Documentof The World Bank FOROFFICIAL USE ONLY X> ,kii 4 ' I/IIA Public Disclosure Authorized Report No. P-5412-MAI MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE Public Disclosure Authorized EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 22.3 MILLION (US$32 MILLION EQUIVALENT) OF THE GOVERNMENT OF MALAWI FOR A Public Disclosure Authorized FINANCIAL SECTOR AND ENTERPRISE DEVELOPMENT PROJECT FEBRUARY 25, 1991 Public Disclosure Authorized This documenthas a restricteddistribution and may be used by recipientsonly in the performanceof their official duties. Its contentsmay not otherwisebe disclosedwithout World Bank authorization. CURRENCYEQUIVALENTS CurrencyUnit = Malawi Kwacha (MK) US$ 1.00 - MK 2.65 (January1991) MK 1.00 = US$ 0.38 MK 1.00 - 100 tambalas FISCAL YEAR April 1 - March 31 GLOSSARYOF ABBREVIATIONS ASAC AgricultureSector AdjustmentCredit ECMAC Entrepreneurshipand CapitalMarket Adjustment Credit CBM CommercialBank of Malawi CDC Commonwealth Development Corporation DEMATT Developmentof Malawian Traders Trust DEVPOL Statementof DevelopmentPolicy DFI DevelopmentFinance Institution EDC Export DevelopmentComponent EEC EuropeanEconomic Community ECGF Export Credit GuaranteeFacility ESAF Enhanced StructuralAdjustment Facility FIAS Foreign InvestmentAdvisory Services INDEBANK Investmentand DevelopmentBank of Malawi IMF InternationalMonetary Fund ITPAC Industrialand Trade Policy Adjustment Credit LFC Leasing Finance Company MDC Malawi Development Corporation MEDI Malawian Entrepreneurs DevelopmentInstitute MEPC Malawian Export Promotion Council NIM Malawian Instituteof Management MIGA MultilateralInvestment Guarantee Agency MTIT Ministry of Trade, Industryand Tourism NBM National Bank of Malawi NBFIs Non-banksFinancial Institutions PFIS ParticipatingFinancial Intermediaries PPF ProjectPreparation Facility POSB Post Office SavingsBank RBM Reserve Bank of Malawi FOR OFFICIALUSE ONLY MALAWI FINANCIAL SECTOR AND ENTERPRISE DEVELOPMENT CREDIT CREDIT AND PROJECT SUMMARY Borrower: Republic of Malawi Beneficiaries: Reserve Bank of Malawi (RBM), participating financial intermediaries (PFIs), Ministry of Trade, Industry and Tourism, the Post Office Savings Bank (POSB), the Chamrber of Commerce and Industry, Malawi Development Corporation (MDC), Investment and Development Bank of Malawi (INDEBANK), and various local Snall and Medium Enterprises (SME) support institutions. Amount: SDR 22.3 million, US$32 million equivalent Terms: Standard IDA terms, with 40 years maturity Onlendinz Terms: RBM would through an Apex Unit onlend US$27.4 million equivalent of the IDA Credit to eligible PFIs in local currency at a pre-determined reference rate. The reference rate would be determined by RBM as the prevailing average cost of term borrowing in the financial system (about 13.625 percent in December 1990, calculated as a simple average of all prevailing interest rates on term deposits in Malawi). PFIs would relend the funds at market rates to finance viable subprojects in the productive sectors. RBM would pass to the Government the interest received from PFIs, less a 0.5 percentage point fee to cover RBM's administrative costs for operating the Apex Unit. The Government would bear the foreign exchange risk out of the interest received from PFIs. The Government would provide US$4.6 million equivalent through RBM for institutional capacity development to beneficiaries on a grant basis. ESTIMATEDCOSTS: LOCAL FOREIGN TOTAL ------- US$ Million------- IDA 2.4 29.6 32.0 Government 0.4 - 0.4 Co-financing 0.1 0.0 0.1 Project Sponsors 14.7 - 14.7 Total 17.6 29.6 47.2 Economic Rate of Return: Not Applicable Staff Appraisal Report : Report No. 9096-MAI Map: IBRD 20924 This document has a restrioed distribution and may be used by recipients only in the perfo iaric' Lt their official dutlie Its contents mas not otherwise be disclosed without World Bank auth Tr7oii&'n MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF MALAWI FOR A FINANCIAL SECTOR AND ENTERPRISE DEVELOPPMENTPROJECT 1. The following memorandum and recommendations on the proposed IDA Credit to the Republic of Malawi for SDR 22.3 million (S32 millicni equivalent) are submitted for approval. The proposed Credit would provide, through a combination of investment credit and technical assistance, term resources through the country's financial intermediaries for investment 4n all productive sectors. 2. Background. Malawi's economic record has been mixed because of a narrow resource base and small domestic market, both of which make the country very vulnerable to external shocks. Stable growth between 1964 and 1978, with an average annual growth rate of over 5 percent, was followed by stagnation between 1979 and 1981 and limited recovery between 1982 and 1985. In the late 1970s, the economy faced a series of exogenous shocks and domestic policy weaknesses that substantially reduced per capita income growth. The shocks included adverse -erms of trade, high oil prices, and a civil war in Mozambique that disrupted external transport routes and led to higher transport costs. A prolonged drought in the early 1980s, an influx of 800,000 displaced persons from Mozambique, rising fiscal deficits and introduction of controls on imports and the rationing of foreign exchange further exacerbated the problems. Since 1987, the Government has been implementing a new economic strategy, with the support of the IMF under the Enhanced Structural Adjustment Facility (ESAF) and the World Bank's Industrial and Trade Adjustment Credit and the Agricultural Sector Adjustment Credit (ASAC). The macroeconomic objective of the strategy is the resumption of higher levels of economic growth on a sustainable basis. Under this strategy, Government is committed to the maintenance of an appropriate framework in: (i) fiscal policy; (ii) the external sector; (iii) pricing, especially agricultural pricing and in smallholder agriculture; (iv) the financial sector; (v) the public sector, with emphasis on the parastatal reform; and (vi) the exchange rate regime. The economy has begun to respond positively to these policy measures. Real GDP grew by 2.9 percent in 1988, is estimated to have grown by 4.3 percent in 1989, and is projected to grow by 4.8 percent in 1990. Despite the breadth of the reforms, Malawi's future growth faces some uncertainties because of several structural weaknesses, especially in the industrial sector, that impede development of a sustainable response. 3. The Government's objectives for the industrial sector are to increase and diversify industrial output, especially in the small and medium enterprises (SMEs) sector, and maintain efficiency of industrial production, while protecting the environment. These objectives are being pursued through general macroeconomic and sectoral reforms, that have been supported by IDA through ITPAC, which was approved by the Bank in June 1988 and has so far been successfully implemented. Reforms under ITPAC have included deregulation of pricing, liberalization of trade and of foreign exchange allocation, and a reduction in industrial licensing. The industrial sector, which accounts for 12 percent of GDP, still faces several constraints in maximizing its contribution to economic development. Government with support from the Foreign Investment Advisory Services (FIAS/IFC), has reviewed the investment climate and identified several necessary reforms, which include: (i) streamlining the regulatory and administrative procedures for business incorporation and licensing; (ii) providing the institutional and incentives framework for promoting private foreign and domestic investment; (iii) improving access to credit, especially for SMEs; (iv) promoting exports by encouraging dtversification into non-traditional exports, and providing adequate export finance; and (v) streamlining the allocation of industrial lar.d leases, and involving the private sector in the development of industrial sites and factory shells. The proposed project will support initiatives in these areas. The Government, with FIAS support, has already drafted an Investment Policy Statement that clearly articulates its policy on private investment in Malawi Establishment of an investment promotion agency will be supported under the proposed IDA Credit. The Bank has also coordinated significant donor assistance and external resources for Malawi. In industry, several donors are already involved (UNDP, USAID, UNCDF, KFW, FMO, IFAD and the EEC), most visibly in the SME sector. 4. The major issue in Malawi's financial sector, which is small and fairly unsophisticated but with few distortions, has been its inability to respond with flexibility to investor financing needs. The Government with IDA support reviewed the financial sector and identified necessary policy reforms to deepen financial markets, improve efficiency in resource mobilization and allocation. Several of the reforms have already been implemented including interest rate deregulation (rates are now positive in real terms), and a revision of the regulatory and prudential supervisory framework. To further improve the performance of the sector, Government proposes to: (i) remove credit ceilings; (ii) encourage competition by allowing entry of new financial institutions and diversification of existing financial institutions; (iii) rationalize tax incentives on financial instruments; (iv) provide adequate financing