smallholder agricultural production, notably maize production.<sup>1</sup> Malawi’s economy is highly vulnerable to adverse weather shocks not only because of the direct impact on agricultural production (and GDP), but also due to the indirect impact on government finances resulting from the unanticipated need for emergency interventions (which may translate into increased domestic borrowing), and increased pressure on the current account because of the need for exceptional food imports (World Bank, 2007a). In fact, every few years there is an unexpected crisis in Malawi, usually because of the impact of adverse weather on agricultural production, GDP and public finances.

The impact on government finances resulting from the weather shocks is evident from the experience during 2000 and 2004 in Malawi, when domestic public debt increased exponentially, and brought the country on the verge of a fiscal crisis. In preparing the 2002/03 budget, the government did not set-aside resources to respond to the emerging food crisis (which resulted from the combination of localized drought and floods in 2001 and 2002), and eventually spent an unbudgeted 5 percent of GDP because of the need to provide food relief. This was a combination of emergency imports of maize (amounting to 3.8 percent of GDP), and transfers to the Agricultural Development and Marketing Cooperation (ADMARC) and National Food Reserve Agency (NFRA) parastatals (1.2 percent of GDP). The cost of the 2002/03 maize imports compounded the already rising interest costs, leading to a rapid increase in domestic expenditures and the crowding out of discretionary (i.e. non-statutory) expenditures. Although government started borrowing on a large scale in 2001/02, the full effect of increased interest costs was not felt until 2003/04, when the domestic interest bill reached 9.1 percent of GDP, corresponding to a massive 40 percent of domestic revenues. Even in 2005/06, when the government carefully planned its humanitarian response to the 2005 drought and included funding in its 2005/06 budget, the actual cost of the interventions turned out to be much higher than initially envisaged, resulting in a larger fiscal deficit (including grants) by 0.8 percent of GDP.

In spite of the frequency of (weather) shocks in Malawi, only a small allowance is made in the budget for such contingencies.<sup>2</sup> As a result, shocks usually translate into higher domestic borrowing, and have a substantial impact on fiscal performance and macroeconomic stability. Further, the long-term impact of the volatility is substantial, as economic uncertainty hampers the country’s ability to generate and/or attract productive investments, to effectively compete in international markets, and, most important, to translate economic growth into employment and income generation that benefit those who need it most (World Bank, 2004; 2007a; 2007b). High level of risk has been identified as an important explanation for slow growth in Africa in general (Collier and Gunning, 1999). In fact, insufficient anti-shock action and finance has been a recipe for magnifying economic instability and other distortions, ending up costing far more in the long-term (Gelb and Eifert, 2006). As discussed above, such costs have been extremely high in the case of Malawi.

> 1 In addition to the lackluster performance of agriculture, the poor economic growth has been exacerbated by an even worse performance in manufacturing, partly due to exceptionally high government borrowing that ‘crowded out’ financing to the private sector.  Macroeconomic performance has improved substantially since 2005.

> 2 A budget line for ‘unforeseen expenditures’ allows for such contingencies, amounting to about 1 percent of GDP. Malawi has traditionally relied on international assistance following climatic disasters.

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