PROGRAM INFORMATION DOCUMENT (PID) APPRAISAL STAGE April 5, 2013 Report No.: AB7280 Operation Name First Economic Recovery Development Policy Operation (DPO-1) Region AFRICA Country Malawi Sector General public administration sector (50%);General agriculture, fishing and forestry sector (20%);Public administration- Energy and mining (10%);Public administration- Other social services (10%);Central government administration (10%) Operation ID P133663 Lending Instrument Development Policy Lending Borrower(s) GOVERNMENT OF MALAWI Implementing Agency Ministry of Finance Date PID Prepared March 21, 2013 Estimated Date of Appraisal April 5, 2013 Estimated Date of Board May 28, 2013 Approval Corporate Review Decision Following the corporate review, the decision was taken to proceed with the preparation of the operation. Country and Sector Background Until 2010, Malawi experienced solid growth averaging around 7 percent (2006-2010) largely through prudent macroeconomic policies and a supportive donor environment, which allowed Malawi to achieve a historic level of income per capita of $350 since independence. Despite the strong economic performance, poverty remains widespread and concentrated in rural areas. Economic imbalances started to build in late 2008 in the context of the global crisis, and were intensified during the run-up to the 2009 Presidential and Parliamentary elections. This juxtaposition of events led to fiscal and external imbalances that required important adjustment to contain aggregate demand. The manifestation of the macroeconomic imbalances included the accumulation of an estimated MK72billion in government domestic payment arrears, severe shortages of foreign exchange and accumulation of external payment arrears by the private sector, estimated at about US$600 million. As a result, the pace of Malawi’s growth started to slow down in 2011, where economic growth is estimated at 4.3 percent. The slowdown in the real sector activities in 2011/12 and the contraction in the agriculture and manufacturing sectors manifested themselves in a much lower estimated real GDP growth of 1.9 percent in 2012. The new Administration under President Mrs. Joyce Banda, which came into office in April 2012, is undertaking decisive policy measures to arrest the slowdown in the economy, including the unification of the exchange rate, tightening of the monetary and fiscal policies, and adoption of the automatic adjustment mechanism for retail prices of petroleum products to reflect import 1 parity prices at the market determined exchange rate. These reforms have facilitated, among others, the removal of market distortions (especially in the petroleum sub-sector and foreign exchange markets), strengthening the macroeconomic management and the clamping down on some of the loopholes in the public finance management, while scaling up social safety net programs to cushion the poor and the most vulnerable groups from unintended effects of the economic adjustment process. While the reforms have laid the foundation for the country’s recovery, a harsher external environment than earlier anticipated has weakened the pace of the economic recovery. The rising cost of living, on the back of high inflation rate and continued depreciation of the Kwacha, has intensified demands for wage increases, especially in the public sector. Greater efforts to restructure the economy to reduce ineffective public expenditure, together with promoting growth in areas where it is sustainable and makes the greatest contribution to the overall development goal, would be key to curbing inflation and ensure that Malawi weathers these challenging times. This notwithstanding, the country is on a recovery path - emerging signs of recovery are being helped by the recovery in the external credit lines and increased availability of foreign exchange for importation of critical inputs. In addition to the stabilization efforts, the Government of Malawi (GoM) is implementing structural reforms to support economic growth by putting in place measures to enhance the country’s competitiveness by removing regulatory hurdles to doing business and undertaking investments in infrastructure to address constraints to growth. Efforts are also underway to improve the efficiency and effectiveness of collecting non-tax revenues. The GoM has also initiated steps to address the contingent liabilities and operational losses risks posed by the State Owned Enterprises (SOEs). Specifically, the GoM now proactively monitors the activities of the SOEs on quarterly basis, with specific attention being paid on procurement activities. The GoM is also in the process of clearing the domestic payment arrears accumulated by the SOE and other Ministries, Departments and Agencies, through the issuance of promissory notes, which in effect addresses the contingent liability risk. The GoM, in close collaboration with development partners, is implementing critical PFM reforms through the Public Finance and Economic Management Reform Programme (PFEMRP) Multi Donor Trust Fund (MDTF) administered by the World Bank, aimed at improving GoM’s macro-fiscal management, accountability and transparency in public financial management and public oversight. The first project in the MDTF, the Financial Reporting and Oversight Improvement Project (FROIP), covers accounting and financial reporting, internal and external audit and program management. According to the recent report of Malawi’s Third Integrated Household Survey (IHS3 2010/11), absolute poverty has declined by less than 2 percent since 2004/05, to 50.7 percent. Although poverty in urban areas reduced from 25.4 percent in 2005 to 17.3 percent in 2011, this gain was counterbalanced by a worsening in rural poverty from 55.9 percent to 56.6 percent. The urban population experienced a rise across the board in real consumption between 2005 and 2011, reflecting the fact that poverty reduction in urban areas has been more solid and that the inequality in urban areas has remained fairly constant at about 0.49. With the majority of the poor living in rural areas, rural growth through agricultural transformation is clearly critical as Malawi strives to reduce the number of its people who live in absolute poverty. Poverty rates among female headed households are significantly higher than male headed households, with their limited access to larger land holdings and failure to engage in cash crop production contributing to the higher household poverty and as such more targeted interventions are needed 2 Operation Objectives In line with the Government of Malawi’s Second Malawi Growth and Development Strategy (MGDS II) 2011-16, Economic Recovery Plan and FY13-16 Country Assistance Strategy, the DPO series focuses on: (i) strengthening macroeconomic and finance management; and, (ii) laying foundation for stronger growth and protection of the poor. Within this framework, the proposed DPO series seeks: Firstly, to build on reforms under the Rapid Response Development Policy Grant (approved in July 2012) as well as consolidate the reforms supported by the recently approved three-year arrangement for Malawi under the Extended Credit Facility (ECF). Secondly, to build on Government commitment to stay the course of macroeconomic policy and structural reforms to support the economic recovery process and lay the foundations for stronger growth and protection of the poor and most vulnerable. Lastly, to use this Bank instrument to provide the Government of Malawi (GoM) with the much needed resources to ease the emerging fiscal pressures and sustain the economic reforms. The Development Policy Operation series will focus on two pillars: 1. Strengthening Macroeconomic and Public Finance Management: Support will focus on broad reform program on macroeconomic management and the management of public resources covering two specific reform objectives, namely: i) achieving macroeconomic stability and fiscal discipline; and ii) enhancing the efficiency and transparency of the public finance management. To achieve these objectives, the Recipient, through its ministry responsible for finance, should have completed the following prior actions:  Prior action 1: Validated its outstanding payment arrears and has developed a plan for the full clearance of said arrears. This will be supported by measures to strengthen commitment controls under the Integrated Financial Management System and other expenditure control measures. This will help support the fiscal consolidation process and restore the credibility of the budget;  Prior action 2: Published the Budget Performance Quarterly Reports for the first two quarters of 2012/13 fiscal years on the website of its finance ministry. The objective is to improve the quality of budget execution, transparency and minimize wastage of public resources by ensuring effective expenditure controls across budget lines and timely corrective actions taken during budget implementation. This also aids the government in addressing efficiency issues in the budget over the medium term, which will ultimately create the much needed fiscal space;  Prior action 3: Submitted Treasury Minutes covering the period July 1, 2006 through June 30, 2007 to the Recipient’s parliament. This will help strengthen accountability and transparency as well as minimize waste in the use of public resources through timely follow-up of audit recommendations; and,  Prior action 4: The Recipient, through its ministry responsible for agriculture and food security, has revised the bidding documents for the annual purchase of fertilizer under the Farm Input Subsidy Program fertilizer procurement. This will bring about efficiency gains in the fertilizer market as well as reduce the fiscal burden. 3 2. Laying foundation for Stronger Growth and Protection of the Poor: Focus measures aimed at enhancing agriculture productivity and diversification, addressing energy constraints and improving efficiency in the provision of social safety nets.  Prior action 5: The Recipient, through the Malawi Energy Regulatory Authority, has undertaken monthly reviews of the Automatic Tariff Adjustment Formula for electricity covering the period May to November 2012. This will, among others, help improve the financial position of the Utility Company as the tariffs become more cost reflective, which would help attract private sector players in the market. The subsequent reforms will help bring about changes in the regulatory environment, which will create conducive environment for Independent Power Producers.  Prior action 6: The Recipient has approved the National Social Support Program. The reform aims at strengthening linkages between existing social programs so as to amplify benefits and also develop an exit/graduate strategy for the beneficiaries. This will help improve efficiency and targeting of social safety nets and support the move towards more productive social protection. Rationale for Bank Involvement The rationale for Bank’s involvement in the proposed new DPO programmatic series is the need to help the government consolidate the implementation of the macroeconomic and structural policy reforms and improve efficiency in public expenditure. The DPO series is an integral part of the Bank’s new Country Assistance Strategy (FY13-16) for Malawi, which is fully aligned to the Africa Regional Strategy, the MGDS II and the ERP. The new CAS aims to contribute to Malawi’s efforts toward a more diversified, competitive, shock-resilient socioeconomic growth through the following pillars: i) Promoting Sustainable, Diversified, and Inclusive Growth; ii) Enhancing Human Capital and Reducing Vulnerabilities; and, iii) Mainstreaming Governance for Enhanced Development Effectiveness. The indicative lending program of the CAS envisaged programmatic support through three consecutive DPOs. The DPO series is also responding to the authorities’ commitment to implement the macroeconomic and structural reforms as well as provide a platform for continuity of reforms in the medium term and ensure predictability of the much needed financing. The program recognizes the importance of enhancing efficiency and effectiveness of government spending; strengthening external oversight, transparency, audit follow-up and internal controls; enhancing agriculture productivity and diversification, addressing energy constraints, improving social safety nets and building the country’s statistical capacity in pushing forward poverty reduction and the inclusive growth agenda. Tentative financing Source: ($m.) BORROWER/RECIPIENT 0 IDA Grant 50 Borrower/Recipient IBRD Others (specify) Total 4 Tranches (if applicable) ($m.) First Tranche Second Tranche Etc. Total Institutional and Implementation Arrangements The Ministry of Finance (MoF) will be responsible for overall implementation of DPO 1 as well as for reporting progress and coordinating actions among other concerned ministries and agencies. The MoF has experience in coordinating and implementing DPO programs as evidenced by the implementation of the PRSC I-III and RRDPG. The institutional arrangements for the preparation and execution of the DPO 1 fall within the framework of the MGDS II and CABS. The Bank’s supervision of the DPO series is aligned with the CABS biannual review meetings. In addition to two joint reviews, the Bank also participates in IMF missions to monitor progress on the macroeconomic framework. Risks and Risk Mitigation Three main risks could influence the expected outcomes of the proposed operation: a) Macro-fiscal risks and vulnerabilities derived in part from the domestic risks such as adverse weather conditions and policy slippages, and risks associated with the global environment, including international fuel and food price hikes. The country remains vulnerable to severe weather conditions, especially drought and floods, which always affects agricultural output and the overall GDP growth. Slippages in policy implementation and structural reforms or policy reversals risks need to be mitigated, especially in the context of a highly contested political environment in view of their potential impact on the macroeconomic stability. The country also faces the risk of a potential spillover from the global economy, including stagnation of euro area and world growth, a substantial fall in non-oil commodity prices, and a reduction in aid flows. The Authorities mitigation plans include measures to mobilize domestic revenue, to leverage on private sector resources and intensify the export diversification drive. Prudent fiscal stance and the maintenance of a flexible exchange rate policy will also provide key anchors for external sustainability. In the event of shortages in revenues the authorities have committed to make necessary but better targeted expenditure cuts in the budget. In addition, the IMF and the Bank are maintaining an on-going dialogue with the authorities on macro-fiscal policy issues, which will help detect potential threats early on. (b) Political environment risk: The risk of political volatility is high in context of a contested political environment in the country, which have a potential of changing the course of reforms. The recent loss of popular support for the economic reforms being implemented by the GoM, has manifested itself in calls by the opposition parties and consumer organizations alike for policy reversals, especially the floatation of the Kwacha and the automatic price adjustment for fuel.. FISP related reforms supported by this operation will not be easy to implement since FISP is highly politicized. These risks will partly be mitigated by the stabilization of the economy through containment of inflationary pressures and the Kwacha depreciation. A better communication by the government on how the policy reforms are having some positive impacts 5 (thus the need for time to let the reform work) and on measures being undertaken to cushion the poor will help calm the voices of concern. (c) Implementation capacity risks. The systemic problem of capacity in continues to pose a risk to the reform program and may cause delays in implementation of some of the reform measures supported by this operation. Weak institutional capacity at the local government level is a serious challenge. Poor management of the public finances and frequent macroeconomic policy reversals make these economic vulnerabilities worse. Corruption and fraud pose a serious challenge in the country’s development as it impedes service delivery and exacerbate inequality and poverty in Malawi society. To address this risk in the short term, the Bank intends to increase its engagement at the technical level to ensure the implementation of the reforms. In addition, the DPs are supporting the GoM through a combination of capacity building and technical support, including support for statistics and monitoring and evaluation. Specifically, the risks can be mitigated by the pace of reforms supported by the implementation of a more harmonized PFM program under the Public Finance and Economic Management Multi-Donor Trust Fund and the proposed series. Poverty and Social Impacts and Environment Aspects Poverty and Social Impacts Overall, the proposed policy actions supported by this operation are likely to have positive impacts on welfare and its distribution. As spelled out in the MGDS II, weak macroeconomic and public finance management systems and poor governance are perceived to be critical causes of poverty since weaknesses, especially in PFM, usually lead to inefficiencies in public spending, limited controls in the use of public resource and fiscal losses, which affect the GoM’s ability to deliver public services to the poor. Strengthening of macroeconomic and public finance management will enhance efficiency, transparency and accountability in public resource use; reduce the outstanding payment arrears (or minimize the accumulation of new ones) in the medium term, which is expected to improve the GoM’s capacity to more effectively manage its resources and the savings generated could be used for investment purposes, especially in social sectors. More investments are also likely to benefit lower income groups through job creation in constructions of public infrastructure and related activities. Reforms under the proposed operation will support efforts to enhance agriculture productivity as well as strengthen social safety net systems to help bring about quick gains for the poor and most vulnerable groups. The proposed measures will enhance productivity of smallholder farmers through use of quality seeds and modern ways of farming, and will also help improve the coordination mechanisms for the provision of social safety nets as well as the targeting of existing programs with a view to reduce the number of duplicate payments from different sources for the same beneficiaries. The improved targeting is especially important for women as poverty incidence for women tends to be higher. This will help improve the welfare of low-income groups, especially women and children, by ensuring that those exposed to shocks at any given time are reached on time. The improvements of statistical capacity and M&E systems will allow better targeting of social program in future. Measures to eliminate implicit subsidy in electricity will result to higher tariffs for consumers of electricity. In view of the fact that the poorest two income quintiles have close to zero households with electricity access, and the middle quintile only a one percent access rate, 6 the impact of tariff hikes will affect mostly those in the higher level of incomes. The tariff increases would also increase the prices of other household consumption goods, which would put additional pressure on all household budgets, even those poor without electricity connections. Electricity subsidies in Malawi are highly untargeted due to a combination of its flat tariff structure and the positive relationship between consumption and income. Considering Malawi’s continuing inflation and exchange rate increases and the persistent large gap between tariffs and the cost of electricity supply, would require further tariffs increases. There are two broad options for the tariff adjustment: a flat increase or a differentiated increase that allows lower tariffs for lower consumption levels. Creating a lifeline tariff instead, in which tariffs are increased more for higher-consuming (generally richer) households than for lower-consuming households, would cushion the direct impact of tariff increases on the poorest electrified households, reduce the total cost of subsidies, and make the distribution of electricity subsidies less regressive than it is currently. Environment Aspects The specific actions supported by the DPO series are not expected to cause significant effects on the environment, forests, and other natural resources of Malawi. The policies supported under this programmatic DPO largely address institutional and regulatory reforms. For instance, the macroeconomic and public finance management reforms should lead to more efficient use of public resources, which may indirectly generate environmental benefits in the form of better use of modern technologies. While the reforms in the energy sector are focusing on institutions (fiscal sustainability of provision of electricity) and the regulatory environment, there are potential indirect effects. Adjustments of electricity tariffs to levels that reflect cost of supply could eventually enable ESCOM to start some of its investment projects, which could have environmental impacts. Reforms related to agriculture also have a potential of indirect effects on environment but the related environmental issues have already been taken care of through the on- going sector lending operation. Contact point World Bank Contact: Appolenia Mbowe Title: Senior Economist Tel: 5394+3203 Fax: Email: ambowe@worldbank.org Location: Lilongwe, Malawi (IBRD) Borrower Contact: Randson P. Mwadiwa Title: Secretary to the Treasury Tel: (265) 1 788 781 Email: stfinance@finance.gov.mw For more information contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-4500 7 Fax: (202) 522-1500 Web: http://www.worldbank.org/infoshop 8