The Afghan Economy I: History and Key Issues

1. The Afghan Economy I: History and Key Issues NS3041 October 2008 Dr. Robert E. Looney relooney@nps.edu

2. Outline I • Introduction • Importance of Understanding the Afghani Economy • The Pre-2001 Economy • General Characteristics of the Pre-war Economy • Effects of the Soviet Occupation • Developments in the Post-Soviet Period • Destruction Caused by the Conflict • Changes Brought on by the Taliban • The Post-2001 Economy -- Overview • Economy after the Fall of the Taliban • Economic Consequences of Conflict • Break

3. Outline II • Economic Strategy Considerations • Key Development Objectives and Priorities • Development Obstacles and Strengths • Building on Economic Positives • Economic Performance • Difficulties in Evaluating Performance • Recent Macroeconomic Performance • Growth • Inflation • Agriculture • Recent Sector Trends

4. Outline III • Macroeconomic Assessment • Unemployment • Poverty • The Working Poor • The Budget • Fiscal Vulnerability • Debt • Afghani Opinions • Break

5. Outline IV • Policy Assessment • Economic Management • Development Management • Sector Policies and Performance • Governance Issues • Problems of Corruption • Over-all Assessment • Difficulties in Evaluating Progress to Date • The Future – Key Variables

6. Introduction • Understanding Afghanistan's economy is central to: • Explaining the staying power of the Taliban • Designing efficient reconstruction strategies • Identifying projects and investments at the local level • Creating the foundation for a viable self-sustaining economy • Incorporating the country’s diverse populations into a modern nation-state • Economic factors, like access to jobs and a better quality of life are vitally important, and will most likely become more so, in determining the outcome of the current conflict and the country’s overall future.

7. The Pre-Soviet Economy • Before the Soviet invasion in 1979, Afghanistan's economy was largely based on rural subsistence, with a small, urban sector that was dependent on the state • About 85% of the population belonged to the rural subsistence economy • As late as 1972, the cash economy accounted for less than half of GDP • Government expenditure constituted less than 10% of GDP, and foreign aid accounted for over 40% of the budget in the 1960s • When aid declined, it was replaced by exports of natural gas from northern Afghanistan to the Soviet Union • The private sector was largely confined to trade • The urban sector relied on government redistribution, and the government controlled most urban employment

8. Period of Soviet Occupation • During the Soviet occupation, from 1979 to 1989: • The rural economy was destroyed as the counterinsurgency battled Soviet forces • Food production fell by one-half to two-thirds. • Afghanis became increasingly dependent on humanitarian aid for subsistence • As traditional elites lost of their control over resources, their power and ability to provide protection weakened • Large numbers of Afghanis were displaced • Forced urbanization occurred as many fled to Afghan cities. • Millions of mainly rural refugees out-migrated to camps and cities in Pakistan and Iran, and refugee-warrior communities arose • Together, these factors led to the development of a culture of dependency

9. The Post-Soviet Period I • After the Soviet withdrawal, the commanders became Afghanistan's main economic actors • The commanders were essentially warlords drawn from a new elite that benefitted from U.S., Pakistani and Saudi support • As Soviet revenues declined, the commanders pursued economic strategies to increase their power, wealth and autonomy • They established bazaars and provided local security to traders in return for tribute • They also sought external aid which, in turn, increased resources under their control • The war-related destruction of agriculture created tremendous incentives for shadow-economy activities, like consumer goods smuggling and opium growing • A fragmentation of the country as Afghan regions integrated into neighboring foreign markets, rather than into a national market

10. The Post-Soviet Period II • To counter the commanders' power, the government embarked on a program of national reconciliation that greatly increased government expenditures • The program enlarged local security forces • It offered subsidies to defecting commanders • The program's end-result was to greatly increase the population's dependence on the state • Government expenditures increased despite a decline in Soviet aid and a fall in gas revenues created by poor maintenance and the exodus of Soviet technicians. • The government financed the resulting deficit by printing money • From 1987-1992, the money supply increased by 45% per year • The result was rapid inflation.

11. Rise of the Taliban • The rise of the Taliban was facilitated by: • Years of war that devastated communities and institutions and destroyed much of Afghanistan’s social capital -- trust • The prevalence of predatory economic activities that reflected the fragmentation of social and economic power • The relatively limited number of organized groups. • Among the best-organized groups were the rural religious ulama, who continued to teach or study in madrasas largely funded by Pakistanis and Saudis • Links among madrasa students and teachers provided an effective form of social capital • Shared madrasa experience superseded tribal affiliations • Religious linkages provided the impetus to overcome warlordism and corruption • External aid from Pakistan and Saudi Arabia (until June 1998) provided the Taliban with training, technology (weapons) and financial support

12. The Economy under the Taliban • The Taliban economy was a war economy comprised largely of the transit trade, the drug trade, the gem trade, and the businesses that serviced them • Foreign exchange earned by exports financed Afghanistan’s imports of arms as well as food and other necessities. • The Taliban controlled the transit trade • The transit trade involved the smuggling of duty free goods from Dubai to Pakistan • At $2.5 billion in 1997, it accounted for half of Afghanistan’s GDP. • In the north, Massoud controlled the gem trade • Opium production and trade expanded in regions controlled by both sides. • In 1999 the Taliban areas produced 97% of Afghanistan’s poppies.

13. The Economy in 2001: Overview • In 2001, Afghanistan had what can best be described as a "survival economy" • The economy was devastated from more than 20 years of war, during which the Soviet occupation giving way to warlord conflicts and, then, to the rise of the Taliban • Over a million had died in a country of 26 million, and the number of disabled was proportionally among the world’s highest • The long period of conflict destroyed most of the country's limited pre-war economic institutions resulting in abject poverty • Economic stagnation, accompanied by severe fluctuations, resulted in little or no growth in real GDP from the late 1970s • Illicit and conflict-related economic activities and behavior patterns were entrenched. • Afghanistan was the leading producer of opium, controlling 75% of world production in 1999.

14. Economic Consequences of Conflict I • As a result of warfare and state collapse, Afghanistan’s economy is largely dominated by the informal sector • The informal sector makes up 80-90% of total GDP, when opium is included • The informal economy encompasses a wide spectrum of activities, from those that are fully legal to some that are illicit in they way they are conducted to others which are outright illegal. • Not only is the informal sector dominant in agriculture, but it is also very important in mining, manufacturing, construction, trade and infrastructure • The large informal sector reflects the lack of basic rule of law and the poor investment climate that resulted from state erosion and loss of capacity • Infrastructural and financial constraints, as well as insecurity, contribute to the size of the informal economy

15. Estimates of the Informal Economy

16. Economic Consequences of Conflict II • The informal sector is dynamic and plays an important role in absorbing excess labor but it does not provide a solid foundation for future economic growth and employment generation. • It is not conducive to technological modernization and improved productivity • Incentives to invest in training are limited • The size of business enterprises tends to be severely constrained • Sustained export generation is hard to achieve because of the difficulty in meeting quality standards, getting around non-tariff barriers, obtaining insurance, etc. • The learning-by-doing associated with formal sector activities does not occur, nor is there strong demand for modern business services

17. Economic Consequences of Conflict III • Education levels are extremely low due to the conflict and underinvestment in education. • Only 28.1 percent of Afghans are literate. • Many classified as literate can read and write only at the second or third grade level. • The majority of teachers in Afghanistan have educational levels equivalent to ninth-to-twelfth grade in the United States. • Although more than 3,500 schools have been established, only 40 percent of students have actual buildings in which to meet. • Thousands of communities have no easy access to schools, causing parents to send their children to madrasas in Pakistan, where Islamic fundamentalism is a focus. • Approximately 30,000 to 40,000 students graduate from high school every year, but only one-third are admitted to universities due to a lack of university capacity.

18. Economic Consequences of Conflict IV • Over the years Afghan conflicts have driven millions from the country. • Since early 2002, nearly four million have voluntarily returned to Afghanistan, placing an added strain on resources. • Currently there are about three million living in neighboring countries: • Pakistan – 2,000,000 • Iran – 910,000 • Other – 90,000. • Presently Iran and Pakistan are forcefully evicting refugees, many of whom have lived there for up to three decades • With violence at record levels and basic services already overwhelmed, large numbers of returning Afghanis are creating another source of instability.

19. Afghan Refugees Voluntarily Repatriated Afghan Index: Tracking Variables of Reconstruction & Security in Post-9/11 Afghanistan, Brookings Institution September 23, 2008, p. 17.

20. Returning Refugees

21. Economic Consequences of Conflict V • In sum, Afghanistan’s human capital has been severely depleted by: • Destruction (deaths and injuries). • Displacement (flight of refugees and émigrés) • Extremely low investment in human capital during the last 30 years. • As a consequence, • The high demand for some forms of labor does not seem to translate into sustained high employment growth, but rather into high wage rates which even attract skilled labor from neighboring countries • The shortfall in human capital is manifested strikingly in Afghanistan's weak government capacity. Although structures and civil servants are in place, government effectiveness is limited.

22. Economic Consequences of Conflict VI • The country also appears to have a number of misaligned markets – in particular an overly strong exchange rate -- the Dutch Disease • The exchange rate reflects large inflows of drug proceeds, aid, and possibly remittances, as well as a scarcity of literate, trained and professionally qualified labor • Wages for skilled and professional labor are high, and unskilled wages are driven up by the labor-intensive opium economy • With domestic inflation running higher than global inflation and the exchange rate holding steady against the US dollar, Afghanistan’s currency has been appreciating in real terms • International experience suggests that chronic overvaluation of the exchange rate is not good for sustained economic growth.

23. Economic Consequences of Conflict VII • Investment climate surveys (2005) indicate that the main concerns of formal sector firms are: • Access to land, electricity and finance together with corruption are the most important constraints to their activities. • Insecurity and lack of rule of law also seen as major constraints deterring many investors from setting up formal-sector business in the first place. • Weak state capacity and poor rule of law combine with the large informal economy to create an “informal equilibrium” • In this equilibrium, incentives to develop formal sector businesses are weak and incentives to remain in the informal economy strong • Breaking out of this vicious circle is a critical element of the overall development agenda, necessary for sustained growth of the formal sector and the associated growth in employment

24. The Informal Equilibrium Source: World Bank, Responding to Afghanistan’s Development Challenge, October 2007, p. iv

25. Economic Consequences of Conflict: Summary • Deficient human capital, Dutch Disease, poor investment climate, opium dominance and the large informal sector prevent Afghanistan's economy from producing a sustainable gross domestic product with strong growth and export potential • Past export markets have been eroded, lost, or have shifted to the informal sector, with its lower levels of quality and value • Import substitution has been occurring to a much more limited extent than might have been expected, given the high demand for imports of goods that were formerly produced in Afghanistan • Overall, Afghanistan's is a high-cost, high-risk economy for investment, employment and growth in the formal sector • Expansion of the formal sector has been more limited than the overall growth of the economy would imply

26. Questions? -- Break • Questions? • Next: • Economic Strategy Considerations • Development Objectives • Economic Performance to Date. • Afghani Perceptions of the Economy

27. Economic Strategy Considerations I • Afghanistan was one of the poorest and most economically backward countries even before the Soviet invasion plunged it into decades of warfare • The pre-war Afghan state had only a veneer of modernity: • It did not reach much beyond Kabul and a few other cities • It was oriented toward keeping the peace and maintaining order rather than toward the economic and social betterment of the population • The pre-war Afghan economy could not have served as a springboard for economic development • It was largely traditional, with exports limited to items such as dried fruits and nuts and carpets. • It lacked fiscal self-sufficiency and required foreign aid to finance its public investments • Its dependence on aid rose out of a long history of relying on external resources, such as payments from British Empire, etc.

28. Economic Strategy Considerations II • Changes in the world economy since the 1970s make it impossible for Afghanistan simply to return to its pre-Soviet economy • There are new constraints on agricultural trade, such as non-tariff barriers and international quality standards • The communications revolution has increased Afghani awareness of other areas of the world • Improvements in transportation and an increasingly globalized economy have dramatically changed the conditions of trade • As a result, any reconstruction program must address underdevelopment and not simply focus on the restoration of the pre-conflict status quo • Reconstruction without development risks renewed conflict and an escalation in terrorist activities

29. Economic Strategy I • To overcome the many conflict-related problems built up over the years and to combat the insurgency, the U.S. has stressed an economic strategy centered on four main areas: • Embracing free market economic policy at senior levels of government • Enhancing government resources • Addressing inflation • Implementing structural reforms • Commitment to free markets means resisting costly subsidies and price controls that serve to reduce resources for other, more constructive expenditures in areas like infrastructure, education, and healthcare.

30. Economic Strategy II • The U.S. and international community efforts are assisting the Afghan government in moving towards a sustainable fiscal policy capable of generating revenue, managing resources and operating without foreign financial support. • The international community is also trying to enhance economic growth by modernizing the country’s infrastructure, particularly in the areas of electrical power, road construction, water management and agricultural development. • Provincial Reconstruction Teams (PRTs) are key elements in these endeavors, ensuring that reconstruction and development efforts are coordinated at all levels and responsive to local needs.

31. Key Development Objectives I • Generating productive employment, raising per-capita incomes and reducing poverty are key long-run development objectives of this strategy • The goal is to draw large segments of the population into the formal economy as quickly as possible • For development to succeed, the low-productivity, opium-based informal economy must be replaced by more productive, formal sector activities. • To this end, development planners must facilitate a transition phase from illegality and informality to formal legitimacy by: • Creating an environment that enables the private sector to flourish • Boosting the rural economy and assisting the poorest and most vulnerable • Defining the role of the state and establishing government capacity • Increasing the effectiveness of foreign aid • Developing Afghanistan as part of a wider Central Asia region • Improving competitiveness so that new exports can emerge to replace opium as the country’s source of foreign exchange. .

32. Key Development Objectives II • A complementary objective is state-building • Afghanistan cannot not achieve sustained development without a reasonably functional, effective and accountable state • A functional state is defined as one possessing adequate institutions, financial resources (ultimately through domestic revenue mobilization to pay for core state functions), human capacity, sound processes and management, and a reasonable degree of integrity • Good governance is critical. Of particular importance for the economy progress must be made in rule of law, regulation, and control of corruption. • Adequate infrastructure, and improved security are prerequisites for sustained private sector-based economic growth in the formal sector • Effective government programs will be critical for building Afghanistan’s human capital

33. Key Development Objectives III • The economic objectives, especially poverty reduction will be especially difficult to achieve given the country’s demography and topography • Afghanistan’s poor are overwhelmingly illiterate, tend to be located in remote areas with difficult topography, and have little land or other agricultural assets • They tend to grow staple crops rather than horticultural products, suffer from very low health indicators, and are highly vulnerable to shocks as well as seasonal patterns of income fluctuation

34. Development Assets • Despite its many handicaps, the country also possesses some notable strengths to serve as a foundation • Afghanistan has an entrepreneurial population, as evidenced by the vibrant informal economy, which allowed most Afghans to survive decades of conflict and displacement • The Afghan refugee population has built up of significant human capital • Afghanistan maintains market-oriented and unrestricted private sector policy environment with low import tariffs, few non-tariff barriers, relative ease of establishing new enterprises, sensible laws and regulations

35. Evaluating Economic Performance • Evaluating Afghanistan’s economic performance is difficult due to: • Lack of accurate economic data • Historically, little effort was made to compile accurate economic data • Limited manpower hindered systematic post-war data collection • Large amounts of Afghanistan’s economic activity occur in the underground, or shadow, economy • Lack of objective reporting • Many accounts are impressionistic, rather than based on verified facts • Lack of reliable surveys • Insurgency limits fieldwork • Many surveys suffer from systematic biases

36. Recent Macroeconomic Performance • Growth in real GDP was estimated at 12.4% in 2007, and is expected to ease to 8.6% in 2008, supported by: • Strong construction investment, much of which is linked to donor-led development projects • Private consumption, which is driven in part by positive income effects of recent large opium crops • The strong GDP may be hard to sustain due to difficulties in other key macro areas. • The trade deficit will likely expand • Inflation, currently under control as a result of a marked reduction in the expansion of the money supply, is predicted to pick up due to rising energy and wheat prices

37. Real GDP Growth (%)

38. Inflation • Inflation has been a problem in Afghanistan and impacts the economy in several ways: • Afghani exports are more expensive, while foreign imports are cheaper • Inflation creates an arbitrary redistribution of income and injures creditors and those on fixed incomes, such as those pensioners • Inflation complicates the planning process, since it is impossible to predict future costs • Inflation makes it difficult to develop deep and efficient financial markets • Inflation creates incentives for speculative investment – real estate, rather than productive investment

39. Inflation (% per annum)

40. Broad Money Growth (%)

41. Agriculture I • Agriculture (excluding narcotics) contributes around 53% to GDP and employs 67% of the labor force: • The sector is central to Afghanistan's economy, and its performance strongly influences overall economic growth • With most of the country’s poor living in rural areas and depending either directly or indirectly on agriculture, improved performance could have major impacts on poverty reduction • Agriculture and related activities are major vehicles for women’s participation in the economy • Agricultural development is part of the government’s core program for promoting the efficient and sustainable use of natural resources

42. Agriculture II • Afghanistan's agriculture has suffered for nearly 25 years: • The main drivers of agricultural growth and rural poverty reduction – technology, roads, irrigation, education – have all deteriorated as the result of war, lack of maintenance and a series of severe droughts. • Agricultural output slowed dramatically from 2.2% a year in the pre-conflict period 1961-78 to 0.2% between 1978-2001. • Cereal output declined by 2.0% between 1978 and 2001, after growing at 1.3% per year during 1961-1978. • After 2001, there was a strong recovery with the return of normal precipitation and improved availability of seeds and fertilizers, but growth could not be sustained due to periods of severe drought • A very small harvest in 2008 left small farmers all over central and northern Afghanistan short of food • Large income differences still exist between licit agricultural output and land devoted to opium poppy

43. Sector Trends

44. Industrial Expansion

45. Service Sector Trends

46. Macroeconomic Assessment • While macroeconomic data show that overall economic growth and that of several key sectors are up, it is unclear the extent to which the living standards of average Afghanis have improved • The current data does not reflect: • Income distribution • Regional and local differences • Important sectarian and ethnic differences • Data on government spending is also meaningless unless the productivity of that spending is also measured.

47. Unemployment • Despite good economic growth, unemployment remains a major problem. Although most analysts estimate unemployment is high in Afghanistan, accurate statistical data is virtually non-existent. • Defining unemployment is difficult as many Afghans are employed on a temporary basis in the informal economy or on a seasonal basis during the agricultural harvest. • The CIA estimated that, as of 2005, the official unemployment rate in Afghanistan was 40%. • The Afghan Central Statistical Office also maintains an official unemployment rate of 40 percent for 2007. • However, other estimates are as high as 60 percent, and unemployment could be even higher in some rural provinces and districts.

48. Poverty • Poverty remains a significant problem for Afghanistan. Per capita income is about $300, making Afghanistan one of the poorest nations in the world despite recent economic growth. As of 2007: • Approximately 50% of the Afghan population lives below the poverty line. • An additional 20 percent of the population is concentrated close to the poverty line and is at risk of falling into poverty. • The impact of rising diesel fuel prices and the doubling of wheat prices may be driving some of these families below the poverty line. • Poverty may be even higher among rural and nomadic populations.

49. The Working Poor • The existence of a large number of working poor in Afghanistan is a major problem. • Low salaries place many who are employed, including government employees, at risk of falling below the poverty line. • Poverty is also unevenly spread throughout Afghanistan: the poverty rates of provinces vary from around 10 percent to more than 70 percent. • Poverty is more severe in the northeast, central highlands and parts of the southeast. • Despite a significant increase in public spending in key sectors to support poverty reduction, scarce domestic resources and limited international assistance result in only limited assistance to the poorest of the poor.

50. The Budget • The components of the budget are the core and the external budget. The core budget is controlled by the government and can be divided into: • The core operating budget, consisting mainly of recurrent expenditure such as employee compensation, transfers, and outlays on goods and services; and • The core development budget which comprises largely donor-financed development projects and some recurrent costs. • The external budget consists of direct donor expenditure that is approved and executed outside the national budget process.