Malawi - Financial policies for sustainable growth

MICROFICHE COPY Report No. 9009-H-IAI Type: (SEC) Report No. 9009-MAI RAGUE, VIN/ X34071 / J11096/ AF6IE Malawi Financial Policies for Sustainable Growth February 19, 1992 Industry and Energv Operations Division Southern Africa Department FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otheryvise be disclosed without World Bank authorization.  CURRENCY EQUIVALENIS (FEBRUARY 1991) Currency Unit - Malawi. kwacha (NI) US$ 1.00 a MI 2.53 MX 1.00 * US$ 0.40 MI 1.00 - 100 ta,mbalas FISCAL YEAR April 1 - March 31  FOR OFFICAL USE ONLY ABBREVIATIONS ADMARC Agricultural Development and Marketing Corporation ASAC Agricultural Structural Adjustment Credit CBM Commercial Bank of Malawi DEMATT Development of Malawian Traders Trust DEVPOL Statement of Development Policies, 1987-1996 DFI Development Finance Institution EEC European Economic Community ECOF Expurt Credit Guarantee Facility EP&D Department of Economic Planning and Development ESAF Enhanced Structural Adjustment Facility FSEDP Financial Sector and Enterprise Development Project GOM Government of Malawi INDEBANK Investment and Development Bank of Malawi INDEFUND Investment and Development Fund of Malawi INDETRUST Investment and Development Trust of Malawi ITPAC Industrial and Trade Policy Adjustment Credit LFC Leasing and Finance Company of Malawi Limited NMC National Mercantile Credit MDC Malawi Development Corporation MDI Malawi Dairy Industries MEDI Malawian Entrepreneurs Development Institute MHC Malawi Housing Corporation MIDCOR Mining Investment and Development Corporation Limited MMF Malawi Mudzi Fund MTIT Ministry of Trade, Industry and Tourism MUSCCO Malawi Union of Savings and Credit Cooperatives Limited NBFI Non-Bank Financial Institution NBM National Bank of Malawi NBS New Building Society NICO National Insurance Company Limited NSO National Statistical Office POSB Post Office Savings Bank RBM Rese.ve Bank of Malawi READI Rural Enterprises and Agribusiness Development Institutions SACA Smallholder Agricultural Credit Association SCA Smallholder Coffee Authority SEDOM Small Enterprise Development Organization of Malawi SME Small and Medium Enterprises SSE Small Scale Enterprises UNDP United Nations Development Program USAID United States Agency for International Development WWBM Women's World Banking of Malawi This document his a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  MtALAWI FINANCIAL POLICIES FY)R SIUSAINBE RW TABLE OF CONTENTS PREFACE EXECUTIVE SUMMARY ..................................... i-xi CHAPTER I - THE MACROECONOMIC SETIING ........ ................ 1 A. General Background ..................................... 1 B. Macroeconomic Developments . ................................ 2 C. Development Policy Framework . .............................. 15 CHAPTER H - MONETARY MANAGEMENT ........................... 16 A. Introduction .16 B. Present Monetary Policy Arrangements .16 C. Problems and Issues with Prevailing Monetary Policy Arrangements .21 D. Monetary Policy Reform .27 E. Perspectives for Further Implementation of the Reform Program ............................................ 31 CHAPTER HI - RESOURCE MOBILIZATION AND ALLOCATION BY THE FINANCIAL SYSTEM .................................... 36 A. Resource Mobilization .................................... 36 B. Resource Allocation ...................................... 49 C. Flow of Funds Analysis .................................... 59 CHAPTER IV - INST ONAL SUES ........... .. ................ 68 A. Commercial Banking Issues .68 B. Post Office Savings Bank .73 C. New Building Society .75 D. Leasing Insttutions and Leasing Activities .76 E. Malawi Development Corporation .76 F. Investment and Development Bank of Malawi .78 G. Investment and Development Fund of Malawi ..................... 78 H. Insurance Companies .78 I. General Financial Institutions Issues .79 J. Conclusion .; 80  CHAPTER V - SECTORAL ISSUES ................................. 82 A. AgriculturalFinance 82 B. Housing Finance 88 C. Finance for the Small and Meitum Enterprise (SME) Sector . .92 D. ParastatalFinance ..102 E. Recommendations ..107 CHAPrER VI - THE DEVELOPMENT OF THE CAPITAL MARKET .... ..... 109 A. IntrodLuction .......................................... 109 B. Prospects for Securities Market Development in Malawi ............... 111 C. Creating the Enabling Enviromnent ........................... 116 D. Summary and Recommendations ............................. 121 CHAPTER VII - FINANCIAL POLICIES FOR SUSTAINABLE GROWTH AND POVERTY ALLEVIATION ........................... 122 A. Introduction .122 B. Monetary Policy and Monetary Management .122 C. Domestic Resource Mobilization and Allocation .123 D. Institudonal Issues .124 E. Sectoral Issues .125 F. The Development of a Capital Market .127 LIST OF TABLES IN THE TEXT Table 1.1: Overall Deficit and Financing .....8.................. 8 Table 1.2: Comparadve Financial Depth Ratios - 195 ............ ............ 12 Table 1.3: Sources of Change in the Money Base ......... ................ 13 Table 1.4: Monetary Aggregates .14 Table 2.1: Principal Interest Rates .22 Table 2.2: Indicators of Financial Sector Liquidity 1969- 89 .26 Table 3.1: Bank Deposit Terms as at 31 Dec 1989 and 30 June 1990 .37 Table 3.2: Commercial Bank Deposits .38 Table 3.3: Balance Sheet of the Leasing Finance Company .44 Table 3.4: Deposits and Total Liabilities of POSB, 1980 to 1987 .45 Table 3.5: Total Domestic Resource Mobilization by the Financial System .48 Table 3.6: Commercial Bank Advances by Main Sectors .50 Table 3.7: Credit Extended by Leasing Companies .53 Table 3.8: Credit Extended by Nonbank Financial Institutions .54 Table 3.9: Malawi, Flow of Funds - Reserve Bank of Malawi .62 Table 3.10: Malawi, Plow of Funds - Commercial Banks ...... ............... 63  Table 3.11: Malawi, Flow of Funds - All Non-bank Financial Institutions .......................................... 64 Table 4.1: Distribution of Financial Sector Assets, (1935 to 1988) ......................... ........... 71 Table 5.1: Smallholder Sub-Sector by Size of Holdings .83 Table 5.2: Malawi Housing Corporation Management of Houses: Demand for Traditional Housing Area Plots and Plots Administered in THA's ........ ......... 89 Table 5.3: Mean Capital and Emptoyment per Activity in Licensed Small Industrial Farms .94 Table 5.4: Credit from SME Financial Institutions .95 Table 5.5: Comparative Arrears Rates for NBFIs Servicing the SME Sector ................ 100 Table 5.6: Expansion of MUSCCO Operations 1986 to 1989 .... .......... 101 Table 5.7: Parastatal Debt as at 31.3.89 ........................... 105 LIST OF FIGURES IN THE TEXT Figure 1.1: Malawi - Exchange Rate ................................... 6 Figure 1.2: Malawi - Consumer Price Index ........... .................. 11 Figure 2.1: Real Interest Rates in Malawi . .............................. 30 Figure 3.1: Structure of Malawi's Financial System ........ ................. 39 Figure 3.2: Commercial Bank Deposits - By Type ........ ................. 40 Figure 3.3: Dictribution of Commercial Bank Deposits ....... ............... 41 Figure 3.4: Total Deposits by Sector ................................ . 43 Figure 3.5: Commercial Credit by Sector . ............................... 1 Figure 3.6: Flow of Funds for the Period 1980 to 1989 ....... ............... 65 Figure 3.7: Flow of Funds for the Period 1980 to 1985 ....... ............... 66 Figure 3.8: Flow of Funds for the Period 1985 to 1989 ....... ............... 67 ANNEXES ANNEX A1.1: Revenue from Monetization - Intlation Tax and Seignorage ... ..... 131 Table Al.1: Revenues from Monetization: Seignorage and Inflation Tax .................................. 133 Table A1.2: Sub-Saharan Africa Selected Macro Financial Data, 1985 ................................... 134 Table A1.3: Money Base, year end Balances, 1970-1979 ................... 135 Table A1.4: Money Base, year end Balances, 1980-1989 ................... 136 Table Al.5: Source of Expansion of the Monetary Base, 1970-1979 ................................... 137 Table A 1.6: Source of Expansion of the Monetary Base, 1980-1989 ................................... 138 Table A 1.7: Inflation Tax and Seignorage on Deposits, 1970-1989 ................................... 139  Table A1.8: Inflation Tax and Seignorage on Base Money, 1970-1989 ................................... 140 Table A1.9: The Money Supply Process, 1970-1979 ..................... 141 Table Al.10: The Money Supply Process, 1980-1989 ....................... 142 ANNEX A2.1: A Note on the Tax Treatment of Finandal Instruments .... ...... 143 ANNEX A3.1: The Structure of The Finandal System in Malawi ............ .. 146 Table A3.1: Reserve Bank of Malawi - Assets .158 Reserve Bank of Malawi - Liabilities .158 Table A3.2: Commercial Bank - Assets .159 Commercial Bank - Liabilities .159 Table A3.3: Assets of the New Building Society .160 Liabilities of the New Building Society .160 Table A3.4: New Building Society - Interest Rates, 1980- 1989. .................. 161 Table A3.5: Malawi Development Corporation. Balance Sheets .162 Table A3.6: Malawi Development Corporation, Income Statements .163 Table A3.7: INDEBANK, Balance Sheets, 1985 - 1989 .164 Table A3.8: INDEBANK, Income Statement, 1985 - 1989 .165 Table A3.9: INDEFUND - Assets and Income .166 Table A3. 10: Distribution of Financial Sector A$ets ..167 Table A3. 11: Commercial Banks: Demand Deposits by Main Sectors .168 Table A3.12: Commercial Banks: Time & Savings Deposits by Main Sectors .169 Table A3.13: Commercial Banks: Total Deposits by Main Sectors ..................................... 170 ANNEX A4.1: Brief Description of the Commercial Parastatals Operating in Malawi .......................................... 171 Table A4. 1: Malawi Statutory Bodies - Financial Summary, 1988/89 and 1989/90 ................................ 174  PREFACE This report is based on the work of financial sector missions to Malawi in November, 1989 and March, 1990, consisting of Vincent M. Rague (mission leader), Paul Popiel (Senior Financial Economist) and Simon Bell (Financial Economist), Christopher Barltrop (Commercial Banking Consultant), Robert Wieland (Smallholder Agricultural Credit Consultant) and Ms. Shari Berenbach (Small and Medium Enterprise Consultant). The mission was briefly joined by David Cook, Chief, Industry and Energy Operations Division, Southern Africa Department. Monish Dutt (IFC) contributed the section on Capital Market Development. Patrick Honahan was the lead advisor for this study. Mesdames Irene Chacon, Nuria Plaza and Adriana Arriagada processed the report. Messrs. David Cook (AF6IE) and Stephen Denning (AF6DR) are the managing Division Chief and Department Director, respectively. The report was prepared as a collaborative effort between the Government of Malawi and the World Bank Group (IBRD and IFC). The report reviews the financial system and makes recommendations for the sector's contribution to Malawi's longer term sustainable economic growth. Growth prospects are tied to the Government's long-term development strategy whose aim is to achieve a sustainable higher level of economic growth by channelling adequate resources to the productive sectors through more efficient domestic resource mobilization and allocation. The report concludes that important prerequisites for the financial sector to make effective contribution to the development process are the existence of a stable, market based macroeconomic environment and a robust, efficient and competitive financial structure. To achieve this objective the authorities in Malawi have been liberalizing financial markets in order to encourage competition, the development of new financial instruments, and the evolution of market-based monetary policy. This report, therefore provides a road map for the authorities as they steer towards a more diversified, liberal and competitive financial system that would help finance sustainable growth.  MALAWI ElANCIAL POLICIIES FY)R SIMLEM GROWT Executive Summa. The Macroeconomic Settiny i. As one of the world's poorest countries, Malawi's open economy has a fragile and narrow resource base, which is dependent upon a few exports and small domestic markets. Such features make Malawi's economy susceptible to economic shocks, which lead to marked fluctuations in GDP performance. On average, the economy performed better during the 1960s and 1970s, led by higher investment in agriculture and infrastructure, than during the 1980s. Between 1964 and 1974 real GNP per capita growth was 4.3 percent per annum, making it one of the fastest growing economies in the region. However, in the late 1970s, Malawi experienced a series of economic shocks and domestic policy weaknesses that substantially reduced its per capita national income growth. It is estimated that, from 1978 to 1981, the term:s of trade fell by about 28 percent, a situation exacerb&ted by drought, sharply higher oil prices, and the civil war in Mozambique which led to increased transport costs, disrupted foreign trade transport routes, and resulted in an influx of refugees. These shocks posed a serious challenge to an economy that has historically been characterized by pragmatic management. ii. In 1988, the Government initiated a broad-based structural adjustment program that is supported by the IM4F and the World Bank. The reform program involves a reassessment of the country's medium-term development strategy as outlined in the Statement of Development Policies of 1987 and re- stated in the Policy Framework Paper of 1991. The underlying theme of the program is achievement of a higher sustainable level of economic growth with,in the context of viable medium-term balance of payments and relative price stability. The impact of the reform program has been reflected in a reversal of negative GDP growth in 1987 to a positive level in 1988 through 1990. GDP grew by 4.3 percent in 1989 and an estimated by 4.8 percent in 1990. iii. In the financial sector, reform is focusing on liberalizing financial markets and introducing market-based instruments for monetary policy management as a means of enhancing the sector's efficiency in resource mobilization and allocation and improving Malawi's growth prospects. The issues and measures being implemented are outlined below. iv. tary develgents in Malawi have tended to reflect underlying macroeconomic and fiscal developments. Short-term fluctuations in the main monetary aggregates are pronounced, responding to changes in the country's external position and the flscal policy stance under the constraint of currency inconvertibility. The direct transmission of monetary effects is due on the one hand, to the economy's .iarrow base and sensitivity to internal and external shocks, and on the other hand, to the shallowness of the financial system. v. Fiscal policy has exerted a major influence on the growth of the monetary base, with borrowing requirements of the public sector being a consistent and increasing source of monetary growth. In most years since 1979, credit extended by the Reserve Bank of Malawi (RBM) to Government and public enterprises has represented a large injection into the money base.  -ii- vi. Malawi's financial depth is in line with the average for Sub-Saharan African countries and better than the average for low-income Sub-Saharan countries. Although the financial system has been sufficiendy efficient to allow financial zasources to move out of narrow money into qursi money, the lack of depth has prevented the xbrther diversification into alternative financial instruments. This pardy explains the build up in excess liquidity in the commercial banking system in the second half of the 1980s. vii. An important prerequisite for overall improvement and reform of monetary management is the avoidance of excess liquidity and developing the capacity to manage liquidity so that money and credit conditions are consistent with price stability and sustainable growth in the real sectors. The accumulaticn of excess liquidity in the financial system, particularly in the commercial banks, severely constrained tie capacity of the authorities to effectively utilize monetary policy to achieve macroecowomic balance and finan^ial system development. Historically, monetary policy in Malawi has relied on the use of credit ceilings, the flexible adminiaration of interest rates and changes in the levd of reserve requirements. Towards the end of the 1980s, a reform process was initated that aimed to: increase the effectiveness of monetary policy, and thereby, improve the efficiency of resource mobilization and aRlocation; promote market determined interest rates; and promote the development money and capital markets. 'he main thrust of the refornms, most of which have been implemented, is to move away from central, direct control of monetary var...bles towards ths use of more flexible, market-oriented, indirect monetary policy management. viii. urrent ieforms have already enhanced monetary mnagement capacity as well as the development and deepening of f nancial markets. This will uldmately help increase the economy's capacity to cope with economic shocks while increasing its overall growth potential. lx. C i ns. A major monetary policy reform was the abolition of credit ceilings in January 1991. Necessary as the ceilings were during the 1980's to bring the macroeconomic aggregates under control, they have had a detrimental effect on the development of the financial sector. x. Irest rates have also become gradually liberalized over the second half of the 1980s. From a system of complete central bank regulation prior to 1985, the monetary authorities graduaiy deregulated the interest rate system by mid-1990. The banks introduced a new interest rate schedule in May 1990. RBM retains its discretionary powers of maintaining stability in the markets. This move, in conjunction with a healthier overall economic environment, has resulted in lower lending rates and higher deposit rates in the commercial banking system. xi. Exa sLuidity reduces the effectiveness of traditional monetary control mechanisms. Commercial banks with excess financial resources are not reliant upon the central bank for fiading and monetary policy levers, sucb as the bank rate and liquidity reserve requremes, are rendered less effective. This was the case in Malawi in the second part of the 1980'P id forced the monetary authoritder to resort to blunter tools of monetary management, such as credit ceilipgs and direct interest rate management. Begining in 1989, RBM started a process of using more indirect methods of monetary management, such as reserve requirements to sterilize excess liquidity. Recenty, there has been a general decline in excess liquidity caused by economic recovery.  - iii - xii. Development of Money Markets. A central element of a market oriented monetary policy re3ime is the use of open market opelations, to inject into or withdraw money from the financial system. Discount and advance facilities of the RBM have rarely been used in the past and remained inoperative during the recent period of excess liquidity. The decline in overall liquidity le.vels and the move toward the use of indirect monetary instruments will increase the importance of such facilities and hence the ability of the RBM to influence the level of interest rates. Open market operations in Government securities have also been sparsely used, but the lower level of liquidity and ongoing reforms will also assist in the development of an active money market. xiii. As a result of recent reforms, positive effects have already begun to emerge in terms of declining excess liquidity, positive rates of interest, and more active resource mobilization by financial institutions. The full movement towards a properly and smoothly functioning system of indirect monetary control will, however, take time. Nonetheless, further developments, such as the movement away from frequent reserve requirement changes as a tool of day-to-day liquidity management, towards discounting and open market operations, will remain necessary. To encourage tha evolution, the authorities should move more of the banking business of the parastatal sector from Government and RBM to the commercial banking system. As a longer term goal, the authorities should also encourage the evolution of an inter- bank market. xiv. As the authorities experiment with a more indirect form of monetary control, caution will be necessary to ensure that these nu w tools are used in appropriate ways. The Government has already implemented a substantial part of the reform program and success in further reforms will continue to hinge on careful sequencing of its implementation. The Financial System and Resource Mobilization and Allocation xv. By the end of 1990, the financial system was Malawi wzs comprised of a central bank (RBM); two commercial banks, the National Bank of Malawi (NBM) and the Commercial Bank of Malawi (CBM); two finance houses Leasing and Finance Company of Malawi Limited (LFC) and National Mercantile Credit (MC); a building society New Building Society (NBS); four developmcnt finance institutions, the Malawi Development Corporation (MDC), the Investment and Develoim-s Bank of Malawi (INDEBANK), the Investment and Development Fund of Malawi (INDEFUND), and the Small Enterprise Development Organization of Malawi (SEDOM); two savings institutions, the Post Office Savings Bank (POSB) and the Malawi Union of Savings and Credit Cooperatives Limited (MUSCCO); an insurance industry comprising a series of insurance companies and brokers as well as several pension and provident fund managers; and an informal financial market. By the end of 1991, two new finance household had entered the market. xvi. Resource Mobili7ation. The two commercial banks are the most important institutions in terms of resource mobilization. The wide branch network of the banks and the use of mobile units in rural areas, helps to generate a large deposit base, with a growth rate of almost 17 percent per annum, in line with the overall growth of their total assets over the period 1980 to 1989. Initially, high levels of excess liquidity led to a change in the structure of commercial bank liabilities, from long to short dated deposits, however, this trend has recently reversed. xvii. The non-bank financial institutions (NBFIs) have also played an important role. The growth in the deposit base of many of the NBFIs has been significantly higher than that of the commercial  - Iv - banks, indicating a broadening and deepening of the financial strucure. The Leasing Finance Compay (LFC), since commencing operations in September 1986, has emerged a one of the more important NBFIs. By offering relatively higher interest rates, LFC's deposit base increased at a ,ctacuar pace of around 100 percent per annum over the two and a half years period after Its inception. LFC has come to represent an important source of competition for commercial bank deposits, and ranks in size next to the NBS. xviii. The POSB by providing the most accessible deposit services has also played an important role, especially for the small and rural saver and ranks as the largest deposit taker outside the commercial banking system. Tax advantages offered by the POSB have also diverted some corporate fiuds from other financial institutions and this has helped to explain the 23 percent per annum growth in deposits at this institution between 1980 and 1987. Deposits at the NBS have also increased at a faster rate (27 percent per annum between 1980 and 1989) than in the commercial banking system, also in part due to tax advantages on certain types of NBS deposits. MUSCCO has also been instrumental in raising deposits from small-scale depositors. xix. Potentially, the inost important source of deposit mobilization is the insurance industry, which in conjunction with the numerous private pension funds, represents an important soura of long term investible resources for economic growth. Although resource mobilization by fiancial institutions outside of the insurance sector has been growing at 18.5 percent per annum over the 1980s, an averge annual rate of inflation of 16.9 percent has meant that real growth has been slow. Insurance concepts are not well developed in Malawi and growth in the sector has been erratic over much of the 1980s. xx. Resource mobilization in Malawi has been hindered by many economic uncerties, especially from the various shocks to the economy and the associated high levels of inflation. Although there is not a strong relationship between deposit mobilization and the level of inflation, the level of real returns on savings will inevitably have some impact on mobilization levels. Hence, the maintenance of positive real interest rates will be an important determinant of long-term savings paterns. xxi. Reorce Allation. In general, the financial system in the 1980's tended to act as a conduit of funds from the private to the public sector. This resulted from the various economic shocks which led to fiscal imbalances and a growing reliance upon the financial system as a source of public funding. xxii. Credit allocation from commercial banks was constrained to some extent by credit ceilings but, more importantly, by depressed economic conditions, which led to only a 6 percent per annum increase in credit allocation over the decade. This represented sharply negadve growth in real terms. In turn, much of the growth in credit extended by the banks was to the public sector rather than to the private sector. Recent developments have led to a reversal of this trend as Government borrowing declined and private secter credit Increased dramatically in 1989. The establishnient of LFC introduced a now financing mechanism (leasing) which has found a strong and growing niche market. Despite charging substially higher interest rates than commercial banks, LFC increase. the amount of leasing activity it undertakes by almost 100 percent per annum over the period 1987 to 1989. xxiii. The majority of the resources mobilized by POSB and NBS have been used to fince the activities of the public sector. POSB is required by law to invest all its assets in risk-free Government seurities or place them on deposit at RBM. Deposits at NBS are channelled primarily Into resideal  - v - mortgage financing, however, a large proportion is also invested in Government debt. By channelling short-term liabilities into long-term assets, NBS is the only financial institution in Malawi that effectively engages in matur v transformation. As the Government's fiscal position improves in the 1990s, both POSB and NBS will need to explore alternative investment options. The authorities are addressing the issue by restructuring POSB into an autonomous financial intermediary. xxiv. Other institutionsthat allocate financial resources include the MDC, INDEBANK, a range of small scale financial institutions (including SEDOM, INDEFUND, SACA and MUSCCO), the insurance industry and the informal financial sector. MDC and INDEBANK have potentially important roles to play in resource allocation, although their activities in this regard are currently restricted because they are heavily dependent on Govermnent and external funding, with limited capacity to raise Kwacha resources. Recently INDEBANK issued long-term bonds are specifically designed as a first step to address this constraint. Experience with the small-scale sector has been variable, with some institutions providing excellent examples of credit allocation while others have functioned pcorly. The role of the insurance sector is also becoming increasingly important as the volume of funds held by these institutions expands and the alternative of Government lending declines. Investments from the insurance industry portfolio of K174 million at the end of 1988 is almost evenly distributed between government securities, deposits with other financial institutions and investments in private sector. Lastly, although there is little hard data, some research work suggests that the volume of funds both saved and lent through informal channels may be very significant. xxv. Given the healthier financial position of the Government by 1990, the financial system's funding of the public sector was beginning to decline and increasingly more finance was freed for use by private sector. Nonetheless, the oligopolistic nature of the economy and the skewed distribution of incomes in Malawi will continue to provide some bias against the allocation of resources more widely throughout the economy. xxvi. The hitherto fragmented nature of the financial system and the high level of specialization of financial services has also tended to work against a better allocation of resources. In this regard, there are strong arguments for the development of more multipurpose financial institutions. A wider range of financial activities by each institution will provide an important element of competition within the system. Already, a number of financial institutions are diversifying their product range and activities. Further competition could be provided by a lower Government profile in the sector, and by offering less high yielding, risk-free Government paper. As a longer term development, the evolution of a wider selection of readily marketable financial instruments will also serve to raise additional funds and allocate them in a more appropriate manner. There is also a need for the authorities to educate the general public about financial markets. xxvii. A flow of funds analysis confirms that the financial system has acted as a conduit of funding from the private to the public sector. Nonetheless, a disaggregation of the first and second half of the decade indicates that Malawi's financial system has become a more efficient mobilizer of financial resources from the private sector, over time, and that less of the financial resources mobilized now flow to Government. This analysis also indicates the small, but nonetheless important, role played by NBFIs in the financial sector, both as mobilizers and allocators of financial resources. Lastly, the analysis confirms that the parastatal sector, which has never been an important user of commercial banking services, now relies even less on the financial system to meet its finansing requirements than what it did  -vi - at the beginning of the decade. The Government should encourage the financially stronger parastatals to make greater use of the commercial banking system. Institutional Issues xxviii. Tbe Government's strategy for the financial sector, involves strengthening monetary control, deepening the financial system and improving the efficiency of resource mobilization and allocation for private sector investments. Among the major institutional issues that explain the sector's inability to respond flexibly to investor needs are the high level of concentration of assets in the economy and the consequent concentration of banking activities. Most financial institutions are effectively controlled by a small number of agricultural and industrial conglomerates which have dominant market positions in Malawi through interlocking ownerships. The resulting concentration of both deposits and lending, goes against sound banking principles of diversification and reduces intermediation efficiency. The best solution to the problem of concentration would require a complete structural change in the economic base. However, this solution is not feasible in the shorter term. Nonetheless, several efforts have been initiated to help mitigate against the more perverse effects of excessive banking concentrations. These include encouraging the entry of new players into the banking sector, switching parastatal finacing from the budget to the commercial banks, and syndication of large loans so as to spread their risk. In the medium term, the authorities should also encourage the stronger financial institutions to offer equity shares to the general public as a means of de-concentrating ownership and broadening Malawian participation in the economy. xxix. The second commercial banking problem has been, untl recently, a lack of adequate prudential regulation and supervision. Tbis problem was, in turn, exacerbated by the concentration issue discussed above. Recent assistance from the IMF in the form of an experienced bank supervisor to RBM has helped address this problem. Although much remains to be done to ensure adequate surveillance and inspection, this appeared to be in process by mid-1990. XXx. The high concentration of assets has led to concerns over the lack of competitive pressures in the banking sector. Several important developments make this less of an issue for the future. These include an emerging competition between the two commercial banks; the aggressive entry by LFC into the market; the movement by the commercial banks into non-traditional areas of activity such as term lending; the granting of a license to INDEBANK to engage in a wider range of merchant banking activities and other financial services. The authorities should continue pursuing the goal of attracting more players into the market. xxxi. Term Finance. Although excess liquidity declined significantly in early 1990, the commercial banks tend to have excess liquidity, which they invest in government securities. The excess liquidity also reflects both the traditional reluctance to lend for terms much over 12 months and the attractive yield offered on government securites. The NBFIs, such as INDEBANK, LFC and MDC, which potentially represent the most innovative part of the market, have only been able to play a limited role. Therefore, the challenge is to create effective intra-market intermediation mechanisms in Malawi that facilitate the flow of resources between institutions and enable some term transformation to take place. Subtle pressure from the authorities may lead to some smal shift in the maturity of the bank's lending portfolios. However, in the longer term investors may have to rely on the development of new instruments such as bonds, loan syndications and share issues to provide term resources.  - vii - xxxii. The Post Offce Saving Bsank 1POSB) has the potential to be an important player in the financial system, but suffers from operational difficulties, which resulted from technology changes that led to a work bacldog that has persisted until now. There is a need for POSE to: determine alternative investment options in order to reduce its tradidonal reliance upon Government paper; eliminate the provision of tax exempt status on corporate savings deposits at the POSB; and determine its role in the evolving financial system. The authorities have initiated actions to deal with these issues as part of the program to restructure POSB. xxxiii. In common with the POSB, NBS faces problems of investing its surplus resources in the absence of a ready supply of high yielding and risk-free Government paper. The removal of the tax exempt status on a certain class of NBS deposits could help to redirect some of the deposits at NBS into alternative investments. In addition, the NBS faces non-financial problems in the housing sector which have impeded its ability to provide housing mortgages. The authorities need to address these non- financial constraints if NBS is to be able to effectively and efficiently engage in term transformation. xxxiv. Although the Malawi Development Corporation N WDC) has the potential to contribute more to the development of the financial system and the industrial sector, since its restructuring it has remained virtually dormant. Part of the reason has been the lack of autonomy and discretionary authority for management that a private and commercially oriented institution should have. Government should consider conferring more discretion to the management of the institution. The quid pro quo, should be that the Corporation's management be strengthened and that it adopt a significantly more aggressive stance in its development of both the industrial and financial sectors. Sal Issuem xxxv. Agcultural Financ. The system of financing small-scale farmers in Malawi has experienced a reasonable degree of success. Agriculture is a large and important part of the Malawi economy and the Government's policy objective is to improve income levels of smallholder agriculture by helping them increase production. This is reflected in the large proportion (over half) of the commercial banks' lending portfolio allocated to agriculture. However, bank lending to agriculture is almost exclusively to the large estate sector while medium and small-scale agriculturalists are locked out by a lack of security and an absence of an established banking history. Outside of the estate sector, the typical farmer is very small with holdings of less than one hectare. The Government has implemented several policies to help satisfy the credit demands of smaller farmers, including credit programs through the Smallholder Agricultural Credit Administration (SACA) in the Ministry of Agriculture (MOA) and SME term credit through other formal financial intermediaries. Together with agricultural services, SACA provides mainly short-term seasonal input loans. This scheme, which has been limited to larger small-scale farmers, has been extremely successful with collection ratios of between 75 and 95 percent. Although the scheme has recently been expanded to cover a wider range of small-scale farmers, further steps will be needed to cater fully for the needs of smallholder agriculture in general. The entry of the Malawi Mudzi Fund (MMF), which is modeled on the Grameen Bank and started operations in mid-1990, may help expand access to credit for commercial smallholder farmers. xxxvi. It is recommended that credit to this sector should not be subsidized. Although Governments have often tried to target and assist specific types of development through subsidized lending, their performance has been almost uniformly bad and, in many cases, perverse. Any subsidy element to small scale lending should be on extension support. In such cases, it will be neceay for any  - viii - subsidies to be transparent and appropriately targeted. Lending institutions that supply credit to SMEs should seek to utilize the social sanction inherent in stable societies and which the SACA program has used to good effect. Social sanction can act s a substitute for other forms of loan security that are often not an option for this clientele. It is recommended that the social cost of defaulting on loan repayments be increased through this type of sanction in order to meet the objectve of increasing lending. The longer term solution to the collateral security problem is to review and, eventually, amend the administration of the land tenure system in order to enable small scale and medium scale agricultural producers to use land as security. xxxvii. Hausing Flangn. In common with many developing countries, especially those with new capital cities, a large proportion of the housing stock in Malawi is provided by the Government. The Government has remained a pervasive participant in the housing market through its parastal arm, the Malawi Housing Corporation (MHC). Nonetheless, NBS was established with the aim of providing mortgage loans to encourage private house purchase. However, a substantial proportion of the assets of NBS are held in Government securities due to a lack of demand for housing mortgages. xxxviii. The lack of demand for home mortgages is due to a series of non-financial constraints, including limited affordability resulting from very low income levels, the rapid escalation of construction costs over the last decade, the provision of highly subsidized Government housing to civil servants, and the slow bureaucratic process of allocating both land and existing housing to home buyers. xxxix. The Government recognizes that there is an urgent need to emphasize home ownership as an important component in the efforts to encourage asset accumulation. Therefore, there is a need for the Government and other employers to consider the feasibility of providing employor-supported financing arrangements. In additien, innovative financing mechanisms, such dS graduated payment mortgages and shared appreciation mortgages, could also be introduced to reduce the affordability constraint. The Government should also plan for future growth of the housing finance market by encouraging more participants to be involved in mortgage finance, including the commercial banks, NBFIs, and insurance companies. Xi. Small and Medium Enterprise (SMO Finance. SME sector experiences particular problems in accessing sources of finance. Low levels of income, lack of financial background, inadequate project preparation and an absence of adequate acceptable collateral, all effectively reduce the provision of financial services to this sector. To help address this problem, three financia institutions were established to service the SME sector. These are INDEFUND, SEDOM and MUSCCO. INDEFUND became profitable in the later part of the 1980s, and between 1981 and 1988, it lent K1O million for agro-industry and manufacturing. SEDOM provides both working capital loans and medium- term credit, although the former is by far the more important. Support from both the Government and the European Economic Community (EEC) has been important for SEDOM's activities. MUSCCO is a significantly smaller institution which focuses on lending internally generated resources. The recently established MMF is another participant in this market. These institutions are supported by non-financial service institutions such as the Development of Malawian Traders Trust (DEMATh, the Malawian Entrepreneurs Development Institute (MEDI) and Women's World Banking of Malawi (WWBM) which provide, business advisory services and training, technical and management training, and credit guarantees on borrowing by businesswomen, respectively. The inforna finmancial sector and personal and intenly generated savings additional and important sources of finance for the SME sector. The commercial banks  - ix - and other larger financial institutions are hesitant to service the sector because of the high administrative costs and the perceived high-risk associated with clients in the sector. xli. Careful examinatiozi of the constraints facing the sector demonstrates inter-relationships between these three elements and the limited impact of short-term solutions on these constraints. The establishment of venture capital funds and credit guarantee facilities are currently being considered by some donors and may provide some limited assistance to the sector. Women borrowers face particular problems and initiatives such as WWBM and MMF will help to address the constraints faced by this particular group. There is also a need for SME support organizations to broaden their target groups so as to include types of enterprises that rural women are likely to be involved with and to include more women on their staff. The Government is also committed to liberalizing the financial sector in order to provide adequate finance and ease access to credit for SMEs. xlii. Parastatal Finance. The performance of the parastatal sector, which forms a large part of the economy and accounts for around 25 percent of the national income, has been erratic. Poor performance in the mid-1980s led to a World Bank survey of the parastatal sector in 1987 that identified the following main problems; a focus on bureaucratic detail at the expense of bigger issues; a focus on smailer parastatals and inadequate monitoring of the larger ones; insufficient attention paid to efficiency; and, over centralization by Government of decisions best made at the parastatal level. Since then rationalization and restructuring of many of the parastatals has led to a substantially improved financial position. As a result, Agricultural Development and Marketing Corporation (ADMARC) (which is one of the largest parastatal organizations) has divested itself of a series of subsidiaries as part of an ongoing process of rationalization. Other parastatals, such as MDC, have also divested themselves of several operations and have emerged more financially sound. The privately held Press Group, which operates like a quasi-public entity was also included in the restructuring program and is now a much stronger organization. xliii. There are four issues of concern in the area of parastatal finance: the past practice of providing intermediated loans to private companies through parastatals by RBM; a lack of consistency in the policy relating to who assumes the foreign exchange risk and on the level of interest rates charged to parastatals; the current dormant state of MDC and its potential as a market maker and developer in the financial sector; and parastatal borrowing from the domestic banking system, especially from Government which is the single most important source of loans for parastatals. In general, it is recommended that intermediated loans through parastatals to private companies should be discontinued; that a consistent set of rules on interest rates and exchange rate risk should be applied; that MDC be strengthened and assisted to adopt a more aggressive and catalytic role in the financial sector; and, that more parastatal financing should be moved into the commercial banking sector and away from its current reliance upon Government. Development of Capital Markets xliv. Capital markets are playing an increasingly important role in economic development. Capital markets that develop in a fashion appropriate to their host country can help increase the level and efficient utilization of financial resources, and thereby stimulate and accelerate the process of economic growth. Capital markets help to increase the choice of financial instruments available to investors. They also increase competition in the financial sector and channel resources towards investments with the highest returns. Capital markets can only thrive if the environment is conducive to economic growth.  -x - xlv. In Malawi, the authorities are committed to encouraging the development of such markets. Although the types of instruments that capital markets would provide are currently not available, there is evidence of demand for these type instruments. Although Malawian individuals are considered too poor to become involved in capital market activities on a large scale, there are undoubtedly some individuals to whom the development of such a market would be of interest. More important, however, would be the institutional investors such as the insurance companies and other types of managed funds, which have large and increasing volumes of long term funding and limited opportunities for investment. xlvi. In 1990, the passing of the Capital Market Development Act and the issue of bonds by INDEBANK were a significant first step towards the development of a capital market in Malawi. As the market develops further, brokers/dealers will need to emerge to provide a secondary market to issuers of capital market instruments. xlvii. A major issue in Malawi is the lack of incentives for private companies to issue their shares to the general public. As a result there are virtually no public companies in Malawi. Under current legislation, private companies are restricted from transferring their shares without giving first right of refusal to existing shareholders, or having more than 50 share holders, and/or making any invitation to the public to acquire any shares or debentures of the company. Initially, to stimulate the market, the authorities may have to provide incentives to companies that go public and to individuals and companies that purchase debt and equity through capital market mechanisms. xlviii. Malawi has all the ingredients needed to establish a successful capital market. To assist in the development of such a market, the authorities should review and amend, as necessary, both company and taxation legislation as it effects capital market development. As indicated under the Capital Market Development Act, RBM should also begin to develop its capacity to supervise and regulate to ensure that a properly functioning capital market with adequate prudential regulatory measures emerges. As a first step in this direction, it is recommended that the authorities establish a capital market development authority to formulate guidelines and provide direction for the development of the market. To help provide further support, the authorities could usefully consider allowing those parastatals and Government owned institutions, with proven profitability, to issue bonds and shares. The establishment of an investment or unit trust, initially holding shares of some of the parastatals to be privatized, could also assist in market growth. Conclusions xlix. The new direction of monetary management and the development of the financial system have been significant since late 1988, as the authorities have initiated a comprehensive financial sector reform program. Recognizing the strong linkages between an efficient financial system, the quality of investment and overall economic development, the authorities are seeking to: strengthen their capacity to encourage and effectively manage a more market oriented monetary policy system; enhance competition, by allowing new financial institutions (both local and foreign) to enter the market; and by licensing existing institutions to broaden the scope of their activities. Steps have already been taken on the latter by granting a limited banking license to INDEBANK and by initiating measures to re-orientate the operations of POSB. It is also likely that other financial institutions will branch out into new areas of activity. If the financial sector is expected to become dynamic and contribute more to economic development, issues which should be kept under active review are: a reduction in direct or indirect public ownership of financial institutions; Government maintenance of fiscal discipline in order to avoid  - xi - crowding out the private sector; maintenance of market determined interest rate policy; and, shifting parastatal sector banking requirements to the commercial banks rather than the Government. Government should work towards finding appropriate ways and means of deconcentrating asset ownership and increasing private participation in the economy. One of the most significant measures recently taken is the enactment of the Capital Market Development Act, that provides the legal framework for the longer term development of the capital markets in Malawi. Besides introducing competition, the development of money and capital markets would help both competition and foster a more efficient intermediation process and direct financial flows for investment in appropriate maturities and price to investment with the highest return. Recent Developments 1. The findings in this report reflect the situation in Malawi as it prevailed at the time of the main mission in March, 1990. Since then, the financial markets have experienced a sharp increase in competition and Government has been consistent in implementing reforms at the macroeconomic and financial policy levels. These developments are consistent with the recommendations contained in this report and reforms initiated by Government. As a result, the financial markets have become more competitive, particularly in the nonbank financial institutions segment. The previously moribund Mercantile Credit (renamed National Mercantile Credit) was purchased by the National Bank of Malawi (NBM), while a financial services company has been established as a joint venture between First National Bank of South Africa, the National Insurance Company (NICO), and the Commercial Bank of Malawi (CBM). At the same time FINCOM (a joint venture between ADMARC and Lonrho) has been converted into a full-fledged finance house, while the diversification of INDEBANK into merchant banking has been initiated with the creation of a deposit taking and trade finance window in October, 1991. As of December, 1991 there were indications that a local group had submitted an application to establish a commercial bank, while another set of local investors is considering applying for an NBFI license to establish a merchant bank. Meanwhile, Government has accepted preliminary recommendations of consultants for the reform and eventual transformation of the POSB from a deposit taking arm of the Ministry of Finance into an autonomous financial institution. At the policy level, Reserve Bank of Malawi (RBM) has moved to an indirect system of monetary policy management. Based on these developments, RBM recognizes that the next step in consolidating the gains from the reform process is to build up a strong human resource base to support financial institution development and sustain the evolution of the sector. From this point of view the authorities are contemplating the establishment of an institute of bankers that would become the focal point for related seminars and training activities.  CHAPTER I THE MACROECONOMIC SEITING A. General Background 1.1 Malawi is a land-locked nation of 8.2 million people in Southern Africa with a per capita national income of US$170 (1988), making it one of the poorest countries in the world. Since independence in 1964, Malawi has been characterized by effective and pragmatic management of its economy. However, the economy has a fragile and narrow resource base, with a large proportion of population still dependent on subsistence agricultural production and on a small range of exports. Foreign trade is a large sector of the economy; with exports and imports accounting for about 50 percent of GDP. These attributes make the economy very vulnerable to economic shocks. 1.2 Real growth in GDP fluctuated markedly from year to yeir, with average growth in real GNP per capita between 1964 and 1974, of 4.3 percent per annum.2 Nonetheless, Malawi was one of the fastest growing countries in the region. In the late 1970s, the rate of growth fell as Malawi experienced a series of economic problems, which included: a sharp deterioration in terms of trade (estimated to have fallen by about 28 percent over the period 1978 to 1981) as a result of lower export prices on world markets and a sharp increase in oil prices; prolonged drought, which severely reduced export volumes; and a rapid increase in transport costs as a consequence of the disruption of traditional transport routes due to civil disturbances in neighboring Mozambique. 1.3 The initial response of the Malawi Government was fiscal expansion to counteract the effects of a weakening external position. This led to a significant fiscal deficit, which was largely financed by external debt that by 1980/8 1, amounted to 11 percent of GDP. In 1981, the Government introduced stabilization measures, that were supported by the World Bank and the International Monetary Fund (IMF), which led to some recovery over the period from 1982 to 1985 as both internal and external imbalances were partially brought under control. However, commodity price decline, combined with high external debt-service payments and associated rising public sector deficits, led to further deterioration, such that by 1986 it was necessary to ration foreign exchange. Meanwhile, the worsening security position in Mozambique, led to the closure of the primary transport routes in 1985 that forced Malawi to rely upon the more expensive routes through South Africa and the northern corridor through Tanzania. The war in Mozambique also led to an influx of displaced persons and by late 1989 the numbers had reached 800,000 people, equivalent to 10 percent of Malawi's total population, which added further to Malawi's mounting economic problems. 1.4 As a consequence of the shocks, there was a further deterioration in the fiscal deficit, from 8.5 percent of GDP in 1984/85 to 13 percent in 1986/87. In response, the Government undertook a series of new adjustment measures. A three year program was developed covering the period from A more detailed treatment of macroeconomic developments in Malawi is contained in the Country Economic Memorandum: "Malawi - Growth Through Poverty Reduction." Report No. 8140-MAI of March 22, 1990. 2 World Development Report.  April 1988 to March 1991 and was supported by a three-year arrangement under the IMF Enhanced Structural Adjustment Facility (ESAF), the World Bank's Industrial and Trade Policy Adjustment Credit (ITPAC) and the Agriculture Sector Adjustment Credit (ASAC). 1.5 The policy framework for adjustment lending was the achievement of a higher sustainable level of economic growth within the context of a viable medium-term balance of payments and relative price stability. The program also emphasized the role of the private sector and a return to more liberalized economic policies. Principal policy reforms were adopted in four basic areas: the external sector, public finance, monetary policy and agriculture. 1.6 In the external sector, the structural adjustment program emphasized the adoption of a flexible rate exchange policy, removal of the requirement for prior approval for foreign exchange on current payments and liberalization of all imports. In addition, the Government has undertaken to review the existing tariff structure for imports and streamline the duty-drawback scheme for exporters. These policies aimed at enhancing Malawi's export competitiveness and assisting the development of non- traditional exports. Various debt rescheduling exercises and a switch from commercial to concessional borrowing helped to further strengthen the country's external position. 1.7 In public finance, the Government introduced several revenue enhancing measures in 1988/89 - 1989/90 aimed at reducing the budget deficit. New tax measures were introduced as part of an ongoing reform of the tax system, including a surtax system, merger of the import duty and levy tariff schedules and improved tax administration and collection. Recognizing the potential disincentive of high taxation, the Government placed the burden of fiscal adjustment with expenditure control rather than revenue generation. 1.8 Tight monetary policies, mainly involving a reduction of ciedit to Government, were also instituted to reduce domestic inflation while providing the private sector with sufficient financial resources. Interest rates were also fully deregulated in May 1990. Success with monetary restraint under the adjustment program, however, was not as good as expected, with the broad money supply increasing by 27 percent in fiscal 1989 against a target of 4 percent. Despite this, the 12 month inflation rate fell from 31.4 percent in December 1988 to around 15.7 percent by the end of 1989. Greater monetary control was supported by revisions to the Reserve Bank of Malawi Act (RBM Act) and the Banking Act which were enacted during 1989. B. Macroeconomic Developments Savings. Investment and GDP Growth 1.9 Both investment and savings performance, however, deteriorated in the 1980s. A major source of domestic savings in Malawi had traditionally been private companies. In the 1980s, their savings performance was adversely affected by weak economic activity. In addition, the savings share of the household sector also weakened as real levels of per capita income fell. The fall in overall domestic saving, however, was most influenced by the persistent decline in public sector savings, which were negative in six of the nine years between 1979 and 1989. 1.10 In the 1980s, investment also suffered as a consequence of fiscal austerity, the deterioration in the economy, the accompanyirg loss of income and, to a lesser extent, fluctuations in  - 3 - foreign capital inflows. The adjustment of domestic consumption fell disproportionately on investment. Gross fixed capital formation fell persistently, from 23.6 percent of GDP in 1973-80, to 12.4 percent in 1985-88. Public investment fell as major public sector investment projects were completed and no new projects were commenced. Private investment (which includes parastatals), also fell steadily, from 8.6 percent of GDP in 1973-80, to a low point of 1.9 percent in 1987. Although the level of investment recovered sharply, growing by 12 percent and 20 percent in 1987 and 1988, fixed capital formation per capita in 1988 was roughly a third of its peak level of 1977-80 and less than half the level of the mid 1970s. 1.11 As a result of lower savings and investment, from 1984 to 1988, real GDP rose by only 2.6 percent a year while population grew by 3.5 percent a year. Consequently, GDP per capita fell by a cumulative 3.2 percent over the period 1984-88 and in 1988 stood 19 percent below its level a decade earlier. Although the share of consumption expenditure to GDP increased from an average of 84.3 percent in 1981-84 to 92 percent in 1988, private consumption per capita actually fell by 12 percent from 1985 to 1987 before rebounding sharply in 1988. 1.12 The economic recovery that began in 1988, was assisted by a resumption of imports of intermediate and capital goods, financed by higher export earnings and higher external inflows. Real GDP growth more than doubled from 1.1 percent in 1987 to 2.9 percent in 1988 and current estimates show that growth in 1989 was an even faster 4.9 percent. 1.13 A large part of the impetus for growth came from the agricultural sector (particularly the estate sector) and from agricultural based manufacturing. The manufacturing sector benefitted from the freeing of foreign exchange restrictions on imports of intermediate inputs and registered strong growth in 1989. This strong growth performance occurred despite further shocks to the economy in the form of lower tobacco prices (which more than compensated for by larger export volumes), a growing population of displaced persons from Mozambique and a series of earthquakes and floods in the first quarter of 1989. The current Policy Framework Paper projects continued strong growth throughout the 1990s of around 4.5 percent per annum. Balance of Payments 1.14 Current Account. Malawi's current account performance reflects the fluctuation of agricultural output, world market conditions for tobacco, tea, and sugar, the disruption of transport routes and other economic shocks. In the 1980s the influx of displaced persons also resulted in substantial emergency imports mostly, but not entirely, financed by foreign aid. In addition, interest payments on a relatively large external debt, incurred in the late 1970s and early 1980s, contributed to the current account deficit. The balance of payment outcome, therefore, depended upon official assistance flows and, occasionally, external borrowing on commercial terms to offset fluctuations in the current account. 1.15 The first manifestations of the economic crisis of 1978-1981 was a sharp deterioration in the current account deficit of the balance of payments which rose to 18 percent of GDP in 1978 and 25 percent in 1979 compared to between 7 and 9 percent during the early 1970s. Subsequent adjustment was directed at deficit reduction, but was not fully successful in steadily improving the trend. Improvement, when it occurred, was to a large extent related to developments in the trade account, either because of short lived terms of trade effects or import rationing.  -4 - 1.16 There was some recovery in 1984 during which the current account deficit fell to 1.7 percent of GDP, largely due to a temporary increase in tea prices and higher tobacco exports. However, in 1985 the deficit rose to 8.1 percent of GDP. This, combined with decreased inflows on the capital account, led to increasingly rapid foreign exchange reserve losses. In 1986, gross reserves fell to less than a month's worth of imports and in response the authorities imposed a strict system of foreign exchange rationing that sharply contained imports and reduced the deficit in 1986 and 1987. 1.17 The relaxation of these controls, along with increased capital inflows, allowed for an increase in the level of imports that led to an increase in the current account deficit to 8.1 percent of GDP in 1988 and expectations of further deterioration during 1989. Import growth arising from the liberalization program more than compensated for the better export receipts. 1.18 Capital Account and External Debt. After peaking in 1980, net long term capital inflows, including official transfers decreased to an annual level equivalent to about 30 percent of the peak during 1982-1986. The decrease mainly reflected the completion of large public sector, foreign financed investments, the virtual cessation of public sector borrowing on commercial terms and the decreased availability of medium and long term credit from commercial banks. In 1987 and 1988 the capital account improved markedly due to a reversal of capital outflows, a pick up of private capital inflows and an increase in grants and concessional external financing. 1.19 The large fiscal and external payments deficits incurred over the period 1978-81 were financed, to a large extent, by external borrowing on commercial terms. As a result, the country's debt service obligations rose rapidly and were projected to exceed 50 percent of exports of goods and non factor services. Consequently, Malawi sought debt relief through periodic rescheduling of official and commercial bank debt. Total debt service obligations in 1985-88 were 10.3 percent of GDP. They declined further as Malawi negotiated additional rescheduling agreements again in 1988, and grant financed loans reduced interest and repayment obligations. Debt relief, along with large capital inflows in 1988, led to all debt service payments being regularized, and the elimination of import payment -. r4ars that had accumulated in 1986 and 1987. 1.20 Future developments on the balance of payments will continue to hinge crucially on the prices of Malawi's major export crops and export diversification. The recent growth in manufacturing, assisted by the more liberal foreign exchange regime for imports is initially having an adverse impact on the balance of payments in terms of higher import levels. However, the ability to create self sustaining export industries should ultimately produce a more diversified economy on which future growth and exports can be based. Exchange Rate Developments 1.21 Since the early 1980s, Malawi's exchange rate policy has relied on making discretionary adjustments against a trade weighted basket of currencies. This is done to offset losses in competitiveness arising from the difference between Malawi's rate of inflation and that of its trading partners. In line with this policy, the kwacha was devalued seven times during the 1980s. 1.22 The Malawi kwacha was pegged to the SDR in June 1975 and the exchange rate remained unchanged until a devaluation of 15 percent in April 1982. Effective January 1984, the currency peg was changed from the SDR to a trade-weighted basket, and at the same time it was devalued by 12 percent.  -5 - Further periodic adjustments ranging from 10 to 20 percent occurred between April 1985 and January 1988. The most recent occurred in March 1990, with a devaluation of 7 percent. Movements in the kwacha against the U.S. dollar, the SDR and the South African rand are shown in Figure 1.1. Flucal Developments 1.23 Until the mid 1970s Malawi's fiscal policy was conservative with the overall deflcit, after grants, fluctuating between 3 percent and 5 percent of the GDP. The second half of the 1970s witnessed an increase in central Government expenditures and transfers from 22 percent of GDP in 1970-72 to 30 percent of GDP in 1979. Much of the rise was concentrated in public investment spending. Parastatals also expanded their spending substantially. Since revenues did not grow at a commensurate pace, the overall deficit after grants increased to around 6.2 percent of GDP in 1977/78. 1.24 The economic difficulties of the late 1970s and early 1980s precipitated a deterioration in the deficit, measured in terms of GDP, which grew rapidly from 1979 to a peak of 11.4 percent in 1982 (15.1 percent excluding grants), as shown in Table 1.1. Between 1981 and 1985, the overall deflcit declined to 6.2 percent of GDP (8.5 percent excluding grants), primarily due to a cut back in development expenditures. However, this situation was briefly reversed in the middle part of the 1980s as the fiscal deficit expanded as a share of GDP from 6.2 percent in 1985 to 9.6 percent in 1987 (8.5 percent to 13 percent excluding grants). The deterioration was due to large extra budgetary expenditures associated with food stocking and the security situation. 1.25 This was followed by a restoration of fiscal discipline in the latter part of the 1980s, resulting from strict expenditure control coupled with a good performance in all areas of tax revenue. Revenues were boosted by better performance in the agricultural and industrial sectors stemming from the liberalized importation system which resulted in increased company and surtax collections. As a consequence, the fiscal deficit declined once again to -1.2 percent of GDP in 1989 (6.6 percent excluding grants).  pU~~~J/~~tJOWIM.)j OS~) I~) aeA 6861 LS6M S961 986L 1861 6L61 161 S6L C