Malawi - Financial Sector and Enterprise Development Project

Document of The World Bank FOR OFFIC IAI. USE ONLY Report No. 9096-MAI STAFF APPRAISAL REPORT MALAWI FINANCIAL SECTOR AND ENTERPRISE DEVELOPMENT PROJECT FEBRUARY 25, 1991 Industry and Energy Operations Division Southern Africa Department This document has a restricted distribution and mas be used by recipients only in the performance of their official duties. Its contents mav not otherwise be disclosed without World Bank authorization.  C'IJRKENCY EQUIVALENTi S Currency Unit = Malawi Kwacha (MK) USS 1.00 = MK 2.65 (January 1991) MK 1.00 = US$ 0.38 MK 1.00 = 100 tambalas GLOSSARY OF ABBREVIATIONS ADMARC Agricultural Development and Marketing Corporation ASAC Agriculture Sector Adjustment Credit CBM Commercial Bank of Malawi DEVPOL Statement of Developmenit Policies DFI Development Finance Institutions ECMAC Entrepreneurship and Capital Market Adjustment Credit EEC European Ecomomic Community ECGF Export Credit Guarantee Facility Africa ESAF Enhanced Structural Adjustment Facility FIAS Foreign Investment Advisory Services IFC International Finance Corporation INDEBANK Investment and Development Bank of Malawi INDEFUND Investment and Development Fund IMF International Monetary Fund ITPAC Industrial and Trade Policy Adjustment Credit LFC Leasing and Finance Company of Malawi MDC Malawi Development Corporation MEPC Malawi Export Promotion Council MIM Malawi Institute of Management MOA Ministry of Agriculture MTIT Ministry of Trade, Industry and Tourism NBM National Bank of Malawi NBS New Building Society NBFIs Non-banks Financial Institutions PFIs Participating Financial Intermediaries PPF Project Preparation Facility POSB Post Office Savings Bank RBM Reserve Bank of Malawi SEDOM Small Enterprise Development Organization of Malawi SME Small and Medium Enterprise SSIU Small Scale Industry Unit USAID United States Agency for International Development WWBM Women's World Banking of Malawi FISCAL YEAR April 1 - Marchi 31  FOR OFFICIAL USE ONLY MALAWI FINANCIAL SECTOR AND ENTERPRISE DEVELOPMENT PROJECT TABLE OF CONTENTS CREDIT AND PROJECT SUMMARY . . . . . . . . . . . . . . . . .i-ii I. SECTORAL ENVIRONMENT . . . . . . . . . . . . . . . . . . . . 1 Economic Setting . . . . . . . . . . . . . . . . . . . . . . 1 Structural Adjustment Policies . . . . . . . . . . . . . . . 1 The Financial Sector . . . . . . . . . . . . . . . . . . . . 3 Institutional Structure . . . . . . . . . . . . . . . . . . . 3 Monetary Developments . . . . . . . . . . . . . . . . . . . . 4 Resource Mobilization .................... 5 Resource Allocation . . . . . . . . . . . . . . . . . . . . . 6 Issues in the Financial Sector . . . . . . . . . . . . . . . 6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . 12 Industrial Sector . . . . . . . . . . . . . . . . . . . . . 13 Issues in the Industrial Sector . . . . . . . . . . . . . . 15 Demand for Investment Credit . . . . . . . . . . . . . . . 17 Government and Bank Strategy . . . . . . . . . . . . . . . 18 II. PROJECT RELATED INSTITUTIONS . . . . . . . . . . . . . . . 19 Introduction . . . . . . . . . . . . . . . . . . . . . . . 19 The Reserve Bank of Malawi . . . . . . . . . . . . . . . . 20 Commercial Bank . . . . . . . . . . . . . . . . . . . . . . 21 Leasing and Finance Corporation . . . . . . . . . . . . . . 22 Investment and Development Bank of Malawi (INDEBANK) . . . . . . . . . . . . I . . . . . . . . . . 23 The Malawi Development Corporation (MDC) . . . . . . . . . 24 This report is based on the findings of an appraisal mission which visited Malawi in June 1990. The mission comprised Vincent M. Rague (Mission Leader), Mr. Simon Bell, Financial Economist (AF6IE); Mr. Roy Karaoglan, Sr. Banking Specialist (AFTTF); Ms. Catherine Seibert covered Small and Medium Enterprise issues (AF6IE); and Messrs. Paak , Benvenisti and Lethbridge (Consultants). Messrs. Paul Ballard, ;.icipal Industrial Economist and K. J. Walraven (AFTIE) were the peer reviewers for the operation. Secretarial support was provided by Mesdames Irene Chacon and Nuria Plaza (AF6IE). Messrs. David Cook (AF6IE) and Stephen Denning (AF6DR) are the managing Division Chief and Department Director, respectively. This document has a restricted distribution and may be used by recipients only in the performrance of their offlcial duties Its contents mas not otherwise be disclosed without World Bank authorization  MALAWI FINANCIAL SECTOR AND ENTERPRISE DEVELOPMENT PROJECT TABLE OF CONTENTS (Cont.) III. THE PROJECT . . . . . . . . . . o . . . . . . . . . . . 25 Project Origin and Rationale . . . . . . . . . . . . . . . 25 Project Objectives and Design . . . . . . . . . . . . . . . 26 Project Description .... . . . . . . . . . . . . . . . . 26 Sector Policy Measures and Conditions . . . . . . . . . . . .. 28 Eligibility Criteria for PFls . . . . . . . . . . . . . . . 30 Eligibility Criteria for Subprojects . . . . . . . . . . 31 Subloan Processing and Administration . . . . . . . . . . . 32 Institutional Capacity Development Component . . . . . . . 33 Project Cost, Financing and Co-financing . . . . . . . . . 36 Terms and Conditions .... . . . . . . . . . . . . . . . 37 Project Implementation . . . . . . . . . . . . . . . . . . 37 Environmental Assessment ... . . . . . . . . . . . . . . 38 Procurement and Disbursement . . . . . . . . . . . . . . . 38 Special Account . . . . . . . . . . . . . . . . . . . . . . 41 Auditing, Accounting and Reporting Requirements . . . . . . 42 IDA Supervision .... . . . . . . . . . . . . . . . . . . 42 Project Benefits and Risks ... . . . . . . . . . . . . . 43 IV. AGREEMENTS AND UNDERSTANDINGS . . . . . . . . . . . . . . . 43 LIST OF TEXT TABLES Table 1 Loans Advanced: Informal and Formal SME Credit Sources . . . . . . . . . . . . . . . . . 10 Table 2 Estimated Project Cost and Financial Plan . . . . . . . 36 Table 3 Procurement Arrangements . . . . . . . . . . . . . . . 40 Table 4 Allocation of IDA Credit . . . . . . . . . . . . . . . 41  lIST OF ANNEXES Annex I Gross Domestic Product by Industrial Origin 1973-89 Annex II Distribution of Financial Sector Assets, 1985-88 Annex III Principal Interest Rates Annex IV Commercial Banks: Advances by Main Sectors Annex V Credit Extended by Non-Bank Financial Institutions Annex VI Commercial Banks in Malawi Annex VII Leasing and Finance Company of Malawi Annex VIII Investment and Development Bank of Malawi Limited Annex IX Comparison of Ratios of Operating Costs of Banks in Selected Sub-Saharan African Countries Annex X Malawi Development Corporation Annex XI TOR for Consultancy on Monitoring and Forecasting Monetary Aggregates Annex XII TOR for Consultancy on the Restructuring of the POSB Annex XIII Export Credit Guarantee Facility Annex XIV TOR for Investment Promotion Agency Annex XV SME Technical Assistance and Training Fund Annex XVI Apex Unit Annex XVII Schedule of Disbursements Annex XVIII Supervision Plan  MALAWI FINANCIAL SECTOR AND ENTERPRISE DEVELOPMENT CREDIT CREDIT AND PROJECT SUMMARY Borrower: Republic of Malawi Beneficiaries: Reserve Bank of Malawi (RBM), participating financial intermediaries (PFIs), Ministry of Trade, Industry and Tourism (MTIT), the Post Office Savings Bank (POSB), the Chamber of Commerce and lddustry, 'lalawi Development Corporation (MDC), Investment and .e-lpmenc Bantc of Malawi (INDEBANK), and various local SME-Suppor: institutions. Amount: SDR 22.3 icillion, US$32 million equivalent Terms: Standard IDA, witvi 4'! years maturity Onlending Terms: RBM would through an Apex Ur:it onlend IJS$27.4 million equivalent of the IDA Credit to eligible PFIs in local currency at a pre- determined reference rate. The reference rate would be determined by RBM as the prevailing average cost of term borrowing in The financial system (about 13.625 percent in December 1990, calculated as a simple average of all prevailing interest rates on term deposits in Malawi). PFIs would relend the funds at market rates to finance viable subprojects in the productive sectors. RBM would pass to the Government the interest received from PFIs, less a 0.5 percentage point fee to cover RBM's administrative costs for operating the Apex Unit. The Government would bear the foreign exchange risk out of the interest received from PFIs. The Government would provide US$4.6 million equivalent through RBM for institutional capacity development to beneficiaries on a grant basis. Project Obiectives: The objectives of the project are to support Government efforts to expand exports and improve the policy and institutional framework relevant to private sector investment. These objectives would be achieved by: (i) encouraging the commercial banks and nonbank financial intermediaries (NBFIs) to c,igage in term financing of viable enterprises in the p-oductive sectors, including SMEs and enterprises owned 1y womin; (ii) improving the institutional framework for export ,inance and investment promotion, including support for a p.oposed investment promotion agency and an industrial infrastructure and factory shell development program; (iii) supporting the strengthening and operational diversification of financial institutions; and (iv) improving monetary policy management.  - ii - Proiect Description: The project would have three components. The Investment finaace component (USS2C.4 million equivalent) would be onlent to eligible PFIs through an apex arrangement at the RBM to finance projects in the productive sectors promoted by foreign and indigenous entrepreneurs. FFIs would make subloans through mechanisms such as leasing, equity finance and term loans. Equity investments would give preference to new ventures and be channelled through the development finance institutions (DFIs). The industrial sites component (US$7 million), as an apex arrangement at the RBM, would ensure timely availability of industrial infrastructure to industrial sites and factory shells to encourage investment by indigenous and foreign investors, especially those investing in export-oriented activities. To qualify as PFIs under these two components, financial institutions would have to be in compliance with the provisions of the revised Banking Act and meet additional eligibility criteria acceptable to IDA. The institutional capacity development component (US$4.6 million) would provide technical assistance and training to: (i) strengthen RBM's monetary policy management capability; (ii) assist Government to develop the institutional framework for the promotion of foreign and domestic investmen.t; (iii) support programs for MDC's reorientation, and INDEBANK's diversification into merchant banking and; (iv) to restructure the Post Office Savings Bank (POSB) into an autonomous and efficient financial institution; and (v) train local financial institutions' staff in project appraisal-related issues, especially the institutions that support SMEs and women entrepreneurs. Benefits and Risks: The proposed IDA Credit would fill a major gap in term financing for the productive sectors in Malawi. Using the existing intermediaries, including the commercial banks and NBFIs, the project would help strengthen institutional capabilities to promote, appraise and supervise viable projects. By increasing competition and the range of financial instruments, the project would enhance efficiency in term resource mobilization and allocation. Broader access to credit for investment will encourage real sector supply response and contribute significantly to the Government's growth and adjustment strategy. Investment promotion would help diversify Malawi's base for foreign exchange earnings by encouraging investments in export oriented activities. Initial investments are likely to be in labor intensive productive activities that would help alleviate the unemployment problem. Support for SMEs will also benefit women, three quarters of whom engage in some form of off-farm income generating activities. The major risks are the possibility of an economic slowdown, (which would discourage new investment), the conservative attitude of banks and large enterprises, and Government slackening on reforms. Malawi has in the past achieved high rates of growth, primarily through a steady expansion in agriculture. The risk  - iii - is alleviated by Government's continued emphasis on the development of agriculture as the mainstay of the economy, recent adjustment measures, and its strong commitment to implementing the reform program. Recent industrial and financial sector reforms have introduced competition in both sectors, which is changing conservative attitudes and making banks and enterprises more responsive to market forces. Another risk is the possibility of low investor response. This risk is mitigated by the favorable investment climate which is being created by the Government. Proiect Cost Suzmnary Estimated Costs: Local Foreign Total (US$ Million)_ Invest. Finance Comoonent: 11.9 20.0 31.9 Industrial Sites Component 2.9 7.0 9.9 Institutional Capacity Development 2.8 2.6 5.4 Total 17.6 29.6 47.2 Financing Plan: IDA 2.4 29.6 32.0 Government 0.4 --- 0.4 Co-financing 0.1 0.0 0.1 Project Sponsors 14.7 - 14.7 Total 17.6 29.6 47.2 Estimated Disbursements: Fiscal Year FY91 FY92 FY93 FY94 FY95 FY96 FY97 Annual 0.5 2.9 6.3 7.3 6.1 5.1 3.5 Cumulative 0.5 3.4 9.7 17.0 23.4 28.5 32.0 *Including the Repayment of PPF advances. Estimated Completion Date: June 30, 1997 Economic Rate of Return: Not Applicable  MALA. FINANCIAL SECTOR AND ENTERPRISE DEVELOPMENT PROJECT I. SECTORAL ENVIRONMENT Economic Setting 1/ 1.01 Malawi, with a population of 8 million and pe. capita income of USS170, remains one of the poorest countries in the world. The economy has a fragile and narrow resourse base that is dependent upon a few exports and a small domestic market. Such features make Malawi's economy vulnerable to external shocks, with the result that real growth in GDP fluctuates markedly from year to year. On average, the economy performed better during the 1960s and 19'70s, led by higher investment in agriculture and infrastructure, than in the 1980s. Between 1964 and 1979 real GNP per capita growth averaged 3 percent per annum, making it one of the fastest growing economies in the region. However, in the late 1970s, Malawi experienced a series of exogenous shocks and domestic policy weaknesses that substantially reduced per capita income growth. These shocks included a deterioration in terms of trade, ribing oil prices, and a civil war in Mozambique that disrupted traditional external transpo:t routes and led to higher transport costs that posed a seriou,s challenge to an economy that has historically been characterized by pragmatic management. In addition, prolonged drought in the early 1980s further exacerbated the situation by severely reducing export volumes. The Government's economic recovery program was impeded by further external shocks starting in the mid-1980s, which included the closure of the main external transport routes, worsening terms of trade, and an influx of displaced persons from Mozambique. Structural Adiustment Policies 1.02 The Government launched a series of structural adjustment programs throughout the 1980s in response to the repeated external shocks. Ultimately in 1987, the Government introduced a comprehensive structural adjustment program, which was supported by the International Monetary Fund (IMF) under its Enhanced Structural Adjustment Facility, and two World Bank operations: Industrial and Trade Policy Adjustment Credit (ITPAC) and the Agriculture Sector Adjustment Credit (ASAC). The macroeconomic objective of the adjustment effort is the resumption of higher levels of economic growth on a sustainable basis. 1/ A detailed review of the Malawi's economy is contained in the Country Economic Memorandum entitled "Malawi, Growth Through Poverty Reduction," (Report No. 8140-MAI), dated March 22, 1990. A Third-Year Policy Framework Paper (PFP), was reviewed by the Committee of the Whole in August 1990.  - 2 - 1.03 In_the External Sector, the liberalization of foreign exchanige allocattion and flexible management of the exchange rate are proceeding well and have resulted in substantial gains, by stimulating investment and increasing capacity utilization. In general, the Gov rnment growth strategy romains to ensure further liberalization of trade and payments system and the .ILtinlellanCe of external competitiveness. 1.04 Fiscal Policy under the program aims at reducing public sector deficits and macroeconomic imbalances caused by expansionary fiscal policy in previous years, and helping to mobilize domestic resources to support private sector investment. Higher revenues and lower expenditures have been achieved through expenditure controls, specific tax reforms and improvement in administration. The budget deficit excluding official transfers declined to 6.6 percent of GDP in 1988/89 from 9.6 percent in 1987. A further reduction was expected in 1990. 1.05 Sectoral Policies. The Government also introduced reforms in several sectors. In agriculture, the reforms emphasize enhanced food security and efficient resource use by improved producer prices, elimination of crop restrictions and increased support of the smallholder sector. In the financial sector, reform is focusing on increasing the role of market forces in resource mobilization and allocation and in the conduct of monetary policy. Reforms are also being implemented to improve the financial performance of the parastatal sector. 1.06 Implementation of the adjustment program has already had a favorable impact on economic performance as reflected in a reversal of negative GDP growth in 1987 to positive levels from 1988 through 1990 (GDP grew by 4.3 percent in 1989 and is estimated to have grown by 4.8 percent in 1990). Annex I shows the structure of GDP. Inflation decelerated from over 30 percent in 1988 to 15.7 percent in 1989. The import liberalization program has led to a strong recovery in manufacturing, construction and financial services, supported by an expansion in fixed investment, which increased from 13 percent of GDP in 1987 to 16 percent in 1989. About half of the investment was financed through national savings. 1.07 Despite the breadth of the reforms, Malawi's future growth faces uncertainty because of some remaining structural weaknesses that constrain development of a sustainable response. The specific reforms needed tc address these structural weaknesses are highlighted in the following brief review of the financial and industrial sectors. The proposed project would support the implementation of the reform objectives in both sectors.  -3- The Financial Sector 2/ Institutional Structure 1.08 The financial sector in Malawi is small and not yet well developed, but operates with very few distortions. The sector consists of formal side informal market segments. The formal sector comprises a central bank (Reserve Bank of Malawi); two commercial banks (the Nationa' Batik of Malawi and the Commercial Bank of Malawi); two finance houses (Mercantile Credit anid Leasing and Finance Company of Malawi Limited - LFC); a building society (Nt,w Building Society - NBS); four development finance institutions (DFIs); two savings institutions; an insurance industry comprising a series of insurance companies and brokers as well as several pension and provident fund managers. Securities markets are almost non-existent and the issue of treasury bills and Government local registered stoAk (LRS) is limited to institutional investors. The DFIs are the Investment and Development Bank of Malawi (INDEBANK), the Malawi Development Corporation (MDC), the Investment and Development Fund (INDEFUND), and the Small Enterprise Development Organization of Malawi (SEDOM). The savings organizations are the Post Office Savings Bank (POSB) and the Malawi Union of Savings and Credit Cooperatives Limited (MUSCCO). Annex II provides summary data on the distribution of financial sector assets. 1.09 The Reserve Bank of Malawi (RBM) was established at the time of independence in 1964 and provides all the normal central banking services. RBM is charged with the responsibility of managing Malawt's foreign exchange reserves and the exchange rate, promoting monetary stability and a sound financial system, and acting as banker and ad-. isor to the Government. In addition, the central bank administers Malawi's exchange control regulations, issues and underwrites Government securities and regulates and supervises the activities of most Cinancial institutions. Regulatory and supervisory functions are being strengthened to respond to the new responsibilities and powers of the RBM under the revised RBM Act (para 2.05). 1.10 Recent Performance. The health of the financial system in Malawi tends to mirror the health of the overall economy. The commercial banks and all the major non-bank financial intermediaries (NBFIs) appear to be sound financially. The financial system in Malawi has recovered from a period of uncertainty and general decline in the mid-1980s and has emerged stronger and more efficient. The good performance is a tribute to the non-interventionist policies of the Government of Malawi that have allowed the fina.cial institutions to make autonomous operating and lending decisions based on commercial considerations. 2/ A detailed description and analysis of the financial sector is available in the Financial Sector Report No. 9009-MAI. This section of the SAR gives a brief overview of the financial sector and highlights issues to be addressed under the proposed IDA credit.  -4- 1. 11 The two Commercial Batiks the National Bank of Malawi (:iM) and th1e Cotmmnercial HanK of Malawi (CBM), have a long history of opera>'CInIS in Malawi andl are generally well regar-led by the banking public. Tho wicle branch network and the use of mobile units in rural areas, lhas helped to gonerate a large deposit base. Both banks have competent management and sound professional staff, who run the institutions on a commercial basis atnd profitably. In the early 1980s, the banks faced liquidity and portfolio probleva; because of over-expo3ure to estate agriculture (tobacco). Throughout the mid-1980s, management focused on rebuilding the banks inito viable financial institutions with strong balance sheets. The process was completed in 1987. In the last five years, both banks earned an average return on assets of becween 1 and 1.5 percent per annum. In the process of rebuildirng the banks, management followed a highly conservative approachi to lending and business development, focusing on cash flow leieding for shlort- term working capital, supported by adequate collateral. 1.12 The larger NBFIs also appear to be in sound financial condition and have played an important role in allocating and mobilizing fin.ancial resources in Malawi. Even the smaller financial institutions have performed reasonably well. INDEFUND, which targets medium scale enterprises, for example, has operated cautiously and managed to achieve profitable operations in 1988 and 1989. The DFIs among the NBFIs also play an important role in resource allocation, their capacity has been constrained by the lack of access .o term funds. For those DFIs targeting Small and Medium Enterprises (SMEs) (such as INLEFUND and SEDOM), the constraint has been weak institucional capacity to promote, evaluate and monitor projects and to provide effective technical assistance to SME entrepreneurs. Monetary Developments 1.13 Monetary developments in Malawi have tended to reflect underlying macroeconomic and fiscal developments. Short-term fluctuations in the main monetary aggregates are pronounced, responding to changes in the countr-'s external position and fiscal policy stance under the constraint of currency inconvertibility. The direct transmission of monetary effect is due, on the one hand, to the economy's narrow resource base and sensitivity to internal and external shocks, and on the other hand, to the shallowness of the financial system. Fiscal policy has exerted a major influence on the growth of the monetary base, with the borrowing requirements of the public sector being a consistent and increasing source of monetary growth. In most years since 1979, credit extended by RBM to the Government and public enterprises represented a large injection into the money base. Although the financial system has permitted financial resources to move out of narrow money into quasi money, the lack of depth has prevented the further diversification into alternative financial instruments. This situation partly explains a build up in excess liquidity in the commercial banking system. 1.14 Historically, monetary policy relied on the use of credit ceilings and flexible administration of interest rates. Other tools of monetary policy were sparsely, if ever, used. Towards the end of the 1080s, however, the Government and RBM initiated a process of reform thiat aimed to increase the effectiveness of monetary policy and, thereby, improve the effiziency of  - 5 - resource mobilization and allocation. The main thrust of the reform, most of which has already been implemented, is to move away from direct quantitative monetary control mechanisms and toward the use of more flexible, market-oriented and indirect monetary instruments. 1.15 Credit Ceilings. A major element of the ongoing reform was the abolition of credit ceilings by the end of 1990. Necessary as these ceilings were during the difficult 1980s for bringing macroeconomic aggregates under control, they have had a detrimental effect on the development of the financial system. 1.16 Interest rates have been gradually liberalized during the second half of the 1980s. From a system of complete administrative control before 1985, the monetary authorities gradually deregulated the interest rate system by mid-1990. This deregulation already has yielded positive real interest rates, lower lending rates and higher deposit rates in the commercial banking system. Principal interest rates in Malawi over the period 1985 to 1989 are given in Annex III. 1.17 Excess Liquidity reduces the effectiveness of monetary policy management. Commercial banks with excess financial resources are not reliant upon the central bank for funding and monetary policy levers such as the bank rate, and liquidity and reserve requirements, are rendered less effective. This was the case in Malawi in the second part of the 1980s and forced the monetary authorities to resort to the use of tools such as credit ceilings and direct inte-est rate management. Beginning in 1989, RBM started a process of using more indirect methods of monetary management, such as reserve requirements (since June 1989) to sterilize excess liquidity. Recently there has been a general decline in excess liquidity caused by economic recovery. 1.18 Development of Money Markets. Discount and Advance Facilities of RBM1 have rarely been used in the past and have remained inoperative during the recent period of excess liquidity. The decline in overall liquidity levels and the move toward the use of indirect monetary instruments will increase the importance of such facilities and thereby the ability of RBM to influence the level of interest rates. Primary sales of Government securities also have been sparsely used but the lower level of liquidity and the ongoing reforms will also foster the expanded use of the facilities and encourage the development of a money market. The IMF has provided an advisor on money market development (para 2.06). Resource Mobilization 1.19 Resource mobiliz. .- in Malawi has been hindered by many economic uncertainties, includint, e), -.l shocks and relatively high levels of inflation. Although mobilization by NBFIs, especially the non-insurance financial institutions, grew by 18.5 percent per annum over the 1980s, an average annual rate of inflation of 16.9 percent meant that real growth was considerably slower. Although there is seemingly not a strong relationship  6- between deposit mobilization and the level of inflation, in the longer term the real returns on savings have an impact on mobilization levels. Hence, the maintenance of positive real interest rates is an important determinant of long-term savings patterns. Resource Allocdtion 1.20 In general, the financial system tended to act as a conduit of funds from the private to the public sector over the 1980s. This resulted from the various economic shocks over the past decade which led to fiscal imbalances and a growing reliance upon the domestic financial system as a sour:e of public funding. This situation began to change in 1988 and increasingly more finance was freed for use by private sector investment. Nonetheless, the oligopolistic nature of the economy and the skewed distribution of incomes in Malawi will continue to provide some bias against the allocation of resources throughout the economy. The fragmented nature of the financial system and the high level of specialization of financial services has also tended to work against a better allocation of resources. Introduction of more institutions in the financial market and development of more multi- purpose financial institutions could provide an element of competition with benefits for both depositors and borrowers. As a longer term development, the evolution of a wider selection cf marketable financial instruments will also serve to raise additional funds and allocate them in a more appropriate manner. Issues in the Financial Sector 1.21 The Government's strategy for the financial sector, as outlined in the Statement of Development Policies (DevPol) and in the Third-Year Policy Framework Paper, involves strengthening monetary control, deepening the financial system and improving the efficiency of resource allocation for private sector investment. The major issue in the sector has been its inability to respond with flexibility to investor financing needs. The Government of Malawi, therefore, with IDA support undertook a review of the financial system that identified necessary policy reforms to deepen financial markets and improve efficiency in resource mobilization and allocation. Several of these reforms in monetary policy have already been implemented as highlighted above, while others are in the process of being implemented. 1.22 Asset Concentration. The financial sector has a high degree of asset concentration. Most banks and NBFIs are effectively controlled by a small number of agricultural and industrial conglomerates, which have dominant market positions in Malawi through interlocking ownerships. The resulting concentration of deposits and loans goes against sound banking principles of deposit and loan diversification and reduces intermediation efficiency. Several steps have been initiated by the authorities that could help mitigate the more perverse effects of excessive banking concentrations. These include encouraging the entry of new players into the banking sector, switching parastatal financing from the budget to the commercial banks, and syndication of large loans so as to spread their risk. Nonetheless, the  - 7 - problem of concentration will remain into the future. In the medium term, the authorities should also encourage the stronger financial institutions to offer equity shares to the general public as a means of de-concentrating ownership and broadening Malawian participation in the economy. 1.23 Lack of comietition. The high concentration, has led to concerns over the lack of competitive pressure in the banking sector. Several developments are now occurring which make this less of an issue for the future. These developments, include emerging competition between the two commercial banks; the aggressive entry by LFC into the market; the movement by the commercial banks into non-traditional areas of activity such as term lending; and the granting of a license to INDEBANK to engage in a wider range of merchant banking and financial services. The authorities are also hoping to attract more players into the market and gradually deconcentrate the ownership structure within the banking sector. As a first step the authorities plan to adopt an open and transparent process in the consideration of applications for entry into the banking system by both foreign and domestic financial institutions and NBFIs. The banking license to INDEBANK was the first granted under the new process. The proposed Project would complement efforts to introduce competition by supporting the reorientation and diversification of several NBFIs (paras 2.14 - 2.20). 1.24 Term Finance. In the recent past, the commercial banks tended to invest the excess of their liquid funds in Government securities. The excess liquidity reflected both the very conservative lending policies of the commercial banks as well as the attractive yield offered by Government securities. For the insurance companies and POSB, which are the main mobilizers of term savings, investment in Government securities has in the past been mandatory. The other NBFIs that potentially represent the most innovative part of the financial market, are constrained by the lack of adequate term resources. INDEBANK and MDC have in the past depended exclusively on external borrowing to fund their lending activities. The challenge is therefore to create effective intra-market intermediation mechanisms in Malawi that facilitate the flow of resources between institutions and enable some term transformation to take place. In the longer term, a likely solution will be to encourage the development of new negotiable instruments, loan syndications, direct domestic deposit mobilization by the DFIs and the issue of equity shares as a means of mobilizing longer term resources. The proposed Project would support the development of new financial instruments (the project has already supported the flotation of a bond by INDEBANK) and encourage the commercial banks to undertake term lending. 1.25 Asricultural Finance. Agriculture is a large and important part of the Malawi economy. This is reflected in a substantial proportion of the commercial bank's loan portfolio allocated to agriculture. However, bank lending to agriculture is almost exclusively to the large estate sector while medium and small-scale agriculturalists are locked out of the more formal financial markets by a lack of security and an absence of an established banking history. Outside the estate sector, the typical farmer is very small with holdings of less than one hectare. These farmers are served, to some extent, by the Smallholder Agricultural Credit Administration (SACA) that is managed by the Ministry of Agriculture (MOA). Together with agricultural  - 8 - services, SACA provides mainly short-term seasonal input loans. Thie 6clk ce, which has been limited to larger small-scale farmere, has bee,, .ely successful with collection ratios of between 75 and 95 percent. Although, the scheme has recently been expanded to cover a wider range of small-scale farmers, further steps will be needed to cater fully for the needs of smallholder agriculture. Under ASAC, the Government is reforming agriculture to increase productivity of a broader range of small holders and estates including changing laws to allow smallholders to grow high-value cash crops. These reforms will increase smallholder access to credit. 1.26 Parastatal Finance. The performance of the parastatal sector, whic1h forma a large part of the total economy and contributes around one quarter to national income, has been erratic. Poor performance in the mid-1980s led to a World Bank survey of the seccor in 1987 that identifi2d the following main problems: a focus on bureaucratic detail at the expense of bigger issues; a focus on smaller parastatals and inadequate monitoring of larger ones; insufficient attention paid to efficiency; and an over centralization by Government of decisions best made at the parastatal level. Since then rationalization and restructuring of many of the parastatals has led to a substantially improved financial position. The restructuring of the parastatal sector included the reorganization of the Agricultural and Marketing Corporation (ADMARC), MDC and the privately held Press Group (which operates like a quasi-public entity). 1.27 The issues that remain of concern in parastatal finance inc)ude: intermediated loans to private companies through parastatals by the RBM; a lack of consistency in the passing of foreign exchange risk to parastatals and the level of interest rates charged; streamlining and reorientating POSB operations (para 1.29); the current dormant state of MDC; and the reliance of parastatals on Government financing. The Financial Sector Report recommended that: intermediated loans through parastatals to private companies should be discontinued; a consistent set of rules on interest rates and exchange rate risk should be applied; MDC should be strengthened and assisted to adopt a more aggressive and catalytic developmental role in both the financial and industrial sectors; and, more parastatal financing should be moved to the commercial banking sector and away from its current reliance upon Government. Measures to address several of these issues have been initiated by Government with IDA support. 1.28 The Post Office SavinRs Bank (POSB) was established in 1911 tc provide savings facilities for small rural and urban savers through the Malawi post office system. POSB plays an important role in mobilizing savings by providing a geographically wide service through 158 post offices and 126 agencies. As at the end of 1987, POSB had total deposits of K89.4 million against total liabilities of K104.1 million. All of POSB'S resources are invested in Government securities. The POSB system apparently functioned well until 1986 and, although it has faced technical difficulties since then, it is still considered to be financially sound. 1.29 After 1986, POSB suffered from a major change in computing systems, which resulted in a work backlog exceeding two years that has persisted until now. Other problems still exist such as determining the new sources of investment for an institution traditionally reliant upon Government paper (in  - 9 - an environment where such paper is in increasingly ohort tuppiy) ; the need to eliminate provision of a tax exempt status on savings deposits to corporate savers who are frequently holding multiple accotunits; and determining the future role of the POSB in the evolving financial system. In addition, the current organizational structure makes POSB management not focussed and without necessary discretionary authority to successfully run a commercially oriented institution. The POSB currently operates as a department of the Malawi Post Office, which in turn operates as a Treasury Fund in the Ministry of Finance. The proposed Project would help Government and the POSB address the operational issues and efforts to create the POSB as a separate legal entity operating separately from the Malawi Post Office. 1.30 Small and Medium Enterprise Finance. Financial services to the sector are from three primary sources: (a) DFIs which onlend donor or Government supplied funds; (b) the informal financial sector; and (c) personal and internally generated savings. The two commercial banks are hesitant to service the SME sector because of the high administrative costs and the perceived high-risk associated with clients in the sector. The Government is committed to liberalize the financial sector in order to provide adequate finance and ease access to credit for SMEs. 1.31 During the 1980s, financial institutions (SEDOM, INDEFUND, and MUSCCO) were established to service the SME sector. These institutions had provided as of end-1989 a combined total of K26 million (approximately US$9.6 Million) through 1,076 term loans and 2,684 short term credits to a total of 3,861 clients. Most of the funds were largely disbursed as term credits with average maturity of 60 months and interest rates ranging from 16.5 to 18.5 percent (slightly below prime). Seventy-two percent of the total number of loans disbursed have been working capital loans extended through SEDOM. These 12 month credits at 18 percent per annum are an important source of funding for entrepreneurs given the limited availability of commercial banking services for the smaller enterprise sector. Agro- industry is the principal sector served, ranging from 32 to 39 percent of the portfolios of DFIs. 1.32 The Informal Credit Market provides a significant share of the SME sector's capital requirements. Although providing only 35 percent of the total value of loans, more than 10,000 SMEs are estimated to have borrowed from the informal institutions. Informal financial intermediaries provide credit services that are suited to the needs of their borrowers, including ease of access to credit, simple procedures, personal guarantees that are consistent with the repayment ability of the borrower, absence of controls and restrictions on the uses to which loans can be put, flexibility in repayment terms, confidentiality, and low transaction costs to the borrower. The very high interest rates do not seem to discourage borrowers (Table 1).  - 10 - Table 1: MALAWI - 1988 Loans Advanced From Informal & Formal SME Credit Sources Amount Interest Lender (KOOO) Number Rates Money Lenders 2,106 10,582 50-100% a/ Traditional Credit and Savings Association 1,221 NA 10-13% Targeted Formal Lenders 6,316 694 16-18% Sources: Chipeta, C. The Informal Financial Sector as Survival Strategy. Author's elaboration of data from 1988 financial statements for INDEFUND, SEDOM, MUSCCO a/ These interest rates may apply for periods varying from a few days to several months. Consequently, the annualized rates end to be substantially higher. 1.33 The recently established Malawi Mudzi Furd is modelled after the successful Grameen Bank of Bangladesh will supplement the lending activities of SACA in rural areas. Mudzi Fund only commenced operations in mid-1990 and hence no assessment of its role has been possible. SACA, which lends through farmers clubs, has demonstrated the benefits which can flow from group lending activities. The development of the Mudzi Fund is a further extension of the group lending concept. Group financial activities have proved themselves more amenable to repayment of loans and hence enhance the capacity for further, future borrowing. 1.34 Technical assistance to SMEs for the development of new entrepreneurs is provided by a number of programs subsidized by donor agencies. Delivery is undertaken by SEDOM, MUSCCO, the Development of Malawian Traders Trust (DEMATT) and, to a lesser extent, the Malawian Entrepreneurs Development Institute (MEDI), the Rural Trade School, the Polytechnic and a technical training school at Salima. Program objectives have so far been modest relative to demand and have favored new entrepreneurs. Existing entrepreneurs would benefit from more and better structured business administration courses. Technical assistance is needed particularly for the training of trainers. 1.35 Constraints to SME Borrowers. Principal constraints to financing SMEs through formal financial institutions include the ability of the borrowers to meet project preparation requirements, equity contribution ratios, collateral requirements and, at times, the viability of project  - 11 - proposals. Equally important is a policy environment that has been a major constraint on SME development. The reactivation of a credit guarantee facility operated by SEDOM and possible establishment of venture capital or equity funds might help to overcome local bankers' reluctance to lend to non- prime borrowers. The recent introduction of market-determined interest rates, together with modifications to the management of the money supply outlined above, would improve incentives to lend to non-prime borrowers. The Government is committed to encouraging lending to SMEs to be based on market determined interest rates (with appropriate adjustments for risk). Equally important the Government and the donors involved in the sector agree on the need for DFIs supporting the SME sector to be self-sustaining in their lending operations. The Government plans to introduce policy changes that reduce key restrictions on the development of SMEs, including liberalizationl of the blanket prohibition of any business activity in residential areas. 1.36 Particular Challenges of Women Borrowers. A large number (about 75 percent) of women engage in some form of non-farm enterprise as an important source of revenue. Nevertheless, women have limited access to the services provided by most financial institutions. For SME assistance organizations to better reach women, they need to broaden their target groups to include the types of enterprises in which rural women participate, experiment with assistance strategies that more effectively reach women and include more women on their staffs. The recent initiatives such as the MUDZI Fund and the newly established Women's World Banking of Malawi (WWBM) may help to address some of these constraints faced by women entrepreneurs. 1.37 Capacity Constraints of SME Institutions. Virtually all of the institutions which service the SME sector are relatively new having began their operations in the last dozen years. A review of these institutions demonstrates mixed performances. Management talent is relatively scarce, hindering the ability of the institutions to effectively deliver technical assistance to SMEs. For these institutions to reach their potential they will have to develop an aggressive human development resource strategy which will groom talent from within their ranks. The newly established Malawi Institute of Management (MIM) is a resource which can be more fully utilized to foster depth in the management ranks (a write up on MIM is available on Project File). The College of Accountancy also provides a variety of courses that are well suited to strengthen the skills of lower-level professional staff. 1.38 Development of Capital Markets. Capital markets are underdeveloped in Malawi, however, the Government is committed to encouraging the development of money and capital markets. Although the types of instruments that capital market development would provide are currently not available, recent studies show that there would be a reasonable demand for these types of instruments. In 1990, the passing of the Capital Market Development Act and the issue of bonds in the local market by INDEBANK are a significanit first step towards the development of a capital market in Malawi. As the market develops further, brokers/dealers need to emerge to provide a secondary market to primary issues of capital market instruments. A major issue in Malawi is the lack of incentives for private companies to issue their shares to the public. As a result there virtually are no public companies in Malawi. Under current legislation, private companies are  r t i I