Malawi - Third Structural Adjustment Operation Project

Docuwent of The World Bank FOR OFFICIAL USE ONLY Report No. 8886 PROGRAM PERFORMANCE AUDIT REPORT MAIAWI THIRD STRUCTURAL ADJUSTMENT LOAN (CREDITS 1644-MAI-, A0090-MA, A0091--MAI) AND OVERVIEW OF SALS I, II, III -AND SUPPLEMENT TO SAL III- JUNE 29, 1990 Operations Ev luation Department This document has a restricted distribution and may be used by reclolents only In. the performance of their official duties. Its contents may not otherwise be f1sclosed without World Bank authorization. ABBREVIATIONS ADMARC - Agricultural and Marketing Development Corporation ASAC - Agriculture Sector Adjustment Credit DSB - Department of Statutory Bodies EFF - Extended Fund Facility EPD - Economic Planning and Development Dept ESW - Economic and Sector Work ESAF - Extended Structural Adjustment Facility GDP - Gross Domestic Product ITPAC - Industrial and Trade Policy Credit MDC - Malawt-Development Corporation MIM - Malawi Institute of Management OPC - Office of the President and the Cabinet PCR - Project Completion Report PFP - Policy Framework Paper PPAR - Program Performance Audit Report PSIP - Public Sector Investment Program SAL - Structural Adjustment Loan SECAL - Sectoral Adjustment Loan SEA - Special Fund for Africa SJF - Special Joint Financing SSA - Sub-Saharan Africa SGR - Strategic Grain Reserve TA - Technical Assistance USAID - United States Agency for International Development FOR OFFlCIAL USE ONLY THE WORLD I)ANK Wa%hmgton. DC 20431 U.S.A. O0ace of DCtim-CeOera 0WEft I~ VACWG" June 29. 1990 RHDR_ADUM TO THE EUTIVE DIRECTORS AND THE PUESIDENT; SUBJECTs Project Performance Audit Report on Malawi Third Structural Adjustment Loan ACredits 1644-WA, A0090-MAI, A0091-MAI) and Overviewv-f SAls It II, III and Supplement to SAL III- Attached for information is a copy of a, report entitled 'Program Performance Audit Report on Malawi Third Structural Adjustment Loan (Credits 1644-MAI, A0090-MAI, A0091-MAI) and Overview of SALs 1, 1I, III and Supplement to.SAU 111 prepared by the Operations Evaluation *Department. 1- Attacbment This document ha a red dsrution and may be'used by nients only la the pefor6axce . of their ofcia duties Its contents emy not otherwise be discloe without WorM Saek auusaton FOA OFFICIAL USE ONLY PROGRAM PERFORMANCE AUDIT REPORT MAIAVI THIRD STRUCTURAL ADJUSTMENT LOAN (CREDITS 1644-MAL A0090-MAI: A0091-MAI) AND OVERVIEW OF SALS I. II. III AND SUPPLEMENT TO SAL III TABLE OF CONTENTS Page No. Preface..... .... i Basic Data Sheet........... . ........... ii Evaluation Summary......... .................. viii PROGRAM PERFORMANCE AUDIT I. BACKGROUND TO THE CRISIS ..................................... 1 II. RESPONSE OF THE BANK AND FUND ................................ 2 III. SAL OBJECTIVES AND POLICIES .................................. 6 Overall Objectives ............................................. 6 SAL I ....................................................... 7 SAL II ................. 7 SAL III...................................................... 8 Supplement tp SAL III ........................................ 10 Design of the SALs ........................................... 11 IV. IMPLEMENTATION OF SAL III AND SUPPLEMENT ...................... 12 Agriculture ........................ ..........................12 Industry and Trade Policy ....................................14 Fiscal Policy ................................................15 Parastatal Reforms .......................... 16 Institutional Development and Improvements ............ .... 18 Disbursempnt, Procurement and Use of Counterpart Funds ........19 V. IMPACT OF STRUCTURAL ADJUSTMENT PROGRAM ..................... 10 Growth ....................................................... 21 External Balance ................................... ......... 22 External Debt ................................................ 22 Internal Balance ............................................. 23 Social Impact ................................................ 24 This document has a restricted distribution and may be used by recipionts only in the performance of their oflicial duties. Its contents may not otherwise be disclosed without World Bank authorization. Tabl of Con a (cont'd.) Dox No. VI, SUSTAINABILITY ............................ 25 Economic Growth ......... 25 Commitment to Policy Reforms ................................. 26 Institutional Capability ..................................... 27 VII. AJOR POLICY AND IMPLEMENTATION ISSUES ..................... 27 Producer Pricing and Other Agricultural Policies ............. 27 The Fertilizer Subsidy ....................................... 29 Participation of Private Sector in Agricultural Marketing .... 30 Deregulation of Prices ....................................... 31 Ownership of the Program ..................................... 32 Timing of Policies ........................................... 32 Lessons of Experience ........................................ 33 I. Summary of Policy Reforms .................................... 35 II. Technical Assistance Loan and Credit ......................... 40 PROJECT COMPLETIQR I. Introduction................................................. 43 II. Economic Background.......................................... 44 III. Objectives and Design of the Structural Adjustment Program.... 45 IV. Implementation of Policy Reforms.............................. 50 V. Impact and Lessons from Experience............................ 54 PROGRAM PERFORMANCE AUDIT REPORT MALAWI THIRD STRUCTURAL ADJUSTMENT IDAN (CREDITS..1644-MAL. A0090-MAI: A0091-MAI) AND OVERVIEW OF SALS I. II. III AND SUPPLEMENT TO SAL III This is a Program Performance Audit Report (PPAR) of the Bank's Third Structural Adjustment (SAL) lending operation (Credit 1644-MAI) and its Supplementary Credit (A0090 and A0091), combined with an Overview of the completed series of three. SALs which concluded with the Third Adjustment Project. The PPAR consists of the Program Performance Audit prepared by the Operations tvaluation Department (OED) and a Project Completion Report (PCR) - prepared by the Africa Regional Office. This PPAR takes cognizance of and should be read in conjunction with the PPAR on the first two SALs (Loan 2026- MAI and Credit 1427-MAI) distributed as Report No. 6833 of June 12, 1987. That part of ; the PPAR which relates to the third SAL is based on the PCR prepared by the Region, the Credit Agreements, a review of the President's Reports, the summaries of Board discussions, economic reports, related documents in the Bank's files, discussions with Bank staff associated with the lending and information supplied by the Borrower. That portion of the PPAR that overviews the three SALs relies on similar sources, but Aso, derives much of its data from Report No. 6833. An OED mission visited Malawi to review the structural adjustment operations with Government officials and discussed with them the effectiveness of the Bank's assistance. Their kind cooperation and assistance is gratefully acknowledged. The PPAR on the first two SALs, together with the PCR on tU third, ably discuss the emergence of the structural problems, the implementation of the various components of the programs, the results achieved and the administration and use of the Loans and Credits. This PPAR and Overview elaborates on the design of the series, and on the interrelationship between the individual parts of the series, and assesses the experience gained in their implementation. Conclusions and lessons of experience are drawn from reflection on the economic , sector and social impact and the sustain4ab1lity of the overall process. Although the original intention was to proceed to a fourth SAL operation, this intent was superseded by a policy decision to continue the procelses through the substitution of a series of sectoral adjustment operations. Following standard OED procedures, copies of the draft P?AR were sent to the Borrower. No comments were, however, received. PROGhAM PERF010MANCE AUDIT REPORT I4ALAWI TmIRD STRUCTUAL A=JSTMENT LOAN (CEDIT 1644-MY AND OVERVIEV OF'SALS 19 II, III AND SUPPLEMENT TO SAL MI BASIC DATA saT LOAN POSITION As of June 8, 1989 Oriainal Disbursed Cancelled Reid Outstanding Credit 1644-NA 30.0 35.09 .01 - 35.10 EE PROJECT DATA original Credit Dates Actual or Reeståmated -.nitiating Memorandum 12103/84 04113185 - Ltir*- veopmnt-Wohicy --- 11t85 ~ -~1140M#8&- Negotiations -11185 11u06s85 Board Approval. 12185 12119185 Credit Agreement 12i20/85- 12/20185 Effectiveness 12185 12/23185 Credit Closing 09130/87 09/30/88 Actual Completion 03/31/88 03I$189 CUMULATIVE CREDIT DISURSEMENT FYS6 FYS7 Fyse FYS9 (i) Planned 20.0 10.0 0 0 (o) Actual 20.6 10.0 1.2 .2 (iii) (ii) as Z of (i) 1031 1001 - STAFF INPUTS FY83 FY84 MYS PYS6 P?87 MYS TOTAL Preappraisal - - 34.9 - - - 34.9 Appraisal 3.9 - 49.0 25.4 - - 78.3 Negotiation - - ---20.9 - 20.9 Supervision -- - - 23.4 20.3 .4 44.2 Other - - 6.9 - 4.4 - 11.2 Total 3.9 - 90.8 69.6 24.7 .4 189.5 MISSION DATA month/ No. of No. of Staff Date of Year Weeks Persons Weeks Report Preparation 12/84 2.6 6 16 01/23/85 Appraisal 05/85 3.1 11 28 06/24/85 Supervision I 05186 1 4 4 07/86 FOLLOW-ON ADJUSTMENT OPERATIONS Malawi: Credit No. 1920-MAI, Industrial and Trade Policy Adjustment Credit, approved June 14, 1988, in the amount of US$70.0 million. Notes Special Africa Facility Credits are reflected in pp. 2 & 3 of -Annex Bl. PROGRAM PERFORMANC E AUDIT REPORT MHALAWI THIRD STRUCTURAL ADJUSTKENT LOAN (CREDIT A009-HAI) An OVERVIEv Oý SALS I. II, III AND SUPPLEENT TO AL III BASIC DATA SaEET LOAN POSITION As of June 8, 1989 Original Disburseg Cancelled Re.aid Outatanding Credit A0090-M&.I 40.0 46.9 - 46.9 EEY PROJECT DATA ORiginal Credit Dates Actual or kestiated Initiating emorandum 1213184 12101185 Letter of=Developmnt Polic 11/85 11"05185 Negotiation- 11/85 1219/85 Board Approval 12/85 12/20/85 Credit Agremnt - 12120185 12/20185 Effectlmveness 12185 12/23185 Credit Closing 09/1307 09130/88 Actual Completion 03/31188 03131/89 CU lUE CEDIT DISBURSEHENT FY"6 - M7 FY88 YY9 (i) Planned 20.0 20.9 -0- 0 (ii) Actual 20.2 23.4 .1 9 (1ii) (ii) as of (i) 1012 117x -- MISSION DATA Mon th/ No. of No. of Staff Date of Year . ek Persons Vecks Report Preparation 12/84 2.6 6 16 01/23/85 Appraisal 05/85 3.1 11 2V 06/24185 $uper"1sion I 05/86 1 4 4 07/86 Supervision 11 Copletion FOLLOW-ON ADJUSTMENT OPERATIONS Malawi& Credit No. 1920-MAI, Industrial and Trade Policy Adjustment Credit, approved June 14, 1988. in the amount of U8$70.0 million. -vi- MALM THI.D STUCTU~L ADJUSTHENT LOAN (CREDIT Åk0091-MAI) OVERVIEN OF SALS I. II, III AND SUPPLEMENT TO AL III ASIC DATA SHEET LOAN POSITION As of June 8, 1989 Orlginat Disbursed Cancelled Reaid Outstandi Credit A0091-MAI 10.0 10.4 - 10.4 XBY PRO zýT D&A Origanal Credit Dates Actual or Reestimated inlating emorandum Letter -af Dvelopent Polley 12/241 "2/45 Negotiations Board Approvat - 01/27187 hl/27/87 Cret=Agreeet 02/ 187 02113187 Effectiveness 04129/87 - -041:9187 Credit Closing 09130187 09/0/088 Actual Completion 03/31/88 03131l89 CUMULATIVE CREDIT DISBURSEMENT FY86 87 1188 1189 Ci) Planned -0- 5.0 5.0 -0- <1) Attual -o- -o- lt.8 .1 (Uy (ii) aZ - of (1)-0- 216% -- STAF INPUTS _Ya _8 TOM~ Appraisal 16.8 - 16.8 Negotiation .2 - .2 Supervision 1.1 - 1.1 MISSION DATA month/ No. of No. of Staff Date of Year Weeks Persons Weeks Regort Preparation Appraisal Supervision I Supervision II Completion FOLLOW-ON ADJUSTMENT OPERATIONS Malavis Credit No. 1920-MAI, Industrial and Trade Policy Adjustment Credit, approved June 14, X988, in the amount of US$70.0 million. PROGRAM PERFORMANME AUDIT REPORT NAIAVI THIRD STRUCTURAL ADJUSTMENT LOAN (CRELTS 1644-MLA. A0090-MAI: A0091-mm) AND OVERVIEW OF SALS I. II. III AND SUPPLEMENT TO SAL III EVALUATIONSUMAR BackLroud 1. After fifteen years of steady growth following independence several indicators of imbalance appeared in the late seventies. GDP declined in both 1980 and 1981 and the current account and fiscal deficits averaged 20.4 and 14.3 percent of GDP respectively during 1979-81. The debt service ratio quadrupled between 1977 and 1981 to reach 32.7 percent. 2. There were several reasons for this crisis. Malawi was seriously affected by the decline in its terms of trade, particularly after 1977. The rail transportation routes through Mozambique became unreliable due to insurgency and the deteriorating railway system. Drought made it necessary to import maize in both 1980 and 1981 and, finally, the increase in interest rates in the late seventies and the appreciation of the dollar led to a sharp increase in debt service payments. Respose of the Bank and Fund 3. The Bank began structural adjustment lending in Malawi in 1981. Three SALs and a Supplement totalling US$180 million were approved during the eighties and these loans attracted cofinancing and joint financing in excess of US$100 million. The first sectoral adjustment loan was provided in 1988 with an Industrial and Trade Policy Adjustment Credit of US$70 million. Some project loans for the agriculture sector and for institutional development materialized from the SALs. 4. The IMF had an active program in Malawi during 1980-88 with Standbys, an EFF, Shadow programs and finally an ESAP in 1988. These overlapped with the SALs except during the second half of 1986. Including the funds that were mobilized from other multilateral and bilateral agenc.es, the net inflow of resources averaged 49 percent of imports during 1979-88, though the ratio was as high as 80 in one year. The extent of the international support that Malawi enjoyed is higher if debt relief is also included. SAL ObieJtives and Design 5. The policy initiatives undertaken by the Government in response to the crisis consisted of the implementation of a series of stabilization programs undertaken with IMF assistance and a structural adjustment program financed by a series of SALs from the Bank and other donors. The adjustment policies were intended to provide better incentives for production and domestic investment, achieve an improvement in the balance of payments and in the management of domestic resources, and strengthening of the institutional capability for economic planning and management. The policies implemented under the structural adjustment program covered agriculture, industry and trade policy, fiscal policy, parastatal reforms, and institutional development. They have been grouped under these categories and summarized in Annex I. 6. The need for balance of payments assistance of the type provided by the SALs was clearly established in the case of Malawi. Since detailed economic and sector work had not been done to underpin a broad based policy reform, a TA Loan and Credit were provided at the time of approval of SALs I and II, respectively. In the design of the policy reforms, sectoral objectives were pursued from the outset in both agriculture and industry. 7. Improvements in agricultural pricing policies combined with research and development were complemented by supporting agricultural projects in the drive to improving agricultural production. While these initiatives contributed to longer-term agricultural growth, there were gaps. Land reform issues were not addressed in the context of a serious over-utilization of smallholder land. The impact of reducing the fertilizer subsidy on smallholder productivity, including the adoption of high yielding maize varieties and the credit needs of this sector were not studied. Similarly, the macroeconomic implications of the deregulation of consumer prices were not reviewed in depth before its implementation. The benefits of this measure could not oe fully realized in the absence of import liberalization due to continuing balance of payments difficulties. The revision of the Industrial Development Act was not included in the policy reforms until SAL III and its implementation was delayed even further. This delay and the continuing foreign exchange shortages made it impossible to promote new investments necessary to increase competition in the domestic market. 8. In sum, the policies were inadequate to achieve overall macroeconomic balance, particularly in response to adverse changes in the external environment. Gross domestic investment, inflation and external debt moved adversely during the implementation of the SALs, with improvements in exports being uneven from year to year. 9. Overall, the policy reforms were all necessary, although the sequencing of some could have been different to allow more time for preparation. Their scope could have been more focussed taking fuller account of the interrelationships between the policy changes. The distortions in the economy were more deep rooted than anticipated, requiring supporting policies and more time for realizing the supply side responses to the price increases. More time was also needed for the implementation of reforms, given Malawis weak institutional base. Implementation of SAL III and Suplement 10. Many of the policies implemented during SAL III and the Supplement were a continuation of those begun during the earlier SALs and a complementary program of project lending, especially in agriculture. In the agriculture sector, the price setting methodology adopted attempted to provide smallholders with prices which were equivalent to or near export parity. This policy gained acceptance within the Government but, with the final decisions made by the Life President, there were some imbalances in the proposed price increases. For example, the price increase of over 40 percent proposed for maize in 1988/89 would have led to a repetition of the over-production that resulted earlier in the decade. Conversely, the decision to hold the price steady during 1983/84 to 1986/87 to correct this earlier imbalance may have exacerbated a shortage that was clearly caused by the influx of refugees and the drought. But given the large stocks that had earlier accumulated, there was some merit in & strategy to keep prices stable. 11. The Government continued with the commitment made under SAL II to eliminate the fertilizer subsidy over an extended period ending in 1989/90. This policy was terminated in September, 1988 and since that time the government hos agreed to maintain the subsidy at a given percantage of total government expenditure, negotiated in the context of the PF. Efforts to improve the productivity of the estate sector commenced with SAL I and a program which was drawn up under SAL II was protracted in its implementation because of administrative difficulties. 12. Consumer prices with the exception of petroleum, vehicle spares, sugar, low grade meat and fertilizers were deregulated. The full benefit of this policy change was not reaped during SAL III due to the government's inability to relax import controls and allow competing imports. Local production could not be encouraged because the Industrial Development Act was not revised until later when it was made a condition for Board presentation of ITPAC. The Government continued to honor the commitment to an a.tri eage rate management policy. The nominal and real exchange rates declined by 32.8 and 10.6 percent respectively, during 1986-88. While this would have contributed to restraining import demand and made existing exports more profitable, it had little impact on export diversification. 13. Following a review of Rarastatals undertaken by the Bank in 1987, the Government began reorganization. This is a continuing exercise, with institutional support provided by the Department of Statutory Bodies (DSB) (which remains understaffed) for reviewing investment plans and for monitoring the performance of the commercially oriented parastatals. These showed a consolidated profit of K 5.5 million and K 18.2 million in 1987/88 and 1988/89, respectively, but these profits may have been the result of price increases rather than of much needed restructuring. .xi- 14. The restructuring of the Malavi Develoment Corporation (MDC) and Press Holdins were major achievements during SALs I and II and their performance continues to be monitored by the Government. The reform of the Agricultural and Manufacturing Develoment Corooration (ADMARC) is yet continuing; it was the major objective of the Supplement. Initially, six investments were identified for sale to the private sector but progress has been slow because of difficulties experienced in raising the required capital. The dominant position of ADMARC in the marketing of smallholder agricultural produce was reduced, except in tobacco and cotton, and the participation of the private sector was encouraged. This was facilitated by the introduction of a differential crop pricing system between ADMARC depots and primary buying points and the setting of the consumer price of maize at cost recovery levels. It is intended that ADMARC's role should become one of market stabilization in the long term, defending a band of producer and consumer prices. Action was taken by the government to improve the financial position of ADMARC by buying its silos, purchasing the Strategic Grain Reserve (SGR) and waiving the contribution to the Fertilizer Fund. An annual payment is to be made for the management of the SGR but action has been stalled pending clarification of development functions !o be ..adertaken by ADMARC, for which annual payments will be made by the Gove.-nment. 15. Several instruments for enhancing the economic planning and management canability of the Economic Planning and Development Department (EPD) and the Treasury were introduced during the SALS such as the preparation of Public Sector Investment Programs (PSIPs), revenue and expenditure forecasts, balance of payments forecasts, program budgeting, and external borrowing strategies. The institutional capability for implementing these improvements was weak because of the staffing situation in the central agencies of Government responsible for economic management. It was not until the Malawi Institute of Management was set up with a mandate to train senior staff in the public and private sectors in management techniques that a serious effort was made to tackle this problem. The Bank provided a Credit of US$11.3 million for an Institutional Development Project in 1989, eight years after the first SAL was approved. Major Policy and Implementation Issues 16. Major implementation and policy issues relate mainly to producer pricing and related strategies for improving the productivity of smallholders; reduction of the fertilizer subsidy; participation of the private sector in agricultural marketing and related activities; and tho deregulation of consumer prices. Producer Pricing and Other Agricultural Policies 17. Price incentives for the smallholder sector were devised on the basis of a methodology developed through consultation with the Government. For many years ADMARC had passed on to the smallholders only a small proportion of the export prices realized for each crop, placing them at a disadvantage vis-a-vis the estate sector which could sell its crop in an unregulated market at prices equivalent to or near export parity. In addition, estates and small holders were required by law to grow different -xii- crops. The pricing methodology adopted under the program was designed to correct this asymmetry and with improvements over time, it gained acceptance in official circles. The technical work to determine prices was done by ADMARC and the Ministry of Agriculture and recommendations were made to an inter-ministerial committee, with the final decision taken by the Life President. 18. A conflict arose between the pricing policies required to achieve food self sufficiency and export crop promotion, with the Government more concerned with food security and the Bank wishing to encourage exportable surpluses of cash crops. The application of the price setting methodology ran into difficulties under the first SAL due to these conflicting objectives. The producer price for maize was raised by 66 percent in 1981/82 following an increase of 32 percent two years earlier. This change in price relativities led to a reduction in the production of cash crops for export and the accumulation of a maize surplus. This proved fortunate for Malawi because it was able to export large quantities of maize to its neighbors in 1984 due to drought conditions in these countries, thereby reducing its current account deficit substantially. 19. The prices of export crops were increased substantially after 1982/83 while the price of maize was unchanged for four crop years from 1983/84. This adjustment had the desired effect on the surpluses of export crops which recovered by 1985/86. Only rice sales declined during this period due to the removal of the high subsidy that had existed during the 1970s. However, the performance of exports of smallholder crops was erratic from year to year; the increases achieved were from a small base and made no significant contribution to a change in the structure of exports. The fragility of the improvements achieved was well demonstrated by the events of 1986/87. The influx of 700,000 Mozambican refugees increased the demand for food. Yet the drought in the southern half of the country had reduced ADMARC purchases to their lowest level since 1980/81. Another factor that contributed to lower output response was the decline in the relative price of maize, which reduced the area planted with maize, an effect which was reinforced by the sharp increase in fertilizer prices as a result of the fertilizer subsidy removal program. These increases inhibited the adoption of fertilizer responsive high yielding varieties of maize. 20. These factors caused a sharp rundown of maize stocks by over 200,000 tons in 1986, leading to imports of 140,000 tons in 1987. Further, ADMARC's financial problems in 1985/86 and 1986/87 led to a fall in confidence on the part of smallholders in its ability to purchase the surpluses and market them. Thus ADMARC did not have the stock reserve to defend a ceiling consumer price for maize or the financial resources to function as a buyer of the last resort in surplus years and hence perform a market stabilization role. 21. Although the income of smallholders producing cash crops increated in the 1980s, much of the income gains were eroded by the increase in consumer prices. Insufficient attention was given to the question of improving the productivity of subsistence farmers and a consequential adverse impact on nutrition. These farmers derived no direct benefit from higher prices for maize but faced higher costs for agricultural inputs. Inadequate credit facilities exacerbated the adverse impact of the subsidy removal programs. High loan repayments in the immediate post harvest period, made worse by higher agricultural input prices, resulted in many smallholders overselling their maize at low prices immediately after the harvest, yet buying maize back later in the season at higher prices to meet consumption needs. 22. The removal of the fertilizer subsidy and the adoption of high yielding varieties required corresponding strengthening of access to credit; it also required research into the factors motivating the use of high yielding varieties by small farmers. However, the provision of credit and extension services, as stated in the PPAR for SALs I and II, was "too diffuse a program covering at the time only a small p%rcentage of smallholders". Land reform issues were also neglected; a serious omission in a country facing an acute shortage of cultivable land. The liberalization of the market for food crops was not introduced until some time after parity pricing of exportable crops, adding to the financial burden on ADMARC, a burden which also had an adverse impact on smallholder production because of the de facto monopoly enjoyed by ADMARC in purchasing smallholder crops and providing agricultural inputs. A larger role should have been provided for research extension and credit, particularly for the development of appropriate high yielding varieties and supply of inputs necessary for their adoption. The Fertilizer Subsidy 23. The attempt to remove the fertilizer subsidy of twenty five percent within three years began with SAL II and had a checkered history. It involved the Bank, the Fund and USAID on the donor side and the Treasury and Ministry of Agriculture on the Malawi side. Tension existed between the two Malawi agencies in the implementation of this policy. The continuing depreciation of the Kwacha and the closure of the Mozambican routes to the sea increased the local costs of fertilizers significantly, and hence the subsidy. The Government declined to reduce the subsidy beyond the level which would have been necessary, had the Mozambican routes been open. Thus, implementation of this policy remained incomplete at the end of SAL II. The period for its removal was extended for a further four years up to 1989/90 under the provisions of SAL III, but this measure was also abandoned in September, 1988. By this time, the application of conditionality with respect to the fertilizer subsidy had devolved to U.S. Aid, which commissioned a study of its effects, in 1987. It was realized that, even at subsidized prices, smallholder fertilizer use was far less than optimal despite an overall increase in fertilizer usage. A continuation of the subsidy removal program as proposed would have had adverse long-term *xiv- implications for the productivity of the smallholder sector. In the PFP for 1989/90 the Government agreed to maintain the subsidy at a level not greater than one percent of total government expenditure. 24. The price paid by smallholders for fertilizers virtually doubled between crop years 1981/82 and 1984/85 and increased by a further 57% in 1987/88. The ratio of fertilizer to maize prices also increased by one-third between 1980/81 and 1986/87 and even after the price increase in maize the following year, the increase in the ratio remained as high as 26 percent. Thus the profitability of maize (excluding local maize which does not require fertilizer) declined in absolute terms between 1980/81 and 1986/87.' 25. The termination of the subsidy removal program was precipitated by a crisis caused by the sharp decline in grain output and of ADMARC purchases in 1986/87 and after. There was no consensus on the issue either on the Malawian side or amongst donors. It was unfortunate that the subsidy removal was originally conceived of as z. budgetary measure; it constituted 6 percent of the budget deficit in 1984/85. A full-scale analysis of the impact of phasing out the subsidy on fertilizer use, the adoption rates of high yielding varieties of maize and on maize production in general should have been conducted at the outset. Such a review will now be undertaken under the terms of the Agricultural Sector Adjustment Credit (ASAC). Participation of the Private Sector in Agricultural Marketing 26. Private sector participation in agricultural marketing has been a controversial issue in Malawi. Acceptance by the Government of this requirement as a condition for the Supplementary loan to SAL III was less complete. The Government felt that closing down some ADMARC purchasing centers and scaling down the operations of others would seriously setback smallholder production if the private sector could not step in to provide the same services effectively. Hence, when agricultural marketing was opened up in 1987 to the private sector, a complex set of regulations was imposed on traders such as the minimum prices to be paid to farmers, restrictions on where trading could take place and detailed statistical reporting. Even so, there were concerns about issues such as grain handling capacity, availability of transportation and finance and the overall impact private trade would have on ADMARC and on agricultural development in general. These implications needed to be studied prior to the privatization of agricultural marketing; some of them were subsequently reviewed in the preparatory work for the Agricultural Marketing and Estate Development Credit which was signed in 1989; this project provides for a pilot credit scheme for rural traders and T.A. for improving the regulatory environment for the private trade. 27. The timing of market liberalization was in one sense appropriate, since it provided an opportunity to test private sector response. The drought in 1986 and 1987 and the consequent decline in ADMARC purchases made it profitable for the private sector to engage in agricultural marketing. 1 It has been estimated that these ratios were higher than those prevailing in Kenya and other comparable producing countries. -xv- This negated the argument that the private sector would not be active in remote areas where supporting infrastructure was weak or because it did not have the capacity or the incentive to access these areas. In the environment of shortage, private traders were purchasing at prices, which in some instances were as high as 50 percent above the official producer price. Similarly, they were selling at prices well in excess of ADNARC's consumer prices. The depletion of ADMARC's stocks and its weak financial position meant that it was unable to play the market stabilization role that had been envisaged. The experience of these shortage years indicates that the private sector could indeed play and active role in marketing if opportunities for profit exist. It is important to ensure, however, that the level and extent of such participation is maintained in normal production years as well. It is, therefore, necessary to address constraints that exist in the fields of credit, storage, transportation and marketing. Deregulation of Prices 28. Although the Government agreed to review the price control system under SAL I, it did not begin the process of deregulation until SAL II primarily because this was a policy reform about which the Government was unenthusiastic. Nevertheless, deregulation was conducted in a phased manner with given numbers of products being decontrolled by particular dates and completed during the early period of SAL III, with the exception of petroleum, low grade meat, fertilizer, sugar and motor vehicle spares. The prices of these products were subject to periodic review and adjustment. 29. Successful deregulation of domestic prices in an environment of protection for manufacturing industry had to be predicated on enhanced competition from imports. However, such competition did not occur because recurring balance of payments pressures placed restraints on imports. Quantitative restrictions on imports were intensified in 1986, the first full year of the deregulated regime. Trade liberalization as a comprehensive reform was only introduced in 1988 in conjunction with the Industrial and Trade Policy Credit (ITPAC), after the SALs were disbursed. There was also a need to infuse competition into domestic manufacturing by &=or &]Ua revising the Industrial Development Act, thereby reducing barriers to new entrants. The Government agreed to review the Act under SAL III, but no action was taken until June, 1988 when it was made a condition for Board presentation of ITPAC. The foreign exchange shortage during SAL III made the licensing of new entrants even more restrictive. 30. Deregulation led to sharp increases in the prices of items that were prominent in the retail price index and in the short term some rose faster than the index as a whole. However, it was not possible even to partially compensate for these price increases by adjusting public sector wages. They remained frozen during 1982/83-1985/86 due to Agreements with the IMF; hence, the flexibility needed in wage policies to retain key personnel in Government, was circumscribed. This was a good example of the potential conflicts that arose in the application of Bank and Fund policies in the context of simultaneous stabilization and adjustment. -Zvi- Ownership of the Program. 31. It has been suggested that the structural adjustment program is perceived in Malawi as a World Bank program which Malawi was forced to accept in order to relieve the acute economic crisis the country was facing in 1979-80. The Life President gave his overall blessing to the program when briefed on the economic situation and the need for external assistance. Malawi's input to program formulation nevertheless increased with each SAL, and the circle of senior officials at the center involved in the negotiations widened. By the time SAL III evolved, strong efforts were being made by the Principal Secretary of Finance to involve line ministries in discussions with Bank staff; this had not been the case in earlier SALs. A greater effort to involve the operating ministries and agencies early on in the adjustment program could have led to better acceptance of the reforms and certainly made the task of EPD and the Treasurer easier. The trade off would have been delays in the commitment of loans but implementation would have been smoother, once started. The first attempt at formulating a longer term development strategy by Malawi in the 1980s was the publication in 1988 of the Statement of Development Policies: 1987-1996. Future policy reforms could be viewed as Malawian if placed in the context of these Statements or subsequent revisions to them. Timing of Policies 32. The Bank faces a dilemma when a country needs balance of payments support and adequate economic and sector work has not been undertaken to draw up a comprehensive program of reforms. If the Bank proceeds with such support, the result may be a structural adjustment program which is largely preparatory in nature. This was the case with SAL I, and much of the reform package had to be deferred to SALs II and III. The impact of SAL I, as a result, was significantly less than it could have been. Some delay and more preliminary work could have resulted in more immediately positive and productive an approach. It can, therefore, be argued that the first SAL was somewhat prematurely timed even though the advantage to Malawi was immediate balance of payments support. It remains, however, the judgement of the Region that the Bank's knowledge of the economy and its outline program for adjustment were so advanced, that the benefits of delaying structural adjustment (including the opportunity thereby to utilize IDA, rather than IBRD funds), until more detailed work could be undertaken, were outweighed by the costs of further deterioration in the economy. And this prognosis is probably correct. Bank/IF Coordination 33. Malawi had its share of difficulties arising from conflicting objectives resulting from simultaneous Bank and Fund Programs. These have reduced over the years and should have been eliminated by the introduction of PFPs, but they, do still exist. Some examples were the inability'to adjust wages following the deregulation of consumer proces due to the freeze on public sector wages; the level of the fertilizer subsidy in relation to government expenditure a matter of intense negotiation hetween the two agencies; and the reduction in the budget deficit which had a major adverse *xvii- impact on public sector investment, making It difficult to sustain future growth. The difficulties senior staff of the borrowing country face in coordinating the policy conditionalities of the two institutions, where their scope and time frame for implementation are different, should not be underestimated. Impact of the Structural Adjustment Program 34. Growth in CDP averaged 4.0 percent in the period 1982-85 compared to an average annual decline of 0.8 percent during 1979-81. It slowed down to an annual average of 2.0 percent in 1986-87, due to the restraints on imports brought about by external factors; this was followed by an increase of 3.0 percent in 1988. There was no significant change in the structure of production. Exports increased at an annual average of 1.3 percent over the period 1982-88, mainly due to exceptional export performances in some years. In common with other developing countries, the burden of adjustment appears to have fallen heavily on investment, which declined substantially over the adjustment period. The better growth performance in the first half of the 1980s reflects higher utilization of capacity and improved efficiency of investments. 35. Malawi achieved a surplus on merchandise trade since 1981 mainly through a reduction in imports and intermittent improvements in export prices of tea, tobacco and sugar. The services account has been substantially in deficit during this period due to the increase in transport costs and high interest payments. -xviii- Table 1: MAIAWI: MACROECONOMIC INDICATORS Annual Averages (percent) 1979-81 1982-85 1986-87 1g A. GQZM (i) Growth in GDP at factor cost -0.8 +4.0 +2.0 +3.6 (ii) Growth in exports -2.5 +4.2 +3.8 -13.0 (iii) Gross domestic investment/GDP 21.1 18.9 12.6 16.1 B. EJNfL BALANCE (i) Current account balance/GDP .20.4 -9.1 -5.9 -8.7 (ii) Real effective exchange rate (1980-100) 99.3 98.5 81.7 82.3 C. EXTERAL_DEBT (i) Debt service/exports 27.9 31.0 45.3 44.8 (ii) Debt outstanding/GDP 65.8 77.5 102.6 116.1 D. INTERNAL BALMCE (i) Fiscal balance/GDP -13.1 -9.8 -10.2 -6.2 (ii) Growth in retail price index 15.2 14.4 22.8 31.4 Sag=e: Table 6. 36. The current account balance improved significantly to 2 percent of GDP in 1984 due to a record level of export earnings including an unprecedented level of maize exports. This was not sustained in 1985 mainly due to the decline in tobacco prices. The situation worsened in 1986-87 but the ratio improved due to stricter import control. Import payment arrears accumulated in 1986 and continued at a lower level during 1987 before they were eliminated in early 1988. The real effective exchange rate depreciated by 13.4 percent in the eighties with most of it occurring during 1986-88 while the nominal rate declined by 68.4 percent. This helped to promote exports but worsened the Government's budget deficit. 37. : Reflecting payments falling due on debt which had been incurred earlier, the debt service ratio increased from 23.1 percent ih 1980 to a peak of 53.8 percent in 1986, before declining to 44.8 percent in 1988. The ratio of debt outstanding to exports peaked it 454 percent in 1987 compared to 261 percent in 1980, before declining to 406 percent in 1988. The ratio of debt outstanding to GDP increased consistently from 65.7 to 116.1 percent during 1980-88. Attempts to establish debt management capability in the Treasury and a borrowing strategy and plan had little impact on the external debt situation of Malawi which is classified as a seriously indebted country. -xix- 38. The fiscal deficit increased in the early eighties to 16 percent of CDP due to the rapid increase in government expenditures, mainly recurrent expenditure, of which, public debt interest was a major item. The financial problems of parastatals also contributed to this increase. The fiscal situation improved after the introduction of stabilization and adjustment measures and the deficit as a ratio of GDP declined. This was brought about by a reduction in expenditures, mainly those earmarked for development purposes. The deficit increased again in 1986-87 though not to the earlier levels, mainly due to higher defence expenditures and lower revenues from import duties and company taxes. A major problem of internal balance was the annual inflation rate of 13 percent that prevailed for much of the 1980s, escalating significantly in 1987 and 1988; the increase was 31.4 percent in 1988. The rapid expansion in money supply of around 25 percent annually and the depreciation of the Kwacha by 68 percent during the eighties were largely responsible for these trends. Social Dimensions 39. The adjustment program had positive and negative social impacts on the population. To the extent that implementation of the reforms helped improve productivity of the workforce, that constituted an important positive effect. On the other hand, the retrenchment of labor and the decline in real wages stemming from price adjustments and subsidy removals, did have an adverse effect on the population, as evident from Table 8. These impacts were exacerbated to the extent that non-optimality in fertilizer application also limited productivity in the smallholder sector. A program for "Growth through Poverty Reduction" has been designed for Malawi by the Southern Africa Region in the context of its economic and sector work.2 This is a praiseworthy initiative to address the four elements which contribute to poverty and social distress in Malawi, viz. unemployment, low productivity, undeveloped human resources, and improperly designed and targeted social transfer programs. 2 Malawi: Growth through Poverty Reduction, IBRD Report No. 8140-MAI, March 22, 1990. *xx-. Table2~: RATES OF GROWTH IN FORMAL SECTOR EMPIDHENT AND REAL WAGES, 1968-77, 1978-87 Emoloyment pepzal Was CPI Deflator GDP Deflator 1968-77 ,1978-87 1968-77 1978-87 1968-77 1978-87 (average annual percentage change) Total 8.3 2.1 -5.9 -4.6 -7.0 -2.5 Of whiih: Agriculture 11.3 0.7 -3.4 15.9 -4.6 -3.7 Manufacturing 7.2 7.4 -2.1 2.9 -3.2 -0.7 Government Services 1.6 4.1 -7.0 -7.2 -8.5 -5.1 Source: Country Economic Memorandum, March 22, 1990 40. Data on the impact of adjustment on poverty and income distribution were not collected. Surveys are now being conducted by the Center for Social Research of the University of Malawi to collect data from households in urban areas to compare with base data collected for 1980. Preliminary conclusions indicate a more than doubling of the share of income spent on food. The political systom in Malawi does not permit social tensions to manifest itself in popular discontent, but its absence should not be taken as evidence of satisfaction with the current state of affairs. 41. SALs I and II are typical of SALs in the first half of the eighties which paid little attention to the social dimensions of adjustment. There was no consideration of the possible effect of policy changes on income distribution and employment. No attempt was made to identify those most seriously affected, with a view to providing specill assistance. These were net food purchasers in rural areas, urban wage earners who were significantly affected by the freeze on public sector wages during 1982/83 to 1985/86, and those who lost employment by the restructuring of parastatals and Press Holdings In particular. The President's Report for SAL III. dealt superficially with the issue of social impact and no specific measures were proposed to identify and monitor the impact on the most disadvantaged groups. It seems to have been accepted that long-term benefits would accrue to all Malavians by the restoration of economic equilibrium and the resumption of growth. The absence of any serious consideration of the aocial impact must be regarded as a fault in the design of the, SAL series. 42. Available social indicators are shown in Table 7 (pg. 46).' The increasel in retail prices ha6 already been commented on. The share of recurrent expenditure allocated to .health and education nas declined by l-Z -xxi- percentage points while the allocations to these sectors from the development budget have increased as a share of the total. What these changes mean in terms of services to the people are not known. Sustainability of Benefits 43. Economic indicators show that although CDP growth recovered, investment as a ratio of GDP declined. These investment levels were inadequate to support sustained growth in the future without a major improvement in investment efficiency. The fiscal deficit was moderated by curtailing expenditures, mainly those earmarked for development. Nevertheless the high inflation rate added to the difficulties of restoring internal balance, particularly in 1987-88. The current account deficit was reduced, in comparison to the early eighties, mainly by reducing imports. The external debt situation worsened, requiring Malawi to seek debt reschedulings; after the start of SAL I and the concurrent IMF programs, Malawi virtually halted all borrowing on commercial terms. Yet the economic basis for sustainability remained fragile. 44. The Life President plays a predominant and in some instances an absolutely determinant role in policy making. It was his acceptance of the need for reforms which made it possible to introduce such an extensive program. This put pressure on some officials to occasionally agree to conditionalities with which they did not fully agree. The commitment to reforms, however, has not diminished amongst the bureaucracy due to the realization that substantial external funding is necessary to support adjustment efforts. Their confidence will however diminish if the supply responses to the new policies are slow to materialize and the economy is unable to withstand external shocks any better after eight years of structural adjustment lending. 45. Frequent rotation of senior staff in the administration could also result in a loss of institutional memory and erode the analytical capability built up by frequent negotiations with aid agencies. It could also lessen the willingness to critically evaluate policy choices. 46. Several policy changes were devised during the SALs to improve economic management and policy formulation capability in the Treasury, the EPD and the DSB. The most important of these have been the preparation of three year PSIPs, revenue and expenditure forecasts, the introduction of program budgetiuS, the preparation of medium-term corporate plans for each parastatal, improvements in project analysis and the overall strengthening of the annual budgeting process in the context of medium-term programs and plans. Their sustainability depends on the appointment of trained and experienced staff to carry out these functions and continuing in their posts for a reasonable length of time. 47. To sum u, Malawi provides a good case study of a country that =aplemented a comprehensive stabilization and adjustment program against heavy odds, both domestic and external. These difficulties were etched against a backdrop of high debt service. On the positive side, however, the -xxii- Bank was correct in its approach, to initially address the structural deficiencies in key parastatals. It was also appropriate to focus on price deregulation and trade liberalization. These were necessary for sensitizing the economy to international competition and improving efficiency in resource allocation. In the same vein, the IMF interaction in support of stabilization was centripetal to the program of adjustment, even though in retrospect, there remained areas where Bank and Pund policy coordination could have been improved. The controversy surrounding the reduction of the fertilizer subsidy and its potentially adverse effects on smallholder productivity and real incomes of the poorest farmers (i.e., those who are net purchasers of food), remains a major dilemma. Problems of this kind are not unique to Malawi; yet, they underscore the importance of appropriate empirical research and the promotion of an active policy dialogue with all parties. The initiatives spelled out in the Bank's most recent Country Economic Memorandum, for a strategy of growth through poverty reduction, represents a refreshing approach, but given Malawi's serious resource shortage, judgment must remain open; optimism must be tempered with healthy skepticism. Approaches of this nature, if they are to succeed, as they indeed deserve to, have to be complemented by constructive debt management and positive resource transfer strategies. A realistic macroeconomic fr,..evork must, of course, form the bedrock of any strategy that seeks to achieve growth with equity. Lessons of ExperieWe 48. A number of lessons, some of general application, may be distilled from the experience of Malawi in structural adjustment. * The sine qua non for all policy change is clear and unequivocal 9olitical commitment, and the intensity and sequencing of the policy prescriptions must be geared to the borrower's capacity to absorb and deliver; sometimes it may be wise to settle for less within clearly established priorities. The Administration's protraction in fulfillment of conditionalities underscored the weak administrative and institutional base which constrained any program for major economic restructuring. * Policy prescriptions have to be anchored in thorough analytical and operationally-oriented country economic and sector work, that has been executed in advance. Malawi' s experience in implementing price deregulation and reduction of fertilizer subsidies, as well as the record with respect to the social dimensions of adjustment show that the adjustment program could have had a potentially stronger impact if there was greater rigor in economic and sector analysis. The Bank's economic and sector work intensified as the program progressed. * In depth analysis is needed to ascertain the poliical, socia and economic imoact of the standard structural adjustment policy prescription, given that countries are at different stages of financial and economic development and there may be unique features of a temporary or more long-lasting nature that require modification of a program. These principles could not always be observed in the -xxiii- case of Malawi. Examples are the failure to address the social impacts of pricing policies for agricultural inputs, especially where poorer smallholders were net purchasers of food, selling when prices were low and buying back grain when prices were high. The most recent Country Economic Memorandum (March 1990) represents a good attempt inter alla to address these issues in the context of a strategy for growth through poverty redressal. * Policy prescriptions that do not take account of all elements relevant to the achievement of a given objective can have negative effects on program credibility. For example, the decision to deregulate consumer prices and reduce subsidies required complementary action on import liberalization. Failure to act on import liberalization perpetuated rent seeking in the commodity markets. These pitfalls could be avoided if an analytical framework is developed to check the consistency of the various elements of the policy prescriptions, both Bank and Fund, and identify potential difficulties. PROGRA PERFORMANCE AUDIT REPORT MALAWI THIRD STRUCTURAL ADJUSTMENT LOAN (CREDITS 1644-MAL A0090-MAI: A0091-MAI) AND OVERVIEW OF SALS I. II, _1 AN SUPPLEMENT TO SAL III I. BACKGROUND TO THE RISiS 1.01 Malawi enjoyed fifteen years of steady growth in the period following independence up to 1979. During this period the annual growth rate in GDP averaged in excess of 5 percent, per capita income grew by 3 percent, inflation averaged around 9 percent and per capita GDP reached US$176. Despite this apparent progress, Malavi remained one of the poorest and most vulnerable countries in the world, in part because of its land locked position and also because of the impact of political developments in Southern Africa. Indicators of imbalance appeared in the late seventies and GDP started to decline in 1980 and 1981. The current account and fiscal deficits averaged 20.4 and 16.3 percent of GDP respectively during 1979-81. The debt service ratio rose from seven to 28 percent and foreign reserves declined to precarious levels. 1.02 In common with other countries that received adjustment loans in the 1980s, Malawi was seriously affected by the decline in its terms of trade. Foreign trade (exports plus imports) was in excess of 60 percent of GDP in 1979-80 and, inevitably, changes in the terms of trade had a significant impact on the growth of the economy. There were also other external factors that affected the situation adversely. The traditional rail transport routes to the ports of Beira and Nacala in Mozambique became unreliable due to the insurgency and the deterioration of the Mozambique railway system. These routes carried 90 percent of Malawi's foreign trade and their total closure in 1984 led to additional costs which were equivalent to 15 percent of the value of exports of goods and services. Drought conditions in 1980 and 1981 made it necessary for a previously self-sufficient Malawi to import maize, its staple food grain, and reduced agricultural production in general and, therefore, earnings from export crops. Malawi had also made considerable commercial borrowings abroad subject to variable interest rates and the increase in these rates in the late seventies affected Malawi adversely. The increased burden of debt and the appreciation of the dollar led to a quadrupling of the debt service ratio. 1.03 The onset of these adverse external factors exacerbated the impact of domestic policies introduced in the late 1970s when large pay increases and major public investments of a non-productive character were undertaken. The budgetary deficit had then risen to 16 percent of GDP by 1981 from 7 percent in the mid 1970s. Malawi's main structural problem was its limited production base. Agriculture accounted for approximately 40 percent of GDP and tobacco, tea, and sugar for 80 percent of exports. Although the smallholder sector provided the sustenance for the majority of the -2- population, it was the estate sector that had grown significantly and increased productivity since independence. In 1982, the estate sector accounted for 80 percent of agricultural exports, emphasizing the need to introduce programs for the diversification of export crops and for improving the productivity of the small holder. 1.04 The financial position of a number of parastatals had deteriorated in the seventies, requiring the transfer of funds from the government budget. Those causing most concern were the Agricultural Development and Marketing Corporation (ADMARC), the Malawi Development Corporation (MDC) and the private sector entity Press Holdings Ltd. which occupied a special place in the Malavi economy because it was wholly-owned by the Life President and its activities extended to all sectors. By the late 1970s, the gross turnover of Press was of the order of one-third of GDP and it employed 10% of the labor force in the non-subsistence sector. Improvements in the management of parastatals was necessary across the board but in the case of these three, measures were necessary for their financial restructuring as well. 1.05 Other issues on which action was urgently needed were the identification of alternative energy sources, particularly for tea drying and tobacco curing (the cost of importing petroleum had gone up seven fold, while the cost of exporting tea and tobacco had tripled as a result of the transport difficulties);' the price controls that appeared to be causing distortions in the economy and constraining domestic production; the inadequate funding of key recurrent expenditures of government, primarily agriculture, roads and the social sectors; and finally, strengthening of economic management and policy formulation capability within the administration. II. RESPONSE OF THE BANK AND FUND 2.01 Structural adjustment lending by the Bank began in July, 1981 when an IBRD Loan of US$45 million was provided along with a loan for technical assistance (TA) of US$1 million. This first structural adjustment loan (SAL) was fully disbursed by August 1982. It was followed by a second SAL of US$55 million from IDA funds in January, 1984 which was fully disbursed by December, 1984. A second TA Credit was also approved at the same time and disbursements from this US$1.5 million credit continued until 1989. The third SAL of US$70 million was approved in December, 1985 and included US$40 million from the 12ecial Fund for Sub-Saharan Africa (SSA). This Credit attracted additional financing of the order of US$79 million from Special Joint Financing (SJF), cofinancing and bilateral aid facilities that were set up under the Special Fund. Further, a Supplement to the third SAL of US$10 million was approved in February, 1987 from the Special Fund along with an additional US$30 million from the SJF. When all the funds channelled through this Credit were fully disbursed, it was finally closed in September, 1988. tMalawi: Promising Reforms. Bad Luck, Ravi Gulhati, EDI, 1989. -3- 2.02 Although it had been anticipated that a fourth SAL would be provided to Malawi, the Bank did not pursue this path and instead began Sectoral Adjustment Loans (SECALs). The first, of US$70 million for an Industrial and Trade Policy Adjustment Credit (ITPAC) was signed in September, 1988. An Agriculture Sector Adjustment Credit (ASAC) became effective in April 1990 and a Financial Sector Credit is planned for 1990. Some project loans also materialized from the SALs; the Smallholder Fertilizer Credit of US$5 million in May, 1983, the Agricultural Marketing and Estate Development Credit of US$18.3 million in March 1989 and the Institutional Development Credit of US$11.3 million in June 1989. 2.03 The IMF paralleled these efforts with an active program in Malawi. The first Standby Agreement for US$32.9 million was negotiated in June, 1979 and covered a 30 month period. (An additional US$23.8 million and US$7.1 million were obtained from the Compensatory Financing Facility and the Trust Fund respectively). This agreement could not be maintained beyond the first drawing due to the economic dislocations resulting from transportation difficulties and the drought. A second Standby was negotiated in April, 1980 for a two year period and it included the funds remaining in the first Standby and those made available from the Supplementary Financing Facility, making a total of US$64.8 million. This Standby overlapped w ih the first SAL. A third Standby, for one year, was negotiated in August, 19b2 but there was no overlapping SAL during this period. The next Agreement negotiated with the Fund was in September, 1983 under the Extended Fund Facility (EFF). It provided for drawings of SDR 100 million over a three year period but the amount was reduced to SDR 81 million following delays in completing the third year review. However, the program broke down in April, 1986 due to Malavi's inability to meet the budget deficit target resulting largely from the Government's decision to assist ADMARC with its financial requirements. The Facility was cancelled in August, 1986 with only SDR 57 million drawn. The EFF overlapped with SAL II and with SAL III, the latter during the early part of it' s implementation. There was no Agreement with the Fund for almost two years (although there was a shadow program in 1987) until the fourth Standby Agreement for a fifteen month period was negotiated in March 1988. This was replaced soon after by an Agreement under the Extended Structural Adjustment Facility (ESAF) in July 1988, the first such agreement concluded by the IMF. It overlaps with the Industrial and Trade Policy Credit. 2.04 The need for close coordination between the Bank and Fund has been critical due to the interlocking policy objectives included in the stabilization programs and structural adjustment loans. The division of labor evolved along traditional lines. The Fund focussed on issues such as target levels of expenditure and budget deficits, exchange and interest rate policy, and domestic resource mobilization. The Bank on the other hand took the lead on the public sector investment program, agriculture pricing, the allocation of funds for key economic sectors and parastatal reform. Close coordination was especially necessary between the two institutions on issues such as agricultural pricing, which affected the finances of ADMARC, tax policy, the fertilizer subsidy and the foreign exchange allocation system. The removal of the fertilizer subsidy, to which reference is made later, illustrates the potential for conflict. It was originally proposed as a -4- measure to reduce the budget deficit but it had adverse consequepces for the policies introduced to encourage th6 use of higher yielding maize varieties by sma1holders. 2.05 These programs, apart from generating funds from the Bank and the Fund, also acted as a catalyst for mobilizing resources from other multilateral and bilateral agencies (including grant funds from some of them). Table 3 illustrates the magnitude of the net inflow of resources annually from these sources during the period 1979-88. 'On average, they financed 49 percent of imports. The ratio is higher if debt relief is included. Iale ALAvi NET RESOURCE FLOMS, IMPORTS AND DEST RELIEF (K NLV) 1m a Im m m 19a 1"6 1 1m A. Grants 38.60 41.00 41.90 39.40 35.90 37.30 45.30 57.90 72.70 207.40 Loans 79.10 143.20 43.30 31.30 77.60 52.00 31.10 76.80 152.30 163.00 INF 27.40 22.10 28.90 *2.00 30.00 24.90 12.10 -46.00 *67.10 - Total Net Resource Flows A45.10 206.30 114.10 68.70 143.50 114.20 88.50 88.70 157.90 370.40 . Imaorts FOB 253.40 258.40 230.80 209.60 236.10 229.00 295.60 286.80 392.30 641.50 C. Net Resource Flows as a Share of lports (%) 57 80 49 33 61 50 30 31 40 58 D. Debt Retief - * * 19.70 59.50 33.30 11.70 5.30 49.90 121.00 ~ggggs CEM October 1989 (Yelto Cover). 2.06 The 1986s was a period in which Malavi introduced a range of policy reforms as a quid pro quo for the international financial support received from various bilateral and multilateral agencies. It was an impressive commitment to reforms by a developing country and the calendar of events that brought these about are listed in Table 4. -5- Tam 4ig WI AAa 07 MICT EVENTS, 1979-8 lundBankother 1979 Standby Agreenment - - (October) 30 montba 1980 Revised Standby - - Agreement (April) 24 fonths 1981 - SALI - (J1y) 1982 Standby Agreement - Paria Club (Ungust) September 12 motba 1983 avP r - Å wndo Club < cr) (March) 36 1outhe, Parig Club (October) 1984 - SAL ii - (January) 1985 - SAL III (December) 1986 Cancellation of - Consultativa Group EF Agreement on External id (August) (March) 1987 Shadov Program SAL III Supplemnt (February) 1988 Standby Agreemmnt trial and Statement of Development (ebruary) Tråda Policy Policies, 1987-96 15 montbe Adjustman Paris and London Clubb Credit (September) E8A ~ Agreemnt rP 1988/89- (July) 1990/91 36 month. -6- III. SAL OBJECTIVES AlD -LICIES Overall Objectives 3.01 The policy initiatives undertaken in response to the crisis that emerged consisted of a series of stabilization programs undertaken with IMF assistance and a structural adjustment program financed by a series of SALs from the Bank and other donors intended to improve internal and external balance and achieve a moderate growth in per capita income. 3.02 The medium-term objectives of the Government at the time SAL I was approved was a GDP growth rate of 4.8 percent with the growth of agricultural smallholders, estates and manufacturing projected to be 5.0, 2.9 and 7.5 percent, respectively. It called for diversification of the sources of foreign exchange earnings and savings, reduced dependence of the modern sector on imported oil, by energy conservation measures and the use of fuel wood, and improvements in external and internal balance brought about by better financial performance of parastatals and the government. These improvements were expected to reduce dependence on external resources and domestic borrowings to manageable levels. 3.03 When the second SAL was approved it was recognized that these growth targets could not be fully met. Transportation problems continued to affect external trade adversely, the external environment was more hostile than had been projected and the Government had not been able to move as fast as anticipated in making and implementing decisions on policy reforms. By the time SAL III was approved, the projected GDP growth was reduced to 3.7 percent for the period 1985-90. It was realized that higher domestic investment was needed to sustain growth in industry and agriculture, which could only be achieved by an increased flow of external resources to supplement domestic savings. Such flows had to be on concessional terms due to the sharp increase in debt service payments that had taken place. 3.04 The stabilization measures agreed with the Fund were intended to restrain demand and bring about internal and external balance. These measures consisted of a combination of government expenditure controls, including the reduction of subsidies and restraints on new hirings and wage increases; current account and budget deficit targets; ceilings on total domestic and net credit to the government; new revenue measures; the monitoring and adjustment of interest and exchange rates; and ceilings on government and government guaranteed borrowings. 3.05 The policy reforms that were introduced under the structural adjustment program were intended to provide better incentives for production and domestic investment, achieve an improvement in the balance of payments and better management of domestic resources, and stronger institutional capability for economic planning and management. The actions to be taken under each SAL have been listed against each policy instrument in Annex I and those that were conditions for tranche releases have been marked with an asterisk. -7- 3.06 The first SAL of US$45 million was signed in July, 1981 and its implementation overlapped with the second Standby Agreement with the IMF. The policy initiatives set out in the Government's Letter of Development Policies covered balance of payments measures, price incentives and incomes policies, resource management and institutional improvements. The major reforms introduced were an annual review of smallholder agricultural prices on the basis of a methodology agreed with the Bank, leading towards parity with export prices; an agreement to review the price control system on domestically produced and imported goods, with a view to increasing the flexibility of the system; an additional allocation from the recurrent budget to agriculture and a commitment to allocate increasing shares of the total budget to agriculture and the social sectors; an increase in tariffs of several parastatals and a commitment to make frequent changes in them in line with cost escalations; the establishment of an Investment Coordinating Committee to monitor and ensure financial viability of new investments and strengthen the Government's debt management capability; and the undertaking of studies and action plans which would lead to specific institutional and policy reforms in subsequent phases of the structural adjustment program. To finance these studies, which are listed in Annex II the first SAL was accompanied by a free standing TA Loan of US$1.0 million. 3.07 SAL I was tranched and several conditionalities set out for the release of the second tranche of $20 million (see paragraph 68 of the President's Report of June 4, 1981 for a full listing). The review in October, 1981 established that further action was required by the Government on a number of issues; the sharp deterioration in the budgetary situation, a rapid increase in external debt service payments, the large increase in the price of maize without a corresponding increase in the prices of export crops and delays in implementing a number of studies under the TA Loan. Although not a condition, the Bank took the position that the preparation of balance of payments and public finance forecasts had to be expedited. Following satisfactory action by the Government on these items, the second tranche was released. 3.08 The Government had difficulty in achieving internal consensus on a number of economic policy issues which were politically sensitive. As a result the second SAL was not signed until January 1984; two and a half years after the first, by which time the economic situation had deteriorated further, requiring a downward revision of the projected growth rate. An agreement with the IMF under the EFF had been signed in September, 1983 and this was in force for the entire duration of SAL II. 3.09 The Government's Letter of Development Policies covered measures which were intended to improve the performance of the productive sectors, mobilize and manage resources better, and strengthen key institutions. The detailed policy instruments are set out in Annex I. The major ones focussed on a continuation of the methodology adopted for setting the prices of smallholder crops and incentives for export crop production; strengthening -8- the institutional arrangements for the appraisal of investments and for debt monitoring and management; improving the management and financial operations of statutory bodies; the introduction of a phased removal of fertilizer subsidies; commencement of a program for the deregulation of domestically produced and imported goods; the implementation of the restructuring and reorganization of Press Holdings, KDC and ADNARC; enhancing the Goverment's capability to budget and undertake forward planning and to implement and monitor its programs; and increasing government revenues and greater cost effectiveness and control of expenditures with a view to reducing the budget deficit. A second T.A. Credit of US$1.5 million was approved at the same time as SAL II (see Annex II). 3.10 SAL II was also trenched and the second tranche of US$25 million was to be released in May, 1984 following a review of performance (see para. 91 of the President's Report for a full listing of the conditions). This review established that further action was required by the Government on the rationalization of the assets of Press Holdings, the adoption of crop price proposals, the setting of fertilizer prices to achieve the proposed reduction in the fertilizer subsidy and on the preparation of an external borrowing plan. Although not laid down as a condition for the release of the second tranche, the Bank took the position during the review that the proportion of the budget allocated to government buildings, in particular the State Houses, was inconsistent with the objectives of the public sector investment program. Following satisfactory action by the Government, the second tranche was released in November, 1984. SAL III 3.11 At the time that the third SAL was negotiated in November, 1984 there were definite indications that growth had improved and that the current account and budget deficits had declined. However, some of this improvement was due to external factors as were some of the original causes of the crisis. For example, the terms of trade had improved from the low levels in 1979-80 and the record world prices of tea and the unprecedented maize exports to neighboring countries made it possible to reduce the current account deficit substantially in 1984. There was, however, uncertainty about the sustainability of these improvements if the external factors returned to earlier levels. The first and second SALs experienced delays in drawdown due to the time needed to implement reforms; which had been seriously underestimated. Nevertheless, advances had been made on several fronts such as agricultural pricing, the deregulation of prices of manufactured goods, restructuring of Press and MDC etc. and Malawi's commitment to reform, though somewhat frayed, continued with the implementation of the three year EFF signed in September 1983. The program negotiated for SAL III was basically a continuation of the reforms introduced under the earlier SALs plus a few new elements. The policy instruments are listed in Annex I and summarized below. -9- (1) Agrigulture. Smallholder prices were to continue to be proposed on the basis of the agreed methodology and the Bank consulted prior to the announcement of prices for 1986/87. The fertilizer subsidy for the smallholder sector which had been reduced during SAL II was to be removed entirely by 1989/90 and the Bank consulted on fertilizer prices for 1986/87. On the basis of earlier studies, a pilot scheme for providing medium-term and long-term credit to estates was to be initiated. Finally, a management training and extension program for estates was to be prepared. (ii) Industr. The program of price liberalization was to be completed by the end of 1985. The government was to continue active management of the exchange rate in consultation with the Fund. The Industrial Development Act was to be reviewed and changes made to encourage competition and restrict the protectionist use of the industrial licensing system. The Government also agreed not to discourage the import of goods produced domestically. Measures were to be taken to strengthen the staffing and organization of the Export Promotion Council and establish a training capability. An export promotion policy and an export financing facility were to be finalized. (iii)Fiscal Policy. On the basis of the tax study under way on the changes necessary to improve efficiency and incentives, the Government undertook to adopt a strategy for restructuring the tax system and implementing some of the changes in 1986/87. (iv) Parastatal Reforms. Since it was expected that ADMARC's problems would be handled through a separate project, the policy in respect of ADMARC was confined to accelerating its rationalization efforts and an undertaking by the Government to relieve it of some of its financial burdens. The role of the private sector in agricultural marketing was to be expanded. The Government was to monitor MDC' s performance following its restructuring and encourage it to invest more in agro-industry. A similar role by the Government was envisaged for Press Holdings where a medium-term corporate plan had been prepared and adopted. An action plan was to be prepared by the Department of Statutory Bodies (DSB) to reduce parastatal deficits and improve their efficiency. (v) Institutional Develogment and Improvements. The Government undertook to improve the effectiveness of the DSB in monitoring the operations of parastatals and to reorganize and strengthen the policy making staff in the Office of the President and Cabinet (OPC) and those undertaking economic analysis in the Treasury. The Economic Planning and Development Department undertook to prepare the Public Sector Investment Program (PSIP) and the Treasury compiled the Revenue and Expenditure forecasts for 1986/87-1989/90. In addition, the Treasury was to revise the external borrowing plan. A new policy was the introduction of program budgeting. -10- 3.12 A special Project Preparation Facility of US$400,000 was approved in May, 1985 to finance studies on budgeting, the reform of the tax system and the establishment of an export financing agency. This facility was set off against the US$1 million earmarked from IDA funds for T.A. under SAL III. These studies were intended to provide the technical basis for some of the policies proposed for implementation under this SAL. 3.13 The disbursement of funds from IDA and the Special Fund for Africa (SFA) were subject to tranche conditions with US$30 million of the total Credit of US$70 million released after a review in June, 1986 (see para. 76 of the President's Report for a listing of all the conditions). As in the case of the earlier SALs, the review established that inadequate action had been taken by the Government on some of these conditionalities; the level of the fertilizer prices, the preparation of the PSIP, revenue and expenditure forecasts and the external borrowing strategy, and the adoption of an export promotion strategy and the establishment of an export credit facility. Following satisfactory action by the Government, the second tranche was released. The release of the funds from the SJF and other facilities of the Special Fund that were allocated to SAL III at the time of its signature were similarly tranched and released in the same manner. Sunplement to SAL III 3.14 The Supplement provided US$40 million, US$10 million from the SFA and the balance from the SJF. It was focussed entirely on the agricultural sector and dealt specifically with reforms in agricultural marketing and pricing and the restructuring of ADMARC. 3.15 The private sector was to be encouraged to trade in smallholder crops other than cotton and tobacco. Differential prices were to be paid between primary and secondary markets to provide incentives to traders and farmers to undertake some of the assembly and transport functions currently undertaken by ADMARC. Further, ADMARCI s selling price of domestically produced goods including maize were to be set high enough to cover domestic marketing and handling costs. ADMARC's marketing operations were to be made more efficient by closing non-viable markets and consolidating the operations of others through periodic visits of mobile buying teams. In the long-term it was expected that ADMARC's role would become one of market stabilization with an increasing share of agricultural marketing handled by the private sector. It had been agreed that the non-marketing activities of ADMARC were to be sold off or transferred to a separate holding company or trust fund. At the time the Supplement was approved, six major holdings had been identified for sale. An investment coordinator was to be hired to assist in the divestiture program which was funded by a USAID project signed in August, 1986. Following the purchase by the Government of Malawi's strategic grain reserve (SGR) and silos complex from ADMARC, it was agreed that an annual fee would to be paid for the management and handling of the SCR. A food security strategy was to be developed and consultancy services provided to the Economic Planning and Development Department (EPD) for this purpose. -11- The Design of the SALs 3.16 The need for balance of payments assistance of the type provided by SALe was clearly established in the case of Malawi. The lack of detailed economic and sector work (ESW) that would have been necessary to underpin a broad based policy reform at the commencement of SAL I has been acknowledged and referred to in the Program Performance Audit Report (PPAR) for SALs I and II. However, SAL I and the accompanying T.A. Loan provided the direction for future ESW and assisted in the formulation of a country strategy. In terms of Malawi's needs the provision of funds at this stage was timely. 3.17 While improvements in agricultural pricing policies with research and development were supported by agricultural projects in the drive to improve agricultural output, there were structurel impediments which affected longer-run growth. No attempt was made to address the need for a more equitable and efficient distribution of land although smallbolder laud was seriously over-utilized and estate land under-utilized. Smallholder productivity had been declining and could not be reversed by increasing producer prices. 3.18 The progressive elimination of the smallholder fertilizer subsidy was introduced primarily as a budgetary measure without a study of the full implications on fertilizer use and in particular on the adoption of high yielding maize varieties by the smallholders. Similarly, the scope and timing of the policy changes introduced for the industrial sector had its shortcomings. The deregulation of consumer prices of locally produced goods and imports was pursued without a study of the full macroeconomic implications. Ideally, import quota and tariff liberalization would have reinforced the competition inducing effects of price deregulation; however, the foreign exchange stringency that persisted, preempted action on this front. A revision of the Industrial Development Act could nqter a have facilitated competition in the domestic market even though some doubts have been raised whether a significant demand existed for such investment. This revision was included only in SAL III, although price deregulation began under SAL II. Thus, price deregulation resulted in windfall benefits to some manufacturers given the monopolistic or oligopolistic structure of domestic manufacturing. The Bank continued to pursue this policy even when it was clear that the foreign exchange situation would not permit the full .benefits of deregulation to be achieved. 3.19 Of the macroeconomic .indicators, gross domestic investment, inflation and external debt service ratios moved adversely during the implementation of the SALs, with the improvements achieved in exports being uneven from year to year. It appears that the policies were inadequate to achieve overall macroeconomic balance, particularly in response to the adverse changes in the external environment. The debt service ratio had quadrupled in four years by 1981, but the need to formulate a borrowing policy and strategy was not adequately addressed until well into the second SAL. Similarly, no action was taken to reverse the trend of falling investment as a ratio of GDP. The formulation of an export promotion policy was not required until the third SAL and the only policy to have an impact -12- on exports was the steady depreciation of the Kwacha, which provided substantial benefits to existing exports, primarily of agricultural products, but which does not appear to have had an impact on the structure of exports. 3.20 Overall, the reforms were necessary, although the sequencing of some of them could have been different to allow more time for preparation and their scope could have been more comprehensive, taking fuller account of interrelationships.. Given Malawi's poorly developed human resource base and weak institutions, more time was needed for their implementation. The distortions in the economy were more deep rooted than anticipated, increasing the time period necessary for realizing the supply side responses to price increases. An adequate macroeconomic framework was necessary to monitor the impact of adverse movements in the economic indicators as they evolved under the program in response to external shocks. IV. IMPLEMENTATION OF SAL III AND SUPPLEMENT 4.01 Many of the policy reforms implemented during SAL III and the Supplement were a continuation of those begun during the earlier SALs, although a few new policies were introduced. Comments on the implementation of these reforms include the earlier experience ae well and cover where appropriate, the entire SAL program. Arricultur 4.02 The review mission for the release of the second tranche found that the producer price proposals for the 1986/87 crop year were acceptable. No price changes were proposed for maize and the main categories of groundanuts and tobacco. Among other increases, 10 and 16 percent increases were proposed for cotton and rice respectively. The producer and input prices and ADMARC purchases for some crops in the years 1980/81-1988/89 are given in Tables 3 and 4, respectively. 4.03 Although the methodology proposed for producer prices had gained acceptance within the Government during SAL I, the decision on prices in 1981/82, failed to conform with the methodology and led to a 66 percent increase in the price of maize (with no significant increase in the prices of other crops with the e-ption of cotton which increased by 24 percent). This resulted in a surp' .. of maize and a reduction in the production of other export crops. This corrected itself when the price of maize was held constant for four crop years but it may have exacerbated a shortage that was clearly caused by the influx of refugees and the drought.' But given the large stocks that had earlier accumulated, there was some merit in a strategy to keep prices stable. Studies have shown that the smallholder price of maize in 1986 was only 50 and 60 percent of the prices prevailing in Kenya and Tanzania, respectively, when convirted at the parity exchange rate. -13- Xqble 5 MAANWI# ADMARC PRODUCER AND INPUT PRICES 1980181-88189 (6.6) (10.6) (9.2) (9.0) (8.1) (7.0) (6.1) (6.6) (7.2) Cotton Grade A 23.0 28.5 38.0 42.0 46.0 50.0 55.0 65.0 77.0 (23.0) (25.8) (31.6) (33.8) (30.4) (28.8) (27.6) (25.7) (23.2) Rice Grade 2 10.0 10.0 11.5 15.0 17.0 19.0 22.0 27.0 30.0 (10.0) (9.1) (9.6) (11.0) (11.2) (10.9) (11.0) (10.7) (9.0) Groundaute 33.0 37.0 55.0 60.0 70.0 75.0 75.0 75.0 82.0 (33.0) (33.5) (45.8) (44.1) (46.3) (43.2) (37.6) (29.7) (24.7) Tobacco IDDI 59.0 70.0 102.0 112.0 145.0 145.0 145.0 160.0 240.0 (59.0) (63.5) (84.9) (82.2) (95.9) (83.4) (72.7) (63.3) (72.2) Fertilier 20s20:0 8.5 8.5 12.6 14.5 17.0 20.5 21.0 27.0 30.0 ropi rIcestdiia5al" ana rartUiar Priee: vaeat.Tu ag. Producer prices deflated by the retail price index are given in parentheets (1980-100). Table 6s NALAIA3 ADIARC CROP PURCHASES ('000 Metric Tonnes) CRP 1980181 1981182 192183 1983184 1984L85 1985l86 1986L87 197188 1988L98 Maize 91.2 136.6 246.1 244.9 296.4 272.3 111.3 59.5 123.3 Tobacco 11.3 12.8 8.7 9.3 19.2 20.8 17.2 18.1 9.3 Groundnaute 31.5 19.5 10.6 10.2 9.7 18.3 53.1 44.8 15.3 Cotton 23.1 21.7 14.6 13.4 32.1 32.7 21.0 21.4 25.6 Rice 16.9 14.6 12.6 8.8 10.2 10.8 12.1 7.7 4.5 Total (excl. (maise) 82.8 68.6 46.6 41.7 72.0 82.6 103.3 92.0 64.9 Total (Incl. (Maize) 174.0 205.2 292.7 286.6 368.4 354.9 2.4.6 151.5 188.2 Sourcet Ministry of Agriculture and EPD. 4.04 Since then producer prices were set in accordance with the agreed methodology; in 1988/89 another increase of over 40 percent was announced for maize, much above the level that would have been established by the price setting methodology. As such an increase would have brought about a situation similar to that which prevailed earlier, the Bank was concerned that the program objective of crop diversification would be endangered, SAL III had been fully utilized by then but the Bank was able to exercise some leverage in the context of the preparation of a Policy Framework Paper (PFP), and contained the problem by persuading the Government to agree to review producer and input prices and adjust them, taking account of costs of production and marketing, border prices and level of domestic supplies. -14- Table 5 shows that the beneficial impact of pricing according to the agreed methodology on ADMARC purchases of maize was significant as early as 1981/82 while it took until 1984/85 and 1985/86 to make an impact in the case of other crops such as tobacco, cotton and groundnuts. 4.05 The review conducted before the release of the second tranche also established that while the commitment to remove the smallholder fertilizer subsidy by 1989/90 remained, the prices proposed by the Government contained a higher subsidy element than agreed for 1986/87. The Government and the Bank then worked out a combination of prices for the different categories of fertilizers that enabled the subsidy to be reduced to 17 percent, but following another year of price increases, the fertilizer subsidy removal program was terminated before completion in 1988/89 as the required price increase was judged to be politically unacceptable. By this time, the application of conditionality with respect to the fertilizer subsidy had devolved to USAID, which commissioned a study of its effects, in 1987. Since that time the Government has agreed to maintain the level of the subsidy at a percentage of total government expenditure negotiated in the context of the PFP. A review of fertilizer requirements, marketing, prices and credit was to be conducted in the context of the ASAC which will include reforms in distribution to limit the leakage of subsidized fertilizer to the estate sector. 4.06 Efforts to improve the productivity of the estate sector commenced with SAL I and a program which was drawn up under SAL II was protracted in its implementation because of administrative difficulties. Studies identified a number of crops for diversification but their realization tentatively was predicated on the establishment of research and extension, training, and credit facilities. The third SAL required the preparation of a program for extension and management training and the establishment of a pilot scheme for extending medium and long-term credit to the estate sector following the failure of the feasibility report to demonstrate the viability of an estate sector credit project. The estate and management training program was prepared with the assistance of an ODA funded consultant and an extension service for the estate sector was to be established, initially funded from external sources and later to be self-supporting through estate contributions. The pilot credit scheme was financed by the Bank through the Industrial and Agricultural Credit Project and channelled through the two commercial banks and the Industrial Development Bank. Industry and Trade Policv 4.07 The Government satisfied one of the conditions for the release of the second tranche by deregulating the prices of the remaining commodities with the exception of petroleum, vehicle spares, sugar, low grade meat and fertilizers. However the full benefits of this policy were not realized due to the Government's inability to liberalize imports and encourage more local production, resulting in some of the deregulated prices increasing faster than the retail price index. The program of deregulation which began under SAL II was not compensated in any way by wage increases which were kept frozen during 1982/83 to 1985/86 due to agreements with the IfF. -15- 4.08 No action was taken by the Government during SAL III to revise the Industrial Development Act of 1964 which was necessary to increase competition in domestic manufacturing. Although the Government indicated that the new Act would be ready by the end of 1986, no action was taken until June, 1988 when it was made a condition for Board presentation of the ITPAC. The other commitment, to resist discouraging the import of goods which would compete with domestic manufactures, was inhibited by the prevailing shortage of foreign exchange. 4.09 Steps were taken to strengthen the Malawi Export Promotion Council and the Government decided that the coordination of all export promotion activities should be undertaken by the EPD. However the formulation of an export promotion strategy and the establishment of an export credit financing facility were delayed. The recruitment of consultants was also delayed and although the Bank was satisfied with the progress made on this conditionality for release of the second tranche after a three month delay, no significant action was taken on a package of export incentives until they were addressed in ITPAC. An export credit financing facility was set up in the Reserve Bank of Malawi in 1987. 4.10 The Government continued to honor the commitment to maintain an active exchange rate management policy, and the exchange rate was changed seven times during 1982-88. During the period 1980-88, the nominal exchange rate declined by 68 percent and the real effective exchange rate by 13 percent. While this depreciation contributed to restraining demand, the supply response of exports, particularly of non-traditional commodities was disappointing. On the other hand, the deteriorating foreign exchange situation in 1986 and the build up of import payment arrears resulted in an intensification of exchange and import controls. These controls caused new distortions and threatened to undermine the benefits achieved by trade liberalization and price deregulation. With the improvement in the foreign exchange situation in 1988 a phased liberalization of imports commenced in the context of ITPAC. Fiscal Policy 4.11 A comprehensive study of the tax system was begun in 1985 under a Project Preparation Facility which was set off against the technical assistance component of SAL III. The study made proposals to, (a) shift the burden of indirect taxation from inputs to final consumption, (b) improve the duty drawback system for exports, (c) improve the coverage of personal income tax and reduce existing inequities, and (d) change the corporate income tax structure to reduce its differential impact on investment in different sectors. 4.12 The Government accepted the main thrust of the recommendations and a strategy was mapped out for its imp1ementation, which also included changes in tax administration. Some of the recommendations were included in revenue measures for the 1986/87 budget. The fiscal targets were monitored under the EFF program and the 1987 shadow program with the IMF. Parastatal Reforms 4.13 The Government created the Department of Statutory Bodies (DSB) in the Office of the President in 1981 to monitor the performance of parastatals and assist them in policy analysis and planning, and financial and personnel management. Its limited capacity for technical analysis meant that the DSB devoted ruch of its time to staffing and administrative matters rather than to corporate planning issues. The Government remains committed to strengthening the institutional capability of DSB and it is expected that criteria for reviewing investment plans and monitoring performance will be formulated, to permit commercially oriented parastatals to function with increasing autonomy on the basis of agreed corporate plans. 4.14 Following a comprehensive review by the World Bank in 1986, the Government began a program of reorganizing parastatals in 1987/88. The institutional support for this continuing program is, however, dependent on the strengthening of DSB. Nevertheless, the twelve commercially oriented parastatals had a consolidated profit of K 5.5 million and 18.2 million in 1987/88 and 1988/89 respectively. Skepticism was expressed that these improvements were the result of tariff increases and not of major restructuring. A few parastatals still continue in deficit and these accounted for 4.2 and 2.0 percent of the fiscal deficit in PY87/88 and FY88/89, respectively. 4.15 The restructuring of the Malavi Development Corporation (MDC) and Press Holdings were major achievements under SAL I and II, with preparatory studies undertaken during the first and implemented during the second. Although Press is legally a private company, its importance to the economy and close linkages to the Government, commercial banks and the main parastatals made it necessary for government intervention in its restructuring as in the case of parastatals. The restructuring involved changes in its board and management, a rationalization of assets by sale and swapping with MDC and ADMARC in activities related to the primary functions of these parastatals, the takeover of the Press debt to commercial banks by Government in return for long-term bonds, and a streamlining of its diverse production, financial and commercial activities. These actions were all completed by 1984 and Press Holdings has continued to make progress operationally and financially and begun to make its debt repayments to the government. However, the future operations of Press need to be closely monitored to ensure that it does not expand in a manner similar to that which led to financial difficulties in the past. 4.16 The rationalization of the assets of MDC took the form of swaps with ADMARC and Press rather than sale due to the paucity of private buyers. The exchanges were based on a separation of functions, with ADMARC concentrating on agricultural and agro- industrial activities, Press Holdings -17- on commercial and manufacturing activities, and MDC on its development banking functions. Apart from the rationalization of its assets, MDC introduced an overall budgeting and monitoring system for its numerous companies and made improvements in its structure, policies and procedures. Following these improvements MDC made profits in 1984 and 1985 after a series of annual losses dating back to 1977. 4.17 The reform of ADMARC has been a major objective of the structural adjustment program. A comprehensive study was conducted of ADMARC and its operations under. SAL I. Steps were taken to implement some of these recommendations under SAL II and ADMARC' s management and financial operations vere strengthened. Action was initiated to sell investments which were not related to agricultural marketing and processing. Initially, sale to private buyers was not possible. Instead, assets were swapped with MDC and Press Holdings. 'While the process of asset rationalization continued under SAL III by the identification initially of six investments for disposal, thereby meeting another conditionality laid down for the release of the second tranche, ADMARC's financial position deteriorated and large losses were incurred in both 1985/86 and 1986/87. There were a number of reasons for these losses. Although ADMARC was a commercially oriented parastatal, it was carrying out non-commercial functions such as the management of the Strategic Grain Reserve (SGR) and construction of silos for its storage. The adjustment of smallholder producer prices to near export parity had eliminated the surpluses enjoyed by ADMARC in earlier years and the implicit tax it was charging smallholders. Further, the control of consumer prices of products such as maize led to losses from crop purchases and conflicted with the objective of making ADMARC a fully commercial parastatal. Thus a Credit geared specifically to tackling the structural reforms necessary in ADMARC was approved as a Supplement to SAL III. 4.18 The dominant position of ADMARC in the marketing of smallholder agricultural produce was reduced, except in tobacco and cotton, and the participation of the private sector was encouraged. A differential crop pricing system between ADMARC depots and primary buying points was introduced as an inducement to the private sector and the Government agreed to set the consumer price <f maize at cost recovery levels. Under this program some 190 out of 1419 ADARC markets were closed and a further 148 were operated on a reduced scale. It was intended that ADMARC's role would become one of market stabilization in the long-term, defending a band of producer and consumer prices. The privatization of agricultural marketing was a contentious issue in Malawi and met with disapproval in some parts of the Government. The Project Completion Report (PCR) on SAL III and the Supplement suggests that the Government's willingness to accept this conditionality was motivated more by a desire to obtain additional funding than by conviction on the desirability of the policy. There was distrust of the private sector and the Government imposed a complex set of regulations on those wishing to trade in agricultural commodities. Nevertheless, it appears that the response of the private sector was impressive, despite being faced with shortages of transport and credit. The timing of the new policy proved to be unfortunate. The droughts in 1986 and 1987 and the high levels of purchases by relief agencies led to the depletion of ADMARC stocks and a shortage in the domestic market. ADMARC was unable to fulfill its intended stabilization role and -18- maize prices more than doubled within a year in the open market, affecting the smallholder sector adversely. Attempts were made to attribute these price increases to the private sector but it appears that they were caused by an imbalance of supply and demand. Given the shortage in grain, private traders moved out into remote areas to collect supplies thereby disproving the argument put forward by the authorities that the private sector had no interest in serving these areas. 4.19 Apart from the staffing and cost reductions achieved by opening up agricultural marketing to the private sector, further action was taken to improve the financial position of ADMARC by buying the silos, paying for the SGR and waiving their contribution to the Fertilizer Fund. It was also agreed that the Government would pay an annual fee for the management of the reserve. These actions improved ADNARC's profitability in 1987/88 and 1988/89. In the meanwhile, ADMARC's divestiture program of non-marketing assets to the private sector is continuing though there have been difficulties in raising the capital necessary for the purchases. Another policy that has yet to be implemented is the delineation of development functions that ADMARC will undertake for which the Government will make payment from annual budgetary appropriations. Institutional Development and Improvements 4.20 The preparation of the PSIP and Revenue and Expenditure forecasts for the period 1986/87-1988/89, which were conditions for the release of the second tranche, were not completed at the time of the mission which reviewed performance of the conditionalities. Similarly, the external borrowing strategy had not been prepared and the lack of performance on these conditions contributed to the delay in the release of the second tranche. These deficiencies were a reflection of the inadequate economic planning and management capability in the Treasury and EPD. On the other hand, good progress was made in reclassifying recurrent and development expenditures, with the assistance of external advisers, and presented for the first time as supplements to the 1986/87 budget. 4.21 The Government merged the Economic Planning and Development Divisions of the OPC with a view to strengthening their policy formulation capability. However, several senior positions still remain vacant both in the Treasury and the EPD. Following the consideration of the report of the Civil Service Review Commission, the Government decided to establish the Malawi Institute of Management (KIM) with a mandate to train senior staff in the public and private sectors in management techniques. The Bank decided that financing the Malawi Institute of Management (MIM) was the best approach to improving the Government's economic planning and management capability and accordingly funded an Institutional Development Project in 1989 with a Credit of US$11.3 million. The project also provides for strengthening the capability of the Treasury to undertake forward budgeting, effective debt management and improve government accounting and auditing. It should also benefit senior staff of the DSB. -19- 4.22 The capability of the administration to deal with economic policy issues improved as the SALs progressed. The consultations on policy issues amongst the permanent secretaries of the economic ministries improved and the preparation of the new Statement of Development Policies involved greater consultation and coordination than any earlier document or policy. Nevertheless, the limited capability for economic planning and management remains. There is an inability to retain professionals in the public sector, the employment of expatriates of whom there are a large number, can often be counterproductive. The lack of protection afforded to technocrats in the civil service who attempt to function objectively, has caused many senior, eyperienced civil servants to leave the public service prematurely. 4.23 The Bank could have made a substantial contribution to improving institutional capability earlier in the structural adjustment program. The instruments for enhancing economic planning and management through the preparation of PSIPs, revenue and expenditure forecasts, program budgeting and external borrowing strategies were set down as requirements without providing for the requisite institutional development that could have brought these about on a more sustainable basis. Disbursement, Procurement and Use of Counterpart Funds 4.24 SAL III. The original SAL III Credit was disbursed in two tranches. After the Credit was declared effective on December 21, 1985, US$40 million was made available. The remaining US$30 million was available for disbursement on October 22, 1986, after it was agreed that tranche release conditions had been fulfilled. The slight delay in fulfilling the tranche release conditions was largely due to administrative problems rather than policy concerns. The Credit closed on September 30, 1988. the final withdrawal authorization was dated October 26, 1988, and an undisbursed balance of US$66 thousand was cancelled as of July 18, 1989. 4.25 SAL III Supplemental. The Supplemental Credit for US$10 million was declared effective on April 29, 1987. The final withdrawal authorization was dated July 6, 1988, and the account was fully disbursed. 4.26 Both operations reimbursed the foreign exchange costs -f eligible imports on the basis of evidence provided by the Reserve Bank. The Reserve Bank was responsible for the necessary documentation, the preparation and submission of withdrawals applications and the maintenance of necessary accounts for the Credit fund. The Foreign Exchange Control Department of the Reserve Bank was responsible for administering and processing foreign exchange applications for imports to be financed out of the loan. Public and private importers alike had adequate assistance in preparing tender documents from this department, which maintained adequate staffing and functioned efficiently throughout the life of the program. Both programs experienced smooth disbursements. 4.27 Use of SAL Counterpart Funds. The Malawian Kwacha equivalent generated by the foreign currency withdrawal from the loan account was credited to a special account in the Reserve Bank of Malawi and used for development purposes in the Central Government Budget. These counterpart -20- funds were used to finance essential recurrent and capital expenditures consistent with sectoral allocations agreed with the Bank and IDA. The provision of these counterpart funds has contributed to overcoming the difficulties with obtaining adequate recurrent budget allocations for Bank and other donor funded projects. 4.28 Procurement. Bank member countries, Switzerland and Taiwan were eligible sources of procurement of imports. The legal agreements provide for procurement through normal commercial channels for private sector imports and Malawi Government practices for Government contracts, except in the case of contracts costing over US$2 million. All purchases under contracts amounting to more than US$2 million were to be procured through international competitive bidding. Certain commonly traded commodities were to be purchased at prices quoted in organized international markets. In general, no particular problems were experienced with procurement. V. IMPACT OF THE STRUCTURAL ADJUSTMENT PROGRAM 5.01 It is not possible to fully evaluate the impact of the structural adjustment program separately from the stabilization program of the Fund and changes in the external environment. However, performance indicators derived after several years of lending for stabilization and adjustment are set out in Table 7. The period 1982-88 has been grouped into three episodes; 1982-85 being the period when recovery began, ollowed by the downturn in 1986-87 and the revival thereafter. A compariso is made with the average performance during 1979-81, 1981 being the year in which structural adjustment lending began. -21- Tabi 7t LMIs RET H&CROECORMHIC IMDIC&TORS Annual Averagee (Percent) 1979-81 1982-85 1986-87 1988 A. CROM (1) Growth in GDPja at factor cost -0.8 +4.0 +2.0 +3.6 (ii) Growth in exportaL -2.5 +4.2 +3.8 -13.0 (11) Growth In gross demeeic investmeat) *19.0@ +2.4 -14.8 +30.8 (IV) Exiports/GDP 23.2 24.0 23.4 2. (v) Gross domestic avestmentIGDP 21.1Lk 18.9 12.6 16.1 B. ECTERKAL BALANCE (a) current account balance/GDP -20.4 -9.1 -5.9 -8.7 (ii) Real effective exchange rate (1980*100) 99.3 8.5 81.7 62.3 C. ElTE8NAL DEBT (1) Debt servicelexports 27.9 31.0 45.3 44.8 (1t) Debt utn exporce 258.4 310.3 429.5 406. (i) Debt outstandin GDP 65.8 77.5 102.6 116.1 D. INTERNAL bARANCE (i) Fiscal deficit/GDP -13.1 -9.8 -10.2 -6.2 (ii) Revenue/GDP 20.5 20.7 21.9 20.6 (iii) Expenditure/DP 33o6 30.5 32.1 26.8 (iv) Recurrent exptotal58.k 68.5 72.6 72.7 expenditure5806.5 76 (v) Parastatal def le Ifiocal detcit -3.01 -13.5 -5.8 -2.0 (vi) Growth in retail price index 15.2 14.4 22.8 31.4 a At constant prices. Average for 1980-81. * Total of deficits in the 12 commercial parastatals. Sources: Economic Report 1989,. KPD; Financial and Economic Revimw, Vol. XX* No. 4, 1988, RIM; An Economic Overview of Nalami, ast 1989, B.P?. Kandoole, draft m1meoi Nalawi P1?P 1989190-1991192; micelanecus World Bank statistics. 5.02 Growth in gross domestic product averaged 4.0 percent in the period 1982-85 compared to an average decline of 0.8 percent during 1979-81. It slowed down to an average of 2.0 percent in 1986-87 due to the restraints on imports in these years, followed by an increase of 3.6 percent in 1988. The growth rate declined during 1986-87 mainly due to exogenous factors. This was unfortunate because the beneficial effect of the reforms introduced under SALs I and II observed in the, earlier period could not be sustained. Further, there was no significant change in the sectoral shares in GDP with agriculture accounting for around 37 percent, of which the smallholder sector was 29 percent, and the manufacturing sector remaining at around 12 percent. 5.03 The performance of exports has been irregular. There vas no significant, change in structure and, despite declines in some years, overall they increased marginally by an annual average of 1.3 percent during the period 1982-88. This increase was mainly due to the exceptional export -22- performance in years when world market conditions resulted in a sharp increase in tea and tobacco prices and drought conditions in neighboring countries offered an unprecedented opportunity for maize exports. 5.04 The burden of adjustment fell heavily on domestic investment which declined sharply after adjustment lending began. The better growth performance during this period therefore reflects higher utilization of capacity and improved efficiency of new investments, but it is unlikely that the latter could be the case to any significant extent so soon after the introduction of reforms. Lower domestic investment in relation to GDP could have adverse consequences for growth in the long term. External Balance 5.05 Malawi achieved a surplus on merchandise trade since 1981, brought about mainly by a contraction in imports and intermittent improvements in export prices of tea, tobacco and sugar. Nevertheless, the service account has been substantially in deficit in the eighties due to the increase in transport costs of both exports and imports and high interest payments. The current account deficit improved significantly in 1984 due to a record level of export earnings including an unprecedented level of maize exports. Unfortunately this improvement could not be sustained in 1985 due to the sharp decline in the terms of trade caused mainly by a drop in tobacco prices. The situation worsened further in 1986 although the current account to GDP ratio improved temporarily due to stricter control on imports. Import payment arrears also accumulated and had reached US$50 million by the end of 1986, equivalent to one-third of the level of imports for that year. 5.06 The ratio of the current account deficit to GDP improved once again in 1987 accomplished by severe restriction of imports. This contraction in imports in the two years had the effect of reducing growth to 1.4 percent in 1987 compared to 2.6 percent in 1986, both rates being lower than the average for 1982-85. However the arrears on import payments were halved by the end of 1987 and eliminated by early 1988. 5.07 The balance of payments enjoyed a healthy overall surplus of the order of US$100 million in 1988, although the current account deficit increased. This was caused by a 28 percent increase in import volume which enabled economic growth to recover to 3.6 percent after the low growth rates in 1986 and 1987. The real effective exchange rate declined by 13 percent during the eighties though most of it took place during 1986-88, but failed to have any impact on the structure of exports or to assist in diversification. External Debt 5.08 Debt indicators in the 1980s reflected the impact of earlier borrowings, the debt service ratio rose from 23.1 percent in 1980 to 53.8 percent in 1986 and declined to 44.8 percent in 1988. Similarly, the ratio of debt outstanding to exports peaked at 454 percent in 1987 compared to 261 percent in 1980, and then declined to 406 percent in 1988. The debt outstanding to GDP ratio increased consistently throughout the 1980s from -23- 65.7 to 116.1 percent in 1988. Consequently, debt service payments placed considerable pressure on Malawi's balance of payments. The attempts made under the SALs to establish a debt management capability in the Treasury and to draw up an external borrowing strategy and plan for Malawi did not have an impact on the external debt situation due to the overwhelming impact of adverse external factors. 5.09 Faced with a debt service ratio in excess of 30 percent in 1981, Malawi sought and obtained a rescheduling of official debt from the Paris Club in September 1982 followed by a rescheduling of commercial debt in March 1983. These agreements were concluded in the context of a Standby Agreement with the Fund in August 1982. A second rescheduling was obtained from the Paris Club creditors in October 1983 following approval of the EFF in September 1983. No further reschedulings were sought until August 1987 when Malawi suspended principal payments on all medium-term loans when faced with an even higher debt service ratio than the peak of 1986. Agreements were reached with both official and commercial creditors in April, 1988 following the Standby Agreement concluded with the Fund in February. The debt relief obtained annually in the 1980s as a result of these reschedulings are given in Table 3. Internal Balance 5.10 The fiscal deficit of the Government increased in the early eighties to 16 percent of GDP due to a rapid escalation in government recurrent expenditures, of which public debt interest was a major item. The financial problems of parastatals also contributed to the increase in the deficit. Following the introduction of stabilization and adjustment measures, the fiscal situation improved and the deficit as a ratio of GDP declined during 1982-85. The revenue expectations during the early SALs were not realized and increases in revenue contributed only marginally. It was the reduction in expenditures, mainly those earmarked for development purposes, that had the major impact. There is now a better control of capital expenditures and public sectnr investment programming improved during the SALS. 5.11 The deficit increased once again in 1986 and 1987 though not to the levels that prevailed in the early eighties, due to an increase in expenditure, particularly on defence, and lower revenues from import duties and company taxes resulting from reduced levels of economic activity caused by the decline in growth rates. 5.12 The deficits of parastatals which required transfers from the budget were higher in the period 1982-87 than earlier. However, there has been an improvement in these deficits in 1988 which could be sustained following the financial and management improvements that have taken place under the SALs. 5.13 The high level of deficits in the 1980s resulted in a significant expansion of credit from the banking sector to the Government and parastatals, which led to a crowding out of the private sector. The situation improved significantly in 1988. Hov4ver, a major problem of internal balance was the annual inflation rate of 13 percent which prevailed -24- for much of the 1980s, escalating significantly in 1987 and 1988 and increasing by 31.4 percent in 1988. This inflationary pressure has been caused largely by the rapid expansion in money supply of around 25 percent annually during the eighties and the depreciation of the nominal exchange rate by 68 percent between 1980 and 1988. Social Imact 5.14 Data on the impact of adjustment on poverty and income distribution are not available, but scattered evidence indicates that adjustment has had social costs. It is only now that surveys are being conducted by the Center for Social Research of the University of Malawi to collect data from households in urban areas to compare with base data collected for 1980. Preliminary conclusions indicate a more than doubling of the share of income spent on food. The political system in Malawi does not permit social tensions to manifest itself in popular discontent, but its absence should not be taken as evidence of satisfaction with the current state of affairs. 5115 SALs I and II are typical of SALs in the first half of the eighties which paid little attention to the social dimensions of adjustment. There was no consideration of the effect of policy changes on income distribution and employment. No attempt was made to identify those most seriously affected with a view to providing special assistance. In Malawi, they would have been among the not food purchasers in rural areas, urban income earners who were significantly affected by the freeze on public sector wages during 1982/83 - 1985/86, and those who lost employment as a result of the restructuring of parastatals and Press Holdings in particular. The President's Report for SAL III dealt only superficially with the issue of social impact and no specific measures were proposed to identify and monitor the impact on the most disadvantaged groups. It seems to have been accepted that long-term benefits would accrue to all segments of the population by the restoration of economic equilibrium and the resumption of growth. The absence of any serious consideration of the social impact must be regarded as a fault in the design of the SAL series. 5.16 The only available social indicators are shown in Table 8. The increase in retail prices has already been commented on. The share of recurrent expenditure allocated to health and education have declined 1-2 percentage points while the allocations to these sectors from the development budget have increased as a share of the total. What these changes mean in terms of services to the people are not known. -25- Tab.e 8: MAIAVI: SOCIAL INDICATORS A. 1272-81 1982-85 1986-87 ]$g () Retail price index (% change) 15.2 14.4 22.8 31.4 (i) Percent of recurrent expenditure allocated to health 8.1 7.8 7.5 6.8 (iii) Percent of r'ecurrent expenditure allocated to education 11.8 11.6 11.2 11.1 (iv) Percent of development expendi- ture allocated to health 1.3 4.0 3.7 8.7 (v) Percent of development expendi- ture allocated to education 9.6 13.6 8.5 8.7 Most Recent B. 1. 2Estimate* (i) Life expectancy at birth (yrs) 39 42 45 (ii) Infant mortality rate (per thousand) 199 184 156 (iii) Student enrollment rates (a) Primary 44 56 63 (b) Secondary 2 4 5 (iv) Per capita supply of (a) Calories per day 2,132 2,469 2,415 (b) Grams of protein per day 63 73 67 * Most recent estimate between 1980 and 1986. Sources: Economic Report 1989, EPD, Malavi. President's Report on ITPAC, World Bank, May 1988. VI. SUSTMANAELITY 6.01 In general terms, sustainability of adjustment programs would require adequate investment levels to ensure per capita growth, a level of income that could be sustained and its equitable distribution to curtail social unrest, stable internal and external balance, and a manageable external debt. In addition, the political commitment to reforms must continue and the institutional capability to carry them out within a realistic time frame strengthened. Economic Growth 6.02 The economic indicators demonstrate that although GDP growth recovered, investment levels declined and were inadequate to support sustained growth nless there was a substantial impiovement in the efficiency -26- of new investments. Internal balance was improved in the 1980s by curtailing expenditures, mainly those earmarked for development purposes. It is unlikely that revenue increases will make a significant contribution to achie-ing fiscal balance until tax reforms are completed and sustained economic growth is*p796Xresum&e latest PFP does not expect this to happen in the case of revenue. The high inflation rate has added to the difficulties of restoring internal financial balance.' The current account deficit has been reduced in comparison to the early 1980s, primarily by reducing imports. As a response to rising debt service resulting from earlier borrowings, Malawi virtually halted all borrowings on commercial terms. Per capita GDP at current market prices has increased only marginally to US$183 in 1988 compared to US$176 in 1979. In sum, the economic basis for sustainability is at best, very fragile. Simultaneously, action is needed to arrest the slow deterioration in the quality of life (Table 8). Commitmet to Policy Reforms 6.03 In most countries, extensive reforms of the type introduced in Malawi would have required a determined effort on the part of government officials and Bank staff to achieve a political consensus and commitmenc to reforms. Such a consensus is not required in Malawi because decision making is a highly centralized activity in which the Life President plays a predominant and in some instances an absolutely determinant role. This centralization, while permitting quick decision making has the disadvantage of dependence on one person's perception and understanding of a problem and the quality of the advice received, which in some instances could be deliberately distorted, and in others, late. 6.04 Frequent rotation of senior administrative staff could also result in a loss of institutional memory and erode the analytical capability built up; by frequent negotiations with aid agencies. It could also lessen the willingness to critically evaluate policy choices. There is no doubt that the extensive program of reforms introduced in Malawi would not have been possible without the total commitment of the Life President. However, this commitment sometimes put pressure on senior officials to agree to conditionalities with which they did not necessarily agree. 6.05 The economic management team, with which the Bar.- staff dealt with during the preparation and negotiation of SALS, were drawn from the Treasury, The Reserve Bank of Malawi, the EPD and OPC, but the reforms involved key sectoral Ministries and parastatals as well. 'hese agencies had to be convinced of the benefits of reform since they were primarily responsible for implementation. In some cases, the economic management team had difficulty in convincing these agencies and had to use institutional coercion on some occasions to ensure implementation. Another consideration is that these agencies lacked the analytical skills to assess the implications of the proposed reforms which led to a hardening of their attitudes. The lack of willingness or inability to actively involve key Ministries and parastatals in the negotiation of a broad based macroeconomic program has been a weakness in the policy formulation process, and may operate to the detriment of sustainability. -27- 6.06 There is no evidence that the political commitment to reforms has diminished. The commitment amongst senior officials at the center remains high, probably due to the realization that substantial external funding is necessary to support Malawi's adjustment efforts. Nevertheless, their confidence in the program will diminish if the supply responses to the new policies are slow in materializing and the ability of the economy to withstand external shocks is now no better after eight years of a structural adjustment program. This enjoins the Bank to undertake a carefully structured economic and sector work program with sound operational content. This needs to be reinforced by a cluster of supporting projects. Institutional Canability 6.07 Several policy instruments were devised during the SALs to improve economic management and policy formulation capability in the Treasury, the EPD and the DSB. Most important amongst these have been the preparation of three year PSIPs, three year revenue and expenditure forecasts, the introduction of programme budgeting, the preparation of an external borrowing strategy and plan, the preparation of medium-term corporate plans for each parastatal, improvements in project analysis and the overall strengthening of the annual budgeting process in the context of the medium term programs and plans. Their sustainability depends on trained and experienced staff being appointed to the Treasury, the EPD and the DSB to carry out these functions. VII. MAJOR POLICY AND IMPLEMENTATION ISSUES 7.01 Major implementation and policy issues relate mainly to producer pricing and related strategies for improving the productivity of smallholders; reduction of the fertilizer subsidy; participation of the private sector in agricultural marketing and related activities; and the deregulation of consumer prices. Producer Pricing and Other Agricultural Policies 7.02 Price incentives for the smallholder sector were devised on the basis of a methodology developed through consultation with the Government. For many years ADNARC had passed on to the smallholders only a small proportion of the export prices realized for each crop, placing them at a disadvantage vis-a-vis the estate sector which could sell its crop in an unregulated market at prices equivalent to or near export parity. In addition, estates and small holders were required by law to grow different crops. The pricing methodology sdopted under the program was designed to correct this asymmetry and with improvements over time, it gained acceptance in official circles. The technical work to determine prices was done by ADMARC and the Ministry of Agriculture and recommendations were made to an inter-ministerial committee, with the final decision taken by the Life President. -28- 7.03 A conflict arose between pricing policies required to achieve food self sufficiency and export crop promotion, with the Government more concerned with food security and the Bank wishing to encourage exportable surpluses of cash crops. The application of the price setting methodology ran into difficulties under the first SAL due to these conflicting objectives. The producer price for maize was raised by 66 percent in 1981/82 following an increase of 32 percent two years earlier. This change in price relativities led to a reduction in the production of cash crops for export and the accumulation of a maize surplus. This proved fortunate for Malawi because it was able to export large quantities of maize to its neighbors in 1984 due to drought conditions in these countries, thereby reducing its current account deficit substantially. 7.04 The prices of export crops were increased substantially after 1982/83 while the price of maize was unchanged for four crop years from 1983/84. This adjustment had the desired effect on the surpluses of export crops which recovered by 1985/86. Only rice sales declined during this period due to the removal of the high subsidy that had existed during the 1970s. However, the performance of exports of smallholder crops was erratic from year to year; the increases achieved were from a small base and made no significant contribution to a change in the structure of exports. The fragility of the improvements achieved was well demonstrated by the events of 1986/87. The influx of 700,000 Mozambican refugees increased the demand for food. Yet the drought in the southern half of the country had reduced ADMARC purchases to their lowest level since 1980/81. Another factor that contributed to lower output response was the decline in the relative price of maize, which reduced the area planted with maize, an effect which was reinforced by the sharp increase in fertilizer prices as a result of the fertilizer subsidy removal program. These increases inhibited the adoption of fertilizer responsive high yielding varieties of maize. 7.05 These factors caused a sharp rundown of maize stocks by over 200,000 tons in 1986, leading to imports of 140,000 tons in 1987. Further, ADMARC's financial problems in 1985/86 and 1986/87 led to a fall in confidence on the part of smallholders in its ability to purchase the surpluses and market them. Thus ADMARC did not have the stock reserve to defend a ceiling consumer price for maize or the financial resources to function as a buyer of the last resort in surplus years and hence perform a market stabilization role. 7.06 Although the income of smallholders producing cash crops increased in the 1980s, much of the income gains were eroded by the increase in consumer prices. Insufficient attention was given to the question of improving the proeactivity of subsistence farmers and a consequential adverse impact on nutrie. n. These farmers derived no direct benefit from higher prices for maize but faced higher costs for agricultural inputs. Inadequate credit facilities exacerbated the adverse impact of the subsidy removal programs. High loan repayments in the immediate post harvest period, made worse by higher agricultural input prices, resulted in many smallholders overselling their maize at low prices immediately after the harvest, yet buying maize back later in the season at higher prices to meet consumption needs. -29- Table 9: SNALLHOLDER MAIZE PRODUCTION AND SALES TO ADMARC (000 metric tonnes) Smallholder Marketing ADMARC Purchases/ 9=o Year Production Year Purchases Productio (%) 1979/80 1198 1980/81 92 7.7 1980/81 1237 1981/82 137 11.0 1981/82 1244 1982/83 246 19.8 1982/83 1369 1983/84 297 17.9 1983/84 1398 1984/85 297 21.2 1984/85 1355 1985/86 272 20.0 1985/86 1295 1986/87 111 8.6 1986/87 1211 1987/88 113 9.3 Sources: Ministry of Agriculture and ADMARC. 7.07 The removal of the fertilizer subsidy and the adoption of high yielding varieties required corresponding strengthening of access to credit; it also required research into the factors motivating the use of high yielding varieties by small farmers. However, the provision of credit and extension services, as stated in the PPAR for SALs I and II, was "too diffuse a program covering at the time only a small percentage of smallholders'. Land reform issues were also neglected; a serious omission in a country facing an acute shortage of cultivable land. The liberalization of the market for food crops was not introduced until some time after parity pricing of exportable crops, adding to the financial burden on ADMARC, a burden which also had an adverse impact on smallholder production because of the de facto monopoly enjoyed by ADMARC in purchasing smallholder crops and providing agricultural inputs. They also contributed to the shortage of maize that occurred in the country in 1986 and 1987. A larger role should have been p vided for extension and credit, particularly for the supply of inputs necessary for the promotion of high yielding varieties. The Fertilizer .SubsidX 7.08 The attempt to remove the. fertilizer subsidy of twenty five percent within three years began with SAL II and had a checkered history. It involved the Bank, the Fund and USAID on the donor side and the Treasury and Ministry of Agriculture on the Malawi side, Tension existed between the two Malawi agencies in the implementation of this policy. The continuing depreciation of the Kwacha and the closure of the Mozambican routes to the sea increased the local costs of fertilizers significantly, and hence the subsidy. The Government refused to reduce the subsidy beyond the level which would have been necessary, had the Mozambican routes been open. Thus, implementation of this policy remained incomplete at the end of SAL II. The pekiod for its removal was extended for a further four years up to 1989/90 under the provisions of SAL III, but this measure was also abandoned in -30- September, 1988. By this time, the application of conditionality with respect to the fertilizer subsidy had devolved to U.S. Aid, which commissioned a study of its effects, in 1987. It was realized that, even at subsidized prices, smallholder fertilizer use was far less than optimal despite an overall increase in fertilizer use. A continuation of the subsidy removal program as proposed would have had adverse long-term implications for the productivity of the smallholder sector. In the PFP for 1989/90 the Government agreed to maintain the subsidy at a level not greater than one percent of total government expenditure. 7.09 The price paid by smallholders for fertilizers virtually doubled between crop years 1981/82 and 1984/85 and increased by a further 57% in 1987/88. The ratio of fertilizer to maize prices also increased by one-third between 1980/81 and 1986/87 and even after the price increase in maize the following year, the increase in the ratio remained as high as 26 percent. Thus the profitability of maize (excluding local maize which does not require fertilizer) dechaed in absolute terms between 1980/81 and 1986/87.' 7.10 The termination of the subsidy removal program was precipitated by a crisis caused by the sharp decline in grain output and of ADMARC purchases in 1986/87 and after. There was no consensus on the issue either on the Malawian side or amongst donors. It was unfortunate that the subsidy removal was originally conceived of as a budgetary measure; it constituted 6 percent of the budget deficit in 1984/85. A full-scale analysis of the impact of phasing out the subsidy on fertilizer use, the adoption rates of high yielding varieties of maize and on maize production in general should have been conducted at the outset. Such a review will now be undertaken under the terms of the Agricultural Sector Adjustment Credit (ASAC). Participation of the Private Sector in Agricultural Marketing 7.11 Private sector participation in agricultural marketing has been a controversial issue in Malawi. Acceptance by the Government of this requirement as a condition for the Supplementary loan to SAL III was less the than complete. The Government felt that closing down some ADMARC purchasing centers and scaling down the operations of others would seriously setback smallholder production if the private sector could uot step in to provide the same services effectively. Hence, when agricultural marketing was opened up in 1987 to the private sector, a complex set of regulations was imposed on traders such as the minimum prices to be paid to farmers, restrictions on where trading could take place and detailed statistical reporting. Even so, there were concerns about issues such as grain handling capacity, availability of transportation and finance and the overall impact private trade would have on ADMARC and on agricultural development in general. These implications needed to be studied prior to the privatization of agricultural marketing; some of them were subsequently reviewed in the preparatory work It has been estimated that these ratios were higher than those prevailing in Kenya ard other comparable producing countries. -31- for the Agricultural Marketing and Estate Development Credit which was signed in 1989, this project provides for a pilot credit scheme for rural traders and T.A. for improving the regulatory environment for the private trade. 7.12 The timing of market liberalization was in one sense appropriate, since it provided an opportunity to test private sector response. The drought in 1986 and 1987 and the consequent decline in ADMARC purchases made it profitable for the private sector to engage in agricultural marketing. This negated the argument that the private sector would not be active in remote areas where supporting infrastructure was weak or because it did not have the capacity or the incentive to access these areas. In the environment of shortage, private traders were purchasing at prices, which in some instances were as high as 50 percent above the official producer price. Similarly, they were selling at prices well in excess of ADMARC's consumer prices. The depletion of ADMARC's stocks and its weak financial position meant that it was unable to play the market stabilization role that had been envisaged. The experience of these shortage years indicates that the private sector could indeed play and active role in marketing if opportunities for profit exist. It is important to ensure, however, that the level and extent of such participation is maintained in normal production years as well. It is, therefore, necessary to address constraints that exist in the fields of credit, storage, transportation and marketing. DereWlation of Prices 7.13 Although the Government agreed to review the price control system under SAL I, it did not begin the process of deregulation until SAL II primarily because this was a policy reform about which the Government was unenthusiastic. Nevertheless, deregulation was conducted in a phased manner with given numbers of products being decontrolled by particular dates and completed during the early period of SAL III, with the exception of petroleum, low grade meat, fertilizer, sugar and motor vehicle spares. The prices of these products were subject to periodic review and adjustment. 7.14 Successful deregulation of domestic prices in an environment of protection for manufacturing industry had to be predicated on enhanced competition from imports. However, such competition did not occur because recurring balance of payments pressures placed restraints on imports. Quantitative restrictions on imports were intensified in 1986, the first full year of the deregulated regime. Trade liberalization as a comprehensive reform was only introduced in 1988 in conjunction with the Industrial and Trade Policy Credit (ITPAC), after the SALs were disbursed. There was also a need to infuse competition into domestic manufacturing inter aLa by revising the Industrial Development Act, thereby reducing barriers to new entrants. The Government agreed to review the Act under SAL III, but no action was taken until June, 1988 when it was made a condition for Board presentation of ITPAC. The foreign exchange shortage during SAL III made the licensing of new entrants even more restrictive. 7.15 Deregulation led to sharp increases in the prices of items that were prominent in the retail price index and in the short term some rose faster than the index as a whole. However, it was not possible even -32- partially to compensate for these price increases by adjusting public sector wages. They remained frozen during 1982/83-1985/86 due to Agreements with the IMF; hence, the flexibility needed in wage policies to retain key personnel in Governmert, was circumscribed. This was a good example of the potential conflicts that arose in the application of Bank and Fund policies in the context of simultaneous stabilization and adjustment. Ownershin of the ProAram 7.16 The structural adjustment program is perceived in Malawi as a World Bank program which Malawi was forced to accept in order to relieve the acute economic crisis the country was facing in 1979-80. The Life President gave his overall blessing to the program when briefed on the economic situation and the need for external assistance. Malawi's input to program formulation nevertheless increased with each SAL, and the circle of senior officials at the center involved in the negotiations widened. By the time SAL II evolved, strong efforts were being made by the Principal Secretary of Finance to involve line ministries in discussions with Bank staff; this had not been the case in earlier SALs. A greater effort to involve the operating ministries and agencies early on in the adjustment program could have led to better acceptance of the reforms and certainly made the task of EPD and Treasurer easier. The trade off would have been delays in the commitment of loans but implementation would have been smoother, once started. The first attempt at formulating a longer term development strategy by Malavi in the 1980s was the publication in 1988 of the Statement of Development Policies: 1987-1996. Future policy reforms could be viewed as Malawian if placed in the context of these Statements or subsequent revisions to them. Timina of Policies 7.17 The Bank faces a dilemma when a country needs balance of payments support and adequate economic and sector work has not been undertaken to draw up a comprehensive program of reforms. If the Bank proceeds with such support, the result may be a structural adjustment program which is largely preparatory in nature. This was the case with SAL I, and much of the reform package had to be deferred to SALs II and III. The impact of SAL I, as a result, was significantly less than it could have been. Some delay and more preliminary work could have resulted in more immediately positive and productive an approach. It can, therefore, be argued that the first SAL was somewhat prematurely timed, even though the advantage to Malawi was immediate balance of payments support. It remains, however, the judgement of the Region that the Bank's knowledge of the economy and its outline program for adjustment were so advanced, that the benefits of delaying structural adjustment, until more detailed work could be undertaken, were outweighed by the costs of further deterioration in the economy. And this prognosis is probably correct. 7.18 To -sum .R, Malawi provides a good case study of a country that implemented a comprehensive stabilization and adjustment program against heavy odds, both domestic and external. These difficulties were etched against a backdrop of high debt service. On the positive side, however, the Bank was correct in its approach, to initially address the structural -33- deficiencies in key parastatals. It was also appropriate to focus on price 4-regulation and trade liberalization. These were necessary for sensitizing the economy to international competition and improving efficiency in resource allocation. In the same vein, the IMF interaction in support of stabilization was centripetal to the program of adjustment, even though in retrospect, there remained areas where Bank and Fund policy coordination could have been improved. The controversy surrounding the reduction of the fertilizer subsidy and its potentially adverse effects on smallholder productivity and real incomes of the poorest farmers (i.e., those who are net purchasers of food), remains a major dilemma. Problems of this kind are not unique to Malawi; yet, they underscore the importance of appropriate empirical research and the promotion of an active policy dialogue with all parties. The initiatives spelled out in the Bank's most recent Country Economic Memorandum, for a strategy of growth through poverty reduction, represents a refreshing approach, but given Malawi's serious resource shortage, judgment must remain open; optimism must be tempered with healthy skepticism. Approaches of this nature, if they are to succeed, as they indeed deserve to, have to be complemented by constructive debt management and positive resource transfer strategies. A realistic macroeconomic framework must, of course, form the bedrock of any strategy that seeks to achieve growth with equity. Lessons of Experience 7.19 A number of lessons, some of general application, may be distilled from the experience of Malawi in structural adjustment. * The sine qua non for all policy change is clear and uneauivocal golitical commitment, and the intensity and sequencing of the policy prescriptions must be geared to the borrower's capacity to absorb and deliver; sometimes it may be wise to settle for less within clearly established priorities. The Administration's protraction in fulfillment of conditionalities underscored the weak administrative and institutional base which constrained any program for major economic restructuring. * Policy prescriptions have to be anchored in thorough analytical and operationally-oriented country economic and sector work, that has been executed in advance. Malawi's experience in implementing price deregulation and reduction of fertilizer subsidies, as well as the record with respect to the social dimensions of adjustment show that the adjustment program could have had a potentially stronger impact if there was greater rigor in economic and sector analysis. The Bank' s economic and sector work intensified as the program progressed. * In depth analysis is needed to ascertain the political. social and economic impact of the standard structural adjustment policy prescription, given that countries are at different stages of financial and economic development and there may be unique features of a temporary or more long-lasting nature that require modification of a program. These principles could not always be observed in the case of Malawi. Examples are the failure to address the social -34- impacts of pricing policies for agricultural inputs, especially where poorer smallholders were net purchasers of food, selling when prices were low and buying back grain when prices were high. The most recent Country Economic Memorandum (March 1990) represents a good attempt inter A11a to address these issues in the context of a strategy for growth through poverty redressal. * Policy prescriptions that do not take account of all elements relevant to the achievement of a given obiective can have negative effects on program credibility. For example, the decision to deregulate consumer prices and reduce subsidies required complementary action on import liberalization. Failure to act on import liberalization perpetuated rent seeking in the commodity markets. These pitfalls could be avoided if an analytical framework is developed to check the consistency of the various elements of the policy prescriptions, both Bank and Fund, and identify potential difficulties. -35- Page 1 of 5 MMW Of POLICY REEOM SAL AL1 .18iL l A. Aariculture 1. Price incentives Annual review of Continue to apply Continue as in SAL II to serve seet holder prices agreed pricing the objectives of food self- by inter-ministerial methodology and sufficiency, crop diversiff committee in accordance discuss proposed cation and export promotion.* wi th methodology agreed crop prices with with Bank and Bank. Improve recoaendat ions methodology as submitted to Sank.* required. Increase in cotton - ** -- producer prices for 1981/82 growing season to a level acceptable to the Bank. Studies to be under- taken on the prospects and price incentives for livestock industry using TA I Loan and the find- ings to be reviewed by the Bank. 2. Estate Production Studies to be undertaken Following review A pitot scheme for providing on the prospects for by the 8ank of medim and longer term credit tobacco industry and the draft estate to be set up. An extension for future diversifi- agriculture pro- and management training pro- cation of estate gram with cor- gram to be prepared. production under rain- ponents for fed and irrfgated con- management train- ditions. Bank to fin- ing and credit, ance studies under the government to separate loans. revise and develop an estate credit project.* 3. Fertilizer Subsidies ** Subsidies to be The subsidy remaining due to phased out over higher transportation costs 3 years, with 601 to be removed by 1989/90. removed by 1984/85 The Dank to be consulted an and the belance in fertilizer prices in 1985/86. 1986/87 4. Fertilizer Supply ** To support the The availability of fertilizers Program fertilter supply to smaltholders to be closely program financed monitored. under an IDA/IFAD loan, ANmC under- took to appoint key personnel to vacant positions and dis- tribute supplies in a timely menner. -36- Page 2 of 5 SALI IU M I SAL I B. InMstry and Trade Poticy 1. Price liberalization Government to review A consultant to Program of price price control system prepare a program liberalization to be with a view to iaprov- for price completed.* Ing flexibility. liberalization. A sabstantial number of item to be decontrolled. 2. Energy Energy sector survey to The institutional- be dame by Bank to framework for energy review sector prospects, policy and management possible investments, to be Iqroved. TA and price policy. and training needs Goverraent to of the sector to be increase fuel wood defined and a time* prices in FY19W2/85. table established for the preparation of a MediUn-term investment program. 3. Agro*Industrial Development of ** -- Investment agro-Industries dependent on the institutional reform of MDC and Press (the best organizations to undertake such investments) and the adoption of appropriate price and incomes policy by the goveronent. 4. Industrial Policy ** ** Industrial Development Act to be amended to encourage competition and restrict pro- tectionist use of the industrial licensing system. The Iport of goods that coopete with domestic products not to be discouraged. S. Export Promotion ** ** Steps to be taken to strengthen the staffIn and orgeniation of Netad Export Promtion Council and to establish training capability. Export promotion policy and export financing facility to be finalized.* 6. Exchange Rate Subject to review As in I As in I & II by INF govermant committed to active exchange rate mnageament. -37- AmeL1 Page 3 of 5 SAL.11 SAL.I C. Fiml Poli 1. Goverment Revenue Committed to take lIprove buoyancy Adopt a strategy for restruc- new revenue measures of tax system turing the tax systen and in 1981/82, including under EFF and laplementing same of the 15% increase in all work out specific changes. specific excise and measures with import duties, the INF at budget introduction of a preparation time. 101 tax on hotel and License fees and restaurant services tariffs to be and an across the reviewed and appro- board increase in priate changes made. tariffs of 3%. Adjustment to be made to tax and non- Prepare detailed plan tax revenues to for Iptementing ensure that the economic rentals for ratio of revenue housing. to GDP does not decline below current ratio.* DeveLop a program to improve the efficiency of collection of fees and charges. Develop a program to address housing subsidies. 2. Recurrent Provide an additonal Ensure that the -- Expenditure K 2.4 an in 1981/82 recurrent budget to agriculture allocations to departments.* critical sectors Coomitment to provide such as agricultural for reat growth in services, and road recurrent expenditures maintenance and of key economic and education are social sectors in adequately 1981/82 to 1985/86 provided for.* development program. 3. Public Development program Sank to review As in II. Investment 1981/82-1985/86 to public allocate increasing investment prog- shares to agriculture, ram annually at water, education, the time of health and housing budget pre, white maintaining a paration. slightly tower share to transport and reducing the alt.- cation of government buildings to tess than one-third the level of recent years. -38- Page 4 of 5 SAL I S_AL II iAL I D. Parastatal Reforms 1. Tariff Changes Commitment to more Annual reviews of As in II. frequent tariff parastatal finen- increases in line cial accounts to be with cost escalation, made by the Depart- ment of Statutory Rate increase for Bodies (DSS) and Blantyre Vater Board where necessary to a level acceptable increases in tariffs to the Bank.* and user charges to be made. 2. Investment Program Prepare prograieplan Imptement recam * and Financial Plan with UNDP/UK assist- mendations on ance to make Afr operational and Natawt and Matawi financial Railways financiatty improvement. viable, 3. Management, Review of the Imptement recom- ADMARC to accelerate its Structure, and efficiency of mendations made rationalization efforts.* Finances AMARC's marketing to improve The Government to review its and storage financial and policies to retleve ADNARC operations.* operational of its financial burden. efficiency of The role of private traders ADMARC. in agriculture marketing to be expanded. The supplement conditionalities were (a) improving the efficiency of smat holder marketing by allowing private sector participation and (b) Improving ADNARC's operations and financial position. Undertake review of Implement recom- Continue to monitor MDC perfor- Malawi Develoanuent mendations of mance. MDC to be encouraged Corls (QC present operational and to invest in agro-industry. and projected financial financial improve- position and make ment of MDC. recommendations on the requirements of debt and equity f inance. Undertake' consultancy studies aimed at improv- ing MDC's management of Inventory and working capital, designing a forward budgeting system and formulating ong* term strategies. Comptete and review Implement restruc- Government to ensure that study underway to turing-of Press asset rationalization of develop a long-term and adhere to Press proceeds program of financial guidelines. satisfactorilty. restructuring of Press Hotdinas.* The legal arrange- An action plan to be ments for restruc- prepared by 0sB to etiminate turing to be parastatal deficits and to finatized *. improve their efficiency. Studies to be carried out bn the sate of assets. -39- AM I SLI SAL I IPage 5 of 5 E. institutional Devtoment and lMrovmments 1. Department of -- Following the Goverrent to improve Statutory Bodies clearer defini- the effectiveness of tion of the role mon:toring operations of DSB, action of parestatals. to be taken to fill vacancies and staff it adequately. 2. Debt Management Strengthen Government to Treasury to revise ex- Capability Goverrnent's capa- ensure that the ternal borrowing plan bility to record, system for debt in consultation with monitor and manage monitoring and EPO and RBN.* government and management Is goverrmoent* operational and a guaranteed debt. borrowing strategy Establish a target and plan to be range for the prepared.* public sector DSR in the future.* 3. Project and Request UNDP for TA to Strengthen staff Reorganize and strengthen Economic Analysis fund five experts for of EPO with skills policymaking staff of OPC Capability the Treasury, EPO and in project and the staff undertaking MAUR. (Two for the analysis and the economic analysis in Treasury to help with formulation of a the Treasury. the financial analysis mediu development of camef-*al activi- strategy. ties and iith public debt monitoring, one macroeconomic planner and one education planner for EPD and one agricultural planner for MANR). ICC to monitor all investments over ** -- K 0.5 Nn using standard economic and financial rates of return criteria.* Following review by ICC, all large projects ** will be subject to a detailed technical review by independent consultants. 4. Planning ** Three year pro- Projections to be updated to and jections of 1986/87-1988/89.(*) Programing revenue and expen- Activities diture repred for 19864/85-196/87. ** ** Program budgeting to be introduced. Public sector Public sector PSIP for the period 1986/87- investment program investment pro- 1988/89 to be prepared.(*) to be prepared for gram to be pre- 1982/83-1984/85. pared for 1984/85- 1986/87. * Conditionalities for the release of second tranche. Source: The President's Reports for SAL's 1, II, III. -40- Annex II TECHNICAL ASSISTANCE LAN AND CREDIT The consultancy services financed under the First Technical Assistance Loan produced the following: (a) a study on the development prospects and price incentives for the livestock industry; (b) three studies of the MDC on working capital, budget and management; accounting and operating strategy; and strengthening its export marketing capability; (c) studies on the restructuring and management reform of Press Holdings and ADMARC; and (d) computerization of the debt recording and monitoring system in the Ministry of Finance. The following were financed under the Second Technical Assistance Credit: (a) consultancy, services, training and supplies for the newly established Energy Unit in the Economic Planning and Development Department (EPD); (b) engineering and consultancy services, vehicles and operating expenses for a pilot fuel wood saving program; (c) consultancy services for a power tariff study; (d) study for drawing up a comprehensive time phased program for deregulating a number of domestically manufactured products; (e) consultancy services to improve the investment programming and management capability of ADMARC; and (f) the purchase of computer equipment and consultancy services to strengthen the debt management capability in the Ministry of Finance and formulate a borrowing policy. PROJECT CO"PLETION REPORT MAIAWI THIRD STRUCTURAL ADJUSTMENT OPERATION (CREDITS 1664-MAI, A0090-MAI, A0091-NAI) Country Operations Division Southern Africa Department - 43 - MALAWI THIRD STRUCTURAL ADJUSTMENT OPERATION CREDITS 1644-1MAI AND A-9 PROJECT COMPLETION REPORT I. INTRODUCTION 1. The Third Structural Adjustment Operation, approved by the Board of Executive Directors in December 1985, was the third phase of a medium- term structural adjustment program that was begun in 1981. In its original form, the financing package of the third operation included about US$30 million equivalent from IDA, about US$40 million equivalent from the IDA- administered African Facility, and US$29 million equivalent Special Joint Financing from Japan and the Federal Republic of Germany (FRO). In January 1987, the Board approved US$10 million supplementary financing from the African Facility to which Japan, FRO and Britain added another US$30 million Special Joint Financing. Unless specified otherwise, the term SAL III used in this report refers to the two original credits (IDA and African Facility) as well as the Supplementary Credit. 2. SAL III was a logical sequence to SALs I and II, which were approved by the Board in June 1981 and December 1983, respectively. As the previous SALs, SAL III was broad and general in nature. Its intention was to consolidate and expand the gains made during the first two phases, and to correct certain weaknesses that had become apparent. In June 1987, the Bank's Operations Evaluation Department issued an evaluation of the first two SALs 1, which contains extensive background information on the nature of the economic and financial difficulties that led to the adoption of the structural adjustment program of which SAL III is a part. This report, therefore, gives only a brief summary of this background. 3. Initially, it was envisaged to assist Malawi's structural adjustment program with a sequence of five SALs of a relatively general nature, complemented with specific technical assistance and project lending. During implementation of SAL III, however, certain weaknesses of the Bank's general approach became apparent, as a result of which both the execution of parts of the SAL III program and the preparation of SAL IV encountered difficulties. Because of this, the Bank has not continued its general, broad approach after SAL III, but has instead concentrated on more narrowly focused sectoral adjustment operations. Although due emphasis will be given to the performance under SAL III proper, in several instances progress will be disgussed over the entire structural adjustment period, Report No. 6833 "Malawi - First/Second Structural Adjustment Loan/Credit,o Operations Evaluation Department, June 12, 1987. -44 - particularly when policy reforms agreed to under SALs I and II had not yet been fully completed during the first two phases. II. ECONOMIC BACKGROUND 4. From Independence- in 1964 until the late 1970s, the Malawian economy grew at a satisfactory average rate of about 5.5 percent a year. The leading sectors were estate agriculture, producing such export crops as tea, tobacco and sugar, and agro-industries and textiles. What budgetary and balance of payments difficulties occurred during that period, remained fairly well manageable. The adverse impact of the first oil shock in 1973 was generally offset by rising export prices. 5. Malawi's economic growth in that period was stimulated by pragmatic economic policies. The Government had adopted an outward-looking strategy, based on agriculture and private sector initiative. Foreign investors were welcome, and fiscal policies were conservative and prudent. Although economic control mechanism, such as wage and price controls and exchange regulations were in place, they were used relatively unobtrusively and were judged not to have caused significant distortions in the allocation of resources. 6. From about 1978 on, however, a number of external and internal factors combined to cause serious setbacks to the economy. A generally unfavorable development of prices for Malawi's export crops, and the rise in import prices associated with world inflation after the second oil shock in 1979 led to an unprecedented fall of 40 percent in Malawi's terms of trade between 1977 and 1980. Droughts in 1980 and 1981 caused declines in agricultural production and export volumes, and forced the country to Import maize. At the same time, rebel activity in ozambique caused serious disruptions of rail traffic to the ports of Beira and Nacala, on which Malawi had traditionally relied for its external trade. Developing longer alternative routes brought sharply increased external transport costs. Also, in the late 1970s, there was a reversal in the Government's conservative policies. Large pay increases led to increases in recurrent expenditures without commensurate revenue increases, and major public investments of a nonproductive character were undertaken, financed, in part, by non-concessional borrowing. 7. As a result of all this, the deficit on the balance of payments current account increased from 8-9 percent of GDP in the aid 1970s to about 20 percent in 1978-80. The debt service ratio rose from 7 to 26 percent between 1977 and 1981. Foreign reserves declined to precarious levels. The Government's budgetary deficit rose from 7-8 percent of GDP in the mid 1970s to more than 16 percent in 1981. GDP showed declines in real terms in both 1980 and 1981. 8. Recognizing the unsustainable nature of the external and internal deficits, and eager to restore growth in the economy, the Government prepared, in consultation with the IMF and the Bank, a medium- term stabilization and adjustment program. Restoring financial equilibrium and improving demand management were considered the most pressing needs at the time. It had also become apparent that certain structural weaknesses - 45 - in the economy had to be overcome before sustained growth could resume. First, the growth of agriculture had been mainly in the estate sector, making the country vulnerable to wide fluctuations in prices of the three main export crops. Second, in spite of substantial foreign-assisted attempts at rural development, smallholder supply response had failed to materialise, largely, it was thought, owing to low producer prices. Third, formal and informal price controls reduced incentives in the productive sectors. Fourth, administration and management of the public sector, central government and parastatals alike, had weakened in recent years and needed considerable strengthening if it were to deal with the difficult financial and economic situation. III. OBJECTIVES AND DESIGN OF THE STRUCTURAL ADJUSTMENT PROGRAM Stabilization and the First Two SALs 9. Although initially the Government attempted to bridge the growing financial gaps by increased external borrowing, it soon became clear that more stringent measures were needed. In 1979, the Government took a number of short-term demand management measures which became the basis for a two-and-a-half year IMP standby arrangement, which was supplemented by drawings from the Compensatory Fund Facility and the Trust Fund. However, unforeseen developments, such as drought and transport difficulties, made it impossible to carry out the stabilization program as designed, and after just one drawing it was terminated and replaced by a new two-year standby (April 1980 through March 1982), drawing on the remaining tranches of the first Standby And the Supplementary Fund Facility. A third Standby program we areed in August 1982, which, in September 1983, was followed by a three-year Extended Fund Facility (EFF). 10. The INF programs largely aimed at reducing both balance of payments and budgetary deficits. Performance criteria involved phased ceilings on total domestic credit and on net bank credit to the Government, as well as a limit on Government-guaranteed borrowing. Specific measures included increases in taxes and duties on imported and domestically produced goods and the use of an active exchange rate policy. The Government was encouraged to seek debt relief, 11. The preparation and implementation of SAL I coincided with the second IMF Standby arrangement, that of SAL II, with the third Standby and the EFF. In designing the SALs, close cooperation was maintained with the IMF. The strategies adopted in the first two SALs addressed four main areas of the economys the balance of payments through renewed export growth, diversification and savings on imported energy; price incentives and incomes; resource management; and institutional improvements. As, in spite of the economic difficulties, the economy was judged to be relatively free of major distortions in any particular field, the SAL programs were broad-based with simultaneous actions on several fronts to enhance efficient resource allocation in the productive sectors, and to improve efficiency in supporting institutions, including the Government itself. 12. When preparing the first SAL, the Bank reco zized that it lacked sufficient specific knowledge to design a program with the desired degree - 46 - of prescriptive detail. Under SAL I the Bank had basically sought and obtained government commitment to increase producer prices for agricultural products, increase budgetary allocations to agriculture, move towards price decontrol, and increase tariffs of various parastatals. Furthermore, the government agreed to undertake studies, and draw up action plans, which would lead to more concrete institutional and policy reforms in following phases of the program. For this purpose, the first SAL was accompanied by a free-standing technical assistance credit. 13. The program under SAL II was indeed more concrete than that under SAL I with, among other things, major policy reforms in two key areas. First, decreasing ADMARC's implicit taxation of the smallholders sector with the implementation of producer price increases, and, second, improving the management and achieving restructuring of the private sector conglomerate Press Holdings and other key institutions in the economy. A second T.A. credit was also attached. 14. At the time SAL III was initiated, it was still difficult to make a firm judgment on the accomplishments under the first two phases of the program. The implementation record of SALs I and II was mixed. Much of the implementation met with some delays or was initially less than agreed, which led to postponements of six months of release of the second tranches of both SALs. Nevertheless, there were the development and utilization of a mechanism for determining relative crop price levels, the removal of most price controls, the rationalization of budget preparation, and the difficult steps that were taken in the restructuring of major parastatals and Press Holdings. A Department of Statutory Bodies (DSB) was established to oversee the commercial parastatals. 15. Although there was not yet any clear evidence of a sustained supply response, the economy showed hopeful signs of recovery during SAL I and II. In the period 1982-84, GDP grew by more than 4 percent a year on average. The balance of payments.current account deficit remained high through 1983, but then declined sharply to about 2 percent of GDP. The Government's budgetary deficit fell from 16 percent in 1981 to 8 percent in 1984. Although demand management measures had started to take effect, much of the economic and financial improvement had been due to exogenous factors, such as normal recovery from losses caused by earlier droughts, an improvement in terms of trade led by record world prices of tea in 1984, and an increase in export volumes, as large accumulated stocks of tobacco and sugar could be moved. Preparation and Desiln of SAL III. 16. The original SAL III, then, was prepared against a background of economic recovery. Although programs under the previous SALs had met with delays, and were only partially implemented, it was recognized by the Bank that, as was usual with early adjustment lending, the time needed to implement reforms had been seriously underestimated. At the time, the Government showed a willingness to continue its adjustment efforts in cooperation with the Bank, and it was successfully carrying out the program under the 1983 IMF EFF. - 47 - 17. The program was designed to continue to encourage productivity and efficiency, diversify the export base and to promote exports. strengthen the Government's policy-making capability, and improve the performance of development institutions. To a large extent, it consisted of a continuation and deepening of the policy reforms started under the previous SALe, some of which were not yet completed. Only a few lements were entirely new. 18. The continuation of the SAL I and II programs involved the following: (i) Agriculture. The Bank would continue to be consulted on smallholder crop prices, which were to be set according to a methodology developed earlier. Fertilizer subsidies had been lowered under SAL I and II and would be entirely removed by 1989/90. As a result of earlier studies, a pilot scheme would be set up to provide credit to estates. An estate extension, and management training program would be prepared. (ii) Industry. The program of price decontrol, started under SALs I and II, would be completed by the end of 1985. An active exchange rate policy would be continued, and a strategy would be adopted, based on studies in progress, to restructure the tax system with a view to improving efficiency and incentives. (iii) Public Sector Management. Apart from updating revenue and expenditure projections and the public sector investment program, the SAL III program pursued institutional improvements. Under the previous SALe little or unsatisfactory progress was made towards the strengthening of government staff engaged in policy formulation, towards implementing an external borrowing plan and strengthening the Department of Statutory Bodies (DSB) which is responsible for monitoring the finances of parastatals. Under SAL III the government reaffirmed its intention to bring about improvements. (iv) MDC and Press. Progress with strengthening management and finances of the Malawi Development Corporation (MDC) and the restructuring of Press Holdings had been quite satisfactory. Medium-term plans had been prepared which were being Implemented. The program under SAL III was limited to continued government monitoring. (v) ADMOC. The official agricultural marketing organization (AWARC), which handles smallholder crops, was still facing considerable difficulties. It was envisaged at the time to address ADMARC's problem in a separate project, so the SAL III program was limited to expressions of intent to accelerate rationalisation efforts and to relieve ADMARC of certain financial burdens. - 48 - 19. The new elements of the SAL III program were, first, a revision of the Industrial Development Act of 1964 which was deemed necessary to encourage competition and make the various regulations in force more transparent and less discretionary. In this context, the Government also undertook to ensure that imports of goods competing with domestically produced goods would not be discouraged. Second, export promoting policies and facilities were to be prepared and established. Third, changes would be made to give the budget a more programmatic content. The system then in use emphasized control and accountability rather than performance. Under the new system it would be possible to identify costs of individual programs, which was necessary to ensure continued funding of important programs at times of budgetary stringency. 20, The period of optimism and economic recovery on which the SAL III program was predicated did not last long. Even before SAL III was approved by the Board in December 1985, the economic tide turned, mainly as a result of a sharp drop in tobacco and tea prices. The situation deteriorated further in 1986. Contributing factors were drought and a flare-up of the regional conflict which led to a sharp increase in security related expenditures and an influx of refugees. GDP declined again, and towards the end of the year the external financial situation had become so tight that the adjustment program itself was endangered. Contrary to the general intention of the program of allowing market forces to determine the allocation of resources, the Government introduced administrative import controls and foreign exchange allocation systems. 21. At this time the need for additignal quick-disbursing external financing was pressing, the more so as the IMF's EFF program had become inoperative because performance targets with respect to the public sector deficit and credit expansion were not achieved. As a result a request for supplemental finance for SAL III was sent, a request supported by the IMF which, despite the termination of the EFF, continued to work with the Malawian authorities on the preparation of a 'shadow programa in anticipation of resuming normal operations. SAL III Supplement 22. The SAL III Supplement (US$10 million African Facility and US$30 million Special Joint Financing) was approved in January 1987. The conditionality attached to the Supplement dealt mainly with agricultural marketing and pricing. The program was directed at improving efficiency through increased private sector participation in marketing and redefining ADMARC'S future role, and correcting ADMARC's financial crisis by narrowing the scope of its activities and increasing management efficiency. Specific measures included ending ADKARC's de facto near monopoly in smallholder produce by announcing that private traders were encouraged to trade in smallholder crops, other than tobacco and cotton, and orienting ADMARC's role to market stabilization. To stimulate private sector participation, an incentive pricing system would be introduced to encourage private traders to take on some of the assembly and transport costs borne by AMARC. Differential prices would be paid between primary and secondary markets, which would be a step to ameliorate some of the cost of the - 49 - government's policy of uniform pan-territorial prices which the Bank had been trying to discourage for some time. 23. Further measures attempted to address ADMARC's financial difficulties, which mainly resulted from its expansion into non-marketing activities. They included a separation of non-marketing operations and taking over by the Government of the cost of the strategic grain reserve, paying an annual fee to ADMARC for management and handling. Finally, ADMARC's operations would be streamlined by closing non-viable markets and making other efficiency improvements. 24. Although all agreed that ADMARC's problems at the time were serious and needed to be addressed, it now appears that the preparation and subsequent implementation of programs under the SAL III Supplement signaled the beginning of a growing tension between some officials in Malawi and Bank staff over the structural adjustment program. Other sources of tension included the program to remove the fertilizer subsidy and the general beginning of gadjustment fatigue". In the following paragraphs the history of the supplemental program and the Bank's role in its design will therefore be reviewed in some detail. 25. The original intention was to address ADMARC's problems in a separate project which was prepared in the first half of 1986, based on recommendations contained in a Bank report 'Improving Agricultural Marketing and Food Security Policies and Organizations - A Reform Proposal,' of March 1986. In July 1986, a project proposal, rather similar to the subsequent SAL III supplemental program, was submitted to the Loan Committee. It was, however, turned down al being not well suited for a fast-disbursing adjustment operation and lacking in new conditionality beyond that in SAL III. The region agreed to pursue alternative means of supporting marketing and pricing reforms and the restructuring of AMARC. 26. The project was revived when it was deemed necessary to attach conditionality to the requested SAL III Supplement. As privatization of agricultural marketing had long been a contentious issue in Malawi, it dppears the Government's willingness to accept it as conditionality was provoked more by a desire to obtain additional funding than by a genuine agreement on the desirability of stimulating private trade in smallholder crops. This is not to say that the choice of ADMARC as the focus of the SAL III Supplement was wrong. The deterioration of ADMARC's financial position, which had begun in 1978, had reached crisis proportions in 1985, and ADMARC had become a substantial burden on the budget and the domestic banking system. It was most unfortunate that the Government did not back more fully the privatization effort. Instead a complex set of regulations were imposed upon those who wished to trade agricultural commodities. These regulations included miniman prices to be paid, restrictions on where trading could take place, detailed statistical reporting requirements and restrictive licensing requirements. The Bank was surprised and disappointed with the complexity of the regulations and the clear indication that neither the private sector nor the working of the free markets was trusted. In its "Report on ADMARC Reconstruction,* April 1986, Government had stateds *It is believed that the incorporation of private traders could relieve ADMARC in the marketing of maize, but the - 50 - implications of this on rural development are not yet clear. It is, in this light, reconmended that a careful study should be conducted on the potential role of private traders and their impact on ADMARC and agricultural development.* The Bank's Role 27. Let us look at the issue of the Bank's and the Government's respective roles in the design of the adjustment program. Ideally, of course, it should be the Government's own program, reviewed and endorsed by the Bank, which would be supported by structural adjustment lending. But as in so many other countries, the Malawian Government's own capability to analyze and formulate policies was weak, and the first two SAL operations were basically Bank-designed programs. Strengthening the Government's policy formulation capabilities was one of the objectives of the earlier SALs, but little progress was made and the further phases of the program continued to be designed mostly by the Bank. 28. Moreover, in discussions on structural adjustment the Bank's formal contact was the Ministry of Fnance, and although contact was maintained with policy-making staff in the Office of the President and Cabinet, other parties concerned, such as the Ministry of Agriculture, and the Ministry of Trade, Industry and Tourism felt they were not Involved fully. (Although in the Ministry of Agriculture the situation was complicated by frequent changes at the top and persistent vacancies in key policy and planning positions.) Initially, this limited involvement seemed to have caused few problems. But it now appears clear from reactions from the Bank's Malawian counterparts, that as the Bank designed programs became more specific and started touching on contentious subjects, the officials in the Ministry of Finance felt pushed beyond the point at which the measures could be defended against internal opposition. This caused growing resentment among the initial supporters of structural adjustment, which was fueled further when the timing of some of the measures tinder the SAL III turned out to be highly unfortunate. IV. IMPLEMENTATION OF POLICY REFORMS 29. The only formal opportunity the Bank had to monitor progress made under the SAL III credit agreements was the second tranche Review Mission .n May/June 1986. As mentioned earlier, SAL III was designed as a phase of a medium-term adjustment program. Certain unfinished reforms under SALs I and II were again picked up under SAL III, and it was reasonable to expect that the unfinished business of SAL III itself would be addressed again in SAL IV. In the event, however, it was decided not to proceed with a further broad-based operation, but to focus the adjustment program more narrowly on key sectors. Certain uncompleted elements of SAL III, however, did get addressed later in sectoral adjustment operations. After the Tranche Release Review Mission it was possible to follow implementation of policy reforms on an ad hoc basis, although in a much less formalized manner than in a review mission. 30. Release of the second tranche of SAL III was conditional on the followings - 51 - (a) agreement on smallholder input and crop price proposals for 1986187, including a target date for fertilizer subsidy removals (b) successful completion of the price liberalization program; (c) agreement on a public investment program for 1986187 - 1988/89; (d) satisfactory progress in developing an export promotion policy packages (e) satisfactory progress in the implementation of AVARC's action plans and (f) preparations of three-year projections for government revenue and expenditure, and an external borrowing plan. 31. In general it may be said that the experience gained under SALs I and 11 had a positive influence on the execution of the program under SAL III. There had been six-month delays in the release of the second tranches of both SAL I and II. There were imperfections in the execution of SAL III, too, but they could be rectified relatively quickly, so that the delay in tranche release was three months. A comparison of objectives and achievement of the individual elements of SAL III is given below. Original SAL III Comliance with Conditfonality 32. In some cases compliance with covenants seems to have been achieved only by the existence of future disbursements conditional on Government actions. Once the second tranche had been released, agreed actions were often postponed. In the agricultural sector the review mission concluded that urige proosals for smallholder agricultural products for the 1986187 crop year were in line with the program objectives of crop diversification and export promotion. The mission worked out an arrangement with the Malawian authorities that would reduce the level of fertilizer subsidies to 17 percent, and a program for continued removal of subsidies was agreed to with USAID. Preparations were being made to set up a pilot scheme for extension and credit service to agricultural estates. 33. The procedures for agricultural price setting continued to be followed in a satisfactory manner in the following year. In 1988, however, prices were not set in accordance with the agreed methodology and with Bank advice. The announced price increase for maize of 40 percent was judged to be too high and could endanger the program objective of diversification. The Bank, however, had at the moment no convenient instrument to exert influence in this matter. The fertilizer subsidy removal program was terminated as the required price increases were judged to be politically unacceptable. Progress with providing extension and management training to the estate sector has remained slow, but the issue is again addressed in the Bank's Agricultural Marketing and Estate Development Project, approved in November 1988. - 52 - 34. in the industrial sector the Government had completed its price decontrol program in December 1985 in accordance with the SAL program. There was no progress, however, with revising the Industrial Development Act of 1964. The Government said that it expected the new act to be ready by the end of 1986, but there was no serious progress until, in June 1988, it was made a condition of Board presentation of the Industrial and Trade Policy Adjustment Credit (ITPAC). 35. The review mission noted no satisfactory progress with formulating an export promotion policy and setting up an export financing facility. This was partly due to the inadequate work done by consultants on this part of the program. New target dates were set, but no significant action was taken until the issue was again addressed in ITPAC. Much better progress had been made toward reforming the tax system with a view to improving efficiency and incentives. Studies had been completed, and some of the recommendations had been incorporated in revenue measures for the 1986187 budget. Progress continues to be made with many reforms in place before Board presentation of ITPAC. 36. The Government has also continued to pursue an active exchange rate policy with devaluations in 1985, 1986, 1987 and 1988. In this context it should be noted, however, that when Malawi's external financial situation deteriorated sharply in 1986 and arrears began to build up, the Government's first reaction was to increase foreign exchange controls and allocation systems. These controls caused new distortions and unnecessary scarcities of certain goods and threatened to undermine recent progress with trade liberalization. In 1988, when the external financial situation started improving, a phased import liberalization program was begun in connection with ITPAC. 37. With respect to public sector management the review mission noted that certain organizat;.nal and staff changes were being made in the Economic Planning and Development Department in the Office of the President and Cabinet, and more changes were being considered. Up to now, however, this does not yet appear to have led to the intended strengthening of the policy formulation capability of the Government. The Bank has now decided that the best mechanism for improving Government capability in this area is through an Institutional Development Project which was approved by the Board in June 1989. On the other hand, good progress was recorded with respect to the reclassification of Public expenditures according to a new programmatic content. A supplement was issued to the 1986/87 budget, presenting all expenditures under the new format. 38. At the time of the review mission the 1986/87 - 1988/89 Public Sector Investment Program (PSIP) and Revenue and Expenditure Estimates were not yet ready, delaying release of the second tranche. After a delay of three months, they were finalized to the Bank's satisfaction, and the second tranche was released. PSIP reviews (later expanded to include all expenditures) have since become a regular feature in the preparation of Policy Framework Papers. - 53 - 39. Little progress was noted with developing an external borrowing strategy, and in general, with the monitoring capabilities of the Ministry of Finance. Its administrative capacity has remained weak. Strengthening financial management is now an important objective of the upcoming Institutional Development Project. 40. Parastatal operations generally improved. The restructuring and restoration of the financial and operational soundness of Press Holdings and WDC had been largely accomplished under SALs I and II 21. The Government monitors the operations of these organizations through representation on their Boards. Both organizations have continued to make progress, both financially and operationally. At the time of the review mission, plans were being worked out for the divestiture of a number of ADMARC's non-marketing activities. ADHARC's operations became the main focus of the program under the SAL III Supplement. However, there was less success in restructuring the operations of DSB. Its staffing has remained weak and implementation of a new system giving more freedom to parastatals to implement agreed upon annual plans has yet to be implemented. The SAL III Supplement 41. The program under the Supplemental Credit had two main elements. First, improving the efficiency of smallholder marketing by allowing private sector participation, and second, improving ADMARC's operations and financial position. Both elements have had successes and failures. 42. Under the program, AWMARC has lowered the cost of its marketing operations by closing some 190 nonviable low-volume markets and reducing its staff. Furthermore, the Government has relieved ADMMC of the financial costs, first, of operating the country's strategic grain reserves, and second, of having to contribute to the Fertilizer Revolving Fund. Also, good progress is being made with relieving ADMAW of its investment and development functions. Its non-marketing assets were separated and in a number of cases, their transfer to the private sector has been negotiated successfully. According to unaudited accounts, these measures have brought about a sharp improvement in ADHARC's financial performance in 1987188-1988189. 43. The privatization of agricultural marketing met with disapproval in some parts of Government and the aid community. First, that particular element of the program was not fully accepted by some in the Government who distrusted the private sector and, second, the liberalization of the maize trade coincided with a number of unforeseen exogenous factors which caused serious maize shortages and increased open market prices. - Despite this disapproval, the response has been impressive with over 900 traders registering within two years and active trading, particularly in the Southern part of the country, reducing trading margins significantly. 2/ For details, see Report No. 6833, 'Malawi - First/Second Structural Adjustment Loan/Credit,* Operations Rvaluation Department, June 12, 1987, pp. 16-20. - 54 - 44. As intended, the Government confirmed in a public notice the legality of private trade in smallholder crops other than tobacco and cotton, and encouraged private traders to enter the market. (There was always some private trade and while this was not illegal, it was discouraged by ADMARC and some elements of the party.) This encouragement was done In spite of considerable internal opposition, particularly from the side of the Ministry of Agriculture where fears existed about collusion by the private sector. To assuage those doubts, the program provided for a study to identify constraints to private sector marketing and develop proposals to address those constraints. It was initially intended that this would be carried out by another aid agency, but budgetary problems prevented them from doing so. Instead mAch of the work was undertaken in the preparation of the Bank's Agricultural Marketing and Estate Development Project which includes technical assistance to improve the regulatory and policy environment for private trade and a pilot credit scheme to test mechanisms for providing credit to traders. 45. After the Government's announcement, a large number of private traders entered the market, and despite the Government's (largely unsuccessful) attempts to tightly regulate their activities, they have become major actors in the marketing of agricultural produce. 46. The timing of the liberalization turned out to be unfortunate. Droughts in 1986 and 1987 and unprecedented domestic sales,including purchases by relief agencies to help feed an unprecedented number of new refugees from Mozambique led to a domestic production shortage and depleted ADMARC's stocks. ADMARC was unable to carry out its function of a market stabilization agency and maize prices more than doubled within a year. There is no proof that the private trade exacerbated these problems and the price rise was clearly caused by a demand and supply imbalance, but some officials have tried to attribute a cause and effect relationship between the introduction of increased private trade and the shortage of maize. V. IMPACT AND LESSONS FROM EXPERIENCE Macro Economic Development 47. Economic indicators leave the conclusion that, in spite of a Government committed to reform, growth has been disappointing in the period of structural adjustment. GDP growth has averaged less than 2 percent a year since 1980, leading to a decrease in per capita income. There were some ups and downs during the periods some growth up to 1985, stagnation in 1986 and 1987 and some recovery in 1988; but clear signs of progress have not yet become apparent. Also, there is as yet no clear evidence of greater export diversification or of overall increases in smallholder productivity under the adjustment program. 48. Much greater success was achieved with restoring financial balances. The Government's budget deficit, which had reached 16.5 percent of GDP in 1981182, was reduced to 8 percent of GDP in 1985186. As a result of external factors there was a temporary setback, but in 1988189 the deficit was reduced to 6.5 percent of GDP, well below the PPP target of 8.1 - 55 - percent. While there were more severe fluctuations in the balance of payments position, there was also a favorable trend, with the current account deficit declining from 23 percent of GDP in 1979 to about 7 percent in 1988. In 1988 international reserves amounted to an equivalent of more than three months of imports, and payment arrears were eliminated. All this, however, was accomplished by severely restricting imports which contributed to the slowdown in economic growth. Another problem has been the recent high rate of inflation. It had been in the range of 10 to 15 percent a year up to 1986, but increased to about 30 percent a year in 1987 and 1988. Scarcity of maize and the resulting high food prices have been an Important contributing factor, and have had a particularly detrimental effect on the standard of living of the poor. 49. The adjustment program has had limited success in insulating the economy from exogenous factors. The cyclical ups and downs in growth and financial performance coincided to a large extent with movements in the external terms of trade, which on the downside were reinforced by droughts and the consequences of the conflict in neighboring Mozambique. 50. This is not to say that the adjustment program did not have a positive impact on the economy. The reduction of the deficits, the turn around of Press and MDC, the increased flow of funds to the rural sector through AUMaU purchases 11 and the strengthening of parastatal performance, all were key elements in Malai's ability to weather the storms the economy continued to face. Another objective of the adjustment (and stabilization) program was to attract quick disbursing balance of payments support. This was achieved. In addition to increases in Bank and IMP transfers, the introduction of reforms-led also to large increases in assistance from bilateral sources. It is difficult to know how much lower the capital inflows would have been in the absence of reform programs. An estimate of some US$100 million a year, however, does not appear to be unreasonable, a figure that is roughly equivalent to 25 percent of imports of goods and services. Without these increased capital inflows, arrears would have run up and scarcities of imported inputs would have led to declines in production. What is more, the Government would almost certainly have bad to resort to much more stringent quantitative controls, which would have led to greater inefficiencies in resource allocation. 51. Two lessons appear to emanate from this experience. First, the assumption underlying the three SALs that the constraints and distortions in the Malawian economy were relatively mild, and that with successful Implementation of broad measures, a sufficient supply response could be achieved, appears to have been too optimistic. The Bank has come to recognize that the constraints to growth are much more deep-seated than previously reali!ed and the Government's ability to implement an adjustment program is not as strong as we had thought. The constraints include, the poorly developed human resource base, both education- and health-wise; the use of land, particularly the concurrent over-utilization of smallholder land and the under-utilization of estate landi and the declining 3j Increased prices and volumes led to a rise in crop purchases from MK28 million in 1981 to NE73 million in 1984 and MK90 million in 1986. - 56 - productivity in the smalholder sector. Administratively and politically the Government has not been able to formulate or implement the adjustment program as quickly as anticipated. These are issues that are now being addressed through the design of much more narrowly focused operations, increased emphasis on hty supply bottlenecks and efforts to strengthen the administrative ability of the Government and key development institutions. 52. Second, the risks associated with external shocks have been seriously underestimated by the Bank. In fact, in preparing SAL III the danger that falling export prices could negate the gains from the program was recognized, but it was thought that this risk would be partly offset by increased productivity. In the event, the external shocks were much more severe than anticipated, and their effects on the economy were one reason why Government confidence in the adjustment program was eroded. Perhaps the most undesirable effect was the high rate of inflation as a result of which the poorest have faced increasing hardship. A design flaw of the first three SAL9 and of the Bank's assistance strategy in general at that time was that poverty alleviation, especially for food deficit smallholders, was not emphasized more. Economic Management 53. The improvement of economic management was most noticeable in the cases of the private sector conglomerate Press Holdings and large established parastatals, such as MDC and ABMARC. Within a relatively short time those organizations were restructured, their respective functions clarified, their management improved and they were put on sounder financial footing. Much less successful were the attempts to create new institutions that would provide services to productive sectors such as agricultural extension for the estate sector and export promotion facilities. 54. Within central Gover-aent, management improved more on stabilization and public finance, with which Government official were familiar. However, the capability and willingness of the Government to develop and carry out market-oriented indirect policies, and to stimulate liberalization ane privatization, came under great stress in times of financial duress. In fact, in 1986 and 1987, the SAL programs were seriously endangered by the introduction of new quantitative controls. 55. A lesson that follows from this is that the timing of proposed reforms is of utmost importance and that great flexibility is required. It is much easier to take difficult measures when the financial situation is relatively sound. When the Government is engaged in crisis management, there is very little-time to think through long-term adjustment measures, and it becomes very tempting to resort to direct controls. But t sn when the new direction in economic management (reducing direct controls) is accepted by our main partners in the dialogue, the Ministry of Finance and the Economic Planning Department, they still need to convince the ministries and agencies whose main role has been to control, allocate, and license. Eventually those 'control agencies* will have to be transformed into "service agencieso. This will be a difficult and time-consuming process that the Bank has only begun to address. - 57 - Sustainability of the Adjustment Process 56. The best way to ensure that the adjustment process is sustained, is to help to build up the Government's capacity and willingness to linternalize the process of policy reform as quickly as possible; in other words, to ensure that the country accepts the adjustment program as its own and not the Bank's, and that it is designed by the country itself. This, however, has been the least successful aspect of the adjustment process. The Government has made increased efforts to design their own reform program and they have been successful in developing a medium term policy framework. Still in spite of attempts to bring about a strengthening of the Government's capability to carry out policy analysis, the programs under the three SALs continued to be mainly designed by the Bank. 57. It has become apparent th;:t instead of becoming easier and more acceptable, it became more difficult. to reach and implement difficult decisions. In particular when the supply response failed to materialize and the effects of the external shocks, became apparent, confidence in the program diminished considerably. It would appear that in certain instances, particularly when it was attempted to achieve liberalization and privatization at times of increasing scarcities, the proponents of adjustment were unable to convince the opponents. This has caused friction and a good deal of *adjustment fatigue* on the part of the Government and Bank staff alike. 58. The lesson of this is that we need to analyze more the reasons for the Government's hesitance to carry out certain programs or accept certain conditions. It would appear that we have not sufficiently realized that major elements of the structural adjustment program were not understood or were disagreed with by important segments in the Government. With the benefit of hindsight, it can be concluded that the Government, with our help, should have played a much more active role in consensus building, and seeking the active participation of the most important parties involved in diagnosing the problems and developing solutions. Bringing those parties together at sufficiently senior levels would require, at certain critical times, the active participation in the dialogue of senior Bank officials and would have meant slower development of the program, but this would likely have been offset by faster and smoother implementation.