies. MIIGATE RISKS FOR FIRMS Firms are negatively impacted by general insecurity, crime, and corruption. Establishing rule of law is a long-term challenge. In the short- term, regulatory reforms should reduce opportunities for corruption and financial instruments should be introduced to help firms manage fragility risks. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 31 STRENGTHENING INSTITUTIONS IS VITAL FOR DEVELOPMENT The impact of income on conflict is mediated by The impact of services on conflict is mediated by institutions institutions Low income countries are much more likely to There is no clear evidence that improvements in experience conflict. There is little international service delivery either address conflict, or increase the legitimacy of the state. Some evidence suggests evidence of a direct causal link between low incomes and violence, however, with most research instead that the introducing services in heavily underserved areas can exacerbate conflict pressures through pointing to institutional weaknesses as driving both insecurity and low incomes. Growth in the presence contestation over new resources. Recent research suggests that equitable access and the perceived of weak institutions may do little to address fragility, while strengthening institutions can be expected tolegitimacy of allocation decisions matters more than deliver both increased growth and reduced conflict.the quality or coverage of services in determining whether service provision will moderate or The impact of unemployment on conflict is mediated exacerbate conflict pressures. by institutions Recent international evidence suggests that insurgents are seldom motivated solely by a lack of economic opportunities. Some evidence suggests that broader economic opportunities can reduce participation in insurgent groups by raising “I did not join the Taliban opportunity costs. But economic motivations are generally secondary to broader factors in driving because I was people to join insurgent groups, including ideological motivations, perceived ethnic partisanship of state poor. I joined institutions and direct or indirect exposure to unfair or disrespectful treatment or violence at the hands of international or domestic security forces. because I was Expanding economic opportunities may play a positive role in reducing conflict, by increasing the angry.” opportunity cost of insurgency and building support for the state. But jobs – on their own – are unlikely to completely address conflict pressures, especially if such opportunities are unevenly distributed and -18 year old Taliban exacerbate real or perceived inequities. recruit ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 32 REFORM EFFORTS MUST BE PRIORITIZED IN A DIFFICULT POLITICAL ENVIRONMENT There have been substantial improvements in formal 1. Acknowledge that a gap between formal rules and actual practices is likely to remain, at least in some areas. rules, regulations, laws, and All developing countries exhibit a gap between formal rules processes across most and actual practices. International experience shows that the sectors. But there are existence of this gap does not seem to prevent countries from reaching much higher incomes and better development continued large and outcomes than Afghanistan. unpredictable divergences Afghanistan is constrained not so much by formal rules not between formal rules and being followed as by instability, unpredictability, and conflict actual practices in areas arising from rules being constantly contested. Uncertainty creates incentives for short-term predation at unsustainable key to growth and levels. development (mining, land, public service delivery, taxation and justice). 2. Ensure realistic expectations regarding the impact of adopting “good practice” institutions. Better quality formal rules will not necessarily lead to stronger institutions or better development outcomes if those rules are Institutions and property not enforced. The political drivers of weak institutions need to rights are constantly be acknowledged. contested by powerful actors who have little 3. Prioritize scarce government capacity and political capital to address the institutional weaknesses that matter most. interest in abiding by or Natural resources are a vital part of Afghanistan’s economic enforcing formal rules. No future. Weaknesses in the justice system and policing are contributing to conflict pressures. Given that government actor wields sufficient cannot enforce all rules all the time, it may be necessary to power to enforce a single focus scarce capacity, resources, and political will on those institutions that matter most for development. set of rules over all others. Contestation leads to uneven and unpredictable 4. Compensate losers when necessary. In some instances, necessary institutional reforms harm the enforcement of rules, interests of powerful actors, potentially undermining undermining state enforcement and limiting the impact and credibility of reforms. Compensating losers – when necessary – can build legitimacy and investor coalitions for required change. confidence. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 33 RISKS TO POOR HOUSEHOLDS ARE PRONOUNCED Households in Afghanistan are uniquely HOUSEHOLDS ARE UNIQUELY EXPOSED TO SHOCKS exposed to shocks. 80% % households experiencing shocks 88 percent of households in Afghanistan 70% Urban Rural experienced at least one shock in 2013/14. 60% The proportion of households experiencing 50% shocks is among the highest in the world. The 40% most common shocks are those related to 30% prices, water, and natural disasters. 20% Poorer households are more likely to 10% experience shocks and adopt harmful coping 0% Vietnam Iraq Afghanistan Peru China Uganda Sudan Tanzania mechanisms. Ethiopia Bangladesh Nigeria Lao PDR Malawi Mexico Maldives Uzbekistan The median household in the wealthiest 20 percent of households experienced 2.6 shocks during 2013/14, compared to 4.3 POORER HOUSEHOLDS EXPERIENCE MORE SHOCKS shocks experienced by the median household 5 2011/12 in the poorest quintile. 2013/14 Total no. of shocks (mean) 4 Poor household are more likely to have to adopt coping strategies when impacted by 3 shocks. A third of all households in the highest wealth quintile reported that they did 2 not need to adopt coping mechanisms when impacted by a negative shock. By contrast, 1 nearly 85 percent of households in the lowest income quintile needed to adopt coping 0 strategies when impacted by shocks. 1 2 3 4 5 wealth quintile Poorer households are also more likely to rely POORER HOUSEHOLDS USE HARMFUL COPING MECHANISMS on harmful coping mechanisms. Across all households, the most common strategies for 60% dealing with shocks are to reduce 50% expenditures and take on loans. Reflecting shocks using coping mechanism that poorer households are exposed to more 40% Households exposed to frequent shocks and have fewer resources available to manage them, harmful coping 30% mechanisms are more frequently employed. 20% Such mechanisms include: decreasing food intake and quality, buying food on credit, and 10% taking on loans. More than a third of all 0% households, and about half of households in 1 2 3 4 5 the lowest wealth quintile households used took loans harmful coping strategies. reduced food quantity or quality sold assets/property Source: ALCS, World Bank analysis ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 34 RISKS ARE EXACERBATED BY INSECURITY AND LACK OF ACCESS TO CREDIT Households in insecure districts are significantly more Reliance on harmful coping mechanisms may be likely to draw on harmful coping mechanisms across exacerbated by very low access to savings and credit. all wealth quintiles. Poor households in areas self-assessed as insecure Accessing savings and credit can be an important were much more likely than those in secure areas to means of avoiding reliance on harmful coping resort to taking on loans, purchasing food on credit, strategies. But households capacity to borrow and save reducing expenditures, and reducing the quantity or appears heavily constrained. More than half the Afghan quality of food purchased. While 44 percent of adults had neither saved nor borrowed in the past 12 households in the lowest quintile resorted to harmful months, well below the FCS average. While 27 percent coping strategies in secure areas, the equivalent figure of adults in other FCS economies saved as well as was 56 percent in insecure areas. borrowed, only 14 percent of Afghan adults did so. Only 10 percent of Afghan adults currently have access to a bank account. HOUSEHOLDS LACK ACCESS TO FINANCIAL TOOLS TO MANAGE SHOCKS 100% % Households using financial tools 80% 60% 40% 20% 0% Saved and borrowed Saved (no borrowing) Borrowed (no saving) Neither saved nor borrowed HOUSEHOLDS IN INSECURE AREAS ARE MORE EXPOSED TO SHOCKS 60% Secure Insecure % Households experiencing shocks 50% 40% 30% 20% 10% 0% Q1 Q2 Q3 Q4 Q5 Total Income Quintile Source: ALCS, World Bank analysis ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 35 A SOCIAL PROTECTION SCHEME COULD HELP MITIGATE RISKS FACING HOUSEHOLDS Afghanistan would benefit from a comprehensive social protection scheme. Efforts to protect the poor and vulnerable in SOCIAL ASSISTANCE COVERAGE IS VERY NARROW Afghanistan face a number of challenges, including fragmentation, extreme reliance on off-budget 100 programming and tight fiscal resources. A review of social protection in Afghanistan found that most of the 90 % Coverage of social assistance initiatives trying to address poverty and vulnerability 80 consist of short-term, small, and fragmented schemes. 70 With few exceptions, safety net interventions are 60 financed and implemented off-budget by humanitarian 50 partners who struggle with decreasing resources and 40 coordination challenges. 30 The Government channels almost all of its social 20 assistance resources to the Martyrs and Disabled 10 program (1.1 percent of GDP), with no resources 0 allocated to safety net schemes targeted to the poor. As a result, social assistance spending and coverage in Afghanistan are among the lowest when compared with similar countries. International comparisons show that many fragile and conflict-affected countries tend to rely more heavily on social safety nets than other countries to help their populations cope with heightened social and economic stress associated with such contexts. Investing in a regular and predictable A HIGH IMPACT, LOW COST SCHEME IS POSSIBLE poverty targeted cash transfer that would provide 20 1.8 90 percent of the basic food basket value to 10 percent of the Afghan population (about 350,000 households). 1.6 80 The annual cost of such a scheme is estimated at about 1.4 70 0.7 percent of GDP, without administrative costs. With Reduction in food poverty the current targeting system of the cash transfer pilot, 1.2 60 Cost (% GDP) it is estimated that close to 70 percent of the funds 1 50 would reach the poor, and the poverty rate could be halved. 0.8 40 0.6 30 The introduction of such a scheme would likely also bring long-term reductions in vulnerability through 0.4 20 human investment channels. If average effects from 0.2 10 other developing countries hold, basic cash transfers (i.e., without conditions) could increase children’s odds 0 0 of school enrolment by over 20 percent. In response to 20% 25% 30% 20% 25% 30% 20% 25% 30% improved food security and smoothing of consumption, 5% Coverage 10% Coverage 15% Coverage households would be expected to increase investment Reduction in food poverty (%) Cost (% GDP) in human capital formation and productive assets. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 36 IN FOCUS: COMMUNITY DEVELOPMENT IN AFGHANISTAN THE NATIONAL SOLIDARITY PROGRAM THE CITIZENS’ CHARTER The National Solidarity Program has been operational The Citizen’s Charter supports the Government’s in some 35,000 communities across Afghanistan over long-term goals of reducing poverty and deepening the past 14 years. Under the program, grants are the relationship between citizens and the state. The provided to communities to undertake development program replaces the NSP and will achieve its projects with use of grant resources governed by objectives in two ways. Community Development Committee, elected by community members. Half of all CDC seats are First, by providing development services and allocated to women, giving them the opportunity to grants through CDCs, the government will participate in decision-making at the village level and increase trust that government can provide a forum to voice their opinions. The program valued local benefits, deepening the social provided: contract and improving perceptions of government. The Charter will help connect 81,000 small-scale reconstruction and government, especially local government and development activities, providing over 13 municipalities, with its citizens. million Afghans with access to improved water supply and sanitation, rural roads, irrigation, Second, by using community oversight over power supply, health, and education services. service provision through a high profile government program, the program will 47.8 million days of work for skilled and strengthen bottom-up accountability for service unskilled workers, injecting much needed short- delivery and provide information to political term wage transfers into poor rural leaders regarding service delivery successes and communities throughout Afghanistan. constraints. Program evaluations have illustrated positive The program is structured around minimum service development impacts but ambiguous impacts on standards. The program will build public confidence in governance. The program had a positive effect on government by guaranteeing access to a basic access to drinking water and electricity, acceptance of package of services and infrastructure. 11,500 democratic processes, perceptions of economic communities in rural and urban areas will receive the wellbeing, and attitudes toward women. Effects on stated minimum service standards under the perceptions of local and national government program. Through building broad community-level performance and material economic outcomes were, knowledge of service standards, accountability for however, more limited or short-lived. While delivery through both CDC-administered projects and perceptions of government entities immediately line-agency programs will be established. improved in communities where the program was active, the impacts faded following project completion. There is no evidence the program improved perceptions of central state legitimacy or increased satisfaction with local leaders. FIRMS ARE HEAVILY IMPACTED BY CONFLICT AND INSECURITY Conflict and insecurity has a pronounced impact on Insecurity reduces incentives for firms to invest. firms. Firms that invest are much more likely to experience New analysis utilizing cell-phone data confirms that crime, especially in Kabul and Kandahar. Informal firms fewer firms are active in areas that experience greater that invest are three times more likely to experience conflict. But – in general – firms are most effected by crime than informal firms that do not invest. general lawlessness and crime. 15.5 percent of firms Investment may be perceived as signaling an experience crime-related business losses – higher than opportunity for predation. SAR comparators – and three-quarters of firms consider crime an obstacle to doing business. Weak Female management and ownership is concentrated in rule of law reduces incentives for firms to grow. firms that invest. Women are three times more likely to Medium-sized firms face the greatest negative impacts be a head manager and twice as likely to have an from insecurity, and are more likely to experience ownership stake in an investing firm relative to a non- crime-related losses than either small or large firms. investing firm. Medium-sized firms represent worthwhile targets for predation, while lacking the resources to protect This could signal a stronger risk-appetite among themselves. Five out of six firms with 20-99 employees women, or overrepresentation of women in firms that reported crime as an obstacle to doing business. are more likely to invest for other reasons. Firms lack access to credit, and many lack access even to bank accounts. CRIME IS CITED AS A CONSTRAINT BY FIRMS FEMALE-HEADED FIRMS ARE MORE LIKELY TO INVEST 80 70.8 70.0 % Firms citing crime to be no/minor obstacle 70 Head 2.77 60 Manager 54.8 53.8 51.4 51.4 Female 8.11 50 40 30 2.03 23.3 Female 20 Ownership 4.46 10 0 0 5 10 % Firms that invested Did not invest Invested Source: Business enterprise survey ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 38 FIRMS LACK EVEN BASIC MECHANISMS FOR MANAGING RISKS Firms lack access to credit, and FIRMS LACK ACCESS TO LOANS many lack access even to bank accounts. Lacking access to credit both reduces the capacity of 1.7 firms to manage risks arising Afghanistan (2014) 4.4 from insecurity and presents a constraint to investment in itself. More than 80 percent of firms that invest use internal funds to 19.5 finance their entire purchases. FCS 26.6 Only 3 percent of firms use bank loans to finance their investment, compared to 18 percent across 0 10 20 30 % Firms with access to loans FCS countries. Loan Application Line of Credit/Loan Less than 1 in 20 firms in Afghanistan has a line of credit or a loan from a financial institution FIRMS LACK ACCESS TO BANKING SERVICES and less than 2 percent of firms reported having applied for a Informal (2008) 28.2 loan in the previous year. Such low levels of external financing Formal: > 19 are consistent with Afghanistan’s Employees 77.9 (2008) very-low credit to GDP ratio (4.0 Formal: 5-19 percent as of end -December Employees 60.5 (2008) 2015, compared with 21.1 in FCS Formal (2008) 66.5 economies on average). Two thirds of informal firms and one - 0 20 40 60 80 100 third of formal firms do not hold % Firms access to banking services a bank account. Source: Business enterprise survey ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 39 REGULATORY REFORMS AND FINANCIAL TOOLS CAN HELP FIRMS MANAGE RISKS Addressing insecurity and reducing opportunities for predation are vital in the longer-term. In the meantime, specific actions can be taken to help firms mitigate risks. 1. Regulatory reforms to reduce unnecessary risks Reforms to the business regulatory environment present opportunities to reduce risks faced by firms, even in the context of ongoing insecurity. The difficult security environment is deterring investment, but additional constraints are unnecessarily created by burdensome regulatory processes that create opportunities for corruption. 2. Financial sector development Over the medium-term, deeper and better functioning financial markets are required to help firms manage risks. This will require development of a well-regulated insurance industry and an increase in savings rates through expanding financial inclusion, including trust-building through strengthened deposit insurance. Financial sector development and expansion of the banking sector would also help with the development of social protection mechanisms. 3. Credit guarantees/ risk sharing facilities Risks of crime and insecurity are to some extent idiosyncratic and can therefore be shared. Internationally, risk sharing facilities have helped promote investment by sharing risks across investors. 4. Political risk guarantees Development agencies offer products by which firms can ensure themselves against political risks. Greater use could be made of such facilities, providing protection to a larger number of smaller firms. Constraints will need to be considered and carefully addressed, given current high pricing of Afghanistan’s sovereign risk. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 40 A BALANCED LONG-TERM GROWTH STRATEGY CAN MEET AFGHANISTAN’S DIFFERENT ECONOMIC DEVELOPMENT NEEDS. 41 GROWTH FROM DIFFERENT SOURCES IS REQUIRED TO MEET DIFFERENT DEVELOPMENT NEEDS Agriculture Growth Agriculture remains the foundation of For broad-based Jobs Afghanistan’s economy and could growth and jobs. provide substantial gains to growth and Revenue livelihoods. Exports Risks Human capital Growth Human capital investment to address A foundation for Jobs existing deficits is required for any any growth feasible growth strategy. Investing in Revenue managed labor mobility can provide strategy. Exports growth, income, and stability benefits. Risks Extractives Growth While there are important risks to be For required Jobs managed, only extractives are likely to exports and provide sufficient exports and Revenue revenues to substitute declining aid. revenues. Exports Risks Trade Growth Trade and regional integration offer Jobs important potential if infrastructure To enable investments are targeted towards agriculture and Revenue enabling agriculture and extractive extractives. Exports exports. Infrastructure investment specifically targeting commodity Risks transit trade is costly and high risk. Growth With a continued oversupply of labor Labor Mobility Jobs even under best-case scenarios, To provide investing in managed labor mobility additional Revenue can provide growth, income, and opportunities. Exports stability benefits. . Risks ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 42 AGRICULTURE IS THE BACKBONE OF AFGHANISTAN’S ECONOMY Afghanistan’s economy is largely agrarian. and displacement prior to 2001, and remain vulnerable to drought and poor disease control. Agriculture is one of the main contributors to Horticulture and livestock products account for a economic growth accounting for one-third of GDP smaller share of output than wheat, but make up a growth over the past decade. Most agriculture is rain- large share of Afghanistan’s exports (fresh and dried fed, which makes agricultural output and GDP growth fruits, nuts, skins, wool, and cashmere) and provide highly volatile and dependent on weather. almost an equally large proportion of jobs. Agriculture has very strong links to the rest of the Opium will be difficult to displace. economy. Private aggregate demand is highly correlated with agriculture output, with agriculture Afghanistan is globally a near monopoly producer of providing a source of income for nearly half of the illicit opium. Opium is Afghanistan’s single most population. Agriculture employs about 40 percent of important cash crop, occupies about 10 percent of the total workforce. Moreover, nearly 90 percent of irrigated land, and provides a source of income for exports and 95 percent of manufacturing relies on many poor and landless farmers. It accounts for 4.5 agriculture. percent of GDP in 2016, with total production at farm-gate values of US$900 million. With its large Wheat is the dominant food crop. Only about 8 negative impact on governance and state-building, million ha of land in Afghanistan is arable (12 percent long-term dependence on poppy cultivation is not in of total). Currently only about 2 million ha is irrigated the country’s interest. However, displacing opium while the remainder is either under rain-fed production is very difficult due to the crop’s relative cultivation or left fallow. Wheat accounts for two- robustness to weather conditions, easy marketability, third of the cultivated area. Yet the country is not and high profitability. Efforts to eradicate or displace self-sufficient in cereal production and imports an opium have so far proven to be generally average of 1.2 million mt/year. There is a long unsuccessful, with opium production reverting to high tradition of horticulture and livestock production. levels of production in recent years. Both sub-sectors suffered from the impacts of war Jobs Livelihoods Poverty Gender Agriculture employs 61 percent of all The poor An estimated 54 about 44 percent of the households derive disproportionately percent of Afghanistan’s total workforce. income from agriculture depend on agriculture. agricultural workforce is – for 28 percent of all The poverty rate in rural female, and women are 70 percent of the households it is the areas is 58.6 percent, especially prominent in population is rural and main source of income. about 17 percentage horticulture and animal mostly dependent on points above urban husbandry. agriculture. areas. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 43 AGRICULTURE HAS GREAT POTENTIAL FOR GROWTH AND JOB CREATION Potential: • Low-risk sector that could contribute 1.6 percentage points to GDP growth annually. • 1.2 million additional jobs over the next 10 years reflecting strong linkages with the rest of the economy. • Relatively low revenue potential as agricultural activity is often informal and incomes will likely remain below the taxation threshold. • Good export potential for horticulture and livestock products but will require relatively complex supply chains. Main constraints: • Insufficient irrigation infrastructure and water conveyance systems. • Poor on-farm water management. • Insecure land tenure and inefficient land markets. • Farmers have limited access to new knowledge and improved technologies. • Few trained female extension workers. What needs to be done: • Rehabilitate and expand irrigation structures. • Improve water management. • Invest in land management systems and capacity. • Improve availability and quality of knowledge extension services. • Provide literacy programs for rural populations to improve productivity and to support rural community mobilization ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 44 HUMAN CAPITAL HAS IMPROVED DRAMATICALLY, BUT PROGRESS IS SLOWING Afghanistan has dramatically increased investment ACCESS TO EDUCATION HAS RAPIDLY IMPROVED in human capital since 2001. 7 6 The number of primary-school students has increased 5 from 770,000 in 2001 to more than 6 million today. Millions Expansion in access to healthcare services has led to 4 impressive reductions in infant mortality (from 93 to 3 66 per 1,000 live births) and increases in life 2 expectancy (44 to 60 years). 1 - Much still needs to be achieved. 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Life expectancy remains 11 years short of the global Enrolment in primary education, both sexes (number) average, and slightly below the low-income country Enrolment in secondary education, both sexes (number) average. Only around half of children attend secondary school, and literacy rates are among the GENDER GAPS ARE NOW GROWING lowest in the world. There are important concerns regarding education quality and perceived 18 16.9 Differences in enrolment ratio – mismatches between investment in skills and labor 17.5 15.7 market demands. The pace of progress against some 16 14.8 indicators is slowing. Largely reflecting the 13.6 boys vs. girls 14 deteriorating security situation, primary attendance rates for girls and in rural areas have declined since 11.4 12 2011/12. The pace of improvement in access to 12.7 maternal care and education outcomes has slowed. 10 11.2 Reduced access to health and education services has 10.3 been especially pronounced in conflict-affected areas. 8 2007-08 2011-12 2013-14 Resources are scarce. primary lower secondary upper secondayr Per capita on-budget government spending on health and education has declined over recent years. Health THERE IS LITTLE PUBLIC INVESTMENT IN HEALTH remains overwhelmingly privately financed (75 30 Expenditure as % total Government percent), and government spends only around US$7 per capita on healthcare. 18 percent of households in 25 Afghanistan borrow to pay for healthcare, while only 20 5 percent borrow for education. Under constitutional Expenditure provisions guaranteeing free education, the majority 15 of education expenditure is by government and 10 donors. With a growing population it will be difficult to maintain current service coverage and standards, 5 let alone improve quality and increase access. 0 AFG LIC World Education Health Source: ALCS, World Development Indicators, Ministry of Finance data ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 45 BASIC PROBLEMS IN THE EDUCATION SYSTEM NEED TO BE ADDRESSED ATTENDANCE AND ATTAINMENT GAP • Half the children and youth who are enrolled in a • Build boundary walls to improve security. school do not attend. Gender, income, parental education and location play a significant role in • Mobilize community involvement to encourage school attendance decisions. Girls stay out of school attendance. because of family pressures. Boys, because of work. Security concerns affect all. • Actively recruit female teachers. • Literacy rates among the 5-15 year-olds have declined between 2012 and 2014. Learning assessments at the 6th grade level show many children are behind. RESOURCE MISALLOCATION • Teacher training, deployment, and pay need • Seek budget allocations and donor support for early significant improvements. Most teachers are childhood education. underqualified. • Include traditional apprenticeships in skills training • No funds are set aside for early childhood education, programs to reach the large number of youth. while adult training and literacy programs are too limited in their outreach, and are not geared • Introduce electronic systems for managing and towards developing life-skills. ensuring validity of education sector payroll. • Staffing costs are too high, crowding out other necessary recurrent expenditures (such as school supplies). INSUFFICIENT AND FRAGMENTED RESOURCING • Overall resources are declining – the share of • Increase overall resource allocation to education. education spending in the budget is 13 percent in 2018, down from 25 percent in 2010. • Prepare a medium-term needs plan, paying attention to regional disparities in inputs and • Funding from the international community—nearly outcomes, with special consideration given to the half of all spending—remains off budget and flows maintenance needs for new schools. directly to projects. • Align on- and off-budget expenditures around the needs plan. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 46 ADULT EDUCATION COULD BRING BENEFITS, BUT INVESTMENT IS NEEDED There is great need for adult education. LITERACY RATES ARE EXTREMELY LOW Nearly 70 percent of the working-age population is illiterate, impeding productivity, communication, and 90 AFG LIC FCS political/social engagement. More than 80 percent of 80 women are illiterate, with international literature 70 Literacy Rate 60 showing a strong relationship between higher 50 women’s education and lower fertility rates. The poor 40 are least likely to be literate, have fewer years of 30 schooling, and larger household sizes. 20 10 Improving education for adults will require greater 0 investment. Adult Adult Adult Youth Youth Youth total female male total female male International experience with adult education programs is mixed, but some evidence suggests well- designed adult programs can address illiteracy within short timeframes and at relatively low cost. Current THE POOR LACK EDUCATION investment in adult education, however, is very 3.5 limited. On-budget spending on adult education was 3 around US$20 million in 2015. Adult education Years of Schooling programs accounted for around 1 percent of total 2.5 expenditure, and 4 percent of education expenditure. 2 Off-budget donor spending on TVET was around 1.5 US$12.6 million in 2015, while investment in adult 1 literacy was around US$3.2 million. Adult education comprised 19 percent of off-budget education 0.5 expenditures in 2015. Total investment in adult 0 education was around 4 percent of total investment 2007-08 2011-12 2013-14 in education in 2015, and around 0.6 percent of GDP. non-poor poor gap (NP-P) While education expenditure has remained a fairly stable share of civilian expenditure, expenditure on adult education has been volatile and has declined over time. THERE IS LITTLE INVESTMENT IN ADULT EDUCATION 12% 10% 8% 6% 4% 2% 0% 2010 2011 2012 2013 2014 2015 As % total (on and off budget) education expenditure As % civilian expenditure ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 47 AFGHANISTAN MUST INVEST MORE IN HUMAN CAPITAL Potential: • Improved human capital is a vital input for any potential growth strategy. Every year of schooling raises earnings by 10 percent. This rate of return is higher than alternative investments, including bonds, stocks, deposits, and housing. • Investment in human capital represents low risk, given potential contribution to growth from different sectors. • Modelled scenarios suggest increases in human capital investment could yield substantial benefits to employment and incomes. • Labor productivity increases will fuel increased output while reduced fertility associated with improved education outcomes drives higher incomes. Main constraints: • Low absolute public spending levels of education and (especially) health constrain development outcomes. • Inequities in access between the rich and the poor and urban and rural areas may be contributing to fragility and urbanization pressures. What needs to be done: • Increase spending on education and health spending from 33 percent to 50 percent of civilian spending to ensure increased access and improvements in quality. • Expand primary healthcare services, prioritizing rural areas. • Invest in early childhood education, skills and literacy programs. • Reform skills training programs to include traditional apprenticeships for unskilled and semi-skilled youth. • Strengthen focus on female education to close the gender gap and reduce fertility. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 48 EXTRACTIVES ARE A VITAL COMPLEMENT TO AGRICULTURE AND RISKS CAN BE MANAGED Afghanistan’s extractive resource base is large and ‘resource curse’. Of predominant concerns for uniquely undeveloped. Afghanistan is the danger that extractives development can: i) erode gains achieved in The country is endowed with a wide range of governance; ii) spur conflict through real or perceived minerals, from well-known assets in copper, coal, iron inequity in distribution of rents; iii) threaten the ore, gold and oil and gas to more speculative deposits environment and cultural assets; iv) trigger disputes in those minerals, as well as lithium and gemstones. over rights to control resources; and v) provide Sector output could meet demand on international financing to insurgent groups. These are all very markets but would also serve domestic needs for legitimate concerns. construction material. The pitfalls of the resource curse can be avoided. Extractive developments in Afghanistan have experienced setbacks in recent years. Recent Many low-income countries have managed to harness experience with small-scale gem mining and medium- their resource wealth to improve human scale coal and gold mining has highlighted that mining development. Countries that were able to succeed in development, when poorly managed, can fuel conflict natural resource development with initially-weak and corruption while delivering few benefits to institutions include Botswana, Colombia, Ghana and citizens. Reflecting this experience, concerns Trinidad & Tobago. These successes suggest the regarding governance capacity have led policy-makers emergence of an international policy learning curve to virtually halt investment and development with many good practice examples that can be progress in the sector. Global commodity price modified and adopted for the Afghan context. developments have rendered some projects less attractive to private investors, but interest remains Afghanistan cannot forgo the potential of extractives high for the majority of opportunities. development. Over the next 15 years, extractives is the only sector Given Afghanistan’s daunting governance risks and that has the potential to produce exports and conflict vulnerabilities, and weak capacity in the revenues at scale. Extractives in Afghanistan will only Ministry of Mines and Petroleum, the challenges to reach maturity over time, but important impacts may develop natural resources into a productive growth be felt early. If properly leveraged through reforms sector are overwhelming. Yet, extractives is the only and public investment, extractives offer sector that could provide sufficient fiscal revenue and opportunities to accelerate growth and support export earnings to offset expected declines in aid. improved livelihoods. Extractives also have important potential to spur growth in other sectors through creating demand for Extractives development brings risks. services or providing inputs into the production process. New, successful investment in extractives There is ample country specific and empirical would provide a positive signal to the broader private evidence showing that – under certain circumstances sector regarding the direction of policy and economic – extractives development can be detrimental to prospects, helping to build confidence. development prospects, especially in fragile and conflict contexts. The phenomenon of countries endowed with natural resource wealth experiencing poorer development outcomes is known as the ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 49 A DIVERSIFIED AND INCREMENTAL APPROACH CAN HELP MANAGE RISKS An iterative, proof of concept approach can bring substantial benefits. • Lowers risks to government and investors through learning Risk to government Production level and investors • Opportunity to anchor capacity building activities and allows to build institutions over time • Stress-tests legal and regulatory framework • Provides signals to both, domestic and international investor community over viability of investments • Provides opportunity to experiment with benefit Time sharing mechanisms. The diversity of Afghanistan’s resources can also be leveraged to reduce risks. • The availability of a range of natural resources reduces exposure to price shocks • Development of different industry types facilitates iterative development, moving progressively towards high risk/high return operations with deep linkages across the economy. Metallic minerals Hydrocarbons Industrial minerals Artisanal mining (small/medium scale) • High risk / • High risk / • Lower exploration risk • Risks limited with Exploration high reward high reward • Probability of losses appropriate licensing • High probability • High probability tied to end-use of losses of losses markets • Capital Intensive • Capital Intensive • Lower capital • Modest capital • Production ($50m to $1b) Global Investors requirements requirements • Global Investors ($1m to $50m) • Domestic investors • Greater emphasis on domestic investors • Lateral linkages • Some lateral linkages • Modest lateral • Few linkages Economic links • Local content • PPP infrastructure linkages • PPP infrastructure opportunities • Formal benefits opportunities • Formal benefits sharing • Formal benefits sharing sharing ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 50 THE RESOURCE CORRIDOR APPROACH REMAINS VIABLE AND RELEVANT The resource corridor program was launched in 2013 as a national priority program but has lost momentum in recent years. The program sought to use extractive sector development as an anchor for infrastructure deployment and policy actions that would equally support growth in agriculture and services sectors and regional connectivity. Synergies between private and public investment in the extractives sector can reduce cost of infrastructure deployment. Benefit sharing mechanisms and skill development programs can leverage enterprise and community development. While a resource corridor is not a panacea it can be a powerful instrument to generate inclusive growth from a sector that otherwise might provide benefits only to a small number of workers in isolated geographical areas. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 51 THE POTENTIAL OF EXTRACTIVES MUST BE HARNESSED Potential: • High risk sector that could see Afghanistan achieve 5 percent annual GDP growth assuming accelerated investment in 2017 - 2020. • Modest job impact: 100,000 – 125,000 jobs additional jobs over the next 10 years through resource corridor approach. • High Revenue potential: 3 percent of GDP annually through 2030 (excl. energy transit). • Exports could grow by 10 percent annually and gradually substitute for the decline in aid. • Large potential to leverage public investment in infrastructure trough PPPs. Main constraints: • Underinvestment in exploration and production due to legal and regulatory uncertainty. • Weak capacity at Ministry of Mines and Petroleum. What needs to be done: • Identify opportunities for scalable proof of concept investments. • Restore interest in exploration activities by disseminating geodata and improving outreach activities to private sector. • Invest in and concentrate required capacity in MoMP. Meanwhile pull in international service providers to oversee and manage licenses. • Reenergize resource corridor program. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 52 AFGHANISTAN’S EXPORT PERFORMANCE IS WEAK, BUT TRADE OFFERS OPPORTUNITIES Afghanistan runs large and longstanding trade Afghanistan’s trade is heavily concentrated, making it deficits. susceptible to external shocks. Afghanistan’s official merchandise exports were The top ten export products account for more than 70 US$694 million in 2015 – just 8 percent of exports percent of total exports, compared with 13 percent for (US$8,724 million). Due to its narrow production and South Asia. The top-five destinations – Pakistan and manufacturing base, Afghanistan depends heavily on India, Iran, Turkmenistan and Germany – account for imports of fuels, food staples, processed materials, and almost 90 percent of exports compared to 38 percent manufactured goods. Imports consistently increased for South-Asia. Similarly top-20 imports and top-ten over the 2000s reflecting the large import needs for import partners account for 50 percent and 80 percent reconstruction, but have been declining in recent years of all imports respectively. Pakistan and India are as a result of the withdrawal of international troops, Afghanistan’s most important trade partners by a wide the decline in aid resources and associated public margin. spending, and due to the weakening currency. The low share of exporting firms suggests low export Exports, though low in overall volume, have grown in capabilities and high barriers to trade. recent years. Merchandise exports have grown by 6 percent per year on average since 2013. Export growth Enterprise surveys indicate that only 6.7 percent of in recent years is largely attributed to an uptake in the Afghan firms export. This share is low compared with production of horticultural products. The largest averages for the South Asia region (13 percent) and the exported categories of goods include fruits and dried developed world (36 percent). Low export performance nuts, metals (consisting almost exclusively of scrap is consistent with very low foreign investment, which iron), mineral products, cotton, and carpets. can provide an important conduit for acquiring knowledge and technology. FDI flows in Afghanistan – mostly originated from the UAE and China – were less than 1 percent of GDP in recent years. AFGHANISTAN HAS SUBSTANTIAL TRADE POTENTIAL Commodity Energy transit Internet export backbone Countries typically broaden Building regional connectivity Afghanistan also has a exports within the existing for energy transit trade can: (i) potentially important role to production base and product mix deliver benefits from play in improving the regional or by moving production up the Afghanistan’s role as a ‘bridge’ connectivity of high capacity, value chain. In Afghanistan, linking the energy reserves of domestic fibre-optic networks. agriculture and – to a much Central Asia with the growing While Afghanistan’s ICT market larger extent mining – stand out demand of South Asia; and (ii) and infrastructure is still as the sectors with the largest provide Afghanistan with nascent, the Government is potential to drive exports in the electricity to meet its own working hard to promote future. Improved agriculture acute domestic shortages. private investment in fibber- production and productivity will Major regional energy projects optic networks including likely drive import substitution are already underway and will through participation in more than increased agricultural help build regional connectivity regional initiatives. exports over the next ten years. in this area. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 53 AFGHANISTAN FACES TRADE CONSTRAINTS BEHIND AND AT THE BORDER GEOGRAPHY AND CONFLICT TRADE POLICY • Complex topography, underdeveloped road • Implementation of APTTA remains challenging and infrastructure and high transportation risks mean that causes congestion at border crossing points with cost of trade are very high. Pakistan. • Around 50 percent of firms in Afghanistan consider • Tariff barriers are on average fairly low in Afghanistan transportation a major or severe constraint. and Central Asia, but tariff peaks in some Central Asian economies exist on several products that are of export • It cost $5,045 to ship a container from Afghanistan interest for Afghanistan. compared to $1,922 from the average South Asian country. CROSS-BORDER INSTITUTIONS PRODUCTION CONSTRAINTS • Afghan exporters spend 86 days on average to ship their • Exports are only weakly correlated with movements of goods. This compares with 33 days on average in South- the currency exchange rate but strongly with Asia. agriculture output. This implies binding constraints in production. • Around 85 percent of total time spent to export is related to documentary compliance and 15 percent is due to border compliance . ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 54 COMMODITY TRANSIT IS A LONG-TERM OPPORTUNITY Gains from commodity transit trade may be modest Overreliance on commodity transit therefore and slow to materialize. represents a risky development option. Roughly estimated, improved transport connectivity Of all modalities of trade, commodity transit is also the between Afghanistan and the rest of Central Asia could most vulnerable to the ongoing context of insecurity, boost regional trade by $5.2 billion and increase providing opportunities for predation and extortion Afghanistan’s revenues by $260 million per year (1.3 along transport routes. percent of GDP). A sensible approach to transit trade development However, Afghanistan’s transportation (road and would be based on careful prioritization of railroads) network is currently underdeveloped. infrastructure investment: i) to resolve existing Globally and within the region, Afghanistan shows the congestion at important trade points; ii) to meet weakest performance in logistics and transportation emerging needs in productive sectors (agriculture and (ranked 158 out of 160 countries). mining); and iii) in partnership with the private sector. Achieving a competitive edge in transportation and logistics will require large investment in transportation and border infrastructure which will compete with infrastructure demands in productive sectors. Moreover, regional trade potential is shaped by sensitive political and geopolitical considerations which are not entirely under Afghanistan’s control. AFGHANISTAN’S LOGISTICS PERFORMANCE RANKINGS ARE POOR 0 20 40 Rank (Low=Good) 60 80 100 137 120 152 149 158 158 156 159 140 160 180 Infrastructure Customs Timeliness Tracking and tracing Logistics quality and International shipments Overall competence Source: Logistics Performance Index ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 55 TRADE DEVELOPMENT SHOULD FOCUS ON AGRICULTURE AND EXTRACTIVES Potential: • Development of agriculture and extractives show combined the largest potential and can boost exports by 14 percent. • Energy transit trade could add 3.1 percent to export growth annually and contribute substantially to revenue growth through 2030. • Reducing export times to 25 days could increase existing exports by 20percent, which corresponds to USD152 million per year if production constraints are eased. • By and large, employment impacts will be maximized through the development of agriculture exports. Main constraints: • Export development is reliant on expanding production capacity in agriculture and extractives. • High transportation cost and risk due to underdeveloped road infrastructure and insecurity. • Customs and border inefficiencies lead to long delays. • Congestion at border crossing points with Pakistan impose substantial costs. What needs to be done: • Improve efficiency in documentation requirements and processes, including establishing a single window and information portal for trade. • Improve cross-border institutions to reduce wait times at strategic border points by offering 24/7 customs services, reducing traffic congestion, and expanding border capacity. • Improve road infrastructure and quality in response to demand from domestic exporters. • Continue discussions with Pakistan on resolving APTTA implementation constraints. • Deepen and expand existing trade agreements with regional partners. Note: Estimates of trade potential and impacts are based on analysis of 2014 data. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 56 IN FOCUS: ENERGY EXPORT AS A DEVELOPMENT STRATEGY Other countries in the region have been able to leverage economic benefits from extensive natural endowments through electricity exports to neighboring economies. Modeling undertaken for this analysis shows that, by prioritizing investment in hydro generation and major transmission infrastructure, including large scale projects such as Kunar A (Shal), Afghanistan could generate in excess of 5 TWh of electricity for export beginning in 2026, although at a cost in terms of slower growth in connecting domestic customers to the grid. While technically feasible, pursuing such a strategy would involve considerable costs and risks. It is likely to be difficult to attract private investment for large-scale development of generation plants given long lead-times, insecurity, and political uncertainty. If publicly financed, large-scale projects would squeeze out alternative, higher- impact public investments (investment space under most plausible aid scenarios). Domestic economic impacts of hydropower projects would be limited given likely reliance on external skilled labour during construction and very limited labour requirements during ongoing operations. Export potential would remain contingent on energy policy decisions in market countries, which could be influenced by unpredictable political developments. Large-scale hydro development may expose Afghanistan to similar fragility pressures as mining, including contestation over the natural resource and distribution of benefits, and potential security vulnerabilities at generation and transmission facilities. INVESTMENT COSTS FOR ENERGY EXPORT ARE EXTREMELY HIGH Investment costs for development of potential exports 4.5 4 3.5 3 USD Bn 2.5 2 1.5 1 0.5 0 2017-2022 2023-2027 2028-2032 Generation Major Transmission Local Transmission Source: World Bank analysis IN FOCUS: EXPANDING ACCESS TO ENERGY IN AFGHANISTAN Distributed generation, including stand-alone and With public investment to support distributed mini-grid systems, offer attractive options for distribution, export would remain a long-term extending electricity supply to the local population option. within the current context of uncertainty. This approach would reduce the need for risky and While Afghanistan would address domestic electricity high-cost investments in large-scale grid-connected demand through a combination of small-scale isolated generation and transmission projects while generation, moderately sized grid-connected accelerating supply of electricity to a large portion of generation and imports over the medium-term, the currently unserved population - especially in areas opportunities for developing export potential could remote from the grid. Expanded and improved access still be pursued. Under a distributed generation to electricity would both improve living standards and scenario, generation investments would include mid- help to fill an infrastructure gap in support of sized hydro and thermal investments connected to the economic growth. Reliance on distributed generation grid, as well as smaller isolated projects in areas where would allow the utility to defer dealing with the grid connection would be costly and/or technically problems of asynchronous operations of different challenging. Imports would continue to be needed to sections of the grid, and to match the investment in meet grid-based energy demand, although energy supply specifically to demand in a particular areas. imports would decline from around 50 percent of total Small scale renewable technologies, such as Solar demand to 19 percent by 2030. Even as a distributed Home System (SHS), would be ideally suited to generation was being pursued, government could distributed generation. Mini-grids are well suited to continue to solicit private investment in large-scale either micro-hydro, solar arrays, or a combination of projects with potential for export. Public investment in either solar or wind supplemented by diesel. Small- large-scale export-oriented projects could also be scale investments would be robust to fragility, and pursued in the future once immediate public could be delivered through the Citizens Charter or investments in agriculture and human capital begin to other community-level programs, potentially deliver growth and revenue returns, generating improving perceptions of the state. additional fiscal space. DISTRIBUTED GENERATION IS THE MOST COST-EFFECTIVE OPTION TO EXPAND ACCESS Investment costs for expanding access 12,000 100 Investment Requirement (USD Bn) % Households Served by 2030 90 10,000 80 8,000 70 60 6,000 50 40 4,000 30 2,000 20 10 - - Master Plan Baseline Hydro for export Distributed Generation Hydro Generation Thermal Generation Major Transmission Local Transmission % Population Served by 2030 Source: World Bank analysis AFGHANISTAN HAS A LONG HISTORY OF LABOR MOBILITY Afghanistan has experienced Afghan out-migration peaked throughout its recent history in the early 1990s, with 6.7 major migration outflows and million Afghans residing Pre-2001 outside the country, 95% of inflows, driven by economic displacement whom were forcibly displaced. opportunities, changing conflict The vast majority of these were dwelling in Pakistan (3.2 dynamics, and natural disasters. million) and Iran (2.4 million) Since 2015, economic migration has outstripped displacement as By 2015, the nature of Afghan the primary component of Post 2015 shift to migration had fundamentally economic migration Afghanistan’s outflows. shifted. Displaced Afghans returned throughout the 1990s and 2000s. By 2015, of 4.8 Of the total 3.8 million million Afghans living abroad, households in Afghanistan in over 50% were economic migrants. OECD and GCC 2013/2014, 16 percent have countries also gained members who are international importance as destinations. migrants. 9.3 percent of households have members who In 2016, internal displacement were refugees and returned to reached approximately 1.2 their home country. 11.2 million. percent of households include 2016 displacement & returns 2.7 million registered and 2.5- economic migrants. The 3.0 million unregistered refugees were living in Iran difference (about 4.5 percent of and Pakistan. The number of households) have family returnees had been increasing since 2015, reflecting growing members who are both forcibly - push factors in Pakistan displaced and economic At least 500,000 returnees migrants. arrived in Afghanistan in 2017, exacerbating humanitarian challenges. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 59 ECONOMIC MIGRATION HAS IMPORTANT IMPACTS ON EMPLOYMENT AND POVERTY Labor mobility represents an important opportunity At the household level, remittances are an important for Afghanistan. source of livelihoods. In Afghanistan, as in many low-income countries, labor Remittances resulting from migration are significant migration presents a critical opportunity to alleviate and likely higher than officially reported. Official labor market pressures, increase wages, and reduce statistics put remittance inflows in 2015 at $340 million poverty, and through remittances contribute to (1.7 percent of GDP) and outflows at $150 million (0.7 increasing domestic income, consumption, and percent of GDP). Using a range of date sources our bolstering foreign exchange receipts. analysis suggests that remittances inflows are more likely between 3 – 7 percent of GDP. At an individual level, labor mobility is critical to expanding employment opportunities. The ALCS 2013/14 indicates that around 6 percent of Afghan households rely on remittances as one of their Our analysis shows in all growth scenarios, job growth three main sources of income (70 percent of labor would not be sufficient to keep pace with the growing income on average). Remittances are highly relevant labor supply, leaving a considerable number of people for those beneficiaries, though, averaging US$1680 un- or underemployed. This means migration pressures annually (more than half of their income). Further, will remain high, with an estimated 150,000 – 250,000 remittances to Afghanistan are negatively correlated people per year searching for income opportunities with GDP growth, implying a risk-diversifying strategy abroad to maintain the current unemployment rate. to mitigate the impacts of economic downturns for Employment abroad also offers increased wages, with Afghan families. Afghans working in Iran receiving four times, and in the United States eight times, the comparable wages in Afghanistan. A number of factors influence individual economic REMITTANCE FLOWS ARE SIGNIFCANT AND migration in Afghanistan: UNDERSTATED IN OFFICIAL DATA Pull factors: improved employment 400 2.5 outcomes, wage differentials ranging 350 Remittances as US$ Million from four to eight times wages in 2.0 Remittances as % GDP Afghanistan, and risk mitigation from 300 economic shocks 250 1.5 Push factors: Insecurity and conflict, 200 natural disasters, economic shocks and 1.0 150 unemployment 100 0.5 Affordability: Migration is costly and 50 requires a set of resources (assets, networks, education). Richer 0 0.0 households are more likely to have individual members migrating because they have the resources to facilitate the Levels As % GDP (rhs) migration. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 60 MANAGED MIGRATION PRESENTS IMPORTANT OPPORTUNITIES Lack of legal channels and high costs have resulted in and more and sustained remittances. They also offer largely irregular Afghan migrant flows. the possibility to maximize benefits from increased incentives for human capital acquisition and better Migration in Afghanistan is currently largely access to diaspora resources. unmanaged, in part because Afghanistan does not have any functioning agreements through which Afghans Our migration simulations show that official may regularly migrate to work abroad. Irregular remittances could grow from 14 percent of GDP by migration accounts for 91.1 percent of Afghans in Iran, 2030 in a scenario of unmanaged migration to 18.5 50 percent of Afghans in Pakistan, and almost all percent of GDP in a plausible scenario of managed Afghans in the GCC. migration. This is roughly the level of civilian aid estimated for 2017 – 2020. Unmanaged migration in Afghanistan limits opportunities for growth and employment. Labor demand in advanced economies presents opportunities for managed migration. Irregular migration poses a number of risks to migrants, such as high costs paid to smugglers and the lack of Demand for managed migration growing in many legal protections against abuse and exploitation. countries due to an aging working population and Further, it leads to inferior employment outcomes, as decline in fertility rates that limits growth in labor constrained legal access to the labor market in the supply. Origin countries such as Afghanistan can destination country, resulting in lower wages and identify promising markets by assessing their labor uncertainty around employment. market need, political receptiveness, and cultural/ language affinities of work forces. Using this method, Managed migration can maximize benefits for Turkey and the GCC countries have been identified as Afghanistan and potential host-countries. potential partners for Afghan managed migration. Managed migration flows, based on bilateral labor PROSPECTS VARY BY LABOR MARKET migration agreements, promise improved regularity of Cultural / Language Affinities migration patterns, access to higher-wage countries, Political Receptiveness Labor Market Need MANAGED MIGRATION INCREASES REMITTANCES 20 18 Overall 16 14 Remittances % GDP 12 Pakistan M L H M 10 M L H M Iran 8 GCC H M M M 6 Malaysia M M M M 4 2 Europe H L L L 0 Australia M M L M 2020 2026 2015 2016 2017 2018 2019 2021 2022 2023 2024 2025 2027 2028 2029 2030 Turkey M H H H Central Asia L L M L Baseline Low High Source: World Bank analysis ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 61 AFGHANISTAN MUST MOVE FROM UNMANAGED TO MANAGED MIGRATION Potential: • Double current levels of economic migrants and offer additional job opportunities for 10,000 to 50,000 people annually, reducing fragility risks through the employment channel. • Immediate wage increases of 300 to 800 percent for workers placed abroad. • Increase remittances to 18.5 percent of GDP by 2030 in a plausible scenario of managed migration. • Increase incentives for human capital investment. Main constraints: • Absence of legal channels for labor migration from Afghanistan. • Insufficient governance framework and lack of institutional mechanisms to facilitate, support and protect migrants. • Exceedingly high time and cost burden associated with regular migration, resulting from overly burdensome exit requirements and poorly functioning systems. What needs to be done: • Identify potential host countries and negotiate labor market access for Afghan workers. • Create an inter-governmental coordination mechanism and streamline visa and exit clearance processes. • Strengthen labor intermediation for Afghans going abroad by establishing systems for recruitment and skills certifications and verification. • Balance mobility with protection by strengthening embassy services in host countries, offering pre- departure training, and conducting information campaigns. ADDRESSING ECONOMIC DEVELOPMENT CHALLENGES 62 IN FOCUS: AFGHANISTAN’S ECONOMIC MIGRANTS Economic migration is predominantly a male, youth and rural phenomenon 53.3 percent of economic migrants are ECONOMIC MIGRANTS ARE MOSTLY YOUNG below the age of 24 and 83 percent are Age profile of economic migrants less than 30 years of age. 45 120 40 Cumulative, % Frequency, % 100 35 75 percent migrate from rural areas – reflecting the deteriorating security and 30 80 economic situation in rural areas. 25 60 20 15 40 The fact that economic migrants 10 typically have low skill levels suggests 20 5 that migration decisions are dominated 0 0 by “push factors” and/or existing [15-19] [30-34] [45-49] [10-14] [20-24] [25-29] [35-39] [40-44] [50-54] [55-59] [60-64] [65+] migration networks for low skill occupations – there is no evidence that Percent Cumulative the highly skilled are better able to access migration opportunities. Iran and Saudi Arabia are the largest host countries of Afghan economic migrants By country of destination, Iran hosted 1.4 Other important destinations for economic million labor migrants in 2015, nearly two- migrants are GCC countries (380,000 workers, thirds of the total workers who migrated from mostly in Saudi Arabia) and OECD countries Afghanistan in search of better economic (350,000 workers). opportunities. ECONOMIC MIGRANTS ARE MOSTLY IN IRAN AND THE GULF Stock of economic migrants by destination 3 2 2 Million 1 1 0 1990 1995 2000 2005 2010 2015 OECD Gulf Iran Pakistan Rest IN FOCUS: ECONOMIC DEVELOPMENT AND CONFLICT RISKS A successful growth strategy for Afghanistan must Utilizing an incremental, proof-of-concept include both extractives and agriculture. But approach to build a diversified portfolio of activities in these sectors present important conflict investments. This approach allows required and governance risks. capacities to be built up over time, while mitigating price shocks and risks associated with Illegal mining is wide-spread, and transactions around reliance on a single project or commodity. licensed mining activities have often been subject to corruption, leading to substantial revenue loss. Establishing clear institutional responsibilities Contestation over illegal and informal mining activities and building required capacities in the Ministry has driven violent conflict, and financial proceeds from of Mines and Petroleum and other involved extractive activities have been used to support government agencies, and accessing sustained insurgent groups. Until recently, Government has been international support for technically-demanding reluctant to pursue further extractives development tasks. given the negative experiences to date and obvious risks. Agricultural development should lead to substitution away from opium production. In agriculture, opium remains Afghanistan’s largest export (estimated at US$2 billion, compared to total Existing research on opium production in Afghanistan formal exports of just US$720 million). Poppy suggests that improvements in agricultural production production almost doubled to 9000 tons in 2017 and and productivity should contribute to reducing opium the area under poppy cultivation increased to 328 cultivation. thousand hectares – the highest ever recorded. The opium economy has proven difficult to displace and is Farmers are often driven to opium production by driven by weak rule of law, easy access to key trade the loss of assets, displacement, or other routes, and absence of alternative livelihood negative shocks. Improved agricultural generating activities. productivity and implementation of an improved social protection system could protect against The financial flows associated with both extractives such shocks. and opium erode governance, undermine confidence in government, generate conflict, and fuel corruption. Increasing returns to licit agriculture is the most effective approach to dis-incentivizing opium farming, leading to substitution towards licit Extractives can be developed in a way that allows production. risks to be managed. Most opium farming takes place on unirrigated Extractive-related risks could be mitigated through the land and there is no evidence that irrigation following measures: expansion has previously led to increased opium cultivation. Pursuing the resource-corridor approach to ensure that extractive activities are fully integrated into the broader economy, and benefits are relatively equitably shared. Ensuring that an appropriate fiscal framework is in place to smooth utilization of mining revenues and support long-term sustainable gains from extractives-financed programs and investments. 4. FINANCING ECONOMIC DEVELOPMENT PRIORITIES Investment required for growth is affordable if resources are tightly prioritized. Increasing the share of aid on budget is vital for realizing growth potential. Afghanistan will continue to rely on elevated levels of international assistance. 1. Economic Context and Current Challenges Development outcomes have improved substantially since 2001 but Afghanistan remains a poor, fragile country. Impacts of “transition” were worsened by realization of security risks. Poverty and humanitarian risks are increasing 65 GROWTH POTENTIAL IS HIGH, BUT WILL DEPEND ON INVESTMENT Economic modeling results show substantial growth Public investment requirements for the Growth+ potential, especially from agriculture and mining. scenario are substantial. Both mining and agriculture scenarios deliver Public investments are costed for all scenarios. significant increases to growth. Results show that mobilizing new growth sources The Growth+ scenario shows that mobilizing requires public investment of around US$1 bn per growth from agriculture and extractives, while year over the next four years. increasing investment in human capital could deliver average annual GDP growth of 6.5 percent over 2016-2030. A BALANCED STRATEGY COULD DELIVER RAPID GROWTH Growth model outcomes to 2030 – Average annual GDP growth at factor prices 7 6.5 5.8 6 5 Percent GDP Growth 5 3.8 4 3 2 1 0 Baseline AG+ Min+ Growth + INVESTMENT NEEDS TO MOBILIZE ALL SECTORS ARE SUBSTANTIAL Public investment requirements for the Growth+ Scenario 1.4 1.2 1 USD Billion 0.8 0.6 0.4 0.2 0 Year 1 Year 2 Year 3 Year 4 Human Capital Energy Other infrastrcture Extractives Agriculture and Rural Devp New social transfers Source: World Bank analysis FINANCING ECONOMIC DEVELOPMENT PRIORITIES 66 REFORMS WILL NEED TO BE INTRODUCED IN A DIFFICULT ENVIRONMENT AND UNDER TIGHT FISCAL CONSTRAINTS Action is required to spur growth. GROWTH WILL REMAIN SLOW WITHOUT REFORM Real GDP Growth – Baseline Projections Under the baseline, growth would average just 3.8 16% percent over the period and provide little 14% employment growth. With population growth of 12% around 3 percent per year, there would be 10% negligible improvements in incomes and living 8% standards. The baseline scenario represents high 6% risk given potential negative security and other 4% shocks, and possible fragility pressures arising from 2% low growth and increasing unemployment. 0% Short-term impacts are limited. SECURITY EXPENDITURES WILL GROW Mobilizing new growth sources will only have an Total security expenditure projections impact after several years, due to lead-times for 10 implementation and investment. Growth will likely 8 remain slow over coming years (around 2.2 Nominal US$ billion percent for 2018, increasing gradually to 3.8 6 percent by 2020), reflecting weak demand and an 4 increasing output gap. 2 Fiscal resources are limited by cost pressures. 0 2030 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 Security expenditures will expand rapidly with Total security expenditure government security commitments consuming a Security expenditure financed by dom. revenues growing share of revenues. Civilian spending will need to grow rapidly just to sustain current service levels, driven by population growth, O&M PUBLIC EXPENDITURE GROWTH IS REQUIIRED TO requirements on existing assets, and changing civil MAINTAIN CURRENT SERVICES service salary structure. This level of spending will Total security expenditure projections still leave a large population underserved, with three million children out of school. 10 Nominal US$ Billion 5 0 2027 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2028 2029 2030 Interest payment Subsidies and other Social transfers and subsidies Capital expenditures Goods & services (incl. O&M) Wages and salaries Source: World Bank analysis FINANCING ECONOMIC DEVELOPMENT PRIORITIES 67 REQUIRED PUBLIC INVESTMENTS ARE POSSIBLE WITH CURRENT AID COMMITMENTS US$2.2 billion of on-budget civilian aid will be required per year for investment to realize the balanced growth scenario. This is affordable if: • Aid is maintained at the level of Brussels commitments • The proportion of aid either delivered on-budget or precisely aligned with the required investment program increases to 60 percent of total aid. EXPENDITURE NEEDS EXCEED AVAILABLE REVENUES Government budget – revenues and civilian expenditure needs 4.5 4.0 3.5 3.0 US$ Billion 2.5 2.0 1.5 1.0 0.5 0.0 Year 1 Year 2 Year 3 Year 4 Cost of service delivery at current level Expenditure program for Growth+ Domestic Revenues after financing security EXPENDITURE NEEDS COULD BE FINANCED BY BRINGING MORE AID ON BUDGET Available resources at different levels of on-budget financing government under aid scenarios (US$ Bn) 2.5 On-budget resources available to 2 1.5 1 0.5 0 35% on budget 50% on budget 60% on budget Required for Growth+ Required to meet recurrent costs Source: World Bank analysis FINANCING ECONOMIC DEVELOPMENT PRIORITIES 68 MORE ON-BUDGET AID IS VITAL FOR GROWTH On-budget aid will be more effective in mobilizing Government can encourage greater on-budget growth strategies for several reasons. support. Firstly, delivering through budget systems supports Donors may require changes or improvements to public alignment and coordination of projects and program. It financial management systems, including procurement can sometimes be difficult to ensure that off-budget and payroll systems or the implementation of anti- aid is used for projects that fully align with government corruption measures before increasing on-budget strategies and priorities, given limited government support. These requirements could usefully oversight and restricted involvement in planning be communicated immediately to Government, with processes. technical assistance provided to implement required reforms. Secondly, there is overwhelming evidence from Afghanistan and internationally that on-budget Discussions regarding the need for increased on- expenditures are more cost-effective than off-budget budget aid should reflect the facts that that: i) expenditures, reducing reliance on expensive imported Afghanistan’s public financial management systems are skills and materials. Finally, international and local relatively advanced compared to other fragile or low- evidence shows that spending through government income countries; and ii) opportunities for corruption systems has a greater positive impact on the local also occur with off-budget expenditure. economy (including in terms of the creation of employment and private sector opportunities) ON-BUDGET AID - GREATER ECONOMIC IMPACT ON-BUDGET AID - GREATER EFFICIENC Cents per dollar spent within the Afghanistan Estimated non-works costs as % project value economy by modality (selected Afghanistan road projects) 100 70% Non-works costs as % project value 90 On-budget Off-budget 60% Cents per dollar spent in local 80 70 50% 60 economy 40% 50 30% 40 30 20% 20 10% 10 0 0% Security Civilian Off-budget On-budget Source: World Bank analysis FINANCING ECONOMIC DEVELOPMENT PRIORITIES 69 PUBLIC INVESTMENT NEEDS TO BE CAREFULLY PRIORITIZED If development partners are to make greater use of government systems, the effectiveness of the budget as a planning tool must be strengthened. Given scarce resources it will be important to prioritize investments carefully to enable growth drivers. Develop costed and coherent sector investment plans linked to the Ensure investment decisions ANPDF are informed by consistent and realistic economic Develop and apply project selection criteria that reflect priorities planning within these plans Assess the adequacy of the existing public investment management Build and concentrate systems capacity for investment management within a small group of growth-relevant ministries Provide training and “train the trainer” programs on project selections, assessment, management, and monitoring to those agencies with key roles to play in managing public investments Maintain progress with improving the budget process, strengthening procurement, building audit capacities, and reviewing alignment Continue to strengthen between public spending and policy priorities and modernize core government public financial management systems Strengthen public investment management processes from project selection to monitoring and evaluation FINANCING ECONOMIC DEVELOPMENT PRIORITIES 70 PROTECTING SOCIAL SECTOR EXPENDITURES IS A LOW-RISK STRATEGY Common distinctions between ‘economic’ and ‘social’ Expenditure on social sectors delivers higher fiscal spending make little sense in Afghanistan. stimulus. A skilled and healthy workforce is a vital input to all An additional benefit of social sector expenditure is the forms of economic activity. Improving health and relatively high direct economic impact. Because a large education is likely to be just as important as hard proportion of expenditure on health and education infrastructure for economic growth. While there is goes into salaries and locally-procured goods and limited international evidence regarding the optimal services, the impact on the local economy is direct and composition of expenditures between social services substantial. This contrasts with infrastructure sectors, and infrastructure, returns on social investment are which tend to depend heavily on imported skills, likely to be high in Afghanistan. This is due to current equipment, and materials. Recent research has extremely low levels of human capital resulting from highlighted the large fiscal multipliers from social years of underinvestment. sector spending in Afghanistan. Multipliers express the ratio by which an additional dollar of public spending Investment in human capital is robust to risk. grows the economy. Large multipliers for social transfers, health, and education reflect that these type Investment in physical infrastructure can be subject to of investments have large direct impacts on domestic a range of risks. The viability of mining investments can demand while also expanding the productive capacity depend on global commodity prices. The returns on of the economy. connective infrastructure can depend on policy actions taken in neighboring countries, security conditions, and global market developments. In this context, investments in health and education are relatively low risk, with Afghans able to apply their labor in a range of different sectors or geographical areas in response to changing economic conditions and opportunities. RECENT EMPIRICAL WORK SHOWS HIGH MULTIPLIERS FROM SOCIAL SPENDING Estimated conditional functional multipliers by sector 2 1 Fiscal multiplier 0 -1 -2 Defence Total Government Social Protection Economic Affairs Education Health General Public Services Spending Source: Asea (2017), commissioned analysis for World Bank FINANCING ECONOMIC DEVELOPMENT PRIORITIES 71 FISCAL SPACE COULD BE INCREASED, BUT AFGHANISTAN WILL REMAIN RELIANT ON AID FOR THE MEDIUM-TERM There are options available to free up additional fiscal space. Revenue mobilization. Continued efforts to improve revenue compliance and policy could help increase revenues over time. Administrative improvements, including the roll-out of electronic systems, should be prioritized. But under Afghanistan’s current economic structure, revenue potential is limited to around 17 percent of GDP even under ideal tax administration and policy settings. Further increasing revenue would require the mobilization of new sources of growth, including extractives. Managing security costs. The current trajectory of security expenditures is unsustainable. Security expenditures are increasingly squeezing out development spending. This may prove counter- productive, given evidence that insecurity can be mitigated through improving access to economic opportunities, generating employment, and strengthening institutions. Reforming security sector expenditures is a long-term challenge, however, and scope for immediate savings is limited. Pension reforms. The current pension scheme is unsustainable. Civil service pension expenditures will outweigh contributions and become a net cost by 2024. Reforms now can free up 0.7 percent of GDP in fiscal space for poverty-oriented spending (e.g. transfers) over the medium-term. Under any scenario, however, Afghanistan will remain highly reliant on aid. The annual financing gap – the external resources that Afghanistan will require to finance all on and off-budget civilian and security expenditures – will be equal to 34.5 percent of GDP through 2030 under the baseline. Under a high-growth scenario, this gap declines, but remains significant at around 30 percent of GDP. EVEN UNDER THE BEST CASE, DOMESTIC REVENUES ARE INSUFFICIENT TO FINANCE EXPENDITURES Public spending and domestic revenues under different scenarios 70% 60% 50% Financing Gap 40% % GDP 30% Max. Revenue Potential 20% 10% Baseline Revenue 0% 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 civilian spending (off-budget) civilian spending (on-budget) security spending (off-budget) security spending (off-budget) FINANCING ECONOMIC DEVELOPMENT PRIORITIES 72 ANNEXES The MAMS Model Modeled Growth Scenarios Development outcomes have improved substantially since 2001 but Afghanistan remains a poor, fragile country. Impacts of “transition” were worsened by realization of security risks. Poverty and humanitarian risks are increasing 73 THE MAMS MODEL MAMS is an economy-wide simulation model designed to analyse development strategies and their impact on economic growth. The model provides a simplified representation of the Afghanistan economy. The model includes government, donors, and the private sector. It is a general equilibrium model, capturing how shocks flow through the economy as relative prices change. The Afghanistan MAMS model parameters are defined using country data. Country data is used to replicate the structure of the economy and certain behavioral parameters, such as elasticities for substitutability in production. The model has been developed using a fiscal framework that is consistent with World Bank and IMF projections. Fiscal expenditures are driven by projected costs while revenue assumptions reflect current revenue policy settings and planned policy reforms. Minor transactions included in the model are not depicted in the graphic below, including: pension payments from households to government; debt service on domestic debt from government to households; and debt service on external debt from government to the rest of world. More information regarding the MAMS model can be found here: http://go.worldbank.org/XSQTI86EN0 AGGREGATE PAYMENT FLOWS IN MAMS ANNEXES 74 MODELED SCENARIOS Baseline Mining+ Current policy settings. $4 bn of civilian aid per year Mining development proceeds with required public through 2020, and then declining to low-income investments and efforts to attract private country average (10 percent GDP). investment. No structural change due to limited public Development of Amu Darya as per baseline. investment. Additional hydrocarbon development (Afghan- Insecurity continues to limit FDI and domestic Tajik oil basin). investment. Additional mining investments (Aynak copper, Slow mining development - only Amu Darya. Hajigak iron ore, medium-scale coal, marble, chromite, gold, lithium). TAPI and CASA-1000 proceed. Agriculture+ Growth+ Agriculture growth driven by irrigation investment Program of growth-enhancing measures and extension services. Assumptions informed by implemented through policy reforms and public agriculture sector studies. investments. Wheat productivity increases by around 50 Agriculture and mining scenarios realized. percent by 2030. Human capital investment increases to 50 Livestock productivity doubles by 2030. percent of civilian expenditures, boosting labour productivity and reducing fertility rates. Land under irrigation increases by 50,000 hectares per annum. Managed labour mobility scheme introduced. Targeted social transfer system introduced. ANNEXES 75