Malawi - Agricultural Sector Adjustment Program

Document of The World Bank FOR OFFICIAL USE ONLY Repoit No. P-5189-MAI REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTFRNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 52.6 MILLION (US$70.0 MILLION EQUIVALENT) TO THE REPUBLIC OF MALAWI FOR AN AGRICULTURAL SECTOR ADJ'JSTMENT PROGRAM MARCH 6, 1990 This document has a restricted distribution and may be used by recipients only In the performance of their official duties. Its contents may not otherwise be d!sclosed without World Bank authorization.  CURRENCY AND EQUIVALENT UNITS Currency Unit Malawi Kwacha (MK) MK/US$ 1985 1.75 1986 1.86 1987 2.21 1988 2.56 1989 2.76 ABBREVIATIONS AND ACRONYMS ADF = African Development Fund ADMARC = Agricultural Development and Marketing Corporation ASAC = Agricultural Sector Adjustment Credit CIMMYT = International Center for Maize anca Wheat Improvement DEVPOL = Statement of Development Policies DRCs = Departmental Recurrent Charges DSB = Department of Statutory Bodies EEC = European Economic Community EP & D = Economic Planning and Development ESAF = Enhanced Structural Adjustment Facility IFAD = International Fund for Agricultural Development IMF = International Monetary Fund ITPAC = Industrial and Trade Policy Adjustment Credit KfW = Kreditanstalt fur Wiederaufbau MDC = Malawi Development Ccrporation NSO = National Statistics Office ODA = Overseas Development Administration of the United Kingdom OECF = Overseas Economic Cooperation Fund (Japan) PEs = Personnel Emoluments PFP = Policy Framework Paper PHL = Press Holidays Ltd. PSIP = Public Sector Investment Program RBM = Reserve Bank of Malawi SFFRFM = Smallholder Farmers Fertilizer Revolving Fund of Malawi SOEs = Statement of Expenditures USAID = United States Agency for International Development FISCAL YEAR April 1 - March 31  MALAVI FOR OFFICIAL USE ONLY AGRICULTURAL SECTOR ADJUSTMFNT PROGRAM Table of Contents Paae CREDIT AND PROGRAM SUMMARY i-iii PART l: THE ECONOMY ........ ........... 1 A. Special Country Features ......................... 1 B. Past Adjuetment Programs and Economic Performance 2 C. Overall Performance of Past Adjustment Programs.. 6 PART II: COUNTRY ASSISTANCE STRATEGY AND BANK GROUP OPERATIONS 7 A. The Government's Development Objectives and Strategy ..... ..... . 7 B. Country Assistance Strategy . . 8 C. Bank Group Lending Operations . . . 11 D. Creditworthiness ................................. 12 E. Macroeconomic Projections and External Financing Requirements .. . .............................. 12 F. Aid Coordination . . ............................... 13 G. Collaboration with IMF . . ......................... 14 PART III: THE AGRICULTURAL SECTOR ...................... ......... 14 A. Salient Features ................................. 14 B. Sectoral Performance . . . 15 C. Main Constraints and Prospects .................. . 16 D. Agriculture Sector Assistance Strategy .. 18 PART IV: THE AGRICULTURAL SECTOR ADJUSTMENT PROGRAM . . 19 A. Overall Objectives and Expected Outcomes ......... 19 B. Continuation and Expansion of Macroeconomic Policies ....................................... 21 C. Product Pricing and Marketing Policies ........... 22 D. Input Pricing and Marketing Policies ............. 25 E. Rationalizing ADMARC Financing and Functions ..... 29 F. Shifting Smallholder Research Policy and Establishing Extension Services for Estates .... 30 G. Introducing New Cash Crops among Smallholders .... 32 H. Halting Transfer of Land from Smallholders, and Intensifying Land Use in Estates ............... 32 I. Prioritizing Agricultural Expenditures ........... 34 J. Reducing Food Insecurity among the Poor .......... 35 K. Monitoring Poverty Impact of Adjustment Program.. 36 This document has a restricted distribution and msy be used by recipients only ;.n the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  PART V: THE AGRICULTURAL SECTOR ADJUSTMENT CREDIT (ASAC) ..... 36 A. Objectives and Rationale for IDA Involvement ..... 36 B. Financing Plan .. ................................ . 37 C. Procurement, Disbursement, Accounts and Audit .... 38 D. Monitoring and Tranche Release ................... 39 E. Impact and Risks ............................. . . 41 PART VI: RECOMMENDATION ....................................... 44 Supporting Tables and Annexes Annex 1: Social and Economic Data Annex 2: Status of Bank Operations Annex 3: Past Structural Adjustment Operations Annex 4: Supplementary Credit Data Sheet Annex 5: Government Letter of Development Policy Annex 6: Policy Agenda Action Matrix  MA,WAI AGRICULTURAL SECTOR ADJUSTMENT PROGRAM CREDIT AND PROGRAM SUMMIRY Borrower: Republic of Malawi Beneficiary: Republic of Malawi Amount: IDA: SDR 52.6 million (US$70.0 million equivalent) Netherlands: DFL 10 million (US$5 million equivalent) The operation is supported under the Special Program of Assistance to Low-Income Debt-Distressed Countries in Sub- Saharan Africa. In addition to the cofinancing identified above, interest to participate in the financing of this program has been expressed by: United Kingdom,LSTG 10 million (US$16.5 million), United States (US$25.0 million), Federal Republic of Germany (amount not indicated), and the European Economic Community (amount not indicated). The Government of Japan has been approached to participate with US$30 million equivalent. Term: Standard IDA terms; 40-year maturity with a 10-year grace period. Description: The primary objective of the proposed Credit is to support the Government's ongoing adjustment program to achiere sustainable growth, food security, and reduce poverty. To these ends, the proposed Credit will support measures to continue and deepen ongoing macroeconomic and sectoral reforms and to initiate new policy changes aimed at reducing poverty through agricultural growth. Past adjustment operations helped to improve external and internal balances. To maintain the competitiveness of exports, 85? of which are agricultural, and to improve efficiency in the industrial sector, about two-thirds of which is agro-based, the Credit will continue reforms to maintain a flexible exchange rate policy, improve export incentives, and expand trade liberalization. The flexible exchange rate policy will be complemented by measures to: (a) keep the fiscal deficit at levels that can be financed largely with concessional external resources; (b) reduce fertilizer subsidies; (c) focus the Public Sector Investment Program on areas of high priority and returns; and (d) implement a revised Banking Act to enhance monetary management and introduce a more market-based monetary and credit system. The Credit will also continue  - ii - reforms to ensure adequate producer incentives and improve marketing efficiency, by expanding the role of the private sector, for smallholder agriculture. Because of structural constraints in agriculture, past adjustment operations have not succeeded in eliciting a sustainable supply response necessary to raise per capita incomes and eliminate the need for balance nf payments support. These constraints are due to policies which have resulted in inappropriate technological packages for maize, limited fertilizer use, a narrow range of cash crops among smallholders, and underutilization of land in estates. Consequently, productivity has remained very low, particularly among smallholders, with the result that half of the population lives in absolute poverty. The proposed Credit will support new policy changes to address the key structural constraints in agriculture by: (a) shifting the research policy and budget to develop high-yielding maize varieties that most of the smallholders will find appropriate to grow; (b) changing laws to allow smallholters to grow high-value cash crops, burley tobacco, and increase prices of smallholder tobacco; (c) halting the transfer of land from smallholder areas to estates; (d) improving fertilizer use and distribution efficiency, particularly through liberalizing the distribution system and improving the financial management and funding of the Smallholder Farmers Fertilizer Revolving Fund of Malawi (SFFRFM); and (e) improving land use efficiency in estates through increasing land lease rents to better reflect land scarcity, adjusting the rents more frequently, improving rent collection, and establishing extension services for estates. The Credit will also support further new initiatives to: (a) improve efficiency in agricultural public expenditures through reviewing arLd restructuring them to ensure consistency with sectoral priorities and cost- effectiveness; (b) implement pilot schemes to develop ways of targeting fertilizer subsidies and credit to the poor; and (c) strengthen the Government's capability to monitor and redress the impact of the adjustment program on the poor. Benefits: The reforms will generate significant efficiency gains across all the productive sectors and will enhance the competitiveness of agricultural and other exports. Considerable increase in agricultural productivity is likely to result from the policies to shift the focus of maize research, to improve availability of fertilizers, and to promote efficient land use among estates. Increased food crop yields among smallholders would release land for  - iii - cash and export crops. Reforms to increase smallholder tobacco prices and allow smallholders to grow burley tobacco would increase rural cash- incomes and expand monetization of smallholder agriculture, thereby raising purchasing power for domestic goods and services. The proposed operation would have a positive impact on the environment by increasing crop yields through developing high-yielding flint maize and expanding fertilizer use, thus reducing population pressure on land; and by enforcing the lease covenant requiring estates to establish woodlots. Risks: Strong opposition may be encountered from estates, many of which are owned by politically influential farmers, against adjustment of estate land rents and allowing smallholders to produce burley tobacco. Concern with the poverty issue aueong Malawian authorities is relatively recent and inadequate appreciation of the poverty situation in the country may dilute efforts to implemen" reforms designed to benefit mainly the rural poor. These risks will be minimized by the fact that most of the politically difficult reforms were taken before Board Presentation; others will be conditions of the second tranche. Development of high- yielding maize acceptable to most of the farmers is subject to uncertainties common to any research activity. Recurrence of external shocks, ouch as prolonged droughts and decline in export prices, may impair growth and reduce the expected benefits, thus weakening Government's commitment to continue with the reform program. Estimated Disbursements: In view of high import demand projected to. arise from continuation of trade liberalization reforms, the proposed Credit would provide quick-disbursing funds for balance of payments support, except an amount of SDR 565,000 earmarked for consultancy services. The Credit proceeds for the balance of payments support would be disbursed in two tranches, one for SDR 26.035 million and the second for SDR 26.00 million. The first tranche would be available for disbursement upon Credit effectiveness; the second would be released upon satisfactory fulfillment of specified conditions, expected in December 1990. The Credit proceeds for consultancy services would be disbursed over a period of eighteen months. Appraisal Report: This is a combined President's and Staff Appraisal Report.  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO MALAWT FOR AN AGRICULTURAL SECTOR ADJUSTMENT PROGRAM 1. I submit the following report and recommendation on a proposed IDA Credit of SDR 52.6 million (US$70.0 million equivalent) to Malawi for an agricultural sector adjustment program. The program ts described in the Letter of Development Policy from the Government of Malawi (Annex 5). The Credit will be on standard terms, with a 40-yeaz maturity. The Netherlands, United Kingdom, United States, Federal Republic of Germany, and European Economic Community have expressed interest to participate in tne financing of this program. The Government of Japan has been approached to participate in co-financing the program. 2. A detailed analysis of the Malawian economy up to 1985 can be found in the Country Economic Memorandum entitled 'Malawi Economic Recovery: Resource and Policy Needs" (Report No. 5801-MAI), which was circulated to the Executive Directors in October 1985. A second-year Policy Framework Paper (PFP) was reviewed by the Committee of the Whole in August 1989. A Country Economic Memorandum will be forthcoming shortly and its findings are incorporated in this report. Basic country economic and social data are given in Annex 1. PART I: THE ECONOMY A. Special Country Features 3. Malawi's economy is severely handicapped by a unique combination of problems, notably poor resource base, high population density, and by being landlocked and far from any sea port. The country has an area of 94,200 sq. km, and a population of about 8.1 million, estimated to be growing at 3.2Z annually 1/. Population density, averaging 85 persons per sq. km, is among the highest in Africa. The country has no known substantial mineral resources but is endowed with moderately fertile soils, ample water resources, and a climate favorable to production of many crops. Agriculture dominates the economy (para 41). The country faces formidable problems including: (a) high population growth, resulting in a severe strain on natural resources, food supply and social services; (b) limited employment opportunities relative to itu fast growing labor force; (c) under-developed human resources; (d) narrow export base concentrated in three commodities (tobacco, tea and sugar), which are subject to frequent 1/ Population data based on preliminary report of 1987 census and staff estimates.  - 2 - price fluctuations; and (e) high transport Costs to the sea due to the closure of transport route through Mozambique. 4. Malawi is one of the poorest countries in the world, with a per capita income of about US$160. As a result of these circumstances, about half of the population lives below the level of absolute poverty, with a per capita income of less than K100 (US$36) annually, which is insufficient to ensure the minimum nutritional requirements and other basic household needs. About 85? of the population living below atsolute-poverty levels consists of smallholder farmers with less than one hectare of land (some 55? of all smallholders). Chronic food shortages and serious malnutrition are widespread, exacerbated by poor health services. B. Past Adiustment Programs and Economic Performance Before 1986 5. Starting from a very low economic base, Malawi was able to achieve impressive growth during the first fifteen years after Independence in 1964. Real GDP grew at an average rate of 5.2% per annum during 1967- 79, well above the rate of population growth. The balance of payments and fiscal positions remained fairly stable, with the current account deficit varying between 7Y and 9? of GDP and the fiscal deficit averaging less than 8? of GDP. The economy suffered a major setback in 1979 and, for three years, Malawi experienced a sharp decline in growth and deterioration of the balance of payments and fiscal positions. GDP fell by a total of 9.5? during 1980-82. The current account deficit rose to 21.2? of GDP in 1980 and the fiscal deficit, before grants, to 15.5? in 1981. 6. The deterioration of the economy was due to a combination of external shocks and structural weaknesses in the economy. Foremost among the external shocks weres (a) a sharp rise in import prices, especiallv for fuel, while the price of Malawi exports fell drastically, causing a major deterioration in the terms of trade; (b) severe droughts in 1980 and 1981, causing a decline in agricultural production and export volumes, and compelling the country to import a large quantity of maize; and (c) rising transport costs due mainly to disruption of the rail route to the sea through Mozambique. The crisis unmasked major structural weaknesses in the economy, including a narrow export base; stagnant smallholder agriculture; heavy import dependence in the industrial and energy sectors; deficient incentive framework; inefficient public enterprises; and weak institutional capacity for planning and managing public resources. 7. Recognizing the fundamental nature of the problems facing the economy, the Government, with IDA and the IMF assistance, formulated a medium-term stabilization and structural adjustment program covering 1981/82 - 1985/86. The program was supported by IDA through three SALs (Annex 3), by the IMF through successive standby arrangements and special facilities, and by other donors through co-financing of the SALs and debt rescheduling in 1982 and 1983. The primary objectives of the program were to stabilize the economy, accelerate agricultural growth and diversify the  export base, encourage efficient import substitution, improve the mobilization and management of public resources, and enhance efficiency of the key parastatals as well as that of the privately-owned Press Holdings conglomerate. To stabilize the economy, the exchange rate and interest rates were adjusted frequently; public expenditures were restrained; and measures were taken to expand the tax base, improve tax buoyaney, and curtail government and parastatal deficits. To encourage efficiency in manufacturing industries, the legal framework was reformed to stimulate competition among domestic industrial enterprises, and the number of commodities subject to price control was reduced considerably. To improve mobilization and management of public resources, the Government's analytical and planning capability was strengthened and a better budgeting process introduced. To enhance parastatal efficiency, measures were taken to restructure and rationalize the financial and operational aspects of key public enterprises, including the Agricultural Development and Marketing Corporation (ADMARC), as well as the privately-owned Press Holdings. 8. To accelerate agricultural growth and diversify the export base, emphasis was placed on improving incentives for smallholders 21. To this end, the Government adopted and has continued to use a price setting methodology developed with Bank assistance. Prices of all the major smallholder crops were periodically raised significantly, with nominal increases ranging from 141X for groundnuts to 1822 for maize between 1982 and 1989. 9. The Government elee initiated actlei-S v'- feduce fertilizer subsidies with a view to eliminating them by 1985/86. The elimination i" subsidies was abandoned in 1986 because of a sharp rise in fertilizer costs following the closure of the route through Mozambique, and a substantial decline in maize production. However, the Government continued to raise fertilizer prices, increasing them by about 702 between 1986 and 1989, thus reducing the rate of economic subsidy from about 352 in 1984/85 to about 27Z in 1988/89 and the financial subsidy from about 29Z to 24Z during the period. Due to increases in fertilizer costs, the rate of economic subsidy rose to 30Z and the financial subsidy to 26Z in 1989/90. Also, rising fertilizer costs and a sharp increase in fertilizer use have led to a continuous increase in the total amount of required subsidy subventions from about K6 million in 1985 to about K 27.2 million in 1989/90 or about 2.02 of Government expenditures. 10. The GoveLnment implemented the program satisfactorily and the three SAL credits were fully disbursed. Although the performance of the key macroeconomic variables remained uneven, the economy experienced significant improvement up to 1985. Real GDP grew by an average rate of about 4.5Z p.a. during 1982-85. The fiscal deficit declined steadily to 1OZ of GDP in 1985/86, and the current account deficit to 8.6Z in 1985. 21 Malawi's agriculture consists of two systems, smallholders and estates (para 42). Historically, Malawi has left prices of estate crops, which account for about 90Z of total agricultural exports, free of Government intervention.  - 4 - Downturn of the Economy and Further Adiustment Program 11. The economy deteriorated again in 1986. GDP growth fell to 1.1? in 1986 and 1.4Z in 1987. The fiscal deficit rose to 13.1Z in 1986, declining to 9.1S? in 1987. Inflation escalated from 14.9Z in 1985 to 26.82 in 1987. However, as a result of a considerable decline in import volumes, the current account deficit fell from 8.6Z of GDP in 1985 to 4.8Z in 1987. These reversals were largely the result of a recurrence of external shocks. In addition to the cumulative effect of the shocks faced in 1980-81, severe shocks occurred after 1985: export prices declined further; another spell of drought, together with an outbreak of plant pests, occurred; and, most importantly, regional political turmoil worsened, resulting in higher transport costs, increased security-related budgetary expenditures, and a large influx of refugees. 12. In response to the continuing deterioration of the economy, the Government in 1987 prepared a new strategy, which is set out in its Statement of Development Policies, 1987-1996 (para 22). It also formulated a three-year program, covering the period April 1988 to March 1991, aimied at continuing and deepening adjustment reforms to: (a) align aggregate demand with the available resources through stricter fiscal, monetary and credit policies, together with active exchange rate management; (b) increase productivity through addressing policy and investment constraints on the performance of the major economic sectcrs; (c) strengthen the role of the pri_ate sector through liberalization ar.d improved incentives; and (d) enhance efficiency in the use of public resources. This adjustment program has been supported by IDA and other donors through the Supplemental Credit to the third SAL, approved in 1987, and the Industrial and Trade Policy Adjustment Credit (ITPAC), approved in 1988 (Annex 3); by the IMF through a stand-by arrangement and Enhanced Structural Adjustment Facility (ESAF)l and by further debt rescheduling in 1988. 13. Supplemental Credit to the Third SAL: The Supplemental Credit focussed on improving efficiency in the agricultural marketing system for smallholders by expanding the role of the private sector 3/. The main actions taken to this end included introducing intra-regionally differentiated producer and consumer prices for maize to make it profitable for private traders to assemble maize and sell it to ADMARC or to consumers and millers. Assemblers and farmers delivering a minimum of one ton of maize to designated ADMARC receiving markets are offered a price which is 141 above the producer prices that ADMARC pays at its market centers 4/. Also, assemblers and farmers may sell directly to consumers at a margin of 3/ Unlike estates, which rely on private channels, smallholders have historically depended on ADMARC for marketing services. 4/ ADMARC operates 30 depots (receiving markets) and about 1,200 rural assembly points (market centers).  302 bet'ween official producer and consumer prices S/. These changes have attracted a wide variety of private buyers and sellers, comprising rural and urban merchants, processors and mill,-rs, and institutions such as hospitals and schools. As a result, ADMARC's share in the marketing of smallholder agricultural production has declined from about 162 in 1986 to 6? in 1988 in terms of value. Its share in total maize marketed has declined from about 202 in 1984-85 to about 7t in 1987-88 in terms of volume. These changes aim at eventually shifting the primary role of ADMARC to that of a price stabilizing agency. While notable progress has been made to this end, the role of the private sector continues to be constrained by several factors (para 66). 14. The Supplemental Credit continued to support measures to improve the financial condition of ADMARC. These measures included: restructuring its organizational setup; divesting investments unrelated to marketing; reducing staff; and closing about 190 loss-making market centers and consolidating others into viable operations. Ir. addition, the Government took over the financing of the Strategic Grain Reserve, with ADMARC managing it on behalf of the Government. As a result of these measures, ADMARC's financial condition has significantly improved, moving from net losses (after depreciation and interest) of K10.6 million in 1986/87 to net profits of KO.6 million in 1987/88 and K14.9 million in 1988/89. However, ADMARC continues to undertake functions which have the potential to reverse these improvements (paras 79-80). 15i, TrpAC The main object-ve oCf ITPAC has been to improve the policy environment in the industria' and external sectors. Its cornerstone is a package of trade liberalization reforms, complemented by flexible erchange rate management, restrained monetary and fiscal policies, improved budgeting process, and improved industrial incentives. To liberalize trade, actions were taken to remove requirement for prior approval of foreign exchange allocation for about 652 of all imports. Other trade liberalization measures included rationalization of the import tariff structure, reduction of commodities subject to industrial and export licensing requirements, and expansion of excise tax base and move to ad valorem rate. To improve monetary management, interest rates were decontrolled. A revised Reserve Bank Act was enacted to enable the Reserve Bank to fully undertake traditional central banking functions, including open market operations, institution of reserve requirements, and effective supervision of the financial system. The Government has also revised the Banking Act to, among other things, improve competition, remove distortions in the financial system, and facilitate more effective mone~tary management. Conditions for the release of the second tranche were met for both ITPAC and the Supplemental Credit to the third SAL. 5/ With these changes, ADMARC retains exclusive rights only in the marketing of smallholder tobacco and cotton (paras 67-68).  -6- Recent Performance of the Economy 6/ 16. Since 1988 the economy has shown signs of recovery, and substantial progress has been made toward achieving the targets and objectives of the 188-1991 program. GDP grew by 3.6X in 1988 and is expected to grow by 3.7Z in 1989, reflecting increased agricultural production as a result of improved weather conditions and producer prices, and increased industrial production as a result of higher capacity utilization facilitated partly by greater import availability. The fiscal deficit (excluding grants) fell from 9.1% in 1987/88 to 6.6X in 1988/89 due to a slight reduction in total expenditures and a sharp rise in tax revenues, and is expected to fall further to 6.32 in 1989/90. The current account deficit rose from 4.8% of GDP in 1987 to 8.3% in 1988 in response to the introduction of the import liberalization program. The rate of inflation, which ran at 31% in 1988 as a result of monetary expansion and demand pressure on scarce resources, declined to 15% in 1989 in response to tight monetary and fiscal policies. C. Overall Performance of Past Adjustment Programs 17. The adjustment efforts to date have helped to improve fiscal and current account balances. Inflation is declining but remains above the international level, thus threatening to erode the competitiveness of Malawi's exports, about 852 of which are agricultural. Efficiency in the industrial sector, about two-thirds of which is agro-based, remains constrained by the fact that trade liberalization reforms have not been completed. The proposed Credit includes reforms to maintain the competitiveness of exports and to enhance efficiency in import-substitution industries. 18. Past adjustment efforts also helped to achieve modest growth in industry, estate agriculture, and among the relatively large smallholders. However, because of remaining structural constraints in agriculture, the most important sector of the economy, they have not succeeded in eliciting supply responses necessary to generate sustainable per capita incomes and sufficient foreign exchange resources to eliminate the need for balance of payments support. Land and labor productivity among the majority of smallholders has remained very low. As a result, nearly half of the population, made up mostly by these smallholders, lives below the level of absolute poverty. 19. The main causes of poverty are high population growth: low productivity of land and labor in agriculture; limited employment opportunities; and low quality of human capital due to low nutrition levels and limited access to education and health services. The Government and donors have initiated several targeted measures to alleviate poverty, including supplementary feeding programs for the vulnerable groups, free 6/ Macroeconomic data for 1988-89 based on second-year Policy Framework Paper.  - 7 - primary health services, and indirect transfer payments through fertilizer subsidies. The Government and donors, however, are aware that, given the high proportion of the poor, the problem of poverty can be addressed effectively and tn a sustainable manner only through growth; and that, to ensure effectiveness and sustainability, poverty reduction measures need to be integrated into the development process. The proposed Credit will support measures to improve land and labor productivity, thus reducing poverty through agricultural growth. PART II: COUNTRY ASSISTANCE STRATEGY AND BANK GROUP OPERATIONS A. The Government's Development Obiectives and Strategy 20. After the successive exogenous shocks of the 1980s, the Government places great emphasis on the restoration of domestic and external balances in its medium-term development strategy. The Government remains committed to maintaining a flexible exchange rate policy and import liberalization in order to promote efficient allocation of foreign exchange, stimulate exports, and ensure efficient import substitution activities. The Government's strategy also envisages a continuation of fiscal and monetary discipline to reduce inflationary pressures and ensure adequate credit expansion to the private sector, and to maintain a stable business environment and external competitiveness. The strategy also provides for a comprehensive reform of the tax system to improve the structure of incentives to investors, broaden the tax base, and allow for a reduction of the relatively high tax rate. 21. Growth is expected to be led by agriculture. The Government, therefore, places first priority on promoting agricultural growth. Its primary objectives for the agricultural sector are to ensure food security at the household and national levels, imnrove rural incomes, and increase export earnings while protecting the environment. The strategy to these ends places emphasis on increased production among smallholders while promoting efficient use of resources among estates. Accordingly, the strategy incorporates measures to ensure adequate producer incentives, promote the use of improved production inputs, and provide an efficient marketing system. With regard to estates, the strategy seeks to increase production by encouraging a higher rate of land utilization. Measures to protect the environment include increased fuelwood planting, better tobacco curing methods, and improved soil conservation. For industry, the strategy seeks to achieve production gains primarily from increased capacity utilization, facilitated by a more liberal access to foreign exchange resources. The country's growth prospects are considerably dependent on significant reduction of external transport costs. The Government's strategy includes efforts to develop the Northern Corridor routes and reopen the less costly route through Mozambique while continuing to improve internal transport infrastructure to facilitate rural and agricultural development.  - 8 - 22. In its Statement of Development Policies, 1987-1996, the Government now places greater emphasis than in the past on long-term objectives of developing human resources, alleviating poverty, and protecting the environment. It gives priority to increasing the productivity of assets available to the poor, mainly labor and land, and to reducing population growth. In addition to increasing agricultural productivity, the strategy envisages policies and investment measures tot (a) expand off-farm employment opportunities through promoting the informal sector, other labor-intensive enterprises, and agro-industries; (b) slow down the rate of population growth through child-spacing programs; (c) enhance the quality of human capital through improving access to education and health services; and (d) improve efficiency in the use of public resources. The donor community and the Bank support the above Government's strategy. B. Country Assistance Strategy Overall Strategy 23. The primary objective of the Bank's country assistance strategy is to provide effective support to the Government's effort in four critical areas: economic growth, sustainable long-term development, poverty alleviation, and macroeconomic management. The Bank's assistance strategy is designed to support the Government's program through both policy-based and pro,ect lending operations, and mobilization of the required external financing. Based on lessons learned from past operations, the Bank's strategy recognizes the need to: (a) continue to strengthen Government's capacity for policy formulation and implementation; (b) sharpen the focus of adjustment operations in order to center policy dialogue on a smaller, more manageable set of priority reform measures; (c) better integrate macroeconomic and sectoral policy reforms; and (d) improve the efficiency of the donor program through increased aid coordination. The Credit under consideration addresses constraints on the supply response in the agricultural sector in order to reduce poverty and attain stable growth. Agricultural Sector Strategy (Summary) 24. The strategy is spelled out more fully in paras 51-53. In summary, the strategy supports the Government's objectives described in para 21 above. It places emphasis on increasing the productivity of land and labor among resource-poor smallholders and female-headed households in order to improve food security and rural incomes. To achieve these objectives, the strategy aims at promoting policies and investments aimed at: (a) promoting the development of more appropriate technological packages; (b) expanding the use of fertilizers and access to credit; (c) improving the effectiveness of extension services; (d) expanding the range of cash crops; and (e) ensuring adequate producer prices and efficient output and input marketing system. It also seeks to increase efficiency of land use among estates and to conserve natural resources. Through operations to improve policies and strengthen institutional capacity and physical facilities, it addresses supply constraints on both smallholder and estate agriculture.  -9- Strategy for Other Sectors 25. Industry, Finance and Employment: While industry presently accounts for only a small share of GDP, it is significant to the efficiency of aggregate resource use; also, light industries have good growth and employment potential. Building oil reforms under ITPAC, the Bank will assist the Government to alleviate constraints on industry and labor- intensive activities through improving the capability of the financial sector in areas of capital mobilization and financial intermediation; promoting development of the informal sector and medium-sized industries by Malawian entrepreneurs; continuing trade reforms; and facilitating both domestic and foreign investments. To develop opportunities for off-farm employment and foster agricultural development, the Bank will continue supporting agro-industrial development through on-lending to the private sector. 26. Transport: The Bank strategy places emphasis on the development of external links; rehabilitation and maintenance of the internal transport system; and appropriate pricing policy for transport services. In these regards, the Bank will continue to support the development of transport facilities required for growth, with new investments restricted to high priorities. A forthcoming study of transport policy and financing issues will identify new policy measures to reduce constraints in both the domestic and external haulage sectors. 27. Housing, Water and Energy: In housing, the Bank strategy is to strengthen local government management capability and financing; broaden the role of the private sector and local authorities in urban housing construction; and make housing more widely affordable. In water, the Bank will continue to support expansion of the urban supply network as well as rehabilitation of rural boreholes, within a policy of adequate cost recovery. In energy, emphasis will be placed on least-cost power development options, cost-recovery in power and petroleum, and incentives to produce and conserve fuelvood. 28. Human Resource Development and Population: In education, the Bank strategy focuses on the primary and secondary school levels with a view to increasing efficiency in resource use and improving cost recovery; and on providing in-service training to middle and senior level officials in the public and private sectors. In health, emphasis is on primary care and preventive medicine, and maternal and child care services. A population study is currently being carried out. The Bank will continue to take an active position on population policy as an important part of the dialogue and lending program. It will continue to support concerted efforts aimed at expanding various informational and educational programs to popularize child-spacing, mobilizing social workers and civic leaders to motivate the public towards small family size, and integrating population planning into the development process. The Bank strategy supports measures to redirect public expenditures toward the social sectors.  - 10 - 29. Environmental Protection: The Bank has assisted the Government in developing a relatively strong institutional and policy framework to address the pressing environmental problems of land and forest degradation. The Bank strategy places emphasis on the development and dissemination of environmentally sound crop and livestock practices; promotion of social forestry and fuelwood plantations in fragile areas; improved charcoal production and tobacco curing techniques; and appropriate pricing policy for forestry resources. The rapidly growing population pressure on land remains the major cause of increasing environment degradation. Therefore, implementation of a comprehensive population program is critical to ensuring sustainable use of natural resources. Pending the formulation and implcmentation of such a population program, the Bank will continue to put high priority on investments and policies to increase crop yields. The Bank is developing an environmental strategy with the Government which will provide a medium-term investment and policy program for action by the Government and donors. In the future, under the Bank's leadership and with donor support, Malawi will develop a tropical forestry action plan. Malawi has also received an environmental technical grant which will be used to prepare a natural resource conservation project. Women in Development 30. Despite their central role in agriculture and off-farm employment, women account for a disproportionately high share of the food insecure households and the poor. The Bank has developed proposals for pilot schemes, to be started during 1990, to test a more appropriate extension approach to reach women farmers; and to deliver subsidized fertilizer, improved seed, and supplementary food targeted to the food-insecure families. The Bank strategy is to assist the Government in strengthening the institutional capacity for incorporating women's issues into the development planning process, orienting programs and projects to directly improve economic welfare among women, especially by relieving time constraints on women and expand income-generating activities to them. Poverty Alleviation 31. The CEM under preparation in FY90 focusses on poverty issues, with a view to developing a poverty reduction strategy, including the identification of: the poor and the major factors underlying the poverty situation; poverty alleviation policies that are consistent with growth and macroeconomic balance; and specific poverty-oriented investment strategies. A food security study is also under preparation and deals with chronic and transient food supply problems at both the national and household levels, and identifies ways to reduce malnutrition and strengthen food security. The actions recommended in the study will be supported in on-going and future projects. The majority of the poor in Malawi consist of smallholders with less than one hectare of land. The policy reforms under the proposed Credit include the main elements of the Bank's strategy in support of Government's efforts to alleviate poverty (para 116). Future operations in health, education, and water will emphasize expansion in service delivery to reach the poor while a planned agricultural services  - 11 - project will broaden orientation of these services to include the smaller smallholders. Public Sector Management 32. To assist Government in maximizing the effectiveness of buldget outlays in the tight fiscal environment, the Bank recently completed a Public Expenditure Review (PER) and an action plan was agreed with the Government to this end. The Bank will continue to support the Government in implementing the agreed action plan to ensure that the composition of expenditures reflects development priorities. To address implementation problems experienced under the three SALs, the Bank will place increased emphasis on projects and technical assistance to strengthen public sector management, particularly at the Ministry of Finance and the Economic Planning and Development Department; and on providing management training to the public and parastatal sectors. C. Bank Group Lending Operations Past and Ongoing Operations 33. Over the past 23 years, the Board has approved 53 projects for Malawi. These projects were financed by 49 IDA credits (totalling US$757 million, excluding cancellations); and 10 IBRD loans (totalling US$106 million, excluding cancellations), of which two were on third-window terms. The assistance (US$863 million) has been distributed as follows: US$255 million (30?) for structural adjustment; US$179 million (20Z) for agriculture; US$124 million (142) for education; US$127 million (152) for transport; US$85 million (10X) for energy; US$31 million (4Z) for water supply; US$18 million (2?) for health; and US$44 million (5?) for development finance, technical assistance, industry, urban housing, and institutional development. In FY89, the following credits were approved: US$18.3 million for the Agricultural Marketing and Estate Development Project, US$46.7 million for the Energy Project, and US$11.3 for the Institutional Development Project. In FY90, two credits were approved for eaucation (US$36.9 million) and infrastructure (US$28.8 million). IFC's equity participation and lending commitments total US$33 million (gross) and include investments in textiles, sugar, tourism, ethanol, plywood, a development finance corporation, and a leasing and financing corporation. In general, these operations have been implemented well. Disbursements of Bank loans and IDA credits have generally been satisfactory and compare favorably with other countries in the region and Bank-wide. A nLumber of projects, however, have experienced implementation problems, mainly due to fiscal constraints and, therefore, inadequate budgetary allocations especially for recurrent expenditures. Future Operations 34. The proposed Bank assistance for the period 1989/90-1993/94 totals about US$550 million. Of this, about one-third is intended for adjustment lending, including the proposed Credit. Of the non-adjustment lending,  - 12 - about one-third is intended for agriculture, one-third for human resources, and one-third to finance energy and infrastructure. D. Creditworthiness 35. In 1988, the Bank Group heid 51.9Z of Malawi's total outstanding medium- and long-term debt (including IBRD with 7.52), and accounted for 11.82 of Malawi's debt service. The IMF held 7.62 of total debt and accounted for 24.72 of total debt service. The predominance of Bank Group position is partly due to the fact that, during the late 1970s, many of Malawi's most active bilateral donors converted their outstanding loans to grants and have since made all of their aid to Malawi in the form of grants. The Bank Group's share of Malawi's debt is projected to rise to 59.1? in 1992 and 60.72 in 1995, while its share of debt service rises to 20.92 in 1992 and 25.82 in 1995. This level of Bank exposure is not expected to affect Malawi's creditworthiness fer borrowing on IDA terms. Malawi has always been punctual in its payments to the Bank Group and other creditors. E. Macroeconomic Projections and External Financing Requirements Macroeconomic Proiections 36. Malawi is characterized by an extremely low income base and potential GDP growth will continue to be limited by the external transport and internal resource constraints. However, implementation of the strategy formulated by the Government in 1987 is expected to generate substantial production gains from the estate and smaliholder agricultural sector, as well as from services and manufacturing. GDP is envisaged to grow by an annual average of: 42 in 1989-1991, assuming industrial capacity utilization returns to the early-1980s level as a result of the import liberalization program, and estate agriculture expands with greater access to credit; 4.5Z in 1992-1993, when smallholder agriculture would begin to rebound as a result of the measures to improve fertilizer availability under the proposed Credit and the cumulative impact of the ongoing credit, extension and research programs; and by about 5.02 in 1994-1995, when most of the measures under the proposed Credit would begin to have major impact among smallholders and estates, and macroeconomic policy reforms and sectoral investments mature and feed into sustained development (Annex 1, page 3) 7/. 37. These growth targets depend on a large transitional increase in imports following the severe import compression experienced throughout the 19809. In agriculture, the emphasis on smallholder productivity implies large increases in fertilizer imports. In industry, firms are expected to exert a large demand for imports in 1989-92 to rebuild stocks and make up for deferred maintenance and investment in line with the ongoing trade 7/ Macroeconomic projections are based on the second-year Policy Framework Paper.  - 13 - liberalization program. The demand for imports is projected to grow by an annual average of about 5.3Z in 1990-91, by 4.42 in 1991-92, and by 3.7Z thereafter. Exports are expected to increase by 5.4Z p.a in the 1990-92 period as a result of improved competitiveness and increased smallholder tobacco prices (paras 59 and 65); and by 4.4? thereafter as a result of increased export production by estates, following the proposed establishment of estate extension services (para 86), and increased manufactured exports following the completion of the import liberalization program (para 59). As a result of the strong import demand, the current account is expected to deteriorate from 8.4Z of GDP in 1989 to 9.9? in 1990, before improving to 6.9Z in 1992 and to 5.3? in 1995. Over the medium-term, as the basic consumption requirements of the majority of the population are met, domestic savings and exports should increase significantly. During the transitional period, the country would continue to rely significantly on the donor community to provide foreign resources to supplement domestic savings. External Financing Requirements 38. Malawi's financing requirement amounts to a total of $912 million in the 1989-92 period, including current account deficits of $554 million, principal repayments (including IMF repurchases) of $298 million, and reserve increases of $60 million. It is expected that disbursements from project financing would provide $476 million, disbursements from adjustment financing would provide $354 million, IMF purchases would provide $63 million, and debt rescheduling would provide $19 million. Disbursements for adjustment financing would come from commitments under ITPAC ($79 million in IDA credit and $108 million in parallel and co- financing arrangements) and ASAC ($70 million in IDA credit and $100 million in co-financing). The debt service ratio is expected to improve significantly, from 442 of exports in 1988 to 20? in 1993 as a result of the increased share of concessional financing in external flows. F. Aid Coordination 39. Malawi's economic reform program will continue to require substantial amounts of external financing. Consequently, a key aspect of the Bank's assistance strategy is to help the country to mobilize external financing. Over the past year, the Government has begun to take a more active role in aid coordination, including strengthening the external assistance section of the Ministry of Finance. However, the government capacity in this regard is still weak and needs substantial strengthening in order to establish mechanisms for effectively coordinating external assistance, which at present is donor driven. The Bank will continue to assist the Government's efforts in aid coordination, using formal channels such as Consultative Group meetings as well as informal channels, including the meetings-periodically convened by donors represented in Malawi. It is also important that the donor community understand and support the overall objectives and strategy of the reform program, and align their assistance to it in a coherent manner. Accordingly, the Bank will continue to collaborate closely with donors in the preparation and financing of  - 14 - adjustment and investment lending operations. In this regard, the donor community has been kept well informed about the proposed Credit at all stages, and prospective co-financiers were invited to participate in negotiations. G. Collaboration with IMF 40. Bank and Fund staff have worked closely in reviewing macroeconomic and sectoral issues, and in preparing the PFP, ESAF, and the proposed Credit. The PFP provides the macroeconomic policies underlying the thrust of the proposed Credit. Several of the issues to be addressed by the Credit have significant bearing on the reforms being pursued under the Fund's ESAF. The Bank has, therefore, kept the IMF fully informed of the discussions with the Government during preparatiorn and appraisal of the proposed Credit. More specifically, the Bank has reviewed with the IMF the budgetary implications arising from the financing of ADMARC's development- oriented activities, agricultural price policy, fertilizer subsidies, and financing arrangements for the Smallholder Farmers Fertilizer Revolving Fund of Malawi (SFFRFM). This collaboration will be continued during the implementation of the proposed Credit. PART IIIt THE AGRICULTURAL SECTOR A. Salient Features 41. Agriculture is the backbone of Malawi's economy. It accounts for about 401 of GDP, 85S of exports and employment, and provides inputs for about two-thirds of the manufacturing sector, while the handling of agricultural produce and inputs dominates commercial and distribution sectors. The country's arable land is about 2.4 million ha, most of which is already under use. Except for the Northern Region, where about 351 of the arable land is still unutilized, there is little arable land available for agricultural expansion 8/. In the Southern Region, the cultivated area is already larger than the arable area, meaning that more land is being farmed than what is arable on a long-term basis. In the Central Region, the unused land (10-15Z) is considered to be generally of very low potential. Maize is by far the most important crop in terms of cultivated area, number of growers, and food security. The other major food crops are groundnuts, pulses, cassava, and rice. Exports are dominated by three crops: tobacco, which accounts for nearly 501 of total exports; tea, 25Z; and sugar, 102. Production is predominately under rainfed conditions, with only a few irrigation schemes (for rice and sugarcane) which amount to about 1.41 of the area cropped annually. 8/ Malawi is divided into three administrative regions: Northern, Central, and Southern regions.  - 15 - 42. Malawi's agriculture is characterized by two distinct farming systems: the smallholder system and the estate system. The smallholder system accounts for about 80? of food production and 102 of exports. It involves about 1.3 million families operating under customary tenure on 1.75 million ha. About 55? of the households cultivate less than 1.0 ha, 312 between 1-2 ha, and 14% above 2 ha. The arable land available per capita varies considerably among the three administrative regions: about 0.48 ha in the Southern Region, 0.72 ha in the Central Region, and 1.3 ha in the Northern Region. Maize covers 75Z of the cropped area; due to unavailability of varieties acceptable to most of the smallholders, only a small proportion of the area is planted with high-yielding varieties. Other principal major smallholder crops are groundnuts, fire-cured tobacco, cassava, cotton, rice, and various legumes. The majority of the households produce primarily for subsistence, using simple hand tools and little or no inputs, thus leading to very low yields at an average of 900 kg/ha for maize. 43. The estate system comprises about 8,500 farms, and accounts for about 20? of total agricultural production and 90Z of exports, consisting mostly of flue-cured and burley tobacco, tea, and sugar. This system occupies about 605,000 ha. Estates vary widely in size, falling between 10-50 ha for the relatively new tobacco estates, 600-1,000 ha for the tea estates and over 7,000 ha for the two sugar estates. Tobacco is the main estate crop, occupying about 60? of the cropped area, while tea occupies about 20% and sugar cane 18?; the balance is taken up by coffee and macadamia nuts. In general, the estates use a much higher level of technology and achieve higher yields compared to smallholders. However, most of the estates regularly use only about 142 of the land available to them. B. Sectoral Performance 44. As a result of structural constraints (para 47), the performance of the agricultural sector has been poor relative to the objectives outlined in para 21 above. After growing at an annual average of about 4.9Z p.a. in real terms during the 1970s, agricultural growth slowed down to an average of 1.02 in 1980-84, recovering only to an average of 2.5Z in 1985-88, far below the rate of population growth. Compared to the 1973-79 period, the production of the main smallholder export crops declined significantly during the 1982-88 period: tobacco production fell from an annual average of 16,000 tons to 13,400 tons, groundnuts from 29,700 to 24,000 tons, and cotton from 24,000 tons to 21,400 tons. Efforts to diversify estate exports have met with little success. As a result, the composition of Malawi's agricultural exports remains very much as it was in the early 1970s. 45. Past adjustment programs have achieved little for the 55? of smallholders cultivating less than 1.0 ha, mainly because the severe shortage of land and low crop yields preclude the availability of marketable surpluses. For these farmers, price and marketing reforms, which have been the focus of past adjustment program, are of little  - 16 - relevance in production decisions. The rest of smallholders able to respond to better prices and marketing services have generally only expanded some crops at the expense of others, with little incre&se in aggregate output. Moreover, the per capita production of n.aize, the staple food grain, has remained about 20Z below the population's nutritional needs and is estimated to have declined from 193 kg in 1983/84 to 185 kg in 1988/89. The per capita income of 557 of smallholders is below the level of absolute poverty. The result is widespread and serious malnutrition. 46. Some progress has been made with regard to the conservation of natural zesources mainly through the use of ridges in cultivated areas and afforestation programs. Environmental degradation is a threat, however, because of the failure to arrest the rapid population growth, which has led to a correspondingly rapid decline in the land-man ratio while crop yields remain stagnant. The need to increase food production has thus necessitated reduction of fallow periods and expansion of the cultivated area into woodlands and steep hillsides which are susceptible to erosion. The rapidly growing demand for fuelwood and building materials has accelerated deforestation and denudation of watersheds. The situation has been exacerbated by the heavy demand placed on forest resources by tobacco curing and the failure to enforce the policy requiring estates to establish woodlots. The Government, the Bank, and other donors are concerned about the degradation of the environment and have intensified their efforts to address the problem (para 29). C. Main Constraints and Prospects Constraints 47. The past adjustment reforms in agriculture were confined to pricing and marketing policy changes (paras 7, 13, 14). These reforms did not, therefore, directly address policies bearing on structural constraints. For smallholder agriculture, land is the fundamental constraint. This constraint has been exacerbated by inappropriate policies which have resulted in: (a) a lack of appropriate high-yielding maize varieties; (b) inadequate supply and use of fertilizers; (c) a narrow range of high-value cash crops; and (d) progressive reduction of the available total land area. The lack of appropriate high-yielding maize varieties is due to the fact that the research policy has focussed on the deveiopment of varieties which the majority of the smallholders find unacceptable to grow because of unfavorable storage and processing characteristics (paras 82- 84). The inadequate supply and use of fertilizers is largely due to inappropriate policies on the financial management and funding of the Smallholder Farmers Fertilizer Revolving Fund of Malawi (para 77); packaging of fertilizers in inappropriate sizes (para 97); and limited access to credit. Limited access to credit is partly the result of institutional arrangements aimed at channelling credit through joint- liability farmer clubs which, to minimize default rates among their members, restrict membership to the relatively better off farmers. The recently approved Smallholder Credit Project is supporting efforts to address this problem; the proposed Credit will reinforce these efforts  - 17 - (para 97). The narrow range of high-value cash crops is partly due to the policy restricting the growing of burley tobacco by smallholders (para 87- 88). The progressive reduction of the available total land area is due to the policy of transferring land from smallholder areas to estates (para 89). Other important constraints include inadequate budget allocations, especially for recurrent expenditures to provide logistic support to extension and research staff (para 94-95); and poor transport infrastructure. 48. For estate agriculture, the main factors inhibiting increased production are inadequate access to credit for farm development and working capital (para 86), and policies which have prevented the establishment of technical advisory services needed by the relatively new estate owners (para 85-86). Moreover, the level of land utilization has remained low due to policies which have resulted in a low level of land lease rent, poor payment of due rents, and long intervals before the rents can be legally adjusted (paras 90-92). 49. Internal transport is also a major constraint on smallholder agriculture while external transport is a serious constraint to both smallholder and estate sub-sectors. In rural areas, many localities lack proper access roads, the general standard of roads is poor due to inadequate rehabilitation and maintenance, the number of transport vehicles is insufficient, and the existing fleet is poorly maintained. These factors have led to high domestic marketing costs and have restricted the role of the private sector (para 66). The closure of the route through Mozambique has resulted in considerable increase in the cost of imported inputs, including fertilizers and agro-chemicals, and has reduced the profitability of ag-icultural exports. The Bank, through several highway and transport projects, has been assisting the Government to alleviate these constraint (Annex 2). Prospects 50. Despite the severe land constraint, Malawi's agriculture has a considerable scope for achieving the supply response necessary for an adjustment process which leads to sustainable growth and at the same time alleviates poverty. This scope is reflected by the fact that, out of 1.14 million ha planted to maize in 1988, only 105,000 ha were under improved maize varieties, only about 351 of the maize crop was fertilized, and fertilizer application rate was about one-half of the recommended dosage. Overall, the use of fertilizers is very low at 11 kg/ha compared to, for example, 42 kg/ha in Kenya. The potential for increasing crop yields exists especially for the 48? of the total arable land in the hands of smallholders cultivating less than 1.5 ha and who at present use little or no itputs. Application of fertilizers on local maize variety in the area at present devoted to this variety would result in incremental maize production of about 320,000 tons per year, which is equal to the minimum requirement for about 1.5 million people. Replacement of local maize with high-yielding flint maize would result in substantially higher production. There is also considerable scope for increasing producticn through policy  - 18 - changes to encourage greater and more efficient utilization of estate lands. D. Agricultural Sector Assistance Strategy 51. IDA's strategy supports the Government's efforts to increase land and labor productivity in smallholder and estate agriculture. For smallholder agriculture, the strategy focusses on shifting research policy to develop high-yielding maize varieties that can be properly stored and processed by traditional techniques, improving the effectiveness of extension services through strengthening physical facilities and introducing better extension methodology, expanding the use of fertilizers, and conserving natural resources. Another research priority is to continue the development of groundnut varieties which are high-yielding and disease resistance, with improved export quality. Once appropriate maize and groundnut packages are developed, research will shift to high value crops including horticultural products. The strategy seeks to expand the use of fertilizers through improved access to credit, targeted fertilizer subsidies, increased supply of fertilizers, and the development of a multi- channel distribution system. The strategy envisages improved producer prices and expansion of cash crops to enable smallholders to generate cash for inputs and food. It also envisages continued reforms in marketing, including increased reliance on private traders and market-determined prices. ADMARC is expected to increasingly focus on price stabilization, food security, and development-oriented functions as the private sector assumes responsibility for commercial market operations. For estates, the strategy seeks to promote increased productivity and land utilization through the establishment of estate extension services, increased access to medium-term credit, and an appropriate lease rent policy. For the environment, the strategy includes measures to ensure adequate incentives for reafforestation, economic fees for wood extraction, and effective soil conservation practices. 52. The ongoing projects are designed to support this strategy. These projects include the recently approved Smallholder Credit, and Agricultural Marketing and Estate Development; and the ongoing Wood Energy II, NRDP IV, Agricultural Research, and Extension and Planning. The proposed Credit will complement these projects by supporting appropriate macroeconomic and sectoral policies to remove the main structural constraints in both smallholder and estate agriculture. Measures to ensure appropriate technology will be supplemented by further marketing and agro-processing development and continued strengthening of extension and credit services. To this end, future lending operations will include projects to support smallholder research, extension, credit, processing and marketing services; and to carry further sectoral policy reforms initiated under the proposed operation as may be necessary. Environmental objectives will be supported through the development of a long-term environmental action plan, preparation of a tropical forestry action plan, and integration of soil conservation measures into farming systems. 53. Recently completed sector work includes NRDP Technical Review, Food Security Study, and an Irrigation Sub-sector Review. Future sector  - 19 - work will include an agricultural sector survey. The above strategy will enable most of the smallholders to achieve improved incomes and enhanced food security through greater and susta ned increases in food and cash crop production. At the same time, estates will continue to produce exports, with some diversification into tree crops and hort.icultural products, and provide expanded employment opportunities. PART IV: THE AGRICULTURAL SECTOR ADJUSTMENT PROGRAM A. Overall Obiectives and ExRected Outcomes Overall Obiectives 54. The agricultural sector adjustment program to be supported by the proposed Credit is an integral part of the Government's medium-term strategy set out in the Statement of Development Policies and the Government's ongoing stabilization and structural adjustment program for the period 1988-91. The agricultural sector adjustment program is detailed in the Letter of Development Policy (Annex 5) and summarized in the policy action matrix (Annex 6). 55. The primary objectives of the program are to achieve sustainable growth and to reduce poverty and food insecurity. To achieve these objectives, the program will continue and expand ongoing reforms to maintain appropriate macroeconomic policies with a view to, inter alia, ensuring the competitiveness of exports, and enhancing efficiency in import-substitution enterprises and in the use of public resources. It will also continue and expand ongoing agricultural policy reforms to ensure adequate producer incentives and efficient marketing services for smallholders, and to improve ADMARC's capability to carry out the functions of a price stabilization agency. The program will include new policy initiatives to alleviate the structural constraints, described in paras 47 and 48 above, which have continued to depress land and labor productivity and to inhibit supply response in both smallholder and estate agriculture. To these ends, the envisaged reforms comprise measures to: (a) continue the flexible exchange rate and restrained monetary and fiscal policies; improve export incentives; and complete the final stages of trade liberalization; (b) focus the Public Sector Investment Program (including agricultural expenditures) on areas of high priority and returns; (c) improve crop pricing and marketing policies through expanding the role of the private sector; (d) improve fertilizer availability and use among smallholders, and enhance efficiency in the fertilizer distribution system;  - 20 - (e) rationalize ADMARC's financing to enable it to play the role as a price stabilization agency more effectively; (f) shift the research policy and budget to develop hybrid flint maize varieties that are high-yielding and acceptable to most of the smallholders; (g) allow smallholders to grow high-value cash crops, especially burley tobacco; (h) halt . transfer of land from smallholder areas to estates, and increase the efficiency of land use among estates through adjusting land lease rents and establishing estate extension services; (i) review and restructure agricultural expenditures to ensure cost-effectiveness and consistency with sectoral priorities; (j) initiate pilot schemes to develop ways of targeting fertilizer subsidies and credit to the poor; and (k) strengthen the Government's capability to monitor and redress impact of the adjustment program on the poor. Expected Outcomes 56. All of the envisaged major policy changes will be implemented during the period of the proposed Credit. However, in common with most policy reforms aimed at addressing structural constraints such as those facing Malawi's agriculture, the impact of these changes will only become substantial over the medium-term. Apart from the efficiency and production gains described in paras 111-114 below, the program to be supported by the proposed Credit is expected to bring about four major structural changes. First, measures to develop high-yielding flint maize and to expand the range of high-value cash crops will raise the production possibility frontier for smallholders. Second, measures to improve fertilizer availability and use, together with high-yielding maize varieties, will help to release land from food to cash crops. This will strengthen the balance of payments through availability of land to increase export crops. Third, measures to halt the transfer of land from smallholder areas to estates and to adjust estate land lease rents, together with allowing smallholders to grow burley tobacco, will begin to redress the agricultural development process in favor of smallholders. The past growth of estates has been based largely on low land lease rents and the fact that only estates could grow burley tobacco. The envisaged adjustment of rents and measures to allow smallholders to grow burley tobacco have the potential to reverse land transfer in favor of smallholders. The reverse in land transfer would occur as some estates respond to these measures by sub- letting or surrendering to smallholders some of the land that estates cannot use profitably. Fourth, availability of high-yielding maize which most of the smallholders will find appropriate to grow, coupled with measures to target income generating activates to the poor, is expected to  - 21 - start integrating the majority of smallholders into the development process and monetary economy. The incomes of the poor would increase due to not only enhanced own-production of food and export crops but also expanded employment from more intensive estate land use and other opportunities linked to a growing rural cash economy. 57. The program is also expected to bring about other important changes. Expansion of the role of the private sector in output and input marketing is expected to enable ADMARC to increasingly focus on price stabilization and the management of the strategic grain reserve. The rationalization of the financing of ADMARC's functions related to the Government's development and food security objectives are expected to improve its effectiveness as a price stabilizing agency and to give greater transparency to the involved costs. Measures to allow farmer clubs or their agents to buy and sell fertilizers are expected to create a cadre of private traders which would expand rapidly when fertilizer subsidies are eliminated or effective ways to target them are developed. Restructuring of agricultural expenditures is expected to enhance the effectiveness of agricultural support services. Finally, the program is expected to have a considerable impact on slowing down the degradation of the environment through increased maize yields and expanded use of fertilizers, thus minimizing the need to expand the cultivated areas into hillsides and woodlands. 58. The proposed operation will also support several studies. Two studies, one on tobacco and the other on cotton, are expected to provide a basis for introducing participation by the private sector in tobacco and seed cotton marketing. A third study will provide a basis for differentiating estate land lease rents; and a fourth study will identify ways to strengthen the management of SFFRFM. Another set of studies will help to assess the poverty impact of the adjustment program. Some of the findings and recommendations of these studies are expected to be implemented under future operation. Also, further actions on some of the policy changes under the proposed Credit will need to be taken under future operations. Such further actions relate to eliminating fertilizer subsidies; completing liberalization of the marketing of smallholder crops and inputs, notably fertilizers; and expanding the targeting of credit and other income generating activities among the poor, depending on the outcome of the proposed pilot scheme. B. Continuation and Expansion of Macroeconomic Policies 59. The Government has already taken major actions to ensure an appropriate macroeconomic policy framework and to liberalize trade (para 15). To maintain the competitiveness of exports and promote efficient import substitution, the Government will continue a flexible exchange rate policy; and carry further the trade liberalization reforms initiated under ITPAC, including elimination of prior approval of foreign exchange for imports except for a small negative list of selected items consisting primarily of luxury goods. The Government will also introduce a more effective duty drawback system to help improve the competitiveness of  - 22 - exports, and a surtax credit system to exempt payment of surtax on imports, including spare parts and capital goods. Furthermore, the Government will review the existing tariff structure for imports, develop tariff reforms and initiate their implementation. 60. The flexible exchange rate policy will be comp'emented with, and integrated into restrained monetary and fiscal policies, with a view to stabilizing domestic prices and external balances. The fiscal policy will be aimed at limiting the overall budget deficit (before grants) of the Central Government to a level that can be financed almost entirely by the available foreign concessional loans and grants, consistent with the program's domestic and balance of payments objectives. 61. Monetary and credit policy will aim at maintaining tight control on money supply, while ensuring availability of credit to the productive sectors. The Government has already set in place a framework for improved monetary management (para 15). The Government will implement these reforms in a phased manner with a view to establishing a system wherein restrained monetary policy is managed through controlling reserve money in an environment of flexible interest rates. 62. To maximize the benefits of public expenditures in the tight fiscal environment, the Government has adopted an action plan to strengthen and improve the budgetary allocation process. To this end, the Government will implement a number of measures, including development of proposals that would facilitate the shifting of donor financing towards recurrent development expenditures in key sectors, reactivation of the forward budget, and improvement in sectoral budget planning to enhance consistency with sectoral priorities. The Government has reviewed with the World Bank priorities for the Public Sector Investment Program (PSIP) for the period 1989/90-1991/92, and will undertake a more detailed review of agricultural expenditures (para 95). Through annual reviews, the Government will ensure that the PSIP remains consistent with priorities and available resources, that infrastructural investments with low economic raturns are excluded, that individual projects are evaluated in terms of their contribution to economic gro-wth and income distribution, and that implications for recurrent costs and the balance of payments are fully taken into account. The Government will also take action to reduce and eventually eliminate fertilizer subsidies after a transitional period (paras 72-73). C. Product Pricing and Marketing Policies Pricing Policies 63. The Government continues to set producer prices for all the major smallholder crops and consumer prices for maize. Since 1987, however, only tobacco and cotton prices are controlled in the sense that the official prices are also the effective purchase prices. For all other crops, actual prices may vary according to supply and demand within the limits set by the official prices. A major focus of the reforms initiated under the first SAL in 1981 has been to ensure adequate prcducer incentives for smallholder  - 23 - crops. Since 1981, the Government has continued to review annually the price of smallholder crops, using a price-setting methodology developed with IDA assistance, and to submit the recommendations of the review to IDA for comments before prices are announced. In the past, however, the price review reports have usually been submitted to IDA only a few days before prices are announced, thus allowing little time for considering IDA comments. Under the proposed Credit, the Government will in future submit the recommendations of the review to the IDA for comments at least 21 days before prices are announced. 64. The Government's policy has been to align producer prices with border-price equivalents, except for maize and tobacco. Because of high transport costs and low value relative to volume, maize is treated as a non-tradable commodity. The price policy for maize is, therefore, aimed at equating domestic supply and demand. Tobacco producer prices have been generally kept substantially below export-parity, reflecting ADMARC's long- standing policy to generate surpluses from tobacco to offset losses in its other crop trading accounts and to finance its functions related to regional development and food security objectives. In 1988, producer prices for smallholder tobacco had fallen to about 29? of the export parity prices as realized through the local tobacco auction. Low producer prices have been one of the factors contributing to the decline in smallholder tobacco production. 65. Under the proposed Credit, the Government will take steps to ensure that smallholder tobacco prices are brought in line with the border- price equivalents by implementing a two-payment price system. A recent review of ADMARC indicated that ADMARC could pay a pre-planting price of about 452 of the expected auction prices without risking over-payment relative to auction prices. Accordingly, the Government will implement a two-payment system for smallholder tobacco, with the pre-planting price set at levels at least equal to 45? of a three-year moving average of auction prices, and a second payment made at the end of the marketing season to reflect actual auction prices, less ADMARC's marketing costs. The Government will also ensure that domestic prices for the other commodities marketed by ADMARC, notably groundnuts and cotton, will reflect border- price equivalents with a view to, inter alia, enabling ADMARC to at least balance its individual crop trading accounts on average over a period of three years. Crop Marketing Policies 66. Maizez Past adjustment efforts have resulted in an expanded role for the private sector in maize marketing. However, the private sector continues to be constrained by several factors. First, the margin of 141 now offered by ADMARC as the spread with which traders operate in maize marketing is inadequate to cover trading costs except in the Southern Region and around the main consuming areas in the Central Region. Second, rural Malawi suffers from a scarcity of transport services as a result of an undeveloped rural road system and shortage of vehicles. This constraint is exacerbated by the limited number of receiving markets at which traders can sell maize to ADMARC, especially in the Northern Region; as a result,  - 24 - traders have to transport maize over long distances thus precluding the use of ox carts and wagons. Third, most of the traders lack sufficient funds to finance fixed assets and working capital. Fourth, many of the traders have little skills in carrying out agricultural marketing as a major occupation. Fifth, traders lack proper storage facilities, particularly for the marketed type of maize (the hybrid dent variety) which cannot be properly stored using traditional techniques. Under the ongoing Agricultural Marketing and Estate Development Project, the Government is taking actions to provide credit to rural traders for vehicles, storage facilities, and working capital; to train these traders in agricultural marketing; and to construct storage facilities for hiring out to the private sector. Under the proposed Credit, the Government will take further actions to expand the role of the private sector through: (a) increasing the number of receiving markets, with emphasis oIn t.be Northerrn Region, to 35; and (b) increasing the margin offered by ADMARC at these markets from 142 to at least 2OZ. 67. Tobacco: Tobacco is sold through an auction system. As a result of the proposed Credit, smallholders will be allowed to grow burley tobacco, which accounts for about 65Z of tobacco exports, thus increasing the impact of smallholders on exports. Malawi has expanded its share in the world tobacco market primarily through maintaining high quality standards. In view of the critical importance of tobacco in export earnings, it is essential that the development of smallholder tobacco proceeds in a manner that maintains high quality standards and minimizes marketing costs. Partly because tobacco produces over 50 grades which need specialized services for assembling, grading, and storing, smallholders are required to market their tobacco exclusively through ADMARC. Under the Credit, a comprehensive study will be carried out to assess the feasibility of alternative channels for marketing smallholder tobacco. The study will, inter alia, evaluate the feasibility of farmers organizing themselves to hire the required specialized services and to market tobacco directly, or through private traders, to the auction system (para 88). 68. Seed Cotton: At present, smallholders sell their cotton to ADMARC which then passes it on to privately owned ginneries to be ginned for a fee. These fees are high because of inefficiencies due to excess ginning capacity, sub-optimal location of ginneries relative to production areas, and a monopsonistic position of the ginneries. Because of high production costs, Malawi is no longer able to export lint profitably and the primary objective is to supply lint to the only local textile mill, with the export market viewed as a residual outlet. The textile mill is privately owned and holds a monopsonistic position. The domestic price structure down to the farm level is determined by what the textile mill is willing to pay for lint and, although the available data suggest that, at the present-costs, cotton is essentially an import-substitution crop, the price the mill offers is related to export prices. The Government plans to allow the private sector to participate in seed cotton marketing. However, the Government is concerned that participation by the private sector will not result in the right price signals to farmers, given the sub-optimal location of the ginneries and monopsonistic position of the ginneries and textile mill. The Government will, therefore, carry out a study to design  25 - a strategy to, inter alia, allow participation by the private sector in the marketing of seed cotton. D. Input Pricing and Marketing Policies Fertilizer Pricing Policy 69. Justification for Fertilizer Subsidies at Smallholder Level: A major objective of the Government fertilizer pricing policy has been to encourage smallholders growing local maize to increase the use of fertilizers. With current subsidies, it is profitable to apply fertilizers to local maize varieties. Without fe:tilizer subsidies, incremental financiai returns would fall from K13.7/ha to minus K 22.5/ha for fertilized local maize compared to unfertilized l3cal maize (Table 1). On the other hand, the use of fertilizers would result in substantial net incremental economic retutns at K47.1/ha (Table 2). The production of a ton of the local maize variety with fertilizers is estimated to involve an incremental foreign exchange savings of about K254.7, reflecting the difference between the cost of fertilizer imports and maize imports. Table 1. Financial Costs and Benefits For One Hectare Local Maize Varieties Unfertili?rd Fertilized 1/ With Subsidy No Subsidy Yields: ton 0.80 1.26 1.26 Gross Value:K 207.3 828.9 828.9 Production Costs:K Seds ----- ----- Fertilizers ----- 102.9 189.1 Labor ----- ------ ----- Total costs ----- 102.9 189.1 Not Returns (Losses) 207.3 221.0 184.8 Inremental Returns (Losses)j 0.0 13.7 (22.6) I/ Fertilizer inputs at about 68.6 kg of nutrionts/ha. / Means the difference between net returns from unfertilized and fertilized maize 70. Justification of Fertilizer Subsidies at the National Level: When valued at its border-price equivalent, the incremental production (135,000 tons) from the 300,000 ha of local maize which is currently fertilized has a net incremental economic value of about K14.1 million and if this production had to be imported, Malawi would use about K34.4 million in foreign exchange over and above the amount of foreign exchange involved in domestic production. This compares favorably with the amount of subsidies needed to induce these gains, which is about K10.8 million.  - 26 - Table 2. Economic Costs and Benefits For One Hectare of Local Maize Varietles Unfertilized Fertilized 1/ With Subsidy No Subsidy Yields: ton 0.860 1.26 1.25 Grove Volue:K ;L 428.8 688.1 668.1 Production Costs:K S ods 2/ 18.8 18.8 18.8 Fortlz4ers 8 ----- 189.1 189.1 Cost of Funds 4/ ----- 28.8 28.6 Labor !/ 100.0 180.0 180.0 Total cost* iT la611an Net Returo, (Looses) 208.8 818.1 810.1 Increental Returns (Losses) 0.0 47.1 47.1 V7FUitTTT P_at about 659. kg of nutrients/ha. V Maize valued at Import parity price at about K688/ton from Zimbabwe; foreign exchange velued at otficlal exchange rate; 8/ Valued at import parity prices; 4/ Reflecting forgone returns, at market Interest rate, on funds used on fertilizers; b/ 100 man-days for unfertilized and 120 man-days for fertilized maize at K1.50/man-day shadow wage rate. 71. Another reason for not removing fertilizer subsidies immediately is that they are essentially indirect consumer subsidies which are necessitated by poverty among most of the population, including half of the smallholders who are net buyers of maize. In view of the severity of poverty in the country, it is not feasible to pass on to consumers the higher maize prices which would be needed, under present input costs and levels of technology, to maintain sufficient producer incentives in the absence of fertilizer subsidies. It has been estimated that, without fertilizer subsidies, consumer prices would need to be cumulatively increased by about 902 during the next two years to maintain adequate producer incentives for the local maize variety. Increases of this magnitude would lead to considerable hardship, especially among urban dwellers and among most of the smallholders who have to buy maize to meet the basic nutritional requirements. The alternative to address poverty and food security concerns through direct consumer subsidies may be more costly than the present fertilizer subsidies, particularly as it may induce farmers to sell a larger proportion of maize, including maize produced without fertilizers, and buy it back at the subsidized price. Nonetheless, this alternative will be evaluated as a part of the proposed studies relating to poverty issues (para 98). 72. The Phasing Out of Subsidies. The Government is committed to the eventual elimination of fertilizer subsidies once it becomes possible to do so without risking a fall in maize production and deterioration of household food security. The present extremely high external transport costs are temporary and are expected to decline significantly once the Northern Transport Corridor project is completed in 1992 and the Nacala line through Mozambique is fully operational. Furthermore, the  - 27 - introduction of a high-yielding flint maize variety would improve fertilizer response and reduce production costs substantially. These two events will, over the medium-term, remove the need for production-related subsidies. Therefore, subsidies could be eventually phased out but continuation of subsidies during a transitional period will be necessary to support smallholder productivity and food security objectives. 73. During the transitional period, the Government plans to keep fertilizer subsidies at a level which, given the projected increase in fertilizer use and prices and free fertilizers from donors, will: (a) maintain producer incentives for local maize at least equal to the present level without having to raise maize consumer prices in real terms by an annual average of more than 1OZ; and (b) maintain the total amount of financial subsidies at no more than 2% of the projected total Government expenditures, a level which is considered unlikely to exert a significant pressure on budgetary resources. Accordingly, under the proposed Credit, the Government will ensure that the rate of economic subsidy will not exceed 30S in 1990/91, 252 in 1991/92, and 200 in 1992/93; and that the total amount of subsidy subventions will not, as a proportion of total Government expenditures, exceed 2.02 in 1990/91, 1.62 in 1991/92, and 1.3Z in 1992/93. 74. To maintain producer incentives for local maize at the present level, the above rates of economic subsidy imply an increase in consumer prices at an annual average of 9.31 in real terms during 1990/91-1992/93. The subsidy amount will be accommodated within the overall expenditure targets as projected in the second-year PFP. This is feasible given the reduced interest expenditures resulting from a higher proportion of concessional external resources; increases in total expenditures as a proportion of GDP in accordance with PFP's projections; and, if necessary, a reduction in lower priority expenditures relating to agriculture. Fertilizer Marketing Policies 75. Fertilizer Distribution: Malawi continues to rely exclusively on the Smallholder Farmers Fertilizer Revolving Fund of Malawi (SFFRFM) for importation of fertilizers for smallholders and on ADMARC for their distribution. The main factor preventing introduction of private traders has been the leakage of subsidies to estates; these leakages are at present estimated at 25Z-30Z of total fertilizer sales to smallholders. The Government appreciates the efficiency gains which may accrue from a multi- channel fertilizer distribution system but is concerned that, while subsidies remain, complete liberalization would exacerbate the diversion of subsidized fertilizers from smallholders to estates. As a first step towards complete liberalization of fertilizer distribution trade, the Government will, under the proposed Credit, take actions to facilitate private sector's participation within a system that safeguards against worsening the leakage of subsidized fertilizers to estates. To this end, the Government will: (a) differentiate fertilizer prices to provide a margin of at least 5? for a minimum amount of 200 kg purchased at ADMARC's  - 28 - 35 receiving markets; 9/ (b) allow bona fide groups of smallholders, including the existing farmer clubs, their appointed buying agents, or agents appointed by ADMARC to buy fertilizers from ADMARC's receiving markets at the differentiated price. 76. Fertilizer Supplies: To improve fertilizer procurement, SFFRF was recently reconstituted into a legally independent body (a trust) to give it greater flexibility to operate on commercial principles. Arrangements were also recently made, with assistance from the EEC, to establish a fertilizer buffer stock amounting to about 90,000 tons or 90Z of the requirements in 1989. The primary purpose of the buffer stock is to improve timeliness of fertilizer availability while actions are under way to procure regular Imports; to reduce costs by scheduling the procurement of regular imports in a manner that takes full advantage of changing world prices and transport bottlenecks; and to allow for disruption of external routes. However, lack of guidelines for the management of the buffer stock is already threatenting to undermine realization of its potential benefits, particularly as the buffer stock is being used with little attention to replenishment. Under the proposed Credit, the Government has formulated sound guidelines for the operations of the buffer stock with special attention to defining: the conditions under which the buffer stock may be used; the proportion which should be physically replenished; the time by when its replenishment should be in place; the financing of replenishment in view of rising fertilizer costs; and management procedures to minimize operation costs. 77. Financial Management and Funding of SFFRFM: The Government has continued to make foreign exchange available without restrictions to meet the requirements for estates and smallholders. In general, estates have continued to secure all the fertilizers they need. However, the ability of SFFRFM to procure fertilizers has been constrained by two factors. First, the purchasing power of SFFRFM's kwacha resources is increasingly eroded by rising fertilizer costs due to rising prices and external transport charges, coupled with frequent depreciation of the kwacha. Revenues from sales of fertilizers in a given year significantly fall short of the resources needed to procure fertilizers in the following year. The problem is exacerbated by the need to procure a larger quantity of fertilizers each year as more farmers adopt fertilizer use. Second, the ability of SFFRFM to procure fertilizers is constrained by cash flow shortfalls especially during the first and second quarters when most of the fertilizers are procured. This problem is largely due to the fact that subsidy subventions from Government are paid to SFFRFM a year in arrears; and that, although SFFRFM is now an independent body, it still operates under Government's instructions in some ways, including not being allowed to borrow from commercial banks, even when it needs to do so to cover its cash flow shortfalls. Under the proposed Credit, the Government has authorized SFFRFM to raise funds from the commercial banks as necessary to bridge cash 9/ This would generate a gross return of about K60 which is the minimum amount on average needed to cover transport costs and leave attractive net return to traders.  - 29 - flow shortfalls; and has started to pay subsidy subventions to SFFRFM on a quarterly basis during the year when subsidies actually accrue. To date, SFFRFM has been managed efficiently. However, given the projected rapid increase in fertilizer use by smallholders, the Government will undertake a study to assess the need for and identify ways of strengthening SFFRFM in order to ensure that it continues to be managed efficiently. 78. Malawi depends significantly on donor-grant fertilizers to ease the foreign exchange requirements and to help maintain the purchasing power of SFFRFM. In the past, donor-grant fertilizers have amounted to about 25Z of annual requirements. However, donor support in this regard has been hampered by lack of a plan on the basis of which they can mobilize their assistance in a timely and systematic fashion -- a fact which contributed to a decline of grant fertilizers to only 1OZ of fertilizer requirements during 1988/89. Under the proposed Credit, the Government has initiated preparation of a rolling five-year projections of fertilizer requirements, indicating the required foreign exchange resources, quantities that can be financed from SFFRFM kwacha resources, and the quantities needed from donors E. Rationalizing ADMARC Financing and Functions 79. The Government has taken significant actions to streamline ADMARC's functions and financing (para 13). However, ADMARC continues to carry out some activities which, although essential for the development of smallholder agriculture, cannot recover their costs. These activities thus have the potential to reverse ADMARC's recent financial improvements and to result again in un-transparent claims on the Government budget. Such activities relate to price stabilization, food security, and regional development objectives. To stabilize prices, ADMARC has to act as a residual buyer, ready to purchase whatever amount of produce farmers are unable to sell to the private sector at official prices. During years of bumper harvest, this requirement forces ADMARC to buy maize in excess of what it can sell profitably or beyond what is needed for the strategic grain reserve. ADMARC is also required to operate about 1,200 market centers, some of which are not financially viable due to low throughput; and to maintain uniform official prices in the three regions, resulting in losses estimated at up to about " 340,000 at 1989 costs and prices. To reduce ADMARC's losses, official prices should be higher in the maize- deficit southern than in the maize-surplus northern parts of the country in order to shift production pattern accordingly. However, the cultivated area in the Southern Region already exceeds the arable land and the unused land in the Central Region is of low potential. In the medium term when fertilizer availability remains inadequate and high-yielding flint maize varieties are not available or widely adopted, relatively higher prices in the south would not induce a significant supply response among smallholders without leading to a decline in the production of other crops, and/or causing extensive damage to the environment through the reduction of fallow periods and expansion of cultivation into hillsides and woodlands. While private-sector prices may vary from region to region, official prices are differentiated on an intra-regional basis. This differentiation is  - 30 - designed to promote the private sector in agricultural marketing rather than to encourage a shift in the regional production pattern. 80. Under the proposed Credit, the Government will take further actions to ensure that the non-commercial functions that the Government wants ADMARC to undertake are adequately funded in a transparent manner. The Government and ADMARC will enter into a formal agreement which will set out criteria for determining the development and food security functions to be carried out by ADMARC, establish a basis and methodology for calculating the involved costs, and define procedures for making budgetary subventions to ADMARC to cover losses that may result for those activities. With regard to the market centers that are not financially viable, ADMARC will determine which ones can be made viable through commission agents and accordingly appoint such agents to buy and sell on its behalf. Otherwise, unviable markets would be either closed or, if the Government wishes them to be retained, the Government wrould provide budgetary funds to cover the ensuing losses. 81. ADMARC's divestiture program has been progressing well, with major assets sold off during the last three years. However, It has not been possible to dispose of a number of assets because of lack of buyers, the need for financial restructuring before offering them for sale, and the need to avoid heavy capital losses. With technical assistance from USAID, the Government is developing a strategy to dispose of the remaining assets and is actively looking for buyers. These efforts will be continued and monitored under the proposed Credit. F. Shifting Smallholder Research Policy and Establishing Extension Services for Estates Shifting Research to Smallholder Needs 82. With Bank support through the ongoing National Agricultural Research Project (Cr. 1549-MAI, approved in 1985), the Government continues to implement measures to improve agricultural research for smallholders. While these measures have helped to strengthen institutional and physical capabilities, the research policy for maize remained inconsistent with farmers' needs. For the past twenty-five years, Malawi's research policy for maize has sought to develop a variety, hybrid dent maize, that genetically offers the highest possible yields. Due to its soft characteristics, most farmers have found hybrid dent maize unsuitable because, unlike the local flint maize variety, it cannot be properly stored or processed (pounded) using the prevailing techniques, and does not meet the preferred taste. Consequently, only about 7? of the land cropped with maize is on average planted with this hybrid variety while the rest of the area is planted with the low-yielding local varieties. The overall maize yields are, therefore, very low at less than one ton per hectare. 83. The Government has come to recognize that, in view of the severe land shortage, the development of smallholder agriculture depends critically on the availability of high-yielding flint maize which the  - 31 - majority of smallholders would find appropriate to grow; and that only when such a variety is available, together with the required supply of fertilizers, will smallholders be in a position to respond to better prices and marketing services. Under the proposed Credit, the Government will continue to shift research policy and increase budget allocations towards the development of high-yielding flint maize varieties. 84. Promising genetic materials have been secured recently and breeding work initiated. During the cropping season starting in September 1989, a selected number of flint hybrids underwent trials and screening for storage and processing qualities. By the time new hybrid flint and other varieties are developed, an effective extension system will be in place. Two varieties are expected to be ready for limited release to farmers during the growing season starting in September 1990. To ensure steady and systematic progress, the Government, with assistance from CIMKYT, has formulated a five-year action plan of key research activities, together with the required budgetary funds. The Government will implement this plan with a view to developing and multiplying sufficient quantities of high- yield flint maize seeds for widespread release to farmers within the next five years. Establishing Extension Services for Estates 85. A large number of estates continue to suffer from lack of technical knowledge due to the lack of technical advisory services. Most of the new estates are now owned and managed by indigenous people, most of whom lack the knowledge and experience necessary to ensure proper crop husbandry and farming techniques. As a result, they achieve generally low yields compared to the older and more established estates. Because of the important role that both the new and older estates have to play in increasing exports, a study under the third SAL underscored the need to provide these estates with facilities for medium- and short-term loans, and technical advisory services. 86. The Agricultural Marketing and Estate Development Project is providing funds for both medium-term and working capital requirements to estates. However, efforts to establish technical advisory services have been frustrated mainly by the fact that the Government wanted the services to be under the Ministry of Agriculture, whereas the estates wanted them to be established under the Trust Act outside the direct control of the Ministry and placed under general auspices of the Tobacco Association of Malawi, given that estates would be financing these services. Under the proposed Credit, the Government has taken action to facilitate the establishment of technical advisory services for estates as a trust body under the general auspices of the Tobacco Association of Malawi. The estates will be responsible for financing the recurrent costs for these services.  - 32 - G. Introducing New Cash Crops among Smallholders 87. In addition to developing and using improved technologies, cultivation of crops that generate high gross margins from small pieces of land is the other way for increasing productivity and incomes among smallholders facing severe land shortages, as is the case in Malawi. Burley tobacco is one of the cash crops that offer high returns. At present, only estates and a few smallholders in resettlement schemes are legally allowed to grow burley tobacco. Smallholders are only allowed to grow fire-cured tobacco, which is more difficult to produce, due to heavy demand on fuelwood for curing, and has less favorable market prospects due to its high nicotine content. As a part of a broader effort to increase productivity of smallholder agriculture and improve household food security, the Government is committed to the diversification of the range of high-value crops available to smallholders. 88. Under the proposed Credit, the Government will expand the growing of burley tobacco by smallholders outside resettlement schemes. To this end, the Government will amend the laws hitherto preventing smallholders from growing tobacco on customary lands. In view of the importance of burley tobacco as a major export crop and the significantly inelastic demand facing Malawi's burley tobacco in the world market, it is essential that the development of burley tobacco proceeds in a manner that ensures high quality standards, avoids over-production, and minimizes production and marketing costs. Accordingly, smallholder burley production on customary land will be initiated under closely supervised schemes, in selected areas where food deficit households are concentrated. To ensure a sound development, the Government has undertaken a study tot (a) formulate appropriate institutional arrangements to ensure efficient extension, input, and credit services; (b) assess the feasibility and identify ways to enable smallholders to sell all types of their tobacco directly, or through private traders, to the auction floor; and (c) identify areas to locate the development of smallholder burley tobacco with a view to ensuring that at least 75% of the farmers in these areas have less than 1.0 hectare of land. Also, the Government has prepared a five-year plan that outlines the Government's proposals regarding the quantity of burley tobacco to be produced by smallholders, the areas of production, and the number of smallholders involved. Finally, during the 1990/91 cropping season, the Government will ensure that at least 5,000 smallholders are licensed to grow burley tobacco on customary land. H. Halting Transfer of Land from Smallholders, and Inte:.sifyinq Land Use in Estates 89. After Independence and given the need to expand exports rapidly, the Government adopted a policy of transferring land out of the customary tenure status and leasing it to estates, thus increasing the land under estates fourfold. In view of the high rate of population growth, the declining farm size in customary smallholder areas, and the low level of land utilization in estates, the Government will discontinue this policy. The Government will, therefore, promulgate the necessary legal changes to  - 33 - halt transfer of land from customary land areas, except in areas of low population density and cases of experimental farms beneficial to smallholders, and cases of smallholders wishing to convert established customary rights into formal rights. 90. The Government is also concerned that, in a country facing an acute land shortage, estate farmers utilize only about 14? of the land at their disposal in any one season. This rate of utilization is about half of the rate that is technically feasible after allowing for the necessary fallow and waste land. With a few exceptions, land is made available to estates under leasehold subject to annual rents. The underutilizat.ion of estate land is partly due to the fact that: (a) rents can be legally adjusted only at intervals of seven years; (b) rents have remained low at K10/ha since 1985 when they were last adjusted; (c) rent collection is poor, at about 452 of the amount due in any given year; and (d) rents are uniform irrespective of the quality and economic value of land. 91. Under the proposed Credit, the Government is committed to ensuring that rents are conducive to efficient use of estate lands. The Government has, therefore, amended the law to allow adjustment of rents at intervals of three years. It has also announced, through the official gazette, increased rents from KIO/ha to K20/ha to become effective during the next rent-year starting April 1991. The Government will take further actions in 1992 to differentiate rents according to land quality and to raise the weighted average rent to a level at least equal to 1985 in real terms. To improve rent collection, the Government will institute arrangements to deduct rents through the tobacco auction system; this will cover about 95? of the estates. leaving the Department of Lands to directly collect rents only from a few estates growing tea and coffee, which have had low default rates in the past. 92. While the Government is committed to the introduction of differentiated lease rents to reflect variations in land value, there is no readily available basis to do so equitably since there is no land market in Malawi. The Government will, therefore, carry out a land classification study to establish a sound and equitable basis for differentiating land lease rents. The study will aim at classifying estates into a few categories, taking into account land potential as determined by technological factors, including ecological and soil conditions; and by economic factors, including proximity to market outlets and transport infrastructure. 93. Resource Conservation on Estates: Although estate leases require that 10X of the land is under forest, few estates comply with this requirement. Non-compliance has been one of the contributing factors to the unsustainable utilization of national forest resources, especially by farmers who need large quantities of fuelwood to cure tobacco. In the interest of conserving forestry resources and protecting the environment, the Government will strengthen the Department of Lands, through increasing the regional inspectorate staff and improving staff mobility, to enable the Department to enforce better compliance with the lease requirements in this  - 34 - regard except in cases where estates are able to obtain fuelwood from forest plantations or private sources. I. Prioritizing Agricultural Expenditures 94. Budgetary resources to agriculture are devoted almost wholly to the funding of support services to smallholders. The level of efficiency in the use of these resources is, therefore, of critical importance in Government's efforts to address the constraints that have continued to stagnate the performance of smallholder agriculture. The agricultural budget faces two major issues: the need to ensure that expenditures remain within available resources; and the need to attain a proper balance between personnel emoluments (PEs) and departmental recurrent charges (DRCs) which relate to goods and services necessary to enhance the effectiveness of personnel resources. In the absence of corrective actions, it is estimated that the funds required for the ongoing projects and programs are likely to significantly exceed the projected budgetary resources during the period up to 1992193. The ratio of DRCs to PEs has recently declined from 1.0 to O.8, meaning that agricultural staff now have a reduced amount of goods and services with which to work. As a result, field extension steff, among others, are increasingly finding it difficult to carry out their work due to shortage of funds to meet the cost of, for example, field travel allowances, fuel and vehicle repairs, and equipment and supplies. 95. The Government recognizes the need to provide effective agricultural support services to smallholders. In an environment of constrained budgetary resources, the Government will place emphasis on aligning expenditures with available resources, and on directing expenditures to activities likely to yield high returns consistent with sectoral objectives. Over the medium to long-run, Malawi would be able to finance agricultural recurrent expenditures from enhanced revenues resulting from implementation of the ongoing structural adjustment reforms. In the short-run, however, budgetary constraints will not allow adequate funding of the recurrent expenditures required to improve the performance of smallholder agriculture. Therefore, the country will need donor assistance to finance not only development but also recurrent expenditures, in appreciation of the fact that recurrent expenditures which result in improved technologies and enhanced knowledge of such technologies among farmers are in the nature of development investments. Under the proposed Credit, the Government is reviewing ongoing and planned agricultural projects and programs for the purpose of: (a) identifying a core of critical activities on the basis of which donors would be encouraged to finence A larSer PhRre of recdnrrpnt cnsta than at present; and (b) restructuring, as may be necessary, these projects and programs to (i) align expenditures with the available resources, (ii) direct expenditures to activities likely to yield highest returns, and (iii) increase DRCs/PEs ratio.  - 35 - J. Reducing Food Insecurity among the Poor 96. Nearly 55Z of farm households run out of food grain long before the next harvest is collected. The Government is attempting to deal with the problem in several ways. A food security unit has been created within the Office of the President and Cabinet, and a major nutrition surveillance project is under way to learn more about the extent and causes of malnutrition. The Government regards it as essential that food security at the household level be achieved through increased household production rather than through food aid programs or transfer payments. Recognizing that food shortage is more acute among those cultivating very small land holdings and that there are several constraints to increasing agricultural production, the Government is pursuing several approaches to address the problem. These include developing improved maize varieties that are more acceptable to smallholders than those presently available, and expanding the use of fertilizers and the range of cash crops for smallholders. However, these approaches may not benefit the relatively smaller smallholders unless they are complemented with actions specifically targeted to the food deficit households. 97. Recent experience has clearly demonstrated that the use of fertilizers by smallholders with relatively smaller land holdings can be significantly increased by making fertilizers available in packages of 10- 25 kg, and that the use of high analysis fertilizers can reduce fertilizer costs substantially. Until three years ago, all fertilizers have been packaged in bags of 50 kg, which contain amounts of fertilizers beyond the needs and financial means of most of the smaller smallholders. Partly as a result of this, subsidies have gone out mainly to the relatively better off and larger smallholders. The Government has already initiated some measures to target subsidies by providing a larger element of subsidy on fertilizers packaged in small bags, which are mostly used by the relatively smaller smallholders. Also, the Government recently approved a UNDP-funded project, to be executed by the Bank, to finance pilot schemes to test ways of targeting fertiltzer subsidies and agricultural credit to the food- deficient households. Under the proposed Credit, the Government will: (a) ensure that in future, at least 50Z of the fertilizers is packaged in bags of not more than 25 kg, at a price prorated to the price of the larger bags; (b) set fertilizer prices to provide a higher rate of subsidy on high than on low analysis fertilizers; (c) locate the smallholder burley production schemes in areas where at least 75? of land holdings are less than 1.0 ha.; (d) initiate implementation of the UNDP-funded project to test various ways for cost-effective and more comprehensive targeting of agricultural credit and fertilizer subsidies to the food-deficient households. Fin&llv. the ooeration of the Strategic Grain Reserve will be strengthened through the formulation of operational guidelines which will include specific criteria for selling to and buying from the SGR, and for determining the optimum stock size.  - 36 - K. Monitoring Poverty Impact of Adjustment Program 98. The Credit will also include a component to strengthen the present capability to monitor the impact of the adjustment program on the vulnerable and resource-poor groups. The objective of this component is to enable the Government to: (a) establish a solid socioeconomic database; (b) build a capability to analyze and formulate options for targeting social programs to the vulnerable groups and the poorer segments of the population; and (c) carry out studies on key policy issues. To these ends, the Government plans to undertake an integrated household survey and carry out studies relating to poverty issues, including a comparative analysis of costs and benefits of fertilizer and direct consumer subsidies as alternative options to address poverty and household food security concerns. The integrated household survey will be carried out under the auspices of the National Statistical Office (NSO). The survey will provide comprehensive socioeconomic data to establish profiles of the adversely affected gruups and be used by line ministries and other concerned organizations to carry out analysis of poverty related issues. It will also gather data that will be used to construct weights to update and expand the coverage of the Constuner Price Index (CPI), and to serve as a baseline for monitoring key socioeconomic variables. The last CPI was constructed from 1979 household data, which covered only the major urban areas. Therefore, it needs to be expanded to include rural areas. To maximize the usefulness of the survey, the Government will ensure that the operating ministries and other governmental agencies will continue to have access to the data collected under the survey, subject to safeguarding needs for confidentiality as appropriate. The component under this operation is expected to be followed by a second-phase initiative to be supported by the Bank and other donors under the proposed Health and Population III project. PART V: THE AGRICULTURAL SECTOR ADJUSTMENT CREDIT (ASAC) A. Obiectives and Rationale for IDA Involvement Objectives 99. The primary objective of the proposed Credit is to support the implementation of the Government's program described in Annex 5. It will also provide additional foreign exchange resources for imported inputs required to realize fully the benefits expected from the program. Since continuation of trade liberalization reforms under the proposed Credit are projected to cause a high demand for a wide range of imports during tne next two years, the proposed Credit would provide quick-disbursing funds in support of the balance of payments. The adjustment program to be supported by the proposed Credit entails elements that will add to the export gains expected from ITPAC, thus reducing the need for balance of payments support over the medium-term. First, measures to increase yields of staple food grain among smallholders will help to release land progressively for cash and export crops while measures to encourage efficiency in land use among  - 37 - estates would increase exports of various commodities. Second, measures to improve prices of smallholder tobacco and to allow smallholders to grow burley tobacco will provide both the incentive and opportunity to devote some of the land released from food crops to the production of export crops. Third, the additional income generated in rural areas will lead to significant multiplier effects in both consumption and production and consequently further growth. After this transitional period, external resources will be needed mainly to support investment-oriented operations. 100. The operation will also provide about US$ 1.5 million to finance technical assistance and short-term consultancies (54 man-months), training, equipment, and vehicles to carry out the survey and studies described in para 98 above. The cost of technical assistance and consultancy services is estimated at US$750,000; equipment, supplies, and vehicles at US$520,000; and training at US$230,000. Rationale for IDA Involvement 101. The proposed Credit is a logical follow-up to the past series of structural adjustment operations through which IDA has been supporting Malawi's efforts to stabilize the economy and resume sustainable growth. It would also help to create a sectoral policy framework which will enhance the impact of the ongoing investment projects supported by IDA. The proposed Credit constitutes a vehicle by which IDA would continue to play an effective role in: (a) assisting Malawi to formulate and implement appropriate policies and strategies as needed to attain sustainable growth; (b) helping to mobilize external resources necessary to support implementation of such policies and strategies; and (c) fostering effective coordination of donor assistance within a coherent strategy. B. Financing Plan 102. A total of US$170 million equivalent is expected to be provided under the proposed Credit. This amount would comprise US$70 million equivalent from IDA, and US$100 million equivalent from co-financing under the Special Program of Assistance. The Netherlands has confirmed cofinancing funds amounting to DFL 10 million. Interest to participate in the Program has been expressed by the United Kingdom (Pounds Sterling 10 million), United States (US$25 million), the Federal Republic of Germany (amount not yet indicated), and the EEC (amount not yet indicated). The Government of Japan has been approached to participate in the program, with an amount of US$30 million equivalent. The governments of the United Kingdom and Netherlands are expected to request IDA to administer their funds. 103. The Credit's proceeds would finance 1002 of the foreign exchange cost of eligible imports (including equipment and vehicles relating to the integrated household survey) on the basis of a negative list; and 100Z of the cost of consultancy services, estimated at US$750,000 (SDR 565,000),  - 38 - related to the integrated household survey 10/. The negative list would comprise goods and services financed from other sources, alcoholic beverages, tobacco, military equipment, and luxury consumer goods. The use of the negative list reflects the fact that the proposed Credit is one of a series of operations supporting ongoing macroeconomic adjustments. In particular, it continues to support trade liberalization measures initiated under ITPAC which would cause a high demand for a broad range of imports. Moreover, the general thrust of the structural adjustment operation is the elimination of administrative controls in all aspects of the economy including the allocation of foreign exchange. Use of the negative list furthers this objective. The local currency generated by the sale of the Credit proceeds to importers would accrue to Treasury. C. Procurement, Disbursement, Accounts and Audit Procurement 104. Except for consultancy services, the proposed Credit would provide quick-disbursing funds in support of the balance of payments. Procurement procedures have been designed to permit rapid use of the funds while ensuring efficiency and accountability. Private, parastatal, and public sector imports of goods and services would be eligible for financing under the Credit. Imports by both the public and private sectors would follow international competitive bidding for amounts exceeding US$2.0 million equivalent. For amounts below US$2.0 million: (a) the public sector would follow Malawi Government procurement procedures which are acceptable except in minor respects which the Government has agreed to modify (under the ongoing IDA-financed Public Procurement Code Revision Study) to make the procedures fully acceptable to IDA; and (b) the private sector purchases would follow established commercial practices, including competitive bidding wherever appropriate, which have worked well in Malawi. Wherever possible, quotations from eligible suppliers from at least two countries should be sought. Direct contracting (single source purchase) could be used only for proprietary equipment or where compatibility with existing equipment would require standardized equipment and spare parts. Some commonly traded commodities may be purchased at prices quoted in organized international markets. Procurement would be limited to goods from Bank member countries, Switzerland and Taiwan. Verification of imports has been currently limited to physical inspections by Customs. This system would be improved by engaging expert agencies to certify goods in respect of quality, quantity and price of shipments; during negotiations, the Government agreed that, subject to availability of funds to meet the costs, such a firm wFil be retained following solicitation from short-listed firms. Regardless oi the procurement methods used, no more than US$12 million would be used to finance imports in any single trade group or subgroup. Consultancy services will be provided according to the Bank Guidelines for the use of consultants. 10/ The training component would be financed from bilateral funds.  - 39 - Disbursement 105. Except for the consultancy services, the proposed IDA Credit would be disbursed in two tranches, the first amounting to SDR 26.035 million, and the second SDR 26.0 million. The first tranche would be disbursed upon Credit effectiveness and the second tranche about eight months thereafter. Disbursement of the second tranche would be conditional on satisfactory implementation of the overall policy reform program outlined in the Government's Letter of Development Policy (Annex 5) and on the actions specified in para 110 below. To facilitate disbursement, a Special Account would be established with a commercial bank of the Government's choice, under terms and conditions satisfactory to IDA. The initial deposit would be US$20 million, which represents three months of the expected expenditures under the Credit; the account would be replenished regularly up to the limit of the initial deposit. Replenishments would be made on the basis cf fully documented reimbursement applications, except for expenditures under $250,000 which would be reimbursed on the basis of Statements of Expenditures (SOEs). The SOEs would show the nature and origin of the goods, the name of the importer, and the payment date. The supporting documents for SOEs (invoices, customs declarations, bills of lading and evidence of payment) would be retained by the Reserve Bank of Malawi (RBM) and made available for review by Bank supervision missions. Expenditures for goods covered by invoices of less than US$10,000 equivalent would not be eligible for financing. Withdrawal applications would be consolidated in amounts of at least US$50,000. The closing date of the proposed Credit is December 31, 1991. Accounts and Audit 106. The RBM would be responsible for maintaining Credit accounts a:id preparing and submitting withdrawal applications. In addition, RBM would be responsible for arranging annual audit of Credit accounts, including the special account and SOEs, by independent auditors acceptable to IDA. The audit reports, including specific comments on SOEs, would be submitted to IDA within six months of the end of RBM's fiscal year. RBM is adequately staffed to undertake these duties and has discharged them effectively under the SALs. D. Monitoring and Tranche Release 107. IDA will review the implementation of the overall adjustment program as well as specific actions outlined in the Govez-nmzct's L'ttar of Development Policy, through regular supervision missions and exchange of views with Government. In view of the critical need to ensure that the macroeconomic framework remains conducive to agricultural growth, IDA will pay attention to the adequacy and consistency of the sectoral as well as key macroeconomic policies. To this end, IDA will coordinate its supervision work closely with the IMF in reviewing key macroeconomic policies and indicators, particularly those regarding exchange rate  - 40 - management, fiscal deficit targets, and fertilizer subsidies. The matrix in Annex 6 shows priority actions to be monitored closely. 108. Actions Before .egotiations: The following actions were taken: (a) preparation of a 5-year fertilizer requirement projection; (b) formal authorization by Government to allow SFFRFM to raise short-term loans from the banking system; (c) preparation and starting implementation of an action plan to shift maize research policy and budget to develop a high- yielding flint maize; (d) agreement with tobacco estate farmers on the establishment of technical advisory services for estate farmers as a trust body, to be funded by estates, under the general auspices of the Tobacco Association of Malawi; and (e) initiating a study to formulate appropriate institutional arrangements to ensure efficient extension, input, credit, and marketing services to smallholder burley tobacco growers. 109. Conditions of Board Presentation: The following actions have been taken: (a) amending Tobacco Growing and Selling regulations to enable smallholders to grow burley tobacco in customary land areas without land leases or other formal title deeds; (b) promulgating a Land Control Order under the Land Act to halt transfer of land from customary land to estates, except in areas with low population density or cases of experimental farms beneficial to smallholders, and in cases involving conversion of established customary rights into formal rights; (c) amending the Land Act to provide for increasing estate land lease rents, and to reduce the intervals at which rents can be legally adjusted from seven to three years; and (d) announcing, in the official gazette, increased rents up to K20/ha, to become effective by the next rent year starting April 1991. 110. Release of the Second Tranche: This would be conditional upon satisfactory implementation of the overall adjustment program described in the Letter of Development Policy (Annex 5) and specifically on: (a) maintaining the exchange rate and fiscal deficit for FY90/91 at levels satisfactory to IDA; (b) preparing a PSIP for 1990/91-1993/94 satisfactory to IDA; (c) eliminating prior approval of foreign exchange for all imports except for a short list of items, satisfactory to IDA, consisting primarily of luxury goods; (d) adjusting fertilizer prices to keep the rate of economic subsidy at a level not exceeding 302 and the total amount of fertilizer subsidy subvention at a level not exceeding 2% of total Government expenditures during 1990/91; (e) announcing a 2-payment price system for smallholder tobacco, with the pre-planting price being at least 45? of a moving 3-year average of auction prices; (f) licensing at least 5,000 smallholders to grow burley tobacco under customary land tenure in areas where at least 75? of the farmers have less than 1.0 ha of land; (g) implementing Loiaigemer- tO collect estate land lease Lents through deductions at tobacco auctions; and (h) starting pilot schemes to test ways of targeting fertilizer subsidies and agricultural credit to smallholders with less than 1.0 ha of land.  - 41 - E. Impact and Risks Efficiency and Production Impact 111. Expected gains from the package of policy reforms under the proposed Credit would be substantial over the medium-term. They are not, however, amenable to reliable quantification. These gains would come from both the macroeconomic and sectoral reforms described above. The measures to ensure flexible exchange rate policy, fiscal and monetary discipline, as well as to carry out further import liberalization and to introduce a more effective duty draw-back system for exports would generate high efficiency gains in the use of resources and would improve the competitiveness of agricultural and other exports. Significant efficiency gains in the use of resources are also expected from measures to improve the quality of the Public Sector Investment Program, including restructuring of agricultural expenditures; and to expand private sector participation in agricultural marketing and input distribution for smallholders. 112. Changes to shift the research policy to develop high-yielding flint maize, improve the availability of fertilizers, and continue adequate producer incentives would considerably increase maize yields and total production among smallholders. It is estimated that fertilized high- yielding flint maize would increase yields by up to 602 on average over and above the fertilized local maize variety. Replacing the local maize variety with high-yielding flint maize in the area now devoted to fertilized local maize would result in incremental production of some 225,000 tons annually, more than the total amount of maize marketed in a typical year through ADMARC before 1987. 113. Measures to enable smallholders to grow burley tobacco would enhance productivity and increase cash incomes, thereby raising rural purchasing power most of which is likely to be reflected in increased demand for domestic goods and services. Based on projections by tobacco buyers, it is feasible for smallholders to increase burley tobacco production to about 9,000 tons annually within the next six years without causing a reduction in estate production in absolute terms. At current prices, this would inject into the rural economy an additional net cash income of about K22.7 million (Us$8.4 million) annually. Efficiency gains are also likely to come from the fact that, in terms of domestic resource costs, smallholders appear more efficient than estates in the production of burley tobacco. Finally, the envisaged improved collection and adjustment of estate land lease rents, together with the provision of technical 5UZViZZ7- -Uex e5LaLE&' bwuu;U ct&LUuxag eLxicient use or estate lands, leading to a higher level of land utilization, production, and increased formal agricultural employment. It is estimated that, at a weighted average (according to the major estate crops) of 1.12 workers/per ha, a 1Z increase in utilization of estate land would result in about 6,700 new jobs, about 3.7? of the present formal agricultural employment.  - 42 - Balance of Payments and Fiscal Impact 114. In addition to maintaining the competitiveness of exports, the proposed Credit would help to improve the balance of payments as a result of increased production of export crops facilitated mainly by the release of land from food crop production as high-yielding flint maize becomes available and fertilizer use expands, improved prices of smallholder tobacco, and greater utilization of estate lands. With regard to the fiscal impac~t, the proposed Credit would, by raising smallholder tobacco prices, sigsificantly reduce surpluses accruing to ADMARC and, by implication, to the Government as such surpluses have been an indirect tax on smallholders partly to finance the Government's development and food security objectives. This loss of revenues would be offset by increas3d lease rents on estate land, which is estimated to generate incremental revenues of about K6 million (US$2.3 million) annually; improved collection of estate rents, with incremental revenues estimated at K3.1 (US$1.2 million) million annually; and reduction of fertilizer subsidies, combined witlh increased maize consumer prices. 115. Other measures under the proposed Credit are unlikely to have a significant impact on budgetary resources. The reorientation of maize research is expected to involve capital expenditures of about K600,000, all of which is being funded from external sources, while recurrent costs would be financed by switching funds from low priority areas and from donor funds. The initial capital costs for technical advisory services to the estates would be financed from external sources while recurrent costs would be financed by the estates. Support to smallholders growing burley tobacco would come from the existing services and facilities. Strengthening of the Department of Lands to enforce lease covenants is expected to involve additional three inspectors and vehicles, coupled with mobilization of support from existing district administration staff. This would be financed mainly by reallocation of funds from within the available budgetary resources. Social Impact 116. The main thrust of the Program is to improve the supply response in the agricultural sector, particularly with regard to the smaller smallholders who constitute the majority of the poor and who have benefited little from the past adjustment efforts. The program would have a positive impact on the general level of rural incomes mainly through introduction of high-yielding flint maize, expended access to fertilizers, and permitting smallholders to growS burley tobacco. Although the growing of burley tobacco by smallh.soldr msy sl^w down the epanesion o-r -state burley tobacco and thus the growth of employment opportunities in tobacco estates, this would be more than offset by the fact that smallholder production is more labor intensive, by a factor of about 1.3, than estate production. Also, measures to encourage greater land utilization in estates would increase overall employment opportunities, an important source of income for the poorer smallholders in Malawi. As with past adjustment reforms, some of the macroeconomic policy changes will have a negative impact on the poor while others will have a positive impact. Policy changes with a  - 43 - negative impact on the poor include budgetary restraints, increased consumer prices for maize arising from higher fertilizer costs due to reduction of subsidies and exchange rate adjustments. Policy changes with a positive impact include measures to reduce inflation and to liberalize imports. In the short-run, the proposed Credit will help to minimize the negative impact on the poor through reducing fertilizer subsidies gradually so as to avoid a rapid escalation of maize prices; and strengthening the capability to monitor such impact so that actions can be taken to ease the negative impact. Over the medium term, the Credit will help the poor by increasing the productivity of their land and labor through the development of high-yielding flint maize and expanded fertilizer use, and by targeting burley tobacco and agricultural credit to the food-deficient households. Environmental Impact 117. The major cause of degradation of the environment in Malawi is the high rate of population growth in the face of severe land shortage and limited availability of technological packages to increase crop yields. The proposed Credit will have a positive impact on the environment, mainly through supporting measures tot (a) reduce population pressure on land by increasing crop yields through developing high-yielding maize varieties that most of the farmers will find appropriate to grow, and expanding availability of fertilizers; (b) restructure agricultural expenditures to improve allocations to recurrent costs for extension staff, including those concerned with soil conservation; (c) allow smallholders to grow burley tobacco, which is less demanding on fuelwood than the type of tobacco smallholders are now allowed to grow; and (d) enforce compliance with covenants relating to afforestation in estate lands. To minimize pest and disease problems associated with mono-variety cropping and to reduce the need for agro-chemicals, the Government, with support from CIMMYT, is ensuring that the maize breeding program will develop several varieties of high-yielding flint maize and that it will address pests and diseases through resistant strains. At negotiations, the Government agreed to submit to IDA for review the list of agro-chemicals recommended for use in the country. Risks 118. The main risks are related to: (a) possible opposition from groups that may be adversely affected by some of the reforms envisaged under the Credit; (b) uncertainties common to agricultural research; and (c) external shocks. Strong opposition may be encountered from estate farmers, many of whom are influential political figures and civil servants, aQainst adit:itm.nt *f esntte land lease rent and a1lowir;g smallholders to grow burley tobacco. In addition, while there has been a growing awareness of the widespread poverty, there is still a political reluctance to recognize the severity of the problem, particularly with regard to smallholders. This political reluctance may underminu the commitment to carry out new major reforms directed at benefiting mainly the resource-poor smallholders, such as the proposed targeting of income generating activities. To address these risks, most of the politically-difficult  - 44 - actions were taken before Board presentation, while others will be conditions for the release of the second tranche. 119. A major objective of the program is to develop a high-yielding maize variety that most of the farmers will find appropriate to grow. Although a sound action plan has been prepared, the development of such a maize variety is subject to the uncertainties common to any biological research activities. The uncertainty will be reduced through the continuation of technical support from, and close monitoring by, CIMMYT'S team of experts located in Zimbabwe. A similar situation applies to the pilot schemes envisaged under the Credit to target income-earning activities, including fertilizer subsidies, to the resource poor farmers; the design of these schemes will incorporate a system to monitor them closely so as to enable corrective action in a timely manner with a view to enhancing the chances of success. 120. The commitment to implement the program may be impaired by a recurrence of major external shocks, such as prolonged droughts, decline in export prices or further transport disruptions, leading to poor economic growth and thus reducing the benefits expected from the program; or by inadequate flow of external funds on concessional terms to support the program. To minimize the risks relating to the macroeconomic policies, IDA, in conjunction with the IMF under the PFP process, will closely monitor implementation progress and trends of the key macroeconomic variables and maintain an active dialogue with the Government to encourage Government to respond appropriately to any unfavorable external development. With regard to external assistance, there is considerable goodwill among donors towards Malawi, which should be readily translated into tangible financial assistance. PART VI: RECOMMENDATION 121. I am satisfied that the proposed IDA Credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed Credit. Barber B. Conable President by Moeen A. Qureshi Attachments Washington, DC March 6, 1990  ANNEX 1 - 45 - Page 1989 SOCIAL INDICATOR DATA SHEET 25M 30 1-20 t#t So,k hehr _ s,g~~~~~~~~~(e t) SW HUMAN RESOURCES ShPgew gVOUIh, dpapUtMI Todi n36iasp .4 33 * 1 14 p7d'AM Om - IM) 3 4 8&18 ~~~~46662 51.8 506 513 54 60 57.4 udi 0l Ol 0.9.9 0.74 *dpap. 52 ?7.7 13.4 31.7 34. 5 UIba .. .. .. . .. Ruad .. .. .. . .. P l1acnrwth mic 41213011 2.3 2.9 3.1 3.1 2.0 2.2 PV &tg h " e 525 7.5 8.6 6.1 3.7 3.5 U_ _mlIpwthdieax dtee 33 4.9 6.1 4.1 2.2 2.5 miMnu .. .. I2.2 673 3,625 805 Suyporal * .. .. 96647 IY jbiwh .p P. 560 55.6 53.1 47.2 30.4 31.5 Twal fcniliye raw wiwoper m 7.75 7.66 7.60 6.56 3.89 4.08 Canuscq2Iiweva1mfoe ~ dwof1 1549 .. .. .. .. 57.4 Cmd (0.4) /woman (1549) rps Ugg 300 mn .. .. .. =ddealtb F pVWlaba. pop. 263 23.3 19.6 i5,8 I0.0 8.6 Ifd moSrtYe pWtbalivil dhs 199.8 182.6 ! 3 I VndS=M On 0 .. 2.00 1n.4 174.68 1965 Life cseqcwanc ai bih: overall Man 39.1 42.0 46.0 506 61.4 63.8 female 39.8 42.9 47.7 523 62.3 66.8 I.Abortbrare.(1S. TOullbborfee mn=i0s 94 RO38 3.33 189 1.343 232 1u ' dIsabr ferns L' It .. .. mwiauy ~~~ ~~~~~~3.2 5.6 Fale 45.5 44.7 41.7 38.0 36.0 31.2 Females per 1O00m!. U,ban mamber .. .. .. Rnd Pefic4otion aw:oveu11 *dofRorforce 48.9 46.1 43.3 41.6 49.2 39.0 fanale 42.8 39.8 35.6 3Q.S 34.9 23.5 EduediMl mbl.u atlabor ae School yeam campland: oval .. .. .. mink .. .. .. . .. NATURAL RESOURCES Area thau. mq. m 1I 118 118 22,242 36997 17.083 Densm a q.e r .=km 34 44 67 20 76 36 Agded"micaInualld Waland 32.3 34.8 35.6 32.7 361 38.3 * Agric~z1wrJdeasizy n.persa.ltm 104 127 187 62 211 94 Famu -ad wood1zd tiusL sq.lu51 51 44 6.634 9,154 5,449 0.0 0.0 -2.4 0.5 .03 0.7 Aum tonler *afzpap. .. .. 95.0 36.. Urba .w 97. 755 73.4 76. Rundl .500 24.i! 46.3 Population gowb Infant moraity Prnmy school enroment 'b .~~~~~~~~1 1120. 4 U 2 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~0 0 a NOTE: Population data included here dues nor reflect recent adjustments made to the 1987 census data.  - 46 - ANNEX 1 Page 2 Mlawi 1989 SOCIAL INDICATOR DATA SHEET mn Sa resiu wo gro Nnc 8