l z 1 .5 11-2 &') - /A /q Doc=mt of The World Bank FOR OFCAL USE ONY Rega No. P-6428-MAI REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INlENATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED SUPPLEMEAL FINANFCING ARRANGEMENT OF SDR 27.6 MILLION (US$40 MILLION EQUIVALENT) TO THE REPUBLIC OF MALAWI UNDER THE ENTREPRENEURSHIP DEVELOPMENT AND DROUGHT RECOVERY PROGRAM (CREDIT NO. 2396-MAI) OCTOBER 11, 1994 MICROGRAPHICS This document bas a resicted disibution 5 Report No: P- 6428 MAI dteir official duies. Its contents may DOt C Type: MOP CURRENCY AND OTHER EQUIVALENTS CURRENCY EQUIVALENTS Currency Unit: Malawi Kwacha (MK) US$ 1 = MK 9.0 MKI = US$0.11 MKl = 10 Tambala WEIGHTS AND MEASURES 1 cubic foot (cu ft) 0.0283 cubic meters I cubic meter (m3) = 35.3 cubic feet = 264 US gal 1 kilometer (kIn) - 1,000 meter = 0.621 miles I hectare (ha) - 10,000 square meters - 2.47 acres GLOSSARY OF ABBREVIATIONS ADMARC - Agricultural Development and Marketing Corporation DCA - Development Credit Agreement EDDRP - Entrepreneurship Development and Drought Recry Program ESAF - Enhanced Structural Adjustnent Facility FAO - Food and Agricue Organition of the United Nations MRFC - Malawi Rural Finance Company NGOs Non-Govemetal O nizations PFP - Policy Framework Paper SACA Smallholder Agricultural Credit Association SAF - Social Action Fund SGR - Stategic Grain Reserve WFP - World Food Programme Government of Malawi Fiscal Year April I - March 31 FOR OFFICIAL USE ONLY MALAWI SUPPLEMENTAL FINANCIAL ARRANGEMENT UNDER THE ENTERPRENEURSHIP DEVELOPMENT AND DROUGHT RECOVERY PROGRAM Table of Contents Page SUMMRY ..... OVERVIEW.1 EMEROENCY FOOD ImPORTS - NEEDS ASSESSMENT ..........................................2 M EASURES TAKEN TO ADDRESS RECURRENT DROUOHT ......................................... .........................5 MEDIUM-TERM MACROECONOMIC OBJECTrVES .6 PROGRESS UNDER THE ADJUSTMENT OPERATION .8 JUSTICATION OF PROPOSED BANK ACTION ........................................ 10 EXTERNAL FINANCING PLAN ........................................ 11 DISBURSEMENT, PROCUREMENT, AND AUDrI ........................................ 12 ECMIOMEDATION ........................................ 13 FIGUS Figure 1: Malaui - Maize Production .....................................3 Figure 2: Malawi - Sources for Meeting Maize Requirements ....................................4 TABLES Table 1: Malawi - External Financing Requirements .................................... 12 Annex I: Malawi: Key Macroeconomic Indicators, 1989-97 This report is based on the findigs of a drought assessment mission which visited Malawi in May 1994. The mission consisted of Mr. Hartwig Schafer (Mission Letder and Country Economist). Mr. Ataman Aksoy is the managing Division ChieŁ, Mr. Robert Christiansen is the Country Operations Manager, and Ms. Katherine Marshall is the Departnent Director for the operation. This document has a restricted distnribon and may be used by recipiens oly in the pefomance of their official duties. Its contents may not otherwise be disclosed without World Bank ithodzation REPUBLIC OF MALAWI SUPPLEMENTAL FINANCIAL ARRANGEMENT UNDER THE ENTREPRENEURSHIP DEVELOPMENT AND DROUGHT RECOVERY PROGRAM SUMMARY Borrower: Republic of Malawi Beneficiary: N/A Amount: IDA: SDR 27.6 million (US$40 million equivalent) Total extenal support under the program amounts to more than US$266 nmillion. In addition to the original IDA allocation (US$120 million) plus US$10 million in IDA reflows, cofinancing is provided by the Govermnent of Japan (US$70 million), by the African Development Fund (FUA 10 million), by the Gennan Government (DM 20 million), and by the European Union (ECU 30 million). Poverty: The cental objective of the supplemental financing arrangement is to reduce drought related food insecurity and help stabilize maize markets. Description: The proposed supplemental financing arrangement under the ongoing EDDRP adjustment credit is IDA's contribution to help close the unanticipated exteal financing gap that is the result of drought-related import requirements (equivalent to US$102 million). Malawi is affected by severe drought for the second time in three years. The new Govenmment - in office since May 1994 following the first multiparty elections in three decades - has asked the donor comnmnity for additional assistance during this emergency situation. The most immediate consequence of the drought is the need to import 445,000 MT of maize (comprising 200,000 MT for targeted free distribution to food deficit households in drought areas and 245,000 MT to be distributed through commercial channels) to achieve food security and stabilize commercial maize markets. The Government needs to provide adequate levels of commercial maize to help maintain consumer prices at affordable levels (i.e., at the target consumer price) so that free maize distribution is limited as a measure of last resort for the very poor. TIus pokcy is consistent with the new Government's strong commiutment to poverty alleviation as the core of the development agenda. The current unanticipated external supply shock was highlighted as an inherent risk of the Country Assistance Strategy presented to the Board on June 7, 1994, in conjunction with the Second Institutional Development Project (Credit No. 2624-MAI). The Government and Bank are in full agreement with regard to rnacroeconomic and structural policies, particularly with regard to the Government driven initiatives on private sector development and poverty alleviation. Th:tre is a high probability that the Bank mnay shift into the high lending scenario as Government has already demnonstrated its commitment to quickly removing structural obstacles to an accelerated supply response and sustainable poverty alleviation. Effective and timely assistance by IDA and other donors - during the current drought emerency - will support macroeconomic stabilization and will allow the new Govenment to contiue implementing its adjustment policies. The original EDDRP was approved by the Executive Directors on June 23, 1992, and became effctive on July 7, 1992. The EDDRP provides financing to (i) prevent widespread food insecunty, and alleviate the impact of severe drought; and (ii) facilitate reforms to broaden economic participation and enable a sustinable supply response consistent with medium-term balance of payments viability, growth, and poverty reduction. IDA released the second credit tranche on September 23, 1993, after: (i) satisfactory progress had been made in carrying out the reform program; (ii) monetary and fiscal policies had been tightened to ensure stabilization of the economy; (iii) sufficient new exnal aid had been mobilized to ensure that the adjustment program was fillly financed, and (iv) specific conditions for release of the second trnche were met. The closing date of the credit has been extended through June 1995, to facilitate full disbursement of all existng cofinancing arrangments. The current overall rafing for the credit is "Highly Satisfactory." Term: Standard IDA terms; 40-year maturity with a 10-year grace period. Commitment Fee: 0.50% on undisbursed credit balance, beginning 60 days after signig. Staff Appraisal Report: N/A for amendment to existing adjustment operation. INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SUPPLEMENTAL FINANCING ARRANGEMENT TO THE REPUBLIC OF MALAWI UNDER THE ENTREPRENEURSHIP DEVELOPMENT AND DROUGHT RECOVERY PROGRAM (CREDIT NO. 2396-MAI) 1. I submit for your approval the followMng report and recommendation on a proposed supplemental financing arrangemet, to the Republic of Malawi for SDR 27.6 million (US$40 nmllion equivalent) under the Entrepreneurship Development and Drought Recovery Progran (EDDRP; Credit 2396-MAI). The supplemental financing arrangment would be on the same tms as the main credit, i.e., standard IDA terms with 40-year maturity and a 10-year grace period. This memorandum (i) gives a short overview of post transition developments in Malawi and the curren drought which is the cause for additional fnancing needs; (ii) assesses food import requrements; (iii) outl the measures already taken to address the drought situaton, (iv) summarize the medium-term macroecononuc firamework; (v) reviews the credit's history and progress to date; (vi) highlights the relationship between the Country Assistance Strategy and the proposed Bank action; and (vii) presents an extemal financing plan for 1994-95. OVERVIEW 2. Malawi, one of the poorest countries in Sub-Saharan Africa, has recenty completed a peaceful political transition from over 20 years under a single party system to a multiparty democracy. International observers commended the tramsition process, including the geneal elections of May 1994 which ushered the previous opposition into goverment. This achievement is all the more inpressive given the economic challenges of 1992-93; including withdrawal of non- humanrian bilatal donor support because of governance issues and the worst regional drought on record. 3. The new Govemment is fully committed to consolidating the econornic stbilization process and attacking the coumtys pervasive poverty problem. After four months in office, the new Govermnment's track record with regard to poverty alleviation is impressive; e.g., school fees for primary education were waived, cntical restrictions on prices and markting in agncultre have been lifted, and a Social Action Fund (SAF) for community based invesnts in social sectors is being put in place on a fast track, wih IDA assistance. A Presidential Council on Poverty Alleviation (with broad based participation of NGOs, traditonal leaders, religious groups, and political parties) has been put in place to set overall policy direction, mobilize resources, and sensize the populace at large about poverty issues and programs. The challenges facing a new Govenment would be formidable even under normal circumstances. In Malawi, the new Govenmment's credibility and economic managemet are, m addition, being tested by anoter severe drought. 4. For the second time in three years, economic managenat is being challenged by a massive crop failure due to a drought as serious as the one in early 1992. Maize production in 1994' 'MTe platig sason is iomOzober thwugh November he harvtng seasn is ifim Apriltsmgu May oftbe followig y Report nd Recommendaon of the President EDDRP SupplementalFinancingArrangement 2 dropped to 831,000 MT from over 2 million MlT in the previous year. The situation has been aggravated by the collapse of the agricultural credit system during the months preceding the general elections. Use of hybrid seed and fertlizer dropped sharply because farners who defaulted on the previous years' loans could not obtain new credit. The new Govermnent has already taken effective steps to resuscitate the rural credit system; including the transfer of the system from direct Government control to an autonomous financial institution (with support from IDA under another credit). By developing sound operational procedures and lending requirements the new rural credit system will help prevent future large-scale defaults. The restructured credit system began operation in October 1994 and will work to ensure credit availability for those fanners who qualify under the strengthened eligibility criteria and will help increase food supplies through higher yields in 1995. 5. The most immediate consequence of the drought is the need to import 445,000 MT of maize to achieve food security. Out of the total, a mmnmum of 200,000 MT is needed for distribution as emergency food aid for some 600,000 smallholder families whose crops failed. The balance of 245,000 MT is urgently required as coumercial food aid to stabilize the market until the next crop is harvested (May 1995). The Govermnent is particularly concemed to ensure sufficient supplies of conunercial maize so that consumer prices can be maintained at the targeted levels and free maize distribution can be limited as a measure of last resort to reach the very poor. This policy is consistent with the new Govenmment's strong commitment to poverty aDleviation and support of private sector participation in agricultural marketing. 6. The additional import requirements inevitably increase the external financing gap for 1994/952. Assuming that all maize can be imported from within the region, the total foreign cost for maize imports is estimated at US$102 million (at total cost of US$230 per MT). The new Govemment has asked the donor community for additional assistance to help finance this amount. Despite a substanial and rapid donors' response through pledges for commercial and relief maize nd offers to divert existing balance of payment commitmnets to maize imports, the overall fancing gap cannot be closed without multilateral support. The proposed supplemental financing arrangement under the ongoing EDDRP adjustment credit is IDA's contribution to help dose the unanticipated external financing gap and help ensure that external funding levels are adequate for (i) drought related imports to achieve food security; and (ii) general import support under the adjustment program. EMERGENCY FOOD IMPORTS - NEEDS ASSESSMENT 7. Production. The 1994 production of Malawi's main stable food - white maize - is estimated at 831,000 MT. This is 60 percent lower than last year's record harvest of 2 million MT and only slightly higher than the extremely poor crop in 1992 (657,000 MT) when the country was hit by a devastatn drought which affected the entire southern Afiica sub-region (Figure 1). The small size of the 1994 harvest mainly reflects the delayed onset of the rainy season, extended dry spells, and insufficient and poorly distributed rainfal throughout the growing season. The sharp fal in maize production has resuled in a large food deficit in 1994/95, and substantial maize imports are needed. 2Bc 8fthisdrought, &e toa fancnggap for 1994 badb filled by dons' oobalancoofaffpayment Repot and Recmmendaon of thePrdent EDDRP SupplemenmalFinancingArmangement 3 Figure 1: Malawi - Maize Production ('000 Metric Tons) 2600 2034 2000 1589 1500 1990191 1991192 1992193 1993194 8. Import Requirements. Due to the unusually large 1993 harvest the Agriculural Development and Markefting Corporation (ADMARC) started the 1994/95 marketing year (April 1994 through March 1995) with a stock of 1 10,000 MT and a Strategic Grain Reserve (SGR) of 180, 000 MT. On-farm stocks from last year's harvest are estimated at 30,000 MT. This amount combioed with the expected draw-down of the entire ADMARC stocks and 140,000 MT from the SGR implies total available stocks of 280,000 MT. Hence total domestic availability of maize is about 1.11 million MT (Figure 2). Tle toal requirement for 1994/95 is estinated at 1.55 million MT, assuming a trget per capita consumption level of 150 kg of maize for a population of 9.5 million plus allowance for seed, feed and wastage of 138,000 MT. Consequently, the maize import requirement for 1994/95 is 445,000 MT (excluding the needs of the Mozambican refigees which are covered through other relief channels).? 9. Out of the total import requirment some 200,000 MT wil be needed as emergency food aid for 3 million drought-affected Malawians. The remaiing 245,000 MT are being handled as program food aid (provided through commercial dhannels) to stabilize maize pnces in the 1994/95 marketing year. In a year of a subsal drop in food crop production coupled vwith a sharp decline in the production of major cash crops, such as groundnuts and cotton, many rural households are sufring a significant decline in mcome. This reinforces the need for adequate maize supply through commercial channels to prevent sharp increases of consumer prices due to rationing or specuative stockpiling. The consumer price of maize is currently at MK 67 per 90 kg bag; the official consumer price applicable for the 1994/95 marketing year. Prices so far have remained stable because markets have been adequately supplied from ADMARC stocks and the SGR However, to hold prices at this level requires adequate maize supplies through April 1995. Failure to maintan stocks in rral areas for sale at the official pnce would seriously jeopardize the 3 Co nVutaonoftheie impsnt requu based on the findins of a WFP/FAO drought _snent missionto Malawi in May 1994 amn bsq updtes of the na anslyze. Report and Recomm aton of the President EDDRP Supplemental FinancingAmwngement 4 effectiveness of the limited relief program and could undermine the credibility of the market support systms. This was the expenence in 1992 drought relief efforts when ADMARC ran short of commercial maize supplies and had to impose stringent rationing. The counercial maize imports will be critical for maintaining price stability. Figure 2: Malawi - Sources for Meeting Maize Requirents April 1994 - March 1995 ('000 Metric Tons) 200 Relief Production 245 Commercial 831 20 Stocks 10. Logistics. The lessons leamed in the 1992 drought operation will be taken into consideration during the 1994 drought. The Govemment plans to work closely with NGOs in coordinating drought relief efforts. This will provide an excellent springboard from which to launch various programs over the next two months to penrit a successful distribution, including commnity-based food-for-work activities. However, the local administrative, managal and technical capacity to undertake such programs is limited. In addition, NGO cpacity has declined since the 1992 drought and many NMOs have sen key staff into neighboring Mozambique to taclde problems connected with the retuming refiugees and the demobilization program. Consequently, free distribution may have to remain ue principal food distribution mehanism for meeting relief needs in regions where food-for-work schemes cannot cope. 11. Malawi has a proven capacity to handle and transport 600,000 MT of imported cereals, and the impor, storage, and internal distribution of 445,000 MT of maize in 1994/95 should not pose serious logistical problems. During the 1992 drought relief operation, ahmost 300,000 MT of maize were imported and distributed throughout the country using the storage facilities of ADMARC and the transport fleet of the local private sector. Commercial imports financed by IDA added a fiurter 100,000 MT, and the Mozambican refiBgee program imported 200,000 MT. Repon and Rfcomiendxtin ofte Preidnt EDDRP Supplemental Finandn6 m'ra'ngement 5 MEASURES TAKEN To ADDRESS -CURRENT DROUGHT 12. Drought Preparedness. Drought is a common event in Malawi; extreme weather fluctuations over the past decade have caused significant shifts in food production. As a result, achieving food security -- as part of a poverty alleviation program -- is a priority on the Government's development agenda. Establishment of the SGR has helped the country achieve national food security in most years, except during unusually severe droughts In the longer term, Government aims to reduce susceptibility to weather-related shocks by promoting agricultural and economic diversification, and promoting the development and adoption of drought-resistant maize varieties and water-conserving cultivation techniques. 13. An improved price and marketing incentive system for nontraditional smallholder crops will facilitate diversification away from maize and tobacco, thus reducing drought susceptibility. The Government is committed to accelerating structural reforms in order to remove the remaining constraints to production and marketing of agricultural produce and inputs. In August 1994, Government removed all private sector restrictions on domestic trading of agricultural products. At the same time, Govermnent lifted export licensing requirements for all agricultural products, except maize, groundnuts, and beans; the latter two will be fully liberalized after the current drought year and export licenses for maize will remain in place for food security reasons. The Government also recognizes the importance of maintaining adequate and sustainable price incentives for all smallholder crops. Except for maize, the Government plans to further deregulate crop prices with the 1994/95 crop season so that prices and marketing arrangements will be determined principally by market forces. In the medium-term, the Government plans to fully liberalize fertilizer markets, including imports. 14. Research and extension efforts are geared toward promoting efficient supply and the use of high-yielding agricultural inputs through a wider delivery of public research and extension services. These improved services focus on generating and disseminating lower cost technical methods to strengthen drought preparedness at the farm level. Another aspect of the agricultural strategy will be the development and implementation of small-scale irrigation schemes - where economically viabie -- driven by the participation of the benefiting communities in execution and maintenance. Given the large proportion of resource-poor households which will not be able to afford the maize hybrid and fertilizer package, the research and extension system will also be important in promoting more drought-resistant crops (e.g., cassava), intercropping of maize with pulses, agroforestry, and soil and water conservation technologies. 15. Rural Credit System. The drought-related drop in maize production was aggravated by the collapse of the rural credit system after farmers did not repay their loans. This collapse is the result of the politization of the agricultural credit program during the transition period when most parties used the prospect of "credit forgiveness' as a campaign tool. While credit recovery rates exceeded 90 percent in the past, they dropped to 15 percent in 1993. As a consequence, farmers in default on previous credits had no access to credit to purchase fertilizer and certified seed for the fall 1993 planting season. 16. One of the first issues on the agenda of the new Government was the re-establishment of the rural credit system to avoid a continuing downward spiral of low credit, low fertilizer use, and poor harvest. An Action Plan for addressing the poor rural credit recovery was agreed upon in March 1994 and consisted of three major actions, which were to be Repot and Recommedtion of the President EDDRP Supplemental FinancingArrangement 6 implemented immediately: (i) Govenmment statement on credit recovery policy and enforcemnent; (ii) restoration of 100¶) repayment policy; and (iii) specific credit recovery operations including stop-orders and court actions against the largest defaulters. Although the implementation of the Action Plan was planned to start in early April with radio and newspaper announcements, it was not until after the ` ;ctions (late June) that the new Governmnent issued a radio press release and followed up with weekly newspaper press releases. At the same time, the President's address to members of Parliatnent included a credit policy statement, which emphasized that credit discipline must be enforced and that all borrowers had to repay their loans. Since then, a list of defaulters has been compiled and stop-orders against tobacco producers and payroll deductions against civil servants have been authorized. 17. The collapse of the rural credit system highlighted some of its inherent structural weaknesses which had long been a subject of concern; for example, insufficient criteria for creditworthiness, and lack of autonomy of the Smallholder AgricultumI Credit Association (SACA). To redress the inherent structural weaknesses, IDA and the Govermnent prepared the Rural Financial Services Project (IDA Credit No. 2513-MAI; presented to the Board on June 15, 1993). Under the project, the rural credit system (SACA) has been transferred from the direct control of Government to a new autonomous financial institution, the Malawi Rural Finance Company (MRFC) which will be privatized within three to four years. As safeguards against future large-scale credit defaults, MRFC has adopted sound operational and lending requirements based on commercial principles of creditworthiness and repayment ability; including 100% repayment on old loans before being eligible for additional credit. Credit effectiveness was delayed by 15 months pending Government's implementation of the pre- requisites that would help achieve commercial viability of the Tevised rural credit system. T'he necessary legal and policy actions were carried out by the new Government and the credit was declared effective in September 1994; in time to commence MRFC lending operations with the fall 1994 planting season. 18. Although the full impact of Governuent's commitment to 100% credit recovery and joint liability of farmer credit clubs before extending new credit will not be evident for some time, IDA is satisfied with progress made to date. Moreover, the Goverrnment's clear determination not to compromise the financial integrity of the new rural credit system and to give in to popular pressure for credit forgiveness are impressive and bode well for future progress. MEDIUM-TERM MACROECONOMIC OBJECTIVES 19. The new Government inherited several daunting and inmnediate challenges when it took office. Fiscal and monetary discipline suffered in the months immediately preceding the May elections. As a consequence, the economic and financial stabilization efforts that started in early 1994 were not sustained. Instead, excessive borrowing by the outgoimg Government from the banking system in the first two months of the fiscal year, along with pressures induced by exchange rate du-preciation, led to an increase in the projected rate of inflation from less than 20 percent to around 30 percent for 1994. 20. The new Government is committed to an expeditious reversal of the recent deterioration in monetary and fiscal aggregates. The broad parameters of Government's medium-term macroeconomic and structural policy framework were endorsed by a Bank macroeconomic mission Report and Recommendation of the Pwdent EDDRP SupplementalFinancingArrangement 7 (in July) with participation of the Fund. Although the new Government had been in office for only four weeks, they reached agreement with the Fund on a short-tenn stand-by arrangement (starting in October 1994) which is to be succeeded by a three-year ESAF arrangement (starting in April 1995) to support the Government's comprehensive poverty alleviation strategy. In late September, another Fund staff visit to Malawi confinned that all prior actions for the stand-by arrangement are in place. Furthermore, Government Nith the assistance of Bank and Fund, is now in the process of finalizng details of its medium-term fiscal, monetary, and extemal policies as well as its poverty alleviation program. Government plans to present this medium-term strategy to the external parners at the Consultative Group meeting in December 1994. 21. In the meantime, Govenmnent has already started to implement the necessary policy changes to achieve financial stability. A brief outline of the medium-tem macreonomic targets follows: * Fiscal Policy: The underlying strateg) will emphasize fiscal discipline and the consolidation and extension of structural fiscal policy refonms. On this basis, the overall central government budget deficit (before grants) is trgeted to decline from an estimated 11.9 percent of GDP in drought-affected 1994/95 to 6.6 percent in 1995/96; aRer grants, the deficit is projected to be reduced to less than 3 percent by 1996/97. * The ratio of revenue to GDP is expected to rise from about 17.5 percent (excluding grants) in 1993/94 to an average of about 20 percent during 1994/95-1996/97. Following administrative strengthening of tax and tariff revenue collection and strict enforcement of tax compliance, actual tax revenues have exceeded estimates in the third quarter of FY94/95. * In view of the pressing need to restore fiscal discipline, the new Govermnent no longer tolerates unauthorized overspending by line mmistries and will move to a cash flow budget by November 1994. Expendiue policies are also guided by the need to reorient recurrent expenditures to provide more emphasis on outlays in key social sectors and on efficiency in the delivery of services. For instance, recurrent expenditures were cut in non-priorty areas (e.g., civil service travel, replacement of official vehicles) to acconmodate salaries for additional teachers that were hired following the increase in enrollment numbers after all school fees for primary education were waived. Within this framework, Government expenditure (mcluding drought-related operations) as a percentage of GDP is targeted to decline fiom 33.4 percent in 1993/94 to 24 percent in 1995/96. * The Government plans to introduce a tax-inclusive budgeting system starting in 1995/96 and adopt a medium-term expenditure framework with the 1996/97 budget. To improve overall budget planning, the Govermnent, the World Bank and the donors have embarked on a Budget Managment Review which seeks to identify and accommodate sectoral priority expenditures wtthi the overall constraints of the fiscal framework. Report and Reconmenation ofthe PiwdWr EDDRP Supplemental Financing Arrangement 8 * External Sector Policy. Exchange rate policies will continue to focus on the maiatenance of extemal competitiveness and the attaimnent of medium-term balance of payments viability. In Febniray 1994, the fixed exchange system was replaced with a market based exchange system. The new Govenmt is filly committed to the market-based exchange system, and has now put emphasis on refinmg the new exchange system to redress speculation againt the kwacha and ensure that export revenues are circulated withn the system. Specific measures that have been implemented include prudential limits on foreign exchange holdings by comnmercial banks, 35 percent reserve reqwirement on private foreign exchange accounts, and complemeing monetary polices. CoAntinuous supply of foreign exchange, either from export revenues or from balance of paymet support, is critical for sustinability of the liberalized exchange system. The evetual objective of the exchange reform is to move to a free interbank market in foreign excbange by end- 1994/95. - Monetary Policy. A tight monetary stance will aim at achieving and sustaining a low rate of inflation consistent with oveall growth and balance of payments objectives. Total outsting bank credit to Goverment is projected to decline substantiay over the medium-term, so releasing resources to the private sector. In the short-trni, the Reserve Bank will coninue to pursue a restrictive monetary stance through tight control of the liquidity position of commuerl banks, maintenance of a market-dermied interest rate structure, and greater use of market-based intervention policies; i.e., appropriate use of the Reserve Bans rediscount and repurchase facilities and frequent issues of Treasury BiDls at auctions. First results of a tighter monetuy policy are already observed in the decline of the annualized rate of monetary expansion from 53 percet in June 1994 to 28 percent in September 1994. 22. Supported by these policies, the overall macroeconomic noaLs for 1994/95-1996/97 are: (i) an acceleration of real GDP growth, which after a drought-induced drop by 9 percent in 1994, should rise to 4.5 percent by 1996-97; (ii) a deceleration in the rate of inflation to 5 percent by 1997; and (iii) a further reduction in domestic and extemal imbalances with a view to attaining a sustainable balance of payments position by the end of the decade. PROGRLSS UNDER THE ADJUSTMENT OPERATION 23. The EDDRP was approved by the Executive Directors on June 23, 1992, and became effective on July 7, 1992. Tle EDDRP provides financing to: * prevent widespread food insecurity, alleviate the impact of severe drought, and help stabilize local maize markets; and * facilitate reforms to broaden economic participation and enable a sustainable supply response consistent with medium- Reportand Recounendan of se Paident EDDRP Suppt. mental Financing Anrmngement 9 term balance-of-payments viability, grwth, and poverty reduction;. 24. Policy reforms supported under the EDDRP seek to: (i) improve the environment for entrepreneurial activity and investment in labor-mtensive production; (ii) deepe financial markets; and (iii) re-orient fiscal and labor policies toward developing hunan capital. 25. IDA released the second credit tranche on September 23, 1993, after: (i) satisfactory progress had been made in carTying out the reform piogram, (ii) monetary and fiscal policies had been tightened to ensure stabilization of the economy; (iii) sufficient new external aid had been mobilized to ensure that the adjustment program was fully financed; and (iv) specific conditions for release of the second tranche had been met. 26. The first tranche of US$86 million (including US$6 million IDA reflows) and the second tranche of US$44 million (including US$4 million IDA reflows) have been fully disbursed. Under the first tranche US$40 million was used for maize imports to help offset the impact of the 1992 drought. 27. Total extemal support under the program amounts to more than US$266 million. In addition to the original IDA allocation (US$120 million) plus US$10 million IDA reflows, cofinancing is provided by the Govemment of Japan (US$70 million), by the African Development Fund (10 million FUA), by the German Govemnment (DM 20 million), and by the European Union (ECU 30 million). The closing date of the credit has been extended through June 1995, to allow fill disbursement of all existing confinancing arangements. 28. The current overall rating for the credit is 'Highly Satisfactory". Govemment has implemented all actions set out under the Development Credit Agreement and the policy actions are showig the desired impact. The new Govemment continues to deepen and strngthen policy impleentation to fully achieve and sustain the objectives of the EDDRP. Goverment has enacted polcy measures to effctively reduce investment delays, accelerate land lease procedures, and extd trade refonn to facilitate outward onentation of the private sector. Initial contacts with foreign investors have been highly successfiul; several foreign investors have registered their companies in Malawi and have signed letters of intent for joint ventures. Goverment has enacted financial sector reforms to promote wider resource access and mobiliation of additional resources in a more competitive environent. A major component of this stratW was the restructuring of the Post Office Savings Bank into an autonomous financial institution, now called the NMlawi Savmgs Bank. The recent licensing of two new foreign banks reflects Governmnts commtmnt to enhance competiion in the financial sector. Rationalization of the tariff structure and broadening of te tax base are well underway, and particular emphasis is given to administrative measures to protect fiscal revenues. The Goverment has strengthened human resource development through reorientation of public expenditures in favor of the priority social sectors. The Government has undertaken measures to improve the functionmg of labor markets, support decenalized employer and employee wage bargaing, has enacted policies to improve the situation of tenant laborers on estates, and has sbamlined the minum wage legislation. Repon ad Recommendaion of th Presidet EDMRP Supplemental Financing Arrangement JO JUSTIFICATION OF PROPOSED BANK ACTION 29. The current unanticipated external supply shocks were highlighted as an inherent risk of the Country Assistance Strategy presented to the Board on June 7, 1994. Following the political transition, the Bank has become a major partner in helping Malawi tackle its day-to- day economic problems as well as in addressing long-term economic and social issues of development. There is a high probability that the Bank may shift into the high lending scenario as Government has already demonstrated its commitment to quickly removing structural obstacles to an accelerated supply response and sustainable poverty alleviation. The Country Assistance Strategy is being adjusted to directly reflect Government's emphasis on private sector development and poverty alleviation. 30. The Bank has made particular efforts over the past two months to assist Govermnent's efforts to prepare and launch a SAF. This will be integral to Government's broad-based poverty alleviation initiative through providing resources for community-based projects, including schools and water supply. Nevertheless, the adjustment process in Malawi will take time and the expected supply response could be delayed by negative developments in Malawi's external environment, such as the current drought. Under such adverse circumstances, the donor commuwity - including the Bank - should contnue to assist Malawi, especally through aditional quick-disbursing balance ofpayments support. The proposed supplement under the ongoing adjustment operation complements the assistance provided by other donors in the forms of food aid and additional balance of payments support on humanitarian grounds. 31. Given the seriousness of the drought, Governmes limited financial resources, and the need for a timely response - and after weighig alternative options for Bank assistnce -a supplementl finacing arrangement is the most approprate masure to help ensure consoLdation of the transition process and sustain economic adjustment and stabilization. The present sitation in Malawi meets the prerequisites under which supplemental financing for adjustment operations could be considered: V Malawi's economic program is proceeding on track and there is ful compliance with the agreed policy agenda. During a July mareconomic nission of Bank and Fund teams, the Govermnt negotiated a medium4-tern policy flwework that filly endorses and even stregths several areas of the fifth PFP(distributed to the Board on March 11, 1994).4 The zeal of the new Goverment to taclde Malawi's structural problems is impressive. In addition to taldng over the "driver seat" with regard to poverty alleviation, Maaawi's structal policy agenda now carres a number of issues that had been too sensitive to be addressed with the former Government. The new Government has launched an comprehensive initiative that focuses on private sector development, privatization of public enterprises, and the need to achieve a sustainable supply response and diversify the econoic base. / The time available is, however, too short for processing a freestanding IDA operation. Although it is Govemment's wish to accelerate processing of the next adjustment operation which will focus on privatization of public enterprises and 41emed ium4=pocyfiamewk abo serves asa dftfrtsixth F wchP wivnl be concuded as access the Govemnmet has finaied the ds ofiftpovatyonprogan Repot and Reommndaton ofta President EDDRP Supplemental Financing Arrangement 11 removal of economic monopolies in the manufacturing, finance, and distribution sectors, the complexity of issues and likely legal obstacles involved could delay a freestanding operation. In that case, any balance of payment support would come too late to be effective during the current drought. " The drought-related financing gap is unanticipated and seriously jeopardies the adjustment program. v The financing gap has arisen for reasons beyond the control of Government. I The additional financing requirements wiUl not be met without IDA resources. I The proposed amount under the supplemental financiDg arrangement is reasonable. It is equivalent to 15 percent of the overall external support (IDA plus cofinancing) provided under the EDDRP; it amounts to one third of the original IDA allocation under the credit. v One objective of the EDDRP is to help prevent widespread household food insecurity, alleviate the impact of severe drought, and stabilize local maize markets. The proposed supplemental financing arrangement will provide the necessary foreign exchange to allow Malawi to remain on the adjustment track and achieve food security. JXRNAL FINANCING PLAN 32. Malawi's total external financing requirements for 1994-95 amount to US$1536 million, of which US$102 million are drought-related (assuming import of 445,000 MT of maize at an average cost of US$230 per MT). Malawi's own resources are estimated to account for US$850 million: The remainder of US$686 million will have to be provided through official donor grants and loans. 33. Before the emergence of the drought, the external financing gap for 1994 had been closed by multilateral and bilateral donor support; including the envisaged Stand-by Agreement with the IMF. Following the May elections, donors further upgraded their non-humanitarian support equivalent to pre-transition levels. In view of the emerging drought crisis, several donors agreed to allow Malawi to use general import support to procure relief and commercial maize. While this measure has allowed the Govermnent to immediately start the process of maize purchasing, it has also resulted in a widening of the external financing gap for general import support. At this time, incremental donor pledges (excluding the proposed IDA supplemental financing arrangement) specifically for drought-related operations have reached the equivalent of US$42 million for relief maize (free distribution) and US$12 million in balance of payment support for commercial maize imports. Not accounting for the proposed IDA supplemental financing arrangement, a total external financing gap of US$20 million and US$64 million would remain for 1994 and 1995, respectively. 34. With the proposed IDA supplement, the financing gap for 1994 would be fully closed, and the financing gap for 1995 would be reduced to US$44 million of which US$8 million would be drought-related and the remaining US$36 million would be for general import Report and Recmnmendaton of the P,sidnt EDDRP SupplementalFinancingAnrngement 12 support. The proposed levd of IDA assstance Is equivalent to the assistance provided during the 1992 drought (when total drought-related imports were of similar magnitude as the current import requirements). It is expected that the remaining drought-related financing gap for 1995 will be closed through additional donor support over the coming two months. Under extrenely adverse circumstances, the Government would have to resort to the "iron reserve" of 40,000 MT that was planned to remain in the SGR. The 1995 financing gap for general import support is expected to be closed through the envisaged IMF ESAF arrangement (to succeed the short-term Stand-by) and through additional donor support to be mobilized at the forthcoming Consultative Group meeting in December 1994. Table 1: Malawi - Extemal Financing Requirements (IN MILLION US$) 1994 1995 TOTAL FINANCING REQUIREMNTS 764 772 1=536 NON-DROUGHT IMPORTS AND ALL SERVICES 576 613 1189 DROUGHT-RELATED IMPORTS 56 46 102 DEBT SERVICE (EXCL. INTEREST) 73 79 153 RESERVES BUILD-UP 21 17 38 OTHER OUTFLOWS 37 17 54 FINANCING RESOURCES 744 708 1452 EXPORTS AND ALL SERVICES 374 399 774 PRIVATE SECTOR TRANSFERS AND LOANS 36 41 76 NON-DROUGHT OFFICIAL GRANTS 93 97 190 PROJECT FINANCING 40 53 93 ADJUSTMENT SUPPORT 52 45 97 NON-DROUGHT OFFICIAL LOANS 205 153 359 PROJECT FINANCING 85 90 175 ADJUSTMENT SUPPORT 121 63 184 O/W IMF 22 0 22 IDA 5 45 50 DROUGHT-RELATED FINANCING 36 18 54 Q/W GRANTS AND TRANSFERS 36 18 54 INANCING GAP WITHOUT IDA SULM __ 20 164 _ 84 __ FINANCING GAP WITH US$40 MILLION IDA SUPPLMNT . 44 44 NON-DROUGHT RELATED 0 36 36 DROUGHT RELATED 8 8 SOURCE:: GOVERNMENT INFORMATION AND STAFF ESTTES DIuRsEMNr, PRocuREMEw, Am AuDf 35. The resources provided under the proposed supplement would be disbursed upon effectiveness of the Amendment to the Development Credit Agreement (DCA) and would be subject to the procurement and audit covenants contained in the original DCA. The quick- disbursing finds would be used toward (i) general import support to replace Govemment's ReptandPRecomdagi of thePmoen EDDRP Suppleln FbwwinganArgemme 13 own foreign exchange reserves that have been used for drought-related iports; (ii) closing the extemal finacing gap after diverting other donors' general import support to drought-related impots; and (iii) drought-related imports to achieve food security, RECOMMENDATION 36. 1 am satisfied that the proposed supplemental financing arrangement would comply with the Articles of Agreement of the Association and recommend that the Execaive Directors approve it. Lewis T. PreSton President Attachment Washington, D.C. October 11, 1994 ReorwdRec==mmndaffm.fdwPDsWd ANN3EX I Malaw: Key Maroeomic Indkators, 1989.97 1989 1990 1991 1992 1993 1994 1995 1996 2997 Pie) Projectio (Anual w p casuge) GDP growth rate (factorodt) 4.1 4.8 7.8 -7.9 10.8 -9.3 12.1 4.5 4.5 Consumption per capita growth rate / 4.3 -0.4 2.4 -2.7 1.5 4.3 0.2 0.7 0.6 C chane I5.7 11.5 8.2 23.2 22.8 29.3 15.1 6.S 5.0 (In percent, unless otherwise spefied) Debt service (million of SDRs) V1 92.0 76.7 79.4 73.3 60.2 62.5 69.5 81.9 85.0 Of hich: inktrest 31.0 30.4 28.5 25.9 25.1 25.0 27.1 28.6 29.0 Debt sevice/E of 0 & S 39.5 23.3 21.2 24.7 25.1 23.4 24.1 26.1 25.6 Dcbt seicc/XGNFS (aftaerdebtelief) 33.6 23.3 21.2 24.7 25.1 23.4 24.1 261 25.6 Debt service/GDP 7.7 5.8 5.0 5.6 4.2 5.7 5.4 6,0 5.8 Grow invetme/GDP 3/ 21.2 19.7 20.1 18.8 12.3 15.2 16.7 18.1 19.4 Private fixed investment/GDP 4/ 11.2 11.7 8.8 6.7 2.6 4.5 4.7 5.0 5.5 Govrnmwnt fixedinvesme/GDP 5.4 5.0 8.1 9.4 7.4 8.2 9.7 10.9 11.8 StockbuildingfGDP 4.5 3.0 3.3 2.7 2.3 2.6 2.3 2.2 2.1 Domestic saving/GDP 5/ 4.7 9.7 7.9 1.8 5.1 7.0 9.6 11.2 13.5 National saving/GDP 7.2 11.7 8.1 0.2 1.2 40.8 3.8 9.3 11.9 Government avig/GDP 2.6 4.6 3.7 0.0 .0.6 3.2 5.0 5.2 5.6 Privae savin/GD!P 1.9 4.8 4.2 1.8 5.6 3.7 4.6 5.9 7.9 Govrnmt revenue/GDP 61 22.7 20.0 18.9 18.4 17.5 21.5 19.8 20.2 20.4 GovrmeG expenditure/GDP 6/ 30.7 26.3 24.5 32.7 2S.4 33.4 26.5 24.2 23.5 Fisal ddoit exloding gs/GDP 6/ .6.9 46.9 46.3 -14.3 4.6 -11.9 46.6 4.0 -3.1 Fiscl deficit including grans/GDP 6/ -.1 -4.7 -3.0 -11.9 -5.5 -3.0 -3.1 -24 -1.4 Export volume growth (mehadise) 7/ -10.0 45.7 4.6 -1.3 -5.0 8.6 4.6 4.1 4.0 Exports/GDP 17.7 22.8 21.8 21.4 15.7 23.2 21.5 22.0 21.7 Importvolumeg rowth(mercandise) / 11.6 133 15.1 -4.8 -18. 1228 10.3 4.5 4.S ImportsGDP S/ 26.6 27.2 27.1 35.5 25.5 35.9 31.4 27.9 26.6 Curend accoun (millions of SDRs) U/ .165.8 -106.6 -182.8 -245.0 -159.9 -176.3 -164.2 -119.8 -108.8 Cuent aooount/GDP 8/ -14.0 -8.0 -11.5 -14.9 -7.3 -12.3 -11.3 4.8 -7.5 CuaetaccAt includin grsaW/DP9/ -9.1 -3.5 48 -8.5 -3.4 -4.2 -4.8 47 -3.8 Curent awooutwlo transfes w/mze onpors -14.0 -8.0 -11.5 -18.6 -11.1 -16.0 -12.9 -8.8 -7.5 Enatm reseves (milhonsoffSDRs) 78.5 95.5 102.7 33.4 39.2 21.5 47.6 63.4 64.7 Inmonthsofnonwmaieeimports V 3.0 3.2 2.9 1.1 1.5 0.7 1.5 2.0 2.0 Sourcs: Dta provided by Om X Mw authorities; and stffesimat ad prfojecto 1/ Consumptin exoludes energeny iupn tated to displaced perso 2/ Bdeore debt rieh excluding debt converion inouding intes an short-term debL 3/ Excluding puchase of an aiple by Air Malawi in 1991, which amont to SDR 18.8 million 4/ Stgatuy bodie not included m th central govnment budget are iuded m privat tor inve_men 5/ Samg excludes emegecy grant and impor rtd to displaced pesons. 6/ Fiscd y beginning in Apil of the yewr i ed; including spm dro%Vht4 adopma in 199293, 1993/94 and 199419S. 7/ Figures in 1989-92 are afected by ubstmnti dotcks eTied over at end-1989 and, to a tes aler, at end-1990 and end-1991. St xuding purcas of the aile in 1991 and drought4eWled maie in 1992-93 and 1994. 9/ Excludtingpurchas of the airplanoe in 991; incldg drouW lated mai impos and financing (which incldes drought4lated IDA) for 199293.