Malawi - Industrial and Trade Policy Adjustment Program Project

Document of The World Bank FOR OFFICIAL USE ONLY 6-iZ 1O-fr d 2 Report No. P-4778-MAI REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT IN AN AMOUNT EQUIVALENT TO US$70 MILLION TO THE REPUBLIC OF MALAWI FOR AN INDUSTRIAL AND TRADE POLICY ADJUSTMENT PROGRAM May 25, 1988 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRE NQUIVALET Calendar 1987 February 1988 Currency Units - Malavi Kwacha (MK) MK US$1.00 a MK 2.22 2.52 MK 1.00 - US$0.45 0.40 FISCAL YEAR April 1 - March 31 GLOSSARY OF ABBREVIATIONS ADF African Development Fund ADMARC Agricultural Development and Market-Lsg Corporation DFI Development Finance Institu-ion DRC Domestic Resource Cost ECU European Currency Unit EEC European Economic Community ESAF Enhanced Structural Adjustment Facility FUA Fund Units of Account INDEBANK Industrial and Developmznt Bank of Malawi INDEFUND Investment and Development Fund ISIC International Standard Industrial Classi!ication MDC Malawian Development Corporat4.on MEDI Malawian Entrepreneurs Development Institute MTIT Ministry of Trade, Industry and Tourism MVA Manufacturing Value Added ODA Overseas Development Administration OECF Overseas Ecor'omic Cooperation Fund OGL Open Generai License POSB Post Office Savings Bank PSIP Public Sector Investment Program SEDOM Small Enterprise Development Organization of Malawi SOEs Statement of Expenditures USAID United States Agency for International Development  M eR OFFICAL UR ONLY INCOUAl1L AND TttE POLICT ADJnST=IDT CREDIT TAILK Of COETUTS Page No. CREDIT AND PROJECT SUMMARY ... ..... . l-it I. THE ECONOMY 1..... A. Background 1... B. Recent Economic Developments. 2 C. Medium-Term Prospects and Policies . 4 D. External Financing Requirements. 5 E. IMF Program .6 F. Collaboration with the IMF. 7 G. Bank Group Strategy. 7 II. INDUSTRY, TRADE AND FINANCE SECTORS. 8 A. Industrial Sector Overview. 8 B. Industrial Sector Policy Environment . 9 C. Financial Sector Overview. 9 III. THE SECTORAL ADJUSTMENT PROGRAM .10 A. Introduction . 10 B. Trade Policy and Exchange Rate Management 11 C. Fiscal Policies . 13 D. Tax Reform . 14 E. Export Promotion .15 F. Industrial Licensing .16 G. Price Decontrol . 16 H. Small-Scale Industries . 17 I. Financial Sector Policies .17 IV. THE PROPOSED OPERATION .18 A. History .18 B. Objectives .18 C. Financing Plan .19 D. Disbursement and Procurement .19 F. Monitoring and Tranche Release .20 F. Economic Impact .21 G. Social Impact of Proposed Operation .23 H. Risks .24 V. BANK GROUP OPERATIONS . 25 Bank Group Operations . 25 VI. RECOMMENDATION . 27 This document has a restricted distribution and may be used by recipients only in the perfornance of their official duties. Its contents may not otherwise be discosed without World Bank authorizaon.  -2- NALAWI INDUSTRIAL AND TRADE POLICY ADJUSTHCNT CREDIT TABLE OF CONTENTS Pate No. CHARTS Chart 1 - Malawi - FOB Exports & Imports 1980-87 at 1980 Prices ............ .................. 3 Chart 2 - Malawi - Real Exchange Rate 1970-1986 ........ 12 Chart 3 - Malawi - FOB Exports & Imports 1980-1992 at 1980 prices .22 ANNEXES Annex I Economic Indicators: Key Macroeconomic Indicators . . 28 Balance of Payments . . 29 External Financing Requirements .......... 30 Foreigi Exchange Requirements and Debt Service Ass.'imptions ................ 31 Annex II Letter of Development Policy . . 32 Annex III Sectoral Adjustment Policy Reform Matrix .... 41 Annex IV Stament of Bank Loans and IDA Credits ...... 43 Statement of IFC Investments ........... 44 Annex V Supplementary Project Data Sheet ......... .. 45 Annex VI Social Indic atorDa Sheet .................. 46 Map -...... 48  MAAWi INDUSTRIAL AND TRADE POLICY ADJUSTHENT CRUDIT Credit and Proares Sumary Borrower% Republic of Malawi. Beneficiarys Republic of Malawi. Amount: IDA Credit SDR 50.6 million (US$70.0 million) Japan OECF US$30.0 million European Economic Community ECU12.5 million (US$16.0 million) African Develop- ment Fund rUA15 million (US$19.5 million) USAID US$25 million The program is supported under the Spacial Program of Assistance to Low-Income Debv-Distressed Countries in sub-Saharan Africa. Terms: Standard IDA terms, 40 years maturity. Descriptions The proposed credit would support the continuation of the Government's reform program of industrial and international trade policies. The principal objectives of the program are to improve the policy environment for manufacturing, to increase efficiency of resource use and spur employment and exports. Following a significant effort in the area of economic stabilization, the cornerstone of the proposed policy package is a major trade liberalization eftort supported by fiscal policies, exchange rate adjustment, and tax reform. Market allocation of foreign exchange would be accompanied by rationalization of the import tariff structure. The quick-disbursing proceeds of the credit would increase the total amount of foreign exchange available to finance imports by all economic agents under a liberalized import regime, thereby supporting a market-determined foreign excharge allocation.  - ii - Benefits: Implementation of the Government's industrial and trade policy adjustment program would make a major contribution to the recovery and sustained growth of the Halawian economy. The policy environment under the rogram gives incentives to efficient enterprises to expand their production and will force less efficient firms to improve or suspend operations. Export growth spurred by greater profitability will contribute to easing the foreign exchange constraint, employment generation, and economic growth. Riskst There is a risk that the full benefits from trade liberalization might not be achieved if an appropriate macroeconomic framework is not maintained throughout the program period. An erosion of fiscal discipline, for example, might crowd out credit and foreign exchange to the private sector thereby stifling growth. A second risk is that competition trom imports and ensuing financial problems of inefficient firms might create pressures to slow down the liberalization process. If factors of production cannot be transferred expeditiously to expanding efficient product lines and firms, pressures against liberalization may escalate. To minimize these risks, the program includes close monitoring of the real exchange rate, fiscal deficit targets, and other key macroeconomic indicators. Government's commitment to the reform program, as demonstrated by its performance under SAL III and the recent IMF shadow program, its agreement with the IMF on a stand-by arrangement, and agreement with the Bank and the Fund on a Policy Framework Paper suggent that the risk of significant policy deviation is low. The third risk concerns further deterioration of the external environment. While further decline in Malawi's terms of trade cannot be ruled out, present trends r'%int to an improvement, and Government is taking steps to ease international transport constraints--a major source of adverse terms of trade movements in the past. Estimated Disbursements: The credit would be disbursed in two tranches of US$35 million each. The first tranche would be available for disbursement at the time of credit effectiveness; the second would be released upon fulfillment of specified conditions, expected by April, 1989. Appraisal Report: This is a combined President's and Staff Appraisal Report.  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND CSHENDATION OF THE PRESIDENT TO THE EECUTIv DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF H1LAWI FOR AN INDUSTRIAL AND TRADE POLICY ADJUSTHENT PROGRAM 1. I submit the following report and recommendation on a proposed credit for the equivalent of US$70 million (SDR 50.6 million) on standard IDA terms 40 years maturity, to the Republic of Malawi in support of Government's industry and trade policy adjustment program. Japan, the European Economic Community, the African Development Fund, and the United States Agency for International Development will participate in the nancing of this program. T. THE ECONOMY 2. A report entitled "Malawi - Economic Recovery: Resource and Policy Needs" (Report No. 5901-MAI) was distributed to the Executive Directors in October 1985. Its conclusions as well as more recer.t developments are reviewed below. A. Background 3. Malawi witnessed remarkable growth and structural transformation during its first fifteen years after independence in 1964. Total GDP more than doubled and per capita GDP increased by almost two-thirds. This growth was sustained by the steady expansion of agricultural production, with a modest contribution from a nascent manufacturing sector based on agro-processing and simple import substitution. During this period, relatively high rates of investment and an efficient utilization of capital stock resulted in low unit production costs. Gross fixed capital formation rose from 16Z of GDP in 1965 to 26% in 1980, and savings rates from 4% to 18%, while inflation rates dur'ng the 1970s averaged about 8% per year, virtually the same as the industrialized countries. Unlike other Sub-Saharan African countries whose currencies underwent gross appreciations in real terms, the real effective exchange rate depreciated almost 5% between 1970 and 1980. The economy was relatively open, with an average import to GDP ratio of about 35% in the 1970s, and the trade regime was conducive to efficient resource allocation, with average import duties on the order of 12%. 4. Malawi's economic performance began to weaken in the mid-1970s and entered into severe problems at the beginning of the present aecade. Fiscal policies, which throughout the early 1970s resulted in a central Government's budget deficit equivalent to about 6% of GDP, became highly expansionary in the late 1970s and early 1980s as the authorities  - 2 - respcnded to a series of external shocks. Falling international prices for export commodities, soaring oil prices and a gradual disruption of external transport routes through Mozambique led '.o a deterioration of the terms of trade of some 28Z betweea 1978 and 1981. Drought reduced agricultural production and made it necessary to import maize in 1980181. Government mistook these shocks as temporary and tried to maintain aggregate demand and the country's income level through deficit spending; the Central Government deficit, financed to a considerable extent with external debt contracted on commercial terms, rose to 11Z of GDP in 1980/81. Despite the injection of foreign exchange and the stimulus to domestic deman;., GDP fell by 5.22 in 1981. Moreover, deterioration of the terms of trade and increased excess demand from higher fiscal deficits put considerable pressure on the balance of payments. The current account deficit rose from an average of 9.5% in 1973-77 to an average of 222 in 1979-81. In the process of dealing w.th the external and fiscal imbalances, among other things, the authorities increased import duties. Relative to imports, import duty receipts rose from an average of 12% in the mid-1970s to about 322 in 1981. The spread between the highest and the lowest rate &lso increased, from 30 percentage points in 1975, to 90 in 1981. 5. Starting in 1981, Government launched a broad-based structural adjustment effort geared to restoring macro-economic stability and removing structural constraints. This program was supported by three SXLs and successive stand-by arrangements with the IMF, and external debt rescheduling in 1982 and 1983. The adjustment package comprised: (i) price rationalization and liberalization, including use of agricultural prices to increase incentives to smallholders, decontrol of most industrial prices, gradual removal of fertilizer subsidies, and introduction of tariffs based on long-run marginal costs in several public utilities; (ii) improvei public sector resource mobilization and management, including strengthening of government budgeting and planning operations, development of a rolling public sector investment program, and development of a tax reform program; (iii) rationalization of external sector policies, including active exchange rate management; and (iv) restructuring of the parastatal sector, including parastatal divestiture and reorganization, and introduction of a multi-channel marketing system for most agricultural commodities. B. Recent Economic Developments 6. With the help of these programs, Malawi managed to reduce domestic and external imbalances while resuming GDP growth in 1982-85. The current account deficit declined from 21% of GDP in 1980 to 8.2% in 1985, the fiscs.l deficit (excluding grants) dropped from 15.1% in 1981/82 to 8.42 in 19f. '5, and GDP grew at annual rate of about 4% during this period. This was a remarkable achievement considering that the Malawian economy underwent a major import compression. As Chart 1 shows, by 1985 real imports on an FOB basis were only about two-thirds the 1980 level. Progress, however, was cut short. The progressive disruption and final closure of direct rail links to Mozambican ports increased transport costs and caused an adverse shift in the terms of trade of 18%, and an 82 loss of gross domestic income in 1982-85. Iui 1985/86 the public sector deficit increased to 9.6% of GDP, reflecting an increase in debt service arising  from the expiration of the grace period on the 1982-83 debt rescheduling, and large, unbudgeted expenditures on displaced persons from Mozambique, and on security. Deterioration of export crop prices exacerbated balance of payments pressures and, by end-1986 international reserves had been virtually depleted and Malawi had accumulated external trade arrears equivalent to 61 of GDP. To make ends mcet, Government tightened the rationing of foreign exchange to the private sector. As a result of all these events, real GDP grew by only 2.8Z in 1986. Chart 1: MALAWI--FOB E4xprt. & hprtg. 1M0-87 ct 101 PF1o . . . . . . . ... .. . . . . . .. . . .. ... ... .. . . 1 "0 1081 1I " 2 1083 1084 lm low 10 1 7. After two years of severe fiscal and balance of payments pressures, Malawi initiated a number of reforms in 1987 and 1988 to restore domestic and external balance. Under a SAL III Supplemental Credit (approved in January 1987) and a shadow IMF program, Government reduced the fiscal deficit from 12.5% of GDP in FY86/87 to 10.2% in FY87/88 with the help of increases in taxes and tariffs, limits on the civil service wage bill, reduction in capital expenditures, and improved budgetary monitoring. Government also removed controls on lending interest rates while increasing deposit rates by three percentage points. 8. The balance of payments also improved in 1987, but the external financing position continued to be tight. Although the kwacha was devalued b) 20% in February 1987, the effects of the depreciation were largely eroded by inflation, and the kwacha had to be devalued again by 151 in January 1988. Nevertheless, non-maize imports fell by 0.8%, but exports (including re-exports) also fell by about 11 in 1987. The current account deficit was reduced from 6.1% of GDP in 1986 to 4.1% in 1987, owing mainly to an increase in net current transfers. The capital account also  - 4 - improved, mainly because of a reversal in the flows of short-term capital movements. As a result, international reserves increased for the first time since 1984, by US$45 million. While rationing of foreign exchange remaineo in place, a number of actions were taken in 1987 to give priority to the productive sectors of the economy and to reduce the adverse impact of these restrictions on the private sector. In view of the high debt service ratio (48.3% in 1987) and the continued tight foreign exchange position, in August 1987 Government approached the Paris and London Clubs for a rescheduling of commercial and bilateral debt. All other debt obligations continued to be met in full. 9. Government, in addition to curtailing public sector nonsumption, also took a number of actions to impr-e the performance of parastatals in 1987. Management of the agricultural marketing parastatal, Agricultural Development and Marketing Corporation (ADMARC), was restructured, its staff reduced, and some assets sold. Steps were also taken to encourage private sector participation in -.aarketing smallholder agricultural produce, with a view to reducing ADMARC's monopoly on smallholder marketing. There was also a wide range of price and tariff increa>ses that resulted in significant improvement of the overall fi..ancial performance of parastatals. 10. The external situation, however, continued to deteriorate. The number of displaced persons from Mozambique increased to an estimated 450,000--equivalent to 6% of Malawi's population--contributing to a sharp rundown of Malawi's strategic grain reserve and imposing further budgetary burdens. In addition, poor rains and crop diseases depressed agricultural production and required emergency food imports. Nevertheless, imports (FOB basis) remained compressed 55% below the 1980 level (see Chart 1); GDP fell by 0.2%, and inflation increased to 26% in 1987. Future growth will be predicated on enhanced availability and better allocation of foreign exchange. In the short run, Malawi will be reliant on foreign grants and credits to increase its capacity to import; in the medium to long term, its exports must increase. To improve resource allocation, the authorities must phase out the present rationing system and relnstate the market as the vehicle to allocate foreign exchange. These changes will have to be supported by appropriate demand management through a combination of fiscal and monetary restraint, and changes in relative prices of traded vis-a-vis non-traded goods. C. Medium-Term Prospects and Policies 11. Government began preparing a new medium-term development strategy in 1987. This new program is described in detail in the "Statement of Development Policies, 1987-1996," a comprehensive report produced b-y Government, and the Policy Framework Paper, negotiated in Malawi in March 1988 and scheduled for review by the IMF Board and World Bank Executive Director's Committee of the Whole in June 1988. 12. Governent's strategy is designed to stabilize the economy and establish the foundation for resumed economic growth despite the difficult external environment. The basic macroeconomic objectives of the program include: (i) raising the rate of real GDP growth from 1.5% in 1988, to 4X  in 1989, 4.32 in 1990, and 4.92 by 1992; and (ii) restoring fiscal discipline consistent with balance of payments targets and reducing the annual rate of inflation from 262 in 1987 to about 52 by 1991. To achieve these objectives, G.verrnment will pursue a two-pronged strategy of structural reform and financial stabilization. Reduction of the fiscal deficit, strict monetary and credit policies, and exchange rate adjustments are expected to bring aggregate demand in line with available resources. Complementary supply side measures, such as increasing flow of foreign exchange to the private sector, trade liberalization, re-direction of credit away from the public sector, and tax reform are designed to stimulate private sector production. 13. The medium-term development program also provides for new investments and policy reforms in the key productive sectors to increase output. The sectoral growth strategy focusses on increased private sector activity, improved efficicncy in public sector resource management, and greater role for market forces in resource allocation. In agriculture, the major source of growth and export earnings, Government emphasizes a more intensive and productive use of resources and greater crop diversification, in view of growing land pressures and the vulnerability of Malawi's narrow export base to world price fluctuations. The continuing reform of ADMARC, and expanding the scope of the private sector in crop marketing, will remain important policy objectives. In transport, the disruption of Malawi's external routes has resulted in increased transport costs and reduced reliability in the supply of imports and exports. Government is therefore developing the Northern Corridor with Bank and donor assistance while working to reopen the traditional lines. In industry, Government intends to revive production and investment by revising incentives fox domestic and foreign investment, stimulating efficiency through competition by eliminating quantitative restrictions on competing imports, and stimulating the flow of credit to small-scale industry. In the social sectors, Government's strategy is to broaden the level of services to raise education, health, and nutrition levels. In education, the emphasis will be on the expansion and quality improvement of primary education and on shifting the emphasis from secondary boarding schoole in favor of secondary day schools, enhancing scientific and technical skills and improving teacher training. To address the major problems of population growth and health serv ces, Government is improving staffing of primary health education care facilities and increasing the allocation of resources for maternal and child care services. To improve nutrition levels, in 1987 Government established a food security monitoring and reporting system which it expects to be fully operational in late 1988. Government is also extending the credit and extension system and reorienting the research and extension program to bring farms under 1.5 acres, which constitute 752 of all smallholder farms, closer t. subsistence levels. D. Exterral Financing Requirements 14. Balance of payments and external financing requirement projections based on Government's medium-term development program are included in Annex I. Under these balance of payments projections, the total financing requirement would be about US$838 million in 1988-1990, including current  -6- *ccount deficits of US$447 million, principal repayments of US$:58 millicn, repurchase* from the IMF of about US$71 million, increases in gross reserves of US$85 million, elimination of US$46 million in import anid debt- service arroars, and other changes in Reser*e Bank liabilities of US$31 million. Disbursements from existing and expected coumntments would provide US$698 million of this requiremex.t (including US$160 million in financing under the proposed operation), IMF purchases would provide US$88 million, and debt relief would provide US$65 million in 1988189. The residual financing gap would be US$75 million, which is expected to be covered primarily through co-financing of the FY90 Agricultural Sector Credit under the Special Program of Assistance for Low-Income Debt- Distressed Countries in sub-Saharan Africa. E. IMF Program 15. After terminating a three-year extended arrangement in Septeniber 1986, which had been suspended in June 1986, Malawi was unable to reach agreement with the IMF on a successive facility in 1986 and 1987. During this period, however, Malawi remained current on all IMF repurchase obligations, which amounted to almost US$70 million. With the collaboration of Fund staff, Co-zernment introduced a "shadow program"' in August 1987 designed to reduce the fiscal deficit through expenditure and revenue measures. This shadow program was successful in restoring a degrce of fiscal balance and, more importantly, in signalling Government's serious intent to undertake appropriate adjustment measures. After reviewing progress under the shadow program, the IMF approved a 15-month stand-by drrangement of approximately US$18 million in March 1988. Under the arrangement, Government has agreed to undertake the following: vi) reduction of the fiscal deficit from 10.2% of GDP in 1987/88 to 8.1% of GDP in 1988/89; (ii) maintenance of a flexible exchange rate policy; (iii) introduction of a phased import liberalization program; (iv) elimination of all commercial trade arrears (this step was taken in January 1988) and progress in debt relief negotiations; (v) maintenance of market-based interest rates; and (vi) strict limits on money and credit expansion. Quantitative performance criteria under the IMF program include limits on net domestic assets of the banking system, net domestic credit to Government and parastate , and new non-concessional external borrowing contracted or guaranteed Dy Government. 16. The first IMF program review took place in March 1988, and the second is scheduled for September 1988. During May 1988 Bank-IMF staff completed negotiations on a policy framework paper (PFP) for the period 1988/89-1990/91 and a three-year arrangement under the Enhanced Structural Adjustment Facility (ESAF) for US$75 million. The ESAF, which reinforces and expands the stand-by arrangement in the areas of external sector policies, public finance and sectoral reforms, is scheduled for IMF Board presentation in June 1988.  -7- F. Collaboration with the IMF 17. Bank and Fund statf have worked closely reviewing macroeconomic and sectoral developments, and in formulating a new medium-term development strategy, the ESAF and the proposed operation. The PFP, scheduled for review by the Bank's Executive Directors' Committee of the Whole and IMF Board in J.ne 1988, provides the underlying macroeconomic framework as well as the general policy directions for this proposed operation. Since several of the specific reforms proposed under this credit reinforce and expand agreemerts and understandings reached under the IMF stand-by arrangement and the ESAF, the Bank has kept the Fund fully informed on all discussions aield with Government during crecit preparation, appraisal and negotiations. In particular, the Bank has reviewed exchange rate management, import liberalization, fiscal deficit, and tax reform issues with the Fund to ensure that the reform steps outlined in the credit are consistent with the IMF program. To avoid overlapping performance criteria between the IMF and Bank programs, the two institutions have pursued separL&ie but complementary actions. The Fund has led on exchange rate management, aggregate fiscal deficit targets, and monetary policy and credit targets. The Bank has focussed on the tax reform, export promotion, and trade and industrial policy. Since the import liberalization program bridges both macroeconomic and sector policy issues, the Bank and Fund have wor ed together in reviewing the scope and timing of the remaining liberalization program. G. Bank Group Strategy 18. Bank Group's strategy in Malawi focuses on continued support for broad-based structural adjustment of the economy leading to sustained real growth. In the short-term, the objective is to restore macroeconomic balance by reducing the fiscal deficit, improving the efficiency of foreign exchange allocation, and strengthening incentives for private sector production. The medium-term objective is to expand agricultural and industrial production by strengthening agricultural incentives and productivity, improving export competitiveness, and expanding the role of private conmnerce and trade. The Bank will also seek to build up the institutional basis for sound macroeconomic and sectotal planning and management. There will be continued support for the long-term goal of human resource development. 19. The Bank plans to complement broad-based Structural Adjustment Programs with a series of policy-based sectoral operations designed to address remaining structural constraints in the key productive sectors and deepen policy implementation. Initially, this will be accomplished via two operations that address both sectoral and macroeconomic policies: the proposed Industrial and Trade Policy Adjustment Program, and the FY90 Agriculture Sector Program. This phased approach acknowledges that Government will need to devote considerable time and energy on implementing, coordinating, and monitoring the related policy reforms.  Institutional strengthening will be addressed in the FY89 Institutional Development Project, which is designed to improve the capabilities of the Ministry of Finance and establish a management institute. II. INDUSTRY. TRADE AND FINANCE SECTORS A. Industrial Sector Overview 20. Industrialization in Malawi began after independence. Between 1964 and 1980, manufacturing value added (MVA) increased at an annual real rate of 10% per year and the sector's output share in GDP expanded from virtually nil to 12%. Industry currently contributes about 12% to GDP and about an equal share to wage employment, but the sector is still at a relatively early stage of development. The foods, beverages and textiles subsectors account for about two-thirds of total output. Malawi's landlocked position and ensuing high transportation costs provide natural protection but, by the same token, decrease the profitability of exports. Consequently, ti. sector is heavily oriented towards the domestic market. Industrial exports as a percent of sales are about 3%; the share of industrial exports in total exports is about 4%. Industry imports about two-thirds of its raw materials and, with the exception of agro-processing, has few linkages within itself and with other sectors in the economy. 21. Despite its inward orientation, Malawian industry has considerable strengths and in many respects is more solidly based than manufacturing sectors in other East African countries. First, the sector's efficiency, as measured by domestic resource cost (DRC) ratios, is relatively high. The average long-run DRC for the industrial sector is about 1.2, compared to 1.3 for Kenya, 3.0 for Tanzania, and 1.3 for Zimbabwe. Second, the industrial sector is well managed, altiiough management is predominantly foreign. Third, most firms are in sound financial health. Finally, product quality is adequate. 22. There are, however, some negative aspects. The small domestic market often cannot support more than one or two factories in a given subsector and as a result there is considerable degree of concentration. At the three-digit level ISIC classification, eight out of twenty-one subsectors have less than three firms. In the absence of strong competition from imported goods, this structure can lead to inefficiencies or high monopoly rents. There is, moreover, an unusual degree of concentration of ownership. Three holding companies--Press Holdings, the Malawian Development Corporation (MDC) and the Agricultural Development and Marketing Corporation (ADMARC)--own a sizable percentage of the sector's total equity. There are very close relations between industry and financial institutions: Press Holdings and ADMARC own 80% of the National Bank of Malawi and 70% of the Commercial Bank of Malawi.  - 9 B. Industrial Sector Policy Environment 23. The sector's early growth and present relatively high efficiency are in part the result of relatively good mac-oeconomic and sector policies. The sector benefited from: (i) stable prices; (ii) good exchange rate management; (iii) high savings and investment rates; (iv) liberal policies towards foreign and private investment; (v) very low protective tariffs; (vi) no distorting privileges for 'infant industries"--such as tax holidays; and (vii) relatively free entry.1 Expansionary fiscal policies throughout the 1970s and a mild form of price controls were the most salient negative features of the policy environment. 24. The macroeconomic policy response to the deterioration of the external environment in the 1980s has had deleterious effects on the performance of the industrial sector and on the quality of sectoral policies. From 1980 to 1986, industrial output growth slowed to an average annual rate of 1% initially because of slack domestic demand and since 1986 because of a binding foreign exchange constraint. Employment in manufacturing increased by only 500 workers, or 1% of the industrial labor force, compared to an average annual rate of growth of about 7% in the 1970s. The adoption of a discretionary system of foreign exchange allocation beginning in 1982 but particularly after mid-1986 has greatly increased protection through non-tariff barriers and undermined efficient resource allocation. Imports of goods, on an FOB basis, have fallen from 24% of GDP in 1980 to 14% in 1986. Competing imports have been effectively banned and the market share of firms is now largely determined by their allocation of foreign exchange. Although sectoral policies are still conducive to growth and efficient resource use. former macroeconomic policies must be restored in order to preserve the sector's efficiency and stimulate its growth and contribution to employment and exports. C. Financial Sector Overview 25. Malawi's financial system, like that of many other sub-Saharan African countries, is small and at an early stage of development. The main financial institutions are the Reserve Bank of Malawi, two commercial 1/ By law, any new manufacturing firm must obtain a license to begin production. Among other things, it must show that it will be profitable and comply with pollution laws. Its geographical location must be sanctioned by the authorities. To obtain the license, a notification of intention to begin operations is published in the official gazette. Existing firms have the option of objecting to its establishment on virtually any grounds, including defending their market share. This objection is only a recommendation to the Ministry of Trade, Industry and Tourism (MTIT) and in practice it has not posed a major barrier to entry: out of 136 requests submitted to the MTIT in 1985 and 1986, only 11 were rejected.  - 10 - banks, two finance houses, three development finance institutions (DFIs), the Post Office Savings Bank (POSB) and a building society. Financial instruments consist mainly of currency, deposits and government securities. Although the financial system has played an important intermediation role, several constraints have limited its growth and supply of financial services to the economy. The constraints include: (i) restrictive monetary policies to contain inflation while satisfying the credit requirements of the public sector; (ii) lack of an up-to-date and uniform legal framework for effective supervision of the operations of the financial institutions in the sector; (iii) low economic and operational efficiency owing to first, lack of competition and second, preferential tax treatment of interest income on deposits with the POSB and interest paid on mortgages with the building society; (iv) inadequate long-term credit; and (v) stringent lending practices that limit access to credit for industry. The Reserve Bank's banking inspection department is short of qualified and experienced staff and needs to be strengthened through recruitment and training. Similarly, POSE, the principal institution in small-scale savings mobilization and an important potential source of term funds for industry, has weak management and outmoded management information and accounting systems. The DFIs (INDEBANK, INDEFUND and SEDOM) lack recourse to kwacha denominated funds for term lending owing to legal restrictions on their activities. 26. The fiscal deficit has had an impact on the distribution of domestic credit and the performance of the banking sector. Whereas net domestic credit to the public seccor (stemming solely from the Reserve Bank) more than doubled relative to GDP between 1979 and 1986 (from 11% in 1979 to 23% in 1986), credit to the private sector fell by more than one- half, from 23% of GDP to 10%. Restrictions on the expansion of domestic credit to the private sector also crowded out the commercial banking system. In the early 1970s commercial banks accounted for virtually all of the domestic credit outstanding; by 1979 ..Ieir share had fallen to 75% and by 1986 to 45%, with the Reserve Bank accounting for the rest. The restrictions on commercial bank credit expansion hampered the growth of the banking system and reduced the potential impact of a larger market on the promotion of competition in the commercial banking system. III. THE SECTORAL ADJUSTMENT PROGRAM A. Introduction 27. Government has developed a comprehensive industry and trade policy adjustment program to implement a major part of the macroeconomic and sector policy reforms set out in its medium-term development strategy. reviewed in paras. 11-13. The program reinforces macroeconomic stabilization strategies initiated under the IMF stand-by arrangement and introduces a series of policy measures and institution-building components designed to increase competition, efficiency, and productivity in key productive sectors. The backbone of the program is trade liberalization, complemented by flexible exchange rate management, fiscal deficit reduction, reform of foreign exchange allocation, and tax reform. The strengthening of a market-oriented system of foreign exchange allocation would be accompanied by the removal of import prohibitions, rationalization of the import tariff structure, ani. further price decontrol. The program also includes measures to support development of small-scale enterprises  - 11 - and increase efficiency in the finance sector. The overall program is described in detail in Government's Letter of Development Policy, included as Annex II, and reviewed below. The major policy reforms are summarized in matrix form in Annex III. B. Trade Policy and Exchanxe Rate Manaaement 28. The centerpiece of the industry and trade adjustment program is a major liberalization of the trade regime. The industrial sector evolved into an efficient sector because it grew in a relatively free-trade environment with price signals that, in general, were conducive to efficient resource allocation and adequate resource mobilization. Since 1980, but particularly since 1986, the authorities' response to the exogenous shocks that Malawi has suffered has resulted in a serious deterioration of the macroeconomic env!-xnzment. Malawi's domestic market cannot support efficient production of all industrial goods; Imports are needed to complement domestic procuction, allow specialization, and provide competition to local monopolies. The progressive closing of the economy during the past ten years has encouraged excessive product diversification, inefficient import substitution, and monopolistic pricing behavior. To help reverse these trends, former trade policies must be restored. In particular, the discretionary allocation of fore!gn exchange should be eliminated and import duties lowered. 29. Government is conmitted to phasing out the administered foreign exchange allocation mechanism and reinstating a market-determined system that would allow importers to obtain foreign exchange on request without prior approval. In view of existing external imbalances and the low level of reserves, liberalization of the foreign exchange allocation system is being phased in over three years. The first stage, introduced in February 1988, removes prior foreign allocation approval for a range of items comprising about 25% of the total import bill, including fertilizer, petroleum and 25% of raw materials and spare parts. The second stage will apply to about 30% of the total import bill and expand coverage to a further 50% of raw materials and spares and a small amount of finished goods to reintroduce competition through imports in the domestic market. In collaboration with the Bank and the Fund, Government will continuously review resource availability to adjust the pace of liberalization accordingly. Subsequent steps will focus on remaining raw materials and spare parts, followed by most intermediate and capital goods. Government aims to attain complete liberalization by mid-1991. The specific timetable will be developed for second tranche release, when Government has more information on the level of expected external commitments for 1989-91 and on the projected demand for imports under the liberalized regime. 30. In parallel with the elimination of prior Reserve Bank foreign exchange approval for imports, Government is liberalizing import licensing by expanding its Open General License (OGL) System. While about 85% of the  - 12 - total import bill is subject to OGL, 34 specific categories of goods and all goods from certain countries require import licenses from the Minl.try of Trade, Industry and Tourism. As part of the reform program Government is eliminating this licensing requirement for 7 categories of goods and 22 countries. The few remaining licensing requirements remain primarily in the interests either of public health, safety, or food security. 31. Malawi pursued flexible management of the exchange rate throughout the 1980s and, save for a slight appreciation in 1980 and 1981, kept the real effective exchange rate at about the average 1979 level. However, as a result of adverse shifts in the terms of trade, high debt servicing costs, and unbudgeted food and security-related expenditures, Malawi has experienced significant excess demand for foreign exchange since mid-1986. While the kwacha was devalued by 20% in February 1987, the effect of the depreciation was largely eroded by inflationary developments, and Malawi's external position remained extremely tight throughout most of the year, prompting the retention of controls on the allocation of foreign exchange. To restrain relative demand for imports while reinforcing export incentives, the kwacha was further devalued by 15% in January 1988. Government will continue to pursue a flexible exchange rate policy with the aim of maintaining external competitiveness and achieving balance of payments objectives. In particular, Government will ensure that the management of the exchange rate complements trade liberalization, tariff rationalization, and external resource availability. Cw.t 2: MALAWI--Reil Exchange Rate 1 70-87 110 . TT TT. T . T.I ~~~~~ S.M . ,. ,-,!T .I 4 t t r **tT.| I ! 'iw ': l t I 8 96 ~~~~..... .. . .... ..... ....... .... ... ..... .......i, iT\, 5.. .. 1 o . . . i . , . t l X . i 100.4~~~.............1. X 7, , !A' ;l 4, I ' I - Ij m 197 t 1t7'+ ' 1 10 - l I 1970 172 1974. 1076 1978 196 1 164 196  - 13 - 32. The proposed credit would support Government's program of trade liberalization by providing foreign exchange to meet the increased demand for imports under liberalization and by reinforcing key macroeconomic and sectoral policy reforms. The operation, including substantial co- financing, would finance about 11% of the 1988-90 import bill. An initial implementation schedule for key actions necessary to support trade liberalization has been established. The Government has already completed a number of these actions, including devaluation of the kwacha by 15%, introduction of the first stage of liberalization, agreement on the approximate timing and general content of the second stage, and reduction of the scope of import licensing. Before the release of the second trauiche, Government would implement the second stage of liberalization, agree on the timing and content of the remaining liberalization steps, and ensure that exchange rate management is consistent with the overall balance of payments objectives. While the Bank would monitor the real effective exchange rate to ensure the macroeconomic consistency of the trade reform program, the IMF would contir.a to assume primary responsibility for ne