Document of The World Bank FOR OFFICIAL USE ONLY Report No. 78257-AF INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT ON A PROPOSED DEVELOPMENT POLICY GRANT IN THE AMOUNT OF SDR 33.3 MILLION (US$50 MILLION EQUIVALENT) TO ISLAMIC REPUBLIC OF AFGHANISTAN FOR A PROGRAMMATIC DEVELOPMENT POLICY SERIES PROMOTING ECONOMIC GROWTH AND FISCAL SUSTAINABILITY July 10, 2013 Poverty Reduction and Economic Management South Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Afghanistan – GOVERNMENT FISCAL YEAR December 21-December 20 CURRENCY EQUIVALENTS Exchange Rate Effective as of July 10, 2013 Currency Unit = Afghani US$1.00 = Afs 55.75 ABBREVIATION AND ACRONYMS AAA Analytical and Advisory Activities ACD Afghan Customs Department AFMIS Afghanistan Financial Management Information System AfTel Afghan Telecom AGCHO Afghan Geodesy and Cartographic Head Office ANDS Afghan National Development Strategy ANSF Afghan National Security Force ARAZI Afghan Land Authority ARTF Afghanistan Reconstruction Trust Fund ARTF IP ARTF Incentive Program ASYCUDA Automated System for Customs Data ATRA Afghan Telecom Regulatory Agency CAO Central Audit Organization CGE Computable General Equilibrium CPI Consumer Price Inflation CSO Central Statistics Office DAB Da Afghanistan Bank DPG Development Policy Grant DSA Debt Sustainability Analysis ECF Extended Credit Facility EI Extractive Industries EIA Environmental Impact Assessment EITI Extractive Industries Transparency Initiative ESIA Environmental and Social Impact Assessment GDP Gross Domestic Product GSM Global System for Mobile Communication HIPC Heavily Indebted Poor Countries ICT Information and Communication Technologies IDA International Development Association IDPs Internally Displaced People IFC International Finance Corporation IMF International Monetary Fund   INTOSAI International Organization of Supreme Audit Institutions ISN Interim Strategy Note ISPs Internet Service Providers JCMB Joint Coordination and Monitoring Board M&E Monitoring and Evaluation MCC MCC-Jiangxi Copper Consortium MCIT Ministry of Communication and Information Technology MoF Ministry of Finance MoMP Ministry of Mines and Petroleum NATO North Atlantic Treaty Organization NEPA National Environment Protection Agency NPPs National Priority Programs NRRCP National and Regional Resource Corridor Program NRVA National Risk and Vulnerability Assessment O&M Operation and Maintenance PEFA Public Expenditure and Financial Accountability PFM Public Financial Management PSIA Poverty and Social Impact Analysis RC Recurrent Cost SDNRP Sustainable Development of Natural Resources Project SDR Special Drawing Rights SESA Strategic Environmental and Social Assessment TA Technical Assistance TMAF Tokyo Mutual Accountability Framework UNAMA United Nations Assistance Mission for Afghanistan UNODC United Nations Office on Drug and Crime VAT Value Added Tax WB World Bank Vice President: Philippe H. Le Houérou Country Director: Robert J. Saum Sector Director: Ernesto May Sector Manager: Vinaya Swaroop Task Team Leader: Claudia Nassif   AFGHANISTAN PROMOTING ECONOMIC GROWTH AND FISCAL SUSTAINABILITY TABLE OF CONTENTS GRANT AND PROGRAM SUMMARY ...................................................................................................... i  I.  INTRODUCTION ................................................................................................................................. 1  II.  COUNTRY CONTEXT ........................................................................................................................ 2  RECENT ECONOMIC DEVELOPMENTS IN AFGHANISTAN ....................................................... 2  MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ................................................... 8  SELECTED ECONOMIC INDICATORS .......................................................................................  14  III.  THE GOVERNMENT’S PROGRAM AND PARTICIPATORY PROCESSES ............................. 15  IV.  BANK SUPPORT FOR THE GOVERNMENT’S PROGRAM ........................................................ 16  LINK TO INTERIM COUNTRY STRATEGY NOTE (ISN) ............................................................... 16  COLLABORATION WITH THE IMF AND OTHER DONORS ........................................................ 16  RELATIONSHIP WITH OTHER BANK OPERATIONS .................................................................. 17  LESSONS LEARNED .................................................................................................................  18  ANALYTICAL UNDERPINNINGS ..............................................................................................  20  V.  THE PROPOSED DEVELOPMENT POLICY PROGRAM SERIES............................................ 20  OPERATION DESCRIPTION .....................................................................................................  20  POLICY AREAS ........................................................................................................................  21  VI.  OPERATION IMPLEMENTATION .................................................................................................. 30  POVERTY AND SOCIAL IMPACTS ............................................................................................  30  ENVIRONMENTAL IMPACT ....................................................................................................  31  IMPLEMENTATION, MONITORING AND EVALUATION .......................................................... 31  FIDUCIARY ASPECTS  ...............................................................................................................  32  DISBURSEMENT AND AUDITING ............................................................................................  34  RISKS AND RISK MITIGATION .................................................................................................  35  ANNEXES Annex 1: Letter of Development Policy ........................................................................................................ 39  Annex 2: DPG Policy Matrix ......................................................................................................................... 50  Annex 3: Fund Relations Note ....................................................................................................................... 55  Annex 4: Country at a Glance ....................................................................................................................... 57  Annex 5: Analytical and Advisory Activities – Major Findings and Recommendations ......................... 59  Annex 6: Anticipated Poverty and Social Impact ........................................................................................ 61  Annex 7: Public Financial Management ....................................................................................................... 67  Annex 8: Map of Afghanistan ........................................................................................................................ 73  The Grant was prepared by an IDA team consisting of Claudia Nassif (Senior Country Economist and Task Team Leader, SASEP) Omar Mohammed Joya (Economist, SASEP) Markus Kitzmuller (Young Professional, SARCE) Paul Sisk (Lead Financial Management Specialist, SARFM) Michael Stanley (Lead Mining Specialist, SEGOM) Siddhartha Raja (ICT Policy Specialist, TWICT ) Hasan Zaidi (Transport Specialist, SASDT) Asta Olesen (Senior Social Development Specialist, SASDS) Guillemette Sidonie Jaffrin (Senior Private Sector Development Specialist, SASFP) Sonya Sultan (Senior Social Development Specialist, SDV) Anna Lisa Schmidt (ET Consultant, SDV) Pedro Olinto (Senior Economist, PRMPR) Vidya Kamath (Program Assistant, SASGP) Muhammad Shafiq (Program Assistant, SASEP)   GRANT AND PROGRAM SUMMARY AFGHANISTAN PROMOTING ECONOMIC GROWTH AND FISCAL SUSTAINABILITY Borrower Islamic Republic of Afghanistan Implementing Agency Ministry of Finance (MoF) Financing Data SDR 33.3 million (US$50 million) Operation Type Programmatic Development Policy Series Main Policy Areas Macroeconomic and fiscal management, economic growth, institutional reform Key Outcome Indicators From a baseline at the beginning of 2012 to a program target to be achieved by mid-2015  Customs duties increased from US$390 million to US$ 530 million  Detection of non-compliance (in total customs examination) increased from below 1 to 8 percent  Roll-out of tender for three large-scale mines (to evaluation stage)  The prices of wholesale bandwidth decreased from US$900 to below US$80/Mbps per month  The number of subscribers to GSM broadband services increased from 0 to 1 million  The revenue of the Afghanistan Land Authority (ARAZI) increased from US$1.5 million to US$3 million  The area of surveyed land increased from 35,000 hectare to 45,000 hectare annually  Three infrastructure projects concluded agreements for passive infrastructure sharing Program Development This program document describes the first in a series of two Objective and programmatic grants to Afghanistan. The proposed first operation is Contribution to ISN in the amount of US$50 million, out of US$100 million for the programmatic series The objective of this operation is to support policy reforms in selected areas critical to strengthening revenue mobilization and improving the enabling environment for investment in sectors with a high growth potential. In this way, the operation expects to contribute to the government’s strategy towards developing greater economic and fiscal self-reliance. To this end, the operation supports legal, regulatory and institutional reforms in customs, land administration and management, mining, and information & communication technologies (ICT). The operation underpins the objectives of the Interim Strategy Note (ISN) in all dimensions. Through its impact on fiscal management, i the DPG will strengthen institutions and processes associated with transparent and competent financial and economic management – one of the operational objectives of ISN Pillar I: Building Institutions. Some actions, such as the strengthening of customs and land management systems, will help with more efficient and equitable delivery of services (ISN Pillar II). However, the DPG is designed to have its strongest impact at sector level, in support of economic growth in the areas of mining, ICT, and agriculture development, by strengthening the functioning of markets (including land markets) and through changes in the regulatory and legal environment (ISN Pillar III: Inclusive Growth and Jobs). As such, the operation complements other investment and technical assistance operations proposed in the ISN. Risks and Risk Mitigation Afghanistan is undergoing a political, security and economic transition which exposes the country and this operation to high risk. Many of these risks cannot be mitigated. Security risks: The security situation has deteriorated over the past several years and may become even more challenging in the transition period and the run-up to the presidential elections. Political uncertainty related to presidential elections in spring 2014 also remains an important factor. The operation acknowledges these risks but their mitigation is beyond the scope of this operation. Governance and Political Economy risks: Political uncertainty and instability could intensify rent seeking by individuals who are bound to lose from the reduction in aid, undermine public finance institutions, and lower fiscal revenue. This risk is directly addressed by intensifying customs reforms which should reduce the scope for rent seeking. Another risk is that the reform progress could slow as the decision-makers’ attention shifts increasingly to the elections, or the reforms themselves become the target of political campaigns. This is compounded by the already-long backlog of issues pending cabinet approval. The design of the DPG takes this risk into consideration by balancing institutional with legislative actions, and by moderating them to the extent that they can be implemented before the political campaigns intensify. Economic risks: The transition process may complicate the challenges to macroeconomic stability in the next few years, including further a slow-down in economic growth. The government has few instruments to respond to adverse macroeconomic developments. The ongoing dialogue between the government and the IMF and World Bank involving ongoing analytical work operations on economic and fiscal issues is intended to mitigate this risk. Beyond this dialogue component, the DPG objective and actions are specifically geared to address some of these risks. The customs reforms aim to increase fiscal revenues. Implementation of the economic reforms supported by this DPG is expected to support the economic development process in the long run. However, large, negative shocks (e.g., prolonged drought) could undermine the results of the operation. Programmatic risks: The reform program supported by the proposed operation may face headwinds due to capacity constraints and weak policy coordination. These risks are mitigated as follows: ii First, the DPG actively counteracts coordination failure by encouraging ministries to use the DPG itself as an instrument for coordination. Second, the proposals of the DPG are intended to mitigate overall implementation and coordination failure risks by ensuring that technical assistance is provided at all levels of government concerned with implementation of the reforms. Fiduciary risks: Fiduciary risks are high despite good progress in most phases of budget operations. Previous DPGs and investment operations have helped to put in place adequate processes and practices for financial management, procurement and control. Afghanistan has a relatively strong public finance capacity track record, as noted in the 2013 PEFA. However, fiduciary risks remain high due to limited internal and external controls. For the most part, the DPG relies on the self-reinforcing actions committed to under the PFM Roadmap, the ARTF Incentive Program, the IMF Program and the Second Public Financial Management Reform Project. The ARTF Incentive Program, in particular, focuses heavily on the timely implementation of PFM measures, including internal and external audits, procurement certifications, and budget transparency. Social and Environmental risks: The operation is expected to have impacts on social livelihoods as well as the environment. Most of these are related to the development of the mining and hydrocarbon sector and to changes in land-related legislation. However, the legislative actions supported by this operation have been designed to specifically include provisions that improve social and environmental safeguards and address stresses produced by the reforms. In this sense, the DPG serves the additional objective of making future investment operations, particularly mining, more inclusive and sustainable. Notwithstanding these high risks, the benefits of this operation to Afghanistan’s development process, in our view, far outweigh its cost. This operation helps the government of Afghanistan to undertake momentum and discipline reforms in these challenging times. Even if not fully measurable in the short-term, the reforms supported by this operation are designed to have a tangible, positive impact not only on fiscal and economic developments but ultimately also on the life of the people of Afghanistan. Without it, the chances of achieving these results would be lessened. Operation ID P118027   iii IDA PROGRAM DOCUMENT FOR A PROPOSED PROGRAMMATIC DEVELOPMENT POLICY GRANT TO AFGHANISTAN I. INTRODUCTION 1. Afghanistan is undergoing a major security and political transition. At the Kabul and Lisbon Conferences in 2010, the North Atlantic Treaty Organization (NATO) and the Afghan government agreed that full responsibility for security would be handed over by 2014. The country now faces the prospect of a drawdown of most international military forces that so far have supported the fight against the ongoing insurgency. At the same time, Afghanistan is gearing up for a presidential election in April 2014 which many anticipate to be a difficult process given the complex political environment and challenging logistics. 2. The transition process carries major economic implications. The operations of international troops were supported not only by a high level of military but also civilian aid that financed reconstruction efforts and the provision of public services. Aid is therefore set to decline as the international troops leave, presenting Afghanistan with a new economic reality to which it will need to adapt. Specifically the decline in aid will pose risks to (i.) Fiscal sustainability: Currently, 65 percent of the budget is financed by donors. Public expenditures are expected to grow significantly as a result of the handover of security responsibilities and donor-built assets from foreign actors to the Afghan government. Higher expenditures are also required to further expand and improve the provision of public services that are still limited in coverage and quality. (ii.) Macroeconomic stability: Afghanistan’s export base is currently very small and the country receives little foreign direct investment. At the same time, the country is highly dependent on food and oil imports. The country relies on foreign aid inflows to balance its current accounts. While Afghanistan currently enjoys a strong foreign reserve position, adjustment processes in tradable sectors are expected to be slow and could further compound external imbalances. (iii.) Economic growth: The reduction in foreign aid is bound to impact negatively on economic activities that have so far benefited from aid, especially construction and services industries. World Bank analysis suggests that even a gradual decline in aid could significantly reduce Afghanistan’s growth prospects to about half of its current average – insufficient to reduce the country’s high poverty rates and create jobs for the 400,000 to 500,000 young people who will be entering Afghanistan’s labor markets every year. (iv.) Political economy: The anticipated decline in aid, compounded by the general uncertainty about the economic outlook, may increase incentives for rent-seeking behavior and puts public institutions under greater stresses. This factor has already contributed to a decline in fiscal revenues. 3. Afghanistan vision is to become more self-reliant by 2025. The government is cognizant of its donor dependence and the implications of the anticipated decline in aid. In order to prepare itself for the challenges ahead, it has embarked on an ambitious reform program that aims to foster domestic sources of economic growth and enhance revenue mobilization. In addition, the government has put in place a series of austerity measures to mitigate the current decline in fiscal revenues, including stronger expenditure controls and increases in selected customs duties and fees. 1 4. Despite these steps, Afghanistan will need to rely heavily on donor financing to ensure the continued provision of public services and investment through the transition period. In 2012, the government secured sufficient pledges for funds for the security sector and for civilian aid to balance the budget throughout the transition period and for a few years beyond. In return, the government of Afghanistan committed to hold timely elections, strengthen human rights, and improve governance, public financial management and macro-economic management, including stronger efforts in revenue mobilization. 5. At the request of the authorities, this DPG series is designed to support the government’s strategy for developing greater economic and fiscal self-reliance. The proposed operation seeks to achieve this goal by supporting policy reforms in selected areas critical for strengthening revenue mobilization and improving the enabling environment for private investment. To this end, this operation reinforces legal, regulatory, and institutional reforms in customs, land administration and management, mining, and ICT. 6. The reform program is ambitious, especially in light of the upcoming elections, but it is strongly supported by the government, key stakeholders and donors. Many reforms in Afghanistan are contested by vested political interests and it is often difficult for the reform- minded parts of the government to attain their goals. As with other reforms, and to varying degrees, the reform program supported by this operation is likely to face resistance as well. However, the government has shown firm resolve in keeping the program and this operation afloat since preparations began in mid-2011. With the prior actions of the first operation in this series undertaken, the government has created a momentum that will help to sustain the implementation of the reform program. Donors have been involved in the preparation of this operation since its inception and participated in review processes. Given the complementary and expected synergies of this operation with the Tokyo Mutual Accountability Framework (TMAF – see Box 2 below), the ARTF Incentive Program, and the IMF program, donors are very supportive. 7. This program document describes the first in a series of two programmatic grants to Afghanistan. The proposed first operation is in the amount of US$50 million, out of US$100 million for the programmatic series. A programmatic approach is proposed to carry on reform momentum and strengthen reform incentives during times in which political incentives for reforms are typically low due to upcoming election. Moreover, lessons from other operations in Afghanistan favor a carefully sequenced and continuous reform-approach. II. COUNTRY CONTEXT RECENT ECONOMIC DEVELOPMENTS IN AFGHANISTAN 8. Afghanistan had a solid development track record between 2001 and 2012,1 but major challenges remain. There have been some major achievements – rapid economic growth, relatively low inflation, significant improvements in public financial management, and expansion of basic health and education. Starting from a low base, key social indicators such as life expectancy and maternal mortality improved, and women have started to increasingly participate in the economy. However, in spite of the efforts made, Afghanistan remains a country facing major development challenges. Its GDP per capita was estimated at US$595 in 2012, 36 percent of the population lived below the poverty line in 2008, and more than half of Afghanistan’s population is considered vulnerable. With respect to security, institution building, and governance of public finances and private markets, considerable weaknesses and uncertainties remain. 9. Real GDP growth in Afghanistan has been strong but volatile due to weather-related cyclicality in agricultural output.2 Real GDP grew at an average rate of 9.2 percent between 2003 and 2012, driven mainly by capital investments for reconstruction activities, large aid flows 1 The Persian solar year (March 22-March 21) is expressed in this section as the year in which it begins, i.e., 2011/12 is expressed as 2011, since the lion’s share – nine months – of the twelve month-period falls into the first calendar year of the split. 2 A large proportion of agricultural output is rain-fed. 2 fuelling the service sector, and occasional surges in agricultural production (Figures 1, 2, and 3). Since 2007, agriculture has consistently been the second-most important growth driver of real GDP in Afghanistan – after services and closely followed by construction. Figure 1: Real GDP and Agricultural Growth Table 1: Selected Development Indicators Nominal GDP (2012, billion US$) 19.8 50 Average Real GDP growth 2003-2012 9.2 20 40 (%) 15 30 CPI inflation (2012 period average, %) 6.4 10 20 GDP per capita (2012, US$) 595 10 Population (million, 2012 estimated) 33.4 5 Unemployment (2008) 7.1 0 0 Poverty rate (2008, %) 36 �10 �5 Life expectancy 49 �20 Infant mortality (per 1,000 live births) 73 �10 �30 Literacy rate 39 Gross primary enrollment 98 Real GDP growth (left axis) Agriculture growth (right axis) Source: CSO and Ministry of Agriculture, Irrigation and Livestock , *denotes projection 10. With growth in services and construction expected to slow as the reconstruction boom fades, agriculture will become ever more important. Between 2003 and 2011 agriculture typically accounted for between one-fourth and one-third of GDP, and real agricultural growth ranged from minus-22 percent to 45 percent, thereby driving a significant proportion of overall GDP growth (Figure 1). Moreover, agriculture is by far the largest employer, with 60 percent of the working population, which means that rural development plays a crucial role in sustaining growth. Figure 2: Sector Growth in Value Added (percent) Figure 3: Sector Contributions to GDP Growth (percent) 50 20 40 18 30 16 14 20 12 10 10 0 8 6 �10 4 �20 2 �30 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Agriculture Industries Services Agriculture Manufacturing Construction Mining Services Sources: IMF and Central Statistics Organization (CSO), WB staff calculations. *denotes projections. 3 11. The illicit production of opium3 declined by 36 percent in 2012 but continues to play a significant role in the rural economy. Recent UNODC estimates4 put the farm gate value of opium at 3.3 percent and export value at 7-8 percent of GDP. While the nominal difference between opium-GDP and non-opium-GDP is relatively small – an average of US$500 million each year – non-opium- and opium-GDP growth can differ by more than 5 percentage points in some years (Figure 4). However, the average growth gap of around 0.2 percentage Figure 4: Licit and Illicit Real GDP Growth points between 2003 and 2012 indicates 25.0 that opium has not been an important driver of economic growth. Nevertheless, 20.0 the raw drug is still considered an important cash crop and often determines 15.0 income and consumption for poor, rural households. Relative prices of opium vis- 10.0 à-vis other crops such as wheat may 5.0 continue to provide unfavorable farm incentives towards opium production. In 0.0 the meantime, opium continues to not only fuel conflict but also undermine Real GDP growth (non�opium) governance by providing income to Real GDP growth (opium) insurgents and other criminal groups. Source: Central Statistics Organization (CSO). *denotes projections. 12. Mining’s contribution to GDP has historically been small – less than 0.5 percent between 2003 and 2010 – but is set to increase substantially. Two decades of war, chronic neglect, and severe under-funding have limited the development of this sector (Figure 3). The two large-scale investments in Aynak and Hajigak and the oil field investments at Amu Dayra in 2012 could mark a fundamental shift in the future economy of the country. It is estimated that Afghanistan has substantial untapped mineral deposits, which have the potential to make the country a large exporter of minerals. In 2012, the mining sector is estimated to have contributed 1.8 percent of GDP, underlining the sector’s increasing importance in value generation in the Afghan economy. 13. Recent developments in the economy signal early repercussions from transition. The uncertainty attached to the political and security transition process has started to negatively affect investor confidence. Consequently, the number of newly-registered firms declined by 8 percent in 2012 (Jan-Dec) and FDI stagnated at 2 percent of GDP. The construction sector, in particular, experienced slower company growth: only 1,760 new firms were registered in 2012 compared to 2,630 in 2011. 14. Over the last 10 years, macroeconomic stability has relied heavily on large aid flows (see Box 1 below). Not surprisingly for a country in a period of reconstruction and recovery supported by foreign assistance, the large material needs of the reconstruction period skewed Afghanistan’s trade balance heavily towards imports. The resulting trade deficit continually accounted for a substantial part of the large current account deficit (excluding grants) of 42.9 percent of GDP in 2012. The financial and capital account balance has been marginal compared to the trade balance. The current account deficit continues to be financed by international aid, yielding a positive overall balance since 2004 (Figure 5).5 Inflation has been trending downwards, helped by declining food and non-food prices, to 6.4 percent in 2012, from 10.9 percent in 2011. Reserves steadily built up to a historic high of US$7.1 billion in December 2012 (Figure 6), but declined to US$ 6.5 billion in March 2013. Exports, estimated at US$2.6 billion, declined by 5 percent in 2012 in spite of a depreciating currency (8 percent), implying limited export capacity and a loss of competitiveness in key markets. 3 Opium production is not included in the GDP figures in this section, as measurement within a national income framework is complicated by uncertainties about value creation and distribution in processing and trading. 4 United Nations Office for Drug and Crime (2013). Afghanistan Opium Risk Assessment. Vienna. 5 Reliable data on the significance of remittance are currently not available.  4 Figure 5: Current Account and Overall Balance Figure 6: Gross International Reserves 20.0 8.0 Percent of GDP 0.0 7.0 Billion USD �20.0 6.0 5.0 �40.0 4.0 �60.0 3.0 �80.0 2.0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1.0 CAB (excl. foreign aid) Overall balance 0.0 2006 2007 2008 2009 2010 2011 2012 CAB (incl. foreign aid) Sources: IMF, CSO, and World Bank. 15. Following the Kabul Bank crisis of 2010, low deposit growth and loss of trust in banks has put a strain on money growth and financial sector performance. The crisis induced by fraudulent activities within Kabul Bank highlighted weaknesses in banking governance. Broad money (M2) declined from 38.2 percent of GDP to around 33 percent in 2012 in spite of low inflation and strong economic growth. Total assets declined to US$4.4 billion, from US$5.5 billion in 2010. Transferable/demand deposits, which grew at an average 80 percent between 2005 and 2009, have slowed to an average 12.5 percent over the past three years. At the same time, growth of commercial loans, which averaged around 40 percent annually before the crisis, has plummeted to -20 percent since 2010, significantly lowering the loan-to-deposit ratio (Figure 7). As a response to such loss of confidence and increased risk perception, amendments to the banking law approved in March 2013 aim at improving regulatory oversight, while recent efforts to privatize part of Kabul Bank have not yet yielded satisfactory results. Figure 7: Banking Performance Figure 8: Fiscal Sustainability 70.0 20.0 60.0 15.0 Percent of GDP 50.0 Percent 40.0 10.0 30.0 20.0 5.0 10.0 0.0 0.0 2006 2007 2008 2009 2010 2011 2012 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Financing gap (operating budget) Loan�to�deposit ratio Loan in percent of GDP Operating expenditures financed by revenues Source: DAB. Sources: World Bank Staff calculations based on data provided by Ministry of Finance. 16. Fiscal performance, solid up to 2012, has begun to falter. The public financial management system has undergone a structural transformation which has allowed the budget to grow from US$346 million in 2002 to US$4.4 billion in 2011, demonstrating rising absorption capacity for funding channeled through the budget. Domestic revenues increased by 40 percent nominally per year over the same period, and grew from a low base of 3 percent of GDP in 2002 to 11.3 percent in 2011, thanks to reforms in tax and customs administration. A smaller budget and a truncated budget period6 narrowed the financing gap in the operating budget from 6.1 percent of 6 The new fiscal year runs from December 21 to December 20. 5 GDP in 2011 to 5.3 percent in 2012 (April-December). However, while an increased security bill boosted public spending by 45 percent in 2012, growth of domestic revenues slowed (to 13.1 percent in 2012) and fell short of targets. As a result, the proportion of domestic revenues over operating expenditure decreased from 65 percent in 2011 to 60.2 percent in 2012 (Figure 8).   BOX 1: AFGHANISTAN’S AID DEPENDENCY   Afghanistan has entered transition as a country grown highly aid-dependent; foreign aid disbursements amounted to nearly 100 percent of GDP in 2010, counting expenditures for both military-supported and civilian aid.7 Official development aid and military assistance to Afghanistan has risen since 2002, from US$404 million to more than US$15.7 billion in 2010. While the bulk of this represents security spending, civilian aid was estimated at around US$6 billion, or nearly 40 percent of GDP. Such aid Figure 8: Aid Flows to Afghanistan 2002-2010 dependence is almost uniquely high. Only a few  18 140 much smaller countries (and territories), such as  16 Liberia and West Bank and Gaza, receive more 120 aid per capita.  14 100  12 Aid is provided via two different modalities: a  10 80 relatively small portion of official development  8 60 assistance has come as on-budget support to the  6 40 government of Afghanistan, financing both  4 public investments and parts of the operating  2 20 budget. The contribution of this support is  � 0 critical because over 65 percent of total budget 2005 2006 2007 2008 2009 2010 expenditures (operating + development budget) are financed by aid. Much of foreign aid, Total (bn US$) Share of GDP (percent) however, has been spent directly by donor agencies outside of the budget.   Source: World Bank. Figure 9: Domestic Revenue Composition 2012 (left) and Recent Performance (right) 30 Pipeline Income,  profits  25 Nontax  and  revenues Social capital  27% gains 20 Contributions Billions Afg 27% Sales of non Other 15 current Assets 2% Customs  Other sources Sales tax duty 18% 26% 10 Non Tax 5 Revenues Customs 0 Revenues Q12012 Q12013 Source: Ministry of Finance.   17. After slowing in 2012, domestic revenues declined by 19.6 percent in the first quarter of 2013 compared to the same period the previous year. The weakening revenue performance 7 This refers to normal civilian aid as well as support to the Afghan security sector, but excludes money spent on international military forces. 6 was driven mainly by declining customs revenues – a key component of overall domestic revenue generation. Customs duties declined by 9.6 percent in 2012, and dropped by another 8.1 percent in the first quarter of 2013. Other categories of revenue declined as well (Figure 9).     18. The decline in customs revenues appears to be caused by an increase in rent-seeking activities. Customs reforms have led to average annual revenue growth of 25 percent to US$636 million in 2011. This was driven by both annual increases in the volumes of imports and efficiency improvements in duty collection. However, in 2012 customs revenues dropped to US$443.9 million, from US$491.7 million in 2011 (Figure 10). Agencies reported a simultaneous increase in imports with a symmetric decline of customs revenues across all import categories (Figure 11).8 As far as tariffs are concerned, the applied weighted average tariff rate of most dutiable items decreased by only 0.5 basis points in 2012 (from 7.2 percent to 6.7 percent) and rates for some items increased. Hence, the declining trend in the collection of customs revenue cannot be fully explained by external shocks in economic demand or policy. More likely, the decline is caused by increasing corruption at borders due to shifts in the political economy as the transition takes hold (see Box 2). Figure 10: Imports and Customs Revenues Figure 11: Imports and Customs Revenues, 2011 and 2012 (truncated) 2008-2012  7 0.8 7.0 0.7 6.0  6 0.6  5 5.0 Billion US$ Billi US$ 0.5 Billion USD 4.0  4 0.4 3.0  3 0.3 2.0  2 0.2 0.1 1.0  1 0.0 0.0  � 2008/09 2009/10 2010/11 2011/12 2012 2011 (Q2�Q4) 2012 (Q2�Q4) (Apr�Dec) Imports (right axis) Customs revenue (left axis) Imports Customs revenue Source: CSO (imports) and Ministry of Finance (customs revenue). 19. Declining revenues are putting a strain on cash management. The revenue situation will require efforts to consolidate the budget, both on the revenue and expenditure sides. As a first reaction, authorities have started to reduce the allocation of discretionary development expenditure. In addition, strong efforts are underway to implement a set of mitigating measures to reverse the current revenue trends. In a bold effort to address governance and control weaknesses, the leadership of the revenue department was replaced in March 2013. Other efforts include an increase in tariff rates, changes in the customs valuation for selected items, and increases in fees for selected public services and air travel. Nevertheless, there are cash management risks if the government does not manage to stabilize and increase revenues over the coming months. 8 Note that data are subject to severe limitations, and this analysis should be seen as indicative rather than definitive. 7 BOX 2: THE POLITICAL ECONOMY OF TRANSITION The security, political and economic transition poses several complex challenges to the political economy environment:  Afghanistan is a nascent democracy and state-building is still evolving. The country is very fragmented along ethnic and tribal lines. A peaceful transfer of power from the outgoing to incoming government will require free and credible elections. Without it, the resulting power struggles might tip the country into an even bigger conflict. Moreover, support from aid-weary donors will be at serious risk, if the election were to be delayed or tainted.  The security situation is fragile. It is expected that insurgency activities will increase in the run-up to the election. As of now, the Afghan army and police have proven to be adequately prepared to capably manage security risks and incidences. However, if the security situation takes a turn for the worse, the government may not be able to sustain service delivery and other government operations, especially if aid to the budget ceases.  Afghanistan’s budget is highly dependent on foreign aid. Donors have committed to support budget operations until 2016 and beyond. However, this support is predicated on commitments by the government ranging from timely election, human rights, improvements in governance and public financial managements, macro-economic management, and strong efforts in revenue mobilization. These commitments are formalized in the Tokyo Mutual Accountability Framework (TMAF) and progress on achievements in these areas is regularly reviewed. While not explicit, the TMAF contains the notion that civilian aid may be reduced or discontinued if commitments are not fulfilled.  Over the past decade, reforms have been driven by a small and expanding group of technocratic officials, supported by international donors. Resistance in the form of non-reforms is often based on skepticism around international community support that is perceived as either too short-term or a threat to Afghan sovereignty. This is often combined with fears of a geopolitical stronghold.  The perspective of declining aid and uncertain economic outlook may increase the rent-seeking incentives for individuals who have benefited from aid and other financial flows in the past, especially those outside the control of the budget. This may expose public finance institutions to greater risks of corruption as these individuals look for alternative sources of rent. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 20. Economic growth is expected to slow in 2013 and 2014. As noted above, much uncertainty is being caused by the upcoming elections in 2014 and the deteriorating security situation. These factors hamper the private sector’s willingness to invest – a trend of declining new firm registrations is expected to continue. Increased public spending, however, will continue to fuel demand for services and construction through 2013. Mining should contribute more noticeably to growth with the increase in oil production in Amu Darya. However, the moderate rainfalls of earlier this year will probably reduce the 2013 harvest to a more ordinary output level and slow GDP growth to 1.5 percent in 2013. If weather conditions are favorable and the elections pass relatively peacefully, however, growth could pick up in 2014. 21. The decline in aid is expected to reduce long-term growth prospects by half. Simulations9 suggest that even with favorable assumptions, which hinge on good progress in extractive industries and a relatively stable security environment, real GDP growth may fall from an average of 10 percent annually over of the past decade to 4.8 percent during 2011-2018. Given Afghanistan’s annual population growth of 2.8 percent, this would mean only limited improvement in average per-capita income, continuing high rates of underemployment, and little progress in reducing poverty. Only growth at the upper level of the range of plausible scenarios would enable Afghanistan to meaningfully reduce poverty and achieve higher per-capita incomes. For example, at a rate of 4.8 percent GDP growth per year, it would take Afghanistan more than two generations 9 The World Bank (2013, upcoming). Afghanistan: Pathways to Inclusive Growth. Washington, DC. 8 to increase real GDP per capita from its current estimated level to that of the South Asian region (2011), which is US$786.10 22. Security considerations aside, Afghanistan’s future growth model will in all likelihood rely on its natural resource abundance. Education levels are too low and the manufacturing sector too underdeveloped (in size and capacity) to expect leapfrogging the classic pattern of structural transformation in which a natural resource-based economy is transformed into a diversified and productive economy dominated by manufacturing and services. Currently the potential for productivity growth is the largest in the agriculture and mining sectors, which suggests that Afghanistan is still at an early stage of structural transformation.11 23. Extractive industries offer good opportunities for more growth. It is reasonable to believe that an improved security environment and a more favorable legal and regulatory environment in the mining sector would lead to the exploitations of more mines than those already factored in to the current projections. In a scenario with higher investment in mining development, growth could increase to 5.9 percent on average until 2025, and fiscal revenues could reach 2-4 percent of GDP in the early 2020s, depending on the number and scale of the exploited mines and the pace of their development (Fig. 12). 24. Even so, the direct impact of mining is unlikely to be transformative. Mining is a capital-intensive economic activity and produces few jobs. In the best-case scenario, mining in Afghanistan could directly and indirectly generate about 100,000 to 125,000 jobs over the next 10 years. This is a rather small number, considering that more than 400,000-500,000 people will be entering the workforce annually over the next five to ten years. With most of these jobs being for skilled and semi-skilled workers, with a relatively small proportion being unskilled and involving heavy manual work, the direct benefits for the poor and women are likely to be limited. 25. On the other hand, there is a chance to multiply the impact of the mining sector by sequencing investment and reforms that are within the control of the government, the development community and the private sector. Such a sequence of actions is articulated in the Resource Corridor approach which rests on the idea of using mining development as an anchor for the infrastructure that underpins the viability of the other sustainable activities. It combines necessary investment in mining infrastructure with the enhancement of objectives in local livelihood, social and environmental ideals and governance. This involves strategic planning and investment in supply chains which produce spillovers to other economic activities and synergies with private- 12 sector investment. 26. Agriculture has good potential for growth. Afghanistan has a long tradition in horticulture and livestock production and used to be an important exporter of fresh and dried fruits, vegetables and nuts. But the last three decades of conflict have brought destruction and disinvestment to Afghanistan’s agricultural sector. The country’s agricultural productivity is currently 50 percent of its pre-war level. Household-level data show that a significant portion remains underutilized due mainly to lack of water and poor soil quality. Only 63 percent of farmers use fertilizer, a much smaller fraction uses pesticides or herbicides, and only few obtain information or advice on crops or planning methods.13 From a positive point of view, the challenges offer ample opportunities for productivity enhancement through, for instance, investment in the rehabilitation of irrigation systems, new production and post-harvest processing technologies. 10 Underlying projections assume a constant annual population growth rate of 2.8 percent, a constant exchange rate of Afs 48.2 to 1US$. However, the estimated growth path may be biased by the fact that Afghan real GDP is measured in 1990 prices while South Asia real GDP is based upon 2000 prices. 11 The World Bank (2013 upcoming). Afghanistan: Pathways to Inclusive Growth. Washington, DC. 12 The World Bank (2012). Resource Corridor Initiative – Technical Summary. Washington, DC. 13 The World Bank (2013 upcoming). Afghanistan: Challenges and opportunities for inclusive growth – A labor market view. Washington, DC. 9 27. Agriculture is highly relevant to poverty reduction and job creation, as 84 percent of the poor live in rural areas. Workers employed in the agriculture sector represent 60 percent of total employment, meaning that three out of five workers have their main source of income in farm-related activities. Employment in agriculture is characterized by small family businesses, often producing merely for subsistence and seldom providing enough resources to sustain families throughout the year. To improve this situation would require mobilizing much of the Afghan population, the largely underutilized rural labor force, and stimulating development of markets, internal demand and, indirectly, the development of the non-farm sector. 28. Additional investments in agriculture could increase general GDP growth to 5.8 percent annually on average (compared to the 4.8 percent baseline). An improved investment climate that boosted the potential for both, mining and agricultural, could raise average GDP growth to 6.7 percent. The services sector, though, which accounted for 46.6 percentage of GDP in 2012 – is set to decline in importance. This would be due mainly to reduced demand in military and international service contracts for transportation and retail services, which would be only partly offset by increased demand for ICT services and secondary demand from the growth of other sectors. Figure 12: Growth Simulations for Different Development Scenarios 2011-2025 8 6.7 % annual GDP at factor cost (in %) 7 5.8 % 5.9% 6 4.8% 5 4 3 2 1 0 Base AGR+ MIN+ AGR+MIN+ Mining Industry (non�min) Services Opium Agriculture 29. While services are expected to decrease in the medium-term, ICT sectors show some potential for growth. The past decade has seen a rapid increase in the number of Afghans using ICT. Mobile telephones are now widespread and networks continue to expand and attract new subscribers. Yet the domestic market is far from being saturated. And the introduction of new technologies, notably mobile broadband, is expected to drive additional private investment and connect more people and businesses to the Internet, with consequent positive spillovers for the entire economy. With 8 percent of total domestic revenues, ICT companies comprise the largest tax-paying community. Equally important, a development focus on agriculture and mining is also a shift away from cities. However, sustaining economic activity in urban areas will be important because cities like Kabul are rapidly growing and are attracting especially young people. 30. These scenarios are predicated on improvements in security. The fragile security environment has been the single most binding constraint to private-sector investment and private- sector-led growth. The high level of uncertainty around the upcoming elections in 2014 and the impact of the transition process on Afghanistan’s security situation are key factors in this regard. Continued violence and economic crime have also often undermined progress in Afghanistan’s governance and state-building agenda. Much will depend, therefore, on Afghanistan’s success in achieving peace, stability, and reconciliation. Without it, the previously-mentioned growth prospects will not materialize. 10 31. Substantial risks lie in rising fiscal financing needs. Ongoing analysis projects revenues to reach more than 17 percent of GDP by 2025 (from current levels of 11 percent).14 However, expenditures are expected to grow much faster. Total government spending could rise to 39 percent of GDP over the next 10 years, and potentially even higher in many of the intervening years. The increase in expenditure is largely a result of rising security spending for both operations and maintenance (O&M) and wages for the army and police, which are currently funded by donors outside of the budget. But it will also be driven by non-security spending, which will increase due to additional O&M liabilities associated with the handover of donor-built assets and with a rising government payroll as civil service reforms unfold. Security spending is projected to be more than 15.2 percent of GDP in 2021 (about as much as total projected domestic revenue in that year), the civilian wage bill 4.8 percent, and the civilian nonwage O&M bill 7.2 percent. The resulting financing needs of the budget could reach as much as 30 percent of GDP between 2013 and 2016 depending on how many of the liabilities the government takes on. Figure 13: Financing Gaps, With and Without Security 0.0 �5.0 �5.6 �10.0 Percent of GDP �12.1 �15.0 �20.0 �20.1 �25.0 �30.0 �35.0 Operating balance incl. security Total balance incl. security Total balance w/o security Source: World Bank. Note: Operating balance is the ratio of operating expenditures to domestic revenues. 32. Donors have committed to cover the financing gap. The July 2012 donor meeting in Tokyo pledged US$16 billion in development aid for Afghanistan over 2012-2016. Together with earlier pledges on the security side, this means annual aid of about US$8 billion – roughly equally divided between civil and security aid. This should help to cover the projected financing gap (Figure 12) and allow the authorities to progress towards development and infrastructure targets. 33. However, these funds will only be made fully available if the government makes satisfactory progress on the TMAF. An important indicator in the TMAF is the increase in domestic revenue; to this end the government committed to increasing revenues to 15 percent of GDP by 2016 and 19 percent of GDP by 2025.15 Such levels of revenue could only be achieved in Afghanistan by developing the mining sector, fostering private sector development, broadening the tax base, and reducing the leakages at customs. The current decline in revenue, therefore, poses not only risks to long-term fiscal sustainability but also to the achievement of TMAF targets. To regain momentum in revenue generation, the government, supported by the IMF, is pressing ahead with plans to introduce a VAT in 2014 and, supported by this operation, is intensifying efforts to reform customs and to attract investment into the mining sector. 14 This outlook assumes that the Aynak copper mine and the Hajigak iron mine commence operations as envisaged. 15 The TMAF commitments are more ambitious than the IMF/World Bank projections 11 34. Afghanistan’s risk of debt distress was labeled high in spite of improvements in the country’s debt profile. Afghanistan reached the Heavily Indebted Poor Country (HIPC) completion point in 2010. Subsequent debt relief reduced public external debt from US$11.9 billion in 2006 to US$1.17 billion by end-March 2013 and the debt-to-GDP ratio from 19.8 percent in 2008 to 8.2 percent in 2011. The government has incurred very little new debt since 2008. However, the Debt Sustainability Analysis (June 2012) identifies significant risks stemming from very high security and development spending needs as well from vulnerabilities to the macroeconomic outlook. Should donor support or security deteriorate, Afghanistan’s debt burden would become unsustainable. Under the assumption that the external debt-to-GDP ratio remains constant, the country will still need to borrow domestically in addition to receiving substantial grant-equivalent financing (Figures 13 and 14). Sensitivity analysis reveals that if grants fall short by 50 percent compared to the baseline scenario, the country will face not only a present value of the debt-to-GDP ratio reaching 126 percent by 2032, but also pressure on its exchange rate. Figure 14: External and Total Public Debt Figure 15: Public Debt Scenarios (present value) Projections 30.0 250.0 25.0 200.0 Percent of GDP 20.0 150.0 15.0 100.0 10.0 5.0 50.0 0.0 0.0 2013 2015 2017 2019 2021 2023 2025 2027 2029 2031 2013 2015 2017 2019 2021 2023 2025 2027 2029 2031 External debt Baseline Public sector debt Lower real GDP growth rate Grant�equivalent financing Lower grants Source: Debt Sustainability Analysis, WB/IMF, June 2012. 35. Therefore, the government needs to carefully prioritize its spending needs, and avoid any rapid expenditure increase until continuous financing has been clearly identified or domestic revenue mobilization picks up reasonably. The analysis also underscores the importance of substantial long-term grant financing, in combination with a strong reform agenda and progress in security and governance reforms. However, with the recent donor pledges and the current government’s plans to not incur any new debt (other than domestic) – not even concessional – debt management issues are fairly well managed. 36. Program implementation under the IMF-supported Extended Credit Facility (ECF) has been mixed. The program focuses on maintaining macroeconomic stability and structural measures to mobilize budget revenue to move toward fiscal sustainability, strengthen economic governance, and strengthen the financial sector. Security transitions, slow policy responses to transition uncertainties as well as delays in implementing structural reform have negatively impacted the economy. These developments also led to delays in the second and third ECF reviews. In May 2013, IMF staff reached agreement with the authorities on an updated macroeconomic framework and a set of informal targets and measures, through September 2013, to establish a track record for a possible ECF review later this year. 12 37. Provided continued progress in implementing the updated framework and structural reform timetable, the authorities' macroeconomic policy framework will remain adequate for the proposed operation. Afghanistan’s economy is vulnerable in light of potential changes in the security situation, a slowdown in capital inflows, and the challenges related to governance and corruption. However, the authorities held a tight monetary stance in response to acceleration in inflation. Fiscal policy is focused on revenue mobilization and reducing the deficit in the operational budget. The government responded to the decline in fiscal revenues by exercising tighter control over expenditures and addressing weaknesses and leakages in the customs administration. The government pursues an ambitious structural reform agenda which includes introducing a VAT, strengthening the institutional framework for dealing with economic crimes, improving the fiscal regime for natural resources, strengthening banking supervision, customs and tax administration. The government has confirmed its commitment to structural reforms vis-à-vis the IMF (see Annex 3) and, with this operation, also vis-à-vis the World Bank. Assuming good progress with structural reforms, the largest residual risk arises from Afghanistan’s fiscal situation, and here specifically from failure to deliver on the TMAF commitments (on both donor and government sides). In this context the government recognizes that the likelihood of achieving targets in both, the TMAF and the ECF, increase with the implementation of reforms under this operation. Likewise, the probability of implementation of the reforms itself increases because the operation will increase the leverage of the ministries that are carrying these reforms forward. 13 SELECTED ECONOMIC INDICATORS (% of GDP, unless stated otherwise) est. proj. proj. 1388 1389 1390 1391 1392 1393 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 Real Sector Nominal GDP (excl. opium; billion 615 730 864 1,023 1,100 1,190 Afs) Nominal GDP (excl. opium; billion 12.5 15.9 18.0 19.8 20.2 20.9 US$) Real GDP growth (%) 21 8.4 7.0 11.8 1.5 3.2 GDP per capita (US$) 408 507 557 595 ... ... Money and Prices CPI inflation (period average, %) -12.2 7.7 10.2 6.4 6.2 5.0 Core inflation (excl. fuel & cereals, %) 1.7 9.8 14.6 6.6 ... ... Broad money (M2) 36.8 38.2 36.8 33.1 ... ... Government finance /1* Domestic Revenue 10.3 11.0 11.3 10.6 10.5 12.3 o/w: tax revenue 8.4 9.1 8.7 7.8 8.3 9.6 Donor grants 10.2 11.0 10.8 16.2 17.0 ... Total Core Budget expenditure 22.1 21.1 23.0 24.6 28.7 ... Operating 14.5 15.2 17.4 17.7 21.3 ... Development 7.6 5.9 5.7 6.9 7.3 ... Operating balance 1.2 3.3 0.9 5.1 6.2 ... Overall Core balance (incl. grants) -1.6 0.9 -0.9 2.1 -1.2 ... Security spending 7.3 8.8 10.0 10.7 12.3 ... Fiscal sustainability ratio 71.3 72.7 65.0 60.2 ... ... External Sector Exports FOB (billion US$) /2 2.52 2.64 2.75 2.61 2.57 2.59 Imports FOB (billion US$) /2 9.47 9.95 10.62 11.17 11.0 11.0 Trade balance -55.7 -45.9 -43.6 -43.1 -41.6 -40.2 Current account balance (incl. grants) 1.6 2.8 2.2 3.9 3.3 2.7 Current account balance (excl. grants) -58.6 -48.5 -45.9 -44.9 -41.5 40.2 Gross reserves (million US$) 4,312 5,560 6,193 6,867 6,660 6,700 Gross reserves (months of imports) 5.5 6.7 7.0 7.9 7.5 7.4 Total External debt Total debt stock (billion Afs) /3 106.2 100.8 114.3 112.2* ... ... Debt-to-GDP Ratio (%) 17.3 13.8 13.2 11.0* ... ... Memorandum items Nominal GDP (incl. opium; billion Afs) 633 747 904 1,106 ... ... Population (millions) 30.6 31.4 32.4 33.4 ... ... Exchange rate, average (Afs/US$) 49.3 45.8 47.9 51.6 ... ... Exchange rate, end-year (Afs/US$) 48.0 45.3 49.5 52.5 ... ... * indicates values as of December 2012. Underlined numbers indicate forecasts or projections. /1: Fiscal indicators for 2012 have been projected over 12 months to facilitate comparison with previous years. /2: Includes both official trade and unofficial trade (smuggling) estimates. /3: Official statistics by the MoF.   14 III. THE GOVERNMENT’S PROGRAM AND PARTICIPATORY PROCESSES 38. Afghanistan’s vision is to become more self-reliant by 2025. The government is cognizant of its donor dependence and the implications of the anticipated decline in aid. The stated objective in its Strategic Vision for the Transformation Decade, presented at the Tokyo Conference in 2012, is “to reduce its dependence on international assistance to non-security sectors to levels consistent with other least developed countries by 2025�.16 The strategy recognizes that achievement of this vision will rely on “a vibrant, fast growing, equitable and sustainable economy requiring good governance and significant foundational investment�. 39. This vision is embedded in the Afghan National Development Strategy (ANDS), and within it the National Priority Programs (NPPs). The ANDS was launched in mid-2008, responding to the need to define a poverty reduction strategy and ensure aid coherence. At the Kabul Conference in 2010, the government agreed to prioritize the ANDS with the development of 22 NPPs to better reflect budgetary realities and measure results. These NPPs provide a foundation for the government’s plans to allocate resources to areas of importance for growth, security, governance, and service delivery. 40. The NPPs highlight the need for investment in priority sectors that are critical to achieving economic growth: mining, agriculture, and infrastructure (transportation, energy, and telecommunication). In addition to these sectors, the NPPs support the development of targeted human capital, improvements in governance, public financial reform, and overall stability in the country. Their implementation is considered key to (i) achieving financial sustainability through revenue streams by creating infrastructure critical to private sector led growth, (ii) increasing productivity in agriculture and rural areas for both growth and poverty reduction, (iii) establishing an enabling environment for private investment, (iv) building critical human capital, (v) reforming and creating institutions for effective governance, and (vi) achieving economic and social stability through better job opportunities. 41. Managing the fiscal deficit and increasing domestic revenue are key objectives of the government’s development strategy. As part of its commitment in the TMAF, the government committed to increasing revenue mobilization in order to achieve 19 percent of GDP by 2025 and to narrow the financing gap to 12 percent. To achieve this goal and address the fiscal gap, the government has committed to an aggressive program, supported by the IMF, the Afghanistan Reconstruction Trust Fund (ARTF), and IDA, which includes (i) measures to increase the efficiency of customs and revenue departments, (ii) continued development of a sound public financial management architecture, (iii) introduction of VAT by 2014, (iv) increased capacity and institutional framework to respond to economic crime, and (v) strengthening the financial sector. 42. The authorities carried out comprehensive consultations on the NPPs. The preparation and implementation of the NPPs is governed by the Joint Coordination and Monitoring Board (JCMB), which consists of senior representatives of the Afghan government and representatives of the international community. While each NPP cluster defined its own consultation process, the preparation of most NPPs followed a participatory and transparent approach involving representatives from the donor community, civil society, and the media. 43. In addition, emphasis was placed on consultations for legislations supported by this Development Policy Grant. The mining law, as well as both land related laws were informed by comprehensive and structured consultations including private sector, media, NGOs, and academia at central and sub-national level. The results of the consultations have been documented and were discussed with the World Bank. 16 Government of Afghanistan, 2012. Supporting Self-Reliance in Afghanistan. Strategic Vision for the Transformation Decade. Afghanistan. Link: http://mof.gov.af/Content/Media/Documents/Towards-Self-Reliance-27-6- 2012167201210282583553325325.pdf 15 IV. BANK SUPPORT FOR THE GOVERNMENT’S PROGRAM LINK TO INTERIM COUNTRY STRATEGY NOTE (ISN) 44. The ISN 2012-2014 was presented to the Bank Group’s Board on April 26, 2012. The Bank Group’s overall strategic objective for the 2012-14 period is to support the government of Afghanistan with adjustment processes during the transition period, sustain and accelerate progress made in the areas of state building and service delivery, while assisting the government to address the country’s long-term development challenges and opportunities. The Bank’s interventions are focused on three areas: (i) building the legitimacy and capacity of institutions, (ii) equitable service delivery, and (iii) inclusive growth and jobs. 45. The proposed operation underpins the objectives of the ISN in all dimensions. Through its impact on fiscal management, the DPG will strengthen institutions and processes associated with transparent and competent financial and economic management – one of the operational objectives of Pillar I: Building Institutions. Some actions, such as the strengthening of customs and land management systems, will help with more efficient and equitable delivery of services (Pillar II). However, the DPG is designed to have its strongest impact at sector level, in support of economic growth in the areas of mining, ICT, and agriculture development, by strengthening the functioning of markets (including land markets) and through changes in the regulatory and legal environment (ISN Pillar III: Inclusive Growth and Jobs). As such, the operation complements other investment and technical assistance operations proposed in the ISN. COLLABORATION WITH THE IMF AND OTHER DONORS 46. As administrator of the Afghanistan Reconstruction Trust Fund (ARTF), the World Bank is a key coordinating actor. Although the United Nations Assistance Mission (UNAMA) has the overall lead on donor coordination in Afghanistan, the Bank plays an important role in supporting the government’s policy of using the budget as a vehicle for improved donor coordination and development coherence. The ARTF serves as the primary multi-donor funding mechanism in the country, financing both essential running costs of government through the recurrent cost window and key national programs. Over the past few years, the Bank has also assumed a strong role in leading policy dialogue around economic and fiscal management. 47. The Bank’s primary instrument to coordinate donors around policy issues is the ARTF Incentive Program. Since the establishment of the ARTF, donors have been providing support to cover the running costs of the government through the Recurrent Cost (RC) Window. The incentive program was devised to gradually shift the RC into a more policy-based approach, and is oriented towards actions aimed at improving fiscal sustainability. It rewards government through additional allocations of ARTF resources for progress against agreed benchmarks which focus on budget transparency and accountability, customs and civil service reforms, and establishing an enabling environment for the private sector (see Box 3). In this sense, the incentive program is increasingly active in the policy space previously covered by DPGs, while this DPG series is moving IDA support towards structural reforms in growth sectors. The preparation of the incentive program for 2012-2014 took place in parallel to the preparation of this operation, and was closely coordinated with donors. The team has undertaken consultations with key donors at different stages of the program. Key donors were also invited to participate in the concept note review of this operation. 48. The Bank team has worked closely with the IMF on this program. The Bank collaborated with the IMF especially in preparation of analysis for the Bonn and Tokyo Conferences, including issues of fiscal sustainability. Over the DPG implementation period, it is expected that both institutions will continue close cooperation, especially on issues related to fiscal management. It is particularly important for this operation that both institutions continue to cooperate closely on the macroeconomic framework and Joint Debt Sustainability Analysis (DSA). 16 Dialogue with the government on issues relevant to the management of mineral resources will also be jointly organized. 49. The proposed DPG is expected to foster policy dialogue beyond the objectives of the ARTF Incentive Program and other policy-based programs. The proposed DPG supports a subset of the government’s reform agenda which complements (i) the ARTF Incentive Program, and (ii) the IMF-supported Extended Credit Facility (approved in November 2011). There is no overlap with prior actions and subsequent triggers of the proposed operation. The DPG is considered an alternative financing instrument for the government’s budget, providing discretionary, fungible resources (as opposed to the ARTF Incentive Program which is earmarked to the financing of recurrent costs only).   Box 3: The ARTF Incentive Program The ARTF Incentive Program supports the government of Afghanistan’s budget with a reform program that aims at improving fiscal sustainability by increasing domestic revenue mobilization and strengthening expenditure management. The timeline for the implementation of the current program is July 2012-2014 (i.e., SY1391-1393) with funding allocated through three schemes: 1. The revenue matching grant scheme incentivizes performance in revenue mobilization and collection and is anchored in the annual revenue targets agreed between the Ministry of Finance and the IMF. 2. The structural reform scheme rewards achievements towards milestones on agreed reforms over the lifetime of the program. These milestones include:  External Audit Performance. Fifty percent of total expenditure has been audited according to international standards;  Internal Audits. Fifteen line ministries have carried out internal audits;  Procurement Performance. Nine line ministries are certified for procurement;  Budget Transparency. Recommendations of the Open Budget Initiatives are implemented;  Civil Service Reform. The Civil Servants Law is amended and regulatory instruments are issued;  Anti-Money Laundering/Combating the Financing of Terrorism. Agreed actions under the Financial Action Task Force (FATF) plan are implemented;  Business Licensing. The business licensing process is simplified and unified;  Trading across borders. Key administrative obstacles to export are removed;  Customs. The customs action plan is approved by Cabinet and selected actions are implemented (focus on strengthening enforcement functions);  Sub-national finance. Norm-based allocation rules are formulated and implemented for selected ministries. 3. The operations & maintenance (O&M) facility incentivizes progress on O&M management and provides matching grants for incremental spending on O&M       RELATIONSHIP WITH OTHER BANK OPERATIONS 50. IDA has committed a total of over US$2.65 billion to Afghanistan since 2002. To date, 49 development and emergency reconstruction projects, including three DPGs have been implemented. IDA’s current active portfolio (2012-14) comprises 19 investment projects, eight of which are IDA-ARTF co-financed projects, with a combined net commitment of US$1 billion, of which 45 percent had been disbursed by April 30, 2013. The proposed DPG accounts for 10 percent of the IDA 16 net commitment to Afghanistan. As administrator of the ARTF, the Bank also supervises the implementation of the ARTF investment portfolio, with 20 active grants as of April 30, 2013 for a total grant amount of US$1.85 billion. 51. There is close interaction between the DPG and other projects in the Afghanistan portfolio. The DPG supports several ongoing investment projects and technical assistance operations at policy level, including the ICT Sector Development Project, the Customs Reform and Trade Facilitation Project, Second Sustainable Development of Natural Resources Project (SDNR 17 2). The proposed operation is also an integral part of the Bank’s resource corridor initiative. In addition, with its strong focus on land policy and management, the Bank supports the implementation of all infrastructure projects, such as the Irrigation Restoration Development Project, Power Rehabilitation Project, Urban Water Sector Project, and Rural Access Project, all of which depend on progress in land acquisition and require formal resettlement and compensation frameworks. In turn, the DPG benefits from technical assistance provided through these projects and initiatives. Table 2: Technical Assistance (TA) Activities In Support of Implementation of the DPG   Policy Area TA Activity Related WB Project Mining  TA with legal drafting SDNR 2 and Resource Corridor  Legal review Initiative  Dialogue about issues pertinent to development of the mining sector. ICT  Follow-up capacity building and The ICT Sector Development technical assistance on enactment of Project relevant policy directives and regulations  Technical support with drafting open access policy and regulations  Policy dialogue on licensing reforms Infrastructure Sharing  Technical assistance and capacity The ICT Sector Development building through peer learning events Project and South-South and policy dialogue Exchange Facility Land administration  TA with drafting operational strategy The Resource Corridor Initiative and management  Technical and legal review of Land and Poverty and Social Impact Management and Land Acquisition Assessment under DPG Laws  Preparation of new investment operation (begins FY2014) Customs  Technical assistance in the roll-out of the Second Customs Reform and ASYCUDA selectivity module Trade Facilitation Project  Support with roll-out of post-clearance audit LESSONS LEARNED 52. The successful implementation of previous DPGs and investment operations in Afghanistan provides several valuable lessons that are in line with and build on lessons learned in other fragile states (Box 4).17 53. First, previous experiences demonstrate that a DPG can work well in a high-risk environment. Both the assessments of previous budget support operations18 in Afghanistan as well as the ARTF Incentive Program show that the instrument can be designed in ways that mitigate the significant risks of providing budgetary support in a post-conflict country, while still allowing for a strong reform program. This operation takes this lesson into consideration by pursuing a programmatic approach to support meaningful reforms in Afghanistan in order to allow for a continuous and intensive engagement with counterparts as flexibility with timing. The advantage that a programmatic approach in Afghanistan has is that it gives opportunity to review reforms measures implemented in the first phase and to mitigate any weaknesses in the follow-up operation. Finally, the programmatic approach is helpful in managing political economy risks in 17 World Bank (2005). Good Practice Note: Policy Operations and Program Conditionality in Fragile States. Washington, DC. 18 Programmatic PSIB series I-III and the Strengthening Institutions DPG.  18 the run-up to the election: the first DPG creates reform momentum; the second DPG advances the implementation of the reform actions. 54. Second, strong government ownership determines the success of development policy operations. Previous operations achieved good results in areas in which the government had a strong track record of reforms, such as in Public Financial Management, and was proactively carrying the reform process forward. This operation is, in part, venturing into new reform areas for which reform commitment and sustainability are yet to be tested. This is true for reforms proposed in the areas of land policy and management or infrastructure sharing arrangements. However, it was the desire of the government to focus on reforms that carry a strong element of inter- ministerial coordination and agreement. The fact that the government recognizes this development policy operation as an adequate instrument to foster inter-ministerial cooperation and is willing to use this instrument to discipline reforms that are considered difficult shows strong commitment to the program. The team also ensured during the relatively long preparation phase of the project that all implications and limitations of the operation are understood by all implementing partners involved. Strong ownership was also demonstrated by the perseverance of the government to conclude this DPG in spite of the delays encountered during the preparation period. 55. Third, progress depends on providing technical assistance during the implementation phase. Without exception, reforms in previous DPGs were supported by active investment or technical assistance operations which reportedly facilitated implementation. This has helped to create a better understanding of the steps required to implement agreed-upon reforms and enabled government counterparts to draw on technical assistance whenever needed. This lesson has also been integrated into the design of this operation (see Table 2 above). While the team interacts much with other donors active in the DPG areas (e.g., USAID project “LARA� in land management), the operation relies predominantly on technical assistance provided by World Bank- funded or managed projects to support this operation. This was a conscious decision in light of the operational constraints on the ground (e.g., joint missions are difficult to coordinate, different timelines and delays, etc.). 56. Fourth, close coordination and follow-up with counterparts facilitates implementation. The DPG operates in a limited-capacity environment. Previous DPGs highlighted the need for continuous engagement with the authorities in monitoring and implementing agreed actions. Adequate supervision arrangements and on-the-ground presence will ensure accountability and progress during the implementation of this operation. 57. Lastly, DPG operations are important in leveraging larger amounts of on-budget donor funding. An important, unintended outcome of the previous DPG was the signal it sent to the donor community regarding the World Bank’s confidence in providing direct budget support. This encouraged other donors to consider channeling more resources through the Afghan budget and to use country systems for the implementation of donor-funded projects. The signaling function of this DPG will become more apparent as donors work towards placing 50 percent of their assistance on budget, as agreed under the Tokyo Mutual Accountability Framework. 58. The lessons learned have been instrumental in allowing the team to develop good practices in conditionality (Box 4). This is reflected in the operations policy matrix, which outlines specific actions and outcome indicators for the proposed DPG (Annex 2).       19     Box 4: How the DPG Reflects Good Practice Principles on Conditionality Principle 1: Reinforce ownership. The government demonstrated strong ownership of the supported reform program throughout its preparation, in line with its excellent track record in previous operations. Continued progress in core areas of previous DPGs and the government proposing to support an ambitious reform program in areas that require a high level of inter-ministerial coordination are testimony to the Ministry of Finance’s ownership of the reform program and its continued leadership function within government. Principle 2: Agree up-front and with other financial partners on a coordinated accountability framework. The authorities took an active part in the design of the proposed program (Annex 2), clarifying expectations and monitoring requirements early on. Reforms were discussed with the main development partners and the IMF. Given the context of weak capacity in the government, the policy matrix was kept as simple as possible to crystallize key reform steps required and allow monitoring by counterparts. Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances. The DPG reflects country circumstances and priorities as indicated by the government. All reforms are continuously supported by analytical work, technical assistance and investment projects. In order to ensure accountability, a team within the Ministry of Finance was set up to act as a focal point, and progress will be monitored continuously. Principle 4: Choose actions critical for achieving results as conditions for disbursement. Prior actions and triggers build upon each other in that prior actions initiate or lock in a certain reform process which is then either continued or concluded with the implementation of prior actions. Selectivity is critical in a low- capacity environment. Actions were therefore limited to three (at maximum) per implementation partner per DPG. Principle 5: Conduct transparent progress reviews for predictable and performance-based financial support. Progress reviews under the proposed DPG are planned on a monthly basis, based on joint discussions with all involved counterparts. The Ministry of Finance will lead and guide the progress reviews. They will be thoroughly documented to ensure transparency and predictability.     ANALYTICAL UNDERPINNINGS 59. The proposed DPG is informed by previous and ongoing analytical work and technical assistance by the Bank and other international organizations. Analytical work has been carried out in all areas covered by the DPG. Continued support is provided by means of technical assistance planned throughout the project period (ICT and mining projects, restructuring of the land authority, the resource corridor initiative). Technical assistance is provided directly by the team and/or in cooperation with the IMF (e.g., macroeconomic analysis). During preparation of the operation, the team ensured that all actions were built on a rigorous evidence base and that sufficient analytical capacity would be available to inform the authorities throughout the implementation of the reforms. The findings and policy recommendations from analytical and advisory activities (AAA) that have provided major input to the preparation of the proposed operation are described in Annex 5. V. THE PROPOSED DEVELOPMENT POLICY PROGRAM SERIES OPERATION DESCRIPTION 60. The objective of this operation is to support policy reforms in selected areas critical to strengthening revenue mobilization and improving the enabling environment for investment in sectors with a high growth potential. With this, the operation expects to contribute to the government’s strategy towards developing greater economic and fiscal self- reliance. The measures proposed in this operation were chosen in view of their importance, informed by analysis undertaken by the World Bank, and complementarity with other programs, 20 especially the TMAF, ARTF IP and the IMF ECF. They were also chosen with respect to their ability to reinforce signals of good economic and fiscal governance during times of high political uncertainty. 61. In the long-term, these measures are expected to (i) boost investment in mining, agriculture, and ICT, and (ii) increase fiscal revenue through enlargement of the tax base in these key sectors and improved collection of customs duties. The outcomes are tracked by a series of measurable outcome indicators described in Annex 2. 62. This is the first of a proposed series of two development policy grants (DPG1 and DPG2). A programmatic approach has been chosen to better support meaningful reforms in Afghanistan through a continuous and intensive engagement with counterparts. A programmatic approach gives opportunity to review reforms measures implemented in the first phase and to mitigate any weaknesses in the follow-up operation. This is an important feature considered Afghanistan’s low-capacity environment. Finally, a programmatic approach is proposed to carry on reform momentum and strengthen reform incentives during times in which political incentives for reforms are typically low due to upcoming election. 63. The prior actions of the first operation have been implemented and successfully appraised. Box 5 sets out the prior actions for DPG 1 and the triggers for a programmatic follow- up operation. These measures are presented also in the DPG Policy Matrix in Annex 2. POLICY AREAS Policy Area I: Strengthening revenue mobilization 64. The transition process poses several risks to public finances. In the short term, changes in the political economy, induced by the upcoming elections and the anticipated decline in aid, are likely to increase rent-seeking activities and, in turn, mount pressures on vulnerable public finance institutions such as customs. These pressures have already begun affecting domestic revenue performance. 65. In the long term, the anticipated decline in aid poses a serious risk to the sustainability of public finance due to Afghanistan’s high dependency on external financing sources for budget operations. Debt financing and scaling back public expenditure do not present viable policy options over time as these would either further undermine fiscal sustainability or negatively affect Afghanistan’s growth prospects. Mobilizing additional revenue will be critical to ensuring that public service delivery is sustained. The planned introduction of the value added tax (VAT) in 2014 exhausts the politically acceptable scope for more tax collection in a slowly emerging private sector; customs, however, still provides much opportunity for additional revenue mobilization by reducing the existing leakages and opportunities for rent-seeking.   Customs PRIOR ACTION: The Recipient’s Customs Department has rolled its strategic approach to risk management through the implementation of a computerized (“ASYCUDA�) risk management in daily customs operations at the Regional Customs House in Jalalabad in order to limit arbitrary controls and related integrity issues. DPG2 TRIGGER: The Recipient’s Customs Department has rolled out its strategic approach to risk management through the implementation of a computerized risk management in daily customs operations to, at least, three additional, major regional Customs Houses in order to limit arbitrary controls and related integrity issues. DPG2 TRIGGER The Recipient’s Customs Department, as part of its strategic plan, has increased customs efficiency and custom controls by (i.) rebalancing the number of customs examiners across major customs houses, (ii.) improving procedures for random 21 post-verification of examination, (iii.) mobilizing post-clearance audits at the Inland Clearance Depot in Kabul (desk PCA), and Jalalabad (on-site), and (iv.) linking salary incentives for the post-examination and post-clearance teams to the detection of non- compliance. 66. Until recently, customs reforms have been largely a success story. The government has implemented major reforms over the past years – including the introduction of a new tariff schedule, procedures to control and monitor exemptions, roll-out of the Automated System for Customs Data (ASYCUDA), and the establishment of regional customs valuation and post- clearance control units. These reforms yielded impressive results: customs revenues grew by an average 25 percent per year from 2004, reaching US$636 million by 2011. This was driven by both an annual increase in the volume of imports and higher efficiency in duty collection. 67. However, customs revenues have been declining since, mainly due to a worsening governance situation.19 From an institutional perspective, customs is vulnerable to corruption.20 Mirror data21 for imports imply that current customs revenue collection is below par and could certainly be much higher. Hence, opportunities exist for increased duty collections by reducing the scope for rent-seeking at borders. 68. In response to this development, the Ministry of Finance is strengthening current reform efforts. In order to build a new reform momentum, the senior management team in the revenue and customs department was replaced in March 2013. The customs department is working on a new, comprehensive strategic reform action plan for the next five years which aims at addressing the several institutional deficiencies that open room for corruption. A new valuation system will be introduced to increase revenue over the short term. These measures will be complemented by the introduction of a risk-based inspection system which has started with the roll-out of the ASYCUDA risk management and selectivity module to Jalalabad in early June 2013. 69. Introducing risk management at borders is an important step towards corruption control at borders. In Afghanistan, customs officials are required to physically inspect all declared goods, except for those imported under an exemption scheme. However, inspections in Afghanistan often do not happen, partly because of the high workload of staff and partly due to the influence of vested interest. Most shipments are therefore cleared with no inspection. Not surprisingly, almost all counter-inspections performed by audit teams have found undeclared items of much higher value than those entered in the declarations. To increase the number of physical examinations and ensure due diligence, the customs administration plans to move to a risk-based management and selectivity system for inspections and examinations. This will involve carrying out inspections and examinations based on a pre-defined, and partially randomized, risk-profile which will help to support decisions concerning which transactions to target for inspection and examination. 70. In order to increase the robustness of these measures the Ministry of Finance will complement the risk management system with additional physical and administrative control and an improved examination procedure (i.e. better detailed examination reports, signature on examined boxes etc.) to establish a documentation trail that facilitates the detection of non- compliance. Finally, the current staff allocation will be revised to ensure that custom houses have the necessary staff to conduct the required inspections. Together, these measures are expected reduce the margin of discretion for customs officers, enforce stronger controls and reduce opportunities for corruption. The expected result is an increase the detection of non-compliance to rules and procedures from currently near zero to 8 percent and increased customs revenue from US$390 million in 2012 to US$530 million by mid-2015. 19 World Bank (2013). Afghanistan in Transition. Looking beyond 2014. Washington, D.C.: 42-43. 20 United Nations Office on Drugs and Crime, Corruption in Afghanistan: Recent Patterns and Trends, (Vienna, 2012). 21 Mirror trade data is data reconstructed on the basis of statistics reported by partner countries 22 71. The customs department decided to roll-out in the Inland Customs Depot in Jalalabad which is the second biggest customs location in Afghanistan after Herat (prior action in DPG 1). The pilot started in June 6, 2013 and has already produced some modest but encouraging results. Through adjustments in the risk profiles and additional controls the customs department intends to test which risk profile and combination of measures maximizes revenues. This process will eventually determine the risk profile and measures implemented in other customs houses (supported by DPG 2). Policy Area II: Improving the enabling environment for investment in sectors with high growth potential 72. Public investment, financed predominantly by aid, has so far been Afghanistan’s most important driver for economic growth. With aid declining, the country will need to shift its focus to attracting more private investment and increase its efficiency of public investment. Clearly Afghanistan’s investment climate is currently very challenging for investors. Given that the security situation and transition uncertainties override incentives to invest, implementing growth- enhancing policy initiatives might seem daunting. But considering the time it requires to prepare and implement institutional or legislative reforms, the government wishes to build a strong foundation for growth now in order to provide the right set of incentives at more opportune times. In addition, a strong reform effort would send a signal to Afghanistan’s business community about the governments confidence in the country’s future. This could help with managing some of the uncertainty that currently affect Afghanistan’s economy. 73. Three sectors in Afghanistan are considered important because of their expected impact on growth, job creation or revenue mobilization: mining, agriculture and ICT. Major obstacles in mining and ICT development relate to the legal and regulatory environment for private investment. In agriculture, investment in irrigation and knowledge extension systems is currently the main priority. But at the policy level, the low capacity to adequately manage land tenure is a serious problem that often results in conflict over land and hinders rural development. Indeed, issues with land cut virtually across all economic activities in Afghanistan; access to land is repeatedly cited as one of the top 5 constraints to private investment in Afghanistan. 74. However, not only private but also public investment suffers from constraints to their efficiency. Public infrastructure projects, needed to reduce Afghanistan’s large infrastructure gap, require several years of preparation due to the time needed to resolve complex land and resettlement issues. And in the light of the limited fiscal space, the government recognizes that it needs to make better use of economies of scope by combining network infrastructure projects in order to reduce the cost of their deployment. Mining PRIOR ACTION: The Recipient’s Council of Ministers has approved and submitted to parliament a new draft minerals law which is aimed at improving security of tenure for private investors, providing guidance on licensing, tendering and mining obligations, and strengthening social and environmental safeguards. DPG2 TRIGGER: The Recipient, through its Ministry of Mines and Petroleum, has issued regulations for the 2013 Minerals Law on (i) administration, (ii) licensing of businesses in the mining sector, and (iii) social and environmental safeguards. 23 75. A major obstacle to new investments in the mining sector is the legal and regulatory environment. As of now, the mineral and hydrocarbon markets are insufficiently governed by the 2005 Minerals Law and Hydrocarbons Law of Afghanistan (amended 2009). Importantly, the law does not provide safeguards for Afghan or international investments and does not provide clear guidance on licensing, tendering and mining obligations. As a result, the law neither provides an adequate tool for the government to support long-term mining investment nor protect local communities from negative impacts of mining operations. 76. Supported by this operation (DPG 1), the government drafted a new mining law in order to improve security of tenure for investors, provide better guidance on licensing, tendering and mining obligations, as well as improve social and environmental safeguards. A first draft of the mining law was sent for approval to the Council of Ministers in July 2012. However, the political environment proved to be difficult, discussions lengthy and the draft law only found consensus after several rounds of changes. The finally approved draft law shows significant improvements with respect to transparency, including the obligation for all stakeholders to comply with EITI financial disclosure requirements and standards. Moreover, it substantially strengthens environmental and social safeguards through stricter requirements for impact assessments and mitigation plans, reporting and financial guarantees for compliance. While the draft law did not fully achieve the initial ambition of providing better guidance, clarity and protection to private investors, the Ministry of Mines and Petroleum intends to address some of these gaps by issuing strong regulations and procedures (DPG 2). 77. In the long-term, the result from these actions is expected to increase the investment volume in the mining sector. As an inter-mediate result for this operation, the expected result is the roll-out of three tenders for the exploration of large-scale mines in Afghanistan. Information and Communication Technology 78. Private investment in telecommunications amounts to about US$1.9 billion since 2001. Much of this investment has focused on basic mobile telephone services, and to some extent fixed Internet services deployment. With the government looking to increase access to both mobile telephone services and broadband Internet services, it will be important to align the policy and regulatory environment to recent technology and market developments in order to attract private investment in these areas. To achieve this, two actions will be critical. PRIOR ACTION: The Recipient has, through its Ministry of Communication and Information Technology, approved the Open Access Policy that grants to open access to the AFTEL fiber-optic network for all licensed telecommunications service providers at transparent cost-based price. 79. A key constraint in the ICT sector was that all four existing “GSM� mobile telephone licensees were not permitted to introduce advanced wireless services (e.g., 3G) and were subject to different terms and conditions. This created an uneven playing field and generated regulatory uncertainty that limited the introduction of new technologies that could support wider use of the Internet and attract private investment for new networks and services. 80. The Ministry of Communications and IT, working with the Afghan Telecom Regulatory Agency (ATRA), equalized these licenses in mid-2012 as a step towards promoting competition and opening new markets for more advanced wireless services (DPG 1). Already, three private mobile telecommunications companies have secured the licenses needed to offer mobile broadband services.22 These actions will allow private service providers to invest in new technologies and services and extend the reach and capabilities of their networks. The sale of the licenses brought one-time revenues of US$75 million and economic benefits in the form of new jobs, more competitive, Internet-enabled businesses, and taxes. Ultimately it is expected that 22 Three new licenses have been issues between March and September 2012. Another GSM operator may seek a license during 2013. 24 the number of GSM subscriptions will increase from 17 million in mid-2012 to over 20 million by mid-2015, and GSM mobile broadband service subscriptions go from zero to 1 million by mid- 2015. PRIOR ACTION: The Recipient has, through the Afghanistan Telecom Regulatory Authority, implemented its policy to engage private investment and establish a level playing field for competition among existing GSM providers, and facilitated the introduction of advanced wireless services as evidenced by the issuance of mobile telecommunications service licenses for existing GSM providers with uniform terms and conditions. DPG2 TRIGGER: The Recipient has, through the Afghanistan Telecom Regulatory Authority, issued relevant regulations on open access and tariffs for the national fiber- optic network. 81. A prerequisite to fair and transparent competition in the telecommunications market is ensuring open access to the fiber-optic network. Afghanistan has a state-owned national fiber-optic backbone network operated by Afghan Telecom (AfTel). This network is open, at reasonable tariffs, due to the pro-competition stance of the MCIT, which oversees AfTel. It is expected that this network will remain dominant in the years to come due to large sunk investment needed to develop alternate fiber-optic networks. 82. However, there is a high probability that AfTel will be partially or fully privatized in the near future. This could bring risks to open access under private ownership. The risk is that a closed, private backbone will constrain overall telecommunications market development by raising prices or limiting access to wholesale Internet capacity for competitive downstream (retail) service providers. This would hinder overall market development and network expansion, as competitive service providers would need to redirect investments into duplicative upstream networks rather than downstream “last mile� access networks. 83. Supported by the first DPG in this series, the government issued an open access policy in July 2012. With this the government intends to provide market participants with a clear forwards-looking governance framework and ensure a level-playing field with AfTel as an integrated operator. As a next step, supported by DPG 2, the government intends to cement the policy with associated regulations. The prior action and trigger propose to issue an open backbone access policy, regulations and tariffs. The expected result of these measures is reduced prices for wholesale bandwidth, from US$900/Mbps per month to below US$80/Mbps per month. Land Management and Land Acquisition 84. Afghanistan’s development depends to a large extent on access to and efficient use of its land resources. Demand for land for agriculture and commercial development is high; while the government is also endeavoring to develop Afghanistan’s physical infrastructure (including roads, dams and power networks). The development of the mineral sector and associated infrastructure investments for the resources corridor will require large-scale land acquisition in the coming years. PRIOR ACTION: The Recipient has strengthened the institutional framework for land management and administration in Afghanistan by mandating ARAZI to administer the land acquisition law. DPG2 TRIGGER: The Recipient’s Council of Ministers has approved and submitted to parliament a Land Management Law that improves security of tenure for the various categories of land users and provides more accessible procedures for formal titles to be issued, including to communities and investors. 25 85. The current institutional framework for land management and acquisition is not conducive to economic development. Out-dated systems, overlapping responsibilities, lack of capacity at local levels, conflicting systems for land ownership, and uncertain or incomplete legal frameworks, compounded by decades of conflict and widespread displacement, result in competing claims to land and conflicts between individuals, among communities, and between citizens and the state. 86. As a result, access to land is one of the major constraints for private and public investments across all sectors.23 Agricultural development, and rangeland rehabilitation is severely hampered by the lack of clear tenure rights. Rapidly growing metropolitan areas, especially around Kabul, face serious problems with massive inmigration of people looking for work, housing and services, putting continuous pressures on urban services and land administration. Around 60-70 percent of the population in urban centers lives in often miserable informal settlements. Studies have identified the lack of access to land or secure tenure as a major factor driving the lack of socio-economic reintegration of returning refugees and IDPs. 87. Moreover the acquisition process by which the state may acquire private or occupied lands for public purposes lacks the legal and procedural guidance needed to ensure that this is conducted in efficient and fair ways. Although more than 70 percent of rural and urban landholders lack formal or court-issued documentation for their properties, current land acquisition law only requires the minority with documentation to be compensated when their land is needed for public investment purposes. There is no formal resettlement policy in Afghanistan. Although some improvements in practice have been noted, the absence of clear legal guidance permits unjust evictions to occur, compensation to be insufficient, and local dissatisfaction to rise. Resolution of disputes is lengthy; even small-scale land acquisition cases have exceeded 120 weeks in recent years. 88. The government is seeking to improve the legal framework for land management. Amendments to the Land Management Law (2008) have been drafted and subjected to public consultation. These take account of many of the recommendations of the new National Land Policy (2007) which will directly inform the drafting of amendments in the land management law. Amendments include a range of issues, such as enabling communities to secure off-farm lands as community land, to establish land governance councils at community level, and enabling land investment developments to proceed on secure terms. Another important amendment is the recognition of nikah khat (traditional marriage contract) as valid proof of land ownership if land was part of the dower. This specifically would strengthen and protect women's claim to land rights and ownership of women. 89. The government also plans to improve terms and procedures for compensation and resettlement in the land acquisition law. However, institutional changes over the past decade have created uncertainty as to which agency should hold responsibility for drafting amendments of the land acquisition law, and this needed to be resolved before drafting can begin. Ultimately, the amendments of both laws are expected to improve security of tenure across all categories of landholders, improve land governance, make compulsory land acquisition for public purposes fairer, accelerate issue of formal title by making this more accessible and affordable, and to clarify and status and protection of unregistered land rights in the interim. Investors and public infrastructure projects will benefit from steady improvement in the tenure security and land administration climate. 90. The legal drafting is well underway. Supported by this operation, amendments to the Land Management Law (2008) have been proposed and widely consulted with the administration and civil society. Cabinet presentation is planned for September 2013 (trigger in DPG 2). The mandate for the administration of the land acquisition law has been transferred the Afghan land authority in June 2013 (prior action in DPG 1) and drafting of the amendments has begun in July 2013. 23 Investment Climate Survey (2008) and Doing Business Report (2011). 26 PRIOR ACTION: The Recipient has strengthened the institutional framework for land management and administration in Afghanistan b granting to ARAZI the status of an independent agency in accordance with the Recipient’s law and by transferring cadaster responsibilities from Afghan Geodesy and Cartography Head Office to ARAZI. DPG2 TRIGGER: The Recipient has strengthened the institutional framework for land management and administration in Afghanistan by issuing a five-year operational strategy for ARAZI that includes (i) a new governance structure of ARAZI, (ii) the establishment of a task force on land clearance and land acquisition, (iii) the establishment of a task force on Regional Resource Corridors, and (iv) a fully-resourced human resources plan reflecting the agreed expansion of ARAZI. 91. The government established ARAZI in order to address the vast challenges of land administration and management. ARAZI is responsible for land management in the fields of tenure clarification, resolving land disputes, leasing and transfer of land, recording and surveying of land, and other land issues. 92. In this context, an important concern has been the lack of an integrated land management system. ARAZI has a land inventory and survey department, but legal cadaster responsibilities has resided with the Afghan Geodesy and Cartography Head Office (AGCHO), a state-independent institution. Capacity and manpower has been even more of a challenge for AGCHO than for ARAZI, since the former lacks a viable revenue stream. Moreover, the separation of cadaster and land management functions led to serious coordination problems in the completion of the land inventory. Only about one-third of all cultivated land is covered by cadaster which poses substantial problems for resolving tenure issues. To resolve these issues, the Council of Ministers approved the transfer of cadaster responsibilities from AGCHO to ARAZI in May 2013. 93. One of the immediate challenges ARAZI faces is the need to increase its human and institutional capacity. Current capacity and the operational framework are too limited to deal with the vast challenges of land administration and management. ARAZI has not yet set out an operational strategy that would provide a viable resource plan to expand its services and integrate the cadaster. In order to strengthen ARAZI’s institutional responsibilities and support its expansion plans, the Council of Ministers de-associated ARAZI from the purview of the Ministry of Agriculture, Irrigation and Livestock (where it was previously located) and turned it into an governmental agency with own budgetary responsibilities and independent decision making processes. 94. The prior actions in the first operation support ARAZI through (i) assigning independence from any line ministry and (ii) better integrating the land administration and management systems by transferring cadastral responsibilities from AGCHO to ARAZI. These actions are further strengthened under DPG 2 by (iii) preparing a five-year operational strategy which reflects ARAZI’s new governance structure and expansion plans. Overall, these steps are expected to increase the income from land leases from US$1.5 million to US$3 million by 2015 and increase the area of surveyed land from 35,000 hectare to 45,000 annually, reflecting ARAZI’s increased capacity. Infrastructure Sharing 95. Investments over the past decade have significantly changed the infrastructural landscape. Travel times, for instance, between Heart and Kabul have fallen from three days to 11 hours due to the large-scale rehabilitation of roads. The number of subscriptions for mobile phone services is estimated to be about 17 million in 2011 – compared to fewer than 60,000 telephones in operation across Afghanistan in 2002.   27 96. Nevertheless, the infrastructure gap remains large and hampers the development of economic activities across all sectors. The resource corridor alone would require investment of US$1.6 billion in public roads, electricity, and water supply and treatment infrastructure over the next five years. About US$400 million annually would be required to meet the targets outlined in the E- Afghanistan NPP, including those for telecommunications.24 PRIOR ACTION: The Recipient’s Council of Ministers has, in order to improve the efficiency of public spending and promote infrastructure investment, approved an infrastructure-sharing policy requiring coordination among relevant ministries in the availability of existing rights of way and passive infrastructures associated with telecommunications, roads, and electric power networks. PRIOR ACTION: The Recipient, through its Ministry of Finance, has amended the budget circulars for relevant ministries to reflect the arrangements under the infrastructure- sharing policy directive DPG2 TRIGGER: The Recipient, through its Ministry of Finance, includes a statement in the 1393 draft budget which sets out plans for future deployment of shared infrastructure. 97. The government recognizes the need to reduce the costs of building and using infrastructure networks and services. Policy and regulatory frameworks, as well as institutional mechanisms that promote the sharing of infrastructure, would help to reduce costs and expand the reach of infrastructure services. This includes, in particular, coordination of rights of way (legally granted access or right to use land strips for infrastructure development) and passive infrastructures (e.g., adding telecommunications cables to power lines) in network deployment. For instance, civil works associated with laying telecommunications cables (digging and ducting) accounts for 70-95 percent of network deployment. With adequate coordination, ducts and conduits for telecommunication could be deployed alongside new infrastructure and existing rights of way and infrastructure. This would reduce the costs of deployment and cut the costs of offering infrastructure services, drive market growth, and generate additional fiscal revenue. 98. Infrastructure sharing is often hindered for two reasons: coordination failure and/or a lack of economic incentives. In principle, infrastructure-sharing arrangements between providers should happen without institutional support, assuming sufficient economic incentives exist among partner agencies. However, in Afghanistan, infrastructure sharing often does not happen, in spite of the economic viability and profitability of such arrangements for all parties involved, most likely because they are unaware of the economic benefits or the opportunities new projects might offer. 99. To overcome the difficulties with coordination of rights of way and passive infrastructures, the government, supported by the first DPG operation, formalized infrastructure-sharing arrangements in the form of a clear policy. In support of this, the Ministry of Finance amended the budget circular which now requires infrastructure ministries to lay out their plans for infrastructure sharing for the year ahead. This will inform future budget planning processes and provide an additional basis for budget allocation decisions. Future budget laws will include a statement about plans and implementation status of shared infrastructure deployment in order to increase transparency over the process. The expected result would be three infrastructure-sharing arrangements in place by mid-2015.            24 Three-quarters of the population connected by phones, with 25 percent doing so through the Internet and the rest through a 4,000 km National Backbone Network to be completed by 2015. 28 Box 5: Overview of Prior Actions and Indicative Triggers for Subsequent Operation DPG1 Prior Actions 1. The Recipient’s Customs Department has rolled its strategic approach to risk management through the implementation of a computerized (“ASYCUDA�) risk management module in daily customs operations at the Regional Customs House in Jalalabad in order to limit arbitrary controls and related integrity issues. 2. The Recipient’s Council of Ministers has approved and submitted to parliament a new draft minerals law which is aimed at improving security of tenure for private investors, providing guidance on licensing, tendering and mining obligations, and strengthening social and environmental safeguards. 3. The Recipient has strengthened the institutional framework for land management and administration in Afghanistan by: (a) granting to ARAZI the status of an independent agency in accordance with the Recipient’s laws; (b) mandating ARAZI to propose amendments to the land acquisition law; and (c) transferring cadaster responsibilities from Afghan Geodesy and Cartography Head Office to ARAZI. 4. The Recipient has, (a) through its Ministry of Communication and Information Technology, approved the Open Access Policy that grants to open access to the AFTEL fiber-optic network to all licensed telecommunications service providers at transparent cost-based price; and (b) through the Afghanistan Telecom Regulatory Authority, implemented its policy to engage private investment and establish a level playing field for competition among existing GSM providers, and facilitated the introduction of advanced wireless services. 5. The Recipient’s Council of Ministers has, in order to improve the efficiency of public spending and promote infrastructure investment, approved an infrastructure sharing policy requiring coordination among relevant Ministries in the availability of existing rights of way and passive infrastructures associated with telecommunications, roads, and electric power networks. 6. The Recipient, through its Ministry of Finance, has amended the budget circulars for relevant Ministries to reflect the arrangements under infrastructure sharing policy directive. DPG2 Triggers 1. The Recipient’s Customs Department has rolled out its strategic approach to risk management through the implementation of a computerized risk management and selectivity module in daily customs operations to, at least, three additional, major regional Customs Houses in order to limit arbitrary controls and related integrity issues. 2. The Recipient’s Customs Department has increased customs efficiency and custom controls by (i.) rebalancing the number of customs examiners across major customs houses, (ii.) improving procedures for random post-verification of examination, (iii.) mobilizing post-clearance audits at the Inland Clearance Depot in Kabul (desk PCA), and Jalalabad (on-site), and (iv.) linking salary incentives for the post-examination and post-clearance teams to the detection of non-compliance. 3. The Recipient, through its Ministry of Mines and Petroleum, has issued regulations for the 2013 Minerals Law on (i) administration, (ii) licensing of businesses in the mining sector, and (iii) social and environmental safeguards. 4. The Recipient, through ATRA, has issued relevant regulations on open access and tariffs for the national fiber-optic network. 5. The Recipient’s Council of Ministers has approved and submitted to parliament a Land Management Law that improves security of tenure for the various categories of land users and provides more accessible procedures for formal titles to be issued, including to communities and investors. 6. The Recipient has strengthened the institutional framework for land management and administration in Afghanistan by issues new five-year operational strategy for ARAZI including (i) a new Governance structure of ARAZI, (ii) the establishment of a task force on land clearance and land acquisition, (ii) the establishment of a task force on Regional Resource Corridors, and (iii) a fully-resourced human resources plan reflecting the agreed expansion of the ARAZI. 7. The Recipient, through its Ministry of Finance, includes a statement in the 1393 draft budget which sets out plans for future deployment of shared infrastructure. 29 VI. OPERATION IMPLEMENTATION POVERTY AND SOCIAL IMPACTS 100. The DPG is supported by a substantive Poverty and Social Impact Analysis (PSIA) and stakeholder dialogue. The PSIA has been organized around several exercises: An initial assessment of the likely poverty and social consequences of the DPG’s prior actions and triggers was carried out based on pre-existing analytical work from the Bank’s SDNRP 2 project, the Resource Growth Corridor Development Program, as well as the SOFRECO Mineral and Hydrocarbon Sector Strategic Environmental and Social Integrated Assessment.25 This was complemented by a first round of stakeholder consultations with representatives from government, civil society, media and the private sector. Knowledge gaps identified in the initial assessments have been addressed through a series of PSIA policy briefs26 which are currently in preparation and will be completed in October 2013, prior to commencement of DPG 2. Interim results have been presented to and discussed with the government. 101. Based on the whole spectrum of analysis undertaken, the effects of all DPG prior actions and triggers on poor and vulnerable groups are expected to be significant and positive in the long run. Particularly the reforms under the fiscal management pillar are expected to alleviate some of the fiscal pressures and should make service delivery in infrastructure services more efficient, including ICT services for the poor. Rather than having significant employment effects, the new mining law is expected to generate increased revenues for the general budget. Dependent on adequate management of governance and fiduciary risks, this may not only allow for expansion of public service provision and poverty reduction, but also provide an opportunity to indirectly include women into benefit sharing.27 Amendments to land laws are expected to have the most pronounced positive poverty impact through better protection of property rights and improved and recognized dispute settlement mechanisms. This will ultimately improve not only the regulatory and investment climate, but also tenure security at provincial level. Annex 6 summarizes the results of the ongoing assessment of poverty and social impacts. 102. However, several risks to the livelihoods of poor people and vulnerable groups need to be carefully managed. First, customs- and ICT-related reforms bear no obvious risks in this context. However, land acquisition from and resettlement of communities living in mining areas can have a significant negative impact on livelihoods. The current Land Management Law provides limited recognition of customary claims to land and no recognition of user rights to pasture land. There is also a risk that grievances from mining related broader social and environmental impacts may not be properly addressed due to a lack of clear institutional mandates and weak institutional capacity, potentially leading to local conflicts. 103. The government is aware of the above concerns and has been in dialogue with the Bank regarding appropriate mitigation measures. Above all, prior actions and triggers have been chosen to directly mitigate social impact. The amended Minerals Law stipulates Community Development Agreements (CDAs) – formal agreements between mining companies and local communities defining the responsibilities of each party – as instruments to ensure sustainable local development and welfare among the affected mining community. Furthermore, efforts are underway to address these concerns in amendments to land management and acquisition laws as well as to increase capacity of the Ministry of Mines to develop clear guidelines and policies for resettlement and compensation, to manage the resettlement process, and to have community consultations. Lastly, the Bank, in partnership with an NGO, is supporting a new Social 25 SOFRECO (October 2011). Mineral and Hydrocarbon Sector Strategic Environmental and Social Integrated Assessment. Interim Report. Ministry of Mines and Petroleum, Afghanistan. 26 On land management and amended mineral law impacts, Community Development Agreements (CDAs) as mechanisms for mitigation and recognition of communities affected by mining. 27 The Minerals law includes a specific clause requiring concession holders to enter into CDAs with mining communities. In this respect, current work on the Resource Corridor and SDNRP2 aims at specifically targeting women in the development of CDA regulations and pilot activities. Furthermore, according to government policy, all development activities at local level should be channeled through Community Development Councils, where women are guaranteed 50 percent representation. 30 Accountability pilot in Logar province to test a grievance redress mechanism and raise awareness among mining-affected communities in general towards social auditing. ENVIRONMENTAL IMPACT 104. Increased mining activities, if not well governed and mitigated, can pose significant risks to the environment. According to a recently completed Strategic Environment & Social Assessment, mining may cause significant adverse effects on Afghanistan’s environment through (i) topographic, flash flooding and seismological issues; (ii) subsidence and groundwater pollution on Karstic carbonate formations; (iii) availability of water; and (iv) river bed and river bank destruction issues. In this respect, the government has worked towards the establishment of a legal and institutional framework for environmental protection and the sustainable use of natural resources. Achievements in this field include the promulgation of the National Environmental Protection Act and the establishment of the National Environmental Protection Agency (NEPA) as an independent entity in charge of environment matters. 105. Prior actions required in the DPG directly address the improvement of environmental safeguards in mining development. The mining law, supported by this operation, requires mining companies to have their environmental management and risk mitigation plans endorsed by the NEPA prior to commencing their exploitation activities. The environmental and social management plan, as described in the legislation, will include: detailed data regarding contaminating substances and resources; identification of likely environmental impacts; mitigation actions with respect to each environmental impact of each contaminating source; methods and equipment required to mitigate environmental effects and measures to be taken to anticipate the latter; and an implementation plan. The government will also issue an Environmental Protection Policy in the near future – which will also include emissions standards – in order to further strengthen government oversight of environmental safeguards measures of mining activities. 106. In addition, the Bank provides technical assistance to NEPA and the Ministry of Mines and Petroleum (MoMP) though SDNRP II as well as a non-lending TA to support the mitigation of adverse environmental effects. This includes: (i) strengthening coordination for the oversight of the Environmental Impact Assessment (EIA) process; (ii) facilitating short- and long- term training on the social and environmental management of mining activities; (iii) supporting the establishment of an EIA Board of Experts; and (iv) overseeing compliance of MCC-Jiangxi Copper Consortium (MCC) with the Aynak mining contract, particularly in relation to the EIA requirements, where NEPA has been actively participating. SDNRP II aims to build the capacities within the MoMP to manage the tasks related to environmental and social safeguards. Such capacity building involves staffing, development of a mining inspectorate (including artisan mining), communication and engagement of civil society, development of social standards (including gender related), monitoring contracts, support for NEPA in reviewing and analyzing mining related technical reports, their implementation and ultimately monitoring operations. IMPLEMENTATION, MONITORING AND EVALUATION 107. The Ministry of Finance will be responsible for overall implementation and monitoring of the DPG. The office of the deputy minister will provide overall coordination for the DPG process. 108. The MoF will organize monthly monitoring meetings with all implementing partners to discuss progress on the implementation of the reform program. The MoF may request the presence of a World Bank expert at these internal meetings whenever deemed helpful. Subsequent to the meeting, the MoF will submit a brief progress report (in matrix form) to the World Bank team. Meetings will be held after each monitoring meeting to discuss the implementation of the reform program. 109. The Bank team will monitor actions and review implementation on a continuous basis through local presence of the TTL as well as through the supervision of associated 31 investment projects. Given the complexity of the reform program, close monitoring of its implementation will be critical to assess if further technical assistance is required. 110. The progress indicators reflect data gaps and capacity needs to be enhanced at all levels of planning, design, data collection, and analysis. The government is committed to continue developing its statistical capacity, but institutional reform in the statistics sector, including the CSO, is slow. IDA in collaboration with other agencies is supporting the government’s strategy in the area of monitoring and evaluation, through technical assistance to the NRVA and team of the Ministry of Economy. FIDUCIARY ASPECTS 111. There has been significant progress in implementing PFM reforms. Over the past few years, reforms have been implemented in the areas of credibility, comprehensiveness and transparency of the budget, the budget-policy link, predictability and control in budget execution, accounting recording and reporting. According to the Afghanistan Public Expenditure and Financial Accountability (PEFA) Update 2013 (see Annex 7), these reforms have produced public financial management which outperforms an average of 27 LICs on four dimensions28 and scores better than the average of 51 MICs on two dimensions.29 112. The critical findings of the PEFAs, the line ministry assessments, and oversight by the World Bank of its own technical assistance operations concur that most parts of budget operations are performing well. For example, the national budget is carried out in an orderly, transparent fashion and is largely comprehensive of all general government-sector operations. Since 2008/2009 the national budgets have been thoroughly reviewed by the parliament since its budget and finance committee was strengthened to better scrutinize the budget, its formulation, execution and control. Medium-term fiscal policy objectives are formulated in the MTFF and presented in the budget document. 113. Afghanistan is closely pursuing improvement in the transparency and accessibility of the budget. To this end, the MoF implemented recommendations of the Open Budget Initiative which regularly publishes the Open Budget Index,30 a barometer of transparency in budget operations. The MoF’s efforts led to a remarkable record of improvement and increased the rating from 8 percent in 2008 to 59 percent in 2012. 114. Progress in PFM reforms across line ministries is continuing. The authorities concluded PFM assessments in 14 key line ministries, supported by an international accounting firm which assessed both PFM arrangements (budgeting) as well as internal controls. The assessments provide deep insight into PFM and internal controls across government and confirmed that commitment controls, internal controls, rules and procedures are well understood. Line ministries now have online access to the system for all queries and for the submission of payment requests. Similarly, all provincial offices of the Treasury Department (mustoufiats) process all payments through AFMIS thereby benefiting from the automated controls on budget and vendors. However, the incidence of incompliance is high. Weaknesses also persist in internal auditing. Actions to address these weaknesses have been already agreed under the ARTF Incentive Program, the IMF ECF program, and the PFM Roadmap. 115. A major challenge over the last few years has been the low budget execution for the development (capital) budget. While operational expenditures are usually in line with the budget at the aggregate level, development expenditures deviate significantly from the budget. The execution rate of the development budget was 50 percent last fiscal year. Issues contributing to 28 External scrutiny and audit, comprehensiveness and transparency, predictability and control of budget execution and accounting, recording and reporting. 29 Predictability and control of budget execution and external scrutiny and audit. 30 International Budget Partnership, Center on Budget and Policy Priorities, Washington, DC 20002. www.internationalbudget.org; www.openbudgetindex.org 32 this poor rate include: limited flexibility because donor funds are earmarked to specific projects, pledges to the budget that sometimes do not materialize on time, and limited procurement capacity in line ministries. 116. However, fiduciary risks remain significant. Procurement and financial management legal frameworks are in place along with adequate processes and practices but the incidence of noncompliance remains high and oversight by internal and external audit remains weak. This is evidenced by the rate of ineligibility under the ARTF Recurrent Cost Trust Fund monitoring: 40 percent of all O&M and 10 percent of payroll transactions fall short of full compliance with PFM rules and procedures. The corruption mitigation measures for Bank funds in regular investment projects focus on prevention through: (i) robust controls through the budget; (ii) ring fencing of Bank funds via identification of the funds throughout the budget cycle; (iii) centralized procurement oversight of all civilian procurement; (iv) external monitoring by a Bank agent of all civilian recurrent costs and of rural infrastructure investment and (v) external audit of receipt and uses of Bank-funded operations by the Auditor General (CAO) supported by technical assistance. However, of these measures, only the government-wide controls of the budget and external monitoring of recurrent costs would apply to the uses financed by the DPG. 117. Concerns remain on the quality and extent of internal and external audits. Under the Public Finance and Expenditure Management (PFEM) Law of 2005, the MoF could oversee internal audits across government. Technical assistance from the World Bank and US Treasury have contributed to institutional strengthening and capacity development of this function to a point where the Internal Audit Department of the Ministry of Finance can carry out audits to acceptable standards with a minimum of supervision from an international advisor. It was intended to extend their work to line ministries. However, in 2013 the government amended the PFEM Law to limit the purview of the Internal Audit Department of the MoF to its own ministry. This is regrettable since line ministries have no effective internal audit function and will require years to develop them. On the other hand, a new legal framework for external audit was enacted in 2013. The new law represents an improvement to the previous legal framework but falls short of establishing independence for the Supreme Audit Institution from the executive in the appointment or removal of the Auditor General. 118. However, to some extent, these fiduciary risks are mitigated by the self-reinforcing actions committed to under the PFM Roadmap, the ARTF Incentive Program, and the Second Public Financial Management Reform Project. The government’s public financial management (PFM) improvement program is extensive. The central piece of the reform plan is the agreement with the donor community at the Kabul Donor Conference (July, 2012) – the PFM Roadmap. Actions under the roadmap cover the following themes: (i) strengthening the budget in driving effective delivery of key priority outcomes; (ii) improving budget execution, and (iii) its accountability and transparency. Specifically, on the weaknesses of internal and external audit, the roadmap commits the government to extend internal audit to the line ministries and to make the CAO independent in reporting and mandate. Commitments of the government on internal and external audit are undertaken through the ARTF Incentive Program for the next three fiscal years whereby the government commits to extend internal audit to line ministries and to have external audit of 50 percent of the budget done to INTOSAI standards, including the standards on independence. Technical assistance under the Second Public Financial Management Reform Project (TF10024) supports the implementation of the reforms in both internal audit and external audit implied in these commitments. Based on the progress to date, soundness and ownership of the PFM improvement program, and the quality of engagement on the PFM agenda, it is concluded that there is solid commitment to future improvement on PFM. 119. Moreover, this operation further supports the strengthening of PFM institutions, specifically customs. It does not include, however, specific reforms to address the weaknesses in internal and external audit identified in World Bank diagnostics. The related reforms, on the other hand, are agreed under other government commitments which are managed by the Bank. Technical assistance is in place to support the implementation of these and other reforms. 33 120. The financial statements for FY2012 of Afghanistan’s central bank, Da Afghanistan Bank (DAB), were audited by KPMG (Afghanistan) and provided to the World Bank for review. The auditors gave an unqualified opinion on the statement concluding that the statements give a true and fair view of the financial position, financial performance and cash flows for FY2012. As matters of emphasis, nevertheless, the auditors did point out in the report that: (i) at year-end the capital of DAB was short of what is required under Article 31 of the Da Afghanistan Bank Law, and (ii) that foreign currency liabilities of the bank at this date exceeded the limit prescribed by Article 74 of the same law. A safeguards assessment of DAB was completed on June 12, 2006 and updated on March 18, 2008, and again in 2011, which were also reviewed. 121. To monitor the flow of funds at DAB, for the purpose of this operation, a dedicated foreign currency deposit account and local currency deposit account will be established at DAB (see below). This will form part of the country’s official foreign exchange reserves. DISBURSEMENT AND AUDITING 122. Grant Amount, Beneficiary, Terms, and Tranching: The recipient is the Islamic Republic of Afghanistan, represented by the MoF. The grant is for an amount of SDR 33.3 million, equivalent to US$50 million, on IDA grant terms to be released in one tranche following approval of the grant and notification by IDA of grant effectiveness. The completion of the prior actions and the maintenance of a satisfactory macroeconomic framework are sufficient to release the grant. 123. Implementation, Monitoring, and Supervision: During the preparation of the grant, IDA has assisted the government to help ensure timely implementation of the agreed measures. Counterparts responsible for monitoring progress have been identified and a plan to monitor indicators developed. To assess the impact of the proposed operation, IDA will monitor progress in achieving the progress indicators described in the government policy matrix and LDP. 124. Grant Management: A dedicated foreign currency deposit account, in US dollars, and a local currency deposit account will be established at DAB in the name of the MoF. The accounts will be managed by the MoF, on terms and conditions satisfactory to IDA. The only funds paid to these accounts would be the proceeds of the grant. 125. Disbursements: Upon notification by IDA of grant effectiveness, and with the submission by the recipient of a withdrawal application, the proceeds of the grant will be deposited by IDA into the foreign currency deposit account of the recipient. An amount equivalent to the grant proceeds will then be credited within five (5) working days to an account of the government to finance budgeted expenditures. The recipient, within 30 days, will provide to IDA a written confirmation that this transfer has been completed, and provide to IDA any other relevant information relating to these matters, including the exchange rate of the conversion from US dollars to AFN, that IDA may reasonably request. Disbursements will not be linked to specific purchases and no procurement requirements will be necessary. 126. However, the proceeds of the grant cannot be used for ineligible expenditures (i.e., to finance goods and services from IDA’s standard negative list as reflected in the financing agreement). If, after deposit into the foreign currency deposit account, the proceeds of the grant are used for ineligible expenditures, IDA will require the recipient to refund the amount directly to IDA. Amounts refunded to IDA shall be cancelled. Eligible expenditures would include payments by the government to meet its external service obligations, provided that there are legal agreements that establish such external debt service obligations. Transactions and balances of the government account will be fully incorporated into the government’s accounting records and financial statements, via the AFMIS. 127. Reporting, Accounting, and Auditing: The financing agreement gives IDA the right to require the recipient to audit the foreign currency deposit account through agreed terms of reference. IDA may also request audits of the foreign currency deposit account prior to its closure in accordance with the financing agreement. 34 128. Closing Date: The expected closing date of the last grant in the programmatic series will be June 15, 2015. RISKS AND RISK MITIGATION 129. Overall, the risks to this operation are considered high. The security situation has deteriorated over the past several years and may become even more challenging over the transition period and the run-up to the presidential elections. By their nature, insecurity and political instability are intertwined, and both could severely undermine the implementation of the reforms supported by this operation and their expected outcomes. 130. Many of the risks to this operation cannot be mitigated. The design of this operation acknowledges the complex risk situation and attempts to mitigate as many risks as possible. Risks that can be relatively effectively mitigated by this operation include social and environmental risks and stakeholder risks. The operation directly addresses economic and development risks at country level but several factors outside of the control of the team can undermine the impact of this operation (e.g., political and security risks, and weather volatility). Risks and options for risk mitigation are described below and summarized in Table 3.     Table 3: Risk Factors and Mitigation Risk Description Mitigation Rating Governance and  Decline in aid and shifts  Strengthening Customs will High political economy in political economy partially manage rent-seeking risks might induce increase in risks rent-seeking behavior and affect vulnerable  DPG is designed to be institutions implemented before end-2013 and begin of intense political  Upcoming presidential campaigning. elections may slow or undermine reforms  Parliament might delay passage of laws or undermine initial objectives Economic and  Strong economic  Support effective High development volatility caused by macroeconomic management risks weather and changes in during the transition period international prices (through IMF and WB programs and dialogue)  Transition process heightens uncertainty;  DPG actions mitigate some of macroeconomic the economic transition stresses imbalances during and prepare Afghanistan for transition years post-transition period  Increase in conflict and  DPG reforms have positive violence signaling effect and might reduce some uncertainty  Security risk cannot be mitigated 35 Fiduciary risks  Weaknesses in fiduciary  ARTF Incentives Program and High framework continued support through Second Public Financial Management Reform Project Programmatic  Weak implementation  (Ongoing) Technical assistance Moderate risks capacity to all implementing government units  Coordination failure  DPG itself brings about coordination  Moderation in the strength of prior actions and triggers  Effective stakeholder management Social and  Various impacts related to  Supported by this DPG, the High Environmental the development of legislations includes specific risks mining and hydrocarbon provisions that improve social sector as well as to and environmental safeguards, changes in land-related resettlement and compensation legislation.  Dialogue on community development agreements is underway  Within the framework of the PSIA, the DPG supports the creation of a baseline survey to improve social impact monitoring  SRNDP II includes technical assistance for NEPA Stakeholder risks  Resistance to reforms by  Providing assistance with Moderate internal stakeholders due stakeholder dialogue and to public and political development of a media strategy debate  The implementation of the  Donors could reduce/halt reforms helps the government to their support in response meet the commitments, to delays in meeting the especially with respect to Tokyo Mutual revenue mobilization Accountability commitments   131. Governance and Political Economy: Transition is imposing major changes on the political economy, and contributes to a likely deterioration of the general governance environment. Political uncertainty and instability could intensify rent-seeking incentives for individuals bound to lose from lessened aid, potentially affect public finance institutions, and lower fiscal revenue. The purpose of this operation is to mitigate this risk by strengthening the Customs institution. While these measures could help to reduce corruption risk, however, they may not eliminate them. 132. Another risk is that the reform progress could slow as the attention of decision-makers shifts increasingly to the elections, or the reforms themselves become the target of political campaigns. This is compounded by the already-long backlog of issues pending cabinet approval. This mainly affects the legislation supported by this operation. The design of the DPG takes this risk into consideration by balancing institutional with legislative actions, and by moderating them to the extent that they can be implemented before the political campaigns intensify. Moreover, the 36 programmatic approach is sequenced in a way that it also allows the series to be completed by the new government in case delays occur. 133. There is also political-economy risk related to parliament. Being a relatively young democratic institution, the Afghan parliament (Wolesa Jirga) is yet to develop capacity to fully perform its legislative and oversight functions. Moreover, for reasons that relate to the structure of the state and legal systems, there is a lack of incentives to form alliances and associate with parties or other political platforms to effectively negotiate legislation with each other and the executive. As a result, laws submitted to parliament often require a lot of time to achieve the necessary majority votes. Since the DPG cannot overcome this problem, the prior actions and triggers related to the amendments of the land management and acquisition laws have been devised to reflect realism by requiring cabinet approvals instead of parliamentary ratifications for laws. For the mining law, however, the DPG maintains an implicit parliamentary approval since the regulations for implementation of the law is critical to the achievement of long-term objectives of the government’s development strategy. While this approach has obvious risks to the outcomes of the reforms and their sustainability, the team feels that this approach allows advancing reform effort to the extent possible within the prevailing political economy. 134. Economic risks: The transition process may pose continued challenges to macroeconomic stability in the coming few years, including further slowing of economic growth, and exchange rate depreciation. Moreover, the economy is susceptible to exogenous shocks such as changes in weather and international prices, especially for food and fuels. The government has only a few instruments, mainly in the monetary sphere, to respond to adverse macroeconomic developments. The ongoing dialogue of the government with the IMF – through its Extended Credit Facility – and with the World Bank through its ongoing analytical work on economic and fiscal issues is aimed at supporting the government in managing economic risks. Beyond this dialogue component, the DPG objective and actions are specifically geared to improving economic and fiscal management: In the short-to-medium term, the customs reforms are aimed at stabilizing fiscal revenues. The implementation of the economic reforms under the DPG’s second policy area prepares the ground for life post-transition. The longer-term horizon of these reforms may serve as a signal of the government’s commitment to tackling transition-related challenges and may lower uncertainty among investors. Finally, the DPG is provided at grant-terms which will help to alleviate some of the pressures on cash management and creates some discretionary space within the budget to adjust to economic developments. Nevertheless, large negative shocks (e.g., prolonged drought) could undermine these efforts. 135. Programmatic risks: The reform program supported by the proposed operation may face headwinds due to capacity constraints and weak policy coordination. First, the DPG actively counteracts coordination failure by encouraging ministries to use the DPG itself as an instrument for coordination. Second, the proposed DPG also mitigates overall implementation and coordination failure risks by ensuring that technical assistance is provided at all levels of government that are concerned with the implementation of the reforms. To this end, the DPG team works very closely with sector TTLs throughout the DPG period (see Table 2 in Section IV). 136. Fiduciary risks: Fiduciary risks are significant despite good progress in most phases of budget operations. Previous DPGs and investment operations (e.g., Public Financial Management Reform Projects I and II) have helped to put in place adequate processes and practices for financial management, procurement and control. Afghanistan has a relatively strong public finance capacity track record as witnessed by the 2013 PEFA. However, fiduciary risks remain high due to low compliance with PFM rules (see paragraph 103) and limited internal and external controls. For the most part it therefore relies on the self-reinforcing actions committed to under the PFM Roadmap, the ARTF Incentive Program, the IMF Program and the Second Public Financial Management Reform Project. The ARTF Incentive Program (IP), in particular, focuses heavily on the timely implementation of PFM measures, including internal and external audits, procurement certifications, and budget transparency (see Box 3 in section IV). 37 137. Social and Environmental risks: As discussed in paragraphs 87-93, the operation is expected to have impacts on social livelihoods as well as the environment. Most of them related to the development of mining and hydrocarbon sector as well as to changes in land-related legislation. However, the legislations supported by this operation have been designed to specifically include provisions that improve social and environmental safeguards and address stresses produced by the reforms. For instance, the inclusion of the land related actions and triggers are partially motivated by the need to mitigate the negative impact that could arise from the development of mining through the formalization of a resettlement and compensation framework or an improved basis for the recognition of informal land dispute resolution. In this sense, the DPG serves the additional objective to make future investment operations, particularly mining, more inclusive and sustainable. Other risk mitigation measures are discussed in the social and environmental sections above. 138. Stakeholder risks: The main stakeholder risk to the operation is resistance to reform by internal stakeholders. The changes in mining and land-related legislations are expected to trigger public and political debate during the implementation of the program, which in turn could influence decision-makers in the government and parliament. The DPG assists the government of Afghanistan in conducting informed discussions on these issues, carrying out adequate consultations with the affected social groups, the private sector and civil society, identifying risks and mitigation measures and implementing them. Technical assistance extended to the land management authority also includes the development of a media strategy to promulgate the changes in the law. 139. In light of Afghanistan’s aid dependency, continued donor support will be crucial for balancing the budget. At the Tokyo and Chicago Conference in 2012, international partners committed to providing military and civilian support to Afghanistan through 2016. However, in return the Afghan government committed to, among other things, holding timely elections, strengthening governance, and increasing fiscal revenue. A possible risk is that donor support wanes if the government reneges on these commitments. The DPG operation itself contributes positively to mitigating this risk by supporting the government in meeting the Tokyo commitments. 140. Notwithstanding these high risks, the benefits to Afghanistan’s development process, in our view, far outweigh the cost of this operation. This operation helps the government of Afghanistan to carry on the momentum and discipline of making reforms in challenging times. Even if not fully measurable in the short-term, the reforms supported by this operation are designed to have a tangible, positive impact on not only fiscal and economic developments but ultimately the lives of the people of Afghanistan. Without it, the chances of achieving these results would be lessened. 38 Annex 1: Letter of Development Policy ""~~·~·· ~~~· <.$~ .o.,!Lou~IJJ u~IJJ~ Islamic Republic of Afghanistan Mi.n istry of Finauce ]UI)e 12,2013 Mr. Jim Yong Kim President The World Bank Oroup 1818 H Stree~ NW Washington, DC 20433 USA Dear Mr. Kim, I run writing to request funding for a new Development Policy Orant (DPO) Series to suppor1 a number of critical economic and fiscal reform me.."lSw-es. As Afghanistan enters Trnnsition, munerous challenges lie ahead and my govenunent js committed to address them. In doing so, the refonns ·within the DPG are in(ended to bolster two principal areas .. fiscal sust.ainabiliry and economlc growth. Both are critical for achieving greater self-reliance. Specifically. we would intend to intensifY reforms in customs to attain higher revenues; in land management to boost infrastructure developmeo. i; and in telecommunications ond mining to increase private· investments. The attached Letter of Development Policy outlines these reform measures within d>e DPG operations which we have prepared in close cooperation with the \Vorld Bank. Dr. Omar Zakhilwal Minister of Finance W\'1'\Y,Iaof.sa•uf qil>.fiJ -ci-..0093 (()) l 021003S1 !~v'>~ d\i •.:.i J Q.O.oOA:~ Addr~; flu. ,nCSIIII! Wnu, Kalllll, ,\fslt-lnG-1;.,., Phun~: 0093 (0) 2021003S'7, Wd6f~ ww.....morJ,•