On April 30, 2018, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malawi. At the same time, the Board also approved a new three-year Extended Credit Facility Arrangement for Malawi and a press release on this was issued separately.

The economy recently rebounded from two years of drought. Growth picked up from 2.3 percent in 2016 to an estimated 4.0 percent in 2017 owing to a recovery in agricultural production. Inflation has been reduced below 10 percent – from high double digits in recent years – due to the stabilization of food prices, prudent fiscal and monetary policies, and a stable exchange rate. The current account deficit narrowed to 10.0 percent of GDP in 2017 from 13.6 percent in 2016, following lower maize imports and higher prices for some exports. The banking system remains stable though vulnerabilities have somewhat increased.

While the authorities regained control over the budget during FY16/17, this proved challenging during FY17/18. Revenue shortfalls and expenditure overruns, including the bailout of maize purchase loans by a parastatal exerted significant pressures on the budget. The authorities are implementing remedial measures to improve the fiscal position in FY18/19. These measures will also help contain public debt which has doubled over the last decade, reaching 55 percent of GDP in 2017, after the withdrawal of donor budget support, securitization of arrears, and recapitalization of the Reserve Bank of Malawi and two public commercial banks.

Economic growth is expected to increase gradually, reaching over 6 percent in the medium term. Growth will be supported by enhanced infrastructure investment and social services as well as an improved business environment, which will boost confidence and unlock the economy’s potential for higher, more broad-based, and resilient growth and employment. Downside risks to growth include political pressures in the run-up to next year’s elections that could weaken policy discipline and reform efforts, weather-induced shocks, and declines in agricultural commodity prices.

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Staff Report

Article IV Discussions: A new path for growth and debt sustainability

Fostering Higher, More Inclusive, and Resilient Growth

The authorities have adopted a new Malawi Growth and Development Strategy (MGDS) III for 2018-23. Finalized in 2017 Q4, MGDS III aims at building productivity, competitiveness, and resilience mainly through stepped-up investment in infrastructure and social sectors but also with reforms to improve financial market development and the business environment – including governance – against a sound macroeconomic backdrop. These areas coincide with staff’s recommendations on key reforms to ignite higher, more inclusive, and durable growth as well as job creation (Selected Issues Paper). Staff and the authorities concurred on the need to advance reforms on multiple fronts while prioritizing the agenda. The authorities plan to prioritize improving low quality and coverage of infrastructure (especially electricity, roads, telecommunications, water, and irrigation) and social spending (particularly, education, healthcare, and gender issues.

Governance reforms (related to PFM, procurement, and broader governance areas) are expected to catalyze concessional financing in these areas. Staff emphasized gains could be achieved by, in parallel, improving the quality and efficiency of public spending and raising access and affordability of credit. The authorities also plan to implement deep agricultural market reforms to foster growth and ensure food security. These include a strategic review of ADMARC, aligning export and import control systems with the WTO norms, further FISP reforms, and implementing the new land reform bills (MEFP ¶33). Once these are underway, measures related to reducing regulatory burdens and strengthening the judiciary will be considered. Staff noted that progress in removing trade barriers, exchange rate flexibility (especially during 2012-16), and liberalization of fuel prices supported moderate growth, and adaptive policies should continue being implemented.

Preserving Debt Sustainability

Malawi’s risk of external debt distress is moderate. The debt sustainability analysis (DSA) update carried out jointly by staffs of the IMF and the World Bank (Annex V) indicates that all baseline external debt burden indicators are below their policy-dependent debt burden thresholds. Stress tests highlight vulnerabilities to exogenous shocks, especially export revenues and exchange rate – reflecting the country’s narrow export base and heavy reliance on rain-fed irrigation. However, rising domestic debt has increased vulnerabilities. Domestic financing increased sharply after the withdrawal of donor budget support, securitization of arrears, and recapitalization of the RBM and two public banks. As a result, total public debt more than doubled since HIPC and MDRI debt relief in 2006 – projected to reach 55 percent of GDP in 2018. Staff and the authorities agreed that future borrowing for large infrastructure needs to be balanced against elevating the risk of debt distress (MEFP ¶24).

To maintain debt sustainability, the authorities agreed to suspend contracting of new non-concessional loans. However, under the program, exceptions can be considered on a case by case basis for new loans backing priority growth-enhancing projects – accompanied by fiscal measures that offset the debt impact of the non-concessional portion of the loan. The authorities concurred with staff on the importance of developing a comprehensive medium-term debt strategy, including prioritizing investments based on rigorous cost-benefit analysis, absorptive capacity, growth, poverty reduction, and debt sustainability considerations. To this end, they have requested FAD Technical Assistance (a Public Investment Management Assessment) with a mission planned for mid-2018. In addition, state-owned enterprise reforms, beginning with enhanced oversight, aim to reduce contingent liabilities.

Annex III. External Sector Assessment

The external position of Malawi in 2017 was broadly consistent with the level implied by medium-term fundamentals and desirable policies. The current account is expected to improve gradually over the medium term, reflecting higher export growth but also persistent need for investment-related imports. Policies should strive to enhance macroeconomic resilience, preserve fiscal and debt sustainability, and advance growth-friendly structural reforms.

Current account

The current account deficit narrowed last year – to an estimated 10 percent of GDP, down from 13.6 percent in 2016, but still about one percentage point higher than the 2011-15 average. The improvement reflects a large base effect in 2016 from increased imports of maize and related services in response to the humanitarian crisis, which more than offset the impact of deteriorating terms of trade (-4.6 percent). The persistent current account deficit reflects a narrow export base (with three products – tobacco, sugar, and tea – accounting for over three-quarters of total exports), heavy reliance on investment-related imports, and strong population growth. Going forward, the current account balance is projected to improve gradually, on the back of stronger export growth and resilient investment-related import demand.

Capital and Financial Flows

Net financial inflows in the past year recovered from low levels in 2016 to the 2011-15 average (relative to GDP). Medium- and long-term loan disbursement doubled, thanks to the agricultural support funds from the World Bank and stronger project support. Capital account balance, reflecting project, dedicated, and off budget grants, stood at 5.2 percent of GDP last year, steadily improving from the 2015 level, though lower than the temporary spike (9.1 percent of GDP) in 2016 reflecting the humanitarian support in response to the drought. Foreign direct investment flows (2 percent of GDP) disappointed last year, amid investor concerns over power shortages and rising factor costs. Capital and financial flows more than fully financed the current account deficit, leading to a positive overall balance.

Reserves

International reserves improved to an adequate level last year. At end-2017, gross international reserves stood at US$757 million, reflecting strong capital and financial inflows. This is equivalent to 3.3 months of prospective imports of goods and services, up from 2.9 months in 2016. The IMF’s metric to assess reserve adequacy in credit-constrained economies, which explicitly weighs the cost and benefits of holding reserves, indicates that a reserve level of 3.2 months of imports would be adequate for Malawi, assuming a low opportunity cost of holding reserves.

Two traditional approaches – with broad money coverage at 52 percent (against a 20 percent threshold) and short-term debt coverage at 360 percent (against a 100 percent threshold) – also indicate that the current reserve stock is adequate. However, the rise in reserves in 2017 reflects largely the agricultural support funds from the World Bank ($80 million, equivalent to 0.4 months of imports), which is soon expected to be fully spent. Moreover, the country has been vulnerable to multiple shocks historically (especially to international commodity prices and weather shocks), while import needs are persistently strong. Over 2001-17, the reserve import coverage averaged 1.8 months, with a standard deviation of 0.9 months. Going forward, reserves are expected to rise to about 3.8 months by 2021 and reach 4.5 months over the medium term.

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Selected Issues paper

Supporting growth through increased credit to the private sector

A sound and inclusive financial system lays the foundation for sustained and broad-based growth. Financial deepening increases a country’s resilience and boosts economic growth by mobilizing savings, promoting information sharing, improving resource allocation, and facilitating diversification and management of risk.

Malawi is one of the least banked countries in the world. The banking system’s credit to the private sector (relative to GDP) is low compared to peers. Other measures of financial depth, such as the ratio of broad money to GDP exhibit a similar pattern. Only 16 percent of the population have accounts at a financial institution, compared to averages of 29 percent for the Sub-Saharan African (SSA) region and 22 percent for Low Income Countries (LICs). Raising credit growth across the population will benefit broad-based economic growth.

Role of Public Policy in Facilitating Deepening

Promoting higher credit growth and financial inclusion requires a detailed Financial Sector Development Strategy. Key elements of this strategy are outlined below.

• Fostering macroeconomic stability. Continued disinflation would support macroeconomic stability, in turn, lowering uncertainty and the cost of funds, reducing the costs of opening and maintaining an account in financial institutions, and expanding demand for financial services. Reducing crowding out – through better fiscal and government debt management – would help credit growth, reduce risks to financial stability, and increase competition across banks for new lending opportunities.

• Addressing information gaps. Strengthening collaboration across banks, the RBM, and the government to offer financial literacy education and training would facilitate better targeting these efforts and expanding them to those at the bottom of the income pyramid.

• Enabling legislation for microfinance and savings and credit cooperatives (SACCOs). Enabling these institutions that traditionally serve lower-scale operations could spur access to financial services. The benefits of greater microcredit penetration should be balanced with concerns over the lack of regulatory oversight, potential distortions from extensive government support (e.g., discouraging private incentives to mobilize savings), and directed lending.

• Promoting mobile technology. Supporting technological innovation by promoting the role of the private sector and creating infrastructure to encourage participation would reduce the cost of providing financial services and broaden access of payment services to under-served segments of the population (e.g., in rural areas). Introduction of digital identification (ID) can enhance the reach of mobile banking and deepen financial inclusion. Applying biometric technologies (fingerprinting, for instance, already practiced by two microfinance institutions) to credit approval helps build financial transaction history, allows banks to identify good borrowers, and increases overall efficiency. With adequate coverage, the low transaction costs of the mobile platform could facilitate payments for state benefits such as the FISP and social cash transfers.

• Managing risks. Proactive oversight, continuous risk monitoring, and mitigating of systemic risks will be critical to supporting a healthy process of financial deepening. For example, regulatory and supervisory frameworks should keep up with market deepening to avoid creating new sources of risk and instability. Stronger regulation and enforcement of connected and insider lending and encouragement of micro-credit would also reduce risks.

• Strengthening financial frameworks. Improving informational and contractual frameworks would lower financial transactions costs. For example, building or upgrading credit registries. Well-targeted partial credit guarantee schemes could address market failures and promote access in environments with weak credit information and creditor rights. The effectiveness of commercial courts and insolvency regimes could be improved with a commercial courts arbitration mechanism and training for judges to professionalize financial and economic justice systems. Reducing high overhead, personnel, and loan loss provisioning costs would also contribute to lower borrowing costs.

• Improving property rights. Better titling, registration, and security of land tenure would broaden the use of land as collateral. Responding to the challenges in this area, the government passed 10 new Land Laws in 2016 that strengthen smallholders’ tenure security and gender equity by registering customary estates in participatory and low-cost ways. Initial steps have also been taken towards better land administration service delivery, establishing a fully electronic land information system, and modernizing estate leasehold management and ground rent collection. Effective implementation of these laws together with registration and documentation of land rights will facilitate the emergence of functional land markets and the use of land for collateral.

Malawi has made progress toward financial deepening but considerable efforts are still needed to promote entrepreneurship development by addressing the structural challenges constraining SMEs. Alleviating the various structural barriers to financial deepening, both in terms of depth and access to financial services, will bring substantial benefits for the economy in terms of growth, poverty alleviation, resilience to shocks, and effectiveness of monetary and fiscal policies.

A path toward higher and more inclusive growth

Over the past decade, Malawi's economic growth has been weak and not as inclusive as in peers. Malawi's real GDP growth dropped from 7.5 percent in 2007-11 to 3.6 percent in 2012-16. As a result, per capita GDP is far below that of regional peers and other fragile states. The average poverty rate was around 70 percent in 2016 (the World Bank’s World Development Indicators (WDI) estimates based on international poverty line of US$1.90 per day) and rural poverty is on the rise due to high population growth (3 percent) and density. These pressures will only continue to build with nearly half the population below the age of 15.

Malawi’s growth trends reflect a lack of both economic diversification and resilience – raising Malawi's vulnerability to external and weather-related shocks. Two thirds of the population are employed in agriculture (primarily maize farming). However, this sector's share of GDP has declined from 40 to 30 percent of GDP over the past decade due to its low productivity and vulnerability to weather-related shocks – reflecting low coverage of engineered irrigation systems, high transport costs, insufficient services, and limited access to credit. The two-year El-Niño-induced drought (2015-16), for example, dented maize production and adversely affected parts of manufacturing and retail trade closely linked to agriculture. It also reduced hydroelectricity generation (Malawi's main source of electricity), which increased operating costs and lowered capacity utilization in manufacturing and trade. In addition, Malawi is vulnerable to shocks in global tobacco, tea, and sugar prices – altogether about 80 percent of Malawi's exports. Over the past decade, policy uncertainty, governance challenges and high inflation have also taken a toll on confidence and economic activity.

This paper examines these challenges and policies to overcome them and, ultimately, achieve higher and more inclusive growth.