Report No: ACS8228 Islamic State of Afghanistan Pathways to Inclusive Growth Full Report March 2014 SASEP SOUTH ASIA 2 Afghanistan: Pathways to Inclusive Growth Standard Disclaimer: This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Copyright Statement: The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development/ The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978- 750-4470, http://www.copyright.com/. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org. 3 Afghanistan: Pathways to Inclusive Growth CONTENTS OVERVIEW ............................................................................................................................................................. 3 WHAT FUELED GROWTH IN AFGHANISTAN ..........................................................................................................................4 AFGHANISTAN’S GROWTH AND DEVELOPMENT PROGRESS REMAINS FRAGILE ............................................................................5 PATTERNS OF EXCLUSION .................................................................................................................................................5 TRANSITION – A GAME CHANGER ......................................................................................................................................6 FUTURE SOURCES OF ECONOMIC GROWTH..........................................................................................................................7 NATURAL RESOURCE DEVELOPMENT – A DOUBLE-EDGED SWORD ...........................................................................................8 A CONCEPTUAL FRAMEWORK FOR INCLUSIVE GROWTH IN AFGHANISTAN ................................................................................10 WHAT NEEDS TO CHANGE ..............................................................................................................................................13 1. CHAPTER ONE: EMERGING FROM CONFLICT ................................................................................................ 17 KEY MESSAGES ............................................................................................................................................................17 A BRIEF HISTORY OF GROWTH ........................................................................................................................................17 FROM CONFLICT TO RECONSTRUCTION .............................................................................................................................19 DRIVERS OF GROWTH: AID AND PUBLIC SECTOR DEMAND....................................................................................................28 WHAT GROWTH HAS AND HAS NOT DELIVERED .................................................................................................................30 2. CHAPTER TWO: CHALLENGES TO INCLUSIVE GROWTH ................................................................................. 32 KEY MESSAGES ............................................................................................................................................................32 PROFILING AFGHANISTAN’S LABOR FORCE .........................................................................................................................33 LABOR DEMAND: JOBS IN AFGHANISTAN ...........................................................................................................................36 ADDRESSING THE NEEDS OF VULNERABLE POPULATION GROUPS ...........................................................................................39 3. CHAPTER THREE: GROWTH OPTIONS FOR A COUNTRY AT A TURNING POINT .............................................. 52 KEY MESSAGES ............................................................................................................................................................52 TRANSITION – A GAME CHANGER ....................................................................................................................................53 FUTURE SOURCES OF GROWTH .......................................................................................................................................57 RISKS TO FUTURE GROWTH PROSPECTS ............................................................................................................................61 4. CHAPTER FOUR: MAKING GROWTH MORE INCLUSIVE ................................................................................. 69 KEY MESSAGES ............................................................................................................................................................69 A CONCEPTUAL FRAMEWORK FOR INCLUSIVE GROWTH IN AFGHANISTAN ................................................................................70 IMPROVING AFGHANISTAN’S GOVERNANCE ENVIRONMENT ..................................................................................................72 TRANSFORMING THE AGRICULTURE SECTOR .......................................................................................................................75 RESOURCE CORRIDORS: AN APPROACH TO MORE INCLUSIVE MINING .....................................................................................80 SUPPORTING GROWTH DYNAMICS IN SERVICES SECTORS ......................................................................................................87 INFRASTRUCTURE – THE CENTRALITY OF WATER AND ENERGY ...............................................................................................88 HUMAN CAPITAL DEVELOPMENT .....................................................................................................................................91 ACCESS TO LAND ..........................................................................................................................................................93 ACCESS TO FINANCE ......................................................................................................................................................95 REFERENCE LIST .................................................................................................................................................. 98 ANNEX 1: MAMS AFGHANISTAN ........................................................................................................................ 101 METHODOLOGY: OVERVIEW OF THE MAMS FRAMEWORK.................................................................................................101 SIMULATIONS ............................................................................................................................................................103 4 Afghanistan: Pathways to Inclusive Growth TABLES TABLE 1.1: CONTRIBUTIONS OF PRODUCTION FACTORS TO GROWTH (AVERAGE SHARE OF REAL GDP GROWTH).................................20 TABLE 1.2: SECTOR SHARES OF TOTAL VALUE ADDED..............................................................................................................21 TABLE 1.3: CEREAL PRODUCTION IN AFGHANISTAN (THOUSANDS OF TONS) .................................................................................24 TABLE 2.1: LABOR MARKET INDICATORS ...............................................................................................................................34 TABLE 3.1: DESCRIPTIONS OF SCENARIOS ..............................................................................................................................59 TABLE 3.2: SPEED OF PROGRESS IN INSTITUTIONAL REFORM.....................................................................................................64 TABLE 3.3: SECURITY, ECONOMIC, AND POLITICAL STRESSES OF THE CONFLICT.............................................................................66 TABLE A1.1: DESCRIPTIONS OF SCENARIOS ..........................................................................................................................103 TABLE A1.2: REAL MACRO INDICATORS BY SIMULATION (% ANNUAL GROWTH 2011/12-2025/26) ............................................106 TABLE A1.3: DOMESTIC DEMAND FOR DIFFERENT TYPES OF AID (%) .......................................................................................106 TABLE A1.4: AVERAGE ANNUAL GROWTH IN VALUE ADDED, 2011/12-2025/26 (%)* ............................................................107 TABLE A1.5: SHARES OF GDP AT FACTOR COST (%)* ...........................................................................................................108 TABLE A1.6: SECTOR DISTRIBUTION OF NEW EMPLOYMENT OPPORTUNITIES (% OF TOTAL EMPLOYMENT CHANGE) ..........................109 FIGURES FIGURE 1.1: GDP, 1965-2000 .........................................................................................................................................18 FIGURE 1.2: GDP PER CAPITA, 1965-2000 ..........................................................................................................................18 FIGURE 1.3: SECTOR DEVELOPMENTS (GDP IN INTERNATIONAL US$), AFGHANISTAN 1965-1993 .................................................19 FIGURE 1.4: REAL GDP GROWTH, 2003/04-2012/13 .........................................................................................................20 FIGURE 1.5: SOURCES OF GROWTH IN SOUTH ASIAN ECONOMIES, 2002-2011 (AVERAGE SHARE OF REAL GDP GROWTH)..................21 FIGURE 1.6: SERVICES SUB-SECTORS SHARES OF GDP, 2012/13 .............................................................................................22 FIGURE 1.7: AVERAGE GROWTH RATES OF SERVICES SUB-SECTORS, 2003/04-2012/13 .............................................................22 FIGURE 1.8: SECTOR CONTRIBUTIONS TO REAL GDP GROWTH (PERCENTAGE POINTS)...................................................................23 FIGURE 1.9: GROWTH IN REAL GDP & PRIVATE CONSUMPTION PER CAPITA ...............................................................................24 FIGURE 1.10: GROWTH OF REAL GDP AND SECTORS ..............................................................................................................24 FIGURE 1.11: TRADE BALANCE (% OF GDP) .........................................................................................................................25 FIGURE 1.12: STRUCTURE OF EXPORTS, 2012 (% OF TOTAL) ....................................................................................................25 FIGURE 1.13: EXPORTS-TO-GDP RATIO VS. GDP PER CAPITA (AVERAGE 2007-2012) .................................................................25 FIGURE 1.14: OFFICIAL DEVELOPMENT ASSISTANCE VS. GDP PER CAPITA ...................................................................................28 FIGURE 1.15: GROWTH IN SOURCES OF AGGREGATED DEMAND, 2004/05-2009/10. ................................................................28 FIGURE 1.16: GROSS DOMESTIC INVESTMENT IN SOUTH ASIAN COUNTRIES ................................................................................29 FIGURE 1.17: DOMESTIC SAVINGS VS. GDP PER CAPITA, 2011.................................................................................................29 FIGURE 1.18: NUMBERS OF VIOLENT INCIDENTS ....................................................................................................................29 FIGURE 1.19: INVESTMENT CLIMATE CONSTRAINTS 2013 .......................................................................................................29 FIGURE 1.20: AFGHANISTAN POPULATION PYRAMIDS .............................................................................................................31 FIGURE 2.2: LITERACY RATES BY AGE GROUP, AREA OF RESIDENCE, AND GENDER ........................................................................35 FIGURE 2.3: SKILL COMPOSITION OF THE LABOR FORCE AGED UNDER 30, BY AREA OF RESIDENCE AND GENDER ................................35 TABLE 2.4: TYPE OF EMPLOYMENT ......................................................................................................................................36 FIGURE 3.1: PROJECTED EXPENDITURE AND DOMESTIC REVENUE ..............................................................................................54 FIGURE 3.2: FINANCING GAPS, INCL. & EXCL. SECURITY ..........................................................................................................54 FIGURE 3.3: GROWTH SIMULATIONS FOR VARIOUS DEVELOPMENT SCENARIOS 2011-2025 ..........................................................59 FIGURE 4.1: A CONCEPTUAL FRAMEWORK FOR INCLUSIVE GROWTH ..........................................................................................72 FIGURE 4.2: PRIORITIZATION OF REQUIRED SKILLS FOR PLANNED EXTRACTIVE PROJECTS ................................................................86 FIGURE 4.3: STEPPING UP HUMAN DEVELOPMENT EFFORTS FOR AFGHANISTAN’S FUTURE ............................................................92 FIGURE 4.4: EVOLUTION OF AFGHAN MICROFINANCE SECTOR, 2003-2013 (MAIN INSTITUTIONS)..................................................97 FIGURE A1.1: AGGREGATED PAYMENT FLOWS FOR MAMS, AFGHANISTAN ..............................................................................101 5 Afghanistan: Pathways to Inclusive Growth FIGURE A1.2A: ASSUMED AID DEVELOPMENTS,...................................................................................................................104 FIGURE A1.3: DECOMPOSITION OF GROWTH IN GDP AT FACTOR COST (%) 2011/12-2025/26* ...............................................108 FIGURE A1.4: AGRICULTURE VALUE ADDED DEVELOPMENT, 2009/10-2025/26 .....................................................................110 FIGURE A1.5: ADDITIONAL MINING VALUE ADDED IN BASE AND MIN+ (CONSTANT US$ M) ......................................................111 BOXES BOX 1.1: OPIUM’S CONTRIBUTION TO AFGHANISTAN’S ECONOMIC GROWTH ..............................................................................27 BOX 2.1: INTERNATIONAL AID AND THE GROWTH OF THE NON-FARM SECTOR IN AFGHANISTAN .....................................................38 BOX 2.2: AGRICULTURE GROWTH AND POVERTY REDUCTION ...................................................................................................40 BOX 3.1: REVENUE MOBILIZATION IN THE POST-TRANSITION PHASE ..........................................................................................55 BOX 3.2: THE POLITICAL ECONOMY OF TRANSITION................................................................................................................56 BOX 3.3: LIMITATIONS OF THE MODEL .................................................................................................................................61 BOX 3.4: QUANTIFYING THE IMPACT OF CONFLICT..................................................................................................................62 BOX 3.5: PUBLIC FINANCIAL MANAGEMENT REFORMS IN AFGHANISTAN – A SUCCESS STORY .........................................................63 BOX 4.1: INTEGRATED SKILLS AND LITERACY PROGRAMS – FARMERS’ FIELD SCHOOLS ...................................................................79 BOX 4.2: DEVELOPING VALUE CHAINS THAT WORK FOR WOMEN – RAISINS, ALMONDS, AND SAFFRON ...........................................80 MAPS MAP 3.1: PRINCIPAL NATURAL RESOURCES IN AFGHANISTAN ...................................................................................................58 MAP 4.1: PLANNED RESOURCE CORRIDORS – SHORT- AND MEDIUM-TERM SEGMENTS ................................................................83 6 Afghanistan: Pathways to Inclusive Growth Abbreviations AMA Afghanistan Association of Micro Finance ANDS Afghanistan National Development Strategy ARAZI Afghanistan Land Management Authority CDA Community Development Agreements CGE Computable General Equilibrium Model CSO Afghanistan Central Statistics Organization EFS Externally Funded Staff EITI Extractive Industries Transparency Initiative EPHS Essential Package of Hospital Services FAO Food and Agriculture Organization of the United Nations GDP Gross Domestic Product LIC Low Income Country MIC Middle Income Country MISFA Microfinance Investment Support Facility for Afghanistan NATO North Atlantic Treaty Organization NEPS North Eastern Power System NHESP National Higher Education Strategic Plan NPP National Priority Program NRRCP National and Regional Resource Corridor Program NRVA National Risk and Vulnerability Assessment NTA National Technical Assistance O&M Operation & Maintenance PFM Public Financial Management SAO Supreme Audit Organization SME Small and Medium Sized Enterprises TFP Total Factor Productivity TMAF Tokyo Mutual Accountability Framework TVET Technical & Vocational Education & Training UNODC United Nations Office on Drugs and Crime USAID U.S. Agency for International Development USCENTCOM United States Central Command VAT Value Addeds Tax Acknowledgements 7 Afghanistan: Pathways to Inclusive Growth This report was prepared by a team led by Claudia Nassif and included Omar Joya, Hans Lofgren, Susanna Gable, Silvia Redaelli, Luke Jordan and Guillemette Sidonie Jaffrin. Important contributions were made by Philippe Chabot, Johannes Georges Pius Jansen, and Asta Olesen. The team thanks Ekaterin Stefanova and Peter Honey for tireless efforts and excellent assistance in editing and formatting. This report would have never seen the light without the strong encouragement and continuous support from Robert Saum, Ernesto May, Vinaya Swaroop and Faruk Khan. Priceless suggestions guidance and advice was received from the peer reviewers of this report: Auguste Tano Kouame, William Byrd, and Johannes Herdersche. The team is grateful to the World Bank country team in Afghanistan for continuous support and feedback during discussions. Preface In the first quarter of 2014 Afghanistan finds itself locked in a difficult political, security, and economic transition with outcomes uncertain. Presidential elections are scheduled for April 2014, and it is clear that the new government will face formidable challenges in reducing uncertainty so as to restore growth and sustainability in a context of pressing poverty, mounting employment issues, and an ongoing insurgency. The objective of this report is to present Afghanistan’s growth dynamics and challenges, analyze patterns of social inclusion, and discuss opportunities for sustained and shared growth and prosperity in the post-transition phase. This report is intended to serve as a foundation stone in the preparation of policy notes for the new government that is expected to take office in late spring of 2014. It builds on a large body of work produced by the World Bank country team in Afghanistan over the past couple of years. Specifically, it incorporates analysis and messages from  Afghanistan in Transition. Looking Beyond 2014. 2013  Afghanistan Resource Corridor Strategy. 2013  Resource Corridor: Community Benefits Sharing. 2013  Afghanistan Resource Corridor Development: Water Strategy - Final Kabul River Basin Report. 2013  Afghanistan Resource Corridor Development: Power Sector Analysis. 2013  Afghanistan Resource Corridor Skills Strategy Development Final Report. 2013  Women’s Role in Afghanistan’s Future - Taking Stock of Achievements and Continued Challenges. 2013  Public Expenditure and Financial Accountability. 2013  Afghanistan - Understanding Gender in Agricultural Value Chains: the Cases of Grapes/Raisins, Almonds and Saffron in Afghanistan. 2011  Poverty Status in Afghanistan. 2010  Afghanistan Gemstone Value Chain Report. 2010  Afghanistan Diagnostics Trade Integration Study. 2012  Afghanistan Agriculture Sector Review. 2014 (forthcoming)  Protecting Peoples’ Interests? A Social Analysis of Land Expropriation Law of Afghanistan. 2014 (forthcoming) This report uses all available data sets for household level, fiscal, monetary, and national accounts, drawn from official Afghan sources. Data availability and reliability in these data sets have improved greatly over time which has allowed for much deeper economic analysis, but as with many post-conflict countries, data collection and aggregation is still hampered by many security-related challenges and institutional weaknesses. Whenever possible, the team has cross-tabulated data and made adjustments based on technical judgments. Still, in light of the data challenges, the robustness and accuracy of the findings should be treated with a degree of caution and discretion. 2 Afghanistan: Pathways to Inclusive Growth Finally, a few topics relevant for growth and development in this report did not receive the in-depth treatment they probably deserve, due mainly to the attempt to keep the report concise and reader- friendly and because a discussion of these issues would have required a much larger research effort. The authors would like to highlight the following areas for future analysis and research to complement this report: (i) the magnitude and role of international migration and remittances, (ii) the optimal degree of regional integration beyond infrastructure cooperation, (iii) the role of cities and urban growth, (iv) job-creation in the informal sector, and (iv) deep determinants of governance and state building. 3 Afghanistan: Pathways to Inclusive Growth Overview By the time the Taliban regime was toppled in 2001, Afghanistan had already been deeply scarred by decades of civil war and military occupation. The economic infrastructure was massively destroyed, more than five million Afghans were displaced as refugees in neighboring countries, what economic activities remained were directed mostly in informal or illicit directions by insecurity, lack of public services, and a general absence of viable economic opportunities. The Afghan state was virtually non- functional. From this point, the country started to recover. Concerted government actions and strong, efforts in reconstruction and state building have led to a revival of the economy, increased domestic revenues, and a gradual expansion of public services across the country. The development outcomes achieved during this relatively short period (between 2002 and 2011/12) are impressive: GDP per capita increased from US$186 to US$688. Gross primary school enrollment has risen from 19 percent to 72.4 percent; the percentage of Afghans with access to improved water sources has grown from 22 percent to 45.5 percent; maternal mortality has almost halved, and life expectancy has improved from 45 years to 48.7 years. But 12 years after it began its march towards peace and prosperity, Afghanistan is once again at a difficult juncture in its history. The government is dealing with an unprecedented political, security and economic transition with challenges that could potentially threaten the future stability and development of the country. Presidential elections are scheduled for April 2014 and a degree of uncertainty exists over efforts to build broad-based alliances and whether the new government will be sufficiently cohesive to make significant policy decisions. Meanwhile, the country faces the prospect of a drawdown of most international forces that so far have that supported the fight against the ongoing insurgency. While the Afghan forces have demonstrated growing competency in responding to security incidences against the backdrop of increased violence, uncertainty persists about the security outlook once most international forces have left. The largest challenge, however, is an economic one. The military operations were supported by massive amounts of international aid that have fueled the economy and financed most of the government’s operations and investment. With this aid set to decline, Afghanistan is presented with a new reality: the loss of its primary growth driver and consequent rise in risks to macroeconomic stability and fiscal sustainability. At the same time, poverty rates remain stubbornly high and demographic pressures are mounting. Afghanistan urgently needs to nurture a growth model that not only produces new jobs for the many labor market entrants and provides opportunities for those left behind but also generates sufficient domestic revenue and foreign exchange to sustain government and development operations. This report identifies conditions and opportunities for a more job-rich and inclusive growth agenda for Afghanistan. It is organized into five chapters:  Chapter 1 analyzes Afghanistan growth patterns and dynamics and highlights the country’s pressing development challenges  Chapter 2 identifies excluded groups in Afghanistan and discusses constraints to social and economic inclusion 4 Afghanistan: Pathways to Inclusive Growth  Chapter 3 discusses the implications of the ongoing transition process and the country’s options for future growth  Chapter 4 proposes a conceptual framework for growth and present priority actions for reform What Fueled Growth in Afghanistan Albeit volatile, Afghanistan’s economic growth averaged 9.4 percent per year between 2003 and 2012. Part of this exceptional growth performance is explained by the high level of aid Afghanistan received over the past decade. Official development aid and military assistance grew continuously from US$404 million in 2002 to more than US$15.7 billion in 2010, the equivalent of 98 percent of GDP. About one- third of these aid flows went into the development of civilian infrastructure and services, such as education, health, electricity, and roads. This has produced higher aggregate demand for goods, services, and construction. The needs of post-conflict reconstruction shifted Afghanistan’s economic structure away from agriculture (24.6 percent) to a higher share of services in GDP (53.5 percent). However, services remain largely unsophisticated, dominated by wholesale and retail services, transportation, and government services. At 12.8 percent, manufacturing is a relatively marginalized economic activity which hardly contributed to economic growth over the past decade. Afghanistan’s economy remains essentially agrarian. In spite of the structural shifts in the economy, agriculture remains one of the largest contributors to economic growth. In 2012, for instance, it contributed over half of the 8.3 percent of GDP growth, thanks to favorable weather conditions and an exceptionally rich harvest. The heavy reliance on agriculture also explains the large volatility: around one-third of Afghanistan’s agriculture is rain-fed, which makes agricultural output and GDP growth heavily dependent on weather. However, the economy is driven by agriculture in more than just one dimension: 96 percent of manufacturing and most of Afghanistan’s exports depend on agricultural production. Not surprisingly, private aggregate demand is highly correlated with agricultural output, as it constitutes a source of income for nearly half of the population. Nevertheless, Afghanistan is not able to fully meet its food needs in most years and depends on food imports from neighboring countries. Afghanistan’s export base is very narrow, reflecting the country’s limited agricultural production and small manufacturing base. Official exports – mostly dried nuts and fruits, other derivatives of agricultural production, and carpets – amounted to only 5.5 percent of GDP in 2012/13. There is also the large, unrecorded export of opium (estimated at 7-8 percent of GDP). But even factoring in illicit exports, Afghanistan underperforms in exports. Countries at similar income level tend to have an export-to-GDP ratio closer to 30 percent. From a demand perspective, aid is the second-largest economic force in Afghanistan. The country is highly aid-dependent, financing most of the national budget, investment, and imports. Private investment, domestic or foreign, has been very low and contributed little to growth in recent years. This is mainly a reflection of Afghanistan’s challenging security environment. Crime, theft, and disorder – a proxy for violence – and political instability have been identified as the largest constraints to investment, followed closely by limited access to electricity, finance, and land. 5 Afghanistan: Pathways to Inclusive Growth Afghanistan’s Growth and Development Progress Remains Fragile The 2011 World Development Report on Conflict, Security and Development argues that governments need to provide security, jobs, and justice to citizens in order to move away from fragility and conflict. While initial progress in producing development outcomes was very encouraging in the immediate post- Taliban era, recent trends point to rising insecurity, deteriorating governance, a stagnant poverty rate, and mounting challenges to employment:  The security situation deteriorated after 2009 and the level of violence remains high. Annually, between 2,000 and 3,000 civilians are harmed or killed in violent incidences related to the ongoing insurgency.  Economic growth has not been pro-poor. Poverty levels are high, with 36 percent of the population living below the national poverty line in 2011/12 and more than 50 percent vulnerable to becoming poor. Recent data suggests that overall poverty levels have not declined between 2007 and 2011, despite rapid growth in this period. At the same time, inequality measured by the Gini coefficient appears to have increased somewhat.  Unemployment is relatively low, at 8.2 percent in 2011/12 but underemployment is a serious issue, with 16.8 percent of the employed population working less than 40 hours per week. At the same time, labor participation is low, at 60 percent, due mainly to a very low participation of women in the labor market.  The governance deficit relative to other low-income countries is still very large. Reforms in areas that could have improved rule of law and control of corruption have been very slow. Corruption is pervasive and widespread. In 2012 Transparency International ranked Afghanistan 174th out of 176 countries, joint last with North Korea and Somalia. But most concerning is that the governance situation appears to have regressed, especially in areas such as control of corruption, rule of law and political stability. In addition, the country is facing huge demographic challenges. The Afghan labor market is characterized by a young and fast-growing workforce. Decades of conflict, international migration and staggeringly high fertility rates make Afghanistan – together with Pakistan and Nepal – one of the youngest countries in South Asia. Between 2010/11 and 2015/16 alone, the labor force is expected to increase by 1.7 million people, and by an additional 4 million by 2025/26. These trends pose significant risks to social cohesion in a situation that is already characterized by strong political, regional, and ethnic tensions. Patterns of Exclusion Why has growth not been more pro-poor? Preliminary analysis suggests a number of reasons why growth has so far failed to produce more jobs and income for the poor: First, the volatility of agricultural 6 Afghanistan: Pathways to Inclusive Growth growth likely hampers prospects for poverty reduction since agriculture accounts for more than half of employment. Poor households in Afghanistan, especially those who subsist on agriculture, have few risk- coping mechanisms and are more strongly affected by agricultural output contractions than richer, wage-earning households. This would explain why growth has not benefited the poor and also perhaps why inequality has increased. Second, the persistent high level of un- and underemployment implies that growth in Afghanistan did not produce sufficient employment opportunities, which might have reduced the poverty impact. Finally, the increase in violence over the same period might have disproportionally affected the poor. Deterioration in the security situation limits the possibilities for public service delivery, the outreach of humanitarian development efforts, and access to markets for the poor. Moreover, insecurity also restricts access to public services, especially for women and children who might refrain from visiting clinics or going to school. The report identifies four main population segments that have been largely excluded from the growth process and are at risk of being disadvantaged in future:  The low-skilled workforce. Literacy levels in the Afghan working population are extremely low, especially among adults and women. Both literacy and education level tends to correlate with lower levels of poverty in Afghanistan.  The rural poor. Agriculture provides income for around half of Afghanistan’s population; for 30 percent of households it constitutes the most important source of income. Agriculture is the main source of livelihood and subsistence for 70-80 percent of the rural population in Afghanistan. Employment in agriculture is characterized mainly by small family businesses that produce mainly for subsistence.  Youth. The proportion of population aged 15 or below is as high as 51.3 percent, meaning that more than one in every two Afghans is economically dependent. Young people tend to be better educated on average, especially in urban areas. However, they are also less likely to find paid employment.  Women. While almost every man in the age range of 25-50 is economically active, only one in every two women participates in the labor market. While the female participation rate does not appear very low within the South Asian cultural context, women in Afghanistan are much less engaged in wage-earning employment. At the same time, the fertility rate is very high, at 5.1 percent in 2011/12. Increasing the share of female labor market participation will key to reducing fertility and reducing demographic pressures in the future. Transition – a Game Changer In light of the large role of aid in Afghanistan’s economy, the transition raises the question of how the decline in aid will affect the Afghan economy. Simulations show that the decline in aid (as currently implied by donor commitments) is likely to halve Afghanistan’s future growth prospects. Even with favorable assumptions, which include gradual improvements in security and good progress in developing extractive industries, Afghanistan is unlikely to achieve growth rates averaging higher than 4.8 percent annually through 2025. 7 Afghanistan: Pathways to Inclusive Growth 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 un- and underemployment, and little progress in reducing poverty. For example, at a rate of 4.8 percent GDP growth per year, it would take Afghanistan more than 20 years to increase real GDP per capita from its current estimated level to that of the South Asian region (2011), which is US$786. Convergence to South Asian income levels would then become an even further distant goal. 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. But a larger risk looms on the fiscal and macroeconomic front. Afghanistan’s aid dependence is predominantly a fiscal issue. While most civilian and military aid has been delivered in the form of development projects outside of the government’s budget system, on-budget aid is an important financing source. While domestic revenues increased to an impressive 11.4 percent of GDP in 2011, Afghanistan can today only finance about 40 percent of its total expenditures on its own. Moreover, expenditures are expected to increase, as the government will assume more financial responsibilities over the military apparatus and the operation and maintenance of public assets which were built outside of the budget and have not yet been factored into the budget. Finally, Afghanistan will need to continue to invest in expanding public service delivery and physical infrastructure in order to safeguards the gains of the reconstruction process and further support the growth process. Public investment will continue to play a dominant role in Afghanistan’s economy, at least until the security situation and the investment climate improves. Current projections see a financing gap of 20 percent of GDP in 2025, on the assumption that the government manages to increase domestic revenue to 17 percent. This renders government operations unsustainable without additional external financing. Continued, strong donor engagement in Afghanistan will therefore be of paramount importance to Afghanistan’s future development, if not its survival as a state. Macroeconomic stability has relied heavily on large aid flows. 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. Consequently, the balance of payment showed a persistently high deficit in the current accounts. So far, the high level of aid have helped to keep the overall balance of payments in surplus and even contributed to a sizable accumulation of international reserves over the years. However, with aid declining, an alternative source of financing will be required to balance payments for imports. The implications of the transition process, therefore, give urgency to Afghanistan’s need for a growth model that provides not only high numbers of jobs but also high levels of fiscal income and foreign exchange earnings to finance Afghanistan’s development process. Future Sources of Economic Growth With its low levels of development and economic structure, Afghanistan is still at an early stage of economic transformation. The country’s future growth model will therefore in all likelihood rely on its 8 Afghanistan: Pathways to Inclusive Growth agricultural potential and natural resource abundance. Education levels are too low and the manufacturing sector too underdeveloped (in size and capacity) to expect leapfrogging of 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. Moreover, the limited production of primary goods as inputs into production and the prohibitive cost of trade smother the development of a competitive manufacturing sector. Currently the potential for productivity and output growth is largest in the agricultural and extractive industry sectors. As agriculture and extractive industries develop further, along with related infrastructure, development in other sectors will ensue through demand for construction, upstream and downstream services, and possibilities for manufacturing. Extractive industries offer good opportunities for growth, fiscal revenues and export earnings. Afghanistan is endowed with a wide range of minerals, from well-documented assets in copper, coal, iron ore, gold, and oil and gas, to more speculative deposits in those minerals, as well as lithium and others. The Aynak (copper) and Hajigak (iron ore) are the first two large-scale mines to be developed (and already tendered). In addition, geological surveys identified another 11 highly prospective mineral resources and at least two hydrocarbon basins: the modest Amu Darya basin, which began production in 2012, and the Afghan-Tajik basin, which is currently being tendered. If all of these opportunities for mineral development were to be seized, simulations show that economic growth could increase to 5.9 percent on average to 2025, compared to 4.9 percent in the BASE case which features only the development of the current projects in Aynak, Hagjigak, and Amu Darya. Improving productivity in agriculture could also increase GDP growth to 5.8 percent annually on average to 2025 (compared to the 4.8 percent baseline). An improved investment climate, predicated on improvements in security, that boosted the potential for both, mining and agricultural, could raise average GDP growth to 6.7 percent. While Afghanistan would require even higher growth in order to reach income convergence to other South Asian countries within a reasonable timeframe, it is difficult to conceive plausible scenarios for higher growth. Violence and conflict currently override all other constraints to investment. Achieving lasting peace, stability, and reconciliation therefore in the years to come remains the most critical determinant to growth and shared prosperity. Natural Resource Development – a Double-Edged Sword In the context of Afghanistan’s challenging security environment, a growth model-based approach to developing the agricultural sector and extractive industries is an attractive option for Afghanistan. Afghanistan has much reason to be optimistic about its future development prospects. Challenges are large but the hard-fought gains in health, education, infrastructure development, and institution building certainly improve the country’s chance of achieving a virtuous circle of productivity, growth, and development. However, considering the current level of violence and political developments, it is likely that it will take many years to fully restore peace and stability even in the best-case scenario. Any growth-enhancing policies therefore need to be realistic and aim at supporting sectors and economic activities that show the best potential for conflict resilience and, in turn, provide the largest impetus for conflict reduction. 9 Afghanistan: Pathways to Inclusive Growth Agricultural development meets this requirement as it would directly improve income for the majority of households in Afghanistan. And as the large volatility in agriculture output demonstrates, the sector still has potential to grow even within the existing parameters of insecurity and violence. The large international interest and successful outcome of the recent tenders for the exploration and production in Amu Darya, Aynak, and Hajigak indicate a similar “conflict resilience” for extractive industries. However, international experience shows that not only does natural resource exploitation have limited job creation potential, but that it also carries large risks, especially for governance, social cohesion, and conflict. With the development of the extractive industries, Afghanistan is now adding another stress factor to its already-vulnerable country context. In fact there is ample empirical evidence that natural resource endowment can be detrimental to the development prospects of a country – even under more favorable circumstances than those found in Afghanistan. The phenomenon of countries endowed with natural wealth producing low development outcomes is described as the “natural resource curse” which is usually a result of (i) a decline in the competitiveness of other economic sectors due to an appreciation of the real exchange rate as resource revenues enter an economy (the “Dutch disease” effect), (ii) volatility of revenues from the natural resource sector due to exposure to global commodity market swings, (iii) governmental mismanagement of resources, and/or (iv) weak institutions, rent-seeking behavior, and redistributive struggles. Most critical for Afghanistan is the notion that natural resources can undermine governance and spur conflict by challenging livelihoods, threatening the environment, and raising disputes over rights to control the resources; feelings of relative deprivation arise from the distribution of revenues from resource exploitation or providing financing to insurgent groups. In this sense, the development of extractive industries poses a serious threat to Afghanistan’s weak governance environment. How can Afghanistan manage the risk of a resource curse? Avoiding the pitfalls of such a curse will require a strong and concerted effort to improve economic management and governance. Development options include:  Promoting diversification. The risk of Dutch disease is expected to be relatively low in the medium term given that the depreciative effect of the expected decline in aid will likely outweigh the appreciative pressures arising from new investment and export receipts across the various mining scenarios. This provides an opportune time window to use resource-based development as an anchor for diversification. As the natural resources sector develops, mining- related commodities will quickly dominate Afghanistan’s exports. This could exacerbate volatility, both of fiscal and export revenues. Further diversification of the economy is therefore a good strategy by which to avoid heavy reliance on natural resources and reduce exposure to price volatility. The National and Regional Resource Corridors Program (NRRCP), together with the National Priority Program on agriculture and rural livelihoods, developed by the government, could provide a good anchor for diversified development. Priority programs for implementation could include:  Deepening the commitment to transparency by establishing social accountability mechanisms . Ensuring transparency and accountability over revenues from natural resources is vital for reducing corruption and rent-seeking opportunities. Recognizing the importance of 10 Afghanistan: Pathways to Inclusive Growth transparency, the government has demonstrated a formal commitment to good governance in the extractive sector by joining the global Extractive Industries Transparency Initiative (EITI). This commitment can be deepened by strengthening social accountability mechanisms to ensure that the needs of Afghans affected by mining operations are understood and attended to.  Fostering a transparent and strong budget process. The government has made the policy decision to treat the revenues from the sector within the normal budgetary process. Continuing to build the strength and transparency of the budget process and public finance institutions will therefore be critical to the effective use of these funds once they arrive in the single account.  Community benefits sharing. The licenses for both Aynak and Amu Darya mines contain provisions to provide benefits for the communities affected by the extractive investments. Licenses for the next deposits awarded are expected to contain similar provisions. The Ministry of Mines recently published social policy guidelines for the mining sector, identifying key social issues to be addressed by the government, mining investors, and civil society. Funding requirements likely to result from such provisions could be significant, and it is imperative to develop a framework for community benefits sharing to inform existing and forthcoming mining sector investments. A Conceptual Framework for Inclusive Growth in Afghanistan Afghanistan’s development challenges are daunting and complex. Many of the problems Afghanistan faces need a broad, holistic approach to resolve them. However, efforts in the past couple of years have failed to fully achieve stability, poverty reduction, and job creation. Afghanistan’s development approach, therefore, must change to become more effective. Given Afghanistan’s limited fiscal space, development efforts need to become more selective and targeted at the country’s main sources of growth and drivers of social and economic inclusion. Investments and policy reforms to enhance growth need to be combined with interventions targeted in favor of the four population groups that have benefited least from the growth of recent years: low-skilled workforce, unemployed youth, excluded women, and vulnerable poor. This report proposes a framework for inclusive growth that could help to better prioritize development efforts. In essence, the proposed framework for inclusive growth suggests concentrating development efforts on (i) enhancing growth prospects by removing constraints to private investment and productivity in agriculture, mining, and services, (ii) addressing common obstacles to growth with strategic interventions, and (iii) identifying and implementing mainstream interventions that promote inclusion of the four target groups identified in the previous paragraph. The growth framework is underpinned by a stable macroeconomic framework and concerted efforts to improve the governance environment. 11 Afghanistan: Pathways to Inclusive Growth Figure 0.1: A Conceptual Framework for Inclusive Growth The report discusses the following elements of the proposed framework:  A stable macroeconomic and fiscal framework. From a strategic perspective and in recognition of all risks, a parallel concentration on the development of agriculture and natural resources promise to provide the necessary foundations for macroeconomic stability since both would foster fiscal revenues and export earnings which, in turn, would contribute to attaining fiscal sustainability and external stability. However, macroeconomic policy in Afghanistan is predominantly a fiscal affair. Increasing domestic revenues to 17 percent – as outlined in the current fiscal projections, concerted efforts to mobilize revenues will be needed.  Governance. There is an urgent need to strengthen governance in Afghanistan. Not only is better governance necessary to reduce violence and conflict in the country but it will be crucial to the success of a growth model based on natural resources. Moreover, Afghanistan will remain aid-dependent for years to come, and although donors have committed sufficient funds to sustain development gains throughout 2016, the flow of funds is by no means guaranteed. It is, rather subject to – among other conditions – improvements in governance. Accelerating governance reforms is therefore not just a development option for Afghanistan, but it is essential for the country to survive as the state it emerged in the early 2000s. More and deeper analysis is required to better understand governance dynamics in Afghanistan and constraints to reforms in Afghanistan. But at a pragmatic, institutional level, there are five broad governance 12 Afghanistan: Pathways to Inclusive Growth areas that call for attention in view of Afghanistan’s growth challenges: public finance management, anti-corruption, rule of law, and civil service reforms in sub-national governance.  Agriculture. Maximizing growth in agriculture will require more attention to improving irrigation water conveyance, area expansion in both irrigated and rain-fed agriculture, and public investment in agriculture research and knowledge services. Job creation can be fostered by supporting access to credit, marketing and technology, promoting crop diversification and promoting opportunities for female participation through targeted value chain interventions.  Services. The development of the agricultural and mining sectors are expected to increase the demand for services in down- and upstream industries, including transportation, logistics, communications, retail, and finance. Given the limited need for highly sophisticated services in these sectors at this stage of development, it can be expected that, for the most part, the services industry will “take care of itself” in the sense that it will naturally adapt to the level and patterns of demand and develop the necessary capabilities. The historic expansion of the services sector in Afghanistan proves the case in point. However, to support the dynamism of the services sector, efforts to improve the investment climate, especially with regard to ease of entry and exit of businesses as well as the costs of doing business, should be continued. The development of the services sector also offers good opportunities for entrepreneurship programs targeted to women and youth, especially in urban areas.  Mining. Giving Afghanistan’s capital and knowledge constraints, developing natural resources requires large international investment. While many investors have signaled interest, there are still a number of imposing constraints that need to be overcome, including the lack of critical infrastructure, general shortage of skilled, professional workers, and large gaps in the legal and regulatory environment. But even if these development challenges were met, the job impact from developing the mineral sectors is expected to be minimal. Implementing the planned natural resource corridor program could help to maximize the job impact and make mining more inclusive of local community interests.  Infrastructure. Agriculture and the natural resource sectors share common constraints with respect to infrastructure, specifically with respect to water and power supply. Here, developments in both sectors will add to the already high and increasing demand. While it is important to enhance existing infrastructure to reduce inefficiencies and improve distribution, it will be equally necessary to think about the development of new water resources and sources of power supply. Solutions to increase supply exist domestically but are ultimately best supported by fostering regional cooperation efforts.  Human capital. Prioritization of human capital interventions is made difficult by the large human development gaps in Afghanistan. Interventions need to be holistic in nature and cover an entire range of instruments across the entire spectrum of human capital development. TVET interventions, however, could be better linked to market needs and formulated within a sector approach for agriculture and natural resource development. It is therefore recommended to 13 Afghanistan: Pathways to Inclusive Growth improve social safety as an integral part of Afghanistan’s human development strategy in order to reduce the vulnerabilities of poor population groups.  Ownership and access to land. Land markets in Afghanistan suffer from a broad range of issues related to the legal, regulatory and institutional environment. Accelerating land title clearance processes for the resource corridor and develop better leasing schemed for small holders could directly support the development of the two key sectors, natural resources and agriculture, in Afghanistan. However, changes to land laws and regulations as well enhancing the institutional capacity of Afghanistan’s land authority will be equally important to ensure that land issues, especially those of excluded population groups, are adequately addressed.  Access to finance. After some initial progress in the banking and microfinance sector in Afghanistan, crises emerged that pointed to fundamental issues with banking/microfinance regulations and oversight as well as limitations of available financing products. It is recommended that efforts continue to improve supervision and oversight in the banking and microfinance sector and further strengthen institutional capacities. What Needs to Change The government of Afghanistan has a clear, formulated vision to become more self-reliant by 2025. 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”. 1 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”. This vision is embedded in the Afghan National Development Strategy (ANDS) and, within it, the National Priority Programs (NPPs). The NPPs highlight the need for investment in all priority sectors that are critical to achieving economic growth: mining, agriculture, and infrastructure (transportation, energy, and water). 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. However, Afghanistan has not yet formulated a growth strategy for the post-transition phase that would help to prioritize resources and policy actions. Both, the ANDS and NPPs are too comprehensive in their coverage and include too many projects that far exceed the funds likely to be available. The sheer number of proposed projects and programs opens the possibility for donors to cherry pick their favorite programs and leaves essential programs that are needed to enhance growth and job creation under- or unfunded. Moreover, both ANDS and NPP’s are too focused on investment as opposed to policy reforms that could equally well support Afghanistan’s growth and development objectives. 1 Government of Afghanistan, 2012. Towards Self-Reliance: Strategic Vision for the Transformation Decade . Afghanistan. Link: http://mof.gov.af/Content/Media/Documents/Towards-Self-Reliance-27-6- 2012167201210282583553325325.pdf 14 Afghanistan: Pathways to Inclusive Growth The new government will have an opportunity to reexamine and consolidate Afghanistan’s development program and underpin it with a well-formulated growth strategy. The inclusive growth framework proposes to focus on addressing short-term macroeconomic and fiscal concerns as well as long-term microeconomic interventions to remove constraints to investment, productivity, job-enhancement and social and economic inclusion. The following table outlines priority actions for reforms. Ongoing work on the policy notes for the new government will further refine and elaborate these options with suggestions for the short and medium term: Area and objective Priority actions for reforms  Expedite the introduction, implementation and subsequent Maintaining macroeconomic widening of the VAT stability and improving fiscal  Reduce leakages at customs by expanding the computerized risk- sustainability management system, increasing controls and strengthening the enforcement capabilities of the customs administration  Create an enabling environment for mining investment by continuously improving the legislative and regulatory framework Improving agriculture  Improve irrigation water conveyance and use efficiency productivity and inclusion in  Increase agricultural production (area) agriculture development  Increase public investment in agricultural research and knowledge services  Support access to credit, marketing, and technology  Promote crop diversification and improve value chains  Mainstream gender in value chains Implementing the National  Launch preparation activities for infrastructure investment along Resource Corridor Program and the resource corridor fostering inclusion in natural  Improve and enact mining law and regulations resource development  Step up EITI validation efforts  Deepen commitment to transparency by establishing social accountability mechanisms  Strengthen government oversight departments within the Ministry of Mines and Petroleum  Support small-scale mining and women jewelry makers  Provide livelihood support and targeted vocational training  Encourage community development agreements between mining investors and communities Ensuring continued  Streamline paperwork required for the transfer and registration. development of services This could involve computerizing the process and the creation of a single-access point for property registration  Amend the laws for joint stock companies, corporations and Limited corporations to improve disclosure requirements, increase director liability in related party transaction and to make it easier for investors to enforce their rights through courts  Reduce the number of required documents for trading across borders and align process with international god practice, including 15 Afghanistan: Pathways to Inclusive Growth the elimination of product-specific export permits  Conduct a mapping exercise to identify delays during trials and enforcement of the judgment Improving and expanding  Construct new dams in Kabul River basin or, alternatively, critical Infrastructure construct a water reservoir (“impoundment dam”) as a medium- term solution.  Rehabilitate existing dams throughout Afghanistan, especially in the South (high water scarcity)  Establish a clear definition of the institutional setting for O&M of the irrigation facilities  Start River Basin-based Integrated Water Resources Management approach  Initiate Disaster Risk Management by (i) strengthening data collection and analysis capacity, (ii) sharing hydromet data with neighboring countries, and (iii) establishing an inter-ministerial platform  Strengthen on-farm water management  Continue active engagement in international forums such as the South Asia water initiative and use other platforms for regional cooperation on trans-national water issues  Continue to (i) improve electricity transmission and distribution, (ii) strengthen the regulatory framework, and (iii) improve service delivery and O&M management to restructure energy institutions  Maintain strong commitment to regional power projects such as TAPI and CASA 1000 Enhancing human development  Continue to expand equitable access to basic education by constructing more schools and recruiting more teachers  Promote public-private partnerships in higher education and TVET  Improve equity of education by implementing targeted interventions such as increasing the numbers of qualified female teachers, create more female-only institutions, strengthen data collection on marginalized groups or test innovative approaches to improve enrollment and retention  Increase the quality of basic, secondary, tertiary education and TVET by implementing the National Qualifications Framework n  improve higher education by (i) strengthening government systems to increase the quality of basic and secondary education services, and (ii) better linking TVET and vocational training initiatives to market needs and aligning them with a sectoral approach for agriculture and natural resource development  Strengthen systems at the Ministry of Public Health to support basic service delivery, improve tertiary care hospitals that are in a very poor state of maintenance, and address an array of barriers to health service delivery  Establish a robust early childhood education and nutrition program  Carefully study and consider different social protection and social safety options with respect to financial affordability with the public finance system  Issue national youth policy and implement targeted interventions to mainstream youth in development programs Improving access to land  Support amendments to land management and land acquisition 16 Afghanistan: Pathways to Inclusive Growth laws and ensure public awareness of land related policies and laws  Formalize out-of-court dispute settlement through a recognized process  Increase capacity of ARAZI and improve its governance structure  Shift from court-based registration to an administrative system and accelerate land title clearance along resource corridor  Formulate a state land allocation policy Improving access to finance  Enhance banking supervision by enacting improved banking laws and further increase capacity at the Afghanistan Central Bank.  Strengthen the credibility and regulatory and supervisory capacity of Da Afghanistan Bank critical for financial sector stability  Strengthen the microfinance sector with a dual focus on stability and innovations  Strengthen financial sector infrastructure(collateral registry, public credit registry, payment system, Afghanistan Institute of Banking and Finance) Improving governance  Formulate and implement an anti-corruption action plan  Enhance transparency and accountability of the budget process by improving internal and external audits and reviewing the legal foundations and institutional arrangements for budgeting  Initiate a comprehensive procurement reform program  Initiate the devolution of PFM/fiscal responsibilities to front-line service units and improve financial managements functions of line ministries down to provincial level  Increase productivity and strengthen accountability structures of judiciary institutions  Regulate modalities in the civil service system by (i) developing staffing capacity to manage harmonization and monitor skill transfer from 2nd to core civil service, (ii) improving data management for civil service employees, (iii) implementing the National Technical Assistance (NTA) guidelines for pay harmonization, and (iv) transitioning out of temporary pay modalities within the core civil service  Strengthen and professionalize the civil service by (i) approving the civil service law, (ii) establishing professional cadres in priority areas, (iii) improving recruitment process, and (iv) increasing staffing capacity at sub-national levels  Increase accountability of the civil service by (i) approving the Administrative Procedure Law which covers the right of citizens to government information, (ii) defining service standards for key services in line ministries and (iii) strengthening public service grievance redress measures. 17 Afghanistan: Pathways to Inclusive Growth 1. Chapter One: Emerging from Conflict With a population of approximately 30 million, Afghanistan is a medium-sized, low-income country that has undergone a large transformation over the past decade. The changes that occurred in the country’s developmental landscape since the beginning of reconstruction from 2001/02 are clearly visible. There have been major achievements: expanded public services delivery (especially basic health and education), improved life expectancy and maternal mortality rates, and greater participation of women in the economy and political decision-making process. A strong and solid growth record has supported this progress; real GDP grew at an average annual rate of 9.2 percent between 2003/04 and 2012/13. However, as this and the following sections will argue, Afghanistan’s growth and development process remains very fragile. The 2011 World Development Report on Conflict, Security and Development emphasizes the necessity of building and transforming institutions in ways that provide security to citizens, jobs, and justice in order to move away from the fragility and conflict. Initial development progress was very encouraging, but recent trends point to rising insecurity, deteriorating governance, a stagnant poverty rate, and mounting challenges to employment. This chapter is a first step toward better understanding Afghanistan’s economic development process over the past decade. It will analyze growth patterns and dynamics in Afghanistan, take stock of development achievements, and discuss some of the major development challenges ahead. Key Messages  Afghanistan’s economy remains largely agrarian. Manufacturing contributed very little to economic growth over the past decade with the economy dependent primarily on agricultural output. The service sector is relatively unsophisticated and mainly informal.  Structural changes observed over the past ten years have come from reconstruction and recovery activities financed predominantly by donors.  Private-sector investment, hampered by persistent and increasing violence, has been very small. Growth over the past decade was driven mainly by demand from public sector activities.  There have been some important achievements. However, development challenges are still very large. In spite of strong economic growth, poverty remains pervasive and has not decreased in the past five years.  With 400,000-500,000 young people entering the labor market annually, Afghanistan faces an unprecedented demographic challenge. Without drastic changes in the country’s security situation to enable greater private investment, labor market pressures will continue to rise, and in turn increase the risk of conflict and violence.  Enhancing the impact of growth on poverty and shared prosperity in the post-transition period will require steps to ensure that growth is strong and steady, accompanied by greater job creation. A Brief History of Growth Protracted conflict, accompanied by droughts and other natural disasters, severely damaged the Afghan economy. Up until the early 1970s, Afghanistan enjoyed a period of peace and stability. But two political coups in 1973 and 1978, the ensuing Soviet occupation, civil war in the 1990s, and the rise and 18 Afghanistan: Pathways to Inclusive Growth fall of the extremist Taliban government, kept Afghanistan in a state of conflict until the end of the NATO intervention in 2001. Historical data and information on Afghanistan’s economy is scarce. But what we do know is that Afghanistan started out with a GDP per capita level similar to that of other developing countries in the 1960s. However, with low growth in the 1970s and then a decline after the Soviet occupancy in the 1980s,2 Afghanistan’s development path fell away from that of other developing countries.3 Under Taliban control, GDP growth recovered somewhat but the consequences of a very restrictive policy agenda, extremely low investment in physical and human capital and marginal global integration practically destroyed Afghanistan’s economic basis for production (Figures 1.1 and 1.2). Figure 1.1: GDP, 1965-2000 Figure 1.2: GDP per capita, 1965-2000 Source: Bolt, J. and J. L. van Zanden (2013) Source: Bolt, J. and J. L. van Zanden (2013) Agriculture was the dominant sector up until the reconstruction phase and accounted for more than half of GDP (Figure 1.3). With rain-fed agriculture being the most prevalent form, output was subject to climate-related changes and droughts. Nevertheless, by the end of the 1970s, before the Soviet occupation, Afghanistan was almost self-sufficient in agriculture and a net exporter of agricultural products (mostly raisins and nuts). But the conflict in the following decades affected important production factors: labor migrated or joined resistance forces, land was damaged, and irrigation systems and other infrastructure were destroyed. As a result agricultural development was suppressed. This, combined with a growing population, left Afghanistan far from self-sufficiency in agriculture, in spite of the fact that it was the most important economic activity. By contrast, other countries in the region experienced a “green revolution” that helped increase productivity and integrated the agriculture- dependent economies among them with global markets, thereby reducing poverty. 2 The peak in 1986 is believed to be a data error. 3 Maddison, 2010. 19 Afghanistan: Pathways to Inclusive Growth Figure 1.3: Sector Developments (GDP in international US$), Afghanistan 1965-1993 Source: World Bank (2004). The sectoral GDP data are based on several sources and are extrapolated for the years without data. GDP from Bolt, J. and J. L. van Zanden (2013) Historically, the industrial sector has been very small. In the 1970s, Afghanistan’s industry was small (around 10 percent of GDP) and processed mostly primary products (cotton textiles, fertilizers, cement, and other construction materials). A large part of the manufacturing industry was public; non- agricultural private businesses were small, mostly family-based and focused on handicrafts. War prevented further growth because it lowered household income and, consequently, aggregate demand, which in turn diminished infrastructure and decreased the labor supply. Estimates of the extent to which conflict affected industrial growth vary among data sources, but there is general agreement that after initial growth based on low-value-added products, Afghanistan failed to industrialize further and never built up its capabilities for modern production. Services were relatively dynamic before the conflict period. Services accounted for more than one- third of GDP by the end of the 1970s, but declined steadily thereafter. Data on sub sectors are limited but there seems to have been a reduction across all sub-sectors, from transport to banking, tourism, and social services. In 1993, services accounted for about one-quarter of GDP, as did industry, while agriculture made up about half of GDP. From Conflict to Reconstruction Starting from a very low base in the early 2000s, the economy began to recover as the reconstruction process gathered momentum. GDP growth reached an average of 9.2 percent between 2003 and 2012, and for the first time in decades, GDP per capita was rising (Figure 1.4). Such high growth rates are not unusual for counties emerging from conflict. Conflicts often result in massive physical and human capital destruction (as in Afghanistan), and during a recovery phase investments generate high returns in capital accumulation. Consequently, Afghanistan’s GDP per capita increased from US$186 in 2002 to US$688 in 2012. 20 Afghanistan: Pathways to Inclusive Growth Figure 1.4: Real GDP Growth, 2003/04-2012/13 . Source: Afghanistan Central Statistics Organization (CSO) Post-2002 growth was driven primarily by the country’s reconstruction needs. Not surprisingly for a country emerging from conflict and with low capital stock, GDP growth in Afghanistan was largely driven by an increase in capital – or simply put, equipment and structures. Table 1.1, which decomposes economic growth into different factors of economic production, shows that capital investment contributed 47.2 percent to the economic growth between 2002 and 2012. T ABLE 1.1: Contributions of Production Factors to Growth (average share of real GDP growth) Growth Accounting Contributions to Growth (α = 40%) † (%) ‡ 2002-2012 2002-2007 2008-2012 Capital Stock 47 64 30 Labor 22 27 16 Human Capital per Labor 5 6 3 Total Factor Productivity 26 3 51 Real GDP 100 100 100 Source: World Bank staff calculations based on CSO data Since returns on capital investment are higher when capital stock is low, capital accumulation contributed more to economic growth in the initial years of the reconstruction process (2002-2007), and was evidently higher in Afghanistan than in other South Asian economies (Figure 1.5). Total factor productivity (TFP), which captures the portion of growth that remains unexplained by either capital or labor, seems to have increasingly contributed to growth in recent years. On average, around 26 percent of growth over 2002-2012 is attributable to growth in total factor productivity. TFP's contribution to growth increased from merely 2.8 percent between 2002 and 2007, to around 50 percent between 2008 and 2012. The increase in TFP's contribution to growth is, however, unusually high and could be explained by either improvements in institutional capital (e.g., better governance, enhanced administrative systems, etc.), technological progress and/or improvements in efficiency or the favorable weather conditions that led to much higher than average agriculture growth between 2008- 2012. Even so, the contribution of human capital to growth has been rather low in Afghanistan, especially between 2008 and 2012. This is due most likely to slow growth in the country’s active labor 21 Afghanistan: Pathways to Inclusive Growth force and low returns on human capital investment which, in the case of Afghanistan, would not at all be surprising, considering the low level of education in the existing work force and that it typically takes a long time to capitalize on investment in human capital (see also Chapter 2). Figure 1.5: Sources of Growth in South Asian Economies, 2002-2011 (average share of real GDP growth) 100% 25.7 25.1 33.4 80% 43.4 5.0 13.3 5.2 Total Factor Productivity 60% 22.0 15.5 4.0 Human Capital per Labor 34.5 11.3 40% Labor Capital Stock 47.2 46.0 20% 41.3 27.1 0% Afghanistan Pakistan India Sri Lanka Source: World Bank staff calculation based on WDI data The needs of post-conflict reconstruction shifted Afghanistan’s economic structure. Typically, reconstruction increases the demand for goods, services, and construction. But given Afghanistan’s limited production base, goods were mostly imported. Reconstruction efforts, therefore, have mostly benefited growth of the construction and services industries. This has shifted the structure of the economy towards services (Table 1.2), which grew as a proportion of GDP from 37.8 percent in 2002 to 53.5 percent in 2012, while other sectors contracted. On average, services contributed 5.8 percentage points to the average 9.4 percent of growth between 2003 and 2012 (Figure 1.8). Table 1.2: Sector Shares of Total Value Added 2002/03 2004/05 2006/07 2008/09 2010/11 2012/13 Agriculture 38.5 30.3 29.2 25.4 27.1 24.6 Industry 23.7 26.7 28.8 27.5 21.9 21.8 Manufacturing 18.7 17.9 16.7 18.2 12.9 12.8 Mining 0.1 0.3 0.4 0.5 0.6 1.0 Construction 4.8 8.4 11.6 8.7 8.2 8.0 Industry-other 0.1 0.1 0.2 0.1 0.1 0.1 Services 37.8 43.0 41.9 47.1 51.0 53.5 Source: World Bank staff calculations based on CSO data The fastest-growing services subsectors have been communications (55.3 percent), government services (19.1 percent), and financial services (16.4 percent). However, in terms of impact on overall services growth (taking account of both the growth rate of the sub-sector and the share in total 22 Afghanistan: Pathways to Inclusive Growth services), the contributions of financial and business services are still marginal (Figures 1.6 and 1.7). Services growth is driven mainly by the large share and strong growth in transportation and basic communications, followed by government services. Wholesale and retail trade also plays an important role but mainly through its weight in total services rather than its growth. Overall, the services sector shows little sophistication. Figure 1.6: Services Sub-Sectors Shares of GDP, 2012/13 Wholesale and retail 0.8 1.2 trade Transportation and 2.0 storage 1.0 8.2 3.6 Communications and postal services Government services Financial services and real estate 13.0 Ownership of dwellings 19.4 Community, social and personal services 4.4 Restaurants and hotel Other services Figure 1.7: Average Growth Rates of Services Sub-Sectors, 2003/04-2012/13 Communications and postal services Government services Financial services and real estate Restaurants and hotel Transportation and storage Other services Wholesale and retail trade Ownership of dwellings Community, social and personal… 0.0 10.0 20.0 30.0 40.0 50.0 60.0 Percent Source: both CSO Manufacturing remains marginalized. Within the industrial sector, construction and the production of food and beverages alone made up 94 percent of total industrial output in 2012/13. And while growth rates have been respectable in some industries, their impact on industry growth as a whole is very small (Figure 1.8). This is not surprising, since Afghanistan does not yet produce sufficient primary products to 23 Afghanistan: Pathways to Inclusive Growth use as inputs for subsequent stages of production. Agricultural production (other than opium) is below a self-sufficiency level, and mining activities are just starting to emerge on a larger scale. Consequently, manufacturing relies on imports. However, inadequate infrastructure, cumbersome trade logistics, and an insecure environment render imports too costly to manufacture competitively. In 2012, Afghanistan ranked 133rd among 155 countries in the Global Logistics Performance Index measuring the “friendliness” of a country’s trade and logistics environment. Agriculture, together with services, is still the largest contributor to economic growth. In spite of the structural shift in Afghanistan’s economy, agriculture remains one of the largest contributors to economic growth. In 2012, for instance, it contributed over half of the 14.4 percent of GDP growth, thanks to favorable weather conditions and an exceptionally rich harvest. Depending on the harvest in any given year, agriculture accounts for one-fourth to one-third of GDP. Figure 1.8: Sector Contributions to Real GDP Growth (percentage points) 25.0 20.0 15.0 Services 10.0 Electricity, gas, water Percent Construction 5.0 Mining and quarrying 0.0 Manufacturing Agriculture -5.0 -10.0 Source: World Bank staff calculations based on CSO data Afghanistan’s economy is dominated by agriculture in more than one dimension. Aside from its direct contribution to GDP, agricultural production feeds into the economic growth process through its impact on aggregate demand and significance in manufacturing. In 2011/12, 49 percent of all households derived their income from agriculture; for 30 percent of all households agriculture constitutes the main income source. Not surprisingly, private aggregate demand is highly correlated with agricultural production (Figure 1.9). Moreover, 96 percent of the manufacturing sector depends on agricultural products for inputs (food and beverages, textiles, and leathers). Due to its strong dependence on agriculture, economic growth in Afghanistan is volatile. Wheat accounts for approximately 60 percent of agricultural output and is the most important crop, next to opium (see Box 1.1). Around one-third of wheat production is rain-fed, which makes agriculture output highly volatile and dependent on rainfall. Given agriculture’s weight in GDP, economic growth tends to follow the same cyclical pattern as agricultural output (Figure 1.10). 24 Afghanistan: Pathways to Inclusive Growth Figure 1.9: Growth in Real GDP & Private Consumption Figure 1.10: Growth of Real GDP and Sectors per capita Source: CSO Source: CSO Notwithstanding agriculture’s importance to the economy, Afghanistan is not able to fully meet its food needs. Before the conflicts, Afghanistan was self-sufficient in cereals – and in some years was able even to be a small exporter. Today, however, and despite the large area devoted to cultivation of the primary staple (wheat), Afghanistan remains a highly food-insecure country (Table 1.3). High year-to- year fluctuations in domestic cereal production make the country dependent on food imports and have exposed the economy to external food-price shocks. For example, wheat demand in 2011 stood at 4.69 million tons, while national production was only 3.46 million tons, leaving a food deficit of more than 1.20 million tons. Adding to this a seed demand of 626,000 tons, the overall wheat deficit in 2011 was nearly 1.86 million tons. Table 1.3: Cereal Production in Afghanistan (thousands of tons) 2007 2008 2009 2010 2011 2012 Total wheat production 4,343 2,767 5,064 4,532 3,456 5,008 Estimated wheat demand 4,330 4,416 4,505 4,595 4,687 4,362 Seed demand and losses 734 677 806 753 626 1,067 Surplus/shortfall -721 -2,326 -247 -816 -1,857 -422 Sources: World Food Program (2012); Agriculture Commodity Price Bulletin (year 8, vol. 7), and Agriculture Prospects Report, July 2012 As a result of the limited agricultural production and narrow manufacturing base, Afghanistan is underperforming in exports. The few data points that exist for historical trends in trade imply that trade, just before the Soviet occupation, was fairly balanced but constituted an extremely small part of the economy.4 Since then, imports have always been higher than exports, resulting in an increasing trade deficit, especially during the Soviet occupation. Demand for imports increased during the reconstruction period and has resulted into a large, structural trade deficit, estimated at 41.9 percent of GDP in 2012/13 (Figure 1.11). Official exports amounted to only 5.5 percent of GDP in 2012/13. 4 Structural Performance of the Afghan Economy. Report No. 30861. World Bank, Washington, DC, 2004. 25 Afghanistan: Pathways to Inclusive Growth Countries at a similar income level to Afghanistan tend to have an export-to-GDP ratio closer to 30 percent (Figure 1.13). The structure of exports remained largely unchanged, ignoring the temporary surge of natural gas exports during the Soviet occupation: the largest export is dried fruits, followed by carpets, derivatives of agricultural production (cotton, skins, wool), and medicinal plants (Figure 1.12). Figure 1.11: Trade Balance (% of GDP) Figure 1.12: Structure of Exports, 2012 (% of total) Source: IMF, 2012 Source: World Bank Staff calculations based on CSO data Figure 1.13: Exports-to-GDP Ratio vs. GDP per capita (average 2007-2012) 250.0 200.0 150.0 Percent 100.0 50.0 0.0 Afghanistan 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 13.0 GDP per capita (current US$, in log) Source: World Bank staff calculations based on WDI Aside from the officially recorded agricultural output, Afghanistan is noted for its large, unrecorded export of opium. Poppy cultivation emerged in the 1970s and has become Afghanistan’s leading economic activity and an illicit export commodity. Between 1990 and 2007, opium production increased from 1,500 metric tons to 8,200 metric tons. In the early 2000s, opium generated between one-sixth and one-third of national income, depending on data sources. More recently, the economic importance of opium is declining, due partly to lower production and growth in other economic sectors. Opium’s contribution to economic growth was only 0.2 percentage points on average (see Box 1.1). Nevertheless, 26 Afghanistan: Pathways to Inclusive Growth opium remains a significant economic activity that provides income for 6-7 percent of all households (NRVA 2011/12). 27 Afghanistan: Pathways to Inclusive Growth Box 1.1: Opium’s Contribution to Afghanistan’s Economic Growth Afghanistan is the world’s largest producer of illicit opium. The raw drug is considered the most important cash crop and provides livelihoods for many households in rural areas. But it also fuels conflict and undermines governance by providing income to insurgents and other criminal groups. Given the illicit nature of opium and the inherent lack of information, there are many misperceptions about its significance to the Afghan economy. A question that often arises, therefore, is how important opium production really is to Afghanistan’s economy. In terms of production and share of GDP, opium’s importance has been declining since 2007, when it reached a record production of 8,200 tons. Nowadays, production is closer to 3,700 tons (UNODC, 2012), which amounts to 3.3 percent of GDP in farm-gate value, or 10 percent in export value – compared to 13 percent of GDP by farm- gate value in 2007. However, measuring opium production as part of the national income is not straightforward. While the UNODC and the Afghan authorities survey opium production and prices, it is unclear how this should be factored into the national accounts. Should the national accounts include only opium production? Or should they also include the value created in the processing and trading of the drug? How much of the value created is captured by the local economy, e.g., in farmers’ income? How much of it is directly expatriated and would, therefore, have only minimal benefit for the Afghan economy? Opium exports are not recorded in the balance of payments in Afghanistan, which diminishes the Central Bank’s monetary control. However, the drug income may underestimate per-capita income. Nevertheless, the data is principally available and reported by the Afghan Central Statistics Organization’s national accounts publication. The CSO records the farm-gate value of opium production as agricultural output and disregards the value-addition from subsequent processing stages and trade. Figure 5: Opium Production in Afghanistan (1994-2012) Figure 6: Licit and Illicit Real GDP Growth 9,000 25.0 8,000 20.0 7,000 6,000 Metric Tons 15.0 5,000 4,000 10.0 3,000 2,000 5.0 1,000 - 0.0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012* 1994 2001 2008 1995 1996 1997 1998 1999 2000 2002 2003 2004 2005 2006 2007 2009 2010 2011 2012 Real GDP growth (non-opium) Real GDP growth (opium) Source: UNODC/MCN opium surveys Source: Central Statistics Organization 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 6). However, average opium GDP growth has been only slightly higher than non-opium GDP growth: 9.4 percent compared to 9.2 percent, which suggests that between 2003 and 2012 opium has not been an important driver of economic growth. That said, opium is still Afghanistan’s single most important cash crop and therefore has significant implications for income and consumption of rural, poor households. The average cash income of poppy-growing households is 52 percent higher than that of households that had never grown poppy. Poppy-growing households also tend to be 5 farther away from markets. This, in turn, adds to the complexity of finding the right approach to reducing opium production, which ultimately hinges on the development of alternative and competitive agricultural supply chains. 5 United Nations Office on Drugs and Crime, Afghanistan Opium Survey 2012, Vienna, Austria. 28 Afghanistan: Pathways to Inclusive Growth Drivers of Growth: Aid and Public Sector Demand From a demand-side perspective, the public sector – financed by aid – is the economy’s largest driving force. To understand the structure and dynamics of the Afghan economy, it is critical to acknowledge the country’s large aid dependence. Reportedly, foreign aid has long played a large role in Afghanistan’s economy. Public expenditure grew from 17.8 percent of GDP in 1978 to 48.2 percent in 2002 and nearly always exceeded the government’s capacity to mobilize revenue. The rising fiscal deficit was financed by foreign aid or borrowing (Guimbert, 2004).6 Military and financial aid from the Soviet Union was vital for to the government in the 1980 to early 1990s.7 It is probable that the Taliban government’s minimal government operations and investments were financed mainly by money printing (Guimbert, 2014). Then, during the 2000s, reconstruction efforts, military and civilian aid steadily increased to US$15.7 billion by 2010, about the same as the level of Afghanistan’s GDP in the same year.8 Such an aid level is uniquely high; relative to GDP per capita Afghanistan is an outlier among aid-receiving countries, even if only civilian aid is counted (Figure 1.14). Decomposition of growth in the sources of demand illustrates the extent to which aid influences Afghanistan’s economy: Figure 1.15 shows that private and public consumption, rather than investment or exports contributed to growth. Within consumption, private consumption appears to play a larger role. However, this picture is somewhat misleading because public aid projects, financed by donors outside of the national budget, are considered private consumption in the national accounts. Considering the high amounts of aid Afghanistan received over the past years, it would be fair to assume that a large chunk of private consumption can also be considered “public”. Figure 1.14: Official Development Assistance vs. GDP Figure 1.15: Growth in Sources of Aggregated per capita Demand, 2004/05-2009/10. Source: World Bank staff calculations based on WDI Source: World Bank staff calculations based on CSO data Private investment, by contrast, contributed little to economic growth. At first glance, gross domestic investment does not appear much lower than other South Asian countries and relative to Afghanistan’s income level (Figure 1.17). However, the domestic saving rate is much lower than one would expect 6 It is unclear how the budget was financed during the Taliban government but it is believed that the budget was small and that expenses were being financed by printing money (Guimbert, 2004). 7 World Bank (2013). Afghanistan in Transition: Looking Beyond 2014. Washington, DC 8 World Bank (2013). Afghanistan in Transition: Looking Beyond 2014. Washington, DC. 29 Afghanistan: Pathways to Inclusive Growth from a country with similar GDP per capita, and is indeed negative (Figure 1.18). This implies that domestic investment must have been financed by foreign savings, in the form of foreign direct investment or grant transfers. Foreign direct investment has been very low – averaging only about US$252 million (2.5 percent of GDP) annually, leaving only foreign grants as financing source. Figure 1.16: Gross Domestic Investment in South Figure 1.17: Domestic Savings vs. GDP per capita, Asian Countries 2011 70.0 60.0 50.0 in % of GDP 40.0 30.0 20.0 10.0 0.0 Sources: World Bank staff calculations based on WDI, both Private investment is low due largely to the unstable security environment and political instability. The level of violence in the ongoing insurgency is still very high, and increased between 2007 and 2011 (Figure 1.18). Annually, between 2,000 and 3,000 civilians are harmed or killed in violent incidents. According to the latest Asia Foundation “Survey of Afghan People” (2013) nearly half of all Afghans fear for their personal safety or that of their families. Insecurity therefore remains Afghanistan’s largest development challenge. Crime and violence raise the cost of doing business in Afghanistan and deter domestic and foreign investment, as does uncertainty in the political environment. Political instability has been identified as the most important constraints in investment climate surveys in 2013, replacing crime, theft, and disorder which were considered the largest constraints to investment in 2008. However, in the Afghan context, both categories likely express general perceptions about security, political uncertainty, and law and order and might therefore be somewhat interchangeable. Figure 1.18: Numbers of Violent Incidents Figure 1.19: Investment Climate Constraints 2013 Source: US Department of Defense, 2012 Source: World Bank, Business Enterprise Survey, 2014 30 Afghanistan: Pathways to Inclusive Growth What Growth Has and Has Not Delivered Supported by foreign aid and a solid growth performance, the country has made great strides in providing its people with access to public services and improving key social indicators. Some of the most remarkable achievements include:  Gross primary school enrolment has soared from 19 percent in 2002 to 72.4 percent in 2011/12. More general school enrollment increased from 1 million in 2002 to 7.2 million children in 2011/12, of which 2.7 million (37 percent) are girls.  The percentage of population with access to improved water sources has increased from 22 percent in 2000 to 45.5 percent in 2011/12; the number of health facilities in Afghanistan increased from under 500 to over 2,000 between 2004 and 2012, of which 1,680 are primary care facilities and 74 percent have at least one female staff member. 91.2 percent of the population has now access to basic health care facilities within less than 2 hours distance.  Childhood mortality (under 5 years) decreased from 161 per 1,000 live births in 2007/8 to 91 per 1,000 live births in 2011/12. The maternal mortality rate has almost halved between 2000 and 2011. Life expectancy has improved from 45 years in 2000 to 48.7 years in 2011. In spite of these important milestones, Afghanistan remains a country with major development and inclusiveness challenges. Foremost, poverty levels in Afghanistan are still very high with 36.5 percent of the population living below the national poverty line in 2011/12 and more than 50 percent vulnerable to becoming poor. Unemployment is relatively low at 8.2 percent in 2011/12 but underemployment is a serious issue with 16.8 percent of the employed population working less than 40 hours per week. This means, that the labor market is currently short of 1.8 million jobs that can provide a sustainable living. At the same time, labor participation is low, at 49.8 percent, due mainly to a very low participation of women in the labor market (15 percent only). Growth in Afghanistan has not been pro-poor. The most recent NRVA 2011/12 suggests that overall poverty levels have not declined between 2007 and 2012 despite rapid growth during this period. At the same time, inequality measured by the Gini Index increased somewhat from 29.7 to 31.6.9 This trend poses risks to social cohesion in a situation that is already characterized by strong political, regional and ethnic tensions. Why has growth not been more pro-poor? A detailed, empirical analysis on this question is currently pending. However, there are indicators as to why growth has failed to produce more jobs and income for the poor. First, the volatility of agricultural growth likely affects prospects for poverty reduction since agriculture accounts for more than half of employment. Although agriculture grew by 45 percent in 2009, it actually contracted in 2008, 2010, and 2011, with limited irrigation and dependence on rain-fed crops contributing to volatility. Poor households in Afghanistan, especially those who subsist on agriculture, have only few risk-coping mechanisms and are more strongly affected by agricultural output contractions than richer, wage-earning households. In many cases, livelihood risks are being managed by disposing household assets or deferring expenditures for health and education services which, in turn, have negative dynamic effects for future income. This would not only explain why growth has not benefited the poor but could also explain the increase in inequality. Second, the persistent high level of 9 The Gini index measures the extent to which the distribution of consumption among individuals or households differs from a perfectly equal one. A value of 0 represents absolute equality with everybody consuming the same amount; a value of 100 represents absolute inequality, where all consumption is concentrated in one person/household. 31 Afghanistan: Pathways to Inclusive Growth un- and underemployment implies that growth in Afghanistan did not produce sufficient employment opportunities, especially for the poor and underprivileged segments of the population. Finally, the increase in violence over the same period might have disproportionally affected the poor. A deteriorated security situation restricts public service delivery, the reach of humanitarian development efforts, and access to markets for the poor. Moreover, insecurity also restricts access to public services, especially for women and children who might refrain from visiting clinics or going to school. The country is facing huge demographic challenges which will add pressures to the labor market. The Afghan labor market is characterized by a young and fast-growing workforce. Decades of conflict, international migration and relatively high fertility rates make Afghanistan – together with Pakistan and Nepal – one of the youngest countries in South Asia.10 The proportion of population aged 15 or below is as high as 51.3 percent, meaning that more than one in every two Afghans is economically dependent.11 Afghanistan’s population pyramid is characterized by a wide base that will maintain a sustained rate of growth in the number of new labor-market entrants for decades to come (Figure 1.20). Between 2010/11 and 2015/16 alone, the labor force is expected to increase by 1,7 million people, and by an additional 4 million by 2025/26, not accounting for any return migration or changes in participation rates. This means that every year 400,000 to 500,000 will potentially seek jobs. Afghanistan has one of the highest fertility rates in the world – 5.1 percent in 2011/12. Unless the fertility rate decreases, demographic pressures will continue to rise and reduce the demographic dividend. A high fertility rate, coupled with declining mortality rates, tends to produce a “youth bulge”. Normally, a youth bulge presents an opportunity for growth in the impending years, since it would lower the age dependency ratio, i.e., the population younger than 15 or older than 64 as a share of the number of people of working age. A decreasing dependency ratio means that a higher proportion of the population contributes to productive, income-raising work, relative to non-active dependents (e.g., elderly and children) which would consequently increase domestic savings and GDP per capita growth. But, a youth bulge could also pose a risk to stability if young people are left without viable jobs or other economic opportunities. Figure 1.20: Afghanistan Population Pyramid Source: World Bank staff calculation based on NRVA 2011/12 10 More and Better Jobs in South Asia. World Bank, 2011. 11 The dependency ratio – defined as the number of children aged 0-15 relative to the working age population (16 and above) – is 52.44 percent and 46.68 percent in rural and urban areas, respectively. 32 Afghanistan: Pathways to Inclusive Growth 2. Chapter Two: Challenges to Inclusive Growth As a result of decades of conflict, the Afghan labor market is very weak and faces tremendous challenges. The current sectoral and geographical distribution of the Afghan labor force emphasizes the stark predominance of the agricultural sector and provides limited prospects for mobility in more productive sectors. This is due to the poor skill levels of the labor force and to sluggish demand in non- farm sectors which tend to be dominated by small, family owned trade businesses and a low-skill, poor quality construction sector in which precarious, low-quality informal labor arrangements prevail. As pointed out in Chapter One, much of the growth achieved over the past 10 years has been fueled by massive aid inflows that stimulated demand in services, construction, and public sectors but did little to modernize the agricultural sector. This has led to a dualization of the Afghan labor market, with relatively few high-skilled positions predominating in the formal and public sector, while a plethora of vulnerable low-skilled or casual job opportunities populate the construction and services sectors. Inclusive growth with productive employment opportunities and empowerment of all groups in society will be crucial for continued peace and sustainable economic development in Afghanistan. Strong population pressure will continue to challenge labor market absorption capacity in the years to come, while growth and security prospects remain uncertain. The economy is now expected to transform from an aid-dependent economy to an economy based increasingly on mining and agriculture. However, especially with mining emerging as an important sector, there is also a significant risk that the benefits of growth will not be shared. Understanding Afghan patterns of exclusion and identifying constraints to inclusion within Afghanistan’s labor market characteristics is an essential step in the development of a strategy for inclusive growth. This section will look at labor market characteristics in Afghanistan and address the ability of people in Afghanistan to contribute to and benefit from economic opportunities, given their health, skills, and poverty situation as well, as the nature of labor and product markets. It will conclude with a discussion on implications for more a more inclusive growth and employment strategy. Key Messages  The labor market in Afghanistan is characterized by a strong rural-urban divide, low participation of women, and an increasingly young workforce and low literacy skills.  Women are largely excluded from income-earning activities. Greater inclusion of women in the labor market will be critical to reduce the staggeringly high fertility rate, which will otherwise continue to add to the demographic pressures.  The informal sector, especially households, is the first employer in Afghanistan, while the formal labor market is very thin and dominated by the public sector. Agriculture is the largest sector of employment but half of the time production is at subsistence level.  Increasing productivity in the agriculture sector has the potential of affecting directly the lives of 7 million people. However, since development needs time, it will be important to consider public protection and social safety options to be protect the vulnerable, rural population.  Addressing human capital challenges of the workforce need to focus on both young and adult generations. Progress in educating new generations could be encouraged through interventions aimed at 33 Afghanistan: Pathways to Inclusive Growth directing education choices towards addressing skill shortages of growth-relevant sectors (agriculture, mining, construction, business management). Ad-hoc TVET interventions and adult literacy-cum-skills training programs could help the adult generations with increasing chances of employability.  Youth unemployment is very difficult to tackle. Solutions are intrinsically linked to the development of a vibrant private sector which is currently hindered by the challenging security environment. Improving Afghanistan’s investment climate will be the best way to address youth unemployment. In the meantime, providing more and better education, mainstreaming youth issues in development programs, and strengthening civic and political participation can reduce the risks to social cohesion.  Providing women with employment opportunities is key to reducing fertility rates and demographic pressures. There are no simple solutions to reducing gender gaps in countries where the gap is deeply rooted in cultural and social practice. However, there is a range of instruments available to promote female employment within the Afghan country context, including mainstreaming gender in agriculture value chain programs, providing women with better access to health and education services, providing incentives for female employment, providing incentives and regulations for better childcare, mobility and women-friendly work places, and encouraging active participation of women in microfinance programs. Profiling Afghanistan’s Labor Force Labor force participation is generally low and characterized by a large gender gap and a strong urban- rural divide. Due to the very large share of children, only just over the half of the Afghan population (52 percent) is in the working age of 14 years and over. Within this working-age population of 14 million people, half is inactive and half in actively engaging in the labor market, either by working or looking for work. In comparison with other countries, this is considered very low. Low-income countries typically have a labor force participation rate of around 70 percent. This results in high dependency ratios. Moreover, the gender gap in Afghanistan’s labor market is particularly large: less than 19 percent of working age females is currently active in the labor market. In comparison, over 55 percent of females are participating in labor markets in low-income countries on average. It is noteworthy that Afghanistan’s urban labor market shows significantly lower participation and employment rates, due mainly to the lower participation of women, the elderly, and youth in urban labor markets. 34 Afghanistan: Pathways to Inclusive Growth Table 2.1: Labor Market Indicators Labor Force Employment to Underemployment Unemployment Participation Rate Population Ratio Rate Rate Urban 43.1 39.2 8.6 9.0 male 72.0 66.5 7.7 7.7 female 12.9 10.8 14.1 16.7 Rural 51.3 47.1 18.7 8.2 male 82.1 77.1 17.5 6.1 female 19.3 15.9 24.0 17.6 National 49.8 45.7 16.8 8.2 male 80.0 74.9 15.4 6.4 female 18.5 15.5 22.8 16.5 Source: NRVA 2011/12 Note: Underemployment defines all persons aged 14 and over who, during the reference period of one week, were (i) working less than 40 hours, and (ii) available and willing to work additional hours. Unemployment defines all persons aged 14 and over who, during the reference period of one week, were (i) without any work or working less than eight hours, and (ii) seeking work. The Afghan labor force is male-dominated, due to significantly lower female participation rates. Almost seven in every ten workers in Afghanistan are men, reflecting strong gender-based differentials in labor force participation (Table 2.1). The gender gap in participation rates is the greatest in urban areas, where only one in five women is active on the labor market.12 The role of women in the Afghan labor market is marginal. Of the 46.5 percent of women participating in the labor market, only 25 percent are actually engaged in paid employment, almost exclusively in the informal sector. In general, households rely on female employment as a last resort and female labor mainly serves as a buffer stock to be used in times of need and/or when labor demand is highest.13 Literacy levels in the Afghan working-age population are extremely low, especially among adults and women. Poor literacy and education levels represent a major constraint to labor market functioning, hindering overall productivity and limiting the scope for intra-sectoral mobility. Three decades of conflict have had long-lasting consequences in terms of stock of human capital; only one in three adult Afghans is able to read and write or has completed some formal level of schooling. These figures place Afghanistan in a very disadvantageous position with respect to other countries in the region, and are a large impediment in attracting productive investments and to future growth. The limited local availability of a skilled labor force has also shaped the poverty reduction potential of aid-induced growth that has occurred since 2001. Anecdotal evidence suggests that, because of local skills shortage, many of 12 Participation rates tend to be higher in rural areas, mostly due to labor intensive and low productivity employment in the agriculture sector. 13 Female labor force participation correlates strongly with seasonal labor demand in agriculture, reaching its peak during summer harvest times. Moreover, female participation correlates strongly with household wellbeing, being the highest in poorest households. Relatively higher participation rates in rural areas correlate strongly with lower levels of wellbeing and with the prevalence of underemployment, especially among marginal workers: women, youth, and the elderly. 35 Afghanistan: Pathways to Inclusive Growth the better-quality jobs created in the growing service and construction sectors had been filled with foreign labor. Education levels are improving for younger cohorts, benefiting from post-conflict investments in education. As is evident from Figure 2.2 and 2.3, literacy rates tend to be on average higher for younger people, especially in urban areas where schools are more accessible and where most of the skilled labor force migrates looking for employment opportunities. Low-skill employment will remain dominant until older workers retire and/or have their skills improved through training or ad-hoc literacy programs. However, it is important that the education system accommodates increasing demand for higher education14 and that the labor market provides enough good quality jobs to meet the increasing influx of younger and more educated workers. Every year, about 40,000 high school and 4,000 university graduates will enter the labor market and will look for good quality jobs, mainly in the public sector and especially in urban areas. Figure 2.1: Literacy Rates by Age Group, Area of Residence, and Gender Source: World Bank Staff calculation based on NRVA 2011/12 Note: Youth denotes the population group of ages 15-24 years Figure 2.2: Skill Composition of the Labor Force Aged Under 30, by Area of Residence and Gender Rural Urban 100% 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% Male Female Male Female No education Primary school No education Primary school Secondary/High school Tertiary Secondary/High school Tertiary Source: World Bank Staff calculation based on NRVA 2007/08 14 See the National Higher Education Strategic plan (NHESP) 2010-14. 36 Afghanistan: Pathways to Inclusive Growth Labor Demand: Jobs in Afghanistan Informality is a distinctive feature of the Afghan labor market. Households are the first employer in Afghanistan, while the formal labor market is very thin and dominated by the public sector. In common with other fragile and less developed countries, self-employment working arrangements are the most common form of employment in Afghanistan (Table 2.4). Including unpaid family work, Afghan households are responsible for more than 70 percent of total employment nationwide, or about 5.8 million jobs. Formal employment is more common in urban areas,15 due mainly to the contribution of public jobs, which represent 12 percent of total employment and almost twice as much as the number of salaried jobs in the private sector, nationwide. The large majority (81 percent) of the employed in Afghanistan fall within the category of vulnerable employment. Agriculture is the largest sector of employment in Afghanistan. Around 40 percent of the employed population works in the agricultural sector. Employment in agriculture is characterized mainly by small family businesses that produce mainly for subsistence and seldom provide enough resources to sustain families throughout the year.16 There is wide regional variation in the share of households relying on agriculture for living (Table 2.4), as well as substantial differences in the type of agricultural activity (e.g., subsistence, market, or wage labor). Table 2.3: Type of Employment Household Head Poverty Share of Poor Share of Characteristics Headcount (%) Population (%) Population (%) Day laborer 52.07 30.36 21.06 Salaried worker, private sector 31.43 6.65 7.64 Salaried worker, public sector 29.81 9.94 12.04 Self-employed 32.78 47.91 52.77 Employer 18.18 0.57 1.13 Unpaid family worker 30.81 4.57 5.35 Figure 2.4: Household Dependency on Agriculture as Principle Livelihood & Poverty Rate, Regional Shares 100 80 60 40 20 0 Southwest Central West East North South Northeast WestCentral WAGE LABOR AGRICULTURE FARMING Note: Poverty rate on the secondary axis Source: World Bank Staff calculation based on NRVA 2007/08 15 Formal jobs represent 29 percent of total employment in urban areas and 6 percent in rural areas. 16 As discussed in the Poverty Status Report, rural agricultural households have to rely on more than one income source throughout the year, especially during winter and spring. 37 Afghanistan: Pathways to Inclusive Growth The non-farm sector is dominated by employment in family-based, small-scale trade activities. Retail trade, with petty trade and shop-keeping, represents the main source of employment in the non-farm sector, followed by services and construction that benefited enormously from the massive inflows of aid over the last ten years (Figure 2.5 and Box 2.1).17 Manufacturing plays accounted for less than 5 percent of total employment nationwide. Other than the public sector (including health and education), occupations tend to be vulnerable, providing varying levels of income, often only on a seasonal/daily basis. Figure 2.5: Sectoral Distribution of Employment (Percent of Total Employment) Source: World Bank Staff calculation based on NRVA 2011/12 17 The non-farm sector accounts for 32 percent of employment in rural areas and 91 percent in urban areas. 38 Afghanistan: Pathways to Inclusive Growth Box 2.1: International Aid and the Growth of the Non-Farm Sector in Afghanistan Due to the nature and type of donor involvement in Afghanistan, much of security and civilian aid spending has been allocated to construction and services, especially transportation and logistics, retail and maintenance/repair. Over 75 percent of contractual spending by the United States alone was directed at these sectors. The Peace Dividend Trust (2011) surveyed 146 local businesses that won aid-financed contracts during 2006-2011 and found that the average length of a contract was six months with over half of the jobs lasting less. But it also found that efforts to improve local sourcing led businesses to retain some of the workers they employ; 58 percent of businesses that won aid-financed contract tenders ended the assignments with more employees than they started with. The authors of the study concluded that the contracts, which had a total value of $1.1 billion, created an estimated 118,000 jobs for six months. Afghan employment information varies due to disparate sourcing. The Ministry of Finance which reports that in 2010, 6,647 individuals working within the government received salaries or salary top-ups financed by donors. Including policemen and soldiers financed through donor trust funds, raises this number to 278,887. ISAF registers between 60,000-80,000 Afghans directly employed through various military-related contracting agencies without stating the length of employment or possible errors due to double counting. The United States Agency for International Development (USAID) estimates that between 31,600 and 60,000 jobs (based on various sources) were created through USAID contracts. However, it is unclear if this number includes second-round effects – for example, jobs created indirectly through aid money via the economic stimulus. USCENTCOM reports that US- financed contracts employed between 34,200 and 78,500 Afghans, including contracts conducted by USAID and military agencies. There is, hence, much uncertainty even with regard to direct employment through aid contracts and the impact of transition on employment. While it is clear that transition will, at least in the perception of the population, exacerbate the current employment situation, the impact is likely to be dwarfed by the employment challenges of the future. Source: The World Bank (2013): “Afghanistan in Transition – Looking Beyond 2014” There are strong sectoral differences in the education composition of the labor force. Agriculture has the highest prevalence of low skilled jobs of all sectors in Afghanistan, with 87 percent of agricultural workers not having any formal education and unable to read and/or write. Similarly, low skill levels are in the construction and residual ”service” sectors, which have been among the fastest growing sectors for employment over the past decade, fueled by the massive inflow of international aid. Manufacturing, too, employs a predominantly uneducated workforce. Figure 2.6: Education Levels of Workers, by Employment Sector Other services Health Wholesale trade Manufacturing Road construction Agriculture/ livestoc 0% 20% 40% 60% 80% 100% No Education Primary Secondary Tertiary Source: World Bank Staff calculation based on NRVA 2007/08 39 Afghanistan: Pathways to Inclusive Growth Addressing the Needs of Vulnerable Population Groups Promoting inclusive growth requires a good understanding of the characteristics and needs of the population groups currently excluded from the Afghanistan growth process. The analysis above highlights four large population groups that deserve more attention in the formulation of an inclusive growth strategy and in the planning and execution of development interventions. These include (i) the rural poor, (ii) the uneducated workforce, (iii) youth, and (iv) women. The Rural Poor Poverty at the household level is the highest in rural areas. Agriculture (defined as annual crops, horticulture – including fruits and vegetables – and livestock) provides income for around half of Afghanistan’s population; for 30 percent of households it constitutes the most important source of income. Agriculture is the main source of livelihood and subsistence for 70-80 percent of the rural population in Afghanistan. Most of rural households that engage in subsistence farming activities focus on staple crop production while owning a few head of livestock. The predominant farming system is anchored in cereal production (primarily wheat) for household food security, but most smallholder households manage food self-sufficiency for only a few months of the year. Agriculture was badly affected by three decades of war to the extent that the irrigated cropped area decreased by almost 70 percent and crop productivity plummeted to less than 50 percent of the pre-war levels. Any growth strategy aiming to include the poorest segments of the Afghan population must focus on agriculture. Agricultural growth has long been recognized as an important instrument for poverty reduction, especially in countries where rural areas account for the bulk of the (poor) population, and where the dependence on labor-intensive agriculture is the highest. In the case of Afghanistan, improving productivity in the agriculture sector has the potential of directly affecting the lives of about 7 million Afghans. Agriculture growth offers rural households a number of pathways out of poverty: they can increase their incomes by selling agricultural products on markets, they can leave the subsistence economy and become market participants, and they can improve their well-being in the subsistence economy either through farming or through better opportunities in the non-farm sector. 40 Afghanistan: Pathways to Inclusive Growth Box 2.2: Agriculture Growth and Poverty Reduction A growing body of literature provides evidence on the capacity of agricultural growth to serve as an effective instrument for poverty reduction. Expenditure effects of GDP growth originating in Bravo-Ortega and Lederman (2005) estimated the effect of agriculture and non-agriculture an increase in sectoral labor productivity on GDP growth and the income of the poor. They found that overall GDP growth originating in an increase in agricultural labor productivity is on average 2.9 times more effective in raising the income of the poorest quintiles in developing countries than an equivalent increase in GDP growth originating in non-agricultural labor productivity. Christiansen and Demery (2006) estimated the effect of sectoral growth on the headcount poverty rate rather than on the income of the poorest. They found for Africa that overall GDP growth coming from agriculture is 2.7 times more effective in reducing US1$/day poverty in the poorest quarter of countries in their sample, and twice as effective in the richest quarter of countries as growth coming from non-agriculture. Ravallion Source: and Chen World (2007) estimated Development the effect Report of sectoral growth on the headcount poverty rate in China using (2008). annual poverty data over 21 years. They find that the primary sector has a 3.5 times larger impact on poverty reduction than either the secondary or tertiary sectors. Using cross-country data from 55 countries with spells of observations, Loayza and Raddatz (2010) show that what matters for the poverty reduction capacity of growth is the unskilled labor intensity of a sector. In that perspective, agriculture comes ahead of industry and services. Growth originating in agriculture is 2.9 times more poverty reducing than growth originating in manufacturing and 1.8 times that of growth originating in construction. For the World Development Report 2008 on Agriculture for Development, Ligon and Sadoulet (2007) estimated the expenditure growth effect for each household decile in the distribution of expenditures due to GDP growth originating in the agricultural sector and to GDP growth originating in the nonagricultural sector, respectively. Results indicate that GDP growth originating in agriculture has a much larger positive effect on expenditure gains for the poorest households than growth originating in the rest of the economy. Afghan households, especially those living in rural areas, are highly vulnerable to shocks. Analysis of NRVA 2007/08 data shows that 71 percent of households had suffered from (at least) one negative shock during the year preceding the survey, with multiple shocks being the norm rather than the exception.18 The frequency of shocks is the highest in rural areas – consistent with the prevalence of natural (weather related) and agricultural shocks – and decreases monotonically from the poorest to the richest quintiles of (per-capita) expenditure. The main “coping” mechanism of Afghan farmers entails decreasing expenditure (Table 2.5). In the specific context of Afghanistan, where more than half of the population is consuming at a level of less than 120 percent of the poverty line, even small negative shocks have the potential to push many individuals into poverty.19 There is also prevalence of informal arrangements based on mutual assistance from community members or informal credit. However, these 18 Afghan households faced, on average, two shocks during the year before the interview; 2.2 shocks in rural and 0.9 in urban areas. 19 World Bank. Afghanistan Poverty Status Report. July 2010 41 Afghanistan: Pathways to Inclusive Growth are only available as long as the shock does not affect the entire community. Poor households tend to suffer the most from negative shocks as they have limited access to credit and are more likely to respond with behaviors that have long lasting welfare reducing implications in terms of health (by reducing quantity and quality of food intake) and income generation (by depleting productive assets). Table 2.5: Main Risk-Coping Behaviors – Households Cope by... Coping Strategy Urban % Rural % Total % Reducing food quantity 29 40 37 Reducing food quality 66 82 79 Decreasing food expenditure 69 84 80 Purchasing food on credit 16 40 34 Taking loans or credit 68 66 66 Selling house or land 3 5 4 Selling reproductive livestock 2 24 21 Selling other productive assets 5 6 6 Dropping children from school 5 11 10 Increasing child labor 10 23 20 Selling child bribes 2 3 3 Begging 1 1 1 Source: NRVA 2011/12 Negative coping strategies have detrimental effects on households’ ability to make productive investments in their future. A growing body of research shows that high vulnerability to risk is associated with underinvestment in productive assets and with negative outcomes of malnutrition and underinvestment in education.20 In the case of Afghanistan, long and repeated series of shocks continue to have tremendous costs on the country’s human capital, with obvious negative consequences for its future growth performance. Afghanistan has one of the highest mortality rates in the world for children under five years of age21 and the highest rate of chronic malnutrition (stunting) among South Asia countries (Figure 2.7). Nutrition, especially at early stages of childhood development, plays a critical role in shaping the potential for human capital accumulation. A growing body of research shows that benefits of health and nutrition for infants can have long lasting effects that persists through life, and that damages from childhood disease and malnutrition in terms of lost opportunity for learning can be difficult to undo. Low levels of cognitive development in early childhood are often strongly correlated with low socioeconomic status and malnutrition. Protein and micronutrient deficiencies, which often begin before birth, can impair cognitive and physical development, with negative impact on school, and consequently, on future labor market outcomes. 20 See Grosh et al. (2008). 21 Estimated at 102-105 out of 1000 live births for children under 5. Afghan Public Health Institute, Ministry of Public Health (APHI/MoPH), Central Statistics Organization (CSO), ICF Macro, Indian Institute of Health Management Research (IIHMR), and World Health Organization Regional Office for the Eastern Mediterranean (WHO/EMRO) (2011). “Afghanistan Mortality Survey 2010”. Calverton, Maryland, USA: APHI/MoPH, CSO, ICF Macro, IIHMR and WHO/EMRO. 42 Afghanistan: Pathways to Inclusive Growth Figure 2.7: Children (Under Five) with Malnutrition in South Asia 70 60 50 40 30 20 10 0 STUNTING UNDERWEIGHT WASTING (height for age) (weight for age) (weight for height) Sri Lanka (2000) Maldives (2001) Bhutan (1999) Pakistan (2001) Bangladesh (2005) India (2006) Nepal (2006) Afghanistan (2004) Source: World Bank 2011 “More and Better Jobs in South Asia” Assisting Afghan households coping with risk is essential given their crucial role in generating employment. Self-employment and small businesses are the main sources of employment beyond the public sector and the casual labor originated by international contractors. With the expected decrease in foreign assistance in the coming years, the role of Afghan households as a motor of employment generation will be even stronger. In this respect, policies aimed at supporting households to effectively reduce, mitigate and cope with risk are likely to have a strong stimulating impact on growth. Table 2.6 outlines some risk management options that could be applied in Afghanistan. 43 Afghanistan: Pathways to Inclusive Growth Table 2.6: Risk Management Options Arrangement Informal Market-based Public /Strategies Risk Reduction  Less risky production  In-service training  Labor standards  Migration  Financial Market  Pre-Service training  Proper feeding and weaning literacy  Labor market policies practices  Company-based and  Child labor reduction  Engaging in hygiene and market-driven labor interventions other disease prevention standards  Disability policies  Good macroeconomic policies  AIDS and other disease prevention Risk Mitigation Portfolio  Multiple jobs  Investment in multiple  Multi-pillar pension systems  Investment in human, financial assets  Asset transfers physical and real assets  Microfinance  Protection of property  Investment in social capital rights (especially for (ring ritual, reciprocal gift- women) giving)  Support for extending financial markets to the poor Insurance  Marriage/family  Old age annuities  Mandated/provided  Community arrangements  Disability, accident and insurance for  Share tenancy other personal unemployment, old age,  Tied Labor insurance disability, survivorship,  Crop, fire and other sickness etc. damage insurance Risk Coping  Selling of real assets  Selling of financial  Transfers/social assistance  Reduced savings or assets  Subsidies investment  Borrowing from banks  Public works  Borrowing from neighbors  Intra-community transfers/charity  Sending children to work  Dis-saving in human capital  Migration Source: Holzmann, Jorgensen (2001): “Social Risk Management: a new conceptual framework for Social Protection, and beyond”, International Tax and Public Finance, 8 (2001), 529-556 The Low-Skilled Workforce Improving human capital is key to fostering growth in Afghanistan. Decades of conflict have had a long-lasting impact on the human capital stock of the country. Despite significant improvements in school enrollment rates and education achievement in younger (urban) cohorts, the education gap remains substantial by international standards, also taking into account country’s level of development. In each sector of the economy, the education level of the Afghan labor force is the lowest among South Asia countries (Figures 2.8 and 2.9). Particularly challenging are education gaps in sectors crucial for future economic growth and development such as agriculture, mining, construction, commerce and manufacturing. 44 Afghanistan: Pathways to Inclusive Growth Figure 2.8: Education Levels (Average Years) by Sector, South Asian Countries Source: World Bank 2011 “More and Better Jobs in South Asia” Figure 2.9: Share of Labor Force with no Education, by South Asian country 45 Afghanistan: Pathways to Inclusive Growth Notes: The dark line shows the predicted values of the share of the labor force with no education by per capita GDP, based on a cross-country regression (excluding high-income countries). The shaded area is the 95 percent confidence interval band around the regression line. GDP = gross domestic product. Source: World Bank 2011 “More and Better Jobs in South Asia” Improved human capital is also essential to reap gains from migration. Labor mobility is one of the main strategies to address surplus of labor and stimulate development 22 through the flow of remittances and skills between countries (international migration) and economic regions (e.g., urban/rural migration). Mobility has been a fundamental coping and survival strategy for Afghans over the last 35 years. An estimated 10 million Afghans – or about one in three of the population – has been a refugee at least once during this period. Today, more than one in eight Afghans still lives outside the country, as refugees, undocumented migrants, or as part of the wider diaspora. Within Afghanistan, an estimated 20 per cent of the population comprises returned refugees, while perhaps one in thirty is internally displaced, and millions more have moved from rural to urban areas.23 According to NRVA 2011/12 data, 4 percent of the population of 14 years and over rely on seasonal migration. Longer term cross-border migration toward Iran, Pakistan, and Gulf countries is also relatively common. A significant number of Afghans, around 650,000, also live outside the immediate region in countries such as the United States, United Arab Emirates, Germany, Canada, and Australia, and form what has been described as a wider diaspora. The economic and political significance of the diaspora outweighs its 22 Recent World Bank research shows that an average ten percent increase in the number of international migrants in a country’s population can lead to a 1.6 percent decline in poverty and that a ten percent increase in the share of remittances in a country’s GDP can lead to a 1.2 percent decline in poverty. See World Bank; Global Economic Prospects; Washington DC; 2006. 23 International Organization for Migration (2014): “Transition, Crisis and Mobility in Afghanistan: Rhetoric and Reality,” Geneva, Switzerland. 46 Afghanistan: Pathways to Inclusive Growth numerical significance. It sends home remittance on a significant scale that support households and communities in Afghanistan, it invests in Afghanistan, and has contributed significantly to political processes over the past 12 years. Estimates of the contributions of migration to Afghanistan’s economic development are complicated by the lack of data, mainly due to the informal channels used to transfer or invest money back home (hawala) and to the irregular nature of most of recent migration flows. Since 2001, the character of Afghan migration has shifted from forced and conflict-driven migration, toward that of economically-motivated labor migration.24 Given Afghanistan labor market pressures, an argument can be made to devise human capital development strategies to promote out-migration and benefit from remittance, knowledge transfers in diaspora networks, and higher skill profiles of return migrants (see Box 2.3). However, massive out-migration can have a negative impact on social cohesion. Despite the potential of migration for development, one cannot ignore that international migration may also entail negative implications, which need to be taken seriously. These include negative effects on the health, security, and well-being of migrants due to inadequate right provision and enforcement. Others may relate to socio-economic effects. In Nepal, for instance, social phenomena such as an increase in divorces and elopement of spouses have been associated with high levels of male outward labor migration. From a political point of view, promoting out-migration could also be tricky for a government that is still pursuing stronger legitimacy in a post-conflict setting as it could be easily viewed as failure by government to provide the requisite environment for job creation within a country. Box 2.3: Costs and Benefits of Migration Migration was long viewed as a sign of failure of development, reflecting the lack of economic opportunities in the country of origin. These days, the role of migrations as an engine of growth for the countries of origin, is emerging. It may bring important financial resources, investment and knowledge transfer, skills development, and networks for businesses. However, there are many costs and the benefits of migration in the three different stages of the migration cycle (see table below from World Bank, 2010) and their net-effect varies substantially depending on country-specific characteristics (job and business-start prospects, wages, training, etc.) and migrant-specific characteristics (education, occupation, employment status, single or family, expected temporary or permanent, age, income, etc.). The impacts from the first stage (“ migrations”) in the migrant life cycle can be considered the pure effects of migration as a result of time of absence, and not considering subsequent contributions from the migrant, but allowing for impacts on the actions of those remaining. During the second stage (“time abroad”), the period of residing abroad, the migrant can add economic value to the home country, primarily through international remittance and the myriad actions which have come to be grouped as “diaspora initiatives” . But migrants may also incur costs to the home country. The third stage (“return”) is where the migrant’s net contributions to society can be evaluated relative to the net contributions had the migrant stayed. 24 While insecurity in many provinces of Afghanistan continues to fuel internal displacement, there is evidence that, when forced to leave their communities of origin due to conflict, displaced households choose where to go (mainly urban areas) driven by economic considerations. 47 Afghanistan: Pathways to Inclusive Growth The most obvious benefit is the potentially higher income earned in the host country. In most developing countries the amount of remittance received from a migrant abroad is two to five times higher than the wage received when working at home. However, this amount also depends on factors such as if the migrant left his family in the country of origin, if the intent is to migrant temporarily or permanently (with the latter increasing with the time working abroad), etc. Remittance as an additional source of income may also affect the labor force participation decision of those remaining. On the one hand, the reservation wage may increase resulting in less effort from the remaining working age population. On the other hand, if there are economic opportunities, the additional financial resources may encourage higher participation rates not least through self-employment. There are also effects beyond the current labor force. The share of female-headed households is substantially higher among migrant household than the rest of the households, which partly affect expenditure decisions such as schooling for children. The limited empirical literature has found mixed results on the impact of migration and remittances on growth, both at the micro and macro level. This is partly due to the quantity and quality of migration data, and partly due to the way migration data is collected leaving few possibilities to account for country or migration specific factor – factors that are crucial in determining the net impact of migration. For example, to profit from remittance, the country needs to have the capacity to absorb large financial inflows. This is especially true of demand-side credit in the receiving country, i.e., there must be economic opportunities within the country towards which the money can be invested. On the supply side the opposite seems true, i.e., remittances seem to have a larger impact when acting as substitutes for an under developed financial system. Moreover, the effect on growth depends on the opportunity cost of migration. If the migrant was unemployed in the country of origin the opportunity cost is low, while the migration of an employed (especially high-skilled given their positive external effects) creates a higher opportunity cost. The skill profile of the migrant has major impacts on the final effect on growth. Skilled emigration may increase the welfare of the sending household but have negative effects on the rest of the society by lowering the average level of human capital and capacity. Human capital has positive external effects in terms of innovation, technological adaptation, and learning for co-workers, and institutional development (actual state building as well as the public debate). Shortage of engineers, state-builders, doctors, etc., may create bottlenecks within the country of origin. However, skilled emigration can also bring benefits, especially if there is a lack of opportunities within the country of origin (i.e., skilled labor is not the binding constraint). Working abroad may increase the returns to education for the individual as well as the country, and a skilled diaspora may serve as an important network for knowledge transfer, insights about institutional and state development, and as important contacts when exploring and promoting exports. Addressing Afghanistan’s human capital challenges should focus on both young and adult generations. On the one hand progress in educating new generations should be supported and encouraged through interventions aimed at directing education choices toward addressing skills shortages of specific sectors crucial for growth (agriculture, mining, construction, business management). On the other hand, current 48 Afghanistan: Pathways to Inclusive Growth low levels of literacy and skills in the adult population make it challenging to offer more sophisticated skill or vocational training required to match the needs of the private sector. This could be best addressed through ad hoc interventions through adult literacy-cum-skills training programs. The current National Education Strategic Plan for 2010-14 is aimed at addressing both these goals. In particular, relevant focus is devoted to improving the supply of training and vocational education to reach a seven- fold increase in enrollment in TVET25 and to improving literacy for individuals aged above 15, raising investment in literacy programs from US$5 million in 2010 to US$21 million in 2014. Youth Unemployment A particularly difficult challenge will be to deal with the large number of young labor market entrants. Even in a more promising economic environment, young people, especially if low-skilled, have more difficulties finding a job, are more likely to be unemployed or find themselves in jobs of low quality and low earning. While youth unemployment does not necessarily pose a risk to security, recent events in the Arab world have demonstrated that stability and security may be at risk if job opportunities fall short of expectations, especially among the more educated youth. But a much more problematic consequence of youth unemployment is the enormous economic cost in the long run; analysis shows that un- or underemployment among young people can lead to lower future earnings or, especially among females, a drop-out from the labor force. The youth unemployment problem cannot be overstated in Afghanistan. The current outlook for job creation in Afghanistan is bleak. Young labor entrants in Afghanistan tend to be more educated than the labor force on average but the economy lacks more sophisticated job opportunities outside the public sector. Moreover, given security constraints, job opportunities in new sectors such as mining or agro- processing are emerging only slowly. It is therefore vital that the problem, in all its dimensions, is duly recognized and openly acknowledged. There are no simple solutions to youth unemployment. In many countries, youth unemployment is often addressed through a combination of labor market interventions that focus on matching labor demand and supply, counseling, skills training and offering temporary employment opportunities. However, these solutions might help some job seekers but will not resolve the inherent lack of job opportunities that young people in Afghanistan are faced with. All these interventions are also unlikely to diminish frustration or change any aspiration young people have. What can be done? The 2013 World Development report on jobs highlights the importance of promoting a vibrant private sector that can create employment opportunities commensurate with the education and the aspirations of new entrants to the labor market. In many cases, this means to ease the entry and exit of firms, improve the investment climate, reduce red tape, corruption and nepotism and provide better access to finance. In Afghanistan, it means all of this but above all reaching political settlement and reconciliation for a more peaceful future. In the meantime, providing more and better education to young people in order to increase their labor mobility; involving young people in the country’s development process by mainstreaming youth issues in development programs; prioritizing youth programs and strengthening civic and political participation of young people might be the best options that are currently available. 25 The plan envisages increasing the number of TVET regional institutes from 16 to 32; TVET provincial schools from 38 to 102; and establishing 364 TVET district schools. It aims to increase enrolment in TVET institutions from 19,500 in 1388 (2009) to 150,000 in 1393 (2014). 49 Afghanistan: Pathways to Inclusive Growth Women As mentioned elsewhere in this report, the high fertility rate threatens to trap Afghanistan in a cycle of poverty. Greater labor-force participation and empowerment for women is, hence, not just a social development objective but indeed an economic imperative to reducing fertility and easing demographic pressure. Although women in Afghanistan have (nominally) higher labor market participation than in other South Asian countries, the gap between female and male employment in Afghanistan is large. But more importantly, women in Afghanistan work fewer hours in paid employment, earn less, are more likely to work in vulnerable jobs and have limited financial autonomy.26 Studies have shown that women tend to dedicate larger portions of their earned income towards household welfare than men, whether towards household nutrition, education or health costs.27 Limited income opportunities for women have therefore important repercussions on intra-household resources allocation, with negative long-term implications on gender equality, human capital investments for children and, more generally, on households’ economic wellbeing. There are strong gender-specific differences in Afghanistan’s labor market. In rural settings, female involvement is significantly higher than in cities, due to the predominance of agriculture as the major employment sector. Here, over half of the female workforce is engaged in agriculture. However, employment in agriculture tends to produce low earning for women, largely because most farms practice subsistence farming or because women are typically confined to activities that are not related to decision making or brokering trade exchanges with the market. It is notable that women dominate employment in manufacturing (Figure 2.10), due mainly to the country’s specialization in carpet weaving. Nevertheless, after agriculture, the public sector remains the largest employer of women. Women are underrepresented in the provision of education, health services, and the public sector. This is largely a reflection of women’s generally low skill and education level in Afghanistan but has, at the same time, negative implications for women’s access to education and health services, and public services in general. In this context, the lack of security and the ways this affects the mobility of women is an important constraint across sectors. This is particularly evident in the education sector: although 31 percent of all teachers today are female, 90 percent of all female teachers are concentrated in urban areas. Kabul, for instance, has three times as many female than male teachers while in many rural areas teachers are predominantly male which often reduces families’ inclinations to send their daughters to schools. The large gender disparity in the non-agricultural private sector is mainly a result of acute barriers to participation, since finding work in private enterprises often depends on activities and networks of relationships that take place outside of home. Other key obstacles to employment in the private sector include limited mobility, little social acceptance and the necessity to balance childcare and household chores with work. 26 World Bank (2013). Afghanistan: “Women’s Role in Afghanistan’s Future - Taking Stock of Achievements and Continued Challenges.” Washington, DC. 27 World Development Report on Gender and Development, 2012. 50 Afghanistan: Pathways to Inclusive Growth Figure 2.10: Gender Distribution of Workers, by Sector of Employment PUBLIC ADMIN/GOV'T OTHER SERVICES EDUCATION HEALTH RETAIL TRADE WHOLESALE TRADE TRANSPORTAT., COMMUNI MANUFACTURING CONSTRUCTION ROAD CONSTRUCTION MINING & QUARRYING AGRICULTURE/ LIVESTOC 0% 20% 40% 60% 80% 100% FEMALE MALE Source: World Bank Staff calculation, National Risk and Vulnerability Assessment (NRVA) 2007/08 Female self-employment is hindered by limited access to finance and limited authority over financial decisions given to women. Only 3 percent of Afghan women have bank accounts (compared to 9 percent of men). This compares to an average of 26 percent in South Asia. The Afghan government, supported by donors, is supporting an array of microfinance products available to women which have shown promising results. Nevertheless, microfinance is no silver bullet. There are reported cases of women simply handing over loan money to their husbands or other male family members to administer it on their behalf. Programs, therefore, need to take cognizance of better opportunities to promote women’s participation in financial decision-making. No simple solutions are available to reduce employment gender gaps, especially in countries like Afghanistan where the gaps are deeply rooted in norms, cultural and social practices; further entrenched by poor infrastructure and service delivery. However, the analysis in this chapter does point out a few avenues through which the government and donors can contribute towards reducing gender gaps by strengthening the supply of and demand for policies and programs favoring women's access to the labor market. The 2013 Afghanistan Gender Stocktaking recommends the following measures:28  Women in Agriculture – Support agricultural value chains that allow for greater participation of women and support the expansion of models proven to include women in more diverse stages of the value chain such that their knowledge and roles can expand.  Education for Social Sector Employment – Women’s participation in health, education, justice, other social services, and in the civil service is critical. Develop policies and systems to encourage their higher education to qualify for these roles, and incentives for women to work in these sectors across the country. 28 World Bank (2013). “Afghanistan: Women’s Role in Afghanistan’s Future - Taking Stock of Achievements and Continued Challenges.” Washington, DC. 51 Afghanistan: Pathways to Inclusive Growth  Skills Development – Link vocational training or other support to women’s skills development directly to markets, based on sound analysis. Ensure that women can be included in emerging sectors (such as ICT), in which gender norms are less established.  Childcare, Mobility, and Woman-friendly Workplaces – The public sector could lead the way in developing models of access to affordable childcare, safe transportation options, and positive working environments for women, to help attract women to formal employment and retain positions once they have taken up work.  Access to Finance – Support microfinance programs that facilitate access to finance at local levels. Be sure to deliberately incorporate elements of women’s savings groups, women’s cooperatives, training of women in literacy, numeracy, and other skills, or programming that requires the active participation of women and their interaction with each other in a variety of ways. 52 Afghanistan: Pathways to Inclusive Growth 3. Chapter Three: Growth Options for a Country at a Turning Point Afghanistan is in the midst of 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 security responsibilities would be handed over by the end of 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. The transition process carries major economic implications. The operations of the troops were not only supported by a high level of military assistance, 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. As a direct consequence of the anticipated decline in aid, growth is expected to decline. Moreover, it will increase the risks to fiscal sustainability and macroeconomic stability. Cognizant of its donor dependence and the implications of the anticipated decline in aid, the government of Afghanistan has developed a vision to become more self-reliant by 2025. As part of this vision, Afghanistan will need to develop a new growth model that not only produces new jobs for the many new labor market entrants but also generates sufficient domestic revenue and foreign exchange. This chapter summarizes the transition-related challenges Afghanistan faces and discusses the country’s options for future growth. Key Messages  The expected decline in aid is expected to reduce growth prospects by half, and increase risks to fiscal sustainability and macroeconomic stability.  Supporting the country’ development efforts will require more financing. There is potential to further increase domestic revenue over the next decade but the country will also continue to rely on donor support in the post-transition phase.  Achieving the revenue targets by 2025 will require concerted efforts in reforming the tax system and administration as well as more progress in creating an enabling environment for investment in the mining sector.  Considering Afghanistan’s current stage of development, the country’s future growth model will in all likelihood rely on its agriculture potential and natural resources abundance. A high-growth scenario, predicated on improvements in security, further investment in extractive sectors, and increased agricultural productivity, posits Afghanistan achieving growth of nearly 7 percent annually on average.  Developing the extractive sectors carries great risks of conflict and political instability. In light of Afghanistan’s weak governance framework, it will be critical to recognize and mitigate the risks of natural resource-based development. This can be done by fostering the diversification of the economy through the development of resource corridors, strengthening the budgetary process and public finance institutions, deepening commitment to transparency by establishing social- accountability mechanisms, and implementing selective revenue-sharing options with communities. 53 Afghanistan: Pathways to Inclusive Growth Transition – a Game Changer In light of the large role aid plays in Afghanistan’s economy, the transition process evokes the question of how the decline in aid will affect Afghanistan’s economy. The reduction in foreign aid is bound to constrict economic activities that have so far benefited from aid, especially the construction and services industries. Analytical work conducted by the World Bank in 2012 for this report suggests that the decline in aid could affect Afghanistan’s economy through (i) a decline in growth, (ii) increased risks to fiscal sustainability, (iii) macroeconomic instability, and (iv) increased political economy risks. Average growth is expected to fall as aid declines. The analysis found 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 2011/12-2025/26 (see BASE case scenario in the section below). 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 un- and 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 twenty years to increase real GDP per capita from its current estimated level to that of the South Asian region, which is US$786 in 2011.29 The fiscal situation will remain very fragile. Afghanistan’s aid dependence is predominantly a fiscal issue. Much of civilian and military aid has been delivered outside of the budget through external budget contributions. Of the US$15.7 billion in aid to Afghanistan in 2010/11, only a small portion, roughly 11 percent, was delivered on-budget. Nevertheless, on-budget aid is an important financing source. While domestic revenues significantly increased between from 3 percent in 2002 to 11.4 percent in 2012, they have been insufficient to sustain the government’s operation and investment. In 2012, domestic revenues only financed 40 percent of total expenditures; the remainder was financed by foreign grants. The fiscal sustainability ratio, which measures domestic revenue over operating expenditures, was only 60 percent in 2012, which means that Afghanistan can currently not even fully meet the recurrent costs of its public service provision. This renders the operations of the government unsustainable without additional external financing. The analysis projects revenues to reach more than 17 percent of GDP by 2025 (from current levels of 11 percent), assuming good performance in revenue collection and continued development of extractive industries.30 However, on-budget expenditures are expected to grow much faster, largely as a result of rising security spending for both operations and maintenance (O&M) and wages for the army and police, which were historically funded by donors outside of the budget (Figure 3.1). 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. Depending on how many of the O&M liabilities the government takes on, total government spending could assume between 38 percent and 54 percent of GDP by 2025. This would 29 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. 30 This outlook assumes that the Aynak copper mine and the Hajigak iron mine commence operations as envisaged. 54 Afghanistan: Pathways to Inclusive Growth result in a total financing gap of 20 percent of GDP in 2025, and even higher levels in the intermediate years (Figure 3.2). Figure 3.1: Projected Expenditure and Domestic Figure 3.2: Financing Gaps, Incl. & Excl. Revenue Security Source: World Bank Note: Operating balance = dom. revenue minus operating expenditures. The spike in 2015 is a theoretical construct that assumes the government will take on all off-budget liabilities. A concerted effort will be needed to increase revenue mobilization in the years ahead. In light of Afghanistan’s development and security needs, rationalizing expenditures will be very challenging. Even if the security situation improves, it will likely take years to moderate security spending to levels that are more comparable with other post-conflict countries. Given the continued importance of public spending to support the country’s growth process, it will important for the international community to recognize the continued need for external financing. At the same time, it will be critical to carefully monitor spending especially in the security sector in order to seize opportunities for rationalization as they arise. It will be important to intensify efforts to further strengthen revenue mobilization (see Box 3.1). 55 Afghanistan: Pathways to Inclusive Growth Box 3.1: Revenue Mobilization in the post-Transition Phase Afghanistan’s public financial management system has undergone a structural transformation which has allowed the budget to grow from US$645 million in 2003 to US$4.2 billion in 2011, demonstrating rising absorption capacity for domestic revenue mobilization and external funding channeled through the budget. Domestic revenue increased from 4.5 percent of GDP in 2003 to 11.3 percent in 2011, thanks to reforms in the tax and customs administration. However, domestic revenues started to decline in 2012 and 2013 as a result of a slowing economy, changes in the structure of imports as well as an increase in leakages and weaknesses in enforcement, particularly in customs. In order to consolidate the budget in 2012 and 2013, the government has rationalized expenditure and increased efforts at customs (e.g., changes in the valuation, increase in tariff rates, and introduction of a computerized risk-management system). Current fiscal projections see revenue increasing to 17 percent of GDP by 2025. The government plans to introduce a value added tax in 2014 which is expected to generate 1-2 percent of GDP in tax revenue annually. The development of the mineral sector is expected to generate an additional 2-4 percent of non-tax revenue annually. The remainder is expected to derive from efficiency gains in the tax and customs administration. However, reaching the set revenue target will require strong efforts in reforming Afghanistan’s tax system, and administration and ensuring an enabling environment for mining investment. Of special concern is the decline in customs revenues that begun in 2011. Controlling corruption at borders will be even harder to achieve in the post-transition phase as rent-seeking is expected to increase (see Box 3.2). The following options for reforms could be considered to strengthen revenue mobilization in the post-transition phase: (i.) Expedite the introduction, implementation, and subsequent widening of VAT; (ii.) Reduce leakages at customs by expanding the computerized risk-management system, increasing controls, and strengthening enforcement capabilities of the customs administration; and (iii.) Create an enabling environment for mining investment through continuous improvements in the legislative and regulatory framework. Ensuring macroeconomic stability will require new sources of foreign exchange. Over the last ten years, macroeconomic stability has relied heavily on large aid flows. 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. Not surprisingly for a country in a period of reconstruction and recovery, 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. Remittance inflows are mostly informal, and proceeds from illicit opium trade, which are believed to be large, are not captured by the balance of payments statistics. However, the high level of aid was sufficient to keep the overall balance of payments in surplus and even contributed to a sizable accumulation of international reserves, which reached an all-time high of US$7.1 billion in December 2012, or 7.7 months of imports (Figures 3.3 and 3.4). In the absence of sufficient receipts from exports and low capital inflows, the current accounts will continue to show a large structural deficit which needs to be financed. There are large political economy risks associated with the transition process. The anticipated decline in aid, compounded by the general uncertainty about Afghanistan’s future in the run-up to the election, may reduce economic reform readiness, undermine stability, and increase incentives for rent-seeking behavior and corruption (see Box 2.2). Some of these risks have already materialized and have begun to 56 Afghanistan: Pathways to Inclusive Growth affect the short- and medium-term economic outlook. Revenue performance weakened in 2012 and 2013 as a result of a slowing economy and greater rent-seeking and leakage at the customs administration. New reform initiatives have become increasingly politicized as demonstrated by controversy around a material mining law in the fall of 2012. Table 3. 1: Medium-Term Macroeconomic Framework, 2011 - 2016 2011 2012 2013 2014 2015 2016 -------Actual------- -----------------Projected------------------ Nominal GDP (billions of US dollars) 17.9 20.5 20.6 21.8 23.1 24.6 GDP Growth Rate 6.1 14.4 3.1 3.5 4.8 5.3 CPI (period average) 10.2 6.4 7.1 5.5 4.9 4.9 percent of GDP, except where noted Fiscal Revenues and Grants 22.3 23.1 26.1 26.7 29.0 30.9 Domestic Revenues 11.6 10.3 10.1 10.6 12.1 12.6 Grants 10.7 12.8 16.0 16.0 17.0 18.2 Total Expenditures 23.6 23.8 26.7 26.6 28.6 30.3 Operating Expenditures 17.4 17.1 19.9 19.9 21.9 23.5 Development Expenditures 6.2 6.7 6.8 6.7 6.8 6.7 Operating Balance (incl. op. grants) 1.2 1.5 0.4 1.6 1.7 1.1 Overall Balance (incl. grants) -1.2 -0.8 -0.6 0.0 0.4 0.6 External Trade Balance -42.0 -41.9 -41.6 -39.5 -35.7 -33.0 Current Account Balance (excl. grants) -44.2 -43.8 -41.5 -39.6 -35.5 -32.8 Current Account Balance (incl. grants) 3.1 3.9 2.5 1.8 1.2 0.7 Gross Intl Reserves (months of imports) 6.9 7.7 7.3 7.7 7.9 7.9 Debt Total External Debt 6.9 6.5 6.6 7.0 7.2 7.5 Box 3.2: 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 fragmented along ethnic and tribal lines. A peaceful transfer of power from the outgoing to incoming government will require free and credible elections. Without these, the resulting power struggles might tip the country into 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 worsens, 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. 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 could help to cover the projected financing gap (and allow the authorities to progress towards development and infrastructure targets. 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.  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 57 Afghanistan: Pathways to Inclusive Growth individuals look for alternative sources of rent. Future Sources of Growth A number of inferences for future long-term growth can be made from the preceding analysis.  First, so long as the security situation remains problematic, Afghanistan will remain dependent on public sector investment and donor financing, which may be for years to come, to ensure the continued provision of services and growth. Only when the security situation improves will the government be in the position to reduce its security budget and divert spending towards development. And only then will the economy begin to attract sizable private investment. In the meantime, the level of violence and conflict will determine Afghanistan’s prospects for growth.  Second, the country’s large output volatility implies that there is scope for growth even within the given security parameters. And considering that development takes time, there are good reasons for Afghanistan to build strong foundations for growth in the future now.  Third, jobs aside, Afghanistan’s growth model needs to produce sufficient fiscal income and foreign exchange to gradually replace the role of aid in the economy and ensure fiscal sustainability and macroeconomic stability. With its low level of development and current economic structure, Afghanistan is still at an early stage of economic transformation. In essence, Afghanistan is still very much an agrarian economy characterized by little product sophistication. The country’s future growth model will therefore in all likelihood rely on its agricultural potential and 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. Moreover, the limited production of primary goods as inputs into production and the prohibitive cost of trade smother the development of a competitive manufacturing sector. Currently the potential for productivity and output growth is largest in the agriculture and extractive industries sectors. As agriculture and extractives industries develop further, and with it related infrastructure, development in other sectors will ensue through demand for construction, upstream and downstream services, and possibilities for manufacturing. Extractive industries offer good opportunities for growth, fiscal revenues and export earnings . The country is endowed with a wide range of minerals, from well-documented assets in copper, coal, iron ore, gold and oil and gas, to more speculative deposits in those minerals, as well as lithium and others (see Map 2.1). The Aynak (copper) and Hajigak (iron ore) are the first two large-scale mines to be developed (and already tendered). In addition, geological surveys identified another 11 highly prospective mineral resources and at least two hydrocarbon basins: the modest Amu Darya basin, which began production in 2012, and the Afghan-Tajik basin, which is currently being tendered. Overall, the largest impact will likely come from the copper, iron ore, and hydrocarbon deposits. 58 Afghanistan: Pathways to Inclusive Growth Map 3.1: Principal Natural Resources in Afghanistan Source: The World Bank, 2012 A computable general equilibrium model (CGE) that mimics the characteristics of the Afghan economy allows us to analyze alternative development scenarios for mining (see Annex 1 for technical notes). The baseline scenario (see BASE, in Table 3.1) outlines the likely impact of the development of the two large scale-mines in Aynak and Hajigak and the already-active oil deposits in Amu Darya. Assuming that both mines start production in 2016/17, military and civilian aid declines as implied by the Tokyo/Chicago discussions (see Box 3.2), and agriculture grows at historic rates, growth at factor cost could reach 4.8 percent per year between 2012/13-2025/26. Fiscal revenues would be expected to reach 17 percent by 2025. Exports would grow by 6.5 percent annually and, together with the foreign direct investment in mining and related activities, compensate partially for the decline in aid. 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 exploitation of more mines than those already factored in to the baseline projections. In a scenario with investment in the 11 additional mines (MIN+), growth could increase to 5.9 percent on average until 2025. Apart from the mining value-added growth itself, overall growth is stimulated by the higher public capital stock resulting from (i) the additional government revenue and (ii) the share of mining infrastructure investments that is assumed to be available to the rest of the economy (including roads and power plants; some 20 percent of total mining investments). Growth in public consumption and expenditure increases from 1.0 to 1.5 and -0.1 to 0.6, respectively, due to stronger growth in fiscal revenues – not least from mining itself. Household 59 Afghanistan: Pathways to Inclusive Growth consumption and especially household investment also increase; growth in private investments is 6.0 percent on average instead of 4.1 percent in the BASE case with less mining exploitation. In terms of sector effects, the contribution of extractive industries to growth increases from 0.8 in the BASE to 1.8 percent as an average for the whole period in MIN+. Behind this is a mining-specific annual sector growth that is as high as 75.9 percent. The resulting mining share in 2025 is 19.4 percent of GDP, which is similar to the share of non-mining industry (21.1 percent) and just slightly lower than the shares for agriculture (24.2 percent) and services (25.7 percent). Agriculture grows at a slightly lower rate than in the BASE scenario, not least due to the lower depreciation challenging its exports. The growth of non- mining industry, such as construction, increases, though, due to the heavy investments needed for mining. Private services grow by an additional 0.4 percentage point and public services by an additional 0.8 percentage point, due to the high fiscal revenue from mining. Table 3.1: Descriptions of Scenarios BASE Expected developments, including decline of aid by 50 percent until 2016, gradual improvement of the security situation, some mining expansion and historic growth in the agricultural sector AGR+ As BASE but with higher agricultural growth MIN+ As BASE but with large mining expansion AGR+MIN+ As BASE but agriculture growth as in AGR+ and mining growth as in MIN+ Source: World Bank Figure 3.3: Growth Simulations for Various Development Scenarios 2011-2025 8 6.7% annual GDP at factor cost (in %) 7 5.8% 5.9% 6 5 4.8% 4 3 2 1 0 Base AGR+ MIN+ AGR+MIN+ Mining Industry (non-min) Services Opium Agriculture Agriculture has good potential for growth and is highly relevant to poverty reduction and job creation. 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. 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. Workers employed in the agricultural sector represent 60 percent of total employment, meaning that three in five workers have their main source of income in farm-related activities (see Chapter 2). 60 Afghanistan: Pathways to Inclusive Growth 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. Additional investments in agriculture could increase general GDP growth to 5.8 percent annually on average (compared to the 4.8 percent baseline). Over the past decade agriculture has been subjected to high volatility and low average growth (4.1 percent on average between 2002 and 2012). Assuming more productivity-enhancing investment (e.g., irrigation technology) that increases agriculture growth to 6.7 percent annually on average, economic growth could reach 5.8 percent (AGR+). Such a scenario would almost double the contribution of agriculture to growth compared to the baseline scenario (from 1.1 to 2.1 percentage points). Higher agriculture growth has a strong impact on poverty through its effects on household budget. The model results imply a reduction of the poverty headcount rate by more than 50 percent (from 33.6 percent in 2011 to 15.3 percent by 2025). However, these results should be treated with extreme caution, given the strong assumptions made for Afghanistan’s poverty elasticity.31 An improved investment climate that boosted the potential for both, mining and agricultural, could raise average GDP growth even further. To illustrate the potential of the Afghan economy, the results of a scenario with high investment in mining (MIN+) are combined with high growth in the agriculture sector (AGR+). This could represent a scenario where the government taps the potential of its vast natural resources and uses the increased fiscal space for broad-based growth through investments in agriculture. The resulting overall average growth rate increases to 6.7 percent in the AGR+MIN+. Public investments grow with as much as in the MIN+ scenario (0.6 percent) while private investments grow at a rate as high as 7.2 percent. Exports also stand out, growing at 9.5 percent on average, kept in check by a marginal appreciation of the exchange rate by 0.1 percent per year. Private services are encouraged by the broad-based nature of the growth while public services expand through the high mining revenues in addition to an increase in other domestic revenues. Nevertheless, even in the best case scenario prospects for job creation are not very encouraging . Future growth dynamics will favor investments in mining. But mining is capital-intensive and produces relatively few jobs – perhaps 10,000-30,000 by the 2020s, which would be a drop in the ocean in light of the larger employment challenges Afghanistan is facing. The sector’s impact must therefore be multiplied for it to be a boon to the country; approaching mining development as an anchor for more broad-based development could help to maximize the job and development potential of extractive activities (see next chapter). Yet, in the best case scenario, mining in Afghanistan could directly generate about 100,000 to 125,000 jobs over the next ten years – far too modest to absorb the 400,000 – 500,000 (young) people who enter the workforce annually. And with most of these jobs being for skilled and semi-skilled workers, with a relatively small portion of jobs suitable for the unskilled, the direct benefits for the poor and women are likely to be limited. Moreover, even in the best case scenario, developments in the various sectors will require several years; excluding many Afghans, especially the youth, from being able to find regular jobs or income streams. Nevertheless, Afghanistan has no alternative development opportunities that that promise such high levels of fiscal revenue and foreign exchange. 31 In the simulation, household consumption per capita follows a lognormal distribution with a Gini of 0.29. The simulated poverty elasticity is -1.48 for the full period (2011-2025). 61 Afghanistan: Pathways to Inclusive Growth The job impact from agriculture growth is more substantial. Currently the agriculture sector generates approximately 3.2 to 3.4 full time equivalent jobs32 across row crop, horticulture, and livestock activities. Using an on-farm accounting approach, a recent World Bank analysis33 estimated that the number of jobs could significantly increase by increasing land use or raising productivity. The results imply that:  Increasing the area for cereal production by 100,000 hectare could produce an additional 80,000-90,000 jobs;  Irrigating 1,000 hectare of arable land for agriculture production could create 33-60 percent more jobs; and  Shifting one hectare of land from wheat to horticulture production could triple or even quadruple the labor input for certain crops. However, it should be noted that for reasons of simplicity these calculations use a rather theoretical definition of job. In reality, increases in output and gains in productivity would first result in larger household incomes before creating actual new jobs, which even then might not necessarily qualify as full-time occupations. Box 3.3: Limitations of the Model The model exploits all available macro and fiscal data, sector studies, enterprise surveys, and household survey sources from the government, as well as International Monetary Fund (IMF) and World Bank publications. Wherever necessary, data for comparable countries were used to fill in for missing information. Due to the simplifications that are inherent in any model, combined with the particularly weak datasets for Afghanistan, readers should view the results as approximate indicators of the effects of alternative policy options, to be considered with other inputs to economic policymaking in Afghanistan. Readers should also remember that the model has been developed to assess the integrated effects on an economy of certain policy or external variables. It is a model intended to help the policy discussion in considering the overall general equilibrium effects, not just the direct partial equilibrium effects. Thus, the quantitative results and the analysis of changes in parameters, size, and direction should only be taken as indicators of orders of magnitude. Finally, the model hinges on a set of underlying assumptions about developments in growth in Afghanistan that depend on a stable security environment – or at least on a general improvement in the investment climate (due to a stable security environment, institutional reforms, and infrastructure improvements) – that leads to higher levels of private investment. The results, therefore, are particularly sensitive to changes in the security environment and exogenous shocks, such as higher fuel prices. Risks to Future Growth Prospects The growth scenarios presented above 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 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. Much will depend, 32 A full-time equivalent job is defined as 200 work days per year. The analysis includes linkage effects. 33 The World Bank. Agriculture Sector Review. 2014, forthcoming. 62 Afghanistan: Pathways to Inclusive Growth therefore, on Afghanistan’s success in achieving peace, stability, and reconciliation. Without it, the previously-mentioned growth prospects will not materialize. Afghanistan is beset with a range of conflicts. The country’s conflict vulnerability is inherently complex: Violence is present in the form of local intergroup conflicts (incidents involving militias), conventional political conflict to seize state power (Taliban), widespread gang-related violence (warlordism), organized crime/trafficking (opium), and local conflicts with transnational ideological connections (e.g., Taliban and Al-Qaeda) (World Bank, 2011b). These conflicts are partially interdependent and fuel each other, such as the illegal trafficking of opium which is also an important source of finance for armed groups in Afghanistan (UNODC, 2010). It is difficult to quantify the impact of conflict on Afghanistan’s economy and livelihoods but numerous empirical studies point to a large negative impact on growth, poverty, and equality which could last decades after a conflict has ended (see Box 3.4). Box 3.4: Quantifying the Impact of Conflict The effects of an ongoing conflict on economic growth and poverty reduction have been confirmed in many studies. Economic growth is directly affected through, for example, destruction or lack of maintenance of crucial infrastructure, lack of incentives to invest in physical capital and the decrease in available labor for productive activities. It is mainly young men that are pulled into different forms of violence at the expense of seizing job opportunities. In addition, fiscal expenditures that could have been used for productive investments may in a conflict environment be directed towards the military or security forces. Compared to pre-war, military expenditures would on average increase with 2.2 percent during the civil war and remain 1.7 percent higher after the conflict (Hoeffler, von Billerbeck, and Ijaz, 2010). Indirect effects frequently include a slowdown in human capital accumulation, due to inability to frequently visit schools, destruction of school infrastructure, or a diminished return to investments in human capital due to the risky environment (e.g., children are kept home). Conflict also has a distributional aspect – geographical but also in terms of income since the most vulnerable groups are frequently the most affected by conflicts. Poverty reduction in countries affected by violence is about one percentage point slower per year than in other countries (World Bank, 2011b). On average, a country in conflict over the whole period of 1981-2005, had a poverty rate 21 percentage points higher than an average country without violence. The effects of conflict are long-lasting. After peace, it takes an average of 14 years for a country in civil war to get back on the same growth path (Hoeffler, von Billerbeck, and Ijaz, 2010), and 20 years on average to recover to the same trade levels (Martin, Mayer, and Thoening, 2008). The main challenge is to reassure investors, domestic and dsforeign, to re-invest in the economy. Cross-country panel data estimates suggests a cost of civil war was equivalent to 1.6-2.3 percentages of GDP per year of violence (World Bank, 2011b). Afghanistan can pride itself on a number of extraordinary achievements in rebuilding state institutions and establishing the foundations for effective governance since 2002. Institutions matter for sustained growth, doubly so in a post-conflict environment. They shape the incentives to invest in physical and human capital and to allocate resources towards their most efficient use. They determine who gets profits, revenues, and residual rights of control. But more than this, capable and legitimate institutions are a crucial requirement for breaking the circle of violence, providing justice and securing. Weak institutions slow development and increase the risk of violence and conflict, which, in turn reverses development. Since 2002 Afghanistan succeeded in establishing and sustaining several critical governance institutions and initiatives, among the most remarkable: (i) a new constitution was ratified, (ii) governance institutions (e.g., ministries and public agencies, oversight institutions etc.) and their responsibilities were established or redefined, (iii) two presidential and parliamentary elections were held, (iv) civil service structures were reformed, (v) and an orderly, transparent budget process was introduced and robust public finance institutions were established (see Box 3.5). 63 Afghanistan: Pathways to Inclusive Growth Box 3.5: Public Financial Management Reforms in Afghanistan – a Success Story From the outset of the reconstruction, Afghanistan made a firm commitment to fiscal discipline and transparency. The foundation of this commitment is the annual budget as key instrument for policy implementation. Reforms therefore have been implemented to bolster credibility, comprehensiveness, and transparency of the budget, the budget-policy link, predictability and control of budget execution, accounting recording and reporting. The 2013 Public Expenditure and Financial Accountability (PEFA) assessment of Afghanistan’s budget management performance found that most of its operations are performing well. For example, the national budget is carried out in an orderly, transparent fashion and broadly covers all general government-sector operations. Since 2008/2009, when parliament strengthened its budget and finance committee, it has thoroughly reviewed the budget, including its formulation, execution, and control. Meanwhile Afghanistan’s public financial management outcomes are better than the average of 15 fragile states in six core dimensions of PFM (except for credibility of the budget, and policy-based budgeting where it is Afghanistan PEFA Score for 2013 – International Comparisons on par). Also, Afghanistan outperforms 27 low-income A. Credibility of the budget 4.00 countries (LICs) in four dimensions. 3.50 And, compared to the average of 3.00 51 middle-income countries (MICs), 2.50 Afghanistan’s PFM system scores F. External scrutiny and audit 2.00 B. Comprehensiveness and transparency better in two dimensions, on par in 1.50 one dimension, and scores lower in 1.00 three dimensions (see web graph 0.50 below). In recent years, 0.00 Afghanistan also has been trying hard to improve transparency and accessibility of the budget, and E. Accounting, recording C. Policy-based budgeting and reporting managed to increase its rating in the Open Budget Index, a barometer of transparency in Afghanistan 2013 budget operations, from 8 percent 15 Fragile States D. Predictability and 26 LICs in 2008 to 59 percent in 2012. control in budget 52 MICs execution Source: Afghanistan: Public Expenditure and Financial Accountability assessment 2013 However, the governance deficit relative to other low-income countries is still very large (Figure 3.6). Governance performance is inherently difficult to measure and often rely on qualitative and perception- based indicators. Given that these are often subject to biases, e.g., reports in media need to be treated with caution. Nevertheless comparing indicators across source, countries and time periods can provide useful insights on the dynamics of reform processes. The World Bank’s Worldwide Governance Indicators – a composite index constructed from information across different sources – suggest that in areas such as rule of law and control of corruption, reform progress in Afghanistan has been slow. Media outlets and reports indicate that overall there is still a widespread culture of impunity for the elite while most citizens see little evidence of improved delivery of government services. Corruption is pervasive and widespread. In 2012 Transparency International ranked Afghanistan 174th out of 176 countries, joint last with North Korea and Somalia. 64 Afghanistan: Pathways to Inclusive Growth Figure 3.6: Governance Performance Compared to South Asia Average, 2012 Source: World Bank, Worldwide Governance Indicators (www.govindicators.org) Reforming institutions is a daunting task. International experience shows that it can take generations to increase the capability of institutions. The 2011 World Development Report found that in the best case it takes fragile states 20 years to achieve and observe the institutional quality that could be considered “good enough”, meaning that they provide the minimal conditions of governance necessary to allow desirable development outcomes to occur (Table 3.2). Table 3.2: Speed of Progress in Institutional Reform Years to threshold at pace of: Indicator Fastest 20 Fastest over the threshold Bureaucratic Quality (0-4) 20 12 Corruption (0-6) 27 14 Military In politics (0-6) 17 10 Government effectiveness 36 13 Control of corruption 27 16 Rule of Law 41 17 th Note: The table shows also the time it took the fastest reformers in the 20 Century to achieve basic governance transformations. Source: Pritchett and de Weijer (2010) for 2011 World Development Report 65 Afghanistan: Pathways to Inclusive Growth In this light, considering the country’s starting point, it is not surprising that Afghanistan fares poorly in most governance surveys. Nevertheless, even with appropriately modest expectations about the pace of institutional reform, Afghanistan’s progress in institution building is slow and uneven. Moreover, institutional quality in Afghanistan does not compare favorably to that of other countries with recent post-conflict experience: Byrd, Milante and Anye (2013) conclude that that on most governance indicators, the gap between Afghanistan and strong performing post-conflict countries the gap is large and increasing over time. The picture is more mixed if Afghanistan’s performance is compared with medium- and slow-reforming, post-conflict countries but it’s evident that Afghanistan’s performance in areas related to political stability, rule of law, and government effectiveness has been lackluster (Figure 3.7). But most concerning is that the governance situation appears to have regressed in important areas (Figure 3.8). While ratings improved for government effectiveness, voice and accountability, and regulatory quality due to the government’s laudable progress with PFM reforms, investment climate improvements and government transparency initiatives, control of corruption, rule of law and political stability have fallen back to lower levels. For a country with such a low starting point as Afghanistan, it can be expected to experience slippage in governance achievements over time. However, there is an urgent need associated with Afghanistan’s governance situation: not only is better governance necessary to reduce violence and conflict in the country, but better governance will be absolutely critical for securing the country’s financing needs. Afghanistan will remain aid-dependent for years to come, and although donors have committed sufficient funds to sustain development throughout 2016, the flow of funds is by no means guaranteed. It is, rather, subject to – among other conditions – improvements in governance. Accelerating governance reforms, therefore, is not just a development option for Afghanistan, but is essential for the country to survive. Figure 3.7: Governance Performance Compared to Figure 3.8: Uneven Performance of Governance Other Post-Conflict Countries (2012) in Afghanistan, 2002-2012 Source: World Bank, Worldwide Governance Indicators (www.govindicators.org). Note: Rwanda Zimbabwe and Burundi represent strong-, medium-, and weak-performing post-conflict countries respectively, according to the country clusters in Byrd, Milante and Anye (2013). The development of extractive industries will add another stress factor to its already-vulnerable country context. The 2011 World Development Report presents a typology of stress factors that affect a country’s probability of conflicts (Table 2.2). A sober assessment of these factors would conclude that Afghanistan is more-or-less dealing with all of the stresses mentioned in this typology and is now adding natural resource development into the mix. Indeed, beyond individual examples such as Nigeria, Angola, Congo, and Cote D’Ivoire, there is ample empirical evidence to support the notion that natural resource endowment can, under certain circumstances, be detrimental to the development prospects of a 66 Afghanistan: Pathways to Inclusive Growth country, especially in the early stages of development.34 The phenomenon of countries endowed with natural wealth producing low development outcomes is described as the “natural resource curse”. Most critical for Afghanistan is the notion that natural resources can undermine governance and spur conflict by challenging livelihoods, threatening the environment, and raising disputes over rights to control the resources; feelings of relative deprivation arise from the distribution of revenues from resource exploitation or providing financing to insurgent groups. Table 3.3: Security, Economic, and Political Stresses of the Conflict Source: World Bank (2011b) Within the context of Afghanistan’s challenging security and governance environment, a growth model based on the development of natural resource and extractive industries is the most viable option for the country. Afghanistan has reason to be optimistic about its future development prospects. Challenges are large but the hard-fought gains in health, education, infrastructure development, and institution building certainly improve the country’s chance of enabling a virtuous circle of productivity, growth, and development. Paul Collier and others have found, that if a post-conflict country can grow its economy by 10 percent per year it can reduce its risk of returning to conflict from more than 40 percent to just over 25 percent.35 However, considering the current level of violence and political developments, it is likely that it will still require a number of years to fully restore peace, stability, and reconciliation even in the best case scenario. Any growth-enhancing policies therefore needs to pursue realism and aim at supporting sectors and economic activities that show the best potential for conflict resilience and, in turn, provide the largest impetus for conflict reduction. Agriculture development meets this requirement as it would directly improve the incomes of the majority of households in Afghanistan and – as will be discussed in other chapters – offers many opportunities for inclusive growth. And as the large volatility in agriculture output demonstrates, the sector has still potential to grow even within the current parameters of insecurity and violence. The large international interest and successful outcome of the recent tenders for the exploration and production in Amu Darya, Aynak, and Hajigak indicate a similar “conflict resilience” for extractive industries. 34 Frankel, Jeffrey “The Natural Resource Curse: A Survey” Discussion Paper 2010 --21, Cambridge, Mass.: Harvard Environmental Economics Program, September, 2010. 35 Collier (2009). 67 Afghanistan: Pathways to Inclusive Growth However, considering Afghanistan’s daunting governance challenge and conflict vulnerabilities, is developing extracting industries really worth the risk? Managing natural resources is a challenge, even in resource-rich countries that are not in conflict. Given Afghanistan’s weak governance environment, the challenges to develop natural resources into a productive growth sector are overwhelmingly large. Yet, there really is no development alternative for Afghanistan that could provide an equal amount of fiscal revenue and export earnings; the country therefore critically depends on the exploitation of natural resources to finance its future development. But in order to avoid that the country’s resource wealth turns into curse, the government will need to exercise extreme caution in planning sector development and ensure that all governance and economic risks are being properly addressed. Avoiding the pitfalls of the resource curse will require a very strong and concerted effort in improving economic management and governance. A resource curse can arise from a variety of factors: (i) a decline in the competitiveness of other economic sectors due to an appreciation of the real exchange rate as resource revenues enter an economy (“Dutch disease” effect), (ii) volatility of revenues from the natural resource sector due to exposure to global commodity market swings; (iii) governmental mismanagement of resources; and/or (iv) weak institutions, rent-seeking behavior, and redistributive struggles. However, some countries such as Chile, Mozambique, and Zambia were able to achieve strong productivity growth in their natural resource sectors and diversify into new economic activities, resulting in steady and robust income growth over many decades. Afghanistan has a valuable opportunity to learn from the experiences of other countries and build the foundation for good governance of natural resource management. Given the early development stage of the natural resource sector, not all natural resource governance and management aspects will be immediately relevant to Afghanistan. The risk of Dutch disease, for instance, is expected to be relatively low. The CGE simulations show that the depreciative effect arising from the expected decline in aid will likely outweigh the appreciative pressures arising from new investment and export receipts across the various mining scenarios. An opportune time window exists to use resource-based development as an anchor for diversification. As the natural resources sector develops, exports will be dominated by mining products. This could exacerbate volatility, both of fiscal and export revenues. Promoting diversification within the economy is therefore a good strategy to avoid heavy reliance on natural resources and to reduce exposure to price volatility. Many countries find it difficult to diversify when they have to deal with an appreciating currency as the natural resources sector develop. In light of the expected depreciation of the Afghani, however, Afghanistan has a good opportunity to foster the development of economic activities. In foresight, the government has rightly adopted the National and Regional Resource Corridors Program (NRRCP) as an approach to ensure more broad-based development. The NRRCP builds on the idea to strategically invest in “soft” and “hard” infrastructure that is not only is beneficial for the development of natural resources but also favors the development of upstream and downstream industries as well as economic activities in geographic proximity. Implementation of the NRRCP could be intensified over the next years in order to establish competitiveness before it becomes more difficult for new companies to penetrate markets at later stages of natural resource development.36 It is important to deepen the commitment to transparency by establishing social accountability mechanisms. Ensuring transparency and accountability over revenues from natural resources is vital for 36 Joya, Mohammad Omar, 2012. “Natural Resources: What Strategy for Afghanistan?” Samuel Hall, Policy Paper Series No. SH/2012/01 68 Afghanistan: Pathways to Inclusive Growth reducing corruption and rent-seeking opportunities. Recognizing the importance of transparency, the government has demonstrated a formal commitment to good governance in the extractive sector by joining the global Extractive Industries Transparency Initiative (EITI). It has also published all mining contracts it has issued (with the exception of the contract for the Aynak mine), implemented a resettlement action plan and developed social and environmental policies to support communities affected by mining operations. This commitment can be deepened by strengthening social accountability mechanisms to ensure that the needs of Afghans affected by mining operations are understood and attended to. Such mechanisms can take the form of participatory budgeting or monitoring (e.g., citizen/community report cards, social audits), expenditure tracking, citizen juries, transparency portals, public oversight committees, and others. Fostering a transparent and strong budget process will be imperative. As described above, the financial revenues from mining in the early 2020s are likely to range from roughly 2 percent of GDP – a prudent estimate – to possibly 4 percent of GDP, depending on the scale of new deposits and the pace of their development. Since the government of Afghanistan by then may have a financing gap of some 25 percent of GDP, revenues from undeveloped deposits will not be available for “additional” investment – as they would be in most other countries in a similar situation – but will be required for ordinary fiscal sustainability. As such, the government has made the policy decision to treat the revenues from the sector within the normal budgetary process. Continuing to build the strength and transparency of the budget process and public finance institutions will therefore be critical to the effective use of these funds once they arrive in the single account. Of particular importance will be the perceived effect of public spending in the provinces where the mines are located, and the perceived link to revenues from them (even if these links are not fixed directly in budget allocations). This is because governors and other stakeholders in those provinces will exert a strong de facto influence on the monitoring of contracts, revenue flows, and the overall operating environment for the investments. The failure to strike a credible balance between central and provincial shares of revenues has caused long-standing problems in countries such as Nigeria and Iraq, fostering corruption in the former and holding back the development of the extractive industry in the latter. Community benefits sharing is crucial. The licenses for both Aynak and Amu Darya mines contain provisions to provide benefits such as schools and clinics for the communities affected by the extractive investments. Licenses for the next deposits awarded are expected to contain similar provisions. The Ministry of Mines recently published Social Policy Guidelines for the mining sector, identifying key social issues to be addressed by the government, mining investors, and civil society. Funding requirements likely to result from such provisions could be significant, and it is imperative to develop a framework for community benefits sharing to inform existing and forthcoming mining sector investments. The development of such a framework would need to be undertaken in close collaboration with other key stakeholders, notably mining investors and civil society. Global experience suggest center such a framework on community development agreements (CDA), which involve communities themselves in setting priorities and help clarify roles, expectations and anticipated results. CDAs are negotiated between investors and each affected community, and outline mechanisms to determine how benefits are shared, such as minimum funding requirements and the representation of women and other marginal groups in decision-making. These agreements will be crucial to generate inclusive growth around the mines.37 37 Joya, Mohammad Omar, 2012. “Natural Resources: What Strategy for Afghanistan?” Samuel Hall, Policy Paper Series No. SH/2012/01 69 Afghanistan: Pathways to Inclusive Growth 4. Chapter Four: Making Growth More Inclusive 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”.38 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”. This vision is embedded in the Afghan National Development Strategy (ANDS), and within it, the National Priority Programs (NPPs). 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. However, Afghanistan has not yet formulated a growth strategy for the post-transition phase that would help to prioritize resources and policy actions. Both, the ANDS and NPP’s are too comprehensive in their coverage and include too many projects that far exceed the funds likely to be available. The sheer number of proposed projects and programs provides opportunities for donors to cherry pick their favorite programs and may leave essential programs that are needed to enhance growth and job creation under- or unfunded. Moreover, both ANDS and NPP’s are too focused on investment as opposed to policy reforms that could equally well support Afghanistan’s growth and development objectives. The new government will have an opportunity to reexamine and consolidate Afghanistan’s development program and underpin it with a well-formulated growth strategy which addresses short-term macroeconomic and fiscal concerns as well as long-term microeconomic interventions to remove constraints to investment, productivity, job-enhancement and inclusion. This chapter provides a framework for inclusive growth and outlines some of the critical investment needs and policy interventions to support growth, job creation, and inclusion during the post-transition phase. Complementing the findings from earlier chapters, this chapter focuses on interventions anchored in agriculture and natural resource development, as well as areas that are equally important for both sectors: infrastructure, human capital, and access to finance and land. Key Messages  The framework for inclusive growth proposes to focus development efforts on (i) enhancing growth prospects by removing constraints to private investment and productivity in agriculture, mining and services, (ii) addressing common obstacles to growth with strategic intervention, and (iii) identifying interventions that promote inclusion of the four target groups. The growth framework is underpinned by a stable macroeconomic framework and concerted efforts to improve Afghanistan’s governance 38 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 70 Afghanistan: Pathways to Inclusive Growth environment.  Maximizing growth in agriculture will require more attention to improving irrigation water conveyance, area expansion in both irrigated and rain-fed agriculture, and public investment in agriculture research and knowledge services. Job creation and inclusion can be fostered by supporting access to credit, marketing and technology, promoting crop diversification, and promoting opportunities for female participation through targeted value-chain interventions.  Giving Afghanistan capital and knowledge constraints, developing natural resources requires large international investment. While many investors have signaled interest, a number of imposing constraints remain to be overcome, including lack of critical infrastructure, general shortage of skilled, professional workers, and large gaps in the legal and regulatory environment. But even if these challenges are met, the job impact from developing the mineral sectors is expected to be minimal. Applying a corridor concept to natural resource development could help to maximize the job impact and make mining more inclusive.  The agriculture and natural resources sectors share common constraints with respect to infrastructure, specifically with respect to water and power supply. Here, developments in both sectors will add to the already high and increasing demand. While it is important to enhance existing infrastructure to reduce inefficiencies and improve distribution, it will be equally necessary to think about the development of new water resources and sources of power supply. Solutions to increase supply exist domestically but are ultimately best supported by fostering regional cooperation efforts.  Prioritization of human capital interventions is made difficult by the large human development gaps in Afghanistan. Interventions therefore need to be holistic in nature and cover an entire range of instruments across the entire spectrum of human capital development. TVET interventions, however, could be better linked to market needs and formulated within a sector approach for agriculture and natural resource development.  Finally, inclusive growth process can be supported by removing constraints to access to land and finance. Both areas require attention, especially at policy level, beyond the interventions planned in the National Priority Programs. A Conceptual Framework for Inclusive Growth in Afghanistan Growth in Afghanistan needs to satisfy multiple objectives. The preceding chapter highlighted a number of challenges to growth and inclusion that need to be addressed in the post-transition period, and provided directions for an integrated conceptual growth framework. In summary:  Afghanistan needs high, job-rich growth in order to provide opportunities for the large number of young people that will be entering the labor market over the next decade. Meeting this challenge will ultimately depend on Afghanistan’s ability to improve its security situation, attract investment and develop a vibrant private sector.  Agriculture needs to be at the center of Afghanistan’s growth agenda given its relevance for poverty reduction and potential to provide income and livelihoods for the majority of the population.  As aid is set to decline, growth will need to produce high levels of fiscal income and foreign exchange earnings in order to maintain macroeconomic stability and improve fiscal sustainability. The development of the natural resource sector appears to be the only realistic 71 Afghanistan: Pathways to Inclusive Growth option that could achieve this objective but, evidently, adds additional challenges to fiscal and macroeconomic management.  The development of the natural resources sector will introduce additional stresses into an environment that is already characterized by a high degree of fragility and governance weaknesses. Utmost attention needs to be given to improving Afghanistan’s governance environment.  The high fertility rate threatens to trap Afghanistan in a cycle of poverty. In the long run, dependency ratios need to decrease so that saving rates and incomes can rise. Better health and education combined with greater labor-force participation and empowerment of women could help to reduce fertility.  Even in the best-case scenario, development will take time. Meanwhile over 50 percent of the population have only limited options to cope with recurring risks such as droughts and food price shocks and are vulnerable to falling into poverty. Public social safety options could be considered to prevent the erosion of assets and human capital at household level. A conceptual framework for inclusive growth. Afghanistan’s development challenges are daunting and complex. There is no question that any of the problems Afghanistan is faced with requires a broad and holistic approach to its solution. However, efforts in the past couple of years have failed to fully achieve desired results for stability, poverty reduction, and job creation. Afghanistan’s development approach must therefore change to make future efforts more effective. For the most part, this will mean that development efforts need to become more selective as fiscal space tightens and oriented towards Afghanistan’s main sources of growth and drivers of inclusion. Investments and policy reforms to enhance growth need to be better complemented with interventions targeted towards the four population groups that have benefited less from growth over the past years (see prioritization framework, Figure 4.1). In essence, the proposed framework for inclusive growth suggests concentrating development efforts on (i) enhancing growth prospects by removing constraints to private investment and productivity in agriculture, mining and services, (ii) addressing common obstacles to growth with strategic intervention and, (iii) identifying and mainstream interventions that promote inclusion for the four target groups (low-skilled workforce, unemployed youth, excluded women, and vulnerable poor), building on the interventions suggested in Chapter 2. The growth framework is underpinned by a stable macroeconomic framework (see Chapter 3) and concerted efforts to improve Afghanistan’s governance environment. 72 Afghanistan: Pathways to Inclusive Growth Figure 4.1: A Conceptual Framework for Inclusive Growth Improving Afghanistan’s Governance Environment A country with such a low starting point in development such as Afghanistan, can expect to experience slippages in governance achievements. However, there is a very urgent need associated with Afghanistan’s governance situation; not only is better governance necessary to reduce violence and conflict in the country but better governance will be critical for a growth model based on natural resources to succeed. Moreover, Afghanistan will remain aid-dependent for years to come, and although donors have committed sufficient funds to sustain development gains throughout 2016, the flow of funds is by no means guaranteed but is, among other conditions, subject to improvements in governance. Accelerating governance reforms is therefore not just a development option for Afghanistan, but a necessity for the country to continue to grow as did in the early 2000s. The sheer complexity of Afghanistan’s governance challenges cannot be fully portrayed in a report such as this. More and deeper analysis is required to better understand the governance dynamics and constraints to the reforms required. There is growing recognition in the academic governance literature that governance problems, especially in post-conflict countries, can no longer be addressed in the assumption that the government and political system is conveyed by people who have an uncomplicated commitment to developing their country, improving governance, and providing public goods effectively, and that citizens have an uncomplicated desire and potential ability to hold their rulers accountable for their performance. In reality, development actors face collective action problems at many different levels and these prevent them from pursuing their interest.39 As Booth (2012) argues, “Governance challenges are not fundamentally about one set of people getting another set of people to behave better. They are about both sets of people finding ways of being able to act collectively in their own best interest.” Afghanistan is in many respects and at different levels a deeply fragmented country; analyzing collective actions problems between different actors and groups in society and within the 39 Booth, David (2012). “Development as a Collective Action Problem: Addressing the Real Challenges of African Governance.” Africa Power and Politics Programme, United Kingdom. 73 Afghanistan: Pathways to Inclusive Growth political system might therefore well be a worthwhile endeavor for future research an adequate approach to re-thinking governance issues and reform dynamics in Afghanistan. At a more pragmatic, institutional level, the NPPs in the governance clusters offer a comprehensive roadmap for future governance reforms, albeit with a few gaps. Priority areas and actions moving forward ideally include:  Public Finance Management. Afghanistan is regarded as a success in PFM for fragile states because it has contributed to maintaining overall fiscal balance and produced reliable reports on government finances. However, achievements to date face two threats: First, from the generally weak governance in the public sector and the increasing risks for rent-seeking during the transition process; and Second, from the constraints to service delivery arising from limited delegation from central government control to front-line service units and an excessive dead- weight, bureaucratic duplication of effort. Enormous opportunities for better public sector outcomes are afforded by the transition of billions of donor funds to on-budget reckoning from now to 2016 that would greatly improve the coordinated management of this public investment. Moreover, the need to fulfill minimum requirements in oversight of public finance, including of on-budget donor funds, make continued PFM reforms a sine qua non condition for success of future reforms. Next steps in PFM reform could include: (i) keeping the budget as the primary policy instrument and improve/apply whatever controls are needed to manage the fiscal aggregates and report reliably to all stakeholders on public finances; (ii) gradually, and in an orderly manner, reduce centralization and build capacity in the spending ministries to absorb responsibility for their internal control and devolve more decision making power to these, including their provincial level operations. In this context it will be important to strike balance must be struck between centralized financial control, which cannot be compromised, and the devolution of budget decisions to spending ministries and their provincial departments; (iii) establish government-wide internal audit; and (iv) invite civil society organizations to cooperate with the external Supreme Audit Organization (SAO) to achieve more impact from their work.  Anti-Corruption. In 2012, Transparency International ranked Afghanistan in a tie with Somalia and North Korea as the most corrupt countries in the world. Considering bribery alone, the cost of corruption was estimated at nearly US$4 billion in 2012, according to survey by UNODC. Corruption is a complex and multifaceted phenomenon which requires a broad-based, multi- pronged strategy to fight it. Afghanistan’s national anti-corruption strategy dates back to 2008 and were complemented by the emergence and dismissal of new and even newer initiatives or programs by the government and international donors alike. The National Transparency and Accountability NPP, the latest effort in formulating priorities in controlling corruption, has not been finalized. There is, therefore, a lack of a cohesive vision or framework towards which government institutions can work or against which it can be held accountable. Fighting corruption requires a strong and persistent political will exercised through sanctions and institutional reforms. The incoming government has the opportunity to take a hard look at previous anti-corruption efforts, the ways to which it and the international community contributed to problem of corruption, and commit to a new strategy and action plan with short- and medium-term solutions that can be realistically supported and implemented by all layers of government, the Afghan society, and the international community. The scale of Afghanistan’s corruption problem demands nothing less. 74 Afghanistan: Pathways to Inclusive Growth  Rule of Law. The judicial system in Afghanistan is comprised of a multitude of complementary, competing, and conflicting spaces for rule setting and conflict resolution, all with varying degrees of legitimacy and with blurred and shifting divisions between the spaces. All formal and informal justice institutions can and do enforce state laws, sharia laws and/or customary laws. Locally, for instance, community organizations are the primary sources of societal order. These institutions are powerful players in resolving up to 80 percent of disputes at the community level While a pluralistic legal system is simply a matter of fact in many societies, some crucial pieces within the legal architecture are missing in Afghanistan that would otherwise allow for the judiciary to function effectively. Most critically, there is no mechanism to preclude parties from recycling disputes (including land disputes) through different formal or informal forums. This compounds the uncertainty of the legal system in all substantive areas of law, allows for forum shopping and enables conflicting decisions. More generally, this uncertainty constrains the peaceful contestation of grievances (e.g., in land disputes) and the development of transactions outside of family and clan networks that would form the basis for more robust private sector growth. Rule of Law reforms have so far focused on strengthening the formal sector mainly at the central level (predominantly through capacity building), with the assumption that these reforms will automatically benefit the people. These reforms have made modest progress but have not yet yielded tangible results in the form of more accessible or better legal services. Critically the judicial institutions have been unable to deliver on one of their core set of functions – that of ensuring accountability. This is due to a number of reasons, including a lack of will and capacity on the part of the courts and the offices of public prosecution, corruption and a lack of space for the demand from citizens for such accountability to manifest itself in the courts. Similarly, the courts have been unable to hold individuals accountable to each other – either in civil law or criminal law – in an objective and transparent manner, thus undermining the legitimacy of their institution. Finally, both, the Supreme Court and the Attorney’s General office have been unable to make judges within the system accountable for their actions. The NPP “law and justice for all” builds on previous reform efforts and includes a number of important initiatives to improve access to and efficiency of the legal and judiciary system. There is, however, a notable lack of interventions to strengthening accountability of the judiciary system and this needs to be addressed.  Civil Service Reform. Since 2002/3, the establishment of a more effective civil service has been one of the government’s priorities. The pay & grading reform launched in 2008, for instance, aimed to bring more coherence to ministries’ organization and staffing structure and their process to improve effectiveness. However, the immediate need to boost capacity in the civil service, e.g., through engagement of foreign experts or through the hiring of externally funded staff (EFS) to perform civil service functions, has often substituted rather than built capacity within the civil service sector. In 2013, the civil service still relies heavily on EFS and international experts that earn much higher wages than regular civil servants. The anticipated reduction in donor aid will sharply restrict the funds available for EFS and international expertise and this will threaten to undermine crucial functions of the public administration. The government has deepened civil service reforms in 2012 and is working on the adoption of new civil service pay scales, harmonization of professional cadre’s, improvement of recruitment process e tc. – measures that will help to transfer capacity into the core civil service. These reform processes, embedded in the NPP for Efficient and Effective Government, need to be continued and accelerated in the coming years. 75 Afghanistan: Pathways to Inclusive Growth  Subnational Governance and Service Delivery. Afghanistan’s administrative structure is highly centralized. Numerous studies have found that this centralization and the small size and weak capacity of the provincial and district level government offices constrain the ability of the public sector to serve the Afghan people equally and effectively across provinces. Improving local service delivery, and in this context improved provincial budgeting, seems therefore to be a feasible entry point for a more “evolutionary” approach to decentralization. The government has begun working on a provincial budget policy in 2013 that aims at larger involvement of provincial authorities in the budget process and greater autonomy in budgetary spending. This is a laudable first step in recognizing and alleviating service delivery constraints. In parallel, the implementations of such a policy need to be accompanied by building more capacity in local administrations. In recognition of Afghanistan’s vulnerabilities to corruption, it will also be critical to improve monitoring and accountability mechanisms for local authorities within Afghanistan’s PFM system Transforming the Agriculture Sector Agricultural production in Afghanistan is sup-optimal. Of Afghanistan’s total land area of 65 million hectares, only about 8 million hectares (about 12 percent) are arable – major parts of the country comprise mountains and deserts.40 However, the actual area under cultivation each year is substantially less than the arable capacity – mainly because of shortages of irrigation water. As a result, most arable land can only be cropped on rotational basis. Food crops account for over two-thirds of the cultivated area and are typically grown for subsistence and/or mixed with a variety of other crops, such as perennial horticultural crops and vegetables. Average farm sizes range from 2-5 jeribs (0.4-1.0 hectare) for small-scale producers to 5-10 jeribs (1.0-2.0 hectares) for larger-scale producers. Most poor farmers grow cereals for household food security. Wheat is grown on 80 percent of the cereal area (about 45 percent of total wheat area is irrigated) and accounts for about 70 percent of total national cereal consumption. Wheat is both a major crop in terms of agricultural production and the main staple of the Afghan diet. Supporting agricultural sector development could provide a foundation for sustainable and inclusive growth in coming years. While international aid has stimulated growth in services and the construction industry over the last ten years, the agricultural sector has remained on the margin of modernization. However, agriculture has the potential to grow and contribute to food security, by ramping up the sector's low production and productivity and creating on- and off-farm jobs across value chains. There is broad consensus about the main problems and constraints in agriculture. The World Bank’s agriculture sector review (2014, forthcoming) describes the main constraints to increasing agriculture production as: 40 Afghanistan has an arid to semi-arid climate and availability of water is a key limiting factor on agricultural production. The average annual precipitation (rain and snow) is approximately 250 mm; and varies from 60 mm in the south western parts of the country to 1,200 mm in the north-eastern Hindu Kush Mountains. Evapo- transpiration (a proxy for plant water requirements) ranges between 1,200 mm in the Hindu Kush to more than 1,800 mm in the south west. 76 Afghanistan: Pathways to Inclusive Growth 1. Low agricultural productivity. Years of conflict have led to systematic destruction of productive rural infrastructure (e.g., irrigation systems and rural road networks), insufficient provision of basic technical services (e.g., poor research and extension services), low availability of quality agricultural key inputs (water, improved seeds, fertilizers, and agrochemicals), unavailability of agricultural credit, and poor market access. Afghanistan lags significantly behind its neighbors in terms of agricultural productivity of virtually all crops. Whereas Afghanistan’s average wheat productivity over the past three decades has increased by 25 percent and average production by 54 percent, yields in Iran and Pakistan have increased by 150 percent and 79 percent.41 This has led to production gains of 157 percent and 125 percent in Iran and Pakistan, respectively. This demonstrates the huge potential for increasing agricultural production in Afghanistan. If average yields of irrigated wheat, for example, could be increased from the current 2.5 tons per hectare to 4.5 tons, present demand for imported wheat could be met by domestic production in most years. By narrowing the productivity gap, Afghanistan has a potential to significantly increase its production – even without expanding the area under current cultivation. 2. Low private investment. Unlike in many other countries, Afghanistan’s agricultural sector does not suffer from major price distortions arising from subsidies or trade restrictions. Incentives are largely market driven. Nevertheless, there is little investment both in primary production and processing and there is very little value addition. Most crops and livestock products are exported in a raw, usually dried form. The fundamental cause of low investment in Afghan agriculture is the expected low profitability, resulting from low productivity. Other factors contributing to low levels of investment in Afghanistan’s agriculture include infrastructure deficiencies (e.g., water and power supply), limited access to long-term credit, weak governance, and high security risk. Informal and unclear land tenure arrangements and land disputes also remain serious impediments to investing in agriculture. 3. Poor rural infrastructure. Insufficient irrigation is the most critical constraint to revitalizing Afghanistan’s agriculture. With only about 12 percent of total land area being suitable for crop production, and given the country’s arid climate, inadequate and/or unreliable irrigation water supply prohibits cultivation of up to two-thirds of arable land at any given time. Irrigated agriculture, which accounts for the bulk of the total agriculture production in Afghanistan, has decreased by almost 70 percent. Furthermore, agricultural productivity has fallen to below 50 percent of pre-war levels. This is mainly because of rampant destruction and lack of maintenance of irrigation schemes during the three decades of conflict and insurgency which has reduced the amount of irrigated land to about 1.8 million hectares (50 percent of its pre-war level). Today, there are an estimated 29,000 irrigation schemes in Afghanistan, of which only 9,000 (31 percent) are fully functional, with 13,000 (44 percent) non-functional, and the remaining 7,000 (25 percent) requiring repairs and maintenance to bring them to an acceptable level of performance and productivity. The rural roads network is also in a state of disrepair due to lack of regular maintenance. State-run storage facilities located in various parts of the country are dysfunctional after years of neglect and mismanagement. As a result, production and marketing costs, and post-harvest losses are high, contributing to food insecurity. 41 FAO (2012), Afghanistan: Formulation of a Comprehensive Wheat Sector Development Program. Project Document: 77 Afghanistan: Pathways to Inclusive Growth Maximizing growth in agriculture. The high-growth scenario outlined in Chapter 3 posits agriculture growing at a steady average rate of at least 6 percent per annum over the next decade. Exploiting this growth potential would require increasing output from the current low level of productivity that inhibits subsistence and landless farmers, and further promoting farm-to-market linkages for semi-commercial farmers. The main potential drivers of agricultural sector growth, job creation, and food security are:  Improving irrigation water conveyance and use efficiency. This is an important factor for increasing agricultural production and productivity, as well as macroeconomic stability. The large output swings are mainly due to the large dependence of agriculture on seasonal rainfall. However, with rising populations, water is becoming an increasingly scarce commodity. It is therefore recommended to promote the production of certain types of high value crops that use less water per unit value than staples and have high potential for increasing growth and agricultural jobs. Further development of relatively simple and small scale irrigation structures is important in this respect. During the past decade, Afghanistan has invested significant amounts of public funds in the rehabilitation of irrigation infrastructure. While substantial potential for further investment in physical irrigation infrastructure remains, there is an equally pressing need to enhance the institutional framework and capacity for management of irrigation systems. This is primarily because the main reasons for high conveyance losses and low water use efficiency are not only outdated irrigation structures, but also poor maintenance and inappropriate water management systems. The inefficient use of available irrigation water poses serious challenges to the sustainability of what is perhaps the most important resource for agricultural growth. Given the scarcity of water and the generally poor water management in Afghanistan, improving efficiencies in irrigation management through decentralization to water user associations and irrigation associations could be more strongly encouraged.  Increasing agricultural production (area). Afghanistan still has room for area expansion in both irrigated and rain-fed areas. An estimated 1.8 million hectares of the arable land is classified as government-owned. With appropriate land re-distribution policies, much of this land could be put into production, thereby increasing on-farm employment. Overcoming issues in land markets/tenure systems is critical in this context (see further discussion below).  Raising public investment in agricultural research & knowledge services. Productivity growth in agriculture is based largely on the application of science, technology, and information. However, Afghan farmers have little exposure to knowledge and information services. According to NRVA 2007/08 data, despite shortages of agricultural land in the country, a significant portion remains under-utilized and left fallow during the main growing season due mainly to lack of water and poor soil quality.42 Only 63 percent of farmers use fertilizers, only 16.5 percent use pesticides or herbicides, and only 10 percent obtained information or advice on crops or planning methods; for those who succeeded in doing so, the source of advice was mainly informal rather than coming from qualified experts. The agriculture extension system is largely dysfunctional in spite of many efforts by donors and the government to rebuild knowledge and extension services. There is, therefore, a continued need for strong investment in agricultural R&D; and to link this to pluralistic, demand-driven extension services. 42 Some 28 percent of households with land access report having left unutilized some of their plots. On average, 5 jeribs of rain-fed land and 1.5 jeribs of irrigated land are reported to be left fallow during the summer season. 78 Afghanistan: Pathways to Inclusive Growth Maximizing job growth and inclusion. Overcoming the most binding constraints to growth in the agriculture sector will have a direct impact on poverty by increasing income of rural households. However, the above-mentioned interventions may not necessarily lead to new and more inclusive job creation. Growth-enhancing policies therefore need to be complemented by targeted interventions tailored to easing the constraints faced by poor households, smallholders, and women (see Boxes 4.1 and 4.2). These could include:  Supporting access to credit, marketing, and technology. Smallholders are more likely to face strong financial constraints if they lack asset ownership that can serve as collateral (wealth rationing) or if they are reluctant to put at risk as collateral assets that are vital to their livelihoods (risk rationing). Small farmers are thus disadvantaged in accessing credit to finance productive investments precisely because they lack resources to take advantage of market opportunities and new productive technologies. In order to ease these constraints, the government may have to consider supporting credit inputs and new technologies targeted at small farms. Moreover, supporting collective action and incentivizing the formation of local producers’ organizations and cooperatives would increase smallholders’ market access and competitiveness, and facilitate the delivery of government assistance (group-based credit, in- kind input subsidies, extension services, etc.). In particular, high returns should be expected from investments in rural education to address existing constraints within the adult population. As widely recognized in the literature on TFP in agriculture, literacy and numeracy bring appreciable benefits to farm productivity and modernization, enhancing farmers’ abilities to adopt new production technologies and take advantage of market opportunities (see Boxes 4.1 and 4.2).  Promoting crop diversification for the production of high-value commodities. Cash crops have traditionally been important sources of agricultural growth and employment in many parts of South Asia (e.g., tea, sugarcane, cotton, spices, and rubber in India and Sri Lanka). They are more labor intensive than food staples, with limited options for mechanization and therefore well suited to small-scale production. Afghanistan has significant potential for increasing production of high-value crops, especially fresh and dried fruits and vegetables, to meet the expanding demand in neighboring countries and beyond. However, this potential remains largely unexploited due to poor marketing institutions, security concerns, and high transaction and transport costs resulting from low levels of infrastructure development. To this end, the government could consider increasing support to horticulture sector development and high- value crops introduction43 (saffron, mint, cucumber, and others) through subsidized credit access, investments in agriculture research, technology transfer and training in harvest and post-harvest technologies, or investment in storage facilities and marketing services.  Mainstreaming gender in value chains. Men and women perform different functions in agriculture value chains. Women are generally concentrated at the lower levels of value chains, where they perform irrigation, weeding, harvesting, and minimal processing, such as drying and packing, at the household level. Men, on the other hand, link households with the market to obtain input supply and sell the products, in addition to their substantial engagement in 43 According to crop experts, horticulture – the growing of fruits, vegetables and flowers – is the only sector that offers competitive financial returns. These once made up 40 per cent of Afghanistan's exports, but today the sector is hindered by antiquated production methods, old or non-existent processing facilities, and a lack of commercial nurseries. High-value crops include mint, saffron, and cucumber. 79 Afghanistan: Pathways to Inclusive Growth production. Most of these activities also involve heavy lifting, such as carrying 50-plus kilogram bags to the local market. Men also serve as the actors in the upper levels of the value chains, including middlemen or village-level traders and processors, wholesalers, retailers, or exporters. This division of labor is largely a reflection of social and cultural norms, which do not allow women to interact with men, travel by themselves, or own land. These factors severely curtail women’s access to resources and services, including credit, training, extension, inputs, and trading and marketing networks. Women do not have collateral to apply for credit or opportunities to participate in extension training because selection for these opportunities is often based on land ownership. Moreover, there are few or no women service providers in extension, credit, input supply, or marketing. Despite the key roles women play in harvesting and post-harvest processing, there is little or no training on quality control, including hygiene, sanitation, and higher-value varieties. Recognizing gender patterns in specific value chains can help to design gender-aware policies and support the participation of women in the production of high value commodities (see Box 4.2) Box 4.1: Integrated Skills and Literacy Programs – Farmers’ Field Schools Farmers’ Field Schools with Integrated Production and Pest Management was introduced and supported by the FAO in India and several other countries, by World Education Inc. in Nepal, and by CARE International in Sri Lanka. The program takes a group of farmers through an entire season of a crop, from soil preparation to harvest, storage, and marketing. It aims to help them optimally manage all the inputs in terms of nourishment, pest and disease control, and use of natural and manufactured aids. The farmers – men and women – continue to farm their own land throughout, but they observe a small plot that demonstrates externally recommended practice for comparison with local current practices. The observations and comparisons require close and detailed measurements and recording by each farmer, which means they require the farmers to be sufficiently literate and numerate to be able to take and record the measurements. Although Kenya reports that most of its participating farmers were literate in both Swahili and English, many farmers elsewhere, even, surprisingly, in Sri Lanka (ASPBAE 2000f), are not able to manage the tasks and need tuition in literacy and numeracy. The fact that the farmers see the need and want to participate in the program provides sufficient motivation to start learning the skills. According to the FAO, the motivation is strong enough to enable the program to use existing literacy materials and to apply the “user pays” principle in remunerating the literacy instructors. The farmers recruit their own suitably qualified instructors, and the FAO contracts a suitably qualified organization to train and support the selected people. 80 Afghanistan: Pathways to Inclusive Growth Box 4.2: Developing Value Chains that Work for Women – Raisins, Almonds, and Saffron A gender-disaggregated study of raising almond and saffron value chains in 2011 shows that because men and women perform different functions, the difference in their wages is not comparable. Rural women perform harvesting and post-harvest processing of raisins, almonds, and saffron as a part of household chores; thus, their work goes unpaid. In the case of saffron, however, some women (most likely from women producer associations) are hired by small- or large-scale farmers at Afs 200-300 per day, because these activities are highly labor-intensive and time-bound. A similar wage (Afs 100-200 per day, or Afs 100 per 50-kilogram processed) is paid to women in urban or peri-urban areas, who are hired by processors or wholesalers to clean, sort, grade, and package raisins or almonds for national, regional, and international markets. Post-harvest processing is among the lowest paid work, in which men – who have other opportunities – would not be interested. For example, male laborers, who are hired by exporters to harvest, pack, and load crates of fresh grapes, are paid Afs 400 per day. The case studies show that it is vital for women producers to, firstly, remain in charge of harvesting and post- harvest processing and, secondly, be provided with women-to-women service delivery. These conditions can be achieved by (i) providing training for quality control in harvesting and post-harvest handling, including hygiene, sanitation, sorting, and grading; (ii) mobilizing women producer associations; (iii) developing a pool of women para-professionals at the village level, who would work in critical areas such as input supply, extension, quality control, credit, and trade/market linkages; (iv) facilitating women’s access to credit by developing MFI linkages; (v) facilitating women’s access to medium and high-end export markets by providing certification and supporting research on high-end market preferences; and (vi) using information technology in service provision. Source: The World Bank (2011). Understanding Gender in Agricultural Value Chains: The Cases of Grapes/Raisins, Almonds and Saffron in Afghanistan. Resource Corridors: an Approach to More Inclusive Mining Afghanistan’s large resource base is undeveloped. The country has a portfolio of minerals, from well- documented assets in copper, coal, iron ore, gold, and oil and gas, to more speculative deposits in those minerals as well as lithium and others. Developing this resource base and turning the mineral sector into a viable source for economic growth and fiscal revenue is costly. Extractive industries are very capital intensive compared to most other economic activities because they require high sunk cost, high search costs for exploration, continuous injections of capital to maintain production, and high financing costs. Furthermore, as a primary sector its returns to investment are sensitive to volatility in global commodity markets. The investment required to develop and exploit Afghanistan’s natural resources far exceed the country’s available resources. The primary challenge in developing the mining sector in Afghanistan is therefore to attract and secure international, private investment. In recent years, the government has made tremendous progress in creating an enabling environment for private investment in the extractive sectors. Decades of conflict and the Soviet legacy of centralist planning left Afghanistan with a sector that was characterized by large, inefficient state-owned mining companies, many small illegal mining operations and an inadequate institutional, legal and regulatory framework for investment, social and environmental safeguards. Recognizing the need for reforms, the government, with support from international partners, restructured the Ministry of Mines and Petroleum, built up capacity among its core staff to tender, negotiate and manage contracts, revamped a number of laws and regulations and improved overall governance and transparency of the sector. As a result, the government succeeded in attracting international investors for the development of two large- scale mining deposits in Aynak, Hajikgak, and Amy Darya. Contracts for another 11 prospective mines are expected to be tendered in the near future. 81 Afghanistan: Pathways to Inclusive Growth However, there are still a number of imposing constraints to the growth of the mineral sector. The National Priority Program on Extractive Industries Development recognizes, first and foremost, that there is a general lack of critical infrastructure, poorly developed roads, an absence of rail and road links to land ports, insufficient power and water distribution systems, and poor spatial planning that limit production and access to regional and global markets. Second, there is a general shortage of skilled, professional workers and limited availability of vocational training opportunities and higher education. Finally, there are still large gaps in the legal and regulatory environment of the mineral and hydrocarbon sector. Applying a corridor concept to natural resource development could help to maximize impact and make minerals more inclusive. One of the largest pitfalls in developing the mineral sector is that extractive activities often happen in isolated, local enclaves, with many inputs (including labor) imported from other countries, minimal infrastructure directly linked to the mines but without much other development around it. Breaking out of enclave development, requires a broader approach that uses resource extraction as an anchor for subsequent development of local upstream and downstream industries, infrastructure connectivity, and spillovers to the rest of the economy. Such a “resource corridor” approach is more than a geographic concept; it is defined as “a strategic sequence of investments and actions to leverage a large extractive industry investment in infrastructure, goods and services, into viable economic development and diversification along a specific geographic area”. The concept has existed implicitly for some time: in a sense, the developed world itself industrialized along resource corridors: for instance, the coal belt in north England, the iron and steel industry in Belgium, and the Ruhr Valley in Germany. In recent decades resource corridors have been developed in Chile, Mozambique, Zambia, and elsewhere. The Afghan government has recognized the importance of such an approach in its National and Regional Resource Corridor Program (NRRCP), one of the National Priority Programs (NPPs). The program is a powerful approach to generating inclusive growth from a sector that otherwise might be an enclave of isolated activities. There will be significant challenges and risks, particularly around governance and the timing of the resource investments. These will need to be addressed by combining and sequencing “soft” and “hard”44 interventions to maximize economic impact and inclusive job creation. Synergies between public and private sector actions will need to be found and leveraged. The approach taken must be robust to the significant uncertainty ahead, ranging from political and security to commodity markets and exploration results, to sequencing actions both to avoid too much waste if negative scenarios materialize and to quickly capture benefits if uncertainties are resolved positively. If that can be done, then within the limits of the possible the resource corridor can be a new source of inclusive growth in the transformation decade. While direct job creation will be limited, as described above, if a modest supply chain is successfully developed, and downstream investments – in particular, in a steel mill – take place, indirect job creation could reach 100,000, in an optimistic scenario. The largest job effects will occur, however, through induced activities enabled by the public and club goods45 44 “Hard” refers to physical infrastructure, such as roads, rail and power, and the operational systems required for it to operate. “Soft” refers to social infrastructure, such as organizations for collective action, firm capabilities, skills, health services, cultural preservation, and so forth. 45 “Public goods” are goods or services from which consumers cannot be excluded (non -excludable), and of which one person’s consumption does not diminish another’s ability to consume it (consumption is non -rival). One example of this is public broadcasting radio. A “club good” is one where the second condition holds, but the first 82 Afghanistan: Pathways to Inclusive Growth created by leveraging resource-related investments (e.g., expanded and more reliable electricity generation and access, higher quality roads, small and strategic communal investments along the corridor). While problems of attribution make estimates of such an effect difficult, there is some evidence that even in environments like Afghanistan they could generate more jobs and improved livelihoods in comparison to enclave development. As set forth by the Afghan government, the Resource Corridor process divides the extractive industry investments into four dimensions: infrastructure (developing roads, power, water and rail), livelihoods (creating jobs), governance (strengthening governmental financial management and monitoring of revenues and policy implementation), and environmental impact and social issues (mitigating environmental impacts, especially to water, and ensuring that benefits are shared throughout each region). The government has also has identified the short-, medium- and long-term actions needed to achieve this development (Map 4.1). The first such segment to come online will be developed in the north, around the hydrocarbons. The second will be in the east, anchored on Aynak and the coal fields, while also touching the gold deposit at Qara Zaghan. The third segment is not anchored in any specific resource investment, but connects the country and expands the number of transport options for each of the resource investments and associated activities. This segment – the “cross-Hindu Kush” – is anchored on the Salang Tunnel and on a North-South transmission line which bypasses the Salang. Both of these critical investments align closely with strategies and plans developed within sector processes (e.g., the Salang being identified as a critical road investment in transport plans and the transmission line fitting in the Power Master Plan). The final segment anchors on energy and steel, with a number of options on the size and nature of the actions to be taken that will be clarified only after the next two to three years of exploration (e.g., dimensions of the steel mill and potential downstream activity; voltage level of power transmission). does not, i.e., one person using it does not prevent another doing so, but not all can use it freely. An example of this is a toll road. 83 Afghanistan: Pathways to Inclusive Growth Map 4.1: Planned Resource Corridors – Short- and Medium-Term Segments The financing requirements for the planned resource corridors are high. The development of all four short- and medium-term segments would involve, across all segments, investment in soft and hard infrastructure in the amount of US$ 7-9 billion over the next decade. Programs, however, could be scaled by implementing a pilot in one segment, linked to an anchor investment, and then replicated to others. Such an approach could generate relatively large economic returns from a much smaller investment. Much larger investments, though, are required in road, power, water, and rail. Investors have already committed to fund infrastructure in the amount of US$2.5 billion; relevant projects in the amount of US$1 billion are already funded and underway. The remainder is still unfunded and would require additional donor support. Priority actions for reform and investment. Developing a resource corridor is a continuous process that will require many reforms and investment over time. Given the large work program, it is not easy to single out and give priority to specific actions. However, a number of issues require some more urgent attention, either because they will help securing already committed investment or because they would serve as a strong political signal for the government’s commitment to a sustainable development approach in the extractive sectors. The latter, especially, could help to reduce transition-related uncertainties. Two other issues relating to land acquisition and water are discussed in the sections below.  A series of preparatory activities are needed for infrastructure investment. Full feasibility studies, environment and social impact assessments (ESIAs) – and, if appropriate, design studies and resettlement action plans (RAPs), and environment 84 Afghanistan: Pathways to Inclusive Growth management plans (EMPs) – need to be developed for hard infrastructure in the Resource Corridor Strategy. The initial pipeline of investments to be prepared includes: the North-South transmission line (Mazar-Bamyan-Kabul); Mazar-Kunduz road upgrade; and the development of the Middle and Upper Logar aquifers. These sets of activities could be specifically targeted towards infrastructure that clearly relates to the resource corridor, i.e., which accelerates and/or leverages large extractive industry investments, underpins inclusive growth and which is, in the early phases, justifiable even without extractive investments.  Mining Law and Regulations. At present the mining sector is still insufficiently regulated by the 2005 Minerals and Hydrocarbon laws of Afghanistan (amended in 2009). One of the largest gaps in the legal and regulatory framework relate to safeguards for international investments as well as guidance on licensing, tendering and mining obligations. The government has drafted a new law which was approved by the Council of Ministers in July 2012. The approved draft law shows significant improvements with respect to transparency, including the obligation for all stakeholders to comply with the EITI’s 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. However, provisions related to investment safeguards, award and type of mineral rights and licensing requirements are somewhat blurred and still leave too much room for discretionary decisions by the government. If the law cannot be further changed prior to ratification, the government could consider addressing some of these gaps by issuing strong regulations and procedures and complementing the law with a targeted outreach activities. Other regulatory gaps that need to be filled exist with respect to mining royalties, community development agreements and artisanal and small-scale mining.  Extractive Industries Transparency Initiative (EITI) validation. Afghanistan endorsed the principles of the EITI in 2010 and is currently in the process of validation of compliance with EITI standards. The independent validation report was finalized in March 2013 and found that Afghanistan has been falling short of fully meeting all EITI requirements. Specifically, the validator expressed concerns regarding the functioning of multi- stakeholder groups, the scoping of the EITI Report, the full participation of all companies and government agencies, the quality of the data provided, and the follow up on discrepancies. Afghanistan has now time until end-2014 to implement specific interventions and apply for re-assessment. It will be critical that the Afghan government vigorously follow-up on the EITI process and achieves full compliance within the given timeframe as it would risk suspension or even de-listing.  Government oversight departments must be strengthened. Government institutions and departments responsible for the mining sector need to be strengthened. This will entail some redeployment, training, and reskilling of staff. Emphasis needs to be given to training in negotiations with investors, monitoring of compliance with various regulations and contract obligations, and ability to maintain open and transparent communication with all stakeholders. 85 Afghanistan: Pathways to Inclusive Growth  Community involvement must be an integral part of resource development. Livelihood support and vocational training are key elements of this process. The biggest challenge in the development of extractive industries appears to be increasing the value-addition generated by mining operations in a way that local communities and excluded groups can benefit from this development. For this to happen, the development of private sector capability will need to deepen in both downstream and upstream industries. The first step in increasing the involvement of domestic companies in mineral value chains is to make existing companies aware of the possibilities. This means that the government or business groups (e.g., chamber of commerce) need to create information banks that include all the contracts up for bid. As a first step, the government is planning to increase the ability of the national and local private sector to enter the supply chains of the oil and gas (Amu Darya and the Afghan-Tajik basin) and copper investments (e.g., Aynak). It will do so through contracting the relevant private sector associations to establish industry liaisons, to spread information about opportunities, organize general purpose trainings, etc. and provide general SME support through existing donor programs. A wide range of skill sets will be needed by the extractive industries, from top management to basic mining operations. To ensure Afghans can seize these upcoming employment opportunities, actions will be required to increase the quality and the quantity of available professional and vocational qualifications available in Afghanistan. A recent World Bank analysis46 found that unskilled and semi- skilled positions will account for 70 percent of the employment estimates. A fair share of these jobs will be cross-sector jobs, meaning that workers could work in other industrial sectors after being properly trained. High-end jobs, specialized in geology, resource management, and petroleum engineering represent only 10-15 percent of skills needed. While actions on all types of skills need to be taken to ensure an adequate supply could be provided, priority need to be given to skills that are easier and less costly to develop, with a maximum impact on the workforce (Figure 4.2 shows this, with a timeline of currently planned extractive projects). To this end, he government is currently planning to establish a matchmaking facility to coordinate skill initiatives with donors, higher education institutions along the first segments of the resource corridor (such as Kabul University and Balkh University), TVETs in the same areas, and private sector investors. The idea is to match demand and supply of skills, for example, through funding career service officers and jobs fairs. 46 World Bank (2013). Afghanistan Resource Corridor Skills Strategy Development Final Report. Washington, D.C. 2013. 86 Afghanistan: Pathways to Inclusive Growth Figure 4.2: Prioritization of Required Skills for Planned Extractive Projects Source: World Bank, 2013 Support for small-scale mining and women jewelry producers. Afghanistan is well-known as a producer of high quality gemstones, including sapphire, ruby, emerald, tourmaline, and the like. As opposed to other minerals value chains, gemstones have the added benefit that most of the value chain can be developed domestically, thus forming a viable and strong sub-sector, with significant employment and skills creation, especially for women, as well as substantial revenue generation for governments. There are good examples in other countries that have demonstrated the beneficial labor effects of women being integrated into the gemstone value chain at production, trading, cutting/polishing and jewelry design stages. An additional benefit is that it could take less time to develop gemstone value chain while larger mines are still being built. As such, in the short run, smaller and traditional mines could more likely to contribute to Afghanistan’s economic development. A number of small donor-funded initiatives are already underway that provide training, technical assistance and market linkages in the gemstone sector. At present however, the sector suffers from unlicensed operations, with miners often being underfunded, untrained, and ill-equipped. As a result, miners export only the raw, uncut stones across the border to Pakistan, and lose most of the value addition. Many gemstone mines are also subjected to looting and raids. Regulating illegal mining is currently difficult because of the many vested interests involved in exploitation, smuggling and trading of gemstones. And – as with opium production – many livelihoods depend on illegal mining of gemstones. Nevertheless it might be worthwhile exploring the opportunities that a more regulated approach has to offer. The government is currently also investigating women‘s employment opportunities in mining value chains through the handicraft production of copper-based jewelry. The Aynak valley has produced 87 Afghanistan: Pathways to Inclusive Growth copper jewelry for hundreds of years, and it is believed that women, equipped with the relevant skills, could again work in jewelry production. Through targeted and publicly supported intervention, the Aynak copper production could address employment and local revenue generation, recreate the links between the copper deposits and the communities, and provide additional incentives for the local populace to protect and promote mining activities. Supporting Growth Dynamics in Services Sectors Services play a key role for inclusive growth since they tend to be more labor intensive and can as an engine for creating jobs. It is a stylized fact the share of services in a country’s total economic output will increase as its per capita income rises. Services are a key input of nearly every business and are a primary determinant of productivity growth within an economy. Services in in Afghanistan are expected to grow over time, mainly as a result of increasing demand for services in the down- and upstream industries, including transportation, logistics, communications, retail and finance, from anticipated developments of the agriculture and mining sectors. In fact, the simulations outlined in Chapter 3 imply that the growing demand arising from these two sectors would be sufficient to more than offset the drop in demand associated with the decline in aid. As growth in agriculture and mining unfolds, it will be important to continuously improve the investment climate to ensure that entrepreneurship and private enterprises are not stifled. Given the limited need for highly sophisticated services in Afghanistan’s agriculture and mining sectors at this early stage of development, it can be expected that, for the most part, the services industry will “take care of itself” in the sense that it is likely that for the next decade it will naturally adapt to the level and patterns of demand and develop the necessary capabilities without much policy attention. The historic expansion of the services sector in Afghanistan proves the case in point. Nevertheless it will be important to ensure that that the private sector has a fertile ground to grow and that policy reforms ease impediments for entry and exit of firms as well lower the cost of doing business in Afghanistan. Ongoing reforms show encouraging results. Afghanistan still ranks low in the World Bank’s Doing Business index (which measures the ease of doing business), at place 164 out 189 countries surveyed for the 2014 Doing Business report. However, recent policy reforms have demonstrated the government’s commitment to private sector development and have helped to improve Afghanistan ranking. These include (i) easing starting a business by reducing the time and costs to obtain a business license and by inspections of the premises of newly established companies, (ii.) improving access to finance by implementing a unified collateral registry and (iii.) decrease the time, costs and number of steps to obtain a construction permit. Future reforms need to address remaining policy barriers in the investment climate. The 2014 Doing Business survey highlights four areas with the largest policy-induced impediments to business: trading across borders, protecting investment, registering property and enforcing contracts. Possible next steps in investment climate reforms in these areas could include:  Registering property: streamline paperwork required for the transfer and registration. This could involve computerizing the process and the creation of a single-access point for property registration.  Protecting investors: amend the laws for joint stock companies, corporations and Limited corporations to improve disclosure requirements, increase director liability in related party transaction and to make it easier for investors to enforce their rights through courts. 88 Afghanistan: Pathways to Inclusive Growth  Trading across borders: reduce the number of required documents for trading across borders and align process with international god practice, including the elimination of product-specific export permits  Enforcing contracts: conduct a mapping exercise to identify delays during trials and enforcement of the judgment. Table 4.1: Afghanistan Doing Business Ranking Topics DB 2014 Rank DB 2013 Rank Starting a Business 24 31 Dealing with Construction Permits 167 170 Getting Electricity 104 111 Registering Property 175 176 Getting Credit 130 154 Protecting Investors 189 189 Paying Taxes 98 95 Trading Across Borders 184 181 Enforcing Contracts 168 170 Resolving Insolvency 115 118 Source: World Bank. Doing Business Report 2014 Note: Data points indicate ranking for 189 countries surveyed. Infrastructure – the Centrality of Water and Energy Infrastructure is central to Afghanistan’s development. While there are gaps along the entire spectrum of physical infrastructure, two resource areas in particular pose obstacles to the development of mining: water and power. Water Water is indispensable for agricultural development and livelihood support in Afghanistan. The 2011 drought affecting a major part of the country highlighted the importance of water for human survival, agriculture systems, and the environment. While droughts are temporary phenomena, an estimated 75 percent of land in the country is characterized by moderate or severe desertification. The looming threats of population growth, urbanization and climate change can only exacerbate the situation further – with possible repercussions on food insecurity and water scarcity which could fuel insecurity and 89 Afghanistan: Pathways to Inclusive Growth conflict. Moreover, mining development will add further stresses to limited water supply in Afghanistan.47 Water resources are limited in spite of available resources. In principle, Afghanistan has many water resources and its mountain and river geography provides plenty of opportunities for their exploitation. However, insufficient infrastructure and a lack of capacity limit Afghanistan’s ability to store, properly manage and develop its water sources. Moreover, of the five river basins in Afghanistan, only the Helmand River has a water sharing agreement that can currently be used. The overarching vision of the water sector, as expressed in the National Priority Program is “the development of resilient water management systems that optimally manage the water resources of the country in a manner that contributes positively towards the enhancement of food security in the country.” The currently favored approach to the development of water resources is to build or rehabilitate small-scale infrastructure, such as water gateways (karezes), rainwater harvesting, small weirs in rivers, and small dams and reservoirs. However, such community development approaches to water development will soon reach their limits. Developing large-scale water resources to meet the increasing demand for water is inevitable. Already, the expected growth of Kabul is challenging available water resources. At present the city is drawing groundwater from medium-depth aquifers, which are being depleted and likely contaminated since the city has almost no wastewater treatment system. Through its public pipes and private boreholes, the city draws approximately 30 million m3 of water per year – about the maximum sustainable amount that can be drawn from its aquifer. If Kabul’s population grows to six million over the next years, as some estimate, demand will treble to 90 m3 per year. At the same time, the development of the Aynak copper mine (close to Kabul) will require around 12-20 million m3 of water per year. The aquifer beneath Aynak is upstream from Kabul’s, so there is a significant risk that Aynak’s water withdrawal will contribute to the depletion of Kabul’s supply. The development of Aynak, therefore, will not be sustainable unless a solution is found to Kabul’s water needs. Possible solutions to this problem include:  Construction of new dams in the Kabul River basin. The last large-scale water development dates back to the 1950s. While Afghanistan has a number of dams in the country, only few are operational. The construction of a new dam is therefore recommended, also in light of the increasing electricity needs of the country (see below). Good candidates are “Shatoot” or “Golbahar”, which would require about US$350 million or US$1 billion to finance. Each dam could provide 100 mcm/per year – sufficient water supply for municipal development in Kabul, the mining development in Aynak, and irrigation of areas in Kabul/Panisher area.  Alternatively, the construction of a reservoir (‘impounding dam’) for Aynak could be considered as a medium-term solution. This reservoir could provide another source of water for Kabul in the long-term, after the mine stops operating. However, in a range of scenarios, the water supply from the reservoir would not suffice and conflict over water among Kabul city, irrigation and Aynak might develop. 47 Mining requires water for the extraction of minerals that may be in the form of solids – such as coal, iron, sand, and gravel – liquids, such as crude petroleum, and gases – such as natural gas. This includes quarrying, milling (crushing, screening, washing, and flotation of mined materials), re-injecting extracted water for secondary oil recovery, and other operations associated with mining. 90 Afghanistan: Pathways to Inclusive Growth  Rehabilitation of existing dams throughout Afghanistan, especially in the South (high water scarcity), could be considered as a next step. Water is a regional cooperation issue. Afghanistan shares all of its four river basins with most of its neighbors (Pakistan, Iran, Uzbekistan, Turkmenistan, and Tajikistan). However, Afghanistan has only one existing bilateral treaty, a 60-year old agreement with Iran concerning the Helmand river. Since any new water resource development will affect the water flow to the neighboring countries, trans-boundary agreements with downstream countries are needed. The lack of regional treaties on existing water resources already pose a significant threat of causing tensions that could affect regional stability and economic development. It is recommended that Afghanistan continue its active engagement on international platforms such as the South Asia water initiative. However, water sharing agreements and joint water management take time, resources and commitment. In this respect, the Afghan government is faced with the dilemma of which comes first: the agreement or the commitment to build the infrastructure. Since Afghanistan is financing constraint, neither may occur until one or more donors step forward to fund both the process for negotiations and the infrastructure. Electric Power There remains a significant mismatch between electricity supply and demand, despite the fact that the Afghan government has made tremendous strides in improving access to electricity for its people. While just 5 percent of all households had access to electricity in 2002, connections have increased to 30 percent of all households. Still, next to insecurity, access to electricity is considered one of the biggest constraints to private sector development. As with water, demand is expected to increase due to population pressures, agriculture supply chain development, and mining. Currently, Afghanistan imports around 73 percent of its total power supply. Over the next three years alone electricity imports are expected to increase from 900 MW to 1,400 MW. Mining activities and agricultural value-chain development will further increase the demand for energy. The government’s National Priority Program appears comprehensive in its approach to improving electricity transmission and distribution, strengthening the regulatory framework, improving service delivery and O&M management, and restructuring energy institutions. Nevertheless, in the long run, Afghanistan needs to develop more indigenous power resources to diversify energy and electricity sources, and meet the growing demand. Mining development could help to mitigate some of the energy pressures. The resource corridor developments are not just potential consumers but also sources of power for Afghanistan. The resource corridor may indeed offer Afghanistan an opportunity for partnerships with the private mining developers to generate and transmit power from its domestic coal and gas resources while also undertaking the development of hydro capacity near Kabul. One of the largest challenges to power supply and distribution is the limited interconnectivity of its power system. All neighboring power systems operate asynchronously, and through their exports oblige Afghanistan to operate six separate power systems each synchronized with its neighboring supplier. This limits the opportunities to interconnect and expand the power network in a rational way and raises the questions how to connect the resource corridor power generation with the remaining systems. Of the five main geographically separate power networks in Afghanistan, the North Eastern Power System (NEPS) is the largest. They could all be interconnected if the respective country sources decided to operate either in synchronization or agreed to interconnection with each other through high voltage direct current links. The NEPS currently supplies part of Kabul city over long 220 kV links from Tajikistan 91 Afghanistan: Pathways to Inclusive Growth and Uzbekistan. Other parts of Kabul are supplied from various local hydro and diesel generators which are currently not synchronized with the NEPS. Further investment in transmission cannot avoid the synchronization issue. Asynchronism, long distances, and power transit opportunities, mean that that HVDC systems in some form or another will have to be part of any future Afghanistan transmission system. Indeed, there are several options as to how interconnectivity can be achieved but each comes at its own cost and uncertainty over economic viability which will need to be carefully studied under the National Resource Corridor program. Regional cooperation would provide a compelling opportunity for Afghanistan to meet its energy needs. Afghanistan’s vision, expressed in the National Priority Program, is to retain its significance as an energy transit country linking energy-rich central Asian countries with energy-constrained south Asian countries. To this end, the government participates in two important regional Initiatives, CASA 1000 (intra-regional electricity transmission system) and TAPI (intra-regional gas pipeline). Both projects are expected to produce important transit revenues for Afghanistan and to improve energy security. In this sense, they will constitute important contributions to Afghanistan’s development in the future. Since regional projects of this dimension are complex undertakings that require collective action by several countries who all operate in more-or-less fragile country settings, it will be paramount that political commitment to the regional projects, as well as the regional peace process, is sustained. Human Capital Development Addressing the challenges facing the education sector in Afghanistan will require attention in a number of areas. As Chapter 2 sets out, the stock of skills available to the domestic labor market in Afghanistan is extremely low, in spite of significant improvements in school enrollment rates and education achievements over the past decade. The recent gains have attempted only to keep pace with lost opportunities during decades of conflict. In addition, human capital interventions need also to address the specific needs of the most vulnerable and excluded groups of the society: the rural poor, youth and women. In light of the challenges, it is nearly impossible to single out specific interventions as priorities because a priority list would be impracticably long once all needs were factored it. There is, hence, no question that human capital intervention in Afghanistan ought to be holistic in nature and cover an entire range of instruments across the entire spectrum of human capital development (see Figure 4.3). 92 Afghanistan: Pathways to Inclusive Growth Figure 4.3 : Stepping Up Human Development Efforts for Afghanistan’s Future The current National Priority Programs for human capital development are already quite comprehensive. Their approach is balanced, in the sense that it is planned to continue to expand equitable access, increase equity and improve the quality of basic education, TVET, and higher education. In this context, targeted interventions will be needed to address the issue of out-of-school children and high female dropout rates. The second area is to strengthen government systems to deliver quality basic and secondary education services. While the focus of the past decade has been on emergency rehabilitation of the education sector, the emphasis now is to strengthen systems and ensure quality of education service delivery. Third, the quality and relevance of TVET and higher education will need to be improved, particularly with increasing enrollment in both. To this end, specific TVET interventions and university curricula could be better linked to market needs and formulated within a sector approaches for agriculture and natural resource development. In addition, reducing health vulnerability of the population will require strengthening health and social protection services. The Afghan health system has made considerable progress over the last decade. Infant and maternal mortality rates have declined, the Basic Package of Health Services (BPHS) and Essential Package of Hospital Services (EPHS) have been defined, and a system for contracting with NGOs for delivery of these services has been established. Afghanistan spends a large share of GDP (10 percent) on health, but remains dependent on donor financing and delivery. Future challenges in the health sector include strengthening systems at the Ministry of Public Health to support service delivery, improving tertiary care hospitals that are in a very poor state of maintenance, and addressing an array of barriers to health service delivery. 93 Afghanistan: Pathways to Inclusive Growth Given the limited job prospects in the years to come, strengthening social safety nets will be critically important. Even in the best-case scenario, developments in the various sectors will take some time. It is likely, therefore, that for years to come many people in Afghanistan, especially the youth, will face insufficient opportunities for regular jobs or income streams. The risks this trend poses – including social instability – will continue to grow. Strengthening social safety nets could help to prevent extreme deprivation and provide incentives for further investment in social capital. In this context, social safety could involve developing a mix of interventions including cash transfers (to improve take-up of immunization and nutrition) and short-term employment interventions to address chronic poverty, underemployment, and vulnerability. However, the variety of safety-net options would need to be carefully studied and assessed with respect to financial affordability with the public finance system. Access to Land Afghanistan’s development depends to a large extent also on access and efficient use of its land resources. Private demand for land for agriculture and commercial development is high while the government is endeavoring to develop Afghanistan’s physical infrastructure (including roads, dams, and power networks). The development of the mineral sector and associated infrastructure investment for the resource corridor will require large-scale land acquisition in the coming years. Access to land is central to poverty reduction. According to the NRVA 2007/08 54.6 percent of all Afghan households had access to land, although it is not known how many were considered private owners under the law. Most rural households (69 percent) had access of some kind and 31 percent had no access; the latter may be interpreted as landlessness, but this could also include families who are voluntarily renting accommodation or are otherwise employed off-land. Half of all rural families had access to irrigated land (52 percent), and 22 percent to rain-fed land. While these figures appear high, land ownership correlates with poverty: those who own no land and work as sharecroppers, tenants or farm workers are predominantly in the lowest-consumption quintile.48 Moreover, 79 percent of all rural households owned livestock in 2007/08, signaling high off-farm land dependence, and confirming the importance of clear and fair norms as rangeland ownership and/or controlling and secure rights. Land markets do not function well in Afghanistan, for two main reasons. First, the high intrinsic asset value of land in relation to use value and lack of financial institutions to facilitate land acquisition result in a very thin land market. Second, legal and regulatory impediments to the sale and purchase of land, combined with a lack of a transparent land records and an efficient land administration system, prevent the development of an efficient land market. Outdated 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, communities, and citizens and the state. These shortcomings result in abuses at all political levels and in high transactions costs for land transfers. As a result, access to land is one of the major constraints to private and public investments across all sectors.49 Agricultural development and rangeland rehabilitation are severely hampered by the lack of clear tenure rights. Rapidly growing metropolitan areas, especially around Kabul, face serious problems with massive in-migration 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 48 National Risk and Vulnerability Assessment 2007/8 A Profile of Afghanistan , Icon Institute for EU, October 2009, Kabul. 49 Investment Climate Survey (2008) and Doing Business Report (2011). 94 Afghanistan: Pathways to Inclusive Growth or secure tenure as a major factor driving the lack of socio-economic reintegration of returning refugees and IDPs. Moreover, the process by which the state may acquire private or occupied lands for public purposes lacks the legal and procedural guidance necessary for efficiency and fairness. Although more than 70 percent of rural and urban landholders lack formal or court-issued documentation for their properties, current land acquisition law requires only that minorities with documentation be compensated when their land is appropriated for public investment purposes. Also, there is no formal resettlement policy in Afghanistan. While some improvements in land practices 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 dragged on for years. The government is in the process of improving the legal framework for land management . Amendments to the Land Management Law (2008) and the Land Acquisition Law (2005) have been drafted and submitted to public discussion. Amendments include issues such as formalizing resettlement and compensation principles, enabling communities to secure off-farm lands as community land, establishing 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 women’s ownership rights. The government plans also 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 the 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. Another important concern is the institutional capacity of the land management authority. The government established the independent Afghanistan Land Authority (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. ARAZI is currently establishing an integrated land management system which will also allow improving cadaster responsibilities – an issue of particular urgency for the development of the resource corridor. Only about one-third of all cultivated land is covered by cadaster which poses substantial problems for resolving tenure issues. 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 across the Resources Corridor within a reasonable time frame. Policy priorities for consideration. Experiences elsewhere suggest that reforming land laws and regulations, especially those that touch upon land tenure and security issues can be complex and politically controversial. Given the inherent complexities of Afghanistan’s land issues, any changes in the way the current land system works is likely to face strong opposition. Nevertheless, the development of agriculture and natural resources is unlikely to happen unless the above issues are addressed. Reforms to land management, acquisition and administrations should be therefore considered as an urgent priority on the government’s agenda. Urgent policy actions to be considered include: 95 Afghanistan: Pathways to Inclusive Growth  Advancing land title clearance along the resource corridor. ARAZI could begin the process of clearing title to land along the key resource corridor segments. Clearance refers to the surveying of land, cataloguing the claims to parcels of it, and resolving such claims to establish clear title.  Supporting amendments to land management and land acquisition laws. The legal drafting and consultation process for the land management and acquisition laws is well underway. Given the contentious nature and complexity of these reforms, and the fact that some proposed changes will touch upon vested interests, it will be important that the process receives strong political support by members of the government. Ensuring public buy-in through public awareness campaigns and outreach could further support this process.  Improving the governance structure for ARAZI. As ARAZI assumes increasing responsibilities as an independent authority, it could be encouraged to rethink its transparency and accountability mechanisms. In addition, it could consider opening legal doors to community participation in all land governance matters to help counteract exclusion of poorer sectors and malfeasance and corruption in land and property matters. No amount of improved law can protect the interests and rights of the majority and vulnerable populations without changes in governance. Most immediately, it is recommended that public land expropriation includes consultations with local stakeholders and communities in the affected area.  Land allocation to smallholders. An important indicator of a well-functioning land market is the extent to which land is rented or leased out. This is because renting land requires limited initial outlays of capital, hence there is less divergence between land prices and productive value of land; and renting involves lower transaction costs than land sale. In fact, long-term leases that are secure can be a substitute for individual ownership. To this end, Afghanistan could lease out more of the state-owned land to smallholders. It might also be worthwhile to look into possibilities of market based land purchase system schemes to facilitate land access across different size of farmers.  Increasing capacity of ARAZI: Despite a number of initiatives being tried to ensure ARAZI becomes financially independent, at this time, ARAZI is still lacking sufficient funds for the organization’s daily operation and is therefore hampered by a restrictive budget, which skews priorities. This is mainly due to the current government’s legal and fiscal frameworks that do not allow direct re-investment of fee incomes outside of the normal annual budgetary cycle. At the same time, due to the current volume and complex nature of work, the existing staff of ARAZI are overloaded with the daily operations, giving the leadership less time to focus at a policy formulation and strategic level. Moreover, the required land for mining-related infrastructure investment in the near future will necessitate that ARAZI has more resources available to augment its current institutional capacity (equipment, skilled staff, and training). Ensuring that ARAZI has sufficient staff and financial resources to carry out its work, will be critical to achieving success with the on-going land governance reforms. Access to Finance Improving financial inclusion is critically important to creating opportunities for income and employment. As mentioned earlier in this report, across the board, enterprises and farming households suffer from a shortage of capital. In 2011, less than 9 percent of Afghans used formal banking products, 96 Afghanistan: Pathways to Inclusive Growth only 7 percent had loans from a formal financing, and only 3 percent had savings deposited at formal financial institution.50 The use of informal financial services (hawala) is widespread and preferred. The government has recognized that small and medium enterprises face several challenges in access to finance and that it is one of the main business constraints hampering firms’ growth. Improving access to finance is therefore one of the key elements in the National Priority Programs. Commercial banks and the microfinance sector have the potential to provide increased access to finance to SMEs but the underdevelopment and the fragility of the financial system in Afghanistan have prevented them to do so on a significant scale. Banking services in Afghanistan remain largely underdeveloped. The banking sector is composed of three state-owned banks (including the newly-created bank following the Kabul Bank crisis, New Kabul Bank, currently under privatization), nine private, fully-fledged banks, and four branches of foreign commercial banks. The assets of the banking system have grown tenfold since 2005, from US$388 million in March 2005 to US$4.32 billion in July 2013, albeit from a very low base. Total outstanding loans amount to US$818 million in July 2013 with loans mainly concentrated in the trade and service sectors (29 and 19, percent respectively) and geographically concentrated in Kabul (81 percent). The banks sustain high liquidity, with US$3.72 billion in deposits as of July 2013. Nevertheless SMEs remain chronically financially underserved and only few banks have specialized SMEs financing. A donor- supported SME Credit Guarantee Facility has been operating in Afghanistan since 2006 and is showing promising results: the Facility has guaranteed loans of a total value of US$108.2 million to more than 3,000 businesses (cumulatively), as of July 2013. In addition, there are six active microfinance institutions and five formal community-based savings institutions. The overall weak commercial banking sector is still shaken by the Kabul Bank crisis. The banking sector is still coping with the aftermath of the Kabul Bank crisis, which was the result of fraud and money laundering activities in which bank shareholders and top management manipulated the bank’s loan books. The crisis threatened the overall stability of the banking sector (as the bank held about one-third of the system’s assets of US$4 billion). A detailed report of the public inquiry into the Kabul Bank crisis (November 2012) highlighted that there are severe weaknesses in governance in the financial sector and the judiciary. A microfinance sector emerging from a major consolidation phase. SME’s (the lower end of the market) also suffer from limited access to finance, as the microfinance sector went through a boom-and- bust cycle, with a steep consolidation of the sector since 2008. From 2003-08, growth of the microfinance sector was steady, with 373,080 active borrowers (and around 450,000 clients) reported by March 2008 and a cumulative US$204 million of loans disbursed by Afghanistan’s microfinance institutions. During that period, the main focus was to scale outreach of microfinance institutions. The microfinance experience in Afghanistan was considered a unique success as it had managed to build a microfinance sector from scratch in five years. However, the extremely rapid growth of the sector with fragile institutions led to a repayment crisis in 2008 – an experience that other countries, such as Nicaragua, Bosnia and Herzegovina, and Pakistan also endured. The rapid client outreach had come at the expense of proper due diligence in lending, compliance with internal control processes and internal monitoring of performance. These factors, combined with cost inflation and a deteriorating security environment, contributed to a decline in 50 The World Bank, 2013. Financial Inclusion Data. Washington, DC. 97 Afghanistan: Pathways to Inclusive Growth portfolio quality of most microfinance providers. During the course of the crisis, several microfinance institutions exited the market and several others merged (see Figure 4.4). Figure 4.4: Evolution of Afghan Microfinance Sector, 2003-2013 (main institutions) 400 $ 140 350 $ 120 300 Millions $ 100 Thousands 250 $ 80 200 $ 60 150 $ 40 100 50 $ 20 0 $0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Gross Loan Portfolio (right) Number of active borrowers (left) Source: MISFA and AMA Policy priorities for increasing access to finance. Increasing access to finance will be crucially important to developing the agriculture and mineral sector including all its linkages in the up- and down-stream industries. It will therefore be critical that the government continues to implement its reform agenda vigorously in order to increase access to finance. This would include:  Enhancing banking supervision by strengthening banking laws and further increasing capacity at the Afghanistan Central Bank. The new, consolidated banking law, once enacted, will help prevent, mitigate, and effectively respond to the problems in the financial sector. The revisions strengthen corporate governance provisions, regulate capital requirements and large exposures as well as enhance supervision and bank resolution. It is recommended to continue focusing capacity building efforts on strengthening of enforcement regulations, improving the timeliness of enforcement, actions, hiring additional staff, provide more training in risk-based banking supervision, and implement a new organizational structure for the Financial Supervision Department.  Strengthening the microfinance sector, with a double focus on stability and innovations. This includes the development a wider range of micro finance products through, for example, credit guarantee mechanisms targeted at underserved groups, small and medium enterprises, low- income households, smallholders in agriculture, and youth.  Strengthening financial sector infrastructure (i.e., public credit registry, collateral registry, payment system and Afghanistan Institute of Banking and Finance). 98 Afghanistan: Pathways to Inclusive Growth Reference List Afghan Public Health Institute, Ministry of Public Health (APHI/MoPH), Central Statistics Organization (CSO), ICF Macro, Indian Institute of Health Management Research (IIHMR), and World Health Organization Regional Office for the Eastern Mediterranean (WHO/EMRO) (2011). “Afghanistan Mortality Survey 2010”. Calverton, Maryland, USA: APHI/MoPH, CSO, ICF Macro, IIHMR and WHO/EMRO. Asia Foundation, The. Afghanistan in 2013: A Survey of the Afghan People. San Francisco, USA. 2013. Bravo-Ortega, Claudio & Daniel Lederman (2005). Agriculture and National Welfare around the World: Causality and International Heterogeneity since 1960. Policy Research Working Paper Series 3499. World Bank, Washington, D.C. 2005 Bolt, J. and J.L. van Zanden (2013). The First Update of the Maddison Project: Re-Estimating Growth before 1820. Maddison Project Working Paper 4. 2013. Booth, David (2012). Development as a Collective Action Problem: Addressing the Real Challenges of African Governance. Africa Power and Politics Programme, United Kingdom. 2012. Byrd, Milante and Anye (2013). A New Approach to Understanding Afghanistan’s Transition. United States Institute of Peace (USIP). Washington, D.C. June 2013. Chen, Shaohua & Martin Ravallion (2007). Absolute Poverty Measures for the Developing World, 1981- 2004. Policy Research Working Paper Series 4211. The World Bank. Washington, D.C. 2007. Collier, Paul (1995). Civil War and the Economics of the Peace Dividend. Centre for the Study of African Economies, WPS/95-8. University of Oxford. March 1995 De Janvry, Alain and Elisabeth Saudolet (2009) Agricultural Growth and Poverty Reduction: Additional Evidence. The World Bank Research Observer, 25:1-20. 2009. Food and Agriculture Organization (2012). Afghanistan: Formulation of a Comprehensive Wheat Sector Development Program. Project Document, Kabul, 2012 Frankel, Jeffrey (2010). The Natural Resource Curse: A Survey. Discussion Paper 2010--21, Cambridge, Mass.: Harvard Environmental Economics Program. September, 2010. Government of Afghanistan. Central Statistics Organization. The National Risk and Vulnerability Assessment 2011/12. Kabul, Afghanistan. 2013. Government of Afghanistan. Central Statistics Organization. The National Risk and Vulnerability Assessment 2007/8. Kabul, Afghanistan. 2009. 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 99 Afghanistan: Pathways to Inclusive Growth Government of Afghanistan, Ministry of Higher Education. National Higher Education Strategic Plan 20120-14. Afghanistan, Kabul. http://www.mohe.gov.af/?lang=en&p=plan Grosh, M., C. del Nino, E. Tesliuc, and A. Ouerghi (2008). For Protection and Promotion: the Design and Implementation of Effective Safety Nets. World Bank, Washington, D.C. 2008. Guimbert, Stephane (2204). Structure and Performance of the Afghan Economy. World Bank SASPR Working Paper. World Bank, Washington, D.C. March 1, 2004. Hoeffler, Anke, Syeda ShahBano Ijaz, and Sarah von Billerbeck. Post-Conflict Recovery and Peace Building, Background Paper for the World Development Report 2011. The World Bank, Washington, DC,. 2011. Holzmann, Jorgensen (2001). Social Risk Management: a New Conceptual Framework for Social Protection and Beyond. International Tax and Public Finance, 8, p 529-556. 2001. International Monetary Fund. Islamic Republic of Afghanistan: First Review under the Extended Credit Facility Arrangement. August 2012, Washington, DC. 2012. International Organization for Migration (2014): Transition, Crisis and Mobility in Afghanistan: Rhetoric and Reality. Geneva, Switzerland. 2014. Joya, Mohammad Omar (2012). Natural Resources: What Strategy for Afghanistan? Samuel Hall, Policy Paper Series No. SH/2012/01. 2012. Loayza, Norman V. and Claudio Raddatz (2010). The Composition of Growth Matters for Poverty Alleviation. Journal of Development Economics, Elsevier, Volume 93. 2010. Martin, Philippe, Thierry Mayer and Mathias Thoenig (2008). Civil Wars and International Trade. CEPR Discussion Papers 6659, C.E.P.R. Discussion Papers. 2008. United Nations Office for Drugs and Crime (UNODC). Afghanistan Opium Survey. Vienna, Austria. 2012. US Department of Defense. Report on Progress Toward Security and Stability in Afghanistan. December 2012. http://www.defense.gov/pubs/pdfs/1230_Report_final.pdf World Food Program. Afghanistan Agriculture Commodity Price Bulletin (year 8, vol. 7), 2012. http://coin.fao.org/cms/world/afghanistan/en/PriceBulletins.html World Food Program. Afghanistan Agriculture Prospects Report, July 2012. http://mail.gov.af/Content/Media/Documents/MAIL_Agriculture_Prospects_Report_2012Jul8th138201 211537380553325325.pdf World Development Report on Gender and Development. 2012. World Bank publications: — Afghanistan in Transition: Looking Beyond 2014. Washington, DC. 2013. — Afghanistan Poverty Status Report. Washington, D.C. July, 2010. — Afghanistan Resource Corridor Strategy. Washington, D.C. 2013. — Afghanistan Resource Corridor Development: Water Strategy - Final Kabul River Basin Report. Washington, D.C. 2013. — Afghanistan Resource Corridor Development: Power Sector Analysis. Washington, D.C. 2013. — Afghanistan Resource Corridor Skills Strategy Development Final Report. Washington, D.C. 2013. 100 Afghanistan: Pathways to Inclusive Growth — Afghanistan: Women’s Role in Afghanistan’s Future: Taking Stock of Achievements and Continued Challenges. Washington, D.C. 2013. — Business Enterprise Survey. Washington, D.C. 2014. — Doing Business Report. Washington, D.C. 2011 — Public Expenditure and Financial Accountability. Washington, D.C. 2013. — Afghanistan - Understanding Gender in Agricultural Value Chains: the Cases of Grapes/Raisins, Almonds and Saffron in Afghanistan. Washington, D.C. 2011. — Afghanistan Gemstone Value Chain Report. Washington, D.C. 2010. — Afghanistan Diagnostics Trade Integration Study. Washington, D.C. 2012. — Afghanistan Agriculture Sector Review. Washington, D.C. 2014 (forthcoming). — Global Economic Prospects. Washington, D.C. 2006. — More and Better Jobs in South Asia. Washington, D.C. 2011. — Protecting Peoples’ Interests? A Social Analysis of Land Expropriation Law of Afghanistan. Washington, D.C. 2014 (forthcoming). — Resource Corridor: Community Benefits Sharing. Washington, D.C. 2013. — Structural Performance of the Afghan Economy. Report No. 30861. Washington, D.C. 2004. 101 Afghanistan: Pathways to Inclusive Growth Annex 1: MAMS Afghanistan Methodology: Overview of the MAMS Framework MAMS is an economy-wide simulation model created to analyze development strategies and their impact on economic growth and outcomes for the Millennium Development Goals.51 The model integrates a relatively standard dynamic recursive computable general equilibrium model with optional modules that link government policies and other relevant indicators to these outcomes. As opposed to partial models, MAMS takes into account intersectoral flows in the economy. To what extent and how the model is disaggregated depends on the questions raised, the specific country context, and data availability. Below we describe the overall model as applied to the case of Afghanistan, referring to the Afghani database that we constructed. We give more detailed explanations of the model when describing the BASE scenario in the next section. Among the Millennium Development Goal indicators, we only consider poverty because of data limitations. Figure A1.1 gives an overall illustration of MAMS for Afghanistan. The actual model takes the disaggregation further, however, such as different commodity and activity sectors and different production factors, and divides the donor and government sectors into security and non-security. Figure A1.1: Aggregated Payment Flows for MAMS, Afghanistan Source: Authors’ illustration. 51 This section draws on Bourguignon, et al (2008). For detailed technical documentation see Lofgren, et al. (2013). 102 Afghanistan: Pathways to Inclusive Growth The core computable general equilibrium model includes a government institution (on budget), the services of which are split into two functions: security and non-security, with each of these requiring current (consumption) and capital (investment) spending. Like other production activities, these government sectors use production factors and intermediate inputs to produce an activity-specific output (in the case of the government this means different types of services). In addition, there is a donor institution that also provides public services but with a budget external to the government, fully managed by donors. The donor institution also provides services disaggregated into two functions: security and non-security, both requiring consumption and investment spending. The combination of government and donor sectors is referred to as the public sector. The private sector is divided into opium, agriculture, mining, other industry, and private services. The factors of production in the model include labor, public capital stocks by government activity, and a private capital stock. The government finances its activities from domestic taxes, other domestic revenue, domestic borrowing (expected in the future), and foreign aid (grants). The donor sector is fully financed by aid grants. Growth in the stock of public (government and donor) non-security capital contributes to overall growth by adding to the productivity of other production activities (both private and public); growth in the security capital stock generated by public investments is only partly linked to productivity.52 An assumed share of the mining capital adds to public capital, reflecting the benefit of mining-related infrastructure for the rest of the economy. The model includes a single household (an aggregate private domestic institution). The receipts of the household consist of factor incomes, transfers from the government, and transfers from the rest of the world (including worker remittances). These receipts are allocated to direct taxes (reflecting government policy), savings (with a savings rate that responds to higher per capita incomes net of taxes), transfers to the government, and consumption (using demand functions derived from utility maximization). In its interactions with the rest of the world, Afghanistan spends foreign exchange on imports and on interest, and how much varies among the household, government, donors, and firms in the different sectors. This implies that the domestic impact of activities will differ. The country’s receipts stem from exports; foreign transfers to the government, the donor sector, and households; government borrowing from abroad; and foreign direct investment. Domestic commodity supplies are imperfectly transformable between two destinations—domestic sales and exports; the ratios between sales to these two destinations respond to changes in the ratio between domestic sales and export prices. Similarly, commodity demanders view imports and domestic output as imperfect substitutes and respond to relevant relative price changes. A MAMS country database is a synthesis of information from a variety of sources, structured to meet the requirements of the model. The model parameters are then defined using this data. The main components of the database are a social accounting matrix (SAM) and other data that reflect the functioning of the economy. The latter are primarily related to stock and share data (for labor and other production factors) and elasticities (related to substitutability in production, consumption, and trade). For the simulations, it is also necessary to provide assumptions about the evolution of policies and other factors that are exogenous to the model. For the Afghanistan MAMS database, several sources were used, including various publications by the government of Afghanistan, the International Monetary Fund, and the World Bank, covering macro and 52 Some security capital is strictly military related and assumed necessary to keep the same level of security. But some security capital involves investments in roads that will add to the economy’s productivity. 103 Afghanistan: Pathways to Inclusive Growth fiscal data, sectoral studies, enterprise surveys, and household surveys. Data for other countries considered similar in terms of relevant structural features were used when the required information was unavailable for Afghanistan. This should not be seen as a serious drawback since the parameters used all fall within the range of those for similar countries. Nevertheless, given data weaknesses, the simplifications that are inherent in any model, and the economic context in a fragile state such as Afghanistan, the results should be taken as approximate indicators of the effects of different policy options and should be considered in conjunction with other inputs to economic policy making in Afghanistan. Simulations Using MAMS, we carried out a set of simulations to assess the effect of alternative policies and exogenous shocks on the macroeconomic and sectoral evolution of Afghanistan’s economy from 2011/12 to 2025/26. The BASE scenario was designed to reflect a likely development of the Afghan economy while, in each non-BASE scenario, selected assumptions were altered. Each scenario is briefly described in table A1.1, and further under each section below. Note that MAMS and its database include the opium sector in its GDP numbers and that the figures in the reference year for 2011/12 are adjusted for historical averages.53 Table A1.1: Descriptions of scenarios BASE Expected developments, including some mining expansion and continued growth in the agricultural sector AGR+ As BASE but with higher agricultural growth MIN+ As BASE but with large mining expansion AGR+MIN+ As BASE but agriculture growth as in AGR+ and mining growth as in MIN+ PUBK- As BASE but with lower returns to public capital Source: World Bank Base Scenario, BASE The BASE scenario (BASE) is designed to represent a plausible development for Afghanistan, incorporating data and projections from multiple sources. It also serves as benchmark for comparison with the alternative scenarios, which address the consequences of major structural changes in the economy, including the scaling up of investments in the agricultural sector and in mining developments. The basic assumption for the BASE is that, unless otherwise stated, the main variables of the economy develop in a manner that is similar to recent trends with little structural change. In selected areas, such as changes in aid and the mining sector, we incorporate additional information. In the BASE, real GDP growth is exogenous for 2012/13–2014/15 (reflecting IMF/World Bank medium- term projections) but endogenous for the remaining years.54 The mining assumptions used in the BASE 53 In addition, the MAMS database has been adjusted to ensure consistency (in the sense that the receipts and outlays of different sectors and institutions are equal), a prerequisite for accurate statistics that rarely (if ever) has been imposed on Afghani economic statistics. 54 Productivity growth is in part endogenous (depending on public capital stocks) and in part exogenous. In the BASE scenario, the otherwise exogenous part is adjusted to generate the target growth rate during the initial period (up to 2014/15). Opium and mining have sector-specific treatments. For opium, productivity growth rates are scaled down on the assumption that the sector is discriminated against in terms of laws and policies. For mining, total factor productivity (TFP) growth is not explicit to ensure that production replicates exogenous data. 104 Afghanistan: Pathways to Inclusive Growth scenario are based on mining data from the World Bank/IFC (2011a). It includes the exploitation of the copper mine Aynak and the iron ore mine Hajigak as well as the Amu Darya oil fields. Production for Aynak is assumed to start in 2016/17 with 50,000 tons and progressively reach 200,000 tons in 2019/20. Investments will total US$2,400 million over the period 2013/14–2017/18. For Hajigak production is assumed to start with 3.8 Mtons in 2016/17 and reach 15 Mtons in 2022/23, with total investments of US$3,000 million over the period 2016/17–2023/24. The oil production at Amu Darya starts in 2013/14 with 150 Mbbls and increases to about 4,500 Mbbls in 2016/17 and onwards, with investments of US$400 million during 2013/14-2016/17. The price of copper is set to US$6,300 per ton, and the cost of production to US$3,160 per ton, while the price of iron ore is set to US$105 per ton and production cost to US$72.5 per ton. The price of oil is US$88 per bbl with a production cost of US$35 per bbl. Profits are then calculated and amortization taken into account, resulting in government revenue (royalties, corporate income tax on profits, and bonuses) and net profits. The domestic impact of mining activities is affected by profit remittances abroad and the extent to which the sector relies on imports (for investments and intermediates) and foreign workers. For the (on-budget) government revenue side, domestic non-mining tax rates are increased gradually and the tax rates on the mining operating surplus are set to replicate exogenous projections for the tax intake from the mining sector. Domestic transfers to the government (representing miscellaneous domestic non-tax receipts) are a fixed share of absorption. These assumptions will increase domestic revenue as a share of GDP from about 11 to 17 percent for the projected period. Foreign borrowing is exogenous in foreign currency, set to let the government foreign debt grow at the same rate as GDP. Foreign grants to the government budget are exogenous in foreign currency and are assumed to increase gradually during the whole period - despite a decrease in overall aid as a larger share of foreign aid goes on-budget (from 17.5 to 90.8 percent). In foreign currency the 2025/26 level is 3.8 times higher than the level in 2011/12. In 2011/12, of the aid going to the government, 55 percent was for non- security (of which 34 percent was investments) and 45 percent for security, almost exclusively consumption (Figures A1.2 a&b). In 2025/26 the government has taken over all security, which results in 43 percent of the government aid being related to non-security and 57 to security. The investment/consumption shares in government security change somewhat during the period, as does its domestic content, since the previously donor managed security activity retain some of its characteristics in those regards (see below). Total government expenditures are determined by the limits of the fiscal space (total receipt net of domestic transfers from the government to the private sector). Figure A1.2a: Assumed Aid Developments, 2009/10-2025/26 Figure A1.2b: Changes in Decomposition of Aid, 2011/12-2025/26 (% of total) Source: Authors’ calculations. 105 Afghanistan: Pathways to Inclusive Growth The donor sector (covering external budget public receipts and spending) has a separate budget. All revenues come from external grants, which decline rapidly as total aid as well as the share of external aid in total aid is phased out (only 9.2 percent of total aid in 2025/26; (Figures A1.2a & b). In foreign currency the 2025/26 level is 8 percent of the level in 2011/12. Out of the total donor budget, in 2011/12 about 62 percent were security related and 38 percent non-security. Out of non-security spending about 68 percent is investment, while about 30 percent of the security budget is investments. The donor spending allocation is assumed to gradually increase the share of non-security spending and by 2015/16 all external security aid is phased out. In the private or household sphere of the economy, incomes are determined by factor returns, transfers from government (a fixed share of absorption) and transfer from the rest of the world (exogenous in foreign currency with growth at the same rate as GDP). These incomes are allocated in roughly fixed shares to direct taxes, transfers, consumption, and savings. The non-government domestic savings are driven by a savings rate that depends on income net of direct taxes and adjusts (relatively marginally) in response to changes in per capita net income as well as an exogenous component, which is marginally increased during the period on the assumption that the investment climate will improve somewhat.55 Private investment is driven by available financing from private savings and FDI (net of government domestic borrowing, which is assumed to be zero in the case of Afghanistan). FDI, split into mining and non-mining, is exogenous in foreign currency. The market for the private capital factor is cleared by its rent. Over time, supply is endogenously determined for non-mining private capital (and labor as described below), but exogenously for other factors (mining capital and land, split into land for opium and land for other agriculture). The marginal product of public (government and donor) capital is initially set at 7.1 percent,56 and will after that depend on depreciation and the growth in sectors that profit from the accumulation of new capital— that is, private non-mining and, to less extent, government sectors. To consider possible capacity constraint when the government takes over parts of the external budget, or just as a general analysis of the importance of efficiently managing public investments, an alternative scenario (discussed below) assumes a 50 percent cut in the marginal product of public capital. We now turn to the results of the BASE scenario. The resulting average annual growth rate for GDP at factor cost for the BASE scenario is 4.8 percent per year for 2012/13–2025/26 (Table A1.2). Growth in GNI (GDP at market prices plus net factor income) is slightly slower at 4.3 percent, while growth in GNDI (GNI plus net current transfers) is much slower at 2.6 percent due to the decline in transfers (as grant aid declines). This GDP growth rate of 4.8 percent is significantly lower than the 9.2 percent average the latest decade. The withdrawal of aid plays a large part (see further in World Bank (2012)) but maybe to a lesser extent than expected. There is a difference in local content (domestic demand share) between the government and donor budget, resulting in a somewhat higher domestic impact when aid is on-budget. Table A1.3 presents the resulting domestic demand share in MAMS drawing on approximate data for import of goods and labor for the specific activity and related investments (import shares of intermediate value added is included). Hence, total aid does decline drastically but the negative impact on growth is dampened somewhat by a higher average domestic impact of aid as it goes on-budget. 55 Improvements in the general investment climate will be discussed below but is not least expected given the development of resource corridors from mining investments. 56 This means that for every 100 Afghanis worth of public investments total value added will increase by 7.1 the following year. 106 Afghanistan: Pathways to Inclusive Growth Table A1.2: Real Macro Indicators by Simulation (% annual growth 2011/12-2025/26) Source: Authors’ calculations. Table A1.3: Domestic Demand for Different Types of Aid (%) Type of aid Domestic impact Government managed Nonsecurity 69 Security 96 Donor managed Nonsecurity 25 Security 14 Note: These calculations include adjustment for the use of foreign labor, directly imported goods, imported content in sectors used as intermediate inputs, and any capital income remitted. To illustrate, for government-managed non-security spending, 69 means that, if 100 Afghanis is spent in this area, 69 Afghanis will be the direct increase in demand for domestic output. Indirect effects will add to this direct effect. Source: The World Bank Growth in absorption (total domestic consumption and investment—that is, final domestic demand) is slower than GDP growth, at only 2.6 percent. This is related to the balance of payment constraint and the loss in aid—over time, the economy is forced to drastically reduce its (goods and services) trade deficit from about 60 percent of GDP in 2011/12 to around 25 percent in 2025 in the BASE case, following the decline in grant aid. As a result exports have to grow much more rapidly than imports (6.1 percent a year compared to 1.4 percent a year), imposing the lower growth in domestic demand growth compared to GDP growth. This scenario also results in a significant depreciation of the real exchange rate by around 0.7 percent per year, or a total depreciation of about 12 percent between 2011/12 and 2025/26. This effect, in particular, will boost exports and limit imports to the extent needed to maintain a balance in the external accounts. The depreciation may be surprising as there is an expected appreciation pressure from the expansion of mining. However, the decline in aid is significantly larger, resulting in a net effect 107 Afghanistan: Pathways to Inclusive Growth of a depreciating exchange rate, encouraging exports rather than challenging the competitiveness of non-mining exports. Among the components of domestic final demand (absorption), public (government and donors) consumption grows at only 1.0 percent and public investments even declines by 0.1 percent, due to the drastic decline in the external donor budget. However, private consumption and investments (including FDI) grow at 4.0 and 4.1 percent respectively. The assumed gradual increase in the household savings rate underpins private investment growth. Sectors will respond differently to the changes in economic fundamentals, not least due to relative price changes in favor of relatively tradable sectors driven by the depreciation of the exchange rate. The non- mining industry grows at 4.6 percent, and more or less follows the economy-wide annual average for the 2011/12–2025/26 period. The non-mining industry, which includes construction, is negatively affected by the withdrawal of aid, but positively affected by the expansion of mining and its construction of ancillary infrastructure. Mining, which starts from close to zero growth, grows at a very high rate of 64.9 percent; however, given its small initial size, it is more meaningful to assess the mining sector on the basis of its GDP shares (Table A1.4). Agriculture grows close to its historical rate at 4.1 percent on average, as does the opium sector initially. This is reflecting the assumption that opium expansion is a likely coping mechanism for households affected by the withdrawal of aid. However, opium growth declines significantly after 2016/17 resulting in an average annual growth of only 2.3 percent over the whole period. The service sector grows much slower than during the reconstruction phase, not least due to the significant reduction in donor activities. However, the sector still grows close to the rate of the overall economy (4.7 percent on average). In particular, public services grow at the annual rate of 6.0 percent, with a decreasing contribution from the donor activities and increasing from the government. Private services grow at only 3.9 percent, affected by the decline in aid and the limited ability of this sector to profit from the depreciated exchange rate. Table A1.4: Average Annual Growth in Value Added, 2011/12-2025/26 (%)* * By activity in first report year and by simulation in final report year. Source: Authors’ calculations. As shares of nominal GDP the major change in 2025/26 compared with 2011/12 is that mining increases from close to zero to 9.5 percent of GDP (Table A1.5). Another major change is the decline of private services from 18.1 percent of GDP to only 13.6 percent. Considering the increase in the share of public services, overall services decrease from 29.0 to 27.4 percent of GDP. Agriculture declines somewhat, from 29.5 to 28.4 percent, as does opium (from 14.6 to 11.5 percent), and non-mining industries (from 26.4 to 23.3 percent). Hence, as expected, we see a structural transformation with increased emphasis on mining while especially private services decline in importance. 108 Afghanistan: Pathways to Inclusive Growth Table A1.5: Shares of GDP at Factor Cost (%)* * By activity in first report year and by simulation in final report year. Source: Authors’ calculations. Considering both sectoral growth rates and GDP shares, Figure A1.3 presents the contribution to overall growth by sector for each scenario and for the 2010/11-2011/12 average for comparison. Services are less important to growth (contributing 1.4 percent) compared to the reconstruction phase, due to the withdrawal of aid and hence declines both in public and private services (the latter including transport). Government services’ contribution to growth is negligible to begin with, but becomes increasingly more important as the share of on-budget aid increases and as both mining revenues and general domestic revenues take off. The same happens to private services that decline during the transition but recover somewhat. Public (donor and government) services and private services each contribute with 0.7 percent on average for the whole period. Non-mining industry contribute with 0.8 percent on average, which again is lower than before, implying that the decline in demand from aid related activities weighed more heavily than other changes, including the increase in mining related construction demand. Mining increases its contribution from close to zero to 0.8 percent, even though mining expansion does not take off until a few years into the period of analysis. Agriculture’s contribution of 1.1 percent is lower than in 2010/11-11/12 but that should be read as a sign of volatility rather than a trend. Opium’s contribution increases for a few years before it decreases, generating an average growth rate of 0.3 percent. Figure A1.3: Decomposition of Growth in GDP at Factor Cost (%) 2011/12-2025/26* 109 Afghanistan: Pathways to Inclusive Growth * By activity in first report year and by simulation in final report year. Source: Authors’ calculations. Overall headcount poverty decreases from 33.6 in 2011/12 to 24.2 percent in 2025/26 in the BASE scenario, given a GINI of 0.29 as reported from a recent household survey.57 Interestingly, there is little change in the un- and underemployment rate, which decreases from 27.5 to 27.2 percent, so the main factor contributing to poverty reduction is an increase in the return to employment. The distribution of the new employment opportunities are presented in Table A1.6. Not surprisingly, the mining sector’s contribution to employment is marginal due to the capital-intensive nature of mining and the high share of foreign workers. The main sector contributing to employment is the agricultural sector. Even though it grows at a lower rate than the overall economy in the BASE scenario, it contributes to 52 percent of the new employment opportunities due to its high labor intensity. Non-mining industries, private services and public services each contribute to 11-15 percent of the new employment opportunities. Employment in the donor sector is reduced drastically but the government is expected to increase employment as more aid is channeled through the state budget. Table A1.6: Sector Distribution of New Employment Opportunities (% of total employment change) Source: Authors’ calculations. Increased Agricultural Growth, AGR+ Historically, agriculture has been subjected to weather dependent output volatility and low average growth rates (3.9 percent on average during the reconstruction). The AGR+ scenario assumes more investments in the agriculture sector (such as in irrigation technology), resulting in growth of 6.7 percent 57 As a sensitivity analysis a GINI of 0.4 – the average of developing countries – was also used resulting in a higher poverty rate of 27.6 percent for the BASE scenario. 110 Afghanistan: Pathways to Inclusive Growth annually on average rather than 4.1 percent in the BASE scenario (value added developments are illustrated in Figure A1.4). Figure A1.4: Agriculture Value Added Development, 2009/10-2025/26 Source: Authors’ calculations. With the higher growth in the agricultural sector, overall growth increases from 4.8 percent in the BASE scenario to 5.8 percent annually on average between 2011/12 and 2025/26. Absorption increases by 0.7 percentage points as domestic demand is stimulated. The main difference in domestic demand compared to the BASE scenario is the increase in private consumption growth from 4.0 percent to 5.2, and growth in private investment from 4.1 to 5.7 percent. Export growth also increases compared to the BASE (from 6.1 to 7.6 percent), despite the lack of depreciation of the exchange rate (constant on average rather than growing at a rate of 0.7 as in the BASE) – resulting not least from the higher GDP growth. Under the AGR+ scenario, the contribution of agriculture to growth almost doubles compared to the BASE (from 1.1 percent to 2.1). Non-mining industry and private services increase their contribution somewhat while public services become less important. Higher agriculture growth has a strong impact on poverty through its effect on the household budgets. The headcount poverty rate declines by an additional 8.9 percentage points compared to the BASE (i.e., from 33.6 percent in 2011/12 to 15.3 in 2025/26). The un- and underemployment rate declines by an additional 1.7 percentage points compared to the BASE. Note however, that the additional employment effect is not heavy in agriculture itself. The higher growth in agriculture is due to (i) extensive expansion (new land can be cultured) that leads to more agricultural employment, and (ii) intensive expansion (currently cultivated land can be more productive) that leads to labor being able to leave agriculture for other sectors. Hence, the additional employment due to the high agriculture growth mainly happens in non-mining industry and services (Table A1.6). Additional Expansion of the Mining Sector, MIN+ In addition to the well-known Aynak and Hajigak mines and the Amu Darya oil fields, eleven other highly prospective mines have been identified. IFC (2011b) has estimated the expected production value, operational costs, and investment needs (taking into account the public character of many investments that could be shared among several mines) for a scenario that also includes these 11 additional mines. 111 Afghanistan: Pathways to Inclusive Growth On the basis of this database, we simulate the impact of such a strong, but still plausible, mining expansion. Figure A1.5 shows the resulting mining value added magnitude of this scenario compared to the BASE. Figure A1.5: Additional Mining Value Added in BASE and MIN+ (constant US$ m) Source: Author’s calculations, based on data from IFC (2011b). Apart from the mining value added growth itself, overall growth is encouraged by the higher public capital stock resulting from (i) the additional government revenue, and (ii) the share of mining investments that is assumed to be available to the rest of the economy (including roads and power plants; some 20 percent of total mining investments). According to the simulation results, GDP growth would increase from 4.8 percent in the BASE case to 5.9 percent with the additional 11 mines. Growth in public consumption and expenditure increases from 1.0 to 1.5 and -0.1 to 0.6, respectively, due to stronger growth in fiscal revenues – not least from mining itself. Household consumption and especially household investment also increase; growth in private investments is 6.0 percent on average instead of 4.1 in the BASE case with less mining exploitation. Consequently, absorption grows by 3.1 percent annually instead of 2.6 in the BASE. The real exchange rate depreciation is somewhat lower due to the increased inflow of foreign currency related to mining – reflecting both increased exports and increased FDI – even though this effect is mitigated by remitted profits and the relatively low domestic content in mining intermediate demands and investment. Exports grow by as much as 8.3 percent per year, which is 2.2 percentage points higher than in the BASE. In terms of sector effects, the contribution of mining to growth increases from 0.8 in the BASE to 1.8 percent as an average for the whole period in MIN+. Behind this is a mining specific annual sector growth that is as high as 75.9 percent. The resulting mining share in 2025/26 is 19.4 percent of GDP, which is similar to the share of non-mining industry (21.1 percent) and just slightly lower than the shares for agriculture (24.2 percent) and services (25.7 percent). Agriculture grows at a slightly lower rate than in the BASE scenario, not least due to the lower depreciation challenging its exports. The growth of non- mining industry, such as construction, increases due to the heavy investments needed for mining. Private services grow by an additional 0.4 percentage points and public services by an additional 0.8 percentage points, not least due to the high fiscal revenue from mining. Note that even though overall growth in the MIN+ scenario is more or less the same as in the AGR+ scenario, the effects on poverty is vastly different due to the difference in household income effects 112 Afghanistan: Pathways to Inclusive Growth resulting from local labor intensity in production. In the MIN+ scenario, the poverty headcount rate is 22.1 percent in 2025/26, compared to 15.3 percent in the AGR+ scenario. High Growth Scenario, AGR+MIN+ To illustrate the potential of the Afghan economy, we also present the results of a scenario where mining is exploited as in MIN+ combined with high growth in the agriculture sector as in AGR+. This could represent a scenario where the government taps the potential of its vast natural resources and uses the increased fiscal space for broad-based growth through investments in agriculture. The resulting overall average growth rate increases to 6.7 percent in the AGR+MIN+. Public investments grow by as much as in the MIN+ scenario (0.6 percent) while private investments grow at a rate as high as 7.2 percent. Exports also stand out, growing at 9.5 percent on average, kept in check by a marginal appreciation of the exchange rate by 0.1 percent per year. The headcount poverty rate is as low as 13.9 percent in 2025/26. Apart from in agriculture, many of the new employment opportunities are created in services. Private services are encouraged by the broad based nature of growth while public services expand through the high mining revenues in addition to an increase in other domestic revenues.□