The Afghan economy is struggling to confront deflationary winds. 

Over the past two years, Afghanistan's economy has been characterized by a tumultuous downturn, underlined by a staggering 26 percent contraction in real GDP. The aftermath of the Taliban takeover has seen a stark decline in international aid, leaving the nation without any internal engines of growth, and the recent return of Afghan migrants and an earthquake in Herat have intensified these challenges. The October 2023 earthquake damaged critical infrastructure, reducing GDP growth by estimated 0.5-0.8 percent. With no policy levers to stimulate aggregate demand, the economy remains stagnant, with low demand driving a noticeable deflation.

By February 2024, headline inflation plummeted to -9.7 percent year-over-year, propelled primarily by substantial reductions in food (-14.4 percent) and non-food (-4.4 percent) prices. Core inflation, excluding food and energy, mirrored this downward trajectory, registering at negative 3 percent. While the food sector has benefited from better supply, weakened demand due to low purchasing power is a major driver of the deflationary process that started in April 2023 and is persisting through February 2024. This protracted deflationary process stems from a confluence of factors, including the adverse ramifications of the opium ban, the shrinking of the money supply, and the appreciation of the Afghani.

The ban on opium cultivation precipitated a staggering $1.3 billion loss in farmers' incomes, equivalent to approximately 8 percent of GDP. According to United Nation’s Office on Drugs and Crime (UNODC), the opiate economy’s value has contracted by 90 percent, the area under cultivation declined by 95 percent and has cost Afghan 450,000 jobs at the farm level alone and doesn’t include the high economic losses downstream. Furthermore, repurposing around 200,000 hectares of land previously dedicated to illicit crops towards food production has led to downward pressure on domestic food prices, albeit at the expense of heightened unemployment.

Constraints to monetary policy also contributed to the deflationary process. Da Afghanistan Bank (DAB) has reported a significant decrease in money supply, with M2 contracting by nearly 11 percent from the fourth quarter of 2020 to the second quarter of 2023. This decline is due to sanctions, frozen assets, banking disruptions, domestic payment system issues, and a shift to Islamic banking, leading to a cash-dominant economy. The country's inability to mint new currency, compounded by sanctions that prevent replacing old banknotes, has further tightened the money supply. Lower currency in circulation has limited access to credit for consumers and deterred spending, while businesses encounter obstacles in securing investment loans. Consequently, this is dampening demand for goods and services, prompting businesses to lower prices to attract customers, exacerbating deflationary trends.

A reduced money supply has also led to an exchange rate appreciation, exacerbating the deflationary cycle. Since August 2021, the Afghani has appreciated 22.8 percent against the US dollar. This has been instrumental in mitigating the costs of imported goods, amplifying the deflationary pressures affecting the economy. It has also rendered Afghanistan's exports pricier on the international market, diminishing their demand and undercutting Afghanistan's export sector's potential to catalyze economic growth in the postconflict landscape. It is also adding to the widening trade deficit.

The widening trade deficit poses yet another challenge to Afghanistan's economic situation. Notwithstanding a 46 percent decrease in coal exports, food and textile export gains have provided a semblance of equilibrium. Despite a shrinking economy, Afghanistan's imports surged by 23 percent to $7.8 billion in 2023. The trend continued into 2024, with January seeing a 37 percent increase in imports year-over-year. The rise in imports, particularly in secondary commodities like machinery and chemicals, is partially due to an overvalued exchange rate and complex factors such as purchases by Pakistani buyers in the United Arab Emirates. While food, minerals, and textiles still make up a significant portion of imports, their relative share has decreased as Afghanistan's import patterns shift.

Prolonged deflation threatens to engender a negative cycle where consumers defer spending, businesses curtail investment, and economic growth languishes, impeding sustainable poverty alleviation and job creation. While the price decline may alleviate financial burdens for vulnerable households by reducing living costs, it also portends risks for the broader economy. Consumer reluctance to purchase in anticipation of further price declines can deepen economic downturns, reducing production, job losses, and heightened unemployment, thus contributing to recessionary pressures. The economic strain has triggered a surge in labor force participation, exacerbating unemployment amidst limited job opportunities. Approximately half of the population is trapped in poverty, and 15 million individuals are facing food insecurity.

Amidst these economic changes, the fiscal landscape remains a focal point of scrutiny. The fiscal year 2023 conveyed a 9 percent uptick in total revenue; buoyed by heightened imports and non-tax revenues, it surpassed Interim Taliban Administration’s (ITA) target. However, the FY2023-24 budget, augmented by 43 percent from the preceding year, accentuates ITA’s preference for security spending over essential social sectors, such as health and agriculture, thereby potentially compromising social protection mechanisms.

Compounding these challenges is the financial sector's sluggishness in facilitating financial intermediation, hampering private sector dynamism. Banks, entangled by international payment restrictions and compelled shifts towards Islamic Finance, have scaled back lending activities, exacerbating economic headwinds. The efficacy of the Central Bank in monitoring risks, particularly in anti-money laundering and counter-financing of terrorism (AML/CFT), also warrants scrutiny. The declining assets and deposits, challenges in international payments, and the transition to Islamic Finance have precipitated a heightened reliance on cash and non-traditional payment methods. This has further constricted the money supply, exacerbating the economic downturn and deflationary pressures discussed above.

Outlook: Navigating Turbulent Waters in Search of New Engines of Growth

Afghanistan's economic outlook remains uncertain, with the threat of stagnation looming large until at least 2025. The absence of GDP growth coupled with declining external financing avenues for off-budget expenditures paints a bleak picture of the nation's economic prospects. Structural deficiencies in the private sector and waning international support for essential services are anticipated to impede any semblance of economic progress. The trajectory for 2023-2025 envisages a persistently stagnant economy, with real GDP growth projected to flatline, leaving economic activity by 2025 at par with 2022 levels as per capita income shrinks due to population growth.

This economic stagnation is poised to deepen poverty and unemployment, with job opportunities expected to fall, exacerbating food insecurity and widening social fissures. The decline in off-budget transfers will continue suppressing overall demand and slash spending on poverty alleviation as funds are diverted to security. The ban on female education above the primary level exacerbates these challenges, limiting the pool of educated women in the workforce and potentially triggering a further reduction in international aid.

Revenue and expenditure are expected to remain stable, with a decrease in off-budget transfers. Domestic revenue is projected to consistently account for 15 percent of GDP, with on-budget spending estimated to be between AFN 200-220 billion annually. However, the real value of these figures will be less than in 2022. Off-budget transfers are projected to fall to AFN 269 billion by 2025, from AFN 327 billion in 2022, leading to reduced demand and diminished spending on poverty alleviation as security takes precedence. The expected decrease in off-budget transfers will likely dampen economic activity, with the economy projected to reach 2022 levels by 2025.

The baseline scenario is subject to risks, including the ITA exclusionary and gender policies. Further cuts beyond the current projections will result in an even more pronounced decline in economic activity. The ITA may partially offset the loss in off-budget transfers through improved domestic revenue collection, but this will not fully compensate for the shortfall. If the ITA reallocates its spending priorities, it could reduce the negative impact on social sector expenditures and service delivery. Without such reallocation, any additional domestic revenue will likely be directed toward security, significantly reducing funding for social services. The deflation trend that started in April 2023 may further contract the economy. Banking sector instability and climate issues also pose threats to the GDP trajectory. These risks could exacerbate poverty and food insecurity regionally and globally.

Amidst the gloom, glimmers of hope emerge as the potential for growth and change exists. Afghanistan's long-term growth prospects are contingent upon a significant shift from the previous 15 years of reliance on international aid and consumption-driven growth to a more resilient, private-sector led economy that capitalizes on the nation's inherent strengths. Afghanistan must focus on its comparative advantages for a sustainable future, particularly in the agricultural and extractive sectors. Agriculture is poised to be a key driver of growth and poverty reduction, potentially creating jobs and positively impacting income distribution. Strategic investments in irrigation infrastructure, land tenure security, research, and market access are essential to enhance agricultural productivity and resilience. These efforts should be supported by strengthening human capital and institutional frameworks to create a conducive business environment.