Malawi - Second Technical Assistance Project

Document of The World Bank FOR OMCIL USE ONLY Repout No. P-3662-AI REPORT AND EO NDIO OF TE PRESIDENT OF TUE T N BANK FOM RECOSTRUCTION AND DEVELOPENT ON A PROPOSED CREDIT OF SDR 1.4 MIL2LION TO THE REPUBLIC OF MUALWI FOR A SECOND TECECAL ASSISTACE PROJECT NOVEMBER 29, 1983 - This d_cinet has a restricted distribution and may be used by recipients only in the performance of their offical duties. Its contents may not otherwise be disclosed without World Bank authorization  CURRENCY EQUIVALENT C,urrency Units Malavi Kvacha (MK) and Tambala SDR 1.00 MK 1.3577 USSU.Oo - MK 1.25 MK 1.00 US$.80 WEIGHITS um MEASURES 1 foot (ft) 0.305 meters (a) 1 mile (mi) - 1.609 kilometers (km) 1 square mile (mi2) 2.590 square kilometers (km2) 1 ton (t) - 0.907 metric tons (m ton) (As the malavian KRacha is officially valued in relation to a basket of the currencies of MalawiTs trading partners, the USdollar/Malawian Kwacba exchange rate is subject to change. Conversions in this report were made at US$1.00 = K 1.25.) GLOSSARY OF ABEVIAIONS ADMARC Agricultural Development and Marketing Corporation AfDB = African Development Bank CCDC Capital City Development Corporation DRIMP District Roads Improvement and Maintenance Program DSB Department of Statutory Bodies EDF = European Development Fund EPD - Economic Planning Division (Office of the President and Cabinet) ERR Economic Rate of Return ESCOK Electricity Supply Commission INDEBANK Investment Development Bank MDC = Malawi Development Corporation MRw = Malawi Housing Corporation KTC - Ministry of Transport and Communications MTI Ministry of Trade, Industry and Tourism MWS Ministry of Works and Supplies NRDP = National Rural Development Program ODA Overseas Development Adminfstration OILCOb! Oil Company of Nalswi PGL - Press Group limited PVHO - Plant and Vehicle Hire Organization TMA - Tobacco Research Authority GOVERNMENT OF MALAWI FISCAL YEAR April 1 - March 31  FOR OMCIAL USE ONLY REPUBLIC OF MALAWI SECOND TECHNICAL ASSISTANCE PROJECT CREDIT AND PROJECT SUMMARY BORROWER: Republic of Malawi AMOUNT: A development credit of SDR 1.4 million (US$1.5 million equivalent) TERMS: Standard PROJECT DESCRIPTION: The proposed pro,ect supports the related structural adjust- ment credit which is being submitted separately. It alms at assisting the Government in achieving its goals of improved energy planning and coordination, substantially reducing its consumption of fuelwood, improving its pricing of power and industrial commodities, strengthening the debt and financial management capabilities of the Ministry of Finance and the agricultural Development and Marketing Corporation (ADMARC) and in carrying out its structural adjustment program. Specifically, the proposed three year project would finance: (a) an energy economist/planner, consultant services for a power tariff study, in-service and overseas training and office supplies for the newly established Energy Unit in the Economic Planning Division (EPD); (b) vehicles, operating expenses and engineering and consulting services for a pilot fuelvood savings program for the Tobacco Research Authority (TRA); (c) consultant services to examine price controls for industrial commodities; (d) a financial controller and fin- ancial analyst to be seconded to ADMARC; (e) consultant sup- port, equipment and in-service training for the Debt Manage- ment Unit of the Ministry of Finance; and (f) consultant services for other studies needed to carry out the structur- al adjustment program. Overall responsibility for project execution and monitoring rests with the Ministry of Fin- ance. The proposed project would be implemented by EPD, the Electricity Supply Commission (C..COM), TRA, ADMARC, and the Ministry of Trade and Industry. As a result of tie project, Malawi would have developed a medium term energy investment plan which addresses its major energy problems, a fuelwood savings program to reduce the level of wood consumption by 40 percent by 1990, a revised power tariff structure reflecting the long run marginal costs to the economy of meeting the demand for electricity in Malawi, a phased program for decontrolling industrial prices, and an improved system of financial and debt management. This documen has a restrited distributon and may bc used by rcipents only in the orfortmance of their official duties. Its contents may not otherwise be dislosed without World Bank authorization  - II - Risk: The most important risk is one inherent in all technical assistance projects of this kind, namely, that expatriate staff may not become fully integrated into the local system, and that their relations with Malawian personnel may not be as effective as required to fully achieve the objectives of the project. The other major risk is that delays may occur both in the execution of the project and in follow-up of the recommendations to be put forward. Appropriate steps have been taken to reduce this risk by: (i) early identification of most of the technical assistance personnel by the Government in consultatioa with the Association; (ii) identifying and actively involving project counterparts in study design and implementation; and (iii) agreeing with Government on a timetable for exchanging views on follow-up of the studies.  - iii - Estimated Cost Local Foreign Total - $US '000- Assistance to EPD and ESCOM Energy economist/planner 20 160 180 Consultant services for a power 20 130 150 tariff study Training (incl.travel expenses) 10 40 50 Equipment and support services 10 20 30 Subtotal 60 350 410 Assistance to TRA Equipment (for barn improvements) 15 33 48 Extension (incl. engineer and vehicles) 7 120 162 Research and evaluation (incl. consultant services, equipment and vehicle) 5 160 130 Subtotal 27 313 340 Assistance to Ministry of Trade and Industry Consultant services for price decontrol study 5 40 45 Assistance to ADMARC Financial Controller 10 110 120 Financial Analyst 20 - 220 240 Subtotal 40 320 360 Assistance to Debt Management Unit Equipment 0 60 60 Consultant Services 2 30 32 Training (incl. travel expenses) 0 8 8 Subtotal 2 98 100  - iv - Assistance to Ministry of Finance Consultant services related to the structural adjustment program 15 85 200 Baseline Costs 149 1166 1315 Physical Contingencies - 10 10 Price Contingencies 50 325 375 Subtotal 50 335 385 GRAND TOTAL 199 1501 1700 Financing Plan Local Foreign Total $US '000 IDA - 1501 1500 Government 199 0 199 Total 199 1501 1700 Estimated Disbursements FY84 FY85 FY86 FY87 Annual - 700 600 100 Cumulative 100 800 1400 1500 Economic Rate of Return: N.A. Staff Appraisal Report: None prepared.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND TECHNICAL ASSISTANCE CREDIT TO THE REPUBLIC OF MALAWI 1. I submit the following report and recommendation on a proposed credit to the Republic of Malawi for SDR 1.4 million (US$1.5 million equivalent) on standard IDA terms, to assist in financing a second technical assistance project. PART I. THE ECONOMY 1 2. A report entitled -Malawi: Growth and Structural Change, A Basic Report' (Report No. 3082a-MAI) dated February 8, 1982, was circulated to the Executive Directors on March 9, 1982. Annexes to the report were distributed on June 26, 1981. Annex I contains the basic country data. 3. Malawi is a small (118,500 sq. km), densely-populated (about six million people in 1981) landlocked country in southeastern Africa. Its main assets are moderately fertile soils, good water resources and a climate favorable to crop production. Unlike its neighbors, Malawi has no known substantial mineral resources. Background and Development Strategy 4. When Malawi gained independence in 1964, its economy was charaterized by surplus labor and few natural resources other than a favorable climate and moderately fertile agricultural land. It lacked capital, technology, entrepreneurship, skilled labor and managerial talent. Being landlocked, it has to depend on other countries for access to the sea. 5. Despite these constraints, the Government was determined to achieve rapid, sustained economic development. It has opted for an outward-looking, export-oriented growth based on agriculture and agro-based manufacturing. This strategy has been reflected in the Government's policies toward the agricultural and manufacturing sectors, and toward the roles of domestic and foreign investment. In order to attract foreign capital and managerial skills, government policy has encouraged the establishment of an open, market-oriented ecanomv with the private sector 1 This section is the same as Part I of the President's Report on the Second Structural Adjustment Credit (Report No. P3663-MAI).  as the primary engine of economic growth. The role of public enterprises has been limited to a few key sectors and to that of investment partners with the private sector. Relatively low tariffs and limited use of quantitative restrictions on imports have prevented the emergence of inefficient local import substitution industries so characteristic of many other developing countries. The Governuent has deliberately restrained those forces which would raise wages above market-determined levels (e.g., trade unions, excessive decreed wage increases), thus encouraging the establishment of labor-intensive manufacturing firms and agricultural estates. Moderate wage expansion, coupled with growitig labor productivity in most sectors of the economy, has helped to keep Malawian goods competitive in international trade. Wage moderation has also kept the demand for labor high and the resultant rapid expansion of employment opportunities has helped control the rural-urban income gap and hence the rate of internal migration. 6. Public investment has been intended primarily to support private efforts in the directly productive sectors through provision of essential infrastructure, public utilities and supporting services. The Government has opted for a two-pronged approach to agriculture, involving the traditional smallholder and estate sectors. The smallholder sector has produced the food crops and a limited amount of export crops while the estate sector has concentrated on the major exports of tobacco, tea and sugar (see para. 48 for details). Attaching high priority to public investment in the traditional sector, the Government has undertaken, in the past, a number of regional integrated rural development projects involving provision of infrastructure and agricultural inputs and services. More recently, it embarked on the National Rural Development Program (NRDP), an ambitious 20-year program designed to extend agricultural services to smallholders country wide. The estate sector has been left largely in private hands (except for public enterprise participation in sugar and in some tobacco estates) and the Government has limited its role to that of providing a favorable investment climate. The Government's decision to emphasize directly productive sectors and related economic infrastructure has resulted in relatively slower development of the social services such as health and education until recent years. Evaluation of Past Performance 7. In terms of its stated objectives, Malawi has an impressive record of accomplishments. Aggregate and per capita real incomes have grown rapidly. Real GDP grew at an average rate of 5.5 percent per annum over 1967-79 and per capita income at about 3.0 percent per annum. Growth in all sectors (except in subsistence production) exceeded 5.0 percent per annum. By 1979, GNP per capita in current prices reached US$190. Over the same period, inflation averaged 9.0 percent per annum.  - 3 - 8. At indepeiadence, investment constituted only 8.6 percent of GDP and domestic savings were virtually nil (0.5 percent of GDP). The little capital formation that took place had to be financed from foreign sources. But since then, the picture has changed dramatically. Between 1967 and 1979, gross domestic investment grew at an average annual rate of 12.5 percent per annum, raising investment's share of GDP from 16 to 29 percent. The domestic resource mobilization effort has been even more impressive. Domestic savings rose from 4 percent of GDP in 1967 to 17 percent in 1979, increasing the share of investment financed from domestic sources to aboutt 60 percent. Owing mainly to government mobilization of foreign assistance but with increasing contributions for private and public enterprise ventures, net foreign long-term capital flows increased from a total of US$66 million over 1967-69 to US$328 million over 1977-79. 9. Over the 1967-79 period, export volume grew at an annual average rate of 4.5 percent while import volume grew at 3.5 percent. Agriculture accounts for some 90 percent of export earnings. Since 1967, agricultural estate production grew much faster than smallholder output and during 1967-79, agricultural exports from estates expanded at 15.0 percent per annum while smallholder exports recorded no growth. Thus the estates' share of agricultural exports increased from 32 percent in 1967 to 65 percent in 1979 and 80 percent by 1981-82. Since estate exports are tobacco, tea and sugar, the concentration of Malawi's exports has increased significantly. 10. The country's favorable export performance can be partly attributed to the policy of moderate wage increases and to growing labor productivity which has kept Malawi's products competitive in the international market. Over the same period, wage employment expanded almost as rapidly as the modern sector as a whole (over 8 percent per annum) suggesting a labor-intensive pattern of growth. Recent Economic Developments 11. Notwithstanding these impressive achievements, the Malawian economy, increasingly dependent on three primary commodity exports, tobacco, tea and sugar, remained highly vulnerable to international price fluctuations. (Production of previously important export crops, particularly cotton, groundnuts and tung oil, declined and worker's remittances, which were an important source of foreign exchange, were greatly reduced.) Since 1974 the country experienced periodic balance of payments disequilibria of increasing severity due primarily to (a) rapid escalation in import prices, particularly of fuel and intermediate and capital goods; (b) cyclical swings in export prices of tobacco, tea and sugar; and (c) significantly higher costs of transport for both exports and imports owing to rising ocean freight charges, port congestion in Mozambique, and disruptions of the overland route.  12. While the Government successfully steered the economy through balance of payments crises in the past, the deterioration in the balance of payments since 1978 has been less manageable. Between 1977-80 Malawi's terms of trade fell by 40 percent. The petroleum import bill more than doubled, raising its share in total imports from 10.2 percent in 1977 to 12.5 percent in 1980. In 1980 and 1981, agricultural production suffered from drouzht. reducine export volumes and necessitating large imports of maize, a commodity in which Malawi had been self-sufficient during most of the 1970s. finally, disruptions of the transport system through Mozambique forced Malawi to use more costly air, or alternarive rail and road routes. As a consequence, Malawi's current account deficit rose sharplv from an average of 8-9 percent of GDP ir the mid 1970s to an average of 20 percent iN 1978-80 before falling to 12 percent in 1981 and 9 percent in 1982. Capital inflows, although increased, did not cover current account deficits and foreign exchange reserves fell from the equivalent of over five months of imports to less than two months between 1977-82. Moreover, in contrast -o past capital inflows which were mainly grants and soft loans, over 50 percent of the 1978-81 borrowings of US$570 million were on aon-concessional terms. As a result, the debt service ratio climbed rapidly from 7 percent in 1977 to 26.3 percent in 1981 and would have been over AV percent in 1982 were it not for a rescheduling of Malawi's debt. 13. Economic growth, savings and investment have declined sharply. GDP growth fell from 5.5 percent in 1979 to only 0.4 percent in 1980 and -0.8 percent in 1981 as virtuallv every sector contracted during the two vear period. Growth was back up to 3.0 percent in 1982 and should be at a similar level in 1983. While domestic savings declined somewhat, investment dropped sharply from 34.3 percent of GDP in 1979 to 21.2 percent in 1981 and 20.3 percent ifn 1982. 14. Malawi's fiscal position also seriously deteriorated. From independence through 1977/78, government expenditures expanded roughlv in line with GDP, and deficits rarely exceeded 7-8 percent of GDP. Subsequently, however, rapidly rising expenditures outstripped revenues and pushed government deficits up to an average of 13.6 percent during 1978/79-1981/82, before falling to 9.4 percent in 1982/83. Government expenditures in these four years averaged around 33 percent of GDP compared to 25 percent in the previous six years. To finance these deficits, the Government resorted to increased domestic borrowing, mainly from the monetary system, and foreign borrowing, partly on commercial terms. Inflationary pressures grew and prices rose at an average rate of almost 13 percent per annum between 1979 and 1982.  -5- Emerging Structural Problems 15. While the primary cause of Malawi's economic difficulties was a serious deterioration in the country's terms of trade and transport cenditions, the crisis also revealed important structural weaknesses in the economy. First, the heavy concentration of exports in a few estates producing agricultural commodities; second, the slow growth of smallholder production for export and the narrowness of the export base; third, the modern sector's dependence on costly imported oil, and the progressive depletion of domestic fuelvood -esources; fourth, the deteriorating financial position of public enterprises; fifth, the budget deficits described earlier (para. 14); sixth, a growing imbalance between government recurrent and capital expenditures; seventh, rigidities in the system of administered prices and wages. 16. Concentration of Exports. Malawi's exports are heavily concentrated on tobacco, tea and sugar produced on estates. Each, unfortunately faces uncertain growth prospects, both in terms of supply and demand. In the first place, the shortage of suitable land will severely limit any increase in output from extending cultivation. Any expansion will have to come largely from higher yields. Moreover, a growing shortage of fuelwood threatens the production of flue-cured tobacco and tea (which requirts wood for drying). In addition, shortage of credit and scarcity of managerial talent in the country are expected to become a serious constraint to any rapid expansion of both burley and flue-cured tobacco. Thie recent sharp drop in sugar prices and the imposition of quotas by the United States has shown the vulnerability of this crop. For the estate sector to recover and expand its foreign exchange earnings, diversifying into other crops is essential. 17. Slow Growth of Smallholder Production. Following a decade of rapid growth, smallholder produced exports of tobacco, cotton and groundnuts have stagnated over the past ten years despite sizeable public investments in smallholder agriculture. While such performance can partly be attributed to limited coverage of past agricultural projects, low producer prices have almost certainly played an important role. A Government and Bank analysis has shown that, on balance, prices paid to smallholders by the Agricultural Development and Marketing Corporation (ADMARC), which handles smallholder crops, have been less favorable than those paid for estate produced crops sold on the world market. Within the smallholder sector, maize and rice prodtuction have been subsidized while production of export crops (i.e. cotton, groundnuts, and tobacco) have been taxed. Incentives for expanding meat, poultry and dairy output, mostly produced by smallholders, also are weak. In addition, the Government's pricing decisions have been ad hoc and frequently arbitrary; since prices were changed infrequently, the resultant quantum jumps, made adjustments difficult for both consumers and producers.  - 6 - 18. Cost of Energy. Malawi is totally dependent on imported petroleum. While imports increased only 8 percent in volume between 1977 and 1980, their cost doubled and as a share of total imports rose from 10 to 12.5 percent. Fuelwood accounts for some 80 percent of the total energy consumed in Malawi. In the rural areas, wood is used for cooking and for curing tobacco and tea. As a result of population growth and expansion in tobacco and tea production, the demand for fuelwood is outstripping available supplies, leading to deforestation and environmental degradation. Thus, the Government faces the task of developing indigenous energy sources in the rural areas and reducing the modern sector's dependence on imported oil (paras. 91 and 92). 19. Deteriorating Finances of the Public Enterprises. As a group, Malawi's statutory boards and public enterprises have functioned well both by providing essential services with reasonable efficiency and by making a contribution to their own investment requirements. However, the financial condition of several has deteriorated since 1978. ADMARC, a government marketing institution for smallholder crops, which has operated relatively efficiently, suffered a substantial loss in 1980 as a result of higher fuel costs, improper crop handling and poor transport planning. Air Malawi suffered large losses on its intercontinental service which had to be terminated at the end of 1979. Domestic tariffs were increased by 60 percent in early 1980 and international charter rates were raised later that year. To reduce losses further, additional tariff increases on domestic and cargo service may be necessary. Malawi Railways finances have been adversely affected by rising fuel costs and transport problems at the ports and on lines through Mozambique. Despite a 1979 tariff increase of 17 percent, the company suffered an operating loss for the first time since 1972 and its overall cash deficit, after debt service and renewal investments, rose substantially. Hitherto financially sound Eleczricity Supply Commission (ESCOM) also began to experience large cost overruns on its Nkula project, primarily as a result of transport difficulties. While annual tariff increases averaging 10 percent from 1979 to 1983, have helped to alleviate the cash deficit, the company was still experiencinf cash flow difficulties and has had to defer some payments on Government d -. The Malawi Housing Corporation (MHC) and Capital City Development Corporation (CCDC) have been channeling Government funds and external loans into housing and construction of the new capital at Lilongwe, and are now experiencing difficulties meeting their mounting debt service obligations out of their low income from rents. MHC recently increased rents for low cost housing by 40 percent but it is not generating sufficient funds even to provide for maintenance. The Malawi Development Corporation (MDC) is a wholly government-owned holding company with interests in agriculture and agro-industry, manufacturing and commerce. Its financial position has  - 7 - steadily deteriorated in recent years, as the liquidity position of its subsidiaries declined with the onset of recent economic crises, and MDC has had to provide more guarantees for its subsidiaries' borrowing. It has also accumulated medium-term debt, borrowed mainly on hard terms to finance equity investments. Given its large interest payments, MDC suffered sizable losses during 1980 and 1981. The deterioration in the performance of these public enterprises is having an adverse impact on the Central Government's budget by increasing the requirements for subsidies or for deferment of debt service owed to Government. In addition, the demand by the public enterprises for new medium-term external credit and for additional domestic borrowing has increased. 20. Although nominally a private enterprise, Press (Holdings) Limited's operations are so large that they have a profound impact on the country's economic life. Press is a holding company with wholly-owned subsidiaries and associate companies in most sectors of the economy, including agriculture, industry, wholesale and retail trade, building and construction, transportation, banking and insurance. Until 1979, Press and its subsidiaries had been consistently profitable, but thereafter, the group's financial position deteriorated rapidly. Press" enormous cash needs have placed severe strains on Malawi's two commercial banks and this led to restricted domestic credit expansion to the rest of the private sector. A good start has been made on resolving Press' financial and operational problems. Given the impact on the country's output, employment and exports, early resolution is imperative. 21. Budgetary Deficits and Underfunding of Recurrent Activities. The Government has generally managed its finances prudently. Revenue increased as rapidly as GDP, the revenue accoun- consistently generated surpluses (since 1972/73) to contribute to development expenditures, and budget deficits have been relatively modest. Since 1978/79, however, the Government's fiscal position has deteriorated. While revenues have increased slightly faster than GDP, recurrent and development account expenditures have grown even more rapidly owing to a rapid expansion of development projects. In addition, there is growing evidence of underfunding of recurrent budget requirements. Control over recurrent expenditures has been tight because of domestic revenue constraints. On the other hand, because of the availability of foreign finance on concessionary terms, capital projects have been relatively easy to finance. Thus, the expansion of government employment and expenditures for goods and services has not kept pace with the growth of capital expenditures. The problem is particularly acute in agriculture (and to a lesser extent in road maintenance and in health). The lack of adequate provision for recurrent operations reduces the benefits originally expected from project investments.  - 8 - 22. Rigidity of Price Controls and Wage Policy. A system of formal and informal price controls has evolved for most domestically manufactured goods in Malawi over the past decade. The Ministry of Trade, Industry and Tourism exercises formal controls over products such as cement, fertilizers and sugar; and items important to low income consumers -vegetable oils, bread, milk, matches and fish. In addition, manufacturers are required to notify and receive comments from the Ministry before raising prices for practically all other manufactured gods. Disincentives created by the system have even grown with increased inflationary pressure. Long delays between price increase applications and approval have adversely affected the financial position of many businesses. Similar delays have characterized granting of tariff increases for the country's principal statutory bodies. 23. The Government has also adopted a system of controls designed to restrain real wage increases. However, the Government's practice of holding down wagaz for long periods and then granting large wage increases has teen destaILilizing for the economy. For example, the minimum wage for urban unskilled workers, which had remained unchanged since 1973, was increased bv 12.5 percent in 1980 and by additional 56 percent in January 1981. (Even with these quantum jumps the minimum wage in 1981 is only three-quarters of its 1973 level in real terms.) PART II. THE GOVERNMENT'S MEDIUM-TERM PROGRAM Z 24. Recognizing these problems, the Government, in consultation with the Bank and the DIMF, formulated a medium-term program covering 1981/82-1985/86 and developed a related technical assistance project. The Government's major objectives for the five years were: (i) a real GDP growth rate of 4.8 percent; (ii) increased diversification of foreign exchange earnings or savings by developing new smallholder and estate crops, accelerating smallholder export crop growth, livestock and forestry industries and expanding agro-business; and (iii) improvement in the financial performance of the Government and public enterprises to reduce dependence on external resources and domestic borrowing and iicrease foreign exchange reserves. 25. The policies for achieving these objectives were incorporated in a comprehensive structural adjustment program which aimed at improving (i) the balance of payments, (ii) price incentives and income policies, (iii) resource management, and (iv) the institutional structure. Specific policy measures were: 2 This text is substantially the same as in Part II of the President's Report on the Structural Adjustment Credit (Report No. 3663-MAI).  - 9 - (i) Balance of Payments. Increased prices for agricultural export crops with periodic reviews; increased recurrent budgetary allocation to the Ministry of Agriculture; review of the efficiency of the agricultural marketing organization; studies of the livestock and tobacco sectors, including diversification of tobacco estates; continued adjustments in energy prices; and increased agro-industrial investment. Uiil Price incentives and tncomes. Government review of the price and wage control system with a view to introducing more flexibility and more frequent adjustments; increased public utility and transport tariffs with closer monitoring and adjustment in the future; studies of the railway and the airline; a detailed plan for implementing economic rentals of housing; and veriodic review of the exchange rate. 'iii Resource Management. Establishment of Mte Department of Statutory Bodies to assist public enterprises in planning and financial management: periodic review of interest rates; steps to increase Government revenue to its historic levels in rteiation to GDP; strengthened control and monitoring of domestic expenditure; improved monitoring and management of public debt; limiting government domestic and foreign borrowing to ceilings agreed with the IMF; a new five-year development program with increased shares for directly productive sectors and social services; a commitment to adequate levels of recurrent financing for kev development ministries. (iv) Institurional Improvement. Establishment of an Investment Coordinating Committee to oversee all major investments; technical assistance to strengthen key planning and budgeting ministries; and rehabilitation of the key public and private sector conglomerates (notably Press Holdings, Ltd.) through studies, improved management and financial restructuring.  - 10 - I-plementation 26. Initially, implementation of the program was uneven. On the positive side, additional funds were allocated to the agricultural sector, agricultural prices were adjusted, public utility tariffs were increased, the Investments Coordinating Committee was established to screen all major investments, a joint energy assessment study was carried out and steps were taken to strengthen the management and the policies of Press. 27. At the same time, however, there were areas where execution was less satisfactory: inadequate expenditure control, delays in adjusting government charges and prices, continued poor performance of many public corporations and lack of public debt management. These combined with continued adverse international developments (rising interest rates and fuel prices, cyclical swings in export prices of tobacco, tea and sugar) and poor weather, led to a serious deterioration in the Government's budgetary position and the balance of payments. As a result, the Government was not able to make its last two drawings in its two-year IMF stand-by. There were also delays in starting the various studies stipulated in the SAL, formal agreement between the Government and Press on principles of restruLturing was slow in coming and the set of agricultural prices chosen emphasized maize to the detriment of export crops. As a result, the Bank delayed releasing the second tranche of the SAL, while continuing discussions with the Government on steps that could be taken to get the adjustment program back on track. After these discussions, the Government agreed to modifications in the methodology of setting agricultural prices, strengthened its ability to monitor and control external debt and agreed on a debt servicing target. The studies stipulated in the SAL began to progress well, the budget for 1982/83 was a realistic one with sufficient resources provided for the major development sectors, and agreement with the Fund on exchange rates was reached. The second tranche was therefore released in April 1982. The Revised Program 28. The growth targets set out in the Government's program two years ago, will not be realized soon. Since then problems with external transport have continued to plav havoc with the country's external trade, the world economy remains more depressed than had been projected and the Governmental system of Malawi has been slow to make decisions and meet the increased demands placed on it. As the Letter of Development Policy (Annex IV of the Second Structural Adjustment Credit) makes clear, the Government will continue to address the structural problems outlined in paragraphs 15-23. In continuing this program, however, some modifications and shifts in emphasis are necessary. Specifically these include:  - 11 - (i) further incentives for export crop production; (ii) continued improvements in institutions dealing with external debt and investment screening; (iii) further work with statutory bodies to strengthen them managerially and financially; Civ) implementation of the agreement on Press' reorganization and debt servicing; (v) further upgrading of the Government's capacity to budget, plan, implement and monitor its programs; and (vi) increased revenues and cost effectiveness which are needed to bring the budget in line. 29. The Letter of Development Policy takes cognizance of these problems and outlines an action program for dealing with them. In this program the Government will build upon the foundation laid during the last two years, shoring up weak points and branching into other areas that have emerged as crucial to a successful adjustment. The program will focus on measures to: (i) increase performance of the productive sectors; (ii) mobilize and manage resources better; and (iii) strengthen key institutions. 30. To increase performance of the productive sectors, more attractive prices, better marketing operations and improved procurement and distribution of fertilizers will provide incentive for smallholders to raise their output, especially for export. For the estates, steps will be taken to help them upgrade their management, have greater access to credit and diversify their production. In the industrial sector, emphasis will be on relaxing the present system of price controls. 31. To improve resource mobilization and management, the Government is committed to increasing revenues proportionate to GDP, emphasising non-tax sources, to raising the efficiency of capital use through a solid public investment program, and to expanding the parastatals' profits through improved policies (including pricing) as well as better management. The work begun under the first SAL in strengthening the Government's expenditure control, foreign debt management, and planning and budgeting capabilities will be continued, as will monitoring of recurrent allocations to key developmental agencies. The Government also will take steps to reduce the current high costs of its social services in housing, health and education, raise user charges and eliminate or minimize subsidies. Agricultural subsidies have been examined too, and a phased program of eliminating them developed.  - 12 - 32. Strengthening Key Institutions continues to be an important part of the Government's action program. Toward this end, implementation of detailed action plans - produced from studies for restructuring ADMARC, MDC and Press Holdings will continue. In addition, the program calls for improving the management capacities of other key parastatals and the Government, particularly the Economic Planning Division of the Office of the President and Cabinet (EPD). 33. Economic Framework. The revised program has been set in a general macro-economic framework for the 1983-87 period, which projects an annual average growth in GDP of 3.4 percent versus 4.8 percent envisaged two years ago. As discussed above, given continuing unfavorable conditions externally and the Government's inability to move as quickly as originallv anticipated, the revised figure probably is a realistic target for GDP growth. Sectorally, the framework projects agriculture growing at a yearlv average of 3.4 percent, industry at 3.7 percent and the rest of the economy at 3.& percent. Table 1 below sets out our estimates. Table 1: Development of the Malawian Economy with and without Structural Adjustment Policies With Without Structural Structural Indicator Adjustment Adjustment Growth of GDP(Z) 1983-87 3.4 2.5 Agriculture 3.4 2.4 Industry 3.7 2.6 Export Growth 1983-87 5.5 4.0 Primarv 5.5 4.0 Other 5.0 4.0 Resource Gap 1987 $105.0 million $120.0 million Current Account Deficit 1987 $152.0 million $175.0 million  - 13 - 34. One key to attaining these growth rates is Improvement in the export performance, particularly that of agricultural products. After examining the potential for every major export category, a 5.5 percent annual growth for total exports in real terms over the next five years appears to be feasible. Overall export volumes fell by 10 percent in 1981 and another 9 percent in 1982; thus, most of the targeted increase represents a recovery from the current low levels to those that were attained in the past. 35. A second key requirement is to further reduce the current account deficit. Having risen to 24 percent of GDP in 1979, the current account deficit was reduced to 13 percent in 1981 and 1982 largely due to a sharP fall in imports. The IMF's EFF program calls for the deficit to decline gradually to 5.0 percent of GDP by 1987. 36. Malawi's foreign financing needs and expected resources are shown in Table 1 below. Total available foreign financing for the 1983-87 period has been based on past trends, as well as expected levels of grants, and medium and long term loans from individual sources. Even allowing for two SALs totalling US$115 million and possible IMF programs throughout the five years, 3 a gap of US$110 million remains to be filled. 37. It should be noted that Malawi had very heavy debt repayments due in the period of 1982-1984, but has recently completed a rescheduling of both its commercial and official debts. The first year of commercial debt repayments will be stretched out over the next 6 1/2 years and official repayments over the next 8 years; Table 2: MALAWI-Foreign Financing, 1983-1987 (US$ million) Current Account Deficit 725 Capital Account Amortization 285 Reserve Build-up 50 Total Requirement 1060 Official Grants 270 M&LT Loans 505 Net IMF 85 SALs 115 Other Capital 65 Total Available 950 3 The IMF has recently agreed to a three year EFF with Malawi, but has no commitment for any program beyond mid-1986.  - 14 - With this rescheduling, Malawi's debt service ratio, which would have reached over 40 percent in 1982 will be very flat over the period at about 25-30 percent per annum. The debt rescheduling will provide about US$35 million in resources. 38. Another key to attaining sustained growth with a manageable balance of payments current account deficit will be substantially reducing the Government's budgetary deficits, which reached an average of almost 16 percent of GDP during FY80-FY82. Under the EFF, the deficit is targeted to decline gradually each year to reach 7.5 percent of GDP by FY86 by keeping development expenditures to 8.8-9.0 percent of GDP; reducing the revenue account expenditures from 17.6 percent of GDP in FY83 to 15.4 percent by 1985/86, and keeping revenue between 16.6 and 16.9 percent of GDP throughout the period. 39. To ach-eve the growth targets set out, both the saving and investment rates will need to recover from the depressed levels of recent years. At the same time, the efficiency of investment will need to improve. Domestic savings will have to increase from the 1982 figure of 13.5 percent of gross domestic product to 17.8 percent by 1987, and the decline in investments by both private and public enterprises must be reversed. 40. Given the program proposed by the Government and the latter's political commitment to it, the targets above should be achievable. Malawi already is pursuing an agriculturally based, export-oriented policy which has been implemented well in the past. Therefore, the present program does not aim to introduce radical changes, but has as its major goals enhancing the efficiency of implementation and strengthening the relevant institutions. The Productive Sectors 41. Agriculture. As in the first SAL operation, monitoring the price incentives for smallholders, will continue to be a major focus of the adjustment program. Over the last two years, a methodology for setting prices for smallholder crops has been developed, which sets the price levels which will provide the incentive to expand both overall and export crop production. With recent increases in smallholder crop prices, the terms of trade are shifting in favor of agriculture and the returns per labor day for all major crops in most locations are greater than the  - 15 - opportunity cost of labor. Table 3 below sets out the returns to labor in real terms for the period 1979/80-1983/84 and shows the reversal of the downward trend beginning for many crops in 1981/82 and other crops in 1982/83. The Association will continue to be involved in ensuring proper application of the agreed pricing methodology and help as needed to improve the system further. Specifically the question Gf the comparative advantage of various crops will be looked at and the effect of pricing policies on the budget, the balance of payments and other macroeconomic variables will be examined. In recent years, production of groundnuts, cotton and a number of minor crops has fallen significantly. Incentives provided under recently increased prices and available technical packages should restore the production of most of these back to previous levels. Despite a bouyant international price, the export parity price for cotton is low due to relatively inefficient and costly cotton ginning and processing and the high cost of external transport particularly in view of recent disruption in the shortest and cheapest routes through Mozambique. The Government has deemed cotton self-suffiency necessary and will set prices sufficient to achieve this. In the meantime, it plane to reduce processing and transport costs through further investments in roads and ginning capacity. Table 3: Real Gross Margins per Labor Day for Smallholder Crops (1974 tambala) 1983/84 1979/80 1980/81 1981/82 1982183 (est.) Maize (local) 45.4 39.0 60.9 54.0 51.2 (hybrid) 48.6 37.3 75.5 56.3 53.7 Tobacco (Northern Div. dark-fired) 28.1 24.3 20.6a/ 26.8 26.8 (25.6) Groundnuts (chalimbane) 32.6 24.9 25.7 30.9 36.3 Cotten 31.3 24.3 28.7 36.3 38.0 Rice (faya) 48.6 40.1 33.7 38.6 47.5 (blue bonnet) 49.2 41.2 44.8 44.0 48.3 a/ A 15 percent second payment was made in 1981/82 resulting in total receipts of 25.6 tambala in 1974 prices.  - 16 - 42. The Government will continue to review the recurrent budget allocations to the Ministry of Agriculture to be sure they are adequate, as was done in the first SAL. 43. ADMARC is the major source of inputs and marketing for smallholders. It was established in 1971 to increase exports, provide supplies to those farming on customary land (i.e. smallholders), and to maintain a system for export marketing. While it provides an outlet for all produce grown on customary land, its monopoly extends only to certain types of tobacco and cotton. Besides these functions, ADMARC was also given the task of assisting by credit or investment any "works, undertakings, projects, schemes or enterprises relating to the development or improvement of the economy of Malawi'. ADMARC was to be run as a commercial enterprise and its selling price for produce sold within Malawi was to be no less than the purchase price plus ADMARC costs or, if sold below this price, the Government was to make good any losses from public funds. Unfortunately, misapplication of these two provisions has led to some of ADMARC's present difficulties. 44. While ADMARC was conceived primarily as a marketing agency, during the 1970s it gave much more attention to the development aspects of its mandate. In effect, it u;ed its pricing decisions to tax the smallholder sector and invest the revenue in the rapidly expanding estate sector. Until 1978, ADMARC showed large profits and was able to carry out its investment plans and still provide most of the services needed by smallholders, including the procurement and distribution of subsidized fertilizer. By the end of the 1970s, however, ADMARC began to lose money on its operations due mainly to increased marketing costs (despite a slight decrease in the volume purchased), due to excessive staffing, and buying points, failure to adapt to more difficult and costly transport, and a shift to excessive distribution of maize and subsidized fertilizer within the countrv relative to more profitable export activities. 45. Contrary to statutory requirements, ADMARC has not been compensated by the Government for losses incurred in maize and fertilizer distribution. In addition, export markets have been eroded or lost due to poor crop forecasting, irregularity of supply and shipment, and for groundnuts, poor grading standards and declining quality. By 1980 ADMARC's trading profits had disappeared and overall operations showed a loss of almost MK 9 million. As a result, it was unable to order sufficient fertilizer to meet farmer demand that year. The same happened the following year when it lost more than MK 10 million. The Finance Ministry, forced to procure half of the fertilizer to help alleviate the financial burden on ADMARC, was not able to do so in a timely manner, so that a  - 17 - second consecutive year of shortage occurred. To help ADMARC overcome its cash flow problem, reduce its deficit and encourage efficient use of fertilizer, the Government reduced the fertilizer subsidy by 50 percent in 1983 and is committed to eliminate it wholly within three years. 46. A study of the financial and operating efficiency of ADMARC, financed by the first Technical Assistance Loan, recommended the following: (i) improve ADMARC's pricing policies through better planning and analysis; greater use of interseasonal stabilization funds and review of the use of subsidies, with any remaining producer and consumer subsidy costs being met by Government rather than ADHARC; (ii) reduce marketing costs by cutting back on the number of markets; (iii) limit ADMARC's investments and other related interests to those which are or could be beneficial to marketing or processing. (Thus freeing both financial and management resources for these primarv functions); (iv) establish a planning unit to assess and analyze likelv consequences of alternative plans of action: (v) strengthen the financial management of ADMARC; 'viz improve crop marketing and distribution bv increasing the role of the informal sector: and (vii) improve training and manpower development. The Government has already reconstituted the Board of ADMARC and created the post of General Manager to run the company. It has drawn up a program of specific steps to be taken and a timetable based on the consultant's report was agreed with the Association at negotiations.  - 18 - 47. The fertilizer supply problem is being addressed by an IFAD/IDA jointly financed project administered by the Bank. The project will help improve the Government's and ADMARC's ability to estimate requirements and procure and distribute supplies to smallholders. Toward this end, a revolving fund for fertilizer procurement has been established in the Reserve Bank and funds provided for technical assistance and local staff training. The program will also evaluate research data and extension recommendations, focusing on the monitoring of farm demand and success in the use of fertilizers. The program will assist institution building in ADMARC to strengthen the parts of it dealing with the procurement and distribution of inputs. 48. In Malawi farms are classified as 'estates" or "smallholdings' according to tenure status rather than size. All farms under freehold or leasehold are classified as estates while those with communal tenure are smallholdings. This can be misleading as there are large commercial smallholder farms while most burley tobacco estates are farmed in small units by tenants. Land tenure determines the crops that may be grown (only estates can grow burley tobacco) and the access to markets (only smallholders are serviced by ADMARC), credit institutions (only estates receive commercial bank credit) and extension services (only smallholders are served by Government extension agents). 49. Because the vast majority of Malawi farmers are "smallholders" Bank assistance to agriculture has focussed on this subsector. However, the estate sector production has been growing rapidly, by 17 percent per year over 1968-77, largely by conversion of communal land to freehold and leasehold. The sector produced 80 percent of Malawi's agricultural exports in 1981 and 1982, but in recent years has suffered sharp financial reverses. Tobacco prices fell steeply in 1979 and 1980. A number of estates were not able to meet debt payments to Malawi's two commercial banks, and were either placed in receivership or put under the control of the banks' management advisory services. With the recovery of tobacco prices, the financial positions of the estates have improved, and the banks have cut back or disbanded their management advisory services. Yet most estates still suffer managerial and financial weaknesses. The importance of this sector in generating export earnings requires that the structural adjustment program include measures to improve its efficiency. Thus the program will provide for improving their technical and financial management and for giving greater incentives to diversify production through strict enforcement of government tobacco regulations, establishment of a managerial training scheme and development of a credit plan. The Government does not have a policy on the expansion of the estate sector and the future of communal Eorms of tenure. There are increasing land pressures in Malawi which could become a serious problem in the future.  - 19 - However, there is insufficient knowledge about the effects of conversion to freehold or leasehold status on concentration of landholdings and factor productivity to formulate a policy. The Government has begun the process of policy formulation with a study on size distribution of farms, yields and other productivity measures in smallholder and estate agriculture. 50. The expansion of Malawi's tobacco exports will require improvtd control over the quality and volume of production. Malawi tried to control the quality and quantity of its tobacco production in the late 1960s and early 1970s, as it was felt that there was a limited market for its products. During the rapid expansion of the 1970s effective control was lost, although regulations still remained on paper. During the 1983 sfason a large increase in the production of burley tobacco has led to a sharp drop in the price and pointed out again the limited market for Malawi's tobacco. Under the program the Government will again enforce regulations strictly and encourage diversification to other crops. 51. The recently completed -Tobacco Sector Study' has compiled and analyzed a substantial quantity of data which can provide a basis for a long term strategy for the tobacco sector. This strategy will include the development of an extension service for the estates, a management training plan and medium- to long-term credit facilities. 52. The commercial banks provide production credit for seasonal requirements, but have been reluctant to provide medium and long-term financing because of their limited overall resources, current heavy concentration of their portfolio in agriculture, and poor experience on loan recovery in the late 1970s. Because the amount of funds required is not likely to be very large, it should not be necessary to set up a new, separate institution to provide long-term credit to the estates. This zould be done by either the commercial banks or an existing institution such as the Investment Development Bank (INDEBANK), a well run development finance company experienced in evaluating and supervising loans in many different areas. Both INDEBANK and the commercial banks have expressed interest in handling the needs of the estates for medium- and long-term financing, especially as it relates to estate diversification, if the Government will provide assistance such as a guarantee scheme or rediscounting facilities. A timetable for developing a program was agreed to at negotiations.  - 20 - 53. Industry. The Government has emphasized the role of the private sector in industrial development providing incentives through taxes, profit repatriation and import rebates. The small size of Malawi's market and high transport costs afford natural protection to the industrial sector despite relatively low tariffs. The Government can and does exert substantial influence on the system. As the economy has become more complex and the internal and external environment more volatile, requiring more frequent changes, the management of the largely informal system has become more and more strained. Even though it has functioned reasonably well in the past, it has become increasingly clear that some of the Government's approaches toward regulatory practices require some overhauling. A study is being undertaken by the Association to evaluate the system of incentives affecting the manufacturing sector in Malawi and the recommendations of that study will be used in our dialogue with Government. 54. Both the formal and informal price controls are based on a cost plus pricing system, which has led to cost inefficiences and has limited the effectiveness of the pricing system in signalling surpluses and shortages. Production of domestic food, edible oil and cotton crops may be affected by inadequate retail prices. The volume of applications to the Ministry of Trade, Industry and Tourism (MTI) has increased rapidly in recent years, both because the coverage of price controls has expanded significantly, and because costs have risen rapidly. It can now take several months for the MTI to respond to the price applications because staff are limited. These delays cause a serious financial burden on those firms experiencing large increases in their input prices, and considerable management time is lost in following up on the applications. This weakens the financial position of these firms, constitutes a serious disincentive to investment, and adversely affects the overall business climate in the country. 55. The program will provide for gradually dismantling the system and replacing it with one that would remove or alleviate most of the present drawbacks. This will require the Government to identify a short list of essential commodities subject to price fixing and review the prices of these controlled items every year in order to avoid supply problems that could arise if prices are repressed for a long time, and develop a timetable for removing the controls on other products, removing the controls on a substantial number before the release of the second tranche of the SAL.  - 21 - Resource Mobilization and Management 56. Even though the targets for GDP and sectoral growth rates in the program are modest compared with results accomplished in the 1970s, the need for resource mobilization is still formidable. The share of both total investment and domestic savings in GDP has dropped sharply since 1978. Reversing this decline will be difficult because of continued deterioration in external transport which increases costs, depresses profits and decreases the willingness to invest; the recent financial deterioration of the parastatals which restricts their ability to save aad invest; the low elasticity of the Government's revenue system and the limited scope for increasing tax revenues, especially in a time of low growth; and pessimism in the private sector engendered by the current recessionary climate, deteriorating transport and declining regional markets. The need for additional resources can be minimized by improving the efficiency of investment. The careful scrutiny of investment projects both in the central budget and those implemented by the parastrtaln is required with priority given to more directly productive invesaC:zts. 57. Malawi has not had a formal public investment program in the past. The Goverment had no. selected a complete set of projects based on their priority and then worked out a program based on resources likely to be available. In addition, information about the investments of the parastatals was not centralized. Thus it was not possible to assess public investment, both ongoing and planned, in its totality. Under the adjustment program progress has been made in preparation and review of a public investment program based on agreed projections of resource availability. Decisions on parastatal investment plans are incomplete for later years in the period. 58. The program will contain a continued reduction in the budget deficit. This requires reductions in expenditure growth since there is limited scope for additional revenue measures in the near term. With the budget for recurrent expenditures under heavy pressure from the past development expenditures of the Governm-nt and the need for funds to carry out existing programs, the development budget is likely to be highly constrained. rhis reinforces the need for developing and updating a formal investment prograz- for this and coming years, so that the limitation of the develop=ent budget can be done efficiently. As was the case with SAL I, the Government is giving priority to sustaining adequate recurrent outlays for agricultural services, road maintenance, and education. The IMF has supported these our efforts to ensure adequate recurrent expenditures.  - 22 - 59. In the medium term, however, continued reduction of development outlays could have serious adverse effc-.cs on economic growth. The Government must therefore address the issue of increasing revenues within the framework of a medium-term adjustment program. During the 1970s government revenue had been steadily increasing as a percentage of GDP and by FY80 was above 20 percent, due mainly to changes in tax rates, especially the surtax (a form of sales tax) which was introduced in 1970. In FY81 and FY82 revenues fell to 19.1 percent of GDP and 17.4 percent respectively. The Government introduced a number of revenue measures in the 1982/83 budget, including a cax on hotels and entertainment, an increase in the maximum rate of the income tax on both individuals and companies, the application of the income tax to insurance companies, and a measure limiting the ability of holding companies to offset losses against taxable income. The 1983/84 budget simplified the system of individual income taxation, eliminated some deductions, increased custom and excise duties and raised vehicle fees. However, the revenue increases from these measures are expected to be modest. Additional measures will be needed in the coming years in order to expand the Government's revenue base and control costs. The Government has decided to (i) improve the buoyancy of the tax system, (ii) adjust tariffs, fees and charges, and (iii) reduce subsidies and increase cost recovery efforts. The goal is to keep revenue growth proportionate to GDP growth. A detailed package of tax and non-tax revenue measures is being developed under the IMF's EFF. The Bank will continue to work closely with the DMF on this issue to ensure that proper investment and allocation incentives are provided. 60. The social services that the Government provides have become a serious burden on the budget. Failure to recover costs adequately limits the Government's ability to expand social services throughout the population. The Government has also been slow to increase fees for Government services. As a result, the share of non-tax revenues in total revenue has declined significantly over the years. In view of the limited prospects for tax revenue increases, a major effort has to be made to expand non-tax revenues. The program provides for a review of existing duties, license fees and tariffs with a view to making appropriate changes in them, including more frequent changes in departmental charges and in licenses and fees and increases in ground rent on leasehold land, which is still very low, despite some recent changes.  - 23 - 61. Fertilizer prices have averaged only half of t!e real costs and the maize account has usually operated at a loss. Conversely up until the late 1970's, ADMARC operated with an overall profit, while paying smallholders less than half the world market price on some export crops. As described above, the adjustment program will continue to adjust export crop prices to appropriate levels to provide proper incentives, especially for smallholders At the same time the Goverrnent will continue to remove the subsidies on fertilizer and maize to prevent these from draining ADMARC's or the Government's budget. 62. Cost recovery for government-supplied services also must be improved. The Government raised tuition fees for primary and secondary schools in 1982, for the first time since 1975. In tertiary education, unit costs are high compared to other African countries but no fees are charged, and students receive personal allowances. Even though the university has only 1,700 students, it absorbs 25 percent of all educational expenditures. The Government has agreed to reduce these high costs and increase the contributions from students. 63. In the area of health services, the program will include a review of the various charges for health services and immediate measures to improve collection. While in principle, the Water Department aims at covering costs, it is not successful in achieving its targets in all types of services provided. There were some rate increases effected in 1982, but under the program the Government will annually go over the system and make changes necessary to improve revenues. The same is true for the price charged by the Department of Forest Industries for the sale of their products. 64. Government-supplied housing to civil servants, parastatals and the private sector in Malawi not only is a drain on the budget (at least NK 3 million yearly) in terms of subsidies and the balance of payments, due to high unit costs and import content, but inhibits development of the private housing sector as well. Based on discussions connected with SAL I, a recent Bank housing sector mission outlined possible approaches to solving the problem. The Government proposes now to examine the matter more thoroughly in order to consider fully the financial, institutional and political implications of the various options open to it. The Government is committed to reducing its housing subsidies and to encouraging development of the private housing sector. In the course of ongoing policy discussions and preparation of a proposed urban project, we will work with the Government to develop an appropriate program for dealing with the problem.  - 24 - 65. For the parastatals to resume their role as major contributors to resource mobilization and investment in the Malawian economy, they have to improve their financial performance significantly. Under the first SAL program, the Government has taken a number of steps in this direction, including moderate tariff increases (Air Malawi, *nalavi Railways, ESCOM, and Blantyre Water Board), initiation of a number of financial and management studies (Malawi Railways. ADMARC, and MDC) and establishment of the Department of Statutary Bodies (DSB) in 1980 to oversee and coordinate the parastatal sector. A number of management changes have been made and the structure of management has been reorganized in certain parastatals. The DSB has developed a financial reporting system that will enable the Government to monitor the financial performance of the parastatals. Surveys have been initiated by the DSB to review the functions and viability of individual parastatals. The SAL II operation will provide for the Government to use the studies already launched, to improve the management and financial performance of parastatals. More specifically, the Government nas agreed to: (i) Increases in tariffs and user charges where needed; (ii) Filling of high level management vacancies as soon as possible; (iii) A periodic review of parastatal financial accounts by DSB; and (iv) Implementation of the findings of ongoing studies for operational and financial improvements. 66. There has been a noticeable decline in the rate of growth of credit to the private sector in recent years. The annual average increase for the last two years was only eight percent, nominally. However, as a result of the projected decline in the budgetary gap, the Government's recourse to domestic credit should substantially decline. This, in turn, would release credit resources for the use of the private sector. This should provide some incentive for the expansion of private sector activities, including investments. Thus, it is essential that the budgetary deficit be kept within the ceiling agreed with the IMF so that availability of credit will not be a constraint on resource mobilization in the private sector.  - 25 - 67. Malawi devalued the kwacha by 15 percent vis-a-vis the SDR on April 24, 1982, in preparation for the stand-by agreement it signed with the IMF, in August 1982. The adjustment of the exchange rate was undertaken to enable ADMARC to pay higher producer prices, without adverselv affecting its financial position and to improve incentives for production of other agricultural products not handled bv ADMARC such as tobacco and tea. The change in the exchange rate is not expected to have much impact on manufactured exports which are limited more by the extreme difficulties experienced in external transport and the trade and payment policies of potential buyers among the neighboring countries. Since that devaluation the rate appreciated by about 12 percent compared to its major trading partners. The Government as part of its EFF agreement approved by the DMF board in September 1983 devalued by 12 percent and agreed to keep such an appreciation from happening again by a more active exchange rate management policv. 68. Deposit rates were increased by two percentage Doints in May, 1983. Currentlv, the lending rates range between 13.5 percent and 16.5 percent with most of the lending taking place closer to the upper end of the range. When measured against the consumer price index, the maximum lending rate is positive bv approximatelv 7 percentage points, and the real saving deposit rate is positive by about 1 point. The Government is committed to make neriodic adjustments as the need arises, to keep rates positive. 69. In SAL I the Government agreed to strengthen its ability to monitor and control external debt and to set a target debt service ratio. A target of 20 percent of exports of goods and services has been agreed to and a debt monitoring unit established in the Ministry of Finance. A consultant has recently been hired to help set up a computerized recording and monitoring system. This system will help not onlv in recording debt already contracted but alco help in the formulation of future borrowing policy that will reduce the ratio to the targeted range. A borrowing strategy and plan will be developed. Institutional Improvements 70. The economic difficulties of recent years have accentuated the weaknesses in public sector institutions in Malawi. In addition, the largest private sector company in the country, Press (Holdings), faces great financial problems which unless resolved could adversely affect the whole credit system of the country. In the first SAL a program to strengthen key planning and budgeting ministries was developed along with studies of Press and key public sector companies. In this second operation the Government will implement the recommendations of these studies and continue strengthening its agencies and institutions.  - 26 - 71. Press (Holdings). Because of the crucial role Press plays in the Malawian economy and the extremely weak financial position of the company, the first SAL provided for initial steps to be taken toward correcting its problems. Consultants reports were prepared on the operations of subsidiaries with some work done on the central management. Assurances were obtained that dividends would not be paid as long as the financial health of the company remained precarious and future ownership would go to a trust set up by the owner, the Life President of Malawi. 72. Press is insolvent and its debts to the commercial banks and ADI1ARC are such that these institutions would also be threatened with bankruptcy if Press were to go under. In the past, some operatiors were undertaken for political reasons even when they were commercially uneconomic. While the consultants concluded that the value of investments in non-Press enterprises was overstated in Press' books, most of the comoanies are profitable. (Press has 22 companies in its investment portfolio.) By contrast, the major subsidiaries of the company have at best a mixed record of performance, are being hurt badly by the liquidity problems of the group, and, in some cases, are experiencing serious crises as a result. (Press has 15 major subsidiaries and 8 inactive companies. These are companies where Press has a majority share and manages the company.) 73. To return Press to profitable operations, the Government has decided on a major restructuring of the company. A new agricultural subsidiary (PAL) will be created and will become the major focus of the company. Minority holdings will be placed in an investment trust (PITH) and eventually sold off either locally or internationally. Some of the remaining subsidiaries will be sold off or closed down. The Government will take over the claims against Press of the commercial banks and the external creditors. Special locally registered stock will be issued to the com-erciial banks by the Government to pay Press' debt. Press will issue income notes to ADMARC and to the Government. 74. The objective of the restructuring is to ensure the proper management and financial viability of the companies retained in the Press group. Toward this end, Press Holdings' non-commercial functions would be clearly separated from its commercial ones. This will be accomplished by creation of a new holding company, Press Group, Ltd. (PGL), which will initially hold all of Press Holdings' assets and liabilities. Limitations have been set on PGL's paying dividends, but provision has been worked out to ensure that Press Trust, the owner of Press Holdings, receives a reasonable flow of income. The restructuring has been done in such a way as to limit the impact on the Government budget and close consultations have been held with the IMF throughout the process. Still, given the  - 27 - financial condition of the commercial banking system and the slow movement on the sale of assets, the additional burden on the Government's budget will be substantial. To ensure that the companies are operated on a commercial basis a set of corporate guidelines has been drawLi up and discussed with the Association. These set out pricing policy, investment criteria, overdraft guidelines, rules for intercompany loans, etc. Finally, in order to reduce the debt burden of the company, detailed studies on possible asset sales will be carried out. 75. Development Management. With the implementation of the SAL II program, the Government is taking specific measures to improve and strengthen the management capacity in the public sector. Since the late 1970's the Government's management capacity has been severely strained by the increasing demand of day-to-day operations, and manpower shortages at all levels. Indeed, a number of the problems confronting Malawi can be traced directly or indirectly to shortcomings in the Government's institutions and bureaucratic systems. Some of these deficiencies manifest themselves in terms of weaknesses in the areas of policy formulation, coordination among various Ministries, public sector investment programming, reconciliation of annual budgets with longer term development objectives, and the appraisal and monitoring of public expenditure programs. Even though under SAL I the Government established an Investment Coordination Committee to oversee major investments, reinforced the planning units in some Ministries, improved its debt management capabilities, and strengthened the planning and financial management of some parastatals, much remains to be done. 76. The measures Government will take include (i) strengthening the staffing of EPD with an emphasis on development of medium term policies, project identification, evaluation and monitoring as well as coordination capabilities, 4 {ii) institutionalizing the process of forward budgeting, estimating revenues and providing improved guidelines to spending Ministries for budget preparation and (iii) improving the institutional frai.ework for energy policy and management (paras. 91 and 93). 77. EPD occupies a central position in the process of development management ia Malawi, but it has been constrained by manpower shortages and the absence of institutional guidelines/framework. The adjustment program provides for necessary measures to be taken to strengthen EPD, including the identification of staffing gaps and filling them, as well as delineating its functions. The UNDP advisors in economic planning, human resource development and project evaluation, and the IDA financed transport economist will assist in this process. Work is expected to be completed by April 1984. 4 The Government has decided that EPD is a more appropriate institution to screen investments and has not used the ICC recently.  - 28 - 78. Malawi does not have an adequate system of forward budgeting. Even though an effort is made to predict changes in the macro-economic variables in the coming five-year period in the -Economic Report' prepared annually, this does not provide the Government with a framework for expenditure and revenue estimates beyond the current fiscal year. In order to overcome the existing deficiencies in the system, the structural adjustment program will include the adoption of the practice of forward budgeting for development and recurrent expenditures covering a three-year period. By the time for release of the second tranche the Government will have prepared revenue and expenditure estimates for the next three fisca-l years. 79. Coordination of energy policy and management is a particularly important problem in Malawi. The Government needs to develop policies to decrease its consumption of fuelwood and to reduce its dependence on imported petroleum. The former will need steps to induce the tobacco industry to improve flue and barn design. The latter will require improving existing transport arrangements, better monitoring of stocks, development of a plan for fuel emergencies and strengthening the institutional framework for coordinating, formulating and implementing energy policy. During the last 12 months, progress has been made in addressing some of these problems. The Energy Unit has been established and staffed with a part-time professional and an agenda of high priority studies drawn up. The proposed project will provide funding for helping fully staff the Energy Unit, for-a power tariff study and for carrying out a pilot project on fuelwood savings in the tobacco sector (paras.. 90, 93, 94 and 98). A timetable has been established for completion of needed studies and a medium-term investment program. 80. In the past public enterprises have as a group been financially viable and have made a significant contribution to domestic savings and investment. However during the last few years, their financial position has deteriorated sharply and their savings and investment levels have fallen. From 1976-1978 the major enterprises had an aggregate net profit of MK 66f. million, while from 1979-1981 they had a net loss of MK 16.0 million. There are a number of reasons for this. The external economic environment has deteriorated and they were affected. Their management has been uneven and financial forecasting has been especially weak. Sometimes decisions have been based on political factors rather than economic or commercial ones. The most noticeable deterioration in the parastatals has been that of ADMARC, which has been discussed above. The major source of financial difficulties has been the operation of CCDC, which borrowed short term money, often at high, floating rates, and used it to make investments in housing and other buildings that have only a long-term payoff and that are often rented at uneconomically low rates.  - 29 - 81. Under the first SAL and under separate projects, individual problems of the parastatals are being addressed. Rates of return, and therefore tariff levels for the Blantyre Water Board and ESCOM, are mandated in project agreements. A study of MDC is being paid for under the first Technical Assistance Credit, as was the study of ADMARC referred to above. Problems of MHC and CCDC are to be addressed under a proposed urban project. Some of ADMARC's staffing and fertilizer procurement difficulties will be addressed through the fertilizer project described above and other aspects such as investment rationalization will be key issues in SAL II. A study of Malawi Railways has recently been completed. These studies will be reviewed as they are completed and recommendations will be included in the adjustment program as appropriate. 82. There is also the need to evaluate the system as a whole with a view to making changes in the structure. DSB which was established in 1980 to assist parastatals in financial management, planning and staffing, has served well as a central unit for monitoring the financial activities of the parastatals. DSB has also played an active role in recruiting managers, financial controllers and filling other vacancies in the parastatals. However, there are indications that DSB is attempting to perform too wide a role in overseeing public enterprise developments. All parastatals still have a parent ministry and they are also overseen by EPD and the Ministry of Finance. DSB should be the body responsible for monitoring financialperformance, facilitating coordination and improving management, but leave investment plans, policy decisions and requests for tariff increases to other agencies. The Government has clarified DSB's role to ensure it does not duplicate the work of other governmental units. Transportation 83. As a landlocked country Malawi has always had to depend on external transport routes to reach the sea. Traditionally most imports and exports have moved by rail on two different lines through Mozambique. However in recent years there have been difficulties on these lines and Malawi has had to use other, longer routes using both rail and road transport and in time of emergency turning to costly air freighting of essential commodities. Because it appears that the capacity of the Mozambique routes could be constrained for a number of years, Malawi has set up a secretariat in the Ministry of Communications and Transport to improve the coordination of procurement of imports and their routing into the country, to plan and implement strategies to alleviate the current restrictive situation on present routes and to develop alternative routes and services and to coordinate between the Government and the private sector on these matters. Initial funding for the transport secretariat was  - 30 - only for a period of six months, ending August 31, 1983. Arrangements (will be) made (before Board presentation) for another eighteen months of funding so that this important work on transport can be continued. The most cost effective alternative route at present appears to be through the port of Dar-es-Salaam and then by road and rail through the TANZAM corridor to northern Malawi. Terms of reference for a study on the necessary investments and arrangements needed for this route have been drawn up and agreed to by the Association and agreement has been reached with the Tanzanians on appointing consultants to develop a plan for using this route and to carry out detailed engineering work. PART III - BANK GROUP OPERATIONS IN MALAWI 5 84. Over the past 17 years, Malawi has received 28 IDA credits totalling around US$325 million and seven Bank loans totalling US$75 million of which two were on third window terms. Of the Bank Group assistance, some US$121 million (30 percent) was for agriculture, US$107 million (27 percent) for education, US$65 million (16.3 percent) for roads, US$45 million (11.2 percent) for structural adjustment, US$38 million (9.8 percent) for power development, US$7 million (1.7 percent) for a health project, US$3 million (0.8 percent) for a developing finance company (INDEBANK), and the balance of US$13 million (3.2 percent) for water supply technical assistance and to finance feasibility studies for the proposed wood industries project. The first Bank loan to Malawi was made on third window terms in June 1976 and the first standard Bank loan in April 1977. The most recent operations were a US$26.9 million equivalent credit and a US$18 million loan for the Fifth Highway project. 85. IFC's investment in Malawi consists of a loan of US$10.8 million for a textile mill, another of US$9.9 million for a sugar mill, a US$0.6 million equity investment in INDEBANK and a US$2.0 million loan to Malawi Motels Limited for tourism. A US$262,000 equity and a loan of US$1.7 million for the production of ethanol from molasses were approved in July 1980. Project implementation has been generally satisfactory. However, due to depressed world sugar prices and difficulty of transporting sugar to world markets, the Dwangwa Sugar Corporation is experiencing financial difficulties and IFC and other project lenders have agreed to a rescheduling of the finances of the company. Malawi Hotels Limited is in critical financial condition due to reduced business traffic, weak management and low tariffs. IFC is assisting the Board of Malawi Hotels to 5 This text is substantially the same as in Part IV of the President's Report on the Structural Adjustment Credit (Report No. 3663-MAI).  - 31 - obtain higher tariffs from Government and to attract new management to the company. A Summary Statement of Bank Group Operations is provided in Annex II. 86. During the next five years, Bank Group assistance to Malawi will continue to be closely tailored to help Malawi restructure its economy, to help improve agricultural productivity and the efficiency and effectiveness of public and private enterprises, and to assist Malawi in dealing with its external transport constraints. Further investments in transport, agriculture, education, health and housing are contemplated as well as a wood processing project and a second line of credit to INDEBANK. The Bank Group's economic and sector work will focus on five high priority areas which will over the medium term, help Malawi improve its economic performance: (a) external transport; (b) agricultural productivity; (c) public sector management; (d) industrial productivity; and (e) development of Malawi's human resource potential by addressing the problems of population growth and the cost effectiveness of the social sectors. Disbursements 87. Disbursements of Bank Group loans and credits in Malawi generally have kept close to schedule and compare favorably with other countries in the region and even on a Bank-wide basis. During the period FY80-82, the disbursement rate on loans and credits to Malawi (excluding the effect of non-project lending) averaged about 26 percent per annum, significantly higher than the Eastern Africa Regional average of 17.8 percent and the Bankwide average of about 21 percent. In FY83, the disbursement rate for Malawi was about 29 percent, again significantly higher than the Eastern Africa Regional average of 20.7 percent and the Bankwide average of 21 percent. Only one project--the US$7.0 million Blantyre Water Supply Project-is appreciably behind schedule due to the late delivery and installation of electrical and mechanical equipment for the pumping stations. However, deliveries have been expedited and the improvement in disbursements over the past several months should continue. As of September 30, 1983, disbursements on this project totalled US$5.9 million. PART IV - THE PROJECT Background 88. The proposed project was prepared by the Kalawi Government with the assistance of the Association. The need for technical assistance was first discussed in June 1982, and the components of the project identified  - 32 - during the appraisal of the second structural adjustment credit. The proposed project was appraised in July and August 1983. Negotiations were held in Washington from November 14, to 18, 1983. The Malawi delegation was led by Mr. C.L. Mphande, Principal Secretary in the Ministry of Finance. Annex III provides supplementary project data. Project Objectives 89. In combination with the accompanying structural adjustment credit, which is being submitted concurrently, the proposed technical assistance project will support the Government's economic program outlined in Part II. The main objectives of the proposed project are to assist the Government in: (a) achieving its goals of improved energy planning and coordination; (b) achieving substantial fuelwood savings; (c) improving pricing of electric power and industrial commodities; (d) strengthening the debt management and the financial manageme