35570 The Investment Climate In AFGHANISTAN Exploiting Opportunities in an Uncertain Environment December 2005 Finance and Private Sector Development Unit South Asia Region The World Bank The Investment Climate in A F G H A N I S T A N Exploiting Opportunities in an Uncertain Environment December 2005 Finance and Private Sector South Asia Region World Bank Abbreviations and Acronyms AISA Afghanistan Investment Support Agency AWCC Afghanistan Wireless Communication Company CIS Commonwealth of Independent States DAB Da Afghanistan Bank DABM Da Afghanistan Breshna Moassesa FDI Foreign Direct Investment GDP Gross Domestic Product IBRD International Bank for Reconstruction and Development ICA Investment Climate Assessment ICS Investment Climate Survey IMF International Monetary Fund IPDA Industrial Parks Development Authority MAAH Ministry of Agriculture and Animal Husbandry MFI Microfinance Institution MMI Ministry of Mines and Industry MoC Ministry of Commerce MSTQ Metrology, Standards, Testing and Quality MWP Ministry of Water and Power NDF National Development Framework NEEP National Emergency Employment Program NGO Nongovernmental Organization OECD Organisation for Economic Co-operation and Development PRSP Poverty Reduction Strategy Paper PSD Private Sector Development SME Small and Medium Enterprise SOE State-owned Enterprise TRB Telecommunications Regulatory Board UNAMA United Nations Assistance Mission in Afghanistan UNDP United Nations Development Program UNODC United Nations Office on Drugs and Crime WTO World Trade Organization CURRENCY EQUIVALENTS (Exchange Rate effective January 1, 2006) Currency Unit = Afghani (Af) Af 1 = US$0.02056 US$1 = Af 48.65 FISCAL YEAR July 1-June 30 Acknowledgments T he Afghanistan Investment Climate Assessment was prepared by a team led by Syed Mahmood (SASFP) and Samuel Munzele Maimbo (SASFP), and including John Nasir (CICIC) and Reazul Islam (SASFP). Alastair McKechnie (Country Director, Afghanistan) and Simon Bell (Sector Manager, SASFP) provided overall guidance. The firm-level survey was conducted by Altai Consulting under the supervision of Stan Byres. Kadija Jama, Gozde Isik, Nazir Ahmed, and Mustafa Mehrzad provided valuable inputs to the preparation of the report. Peer reviewers are: William Byrd (SASPR), Simeon Djankov (CICMA), and Andrew Stone (MNSIF). In addition to the peer reviewers, several participants in an internal World Bank review meeting, including Julia Fraser (SASEI), Stephane Guimbert (SASPR), Michael Haney (SASEI), Axel Peuker (CICIC), Michelle Riboud (SASHD), Mariam Sherman (SAC01), and Mona Sur (SASAR), provided valuable comments. Comments were also received from Paul Banerjee, Paul Barker, Andrew Clark, Eugene Fatakanwa, Rob Hager, Mariam Nawabi, Roger Nye, Glenn Tasky, Emilo Todoroki, and Omar Zakhilwal. 3 C o n t e n t s Executive Summary i 1. Overview 1 Introduction 1 Background 1 Objective of the Investment Climate Assessment 5 Structure of the report 6 2. The State of the Private Sector 7 Introduction 7 Investment 7 Growth and performance 9 Opportunities 11 3. Today's Investment Challenges 13 Introduction 13 Obstacles: An overview 13 Security and informal arrangements 14 Electricity and infrastructure 16 Access to land 19 Corruption 21 Access to finance 21 Limited access to skilled labor 24 Legal and regulatory framework 24 Trade policy 27 Conclusion: The dominance of informal arrangements-a vicious circle? 30 4. Accelerating Private Investment: What Needs to be Done 33 Introduction 33 Legal framework for PSD 36 Access to land 37 Infrastructure 38 Access to finance 40 State-owned enterprise reform and privatization 44 Trade reform 46 Business services 46 Government capacity to promote and facilitate private investment 47 Policy Recommendations Matrix 49 ANNEX A: The Investment Climate Survey 55 A.1 Sample 55 A.2 Selection of enterprises 56 A.3 Overall attitude of respondents 56 A.4 Interviewer profile 57 A.5 Respondent profile 57 ANNEX B: Managers' Perceptions of Major Constraints 58 ANNEX C: Doing Business in Afghanistan 62 REFERENCES 66 Executive Summary I n a postconflict environment, attracting new situation in the country has improved and a return to foreign and domestic firms is central to private general warfare does not appear to be imminent. With sector development. New decisions about the aid of the international community, the central investment (in existing or new firms) usually depend on government has begun to build a multiethnic army and the availability of five basic factors: political and police force that are able to exert the government's economic stability and security; clear unambiguous control in regions outside the capital. The current regulations; reasonable tax rates that are equitably government is strongly entrenched in Kabul and has a enforced; access to finance and infrastructure; and an high degree of legitimacy throughout the country. appropriately skilled workforce. In Afghanistan, these However, there remain many areas where the conditions are lacking. The challenges facing the government is not very effective and provides few government of Afghanistan in addressing these services, especially where the insurgency is strong. constraints and in turn attracting further foreign and domestic investment cannot be underestimated. But, as Economic growth, which has received far less the experience of other reconstruction efforts shows-for international attention than has Afghanistan's political example, in Bosnia and Herzegovina and East Timor- process, has been dramatic during the recent recovery. reform can be achieved. This report was prepared to The International Monetary Fund estimates that assist the government of Afghanistan in addressing its official (nonopium) gross domestic product (GDP) private sector development challenges. It is based on a growth averaged 22.5 percent between 2002 and 2004. survey of 338 firms and draws on numerous recent It estimates annual growth in 2004/05 at around 7.5 studies on Afghan private sector issues. percent and predicts 14 percent growth in 2005/06. Investment is high and accounts for nearly 22 percent A. Recent Reforms and Progress of GDP; however, the bulk of this investment (90 percent by some estimates) is public investment Afghanistan has taken tremendous strides toward financed through international aid. This rapid reestablishing itself as a politically and economically expansion can be attributed to a number of factors viable state. Since the fall of the Taliban regime in including the low starting base, the end of major 2001, the government, with the support of the conflict and the associated revival of economic activity, international community, has reestablished a number and the end of the drought, which allowed sharp of political institutions and spearheaded economic increases in agricultural output in many regions. reforms. A new constitution has been adopted, nationwide elections were held to select Afghanistan's A stable macroeconomic environment has been first democratically elected president, and, in established and a number of steps taken to foster trade. September 2005, a parliament was elected. The security Currency reform was completed in early 2003 and since The Investment Climate in Afghanistan then inflation has been low and the currency stable, and is likely to figure prominently in the country's helped by strong fiscal discipline and a prudent debt poverty reduction strategy paper, the "Afghanistan policy. The tax code was restructured in 2004, National Development Strategy," to be adopted soon. expanding the tax base, simplifying the code, and providing clarification. Customs tariffs have been The government has taken a number of steps to foster rationalized. Existing trade agreements have been private sector investment. There has been significant renewed and new agreements entered. The government progress in developing the financial sector. The Da is working toward accession to the World Trade Afghanistan Bank (DAB) and Banking Laws have been Organization (WTO) within the next few years. Trade gazetted (i.e., formally enacted), a number of private has increased dramatically, with the value of annual commercial banks have been licensed, and three state- exports and imports growing at double-digit levels. owned banks have been relicensed. Progress has also However, this increase does not reflect an increase in been made in developing the microfinance sector. The Afghanistan's international competitiveness: Most are government has established the Afghanistan reexports to Pakistan. Investment Support Agency (AISA) with the mandate of promoting and facilitating investment. The AISA Despite rapid economic growth, the structure of has helped streamline the business registration process Afghanistan's economy has changed little. Some 80 to to the extent that Afghanistan now ranks among the 90 percent of economic activity is informal and best countries in the World Bank's 2005 Doing agriculture accounted for 47 percent of estimated total Business indicators of firm registration. However, a GDP in 2003. One of the largest sectors in the economy host of clearances and procedures are still required is the illicit production of opium, which in 2003 before a business can actually begin operating. accounted for nearly one-third of GDP. There was a 20 percent decline in area devoted to opium production in B. The State of the Private Sector 2005, but opium remains a major activity and a serious threat to security and stability. Afghanistan remains one Long years of conflict destroyed most of Afghanistan's of the world's poorest countries with an estimated per production capacity and forced the flight of many capita GDP of only US$315. Social indicators are also skilled workers and managers. Sabotage of some of the worst in the world as reflected in high rates infrastructure crippled domestic and international of infant and maternal mortality, illiteracy, malnutrition, distribution channels and cut off industry from its and gender disparity. traditional markets. The Soviet-backed government in the 1980s worsened the situation by attempting to set The government has been able to raise domestic revenues up a centrally planned economy. Many traditional to almost 4 percent of GDP, but international assistance industries, such as carpets, closed and moved to funds the majority of the government's recurrent neighboring countries and others, such as horticulture expenses and almost all development programs. The products, basically shut down because of the lack of government has clearly recognized that Afghanistan's suitable inputs. Today, despite a recent resurgence, the success will depend on its ability to quickly develop a Afghan economy is dominated by small-farm strong and vibrant private sector that will be able to agriculture. Outside of agriculture, the private sector provide jobs and generate the resources needed by the is overwhelmingly composed of informal family- government to accomplish its development goals. owned microenterprises, most of which are engaged Private Sector Development (PSD) was identified as in trading or basic services. Eighty to 90 percent of all one of the three pillars in the Afghan government's economic activity is informal. There are few small and National Development Framework approved in 2002 medium enterprises (SMEs) and only a handful of ii Executive Summary large firms. The manufacturing sector is tiny, export foreign investors prefer government- and donor-funded orientation is minimal, and most producers, with the reconstruction projects or services through which they exception of a few agro-processors, source their raw can quickly recover their investment, to the longer- materials from abroad. term process of building markets for manufactured goods. The government has touted Afghanistan as a The end of major conflict and the fall of the Taliban land bridge that will facilitate trade between Central regime led to an increase in private investment, but Asia and South Asia. However, so far there has been investment has been limited relative to Afghanistan's little foreign investment to support this trade. potential. New entry and expansion have been far less than policymakers had hoped for. Only two Despite the difficult business environment, Afghan enterprises have been privatized. AISA has registered industry is steadily recovering and existing firms are nearly US$1.3 billion in new investment (not coping well, performing on par with firms in including the telecom firms) in the past two years, but neighboring Central Asian countries. Firms in the most of this is merely approved investment; and just a Afghan survey report a 67 percent average increase in fraction has actually occurred. Nearly 50 percent of employment over the past five years, with 22 percent the new investment approved by AISA has been in in the past year alone. Average capacity utilization of construction and construction material. The manufacturing firms rose by 10 percent last year. The remainder is split almost equally between industry and rapid increase in employment was matched by a services. The concentration on construction, which is similar increase in sales and reflects the low base from not unusual in postconflict countries, reflects the which Afghan firms are starting. The median value of massive flows of external aid and the need to rebuild sales per worker in Afghan manufacturing firms is Afghanistan's devastated infrastructure. The biggest around US$3,333-greater than that reported in sectors in industry include plastics, bottlers, and Tajikistan or Uzbekistan but only around one-third processors of simple packaged foods-all aimed at the that of small manufacturing firms in Pakistan or India local market. Most are technologically simple and and much less than reported by Chinese firms. Afghan need only small investments; examples include small industry's low capital intensity explains much of this producers of biscuits and other inexpensive packaged shortfall in labor productivity. At 60 percent, average foods that aim to replace more expensive imports. For capacity utilization in Afghanistan manufacturing is the most part, Afghan industrial enterprises are only slightly below its neighbors and high for a nascent and unable to effectively compete against country just emerging from sustained conflict. In imports or enter the export market. 1997, Mozambique was also three or four years out of major conflict, and average capacity utilization in Success in attracting investment from overseas Afghans manufacturing was only 48 percent. has been limited. But they are a potentially important source of funding: Nearly 20 percent of the firms Industry's recovery is also evidenced by its investment sampled in the survey are owned by investors who have activity. Though the rate of foreign investment and the returned to Afghanistan since the fall of the Taliban return of expatriate Afghan investors may be regime. Besides bringing capital, returnees also bring disappointing, existing local firms are steadily adding to contacts in foreign markets and knowledge of their capital stock. Nearly 70 percent of the surveyed international business methods. Policymakers have firms reported investing in new equipment or looked to foreign direct investment as a key source of machinery sometime in the past year. This is a much funding for Afghanistan's reconstruction, so far with higher rate than found in postwar Mozambique where mixed results. In the risky environment of Afghanistan, only about 56 percent of firms invested in the year iii The Investment Climate in Afghanistan before the survey. In addition, over one-third of the The most serious constraints reported by the surveyed Afghan sample introduced a new product line and more firms are electricity and access to land. Over 64 percent than 40 percent upgraded an existing product line in of the surveyed enterprises cited electricity, and 60 the past two years. Clearly, the existing Afghan firms are percent cited access to land as either a severe or major engaged in increasing their capital stock and upgrading obstacle to doing business in Afghanistan. Corruption their capabilities in anticipation of future opportunities. and access to finance were also mentioned as significant constraints. Surprisingly, "crime theft and disorder" was However, this optimistic view is tempered by the fact cited by few firms as a significant problem. When firms that industry is starting from a low base and most of the were asked to name the single biggest constraint, the investment is in the most basic production processes. rankings of land and electricity were reversed; nearly 34 Afghan firms offer less training than do their neighbors percent of managers cited access to land as the biggest and their managers, and workers are less skilled than constraint, 15 percent reported electricity, and 18 are those in competitor countries. Many businesses in percent reported corruption. Few reported security. Afghanistan do not feel the threat of strong competition. These facts suggest that substantial The perceived obstacles are similar across all regions in barriers protect incumbent firms and relieve them of Afghanistan, with only slight differences. Electricity, pressure to constantly upgrade their capabilities. access to land, corruption, and access to finance are the issues most often cited as either severe or major C. Today's Investment Challenges: Investment constraints. However, the ranking of these obstacles Climate Constraints differs by area. In Herat, access to finance was the most often cited severe constraint, with electricity much less Overall often cited, which may reflect the fact that Herat has The Afghan government has taken a number of steps to been relatively more successful than other cities in improve the business environment and attract restoring power supplies. In Kandahar, customs and investment. Tax reform is a notable example. The gross trade regulations were cited as often as access to finance profit tax is 21.4 percent, compared with 35 percent for was, possibly because of the large number of traders the region and 46 percent in the Organisation for found in the Kandahar sample. Also in Kandahar, the Economic Co-operation and Development (OECD). managers were much less likely to report obstacles as Afghanistan has made the process of registering a severe or major than were managers in other cities. In business, if not actually starting operations, simple and Mazar-e-Sharif anticompetitive practices is cited more the country now ranks 16th in the Doing Business often than elsewhere, which could reflect deeply rankings for starting a business. Significant progress has entrenched local business interests that use their close also been made with regard to labor regulation, ties to powerful political patrons to restrict competition. regarding which Afghanistan ranks 25th in the 2005 Doing Business list. Regulations governing hiring, Security firing, and working hours all give Afghan firms more It is counterintuitive that most managers in the survey flexibility than firms have in most other countries of the did not rank crime and disorder as a major or severe world, particularly among its neighboring countries. constraint. But this result can be explained. There have The government has made important strides toward been real improvements in the security situation in the creating an enabling investment climate, but much major cities covered by the survey. The central more remains to be done-particularly removing government has made significant progress in disarming informal barriers to new entry, improving militias and integrating them into the police forces. infrastructure, and reducing uncertainty. Regional commanders who once dominated iv Executive Summary Afghanistan have been reined in, often by being co- generator; in one city, Jalalabad, the figure is 97 opted in government. At the same time, existing firms percent. Of the country's installed power generation have developed mechanisms to cope with insecurity, capacity of 420MW, only 270MW is operational; though at high cost. The surveyed firms reported moreover, transmission and distribution capacity are spending 15 percent of sales for security infrastructure, inadequate. With international help, the government is significantly more than did firms in neighboring working to rehabilitate generation, transmission, and countries. Many firms have formed close ties with distribution facilities. powerful elements in society, including warlords and government officials, to obtain protection in addition Transport. Like their counterparts in many other to resources. Security is thus a lesser concern for them. countries, a relatively small proportion of firms in Afghanistan (25 percent) report transport as a major or However, new entrants and potential investors who do very severe problem. However, this result may reflect not have established contacts with powerful figures find the limited horizons of many private firms that operate the environment much more daunting and are often in a localized economy and have limited transport discouraged from investing. Many former commanders needs. When asked what factors constrain exports, a remain influential, increasingly forging close ties to the larger proportion (39 percent) identified lack of roads, business world and using their power and influence to air connection, railroads, and other infrastructure as a further their business interests. Relatively small groups major constraint. Protracted conflict and lack of of businesspeople dominate many trading activities in maintenance have led to the dilapidation of the Afghanistan. These small groups of insiders use their transport network. Rehabilitating the road network has contacts to access land, settle disputes, ensure security, been a top priority for the government, which has obtain credit, and win contracts that others without developed a large investment program for major connections could not. Wide-scale poppy production highways. Thousands of kilometers of roads have been remains a security threat, despite some recent successes built, including the ring road from Kabul to Kandahar. in restraining its spread. Some improvements in travel times have begun to materialize. But there is still a long way to go. Transport Infrastructure service was an important activity during the conflict, Most indicators of infrastructure availability in and private transport companies have expanded rapidly Afghanistan are among the worst in the world, well since the end of the war. However, the government below the corresponding figures for Sub-Saharan remains heavily involved in the transport sector. Africa. Decades of fighting devastated the country's infrastructure and rebuilding it has been one of the Telecommunications. The telecommunications sector in government's foremost goals. International aid has Afghanistan is developing very rapidly. Only 26 percent poured in and many significant projects have been of the surveyed firms mention telecommunications as a completed. But this is a long-term agenda; meanwhile, major or very severe problem. Driven by a competitive infrastructure remains a major constraint for business. market and US$200 million in private investment, the mobile footprint covers as much as 50 to 60 percent of Power. Power supply is of poor quality, characterized by the country's population, providing services in 23 low voltage, intermittent supply, and blackouts. Only provinces (as of March 2005). There are two private about 76 percent of the sample was connected to the mobile operators, and two additional licenses for mobile power grid but even they received power on average telecommunications have recently been awarded. The about six and a half hours a day. Not surprisingly, 74 publicly owned Afghan Tel has also started providing percent of businesses reported owning at least one services and now carries approximately 22 million calls v The Investment Climate in Afghanistan per month. An access agenda for rural areas remains, as small fraction-5 percent of Afghan firms-offer training. does a need to considerably improve the quality and Only about one-third of the workforce in Afghan range of services and to further reduce prices. enterprises has a secondary education or higher. Sixty- Nonetheless, progress to date has been remarkable. two percent of Afghan managers have secondary or higher education compared with 96 and 98 percent in Access to factors of production: land, labor, Pakistan and India respectively. The shortage of skilled and capital labor helps explain the low productivity of Afghan Access to land. In many countries, access to land is a firms. Unless this shortage is solved, Afghan firms will problem only for firms wanting to significantly expand. find it very difficult to compete against imports or on In Afghanistan, even the majority of existing firms find the export market. The situation in government is accessing land, especially serviced land, a serious similar. Though some returning Afghans have brought problem-which indicates just how severe a constraint it with them significant technical skills, the majority of is. Nearly 56 percent of the surveyed firms who had the civil service lacks training, skills, and education to tried to acquire new land in the past three years were effectively provide services. unsuccessful and more than 10 percent reported having ongoing land disputes. The different waves of conflict, Access to finance. Afghanistan's financial system is just land reform, and nationalization have left the land beginning to recover and businesses have almost no tenure system in disarray. Properties have changed access to bank credit and only limited access to banking hands numerous times. Many plots of land are not services generally. Most of the 12 commercial banks registered and even if they were, records have been licensed to operate in Afghanistan are concentrated in destroyed or are now inaccessible. Multiple claims are Kabul and provide services primarily to international common and dispute resolution is difficult, especially donors and businesses, foreign nongovernmental given the overlapping, inconsistent, and ambiguous organizations, and foreign government agencies. legal systems and ineffective judiciary. The lack of Commercial banks in Afghanistan offer financing with certainty in land tenure discourages existing business a maximum tenure of financing of up to three years. from making large new investments and effectively There are a small number of nonbank financial prohibits new investors, especially foreign investors, institutions (11 microfinance institutions, one credit from entering the market. union, and one leasing company), but although growing, they are still nascent and can meet only a very Skills. High illiteracy, poor education, war, and political small fraction of credit needs. There are no credit upheaval have resulted in a critical shortage of skilled bureaus or credit rating agencies. Only three firms in labor in Afghanistan. During the conflict many of the survey reported having bank credit. Afghanistan's best qualified workers, those with the best opportunities abroad, fled. Consequently, qualified Informal sources play an important part in supporting management, skilled technicians, and educated Afghan businesses. Many businesses rely on informal professionals are scarcely available to today's enterprises. funds transfer systems generally known as hawala. Only The problem is exacerbated by the barriers to educating 30 percent of the sample reported having a bank girls and employing women in most jobs outside the account whereas nearly 21 percent of surveyed firms home. Afghanistan is caught in a trap. The lack of had a loan from a hawaladar and 14 percent of opportunities discourages workers from improving their exporters received payments through hawala transfer. skills and education. But the lack of employment Remarkably, hawala transfers for foreign trade appear to opportunities is partly caused by investors not wanting be more than or at least as efficient as bank transfers: to expand because of the lack of skilled labor. Only a The length of time to clear a hawala transfer is not vi Executive Summary significantly different from the time taken for a bank survey sample mentioned the legal system as a major or draft. However, informal financial sector credit is not severe constraint. However, good laws, effectively adequate for long-term private sector development. enforced, are essential to encourage large-scale There is a pressing need for bank and nonbank financial investment, especially by foreign investors and institutions to provide viable alternatives to the informal returning Afghans. sector. Low household savings, poor infrastructure, low integration with complementary markets, high costs of Regulatory issues such as business registration, tax service provision (particularly in rural areas), poor administration, and labor law were not cited as registries, and lack of credit information, a secured significant obstacles. They are not seen as significant transaction law, and insurance are the main factors obstacles not because the registration, tax and labor constraining the growth of the formal financial sector. requirements are clear and efficient but because they are poorly enforced and hence do not affect most firms. Governance: legal framework, judicial and regulatory However, there are problems in some areas. Although enforcement, and the functioning of government illegal checkpoints established by local commanders and Legal framework. The absence of a clear legal militias are no longer a major constraint, inspections by framework compounds the high level of uncertainty government officials remain a hassle. Traders report that and risk facing investors in Afghanistan. Many of the they face frequent inspections and fees levied by existing laws are holdovers from the communist era or different government agencies and local authorities. The even the earlier monarchy, and many of the basic laws government, led by the Ministry of Commerce, is necessary to encourage private investment are missing. attempting to resolve some of these issues, but currently, With three overlapping legal systems (the Sharia, the businesses report multiple inspections and delays as a Shura, and the formal system based on the 2004 serious issue that raises costs. constitution), managers are often confused about which laws actually apply to them. The new government has Predictability of government policies and actions. worked to propose, pass, and implement new Because Afghanistan has a risky investment climate legislation, but there remains a vast backlog of laws and that deters investment, it is essential that whenever regulations that need to be enacted. possible the government should engender certainty and predictability. In some ways the government is doing Judicial and regulatory enforcement. Firms mostly use well on this score. Nearly 60 percent of the participants informal mechanisms, including force, to resolve in the survey reported that they tended to agree or fully disputes and enforce property rights. There are no agreed with the statement that "in general, government formal alternative dispute resolution mechanisms such officials' interpretations of regulations affecting my as arbitration or mediation. The formal court system establishment are consistent and predictable." But the suffers from a lack of qualified legal professionals, no government is still in a precarious position. The recent method to hold judges accountable, and reportedly experience with tax holidays shows that inadequate endemic corruption. Consequently, businesses do not information about policy and specific procedures can rely on the formal judicial system. Only 3 of the 338 create considerable uncertainty for investors. firms surveyed reported using the commercial courts to settle a payment dispute in the past two years. Many Corruption. Corruption is endemic in Afghanistan and managers do not understand the benefits of a strong adds to the uncertainty facing investors, especially and efficient legal system and, given the arbitrary foreign investors or returning Afghans who do not enforcement and lack of effective courts, do not spend understand the system. Nearly 58 percent of surveyed much time worrying about it. Only 10 percent of the firms cited corruption as a major or severe problem, just vii The Investment Climate in Afghanistan behind access to land and electricity. Firms reported Customs administration. According to the World paying an average 8 percent of sales as bribes, more than Bank's Doing Business 2005 report, Afghanistan four times the average reported in neighboring Pakistan. ranks 128 in cross-border trading, and importing AISA's investment facilitation activities have helped requires 10 documents and 57 separate signatures. many investors negotiate the regulatory maze without Businesses report that customs officials continue to paying bribes, but this function is still limited in scope. use wide discretion on the valuation and inspection procedures, which leads to corruption and delays. The Weak government institutions. In nearly 25 years of war, investment climate survey found that on average it Afghanistan's government institutions were devastated took firms nearly 10 days to clear exports last year and and the new government, with international assistance, about 8 days to clear imports. Shipping agents report has been striving to rebuild them. There has been some that this time could be lowered to a few hours if they progress in rebuilding institutions. Most ministries are were willing to pay a large enough bribe. Medium- now staffed and functioning at some level. The central sized firms complain about discrimination by the bank is functioning well and has issued a new currency. customs regime. Small traders can evade duties, taxes, The customs department is collecting taxes and and informal payments, and the very large companies, forwarding the revenue to the central government, and particularly foreign companies, are able the security forces are loyal to the elected government. to negotiate tax incentives. But the average small However, the government infrastructure is nascent and Afghan company is too big to hide and too small to many ministries lack the capacity to provide some of the fight, so it bears the burden of the government taxes basic services. The courts and criminal justice system are and regulations. inefficient and rarely used. Land registries are incomplete and inaccurate, and often fraudulently abused. There are Trade facilitation services. Trade facilitation services no standards commissions and the once-extensive are weak or nonexistent. Exporters and potential agriculture extension service barely functions. exporters covered by the survey identified the lack of trade finance, the lack of cold storage and other Trade policy and trade facilitation storage infrastructure, and the inefficient customs and Trade policy. The government has made trade a clearance procedures as the biggest impediments to cornerstone of its development strategy and envisions increasing exports. Trade credit is rare and expensive, Afghanistan becoming a land bridge between the rest of forcing most producers to rely on middlemen who Central Asia and South Asia. Accession to the WTO in have connections and strong finances. In addition, the next five years is a top priority. A number of steps there are no independent agencies that assure have been taken to facilitate trade. These include trade standards or certify quality. The Ministry of and transport agreements with neighboring countries, Commerce is forming an Afghan metrology, preferential trade arrangements internationally, passage of standards, testing, and quality (MSTQ) body to test a customs reform package (2004) that makes Afghanistan the quality of goods in Afghanistan. Though badly one of the most open economies in the region by needed, as of summer 2005 it was not yet functioning. simplifying the tariff structure and reducing the range of tariffs from a maximum of 150 percent to a range of 2.5 Some 38 percent of the surveyed exporters identified the to 16 percent, and initiation of a Customs Modernization cost of transport as either a major or very severe Program. However, anomalies remain. For example, obstacle-the same percentage that identified inefficient manufacturers complain that the tariff structure is such or corrupt customs clearance procedures. Afghan that they often pay more duty on imported inputs than shippers often have to transship goods into the carriers of traders do on imports of the finished goods. neighboring countries, which raises costs and means loss viii Executive Summary of all control of goods once they cross the border. reluctant to risk their capital because they fear they will Surveyed firms reported losing up to 5 percent of be crowded out by those with connections. In brief, international shipments to spoilage and loss on average; though existing firms in the nonformal economy may for some this loss was as high as 30 to 50 percent. be growing, there is little new entry and low rates of Shippers say that some insurance is available, but investment. The informal mechanisms that allow firms apparently few can access it. Over 80 percent of the firms to cope with the high levels of uncertainty are not that experienced losses were not compensated. It is clear conducive to long-term growth and equity. that transport is expensive and risky in Afghanistan. D. Accelerating Private Investment: What The dominance of informal arrangements-aa vicious needs to be done? circle? Much of private sector activity in Afghanistan, even by The key challenge is to broaden participation in the significant business concerns, is carried out in an market by removing barriers to new entry and creating environment dominated by informal arrangements and conditions that will encourage those already in the practices. Firms lie on a spectrum of such arrangements market to invest more. The present investment climate ranging from formally registered, tax-paying firms challenges are not insurmountable. Many factors stand engaged in legal activities but often using informal Afghanistan in good stead. Afghanistan has a long channels for protection and access to resources, to entrepreneurial tradition of SME industries and enterprises engaged in illicit activities (production services on which an active market-oriented private and/or distribution) with even greater reliance on sector can be built. Some of the required actions are unofficial contacts to carry out business. In between are outside the scope of any PSD agenda as conventionally informal (i.e., nonregistered) enterprises carrying out defined. There is a need for an overall political and legal activities within a nexus of informal arrangements. security strategy that limits the power of those who A subset of these informal arrangements and practices have gained control of the markets through force of are similar to those found in patronage-based organized arms and illicit activities. Issues related to politics and criminal networks (generally referred to as mafia-type security is beyond the scope of this report, which networks), but it is difficult to say how large this subset focuses on actions that fall within the domain of PSD. is in Afghanistan. Some observers believe that informal However, these actions may address the paradigm of markets and informal patterns of trading may have now informality and help weaken the nexus of informal become quite strong and be operating according to well- relationships by extending the writ of formal established patterns. arrangements. These informal arrangements may be useful for many Four categories of actions are recommended (specifics investors in the short run but have negative effects for are provided in chapter IV). Together, these will increase overall growth. They stop many participants from incentives to invest (by reducing uncertainty and entering the market, lead to inequitable distribution of transactions costs) and improve capacity to carry out the benefits, and may have a negative effect on political productive activities (by improving access to inputs, governance and state-building. The informal economy business services, and markets). There are many is relatively free from official regulations because of complementarities among these actions, some of which poor enforcement but is nonetheless subjected to may affect both incentives and capacities. informal regulations that restrict entry and competition, even among incumbents. Many returning Improve access to inputs. Firms need factors of Afghans who have good ideas and capital to invest are production, notably finance, land, skilled labor, and ix The Investment Climate in Afghanistan physical utilities and infrastructure, including power, number of actions including removing policy barriers to water, telecoms, roads, and ports. Improved access to private sector entry, regulating standards, introducing such inputs is important to weaken the hold of informal tariff structures conducive to private participation, and arrangements, which draw their strength to a large helping to introduce risk mitigation arrangements. extent from control over such resources. Improved access will require an expansion in the supply of inputs To improve access to finance it is recommended that the and also a more transparent process of allocating them. government focus on improving the institutional Freeing up land currently locked up in nonviable state- mechanism for delivering credit, improving access to owned enterprises, injecting money into the banking financial services for SMEs and rural communities, system, and expanding the power-generating capacity and broadening and deepening the financial sector. In are all examples of actions that increase the supply of the medium term, efforts should be made to increase inputs (land, finance, electricity). Though these will the capacity of formal financial institutions with help, they may not substantially increase market sizeable branch networks to provide credit. Afghanistan participation and may largely benefit the well- should abandon the old, discredited model of directed connected incumbents if the allocation process is lending through publicly owned and managed nontransparent and is subordinate to the informal development finance institutions. It should move arrangements described earlier. toward a strong, market-based, competitive financial system that serves business needs in a much more Though a privatization policy has recently been efficient and cost-effective manner. This does not rule adopted, more detailed modalities need to be developed out some public policy intervention, especially given to ensure transparent privatization transactions with the postconflict conditions, on behalf of underserved clear institutional responsibilities for initiating and SMEs and rural communities. Whereas the banking implementing privatization. With regard to improving sector is likely to remain the largest component of the access to land, an intermediate solution is the financial system for some time, there is also a need to establishment of industrial estates. The government is broaden the financial sector by developing leasing moving in this direction. An effective industrial estate companies, commercial credit companies, credit program will require an independent, commercially unions, factoring companies, insurance companies, and oriented agency to develop and maintain the estates pension and provident funds, and, in the longer term, with progressively greater involvement of the private debt and equity markets. Actions should also be taken sector. However, industrial estates are not a substitute to enhance competition in the financial sector. for a functioning land tenure system, on which work Through regulation, authorities must create an needs to be accelerated. environment to prevent collusive behavior among banks and conglomerate relationships between banks Improving the supply of infrastructure services requires and nonbank financial institutions. not only massive investment in new facilities but also reforms in policies, regulations, and institutions, Clarify and strengthen property rights by creating a including systems for operation and maintenance. sound legal, judicial, and regulatory framework for Public utilities may increasingly be run on commercial investment. Property rights refer not only to tangible principles based on accountability for performance, cost property such as land and equipment but also recovery, and sustainable operations. There is intangible "properties" such as a license to operate or considerable scope for corporatizing state-owned firms a permit to import raw materials. Strengthening and private sector provision of infrastructure. To property rights will require developing a sound legal encourage the latter, the government needs to take a framework and an effective judicial system that x Executive Summary enforces decisions and helps resolve disputes so that Improve the provision of business services. Enterprises recourse to informal means of dispute resolution is need a variety of business services to help them enter reduced. A number of laws, such as the revised Law (e.g., help with preparing business plans and on Investment and Laws on Business Organizations, negotiating with creditors), operate, and grow (e.g., Insurance, and Financial Leasing, urgently need to be trucking, freight forwarding, accounting, market enacted. The administrative systems need to be information, quality assurance services, management developed in other areas as well before laws are put in services, and legal assistance), and manage risk (e.g., place; the administration of land deeds is an example. insurance). These services are best provided by the It is also important to make the regulatory system private sector but the government needs to put in place predictable, transparent, and simple to reduce the a policy and regulatory framework to facilitate private need to fall back on informal contacts to navigate the entry. There may also be scope for public-private regulatory maze. partnerships to jump-start markets for services where currently there are very few or no providers. Improve the flow of information. Informal arrangements thrive when information flows are weak. Underlying all these issues is the need to improve When market players lack information-about market government capacity to analyze private sector issues and opportunities and trends, quality of products, formulate and implement private sector development availability of resources, and government policies and policies and programs. Promoting private sector regulations-they become dependent on informal development in an era of globalization requires a good contacts and patrons both for information and because understanding of international and domestic market they do not know where else to go. Lack of information trends, sectoral knowledge, and appreciation of the needs about government policies also increases uncertainty. of business. There is a need for effective coordination Actions in this area will need to focus on increasing among different parts of government whose work has a awareness of government policies, laws, and bearing on private sector development. The High regulations, making the award of public contracts Commission for Investment, where several ministries are transparent and competitive, building an effective represented, can be one vehicle for achieving these goals, MSTQ system, regulating utility standards, and but effective coordination will also require an appropriate establishing credit bureaus. It is also important to division of labor between the various ministries and develop private sector collective bodies, such as agencies based on the comparative advantages of the chambers and trade organizations, and mechanisms for different parts of government. The overall economic effective public-private sector dialogue to gather policy of government, such as trade and tax policy, will feedback and disseminate knowledge about also be relevant because it will influence the broad government policies. incentive structure for private sector players. xi 1 Overview Introduction challenges. It acknowledges the achievements that have been accomplished since the fall of the Taliban regime, I n a postconflict environment, attracting new foreign and it highlights both the investments that have taken and domestic firms is central to private sector place and the opportunities that remain to be captured. development. Existing firms at the end of sustained More important, it reviews the constraints that firms conflict are typically state-owned, are highly currently operating in Afghanistan face and makes undercapitalized, have weak or nonexistent management, policy recommendations on how these constraints can have a deskilled and underemployed labor force, and are be addressed. In addition to a survey of 338 firms, the in need of significant new capital investment. As is the study makes reference to the numerous studies on the case in any business environment, particularly in private sector that have been conducted recently. postconflict countries, new investment decisions (into existing or new firms) usually depend on the availability Background of five basic factors: political and economic stability and security, clear unambiguous regulations, reasonable tax Afghanistan has taken tremendous strides toward rates that are equitably enforced, access to finance and reestablishing itself as a politically and economically viable infrastructure, and an appropriately skilled workforce. In state. Since the fall of the Taliban regime in 2001, the Afghanistan, these conditions are lacking. government, with the support of the international community, has reestablished a number of political The challenges facing the government of Afghanistan in institutions and spearheaded economic reforms. However, addressing these constraints and in turn attracting as noted in this chapter, more needs to be done if the further foreign and domestic investment cannot be government is to consolidate the ongoing state rebuilding underestimated. But as the experience of other efforts and accelerate the economic development process. reconstruction efforts shows, as in Bosnia and Herzegovina and East Timor, reform can be achieved. Political reforms Postconflict reconstruction is not new, and many Since the fall of the Taliban regime in late 2001 and the countries have successfully rebuilt viable and modern high level of international support that followed, private sectors after harsh devastation. Although war and Afghanistan has made significant progress toward conflict are not the same everywhere, those countries forming a stable central government that has legitimacy show that successes have been achieved in some of these throughout the country and with all major ethnic countries under challenging circumstances. groups. In December 2001 a Loya Jirga [assembly] was held to select an inclusive interim government. This This report has been prepared to assist the government was followed by a Loya Jirga that adopted a of Afghanistan to address its private sector development constitution and nationwide elections to select The Investment Climate in Afghanistan Afghanistan's first democratically elected president. persons to return to their homes. Though there are few Parliamentary elections were successfully carried out in good statistics on the Afghan economy, the September 2005. International Monetary Fund (IMF) estimates that official (nonopium) gross domestic product (GDP) The security situation in the country has improved and growth averaged 22.5 percent between 2002 and 2004. a return to general warfare does not appear to be This rapid expansion can be attributed to a number of imminent. The largest militia forces have been factors including the low starting base, the end of demobilized, almost all of the heavy weapons in the major conflict and the associated revival of economic country have been cantoned, and many of the most activity, and the end of the drought, which allowed significant militia commanders have been given sharp increases in agricultural output in many regions. positions in the government. With the aid of the The IMF estimates annual growth in 2004/05 at international community, the central government has around 7.5 percent and predicts 14 percent growth in begun to build a multiethnic army and police force that 2005/06. Investment is high and accounts for nearly 22 are able to exert the government's control in regions percent of GDP. The bulk of this investment (90 outside of the capital. Currently, there are almost percent by some estimates) is public investment 21,000 trained and equipped soldiers and nearly financed through international aid. These figures may 40,000 national police. The enhanced security has be biased because private investment is most certainly allowed large numbers of refugees to return from underestimated but the primacy of donor-funded neighboring countries and most internally displaced public investment is beyond question. persons have been resettled. The Afghan government has been remarkably successful The current government is strongly entrenched in in establishing a stable macroeconomic environment. Kabul and has a high degree of legitimacy throughout Currency reform was completed in early 2003 and the country. Its influence in the provinces is growing, since then inflation has been low and the currency but in many areas, especially where the insurgency stable. The government has shown strong fiscal remains strong, the government has limited influence. discipline and has implemented a no-overdraft policy Until recently, war and poor infrastructure led to the by which they refrain from printing money to finance rise of regional political powers that limited the ability a deficit. The government has also followed a prudent of the central government to project its influence. debt policy and has sought most of its external Today, the government has made efforts to appoint assistance in grants or highly concessional credits. The strong provincial governors loyal to the elected tax code was restructured in 2004 to expand the tax president and has replaced militias with the central base, simplify the code, and provide clarification. The government security forces. Of greater concern is the gross profit tax rate is 21.4 percent, compared with 35 very weak capacity of most provincial governments to percent for the region and 46 percent in the deliver services effectively. Organisation for Economic Co-operation and Development (OECD). Economic reforms Economic growth, which has received far less The government has taken a number of steps to foster international attention than has Afghanistan's political trade and reestablish relationships with trading process, has been dramatic during the recent recovery. partners. Customs tariffs have been rationalized, The economy has grown by more than 50 percent since existing trade agreements renewed, and new agreements the end of the conflict, which has allowed nearly 2.4 entered. Afghanistan has obtained preferred trade status million refugees and 600,000 internally displaced -- or Generalized System of Preferences (GSP) status in 2 Overview the United States, receives preferential treatment from declined by 21 percent to 104,000 hectares, and one Japan, Canada, and the European Commission, and has field in five that was planted with an illicit opium crop signed trade agreements with India, Pakistan, and in 2004 was planted with a licit crop in 2005. It Turkey and bilateral investment treaties with Germany, appears that the comprehensive eradication program Turkey, and Pakistan. A trade and investment initiated during the 2004-2005 growing season is framework agreement has been signed with the United bearing some fruit. The challenge is to sustain this States and the first meeting under this agreement was momentum (UNODC 2005).1 held in Washington, D.C., in December 2005. A decision to include Afghanistan in the South Asian Of even greater concern, Afghanistan remains one of the Association for Regional Cooperation was made at the world's poorest countries with an estimated per capita last summit of the Association in Dhaka, Bangladesh, in GDP of only US$315. Social indicators are also some of November 2005. The government has promised to the worst in the world: Infant mortality is 115 per 1,000 build a trade regime that will allow Afghanistan to enter live births, maternal mortality is 1,600 per 100,000 the World Trade Organization (WTO) within the next births, and 57 percent of men over the age of 15 are few years. Trade has increased dramatically, with the illiterate. Malnutrition is a critical issue as 70 percent of value of annual exports and imports growing at double- children do not receive timely complementary feeding digit levels. However, most of the exports are reexports and 85 percent of households consume noniodized salt. to Pakistan, which suggests that the increase in trade There is a very large gender disparity. Illiteracy for does not reflect an increase in Afghanistan's women above 15 years of age is 86 percent and in some international competitiveness. areas the net enrollment of girls in school is as low as 1 percent (World Bank 2004, p. 3). Yet, despite rapid economic growth, the structure of Afghanistan's economy has changed little. Some 80 to Though the government has been able to raise domestic 90 percent of economic activity is informal (World revenues to almost 4 percent of GDP, international Bank 2004, p. 5) and agriculture accounted for 47 assistance funds the majority of the government's percent of estimated total GDP in 2003. Other sectors recurrent expenses and almost all development programs are relatively small and will remain small. Though aimed at redressing Afghanistan's economic woes. Under industry and services are projected to grow at nearly 30 the government's scenario it will be able to fund percent, Afghanistan will remain an agrarian economy recurrent expenses in nine years' time, but development for some time. Industry is expected to remain about 24 programs would still be entirely dependent on donor percent of GDP in 2005, with manufacturing staying funds. Donors have been generous and are poised to around 15 percent. Illicit production of opium is a continue, but there is no certainty that international major activity in Afghanistan and accounts for 87 assistance will remain at such high levels over the percent of world production. In 2003, it accounted for medium term. If Afghanistan fails to meets its revenue one-third of GDP (World Bank 2004, p. 3-4). requirements it would not only delay development, but However, for the first time since 2001, there was a would have far-reaching political effects. decrease in opium poppy cultivation in 2005. According to the United Nations Office on Drugs and The government has clearly recognized that Crime (UNODC), the area devoted to drug crops Afghanistan's success will depend on its ability to 1 Although acreage declined substantially, the total potential opium production decreased by only 2.5 percent because of favorable weather conditions and low rates of plant disease, which led to much higher yields in 2005 than in the previous year. 3 The Investment Climate in Afghanistan quickly develop a strong and vibrant private sector. Security concerns: Despite significant progress, Only a growing private sector will be able to provide security threats remain. Some demobilized the jobs and increasing income expected by the fighters have retained their weapons. Many have population and generate the resources needed by the been integrated into the police forces, but most government to accomplish its development goals. have returned to civilian society where they have not yet fully integrated. An ongoing insurgency The private sector is aimed at the central government and the The government has taken a number of steps to foster United States-led coalition forces. Though the private sector investment. There has been significant insurgency is centered in the South and East, progress in developing the financial sector. The Da there is fighting throughout the country, and in Afghanistan Bank (DAB) and Banking Laws have been some areas it is increasing in intensity. Possibly gazetted (i.e., formally enacted) and a number of the largest security threat is the spread of poppy commercial banks licensed. DAB has divested its production. This vast illegal industry threatens headquarters-based commercial banking activities and the very stability of the Afghan government, divestment will be extended to branches in provinces although there are now signs of some success in where commercial banks are active. Three state-owned curtailing its growth. banks (Mille, Pashtany, and Export Promotion) have been relicensed, with corrective action provisions to Weak institutions: In nearly 25 years of war, improve performance. Progress has also been made in Afghanistan's government institutions were developing the microfinance sector. In addition to devastated and the new government has been reforming the central bank and establishing a new striving to rebuild them with international payments system, the government founded an institution assistance. There has been some progress on this to encourage private sector activity and streamlined the front. Most ministries have been staffed and are business registration process. It established the functioning at some level, including in some cases Afghanistan Investment Support Agency (AISA) with the delivering services. The central bank is mandate of promoting investment in the country. AISA functioning well and has issued a new currency. provides information to investors and facilitates the The customs department is collecting taxes and registration and establishment of new businesses. The forwarding the revenue to the central government, creation of AISA in general, and specifically the more and the security forces are loyal to the elected simple registration process, has resulted in Afghanistan government. However, government infrastructure ranking among the best countries in the 2005 Doing is nascent and many ministries lack the capacity to Business indicators of firm registration.2 provide some of the basic services. The courts and criminal justice system are inefficient and rarely Despite the government's recent efforts, the present level used. Land registries are incomplete and of private investment is still not sufficient to meet inaccurate, and often fraudulently abused. There Afghanistan's economic development needs. As the are no standards bodies and the once extensive following chapters show, several factors still pose agriculture extension service barely functions. And serious challenges to the emergence of a new and despite noteworthy progress in reestablishing vibrant private sector. The most notable constraints, banking services, reasonably reliable banking perceived and actual, include the following: services are limited to Kabul. Provincial branches 2 Despite the ease of registering a company, a host of clearances and procedures are required before a business can actually begin operating. 4 Overview of state-owned banks maintain low cash reserves modern legislative framework. Many of the and are often unable to pay depositors and existing laws are holdovers from the communist claimants in a timely fashion. era or even the earlier monarchy. Though the new government has worked to propose, pass, Poor infrastructure: Decades of fighting and implement new legislation, there is still a devastated the country's infrastructure, and vast backlog of laws and regulations needed to rebuilding it has been one of the government's guide government activities and provide stability foremost goals. International aid has poured in to the citizens. Currently more than 200 laws and many significant projects have been considered by the government to be high priority completed. Thousands of kilometers of roads, are waiting to be passed, and for those that have including the ring road from Kabul to Kandahar, been enacted, enforcement is a major problem. have been built and several important roads are under construction. Power generation and In addressing the constraints listed above and many distribution facilities have been renovated and others, the Afghan government's National Development hundreds of kilometers of irrigation canals have Framework (NDF)-its principal planning tool-lays out been cleaned and repaired. Although the country three pillars of development: (a) security and human is increasingly being linked, poor physical development, (b) rebuilding physical infrastructure, and infrastructure remains one of Afghanistan's (c) enabling the creation of a viable private sector as the greatest challenges. Less than 13 percent of the engine for sustainable and inclusive economic growth. population has access to safe water, teledensity is The NDF was completed quickly and now the 2.6 percent, and there are no operational railroads. government is preparing to update it with an Afghanistan National Development Strategy. To do this Unreliable power supply: Of the country's they are undertaking careful analysis and broad and installed power generation capacity of 420MW, thorough consultations with all stakeholders. only 270MW is operational and in most areas Undoubtedly the strategy will also emphasize the service is available only for a few hours a day. private sector as the engine of growth. And ultimately, About 6 percent of the population is connected private sector development will depend on establishing to the public grid and the rest depends on an environment conducive to private investment. generators and illegal connections. Objective of the Investment Climate Assessment Limited human and technical capacity: During the war years, many of the educated and The Investment Climate Assessment (ICA) is a standard technically proficient civil servants fled. Those World Bank Group product, but this is one of the first that remained were cut off from learning postconflict ICAs. Its objectives are to (a) evaluate the opportunities and lost many of their capabilities. state of the private sector business environment; (b) Though some returning Afghans have brought identify the key constraints to increasing firm with them significant technical skills, the majority productivity and the growth of small companies; (c) of the civil service lack the training, skills, and evaluate how the investment climate in a particular education to effectively provide services. country or subnational region compares to the investment climate in competitor countries and other Weak legal framework: In addition to low regions of the same country, and (d) identify policies capacity in the civil service, government that will alleviate obstacles and improve firm effectiveness is also hampered by the lack of a productivity and export competitiveness. 5 The Investment Climate in Afghanistan The ICA is based on a number of sources. It relies heavily available. Any available lists were inaccurate and on an Investment Climate Survey (ICS), which generates incomplete. Consequently, the survey proceeded by firm-level quantitative and qualitative information sampling based on a sector's share of the estimated GDP through face-to-face interviews with senior managers. with a quota for size of firm (see Annex A for more details These data can be used to evaluate firm-level on sampling). The implementing agency was forced to performance and identify constraints to doing business. initially rely largely on a list of enterprises it had compiled The survey data provided indicators of Afghanistan's in the course of conducting other research on the Afghan investment climate and business performance that have private sector. Though this list focuses on the sectors of been used in this report to identify reform priorities to interest for previous projects, the sectors represent a large track changes over time. The survey results are useful in proportion of the private sector and the list includes benchmarking Afghanistan's investment climate against many of the known medium to large companies in the neighboring countries and for comparing the investment country. The bias of the original list was mitigated by climate of regions within Afghanistan. The ICS is using the snowball methodology, which entails asking designed to be repeated in three to five years to assess the interviewed firms and other contacts for suggestions of impact of government policies on private sector growth firms that meet the sampling criteria. These new firms in and productivity increases. In addition to the ICS, the turn are asked for their suggestions. Thus, the sample report synthesizes other available analytical information potentially included a large proportion of the firms to identify investment climate constraints and policy operating in the sectors and cities covered by the survey. recommendations, including the World Bank's Doing Business Indicators, academic research, government Structure of the report publications, and reports by other donor organizations. Chapter II reviews the present state of the private sector in The ICS sample covered 338 firms in five major cities in Afghanistan. It considers the rate of foreign and domestic Afghanistan (Kabul, Kandahar, Mazar-e-Sharif, investment today and their growth and performance Jalalabad, and Herat). The sample was drawn from under present conditions. Chapter III synthesizes the manufacturing, transportation, wholesale and trade, and constraints the private sector is facing as identified by other service sector firms. Financial institutions, firms that participated in the ICS. Finally, chapter IV consulting companies, and security companies were not presents the policy recommendations that will help included. A sample frame of firms in Afghanistan is not Afghanistan exploit tomorrow's investment opportunities. 6 2 The State of the Private Sector Introduction companies are among the 78 existing SOEs, which include financial institutions as well as manufacturing L ong years of conflict devastated Afghan industry. and service firms. The manufacturing sector is tiny and The fighting destroyed most of Afghanistan's production is highly concentrated in a few industries. It production capacity and forced the flight of is almost completely inward oriented and few firms many skilled workers and managers. Sabotage of export a substantial portion of their output. In addition, infrastructure crippled domestic and international the sector exhibits a low degree of intrasectoral linkages. distribution channels and cut off industry from its Most producers, with the exception of a few agro- traditional markets. In addition, the Soviet-backed processors, source their raw materials from abroad. government in the 1980s worsened the situation by nationalizing large portions of the economy, imposing Investment price controls, and attempting to set up a centrally planned economy. In response, many traditional The end of major conflict and the fall of the Taliban industries, including carpet weaving, closed and regime led to an increase in private investment. But moved to neighboring countries. Others, such as despite several high-profile investments, by such horticulture products, basically shut down because of companies as Coca- Cola, Baghlan Sugar, and the the lack of suitable inputs. There was a brief recovery mobile telecom firms, investment has been limited of agriculture (primarily horticulture and livestock) in relative to Afghanistan's potential. Some of the the 1990s, which was wiped out by the drought of the moribund enterprises have been revived and new ones late 1990s. Many of the large state-owned enterprises have been created. But overall, new entry and (SOEs), such as the cotton and transportation expansion has been far less than policymakers had companies, continued to exist but by the end of the hoped for. One of the common ways for new investors, 1990s were essentially moribund. especially foreign investors, to enter a market is by purchasing firms in the government's privatization Today, despite a recent resurgence, the Afghan economy program. Yet, though the Afghan government has made remains agriculture based, mostly consisting of small an effort to privatize the SOEs, there seems to be little farms. Outside of agriculture, the private sector is political will to do so and to date only two enterprises overwhelmingly composed of informal family-owned have actually been privatized. microenterprises, most of which are engaged in trading or basic services. Recent World Bank estimates suggest As of May 2005, AISA has registered nearly US$1.3 that 80 to 90 percent of all economic activity is billion in new investment (not including the telecom informal. There are few small and medium enterprises firms) in the past two years. However, this figure must (SMEs) and only a handful of large firms. The largest be carefully interpreted. It represents only the The Investment Climate in Afghanistan approved investment, and just a fraction has actually By some estimates, businesspeople in the Afghan occurred.3 Nearly 50 percent of the new investment diaspora are worth as much as US$5 billion, with approved by AISA has been in construction and much of it in Dubai.5 Donors and the Afghan construction material. The remainder is split almost government hoped that the end of major conflict and equally between industry and services. The AISA the establishment of a stable government would figures represent very little agriculture, which is prompt much of this money to return and drive the understandable as most agriculture is small scale and reconstruction process. However, there has been does not have an incentive to register investment.4 limited success in attracting back investment from overseas Afghans. Just over half of the investment The concentration on construction reflects the massive approved by AISA has been from Afghans and not all flows of external aid and the need to rebuild of this has come from outside. Yet the returnees and Afghanistan's devastated infrastructure. The outside funds are important. Nearly 20 percent of the predominance of construction is not unusual in firms sampled in the ICS are owned by investors who postconflict countries. Not only is there a need to have returned to Afghanistan since the fall of the rebuild basic infrastructure, but often investment is Taliban regime. In addition, another 7 percent of the directed into construction because of a lack of other sampled firms received substantial startup capital from opportunities. This is particularly true when an influx friends and family outside of Afghanistan or have of aid and donor organizations demands modern owners that still live abroad. accommodations. The service sector includes hotels, restaurants, transportation, communications, and Returnees are important in many ways. Besides other basic services needed by an emerging economy. bringing capital, they also bring with them contacts in foreign markets and knowledge of international The biggest sectors in industry include plastics, bottlers, business methods that will strengthen Afghan business. and processors of simple packaged foods. All of these In the ICS survey, nearly 35 percent of the owners who industries are aimed at the local market. Some, such as have returned since 2002 have a high school education bottlers, have natural protection because of the high or higher, compared with only 24 percent of the rest of cost of transportation. Most are technologically simple the sample of business owners who were in Afghanistan and need only small investments. For example, many prior to 2002. In addition, recent returnees are nearly small producers of biscuits and other inexpensive three times more likely to have experience working for packaged foods aim to replace more expensive imports. foreign-owned companies. Research has shown that For the most part, Afghan industrial enterprises are both the manager's education level and experience nascent and unable to effectively compete against working in a foreign company lead to a higher level of imports or enter the export market. firm productivity. 3 The AISA staff is making a valiant effort to track the approved investments and registered firms to determine if they are in fact operating. But the task is slow and difficult and to date they have verified only a few firms. There is no way of knowing just how much actual investment has taken place compared to approved investments, but the rule of thumb used by many observers is to discount the approved investment by half when estimating actual investments. On the other hand, only large firms, foreign investors, and investors wanting to do business with the government have an incentive to register with AISA. Thus, substantial investment in the formal sector is not accounted for by the AISA figures. Nonetheless, the AISA lists give a good idea of the direction and magnitudes of investment activity. 4 The lack of regulations of non-governmental organizations has also led to a plethora of for-profit organizations masquerading as not-for- profit organizations-undermining the legitimacy of the formal economy and displacing the private sector. 5 Press Briefing by David Singh, Office of Communication and Public Information, United Nations Assistance Mission in Afghanistan (UNAMA), 25 September 2003. 8 The State of the Private Sector In addition to investment by overseas Afghans, Growth and performance policymakers have looked to foreign direct investment (FDI) as a key source of funding for Afghanistan's Despite the difficult business environment, Afghan reconstruction, so far with mixed results. To date, AISA industry is steadily recovering, and existing firms has approved over US$520 million in FDI. More than perform on par with firms in neighboring Central half of this is in the construction sector and one-third Asian countries. Firms in the Afghan survey report in services. Less than 20 percent of the approved FDI a 67 percent average increase in employment over has been in the AISA industry classification, which is the past five years. Much of this growth has been mostly manufacturing. Given the risks of investing in recent, with employment growth averaging around Afghanistan, foreign investors prefer government- and 22 percent in the past year alone. Also in the past donor-funded reconstruction projects or services, year the average capacity utilization of where they can quickly recover their investment, to the manufacturing firms rose by 10 percent. The rapid longer term process of building markets for increase in employment was matched by a similar manufactured goods. The government has touted increase in sales and reflects the low base from Afghanistan as a land bridge that will facilitate trade which Afghan firms are starting. Typically, new between Central Asia and South Asia. However, so far firms grow at higher rates than do older, established there is no indication that there has been any foreign firms because they are starting from a lower base. investment to support this trade. However, in Afghanistan, firms that were established after the fall of the Taliban report the Turkey is the largest investor and accounts for over one- same growth rate for the past year as do older firms. fifth of FDI approved by AISA. Almost all of the Turkish This statistic indicates to how low a level of output investment is in construction. The United States is next many existing firms had fallen. with around 17 percent of approved investment, followed by China and United Arab Emirates (Dubai) Firm performance in Afghanistan is similar to that with less than 10 percent each. Pakistan and Iran found in other small Central Asian countries but is account for only around 5 percent of AISA-approved considerably behind India, China, and even Pakistan. investment. Because they are Afghanistan's traditional The median value of sales per worker in Afghan trading partners, this small share suggests that a manufacturing firms is around US$3,333 (see Table significant amount of investment from neighboring 2.1). Though greater than that reported in Tajikistan or countries may not be accounted for on the AISA list. It Uzbekistan, the median value is only around one-third is also interesting to note that firms from Iran are more that of small manufacturing firms in Pakistan or India likely to be investing in food products and other and much less than that reported by Chinese firms. At manufactured goods than are firms from other countries. 62 percent, average capacity utilization in Afghanistan Table 2.1: Median Output Per Worker (US$ for manufacturing firms with fewer than 100 workers) Afghanistan Pakistan Uzbekistan India China Tajikistan Syria 3,333 10,043 567 9,146 20,374 1,859 4,333 Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. For firms with 100 workers or fewer in comparator countries. 9 The Investment Climate in Afghanistan manufacturing is only slightly below its neighbors and more than 40 percent upgraded an existing product high for a country just emerging from sustained conflict line in the past two years. Clearly, the existing Afghan (see Table 2.2). In 1997, Mozambique was also three or firms are engaged in increasing their capital stock and four years out of major conflict, and average capacity upgrading their capabilities in anticipation of future utilization in manufacturing was only 48 percent. opportunities. However, this optimistic view is Afghan industry is very small and only just emerging, tempered by the fact that industry is starting from a but those firms that do exist seem to be coping well. low base and most of the investment is going toward establishing the most basic production processes. Industry's recovery is also evidenced by its investment activity. Though the rate of foreign investment and Afghan industry's low capital intensity undoubtedly the return of expatriate Afghan investors may be explains much of the difference in labor productivity disappointing, existing local firms are steadily adding between Afghanistan and its larger neighbors. But to their capital stock. Typically, investment at the firm recent research indicates that a number of other firm level is lumpy and in any given year a firm may not characteristics, along with the investment climate and invest as it absorbs previous investments. Yet, 71 the capital labor ratio (see Table 2.4), also contribute to percent of both Afghan manufacturing and service labor productivity differences. Enterprises that offer sector firms in the sample invested in new equipment worker training and have well-educated workers and or machinery some time in the past year (see Table managers are more productive than those that do not 2.3). This proportion is higher than in any of the offer training and have less-educated workers. Probably comparator countries except China. It is also a much the most important factor affecting productivity is the higher rate than that found in postwar Mozambique level of competitive pressure a firm faces. Stronger where only about 56 percent of firms invested in the competition forces unproductive firms out of the year before the survey. In addition, over one-third of market and surviving firms to continuously improve the Afghan sample introduced a new product line and their performance. Table 2.2: Average Capacity Utilization for Manufacturing Industry (%) Afghanistan Pakistan Uzbekistan India China Tajikistan Syria 62 N/A 73 78 71 91 60 Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. For firms with 100 workers or fewer in comparator countries. N/A = not available. Table 2.3: Firms Investing in Equipment or Machinery Last Year (% of Sample) Afghanistan Pakistan Uzbekistan India China Tajikistan Syria 71 5 26 38 74 36 42 Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. For firms with 100 workers or fewer in comparator countries. 10 The State of the Private Sector Table 2.4 : Median Capital/Labor Ratio in Manufacturing (US$ per worker) Afghanistan Pakistan Uzbekistan India China Tajikistan Syria 1,500 2,063 229 2,307 3,170 721 567 Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. For firms with 100 workers or fewer in comparator countries. As will be discussed in chapter III, Afghan firms offer traditional activities. Some involve the breaking of new less training than do their neighbors. In addition, their ground (e.g., mobile phones and nontraditional managers and workers are less skilled than are those in exports). Yet others represent activities that were carried competitor countries. Most important, many out in the past but either on a smaller scale (e.g., businesses in Afghanistan do not feel the threat of construction) or exclusively in the public sector (e.g., strong competition. Over 40 percent of surveyed firms power generation, banking, and airlines). These said that both domestic and foreign competition was activities may be categorized into several groups: either not important at all or only slightly important. These facts suggest that substantial barriers protect Import-substituting activities. As Afghanistan incumbent firms and relieve them of pressure to never had a broad, diversified industrial base, a constantly upgrade their capabilities. substantial part of local demand was historically met through imports. With a large part of the Opportunities industrial base destroyed, imports have become even more important in postconflict Afghan industry is recovering and growing, albeit from a Afghanistan. Many of these products, especially low base. Though foreign investment and new large-scale the low value-added products that use simple investment has lagged, existing firms are steadily technology, represent areas where Afghanistan increasing sales, adding workers, and investing in their may have a comparative advantage. Examples capabilities.The better Afghan firms, which were what the include food products, such as poultry and ICS covered, have attained labor productivity and capacity wheat-based products, and light consumer utilization levels similar to those of small firms in other products such as soaps, shampoo, and laundry Central Asian countries. But they still fall far short of the detergents (see Box 2.1).6 performance of small firms in India, Pakistan, and China. Traditional exports. These include carpets and a Moreover, investors in Afghanistan are exploiting only wide range of fruits. The bulk of Afghanistan's a small subset of available opportunities. As carpets are produced in villages, by women Afghanistan comes out of more than 20 years of weavers. During the conflict, many carpet conflict, a variety of investment opportunities are weavers and traders migrated to Pakistan, mostly emerging. Some of these involve the revival of to Peshawar. As a result, a large proportion of 6 Some of these activities, such as home egg and chicken production, have proved to be useful sources of income for poor households, including those headed by widows. There is some concern that entry of large poultry farms may drive such households out of business, although, with proper linkages between large enterprises and microenterprises, this need not be the case and such a development could turn out to be beneficial for the latter. 11 The Investment Climate in Afghanistan carpet exports in Pakistan's trade statistics are Infrastructure and utilities services. Mobile attributable to the Afghan carpet industry. The telephony remains the best known example in production of raisins, once the most successful Afghanistan of significant private sector entry Afghan export, has been hampered by damage in the infrastructure and utility sector. to orchards and processing plants, although the However, a wide variety of opportunities wait recent preferential trade agreement with India to be exploited across various sectors. These has seen significant increase in the market share sectors include small-scale power generation, of Afghan dried fruits in the Indian market. management contracts in power distribution, fixed-line telephony, value-added services in Exotic exports. A second potential area consists telecommunications, and construction and of "exotic" exports. Some of these are agro-based maintenance of roads and small-scale water and some mineral based. Examples include systems. cashmere, spices such as cumin and saffron, perfumes, herbicidal medicines, and gems. What would it take for investors in Afghanistan to venture into these promising areas? And what would it Construction-related activities. The current take for existing firms to improve their performance boom in construction spending, not an unusual and bring it to par with that of their counterparts in the feature in postconflict situations, has generated region, if not better? The rest of this assessment substantial opportunities in construction-related addresses these questions. Chapter III looks at the key activities. It is unclear if this sector will continue issues in Afghanistan's investment climate that help to remain an important arena for investment explain the current shortfall in performance. It activity, as experience in other postconflict examines investment climate constraints in greater countries shows a drop in construction-related detail and considers their implications for present spending after the initial boom. However, in the business operations and the potential for attracting interim, this environment can be a breeding further international and domestic investments. ground for entrepreneurship, which, in the Chapter IV then lays out a road map for addressing the future, may be channeled into other activities. biggest constraints. Box 2.1: Examples of import-substituting activities Poultry: Despite existing local demand, the poultry sector in Afghanistan remains underdeveloped when compared with neighboring countries. Startup costs are relatively small, and facilities can be established quickly, making the sector appealing for businesspeople of more limited financial resources. Wheat-based Products. Wheat is the primary staple in Afghanistan. Though Afghanistan has yet to reach self-sufficiency, numerous business initiatives are currently underway to expand production and improve processing. The emergence of an Afghan wheat-based food sector could play an important role in the development of small and medium enterprises. Soap, Shampoo, and Laundry Detergents: Afghanistan imports almost all of these consumer goods. Soap, shampoo, and laundry detergents share the common characteristic of transportation representing a disproportionately high share of their total cost. This cost structure indicates a market opportunity for soaps, shampoos, and detergents manufactured in Afghanistan. Source: United Nations Development Program Market Sector Assessments, March 2005. 12 3 Today's Investment Challenges Introduction Afghanistan. Electricity was closely followed by access to land, which was cited by nearly 60 percent of the sample. T he Afghan government has taken a number of Corruption and access to finance were also mentioned as steps to improve the business environment and significant constraints (see Figure 3.1). Surprisingly, attract investment. Tax reform is a notable "crime theft and disorder" was cited by few firms as a example. Afghanistan is now at number seven of 155 significant problem. When firms were asked to name the countries in the 2005 Doing Business rankings for paying single biggest constraint, the rankings of land and taxes (World Bank 2005). The gross profit tax is 21.4 electricity were reversed; nearly 34 percent of managers percent (compared with 35 percent for the region and 46 cited access to land as the biggest constraint, 15 percent percent in the OECD), and the average medium-size reported electricity, and 18 percent reported corruption as company makes two payments and spends about 80 hours the biggest constraint. Few reported security. per year complying with taxes. Currently, entrepreneurs do not see tax administration as a big issue because there is The importance of access to land is highly unusual in little enforcement. But as the economy grows and becomes investment climate surveys. The surveys target existing more formal, it will benefit from having an efficient system firms; even in other postconflict countries, such as in place. As already mentioned in chapter I, Afghanistan Mozambique, where the land tenure system is in has made the process of registering a business, if not disarray and it is difficult to secure clear title, most of actually starting operations, simple. Labor regulation is the surveyed firms have solved their land issues. Access another area where Afghanistan has made significant to land remains a problem only for firms wanting to progress. It ranks 25th in the 2005 Doing Business list. significantly expand, especially those seeking greenfield Regulations governing hiring, firing, and working hours expansion. The fact that access to land is perceived as all give Afghan firms more flexibility than firms have in such a significant problem in Afghanistan even by most other countries of the world, particularly among its existing firms indicates just how severe a constraint it is. neighboring countries. The government has made important strides toward creating an enabling investment In investment climate surveys, the cost of finance is usually climate, but much more remains to be done, particularly highly correlated with access to finance. However, in in removing informal barriers to new entry, improving Afghanistan, the fact that access is seen as a significant infrastructure, and reducing uncertainty. issue and cost is not reflects the fact that for most firms external finance is unavailable at any cost. Regulatory Obstacles: An overview issues such as business registration, tax administration, and labor law were likely not cited as significant obstacles Over 64 percent of the surveyed enterprises cited electricity not because they are efficient but because they are so as either a severe or major obstacle to doing business in poorly enforced that they do not have an impact on most The Investment Climate in Afghanistan firms. Likewise, the legal system is rarely considered. managers in other cities. In Mazar-e-Sharif Firms have always used informal mechanisms to resolve anticompetitive practices is cited more often than it is disputes and to enforce property rights. Thus, it is elsewhere, which could reflect deeply entrenched local unlikely that many managers even understand the business interests that use their close ties to powerful benefits of a strong and efficient legal system. political patrons to restrict competition. (See Annex B for charts on investment climate constraints by cities.) The perceived obstacles are similar across all regions in Afghanistan, with only slight differences. Electricity, The following sections consider these constraints in slightly access to land, corruption, and access to finance are the more detail. Each section reports the survey findings and issues most often cited as either severe or major complements the results with both primary and secondary constraints. However, their order is not the same. In information collected during the survey process. Herat, access to finance was the most often cited severe constraint, with electricity much less often cited, which Security and informal arrangements may reflect the fact that Herat has been relatively more successful than other cities in restoring power supplies. Afghanistan remains a dangerous country with a highly In Kandahar customs and trade regulations were cited uncertain business environment. An ongoing insurgency as often as access to finance, possibly because of the appears to be accelerating in some provinces. Although large number of traders found in the Kandahar sample. there have been some recent successes in curtailing the Also in Kandahar, the managers were much less likely growth of drug production, the illicit opium industry is to report obstacles as severe or major than were a major part of the economy and there remains a risk of Figure 3.1: Afghanistan: Percentage of Firms Citing Constraint as Major or Severe Source: World Bank Afghanistan Investment Climate Survey. 14 Today's Investment Challenges Afghanistan becoming a narco-state. Thus, it is that on average they spend an amount that is close to 15 counterintuitive that most managers in the ICS did not percent of sales on security infrastructure, significantly rank crime and disorder as a major or severe constraint. more than do firms in neighboring countries (see Figure This paradox partly reflects the real improvements in 3.2). They spend an additional 3 percent of sales for security, especially in the major cities and in the north protection payments to commanders, government and west. However, it also reflects the fact that the survey officials, or organized criminals. The cost of security is covered established firms, most of which have been particularly high for foreign firms. Rent for secure operating in Afghanistan for some time. To survive, these buildings in Kabul can be similar to prime property in firms have had to find ways to cope with the lack of Tokyo, London, or other major cities. security. The most common way seems to be by forming close ties to former warlords and government officials. The central government has made significant progress in Consequently, for firms in the survey sample, security is disarming militias and reining in the regional now a less pressing issue than is the constant struggle to commanders who once dominated Afghanistan. In many obtain adequate power and deal with corruption. cases the commanders have been co-opted by giving Though the business environment imposes high costs, them positions in the government and integrating their these established firms are investing and slowly growing. militias into the police forces. Despite this progress, the However, new entrants and potential investors, who do former commanders remain influential, especially within not have established contacts with powerful figures, find their home regions, and often continue to maintain the environment much more daunting and are often significant military power. These former commanders are discouraged from investing. increasingly forging close ties to the business world and using their power and influence to further their business Providing security imposes a high cost on all businesses in interest. Some observers argue that the reduction of Afghanistan. Because they have learned to cope with the outside support beginning in the early 1990s forced lack of security, few managers ranked crime, theft, and many of the commanders and political leaders to look to disorder as a major or severe problem. However, security the local economy, including the illicit drug economy, to remains a significant problem and surveyed firms report fund their political ambitions.7 This trend intensified Figure 3.2: Security Costs as a Percentage of Sales Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development/Business Environment and Enterprise Performance Surveys. 7 See work by Giustozzi and Lister for discussion on warlords and their entry into business. 15 The Investment Climate in Afghanistan after the fall of the Taliban and continues today. In some excludes new entrants and limits competition. cases, the commanders have formed their own businesses Returnees, foreigners, and potential new investors or have openly established monopolies to capture rents. without powerful contacts are reluctant to enter, fearing Examples include the well-known monopolies on fuel that they cannot cope in such an unsafe environment or distribution and construction material in Kandahar. In that the costs would be too high to warrant investing. other cases, the links are not as clear; the commanders work through close associates, and their businesses Electricity and infrastructure interests are not transparent. In many developing countries, private investors identify In some ways, the entry of warlords into the business infrastructural deficiencies, particularly inadequate world has been beneficial, but the negative consequences and unreliable power supply, as among the most binding are profound. The rapid removal of the checkpoints that constraints they face. It is no surprise then that this is once dominated Afghanistan's roads is often attributed also the case in Afghanistan, where the infrastructure to the interests that the commanders have developed in either was destroyed during the conflict years or has trade. Also, a return to full-scale civil war is less likely been severely run down by lack of investment and when commanders and their supporters are busy maintenance. Indicators of infrastructure availability in enriching themselves through economic activity. Afghanistan are in most respects the worst in the world, However, the negative consequences are more profound well below the corresponding figures for Sub-Saharan (Giustozzi 2005). Relatively small groups of Africa. For example, only 6 percent of the population businesspeople dominate most trading activities in has access to power from the grid. Power supply is of Afghanistan, and it is suggested that to operate on a poor quality, characterized by low voltage, intermittent large scale it is necessary to have close relations with supply, and blackouts. Access to telecommunications commanders or former warlords (Lister and Pain 2004, remains limited particularly in rural areas. p. 3). These small groups of insiders use their contacts to access land, settle disputes, ensure security, obtain Power credit, and win contracts that others without Power has a serious impact on private sector activity, connections could not. This closed network of with businesses citing power supply as the most serious commanders and their crony businesspeople effectively infrastructural problem in Afghanistan (see Box 3.1). In Box 3.1: Voices of Afghan Entrepreneurs: Waiting for power connections "We have no power grid connection. Our factory is located outside the national grid area. Our machinery is old and manually operated and does not require power. But this creates problems in retaining workers who do not like to operate machinery by hand. We need to install modern machinery and for this we need land in the industrial estate. We use a small generator just for lighting during the night, if we work at night." - beverage company 1 "We expect to go for production in one month's time. However, we are not yet connected to the National Grid. We applied for power connection to the Ministry of Water and Power about three months back, along with a letter from the Ministry of Mines and Industry (MMI). The Minister of Water and Power approved the application, and gave an order of national grid access to the Directorate of Water and Power. The Director said that his office will contact me when the processing of the application is finished in the Ministry of Water and Power. We are still waiting to hear from the Directorate. Meanwhile, the validity of the Minister's approval, which is for a month, has expired. We will get the Minister's approval for the second time and again meet the Directorate. Meanwhile, we are also buying a generator, since power from the National Grid, even if I get it, is not reliable." - beverage company 2 "Power is one of the main problems we are facing. We are connected with the national grid since the area is outside the City power supply. We use generators for 24 hours in a day for the production of medicine. We need 7-11 liters of oil per hour to run the generators. Each liter costs 30 AFs which means we spend 210-330 AFs per hour for using generators." - pharmaceuticals company 16 Today's Investment Challenges fact, more firms cite power as a severe or major obstacle connected to the public grid, an equal proportion (76 than they cite any other business constraint. This is true percent) say that they have at least one generator (Table for all cities except Herat, where it was mentioned as the 3.1). In Jalalabad, almost all surveyed firms (97 third most important constraint, after access to finance percent) rely on generators. Even in Herat, where firms and corruption, and in Kandahar, where it was a close complain less about electricity than they do in other second after access to land. Herat has been relatively cities, 71 percent of firms use generators. In terms of more successful than other cities in restoring power reliance on generators, firms in Afghanistan are closer supplies; however, even here more than half (56 to their South Asian neighbors and in sharp contrast to percent) cited power as a major or severe constraint. In their Central Asian neighbors. Firms report losing some cities the problem is acute. An example is about 18 percent of their merchandise value because of Jalalabad, where 90 percent of the surveyed firms cited power disruptions; the proportion is highest for firms electricity as a major or severe problem. based in Kandahar (30 percent), where the ownership of generators is least common (65 percent own The sector suffers from an array of problems. generators), and lowest for those operating from Generation capacity is grossly insufficient, although Jalalabad (8 percent), where, as mentioned above, augmented somewhat by imports of power from generator use is almost universal.8 neighboring countries. Transmission and distribution capacity is inadequate. Most of the equipment in the A Power Sector Master Plan outlining an investment power sector is old, dilapidated, and failing, and program to help rebuild the power infrastructure has backup equipment is rare. Even though the ICS been adopted. Implementation of the investment covered the stronger, more established companies in program has started and has focused on rehabilitation urban areas, only about 76 percent of the sample was of damaged generation capacity for Kabul and connected to the power grid. And for these firms power Kandahar, construction of transmission lines from was available only an average of about six and a half existing hydro plants to Kabul, and the Northern hours a day. Transmission System, which will allow import of low- cost power from Uzbekistan to Kabul (expected Deprived of power from the public grid, businesses completion by end of 2008). In addition, there is overwhelmingly rely on their own generators. Thus, investment in rehabilitation and expansion of the although 76 percent of the surveyed firms are distribution systems in Kabul and other cities. There is Table 3.1: Percentage of Firms Owning Generators Afghanistan Pakistan Uzbekistan India China Tajikistan Syria 76 42 2 64 18 0 73 Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development/Business environment and Enterprise Performance Surveys. 8 Power generation, including by small generators, is heavily dependent on imported fuel, which is one of the biggest cost items in power production. High fuel prices are a global issue beyond Afghanistan's control, but distortions in this market could be amenable to policy actions. A recent study suggests there is abuse of market power, corruption in allocation of import licenses, barriers to entry, and unregulated imports of poor-quality fuel (Paterson 2005). The fuel market is dominated by a very small number of large players, who may be politically well connected. The small end of the market is more competitive, with a large number of small players making very small margins. Imports of low-quality and adulterated fuel pose health risks and reduce the life span of engines. 17 The Investment Climate in Afghanistan also a proposal for a combined cycle generation turbine Rehabilitating the road network has been a top priority plant at Shebergan that could add 100MW to 150MW for the government, which has developed a large of generation capacity and is a good opportunity for an investment program for major highways, including international management contract. Currently, the rehabilitation of the existing network, completion of the Ministry of Water and Power (MWP) is in charge of network, and, over time, construction of new roads. the power sector in Afghanistan. A state-owned power Despite some delays there have been noticeable utility, Da Afghanistan Breshna Moassesa (DABM), is improvements in some areas with some improvements in charge of generation, transmission, and distribution in travel times already beginning to materialize. In of electricity. Its several regional electricity departments addition to work on the main highways, there have been are responsible for running electricity facilities in efforts to repair and improve smaller roads, primarily different parts of the country. Weak capacity in the through public works employment programs, most MWP and DABM remains a huge challenge to the notably the National Emergency Employment implementation of the investment program. DABM Program. Nonetheless, there is still a long way to go in has neither an appropriate governance structure nor rehabilitating the highway system and completing its financial resources to improve electricity services. segments including the remaining "ring" connection in Northwest Afghanistan. Transport As in many other countries, a relatively small Transport service was an important activity during the proportion of firms in Afghanistan (25 percent) report conflict, and private transport companies have transport as a major or very severe problem. However, expanded rapidly since the end of the war. There are a this statistic may reflect the limited horizons of many number of flourishing freight and passenger transport private firms who operate mainly within a localized companies. (The government truck fleet has stopped economy and may find the poor-quality transport working.) Estimates of the total size of the private truck infrastructure adequate for their needs. It is noteworthy fleet in Afghanistan range from 47,500 to 80,000 that when asked about factors constraining exports, a (World Bank 2004). The government remains heavily larger proportion (39 percent) identified lack of roads, involved in the transport sector. There are a number of air connection, railroads, and other infrastructure as a trucking companies among the SOEs and the major constraint. In fact, this was the second most government retains ownership of the largest bus fleet. important factor inhibiting exports after lack of trade In addition, the government has revived Ariana, the finance. Firms reported losing 5 percent of their public sector airline. Though the government has also domestic merchandise value during transit because of licensed a number of private airlines, any government breakage or spoilage and losing only 0.6 percent to favoritism to Ariana will undoubtedly impede the theft. The proportions are not much different for development of private airlines and competition in the international shipments: 4.6 percent and 0.9 percent, air transport sector. respectively. Firms rarely receive any compensation for such losses; only 2 percent said they were ever Telecommunications compensated by the transport operators. The telecommunications sector in Afghanistan is developing very rapidly. Twenty-six percent of the Prior to the conflict, Afghanistan's paved highway surveyed firms mention telecommunications as a major network was of reasonably good quality though limited or very severe problem. Driven by a competitive market in coverage. Protracted conflict and lack of maintenance and US$200 million in private investment, the mobile left this network largely dilapidated-road trips that took footprint covers as much as 50 to 60 percent of the hours 30 years ago took days by the end of the war. country's population, providing services in 23 provinces 18 Today's Investment Challenges (as of March 2005). The country has a teledensity of 2.6 passage of a telecommunications law and a separate law percent (up from 0.1 percent in 2002), which puts it covering the corporatization of Afghan Tel. Both are ahead of a considerable percentage of low-income vital pieces of legislation that cover moving toward a countries. There are two private mobile operators and unified licensing regime, opening up the sector to two additional tenders for mobile telecommunications considerably greater competition, providing greater are now being negotiated. The first, the Afghanistan autonomy and power to the regulator, providing a Wireless Communications Company, offers prepaid framework for extending access, and giving Afghan Tel GSM services in four major cities. It is a joint venture 20 freedom from bureaucratic strictures covering areas such percent owned by the Ministry of Telecommunications as pay and investment that hobble its ability to attract and 80 percent by Telephone Systems International, staff and financing as well as to compete in the sector. which is controlled by an Afghan investor who provides the management. An international competitive tender The Internet has come to be one of the most efficient process in 2002 resulted in the award of a second mobile ways for firms to communicate and to conduct business license in January 2003 to Roshan.9 Competition with distant clients. However, in Afghanistan, business between the two privately owned mobile networks has use of the Internet is nearly nonexistent outside a few of resulted in prices consistent with international norms; the largest cities. On average, 15 percent of the surveyed mobile prices have dropped approximately 70 percent firms regularly use e-mail in interactions with their over the past 18 months. clients and suppliers and 9 percent use Web pages (Table 3.2). There is a distinct regional difference in the The Ministry of Communications has also started use of the Internet. Almost a quarter of enterprises in providing services, and approximately 22 million calls Kabul, Herat, and Mazer-e-Sharif reported using the per month are carried by the publicly owned Afghan Tel Internet. But in Jalalabad and Kandahar no firms network. With the government and District reported using Web sites and only 6 percent of the Communications networks, it is expected that Afghan sample in Kandahar reported using e-mail. Tel services will reach every provincial and district capital by the end of the year. The challenge of Access to land improving access to rural areas, improving the quality and range of services and more importantly the More firms cite access to land as their biggest problem. It challenge of further reducing prices, remains. is exceptionally difficult for businesses to get clear title Nonetheless, progress to date has been remarkable. To to new land, especially serviced land (see Box 3.2). The sustain that progress, the Ministry is pushing the lack of certainty in land tenure discourages existing Table 3.2: Percentage of Firms Regularly Using E-mail and Web Sites in Interactions with Customers and Suppliers Afghanistan Kabul Herat Kandahar Mazar-e-Sharif Jalalabad 15 17 26 6 29 0 9 8 24 0 11 0 Source: World Bank Afghanistan Investment Climate Survey. 9 Roshan is owned by a consortium led by the Aga Khan Fund for Economic Development (51%), Monaco Telecom International (35%), MCT Corporation (9%), and Alcatel (5%). 19 The Investment Climate in Afghanistan business from making large new investments and register to demonstrate their rights. All of these systems effectively prohibits new investors, especially foreign overlap and are inconsistent and ambiguous. In the investors, from entering the market. The difficulty of absence of clear guidelines or procedures for land obtaining new land is borne out by the survey and the administration, asserting one's property rights is a costly, 2005 Doing Business indicators (see Annex C). Nearly uncertain, and tenuous process. Even property with valid 56 percent of the firms who had tried to acquire new documentation is not free from litigation as often land in the past three years were unsuccessful. The multiple titles may have been issued under different Doing Business database indicates that on average it political regimes. Indeed, over 10 percent of the survey takes 252 days and costs 9.5 percent of the value to sample reported having ongoing land disputes. register a property, which means it takes longer in Afghanistan than in most countries in the world. Access to land is another area in which having powerful patrons can help. In many cases local The different waves of conflict, land reform, and commanders have illegally distributed government nationalization have left the land tenure system in land to their supporters. In other cases they have used disarray. Properties have changed hands numerous times force or their positions in government to resolve land with few records. Many registries were destroyed or are disputes in favor of their business partners. The policy not accessible and most land was never registered to of the government is to award ownership to whoever begin with. The returning refugees and displaced persons owned the land in 1978. However, the process is slow have exacerbated the problem and now much of the best and it will take many years to make significant land has multiple claims. Different legal foundations headway on establishing clear land tenure. In the exist for claiming land tenure and landowners variously meantime, having powerful allies is the best way to use custom, Sharia law, or evidence from the land ensure security of land tenure. Box 3.2: Voices of Afghan Entrepreneurs: The challenge of getting land "Obtaining land has been the main problem for us. The former Ministry of Light Industries had allocated a plot of land for us in the Pul- e-Charkhi area of Kabul, but we are yet to get this government land and are not sure we ever will. We have applied for a plot of land to AISA but have not got a response yet. AISA has promised to help, but we do not know if they have the capacity to allocate land. We thus rented a house in Kabul in March 2002 and installed our machinery. We pay a rent of US$1,260 per month for the house. It has limited space and, being located in a residential area, it is not good for the local environment. Lack of land is constraining us in many ways. If we had the land we would construct a factory with modern systems used in Europe and North America, expand employment from the current 30 to 150 by expanding production capacity, marketing network, and sales volume, and help reduce the country's dependence on imported medicine and perhaps even export to the neighboring CIS countries." - pharmaceutical company "We applied to the Ministry of Mine and Industry for land in 2003 and were allocated a plot of land by them. Unfortunately, a few days later, we received a letter from the Ministry saying that the allocation is cancelled. This was a big disappointment since we had to work hard to get the allocation and had faced many difficulties down the road. Meanwhile, we were running the factory on rented land, where we do not have water or connection to the national grid-both important for us. We contacted AISA for land where we were told that we can get land for which the payment will have to be made in three installments in three years, with an advance payment of the first installment of US$13,600. We got land allocation from AISA within three months of applying." - iodine manufacturer "We approached the Ministry of Agriculture to obtain land. We did get an allocation from the Ministry and it was agreed that our project will be a joint venture with the government, with the Ministry owning 30 percent of the shares. While it was relatively easy to get the allocation letter from the Ministry, we are having a hard time getting the land title cleared. It is not enough to get the approval of the Ministry. We have to visit several offices to get all the clearances required and we do not think there is a single government office that we have not visited! Particularly difficult has been the Municipality, the Ministry of Water and Power, and the Kabul Provincial Office. They do not care whether you have a letter from the Minister or Governor. They will always find some problem with your documents. We would not tell you which offices we had to pay bribes to, but there are some where we had to pay a hefty amount. Finally, we got the title after one year." - poultry farm 20 Today's Investment Challenges Access to land with clean title is critical for private sector four times the average reported in neighboring Pakistan. development. Not only does the uncertainty in land In addition, when firms obtain a government contract tenure discourage investment but, as property rights they have to pay almost 8 percent of the contract value in cannot be easily enforced, land cannot be easily used as bribes (see Figure 3.3). AISA's investment facilitation collateral to generate the financial resources crucial to activities have helped many investors negotiate the private sector development. Until Afghanistan institutes regulatory maze without paying bribes but this function is a land policy that establishes and enforces clear property still limited in scope. Coupled with corruption is the rights, investment in the private sector will be hobbled. general inefficiency of the government in delivering services. Government agencies are only slowly developing Corruption their capacities to deliver the services businesses need. When asked to generally rate government efficiency, Corruption is endemic in Afghanistan and adds to the nearly 75 percent of the sampled firms ranked it as uncertainty facing businesspeople. It is especially somewhat to very inefficient. threatening to foreign investors or Afghans returning from overseas who do not have powerful patrons or understand Access to finance the system. In the 2005 Transparency International Corruption Index, Afghanistan ranks 117th, which places Afghanistan's financial system is just beginning to it among the world's most corrupt countries.10 Nearly 58 recover and businesses have almost no access to bank percent of the sample cited corruption as a major or severe credit and only limited access to banking services problem, which ranks corruption just behind access to generally. In the most recent Doing Business rankings land and electricity. Corruption is especially threatening to for Getting Credit, a measure of credit information foreign investors or Afghans returning from overseas who sharing and legal rights of borrowers and lenders, do not have powerful patrons or understand the system. Afghanistan ranks 153rd out of 155 countries. Firms report that on average they pay an amount in bribes Although 12 commercial banks are licensed to operate equivalent to over 8 percent of sales, which is more than in Afghanistan,11 most are concentrated in Kabul and Figure 3.3: Average Unofficial Payments Made to Get Things Done as a Percentage of Sales Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys 10 Despite Afghanistan's poor performance, it still does better than its closest neighbors, including Pakistan and Tajikistan, which tie for 144th, and Uzbekistan, which comes in at 137th. 11 Arian Bank, Habib Bank, National Bank of Pakistan, Punjab National Bank, Standard Chartered Bank, First MicroFinance Bank, Kabul Bank, Bank Mille Afghan, Pashtany Tejaraty Bank, and Afghanistan International Bank. 21 The Investment Climate in Afghanistan Box 3.3: Voices of Afghan Entrepreneurs: Getting registered and obtaining construction permits "We are a pharmaceutical company and were first registered with the Ministry of Commerce in 2002. We then had to register with the Ministry of Public Health, the Ministry of Finance, and the Trade Court in order to get a legal approval for production and marketing of our pharmaceutical products in Afghanistan. Getting registration from these ministries was a hassle and, in some cases, required the payment of bribes to officials. We refused to pay bribes. This resulted in a two-and-a-half-month delay in getting the necessary approvals from various sections in the ministries. Our company was re-registered with the AISA in April 2003. The registration process in AISA was relatively easy and transparent and no unofficial payments were required." - pharmaceutical company "We are in business since 1988. The company was registered with the Ministry of Commerce in January 2003-the whole process took two weeks. It was re-registered with AISA in September 2004. In AISA we paid 50 USD for reregistering and were also requested to show the operation work statement letter. It took us a few days to obtain it from the Ministry of Finance Taxation Office." - metallic production and carpentry company "We registered with AISA in 2003. After completing registration, we started constructing the factory building in November 2003 and completed in January 2004. We had to make some unofficial payments (about 50% of the official fees) to the Municipality to obtain the construction permits." - beverage manufacturer "We were allocated some land in an industrial park. After getting the title for the land, we hired a construction company and started constructing the factory building. After construction work had started, some officials from the Municipality came and stopped the work on the grounds that they had not obtained the necessary permits from the Ministry. We think the officials just wanted some money from us. We then contacted AISA who solved this problem and construction started after a delay of 10 days. We subsequently had problems with the construction company who turned out to be inexperienced-but that is another story." - iodine manufacturing company provide services primarily to international donors and are augmented by a wide variety of informal money businesses, foreign nongovernmental organizations lenders and other credit sources. There are no credit (NGOs), and foreign government agencies. No bureaus or credit rating agencies. commercial banks in Afghanistan offer long-term finance. The maximum tenure of financing is three Because the financial system is so underdeveloped, years. Most focus on opening commercial letters of Afghan firms are almost entirely reliant on internal credit (L/Cs). Transactions are very secure because the funds and money from friends and family to fund their importer has to deposit the total imported costs of operations. Only three firms in the ICS sample goods in the bank before opening the L/Cs or a secured reported having bank credit and on average nearly 94 contract, such as for construction or other awarded percent of new investment by firms was funded by contracts, which are financed by donor agencies. A either internal funds or money from family and friends small but ever-increasing number of nonbank financial (Table 3.3). Remittances are also important, and on institutions, including one credit union and 11 average funds from family and friends outside of microfinance institutions, provide limited services and Afghanistan financed 3 percent of investment. small amounts of credit. In addition, a new leasing organization has just become active in Kabul and other Informal sources play an important part in supporting areas. However, these institutions are nascent and able Afghan businesses. Because the banking system is so to provide only a fraction of what is needed. Thus, they new and concentrated in Kabul, many businesses rely Table 3.3: Average Percentage of New Investment Financed by Different Sources Internal Funds or Family and Friends Family and Bank Credit Other New Equity Retained Earnings in Afghanistan Friends Abroad 78 13 3 1 2.5 2.5 Source: World Bank Afghanistan Investment Climate Survey. 22 Today's Investment Challenges on informal funds transfer systems generally known as institutions to provide viable alternatives to the hawala to make payments and transfer funds. Only 30 informal sector. Low household savings, poor percent of the sample reported having a bank account. infrastructure, low integration with complementary Though the majority of business transactions are cash- markets, and high costs of service provision, based, more than 10 percent of the sample said that particularly in rural areas, make it difficult to provide domestic customers usually pay them through money formal financial services. Moreover, the lack of a exchange dealers in a process known as a hawala secured transaction law and poor property registries transfer. The hawala system is even more important for make it extremely difficult for borrowers to provide the foreign customers; almost 14 percent of exporters said necessary security. Currently, managers complain more that foreign customers usually pay them by hawala about the availability of electricity and access to land transfer. Remarkably, hawala transfers for foreign trade than they do about access to finance. But as the appear to be more than or at least as efficient as bank economy grows and these more immediate problems transfers. The length of time to clear a hawala transfer are mitigated, the inability of firms to obtain external is not significantly different from the time taken for a finance will become a crippling constraint to growth. bank draft. The hawaladars also provide short-term loans to finance working capital needs. Nearly 21 In addition to the lack of external finance, Afghan percent of firms responding in the survey reported firms are faced with the almost complete absence of having a loan from a hawaladar with an average term of insurance. Many managers and potential investors have 3.8 months (Table 3.4). cited the lack of insurance as a major reason that they are hesitating to invest. The insurance sector in Though informal financial sector credit may be Afghanistan is in dire straits. The sole insurance adequate for subsistence commercial activities, it is not company, the Afghan National Insurance Company, is adequate for long-term private sector development. At substantially undercapitalized and in a weak financial present the level of financing emanating from financial position. The Afghanistan Investment Guarantee institutions in Afghanistan is severely limited. There is Facility has been established to mitigate political risk a pressing need for bank and nonbank financial and not life and nonlife commercial risks. But until Table 3.4: Hawaladars vs. Banks % of firms with a loan from a hawaladar 21 % of firms with some form of bank credit .9 % of domestic firms that primarily pay by hawala transfer 10 % of domestic firms that primarily pay by bank transfer, check, or bank draft 11 % of exporting firms that primarily pay by hawala transfer 14 % of exporting firms that primarily pay by bank transfer, check, or bank draft 30 Average time to clear hawala transfer from domestic customer 28 days Average time to clear a bank draft from domestic customer 7.3 days Average time to clear hawala transfer from export customer 9.2 days Average time to clear a bank draft from export customer 7.2 days Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. 23 The Investment Climate in Afghanistan there is a new insurance law, it is unlikely that there will employees is exacerbated by the barriers to educating be any new providers of normal business insurance. girls and employing women in most jobs outside of the The existing insurance law is more than 40 years old home. Afghanistan is caught in a trap. The lack of (1962) and therefore requires substantial modifications opportunities discourages workers from improving their or indeed replacement by a new law in order to be skills and education. But opportunities are lacking consistent with the new commercial environment. partly because investors do not want to expand because of the lack of skilled labor. The shortage of skilled labor Currently, the financial system provides little or no access is illustrated by what happens in Jalalabad during the to financial products and services for small urban or rural poppy harvest season when much skilled labor goes to enterprises. Instead, an extensive array of informal money work in the harvest. With skilled labor able to find exchange dealers and some NGOs support urban and better pay havesting poppies, nearly 34 percent of the rural microenterprises with limited financial services. As sample said that wages rise during the season, with an the reconstruction effort progresses, there is a pressing average increase of 39 percent. need to address the burgeoning requirements of such enterprises, along with the needs of more formal In Afghanistan, only a small fraction of enterprises enterprises and those of international investors. The offer formal training and the level of worker and development of rural financial markets is currently manager education is also low. Just over 5 percent of hindered by several factors: (a) dispersed populations and Afghan firms offer training (see Figure 3.4) and only poor transport and communications facilities; (b) high about one-third of the workforce in Afghan enterprises risks associated with rain-fed agriculture; (c) absence of have a secondary education or higher (see Figure 3.5). physical collateral and land-tenure systems that minimize In comparison, in India almost 17 percent of small the value and use of land as collateral; and (d) past history firms train and on average nearly half of their of state involvement and subsidized lending, which led to workforce has a secondary education or higher. Afghan low recovery rates. These problems, some of which may managers are also less educated than in neighboring affect urban microenterprise finance, tend to be more countries. Sixty-two percent of Afghan managers have acute in rural areas. secondary or higher education compared with 96 and 98 percent in Pakistan and India, respectively. The lack Limited access to skilled labor of training and low education and experience level of the Afghan workforce is an important cause of Afghan High illiteracy, poor education, war, and political industry's low relative productivity. Until the shortage upheaval have resulted in a critical shortage of skilled of skilled labor is solved, it will be extremely difficult labor in Afghanistan. The low level of education, lack of for Afghan firms to be able to compete against imports training facilities and high illiteracy rate have always or on the export market. made for acute shortages of skilled labor. In fact, Afghanistan traditionally relied on foreign experts to Legal and regulatory framework direct the country's economic development: Germans, Americans, and Soviets had been heavily involved since In addition to insecurity, poor land tenure, and the end of World War II. However, the problem was corruption, the high level of uncertainty and risk magnified by the recent war. During the conflict many facing investors in Afghanistan comes from the of Afghanistan's best-qualified workers, those with the absence of a clear legal framework. Many of the basic best opportunities abroad, fled. Consequently, qualified laws that are necessary for the private sector to management professionals, skilled technicians, and operate in confidence are missing and government educated professionals are scarce. The lack of qualified actions are often unpredictable. The Afghan legal 24 Today's Investment Challenges Figure 3.4: Percentage of Establishments Offering Formal Training Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. Figure 3.5: Percentage of Firms Whose Managers Have a Secondary Education Level or Higher Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business environment and Enterprise Performance Surveys framework consists of three overlapping systems: In Afghanistan's uncertain business environment, Sharia (Islamic law), Shura (traditional systems of individual firms experience many benefits from having informal justice), and the formal system based on the close ties to influential commanders. Not the least of 2004 constitution (Asian Development Bank 2005, these is the ability to apply force to resolve disputes p. 23). Few managers are clear about which laws when the formal dispute resolution mechanisms do not actually apply to them and, given the arbitrary work. There is nothing but anecdotal evidence on how enforcement and lack of effective courts, they do not often force is actually used or threatened, though the spend much of time worrying about it. Only 10 amount of such evidence is substantial. However, there percent of the survey sample mentioned the legal are abundant indications that the formal dispute system as a major or severe constraint. However, resolution mechanisms do not work. establishing a strong legal framework would lower risk and encourage investors. In addition, an effective The formal court system barely functions and most legal system that enforces property rights would people rely on informal dispute resolution mechanisms. reduce the power and influence of the former The formal court system suffers from a lack of commanders, leading to new entry, increased qualified legal professionals, no method to hold judges competition, and higher growth. accountable, and reportedly endemic corruption. 25 The Investment Climate in Afghanistan There are no formal alternative dispute resolution increases risks and may serve as a barrier to entry mechanisms such as arbitration or mediation. because entrepreneurs do not know how much it will Consequently, businesses do not rely on the formal cost them if they have to close a business. Laws are also judicial system. Only three of the 338 firms surveyed needed for land titling and registration but will need to reported using the commercial courts to settle a follow ongoing policy and administrative work in this payment dispute in the past two years. For the three area. The need for a secured transaction law will become firms that did use the court system, on average it took evident in the medium run because it would allow over 34 weeks to decide the cases and then only one borrowers to use other forms of collateral besides land. firm said the court decision was effectively enforced. The survey also revealed that fewer than half the Above all, the government must be consistent and incidents of crime or theft were reported to police and predictable. For the many reasons discussed, less than 30 percent of those reported were solved. In Afghanistan has a risky investment climate that light of the failure of the formal system, it is not discourages investment. Thus, whenever possible the surprising that available data, though limited, indicate government should attempt to engender certainty and that as many as 80 percent of people rely on the Shura predictability. In some ways the government is doing system as their primary mechanism to resolve well on this score. Nearly 60 percent of the participants disputes.12 However, Shura rulings can contradict the in the survey reported that they tended to agree, agreed principles found in Sharia and the constitutional in most cases, or fully agreed with the statement that "in system and there is no measure of the system's fairness general, government officials' interpretations of or efficiency. In addition, it is usually assumed that regulations affecting my establishment are consistent powerful local leaders can heavily influence the Shura and predictable." But the government is still in a rulings. Thus, it is not possible for businesses, precarious position. The large amount of new legislation especially foreign ones, to anticipate how a dispute will and regulation that is required will inevitably introduce ultimately be resolved. uncertainty and add to the risk of doing business. Most recently, the government reversed itself on tax holidays Despite ongoing efforts at legal reform, the legislative offered to investors. Many new investors were lured to process is slow and a number of important laws have Afghanistan with the promise of a four- or seven-year been languishing, awaiting parliamentary approval, tax holiday. Now, at least some of them are being final drafting, or implementation. The private sector informed that not only are they going to lose the tax needs a new private investment law. The original version holiday, but also they must pay tax retroactively for past of the law, enacted in 2002, which sets out the years. The government states that the phaseout of the requirements for investment, is deficient and despite tax holiday is not retroactive and that only firms that more than two years of effort the revised version is yet did not complete the formalities to receive the tax to be enacted. A business organization law has been holidays in a timely manner or were promised them by drafted but progress toward approval has been slow. unauthorized persons are losing them. But many firms This, and an insurance law, is an important priority. did not understand what the process was or who was Afghanistan has no bankruptcy law and the country authorized to grant them a holiday. The firms' ranks 142nd in the Doing Business indicators for perception is that they followed proper procedures and closing a business. Lack of legislation in this area are now losing what was promised. This experience 12 United Nations System. Common Country Assessment for the Transitional Islamic Sate of Afghanistan, October 2004, p. 26 as quoted in the Private Sector Assessment for Afghanistan, Asian Development Bank, 2005. 26 Today's Investment Challenges illustrates the uncertainty created by inadequate tariffs from a maximum of 150 percent to a range of information about policy and specific procedures to be 2.5 to 16 percent. In addition, the Ministry of Finance followed, on top of the already substantial risk and with the Ministry of Commerce is implementing a uncertainty of doing business in Afghanistan. Customs Modernization Program designed to clarify roles and responsibilities among government agencies Trade policy and improve service by building capacity in the customs service. However, there is still much to do. In The government has made trade a cornerstone of its Doing Business 2005, Afghanistan ranks 128th in development strategy and the Ministry of Commerce cross- border trading, and importing requires 10 has made WTO accession within the next five years a documents and 57 separate signatures. Businesses key goal. Ultimately it envisions Afghanistan becoming report that customs officials continue to use wide a land bridge between the rest of Central Asia and discretion on the valuation and inspection procedures, South Asia. In addition, the vast majority of Afghan which leads to corruption and delays. The ICS found industrial inputs are imported. Improving the that customs procedures in Afghanistan are efficiency of trade is necessary to reduce the cost of significantly slower than among its neighbors, which domestic production and increase the competitiveness further erodes the competitiveness of Afghan products. of exports. On average it took firms nearly 10 days to clear exports last year and about 11 days to clear imports (see Figure Afghanistan has taken a number of steps to facilitate 3.6). Shipping agents report that this time could be trade. It has entered into trade and transport lowered to a few hours if they are willing to pay a large agreements with various neighboring countries and has enough bribe. negotiated trade preferences internationally. In 2004 the government passed a customs reform package that Despite the customs modernization, manufacturing firms makes Afghanistan one of the most open economies in report that the customs regime discriminates against them the region. Among other reforms, the new law and adds to the burden of trying to set up a new simplified the tariff structure and reduced the range of production facility in the country. As is the case in many Figure 3.6: Average Number of Days for Goods to Clear Customs Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. 27 The Investment Climate in Afghanistan developing countries, the managers of manufacturing Illegal checkpoints established by local commanders and enterprises argue that because they are so big and militias are no longer a major constraint, but prominent they cannot avoid paying required taxes and inspections by government officials remain a hassle. The duties, must carefully follow regulations, and are often new government has made remarkable progress in the targets of bribe-seeking officials. However, they must eliminating illegal checkpoints and few exporters cited compete with small traders who are able to bring goods them as a problem in the survey (Table 3.5). However, into the country without paying the required duty and traders report that they face frequent inspections and also do not pay business taxes or a large amount of fees levied by different government agencies and local informal payments. The very large companies, authorities. In many cases the local police are in fact particularly foreign companies, are able to negotiate tax former fighters associated with commanders who are incentives. But the average small Afghan company is too now in government. The responsibility for inspecting big to hide and too small to fight, so it bears the burden shipments beyond the border is not delineated among of the government taxes and regulations. different agencies, causing shippers extra delays and costs. The government, led by the Ministry of Manufacturers also argue that the tariff structure is Commerce, is attempting to resolve some of these such that they often pay more duty on imported inputs issues, but currently businesses report multiple than traders do on imports of the finished goods. One inspections and delays as a serious issue that raises costs. entrepreneur attempting to establish a pharmacy company believes that a combination of high transport The lack of trade facilitation services is another costs, import duties, and illegal payments add 25 to 30 important constraint facing Afghan businesses. In the percent to the cost of imported machinery. He reported ICS, a group of exporters and potential exporters paying a 5 percent tariff on imported inputs, but identified the lack of trade finance, lack of cold storage traders can import the final product and pay only 2 and other storage infrastructure, and the inefficient percent because it is a medicine. In this situation it will customs and clearance procedures as the biggest be very hard for the Afghan entrepreneur to break in impediments to increasing exports. They did not cite and firmly establish himself in the market. The the high cost of production in Afghanistan or the lack customs modernization has been a significant step of knowledge about foreign markets as issues, but forward, but work remains to be done on the actual focused on trade services. Trade credit is rare and implementation if it is to encourage local production. expensive, forcing most producers to rely on Box 3.4: Voices of Afghan Entrepreneurs: Importing machinery "We bought the machinery from China and transported them to Kabul by land transport. We used a clearing forwarding agent to transport and clear the machinery. We did not have to deal with the custom authority directly, and therefore, did not directly handle any financial transactions. We paid a total amount of US$13,000 for transportation and customs, which is over 8 percent of the total cost of machinery. Almost all the machinery is at the site and two Chinese engineers are expected to come and install the machinery. We faced a number of problems during transportation and tax clearing. The vehicles were not good, the road condition was bad, and the transportation cost is high. The machines remained in tax clearance office for 25 days. There were no rules or regulations in tax office, and it was not easy to find the person whom we needed to contact. The Tax Office does not have a fixed rate on taxation and it took them time to determine the value of the machinery." - beverage company "Transportation of machinery to Afghanistan and custom clearance are major problems and barrier for investment in Afghanistan. We bought the machinery from Dubai, China, and Iran. Machinery was transported by land and air freight. Due to the lack of a good road system and corruption, unofficial payments were made at every transportation point. Since the taxation system is not standard and the amount of tax on imported good is fixed based on the discretion of the tax officers, the importers of goods are at the mercy of the tax officials. This arbitrary taxation system discourages domestic investment and encourages import of consumer goods, including medicines." - pharmaceuticals company 28 Today's Investment Challenges Table 3.5: Constraints to Exporting % of Firms Reporting Constraint as Major or Severe Problem Lack of trade finance 42 Lack of roads, air connection, railroads, and other infrastructure 39 Lack of cold storage, warehouses, and other storage infrastructure 37 Inefficient or corrupt customs clearance procedures 37 Cost of transport 37 Lack of shipping insurance 32 Tariffs and other barriers imposed by other countries 32 Illegal checkpoints 27 High cost of production in Afghanistan 21 Lack of knowledge about foreign markets 16 Low quality of product 5 Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. middlemen who have connections and strong finances. body to test the quality of goods in Afghanistan. There are few, if any, cold storage facilities or other Though badly needed, as of summer 2005 it was not facilities needed to transport high value-added yet functioning. products. In addition, no independent agencies assure standards or certify quality. Many industries are The high cost of shipping and the lack of insurance is required to seek certification of exports from another impediment to trade in Afghanistan. Some 38 government agencies. However, these certifications are percent of the surveyed exporters identified the cost of usually worthless and serve only as an opportunity for transport as either a major or very severe obstacle, the rent seeking. For example, raisin exporters are required same proportion of exporters who identified inefficient to seek certification from provincial departments of the or corrupt customs clearance procedures as a major or Ministry of Agriculture and Animal Husbandry. very severe obstacle. The fact that Afghan shippers However, laboratory testing is rare or nonexistent (see often have to transship goods into the carriers of Box 3.5 on charges levied on raisin shipment).13 The neighboring countries raises costs and means that they Ministry of Commerce is forming an Afghan often lose all control of goods once they cross the metrology, standards, testing, and quality (MSTQ) border. In the survey, shippers reported that on average 13 See the following studies: Understanding Markets in Afghanistan: A Case Study of Carpets and the Andkhoy Carpet Market; Understanding Markets in Afghanistan: A Case Study of Market in Construction Materials; and Understanding Markets in Afghanistan: A Case Study of the Raisin Market. These three studies, which were sponsored by the World Bank and conducted by the Afghan Research and Evaluation Unit, provide in-depth information on the costs and procedures of exporting as well as the use of trade facilities by traders in each industry. In addition there have been a number of other studies by On the Frontier and other NGOs identifying the lack of trade facilitation services as a significant constraint to exports. 29 The Investment Climate in Afghanistan Box 3.5: Typical charges levied on a trader's shipment of raisins from Mazar through Hairaton The Afghan Side Government' s charges: · Trading license to be renewed annually at a cost of Af 3,500. A new, simplified and more transparent process for this was introduced in April 2004. · Phytosanitary certificate from the Ministry of Agriculture and Animal Husbandry in duplicate or triplicate--Af 40­60. · Certificate from Raisin Export Institute--50 Afs/ton · Export tax--temporarily removed by presidential decree on September 24, 2002, but a 0.5 percent tax has been temporarily reimposed on all export and import operations and must be paid to Ministry of Finance (MoF) bank account in Mazar. Some exporters firmly assert that they are still paying a 2.5 percent export tax. · Export license fee of 0.018 percent payable to MoF · Income tax of 20 percent on trading profits payable to MoF · Sales tax of 2.5 percent payable to MoF · Additional "local government" taxes and payments at checkpoints · Other additional taxes; for example, in the north a "security tax" of 0.5 percent of the market price of the raisin is levied. This tax is supposed to be refundable, but is never actually refunded. In addition, total bribes and port handling fees payable on export are estimated at US$8/ton. The Uzbek Side Traders assert that if the trade is legal and all the relevant documents are in order, then there is no import duty. If documentation is not in order, then a 20 percent charge is levied by the Uzbek government. Bribes on this side are about US$4/ton. they lose up to 5 percent of international shipments as existing one. Whatever the reason, it is clear that a result of spoilage and loss (Table 3.6). transport is expensive and risky in Afghanistan. However, this average may understate the problem as Conclusion: The dominance of informal many firms reported losing nothing as a result of delays arrangements-aa vicious circle? and spoilage, which is unusual for most products. For those who reported at least some loss, the average was 17 The analysis in this chapter suggests that much of percent, with some firms reporting as high as 30 to 50 private sector activity in Afghanistan, even by percent. Shippers say that some insurance is available, significant business concerns, is carried out in an but apparently few can access it. More than 80 percent environment dominated by informal arrangements and of the surveyed firms that experienced losses were not practices. There is a spectrum of such arrangements. At compensated. The main reasons given were the lack of a one end are enterprises that are formally registered, tax- carrier liability regime or the lack of enforcement of the paying, and engaged in legal activities but often using Table 3.6: Cargo Loss Arising from Shipping Internationally (% of shipment) Afghanistan Pakistan Uzbekistan India China Tajikistan Syria 4.6 NA 0.1 N/A 1.2 0.7 2.4 Source: World Bank Investment Climate Surveys and World Bank/European Bank for Reconstruction and Development Business Environment and Enterprise Performance Surveys. N/A = not available. 30 Today's Investment Challenges informal channels for protection and access to security and access to markets and reduce resources. At the other end are enterprises engaged in uncertainty. Some observers believe that informal illicit activities (production and/or distribution) with markets and informal patterns of trading may have even greater reliance on unofficial contacts to carry out now become quite strong and operate according to business. In between are informal (i.e., nonregistered) well-established patterns. The dynamics of enterprises carrying out legal activities within a nexus informality are complex. Informality is driven by the of informal arrangements. comparison of the risks and benefits of being in the formal and informal sectors. It is possible that some A subset of these informal arrangements and firms frequently shift between the formal and practices is similar to those found in patronage- informal sectors depending on business needs. based organized criminal networks (generally referred to as mafia-type networks), but it is These informal arrangements may be useful for many difficult to say how large this subset is in investors in the short run but have negative effects for Afghanistan. However, it can perhaps be safely said overall growth. As argued above, they stop many that much of private sector activity in Afghanistan, participants from entering the market, lead to whether legal or not, is carried out in an informal inequitable distribution of the benefits, and may have a setting with numerous informal (extralegal) negative effect on political governance and state- influences on their activities. According to a recent building (Lister and Pain, 2004). The informal study on markets in Afghanistan, "...many aspects economy is relatively free from official regulations of market performance depend on extra-market because of poor enforcement but is nonetheless conditions, including history and non-market subjected to informal regulations that restrict entry and institutions, which combine to exclude many from competition, even among incumbents (see Box 3.6).14 taking part and enjoying the benefits of It is reported that many returning Afghans who have participation. These aspects include social and good ideas and capital to invest are reluctant to risk economic structures, gender relations, ethnic their capital for fear that they will be crowded out by identities and spatial patterns of production" (Lister those with connections. and Pain, 2004). In brief, though existing firms in the nonformal Such networks are the legacy of the conflict in at least economy may be growing there is little new entry and two ways. First, at one stage in the conflict when low rates of investment. The informal mechanisms that other funding sources dried up, warlords sought allow firms to cope with the high levels of uncertainty economic opportunities to raise money. Second, are not conducive to long-term growth and equity. A though business is inherently risky and uncertain, in vicious circle may be at work here. The Afghanistan Afghanistan the destruction of formal institutions Research and Evaluation Unit study referred to earlier have dramatically increased risk and uncertainty for suggested that "Businessmen receive security, tax the private sector. To cope, enterprises have exemption, credit and in some sectors (such as developed a wide range of informal mechanisms, construction), access to lucrative contracts. For power including close association with powerful political holders, the linkages provide a means of investment leaders and militia commanders, to ensure their and the potential for money laundering. The accrual 14 However, as the Afghanistan Research and Evaluation Unit studies indicate, the absence, or lax enforcement, of regulations may be having an adverse environmental and health impact, such as natural resource depletion resulting from unregulated logging, vulnerability to earthquakes resulting from lack of building regulations, and poor working conditions in carpet production. 31 The Investment Climate in Afghanistan Box 3.6: Barriers to entry Incumbents in business in Afghanistan may exclude competition and position themselves to be the major beneficiaries of growth through a variety of mechanisms and processes: (a) price manipulation through various means; (b) possession of capital (when credit is unavailable to others); (c) political influence; and (d) quite high levels of vertical integration at the "top" of the chain (that is, their companies own other companies or service providers with which they do business). Big and medium-sized traders deal in multiple commodities and hence, within a given region, the actors in the middle of commodity chains (i.e., not primary producers or retailers) tend to be the same. This form of commodity chain contributes to the dominance of a limited number of traders. It also reflects the lack of formal financial systems and issues of seasonality and risk. Even if traders have not themselves been involved in the illicit economy, they require good relationships with those who are involved because this latter group controls the supply routes and transport systems. The social networks provide information, regular trade flows, trade credit, and risk sharing. The business-politician relationships are mutually beneficial; for businesspeople they provide security, tax exemption, and credit and, in some sectors such as construction, lucrative contracts. For power holders, they provide a means of investment, the potential for money laundering, and an overall strengthening of influence by the linking of military, economic, and political power. Power holders also often control the "inputs" to production processes such as water and land. Source: Lister and Pain 2004 of benefits from these markets provides them with the efforts at state-building and improving political resources to strengthen their military and political governance, which in turn may reinforce these power still further."15 Thus, some aspects of the informal practices. What is the way out? That is the current functioning of markets may compromise subject of the next chapter. 15 See World Bank (2004), for an exposition of the vicious circle story in general for Afghanistan. 32 4 Accelerating Private Investment: What needs to be done Introduction defined. There is a need for an overall political and security strategy that limits the power of those who have gained D espite adverse conditions, the entrepreneurial control of the markets through force of arms and illicit spirit is alive in Afghanistan, investment activities.16 This chapter focuses on actions that fall within opportunities are being exploited, and jobs are the domain of PSD but that may address the paradigm of being created. However, performance levels are still modest informality and provide entry points to break the vicious compared with the range of emerging opportunities. Much circle described in chapter III by weakening the nexus of more needs to happen in the enterprise sector if it is to informal relationships and extending the writ of formal fulfill expectations and make a substantial contribution to arrangements. Some of these interventions, such as job creation and improvement in the dismal human regulatory streamlining and improving the flow of development indicators of Afghanistan. The challenges information on PSD issues, will also support the highlighted in chapter III-that the private sector is often anticorruption agenda. Four sets of actions are oligopolistic, works through social and political networks, recommended. Together, these will increase incentives to and is anticompetitive-need to be addressed. The key invest (by reducing uncertainty and transactions costs) and challenge is to broaden participation in the market by improve capacity to carry out productive activities (by removing barriers to new entry and creating conditions that improving access to inputs, business services, and markets). will encourage those already in the market to invest more. There are many complementarities between these actions and some may affect both incentives and capacities. The present investment climate challenges are not insurmountable. Many factors stand Afghanistan in Improve access to inputs. Firms need factors of good stead. A significant international effort to production, notably finance, land, skilled labor, and reconstruct Afghanistan is currently underway and physical utilities and infrastructure including power, increased rainfall from 2001 to 2003 has helped to water, telecoms, roads, and ports. Improved access alleviate the once dire agricultural situation. But most to such inputs is important to weaken the hold of important, Afghanistan has a long entrepreneurial informal arrangements that draw their strength to a tradition of SME industries and services on which an large extent from control over such resources. active market-oriented private sector can be built. Improved access will require an expansion in the supply of inputs and also a more transparent process Some of the actions required are outside the scope of any of allocating them. Freeing up land currently locked private sector development (PSD) agenda as conventionally up in nonviable SOEs, injecting money into the 16 Some interventions, such as those that help spread educational opportunities or help in the creation and accumulation of assets by poor people, indirectly promote security and a good political environment, albeit in the longer run. The Investment Climate in Afghanistan banking system, and expanding the power- public contracts transparent and competitive, generating capacity are all examples of actions that building an effective MSTQ system, and regulating increase the supply of inputs (land, finance, power). utility standards and credit bureaus. It is also Though these actions will help, they may not important to develop private sector collective substantially increase market participation and may bodies, such as chambers and trade organizations, largely benefit the well-connected incumbents if and mechanisms for effective public-private sector the allocation process is nontransparent and is dialogue to gather feedback and disseminate subordinate to the informal arrangements knowledge about government policies. described earlier. Improve the provision of business services. Clarify and strengthen property rights by creating a Enterprises need a variety of business services to sound legal, judicial, and regulatory framework for help them enter (e.g., help with preparing business investment. This framework is needed both for plans and negotiating with creditors), operate and tangible property, such as land and equipment, and grow (e.g., trucking, freight forwarding, for intangible property, such as a license to operate accounting, market information, quality assurance or a permit to import raw materials. Strengthing services, management services, and legal assistance), property rights will require developing a sound legal and manage risk (e.g., insurance).These services are framework and an effective judicial system that best provided by the private sector but the enforces decisions and helps resolve disputes so that government needs to put in place a policy and recourse to informal means of dispute resolution is regulatory framework to facilitate private entry. reduced.17 It is also important to make the There may also be scope for public-private regulatory system predictable, transparent, and partnerships to jump-start markets for services for simple in order to reduce the need to fall back on which currently there are very few or no providers. informal contacts to navigate the regulatory maze.18 Underlying all the above efforts is the need to improve Improve the flow of information. Informal government capacity to analyze private sector issues arrangements thrive when information flows are and formulate and implement private sector weak. When market players lack information-about development policies and programs. The overall market opportunities and trends, quality of economic policy of government, such as trade and tax products, availability of resources, and government policy, will also be relevant because it influences the policies and regulations-they become dependent on broad incentive structure for private sector players. informal contacts and patrons both for information and because they do not know where else to go. Figure 4.1 describes in schematic form these broad Lack of information about government policies also categories of actions. The rest of the chapter provides increases uncertainty. Actions in this area will need detailed recommendations. For ease of exposition, these are to focus on increasing awareness of government organized in a different thematic format, but they will help policies, laws, and regulations, making the award of further one or more of the objectives mentioned above. 17The latter is particularly important in the current context where investors often fall back on the informal connections and relationships to help settle disputes. 18The case studies reported in chapter III provide examples of permits being granted for limited periods and investors needing to go back to the authorities, including ministers, to get fresh permits. Reducing the need to interface with government officials is one way of weakening the hold of informal relationships because such relationships are often needed by businesspeople to intermediate with government officials. 34 Accelerating Private Investment: What needs to be done 35 The Investment Climate in Afghanistan Legal framework for PSD is archaic. A modern law that would help free business organizations from current constraints Currently, the legal framework for PSD in Afghanistan is and encourage the use of the corporate entity characterized by gaps as well as lack of clarity. Progress in has been drafted, reviewed by the private improving the legal environment for private investment sector, and translated into Dari, the principal has been limited since the fall of the Taliban. A Law on local language. Domestic and Foreign Investment was gazetted in 2002. This law was followed by the enactment of the Central Insurance. Current donor programs address Bank and Commercial Banking laws in September 2003, political risk, but general liability, product paving the way for the issuance of prudential regulations liability, auto, fire, and other insurance are not in the months that followed. The legal agenda is broad available because of the lack of legal mechanisms and will take a number of years to be implemented. At to protect companies that want to provide such this point, a number of laws are in draft stage and the products. A new law is required to liberalize the priority areas are the revisions to the Law on Domestic sector and establish a new regulatory framework and Foreign Investment and the enactment of a Business to supervise private insurance companies. Organization Law, an insurance law, and a financial leasing law. Progress has also been made in introducing Financial Leasing. This alternative to collateral legislation indirectly related to the private sector (e.g., the financing has begun to fill in for the lack of any Procurement Law). history of nonpossessory liens in Afghanistan. A legal framework for financial leasing is a higher The Ministry of Commerce has tried to push PSD- priority than is secured lending law. Work on related legislation but has been handicapped by lack of financial leasing has begun but needs to be capacity and technical understanding. The Ministry is speeded up. now developing a program to help convert policy intentions into the relevant legal and regulatory Medium-tterm priorities framework. The program will include advocating Secured Transactions Law. Until the land legislative change in areas that do not fall within its tenure and registration system is improved, it domain. This overall program should be viewed as high will remain difficult to use land as collateral. priority. It will also be important to focus on building A secured transaction law would enable understanding and knowledge of the purpose, content, enterprises to use a wider range of assets to and implications of new legislation among the wider secure loans. In many transition countries community of private sector development stakeholders, such as Albania and Romania, the including the new elected parliament members. introduction of secured transaction laws in Specific legislative priorities are mentioned below. conjunction with other reforms has increased firm-level access to credit. Short-tterm priorities The Law on Domestic and Foreign Investment. Bankruptcy Law. The proposed Business The current law has a number of deficiencies Organization Law contains liquidation and a revised version has been drafted, but provisions that provide for an orderly winding up enactment has been held up for several months. of enterprises. However, a bankruptcy law will become important as the banking sector matures Law of Business Organization. The current law and starts demanding that its secured lending be governing the formation of private companies accorded priority in the event of insolvency. 36 Accelerating Private Investment: What needs to be done Access to land in chapter III. By focusing infrastructure on a specific area, government will be able to service investor needs The ICS revealed access to land as one of the most quickly, instead of forcing investors to wait for a important, if not the most critical, constraints facing general municipal infrastructure program that may or the private sector. The government needs to establish a may not address their facility requirements. The clear legal framework that regularizes property rights. government created an Industrial Parks Authority as a An enduring solution must consider and address how department within AISA and initiated work on an land had been acquired over the various periods of industrial park development program. Three industrial political upheaval. Policymakers should undergo a parks are currently being built, with plans for more. thorough analysis of the public sector institutions involved in the land ownership and registration process An effective industrial park development program will and eliminate redundancies and inconsistencies among require an appropriate policy and institutional the various institutions (both formal and informal). framework. In particular, an independent, The government also needs to plan adequately for commercially oriented agency is needed to develop and future land development.19 maintain industrial parks with progressively greater involvement of the private sector. Land ownership. Reducing the regulatory and bureaucratic complexity of the property Clarify institutional responsibilities in ownership process is a key element to promoting government. In May 2004, the government effective property rights. Land-related legal relocated the industrial park planning department reforms are complex and will be ineffective, or from the then-Ministry of Light Industry to the even counterproductive, if adequate work is not Ministry of Commerce. However, this decision done in rebuilding the administration of deeds, has been recently reversed. Planning for future and working out satisfactory dispute resolution parks will reside in the Ministry of Mining and mechanisms and a transparent means for Light Industry (successor to the Ministry of Light enforcing judicial decisions. Industry). The Ministry is not equipped to implement an effective industrial parks program Land registration. Though land registration and giving responsibility to a ministry, rather than pilot projects have been proposed, their scale an independent, commercially oriented agency, is will need to be substantially increased to address inconsistent with global good practice. This urgent national needs. A significant responsibility should be given either to a separate commitment on the government's part will be Industrial Parks Development Authority or to required, which is critical for improving the AISA with a dedicated industrial parks investment climate in the country. department, as is currently the case. The agency should be given adequate authority and legal basis, While work continues on establishing a functioning and be adequately staffed with the right expertise. land tenure system, the establishment of industrial The role of other government agencies, such as the parks will loosen the land and infrastructure Ministry of Housing and Urban Development constraints faced by private investors. Industrial parks and the municipalities in this area, needs to will also serve to reduce security-related costs discussed be clarified. 19 The last land development plan for Afghan cities was prepared in 1978. 37 The Investment Climate in Afghanistan Enhance the role of the private sector. The private institutions. Along with building new infrastructure, it sector can get involved early on in the is also important to develop systems for operation and management of the industrial parks. There is also maintenance. With public resources limited, scope for early private sector involvement in the opportunities for private provision of infrastructural development of some parks; in any case, the services need to be exploited. medium-to-long-term goal should be to have most, if not all, industrial parks developed and Afghanistan inherited a highly centralized model of maintained by the private sector. In brief, public government service delivery in the infrastructure sector investment should be used to enable private and with the exception of mobile telephony, which the investment, not to supplant it. Focusing public private sector has entered in a big way, the main utility funds on off-site infrastructure provision for providers are likely to remain in the public sector for industrial parks conserves scarce infrastructure the foreseeable future. However, they may increasingly resources and allows proactive urban planning. be run on commercial principles based on The public sector should decouple the accountability for performance, cost recovery, and promotion and regulation functions of industrial sustainable operations. There is considerable scope for estates, to avoid conflicts of interest and risk corporatizing state-owned firms and private sector failure on both fronts. provision of infrastructure. Operate the industrial parks on commercial Improving public sector provision of infrastructure principles. Parks developed in the public sector Power Sector Development: Government needs now should be run on commercial lines so that to further clarify its vision of the power sector, they can be privatized in future. In light of the including its strategy regarding tariffs, scarcity of land and difficulty of obtaining clean investments, and private sector participation. titled land, the case for providing serviced land There is an urgent need to corporatize DABM; at highly subsidized rates is weak.20 Charging strengthen its managerial, technical, and prices at, or close to, market rates will not only financial capacity; and restructure it in the form help meet the land and construction costs, but of regional business units. This needs to be may also generate surplus to pay for future accompanied by a new board of directors and industrial parks development activities. commercially oriented managers, building Currently, the pricing does not correspond with capacity, a more businesslike corporate culture, the costs of developing the parks. better commercial cash management and pricing practices, and improved billing and Infrastructure collection, including through computerization. In the medium term, the government should Poor infrastructure is one of the two leading constraints embark on a relatively ambitious power tariff reported by the Afghan private sector, with access to land reform program as the quality of power supply is being the other. Establishing efficient infrastructure improved and the network is expanded and services after years of conflict requires not only massive develop a rural energy strategy to bring investment but also reforms in policies, regulations, and electricity to rural areas. 20 For the Bagrami industrial park being constructed near Kabul, the demand for industrial plots was oversubscribed by more than 200 percent. Excess demand is an indication that land prices were fixed at substantially below-market rates. 38 Accelerating Private Investment: What needs to be done Transport: The foremost challenge in the transport particularly true in the power sector, where large parts of sector is to rehabilitate the primary road network the country will not have access to the grid for many more and key airports to accommodate increasing traffic years to come. The private sector should be encouraged to volume and promote trade. Inadequate transport provide services, particularly where public services are facilities are a major impediment to exports and absent. Small local providers of power would be more increase the costs of all products. Improvements in efficient than each enterprise having its own generator. the transport system have been the top priority for This is already happening in a small way. Nearly 5 percent the government during the past three and a half of the ICS sample sells excess power from their generators. years. The Ministry of Public Works, which is To expand private provision of infrastructure services an responsible for the national highway system, needs internal World Bank paper argues that the government to build technical and managerial capacity in order should undertake a number of actions: to oversee and coordinate the major donor-funded road investment program underway, and to Removing policy barriers to private sector entry. prepare and evaluate bankable major road projects The government should clearly articulate, for all for future investments. The financing of recurrent sectors, its position on the role of the private sector costs of the road sector is far from adequate, and in delivering infrastructure services. Where the funding mechanisms for cost recovery need to government is committed to encourage private be developed. entry, it is necessary to identify specific policy barriers that may impede private entry in practice Telecommunications: A priority in the despite overall government commitment. The telecommunication sector is to further improve the government's reluctance to give up its interests in regulatory framework in the sector to open it to public transport is a good example of where the greater competition and strengthen the regulator, public provision of services could potentially the Telecommunications Regulatory Board (TRB, damage the growth of the private sector through to be renamed the Telecommunications unfair competition. Specific examples of actions Regulatory Authority of Afghanistan after the that can be taken in the power sector include (a) Telecommunications Law is passed). Substantial amending legislation and regulations largely assistance will be required to further developTRB's dating from the period of Soviet occupation that capacity to develop policies and implement them. for obvious reasons do not envision private sector Furthermore, the newly corporatized Afghan Tel participation in the economy; (b) allowing captive needs to be strengthened. The Ministry of generation under all circumstances in which Communications has drafted two new laws, a business activities are allowed; (c) allowing telecommunications law and a separate law business-to-business sales of surplus production covering the corporatization of Afghan Tel. These from captive generation; (d) explicitly allowing laws need to be enacted and gazetted. private generation and distribution to commercial and industrial consumers; and (e) adopting and Encouraging private entry into infrastructure proclaiming a policy of light-handed regulation The public sector will be unable to provide all the for such circumstances-including for rural and infrastructural needs of the private sector. This is peri-urban electrification.21 21 One approach could be to totally deregulate projects below a certain size (e.g., all hydro at 10MW or less). Above this threshold, regulatory requirements should be minimal and benchmarks established (e.g., issuance of license to generate within 10 days). 39 The Investment Climate in Afghanistan Regulation of standards. The government of local private firms, especially in dealing with should provide clear standards for the provision contracting procedures, is a particularly important of infrastructure. For example, water quality and issue in the road construction sector but also of performance standards are very important if relevance to other sectors such as water and private sector provision of water is to be sanitation. A concerted and coordinated effort by adopted. However, it is important to ensure that the government and donors to create regulations are enforced in a hassle-free manner. opportunities for Afghan contractors will help. This effort would include, for example, (a) an Regulation of tariffs. In the power sector, for agreed-upon, common set of principles for example, a key risk to private sector, particularly encouraging Afghan companies; (b) ensuring the in the distribution business, is the risk that the donor procedures for these contracts are at least government will not allow tariffs to rise to a level consistent with each other; (c) common standards that covers costs. The experience in Afghanistan for quality supervision and slower supervisions of suggests that people are willing to pay higher works; (d) common short-lists, and sharing of tariffs for a reliable electricity supply. Tariffs information on prequalification of companies and should therefore be raised to a cost-reflective references; (e) a common approach to the level as soon as possible. Similarly, if the private provision of direct technical assistance to sector is to be involved in the operation of the construction companies; and (f) ensuring that public sector water systems, charges must be small-scale tender documents are written in the collected to cover the operations and local language, where possible. maintenance costs, which means that tariffs will have to rise and bills collected. Access to finance Risk mitigation. A number of risks are inherent Despite recent advances in the financial sector system, in private investment in infrastructure and Afghan firms have almost no access to external sources utilities, more in some activities than others.22 of credit from formal sources. Expanding formal credit This would require risk mitigation arrangements faces many challenges, some of which are as follows: (i) such as political risk insurance and financing the legal and regulatory environment remains weak mechanisms to reduce the risk of nonpayment beyond the banking sector, (ii) DAB still remains of revenues.23 Operators may require political behind basic standards of modern central banking, (iii) support for revenue collection, including little progress has been made with regard to the three disconnection as well as some form of protection publicly owned commercial banks that have been against foreign exchange risk. relicensed (These banks have rural bank branches that could be used to deliver formal credit to rural Aligning contracting procedures with private communities.), and (iv) the financial system needs to sector capacity. As mentioned above, poor capacity be expanded to the rural economy. 22For example, private investment in electricity infrastructure may be discouraged by the following risks: (a) investments generally have long payback periods; (b) the majority of the investments are in fixed assets, which are difficult or impossible to move and often have low resale value; and (c) revenues are often paid by government or government-owned parastatals. 23An alternative approach is to encourage small-scale projects that may have higher rates of return and shorter payback periods. Generation projects may also be more attractive to private investors if they also own the distribution network and collect revenues, which allow investors to limit the political risk of nonpayment. 40 Accelerating Private Investment: What needs to be done In considering the feasible options for providing intermediaries to expand credit. Examples include the immediate and long-term finance to entrepreneurs, the following: following working principles are especially important for Afghanistan: Dealer credit: In the short term, dealer credit to entrepreneurs may work best for short-term That no single solution is capable of addressing credit, primarily to finance primary inputs for the present and future finance needs. All options- basic farming or manufacturing. Dealer credit commercial banks, input dealers, microfinance programs often require the active participation institutions, leasing companies, informal lenders, of formal financial institutions lending to cooperatives, and state banks-are complementary importers and other formal dealers who would rather than exclusive choices. lend to retailers and then to farmers or other nonfarm producers. Lending could be on terms That both the short- and long-term options that recognize the lack of collateral at the firm must be developed as part of an overall strategy level. The government could play a role in to strengthen the financial system, including (1) bringing together the commercial banks and the improving the legal regulatory and enforcement input dealers to work out a system of larger environment for lending and (2) maintaining a credit flows to entrepreneurs. Aggressive dealer level playing field in the financial sector and financial management training would be supporting a competitive environment. required to pursue this option. To start with, the dealers would likely focus on medium- to large- That private-sector-led reforms work best. scale entrepreneurs; smaller firms would Subsidies for specialized banks distort the probably have to rely on microfinance. market interest rates. Lessons learned around the globe indicate the restructuring of agricultural Microfinance: Microfinance is desirable in the development banks to be costly, unsustainable, context of rapid entrepreneurial growth among and largely unsuccessful. small-scale enterprises that lack collateral. To scale-up current microfinance finance operations, In applying the principles stated above, it is microfinance institutions (MFIs) require further recommended that the government focus on three technical assistance to strengthen their operations principal objectives: (1) improving the institutional (e.g., management information systems, new mechanism for delivering credit, (2) improving access product development, business planning, to financial services for SMEs and rural communities, financial analysis, internal control). MFIs will also and (3) broadening and deepening the financial sector. need to develop strategies to reduce their dependency on donor funds, such as developing Improving the institutional mechanisms for partnerships with larger financial institutions to delivering credit fund the growth of their microfinance portfolio. Institutionally, the following short-, medium-, and MFIs will also need to develop innovative longer-term interventions are recommended. strategies to address the needs of the rural sector (such as agricultural lending and offering In the short term, it is recommended that the financial services in low population density areas). government focus on initiatives that help increase access to finance, in particular creating the policy, legal, and Strategic partnerships: Commercial banks regulatory framework that encourages private financial initially do not want to provide resources 41 The Investment Climate in Afghanistan directly to small- and medium-scale enterprises, infrastructure and the regulatory environment especially those in rural areas. But the work to along with enduring political support. The encourage enterprise lending by banks needs to decision to privatize a bank should therefore be start now. Strategic alliances between banks and part of a broader policy plan to privatize the nonbank financial institutions, such as MFIs, financial sector and should be implemented in a with closer links with firms are worthy options systematic and sequenced manner. to explore. The private commercial banks have the resources, skills, and capacity to finance Credit Bureau: Another medium-term goal long-term agricultural development. would be to create a private sector credit bureau. The lack of information on borrowers and the In the medium to long term, it is recommended that difficulty in enforcing agreements are the main efforts be made to increase the capacity of formal impediments to increasing credit from formal financial institutions with sizeable branch networks to institutions. Experience in a number of provide credit. Options include: countries has shown that credit bureaus that provide information on the credit worthiness of Integration with traditional systems: Traditional borrowers help increase the availability of bank credit providers, such as hawalas, with their credit. In some countries, efforts to establish extensive informal networks can play a role in credit bureaus have been thwarted by banks and Afghanistan. Unfortunately, at present other lenders who see such information as integration of the traditional credit providers proprietary and a source of their competitive into formal national and global financial advantage. Establishing a credit bureau in markets is modest. More effort is required to Afghanistan now, when banks welcome it, gain full value of the wealth of information that would increase available credit and eliminate the these traditional systems hold; and also, more chance that established interests would prevent competition is required to ensure that interest its establishment in the future. rates are appropriate for agricultural purposes. Improving access to financial services for SMEs and Rehabilitation of State-owned banks: A for rural communities promising medium-to-long-term option is to The old model of directed lending to SMEs and to rural restructure Bank Mille and Pashtany Tejaraty communities through publicly owned and managed Bank. With strong political will, support from development-finance institutions or specialized banks DAB, and an independent management has become redundant and outdated. Universal company, a new, modern financial institution experience shows that a strong, market-based, could be created out of these two banks. In the competitive financial system comprising banks as well longer term, this bank should be put into private as capital markets serves these needs in a much more hands and a timetable for privatization should efficient and cost-effective manner.24 At the same time, be part of the plan. Experience has shown that market failure, particularly in postconflict countries, to be successful, privatization requires justifies public policy intervention on behalf of improvements in the financial sector underserved SMEs and rural communities. 24 Provision of funds through directed and subsidized credits by development-finance institutions contributed to the current state of the financial sector in Afghanistan. 42 Accelerating Private Investment: What needs to be done Bringing the commercial financial system closer to rural Though the banking sector is likely to remain the customers will require improving the business largest component of the financial system for some environment and regulatory framework to facilitate rural time, there is also a need to develop complementary finance operations and increase the perceived nonbank financial institutions, such as leasing creditworthiness of clients; using technology to lower companies, commercial credit companies, credit transaction costs and improve transfer mechanisms; unions, factoring companies, insurance companies, a introducing new products and risk-reduction techniques; credit bureau, and pension and provident funds, and, and encouraging the use of agency arrangements to in the longer term, to develop debt and equity leverage scarce or expensive infrastructure and to create markets. The establishment of a broad range of flexibility and mobility in service provision. instruments into which savers can deposit their funds and through which companies and consumers can One option for increasing the availability of finance to obtain access to capital and credit will spur the overall small enterprises would be to develop "downscaling" development of the economy. programs with interested commercial banks (i.e., to support these banks to develop small-business lending To enhance competition and make the operations). Considering the size of the informal intermediary role of the banks and nonbanks economy and the current weakness of the financial more efficient, DAB should maintain a sector, Afghanistan represents an ideal ground for such competitive banking policy. Conventional means downscaling operation. The downscaling model was of enhancing competition within banking successfully undertaken by the European Bank for systems-such as bank privatization and changes Reconstruction and Development in the former Soviet in laws and regulations affecting companies, Union and in the Balkans, and in countries such as banks, foreign ownership, and bankruptcy- Russia, Kosovo, Georgia, and Tajikistan. Support to should constitute the basis of such a policy. commercial banks to downscale usually includes a technical assistance component (to train the bank on Authorities must create an environment, how to lend to small businesses: development of new through regulation, to prevent collusive credit procedures, training of loan officers, strengthening behavior among banks and conglomerate of management information system, development of relationships between banks and nonbank incentive system for loan officers, marketing, etc.) as well financial institutions. Therefore, the present as a credit line when liquidity is an issue. ownership structure of the two state banks to be relicensed should be gradually changed through Broadening and deepening the financial sector their privatization and through the entry of Achieving the high rates of growth necessary to reduce reputable new private banks and financial poverty significantly will require increased institutions. To ensure continuing effective mobilization of domestic and foreign savings to support competition, DAB should permit new banks to higher rates of private sector investment. Mobilizing be set up only by qualified, professional, and savings implies a broadening and deepening of experienced parties. financial markets, institutions, and products, particularly long-term project finance. It also means In the long run, financial sector reforms should produce supporting the creation of banks and nonbank the following outcomes: financial institutions offering a range of products and services that compete with or complement those Only self-sustaining and commercially viable traditionally provided by banks. financial institutions that do not depend on the 43 The Investment Climate in Afghanistan government's support for resource mobilization or Moreover, a substantial amount of assets, notably land, pricing should be allowed to operate in the is locked up in these enterprises. Several SOEs are market.The government should channel resources nonviable and should be liquidated. Even the to priority sectors or subsectors in cases of market potentially viable ones that could be privatized may failure, for reasons of equity, or to achieve social have more land than they need. Unlocking these assets objectives, but such allocations should be explicit through liquidation and privatization will help loosen budgetary costs and not subsidized through a tax one of the most important constraints faced by private on financial intermediation. investors, that is, access to land, although it is not a substitute for the broader and urgent land-related The government's role should be confined to reforms discussed earlier. Privatizing the SOEs would creating a regulatory environment and an also provide an entry point for new investors, where the incentive regime that will draw investors and land assets are not in dispute and there are no savers to financial institutions. Where entrenched monopolies. government participation in equity becomes necessary, it should be done without There has been some progress in laying the ground for involvement in management. privatization. The government has carried out a preliminary classification exercise, based on a survey of State-oowned enterprise reform and SOEs, categorizing SOEs into those to be privatized, privatization liquidated, or retained under public ownership. However, the preparations for a privatization program More than 75 enterprises in Afghanistan are are moving slowly. So far, only two enterprises have classified as SOEs, with about 18,000 employees, been privatized.25 limited liabilities, and assets largely in the form of land. In addition, the government has a stake in To speed privatization and to put SOEs' assets to other firms that are not defined as SOEs under productive use in the private sector, the government Afghan law. A prominent example of this is Ariana among other things should undertake the following steps: Airlines. Unlike in many other developing countries, Afghan SOEs do not impose a significant burden on Adopt a privatization policy. The government the budget and are not major claimants on bank has recently adopted a formal privatization credit. This is because most SOEs are either not policy. It will need to be supplemented by functioning or operating at very low levels of detailed implementation guidelines that spell capacity utilization, and the government so far has out the modalities of privatization and specify been reasonably successful in imposing a hard where in government lies the authority for budget constraint on them. Hence, Afghan SOEs do initiating and implementing privatization. The not have a significant crowding-out effect on the SOE Law has provisions to liquidate or privatize private sector as their counterparts do in many SOEs that do not meet financial targets. countries. However, in some cases, such as in cotton- However, in actuality privatizing an SOE ginning, SOEs have tried to stop private enterprises requires agreement by the line ministry that from operating, and risk remains that other SOEs owns it. For many ministries the income or may indulge in similar behavior. potential income from the assets owned by the 25 These are two ginning and pressing mills that have been given out on 31-year leases (with option to buy) to a French company. 44 Accelerating Private Investment: What needs to be done SOE is seen as an important funding source for SOEs and did not cover privatization. It did the ministry. Thus, obtaining agreement to have well-defined provision for liquidation of privatize is difficult. SOEs but these have not been invoked yet to carry out any liquidation. Some SOEs, Develop an institutional framework for especially utilities, will likely remain under privatization. Develop adequate institutional public ownership for some time, and there may capacity to implement a privatization and be some public investment in these enterprises. liquidation program. No separate agency, Such investments should be guided by a clear such as a privatization commission or board, policy and rigorous criteria and within an is entrusted with carrying out privatization. appropriate corporate governance framework. The SOE department in the Ministry of Finance is currently carrying out some Address labor retrenchment issues. Develop a preparatory work and it relies almost program to deal with labor retrenchment. exclusively on external advisors.26 However, Privatization and liquidation could be socially the role of the Finance Ministry vis-à-vis contentious, especially because substantial job other ministries in initiating and losses (currently estimated at about 6,500) will implementing privatization is still unclear be involved. Indeed, this factor is partly despite the adoption of the privatization responsible for the relative lack of commitment policy and the amendments to the SOE law. and action in government on this front. Its The government needs to clarify the advisors have worked out a set of options on institutional responsibilities and put in place severance packages on which the government an adequate institutional framework for needs to make a decision, keeping in mind that carrying out privatization. severance payments should not be unduly generous. Any package for SOE employees will Adopt a mechanism for allocating surplus SOE set precedent for other public sector land. Articulate a clear policy and legal retrenchment programs. framework for ensuring that the freed-up land is made available for private investors. This may Introduce strong corporate governance for SOEs require consolidating ownership of such land, that will be retained. It is very important to currently diffused across several ministries and ensure that SOEs that remain in the public government agencies, in a single authority with sector are run efficiently, do not become a clearly laid-down procedures for its disposal. significant fiscal risk factor for Afghanistan, and do not crowd out resources that have better uses. Create a strong legal basis for privatization. There should be regular reporting of key The SOE law, which has recently been financial variables by SOEs (including those amended to facilitate privatization, should be with less than 100 percent government gazetted. The previous version of the law had ownership) and their compilation for use in no provision for private sector participation in monitoring and policy decisions. SOE 26The advisors working on privatization are mandated to work only with those enterprises that are classified as SOEs, that is, those enterprises that have a separate board and budget, and are controlled by a line ministry. Some enterprises, including the national airline company Ariana, which is a joint venture, are not classified as SOEs. 45 The Investment Climate in Afghanistan investments, including those occurring outside Business services the Core Budget, should be carefully monitored, and financial transfers between SOEs and the Few, if any, business services are available in government budget should be transparent. Afghanistan. Local consulting companies are focused There should not be any investments in SOEs almost exclusively on servicing the large donor that are to be liquidated or privatized and there community. Consequently, Afghan private sector should be rigorous criteria for approving enterprises have few options to obtain help on marketing, investments in SOEs to be retained. accounting, engineering, quality control, and other important services. Few private sector managers Trade reform complain about this lack of services. Larger firms bring in experts from outside and for other firms it is probably Following reforms carried out in 2004 (simplification an issue that they "don't know what they don't know." of tariff to a six-band structure, with a maximum rate Having never had access to consulting services, they do of 16 percent and utilization of a uniform floating not know the benefits to be gained from outside experts. exchange rate), Afghanistan has one of the most open The need for business services is clearly illustrated by the economies in the region, with an average tariff of 5.3 fact that the first enterprises to get loans from local banks percent. The import license application process has needed extensive help from NGOs to write business been drastically reduced. Border and clearance times, plans and put together financial statements for their while significant, are within a reasonable range for the applications. Many businesses fail to access finance from region. However, the customs administration remains the banks because their business accounts are not weak, several transit-related issues need to be addressed, credible. There are no domestic accounting firms that and institutional responsibilities in the government can help prepare accounts or audit reports and the need to be clarified. services of foreign accounting firms are beyond the reach of most Afghan businesses. It is important to develop the Improve customs infrastructure and reduce accounting and auditing profession within the country. discretion in valuation and tariff collection. Given the lack of a local consulting market, it may be necessary for government or donor agencies to initiate Define clear roles for different agencies to reduce programs to spur their development. multiple inspections. A major constraint revealed by many sector studies in Further reduce the dispersion in tariff rates to Afghanistan for both exporters and other producers is avoid discriminating in favor of or against the lack of testing facilities and standards to ensure different activities. quality.27 Exporters are required to obtain certificates of quality-but the government agencies issuing them Improve trade infrastructure, especially storage are not able to test. The government has begun a pilot facilities. project in Metrology, Standards, Quality, and Testing (MSTQ) housed in the Ministry of Commerce, but to Continue to negotiate more open trade, date little progress has been made. Initial plans call for including allowing Afghan carriers to operate in a focus on testing imports for consumer protection. neighboring countries. However, quality assurance for exports is equally 27 See United Nations Development Program and Afghanistan Research and Evaluation Unit sector studies. 46 Accelerating Private Investment: What needs to be done important, for without it the values of exports will investment policy work with AISA's investment always be constrained. Some current markets for promotion activities; and (d) providing comprehensive, Afghan products, such as India and Russia for dried updated information on PSD policies to the private fruits, may not have high-quality requirements, but sector. In addition, some basic skills in such areas as western markets have exacting standards and English language, business language, computers, and traditional markets may raise standards in the future. A financial management need to be developed. good MSTQ system will become increasingly important if Afghanistan wants to expand exports, Priorities for AISA are (a) further developing its role especially of higher valued products. In addition, the in facilitating investors; improving its capacity to focus on imports and consumer protection raises the operate as a one-stop shop for investors, defining possibility that it could become a source of nontariff interagency workflows, and establishing procedures to barriers for influential firms seeking protection. The foresee and address client requirements; (b) establishment of a viable MSTQ program is essential developing policy advocacy capacity and a mechanism for private sector development, and substantial for obtaining feedback from the private sector; (c) resources should be devoted to expanding the pilot clearer definition of the range of services it will offer project into a sustainable program that meets the to investors, both before and after they invest in private sector's needs. Afghanistan; (d) developing a system to screen potential investors so that scarce AISA resources are Government capacity to promote and facilitate not spread thin; (e) reviewing and clarifying staff private investment responsibilities and providing adequate training to staff in areas such as sales presentation, negotiations, Policy reform in the investment climate area is "closing the deal" with potential investors, and basics handicapped by lack of capacity in the government to of accounting and corporate finance; (f) identifying analyze private-sector-related issues, obtain systematic career development paths for staff; and (g) developing feedback from the private sector, and, on this basis, investor tracking systems. formulate appropriate policies and programs. This capacity needs to be built across the government Clearly, these agencies will have to coordinate with because the work of several ministries and agencies is other parts of government; the High Commission for relevant to private sector development. However, in Investment, in which several ministries are represented, light of the limited resources, initial focus may be on can be one vehicle for this. Currently, coordination and the AISA-to help promote Afghanistan as an collaboration among ministries is weak. Effective investment destination and to facilitate individual coordination will require an appropriate division of investors-and the Ministry of Commerce, as the main labor among the various ministries and agencies based driver of private-sector-related policies. on the comparative advantages of the different parts of government. Promoting private sector development in Priority areas for capacity building in the Ministry of an era of globalization requires a good understanding of Commerce include (a) a mechanism for reviewing the international and domestic market trends, sectoral regulatory interface between government and the knowledge, and appreciation of the needs of business. private sector, identifying areas where regulatory As was argued in the section on industrial park streamlining is required and assessing the costs and development, historical divisions of labor within benefits of proposed regulations; (b) identifying and government will have to be reconsidered if pursuing legislative changes required to fulfill the effective policies for private sector development are to government's PSD policy intentions; (c) coordinating be formulated. 47 The Investment Climate in Afghanistan Efforts should also be made to strengthen private sector actions. Private sector organizations may also play a collective bodies, such as chambers of commerce and role in helping to develop a shared stakeholder vision industry organizations. These have a very important on the role of markets and the private sector in role in private sector development because they serve as Afghanistan. The government has taken some steps a bridge between the private sector and the toward fostering the development of private sector government's policymakers, providing two-way collective bodies. It has formed a committee to review feedback. They may provide government with insights the future role of the quasi-government Afghanistan and knowledge on constraints faced by the private Chamber of Commerce and recommend actions that sector and may advocate policies and laws that help will convert it into a truly private sector chamber. private sector growth. They may provide the private However, it is important that this does not crowd out sector with information on government's policies, both other private sector chambers and associations. AISA actual and proposed, thus reducing uncertainty for the has started reaching out to the private sector through private sector and enhancing credibility of government activities such as roundtables in provincial cities. 48 ears)y actions 5 thane Long-term (mor . along, tariff e. system. for ate for law for agency cial ds uctur legislation, egulations.r in priv to dispute means . Matrix 1353 y agency standar infrastr actions egistrationr ent decisions. Law the y commere capacity y of insurance on barriers ears)y mor land uptcy w satisfactor mechanisms. d transpar judicial ne the based implementing egulatorr build .y visiono (2-5 out cing ankrB the the policyev war egulatorr entr pr edium-term k oduce elop ate M ebuildR or W esolutionr ntrI enfor nactE nactE perhaps with Establish insurance; emoR toevo sector M egimes.r ev D priv . Law a the ound eformsr for sector ecommendationsR of . vices. and legislation, ate identify law . ernmentv ser estment legal actions ear)y rganizations. 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These yb k in mora and y e, itst of oject and y ecor y wor with engthen financial units. inistr er sector pr oadr estment arrangements str the ex management ate inistr inv cost the and and M of managers, (land and DABMe cultur for the lead and M accompanied priv ts framey instilling cash CGCT egulatorR the actions associated Afghanistana business be ectors of to for por the erseevo engthen uctur ears)y dir oriented cial ogram in to str risks De technical, to corporate practices. ater key W for ks egulatorr risk-mitigating (DABM) d building, y and or mechanisms and (2-5 ess estrR. of pr ole.r egionalr ehabilitationr need cially capacity of commer and optionse k capacity W edium-term elop boar pricing elop elop theevo sector M ev addr estment. oassesa w ev D to inv Corporatiz M managerial, capacity form actions ne commer capacity businesslike better and D erwoP estment inv egulatorr xplorE contracting hebagan.S Continue networ uildB ublicP ogram. ev pr D mprI the elecommunicationsT for if . and the el.T k strategy vision and sector ette its barriers, ate az generation networ Afghan actions ear)y G. of 1 estments, collection, erw priv the oadr Law ernment'sv computerization. po y air). the t-term than go including, inv ticipation. policyev and yb and par ough emor ette horS primar (less sector tariffs, thr (land gaz clarify erw sector and small-scale ts Corporatization and ther po ding ate billingevo to, distribution por on urF the egarr priv mprI including dentifyI any and ehabilitateR key nactE elecommunicationsT Law ea Ar t erwoP ransporT elecommunicationsT 50 Policy Recommendations Matrix of ate banks. ears)y priv atization in actions 5 state priv thane the full-scale finance. estment inv Long-term (mor ehabilitatedr Complete the ncourageE sector agricultural the of it.e an the e atiz eate ement eplacer for the for after passed). cr es (to d is capacity on priv eau. etirR expansions. bur and collusiv y vices. Boar Law estor fully agricultural ent account ser edit commitments. ev incentiv actions inv branch then cr pr oluntarV and into ears)y Afghanistan to fiscal management and of competition the dedicated bank (2-5 el.T oducts strategica elT public . taking pr economic cial onment edium-term M uthorityA elecommunicationsT elecommunicationsT engthentrS Afghan ringB Afghan Establish ncourageE ernment'sv envir behavior Commence Scheme, go Commence finance videorP commer in to and and its to the cial plan, the of el.T on vices. e for ate for licenses Afghanistana the existing activities ser actions ear)y activities) D . facilities. of commer plan for plans ehensiv management operations. 1 Afghan of activities (continuing cial banking. public-priv ed-line to its banking financial wned dates capitalizationa corporatization t-term than fix capacity action eformr cial compra uralr sound guarantee commer its expansion long-term state-o of team, and horS (less ehabilitated.r the functions its the and and nonbank strategic focusing y additional competition yb out commer up specificae of includes and independent t- be loan that to ate shor urban safee oduce oduce ssueI open Continue ankB engthening egulatorr phase str ncourageE priv scaling eparrP tnerships. esolutionr banks appointment management and ehabilitationr their ntrI banks evivR ncourageE par ntrI ea Ar finance to bank banks banks ate ccessA Central tateS rivP 51 The Investment Climate in Afghanistan money banks and ograms. and ograms. ears)y pr pr actions 5 into finance. larger transformation thane the uralr the of dealers in geographic geographic expansion expansion Long-term (mor some change oduct oduct Consider of ex engaging Continue pr Continue pr of with for money to note permitting range . uralr ar a wned activities. ograms ailable est that thus pr dedicated ograms and in av nonbanking compliant as widera sector div up pr . state-o edit land to actions in cr financial ears)y financial ell-managedw, purposes. scale farmers atization to finance manner make enterprises licensing institutions, engage dealer priv nonviable (2-5 businesses eam larger ent strategies SOEs. to egulated out industrial edium-term ust y elop vice M Consider ser financial them ell-rw ernmentv ntegrateI mainstr ntrE ev institutions agricultural medium-scale enterprises. 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Lists of registered importers and exporters could not be accessed. T he Afghanistan Investment Climate Survey (ICS) sampled 338 private sector enterprises Because there was no valid sample frame, the survey spread across five major cities in May through proceeded by sampling based on a sector's share of the July 2005. The survey was conducted through face-to- estimated gross domestic product (GDP) with a quota face interviews at the establishment level. At the time for size of firm. The survey included manufacturing, of the survey there was no accurate available list of trade and wholesale, other services, transport, and enterprises in Afghanistan from which to construct a shipping and construction companies. It excluded sample frame. The best list was provided by AISA, healthcare, security, consulting, and financial sector stating registered enterprises and enterprises enterprises. Agriculture processors were included in previously registered with local chambers of manufacturing but farms were excluded. Manufacturing commerce. Unfortunately, this list was completely was overweighted to make the sample more comparable inaccurate. Many of the listed enterprises no longer to other ICSs. The sample was distributed geographically existed and for those that did, the location, size, and based roughly on population estimates in each city. For other information were inaccurate. More problematic consistency with the sample from other countries was the fact that many of the active enterprises were included in the World Bank's Investment Climate not on the list. Currently, only large enterprises, Database, the sample was restricted to enterprises of five foreign enterprises, or those that want to do business or more workers. Smaller enterprises do not show many with the government has an incentive to register with of the organizational elements of a firm. Table A.1: Sector Distribution: Afghanistan ICS 2005 Sector % of Sample Cities Number of Establishments Manufacturing 34 Kabul 99 Construction 15 Kandahar 55 Construction material 6 Herat 62 Services 17 Jalalabad 59 Trade and wholesale 23 Mazar-e-Sharif 63 Transport and communications 5 The Investment Climate in Afghanistan A.2 Selection of enterprises and other contacts for suggestions of firms that met the sampling criteria. These new firms were in turn asked Because of the lack of a sample frame, the for their suggestions. implementing agency (Altai Consulting) was forced to rely largely on a list of enterprises it had compiled in A.3 Overall attitude of respondents the course of conducting other research on the Afghan private sector and a "snowball" approach. The Altai list The survey lasted an average of 1 to 1.5 hours. Despite is limited because it consists of companies that Altai this length, the survey firm reported that the majority had already contacted and interviewed, in some cases of respondents were interested in and cooperative with multiple times. It also focuses on the sectors of interest the survey and understood its purpose. Because of the for previous projects, including poultry, cumin and low number of national businesses of significant size, saffron, gems, services related to construction and many of the respondents have been interviewed before, construction materials, wheat-based products, some multiple times, on similar topics. These cashmere, soap, shampoo, and laundry detergents. continuing studies have raised expectations; however, However, the effect of this bias was minimized by the there has not yet been a corresponding level of visible fact that cited sectors represent a large proportion of activity to help the private sector. This lack of progress the Afghan private sector and the list included many of has caused a growing number of businesspeople to the known medium-to-large companies in the country. question the effectiveness of contributing their time In addition, the snowball method mitigated the bias. and energies to further interviews and of the The snowball method entailed asking interviewed firms implementing agencies in general. Table A.2: City Distribution: Afghanistan ICS 2005 City No. of Observations % of Sample Kabul 99 30 Herat 62 18 Kandahar 55 16 Mazar-e-Sharif 63 19 Jalalabad 59 17 Total 338 100 Table A.3: Size Distribution (number of full-time workers): Afghanistan ICS 2005 Sector % of Sample Fewer than 20 55 20-49 25 50-99 10 100 or more 10 Average number of full-time employees 37 56 Annex A.4 Interviewer profile have realized its significance or function as an analytic instrument. The interviewers trained for the survey were generally college-educated in Afghanistan or a neighboring A.5 Respondent profile country and/or had previous experience with conducting interviews in the country. However, it All respondents were men. The large majority are owner- was not possible to find interviewers that had operators of their companies, which is typical in previous exposure to the level of business or financial Afghanistan where large companies are few and most concepts or terminology used in the questionnaire. management staffs do not exceed a few individuals. Many The practical result of this limitation was that the are in business for the first time and nearly none have had presurvey training did not fully prepare the formal management or business training. Few have had interviewers to conduct what for Afghanistan was a more than a basic general education. However, because of complex and sophisticated survey. In many cases, the their relatively high position in a hierarchical society, some interviewers may not have completely understood the interviewers may have felt uncomfortable asking sensitive implicit logic of the survey's structure and may not questions or pushing for more complete answers. 57 ANNEX B: Managers' Perceptions of Major Constraints Figure B.1: Afghanistan: Percentage of Firms Citing Constraint as Major or Severe 58 Annex Figure B.2: Kabul: Percentage of Firms Citing Constraint as Major or Severe Figure B.3: Mazar-e-Sharif: Percentage of Firms Citing Constraint as Major or Severe 59 The Investment Climate in Afghanistan Figure B.4: Herat: Percentage of Firms Citing Constraint as Major or Severe Figure B.5: Kandahar: Percentage of Firms Citing Constraint as Major or Severe 60 Annex Figure B.6: Jalalabad: Percentage of Firms Citing Constraint as Major or Severe 61 ANNEX C: Doing Business in Afghanistan Afghanistan Region: South Asia Income category: Low income Population: 23.9 million GNI per capita (US$): 250 Ease of... Economy rank Best performer Worst performer Doing Business 122 New Zealand Congo, Dem. Rep. Starting a Business 16 Canada Angola Dealing with Licenses .. Palau Tanzania Hiring and Firing 25 Palau Burkina Faso Registering Property 150 New Zealand Nigeria Getting Credit 153 United Kingdom Cambodia Protecting Investors 145 New Zealand Afghanistan Paying Taxes 7 Maldives Belarus Trading across Borders 128 Denmark Iraq Enforcing Contracts 93 Norway Timor-Leste Closing a Business 142 Japan West Bank and Gaza Starting a Business (2005) The challenges of launching a business in Afghanistan are shown below. Entrepreneurs can expect to go through 1 step to launch a business over 7 days on average, at a cost equal to 52.8 percent of gross national income (GNI) per capita. No minimum deposit is required to obtain a business registration number. Indicator Afghanistan Region OECD Procedures (number) 1 7 6 Time (days) 7 35 19 Cost (percentage of income per capita) 52.8 39.7 6.5 Min. capital (percentage of income per capita) 0.0 0.8 28.9 ll Annex Hiring & Firing Workers (2005) The difficulties that employers in Afghanistan face in hiring and firing workers are shown below. Each index assigns values between 0 and 100, with higher values representing more rigid regulations. The Rigidity of Employment Index is an average of the three indices. For Afghanistan, the overall index is 39. Indicator Afghanistan Region OECD Difficulty of Hiring Index 67 37.6 29.5 Rigidity of Hours Index 20 35.0 50.0 Difficulty of Firing Index 30 42.5 27.3 Rigidity of Employment Index 39 38.5 35.7 Hiring cost (percentage of salary) 0 5.1 20.8 Firing costs (weeks of wages) 4.0 75.0 32.6 Registering Property (2005) The ease with which businesses can secure rights to property is measured below. In Afghanistan, it takes 11 steps and 252 days to register property. The cost to register property there is 9.5 percent of overall property value. Indicator Afghanistan Region OECD Procedures (number) 11 6 4 Time (days) 252 124 33 Cost (percentage of property value) 9.5 6.3 4.7 Getting Credit (2005) Measures on credit information sharing and the legal rights of borrowers and lenders in Afghanistan are shown below. The Legal Rights Index ranges from 0 to 10, with higher scores indicating that those laws are better designed to expand access to credit. The Credit Information Index measures the scope, access, and quality of credit information available through public registries or private bureaus. It ranges from 0 to 6, with higher values indicating that more credit information is available from a public registry or private bureau. Indicator Afghanistan Region OECD Legal Rights Index 0 3.8 6.3 Credit Information Index 0 1.8 5.0 Public registry coverage (percentage of adults) 0 0.1 7.8 Private bureau coverage (percentage of adults) 0 0.6 58.0 63 The Investment Climate in Afghanistan Protecting Investors (2005) The indicators below describe three dimensions of investor protection: transparency of transactions (Extent of Disclosure Index), liability for self-dealing (Extent of Director Liability Index), shareholders' ability to sue officers and directors for misconduct (Ease of Shareholder Suits Index and Strength of Investor Protection Index). The indexes vary between 0 and 10, with higher values indicating greater disclosure, greater liability of directors, greater powers of shareholders to challenge the transaction, and better investor protection. Indicator Afghanistan Region OECD Disclosure Index 0 4.1 6.0 Director Liability Index 0 4.6 5.3 Shareholder Suits Index 2 6.4 6.7 Investor Protection Index 0.7 5.0 6.0 Paying Taxes (2005) The effective tax that a medium-size company in Afghanistan must pay or withhold within a year is shown below. Entrepreneurs there must make 2 payments, spend 80 hours, and pay 21.4 percent of gross profit in taxes. Indicator Afghanistan Region OECD Payments (number) 2 25 16 Time (hours) 80 331 192 Total tax payable (percentage of gross profit) 21.4 35.3 46.1 Trading across Borders (2005) The costs and procedures involved in importing and exporting a standardized shipment of goods in Afghanistan are detailed under this topic. Every official procedure involved is recorded, starting from the final contractual agreement between the two parties and ending with the delivery of the goods. Indicator Afghanistan Region OECD Documents for export (number) .. 8 5 Signatures for export (number) .. 12 3 Time for export (days) .. 33 12 Documents for import (number) 10 12 6 Signatures for import (number) 57 24 3 Time for import (days) 97 46 14 64 Annex Enforcing Contracts (2005) The ease or difficulty of enforcing commercial contracts in Afghanistan is measured below. It takes 400 days to enforce contracts there. The cost of enforcing contracts is 24.0 percent of debt. Indicator Afghanistan Region OECD Procedures (number) .. 29 19 Time (days) 400 385 232 Cost (percentage of debt) 24.0 36.7 10.9 Closing a Business (2005) The time and cost required to resolve bankruptcies is shown below. The recovery rate, expressed in terms of how many cents on the dollar claimants recover from the insolvent firm, is 0. Indicator Afghanistan Region OECD Time (years) No practice 4.2 1.5 Cost (percentage of estate) No practice 7.3 7.6 Recovery rate (cents on the dollar) 0.0 19.7 73.5 65 References Asian Development Bank. 2005. A Private Sector Andkhoy Carpet Market. Kabul: Afghanistan Research Assessment for Afghanistan. and Evaluation Unit. Giustozzi, Antonio. 2005. Understanding Relationships Paterson, Anna. 2005. Understanding Markets in between Businessmen and other Power Holders [draft]. Afghanistan: A Study of the Market for Petroleum Kabul: Afghanistan Research and Evaluation Unit. Fuels. Kabul: Afghanistan Research and Evaluation Unit. Lister, Sarah, and Tom Brown, with Zainiddin Karaev. 2004. Understanding Markets in Afghanistan: A Case United Nations Development Program. 2005. Market Study of the Raisin Market. Kabul: Afghanistan Sector Assessments. Kabul: UNDP Research and Evaluation Unit. United Nations Office on Drugs and Crime. 2005. Lister, Sarah, and Adam Pain. 2004. Understanding Afghanistan Opium Survey 2005. Kabul: UNODC Markets in Afghanistan: A Synthesis Note for the Case Studies on the Markets in Construction Materials, World Bank. 2004. State Building, Sustaining Growth, Raisins and Carpets. Kabul: Afghanistan Research and and Reducing Poverty: a Country Economic Report. Evaluation Unit. Washington D.C: World Bank Pain, Adam. 2004. Understanding Markets in World Bank. 2005. Doing Business in 2006: Creating Afghanistan: A Case Study of Carpets and the Jobs. Washington D.C: World Bank A fghanistan has taken tremendous strides toward reestablishing itself as a politically and economically viable state. Since the fall oftheTalibanregimein2001,thegovernment,withthesupportof the international community, has reestablished a number of political institutions and spearheaded economic reforms. A new constitution has been adopted, nationwide elections were held to select Afghanistan's first democratically elected president, and, in September 2005, a parliament was elected. The government has also taken a number of steps to foster private sector investment - particularly establishing the Afghanistan Investment Support Agency (AISA) with the mandate of promoting and facilitating investment. The AISA has helped streamline the business registration process to the extent that Afghanistan now ranks among the best countries in the World Bank's 2005 Doing Business indicators of firm registration. However, much more remains to be done, particularly removing informal barriers to new entry, improving infrastructure,andreducinguncertainty. In a postconflict environment, attracting new foreign and domestic firms is central to private sector development. New decisions about investment (in existing or new firms) usually depend on the availability of five basic factors: political and economic stability and security; clear unambiguous regulations; reasonable tax rates that are equitably enforced; access to finance and infrastructure; and an appropriately skilled workforce. The challenges facing the government of Afghanistan in addressing these constraints and in turn attracting further foreign and domestic investment cannot be underestimated. But, as the experience of other reconstruction efforts shows, for example, in Bosnia and HerzegovinaandEastTimor,successfulreformcanbeachieved The World Bank 1818 H Street NW, Washington, DC 20433, USA Fax: 202-522-2422, www.worldbank.org