Malawi: Third and Fourth Reviews Under the Extended Credit Facility Arrangement, Request for Waivers for Nonobservance of Performance Criteria, Extension of the Arrangement, Rephasing of Disbursements, and Modification of Performance Criteria
Author:
International Monetary Fund. African Dept.
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Publication Date:
07 Feb 2014
eISBN:
9781475573046
Language:
English
Keywords:
ISCR; CR; authority; development partner; expenditure execution; complying disbursement; ECF arrangement; payment arrears; Budget planning and preparation; Global; Southern Africa; domestic borrowing; government obligation; fiscal dominance; issuance of promissory note; asset forfeiture regime; Monetary base
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1. In early October 2013, the authorities informed staff of misappropriation of significant amounts of public funds through fraudulent transactions carried out in the government’s Integrated Financial Management Information System (IFMIS). The fraud was uncovered during an exercise to reconcile funding levels authorized by the Ministry of Finance (MoF) and payments being made from government accounts in the banking system (MEFP ¶2).1 In view of governance, safeguards, and financing assurances issues raised by the fraud, Executive Board consideration of the third review—scheduled for October 21—was postponed to allow staff to assess the situation and discuss remedial measures with the authorities. The government estimates that about MK9 billion (approximately US$25 million, or 0.7 percent of GDP) was misappropriated through the fraud during the first quarter of FY2013/14 (July-September 2013). Misappropriations may also have occurred in previous years; the government intends to extend investigations back to FY2009/10 to establish orders of magnitude.

Abstract

1. In early October 2013, the authorities informed staff of misappropriation of significant amounts of public funds through fraudulent transactions carried out in the government’s Integrated Financial Management Information System (IFMIS). The fraud was uncovered during an exercise to reconcile funding levels authorized by the Ministry of Finance (MoF) and payments being made from government accounts in the banking system (MEFP ¶2).1 In view of governance, safeguards, and financing assurances issues raised by the fraud, Executive Board consideration of the third review—scheduled for October 21—was postponed to allow staff to assess the situation and discuss remedial measures with the authorities. The government estimates that about MK9 billion (approximately US$25 million, or 0.7 percent of GDP) was misappropriated through the fraud during the first quarter of FY2013/14 (July-September 2013). Misappropriations may also have occurred in previous years; the government intends to extend investigations back to FY2009/10 to establish orders of magnitude.

Context: Fiscal Scandal and Risks to Economic Recovery

1. In early October 2013, the authorities informed staff of misappropriation of significant amounts of public funds through fraudulent transactions carried out in the government’s Integrated Financial Management Information System (IFMIS). The fraud was uncovered during an exercise to reconcile funding levels authorized by the Ministry of Finance (MoF) and payments being made from government accounts in the banking system (MEFP ¶2).1 In view of governance, safeguards, and financing assurances issues raised by the fraud, Executive Board consideration of the third review—scheduled for October 21—was postponed to allow staff to assess the situation and discuss remedial measures with the authorities. The government estimates that about MK9 billion (approximately US$25 million, or 0.7 percent of GDP) was misappropriated through the fraud during the first quarter of FY2013/14 (July-September 2013). Misappropriations may also have occurred in previous years; the government intends to extend investigations back to FY2009/10 to establish orders of magnitude.

2. The scandal has sparked public outrage in Malawi. As part of her response to the public outcry, President Banda reconstituted her cabinet in October, including the appointment of a new Minister of Finance. She has repeated in several public statements that she is determined to fight corruption in Malawi and will not protect anyone involved in the scandal—including those with links to her ruling People’s Party—from the full force of the law. With general elections (presidential, parliamentary and local councils) scheduled for May 2014, the opposition parties may try to use the scandal against the ruling party in their political campaigns. However, commentators have noted that the major opposition parties have also been involved in corruption scandals in the past and so ay not be able to claim the moral high ground.

3. In response to the scandal, donors suspended disbursements of financial assistance to the budget. The immediate impact of the aid freeze was a delay in disbursements of general budget support and dedicated grants (mainly targeted at social sectors) amounting to about US$180 million in the second fiscal quarter (October—December 2013), equivalent to about 55 percent of the total budget support and dedicated grants for the year. The large share of disbursements programmed for the second quarter was designed to provide timely support for the Farm Input Subsidy Program (FISP); the bulk of spending on the main input (fertilizers) is made in that quarter.

4. The government is implementing an Action Plan (AP) to address the weaknesses in public financial management exposed by the fraud (Box 1). In late-September, the authorities suspended the use of IFMIS for processing government financial transactions and invited the vendor of the software to assess the situation, fix identified problems, and recover data that had been erased by the perpetrators of the fraud. The use of IFMIS for government transactions resumed in early November after installation of a stronger firewall and implementation of several measures to improve access control and the overall management of the system (MEFP ¶26). A forensic audit is underway, which will ascertain the magnitude of the fraud, assess the security and control weaknesses of IFMIS (including how it is currently operating), and make recommendations for enhancing the security of the system (MEFP ¶25). Implementation of the AP is being monitored through weekly reporting to a ministerial level committee chaired by the Minister of Finance, with participation of donors.

5. Donors who provide budget support have developed a “Extraordinary Performance Assessment Framework” (EPAF) to monitor progress in implementation of remedial measures. The EPAF draws from and elaborates on items from the AP, with a focus on short term measures (to be implemented by March 2014) designed to restore confidence in government systems and to strengthen ongoing reforms in public financial management (PFM). Specific actions in the EPAF include: independent verification of the security and robustness of transactions being undertaken through IFMIS after its reactivation, institution of daily bank reconciliations by the Treasury, compliance with expenditure ceilings under the ECF-supported program, and disciplinary action against those who approved the fraudulent payments or signed the associated checks.

Malawi: Action Plan to Address Weaknesses in Public Financial Management Exposed by Fiscal Scandal

Process weaknesses were exploited to gain unauthorized access to the government’s Integrated Financial Management Information System (IFMIS) to generate a series of fraudulent payment transactions. Payments were made on behalf of a few government agencies to dozens of companies that had not delivered any goods or services to the government, and the related entries were deleted from the system. Inadequate organizational and management arrangements and weak adherence to established rules led to inappropriate password sharing, failure to delete passwords and access rights of terminated or transferred staff, inappropriate use of system administrator privileges to process transactions, and inadequate maintenance of the audit trail. The absence of effective systems audit arrangements, inadequacies in documentation and incomplete and belated bank reconciliation, and an ineffective sanctions regime also contributed to a weak control environment.

The authorities responded to the crisis by shutting down the compromised IFMIS and initiating a set of remedial measures. Realizing that manual processing of government payments is subject to even higher risks, the government aimed at quick reinstatement of IFMIS after critical system safeguards have been achieved. The authorities developed a comprehensive Action Plan (with input from donors), which they are implementing with the assistance of the international community. It covers five broad areas:

  • Investigation and prosecution. In addition to the prosecution of all individuals involved in the scandal, the authorities have started profiling the properties of public officers connected to suspicious transactions which should help in recovering stolen monies.

  • Audit. A two-pronged forensic audit has been initiated. The first, which will cover a limited period in 2013 (April—September), is due to be completed by end-January 2014. The second, covering a period going back to FY2009/10, is expected to be completed in the second half of 2014. Furthermore, the government will procure an audit management system, introduce a system of ad hoc audits and enhance its audit capacity.

  • Accounting. To prevent similar abuses, the software provider identified potential security gaps and introduced relevant system enhancements to fill them. User rights were recreated based on more regulated and restricted system access ensuring internal checks and segregation of duties. The reinstatement of IFMIS started in early November and will progress until becoming fully operational by end—2013. To facilitate system integrity and the early detection of irregular payments, the government is embarking on clearing a backlog of bank reconciliations after which it will adopt daily reconciliation.

  • Administrative measures. Disciplinary actions will be taken against public officials whose negligence contributed to the fraud.

  • Legal and institutional reforms. The authorities are taking steps to strengthen the legal framework for fighting corruption and to accelerate PFM reforms. Legal reforms include amendments to anti-money laundering legislation (e.g., introduction of a civil asset forfeiture regime) and a new law requiring the declaration of assets by public officials. PFM reforms are being supported by a multi-donor trust fund.

Recent Economic Developments and Performance Under the Program

A. Recent Economic Developments and Near-Term Outlook

6. The pace of economic activity picked up significantly in 2013 (Table 1). Real GDP growth is estimated to have rebound from 1.9 percent in 2012 to about 5 percent in 2013, mainly on account of an improved harvest (due to improved weather) and increased availability of foreign exchange (including through re-established external credit lines facilitated by the clearance of the bulk of accumulated private sector external payments arrears). While agriculture has driven the recovery, growth has also picked up in manufacturing (from a 1 percent contraction in 2012 to over 6 percent growth in 2013), construction (from less than 3 percent in 2012 to over 7 percent in 2013), and wholesale and retail trade (from less than 2 percent in 2012 to over 5 percent in 2013).

7. A buoyant tobacco season helped to strengthen the kwacha temporarily and contributed to a significant build up of international reserves. After nearly a year of persistent depreciation, the kwacha appreciated sharply (by about 20 percent) in May 2013 and remained relatively stable through early September, buoyed by increased proceeds from tobacco sales during the 2013 season ( Text Table 1)). The RBM seized the opportunity to purchase foreign exchange from the market to boost Malawi’s international reserves. Gross official reserves rose from US$185 million (less than one month of import cover) at end-March 2013 to US$447 million (over 2 months of cover) at end-September.

Text Table 1.

Malawi: Tobacco Sales Revenue 2010—13 (All auction floors)

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Source: Malawian authorities.

8. The kwacha has come under pressure since the beginning of September. It depreciated by 21 percent between end-August and mid-December, mainly on account of the onset of the “dry” season for private foreign exchange inflows and relatively little intervention in the market by RBM. Other factors that may have contributed to the downward pressure include the loosening of policies in July and August and a loss of private sector confidence as news of the fiscal scandal started to emerge.

9. Inflation has been on a downward path, albeit at a slower pace than programmed. The year-on-year rate of increase in the overall CPI decreased from a peak of 37.9 percent in February 2013 to 22.2 percent in October, with food and nonfood inflation at 19.4 percent and 23.9 percent, respectively. The pace of disinflation has been slower than projected, reflecting a prolonged and more pronounced depreciation spell after the initial devaluation of the exchange rate (in May 2012) than expected. The evolution of the exchange rate between May and early-September 2013 helped lower nonfood inflation, but the subsequent pick up in the pace of kwacha depreciation has led to a subsequent uptick.

Malawi: Year on Year Inflation

Citation: IMF Staff Country Reports 2014, 037; 10.5089/9781475573046.002.A001

10. There was a marked loosening of fiscal policy in the first quarter of FY2013/14 after broadly satisfactory performance in FY2012/13. For FY2012/13, domestic revenue exceeded the programmed level while total expenditure was in line with the program (Table 2a) and (Table 2b). Notwithstanding continued strong domestic revenue collection, the fiscal situation deteriorated in FY2013/14 Q1 as government incurred substantial domestic debt to meet overruns in primary expenditures as well as a significant increase in interest payments (MEFP ¶13). These overruns reflected an underestimation of interest payments—nominal interest rates and the stock of domestic debt are both higher than programmed—as well as advancement of arrears payments, pre-spending on items programmed to be financed by dedicated grants, unplanned spending on peace keeping operations, and payments related to the fiscal scandal. Net domestic borrowing by the government amounted to MK56 billion (3.5 percent of GDP), instead of a programmed small net repayment.

11. Growth in reserve money and broad money during 2013 mainly reflected developments in the foreign exchange market and government operations. The RBM succeeded in slowing the year-on-year growth in reserve money from 36 percent in December 2012 to 2 percent in March 2013 by using foreign exchange operations to offset liquidity injections from its lending to banks and the government ( Text Table 2)). In the second quarter, RBM foreign exchange purchases injected substantial liquidity into the system to meet increased demand for real money balances associated with increased tobacco earnings. The RBM partially sterilized the impact of its foreign exchange purchases on liquidity through open market operations. Reserve money growth accelerated again in the third quarter, driven mainly by RBM lending to government. After moderate increases in the first half of 2013, broad money grew rapidly in the third quarter. The principal sources of growth in broad money were lending to the private sector in the first quarter and accumulation of net foreign assets in the second quarter. Sharply increased government borrowing during the third quarter crowded out private sector credit, which recorded a small decline in absolute terms.

Text Table 2.

Malawi: Sources of Growth in Reserve Money (%)

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12. Market interest rates fluctuated widely in 2013 (chart). Money market liquidity increased substantially in the middle of the year, mainly as a result of RBM’s foreign exchange purchases. Reflecting this development, the interbank market rate declined from 37.4 percent in March to 16.5 percent in August 2013, and the average Treasury bill yield dropped from a peak of 45.0 percent in March 2013 to 19.37 percent in August 2013. Subsequent tightening by the RBM, mostly through open market operations beginning in September, pushed the interbank rate and treasury bill yields back up. The RBM maintained its bank rate at 25.0 percent throughout 2013.

Malawi: Evolution of Interest Rates

Citation: IMF Staff Country Reports 2014, 037; 10.5089/9781475573046.002.A001

13. The current account deficit narrowed modestly from 4.4 percent of GDP in 2012 to 3.5 percent in 2013 ((Table 4b)). Exports grew faster than GDP in spite of a projected 15 percent decline in tobacco exports.2 This decline is expected to be more than compensated by strong export growth in cotton, sugar, uranium and edible nuts. A scarcity of containers in Malawi was cited as a factor in the decline in tobacco exports in 2013. Imports accelerated across different categories, reflecting underlying economic growth.

B. Performance Under the Program

14. Performance in relation to quantitative targets for the third ECF review (March 2013 test date) was good, but weakened for the fourth review (September test date) (Table 8a).

  • For the third review, the only quantitative performance criterion (PC) that was not met was the continuous PC on contracting new non-concessional external debt maturing in more than one year. The authorities contracted a loan from the Export and Import Bank of China equivalent to US$65 million that had a grant element of 30 percent when it became effective in May 2013. This is below the 35 percent threshold for new concessional external debt under the program.3 The authorities have indicated that this nonconcessional borrowing was inadvertent—it was due to the use of an outdated discount rate in the calculation of the grant element of the loan (MEFP ¶11).

  • For the fourth review, while the PC on net international reserves was observed comfortably, the PCs on government net domestic borrowing and the net domestic assets of RBM were missed by significant margins, reflecting substantial over-borrowing by government, mostly from the RBM. However, about half of the deviation from the target reflected a promissory note issued in June by the government to RBM to cover devaluation losses incurred in 2012.4

  • Indicative targets for reserve money for June and September were missed, reflecting the buildup of international reserves and RBM concerns that a more aggressive effort to sterilize the impact of the central bank’s purchases of foreign exchange from the domestic market would derail a nascent recovery.

  • The authorities met the indicative target for social spending in September after missing the March and June targets. The earlier under-performance reflected savings on fertilizer purchases for the FISP as well as lower-than-expected absorption of the maize seed subsidy component of FISP (MEFP ¶12). Other categories of social spending, including education and health, were in line with the targets.

15. There has been progress in the implementation of structural benchmarks though at a slower pace than programmed (Table 9a). Several measures to strengthen public financial management were implemented, including expansion of the coverage of the purchase order module of IFMIS. With respect to reforms in the financial sector, the terms of reference for the third party diagnostic assessment of vulnerable banks (structural benchmark for end-June 2013) was completed in October. The exercise will now cover all banks and the process of selecting auditors for each bank is underway. An amendment to the RBM Act has been submitted to parliament to lower the limit on RBM advances to government from 25 percent to 10 percent of budget revenue. However, it does not cover other forms of RBM lending to government and so does not plug the loophole in the RBM Act that allows advances to be routinely converted to treasury bills when the limit is reached.

Policy Discussions

16. The policy discussions focused on managing the fall-out from the fiscal scandal, addressing the recent fiscal slippage, and policies to lower inflation. The government has implemented bold economic policy re orms that are beginning to show positive results. However, the success of the reforms in achieving the stated goals of macroeconomic stability, growth and poverty reduction, depend to a large extent on continued external assistance from Malawi’s development partners over the medium-term. Strong implementation of corrective actions to strengthen public financial management is critical to ensure the timely resumption in aid inflows.

17. The mission worked closely with the authorities and development partners to update the external resource envelope, including the likely timing of disbursements. Several bilateral donors indicated that they are unlikely to be able to channel any financial resources through government financial systems for the rest of this fiscal year (ending June 2014). For them, implementation of strong remedial measures is necessary but not sufficient for resuming support through government systems; it will take time for their confidence in these systems to be restored. However, most donors foresaw some resumption of financial assistance to the budget in the second half of the fiscal year (January—June 2014) if the government carries through with strong remedial measures to prevent a recurrence of the fraud, holds senior officials involved accountable, and takes steps toward recovering stolen funds. On that basis, the updated fiscal outlook assumes resumption of budget support from multilateral agencies (World Bank, African Development Bank and the EU) in the second half of the fiscal year. External support to the budget this year is expected to fall significantly short of the levels projected during the June 2013 mission (which held detailed discussions on the FY2013/14 budget), and compared to FY2012/13 (Text Table 3)). The second fiscal quarter takes the biggest hit.

Text Table 3.

Malawi: Central Government External Financing

(In millions of US dollars unless otherwise indicated)

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Sources: Malawian authorities; and IMF staff estimates.

Includes SWAp loans.

A. Macroeconomic Framework

18. The macroeconomic framework has been adjusted to capture the revised profile of external financing.

  • Staff and the authorities agreed to maintain the growth projections from the third review discussions (June mission) which entailed slightly lower growth in 2013 compared to the second review projection (Text Table 4)). Indications from the authorities’ business sentiment survey conducted in September and the latest crop estimates pointed to continuing strong recovery in 2013 and 2014, including another good tobacco season in 2014. In the absence of the fiscal scandal, there would have been a basis for upward revision of growth projections for 2013 and 2014. However, in view of the uncertainty about donor support and some public investments in the near term, projections were kept unchanged.

  • Disinflation will be at a slower pace, but single digit inflation remains the goal by end-2014 (Text Table 4)). Inflation is programmed to fall, but the path for 2013—15 has been raised moderately to reflect the higher-than-projected outturn so far in 2013 and the likely impact of recent depreciation of the kwacha on non-food inflation in the next few months. The revised monetary program is based on RBM tightening monetary policy over the next few months and more aggressively sterilizing foreign exchange inflows when the tobacco season starts in March/April 2014.

Text Table 4.

Malawi: Selected Indicators 2012—2015

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Sources: Malawi Authorities and IMF staff estimates

For example, 2012 refers to FY2011/12, spanning July 1, 2011 to June 30, 2012.

19. Risks to the economic outlook remain substantial ((Table 10), Risk Assessment Matrix). Key risks include:

  • A significantly longer delay in disbursements or reduction in the amount of aid. Protracted delays in the disbursement of aid flows in response to the fiscal scandal could lead to increased resort to domestic borrowing, followed by reserve losses, exchange rate depreciation, and rising inflation. Determined implementation of remedial measures and policy commitments in the framework of an active program engagement with the Fund will help contain this risk. The donors have welcomed the Fund’s active engagement in Malawi. Still, if this risk comes to fruition, the authorities can help to mitigate impacts by making additional cuts in domestically financed development expenditure and goods and services (MEFP ¶19).

  • Policy reversals ahead of the May 2014 general elections. Malawi has a history of loosening macroeconomic policies in election years. Such a scenario would also likely be marked by reserve losses, exchange rate depreciation, and rising inflation, and would jeopardize the prospects for sustained growth (including by leading to cuts in aid flows). The prior actions implemented give some assurance that policy can remain on course.

  • Adverse weather conditions. These will continue to pose a significant risk because of the country’s reliance on rain-fed agriculture. It is estimated that up to 1.9 million people (13 percent of the population) may be at risk of severe food insecurity during the 2013/14 lean season because of dry spells in several parts of the country (MEFP ¶22). A supply shock of this sort would be associated with weak GDP growth, higher inflation, and a weaker currency. Fully implementing the program, and gaining access to larger donor resources would help mitigate such a shock.

20. The DSA update, undertaken jointly by Fund and World Bank Staff, indicates that Malawi remains at moderate risk of debt distress. The present value of public debt is projected to decline steadily from 42.5 percent of GDP in 2013 to 23.6 percent of GDP in 2018. The main risks to debt sustainability are deterioration in the terms of trade and adverse weather conditions. Stress tests indicate vulnerability to export-related shocks. Fiscal consolidation and measures to arrest declines in the quality of institutions (e.g., as reflected in Malawi’s CPIA score) are needed to ensure capacity to manage a growing debt load.

B. Fiscal Policy and Related Structural Reforms

21. The cutback in donor inflows and the net impact of other revisions to the fiscal outlook result in a financing gap of MK32 billion (2 percent of GDP) in the FY2013/14 budget. The shortfall in donor flows is projected at MK27 billion (1.8 percent of GDP). The following are the other main revisions to the fiscal outlook for the rest of FY2013/14 ((Tables 2a) and (2b)):5

  • Higher interest payments, reflecting higher-than-expected nominal interest rates and higher stock of domestic debt.6

  • Higher tax revenues, based on continuing strong collections across tax categories, supported by strong economic activity, higher domestic and import prices, and ongoing revenue administration efforts.

  • Increased nontax revenues, mainly on account of profit transfer from the RBM.7

22. A combination of expenditure cuts and domestic financing is proposed to cover the financing gap while protecting social expenditure (Text Table 5)). Social spending is maintained at roughly the same level programmed during the June 2013 mission. The authorities have announced expenditure control measures that are expected to yield gross savings of about MK31 billion (2 percent of GDP). The measures involve stringent cuts to travel, postponement of domestically financed development projects, and savings from efficiency gains from the operation of FISP (MEFP ¶19).8 With some offsetting increases in other current expenditure (reflecting higher than expected inflation and exchange rate depreciation), the expected net yield from expenditure measures compared to the June mission projections is MK18 billion (1.1 percent of GDP). To cover the remaining financing gap, net domestic borrowing was increased by MK14 billion (0.9 percent of GDP); from the programmed repayment of MK7 billion to borrowing MK7 billion for the year as a whole.

Text Table 5.

Malawi: Malawi: Measures to Cover Financing Gap in FY2013/14 1/

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Sources: Malawian authorities; and IMF staff estimates.

Project grants and loans and the associated foreign-financed development expenditure are not included as they do not affect financing gap calculations.

Budget support grants and loans and dedicated grants.

Difference between financing data and above-the-line fiscal data. Includes fraudrelated payments.

23. Domestic borrowing is projected to increase slightly in Q2 followed by repayments in Q3, Q4 and in the medium term. Excessive borrowing in the first quarter limited the scope for additional domestic borrowing to offset the shortfall in external funding. As the shortfall in donor disbursements is particularly acute in Q2, the authorities will need some additional domestic borrowing to avoid a collapse in government services, including critical social expenditure. However, in Q3 the government will start reducing the outstanding stock of domestic debt as donor inflows are projected to resume and the full effects of the expenditure cuts take effect. The bulk of debt repayment is expected in Q4 when domestic revenues are expected to peak and quarterly expenditure expected to be at its lowest level. The government is programmed to make net repayment of domestic debt of 0.6 percent of GDP on average during FY2014/15-2015/16, which would bring down the net domestic debt to less than 10 percent of GDP at end-FY2015/16. To help the development of the domestic debt market, it is important that most of the decline be in government debt held by RBM.

Gross Domestic debt*

(In Billions of Kwacha)

Citation: IMF Staff Country Reports 2014, 037; 10.5089/9781475573046.002.A001

* From March 2013 includes MK41.4 billion in securitized domestic payment arrears.

24. The government needs to curtail the accumulation of domestic arrears. While the government has been reducing the outstanding stock of verified expenditure arrears (estimated at MK72 billion in 2012), it also needs to avoid accumulating new arrears. MoF is taking steps to institute a mechanism for regular monitoring and reporting on arrears and by strengthening commitment control (MEFP ¶28).

25. Recent events underscore the need to tackle long-standing issues in public financial management. In addition to immediate remedial measures, the broader PFM reform strategy needs to be revitalized including fuller deployment of IFMIS capabilities such as timely generation of comprehensive financial and management reports to monitor fiscal developments and inform policy adjustments. The authorities acknowledge a need for comprehensive and regular analysis of fiscal risks, including contingent liabilities (MEFP ¶29). In particular, risks associated with the recently introduced Farm Input Loan Program (FILP) need to be carefully monitored.9 The authorities are also encouraged to enhance fiscal transparency and accountability by strengthening fiscal reporting through timely and complete capture of data and better commitment management.

26. The authorities are implementing a number of measures to strengthen revenue administration and improve taxpayer compliance. The modernization efforts at the Malawi Revenue Authority (MRA) include installation of cargo scanners and upgrade of IT systems at the customs, a roll-out of electronic fiscal devices and automation of business processes (MEFP ¶30). MRA recently announced a form of tax amnesty—a voluntary compliance window—to encourage noncompliant taxpayers to settle their outstanding tax obligations without incurring penalties (MEFP ¶31). The principal amount of the tax liability remains intact and must be paid. It will be important for the authorities to implement this program in a manner that minimizes risks to tax compliance.

C. Exchange Rate and Monetary Policies

27. The authorities are committed to a flexible exchange rate regime, allowing the kwacha to adjust to domestic and international developments. The RBM indicated that it will intervene in the foreign exchange market mainly to manage liquidity and excessive volatility in the exchange rate arising from the highly seasonal pattern of private foreign exchange inflows (related to the tobacco season) and the lumpy disbursement of official flows. Given the need to maintain an international reserves buffer, the RBM has limited its intervention during the lean season, and is relying more on the maintenance of tight monetary conditions as a bulwark against depreciation pressures. The authorities agreed with staff that maintaining a market based exchange rate regime is critical for boosting Malawi’s exports and international competitiveness. The real depreciation of the kwacha has been sustained.

Nominal and Real Effective Exchange Rates, January 2010—June 2013

Citation: IMF Staff Country Reports 2014, 037; 10.5089/9781475573046.002.A001

28. The RBM’s main monetary policy objective is to achieve low (single-digit) inflation. The RBM indicated that, in light of the still high level of inflation and the recent pressures from the depreciation of the kwacha, in the nearterm it will monitor the evolution of the banks’ excess reserves through its liquidity forecasting framework and maintain a tight monetary stance. To support continued disinflation, revised program targets for money growth were set broadly in line with growth in nominal GDP (i.e., assuming constant velocity). If needed, the RBM will use open market operations to mop up excess liquidity in the system.

29.The authorities have taken steps to address fiscal dominance. An Amendment to the RBM Act was submitted to parliament limiting RBM advances to government, but stopping short of imposing a limit on overall government borrowing from RBM. The authorities indicated that such a further change would need to be coordinated with changes to the Public Finance Act which contains limits on total government borrowing. Staff encouraged the authorities to carry the necessary coordination needed to achieve the objective of limiting RBM lending to government. The government has, however, instructed the RBM to stop the automatic conversion of overdrafts to government securities (MEFP ¶15). This allows for closer monitoring of government borrowing from the RBM and should facilitate more prompt corrective action as needed to stay within program targets.

D. Financial Sector Reforms

30.The overall liquidity situation in the banking system has improved but some banks continue to have weak liquidity positions, posing risks to financial stability. To address liquidity pressures, banks have resorted to high interest rates to attract deposits, and some have obtained emergency liquidity support from RBM or been exempted from compliance with prudential norms. Moreover, for some banks, loan quality continues to deteriorate and they also present solvency concerns. Against this background, the RBM has received Fund and World Bank technical assistance aimed at strengthening legislative and prudential frameworks, banking supervision, crisis management preparedness, and bank restructuring and resolution.

31.The RBM is pursuing an ambitious financial sector reform agenda. The authorities are taking steps to strengthen the legal framework for bank restructuring and resolution (MEFP ¶39). RBM has submitted to government, proposed Amendments to the Banking and Financial Services Acts to align the legal framework for bank resolution more closely to international best practice. The amendments are expected to be considered by parliament at its next sitting (January/February 2014). To determine the true condition of banks, the RBM is requiring banks to undergo comprehensive third party diagnostics (MEFP ¶38). The four weakest banks will be analyzed first. Reports on them were originally expected by end-December 2013, but because of delays in the procurement of the services of the firms that will be conducting the exercise, the reports are now expected by end-February 2014. Reports on the remaining banks are expected by end-June 2014. The outcome of third-party diagnostic assessments and a stronger legal framework for bank restructuring and resolution will form the basis for designing a credible strategy for resolving weak banks.

32. The RBM is taking steps to strengthen its framework for addressing banking problems as well as its bank supervision capacity. It is getting ready to introduce a prompt corrective action (PCA) framework to clarify existing triggers for early remedial action and discontinue routine waiver of prudential norms (MEFP ¶40). Specific measures to strengthen bank supervision include improving prudential norms and bank reporting for loan classification, provisioning and liquidity (MEFP ¶42). The RBM is awaiting the official publication of new directives on the PCA and on Asset Classification in the government gazette for them to take effect,

E. Business Climate and International Competitiveness

33. The authorities are committed to implementing measures to improve the investment climate and enhance Malawi’s international competitiveness (MEFP ¶¶43-47). The government announced a goal of improving the country’s ranking in the annual World Bank Doing Business Survey from 157th (out of 185 countries) in 2013 to at least 100th by 2016.10 To this end, the government has taken actions to remove regulatory obstacles in the areas of starting a business, obtaining permits, registering property, enforcing contracts, and trading across borders. This year, parliament reviewed several economic laws, including the Business Registration Act, the Companies Act, and the Investment and Export Promotion Act. The authorities need to focus on implementing the laws in order to make a difference on the ground.

Program Issues

34. Several prior actions have to be met before the third and fourth reviews will be completed (Table 9a). The following prior actions are designed to gauge progress in implementation of remedial measures to address the governance weaknesses: (i) reactivation of IFMIS in all ministries after strengthening security and access control; (ii) auditing of the manual transactions undertaken when IFMIS was suspended; (iii) submission of a preliminary forensic audit report to Fund staff. Recommendations from the final report of the forensic audit (due by end-January 2014) will inform program conditionality in the next review. The authorities will also take prior actions to implement the revised macro-fiscal program by: (i) seeking cabinet approval for the revised spending plans in line with understandings reached with Fund staff; and (ii) observing three quantitative targets (government net domestic borrowing, NDA and NIR of the RBM) for December 13, 2013. The December 13 targets were set at the same level as the respective targets for end-December 2013, with the expectation that the December 13 outturn would provide a good indication of the prospects for meeting the end-December targets.

35. The authorities are requesting a waiver for the nonobservance of the continuous PC on new nonconcessional external debt with a maturity of more than one year. They have indicated that the contracting of the non-concessional loan from China was inadvertent; the use of an out-of-date discount rate led them to believe the loan was concessional. They have adopted corrective actions—closer consultation with Fund staff before submitting loan proposals to cabinet and parliament, and including information on grant element in the submissions—to prevent a recurrence of non-observance of the PC (MEFP ¶11).

36. The authorities are also requesting waivers for the nonobservance of the performance criteria on government net domestic borrowing and the net domestic assets of the RBM (fourth review). The overrun on domestic borrowing was caused in part by poor spending control and planning. The amounts paid out as part of the IFMIS fraud further contributed to excessive borrowing during that quarter. Exceeding the limits on RBM domestic assets is closely related, as the RBM holds a large share of government debt. The authorities have adopted extensive remedial actions, focusing on the strengthening of PFM. Furthermore, implementation of the revised macrofiscal program signals the authorities’ commitment to achieving the objectives of the program.

37. The authorities are also requesting an extension of the arrangement, a rephasing of disbursements, and modification of performance criteria. They wish to better align the ECF review cycle with the fiscal year in Malawi by shifting test dates from September and March to December (mid-year) and June (year-end) (LOI). They also request an extension of the arrangement by four months (to November 22, 2015) alongside the addition of a further review resulting from the rephasing of disbursements associated with the third, fourth and subsequent reviews ((Tables 6a) and (Table 6b)). They request a halving of the disbursements originally associated with the third and fourth reviews, and applying the balance to the additional review. New PCs are proposed for December 2013 and June 2014. It is proposed that the end-March 2014 PCs become indicative targets. Structural benchmarks have been added for FY2013/14 to address the fiscal scandal (Table 9b).

38. Financing assurances are in place for the review. Donor commitments to Malawi remain significant, and the authorities have compensated for shortfalls by adjusting their spending plans, and by identifying alternative sources of domestic financing. It will be critical for Malawi to stick to its commitments to correct governance problems to fully realize aid commitments from development partners.

Staff Appraisal

39. The authorities are to be commended for sticking with core elements of the policy reforms they initiated in May 2012. Adoption of a market-based exchange rate regime has improved the availability of foreign exchange and is supporting a broad based recovery in economic activity. The automatic adjustment mechanism for fuel prices has ensured a steady supply of fuel to the country. However, inflation remains high and implementation of structural reforms have been slow.

40. The fiscal scandal and a loosening of policies in the first quarter of FY2013/14 require strong and focused remedial actions. The scandal undermined the government’s standing both with the Malawian public and the donor community. Rebuilding trust requires that the fraud be investigated thoroughly and that the relevant procedures be followed in accordance with the law. Furthermore, government has to strengthen PFM procedures and reform fiscal institutions to prevent a recurrence of fraud. Adoption of the action plan, re-activation of a strengthened IFMIS, initiation of the forensic audit, and ongoing criminal investigations are important steps in the right direction. In addition, strict implementation of the publicly announced stringent spending cuts and timely adoption and implementation of the recommendations of the forensic audit would demonstrate the government’s commitment to address the cumulative impact of the fraud and the fiscal slippage.

41. The authorities will need to monitor closely expenditure execution and financing in order to maintain fiscal discipline. The authorities should be mindful of revenue and financing risks and should be ready to act swiftly in case such risks materialize. In the event of shortfalls in projected domestic revenues or external grants and loans, the authorities will need to adopt more stringent expenditure restraint and expenditure reprioritization. The presence of significant fiscal risks warrants contingency planning.

42. Continued external support is critical for mitigating the risk of policy reversal. Because of the heavy reliance of the budget on external assistance, a protracted suspension of aid flows and the pressures of upcoming general elections could combine to trigger policy reversals. Malawi’s development partners are aware of this risk and are supportive of resumption of some aid flows in the second half of the fiscal year provided the authorities implement strong remedial measures and adhere to their Fund-supported program.

43.Staff welcomes the RBM’s commitment to tighten monetary policy to contain inflation pressures. Given the still high level of inflation, it is imperative that the RBM be proactive in tightening monetary policy going forward. In this context the RBM should limit its intervention in the foreign exchange market during the lean season, and rely more on the maintenance of tight monetary conditions as a bulwark against depreciation pressures. It will also be important for the authorities to coordinate amendments to the RBM Act and the Public Finance Act to address the problem of fiscal dominance by setting a legal limit on total RBM lending to government.

Staff welcomes the steps taken by the authorities toward establishing the true financial condition of the banking system (by commissioning third party diagnostic assessments of each bank). It will be important to complete the first stage of the bank diagnostics and to strengthen the legal framework for bank restructuring and resolution early in 2014. Alongside this, the authorities should speed up the gazetting of the RBM directives on the Prompt Corrective Action framework and Asset Classification so that they become effective as soon as possible. Implementation of the PCA is a key instrument to help RBM move away from a culture of forbearance.

44. Staff recommends completion of the third and fourth reviews and release of the fourth and fifth disbursements based on the remedial actions taken to strengthen governance, program performance to date, and policy commitments by the authorities. Staff supports the authorities’ request for waivers for the nonobservance of the PCs on new nonconcessional external debt with a maturity of more than one year, on government net domestic borrowing, and on net domestic assets of the RBM, based on the strong corrective actions being implemented to address the fraud and fiscal slippage, as well as the corrective actions the authorities have adopted to strengthen debt management. Staff further supports the extension of the arrangement, rephasing of disbursements, establishment of performance criteria for end-December 2013 and end-June 2014, and conversion of end-March 2014 PCs into indicative targets.

Table 1.

Malawi: Selected Economic Indicators, 2011—16

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Sources: Malawian authorities and IMF staff estimates.

The fiscal year starts in July and ends in June. The current financial year, 2014, runs from July 1, 2013, to June 30, 2014.

Estimates of external debt as percentage of GDP are higher than previously reported due to a change in methodology. The discrepancy is due to differences in average and end-of-period exchange rates. The new methodology is aligned with the DSA.

Table 2a.

Malawi: Central Government Operations: 2010/11—2015/16

(Billions of kwacha)

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Source: Malawi Ministry of Finance and IMF staff estimates.

Nontax revenues in 2013/14 include the RBM profit transfer to government of MK15 billion.

Part of the discrepancy in FY2012/13 is explained by the government’s issuance of promissory note for RBM recapitalization in the magnitude of MK28.5 billion, which was included in financing but did not have an associated cash expenditure. In FY2013/14 the discrepancy includes payments made in connection to the fraud.

Domestic fiscal balance is calculated by subtracting current and domestically-financed development expenditures from domestic revenues.

Table 2b.

Malawi: Central Government Operations: 2010/11–2015/16

(Percent of GDP)

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Sources: Malawi Ministry of Finance and IMF staff estimates.

Nontax revenues in 2013/14 include the RBM profit transfer to government of 1 percent of GDP.

Part of the discrepancy in FY2012/13 is explained by the government’s issuance of promissory note for RBM recapitalization in the magnitude of 2.3 percent of GDP, which was included in financing but did not have an associated cash expenditure. In FY2013/14 the discrepancy includes payments made in connection to the fraud.

Domestic fiscal balance is calculated by subtracting current and domestically-financed development expenditures from domestic revenues.

Table 2c.

Malawi: Central Government Operations: 2013/14

(Billions of kwacha)

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Sources: Malawi Ministry of Finance and IMF staff estimates.

Nontax revenues include the RBM profit transfer to government of MK15 billion in Q4.

Domestic fiscal balance is calculated by subtracting current and domestically-financed development expenditures from domestic revenues.

Table 3a.

Malawi: Monetary Authorities’ Survey, 2011–16

(Billions of Kwacha, unless otherwise indicated)

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Sources: Reserve Bank of Malawi; and IMF staff estimates and projections.

Including SDR allocation and the entire assets and liabilities of the RBM.

Table 3b.

Malawi: Monetary Survey, 2011–16

(Billions of Kwacha, unless otherwise indicated)

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Sources: Reserve Bank of Malawi; and IMF staff estimates and projections.

Including SDR allocation.

Table 4a.

Malawi: Balance of Payments, 2011–16

(US$ millions, unless otherwise indicated)

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Sources: Malawian authorities; and IMF staff estimates and projections.

Includes estimate for project grants not channeled through the budget.

Excluding SDR allocation.

Months of prospective imports of goods and nonfactor services.

Table 4b.

Malawi: Balance of Payments, 2011–16

(Percent of GDP)

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Sources: Malawian authorities; and IMF staff estimates and projections.

Includes estimate for project grants not channeled through the budget.

Excluding SDR allocation.

Months of prospective imports of goods and nonfactor services.

Table 5.

Malawi: External Financing Requirement and Source, 2009—17

(In millions of US dollars)

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Source: IMF staff estimates.
Table 6a.

Proposed Schedule of Disbursements Under ECF Arrangement, 2012—15

(Millions of SDR)

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Source: IMF staff estimates.
Table 6b.

Malawi: Proposed Schedule of Disbursements Under ECF Arrangement, 2012—15

(Millions of SDR)

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Source: IMF staff estimates.
Table 7.

Malawi: Indicators of Capacity to Repay the Fund, 2013—221

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Sources: Malawian authorities; and IMF staff estimates and projections.

Assumes disbursements as per schedule in Table 6. Payments for 2013 cover only the period of September to December.

Table 8a.

Malawi: Quantitative Targets (2012–13)1

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Sources: Reserve Bank of Malawi; Malawi Ministry of Finance; and IMF staff estimates.

Targets are defined in the technical memorandum of understanding (TMU). Presentation uses stocks for all PCs except for the ceiling on the government’s net domestic borrowing.

“PC” means Performance Criterion, and “IT” means Indicative Target.

Defined as stocks. All stocks of NDA adjusted for consistency with the program definition (specified in the TMU).

Target is subject to an adjuster for liquidity reserve requirement.

Targets are subject to an adjuster for budget support and debt service payments.

Targets are subject to an adjuster for donor-funded social sector expenditures consistent with the TMU.

Defined as a cumulative flow.

Priority social spending as defined in the TMU and quantified in the authorities’ budget. End-September 2013 “Prog.” target was calculated comulatively from July 1, 2012 (second review). The figure under “Adj. Prog.” is calculated from July 1, 2013.

Evaluated on a continuous basis.

Other standard PCs include introducing or modfying MCPs, concluding bilateral payments agreements that are inconsistent with Article VIII, and imposing or intensifying import restrictions for balance of payment reasons.

Table 8b.

Malawi: Quantitative Targets (2013—14)1

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Sources: Reserve Bank of Malawi; Malawi Ministry of Finance; and IMF staff estimates.

Targets are defined in the technical memorandum of understanding (TMU). Presentation uses stocks for all PCs except for the ceiling on the government’s net domestic borrowing.

“PC” means Performance Criterion, and “IT” means Indicative Target.

Defined as stocks. All stocks of NDA adjusted for consistency with the program definition (specified in the TMU).

Target is subject to an adjuster for liquidity reserve requirement.

Targets are subject to an adjuster for budget support and debt service payments.

Targets are subject to an adjuster for donor-funded social sector expenditures consistent with the TMU.

Defined as a cumulative flow.

Priority social spending as defined in the TMU and quantified in the authorities’ budget. End-September 2013 “Prog.” target was calculated comulatively from July 1, 2012 (second review). The figure under “Adj. Prog.” is calculated from July 1, 2013.

Evaluated on a continuous basis.

Other standard PCs include introducing or modfying MCPs, concluding bilateral payments agreements that are inconsistent with Article VIII, and imposing or intensifying import restrictions for balance of payment reasons.

Table 9a.

Malawi: Prior Actions and Structural Benchmarks, July 2012—Nov 2013

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Table 9b.

Malawi: Prior Actions and Structural Benchmarks, Dec 2013—Sept 2014

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Table 10.

Malawi: Risk Assessment Matrix 1/

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The risks cited in this table are those considered most relevant at the time when discussions were held in Lilongwe.

Appendix I. Uganda: Letter of Intent

December 26, 2013

Madam Christine Lagarde

Managing Director

International Monetary Fund

Washington, D.C. 20431

USA

Dear Madam Lagarde:

On April 8, 2013, the Executive Board of the International Monetary Fund (IMF) completed the second review under the three year Extended Credit Facility (ECF) arrangement for Malawi which it approved in July 2012. The arrangement—in the amount of SDR104.1 million (150 percent of quota)—covers Malawi’s fiscal years 2012/13 through 2014/15. This letter and the attached Memorandum of Economic and Financial Policies (MEFP) report on recent economic developments, performance under the ECF program since the second review, and on policies for FY2013/14 and the medium term.

The policy reforms initiated by President Joyce Banda’s administration in May 2012 are showing positive results. Foreign exchange earnings during the 2013 tobacco season were approximatel double the level in 2012, and the increased availability of foreign exchange has facilitated a broadbased recovery in economic activity. Inflation has been falling, though not as quickly as previously programmed. The government remains committed to implementing sound policies aimed at further lowering inflation and interest rates in order to enhance the prospects for sustained growth and poverty reduction.

The economic outlook has been adversely affected by a recent fiscal scandal. In the course of a reconciliation exercise between the Ministry of Finance and the Reserve Bank of Malawi (RBM) in September, officials discovered several fraudulent transactions effected in the government’s Integrated Financial Management Information System (IFMIS), resulting in the payment of large amounts of money to entities that had not provided any goods or services to the government. Based on a preliminary assessment, it is estimated that nearly MK9 billion (equivalent to about US$25 million) was misappropriated in the first quarter of this fiscal year (i.e., between July and September 2013) under this fraud. In response to the fraud, several of Malawi’s development partners suspended disbursement of their financial assistance to the government budget, creating a substantial financing gap in the FY2013/14 budget approved by parliament in June. The use of IFMIS for government transactions was suspended between late-September and early November to allow the vendor of the software to strengthen its security features and the government to strengthen the management of the system (MEFP paragraph 26). Government transactions were processed manually during the period when the use of IFMIS was suspended. The use of the manual system stopped when the use of IFMIS was resumed. All Ministries are now processing their transactions through IFMIS.

The government is implementing an Action Plan (formulated with input from development partners, including the IMF) to address the weaknesses in the public financial management system exposed by the fraud. Areas covered by the Action Plan include: (i) investigations and prosecutions; (ii) auditing (including a forensic audit undertaken by an internationally reputable firm); (iii) accounting; (iv) administrative measures; and (v) legal and institutional reforms.

We adhered to most of the ECF program’s quantitative targets for end-March and end-June 2013. In particular, all the performance criteria (PCs) for the third ECF review were met except the continuous performance criterion on new nonconcessional external debt maturing in more than one year contracted or guaranteed by the central government, the Reserve Bank of Malawi, public enterprises and other official sector entities. The government contracted a loan from the Export and Import Bank of China which, at the time it became effective in May 2013, had a grant element that was less than the 35 percent threshold for concessional loans under the program. As explained in the MEFP, the nonobservance of the performance criterion was inadvertent; it arose from the use of an out-ofdate discount rate. We have taken corrective measures to strengthen the monitoring of the concessionality of new external loans in order to ensure observance of the continuous performance criterion. Specifically, we will seek input from Fund staff on the terms of new loans before recommending approval to cabinet and parliament, and we will henceforth routinely include information on the grant element as part of the submission to cabinet and parliament. On the basis of the corrective actions we have put in place, we request a waiver for the nonobservance of the performance criterion on new nonconcessional external debt.

With respect to the targets for the fourth review (end-September 2013 test date), the PC on net international reserves was exceeded by a wide margin while the PCs for net domestic borrowing by the government and the net domestic assets of the RBM were missed by significant margins (TMU Table 1a). The nonobservance of the latter two PCs reflected over borrowing by the government to finance higher-than-programmed spending in the first quarter of this fiscal year, mainly on interest payments. However, payments associated with the fraud, unplanned spending on peace keeping operations, and spending on social services in advance of receipt of dedicated grants also contributed to the over borrowing (MEFP, paragraph 13). We have reached understandings with IMF staff on remedial fiscal measures and a policy path going forward. In order to enhance the monitoring of the implementation of the revised policy path, we request an additional review under the ECF arrangement, with a test date of end-December 2013. Based on the corrective measures and policy commitments, we request waivers for the nonobservance of the end-September PCs on net domestic borrowing by government and the net domestic assets of the RBM.

We have committed to undertake the following actions before consideration of the third and fourth ECF reviews by the IMF’s Executive Board: (i) reactivation of IFMIS use for all Ministries after strengthening the management and security of the system; (ii) auditing of the manual transactions during the period when IFMIS use was suspended; (iii) cabinet approval of the revised FY2013/14 budget in line with understandings reached with IMF staff; (iv) provision of interim report of the forensic audit to IMF staff; and (v) observance of mid-December 2013 quantitative targets on government net domestic borrowing, net domestic assets of RBM, and net international reserves. We have already implemented items (i), (ii), (iii) and (iv), and will implement the remaining action before end-December.

On the basis of our overall performance, the corrective actions taken, as well as the strength of policies set forth in the attached MEFP, we request that the Executive Board of the IMF complete the third and fourth reviews under the ECF arrangement and release the fourth and fifth tranches totaling SDR 13.01 million. We also request a rephasing of test dates and associated disbursements to better align the ECF review cycle with Malawi’s budget calendar. Specifically, we request that the test dates be shifted from March and September to June (year-end) and December (mid-year). To accommodate this change, we request an extension of the arrangement by four months to November 22, 2015. Thus, the test dates for the fifth, sixth, seventh and eighth reviews will be end-December 2013, end-June 2014, end-December 2014, and end-June 2015, respectively. We request that the end-March 2014 PCs be converted to indicative targets.

We believe that the policies set forth in the MEFP are adequate to achieve the objectives of the program, but we will take any further measures that may become appropriate for this purpose. We will consult with IMF staff on the adoption of these measures, and in advance of revisions to the policies contained in the MEFP, in accordance with the IMF policies on such consultation. Moreover, we will provide the IMF with such information as the IMF requests in connection with the progress in implementing the policies and reaching the objectives of the program.

The Government of Malawi authorizes the IMF to make this letter and the attached MEFP and TMU available to the public, including through the IMF internet website.

Yours sincerely

/s/

Dr. Maxwell Mkwezalamba

Minister of Finance

/s/

Mr. Charles Chuka

Governor of the Reserve Bank of Malawi

Attachments

Memorandum on Economic and Financial Policies;

Technical Memorandum of Understanding.

Attachment I. Memorandum of Economic and Financial Policies

Background

1. This memorandum supplements the Memorandum of Economic and Financial Policies attached to the Letter of Intent dated March 28, 2013. It describes recent developments and performance since the second review under Malawi’s Extended Credit Facility (ECF) arrangement, and elaborates on policies and structural reforms for fiscal year 2013/14 (FY2013/14) and the medium term. In particular, it includes measures being taken to address weaknesses in the management of the government’s Integrated Financial Management Information System (IFMIS) which enabled fraudulent transactions to be undertaken in the system, resulting in the theft of substantial amounts of public funds.

2. In early September 2013, in the course of a reconciliation exercise between the Ministry of Finance and the Reserve Bank of Malawi (RBM), officials noted movements of cash that exceeded the authorized level of funding. Investigations revealed that several fraudulent transactions had been effected using IFMIS, resulting in the payment of large amounts of money to entities that had not provided any goods or services to the government. The use of IFMIS for processing government financial transactions was suspended with effect from September 25, 2013 to allow the vendor of the software to strengthen its security features and for the government to address weaknesses in the management of the system that were exposed by the fraud (see paragraph 26 below). With the help of the software vendor, critical information has been recovered which is helping investigations into the fraud. Based on the recovered data, it is estimated that nearly MK9 billion was misappropriated through these fraudulent transactions between July and September 2013.

3. In response to the recent incidents of fraud, several of Malawi’s development partners have suspended disbursement of their financial assistance to the government budget. Given the heavy reliance of the budget on aid flows, a delay in disbursement of significant amounts beyond a few months would severely curtail the ability of the government to deliver the level of services assumed in the budget approved by parliament in June 2013. The government is determined to tighten the control environment around IFMIS, hold accountable the perpetrators of the fraud and recover the stolen money. We are also working closely with our development partners to address these concerns.

4. The objectives of the program remain macroeconomic stability, sustained high and inclusive growth, and delivery of social-protection programs to mitigate the adverse impact of adjustment measures on the poor. Structural reforms under the program emphasize enhancing domestic revenue mobilization, strengthening public financial management, ensuring the operational independence of the RBM, safeguarding the stability of the banking system, and improving the investment climate. We are adding new structural measures to strengthen governance in light of the recent fraud.

Recent Economic Developments

5. The policy reforms initiated in May 2012 are showing positive results. The introduction of a flexible exchange rate regime has improved the availability of foreign currency and facilitated the clearing of private sector external arrears and the re-establishment of external credit lines. In parallel, adoption of an automatic adjustment mechanism for the retail prices of petroleum products eliminated costly subsidies and greatly improved the fuel supply situation in the country. With needed production inputs now available, capacity utilization rose sharply, contributing to a broadbased expansion in economic activity. Real GDP growth is estimated to have increased from less than 2 percent in 2012 to about 5 percent in 2013, with agriculture, manufacturing, construction, and wholesale and retail trade registering the most pronounced improvement compared to performance in 2012.

6. Inflation has been on a downward trend but has not fallen as quickly as previously programmed. On a year-on-year basis, headline consumer inflation has fallen from a peak of 37.9 percent in February 2013 to 22.2 percent in October. Over the same period, food inflation has fallen from 38.2 percent to 19.4 percent while non-food inflation has gone from 42.5 percent to 23.9 percent.

7. Monetary conditions were tightened following the freeing of the exchange rate. Nonetheless, trust in the new exchange rate regime was not immediate, and the exchange rate depreciated persistently until the onset of foreign exchange inflows at the beginning of the tobacco season. The kwacha appreciated sharply during May 2013 and the RBM increased its holdings of international reserves significantly. The reserves reached USD472.9 million equivalent to 2.5 months of import cover in July 2013, the highest level recorded since December 2007.

8. In the first quarter of FY 2013/14, higher than anticipated government expenditures were financed largely by domestic borrowing, and the accompanying liquidity effects weakened the monetary policy stance. While we have since succeeded in re-establishing control over both liquidity and government borrowing, developments in the first quarter weakened our position in responding to the repercussions of the fiscal scandal. The suspension of budget support by donors opened a large financing gap at a time when our policy credibility was under great strain. Market perception of risk has therefore increased, with this most evident in the foreign exchange market where the kwacha has weakened. In order to maintain reserves in the face of uncertainty, we have not intervened to support the currency, but have instead accepted a slower pace of disinflation.

Performance Under the Program

9. Fiscal performance in FY2012/13 was broadly in line with the program. Domestic revenue (tax and nontax revenue) exceeded the programmed level by MK15 billion while grants fell slightly short of program by about MK3 billion. Total expenditures and net lending exceeded the programmed level by about MK13 billion, reflecting higher-than-programmed foreign-financed development expenditure. Actual net domestic repayment of MK2 billion fell short of the programmed level of MK19 billion due entirely to the issuance of a promissory note in the amount of MK28.5 billion by the government to the RBM in June to cover losses arising from the 2012 devaluation of the exchange rate (as provided for in the RBM Act).

10. Nearly all the quantitative targets for the third review (end-March 2013 test date) were met (TMU (Table 1a)). In particular, after adjusting for shortfalls in the disbursement of aid flows, the performance criteria on net international reserves, government net domestic borrowing, and net domestic assets of the RBM were met. However, the continuous performance criterion on new nonconcessional external debt was not met. The indicative target on reserve money was met, while the indicative target on social spending was missed due to savings made on fertilizer payments under the Farm Input Subsidy Program (FISP).

11. The nonobservance of the performance criterion on external debt was on account of a loan contracted by the government, which at the time it became effective, had a grant element that was below the 35 percent threshold for concessional loans under the program. The loan was from the Export and Import Bank of China for the construction of a national stadium. Parliament approved the contracting of this loan in 2010, but problems in identifying the site of the project delayed its commencement. In the course of the delay in finalizing the loan agreement, the discount rate fell, thus reducing the grant element of the loan. The use of an outdated discount rate was the principal reason for the nonobservance of the performance criterion. Going forward, the government has taken steps to ensure compliance with the performance criterion on new nonconcessional external debt. Specifically, we will consult IMF staff on the terms of every external loan before it is presented to cabinet and parliament. As a standard practice, the Ministry of Finance will include information on the grant element of any loan proposal submitted to cabinet and parliament. On the basis of these corrective measures we request a waiver of the nonobservance of the performance criterion.

12. With respect to the quantitative indicative targets for end-June 2013 (TMU (Table 1a)), net international reserves exceeded the target by more than US$200 million, reflecting RBM purchases of foreign exchange in the second quarter to build up international reserves. This rapid buildup in international reserves was the main reason the target on reserve money was missed. Social spending fell short of target on account of savings on fertilizer purchases as well as low absorption on the maize seed subsidy component of the FISP. The net domestic financing target was also missed, not because of borrowing to finance government spending, but rather because of the promissory note the government issued to the RBM to cover devaluation losses in 2012.

13. With respect to the performance criteria for the fourth review (end-September 2013 test date), net international reserves exceeded the target by US$136 million while the ceilings on the net domestic assets of the RBM and net domestic borrowing by the government were exceeded by large amounts. In particular, net domestic borrowing by the government amounted to MK56 billion compared to an adjusted program target of a net repayment of MK2 billion. The main factors that accounted for government’s over borrowing in the first quarter included: (i) a significantly larger interest bill; (ii) unplanned spending on peace keeping operations; (iii) spending on social services in advance of the receipt of dedicated grants; (iv) bringing forward payment of arrears to the private sector; and (v) payments associated with the fraudulent transactions undertaken through IFMIS.

14. There has been progress in the implementation of structural benchmarks (TMU (Table 2a)). Three benchmarks that had been delayed or were only partially met a the time of the second review have now been met: (i) verification of existing stock of government arrears and conversion into promissory notes; (ii) configuration of the IFMIS purchase order module to support commitment control; and (iii) approval of the Financial Sector Development Strategy. Furthermore, the IFMIS purchase order module has now been extended to cover all types of procurements (i.e., goods and services under the recurrent budget as well as capital expenditures under the development budget). With respect to reforms in the financial sector, the third party diagnostic assessments will now cover all banks, not just those that are vulnerable (structural benchmark for end-June 2013). We have secured funding from the World Bank for the exercise. The RBM finalized the terms of reference in October 2013, in close cooperation with staffs of the IMF and the World Bank.

15. An amendment to the RBM Act was submitted to parliament in June 2013 but has not yet been considered. The amendment lowers the limit on RBM advances to government from 25 percent to 10 percent of estimated government revenue for the year. The benchmark foresaw the placing of a limit on all forms of RBM lending to government, in order to contain the practice of automatic conversion of advances to other forms of lending (e.g., treasury bill) when the limit on advances is reached. However, we received legal advice that indicated a potential tension between the provisions of the RBM Act and the Public Finance Management Act (which sets limits on the issuance of treasury bills). While we consider how to proceed, the government has instructed the RBM to stop the automatic conversion of advances to government securities when the limit on advances is reached. This will allow for closer monitoring of government borrowing from the RBM and facilitate more timely action to meet program targets.

Policies

A. Fiscal Policy, Governance and Related Structural Reforms
Fiscal Policy

16. Parliament approved the FY2013/14 budget on June 21, 2013. In line with the ECF program, the approved budget provided for net domestic repayment amounting to MK7 billion, equivalent to 0.5 percent of GDP. The approved budget reflected several government commitments from FY2012/13, including those related to the clearance of domestic arrears and the new wage settlement and deferred wage payments for civil servants agreed in February 2013. It also included provisions for funding the tripartite (i.e., presidential, parliamentary and local council) elections scheduled for May 2014. Aid inflows—grants and concessional external loans—were programmed to cover about 44 percent of total government expenditure in FY2013/14.

17. The suspension of aid disbursements created a significant financing gap in the budget, especially in the second fiscal quarter when a large share of the aid was programmed to be released to help provide timely support to FISP. Apart from the shortfall in donor assistance, there have been two other significant developments with broadly offsetting impacts on the budget. First, there has been a large upward revision in the government’s projected interest bill, reflecting high interest rates and an updated (higher) estimate of the stock of interest-bearing domestic debt, including the large borrowing by the government in the first fiscal quarter as well as the promissory note issued by the government to the RBM to make up for devaluation losses from 2012. The other development has been the very strong performance of domestic revenues. In the first five months of the current fiscal year, total tax revenue exceeded the projected level for the first half of the year by about 5 percent. We expect this level of performance to continue. Buoyant economic activity and ongoing revenue administration efforts have been the main drivers of strong tax collection this calendar year (2013).

18. Based on discussions between the government, our development partners, and the IMF mission, we have reached understandings on a revised budget framework for the rest of the fiscal year. It is premised on the government a gressively implementing the Action Plan formulated in response to the fiscal scandal (see section on “Governance and Public Financial Management Reforms” below), and implementing policy adjustments to close the updated financing gap. The framework allows a moderate amount of domestic borrowing in the second quarter, followed by net repayments in the third and fourth quarters when some donor disbursements resume.

19. The cabinet has endorsed expenditure measures that are estimated to save about MK31 billion, coming mainly from: (i) the postponement of domestically-financed development projects that have not yet started (MK16 billion); (ii) cuts in the travel budget across the whole government (MK11 billion); and (iii) savings from efficiency gains in the operation of FISP (MK4 billion). Notwithstanding the significant expenditure cuts, we will ensure that social spending—a top priority for the government—is shielded as much as possible. In the event of a shortfall in domestic revenue or further delays in donor disbursements, we will make further cuts to ensure that aggregate spending stays within available resources. We expect to be able to make additional marginal cuts in domestically financed development expenditure and in goods and services if needed.

20. In November 2013, the government announced the following stringent expenditure control measures to help achieve the savings needed to close the financing gap: (i) Limit domestic travel to only essential travel, and drastically reduce allocations for travel-related activities; (ii) suspend external travel, with the exception of critical and/or fully-funded (sponsored) travel; (iii) freeze the procurement of capital goods, including motor vehicles, office furniture and equipment; (iv) suspend hiring and creation of non-established positions; and (v) improve fleet management and limit pool vehicles of Ministries and Departments.

21. The government is determined to restore fiscal discipline and reduce the accumulation of domestic debt. We will monitor closely information on government borrowing, including overdrafts at RBM. Through a strengthened commitment control system, we will ensure that the expenditure ceilings set by MoF are complied with. We will refrain from contracting new liabilities outside the government securities market and the RBM. In this context, we stress that the issuance of promissory notes in October 2013 by the Ministry of Finance for the procurement of maize was a one-off operation necessitated by an urgent need to replenish the government’s strategic grain reserves.

22. As was the case last year, the government is seeking the support of its development partners to respond to emergency food needs of segments of the population during the lean season. It is estimated that about 1.9 million people (13 percent of the population) will face food shortages this year. Although the number of people at risk is similar to the level last year, more districts have been affected due to unusual dry spells in the northern and central regions. With the support of donors the government is in the process of replenishing the strategic grain reserve in order to be able to provide humanitarian assistance to the affected households during the lean season.

Governance and Public Financial Management Reforms

23. The government’s Action Plan formulated in response to the recent fraud includes measures to address weaknesses in public financial management and governance. The Action Plan, which was developed with input from development partners, covers five broad areas: (i) investigations and prosecutions; (ii) auditing; (iii) accounting; (iv) administration measures; and (v) legal and institutional reform.

24. The government is determined to ensure that all those who embezzle public funds are prosecuted to the fullest extent of the law and that misappropriated amounts are duly recovered. A multi-agency investigation team has been set up and has already made dozens of arrests of individuals linked to the fraud. The government has also started profiling assets of public officers connected with suspicious transactions. The government will make full use of existing disciplinary and legal measures against officials who approved or facilitated fraudulent payments as well as those who neglected their duties.

25. With the support of the UK government we have initiated a two-stage forensic audit; the first phase covers April-September 2013 (i.e., the last quarter of FY2012/13 and the first quarter of FY2013/14), while the second phase will cover the period from July 1, 2009 to March 31, 2013. The audit will ascertain the facts about the misappropriations (including an estimate of the total amount), thoroughly assess the control and security weaknesses of IFMIS (including since its reactivation in November), and make recommendations to strengthen its security. It is also expected to provide important information for the ongoing criminal investigations. A preliminary report of the audit will be prepared in December and a final report on the first phase is expected by end-January 2014. Circulation of the preliminary report will be restricted in order not to jeorpadize the work of the auditors. However, the government intends to publish the final report. Work on the second phase will commence in January and is expected to be completed in the second half of 2014.

26. After closing identified security gaps and instituting measures to strengthen access control and overall management of the system, the government reactivated the use of IFMIS in early November 2013. Remedial measures implemented before IFMIS was reactivated included: (i) improving the security of the system through the installation of a stronger firewall; (ii) revocation of all old user rights; (iii) more limited assignment of new user rights to staffs of Ministries and Departments; (iv) enhanced access control by limiting access to each user’s area of responsibility only (a change from the practice of giving access at group level to numerous users); and (v) disabling of capacity of remote access users to delete transactions from the database. The government has entered into a short-term service-level agreement with the software provider for functional and technical support including overseeing all IT functions. At the same time the government has initiated the process of recruiting an ICT security officer and IFMIS manager.

27. The transactions that were conducted manually during the period when the use of IFMIS was suspended are being audited (to be completed by end-December 2013), and will be uploaded to IFMIS by end-January 2014. The government has issued notices to RBM and commercial banks to clear government checks only after verification against IFMIS generated check lists issued daily. The Ministry of Finance (Accountant General’s Department), will institute daily bank reconciliation. In view of the current heavy work load of staff in the Accountant General’s Department, we expect the backlog of reconciliations to be cleared by end-February 2014 so that daily reconciliations can start from March 1, 2014.

28. Additional actions to supplement the above measures include: (i) use of electronic funds transfer through IFMIS; (ii) registration of commitments in IFMIS, or where necessary, in an equivalent commitment register; (iii) controlling officers to check commitments against limits at the item level to reduce the risk of excessive virements; and (iv) sensitization of IFMIS users to refrain from sharing passwords. MoF will continue to notify Ministries, Departments and Agencies of their monthly commitment and cash funding limits, and all purchases must be accompanied by a commitment reference number and an IFMIS generated Local Purchase Order to ensure that all proposed expenditures are committed in the system.

29. Recent events highlight the need for a comprehensive and regular analysis of fiscal risks. Such risks may emanate from macroeconomic and governance-related shocks, realization of guarantees or contingent liabilities (e.g., from state-owned enterprises and local governments), and build-up of arrears. While the Public Finance Management Act requires fiscal risk reporting, capacity constraints and limited information have prevented the government from doing this exercise on a regular basis. The government intends to develop a fiscal risks statement, in line with IMF technical assistance advice. This will become an integral part of the main budget documents.

Domestic Revenue Mobilization

30. Sustained strong revenue performance is a key element in the government’s strategy for reducing Malawi’s fiscal imbalance. Modernization efforts at the Malawi Revenue Authority (MRA) are continuing through automation of business processes and upgrading IT infrastructure. MRA has started a nationwide pilot project to roll out electronic fiscal devices (EDs) to strengthen VAT enforcement. The project involves the installation of machines that will electronically record sales transactions to permanent memory where they cannot be erased or manipulated by retailers. In the customs area, MRA has installed cargo scanners and introduced joint border patrols and information sharing with neighboring countries on goods under shipment.

31. MRA is implementing a new initiative to help improve taxpayer compliance. Under the Voluntary Compliance Window (VCW), it has offered a unique opportunity to taxpayers to disclose and pay down outstanding tax liabilities without the associated payment of penalties and interests for late payment. This initiative does not exempt the taxpayer from the principal amount of its tax liability. The VCW was opened on November 1, 2013 and will close on January 31, 2014. We expect the VCW to have a permanent effect by increasing the number of registered taxpayers and also generate one-off revenues in the second and third quarters of the current fiscal year.

B. Exchange Rate and Monetary Policies

32. We remain committed to a flexible exchange rate regime to allow the kwacha to adjust to domestic and international developments. The value of the kwacha will continue to be market determined, with RBM intervention limited to managing liquidity and excessive volatility arising from the highly seasonal pattern of private inflows (mainly related to tobacco sales) and lumpy disbursements of aid flows. During the last 12-15 months, the nominal exchange rate has been volatile. From October 2012 to March 2013, the kwacha depreciated by approximately 25 percent against the US dollar and then appreciated by about the same amounts over s period of about three months. Since September 2013, we have seen another sharp and unexpected depreciation which may have been caused, in part, by the fiscal overruns in the quarter up to end-September and market concerns about the emerging news on fiscal fraud.

33. The principal objective of the RBM’s monetary policy is to achieve low (single-digit) inflation. Inflation remains high at around 20 percent year-on-year. Around mid-2013, money market liquidity increased substantially as a result of RBM intervention in the foreign exchange market to build up reserves and increased government borrowing. Reflecting this development, the interbank market rate declined sharply from 37 percent in March 2013 to about 16.5 percent in August 2013. To contain the inflationary impact of this liquidity, the Monetary Policy Committee resolved to maintain the Bank rate at 25.0 percent throughout 2013 to sustain the tight monetary policy stance. This was against the backdrop of continued inflationary pressures, including the recent exchange rate depreciation and high levels of domestic borrowing by government. In Malawi, the evolution of the exchange rate is an important driver of non-food inflation. With a more adequate level of foreign exchange reserves and stronger confidence in the kwacha, lower volatility in the exchange rate may translate into more stable prices in future.

34. The RBM will continue to monitor the evolution of the monetary aggregates using its liquidity forecasting framework, and stands ready to deploy all the instruments in its tool kit—including open market operations and changes in the bank rate—to tighten monetary policy should inflation pressures persist.

35. The RBM will continue to build and maintain an adequate level of reserves to provide the economy with a buffer against exogenous shocks. Official foreign exchange reserves nearly doubled in the year to end July 2013. Due to the seasonality in foreign exchange inflows, a modest decline in reserves is expected during the lean season that ends around April 2014. As a result of the suspension of some aid flows to Malawi, foreign exchange receipts will be particularly tight until the onset of the tobacco season. Fiscal measures adopted in response to the emerging fiscal gap will moderate foreign exchange demand. Nonetheless, the RBM will limit interventions and maintain an adequate level of reserves. The RBM aims to accumulate reserves equivalent to at least three months of imports over the medium term.

C. Financial Stability Issues

36. Prior to the devaluation and adoption of a floating exchange rate regime in May 2012, banks were highly liquid in domestic currency due to high government spending and failure to meet foreign obligations because of scarcity of foreign exchange. Banks used this liquidity to extend long term loans to various sectors of the economy and/or to undertake expansion drives in terms of points of representation. Thus, a considerable amount of capital was locked up in illiquid assets. Following the exchange rate adjustment, foreign exchange became available and as clients sought to clear their external payment obligations by withdrawing deposits, banks had difficulty unwinding the long positions and so faced a liquidity crunch.

37. Although the overall liquidity situation has improved, some banks continue to be weighed down by weak liquidity positions, posing risks to financial stability. Moreover, there are indications of deteriorating loan quality and fragile capital positions in a number of banks. Against this background, the RBM is taking steps to address vulnerabilities in the financial sector by: (i) determining the true conditions of the banking system and individual banks through third-party diagnostic assessments; (ii) strengthening the legal framework for early intervention and bank resolution; and (iii) enhancing its supervisory and regulatory framework. These steps will enable the RBM to develop an appropriate strategy for resolving weak banks.

38. The RBM is in the process of commissioning third-party diagnostic assessments of all banks, commencing with the weakest banks. At the invitation of the RBM, audit firms submitted their expressions of interest in early November and were given until November 19, 2013 to submit technical and financial proposals. Contracts were awarded in December 2013 for the diagnostic assessments of four banks. The assessments for these banks are expected to be completed by end-February 2014. The contracts for the assessment of the remaining eight banks will be awarded by end-February 2014 with the expectation that the assessments will be completed for all banks by end-June 2014. We will share the results of the diagnostics with IMF staff and in consultation with them, design appropriate interventions within the legal framework to address issues raised by the reports in order to safeguard the stability of the financial system.

39. The RBM consulted key stakeholders (financial sector, Ministry of Finance, Attorney General) as part of the process of formulating proposed amendments to the Banking Act of 2010 and Financial Services Act of 2010. The legislative reforms, which were informed by IMF technical assistance recommendations, will align the legal framework for bank resolution more closely with good practices and provide more options for dealing with problem banks, including two-tiered depositor preference that favors smaller depositors. RBM submitted the proposed amendments to the government in August 2013. The government will formally submit the proposed amendments to parliament by end-December 2013 for consideration at the next sitting of parliament scheduled for January/February 2014.

40. The RBM is preparing to adopt a prompt corrective action (PCA) framework to strengthen and clarify existing triggers for early remedial action. The Directive has already been formulated and is awaiting publication in the Government Gazette to become effective. It establishes a hierarchy of corrective actions the Registrar should take or impose on banks (while the bank is still under the control of its owners) and the circumstances under which such actions may be taken. It also describes circumstances under which the Registrar and/or his agent may exercise powers under the existing legal framework to resolve banks (while suspending the rights of the owners and management) before a bank reaches actual insolvency. The PCA will introduce a sliding scale intervention framework where the form of intervention is proportionate to the severity of the problems encountered by a bank, leaving little supervisory flexibility or discretional judgment. Adoption of this framework will discourage the use of regulatory forbearance such as waiver of prudential norms. Waivers will be used rarely; for example, for the sake of protecting depositors’ interests or the overall stability of the banking/financial system. The decision-making and approval processes for issuing waivers will be well documented and approved at the highest appropriate RBM executive management level.

41. Through the Public-Private Partnership Commission, and with support from the World Bank, the government has engaged a Transaction Specialist to advise it on options for restructuring the state-owned Malawi Savings Bank (MSB). Concurrently, the Registrar has contracted Ernst & Young to do a valuation of MSB as part of advance planning in case the Registrar decides to sell the bank himself. The valuation report will provide a starting point for evaluating potential bids for MSB.

42. The RBM is committed to strengthening the supervisory and regulatory framework of the banking system. In addition to introducing Basel II and raising capital requirements (to become effective January 1, 2014), the central bank will improve prudential norms in the areas of asset classification, provisioning and liquidity. In this regard, RBM will ensure prudent loan quality assessments, including for restructured, refinanced and renegotiated loans and implement prudentially sound loan provisioning standards. A revised directive on Asset Classification containing all these norms was finalized and submitted to Government in September, 2013. The Directive will become effective once gazetted by Government. Its provisions were informed by IMF Technical Assistance recommendations. The revised directive will: (a) improve the quantitative and qualitative criteria for loan classification; (b) incorporate clear requirements for re-classification of assets; (c) incorporate clear requirements for the classification of restructured, refinanced and renegotiated loans; and (d) extend the coverage of prudential reporting for bank provisioning.

D. Business Climate and International Competitiveness

43. The government is committed to creating a conducive environment to do business in Malawi. To this end, government has embarked on a number of regulatory reforms aimed at moving Malawi into the top 100 countries in the World Bank’s annual “Doing Business Survey” by 2016. This goal has been rendered more challenging by Malawi’s fall by 10 places in the recently released 2014 survey.

44. Government pushed for the review of 9 economic laws by parliament in 2013, including: Business Registration Act; Companies (Amendment) Act; Business Licensing Act; Investment and Export Promotion Act; and Malawi Bureau of Standards Act, Companies Bill, Personal Property Security Bill, Insolvency Bill and Export Processing Zones (Amendment) Bill. The Personal Property Security Bill is particularly useful in enhancing SMEs access to finance because it will introduce a secured transactions framework so that moveable property such as machines, and vehicles, can be used as collateral in securing credit.

45. Additionally, high-level Doing Business fora have been held to enhance national dialogue on issues of reforms and a Doing Business Tracker has been employed in the Ministry of Industry and Trade to assist in fast-track progress on the outstanding issues that require administrative and regulatory reforms by key institutions in the country. Institutionally, government has designated the Malawi Investment and Trade Centre as a one stop shop for investor facilitation services while a number of parastatals in the SMEs sector have been merged to create the Small and Medium Enterprise Development Institute (SMEDI). Government has also digitized the records and processing systems at the Registrar General which is expected to reduce the processing time to no more than 48 hours once applications have been lodged with the Registrar General. The creation of an enabling environment for the private sector is supported by various development partners such as the World Bank, the European Union and DFID.

46. The strategic objective of the National Export Strategy (NES) is for the long-term export trend to match the long-term import trend. This will enable the country to reduce its trade deficit, strengthen its foreign exchange reserves, reduce its dependence on imports and aid, and ultimately, contribute to the achievement of goals as outlined in the ERP and the MGDS II. To this end, the strategy aims at developing a productive base of sufficient magnitude so that exports as a share of imports can be increased from about half in 2010 to three-quarters by 2018 and to about 90 percent by 2023. In order to achieve this, government has embarked on a number of initiatives including: export diversification, specifically non-traditional products; implementation of reforms to make it easier, cheaper and faster for businesses/investors to do business in Malawi; and improvement in the quality of infrastructure. Additionally, Government is working towards implementing the National Single Window and the One Stop Border posts as part of its efforts to improve trade facilitation. If successful, these initiatives are expected to unlock the potential of farmers, women’s groups, youths, micro businesses and the larger private sector. Currently, these initiatives are being implemented through the Trade, Industry and Private Sector SWAp framework.

47. Beyond improvement in the macroeconomic environment, the government is committed to addressing infrastructure challenges that are negatively affecting the country’s international competitiveness. In particular, efforts are underway to develop a long-term energy plan that will enable access to reliable and affordable power.

Information Sharing and Program Monitoring

48. In order to enhance economic management, we will strengthen processes and practices to achieve timely information-sharing in the following areas: (i) reconciliation of fiscal and monetary accounts involving the Malawi Revenue Authority, MOF and RBM, to reduce statistical discrepancies between above-the-line fiscal data and below-the-line financing data from the RBM; (ii) provision of information on government operations by MOF to feed into the RBM’s liquidity forecasting framework that guides monetary operations; (iii) provision of data on projected aid inflows by MOF to inform the RBM’s foreign exchange cash flow projections; and (iv) provision of a complete information on the outstanding stock of domestic debt which would include promissory notes issued for arrears’ clearance and all other newly issued promissory notes.

49. Program implementation will continue to be monitored with quantitative financial targets and structural benchmarks (TMU Tables 1a, 1b, 2a and 2b). PCs have been established for December 2013 and June 2014 (TMU Table 1b), in line with our request for a rephasing of test dates and associated disbursement in order to align the review cycle more closely with Malawi’s budget cycle. The fifth review is expected to be completed by mid-March 2014 based on the end-December 2013 test date and the sixth review is expected to be completed by mid-September 2014 based on the end-June 2014 test date.

Table 1a.

Malawi: Quantitative Targets (2012–13)1

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Targets are defined in the technical memorandum of understanding (TMU). Presentation uses stocks for all PCs except for the ceiling on the government’s net domestic borrowing.

“PC” means Performance Criterion, and “IT” means Indicative Target.

Defined as stocks. All stocks of NDA adjusted for consistency with the program definition (specified in the TMU).

Target is subject to an adjuster for liquidity reserve requirement.

Targets are subject to an adjuster for budget support and debt service payments.

Targets are subject to an adjuster for donor-funded social sector expenditures consistent with the TMU.

Defined as a cumulative flow.

Priority social spending as defined in the TMU and quantified in the authorities’ budget. End-September 2013 “Prog.” target was calculated comulatively from July 1, 2012 (second review). The figure under “Adj. Prog.” is calculated from July 1, 2013.

Evaluated on a continuous basis.

Other standard PCs include introducing or modfying MCPs, concluding bilateral payments agreements that are inconsistent with Article VIII, and imposing or intensifying import restrictions for balance of payment reasons.

Table 1b.

Malawi: Quantitative Targets (2013–14)1

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Targets are defined in the technical memorandum of understanding (TMU). Presentation uses stocks for all PCs except for the ceiling on the government’s net domestic borrowing.

“PC” means Performance Criterion, and “IT” means Indicative Target.

Defined as stocks. All stocks of NDA adjusted for consistency with the program definition (specified in the TMU).

Target is subject to an adjuster for liquidity reserve requirement.

Targets are subject to an adjuster for budget support and debt service payments.

Targets are subject to an adjuster for donor-funded social sector expenditures consistent with the TMU.

Defined as a cumulative flow.

Priority social spending as defined and quantified in the TMU.

Evaluated on a continuous basis.

Other standard PCs include introducing or modifying MCPs, concluding bilateral payments agreements that are inconsistent with Article VIII, and imposing or intensifying import restrictions for balance of payment reasons.

Table 2a.

Malawi: Prior Actions and Structural Benchmarks, July (2012–Nov 2013)

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Table 2b.

Malawi: Prior Actions and Structural Benchmarks, Dec (2013–Sept 2014)

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50. New prior actions and structural benchmarks are proposed (TMU Table 2b), covering reforms in the financial sector and in public financial management, including monitoring progress in implementation of remedial measures to address governance issues arising from the recent fraud. Budget execution will be monitored through IFMIS-generated monthly reports that track funding authorizations and actual payments by vote.

Attachment II. Technical Memorandum of Understanding

1. This memorandum sets out the understandings between the Malawian authorities and the International Monetary Fund regarding the definitions of quantitative performance criteria, benchmarks, and indicative targets for the program supported by the ECF arrangement, and the related reporting requirements.

Coverage

2. The central government includes all units of government that exercise authority over the entire economic territory. However, in contrast to the System of National Accounts 1993 (SNA 1993) and Government Finance Statistics Manual 2001 (GFSM 2001) standards, nonprofit institutions that are controlled and financed by the central government are excluded for purposes of this memorandum. The accounts of the monetary authorities include those of the RBM. Monetary aggregates under the program are based on the twelve-bank monetary survey.

Quantitative Performance Criteria: Definitions and Data Sources

Floor on Net International Reserves of the RBM

3. Definition of net international reserves (NIR) of the RBM: The NIR of the RBM is defined as gross reserve assets minus gross reserve liabilities (IMF, other short-term liabilities, including all foreign currency liabilities to residents (for instance, deposits of domestic banks with the RBM). The values of all foreign assets and liabilities will be converted into U.S. dollars at each test date using the program cross exchange rates for the various currencies and then converted into kwacha using the program exchange rate for the U.S. dollar–kwacha exchange rate. The program exchange rate of the Malawi Kwacha to the U.S. dollar is set at MK320 = US$1. The corresponding cross exchange rates and program gold price for the duration of the program are in Table 3.

Table 3.

Malawi: Cross Rates for Nominal Exchanges Rates and Gold Price for the (2013–13 Program)

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Source: IFTS, RBM

LBM connotes London Bullion Market.

4. Gross reserve assets of the RBM are defined in the International Reserves and Foreign Currency Liquidity Guidelines for a Data Template as external assets immediately available and controlled by RBM “for meeting balance of payments financing needs, for intervention in exchange markets to affect the currency’s exchange rate, and for other related purposes (such as maintaining confidence in the currency and the economy, and serving as a basis for foreign borrowing).” (BPM6, paragraph 6.64).

5. This concept includes the following: (1) monetary gold holdings of the RBM; (2) holdings of SDRs; (3) the reserve position in the IMF; (4) foreign convertible currency holdings; (5) deposits held in foreign central banks, the Bank for International Settlements, and other banks; (6) loans to foreign banks redeemable upon demand; (7) foreign securities; and (8) other unpledged convertible liquid claims on nonresidents. It excludes the following: (1) any foreign currency claims on residents; (2) capital subscriptions in international institutions; (3) foreign assets in nonconvertible currencies; (4) transfers of foreign currency claims to RBM by other institutional units in Malawi just prior to reporting dates with accompanying reversals of such transfers soon after those dates; (5) assets obtained through currency swaps of less than three months duration; (6) gross reserves that are in any way encumbered or pledged, including, but not limited to: (i) assets blocked when used as collateral for third party loans and third-party payments, or pledged to investors as a condition for investing in domestic securities; (ii) assets lent by RBM to third parties that are not available before maturity, and are not marketable; and (iii) foreign reserves blocked for letters of credit.

6. Gross reserve liabilities of the RBM are defined as the sum of the following: (1) SDR allocations; (2) outstanding medium and short-term liabilities of the RBM to the IMF; (3) all short-term foreign currency liabilities of the RBM to nonresidents with an original maturity of up to, and including, one year; and (4) all foreign currency liabilities to residents (including, for instance, deposits of domestic banks with the RBM).

7. Definition of budget support: Budget support includes all grants and foreign financing not directly linked to additional budgetary expenditure. Excluded from this definition is external project financing to fund particular activities, including food security funding from the European Union and loan financing from the IMF, and donor inflows (in kwacha) from the U.S. dollar–denominated donor pool accounts for the health SWAp, education SWAp, agricultural SWAps, and National AIDS Commission (NAC) held in the Malawi banking system.

8. Adjustment clause on NIR—budget support: The floor on the NIR of the RBM will be adjusted upward by the full amount by which the cumulative receipts from the budget support are greater than US$10 million above the program baseline (See Table 1). The floor on NIR of the RBM will be adjusted downward by the full amount up to a maximum of US$ 5 million by which the cumulative receipts from the budget support are less than the program baseline. Budget support is measured as the cumulative flow from the beginning of the fiscal year.

9. Adjustment clause on NIR—donor accounts for the social sector (including health, education, and other SWAps, and National AIDS Commission (NAC): The floor on the NIR of the RBM will be adjusted downward by the amount by which the donor inflows (in kwacha) from the U.S. dollar–denominated donor accounts for SWAps and NAC held in the RBM are smaller than the donor inflow (in kwacha) to those accounts in the program baseline. The downward adjustment will be capped at US$ 5 million. Donor inflows are measured as the receipts (in kwacha) by the budget from the beginning of the fiscal year.

10. Adjustment clause on NIR—debt service payments: The floor on NIR of the RBM will be adjusted upward (downward) by the full cumulative amount by which debt service payments to the World Bank and the African Development Bank (ADB) fall short of (exceed) the program baseline. The cumulative amount will be measured from the beginning of the fiscal year.

11. The total downward adjustment to NIR from a shortfall of (i) budget support and (ii) donor inflows to the donor accounts for the social sector relative to the program assumptions, and (iii) an excess of debt service payments to the World Bank and the African Development Bank (ADB) relative to the program assumptions will be capped at US$10 million. The floor on the NIR of the RBM will be adjusted upward by the full amount by which the cumulative receipts from the budget support are greater than US$10 million above the program baseline and by the full cumulative amount by which debt service payments to the World Bank and the African Development Bank (ADB) fall short of the program baseline.

12. For this target and those for external debt and arrears, valuation will be in U.S. dollars, using the above defined program exchange rates.

13. Data on NIR, including its components, will be reported by the RBM on a weekly and end-month basis.

Ceiling on the Net Domestic Assets of the Reserve Bank of Malawi and Reserve Money

14. Definition of net domestic assets (NDA) of the RBM: NDA of the RBM are defined in kwacha terms as end-quarter reserve money less NFA of the RBM at the program exchange rate. Reserve money consists of currency issued by the RBM and balances of commercial banks’ accounts with the RBM. It includes required reserves held for Malawi kwacha deposits and any other domestic currency reservable liabilities and other demand and time deposits held with the RBM. The NDA program ceilings are the indicative money targets defined below less the NFA of the RBM.

15. Definition of NFA of the RBM: The NFA of the RBM are defined as the above-defined NIR plus other foreign assets of the RBM—including but not limited to: (1) capital subscriptions in international institutions; (2) foreign assets in nonconvertible currencies; and (3) gross reserves that are in any way encumbered or pledged, less any medium- and long-term foreign liabilities of the RBM.

16. Adjustment clause on NDA—budget support: The ceiling on NDA of the RBM will be adjusted downward by the full amount by which the cumulative receipts from the budget support are greater than US$10 million above the program baseline. The ceiling on NDA of the RBM will be adjusted upward by the amount by which the cumulative flow of receipts from budget support are less than the program baseline, up to a maximum of US$5 million. The kwacha value of the cumulative shortfall (excess) will be calculated at the program exchange rate. Budget support is measured as the cumulative flow from the beginning of the fiscal year.

17. Adjustment clause on NDA—donor pool accounts for the social sector (including health, education, and other SWAps, and NAC): The ceiling on NDA of the RBM will be adjusted upward by the amount by which the donor inflows to the budget (in kwacha) from the U.S. dollar–denominated donor accounts for the SWAps and NAC held in the RBM fall short of the donor inflow (in kwacha) to those accounts in the program baseline. The upward adjustment will be capped at US$5 million. Donor inflows are measured from the beginning of the fiscal year.

18. Adjustment clause on NDA—debt service payments: The ceiling on NDA of the RBM will be adjusted downward (upward) by the full cumulative amount by which debt service payments to the World Bank and the ADB falls short of (exceeds) the program baseline (Tables 1a and 1b). The cumulative amount will be measured from the beginning of the fiscal year.

19. The total upward adjustment to NDA from a shortfall of (i) budget support (ii) donor inflows to the donor accounts for the social sector relative to the program assumptions and (iii) an excess of debt service payments to the World Bank and the African Development Bank (ADB) relative to the program assumptions will be capped at US$15 million. The downward adjustment to NDA will reflect the full amount by which the cumulative receipts from the budget support are greater than US$10 million above the program baseline and by the full cumulative amount by which debt service payments to the World Bank and the African Development Bank (ADB) fall short of the program baseline.

20. Adjustment clause on NDA—liquidity reserve requirement: The ceiling on NDA of the RBM will be adjusted downward for a decrease in the reserve requirement ratio on domestic deposits, and will be adjusted upward for an increase in the ratio. The adjustment will be spread equally over two quarters, starting in the quarter in which the reserve requirement ratio is reduced. The adjuster will be calculated as follows: (one minus the existing required fraction of reserve assets) multiplied by (the program baseline required reserve ratio minus the new required reserve ratio) multiplied by (the amount of average reservable deposit liabilities in commercial banks during the last month before the change in regulation).

Ceiling on Central Government Net Domestic Borrowing (CGDB)

21. Definition of CGDB: CGDB is computed as the sum of (1) net borrowing from the RBM (including ways and means advances, loans, holdings of local registered stocks, government bonds, and holdings of treasury bills minus deposits); (2) net borrowing from commercial banks(including advances, holdings of local registered stocks, and holdings of treasury bills minus deposits); (3) net borrowing from nonbanks (including, but not limited to, holdings of local registered stocks and holdings of treasury bills); and (4) holdings of promissory notes. The treasury bills and locally registered stocks are valued at cost rather than face value. The ceiling is measured as the change in the stock of CGDB cumulative from the beginning of the fiscal year, including promissory notes and securities transferred to the RBM from the treasury since the beginning of the fiscal year. Transfers from extra-budgetary funds will not be considered revenues for this performance criterion. They will be treated the same as borrowing from the private sector (as their accounts are outside the definition of government) and therefore as domestic borrowing. Asset sales or privatization revenues will be accounted for under financing as a separate category, separate from domestic or foreign financing in calculating CGDB.

22. Definition of domestic arrears: Domestic arrears are overdue payment obligations of the central government other than external payment arrears, including on wages and salaries, pensions, transfers, domestic interest, goods and services, obligations arising from court cases, legally established compensation claims, and tax refunds. Payments on wages and salaries, pensions, transfers, court-established obligations, and compensations are in arrears when they remain unpaid for more than 30 days beyond their due date. Domestic interest payments are in arrears when the payment is not made on the due date. Payments for goods and services are deemed to be in arrears if they have not been made within 90 days of the date of invoice, or—if a grace period has been agreed—within the contractually agreed grace period.

23. Adjustment clause on CGDB—budget support: The ceiling of CGDB will be adjusted downward (upward) by the full amount by which cumulative kwacha receipts from budget support are greater (less than) the program baseline. The upward adjustment will be capped at US$5 million. In the event of excess budget support, the ceiling on CGDB will be adjusted by the full amount less US$10 million. The kwacha value of the cumulative shortfall (excess) will be calculated at the program exchange rate. Budget support is measured as the cumulative flow from the beginning of the fiscal year.

24. Adjustment clause on CGDB—donor accounts for the social sector (including health, education, and other SWAps, and NAC): The ceiling on CGDB will be adjusted upward by the full amount by which the donor inflows to the budget (in kwacha) from the U.S. dollar–denominated donor accounts for health, education, and other SWAps, and NAC held in RBM are smaller than the donor inflows (in kwacha) to those accounts in the program baseline. The upward adjustment will be capped at US$5 million. Donor inflows are measured from the beginning of the fiscal year.

25. Adjustment clause on CGDB—debt service payments: The ceiling (floor) on CGDB will be adjusted downward (upward) by the full cumulative amount by which debt service payments to the World Bank and the ADB fall short of (exceed) the program baseline. The cumulative amount will be measured from the beginning of the fiscal year.

26. The total upward adjustment to CGDB from a shortfall of (i) budget support (ii) donor inflows to the donor accounts for the social sector relative to the program assumptions and (iii) an excess of debt service payments to the World Bank and the African Development Bank (ADB) relative to the program assumptions will be capped at US$10 million. The downward adjustment to CGDB will reflect the full amount by which the cumulative receipts from the budget support are greater than US$10 million above the program baseline and by the full cumulative amount by which debt service payments to the World Bank and the African Development Bank (ADB) fall short of the program baseline.

Ceiling on External Payment Arrears

27. Definition of external payment arrears: External payment arrears consist of debt-service obligations (principal and interest) of the central government or the RBM to nonresidents that have not been paid at the time they are due, as specified in contractual agreements, except on external debt subject to rescheduling or restructuring. This performance criterion will be monitored on a continuous basis.

Ceiling on Nonconcessional External Debt

28. Definition of nonconcessional external debt: The definition of debt, for the purpose of the limit, is set out in Executive Board Decisions No. 6230-(79/140) August 3, 1979, and as amended by Decisions No. 11096-(95/100), October 25, 1995; 12274–(00/85) August 24, 2000; and 14416-(09/91), August 31, 2009. For program purposes, short-, medium- and long-term debt is nonconcessional if it includes a grant element of less than 35 percent, as indicated in Decision No. 11248-(96/38), April 15, 1996. The grant element is calculated using a discount rate of 5 percent. The ceiling on nonconcessional debt applies to the contracting and guaranteeing of debt with nonresidents by the central government, the RBM, public enterprises, and other official sector entities, unless an explicit selective exclusion is made. This performance criterion is monitored on a continuous basis. The ceiling applies to debt and commitments contracted or guaranteed for which value has not been received. The ceiling is measured cumulatively from the beginning of the fiscal year.

29. Short-term debt: Outstanding stock of debt with an original maturity of one year or less.

30. Medium- and long-term debt: Outstanding stock of debt with a maturity of more than one year.

31. Excluded from the limit is the use of IMF resources, and any kwacha-denominated treasury bill and local registered stock holdings by nonresidents. Excluded from the limit are also (i) debts classified as international reserve liabilities of the RBM; (ii) new debt issued to restructure, refinance, or repay existing debt up to the amount actually used for the above-mentioned purposes; (iii) normal import financing; and (iv) arrangements to pay overtime obligations arising from judicial awards to external creditors. A financing arrangement for imports is considered to be “normal” when the credit is self-liquidating.

Quantitative Indicative Targets and Structural Benchmarks

32. Definition of reserve money: Reserve money is defined as the sum of currency issued by the RBM, including the vault cash of commercial banks, and balances of commercial bank accounts with the RBM. It includes required reserves held for kwacha deposits, other domestic currency liabilities, and other demand deposits held with the RBM.

33. Definition of social spending: Using functional classification of expenditure, social spending is computed as the sum of central government spending on health, education, the farm input subsidy program, and government social protection (comprising the government expenditures by the ministry of gender, children and social welfare, the ministry of disability and elderly affairs, and the local development fund). In order to maintain Malawi’s commitment and progress toward poverty reduction and the MDGs, the social spending allocations in the government budget will not be adjusted downward to meet fiscal targets of the program (Table 4).

Table 4.

Malawi: Social Spending: FY2013/14

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34. Structural benchmarks are contained in Tables 2a and 2b.

Table 5.

Reporting Requirements

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D- Daily, W-Weekly, M -Monthly, Q-Quarterly, BA-Bi-annual, F-Friday, 30-Every 30th, T30-Every third 30th, E-Electronic, H-Hard Copy

Detailed information on the amounts , currencies, terms, and conditions, including debt contracted or guaranteed by the RBM or any other agency on behalf of the central government.

Agriculture Development and Marketing Corporation, Air Malawi, Electric Supply Company of Malawi. Malawi Development Corporation, Malawi Housing Corporation, Malawi Postal Corporation, Malawi Telecommunications Ltd., Northern Regional Water Board.
1

Another recent incident that may be linked to attempts to defraud the government was the shooting of the Director of Budget of the Ministry of Finance in mid-September. He was severely injured but survived the attack.

2

Large movements in tobacco stocks in recent years have given rise to a marked discrepancy between output, sales on the auction floors and exports in any given year. Sales on the auction floors, rather than exports, are the main source of foreign exchange supply to the domestic foreign exchange market.

3

As noted in EBS/13/125 (issued on 9/20/2013), the authorities experienced a similar problem with a loan from the Export-Import Bank of India in an amount of US$76.5 million. That loan became effective in March 2013 (i.e., before the second review) and resulted in misreporting under the ECF arrangement.

4

Although the issuance of a promissory note for RBM recapitalization is reported as part of the RBM’s net claims on government, it did not involve any lending to finance government operations.

5

The calculations also include MK18 billion in unexplained expenditure (discrepancy) from FY2013/14 Q1, which includes fraud related payments.

6

About 40 percent of the projected increase in interest payments in FY2013/14 resulted from the promissory note issued by the government for the RBM recapitalization in June 2013 and start of interest payments on securitized portion of expenditure arrears.

7

As about 60 percent of the stock of government domestic debt is held by the RBM, the projected large increase in interest payments is expected to boost RBM operational income significantly. Valuation losses which largely depend on exchange rate developments this year compared to last year could offset some of RBM’s operational income.

8

Most of the proposed cuts are from the travel budget and domestically financed development expenditure, which had annual allocations of MK28.5 billion and MK47 billion, respectively (Text (Table 5)). Five months into the year (at end-November), about MK10 billion and MK20 billion had been spent on travel and domestically financed development projects, respectively.

9

Under FILP, farmers’ clubs are able to obtain fertilizer from suppliers, make a down payment and pay the balance after the harvest. The fertilizer is sold at market price plus a fee (to cover administrative costs) and so does not entail a subsidy. However, the program is administered by the Malawi Rural Development Fund, a state-owned enterprise, and in the event farmers default there will likely be pressure on the government to step in. In that sense, the government is providing an implicit guarantee.

10

These indicators should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints and information availability.

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Cover IMF Staff Country Reports
Malawi: Third and Fourth Reviews Under the Extended Credit Facility Arrangement, Request for Waivers for Non-observance of Performance Criteria, Extension of the Arrangement, Rephasing of Disbursements, and Modification of Performance Criteria-Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Malawi
Author:
International Monetary Fund. African Dept.
Volume/Issue:
Volume 2014: Issue 037
Publisher:
International Monetary Fund
ISBN:
9781475573046
ISSN:
1934-7685
Pages:
113
DOI:
https://doi.org/10.5089/9781475573046.002

Malawi: Year on Year Inflation

Malawi: Evolution of Interest Rates

Gross Domestic debt*

(In Billions of Kwacha)

Nominal and Real Effective Exchange Rates, January 2010—June 2013