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Malawi - Fifth and Sixth Reviews Under the Extended Credit Facility Arrangement, Request for Waivers for Non-Observance of Performance Criteria, Extensions of the Arrangement, Modification of Performance Criterion, and Rephasing of Disbursements-Staff Report; Press Release; and Statement by the Executive Director for Malawi
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Statement by Mr. Mkwezalamba, Alternate Executive Director, Mr. Tucker, Senior Advisor to the Executive Director and Mr. Sitimawina, Advisor to the Executive Director for Malawi, March 23, 2015

Author(s):
International Monetary Fund. African Dept.
Published Date:
March 2015
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Introduction

1. The Malawian authorities appreciate the meaningful policy advice and guidance of the Fund Executive Board and Management in their efforts to achieve macroeconomic stability, reduce poverty and attain sustainable and inclusive growth. Further, they welcome and commend the constructive policy dialogue with staff during the program discussions.

2. The elections of May 2014 ushered in a new government of Prof. Arthur Peter Mutharika, which is firmly committed to the objectives of ECF supported program, including vigorously pursuing the implementation of the recommendations of the forensic audit report, strengthening PFM systems, and implementing critical structural reforms. Their commitment is manifested through their efforts to stabilize the macroeconomic situation and the continued implementation of various reforms. Most of these reforms have been covered in the staff report and we will emphasize on some of them in our statement. It is against this backdrop that the authorities solicit the Executive Directors’ support for their request for completion of the fifth and sixth reviews under the ECF arrangement, the request for waivers for non-observance of performance criteria, extension of the arrangement, modification of performance criterion and the re-phasing of disbursements.

Performance under the ECF arrangement

3. The uncovering in late 2013 of the misappropriation of public funds, referred to in Malawi as ‘cashgate’, disrupted the progress towards macroeconomic stabilization and structural transformation of the Malawian economy. The authorities’ response to the ‘cashgate’ scandal was swift and robust. Immediately, a forensic audit of the suspected transactions was launched and action to address weaknesses in public financial management (PFM) was initiated. In this regard, prosecutions arising from the audit report are being pursued resulting in convictions and recovery of some assets.

4. However, the ensuing suspension of budget support by development partners exacerbated the economic situation, rendering budget execution and implementation of the Extended Credit Facility (ECF) program challenging. Attempts by the authorities at fiscal adjustments in response to this development proved ineffective, as the programmed domestic borrowing ceiling was breached and large domestic payment arrears accumulated. The pace of reserves accumulation slowed and efforts at managing domestic liquidity was constrained. Consequently, as highlighted in the staff report, several quantitative performance criteria (PCs) in respect of the fifth and sixth program reviews—end-December 2013 and end-June 2014 test dates, respectively—were missed. On the structural reform agenda, some delays in implementation were experienced, though key measures, including verification of the stock of government domestic arrears and third party diagnostics of commercial banks, were implemented.

5. In spite of the challenges, the Malawian authorities have remained committed to implementing sound macroeconomic and structural policies, and returning the program on track. This has been manifested in the attainment of all but one of the informal quantitative targets agreed with the staff team on Net Domestic Assets, Net Domestic Financing and gross official reserves for end-September 2014 and end-January 2015. More importantly, the prior actions agreed upon for completion of the fifth and sixth reviews under the program, in the areas of fiscal policy, public financial management, monetary policy and financial sector, have been fully implemented.

6. The authorities underscore their determination to prevent the recurrence of the breach of the continuous PC on new non-concessional external debt maturing in more than one year and the continuous PC on the non-accumulation of external payment arrears. As expressed in the authorities’ response to the Managing Director’s letter on the subject and in their Letter of Intent, appropriate remedial measures have been undertaken. These include cancellation and replacement of the Supplier’s Credit Agreement with a suppliers’ agreement with a much reduced total value of the overall transaction of only US$33 million from US$145.3 million and normalization of all outstanding external payment arrears. In addition, debt management capacity is being enhanced following the resuscitation of the Debt Management Committee. The authorities have also made an undertaking to share with Fund staff all new loan proposals to ensure conformity with program understandings. Against the backdrop of these measures, our authorities request waivers for non-compliance with the missed continuous PCs.

Recent economic developments, macroeconomic outlook and policies

7. The medium-term macroeconomic outlook remains favorable, with policies focused on strengthening the macroeconomic position and sustaining growth on its upward trajectory. Consistent with this outlook, the authorities’ short-term priorities will be on restoring macroeconomic stability, reinforcing PFM systems, and preserving the stability of the financial sector. Economic growth is expected to be somewhat resilient on account of increased public investment in infrastructure and an improved policy and business environment. Inflation is to decline from current levels to low double digits by end-2015 and then single digit levels towards end-2016, benefiting from a well-calibrated monetary policy and lower international fuel prices.

8. While real GDP is projected to have grown by around 6 percent in 2014 driven by agriculture, wholesale and retail trade, and information and communication sector, the outlook in 2015 could be affected the by heavy downpour of torrential rains and subsequent worst floods Malawi has suffered in its history. The floods have affected 15 of the 28 districts in the country, causing severe toll in human lives and destroying crucial transport infrastructure and disrupting energy generation. Over 172 people are missing while 106 have died. In addition, livestock, houses and a significant portion of agricultural land have also been destroyed. This will affect growth in the agricultural sector and may in turn affect food security in the next consumption year, with undesirable implications for public finances. This development poses immense risks to the realization of the envisaged near-term growth and inflation outlook. The authorities express their appreciation to the international community for their rapid response to the disaster and their continued support which is helping to alleviate the plight of those affected.

Fiscal and debt management policies

9. In spite of the difficult domestic fiscal environment, the authorities remain committed to pursuing prudent fiscal policy geared towards consolidating the fiscal position while avoiding a further build-up of domestic payment arrears. The current FY2014/15 budget is predicated on large fiscal adjustments, with significant reduction in non-statutory recurrent expenditures and domestically financed capital spending against the backdrop of the dearth of external budgetary support and the constrained space for domestic bank financing. While this has been challenging, the authorities continue to exercise fiscal discipline by restraining budget execution within program limits. Going forward, efforts will continue to strengthen fiscal management and shore up public finances. On the revenue front, policy measures will focus on strengthening tax administration and minimizing tax exemptions. On expenditures, the authorities will seek to further rationalize the budget envelope while preserving allocations to growth-enhancing sectors. Regularizing the large stock of domestic arrears accumulated over the years remains a priority over the medium term. To this end, the authorities are determined to proceed with clearing all audited and verified domestic arrears through cash payments and the issuance of ‘zero coupon bonds’ over the next three fiscal years.

10. The authorities reiterate their commitment to preserving debt sustainability over the medium to long term. While the country remains at a moderate risk of external debt distress, as assessed by the staffs’ debt sustainability analysis, they are mindful of the heightened overall risk of debt distress resulting from the increasing vulnerabilities from domestic debt accumulation. Thus, in addition to the measures highlighted above to strengthen debt management and prevent the incidence of misreporting, they will continue to exercise fiscal restraint while relying mostly on concessional external borrowing to finance critical development projects.

Public financial management

11. A centerpiece of the authorities’ near-term reform agenda is the strengthening of public financial management systems to facilitate efficient government financial operations and restore public confidence in budget execution. In this regard, the authorities commend the TA that has been received from FAD. Already, significant progress has been accomplished in strengthening commitment controls, reconciling fiscal accounts, and improving cash management. Further consolidation of these efforts will be sought through judicious implementation of the recently adopted PFM strategy, within the framework of the authorities’ Public Finance and Economic Management Reform Programme. In view of the several operational and system deficiencies in the current Integrated Financial Management Information Systems (IFMIS), the authorities have initiated the process of procuring a new, well secured and efficient IFMIS. In the interim, the current system is being enhanced to ensure that efficient government financial transactions continue while prosecutions of the alleged cases of fraud identified in the Forensic Audit report are resolutely being pursued. Subsequently, an assessment of the implementation of these recommendations will be undertaken by a reputable international audit firm.

Monetary and exchange rate policies

12. The Reserve Bank of Malawi (RBM) has demonstrated a strong commitment to stabilizing monetary conditions and bolstering the external reserves position, using monetary policy instruments at its disposal. In response to increased inflationary pressures and a sharp depreciation of the Kwacha in 2014, the Bank raised the policy rate by 250 basis points and increased the liquidity reserve requirement on foreign currency deposits with commercial banks. Further, a ‘currency swap’ arrangement was implemented involving the purchase of government debt denominated in Kwacha by a foreign commercial bank, the Preferential Trade Area (PTA) Bank, using US dollars. These policy actions culminated in a tightening of monetary conditions through a rise in both the interbank and the treasury bills rate, restoration of some order in the foreign exchange market, and the strengthening of the foreign exchange reserves position. Important steps have also been taken to address the perennial problem of fiscal dominance, including amendments to the RBM Act that impose tighter limit on total government borrowing from the central bank, and the prohibition of the automatic conversion of overdrafts into government securities.

13. Over the near term, the RBM will maintain a tight monetary policy stance to return inflation to a downward path and to appropriately anchor inflation expectations. To this end, the Bank’s liquidity forecasting and management framework will be further strengthened to closely monitor the build-up of excess liquidity in the banking system. The current flexible exchange rate regime will be maintained, as it has served the economy well especially in facilitating economic adjustments to exogenous shocks. The RBM will, nonetheless, continue limited interventions in the foreign exchange market to smoothing short-term volatility in the exchange rate and bolster the foreign reserves position.

Financial sector policies

14. The authorities remain committed to taking appropriate steps to address any risks posed by weaknesses in the financial sector. This far, third party diagnostic assessments have been conducted on the banking system, and a restructuring process to resolving issues with two banks identified as weak has commenced. A comprehensive strategy is being developed to address banking sector-wide problems from the assessments. In addition, migration to Basel II Core Principles has been completed, with an increase in total capital requirement ratios of banks. A prompt corrective action framework to strengthen and clarify existing triggers for early remedial action against distressed banks has been adopted. The RBM will continue efforts to strengthen the supervisory and regulatory frameworks of the banking system. On-site inspection and off-site supervision will be intensified, compliance with prudential norms strictly enforced, and loan concentrations closely monitored. Further, the enactment of amendments to the Banking and Financial Services Acts to ensure consistency with international best practices in bank resolution will be pursued.

Request for waiver of non-observance of performance criteria

15. The Malawi authorities deeply regret the misreporting associated with the third and fourth reviews and request a waiver for non-observance of a performance criterion (PC) under the ECF supported program. As explained in EBS/15/13, the misreporting relates to the nonobservance of the continuous PCs on new non concessional external debt maturing in more than one year and external payments arrears.

16. In line with the Managing Directors report, the Malawi authorities did not, at the completion of the third and fourth reviews, report to the Fund that it had not contracted new non-concessional external loans after the completion of the second review on April 8, 2013, aside from a non-concessional loan with China for which a waiver was requested, and that it had accumulated no external arrears during the review period. The reported observance of the external payments arrears PC, as well as the corrective actions taken by the authorities to address the non-observance of the non-concessional external debt PC at that time formed part of the basis for the Executive Board’s completion of the third and fourth reviews. As it turned out, the information provided by the authorities, was inaccurate, leading to non-complying disbursements.

17. The new administration recognized that the terms of the Supply Credit Agreement run counter to the understanding of the ECF arrangement and immediately took corrective measures. The measures which are outlined in the authorities’ response of February 19, 2015 to the Managing Director’s letter of February 12, 2015, (EBS/15/13), include cancellation and replacement of the Supplier’s Credit Agreement with a suppliers’ agreement with a much reduced total value of the overall transaction and normalization of all outstanding external payment arrears. In addition, debt management capacity is being enhanced following the resuscitation of the Debt Management Committee. The authorities have also made an undertaking to share with Fund staff all new loan proposals to ensure conformity with program understandings.

Conclusion

18. The authorities reiterate their commitment to implementing sound macroeconomic policies and far-reaching structural reforms, within the framework of the ECF arrangement. On the basis of the progress accomplished by the Malawian authorities in addressing the weaknesses in public financial management and correcting underlying macroeconomic imbalances, our authorities solicit the Executive Directors’ support for their request for completion of the fifth and sixth reviews under the ECF arrangement, the request for waivers for non-observance of performance criteria, extension of the arrangement, modification of performance criterion and the re-phasing of disbursements.

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