Malawi - Second Fiscal Restructuring and Deregulation Program Technical Assistance Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No: P 7273 MAI REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT AND TECHNICAL ASSISTANCE PROJECT iN THE A\MOUNT EQUIVALENT TO SDR 65.7 MILLION AND SDR 1.5 MILLION TO THE REPUBLIC OF MALAWI FOR THE SECOND FISCAL RESTRUCTURING AND DEREGULATION PROGRAM AND THE '.ECO\D FISCAL RESTRUCTURING AND DEREGULATION PROGRAM TECHNICAL ASSISTANCE PROJECT NOVEMBER 10, 1998 Tlhis 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 WVorld Bank authorization.  CURRENCY EQUIVALENTS (Exchange Rate Effective October 1, 1998) Currency Unit = Malawi Kwacha (MK) US$ I = MK42.875 MK I = US$0.0233 SDR I US$1.369863 MEASURES Metric System FISCAL YEAR July I to June 30 (as of July 1998) Vice President :C allisto E. Madavo Country Director :Barbara Kafka Sector Manager :Ataman Aksoy Task Team Leader : Ahmad Ahsan  FOR OFFICIAL USE ONLY GLOSSARY OF ACRONYMS ADMARC Agricultural Development and MIarketing Corporation BOP Balance of Payments CAS Country Assistance Strategy CBM : Commercial Bank of Malawi COMESA Common Market for Eastern and Southem Africa ESAF Enhanced Structural Adjustment Facility ESCOM Electricity Supply Corporation i(previously, Commission). GDP Gross Domestic Product GOM Government of Malawi HIAL High Impact Adjustment Lending IBRD International Bank for Reconstruction and Development IDA International Development Agency IDF Institutional Development Fundl IMF International Monetary Fund LDP Letter of Development Policy MDC Malawi Development Corporation MK . Malawi Kwacha MPTC Malawi Posts and Telecommunications Corporation MT : Metric Tons MTEF Medium-Term Expenditure Framework OED Operations Evaluation Department PAR Project Audit Report PCR Project Completion Report PFP : Policy Framework Paper PRP . Permanent Residence Permit PSD Private Sector Development RBM Reserve Bank of Malawi SPA Special Program of Assistance to Low-income Debt Distressed Countries in Sub-Saharan Africa TA : Technical Assistance TEP Temporary Employment Permiit TOR Terms of Reference VAT Value Added Tax This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may nol: otherwise be disclosed without World Ban}c authorization.  MALAWI SECOND FISCAL RESTRUCTURING AND DEREGULATION PROGRAM (FRDP) AND FRDP II TECHNICAL ASSISTANCE Table of Contents I. INTRODUCTION .......................................................1 II. ECONOMIC DEVELOPMENTS AND PROSPECTS ........................................2 Box 1: Policy Reforms Undertaken by the Government Since 1994 .................. 3 III. THE REFORM PROGRAM ......................................................6 A. Improving Public Sector Efficiency .......................................................6 Improving Public Expenditures .......................................................6 Rationalizing Government Functions .......................................................8 Tax Policy Reforms .......................................................9 B. Supporting Growth Through Private Sector Development ..............................9.... 9 Box 2: Policy Reforms Supported by FRDP II ......................................... 10 Privatization ...................................................... 11 Infrastructure Policy Reforms ...................................................... 12 Agriculture Markets and Storage ...................................................... 13 Maize Price and Marketing Reforms ...................................................... 14 Facilitating Temporary Employment Permits ...................................................... 14 IV. IMPACT OF REFORMS ......................................................5 S Box 3: Overview of FRDP II: Instruments, Intermediate Targets and Outcomes ...................................................... 16 V. DESIGN OF CREDIT, IMPLEMENTATION AND DISBURSEMENT ....... 17 Lessons from Operations Evaluation Department Reports and the High Impact Adjustment Lending ........................................... 17 Relationship with the Country Assistance Strategy .......................... 18 Disbursement Procedures and Implementation Arrangements ............. 18 VI. BENEFITS, RISKS AND GOVERNMENT OWNERSIHIP ........................... 19 VII. CONCLUSION ...................................................... 20  Annexes Annex I Matrix of Policy Reforms Annex II Government of Malawi's Letter of Development Policy Annex 1I- I Expenditure Prioritization Targets in the 1998/99 Budget Annex II-2 Expenditure Prioritization/Medium Term Expenditure Framework Preparation Plan for 1998/99 Annex II-3 Expenditure Monitoring and Control Procedures Annex 11-4 Rationalization of Government Functions Annex 11-5 Divestiture Sequence Plan Annex II-6 Implementation Plan for Telecommunication Sector Reforms Annex III Previous IDA Adjustment Operations in Malawi Annex IV : Status of Bank Group Operations in Malawi: IBRD Loans and IDA Credits in the Operations Portfolio Annex V Statement of IFC's Committed and Disbursed Portfolio Annex VI : Malawi at a Glance Annex VII : Malawi Social Indicators Annex VIII : Key Economic Indicators and Key Exposure Indicators Annex IX Balance of Payments Annex X : Procurement and Disbursement Procedures for the FRDP II TA Project Map IBRD No. 29374 The FRDP II credit and the FRDP II TA Project were prepared by an IDA team consisting of Ahmad Ahsan (Senior Country Economist and Task Team Leader, AFTMI), Peter Moll (Country Economist, AFTM 1), Tejaswi Raparla (Research Analyst, AFTM 1), Rose Thunyani (Senior Task Assistant, AFTM1), Elizabeth Adu (Principal Counsel, LEGAL), Steve Gaginis (Disbursement Officer, LOAAF), Jim Smith, Deputy Resident Representative (AFMMW), Maxwell Mkwezalamba (Economist, AFMMW),. Stanley Hiwa (Agricultural Economist, AFMMW), Ahmet Soylemezoglu (PSD Specialist, AFTPI), Arnold Sowa (PSD Specialist, AFTPI), Paul Bermingham (Principal Financial Analyst, IEN), Anna Bjerde (Economist) and Paivi Koljonen (Economist, AFTGI). Peter Miovic (Sector Manager, AFTM2), Gene Tidrick (Lead Specialist, AFTMI), and Shahid Yusuf (Economic Advisor, DECVP) were reviewers. Overall supervision and guidance were provided by Robert Liebenthal (Resident Representative), Ataman Aksoy (Sector Manager) and Barbara Kafka (Country Director).  MALAWI THE SECOND FISCAL RESTRUCTURING AND DEREGULATION PROGRAM CREDIT (FRDP II) AND THE SECOND FISCAL RESTRUCTURING AND DEREGULATION PROGRAM TECHNICAL ASSISTANCE PROJECT (FRDP II TA) SUMMARY Borrower: Government of the Republic of Malawi Guarantor: Not applicable Beneficiary: Republic of Malawi Amounts: SDR 65.7 Million (US$90 Million equivalent) and SDR 1.5 Million (US$ 2 Million equivalent). Terms and Commitment Charge: Standard IDA Terms, with 40 years maturity and I 0-year grace period. Co-financing: Co-financing discussions are taking place with the African Development Bank and the Overseas Economic Cooperation Fund of the Government of Japan. Staff from these organizations participated in the IDA Appraisal mission for the credit. Disbursement: The FRDP II Credit will follow the Bank's new simplified disbursement procedures for structural adjustment credits. Under the revised procedures the Credit will be disbursed against satisfactory implementation of the adjustment program and not tied to any specific purchases. Once the Credit is approved by the Board, and becomes effective the proceeds of the first tranche of SDR 43.8 million will be deposited by IDA in an account at the Reserve Bank of Malawi at the request of the Borrower. The second tranche of SDR 21.9 million will be disbursed after the second tranche conditions on expenditure prioritization, rationalization of Government functions and privatization have been met. The disbursement and procurement procedures for the FRDP II TA project are laid out in detail in Annex X of the text. Objectives: The proposed programs will support policy reforms to accelerate economic growth and poverty reduction and technical assistance to help implement policy reforms. The adjustment credit aims to maintain the momentum of policy reforms launched by Government of Malawi since 1994 by improving public  expenditure management and promoting private sector development. The credit will help to meet the balance of payments financing requirements that Malawi faces this year that have increased due to a sharp fall in export earnings, and to implement policy reforms by maintaining economic stability and mitigating the transitional costs of adjustment. Objectives FRDP II TA Project: FRDP II Technical Assistance Project has been designed to provide necessary technical support, training and equipment to meet three objectives: (i) implement policy reforms, including the medium term expenditure framework, auditing and reviewing the development budget, reforrning expenditure control procedures and systems, and implementing civil service reforms; (ii) evaluate the impact of structural reforms on Malawi's economy, in particular by examining the effects of liberalizing trade and exchange rate policy on manufacturing, and liberalizing agriculture production and trade on the agriculture sector; and (iii) develop the agenda for the next ound of macroeconomic and sectoral policy reforms through research into further constraints to growth. A separate proposed Privatization Technical Assistance Project (US $ 10 million) will provide assistance to implement the privatization program. Government Commitment: The Government of Malawi has a credible track record of implementing policy reforms (see Box 1, pp. 3 of President's Report). The FRDP II credit is primarily based on detailed reforms programs prepared by the Government in the areas of expenditure management, rationalization of Government functions and privatization. Following this, the basis of the legal documents, the Development Credit Agreements has been the Government's Letter of Development Policy which details, in the text and in Annexes all these reforms. This ownership of the design of the program will be publicly affirmed by the Government issuing and disseminating a White Paper (in November 1998) presenting this reform program to the people of Malawi. The Cabinet Committee on the Economy will oversee the implementation of the FRDP II as a key part of its overall economic reform program. This committee will be assisted by a Task Force of officials led by the Ministry of Finance to supervise and to coordinate the implementation of the program. Benefits: The reform program, supported by this credit, will benefit the people of Malawi by leading to accelerated reduction in poverty in two ways: (i) helping to create conditions -- macroeconomic stabilization, improvement in infrastructure and major advances in privatization --for a broad based GDP growth of between 5% - 6% p.a. in the 1999 - 2001 period; this high case scenario ii  should, ceteris paribus, lead to a decline in the poverty head count ratio from 43% to roughly 38% of the population in the next five years; and (ii) by improving the targeting of public expenditures and Government s:rvices towards the poor. Risks: The key risk arises from the possibility that the commitment to policy reforms may be unsteady, especially in the face of approaching elections in May 11999. However, in early 1998, the political economy changed mairkedly as a reconstructed cabinet committee on the economy has now the authority to make and implement key decisions on the economy. Nevertheless, in the run up to the elections these ris:ks will persist: there will be, inter alia, pressures to relax expendliture controls, provide subsidies on inputs and on credits to farmers, avoid difficult decisions in areas such as retrenchment of unqualified civil servants, and sell large assets to non-indigenous persons. However, these political risks are moderated by the GOM's appreciation of the gains that can be obtained through implementing these reforms and by making the people aware of the benefits of these reforms. Government can get credit for welfare improvements from directing public expenditures to goods and services that benelit the poor, and lead to a more equitable distribution of income and opportunities, generating growth and employment through deregulation and private sector development, implementing safety net programs to help the poor such as the starter packs program of 1998/99 that will distribute 0.3% of GDP in input packages to smallholder households, expanding the public works program and the smallholder credit, and providing a temporary subsidy to Government sales of maize to ease the burden of a sharp increase in prices. The second risk arises from the lack of capacity to implement this multi-pronged operation. This risk is being addressed by providing technical assistance and by setting up a high level Government body to oversee the implementation of these reforms and mobilize necessary resources for doing so. The final set of risks are posecl by exogenous shocks such as the effects of drought or large terms of trade losses, such as those between 1992 and 1994, and 1998, on savings, investment and growth. The risks posed by these exogenous shocks are best addressed in the long run by economic growth, employment and diversification through implenmenting structural reforms that are supported by this credit. In the short run the disbursements from this credit will provide the economy a buffer against these shocks and thereby help the Government maintain the course of reforms. ...  REPORT AND RECOMMENDATION OF TH[E PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 65.7 MILLION (US$ 90 MILLION EQUIVALENT) TO THE REPUBLIC OF MALAWI FOR THE SECOND FISCAL RESTRUCTURING AND DEREGULATION PROGRAM (FRDP II) AND SDR 1.5 MILLION (US$ 2 MILLION E]QUIVALENT) FOR THE SECOND FISCAL RESTRUCTURING AND DEREGULATION PROGRAM TECHNICAL ASSISTANCE PROJECT (FRDP II TA) I. Introduction 1. This memorandum seeks approval to extend a SDR 65.7 million (US$ 90 million equivalent) structural adjustment credit to Malawi in support of policy reforms to accelerate economic growth and poverty reduction, and a Technical Assistance Project of SDR 1.5 million (US$ 2 million equivalent) to help implement poliicy reforms.' The credit aims to maintain the momentum of policy reforms launched by the (Government of Malawi since 1994 by improving public expenditure management and promoting private sector development. The credit will help to meet the balance of payments financing requirements that Malawi faces this year that have increased due to a large fall in export earnings, and to implement policy reforms by maintaining economic stability and mitigating the transitional costs of adjustmnent. 2. The proposed credit will support Government's policies to reduce poverty in three ways. First, by creating the policy environment for higher private sector investment and efficiency, leading to a sustained and diversified growth of GDP of around 5 to 6 % per annum -- without which there may be no reduction in poverty in Malawi.2 Second, by supporting Government policies to redirect expenditures into social sectors and programs that benefit the poor. The targeted growth rate combined with a better targeting of public expenditures to the poor -- i.e. a more equitable distribution -- should lead to an accelerated reduction of poverty. Third, the financing of the credit will help Government to maintain macroeconomic stability in a year affected by a large terms of trade shock (a 28% drop in tobacco prices) and a US$ 60 million (over 3% of GDP) cut in export earnings. 3. This credit comes at a critical period, when Malawi is at a crossroads: it can deepen reforms launched in 1994 which led to economic stabil:ity, and liberalized the economy, especially in agriculture, with impressive results (see Box 1, pp. 3). Or Malawi can slip into a costly period of instability and lost growth, as it did in the second half of 1997 and early 1998. A broad range of key policy reforms undertaken by the Government in recent months (see Box 2, pp. 10) underscores the Government's renewed commitment to deepen structural reforms and sustain growth and poverty reduction. ' The implementation of these policy reforms will also be supported by technical assistance provided from other sources such as the Institutional Development II credit ($22 million), and the proposed Privatization TA credit (US$ 10 million). 2 The study, "Accelerating Malawi's Growth" (September 1997) showed that, with unchanged income distribution and population growth, Malawi needs an annual growth rate of GDP of 5.3% to reduce the absolute number of people living below the poverty level.  4. Malawi went off-track its macroeconomic program in December 1997, during a period of uncertainty and large expenditure overruns. In March 1998, Government appointed a new economic management team with wide authority to design and implement stabilization and structural reforms. Subsequently, in May 1998, the Government and the IMF agreed on a Staff Monitored macroeconomic program that, after satisfactory implementation, will now lead to the renewal of the third year arrangement of the current Extended Structural Adjustment Facility (ESAF). The staff papers recommending approval of this arrangement will be issued to the IMF Board in early December 1998 for their Board meeting in mid-December 1998. Given that Malawi is implementing a satisfactory medium term macroeconomic framework and has started implementation of wide ranging structural reforms, and that there is a serious foreign exchange shortage that can destabilize the economy over the medium term unless quick balance of payments support is provided, this adjustment credit is being submitted for consideration by the Bank's Board of Directors two weeks ahead of the Fund Board's consideration of the third year ESAF Arrangement. II. Economic Developments and Prospects 5. In the first 15 years after independence in 1964, Malawi's GDP grew at an average annual rate of nearly 6%. But the fruits of this growth were poorly distributed3, and growth itself was narrowly based on estate owned agriculture, and large public and private Table 1: Some Economic and Social Indicators conglomerates protected by pervasive barriers Economic Indicators Malawi SSA to entry. As a result, at the end of this period Per capita income (USS) 220 490 Malawi emerged with one of the worst sets of Population (millions) 10.3 583 human welfare indicators in the world [See of which urban % 13 31 Table 1 and Annex VII for datal. Then, Agriculture as % of GDP 32 24 starting in the late 1970s, Malawi suffered from Social Indicators 13 30 a series of exogenous shocks -- high import Life expectancy (years) 43 52 costs due to disruptions in trade routes, oil Adult illiteracy (%) 43 44 price shocks, the influx of refugees from Infant mortality rate (per 000) 133 91 Mozambique, and droughts -- that disrupted Child mortality rate (per 000) 225 157 Access to safe water (%) 54 47 even this pattern of growth. Since 1981, Primary enrollment (%) 81 75 Malawi has been implementing policy reforms, Male 84 82 supported by successive adjustment credits, to Female 77 67 stabilize and restructure its economy, but with HIV prevalence little sustained success. These policy reforms among sexually active adults(%) 13 na and .Iwomen in urban antenatal 3 1 na mainly aimed to stabilize the economy, and care clinics(%) liberalize international trade, investment licensing and financial markets, while neglecting important structural regulatory constraints and entry barriers in product and factor markets. The results were poor, and the growth rate of GDP during the 1981 -1994 period was 2.4% per annum, well below the annual population growth rate of 3 %. 3 Malawi's Gini coefficient of 0.62 makes its income distribution among the worst in the world 2  Box 1: Policy Reforms Undertaken by Government Since 1994 Fiscal, External Sector and Financial Policy Reforms * Implementation of stabilization policies that have brought down fiscal deficits (before grants) from 28 % of GDP (1994/95) to 8% of GDP (1996/97), before increasing it again to 12% in 1997/98. * Reforms in tariff and surtax policies, that have reduced average weighted statutory tariffs from 19% 1994 to around 14 % currently. Surtax refonns extended the base and rationalized rates. * In expenditures the share of education and health sectors increased lFrom around 14% of expenditures to 26% in 1997/98. A medium term expenditure framework was introduced to manage expenditures. * The exchange rate was floated in 1994 and Malawi attained current account convertibility in 1995. * A treasury bill market was successfully launched avoiding inflationary borrowing from the Reserve Bank. * The stock exchange was opened in 1996. * Export processing zone (s) were introduced, while the processing oiF export duty drawbacks was improved to increase incentives for exporters. There is now a fledgling export oriented manufacturing sector in garments and cut flowers. Civil Service Reforms * The ci-il service structure has undergone significant changes as 20,1300 new teachers were appointed in place of 20,000 other temporary employees who were laid off. * A Civil Service Reform Action Plan was adopted and is now being implemented. Under this, the common services cadre was abolished enabling better accountability and management in professional services. - The completion of the first phase of the Functional Reviews of the Government and rationalization of Government ministries was completed in 1996. Based on that the number of Ministries have been reduced from 27 (June 1997) to 19 (March 1998). Agriculture - Restrictions on smallholder production of tobacco were removed by amending the Special Crops Act * Restrictions on private trading in fertilizer, seeds and burley tobacco were removed. - Subsidies on fertilizer were removed. * The agriculture financing system was revamped by introducing the Malawi Rural Finance Company on a sound financial basis in place of the Smallholder Agriculture Credit Authority that went bankrupt. Transport, and Private Sector Development * The Malawi Railways a parastatal, previously a big drain on Government finances, was restructured. A new company was formed, and will be transferred to private management as a concession by end- 1998. * The minimum freight charges on domestic transport were eliminated (1996), and imports of second hand transport and equipment were deregulated, leading to more competjition and services. * A Privatization Law was passed (1996) laying the legal foundations and the institutional framework for privatization. Some 25 companies have been privatized. Social Sectors * Primary education was made free in 1994. In response, enrollment increased by nearly a million. * Government has also launched a secondary education expansion program to accommodate the rising number of primary school graduates (1997). * A Social Action Fund (MASAF) is being used to help organize and finance 988 (as of June 1998) community demanded projects and support public works. The communities play a critical role in designing and funding these projects in building classroom, boreholes, clinics, roads and irrigation. * A Poverty monitoring system has been launched to measure changes in the welfare of the people through regular household surveys. 3  6. Since 1994, however, with the advent of new political leadership, the pace of reforms accelerated significantly (See Box 1, previous, for details). Supported by IDA adjustment -- the Fiscal Restructuring and Deregulation Credit approved in April 1996 -- and investment credits, the Government removed restrictions on small-holder production of burley tobacco and other cash crops, liberalized the trading of agriculture outputs and inputs, launched major programs of privatization, civil service reforms and expenditure prioritization, implemented substantial tariff and surtax reforms, and attained current account convertibility. At the same time, large investments in education, health and community development took place. 7. The economy responded well to these reforms. Macroeconomic balances were stabilized as fiscal deficits (before grants) were reduced from 28% in 1994/95 and 15% in 1995/96 to around 8% in 1996/97, mainly through expenditure adjustments. The average annual inflation rate4 fell from 83% in 1995 to 9 % in 1997, interest rates declined and the exchange rate, floated in 1994, was stable as foreign exchange reserves rose to more than four months of imports by end 1996. Growth averaged more than 10 % p.a. in the last three year (1995 - 1997), although around a third of this growth was based on recovery from the 1994 drought. Equally significant, this recent growth has been more broad based and diversified than anytime in the past, and is being led by the small-holder economy and the service sector. Smallholder production of burley tobacco -- the most valuable cash crop produced by Malawi - - has increased threefold since 1993. This has injected US$ 185 million in earnings in the last two years into the smallholder economy, and generated growth of trading, markets and other secondary activities in the countryside. A non-traditional exports sector has emerged, exporting garments and cut flowers and has grown by 80% in US Dollar terms between 1995 and 1997, albeit starting from a small base. 8. But macroeconomic performance slipped again in the second half of 1997 mainly as a result of loss in expenditure control. A higher than budgeted wage bill, excessive travel related expenditures, and a shortfall in income tax collections resulted in an increase in the 1997/98 fiscal deficit to 12 % of GDP, while the primary deficit' -- targeted to be zero -- was 4.6% of GDP. At the same time gross official foreign exchange reserves declined to 2.1 months of imports of goods and non-factor services at end-1997 and the exchange rate depreciated by nearly 60% in 1998. This large depreciation reflected the correction of the previously misaligned rate, terms of trade losses, depreciation in the currencies of major trading partners as well as lack of confidence in the private sector on the Government's commitment to stabilization and reforms. 9. In addition to continuing problems in expenditure management, Malawi's growth prospects confront deep-rooted structural problems, vulnerability to shocks and an overall inhospitable climate for the private sector. This is reflected in low private fixed investment and gross domestic savings rates which have averaged around 4 % (gross private investment including inventories was more than 3% of GDP) and 1.5% of GDP6 respectively, in the last 4 The change in the average annual CPI index over the previous year's average CPI index. 5 Primary deficit is defined as overall deficit less interest payments and foreign financed development expenditure: (All Expenditure - Revenues) - (Interest Payments + Foreign Financed Development Expenditures). 6 This refers to only the measured investrnent which probably underestimates investment in smallholder dwellings, the purchase of transport (e.g. the large sale of bicycles in the countryside) and other such activities. 4  two years.' Crowding out by high Government consumption and domestic borrowing (5% of GDP in 1997/98), a shallow and oligopolistic financial sector, deteriorating infrastructure, the dominance of inter-locking public sector ownership in production, trade and finance, and bureaucratic red tape all deter private investment and savings. Malawi's economy also remains highly vulnerable to shocks: as in 1998, there were also large income losses between 1992- 1994 (cumulatively 10% of GDP) due to deterioration in terms of trade. Poor rainfall in 1997 led to a 23 % drop in maize production -- the main staple. Hence a key task clearly is to accelerate the diversification of the economy to make it less vulnerable to such shocks. 10. As noted, Government launched wide ranging reforms in 1995 and 1996 supported by the last IDA adjustment credit, the Fiscal Restructuring and Deregulation Program. This new credit will complement the previous adjustment credit by focusing more on reforns to promote private sector led growth in the non-agriculture sector, through accelerating privatization and infrastructure development thereby diversifying the economy and making it less vulnerable to shocks. Alongside, public sector management reforms will increase the focus of Government functions and expenditures on public goods and services, and strengthen expenditure monitoring and control systems. 11. This program of policy reforms is also underpinned by a strong stabilization program that is expected to be supported by the renewal of the IMF ESAkF program. Under this program GDP growth, expected to decline to 4% in 1998, is projected to increase to around 5% in 1999 and even higher thereafter as the economy adjusts to exchange rate depreciation and the export price shock of 1998. The primary fiscal balance in 1998/99 is expected to improve by around 4.5 % points of GDP, compared to 1997/98, even though the budget accommodates Government expenditure for the May 1999 elections, an increase in development expenditures and provision for a temporary subsidy on maize sold from Government stocks as a social safety net measure 8. The program includes a large repayment of domestic Government debt (by over 6% of GDP in 1998/99), which will ease pressure on interest rates and the exchange rate, an increase of external reserves to more than 3 months of imports of goods and non factor services by end of 1998 and to around 4 months by end-1999, and a tight monetary policy -- with declining net domestic assets in 1998 -- which still accommodates a real increase of credit to the private sector. Inflation is expected to average around 30% in 1998 and then decline to around 25% in 1999 as the effects of the 1998 exchange rate depreciation is expected to cause high inflation in the first half of 1999. The program is also expected to supported through 1999 by an increase of external assistance to around US $ 340 million in 1999 both through lending and grants. Malawi's external debt burden is high vhich makes it a severely indebted low income country. However, debt sustainability anal,ysis carried out for the last CAS (August 1998) have confirmed previous findings that M:alawi's external debt position is expected to improve over the medium term, thereby making it ineligible for the HIPC initiative. Given Malawi's borderline situation, Malawi's debt position will be continuously monitored. The next debt sustainability analysis will be undertaken before end-1998. 7 Private total investment has averaged around 8% in the past three years. However, this includes nearly 3% of inventory changes. ' The landed price of maize imports has increased by nearly 100% in 1998/99 mainly because of depreciation. The maize subsidy thus cushions maize buyers by allowing more graduail increase in the price of maize in one year. 5  III. The Reform Program 12. The proposed credit supports structural reforms in two main areas: (a) public sector reforms to improve the quality and management of public expenditures, restructure Government functions and the civil service in line with priorities; and (b) private sector development reforms through privatization and improving infrastructure policies (Box 2, p. 10 provides a full list of the policy reforms undertaken under this credit). A complementary package of investment operations and technical assistance is designed to help implement these measures and longer term institutional reforms [See Annex I]. These reforms are based on consultations with stakeholders during the preparation missions and discussions on the August 1998 Country Assistance Strategy. 13. The main analytical underpinning of the credit has been provided by the study, "Accelerating Malawi's Growth" (September 1997). This study concluded, inter alia, that a wide range of policy reforms was needed to promote high investment and growth rates including (i) good fiscal management, i.e. keeping budget deficits low, avoiding domestic financing of deficits, and prioritizing expenditures to ensure adequate funding of key social sector items; (ii) improving land policies to encourage higher utilization of estate lands through facilitating sale and sub-lease arrangements, streamlining land transfer and titling requirements; (iii) improving infrastructure services and inviting private sector participation in infrastructure; and (iv) increasing the supply of industrial land sites and streamlining procedures for the approval of employment of skilled expatriate workers. The proposed reform program focuses on some of these key recommendations: improving expenditure management, accelerating privatization and private sector development, and improving infrastructure. A. Improving Public Sector Efficiency: Expenditure Policy Reforms, Rationalization of Government Functions and Tax Reforms. 14. Improving Public Expenditures: Improving the quality and management of public expenditures is among the most important challenges facing Malawi. A significant positive shift in public expenditures has taken place in favor of the social sectors in Malawi as the share of education and health increased from 14% of all aggregate expenditures in 1993/94 to a planned 29% in 1998/99. As a result, the share of Malawi's expenditures in social sectors compares favorably with many other countries. Hiowever, public expenditures have continued to be a problem in three respects. 15. First, public expenditures and functions have been thinly spread over too many activities. Given existing trends, recurrent expenditures are expected to be 20% less than requirements in 2005 even after assuming that non-essential areas are excluded. Critical expenditures on public goods (such as road maintenance, which received only 40% of its required expenditure in recent years) and key social sector programs where there are strong externalities -- such as primary education, and primary health care programs -- have been inadequately funded. The full implementation of the Government's secondary school 6  expansion program would require that education's share of the recurrent budget rise from 23% at present to nearly 40% in the next three years, if cost recovery is not improved. 16. Second, as there will be probably be a cut in the goods and service budget in real terms in the 1998/99 fiscal year, compared to 1997/98, it becomes even more important to prioritize expenditures.9 Without prioritization, such expenditure cuts can become unsustainable and damaging. Third, weaknesses in prioritizing the budget have been compounded by poor expenditure monitoring and control procedures. As a result, actual expenditures deviated sharply from budgets, as in 1997/98 when travel and travel related expenditures were 50% higher than budgeted in the first nine months of the fiscal year, while expenditures on teaching and learning materials were only 40% of what had been budgeted. 17. Government has used the Medium Term Expenditure Framework (MTEF) -- introduced under the FRDP credit, to prioritize expenditures in the last three years. First introduced in the planning for recurrent expenditures only in four ministries in 1996 and then gradually extended to other Ministries, the MTEF introduced a process of strategic thinking under which key goals of the Ministries were defined and mapped to programs and sub-programs. The costs of these programs were to be estimated and prioritized within the overall resource envelope depending on their relevance to the objectives. This exercise was to provide the basis for activity based budgeting and prioritization of expenditures based on the importance of these activities. All these steps represent important advances. 18. However, the MTEF process was undermined in the past by some serious weaknesses in implementation including: (i) lack of involvement of senior managers -- both Ministers and civil servants; (ii) lack of clear decisions on inter-sectoral and intra-sectoral allocations based on explicit choices and trade-offs under which expenditures in non-essential items are reduced sharply or completely cut providing room for more expenditures in priority areas; (iii) lack of clearly defined and prioritized strategies, programs and outputs of Ministries and the costing of such programs and outputs; (iv) delays in preparing and forecasting the sectoral allocations and indicative ceilings in a timely manner; and (v) failure to effectively integrate the development budget and the programming of aid resources into the MTE,F budget. As a result, the MTEF turned into more of a pro forma accounting exercise than a strategic resource allocation plan. 19. The Government is now addressing these problems. The MTEF has been made comprehensive and integrated with the budget process. Two rounds of expenditure prioritization for the 1998/99 budget increased allocations of expenditures on current non- wage expenditures for agriculture (by 22% over previows year), health (24%), education (49%), and police services (23%) sectors. The expenditure on road maintenance has been increased sharply by over 100% and is expected to meet around 75% of road maintenance requirements. At the sub-sectoral level, allocations have been increased or maintained in real terms for high priority items such as provision of teaching and learning materials in primary and secondary education, drugs, preventive medicine progrems, water and sanitation, and road maintenance; [Annex II. 1 of Letter of Development Policy (LDP) shows details of expenditure This large cut arises from the need to accommodate expenditures on the national and local Government elections that will take place in May 1999, and an increase in the wage bill of more than 20%. 7  prioritization]. At the same time, non-essential public expenditures in all other sectors, and especially in foreign affairs, works,. office of the Vice President, and other administrative departments have been reduced or eliminated. In addition, the Government has introduced clear procedures that engage both the Cabinet and senior civil servants in preparing the 1999/2000 MTEF through prioritizing programs, costing them and allocating resources in line with priorities and within indicative ceilings that are provided early, and integrating development and recurrent budgets in a consistent manner [See Annex 11.3 of LDP for details of the medium term expenditure framework implementation plan]. 20. Alongside expenditure prioritization, new expenditure monitoring and control procedures have been introduced to ensure that actual expenditures are allocated as budgeted unless explicitly sanctioned by approved virement procedures [See Annex II.2 of Letter of Development Policy for details of new expenditure monitoring and control procedures]. Under the new system, monthly expenditure data from Ministries, especially on core programs and major areas of deviation, are received and distributed to the Special Cabinet Committee on the budget and the Finance and Audit Committee of Principal Secretaries by the 25th of the following month to identify, correct or approve deviations (if expenditures are more than 10% above or 25% below pro-rated budgeted levels). There has also been agreement on reporting arrangements between the Government and the World Bank on key targets. In the area of expenditure controls, Government has issued clear instructions to enforce virement rules and punitive measures against violators. Alongside, a circular has also been issued notifying that all Government procurement will be done on a cash basis. Lastly, and most significantly, the Special Cabinet Committee on the Budget has been made responsible for reviewing all requests for extra-budgetary expenditures -- the source of most expenditure overruns in the last year -- and approving them only after financing from expenditure cuts elsewhere or additional resources have been explicitly identified. 21. Rationalizing Government Functions: Rationalizing government and civil service functions in line with the new more focused definition of the role of the Government is another key area in need of reform, and one directly related to expenditure prioritization and government efficiency. The problem in Malawi is not so much with the size of the civil service, but more with the breadth of its functions and its composition. There are 120,000 civil servants in Malawi (population: 10.6 million) of which some 55,000 are teachers, health workers and police personnel. However, lack of focus in Government functions results in understaffing in priority areas (e.g. nurses, teachers and police), but overstaffing and wage compression in general. Lack of clear job descriptions and accountability, inadequate linkage between performance and career path, inadequate salary levels and a compressed salary structure, and the lack of adequate training of the civil service all lead to deteriorating efficiency and morale. 22. The Government has been undertaking civil service reforms since 1995, under which the composition of the civil service has changed significantly as 20,000 temporary employees and industrial class workers were retrenched and replaced by school teachers. Under the preceding adjustment program, the FRDP I, the Government prepared a Civil Service Reform Action Plan that is now being implemented. Accountability of civil servants has been increased by eliminating the common service cadre, and establishing clearer, specialized career 8  paths within Ministries. Some 3,300 civil servants have been discharged in the past two years as a part of the rationalization of the civil servants. A civil service salary and a job evaluation study is to be completed by December 1998 to prepare for clearer job definitions and civil service salary reforms and wage decompression. The number of Ministries has been consolidated from 27 to 19, though without significantly adjiusting the size or composition of the civil service. Consequently, the effectiveness of this reduction has been limited. 23. Government is now undertaking a program of eliminating, privatizing and outsourcing functions, agencies and departments. Progress in this area has been held up by delays in completing detailed functional reviews of Ministries (a condition of rationalizing four Government services was waived before disbursing the second tranche of the previous adjustment credit). But now, based on recommendations from the detailed functional reviews of five major ministries and the overall strategic review of all ministries undertaken in 1996/97, the Government has taken the decision to eliminate, outsource or privatize 47 functions [See Annex 11.4 of Letter of Development Policy] in five major ministries that now employ more than 60% of the civil service. The rationalization of 30 of these functions is expected to be carried out by end-March 1999. The civil service composition and deployment will also change through a program for the separation and recruitment of civil servants in line with priority functions. The budget includes provisions for separation benefits. 24. Tax Policy Reforms: Government has continued tariff and surtax policy reforms to increase efficiency of the tax system while protecting revenues. Tax policy -- especially high taxes on raw materials, intermediate and capital goods comb:ined with low taxes on final goods from COMESA countries and other countries with which Malawi has bilateral agreements -- is routinely cited by the private sector as among its top constraints. There has been steady progress in this area as average weighted tariffs have decreased from 19% to 14% while surtax (which credits taxes paid on inputs, like a VAT) rates halve been rationalized and the base extended. In April 1998 the Government eliminated all taxes on exports which it first introduced in 1994 as a temporary fiscal measure. 25. In the 1998/99 budget, the maximum tariff rate on consumer goods was reduced from 35% to 30%, while those on selected intermediate goods, raw materials and capital goods was reduced from 10% to 5 %. Combined with the removal of the export taxes, this tariff reduction amounts to major gains in promoting Malawi's internationa]b trade. The revenue shortfall will be partly offset by another extension of the base of the surtax that presently covers only manufacturing and imports. The planned introduction of a well staffed, properly funded and motivated Malawi Revenue Authority is also expected to, improve revenue collection and efficiency of the tax system. B. Supporting Growth through Private Sector Development 26. The 1997 study, "Accelerating Malawi's Growth" concluded that raising private fixed investment would be a decisive condition for increasing GDP growth rates to the targeted 5- 6% range. Second, it also concluded, that while agriculture (:35% of GDP) would be the main 9  Box 2: Policy Reforms Supported by FRDP II Implemented Before Board (December 1998, US$ 60 million equivalent) A. Fiscal Restructuring and Public Sector Management * Established expenditure level targets (specified in amounts and shares of expenditures that have been increased) on key sub-sectoral items in education, health, roads and agriculture sectors in the 1998/99 budget. Identified expenditure cuts to finance expenditures on priority sectors. * Introduced agreed system to monitor (wage, and current expenditure targets on a monthly basis) and control expenditures, including monitoring of priority expenditures by IDA. * Established agreed procedures and timetable for expenditure prioritization under the MTEF in 1999. * Started implementing policy to eliminate, outsource and privatize 47 specifically identified functions (30 by end March 1999) activities, and agencies in the 5 major Ministries, and re-deploy civil service based on the detailed functional reviews. * Reduced tariffs on final goods from 35% to 30%, on selected intermediate goods, raw materials and capital goods from 10% to 5%. Changed all zero rated surtaxes (except on exports) to exempt (in the case of unprocessed agriculture sector goods, and merit goods) or to 20%. B. Privatization and Deregulation * Approved and publicized a National Communications Policy statement. This policy, among other things, specifies the Govemment's intention to offer a stake in Malawi Telecoms to a strategic partner, through an international competitive tender; licensed a second cellular operator introducing competition. * Published the bill laying the proposed legal framework for implementing the approved communication policy, in particular, to create a separate telecommunications regulatory body, to split posts and telecommunications into separate legal entities, and to facilitate further liberalization and private participation in the sector. * Approved a detailed time-bound program, and implementation plan, to bring to point of sale a list of assets (the "divestiture sequence list") including banks, held by MDC, ADMARC, ADMARC Investment Holdings and implementation of the communications policy, in particular finding a strategic partner for Malawi telecoms; * Enacted Electricity Act that establishes independent regulatory body, invites private sector entry into the sector, licenses all electricity producers (including ESCOM) and distributors; corporatized ESCOM under the Companies Act. * Initiated debt restructuring and adjusted tariffs to make ESCOM viable; started reorganization of ESCOM. * Gazetted a clear temporary employment permit (TEP) policy for expatriates such that all TEP applications are responded to within 40 working days. * Announced policies to widen the maize price band for 1998/99 and reforms of maize marketing arrangement. Before Second Tranche (April 1999, $ 30 million equivalent) A. Fiscal Restructuring and Public Sector Management * Implement agreements of the first tranche on meeting agreed public expenditure targets in the first two quarters of the 1998/1999 fiscal year, on public expenditure monitoring and control procedures, and preparing the MTEF. * Implement the rationalization of 30 Government functions as per agreed timetable. B. Privatization and Deregulation * Implement agreed action plan for bringing to the point of sale government's interests in at least 15 enterprises. * Prepare privatization/commercialization program for ADMARC. * Implement agreed plan to reform telecommunications sector, as per first tranche (i.e. enact communications law, appoint investment bankers/consultants to secure strategic partner for Malawi Telecoms). * Review Electricity law, in line with agreement with IDA, to establish clear procedures for licensing, tariff rate adjustment mechanisms that provides adequate incentives to private investors and establishes autonomy of electricity council from the Government. * Finish review of financial sector regulatory framework to identify reforms to strengthen and unify regulatory framework, restructure and privatize the financial sector, and issue guidelines for the privatization of the two main commercial banks - on the basis of the study agreed to in the first tranche. 10  source of growth in the near term, growth would have to be driven by manufacturing and other non-agricultural activities in the medium term and beyond. 27. Achieving these objectives will be a significant challenge, as private sector performance, especially in the industrial sector, has been weak, and measured private sector fixed investment has been virtually stagnant since 1992 due lo several factors, as noted earlier: (i) the continued macroeconomic instability of the last few years that has crowded out private investment, created price and exchange rate instability and generally signaled an unstable economic management; (ii) the continued presence and dominance of public or semi-public parastatals that control most of the economy through their size, inter-locking ownership in production, trade and financial sectors; (iii) inadequate and deteriorating public sector infrastructure, especially in telecommurnlcations and power; (iv) regulatory obstacles to the supply of key factors of production such as skilled labor and serviced industrial land sites;(v) the inefficient utilization of land in estates and inadequate land husbandry due to inequitable and unclear landholding rights, and (vi) interventions in the maize markets through large scale public sales at below market prices, taxing producers and maize traders. 28. The reform program supported by this credit addresses some of these areas through: (i) reducing fiscal deficits and eliminating domestic deficit financing, such that it can "crowd in" the private sector; (ii) implementing a privatization program including the shares of major commercial banks; (iii) preparing reforms in the financial sector regulatory framework that can meet the needs of a more diversified and privatized financial sector; (iv) improving infrastructure services through commercializing and corporatizing operations and inviting private sector investment; and (v) promoting agricultural production and trade through a more liberalized maize pricing policy. Problems on the supply of industrial land sites and land reforms will be addressed separately by the proposed private sector development project and reforms currently being prepared by the Presidential Commission on Land Reforms. 29. Privatization: Private sector development in Malawi has been constrained in the generation of new markets, capital, technology, and management partly because of the dominance of parastatal companies. While public sector parastatals account for around 20% of GDP, their influence is greater because of the oligopolistic nature of the formal sector in Malawi and the integration of these firms in inter-lockiing ownership of other firms in manufacturing, agriculture, trade, transport and finance. At present, some 100 wholly or partly public sector owned banks, transport companies, utilities and industries (in grain processing, textiles, chemicals, tobacco, tea, leather, building, and packaging) maintain a dominating presence in non-agriculture economic activity in Malawi. In the case of the financial sector, Government owns around 70% of all assets, directly or indirectly through its ownership of public holding companies such as ADMARC Holdings and Malawi Development Corporation (MDC). Interlocking ownership structures have resulted in the two dominant commercial banks, the National Bank and the Commercial Bank, which account for more than 90% of all banking sector assets, being controlled by Government, ADMARC, the MDC and the quasi-private PRESS corporation. Predictably, the level of efficiency of the financial sector -- measured by interest rate spreads and the limited range of financial instruments -- is relatively low, while profit margins are high. II  30. In 1996, the Government embarked upon an ambitious privatization program, executed by a Privatization Commission, but with modest success so far. Some 25 companies have been partially or fully privatized in the last two years. Nevertheless, compared to some other countries in the region -- such as Ghana, Uganda, and Mozambique -- the pace of privatization has been slow and halting. While the Privatization Act has laid a clear legal basis, there is need to accelerate the implementation of the privatization program. Moreover, until recently, the utilities, agriculture and financial sectors activities have been excluded. In the case of the financial sector, privatization is further complicated by the need to review and reform, as required, the regulatory framework in order to ensure that prudential standards meet the needs of the changing landscape where four new private banks have entered and the two main banks are being wholly privatized. 31. Under the FRDP II program the Government has accelerated the pace of privatization by approving (in August 1998) and starting to implement a privatization plan, the "Divestiture Sequence List" of assets, held by Government directly and indirectly through MDC and ADMARC HoIdings'