Aid, expatriates and the Afghan Economy

The reconstruction of the Afghan economy hinges on the development of infrastructure, the restoration of the institutions of state and the economic space within which they can pursue a national development agenda. But what is the reality of aid-supported development in the country? Is the present model sustainable?

On December 22, 2001, an interim administration under Hamid Karzai mandated from above under the Bonn peace argeement took charge of Afghanistan. The country's economy had already disintegrated at the time of formation of the interim administration. The economy in 2002 was seen to be structurally at an early stage of modern development with 85 percent of the population reportedly dependent on agriculture and 53 percent of the GDP estimated to be originating in agricultural, livestock and forestry. As against this, light industry contributed 28 percent, trade 8 percent and construction 6 percent. Extremely rough estimates quoted by the Asian Development Bank (ADB) suggest that in 2002, Afghanistan´s GDP amounted to USD 4.4 billion. Per capita this works out to an abysmally low USD 170 per head.

These figures, however, could overstate the level of backwardness implicit in the initial conditions from which Afghanistan must begin its process of reconstruction and revival. Two factors have contributed to the high "aggregate poverty" indicated by a per capita income that is less than half of the international poverty norm of a dollar per day per head by 2001. The first is the war that led to the ouster of the Taliban. An earlier estimate, also quoted by the ADB, relating to 1989, placed Afghanistan´s GDP at a much higher USD 6.9 billion and its per capita income at around USD 300. The situation could have further improved in the years following 1989, since reports indicate that at least in regions fully occupied by the Taliban, economic conditions were stable during the early and the mid-1990s.

Underlying the subsequent massive contraction of the economy was the war which devastated the limited infrastructure of the country, triggered the exodus of more than 3 million refugees to Pakistan, Iran and elsewhere and displaced a large number of people within the country. This disrupted or even brought to a standstill much of the economic activity within the country. A corollary of this role of the late 1990s war in worsening economic condition is that a concerted reconstruction effort focused on quick-impact projects combined with the observed large-scale return of refugees to Afghanistan, could have ensured a sharp rise in GDP and per capita income to levels in the early 1990s.

Secondly, nature added to the woes of an already war ravaged economy, with a protracted drought that began in 1999 and lasted till 2001. According to estimates by the World Bank, crop production during this period was halved and livestock herds substantially depleted, making the situation desperate by 2002. According to a March 2002 Food and Agriculture Organisation (FAO) survey, the livestock count in the country had declined by 60 percent due to the distress sale of livestock herds in the summer and autumn of 2001 triggered by the persisting drought. The crucial role of the drought in worsening economic conditions is indicated by an FAO and World Food Programme estimate that agricultural production in 2002 rose by 82 percent, following better rainfall conditions. However, even for that year cereal production was estimated at 4 percent below its 1998 level. Given the importance of agriculture for employment and GDP, these figures suggest that the rough GDP estimates relating to 2002 may be exaggerating the poor state of the economy.

The unaccounted economy
These real factors that may be exaggerating the extent of backwardness of the economy could have been compounded by statistical errors that remain uncorrected because of the temporary closure of the statistical system. It is known that GDP and revenue estimates in Afghanistan are quite unreliable given the large role of the unaccounted, underground economy in the country. Two factors contribute to the magnitude of the unaccounted segments of the economy. To start with, Afghanistan, being a landlocked country, is also a transit hub for trade between some of its larger neighbours. Such trade flows occur through its porous borders with Pakistan (2,450 km), Tajikistan (1206 km), Iran (936 km), Turkmenistan (744 km), Uzbekistan (137 km) and China (76 km).

Unfortunately, accurate data on Afghanistan's domestically oriented as well as re-export trade are not available. A June 2000-February 2001 UNDP study, based on an investigative survey of border crossings and major trading centres, estimated that "indigenous exports" at USD 130 million constituted just 10.6 percent of total exports, while re-exports totalled USD 1097 million (see chart 1). Similarly, imports for domestic consumption, based on types of commodities, amounted to USD 396 million or 33 percent of the total, whereas imports that were potentially for re-export totalled USD 806 million (see chart 2).

It is to be expected that the huge volume of transit or re-export trade would sustain an economy whose activities are not fully captured in estimates of GDP tracking the real economy. It is a well known fact that much of this trade is not officially accounted for. Therefore, the profits accruing to Afghan nationals from such trade (in which exports account for more than a quarter of estimated 2002 GDP) are also likely to be inadequately captured by national income figures.

The second reason why the magnitude of the unaccounted economy is likely to be great is the historically important role of poppy cultivation and opium production in the rural Afghan economy. According to an estimate by the United Nations Office for Drug Control and Crime Prevention, land under poppy cultivation amounted to 82,171 hectares in 2000 and opium production in 2002 was 3,400 tons, which was similar to levels that prevailed in the mid- to late-1990s. With the Taliban having imposed a ban on opium production and the Karzai government having declared a ban on poppy cultivation in 2002, inevitably a large part of this activity will occur in the underground economy. The cultivation of poppy, the production of opium and its trade will be generating a significant income, which again goes substantially unrecorded.

Disregarding the potential areas for rapid reconstruction of war-damaged assets, the effect of the prolonged drought and the important role of the unrecorded economy, tends to exaggerate the poor initial conditions, which are then attributed solely to the long years of conflict. This is not to say that the two-decade long war had no serious consequences. To start with, it did have damaging implications for the country's infrastructure, in the creation of which foreign aid had a historically important role to play because of Afghanistan's strategic location and transit trade importance.

This reduction in infrastructural capacity made agriculture more climate dependent, besides also fragmenting the economy by raising transportation and communications barriers and creating bottlenecks in sectors like energy. Secondly, by driving out large sections of the population and weakening the state it undermined public institutions, including the central bank, the financial system, tax collection and customs machinery, the statistical apparatus, the civil service, and the law and order and judicial system. Finally, it undermined the ability of the state to collect a share of the surplus being generated within the economy to finance the expenditures necessary to take on crucial governance and development responsibilities.

With regard to the last of these effects, it must be recalled that local revenue in Afghanistan comes from the taxes on trade, much of which occurs by land across the extensive borders with its neighbours. A major problem being faced by the current government in Kabul is to get the provincial governors such as in Herat (still referred to as warlords by many) to part with a reasonable share of the revenue thus garnered. Even though a meeting in May saw 12 governors signing an agreement to do so (and one of them delivered USD 20 million immediately thereafter) it is unclear as to how much of the provincially realised revenue will finally accrue to the central government.

Pillars of reconstruction
Once these features of the Afghan economy are understood and the unwarranted pessimism that springs from reports and perceptions of near complete devastation and penury is set aside, the direction of the aid-supported reconstruction effort and its likely consequences can be easily deduced. There are three pillars on which that effort should rest: (i) restoration of the infrastructure with initial focus on quick-impact projects that can yield substantial benefits in a short period; (ii) restoration of the institutions of state and their powers so that the state can mobilise revenues and undertake crucial developmental expenditures, which only it can pursue since low per capita income levels imply inadequate incentives for private investment in many areas; and (iii) restoration of the "economic space" within which the new state can pursue a national development agenda.

A range of specific initiatives can be identified within this overall framework. To begin with, a greater degree of security and an end to periodic local conflict must be ensured. This must build on the intense and conspicuous desire of the Afghan people to get on with their lives. Only an international, UN-mandated force that is seen as a source of support and not an instrument of occupation can secure this. Second, the damaged and destroyed infrastructure must be immediately reconstructed, with a large proportion of aid diverted for the purpose, so that the economy is reintegrated and rendered functional.

Third, the ability of the state to the mobilise resources needed to finance crucial developmental responsibilities must be restored, for which an appropriate monitoring, tax collection and revenue sharing system must be worked out. Given the fact that Iran and Pakistan account for a substantial share of Afghanistan´s trade, and that trade revenues constitute a large share of the total, the initial task should not be too difficult. But over time, it will be necessary to widen the tax base and obtain resources from internal direct and indirect taxation, particularly the former.

Fourth, it will be necessary to rebuild the financial system with a two-fold purpose: that of mobilising household savings and of channelising those savings to priority areas, using mechanisms such as directed credit and differential interest rates. This implies that an overemphasis on microfinance and any neglect of the task of creating a well-regulated formal banking system will be misplaced. Fifth, the rural infrastructure needed to restore dynamism to agriculture, reduce dependence on rainfall for irrigation and encourage growth of non-agricultural activities needs to be created by the state.

Finally, Afghanistan needs to move out of being a mere transit hub for trade between its neighbours and must seek to develop activities which add value to imported inputs to produce outputs for export and benefit to a greater extent from its crucial role in regional trade. The problem with the transit trade is not that it adversely affects the balance of payments. The field survey-based estimates quoted above show that though there was a small deficit in terms of the indigenously directed and originating trade, Afghanistan did not suffer from a trade imbalance that needed significant external financing. The real difficulty is that the unregulated growth of such trade creates disincentives for investment aimed at increasing domestic employment and value-added through processing and production activities within Afghanistan.

Is this the direction in which the ostensibly UN-coordinated reconstruction effort is moving? Expectation were high when, soon after the Bonn agreement that brought the peace, a meeting of donors in Tokyo in January 2002 pledged to deliver sums estimated at an aggregate of USD 4.5 billion within a 30-month period, to kick-start the reconstruction effort. A year-and-a-half thereafter, even in Kabul, the capital city and therefore the executive headquarters of development, the process of reconstruction has been slow. The inadequacy of the reconstruction effort is all the more puzzling since even the limited and scattered information on aid transfers does suggest that inflows have been significant, if not actually massive.

The mechanics of aid
Aid flows take many forms. They occur directly to the government, through the World Bank administered Afghan Reconstruction Trust Fund (ARTF), the Law and Order Trust Fund (LOTF, which funds the police), the Afghanistan Trust Fund (that pays for the army) and a number of other channels. They occur through routes indirectly linked to the government, inasmuch as local and international NGOs are supported by donors to undertake projects that are in keeping with the National Development Framework adopted by the government in consultation with the donor community. And they also flow in completely outside the governmental framework since US "coalition forces", other than the International Security Assistance Force (ISAF), and international NGOs bring in their own funds besides those provided by donors abroad for activities that are not necessarily reported in full.

The most easily accessed information is that on sums contributed directly to the government. To coordinate these flows, donors constituted the ARTF in response to a government request that the budget be made the central instrument to identify and allocate funds for projects. From the government's point of view, linking donor funds with the budget would help it both guide and take credit for the reconstruction financed by aid. It would also ensure that aid could be used to meet the recurrent expenditure of the government, including a large part of its wage and salary bill. This request was, in turn, acceptable to the donor community, because it ensured "national ownership" of the policies that open or covert aid conditionality prescribed and it ensured a degree of transparency about the allocation and use of aid flows.

Moreover, the ARTF is being administered, for a fee, by the World Bank. The bank sees the fund as a means of appropriating the policy leverage that the combined aid of numerous donors provides. Meanwhile, powerful groups within developed-country donors could be reassured that their interests would be protected. In principle, the mandate of the ARTF is extremely wide. Besides funding the government's recurrent expenditure, including its salary bill (which though it goes against the grain of the World Bank´s perspective is a source of substantial leverage over a resource-starved state), the ARTF can finance investment activities and programmes, including quick-impact recovery projects, capacity-building projects and payments made to Afghan experts resident abroad who are willing to temporarily or permanently relocate to their home country. The control over expenditure on the last two categories is also a major means of influencing government decision-making.

Indications are that the World Bank-led donor effort to direct aid flows to the government and to coordinate these flows through agencies like the ARTF and the Afghan Assistance Coordination Authority (ACCA) has progressed substantially. During the first full financial year (FY) 2002-03 under the new administration (coinciding with Solar Year (SY) 1381 stretching from 21 March 2002 to 20 March 2003), which came soon after the Tokyo meet in January 2002, and before the aid coordination framework could be put in place, the budget was not the principal means of centralising aid flows and utilisation. In April 2002, the interim administration adopted a recurrent budget for FY2002 involving expenditures of USD 483 million, including USD 23 million for clearance of wage arrears.

With domestic revenues estimated at USD 83 million, aid was expected to finance USD 400 million or 83 percent of the budget. However, figures collated by the ACCA indicate that total grant disbursements during the last quarter of SY 1380 and the full SY 1381 (FY 2002) amounted to USD 1.8 billion, of which USD 295.9 went to the government through the budget, the ARTF, the Law and Order Trust Fund and other channels. The channels of disbursement and the local target agency for the remaining money are unclear, but a substantial part (USD 700 million according to one estimate) reportedly went to finance humanitarian assistance to ameliorate the effects of the drought.

The process of coordinating aid flows began to be consolidated only in the financial year starting 21 March, 2003 (SY 1382). In March 2003, the Transitional Government of Afghanistan announced a comprehensive budget for FY2003 — comprising an ordinary (recurrent) budget of USD 550 million, of which USD 200 million is expected to be financed through local revenues and USD 350 million by external assistance, and a development budget of about USD 1.7 billion. According to ACCA, by June, financing from donors to the tune of USD 211.2 million for the recurrent budget and USD 1.2 billion for the development budget had been confirmed.

Interestingly, only the USD 211.2 million for the recurrent budget has been channelled through the ARTF, the LOTF and the Afghanistan Trust Fund, whereas grant funding for development programmes in the national budget has come through other channels. The process of using the World Bank to enforce conditionality appears to work through a mechanism in which the bank controls funding for the crucial and politically sensitive recurrent budget. Thereby it is able to influence both the government's policies and its utilisation of the remaining aid directly provided to the government.

Given that the funding for FY 2003 is confirmed so far, expectations are that the budgetary target for external financing is likely to be fulfilled. Thus, the evidence collated by the ACCA suggests that aid to the government through various channels would amount to USD 3.4 billion by the end of FY 2003. Thus, over a period of 26 months after the Tokyo meeting in January 2002, grants disbursed to the government would cover 87 percent of the pledges made for a 30 month period after the meeting and 75 percent of the total pledges made at and after the Tokyo meeting. According to ACCA sources, it is this high rate of disbursement that has made the Karzai administration bid for a USD 15-20 billion aid package over a five-year period.

Though information on the flows through channels not directed at the budget and monitored by the ACCA is as yet difficult to come by, the actual disbursement of aid is likely to have been substantially more than the figures mentioned above. Even though a variety of sources in Kabul believe that the sums involved would not be as large as that provided to the budget, it is likely that such flows would significantly add to the total. Thus clearly, overall disbursements have been in keeping with the expectations generated at Tokyo.

The investment deficit
What then accounts for the picture of a slow and clearly inadequate pace of reconstruction? There are two obvious reasons why aid flows have not worked to refurbish the infrastructure even in Kabul. For one, a large part of the flow that occurred prior to FY 2003 went to support the humanitarian assistance programme to deal with the consequences of the drought between 1999 and 2001. This took the form of food aid, much of which neither involved any capital spending nor entailed expenditures inside Afghanistan, since the food was imported. Additionally, a large part of the grant disbursement, even in FY 2003 has gone to support the recurrent expenditures of the government, especially its wage and salary bill, which while spurring domestic consumption spending, has not contributed to savings and investment.

This use of aid to support the recurrent expenditures of the state, including its wage bill, has a number of implications. The inability of the government to finance its own recurrent expenditures reflects the fact that government in Kabul does not as yet have the legitimacy or the power to garner a large enough share of revenues which are reportedly being collected at the provincial level. A very large proportion of the government's 240,000 non-military personnel are located in Kabul. This creates an environment in which, in a direct sense, the government in Kabul is supported by the donor community, whose leverage is therefore substantial.

Simultaneously, the expatriate presence and spending in Kabul has generated a services and construction boom there, which is bound to widen differentials between Kabul and the rest of the country. In a country riven with ethnic and other divisions, this distancing of Kabul and its identification with a foreign presence could further undermine the legitimacy of the Kabul government, making it difficult for it to garner the revenues it needs to do away with dependence on aid. A consequence is that the cycle of dependence of the government on aid would only be strengthened.

The second set of reasons why aid does not seem to be having the expected impact is related to allocation decisions. As Chart 3 indicates, budgetary allocations for SY 1382 (FY 2003) show that while social sectors like education, health and refugee rehabilitation are allocated a total of USD 775 million and another USD 210 million is to be spent on foreign investment promotion, technical assistance  and capacity-building in the areas of trade and investment, public administration and economic management and justice, only USD 509 million has been allocated to the crucial areas of transport and energy, mining and telecommunications. When seen in terms of aid commitments to finance these expenditures as of June 2003, this bias appears even greater (Chart 4). Thus part of the reason for slow reconstruction of infrastructure is that only a small part of even the development budget is being allocated for the purpose.

This overemphasis on technical assistance and capacity building is being justified in the name of reconstituting the damaged Afghan state. Much of the money under these heads goes to institutions like the Adam Smith Institute and expatriate professionals who are paid huge consultancy fees in foreign currency, not all of which is being spent in Afghanistan. A constant refrain heard among the expatriate population in Kabul is that Afghans lack the capacity to manage their own affairs. Despite the fact that these institutions and most NGOs manage their programmes, especially those outside Kabul, with the aid of local partners, and though many skilled personnel who left as refugees to Pakistan, Iran and elsewhere have returned, this line of thought overwhelmingly influences the management of aid-financed programmes.

It almost appears that the "lack of capacity" discourse supports a nexus of aid-financed professionals, who find in such arguments the justification for their own dollar-funded presence in the country, and of aid donors, especially agencies such as the World Bank, which can use those arguments to prevent the entry of more nationalist orientated people into the decision-making and implementation process. This is not a fact that goes unnoticed among the Afghan population. Interviews with Afghan professionals and members of the faculty at the University of Kabul inevitably generate comments to the effect that Afghan talent, more attuned to the socio-cultural and economic context of the country, is being ignored, while expatriate and non-resident Afghan "experts" are imported even when not required.

The still-evolving policy framework in Afghanistan provides reasons why nationalist perceptions may be considered dispensable. It is to be expected that with government expenditure substantially driven by aid disbursements, explicit and implicit aid conditionality is bound to influence the policy framework. The effort, therefore, is to ensure that those manning the government "own" the policies that such conditionality implies. Unfortunately that policy framework is not of a kind that could support the creation of a "domestic economic space" within which the Afghan state can fashion a nationally beneficial and egalitarian development strategy. Though the government's donor-driven strategy is yet in the making, it is clear that the inevitable import dependence of a war-devastated economy is being intensified, by encouraging an open trade policy that would discourage domestic industrial investment. Crucial social sector areas like health provision are being handed over to private entities and NGOs to run at a price, which though currently subsidised by aid, could easily be charged to the user at a later date.

Structuring dependence
The state has adopted as law the principle that the central bank cannot lend to the government. Thus, deficit-financed expenditure to revive the economy is ruled out, resulting in a near-complete dependence on aid for budgetary finance. The battered, publicly-owned financial sector, rather than being supported and strengthened, in order to be leveraged for domestic industrial financing, is soon to be subjected to competition from private, especially foreign, players. Since the need for a banking system that can mobilise local savings and channelise it to priority investments crucial to domestic private sector development is great, this shift can be disastrous. Foreign banks will only wean away the most lucrative (mainly expatriate) businesses from the local, publicly owned banking sector, while refusing to take any responsibility for development. Finally, though the new Afghani is formally the national currency, aid flows and the expatriate presence is dollarising the economy, with the dollar being traded on the streets and many service establishments quoting dollar prices and expecting payment in dollars.

These developments continue unchallenged partly because the vocal, urban domestic elite is being incorporated into the aid economy. Not only are salaries paid on time with the help of aid, the demand for services from the expatriate population is also on the rise. Rents quoted in dollars are rising fast because of the expatriate rush into Kabul and some other cities. These and other opportunities are resulting in the emergence of a new class of richer Afghans, living off the aid economy, which is happy with the freedom that an open, dollarised economy provides.

All this is fine for the moment since aid flows are leading to foreign exchange reserve accumulation with the central bank, which can use those reserves when required to prop up the new Afghani and prevent local prices of imported commodities from rising. But in the medium term, aid, import-dependence and dollarisation can all prove a burden. If the pace of aid inflow slows, not only will the just-reviving economy contract, but the Afghani would depreciate pushing up the prices of essentials in that segment of the economy still earning and living off the local currency. Stagflation, in an already depressed economy, will be the result. On the other hand, if aid inflows continue at present levels or rise in volume, inequalities between Kabul and the rest of the country, across differentially endowed regions and between income classes are bound to increase. That can have dangerous implications in a country that is still scarred by a complex chain of civil strife influenced by ethnic and religious divides.

The current model of development in Afghanistan is clearly unsustainable. But for those present in the country with short-term military and economic interests in mind, who are protected by the façade of altruism that a small dose of aid to a poor and devastated nation helps provide, this appears to be of no concern.

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