Malawi - Investment and Development Bank Project

FILE Copy Document of The World Bank International Finance Corporation FOR OFFICIAL USE ONLY Report No. P-2227a-MAI REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS OF THE BANK AND TO THE BOARD OF DIRECTORS OF THE CORPORATION ON A PROPOSED LOAN BY THE BANK TO THE INVESTMENT AND DEVELOPMENT BANK OF MALAWI WITH THE GUARANTEE OF THE REPUBLIC OF MALAWI AND A PROPOSED INVESTMENT BY THE CORPORATION IN THI INVESTMENT AND DEVELOPMENT BANK OF MALAWI June 22, 1978 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Malawi Kwacha (MK) US$1.00 = MK 0.89 MK 1.00 = US$1.12 MK 1,000 = US$1,120 MK 1,000,000 = US$1,120,000 WEIGHTS AND MEASURES 1 foot (ft) = 0.305 meters (m) I mile (mi) = 1.609 kilometers (km) 2 1 square mile (sq mi) = 2.590 square kilometers (km ) 1 ton (t) = 0.907 metric tons (m ton) GLOSSARY OF ABBREVIATIONS ADMARC - Agricultural Development and Marketing Corporation CDC - Commonwealth Development Corporation DEG - Deutsche Entwicklungs Gesellschaft DEVPOL - Government's Statement of Development Policies EIB - European Investment Bank FMO - Nederlandse Financierings - Maatschappij voor Ontwikkelings Landen N.V. IECM - Import-Export Company of Malawi INDEBANK - Investment and Development Bank of Malawi MDC - Malawi Development Corporation MWS - Ministry of Works and Supplies GOVERNMENT'S FISCAL YEAR April 1 - March 31  FOR OFFICIAL USE ONLY MALAWI INDEBANK PROJECT LOAN, EQUITY AND PROJECT SUMMARY IBRD Loan Borrower: Investment and Development Bank of Malawi Limited (INDEBANK) Guarantor: Republic of Malawi Amount: US$3.0 million equivalent Terms: Repayable in accordance with a schedule which would conform substantially to the aggregate of the amortiza- tion schedules applicable to the sub-loans. The maximum repayment period would be 17 years. Interest would be 7.5 percent per annum. Relending Terms: INDEBANK would relend the proceeds of the loan at an interest rate which could vary between 10.5 and 11.0 percent per annum for a maximum period of 15 years, including 2 years of grace. The foreign exchange risk would be borne by the sub-borrowers. IFC Investment: 500,000 INDEBANK shares of par value MK1 each to be subscribed by IFC at par (approximately US$562,000 equivalent). Project Description: The project seeks to assist the growth of medium- to large-scale enterprises in Malawi by providing funds to INDEBANK for financing the foreign exchange component of industrial projects. It would also seek to improve the operational policies of INDEBANK and, through IFC's representation on the institution's board, to provide technical advice to INDEBANK's management. It would create an estimated 1,100 new jobs. The project faces no special risks. INDEBANK will pass the foreign exchange risk to its borrowers. Estimated Resource Local Foreign Total Requirement (1978-mid 1981) (US$ million): Industry 4.0 7.4 11.4 Agriculture 1.2 2.4 3.6 Real Estate and Others 1.4 2.5 3.9 Total 6.6 12.3 18.9 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Financing Plan (US$ Million): Local Foreign Total Resources available at end 1977 0.9 1.6 2.5 European Investment Bank (Loan) 0.0 3.3 3.3 Internal Cash Generation by INDEBANK 4.4 0.0 4.4 INDEBANK's existing shareholders 1.1 3.3 4.4 Proposed Loan 0.0 3.0 3.0 Proposed IFC Investment 0.0 0.6 0.6 Gap 11 0.2 0.5 0.7 6.6 12.3 18.9 Estimated Loan Disbursements (US$ million): Bank FY 1979 1980 1981 1982 Annual 0.2 1.3 1.3 0.2 Cumulative 0.2 1.5 2.8 3.0 Rate of Return: n.a. Appraisal Report: Ref. No. 1914a-MAI June 9, 1978. 1/ The European Investment Bank has expressed willingness to make another loan to INDEBANK when its present loan is fully committed.  REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS OF THE BANK AND TO THE BOARD OF DIRECTORS OF THE CORPORATION ON A PROPOSED LOAN BY THE BANK TO THE INVESTMENT AND DEVELOPMENT BANK OF MALAWI LTD. WITH THE GUARANTEE OF THE REPUBLIC OF MALAWI AND A PROPOSED INVESTMENT BY THE CORPORATION IN THIS DEVELOPMENT FINANCE COMPANY 1. I submit the following report and recommendation on a proposed loan to the Investment and Development Bank of Malawi Ltd. (INDEBANK) with the guarantee of the Republic of Malawi for the equivalent of US$4.0 million, and a proposed IFC investment of MK 500,000 (approximately US$562,000 equiva- lent) in the share capital of INDEBANK. The loan would bear interest at 7.5 percent per annum and the repayment would conform substantially to the aggregate of the amortization schedules applicable to the sub-loans made pur- suant to this loan. The maximum repayment period would be 17 years. INDEBANK would use US$3.0 million to help finance the foreign exchange component of its loans and investments and would channel the remaining US$1.0 million through two commercial banks to help finance the foreign exchange component of loans and investments in small-scale enterprises. PART I - THE ECONOMY 2. A report entitled "Memorandum on the Economy of Malawi" (Report No. 1677a-MAI) dated September 30, 1977 was circulated to the Executive Directors on October 10, 1977. Country data sheets are provided in Annex I. 3. At independence in 1964, Malawi was the poorest of the three terri- tories of the former Central African Federation. With a population of 5.2 million and a land area of about 118,500 square kilometers, Malawi is also densely populated. Its main assets are moderately fertile soils, good water resources and a climate favorable to crop production. Unlike its neighbors, Malawi has no substantial mineral resources. Forests constitute the main essentially untapped resource which could be exploited on a signi- ficant scale in the future. At independence, the tax base was very narrow, government revenues had to be supplemented with British budgetary aid to support the administration, and prospects for economic development were generally regarded as bleak. 4. Malawi has a GNP per capita of only US$140 and is listed by the United Nations among the world's poorest countries. Measured against the country's natural endowments, however, progress since 1964 has been remark- able. Between 1964 and 1976, GDP at constant prices grew at an average annual rate of 6.5 percent, domestic investment and savings increased rapidly, and government finances had improved sufficiently to eliminate the need for budgetary aid. Agriculture, which dominates the economy (46 percent of GDP and 40 percent of paid employment in 1976), has been directed towards export markets by encouraging cash crop estates production and integrated rural development schemes. In addition, rapid industrial development (the share of industry rose from 9 percent of GDP in 1964 to 18 percent in 1976) has significantly broadened the economic base.  -2- 5. The continuing success of Malawi's development efforts has been the result of realistic and purposeful planning by the Government. A State- ment of Development Policies (DEVPOL), which provides a general framework for three-year rolling plans, was published in 1971. DEVPOL contains guidelines for major economic targets up to 1980 and states as main socioeconomic objec- tives: (a) raising living standards and productivity in rural areas; (b) achieving an average annual growth of GDP of 8 percent through the parallel development of smallholder output, estate agriculture and industry; (c) promoting a more balanced regional development; and (d) developing local initiatives by gradually increasing local participation in the economy. 6. Within the public sector, agriculture will receive 19 percent, public utilities 11 percent, and social services 15 percent of total in- vestment during 1971-80. The transportation sector will receive about 29 percent, although between now and 1980 the proportion is expected to be tem- porarily higher (46 percent) because of the concentration of several large investments in those years. Malawi has an effective administration which has been quite successful in preparing and implementing development projects. 7. DEVPOL recognizes the important role of private investment in devel- opment which, it is anticipated, will account for about one-half of total fixed capital formation over the 1971-80 period. The Government also recog- nizes the role of a healthy private sector in generating foreign exchange and savings needed to sustain other elements of the development strategy, and has adopted policies which are intended to attract foreign investors and to ensure a continued high growth of the private sector. Trade and payments policies are liberal, profits moderately taxed and wages are held down to favor labor- intensive estates and industries. The modern private sector has been the leader in economic growth. The output of estate agriculture increased by 10 percent a year in real terms over the past decade, and industrial production rose by 13 percent annually. 8. In 1969 (the last year for which reliable income data are avail- able), the poorest 40 percent of Malawi's households received 15 percent of the total; the highest 20 percent received 53 percent and the top 5 percent received 30 percent. These figures compared well with those of other develop- ing countries. Since then, the rapid development of the modern private sector has probably led to a less equitable situation. 9. To offset the adverse distributional effect of the growth of the modern private sector, the Government has directed some of its agricultural investment program toward the smallholders. However, for some years, the Government kept producer prices well below international prices until they started acting as disincentives to producers. The Government has recently recognized the importance of sufficiently remunerative commodity producer prices and has authorized substantial increases. Indirectly, wage and price policies have reduced the gap between wage earners and subsistence farmers. Over the past seven years, real wages have fallen somewhat, while the real earnings of smallholders have risen. Nevertheless wage employment has in- creased by 8 percent a year on the average since 1968.  -3- 10. Malawi's population is unevenly distributed, and the population pressure in some areas is heavy in relation to arable land. While recognizing the existence of this problem, the Government has been reluctant to introduce population control policies and intends to rely instead on balanced regional development policies that would encourage the movement of population to the less densely populated areas. Only about 6 percent of the total population live in urban areas. However, because of the diversification of the economy, urban population is increasing by more than 10 percent per annum, in line with the expansion of wage employment opportunities in the non-agricultural sectors. 11. As about 90 percent of the population live in rural areas, rural development is a primary social and economic objective. At present, the majority of farmers are smallholders on the fringe of the market economy. Their staple crop is almost exclusively maize, and their principal cash crops are cotton, tobacco and groundnuts. Until now, the principal instrument for increasing smallholder productivity has been relatively intensive, integrated development projects in specific areas, which at the moment reach about 25 percent of the rural population. 12. In spite of the Government's efforts, however, production from traditional agriculture has lagged behind that of the estates. Although firm figures are lacking, indications are that the production from the tradi- tional sector has not increased by much more than 3 percent a year over the past decade. The Government is concerned about this relatively slow growth and is preparing a new country-wide approach to rural development. This would be a departure from the previous approach in that it would primarily concen- trate on providing farm inputs and extension services, with less emphasis on infrastructure. The new approach - the National Rural Development Program - is to become the Government's chief vehicle for smallholder development. 13. The country's progress in generating and using domestic resources on the whole has been impressive. Both domestic savings and fixed investment have risen steadily since independence. Savings, virtually nil in 1964, were 11.5 percent of GDP in 1976, and fixed investment during the same period rose from 8.5 to 22 percent of GDP. In general, the Government's fiscal management has been skillfull. By holding recurrent expenditures down and, at the same time, expanding revenues, the Government has managed to achieve small budget surpluses and to bring the domestic contribution to financing development ex- penditures, which was negative in 1964, to 27 percent in 1976. Nevertheless, the expanding level of development activities will place additional demands on recurrent expenditures, possibly limiting future government contributions to the capital budget. Consequently, there is need for stepping up domestic resource mobilization, particularly through taxation. Since 1971, the in- crease in recurrent revenue has lagged behind the increase in monetary GDP. On the other hand, the increasing tempo of development is adding rapidly to recurrent expenditure requirements. In response, the Government has increased the company tax, personal income tax and import duties and excise taxes on some commodities. Further increases, however, will be needed, both for re- current expenditures as well as to help finance future development. The Government is concerned about the problem and with Bank assistance, has initiated a study of future recurrent budget requirements.  -4- 14. After serious deterioration in 1975 and 1976, Malawi's balance of payments recovered sharply in 1977. The deterioration was due principally to international inflation (and consequent deterioration in the terms of trade), exacerbated by the suspension in 1974 of the flow of Malawian migrant workers to South Africa, which drastically reduced remittances, and substan- tial capital outflows in 1975 and 1976. As a result, Malawi's foreign re- serves declined from US$82 million in 1974 to US$26 million - equivalent to about 1-1/2 months of imports - in 1976. The Government took fiscal and mone- tary measures to deal with the problem, and in 1977 the IMF made available a first tranche standby credit, equivalent to US$6.3 million. Demand for Malawi's main agricultural exports, however, continued strong, and foreign exchange reserves rose to a record level of US$88 million (equivalent to about four months of imports) by the end of 1977. 15. The expansion of the Government's investment programs has been assisted by increased public capital inflows on very concessionary terms. The net contribution from foreign official sources to the financing of public investment increased from US$17 million in 1967 to about US$45 million in 1976, of which US$11 million were in grant form. The sources also have gradually been diversified. At independence, Britain was virtually the only source; but by 1976, the British contribution had declined to about 40 per- cent. Multilateral sources, especially IDA, provided about 40 percent, and a variety of bilateral sources, notably Canada and the USA, accounted for the remainder. 16. At the end of 1976, Malawi's external public debt totaled US$343 million, of which US$258 million had been disbursed. Debt service in 1976 amounted to US$12.7 million, equivalent to about 7 percent of foreign exchange earnings. At the end of 1976, IDA's share in Malawi's disbursed debt was 28.5 percent, and servicing of IDA credits accounted for 3.2 percent of total debt service. By 1985, Bank Group share in Malawi's total debt service pay- ments will be about 24.2 percent. With the continuing increase in public investment, external capital inflow is estimated to increase to about US$125 million by 1982. In the future, we may expect some hardening in the average terms of lending. However, even if the average grant element of official assistance were to fall from the 80 percent level of 1971-75 to, say, 50 percent by 1985, Malawi's public debt service obligations would still remain below 10 percent of export earnings in 1985. Because of the Government's limited ability to mobilize domestic resources for the pipeline of projects it is able to prepare and implement (para. 13), external financing usually covers a substantial part of the project cost, including local costs when the foreign exchange component is relatively small. Despite the Government's steady improvement in upping the domestic share of development expenditures (27 percent in 1976), new investment is expanding more quickly than the domestic resource base. Moreover, much of the Government's development outlays is necessarily concentrated in activities not suitable for external assistance, so that the proportion of external financing in specific projects usually ranges higher than the 73 percent overall figure in 1976. In consid- eration of the Government's good performance in economic management and proj- ect preparation and implementation, Malawi became a blend country in 1976 when it received a Bank loan on Third Window terms.  -5- PART II - BANK GROUP OPERATIONS IN MALAWI 17. Malawi has received sixteen IDA credits totalling US$122.2 million and three Bank loans totalling US$26.2 million, of which two were on Third Window terms. Of the total Bank Group assistance, US$51.8 million (35 per- cent) was for agriculture, US$37.8 million (25 percent) to power development, US$17.9 million (12 percent) to education, US$32.5 million (22 percent) for roads and the balance of US$9.0 million (6 percent) for water supply and to finance preparation of a planned pulp mill at Viphya. The first Bank loan to Malawi was made on Third Window terms in June 1976 and the first standard Bank loan in April 1977. IFC's first investment in Malawi was in February 1976 with a loan of US$6 million for a textile mill. IFC made its second loan of US$9.0 million for a sugar development in April 1977. A summary statement of Bank Group operations and notes on the execution of ongoing projects are provided in Annex II. Project implementation is generally satisfactory. 18. While Bank Group operations in Malawi will continue to emphasize rural development, infrastructure (power, water supply and roads) and educa- tion development also will receive attention. In agriculture, the first phase of the 20-year National Rural Development Program was appraised last November and a credit proposal is expected to be submitted to the Executive Directors later this year. In education, a joint sector study was recently carried out by UNESCO and the Bank. We expect to appraise a project later this year based on its results. With regard to water supply, a WHO/Bank mission visited Malawi in November 1977 to assess conditions in the sector and carry out pre- liminary project identification. Finally, the Bank Group is also assisting the Government, through a technical assistance/engineering credit, to prepare the Viphya pulp and paper project. PART III - THE INDUSTRIAL AND FINANCIAL ENVIRONMENT IN MALAWI Performance of Industry 19. Industrial production in Malawi has grown at a remarkable rate averaging 13 percent per annum between 1964 and 1975. In 1976, Mozambique closed its border with Rhodesia and South Africa thus compelling Malawian industrialists to reroute their supplies of raw materials and equipment through the congested Mozambican ports. The resulting delays, compounded by the foreign exchange problems of the country (para. 14) reduced manufacturing output in 1976. By 1977, most industries had recovered and manufacturing output during the first eleven months was 10 percent higher than during the comparable period in 1976.  -6- 20. While agriculture still dominates the economy, industry in 1976 accounted for 18 percent of GDP and 21 percent of wage employment. Malawian industry is one of the most profitable and labour-intensive in Africa. The latest survey of enterprises with more than 20 employees, conducted in 1973, indicated a net profit before tax of 13 percent of total assets, and an average of MK 1,300 of capital assets per employee. Structure of Industry 21. Industrial production is mostly manufacturing (72 percent) and con- struction (28 percent). By 1973, manufacturing which traditionally consisted of the processing of tobacco and tea for export had diversified into the import-substitution of basic goods, such as food and beverages, textiles, clothing, footwear and metal and wood products. Since then, there has been an acceleration in the production of sugar, which had become the third largest export after tea and tobacco. The manufacture of agricultural implements and equipment also received an increasing share of recent investments. 22. Three fourths of industrial employment is located in the Southern Province . Because of the poverty and low level of savings in the country, only a few local enterprises with strong government support, and often in collaboration with foreign partners, can mobilize the investments required in medium- and large-scale industry. Strengthened by the profitability of their investments, these enterprises (notably the Malawi Development Corporation, Press Holdings Limited and the Agricultural Development and Marketing Corpora- tion) have succeeded in placing the industrial sector, except textiles, under majority Malawian ownership. However, since there are relatively few Malawians skilled in management, expatriate staff, frequently provided by minority foreign partners, still occupy most of the managerial and specialized tech- nical positions in the larger enterprises. In its 1978-81 development pro- gram, the Government proposes to emphasize the training of accountants, engineers and business administrators. 23. Most Malawian entrepreneurs concentrate on small-scale industries which seldom employ more than ten people or have investments exceeding MK 50,000. They operate in wood and metal working, garments, leather works, furniture, construction materials, and, in rural areas, in blacksmithing and sawmilling. To date, there are no institutions in Malawi which specifically look after the needs of small-scale industries. The Government, through several special schemes, including two industrial estates, has, in the past, extended some financial assistance to such industries. The commercial banks, notably the National Bank of Malawi and the Commercial Bank of Malawi, also make some loans to small-scale businesses. Nevertheless, a good knowledge of the real needs, and development constraints, of small-scale industries does not exist. Therefore, the Government, with the assistance of a consultant financed by the Bank, is currently undertaking a feasibility study of small- scale industrial development in Malawi. When completed, in the next few months, the study should provide the basic data necessary for the preparation of a nation-wide small-scale industrial project, if justified.  - 7- Government Policies in Industry 24. Since 1964 the Government has followed a pragmatic policy which gives priority to industries using local resources and aiming at self-suffi- ciency in basic goods such as food and clothing. Strong emphasis has been placed on competitive and profitable private companies, which are viewed as the most efficient vehicle of industrial growth. To attract foreign investors, the Government has pursued a well-publicized, liberal policy of full repatria- tion of profits and, eventually, disinvestments. Industrial investors are usually granted tax deductions, including 10 percent of new plant and equip- ment costs, all preoperating expenditures and accelerated depreciation. Some may also be granted concessionary duty rates on imports of machinery, parts and raw materials. Manufacturers of export commodities are automatically granted a full rebate of duties on parts and raw materials. 25. Although the Economic Planning Division in the Office of the President formulates overall economic development policies and the Ministry of Finance controls public sector financing and external capital inflow, the Ministry of Trade, Industry and Tourism strongly influences industrial devel- opment through its day-to-day administration of the licensing, incentives and price control systems. Industrial licenses are seldom denied, but applicants are encouraged to avoid saturated domestic markets and to minimize their requirements of imported supplies. In addition, the licensing system is used selectively to encourage the development of Malawian entrepreneurs. The Ministry also issues guidelines for retail prices of locally manufactured products. Although these guidelines are not legally binding, except for a few essential consumer goods, they are generally observed. Price increases are usually granted if they are justified by higher costs of production or imports. This flexible price control is balanced by the Government's policy of limiting wage increases to productivity increases. Prospects 26. Several large investments are presently coming into fruition. A financing plan of MK 59 million, including an IFC loan of US$9 million, was finalized in April 1977 for the establishment of a large, export-oriented sugar complex which, on completion, is expected to almost double the national sugar production capacity. The Government is also seeking financing for a pulp and paper project which would utilize 160,000 acres of timber on the Viphya plateau in the Northern Province. The total cost is estimated at over US$500 million. Feasibility studies for molasses utilization, ceramics, tannery, motor oil re-refining, and knitted fabrics and infusion solutions are being financed with a DM 1.2 million grant from KfW. Several other import substitution opportunities are still unexploited, and the gradual return of Malawian workers to South African mines is expected to increase rural incomes and enhance the growth of rural industries. Legislation attractive to for- eign capital, liberal and consistent investment policies, relatively low cost labour, a stable political situation and a relatively efficient administration all combine to foster an attractive investment climate.  -8- Financial Environment 27. Domestic credit has been increasing sharply in Malawi in the last few yearsdue mostly to public sector borrowings and larger deficits in the Government budget. In view of Malawi's worsening balance of payments position, the Reserve Bank, in the second half of 1976, started to require a liquidity ratio of 25 percent, accompanied by a stricter definition of liquid assets. As a result, the total credit outstanding levelled off in the first quarter of 1977, while a marked increase in the inflow of resources enabled the building- up of foreign exchange reserves after a continuous decline since the beginning of 1975. 28. In November 1976, the Reserve Bank announced the first substantial increase in interest rates since 1970. The Reserve Bank's discount rate went from 6 to 7 percent and the minimum lending rate of commercial banks was increased from 8.5 percent to 10 percent per annum, with a new maximum of 15 percent. At present, annual interest rates on savings deposits range from 5.5 percent for savings to 8.5 percent for 36 months' deposits, while the average lending rate for commercial banks is between 12 percent and 13 percent per annum. 29. Malawi has a relatively well-developed financial system which comprises: (i) two commercial banks; (ii) eight specialized financial in- stitutions, two of which (the Malawi Development Corporation (MDC) and the Agricultural Development and Marketing Corporation (ADMARC)) play an im- portant role in industry; (iii) a trading company, Import-Export Company of Malawi (IECM), (iv) a large holding group, Press Holdings Ltd, and (v) a traditional development bank, INDEBANK. 30. Commercial Banks: The two commercial banks are partnerships of foreign banking groups with large domestic financial institutions active in the industrial field. Their boards, with local interlocking directorships are chaired by the managing director of Press Holdings Ltd. (para. 33). Agriculture has represented the bulk of the banks' operations, with industry and trade accounting for less than one-third. The National Bank of Malawi (NBM), owned by Press Holdings Ltd. (57 percent), by Barclays and Standard Banks (10 percent each), and local interests, had assets totalling MK 111 million at March 31, 1977. NBM has shown a continuously strong performance, with no write offs for bad debts, and an excellent profitability. NBM's lending, mostly in the form of overdrafts, is mainly to agriculture (50 percent) and manufacturing and trade (30 percent), through a large network of branches and other offices. It has 70 percent of the country's private domestic deposits. The Commercial Bank of Malawi (CBM) is owned by Press Holdings Ltd. (40 percent), MDC (20 percent), ADMARC (10 percent) and Bank of America (30 percent). Since a major capital restructuring in 1974, CBM has steadily eliminated accumulated deficits and distributed a first dividend in 1976. CBM's lending, also again mostly overdrafts, goes mainly to agriculture (72 percent) and manufacturing and trade (21 percent). Although CBM's total assets of MK 40 million are only about one-third of NBM's, and its share of private domestic deposits is 30 percent, it has a more extensive network of branches and other offices.  -9- 31. Malawi Development Corporation (MDC) and Import-Export Company of Malawi Ltd. (IECM). MDC is a statutory corporation, set up in 1964 to promote non-agricultural projects according to national priorities. It is wholly owned by the Ministry of Finance. In addition to annual equity contributions from the Government and local borrowings, MDC has drawn resources since 1973 from substantial Euro-dollar borrowings on rather hard terms. MDC operates as a holding company, making mostly equity investments and lending only to companies in which it holds shares. Sixty percent of MDC's investments are in industry, 10 percent in tourism and the rest in commerce and services. At the end of 1976, its assets totalled MK 14 million and its consolidated holdings totalled MK 44 million. MDC does not have any single exposure limit for individual projects nor any maximum on investment amounts. The Import-Export Company, created in 1975, is controlled by MDC, which owns 51 percent of the shares, while Press Holdings Ltd. owns the remaining 49 percent. With assets of MK 15 million, it primarily operates wholesale stores (selling MK 25 million per year in basic consumer goods through 59 wholesale depots in the country), and marketing services (selling MK 9 million per year in more sophisticated products through 30 mobile vans). 32. Agricultural Development and Marketing Corporation (ADMARC) was established in 1971 as a statutory corporation under the Ministry of Agri- culture to promote agricultural exports by developing an efficient system for purchasing crops produced by small farmers, marketing the main export crops and sponsoring agricultural and agro-industrial enterprises. ADMARC has invested its substantial trading profits (about MK 8 million per year on the average) essentially in agricultural and agro-industrial enterprises and in a few industrial enterprises (e.g. cement, shoe-making). It has no project appraisal capabilities and tends to make its investments at the specific request of the Government. 33. Press Holdings Ltd., created in 1960, is a private limited hold- ing company whose shares are registered under the name of the President who keeps them "in trust for the people of Malawi". With assets of MK 69 million, the company now has shareholdings in 38 other companies, widely diversified in agriculture, industry, commerce, real estate, transportation, banking and insurance. Press Holdings Ltd. reportedly reinvests its substantial profits (about MK 4 million per year on the average) and receives no direct financial support from the Government. PART IV - THE PROJECT 34. The proposed loan to the Investment and Development Bank of Malawi (INDEBANK) would be the Bank's first financing for industrial development in Malawi. The project was identified in May 1977, prepared by INDEBANK, and appraised in November. Supplementary data on the project are in Annex III. Negotiations were held in Washington in April 1978, with a Malawian delegation led by Mr. Gerald Raynor, General Manager of INDEBANK. The Staff Appraisal Report No. 1914a-MAI of June 9, 1978 is being circulated separately to the Executive Directors.  - 10 - Role and Strategy of INDEBANK 35. INDEBANK was established as a private limited company in December 1972 to promote projects in industry, agriculture and commerce, through medium- and long-term finance and equity investments. In lending, it gives preference to projects sponsored and financed by Malawian interests, and encourages foreign investors to find local partners. INDEBANK is, however, prohibited from financing projects sponsored by Government ministers, chairmen of public corporations and executives of the Malawi Congress Party. INDEBANK plays a catalytic role in promoting projects proposed by the Press Holdings Group, MDC and the Government; it also mobilizes foreign sources of capital and technological expertise. More recently, INDEBANK started promoting projects on its own and initiated three small projects in 1976-77. INDEBANK's eval- uation of projects, although subject to improvements, is helping to raise standards in the entire financial community. Compared to other Malawian institutions, INDEBANK's most distinctive feature is its independence from the Government and local interest groups. Ownership and Resources 36. INDEBANK's founders and present shareholders are ADMARC and three bilateral development agencies, Commonwealth Development Corporation (CDC), Deutsche Entwicklungs Gesellschaft (DEG) of Germany and Nederlandse Financier- ings-Maatschappij voor Ontwikkelingslanden N.V. (FMO) of Holland. A compre- hensive Finance and Cooperation Agreement, signed at INDEBANK's inception by the Government, INDEBANK and its shareholders, defines the mutual rights and obligations of the parties. INDEBANK's Board includes one director and one alternate appointed by each shareholder, and is chaired by ADMARC's chairman. In consideration of IFC's proposed equity investment, INDEBANK has offered IFC a seat on its Board of Directors. The foreign shareholders play a useful role in providing both technical advice and quality control for INDEBANK's activities. The four shareholders provided, pari passu, all of INDEBANK's resources through 1977. On a need basis, they increased the paid-up share capital in each year and followed each increase by issuing a threefold amount in income notes, a peculiar form of long-term debt (para. 37). At the end of 1977, INDEBANK had received MK 2,840,000 in share capital and MK 7,350,000 in income notes, and the shareholders have recently complemented these amounts with MK 3 million in share capital and MK 9 million in income notes. 37. Income Notes. As specified in the Finance and Cooperation Agreement, interest on income notes is limited to 8 percent per annum, payable out of available earnings after deduction of all other expenses. Because of satis- factory profits, INDEBANK has consistently been able, since inception, to pay 8 percent interest on income notes. Income notes which are convertible into shares at par, at the option of the holder, are unsecured and become repayable in the year 2020, by which time the holders would decide on whether or not to convert them into equity. Holders can demand prepayment in case of INDEBANK's liquidation, its nationalisation, or if INDEBANK fails to meet any of its contractual obligations with the shareholders, such as the payment of interest on income notes. The shareholders view such prepayment provisions as a means of ensuring that INDEBANK carries out its business in accordance with the  - 11 - general objectives agreed at its inception. It is not expected, however, that INDEBANK's shareholders would request prepayment of income notes in a way that would place INDEBANK in financial jeopardy, since such an action would be contrary to the shareholders' interests. Probably only a serious dispute between the Government of Malawi and the foreign shareholders could lead to prepayment. Such a situation would in itself require a complete revision of INDEBANK's financial structure. If any of INDEBANK's shareholders should decide to request prepayment of income notes from INDEBANK, the Bank would be advised in advance and would also be entitled to demand prepayment of its loan (Sections 4.05 and 5.01(a) of the draft Loan Agreement). Policies 38. INDEBANK's investment policies have been amplified over time by a series of special resolutions of its Board. Normally INDEBANK will not invest in infrastructure projects, participate in refinancing operations, accept management responsibilities in the enterprises it finances, nor provide more than 35 percent of the total equity investment in a project. Sponsors are required to put up at least 25 percent of the total cost of their projects. These policies have been incorporated in a single policy statement. 39. Exposure in a Single Project. INDEBANK's loan limit (raised last April from MK 600,000 to MK 1.0 million when INDEBANK's share capital was increased from MK 3.0 million to MK 4.0 million) can be exceeded at the Board's discretion in projects of particular national importance. So far, INDEBANK has made loans of more than MK 600,000 to two projects: a MK I million loan to the Dwangwa Sugar Company and a MK 0.9 million loan, fol- lowed by another loan of MK 0.3 million, to General Farming, one of the largest producers of flue-cured tobacco in the world, producing about 20 percent of Malawi's total exports. Both projects are of particular national importance. In addition, two publicly owned corporations each received suc- cessive loans totalling more than MK 600,000 but these are guaranteed by the Government. INDEBANK's total exposure (loan plus equity) in a single enterprise will not exceed 25 percent of INDEBANK's net worth except that the limit may be exceeded in cases of projects of particular national impor- tance provided INDEBANK obtains a Government guarantee for any financing in excess of the limit (Section 4.10 of the draft Loan Agreement). 40. Provisions. INDEBANK has no formal policy for provisions for possible losses on investments. In view of the quality and youth of its portfolio, it has simply limited dividends to 75 percent of net profit, thus building up its retained earnings in a general reserve now amounting to about one percent of total portfolio. This practice is acceptable for the time being. For the future, however, INDEBANK will retain its earnings in a general reserve in an amount adequate to cover possible portfolio losses and will make specific provisions for projects in difficulty in accordance with its auditors' recommendations. (Section 4.12 of the draft Loan Agreement).  - 12 - Management Organisation and Staff 41. INDEBANK's General Manager since 1972 has been seconded from CDC. In April 1978, INDEBANK designated a Malawian national to succeed the incumbent General Manager when the latter's contract expires in mid-1979. The designee, who has held several senior government posts including that of General Manager of the Malawi Central Bank, should benefit greatly from the one year he would spend with the incumbent. INDEBANK has two departments for the promotion and appraisal of agricultural and industrial projects; a third reviews the finan- cial aspects of project proposals and follows up the implementation of approved projects, while a fourth department is in charge of general accounting. All four departments have a total of ten professionals who, though well qualified, are relatively inexperienced. Only the accounting department manager is a Malawian. In support of its projected operational growth and to improve its management generally, INDEBANK has recently adopted a plan under which (i) a Controller of Project Investigations will be recruited to coordinate project appraisal work; (ii) a third Projects Investigation Manager with an engineer- ing background will be recruited to reduce current dependence on consultants' services in project appraisal; (iii) five Malawian university graduates will be recruited to INDEBANK's staff this year and (iv) at least two Malawian staff members will be sponsored for overseas training annually. The proposed staffing and staff development plans are satisfactory. Completion of items (i) and (ii) and the selection of the graduates under item (iii) are condi- tions of effectiveness for the proposed loan (Section 6.01 of the draft Loan Agreement). Procedures 42. INDEBANK's project appraisals are good but can be further improved in the following respects: (i) appraisal reports are sketchy and not properly coordinated with inputs from the marketing, financial and technical analysis departments; (ii) INDEBANK relies exclusively on outside consultants and promoters' views for the engineering evaluation of projects, and (iii) eco- nomic analysis of projects is not thorough. The first two weaknesses should be remedied with the recruitment of the Controller of Project Investigation and the new Projects Investigation Manager. INDEBANK would make formal evaluation of projects, including the calculation of economic rates of return (Section 2.03(a) of the draft Loan Agreement). 43. INDEBANK submits progress reports on all projects financed at each Board meeting. However, because of its limited staff, INDEBANK makes few formal follow-up visits in situ, relying rather on the regular reporting from its clients or focusing on a few projects in difficulty. This light follow-up has proved sufficient until now due to the good quality and limited size of its portfolio. The staffing plan includes the recruitment in 1978 of two professionals for follow-up work. To formalize procedures in anticipation of the projected growth in operations, INDEBANK's management, with the Bank's assistance, is now preparing operational manuals for project appraisal and follow-up. INDEBANK's other procedures for disbursement and procurement are generally adequate.  -13- 44. INDEBANK makes loans with maturities of 3 to 15 years and takes adequate security. It normally charges annual interest rates of 9.5 percent in agriculture, 10.5-11 percent in industry and 11-12 percent in commerce and real estate. These rates are consistent with the country's interest rate structure, and provide INDEBANK with a good margin over the interest rate of 8 percent per annum on income notes. In the past, all INDEBANK's resources came from its shareholders and were denominated in Malawi Kwacha. For all operations financed with foreign currency borrowings, INDEBANK will pass on the foreign exchange risk to its clients. Past Operations and Results 45. Operations. From its inception in 1972 to December 1977, INDEBANK had approved total investments of MK 13 million, 87 percent in loans and 13 percent in equity, in 31 projects. Its operations grew rapidly to MK 3.9 mil- lion in its first year of operations but levelled off thereafter at an average of MK 2.6 million per year, due to INDEBANK's prudent investment policy. Given its small professional staff size until 1977, its volume of approvals indicates a staff productivity level which compares favorably with most DFCs at the same stage of development. In addition, INDEBANK's project processing record is good. The time between approval and commitment and between com- mitment and full disbursement average 4-1/2 and 5 months respectively. 46. The total cost of projects approved by INDEBANK (excluding the exceptionally large project at Dwangwa Sugar with a total cost of MK 59 mil- lion) averages MK 2.1 million; 81 percent of all the projects approved have total costs which range between MK 1.0 million and MK 6.0 million. INDEBANK's investment (loan plus equity) per project ranges mostly (70 percent of the amount approved) between MK 200,000 and MK 600,000, and averages MK 415,000 or 20 percent of total project costs. Most projects are under majority Malawian ownership (79 percent by amount) and primarily use local raw materials (78 percent). Despite their relatively large size, INDEBANK's investments are reasonably labor-intensive and show an average investment cost per job of US$13,000, notably below the overall average of about US$25,000 observed among other African DFCs. Financial rates of return calculated for a sample of INDEBANK's projects show an average of about 24 percent. The total amount of approvals is distributed among three main sectors: 54 percent in industry and agro-industry, 19 percent in pure agriculture (mostly tobacco growing - 16 percent) and 17 percent in commercial buildings and housing. 47. Portfolio. As of December 31, 1977, INDEBANK held a portfolio of MK 9.9 million in 27 projects. Two-thirds of these projects are already completed and only three (10 percent by amount) are causing some concern but they are guaranteed by ADMARC, MDC and CDC respectively; INDEBANK is follow- ing them closely and providing advice to their management. Apart from these three, all companies operating in INDEBANK's portfolio made profits in FY76 and one-third of them, accounting for 29 percent of portfolio amount, showed net returns above 20 percent on equity. As of November 30, 1977, eight loans - representing 33 percent of total outstanding portfolio - had commenced repay- ments. INDEBANK had no interest or principal arrears. Overall, the quality of INDEBANK's portfolio is good and ranks above average among African DFCs.  - 14 - 48. Despite its youth, INDEBANK has shown a proficient financial man- agement and is already one of the most profitable DFCs in Africa. Net earn- ings before tax have increased at an average rate of 100 percent per year and reached MK 154,000 in 1977; this represented a return of 6.2 percent on average equity. Resource Requirements 49. At the end of 1977, INDEBANK had a large and diversified pipeline of 36 possible projects which would require INDEBANK financing of MK 16 mil- lion. Based on this pipeline and taking into account the development of INDEBANK's promotional activities, INDEBANK's total commitments in loans and equity investments are projected to total MK 17.2 million (US$18.9 million equivalent) over the three-and-a-half-year period from 1978 to mid-1981. After deducting cash generation projected at MK 4.0 million over the same period and the surplus of uncommitted resources of MK 2.3 million carried over from 1977, new resources of MK 10.9 million are required. INDEBANK has already secured from the European Investment Bank (EIB) a loan of 3 million units of account (approximately MK 3 million) which was signed in November 1977. The use of this loan is, however, restricted to manufacturing industry, mining and tourism. In addition, the shareholders have agreed to contribute up to MK 4 million to cover part of INDEBANK's needs during the next four years, although the final form of this contribution is not yet determined. The proposed IBRD loan (about MK 2.6 million equivalent) and IFC's MK 0.5 million investment would cover most of the remaining gap, and INDEBANK should be able to raise the balance without great difficulties. The Bank loan and IFC investment would be financing about 24 percent of INDEBANK's total commit- ments over the two and a half year period 1979 to mid-1981. 50. Share Capital. Considering INDEBANK's sound portfolio and the special nature of its repayment obligations on income notes, INDEBANK can moderately increase its debt-to-equity ratio which has remained below 3:1 in the past, but an upper limit of 4:1 should be set on this ratio in view of INDEBANK's relative youth. On this basis, INDEBANK has to raise about MK 1.5 million in new share capital through mid-1981. The current four shareholders have agreed to provide MK 250,000 each of their expected contribution of MK 1 million during this period in the form of share capital, the remaining MK 750,000 being income notes except for CDC which has indicated that it would provide its MK 750,000 equivalent as a sterling loan instead of income notes. The proposed IFC equity investment of MK 500,000 (US$562,000 equiva- lent) will cover the remaining share capital required. This subscription would give IFC about 11 percent of INDEBANK's share capital. The Proposed Loan 51. The proceeds of the proposed loan of US$3 million will be used by INDEBANK to provide medium- and long-term financing for fixed investments and permanent working capital for medium- to large-scale projects in industry, agro-industry and tourism, excluding smallholder agriculture, commercial buildings and trade. The individual project free limit would be set at US$100,000 and the aggregate free limit at US$750,000. At this level, the  - 15 - Bank would review about 80 percent of the number of projects submitted and thus monitor closely the improvements expected from the consolidation of INDEBANK's procedures. The proceeds of the proposed loan in any single project would be limited to MK 600,000 to avoid the loan being used up by a few larger projects (Section 2.02(a) of the draft Loan Agreement). INDEBANK will on-lend the pro- ceeds of the proposed loan at an interest rate of 10.5 to 11.0 percent per annum and will pass on the foreign exchange risk to its borrowers. The Proposed IFC Investment 52. An IFC investment of MK 500,000 (equivalent to about US$562,000) in the share capital of INDEBANK has been requested by the company, which would give IFC 11.1 percent of INDEBANK's share capital. This additional share capital would enable INDEBANK during the commitment period of the Bank loan, to remain within the 4:1 debt/equity limitation agreed with the Bank. It would also provide INDEBANK with additional funds needed for making equity investments. By investing in the share capital of INDEBANK, IFC would be supporting an institution which has been the main source of assistance and encouragement to the development of the private sector in Malawi, with over 80 percent of its financial assistance having been extended to companies which have substantial private ownership. INDEBANK's current shareholders consider INDEBANK's support of the private sector in Malawi to be an important role, as has been demonstrated by its past operations. IFC's representation on INDEBANK's Board of Directors, especially at this time of a change in the top management of the company, is also expected to make a significant con- tribution to the development of INDEBANK's policies and operations. 53. The proposed IFC investment is expected to be reasonably profitable. The discounted return on the investment is expected to be about 9.0 percent, given the projected dividends and assuming capital appreciation resulting from selling shares at net asset value and no change in the kwacha/dollar exchange rate. Given the forecast that INDEBANK's profitability and dividend yield will continue to increase, its shares could become a reasonably attrac- tive investment, especially for an institutional investor such as one of the half-dozen financial institutions in the country. However, being a private limited company, the potential marketability of INDEBANK's shares is affected by its Articles of Association, which limit the number of shareholders to 50 and prohibit a public offering. The Articles also provide that, should any shareholder wish to sell his shares, then the other shareholders have pre- emptive rights at a sales price to be agreed with the directors. The current shareholders have agreed that if IFC should want to sell its shares, then the price would be the shares' net asset value. In addition, ADMARC has agreed to give IFC a put option whereby, if the existing shareholders do not take up IFC's shares offered to them and IFC has been unable to find other purchasers, then IFC may require ADMARC to buy its shares at their net asset value over a period of 4 years after IFC had held the shares for 8 years. 54. Through this investment IFC would provide both financial assistance to support INDEBANK's operations as well as technical assistance by sitting on its Board of Directors. The investment would meet IFC's objectives of support- ing the private sector in the smaller and poorer countries through establishing  - 16 - closer links with local DFCs. It also promises to be a reasonable investment from the point of view of profitability and marketability. An outline of relevant laws of the Republic of Malawi affecting the investment by IFC is attached to the Staff Appraisal Report. Procurement 55. Procurement under INDEBANK-assisted projects is undertaken on the basis of competitive quotations with close attention to both prices and the quality of machinery and equipment. In the past, INDEBANK's lack of engineers with appropriate experience limited the coverage of this practice so that on occasions, INDEBANK used consultants. The Project Investigations Manager for technical evaluations (para. 41) being recruited under the proposed project will further improve this practice. Overall, INDEBANK's procurement practices are satisfactory. 56. Disbursements. The proceeds of the loan will be disbursed for eligible sub-projects against: (i) the foreign exchange cost of imported equipment and services; (ii) up to 75 percent of the cost of equipment pre- viously imported into Malawi and purchased locally; and (iii) up to 50 percent of the total cost of civil works, representing the foreign exchange component. Project Justification 57. INDEBANK is the most independent, reputable and efficient institu- tion involved in financing industrial development in Malawi. The projects that it has helped to implement are profitable, relatively labour-intensive and primarily based on local raw materials. It has played a useful role in bringing foreign capital and technology into the country, and in improving the standards of project selection. Supported by a capable management and experienced shareholders, INDEBANK has carefully built-up a good portfolio and a solid financial situation. It now plans to consolidate its operational procedures and staffing to enter a second stage of its development in which it will increase its activities in project promotion and expand the volume of its investments substantially. 58. The proposed Bank loan would be the first one to INDEBANK. It would enable INDEBANK to achieve its planned higher investment levels and will give the Bank Group the opportunity to participate actively in the future develop- ment of the sector through an efficient financial intermediary. By assisting INDEBANK, through a continous relationship, in training its Malawian staff, rationalizing its procedures and developing the new project promotion policies, the Bank Group could have a significant impact on the institution at this early stage of its development. The improvements in INDEBANK's general policies fostered by the Bank Group involvement should further strengthen the institution (paras. 38-40). In addition, the proposed Bank loan would help finance investments totalling about US$15 million and generating about 1,100 jobs. The on-going study of small-scale enterprises development (para 23) would enable the Bank to collaborate early with the Government in formulating a policy for future SSI development.  - 17 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 59. The draft Loan Agreement between the Bank and the Investment and Development Bank of Malawi Ltd., the draft Guarantee Agreement between the Republic of Malawi and the Bank, the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement of the Bank and the text of a resolution approving the proposed IFC investment are being distri- buted to the Executive Directors separately. 60. Special conditions of the Project are listed in Section 3 of Annex III. Recruitment by INDEBANK of (i) a Controller of Project Investigations and (ii) a Projects Investigation Manager in charge of technical analysis, and selection of five additional Malawian professionals to be trained by INDEBANK are conditions of effectiveness (para. 41). 61. In accordance with Section 3 (ii) of Article III of the Articles of Agreement of the Corporation, the Government of Malawi has been notified of the proposed investment. 62. Malawi is a Contracting State for the purposes of the ICSID Conven- tion. However, there are no contracts or arrangements between the Government of Malawi and any national of another Contracting State in the context of this investment which might give rise to an investment dispute. 63. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and that the proposed investment would comply with the Articles of Agreement of the Corporation. PART VI - RECOMMENDATION 64. I recommend that (a) the Executive Directors of the Bank approve the proposed loan and that (b) the Board of Directors of the Corporation approve the proposed investment by the Corporation. Robert S. McNamara President Attachment May _, 1978  ANNEX I TABLE 3A }fiLAWI - SOCIAL INDICATORS DATA SHEET LAND AREA (THOU KS2) ------ -