Report No. 25293-MAI Malawi Country Economic Memorandum Policies for Accelerating Growth June 2004 Poverty Reduction and Economic Management 1 Africa Region Document of the World Bank CURRENCYEQUIVALENTS (ExchangeRate EffectiveJune 1,2004) CurrencyUnit = Malawi Kwacha (MK) MK1 = US$0.00914 US$1 = MK109.4 SDR 1 = US$1.479 MEASURES Metric System FISCAL YEAR July 1to June 30 (as of July 1998) Vice President : Callisto E. Madavo Country Director: Hartwig Schafer SectorDirector: Paula Donovan SectorManager: Emmanuel Akpa Task Team Leader: Sudhir Chitale GLOSSARYOF ACRONYMS AD Anti-Dumping ADD Agricultural Development Division ADMARC Agricultural Developmentand Marketing Corporation AGOA African Growth and Opportunity Act AHL Auction Holding Limited APIP Agricultural Productivity InvestmentProgram ARET Agriculture Researchand ExtensionTrust BLNS Botswana, Lesotho,Namibia and Swaziland BOP Balance of Payments CAMA ConsumersAssociation of Malawi CEAR Central East African Railways CEM Country Economic Memorandum CET Common External Tariff COMESA Commonmarket for Eastern and Southern Africa CVD Countervailing Duty Procedures DACC DistrictAIDS Coordination Commission DANIDA DanishIntemational Development Assistance DEMATT Developmentof Malawi EntrepreneursTrust DffD Departmentfor Intemational Development DHS Demographic Health Survey DTBS DesignatedTobacco Buyers Scheme ECAM EmployersConsultative Association of Malawi EBA Everything But Arms EPZ Export ProcessingZone ESCOM Electricity Supply Commission of Malawi EU EuropeanUnion FEWS FamineEarly Warning System IB IntermediateBuyer FA0 Foodand Agriculture Organization ofthe UnitedNations FTA FreeTrade Area GDP Gross Domestic Product GOM Governmentof Malawi HAART Highly Active Anti-Retroviral Therapy HIPC Highly IndebtedPoor Countries IDA International Development Association IFC International Finance Corporation IHS IntegratedHouseholdSurvey IM Information Memorandum IMF InternationalMonetary Fund LDC Less DevelopedCountries LRS Local RegisteredStocks MASAF Malawi Social Action Fund MASlP Malawi Agriculture Sector InvestmentProgram MBS Malawi Bureauof Standards MCCCI Malawi Confederationof the Chambers of commerce and Industry MDC Malawi DevelopmentCorporation MDC Malawi DevelopmentCorporation MEPC Malawi Export Promotion Council MFA Multi-Fiber Arrangement MGF Matching Grant Facility MIPA Malawi Investment Promotion Agency MITCO Malawi Intemational Transport Company MMTZ Malawi, Mozambique, Tanzania and Zimbabwe MoAl Ministry of Agriculture and Irrigation MOHP Ministry of Health and Population MRA Malawi Revenue Authority MPRSP Malawi Poverty Reduction Strategy Paper MRFC Malawi Rural FinanceCompany MTL Malawi Tilecommunications Ltd. NABW National Association of BusinessWomen NAC NationalAIDS Commission NACP NationalAIDS ControlProgram NASFAM nationalsmall FarmersAssociation NCPl NationalConsumer Price Index NEER NominalEffectiveExchangeRate NFRA NationalFoodReserve Agency NGO Non-Govemmental Organization NPV Net Present Value NRA NationalRoadAuthority NSF NationalStrategic Framework NSO NationalStatisticalOffice ORT Other RecurrentCosts PCL PressCorporationLimited PER Public ExpenditureReview PROSCAP Technical Assistance to the Promotion of Soil Conservation and Rural Production PRSP Poverty ReductionStrategy Paper PSI Pre Shipment Inspection QR QuantitativeRestrictions QUAD Stands for marketsof US, Canada, EUand Japan RBM Reserve Bank of Malawi REER RealEffective ExchangeRate REPA RegionalPreferentialArrangement RPED Regional Programof EnterpriseDevelopment RTA RegionalTrading Agreement TROA RoadTransporter OperatorsAssociation SA SouthAfrica SACA Smallholder Agricultural CreditAdministration SUCOMA Sugar Corporationof Malawi SACU SouthemAfrican Customs Union SADC Southem Africa DevelopmentCommunity SEDOM Small EnterpriseDevelopmentOrganizationof Malawi SFFRFM Smallholder Farmers' FertilizerRevolvingFundof Malawi SGR Strategic GrainReserve SME Small and medium Scale Enterprise SMEF Small and Medium EnterpriseFund TAMA Tobacco Association of Malawi TBT Technical Barriers to Trade TCC Tobacco ControlCommission TEVETA Technical Entrepreneurialand VocationalTraining Association TIP targeted InputsProgram TNL telecommunicationsNetwork Limited USAID UnitedStates Agency for InternationalDevelopment USBOC UnitedStates Bureauof Census VAT Value Added Tax WTO World Trade Organization MALAWI CountryEconomicMemorandum Policies For Accelerating Growth Tableof Contents PrologueandDevelopmentsin2003-04 1 ExecutiveSummary.................................................................................. i Chapter 1: GrowthandPovertyReduction-RecentPerformanceandProspects A: Introduction......................................................................... 1 B: Recent Economic Developments................................................. 1 C: Poverty............................................................................... 4 D: Impact o f HIV/AIDS................................................................. 6 E: Prospects for Growthand PovertyReduction.................................... 10 Chapter2: CrossCuttingIssuesAffecting All Sectors A: Introduction............................................................................ 14 B: Macroeconomic Volatility........................................................... 14 C: Volatile Exchange Rate and Rapidly ChangingTrade Regime................ 24 D: HighCost ofTransport., ............................................................. 31 E: HighLevelsofCorruptionandWeak Governance.............................. 34 Chapter3: Agriculture A: Introduction.......................................................................... 37 B: Main, Features. Recent Agricultural Strategies. and Performance............. 37 C: Factors Behind the Poor Agricultural Performance.............................. 41 D: Suggestions for Reform............................................................ 50 E: Special Issues inthe Tobacco Sub-sector ........................................ 53 Chapter4: BusinessEnvironmentfor Manufacturing A: Introduction........................................................................... 59 B: Structure andPerformance.......................................................... 59 C: Constraints to the Performance of ManufacturingEnterprises................. 61 D: Suggestions for Reform............................................................. 68 Annexes .......................................................................................... 73 References .......................................................................................... 105 Map IBRD31130 LISTOFTABLES Table 1 Key Economic Indicators............................................................................ Summary o f Recommended Policy and Institutional Reforms................................. X Table 1.1 2 Table 1.2: 2 Evolution o f Dimensions o fPoverty duringthe 1990s.......................................... Social and Economic Indicators..................................................................... Table 1.3: 5 Table 1.4: Impact o f AIDS on Demographic Trends......................................................... 8 Table 1.5: 8 Projections -Base Case With Accelerated Reforms............................................. LongTerm Impact o fHIV/AIDS on GDP inMalawi............................................ Table 1.6: 11 Table 2.1: Factors influencing High Inflation and InterestRates............................................ 15 Table 2.2: Macroeconomic Framework Fiscal and Monetary Accounts ........... 23 Table 2.3: Textile Exports to the US............................................................................. 28 Table 2.4: Trend inthe Corruption Perception Index......................................................... 35 Table 3.1: Comparative Natural Resource Endowments and Indicators o f Intensification............... 38 Table 3.2: Agricultural Performance as per Official Statistics............................................... 39 Table 3.3: 42 ADMARC Participation inthe Maize Markets................................................... Exchange Rate Movements Relevant to Tobacco Earnings...................................... Table 3.4: 45 Table 3.5 Fertilizer Prices Comparison......................................................................... 48 Table 3.6: Fertilizer Consumption................................................................................ 48 Table 3.7: Malawi Tobacco Production Trends............................................................... 54 Table 3.8: Net Returns for (NASFAM) Smallholder BurleyGrowers...................................... 55 Table 4.1 59 Capacity UtilizationinManufacturing Sector..................................................... Share o f Value AddedinManufacturing by Sector............................................... Table 4.2: 60 Table 4.3: 61 Banks and Other Financial Institutions inMalawi................................................ Constraints on Private Business, Malawi and Africa.............................................. Table 4.4: 63 Table 4.5: Institutions inSupport o fBusinesses............................................................... 67 LISTOFFIGURES Figure 1.1: ProbableNumberof Deaths per 1.000 Survivors with and without HIVAIDS.............. 7 Figure 1.2: Reduction inthe Proportion o f Poor Under Alternative Growth Scenarios.................. 13 Figure 2.1: Mechanisms Behind HighInflation and Interest Rates.......................................... 14 Figure 2.2: Inflation and M2 Growth............................................................................ 16 Figure 2.3: Food andNon-Food Inflation during2001........................................................ 16 Figure 2.4: T-Bill Rate............................................................................................. 17 Figure 2.5: Interest Rate Spread................................................................................... 17 Figure 2.6: Distributiono f Commercial Bank Assets.......................................................... 18 Figure 2.7: Total Net Domestic Credit o f Government........................................................ 20 Figure 2.8: Volatility o fAid Flows.............................................................................. 21 Figure 2.9: Credit to Government from RBMand Open market Operations for 2001.................... 22 Figure 2.10: Trends inReal andNominal Exchange Rates..................................................... 25 Figure 2.11: MERandDiscretionary Imports................................................................... 26 Figure 3.1: 38 Malawi's Export Earnings.......................................................................... Smallholder Maize Yields........................................................................... Figure3.2: 40 Figure 3.3 MainAgricultural Export Prices.................................................................... 41 Figure 3.4: 41 Regional Comparison o fFertilizer Prices......................................................... Smallholder Average Gross Margins............................................................... Figure 3.5: 48 Figure 3.6: Comparative Tobacco Yields (KGMA)........................................................... 54 Figure 3.7: Recent Trends inMalawi Tobacco Auction Prices.............................................. 55 LISTOFBOXES Box 2.1: Anti-DumpingVersus Safeguard Mechanisms...................................................... 31 Box 3.1: The 2002 Food Crisis inMalawi....................................................................... 44 Box 4.1: Regulation and Incentives inLobbying............................................................... 68 Box 4.2: FirmCapacity Buildingthrough Matching Grants Scheme......................................... 72 ANNEXES Annex 1.0 CEM andthe MPRSP ..................................................................................... 74 Annex 1.1: ReasonsBehindGrowth Performance................................................................... 75 Annex 1.2: Poverty Measures and Average Consumptionby Region............................................... 76 Annex 1.3: 77 Impact o f HIVIAIDS inthe Region....................................................................... Sources o fIncome as a Percentageo fTotal Income Per Capita Per Day............................ Annex 1.4 78 Annex 2.1: PatternofTotal Financial Institutions Holdings o f T-Bills and RBMBills as o f December 79 An Econometric Modelo fInflationinMalawi ......................................................... 2001 ........................................................................................................... Annex 2.2: 80 Annex 2.3: Malawi: Central Government Operations Calendar Year 1993-2001................................ 82 Annex 2.4: Food Production and Food Inflation...................................................................... 83 Annex 2.5: Chronology o f Trade Liberalization Measures, 1988-98.............................................. 84 Annex 2.6: Bilateral, Regional, and MultilateralAgreements o fMalawi......................................... 85 Annex 2.7: Import Regimes.............................................................................................. 86 Annex 2.8: AGOA Eligible Items o fInterest to Malawi and their TariffRates.................................. 87 Annex 2.9: 88 Major Cases o f Corruption., ............................................................................... Corruption PerceptionIndex 2002 : Sub-SaharanAfrica............................................. Annex 2.10: 89 Annex 3.1: Reliability o f Agricultural Data........................................................................... 90 Annex 4.1: Holdings o fPress, MDC, and ADMARC............................................................... 95 Annex 4.2: Top Twenty Manufacturing Exports from Malawi..................................................... 96 Annex 4.3: Obstacles to Business Expansion., ...................................................................... 97 Annex 4.4: Tax Incentives Available to Manufacturing Enterprises inMalawi................................. 98 Annex 4.5: Malawi inRelationto 24 Countries inAfrica inTerms o f the Quality o f Institutions to Support Businesses......................................................................................... 101 Statistical Annex 1: GDP Growth by Sector. Constant 1994Prices.............................................. 102 Statistical Annex 2: 103 Malawi: Balance o f Payments................................................................. Central Governance Operations. Calendar Year 1998-2007............................... Statistical Annex 3: . 104 Acknowledgements This report was prepared as a part of the PRSP process. The report focuses on the problem of accelerating growth in Malawi, which is one o f the four pillars o f the poverty reduction strategy identifiedinthe PRSP. This report was prepared in close collaborationwith the Government of Malawi and draws upon the ongoing analytical and operational work in the World Bank. The Bank core team that prepared this report consisted of Sudhir Chitale (Task Team Leader), Lalita Moorty, Dilip Ratha, Aline Coudouel (Macroeconomic Analysis), Jorge Mwoz, Stanley Hiwa, Steve Jaffe (Agriculture), andTaziona Chaponda (Business Environment). Christine Kimes contributedto the HIV/AIDS section inthe report. The Bank team worked closely with a small counterpart team drawn from the relevant government ministries. The government counterpart team consisted of: Dr. M. Mkwezalamba, Ministryof Finance (MOF), team leader; Mr.T. Stimawina (MOF); Mr.Cliff Chiunda, National Economic Council; Mrs.Angela Mjojo, Reserve Bank o f Malawi; Mr.Z. D. Chikosi, Ministry of Agriculture; Mr. Brian Mtonya, Ministry o f Commerce and Industry; and Mr. Alick Sukasuka (MIPA). The peer reviewersfor this reportwere: Ataman Aksoy, Gene Tidrick, and Sandeep Mahajan. The report was prepared under the guidance o f Philippe HLe Houerou, Sector Manager (AFTPl) and Emmanuel Akpa', Sector manager (AFTPl). The report has benefited from comments by Darius Mans, Dunstan Wai, Hassan Zaman, Peter Moll, Antonio Nucifora, Basil Kavalslq, Robert Liebenthal, Barbara Kafka, KarenMcconnell Brooks, Alan Gleb, Alfred Kammer, Johan Mathisen, and Kristina Kostial. Zoe Vantzos edited the document and Rose Kumsinda provided excellent assistance indocument preparation. A green cover version of this report was discussed in a meeting chaired by the Governor o f the Central Bank Mr. Ngalande on Friday March 7, 2003. The meeting was attended by Government officials, members of the press, representatives o f the private sector, civil society and the University o f Malawi. Since then, this report has been further disseminated and has formed the basis for many o f the structural and macro reforms undertaken by the Govemment during2003-4. 'For the grey cover version o fthe report. Prologue and Developmentsin2003-04 A. Introduction 1. The purpose of this prologue is to summarize the main economic developments in 2003- 04 as well as the main reforms implemented by the government since a green cover version of this report was prepared and shared with the government inMarch 2003. Since early 2003, the government has continued to implement both macro and structural reforms designed to generate sustainable growth. The economic performance over the past year indicates that these efforts have had mixed results. As the discussed in Section C below, after adopting a macroeconomic framework inmid-2003 that ledto the conclusion of the first review o fthe IMF's PRGF program, the government repeatedly faced slippages on the fiscal targets. Inparallel, the government also implementedhitiated a number of important growth oriented structural reforms to improve parastatal management, restructure ADMARC and the food markets, improve the working o f the tobacco sector, and alleviate the impact of HIV/AIDS. All these reforms are in line with the development strategy outlined inthe main report and summarized inthe policy matrix attachedto the executive summary (Table 1) and are being supported by a Bank adjustment credit. While much has been achieved since the beginningof 2003, as discussed in Section D, much remains to be done in maintaining fiscal discipline, implementingthe next phase of the reforms in maize, tobacco and agriculture services, and the reforms to improve the business environment and trade. The CEM continues to provide a useful framework as the government moves into the next phase of reforms. 2. Inwhat follows, Section B describes the mainmacro and sectoral developments, Section C describes the main reforms and Section D describes the main areas where reforms needs to be further accelerated. B. Macro and Sectoral Developments in 2003-04 3. There has been a steady improvement inthe growth performance over the last three years (see Table A below). Growth rebounded from a negative 4.1 percent in 2001 to almost 4.4 percent in 2003. The rebound in growth could be mainly attributed to the rebound in agriculture to about 4 percent in 2003 from the droughthlood-induced decline in output during 2001-2002. Similarly, the rebound in industry in 2003 can also be attributed mainly to a rebound in agro- based industryfrom a very low base. 4. Despite some gains on the inflation front during 2002-03, sustainable macroeconomic stabilization continues to be elusive. Inflation measured by the NCPI reduced from nearly 30 percent in 2001 to about 10 percent in 2003. But this was accompanied by continued high real interest rates o f around 30 percent, which, as explained in Chapter 2 in the main text have traditionally made it difficult for the farmers and businessmen to plan ahead, invest and expand production. 5. As discussed in Chapter 2, the main reason behind these high interest rates is the high government domestic borrowing driven by a combination of high fiscal deficits and falling and unpredictable donor inflows. Duringthe past two years, the domestic balance' has grown from about 5 percent in 2001 to about 8 percent in 2002 (excluding maize imports of 4.4 percent of Domesticbalance is a measure ofthe revenues and expenditures that can be directly controlledbythe Government 2 GDP) and is projected to be reduced to 5 percent only in 20032. Fiscal slippages have been accompanied by a severe reduction in donor inflows (compared to budgetedamounts) forcing the government to borrow domestically to finance expenditure commitments made at the beginning o f the year. As discussed in detail in Chapter 2, the domestic borrowing was accompanied by the mopping up operations by the Reserve Bank o f Malawi. While this led to a moderationinmoney supply growth and lower inflation it has ledto highreal interest rates o f around 30 percent. Table A: Economic Trends in2001-2003 2001 2002 2003 2001-2003 GDP growth (constant, percent) -4.1 1.8 4.4 0.7 Agriculture* -4.7 0.7 6.8 0.9 Industry -6.4 0.5 8.2 0.8 Services -9.7 9.7 -5.0 -1.7 CPI (average increasefor the year) ( percent) 22.7 14.7 9.6 15.7 Food 17.6 16.0 13.1 15.6 Non-Food 26.9 13.4 10.0 16.8 Treasury bill rate (average. Ofthe year) 50.4 40.8 37.0 42.7 Exchangerate (MW$,PeriodAv.) 72.2 76.7 97.4 82.1 Money and quasi money growth ( percent) (end Year) 12.1 23.4 26.4 20.6 Current account balance(percent of GDP) Excludinggrants -12.6 -23.9 -17.0 -17.8 Including grants -6.8 -11.4 -8.0 -8.7 Gross international reserves (months of imports) 2.7 1.7 1.9 2.1 Fiscal balance( percentof GDP) ** Excludingofficial transfers -14.7 -14.5 -17.2 -15.5 Including official transfers -7.9 -7.7 -5.2 -6.9 Financedby: Foreign financing -0.2 -0.5 4.9 1.4 Domestic financing** * 8.1 8.3 -0.3 5.4 Domestic Balance**** 4.7 7.7 4.9 5.8 Sources: IMF, IFS, and Bank staff estimates *** Includes forestry and fishing. For fiscal data, year 2001 refers to fiscal year 2001-2002. The datafor year 2003 are therefore estimates. *** ****Includes statistical discrepancy. Domestic balance is defined as: Overall balanceexcluding grants, total interest, and foreign financed development expenditures. 'For fiscal data, year 2001 refers to fiscal year 2001-2002. The data for year 2003 are therefore estimates. 6. The balance of payments deteriorated considerably in2002 and 2003. The deterioration inthe current account deficit in2002 was mainly on account of large food imports that amounted to almost 4.4 percent of GDP. Although a large part of these were financed by donor humanitariangrants, 2002 also saw a sharp fall in balance o f payments support. Thus in2002 the government had to finance the higher current account deficit after grants by resorting to a combination o f a bridge loan from private foreign creditors and a draw-down of reserves. Although the need for food imports reduced in 2003, there was no resumption of broad based balance of payment support and consequently the overall balance of payments remained under strain and the gross reserves on average, have remained less than two months o f imports. Despite these pressures on the balance o f payments Malawi has continued to maintain a liberal trade and exchange system and meets the IMF's criterion for Article VIII. 7. Food Security. As in the past, the government continued to grapple with challenges of food insecurity and its fiscal impact caused by the sharp annual fluctuations in maize production during the past two years. As indicated Box 3.1 in the main text, the maize production inyear 2001-023was roughly 30 percent below the requirements, leadingto fears o f major crisis in2002- 03. The expected food crisis in 2002-03 was, however, successfully averted through a combination o f government and private sector imports financed by generous external assistance4. Inreality the shortfall in maize availability was less pronounced than originally feared; and both the donor community andthe government hadunderestimated the capacity ofthe private sector to respond to the crisis. In 2002-03 therefore the government had to bear the budgetary cost o f building a large stock o f maize' amounting to almost MK 7.4 billion (or about 4.4 percent of GDP). The food production situation in2002-03 season improved considerably. Summer maize production was expected to increase by nearly 27 percent over 2001-02. Thus during 2003104 consumptionseason, the government was obliged sell stock of maize including the SGRat a large subsidy. The cost of replenishingthe SGR amounting to 0.5 percent o f GDP6will have to be borne inthe 2004-05 budget. 8. Inresponding to the food crisis, duringthe course of the past two years, the government strengthened the management of the Strategic Grain Reserve (SGR). Rules for accessing the SGR were clarified and a committee consisting o f all major stakeholders was created to oversee the working o f the SGR. There have nevertheless been problems with managing the SGR. For instance, some of the maize accessed by ADMARC in January-March 2004, was not accessed following rules laid down by the government, raising issues o f governance. The government has recognized this issue and for the future, proposes to mange the access to SGR with increased sensitivity to governance and transparency. The government also initiated a medium term program for managing food security, including the preparation of a new food security policy and a reform of the ADMARC. This is discussed insection C below. The productionseasonstarts inNovember and ends inMay. This together with imports determinesthe availability for the subsequent marketinghonsumptionseason. The Governmentfood security operationswere supported by aIMF emergencyassistance($26million) and aIDA EmergencyDraughtRecovery Credit ($55 million) The government importedalmost 235,000 MTs o fmaize. After taking into account some sales and additionalhumanitarianassistance the Government was left with acarry over stock of 231,00 MTs of which nearly74,000 were inthe Strategic Grain Reserve(SGR). This will dependon the marketprice o fmaize. 4 C. Reforms Initiatedhmplementedin2003-04 9. As indicated in para. 1 above, over 2003-04, government continued to implement both stabilization and structural reforms with mixed results. Many o f the measures implemented over the past year in budget formulation, expenditure control, land, improving the tobacco supply chain, improving the food markets were in line with the reform program described in the C E M and summarized in Table 1 attached to the executive summary. In what follows, these reforms are described and are cross-referenced to the specific suggestions in Table 1 o f the executive summary. Stabilization Efforts and the Public Sector Reforms. 10. The broad logic o f the macroeconomic stabilization remains essentially the same as described in Chapter 2. As per the (revised in October 2003) macroeconomic framework adopted by the government, the key to reducingthe highinflationand interest rates is a reductioninbroad money (M2) growth from 26.4 percent in 2003 to about 10 percent p.a. by 2006 combined with reduced domestic borrowing by the public sector. The key to achieving this is a reduction o f the fiscal deficit (after grants), from about 5.2 percent o f GDP in2002, to a surplus o f 0.4 percent o f GDP by 2006 through strengtheningtax collection efforts, reducingnon-priority expenditures and implementing cost recovery measures announced in the 2003/04 Budget. The reduction in the overall fiscal deficit, together with anticipated inflows from donors, is expected to result in net repayments to the banking system o f between 2-4 percent o f GDP during 2004-06 and will result ina reduction inthe stock o f domestic debt from about 18 percent o f GDP at end 2003 to around 14 percent o f GDP by 2006. This will create a virtuous circle whereby reduced market borrowing by the government will result in lower interest rates (and therefore lower interest payments burden) and will create conditions for increased business lending and growth. 11. Since the beginning o f 2003, the government has had mixed success in adhering to the macroeconomic framework described above. The revenue and expenditure measures implemented in the first half o f 2003 brought the fiscal program in line with the macroeconomic framework and led to the conclusion o fthe first review o fthe PRGF inOctober 2003. Since then, however, the government has struggled to maintain the momentum o f reforms, especially expenditure control, on a sustained basis. Consequently there have been repeated slippages and delays in meeting the fiscal targets set out in the macroeconomic framework supported by the IMF's PRGF program. This has not only resulted inhigh inflation and interest rates but also has led to a slowdown and increased unpredictability o f donor funds creating a vicious cycle of increaseddomestic borrowing and macroeconomic instability. Reforms to Improve Public Finances. 12. Duringthe 2003-2004, the government implemented a number o f measures listed below to improve public finances. These measures, mainly took the form o f institutional innovations in budget monitoring, execution and control. While these improvements are welcome, their benefits interms o f improved fiscal outcomes will only be realizedwhen these changes are made to work and achieve their goals. Budgetformulation: The government completed a study to develop Medium Term Pay Policy (MTPP) in May 2003 with IDA assistance. A public service renumaration board was created and a pay policy advisor was appointed to help implementation o f wage reform. This is expected to result in a more predictable wage bill and a rationalized 5 structure of wages. In addition, a line was introduced inthe budgetto track HIV/AIDS expenditures. {See Table 1policy: A (i)} ' 0 Budget Execution: The Commitment Control System (CCS) and the Credit Ceiling Authority (CCA) system was strengthened by appointing Commitment Control Officers to eachvote to control expenditure. Public Finance Management, Public Audit and Public Procurement bills were formulated and passed by Parliament in June 2003. A fully functioning Directorate of Public Procurement (DPP) was created eliminating the Government ContractingUnit (GCU) clearance currently needed for public procurement. A fully functioning Internal Audit Unit (IAU) with Director and staff was created inthe Office of the Presidentand Cabinet (OPC). A Debt Management Strategy was prepared, adopted in2003 and is beingadheredto. Amendments to the Corrupt PracticesAct were approved by the Cabinet in2003, to make it easier for the Anti Corruption Bureau(ACB) to prosecuteand dispose off cases inatimely manner. {See Table 1policy: A (iv)} e Budget Monitoring and Control: The system of quarterly expenditure reports to be submitted to the Cabinet Committee on the Economy was strengthened. Pro-Poor Expenditures (PPEs) were identified and budgeted and actual expenditures are being posted on the website of the Ministry of Finance to enhance transparency and accountability. {See Table 1policy:A (i)} 0 Fiscal Decentralization. Inline with the framework for fiscal decentralizationdeveloped over the past ei ht years, beginning in January 2004, a program for decentralizing specific activities was initiated. Staff for carrying out these activities will be transferred 8 to District Assemblies and budgets for these activities will go directly from the MOF to the District Assemblies. So far agriculture extension services have been decentralized. The government is planning to decentralize primary health, education and collection of landrent inFY 04/05. {See Table 1policy:B (ii)} Parastatal Reforms. 13. During 2003, the reform of the telecommunication sector was completedby selectingthe preferred bidder for the eventual sale of the Malawi Telecommunications Limited (MTL). Cabinet approved a Power Sector Reform Strategy on January 22, 2003. Three new bills: the Energy Regulation Bill, the Electricity Bill, and the Rural Electrification Bill are under preparation. Approval of these bills by Parliament will set the stage for the appointment of transactions advisors for the privatization of ESCOM. Finally, during 2003 many ofthe non-core assets (ones that are not related to food security considerations) of ADMARC were either privatized or closed. These include: (a) David Whitehead and Sons - Sold; (b) Cotton Ginning Company - Sold; (c) Cold Storage Company (Blantyre Abattoire) - Sold; and Grain and Milling Company-broughtto the point of sale. (See Table 1policies: C (i)and B (i)} StimulatingAgricultural Growth 14. Land. During 2003, the governmenthas implementedimportant measuresto improve the efficiency and utilization of land. An intensive communication campaign in principal Malawian languages was launchedas a precussorto launch the new land law towards the end of 2004. In '*Thesenumbersrefer to the specific policy inthe policymatrix attachedto executive summary. The list of activities to be decentralized to district assemblies include: agricultural extension, primary education, primaryhealthcare and collection of landrent. 6 addition supported by an IDA grant, the government has launched a highly innovative programto acquire and redistribute land using a community and market based mechanisms. Land fees on leasehold estates that had not changed in more than 8 yearsgwere increased from MK5O/Ha to MK 500/Ha in 2003 and is proposed to be increasedto MK 1000/Ha in 2004. {See Table 1 policy: B (i)} 15. Tobacco. During 2003, the government also implemented a number of reforms in the Tobacco sector along the lines suggested in Chapter 3. The tobacco reforms can be grouped into three categories: e Immediate Impact Component -Reducing Institutional Levies: The profitability of tobacco production is depressed by the high level of the numerous statutory levies collected when tobacco is sold at the auction floor. During 2003, these levies were restructured resulting in an immediate 2.5 percent increase in farmers' gross proceeds from tobacco (amounting to a 25 percent increase in net returnkg)". {See Table 1 policy: B (iii)} e Marketing Component Improving Competitionin DomesticMarketing. The - government issued and widely publicized detailed operational guidelinesfor direct exports and contract farming o f tobacco. {See Table 1policy: B (iii)(b)} e Institutional Component -- Improving the Transparency and Inclusiveness of the Sector's Institutional Structure. As discussed in Chapter 3, the current institutional framework and governance structure of the tobacco sector is not representative o f the sector's stakeholders and lacks transparency and accountability". The government launched an in-depth policy, marketing and institutional review o f the tobacco sector in May 2004 and, based on its findings, the government will restructure institutions serving the tobacco industry. (See Table 1policy: B (iii)} 16. ADMARC and thefood markets. During2003, the government implemented a number o f reforms to improve the hnctioning o f the food markets and clarify the role o f ADMARC along the lines of the discussion in Chapter 3. The ADMARC law was repealed by the Parliament in December 2003 and ADMARC was incorporated under new statutes as a limited liability company for commercially viable activities. A performance contract will be signed between GOM and suitable implementation agencies for carrying out social activities and the budget subsidy to fund social activities will be clearly identified and capped starting with the 200405 budget. {See Table 1policy: B (i)} The current levelof landfees is equivalentto 10percentof its level in 1990 inrealterms, lo Withholding tax for farmers selling less than MK36,OOO worth of tobacco was eliminated. TCC levy was reduced from 0.13 centfkg to 0.10 centskg; AHL levy from 3.95 percent of gross proceeds to 3.25 percent of gross proceeds; the Hessian bag levy from 0.92 centhale to 0.30 centhale; ARET levy was frozen at 1percent of gross proceeds; classificationlevy and function was shiftedto TCC with a lower levy based on efficiency gains. TAMA levy was reduced from 0.85 centkg to 0.7 centfkg and, more importantly, in recognition o f the fact that the membership in TAMA and other grower organizations is voluntary, the levywas made voluntary. For instance, it would be usefulto increasethe representationof growers onthe board ofthe TCC. 7 Reforms to alleviate the impact of HIV/AIDS 17. Along the lines discussed in Chapter 1, during 2003 the government implemented a numberofpoliciesto alleviatethe impactof HIV/AIDS12.{See Table 1policy: A (v)} e Guidelines for General Grants to Districts were issued, specifying that HIV/AIDS interventionsare eligibleexpenditures. {See Table 1policy: A (v)} e At least 2 percent of the non-salary recurrent budget ("other recurrent transactions") was allocatedinFY (02/03) to and spent on HIV/AIDS interventionsinline with the public sector mainstreamingstrategy. (See Table 1policy:A (v)) D. Next Steps and UnfinishedAgenda 18. As described above, the government has made reasonable progress in implementingthe macro and structural reforms to create conditions for accelerating growth. However, much remains to be done in completingthe reforms that have been initiated and initiatingreforms in trade, transport and improvingbusiness environment. The key areas where effortsare neededare: Impressive beginning was made in addressing the HIV/AIDS, the reforms in this area describedinChapter 1needto be vigorously sustained. Macroeconomic stabilizationremains elusive. Here much remains to be done in completing wage restructuring, improving the mechanisms for expenditure control and monitoring as discussedinthe policymatrix. Impressivebeginningwas made to improve agriculture productionand productivity. For the coming year the reforms initiated in land, maize and tobacco need to be completed as outlinedin Chapter 3. Inaddition,the decentralizationo fMinistry ofAgriculture needsto be expandedas discussedinChapter 3 to improveservicesto farmers. Importantreforms needto be initiatedto reduce transport costs, facilitate trade and improve the business environment. Resolution of the problems in the Nacala corridor is urgent. Similarly the government needsto beginto address trade facilitationissues as analysed inthe recent diagnostic report on trade13. Finally, much remains to be done in simplifying the tdincentive structure (discussed in Chapter 4) and improve the reliability of electricity supply to improvethe businessenvironment for manufacturing. 19. Insum, the reforms initiatedby the government are in line with the broad development strategy described inthe CEM. We believethat the analysis inthe CEM, and the policy matrix attached to the executive summary will continue to provide a useful framework as these reforms are completedandnew reforms are initiatedto lay the basis for growth inMalawi. l2The Government's HIV/AIDSprogramis supportedby an IDA credit to support a Multi-donorAIDS Program(MAP). l3DTIS studyWorldBank. Malawi Policies to Accelerate Growth Executive Summary A. Malawi's Development Strategy and Growth i. Malawi's growthperformancesincethemid-1990shasbeenmodest,volatile, andhas worsened inrecent years. Over the past three years, per capita growth has been less than 1percent pa.' with private savingshvestment amounting to only 4 percent of GDP. Malawi's agriculture suffers from stagnation in yields, low profitability, and i s vulnerable to weather - making the economy prone to repeated food shortages. Manufacturing output has contracted over the past three years and capacity utilization is currently running at 50 percent. Poverty has remained virtually unchanged over the decade and currently nearly 60 percent of the Malawians live below the poverty line. Malawi's growth potential has also been severely affected by the onset of the HIV/AIDS crisis. At the end of 1999, the adult prevalence rate was nearly 16 percent placing Malawi among the 16countries with the highest HIV/AIDS incidence inthe world. .. 11. This report argues that the explanationfor the slow growth inMalawi lies not so much in the broad direction of its development strategy, but in the failure of its detailed and consistent implementation to reduce the risk facing key economic agents for participating in markets. The continued highly risky environment2 facing rural households, manufacturing enterprises, traders, and financial institutions arises due to three reasons. First, the macroeconomic environment over the past five years has been highly unstable. Highinflation; high, volatile real interest rates; and a volatile real exchangerate have resulted inunpredictable prices for inputsand outputs for farmers and businessmen and unavailability of credit for productive activities. Second, markets for important goods and services, such as maize and fertilizers, have not functioned well because unpredictable and sometimes significant government interventions have undermined the development of a competitiveprivate sector. Third, key government services have been weak and unreliable. The government's efforts at improving infrastructure - water, power, transport services, and rural roads - through corporatization or pri~atization,~although in the right direction, have been slow and incomplete. Other important services and institutions in support of rural households and businesses, such as land and irrigation services, agricultural research and advisory services, export promotion and business advisory services, administration of incentives, trade facilitation, and customs have all been suffered from lack of budgetary resources, highly centralized delivery mechanisms, and growing problems of corruption and weak governance. iii. TheslowgrowthinMalawithereforecanbeseenasalogicalresponseoffarmersand businessmen as they traded increased security for aggressive participation in the markets to achieve higher production and incomes. Farm households have retreated into low value subsistence crops, manufacturing firms have responded by simply scaling down their activities, Eventhis modestrate of growth reported inofficial statistics is likely to be overstateddue to problems in measuringagricultural output, as discussed inChapter 3. Highlevel of risk has beenidentifiedas an important explanation for slow growth inAfrica ingeneral. See: Collier and Gunning, "Explaining African Economic Performance", Journal of Economic Literature, Vol. XXXVII, March 1999. Ruralroadsthrough the creation of NRA. .. 11 traders have responded by collusive behavior4 and relying on government contracts for bulk of their businesses, and financial institutions have invested their resources in low-risk government paper rather than aggressively engaging inbusiness lending.5 iv. Accelerating growth in Malawi therefore requires implementing policies and institutional reforms in four areas listedbelow, and indetail inTable 1. 0 First,reforms are neededto reduce riskacross all sectors of the economy. This involves: (i)Creating a stable macroeconomic environment with low inflation and real interest rates. (ii)Reducing the volatility in the real effective exchange rate and managing the rapidly changing trade regime. (iii) Reducingthe cost and improving the reliability of the internal and external transport system. (iv) Addressing growing corruption and weak governance. 0 Second, reforms are neededto reduce the risk facing smallholder agriculture production. This involves setting up a reliable system for managing periodic food emergencies, implementing a program for enhancing agricultural productivity and improving marketing arrangements (supply chain) intobacco. 0 Third, reforms are needed to improve the highly risky business environment facing manufacturing enterprises by improving the reliability of infrastructure, making the taxhncentive regime simple, transparent, and less discretionary; and making the public and private institutions that support businessesmore responsive to their clients. 0 Fourth, reforms are neededto check the spread of HIV/AIDS, which significantly affects the growth potential of the Malawian economy. B. Prospectsfor Growth and Poverty Reduction v. IfMalawisucceeds inimplementingthe reformsdescribedabove (including aprogramto restrict the prevalence of HIV/AIDS at the present levels), it should be possible for the economy to grow by about 5.2 percent p.a. over the medium term. The higher GDP growth will be contingent on a higher export growth of 7 percent p.a. and an increase ininvestment from current levels of 11 percent of GDP to about 18 percent of GDP. An acceleration in growth will also require substantial external assistance,6 amounting to about $380 million p.a. or about 16 percent of GDP on average over the next three years, which is almost 15 percent higher than the assistancereceived over the past three years. vi. Achieving a steady and sustained growth of GDP of 5.2 percent p.a. over the medium term will not be easy. As the analysis of the HIV/AIDS carried out inChapter 1indicates, achieving a growth of 5.2 percent p.a. inthe presenceof HIV/AIDS i s equivalent to achieving a When petroleum imports were liberalized the five companiesbandedtogether into one company for the imports of petroleum to replacethe government monopoly. Similarly, companies importing fertilizer rely on NIP,adonor financed government program, or deal only with large estatesto generatethe bulkof their business. Inagriculture,for instance,the only commercially runcredit systemfor smallholder farmers that has survived inMalawiis one that relies on compulsory group repaymentenforced by the stop-order mechanismat the tobacco auctions. This systemis runby the MalawiRural Finance Company (MRFC) and cannot be expanded to cover other crops. Disbursementsof concessional loans and grants excluding HIPC debt relief. iii growth of nearly 6.2-6.7 percent p.a. inan economy without as higha prevalence of HIV/AIDS as inMalawi. Further, the 5.2 percentp.a. growth dependson successfully makingprogress onmany fronts especially the following "core" set of reforms. Vigorously implement the programto restrict HIV/AIDS. Achieve macroeconomic stability: low inflation and interest rates. Resolve problems inthe Nacala corridor and increase investment inrural roads. Create a reliable food security systemand better functioning markets for maize and fertilizers. Eliminate of bottlenecks inthe tobacco supply chain. Improve land managementand irrigation services. Increase reliability of electricity supply. Create simple, predictable and transparent tadincentives structure for businesses. vii. Ifthere is a slippage inany of the core set of reforms indicatedabove, under amoderate reform scenario, the economy would grow at a slower rate of around 4 percent p.a. Under this scenario, Malawi would achieve export growth of only 4.5 percent p.a. but will require a lower level of imports consistent with a lower GDP growth. Consequently the external assistance required for sustaining this scenario will be US$320 million for the next three years or about 15 percent lower than in the accelerated reform scenario. Finally, if there i s continued macroeconomic instability, lack of progress in improving agricultural productivity, privatization of infrastructure, and failure to resolve problems with the tobacco supply chain, the economy would be ina no reform scenario and would grow by only about 2 percent p.a. viii. Under the accelerated reform scenario, on the basis of a poverty elasticity of 1.073, the proportion of poor will fall from about 65 percent in2002 to around 38 percent by 2015. A lower growth of about 4 percent p.a. will reduce the number of poor to 44 percent and under a no reform scenario there would be no reduction in the proportion of poor. It is, however, important to observe that even in the first two scenarios where the proportion of poor would fall, the absolute number of poor who spend less than US25 cents per capita per day will continue to remain unacceptably highat between 4 -5.5 millionpeople. C. FactorsAffecting Risk Across All Sectors (i) Macroeconomic Volatility ix. Since 1995 inflation and interest rates in Malawi have been high and volatile. On average, the National Consumer Price Index (NCPI) has grown by 34 percent p.a. and has fluctuated between 7 and 75 percent p.a.; further, real interest rates have been around 20 percent. The overall inflation rate i s strongly correlated to the movements in the aggregate money supply that are, in turn, driven by the fiscal impact of the central government and the parastatal operations. The domestic balance' of the central government, which measures the direct impact of government operations on domestic absorption has been on average around 5 percent of GDP over the last five years and forces the central government to annually borrow between 2-3 percent of GDP from the market. In addition, there have been large unpredictable borrowings by parastatal corporations from the banking system. Domestic balance is defined as: Revenue - (Expenditure - Foreign Interest - Foreign financed DevelopmentProjects). iv X. The impact of the government operations on broad money, inflation, and interest rates i s exacerbated by the sharp/unpredictable intra-year borrowing from and repayments to the banking system. First, in the past five years, the government has not been able to issue long-term debt at reasonable interest rates. At end 2001, nearly 60 percent of the central government debt, amounting to about 7 percent of GDP, was held in the form of 91-day T- bills. This has meant that the government has to borrow between 3-4 percent of GDP every three months merely to roll over the debt falling due. If this debt i s not rolled over and paid back, it would release the equivalent liquidity in the economy and lead to inflation. Second, aid flows amount to almost 12 percent of GDP and finance 40 percent of the total expenditures. Since expenditures are budgeted and carried out in anticipation of aid, the government is obliged to borrow from the market if that aid i s delayed either due to the government's inability to meet the attached conditions or procedural problems. This could result in a sharp, albeit temporary, increase in market borrowings resulting in higher interest rates and inflationary expectations.* Third, poor financial performance of the parastatals, in addition to their directly borrowing from the market, often places unplanned fiscal demands on the central government resulting in unplanned borrowing from the market. xi. A reduction in inflation and interest rates will require strict adherence to a macroeconomic framework over the next three to five years. The macroeconomic framework currently formulated by the government aims to reduce the high levels and volatility of inflation and interest rates by restricting broad money growth to about 13.4 percent p.a. over 2002-2004, mainly through a reduction in the overall fiscal balance (after grants) from almost 8.9 percent of GDP in 2001 to a slight surplus in 2004. Given the limited scope for expanding revenues, this reduction in overall balance will require a reduction in the non-interest expenditures (excluding debt relief) of about 1.3 percent of GDP: from 18.0 percent of GDP in 2001 to about 16.7 percent of GDP by 2004. xii. Achieving the reduction indomestic non-interest expenditures as indicated above will not be easy and will require action on three front^.^ First, as discussed in the World BanUGovernment Public Expenditure Review (PER)," it shouldbe possible to realize savings by reducing outlays on general administration, consolidating all government operations at one capital city, reduction in foreign travel and allowances, and reducing waste, fraud, and corruption. Second,parastatal finances could be improved by better tariff setting policies, greater autonomy, and accelerated privatization program. Third, explicit budgetary provisions are needed for emergency food relief, together with the institutional reforms discussed in Chapter 3, to ensure that food security i s addressedwithout unplanned budgetary demands. (ii) Rapidly Changing TradingEnvironment xiii. Volatile exchange rates and rapidly changing trade arrangements have also contributed to the uncertain business environment inMalawi. * This is not an uncommon problem in sub-SaharanAfrican countiesthat receive large aid. See: Aies Bulir and A. Javier Hamann, "How Volatile and Unpredictable are Aid Flows and What are the Policy Implications?" IMFWorking Paper, WP/01/167, October 2001. The strategy of achieving such areduction while minimizing the adverse impact on growth and poverty is discussed inthe Public Expenditure: Issuesand Options (2001). loWorld Bank, Report NO. 2240-MAI, Malawi Public Expenditures, Issues and Options", Gray Cover, " September 2001. V 0 Volatility in Exchange Rates. Duringmost of the 1990s, the Reserve Bank of Malawi's (RBM's) policy of maintaining relatively stable nominal exchange rates through open market operations resulted in long periods of steady appreciation of the Real Effective ExchangeRate (REER) only to be followed by sharp devaluations when the appreciation inthe REERreachedunsustainablelevels. This ledto surgesindiscretionary imports and adversely affected profitability indomestic industryand exports. 0 Trade Agreements. Malawi is currently a member of Common Market for Eastern and Southern Africa (COMESA) and Southern Africa Development Community (SADC), has preferential market access to the European Union (EU) and United States, and has bilateral agreements with the Republic of South Africa and Zimbabwe. While the evolving trade agreements present Malawi with opportunities of expanded market access, they contain a number of risks, such as tax losses from the removal of tariffs and increased complexity of customs procedures due to multiple trade arrangements each with its own rules of origin. xiv. Suggestions for Reform. Malawi has made significant progress in liberalizing the exchange rate system since 2000, which has resulted in a more stable REER. The government's current policy i s to further reduce the volatility in the REER by limiting interventions in the foreign exchange markets only to meet the gross international reserve targets." Inthe future, the government plans to build on the recently introduced measures to further expand the market for foreign exchange" by further reductions inthe surrenderrequirements and working with financial institutions to develop instruments to hedge against risk of seasonalexchange rate movements. xv. The government also needs to help domestic businesses adjust to the rapidly changing trade agreements. Indomestic policies, this would require efforts to (i) strengthen the customs-, service-, and trade-related institutions to help exporters and importers respond to unpredictable changes in trading arrangements. (ii) Create capability to help industries take advantage of the African Growth Opportunities Act (AGOA) and the Everything But A r m s (EBA) arrangements. (iii) inplacesafeguardmechani~m'~allowedundertheWorldTradeOrganization(WTO)to Put protect industries from unfair competition, and (iv) strengthen the Malawi Bureauof Standards to provide improvedcertification services. xvi. Ininternationalnegotiations, Malawi's strategy shouldbe, (i)strengthen the capacity to within the government to negotiate and administer Regional Trade Agreements (RTAs) where the strategy should be to maintain access to South Africa as it i s potentially Malawi's largest trade partner. (ii) Continue to participate in both the COMESA and SADC and work within these organizations to lobby for lowest possible common external tariff (CET). (iii) Given Malawi's access to the EU markets under the Everything But Arms (EBA) agreement until 2008, the advantages of joining the EU's proposed Regional Preferential Agreement (REPA) at this point are not clear. However, Malawi needs to aggressively participate in the REPA discussions to ensurethat the current preferential access to SouthAfrica i s maintainedfor as long as possible. MovementsinMalawi's REER dependon the movementsinthe South African Rand, since the Randhas a weight of nearly 33 percentinthe estimation of Malawi's trade weighted REER.For instance, the appreciationinthe REER in2001 can be explained by a depreciation of the Randto aboutR13.2NS$. This, however, was corrected in2002 when the Rand strengthenedto about RlONS$ by end 2002. l2In2001, theRBMreducedthe surrenderrequirement to 40 percentof all export receiptsfrom60 percent, and temporarily increasedthe foreign exchange exposure limit of banks to 45 percentof core capital from 35 percent. l3This is different from antidumping. Antidumping appliesto countries and safeguards apply to products. vi (iii) Costly and Unreliable Transport Services xvii. High cost and unreliability of transport remains a major constraint to growth in both agriculture and manufacturing. Nacala, the cheapest route for Malawi's trade, continues to be beset with problems thereby, diverting nearly 70 percent of Malawi's trade through Durban, South Africa, which i s 50 percent more expensive. Malawi's internal transport costs are also high due to the poor network of secondary roads, trucking cartels that keep prices high, restrictions on the operation of foreign vehicles, and high taxation (including a 20 percent surtax) on the transport sector. xviii. Suggestions for Reform. Three actions are needed to reduce cost and improve the reliability of transport services inMalawi. First, more resources need to be allocated to buildand maintain rural roads and decentralize their planning down to the district assembly level. Second, the Government of Malawi needs to work with the Government of Mozambique to fix the Nacala corridor - the cheapest route to the sea for Malawi. There i s an urgent need to repair the 77 kilometer stretch between Cuamba and Entrelagos that i s damaged. Third, the government needs to improve the functioning of the domestic trucking market by creating a level playing field across foreign and domestic trucking companies by removing the restrictions on foreign trucks that allow goods to be delivered only at designated locations inMalawi. (iv) High Levels of Corruption and Weak Governance xix. Surveys of businessmen, farmers, and traders indicate that highlevels of corruption are a major obstacle to conducting business in Malawi. Further, there i s evidence that the extent of corruption has worsened since 1999. Malawi has a reasonable institutional and legal infrastructure for addressing corruption through public education, prevention, and enforcement. These institutions, however, suffer from lack of political support, low budgetary resources, and a weak court system for effective prosecution of highprofile cases. xx. Suggestions for Reform. The whole process of investigation and prosecution of corruption cases needs to be strengthened by garnering greater political support, better training, and more resources for the Anti-Corruption Bureau (ACB) and the Department of Public Prosecutions (DPP). Drawing on international experience, the government could also consider establishing an independent institution combining investigative and prosecutorial powers. A substantial effort needs to be launched to reduce the complexity and discretion and increase transparency inthe laws governing business environment. Finally, the government needs to bring about greater transparency in the use of public money with improved public procurement processes, better expenditure control, and clarification of responsibilities for budget execution between the Minister and the Permanent Secretary (PS) in the context of a comprehensive civil service reform. D. Creatingthe Environmentfor Agricultural Growth xxi. Agriculture accounts for about one third of GDP, but nearly 90 percent of foreign exchange earnings and 85 percent of employment. About 84 percent of the agricultural output comes from smallholders cultivating less than 1 ha, and the rest from large and medium estates mainly producing cash crops. Malawi's recent agricultural performance has been dismal, with low growth during 1994 and 1998 and almost total stagnation since then.14 Within this overall l4Agricultural statistics, especially those for root crops such as cassava and sweet potatoes, are weak. The analysis is basedon data on production and export data of main export crops and are more reliable. vii trend, there was a sharp decline inprofitability of nearly all crops due to declining yields and fall in prices. Further, during the 1990s there was a withdrawal into low risk, low value drought resistant crops for self consumption such as cassava, potatoes, and barley. Expansion into higher value crops such as groundnuts, beans, and pulses was minimal. xxii. Malawi's weak agricultural performance is explained by the highly risky environment facing smallholder farmers due to three fact~rs.'~ First, Malawi has not achieved food security. In five out of the past seven years, maize production has been insufficient to meet the domestic demand. Imports and domestic trade have been hampered by an undeveloped private sector, logistical bottlenecks, and frequent, unpredictable government interventions inthe maize markets. xxiii. Second, agricultural productivity in Malawi has stagnated due to weak and unreliable delivery of agricultural services. Nearly 32 percent of the total arable land remains unutilized16 due to regional imbalance, weak institutions to support land tenure, and an undeveloped land market. Similarly, much of the public spending on irrigation during the past five years has been on large-scale public irrigation schemes, whose performance has been disappointing because they are centrally administered with little involvement of farmers in management or operations. Both research and extension services in Malawi suffer from lack of budgetary resources as well as institutional problems in service delivery. Fertilizer prices in Malawi remain nearly three times the world market prices and at least 20 to 50 percent higher than those in the neighboring landlocked countries due to (i) hightransport costs and (ii) share of fertilizer trade undertaken the by public organizations i s almost 40 to 50 percent of the total trade and has fluctuated unpredictably. This has constrained the sustained expansion of the private sector in fertilizer trade. Malawi's rural credit system i s currently under considerable strain due to falling profitability, highinterest rates and low recovery. Further, MRFCthe mainrural credit institution i s seriously undercapitalized. xxiv. Third, the tobacco sub-sector, which accounts for 80 percent of Malawi's exports, is beset by declining yields and unreliable marketing arrangements. Auction Holding Limited (AHL), the sole auctioning company, charges growers a high fee for participating in auctions. The government policy on private-sector tobacco buyers -the Designated Tobacco Buyer System (DTBS)- has been unclear. The performance of the satellite depots managedby the members or counselors of Tobacco Association of Malawi (TAMA) has been inconsistent and the existing system of delivery quotas at the auction floor i s not functioning well, resulting in long lines at the Lilongwe auction floor. xxv. Suggestions for Reform. The core agenda for agricultural reform would involve addressing the problems identified above. a Food Security and the Maize Economy. Setting up a workable food security system involves action inthe following four areas: Create a robust early warning system based on which the government could raise aid resources, borrow, or make budgetary provisions to finance food imports. Donations inkind as well as grain held in the strategic grain reserve (SGR) would be monetized at auctions at designated sites. The proceeds together with all other financial resources would flow to a fundfor assistanceto affected people. l5 Inaddition to the factors that affect all the economy described above inSectionB. l6 Currently nearly 400,000 hectares o f estate lands and another 400,000 hectares of public or quasi-public land are unutilized. ... V l l l Assistance to affected people would be largely through cash transfers, food stamps, or vouchers, probably with community-based targeting mechanisms. The government would facilitate the private sector to procure maize locally through imports or by purchasing at auctions and selling it on a commercial basis. Creating the food security system described above would take time and sustained efforts in three areas. First, the private sector engaged in the maize trade needs to be nurtured and strengthened by making all government interventions in maize markets predictable and transparent, holding joint consultations on government plans to distribute food aid, and sharing information on domestic and foreign maize markets. Second,the government needs to increase resources for rural roads and target them to inaccessible areas to facilitate the entry of the private sector. Third, the government needs to strengthen income augmentation programs such as the public works program and pilot the cash transfer or voucher program so that they could be rapidly expanded in times of food shortage. e StrengthenAgricultural Services to Zmprove Productivity.To increasethe availability of land, the government should approve a new Land Act based on the new land policy and implement a community-driven land redistribution program. The delivery of irrigation services could be improved by transferring the management of the irrigation budgets including the proposed irrigation fund to the District Assemblies and limiting the role of the Irrigation Board to regulatory issues. Extension services to smallholders could be improved if their delivery is decentralized to the districts, private providers, and farmer's organizations while the Ministry focuses on policy and sector analysis. Agricultural research could be made more effective by introducing a program of competitive grants and public-private cost sharing for designated research projects. Reducingfertilizer costs would require, removing the transportation bottlenecks (Section C), establishing a mechanism for collaborative logistical planning of imports and minimizing the extent of government involvement in direct import and distribution of fertilizer. To improve the functioning of the rural credit system, the government could strengthen MRFC by: (i) increasing the equity base for MRFC either through appropriate budgetary transfers or channeling donor resources and (ii)finding a strategic partner prepared to bring in resources and know-how. e Reduce Costs and Remove Bottlenecks in the Tobacco Marketing System. The reform objective for the tobacco marketing system should be to provide the grower with as many channels as possible to market his product. This would involve: (i) developing the Designated Tobacco Buyer System (DTBS) system with transparent rules for licensing buyers and their area of operation. (ii) Encouraging existing transporters and rural input retailers to offer competing satellite depot services. (iii) Treating Auction Holding Limited (AHL) as a regulated monopoly and negotiating reduced auctioning fees and statutory levies. (iv) Piloting direct exports of tobacco with large growers of flue-cured tobacco. (v) Revamping the grower registration system and strengthening the statistical and monitoring capability of the Tobacco Control Commission (TCC). E. Improvingthe BusinessEnvironment for Manufacturing xxvi. Malawi's formal manufacturing sector i s small, amounting to about 13 percent of GDP and employs about 3 percent of the total labor force. Output in Malawi's manufacturing sector has been stagnating over the past five years and has in fact contracted over the last two years by i x 2.5 and 1percent respectively. Capacity utilization duringthe past five years has been runningat about 50 percent, and private investment has fallen from 8 percent of GDP in 1995 to only 2.7 percent of GDP in2000. xxvii. Poor performance of manufacturing can be traced to the highly risky environment faced by manufacturing firms engaging in production and trade due to: (i)highly unstable macroeconomic environment. (ii)Costly and unreliable infrastructure - water, electricity, and telecommunication services.17 (iii) The current system of duty drawbacks and rebates, while generous, are complex, non-transparent, and highly discretionary. Further, all enterprises face delays in obtaining tax refunds, which impose additional costs on businessmen due to the high interest rates. (iv) While Malawi has a large number of institutions" in the private and public sectors to support businesses, these institutions have not been successful in assisting manufacturing enterprises in improving their competitiveness due to inadequate budgetary resources, overlappingresponsibilities, and unclear mandates. xxviii. Suggestionsfor Reform. In addition to addressing the cross-cutting issues discussed in Section B, action in the following three areas is needed to lay the basis for growth in manufacturing enterprises. Vigorously push ahead the privatization of basic infrastructure, namely telecommunications, power, water, and Air Malawi, within a liberalizedregulatory framework. Implement a program for the rationalization of taxes and incentives, decrease the time taken to process tax refunds by automating the processing at the Ministry of Revenue Authority, simplify and eliminate discretion in the incentives given for investment and export promotion, develop a mechanism for monitoring the EPZ system and link incentives to export performance. Following up on the rationalization of incentives, consider merging institutions to save on budgetary resources and clarify responsibilities. One possible candidate i s the merger of MIPA, MEPC, and the staff in different ministries administering the EPZ system into one institution. Further, this merged institution could focus more on the assisting businesses through providing regular marketing information, outlining the implications of trade agreements, and work to simplify the procedures for establishing new businesses rather than administering incentives. l7 '*HighcostofCommerceandIndustry, of transport discussedinSectionC. Ministry Bureauof Standards,MPEC, MIRTDC,MIPA, BusinessRegister, etc. See Table 4.5 inthe maintext. X Table 1. Summary of RecommendedPolicy and Institutional Reforms Probledssue Timing SuggestedPolicyIInstitutionalReform ST: Immediate MT: 2-3 years STMT: Initiate immediateactionand sustainover medium refUyess term Cutting sues MT Restrict money supply growth to around 14percentp.a. macroeconomic volatility. STMT Reducedomestic non-interestexpenditurefrom 18 Adhere to apre- percent in2001 to 16.7 percentof GDP by 2004 by announced adopting measures outlined inthe PER. macroeconomic framework. STMT Improve expendituremanagementthrough measures outlined inthe PER. MT Improve monitoringand managementof foreign aid flows. MT Build5 monthsof reservesto insulatedomestic expenditures from fluctuations in aid flows. Createan open and competitive tradereiime. Maintaina ST/MT Adhere to a macroeconomicframework as above. competitive real exchange rate. STiMT Minimize interventions inthe foreign exchange market subject to amaintaining areservetarget of approximately 5 months of imports. M T Encouragethe developmentof aforward market for foreign exchange. Furtherreducesurrender requsementsfGr major exporters. Reducerisks and Indomesticpolicies: exploit opportunities M T Put inplace safeguardmechanismsfor domestic presentedb a industries as allowed under the WTO rules. rapidly evor"ving trade environment. M T Strengtheninstitutions for trade facilitation such as MalawiBureauof Standards and Customs. M T Help domestic industries access AGOA and the EBAof EUthroughmarketing assistanceand government-to- governmentcontacts to resolve trade issues. Inexternalpolicies: ST Stren then capacity for negotiating and making the best use ofRegiona1Trading Agreements (RTAs). ST Whenjoining aRTA, lobby for the lowest possible common external tariff. M T Belongto as large aFreeTrade Area (FTA) as possible while maintaining access to the South African market. xi Reducetransport costs ST / Mozambicanpart of the Nacalarailway and the Nacala port. ST Rehabilitate the railway track betweenCuamba and Entrelagos. ST Be proactive in improving competition on trucking routes inand out of Malawi. Createalevelplayingfield betweenforeign and local trucking operators. ST Improve rural road network by increasingresourcesfor maintenanceand transferring planning and management of rural roadsto District Assemblies. Reducecorruption and M T & improve governance. resourcesfor staffing andtraining. Explorethe possibility of creating a single institutionwith both investigative and prosecutorial mandate. ST Restructurethe tadincentive systemto reduce discretion, as inC (iii)below. S T N T Implement a comprehensivecivil servicereformand improve expendituremanagementto eliminate the misuse of public resources. Implementaprogramto ST Strengthenthe NationalAids Commission (NAC) to addressHIV/AIDS. enableit to coordinate the national multi-sector effort. S T N T Increasefunding and coordinate donor effort for the National Strategic Framework (NSF), for HIV/AIDS, which contains clearly identifiedpriorities. e Environment for Agrict ural Growth ST an ear Improve the systemsfor Improvet e early warning systemto a owand appealfo!international assistanceinc:sh kinfi: managing.food emergencies. ST Createa strategic grain reserve(SGR)of maize. Monetize donationsinkindat designatedauctions. Place MT Food roceeds from the auctionsand assistanceincash ina security contingency fund. Assist affected people through vouchers, food stamps, or MT similar instrumentsthrough community basedtargeted mechanisms. Facilitate the rivate sector to handle the import and S T N T distribution o rfood on acommercial basis. productivity. -- xii Improveagricultural T Approve a new land act basedon the new landpolicy. irri-gationservices. STMT Implement a community driven land distribution I programfollowing the successfulMASAFmodel. Usesmall irrigation schemes rather than largepublic STMT irrigationschemesto expandirrigation. M T Inline with the new irrigationact, devolve irrigation expendituresto the District Assemblies and involve localcommunities inplanning andexecution of irrigationprojects. Accelerate the decentralizationof theprovisionof agricultural services. As per MASIP initiate the decentralizationof the Ministry of Agriculture. Expandthe currently successfulPROSCAP model to the national scale. STMT Introduce aprogram of competitive grants for designatedresearchprojects, and developresearch agendajointly with NASFAM and other NGOs. M T Increasethe share of funding for extensiongoing directly to the RDPs. Reducethe cost of ST Establish a mechanismfor the 'oint logistical planning fertilizers. for import and distribution of 2ertilizer. STMT Withdraw public sector from direct importkale of fertilizers and facilitate the entry of private sector. M T Use vouchers to strengthenlinkage between smallholders and the private sector. Improve access to rural ST StrengthenMRFC finances through increasingits credit equity base. STMT Finda strategic partnerpreparedto bringinresources and know-how. M T Avoid creation of new subsidizedcredit schemes. Improvethe environment for tobacco production and marketing. M T Reducecosts of transport as inA (iii) above. tobacco. M T Strength NASFAMandrestructureTAMA. M T Strengthenthe ARET programof research. ... Xlll Improvemarketing ST Revampthe grower registration system. arrangements ST Reduce AHL's auctioning fees and other statutorylevies and restrict withholding tax to large estates. MT Supportemergenceof competing services to the satellite depots. ST Pilot direct exports for few large growers of flue-cured tobacco. ST Develop transparentnon-discriminatory rules for the operation of the DTBS systemwhich has replacedthe IB system. c 0 ve BusinessEnvironmentfi 8Manufacturing Improve infrastructure STIMT Acceleratethe ongoing private sector services. participation inthe provision of infrastructure servicesunder a liberalized policy framework. -(ii) Improve access to finance. ST s below market rate. ST Approve and adopt the new microfinance policy. Revisethe regulatory framework to allow microfinance institutions to mobilize savings. (iii) Improve the complex, non- ST Speedup the processingof surtax refund on ~ transparent, and transportandreplacethe turnover by a more discretionary tadincentive reasonableproxy for income to calculatethe system. income tax. ST Strengthenthe MRA to speed up the processing of tax refunds. ST Rationalize and simplify the potential1 overlapping incentives offered under t e Export rl ProcessingZone (EPZ), Manufacturing inBond, and the Industrial RebateSchemes. Especially eliminate the highly discretionary Section52 of the income tax act. ST Improve the monitoringof the Export ProcessingZone to ensure that the firms meet the necessaryexport obligation. FT 7 SI' Buildahighlevelforum for public private sup ort and public private consultation. diaigue ST Rationalize public institutions with overlapping responsibilities. Consider merging MIPA, MEPC, and staff administering the EPZ system. Chapter 1 Growth and Poverty Reduction -Recent Performance and Prospects A. Introduction 1.1 Despite early successes resulting from a new development strategy adopted since the mid-1990s, official statistics show that Malawi's economic growth performance has beenmodest, volatile, and inrecent years has even worsened. The economy remains vulnerable to droughts and is beset by erratic fiscal performance. Furthermore, poverty in Malawi is widespread and severe - it has remainedunchanged over the last decade and gains from reforms are beingunderminedby the prevalence o f HIV/AIDS.A reversal ofthese trends and an acceleration in growth will require vigorous implementation of reforms to reduce macroeconomic volatility, improve agricultural productivity, improve the business environment for manufacturing, and alleviate the impact of HIV/AIDS. If these reforms are implemented, Malawi could grow by about 5 percent per year over the mediumterm, leading to a nearly 30 percent reduction inpoverty levels by 2015 from its present levels. If,however, there is slippage in the core set of reforms, growth would be reduced to 4 percent per year, corresponding to a more modest reduction inpoverty. The absolute number o f poor under bothscenarios will, however, continue to remain high. B. Recent Economic Developments (0 Past Pattern of GDP Growth 1.2 Like much of sub-SaharanAfrica, Malawi is largely a rural economy. Nearly 85 percent of the population lives in rural areas and only 10 percent of the population is engaged in formal sector wage employment. Agriculture accounts for 33 percent of the country's GDP, while manufacturing accounts for only 12 percent. Nearly 22 percent of Malawi's GDP comes from the distribution sector and is mainly accounted for by trading and retailing activities, most of which are based inor linkedto the rural economy. Very little diversification of output took place during the last decade except withinagriculture, where the share o f small-scale agriculture has increased while that of large-scale estate agriculture has stagnated. 1.3 Duringmost of the 1990s, Malawi's growth performance was modest. Official statistics show that since 1995, the GDP has grown on average by about 3.0 percent per annum, which is about 0.8 percentage points above the population growth rate of 2.2 percent. The trends also indicate that economic growth performance has worsened recently (Table 1.1). GDP grew by 1.4 percent per annum during 1998-01 compared to 4.6 percent per annum during 1995-98. According to official statistics, Malawi's growth has been better than the sub-Saharan Africa average, better than other landlocked neighboring countries such as Zambia and Zimbabwe, but i s significantly lower than Mozambique and Uganda(Table 1.2). 1.4 Eventhe observed modest growth reported in official statistics is likely to be overstated. Agriculture, a primary component of the economy, accounts for 33 percent o f GDP, and much of GDP growth during 1995-01 can be traced to agriculture's highgrowth rate o f almost 6.7 percent per annum. However, an analysis carried out in Chapter 3 indicates that these high growth rates are inconsistent with the trends in crop production, yields, and the implied household caloric consumption. In addition, the per capita consumption data from the IntegratedHousehold Survey (IHS 1998) and the relatively unchangingsocial indicators, as discussed inthe section on poverty later in this chapter, imply a much lower growth in per capita GDP than reported in official statistics. 2 Table 1.1: Key Economic Indicators 1995 1996 1997 1998 1999 2000 2001 1995-98 1998-01 GDP Growth(constant, % p.a.)* 16.7 7.3 3.8 3.3 4.0 1.7 -1.5 4.6 1.4 Agriculture** 39.6 25.5 0.0 2.7 11.2 5.7 -8.5 7.6 2.7 Industry 4.6 8.6 -0.1 1.2 2.5 -0.5 0.6 2.8 0.9 Services 8.9 -0.8 8.3 4.6 2.6 0.6 3.0 3.6 0.8 CPI(end-of-period,%) 74.9 6.7 15.2 53.1 28.2 29.6 27.2 37.5 35.4 Treasury Bill Rate 46.3 30.8 18.3 33.0 42.9 39.5 41.7 32.1 39.3 ExchangeRate(MW$, Endo f Period) 15.3 15.3 21.2 43.9 46.4 80.1 65.2 23.9 58.9 Money andQuasiMoneyGrowth (% p.a.) 56.2 39.6 2.1 60.0 26.5 42.4 12.1 *** 39.5 35 CurrentAccount Balance(% of GDP) Excludinggrants -12.0 -12.0 -15.7 -10.3 -16.9 -14.2 -12.9 -12.5 -13.6 Includinggrants -1.4 -7.6 -12.2 -0.8 -8.2 -5.3 -7.3 -5.5 -5.4 GrossInternationalReserves (months o f imports) 2.3 3.6 2.1 4.6 3.2 4.4 3.6 3.2 4.0 FiscalBalance(% o fGDP) **** Excludingofficial transfers -12.4 -7.2 -9.0 -11.5 -12.6 -15.0 -15.9 -10.0 -13.7 Includingofficial transfers -A I .., -2.8 -5.6 -5.1 -5.6 -5.8 -8.9 -4.6 -6.4 Sources: IMF, IFS, andWorldBank staffestimates * Growthrates from 1995-98 and 1998-01are leastsquares estimates ** Includesforestry and fishing. *** Firstthree quarters **** Fiscalyear 1995 refersto 1995-96 Table 1.2: Social and Economic Indicators (Latest year available) Botswana Kenya Malawi Mauritius Mozambique S. Africa Tanzania Ueanda Zambia Zimbabwe GDPPer Capita (constant 1995US%) 3951 328 157 4429 195 3985 193 355 392 656 GNIPer Capita, PPP(currentUS%) 7190 1010 600 9940 820 9180 530 1230 750 2590 Growth of Per Capita GDP 3.2 0 3.5 4.5 5.2 0.7 1.6 4.2 -0.6 0 1995-2000(%pa.) Life Expectancyat Birth 39 48 39 71 43 48 45 42 38 40 Under4 Mortality Rate (per 1,000 live births) 95 118 227 23 203 76 152 162 187 118 Adult Illiteracy (% of peopleages 15 and above) 23 18 40 15 56 I S 24 33 22 11 Gin1Coefficient .. 045 0.40 040 0.59 038 0.39 0.50 0.57 PercentShare of IncomeIConsumptionofthe Lowest 10% of Population 1.80 2.50 2.50 1.10 2.80 2.60 1.60 1.80 PercentShare of IncomelConsumptionof the Lowest 20% of Population .. 5.00 6.30 6.50 2.90 6.80 6.60 4.20 4.00 Survey Year 1994 1997198 .. 1996197 1993194 1993 1992193 1996 1990/91 Source. WorldDevelopmentIndicators 1.5 Low growthduringthe 1990s has beenaccompaniedby a highdegree of macroeconomic volatility, with sharp falls inoutput followedby periods of recovery. There are three mainfactors behindthe observed volatility (Annex 1.1). First,the economy is highly vulnerable to droughts - 3 the fall in output during 1994 and low growth in 1998 and 2000 can be directly traced to droughts. Second, sharp deterioration in fiscal performance in 1994 and during 1998-01 has affected growth through high inflation and interest rates. Third, on the positive side, rapid recovery during 1995 and 1996 can be traced to the acceleration in the implementation of reforms, especially the liberalization o f smallholder agriculture. (ii) Savings and Investment 1.6 Investment rates in Malawi are low and falling. Gross fixed investment has fallen from about 14 percent of GDP in the early 1990s to only around 10 percent of GDP in 2001. Private investment has only been around 2-3 percent o f GDP, the rest beingpublic investment primarily directed to health, education, and rural roads, which is financed by external aid. In terms of savings, domestic saving rates are low in Malawi - even by developing country standards. Gross domestic savings averaged about 4 percent during 1994-01, compared to 16.6 percent in sub- Saharan Africa and 20.5 percent in low-income countries during 1994-99. Most o f the domestic savings in Malawi are private savings, while government savings are low or negative in many years. (iii) Balance of Payments 1.7 Due to external sector reforms implemented since 1996, Malawi now has a market- determined exchange rate, no export tax, no quantitative restrictions on imports, and a low average tariff rate of 12 percent.' Malawi's current account deficit before grants is large - 14 percent o f GDP over 1998-01. However, most of it has been financed through grants and highly concessionary loans. Malawi has, therefore, been able to maintain foreign exchange reserves above 4 months o f imports during 1998-01 and have no restrictions on its trade account.2 1.8 Malawi is highly dependent on tobacco for its export earnings, making export earnings highly vulnerable to the price o f tobacco. Tobacco accounts for about 65 percent of the total exportsY3followed by tea and sugar, which account for about 8 percent each. Intotal, nearly 90 percent of Malawi's exports are agricultural commodities. Manufacturing exports account for about 10 percent o f Malawi's total exports, these include mainly textiles, clothing, furniture, and some food processing items such as biscuits. Export of services is very low. Tourism - a major source of earnings for other countries in the region - is only 1 percent of export revenue and is declining. 1.9 Malawi is a highly open economy where imports amounted to nearly 34 percent o f GDP in 1998-01. Duringthis period, oil accounts for only 10 percent of total imports and nearly 65 percent is manufactured commodities such as vehicles, electrical and non-electrical cement machinery, and agricultural inputs such as fertilizers. 1.10 Malawi has faced declining terms o f trade since 1995 (see Table 2.1 inChapter 2). This is mainly due to falling tobacco prices and increasingprices o f manufactured commodities and oil. Terms of trade improved slightly in 1999 and 2000 because during this period the continued decline in tobacco prices was more than compensated by the sharp decline in the price o f oil. Terms of trade have, however, declined in 2001 and are expected to further decline in 2002 mainly because of further weakening o f tobacco prices and stabilizing oil and manufactured commodities prices. Malawi's trade regime is discussedindetail in Chapter 2. Malawi meets article VI11o fthe IMF. This is one ofthe highest level o f dependenceof exports on a single commodity inthe world. 4 1.11 Malawi is much more dependent on foreign aid to finance the BOP than most other African countries - foreign aid is nearly 15 percent o f GDP. This high dependence on aid, most of which finances public expenditures, creates special problems for intra-year monetary management and is an important factor behindthe observed fiscal volatility. In 2000, Malawi's external debt amounted to 146 percent of GDP -eventhough most of the debt was official debt at highly concessional terms. Consequently, Malawi's ratio of debt service to exports o f goods and non-factor services was 21 percent and the NPV of the debt/GDP ratio (on an accrual basis) was 86 percent. This made Malawi a highly indebted country eligible for HlpC relief. Malawi was granted HIPC relief, amounting to 42 percent of its debt, after reaching the decision point in December 2000. When Malawi reaches the completion point in 2004, the baseline NPV of the debt/GDP ratio is projectedto reduce to 50 percent from the presentlevel o f 86 percent. (iv) FiscalAccounts4 1.12 Since 1995/96, domestic revenues moved within a narrow band o f 15-18 percent of GDP. Duringthis period, the composition of revenues underwent a change. Simplification of the tariff structure and reduction in rates led to a fall in trade taxes from 4.3 percent in 1997/98 to 2.0 percent of GDP in2000/01. This decline inrevenue from trade taxes has been offset, inpart, by a rise in income taxes from 5.6 percent in 1995/96 to 7.5 percent in 2000/01. Tax revenues from goods and services have also risen from 5.5 percent in 1995/96 to 7 percent of GDP in2000/01. 1.13 Total expenditures have fluctuated within a wider band o f 23-30 percent o f GDP since 1995/96 and current expenditures averaged 20 percent o f GDP during this period. Development expenditures rose from 6.4 percent in 1995/96 to 10 percent of GDP in 2001/01. However, most of the recent rise indevelopment spending can be attributed to better recording of previously off- budgetaid projects. 1.14 The centralgovernment fiscal deficit (before grants) fluctuatedbetween 7-14 percent since 1995/96.5The deficit has largely beenfinanced by foreign grants, which averaged 6.4 percent o f GDP duringthis period. The resultingdeficit after grants amounted to 4.6 percent on average since 1995/96. The deficit after grants has been largely financed by concessional foreign loans, leavinga small amount to be financed by domestic borrowing. Although annual domestic borrowing figures are low, they mask sharp intra-year variations. These fluctuations are caused by periodic unplannedincreases inexpenditures as well as delays indonor financing. C. Poverty 1.15 Poverty in Malawi is widespread and severe (Annex 1.2). In 2000, measured by the headcount index, nearly 60 percent of population lived below the poverty line.6 The income distribution in Malawi is also highly unequal - Malawi has a Gini coefficient of 0.4, and the lowest 10 percent of the population accounts for only 2.5 percent o f the consumption. The incidence o f poverty is higher in rural areas than in urban areas - nearly 61 percent o f the rural population and 51 percent o f the urban population live below the poverty line. However, inequality is higher in urban areas (Gini: 0.52) than in rural areas (Gini: 0.37). The variation in poverty across Malawi's three regions -south, central, and northern-i s not significant. See MalawiPublicExpenditures: Issues and Options(September 2001) for amore detailed discussion. The deficit includesdirect transfers to parastatalsand parastatal debt absorbedby the government, but not contingent liabilities arising fromparastatalborrowingsthat are not likelyto be repaid. The poverty line is defined as expenditure neededto afford minimumnutritional requirementsanda basketof basic non-foodgoods and services. 5 1.16 Income poverty is also reflected in poor social indicators in Malawi. Malawi has a life expectancy at birth of only 37.8 years, under-five mortality of 189 per 1,000 live births, and nearly 49 percent of the children are stunted, Le., have low height for their age. All social indicators are worse inrural areas compared to urban areas. 1.17 Available evidence indicates that poverty has largely remained unchanged during the 1990s. The methodology adopted inthe 1997/98Integrated Household Survey (IHS), the basis of the latest poverty estimates, is not comparable to earlier surveys. Nevertheless, other indicators' suggest that overall poverty has remained relatively unchanged during the 1990s(Table 1.3), with the exception o f maternal mortality rates, which have risen sharply while life expectancy has fallen during this period. Other indicators, such as percentage o f stunted and wasted children, have, on the other hand, remained unchanged over 1992-00.8The unchanging level o f poverty over time suggested by the DHS and the I H S numbers is in sharp contrast with the per capita growth in aggregate GDP and consumption of almost 1 percent p.a. over 1995-01 as reported in the national accounts. 1.18 The overall stagnation of poverty duringthe 1990s was also accompanied by an increase in urban poverty. Surveys carried out in the early 1990s show that in relative terms, the proportion o f urban poor was only half of those in rural areas, whereas by 1998, it was almost as much as that inruralareas. 1.19 There are three important characteristics o fthe poor inMalawi. First,the poor have larger households on average (an additional 1.5 people) in both rural and urban areas. These additional members are typically children, which is consistent with the higher fertility rategof 3.1 in rural areas compared to 2.2 in urban areas. The higher fertility rate inrural areas is possibly caused by the lower female literacy - only 44 percent of women in rural areas are literate compared to 75 percent o f urban women. Second, Malawi has an unusually large proportion of female-headed households constituting almost a third of the total poor households. Female headed households are more vulnerable because (i) they have fewer potential adult workers than other households, (ii) aremoredemandsontheprimaryadultbreadwinnerbecauseshehastheresponsibility there for childcare and household management, and (iii) she is also - by both custom and skills - less readily employable in the outside world. Third, there is also a growing group o f orphans and foster children due to the AIDS epidemic. Nearly 11 percent o f children have lost either one or both of their parents to the AIDS epidemic," and nearly 16 percent o f children under 15 do not live with either of their parents. This causes increased pressure on the households o f relatives and necessitates social transfer or other forms o f social support, given that creating income opportunities is not away out o f poverty for this section o f the population. Table 1.3: Evolutionof Dimensionsof Poverty during the 1990s 1992 2000 Life expectancy (years) 44 37.8 Under-fivemortality (per 1,000 live births) 220 189 Maternalmortality rate (per 100,000 live births) 620 (1986-92) 1,120 (1994-00) Illiteracy rate, adulttotal (%ofpeopleage 15 and above) 46 40 Fertility rate 6.7 6.3 Childrenvaccinated(%) 81.8 70.1 Low weight for height (wasted children,YO) 5.4 5.5 Low height for age (stunted children, %) 48.7 49.0 Low weight for age (%) 27.2 25.4 Sources: WorldDevelopment Indicators and Demographic and Health Surveys,variousyears 'These are basedonthe various annualDemographicand Health Surveys(DHS) that are compatiblewith each other andtherefore lendthemselves to comparison over time. The improvement inthe school enrolment could be tracedto the introductiono ffree primaryeducation in 1995,and is not an indicationo fa decline inpoverty at the household level. Meannumber of childrenbornto all women betweenages 15 and 45. I OSourceDHS. 6 1.20 An analysis of the sources of income for the urbanand rural poor indicates that the main distinguishingfactor between the poor and the non-poor is their linkages to markets and business opportunities. As expected, most o f the rural population derive their income from agriculture and consume a large proportion (61 percent) of their income. However, nearly 20 percent of the non- poor derive their income from non-farm business activities compared to only 14 percent of the poor. In rural areas, on average, the poor have smaller landholdings on a per capita basis (0.18 hectares) compared to the non-poor (0.28 hectares). The poor also typically cultivate local maize incontrast to wealthier households who cultivate hybridmaize along with other crops and earn a larger share of their income from non-farm activities." In urban areas, as expected, nearly 56 percent of the income for both poor and non-poor is derived from employment. However, as in rural areas, what distinguishes the non-poor is that they derive a much larger share of their income (20 percent) from non-farm business activities compared to the poor (14 percent). The data therefore suggest that improving the productivity in agriculture combined with creating micro-level business opportunities in both urban and rural areas are important elements of the overall strategy for addressingpoverty in Malawi. 1.21 Consultations with the poor carried out as part of the World Development Report (2000) include criteria that are similar to the household survey with regards to identifying the main characteristics o f the poor and non-poor in their community. In addition to the variables found above, the poor cite rising prices and lack o f affordable agricultural inputs as determinants of poverty. The poor also cite that poverty leads to greater physical insecurity and social exclusion. D. ImpactofHIV/AIDS 1.22 As in other southern African countries, the HIV/AIDS epidemic has reached crisis proportions in Malawi. At the end o f 1999, the adult prevalence rate was about 16 percent, placing Malawi among the 16 countries with the highest HIVIAIDS incidence in the world (Annex 1.4). The adult prevalence rate in Malawi12 i s higher than the sub-Saharan African average o f 8.6 percent, which in turn is considerably higher than the global rate o f 0.2 percent (excluding sub-Saharan Africa), but lower than the southern African average of 19.1 percent. As noted in the PRSP, apart from just being just a health issue, HJY/AIDS undermines developmental efforts and erodes growth becauseit affects economically active adults. 1.23 As expected, nearly 95 percent o f the people affected by HIV/AIDS are economically active adults in the 15-49 age group. In Malawi, the HJY prevalence is higher in the southern region where the population density is high and there is more migrant labor. As in all countries, women are more vulnerable to the diseasethan men. As indicated inthe PRSP, the infection rates in the younger females in the 15-24 age group are 4 to 6 times higher than in their male counterparts. Further, the National AIDS Commission WAC) estimates that 46 percent of all new infections in 1998 occurred in the 15-24 age group, and 60 percent o f the new infections in this age group occurred in women. This has serious implications for mother-to-child transmission of Out of the poorest 20 percent o f rural households, 51 percent cultivate local maize while 42 percent of the wealthiest 20 percentofruralhouseholdsdo so. Incontrast, only 26 percentofthe poorestrural quintile cultivates hybrid maize while 42 percent of the top rural quintile does. The poorest quintile of households in Malawi only derives 1.5 percent of its household income from non-farm business sales while the wealthiest quintile derives 14.6 percentof its incomefrom this source. l2As in other African countries, the principle mode o f transmission in Malawi is through heterosexual contact. In Malawi, around 89 percent of transmission is through heterosexual contact, 10 percent is from perinataltransmission, and 1.7percentthrough bloodtransfusions. 7 the virus creating a new generation of infected children, and also presents a challenge for improving maternal and child health status. (i) Impact of HIV/AIDS on the Growth Potentialfor the Malawian Economy 1.24 There are three ways in which the prevalence of HIV/AIDS affects the growth potential of the Malawian economy. The first and most direct impact is demographic. HIV/AIDS reduces life expectancy and increases infant and child mortality beyond the levels already projected. By the year 2000, as per USBOC calculations, the population growth rate hadalready declinedby 0.5 percent per annum (compared to a "no AIDS scenario"), from 2.6 percent per annum to 2.1 percent per annum. Based on present trends, the population growth rate can be expected to decline further to 1.7 percent per annum. 1.25 Second, HIV/AIDS affects the growth potential through reducing the economic efficiency of the population by increasing the mortality of the working age population. As indicated in Figure 1.1, the prevalence of HIVIAIDS significantly increases the probability of dying during the working ages of 15 to 49. In addition, the efficiency and productivity of the smaller working age population is likely to suffer due to the increasedabsenteeism, poor onjob health, high staff turnover, and replacement of more experiencedpersonnel by less experienced staff. Figure 1.1:ProbableNumber of Deathsper 1,000 Survivors with and without HIV/AIDS 350 d a a 300 g2 `E 250 200 2 0 53& g 6 150 100 50 o 0 10 20 30 40 50 60 70 80 Age Probability with HIV/AIDS+Probaility without HIV/AIDS Source:World Bank staffestimates 1.26 Third, HIV/AIDS affects growth potential through diverting both public and private resources from productive activities into expenditures related to the disease. The HIV/AIDS epidemic has had an immediate impact on the health sector by increasingthe demand on public services and taking its toll on health sector personnel. A recent World Bank study13indicatesthat the cost of offering a modest coverage rate of 30 percent for palliative care, 20 percentfor clinical treatment of opportunistic infections, and 10 percent for highly active anti-retroviral therapies (HAARTs) could amount to 6.5 percent of GDP by 2010, which is almost doublethe total public and private sector expenditures on health today. Similarly, in educationthe main impact will be felt through the need to train and replace teachers who are victims of HIV/AIDS. An analysis carried out in a recent IMF working paper14indicates that to even maintain the current pupil- l3 WorldBank, Working Paper, Bonnel, "Costs o f Scaling up HIV ProgramActivities," 2001. l4 IMF, HaackerMarkus, "The EconomicConsequences ofHIVIAIDSinSouthernAfrica," 8 teacher ratio o f 62:l (which is itself quite high), by 2010 the number o f teachers trained, and consequently the teacher training budget, will have to be increased by 30 to 45 percent from the present level. The main fiscal impact o f HIV/AIDS on the outlay on civil service wages will be felt through an increase in the pension, gratuity, and death benefits. An analysis in the World Bank's Public Expenditure Review (PER)" shows that pensions and gratuities have already doubled from 0.8 percent o f GDP in 1995 to 1.7 percent of GDP in 2000. A large part o f this unusual increase stems from the increasing prevalence o f HIV/AIDS among civil servants and their dependents. Table 1.4: Impactof AIDS on Demographic Trends 2000 2010 Baselinedata With AIDS Without AIDS Population Growth Rate 2.1 1.7 1.9 Life Expectancy 37.8 34.8 56.8 Crude DeathRate(per 1,000 people) 22.4 25.3 10.4 Infant Mortality (per 1,000 live births) 122.3 113.1 88.4 Child Mortality (per 1,000 live births) 220 202.6 136.0 Sources: United StatesCensus Bureau, Haacker 2001, World Bank 1998. 1.27 A number o f recent studies attempt to capture the impact of the factors discussed above on Malawi's growth potential. In most o f these studies, the H N / A I D S epidemic decreases the growth potential by reducing (i)the efficiency o f the labor force due to frequent turnover and absenteeism and (ii) the investment rate due to lower savings and a fall inproductivity. These two negative influences are balanced against the potential increase in the per capita GDP by a lower growth rate o f population to calculate the net impact. As shown in Table 1.5, studies indicate that as a result o f HIV/AIDS the potential GDP growth during 2000-2010 could be reduced by between 1.5 percent and 2 percent per annum. In turn, given the 0.5 percent reduction in population growth, this would imply a reduction o f between 1 percent and 1.5 percent per annum inper capita GDP. Table 1.5: Long Term Impact of HIV/AIDS on GDP in Malawi (percentp.a.) Study Reduction Total Reduction in Reduction inPer GDP Growth 11 Population Capita GDP Growth 2/ Growth Cudddington and 1.5 0.5 1.o Hancock (1995) Haacker (2002) 1.9 0.5 1.4 1/The figure showsthe reductioninlongrun(by 2010) potential GDP growth. 2/ Populationgrowth adjustedon the basiso fthe latest data. January 2002. l5 World Bank, "Malawi, Public Expenditure Review - Issues and Options," September 2001. 9 (ig National HIWAIDS Strategy 1.28 Given its impact on growth, addressing HIV/AIDS needs to be at the center of the government's strategy for growth. Malawi adopted a National HIV/AIDS Strategic Framework (NSF) in 1999 to "reduce the incidence of HIV and other sexually transmitted infections and improve the quality o f life of those infected and affected by HIV/AIDS." The NSF is based on a multi-sectoral approach and identifies nine priority areas o f intervention: Facilitate changes incultural values and norms to reduce the spread o f AIDS. Strengthendialogue with youth to promote responsible behavior. Empower economically and socially vulnerable groups to resist behavior harmfulto their health status. e Promote love, care, and support for those infectedby or living with HIV/AIDS. e Implement effective, multi-sectoral mitigation plans in the home, hospital, and work- place settings. Care for orphans, widows, and widowers. Strengthenthe effectiveness of HIV preventionprograms. Establisha comprehensive and effective strategy to reduce the spread o f HIV. Increase accessibility of ethically sound services for men, women, and youth. 1.29 Responsibility for spearheading implementation of the NSF was initially held by the National AIDS Control Program (NACP), which operated within the Ministry o f Health and Population (MOW). In July 2001, the government established the National AIDS Commission (NAC) as an independent entity to ensure effective leadership for the national HIV/AIDS effort. Composed of 19 commissioners drawn from civil society and the public and private sectors, the NAC's mandate is to coordinate the national response to HIV/AIDS, provide technical and financial support to implementingagencies, mobilize resources to support the various initiatives underway against HIV/AIDS, and monitor and evaluate progress and impact o f HIV/AIDS related programs. The NAC is supported by a secretariat and its efforts are now focused on building its internal management systems to enable effective coordination, funding, and tracking of the national effort. 1.30 Our preliminary analysis suggests that the resourcestargeted to prevention, care, mitigation, and treatments are inadequate at all levels, whether for public, private, religious, or community organizations. Inaddition, although the NSF is basedon a multi-sectoral approach, the coordinationmechanisms which have beenestablished at the national and district levels, while inprinciple multi-sectoral, have beenledprimarily by health sector staff who have adopted a predominantly bio-medical approach (untilAugust 2002, the N A C reportedadministratively to the Ministryof Health). The needfor a broader approach and outreach effort hasbeenrecognized by the country's leadership, and inAugust 2002 the N A C was shifted administratively to the Office of the President. This is expected to enhance its ability to mobilize partnersfrom walks of life outside the healthsector. 1.31 Much remains to be done inMalawi to fully mobilize public institutions inpartnership with civil society for the effective management o fthe epidemic and containment o f its humanand economic costs. Recent initiatives by the Government o f Malawi are indicative o f a more pro- active and inclusive approach -for example, beginningwith the fiscal year 02-03, a budget line has beencreated within each public sector institution's ORT budget to finance HIV/AIDS-related activities. Fundingrequests to the World BankADA and to the Global Fundfor AIDS, Malaria, and Tuberculosis have beenmade, and when approved, will greatly expandthe resources available for HnT/AIDS programs. The NAC Secretariat is inthe process of designinga grant mechanism to channel resources to implementingpartners, reachingall the way down to the 10 villages. These promising steps needto be reinforcedandactions intensifiedthrough open discussion of HIV/AIDSby the country's respectedleaders. E. Prospects for Growth and Poverty Reduction (0 Elementsof GrowthStrategy a 1.32 The analysis inthe report shows that the explanation for slow growth inMalawi lies not so much in the broad direction of its development strategy, but in the failure of its detailed and consistent implementation to reduce the risk facing rural households, manufacturing firms, traders, and financial institutions in participating in markets. Therefore, accelerating growth in Malawi requires action inthree area listed below to reduce such risk. Inaddition, the government needs to implementa programto alleviate the impact ofHN/AIDS (discussedin detail in Section Dabove). 0 First,Malawi needs to address the four problems that increase risk across all sectors of the economy by taking the following measures. (i)Create a stable macroeconomic environment with low and predictable inflation and real interest rates. (ii)Reduce the volatility in real effective exchange rate and manage the rapidly changingtrade regime. (iii)Reducethecostandimprovethereliability ofinfrastructure,especiallytheinternal and external transport system. (iv) Address the growing levels of corruption and weak governance. 0 Second, reforms are required to reduce the risk facing smallholder agriculture production. First, Malawi needs to set up a reliable system for managing periodic food emergencies. Second, a medium term program for enhancing agricultural productivity and improving farmers' accessto markets must be initiated. This would include improved and reliable delivery of agricultural technology and advisory services to smallholder farmers, improved management of land and water resources, reduced cost and reliable availability of fertilizers, and improved access to agricultural credit. Finally, marketing arrangements (supply chain) in tobacco have to be improved to increase their reliability and ensure that a larger share of world price is realizedby the grower. 0 Third, reforms will improve the highly risky business environmentfacing manufacturing enterprises. First, reforms would improve the reliability of infrastructure - telecommunication, power, and transport. Second, the tax and incentive regime facing businessmen needs to be simplified, made more transparent, and less discretionary. Further,its administration(i.e. tax refunds) mustbefaster andmorereliable. (io Growth Prospects 1.33 If Malawi succeeds in implementing the reforms described above (and in detail in Chapters 2-4), it should be possible for the economy to grow by about 5.2 percent p.a. over medium term. The higher growth under such an accelerated reform scenario would be basedon a growth of about 5 percent p.a. in agriculture, 6.5 percent p.a. in manufacturing, and 5 percent p.a. in services. The growth process underpinning the acceleration in growth would be as follows.'6 Creating a reliable food security system, better agricultural services, and improved marketing arrangements will reduce the risk facing farmers and would facilitate a shift away from root crops for self consumptionto market basedcrops such as maize andtobacco, as well as other l6 FromActionto Impact:the Africa Region's RuralStrategy, RuralDevelopmentOperations,andthe Africa Region.July 2002. 11 higher value export crops such as paprika, cotton, macadamianuts, and pulses. Increasedincome from expanded agricultural output would stimulate rural non farm-enterprises. In parallel, an improved business environment could generate the growth of small and medium scale manufacturing on the basis of Malawi's long run comparative advantage based on low wages, increased availability of agricultural commodities as inputs, and opportunities generated by the increasingly open trading environment in the region and improved access to the U.S. and EU marketsunder the AGOA and the EBA agreements. Table 1.6: Projections -- Case withAccelerated Reforms (Growth rate% p.a. unlessotherwisespecified) Average 1998- 2001 2002 2003 2004 2005 Average 2001- Average 2001 Est Proj. Proj. Proj. Proj. 2005 2005-2010 Actual * GDP 1.4 -1.5 1.8 4.5 5.2 5.2 3.0 5.2 Agriculture 2.7 -8.5 1.5 3.5 4.6 4.8 1.2 4.9 Manufacturing 0.9 0.6 1.0 5.0 5.5 6.0 3.6 6.5 Services 0.8 3.0 2.0 4.0 5.0 5.0 3.8 5.0 Per Capita GDP Growth -0.6 -3.5 -0.2 2.2 3.2 3.4 1.o 3.5 GrowthRateofRealExports om *+ 0.1 0.0 2.0 3.7 6.0 6.5 3.6 7.0 Tobacco -1.0 -0.5 0.0 3.2 5.0 5.5 2.6 6.0 Other Agriculture 1.o 0.5 2.1 3.5 4.7 6.0 3.4 6.5 ManufacturingProcessed 3.0 0.0 -0.3 4.0 7.0 7.5 3.6 8.0 As a Percentage of GDP Investment 11.0 10.9 9.0 13.9 15.4 15.8 13.0 18.0 Public 8.6 8.1 8.0 9.6 8.9 8.2 8.6 9.0 Private 2.4 2.8 1.0 4.3 6.5 7.6 4.4 9.0 Domestic Savings -1.0 -1.0 1.6 0.7 2.4 3.1 1.4 5.0 Fiscal Deficit After Grants -6.4 -4.5 -8.9 -3.1 -0.2 -0.7 -3.5 NIA Current Account DeficitAfter Grants -5.4 -5.3 -7.3 -11.3 -6.7 -5.7 -7.3 NIA ***Actualsbasedon official statistics. Pojectionsare staff estimates. Weight in 1998-01: Tobacco: 70%, Other Agriculture: 10% Manufactured (Includestextiles as well as agroprocessing): 5% 1.34 As indicatedinthe macroeconomicframework presented inTable 1.6 above, 5.2 percent p.a. growth between2005-10 is contingent on an accelerationinexport growth to about 7 percent p.a., about 2 percentage points higher than the GDP growth. A large component of this export growth would have to be based on expansionintobacco exports, which is feasible as indicated in the market analysis presented in Chapter 3. Similarly, the growth in manufacturing output will also have to rely on an expansion in exports of textiles (based on AGOA) as well as other agro- processingactivities. 1.35 The acceleration in overall growth will also depend on Malawi's ability to push up the rate of investmentfrom only about 11percent of GDP in the past four years to about 18 percent of GDP over the medium term resulting in an ICOR of about 3.5 - in line with similar reforming economies. Given the fiscal constraints, this would be possible only if (both domestic and foreign) private investmentcould be expandedto about 10 percent of GDP from the current levels of only 3-4 percent of GDP. This is possible only if the reforms to improve the business environmentdescribedinChapter 4 are successfully andrapidly implemented. 1.36 Even if Malawi succeeds in pushing up the rate of savings as indicated in the macroeconomic framework, accelerationin growth would require substantial inflows of external resources. Balance of payments projections consistentwith the real growth scenario indicate that, 12 on the basis o f an elasticity o f imports o f around 1, the average imports o f goods and non-factor services over the next three years (2003-05) would be on around US$SlO million per annum. Even with an acceleration o f exports, financing these imports would require total external assistance of, on average, US$380 million p.a. or about 16 percent o f GDP, which is nearly 15 percent higher than in the past three years. O f these, nearly US$180 million are expected to be available as grants and the remaining US$200 million as highly concessional bilateral and multilateral loans. 1.37 Achieving a steady and sustained growth o f GDP o f 5.2 percent p.a. over the medium term will not be easy. The analysis of the HIV/AIDS carried out earlier inthis chapter indicates that achieving a growth o f 5.2 percent p.a. in the presence of HIV/AIDS i s equivalent to achieving a growth of nearly 6.2-6.7 percent p.a. in an economy without as high a prevalence of HIV/AIDS as in Malawi. Further, the 5.2 percent p.a. growth depends on successfully making progress on many fronts, especially the following "core" set of reforms. Vigorously implement the programto restrict HIV/AIDS. Achieve macroeconomic stability: low inflation and interest rates. Resolve problems inthe Nacalacorridor and increase investment inruralroads. Create a reliable food security system and better functioning markets for maize and fertilizers. Eliminate bottlenecks inthe tobacco supply chain. Improve land management and irrigation services. Ensurereliable electricity supply. Introduce simple, predictable, and transparent taxes and incentives for businesses. 1.38 Ifthere is slippage inany ofthe coreset ofreforms indicatedabove suchasastopandgo progress inreducing inflation and interest rates, insufficient progress inachieving food security and resolving the marketingproblems facing tobacco, the economy will grow at a slower rate o f around 4 percent per annum.17The slower growth under such a moderatereform scenario will result from a much slower growth inagriculture o f only 3 percent p.a., while manufacturingand services could recover from their very low levels to grow by around 4.8 percent per annum. Under this scenario, Malawi would achieve a lower rate o f investment at about 15 percent o f GDP, accompanied by a higher ICOR than in the base case. Under this scenario, Malawi would achieve export growth of only 4.5 percent p.a. and will require a lower level o f imports consistent with a lower GDP growth. Consequently the external assistance requiredfor sustaining this scenario will be US$320 million for the next three years or about 15 percent lower than in the accelerated reform scenario. Finally, if there is continued macroeconomic instability, lack of progress in improving agricultural productivity, privatization o f infrastructure, and failure to resolve problems with the tobacco supply chain, the economy would be ina no reformscenario and would grow by only about 2 percent p.a. (iii) Growth and Poverty Reduction 1.39 If Malawi could achieve acceleration in growth to around 5.2 percent p.a. under an accelerated reform scenario, there would be a substantial reduction inthe incidence of poverty by 2015, although the number of absolute poor would continue to remain high. The impact of growth on the incidence o f poverty is captured by the poverty elasticity o f growth, which measures the change in poverty ratios for a given change in average incomes, assuming no change in the distribution of incomes. On the basis o f the 1998 IntegratedHousehold Survey (IHS), the poverty elasticity was estimated to be 1.073. This means that 1percent rate o f growth inper capita incomes will result in 1.073 percent reduction in the proportion o f poor living below the poverty line. Not illustrated by detailed projections. 13 Malawi's current poverty elasticity is slightly higher than the elasticity measured with the 1992/93 IHS data,18 but still remains low compared to those inmuch o fthe world, including many countries inAfrica. (Representative estimates from other countries are -Ghana: 1.7, Uganda: 0.8, Peru: 1.4, and Indonesia: 2.8). Flgure 1.2: Reductioninthe Proportion ofPoor Under Different Growth Scenarios 65 60 g 5 5 & "0 50 B 45 0 40 p" 35 30 1995 2000 2005 2010 2015 2020 Year -Growth5.2%p.a. +Growth4%p.a. +Growth2% p.a. 1.40 On the basis o f the poverty elasticity of 1.073, under the accelerated reform scenario, with a steady growth o f 5.2 percent p.a. over the mediumterm, the proportion ofpoor will fall from the 2002 level of about 65 percent to around 38 percent by the year 2015 (Figure 1.2). A lower growth o f about 4 percent p.a. under the moderate reform scenario will reduce the number o f poor to 44 percent and under a no reform scenario there would be no reduction inthe proportion of poor. It is, however, important to observe that even in the first two scenarios where the proportion of poor would fall, the absolute number of poor who spend less than US25 cents per capita per day will continue to remain unacceptably highat between4-5.5 millionpeople. l8 The povertyelasticityof 1.073 is higher than the elasticity reportedinthe last CEM of 0.83. The two elasticitiesare not comparable becausethe two IHSs on which they are based use differentmethodologies. The differences arise mainly becausethe last poverty line was basedon householdand not individual income, andthere has beena change inthe distributionof incomearoundthe povertyline -where the elasticity is calculated. 14 Chapter 2 Cross-CuttingIssuesAffectingAll Sectors A. Introduction 2.1 There are four problems that affect the performance of all sectors of the Malawian economy. First, all sectors continue to face an unstable macroeconomic environment. Inflation and interest rates remain high and volatile, which create an uncertainenvironment for businesses by crowding out private sector investment, increasing costs, and thus eroding profit margins for all sectors of the economy. Second, inthe external sector, Malawi businesses are faced with high volatility in exchange rates. In addition, Malawi is confronted with a rapidly evolving trade regime, which creates both opportunitiesas well as increased risk for businesses. Third, transport costs in Malawi remain high for both agriculture and manufacturing. Fourth, high levels of corruption and weak governance adversely affect the business environment and the delivery of key public services. Addressing these problems should be at the heart of Malawi's growth strategy and each ofthese issues will be discussed inturn inthis chapter. B. Macroeconomic Volatility (0 TheMechanics of High Inflation and Interest Rates in Malawi 2.2 Like mosteconomies, high, chronic inflation and interest rates inMalawiare the result of a combination of supply and demand factors, some of which are exogenous while others are policy induced (Figure 2.1). As a small and open economy Malawi is highly vulnerable to two kinds of external shocks. First, Malawi's food production remains highly vulnerable to weather. Poor weather, combined with the logistical and institutional problems inthe importation of food, leads directly to high food prices. Second, given Malawi's high dependence on imports, changes interms of trade and resulting movements inthe exchange ratetranslate directly into high prices of non-food consumer goods. Figure: 2.1 MechanismsBehindHighInflation and Interest Rates External Shock GovernmentPolicy Outcomes y+:::::I) Response \ Terms of Trade ExchangeRate and K g h prices of imported Changes + OpenTrade -b inputsandconsumer Poor Weather Agricultural Policies goods Low food production Inflation(55% + Policies +combined w t h logistical constraints to maize imports K g hInflation(NCPI) Unpredictable Aid Fiscal Policies K g hdomestic balance +E g h money HighNan-food/ Flo\w, varying + Inabilityto control+Kgh government supply growth +Inflation (45% between7-15% of expenditures borrowng of the NCPI) GDP Monetary Policies High open market Ollgopollstlc KghInterestRates, Openmarket borrowng of the RBM + financial market-b directly relatedto the operationso f the reducesmoney supply, structure open market borrowng RBM lowers inflation, and increasesthe interest rates 15 2.3 On the demand side, as discussed in Section (ii) below, there is a strong correlation between inflation and money supply. Here, as discussed in Section (iii), the government's large role inthe economy, as indicatedby levels of domestic absorption' as high as almost 5 percent of GDP during the last five years, forces the central government to annually borrow about 2-3 percent of GDP from the domestic market. The impact of the public sector operations on broad money is far more serious than is suggested by the annualborrowing requirementsof the central government. Short maturity of public debt, coupled with volatile, unpredictable aid flows, produces highly volatile intra-year government borrowing requirements - thereby creating inflationary expectations and high interest rates. Finally, the ReserveBank of Malawi (RBM) has attemptedto limit the inflationary impact of the expansionary fiscal policies through openmarket operations. However, the reduction in inflation has been accompanied by high and volatile interest rates that have constrained growth. The impact of RBM and government borrowing on interest rates is further exacerbated by the fact that the bond markets are highly oligopolistic. As indicated inAnnex 2.1, in2001 four large financial institutions and their subsidiariesheldnearly 60 percent ofthe stock ofT-bills andRBMbills. Table 2.1: FactorsInfluencingHigh Inflationand Interest Rates 1995 1996 1997 1998 1999 2000 2001 InflationTotal (NCPI % p.a.) 74.9 6.7 15.2 53.1 28.2 29.6 27.2 Food Inflation(YOp.a.) 88.5 2.3 19 46.6 21.9 22.4 32.6 Nonfood Inflation(YOp.a.) 24.6 17.7 11 74.6 21.5 63 -3.5 InterestRate(Treasulybill rate, %) 46.3 30.8 18.3 33.0 42.9 39.5 41.7 ExchangeRate(MK/$average for year) 15.3 15.3 16.4 31.1 44.1 59.5 72.2 NominalEffective ExchangeRate * (Index) 100 104 104.7 62.3 43.6 36.0 30.4 RealEffective ExchangeRate * (Index) 100 137.7 152.9 111.2 111.8 112.7 116.8 Terms of Trade Index (1990=100) 114 113 106 99 102 104 98 FoodProduction(`000 MT) 1.33 1.79 1.22 1.53 2.48 2.5 1.71 M 2 Growth ("hp.a.) 43.7 39.9 2.2 55.6 33.6 42.4 12.1 OverallBudget Deficit ("hof GDP) -12.4 -7.2 -9 -12.8 -11 -15 -15.9 Domestic Balance("ho fGDP)** __ -- 6.5 2.8 2.7 4.7 8.1 Domestic Borrowing (% ofGDP) 2 -0.4 2.3 -2.5 1.8 1.2 7.3 * **Decreaseinbudgetdeficit the index implies devaluation. Overall excludinggrants, foreign interestpayments, and foreign financeddevelopment expenditures. Source: Governmento fMalawi, World Bank staffestimates Definedas Revenue-( Expenditure-ForeignInterestPayments-ForeignFinancedDevelopment Projects). 16 (ii) TheNature of Macroeconomic Volatility 2.4 Inflation. Malawi has suffered chronic high inflation. Measured by the National Consumer Price Index (NCPI), average inflation over the last ten years was 32 percent p.a., reaching as high as over 75 percent in 1995. As illustrated in Figure 2.2, inflation in Malawi is closely correlated to the growth of broad money (M2) which, in turn, is closely related to the movements in reserve money.* Econometric analysis presented in Annex 2.2 also indicates that inflation is closely relatedto monetary expansion. I Figure 2.2 Inflation and M2 Growth SO 7.00 70 6.00 60 5.00 50 4.00 40 30 3.00 20 2.00 10 1.00 0 0.00 1994 1995 1996 1997 1998 1999 2000 2001 2002 --C-Total Innation(End Year) -Change of M281a %of GDP Source: Reserve Bank of Malawi 2.5 Traditionally, the two main components o f inflation - food and non-food prices, which account for 55 percent3 and 45 percent of the overall CPI respectively - have also moved in tandem with each other. This is to be expected since producers of food grains have to purchase non-agricultural commodities and services and urban consumers have to purchase food using their non-agricultural incomes. However, within this broader trend, movements infood prices are strongly influenced by maize production, which i s influenced by weather, other agricultural policies, and the logistical and institutionalproblems in importation o f food grains as discussed in Figure 2.3: Food and Non-Food Inflation during 2001 ~ 1 8 0 1 1 70 60 ~ 50 40 30 20 10 0 -10 Im W b Mar Apr May Sun lul Aug e p a t Nov De0 - - C A l l l t e m s +Food +NonFood Source: Reserve Bank of Malawi * The relationshipbetweenbroad and reservemoneycaptured by the money multiplier is fairly stable in Malawiover the mediumterm. Foodcosts have a higher weight of 63 percent inrural CPIcomparedto 34 percent inurbanCPI. 17 Chapter 3, while non-food inflation is strongly relatedto money supply gr~wth.~ relationship This i s illustrated in the pattern of inflation in 2001, during the course of which, as indicated in Figure 2.3, reduction in overall money supply growth in this year resulted in a fall in non-food prices, while the drought and the resultingfall inmaize production resulted inan increase infood prices. Consequently, there was only a modest fall inyear-to-year inflation (Table 2.1). 2.6 Interest Rates. Malawi's commercial banks are largely free to set their own lending and deposit rates. However, most rates move in tandem with the interest rates set by the government borrowing from the market inthe form of T-bills or RBMbilk5As indicated in Figures 2.4 and 2.5, high inflation in Malawi has been accompaniedby high interest rates. Since 1998, 3-month T-bill rates have fluctuatedbetween40 and 70 percentat the going ratesof inflation -this implies a highreal interest rate of about 20 percent. 2 FTgure 2.4: T-Bill Rate I I I , I I , I 1 2 Figure 2.5: Interest Rate Spread* 30 25 20 15 10 5 0 -5 I Source: Reserve Bankof Malawi As indicated inAnnex 2.4, in 1999 and2000 when Malawihad abumper maizecrop there was a sharp fall in food prices. RBMbills pay a slightlyhigher ratethan comparableT-bills. This is becauseRBMbills are available for purchase by only banks and financial institutions, whereas T-bills purchases are open to all, including domestic and foreign individuals. Both T-bill and RBM bill holdings, however, are concentrated in a few banksand institutional investors. 18 2.7 High real interests have been accompanied by high spreads between the lending and borrowing rates. For example, the spread between the maximum rate on unsecured loans o f commercial banks andthe rate on three- to five-month time deposits offered by commercial banks has remained at about 20 percent during 1997-2001 (Figure 2.5).6 These high spreads are due to the monopolistic banking system,' high reserve requirements,* high central bank discount rate (linked to 271-day T-bill rate), and high inflation (Mlachila and Chirwa 2002). Figure 2.6: Distribution of Commercial Bank Assets 60 50 40 30 20 10 Credit to Private Sector -T-bills+RBM bills Source: Reserve Bank o f Malawi 2.8 High interest rates have been disastrous for businesses. Government borrowing has crowded out credit to the private sector by providing commercial banks with a safe and high return financial asset. On average, business lending has gone down from 51 percent o f the commercial banking system's total assets in the first six months o f 2000 to 36 percent in the last six months o f 2001.' Over the same period, the holdings o f government paper, T-bills, and RBM bills has gone up from 8 to 16 percent o f the commercial banking system's total assets (Figure 2.6). (iii) Factors Behind the High Inflation and Interest Rates 2.9 As discussed above in paragraph 2.3, in addition to external shocks, persistence o f high inflation and interest rates over a long period stems from the movements in the aggregate money supply that results fromthe interplay of: (a) the fiscal impact o fthe operations o fthe public sector (consisting o f the central government and parastatals), which lead to their highand unpredictable borrowing from the market and (b) the attempts by the RBM to counteract the monetary Controlled lending and borrowingratesexplain the low spreads prior to 1995.The negative spread for two months in 1995 is due to the aggregationproblems incalculating lending andborrowingrates ina 'periodoftransition. There are four commercial banks; but two banks, The National Bank o f Commerce and The Commercial Bank ofMalawi, account for more than 90 percentof bank credit inthe economy. The liquidity reserveratio is currently set at 30 percent o fbank deposits.Inaddition, 25 percent of banking sector assets haveto be placed towards cash reserverequirementswith the RBMthat earn no interest. All of this is short-term credit for working capital requirements.There is no institutionthat is engaged in significant term lending. 19 expansion through open market operations that, while reducing inflation, leads to increased interest rates. (a) Public Sector Operations,Inflation, and Interest Rates 2.10 Much of the pressure on broadreserve money growth can be traced to high levels of domestic absorption driven by public sector operations. As indicated in Table 2.1, the domestic balance" of the central government, which measures the direct impact of government operations on domestic absorption, has been, on average, 5% ofGDP duringthe past five years. As indicated inAnnex 2.3, the large domestic balance is mainly due to the government's inability to control expenditures that have to be financed through discretionary resources available to it such as revenues and untied aid. Total expenditures have remained around 30 percent of GDP over the past four years. Within the total expenditures, wages including pensions and gratuities amount to almost 6.5 percent of GDP, domestic interest paymentshave fluctuated between2.5 and4 percent of GDP and subsidies, and transfers to statutory corporations are about 3 percent of GDP. With revenues around 18 percent of GDP, the overall deficit has increased from 8 percent of GDP in 1996 to almost 16 percent of GDP in 2001. The large deficit is, however, financed to a large extent by foreign loans and grants resulting in a need for the government to annually borrow between2-3 percent of GDP from the market. 2.11 The impact of public sector operations on broad money (and hence inflation and interest rates) through its borrowing operations is far more serious than is suggested by the "annual" borrowing requirements of the central government. First, large borrowings by the parastatal organizations directly from the banking system accounted for about 15 percent of the growth of broad money during 1996-1998. This increasedto almost 50 percent in 1999, mainly for maize operations by ADMARC - a parastatal fully owned by the government. Second, sharp, unpredictableintra-year fluctuations inthe centralgovernmentborrowing from andrepaymentsto the banking system create inflationary expectations and high interest rates. For instance, as illustrated in Figure 2.7, over a two year period, 1999-2001, the net domestic credit to the government fluctuated betweenMK2 billion or about 2 percent of GDP to MK 9 billion or about 9 percent of GDP." These high intra-year variations in central government borrowinghepaymentsare due to: the short maturity of government debt, large andunpredictable aidflows and unplanneddemands from the parastatals. lo Domesticbalance is definedas: Revenue- (Expenditure - ForeignInterest - ForeignFinanced DevelopmentProjects). l1 The sharp drop inthe domestic debt ofabout MK7billion, about 7 percent ofGDP, overjust two monthsbetweenDecember 2000 and February2001 was due to the disbursemento fa largetranche of untiedaidthat was usedbythe governmentto repaythe RBMdebt. 20 I Figure2.7: Total NetDomesticCreditof Government 10,000 9,000 8,000 =g - 7,000 'T 5,000 6,000 Y 4,000 E 3,000 2,000 1,000 Source: Reserve Bank o fMalawi 2.12 Short Maturity of Domestic Public Debt. Duringthe past five years the government has not been able to issue long-term debt in the market at reasonable interest rates, resulting in an extremely short-term maturity structure of domestic debt. At the end o f 2001, nearly 60 percent of the total gross debt of the government - about MK9 billion (or about 7 percent of GDP) - was held in the form of 91-day T-bills, the rest was borrowed from the RBM or held as longer maturity locally registered stock (LRS). This means that the government has to approach the market to borrow between3-4 percent of GDP every three months merely to roll over debt falling due. Ifthis debt is not rolled over and instead repaid, it would release the equivalent liquidity in the economy and leadto inflation. 2.13 High and VolatileAid Flows. Over the period 1993-2001, Malawi received foreign aid amounting to on average 12 percent o f GDP per annum.12As illustrated inFigure2.8, duringthis period the lowest aid was halfthis average level (in 1997) and the highest was twice this average (1994). The high levels and the unpredictability o f aid flows have contributed to macroeconomic ~olatility.'~ Expenditures are normally budgeted and carried out inanticipation o f aid, and ifthat aid is delayed or does not materialize alt~gether;'~ the government is obliged to borrow from the market to maintainexpenditures to honor its prior commitments. This could leadto a sharp, albeit temporary, increase in market borrowing resulting in high interest rates and raised inflationary expectations. ~~ Estimatedas grants plus net foreign financingofthe budget. l3This is not an uncommon problem in sub-Saharan African countries that receive large aid. See: Aies Bulir and A. Javier Hamann, "How Volatile and Unpredictable are Aid Flows and What are the Policy Implications?",IMF Working Paper, WP/01/167, October 2001. l4 The delay inaidcouldbe due to manydifferentreasonssuch as delay infulfilling the obligationsto donors, bureaucratic delays inprocessingdisbursementrequests, or complexprocedures onthe part o f donors for drawing on aid. All these problems that are commonin manycountries, are particularly importantinMalawi where aid is as large as 12 percentof GDP. 21 25 20 15 10 5 0 I , , , , , 1 --t Total Aid as a%o f GDP -8- ProeramAid as a %o f GDPI Source: World Bank staff estimates 2.14 UnpredictableDemands of Parastatal Corporations. Poor financial performanceof the parastatals, inaddition to resulting intheir directly borrowing from the marketalso adds to the unpredictability of centralgovernment borrowingfrom the market. Parastatalcorporationsare often unableto service their debt that is underwrittenby the Government. The Governmentis thenobligedto take onthese obligationsthat are not budgetedinthe beginningofthe year, and borrow from the marketto meet them. For instance in2001,the Governmentwas obligedto take on and service anNFRA debt of MK1billion amountingto about 1%of GDP andpay off an ADMARC loan guarantee andvarious other domestic liabilities amountingto nearly 1.75% of GDP. Similarly, at the endof FY 99/00, ESCOM owed nearly MK 322 millionto the Governmenton account of externaldebt service andhadunpaid surtax liabilities amountingto MK140 million. This revenue shortfall resulted inunplannedborrowing by the Government. (a) Monetary Policy Response and Interest Rate 2.15 The need for the government to manage large short-term maturity domestic debt and unplannedexpenditures that require borrowing from the market presents the government with the difficult trade off between volatile interest rates and inflation. For instance, during 2001 government borrowing from the RBM increased by nearly 7 percent of GDP (See Figure 2.9 below). This would have ledto an increase inthe broadmoney (and therefore inflation), ifit were not accompanied by a mopping up operation carried out by the RBM by issuing an equivalent amount of RBMbills. Consequently, during 2001 monthly non-food inflation on an annual basis came down from 58.3 percent in January to only 12 percent by December. The T-bill rate also declined at first from 50 to 37 percent between January and June, but as the RBM bills were issuedto reduce money supply, the interest rates went back upto 45 percent by December2001. 22 Figure2.9: Credit to Government from RBMand Open Market Operationsfor 2001 10,000, I 8,000 .- =g 6,000 2 4,000 g-2,000o 2,000 -4,000 -6,000 -8,000 Dcc. Jan. Feb. Mar. Apr. May June July Aug. Scp. Oct. No". Dec. +Open market operations:holdings o fmonetarypolicy bills -Net Credit to the Government from RBM Source: Reserve Bankof Malawi 2.16 One of the main reasons behind the high interest rates in government auctions is the oligopolistic structure of the market. As indicated in Annex 2.1, at the end of 2001, four large financial firms and their subsidiariesheldnearly 60 percent o fthe stock of T-bills andRBMbills. Financial institutions controlled by the Press Corporation alone, for example, held nearly 27 percent of these securities outstanding in December 2001. Annex 2.1,however, underestimates the extent of market concentration because there are a number of non-financial firms (e.g., ADMARC andMDC) that have cross-holdingswith the large financial firms. (iv) Strategyfor ReducingMacro Volatility -A Macroeconomic Framework 2.17 The key to reducing macroeconomic volatility lies in reducing the growth of broad money by reducingthe borrowing needs ofthe governmentover the mediumterm. Inparallel, the governmentneeds to implementmeasuresto reduce short-termintra-year fluctuations indomestic borrowing due to the unpredictableaid flows andparastataloperations. (a) ReducingBorrowing Needs over the Medium-Term 2.18 As indicated inthe Table 2.2 below, the strategy behindthe macroeconomic framework adopted by the government over the next three years is to reduce high inflation and interest rates basically by restricting broad money growth to about 13.4 percent p.a. down from on average about 35 percent p.a. over 1998-2001(Table 2.1). Projectedcomponents of broad money growth show that underpinningthe reduction in broad money is a reduction in credit to the government and parastatals. This is consistent with a targeted reduction in the overall fiscal balance (after grants) from an average of 6.4 percentp.a. over 1998-2001(Table 1.6) to a slight surplus in2004. Given the limited scope for expanding revenues, this reduction in overall balance will require a reduction inthe non-interestexpendituresexcluding debt relief from 18.0 percent of GDP in2001 to about 16.7 percent of GDP by 2004. The reduction in the overall balance, together with anticipated inflows of external loans in line with past trends, is expected to result in net repayments to the banking system of between 2-4 percent of GDP during 2002-2005. This will create a virtuous circle whereby the reduced market borrowing by the governmentwill result in a reduction in interest rate (and therefore interest payments) and will create conditions for an increase inbusiness lending. 23 Table 2.2: Macroeconomic Framework Fiscaland MonetaryAccounts 2000 2001 2002 2003 2004 Act Est Proj Proj Proj GDPat constant prices(annual change, %) 1.7 -1.5 1.8 4.5 5.2 CPI(annual averagechange, %) 29.6 27.2 9.4 5.0 4.4 Exchangerate (average, MW%) 59.5 72.2 71.0 74.9 77.4 M2 growth (% p.a.) 42.4 12.1 7.9 13.4 13.5 Moneyand quasi-money (% ofGDP) 16.2 14.0 13.2 13.7 14.2 Net foreign assets(% of GDP) 14.0 8.9 10.6 14.9 17.4 Net domestic assets (% o fGDP) 2.2 5.1 2.6 -1.2 -3.1 Credit to governmentand statutory bodies(%ofGDP) 0.1 4.5 2.8 0.7 -3.6 Credit to privatesector and other items (YOofGDP) 5.0 4.0 4.5 5.4 6.6 Other -0.2 -1.3 1.2 0.8 Other Items(net) -4.0 -3.5 -4.7 -7.2 -6.1 CentralGovernmentFinance 1/ Revenue(excludinggrants, YOofGDP) 18.3 16.8 18.0 17.8 17.7 Total expenditure(YOofGDP) 33.3 32.7 31.7 28.6 27.2 O N Non-interestexpenditures excludingdebt relief 19.6 18.0 18.2 16.6 16.7 Overallbalance(excludinggrants) -15.0 -15.9 -13.7 -10.8 -9.5 Overallbalance(including grants) -5.8 -8.9 -3.1 -0.2 -0.7 DomestiicBalance -4.7 -8.1 5.7 3.3 2.7 OverallFinancing: Foreignfinancing 4.2 0.8 7.2 3.3 2.6 Domestic financing- 1.2 7.3 -4.2 -3.2 -1.9 Discrepancy -0.4 -0.8 -0.1 -0.1 0.0 ~~ ~~ Source:World Bank staff estimates. Adjustments madeto the GDP numbersfor 2000. 1/ Fiscalyear 2000 is 2000/01. 2/ Domestic balance: Revenue - (Expenditure-ForeignInterest-ForeignFinancedDevelopmentExpenditures) 2.19 Achieving a reduction in domestic non-interest expenditures excluding debt relief, "discretionary expenditure^"'^ will not be easy and will require action on three fronts.` First, as amounting to about 1.3 percent of GDP, over the next three years or nearly 7 ercent of discussed in the World BanWGovernment Public Expenditure Review (PER),I7 it should be possible to realize savings by reducing outlays on general administration, consolidating all government operations at one capital city, reducing foreign travel and allowances, and reducing waste, fraud, and corruption. These savings, combined with the resources from HIPC debt relief, will allow the government to increase outlays on HIV/AIDS and social sectors, strengthen governance, and provide a cushion against natural disasters. Second, parastatalfinances could be improved by better tariff setting policies, greater autonomy, and accelerated privatization program. Third, the institutional reforms discussed in Chapter 3 together with explicit budgetary provisions for emergency food relief are neededto ensure that food security is addressed without unplannedbudgetarydemands. Discretionaryexpendituresare definedas TotalExpenditures-(Domestic andForeignInterest+Foreign FinancedDevelopmentExpenditures). l6 The strategy o f achieving such a reductionwhile minimizingthe adverse impact on growth and poverty is discussed inthe Public Expenditure: Issues andOptions (2001). l7 WorldBank, MalawiPublic Expenditures,Issues andOptions," Gray Cover, September 2001. " 24 (b) ReducingIntra-Year Fluctuations in Borrowing due to VolatileAid Flows 2.20 This couldbe addressedby the following measures: 0 Establish a better monitoring mechanism of aid flows and domestic expenditures to allow an early warning for potential shortfalls in aid flows and allow time for the necessary fiscal and monetary adjustments. 0 Hold a high level of reserves - about 5 months of imports rather than the traditional 2-3 months - to insulate domestic expenditures from the fluctuations and unpredictability of aid. In this case, if aid flows do not materialize, the expenditures could be financed by a draw down of reserves without creating balance of payments problems. C. Volatile Exchange Rate and Rapidly Changing Trade Regime 2.21 Duringthe 1980s, Malawi's trade and exchange rate regime was restrictive and complex, featuring restrictive licensing requirements, surrender requirements on export proceeds, and high tariffs. Beginning in late 1988 and continuing through most of the 1990s, the government implementeda series of measures liberalizing the trade regime (Annex 2.4). Consequently, today Malawi has a highly liberal and transparent trade regime. In Malawi there are no non-tariff barriers, no generallicensing requirementsfor exports or export tariffs," the tariff structure has a maximum tariff of 25 percent, and there are only three non-zero tariff bands. Malawi's trade liberalization process is nevertheless part of the general trend towards trade liberalization in southern Africa during the 1990s. Consequently, today Malawi's trade regime is not different from those of its neighborsinterms ofthe absence of QRsandthe level oftariff~.'~ (0 Problems Facing Malawi's TradeRegime 2.22 There are, however, two factors that undermine the liberal andtransparenttrade regime and adversely affect the business environment inMalawi. These are: 0 Highvolatility inreal exchange rates, and 0 Regionaltrade arrangements. (a) Volatility in ExchangeRates 2.23 Volatile and unpredictable movements inthe trade weighted real effective exchange rate (REER) have, inthe past, vitiated the relatively liberalized trade regime and low tariffs facing the domestic industry. In the past, RBM's open market operations have resulted in long periods of steady appreciation of the REERresulting from maintaining a relatively stable nominal effective exchange rate only to be followed by sharp devaluations when the appreciation in the REER reached unsustainablelevels (Figure 2.10). The movementscanbe summarizedas follows: Exports o f tobacco, tea, and sugar remain subject to a surrender requirement of 60 percent of foreign exchange receipts. l 9See Annex 2.6 for a comparison of the traderegimeso f differentcountries inthe region. 25 1994-1998: Following a 1,arge devaluation in 1994, the Kwacha was relatively stable in nominal terms until July 1998. Given Malawi's high inflation, this implied a steady appreciation of nearly 111percent inthe REER. 1998-2000: There was a sharp devaluation o f nearly 40 percent inthe Kwacha over August- December 1998. This reversed the appreciation in the REER. This was followed by a relatively stable nominal effective exchange rate untilMay 2000, duringthis periodthere was again a steady appreciation o f the REER. 2000-2001: There was a sharp depreciation of almost 45 percent over May-December 2000. Since then, however, the Kwacha has strengthened innominal terms up untilthe end of 2001 resultingina further appreciation ofthe REER. Figure2.10: Trendsin Realand NominalExchange Rates I -REER 1201 2o 0 i 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Source: GovernmentofMalawi 2.24 These long episodes o f appreciation inthe REERhave been disastrous for the local industry.Appreciation inthe REERreducesthe price of imports (inrealterms) vis-a-vis the price o fdomestically producedgoods, thereby making domestically produced goods uncompetitive in the local markets and reducingthe profitability o f local industry.As indicatedinFigure 2.1 1 below, the episodes of steady appreciation of the REERhave been accompanied by large surges indiscretionary imports. Discretionaryimports exclude importsoffood andproject imports financed out o f foreign aid and are a good proxy for price sensitive imports that compete directly with local industry. 2.25 Malawi has made significant progress inliberalizingthe exchangerate systemsince 2000, which has resulted ina more stable REER.The government's current policy is to reduce the volatility inthe REERby allowing the nominal exchange rate to be market determined by limitinginterventionsinthe foreign exchangemarkets to meetingthe gross internationalreserve targets.20Inaddition, the Reserve Bank of Malawi also follows a difficult policy of moderating 2oMovementsinMalawi's REERare strongly influencedbythe movementsinthe SouthAfricanRand, becausethe Randhas a weight o fnearly33 percentinthe estimationo fMalawi'strade weightedREER. For instance,the appreciationinthe REERin2001 can be explainedby a depreciationofthe Randfrom 26 short-term fluctuations inthe nominal exchange rate without influencing the underlying market trends to alleviate the possible adverse distributional impact on smallholder farmers.21The government plans to build on the recently introducedmeasures to expand the market for foreign exchange.22This could include further reductions inthe surrender requirements and initiating measures to builda futures market. Figure2.11: REER and Discretionary Imports 1 450 I a160.0 ~~~ 400 140.0 3 350 2 0,, .e 0 E 120.0 300 5 250 100.0 2 v I 200 80.0 100 150 60.0 40.0 1994 1995 1996 1997 1998 1999 2000 2001 -W- Real Discretionary Imports (inUS$million) -t-RealEffectiveExchangeRate(Index) Source: Reserve Bank of Malawi (5) Regional TradeAgreements 2.26 Regional Trade Agreements (RTAs) are likely to be a more important determinant of the protection structure in Malawi than the current tariff structure. In addition to its membership in the World Trade Organization (WTO), Malawi has entered into a number o f RTAs, such as Common Market for Eastern and Southern Africa (COMESA), Southern Africa Development Community (SADC), and bilateral trade agreements with Zimbabwe and South Africa. Malawi has also been given preferentialmarket access to the United States and the European Union (EU) through the African Growth Opportunities Act (AGOA) and Everything But Arms (EBA), respectively. In addition, the EU is proposing to negotiate and establish Regional Preferential Arrangements (REPAs) with all members o f the Cotonou agreement, to be put in place after the current unilateral preferences they enjoy in EU markets (under the Lome convention) expire in 2007. The REPAs would provide developing country members free access to EU markets, but unlike EBA they would be reciprocal, i.e. the participating developing countries would have to less than RlONS$ in2000 to 13.2NS$ in 2001. This was, however, correctedas the Rand strengthenedto about RlONS$ by end2002. " As farmers' credit becomes constrainedand farmershaveto surrenderforeign exchange from export receipts,they face income lossesbetweenthe time o f selling their output and purchasingtheir inputs for the '*nextIngrowing season. 2001, the RBMreducedthe surrenderrequirement from 60 percentof all export receiptsto 40 percent and temporarily increasedthe foreign exchange exposure limit o fbanks from 35 to 45 percento f core capital. Moreover, it allowed banksto holdU.S. dollar-denominated depositsat the RBM(so-called FEX- CODs). The FEX-CODsare a certificate of deposit denominatedinU.S.dollars with maturity between7 and 90 days at LIBOR minus 150basispoints. FEX-CODsare excluded from the calculation o f foreign exposure limits. 27 offer preferences to EUimports intheir markets. The current status of agreements is summarized inAnnex 2.6. 2.27 The evolving trade agreements have basically created an open trading environment in southernAfrica andpresent Malawiwith bothrisks andopportunities. Risks 0 Revenue Loss. Given Malawi's trade pattern, the regional trading arrangements will not lead to significant trade diversion, with the possible exception of the REPAs with the EU. They could, however, lead to a revenue loss of almost 7 percent of total tax revenues23that will have to be compensatedfor by other taxes. 0 Complexi& The multiple trade arrangements, each with its own rules of origin, will result in highly complex customs procedures creating obstacles for businesses and opportunities for corruption. 0 Consistency. There are four possible areas where the regional and multilateral trading agreements are likely to face consistencyproblems. First, when COMESA becomes a customs union in 2004, a Common External Tariff (CET) will need to be enforced. Such a CET will be inconsistent with both the non- reciprocal trade arrangement that Malawi currently has with South Africa and, in general, the Free Trade Agreement with SADC. For example, starting in 2004, Malawi and Kenya (who are both members of COMESA and will by then have free trade with each other and a CET) will need to find some way to ensure that imports coming in from South Africa into Malawi do not find their way into Kenya, which is a COMESA member but hasno FTA with SouthAfrica. Second, Malawi plans to participateinthe EBA arrangementwith the EU.The EU, in turn, has another preferential arrangement with SouthAfrica. Thus the rules of origin for exports to the EU from SADC and COMESA will need to be identical if these arrangements are to work. Further, the REPAs that the EU is proposing to establish with groups of developing countries in Africa would have to be made consistent with the existing arrangements between the EU and African countries and among the African countriesthemselves. Third, there is an inconsistency inthe rules of origin betweenthe Malawi-Zimbabwe bilateral andthe COMESA FTA, to which both countries belong. Rules of origin inthe bilateral (25 percent value-added criterion) are less restrictive than in the COMESA FTA (35 percent value added or 65 percent fully produced). Starting in 2004, when COMESA becomes a full Customs Union, the Malawi-Zimbabwe agreement will be supersededby the new regulationsaboutthe internal market. Fourth, the BLNS (Botswana, Lesotho, Namibia and Swaziland) countries have negotiated with South Africa that MMTZ (Malawi, Mozambique, Tanzania and Zimbabwe) countries concede them reciprocal treatment (access to their markets, as a compensation for the preferences that South Africa - basically alone - has granted 23 Mainlyas importsfrom SouthAfricacoming intax free when SADC becomes effective. 28 MMTZ countries under the SACU-MMTZ Protocol). Thus Malawi will have to grant BLNS countries reciprocal access to its market even if the original Malawi-South Africa bilateral is non-reciprocal and more favorable to Malawi. The country will basically lose the preferentialtreatmentthat its textile exports had enjoyed so far inthe South African market, while being at the same time compelled to import duty free items, such as Namibian beer, from the BLNS group. Opportunities Access to EUMarkets. Since Malawi already receiveshighly preferential access to the EU market under the Cotonou agreement, the impact of the European Union's everything but arms (EBA) agreement will be mostly felt on sugar exports. Under the EBA, all duties on sugar will be eliminated by 2009. Meanwhile, the EUwill continue to offer a tariff free quota that will increase by nearly 15 percent per annum. In 2000, the quota for Malawi was 20,000 tons and Malawi was fully able to meet it. Given the substantial price advantage that the quota gives to Malawi, SUCOMA, Malawi's sole sugar producer estimates that a substantial increase in exports to the EU markets is possible. AGOA and theAccess to the U.S.Market. AGOA represents an important opportunity for the Malawian textile industry. The average import weighted MFN tariff rate on textile and apparel imports into the United States in 2001 was around 11.6 which would be waived under AGOA. Moreover, AGOA confers preferential advantage to Malawi and other sub-Saharan African countries vis-his other developing countries such as Bangladesh, India, China, and Vietnam, as well as other major producersof textiles and apparel. As indicatedinTable 2.3 below, the Malawian industry has already taken advantage of the AGOA textile provisions. Exports of textiles from Malawi to the United States have grown four times over 1999-2001. Malawi's exports, however, remain less than one tenth of the exports of Mauritius, South Africa, and Lesotho. Lesotho has been most successful of the three inattracting AGOA based investment. Malawi, however, will have to act fast to fully exploit the opportunity createdby AGOA by addressingthe substantialsupply-side bottlenecks in this sector. The quota restrictions (QRS) imposed by the current multi-fiber arrangement (MFA) on Malawi's main competitors- SouthAsian countries-are due Table 2.3 Textile Exports to the U S Million Square Meters Equivalent Country 1999 2000 2001 Malawi 1.09 3.31 4.36 Botswana 2.83 2.16 1.3 Lesotho 25.8 34.36 50.98 Mauritius 36.95 40.11 41.11 South Africa 45.38 55.18 59.33 Swaziland 5.18 7.35 11.43 Source: National Statistical Office 24The UnitedStates will removequotason clothing and apparel in2004 inline with the Uruguay agreements, but tariffs will remain. 29 to expire in 2005. These QRs are estimatedto be equivalent to a tariff of 30 percent, which more than compensates for the preferentialtariff waiver beyond2005. Apart from textiles, AGOA benefits from exports of light manufactures, tobacco, and other agricultural products are unclear. Preliminary analysis25(Annex 2.8), indicates that of the commodities that are of interest to Malawi, light manufactures into the UnitedStates26already have very low tariffs. Inagriculture, many of the commodities such as sugar, raw cotton, coffee, black tea, certain kinds of peanuts, paprika, pepper, seeds of Orignum, lentils and cut flowers are either governed by a tariff free quota or already have zero tariffs under current (Less Developedcountries) LDC preferences. There are, however, innovative ways in which exporters could take advantage of the AGOA preferences. For instancefresh cut flowers are not eligible in general, but fresh cut roses, which are of idterest to Malawi, are eligible. Similarly, there may be many commodities that could be potentially eligible for a duty waiver under AGOA if appropriately processed. For instance fresh fruits and vegetables may not be eligible, but baby foods based on these products could be eligible. In sum, Malawi should consider the AGOA as a framework within which public and private sectors need to collaborateto identify opportunitiesand act onthem. (ii) Suggestionfor Managing Malawi's TradeStrategy 2.28 Malawi's objective as a small LDC with weak administrative capacity should be to: (i) have as simple and free a trading environment as possible, (ii)minimize the costs of trade diversion associated with all preferencesby keeping external tariffs as low as possible, and (iii) get simple rules of origin at the lowestthreshold ofvalue added as possible. 2.29 To achieve these objectives, Malawi should follow a proactive set of domestic policies and take initiative inmultilateral negotiationsto enhance its interests. (a) Domestic Policies. 0 Strengthen customs service and trade related institutions to assist exporters and importers respondto the changingRTAs. 0 In implementing the South Africa bilateral trade agreement, avoid imposing a minimum value on contracts on tobacco or groundnuts shipped to South Africa. Such limitations result indiscrimination against small producersandtraders. 0 Create capability within the government to help industry take advantage of the AGOA for textile and other commodities. This involves first identifying a set of AGOA eligible commodities that are of potential interest to Malawi and making this information available to the private sector. This should be followed by assisting potentialexporterswith information onrules andregulationsfor accessing the AGOA. 25The analysis is basedonthe list o fAGOA eligible goods available at http://www.ustr.gov/regions/africa/annex2a.pdf 26Suchas aluminumproductswhichhave a tariffo f2-3 percent. 30 0 Create mechanisms for safeguarding industries. Malawi is receiving technical assistance from DfID to prepare appropriate legislation to establish a workable safeguard mechanism.Further assistance is neededto establishan independentbody to administerthis legislationandtrain staffto implementsafeguardmeasures. 0 Strengthenthe MalawiBureauof Standards to provide improved certification services. Malawi is especially vulnerable in the area of meetingTechnical Barriers to Trade (TBT) for labeling and on the grounds of health checks and requirements for tobacco, groundnuts, and spices. (b) Policies to be Pursued in the International Negotiations 0 Strengthenthe administrativeandnegotiatingcapacity for RTAs on anurgentbasis. 0 Innegotiating RTAs make every effort to maintain access to South Africa, which is potentially Malawi's largesttrade partner. 0 Continue to participate inboth COMESA and the SADC. When COMESA becomes a customs union, it will adopt a common external tariff (CET) structure in which the highesttariff on final goods (30 percent) is higher than Malawi's current highest tariff on final goods. With this in view, Malawi should lobby with other countries within COMESA to reducethe proposedCET to the levels currentlyprevalentinMalawi. 0 Consider liberal bilateral trade arrangement with TanzaniaandMozambique, which are currently not members of COMESA. 0 Participateinthe ongoingdiscussionsfor the REPA. Inthese discussions, the strategy for Malawias well as other small countries inthe region shouldbe to maintain their liberal access to each others' markets. Finally, Malawialso needs to ensure that any changes that do occur inthe RTAs do not result inits losing preferentialaccess to the SouthAfrican market. 31 Box 2.1 Anti-Dumping Versus SafeguardMechanisms Many African countries, have enacted anti-dumping (AD) legislations or countervailing duty procedures (CVD) to protect domestic industries from unfair competition from imports. The WTO does not require enactment of AD and CVD legislation for initiating these actions. Members of the WTO are, however, required to abide by the WTO Agreements on Antidumping and Subsidies that prescribe stringent procedural requirementsand significant standards for proofof dumping or subsidization. Most developing countries are ill-prepared to take on the onerous investigatory and quasi- judicial procedures that characterize WTO-consistent antidumping and countervailing duty investigations. Similarly, industries that petition for relief under AD or CVD proceduresare also not equippedto provide evidence in support oftheir complaints. A better option, which is still consistent with WTO obligations, is the enactment of safeguards legislation which provides relief but requires a significantly lower threshold of proof comparedto AD and CVD investigations. The AD/CVD applies to specific country whereas the safe guard applies to a product. Thus, an increase induties have to be applied across the board to all countries - which means that Malawi cannot single out Zimbabwean milk for increasedduties, for example. The enactment of a safeguard requires only that increasedquantities (in absolute terms or in relation to domestic production) are causing injury to the domestic industry. Furthermore, unlike AD and CVD procedures, there is no assumption that "unfair" practices of the exporting country need to be addressed. Safeguards procedures simply reflect the fact that even "fair" exports, but at an increasedlevel, can be problematic to a domestic industry. Finally, developing countries can apply safeguards for ten years while other WTO members are restricted to a period of eight years. D. High Cost of Transpod' 2.30 Duringthe past five years, the government has implemented a number o f measures to improve the transport infrastructure in Malawi. Malawi has successfully privatized the Malawi railways, a component of the Nacala corridor, and has created the National Road Authority to improve road maintenance. Current policies in the road transport sector seek to promote competition and liberalization. The entry into the domestic market is free to all with the exception o f foreign-registered vehicles on secondary routes and the market is free to set freight and passenger rates. 2.3 1 Despite these measures, both internal and external transport costs inMalawi are highand seriously erode Malawi's competitiveness. Transport costs account for 47 percent o f the retail price o f fertilizer (based on delivery to Kasungu), 24 percent o f the pump price o f diesel (inland 27Poorly fknctioning infrastructure -telecommunications, road, rail and air transport, power and water - have increasedthe cost of doing business inMalawi. This section addresses the issue of high cost o froad transportwhich is by far the single most important infrastructure constraint that affects all economic activities ranging from smallholder farmers to manufacturing activities and all trade. Impacts o f other elements o f infrastructureon business environment andtheir solutions are discussedinChapter 4. 32 costs from Beira only), and 12.5 percent of the auction price of tobacco (excluding transport from farms to the auction floor). 2.32 Many o f the reasons for Malawi's high external transport costs are beyond the government's control. Part of the highexternal transport costs can be explained by geography i.e., Malawi's long and uncertain links to ports. Moreover, more than 50 percent of Malawi's trade goes through Durban, South Africa rather than the cheaper routes through Beira or Nacala in Mozambique. There are a number of factors that influence this highcost pattern o ftrade. 2.33 First, Nacala, the cheapest route for Malawi's trade, continues to be beset with structural problems. The recent privatization of the Malawi part o f the Nacala corridor and the formation of the Central East African Railways (CEAR) has improved service on the Malawian section of the line. However, the operations on the Mozambican part of the railway and port continue to be in the public secto?8 and suffer from inefficiencies. These include: 0 Security problems including losses of cargo duringtransit. 0 Unpredictability and inefficiency o fthe port authority, 0 Excessive bureaucracy inprocessing customs documents inNacala. 0 Lack o f flexibility inscheduling shipments. a Occasional derailments duringbad weather. Inaddition, a 77 Kmsection oftrack betweenCuamba and Entrelagos that was damaged infloods in2001 has not been repaired yet. 2.34 Finally, Nacala port remains off the standard international shipping routes. Unless the shipment is large enough to justify the cost of making an extraordinary port of call at Nacala, the goods must often disembark at Durban or Maputo from large, internationally competitively priced ships andtranship to expensive coastal vessels. 2.35 All of these problems have reduced the attractiveness of this short route so much so that few goods that face tight delivery schedules are routed through Nacala. In recent months, the Nacala route has lost its traditional 20 percent volume o f fuel imports into Malawi due to poor safety standards at the port. 2.36 Second, Malawi has a peculiar pattern o f trade where imports are far larger than exports interms of weight and the demand for imports is less seasonal than the supply of exports. This means that trucks bringing goods into Malawi must often return empty. The lack o f back loads means that inwardtransport rates are consistently higher than the outward rates. 2.37 Third, the small size of the country, and therefore the relatively small volume of trade, means the transaction fees charged by freight forwarders are extremely high. While the rail tariff rate for a 20 foot container from Lilongwe to Nacala is only US$425, the total tariff including forwarding charges is 81 percent higher amounting to US$1,500. 2.38 Similarly, the costs of internal transport are also high. Domestic transport rates inMalawi are equivalent to about US$0.065 to US$0.075 per to&. Rates in South Africa and Zimbabwe are much lower at about US$0.02 on trunk roads and US$0.035 on rural roads. High internal transport costs can be attributedto several reasons. 28The concessionagreement was signed inSeptember2000 butthe takeover hasyet to take place. 33 2.39 First, while Malawi has an adequate core road network the condition o f rural roads is below the region's average. The creation o f the National Roads Authority (NRA) and a Road Fund, which is financed by a fuel levy, has improvedthe resources available to roadmaintenance ingeneral. Total roadsector expenditures have increased from about 1percent ofGDP in 1995/96 to 2.35 percent o f GDP in 2000/01. There is also now a better balance between routine maintenance, periodic maintenance, rehabilitation, and new road construction in the budget.29 Maintenance expenditures have increased from 15 percent o f capital expenditures in 1995/96 to 30 percent o f capital expenditures by 2000/01. Despite these improvements, expenditures on rural roads remain inadequate. 2.40 Second is the lack o f competition. The current policy continues to place restrictions on foreign operators. Foreign operators importing goods inMalawi are only allowed to deliver goods inspecified warehouses along the BlantyreLilongweklzuzu route. Any deviation from this route i s subject to additional loadinghnloading fee - increasing costs to the end In addition, as per the third country foreign operators are not permitted to carry domestic freight. Although the market is free to set the freight rates, in practice, freight rates and fares are fixed by the freight and passenger associations with the result that the full benefits o f a liberalized rates and fares system have failed to reach the consumers. 2.41 Third,transport taxes continue to be high, for example, tires carry 30 percent duty and 20 percent surtax, which together add 56 percent to the cost of importing tires. More recently, imported trucks not having the SGS inspection have been required to pay the Pre-Shipment Inspection (PSI) tax. This has introduced another element o f cost inthe industry. 2.42 Clearly the actions taken by the government have created the preconditions for a competitive transport industry. The next phase o f reforms is admittedly more difficult, requiring actions that are in the international arena and actions that will hurt the domestic influential trucking industry.These include the following. 0 The Government o f Malawi needs to work closely with the Government o f Mozambique to increase the efficiency o f the Mozambican part o f the Nacala railway and the efficiency o fthe port to provide Malawi with a cheaper route to the ocean. The 77 kilometers o f the damaged track between Cuamba and Entrelagos urgently needs to be repaired. 0 The government must be proactive in creating competition inthe trucking routes inand out o f Malawi. Given the influential trucking lobby, it would be crucial to lift restrictions excluding foreign operators from the market. 0 A number of specific actions could be taken to improve the ruralroadnetwork. These include: 29 See Malawi, Public Expenditures: Issues and Options. 30 Transport by road is constrained by high off-loading or loading fee faced by international.transporters dueto the requirementthat they deliver to warehouses onthe mainBlantyrelLilongwelMzuzu route. 31 The rule states that a truck is only permitted to carry freight betweentwo countries if it is registered in the country of origin or destination, or in one of the countries through which it travels on the journey. The rule was instigatedby the Federation of Regional Road Freight Association (of which Malawi RTOA is a member). 34 Raising more resources for road maintenance by raising the fuel levy other road user charges (e.g. vehicle licenses, transit tolls, parking charges) and allocating some of HIPC resources for the rehabilitation and constructionofrural feeder roads. NRA could improve the prioritization of rural feeder roads by transferring the responsibility for the planning and management of rural roads to the District Assemblies. The District Assemblies could work with the MASAF and communities to jointly prioritize rural roads. In order to provide an appropriate legal framework for private sector participation in road concessioning, the government should amend the Road Act as a part of which, a concession agreed during a term of office, would not be revoked with a change in regime E. HighLevelsof Corruptionand Weak Governance 2.43 A number of surveys of businessmen, high profile cases investigatedby the Anti- corruption Bureau, and the tone ofthe currentpolitical debate indicatethat corruption has affectedthe performanceof almost all sectors ofthe economy. High levels of corruption have increasedthe cost of doing the business inMalawi andaffectedthe delivery of public services in general.Recent high profile cases suggest high levels ofcorruption inpublic procurement, management of parastatals, management of educationspending, management of land, and provision ofpublic services like police and immigration. More recently, corruption problems have come to light inthe context of non-transparentoperations relatedto maize sales. The rest of this sectionpresentsavailableempirical evidence onthe levelofcorruption inMalawi, the presentinstitutional framework to address corruption, and suggestionsfor reform. (0 Level of Corruptionin Malawi 2.44 A number of surveys on constraintsto businesses inMalawi indicate that corruption and bribery is a major obstacle to private businesses in Malawia3*However, regional analysis indicatesthat the extent of corruption inMalawi is roughly similar to other countries inthe region that are potential competitors for investment. The Corruption Perceptions Index (CPI), released by Transparency International (Annex 2.9), indicates that in 2002, Malawi ranks 68* within a group of 102 countries worldwide. However, within sub-Saharan Africa, Malawi is perceivedto be less corrupt comparedto Nigeria (lOlst), Kenya (96*), and Madagascar (98"), and roughly at the same level as Zambia, Zimbabwe, and Tanzania - its immediate neighbors. The countries in sub-SaharanAfrica that are less corrupt comparedto Malawi are relatively high income countries such as Botswana, South Africa, Namibia, and Mauritius. In addition to the CPI index, public awareness of corruption in Malawi is high due to a number of high profile cases pursuedby the Anti-Corruption Bureau (ACB) over the past three years (Annex 2.10). While Malawi remains comparable to its immediate neighbors interms of the CPI, the incidence of corruption has been steadily worsening since 1999, as indicated inTable 2.4 below. 32See Table 4.3 inChapter 4 for details. Corruption also emerges as a major constraint inthe assessment of businessenvironment inneighbouringcountries as well. 35 Table 2.4: Trend inthe CorruptionPerceptionIndex Year CPI Score Rank Total No. of 10=Best, Countries l=Worst 1999 4.1 45 85 2000 4.1 43 90 2001 3.2 61 91 2002 2.9 68 102 Source: Transparency International (ii) ThePresent Framework toAddress Corruption 2.45 Malawi's constitution contains a section on Public Trust and Good Governance, which stipulates that the state will introduce institutions to improve governance in the country. Parliament passedthe Corrupt Practices Act in 1995; this act has established broad definitions of violations, specified penalties, and created the Anti-Corruption Bureau with statutory authority to conduct investigations and prosecutions. The ACB is not a part o f Malawi's civil service - the officers of the ACB are appointed directly by the president.The ACB director reports directly to the Parliament andthese reports are subject to parliamentary enquiry. 2.46 Since its inception the ACB has followed a three-pronged strategy to address corruption. These involve (i) education - the ACB has initiated a broad and sustained public relation public campaign against corruption; (ii)prevention - the ACB has attempted to review laws and regulations to identify conditions that breed corruption; and (iii) enforcement - the ACB has initiatedthe investigation and prosecution of a large number o f highprofile corruption cases. 2.47 While the broadthrust o fthe ACB's activities has beeninthe right direction, like other government institutions, the ACB has sufferedfrom budgetary problems that have constrained hiringofwell-trained investigators. Inthe areaofprevention, while ACB has initiated investigations o f a large number of cases, there have generally been few arrests and even fewer highprofile convictions. One ofthe problems with the current systemof investigationand prosecutionis that while the responsibility for investigation is with the ACB, the responsibility for prosecution lies with the Department o f Public Prosecution (DPP), which comes under the Attorney General's office but has parliamentary oversight. An assessment o f the present system indicates that the inability of the ACB to prosecute remains a weakness. The DPP's office is also short o f legal professionals. Finally the outcome o f prosecutiondepends uponthe quality o fthe court system, which remains very weak inMalawi. (iii) Suggestionsfor Reform 2.48 Improving governance and reducing corruption requires action infollowing three areas: a The entire process o f investigation and prosecution of corruption cases needs to be strengthened. First, this requires commitment at the highest political levels. Second, the existing legal framework for combating corruption needs to be strengthened by ratification o f the amendments to the Corrupt Practices Act. For instance the ACB has pointed out that current laws do not provide a clear and comprehensive definition of the corrupt practices or appropriate penalties. Third, to address the problems o f the 36 division of responsibility for investigationand prosecutionbetweenthe ACB and the DPP, the government should consider establishing an independent agency to fight corruption drawing onthe Kenyan experience. Fourth, additional budgetaryresources are needed to expand the training program for magistrates, increasing the staffing levels at the ACB, and settingup specializedcourt proceedingsfor corruption cases. 0 A substantial effort needs to be launched to reduce the discretion, complexity, and improve transparency in the laws governingthe business environment including the taxes and incentives offered, as discussed inSectionB (iii) this chapter. of 0 The government needs to take steps to bring about greater transparency inthe use of public money. First, the existingpublic procurementpracticesneedto be restructured to ensure greater transparency and accountability. The government is actively working on a new procurement law and a new institutional structure to bring about this reform. Second, the recent move to a contract system for senior civil servants, clarification of the relative roles of the Minister and the Permanent Secretary (PS) in taking financial decisions related to the budget, and strengthening the role of the Ombudsman are also steps in the right direction. Finally, many of the initiatives for expenditure control such as preparing the new finance and audit laws, the introduction of the IFMIS, and regular publication of actual expenditures against budgeted amounts would also help bring greater transparency to the use of public money and reduce the potential for corruption. 37 Chapter3 Agriculture A. Introduction 3.1 Malawi is highly dependent on agriculture. The recent performance o f agriculture has been weak because o f stagnation inyields, low profitability, and withdrawal into low value crops. The explanation o f the weak performance lies in the highly risky environment faced by farmers engaging in production and accessingmarkets for inputs and outputs. The highrisk environment results first from the macroeconomic volatility and the costly and unreliable transport services - factors that affect all sectors o f the economy. Second, the government has not been successful in creating food security for its population, including large number o f smallholder farmers who are net buyers o f food during periods of declines in food production. Third, the delivery o f key agricultural services such as research, extension, management o f land and irrigation, and rural credit has been weak. Finally, there have been serious problems in the current marketing arrangements for tobacco. Inwhat follows, Section B describes the main features, trends, and past policies in agriculture. Section C analyzes the factors behind weak agricultural performance, including problems o f food security and stagnating productivity. Section D presents suggestions for reform and Section E presents the particular issues facing the tobacco sector and offers suggestions for reform. B. MainFeatures, RecentAgriculturalStrategies,and Performance 3.2 Main Featuresof Agriculture. Agricultural production inMalawi contributes more than 90 percent o f foreign exchange earnings and about 85 percent o f Malawi's people work in agriculture, although they produce only about one third o f GDP. Agriculture inMalawi i s highly dualistic. Approximately 84 percent o f agricultural value added comes from 1.8 to 2 million smallholders who on average own only 1 hectare o f land. They typically cultivate maize as the main food crop. One thirdcultivate some cash crop (19 percent grow burleytobacco), and most grow other food crops as well -smallholders produce most o f Malawi's cotton and paprika. Approximately 30,000 estates cultivate 1.1 million hectares o f land with an average holding size of between 10 to 500 hectares. They produce tea, flue-cured tobacco, coffee, sugar cane, and about one third of the total burley tobacco. 3.3 Malawi has one of the highest population densities in sub-Saharan Africa. The amount of arable land per rural inhabitant is lower than in'other countries inthe region, and even lower than inother developing regions (Table 3.1). InMalawi, incontrast to other densely settled developing countries, high population density has not led to agricultural intensification, but rather to rapid depletion of soil nutrients.Current farming systems are in many cases unsustainable and threaten further environmental degradation. Despite the country's dense population, many Malawian smallholders face labor constraints at key times in the year. The HIV/AIDS pandemic removes productive laborers from the fields and also diverts caregivers from other activities (an estimated 16 percent of rural Malawians are infectedwith the HIV virus). 38 Table 3.1: ComparativeNaturalResourceEndowments and Indicatorsof Intensification, Various Countries, 1999 Malawi Zambia Sub-Saharan India L A C Africa Arable Land per Rural Inhabitant (ha) 0.23 0.86 0.40 0.23 1.25 IrrigatedLandper Rural Inhabitant (ha) 0.003 0.007 0.013 0.15 0.15 Fertilizer Use (kg ofnutrients/ ha) 15.9 10.1 8.4 108.3 71.4 Source: F A 0 3.4 Because the country is landlocked and domestic and regional transport is poorly developed, Malawi's transport costs are high. High transport costs provide natural protection for bulky commodities produced for home consumption and bias exports toward products that are high in value per unit weight. 3.5 Malawi's natural resource endowment is favorable to agriculture, but requires additional investment to overcome constraints and good stewardship to provide sustained returns. The country is vulnerable to periodic droughts (major droughts occurred in 1991/92 and 1993/94) and floods (such as in 1997/98 and 2000/01) that require additional investment inwater management. Forest cover has declined from 26 percent to 19 percent of total area over the past 25 years, with attendant problems associated with management of watersheds. Soil fertility has also declined over the same period. Over 98 percent of agricultural production depends fully on a four-month rainy season; only 57,000 hectares are under irrigation, equivalent to about 2 percent o f total area under cultivation. Dueto the paucity of water outside the rainy season, most ruralfamilies depend on a single harvest of annual crops, dominated by maize and burleytobacco. 3.6 Yields o f local maize are below 1.0 MT/ha' and have remained stagnant for the past decade (Figure 3.1). The small improvement in average yields is the result of increased adoption of hybridand composite maize seeds. However, the use o f these improved varieties has increased largely in response to free distribution of inputs. Agricultural growth in Malawi over the longer run must be based on strong and durable commercial relations between private distributors of inputsand smallholders wishing to adopt improved technologies. Figure 3.1: Smallholder MaizeYields 3.000 -k 2 2.500 2.000 1.500 1.000 0.500 0.000 1995 1996 1997 1998 1999 2000 2001 Agricultural Year 1 +Local -w- Composite Hybrid -%- Smallholder Avg. Source: Ministryof Agriculture 'Ananalysis carried out at the NationalSeeds Co. indicates that the potentialmaize yields inMalawi could easilybe 3 to 8 MTha, which is less than the potentialyields of 13 and 24 MTha inZimbabwe andthe United States, respectively. 39 3.7 Recent Agricultural Strategy. The government's program o f agricultural reforms launched in the early 1990s included a number bold initiatives. The Special Crops Act that had prevented smallholders from growing tobacco in particular was repealed. Investments in agricultural research and extension to promote hybrid maize, roots, tubers, and pulses were undertaken. Price controls were eliminated (except for maize, which remained subject to a price band until 2000) and barriers to private sector participation in the marketing o f agricultural commodities and inputs were reduced or removed. For example, seed and fertilizer subsidies and inputprice controls were eliminated andthere was a partial commercialization o f activities o fthe Agricultural Development and Marketing Corporation (ADMARC). The government established a maize price band and used ADMARC facilities to sell maize stocks at pan-territorial (below market) prices. The Starter Pack Scheme (SPS) was introduced in 1998/99 and 1999/2000 and the Targeted Inputs Program (TIP) in 2000/01 to facilitate access to agricultural inputs. The Smallholder Agricultural Credit Administration (SACA) was eliminated, and the Malawi Rural Finance Company (MRFC) created. The Agricultural Productivity Investment Program (APIP) was introduced to increase fertilizer use through a partially subsidizedlguaranteed credit scheme. Finally, in 2000 the maize price band was eliminated and NFRA was made responsible for managingthe strategic grain reserve (SGR). 3.8 Major Trends in Agricultural Performance. Limitations in the existing agricultural production data2 and the lack o f directly comparable data on rural incomes over time makes a comprehensive evaluation o f the impact o f these reforms difficult. According to official production data, value added inagriculture3 grew at the rate o f 7.6 percent per year over 1995-98 and at the rate o f 6.5 percent per year over 1998-2001, almost twice that o f aggregate GDP growth4(Table 3.2). Ifthis data is correct, then all o f the increase came in domestically produced and consumed food crops since the export data from independent sources do not show the same growth (Table 3.2). Yet booming growth in food crops over the period is not consistent with reports of chronic under-nutrition and the present severe food crisis. Table 3.2: Agricultural Performance as per Official Statistics, 1995 -2001 1995-98 1998-01 1995-01 Annual GrowthRate inValue Added (%). . 7.6 6.5 6.7 Avg. Annual Exports*(US$ million) 409 378 387 AVE.Area under Cultivation**(OOO'sha) 2.405 2.975 2.686 Avg. Annual FoodProductions;* (kcallcaplday) 21641 31649 31135 Sources:*NSO, **MAOI, ***StaffestimatesbasedonFEWS/ MOA1crop estimates 3.9 An analysis of the production and export data o f the main export crops (tobacco, tea, sugar, coffee) based on various sources,' suggests that there was some growth in agriculture A detailed analysis of the limitations of the data is presentedin Annex 3.1. The government has already establisheda task force, which includes the Ministry of Agriculture, the National Statistics Office, and the Ministryof Finance, to review the methodology for collecting agricultural production data and propose changesto improve the quality ofthe data. This includes livestock, fisheries, andtimber products. The analysisuses the 1994/95 agricultural season (that is, the year 1995 inGDP calculations) as the base year because the 1993/94 season was particularly bad due to severe drought. If 1994 had been used as a base, the agricultural sector annual growth rate for 1994-97 would have been 19.1 percent and 9.5 percent for 1994-01. The key sources are: (i)annual export data for tobacco, tea, coffee, and other key crops; (ii)the 1997/98 Integrated Household Survey; (iii)fertilizer,data; (iv) several 1997/98 land utilization studies; and (v) representativesmallholder farm budgets from NASFAM. 40 between 1994 and 1997 followed by stagnation since then. Export earnings o f tobacco peaked at about $450 million in 1997/98 -the source of this growth was the rapid expansion o f smallholder burley production. Since 1997198, export earnings have declined by almost 20 percent (Figure 3.2). This is primarily due to declining export prices (e.g., from US$3,532 per metric ton of tobacco in 1997 to US$3,011 per metric ton in 2001, or from US$2.40 per kilogram of tea to US$2.04 per kilogram in the same period; see Figure 3.3). The decline in export earnings has been accompanied by a dramatic erosion o f profitability in smallholder agriculture (Figure 3.4), due to a combination of declining commodity prices, stagnant yields, and structural and policy constraints that have discouraged investment. 3.10 Although the statistical picture is blurred, several key trends in agriculture over the last few years can be discerned. Reforms over the past half decade have brought a rapid expansion of production o f burley tobacco by smallholders. With the liberalization o f tobacco production and marketing, smallholder farmers have rapidly become the main producers o f burley (in plots of between 0.1 to 0.3 hectares), accounting for roughly 70 percent of the national total. Close to one in five smallholder households (equivalent to roughly 350,000 farmers) in the country now cultivate tobacco, which has led to increased cash flowing into rural areas. Net returns from smallholder burley peaked in 1997-99 period at about US$SOO per hectare, or roughly US$lOO per farmer, but dropped to about US$26 per farmer in 2001. Just under one third o f registered tobacco club members are women. The rapid expansion intobacco productioncan be attributedto a combination o f successful policy reforms, good institutional development (formation of burley clubs, a national association o f smallholder farmers), increased access to credit by small farmers through MRFC, and favorable international conditions. This experience demonstratesthe benefits that strong market-orientedfarmer organizations can provide. 3.1 1 Duringthe 1990s diversification into cassava, potatoes, pulses, and, to a lesser extent, to other higher value-added cash crops took place. There has been some growth in non-maize food crops among smallholders, which is attributable to a successful partnership between the government, donors, and the NGO community. The government strengthened root crop research and encouraged the accelerated and large-scale multiplication and distribution o f superior planting materials of both cassava and sweet potatoes. Many nurseries have been turned over to farmers' groups. Similarly, well-organized smallholder farmers, such as those belonging to NASFAM, have beenable to diversify into paprika, cotton, and groundnuts. I ~~~ ~ Figure 3.2: Malawi's Export Earnings 1 500 1 .-E400 0 300 *E 200 u) 3 100 0 1995 1996 1997 1998 1999 2000 2001 /ISTobacco .Tea OSugar DAll others Source: IMF 41 Figure3.3: MainAgricultural Export Prices y 120 k , I g 100 $ +Tobacco 80 - 60 Sugar .- 40 +--Coffee i o I t 20 wK 1997 1998 1999 2000 2001 Source:IMF -m Figure 3.4: SmallholderAverage Gross Margins 1995-96 2000-01 Source: World Bank staff estimatesbased on Keyser (1996) andNASFAM(2001). 3.12 The contribution of estates to agricultural export earnings has declined from about 80 percent inthe mid-1990s to just under 50 percent inthe last two to three years, largely as a result of poor management and the inability to compete in burley production with the smallholder sector. Estates remain important in the production o f tea, other types o f tobacco, sugar, and coffee. The cultivated area under estates has fluctuated between 120,000 and 150,000 hectares over the last few years, representingless than 5 percent o f the total area under cultivation. Estates occupy over 1 million hectares, and much of this land at present is underutilized - so there i s significant scope for improved efficiency o f land use through negotiated transfer of lands to smallholders. C. FactorsBehindthe PoorAgriculturalPerformance 3.13 Poor performance o f agriculture characterized by stagnation in yields, low profitability, and withdrawal into low value crops can be explained by the following four factors. First,factors that affect all sectors of the economy, notably macroeconomic volatility and costly, unreliable transport services, have been particularly damaging to agriculture due to the inherently risky nature of agricultural production and marketing. Second, Malawi's failure to achieve food security has increased the risk facing farmers engaging in the production o f higher value crops 42 and participating in the markets for credit, fertilizer, and output. Third, the delivery of key agriculture services such as research, extension, managementof land, irrigation, and credit, all of which are critical for increasing productivity, have been weak and unreliable. Fourth, the marketing arrangements for tobacco, which accounts for 80 percent o f Malawi's exports, remain highly inefficient. The sections (i)(iv) below analyze eachofthese factors and offer suggestions - for reform. (i) Macroeconomic Volatility andHigh Transport Costs 3.14 Macroeconomic Volatility. Agriculture is inherently risky because it depends on natural processes (weather, plant growth, pests) over which farmers have little control. Financial institutions often prefer to lendto non-agriculturalactivitiesthat have lower risk and more regular cash flow. Agricultural borrowers often pay a risk premiumand small borrowers face additional high transactions costs. Macroeconomic volatility augments the risk and usually raises real interest rates, crowding or pricing agricultural producers out o f financial markets. The long lead times between the purchase of inputs (e.g., fertilizer) and the sale o f outputs make financing o f working capital particularly sensitive to increases in real interest rates. Similarly, the temporal cycle of agricultural production leaves farmers vulnerable to movements in exchange rates. For example, a sharp devaluation just after producers have sold their products and before they have purchased inputs for the coming year can reduce demand for inputs and erode competitiveness. High inflation followed by sharp devaluations can also have a devastating effect on the real incomes o f poor farmers since they tend to sell a large portion of their output when prices are low (harvest) and they are net purchasers of food and other basic tradable goods (e.g., clothing). Furthermore, instability impedes growth in the non-farm economy, and thus chokes off demand for seasonalwage labor that supplements earnings from agriculture. Table 3.3: ExchangeRate MovementsRelevant to Tobacco Earnings Season Oct-Nov June-August Sept-Nov (inputs) (auction) (exports) 1997/98 17.7 27.9 42.0 1998199 42.5 43.4 44.5 1999/00 45.0 57.2 75.1 2000/01 79.0 71.5 63.1 Source: NSO 3.15 In Malawi, inthree of the past four years, exchange rate movements have hurt tobacco farmers (Table 3.3). In both 1997/98 and 1999/00, in the three-month period immediately following farmers' sales the Kwacha was substantially devalued. Farmers thus faced sharply higher prices when buyinginputs for the coming year. The Kwacha appreciated duringthe course of the tobacco growing and selling season, exacerbating the effects o f low auction sales prices. becauseHigh 3.16 Transport Costs. High transport costs are particularly damaging to agriculture they reduce the competitiveness of bulky products and increase the cost o f the most critical imported input, fertilizers. For example, transporting fertilizer from Europe to the port of Beira, Mozambique costs half what it costs to transport it from Beirato Lilongwe. Hightransport costs are eroding the profitability o f tobacco. Internal transport to satellite depots and the auction floor, as well as the congestion there, adds US$O.lO, or about 10 percent, to tobacco's auction price. Similarly, international transport costs for Malawian tobacco exports are also high. Nearly two-thirds of the exported product is transported by the long route o f road and rail to Durban, South Africa, rather than the less expensive route via rail to Nacala, Mozambique. The savings from use of the closer port would be as much as US$0.07 to 0.10 (or 7 to 10 percent o f recent prices). 43 (io Failure to Provide FoodSecurity. 3.17 Historically Malawi has struggled with providing food security to its population. Food security could be defined as consisting of two elements: (i) ensuring adequate suppliesof food in the market as marketed surplus from domestic production and imports and, (ii) creating incomes and entitlements the hands ofthose poor who have lost a part oftheir incomes duringa period o f food shortage. The former could be thought of as achieving "national" food security and latter as achieving "household" food security. 3.18 The government's food security policy through most of the 1990s has had two primary objectives: (i)ensuring a minimum of 1.8 to 2.0 million metric tons o f domestic maize production' and (ii)avoiding sharp increases in the maize price to consumers, especially during the lean season of November to March. The main instrument usedto achieve the first objective has been the widespread promoiion of hybrid maize and inorganic fertilizer packages through preferential or free distribution of seeds and Urea. To achieve the second objective, the government reliedon ADMARC to domestically buy maize at the time o f harvest or import it and sell it during the rest of the year at (affordable) pan-territorial prices. Beginning in 1999/2000 pan-territorial prices were abolished, and the National FoodReserve Agency (NFRA) was created to managethe country's strategic grain reserve (SGR).' 3.19 The government's food security policy as described above has not been effective. First, aggregate food production and productivity have stagnated (see Section B), second, maize markets have not efficiently delivered available maize to the poor at reasonable prices; and third, the government's entitlement programs for the poor have not been successful and have had large fiscal costs. Consequently, not only has Malawi experienced chronic food shortages but also has faced famine-like conditions as recently as 1998 and 2002, with widespread hunger and malnutrition. The events that led up to the current food crisis (See Box 3.1) are illustrative o f the long standing problems o f food security inMalawi. 3.20 Clearly a major reason behindthe chronic food shortages and periodic food emergencies i s that the aggregate food production in Malawi has not kept pace with population." The per capita production o f maize, Malawi's main staple food, has fluctuated between 170 and 220 kilograms over the last ten years, with sharp declines in 1992 (67 kilograms) and in 1994 (105 kilograms), and is estimated to be only 140 kilograms for 2001/2002. To some extent, the decline in production of maize was compensated by the increase inthe production of drought resistant crops such as cassava. However, the official data on the production o f these crops, which indicate a sharp increases in production, are highly unreliable and overstated. The most convincing indicator of the food security are the household budget surveys that indicate that the aggregate Itis importantto distinguishbetweenproviding food securityandsettingup asocial safety net.A social safety net is createdto protectpersonswho have no assetsor entitlements, and requireassistance even during anormalyear. These are typically widows, orphans, infirm, or the elderly. Onthe other hand, food security policiesdiscussedinthis sectionare designedto assistperfectlyproductiveindividualswho have losttheir incomes due to afall inthe agriculturalproductiondueto adverseweather, war, or other calamities. 'This figure was basedonthe notionthat roughlytwo-thirds ofthe requiredcalories for all Malawians shouldbe supplied by maize. Preferential access to inputs was implemented by the Agricultural Productivity InvestmentProgramme (APIP), launchedin 1997/98, and free access was implementedby the Starter Pack Programme from 1998- 2000 andthe Targeted InputsProgram(TIP) in2000/01. The NFRA is composedof a BoardofDirectors and asmall administrativestaff. Itrelies completelyon ADMARC for storage(inits own andthe government's facilities) andmovementofthe grainreservesto the markets. lo The reasonsbehindthe stagnationinproductivity of most crops including maize are discussed inSection (iii). 44 food supplies in Malawi fluctuated between 1.6 and 1.7 kcal/capita/day during 1996-1999, comparedto a minimumrequiremento f2.2 kcallcapitalday. Box 3.1: The 2002 Food Crisis in Malawi The severe food crisis currently facing Malawi illustrates the long-standing problems of food security. Production of maize, the key food staple, during the 2001/2002 growing season, estimated at 1.6 million metric tons, is approximately600,000 tons short of requirements. Official estimates indicate that nearly 78 percent of the farm families, a total of 2.2 million households will be without sufficient food in 2002. The current food crisis can be traced to a combination of immediate causes during 2002 and long standing systemic problemswith low productivity inmaize. ImmediateCauses Erratic weather. Malawi experienceddrought andfloods in2001and2002 which, althoughnot as severe as those of the early 199Os, resulted in significant drops in maize yields. In the 2001/2002 growing season, rains started late, and when they finally came they were severe in some places, causing water logging and floods. Failure of the early warning systems. While availabledatapredictedamaize shortfall in2001, they also indicated that the increase in other crop harvests (particularly roots and pulses) would adequately compensatefor the maize shortfall. The long-standingproblems with the adequacy of the statisticaldata surfaced in September 2001 when Malawi beganto import food in anticipationof a shortfall. President Muluzi declaredafoodemergencyinlate February 2002. Transportationbottlenecksthat impeded the timely arrival of imported maize in early 2002. Poor Marketing System and Poor Managementof the SGR.By the beginningof 2001, NFRA had sold almost its entire stock of maize. The reserve was sold in a non-transparent manner with insufficient accountingfor its proceeds. Price distortions. The government (ADMARCNFRA) sold its maize reserves in 2000/01 during a period of bumper harvest when prices were already depressed. This led to widespread defaults on agricultural credit as well as insufficientincome to purchase fertilizer and hybrid seeds, and thus led to reducedoutput. Systemic Problemsof Low Productivity Over-reliance on maize. Most farmers dependon maize as the main staple that is not drought resistant, but it needs large applicationsof fertilizers to avoid exhaustionof soil nutrients. Reliance on maize is therefore ahigh risk food security strategy. Low adoption of improved technologies. The country has weak capacity in the development and disseminationoftechnologies, therefore adoptionofnew technologies has remainedlow. Increasedpopulation pressure on land without concomitant improvement in productivity. The rising populationhas increasedpressureon land leadingto reduced landto labor ratios. Without corresponding increaseinyields, foodproductionhas declinedand increasedvulnerability to periodic climatic andother shocks. Respondingto the Crisis Lessonsfrom the 2002 Experience - Short-term actions: Enhancefood supply by establishingdistribution channelsthat reachthe vulnerable, throughprovisionof free food to the poorest andawage incashor a food-for-work program. Medium-term actions: Productive capacity for the next and subsequent production seasons must be enhanced. Long-term actions: Identify investments andinstitutional structuresto reduce long-termvulnerability even ifthese cannot be put inplace duringthe periodof immediatecrisis. 45 3.21 A fall in the production o f maize need not necessarily translate into a reduction in the availability o f maize if private traders respond quickly by importing maize and selling it in the domestic markets. Maize markets in Malawi, however, have not worked well. Domestic and international trade in maize, like other commodities, is beset by bad roads, inefficient ports, and unreliabletrucking services." Similarly, the private sector engaged inthe maize trade is weak and is dominated by a few large companies. These inherent problems are exacerbated by the significant and unpredictable interventions by the government in the past (through ADMARC operations), by setting prices and buyingand selling grain financed by budgetary subsidies. 3.22 During most o f 1995-1999, ADMARC operated a price band consisting o f floor prices (for maize purchases) and ceiling prices (for maize supply). These prices have often changed unpredictably." The average ADMARC purchase price has fluctuated between 37 percent o f the farm gate price in 1995 to as high as 180 percent o f the farm gate price in2000 (Table 3.4). Even after the price band was abolished, during 2001/2002 season, the government continued to influence maize prices by banning traders and forcing ADMARC to sell at a pan-territorial price (MK 17 per kilogram) financed by a budgetary subsidy. Similarly, ADMARC local purchases varied from as high as 31 percent o f the marketable surplus in 1997 and 2000 to less than 1 percent o f the marketable surplus in 2001. This unpredictable government participation in the maize markets made it highly risky for private traders to plan imports, hold inventories, and sell inthe domestic markets. Table 3.4: ADMARC Participationin the Maize Markets 1995 1996 1997 1998 1999 2000 2001 Production Smallholder Production 1.33 1.79 1.22 1.53 2.48 2.50 1.71 (millions of metric tons) Imports 0.23 0.08 0.05 0.32 0.03 0.00 0.04 (millions of metric tons) ADMARC Purchasesas a yoof 4.60 4.90 7.90 0.80 2.30 7.90 0.10 Smallholder Production ADMARC Purchasesas a% o f 18.40 19.60 31.60 3.20 9.20 31.60 0.40 Marketable Surplus 1/ Prices Average Retail Price (MK/Kg) 2.15 2.57 3.36 6.88 8.36 6.58 N A Average Farm Gate Price 1.4 1.55 2.67 3.51 4.28 3.25 N A (MWKg) Average ADMARC Purchase 37.14 80.65 58.43 51.57 80.37 180.62 N A Price as % ofAverage Farm Gate Price. Source: Ministry of Agriculture, ADMARC, FEWS, NEC. 1/ Marketable surplus is estimatedto be about 25% of total smallholderproduction. These problemsare particularly severe for maize due to its bulkynature. l2For instance, in 1998the fixed price for purchaserswent from MK2.5Kg at the start o fthe year to MK3.9Kg inMarchto MK 8.5Kg inAugust. 46 3.23 These market interventions by ADMARC, and more recently by the NFRA, also had large fiscal costs that were not transparently accounted for inthe budget. For instance, over 1998- 2000 the budget had annual allocations amounting to only about 1-2 percent of GDP for the broad category o f "maize purchases." However, debt data indicates that in February 2001 the government assumed an NFRA debt equivalent to 1 percent o f GDP and paid off ADMARC liabilities equivalent to 1.75 percent of GDP. Similarly, the government also absorbed the losses incurred by the NFRA in its maize operations in2001, but the fiscal impact was nottransparently communicatedto the public. 3.24 Given the fiscal difficulties, the cost of providing a subsidy by maintaining a common low maize price for all would be prohibitive. Further, such a subsidy would have problems o f equity since well-connected or well-off consumerswould end up getting preferentialaccess to the maize, and there could be cross border leakages depending upon the prices in neighboring countries. Malawi thus needs to create effective mechanisms to provide entitlements to food insecure households duringperiods of sharp fall inproduction. Over the years Malawi has created a number o f such mechanism^.'^ These include the Public Works Programs (PWP) operated by the Malawi Social Action Fund(MASAF), FoodFor Work Program(FWP) operated by NGOs in collaboration with the World Food Program (WFP), School Feeding Programs, and the Targeted Inputs Program (TIP). The main problem facing each of these programs is implementation capacity. The PWP, for instance, suffers from weak supervisory capacity at the district level and lack o f reliable contractors to execute projects. The FWP operates on a small scale and relies almost entirely on free maize available from the WFP. The School FeedingProgram (SFP) is not targeted since it feeds both poor and non-poor children, and it would be prohibitively expensive to expand the geographical coverage to cover all the poor. Further, the SFP is constrained by the Ministry o f Education's implementationcapacity. The TIP has multiple objectives: to compensate for fertilizer price increases, credit market failures, promote national food self-sufficiency, and serve as a safety net. The TIP is further beset by administrative problems involved in identifying the poor farmers as the main recipients of inputs, and prior attempts at making it universal have provento be prohibitively expensive. (iig StagnatingAgricultural Productivity 3.25 Poor Management of Land and Water Resources. With such a highpopulation to land ratio, one would expect to see increasing land values, intensification o f agricultural production, and more careful use o f land. In contrast, high and rising population density in Malawi has contributed to rapid soil nutrient depletion and declining yields. Due to poor land husbandry practices, harvested crops in Malawi remove about 160,000 metric tons of nutrientsevery year, while mineral fertilizers at present levels o f use replace only about 70,000 metric tons. Organic sources replace an additional 15,000 metric tons. The nutrient deficit makes current farming systems unsustainable and threatens further environmental degradation. Soil depletion derives in part from high costs of fertilizer, and in part from poor access o f smallholders to advisory services that could guide better decision-making on technology and diversification. 3.26 Although much o f the land in Malawi is overused or poorly used, there still remain considerable underutilized lands. These include about 400,000 hectares o f estate lands and 400,000 hectares of public (or quasi-public) lands. These lands could, in principle, be made available for cultivation by land-constrained smallholder farmers. To date this has not happened l3 World Bank, "Malawi: A Safety Net Strategy," GreenCover Document, December 1999. 47 for two reasons: first, most of the available land is inthe North, while the highest land pressures are in the South, and second, the institutions to support land tenure and transactions in land are not well developed. 3.27 Malawi has also not fully used its irrigation potential. Although there has been a three- fold increase in public spending in irrigation between 1996 and 2000, much o f this expenditure has been on large-scale public irrigation schemes, the performance o f which has been disappointing. Many o f these systems are centrally administered with little involvement of farmers inmanagement or operations. The economic returns to irrigating additional land through large-scale public sector irrigation projects are low. However, technical analysis indicates that it should be possible to develop about 350,000 hectares, which lie inseasonally wet valley-bottoms (dambos) through small-scale irrigation schemes basedon private investment. 3.28 Limited Access to Agricultural Technology and Advisory Services by Smallholder Farmers. The problems of land husbandry and management of water noted above derive in part from weaknesses in agricultural services. Public spending on agricultural research averaged around 0.1 percent of GDP between 1996 and 2001 (or about 0.3 percent of agricultural GDP). African countries, on average, spent about 0.7 percent of agricultural GDP on research in 1991, which is in turn much lower than the proportionate investment in agricultural research in developed countries. The small size of Malawi's agricultural economy and very small proportionate investment in research results in a commitment to a generation o f technology seriously deficient relative to the ambitious goals for growth. In addition, expenditure on extension fell by one half between 1996 and 2001. O f the monies allocated to agricultural services, a large share goes to central level administration, flows to research scientists and extension field offices are insufficient to meet the most basic operational needs. Field extension staff are poorly trained, only paid one third of what similar staff at NGOs are paid, and have little accountability to their clients, the farmers. As a result o f reduced expenditures, hiringfreezes, and the increase in deaths due to HIV/AIDS, the ratio of front line extension staff to farm households has deteriorated from 1:980 in 1995 to 1:1,700 in 1999. Linkages between researchers and extension workers are poorly developed - several promising technological options exist on the shelves o f researchstations, but have not been economically validated or disseminated to farmers. Evenwhen extension efforts are successful (such as soil conservation and fertility management efforts in some areas or on-farm root crop multiplication), the over-stretched and centralized public structures are unable to scale these up effectively. 3.29 High Cost of Fertilizers. One o f the most critical constraints to agricultural development inMalawi is the high cost of fertilizers. Although domestic fertilizer prices inMalawi have been decreasing in U.S. dollar terms since 1996 largely in response to a decline in world prices, they remain three times higher than world prices. This is particularly problematic since world tobacco prices have fallen more than fertilizer prices (Table 3.5). Furthermore, fertilizer prices in Malawi are considerably higher than those in other countries o f the region, as shown in Figure 3.5. Several factors explain this - international transport and port charges through Beira are about US$75 per metric ton, local transport adds US$25 per metric ton more, finance charges for 6 months are about 20 percent o f total cost, trading company margins are 25-40 percent (as a result of little competition and highexchange rate risk), and retailer margins are about 10 percent. 48 Table 3.5: FertilizerPricesComparison (Current pricesduring agricultural season,US$ per metric ton) 1995 1996 1997 1998 1999 2000 2001 2002 WorldMarket Prices" Urea 123 186.5 187.5 127.9 103.1 77.8 101.1 95.3 CAN 163 191.4 176.5 163.7 122.5 109.6 157.3 132.5 DAP 173 216.2 213.4 200.0 203.0 177.0 153.6 146.0 Selected Domestic Prices Urea 166 456 489 440 367 345 347 294 CAN 182 384 370 325 269 286 327 263 CrodUrea Price ratio Burley 7.7 3.2 3.3 3.6 3.6 4.0 2.9 * Ammonia andUreaare f.0.b. WesternEurope, DAP is f.0.b. 3.7 U S Gulf. Source: SFFRFM, World Bankstaff estimates 3.30 More profitable use of fertilizer inMalawi will depend inpart on lower costs, but also on greater efficiency o f use at the farm level. Many farmers usinghybrid maize seed and fertilizer achieve less than 50 percent of potential yields. Late application of sub-optimal amounts, poor placement and planting practices, low organic content, and excessive loss through leaching all contribute to reducedyields, but can be remediedby better agronomic practice. Figure3.5 RegionalComparisonof FertilizerPrices, 2001 (US$per metric ton of material) 500 400 300 200 100 0 I CAN SjAmmo DAP 23:21 Urea Source: World Bank staff estimates Table 3.6: FertilizerConsumption (metric tons) 1991 1992 1993 1994 1995 1996 1998 1999 2000 CAN 34,348 29,997 18,204 54,467 51,125 42,580 46,125 48,350 47,225 Urea 38,625 46,227 30,514 36,773 38,167 1,438 39,450 42,116 41,150 DAP 19,040 26,042 10,701 19,266 19,612 866 2,115 1,195 3,119 Other 39,669 40,339 23,653 30,134 87,129 106,590 99,236 91,115 100,158 Total 131,682 142,605 83,072 140,640 196,033 151,474 186,926 182,776 191,652 Source: SFFRFM, World Bank staff estimates 49 3.31 At present about 40-50 percent of fertilizer trade is undertakenby public and parastatal organizations, mainly ADMARC and the SFFRFM. This large public presence in the trade reduces the volume that private traders handle (hence increasing unit costs), and reduces their incentives to invest and expand. Under programs such as the Targeted InputsProgram, producers may become familiar with the use of fertilizer, but they do not builda durable relationshipwith a private retailer or distributor, and hence the longer-term stability of the market is not served. Use of a voucher that is redeemablefor inputs at retail outlets would improve competition and help in reducing costs. Success of the recently established program to develop a national network of input suppliers would be increasedifvouchers (or redeemable purchaseorders) were used inthe TIP instead o f distributions inkind. In addition, government can undertake a number of activities that would facilitate private trade infertilizer and reduce costs to producers. Giventhe established competitiveness of using the Nacala corridor, the government should review progress on the implementation o f measures requiredto get this route fully operational (improving the off-loading and handling facilities at the port, completing the rehabilitation of the remaining rail link). Similarly, the government could facilitate establishment o f a trade association for importers, distributors, and retailers of fertilizer. The association would be a vehicle for generation and sharing o f information, bulking of purchases, logistical coordination to cut costs, and other actions that members finduseful. 3.32 Much can be gained by reducing the costs o f fertilizer and increasing effectiveness o f its use, but not all improvements inagricultural productivity rely totally on intensiveuse of fertilizer. Adoption o f legume intercropping and application o f manure can also raise yields, either in conjunction with or separately from use of fertilizer. Manure application can take place year- round, and hence relieves seasonal labor constraints. Processing o f crop and household residues for composting and use as a manure can also be undertaken on a continuous basis to improve soil fertility. This would supplement crop nutrients in addition to enhancing the soil's potential to conserve moisture and nutrients. Legume intercrops, such as soy, also offer the direct benefit of supplementingthe nutrient and organic content o f soils in addition to providing an additional source o f farm income. 3.33 Limited Access to Rural Credit.I4 High risk in production and marketing, high transactions costs for small loans, lack of collateral, and severe poverty has meant that majority o f the smallholder farmers in Malawi are not creditworthy and will remain so for the foreseeable future. The only commercially run credit system for smallholder farmers that has survived in Malawi is one that relies on compulsory group repayment enforced by the stop-order mechanism at the tobacco auctions. This system is run by the Malawi Rural Finance Company (MRFC) and cannot be expanded to cover other crops. It is thus unrealistic to expect that commercial financial institutions will be significant providers of finance for working capital o f smallholders. It is more likely that rural credit may be available to individual farmers if they belong to a producer group that succeeds in developing successful relations with local financial institutions. Savings are likely to be a more important source of financing o fworking capital, and financial institutions can expand successfully into rural areas by providing services for savers. l4 See the section on access to finance inChapter 4. 50 D. Suggestions for Reform (9 Achieving Food Security 3.34 Achieving food security, defined as ensuring adequate supplies o f food in the market, together with creating incomes inthe hands o f the poor duringa period o f food shortage involves action inthe following four areas. 0 First, Malawi needs to strengthen its systems of early warning and accessing donor assistance. This involves improving agriculture statistics as indicated in Annex 3.1, and obtaining a better handle on the production of drought resistant food crops such as cassava. 0 Second, all aid available in the event o f a food emergency should be used to augment incomes o f the poor rather than intervene in the maize markets. All cash contributions should be placed in an "emergency fund" created for assisting affected persons. All donations in kind should be monetized at auctions at designated sites, and the proceeds should also flow to the same emergency fund. Similarly, maize held inthe strategic grain reserve (SGR)I5should also be auctioned intimes of emergency and proceeds allocated to the emergency fund. To cover any gap between contributions andthe cost of meetingthe needs of the affected persons, the government should either make explicit budgetary allocations or borrow at concessionary rates. 0 Third, assistance to affected people should be largely through income augmentation programs such as the public works program or a program of cash transfers or vouchers for food andlor for agricultural inputssuch as fertilizers. 0 Fourth, with the government mainly engaged in income augmentation programs, a clear signal would be given to the private sector to procure maize locally through imports, or by purchasing donations inkindat auctions and sell it on a commercial basis. 3.35 The system described above would be a low cost food security system that would not place heavy administrative demands on the government. However, having such a system in place takes time and needs sustained efforts in the following areas. First, steps are needed to nurture and strengthen the private sector engaged in maize trade. The key to achieving this involves making government interventions inthe maize markets16predictable, transparent, and designedto encourage private sector participation. It would also be useful to encourage the formation o f a private sector grain traders association" and holdjoint consultations on both the likely demand, available aid resources in cash and kind and government plans for free distribution of food as humanitarianassistance. Similarly, the government should act as a central point for collecting and sharing information on domestic and foreign maize markets. Second, government needs to increase public resources for rural roads and target them to inaccessible rural areas to facilitate entry of the private sector." Third, income augmentation programs currently in place needto be strengthened further. This would involve addressing the institutionalproblems at the district level to enable the rapid expansion of the public works program in times of food emergencies. In Studies have shownthat the level o fthe strategic grain reserves(SGR) should be about 60,000 tons of maize-which amountsto about 3 months ofnationalconsumptionneeds. l6 Duringthe transitionto afully private sector based systemdefined inpara. 3.34 above. Bybuilding on the existinginformal arrangements l8 Other policiesto improvetransport services, describedinChapter2, will also facilitate the entryof privatesector in inaccessible rural areas. 51 addition, the government should urgently pilot the program of cash transfers or vouchers for food or agricultural inputs. 3.36 As efforts to nurture markets, improve infrastructure, and strengthen income augmentation programs bear fruit, the government would not need to intervene in the maize markets except to manage the SGR. Under such a policy stance, the maize operations of the ADMARC, including much of the storage capacity owned by the government, could be privati~ed.'~Preliminary results from an analysis currently beingcarried out inthe World Bank2' suggest that the impact of ADMARC operations on household welfare depends on the geographical characteristics o f the area. In areas that are close to main roads and where private sector currently operates, ADMARC operations do not improve productivity, profits, or household consumption. On the other hand, in remote rural areas, where the private sector does not currently operate?' and where income augmentation programs are not strong, ADMARC operations do have a positive impact on productivity and profits. As Malawi makes a transition to the system described above, it may benecessaryto provide a financial incentive for traders and/or ADMARC to service remote rural markets. However, any such subsidy should be transparently budgetedanddesignedto encouragethe entry ofthe privatetraders inthe rural remote areas. (io ImprovingAgricultural Productivity 3.37 Improving the Management of Land and Water Resources. Considerable rural income growth can be achieved by more efficient and intensive use o f land resources. The new land policy, approved by the cabinet in January 2002, provides a solid foundation to address critical land issues which would result in increased agricultural investment, particularly by smallholders, through the implementation of beneficiary-led land redistribution programs, formalization of customary land tenure rights, simplification of land subdivision and transfer rules, and decentralization o f land administration and conflict resolution mechanisms to the district and traditional authority levels. The government should move to approve a new Land Act based on the new policy, and commence the implementation o f community-driven land redistribution programs taking advantage o f the existing successful institutional and operational procedures under MASAF. 3.38 Agricultural growth will require increased private investment in irrigation and more effective use of public investment.Since the Irrigation Act, approved in December 2001, calls for local community participation inthe development and management o f irrigation and drainage, the government could consider the option of linking the proposed Irrigation Fundto the pool of existing investment funds available to District Assemblies (DDF, MASAF). This may provide opportunities for more effective management and better responsiveness to priorities of communities. Similarly, the government may wish to consider limiting the role o f the Irrigation Board to regulatory issues, while leaving the planning and implementation o f irrigation projects to districts and local communities. Irrigation investment resources could be made available directly to farmers groups and rural communitiesthrough district-level fundingmechanisms. l9 The government could lease private storage for the strategic reservesor keep asmall number of warehouses inpublic ownership exclusivelyfor this purpose. *' The Povertyand SocialImpactAnalysis (PSIA) o f ADMARC markets inMalawi. ?' The qualitativeanalysis carriedout for the PSIA study suggests thatthe recent liberalizationhas increasedthe number of privatetraders engaged in crop marketingeven inremote rural areas. 52 3.39 Improving Access to Agricultural Technology and Advisory Servicesfor Smallholder Farmers. The key to improving the services to smallholder farmers lies indecentralization of the delivery mechanisms to make them more client responsive. A common long-term vision for the future decentralized government structure has been outlined in the DecentralizationAct that was passed inDecember 1998. Elections for District Assemblies were held in 2000, and elections for Area and Village Development Committees are scheduled for the near future. The Ministry of Agriculture and Irrigation has requested that it be included in the first round o f decentralization, with devolution plans already underway. In the context o f the Malawi Agricultural Sector Investment Program (MASIP), the ministry will need to complete its core function analysis and strengthen its capacity to undertake policy and sector analysis, and to improve the collection and dissemination o f agricultural statistics. Conversely, many services currently provided by the ministry can be successfully delegated to districts, private sector providers, and farmers' organizations. 3.40 The government has already implemented successful programs based on integrated approaches to soil fertility and conservation that could be scaled up. For example, under PROSCAP, the field extension agent and the community chose from a large menu o f techniques (manure, compost, high density planting, realignment o f ridges, vetiver grass, precision fertilizer application, and others). The government has already set up a task force to prepare an action plan to expand these initiatives to a national scale. In the first year of expansion, one community in each section (2,400 total) would participate. The ministry plans to use performance-based contracting to enlist additional extension agents. Inthe second year, in addition to performance- based contracting, the program would expand through community-to-community extension. By the third year, all communities in each section would be incorporated. Implementation of this approach to improved agricultural services in a way that puts communities genuinely in charge and provides them with viable options for their own choice will do much to remedy the weakness in agricultural services without requiring large-scale hiring of additional civil servants into the extension service. 3.41 A numberofmechanisms can be introducedto make agricultural research responsive to national priorities and demands of clients. Among these are programs o f competitive grants and public-private cost sharing for designated research objectives. Moreover, the research agenda should be developed jointly by researchers, multiplication stations, NASFAM,NGOs, and other stakeholders. Because of Malawi's small size and modest budget for agricultural research, the country will benefit greatly from cooperative linkages with research organizations at the regional level and inneighboring countries. 3.42 Inthe areaof extension, the share offundinggoing directly to RDPs (as compared to HQ and ADD levels) can be substantially increased as a first step ina gradual transition to a system o f publicly-funded but privately-subcontracted services (using the PROSCAP expansion as a model). Mechanisms for sharing the costs o f community-designed productive investment sub- projects (usingparticipatory planning approaches) could be considered. The mechanisms could be matching grants, vouchers, pay orders, or other instruments that share the costs o f adoption o f improvedtechnologies and bringproducers into stronger relations with private suppliers of seeds, fertilizers, and other inputs. 3.43 ImprovingAccess to Rural Credit. Giventhe highrisk and transaction costs involved in delivering credit to smallholder farmers inMalawi, the scope for expanding access to credit in a sustainable manner through MRFC or other mechanisms i s quite limited in the near future. Nevertheless, two specific interventions could strengthen MRFC in the short run: (i)the 53 government needs to find a way to increase the equity base for MRFC either through appropriate budgetary transfers or channelingdonor resources, and (ii) finding a strategic partner preparedto bring in resourcesand know-how. The framework for rural finance could be improved by a quick approval ofthe micro-finance policy that has been under review for the past three years. It is also crucial to move all the existing subsidized credit schemes to a cost recovery basis since they undermine the development of a sustainable micro-finance sector. Finally, to encourage expansion of financial institutions into rural areas, the government can take measures such as registering liens and providing an information base on liens and credit history of borrowers, as well as providing training to farmers' groups and others in credit management and preparingloan application. 3.44 Reducing the Cost of Fertilizers. Measures to reduce fertilizer prices have been discussed above and are summarized here: progress on completing the Nacala corridor for transport; facilitation of a trade association for sharing of information and attainment of economies of scale in purchase and handling; withdrawal of the state and parastatalsfrom direct activity in import and distribution of fertilizer; and the use of vouchers and other mechanismsto strengthen linkage betweensmallholder producersand private distributors of fertilizer. E. Special Issues inthe Tobacco Sub-sector 3.45 Trends in Level and Structure of Tobacco Production. Tobacco accounts for about 60 percent of Malawi's merchandise exports, 23 percent of its total tax base, and as much as 10 percent of its GDP. Tobacco is cultivated by nearly 18.9 percent of the smallholder households, amountingto nearly 360,000 people.As seen inTable 3.7, tobacco production grew rapidly inthe early 1990sbut has since leveledoff with largeyear-to-year fluctuations. 3.46 The leveling off of production has been accompanied by major structural changes inthe tobacco industry during the 1990s, moving away from estate-based flue-cured tobacco to smallholder burley. The contribution of the estates has declined due to reduced prices and profitability of tobacco and the lack of wood for curing. In addition, the liberalization of burley production has reducedthe availability of labor, and the introduction of the IntermediateBuyers (IB)systemhasprovided achannel for tenants to bypassthe estates. 3.47 Prospectsfor Tobacco. Currently Malawi accounts for 19 percent of the world burley production and as much as 30 percent of the total world trade.22 World demand for Malawi's tobacco will continueto rise and Malawi could continue to have a price advantage. By 2025, the number of smokers is expected to increase to 1.6 billion, from 1.1 billion today.23Total world demandfor tobacco products is estimatedto increase by 2.0 percent p.a. between 1998 and 2005, and accelerate to a 2.3 percent p.a. over the subsequent five years. Thus, even ifMalawi were to only maintain its share in the world market for burley (of 30 percent), it should be possible for Malawi to export between 120,000 to 135,000 tons of green leaf tobacco - levels reached in 1997-2000. In addition, it would also be possible for Malawi to expand the production of flue- curedtobaccoto about 20,000 metric tons from the present levels of 10,000 metric tons.24 22Chinaaccountsfor nearly 25 percentof the world productionofburley, but all of it is domestically consumed. 23Gergos (2001). 24 This amount is below the early 1990s level of about 40,000 metric tons. 54 Table 3.7: Malawi Tobacco Production Trends (000s Metric Tons) Year Burley Flue-Cured Western Types Total 1990-93 Ave. 85.3 27.3 11.9 124.5 1994 71.3 20.7 5.5 97.5 1995 101.4 19.9 8.8 130.1 1996 117.9 15.4 8.3 141.6 1997 133.9 14.9 9.3 158.1 1998 113.8 13.9 6.7 134.4 1999 111.4 14.3 8.8 134.5 2000 142.2 10.7 6.8 159.7 2001 115.3* 8.3 1.o 124.6* * Doesnot include "diverted" crop, estimatedat 5,000 to 10,000 tons. Source: Tobacco Control Commission 3.48 Productivity and Profitability. Average yields for burleytobacco production have fallen, more or less steadily, from 1,150 kilograms per hectare in 1990 to 922 kilograms per hectare in 2001. Average yields have also fallen for flue-cured production from 1,760 kilograms per hectare in 1990 to 973 kilograms per hectare in 2001. For these varieties of tobacco, such yields are extremely low by internationalstandards, and, inrecent years, approximately one halfor less than the yields obtained in each of the major tobacco-producing countries with whom Malawi competes (Figure 3.6). Figure 3.6: Comparative Tobacco Yields 2,500 2.000 F, m 1,500 1,000 500 4 I 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 -United States -Zimbabwe China --+-Brazil +Argentina +India +Malawi* Source: Ministry o f Agriculture 3.49 The decline inyields has been accompanied by a decline in prices at the auction floors, which determinethe returnto farmers. For both burley and flue-cured tobacco, prices (inUS$/kg nominal terms) peaked in 1996, but have declined steadily since then. For burley, despite some recovery in 2001, the auction prices inthe past two seasons are nearly one-third lower than those that prevailed in 1996/97. The decline in prices at the auction floors mirrors the general trend in world prices exacerbatedby a decline inquality o fthe burley crop (Figure 3.7). 3.50 The declines in yields and prices have led to a decline in profitability of tobacco in Malawi. An analysis o f crop budgets from the members o f NASFAM shows that the returns per kilogram for burley tobacco fell by 50 percent in 2000 and then again by almost half in 2001 (Table 3.8). 55 Figure 3.7: Recent Trends in Malawi Tobacco Auction Prices 1 2.5 I I 0.754 I 1994 1995 1996 1997 1998 1999 2000 2001 --tBurley-t-Flue-Cured I Source: Ministry o f Agricultrure Table 3.8: Net Returnsfor (NASFAM) SmallholderBurley Growers 1997 1998 1999 2000 2001 Average Sales Price ($kg) 1.56 1.30 1.42 1.05 1.10 NetReturnsper Kilogram($) 0.36 0.37 0.34 0.17 0.09 NetReturnsper Farmer ($; Output=300 kg.) 108 111 102 51 26 NetReturnsper Hectare 540 555 510 255 130 NetReturnsas a%ofAverage Price 23 28 24 16 8 Source:NASFAM 3.5 1 Reasons Behind the Low Yields and Profitability. Some of the issues affecting the poor performance o f the tobacco industry have been mentioned previously, i.e., the poor delivery o f services to smallholders and the low and declining use o f fertilizers. In addition, tobacco yields are low because of widespread use of low quality own saved seed, an increased incidence of disease and pests due to inadequate crop rotation, and significant post-harvest losses due to inadequate curing barn infrastructure. The decline in profitability is also due to inefficiencies in the current marketing system for tobacco. According to current regulations (i.e., the Tobacco Act), all tobacco exported from Malawi must be sold over auction floors. However, there is currently only one auctioning company, Auction Holdings Ltd. (AHL) and its largest shareholder is ADMARC, a government statutory body. As part o f the country's privatization process, ADMARC'S shareholding in AHL was reduced and part o f the shares were divested to The Tobacco Association of Malawi, a tobacco grower's cooperative, and to individual tobacco growers. 3.52 Currently growers have four means o f bringingtheir tobacco to the auction floor: 0 Larger growers deliver their tobacco straight to the auction floors. 0 A few well-organized smallholder clubs, under the umbrella of NASFAM, effectively negotiate and hiretransport services to bringtheir tobacco to the auctions. 56 e All other growers bringtheir tobacco to the satellite depots that are locatedat 88 sites around the country. Farmers or clubs bring tobacco there, where it is temporarily stored and then transported to the auctions. TAMA negotiates the transport rates. e An intermediate buyer system (IB system) was introduced in 1994. Intermediate buyers buy cured-leaf tobacco from smallholders then place the crop on the auction floor under their own registered sellers names. In September 2000, the IB systemwas replaced by the Designated Tobacco Buyers Scheme (DTBS).25 This i s a modification o f the IB program in that a more limited set o f intermediate buyers is licensed and they are permittedto operate only at designated sites. A series o f rules and regulations on permissible transactions i s devised and enforced by local DTBS Committees, comprised primarily o f TAMA and government representatives. 3.53 Problems with the Current Marketing System. There are a number o f problems with the marketing arrangements that increase the cost to growers. First, the grower registration system is currently not functioning well due to the massive new entry into the sub-sector and its abuse by some people in order to avoid the payment of levies, taxes, and/or financial debts. 3.54 Second, Auction Holdings Limited(AHL), the sole auctioning company, charges growers a fee of 3.95 percent of the gross revenue realized compared to only 2.4 percent in Zimbabwe. The fees charged by AHL to apply a stop order for a financial institution are also extremely high, at 3 percent o f the loan amount, as compared with the fee of only 0.14 percent o f the loan amount charged under similar circumstances in Zimbabwe. In addition, smallholder growers have recently been required to pay a 7 percent withholding tax on the revenues obtained through their auction sales. This withholding tax is essentially an installment payment for income tax, and therefore smallholders, who have low incomes, can claim back this tax. Inpractice, however, it is difficult for smallholders belonging to less well-organized clubs to organize their records and actually get back their withholding tax on time. 3.55 Third, Malawitobacco growers pay a series of levies that are also deducted by AHL from the gross revenues obtained by farmers. These include a levy for ARET (1 percent), associations (0.85 percent), TAMA's classification system (0.5 percent), and the Tobacco Control Commission (0.13 percent), as well as a payment of US$0.92 per bale to cover the cost of a hessian bag replacement scheme. These levies amount to 3.58 percent o f the farmer's gross revenues-a very highlevel by internationalstandards.26 3.56 Fourth, the performance o f the satellite depots managed by TAMA's members and counselors have been inconsistent. For example, TAMA has not been able to negotiate the most favorable transport rates on behalf of the farmers. In the 2001 season, NASFAM clubs were paying KM350 per bale (75 to 100 kilograms) for transport inthe same areas where farmers were beingcharged KM600 per bale by satellite depots. Inaddition, the depots practicethe first in-last- out system which results in bales going missing, being damaged, and/or growers having to pay relatively hightransport costs for the deliveries made to the auctions. These transaction costs are then magnified when tobacco from the satellite depots is delivered to the auction floors. The 25This was inresponseto a cabinet paper on the subject submittedby the ministryinJanuary2000 andthen resubmitted with revisions in July 2000. The uncertainty regarding the status of the IB program in the months leadingup to the marketingseason in2000 contributedto the reductionof licensed IBsthat season. 26InZimbabwe, the combined levy for research and tobacco associationsis 0.5 percent, while the hessian levy i s 0.1 percent. 57 existing system o f delivery quotas to bring an even flow o f tobacco to the auctions has been overwhelmed in recent years by the sheer number of growers and trucks conveying tobacco, together with the practice o f prominent and well-connected growers ignoring their assigned delivery schedules and jumping the queue leading into the auctions. This problem is especially prominent at the Lilongwe auction.27 3.57 A Reform Programfor Tobacco.A reform strategy for tobacco should basically address the two problems identified above. In an effort to improve productivity, the following should be addressed: e Implementation o f a reform programto reduce the cost o f transport and fertilizer. e Capacity-building in producer associations, such as additional support for the extension o f the N A S F A M system and the possible restructuring o f TAMA, including its merger with other associations to bringabout a commercial farmer producer organization. e Improvingthe ARET program. ARET i s inthe process o f developing plans for a "Back to Basics" program o f research and advisory services. CollaborationbetweenARET and the field staff o fthe Ministryo f Agriculture andIrrigation should be enforced. 3.58 Simultaneously, the following actions should be taken in order to improve marketing arrangements and reduce transactions costs in the supply chain: e Revamp the grower registration system and put in place an annual auditing and performance review system for the tobacco supply chain including farmer clubs, satellite depots, intermediate buyer systems, the auction system, and the exporters.28 Part o f this effort will require strengthening the statistical and monitoring capacities o f the Tobacco Control omm mission.^' e Reduce the auctioning fees charged by AHL. In addition, the government should increase the representation o f smallholder farmers on AHL's board. e Issue a directive for a time-bound re-assessment of the existing level of statutory levies being applied with a view toward red~ction.~' 0 Develop a modality by which the withholding (income) tax is assigned only to those estate growers who meet the income thresholds. e Encourage existing transporters or rural input retailers to offer competing satellite depot services. 3.59 Direct Exports. The Government or Malawi issued a directive inJanuary 2001 to enable direct exports by growers. The Tobacco Control Commission is currently in the process of developing the modalities to enable such exports to take place (including making provisions to 27However, the bottleneck at the Lilongwe auction may have more to do with the processingcapacity and use ofthat capacityby the international buyers. More tobacco can be handled and sold on a daily basis at that auctionthan can be processed inthe adjoining factories. Inaddition, the buyers also use those factories to process tobacco when is imported from Mozambique andthenre-exported. 28Maintainingthe confidentiality of certain private informationneed not hamper an overall drive to increasetransparencyinthe industry. 29As well as balancingthe representationon the board ofthe TCC to include more grower representation. 30A possibleexceptionmightbethe ARET levy, dependinguponthere beinginplace an agreedwork program for researchand advisory services. 58 collect the statutory levies, ensure quality control, and ensure the repatriationo f foreign exchange earnings). 3.60 The mainadvantage of allowing direct exports by growers, bypassingthe auctions, is that it will provide an additional channel to the growers and will put pressure on Auction Holding Limited (AHL) to improve efficiency. However there are also risks in opening up this channel, which include: (i) a breakdown in systems to monitor the quality of the crop; (ii)sharp decline a in auction floor volumes resulting in capacity underutilization in the processing facilities; (iii) Malawi brand name losses; and (iv) a possible sanction o f Malawi's tobacco crop by the cartel of international buyers. Therefore we suggest that the direct export arrangements could be piloted for a specific period with a few larger growers especially flue-cured tobacco. 3.61 DTBSSystem. The government needs to clarify the rules and regulations concerning the operation o fthe DTBSsystem that is to replace the IB system. The DTBS systemshould be based on transparent rules on licensing buyers and clear, non-discriminatory rules on their area of operation. The objective should be to encourage the designated markets to evolve into small marketplaces where, provided there is competition among multiple buyers, a mini auction could develop. 59 Chapter 4 BusinessEnvironmentfor Manufacturing' A. Introduction 4.1 Malawi's manufacturing sector is small and is beset by stagnation inoutput, low capacity utilization, and falling investment. The poor performance of the manufacturing sector, like the agricultural sector, can be traced to the highly risky environment faced by firms in engaging in production and trade. The risky environment raises issues that affect all the sectors in the economy such as changing trade regime, problems of corruption, and most importantly, the unstable macroeconomic environment, which leads to high inflation and high real interest rates. Inaddition, manufacturingfirms face costly and unreliable infrastructure; an inefficient, complex, and discretionary system of taxes rebates and incentives; and weak institutions to support businesses. In this chapter, Section B describes the structure and performance o f manufacturing, Section C describes the major constraints to the performance o f manufacturing, and Section D goes on to offer suggestionsfor reform. B. Structureand Performance 4.2 Malawi has a narrow industrial base with GDP in manufacturing amounting to only 13 percent of the total GDP. The structural features of Malawi's economy make it inherentlyrisky to do business in Malawi. The domestic market for Malawian manufacturers is small and historically public investment was usedto develop a few large conglomerates such as the Malawi Development Corporation (MDC), the Agricultural Development and Marketing Corporation (ADMARC), and the Press Corporation. These three firms dominate a wide range o f businesses including agro-processing, consumer goods, banking, insurance, and other financial services. As indicated inAnnex 4.1,in2001 the annual sales of these three conglomerates together accounted for nearly 26 percent o f GDP. In addition, in almost each o f the major sub-sectors of manufacturing, including both the private and the public sectors, a few large firms dominate the market. These include production o f tea, tobacco marketing, sugar, cement, and consumer produck2 Table 4.1: Share of Value Added in Manufacturing by Sector Sector 1994 1996 1998 2000 Agro-processing(inc. food) 35% 35% 30% 33% Textiles, clothing, leather 7% 5yo 7% 5% Wood products, publishing 14% 16% 19% 15% Chemicals, plastics, rubber 24% 23% 23% 19% Non-metallic mineralproducts 4yo 3% 3yo 4% Metal products, machinery 14% 15% 15% 20% Other manufactures 3% 3% 3yo 4% Total (MK in 1994 prices) 1323.7 1389.3 1423.1 1405.6 Source:CSO ' Although this chapter does not explicitly address issues facing enterprises in the services sector, which range from hotels, holiday resorts, and car hire services to security services and generate considerable output and employment; it is believedthat many o fthe manufacturingsector's constraints identified inthis chapter are also the constraintsfacingthe enterprises inthe service sector. DANIDA, "A Profile of Importing and ExportingEnterprises inMalawi," 1998. 60 4.3 The formal manufacturingsector consists of seven sub-sectors(Table 4.1). The food and agro-processing sector is responsible for about 30 percent o f manufacturing output. The major components o f this sector (and exports) are sugar and manufactured tobacco. In addition, this sector includes firms which bottle beverages, produce and sell minor food products such as biscuits, and process locally produced agricultural commodities such as pulses for export. Apart from these firms, which have direct links to agriculture, most other firms use simpletechnology3 and rely on imports for their intermediate inputs. This includes firms producing textiles and apparel, plastic furniture, soaps and detergents, and metallic and paper packaging products. 4.4 The manufacturing sector relies heavily on domestic markets. The detailed 2000 data (Annex 4.2) indicate that of the top 20 manufactured exports from Malawi, amounting to about US$50 million, nearly US$26 million, about 52 percent, were sugar and sugar products. Most of the sugar exports come from a single company - SUCOMA - that is part of a multinational operating in southern Africa. O f the remaining, textile and garments accounted for 42 percent of the total exports4 and less than 3 percent were other manufactured products such as cartons, furniture, beauty products, soap, and organic products. 4.5 Trends. As indicated in the national accounts, the manufacturing sector has been in stagnation over the past five years, and there has been a contraction inoutput duringthe past two years. Over the past five years, there have been 10 closures o f major manufacturing enterprises in tobacco processing, metal products, and garments. Furthermore, value added in manufacturing grew by only 0.5 percent p.a. over 1996-01 and has fallen by 2.5 percent and 0.9 percent in2000 and 2001 respectively. While the fall in output has been observed in all sectors, the largest fall (38.2 percent) has been experienced in the clothing, foot-wear, and textile sector. The fall in output has been reflected in the reduction o f private investment, most o f which goes into manufacturing, from about 8 percent of GDP in 1995to 2.7 percent of GDP in2000. Table 4.2: Capacity Utilization inManufacturing Sector Sub-sector 1997 1998 1999 2000 Food processing 65 54.6 47.5 50 Beverages 60 55 60 43 Textiles 53.5 50.5 46 46 Wood products 63.3 68.3 67.5 85 Paper and packaging 60 65 62.5 61.5 Chemicals 90.9 74.2 78.9 74.3 Metal fabrication 12.7 23.1 21.5 30 Mineral products 42 55 62 63 Source: APRU Baseline Surveys 4.6 The low and declining level of manufacturing activity is reflected in low capacity utilization across all sub-sectors (Table 4.2). Major sub-sectors such as food processing, ~ Some o fthe larger plants such as the David Whitehead or plants inthe dairy industry have more complex but outdatedtechnologies. Most o f the textile exports until 2001 were to South Africa, where Malawi has a non-reciprocaltrade agreement. Since late 2001, with the difficulties in South Africa, this agreement has been under strain- creating problems for the Malawi textile industry. South Africa has increased the domestic content requirement for garment imports from Malawi, and Malawian exporters report informal barriers at the border. To some extent this has been mitigatedby the opportunities under AGOA in2001 and 2002. Inthe long run, however, Malawi's textile industry will have to aim for being internationallycompetitive as the MFA is due to expire in2005. See Chapter2. 61 beverages, and textiles are currently operating below 50 percent capacity. The only exceptions to this are the export-oriented textile firms, especially those taking advantage o f new trade protocols. Export oriented textile firms have grown by more than 10 percent during 2000, compared to a 14and4.2 percent decline in 1998 and 1999 respectively. 4.7 Employment.According to the 1998 population census, only about 3 percent o f the total labor force o f 4.5 miilion were employed inthe formal manufacturing sector (which accounts for 13 percent o f GDP). A comparison with a survey done in 1992, combined with the decline in output and capacity utilization during,1998-2001, suggests that that has been a fall inemployment inthe formal sector. C. Constraints to the Performanceof ManufacturingEnterprises 4.8 A large number of surveys o f businessmen (Table 4.3, Annex 4.3 and 4.5) carried out in Malawi and the Annual Competitiveness Reports compiled by the World Economic Forum indicatethat there are four major constraints facing businessmen inMalawi: 0 Macroeconomic volatility, including unpredictable changes in real exchange rates, highandvolatile real interest rates, andpoor accessto finance. 0 Expensive and unreliable infrastructure services. 0 Complex, non-transparent, and highly discretionary structure o f taxes and incentives. The administration o f incentives schemes is slow which further reduces their effectiveness. 0 Weak public and private institutionsto support and regulate businesses. Table4.3: ConstraintsonPrivateBusiness,MalawiandAfrica Constraint Malawi** Ranking in Africa* 1.Major Obstacle Financing 4.0 24 Infrastructure 3.36 NA Qualityo fRoads 3.5 23 ElectricPower Supply 4 20 TelephonePrice 3 22 Inflation 4 21 ExchangeRate RealExchangeRate N/A 21 ExchangeRateVolatility 5 21 Crime 3.06 22 Corruption& Bribery 4 NA 2. ModerateObstacle Taxation, Tax Regulations 2.58 NA Labor Regulations 3 3 CustomsProcedures NIA 11 *Overall rankingout of 24 African countrieswhere 24 is worst. **Survey scores obstaclesas 1 3 minor, >3.5 serious, 4+ critical. Source: World EconomicForum(2000), EconomicResourcesLtd World Bank (2001), IFC (2001) Recent GEMINIsurveys estimate that a large number of small businesses (traders, tailors, shopkeepers, etc.) are a major source of employment. The total informal employment in off-farm activities, which contribute to barely 3 percentof GDP, couldbe as highas 18 percentofthe total labor force. 62 (0 Macroeconomic Volatility6 4.9 Exchange Rate Volatility. Exchange rate movements discussed in Chapter 2 affect the business environment in two ways. First, long periods of appreciation of the real effective exchange rates (1995-2000) resulting from maintaining a stable nominal exchange rate have seriously eroded profitability in manufacturing firms. Second, sharp intra-year movements in nominal exchange rates have increased the risks for all businesses depending on the timing of their imports andexports. 4.10 High Interest Rates and Access to Finance. Malawian firms are affected by both the high cost of finance due to high interest rates, as well as problems stemming from limited access to finance. As discussed inChapter 2, Malawian firms have faced lending rates of between46 and 50 percent on average over the past two years, compared to a regional average of about 25 percent.' Given the low capacity utilization, this is amajor constraint inaccessing working capital for day-to-day operation of a firm. In Malawi only large firms with access to foreign (working capital) finance through their foreign partners can expect to operate at a level of capacity utilization to remain profitable, this is the case for tobacco, tea, and sugar where international buyers will often provide advance finance to local suppliers. Large firms have also increasingly resortedto using retained profits to carry out small but necessary capital expenditures. However, relying on internal sources severely constrains the ability to invest. The high cost of finance also negates the effectiveness of the incentives and drawbacks offered by the government because delays in refunds under the various drawback schemes impose a high opportunity cost on businesses. 4.11 Quite apart from the high cost of finance, there are institutional and regulatory problems with the access to credit for large firms', small and medium enterprises (SMEs) producing non- traditional products, and for micro enterprises. Clearly the problem is not one of inadequate number of institutions with a mandate to finance business activity. As indicated in Table 4.4, most of the commercial banks are active in lending to large firms and also have specialized windows for lending to SMEs. In addition, over the years nearly twenty institutions have been created in the public, private, and the NGO sectors with a mandate to lend to micro enterprises. Nevertheless, access to finance remains a problem for both large and small firms for the following reasons. For large firms, there is very little term lending carried out by commercial banks - most business lending is to large blue chip firms in the form of short-term overdraft facilities. This is mainly because ofthe availability of high interest government bonds, as a result of which there is no pressure on banksto lendto busines~es.~Further, the traditional term lending institutions suchas pensionfunds are not yet well developed.Inaddition, commercial banks point out that the legalproceduresfor recovery inthe event of default are long and costly. 4.12 The institutions created for financing small businesses also face similar sets of problems." The data in Table 4.4 indicate that the repayment rates in the larger amongst these - MDC, SEDOM, and DEMATT - are erratic and poor. The main problem facing all microfinance institutions is availability of loanable funds. Most of these institutions were created with donor seed capital and had no mandate to collect savings. Consequently, the low recovery rates have directly translated into an erosion of the capital base. In addition, government and donor supported credit initiatives have often had mixed agendas combining welfare and sustainability See Chapter 2. Malawianfirms regularlyreporthighinterestrates as the chieffinancing constraintandto a greater degree than in 13 otherAfricancountries ineast and southernAfrica (ACR, 2001). A comprehensive study o fthe financialsector is plannedinFY %. 9 See Chapter 2. loFinancewas reportedas the key constraint to starting up an SME inthe Gemini survey. Only 15 percent out of 606,000 business owners were ableto secure financialassistance. Ofthese, only 35 percentreceived credit fromMFIs.The creditwent mostly to enterprises involvedinagriculture. 63 objectives. These include government sponsored programs such as Youth Credit, AMED, APIP, and SMEF which have provided credit at lower than market rates of interest. Managers of most microfinance institutions in Malawi believe that these programs have generally undermined their market-based programs by sending wrong signals to the borrowers in terms of the cost of credit andthe needto repay. Table 4.4: Banksand Other Financial Institutionsin Malawi Institution RepaymentRate Microfinance Institutions CARE -International 100% ConcernUniversal 67% Chikondano S&L 75% CBM/Ministry of Gender 50% ECLOF Poor DEMAT/CBM&NBM 60 - 90% FINCA 98% Habitat for Humanity not available MFWC-Mudzi 87% M W C-Indviduals not available MSB-consumer loans 85% MSB-project/ corporate 95% MUSCCOI SACCOs not available NABW 91% Pride Africa 100% Project Hope 97% SEDOM 45-90% Self-Help-Development Int 70% Usiwa Watha Credit Trust 98% World Vision 93% Institutionsfor Lendingto Large- and Medium-Scale Businesses Indefund very good Indebank not available Leasing & Finance Fair NationalFinance Services very good CBM Financial Services not available MDC large scale projects Poor MDC small scale projects -- Poor Source: Ministryof Commerceand IndustryBaseline Survey (ii) Infrastructure 4.13 In most surveys of businesses in Malawi, high cost of transport," unreliable and costly air transport services, and costly, poorly functioning utilities - water, electricity, and " See Section D on Transportation inChapter 2. 64 telecommunication services - are identified as critical factors behind the high cost o f doing business in Malawi. The high cost, low quality, and unreliable infrastructure i s rooted in the continued lack of competition in the provision o f services. The key utilities are under monopoly control in the form o f inefficient, state-run enterprises that have insufficient funds to reinvest in maintenance o f their networks. In addition, the utility sector is burdened by huge arrears, most o f which arise from public sector clients. Further, tariff rates for water and electricity are currently structured in such a way that industry is subsidizing other customer segments. In particular, the electricity rates are based on a maximum demand system where companies pay a fixed rate equivalent to their peak consumption during a given period. While charging on maximum demand is not uncommon, the problem lies in the fact that the rate applied by ESCOM is based on consumption during the peak season o f the year. Firms are therefore paying the maximum applicable rate throughout the year when in fact their consumption varies greatly by season. Moreover, firms cannot chose to only consume power duringthe low demand periods o f the day -theyareobligedtomeetaminimumlevelofconsumptionduringthepeakperiodofthedayas well. 4.14 Inthe telecommunications sector, the MalawiTelecommunications Limited (MTL)has a very high cost structure and is plagued by inefficiencies arising from poor management. The rapid rise o f the mobile telephone operators has partly substituted for MTL's inadequacies, but this development has itself added to the costs o f making domestic calls. Comparedto five years ago, the cost per minute o f overseas calls has increased significantly such that Malawi rates are now about 30 percent more expensive than the regional average, whereas Malawi's rates were below the regional average in 1994. This trend is also reported in the African Competitiveness Report where it is notedthat the telephone prices have increased ineach o f the past 3 years. (iii) Ineffective Taxand Incentive RegimeI2 4.15 Tax System Malawi's tax regime is comparable to other countries in the region. Malawi's corporate tax rate is now equivalent to the regional average o f 30 per~ent.'~ Only two other countries in the region, Botswana and Mauritius, have lower tax rates (15 percent) for b~sinesses.'~ Inan effort to widen the tax base, the government is inthe process o f extendingthe surtax to the retail and wholesale levels, which will effectively create a full VAT system. While this is in line with regional trends, the current rate o f 20 percent, chosen for Malawi, is higher than the regional average o f 12 percent. Further, the extension o f surtax to the transport sector creates distortions. Since foreign trucking firms are not subject to the 20 percent surtax, the surtax discriminates against local transporter^.'^ 4.16 The MRA currently applies a fixed-level tax on turnover o f firms regardless o f whether or not they declare a profit. For instance, any registered company with turnover greater than MKlO million is liable for income taxes o f MK200,OOO. Smaller amounts apply for firms reporting a smaller turnover. The rationale for this policy was to capture lost revenue from perceived widespread under-reporting o f profits. This practice acts as a mandatory tax penalty on all firms irrespective of their past record o f tax compliance. Clearly, this is a very blunt tool for addressing tax evasion and has a negative impact on those firms that may be experiencing a genuine loss. 4.17 Incentives. Malawi also offers a generous set o f incentives to manufacturing enterprises inthe form o f duty drawbacks, income and excise tax rebates, and allowances for transport and training costs. In addition to a general set o f incentives available to all registered manufacturers, See Annex 4.4 for a detailed description of the tax system. l3 The corporate tax rate was 35 percent until fiscal 2001/02, but even this was comparable to other countries. l4Infact, for approvedmanufacturing companiesinBotswana the tax rate is only 5 percent. Although this surtax on transport can be reclaimed as a tax refind for registered manufacturers, the delays inprocessingreturns imposes an additional cost on transportersbecause o fthe high interest rates. 65 increased incentives are available for new investors, exporters, and a special, more generous set o f incentives are available for those exporters who are registered in the special export processing zones (EPZs). A description o f these incentives is available inAnnex 4.4. 4.18 By and large, these incentives are generous and comparable to other countries in the region. However, there are two sets o f problems with the design and operation o f the system that severely limit the effectiveness o f the incentives in encouraging investment and exports. First, these incentives are complex, non transparent, and highly discretionary. For instance, a typical manufacturer could, inprinciple, access customs and excise tax rebates under either the industrial rebate scheme or under the investment promotion act. Ifthe manufacturer is an exporter he has an additional choice between manufacturing in bond or applying for the more complex EPZ status. The process o f accessing the incentives is not automatic - to access tax breaks under the industrial rebate scheme the manufacturer has to register with the MRA. Similarly, to access general incentives for exporters the manufacturer needs to register with the MEPC. The process o f registration introduces an element o f uncertainty in the market and increases cost to the manufacturer due to delays inthe registration process. 4.19 Moreover, the incentive system is also highly discretionary. For example, Section 52 o f the Finance o f Audit Act states: "The Minister may authorize any ofJicer to remit any revenue which may be due or to refund any sum received by way of revenue if he is satisfied that such remission or refund is desirable in public interest.''I6In accordance with this provision, in 2000 and 2001 nearly MK500 million were granted intax breaks to enterprises ranging from hotels and hospitals to poultry farms and oil retailing. In addition to Section 52, nearly all other tax breaks have an element o f discretion embedded in them. For instance, under the investment promotion law, the government has the discretionto declare that certain "strategic" industries may receive a tax holiday o f five years and thereafter a company tax rate o f 15 percent. Notably, the basis for declaring an industry strategic has, however, been left unspecified. 4.20 The EPZ system, which has by far the most attractive incentives package and has been successful in expanding exports in other African countries, also has a number o f problems as a result of which fhe number of companies accessing the EPZ has declined from 26 in 1998 to only 15 in December 2000. First, like other incentives, there are no objective criteria on the basis o f which an EPZ status is automatically granted and there is a great deal o f discretion given to the government in awarding the incentives. For instance, although the condition for accessing the EPZ is that all the output needs to be exported; at the discretion o fthe Ministry o f Commerce and Industry, a small share of the output can be allowed to be sold domestically. Similarly, although the EPZ status i s given for five years, it is subject to two yearly renewals after review by the government. Second, there is no monitoring mechanism to ensure that the expected benefits are being maximized. Once a firm is given EPZ status, there is little or no follow up to determine whether the firm meets its export obligations. 4.21 In addition to the discretionary nature of the incentives, manufacturing enterprises face delays inprocessingtax refunds. Part o f the reason is due to the manual processing inthe Malawi Revenue Authority (MRA).This situation is likely to be aggravated by the extension o f the surtax to the retail and wholesale levels in 2002. The delays in processing tax returns, surtax refunds, and other rebates imposes an additional cost on businesses due to the very high interest rates. (iv) Institutions in Support and Regulation of Businesses 4.22 Malawi has a number o f institutions to support business (Table 4.3, including both public sector institutions and private industry and trade organizations. Public institutions have three types o f responsibilities. First, they are engaged in formulation o f policies such as taxation, l6 The government is currently introducing specific criteria and a point scale rating system in order to determine the rebates under Section 52 as a means of limitingthe discretionary element o f the scheme - nevertheless, the systemremains highly discretionary. 66 tariffs, or other regulatorypolicies such as licensing, development, and ensuring compliance with standards. Second, they provide assistance with export marketing or facilitate investment. Third, they assist inimproving productivity of labor or technology. 4.21 By and large, the business community has not found the existing private sector institutions to be particularly effective in improving their competitiveness. First, most of the public institutions suffer from inadequate budgetary resources. For instance, budgetary resources available for the business register are insufficient for the agency to ensure compliance from all businesses and maintain an up to date business register. Similarly, the resources available for the MIPA and MEPC are not adequate enough to build the necessary information base or retain manpower to facilitate investmentsor exports. 4.22 Second, many of these institutions have overlapping responsibilities and unclear mandates. For instance the responsibility for assisting businesses in accessing incentives for export promotion or investment is spread across MIPA, MPEC, and EPZ, and is implementedby the Malawi RevenueAuthority (MU). 4.23 Third, the institutions created to improve productivity at the firm level are also weak. The main institution created to improve labor productivity through training is the Technical, Entrepreneurial and Vocational Training Association (TEVETA). The TEVETA was intendedto be financed partially through a budgetary transfer and partly through the collection of levy amountingto 2 percent of the payroll of private firms. Inpractice, the collection of the levy from the private sector hasprovedto be difficult andthe budgetarytransfershave not beentimely. As a result, the TEVETA training programs have been chronically under funded and therefore ineffective. Likewise, currently there is also no institution or program to assist manufacturers in improving productivity on the shop floor by reducing the cost of access to new technology that could have spillover effects to the rest ofthe industry. 4.24 The usefulness of private sector business associations is also limited. In a regional context, Malawi ranks 12`h out of 13 countries in eastern and southern Africa in terms of the strength and usefulness of its business associationsto their members.As an example, the MCCCI is expected to take the lead in representing the interests of the private sector, yet some of the largest corporations do not consider it a usefulchannelfor expressingtheir concerns. As a result, there have been numerousattemptsto set up ad hoc forums for constructivedialogue betweenthe private and public sector including several task forces." Analysis of the African experience(Box 4.1) shows that this is perhaps the result of the uncertainties and highly discretionary nature of its policy and incentive regime that promote individual lobbying in preference to group or sector level lobbying. l7The Cabinet Committee on the Economy, the National Economic Council, and the Private Sector Task Forceare all supposedto address private sector issues. 67 Table 4.5: Institutionsin Supportof Businesses Institution Responsibility Problems PublicSector Organizations Ministty ofCommerceand Industry Ministry inchargeofproviding services to manufacturing and businesses. MalawiBureauof Standards(MBS) Promotesstandardization. Also has Low budget. Staff programsto help SMEs improve quality. tumover. MalawiExport PromotionCouncil Extension service and informationfor Low demandon (MEPC) exporters. services. Malawi IndustrialResearchand National focal point for technology Low R&D carried out Technology DevelopmentCentre development. inMalawi. (MIRTDC) Customersare not willing to pay for the services,Inadequate budget. Malawi InvestmentPromotion Promotesinvestmentby making Inadequatebudget. Agency (MIPA) information on rules and regulationsand Low investorinterest incentivesavailable to investors. due to poor macroeconomic climate. BusinessRegister Official custodianofregistered Low budget.Poor companies. compliance from the privatesector. Technical Entrepreneurialand Training to be financed througha levy onThe levy is VocationalEducation andTraining firms amounting to 2% ofthe total unpopular. Training payroll. not seen as useful by the private sector. SmallandMediumEnterprises Help SMEs. Unclearmandate. DevelopmentOrganization Lack of resources. Malawi Entrepreneurship Help createentrepreneurs, Unclear mandate. DevelopmentTrust Lack ofresources. Private Industry and Trade Organizations CAMA: Consumers Association o f Representthe interests of industry and There is no single Malawi ... trade andcarry out dialogue with the focal point ofcontact MCCCI: Malawi Confederationofthegovemment. with the government. ChambersofCommerceand Industry There are overlapping NABW: National Association of responsibilitiesand BusinessWomen functions. ECAM: Employers consultative Association ofMalawiRTOA: Road Transporter OperatorsAssociation 68 Box 4.1: Regulationand IncentivesinLobbying Regulation of firms in Africa has beenpervasive although the extent has differed between countries. Governments have been able to affect firm performance through licensing investment, discretionary tax incentives, and discretionary changes in trade policy. Becausethere have been so many points for discretionary intervention, the main political risks facing firms were probably not at the level of the sector or industry, but were firm- specific, This made group-based lobbying less important relative to individual lobbying. Firms have thus been atypically dependent upon maintaining good individual relations with government. In several countries governments chose to favor non-indigenous ethnic minority businessmen (such as Asians inEast Africa and Lebanese in West Africa). One reason for this was that such people were not in a position to challenge the government politically. Thus, a patron-client relationship could be forged in which the government dispensed both favors and protection to individual businessmen in return for financial support which by-passed the tax system, but which helped the ruling party to maintain power. By contrast, if indigenousbusinessmen became rich they could potentially pose a political threat to the government. A further common feature of regulation policy has been the absence of "competition policy." Indeed, governments have often favored high levels of industrial concentration. For example, at one stage the Kenyan government had a policy whereby importers had to obtain a "letter of no objection" from domestic producers. In such an environment it was easy for producers to operate informal cartel agreements. See Paul Collier and Jan Gunning, "Microeconomics of African Growth: 1950-2000", World Bank, May 1999. D. Suggestions for Reform 4.25 The key to achieving growth in the manufacturing sector lies in creating an environment within which domestic and foreign businessmen can expand output. This could be achieved by responding to the opportunities being opened up by the increasingly open trading environment in the region (See Chapter 2) and by building on the main advantages Malawi has o f being one o f the lowest labor cost countries in the region with a stable political environment. Since it is difficult to predict the precise sub-sectors and products where growth will originate, the government strategy should be to reduce costs and improve the competitiveness o f Malawian businesses across the board by eliminating the main policy and institutional constraints to starting and operating a business inMalawi. 4.26 As discussed above, all the surveys o f the business environment in Malawi indicate that action is needed infour areas listed below. ReduceMacroeconomic Volatility. This has been discussed inChapter 2. ImproveAccess to Finance. The regulatory framework for financial institutions serving the small- and medium-scale enterprises needs to be revised to provide a common set o f guidelines for existing institutions, have stricter prudential guidelines, and allow institutions to raise savings. 69 In order to build sustainable financial institutions to serve small and micro enterprises, the government shouldavoid creatingsubsidizedcredit . The supply of loanable funds to existing institutions needs to be increased by channeling budgetary or donor resources to build the equity base. The institutions supportedin this manner needto have ahighrate of loanrecovery andmust be financially sustainable. For export related endeavors, Malawi needs to take advantage of the existing arrangements, such as the African Trade Insurance Agency, which currently offer politicaltrade insurance, but intime, is planningto broadenthe scope of its instruments e Improve Infrastructure. The functioning of infrastructure18can be improved by increasing private sector participation. The broadgovernment strategy for increasingprivate sector participation in the provision of infrastructure was approved, re-evaluated, and continued in November 2001. The privatization process is being designed and managed by a well-staffed Privatisation Commission. What is needed now is to accelerate the process and refine the legal framework to address regulatory issues. The status of the process in each of the infrastructure areas is as follows. Telecommunications.The privatization of telecommunication services is well advanced. The Information Memorandum (IM) for the government's stake in MTL together with MTL's 40 percentequity stake inTelecommunicationsNetwork Limited(TNL),amobile phone operator, was issued on December 20, 2000. The government is currently in the processof selectingthe preferredbuyer onthe basis of bids received. Power Sector. ESCOM, the electric utility, already has a management contract with ESCOM SouthAfrica. The government has approveda new power sector policy charting a path for increasing private sector participation. The new policy opens the way for the Privatization Commission to hire transaction advisors for the first phase of the privatization of ESCOM. Lilongwe and Blantyre Water Boards. Participation options for the two water boards are currently being developed. One of the key areas which affects both Blantyre and Lilongwe Water Boards is arrears from government ministries and agencies. This problem is especially acute with regard to non-payment by the army, police, and hospitals. A sustainable solution to this issue is critical in order to increase the attractivenessof both entities for the private sector. An action planto deal with this issue has been developed by the government. An innovative element of this plan is the possibility of introducing pre-paid small water meters into the entities with a history of arrears. Air Malawi. The government has approveda strategy for privatization of Air Malawi and an informationmemorandumfor the transactionis expectedto be issuedsoon. e Improve Tax and IncentiveStructure. The 20 percent surtax rate is significantly higher than the regional average. It would, however only be possible to bring this rate down if progress is made in achieving `* Transport issueshave been discussed inChapter2, 70 expenditure reductions in line with the macroeconomic framework and improved tax collection. Similarly, the surtax on domestic transport services also needs to be reduced to create a level playing field between domestic and foreign transporters. Pending these reductions, the processing o f surtax refunds for transport services for registered manufacturers could be speededup on a priority basis. Finally, the policy o f taxing firms on turnover regardless of performance should be replaced with more sophisticated means of tackling tax evasion. The system of providing incentives needs to be simplified, made more transparent, and less discretionary. For instance, the system of registration for the industrial rebate scheme could be made automatic by establishing clear guidelines for eligibility. Similarly, if all the capital goods have zero or low customs duties, the need to offer duty drawback on these under variety of schemes could be eliminated. The amount of discretionary tax breaks given to firms (under the EPZ) needs to be eliminated. Instead, transparent guidelines should be applied equally to all firms. Finally, a mechanism for monitoring the EPZ system shouldbe developed and the incentives need to be linkedto export performance to exert competitivepressure on exporters. Furthermore, the tax and incentive regime is beset with of delays in processing various tax refunds - a problem which is expected to worsen with the extension o f surtax at the retail and wholesale levels. To avoid this scenario, MRA should further automate its tax processing operations. The automation should also be extended to the boarder posts where frequent smuggling operations undermine tax collection and create unfair competition for domestically produced goods. 0 Improve Institutions in Support of and Regulating Businesses. Institutions in support o f manufacturing are weak and fragmented with overlapping functions. There are a number o f ways the existing institutions could be strengthened. In order to improve the public-private collaboration the government needs to build a high-levelconsultation forum comprising a wide spectrum of business leaders and key government agencies. Following up on the rationalization o f the incentives structure, there needs to be a rationalization o f institutions to administer them. It should be possible to merge institutions, clarify responsibilities, and save on budgetary resources. For instance, it should be possible to merge MIPA and MEPC, and transfer the staff administering the EPZ system into one in~titution.'~ Further, this institution could focus more on the assisting businesses through providing regular marketing information, outlining the implication o f trade agreements, and work to simplify the procedures for establishing new businesses rather than administering incentives.*' The existing public and private sector institutions responsible for knowledge and information dissemination, regulating quality standards, facilitation o f investment, and business-to-businessrelations have beenneither very efficient nor successful inproviding these services. In addition to structural and organizational changes to eliminate duplications and overlapping responsibilities (such as a merger o f MIPA and MPEC), institutional development and capacity building are needed if these institutions are to be able to examine their sectors and propose solutions to problems, engage in a meaningful dialogue with the government on behalf o f their members, and increase the capacity to implementthe programs andprojects. A decisionto merge MEPC and MIPA was announcedinthe 2002103 budget. 2oThe recent introductiono f free internet facilities at the new MEPC resource center is a good example of practicalsupportthat is immediatelyusefulto exporters. 71 The existing public institutions responsible for improving capital and labor productivity at the firm level have also not been particularly successful. One o f the options being considered by the government to assist firms is a Matching Grant Facility (MGF - see Box 4.2). A MGF is a cost-sharing grant scheme where Malawian firms would be reimbursed a portion o f their costs o f using business development services. A MGF differs from the existing model o f delivering business services inthat it is demand driven, it finances activities which have a strong "public goods" element, and has spillover benefits for the rest o f the sector. There are currently several MGFs operational or under preparation around the world. InAfrica this type o f grant facility has been established in Benin, Cote d'Ivoire, Kenya, Madagascar, Mali, Mauritius, Mozambique, Niger, Rwanda, Senegal, South Africa, Uganda, Zambia, and Zimbabwe for a total o f approximately US$140 million (of which about half is financed through World Bank loans). 21While the overall monetary value o f injected capital may not be significant in terms o f GDP or total investment, in an environment with limited availability o f external finance and high interest rate on bank loans (like in Malawi) it is often the only available funding for private firms to acquire new technology as well as business, technical and management know-how, and, subsequently, increase their productivity. In addition to country-specific matching grant schemes, there is an EU-ACP Business Assistance Scheme - a regional initiative operating on the basic principles o f matching grant schemes - for which Malawian business are eligible. The experience o f these grants inAfrica has been mixed (see Box 4.2). Further, this instrumentgenerally succeeds ina stable business environment characterized by low inflation and interest rates and more streamlined incentive structure than is currently present inMalawi. Other countries elsewhere includeArgentina, Bangladesh, Baltic States, Bolivia, Canada, Egypt, India, Indonesia, Israel, Ecuador, Jamaica, Jordan, Mexico, Palestine, Philippines, Syria, and Trinidad and Tobago. 72 Box 4.2: Firm CapacityBuildingthrough Matching Grants Schemes. Rationale. The argument for public sector supporting private sector activity is based on the theory o f public goods, Le., public subsidies can only bejustified ifthe interventions generate positiveor preventnegativeexternalities.Fosteringdevelopmentofthe market for provisionof business, technical, and management know-how to private sector enterprises can be regarded as a public good because one o f the key positive spillover effects include knowledge disseminationwithout the incurrenceof proportionaladditionalfinancial cost. Matching grant schemes (MGS) are instruments that fulfill this requirement and act as an intermediarybetweenprivate sector businessesand serviceproviders.The objectiveofMGS is to improve firm-level competitiveness by allowing business people to decide what support servicesthey want and select their own competitive private service providers. MGS are a cost sharing grant scheme, which require a certain level of public sector support (typically a cost sharingformula is 5050). Over the last decade, three mainchanges havetakenplace inthe designand implementationof MGS to increase their economical efficiency and effectiveness in upgrading skills in the privatesector: 1. On the supply side, there has beena shift from publicto private delivery of business developmentservices(BDS).Public supportto private sector developmenthas moved from state agencies to market development instruments, which allow more organizationalflexibility andresponsivenessto demand. 2. On the demand side, it is increasingly agreed upon that grants targeted to firms (service buyers) combined with cost recovery are more efficient than implicit subsidies to BDS suppliers. The rationale is that by allowing business people to decide what support services they want and selecting their own competitive private service providers they stimulate a competitive response from existing and new independentprovidersofbusinessservices. 3. On the implementation side, management and implementation of MGS have been moved away from the public sector. MGS are managed professionallyto ensure that they are reasonablyfree from governmentinterference. Over the past decade the popularity of MGS as an instrument to build firm-level capacity and for ruraldevelopment capacity buildingschemes aroundthe world, includingAfrica, has been growing. The experience of MGS has been mixed. While the output benefitsof such schemes (expressed as export- or sales-multiples of the grant amounts) appear to have been good, sustainability and impact seem to have been weaker. Operating costs have in some cases tendedto be highand implementationhas insome cases beencomplicatedand delayed, calling into questiontheir ability to inject liquidity rapidly,and efficiently, intothe servicemarket. MGS face some challenges as well. Namely: (i)deciding how much handholding to provide to the client in identifyingtheir problems; (ii)how to matchforeign and local consultantswith the client's needs; (iii)whether and to what extent to get involvedintraining localconsultant expertise; (iv) whether to operatepurelyon afirst-come-first-serve basis or to apply a demand stimulationand/or clienttargetingapproach; and ingeneral(v) how to define and implementa strategyfor achievingmaximum impactwith alimitedamount o f funds. 73 ANNEXES 74 Annex 1.0 CEMand the MPRSP 1. This Country Economic Memorandum (CEM) is designedto address the main question facing senior policy makers in Malawi - What needs to be done to accelerate growth in Malawi? The preparation of the CEM was carried out inclose coordination with the Poverty Reduction Strategy Process. The CEM draws on the Poverty Reduction Strategy Paper (PRSP), which was completedinAugust 2002l andthe work ofthe largenumber of working groups that provided inputs into the PRSP. The CEM also follows up on the last Bank CEM2 prepared in September 1997 and draws on the joint Bank/Government Public Expenditure Review (PER) completed in September 2001, the ongoing IMF work on macroeconomic stabilization, the IntegratedFramework (IF) for Trade Study being carried out inparallel, and other analytical work carried out inthe context ofthe ongoing Bankoperations. 2. As indicated in the Bank/IMF Joint Staff Assessment (JSA), the PRSP provides a credible framework for reducing poverty in Malawi. The PRSP strategy is based on the following four pillars: (i) sustainable pro-poor growth, (ii) capital development, (iii) human improvingquality of life for the most vulnerable, and(iv) good governance.The CEMfocuses on the first ofthese pillarsfilling ingaps andextendinganalyses where possible. 3. Givenour close involvement withthe PRSP working groups itnot surprisingthat there is a considerable overlap between the issues raised by the PRSP and the CEM. However, following are some ofthe areas where the CEMpresents further analyses andnew researchon issues raisedby the PRSP.3 InChapter 1,the CEMprovidesadiscussionofthe qualitative aspectsofthetrendsin poverty. The CEM presents new research on how HIV/AIDS affects the growth potential of the Malawianeconomy (Chapter 1). The CEM endorses the need to strengthen the statistical capacity as highlighted in the PRSP. An analysis ofthe agricultural statisticsis providedinChapter 3 andAnnex 3.1. TheCEMprovides afurther analysisofthe macro-volatility problemhighlightedinthe PRSPas a major constraintto growth. The CEManalyses the problemsMalawiwill face as it participates inthe regional integration process insouthernAfrica. The CEMendorsesthe PRSPfindingsthat agriculture is the mainsource ofpro-poor growthandfurther analyses the reasonsbehindthe weak agricultural performance. The CEMcomplementsthe PRSPapproachofanalyzing sub-sectors for their growth potentialby analyzing the cross-cuttingproblems affectingbusiness environment in general(Chapter 4). Startingfrom the openandfrank discussionofgovernance inthe PRSP, the CEMfurther developsgovernanceas a growth issue (Chapter 2). New evidenceon the Transparency InternationalIndex is presented. The CEMupdatesthe macroeconomicframework andtargets inthe lightoflatestdataand their policy implications. ' A Joint (IMF/World Bank) Staff Assessment (JSA) o f the PRSP was presentedto the Word Bank's Boardof Directors on August 29, 2002. World Bank, 1997, "Accelerating Malawi's Growth - Long Term Prospects and Transitional Problems". Some o fthese were identified inthe debate that followed the presentation of the PRSP andthe JSA. 75 Annex 1.1 ReasonsBehindGrowthPerformance Performance Reasons (Percent Growth) GDP growth: -10 1991-94droughts. Suspensionofnon-humanitariandonor assistancedue to poor governance. Weak budgetarycontrol aheadofelections. GDP: 16.7 Buoyantrecovery(partly reflectingrecovery from negative growth in Agriculture: 39.6 previousyear). Industry: 4.6 Favorableweather conditions. Services: 8.9 Adoption of medium-termeconomicprogrambackedby IMF ESAFto re-establish financial discipline. Liberalizedproductionand marketingarrangementsfor smallholders. Reductioninimport andexporttaxes and licenses. Initiationof civil servicereforms. GDP: 7.3 Favorableweather conditions. Agriculture: 25.5 Deepeningof reformsstrengthens smallholdersector. Industry: 8.6 Pricing andmarketingof all agriculturalproducts, exceptmaize, are Services: -0.8 liberalized. ADMARC losesmonopsonyrights for smallholdercrops. Export licensingrequirementsfor beans andgroundnuts are lifted. Restrictionson trade infertilizers andseeds are removed. Trade reformswere implemented, including loweringof import and exporttaxes and removalof some specifiedimport andexportlicenses. Civil servicereformscontinuedandacivil servicecensus was completed. Legal andinstitutional framework for privatizationof SOEs was established.Progressmade inrestructuringkey public enterprisesand preparingthem for privatization. Key administeredpriceswere flexibly adjustedto reflect costs. GDP: 3.8 Progresson structuralreformsweakens. Agriculture: 0.0 Expenditurecontrol andprioritization compromised andcivil service Industry:-0.1 reformspostponed. Targets under IMF SMP breached. Services: 8.3 Privatizationfalters, Some progresson trade liberalization. GDP: 3.3 Unfavorableweather conditions. Agriculture: 2.7 Reducedproductionof tobacco due to low utilization of fertilizers and Industry: 1.2 bad weather. Services: 4.6 GDP: 4.0 Favorableweather conditions. Agriculture: 11.2 Industry:2.5 Services: 2.6 GDP: 1.6 Erratic weather, with floods insome parts anddry spells inothers. Agriculture: 5.7 However, bumper burley tobacco harvests. Industry:-0.5 Erratic stabilizationpolicies. Services:0.6 Highandvolatile inflation. Highrealinterestrates, sharp Kwachadepreciation, andhigh andvolatil inflation depressed growth inmanufacturingandtransport sector. GDP: 2.8 Fiscalandmonetaryprograms were off-track until mid-year. Agriculture: 3.7 Suspensionof balanceof paymentssupport by bilateraldonors- Industry:0.6 Denmark, Norway, Sweden, UnitedKingdom- inDecember2001until Services:3.0 progressis made on key structuralreformsandoneconomic management. 76 Annex 1.2 PovertyMeasures and Average Consumptionby Region, Basedon Responses from 6,586 Households (standard errors in parentheses)l/ Weighted Mean Consumption of the Consumption of the I H S Poverty Poverty Poverty consumption poorest 10 percent of richest 10 percent of population headcount (% of gap index severity ( MKlperson Gini population (As % of total population (As % of Share ( O h ) population) 21 31 index 41 /day) coefficient 51 consumption) total consumption) Malawi 100 59.6 0.2336 0.1194 12.05 0.401 2.5 31.8 (2.55) (0.02) (0.01) (0.52) Southern region 47.1 61.8 0.2535 0.1343 11.94 0.423 2.2 34.0 (3.98) (0.03) (0.02) (0.89) Central region 41.8 56.6 0.2118 0.1048 12.35 0.383 2.6 30.3 (3.80) (0.02) (0.01) (0.69) Northemregion 11.1 61.5 0.2306 0.1 107 11.38 0.362 3.1 28.8 (5.02) (0.02) (0.01) (0.89) Rural 89.7 60.6 0.2385 0.1220 11.30 0.374 2.6 29.0 (2.81) (0.02) (0.01) (0.53) Urban 10.3 50.8 0.1913 0.0967 18.66 0,520 1.7 42.9 (3.85) (0.02) (0.01) (1.91) Source: Profile ofpoverry in Malawi, 1998:National Economic Council, November 2000 l / The standard errors permit the calculation o fthe Z score, which intun can be usedto assesswhether the difference between means is significant. 2 is calculated as the difference between any two means divided by the square root ot the sum o fthe squared standard errors. Ifthe absolute value o fZ is greater that 1.282, the probability is less than 10 percent that there is no real difference the means. I f Z is greater than 1.645, then the probability is less than 5 percent. 2/ Separate poverty lines were computed for different regions and for urban and rural areas taking into account difference inprices and preferences. The headcount measure(based on daily per capita consumption) shows the percent o fpopulationthat lies below the the poverty line. 31Measures depth ofpoverty. I t shows the ratio o faverage extra consumption neededto bring all people to the poverty threshold. This index is defined as the averagedifference between the level o f consumption o f an individual and the poverty line for the population as a whole. This difference is expressed as a proportion o f the poverty line. 4/ Measures severity o fpoverty and is calculated as the meano fthe squared poverty gap. 5/ Gini coefficient reflects income inequalities. A Gini o f0 reflects perfect equality. 77 Annex 1.3 Sources of Income as a Percentof Total IncomePer CapitaPer Day Malawi Rural Urban Poor Non-poor All Poor Non-poor All Poor Non-poor All Netfood crop sales (Yo)1/ -0.5 -0.6 -0.6 -0.5 -0.7 -0.6 -1.0 -0.4 -0.5 Netcashcropsales(%) 1/ 6.7 4.5 5.1 7.5 6.6 7.0 0.2 1.1 1.o Net livestock and product sales (%) 1/ 1.8 1.o 1.3 2.6 1.7 1.8 0.2 0.0 0.1 Netnon-farmbusinesssales (%) I/ 2.3 10.5 8.2 1.0 2.6 2.1 8.1 23.6 21.4 Employmentincome (%) 21.5 30.9 28.2 13.1 17.3 15.8 69.2 53.7 55.8 In-kind income (%) 1.5 3.2 2.7 2.3 1.7 1.7 0.8 5.7 5.0 Interest income(%) 0.1 1.o 0.7 0.0 0.4 0.3 0.2 1.9 1.7 Rentalincome ('Yo) 1.1 1.6 1.5 0.6 0.8 0.7 3.6 2.9 3.O Other income(%) 3.5 4.8 4.4 3.6 4.6 4.2 2.5 5.2 4.8 Incoming incometransfers(%) 6.2 5.0 5.3 6.5 6.0 6.2 4.6 3.2 3.4 Value ofhome productionconsumed(%) 55.9 38.1 43.1 63.7 59.1 60.7 11.8 3.1 4.3 Total per capita daily income(MK) 5.0 18.4 10.4 4.6 13.1 8.0 8.6 55.6 31.7 Source: Malawi: HumanResourcesand Poverty, World Bank, 1995. Based on information from 6,586 households. 1/Net sales are calculated as the difference betweentotal sales and total costs. 78 Annex 1.4 Impactof HIV/AIDS inthe Region Adults living with HIV/AIDS, Adults and children end-99 (YOof living with HIV/AIDS, AIDS deaths, Cumulative Current living adult end-99 (YOof total 1999 (YOof orphans (YOoforphans (YOof population) population) population) population) population) Botswana 35.8 18.2 1.5 4.1 3.4 Burundi 11.32 5.5 0.6 3.5 2.3 Central African Republic 13.84 6.8 0.6 2.8 2.0 Cote d'Ivoire 10.76 5.2 0.5 2.9 2.0 Djibouti 11.75 5.9 0.5 1.1 0.9 Ethiopia 10.63 4.9 0.5 2.0 1.5 Kenya 13.94 7.1 0.6 2.5 1.9 Lesotho 23.57 11.4 0.8 1.7 1.4 Malawi 15.96 7.5 0.7 3.7 2.6 Mozambique 13.22 6.2 0.5 1.6 1.3 Namibia 19.54 9.4 1.1 4.0 3.1 Rwanda 11.21 5.5 0.6 3.7 2.4 South Africa 19.94 10.5 0.6 1.1 0.9 Swaziland 25.25 13.5 0.7 1.3 1.1 Zambia 19.95 9.7 1.1 7.2 5.0 Zimbabwe 25.06 13.0 1.4 7.8 5.4 Source: Based on UNAIDS,EpidemiologicalFact Sheets. P 79 Annex 2.1 Patternof Total FinancialInstitutionsHoldingsofT-Bill and RBM Billsas ofDecember2001 Continental Discount House 13% National Bank Group (major shareholder-Press 17% CorP) NationalBank 13% NBM-Financial Management Service 1% NationalFinance Company 0% New BuildingSociety 3'?"o Insurance Companies (dominated by National 10% Insurance Companies, owned by Press Corp) Indebank group 13% INDERBANKFinancialservices 7% INDEFUND&INDETRUST 4% Leasing & Finance Co. 1% INDEFINANCE 0% CommercialBank 8% CommercialBank 3% CBM-Financial Services 1% Stock Brokers MalawiLtd. 4% FirstMerchant Bank 4% Sumofthe above 64% Memo: Total T- bill and RBMholdings Dec. 2001 12,595 (millions of MK) 80 Annex 2.2 An EconometricModelof Inflation inMalawi The fiscal-monetary approachto inflation is basedonspecifying a demandfunction for money (Durevall and Ndung'u 1999, Nachega 2001). We postulate the following specification for demand for M2: log(M2) -log(P) = a + b*log (IP) + c*depstr -h*tbillr -J"fcdr -g*log(xr) where P indicated CPI, IP stands for industrialproduction; depstr, tbillr and fcdr are respectively interest rates on bank deposits, T-bills, and foreign currency deposits, andxr stands for Kwacha/US$ exchange rate. The above money demandfunction impliesthe followingequation for the price level: log(P) = -a + k*log(M) -b*log(IP) -c*depstr h*tbillr +J"fcdr + + g*log(xr) Inthis equation, the price level(hence inflation) is positively relatedto M,negatively to IPand deposit rate, positively to T-bill rate, foreign currency deposit rate and currency depreciation. The purchasing power parity (PPP) theory suggests that inthe long-run, changes indomestic prices equal changes inforeign prices adjusted for changes inthe exchange rate. Assuming that most o fthe PPP-basedchanges inMalawi's inflation comes from exchange rate changes (and considering non- availability o f high-frequency data on foreign prices and terms o f trade), we have includedthe log(xr) term inthe above inflation equationto capturethis effect (as well as its direct effects onthe demand for money). The estimated equationfor price level, applying ARDL procedure to monthly data for 1994:Ol- 2001:08, is: log(P) = 0.57+ 0.5441og(M2) + O.O5log(IP) + 0.3510g(xr) Adjusted R2=0.64, DW-statistic=l.95 (coefficients in bold are significant at 5 percent level) The coefficients of M 2 and exchangerate are significant and positive, as expected. (The coefficient of industrialproduction is not significant, but the IP index does not adequately capture real economic activities inMalawi.) The error correction representation for the ARDL(4,4,0,0) model, selected usingSchwartz Bayesian Criterion, is summarized inthe following table. Dependentvariable is dLCPI =LCPI-LCPI(-1) 86 observationsused for estimation from 1994M7 to 2001M8 Regressor Coefficient T-Ratio (* indicates significance at 10% level or higher) DLCPI1=LCPI(-l)-LCPI(-2) 0.14267 1.421 DLCPI2 =LCPI(-2)-LCPI(-3) 0.38315 3.648* DLCPI3 =LCPI(-3)-LCPI(-4) -0.24228 -2.383* DLNM2 =LNM2-LNM2(- 1) -0.11679 -1.697* DLNM21=LNM2(-1)-LNM2(-2) 0.036356 .6356 DLNM22 =LNM2(-2)-LNM2(-3) -0.19199 -3.372* DLNM23 =LNM2(-3)-LNM2(-4) -0.1946 -3.170* dLEX = LEX-LEX(-l) 0.059879 2.505* dLIP = LIP-LIP(-1) 0.008615 .2760 DINPT =INPT-INPT(- 1) 0.098713 .4632 ecm =LCPI -.54476*LNM2 -.34870*LEX - -0.17172 -4.841* .050169*LIP -.57484*NPT 81 R-Squared .68330 R-Bar-Squared .63622 S.E. of Regression ,025992 F-stat. F( 10, 75) 15.9659 MeanofDependentVariable ,025135 S.D.ofDependentVariable .043094 Residual Sumo f S uares .049992 EquationLog-likel?hood 198.3320 Akaike Info. Criterion 186.3320 Schwarz Bayesian Criterion 171.6059 DW-statistic 1.9532 Key: LCPI=log(CPI) LNM2=loelM2) LEX=log(zxchange rate) LIP = iog(industria1 productionindex) INPT=interce t DLindicates Erstdifference oflogs. 82 Annex 2.3 Malawi: Central GovernmentOperationsCalendar Year 1993-2001 1993 1994 1995 1996 1997 1998 1999 2000 2001 Act. Act. Act. Act. Act. Act. Act. Act. Est. (Inpercent of GDP, unless otherdse indicated) Total revenueand grants 19.9 31.6 26.3 19.6 18.6 23.0 24.6 26.7 23.8 Revenue 17.1 19.5 18.3 15.1 15.2 16.8 18.1 17.4 17.0 Tax revenue 13.6 17.2 16.2 13.9 14.0 15.3 15.7 16.0 15.6 Non-tax revenue 3.5 2.4 2.2 1.1 1.1 1.5 2.4 1.4 1.5 Total grants 2.8 12.1 8.0 4.5 3.5 6.2 6.5 9.3 6.8 Total expenditureandnet lending 26.0 49.0 31.0 23.3 24.2 29.5 29.1 31.8 30.9 Total expenditure 26.0 49.0 31.0 23.3 24.2 29.0 28.9 31.8 30.3 Current expenditure 20.7 40.6 24.4 18.7 19.5 21.6 19.5 20.3 22.6 Wagesandsalaries 5.6 9.0 7.0 4.6 5.7 5.1 4.9 5.0 5.3 Other purchaseso f goodsand services 9.7 20.3 9.0 7.4 8.8 7.0 8.1 7.8 6.5 Intereston deb! 3.1 5.1 6.4 5.3 3.4 3.8 3.4 4.4 5.0 Foreign 1.4 1.7 2.6 1.1 1.0 1.6 1.5 1.6 1.3 Domestic 1.7 3.3 3.8 4.2 2.4 2.2 1.9 2.8 3.7 Subsidies andother transfers 2.3 6.3 2.0 1.4 1.6 5.3 2.6 2.9 5.4 Transfersto NRA andMRA 0.0 0.0 0.0 0.0 0.0 0.4 0.5 0.7 1.0 Transfer to National Roads Authority 0.0 0.0 0.0 0.0 0.0 0.4 0.4 0.4 0.7 Transfersto MalawiRevenue Authority 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.3 0.4 Pensionand gratuities 1.o 1.5 1.o 0.9 1.2 1.1 1.2 1.2 1.0 Separationbenefits 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.1 Discretionaryexemptions 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other 1.3 4.8 1.0 0.5 0.4 3.8 0.9 0.8 1.5 Maize purchasefor NFRA 1.3 4.8 1.0 0.5 0.4 3.3 0.4 0.0 0.0 Distr. andof free maize 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Water, healthandnutrition 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Saca advance 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Fertilizer subsidy 0.0 0.0 0.0 0.0 0.0 0.0 0.5 0.0 0.0 Fuelsubsidy 0.0 0.0 0.0 0.0 0.0 0.5 0.0 0.0 0.0 Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.8 1.5 HIPC expenditure 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 Expenditure in arrears 0.0 0.0 0.0 0.0 0.0 0.3 0.6 0.2 0.4 Development expenditure 5.3 8.4 6.6 4.6 4.7 7.5 9.3 11.5 7.7 Net lending 0.0 0.0 0.0 0.0 0.0 0.5 0.2 0.0 0.6 Overalldeficit Excludinggrants -8.8 -29.5 -12.7 -8.3 -9.0 -12.8 -11.0 -14.4 -13.8 Includinggrants -6.1 -17.4 -4.7 -3.7 -5.5 -6.6 -4.5 -5.1 -7.0 Total financing 7.0 21.8 3.8 4.6 5.7 6.5 4.9 6.3 6.4 Net foreignfinancing 4.4 12.9 1.8 4.9 3.4 9.0 3.1 3.4 3.9 Domestic financing 2.5 8.9 2.0 -0.4 2.3 -2.5 1.8 2.9 2.5 Bank financing(net) 2.5 3.6 -1.3 0.1 0.3 -3.1 -0.8 1.2 4.2 Non-tank financing(net) 0.1 2.5 2.9 0.5 1.7 -1.7 2.5 2.4 -1.9 Revenue ("Loss recovery") 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Government claimon oil 0.0 0.0 0.0 0.0 0.0 0.5 -0.2 0.0 0.0 Payment o f PCCarrears 0.0 0.0 0.0 0.0 0.0 -1.0 0.2 0.0 0.0 Others* 0.0 2.9 0.4 -0.9 0.3 2.2 0.2 -0.2 0.4 Discrepancy 0.9 4.4 -0.9 0.8 0.2 -0.1 0.4 1.2 -0.6 Memorandum items (in MK million) Nominal GDP 9,117 10,325 21,835 37,233 41,661 53,957 79,804 101,634 131,844 *Consists o f change in arears, privatizationproceeds, andthe petroleumaccount. This is small in most years except 1994 and 1998, mainly on account of achange inarrears 83 Annex 2.4 FoodProduction and Food Inflation 3000 100 90 2500 80 70 2000 60 1500 50 40 1000 30 20 500 010 0 -10 1995 1996 1997 1998 1999 2000 2001 -+-FoodProduction(000s metrictons) +Food Inflation (Average Annual) 84 Annex 2.5 ChronologyofTrade LiberalizationMeasures, 1988-98 Elimhating Non-tariff Barriers February 1, 1988: Exchange controls on about 25 percent of imports of non-petroleum raw materials and spare parts were eliminated. August 14, 1988:Liberalizationo f foreign exchange controls was extendedto an additional 50 percent o f non-petroleum imports (including industrial spare parts), most goods related to commercialtransport, and some consumer goods. January 10, 1991:Authorities introduce a narrow and temporary negative list covering certain luxury items, notably, alcoholic beverages, precious metals, motor vehicles, and electrical goods. February 7, 1994:The negative list for import commodities was finally abolished. However, following a shortage of petroleum imports, the government reinstated a state import monopoly through the Petroleum Control Commission (PCC). June 6, 1997: All licensing requirements on imports and exports were abolished, except for itemsrelatedto health, security, and environmentalconsiderations. Consolidating the TariffStructure April 1, 1998: The customs duty and import levy were combined into one tariff schedule in 1998, followed by a broadening of the tax base. 1992-93: The differential in the surtax rate levied on imports and domestic goods was eliminated incombinationwith an upward adjustment inimport duty rates. 1996:The number oftariff bands was reduced. Reducing TariffProtection 1988 and subsequently:Maximum tariffs were reduced in 1988 on non-governmental imports from 70 percent to 45 percent o f the c.i.f. value, with a weighted average o f about 21 percent. Some tax rates were later abolished. Government imports were exempt from customs tariffs. April 1996 The maximumtariff rate was reduced from 45 to 40 percent. April 1997: The government eliminated the import duty rate on raw materials used in manufacturingand reducedthe maximumrate (on finishedproducts) from 40 to 35 percent. July 1,1999:The maximum tariff rate was reduced to 25 percent. Liberalizing the Export Regime February 7, 1994: The export surrender requirement was abolished, except for tea, sugar, and tobacco; at present, 60 percent o f proceeds are still subject to surrender requirements. April 1995: A 10 percent temporary export levy on tobacco and sugar was reduced to 8 percent. April 1996: The temporary export levy on tobacco and sugar was reduced to 4 percent, and concurrently extended to include coffee. April 1997: The government eliminatedthe corporate tax on firms inexport processing zones. April 1998:The export levy was eliminated. 85 Annex 2.6 Bilateral, Regional, and Multilateral Agreements of Malawi Agreement Type (by Reciprocity Degree of Phase-out schedule number of liberalization members) Malawi-South Bilateral Non reciprocal(Malawi FTA Inforce since 1990, until Africa has duty free access, S.A. 2008 (when SADC tariff= enjoys MFNtreatment) 0) Malawi-Zimbabwe Bilateral Reciprocal FTA Inforce since 1995 Malawi-Botswana Bilateral FTA Since 1968 COMESA Regional Reciprocal FTA to CU FTA (start: 2000) CU (start: 2004) SADC Regional Reciprocal FTA Phase 1: 2000-2004 Phase2: 2004-2008 WTO Multilateral Non-reciprocal ITA Malawi's membership of WTO since 1995 EU-ACP Cotonou Multilateral Non-reciprocal (possibly PTA to FTA Signed 2000, prepare for Agreement shifting to reciprocal) negotiations until2002, negotiate until2008, implement by 2018 AGOA Multilateral Non-reciprocal PTA EBA Multilateral Non-reciprocal PTA Proposed 1997, extended 2000, effective from 2001, or 2008 for rice, sugar, - and bananas Source: World Bank staff analysis 86 Annex 2.7 Import Regimes Country Tariffs/Revenue(1) IMF Average Maximum Number Other Dutiesand YO TradeRestrictivenessIndex I Tariff(2) Tariff Yo of Tariff Charges (Sample) Yo YO I Bands(5) I Tariff(4) 14 3 12 25 4 COMESA: Burundi 17 Comoros 57 Kenya 15 Madagascar 28 3 1 Mauritius 28 6 2 Mozambique 17 2 1 Rwanda 13 3 1 SACU 3.5 i" 2 13 55 47 Seychelles 21 5 28 200 13 Tanzania 11 2 14 25 4 Susuendedduties of Uganda 10 2 1 9 I15 1 3 II uptoso% Tobacco (30%), Selectedimports (10%) Zambia 13 2 14 25 4 Processingfee (flat rate), some specific duties Zimbabwe 15 5 22 600 6 0-10% surchargeon I all goods Source: IMFDirection ofTr: :Statistics, 2001. Note: (1) Ratio of tariff revenuesto totalnon-grantCGrevenue-latestavailablefigures; (2) Unweighted;(3) Scaleof 1to 3; (4) Scale of 1to 5; (5) Includeszero band; (6) Scaleof 1to 10 with 10beingthe mostrestrictive. 87 Annex 2.8 AGOA EligibleItems of Interestto Malawiand their Tariff Rates Tariff Line No. Description TariffRate (YO) Exports to US Total Exports HS 8 digit. of Value 2001 to the World AGOA Higibality * US $ million US $ million 2401208320 Tobacco, partly or wholly stemmed/stripped, 5.65 16.4 278.3 Eligible threshed or similarly processed, not 6omcigar leaf, not orientalor turkish, not for cigarette * 2401208520 Tobacco, partly or wholly stemmed/stripped, 5.65 20.7 Eligible threshed or similarly processed, not fromcigar leaf, described inadd1USnote 5 to chap 24 2401302320 Tobacco refuse, 60mother tobacco, other than Not Eligible for cigarettes, tobacco stems, not cut, ground or pulverized 9011100 Coffee, not roasted, not decaffeinated 0 %58,OOo 7 Not Eligible 9024000 Blacktea 0 12.6 35.5 Not Eligible 902209000 Greentea 0.17 0 Eligible 52 Differentarticles ofweave cotton fabric 8.7 0 9.02 Eligible 1701 Raw sugar not containing added falvoring and Quota 7.8 43.5 Quota rawsugar containing flavoring US$ Thousand US $ Thousand * 120220 Peanuts total 0 0 204 Eligible * 12022080 Peanuts (ground-nuts), not roastedor cooked, 0 0 Not Eligible shelled, not subject to gen note 15or add. US * note 2 to Ch.12 12022005 Peanuts (ground-nuts), not roastedor cooked, 6.2 0 Eligible shelled, subject to gen note 15ofthe H T S * 12022005 Peanuts(ground-nuts), not roastedor cooked, 6.2 0 Eligible shelled, subject to gen note 15ofthe H T S * 12022040 Peanuts(ground-nuts), not roastedor cooked, 6.2 0 Eligible shelled, subject to add. USnote 2 to Ch.12 12021080 Peanuts (ground-nuts), not roastedor cooked, 0 0 Not Eligible inshell,notsubjectto gennote 15or add.US * note 2 to Ch.12 12021005 Peanuts(ground-nuts), not roasted or cooked, 8.8 0 33.44 Eligible inshell,subjectto gennote 15ofthe HTS * 12021040 Peanuts (ground-nuts), not roasted or cooked, 8.8 0 Eligible inshell,subjectto add.USnote2to Ch.12 $us $ US * Thousands Thousands 8029098 ShelledMacadamia 4.5 265.2 2.51 Eligible **8025040 Pistachios, fresh or dried, shelled 0.95 0 78.1 Not Eligible 8022200 Hazelnuts or filberts, 6esh or dried, shelled 12.8 0 11.5 Eligible 90420 Paprika 0 71.4 1.17 Not Eligible 90410 Pepperofthe genus Piper, crushed or ground 0 0 179.2 Not Eligible 91099 Origanum,crude or not manufactured 0 0 16.1 Not Eligible 90920 Seeds o fcoriander 0 0 1.99 Not Eligible 70890 Lentils, fresh or chilled, shelled or unshelled 0 0 59 Not Eligible 60310 Cut flowers and flower buds suitable for 0 0 0 Not Eligible bouquets or ornamental purposes, 6esh cut *These commoditieshave a specific tariffag. They have been convertedto advalorem rate usingthe ZOO0 prices. Source: USTariff Schedule,Ministry of CommerceandIndustry,Malawi 88 Annex 2.9 CorruptionPerceptionIndex 2002: Sub-SaharanAfrica Rank Country CPI 2002 High-low Surveys Standard [l=Best; Score Range used Deviation 102=Worst] [10=Best O=Worst] 24 Botswana 6.4 5.3-8.9 5 1.5 28 Namibia 5.7 3.6-8.9 5 2.2 36 SouthAfrica 4.8 3.9-5.5 11 0.5 40 Mauritius 4.5 3.5-5.5 6 0.8 50 Ghana 3.9 2.7-5.9 4 1.4 59 Ethiopia 3.5 3.0-4.0 3 0.5 66 Senegal 3.1 1.7-5.5 4 1.7 68 Malawi 2.9 2.0-4.0 4 0.9 71 Cote d'Ivoire 2.7 2.0-3.4 4 0.8 Tanzania 2.7 2.0-3.4 4 0.7 Zimbabwe 2.7 2.0-3.3 6 0.5 77 Zambia 2.6 2.0-3.2 4 0.5 89 Cameroon 2.2 1.7-3.2 4 0.7 93 Uganda 2.1 1.9-2.6 4 0.3 96 Kenya 1.9 1.7-2.5 5 0.3 98 Angola 1.7 1.6-2.0 3 0.2 98 Madagascar 1.7 1.3-2.5 3 0.7 101 Nigeria 1.6 0.9-2.5 6 0.6 Source: TransparencyInternational. 89 Annex 2.10 Major Cases of Corruption Following are some of the important cases of corruption investigated by the ACB: PCC. Substantial losses were made by the Petroleum Control Commission in 1997/98(amounting to 3.5% of GDP). The Auditor-General reported in November 1998 that part of this loss reflected the fraudulent award of inflated contracts, unjustifiedexpenses, and misappropriationof funds. ElectionCommission. The Auditor-General reported widespread misuse of donor funds for the 1999 general elections, either stolen or lost through inflated, unused, or unnecessary purchases. Police vehicles. A contract that was awarded to Apex car sales had apparently been inflated by large commission payments and did not satisfy procurement and payment requirements. It was cancelled following non-performance on delivery. Identity cards. A contract that was awarded to Secucom International Holdings Limited had apparently been inflated by large commission payments and did not satisfy procurement and payment requirements. It was cancelled following a courtjudgment against an appeal by Secucom to overturn a restriction by the ACB on the sale. Ministry of Education. The Auditor-General uncovered substantial misuse o f public funds while responding to a request from the Ministry o f Finance to quantify domestic pending arrears. The Parliamentary Accounts Committee reported that the Auditor-General had evidence of contracts being illegally awarded and inflated, buildings not finished, and other offenses. Furthermore, connections were alleged to senior officials and politicians. Charges have since been laid against some officials and contractors. Ministerial vehicles and other perquisites. An order was placed in early 2000 for 39 Mercedes Benz cars for ministers to replace the fleet purchased between 1995 and 1997. The purchases were approved in the 1999/2000 budget, and the cars were delivered at the beginning of the fiscal year. Following well-publicized complaints about extravagance, the president ordered that the cars should be sold. Measures have also been taken to reduce spending on workshops and conferences for public employees, limit the costs o f overseas travel, cut the size o f the government car fleet, and monetize in-kindbenefits. Evasion of customs duties. The director of the ACB ordered the arrest of nine customs officials in March 2000 on suspicion o f falsifying the valuation o f imported shipments (although the DPP later ordered that seven be released). Discretioninthe award ofcontracts tax exemptionand privileges.The award inNovember 1999 of a pre-shipment inspectioncontract to a company rejectedby an advisory panelandthe offer o f a 15-year tax holiday to the Petroda Oil Distribution Company (incontravention o f a 1O-year limit) suggest that discretionary decisions by ministers are leadingto inefficiencies, inequity, and rent seeking. 90 Annex 3.1 ReliabilityofAgriculturalData The official crop estimates from the Ministry o f Agriculture and Irrigation for cassava, potatoes, pulses, and groundnuts are not consistentwith other sources of information. This issue has been noted for a number of years, but the underlyingproblem has not been identifiedor remedied. This annex provides some detailed analysis ofthe quality ofthe data. First, we dissectedthe sources of the reported growth in agricultural value added since 1995 (see Table 3.9 below). If these figures were correct, the combined share of tobacco and maize, the country's main crops to agricultural value added, would have fallen from 56% in 1995toj u s t 35% in2001. This would imply that tobacco contributed only 5% to national GDP. Conversely, the contribution of other food crops (basically cassava, potatoes, and pulses) would have risenfrom 37% to 61% of agricultural GDP. Ifthis were true, in2001 potatoes would havereplacedmaize as the largestcontributor to agricultural GDP, with 24.3% of the total, with cassava in second place with 18.4% in2001. The key questions inthe data are therefore centeredin the performancecassava, potatoes, pulses, and groundnuts, and whether the reported figures are consistent with other observations. Questions also pertainto the data area expansion and yield for these crops. Table3.9: Contributionto AgriculturalValue Added, MainCrop Groups 1995 -2001 (millionMK,constant1994prices) 1995 1996 1997 1998 1999 2000 2001 Maize 920 1,228 833 1,041 1,214 1,202 898 as % of Sector 32 33 23 26 28 26 19 Other FoodCrops 1,061 1,424 1,682 2,080 2,237 2,251 2,886 as % of Sector 37 38 46 51 51 49 61 Tobacco 699 796 898 766 752 943 764 as % of Sector 24 21 25 19 17 21 16 OtherCashCrops 220 260 218 165 171 179 162 as % of Sector 8 7 6 4 4 4 3 Total Crops 2,900 3,708 3,631 4,053 4,373 4,575 4,710 Source:NSO, GDP Calculations. The NSO uses 1994 producer prices and multiplies these by production figures to obtain gross receipts in constant 1994 prices. Then they deduct an aggregate figure for cost o f inputs and depreciation for the entire smallholder sub-sector. N o crop-specific calculations for value added are used. NSO has made corrections to the MOAI's crop estimates, so official GDP figures are at variance with the production estimates. Based on a review of the official MOA1 data on area and yield o f cassava, potatoes, pulses, and groundnuts and after comparing it with other sources o f information, we conclude that the growth in production ofthese four crop groups: 0 Cannotbe explainedbyhigher inputuse (land, fertilizer, or labor), 0 I s inconsistentwithregional data onyields, 0 I s inconsistentwith expenditure and consumption data from the 1997-98 Integrated Household Surveyandthe 1999-2000Demographic andNutrition Survey which show lower levels o ffood intake thanthose impliedby the production data, and 91 0 I s inconsistentwiththe evidenceonthe significant drop inprofitability acrossthe board inthe agricultural sector. DataonArea Expansion The official crop estimates suggest a more than50 percentareaexpansionbetween 1995 and2001 (see Figures 3.9, 3.10, and 3-11), coupled with significant increases in yields for many crops. This is questionable for anumberofreasons: 0 Expansionwould have been intomarginal lands likelyto have lower yields. 0 Although some underutilized estate lands exist in some regions and encroachment has been reported, there is no evidence of major encroachment into estate lands which would have a noticeableeffect on aggregate data. Moreover, land scarcity is largely a local phenomenon, more severe in the southern region than in the northern region. There is no evidence that massive inter-regional migration has taken place. 0 Significant area expansion (coupled with yield increases) would entail some likely increase in fertilizer use and dramatic increases in labor expenditure. Aside from the starter pack program (and most of this fertilizer was usedfor maize), there does not appear to have been an increaseeither infertilizer usedor inlabor. ProductionandYield Data for Many Crops is Inconsistentwith RegionalTrends The most striking cases are those of cassava, sweet potatoes, Irishpotatoes, groundnuts, and some pulses. According to MOAIofficial crop estimates, the production of cassava grew ten-fold, from 328,524 MT in 1995 to 3,362,201 MT in2001. This anomaly has been noted by the NSO. Inthe calculation of GDP for 2000 and 2001, the NSO convertedthe cassavaproduction figures from wet weight to dry weight, which effectively reducedthem by one-third. Butevenwiththis correction, the NSO figures still show an almost four-fold increase in cassava production from 1995 to 1,109,592 MT in 2001. The cassava production estimates seem to be based on the assumptionof 0.078 hectares per farm, for every single farm household in Malawi, but the 1997-98 Integrated Household Survey showed that only 9 percent of households cultivate cassavawith ayield o f 12MTiha (wet weight). Therefore, the mainproblemwith cassavafigures is the hugeareaexpansion, rather than the yield data(see Table 3.10). Inthe case of sweet potatoes, the NSO has also made a correction to the MOAIcrop estimates for the years 1996to 2001becausethe yieldsusedby MOAIwere consideredto be unrealistic (up to 13.4 MTiha in2001, when the sub-Saharan Africa average for the past seven years has beenaround 4.8 MTha). To obtain sweet potato production estimates, the NSOhas usedaconstantyield of 5.5 MT/ha for 1996-01and multiplied it by the area. Nevertheless, the official GDP figures still show a very impressive three-fold surge inproduction due to area expansion. The Irishpotato yield data is highbut seems more believable since the variety release is mostlythrough the private sector (thepotato chip manufacturer). The rapid area expansion is plausible given the low base (from roughly 7,800 ha in the 1994/95 season to 23,000 in 2000/01), but the rapid growth inyields (from 10 MTiha in 1995 to 14 MTiha in 2001) is not consistent withthose ofthe SSA average or those ofMalawi's neighbors. 92 Figure 3.9: Area expansion -- Main crops 3000 , I I 1I OBurley Rice E! Pigeon Peas .Groundnuts OS. Potatoes OCassava W Beans 1995 96 97 98 99 2000 2001 Year Source :Ministry ofAgriculture Figure 3.10: Growth in production Main crops - 500 r - 400 +Beans ua 11 300 Cassava rg 200 i* S.Potatoes - +G'nuts 0 100 +Pigeon peas 0 +Rice 1995 96 97 98 99 2000 2001 Year Source :Ministry ofAgriculture Figure3.11: Average Yields -MainCrops 300 I 5250 FII 200 --tBeans ua =.150 - S. Potatoes K 100 *-Cassava 0 --)IC-Groundnuts -@- Pigeon Peas 1995 96 97 98 99 2000 2001 Burley Year Source :Ministry ofAgriculture The growth ingroundnuts also appearsto be exaggerated. Area underthis crop morethandoubled between195 and2001, while yields increasedtwo andhalftimes. It is undeniablethat Malawihas a long history ofproducinggroundnuts, datingbackto the 1960s, but it is widely acknowledgedthat over the past two decades yields were declining andthe quality ofthe producthadbeen deteriorating.Dueto highdemandfor the productover the last few years, there hasbeenarevivalofthe cropthat would explainsome growth. However, official yield estimates for 2000/01(820 kgiha) placeMalawialready above all its neighborsand approachingthose ofthe largestgroundnutproducersinthe continent, such as Nigeria (1,087 kgiha) and Senegal(1,007 kgiha). Yields during the 1980srangedbetween380 and 93 400 kgihaand The Guide to Agricultural Production worked with ayieldfigure o f450 kgihainthe mid- 1990s. Although the growth data on virtually all pulses is impressive, the case of beans seems the most questionable. According to the MOAIdata, which has not beencorrectedby the NSO incalculating GDP figures, bean production has increased almost five-fold between 1995 and 2001 (from 22,000 MT to 108,000 MT), as a result of both area expansion (almost double) and impressive increases in yields (two andhalftimes). Table3.11: Yields for Major FoodCrops( m a ) , VariousCountries, 1998 - 2001Average MalawiiMOAI) Mozambique. Tanzania Zambia Sub- SaharanAfrica Maize 1,446 965 1,110 1,586 1,266 Cassava 5,43 1 5,675 8,169 6,900 8,769 Sweet Potatoes 11,674 6,437 1,749 14,752 4,6 13 IrishPotatoes 11,567 10,733 6,931 9,077 7,263 PigeonPeas 708 n.a. 706 n.a. 751 Rice 1,794 1,028 1,495 875 1,601 Groundnuts 736 482 637 404 851 Source: FA0 The HugeExpansioninFoodAvailabilityis NotReflectedinConsumptionData The growth inagricultural production suggestedbythe MOAIofficial figures would haveresulted in spectacularincreases infood availability andconsumption,butthis is not supportedby nutritionaldata. If allthe crop estimates were correct, Malawiwould haveproducedbetween3,400 and3,900 kcal /capita/day inthe lastthree years. The average inSub-SaharanAfrica is only around 1,500 (see Table 3.11). Since most ofMalawi's agricultural exportsaretobacco or other non-food items, muchofthis caloric productionwouldhaveto havebeenconsumedat home. Accordingto the 1997-98survey ,average householdlevelfood consumption was only 1.818 kcall capitdday, which although low from anutritionalstandpoint, is more consistentwith the regionaltrends andthe ampleevidence onchild malnutritioninMalawi. The 1997-98survey showedthat 29.2 percentof children under 5 hadweight-for-age scores (which reflect bothstuntingandwasting) below 2 standard deviations from the InternationalReferencePopulation median. The 1999-2000healthandnutrition surveyedshowedaslight improvement, to 25.7 percent, but it is notclearthat the methodologiesusedin these samples are perfectly comparable. And finally, the rapid growthappears inconsistentwiththe deteriorating macroeconomic environment over muchofthis period, andthe deterioration inprofitability as reportedinthe micro-leveldataon crop- specific profitability estimates. Ingeneralhighgrowth is notachievedinan environment of macroeconomicinstability anddeteriorating incentives at the farm level. Malawi's agricultural statistics for the periodunder assessment thus appear to be seriously flawed. Given the importanceofagriculture to the country's economy andthe expectationsfor agricultural growth, itwill be very important to put in place mechanismsto generate and evaluate reliable data. A task force on this issue has beenestablishedand is at work. 94 Table 3.10: StapleFoodProductionand Supply (kcal /capita/day), 1995-2001 1995 1996 1997 1998 1999 2000 2001 Crop ProductionEstimates:* Maize 1,34 1 1,776 1,312 1,687 2,3 12 2,288 1,536 Percent of total 68 63 51 52 58 58 44 Rice 42 76 68 69 92 70 89 Groundnuts 51 66 114 160 203 185 23 1 Wheat 2 2 1 2 1 2 2 Sorghum 20 54 38 39 38 33 33 Millet 12 18 15 17 17 16 17 Pulses 88 189 186 207 227 255 283 Cassava 306 488 637 781 789 785 926 Sweet Potatoes 101 118 155 226 247 266 300 Irish Potatoes 17 23 25 25 32 32 63 Total 1,980 2 3 11 2 3 5 1 3,213 3,959 3,93 1 3,480 Food Sumlv Estimates** (Cereals, RootdTuber) Sub-Saharan Africa (avg.) 1,532 1,537 1,534 1,548 1,541 *Production only, from MOAI, excludes imports/exports and post-harvest losses. Before 1997, smallholders only. ** FA0 Annex 4.1 HoldingsofPress, MDC, and ADMARC Parent Share Annual Sales Subsidiary Industry Company Holding (2001) Blantyre Milling Agro-processing ADMARC 100% 180,528,000 Grain & Milling Company Agro-processing ADMARC 100% Cold StorageLtd Food ADMARC 100% 55,875,909 Mitco Transport ADMARC 100% 193,929,031 Tobacco MarketingLtd Crop marketing ADMARC 100% 66,889,233 Malawi FinanceCompany FinancialServices ADMARC 100% Shire Bus Lines Transport ADMARC 71% Manica Malawi Limited* Transport ADMARC 50% 705301,000 Alexander Forbes Insurance ADMARC 49% 28,92 1,000 David Whitehead & Sons Textiles ADMARC 48% 132,106,000 Auction Holdings Ltd Tobacco marketing ADMARC 47% 389,586,770 Mateco Tea processing ADMARC 40% Indebank FinancialServices ADMARC 26% 407,177,000 SucomaGroup Sugar Processing ADMARC 25% 4,979,827,000 National Bank ofMalawi FinancialServices ADMARC 23% 2,065,000,000 Fincom* FinancialServices ADMARC 2.5% 169,000,000 PeoplesTrading Centre Retail Supermarkets PCL 50% 4,419,035,000 Oil Company o fMalawi Fuel PCL 50% 5,432,183,000 EthanolCompany Ltd Fuel PCL 58.9% 526,595,000 Malawi PharmaciesLtd Pharmaceuticals PCL 67.7% 249,941,000 Hardware & GeneralDealers Retail Hardware PCL 100% 434,356,000 The FoodCompany Ltd Foods PCL 100% MaldecoFisheries Foods PCL 100% 120,964,000 EnterpriseContainersLtd Foods PCL 100% 176,877,000 TambalaFoodProducts Foods PCL 100% 269,425,000 National Poultry Limited* Foods PCL 50% 165,931,000 The BeverageCompany Ltd Beverages PCL 100% CarlsbergBrewery Malawi Beverages PCL 51% 1,048,3 16,000 SouthernBottlers Beverages PCL 34.5% 2,597,755,000 Malawi Distlilleries Beverages PCL 100% 160,673,000 National Bank ofMalawi FinancialServices PCL 48.3% 2,O 17,000,000 Limbe LeafTobacco Company Tobacco marketing PCL 42.0% PressHall Steel MetalProducts PCL 45% Metpress NA PCL 753,987,000 PGI Buildingmaterials PCL 189,946,000 Press Bakeries Foods PCL 328,772,000 Mpico Holdings Ltd Property MDC 76% 307,9 15,000 SunbirdTourism Ltd Hotels MDC 77% 891,926,000 Plastic ProductsLtd Plastic Products MDC 100% 50,030,041 Bain HoggMalawi Ltd Insurance MDC 25% Bata Shoe Company Ltd Retail footwear MDC 49% 150,428,000 Capital DevelopmentsLtd FinancialServices MDC 42% Chemicals& MarketingCompany Chemicals MDC 20% 161,000,000 IndefundLimited FinancialServices MDC 36% 96,888,000 LeopardMatch Company Retail & Wholesale MDC 30% 194,169,000 StockbrokersMalawi Ltd FinancialServices MDC 25% 40,832,000 Kang'ombeInvestmentsLtd Property MDC 33.5% TOTAL 30,159,284,984 Source: Annual Reports, ManagementReports * Annual tumover for these companiesis for 2000 96 Annex 4.2 Top Twenty Manufacturing Exportsfrom Malawi (millions of MK) Countries H S one digit data. South Other Eu USA Rest of the Total Africa Africa World RawCane Sugar (solid) 68.99 740.46 695.75 333.47 0.00 1838.67 Cane or Beet Sugar 0.00 0.01 234.27 0.00 0.00 234.27 Icing Sugar in Cubes 0.00 34.16 151.91 0.00 0.00 186.07 Men's or Boys' Shirts 57.71 17.43 0.52 74.07 0.00 149.73 Men's or Boys' Trousers 117.83 0.00 0.00 4.68 0.00 122.51 T-shirts, Singlets, & Vests 77.37 0.01 33.82 0.00 0.51 111.72 Cartons, Boxes, & Cases 6.58 755.20 0.00 0.00 0.00 761.78 PrintedBedLinen 75.72 0.00 0.00 0.00 0.00 15.72 Men'sor Boys Shirts 72.8 1 1.62 0.00 0.00 0.00 74.43 Icing Sugar in Cubes (packed for retail) 0.00 72.53 0.00 0.00 0.00 72.53 Men's or Boys Trousers 61.94 0.37 0.35 9.03 0.00 71.69 Other Apparel 0.00 47.93 0.00 0.00 0.00 47.93 Petroleum Jelly 0.00 41.43 0.00 0.00 0.00 41.43 Women's or Girls' Blouses 35.56 1.67 0.00 0.35 0.00 37.58 Women's or Girls Trousers 0.00 0.00 0.00 34.70 0.00 34.70 Plastic HouseholdandToilet Articles 0.10 27.72 1.81 0.01 0.74 30.39 Beauty Products 0.00 30.27 0.00 0.00 0.00 30.27 T-shirts, Singlets, & Vests 20.54 8.41 0.00 0.56 0.00 29.51 Track Suits 11.61 8.25 0.00 9.30 0.00 29.16 Soap & Organic Products 0.00 28.63 0.00 0.00 0.00 28.63 Total 606.76 1816.09 1118.43 466.17 1.26 4008.70 Source: Ministry of Commerce andIndustry 97 Annex 4.3 Obstaclesto BusinessExpansion Survey Year Primary Secondary Tertiary World Bank 1997 Infrastructure Crime & Theft Inflation USAID/ Millenium 1999 Telephone Electricity Financing ERL 2000 Policy,Regulation,Taxes ExchgRateInstability Inflation DFID/Kadale+ 2000 Finance Market Problems Input Problems IFC 2000 Inflation Infrastructure Financing ACR(2000101) 2000 HighInterest Rates Infkastructure SecurityICrime APRUBasehe* 2001 Financing Availability of Spare Parts Competition APRUBaseline** 2001 Customs procedures Taxregime MonetaryIXR Policy Note: APRU survey distinguishesbetween*production constraints and **policy constraints. +DFID/Kadalesurvey (Gemini2000) focusedentirelyon SMEsector. 98 Annex 4.4 Tax IncentivesAvailable to ManufacturingEnterprisesinMalawi Malawi has a largenumber oftax andcustoms duty concessions availableto manufacturingenterprises inMalawi. These includeconcessionsavailableto allenterprises, andadditional concessionsavailable to new investmentsandexporters. GeneralIncentivesAvailable to AllRegisteredEnterprises. Malawi's customs and tax legislation allows widespread duty and tax concessions for all "registered" manufacturing industries. To avail ofthis, afmneeds to be registered. The registration process is lengthy and time consuming. The Malawi Revenue Authority is responsible for granting or withdrawing suspensions andrebates. The concessionsinclude. 0 A fill or partial suspensionofMFNor generaltariffs oncertainimported inputsandon manufacturingindustries specified inthe seventhandeighthschedule ofthe Taxation Act. Rebates are not providedwhere inputsare producedlocally. These specified industries are broad andcover mostofMalawi's manufacturing activities. 0 Selectiverebates ofexcisetaxes applied in2000101for inputsto registeredindustries. These include rebates such as onthe use ofsolidcane sugar to manufacturefood; bottled mineral waters, includingsoft drinks; andalcoholic spirits (excluding beer). Ethanol usedinmaking pharmaceuticalsandmedicamentswas also eligible for excisetax rebates. Such rebates appliedto total production, includingthat sold on the domestic market. Farmersmay also be grantedrebatesofexcisedutiespaidoncertain inputs, butno activity receivessucharebate on petroleumproducts. IncentivesAvailable to New InvestorsUnderthe InvestmentAct Malawioffers generous incentivesinthe form of investmentallowancesandduty-free importation ofraw materialsusedinmanufacturingto new investorsunderthe Investment Promotion Act. These include: 0 Tax holiday on new investments (both foreign anddomestic) betweenUS$5-10 million. These haveanoption ofeither afive-year tax holidayor an indefinite companytax rate of 15 percent (instead ofthe standardrate of30 percent), while for investmentsaboveUS$10 million, aten- year holiday maybechosen. The foreign investment share mustbe at least30 percent. 0 40 percentinvestment allowanceonqualifying. 0 Anadditional50 percentallowance for qualifying trainingcosts. 0 Allowance for manufacturingcompanies to deduct all operating expenses incurred up to 18 months prior to the start o f operation; i.e. any expenditure incurred by a manufacturer in establishing a business up to 18 months prior to commencement o f trading is allowed against the income ofthat manufacturer. 0 Indefinite loss carry forward to enable companies to take full advantage o ftheir tax allowances. 99 0 Agreementsfor the avoidanceof doubletaxation. 0 Agreements for reductionofwithholdingtaxes onremittances andpayments. 0 Deferredduties onmachineryandequipment for upto 2 years. 0 Fullrebateofduties onheavycommercialvehicles. Incentivesfor All ExportersIncludingManufacturinginBond Allexportersin Malawi(includingmanufacturinginbond) are eligiblefor agenerousset oftax incentives. Inorderto be eligible for these tax incentives, allexportershaveto beregisteredwith the MalawiExportPromotionCouncil(MEPC). Registrationis approvedifthe councilis satisfiedthatthe businesswill contributetowards the economic developmentofMalawiand will generallybe inthe interest ofthe nationaleconomy (Section 18).' 0 Tax allowance inthe amount of 12percentofexportrevenuesfor no-traditionalexports (i.e. otherthantobacco, tea, sugar, andcoffee); 0 Transport tax allowance inthe amount of25 percentof internationaltransportcosts, excludingtraditionalexports; 0 No duties on importsofcapitalequipmentusedmainly inthe manufactureofexports for those manufacturinginbond; 0 No surtaxes (value addedtax); 0 No excisetaxes onpurchasesofrawmaterials andpackaging; 0 Materialsmade inMalawi for those manufacturinginbond; 0 Timely refundofall duties(duty drawback) on importsofrawmaterialsandpackagingmaterials usedinthe productionofexports; 0 No duties onrawmaterialsandpackagingmaterialsfor those manufacturinginbond. The ExportProcessingZone Inadditionto the incentivesfor allexporters, manufacturersbelongingto ExportProcessingZones are eligible to additional incentives. Malawi has a virtual Export Processing Zone (EPZ) i.e f m s can be grantedEPZstatuswithout geographicallylocatingina nominatedEPZ.Firmshaveto apply for obtaining the EPZ status from the Ministry of commerce and Industry. An EPZ status is granted to a fm for an initial periodof five years but can be extendedby an additionaltwo yearly renewals.The major condition for exportprocessingZone is that the output is entirely exported. However a fm is allowedto sell up to 20 percent of its annualoutput inthe domestic marketto cover rejects which couldnot be exported. Once acompany is grantedanEPZstatus, it is eligiblefor the following generousbenefits. 0 A 40 percent investment allowance on qualifying expenditures for new buildings and machinery, and up to 20 percent investment allowance on qualifying expenditures for used buildingsandmachinery. 0 A 50 percent o allowancefor qualifyingtrainingcosts. 0 A tax allowanceequivalentto 12percentofexport revenuesfor non-traditionalexports. 0 A transport tax allowanceequivalentto 25 percent ofinternationaltransportcosts for non- traditionalexports. 0 A duty drawback on imports of raw materials and packagingmaterialsusedfor exports. Refusalsby the councilare referredto the National ExportPolicyCommitteefor review. Suchdecisions, including cancellationofregistration,maybeappealedto the MinisterofCommerceandIndustry. 100 0 Removal of import duty and surtax on certain capital goods and machines usedfor manufacturing. 0 A five year tax holiday for new investmentvalued at US$5 million, and tenyears for investment valued at US$10 million. 101 Annex 4.5 MalawiinRelationto 24 Countries inAfrica in Terms of the QualityofInstitutionsto Support Businesses This table indicates where Malawi stands inrelation to 24 African countries interms o f the quality o f institutions as an input to business environment. (l=best, 24=worst) Government Governmentregulations are precise 12/24 OK Governmentregulations are fully enforced 20124 Not good Tax evasion inyour country is minimal 17/24 Not good Irregularpayments 7/24 OK Time for permits 5/24 OK Businessassociationsare controlledby the government 13/24 Not good When there is an Industry-wide problem, the governmentdoes littleto help 15/24 Not good Finance Confidencein the financialsystem to providefinancing for privatefirms 14/24 Not good Time to transfer money 18/24 Not good Personalrelations:banks do not make loans based on existing personalrelations 5/24 OK Infrastructure IQualityof road infrastructure 23/24 Notaood I Total ;ailways 13/24 Notgood Automobiles 19/24 Not good Telephones 15/24 Not good Internet hosts 24/24 Not good Internet users 20124 Not good Electric power supply 20124 Not good Clear customstime 22/24 Not good Telephoneprice 22/24 Not good Internetaccess 17/24 Not good Air transport, cost 22/24 Not good Air transport, quality I8/24 Not good Labor Life expectancy 24/24 Not good Infant mortality 24/24 Not good HIVIAIDSprevalence 19/24 Not good Primaryenrollment 3/24 OK Secondary enrolment 8/24 OK Primaryeducationoffers rigoroustraining in math, languageand science 23/24 Not good Secondary educationoffers rigoroustraining in math, languageand science 21/24 Not good Universityleveleducation in your country meets business needs 18/24 Not good Local labor market has enough supply of educated workers to meet hiring needs of my firm 16/24 Not good Hiring and firing practices are flexible determined by employers 3/24 Not good Labor regulationsfacilitate adjustment of working hoursto meet changes in labor demand 1124 OK illenessesimpose costs on business 24/24 Not good Does companyprovide HIV counseling or education 4/24 OK IOrganizedlabor, strikes etc do not impose costs 9/24 OK Institutions ILegal system ineffective in enforcing contracts 15/24 Not aood Enforcedcourt system Certaintyof rules and regulations Publicsecurity Organizedcrime 22/24 Not good 102 Statistical Annex 1 GDP Growth by Sector, Constant 1994 Prices 1994 1995 1996 1997 1998 1999 2000 2001 Agriculture 23 19 3238 4064 4062 4173 4640 4903 4486 Smallscale 1624 2332 3070 2957 3204 3675 3736 3370 Largescale 695 906 993 1105 969 965 1167 1116 1113 Mining &quarrying 43 47 206 157 164 171 189 207 Manufacturing 1597 1685 1675 1694 1698 1734 1691 1700 Electricity & water 149 152 152 161 172 179 198 191 Construction 202 200 232 250 255 263 258 264 Distribution 2452 2660 2663 3010 3161 3250 3242 3339 Transport& communication 465 550 501 '546 573 588 564 570 Financial&professional services 761 848 859 932 930 947 995 1023 Ownershipo fdwellings 162 165 169 172 176 181 186 191 Privatesocial andcommunity services 211 215 237 260 262 265 273 281 Producersof government services 1114 1198 1168 1200 1221 1251 1275 1298 Unallocable financecharges -278 -312 -316 -403 -342 -348 -357 -361 GDP at factor cost 9199 10646 11608 12041 12444 13121 13417 13190 Net indirecttaxes 1126 1406 1326 1383 1425 1307 1255 1267 GDP at market prices 10325 12052 12934 13424 13868 14428 14672 14457 Primary 23 19 3238 4064 4062 4173 4640 4903 4486 Secondary 1992 2084 2264 2262 2290 2348 2336 2362 Tertiary 6014 6730 6606 7100 7406 7441 7432 7608 Source:IMF 103 Statistical Annex 2 Central Government(In Operations,Calendar Year 1998-2001 Millions of MK) 1993 1994 1995 1996 1997 1998 1999 2000 2001 Total Revenueand Grants 1812 3264 5749 7305 7765 12387 19626 27159 31106 Revenue 1559 20 18 3997 5614 6312 9047 14445 11723 22473 Tax Revenue 1236 1772 3527 5193 5839 8229 12550 16265 20527 IndirectTaxes 723 1119 2345 3075 3649 4669 7060 9354 11563 Domestic Taxes onGoodsand Services 478 7 18 1312 1781 2247 3185 4990 6886 8666 Taxes on InternationalTrade 242 401 1013 1285 1380 1461 2036 2284 2405 Non-tax Revenue 323 246 470 422 473 818 1895 1457 1946 Total Grantr 253 1246 1752 1691 1453 3339 5181 9437 8633 Tohl Expenditureand NetLending 2366 5062 6773 8692 10069 15931 23225 32118 40322 Total Expenditure 2366 5062 6773 8692 10069 15670 23041 32294 39738 Current Expenditure 1886 4193 5327 6962 8121 11646 15592 20611 29695 Wages and Salaries 511 925 1535 1700 2364 2769 3 879 5107 6997 Other PurchasesofGoods and Services 882 2095 1972 2745 3682 3777 6497 7824 8500 Interest on Debt 282 522 1391 1992 1423 2062 2711 4519 6591 Foreign 126 177 565 425 409 885 1172 1664 1713 Domestic 156 345 826 1567 1015 1177 1539 2855 4878 Subsidies andOther Ttansfes 211 651 429 525 652 2854 2045 2930 7038 Additional Pro-poorExpendimre 0 0 0 0 0 0 0 0 66 ExpenditureinArrears 0 0 0 0 0 184 460 23 1 504 DevelopmentExpenditure 480 869 1446 1731 1948 4024 7449 11683 10042 Domesticaliy Financed 105 246 371 528 598 862 1597 1813 1813 HIPC-Financed 0 ForeignFinanced 375 623 1075 1203 1350 3163 5852 9870 8229 Net Lending 0 0 0 0 0 261 184 -176 584 Overall Deficits ExcludingGrants -807 -3044 -2776 -3078 -3757 -6883 -8780 -14395 -17849 IncludingGrants -554 -1798 -1024 -1387 -2304 -3544 -3599 -4958 -9216 Tohl Financing 636 2254 834 1701 2384 3490 3912 7330 7811 NetForeign Financing 404 1331 401 1832 1407 4863 2496 4337 4326 DomesticFinancing 232 923 434 -131 977 -1372 1416 2992 3485 Discrepancy 82 456 -190 313 80 -54 313 2371 -1405 104 Statistical Annex 3 Malawi: Balance o f Payments (In Millions of U.S.Dollars; Unless Otherwise Specified) 1995 1996 1997 1998 1999 2000 2001 Current Account Balance (including grants) -20 -173 -302 -14 -148 -89 -128 Trade balance -70 -141 -253 -5 1 -226 -158 -175 Exports 404 483 530 528 447 406 407 ot which: Iobacco 256 jUU 346 321 215 241 236 Tea, Sugar, and Coffee 69 71 78 101 71 81 97 Nontraditional Exports 49 69 72 63 56 56 60 Imports -474 -624 -783 -579 -674 -563 -582 o fwhich: Petroleum 49 60 78 56 66 75 68 Maize 76 28 16 41 0 0 9 Services Balance -Y 7 -105 -114 -Y4 -87 -87 -66 Interest Public Sector (net) -34 -22 -20 -26 -21 -21 -18 OtherFactor Payments(net) -13 -17 -21 -16 -20 -18 -15 Nontactor (net) -4Y -66 -73 -53 -45 -4Y -33 Unrequited Transfers (net) 147 72 65 132 165 156 113 Private (net) -4 -24 -19 -25 9 8 16 Official (net) 152 97 83 157 157 148 98 Capital Account Balance (incl errors & omissions) 125 292 219 122 164 78 96 Medium- and Long-Term Flows 109 150 81 154 90 65 60 Disbursements 156 193 117 210 129 125 127 Amortization (amounts due before debt relief) -47 -44 -36 -57 -39 -60 -67 ForeignDirect Investment and Other Inflows ... 30 24 34 39 27 28 Short-term Capital and Errors and Omissions 16 112 114 -65 35 -14 9 OverallBalance 106 119 -83 108 16 -11 -32 Financing (-increase inreserves) -106 -116 46 -89 -16 11 32 Central Bank -87 -109 53 -77 -3 1 17 12 Commercial Banks -3 -6 -8 -13 15 -6 -8 Debt Relief 0 0 0 0 0 0 27 ResidualFinancing gap (+= underfinanced) 0 -3 38 -19 0 0 0 Memorandum Items: Gross OfficialReserves Inmillions 0fU.S. dollars 106 218 155 258 244 243 202 lnmonths of imports 2 3 3 4 5 4 3 Inmonths ofimports ... ... ... ... ... 4 4 Current Account Balance (percent o f GDP) Excluding OfficialTransfers -12 -12 -16 -10 -17 -14 -13 Including Official Transfers -1 -8 -12 -1 -8 -5 -7 Export Value Growth (inpercent) 24 20 10 0 -15 -9 0 Import Value Growth Excl. Foodstuff (inpercent) -16 50 29 -30 25 -16 2 Debt NYV ottotal debt as percent of exports ot CiNS 152 IbY 1x3 NPV of old debt after HIPC as percent of exports o f GNS ... ... ... ... 152 160 166 NPV of new debt as percent of exports ofGNS ... ... ... ... ... 8 17 Prospective BOP financing (grants& loans), USDmn ... ... ... ... .I. ... 106 Identified financing - ... ... ... ... ... ... 106 Financingexpected but not yet confirmed ... ... ... ... ... ... 0 105 REFERENCES Macroeconomic Issues Ahsan, Ahmad andMoll, Peter, (June 30,2000). "Two Essays on External Sector Policy Reforms in Malawi -Part B: A Strategyfor ExchangeRate ManagementIn Malawi ", The World Bank. BulirandA. Javier Hamann, HowVolatile andUnpredictable are AidFlowsandWhat are " the Policy Implications?", IMF Working Paper, WP/O1/167, October 2001. ChirwaEphraimandMlachila, (January 2002), Financial Reforms and Interest Rate Spreads inthe Commercial BankingSysteminMalawi. 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