EconoMonitor

Ed Dolan's Econ Blog

Afghanistan’s Economic Future, Aid, and the Curse of Riches

We hear a lot about the future of Afghanistan after NATO withdrawal in 2014. Most of the speculation focuses on security and politics. Too little of it concerns economics. A pair of new reports, one from the World Bank and the other from the IMF, help fill the gap. If you thought the security and political prognosis was problematic, wait until you read what lies ahead for the country’s economy.

The most striking fact about the Afghan economy is its extreme dependence on foreign aid. As the following World Bank chart shows, in 2010, aid to Afghanistan exceeded the country’s GDP. Only the West Bank, Gaza, and Liberia are equally aid-dependent.

At first glance, it might seem that the vast aid flows must be holding the Afghan economy together, and that without them, things would be even worse. Clearly some of the aid, both military and civilian, is providing real benefits. Still, world experience suggests that countries have limited capacities to absorb aid. When aid exceeds absorptive capacity, it can do more harm than good. Afghanistan, with its exceptionally large aid flows, is at particular risk.

In a 2005 paper with the provocative title, “Is Aid Oil?” Paul Collier asked whether aid, like natural resource rents, can cause a country to fall victim to the “curse of riches.” Based on African experience, Collier found that aid, on average, is more helpful to development than oil, but that simply scaling it up does not necessarily make it more helpful still. He pointed to two main channels through which the curse-of-riches effect of excessive aid flows can undermine the good intentions of donors.

The first channel is the Dutch disease. That malady comes into play when inflows of external funds drive up a country’s real exchange rate. Regardless of the source of incoming funds—aid, oil, mining, or whatever—the rising real exchange rate makes other sectors of the economy less competitive. Activities that compete with imports, especially small farming and small-scale manufacturing, are especially vulnerable. As a result, the benefits of the incoming cash flows will be spread unevenly, with many people losing jobs or income while a relative few prosper.

Afghan statistics are not especially good, but  such data as are available suggest that the Dutch disease is at work there. The IMF report cited earlier contains a chart of the country’s real effective exchange rate, reproduced below. The REER appears to track the IMF data on aid flows rather closely, with spikes in both indicators in 2007/8 and again in 2010/11. A footnote in the IMF report suggests that the Afghan currency is presently overvalued by about 20 percent relative to where it would be with reduced aid flows.

The second channel through which the curse of riches operates is its effect on governance. Too much money flowing into a country with weak institutions leads to corruption. In countries from Nigeria to Russia to Equatorial Guinea, oil revenues are the source of corrupting cash flows, but Collier warns that aid can produce similar effects if it is not subject to public scrutiny and to the controls of a transparent budget process.

Unfortunately, transparency and public scrutiny are deficit goods in Afghanistan. The World Bank report does not mince words.

Aid has funded the delivery of essential services including education and health, infrastructure investments as well as government administration. There have been substantial improvements in the lives of Afghans over the last 10 years as a result of this effort. But these inflows, most outside the Afghan budget, have been so high that inevitable waste and corruption, aid dependency and use of parallel systems to circumvent limited Government absorptive capacity have impeded aid delivery and the building of a more effective Afghan state. . . . Large financial inflows outside the Afghan budget and fragmented aid in a situation of weak governance have been major sources of rents, patronage, and political power.

The IMF comes to a similar conclusion, citing these measures of Afghanistan’s quality of governance:

  • A ranking of 177th among 178 countries in Transparency International’s 2010 Corruption Perception Index.
  • A rank of 160th out of 183 countries in the World Bank’s 2012 Doing Business report, down six places from the previous year.
  • A rating of 2.6 on the World Bank’s Country Policy and Institutional Assessment Index, well below the average of 3.3. The rating is pulled upward a bit by a favorable score for macroeconomic management, but pulled down by low scores for property rights, governance, and the quality of public administration.

If aid has flowed to Afghanistan beyond the country’s absorptive capacity, one might think the country would actually benefit as foreign assistance tails off in coming years. Unfortunately, the main alternative driver for the Afghan economy is mineral wealth, in the form of vast and largely untapped deposits of copper, iron ore, lithium, and rare earths. Experience elsewhere shows that mineral wealth is even more likely than aid to fuel corruption and bring about a curse of riches.

The IMF and the World Bank are fully aware of the threat. They are working hard, in partnership with the Oslo-based Extractive Industries Transparency Initiative (EITI), to prevent Afghanistan from falling victim to the curse of riches.  Thanks to lots of arm-twisting, Afghanistan has become a candidate member of the EITI. In order to become a full member,the country will be required to put specific reforms in place, including open publication of company payments and government revenues, to ensure that oil and mineral revenues benefit the country’s population at large.

EITI membership is not a magic bullet, however. Consider the case of Nigeria, which committed to join EITI in 2003 and is now a full member. The path to compliance has not been easy. As recently as 2009, an EITI review uncovered “financial discrepancies, mispaid taxes, and system inefficiencies” as well as “numerous issues that call for urgent attention and action by all stakeholders.” Nigeria remains in 134th place on Transparency International’s Corruption Perception Index. True, that is 18 places higher than Russia, which is not an EITI participant, and 42 places higher than Afghanistan, but it is a long way from squeaky-clean.

Neither the IMF nor the World Bank considers Afghanistan to be a hopeless case. It is part of the mission of both organizations to look on the bright side and to outline measures that, if implemented, could help member countries overcome their problems. Here are some of the things that these organizations say will have to happen for Afghanistan to move toward sustainable economic development after 2014:

  • The US and other donor countries will have to ensure that aid is reduced in a gradual and orderly fashion.
  • The Afghan government will have to continue to strengthen public financial management systems and the budget process, and reduce rent-seeking opportunities and leaks in revenue collection, while pursuing public administration reforms effectively and aggressively.
  • The opium economy will, at a minimum, have to remain no larger than it now is.
  • The Afghan economy will have to become more closely connected to the rest of the world, both through removal of trade restrictions and through greatly improved road and rail infrastructure.

If all of these things happen, and if NATO fully meets its political and security goals by 2014, then the United States and its allies will be able to look back on their efforts in Afghanistan and say, “Job well done!” However, failure of any one of the elements—security, political, or economic—would undermine the others. The outcome would very likely be a conflict-ridden, politically fragmented, and abjectly impoverished Afghanistan for years to come, despite all the investments of blood and money made over the last ten years.

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