metadata: authors: 0: author: Hanmer,Lucia C.
1: author: Lea,Nicholas John
count: Malawi
docna: 0: docna: Constraints to growth in Malawi
docty: Policy Research Working Paper
subtopic: Climate Change and Agriculture,Construction Industry,Common Carriers Industry,Food & Beverage Industry,General Manufacturing,Pulp & Paper Industry,Plastics & Rubber Industry,Crops and Crop Management Systems,International Trade and Trade Rules,Food Security,Business Cycles and Stabilization Policies,Inequality
teratopic: Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: This paper applies a growth diagnostics
            approach to identify the most binding constraints to
            private-sector growth in Malawi - a small, landlocked
            country in Southern Africa with one of the lowest per capita
            incomes in the world. The approach aims to identify the
            constraints (in terms of public policy, implementation, and
            investments) most binding on marginal investment, and
            therefore whose relaxation would have the largest impact on
            growth through the investment channel. The authors find that
            growth in Malawi has been primarily driven by the domestic
            multiplier effect from export revenues. The multiplier
            effect is particularly pronounced due to the high number of
            smallholder farmers, which produce Malawis main export
            crop, tobacco, and consequently results in the widespread
            and rapid transmission of agricultural export income.
            Furthermore, despite changes in the structure of
            agricultural production from estate to smallholder farming
            and liberalization of prices and finance, a longstanding
            relationship persists between exports in real domestic
            currency and overall gross domestic product. This central
            role of exports in creating domestic demand highlights the
            importance of the real exchange rate in Malawis growth
            story, which directly increases the strength of the export
            multiplier. The most pressing constraint to growth in Malawi
            continues to be the regime of exchange rate management.
            Despite good progress, there is compelling evidence that the
            rate is still substantially overvalued. Furthermore, it is
            also likely that the inflow of foreign aid - in excess of 50
            percent of exports -contributes to the overvaluation through
            its large component of recurrent expenditures.
geo_reg_key: 517195,517191
repnme: repnme: Constraints to growth in Malawi
display_title: Constraints to growth in Malawi
listing_relative_url: /research/2009/10/11263494/constraints-growth-malawi
topicv3: Agriculture and Food Security m1326205 435,Manufacturing Sectors m1326521 1281,Crop Production m1326627 174,Poverty m1326687 695,Trade m1326924 698
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 48
author_keys: 0: author_key: 428158
1: author_key: 1037696
model_extractions: WPS5097 Policy Research Working Paper 5097 Constraints to Growth in Malawi _Nicholas Lea Lucia Hanmer_ The World Bank Africa Region Southern Africa Poverty Reduction and Economic Management Unit October 2009
Policy Research Working Paper 5097

# **Abstract**

This paper applies a growth diagnostics approach to identify the most binding constraints to private-sector growth in Malawi—a small, landlocked country in Southern Africa with one of the lowest per capita incomes in the world. The approach aims to identify the constraints (in terms of public policy, implementation, and investments) most binding on marginal investment, and therefore whose relaxation would have the largest impact on growth through the investment channel. The authors find that growth in Malawi has been primarily driven by the domestic multiplier effect from export revenues. The multiplier effect is particularly pronounced due to the high number of smallholder farmers, which produce Malawi’s main export crop, tobacco, and consequently results in the widespread and rapid transmission of agricultural export income.

Furthermore, despite changes in the structure of agricultural production from estate to smallholder farming and liberalization of prices and finance, a longstanding relationship persists between exports in real domestic currency and overall gross domestic product. This central role of exports in creating domestic demand highlights the importance of the real exchange rate in Malawi’s growth story, which directly increases the strength of the export multiplier.

The most pressing constraint to growth in Malawi continues to be the regime of exchange rate management. Despite good progress, there is compelling evidence that the rate is still substantially overvalued. Furthermore, it is also likely that the inflow of foreign aid—in excess of 50 percent of exports—contributes to the overvaluation through its large component of recurrent expenditures.

This paper—a product of Southern Africa Poverty Reduction and Economic Management Unit, Africa Region—is part of a larger effort in the department to analyze constraints to growth and poverty reduction. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at nick.lea@kuona-consult.com, l-hanmer@dfid.gov.uk, or jverbeek@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **CONSTRAINTS TO GROWTH IN MALAWI**

**_Nicholas Lea* and Lucia Hanmer**_**<sup>1</sup>

*Consultant, World Bank, Email address:nick.lea@kuona‐consult.com;  ** Senior Advisor, DFID, Email address: l‐hanmer@dfid.gov.uk

> 1 This paper was prepared as a background paper to the Malawi Country Economic Memorandum (CEM) of 2009, and was funded by the UK Department for International Development (DFID) and the World Bank (IDA).  The analysis builds on earlier work done by Alex Culiuc, and benefited greatly from feedback from stakeholders in Malawi where initial results were discussed at a workshop in December 2008.   The authors would particularly like to thank the following for their insights and guidance: Jos Verbeek, Khwima Nthara, Hans Binswanger-Mkhize, Hardwick Tchale, David Rorhbach, Nick Dyer, David Woolnough, Manu Mathri, Alex Gomani, Martha Phiri, Jason Agar, Eduardo Ley, Steven Jaffee, John Panzer, Sudhir Shetty, and Alan Winters.
<!-- Start of picture text --> 1800 _—l_J] , TY<br>— Lesotho<br>180<br>—— Benin<br>140<br>—— Ghana<br>120 —— kenya<br>‘on a>= ~~~ a —,-. * ———— SenegalRwanda<br>ad ~ Aly, “eo<br> XS i, 7 = =-====== Malawi<br>BO i Burundi<br>Bs a “1, A Zambia<br>LF PFFEEF IP EFF.SF MF EF<br><!-- End of picture text -->
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South Africa for migrant labor, reducing remittance incomes of Malawian households. Civil war in Mozambique 1985-1992 damaged transport infrastructure and blocked the ports of Nacala and Beira raising transport costs. Additionally high financial losses of ADMARC and other parastatals - exacerbated by poor sequencing of price and market liberalization - resulted in the steep decline of living standards between 1979 and the late 1980s (Harrigan, 2003).

This rise and fall of incomes between 1960 and the late eighties points to the dominant role of producer terms-of-trade. Estate-led growth was made possible by relatively high product prices, the efficient value chain of estate marketing, good transport infrastructure and cheap credit. The reversal of these factors between 1979 and 1989 correspondingly contracted incomes.

# **Volatility and Transition to Smallholder Growth: 1989-02**

Agricultural reform began in the early 1990s and dismantled many of the constraints imposed on smallholders by the estate-led model. The repeal of the Special Crops Act made it legal for smallholders to grow export crops bringing about a dramatic shift in the sector - from nearly nothing in 1990, smallholders now produce around 70% of the tobacco crop. However growth was volatile in the face of increasing macro-instability and exacerbated by various external shocks: droughts in 1992 and 1994; an increased influx of Mozambican refugees and, suspension of all Western non-humanitarian aid in 1992-3 (Harrigan, 2003).

Inflation reached a high of 83% in 1995 and was only brought under control to around 10% in 2003. The much needed liberalization of the exchange rate in 1994 was not accompanied by fiscal discipline (partly explained by the electoral cycle) and hence higher import prices immediately fed through into the CPI. Excessive government borrowing financed by domestic treasury bills resulted in real interest rates exceeding 20% between 2000 and 2004. For part of this period Malawi had the notoriety of having real interest rates among the highest in the world. Private investment was crowded out, growth was damaged.

# **Stabilization and Recovery: 2002-08**

The change of government in 2004 brought about a rapid turnaround in government finances. In extremely difficult fiscal circumstances, and for the first time since 1994, the government stayed within the budget approved by parliament (Whitworth 2005). As a result government expenditure stabilized and the fiscal deficit improved dramatically.

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<!-- Start of picture text --> Budget deficit (% of GDP} Domestic Debt and Interest Payments (% GDP)<br>8% 95%<br>8 —§<br>14% 20%<br>ah 15%<br>10% mums Net domestic<br>8% 10% debt<br>a<br>a% 5%0<br>—— Domestic<br>2% 0% interest<br>0% payments<br>Oro AMT oO OR nO MOM AHN oe ge oF FF S<br>AAA mWAAABAIAIBIMBMoooToTcT FCCC<br><!-- End of picture text -->
where:

- _c, c_  is consumption, and the derivative of consumption with respect to time.

- _k, k_<sup></sup> is capital, and the derivative of capital with respect to time.

- is the tax rate on investment returns, actual or expected, formal or informal

- is the world rate of interest

- is the elasticity of intertemporal elasticity in consumption<sup>2</sup>

- _r_ is a function of _a_ ,  _, x_ representing the rate of return on capital where:

- _a_ is the indicator of total factor productivity

- _x_ is the availability of complementary factors of production such as infrastructure or human capital

- is the index of externality (a higher  means a larger distortion)

Growth diagnostics consists of analyzing the parameters of the optimization equation to assess which are the most binding to growth. However the data required to empirically estimate most of these parameters is rarely available in developing countries, therefore the exercise becomes one of carefully using available data as proxies. For example a constraint may be binding if historical movements in the constraint produce significant movements in growth; if the shadow price<sup>3</sup> of the constraint is high; if agents in the economy are engaging in significant efforts to bypass the constraint; or if activities less obstructed by the constraint are seen to grow or survive. Constraints in ex-ante risks (such as the anticipation of expropriation) may be signaled by high current profits failing to trigger entry of other firms.

Although the original methodology focused on identifying a single binding constraint – perhaps in reaction to the traditional laundry list approach which disregarded country context – subsequent versions of the HRV have stressed a set of interacting binding constraints. For example poor financial intermediation for smallholder agriculture combined with poor links to export markets can compound the problems faced by farmers seeking to diversify into higher earning export crops.

> 2 Investment is deferred consumption.  The parameter indicates the population’s elasticity for deferment of consumption.

> 3 A shadow price is the change in the price (objective function) due to a relaxation of a constraint at the margin (by one unit)

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|---|---|---|---|---|---|---|---|
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||=<br><br>|=<br><br>|By<br>m—<br><br>|<br>|<br>|oS<br>||
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distribution, finance, construction and manufacturing. The headline data on trade also shows an equivalent change in dynamic: whilst exports have stayed within the region of 20 percent of GDP, the trade deficit has significantly worsened and since 2003 has exceeded 10 percent of GDP.

**Table 1: GDP and sources of growth**

||**95**|**96**|**97**|**98**|**99**|**00**|**01**|**02**|**03**|**04**|**05**|**06**|**07**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
|**National Account ($US m)**<br>||||||||||||||
|GDP ($US m)<br>|1,925|3,149|3,669|2,451|2,447|2,402|2,365|2,665|2,425|2,625|2,755|2,917|3,324|
|Exports, fob ($US m)<br>|444|510|539|539|447|402|427|414|433|499|509|543|706|
|Imports, fob ($US m)|508|588|697|497|573|460|471|595|684|810|1,006|1,055|1,182|
|**Trade ratios (as percentage of**|**GDP)**|||||||||||||
|Exports (fob)|23.1|16.2|14.7|22.0|18.3|16.7|18.0|15.5|17.9|19.0|18.5|18.6|21.2|
|Imports (fob)|26.4|18.7|19.0|20.3|23.4|19.2|19.9|22.3|28.2|30.9|36.5|36.2|35.6|
|Trade balance|-3.3|-2.5|-4.3|1.7|-5.1|-2.4|-1.9|-6.8|-10.3|-11.8|-18.0|-17.6|-14.3|
|**Growth in GDP (factor cost)**|**13.8**|**10.0**|**6.6**|**3.0**|**1.6**|**0.8**|**-3.9**|**1.9**|**3.9**|**5.1**|**2.2**|**8.6**|**9.2**|
|Agriculture|9.8|7.8|0.0|5.3|1.6|2.0|-2.4|1.0|2.3|1.1|-3.5|4.3|3.5|
|Mining, quarrying|0.0|1.5|-0.4|0.1|0.0|0.1|0.1|-0.6|0.2|0.5|0.8|-0.5|0.0|
|Manufacturing|0.9|-0.1|0.1|0.2|0.2|-0.4|-1.8|0.0|0.4|0.8|0.9|0.7|1.0|
|Electricity, water|0.0|0.0|0.1|0.1|0.0|0.1|-0.1|0.1|0.0|0.1|0.1|0.1|0.1|
|Construction|0.1|0.2|0.1|0.0|0.3|0.0|-0.1|0.3|0.3|0.3|0.4|0.4|0.9|
|Distribution|0.6|-0.2|3.7|-1.6|-0.4|-0.1|0.2|0.3|-0.2|1.4|2.8|1.8|1.3|
|Transport, communications|0.9|-0.4|0.4|0.0|0.2|-0.2|0.1|0.6|0.4|0.4|0.5|0.4|1.3|
|Financial, professional|0.7|1.3|2.5|-0.7|0.0|0.2|-0.2|0.5|0.5|0.8|0.7|1.7|1.1|
|Ownership of dwellings|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.1|0.1|0.0|
|Government services|1.0|-0.3|0.2|-0.5|-0.2|-1.0|0.1|0.0|0.2|0.2|0.1|0.3|0.6|

_Source: NSO 1994 series of accounts. GDP is from 2002 series back-adjusted using the 1994 series rates of growth._

# **Maize Production**

Agricultural production and policy is dominated by maize. Although there has been some diversification and a notable increase in smallholder tobacco production, the area under maize cultivation is still roughly equivalent to that of all other crops combined. Over 60 percent of national calorie consumption derives from maize; 97 percent of farmers grow maize; and over half of households grow no other crop<sup>4</sup> . Given Malawi’s vulnerability to drought, the maize harvest is thus central to the welfare of the population, and one of the most important political and social variables. This is reflected by the prominence of food security in public policy. Through the Fertilizer Subsidy Program, the government has made increasing maize yields the mainstay of agricultural policy, and has designated it a “strategic crop” subject to import and export bans (more recently intervening to set the domestic price). Together with good rains, the increased use of fertilizer has increased yields and in the last three seasons has substantially strengthened food security. Given the prominence of maize production in the national dialogue, it seems a reasonable hypothesis that the maize harvest has had a large impact on GDP.

Yet despite the prevailing assumption of the centrality of maize in the economy, the maize harvest drives volatility but does not dominate growth. The per-capita maize harvest is plotted alongside GDP<sup>5</sup> in Figure 5. Following the end of UNFAO monitoring

> 4 Integrated Household Survey, 2005 and Poverty and Vulnerability Assessment, World Bank, 2006.

> 5 The comparison of production weight against value-added is justified here since this series of National Accounts uses fixed baseline prices to construct GDP.

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<!-- Start of picture text --> Exports ($) and GDP, Malawi (WDI)<br>a VF —aay_)_y_s_l_l 1929<br>= 160 ><br>sn —— t= a<br>A}<br>c»<br>§120 a<br>c<br>°<br>2 110<br>a<br>o<br>a 100 topnp-—~4e<br>oO gg SSS—<br>30 50 70 90 110<br>Mechandise exports per capita constant 2000 US$<br><!-- End of picture text -->
<!-- Start of picture text --> 4600 _—\__<br>z=_x1400 SF 4<br>=‘a0 Ligh<br>S 1200 \-<br>o ==<br>Fs SA<br>g 1100 a<br>5 1000 soe5s<br>©<br>BOD : y= 1.896xRe= 0,791+ 599.4<br>100 200 300 400 500<br>Exports per cap (const MK 94)<br><!-- End of picture text --> <!-- Start of picture text --> 4é000 _|_a_OS<br>1400<br>1200<br>1000<br>400 Ss).<br>gogo) —————________—<br>400<br>BREESLLELSSSSRRBEBESOAIHBARIBAIBHSAARR<br>GDP pe (constant 4 MK)<br>—_ Merch Exports oc (constant $4 MK)<br><!-- End of picture text -->
<!-- Start of picture text --> 16<br>#&« 15<br>Gig |Ne<br>a 7 | — 47 ode<br>=$4 | Atawa A\ y =-6E-04xR? = 2E-06 + 12.08<br>i en<br>3 8<br>..l<br>gs 6<br>°<br>2 50 100 160 200 250<br>Ee<br>Maize Production per capita (kg)<br>4600 —§ —— LT. 1600.—_ ——_—<br>1400<br>1500 1200<br>1400 4000 _ASHp>Ymsaav<br>3800<br>1300 600<br>1200 400 ~ 7 — —<br>y= 1.126« + 860.9 200<br>1100 Re=_0.675 0<br>OOODgaggarIaggaoovoTseeoToTonond<br>| |] SSS S SSS SSFRARARAAAA<br>175 275 APS ATS APS<br>—— Merch.Exports pe (constant 94 MK)<br>—— GDP pac (constant94 MK)<br><!-- End of picture text -->
<!-- Start of picture text --> Boo $150<br>400 V/ $90<br>oY * AN I\ —— Merch. Exports pe (constant 94 MK}<br>300 Vy, ay $70<br>non TD7 A Ny- ARN $60 -------VRER (1980100)<br>_ $30<br>— i /<br>Q -$10<br>om OO NNO Or The OM Om Ww<br>SSESSSSESESSSSLSS<br><!-- End of picture text -->
<!-- Start of picture text --> 110<br>papnecpaderdng<br>Oe100 earligi ere 2" oe Wa! a vo - GeRa anor)<br>i vores<br>a on — Natl<br>tal ee hk A f<br>30 a ee ——<br>PO10 SBP IMVWK<br>5 Tp) ZAR Mk<br>65 CSV' — USD: MvviK<br>50<br>Oe OdO POO DOO aOnDOntnOwDODwOnnwan<br>Secorve ese eq1oo0c See qCcoovoc eoo<br>Oooeeore 20 C0 C020 SCTS8 CTO C20 C09<br>SALATUN NMALA ALAMTADA AUNoorAUStnaNANaorTAN NONANS<br>Beoeo0eoeO0THe E0002 2987 TTT e<br>CT NNNsO TOO sp Toe NNTe NPN Oe OM<br><!-- End of picture text -->
<!-- Start of picture text --> YS<br>¥ 680 _—\_aoS—Ss————. | Ss)<br>= 54500 £_ 30<br>+2 400 oNSs 7<br>£300 aom 20<br>2 gr 16<br>5 100 Hi 66<br>a<br>i=]<br>EFba2 PEFPFELESs NbSELES& $ GSLS SoooSSSSesggsssseeeameooos,s Aezeecrccc oO fo<br>SEdible nuts @ Cotton #Apparel Tea @ Sugar @ Tobacco | Other —Apparel —— Cotton —— Edible nuts<br>150,000t<br>—— Tobacco<br>100,000 t —Tea<br>—— Sugar<br>— Catton<br>50,000 t —- RiRice<br>0,000 t - a ‘ = — —— PulsesCoffee<br>Sh s a) AS<br><!-- End of picture text -->
<!-- Start of picture text --> viesMKMean450 NA LSC a A<br>een 9AeA Oe<br>wean WANT<br>meas NE<br>MK 200 ee ee eee<br>wigs _ Aae<br>wkioo LT EAE 49<br>wkso _<br>wko MY |<br>OTN VM TwoOOrFeOOA M OoOTw o rHTwor ©<br>BRRSRISSSSSSSSRRE SS<br>gum Real Auction Price (MK 2008) t-1<br>—— Tobacco auction sales per capita<br><!-- End of picture text -->

<!-- Start of picture text --> ms<br>a<br>5 13g<br>5<br>S itkg<br>3 y = 0.038 +4.655<br>= Re=0.447<br>3<br>7k<br>100 150 200 250 300<br>t-1 tobacco price (const MK 2008 per kg)<br><!-- End of picture text -->
Giving: Or, expressed in real dollar prices and the real exchange rate (  ): Since the real domestic price of exports is equal to the dollar price converted by the real exchange rate, a depreciation in the real exchange rate is likely to increase GDP both by increasing the supply response and by increasing real export revenue. Alongside the domestic price of key exports, this analysis suggests that the real exchange rate has been, and continues to be, a central policy instrument of growth for Malawi.

However, the role of agricultural exports in explaining growth together with a lack of diversification into new sectors reveals a key weakness of the economy. Recent growth can be explained in large part by rises in the tobacco price and improvements in the real exchange rate. Yet expansion based on increased tobacco production does not appear to be a viable strategy for the medium to long term. The majority of Malawi’s tobacco crop is burley which is used mainly as a neutral flavored filler in the market for high-end cigarettes. Although expanding, there is a ceiling on world demand for such tobacco which the industry manages with care. There are also industry indications that recent high prices are due to buyers having unwound their stocks and are now rebuilding. It is unlikely that Malawi could multiply up tobacco production over the medium term without bringing about a decline in world market price.

The lack of diversification into new export sectors puts heavy reliance on the tobacco channel, and commits the economy to growth constrained by world demand for a niche product. A failure to diversify into new export products thus constrains Malawi’s growth and renders the economy vulnerable to adverse price shocks when they occur in the future.

# **D. THE PATTERN OF GROWTH**

How does export growth translate into general growth of the economy? This section considers the transmission mechanism by looking at investment dynamics, sectoral behavior and aggregate demand.

# **Investment**

The behavior of investment is difficult to map accurately in Malawi. Methodological problems and a reluctance by firms to declare their plans has hampered formal sector efforts; and it has been extremely difficult to assess the investments – often in kind – of rural farmers. Tiny outlays in livestock, soil fertility, curing barns, fruit trees are often

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weakly related. However between 1995 and 2003 the macroeconomic environment was extremely hostile. Nominal lending rates exceeded 45% for three-quarters of this period, and inflation peaked at over 90% early on in 1995. It is extremely difficult for any private investment to weather such a macroeconomic winter, and thus plausible that investment failed to respond in this period due to this instability.

Incorporating the dampening effect of macro-instability during 1993-2005, it is likely that investment - like output - is also affected by the demand effect from export revenues. Although investment data is not disaggregated, the next section investigates the output response of each sector. The pattern of growth is indicative of the factors which constrain growth.

# **Sectoral Pattern**

The sectoral pattern of GDP confirms a lack of transmission during the macro-instability of 1993-2003, and presents growth diffusing through the sectors starting with agriculture. The pattern is particularly clear from 2002 where growth resumes in agriculture and diffuses through to financial services, distribution, manufacturing, transport/ communications and eventually through to construction.

**Table 2: Sectoral contributions to growth in GDP**

||1996|1997|1998|1999|2000|2001|2002|2003|2004|2005|2006|2007|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|Agriculture, Forestry and Fishing|7.8%|0.0%|5.3%|1.6%|2.0%|-2.4%|1.0%|2.3%|1.1%|-3.5%|4.3%|3.5%|
|Financial and Professional Services|1.3%|2.5%|-0.7%|0.0%|0.2%|-0.2%|0.5%|0.5%|0.8%|0.7%|1.7%|1.1%|
|Distribution|-0.2%|3.7%|-1.6%|-0.4%|-0.1%|0.2%|0.3%|-0.2%|1.4%|2.8%|1.8%|1.3%|
|Manufacturing|-0.1%|0.1%|0.2%|0.2%|-0.4%|-1.8%|0.0%|0.4%|0.8%|0.9%|0.7%|1.0%|
|Transport and Communications|-0.4%|0.4%|0.0%|0.2%|-0.2%|0.1%|0.6%|0.4%|0.4%|0.5%|0.4%|1.3%|
|Construction|0.2%|0.1%|0.0%|0.3%|0.0%|-0.1%|0.3%|0.3%|0.3%|0.4%|0.4%|0.9%|
|Producers of Government Services|-0.3%|0.2%|-0.5%|-0.2%|-1.0%|0.1%|0.0%|0.2%|0.2%|0.1%|0.3%|0.6%|
|Electricity and Water|0.0%|0.1%|0.1%|0.0%|0.1%|-0.1%|0.1%|0.0%|0.1%|0.1%|0.1%|0.1%|
|Private Social and Community Services|0.2%|0.2%|0.0%|0.0%|0.1%|0.1%|0.1%|0.1%|0.1%|0.1%|0.1%|0.1%|
|Ownership of Dwellings|0.0%|0.0%|0.0%|0.0%|0.0%|0.0%|0.0%|0.0%|0.0%|0.1%|0.1%|0.0%|
|Mining and Quarrying|1.5%|-0.4%|0.1%|0.0%|0.1%|0.1%|-0.6%|0.2%|0.5%|0.8%|-0.5%|0.0%|
|Unallocable Finance Charges|-0.1%|-0.4%|0.1%|-0.3%|-0.1%|0.1%|-0.5%|-0.3%|-0.6%|-0.7%|-0.7%|-0.7%|
|Growth in GDP at Factor cost|10.0%|6.6%|3.0%|1.6%|0.8%|-3.9%|1.9%|3.9%|5.1%|2.2%|8.6%|9.2%|

_Source: National Statistics Office, National Accounts 1994-2007_ The largest contribution to growth comes from agriculture, nearly all of which is attributed to the smallholder sector. Although likely that smallholder output has been overestimated<sup>10</sup> , the sales of rural retail networks and recent growth in livestock indicate that significant rural growth is taking place.

However other factors have been in play alongside the stimulus from agriculture. Financial reform since the 1980s catalyzed growth in the banking sector enabling the number of banks to expand from two in 1994 to nine in 2008. A relaxation of state

> 10 Small holder production of root crops and more recently of maize may be significantly overstated.  The Agricultural Census for 2007 compiled by the NSO is due to be released soon which will enable triangulation of these estimates.

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<!-- Start of picture text --> 6%<br>5% meme Distributionae<br>An Mle Financial and Professional Services<br>a mums Transport and Communications<br>2% memes Manufacturing<br>1% Ga Construction<br>0% —O— Nor-agriculture growth<br>nna nn nn nF nn?<br><!-- End of picture text --> <!-- Start of picture text --> 160<br>140<br>120 a<br>100 Na"-<br>80<br>60<br>40 — _——<br>EL 7<br>20<br>0<br>FE EE4 EES SKFSS Sh SFa} FS<\<br><!-- End of picture text --> Other

- = Plastic Products and Tyre Retreading = Non Metallic Products = Textiles and clothing | Tobacco,tea and wood = Chemicals and pharmaceuticals = Packing Materials, Printing and Publishing = Metallic Products (including machinery)

- = Food and beverages
<!-- Start of picture text --> $1400m<br>$1200m “<br>$1000m a |<br>$800m 4 | | sum Govttransfers($m)<br>an _—— “Ens a mum = Exports, fob ($m<br>a YT ee —=— Imports,fab ($m)<br>$4oom SO Nea cm)<br>vom SO DD 8 DO crosant omissions<br>SERRE= “7 \ ofé EER‘ EARNS. 4<br>$20m @\s/e-8--86 =8s= > 45 = 3ho ho8 ho8 ho8 ha8 38.Lan<br>“400m ————_________<br><!-- End of picture text -->
<!-- Start of picture text --> Import composition (real USD 2005)<br>Consumption BB%<br>a<br>Intermediate 50%<br>Goods fo<br>Investment<br>Goods<br>|_|<br>O 200 400<br>ef4-0R mo4-n3<br><!-- End of picture text -->

<!-- Start of picture text --> Current-account balance/GDP<br>BaaBaeaoeeo5gbgG558<br>PBP P RA AAA AAA<br>oo, ERR Ts<br>4% wee ea<br>“B% See<br>“B% CLE el eeGT hea<br>10% te ee ee ii<br>19% | ff =S<br>14% | eT<br>-18Y“ee a_i<br><!-- End of picture text -->
<!-- Start of picture text --> 0% - Absorption ofaid into the CA deficit<br>18% + Pr “ owe<br>16% 4 /<br>4% 4 rNA -/<br>1% ‘ af<br>10% | ~< ‘<br>8% 4<br>6%5 |<br>4% 4<br>2% 4<br>20002001 200220032004 200520062007 20082009<br>4 _.<br><!-- End of picture text -->

<!-- Start of picture text --> 18% Aid spending<br>168%<br>14% -se Ls<br>12% |. . y<br>10% S47 8<br>7 .<br>8% /<br>B%<br>4%<br>2%<br>sBy & s & SS Fe<br>se FFF SKS 4<br>——— Fisral aid inflaws - -— — — Fiscal rlefirit hefnre aid<br><!-- End of picture text -->
|Aid|per capita 2006|Aid|/ GDP 2006|Aid/Mer|chandiseexports|
|---|---|---|---|---|---|
|Zambia<br>Namibia||Burundi<br>Mozambique||Burundi<br>FRivanda||
|Mozambique||Malawi||Uganda||
|Rwanda||Rwanda||Malawi||
|Uganda||Zambia||Tanzania||
|Malawi||Uganda||Benin||
|Burundi||Tanzania||Mozambique||
|Benin||Benin||Zambia||
|Ghana||Ghana||Kenya||
|Tanzania<br>Kenya||Kenya<br>Namibia||Ghana<br>Namibia||
||$0<br>$50<br>$100||nh<br>1N%<br>Nn||NA<br>Anns<br>Anna|
<!-- Start of picture text --> 1600 GDPper capita and aid 40.0%<br>1400 35.0%<br>1200 30.0%<br>1000 25.0%<br>800 20.0%<br>B00 15.0%<br>400 10.0%<br>200 5.0%<br>0 0.0%<br>ONTOMOONTeDoONTeDoONTe!PPKFASGAAASAAHHSISSPH OOOOH SES<br><!-- End of picture text --> <!-- Start of picture text --> 200% RER and aid/exports 120<br>180%<br>180% wtaon 100<br>140%190% ‘\~ owoNN 80<br>100% - ‘wnmn) 60<br>a0%° ul Noy 40<br>B0%<br>40% an<br>20%<br>OM 0<br>owLeeAAMMAAAMAAMAAAAAaHMOCoOoSSSR SSORO SSOOoSS SS SS RARAoOooS<br><!-- End of picture text -->
Yet the persistently low level of public investment implies that aid is not sufficiently financing supply-side improvements to increase productivity. Whereas aid rose by 4.1% of GDP between 2003/04 and 2007/07, figures from the Ministry of Finance state that gross fixed capital formation only rose by 1.7%. Similarly in aggregate, public investment only amounts to around 40% of aid inflows. This implies that in excess of 60% of aid (since some investment will have been domestically funded) is used for recurrent or consumption spending – greatly limiting its ability to increase productivity.

The data is consistent with the theoretical prediction that aid exerts some appreciation effect on the currency caused by the need to increase private import demand, but this is mitigated by direct imports of the government’s fertilizer program, and probably by other aid funded projects with high import components. It is thus unlikely that aid strongly constrains growth through competitiveness effects, but because of the small proportion of aid allocated to supply-side investment, it is also having limited positive effects on productivity. Although Malawi currently uses aid for social development the data presented suggests that this aid only weakly supports growth. This is a missed opportunity likely to prolong low levels of output and income, and dependence on external financing.

# **Does Malawi Have a Syndrome?**

The analysis of Malawi’s growth dynamics reveals the following:

1. Growth is primarily driven by the domestic multiplier from export revenues.

2. Devaluation of the real exchange rate has had a strong beneficial effect on growth.

3. Growth has fed mainly into the non-tradeable service sectors and there has been very limited diversification into new export sectors or domestic ISI. This is despite evidence of strong consumption demand from imports.

4. Macroeconomic instability 1995-2003 dampened investment and prevented growth transmission out of agriculture.

5. Import elasticities reveal a low marginal propensity to invest.

6. Relatively high aid flows have been absorbed into a large current account deficit (14% GDP).

The lack of response from ISI or new export sectors in the face of booming consumer imports and low reserves of foreign exchange strongly implies that the exchange rate is still overvalued. Despite dramatic improvements in the variable since 1980, it seems that there is still further to go. The source of this overvaluation cannot all be attributed to foreign exchange income. Although by law a managed float, the exchange rate remains de-facto a fixed regime with step devaluations. Malawi persistently faces shortages of foreign exchange indicating that the overvaluation is at least partly due to the management of the fixed peg and may be influenced by reasons of welfare and political economy. An overvalued exchange rate lowers the price of key goods such as fuel and fertilizer and provides the urban populations more access to consumer imports.

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From this analysis the economy could be characterized by the syndrome “ _High-value monocrop export economy with overvalued exchange rate”_ . This syndrome is a variant on Dutch Disease with the distinction that overvaluation is due as much to policy as to export revenues from the booming sector. In such a case we would expect to see the following symptoms:

- GDP is highly sensitive to crop export revenue, and crop price.

- Over-valuation of the exchange rate undermines the competitiveness of nonmonocrop sectors.

- Growth occurs only in non-traded service sectors without import competition.

- There is low growth in import substituting industrialization because of competition from imports.

- There is difficulty in developing new export industries due to the high profitability of the monocrop.

These symptoms are demonstrably present in Malawi, and the economy has responded rapidly to improvements in the real exchange rate. The state of the current account, high growth in consumer imports and the weak growth of ISI manufacturing are strong indications that further carefully managed devaluations of the real exchange rate would have beneficial effect.

# **III. HRV CONSTRAINTS MATRIX**

Although Malawi’s recent growth has been strong, the lack of investment in tradeable sectors, and smallholder productivity (particularly irrigation and livestock) raises questions of its sustainability and robustness. In addition to the exchange rate, it is clear that other constraints operate which deter investment in external or domestic industries. The following section uses the HRV constraints matrix presented earlier to further analyze the causes of low investment and entrepreneurship in Malawi. We discuss in turn whether investment is constrained by finance, complementary factors, government failure or market failure.

## **E. IS GROWTH CONSTRAINED BY FINANCE?**

The banking sector has undergone substantial reforms since the 1980s with foreign investors entering the market from 1994. Deregulation has increased the number of banks from two in 1994 to nine in 2008. Despite this, in the ICA survey (WB, 2006) businesses quote “cost of finance” and “access to finance” as the top two most severe constraints after macroeconomic stability. Furthermore informal firms report that “access to finance” is their _most_ serious constraint. While real lending interest rates have been

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decreasing with improvements in the fiscal position since 2004, interest rates and nominal spreads still remain very high compared to peers.

**Figure 24: Real lending and deposit interest rates**

<!-- Start of picture text --> Ex-ante real interest rates Real lending interest rate (%)<br>50<br>40 Malawi<br>30 Uganda<br>20 Mozambique<br>10<br>Burundi<br>0<br>Botswana<br>-10<br>-20 Tanzania<br>-30 Zambia<br>-40 South Africa<br>-50 Ghana<br>Lesotho<br>Kenya<br>Lending Deposit<br>0 4 8 12 16<br>1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008<br><!-- End of picture text --> _Source: International Financial Statistics, IMF_ Since reform, private investment has shown some elasticity to the real lending rate (although as already discussed the data is patchy): private investment collapsed during the high inflation and high interest rates of 1995-2003, and NSO data suggests a strong recovery associated with lower interest rates from 2004.

For the informal sector which includes rural smallholders, access to finance is reported as the most important constraint to growth<sup>12</sup> . In 2004, 14% of rural households had access to a loan but only 4% from a formal financial institution (IHS, 2005). Rural households have an exceptionally low asset base – only 26% of own a bed, 2% own an oxcart (ibid) – which greatly impedes self-financed investment. The PVA (WB, 2006) argues that illiquidity prevents investment, since farmers revert to traditional crop varieties using minimal inputs. The authors perform a regression into the determinants of yield efficiency and conclude that liquidity considerations through credit or assets have the strongest effect of all variables on the yields of both maize and tobacco<sup>13</sup> . Similarly a regression performed on the determinants of commercial cropping, found that liquidity factors were also strongly associated with the decision to grow cash crops<sup>14</sup> . The significance of the smallholder liquidity constraint is illustrated by the substantial supply response created by the Input Subsidy Program since 2006.

# **Savings Supply**

Do high interest rates result from a shortage of savings? Real deposit rates have hovered around zero since 2004 indicating that banks have made little effort to attract savings.

> 12 84% of informal firms reported access to finance as a serious obstacle to growth (ICA, WB, 2006) 13 p179, Malawi PVA Volume II, World Bank, 2006

> 14 P209, ibid

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<!-- Start of picture text --> 208. acl<br>18%<br>hasea,<br>12%<br>10% —— Domestici creditto<br>8% private sector (%4<br>BM GDP)<br>— Domestic credit<br>aa2% to<br>Df ott publicGOP} sector (%<br>ce) sv 7<br><!-- End of picture text --> <!-- Start of picture text --> Credit to the private sector (% GDP)<br>Narnibia<br>Kenya<br>Burundi<br>GhanaBani<br>enn<br>MozambiqueRwanda<br>TanzaniaZambia<br>UgandaMalawi<br>a 20 40 60 80<br><!-- End of picture text --> <!-- Start of picture text --> Nominal Spread (2006)<br>Malawi<br>Zambia<br>Uganda<br>Kenya<br>Mozambique<br>Botswana<br>Ghana<br>Narnibia<br>Swaziland<br>South Africa<br>n in an An<br><!-- End of picture text -->
<!-- Start of picture text --> Road density (km) per 000 people<br>Zambia<br>Ghana<br>Uganda<br>Benin<br>Tanzania<br>Kenya<br>Burundi<br>FRivanda<br>Mozambique<br>Malawi<br>a 5 10<br><!-- End of picture text --> <!-- Start of picture text --> =<br>a<br><!-- End of picture text -->
improvement, it is unlikely that the domestic road network is currently a binding constraint to growth. However, as discussed later in the chapter on spatial dimensions to growth, the road investments likely to have the highest impact on agricultural growth are feeder roads in areas with high agronomic potential and only moderate connectivity to major cities.

# **Import-Export Infrastructure**

The areas immediately adjacent to Malawi in neighboring countries have relatively low populations - Eastern Zambia and North-Western Mozambique – resulting in limited potential for regional trade with direct neighbors. As a result most imports and exports require international shipping giving Malawi a dependence on transit countries for infrastructure, procedures and the logistics performance of foreign ports.

In the absence of a comprehensive transport study, it is difficult to obtain reliable data on the cost of trade transport and hence establish whether transport infrastructure currently constrains growth – either for the export sector or for import intensive industries for the domestic market. Faye et al (2004) estimated that total transport costs as a proportion of exports were as high as 55% making Malawi an exceptional outlier even among landlocked countries. Taken at face value, this data would imply that weak trade infrastructure was a binding constraint on growth, and that investment was likely to respond strongly to improvements in regional infrastructure.

Yet other sources do not corroborate these findings. Firstly using 2006 IFS data, the cost of transport and insurance as a proportion of imports<sup>17</sup> puts Malawi among comparators at about 15%. Secondly the Doing Business Indicators also rank Malawi as comparable to peers for the cost of importing/ exporting a twenty foot container. The DBI data also shows a significant premium on importing caused by the trade deficit, since the number of import journeys outnumbers export journeys. Thirdly anecdotal evidence from the main commodity exporters put transport costs at between five and ten percent of export value (see Trade Facilitation and Transport chapter).

> 17 That is (imports (CIF) – imports (FOB)) / imports (FOB)

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<!-- Start of picture text --> a RwandaUganda |<br>Botswana<br>Zambia<br>Kenya (|<br>SwazilandMalawi —— |<br>Narnibia a container)Castta export (US$ per<br>TanzaniaLesotho = Costcontainer)to import (US$ per<br>Madagascar<br>TOOT Benin<br>Mozambique<br>Gambia a |<br>fh ana anAN Anan anna snnn<br><!-- End of picture text -->
<!-- Start of picture text --> SEBO MA |<br>330, Mh pa<br>s1oMWw /<br>290 MV =<br>2FOMVY<br>350 MV — ——— Installed capacity<br>230 MW > =" ——_Current capacity<br>210 MW _-*" ~ ------- Net peak load<br>190 MW -<br>VID MW)<br>TwmwWonrewowoemornwt oaotrwoorewdbi wo<br>SSESSSSESSSSESS<br>SE<br><!-- End of picture text -->
**Figure 30: Sales losses due to power outages and firms with generators**

<!-- Start of picture text --> Median sales losses due to power % of firms with generator<br>outages<br>Malawi Kenya<br>Tanzania Tanzania<br>Madagascar Malawi<br>Kenya Zambia<br>Zambia Uganda<br>Uganda Madagascar<br>South Africa South Africa<br>SSA SSA<br>Low income Low income<br>0% 2% 4% 6% 8% 10% 0% 20% 40% 60% 80%<br><!-- End of picture text --> _Source: Malawi Investment Climate Assessment, 2006_ Quality of electricity supply was cited as the forth most serious obstacle to growth by firms in the ICA (World Bank, 2006) and as the primary obstacle given by the 2008 Malawi business climate survey conducted by the Malawian Chamber of Commerce. Additionally there have been specific investment decisions negatively influenced by electricity supply. Inconsistent quality of supply was cited by cigarette manufacturer BAT for moving its operation out of Malawi; the proposed extraction of titanium heavy sands from the lake was cancelled for the same reason; and similarly several potential textile investments were never realized. Power outages damage product quality in the dairy industry, require extensive cleaning of equipment in the plastics industry, and result in high losses in thread spinning (where consistent power is required to produce even width of threads). Firms go to expensive lengths to get around the constraint. Paladin, a mining company in the process of commissioning the uranium mine at Kayelekera, is using diesel generators at a operating cost greatly higher than the industrial electricity tariff.

The state electricity company is currently unable to provide a reliable source of power to businesses resulting in significant losses and deterring investment in power sensitive industry. The lack of reliable power supply significantly lowers social returns and hence is likely to be a binding constraint to growth.

# **Irrigation and Rainfall**

The vast majority of agricultural production is rain-fed. Historically Malawi has experienced serious droughts (1992, 1994, 1997, 2002, 2005) and floods, both of which have impeded agricultural productivity, damaging both agricultural land and crops. This rainfall variability is thought to have intensified risk-averse behavior by farmers and investors in agricultural industries and services, limiting diversification into other cash crops.

How much does rainfall contribute to economic growth? Although a total drought clearly collapses all agriculture (and hence GDP) the data suggests that different rainfall requirements of different crops probably diversifies the economy’s overall sensitivity to a

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<!-- Start of picture text --> Maize production per capita<br>250<br>_a<br>200<br>& 150<br>.<br>2 100<br>60<br>3<br>a 50 100 160<br>eon= 2 28x ag1- 7421 Rainfall; Index (MMI)<br><!-- End of picture text --> <!-- Start of picture text --> Tobacco auction sales per capita<br>18<br>_> 14<br>Pare<br>2 10<br>2 og<br>a2 5<br>FE:<br>Zz?<br>a o 50 100 150<br>y=-O.014emee nnd+ 1945 Rainfall. Index (MMI)<br><!-- End of picture text -->
<!-- Start of picture text --> Primary school completion<br>(% of cohort)<br>Zambia.<br>Narnibia<br>Tanzania<br>Kenya<br>Burundi<br>Ghana<br>Mozambique<br>Benin<br>Uganda<br>Rwanda<br>Malawi<br>o% 50% 100%<br>SLowerprimary Overall primary<br><!-- End of picture text --> Primary pupil-teacher pupil-teacher ratio <!-- Start of picture text --> Primary pupil-teacher pupil-teacher ratio<br>Namibia<br>Ghana<br>Kenya<br>Benin<br>Uganda<br>Zambi<br>am la<br>Tanzania<br>Burundi<br>Rwanda<br>Mozambique.<br>Malawi<br>Q 20 40 60) 80<br><!-- End of picture text --> <!-- Start of picture text --> Tertiary enrollment<br>Namibia<br>Ghana<br>Uganda<br>Benin<br>Kenya<br>R d<br>wan a<br>Zambia<br>Burundi<br>Mozambique<br>Tanzania.<br>Malawi<br>0% 2% 4% 6% 8%<br><!-- End of picture text --> <!-- Start of picture text --> Std6 Literacy and Numeracy Scores Percentageof pupils attaining level5<br>Kenya Tanzania<br>Tanzania Kenya<br>Mozambique Swaziland<br>Swaziland Mozambique<br>Botswana Botswana<br>Uganda South Africa<br>South Africa Uganda<br>Lesotho Zambia<br>Namibia Namibia<br>Zambia Lesotho<br>Malawi Malawi<br>400 450 500 550 600 0 20 80 A<br>SNumeracy Literacy =Numeracy Literacy<br><!-- End of picture text -->
<!-- Start of picture text --> Average sales of tobacco<br>aa<br>940,00 || Pm<br>36,000 ©ee<br>30,000 —<br>25,000 =a aa<br>90 O00 at fel<br>16.000 _——_| | | | | | | |<br>en a Oe<br>soo BOSE TETEETT<br>, MEP EE EEE<br>weSPSSSS SELES<br><!-- End of picture text -->

<!-- Start of picture text --> HH Expenditure by education level<br>00,00 A<br>700,000<br>600,000<br>500,000<br>400,000<br>300,000<br>eee san<br>100,000 «pura<br>0<br>PE(3) SF EF S —<br><!-- End of picture text -->
Malawi’s land expansion has been the second fastest among comparators averaging 2.2% per year between 1980 and 2005.

**Table 5: Land in comparator countries**

||**Arable land per capita**<br>**(hectares)**|**Total land per capita**<br> **(hectares)**|
|---|---|---|
|Zambia|0.46|6.36|
|Namibia|0.40|40.2|
|Benin|0.32|1.26|
|Tanzania|0.24|2.24|
|Mozambique|0.21|3.75|
|**Malawi**|**0.20**|**0.69**|
|Uganda|0.19|0.66|
|Kenya|0.15|1.56|
|Rwanda|0.13|0.26|
|Burundi|0.12|0.31|
|Vietnam|0.08|0.36|
|Bangladesh|0.05|0.08|

_Source: WDI, 2006_ Additionally some land is lying fallow as households are only cultivating about 80% of their plots. The IHS (2005) reported that on average household plots were about 1.2ha of which 1ha was cultivated. The PVA (World Bank, 2006) further concludes that the relationship between household wealth and land holding size is not very strong indicating that availability of land is not an immediate binding constraint on smallholder incomes<sup>21</sup> . This is confirmed by the experience of Asian countries which surmounted the problems of population density through irrigation and technology. Even after the expansion of arable area ceased, the intensification of smallholder farming has provided the underlying driver of diversified growth.

Much greater reserves of unutilized land still exist in the estate sector. A 1998 study estimated that 45% of the 1.1 million hectares of estate land was not under cultivation<sup>22</sup> . Low government rents have encouraged the retention of this land for speculation. Furthermore Malawi has made significant progress in developing a land policy – yet to be enacted into law - which brings all ownership under a single land tenure arrangement. The short-term land rental market is extremely active and expropriation of land has not been, or perceived to be a problem for investors (ICA, 2006). Although the regularization of land tenure and the resettlement of idle estate lands is a priority, it is unlikely that access to land is currently a constraint to growth.

> 21 Agricultural growth and productivity in Malawi, , Malawi PVA Volume II, World Bank, 2006 22 ibid

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<!-- Start of picture text --> Global Competitiveness Index 2008-09 Competitiveness Index 2008-09 Index 2008-09 2008-09<br>Labor market efficiency market efficiency efficiency<br>Institutians ——<br>Financial market sophistication market sophistication sophistication ——<br>Goods market efficiency market efficiency efficiency<br>Innovation ——<br>Business sophistication<br>Higher education and education and and training ———<br>Infrastructure<br>Overall;; Ranking:: See||<br>Health and primary education SS<br>Maes.<br>Technological readiness<br>Macroeconomic stability —— tf<br>go 20 40 60 80 100 120 140<br><!-- End of picture text -->

<!-- Start of picture text --> Corruption Perception Index - 2008 2008<br>Botswana<br>South Africa Africa<br>Namibia<br>Ghana<br>Lesotho<br>Benin<br>Tanzania<br>Rwanda<br>canbe<br>Uganda<br>Mozambique<br>Kenya<br>Burundi<br>a 50 100 150 200<br><!-- End of picture text --> Corruption Perception Index - 2008 2008 Global Competitiveness Index 2008-09 Competitiveness Index 2008-09 Index 2008-09 2008-09 Botswana Labor market efficiency market efficiency efficiency South Africa Africa Institutians —— Namibia Financial market sophistication market sophistication sophistication —— Ghana Goods market efficiency market efficiency efficiency Lesotho Innovation —— Benin Business sophistication Tanzania Higher education and education and and training ——— Rwanda Infrastructure canbe Overall;; Ranking:: See|| Uganda Health and primary education SS Mozambique Maes. Kenya Technological readiness Burundi Macroeconomic stability —— tf a 50 100 150 200 go 20 40 60 80 100 120 140
<!-- Start of picture text --> Doing Business Indicator Ranks<br>;<br>Benin<br>Mozambique<br>Malawi<br>Uganda<br>Ghana<br>Botswana<br>South Africa<br><!-- End of picture text --> <!-- Start of picture text --> Malawi's Ranking<br>Protecting Investors<br>Paying Taxes<br>Getting Credit<br>Registering Property<br>Employing Workers<br>Starting a Business<br>Dealing with Licenses<br>Overall ranking<br>EnforcingClosing a BusinessContracts<br>Trading Across Borders<br><!-- End of picture text --> <!-- Start of picture text --> Documents required to export<br>Uganda<br>Ghana<br>Benin<br>South Africa<br>Rwanda<br>Burundi.<br>Malawi<br><!-- End of picture text -->
input or product marketing chains will also stimulate growth by creating a production response.

Is there market failure in agricultural input and product chains? An analysis of the efficiency of agricultural value chains is presented in later chapters but outline results indicate that several market failures artificially lower smallholder profits. Firstly, prices of fertilizer are higher in Malawi than Zambia or Mozambique. This is partly explained by higher external transport costs, and poor timing in procurement arrangements, but it is also due to higher dealer mark-up – estimated at 16% in Malawi compared to 5% in Zambia and less in Mozambique. Although it is not clear whether this is because of monopoly power or the ex-ante risk of government intervention preventing market entry, the high mark-up inhibits a growth response.

Secondly large efficiency improvements are likely in product marketing chains. The tobacco marketing process, being the dominant export, is a particular example of this. Most tobacco is sold at auction using the floors run by Auction Holdings Ltd (AHL). Smallholders pay transporters to bring their tobacco bails to an auction floor, which on arrival can wait for over three weeks on the back of a lorry before it clears the queue. Alternatively bails are deposited in a TAMA (Tobacco Association of Malawi) depot and transported later. This protracted process results in significant losses to the grower. The transporter charges not only for transport but also for the de-facto warehousing service that the truck provides; those directing the queue have ample opportunities for rent seeking; and bails left in depots are prone to theft (partial or total) or switching of the crop. As a result the shadow price of avoiding the auction queues is high. Producers will often sell tobacco at a huge discount to intermediate traders who take their place in the auction process. Alternatively many growers prefer to export their crop informally to Mozambique or Zambia which have rural markets run by buyers. Many of these operate contract farming, but Malawian growers often prefer to receive immediate payment at contract farming prices (with the cost of inputs deducted) than wait and sell on the auction floor in Malawi.

Thirdly the spatial location of market centers has a strong impact on production response. Tobacco production clusters around the auction outlets of Lilongwe, Kasungu and Limbe, and despite high agronomic potential elsewhere, the IHS data (NSO, 2005) reveals that cropping intensity rapidly trails off with travel time to market centers. The spatial dimensions to growth are discussed in a later chapter, but the clustering of export crop smallholders around market centers is also seen for sugar, tea and cotton.

Because of the demonstrated supply response to farm gate prices, improving efficiencies in the value chain or in reducing travel times to product markets will feed directly into growth. Although more work is required to establish the marketing chains with potential for improvements, there are strong signals that inefficiencies in tobacco marketing results in high additional costs to growers from transporters, traders and risks from rent seeking and theft.

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# **IV. CONCLUSIONS**

Malawi is an export-led economy. Despite changes in the structure of agricultural production, and liberalization of prices, exchange and finance, a long standing relationship persists between export income and overall GDP. The driver of the economy has been real domestic revenue from exports which has created growth by stimulating non-tradeable services, and to a limited extent import substituting industrialization. Malawi has faced chronic deterioration in its terms of trade since the 1970s but has recovered largely due to improvements in the real exchange rate and more recently the tobacco price. The economy has proved highly sensitive to movements in both these variables since improvements (a) cause an immediate rise in real domestic export revenue which multiply through the rest of the economy; and (b) incentivize a production expansion by increasing tradeable returns.

However there are strong signs that despite progress the real exchange rate is still overvalued. Recent strong growth in the demand for consumer imports has failed to stimulate much of a response from domestic manufacturing. There has been extremely poor progress in diversifying out of the traditional exports of tobacco, sugar and tea. There are widespread and persistent shortages of foreign exchange, low reserves and the current account has a higher deficit than any comparator economy. Malawi is in effect running a fixed exchange rate system artificially overvalued not just from revenues from the booming tobacco sector, or aid which finances the capital account, but from government policy that incentivizes importing at the expense of exporting.

1. Growth is primarily driven by the domestic multiplier from export revenues.

2. Improvements in the real exchange rate since 1980 have been strongly beneficial to growth.

3. Growth transmission has run from agriculture to non-tradeable services and only minimally to domestic manufacturing. This is despite strong demand for consumer imports.

4. Thus the exchange rate is still overvalued leading to a strong disincentive to invest in the tradeable sector or in import-substituting industrialization.

5. A macroeconomic winter 1995-2003 suppressed investment through high inflation and interest rates, which prevented growth transmission out of agriculture.

6. Malawi’s large current account deficit (14% GDP) is financed by aid.

Aid inflows are substantial relative to the size of the external sector and have probably contributed to exchange rate appreciation. This effect has been mitigated by the increase in direct public-sector imports particularly from the fertilizer subsidy. But aid has had a limited effect on long-term productivity since it predominantly finances consumption and recurrent expenditure. Expenditure data from the Ministry of Finance indicates that less

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than 40 percent of aid is used for investment. Without financing increases in productivity, aid risks doing long-term damage to growth by appreciating the currency and creating disincentives in the export sector. Because of the centrality of the export sector to Malawi’s economy and its sensitivity to the real exchange rate, it is vital that the use of aid is realigned to support export-led growth.

The most binding constraint on the economy is thus the real exchange rate which can only be ameliorated by a careful managed devaluation to ensure that price stability is maintained. In addition, the analysis further identifies other constraints using the HRV framework which are binding on marginal investment in Malawi: _Financial Binding_ . High overheads have created high real lending rates which _Intermediation_ currently constrain investment. Very limited access to formal finance for smallholders reduces the production response of rural farmers to price signals.

_Power Binding_ . The lack of reliable power source significantly lowers social returns, and deters new investments in manufacturing and mining. The lack of rural power additionally exacerbates deforestation.

_Education Binding or imminently binding_ . Extremely weak performance in quality and access, and evidence of high returns to primary education from cash cropping and tertiary from formal sector employment. Moderate signals of skills shortages from business surveys. The long lead time of reforms suggest that the quality of primary education in Malawi should be addressed with urgency.

_Export value Binding_ . An increase in farm-gate prices achieved through efficiencies _chains_ in input or product marketing chains stimulates growth by increasing the production response _and_ the domestic multiplier. Efficiency improvements are probable from regional infrastructure improvements, administrative barriers to trade, and the domestic input and marketing chains (particularly tobacco). _Micro policy Secondary_ . Government policy facing the firm generally performs well against peers with the exception of administrative barriers to trade and the unpredictability of interventions in agricultural prices. Price interventions are likely to have raised ex-ante risk, creating monopoly rents and in turn raising the cost of inputs to farmers.

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