Lilongwe, October 6, 1999.

Dear Mr. Camdessus:

1. The third annual ESAF arrangement for Malawi, in an amount equivalent to SDR 20.4 million (30 percent of quota), was approved on December 17, 1998 in support of Malawi's adjustment program for the period October 1, 1998-September 30, 1999. Discussions with the Fund staff on the midterm review of the program were held in Lilongwe during the periods May 6-14 and August 15-22, and in Washington during June 28-July 2, 1999. This letter reviews Malawi's recent economic performance and prospects over the remainder of the program period and outlines the government's objectives and policies for the period ahead in the context of the 1999/2000 (July-June) budget.

2. Data for the period October 1998-March 1999 indicate that the end-March quantitative performance criteria were met, but the economic growth and inflation objectives for 1999 are unlikely to be achieved. Real GDP is projected at about 4¼ percent (compared with a program target of 5 percent) in 1999, as the impact of a good maize crop is likely to be offset by that of a decline in tobacco production (because of underutilization of fertilizers and adverse weather conditions). Economic activity in the manufacturing sector has also been weak, owing to reduced domestic demand in the aftermath of the substantial depreciation of the kwacha in August 1998. Pressures on the kwacha continued during the period October-December 1998, reflecting strong inflationary expectations. Accordingly, the exchange rate depreciated slightly to MK 44 per U.S. dollar by end-December and has since remained at about that level. As a result of these developments, as well as a delay in tightening monetary policy, the 12-month rate of inflation accelerated steadily to nearly 57 percent by March 1999 before receding to 50 percent in July.

3. The fiscal situation over the six-month period ended March 1999 continued to improve, and the performance criterion relating to the domestic primary balance was observed. Tax revenue was higher than targeted, reflecting improvements in tax administration, as well as the impact on the tax base of higher-than-projected inflation and a more depreciated exchange rate for the kwacha. Current expenditure (excluding interest) was 32 percent below the program level, owing mainly to a shortfall in outlays on wages and salaries, as well as lower-than-envisaged importation of maize. Transfers were higher than the program target, owing to an expenditure of MK 245 million for the National Road Authority that had not been included in the budget.

4. The adjusted end-December targets and end-March performance criteria on net credit to the government from the monetary authorities were met comfortably. However, the expansion of broad money exceeded the programmed target, owing to higher-than-envisaged accumulation of net foreign assets and a strong expansion of private sector credit. To curb the attendant inflationary pressures, liquidity conditions were tightened through open market operations, resulting in an increase of about 10 percentage points in the nine-month treasury bill rate to 50½ percent by end-March 1999. As a result, the monthly inflation rates declined steadily during February-July. The Reserve Bank of Malawi (RBM) will maintain a tight monetary policy stance in the period ahead, until inflationary pressures have abated substantially.

5. In 1998, the overall balance of payments position was better than programmed, as the shortfall in export earnings and unrequited transfers was more than offset by a sharp decline in imports, owing to the impact of the exchange rate adjustment. The external current account deficit was less than programmed, the capital account improved, and the overall balance recorded a surplus of US$91 million (compared with a programmed target of US$81  million). Gross international reserves at end-1998 were equivalent to 4¼ months of imports of goods and nonfactor services, compared with 3½ months under the program.

6. During April-June 1999, the macroeconomic program remained broadly on track; however, the benchmark on the net credit to government from the monetary authority could not be observed owing largely to higher outlays on the national elections as a result of administrative problems and the need to postpone (from May 25-June 15) the election date, in order to ensure fair results. The problem of the election added to that of factors that had been weighing on the fiscal situation earlier under the program, notably (a) the inability of the Petroleum Control Commission (PCC) to reimburse fully its outstanding obligations to the government; (b) higher-than-expected domestic interest payment; and (c) a shortfall in the privatization receipts. To help correct a part of the fiscal slippage that emerged at end-June, the government, in consultation with the Fund staff, is implementing a number of measures, including the curtailment or postponement of less essential expenditure. Moreover, the government is seeking extra assistance from bilateral and other members of the international community to cover the additional cost of the recent national elections.

7. In the structural area, the Agricultural Development and Marketing Corporation (ADMARC) selling price of maize has been maintained at MK 7.25 per kilogram. Domestic maize purchases (from smallholders) by ADMARC are being effected at an export parity price estimated at about MK 5 per kilogram in 1999. The government expects that the maize will be exported or sold later during the lean season at higher prices, thus obviating the need for subsidy. The performance criterion relating to the completion by end-May 1999 of a study on the commercialization and privatization of the ADMARC was not met, owing to administrative delays. Instead, a preliminary report on the study was prepared in June 1999 and is expected to be finalized, following its review by the stakeholders, before end-September. The completed study will form the basis for consultation with the staffs of the Fund and the World Bank immediately thereafter on follow-up steps.

8. The government took a decision—prior to the approval of the program—to allow the importation of petroleum products by the private sector. However, as a result of preexisting contractual arrangements for the procurement of petroleum products, the private oil companies in Malawi chose to postpone contracting for their own supplies until September 1999 when a consortium of private petroleum companies operating in Malawi is to negotiate a supply contract for the calendar year 2000. The government also announced a pricing structure and formula for petroleum products that allow for an automatic pass-through in international oil prices and fluctuations in the exchange rate. The formula is being reviewed on a biweekly basis, and the pump prices are adjusted whenever the import price (in kwacha) varies by more than 5 percent. Moreover, effective July 1, 1999, two components of the price buildup were revised: (i) the levy earmarked for the repayment of the outstanding obligations (initially MK 560 million) of the PCC to the RBM was raised to allow for their full repayment by June 2000; and (ii) the levy for the National Road Authority was increased to generate MK 420 million for routine road maintenance in 1999/2000. Accordingly, the prices of petrol and diesel were raised by 15 percent and 13 percent, respectively, effective July 1, 1999. The audit of the PCC—a structural performance criterion for May 31—was carried out ahead of schedule. The audit revealed a number of financial and management irregularities, which have been referred to the Anti-Corruption Bureau (ACB), and the key persons implicated in the irregularities have been relieved of their responsibilities in the PCC. The ACB is investigating the financial records of the implicated persons, and the government will follow up firmly on the ACB findings through the courts.

9. The privatization program has remained on track: so far 14 enterprises (out of a target list of 30 entities) have been privatized or brought to the point of sale. Of the 14 enterprises, sales have been completed for 9 entities, and transactions of 3 other enterprises are expected to be completed before end-September 1999. The government has already approved a plan for the divestiture of some assets held by the Malawi Development Corporation (MDC) and ADMARC Holdings, and has also approved guidelines for the divestiture of its remaining public shares in the Commercial Bank of Malawi Ltd. (CBM). Specifically, the government has decided to secure a strategic partner for the CBM, and an investment advisor will be contracted by end-September to assist in the identification of the partner. Regarding the National Bank of Malawi (NBM), the government intends to reach a decision as to whether to associate a strategic partner by end-September 1999.

10. The performance criterion relating to the preparation, by end-1998, of an action plan for improving data on the balance of payments, external debt, and externally financed development expenditure was not met. The plan was, however, prepared in early 1999 with the help of the long-term Fund expert on statistics who has been assigned to Malawi. According to the plan, the National Statistical Office (NSO) was assigned a leading role in the preparation of balance of payments statistics, including the coordination and review of data submission from the Customs Department, the Ministry of Finance, and the RBM. A new Debt and Aid Management Division (DAMD) in the Ministry of Finance has also been established. So far, the efforts of the NSO and DAMD have not yielded the needed improvement in data, in part owing to a chronic shortage of personnel. Consequently, the government has prepared, with the assistance of the Fund expert, a more carefully articulated plan, which is being implemented forcefully. In particular, under the 1999/2000 budget the allocation for the statistical services has been increased by over 80 percent; their personnel is being strengthened through new recruitment or reassignment of staff; and additional vehicles have been provided. The monitoring and implementation of the government's economic program will also be strengthened through (a) bi-weekly meetings of the technical staff of the Ministry of Finance, the RBM, and the National Economic Commission (NEC), to review the accuracy and coherence of needed financial and economic data; (b) monthly reporting of comprehensive information on the implementation of the economic program to the Special Cabinet Committee on Budgetary Measures (SCCBM); a substantial strengthening of the staff of the Ministry of Finance; and (d) closer coordination with the office of the IMF Resident Representative in Malawi. These efforts are expected to substantially improve the quality of economic data and the effective implementation of the government's economic program, in time for the negotiation of a successor enhanced structural adjustment facility (ESAF) program later in 1999.

11. In the area of civil service reform, the audit of the civil service and the job grading exercise have been completed. The outsourcing, privatization, or liquidation of specific services and agencies of the four largest ministries (Health and Population, Education, Transport and Public Works, and Agriculture and Irrigation) have started, and feasibility studies and other needed steps will be accelerated in the period ahead with a view to ensuring, at least, that all these services and agencies are brought to the point of sale during FY1999/2000.

12. The principal macroeconomic objectives underlying the budget for 1999/2000 are to (i) raise GDP growth to 5½ percent in 2000 from 4¼ percent in 1999; (ii) strengthen the balance of payments, with gross international reserves increasing to 4½ months of imports of goods and nonfactor services by end-1999; and (iii) lower inflation to 21 percent by end-1999. In support of these objectives, the budget for 1999/2000 will be aimed at limiting the domestic primary deficit to 2 percent of GDP, and the overall fiscal balance (commitment basis, excluding grants) at about 11½ percent of GDP. Accordingly, gross investment and domestic savings are projected to rise from their 1998 levels by 1¾ and 2 percentage points of GDP, respectively.

13. Revenue collection in 1999/2000 is expected to decline from almost 18 percent of GDP in 1998/99 to about 15¾ percent of GDP, owing to various factors. First, the income tax threshold was raised from MK 6,000 to MK 12,000; this is expected to result in a revenue loss equivalent to ¼ of 1 percent of GDP. Second, the maximum import tariff was lowered from 30 percent to 25 percent, and the tariff rates for those intermediate products and raw materials, that were not lowered in the context of the 1998/99 budget, were reduced from 10 percent to 5 percent, and from 15 percent to 10 percent, respectively. These measures are expected to result in a revenue loss of about ½ of 1 percent of GDP. Third, the government is winding down its involvement in the marketing of maize. Finally, the yield from import-based taxes, notably import duties and the surtax on imports, are expected to grow at a much slower pace than nominal GDP, because of the stagnation of import volume and the relative stability of the exchange rate.

14. In order to compensate for the revenue losses, the government has introduced several revenue-enhancing measures, including an increase in the surtax rate on sugar from 12 percent to 20 percent (expected to yield MK 84 million); a 10 percent excise tax on electronic products and an increase of 10 percentage points in the excise tax on vehicles (together yielding MK 165 million); and an increase in fees on motor vehicles, trading licenses, and immigration documents (MK 290 million). In preparation for the introduction of the value-added tax (VAT), the government will continue its efforts to rationalize the surtax by limiting exemptions and exploring the possibility of increasing the surtax rates on the remaining products.

15. The Malawi Revenue Authority (MRA) is expected to commence operations in the course of the year, following the appointment of a Commissioner General, senior management, and regular staff. The government remains committed to the introduction of a VAT, building on the existing surtax, after the MRA is firmly established.

16. The wage bill will increase by about ½ of 1 percentage point to 5¼ percent of GDP in 1999/2000 as a result of salary adjustments and the hiring of 1,500 persons in education, health, security, and other priority areas. Following a general wage increase of 25 percent that was awarded effective July 1, 1999, another merit-based salary adjustment of 30-40 percent is envisaged for a select group of key administrative and technical staff, effective January 1, 2000. The latter wage adjustment will be limited to 5 percent of the wage bill for 1999/2000. The selection of the eligible employees—not more than 10 percent of the civil service—will be based on the job grading exercise (supported by the World Bank) that was completed in July, as well as rational and transparent guidelines that will be used to develop a revised pay scale (to be introduced on July 1, 2000) for all civil servants. Concomitantly, the government will retrench at least 1,300 employees, starting in the second half of 1999, implying an unchanged number of civil servants in the course of the fiscal year. Some MK 150 million has been allocated for separation benefits during 1999/2000, and donor support will be sought to help cover costs relating to the retrenchment exercise, including the retraining of some workers, and the settlement of carried-over obligations of MK 100 million relating to the last days of the recent parliamentary and presidential elections.

17. Nonwage expenditure will be reoriented toward priority social services as specified in the medium-term expenditure framework (MTEF), especially in the areas of primary education, health, drugs and pharmaceuticals, and police. At the same time, low-priority spending will be frozen in real terms at the 1998/99 levels. The 1999/2000 budget will also incorporate the cost of some newly outsourced government functions. To this end, expenditure on goods and services will be allowed to expand by 1/3 of 1 percentage point to 6¾ percent of GDP. To ensure that all government agencies remain current on their obligations to the utility companies, any accumulated arrears will be settled directly by the treasury, with a corresponding debit of the respective votes. The budget also provides for the funding of the National Road Authority (MK 420 million); the cost of local elections expected to be held in the course of the fiscal year (MK 500 million); and the government's contribution to support the smallholder agricultural input program (MK 500 million).

18. The RBM will maintain a tight monetary policy stance in the period ahead. The monetary program envisages a 12-month rate of growth for broad money of about 29 percent for December 1999, which is consistent with the targeted rate of inflation and the anticipated decline in the income velocity of money. The program also envisages that credit restraint will be sustained through open market operations until a clear pattern of disinflation is established. Accordingly, in 1999, the net domestic assets of the RBM are programmed to decline substantially, by nearly 72 percent of reserve money at end-1998. In view of the projected strong external budgetary support, the RBM will prepare an action plan to repay gradually the government's stock of short-term domestic debt. The net foreign assets of the RBM are expected to increase by about 75 percent, implying a modest buildup in gross official international reserves to a level equivalent to approximately 4½ months of imports at the end of the program year.

19. The government is concerned that some members of the international community might revise their levels of support for Malawi, especially in the aftermath of the Cologne initiative. In the event of a reduction in the level of support, monetary policy will be tightened, and, if necessary, the government will consult with Fund staff on a prudent revision of its monetary and fiscal objectives. Moreover, as a precautionary measure, the government intends to accelerate the preparation of the World Bank's successor structural adjustment operation and ensure timely negotiation of the program to be supported by a new ESAF arrangement.

20. The RBM intends to lower the reserve requirements, which currently stand at 35 percent of total deposits, in the course of 1999 as inflation abates, in order to facilitate a reduction in the spread between deposit and lending interest rates. To this end, the government, assisted by an MAE mission, intends to develop a strategy for reducing the reserve requirements, taking into account the RBM's ability to cope with the resulting liquidity through appropriate interventions in the financial and exchange markets.

21. The RBM has been following closely the situation of the Malawi Savings Bank (MSB), whose deterioration has recently prompted the government to provide financial support, equivalent to ½ of 1 percent of GDP. The financial and administrative linkages between the postal system and the MSB, which contributed to the financial problems of MSB, have largely been severed. The management of the MSB is being substantially strengthened and is expected to present a new business plan, the execution of which will be closely monitored by the RBM. Moreover, the RBM will maintain an active prudential supervision of the MSB.

22. The overall balance of payments is projected to register a smaller surplus of US$65 million in 1999 than in the preceding year, on account of a modest improvement in the current account balance, a marginal improvement in the balance for unrequited transfers, and a slowdown in net capital flows. Export receipts from tobacco are projected to decline by some US$20 million, but other exports will increase slightly. Gross official reserves are targeted to increase to the equivalent of 4½ percent of imports of goods and nonfactor services.

23. Malawi maintains an independently floating exchange rate system and is allowing the exchange rate for the kwacha to reflect market forces. Moreover, its intervention in the exchange market is being guided by the international reserve targets and the need to smooth out temporary fluctuations of the exchange rate. In this connection, the RBM will seek to avoid excessive departures from the reserve targets. The RBM will also be examining ways of broadening and deepening the foreign exchange market, as well as fostering competitiveness within the market. Malawi remains committed to maintaining a liberal exchange regime consistent with its obligations under Article VIII, Sections 2, 3, and 4 of the Fund's Articles of Agreement.

24. In line with the government's policy on trade liberalization, most import tariff rates were lowered by 5 percentage points, in the context of the 1999/2000 budget. The ongoing trade liberalization has exposed some manufacturing enterprises to increased regional and international competition. The government is consulting with the private sector on practical steps for strengthening the country's international competitiveness. These steps will focus on, among other things, reducing the high cost of utilities and transportation in Malawi and bolstering productivity.

25. Malawi has collaborated with the Fund staff in updating the debt sustainability analysis (DSA). According to the exercise, Malawi's external debt is projected to increase from the equivalent of 258 percent of exports of goods and nonfactor services in 1998 to a peak of about 295 percent in 2000 and subsequently to decline; however, it will remain above 200 percent until 2012. Moreover, the debt-service ratio, estimated at about 18½ percent in 1998, is projected to remain in that range during 2000-12. The government is exploring with its partners in the international community ways of enabling Malawi to cope with the onerous external debt-service payments.

26. The government is requesting waivers for the nonobservance of the two structural performance criteria described in paragraphs 7 and 10 concerning, respectively, the completion of a study on the commercialization and privatization of ADMARC, and the preparation of an action plan for improving data on the balance of payments, external debt and externally financed development expenditure. The study is to be completed in September 1999, paving the way for consultation with the staff of the Fund and of the World Bank on follow-up steps. Moreover, the statistical plan was prepared in early 1999, and the government is working closely with the Fund staff to ensure that it will be implemented effectively.

27. The government believes that the policies and measures set forth in this letter are adequate to achieve the objectives of its program, but it stands ready to take any additional measures that may prove necessary for this purpose. During the period of the third annual arrangement under the ESAF, the government will not, without Fund approval, introduce new or intensify existing restrictions on payments and transfers for current international transactions, nor introduce any multiple currency practice, conclude any bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement, nor introduce or intensify import restrictions for balance of payments reasons. The government will also consult with the Fund on the adoption of any additional measures that may be appropriate, either at its own initiative or at the request of the Managing Director. In addition, after the period covered by the third annual arrangement and while Malawi has outstanding financial obligations to the Fund arising from loans granted under this arrangement, Malawi will consult with the Fund periodically, at the government's initiative or whenever the Managing Director requests such a consultation, on Malawi's economic and financial policies.

Sincerely yours,