Public Information Notice No. 02/92

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Malawi

August 16, 2002

On August 5, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malawi.¹

Background

Malawi has experienced a severe food crisis in early 2002, resulting in wide-spread malnutrition and starvation as early warning systems, which are an integral part of the government's food policy, failed. While the acute shortage has been temporarily alleviated by the new harvest, an even larger food shortage is expected for later in the year and the beginning of 2003, and the government and the donor community are in the process of fleshing out an appropriate response.

Economic activity has been stagnating. Real output is likely to have contracted in 2001 and, at best, a weak recovery is expected for 2002. This is mostly attributable to depressed agricultural output owing to a drop in the maize production both in 2001 and 2002. At the same time, high real interest rates have been encumbering private sector activity—growth in the manufacturing and services sectors remained negligible and industrial activity shrank to its lowest level in more than a decade.

Since end-2000, inflation fell considerably, but real interest rates have remained high. The headline 12-month inflation declined to below 17 percent in June 2002, from 35 percent in December 2000 as, for the most part since December 2000, the Reserve Bank of Malawi has followed a tight monetary stance. But real interest rates remain high at over 30 percent, reflecting an expansionary fiscal policy, but also persistent inflation expectations in light of a history of stop-and-go disinflation episodes. After the large real depreciation during 2000, the kwacha appreciated in real effective terms during 2001 correcting for the development in 2000, but reflecting also the fiscal expansion and, later in the year, the depreciation of the South African Rand.

Fiscal policy has been expansionary until the beginning of 2002, crowding out the private sector. Slippages from the program came mostly from policy decisions to bail out parastatals, augment civil servants' wages, increase other low-priority public spending, such as travel and representation, and reduce income taxes. These slippages were exacerbated by a rising interest bill and weak revenue collections due to a decline in firms' profitability and sluggish collection of import-related taxes.

However, expenditure appears to have been contained since March 2002 and the 2002/03 (July to June) budget targets a decisive adjustment in the domestic balance to 6 percent of GDP from an estimated 8 percent of GDP in 2001/02. While this adjustment will require tax measures and substantial cuts in nonpriority spending, this accommodates a subsidy for maize and an increase in spending on priority pro-poor programs to almost 6 percent of GDP from about 5 percent of GDP in 2001/02 and 3½ percent of GDP in 2000/01.

The external current account deficit narrowed to 13 percent of GDP in 2001, down from some 14 percent in 2000. A small deterioration in the trade balance was more than offset by an improvement in the services balance. The current account deficit is expected to widen substantially in 2002, due to food imports. Despite the suspension of balance of payments support by most donors at end-2001, international reserves remained adequate and stood at about 3 months of imports at end-June 2002.

While public expenditure management has been strengthened, progress in implementing reforms with respect to parastatals have gained momentum only recently with the large bailouts highlighting the need for action. The Ministry of Finance has now more control over parastatals' finances and audits of the large agriculture marketing parastatal and its subsidiaries have been completed. After a temporary suspension of the privatization program in mid-2001, the authorities have privatized the Commercial Bank of Malawi in December 2001 and are in the process of completing the privatization of other major parastatals.

The authorities have finalized a Poverty Reduction Strategy Paper (PRSP) at end-April 2002 which emanated from a highly participatory process. Its strategy relies on a framework consistent with achieving the macroeconomic objectives of the program and presents a balanced approach to create the necessary conditions to generate growth, improve social sector outcomes, protect the vulnerable, and improve governance.

Executive Board Assessment

Directors expressed concern over Malawi's impending food shortage, and welcomed the pledges for humanitarian aid by the international community. Directors welcomed the recent call to donor nations by the Managing Director and the President of the World Bank to commit food aid to Southern Africa.

Noting that humanitarian aid would be insufficient to avert widespread malnutrition and starvation, Directors endorsed the authorities' intention to import food and provide it at a subsidized price. In this setting, they generally welcomed the imminent request from Malawi for emergency assistance from the Fund to facilitate food imports without depleting the Reserve Bank of Malawi's (RBM) international reserves to levels that would no longer provide protection against unforeseen shocks. However, Directors stressed in this connection the importance of proceeding with planned reforms and more broadly the need to identify and implement policies that would help safeguard against these risks in the future.

Directors considered that Malawi has made some progress in restoring macroeconomic stability but that, reflecting severe slippages in past program implementation, overall performance under the Poverty Reduction and Growth Facility (PRGF) arrangement had been disappointing. Inflation has been reduced, but growth remains elusive; real interest rates are high, as a result of overly expansionary fiscal policies; and inflationary expectations are ingrained.

Directors welcomed the renewed commitment of the authorities to bring the program back on track and establish a record of performance, so that the first review under the PRGF arrangement could be completed by year-end. They considered that the inflation target for 2002 is well within reach, and that the decisive turnaround in fiscal policy to which the government is now committed will lead to the needed substantial reduction in interest rates and faster economic growth.

Directors stressed that the success of the program would hinge critically on high-level commitment to fiscal restraint—among other things, because of unduly expansionary fiscal policy crowding out private sector investment. Directors therefore welcomed the decisive fiscal adjustment envisaged in the 2002/03 budget, which will halt the increase in public debt and create an environment conducive to private sector-led growth. Directors also praised the reorientation of the budget toward pro-poor spending, facilitated by cuts in nonpriority programs. At the same time, the authorities should guard against any surge in expenditure arising in the run-up to the elections in 2004.

Directors welcomed the progress made in strengthening expenditure management, and were encouraged by the authorities' commitment to track, monitor, and publicize performance in the execution of pro-poor spending. However, as recommended in the report of the Review of Standards and Codes on fiscal transparency, further steps were needed to make the expenditure system a more effective short- and medium-term tool of fiscal control, and to prevent the past large overruns in nonpriority programs.

Directors considered that Malawi's current flexible exchange rate policy continues to serve the economy well. They emphasized that tight monetary policy must be sustained to attain the inflation objective: while inflation has been declining, the authorities should observe the reserve money target and stand ready to tighten the policy stance, if inflationary pressures reemerge.

Directors welcomed the finalization of the poverty reduction strategy paper (PRSP), which contains a sound framework for reducing poverty and creating an enabling environment for private sector-led growth. The PRSP was prepared in a highly participatory process. It represents a balanced approach to public policy which, if fully and effectively implemented, should create the necessary conditions for growth, improve social sector outcomes, protect the vulnerable, and provide an institutional structure for monitoring progress in reaching poverty reduction goals. Given the critical role of gender issues in poverty reduction, Directors encouraged the authorities to take the gender dimension of policies fully into account in implementing the PRSP. Directors also stressed that the PRSP's priorities need to be properly costed and included in the short- and medium-term budgetary framework.

Directors urged the authorities to develop a coherent agricultural policy that would make agriculture the engine for medium-term growth—and directly address the prevalence of poverty in Malawi among the rural and subsistence farming population. A more thorough analysis of the impact of the HIV/AIDS pandemic on Malawi's growth strategy is also needed.

Directors urged the authorities to make parastatal operations more transparent, and to differentiate clearly between the government mandates and commercial activities of these enterprises, in particular those connected with agricultural marketing and the grain reserve.

They encouraged the authorities to follow through swiftly with their privatization and commercialization agenda. They welcomed the recent privatization of the Commercial Bank of Malawi, and the plans to complete the privatization of Malawi Telecom and Air Malawi. Together with privatization in all sectors, it would be crucial to ensure competitive market structures, and nowhere is this more important than in agriculture.

Directors welcomed the strengthening of the legal framework for addressing corruption and building the capacity of the investigative authorities and the judiciary. They stressed, however, that commitment to implementation is crucial, and that Malawi's anti-corruption campaign would gain credibility from bringing to closure high-profile cases.

Directors noted with concern the deterioration of macroeconomic statistics in the last few years. They urged the authorities to step up their efforts to address long-standing deficiencies and reduce delays in the provision of statistics. Recognizing the country's capacity constraints in this area, Directors called for international and multilateral technical assistance support.