Banking and Monetary Policy

The formal banking system in Afghanistan was established during the country's initial economic modernization in the 1930s. Bank-i-Melli was the first bank of any kind and used its resources to develop several profitable industrial enterprises. Following Bank-i-Melli's success, in 1939 the government set up Da Afghanistan Bank, the central bank. It quickly became the country's leading commercial bank and, like its predecessor, opened branches in the major cities. The banking system was never well developed, however, and up to the 1978 coup neither bank's branch offices could approve loans. All loans were made by the banks' head offices in Kabul. By the mid1970s interest rates had remained virtually unchanged in two decades, despite inflation. The poor collection rate of the commercial banks forced them to adopt stringent collateral requirements, and most credit stayed in the form of short﷓term loans. Because the rights and obligations of borrower and lender were not well defined, neither banks nor private borrowers could use the country's credit resources. As a result of these conditions, banking stagnated during the 1960s, despite the government's establishment of a series of specialized banks, beginning in 1948 with a housing and construction bank. During 1975-76 the government nationalized all Afghan banks.

In 1985 the banking and financial system revolved around a government-directed formal banking system and the longstanding private money traders. The organized banking sector comprised Da Afghanistan Bank, which had the dual role of central bank and commercial bank, three commercial banks, and three specialized banks. Da Afghanistan Bank, the largest in the country, was the center of the formal banking system. The key roles of its directors indicated its critical role. In March 1982 the central bank- was made independent of the Ministry of Finance; the governor of the central bank was designated general president and given the rank of a cabinet minister. In addition, the central bank's Supreme Council was reorganized under the deputy prime minister, who was also director of the State Planning Committee. The general president of the central bank and the ministers of finance, agriculture and commerce, and industry were the other members. As the central bank, Da Afghanistan Bank had the sole right of currency issue and acted as a lender of interest-free funds to the government and municipalities. It also exercised the government's control over foreign exchange transactions and determined the afghani's official exchange rate. The central bank also dominated the commercial banking sector, where it accounted for over 60 percent of all nongovernment deposits in 1983.

Of the remaining commercial banks, Bank-i-Melli was the largest. Its loans consisted primarily of credits to a few large enterprises in which it held participation interests and shortterm foreign trade financing. Bank-i-Melli has branches in New York, London, Karachi, Peshawar, and Hamburg. Another commercial bank, the Pashtany Tejaraty Bank, was founded in 1954. Much smaller than Bank-i-Melli, its operations were concentrated in foreign trade finance. The third commercial bank, the Export Promotion Bank, was established in 1978 to assist small- and medium-scale public and private enterprises seeking to export their products. The interest rate payable by commercial banks was fixed by the Ministry of Finance at 9 percent on savings deposits. This rate was essentially unchanged from 1977 and was well below the rate of inflation. It therefore acted as a disincentive to savings and the flow of remittances from abroad. The rate on loans was 6 to 12 percent. This low rate favored speculative stockbuilding and capital investment projects. The rate on lending was also occasionally reduced to encourage imports of essential commodities in short supply. Furthermore, Da Afghanistan Bank provided low-rate loans to the specialized banks so that those institutions could offer credit at preferential rates.

The largest of the three specialized banks was the Agricultural Development Bank, founded in 1959 to assist public and private activities in the agrarian sector. It also sold and serviced machinery. In the mid-1970s its lending increased rapidly, and thousands of loans were made to farmers for the purchase of fertilizer as part of the government's decision to increase its use. There were many defaults on the early loans, but the government compensated the bank for the uncollectible debts on this account. During the early 1980s the bank's outstanding loans declined because some loans to landlords affected by land reform had to be written off. This trend was apparently reversed later as the government sought to finance the acquisition of modern machinery and other inputs. In 1985 the bank's operations were concentrated in areas where land reform measures had been taken.

The other two specialized banks, the Industrial Development Bank (IDB) and the Mortgage Construction Bank (MCB), were relatively small. Established in 1973 as a privately owned bank with 40 percent of its share capital held by foreign banks, IDB was nationalized in 1976. Its total loans outstanding grew steadily during the 1978-82 period through loans to larger enterprises and credit to small-scale industry through the Development Assistance Fund, set up in 1977. The smallest specialized bank, MCB could lend only to government employees for short- and medium-term home loans. It became inactive in the mid-1970s because of difficulties in collecting debts from government employees. In the early 1980s, however, the amount of its outstanding loans showed an increase as more people qualified for loans.

The formal banking system in 1985 was still poorly developed. Its operations were confined mainly to urban areas. Observers noted several underlying problems. The extreme centralization of banking activity in Kabul ignored the provinces. Banking activity of necessity involved reading and writing, which limited the number of people who could use banks. The unsettled security situation also reduced the amount of deposits and the scope of lending activities.


Money Bazaars

The formal banking sector was augmented by the money bazaars, which played an important role in both internal and external trade finance. Moneylending and foreign exchange dealings had been major activities in the bazaars of Kabul and other cities for centuries, dating back to the era when the great overland trade routes between the Mediterranean and the Orient passed through Afghanistan. Until the 1930s, when Afghanistan established banks, all foreign exchange transactions were handled by private dealers located primarily in Kabul and Qandahar. Even the Afghan government's foreign exchange requirements were purchased from these dealers. Through Bank-i-Melli and later Da Afghanistan Bank, the government tried to assert a monopoly of its own over foreign exchange transactions. Despite foreign exchange surrender regulations and occasional prohibitions of free market dealings, the bazaars survived so successfully that Bank-i-Melli and Da Afghanistan Bank had to keep their own dealers in the bazaars. The 1960s were a period of renaissance for the money bazaars even as the formal banking system's growth stagnated. The volume of business and the number of dealers grew; technical improvements, such as electronic calculators, appeared. Among the money traders a specialization of activities occurred. By the 1970s dealers normally traded in either rupees (Indian and Pakistani), convertible currencies, or East European currencies. The money bazaars maintained close telecommunications links with correspondent banks around the world and handled both currencies and foreign bank drafts. By the 1970s they could provide nearly all the services of a commercial bank, giving loans for foreign trade finance, consumer loans (especially for weddings), working capital for farmers and entrepreneurs, housing, and longer term industrial undertakings. Because of the bazaars' high interest rates, businessmen saw them as a last resort for credit. The centralization of loan extension in Kabul, however, raised the relative importance of the bazaars' role for finance in the provinces. The authorities in Kabul in 1985 continued to follow a policy of noninterference with operations in the money bazaars, but the bazaars' legal position remained dubious.

Owing in part to the dealers' suspicions of the government, information and detailed data on the volume of business in the bazaars were scarce. The share of the bazaars in foreign exchange turnover was very large; one observer estimated it to be 65 percent in 1972. In view of the war, Western analysts in the mid﷓1980s believed that without the free-market trade of the bazaars, the Afghani would more seriously depreciate. There was also brisk trade in rubles in the bazaars as Soviets sought to buy hard currencies.


Prices 

By 1985 Afghanistan was suffering from a markedly higher rate of inflation than it had experienced during the previous decade. During the early 1970s there was a sharp rise of 50 percent in price levels as a result of the severe drought that crippled agricultural production. When weather conditions and agricultural output improved, the price index rose at a slower 6-percent annual rate during the middle of the 1970s. This inflation-rate decrease occurred despite the fact that the money supply more than doubled between 1973 and 1977. The huge growth in the money supply was in part a result of a 50-percent increase in government borrowing from Da Afghanistan Bank to pay for development expenditures. Two factors moderated the price increase during the mid-1970s. The afghani appreciated in value against other currencies. This kept the prices of imports down and encouraged hoarding by currency speculators, thus removing much currency from circulation. This hoarding of currency spread to the countryside during the 1970s as the subsistence economy became increasingly monetized and rural households found greater uses for currency.

During the early 1980s the rate of inflation soared. According to government officials, prices more than doubled between 1979 and 1983. Defectors and resistance leaders claimed inflation was in fact much greater. Food prices were said to be especially hard hit, as prices for meat, vegetables, and tea rose by over 500 percent between 1979 and 1984. The prices of cereals, the essential element of the Afghan diet, were said to have doubled. The rate of inflation varied throughout the country, but the rural areas were said by both the resistance and Western observers to be suffering far worse from rising prices than were the cities.
After the 1978 revolution, two of the factors holding down the country's inflation began to erode. After appreciating by more than 100 percent between 1973 and 1978, the exchange rate of the afghani plummeted between 1979 and 1983. At the bazaars the value of the afghani dropped from Af39 to Af99 per US$ 1. The government's official exchange rate fell from Af45 to Af52.6 during the same period. This raised the prices of all imported goods not covered by bilateral trade assistance agreements. A second factor pressuring prices was the fall in domestic production of goods, above all in the agriculture sector. This closely resembled the situation during the drought of 1971-72 when food prices soared.

The decreased availability of goods and the higher prices of those available were also in part a result of skyrocketing transport costs. The national marketing system, which had never been well developed, was crumbling as commercial travel within Afghanistan declined as a result of the war. According to observers, the cost of moving goods between Kabul and Mazar-a Sharif rose by 600 percent between 1980 and 1984; in Hazarajat the cost of moving 199 tons of wheat was seen to equal the purchase price. Meanwhile, the money supply continued to grow, although at a slightly slower rate of 17 to 18 percent annually, compared with 20 percent per annum in the 1970s. This increase in the money supply was caused by government borrowing, in part for war-related expenditures, such as defense and repairing damaged infrastructure.

In order to ease the hardship of soaring prices, the government instituted a system of price controls and consumer subsidies. The prices of such items as wheat flour, tea, and vegetable oil-as well as other goods, such as soap, toothpaste, shirts, cloth, and notebooks-were held low. This was usually made possible through bilateral supply agreements at the official, rather than the bazaar, exchange rate. The government also influenced prices of private traders through its competitive sale of domestic goods at government-sponsored consumer cooperative shops. By 1985 there were 140 cooperative shops around the country, according to the government. Prices of essential goods and commodities were said to be 20 percent cheaper than on the free market.
The government also provided direct cost subsidies to consumers on food and particular utility services through the Food Procurement Department (FPD) and several public utilities. The FPD obtained wheat and sugar from both domestic and foreign suppliers on both commercial and concessionary terms. Public sector employees received coupons allowing them to purchase wheat flour at much reduced prices. This was estimated to cost the government Af600 million in 1984. Government employees were also able to buy vegetable oil at reduced prices. In addition, retail bread prices were fixed at below-cost levels for all citizens. Electricity, water, and bus transport prices were held at below-cost levels, with government funding for the public enterprises covering the difference between costs and revenues from customers. Until 1984 the price of imported petroleum products had also been fixed at a low level. This cost the government Aft billion in 1983 alone. In June 1984, however, prices were raised so high that there was in effect a tax on gasoline consumption.

The government did not try to direct the economy through an active monetary policy. The lack of detailed statistical data hampered any effort to analyze the money supply and its effects. Instead, the government set out broad guidelines for the operations of its banks. After 1981 all banks had to follow annual credit plans prepared at the beginning of the fiscal year. These credit plans determined the credit to be made available based on projected public and private sector requirements for production and for domestic and foreign trade. The annual budget determined the government's borrowing requirements. Although the government's needs occasionally exceeded projections, little adjustment was made in the credit plan. The banks were not allowed to borrow from Da Afghanistan Bank, except for short periods to keep them within the credit plan guidelines (see table 6, Appendix).

This page maintained by Luke Griffin and last updated on 01/14/2002 .