Malawi - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 18349 MAI MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE REPUBLIC OF MALAWI August 4, 1998 Africa Region 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 disclosed without World Bank authorization.  The last Country Assistance Strategy was dated March 19, 1996 CURRENCY EQUIVALENTS (as of July 1998) US$I =MK26.7 MKI = US$.037 MK1 = 100 Tambalas FISCAL YEAR April 1 - March 31 (until March 1998) July I - June 30 (as of 1998) ABBREVIATIONS AND ACRONYMS ADMARC Agricultural Development and Marketing Corporation AFORD Alliance for Democracy CAN Country Assistance Note CAS Country Assistance Strategy CFS Client Feedback Survey CPPR Country Portfolio Performance Review DANIDA Danish International Development Agency EDI - Economic Development Institution ESAF Extended Structural Adjustment Facility ESCOM Electricity Supply Commission of Malawi ESW Economic and Sector Work EU European Union GEF Global Environment Facility HIPC Highly Indebted Poor Countries IDA International Development Association IDF Institutional Development Fund IFAD International Fund for Agricultural Development IFC International Finance Corporation IMF International Monetary Fund LILS Learning and Innovation Loans MASAF Malawi Social Action Fund MCP Malawi Congress Party MIGA Multilateral Investment Guarantee Agency MPTC Malawi Posts & Telecommunications Corporation. MRFC Malawi Rural Finance Company MTEF Medium-Term Expenditure Framework NGO Non-Governmental Organization PHN Population, Health, and Nutrition QAG Quality Assurance Group SADC Southern Africa Development Community SIPS Sector Investment Programs SME Small and Medium Enterprises UNCDF United Nations Capital Development Fund UDF United Democratic Front UNDP United Nations Development Programme Vice President: Callisto Madavo Director: Barbara Kafka Sector Manager: Ataman Aksoy  FOR OFFICIAL USE ONLY MALAWI COUNTRY ASSISTANCE STRATEGY TABLE OF CONTENTS Executive Summary ...................................................i IL Economic and Social Context: Legacy, Performance, Prospects .............................................1 Legacy and Constraints ..............................................1 External Environment ..............................................2 Recent Economic Performance ..............................................3 Growth Prospects .............................................4 H. Malawi's New Strategy .6 IH. The Bank Group's Country Assistance Strategy .9 Previous CAS Perforance .9 The Current CAS .12 IV. Bank Group Country Program .19 Portfolio Management .19 The Bank's Program - Scenarios, Proposed Lending and Triggers .20 Non-Lending Services .22 Partnerships.23 Risks and Concluding Remarks .24 Boxes I Malawi at a Glance .1 2 Poverty, Inequality, and Growth .3 3 The Main Elements of the New Strategy .6 4 Criteria for New Lending Under the CAS .13 Attachments 1 Malawi: Debt Sustainability Analysis for Country Assistance Strategy 2 Policy Reforms Undertaken by Government Since 1994 3 Key Donors in Selected Sectors 4 Client Feedback Survey 5 IFC Assistance Strategy for Malawi Annexes 1 Malawi at a Glance 2 Selected Indicators of Bank Portfolio Performance and Management 3 Bank Group Program Summary, FY 1998-2001 4 Summary of Nonlending Services 5 Social Development Indicators 6 Key Economic Indicators and Projections Under Different Scenarios 7 Key Exposure Indicators 8 Status of Bank Group Operations in Malawi 9 CAS Program Matrix 10 Summary of Development Priorities Map IBRD 29374 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 disclosed without World Bank authorization.  MALAWI COUNTRY ASSISTANCE STRATEGY Executive Summary 1. Since discussion of the last CAS (dated March 19,1996), Malawi has made considerable progress in cementing the democracy introduced in 1994, improving macroeconomic parameters and implementing structural reforms. Good policies contributed to strong growth of more than an average 9% in 1995-97; the growth was more broad based than in the past. However, in 1997/98 the pace of refonrs decelerated and expenditure control weakened, with the result that the fiscal deficit exceeded the target by more than two percentage points of GDP. Disbursements under the IMF ESAF have been suspended; however, in May 1998 Malawi and the IMF agreed on a staff- monitored program, which if implemented successfully, should lead to restoration of the ESAF by November 1998. A budget for 1998/99, in line with agreed parameters, has recently been approved. Early indications are that Malawi is also seizing the initiative to move forward again with structural reforms. 2. Malawi remains a very poor country with difficult development challenges: limited natural resources, periodic drought, heavy reliance on tobacco with difficult long term prospects, landlocked position, rapidly growing population, poor social indicators, high incidence of HIV/AIDS (30% of women attending ante-natal clinics) and environmental degradation. The good growth of the last few years indicates that with luck and good policies Malawi can make important strides. The agricultural liberalization of the past few years has had considerable positive impact on rural incomes. With almost 90% of the population living in rural areas, smallholders will need to be the engine for growth in the near term; however, over the longer term, contributions from the industry and tourism sectors will be critical and the base needs to be set now. Recent analysis indicates that at present population growth rates, Malawi will need to grow at an annual average of 5.3% just in order to keep the number of poor from increasing. 3. Key to achieving adequate growth will be macroeconomic stability, which in turn depends on the prioritization and control of public expenditure. But this will not be enough. Malawi has little choice but to move systematically on a broad front, improving infrastructure and the overall business environment for private sector development; improving the quality and access to education and health services and vigorously pursuing a family planning program and attacking HIV/AIDS; ensuring a safety net for the poorest; and addressing the serious environmental issues, such as land degradation and declining soil fertility. 4. The Bank's Assistance Strategy has tried to balance the need to move on a broad front, and to complete reforms already initiated, with the constraints imposed by the need to develop realistic, costed strategies and build capacity. Selectivity will be pursued by making sure that key prerequisites are present before new initiatives are launched: sectoral strategies, commitment to reforms, adequate capacity to implement and inability  ii of other donors to provide the full scope of needed support. Enhancing donor coordination will also be an important objective. 5. The base case program provides for new lending of some $113 million a year in FY98-01. The base case assumes satisfactory implementation of the current portfolio, macroeconomic stability, adequate progress on developing sectoral strategies and implementation of the civil service and expenditure reforms needed to enable a better focus of and incentive framework for the public sector. Significant support will be directed for non-lending services to help develop sector strategies and priority work on such issues as social safety nets. Cooperation with the other members of the Bank group will also figure prominently. The Bank would continue to monitor Malawi's external debt situation and advise on how Malawi would be able to further improve its debt profile. 6. The Malawi program entails risks: elections are approaching in May 1999, making some decisions difficult, and Malawi always confronts drought and terms of trade risks. However, the experience of the past few years shows Malawi's potential and that the risks can be managed with the right mix of policies and international support. 7. The Board may wish to consider the following issues: * The CAS emphasizes broad based labor intensive growth; fostering environmental sustainability and human development; improving public sector management and capacity; and strengthening policy dialogue, implementation and donor coordination. Are these the right areas of focus for Malawi to realize the gains needed to reduce the level of poverty? * The CAS package of support seeks to help Malawi achieve a balance between the need to move aggressively forward across a broad range and the constraints from capacity limitations and the need for realistic costed sector frameworks. Does the package achLieve the right balance? * The CAS base case assumes that Mlalawi can achieve steady progress in macroeconomic and structural reforms. Are the CAS assumptions on the feasibility and timetable of reforms reasonable?  MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE REPUBLIC OF MALAWI I. Economic And Social Context: Legacy, Performance, Prospects Legacy and Constraints 1. Introduction. Malawi faces formidable challenges to growth and poverty reduction. The Box 1: Malawi at a Glance rapidly-growing population puts pressure on its Economic Indicators Malawi SSA limited natural resources, notably land and the Lake. Per capita income (US$) 220 490 High transport costs resulting from Malawi's Population (millions) 10.3 583 landlocked position and poor infrastructure links of which urban % 13 31 through Mozambique act as a tax on exports. The Agriculture as % of GDP 32 24 legacy from the first 30 years of independence (1964- Social Indicators 13 30 94) under one government is one of inequality and Life expectancy (years) 43 52 inadequate attention to human resource development. Adult illiteracy (%) 43 44 And, in recent years, recurring droughts and the rapid Infant mortality rate (per 000) 133 91 spread of HIV/AIDS have presented additional Child mortality rate (per 000) 225 157 Access to safe water (%) 54 47 obstacles. But Malawi has also shown the promise of Primary enrollment (%) 81 75 meeting the challenges it confronts. Between 1995 Male 84 82 and 1997, the economy grew at an annual average rate Female 77 67 of more than 9% with growth more broad based than HIV prevalence ever before. While recovery from drought explains among sexually active adults(%) 13 na women in urban antenatal 31 naI one-third of this growth, normal rainfall and good care clinics(%) l policies--prudent macroeconomic management and , the liberalization of society and markets--explain the rest. In 1997 and early 1998, slippages in macroeconomic management and a slowdown in the pace of structural reforms threatened these good trends. However, with bold action, which the government shows early signs of taking, Malawi can regain the initiative. 2. The challenge of regaining the reform initiative is complicated by the nexus of presidential, parliamentary and local elections, all planned by May 1999. The three key contenders are the United Democratic Front (UDF), the party of the current administration, the Malawi Congress Party (MCP), the party of the former regime, and the Alliance for Democracy (Aford), which was in coalition with UDF during its first years in power. The three parties have regional links -- south, central and north respectively. As elections draw closer, the impact of decisions on the mood of the electorate undoubtedly will become an increasingly important consideration. 3. Limited and deteriorating resource base. Malawi is one of the most densely-populated countries in Africa, but without the favorable rainfall patterns of most of the East and West African countries of comparable density. Land distribution is also unequal; more than 40% of smallholder households cultivate less than 0.5 hectares. Fertilizer use and irrigation capacity are low. Population pressures on the limited land available for customary or smallholder use have led to reduced soil fertility, stagnant or declining yields, encroachment on estate and public land, and overuse of Lake  -2 - Malawi's coastal resources. The chronic environmental degradation has disproportionately affected the rural poor, whose consumption and production are largely dependent on the natural resource base. 4. Legacy of elitist development strategy. Malawi's enduring poverty and limited social development owe much to the elitist development strategy of the previous regime. At first this strategy delivered economic growth. In the first 15 years after independence, Malawi's GDP grew at 6% per annum, based mainly on tobacco exports. However, growth was led by and benefited a small class of estate owners who were provided preferential access to land, finance and markets, as well as by a large private conglomerate (Press Holdings) with close ties to the state. Entrepreneurship was suppressed, either by design (through overt discrimination against Asian businesses) or by default (through licensing or other restrictions which kept even indigenous entrepreneurs from competing with parastatals or Press). Malawi's education policies were also restrictive. Although a high share of the public budget went to education, it produced only a few well-educated secondary and university graduates and very low primary and secondary enrollment rates. As a consequence of this dualist development strategy, despite average per capita incomes increasing by about 50% during this period, the growth was irrelevant to the vast majority of the population and poverty and social indicators in Malawi remained amongst the worst in the world. The fragility of even this economic performance was exposed during the 1980's and 1990's, when Malawi's macroeconomic stability and growth collapsed under a series of external shocks (paras. 5 and 6). During this period, Malawi faced macroeconomic instability and stagnation in per capita incomes. External Environment 5. Recurrent drought. Malawi remains vulnerable to climatic variability. Two major droughts, coupled with falling tobacco prices, contributed to wide fluctuations in GDP and almost no growth between 1991 and 1995. The effects of drought are exacerbated by inadequate (though growing) diversification of the rural economy as well as inadequate extension support to drought resistant food and industrial crops (e.g. early maturing sorghum and cassava, high yielding sweet potatoes, cotton, groundnuts, etc.), and lack of irrigation. 6. Dependence. Malawi's economy is highly dependent on the external environment in three important ways. First, as a landlocked country, Malawi is dependent on regional peace and stability to ensure transport access. War in Mozambique in the 1980s created an influx of refugees and severed traditional transport routes, raising the cost of fTeight to 40% of F.O.B. trade value. Restoration of peace has helped but transport costs remain high. Second, export revenues (and rural cash incomes) are highly dependent on a few primary crops with volatile prices and uncertain long- term prospects: tobacco ( in 1997 61 % of exports), tea ( 12 %) and sugar ( 6 %)). Third, Malawi is highly dependent on aid. External grants and borrowing have in recent years been equivalent to 10% of GDP and 40% of government expenditure. 7. Debt. Malawi's external debt amounted to about US$2.6 billion as of end-1997. Multilateral debt accounted for a high 86% of the total, with US$1.6 billion owed to the Bank, about US$340 million to the African Development Bank and about US$120 million to the IMF. A combination of growing export revenues and prudent debt management has helped reduce the external debt burden to increasingly sustainable levels. As of 1997. the NPV debt-to-export ratio had fallen to 242% and the debt service ratio to 15%.  - 3 - 8. While Malawi has the key characteristics of a typical HIPC country -- IDA-only status, embarked on a Bank/Fund supported program of adjustment and reform, and a heavy external debt burden --, it cannot be considered for possible HIPC assistance as long as it has not exhausted all existing debt relief mechanisms. Malawi rescheduled its debt with the Paris Club in the 1980's but never sought a concessional rescheduling from the Paris Club, given that eligible pre-cutoff debt (i.e. debt contracted prior to 1/1/1982) amounts to only about US$30 million in NPV terms and would not yield large amounts of debt relief. If such a rescheduling on Naples terms and a necessary track record of policy performance were to be incorporated in a debt sustainability analysis, it would show that the external debt burden would reach sustainable levels within a few years; even without concessional treatment by the Paris Club, the net present value of debt-to-export ratio is expected to fall below 200% by 2001 (Attachment 1). External debt service, however, accounts for some 25% of fiscal revenues, a substantial burden given Malawi's enormous development agenda. To permit more fiscal space for social sector expenditures, Malawi would welcome additional debt relief, and/or more concessional finance, including grants. Box 2: Poverty, Inequality and Growth Malawi is one of the poorest countries in the world (43% of people with inadequate income to acquire basic needs) and has one of the most unequal distributions of incomes (a Gini ratio of 0.62 nationally, and 0.57 among smalilholder farmers). * Malnutrition rates for children below the age of 5 years have averaged between 4045% over the 1990s. M Malawi is estimated to have one of the highest HIV prevalence rates in Africa-- above 30% among women attening ante-natal clinics. Although the total fertility rate has falen from 7.6 in 1984 to 6.6 in 1995, this lower level is still almost doublethe average TFR for low income countries of 3.2. Analysis of household level income distribution data suggests that because of the depth of poverty and ineqalities m access to land, education, and other assets, the responsiveness of poverty measures to changes in average incomes (i.eA, the "wth elasticity of poverty") is comparatively low in Malawi. The clearest impiatiosuchlow rosio for the poverty reduction strategy in Malawi is, therefore, that growth rates need to be. hih andW bro Ol to nil much of a dent in poverty. It is estimated that a distributionally neutral growth rate of 5.3% jis required imlyb to preventhe numbers of poor from growing. 9. Trade and Investment. The direction of Malawi's trade has changed considerably, with regional partners playing a much more important role. Imports from South Africa and Zimbabwe now account for half of all imports, resulting in savings on transport. On the other hand, imports from Zimbabwe mostly enter duty free under a bilateral agreement, with reportedly adverse impact on local manufacturing. These issues are under discussion in the context of regional trade initiatives, including the Southern Africa Development Community (SADC) Trade Protocol, which provides for a free trade area within eight years of adoption, and the Cross Border Initiative, which provides for accelerated liberalization of trade, financial and investment markets among the participating countries. With Southern Africa an increasingly dynamic part of the continent, Malawi's regional position presents both disadvantages and advantages: competition from attractive neighbors for trade, tourism and investment as well as opportunities to benefit from enhanced interest in the sub-region. Recent Economic Performance 10. The new government inherited an unstable and deteriorating macroeconomic situation in 1994 due to loss of fiscal control and foreign exchange mismanagement in the run up to elections. This culminated in a huge fiscal deficit (before grants) of 28% of GDP in 1994/95, a 70% depreciation of the kwacha and an acceleration of inflation to nearly 70% by the end of 1994. Strong fiscal measures  - 4 - and increased balance of payments support helped restore stability, bringing the fiscal deficit down to 7.9% in 1996/97, and average annual inflation down to 9% (in 1997). At the same time, economic growth averaged more than 9% p.a. in 1995-1997, helped by good policies and favorable external conditions: two years of moderately good rains, no major commodity price shocks, and a period of growth and recovery in the region. The fiscal improvements were accomplished by raising revenues as a share of GDP even while lowering average weighted tariffs from 19% to less than 15%, and reducing expenditures from 44% to 25% of GDP, even while increasing the share of the health and education sectors from 14% (in 1993/94) to 26% (in 1996/97) of the total. 11. The growth of the past few years has been more broad based and diversified than any time in the past. With the liberalization of agriculture policies, smallholder agriculture has provided the engine of growth. Lifting of quotas applicable to smallholders has induced a threefold increase since 1993 in the production of smallholder burley tobacco. Due to the expansion of smallholder burley tobacco and root crop production, in 1995/96 the share of smallholder value added was virtually equally divided between maize (35%), other food crops (34%) and industrial/cash crops and livestock (31 %), in contrast to the past when the share of maize was preponderant. The net profits from smallholder burley tobacco have injected significant cash into the rural economy, in turn generating growth in non-farm rural activities. Further, an export oriented manufacturing sector is emerging in cut flowers and garments exporting to Europe, North America and South Africa. 12. However, low savings and investment rates, and unstable fiscal balances continue to undermine growth prospects. Savings and private fixed investment rates, anemic since 1991, have been around 3% of GDP in the last two years. These low rates reflect high government consumption, crowding out of private investment in 1997, and the dearth of instruments and opportunities for savings and investment by the formal private sector due to macroeconomic instability and a still shallow financial sector. The fragility of Malawi's fiscal situation also was again demonstrated in 1997. Expenditure control was relaxed in the second quarter of the fiscal year, leading to a deficit for 1997/98 of 9.7% compared to a program target of 7.1%Wo. In response, IMF ESAF disbursements have been suspended. Overvaluation, compounded by uncertainty about economic management, led to a significant depreciation of the kwacha since October 1]997, from MKwl5/USD to MKw26.7/USD. The rate of inflation also accelerated and at end-1997 stood at 15% compared to an average of 9% for the whole year, with further acceleration in the first months of 1998, before once again decelerating. 13. In early 1998, the government approved a package of revenue and expenditure measures designed to restore fiscal balance. The government subsequently reached agreement with the IMF on a staff monitored program, and agreed macroeconomic parameters were incorporated in the new budget approved by the Parliament in July 1998. Provided the government implements these measures successfully, the IMF hopes to restore the third year of the ESAF by November. Growth Prospects 14. A recent report by the Bank ("Accelerating Malawi's Growth: Long-term Prospects and Transitional Problems") examines Malawi's growth prospects; the main conclusions are discussed in the remainder of this section. The report outlines two growth scenarios for Malawi over the next 10 years: a moderate case scenario of 4% annual growth and a high scenario of 6% growth. Other outcomes are possible. With growth in 1981-95 averaging only 2.4% per annum, it is clear that bad policy or bad luck (e.g. severe drought) could lead to l[ow growth or stagnation over the coming decade. At the same time, the experience of other countries in the region (such as Uganda and  - D - Mauritius) shows that even higher growth than 6% could be attainable with very good policies and good luck. Government has indicated that, consistent with its goals under the Vision 20/20 exercise (para. 20), it would like to aim for growth of 10% per annum. 15. The centrality of good macroeconomic management and public expenditure policy. The Growth Study indicates that public policy will be decisive for Malawi's growth prospects: macro- stability, private investment and growth have been shown in Malawi to be integrally related. The most difficult challenges will be budgetary prioritization. The overall level of public expenditure constantly threatens to undermine macro stability. Attempts to contain expenditure have often undercut the quality of services. Public expenditures have been spread too thinly among competing claims and critical activities have ended up underfunded despite initial intentions. Also important for Malawi's growth would be maintaining a competitive exchange rate, to encourage further growth of non-traditional exports. 16. Moderate growth led by smallholder agriculture is under way. If macro control is maintained, the Growth Study suggests that Malawi is already on track for 4% growth, led by smallholder agriculture and its byproduct of growth in trading, transport, microenterprises, and other off-farm goods and services. Apart from macroeconomic management, particularly fiscal imbalance, the main threats to continued moderate growth are the internal transport constraint (high cost and poor access), inadequate support services for continued growth of smallholder production and other rural activities, and the risk of decline in the price of tobacco (the latter a reality in 1998, during which tobacco prices have been averaging 28% less than in 1997). 17. Much more has to be done to achieve high growth. Raising the growth rate to 6% on a sustained basis will be more demanding. Smallholder agriculture will remain the most important source of growth in the near term and the necessary supporting policy framework, support services, and infrastructure maintenance must be assured to maintain its momentum. In addition, however, land issues must be sorted out to ensure that medium and larger scale estates, whose viability has been severely threatened by the growth in smallholder burley production, contribute to growth and job creation, or release at least their underutilized land to smallholders who will use it more intensively. It is apparent that spontaneous changes in land tenure/usage are already taking place on an informal basis, while changes in land policies are being considered. Over the longer-term the growth induced in other sectors by agriculture will still not be sufficient to ensure a high rate of growth overall. Industry (and tourism) will have to make their own independent contributions. This will require big improvements in infrastructure and a friendly policy regime to raise investment, especially for export-oriented manufacturing and services. In consultations on the CAS, the government has indicated that it wants to shift more rapidly than envisaged in the Growth Study to a process of industrial and modern-sector-led growth. 18. Growth and poverty reduction. In order to avoid a rise in the total number of the poor, and on the basis of the current population growth rate (2.7%), Malawi would need to achieve 5.3% growth on an annual basis over the next decade. It is important to note, however, that the reduction in the numbers of poor expected from the higher growth path can only be achieved if the distribution of income does not deteriorate beyond the present. To improve income distribution in addition to accelerating growth, investments and policies will be necessary to: build basic numeracy and literacy skills, obtain sustainable access to credit and market information for micro-enterprises, increase labor productivity (e.g. closer access to water, fuel, etc.), promote labor-intensive growth (e.g. smallholder burley, labor-intensive exports), increase access to and quality of health services, promote HIV-  - 6 - preventing behavior to strengthen household abilities to utilize economic opportunities, adopt a more equal distribution of land and mobilize community to decide and implement their own program. Targeted safety net programs will also be needed to reach the most vulnerable, whose numbers will remain considerable for some time to come. 19. The prospects for sustainable shared growth would improve dramatically if Malawi were able to reduce the rate of population growth. The new government has recognized population as an integral component of its poverty reduction strateg y and, in 1994, adopted a National Population Policy. However, implementation has lagged, and Malawi still lacks a serious family planning program. II. Malawi's New Strategy 20. Long-term objectives. The long-term aspinrations of a broad cross-section of Malawian society are set out in a recent "Vision 2020" document. Some of the more important objectives include: transformation from one of the poorest countries in the world to middle-income status ($1000 per capita income) by the year 2020; food security; a manufacturing led economy, including an increase in the share of manufacturing from 12 to 25% of GDP; and access to quality health and education for all. The overall objectives espoused are laudable, and in many areas are reflected in sectoral strategies under development. However, they remain visions which need detailed analysis as to costs and feasibility within the proposed time frame. Given the current status of economic development and social indicators in Malawi, as well as implementation capacity, achievement of the goals, however valid, is likely to take longer than the Vision anticipates. 21. New government's policies showed great promise. Malawi's new strategy began to take shape in the early 1990s, but gained impetus with the election of a new government in 1994. The underlying objective of the new government was from the start poverty alleviation, and in 1995, the Policy Framework for Poverty Alleviation Program was formally issued by the President. A Poverty Monitoring System was established in the National Economic Council to coordinate collection and analysis of poverty and social data on an ongoing basis and a poverty profile was jointly developed by the government and Bank in 1995. Box 3; The Main Elements of the New Strategy * The development of smallholder agriculture as the central element. The main component was the complete liberalization of burley production in order to provide smallholders access to this cash crop. * Reliance on the private sector and competitive markets to provide incentives for growth, rather than on parastatals, state-sponsored private oligopolies and regulations. * The elimination of primary school fees and school uniforms in order to promote universal coverage of primary education, and the reorientation of public expenditures to social sectors and levels of service provision which benefit the poor. * All this to be carried out within a sound macro frameworlk which restored macro stability and a competitive exchange rate, while accommodating the reorientation of public expenditure policy. 22. The government made a strong start in implementing its strategy, enacting sweeping reforms in several sectors (Attachment 2 provides a summary of reforms since 1994; see also para. 25). There have been favorable outcomes on several fronts: macroeconomic stability (until 1997), increased incomes among rural middle-sized farmers, dramatic growth in primary school enrollments (with a net primary enrollment rate of over 70%) and a more than doubling since 1994 in the volume of non-  traditional exports. Nevertheless, there have been problems in implementation (paras. 27-30 on performance during last CAS period) and some transitional problems, as follows, have emerged: * The smallholder growth strategy has worked well, but the challenge now is to provide support to sustain gains already made and to find ways of moving income gains forward the next step. The liberalization of agricultural input markets, removal of fiscally unsustainable fertilizer subsidies, and dismantling of the controlled maize pricing and distribution system, have exposed the marginal commercial viability of hybrid maize production and raised concerns about national food production, household food security and maintenance of soil fertility. Similarly, full liberalization of smallholder burley production has exposed the inefficiency of many medium and large estates which now need to adjust, restructure, or transfer land to more efficient producers. Strengthened marketing and extension support are also needed to ensure the sustainability of smallholder production. * Primary education coverage has expanded but quality is an issue. The sudden and large increase in primary enrollments has placed an inevitable stress on the education delivery system. Consequently, the quality of primary education remains of key concern, and the retention and completion rates of primary school students continues to be poor. Given a secondary enrollment rate of at most 11 percent, to provide an outlet for the increased number of primary school graduates, there is also an urgent need to expand capacity at secondary school level. ( Crime increases hurting business environment. The transition to democracy has been achieved with a remarkable absence of political violence and institutional disruption. However, there has been a deterioration in the security situation in terms of petty crime and robberies. While the situation does not threaten political stability as yet, it has reached a point where it does affect the capacity to effectively do business. This is reflected in 1996 survey results which showed that crime and theft are second only to infrastructure as major obstacles to private business. * The impact of AIDS/HIV is increasing Malawi has one of the highest HIV prevalence rates in sub-Saharan Africa. The economic and social impact is enormous and growing. The economic implications include loss of life among the economically active population; productivity losses among family members and coworkers due to the need to care for and attend funerals of AIDS affected persons; and the cost of care to households and the health system. There is widespread agreement that the war against AIDS, which has already reduced life expectancy from 45 years in 1993 to 43 in 1996, has not been waged with sufficient vigor and prominence. * The quality of infrastructure has seriously deteriorated Lack of adequate expenditure prioritization, increased attention to the social sectors, delays in implementing necessary policy reforms (e.g. tariffs, autonomous utilities) and reductions in water flows from Lake Malawi have led to a serious deterioration in the once good quality of physical infrastructure. Road maintenance is seriously backlogged; power disruptions have become an increasing phenomenon; telecommunications services remain poor; and water services have deteriorated. There is also a serious shortage of serviced land for industrial use.  - 8 - * Greater politicalfreedom has brought new problems. Apart from crime, the transition to democracy has been accompanied by other transitional problems. The highly disciplined civil service has become less so; strains between the politicians and long time civil servants have hindered implementation of agency agendas; institutions (e.g. parliament, judiciary) require remolding which will inevitably take time; and there is concern that corruption has grown. While the government moved early to create new institutions for good governance (Ombudsman, Anti-Corruption Bureau), there have been delays in their becoming fully operational. Further, other integral components of an effective anti-corruption strategy (procurement reforms, strengthening of accounting and auditing, judicial reforms) have still to be aggressively pursued. * Renewed interest among donors has strained capacity. Following the transition to democracy, there has been a significant increase in the number of donors, several of whom had withdrawn during the years of poor governance. Donors are particularly concentrated in the sectors of agriculture, education, health and environment (Attachment 3). The donor community (with many agencies reportedly constrained by mandates from headquarters) has yet to succeed in adequately streamlining interventions to maximize impact and minimize claims on capacity. And the government, for reasons of capacity limitations, lack of adequate strategic frameworks and desire to maintain aid flows, has not been able to impose coherence on conflicting donor inputs. 23. The government's commitment to poverty alleviation as its central goal was reiterated in this year's Budget Speech, as were the main elements of the strategy to achieve that goal. In pursuing its development strategy over the coming years, the government is anxious to deal with the above transitional problems. A key development goal is to create the conditions for broad-based labor intensive growth by strengthening supporting services for smaliholders, enhancing the roles of communities in their development, fostering a suitable framework for micro and small enterprise development, implementing land reforms, developing sustainable infrastructure, particularly in rural areas and creating the conditions for growth of a competitive private industrial sector. Environmentalpolicies which prevent further natural resource degradation and promote the sustainability of growth are also central goals, building on recent progress. Social expenditure policies that extend coverage of quality services to the poor in a gender equitable way will continue to be a core focus, while cost recovery will be pursued where appropriate. The President has emphasized his commitment to move forward on the issues of population and AIDS, and government is anxious to develop cost-effective safety net mechanisms for the most vulnerable. A key cross- cutting aim is to strengthen public sector management by reestablishing and maintaining macroeconomic stability, by reinforcing expenditure prioritization and outcomes through a strengthened Medium Term Expenditure Framework (MTEF) and improved expenditure controls and monitoring, and by moving ahead with civil service reforms. Strengthening capacity and governance are also fundamental targets. Government's specific development goals in the period of this CAS are mirrored in the goals of the Bank's strategy and hence further elaborated in Section III B below.  -9 - III. The Bank Group's Country Assistance Strategy A. Previous CAS Performance 24. The Bank Group's last CAS, articulated in a document dated March 19, 1996, was predicated on working with the new government to support its efforts to restore macro stability and to reorient its development strategy towards poverty reduction. The CAS supported restoration of macro stability, especially through better management of public expenditure; human resource development, with emphasis on education and community-based initiatives under the Malawi Social Action Fund (MASAF); private sector growth, especially support for smallholder agriculture and removal of disincentives for private initiative throughout the economy; capacity building and decentralization, the former a central aspect of all operations; and portfolio strengthening through design flexibility, development of integrated sector investment operations in conjunction with the government and other donors, and promotion of a Medium-Term Expenditure Framework (MTEF). What Has Gone Well 25. Good progress was made in the implementation of the CAS in many domains. Apart from bringing macro imbalances under control (until 1997), the government initiated a series of macroeconomic and structural reforms. The government successfully intensified the smallholder growth strategy; extended the Medium Term Expenditure Framework; deepened the process of civil service reforms; embarked on a privatization program and established a sound institutional mechanism to manage the program; maintained its pro-poor stance in government expenditures; and persisted with its emphasis on education. The government has given strong support to community- led development initiatives and has piloted a public works program as an alternative to untargeted hand-outs as a means of helping the very poor. New legislation was passed on the environment, forestry and fisheries, with an important focus on empowering communities. In the domain of infrastructure, the government has begun the process of reforming management and financing of the road sector; and moved very rapidly in recent months in initiating telecommunications sector reforms. Cognizant of the importance of dialogue with civil society, the government has also made greater efforts to explain its economic programs to the population and built a better dialogue with the NGO community. NGO legislation is shortly to be submitted to Parliament. 26. In terms of the CAS objective of portfolio strengthening, there were successes in bringing the Fisheries and PHN projects out of problem status, and there was a remarkably rapid start in the implementation of the social fund (MASAF) project. Dialogue on portfolio matters has intensified, as discussed in more detail below. What Has Not Gone Well 27. Public expenditure discipline and prioritization is weak. Despite the primarily fiscal objectives of the adjustment program (Fiscal Restructuring and Development Program), as discussed earlier, there have been continuing problems with expenditure discipline. Equally or more importantly, while there have been major shifts in expenditures in favor of social services, the ex-post composition of expenditures has been less than satisfactory, with continued excessive spending on non-priority items such as travel, and underfunding of core activities. For example, within education, there has been inadequate funding for textbooks and teacher training; road maintenance was funded at only 40% of the required level in 1996/97, and spending for police and  - 10- security (Malawi has less than 6,000 police for 10 million people) needs to be increased. Even where priorities have been set, lack of good information and clear accountability have prevented expenditures allocated to priorities being realized in practice. 28. Reform has slowed. Progress in launching the analyses required to underpin civil service reforms was slower than anticipated. Despite a mid-1997 reduction in the number of ministries, and some further reduction in March 1998 (together bringing down the number of ministries from 27 to 19), civil service reform has yet to result in significant streamlining of ministerial roles and functions and in increased effectiveness. While the government has an active dialogue with the private sector, concrete follow-up actions are slow: some obvious measures to improve the business climate, such as ensuring access to industrial land and facilitation of temporary employment permits, have been repeatedly promised, but not yet delivered, and the private sector continues to complain of excessive bureaucracy. There has been frequent wavering on the issue of credit subsidies. Decisions on the future of ADMARC, the former single channel marketing agency, have been pending for 18 months since a study on the subject made its recommendations. While the privatization program has made progress, the government has only recently formally approved the list of companies to be privatized. While in some cases there are valid reasons to revisit policies, or adequate capacity to implement reforms within timetables may be lacking, the reason often appears to have been insufficient commitment. 29. Capacity remains weak. Capacity building, arn important objective of the previous CAS, has progressed less than anticipated, notwithstanding the recognition all along that the process would take time. Slower implementation of civil service reforms, coupled with the impact of AIDS, has meant that strengthening of the public service has lagged. Capacity building at the local government level has suffered from the uncertainty regarding decentralization plans and the roles of different government tiers. 30. Portfolio performance remains an issue. As discussed below, while some projects have come out of problem status, some others have deteriorated. Overall indicators of portfolio performance -- disbursement ratios, audit compliance - deteriorated in FY97. While disbursements increased markedly in FY98, there is still a disbursement lag when the maturity of the project portfolio is taken into account. Follow up on action plans agreed at CPPRs has been partial. Lessons Learned and Implications for Bank Strategy 31. Need to evaluate the impact of liberalization on the poor-and on the rich. The Bank needs to listen closely to the concerns of those affected by structural change. The experience with agricultural liberalization suggests that greater analysis and clearly thought-out strategies to offset unintended consequences, especially any adverse effects on the poor, must accompany the implementation of new policies. The removal of fertilizer subsidies has had a significant impact on fertilizer use, and hence on food security and soil fertility, and compensating measures need to be developed. More attention should also be paid to the impact of liberalization on groups, such as estate owners, which benefited from previous restrictions. This is important both to help prevent relatively powerful short-term "losers" from reversing beneficial reforms and to enable them to turn the new opportunities opened up by policy change to their own and society's advantage. Another lesson is the need to pay more attention to the timing and phasing of subsidy removal.  - 11 - 32. Importance of Policies and Institutions. The deterioration in infrastructure underscores the importance of institutional and financial reforms, including utility commercialization. This is equally important in other sectors. The new Assistance Strategy places these issues at the forefront of sectoral dialogues. 33. Importance of Strategic Frameworks and Capacity Issues. Since the last CAS we have attempted to engage on a fairly wide range of complex tasks (for example, civil service reform, expenditure prioritization, agricultural liberalization, land reform). As noted, a number of reforms and projects have moved more slowly than anticipated, and inadequately coordinated donor interventions have strained capacity and delivered sometimes conflicting messages. The analysis of the Growth Study suggests that Malawi will need to move aggressively on a broad front, and that piecemeal reforms will not suffice for growth. At the same time, the experience of the last few years suggests the importance for the Bank of weighing the level of commitment and capacity to move in each area, assessing the adequacy of the sector strategies and calibrating the level of lending accordingly. It also argues for tailoring the size and complexity of projects to prevailing capacity levels and bringing the donor community into common strategic and investment frameworks, with each donor focusing on areas of comparative advantage. The welcome desire on the part of the government that Malawians be engaged as partners in any analytical work argues for focusing ESW on mutually agreed high priority issues and phasing the work to enable Malawian participation. 34. The Bank should support those changes which are genuinely owned. Parts of the reform program have had inconsistent political support. Bank assistance has to be adjusted to the pace the government is willing and able to go. More effort needs to be given to participation, consultations, and forming a consensus within government and across civil society. 35. Country Assistance Note. The Operations Evaluation Department has prepared for Malawi a Country Assistance Note (CAN), dated May 20, 1998, which evaluates the Bank's assistance since 1991. The CAN concludes that the Bank's performance overall was satisfactory, while noting that the effectiveness of Bank assistance was undermined in the pre-1994 period by the degree of government commitment to structural and pro-poor reforms and Bank failure to fully confront some of the underlying systemic weaknesses (e.g. in the civil service, environment for competition). The CAN generally concurs with staff s own assessment of implementation successes and failings. It firther notes the importance in the current CAS period of knowledge generating ESW, attention to underlying systemic weaknesses and developing strategies for infrastructure development, given the inadequate policy frameworks for sustainable operation of a number of past infrastructure projects. The CAN also notes the desirability of greater roles in Malawi for IFC and MIGA, and for greater dissemination of Bank objectives and strategies in Malawi. We have sought to incorporate the CAN's recommendations in the design of this CAS. Issues arising from consultations with government and civil society 36. Starting with the last CAS, the Bank began a process of consultations with the government and civil society. For this CAS, the process involved in October 1997, two half day meetings in Lilongwe and Blantyre with a cross section of civil society and donors, followed by two days of portfolio and strategy discussions with a group of more than 100 government officials and, in July 1998, discussions with the government based on the draft CAS itself. A second client feedback survey (CFS) in June 1997 also served as input (Attachment 4). The issues which surfaced most frequently in the October discussions with civil society were:  - 12- (i) Concern that, despite progress in the reform process, not enough is happening in terms of private sector response, and whether more can be done to facilitate private sector development; (ii) Increased concern with the equity/poverty effects of agricultural liberalization; (iii) Increasingly widespread concern over infrastructure - especially the reliability of power and water supply and the state of roads, and with the declining security situation; and (iv) Concern that higher level education and skills development not be neglected. The discussions with government over the last year have echoed some of the concerns raised by civil society: concern with the lack of private sector response to liberalization; desire for greater emphasis on higher and vocational education, as well as development of domestic research capacity and appropriate technologies; a desire for further work on safety nets, microfinance, and small and medium enterprises; a broader concern that Malawi may need to shift more rapidly to an industrial, as opposed to agricultural-led growth-strategy; and finally greater assistance in managing Malawi's debt burden. To the extent some more recently articulated concerns are not adequately reflected in the current assistance strategy, the dialogue is continuing between the government and the Bank to refine the strategy as it evolves. 37. On the Bank/country relationship, there was a general appreciation from both government and other stakeholders of the efforts the Bank has been making to communicate better, but remaining concerns on the Bank's speed, flexibility and success in adapting international experience to Malawi's special requirements. Some government officials have complained that the Bank does not always adequately take into account their views; and makes insufficient use of local consultants. Government officials have also called for greater delegation of authority to the Resident Mission in taking decisions, particularly on "no objections" for procurement and the approval of work programs. We are seeking to address the issues which surfaced in these discussions through greater attention to consultations and consensus building, encouraging use of local consultants in requests for proposals and enhancing capacity at the Resident Mission (paras. 61 and 69). Drawing on the recommendations of OED's Country Assistance Note (CAN), we also propose to strengthen dissemination of Bank activities, inter alia through reactivating the Resident Mission's newsletter. B. The Current CAS Objectives and Main Themes 38. The ultimate objective of the Bank's assistance for Malawi is far-reaching and sustained poverty reduction. This will require creating broad-based, labor-intensive growth and fostering environmental sustainability and (gender equitable) human development which are essential for Malawi's long term prospects. These themes therefore will be at the core of the CAS. In addition, because of their importance for achieving these goals, the CAS will also pursue critical cross-cutting themes of improving public sector management and capacity and strengthening policy frameworks, implementation and donor coordination. 39. The need for selectivity in the Bank's program has been a subject of country team attention since the time of the 1996 CAS, and of dialogue with the government and other donors in preparing  - 13 - this CAS. The principle followed is that Bank efforts will be focused where they have maximum impact, implying no lending interventions where existing projects are not performing well. As to impact on growth and poverty reduction, the analysis has shown that at this stage in Malawi's development, the country needs to move across a broad number of fronts, and hence that capacity in Malawi, government commitment, donor presence and Bank capacity will be the decisive parameters as to where the Bank intervenes. The matrix in Annex 9 exemplifies the Bank's selective approach, showing both Bank and donor contributions to the government's program. The selectivity principle will be pursued when responding to the government's recent request - in giving comments on the draft CAS - that the Bank become involved in funding additional areas (para. 36). 40. The Bank's ongoing "portfolio" of lending and non-lending services involves a broad range of sectors. It will be important to see these activities through. With regard to launching new activities, given the large number of donors currently active in Malawi, the Bank will need to continue its current practice of questioning whether the Bank's presence is required at all and, if so, in what way: i.e., is it as a catalyst in the policy debate, as a provider of sector analysis or investment resources? The feedback from the government and donors is that in the near term, the Bank needs to be a catalyst fostering the development of cohesive sector strategies and investment programs to provide an umbrella for the activities of the donor community; and that its analytical input is critical on some of the second generation issues with which Malawi is grappling; this implies, with ongoing activities, a broad agenda. The longer term agreed objective is for a greater streamlining of donor activities (para. 55). In the meantime, in some of the sectors with heavy donor presence, the Bank's emphasis will continue to leave activities where possible to others (e.g. lending for irrigation) and emphasize complementing the activities of other donors. For example, while many donors are involved in primary education, which has large resource requirements, only Danida and the Bank are involved in secondary education. And in health, the more sector oriented Bank program complements that of other donors, many of which have tended to limit their involvement to a given set of one or more districts, a given disease or a given subject area. SBo 4:.Criteria for newlending under'the CAS The poverty reduction objective, coupled with the implementation followthug betives sugest four criteria wbywhich newlending activities must be screened for inclusion into the CAS:i * contribution toigrdwth (and hence indirectly; to poverty reduction) *00 dStirect ticonton to pro-poor humanadevelopment and social safetynets i government ownerip, shown by appropriate reforms and sectorstrategies iin place, tor jded tobe imjuminent;ipzlementation cap acity shown.by satisfactory Imlplementation ofanongoingprects in sector andaillocation ofrequisite financial and managerial resources; and dzea tic basis * demonstratedBa oparative advantage to!take lead ortcompletment interetion byother donor as iidicatedby:existenceofodther donors able/willing to provide adequate resources and to lead secter stategy/inivestmoent progra formhulation Creating Broad-Based, Labor-Intensive Growth 41. There is no alternative to focusing on broad-based growth in Malawi for sustained poverty reduction. In the short term, the most important source of growth will be smallholder agriculture and associated demand linkages to off-farm activities which rising smallholder incomes generate. Malawi has made an excellent start in promoting smallholder-based growth. The main constraints to continued smallholder agricultural growth may not, however, lie in the agricultural sector per se, but  -14 - be found in an inadequate internal transport sector, and weak institutions (e.g. marketing) and other services (credit, strengthened extension, etc.) to support the growth of production. Moreover, a large number of very small farming households (up to 40% of smallholders) will not be able to benefit adequately from farming, given their very small landholdings and other assets, and hence cannot achieve food security through agricultural policies alone. These households will need to be absorbed. in rural off-farm industry, urban labor-intensive industries or supported via safety net operations. Much has changed since the government's 1995 agricultural strategy was adopted, and there is a need to reexamine the respective roles of the public and private sectors as well as expenditure and investment priorities. In the new CAS period, therefore, the Bank will focus on implementation of the ongoing Agricultural Services Project, assisting the government to update its agricultural strategy and streamline its interventions to those where it can be most cost-effective, and preparing for a sector investment program (SIP) in FY2001. In this context, it will support government's emphasis on soil fertility issues and the development of unexploited potential for small-irrigation schemes. To support the rural growth process, both farm and off-farm, the Bank is supporting the ongoing collaborative effort among the government, donors, NGOs and financial intermediary organizations to develop a micro-finance strategy and policy framework to which all subscribe, thereby eliminating past tendencies for contradictory approaches. The Bank will also continue to work, in the context of the ongoing Rural Financial Services Project, with the Malawi Rural Finance Company (MRFC), to extend its outreach in a sustainable way and to bring in private partners, possibly including IFC. In addition, through an IDF grant, the Bank is supporting the Land Commission's work towards developing a comprehensive set of land reforms in a consultative approach. 42. More generally, with almost 90% of the population in rural areas, integrated rural development is a major priority. Malawi is a country of focus under the Bank's rural development initiative, and with support under that agenda, the Bank plans to facilitate the government's development and subsequent implementation of a rural development strategy. In the meantime, in addition to the activities discussed above, the Bank is supporting rural activities under its ongoing water, health and education and planned roads projects; and through MASAF. Further, considering that access to modern energy in Malawi is amongst the lowest in Africa (overall access 3%), and that deforestation is a major environmental issue, the Bank also proposes to support the government in its plan to develop a strategy for sustainable development of traditional energy sources and provision of modem energy to rural areas, building on the recent ESMAP study on the issue. Similarly, an important goal in the reform of the telecommunications sector is enhancing access in rural areas. In fostering rural development, the Bank will continue to pay careful attention to gender considerations (para. 48). 43. In the longer term, the Growth Study argues that labor-intensive industry and tourism must grow in order to provide jobs and income opportunities. The foundation for this growth must be laid now by addressing the main constraints to private sector development. The Bank's future assistance in this area will include support (i) under the forthcoming adjustment operations, for policy reforms to improve the business climate, strengthen fiscal and exchange rate management, enhance competition in the financial sector by divesting banlc ownership from public sector conglomerates and encouraging new entry while maintaining prudential standards, open up the infrastructure sectors to private participation, and accelerate the privatization program; (ii) through its dialogue/sector work on secondary and vocational education reforms, for ameliorating the shortage of skilled and professional labor; and (iii) under a proposed Private Sector Development Project, for increasing land availability for serviced industrial land sites, access to investment finance and/or matching grants for export enterprises. Efforts to enhance competition will also involve dialogue on the future  - 15 - role of the Press Corporation. The financial sector reforms, coupled with macroeconomic stability, should lead to a growth in private savings. More generally, the above reforms and interventions are expected to contribute to the promotion of private sector activity not only in existing sectors such as labor-intensive garments production, but also to promote diversification into under-utilized resources or non-traditional sectors, such as horticulture, the sustainable exploitation of Lake Malawi resources, tourism and so on. In these areas, the intention would be for a coordinated Bank Group approach, with involvement of IFC (see Attachment 5) and MIGA, as appropriate and feasible. 44. Regarding infrastructure, the focus of the Bank CAS in transport will be to reduce transport costs through investments in rehabilitating and maintaining the road infrastructure, better management of fiscal resources through the functioning of the Roads Fund, development of the international Nacala corridor to reduce external transport costs and regulatory reforms to free the growth of the domestic small transport vehicle sector, introduce competition in the petroleum sector and improve roads safety. Instruments for supporting these goals will include the ongoing Railways project and the proposed FY99 Roads project, which the Bank is supporting under the leadership of the EU as the amount of required funds requires more than one donor. In the case of power, under the ongoing power project and forthcoming adjustment operation, the CAS is supporting government efforts to financially restructure ESCOM, transform it into an autonomous company under the Companies Act and establish a regulatory framework which allows private participation in the sector. In water, similarly, Bank support, under the ongoing National Water project and proposed Blantyre Water project (FY00) will focus on financial and institutional development of the various water boards and tariff policies to enable their sustainability, as well as helping government to update its longer-term strategy for water resources. In addition, there is a danger that the Shire River may run very low in the next few years due to a recent sequence of low run-off years. This would have serious consequences for agricultural and non-agricultural activities in the Southern region of Malawi, where the bulk of the population and the poor live, as well as for water supply in Blantyre and the whole hydro-based power system. A new IDA Credit is being prepared to assist the government to construct a pumping scheme at Lake Malawi to support the Shire River levels, while the government is actively pursuing the possibility for interconnection with Mozambique to reduce dependence on hydro. In the case of telecommunications, the Bank, under the leadership of Danida, has been providing technical advice to support regulatory reforms opening the sector to private participation and the attraction of a strategic partner for the new telecommunications company; should alternative sources of grant financing not be available, the government would like the Bank to provide financing for further technical assistance to permit full implementation of the telecom reforms, as well as of the privatization program more generally. IFC has also offered to help the government with telecoms privatization. Fostering Environmental Sustainability and Human Development 45. It is clear that the emphasis placed on achieving broad-based growth in Malawi can only be achieved in the context of supportive human development and environmental strategies. Malawi already suffers from losses of natural capital stock, severe deforestation and soil erosion, increased vulnerability to drought, lower growth due to environmental health hazards (e.g. bilharzia affecting exploitation of Lake Malawi tourism, malaria), and so on. Significant progress was made in recent years in developing the regulatory and institutional framework for the environment. Through the ongoing Environmental Management Project, the Bank will be supporting the empowerment of communities to manage their natural resources and a pilot approach to combating bilharzia. Environmental assessments are now mandatory for all public and private investment projects and the  - 16- Bank will be promoting the enforcement of these guidelines through all operations. The government is currently updating its Environment Program which the Bank's project supports. 46. The emphasis of Bank lending in the education sector has recently been on primary education, through the ongoing Primary Education Project, given the massive need for classrooms, teacher training and teaching materials at this level. The Bank has also recently approved a Secondary Education Project which aims to expand the availability of cost-effective secondary education. The next step is to locate this assistance in a more coherent sector strategy. The CAS will therefore focus on the effective implementation of the current portfolio; collaborative development of an updated policy and investment framework, with performance monitoring, which clearly identifies education sector priorities and relates them to labor market needs; and further joint analyses of sector issues, for example in adult education, curriculum reform, appropriate vocational training (building on the issues note of FY98), and coping with the implications of AIDS. These activities are expected to pave the way for a sector program (SIP or adaptable lending program (APL)) in FYO1 and lay the analytical foundation for determining the best response to the government's interest in Bank financial support for higher and technical education. 47. The health services sector in Malawi is struggling to meet the objectives of increased coverage of the population, while at the same time coping with the stagnation or reversal of some key health indicators due to the impact of AIDS: despite increased real budgetary allocations, immunization rates have stagnated, the condition of hospitals has deteriorated (in part due to overcrowding from AIDS), life expectancy has declined and drug availability is problematic. Given the centrality of AIDS to many of these issues and more generally to economic development, and the absence of a strong institutional framework for tackliing the epidemic, the Bank is discussing with government the possibility of supporting strengthening of the national AIDS program through a Learning and Innovation Loan (LIL) (FY99). Further, all projects will aim to address AIDS as feasible (as does the new secondary education project), since this epidemic is not just a health issue but one which cuts across all sectors. The government's health sector strategy remains to be defined fully or costed within the expected fiscal framework; the Bank, in coordination with other donors has been supporting a health expenditure review and the development of a strategy with clear objectives, costing and performance indicators/monitoring arrangements and cost recovery where appropriate including through accelerated development of drug revolving funds. This would pave the way for a sector program in FYOO. 48. The objective of improved nutritional status is recognized as being linked to the overall incomes and employment situation, as well as to environmental health risks (e.g. sanitation). Apart from the overall poverty reduction strategy, the CAS is supporting, under the ongoing PHN project, specific nutritional interventions to protect gains made in micronutrient-related conditions. On the population front, which is critical for Malawi's poverty reduction efforts, the Bank is encouraging the development of a strong family planning program, building on the recent collaborative sector study, and will support, under a recently negotiated LIL, efforts to improve the contraceptive prevalence rate through the piloting of new community-based methods of delivery and communication. On gender, where substantial inequalities remain, the government has adopted an action plan, and the Bank would support its implementation through special attention to gender issues in its sectoral interventions, through the participation of women in decision making community committees under MASAF, through helping to strengthen the framework for microfinance, and through involving Malawi in its gender and law initiative.  -17- 49. At the moment Malawi does not have a clearly articulated safety nets strategy. Various efforts exist, some of which have been more cost-effective than others. Via the ongoing IDA- financed Malawi Social Action Fund, MASAF, the government has supported community infrastructure investment with active community participation, a labor-intensive Public Works Program as a pilot safety net in the poorest rural areas and strengthening the data and analysis systems to monitor poverty. Other donors have supported other initiatives, such as supplementary inputs programs, supplementary feeding programs, fertilizer subsidies, etc. while the government has at various times initiated food aid requests. The Bank will continue to assist with expansion of the MASAF program, which has demonstrated the dynamism with which poor rural communities participate and take ownership of basic needs projects; the government views MASAF as central to its poverty reduction strategy. The CAS will also provide, in collaboration with other donors, assistance to the government to develop and implement a coherent strategy for safety nets consistent with the growth strategy. This is expected to emphasize labor-intensive worksprograms which can transfer incomes to the poorest while building or maintaining communal infrastructure. The components of the strategy will be developed keeping in mind fiscal parameters, the need to reach different types of poor households and to address different types of risk, and issues related to the potential displacement of informal insurance mechanisms, cost-effectiveness and implementation capacity. Improving Public Sector Management and Capacity 50. Absent strengthened public sector management, public sector inefficiencies are likely to constrain growth. The Bank will focus, through the forthcoming adjustment operation and ongoing Second Institutional Development Project (ID2), on improving the MTEF and strengthening dialogue with government on civil service reform as principal instruments of the Bank assistance strategy. The MTEF should enable government to conduct detailed expenditure prioritization, identify and implement expenditure targets at sub-sectoral levels, identify areas to be cut or where better cost- recovery can be introduced, and introduce regular expenditure monitoring systems. Civil Service Reform will entail eliminating overlap and contracting out services where the private sector may have comparative advantage, based on functional reviews of each ministry (with reviews covering 60% of the civil service already completed). In addition to these reforms, the Bank's ID2 project will continue to support institutional development in the public and private sectors while all operations routinely will entail capacity building elements. EDI also will continue to play a key role here. The government has adopted a policy on decentralization, although a consensus still needs to be built around approach and timing as well as capacity building and fiscal pre-requisites. The UNDP, the lead donor on this issue, is providing support for capacity building (as is the Bank under the ongoing Local Government Project), while the Bank with UNCDF is helping government explore appropriate intergovernmental fiscal arrangements. 51. President Muluzi has requested Bank support in attacking the problem of corruption, which has increased in recent years. A mission to review the overall situation recently visited Malawi and is preparing its full report. In the meantime, the Bank has supported a study on procurement reform, and awaits govermnent decision on study recommendations to determine next steps. Under the ongoing ID2 project, the Bank is supporting strengthening of accounting skills and systems, while the national audit function may benefit from a planned regional program. The Bank may provide an IDF grant to the Anti-Corruption Bureau, if additional support is needed to complement that from other involved donors, and possibly work with the EU on strengthening of the legal sector, including the judiciary. Implementation of civil service reforms, including restructuring performance incentives,  - 18 - will also be an important element of the drive against corruption, which merits more focused government attention in the coming period. 52. The MTEF exercise, with its focus on the expenditure side of public resources, will be complemented by efforts to reform the tax structure to increase efficiency and improve revenue mobilization. Under the forthcoming adjustment operation, the Bank will support the government's program to reduce tariffs and to transfer revenue collection from tariffs to surtaxes, by extending coverage from manufacturing and imports to all distribution activities through a well-developed VAT system.. The adjustment operation will also support strengthening tax administration through the introduction of the National Revenue Authority. Strengthening Policy Dialogue, Implementation and Donor Coordination 53. The lessons of the last CAS indicate that there are important generic pre-conditions for Bank engagement to be successful. Hence, strengthening policy dialogue and implementation will be a key feature of this CAS. In many sectors, the government agrees on the need toformulate or update a comprehensive sector strategy, a process underway in agriculture, education and health. In the absence of a well-articulated set of sectoral priorities, strategies, progress benchmarks and assessment of constraints, it is difficult to evaluate the effectiveness of investments, to promote donor coordination or determine if there is need for prior regulatory and institutional reforms versus need for new investments. To pursue this objective, adequate administrative resources will be allocated for non-lending services, policy dialogue, and supervision. 54. Malawi has initiated a number of successful initiatives, which need to be carried through to completion. This impliesfocus on implementation andfollow-through. In agriculture, for example, this approach implies following through to sustain the gains in smallholder agricultural growth by paying increased attention to the marketing and credit problems of smallholders, maintenance of soil fertility, and land reform issues. In the education sector, it implies focusing on issues arising from the expansion of primary enrollments: improving the quality of primary education, and providing more, but cost-effective, secondary and vocational education opportunities. 55. A special CAS objective will be strengthening collaboration with the rest of the international community (Attachment 3) supporting Malawi, such that activities can be streamlined. At one level, donor coordination is very good -- there are weekly meetings convened by the UN Resident Coordinator of the Heads of Missions; the Country Director meets with donors on all visits and in the context of the annual Consultative Group; there are annual donor retreats; there are sectoral donor working groups (with the Bank leading those on economic management, poverty reduction and water, and back-up on transport and agriculture); and various groups of donors have been collaborating towards moving to SIP programs in some sectors. There has been increasing success in integrating the government into the donor meetings. Nevertheless, it is apparent that the coordination has been only partially effective in terms of results. In many sectors, there remains a large number of donors each ultimately pursuing its individual programs, with great cost to the limited Malawi capacity. Despite a recognition that the cumulative effect of donor sponsored training activities (workshops, seminars etc.) means that officials are frequently absent from work, and agreement on the need to be more selective and coordinate, there has been limited progress to date. The government is considering strengthening its system for aid management. For their part, donors, including the Bank, have decided: a) to systematically work through the overall economic agenda as well as each sector and reach agreement on policy priorities and areas of overlap/duplication; b) over time to streamline  -19- interventions as much as possible, drawing on the respective comparative advantages of each donor; c) to reinforce efforts to help government develop strategic frameworks and then to work within them; and d) to strengthen the sector coordination groups. IV. Bank Group Country Program Portfolio Management: IDA 56. Portfolio Description. Malawi's IDA portfolio currently consists of 14 investment projects, one adjustment operation (with only a small technical assistance component remaining undisbursed) and one GEF project; the Bank also supervises a project on behalf of IFAD. The fourteen investment projects have a total approved value (net cancellations) of $576 million, of which $267 million was undisbursed as of July 1998 (Annex 8). 57. At the time of the last CAS there was one problem project (Fisheries), and one project close to being (and subsequently) downgraded to problem status (PHN). Both projects are now performing satisfactorily. Five other projects subsequently experienced deterioration with regard to implementation progress and/or development objectives. In the case of the National Water Development Project, much of the problem is due to premature project approval, such that essential design work is only being completed now. While project management has improved significantly in recent months, completing design of a project whose overall objectives and components remain sound, will need to run its course. A comprehensive agreed action plan is under implementation, and should lead to satisfactory performance within the next six months. In the case of the Power Project, while physical implementation has been satisfactory, the power utility (ESCOM) has suffered institutional decline, due in large measure to inadequate tariff adjustments, with cumulative effect on financial situation, maintenance of assets and institutional morale, as well as to a period of politicization of management. A detailed financial and institutional restructuring plan has now been approved by the government, a tariff increase has recently been implemented, and the project closing date accordingly extended (works are in progress, having suffered delays in early years due to the withdrawal of cofinanciers in the last year of the previous regime). 58. The performance of the Agricultural Services Project, while still satisfactory, deteriorated in 1997. The recent mid-term review concluded that while progress has been made in terms of institutionally strengthening the Ministry of Agriculture, performance in delivering key agricultural services to the smallholder sector has been less positive. A comprehensive action plan for improving performance is under discussion. Implementation of the Local Government Project is proceeding well; however, the project's overly ambitious objectives of strengthening the institutional and policy framework for local governments are currently not being achieved due to weaknesses in the parent ministry (recently abolished) and the still evolving decisions on decentralization, the complexity of which were underestimated at the time of project design. However, the government recently has accelerated the pace of planning for decentralization, and new local government legislation is now expected to be tabled in Parliament shortly. The Implementation Progress rating for the Finance Sector and Enterprise Development Project, which closed in June 1998, was downgraded following the final supervision/ICR mission due to a serious deterioration in record-keeping in the key component; should the reconciliation effort now underway conclude positively, performance could be restored to satisfactory. Notwithstanding the problems discussed above, and under correction, there are some highly successful operations, most notably MASAF, the implementation of which has been far more rapid than anticipated.  - 20 - 59. The QAG indicators suggest that three additional projects -- the PHN, Rural Financial Services and Railways projects -- remain at risk. The former two projects are performing satisfactorily, and continue to be supervised closely to preclude deterioration. In the case of the Railways project, while the implementation pace of project investments and performance of the railways have both fallen short of expectations, achievement of the key objective of privatization is well underway; some of the credit is expected to be canceled to leave investment decisions to the new operator. OED ratings of projects completed since 1991 indicate a decline from the very good performance of earlier years, with 63% and 69% satisfactory by number and amount respectively. The weakest sectors were agriculture, energy and transport, and the lessons of past performance are being considered in new operations. 60. Regarding portfolio indicators, the disbursement ratio (excluding adjustment operations) fell from 17.2% in FY96 to 14.8% in FY97 but improved substantially to more than 25% in FY98. Malawi's performance in audit compliance has deteriorated from the high level of the past, and an action plan is being sought. Generic factors affecting portfolio implementation have included capacity constraints stemming from the loss of life due to AIDS, inefficiencies in the civil service, the general scarcity of skills in Malawi due to the restrictive education policies of the past, uncoordinated demands by the donor community, and frequent absence of implementation agencies' staff on overseas travel and workshops. Further, the failure to adequately prioritize expenditures in a climate of fiscal austerity has contributed to a continuing probliem of counterpart funds. 61. The Bank and government have agreed on the need to intensify focus on portfolio implementation. An in-depth CPPR took place in Malawi in October 1997, opened and closed by the Vice-President/Minister of Finance. This CPPR culminated in action plans for all projects in the portfolio and on the generic issues of financial management, procurement, project design/management and disbursements/counterpart funding. Recognizing that there had not in the past been adequate follow-up of CPPR action plans, the Resident Mission and Ministry of Finance have instituted regular meetings to review progress in iimplementing the regularly updated action plans. Efforts are underway to strengthen financial management, with the decision to recruit into the civil service additional qualified accountants and, with support from the Second Institutional Development Project, to strengthen procedures and systems and strengthen the College of Accountancy. The Resident Mission, which has assumed primary responsibility for portfolio management, is recruiting financial management and procurement specialists, and there has been some reallocation of responsibilities among RM staff to permit a better focus of efforts. While all these measures are expected to contribute to improved portfolio performance, it is also clear that absent civil service reform, expenditure prioritization and better coordination among donors, there will continue to be stresses on portfolio performance. The Bank's Program - Scenarios, Proposed Lending and Triggers 62. Base Case Scenario and Lending Program. The base case scenario assumes Malawi successfully implements the IMF staff-monitored program, leading to a renewed ESAF, and maintains the fiscal deficit within agreed parameters. This would be accomplished through a well- orchestrated set of revenue enhancing measures and prioritization of expenditures in conjunction with civil service reform. The government will strengthen support for smallholders through better transport policies and road maintenance, improved extension services and fostering the continued development of a viable rural credit system. The government will also take greater control of aid  - 21 - coordination, such that uncoordinated demands from the donor community cease to deplete capacity. Measures to enhance security would also be pursued. Social sectors would continue to receive adequate support, and there would be an emphasis on improving the quality of services. On the political front, the 1999 elections would proceed smoothly. 63. The base case calls for lending an annual average of some $113 million for FY98-01. This represents an increase over actual levels of an annual average $92 million for FY95-97 but substantially less than the annual average $143 million forecast in the last CAS, in recognition of the need to develop strategies, activities of other donors and capacity constraints. This scenario assumes improvement in portfolio implementation and the timely development of sector strategies. This scenario is consistent with an annual average growth rate of 4.5% (which takes into account drought), better than the 2.4% average growth of 1981-95, but less than the performance of the past few years. There would be two or three adjustment operations, one in FY99 and, subsequently, either two annual operations in each of FY00 and 01 or one larger two-year operation. The continuation of adjustment lending recognizes that Malawi is expected to have a balance of payments financing need for the medium term and that despite the desirability of shifting completely from adjustment to sector investment program (SIP) lending, the conditions do not yet exist to make that fully possible. While the previous CAS foresaw several SIPs (Education (FY97), Health (FY99) and Agriculture (FY99)), it subsequently became evident that development of well coordinated sector strategies and investment programs would require more time than previously anticipated. Instead, SIP-like operations, Adaptable Program Loans (APLs) and pilots, such as through Learning and Innovation Loans (LILs), will be pursued while strategy frameworks are being prepared and capacity develops. Apart from the Population and possible AIDS LILs mentioned above, it is likely that because of its pilot nature, the roads safety component of the Roads project would be processed separately as a LIL. The base case lending program is shown in Annex 3. 64. Base Case Indicators and Triggers. Malawi is currently in the base case. (Annex 6 presents economic indicators for the base case.) A continuation of base case lending will depend on Malawi meeting the following conditions, which are elaborated in more detail in Annex 9, the Country Assistance Strategy Matrix. Macroeconomic Framework * maintenance of a satisfactory fiscal and monetary framework (deficit declining to less 7% by 2000 and less than 6% thereafter, inflation of 15% in 1999 and 9% thereafter), including the implementation of tariff and surtax reforms * satisfactory implementation on a continued basis of the medium term expenditure framework and budget allocations at agreed levels in accordance with cross and intra-sectoral priorities (especially social sectors) * implementation of civil service reforms covering all ministries by 9/99 Structural Reforms * Privatization of two commercial banks and agreed lists of mature holdings of MDC and ADMARC according to divestiture sequence plan (most by 2000) * Corporatization and restructuring of power utility (FY99) and privatization of a significant part of the telecom utility to a strategic partner by 7/00 * Deepening of agriculture and private sector reforms and strengthening of services for smallholders Portfolio Implementation * Portfolio performance as indicated by share of problem projects (target no more than 20% by FY00) and disbursement ratio (target at least 20%)  - 22 - High Case. The high case lending program would be an average $140 million per annum. This scenario would be consistent with more vigorous reform efforts adequate to push Malawi into a higher growth path of an average 6% (excluding external shocks above normal assumed level of recurrent drought). In this scenario, the proportion of Malawians living without basic needs would decline from 42 to 37% in the next five years. Additional triggers would include: * Satisfactory progress in land reforms, based on the forthcoming recommendations of the Land Commission * Accelerated implementation of infrastructure reforms, of the privatization program and of improvements towards creating competitive business environment * Accelerated portfolio implementation, with share of problem projects declining to 20% in FY99 and lower thereafter * More concerted and rapid efforts to enhance capacity and improve governance: implementation of civil service reforms covering all ministries before 9/99, implementation of procurement reforms and strengthening of financial management and audit functions, the latter reflected in Bank project portfolio accounting and audit performance * Substantial improvement in safety net programs, with better targeting e Development and implementation of an aggressive AIDS Strategy Low Case. The low case would ensue for the following reasons. First, if the macroeconomic situation deteriorated significantly as indicated by inflation rising to the above 20% range, or the deficit before grants rising to around 12% of GDP with substantial domestic financing. Second, if government's expenditure prioritization and expenditure management remained weak resulting in poor expenditure quality. In this scenario, key items (such as primary education, teaching and learning materials, drugs and essential health care program, road maintenance and rehabilitation, and social safety nets) would be substantially underfunded in original budget allocations or actual expenditures, while the share of expenditures on travel related items, administrative overheads, or inessential public functions and agencies, would not be reduced or even increased. Third, if there were slow progress in or reversal of important structural reforms: in the liberalization and development of product and factor markets and in privatization, adversely affecting growth of incomes and employment. In a low case arising for any of the above reasons, there would be no adjustment lending, while investment lending would be limited to a few projects with direct poverty reduction implications; lending would not exceed an average $50 million per annum. The low case would also ensue, as a function of the new lending criteria (Box 4), if portfolio performance seriously deteriorated, as new investment lending would be cut back, in line with the sectors showing deterioration. Non-Lending Services 65. Irrespective of the lending scenario, analytical work, policy dialogue, and advisory support will feature prominently (Annex 4) in the Bank's assistance strategy. As discussed earlier, the Bank has begun working with the government to develop comprehensive strategies and prioritized investment programs in agriculture, education and health. An AIDS assessment has been completed and a health expenditure review, in progress, will be completed in FY99. The Bank, government and other stakeholders are collaborating in a multi-year effort to analyze key education sector issues. Over coming years, the Bank will continue to provide support to the government-led MTEF process; and, through the Country of Rural Focus Initiative, to the evaluation of the significant policy changes in the agriculture sector, formulation of a Rural Development Strategy and testing of the village level participation model. Following on the ESMAP study on Rural Energy and Institutional Development, the Bank will also support government's development of an energy strategy. As the  - 23 - lead donor on poverty issues, the Bank will also spearhead joint donor/government efforts to develop a consistent strategy to strengthen social safety nets. In addition, the Bank will continue to monitor and help Malawi to improve its debt profile. Malawi is participating in the Partnership for Capacity Building. Other non-lending services include continued advice and technical support in such areas as micro-finance development; and trade and tax reforms. In many of these areas, assistance from EDI would be enlisted. As non-lending services will need to respond to emerging needs, not all can be forecast now. Porfolio and Proposed Programs of IFC and MIGA 66. IFC's portfolio in Malawi is relatively small, with $2.9 million (excluding a plywood operation which has been written off) allocated to five ventures (private hospital, stockbroker, flowers, leasing and tourism). Two loans have been approved and are awaiting commitment. One of these is for the establishment of the first discount house in Malawi, which will intermediate among financial institutions by trading and creating markets in bankers' acceptances, commercial paper and treasury bills. The other involves the establishment of the first private housing finance institution in the country (Attachment 5). 67. The government has indicated that it believes IFC can play a role in Malawi's privatization program, focusing initially on tourism, energy and water services. The medium-term program will foster broad based ownership of the newly privatized companies, building on IFC's experience in setting up unit trusts. Preliminary discussions have been held in this regard. The government has also expressed interest in IFC assistance for micro-enterprises and small and medium-sized businesses, and the restructuring and privatization of state-owned banks, such as Malawi Savings and Development Bank and Malawi Rural Finance Company. 68. Malawi is a member of MIGA, but to date there are no MIGA operations in the country. Partnerships 69. The issue of partnerships has several dimensions. The Bank has sought over the past several years to enhance dialogue with the government through consultations on the CAS, regular CPPRs with wide participation, collaborative analytical work, regular meetings between the Resident Representative and Ministry of Finance and organization of selected high-reward training opportunities (e.g. EDI-supported micro-finance workshop, EDI seminar for Cabinet and parliamentary workshop on environment). In response to feedback from the 1997 Client Feedback Survey and CAS strategy discussions, the Bank is enhancing capacity at the Resident Mission from a total of seven specialist staff (besides the Resident Representative) to 10, and the need for further expansion will be under continuous review. 70. A second critical dimension of partnership involves the rest of the international community supporting Malawi (Attachment 3), discussed in para. 55. A third dimension involves partnership with civil society. Progress has been made in the last several years, made possible by the transition to democracy, although further progress is still a goal. The Resident Mission holds periodic meetings with the NGO community, while all missions engage NGOs relevant to their sectors. A wide cross- section of society--from village chiefs to judges, private sector representatives, journalists and academics -- have participated in strategy consultations and feedback sessions in the context of preparation and dissemination of the recent CASs. The Bank is working increasingly with  - 24 - communities-- for example, in the context of MASAF, the environment agenda -- and beneficiary assessments provide feedback on the success of interventions. NGOs will help to implement the micro-project component of the Environmental Management Project, and are successfully involved in community work under the Primary Education Project (PEP). 71. A fourth dimension involves partnership with the IMF. The Bank works closely with the IMF, and parallel missions are the norm. A final dimension involves regional partnership. Being landlocked, Malawi is highly dependent on transport links through Mozambique and improvement in transport corridors is one priority of the Bank through its program and dialogue with both countries. The Bank has recently prepared a strategy for the Southern Africa Development Community (SADC), under which it plans regional IDF grants, a regional trade study and work on strengthening infrastructure links in the sub-region (power pool, water resource management). Risks and Concluding Remarks 72. Despite a long history of Bank assistance, and numerous adjustment operations since the early 1980s, Malawi remains a very poor country. To sonme extent this reflects inherent constraints, but it also reflects a history of adjustment narrowly concentrated on macroeconomic issues, with little structural change until the 1990s. Hence, Malawi's remaining development agenda remains significant and multi-faceted, and the dependence on aid flows a need for the foreseeable future. In the context of capacity constraints, this presents a challenge for Malawi and its partners of striking a balance between moving forward with a cross sectoral integrated package of reforms and investments, without which there will be little prospect for growth, and working within the existing capacity to implement. We have tried to achieve this balance in the proposed strategy, but the risk of failure exists. A second source of risk is the will of the government to act decisively. The deceleration, after a promising start, in reforms in 1997 has been worrisome and despite signs of renewed momentum, the risk that this will not materially change until after the 1999 elections is real. While some of the decisions ahead are politically difficult, others are win-win. The risks to the government of not moving far exceed the risks of implementing sometimes unpopular measures needed to ensure long term sustainable improvement in living standards. The Bank strategy seeks a mix of analytical work and dialogue to help the government take the needed steps, while providing the financial support that can help cushion shocks. A third set of risks is non-economic. Malawi is in a democratic transition which could be threatened by a number of factors: deteriorating security, labor unrest and political discord, although none of these factors appear serious risks to democracy at present. Finally, Malawi will continue to be vulnerable to exogenous shocks--drought and terms of trade reversals. Better international advance warning systems, continued crop diversification and exploitation of small irrigation potential will make it possible to mitigate the impact of drought, while the impact of terms of trade shocks will only improve as the economy diversifies over the longer term. In the meantime, the international community stands ready to help Malawi manage exogenous shocks. James D. Wolfensohn President by Sven Sandstrom Washington, D.C. August 4, 1998  Attachment 1 Page 1 of 3 Malawi: Debt Sustainability Analysis for Country Assistance Strategy This attachment presents an assessment of Malawi's external debt situation as of the end of 1997, and evaluates its sustainability in a long-term perspective. This analysis updates that done for the Country Assistance Strategy of 1996. The essential conclusion is that Malawi's external debt will be sustainable within a few years. Currently classified as a severely indebted low income country, the country is continuing its debt management strategy which focuses on improving its debt profile by focusing on export performance and grant mobilization. Structure of External Debt and Debt Management Strategy At the end of 1997, Malawi's external public debt stood at US$2.6 billion (including IMF and short-term debt) which was equivalent to 107% of GDP. In net present value terms, debt outstanding amounted to US$1.2 billion, or 52% of GDP. Of the total debt disbursed and outstanding, 86% was owed to multilateral lenders, including $1.6 billion to the World Bank, US$340 million to the African Development Bank, and $120 million to the IMF. The most important of the bilateral lenders is Japan, with some 9% of Malawi's debt stock, while other bilateral donors account for 3%. About 93% of Malawi's external indebtedness is on concessional terms, with an average interest rate of 1.3%, average maturity of 38 years and approximately nine years of grace. A combination of growing export revenues and prudent debt management has helped to reduce the external debt burden to increasingly sustainable levels. The country entered into rescheduling agreements with Paris Club creditors in 1982, 1983 and 1988. Some US$84 million was consolidated and rescheduled through these agreements. Malawi has never, however, sought a concessional rescheduling from the Paris Club. The country also rescheduled its commercial debt in 1982 and in 1988. The impact of these operations, together with export growth, was a decline in the debt service ratio from 53% in 1986 to 31% in 1989 and 15% in 1997 (see Figure 2). The debt service ratio is projected to continue its downward trend. Similarly, the ratio of the net present value of debt to exports fell: by 1996 it was 274% and by 1997 242%. In order to improve debt monitoring capacity, the Government has strengthened the Debt Management Unit in the Ministry of Finance by redeploying staff from other areas of the Ministry. The World Bank fielded a mission in February 1997 to reconcile the World Bank's Debt Reporting System database with those of the Ministry of Finance and of the Reserve Bank of Malawi, revising all loan terms and transactions and verifying all inconsistencies. Long-term scenario and debt sustainability The long-term baseline economic scenario shown in Table I and Figures 2 and 3 assumes the implementation of sound economic and financial policies, continued structural reforms, and a stable external environment. Under these assumptions, real GDP is projected to grow at 4.4% in 1998/99 and 4.5% thereafter. This is lower than growth in the past two years, and is intended to reflect the impact of spells of poor rainfall, as well as a 28% tobacco price shock in 1998. Real export growth is assumed to  Attachment 1 Page 2 of 3 be 7.0% per annum on average, consistent with export growth between 1989 and 1996. Net private capital flows are projected to be US$40 million per year. On these assumptions, the country's debt vulnerability was examined, focusing on the liquidity indicator - the ratio of debt service to exports - and the solvency indicator - the ratio of the net present value of debt service to exports (or NPV debt-to-exports ratio). In terms of the ratio of debt service to exports, Malawi is already in a manageable situation as the ratio is below 20% and is projected to stabilize at around 14% by the year 2003. In terms of the NPV debt-to-exports ratio, the country still has a debt overhang, the ratio being 274% at the end of 1996 and 242% at the end of 1997, falling to 219% in 1998 and 157% in 2003. The level frequently considered sustainable is 200%, which Malawi crosses in 2001 (Figure 3). An alternative scenario was developed in order to assess the sustainability of Malawi's debt under less favorable circumstances. Malawi is vulnerable to shocks arising from drought and from fluctuations in the price of its main export, tobacco. These could lead to lower production and export growth, and also to higher government (emergency) expenditures and imports. In the alternative scenario, assuming an extremely serious drought every three years, GDP growth would fall from an average of 4.5% in the base case (Table 1) to 2.2%, export growth would slip slightly to 6.7% (because tobacco production is not much affected by lower rainfall) and import growth would rise to 8.8% (because maize production would slump, necessitating imports). The impact of these assumptions on Malawi's debt vulnerability are significant: the NPV debt-to-exports falls at a slower rate, to 223% in the year 2000, and is still at 220% in the year 2002. Malawi can reduce the debt burden by continuing its present strategy, which emphasizes policies conducive to strong export performance and mobilization of concessional financing and official grants. In fact grant assistance, excluding technical cooperation, rose from US$227 million in 1990 to US$335 million in 1992, but has since fallen to US$206 million in 1996. The Government can continue to seek specially designated grant funding from donors which would be directed towards the social sectors. The Government has extended its social sector spending (14% of the budget in 1993/94, 26% in 1996/97). Given the substantial fiscal burden of the debt (debt service was about 25% of tax revenues in 1997), a strategy of increased bilateral or multilateral grants would tend to lighten the load over time, while gradually reducing the share of multilateral debt financing. In light of its large indebtedness to the multilaterals, it may be prudent for the country to seek more diversified support by opting for more bilateral assistance. Finally, the country could approach the Paris Club for a concessional rescheduling, which would reduce its eligible bilateral debt by 67%. The net present value of the eligible debt (viz. that contracted prior to January 1, 1982) is US$30 million, or 11% of all bilateral debt, or 2.5% of total debt. A Paris Club rescheduling would reduce the total debt service less than 2%. Given its negligible impact on sustainability, the country prefers to focus on the mobilization of additional concessional finance, including grants, that will enable it to improve its debt profile over time. In conclusion, the preceding analysis indicates that, with the implementation of sound economic, financial and structural policies, and in the absence of serious shocks, Malawi's external debt will be sustainable within a few years. This process will be accelerated if the Government is able to attract increased bilateral or multilateral grant finance.  Attachment 1 Page 3 of 3 MALA WI: Data on debt sustainability Other Other Japan Bilateral Multilateral 9% 3% Export Credits 35 30% 1% 30 1 IDA 25- 56% O 20 15 - "Sustainable" level 10 II Figure 1. External debt of Malawi, as of end 1996 1989 1991 1993 1995 1997 1999 2001 2003 Figure 2. Ratio of debt service to exports, 1989 to 2003 (percent) Table 1. Summary of assumptions for alternative scenarios: averages during the period 1998-2006 220 , 200 GDP growth (annual, real) 4.5% 18 Export growth (annual, real, GNFS) 7.0% 160 "Sustainable" level NPV debtto- Import growth (annual, real, GNFS) 4.2% 140 exports Net direct foreign investment, per year, 40 1998 1999 2000 2001 2002 2003 US $ millions Figure 3. Ratio of net present value of debt service to exports, 1998-2003 8/01/1998 rt o M 0t  Attachment 2 Policy Reforms Undertaken by Government Since 1994 Fiscal Policy Reforms * Implementation of stabilization policies that brought down fiscal deficits from 26% of GDP (1994/95) to 8% (1996/97). * Reforms in Tariff and surtax policies, which reduced average weighted tariffs from 19% to less than 15 %, extended the surtax base and rationalized surtax rates. This helped maintain revenue. * Expenditure reforms, which increased the share of education and health sectors from around 14% in 1993/4 of the total to 26% in 1996/7. A medium term expenditure framework was introduced to manage expenditures. External Sector and Financial Sector Reforms * The exchange rate was floated in 1994 and Malawi attained current account convertibility in 1995. * A treasury bill market was successfully launched avoiding inflationary borrowing from the Reserve Bank. The size of the treasury bill stock has grown from less than .1% of GDP to 9 % of GDP. * The stock exchange was opened in 1996. * Export processing zone (s) were introduced, while the processing of export duty drawbacks was improved to increase incentives for exporters. There is now a fledgling export oriented manufacturing sector in garments and cut flowers. Civil Service Reforms e The civil service structure has undergone significant changes as 20,000 new teachers were appointed in place of 20,000 other temporary employees who were let go. - Preparation of a Civil Service Reform Action Plan, now being implemented. Under this, the common services cadre was abolished enabling better accountability and management in professional services. * The completion of the first phase of the Functional Reviews of the government and rationalization of government ministries was completed in 1996. Agriculture