Malawi - Industrial and Agricultural Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Repot N.. P-4156-}I REPORT AND RECOMNENDATION OF TME PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVEIOPMENT TO THE EXECUTIVE DIRECTORS ON A PROFOSED LOAN IN AN AMOUNT EQUIVALENT TO USt7.8 MILLION TO THE GOVERNMENT OF MALAWI FOR AN INDUSTRIAL AND AGRICULTURAL CREDIT PROJECT December 2, 1985 This dooatnet L-s a restioFtd distribudon and may be used by renpiemts OdY in the ped see of 0 ~~their Lfcmd duSe; Its rontents ass not owerwise be dsSosed wit.1twit World Bank uoiza*fiwon  CURRENCY EQUIVALENTS (August 1985) Currency Unit - ILawian Kwacba (MK) US$1 - MK 1.80 MK 1 - US$0.56 GLOSSARY OF ABBREVIATIONS ADB - African Development Bank ADMARC = Agricultural Development and Marketing Corporation CBM - Commercial Bank of Malawi CDC - Comonwealth Development Corporation DEG - Deutsche Entwicklungsgesellschaft (German Finance Company for Investments in Developing Countries) EIB = European Investment Bank FM = Nederlandse Financierings Maatschappi Voor - Outwickeling Sladen (Netherlands Finance Company for Developing Countries) IFC - International Finance Corporation INDEBANK = Investment and Development Bank of Malawi Limited MDC - Nalawi Development Corporation .EPC = Malavi Export Promotion Council NEK = National Bank of Malawi NBS - New Building Society PGL - Press Group Limited POSB = Postal Savings Bank SEDOM = Small Enterprise Development Organization of Malawi FISCAL YEAR Government of Malawi: April 1 - March 31 INDEBANK: January 1 - December 31  FOR OFFICIAL USE ONLY MALAWI INDUSTRIAL AND AGRICULTURAL CREDIT PROJECT Loan and Project Summary Borrower: Republic of Halawi Beneficiaries: Investment and Development Bank of Malawi (INDEBANK), National Bank of Malawi (NBM) and the Commercial Bank of Malawi (CBM). Terms: Repayable in 15 years, including four years of grace, at the standard variable interest rate. Amount: US$7.8 million equivalent Relending Terms: INDEBANK Line of Credit. The Government would onlend US$3.0 million to INDEBANK to finance industrial, and commercial projects at the variable interest rate to be paid by Government on the proposed loan. Repayment would be in accordance with the aggregate of the amortization schedules applicable to subloans. The maximum repayment period is 15 years including four years of grace. INDEBANK would on-lend loan proceeds at a variable rate that would be positive in real terms and adequate to cover reasonable administrative expenses. INDEBANK's current lending rate for industrial credit is 13% p.a. Sub-borrowers would bear the exchange rate risk. Agricultural Credit. The Government, through the Reserve Bank of Malawi, would onlend US$4.5 million to INDEBANK, the National Bank of Malawi and the Commercial Bank of Malawi at a rate initially set at 10.5% p.a. These institutions would onlend at rates initially ranging from 11.5 to 15% p.a. The Government would bear the exchange rate and variable interest rate risks. Technical Assistance Component. US$.3 million would be a Government grant to INDEBANK. Project Description: The project's objectives are to: (i) build upon and further * strengthen INDEBANK's institutional capabilities, assist in diversification of its role in productive sectors, and expand its activities in the agricultural sector-the mainstay of Malawi's economy; and (ii) fulfill the need for term financing for agricultural estates to increase productivity thereby improving the potential for diversification. The proposed project consists of (i) a US$3.0 million credit line to finance viable industrial, commercial, transport and tourism investments; (ii) a US$4.5 million agricultural credit component to Provide investment credit to agricultural estates; and (iii) US$.3 million in technical assistance to INDEBANK to strengthen its capability to promote, appraise and monitor agricultural projects. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contenst may not otherwise be disclosed without World Bank aumiorization.  (ii) Benefits and Risks: The proposed project would strengthen INDEBANK's capabilities to promote the development of productive activities and thereby enable it to create new investment and employment opportunities in Malawi. Benefits would accrue from the agricultural component by (i) satisfying existing unfulfilled demand for term finance for agricultural estates thus filling a void in the financial sector; and (ii) financing productivity improving investments which would free up land and thereby increase potential for diversification. The pilot nature of this component - partly to be channeled through the commercial banks would permit evaluation of-the suitability of these institutions to effectively administer term credit to the estate subsector. - The main project risk is that the estate crops are produced for export and a substantial drop in the international prices for these crops would result in liquidity problems for sub-borrowers and in defaults on loan repayments. Bank forecasts indicate some stability in these commodity prices. Further, investments to be financed are expected to develop lower cost producers better able to withstand price falls. Gradual diversification would further reduce farmers' vulnerability to this risk. Finally, participating financial intermediaries' careful review procedures would screen out marginal investments. Estimated Cost: Local Foreign Total -C USS million) INDEBANK Line of Credit Component 3.42 6.13 9.55 Agricultural Credit Component 1.80 2.70 4.50 Technical Assistance Component .10 .20 .30 5.32 9.03 14.35 Financing Plan: a/ Local Foreign Total (US$ million)- Internal cash generation 2.22 - 2.22 IBRD loan 1.90 5.90 7.80 Other borrowings (from ADB, 1.20 3.13 4.33 EIB, CDC and FNO) 5.32 9.03 14.35 Estimated Disbursements: Bank FY 1986 1987 1988 1989 1990 1991 1992 1993 %,USS million) Annual 1.0 2.0 1.5 1.4 1.0 .3 .3 .3 Cumulative 1.0 3.0 4.5 5 9 6.9 7.2 7.5 7.8 Rate of Return: NA Staff Appraisal Report: No. 5815-HAI, dated December 2, 1985 a/ Commercial banks would provide short term financing to the agricultural estates to supplement term financing provided under the proposed project.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF MALAWI FOR AN INDUSTRIAL AND AGRICULTURAL CREDIT PROJECT 1. I submit the following report and recommendation on a proposed credit to the Republic of Malawi for the equivalent of US$7.8 million to help finance an Industrial and Agricultural Credit Project. The loan would have a term of 15 years, including 4 years of grace, with a variable interest rate. PART I - THE ECONOMY 2. A Country Economic Memorandum dated October 4, 1985, was circulated to the Executive Directors on October 15, 1985. The following paragraphs summarize the principal findings of that report. Annex I contains the basic country data. 3. Malawi is a small (118,500 sq km), densely-populated (about 6.6 million people in 1983) 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. 4. With a GNP per capita of US$210, Malawi has been identified by the United Nations as one of the world's poorest countries. Nevertheless, since independence in 1964 until 1979, Malawi had steady economic growth, averaging six percent per annum in real terms (three percent per capita). The leading sectors were agriculture and manufacturing. Investment rose from 9 percent of GDP at independence to 33 percent in I979, financed by increased domestic savings (from nil to 14 percent of GDP in 1979), and official and private capital inflows. In 1980 and 1981, Malawi met with serious difficulties due to world economic conditions, and GDP contracted by six percent over these two years. Consumption fell somewhat, but savings and investment were reduced drastically. S'nce 1982, recovery has been underway, with annual GDP growth averaging 4.6 percent through 1984. 5. With the exception of the 1980-81 recession, Malawi has enjoyed steady economic growth, due in large part to the pragmatic policies of the Government. Malawi has adopted an outward looking strategy based on agriculture, consistent with the country's resource endowment. Government investment has concentrated on provision of infrastructure, utilities and support services to encourage private initiative. The Government has also emphasized smallholder agriculture, a sound policy given that 90 percent of the population lives in rural areas and depends on agriculture for its livelihood. Traditionally, three quarters of the development budget has been directed towards agriculture and transport, the rest for administrative and social functions. 6. Malawi's economy is heavily dependent on three primary commodity exports (tobacco, tea, and sugar) and is highly vulnerable to international price fluctuations. Since 1974, there have been periodic balance of  payments problems 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, sugar and tea; (c) significantly higher costs of transport for exports and imports owing to rising ocean freight charges, port congestion in Mozambique, and, more recently, severe disruptions of overland transport routes through Mozambique; and (d) an increasing debt service burden. 7. Beginning in 1978, Malawi's chronic balance of payments problems became less manageable. The current account deficit rose from a level of 8-9 percent of GDP in the mid-1970s to 18 percent in 1978 and 23 percent in 1979. This balance of payments crisis was due to declining terms of trade, which fell 40 percent between 1977-80, increased transport difficulties and drought. Import prices rose by 39 percent over this period, primarily due to petroleum price hikes. Conversely, export prices declined by 16 percent (due mainly to falling tea and tobacco prices). In 1980 and 1981, a drought led to reduced agricultural exports and necessitated increased imports of subsistence crops (maize). Nevertheless, by 1981 Malawi enjoyed a surplus on the merchandise trade balance thanks mainly to a contraction in imports and has increased this surplus steadily since 1981. Continuing current account deficits were due to a large deficit on the service accounts. Transport costs for imports and exports were greatly increased due to continuing problems with traditional export routes through Mozambique. Debt servicing also contributed to the deficit on the invisibles account. These current account deficits were initially financed by sharply increased private capital inflows. These were still not sufficient to finance the current account deficit and the country drew down its foreign reserves to less than one month of imports by end 1983. In 1984, the current account deficit was greatly reduced to three percent of GDP and reserves were increased by US$65 million. This was due to improvements in the terms of trade, led by record tea prices, and a sharp increase in exports, as previous stocks of tobacco and sugar were moved out of the country, resulting in a large trade surplus, nearly matching the deficit on the services account. The outlook for 1985 is for a larger deficit as export prices have declined and carryover stocks are not as large. 8. The economic difficulties of 1980-81, as well as problems with public corporations led to an increase in the Government budget deficit reaching 16.5 percent of GDP in 1981, double historic levels. This was due primarily to a rapid increase in government expenditures, attaining 35 percent of GDP in that same year. Much of this was made up of recurrent expenditures, especially interest payments. Revenues did not increase commensurately, given the recession, hence the large fiscal deficit. These deficits were financed by government borrowing, primarily domestic. Public sector credit represented 60% of the total in 1984 and as a percentage of GDP it increased to 13% in 1984 as compared to 9% in 1974. The fiscal position has improved since, with increased revenues and restrained spending so that the deficit has been reduced to 8.2 percent of GDP by FY85, an improvement, though still above target levels. Improving expenditure control is a key element to continuing Malawi's economic recovery. Inflation has been steady at approximately ten percent since 1981.  -3- 9. Given Malawi's early stage of development, foreign capital inflows, especially of a public nature, have been important in development financing. In the pre-recessionary period (1969-79), foreign savings financed approximately half of domestic investment. During the recession (1980-81), public and private capital inflows were used to maintain consumption levels, and domestic savings fell. Since 1981, domestic savings have been increasing, while private inflows have virtually ceased. Public transfers continue, financing approximately 50 percent of all investment, much of this from World Bank Group loans and credits. Grants and bilateral transfers have declined from past levels, and have not kept pace with Malawi's needs. 10. Initially, the country attempted to ameliorate the economic downturn of 1979-1980, by increased external borrowing, mostly on commercial terms, in order to maintain import levels and thus production, employment and consumption. Investment in the economy declined sharply, while consumption declined only slightly. It soon became evident that with increasing inflationary'pressures and fiscal and balance of payments disequilibria, more stringent adjustment efforts were needed. The Government, therefore, launched a stabilization effort designed to reduce short-term fiscal and balance of payments disequilibria and a structural adjustment program designed to improve efficiency of resource use and ensure that positive growth of per capita income can be reestablished and sustained over the medium and longer-term within the context of a manageable balance of payments current account deficit. The structural adjustment program is broad-based; aimed at encouraging diversification of production and exports, improving performance of productive sectors, rehabilitating, restructuring and otherwise strengthening key development institutions, and improving resource mobilization and allocation in the public sector. 11. The Government and the EMF agreed to a standby program for SDR 22 million in August 1982. A first phase of a multi-year stabilization effort, the program aimed at reducing both the balance of payments current account deficit and the budgetary deficit. As part of the program, the Government devalued the kwacha against the SDR by 15 percent in April 1982. The other performance criteria involved phased ceilings on net domestic assets of the banking system and on net credit to the Government and a limit on government external commercial borrowing. The standby was implemented satisfactorily, and the Government and the IMF concluded a new multi-year program, and a three year Extended Fund Facility was approved in September 1983 and, except for a six-month interruption in late 1984-early 1985, it has been implemented successfully so far. As part of the Extended Fund Facility, the Government devalued the kwacha against the SDR by 12 percent in September 1983 and switched to a basket of currencies in January 1984. Since January of 1984, the kwacha has depreciated more than 30 percent against the dollar, including a 15% devaluation in March 1985. 12. The Bank's first Structural Adjustment Loan in support of the Government's program was made in June 1981, for US$45 million. After initial difficulties, good progress was made in implementing the Government's adjustment program. Additional funds were allocated to the agricultural sector, certain agricultural prices were adjusted, public utility tariffs were increased and the budget for 1982-83 was trimmed, with sufficient resources provided for major development sectors. The second  - 4 - tranche was released in April 1982. However, during 1982 the country's efforts were set back by increased disruption of the traditional transport routes and continued depressed demand for Malawi's export products. Nevertheless, the country was ahle to hold its current account deficit to 11.3 percent of GDP in 1983, reduce the budgetary deficit for FY1983 to 9 percent of GDP, and meet its IMF standby borrowing ceilings. 13. The second phase of the structural adjustment program was supported by SAL II and approved by the Board in December 1983. The program builds upon the reforms of SAL I, focussing on measures to improve the mobilization and management of resources, to strengthen key institutions, and to upgrade the performance of the public sector. The program has been successful in achieving most of its objectives. Among the achievements of the program have been (a) increased smallholder export production following an increase in price incentives; (b) increased industrial production and investment incentives resulting from a program of price decontrols; (c) increased domestic energy production; (d) a strengthening of the financial position of key public and private enterprises; and (e) a reduction in the budgetary and balance of payments deficits. Efforts to improve the control and allocation of public expenditures and to reduce the overall size of Government have been slow, but steps in the right direction have been taken. While the economy has grown well in 1983 and 1984, prospects are for continued economic difficulties and the need for continued adjustment to balance of payments, fiscal and transport constraints. Government remains committed to the adjustment process and is preparing to continue its program with the help of a Third Structural Adjustment Operation (paras. 15 and 16). 14. By the end of 1984, Malawi's external public debt outstanding and disbursed totalled US$741 million. In late 1982, Malawi rescheduled both its official and commercial debts. Otherwise its debt servicing, including repayments to the IMF, would have amounted to over US$130 million, equivalent to over 40 percent of exports of goods and services. This compares to a level of about 10 percent in the mid-1970s. A second year of rescheduling was agreed to in October of 1983, keeping the debt service ratio to 26.7 percent in 1983. The Government has indicated that it will not be asking for any further rescheduling, and the debt service ratio is expected to remain at about 40 percent in 1985 and 1986 before falling to less than 25% in 1990. Because of this high debt service ratio, commercial bank borrowing will have to remain sharply curtailed and the balance of payments gap should be closed by concessionary financing. Similarly, constraints on local borrowing would indicate the need for local cost financing to be provided by donors. PART II - BANK GROUP OPERATIONS IN MALAWI 15. Over the past 19 years, Malawi has received 34 IDA credits and one Special Fund credit totalling about US$463 million and 8 Bank loans totalling US$99 million, of which 2 were on third window terms. The first Bank loan to Malawi was made on third window terms in June 1976 and the first standard Bank loan in April 1977. Of the Bank Group assistance, some US$165 million (29 percent) was for agriculture, USS108 million (19 percent) for education, TJSS114 million (20 percent) for roads, USS98 million (18 percent) for structural adjustment, USS39 million (7 percent) for power, USSII million (2 percent) for water, and the balance of US$27  million (5 percent) for health, development finance, technical assistance, and urban housing. For FY86, a credit of US$11.6 million equivalent for an Agricultural Extension and Planning Support Project has so far been approved. Documents for a US$30.0 million equivalent IDA Credit and US$40 million equivalent African Facility Credit for the Third Structural Adjustment Operation are being submitted to the Executive Directors at about the same time as this project. A Forestry/Wood Energy Project is also scheduled to be presented to the Executive Directors during FY86. IFC's equity participations and lending commitments in Malawi total about US$25.8 million and include investments in textiles, sugar, a DFC (INDEBANK), tourism, and the manufacture of alcohol from molasses. In addition, a US$0.5 million equity subscription and US$1.8 million loan investment in the Viphya Plywoods and Allied Industries United were approved in August 1984, but are not yet signed. On September 23, 1985, an IFC investment to finance the first leasing and finance company was approved. Annex II contains a Summary Statement of Bank Group Operations as of September 30, 19B5. Bank Lending Strategy 16. During the next five years, Bank group assistance will focus on helping Malawi restructure its economy, especially in the areas of improved agricultural productivity and dealing with the transport problem. Focus will also be given to strengthening the effectiveness and efficiency of Government and other development institutions. Bank group assistance will also address Malawi's pressing needs in the area of human resource development, including the issues associated with a population growth rate of 3.2%, among the highest in the world. The objectives of key reforms under the Third Structural Adjustment Operation (para. 15) are to further improve incentives and productive efficiency in the economy, including improved export promotion incentives and support for diversification. The credit will also support strengthening the planning and policy formulation process and public investment progra-uming. Project lending will complement Government's structural adjustment program by providing necessary technical, financial and institutional support. Future lending will be in health and population, water supply, transportation, education and agricultural credit. 17. The Bank Group's economic and sector work will continue to build an analytical base for discussions with the Government on key development issues. In agriculture we have concluded a study on diversification and the steps needed to help broaden the export base of the economy; a study of the question of land utilization and what can be done to improve the productivity of this scarce resource is underway, as are project funded studies on livestock, smallholder irrigation and management and training in the Agriculture Ministry. In FY87, we will prepare an updated Agricultural Sector Memorandum, looking at progress made as a result of structural changes in the sector and also analyzing sub-sectoral policies pertaining to agricultural manpower training, production of perennial crops, etc. The transport sector report which deals with external transport constraints has been completed. In the social sectors, we will complete in FY86 a study of the dynamics of population growth, its implications for the economy and the recommended development assistance strategy for the sector. In education we will study the training needs in the economy with special emphasis on the agriculture, health and transport sectors. A Public Sector Investment  -6- Review has recently been carried out. These studies will provide the basis for helping Malawi develop appropriate sectoral strategies and investment programs. Further studies expected to be carried out in the near future include a special study on the institutional aspects of development which will look at shortcomings in the Government's institutions and bureaucratic system which have led to some of the structural weaknesses in the economy. A study of the financial slystem will also be carried out. 18. A Consultative Group meeting is planned for January 1986 to improve donor coordination and increase the level of resources needed to support MalawiTs adjustment process. The Country Economic Memorandum planned for FY87 will concentrate on the long term constraints to Malawi's development (porulation, agricultural land pressure, etc.). Disbursements- 19. The levels of disbursements for Malawi, including program lending were as follows: in 1982, US$70.1 million; in 1983, US$33.2 million; in 1984, US$58.2 million; and in 1985, USS46.4 million. Disbursements of the Bank Group loans and credits in Malawi have generally been good and compare favorably witb other countries in the region and even on a Bank-wide basis. During the period FYBO-85, 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 19 percent and the Bank-wide average of about 21 percent. Project Implementation 20. Overall, implementation of Bank projects continues to be good. The Audit and Project Completion Reports underscore Malawi's sound development record and progress in extending nationwide the benefits of its investments. However, the third National Rural Development Program (NRDP) -project and the Fifth Highways project have experienced moderate problems due to inadequate budget provision and management shortcomings. Efforts are being made to allocate sufficient budgetary resources for these projects. PART III - THE MANUFACTURING, AGRICULTURAL ESTATES AND FINANCIAL SECTORS A. Manufacturing Sector Performance and Structure 21. Malawian industry is still embryonic although it accounted for 12.4% of GDP in 1984, up from 5% two decades earlier. The sector is dominated by the production of food and beverages, textiles and footwear for domestic consumption, and tobacco and tea processing for export. Between 1964 and 1975 the sector was characterized by rapid growth averaging 12% in real terms, approximately twice the growth rate of the national economy. Between 1976 and 1981 manufacturing export growth slowed to an annual average rate of only 3.3% in line with the overall economic recession in Malawi. After 1982, growth in the sector began to recover and has grown in line with the rest of the economy in both 1983 and 1984. This improvement is due in part to price liberalization as part of the  structural adjustment program. Malawian industry in general is one of the most labor-intensive in Africa, consistent with Government's policy to support employment generation. However, the sector's overall share of the total labor force declined from approximately 162 in 1968 to 9% in 1982 due to the faster growth of employment in the estate subsector. 22. Manufacturing activity is concentrated around Blantyre, the commercial center of Malawi. The sector is dominated by large scale firms which generally reflect appropriate economies of scale given the limited domestic market and special transportation constraints posed to export oriented enterprises. Fourteen large firms (tea, sugar and tobacco agroindustries) each with more than 500 employees account for more than 51% of total manufacturing employment while firms with between 10 and 100 employees account for less than 10% of sector employment. 23. Because of poverty and a low level of savings in the country, only a few local enterprises, often in collaboration with foreign partners, can mobilize the investments required in medium- and large-scale industry. Statutory corporations, notably Malawi Development Corporation (MDC), Press Group Limited (PGL) and the Agricultural Development and Marketing Corporation (ADMARC) were formed with the objective of catalyzing the sector's growth and development of a strong indigenous private sector in Malawi. The profitability of these three bodies has, in the past, permitted their investments in and management of many subsidiary companies which together contributed more than 70% of the sector's value added and more than 40% of its GDP in 1979. Each of these enterprises has undertaken extensive reorganization and divestment programs under the Government's Structural Adjustment Program. 24. Results of these reorganization efforts have for the most part been successful. MDC, whose corporate objective is to catalyze new investments and generate funds for new industrial project development, has reduced its subsidiary and associated companies from 32 to 21 through mergers, divestment and new management. After making losses in both 1983 and 1984, the company is expected to make a modest profit in 1985. Efforts to strengthen ADMARC's institutional and financial structure have focused on divestment of non-agricultural enterprises and measures to improve operational efficiency. The objective has been to allow the company to carry out more effectively its mandate to promote development of Malawi's agricultural exports, provide an efficient marketing system for smallholder produce and develop agroindustrial enterprises. In the past the company has been quite profitable. However, it has recently begun to experience serious financial strains due in particular to poor export prices, weakened markets for maize and tobacco, and growing financial obligations incurred as a result of the Government's Food Security Policy. The Bank is working with the Government in dealing with these issues and with issues of ADMARC's restructuring and operational efficiency. PGL's financial restructuring has made substantial progress. A set of corporate guidelines were adopted and a sound strategy for rationalization of the company's assets have been adopted by its Board. Assets have been swapped with MDC and ADMARC and convertible preferred stock was issued to Government to satisfy the company's debt to the two commercial banks which as a result were set on a sound financial footing.  -8- Policy Framework 25. The (overnment is committed to maintaining a mixed economy system with incentives and a policy framework which fosters the development of a strong private sector. Government has pursued a well-publicized, liberal policy of full repatriation of profits. Tax incentives, available equaUly to foreign and indigenous entrepreneurs, take the form of allowances for accelerated depreciation with special allowances of up to 10% of expenditures on industrial buildings, and write-offs over an indefinite period of expenditures incurred before and during start-up (up to lB months). In January 1984, the Malawi kwacha was tied to a basket of currencies. The Government is committed to maintaining a flexible exchange policy. Currency adjustments are made as needed to realign the kwacha with the basket for equalizing the supply and demand for foreign exc.hange. 26. Malawi's sectoral policies are generally sound. However, the economic crisis of the early 1980's has highlighted the following sector related issues which are being addressed in the Government's Structural Adjustment Program. (a) Price Controls. By the early 1980's with increased inflationary pressures the system was creating serious disincentives for producers by failing to signal shortages, surpluses, cost inefficiencies and imposing a financial burden on firms experiencing large input price increases. Under SAL II, Government reduced the number of controlled items from 56 in December 1983 to 9 items in August 1985 and is committed to completing the liberalization program by December 1985. (b) Foreign Exchange Allocations. In the early 1980's the system was strained at times on account of heavier than usual debt repayment requirements, the stagnation in certain categories of export earnings and increased external transport costs. This resulted at times in delays of foreign exchange allocations. Under SAL III, the Government intends to pursue an active exchange rate management policy which should virtually eliminate the need for a formal allocation system. Also, it will actively facilitate importation of competing products to encourage efficiency in production. (c) Export Incentives. A duty drawback system, under which exporters can claim the duties paid on imported inputs used in exported production has been ineffective. Under SAL III, the Government would take specific measures to stimulate exports by developing and adopting an export promotion scheme and setting up an export financing facility. Institutional strengthening, with external technical assistance would be part of the overall export promotion effort. Manufacturing Sector Prospects 27. Assuming a stable international economic environment, the manufacturing sector is expected to grow in line with overall growth in the economy at an average of 4.02 annually, with growth in exports averaging 4.9%, during 1985-89.  - 9 - Bank Group Experience and Strategy in the Sector 28. The Bank has completed one DFC operation in Malawi, a US$3.0 million loan to support INDEBANK's assistance to medium- and large-scale enterprises (Loan 1610-MAI). The Project Completion Report concluded that project objectives to strengthen INDEBANK's capabilities with the development of adequate procedures and policies had been met, and the loan proceeds were being profitably utilized. Overall, INDEBANK was receptive to Bank advice which played an important role in building INDEBANR into a sound and efficient institution. The recently approved Wood Industries Restructuring Project (Loan 2486-MAI) has as its objective rationalizing and privatizing sawmills and other Malawian wood industries. IFC has played an active role in the sector and has to date financed six operations (para. 15). 29. Bank strategy in the industrial sector is to encourage efficient manufacturing expansion based on Malawi's agricultural, forestry and livestock resources. The strategy is to support export-oriented industries given the small size of Malawi's market. Prospects for agro-industrial expansion are good and several promising projects with considerable export potential have been identified with the assistance of a Bank-funded study. The Bank's main lending in the sector in the medium term will be to INDEBANK because of its position as the main source of long-term finance for productive enterprises. The proposed project would support strengthening INDEBANK's role and resource base as part of the Government's efforts under its structural adjustment program to (a) provide a healthy industrial policy and institutional environment; (b) support efficient sector development; and (c) increase investment opportunities and employment. B. Agricultural Estate Subsector 30. Agriculture is the most important sector of the Malawian economy and in 1983/84 employed 85% of the labor force, provided about 40% of GDP and accounted for 85 to 90% of the country's foreign exchange earnings. The sector is divided into the smallholder and estate subsectors. While growth in the smallholder sector averaged about 3% p.a. in the 70's, performance of the estate subsector has been spectacular, with output expanding bv around 17% p.a. in real terms since 1968 and providing about 80% of all foreign exchange earnings in 1984, principally through exports of tobacco, sugar and tea. Despite a threefold increase in tobacco production, productivity has been virtually static as production increases came mainly from increased area brought under cultivation. In recent years, the expansion of estates has outstripped the availability of good management. Although the sector includes many large, well-established tobacco estates with hired professional management, many estates have 1 to 100 hectares and are run by relatively inexperienced farmers who manage their own farms. During the late 70's and early 80's, the financial position of many estates seriously deteriorated and many went into receivership due to management and financial problems combined with weak tobacco prices and problems of international transportation.  - 10 - Development Strategy 31. Because of the potential of the estate sub-sector in export growth and in stabilizing export earnings, the Government's structural adjustment program includes measures to encourage diversification and to improve estates' financial and technical management. Two key elements of Government's strategy to improve the sub-sector's performance are: a) provision of credit for medium and long term investments; and b) formation of an extension and management training service. Government has perceived the lack of access of estates to term finance as a major impediment to estate development and diversification. To remedy this, under SAL II, the Government carried out a feasibility study financed from the Second Technical Assistance Project which showed that under existing conditions establishment of a separate agricultural credit institution would not be financially viable due to high overhead costs and a low level of demand. Consequently, the Government has decided to channel credit funds to estates through established financial institutions-the two commercial banks and INDEBANK. This is intended to be a pilot arrangement to allow assessment of potential demand and the performance of participating institutions. 32. Credit to the less well established estates must be supported by management and extension services. Government has decided to establish an autonomous authority initially to be funded with some R700,000 (US$388,900) in earmarked funds, raised through fines paid by the tobacco industry for overproduction. ODA has firm plans to provide technical and financial assistance to support this initiative. The proposed service is expected to be self-financing in the long-run, with fees and charges to be paid by users. An ODA appraisal team is expected to visit Malawi before the end of 1985 -to define the new institution's scope of activities, its organizational structure, and a detailed annual work program. Initi-aly it is expected that the majority of project credit funds would be provided to estates which have experienced management and which need term finance to improve the efficiency of their tobacco production and curing and to diversify into other crops. 33. A feasible diversification strategy which would address key constraints related to marketing and processing infrastructure is in the process of being developed. An agricultural diversification study was produced in November 1984. A subsequent Bank review which focussed on the estate sub-sector indicated that the principle elements of a diversification strategy could be as follows: a) an increase in the productivity of tobacco estates through improved management, better cropping patterns and increased efficiency of input use; b) a move to production of higher value import substitution crops (eg. wheat) or to crops with significant local value added (eg. cotton and vegetable oil); c) increased utilization of cultivable land through better crop rotation, irrigation and soil conservation; and d) expanded cultivation of existing plantation crops such as coffee, rubber and macademia and cashew nuts. The proposed agricultural credit component would be a first step in the overall strategy and would finance productivity improving investments, particularly on tobacco estates, thus providing the potential for increased profits and freeing land for diversification.  - 11 - C. Financial Environment 34. The financial sector is comprised of the Reserve Bank of Malawi, two commercial banks, the Postal Savings Bank, the New Building Society, the Financial Corporation of Malawi, two insurance companies and three development finance institutions - INDEBANK, its subsidiary INDEFUND which finances Malawian-owned medium-scale enterprises, and SEDOM which promotes and finances small-scale industries. 35. The Reserve Bank plays the customary role of a central bank as a regulator of commercial banks and administrator of national monetary and credit policies. The two commercial banks-the National Bank of Malawi (NBM) and the Commercial Bank of Malawi (CBM) -account for the bulk of domestic credit and domestic resource mobilization mainly through short-term deposits and lending for equally short periods, primarily to agriculture. In the late 1970's, the Government encouraged the two commercial banks to finance tobacco estates to take advantage of the embargo on Rhodesia's production. During the boom period, total loans to tobacco estates went up from about K9 million (US$10.4 million) in 1975 to about K90 million (US$110.8 million) in 1980 and represented 51% of the banks' total advances, compared with a mere 15% in 1975. These loans were characterized by negligible borrower contributions and short repayment periods. When commodity prices fell the banks suffered substantial losses; however, they have since recovered and almost all the bad loans have been written off. 36. The Reserve Bank's interest rate policy is to maintain rates at levels conducive to the growth of savings while fostering the efficient use of investment resources. Accordingly, interest rates have been revised fairly regularly over the past five years. The Reserve Bank discount rate was increased from 8% to 10% in 1980 and recently to 11%. Deposit rates have been recently increased to a minimum of 11.75% on demand deposits and to a minimum of 12.25Z for time deposits. Commercial banks' lending rates currently range from 11.5% to 15% p.a. on loans to the agricultural sector to a maximum of 19% p.a. for loans in other sectors. The current interest rates are in line with Government's objectives and are generally positive in relation to recent experience of average price increases of 10% p.a. since 1981. PART IV - THE PROJECT 37. INDEBANK expressed interest in the proposed follow-on industrial line of credit in September 1983 during supervision of the first project. In February 1985, the Government of Halawi requested the Bank to provide a second line of credit to INDEBANK, to assist in the establishment of an institution for providing medium- and long-term credit to the agricultural estate subsector, and to provide a line of credit to the agrictultural credit institution. During appraisal, however, it was found that such an institution would not be financially viable in the immediate future. On the Bank's recommendation, the Government agreed to channel Bank assistance to the subsector through INDEBANK and the two commercial banks on a pilot basis (para. 31). 38. *The proposed project was appraised in March and May 1985 and negotiations were held in Washington from October 18 to 23, 1985. The Malawian delegation was led by Mr. J. R. Phiri, Deputy Secretary for the  - 12 - Ministry of Finance. A Staff Appraisal Report (No. 5815-MAI) of December 2, 1985 is being circulated separately. A loan and project summary is given at the beginning of this report and a supplementary project data sheet is provided as Annex III. Project Objectives 39. The principal objectives of the proposed project are to: (i) stimulate the efficient expansion of Malawi's industrial, commercial, transportation and tourism subsectors by providing much needed term finance; (ii) improve the utilization, efficiency and productivity of agricultural estates and gradually encourage diversification into viable new crops; and (iii) sustain and strengthen INDEBANK's institutional capabilities to effectively promote efficient development in the agricultural, industrial and commercial sectors. 40. The project would assist the Government in achieving its objectives under its structural adjustment program to increase agricultural diversification in the estate subsector by providing term finance. The agricultural component fills a void in the financial system where currently estates have access only to short-term credit. The project would also encourage INDEBANK to build on its solid institutional foundation by developing its overall project promotion capability and in particular its agricultural projects promotion and appraisal capability. The project, which consists of two lines of credit and funds to finance technical assistance, would be implemented by the two commercial banks and INDEBANK which are described below. The Participating Financial Institutions A. The National Bank of Malawi (NBM) 41. NBK was founded in 1971 by merging the operations of the Standard Chartered Rank and Barclays Bank (both fully foreign-owned). At that time, ADMARC acquired a majority shareholding. At present Press Corporation and ADMARC own 47% and 33% of shares, respectively, and the Standard Chartered Bank 20%. NBM has a network of 14 branches and 66 agencies throughout the country. Top management of the Bank is provided by the Standard Chartered Bank through seconded expatriate staff. 42. Ever since its incorporation, National Bank has been the dominant commercial bank in Malawi. Its financial resources and volume of operations are about three times as large as those of the Commercial Bank of Malawi. Between 1981 and 1984, NBM's customers' deposits increased by 60%, to K244 million (USS207.0 million). Similarly, its loan portfolio, after making provision for doubtful debts, increased by 192 to K126 million (US$107.2 million). In general, NBM follows conservative and sound financial policies and adequately provides for all bad and doubtful debts. Following this policy NBM has set aside nearly 100% of the amount of bad deuLs relating to the tobacco loans made in the late 1970s (para. 35). Despite making such large provisions, NBM has remained profitable.  - 13 - B. The Commercial Bank of Malawi (CbM) 43. CBM was incorporated in 1969 as a joint venture between local and foreign interests. Following the sale of Bank of America's 30% share in 1983, CBM is now owned 40% by the Press Group and 30% each by the Government of Malawi and the Halawi Development Corporation. CBM has a network of 13 branches and over 80 agencies spread throughout the country. 44. Although CBM maintains as large a branch network as NBM, its operations in financial terms are much smaller. As of June 30, 1985, CBM's total assets amounted to K150 million (USS83.3 million). Total deposits amounted to K87 million (USS48.3 million), a large proportion of which came from large depositors. CBM's profitability has in the past been marginal. Due to large provisions against possible losses on its loans, the bank's net profit after tax represented less than 1% of total assets in both 1983 and 1984. However, following this period of having adequately provided for losses, profitability has shown significant improvement in fiscal 1985. Prospects are for continued improvement (para. 46). The Commercial Banks' Operations, Policies and Procedures 45. Both banks are involved in financing all the main sectors of the economy, primarily providing working capital financing. They actively compete for customers' deposits which are the main source of their financial resources. 46. Until the late 1970s, both commercial banks employed minimal agricultural staff. However, with the rapid increase in the banks' lending to the estate subsector and the poor performance of the borrowers (para. 35), the banks recruited additional staff to provide technical and financial management support to the borrowers, and revised their agricultural lending policies. The banks now restrict their seasonal lending mainly to activities that demonstrate strong viakility and now impose greater financial controls on their clients. The banks encourage borrowers to produce alternative crops (other than flue-cured tobacco) and assist them in adopting sound agricultural, conservation and management practices. These measures have resulted in a substantial drop in tobacco loans from a peak of about K100 million (USS94.7 million) in outstanding loans to about 500 estates in 1982 to about K60 million (US$33.3 million) to less than 300 estates at present. 47. The commercial banks charge interest rates ranging from 11.5% to 15% on agricultural loans. Generally, rates charged have enabled the commercial banks to cover their costs and earn a sufficient profit margin. At negotiations, agreement was reached that the Government would annually review and revise interest rates to ensure that the rates are (i) positive in real terms; (ii) in line with the overall interest rate structure in the country; (iii) adequate to enable the institutions to cover their reasonable administrative expenses, provide for possible losses on their loans and earn adequate profit margins; and (iv) adequate to permit the attainment of the objectives of the project. 48. In line with their new agricultural lending policies (para. 46), the commercial banks have strengthened their appraisal procedures and capabilities, which are now satisfactory. To ensure that appraisal  - 14 - standards remain adequate, the Bank would review from time to time agricultural appraisal reports produced by the institutions. Agreement was reached at negotiations that at the Bank's request, each participating bank would submit appraisal reports selected at random by the Bank. NBM and CEM would be required to make the requisite improvements or adjustments in their appraisal methodologies and practices based on the Bank's comments. Also agreement was reached that the Reserve Bank of Malawi would cause NBM and CBM to calculate financial rates of return for all projects of more than K180,000 (US$100,000). The banks regularly supervise their investments - particularly agricultural projects. Management is kept advised of the performance of each borrower through supervision reports prepared at least once a month. These supervision procedures and practices are satisfactory. The commercial banks do not have specific procurement procedures. They rely on subborrowers to obtain goods and services from the most advantageous sources. C. Investment and Development Bank of Malawi (INDEBANK) 49. INDEBANK was established in December 1972 as a private limited liability company under Malawi's Companies Act. Its basic objective is to promote the economic development of Malawi by providing finance and other services to viable projects in the productive sectors of the economy. INDEBANK gives preference to projects sponsored and financed by Mk-lawian interests and encourages foreign investors to find local partners. Ownership, Management and Staffing 50. INDEBANK is owned 22.25Z each by ADKARC, the Commonwealth Development Corporation (CDC), the German Finance Company for Investments in Developing Countries (DEG), the Netherlands Finance Company for Developing Countries (FMO), and 11% by IFC. INDEBANK's capital-authorized and fully paid-amounts to K4.5 million (US$2.5 million). In addition, the shareholders (with the exception of IFC) have provided INDEBANK with resources in the form of income notes amounting to K11.25 million (US$6.2 million) which are unsecured and carry an interest charge of 8%, which is payable only if INDEBANK makes a profit. INDEBANK's Board of Directors consists of eight members representing the shareholders. The ADMARC representative is also the Chairman. The Board members, all senior people in their respective organizations, take active interest in INDEBANK's activities. 51. All management positions in INDEBANK, with the exception of the General Manager and the Coordinator of Project Investigations, are held by Malawian nationals. The INDEBANK Board has recently appointed a Malawian as Assistant General Manager who is expected to replace the expatriate General Manager when his contract expires in August 1986. INDEBANK does not have adequate staff to effectively participate in financing agricultural estate activities. The proposed project would support international recruitment of a Manager for the Agricultural Projects Investigation Division and an agricultural specialist. In addition, recruitment of two qualified Malawians capable of taking over from the expatriate staff would be funded under the project (para. 70). 52. INDEBANK has 26 professional staff. Overall, the staff is of good quality and have solid academic backgrounds in Economics, Business Administration and Accountancy. In order to manage adequately its future  - 15 - operations, INDEBANK plans to recruit four additional project officers within the next 12 months. INDEBANK actively pursues staff training which emphasizes on-the-job training but which effectively utilizes selected overseas training programs. INDEBANK's staff development and training activities are adequate. Policies and Procedures 53. For its investment decisions, INDEBANK is guided by a Statement of Investment Policy Principles and Operating Procedures. The salient features of the policies are that the institution will: (i) base its investment decisions on sound technical, financial and economic appraisal criteria; (ii) encourage local participation in its projects; (iii) limit to 35% of the project's total equity its equity investment in any one project; and,.(iv) maintain a prudent equity to loan ratio. 54. INDEBANK mainly provides long-term loans with maturities of 8 to 12 years including grace periods of one to two years for appropriate projects. Mortgages of projects' assets and the personal guarantees of the borrowing company's directors are used as security. ITTDEBANK's lending rates range from 13% p.a. to 16% p.a. At the time of negotiations, a minimum rate of 13% p.a. was charged on loans denominated in foreign exchange and on projects that are considered to be of high developmental value to the country. Interest rates higher than 13% p.a. are charged on local currency loans. INDEBANK also charges a one-time commitment fee of 0.5% and a project appraisal fee of 1% of the value of the approved loan. Interest rates are adequate to ensure INDEBANK's profitability. The lower interest rate charged on foreign currency denominated loans is adequate to allow INDEBANK to earn an average spread of about 4%, given the low average cost of these funds (9%). The foreign exchange risk is borne by sub-borrowers. Agreement was reached at negotiations that INDEBANK would annualily review and revise its lending ratesl/ to ensure that they are (i) positive in real terms; (ii) in line with the country's overall interest rate structure; (iii) adequate to enable INDEBANK to cover its reasonable administrative expenses, provide for possible losses and earn an adequate profit margin; and (iv) adequate to permit attainment of the objectives of the project. 55. INDEBANK has not developed an adequate project promotion capability and therefore has not utilized fully its institutional resources and capabilities to foster the growth of productive activity in the country. To date most of the projects it finances have been promoted by PGL, ADMARC and MDC. INDEBANK acknowledges the need to develop in-house project promotion capability to help reduce concentration of its portfolio in the investments of the three companies. Agreement was reached at negotiations that INDEBANK would (i) by June 30, 1986, establish a Project Promotion Unit and recruit two experienced Malawian professional staff to carry out a project promotion function; and (ii) by December 31, 1986, prepare a manual establishing appropriate procedures for the promotion, appraisal and monitoring of agricultural projects. Agreement was reached 1/ The Reserve Bank of Malawi sets interest rates for financial institutions registered under the Bank Act. INDEBANK can set its rate structure independently as it was established under the Companies Act.  - 16 - that INDEBANK would comply with the same review by the Bank of agricultural subprojects as specified for the commercial banks participating in the project (para. 48). 56. Appraisals are comprehensive and cover the project's key features. The only major weakness is that most appraisals do not include an economic assessment in sufficient detail. Agreement was reached at negotiations that INDEBANK would calculate economic rates of return for projects requiring financing of more than US$100,000 as well as cover in its appropriate reports aspects such as projects' potential for creating employment and dependence on imported inputs. Projects in the portfolio are supervised regularly. INDERANK submits reports on the performance of selected projects to each Board meeting to seek guidance for dealing with problems. Supervision reports are comprehensive and of high quaiicy. 57. INDEBANK's procurement procedures are in line with pro:edures followed by Bank-assisted DFCs namely, they are based on competitive quotations from the main sources of supply to ensure that purchases are made from the most advantageous source. Operations Portfolio and Financial Position 58. Since inception in 1973, INDEBANK has approved a total of 102 loans amounting to K32.4 million (US$22.8 million) and equity investments totalling K5.2 million (US$2.9 million). INDEBANK's level of operations have shown wide fluctuations, reflecting trends in the manufacturing sector. In the past five years, for example, total approvals declined sharply from R5.0 million (US$6.2 million) in 1980 to K0.5 million (US$0.43 million) in 1983 before rebounding to K4.2 million (US$2.9 million) in 1984. The decline in the level of approvals between 1980 and 1983 was due to two main factors: (i) sluggish growth in the Malawian economy and especially in industrial activity over this period, and (ii) a sharp decline in new investment activity by PGL, MDC and ADMARC due to their liquidity and other operational problems (para. 24). 59. In 1981, INDEBANK established INDEFUND Limited as a subsidiary responsible for financing projects ranging in size from K25,000 (the maximum project size eligible for funding under the Government small-scale industries program) to K100,000 (the minimum loan size allowed under INDERANK's policies). INDEFUND was established with a paid-in share capital of K650,000 (authorized share capital is K1.0 million), of which 62% is subscribed by INDEBANK and 38% by FMO. INDEFUND shares some management and professional appraisal staff with INDEBANK. As of Janu4