Malawi: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
06 Dec 2004
eISBN:
9781451828054
Language:
English
Keywords:
ISCR; CR; center; debt; government; price; government debt; debt stock; sustainability in Malawi; interest cost; simple debt sustainability model; Fiscal stance; Debt sustainability
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This Selected Issues and Statistical Appendix paper analyzes the budget deviations in Malawi, their reasons, and the consequences for the fiscal policy process. It documents the observed deviations of outturn to plan in Malawi, analyzes the reasons for such deviations, outlines some of the consequences, and considers options and actions needed for improvements. The paper evaluates the volatility and predictability of foreign aid inflows and the need for the government to modify its policies, if necessary. The paper also discusses the sources of data used, and evaluates the volatility of total foreign aid and its components.

Abstract

This Selected Issues and Statistical Appendix paper analyzes the budget deviations in Malawi, their reasons, and the consequences for the fiscal policy process. It documents the observed deviations of outturn to plan in Malawi, analyzes the reasons for such deviations, outlines some of the consequences, and considers options and actions needed for improvements. The paper evaluates the volatility and predictability of foreign aid inflows and the need for the government to modify its policies, if necessary. The paper also discusses the sources of data used, and evaluates the volatility of total foreign aid and its components.

II. A Note on Public Domestic Debt Sustainability10

A. Background

46. Recent economic developments in Malawi have been characterized by significant fiscal overspending, with the overall fiscal deficit, excluding grants, averaging 17 percent over the past two fiscal years. The authorities, receiving less external support than they anticipated, have resorted to domestic financing. As a result, interest rates and government domestic debt have risen, threatening macroeconomic stability and Malawi’s implementation of its poverty reduction strategy.

47. Domestic and external public debt share important characteristics but are also fundamentally different in several ways. Both types of debt are liabilities of the government and must be serviced. External debt is denominated in foreign currencies and, therefore, carries an exchange rate risk. In addition, for Malawi, external debt is highly concessional and generally longer term, whereas domestic debt is almost entirely short term and carries high market interest rates. Thus, a high level of domestic debt generally warrants a different policy response than debt denominated in foreign currencies.

48. There are, furthermore, several reasons why it makes sense to analyze the sustainability of domestic debt sustainability separate from external debt sustainability analysis. First, the quality of historic data on domestic debt is frequently inferior to data on external debt, which makes comparability an issue. Second, the economic implications of domestic debt are fundamentally different from those of external debt. For example, domestic debt could stimulate the development of domestic financial markets, while over certain levels domestic debt could lead to higher domestic interest rates with economy wide repercussions through the effects on private sector investments. The impact of a default on domestic obligations would in many countries be more severe than a default on foreign obligations. Furthermore, it is also problematic to deal with sustainability of the total debt. An example would be if external debt were below a certain threshold for sustainability and domestic debt were reaching critical levels. In such a case, then there could be economic merit in increasing external borrowing to reduce the domestic debt.11

49. Against this background, this note assesses the sustainability of Malawi’s domestic debt. Section B describes the evolution and composition of the domestic debt, and Section C presents a simple debt sustainability model and applies some sensitivity analysis based on Malawian data. On the basis of the model, Section D discusses the merits of initiating an upfront fiscal adjustment as envisaged in FY 2004/05 budget versus continuing the recent trends of lax fiscal policy implementation. The last section offers conclusions and recommendations.

B. Malawi Public Debt

50. While Malawi’s nominal debt stock is predominantly external, debt-servicing costs originate mainly from its domestic debt (Figure II.1).12 In 2000, Malawi reached its decision point under the HIPC initiative and has received interim debt relief in the order of US$30-60 million per year.13 Although the external debt is substantial, Malawi is on track to reach its HIPC completion point. The rapidly increasing costs of servicing the domestic debt pose the largest risk to macroeconomic stability in the short to medium term.

Figure II.1.
Figure II.1.

Government Debt and Interest Costs.

Citation: IMF Staff Country Reports 2004, 390; 10.5089/9781451828054.002.A002

51. Domestic debt started to increase in 1999 and 2000 following above budget fiscal spending.14 With the start of the Poverty Reduction and Growth Facility Arrangement (PRGF) in late 2000, the government implemented a tight monetary policy that resulted in high real interest rates, further exacerbating the domestic debt burden (Figure II.2). Following a drought in 2001, Malawi experienced a food shortage in 2002 that, together with continued lax fiscal policy implementation, led to a rapid expansion of domestic debt, which stood at 23 percent of GDP at end-2003. Although inflation decreased, higher real interest rates on domestic debt service threaten pro-poor fiscal policy and macroeconomic stability.

Figure II.2.
Figure II.2.

Nominal and Real Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2004, 390; 10.5089/9781451828054.002.A002

52. Central bank financing of the government deficit increased rapidly in 2001; over the past four years, the Reserve Bank of Malawi (RBM) has held, on average, one-third of the government debt (Table II.1.) Debt-servicing costs remain high, however, because the government is charged market rates on debt held by the RBM, whose high operating costs have precluded any transfer of profits to the treasury.

Table II.1.

Central Government Domestic Debt, 1997 - 2004 (end-June)

article image
Sources: Malawi authorities; staff estimates

C. Domestic Debt Sustainability in Malawi

53. Domestic debt sustainability (or, more generally, fiscal sustainability) can be analyzed through several different approaches. Fiscal solvency can be distinguished from fiscal liquidity, sustainability, and vulnerability. The liquidity of the government is based on its ability to meet current obligations, while vulnerability measures the resilience of the government’s fiscal position to shocks. Solvency of the government depends on a medium-term framework in which the primary surplus can finance interest costs under given assumptions for growth and inflation.

54. The following model will measure, in a simple way, the solvency the fiscal policy in Malawi. Various numerical indicators can be constructed to highlight inconsistencies between current policies and fiscal sustainability. In what follows, the sustainability analysis of Malawi’s domestic debt is based on the concept of the primary gap indicator. However, the inclusion of foreign financing net of debt service reveals the degree to which external support reduces or, alternatively, adds to the domestic debt burden becomes explicit. Thus, domestic debt sustainability is defined as primary balance plus foreign financing in excess of foreign debt service (ds), as a share of GDP, exceeding the differential of nominal interest rate (r) and nominal GDP growth (y) times the beginning-of-period nominal debt as a share of nominal GDP (d):

dst≥(rt−yt)dt−1

55. The following section presents two scenarios that exemplify the potential impact of domestic debt dynamics in Malawi. The first scenario shows the benefits of an early adjustment, while in the second illustrates the cost of delaying adjustment.

D. Outlook Under Different Scenarios

Adjustment scenario

56. The adjustment scenario assumes, in line with the budget, that domestic financing is contained at less than 2 percent of GDP in FY 2004/05 (Table II.2). The adjustment is achieved through a combination of lower expenditures, higher revenues and greater external support. Inflation is assumed to increase temporarily as a result of expansionary monetary policy in the first half of 2004, and economic growth is expected to remain relatively low before increasing to a level that will lead to poverty reducing later in the period.

Table II.2.

Adjustment scenario, 2002/03-08/09

article image
Sources: Malawi authorities; and Fund staff estimates and projections

Expenditures excluding foreign financed development expenditures, and interest payments on foreign and domestic debt.

A measure of domestic primary balance, excluding maize operations. Definition: Overall balance plus statistical discrepancy, less grants, less revenue from maize, plus total interest, plus expenditures for maize, plus foreign financed development expenditures.

57. As a result of the adjustment in 2004/05, the primary balance including net foreign financing will exceed the level required to stabilize the debt, and domestic debt will start to decrease as a share of GDP. Inflation will be contained and then start to decrease, and economic growth reach the level necessary for poverty reduction. Interest rates will come down, creating room for increased domestic primary expenditures and making a reduction of tax revenues possible. Furthermore, Malawi’s dependency on foreign external aid is assumed to decrease.

Delayed adjustment scenario

58. The delayed adjustment scenario, in contrast, offers no break with past fiscal performance for FY 2004/05 (Table II.3). Overall expenditures remain high, and inflation continues to increase. Tax revenues are eroded and economic growth does not pick up after the recovery from the external shock in 2001.

Table II.3.

Delayed adjustment scenario, 2002/03-08/09

article image
Sources: Malawi authorities; and Fund staff estimates and projections

Expenditures excluding foreign financed development expenditures, and interest payments on foreign and domestic debt.

A measure of domestic primary balance, excluding maize operations. Definition: Overall balance plus statistical discrepancy, less grants, less revenue from maize, plus total interest, plus expenditures for maize, plus foreign financed development expenditures.

59. The government is assumed to reduce fiscal expenditures in FY 2005/06 to avoid an unmanageable expansion of the domestic debt. However, the scenario also shows that adjustment will be substantially costlier, and that domestic debt will only start decreasing only in FY2007/08 under this scenario. Furthermore, debt-servicing costs will remain high for an extended period, reducing the room for other fiscal expenditures.

Sensitivity analysis

60. The model can also be used to illustrate the sensitivity of domestic debt sustainability in Malawi to changes in interest rates (Table II.4).15

Table II.4.

Scenario with a five percent increase in the interest rate

article image
Sources: Malawian authorities; and Fund staff estimates and projections.

61. As shown by the table, a five percent increase in the nominal interest rate from FY 2004/05 onwards raises the domestic debt and the threshold for domestic debt sustainability in the medium term.

E. Conclusions

62. Domestic debt dynamics analysis shows that Malawi is at a critical juncture. A rising domestic debt and increasing debt-servicing costs jeopardizes pro-poor spending and macro economic stability. As shown above an early adjustment would lead to a path of lower debt servicing costs. However, if adjustment is delayed, the government will incur significant costs that will extend beyond the period of adjustment.

10

Prepared by Magnus Alvesson (AFR)

11

See Debt Sustainability in Low-Income Countries—Further considerations on an Operational Framework and Policy Implications.

12

Domestic debt consists of all debt denominated in domestic currency.

13

For more information on the HIPC process, see Appendices VII and VIII in the accompanying Article IV staff report.

14

See Selected Issues Paper I. The Malawi Budget and Fiscal Policy (page 4).

15

The sensitivity analysis is carried out relative the baseline scenario.

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Cover IMF Staff Country Reports
Malawi: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Volume/Issue:
Volume 2004: Issue 390
Publisher:
International Monetary Fund
ISBN:
9781451828054
ISSN:
1934-7685
Pages:
82
DOI:
https://doi.org/10.5089/9781451828054.002

Government Debt and Interest Costs.

Nominal and Real Interest Rates

(In percent)