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Cover image: “My Blue in the Gold” by Amabel Banda Cover design, interior design and typesetting: Piotr Ruczynski, London, United Kingdom CONTENTS Acknowledgements 7 Abbreviations 8 Overview 9 1 Economic Developments 16 1.1 Global and Regional Context 17 Emerging markets and developing economies have not returned to their pre-pandemic growth path 17 1.2 Recent Economic Developments 20 Growth remained low amidst delayed steps towards macroeconomic stabilization 20 Recent growth challenges are impacting human development outcomes 24 Imports have remained steady despite low foreign exchange liquidity in the formal market 27 The delayed devaluation of the Kwacha has pushed inflation upwards 31 The fiscal deficit is narrowing for the first time in six years 32 Debt accumulation is slowing but timely and successful debt restructuring remains urgent 35 The RBM adjusted the exchange rate by 44 percent, announced measures to increase kwacha flexibility, and maintained a tightened monetary policy 37 Monetary policy has been tightened further, showing some results 38 The banking sector remains well capitalized, liquid and profitable, and non-performing loans have started to decline 39 1.3 Medium-Term Economic Outlook 41 Policy Priorities: Bolstering macroeconomic stability, creating the foundations for export-led growth, and protecting the poor against shocks 42 2 Healthy Watersheds for A Strong Economy 44 Introduction 45 Healthy watersheds can benefit all Malawians, but they need to be nurtured and cared for 47 Malawi is highly vulnerable to the impacts of climate change 49 Degraded watersheds increase Malawi’s vulnerability to disasters 49 Malawi’s forests are being lost at an alarming rate 50 Expanding agriculture, driven by an increasing rural population with few alternatives to farming, is a key driver of degraded watersheds 51 Unsustainable agricultural practices can be turned around by incentivizing farmers to manage their land sustainably 52 Policies related to watershed management and their implementation often undermine progress 53 Revitalizing precious natural resources requires putting policies into practice 54 Recommendations 57 APPENDIX A Macroeconomic Indicators 59 References 60 BOXES BOX 1.1 What is in the recently approved ECF and DPO BOX 2.1 What is a Watershed, and what is a ‘Healthy’ programs? 21 Watershed? 45 BOX 1.2 The Promise and Risks in Malawi’s Mining Sector 23 BOX 2.2 What are degraded soils? 46 BOX 1.3 Revised trade figures show a more nuanced BOX 2.3 Impacts on Smallholders’ Production and picture of Malawi’s BOP crisis 28 Incomes of Investing in Agricultural Extension and Irrigation 52 BOX 1.4 Lessons from successful exchange rate reforms 38 FIGURES FIGURE O.1 A snapshot of Malawi’s economic situation 11 FIGURE 1.15 More transfers and frozen debt payments FIGURE 1.1 Inflationary pressures are decreasing but are estimated to have made up for a continuedly large so is global growth 17 trade imbalance in 2023 27 FIGURE 1.2 Malawi’s per-capita growth is the slowest FIGURE 1.16 Large errors and omissions mean that in the region despite coming from the lowest base 18 we do not know how Malawi affords its current account imbalance 27 FIGURE 1.3 Malawi and its neighbors have high shares of the population facing food crises 18 FIGURE 1.17 Fuel and fertilizer imports have increased more in value than volumes 27 FIGURE 1.4 A wave of determined reform in the 1990s was followed by accelerated economic growth 18 FIGURE B1.3.1 Malawi’s imported significantly more than previously assumed 28 FIGURE 1.5 Malawi is expected to emerge from negative per capita growth 20 FIGURE 1.19 Malawi’s commodity terms of trade are stabilizing at pre-pandemic levels 29 FIGURE B1.1.1 The ECF envisions a rapid fiscal turnaround in FY25 through fewer expenditures and more FIGURE 1.18 A sharp drop in the real effective revenues 21 exchange rate is likely to boost exports 29 FIGURE B1.1.2 Rapidly accumulating reserves is a FIGURE 1.20 Development partners have stepped up key expectation under the ECF to restore external stability 21 support 29 FIGURE 1.6 Malawi used to source fuel at competitive FIGURE 1.21 Significantly less money is coming in prices, but now pays extra 22 through official remittance channels 30 FIGURE 1.7 Tourist arrivals to Malawi continue to lag FIGURE 1.22 Foreign exchange liquidity in the official most many other countries in the region 22 system is yet to benefit from recent reforms 30 FIGURE 1. 8 More resilient crops that require fewer FIGURE 1.23 Inflation is rising, and broad money inputs had a strong 2023 22 growth has picked up again 31 FIGURE B1.2.1 Mining has great potential, but the FIGURE 1.24 Food and non-food inflation remain elevated 31 scale of revenue gains is highly uncertain 23 FIGURE 1.25 Maize prices are driving up food inflation 31 FIGURE 1.9 Malawi’s south-east faces low per capita FIGURE 1. 26 Net borrowing is expected to decline in production, sparse 2023 harvests, high prices, and high FY2023/24 32 susceptibility to En Nino 24 FIGURE 1. 27 …supported by higher revenue collection 32 FIGURE 1.10 More southern rural Malawians are FIGURE 1.28 Public debt still rising 35 buying maize from markets and food insecurity is more widespread 25 FIGURE 1.29 …and interest expense is eroding fiscal room 35 FIGURE 1.11 Fewer Malawians surveyed in the RFMS FIGURE 1.30 Deficits and the exchange rate are finding ganyu labor despite declining pay 25 depreciation are driving public debt accumulation 36 FIGURE 1.12 While the share of Malawians working FIGURE 1.31 Multilateral institutions hold the highest has increased between May and December 2023, share of external debt 36 employment off family farms has stagnated 26 FIGURE 1.32 Domestic debt is still shifting towards FIGURE 1.13 Increasing shares of Malawians are the banking sector 36 experiencing depression 26 FIGURE 1.33 …crowding out private sector credit 36 FIGURE 1.14 Hunger, illness, crime, and job loss are FIGURE 1.34 While the RBM adjusted the exchange risk factors for depression 26 rate by 44 percent, reserves remain low 37 FIGURE 1.35 While the real Policy Rate continues to FIGURE 2.2 Where is Malawi’s Wealth? — Malawi’s be negative…. 39 Natural Capital 47 FIGURE 1.36 …the yield of seven and ten-years notes FIGURE 2.3 Land degradation across Malawi now climbed over the year 39 covers 41 percent of total land area 47 FIGURE 1.37 The banking sector shows resilience 39 FIGURE 2.4 Forest and grassland is being replaced FIGURE 1.38 Private sector lending is growing, led by by agricultural land and wetland 48 the manufacturing sector 40 FIGURE 2.5 Comparing Malawi’s forested area with FIGURE 2.1 Environmental Drivers, Pressures, and Impacts 46 that of its neighbors 50 TABLES TABLE 1.1 Fiscal accounts 34 TABLE 2.1 The significant drivers of watershed TABLE 1.2 Priority policy areas and key actions 43 degradation in Malawi 48 TABLE 2.2 Key Recommendations 58 7 ACKNOWLEDGEMENTS The Malawi Economic Monitor (MEM) provides an analysis of economic and structural development issues in Malawi. This 18th edition was published in February 2024 and is part of an ongoing series published twice each year. The publication intends to foster better-informed policy analysis and debate regarding the key challenges that Malawi faces in its endeavor to achieve inclusive and sustainable eco- nomic growth. This edition of the Malawi Economic Monitor was prepared by Jakob Engel (Senior Country Economist, Task Team Leader), Yumeka Hirano (Economist, co-Task Team Leader), Yalenga Nyirenda (Country Economist, co-Task Team Leader), Hayaan Nur (Consultant), Efrem Chilima (Senior Private Sector Specialist), Innocent Njati Banda (ET Consultant), Tesfaye Bekalu (Senior Water Resources Management Specialist), Nicholas Zmijewski (Senior Environmental Engineer), and Simon Croxton (Consultant). Abha Prasad (Practice Manager, Macroeconomics, Trade and Investment), Francis Ghesquiere (Practice Manager, Water), Hugh Riddell (Country Manager, Malawi), Preeti Arora (Operations Manager, Malawi), and Nathan M. Belete (Country Director, Malawi) provided overall guidance. The team wishes to thank Aghassi Mkrtchyan (Lead Country Economist), the peer reviewers Emilija Timmis (Senior Economist) and Stephen Ling (Lead Environment Specialist), and Mika Saito and Liam Crowley (both IMF) for their constructive inputs. This report benefited from fruitful discussions, comments, and information provided by representatives of the Ministry of Finance and Economic Affairs; the Reserve Bank of Malawi; the National Statistical Office; and a number of other Government ministries, departments and agencies. The team would also like to thank representatives of the private sector and civil society organizations in Lilongwe and Blantyre for their helpful contributions. Henry Chimbali (External Affairs Officer), Elizabeth Mangani (Team Assistant), and Tinyade Neffie Kumsinda (Team Assistant) provided assistance with external communications, design, and additional production support. Ella Hoffman provided editorial support. The findings, interpretations, and conclusions expressed in this publication do not necessarily reflect the views of the World Bank’s Executive Directors or the countries they represent. The report is based on information current as of February 6, 2024. The World Bank team welcomes feedback on the structure and content of the Malawi Economic Monitor. Please send comments to Jakob Engel (jengel@wordlbank.org), Yumeka Hirano (yhirano@ worldbank.org) or Yalenga Nyirenda (ynyirenda@worldbank.org). 8 ABBREVIATIONS ADD Agricultural Development District AIP Affordable Inputs Program CECF Community Environmental Conservation Fund CEM Country Economic Memorandum COP Conference of Parties CSA Climate Smart Agriculture ECF Extended Credit Facility EMDEs Emerging Markets and Developing Economies FAO Food and Agriculture Organization FMDF Forest Management and Development Fund FOB Free on Board GDP Gross Domestic Product IEA International Energy Agency IFMIS Integrated Financial Management Information System IMF International Monetary Fund IPC Integrated Food Security Phase Classification LMICs Low and Low-Middle Income Countries MDAs Ministries, Departments and Agencies MEM Malawi Economic Monitor MERA Malawi Energy Regulatory Authority MPC Monetary Policy Committee MoFEA Ministry of Finance and Economic Affairs MWK Malawi Kwacha MVAC Malawi Vulnerability Assessment Committee NPLs Non-Performing Loans NSO National Statistics Office OAG Official Airline Guide OECD Organization for Economic Cooperation and Development PFM Public Finance Management RBM Reserve Bank of Malawi ROA Return on Assets SLA Sustainable Land Management SSA Subs-Saharan Africa TT Telegraphic Transfer UNEP United Nations Environment Programme USA United States of America US$ United States Dollar WEO World Economic Outlook WMO World Meteorological Organization WTTC World Tourism and Travel Council 9 OVERVIEW Malawi has now taken bold steps to stabilize the economy, but 2023 saw low growth, and macroeconomic imbalances continue into 2024 Malawi’s economy is estimated to have grown by only 1.6 percent in 2023. The resumption of energy production at the Kapichira hydroelectric power plant has improved access to electricity and supported economic activity, particularly in the industry and services sectors. However, production inputs across sectors were often unavailable throughout 2023 due to foreign exchange shortages, dampening growth. Following Cyclone Freddy, agricultural output in 2023 was only marginally larger than in 2022. Rapid inflation and foreign exchange shortages throughout the year contributed to a weak business environ- ment, further undermining economic growth. Recent exchange rate reforms are yet to translate into increased liquidity in formal foreign exchange markets. While the 2012 exchange rate liberalization led to an immediate uptick in foreign exchange trading among authorized dealers, liquidity levels have remained stagnant following the November 2023 exchange rate reforms. Uncertainty about the new exchange rate regime and the reemergence of spreads against parallel markets after the depreciation likely reduce the incentive for market actors to formalize foreign exchange transactions. Rapid price increases and limited employment options have led to a rise in food insecurity and pov- erty in Malawi. Many Malawians feel the squeeze from the scarcity of available jobs and pressures on real wages. In 2023, approximately 71.7 percent of the population were estimated to be living below the international poverty line. One in five are expected to experience crisis-level food insecurity dur- ing the lean season, with profound implications for human development outcomes, including men- tal health. The food security situation is particularly tense in the southeastern region of the country. Imports have remained steady despite low foreign exchange liquidity in the formal market. Significant revisions in trade data in 2023 show that imports have remained stable in US$ terms during the period of foreign exchange shortages, which started in mid-2022. Increased support from development part- ners likely played a significant role in alleviating the impacts of the current crisis. Nevertheless, due to elevated international commodity prices, Malawi still imported fewer liters of fuel and fewer bags of fertilizer than before the crisis. The exchange rate adjustment appears to be contributing to limiting non-essential imports — a necessity for reducing Malawi’s trade deficit over the medium term. The delayed re-alignment of the kwacha contributed to inflationary pressures. In December 2023, headline inflation surged to 34.5 percent, up from 26.9 percent in October 2023, before the devalua- tion. This marked a reversal of the declining inflation trend observed between August and October 2023. The increase in inflation has been particularly driven by a rise in food inflation, climbing from 34.5 percent in October to 43.5 in December 2023. The fiscal deficit is narrowing for the first time in six years Over the past decade, increased government spending has pushed government financing require- ments to unsustainable levels, but there is now a notable shift towards fiscal consolidation. Financing of the fiscal deficit has resulted in major debt vulnerabilities and a crowding out of private sector cred- it. Ongoing government efforts aimed at consolidating public finances are expected to play a role in Overview 10 curbing borrowing. Reforms in revenue collection, supported by budget support, are expected to re- duce the fiscal deficit to 7.4 percent of GDP, the first reduction in six years, though this excludes the statutory RBM recapitalization following the November 2023 devaluation. Public and publicly guaranteed debt remains in distress and unsustainable, requiring timely and substantial debt restructuring. The stock of public debt is estimated to have increased from 75.7 per- cent of GDP in 2022 to 81.3 percent in 2023. The government is encountering difficulties in securing financing from the domestic market, with subscriptions falling below requirements in most security auctions. The November 2023 joint World Bank-International Monetary Fund (IMF) Debt Sustainability Analysis reported that both external and overall public debt remain in distress and are unsustainable under current policies. The government is pursuing external debt restructuring, having received financ- ing assurances from China and India in late 2023, which have provided momentum that debt relief can be achieved. Agreement with these official creditors, along with progress in negotiations with Malawi’s commercial lenders, will be key for achieving debt sustainability over the medium term. The Reserve Bank of Malawi (RBM) adjusted the official exchange rate by 44 percent, promised to increase kwacha flexibility, and has further tightened monetary policy The RBM implemented a 44 percent adjustment to the MWK-US$ exchange rate and introduced addi- tional measures to increase the flexibility of the kwacha. This revision, announced on November 9, 2023, shifted the selling rate from MWK 1,180 to MWK 1,700 per US$, marking a departure from a period of fixed exchange rate management and diminishing foreign exchange reserves. Since the 25 percent adjustment in May 2022, the official rate had remained largely unchanged, while the parallel rate con- tinued to rise. The spread between the official and parallel market exchange rate peaked in August 2023 at 63 percent. The RBM viewed the adjusted US$-kwacha rate as market-clearing, aligning it with market fundamentals and mitigating arbitrage opportunities. Following the devaluation, the RBM announced plans to increase the frequency of foreign exchange auctions and permit intermediaries to trade at freely negotiated rates. However, the implementation of these measures remains limited. The RBM has tightened monetary policy to contain inflationary pressures. The Monetary Policy Committee responded to high inflation by raising the policy rate twice in 2023, from 18 to 24 percent, and again in early 2024 to 26 percent.1 While money supply growth remained high, it decelerated from its peak of 38.8 percent in December 2022 to 28.3 percent in October 2023. Subsequently, due to revalu- ation gains resulting from the exchange rate adjustment, money supply increased to 32.2 percent year- on-year in December 2023. Additionally, the yields of both seven-year and ten-year Treasury Notes in- creased by 450 basis points over the course of the year. Malawi’s economic recovery requires strong commitment to sustain reforms Economic growth is projected to increase, driven by an improved macroeconomic environment and sustained structural reforms. Growth is estimated to reach around 3 percent in 2024, primarily due to a modest easing of global commodity prices, a moderate improvement in agricultural produc- tion, and increased output bolstered by improved foreign exchange inflows. Over the medium term, growth is expected to average 4 percent, underpinned by ongoing and announced macroeconomic reforms designed to address external and fiscal imbalances. Fiscal consolidation measures and public financial management reforms, supported by the new IMF Extended Credit Facility program and the new World Bank Development Policy Operation, are critical for regaining long-term macroeconomic stability and fiscal sustainability. The gradual stabilization of the current account deficit, expected to 1. This was preceded by two increases in 2022 — from 12 to 14 percent in April, and then to 18 percent in October. Overview 11 FIGURE O.1  A snapshot of Malawi’s economic situation a. Malawi’s per-capita growth lags others in the region despite coming from the b. Food and non-food inflation remain elevated lowest base Year-on-year growth, percnet GDP per capita in 2015 real US$ growth 45 Malawi 40 35 Mozambique 30 25 Percent South Africa 20 Tanzania 15 10 Zambia 5 0 −8 −6 −4 −2 0 2 4 07 7 01/ 7 07 8 18 07 9 01/ 9 07 0 20 07 1 01/ 1 07 2 01/ 2 07 3 23 2 2 1 1 2 2 2 1 1 1 2 20 /20 20 /20 20 /20 20 /20 20 /20 20 /20 20 /20 Percent 01/ 01/ 01/ 2020 2021 2022 2023e 2024f Food Inflation Non-food Inflation c. Government borrowing is expected to decline in FY2023/24  d. Government domestic borrowing is crowding out private sector credit  Net borrowing as a percent of GDP Net claims on government and private sector credit, in million MWK 0 3,000 −2 2,500 2,000 −4 MWK, Million Percent of GDP 1,500 −6 1,000 −8 500 −10 0 07 015 01/ 15 07 016 01/ 16 07 017 01/ 17 07 018 01/ 18 07 019 01/ 19 07 020 01/ 20 07 021 01/ 21 07 022 01/ 22 07 023 23 /20 /20 /20 /20 /20 /20 /20 /20 /20 2 2 2 2 −12 2 2 2 2 2 01/ 11 12 13 20 9 14 /24 20 20 5 16 18 17 20 1 20 3 20 2 /2 1 1 2 /2 10/ 16/ 11/ 12/ 13/ 18/ 14/ 17/ 15/ 21/ 19/ 20 23 22 Net Claims on Government Private Sector Credit 20 20 20 20 20 20 20 20 20 e. While the RBM adjusted the exchange rate by 44 percent, reserves remain low f. Malawi imported significantly more than previously assumed RBM telegraphic transfer (TT) and forex bureau (FXB) cash MWK/US$ rates and spreads Seasonally adjusted imports, exports, and trade balance through Jan 4 and months of import cover 200 200 2,500 1.2 RBM TT and forex bureau cash MK/US$ rates 100 100 2,000 1.0 00 Months import cover US$, millions 0.8 −100 −100 1,500 0.6 −200 −200 1,000 −300 −300 0.4 500 −400 −400 0.2 −500 −500 0 0.0 03 021 05 21 07 021 09 21 11/ 21 01/ 021 03 22 05 022 07 22 09 022 11/ 22 01/ 022 03 23 05 023 07 23 09 023 11/ 23 23 /20 /20 /20 20 /20 /20 20 /20 /20 20 2 /2 2 /2 /2 2 /2 /2 01/ 211 1 20211 10/2021 1 2021 20211 21 222 2 2 10//2022 11/2022 2022 22 05 2023 3 07/2023 08/2023 10//2023 23 2023 23 1 021 2 2 09/2022 1 /2022 3 /2023 09/2023 20 3 4 02 / 02 02 2 2 02 022 2 2 2 02 1 202 02 20 07/20 1 1/ 0 06/20 20 07/20 0 0 06/20 /20 /20 /2 012//2 /2 05 2 09/2 04/2 04/2 03/2 05/2 1/2 1//2 / / 01/ 1 1/ / 02 03 08 04 02 08 02 02 03 06 02 Imports Exports Trade Balance O icial TT Sell Median Cash Sell Gross Reserves (right scale) Pre-Revision Imports Pre-Revision Exports Sources: a. Africa Macro Poverty Outlook 10/2023; b. WB with data from NSO; c. WB with data from MoFEA; d. WB with data from RBM; e. World Bank staff calculations based on RBM data; f. Staff calculations based on National Statistics Office 2023. Overview 12 be around 9 percent of GDP, is anticipated with the support of an improved policy environment. At the same time, stabilization supports an enhanced business climate and increased investment by pri- vate enterprises and in key infrastructure — including for electricity generation and crop diversification. Inflationary pressures will persist in the short term but are expected to ease toward the end of 2024. This projection is based on both the expected reduction of short-term effects from the exchange rate adjustment and the implementation of supportive macroeconomic and structural policy reforms. Nevertheless, the ongoing El Nino season may lead to lower than expected agricultural production and sustained elevated food prices. Looking ahead, the implementation of prudent monetary and fiscal pol- icies is essential to mitigate the impacts of these factors and lower inflation sustainably. The 18th edition of the Malawi Economic Monitor (MEM) outlines urgent actions required to consol- idate the stabilization of the economy, enhance growth, and safeguard the most vulnerable. Specific recommendations include: i) Bolstering macroeconomic stability: Sustain the ongoing macro-fiscal reforms, with a focus on implementing plans to increase the flexibility of the exchange rate, rebuilding foreign reserves, enforcing fiscal discipline, enhancing public financial management, and attaining debt sustain- ability. The success of planned fiscal tightening, related fiscal governance reforms, and effective external debt restructuring will be critical for regaining debt sustainability. ii) Creating the foundations for export-led growth: Stimulate agricultural growth by advancing with reforms of the Affordable Input Program and increased investment in commercialization initia- tives. It is critical to encourage exports by reducing non-tariff barriers and supporting the devel- opment of an efficient and transparent mining sector. iii) Building resilience and protecting the poor: Given the heightened risk of extreme weather events and food insecurity, it is essential to implement expanded social cash transfer and climate-smart public works projects, as well as to strengthen the functioning of agricultural markets. Imple- menting of the Disaster Risk Management Bill will enhance preparedness for future disasters and contribute to overall resilience. Special Topic on “Healthy Watersheds for a Strong Economy” Healthy watersheds can benefit everyone in Malawi, but they need to be cared for and nurtured Watersheds play a crucial role in sustaining the ecosystem, biodiversity, wildlife, agriculture, and human population by serving as the natural resource base for all forms of life. These natural bounda- ries of river catchments form a mosaic covering the entire land surface of the earth. Watersheds describe areas of land that feed water to a river, draining through the landscape into tributaries and main river channels. This MEM Special Topic examines the opportunities to redirect funds currently allocated for agricultural and forestry inputs toward a more explicit emphasis on watersheds. It explores why a stronger focus on watersheds is important for Malawi, discusses options for financing interventions aimed at rehabilitating the country’s degraded watersheds, and suggests ways to enhance the involve- ment of the private sector. The health of Malawi’s watersheds is impacted by rising population density. Since 1970, Malawi’s pop- ulation has surged from just over 4.6 million to nearly 21 million at the start of 2024. The majority of the population resides in rural areas and is characterized by poverty and a heavy reliance on natural resources for sustenance. Consequently, rapid population growth exerts substantial pressure on natural ecosystems. Overview 13 Current livelihood strategies are pushing the natural environment to a critical threshold, where it may soon be incapable of providing the necessary services to safeguard both livelihoods and infrastructure. This jeopardizes the resilience required to address the challenges posed by a changing climate. Human activities are increasingly detrimental to the health of Malawi’s watersheds. The rapid con- version of land for agriculture and widespread deforestation for wood are proceeding at an alarming rate. Forest cover has declined from 47 percent in 1975 to just over 20 percent in 2021. Deforestation, coupled with forest deterioration and the loss of trees on farms, significantly contributes to land and water degradation. In 2017, ‘hotspots’ of degradation, where multiple indicators of degradation con- verge, covered over 40 percent of the country. Currently, approximately 75 percent of Malawi’s soils are degraded or are threatened by degradation. This degradation has a cascading effect on the quality and quantity of water resources. Runoff from degraded landscapes carries soils and agrochemicals, pol- luting watercourses and wetlands. This can lead to the loss of soil fertility and diminishes the overall capacity of watersheds to protect, conserve, and nurture embedded natural resources. This trend is worsened by changing climate patterns. Malawi is already witnessing increased climate variability, characterized by higher temperatures, prolonged dry periods, and more erratic and intense rainfall. These patterns are likely to lead to more frequent droughts and flooding (GoM 2017; World Bank 2022). Such changes exacerbate soil erosion and land degradation, resulting in reduced agricul- tural productivity, an increase in vector-borne diseases, and an elevated risk of damage to infrastruc- ture. Hydropower plants on the Shire River often struggle to meet peak demand due in part to low flows and sediments resulting from the degradation of upstream catchments — a predicament that cli- mate change will intensify. Recent years have seen flooding alone cost the country 5 percent of its GDP (GoM 2023), and a recent study found that soil loss could increase by three to four times compared to 2010 baseline levels (Asfaw et al., 2020). Cyclone Freddy in 2023, causing losses and damage exceeding US$500 million (approximately 3.8 percent of GDP) and displacing 2.5 million people, serves as a warning of impending shocks. However, analysis in the World Bank’s recent “Malawi Climate and Development Report” indicates that acting to reduce soil erosion and improve land management can lead to signif- icant economic gains under a variety of climate scenarios (World Bank 2022). Addressing land degradation presents economic opportunities with substantial financial returns. Aligned with the Malawi 2063 vision, investing in watershed restoration activities has the potential to substantially reduce soil erosion rates, improve crop productivity, and enhance water storage. A recent study (Kirui 2016) estimates that every dollar invested in restoring degraded land would return US$4.3 (in net present value) over 30 years. The technologies required for restoration are standard soil and water conservation practices, including terracing, bunding, tree planting, and the utilization of more organic fertilizers. A government assessment indicates that restoring degraded cropland could boost maize production by 40 percent, benefitting smallholders who adopt restoration practices (GoM 2017). Moreover, carbon markets also present financing opportunities: the restoration of Malawi’s forests, coupled with policies to reduce biomass dependence, could increase Malawi’s carbon stocks by 148 Mt by 2050. This has the potential to generate earnings of between US$24.8 million and US$74.3 million per year (World Bank 2022). Revitalizing precious natural resources requires putting existing policies into practice Malawi’s policy framework for watersheds is relatively strong, yet government implementation remains poor. The government’s vision for watershed management is ambitious and incorporates sen- sible technical approaches. However, both local and central governments struggle to implement pol- icy and legislation. Cross-sectoral coordination and collaboration is weak, monitoring is limited, and compliance is low. Overview 14 Successful land restoration interventions across the country offer scalable models. These include effective forest co-management, profitable agroforestry, sustainable agricultural practices, private sec- tor forestry investments, and community-focused payment-for-results schemes. While these interven- tions have proven successful on a relatively small-scale, they are often linked to donor-funded or NGO- led initiatives. Scaling up these models would require collaboration across government agencies, the enhancement of government staff skills, and a realignment of budget priorities. Certain existing policies create incentives for farmers to engage in unsustainable land management practices. Government subsidies, like the Affordable Input Program (AIP), place too much emphasis on mono-cropping and the use of inorganic fertilizers. While this approach may lead to short-term yield gains, it contributes to long-term land degradation. An alternative approach would be to redirect these funds to support on-farm conservation practices. Additionally, insecure land tenure creates a situation in which farmers lack the incentive to invest in the long-term health of their land. A key challenge lies in establishing suitable financing frameworks to attract and support both public and private sector investment. While existing public funding sources like the AIP, the Forest Development and Management Fund, the Climate Fund, and the National Parks and Wildlife Fund could be repurposed or refocused, practical watershed investments will require a blend of public and private investments. Developing suitable business models is essential to incentivize and support in- vestments from both sectors. One effective tool is the use of revolving community funds, which can promote conservation, restoration, and sustainable resource management when linked to larger funds with stringent environmental criteria. Illustrating this principle, a pilot project in the Shire communi- ties for a local ‘environmental conservation fund’ demonstrated that even small resources can serve as a significant incentive for voluntary community action, as long as the funds are earmarked for agreed conservation activities. Approaches involving ‘results-based payment’ offer an alternative method for providing donor fi- nance and encourage the cross-sectoral collaboration required to rehabilitate watersheds at scale. While public funds should be channeled towards watershed rehabilitation, it is crucial to supplement them with private sector investments, especially in areas such as forest plantations, contract farming, and carbon farming, where watershed rehabilitation aligns with profitable investment opportunities. The challenge is not only in implementing technical interventions but also in establishing effective in- stitutional arrangements to manage and support these types of interventions. Experience in Malawi and elsewhere underscores the importance of careful design that includes both technical and institu- tional support for ensuring the long-term sustainability of watershed rehabilitation efforts. Watershed rehabilitation is expensive but will have widespread benefits and is critical for Malawi’s sustainable future Enhancing the sustainable management and utilization of watersheds offers opportunities to boost Malawi’s economic performance. Healthy watersheds play a crucial role in building resilience to cli- mate risks by providing cover against floods and holding water to mitigate droughts. Moreover, these improvements can contribute significantly to establishing more dependable and sustainable livelihoods, particularly benefiting economically vulnerable households. Any action to halt degradation and sup- port the rehabilitation of Malawi’s watersheds will generate benefits for the entire population. It should be considered a priority for the country. Transforming environmental deterioration into opportunities for economic growth necessitates the complementary protection of land, forest, and water resources. The necessary policies and strat- egies are already in place. The challenge lies in shifting the focus and priorities to ensure that these existing plans are translated into practice. This MEM Special Topic provides recommendations on how this shift can be achieved. These include: Overview 15 Land: i) Redirect existing agricultural practices to increase productivity by protecting and conserving land, rather than degrading it; ii) Broaden land tenure rights to incentivize sustainable land husbandry; iii) Explore the potential to use results-based payments such as the successful Community Envi- ronment Conservation Funds (CECF). Forests: i) Align forestry and energy policies; ii) Use limited public financing to leverage additional private-sector investment in forest manage- ment and restoration; iii) Ensure prices charged by the Forest Management and Development Fund reflect current mar- ket prices; iv) Scale up forest co-management approach to balance responsibility and authority between com- munities and government; v) Promote agroforestry and tree-based systems to reduce pressure on Malawi’s natural forests. Water: i) Ensure that institutional mandates in the water sector are implemented and enforced to realize the benefits of existing policy reforms (such as Malawi Water Resources act, 2013); ii) Strengthen systems and capacities for licensing, allocation, and monitoring of water use. 1 ECONOMIC DEVELOPMENTS 1. Economic Developments 17 1.1 GLOBAL AND REGIONAL CONTEXT Emerging markets and developing economies have not returned to their pre-pandemic growth path Global growth remains below its pre-pandemic levels, with emerging markets and developing econ- omies (EMDEs) lagging the robust levels of growth of the previous decade. During the 2010s, global growth averaged 3.7 percent while EMDEs expanded at an average rate of 5.1 percent. Gross domestic product (GDP) growth in 2023 is estimated to have decelerated to 2.6 percent for the world (Figure 1.1). In part, this growth slowdown reflects the impact of monetary tightening to address inflation, which continues to be above target in most countries. Average growth estimated at 4.0 percent for EMDEs in 2023 hides increasing divergence between those countries with solid economic fundamentals and those without. The long- FIGURE 1.1  Inflationary pressures are decreasing but so is term consequences of the pandemic and the impacts of con- global growth flicts continue to weigh on growth. Additionally, increased Real GDP growth and consumer price inflation global fragmentation,2 the effects of fiscal tightening amidst 16 high debt levels, and increasing climate change impacts have resulted in growth levels trailing those observed in the pre- 12 vious decade. 8 Percent The growth rate in Sub-Saharan Africa (SSA) is estimated to have decelerated to 2.9 percent in 2023, which is 0.3 per- 4 centage points lower than the June projection. In three of 0 the region’s largest economies — Nigeria, South Africa, and Angola — growth slowed down to an average of 1.8 percent −4 (World Bank 2024). South Africa’s continued energy crisis has 2020 2021 2022e 2023e 2023f 2024f contributed to weak levels of growth. Additionally, a signifi- Real GDP growth: World EMDEs SSA cant drop in growth among metal exporters, coupled with re- Consumer price inflation: World EMDEs SSA duced global mineral prices, escalating conflict in the Sahel, multiple coups in West Africa, and diminished external de- Source: World Bank Global Economic Prospects 01/2024 (growth) and IMF World Economic Outlook 10/2023 (inflation). mand — particularly from China — have collectively led to a Note: e indicates estimates and f indicates forecasts. decline in growth across the region. Many African countries were able to reduce headline consumer inflation in 2023, following significant increases in global food and energy prices in 2022. However, the high cost of living persists, exacerbating economic hardship for the poor and contributing to increased food insecurity across the region. Malawi’s neighbors and key trading partners in Southern Africa faced significant economic challenges (Figure 1.2). Economic adjustment and public debt challenges in Zambia, coupled with South Africa’s 2. Growing trade restrictions are reversing past economic integration and its associated benefits (see World Bank 2023a on the pro- liferation of these restrictions). Additionally, cross-border movements of capital, technology, workers, and payments are increasingly curtailed. Recent IMF estimates put the costs of increased geoeconomic fragmentation at up to 7 percent of GDP (Aiyar et al. 2023). 1. Economic Developments 18 persistent structural growth weaknesses, led to a decline in per capita GDP for both countries in 2023 compared to 2022 (-0.3 percent in South Africa and -0.1 percent in Zambia). Despite these declines, per capita growth in both countries was higher than that of Malawi (-0.9 percent). Countries in Malawi’s region are significant mineral exporters and have been impacted by low metals prices. Although glob- al food prices have declined from their peaks in 2022, heightened food insecurity amid elevated food prices remains a major concern across Southern Africa (Figure 1.3). FIGURE 1.2  Malawi’s per-capita growth is the slowest in the FIGURE 1.3  Malawi and its neighbors have high shares of region despite coming from the lowest base the population facing food crises GDP per capita in 2015 real US$ growth Share of population expected to experience crisis-level food insecurity or above as per maximum IPC forecast for the year Malawi 30 Mozambique 25 South Africa 20 Percent Tanzania 15 Zambia 10 −8 −6 −4 −2 0 2 4 5 Percent 2020 2021 2022 2023 2024 2020 2021 2022 2023e 2024f Tanzania Zambia Mozambique Malawi Source: Africa Macro Poverty Outlook 10/2023. Source: IPC 2023. Weakened growth momentum and increased vulnerabilities across the continent highlight the im- portance of resuming structural reforms to reignite growth. The historic growth surge experienced by low- and middle-income countries, including in Africa, beginning in the early 2000s, was underpinned by a wave of decisive reforms in the 1990s, in addition to a favorable external environment (Figure 1.4). Research indicates that actions such as stabilizing the macroeconomy, reducing trade barriers, and embracing foreign investment can each contribute several percentage points to annual growth over the subsequent decade (Chari, Reyes and Henry 2020; Archibong, Coulibaly and Onkonjo-Ileala 2021). Increased vulnerabilities, including those stemming from climate change, highlight the importance of establishing conditions conducive to sustainable, private sector-led long-term growth. FIGURE 1.4  A wave of determined reform in the 1990s was followed by accelerated economic growth Number of countries implementing substantial* liberalization of the legal system and property rights, freedom to trade, or regulatory reforms in the preceding five years and average economic growth in LMICS 25 7 6 20 Number of countries 5 15 4 Percent 10 3 2 5 1 0 0 1985 1990 1995 2000 2005 2010 2015 2020 Legal Systems and Property Rights Freedom to Trade Regulation LMICS Growth (right scale) Source: Fraser Institute Economic Freedom 2023, IMF WEO 10/2023. Note: *At least one Standard Deviation. 1. Economic Developments 19 Global leaders convened in Dubai for the 28th Conference of Parties (COP) with the aim of strength- ening and realigning efforts to meet the climate goals outlined in the Paris Agreement. The over- arching goal of the Paris Agreement is to hold the increase in the global average temperature to well below 2° Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5° Celsius. With an average temperature estimated at 1.45° Celsius above pre-industrial levels, 2023 was the warmest year on record by a significant margin (WMO 2024).3 While current climate policies aim to reduce greenhouse gas emissions, which cause climate change, emissions have increased in 2023 to 57.4 tons of CO₂ equivalent. They need to decline by 28 percent by 2030 for the Paris Agreement 2° Celsius pathway and 42 percent for the 1.5° Celsius pathway (UNEP 2023). In the context of significant climate change already locked in, adaptation efforts and protecting people from the worst effects has increasing relevance. Watershed protection, which is an important tool for climate change adaptation, is gaining prominence in both global and national agendas (see Special Topic Section). 3. 2016 previously held the record with 1.29° Celsius above pre-industrial levels. 1. Economic Developments 20 1.2 RECENT ECONOMIC DEVELOPMENTS Growth remained low amidst delayed steps towards macroeconomic stabilization Malawi has taken important steps towards macroeconomic stabilization in recent months. These actions include an adjustment of the exchange rate, the announcement of increased flexibility of the kwacha, the agreement on an Extended Credit Facility (ECF) with the IMF, a reform program supported by World Bank Development Policy Operation (DPO) (see Box B.1), progress on debt relief, and steps towards monetary tightening. These reforms are expected to bring about improvements in the real economy. However, such reforms often do not immediately yield increased growth. For example, the transmission of monetary tightening to the economy is thought to have an average lag of approximately 29 months (Havranek and Rusnak 2013). Subsequently, additional time is required for increased mac- roeconomic stability to manifest in higher investment, growth, and job creation. These important macroeconomic reforms came too late to significantly contribute to growth for 2023, though their implementation is expected to support accelerated growth in 2024 and beyond. Malawi’s economy is estimated to have grown by only 1.6 percent in 2023 (Figure 1.5). While the re- sumption of electricity production at the Kapichira hydroe- lectric power plant supported economic activity, particularly FIGURE 1.5  Malawi is expected to emerge from negative in the industry and services sectors, production inputs have per capita growth often been unavailable throughout 2023. Following Cyclone Real GDP growth by sector Freddy, agricultural output was only marginally higher than in 6 2022. Rapid inflation and foreign exchange shortages through- 5 out the year contributed to a weak business environment, fur- 4 ther undermining economic growth. 3 Percent Businesses received a significant boost from improvements 2 in the electricity sector. Existing demand was largely met fol- 1 lowing the recommissioning of the Kapichira hydroelectric 0 power plant in May 2023, ending scheduled load-shedding. −1 At the same time, the expansion of energy access gained mo- −2 mentum in 2023, with over 50,000 new households and busi- 2020 2020 2021 2021 2022 2023e 2023e 2024f 2024f nesses being connected to the grid, and numerous others ac- Agriculture Industry Services cessing off-grid solutions (World Bank 2023d). Price alleviation GDP Population Growth for businesses was additionally announced in December 2023, Source: World Bank Macro Poverty Outlook (World Bank 2023d) and World Population with the electricity price increase following the exchange rate Prospects (2022). adjustment suspended until April 2024. Note: e indicates estimates and f forecasts. Despite higher costs, normalizing fuel supplies is taking time. The fuel supply situation in Malawi remains challenging as the foreign exchange market has not stabilized yet, and retailers struggle to raise the additional working capital for their now significantly more expensive stock. The average pump price 1. Economic Developments 21 BOX 1.1  What is in the recently approved ECF and DPO programs? On November 15th, 2023, the Executive Board of the IMF weaknesses in governance, sustainable growth and climate resil- approved an ECF for Malawi, followed by a DPO by the World ience, and capacity development. The program contains five Bank on December 12th, 2023. The ECF is set to disburse a Performance Criteria (targets for key economic variables under credit of US$175 million over four years. The DPO, provided the government’s control, including the domestic primary bal- as a grant, has already disbursed US$80 million, along with a ance and net international reserves; see Figures B1.1.1 and B1.1.2), second tranche of US$80 million upon meeting key triggers. six Prior Actions (reforms that had to take place before approving Additionally, US$57 million have been approved to be made the program), and sixteen Structural Benchmarks (reforms that available immediately in case of a national emergency, acting as must take place during the program for it to continue). an insurance against further shocks. These disbursements play The structural reforms supported by the DPO are designed a direct role in addressing Malawi’s severe fiscal and Balance to bolster the foundations for sustained economic growth. of Payments (BOP) challenges. More importantly, the underly- The DPO, the first in a series of two operations, is anchored in a ing reforms that these programs support are expected to enable robust government-led structural reform agenda to i) strengthen the major adjustments needed for more macroeconomic stabil- fiscal sustainability and transparency, ii) stimulate private sec- ity and growth. tor-led growth, and iii) increase resilience to shocks. Key reforms The ECF-supported program aims at restoring macroeco- that have unlocked the DPO include measures to strengthen the nomic stability through six reform areas. These reform areas legal framework for public finance management and public pri- are creating a sustainable fiscal position, achieving price stabil- vate partnerships, reforms in the digital and energy sectors, ity and safeguarding financial sector stability, rebuilding interna- increased public procurement transparency, reforms to modern- tional reserves and normalizing the market for foreign exchange, ize the Affordable Inputs Program (AIP), fostering financial inclu- restoring debt sustainability and external viability, addressing sion and strengthening shock-sensitive social safety nets. FIGURE B1.1.1  The ECF envisions a rapid fiscal FIGURE B1.1.2  Rapidly accumulating reserves is a key turnaround in FY25 through fewer expenditures and more expectation under the ECF to restore external stability revenues IMF ECF projections of net international reserves IMF ECF projections by FY 0.0 20 −200.0 10 −400.0 0 Percent of GDP −600.0 US$, millions −10 −800.0 −1,000.0 −20 −1,200.0 −30 FY22 FY23 FY24 FY25 FY26 FY27 FY28 −1,400.0 Revenues Expenditure Domestic Primary Balance 2022 2023 2024 2025 2026 2027 2028 Source: IMF 2023. Source: IMF 2023. of MWK2,632 lies significantly above the Shadow Price of MWK2,176 as of late January 2024.4 The impo- sition of high fees, intended to compensate for losses incurred due to a pump price that remained too low for an extended period, contributes to the high fuel prices following the necessary adjustments. Additionally, fuel importers are currently facing unusually high prices from their suppliers, as much of the sourcing is done on open credit rather than being backed up by adequate trade finance. As a result, while Malawi used to import fuel at internationally competitive prices, importers now pay a 49 percent 4. The Shadow Price is calculated as international landed costs of fuel at the median Foreign Exchange Bureau selling rate plus the proportional taxes calculated based on the international landed costs plus the fixed taxes and levies contained in the official price build-up. It does not contain financing levies or levies for the Price Stabilisation Fund (see World Bank 2023a). 1. Economic Developments 22 markup compared to international peers (Figure 1.6). The eco- FIGURE 1.6  Malawi used to source fuel at competitive nomic cost of this delayed adjustment in the foreign exchange prices, but now pays extra and fuel sector is significant: consumers and the private sector, MERA-reported FOB price of fuel and international prices which relies on fuel for production, now pay unusually high 1.2 prices and suffer from uncertain supply. 1.0 The Malawi 2063 priority sectors of tourism and mining con- 0.8 US$ per liter tinue to hold significant potential but did not take off in 0.6 2023. New analysis prepared for the new World Bank Country 0.4 Economic Memorandum (CEM), A Narrow Path to Prosperity, 0.2 shows that Malawi has a robust pipeline of mining projects, including numerous minerals essential for the global green en- 0.0 ergy transition (see Box 1.2; World Bank 2023b). Tourism, de- 18 18 19 19 20 20 21 21 22 22 23 23 /20 20 /20 20 /20 20 /20 20 /20 20 /20 20 10/ 10/ 10/ 10/ 10/ 10/ 04 spite great potential, does not yet operate within an environ- 04 04 04 04 04 ment conducive for rapid growth (see World Bank 2023e for a MERA-reported FOB Price Petrol MERA-reported FOB Price Diesel more detailed analysis). Consequently, the growth in tourist Petrol International Price Diesel International Price arrivals in 2023 has fallen behind that observed among many Source: World Bank staff calculations based on MERA data and State of New York of Malawi’s peers (Figure 1.7). Transportation Fuels Spot Prices data. FIGURE 1.7  Tourist arrivals to Malawi continue to lag most many other countries in the region Year-on-year change in estimated aviation passenger arrivals (Q2 2022 – 2023) 140 120 100 80 Year-on-year change 60 40 Global Median 20 Regional Median 0 −20 −40 −60 Ca pub a Mo am pe Ma go Co Faso é a ots de Sie Nig di Ch r Rw lawi m. a n So bi a Afr e a Se nda Eth oire na a Ga Le a Su e ng ius A a Cô Be li ga i Ga d ba la ia, e Pr na me er Ke e ng U oon Co aurit n Le ep. d'I n Bu Gh ia ia l Bu ros ica an o bo lic Za ep. Gu ca da tin ga a e i Ma uth qu Th De nd za ibi ny mb on rki an rra eri ine bw da a Afr T soth M bo te ni n R zan n Zim ngo mb iop sc Ca Nig i To om B Ver i nd wa inc R R ru ne Ma swa mo o, ga a v r o, m N E Co al oT ntr Sã Ce Source: OAG Traffic Analyzer; WTTC in World Bank (2023d). Groundnuts, tubers, and traditional cereals outperformed FIGURE 1. 8  More resilient crops that require fewer inputs maize and soybean production in 2023 (Figure 1.8). To keep had a strong 2023 per capita production stable given population growth, out- Change in production relative to average output for 2018 – 2022 put for 2023 would have needed to exceed the average for the Groundnuts preceding five years by 6.6 percent (Figure 1.8). Official pro- Tubers duction estimates show that this has not been the case in 2023 Sorghum and Millet for many of Malawi’s most important crops. Maize production lagged 3.4 percent behind the five-year average, with farmers Other Pulses facing challenges in accessing inputs and significant produc- Maize tion volumes being destroyed by Cyclone Freddy. Soybean pro- Soya Stable per Capita duction also lagged the five-year average by 4.3 percent, as the Rice Production crop was affected by rust as well as climate shocks. Inherently −10 −8 −6 −4 −2 0 2 4 6 8 10 12 14 16 more resilient and less input-reliant crops, however, exceed- Percent ed their five-year average, with groundnuts, tubers, and tra- ditional cereals outperforming other crops. Source: Ministry of Agriculture. 1. Economic Developments 23 BOX 1.2  The Promise and Risks in Malawi’s Mining Sector Mining exports have the potential to transform Malawi’s econ- With continued risks in the pipeline, evidenced by the large gap omy in the medium-term. New World Bank research (Malunga between the “potential” and “delayed” scenarios (Figure B.1.2.1), et al. 2024) shows the promise of Malawi’s mining sector to cata- the government also needs to avoid falling victim to the “pre- lyze economic development. It thus validates the importance source curse,” by spending mining revenues which may never accorded to mining in the Malawi 2063, which positions the sec- materialize (Cust and Zeufack 2023). tor as a central driver of growth and industrialization. The report analyses six major mining projects spread across the coun- FIGURE B1.2.1  Mining has great potential, but the scale try for their fiscal and export implications. Even in the most con- of revenue gains is highly uncertain servative scenario, mining exports replace tobacco as Malawi’s Mining Exports, by scenario year top export in the span of six years following the start of produc- tion. Potential fiscal revenues could then also contribute to more 3,500 than 10 percent of total public revenues. The analysis also shows 3,000 that the promise of mining will take some years to fully materi- alize and hinges on adequate policy. The pace and progression 2,500 of mine development in Malawi relies not only on the technical aspects of the projects but equally on the governance of the sec- US$, millions 2,000 tor. Factors such as an adequate fiscal regime, streamlined per- mitting, strong community engagement, and sufficient infrastruc- 1,500 ture play key roles in shaping the trajectory of the mining sector. 1,000 Translating proven resources in the ground into wealth for ordinary Malawians is a critical challenge for policy going for- 500 ward. A first step is an effective fiscal regime. However, how such revenues are then used to further national development also 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 plays a critical role. Mining is highly capital-intensive and poten- tial employment in the researched projects only totals 26,000 Potential Expected Delayed jobs. Therefore, the government must exercise caution to avoid neglecting other sectors that are more employment-intensive. Source: Malunga, Ostensson, Anderson and Aguilar (2024). Malawi’s maize farmers face the quadruple challenge of low per capita production, sparse harvests in 2023, high prices, and high susceptibility to El Nino impacts (see Figure 1.9). Although maize serves as the primary source of calories across much of Malawi, significant variations in maize cultivation and markets exist despite the relatively small geographic scale of the country. For instance, the most pro- ductive Kasungu Agricultural Development District (ADD) is estimated to have produced more than three times as much per capita as the least productive ADD, Blantyre. With a per capita production of only 107 kg, the Blantyre ADD, covering 4.1 million residents in Neno, Mwanza, Blantyre, Chiradzulu, Phalombe, Mulanje, and Thyolo, had the lowest maize production levels in the country. In 2023, the Blantyre ADD also produced the sparsest maize crop compared to recent averages, falling 34.4 percent behind the 5-year norm. Maize was also 63 percent more expensive in December 2023 in the far-South- ern Chikwawa market than in the far-Northern Karonga market (IFPRI 2023). This arises from the lim- ited integration of national maize markets, posing a particular problem as the Blantyre ADD and the neighboring Shire Valley ADD also record the highest prices. Additionally, the south-eastern region of Malawi faces particularly poor prospects for recovery in 2024, given the anticipated impact of the El Nino phenomenon on the growing season. Historically, the Machinga, Salima, Shire Valley, and Blantyre ADDs have suffered disproportionate crop losses during El Nino years. Maize yields in these areas have typically decreased by a quarter to a third in an average year affected by El Nino (Anderson et al. 2023). At the start of the 2023/24 farming season, ambiguity remains regarding the targeting of produc- tive farmers under the Affordable Inputs Program (AIP), which may further constrain agricultural output. The 2023/24 AIP was launched in October 2023, intending to target 1.5 million of the more pro- ductive farming households, based on continued efforts to streamline and reform the AIP. The gov- ernment indicates that the program is on track, having reached 84 percent of beneficiaries as of early January 2024 (Mkwanda 2024). However, the AIP Implementation Guidelines leave some ambiguity on how these beneficiaries were selected, citing a variety of selection methods (Duchoslav and De Weerdt 2023). Additionally, uncertainty remains about how fiscal shortfalls in the program would be addressed. 1. Economic Developments 24 FIGURE 1.9  Malawi’s south-east faces low per capita production, sparse 2023 harvests, high prices, and high susceptibility to En Nino a. 2023 production in kg per capita b. 2023 harvest change over 5-year c. Price in MWK per kg as of 12/2023 d. Mean decline in maize yield in 7 El Nino preceding average years with negative impact Kilograms: Percent: MWK per kg: Percent: 100 60 600 -36 370 120 1,000 -7 Source: Staff calculations based on Ministry of Agriculture 2023, IFPRI 2023, and Anderson et al. 2023. Beneficiary contributions (MWK 30,000), the total number of beneficiaries (1.5 million), and the budget (MWK 110 billion) have been defined in advance, without clarifying which of these parameters would be adjusted in light of higher than anticipated fertilizer prices. In turn, it is possible that not all bene- ficiaries can be supplied at the subsidized price and within the planned budget ceiling. Recent growth challenges are impacting human development outcomes Due to weak harvests on their own land, many Malawians are turning to markets for food purchas- es earlier, driving prices up and resulting in escalating food insecurity. With low personal stocks, Malawians had to start buying maize from markets earlier after harvests than in recent years. Among the respondents of the Rapid Feedback Monitoring System (RFMS) survey of rural southern Malawians5, more than half bought their maize from the market in May (Figure 1.10). In 2021, it took until August to reach this level. Maize prices have doubled for the second consecutive year, driving up food insecu- rity. Ahead of the lean season, the Malawi Vulnerability Assessment Committee (MVAC) estimated that one in five Malawians would experience crisis-level food insecurity or worse (IPC 2023). Since the as- sessment was published in August 2023, the minimum amount of money Malawians need for surviv- al has increased dramatically, by 10 percent in November 2023 alone. This has intensified pressure on Malawians already prone to food insecurity (WFP 2023). Nevertheless, households in the RFMS only re- port to be marginally more food insecure than in previous years as of November 2023, with 38.3 per- cent of households classified as food insecure or worse. 5. Estimations are based on the Rapid Feedback Monitoring System (RFMS) which is representative for Zomba Rural, Mangochi Rural, Chiradzulu, Phalombe, Chikwawa, and Balaka throughout the survey period. Thyolo, Nsanje, Machinga, and Mulanje are represented from July 2021. The urban districts Blantyre and Zomba, as well as the northern districts Karonga have also been added to the RFMS but have been omitted from estimation to ensure intertemporal comparability. 1. Economic Developments 25 FIGURE 1.10  More southern rural Malawians are buying maize from markets and food insecurity is more widespread a. Share of population buying food in the market b. Mean Household Hunger Scale 100 2.4 80 2.0 Household Hunger Scale 60 1.6 Percent 40 1.2 20 0.8 0 0.4 ry ry rch ril y e y pte t er No er De er er Fe y ry rch ril y e y pte t er No er De er er s s Ma Jul r Ma Jul Jun Jun gu gu ua ua ua ua Ap Ap mb tob mb mb mb tob mb mb Ma Ma Au Au Jan br Jan br ve ce ve ce Oc Oc Fe Se Se 2020 2021 2022 2023 Source: Staff calculations based on Rapid Feedback Monitoring System 2023. Ganyu labor, the mainstay especially of poorer households, both pays less and has become scarcer, driving up poverty. Ganyu, a term for casual labor in Malawi, is the main source of income, especially for vulnerable households (Benson and De Weerdt 2023). While in November 2022, 11.9 percent of house- holds in rural southern Malawi reported challenges in finding ganyu during the previous week, that share increased to 20.0 percent in November 2023. Along with seasonality in the share of households engaging in ganyu across the season, the type of work performed changes. More than 4 in 5 ganyu lab- orers were working on farms in January 2023, while almost half of ganyu laborers were pursuing typi- cally more profitable non-farm jobs in July 2023. This leads to fluctuations in wages. However, ganyu wages, while stable in nominal terms, have been trending down in real terms recently (Figure 1.11). In November 2023 a typical full days’ worth of labor brought in only MWK2,623 or just enough to buy 3.5 kg of maize at national average prices. Whether the hike in the minimum wage from MWK50,000 per month (MWK1,923 per day) to MWK90,000 (MWK3,462 per day) announced in January 2024 will make a noticeable difference in typical pay remains unclear. While many public and formally employed work- ers will almost certainly benefit, even before the minimum wage hike ganyu wages were below the min- imum wage for 44.1 percent of RFMS survey respondents. Only 19.1 percent of ganyu laborers received a wage that exceeds the new minimum wage. Consequently, poverty levels are rising in Malawi, and are estimated to have reached 71.7 percent in 2023 at the international extreme poverty line of US$ 2.15 per person per day (approximately MWK 920 in 2022). FIGURE 1.11  Fewer Malawians surveyed in the RFMS are finding ganyu labor despite declining pay a. Share of households with members engaging in ganyu labor in percent b. Nominal average Ganyu wage in MWK per day, real average ganyu wage in 01/2022 MWK per day, and ganyu wage in kg of mailze per day of work at average national prices 70 3,500 9 60 3,000 8 7 kg per Day of Work 2,500 50 6 2,000 5 MWK Percent 40 1,500 4 3 1,000 30 2 500 1 20 0 0 10/ 22 11/ 2 12/ 22 01/ 22 02 23 03 023 04 23 05 23 06 23 07 23 08 23 09 23 10/ 23 11/ 3 23 2 2 10 /20 20 20 20 20 /20 /20 /20 /20 /20 /20 /20 20 20 /2 09 20 20 05 1 21 21 02 1 05 2 08 2 22 02 2 05 3 08 3 23 23 2 2 2 2 2 2 2 /20 /20 /20 20 /20 /20 /20 20 /20 /20 /20 20 /20 20 Nominal Wage Real Wage Maize Wage (right scale) 11/ 11/ 11/ 11/ 02 08 08 Sources: Staff calculations based on Rapid Feedback Monitoring System 2023, Reserve Bank of Malawi 2023, and IFPRI 2023. 1. Economic Developments 26 The share of Malawians working increased for the first time in nearly two years, driven primarily by an increased reliance on family farming. In the last nationally representative High Frequency Phone Survey carried out in December 2023, nine in ten respondents reported to have worked during the pre- vious week (Figure 1.12). This is up from 78.4 percent in May 2022 and similar to the peaks recorded dur- ing the 2020/21 and 2021/22 farming season (the 2022/23 farming season did not record the expected boost in employment). However, the recent boost in employment came entirely from family farming. Employment off family farms continues to stagnate and lag behind pre-pandemic levels in urban areas. FIGURE 1.12  While the share of Malawians working has increased between May and December 2023, employment off family farms has stagnated a. Share of respondents having worked b. having worked where the main work is different than in a family farm, raising family livestock or fishing in the past week 100 100 90 90 80 80 70 70 Percent Percent 60 60 50 50 40 40 30 30 20 20 05 20 08 20 11/ 0 02 0 05 21 08 21 11/ 1 02 21 05 22 08 22 11/ 2 02 2 05 23 08 23 11/ 3 23 20 11/ 0 02 0 05 21 08 1 11/ 1 02 1 05 22 08 2 11/ 2 22 05 23 08 3 11/ 3 23 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 /20 /20 /20 20 /20 /20 /20 20 /20 /20 /20 20 /20 /20 /20 20 /20 /20 /20 20 /20 /20 /20 20 /20 /20 /20 20 /20 /20 20 02 02 05 08 National Urban Rural Source: Staff calculations based on High-Frequency Phone Survey 2024. Concerns about employment prospects and physical safety as well as food insecurity are also associated with the deteriorating mental health of many Malawians. While only one in five Malawians reported symptoms of at least mild depression on the Personal Health Questionnaire Depression Scale in April 2021, that share has increased to more than one in three by June 2023. Half of respondents in June 2023 were assessed to be severely food insecure on the FAO Food Insecurity Experience Scale. Among those fac- ing food insecurity, half of the respondents exhibited symptoms of depression, whereas among those who were more food secure, only one in five showed similar signs. Other shocks associated with depression symptoms were the experience of illness, injury or death of an income earning member of the household, the theft or looting of cash and other property, or the experience of job loss among household members. FIGURE 1.13  Increasing shares of Malawians are FIGURE 1.14  Hunger, illness, crime, and job loss are risk experiencing depression factors for depression Share of respondents scoring on Personal Health Questionnaire Depression Scale Share of respondents experiencing potentially traumatic circumstances, and share of categories these households reporting at least minimal depression 100 Job Loss 80 Theft 60 Ill Percent 40 Severely Food Insecure 20 0 10 20 30 40 50 60 70 Percent 0 12/2020 04/2021 06/2023 Yes No Share of households Minimal Mild Moderate Source: Staff calculations based on High Frequency Phone Survey 2023. Moderately severe Severe Note: Assessment of food insecurity based on FAO Food Insecurity Experience Scale. Illness includes illness, injury or death of an income earning household member. Theft Source: Staff calculations based on High Frequency Phone Survey 2023. includes experiencing theft or looting of cash or other property. 1. Economic Developments 27 Imports have remained steady despite low foreign exchange liquidity in the formal market Estimates indicate that the country is starting to recover from the economic crisis that started in early 2022 (Figure 1.15). The government and firms have faced significant difficulties to pay for imports due to a large, persistent, and increasing trade imbalance as well as low foreign exchange reserves. Interest payments on existing foreign debts make up the bulk of Malawi’s primary income deficit.6 Large transfers for both cur- rent expenditures, called secondary income, and for investment, called capital account transfers, are not able to make up for this imbalance. This imbalance, however, is estimated to have decreased from US$1.5 billion in 2022 to US$1.3 billion in 2023, attributed to larger transfers and reduced interest payments on external debt. The means by which Malawi managed to sustain persistent shortfalls is not clear. The country reports large investment inflows, mostly composed of new debt and arrears payable to foreigners. However, nearly one third of the shortfall remains unexplained, and is classified under “errors and omissions” (see Figure 1.16). FIGURE 1.15  More transfers and frozen debt payments FIGURE 1.16  Large errors and omissions mean that we do are estimated to have made up for a continuedly large trade not know how Malawi affords its current account imbalance imbalance in 2023 Malawi’s financial account by component and year Malawi’s current and capital account by component and year 400 1,000 0 −400 0 US$, millions US$, millions −800 −1,000 −1,200 −2,000 −1,600 −3,000 −2,000 2019 2020 2021 2022 2023e 2019 2020 2021 2022 2023e Net Primary Income Net Secondary Income Direct Investment Portfolio Investment Other Investment Net Trade Balance Net Capital Account Balance Derivatives Change in Reserve Assets Current and Capital Account Balance Net Errors and Omissions Current and Capital Account Balance Source: Staff estimates based on National Statistics Office data. Source: Staff estimates based on National Statistics Office data. Note: e indicates estimates. Note: e indicates estimates. Malawi imports less fuel and fertilizer than before the on- FIGURE 1.17  Fuel and fertilizer imports have increased more set of the crisis, although the share of these commodities in in value than volumes the total value of imports has been increasing (Figure 1.17). Official fuel and fertilizer imports per year Reducing the amounts of non-essential imports is critical to 700 shrinking Malawi's unsustainable trade imbalance. The recent adjustment of the exchange rate is a key policy tool to achieve 600 this by making imports less affordable and exports more com- 500 Million petitive. Recent revisions of Malawi’s trade data (Box 1.3) show 400 that fertilizer and fuel accounted for 27.1 percent of import- ed value since the start of 2022, compared to 18.8 percent two 300 years earlier. However, this still represents 6.1 percent fewer 200 liters of fuel and 30.6 percent fewer bags of fertilizer, reflecting 2020 2021 2022 2023 the substantial increase in the cost of both commodities over Fuel (Litres) Fuel (US$) Fertilizer (Kilograms) Fertilizer (US$) the past two years. However, fuel and fertilizer imports start- ed increasing again recently: Malawi has imported 2.7 percent Source: Staff calculations based on National Statistics Office 2023. 6. Primary income is earned income paid to non-residents. Large components are interest payments on debt and the compensa- tion of non-resident employees. 1. Economic Developments 28 more fuel and 66.3 percent more fertilizer by volume in 2023 than in 2022. Other essential imports, such as medical supplies and pharmaceutical imports continue to experience reductions in import values. BOX 1.3  Revised trade figures show a more nuanced picture of Malawi’s BOP crisis The National Statistics Office (NSO) published revised trade official imports since 2022 — i.e., since onset of the acute phase of figures after working with the IMF to enhance the qual- the economic crisis — had been 0.5 percent higher than the two ity of reporting (see Figure B.1.3.1). According to the NSO, pre- years prior. This contrasts with Malawi’s balance of payments cri- viously published figures had missed imports recorded at ses in 1992 – 1994 and 2012 – 2015 which required a marked nar- inland examination centers, though customs revenue data sug- rowing of the trade deficit by restricting imports. Among Malawi’s gests that imports have nevertheless been taxed throughout. four major BOP crises in the past 30 years, it was only during Where third-party sources of import data exist, such as for fuel the 1997 – 2003 crisis that imports expanded during the second (through MERA) and fertilizer (through the Fertilizer Association half of the crisis (Nur 2024 forthcoming). However, due to ris- of Malawi), the revised figures now match these more closely. ing prices, Malawians can still afford fewer imports of some key Nominal imports were adjusted upward by 37.5 percent for the commodities (see above) and due to distortions in trade and for- period January 2020 to April 2023 with the majority of increases eign exchange markets, imports often do not reach those who in the year from May 2022 to April 2023 (178.8 percent adjust- need them most. ment). Nominal exports remained at similar levels (-1.1 percent These data revisions suggest there are significant weak- adjustment for the entire period). Underreporting was concen- nesses in Malawi’s core statistical capacities. Accurate eco- trated in fuel (23 percent), plastics, paper, printing products and nomic data are critical for good decision-making by both the textiles (17 percent), and fats, cereals, and soap (15 percent). government and other actors. This is especially the case for gen- The revised data shows a more nuanced picture of Malawi’s erally straight-forward and trusted data sources like official trade balance of payments, suggesting that the crisis-induced figures. A new regional World Bank project that includes Malawi import compression was less severe than had been assumed will particularly support the strengthening of statistical capacity in previous analyses (including past MEMs). The US$ value of in the NSO to help address some of these weaknesses. FIGURE B1.3.1  Malawi’s imported significantly more than previously assumed Seasonally adjusted imports, exports, and trade balance 200 200 100 100 00 US$, millions −100 −100 −200 −200 −300 −300 −400 −400 −500 −500 02 021 03 21 04 021 05 21 06 021 07 21 08 021 09 021 10/ 21 11/ 21 12/ 21 01/ 021 02 22 03 022 04 022 05 22 06 022 07 22 08 022 09 22 10/ 22 11/ 22 12/ 22 01/ 22 02 23 03 023 04 23 05 023 06 023 07 23 08 023 09 023 10/ 23 11/ 23 12/ 23 23 /20 /20 /20 /20 20 20 20 /20 /20 /20 /20 20 20 20 20 /20 /20 /20 20 20 20 2 /2 /2 /2 /2 2 /2 /2 /2 /2 /2 /2 /2 /2 /2 01/ Imports Exports Trade Balance Pre-Revision Imports Pre-Revision Exports Source: Staff calculations based on National Statistics Office 2023. Exports in US$ terms in 2023 were 8.3 percent higher than in 2022. During 2023, Malawi’s export bas- ket continued to be dominated by tobacco (42.7 percent of total exports), followed by pulses (7.5 per- cent), and tea (7.3 percent). Especially sugar and pulses have recorded a particularly strong 2023 export season with both higher prices and volumes. Meanwhile, macadamia exporters, despite again achieving a double-digit increase in volumes exported, suffered from a sharp global reduction in prices, bringing 2023 export values down relative to 2022. Smaller quantities of groundnuts have been exported offi- cially in 2023 than in 2022, following last year’s 99 percent growth in volumes. The export competitiveness boost from the depreciation relies on the continued flexibility of the exchange rate. Due to relatively stable nominal exchange rates and considerably higher inflation in Malawi compared to its trading partners, Malawian exporters experienced a loss of competitiveness in the year through October 2023 (Figure 1.18). However, the 44 percent adjustment announced on 1. Economic Developments 29 November 8 has significantly depreciated Malawi’s real ex- FIGURE 1.18  A sharp drop in the real effective exchange rate change rate, bringing it closer to the parallel market rate. New is likely to boost exports World Bank research shows that exports fall rapidly following Real effective exchange rate index, 01/2019 = 100 real exchange rate appreciations but increase only gradually in 130 response to depreciations (World Bank 2023a). While export- 125 ers benefit from a boost in their competitiveness, they need 120 time to identify markets for their newly competitive products, 115 secure the necessary capital for increased production, and ac- 110 cess trade finance. Moreover, this competitiveness boost for 105 exporters will be eroded within months if the inflation differ- 100 ential between Malawi and key export markets (and especial- 95 ly between Malawi and the US) continues and the exchange 90 rate remains inflexible. 05 9 09 9 01/ 9 05 0 20 20 05 1 09 1 21 05 2 22 01/ 2 05 3 23 23 2 2 2 2 2 1 1 1 2 20 /20 /20 20 /20 /20 20 /20 /20 20 /20 /20 20 /20 /20 01/ 01/ 01/ 09 09 09 Malawi’s terms of trade are stabilizing close to their pre-pan- Source: IMF International Financial Statistics 2023. demic level (Figure 1.19). Early in the pandemic, very low oil and fertilizer prices meant that Malawi could afford more imports from its export proceeds. However, a spike in fuel and fertilizer prices in 2021 resulted in an adverse terms of trade shock for Malawi. With oil and fertilizer prices moderating and many of Malawi’s main exports maintaining high prices inter- nationally, Malawi’s commodity terms of trade are stabilizing near their 2019 level. Unprecedented support by development partners likely alleviated the impacts of macroeconomic instability fueled by the currency crisis. From 2018 – 2022, the World Bank, the United States of America (USA), and the IMF have disbursed 44.5 percent of all Official Development Assistance to Malawi accord- ing to the Organization for Economic Cooperation and Development (OECD) Creditor Reporting System. While direct budget support had a diminished role until recently, other on-budget development assis- tance (including front-loading of quickly disbursing operations) has been significantly scaled up since the onset of the pandemic (Figure 1.20). Because a large share of these funds are converted into Malawi kwacha (such as disbursements for social cash transfers) or replace public foreign exchange expendi- tures (such as disbursements for imported machinery to restore the Kapichira dam), they have helped alleviate the severity of Malawi’s balance of payments crisis. FIGURE 1.19  Malawi’s commodity terms of trade are FIGURE 1.20  Development partners have stepped up stabilizing at pre-pandemic levels support Commodity terms of trade, index with 01/2019 = 100 Gross disbursements by source 160 900 150 800 140 700 130 600 US$, Million 120 500 110 400 100 300 90 200 80 100 70 0 2020 2021 2022 2023 2024* 19 19 19 05 0 09 0 20 05 1 09 1 01/ 1 05 2 09 2 22 05 3 23 2 2 2 2 2 2 2 2 20 /20 /20 20 /20 /20 20 /20 /20 20 /20 20 /20 /20 US World Bank IMF 01/ 01/ 01/ 01/ 05 09 Source: Staff calculations based on IMF Commodity Terms of Trade 2023 and World Source: US Department of State 2023, IMF 2023, and World Bank 2023. Bank Commodity Markets Outlook 2023. Note: *budgets and commitments. Officially recorded remittances continued to decline throughout 2023, as many transactions like- ly moved to the parallel market (Figure 1.21). According to the 2019/20 Integrated Household Survey, 4.6 percent of Malawian households received international remittances. The median amount received was 1. Economic Developments 30 MWK 50,000 a year while the mean was MWK 154,000. This implies a national total of approximately US$38 million. The RBM estimate of US$213 million in 2020 for official remittances likely includes other transfers mislabeled as remittances. However, remittances increasingly migrated to the parallel market as the spread between the exchange rates offered by official remittance providers and the parallel market rate widened. FIGURE 1.21  Significantly less money is coming in through official remittance channels Inward and outward remittances, by month 40 30 20 US$, MIllion 10 0 −10 −20 −30 9 04/2019 06/2019 08/2019 9/2019 9 1/22019 0 04/2020 06/2020 08 2020 9/2020 0 0 /20 1 21 06 2021 08 20211 21 211 1/2 21 2 211 1/2 021 / 2 3/2022 5/2022 2 22 /20 2 022 2 1/2 22 2 1 2 22 3 23 /20 3 023 3 7 2 23 /2023 23 3 11/2023 12/20 3 2023 / 8 / 9 /2 9 9 10/2019 12/2019 / 9 0 /2 0 / 0 10/2020 12/2020 02/200220 / 1 /2 1 02 02 1 04 2022 022 2 110/2022 2 /2022 3 /2023 3 23 3 23 5/202 7/ 02 04 02 202 02 2 2 2 2 2 2 3 201 5 201 7 01 1101/201 /202 08 02 02 02 02 2 202 02 3 202 5 02 7/ 02 1101/202 2 02 021 02/201 /20 /200 12/20 12/20 0 /20 20 0 20 12/20 02/20 20 06/20 08/20 12/20 20 3/2 9/2 2 06/2 2 /2 04/2 5/2 9/2 2 21/2 10/ / 110/ / / 10/ 10/ 7/ 9/ 3/ / 10/ / 121 02 04 06 08 012 02 04 06 08 012 02 04 06 08 02 04 06 08 02 04 06 08 10 0 0 0 0 0 0 0 0 0 0 0 Inward Remittances Outward Remittances Net Remittances Average Net Remittances Source: Reserve Bank of Malawi 2023. The depreciation of the Malawi kwacha has not yet resulted in a significant increase in foreign exchange availability. This contrasts with the liberalization of foreign exchange markets in May 2012, which led to an immediate boost to liquidity in Authorized Dealer Bank (ADB) foreign exchange markets (Figure 1.22). Traded volumes continued to increase despite economic hardship as market participants gained trust in the new system. While the reintroduction of an exchange rate peg in March 2016 initially boosted foreign exchange trade, driven primarily by increased ADB foreign exchange purchases, the overvalued exchange rate led to decreasing trading volumes over time. Following the May 2022 depreciation, the market stabi- lized. However, no immediate uptick in foreign exchange liquidity was observed in the weeks following the exchange rate reforms announced in November 2023. Although the more competitive exchange rate and the threat of additional enforcement of penalties for parallel market transactions serve as incentives to shift transactions into the formal market, continued spreads and uncertainty about the credibility of the newly announced exchange rate regime discourage the formalization of foreign exchange transactions. FIGURE 1.22  Foreign exchange liquidity in the official system is yet to benefit from recent reforms Authorized Dealer Bank foreign exchange purchases and sales per week 180 May 2012 March 2016 May 2022 November 2023 170 Liberalization Re-fixing Depreciation Reform 160 150 140 130 US$, MIllion 120 110 100 90 80 70 60 50 40 30 20 10 0 05 011 09 11 01/ 011 05 012 09 12 01/ 12 05 013 09 13 01/ 13 05 014 09 14 01/ 14 05 015 09 15 01/ 15 05 016 09 16 01/ 16 05 017 09 17 01/ 017 05 018 09 18 01/ 18 05 019 09 19 01/ 019 05 020 09 20 01/ 20 05 021 09 21 01/ 021 05 022 09 22 01/ 22 05 023 09 23 01/ 23 24 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 20 /20 /20 2 /2 2 /2 2 2 2 /2 2 2 2 /2 2 2 2 2 2 01/ Purchases Sales Linear Regression Fit Source: Reserve Bank of Malawi 2023. 1. Economic Developments 31 The delayed devaluation of the Kwacha has pushed inflation upwards After a decrease in the preceding months, the 44 percent adjustment of the kwacha in November 2023 elevated inflationary pressures (Figure 1.23). This was primarily fueled by price increases for commodi- ties that had previously been purchased at the official rate. As a result, food inflation rose and peaked at 43.5 percent in December 2023 (Figure 1.24). Previously, the easing of global pressures and the modera- tion of domestic food prices had contributed to food inflation declining to 34.5 percent in October 2023. FIGURE 1.23  Inflation is rising, and broad money growth FIGURE 1.24  Food and non-food inflation remain elevated has picked up again Year-on-year growth, in percent Inflation and broad money growth (year-on-year), in percent 45 40 40 35 35 30 30 25 25 Percent Percent 20 20 15 15 10 10 5 5 0 0 07 7 01/ 7 07 8 18 07 9 01/ 9 07 0 20 07 1 01/ 1 07 2 01/ 2 07 3 23 07 7 01/ 7 07 8 18 07 9 01/ 9 07 0 20 07 1 01/ 1 22 01/ 2 07 3 23 2 2 2 2 1 1 1 1 2 2 2 2 2 1 1 1 1 1 1 2 2 20 /20 20 /20 20 /20 20 /20 20 /20 20 20 /20 20 /20 /20 20 /20 20 /20 20 /20 20 /20 20 /20 20 /20 01/ 01/ 01/ 01/ 01/ 01/ 07 Broad money growth Inflation Food Inflation Non-food Inflation Source: WB with data from NSO. Source: WB with data from NSO. Although year-on-year headline inflation had slightly slowed down to 26.9 percent in October 2023 from its peak of 29.2 percent in May 2023, it subsequently resumed an upward trend reaching 34.5 percent in December 2023. The previous slowing was in part driven by the government’s effort to tackle mounting inflationary pressures by tightening monetary policy, both through increases in the policy rate and decelerating money supply growth. Money supply growth had peaked at 38.8 percent in December 2022, mainly due to a monetization of the fiscal deficit, though this had declined some- what to 28.3 percent in October 2023. Driven by revaluation benefits on foreign currency denominat- ed deposits associated with the 44 percent adjustment, money supply growth increased to 38.5 per- cent in November 2023. Supply constraints and high minimum farmgate prices have FIGURE 1.25  Maize prices are driving up food inflation contributed to domestic food prices maintaining their up- Year-on-year growth, in percent ward trend. The price of maize continued to rise, increasing 300 50 by over 60 percent year-on-year to MWK 744 per kilogram in 250 November 2023 (Figure 1.25). The highest maize prices, exceed- 200 40 ing MWK 800 per kilogram, were reported in the Southern re- 150 30 Percent Percent gion. Given the high share of maize in the food basket, this 100 contributed to food inflation remaining above 30 percent 50 20 throughout the year. Prices of other food commodities also 0 10 increased, driven by both domestic supply constraints, and −50 imported inflation. −100 0 07 17 01/ 17 07 18 01/ 18 07 19 01/ 19 07 20 01/ 0 07 21 01/ 21 07 22 01/ 22 07 23 23 2 20 /20 20 /20 20 /20 20 /20 20 /20 20 /20 20 /20 The November 8 2023 adjustment of the kwacha also exerted 01/ upward pressures on non-food inflation. Non-food inflation Maize Price Food inflation (right scale) had decreased from its peak of 20.5 percent in February 2023 but has since resumed an upward trend, reaching 22.8 percent Source: WB with data from NSO. 1. Economic Developments 32 in December 2023. Due to pricing controls, tariffs for most utilities, including fuel, did not adjust to the depreciation of the parallel rate and to inflation. Consequently, this contained inflationary pres- sure and helped non-food inflation remain steady between June and August 2023. Recent increases in tariffs for water and electricity, as well as for rentals, exerted upward pressure and contributed to non-food inflation rising to 18 percent in October 2023. The 44 percent adjustment of the Kwacha in November 2023 exerted additional upward pressure, especially on transportation and other catego- ries that heavily rely on imports, and pushed non-food inflation beyond 20 percent in December 2023. The fiscal deficit is narrowing for the first time in six years In the last decade, government spending has risen substantially, pushing financing requirements to unsustainable levels. Growth in government expenditure has mostly exceeded growth in revenue (see Figure 1.27). Consequently, the fiscal deficit (net borrowing) has steadily increased over the last decade and exceeded 10 percent of GDP in FY2022/23 (Figure 1.26). This has predominantly been financed by the incurrence of domestic liabilities, mostly from the banking sector (see next section). This has been inflationary and crowded out resources to spur private sector growth. Continuous rising financing needs have made it difficult for the government to source enough resources to finance the deficit, especially in FY2023/24, where resources from the domestic market have mostly fallen short of the required amounts. Net borrowing appears to be moderating in FY2023/24, in line with the government’s efforts to reform public finances. The government expects that the performance during the first half of the fis- cal year will continue throughout the remainder of the year, mainly supported by resumption of budget support and exchange rate gains. Net borrowing is estimated at 7.4 percent of GDP in FY2023/24, an improvement from 10.4 percent of GDP in FY2022/23 (Figure 1.26). This is the first time that the net borrowing is expected to decline in six years. However, this excludes the expenditures required for the statutory recapitalization of the RBM following the November devaluation. This performance will be supported by a marginal decline in expenditure by 0.7 percent of GDP and an increase of 2.4 percent of GDP in revenue (see Figure 1.27). FIGURE 1. 26  Net borrowing is expected to decline in FIGURE 1. 27  …supported by higher revenue collection FY2023/24 Change in revenue, expenditure and fiscal deficit relative to previous FY, in percent of GDP Net borrowing, in percent of GDP 4 0 3 −2 2 1 Percent of GDP −4 0 Percent of GDP −6 −1 −2 −8 −3 −10 −4 19 14 20 /24 /15 /18 /16 17 /21 22 /23 16/ 13/ 18/ 21/ 19/ −12 20 14 17 15 23 22 20 20 20 20 20 20 20 20 20 20 20 11 12 13 20 9 14 /24 20 20 5 16 18 17 20 1 20 3 20 2 /2 1 1 2 /2 10/ 16/ 11/ 12/ 13/ 18/ 14/ 17/ 15/ 21/ 19/ 20 23 22 Revenue Expenditure Net borrowing 20 20 20 20 20 20 20 20 20 Source: WB with data from MoFEA. Source: WB with data from MoFEA. However, recent government actions raise concerns about the veracity of announced fiscal governance reforms. The planned Lilongwe-Salima Water Project raises governance concerns from the modality of its implementation (especially related to a lack of transparency around the borrowing of resources for gov- ernment equity). It also poses challenges for public finance management reforms, and also elevates fiscal 1. Economic Developments 33 risks that could potentially reduce gains from the ongoing fiscal consolidation process. Recent revelations related to the procurement of defense equipment from a company linked to a businessman facing numer- ous corruption charges highlight the importance of the comprehensive roll-out and real-time utilization of the Integrated Financial Management Information System (IFMIS) across all ministries, departments and agencies (MDAs) and ensuring that transparent procedures for procurement processes are followed. Bolstered by increased disbursement of grants, revenue is estimated to continue increasing through- out FY2023/24. Taxes are expected to reach 12.7 percent of GDP, supported by improved collection across categories. The 44 percent adjustment of the kwacha is expected to have a positive impact on interna- tional trade and transactions taxes. Aided by the anticipated budget support and exchange rate gains, the disbursement of grants is expected to surpass the approved target of 1.8 percent of GDP, reaching 3.7 percent of GDP by the end of the fiscal year. Other revenue is also expected to improve and reach 1.2 percent of GDP, from an approved target of 0.7 percent of GDP. Increased spending across all expenditure categories is expected to surpass the approved target. All categories of expenses and acquisition of non-financial assets (development spending) are estimated to exceed their approved levels, contributing to an upward revision of expenditure. Expenditure is estimated to reach 25.0 percent of GDP in FY2023/24, higher than the approved target of 21.9 percent of GDP. Compensation of employees is expected to reach 5.9 percent of GDP, driven by new transport allowances and an upward adjustment of salaries to cushion civil servants from the rising cost of liv- ing. The devaluation of the kwacha and consequent rising inflation is expected to push government spending on goods and services upwards to 3.5 percent of GDP, from an approved target of 3.2 percent of GDP. Moreover, anticipated recapitalization of the Reserve Bank of Malawi to carter for losses incurred from the devaluation may likely push expenses further beyond the approved target. Similarly, rising interest rates and government borrowing exert upward pressure on interest expense, which is expected to reach 5.4 percent of GDP. Development spending is expected to increase to 6.2 percent of GDP, with increases in both the domestically and foreign financed components. Foreign financed development spending is expected to reach 4.6 percent of GDP driven by exchange rate gains and increased alloca- tions for project spending. Similarly, the domestically financed component is expected to increase and reach 1.6 percent of GDP from an approved target of 1.3 percent of GDP. As part of efforts to contain growth of high-cost domestic debt, the government intends to incur more foreign liabilities on concessional terms to finance the deficit. Incurrence of foreign liabilities is expected to increase to 1.1 percent of GDP from an approved target of 0.8 percent of GDP, driven by both increased volumes of concessional borrowing and MWK disbursements becoming larger for a given amount of US$ following the exchange rate adjustment. In turn, a slight reduction in the incurrence of domestic liabilities from an approved target of 6.4 percent of GDP to 6.3 percent of GDP is expected. However, additional borrowing to finance RBM recapitalization may result in incurrence of domestic liabilities even beyond the original approved target. Through the first three quarters of the fiscal year, the fiscal deficit reached 6.1 percent of GDP.7 Bolstered by good performance in all the categories, revenue reached 16.4 percent of GDP. Disbursement of budget support and exchange rate gains contributed to grants reaching 3.2 percent of GDP, the high- est in the past decade. Income, profits, and capital gains taxes made up 5.8 percent of GDP and con- tributed to the tax intake totaling 12.0 percent of GDP. Government expenditure reached 22.5 percent of GDP, driven by both expenses (17.5 percent of GDP) and development spending (5.0 percent of GDP). Statutory expenditures continue to erode fiscal space. Through the third quarter, compensation of employees and interest expenses reached 5.0 and 4.6 percent of GDP, respectively. Development spend- ing reached 5.0 percent of GDP (3.5 percent of GDP foreign financed and 1.5 percent of GDP domestically 7. Shares of GDP are relative to 75 percent of 2023 GDP. 1. Economic Developments 34 financed). If the same momentum can be maintained in the last quarter of the fiscal year, government will likely attain the targets in the revised budget, though in the past fiscal slippages often were most severe in the fourth quarter. Downside risks emanate from the recapitalization of losses incurred by the RBM from the devaluation of the kwacha. This could potentially widen the fiscal deficit. TABLE 1.1  Fiscal accounts Percent of GDP 23/24 Approved Revised 20/21 21/22 22/23 Budget Budget Revenue 14.7 14.6 15.2 14.7 17.6 Domestic Revenue 12.8 12.8 12.1 12.9 13.9 Taxes 12.0 12.1 11.6 12.3 12.7 Taxes on Income, Profits and Capital Gains 5.6 5.5 5.5 5.7 5.9 Taxes on Goods and Services 5.4 5.6 5.0 5.2 5.4 Taxes on International Trade and Transactions 1.0 1.0 1.1 1.4 1.4 Other Taxes 0.0 0.0 0.0 0.0 0.0 Grants 1.9 1.8 3.1 1.8 3.7 From Foreign Governments 0.0 0.0 0.2 0.1 0.1 From International Organizations 1.9 1.8 2.9 1.7 3.6 Other Revenue 0.7 0.7 0.5 0.7 1.2 Property Income 0.4 0.1 0.1 0.3 0.8 Sale of Goods and Services 0.3 0.6 0.4 0.4 0.4 Fines, Penalties and Forfeits 0.1 0.0 0.0 0.0 0.0 Expenditure 21.5 23.2 25.7 21.9 25.0 Expense 17.8 18.5 18.6 17.1 18.8 Compensation of Employees 5.8 6.0 5.6 5.4 5.9 Goods and Services 3.6 3.8 3.1 3.2 3.5 Generic goods and services 2.2 2.2 1.9 1.9 2.1 Interest 3.6 3.3 4.6 5.3 5.4 To non-residents 0.2 0.2 0.3 0.0 0.5 To residents other than general government 3.4 3.1 4.3 0.0 4.8 Grants 1.9 2.1 3.3 1.7 1.9 Social Benefits 2.5 3.0 1.9 1.4 1.7 Fertilizer payments 1.3 1.9 1.1 0.6 0.6 Other Expenses 0.3 0.4 0.1 0.1 0.3 Acquisition of Non-Financial Assets 3.7 4.7 7.0 4.8 6.2 Foreign financed 2.7 3.0 5.4 3.5 4.6 Domestically financed 1.0 1.7 1.7 1.3 1.6 Net borrowing -6.8 -8.6 -10.4 -7.1 -7.4 Primary Balance -3.2 -5.3 -5.9 -1.8 -2.0 Net Incurrence of Liabilities 6.9 10.3 7.0 7.1 7.4 Foreign Liabilities 1.0 2.6 1.9 0.8 1.1 Borrowing 1.0 0.7 1.9 1.7 2.1 Amortization -0.4 -0.4 -0.6 -0.9 -1.0 Domestic Liabilities 5.9 7.7 5.1 6.4 6.3 Source: World Bank calculations, with data from the RBM and MoFEA. 1. Economic Developments 35 Debt accumulation is slowing but timely and successful debt restructuring remains urgent Government uptake of domestic and external debt is slowing but remains high. The stock of pub- lic and publicly guaranteed debt continues to rise, driven by increased uptake of both domestic and external debt. The stock of public debt is estimated to have increased from 75.7 percent of GDP in 2022 to 81.3 percent in 2023. Rising fiscal deficits and subsequent financing through high-cost domes- tic debt has resulted in domestic debt increasing, rising from 30 percent of GDP in 2021 to 42 per- cent of GDP in 2023 (Figure 1.28). External debt also rose and is estimated at 39.3 percent of GDP in 2023. The necessity of tightening monetary policy and the consequent raising of interest rates on treasury securities have not only contributed to a rising fiscal burden resulting in interest expense absorbing over 30 percent of the domestic resource envelope (Figure 1.29), but have also increased debt refinancing risks. With tightened liquidity conditions, the government has mostly struggled to source financing from the domestic market, with subscription amounts falling below requirements in most security auctions. FIGURE 1.28  Public debt still rising FIGURE 1.29  …and interest expense is eroding fiscal room Public debt, as percent of GDP Interest expense, as percent of domestic revenue 100 40 90 35 80 30 Percent of domestic revenue 70 25 Percent of GDP 60 50 20 40 15 30 10 20 10 5 0 0 18 12 13 19 12 13 18 14 16 19 20 14 15 16 15 20 17 21 e 17 e 21 22 22 23 23 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 External Debt Domestic Debt External Debt Domestic Debt Source: WB with data from MoFEA. Source: WB with data from MoFEA. Note: e indicates estimates. Note: e indicates estimates. Public and publicly guaranteed debt remains in distress and unsustainable. The November 2023 joint World Bank-IMF Debt Sustainability Analysis reported that external and total public debt is still in distress and unsustainable under current policies. The recent surge in public debt has been primar- ily driven by escalating fiscal deficits and the depreciation of the kwacha. Figure 1.30 also shows that rising unidentified debt flows (the residual) are pushing public debt upwards. For external debt, the accumulation of commercial external debt through conversion of medium-term swaps into medium term debt in 2020 contributed to a high debt servicing burden. Under the new program with the IMF, as well as the World Bank’s Sustainable Development Finance Policy, the Government will remain com- mitted to refraining from non-concessional borrowing, with most external financing either grants (as is the case for funding from the World Bank and most development partners) or concessional loans. This has already contributed to a slight shift in external debt towards concessional debt held by mul- tilaterals (Figure 1.31). In 2022, multilaterals held 64 percent of total external debt. The authorities are continuing to pursue external debt restructuring. Financing assurances from China and India were received in November 2023, and these will assist the debt restructuring process. Timely and successful implementation will be key for external debt to be considered sustainable on a forward-looking basis. 1. Economic Developments 36 FIGURE 1.30  Deficits and the exchange rate depreciation FIGURE 1.31  Multilateral institutions hold the highest share are driving public debt accumulation of external debt Public debt and change in public debt, as a percent of GDP External debt by creditor, as share of total public debt 40 16 202 Multilateral 2 Bilateral 30 12 Commercial 26% 20 8 28% Percent of GDP Percent of GDP 202 1 10 4 0 0 61% −10 −4 10% 12% 64% −20 −8 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023e Primary deficit Interest-Growth Exchange rate Other flows Residual Public debt change (right scale) Source: WB with data from MoFEA. Source: WB with data from MoFEA. Government borrowing from the banking sector continues to crowd out private sector credit. The share of government domestic debt held by the RBM and commercial banks has increased to 70.1 per- cent of total government domestic debt as of November 2023 (Figure 1.32). This has limited the amount of credit available for private sector borrowing (Figure 1.33), which is essential for stimulating econom- ic activity. By June 2023, exposure of the banking sector to government debt had reached 38.6 percent. Central banking financing alone increased to 35.4 percent of total domestic debt in November 2023, mainly from trading on the secondary market. The resulting increase in the money supply has resulted in inflationary pressures. The RBM financing limit under the new ECF may moderate borrowing from the RBM, potentially leading to increased private sector credit, reduced money supply, and alleviated inflationary pressures. FIGURE 1.32  Domestic debt is still shifting towards FIGURE 1.33  …crowding out private sector credit the banking sector Lending to Government and private sector credit, in MWK million Domestic debt, in MWK million 3,000 6,000 2,500 5,000 2,000 4,000 MWK, Million MWK, Million 3,000 1,500 2,000 1,000 1,000 500 0 0 07 015 01/ 15 07 016 01/ 16 07 017 01/ 17 07 018 01/ 18 07 019 01/ 19 07 020 01/ 20 07 021 01/ 21 07 022 01/ 22 07 023 23 /20 /20 /20 /20 /20 /20 /20 /20 /20 2 2 2 2 2 2 2 2 2 07 015 01/ 15 07 016 01/ 16 07 017 01/ 17 07 018 01/ 18 07 019 01/ 19 07 020 01/ 20 07 021 01/ 21 07 022 01/ 22 07 023 23 01/ /20 /20 /20 /20 /20 /20 /20 /20 /20 2 2 2 2 2 2 2 2 2 01/ Government Borrowing from RBM Commercial Non-bank Foreign Net Claims on Government Private Sector Credit Source: WB with data from RBM. Source: WB with data from RBM. 1. Economic Developments 37 The RBM adjusted the exchange rate by 44 percent, announced measures to increase kwacha flexibility, and maintained a tightened monetary policy The Reserve Bank of Malawi (RBM) adjusted the exchange rate to the US$ by 44 percent. The rate was revised from a selling rate of MWK 1,180 to MWK 1,700 per US$ on November 9, 2023. This follows a period of rigid exchange rate management. The official exchange rate had hardly moved since May 2022, while the parallel rate8 continued to rise. The spread between the official and parallel market exchange rate peaked in August 2023 at 63 percent, then stabilized at around 50 percent by October 2023. This highlighted the need to align the exchange rate with market fundamentals and prevent arbi- trage opportunities (Figure 1.34).9 The new US$-kwacha rate was seen as market-clearing by the RBM. FIGURE 1.34  While the RBM adjusted the exchange rate by 44 percent, reserves remain low RBM telegraphic transfer (TT) and forex bureau (FXB) cash MWK/US$ rates through Feb 2 and months of import cover 2,400 3.0 RBM TT and forex bureau cash MK/US$ rates 2,000 2.5 1,600 2.0 Months import cover 1,200 1.5 800 1.0 400 0.5 0 0.0 02 021 03 21 04 021 05 21 06 021 07 21 08 021 09 021 10/ 21 11/ 21 12/ 21 01/ 021 02 22 03 022 04 022 05 22 06 022 07 22 08 022 09 22 10/ 022 11/ 22 12/ 22 01/ 22 02 23 03 023 04 23 05 023 06 023 07 23 08 023 09 023 10/ 23 11/ 23 12/ 23 01/ 23 24 /20 /20 /20 /20 20 20 20 /20 /20 /20 20 20 20 20 /20 /20 /20 20 20 20 20 2 /2 /2 /2 /2 2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 01/ O icial TT Sell Median Cash Sell Gross Reserves (right scale) Source: World Bank staff calculations based on RBM data. The spread between the official and market exchange rates has widened since the devaluation. After the devaluation in November 2023, the spread between the official and median bureau rates initially nar- rowed to 6 percent but has subsequently widened to over 17 percent in January 2024. The RBM had been conducting monthly forex auctions since June 2023, leading to a 14 percent depreciation against the US dollar from June to October 2023. More recently, it announced plans to increase the frequency of for- eign exchange auctions and permit intermediaries to trade at freely negotiated rates. The devaluation has helped reduce demand for non-essential imports. Moving forward with more flexible exchange rate management will be key for improving external sector competitiveness and building up official reserves. Official foreign exchange reserves have only improved slightly in 2023, despite efforts to rebuild these. Gross official reserves were recorded at US$201.3 million (0.8 month of import cover) in December 2023, an increase from the level at the end of 2022 when reserves were US$120.2 million (0.5 months of import cover). Despite various measures, including conducting foreign exchange auctions, the RBM has rebuilt its official reserves only slowly. Auction purchases have had a very minor role in this regard, contributing only US$700 thousand (less than 1 day import cover) between November 2023 and January 2024. 8. The parallel rate is proxied by the median rate for cash purchases at foreign exchange bureaus, which tend to be less strictly controlled rates. 9. The official exchange rate remained fixed at MWK 1,036 per US$ throughout June 2022 to June 2023 after the official kwa- cha-US dollar exchange rate was adjusted downward by 25 percent in May 2022. Similarly, the official exchange rate hardly moved throughout 2021 and early 2022, resulting in spread at 37 percent in May 2022. 1. Economic Developments 38 BOX 1.4  Lessons from successful exchange rate reforms Malawi is one of several countries that have recently attempted cases such as Uzbekistan in 2017, where the parallel market was to reform an overvalued and overly rigid exchange rate. Burundi, practically eliminated in a matter of days, highlight key ingredi- Egypt, and Nigeria are three other regional examples of countries ents for success: that recently took steps to move towards the parallel market rate. • A supportive monetary and fiscal context is essential. High In all these countries, the overvalued exchange rate had resulted inflation caused by monetary and fiscal misalignments will in lack of access to imported production inputs and consump- lead to a continuously depreciating rate. Successful exchange tion goods, as well as the proliferation of corruption around buy- rate reforms generally involve coordinated fiscal and mone- ing foreign exchange at official rates and reselling it with a profit tary tightening. in the parallel market. • Overshoot now rather than undershoot later. The ideal time An overnight change in the rate is only the first step in suc- for adjustment never comes and the new rate will inevitably cessful exchange rate reforms. As many factors that undergird be perceived as too low by many stakeholders. However, to the emergence of a parallel market, such as restrictive capital reap the benefits and unify the exchange rate, the adjustment control policies, often do not disappear immediately, the adjust- often needs to be swift and reward those switching into offi- ment process can take several months (Gray 2021). An initial cial markets with an attractive rate. overshoot, where the exchange rate at first depreciates beyond the market-clearing rate as foreign exchange sellers factor in • Communication is important. Potential foreign exchange the risk arising from the uncertain situation, is almost inevitable. sellers will want to know the exchange rate policy going for- Many countries also experience a decline in trust in the effective- ward before they trade in the official system. This generally ness of the depreciation, as liquidity takes time to be restored. In takes longer in contexts where there is a history of mistrust turn, some countries opt for a peg at a different level or transition between central banks and market actors. to another managed regime. • Refraining from moral suasion. Attempts to coerce market Instances of successful and sustained unifications of official participants into selling foreign exchange at a given rate will and parallel market exchange rates offer valuable lessons. clearly signal to them that the new rate is not freely available Accomplishing successful exchange rate reform can be chal- or fair. In turn, they will be reluctant to bring foreign exchange lenging both from a technical and political perspective. However, into official markets. Monetary policy has been tightened further, showing some results The RBM has tightened monetary policy to contain inflationary pressures. To address high inflation, the Monetary Policy Committee (MPC) increased the policy rate twice in 2023, from 18 to 24 percent (Figure 1.35).10 With inflation pressures still elevated and intensified, the MPC further raised the policy rate by 200 basis points to 26 percent in February 2024. The MPC also increased the Liquidity Reserve Requirement by 200 basis points to 7.75 percent in July 2023 to curb the expansion of the money sup- ply, and this has been maintained since. The policy rate increase and strong government demand led to a rise in monthly average Treasury Bill and Treasury Note yields across all tenors (Figure 1.36). The yields of both seven-year and ten-year Treasury Notes increased by 450 basis points over the year. This, however, has exerted additional pressure on an already difficult domestic public debt situation by increasing interest payments. Due to monetary tightening, the growth in money supply had decelerated though the recent ex- change rate adjustment has pushed it up once again. Money supply growth reached 38.8 percent year- on-year in December 2022, mainly driven by government borrowing to finance fiscal deficits. However, government borrowing has decelerated which contributed to a slower expansion in the money supply to 28.3 percent in October 2023 (Figure 1.23). Revaluation effects stemming from the 44 percent deval- uation of the kwacha and the subsequent rise in foreign currency-denominated deposits have led to a surge in money supply growth, reaching 38.5 percent in November 2023. 10. This was preceded by two increases in 2022 — from 12 to 14 percent in April, and then to 18 percent in October. 1. Economic Developments 39 FIGURE 1.35  While the real Policy Rate continues to be FIGURE 1.36  …the yield of seven and ten-years notes negative…. climbed over the year Interest rates, in percent Treasury Bill and Treasury Note interest rates, in percent 50 35 500 40 30 400 30 25 20 300 Percent Basis points 20 Percent 10 15 200 0 −10 10 100 −20 5 06 016 11/ 16 04 016 09 017 02 017 07 18 12/ 018 05 018 10/ 019 03 2019 08 020 01/ 20 06 021 11/ 21 04 2021 09 022 02 022 07 23 12/ 023 23 0 0 /20 /20 /20 /20 20 /20 /2 /2 2 /2 /2 2 2 2 /2 /2 /2 /2 01/ 91 182 364 2 3 5 7 10 day day day year year year year year Policy rate Base rate Interbank rate 364-day Tbill Real policy rate Max lending rate 31/01/2023 31/01/2024 Yield Change (right scale) Source: World Bank staff calculations based on RBM data. Source: World Bank staff calculations based on RBM data. The banking sector remains well capitalized, liquid and profitable, and non-performing loans have started to decline While Malawi faces economic challenges, capital adequacy and banking sector liquidity have contin- ued to perform well. By December 2023, Malawi’s banks had a total capital adequacy ratio of 20.1 per- cent, and a tier 1 capital adequacy ratio of 17.1 percent (Figure 1.37). This compares to regulatory min- imums of 10.0 percent and 15.0 percent, respectively. These ratios were slightly higher at 20.9 percent and 17.7 percent, FIGURE 1.37  The banking sector shows resilience respectively, in December 2022. Liquid assets to deposits and Financial stability indicators, in percent short-term liabilities stood at 54.7 percent in December 2023. 70 8 The banking sector continued to post healthy profits in 2023. 60 7 As of December 2023, commercial banks’ return on assets (ROA) 6 increased by 24.4 percent, from 4.1 percent in December 2022 50 to 5.1 percent in December 2023. Similarly, return on equity 5 40 (ROE) increased by 18.6 percent from 33.3 percent to 39.5 percent. Percent Overall profit after tax increased by 50.2 percent to MWK 256.7 4 Percent 30 billion, compared with MWK 170.8 billion recorded in December 3 2022. High profitability was a result of a 55.1 percent increase 20 2 in interest income while non-interest income grew by 52.3 per- cent. This reflects high margins on foreign exchange transac- 10 1 tions in an environment of acute foreign exchange scarcity. 0 0 10/ 22 11/ 22 12/ 22 01/ 22 02 23 03 023 04 23 05 023 06 023 07 23 08 023 09 023 10/ 23 11/ 23 12/ 23 23 In the second half of 2023, non-performing loans (NPLs) /20 20 20 20 20 /20 /20 /20 20 20 20 /2 /2 /2 /2 /2 09 slowed down after growing steadily at the beginning of the year. NPLs decreased slightly from 6.3 percent of gross loans Tier 1 capital Liquidity ROE NPLs (RHS) ROA (RHS) in December 2022 to 6.1 percent in December 2023. Despite this drop, the level of NPLs is still higher than the RBM’s bench- Source: World Bank staff calculations based on RBM data. mark of 5.0 percent, and signals potential risks in the near fu- ture. In addition, the continued rise in interest rates may impact the capability of borrowers to service debts, a situation that may be worsened by exchange rate losses incurred by large corporations with foreign currency denominated liabilities following the exchange rate realignment. These challenges 1. Economic Developments 40 pose further risks to financial stability, especially with regard FIGURE 1.38  Private sector lending is growing, led by the to NPLs, in a sector that has thus far shown remarkable resil- manufacturing sector ience in the face of economic challenges. Share to total lending in selected sectors, in percent Total Private Sector Credit Private sector lending increased in 2023. Credit to firms in- Real estate creased by 22.2 percent from December 2022 to December Wholesale and retail trade 2023 compared to the same period in the previous year. In Transport, storage and communications the year up to December 2023, lending to the manufacturing Restaurants and hotels sector grew by 10.3 percent (Figure 1.38). Lending to commu- Construction nity, social, and personal services grew by 20.3 percent during the 12 months period ending in December 2023 while lend- Agriculture, forestry, fishing & hunting ing to the agricultural, forestry, and fishing sector significant- Financial services ly increased by 49.1 percent in December 2023, and lending Community, social and personal services to the financial services sector by 37.5 percent. The growth in Manufacturing the lending sector reflects a recovery from challenges associ- −20 −10 0 10 20 30 40 50 ated with COVID-19 and cyclones in 2022 and 2023. Lending to Percent real estate shrank while lending to wholesale and retail sector Average from 12/2022 12/2023 grew by only 3.9 percent. Source: World Bank staff calculations based on RBM data. 1. Economic Developments 41 1.3 MEDIUM-TERM ECONOMIC OUTLOOK Economic growth is projected to increase over the medium term, supported by an improved macro- economic environment and ongoing structural reforms. Growth is projected to increase to around 3 percent in 2024, mainly driven by a slight easing of global commodity prices, a moderate improve- ment in agricultural production, and increased output supported by improved foreign exchange inflows. The outlook assumes increased budget support from development partners and that the new IMF pro- gram remains on-track. Growth is expected to average 4 percent in the medium term, supported by ongoing and announced macroeconomic reforms aimed at addressing external and fiscal imbalances. The current account deficit is expected to stabilize in the coming years from the high deficit of recent years. Bolstered by exchange rate reforms and the anticipated accumulation of reserves partly supported by foreign exchange purchases via auctions, exports are projected to gradually improve, con- tributing to a moderating current account deficit. Broader external sector reforms supported under the recently agreed ECF will help boost reserves. Inflation pressures will persist in the next year but are expected to subside as announced reforms are implemented. The recent 44 percent adjustment of the kwacha and increased fuel and utility prices are exerting pressures on inflation. In addition, the upcoming El Nino season may result in lower than anticipated agricultural production and higher food prices. Going forward, prudent monetary and fis- cal policies are essential to arrest the effects of these transitory factors and lower inflation sustainably. The fiscal deficit is expected to continue narrowing if fiscal consolidation efforts are sustained. Under the ECF-supported program, the government has committed to consolidate public finances by 1.3 per- cent per year over the next four years, excluding the recapitalization of the RBM. This will be supported by revenue enhancement measures, including automation of tax administration, VAT tax reforms and streamlining of tax incentives. In addition, the ECF program has catalyzed increased budget support by the World Bank, as well as planned support by the European Union and the African Development Bank. The government will also need to rationalize and prioritize expenditures, including those related to AIP and the wage bill. This will boost available resources and remain critical for regaining macroeconomic stability and fiscal sustainability. The ongoing implementation of public finance management (PFM) reforms is expected to support improved expenditure management and fiscal consolidation. This includes continued progress in the roll-out and real-time use of the IFMIS to support fiscal reforms, including the implementation of sound commitment control and cash management measures. These efforts are expected to contrib- ute to containing the variance between approved budget and outcomes, leading to a reduced fiscal deficit. Furthermore, the government has developed its first PFM Strategy to establish a framework for implementing reforms in PFM and to align government finances with national development planning. However, governance and transparency issues associated with defense procurement contracts and the Lilongwe-Salima Water Project risk undermining PFM reforms and efforts to restore debt sustainability. 1. Economic Developments 42 Numerous downside risks to the Malawian economy persist. Vulnerability to natural disasters and unpredictable weather patterns add uncertainty to the outlook. Delays in PFM reforms could hinder fiscal consolidation and the control of spending arrears, as would fiscal slippages in the final quarter of the current fiscal year. Delayed debt restructuring could further exacerbate debt sustainability. Volatile commodity prices could exert pressure on inflation and the external sector. Exchange rate reforms would need to be adequately supported by sound fiscal and monetary policies to facilitate the accu- mulation of foreign reserves and prevent the re-emergence of a large exchange rate premium. Upside risks include higher-than-expected exports in the agriculture sector, mining production proceeding faster than anticipated, and increased grants. Policy Priorities: Bolstering macroeconomic stability, creating the foundations for export-led growth, and protecting the poor against shocks The government has implemented various measures to mitigate the ongoing economic crisis. Notably, this includes i) strengthening debt management, through initiation of debt restructuring with exter- nal creditors and restricting new non-concessional borrowing, ii) progressively lowering allocations for fertilizer and seed subsidies through the AIP between FY2021/22 and FY2023/24, iii) conducting foreign exchange auctions and increasing exchange rate flexibility to facilitate price discovery, iv) improving fiscal governance through the implementation of the new PFM Act, and v) most recently, moving for- ward with efforts to align the exchange rate. The 18th edition of the Malawi Economic Monitor (MEM) outlines urgent actions and sustained reforms required to consolidate the stabilization of the economy, enhance growth, and protect the most vulnerable. It specifically recommends: i) Bolstering macroeconomic stability: Ongoing macro-fiscal reforms need to be sustained and fully implemented, focusing on rebuilding foreign reserves, enforcing fiscal discipline, enhancing pub- lic financial management, improving debt management, and increasing flexibility in exchange rate management. The planned fiscal tightening and related fiscal governance reforms, and suc- cessful external debt restructuring will be integral to regaining debt sustainability. ii) Creating the foundations for export-led growth: Key measures include stimulating growth of the agriculture sector by advancing with reforms of the AIP and commercialization initiatives, incen- tivizing exports by reducing non-tariff barriers, and supporting development of an efficient and transparent mining sector. iii) Building resilience and protecting the poor: With the heightened risk of extreme weather events and food insecurity, it will be essential to move forward with the implementation of the expanded social cash transfer and climate-smart public works programs, as well as to strengthen the func- tioning of agricultural markets. Implementation of the Disaster Risk Management Bill will be key to enhance preparedness for future disasters and strengthen resilience . 1. Economic Developments 43 TABLE 1.2  Priority policy areas and key actions 1. Bolstering macroeconomic stability Support reserves accumulation, liquidity in the forex market, and the credibility of Building foreign announced exchange rate reforms (including freely negotiated exchange rates between Short reserves ADBs and clients, and fortnightly auctions). Implement fiscal consolidation measures, increase domestic revenue, and improve Balancing the budget forecasts of pre-determined expenditure to demonstrate that Malawi can operate within Short its budget. Improving public financial Adhere to quarterly allotment ceilings in IFMIS to reduce growing spending arrears that arise from overspending and committing outside the system. Medium management Rapidly conclude negotiations with creditors to achieve sufficient reductions in external Achieving debt sustainability debt levels and contain domestic debt levels to pre-defined targets. Short Creating the foundations 2.  for export-led growth Support development of an Accelerate the development of mining projects under negotiation by identifying critical efficient and transparent mining bottlenecks, streamline and expedite permitting processes, and improve government Medium sector that can drive growth coordination and capacity to effectively negotiate multiple agreements concurrently. Proceed with the AIP 2.0 reform process to reduce the fiscal burden, maximize fertilizer Stimulate agricultural growth use efficiency through better targeting, and improve the timeliness of input procure- Short ment and distribution. Review existing NTBs and develop a strategy for phasing these out, especially in sec- Incentivizing exports by tors where Malawi has a comparative advantage (agriculture, agro-processing, mining, Short reducing non-tariff barriers tourism). Building resilience 3.  and protecting the poor Continue the rollout and scaling up of cash transfer and climate-smart public works Facilitate the move to off-farm projects to address current livelihoods needs while encouraging the development of a Medium livelihood strategies local off-farm economy. Strengthen the functioning Minimize interventions in agricultural markets to bolster increased domestic and and integration of agricultural regional food trade, incentivize increased participation by traders in markets and Medium markets reduce grain price differentials throughout the country. Implement the DRM Bill and Post Disaster Needs Assessment (PDNA) lessons to Preparing for the next disaster ensure improved disaster preparedness Short Initiate Strengthen Sustain 2 HEALTHY WATERSHEDS FOR A STRONG ECONOMY 2. Healthy Watersheds for A Strong Economy 45 Introduction This edition of the Malawi Economic Monitor examines the relationship between Malawi’s natural capital, in the form of watersheds, and its economy. Currently, the country’s watersheds are severely degraded. Improving how watersheds are managed and used can open opportunities to improve the country’s economic performance, build resilience to climate risks, and support more reliable and sus- tainable livelihoods for many households, including the poor- est. Box 2.1 explains what a watershed is and the characteris- BOX 2.1  What is a Watershed, and what is a ‘Healthy’ tics of a healthy one. Watershed? A watershed is an area of land that feeds water to a river, The pressures on Malawi’s watersheds are complex, inter- draining through the landscape into tributaries and main related, and longstanding but are magnified by two under- river channels. Watersheds are also called ‘catchments’ or lying drivers: rapid population growth and climate change. ‘river basins.’ In most cases, these three terms are used inter- Rapid population growth places massive demands on nat- changeably. However, to differentiate in terms of scale, ‘river ural ecosystems. Marginal land is converted to agriculture, basin’ is used to describe a watershed covering a large area of land that drains into a major river (e.g., Shire River Basin), while forests are harvested for wood or cleared for agricul- while ‘sub-catchments’ or ‘micro-catchments’ or ‘micro-wa- ture. The quality and quantity of water resources decline as tersheds’ are much smaller parts of a basin that drain into a soils and agrochemicals run off degraded landscapes and pol- tributary stream. lute watercourses and wetlands. The resulting degradation Malawi’s watersheds are dynamic areas that become wet leads to the loss of soil fertility and diminished watershed and dry depending upon the season or even the effects protection. Climate change magnifies existing environmen- of an individual storm. Within a watershed, activities on tal vulnerabilities and accelerates the decline. This results the land interact with the natural hydrologic cycle. Essential in reduced incomes and resilience for rural households and, nutrients and chemicals are circulated throughout the water- shed’s system and supply nutritional sources for plant, terres- at the national level, reduced economic output and nation- trial (birds, small mammals, etc.), and aquatic (fish, aquatic al income. Figure 2.1 illustrates this complex web of envi- insects, etc.) species. People use watersheds to grow food, ronmental decline. harvest forests, build homes and businesses, and travel. Human activities significantly impact water movement, water Severe land degradation in the country’s most important wa- quality, soil conditions, and nutrient availability. tersheds significantly impacts water security (including ac- A healthy watershed can support healthy biological com- cess to drinking water, sanitation, and health), agricultural munities. A habitat with sufficient size and connectivity to support native plant, terrestrial, and aquatic species is productivity, and hydropower generation. Recent studies sug- the critical characteristic of a healthy watershed. A healthy gest that land degradation hotspots (locations where multiple watershed protects and renews valuable natural assets, and indicators of degradation combine) cover nearly half (41 per- provides multiple economic and social benefits for a coun- cent) of Malawi’s land area (Kirui et al. 2021). Around 75 per- try’s population. cent of Malawi’s soils are degraded or threatened by degrada- Source: Adapted from IUCN 2009. tion (Omuto and Vargas 2019). The average annual national soil loss rate in 2014 was 29 tons per hectare (Vargus and Omuto 2016), with other assessments suggesting the rate may be higher in some locations (Asfaw et al., 2018). Chemical land degradation, including soil pollution and salinization or alkalization, was estimated to have led to the loss of 15 percent of Malawi’s arable land (FAO, 2013). Projections for future land deg- radation and soil loss under different climate and population growth scenarios suggest that land deg- radation will become increasingly severe (World Bank, 2022a), with one study indicating that overall rates of soil loss will increase three- to four-fold relative to 2010 baseline levels (Asfaw et al. 2020). Box 2.2 explains the characteristics of degraded soils. The Shire River Basin remains the most prominent hotspot of land degradation. High sediment load deposited in riverbeds, reservoirs, and floodplain wetlands affect irrigation canals, fisheries, and hydropower generation. Existing hydropower plants on the Shire River often need help to meet peak demand, partly due to low flows and sediments in the river caused by the degradation of catchments upstream of the plants. 2. Healthy Watersheds for A Strong Economy 46 FIGURE 2.1  Environmental Drivers, Pressures, and Impacts The relationships between the drivers, the environmental pressures and impacts that work together to create the decline in the health of Malawi’s watersheds Biodiversity loss, reduced tourism income l tura na ion and For Reduced fish ble tract de es g ex our ina yields & incomes t lo dati res susta ra ss on ce Reduced household Un energy security Degradation of wetlands & fisheries Rising Climate Increased indoor population will change air pollution Loss of life, incomes increase demand exacerbates & resilience for environmental other resources impacts Increased need for water, and food n d s g i n al Loss Reduced hydropower sanitation & solid waste management system: etla m a r generation of s d w a health risk from an o il t e r d w in t o unsafe systems f er s h an tu r e t ili Reduced economic , cu ed l a n d ty g ri ts l output and national income pro d e tec gr ada n of a ores ti o n t i o n si o , f E x p a n a re a s Reduced agricultural yields and incomes Relationships between the drivers Environmental pressures Impacts Source: World Bank 2019. BOX 2.2  What are degraded soils? Soil degradation refers to losing land’s physical, chemical, • Ecological: Decreased land productivity due to environ- biological, and ecological qualities due to natural or human- mental factors, mainly climate change (increasing tempera- caused disturbances. Examples of soil degradation processes tures, altered precipitation patterns, extreme weather events). are the exhaustion of nutrients and organic matter, soil erosion, Deforestation and the loss of ground cover contribute to the acidification, desertification, and pollution. ecological degradation of soil by exposing it to erosion and Four main factors contribute to soil degradation: causing disruptions in ecosystems. • Biological: Decreased microbial activity due to destruc- • Physical: Loss and depletion of fertile topsoil due to physical tive biochemical reactions, especially in bare/unprotected impacts (floods, surface runoff, landslides, winds and storms, earth, reduces yields and makes land less amenable to crop intensive tillage, heavy machinery use). Long-term physical cultivation. degradation harms soil fertility, composition, and structure. • Chemical: Unfavourable changes in soil chemistry (caused, In any single location, the importance of each of these factors particularly, by synthetic fertilizers and pesticides) dimin- will vary, depending on the land’s starting condition, the nature ish plant nutrition: beneficial microbes and humus content and severity of the stresses put on it, the land’s reactions to decline; and the pH of the ground shifts. those stresses, and the feedback from those reactions on the natural assets. Source: Based on Kogut 2022. Malawi’s watersheds are the key to understanding the challenges currently threatening the country’s important and valuable assets: land, forests, and water. Together, these resources are often referred to as ‘natural capital’ and are essential to the country’s overall wealth, although quantifying their mon- etary value is challenging. Figure 2.2 shows the composition of Malawi’s natural capital and its impor- tance to Malawi’s total wealth.11 11. Natural capital covers the following assets: Nonrenewable resources: 14 types of minerals and fossil fuels; Renewable resources: cropland, pastureland, forest timber, forest services (an estimate of non-timber forest products), watershed services, recreation values), protected areas (value estimated as the opportunity cost of converting to agriculture). The measurement used here does not yet include the value of carbon retention or sequestration services as part of wealth embedded in biological ecosys- tems (for example, forests and soils), mor does it subtract the social cost of carbon from fossil fuels. 2. Healthy Watersheds for A Strong Economy 47 FIGURE 2.2  Where is Malawi’s Wealth? — Malawi’s Natural Capital Assets measured in market prices and converted to 2018 US$ using market exchange rates 811 Produced Capital Forest 6% Protected Areas 20% Crop 2,666 Natural Capital Pasture Total Wealth: 8% 7,865 3,108 Human Capital 66% -136 Net Foreign Assets Source: World Bank 2021. In combination with other types of capital, natural capital forms part of a country’s wealth. It under- pins a country’s capacity to produce current or potential goods and services in the future to enhance the wellbeing of its citizens. When a country exploits its land, forest resources, and the associated water resources, it may generate income but deplete its natural capital. Healthy watersheds can benefit all Malawians, but they need to be nurtured and cared for Malawi’s watersheds support the country’s natural resources like land, forests, and water. They help crops, trees, livestock, and fish thrive. Healthy watersheds boost land and water productivity and make communities more resilient to floods and droughts. This resilience ensures a steady source of income, food, water, and power, forming the foundation for developing other valuable assets. Conversely, when water- FIGURE 2.3  Land degradation across Malawi now covers sheds are degraded, they struggle to provide these essential 41 percent of total land area resources. Without intervention, their ability to support the Extent and Scale of Degradation environment declines, leading to increasingly severe problems Cumulative over time. Given the significance of natural capital as an as- Degradation Score: set for Malawi (Figure 2.2), it is crucial that it is utilized effi- 1 ciently and managed in a sustainable manner. Failure to act 2 to protect and enhance Malawi’s watersheds may result in a 3 decline in their value, with the associated economic benefits 4 5 going unrealized. 6 7 Around 80 percent of Malawi’s land is degraded, impact- 8 ing the livelihoods of millions (World Bank, 2022a; MoNREM, 2017). This compares with 51 percent in Tanzania, 23 percent in Ethiopia, and 22 percent in Kenya (Kirui et al., 2021). Land degradation ‘hotspots’ cover about 41 percent of the land area in the country (Figure 2.3), with the Shire River basin the most affected (MoNREM, 2017). Two of Malawi’s three prominent soil types are suited to agriculture but also highly susceptible to erosion. The average annual national soil loss rate in 2014 was 29 tons per hectare (Vargus & Omuto, 2016). The nega- tive effects of this rate of loss, if the causes are not addressed, could range up to 20 percent of national agricultural produc- Source: Based on Alliance for Restoration of Forest Landscapes and Ecosystems in tion and 3 percent of GDP, with an additional 10 percent in soil Africa 2023. loss leading to more than 270,000 additional individuals in Note: This map shows cumulative degree to which an ecosystem’s physical condition, composition, structure, and function have been adversely affected by anthropogenic poverty (Asfaw et al., 2020). factors. The higher the score, the more severe the degradation. 2. Healthy Watersheds for A Strong Economy 48 This extensive degradation is fueled by limited livelihood FIGURE 2.4  Forest and grassland is being replaced by options, high population density, and a growing demand agricultural land and wetland for charcoal and firewood. These factors compel people to Change in land use and cover from 1999 – 2018, in km2 expand cropping into forests and wetlands, cultivating steep 50 -8.4% slopes and highly degradable, shallow soils. The scarcity of en- ergy alternatives to charcoal further contributes to ongoing de- 40 forestation. Land degradation also significantly impacts other sectors — particularly water resources, energy generation, ag- 4.9% 30 km , Thousand riculture, and fisheries. Over recent decades, agricultural land -6.5% has progressively expanded into forest areas, albeit at a slow- 9.6% er pace since 2000. This expansion has led to the cultivation 20 of fragile upper catchments (Figure 2.4). This degrades natu- ral habitats, exacerbates downstream flooding, and increas- 10 es exposure to weather shocks. Cropping on unsuitable land is seldom productive, and although short-term gains may be 0 achievable with inorganic fertilizer, the yields are not sustain- Forest Agriculture Wetland Grassland able. This practice inevitably results in increased soil loss and 1999 2018 accelerated degradation (Asfaw et al., 2018). Degraded water- sheds also impact the availability of clean water in Malawi, as Source: Based on Gondwe et al. 2019. environmental degradation and changes in land use/land cover are major causes of clean water scarcity. This problem is par- TABLE 2.1  The significant drivers of watershed degradation ticularly severe in and around urban areas, such as Lilongwe in Malawi (Nkwanda et al., 2021) Proximate drivers Underlying drivers • Charcoal and wood fuel (for • Development processes in Projections under different climate and population growth domestic and commercial use) energy, forestry, agriculture rate scenarios suggest that land degradation will become in- • Timber production and water sectors creasingly severe. Climate change can accelerate soil degrada- • Unsustainable agricultural • Poverty tion as a result of altered weather patterns, increasing temper- methods (slash and burn with • Lack of alternative energy shorter rotations) sources atures and extreme weather events. Land degradation could • Mining • Weak policy environment and increase the damage to Malawi’s infrastructure from inland lack of planning flooding by as much as 25 percent by 2050. (World Bank 2022a). • Insecure land tenure Increased flooding alters local landscapes, is closely tied to the • Lack of/uneven policy enforcement loss of woodland areas, and constitutes the primary cause of the expansion in wetland areas (Gondwe et al. 2019). Source: Adapted from Kirui 2015. Chemical land degradation, including soil pollution and salinization/alkalization, has led to a 15 per- cent loss in the arable land in Malawi in the last decade alone. Land degradation also significant- ly impacts other sectors — particularly water resources, energy generation, agriculture, and fisheries. Increasingly, agricultural land has expanded into forest areas over recent decades, albeit more slowly since 2000, resulting in the cultivation of fragile upper catchments (see Figure 2.4). This degrades nat- ural habitats, exacerbates downstream flooding, and increases exposure to weather shocks. Projections under different climate and population growth rate scenarios suggest that land degradation will be- come increasingly severe. For example, land degradation could increase the damage to infrastructure from inland flooding by as much as 25 percent by 2050. (World Bank 2022a). Effective management of Malawi’s watersheds is necessary to reduce Malawi’s high poverty levels. 71.7 percent of Malawians live on less than US$2.15 a day, the third-highest rate in Sub-Saharan Africa. The country remains predominantly rural, with nearly 85 percent of the population residing in rural areas. Rural poor households make up approximately 94 percent of all poor households (World Bank, 2022b). Most rural households depend on farming for a significant share of their livelihoods. Alternative sources of income in rural areas, such as wage labor or small-scale enterprises, also depend on local natural resources in some way (World Bank. 2022b). Degraded and degrading watersheds directly limit poor households’ ability to improve their incomes and livelihood opportunities. 2. Healthy Watersheds for A Strong Economy 49 Malawi is highly vulnerable to the impacts of climate change Climate change projections indicate that floods, droughts, and heatwaves will increase in sever- ity and frequency. This is expected to accelerate land degradation, contribute to forest loss, and ele- vate the likelihood of more frequent natural disasters. Future climate change scenarios suggest that Malawi will see increasing climatic variability, higher temperatures, longer dry periods, more erratic and intense rainfall, and associated droughts and flooding (GoM, 2017; World Bank, 2022a). These adverse impacts of changes in weather patterns will have nationwide repercussions, threatening local and national food security, undermining livelihoods, damaging critical infrastructure, and reducing economic activity and output. For example, weather shocks have caused more Malawians to fall back into poverty than those who moved out of it between 2010 and 2019 (World Bank, 2022b). In March 2023, when Tropical Cyclone Freddy struck the country, causing loss and damage of well over US$500 million, more than 2.5 million people were affected, over half of these women and girls of reproduc- tive age, including more than 100,000 pregnant women (GoM, 2023). Climate shocks will increase the vulnerability of the poorest households, whose livelihoods often depend on natural resources. Many households have very few other resources to fall back on if their core livelihood strategy fails. Poor rural households are particularly exposed to this type of risk because their livelihood security relies on natural resources. Rehabilitating watersheds is key to mitigating these climate risks to livelihood security. Rehabilitating watersheds will mitigate the impacts of floods and droughts. Healthy watersheds con- tribute to better runoff control after storms, mitigate soil loss from erosion, and prevent or reverse the degradation of productive land. Reducing soil loss plays a crucial role in minimizing sedimentation in watercourses, leading to improved river/stream flows and decreasing the likelihood of rivers burst- ing their banks. As a result, heavy storms do less damage to farmland, property, critical infrastructure, and other assets. Improvements in soil water retention and groundwater recharge mitigate the impact of droughts on crops. Degraded watersheds increase Malawi’s vulnerability to disasters Population growth, and consequently, water demand is surpassing water availability in Malawi. The country has the lowest water availability per capita relative to its neighboring countries. The country’s total renewable water resource is ± 927 cubic meters per capita per year. This is very close to water scar- city (UNICEF, 2022). Due to population growth, watershed degradation, and climate change, per capita water availability has declined by 44 percent in the last 20 years (World Bank, 2020). Restoring water- shed health at scale would make a significant contribution to addressing water scarcity. Malawi’s lakes, wetlands, aquifers, and river systems constitute its most vital natural resources; however, the country is on the verge of experiencing water stress and scarcity. The likely impacts of climate change and insufficient water infrastructure and management systems add to the risk of widespread water stress (World Bank, 2022a). The compounded economic impact of degraded water re- sources in Malawi is hard to estimate collectively. However, just one aspect of degraded water resourc- es, poor sanitation, alone costs the country US$ 57 million annually, around 1.1 percent of GDP (UNICEF, 2022). Severe Floods in 2015, 2019 and 2023 have cumulatively cost the country 1.18 percent of its GDP (GoM. 2015; 2019; and 2023) — a financial burden exacerbated by the absence of water-regulating infra- structures, reduced natural floodwater regulation because of forest loss, and encroachment for both farming and construction into high-risk flood zones (GoM, 2023). The impacts of droughts and floods are exacerbated by the degraded state of Malawi’s watersheds. Extreme weather events, beyond Malawi’s control, become ‘disasters’, where mitigation measures are within the country’s control. Insufficiently protected soil surfaces in degraded watersheds amplify the 2. Healthy Watersheds for A Strong Economy 50 adverse impacts of floods and droughts by increasing runoff, decreasing infiltration, and increasing soil water loss through evaporation. One of the reasons that recent floods have had such devastating consequences is that degraded watersheds were unable to absorb and hold back runoff to protect val- uable assets. Frequent and ongoing disaster responses associated with degraded watersheds displace produc- tive investments. The persistent need for disaster responses ties up human and financial resources that could otherwise be allocated to a diverse array of national development priorities. This includes investments that can mitigate disaster risk, such as rehabilitating watersheds. Reducing the resources required to respond to disasters would free up resources for a wide range of productive investments that could improve Malawi’s development trajectory. Malawi’s forests are being lost at an alarming rate Over half the country’s forests and woodlands have vanished in the last 40 years. Those that remain are being thinned through over-extraction and frequent forest fires. In 1975, around 47 percent of Malawi was forested land (Mauambeta et al., 2010). More than half of these forests were lost between 1972 and 1992, at a rate of 2.5 percent per year. Since 1992, the rapid rate of decline has slowed, and deforestation is currently estimat- FIGURE 2.5  Comparing Malawi’s forested area with that of ed at between 0.63 and 0.76 percent annually, with the scar- its neighbors city of remaining forest being the primary constraining fac- Percent of land area tor (MoNREM, 2019 and 2020). Regional analysis indicates that 70 Malawi’s forested land area share is now lower than the sub-Sa- haran average and considerably lower than that of its neighbors 60 (Figure 2.5). Forests substantially and directly contribute to live- 50 Percent lihoods and the economy and protect vital ecosystem services. 40 Forests provide essential environmental and economic bene- 30 fits, and their decline results in negative environmental and economic consequences. Forests and woodlands contribute 20 1990 2000 2012 2013 2014 2015 2016 2017 2018 2019 2020 to 7 percent of Malawi’s total wealth and represent 20 per- cent of its natural capital (World Bank, 2021). However, these SSA Malawi Mozambique Tanzania Zambia Zimbabwe values are expected to decline steadily as forest resources are depleted. Forests and trees make substantial contributions to Source: World Bank data portal. livelihoods, jobs, and the economy by supplying biomass fu- els as sources of soil fertility, preventing land degradation, protecting watersheds, and providing habi- tats for biodiversity and wildlife. Forests also provide the bulk of Malawi’s energy supply through char- coal and firewood, estimated to be worth US$ 352 million in 2017 — the equivalent of 4.7 percent of GDP. (World Bank, 2019). Many of the ecosystem services forests provide are not easily quantified and tend to be overlooked in economic planning. The loss of forest and associated habitats and biodiversity sig- nificantly impacts the resilience of the surrounding communities dependent on the resources. Forest loss is closely linked to Malawi’s broader problems of land and water degradation. Deforestation, forest degradation, and the loss of on-farm trees are significant contributors to Malawi’s land and wa- ter degradation problems. Forests and other natural vegetation help buffer the impacts of rainfall, pre- venting water runoff and soil erosion. As forest cover is lost, increased runoff carries soil from both the previously forested areas and open land downstream. This reduces the productivity of downstream ag- riculture and erodes stream banks. When soil flows into water courses, it clogs water intakes for irri- gation, drinking water supply, and hydropower generation, imposing a broad range of economic costs. This issue has received particular attention in the Shire River basin in Malawi, partly because all of the country’s hydroelectricity generation plants are on the Shire River, and the economic consequences of power plant closures are severe. 2. Healthy Watersheds for A Strong Economy 51 Expanding agriculture, driven by an increasing rural population with few alternatives to farming, is a key driver of degraded watersheds Land degradation is a significant threat to agricultural development in Malawi and impacts over- all economic growth. The extensive impacts of degradation include a loss in agricultural productivity, heightened expenditure on fertilizers (as degraded soils do not respond optimally to fertilizer treat- ments), and a general decline in the profitability of crop production. Soil loss removes fertile soils from farmlands and reduces the cultivable soil depth. Due to the size of Malawi’s agricultural sector, degraded land significantly constrains the country’s overall economic development. Crop production is facing challenges due to the overall reduction in cropland productivity and an increase in soil erosion in recent years. A rapid expansion in cropland between 1999 and 2018 (an increase of 9.6 percent of the proportion of land area under crops) was characterized by an expansion of crop farming into upland areas, indicating increased land scarcity in Malawi. There is now limited potential for future expansion, as approximately only 5 percent of the total land remains as potentially available cropland — corresponding to 4,671,000 ha. (Chengxiu Li et al, 2021). Rehabilitating watersheds will protect the livelihoods of poor rural communities. Rehabilitated wa- tersheds will be more productive, potentially increasing food and livelihood security (at local and na- tional levels). Each dollar spent on addressing land degradation in Malawi is estimated to yield about US$ 4.3 over 30 years by restoring the productivity of crop land and forest resources (Kirui, 2016). The technologies required to do this are standard soil and water conservation practices such as terracing and bunding, tree planting, using more organic fertilizers, and planting trees. The government’s 2017 Forest Landscape Restoration Opportunities Assessment estimated that restoring 2.4 million hec- tares of degraded cropland would increase maize production by 1.55 million metric tons per year, an increase of 40 percent (MoNREM 2017). The World Bank’s recent “Malawi Climate and Development Report” showed that reducing soil erosion and improving land management can translate into signif- icant economic gains under all climate scenarios (World Bank, 2022a). While the estimated returns to sustainable land management practices appear to be high, achiev- ing them presents challenges. Experience elsewhere in Southern and East Africa indicates that poorer farm households (the majority of Malawi’s rural households) often need more resources to fully bene- fit from investments, and there are high de-adoption rates for techniques such as conservation agricul- ture and agroforestry. This is usually because labor requirements are high and/or subsidies have ended. In Malawi, high levels of interventions in the markets for key crops may also play a role. Insecure land tenure also impacts land degradation because it limits farmers’ incentive to invest in improving their land. Improving and protecting degraded land requires time and labor, and most benefits are not seen immediately. Insecure land tenure reduces incentives to invest in higher-value crops or soil conservation measures, resulting in lower productivity levels and land degradation. In a 2016 study, around 33 percent of households told researchers that they felt their rights to their plots were insecure (Lovo, 2016). The recent introduction of new land policies, including those for custom- ary land, reflects a recognition that the lack of tenure security on customary land limits incentives for smallholders and businesses to invest in sustainable land management (SLM) practices. Agriculture policies play an essential role in shaping natural resource management. Agriculture pol- icies and accompanying state interventions have encouraged mono-cropping, particularly of maize. These policies, such as the current Affordable Input Programme and its predecessor, the Farm Input Subsidy Programme, have worked against crop diversification and sustainable agricultural develop- ment in various ways, such as promoting monocultures and the intensive use of inorganic fertilizers. This has contributed to land degradation and reduced resilience, with farmers continually searching for new land for cultivation, often at the expense of forests or opening up poor-quality land that rap- idly degrades (see also World Bank 2022d). 2. Healthy Watersheds for A Strong Economy 52 Unsustainable agricultural practices can be turned around by incentivizing farmers to manage their land sustainably Creating incentives for the farm-level scaling up of sustainable land management practices can be achieved by strengthening land tenure security and reforming input subsidies. Two policy priorities are central to this: implementing land tenure reforms at scale and reforms to subsidy regimes. Land tenure reforms at scale will increase tenure security and incentivize landholders to invest in sustainable land management. This will reduce land degradation and increase productivity. Unfortunately, poorly targeted input subsi- dies currently work in the opposite direction and directly contribute to land degradation (e.g., by constrain- ing crop diversification and encouraging practices that deplete soil fertility) and indirectly (e.g., crowding out fiscal space for investments in extension services). Therefore, subsidy regime reforms are also needed to effectively target limited public resources and create incentives that encourage better land stewardship. Redirecting existing agricultural subsidies is a practical way to support and ease the transitions to sustainable land and water management practices. More informed expenditure decisions on agricul- tural inputs are required, focusing on encouraging production systems more oriented towards regen- erative practices that tightly recycle nutrients. Extension approaches should steer clear of prioritizing production solely through modern inputs and prescriptive agricultural practices. Instead, they should aim to collaborate directly with communities to address environmental decline and ensure that alter- native approaches are introduced and widely shared. One effective strategy is to promote proven soil and water conservation practices integrated with climate-smart agriculture. This involves diversified cropping combined with soil and water management techniques tailored to both the local agro-eco- logical context and projected changes in climate and weather patterns. These ideas have long been called for by the Agriculture Sector Wide Approach (see https://aswap.mw) and successive Economic Recovery Plans. This is not a simple task because Malawi’s extension services struggle to provide effec- tive management and delivery of extension to smallholders (MoAIWD 2018; Ragasa et al. 2019, see Box 2.3). BOX 2.3  Impacts on Smallholders’ Production and Incomes of Investing in Agricultural Extension and Irrigation A recent modelled cost-benefit study indicates substantial While households that gain access to irrigation benefit positive benefits are possible through increased investments directly, as increased production drives down the price of in agricultural extension and irrigation in Malawi (FAO, ILO, crops, this can cause some non-beneficiaries to decrease UNICEF, 2019). These are the sort of investments that support their crop production. Nevertheless, real incomes rise across better land husbandry and reduce incentives to open up marginal households because food costs decrease due to the larger land for cropping. This study examined different household types crop output. In addition, the multiplier effect of increased pro- (non-poor, moderately poor and ultra-poor) in two categories: duction and incomes generates spill over into retail, services those with more than 1.5 ha of land and those with less than 1.5 and non-agricultural production, which benefit all households. ha. The study assessed the economy-wide impacts (i.e. not just Even ultra-poor households saw income gains ranging from the direct costs and benefits) of increasing these services. For 2.45 percent to 34 percent. Increasing extension coverage has extension, the study looked at doubling access to extension ser- real income and production multipliers above 2 MWK for every vices from 4 percent to 8 percent of rural households with over 1.5 1 MWK spent. Total real income rises by 2.48 percent, and they ha of land. The study also examined increasing irrigation access rise by as much as 7 percent for the ultra-poor. Small spillovers from 17 percent to 34 percent of households with land above 1.5 exist in other production sectors, but the gains from expanding ha. The National Agricultural Investment Plan targets doubling the irrigation are smaller. The additional extension agents required agricultural land under irrigation, which implies doubling the pro- also contribute to the local economy by spending their wages on portion of households with access to irrigation (MoAIWD 2018). local products and services. Unsurprisingly, increasing access to irrigation leads to signifi- On the other hand, irrigation has smaller multipliers in the cant income increases for households with over 1.5 ha of land. local economy, with cost-benefit ratios for both real income However, there are also significant spill-over effects on the incomes and production lower than one. This is due to the high capi- of households with less land. As the cost of establishing irrigation tal cost of irrigation infrastructure. However, local multipliers do schemes is high and spread over 20 years, the study examined the not capture the benefits of lower crop prices for urban consum- total cost of developing irrigation and the annualized cost of main- ers or the resulting increase in food security and exports, which taining and operating irrigation once it is fully completed. Doubling may be sizeable given the significant crop production increases the share of households (with land above 1.5 acres) with access to resulting from increased irrigation access. Smallholder irriga- irrigation results in crop production increases of 9.55 percent (full tion schemes are also rising in Malawi (Chafuwa 2017). Although cost annualized) and 15.58 percent (annual cost once operational), these schemes were not examined in this study, they may be as well as a 5.87 percent (full cost annualized) and 11.3 percent a more cost-effective approach to expanding irrigation and (annual cost once operational) increase in total real incomes. increasing cost-benefit ratios. 2. Healthy Watersheds for A Strong Economy 53 Experience in Malawi illustrates that a well-thought-out and comprehensive approach to water- shed restoration can be implemented effectively at scale. Although not enough to solve the problem entirely, the government of Malawi, with support from the World Bank and other partners, has ongo- ing operations supporting vital investments in water infrastructure, agricultural development, natu- ral resources management, and disaster risk management.12 These programs are building capacity at the national and local level. They are promoting actions such as participatory watershed management, climate-smart public works, reforestation, integrated basin planning, flood risk management, and con- structing small- and large-scale irrigation infrastructure. They are also increasing livelihood options and providing work opportunities for rural communities. One lesson emerging from these interventions is that multisectoral and multiagency endeavors can suffer from a lack of coordination. Different agencies use differing approaches to implementation, targeting, and monitoring, but serious capacity and financing constraints sometimes limit scale-up. A detailed analysis of lessons learned from previous and ongoing interventions is needed to ensure future programming that can contribute to protecting and restoring watersheds is responsive to current and future needs and suited to emerging climate change challenges. Policies related to watershed management and their implementation often undermine progress Malawi has a range of policies and institutional arrangements covering all important aspects of watershed management. The country’s policy environment is relatively strong, with numerous poli- cies and strategies relevant to managing watersheds. Most of these, especially more recent ones, reflect ambitious aspirations and sensible technical approaches. The National Landscape Restoration Strategy (2017), the Forest Landscape Restoration Opportunities Assessment (2017), and the Malawi 2063 are good examples of identifying practical opportunities for restoring the productivity and ecological func- tion of degraded watersheds. Effectively implementing, at a national scale, the approaches to watershed protection and rehabilitation proposed in these documents could significantly improve the health of the country’s watersheds. The recent introduction of new land policies clarifies and strengthens indi- vidual land rights, including those for customary land. This reflects a recognition that the lack of ten- ure security on customary land limits incentives for smallholders and businesses to invest in sustain- able land management practices. Despite references in major policy statements, in practice, key government stakeholders are inade- quately focused on the challenges of cross-sectoral cooperation required to address watershed deg- radation. This is demonstrated by a marked lack of finance as government spends almost nothing on watershed rehabilitation. In part, these financing constraints reflect how recurrent demands for dis- aster and emergency financing crowd out development financing, which would reduce disaster risk if used for watershed rehabilitation activities. The government’s ability to implement policies and legislation that effectively rehabilitate degraded land or reforest and protect denuded hillsides is weak at national and local levels. Both local and cen- tral government struggle to manage significant technical, managerial, and financial capacity constraints. In addition, as in many countries, government planning and implementation systems are more geared to sectoral, project-based interventions and less experienced at managing the coordinated, cross-sectoral interventions required for effective watershed rehabilitation (Chazdon et al. 2021; Ramponi et al. 2022). As a result of these combined constraints, and despite good intentions, monitoring is often limited, and 12. These include the Shire River Basin Management Program — Phase I, the Malawi Resilience and Disaster Risk Management Project, Shire Valley Transformation Programs 1&2, the Malawi Social Support for Resilient Livelihoods Project, the Malawi Watershed Services Improvement Project, Agricultural Commercialization Projects 1&2 and Agriculture Sector Wide Approach Support Projects 1&2. 2. Healthy Watersheds for A Strong Economy 54 the necessary procedures and guidance to deliver policy outcomes cannot be implemented effectively. For example, a recent analysis of flood management in the Shire basin has highlighted gaps in inter-agency communication and coordination around monitoring, data sharing, and planning (World Bank 2023c). Conflicting policies in various implementation areas have often confused local stakeholders. For example, agricultural policies promote crop cultivation along riverbanks or marginal lands, contradict- ing forestry and water policies that aim to enhance watershed management through increased vegeta- tive cover. This misalignment prioritizes short-term gains over long-term sustainability, leading to the overexploitation of crucial forest and water resources. Similarly, policy implementation in the energy sector lacks coordination with the forestry sector, resulting in unsustainable overreliance on biofu- els. For instance, load shedding in electrical power provided through the national grid spurs the con- tinued exploitation of forests for charcoal. Water resource management is often hampered by a lack of detailed procedures and protocols, combined with the weak capacity of key staff (World Bank 2019). Attempts to decentralize and bring government services closer to citizens have been slow to deliver results. The decentralization process has been undermined by a slow and fragmented assignment of functions and resources to local authorities. With insufficient financial resources, weak capacity, and incentives to perform, local government has been unable to play an effective role in environmental management (World Bank 2022c). There are two related reasons for weak institutional capacity for natural resource management at district and local levels. Firstly, the slow pace of implementation of the government’s decentralization policies constrains the extent to which district councils and extension services can support farmers in introducing sustainable land management practices or assist Village Natural Resources Management Committees in protecting and restoring forest resources. Secondly, severe under-resourcing constrains the effective functioning of institutions at district and local levels, limiting their ability to implement policy. Malawi allocates less than 1 percent of its annual GDP to environment-related expenditures, and a very small proportion of this is decentralized to the district level. (World Bank 2022c; World Bank 2020). There needs to be more ownership and coordination both in and between key government agencies. Implementing actions to reverse watershed degradation requires multi-agency coordination, which is not happening effectively. There is often a need for more clarity between key government agencies on relevant roles, responsibilities, and mandates to work together effectively to address degraded watersheds. Revitalizing precious natural resources requires putting policies into practice Rehabilitating degraded watersheds by adopting extensive soil and water conservation practices and restoring degraded forests is both time- and labor-intensive. Most of these time and labor costs inevitably fall on individual smallholders. In addition to direct restoration costs, there are additional opportunity costs as land under production is managed differently by, for example, reducing tillage, utilizing crop residues, planting trees, or shifting grazing and cropping patterns — changes that often reduce returns in the short term. Economic benefits from restoration may only be realized at some future date, while people’s lives and livelihoods have immediate and urgent requirements. Productivity gains and protecting and enhancing land and water resources are not mutually exclu- sive. Substantial positive benefits are possible through increased investments in agricultural exten- sion and irrigation, although adequate and effective systems need to also be in place to manage these investments. Investments that improve access to critical technologies such as irrigation and provid- ing farmers with more information through extension will likely add value to natural capital assets. Well-maintained land is productive year after year; degraded land is not. Managing water resources to reduce wastage and pollution makes better-quality water available to more people. The cost-ben- efit analysis undertaken to prepare government’s 2017 Forest Landscape Restoration Strategy shows 2. Healthy Watersheds for A Strong Economy 55 that smallholders who adopt restoration activities would likely be better off in the long run than those who did not (MoNREM 2017). Continuing with a ‘business as usual approach’ to land and water man- agement will draw down on land, forest, and water resources to such a degree that valuable ecosystem services will be lost. Immediate gains are possible by revising existing watershed management guide- lines to prioritize an ecosystem services-based approach to land restoration activities, focusing on in- creasing soil retention, water flow regulation, and carbon sequestration (World Bank, 2022a). Without these, opportunities to utilize Malawi’s valuable natural capital endowments to build a more diverse and profitable economy will disappear. Nevertheless, there are trade-offs between policies and investments that focus solely on increasing productivity, improving environmental husbandry, and arresting the degradation of natural capi- tal assets. Returning degraded land and water resources to health takes time, money, and skills. In the short term, there is often the challenge that investments focused on addressing degradation have lower returns than alternatives that provide short-term gains from agriculture or forestry. There are well-known and practical technical approaches to watershed rehabilitation, although they require significant investment. A recent study on watershed restoration options in southern Malawi looked at known restoration technologies selected following consultation with local small- holders, government officials, and potential investors (World Bank, 2023f). These options were: agro- forestry systems combined with climate smart agriculture practices (i.e. diversified cropping combined with soil and water management techniques suited to both the local agro-ecological context and pro- jected changes in climate and weather patterns); river and streambank restoration; and buffer zone management. The study calculated that it would cost around US$1,000 / ha. to completely restore just 500,000 hectares of degraded land in the lower Shire River basin. While it is not necessary to restore one million hectares in one intervention, benefits are likely to be limited in smaller intervention that are scattered over a large area. Watershed rehabilitation is most effective when contiguous areas are treated, with a focus on working through neighboring micro-watersheds that together form a substan- tive part of a larger major watershed. Despite the substantive costs, rehabilitation investments provide viable financial and environmental returns. The same study included a financial cost-benefit analysis conducted from a private perspective (investor or smallholder) and an economic analysis from a public perspective. These make a solid case for investing in watershed rehabilitation. For example, the results show that afforestation (especially in buffer zones) and agroforestry with climate smart agriculture (CSA) are economically and financially attractive from the public, private, and smallholder perspectives. Including potential carbon market returns makes the financial picture even more attractive for public and larger private sector investors. In addition, the economic benefit for society in terms of biodiversity conservation, reduced erosion and siltation, and clean water supply for downstream users is highly significant. The study illustrates a clear positive economic case for a substantive investment in watershed rehabilitation in Malawi. This study is not alone in identifying strong returns to investments of this nature. As discussed earlier, the poten- tial return on investing in watershed rehabilitation is over 400 percent over 30 years. Box 2.3, above, highlights other research on how the benefits of increasing investments in agricultural extension out- weigh costs and provide a practical route to rehabilitating watersheds. The basic financial case is strong, but including ecosystem service values and potential carbon revenues makes the case even stronger. Financing mechanisms that support investments in watershed rehabilitation need to be refined and extended. Limited public finance is a major constraint on watershed restoration activities, so it is vital to encourage private sector investment to supplement this. Private sector engagement holds strong potential for increased investment in forest restoration, crop diversification, CSA measures, af- forestation, and value chain development. Payments for environmental services (such as clean water and flood protection) and carbon farming (where there is the potential to earn between US$24.8 mil- lion and US$74.3 million per year (World Bank, 2022a)) offer additional funding opportunities, but de- veloping these mechanisms requires further support, despite existing pilot examples. Existing funding 2. Healthy Watersheds for A Strong Economy 56 sources, such as the Affordable Inputs Program (AIP), the Forest Management and Development Fund (FMDF), the Climate Fund, and the National Parks and Wildlife Fund, could be upgraded, redirected, or used more efficiently. For example, the AIP, which already provides direct subsidies to smallholders, could be redirected to provide tapered support to compensate for any yield losses in the initial sea- sons of converting to more sustainable cultivation practices. The FMDF could easily increase its rev- enues by simply reflecting current market prices to set the prices it charges for forest products, pen- alties, and licensing charges. Currently, fuelwood from government plantations is sold for 700 MWK/ m3 (equivalent to US$0.6), whereas the recent market prices have rarely fallen below 20,000 MWK/m3 (2,850 percent higher). Business models must be developed further to incentivize and support public and private invest- ments in watershed rehabilitation. In practice, watershed investments will be a blend of public and private investments. On their own, no single set of stakeholders will provide sufficient finance and focus. Public sector investment is essential for capacity building and extension services, particularly since the private sector cannot cover all smallholder farmers. Public sector investment is most suita- ble in agroforestry and CSA with smallholders and buffer zone management with afforestation. Public investments are crucial for natural forest management in protected areas and riverbank restoration, as these activities rarely provide direct financial benefits even though they deliver significant econom- ic benefits to society. Public investment is also necessary to establish carbon projects for natural forest restoration, provide capacity building, establish monitoring and verification systems, and increase pol- icymakers’ awareness of the benefits of carbon sequestration (World Bank 2022a). Agroforestry restora- tion offers financial benefits for smallholders and the private sector through improved crop and timber production while reducing erosion, capturing carbon, and stimulating local development. There is also potential for carbon farming projects involving smallholders utilizing agroforestry and CSA techniques. However, models suited to Malawi for pooling carbon sequestration from numerous small plots and sharing the revenues equitably will need to be developed. Existing funds can be redirected to watershed rehabilitation, but they will need augmenting with private sector investments to be effective. Private sector engagement holds strong potential for in- creased investment in forest restoration and afforestation (particularly for plantation crops), crop di- versification, CSA measures, and value chain development. Payments for environmental services and carbon farming offer additional funding opportunities and there are a handful of existing pilot exam- ples. Developing these mechanisms requires further support, particularly in ensuring that policies and regulations assist investment rather than hinder it. In addition, given the scale of the challenge, ex- isting funds can only meet some of the financing requirements and require additional funding to en- hance their effectiveness — a key reason to attract private sector investors rather than simply looking to donor funding to fill the gap. Revolving community funds can effectively promote conservation, restoration, and sustainable resource management when connected to larger funds with strict environmental criteria. For exam- ple, the Community Environmental Conservation Fund (CECF) was established under an earlier World Bank-supported program to encourage community engagement in landscape restoration in the Shire River basin and now continues under another World Bank-supported initiative, the Malawi Watershed Services Improvement Project. The CECF provided financial support to communities that collectively committed to implementing environmental management plans at the community level. Micro-credits were extended to community members adopting these practices, with no usage restrictions, but access to the fund hinged on achieving specific conservation-targeted results. These funds aimed to establish a self-sustaining resource pool managed by the community, accessible to all members even after the project’s conclusion. Some communities have seen growth in the small CECF funds, increasing from the initial grant of MWK1.1 million to between MWK1.5 million and MWK2.8 million, as borrowers repaid small loans with interest. Although the buying power of these funds has now been eroded by Malawi’s high level of inflation, they illustrate the principle that even small resources can provide a significant incentive for voluntary community action. 2. Healthy Watersheds for A Strong Economy 57 Results-based financing may be suitable to finance watershed rehabilitation in Malawi. This is an in- novative financing approach where, instead of providing finance for inputs, payment is linked to achiev- ing specific targets, with achievements verified by an independent third party. The focus on achieving results rather than procuring inputs can both support and encourage the cross-sectoral coordination required for effective watershed rehabilitation. In Ethiopia, the World Bank is using this approach suc- cessfully to support the Ministry of Agriculture in rehabilitating over 2.5 million hectares of severely degraded land in the highlands (World Bank 2023b). Recommendations The following recommendations are all reasonably straightforward to implement, as the necessary policies and strategies are in place. The challenge is to shift focus and priorities to ensure these exist- ing policies and strategies are translated into practice. Land: i) Redirect existing agricultural practices to increase productivity by protecting and conserving land rather than degrading it. This can be a quick win, as it is already happening in some loca- tions, encouraged by government priorities and through programs including the roll-out of climate smart public works to transition out of AIP. This can be supported and encouraged by revising existing watershed management guidelines to prioritize an ecosystem services-based approach to land restoration activities. ii) Strengthen land tenure rights to incentivize sustainable land husbandry. Ensuring security of tenure will provide smallholders with the security to invest in their land for longer-term returns. iii) Explore the potential to use results-based payments for watershed rehabilitation. This financ- ing method may be suited to support rehabilitation activities that are, by necessity, cross-sectoral. It could support community-based initiatives, such as the successful Community Environment Conservation Funds, to incentivize rehabilitation activities directly. It could also be linked to pay- ments to government agencies for achieving specific targets that support watershed rehabilitation. Forests: i) Align forestry and energy policies. Energy policies must explicitly support forestry policies aimed at managing the charcoal trade in ways that do not lead to widespread deforestation. These aspi- rations are already embedded in policies, but coordination and implementation are less clear. ii) Use limited public financing to leverage additional private-sector investment in forest man- agement and restoration. The private sector is critical to providing additional finance for reha- bilitation. Effective financing mechanisms need to be in place to attract private-sector investors. iii) Ensure prices charged by the Forest Management and Development Fund reflect current mar- ket prices. This will significantly increase revenues available for forest rehabilitation. iv) Scale up forest co-management to balance responsibility and authority between communities and government. v) Promote agroforestry and tree-based systems to reduce pressure on Malawi’s natural forests. The potential financial and economic returns to this activity are excellent and should be prioritized. Water: i) Ensure that institutional mandates in the water sector are implemented and enforced to realize the benefits of existing policy reforms (such as Malawi Water Resources Act, 2013). Overlapping functions across the various regulatory and institutional structures responsible for water and sanitation leads to weak policy implementation. ii) Strengthen systems and capacities for licensing, allocating, and monitoring water use. A lack of detailed procedures and protocols, combined with the weak capacity of key staff, results in ineffective water management. 2. Healthy Watersheds for A Strong Economy 58 TABLE 2.2  Key Recommendations Priority recommendations Opportunities and Challenges Lead agencies Land degradation 1. Redirect existing agricultural practices to increase pro- • Redirecting existing agricultural practices can be a quick MoAIWD, ductivity by protecting and conserving land, rather than win, as this is already happening in some locations, encour- MoNRCC degrading it. aged by government priorities. • Reform AIP from an input subsidy program focused only • There are inadequate incentives for cross-sectoral coor- on inputs (fertilizer and mainly maize seed) to a sustain- dination by government agencies around watershed able land stewardship program that promotes agrofor- management. estry, forest restoration and sustainable land manage- • At present, the high cost of the Affordable Inputs ment practices. Programme (AIP) crowds out finance available to the • Revise existing watershed management guidelines to pri- Ministry of Agriculture and hence limits opportunities to oritize an ecosystem services-based approach to land support watershed regeneration efforts. restoration activities. • Some rehabilitation practices have longer payback periods, which discourages poor households from adopting them. 2. Broaden land tenure rights to incentivize sustainable land • Tenure security assist the take a longer-term view of resto- husbandry. ration benefits. • Ensuring security of tenure will provide smallholders with the security to invest in their land for longer-term returns. 3. Explore the potential for results-based payments to • Requires effective monitoring and reporting for verification directly incentivize cross-sectoral rehabilitation activities. that allows payments to be disbursed. • Build on positive experiences with the ‘Community Environment Conservation Fund’ in the Shire basin. • Include payments to government agencies, at national and district level, to support rehabilitation Forest and woodlands 1. Harmonize forestry and energy policies to invest in • Energy and Forestry policies are not currently aligned effec- MoNRCC, Malawi’s energy transition and take pressure off forest tively, so, neither are effectively reducing pressures on for- MoEA, resources. ests as a source of energy. DoF • Energy transition is complex and requires large investments. 2. Use limited public financing to leverage additional private • Forest and Woodland restoration is an urgent but mas- sector investment in forest management and restoration. sive task, with formidable financial and implementation • Provide clear guidelines on land access and opportuni- requirements. ties for forest certification. • Developing institutional and licensing frameworks for legal and sustainable charcoal value chains. • Establish financial framework for forest carbon management. 3. Ensure prices charged by the Forest Management and • Currently FMDF revenues are based on outdated prices Development Fund reflect current market prices. for forest products. Using current market prices will sig- nificantly increase FMDF revenues available for forest rehabilitation. 4. Scale up forest co-management approach to balance • SME’s have potential roles in both plantation forestry and responsibility and authority between communities and value addition to forest products but face regulatory hurdles government. and barriers to new revenue streams such as payments for ecosystem services. 5. Promote agroforestry and tree-based systems to reduce • Tree planting projects are sometimes unsuccessful as the pressure on Malawi’s natural forests. returns do not justify the land or other resources that farm- ers must invest. Careful selection of tree species and mar- kets is required. • Lack of data on land cover and the production and use of forest products, limits understanding of the country’s forest resources and their contribution to the economy. Water resources 1. Ensure that institutional mandates in the water sector are • Overlapping functions across the various regulatory and MoWS implemented and enforced to realize the benefits of exist- institutional structures responsible for water and sanitation ing reforms. leads to weak policy implementation. 2. Strengthen systems and capacities for licensing, alloca- • A lack of detailed procedures and protocols, combined MoWS and tion and monitoring of water use. with weak capacity of key staff, results in ineffective water NWRA management. 59 APPENDIX A Macroeconomic Indicators   2019 2020 2021 2022e 2023p 2024p National Accounts and Prices GDP at constant market prices (% change) 5.4 0.8 2.8 0.9 1.6 2.8 Agriculture 5.9 3.4 5.2 -1.0 0.6 2.4 Industry 7.7 1.2 1.9 0.9 1.6 2.7 Services 5.5 -0.5 2.0 1.8 2.1 3.0 Consumer prices (annual average) 9.4 8.6 9.3 21.8 28.4 22.1 Central Government (FY % of GDP) Revenue and grants 14.6 14.6 14.7 14.0 15.2 17.6 Domestic revenue (tax and non-tax) 13.2 13.1 12.8 12.9 12.1 13.9 Grants 1.4 1.5 1.9 1.1 3.1 3.7 Expenditure and net lending 19.1 20.9 21.5 22.3 25.7 25.0 Overall balance (excluding grants) -5.9 -7.8 -8.7 -9.4 -13.5 -11.1 Overall balance (including grants) -4.5 -6.3 -6.8 -8.3 -10.4 -7.4 Foreign financing 0.8 0.8 1.0 2.7 1.9 1.1 Domestic financing 3.8 4.9 5.9 7.7 5.1 6.3 Money and Credit Money and quasi-money (% change) 10.2 16.7 30.0 38.8 30.5 29.3 Credit to the private sector (% change) 27.3 16.1 17.8 23.2 19.6 11.2 External Sector (US$ millions) Exports (goods and services) 1,446.7 1,308.3 1,587.3 1.486-8 1,559.6 — Imports (goods and services) 3,265.7 3,373.3 3,767.9 3,706.0 3,944.2 — Gross official reserves 815 565 79 120 201 714 (months of imports) 3.9 2.7 0.3 0.5 0.8 2.9 Current account (percent of GDP) -11.9 -13.6 -15.2 -16.9 -15.9 — Exchange rate (MWK per US$ average) 745.9 749.5 805.9 949.0 — — Debt Stock External debt (public sector, % of GDP) 27.8 32.9 31.5 34.8 39.3 35.2 Domestic public debt (percentage of GDP) 17.5 21.9 30.0 40.8 42.0 39.8 Total public debt (percentage of GDP) 5.3 54.8 61.5 75.7 81.3 75.0 Poverty Poverty rate (US$ 2.15 in 2017 PPP terms) 70.1 70.7 70.6 71.3 71.7 71.5 Poverty rate (US$ 3.65 in 2017 PPP terms) 89.1 89.4 89.4 89.5 89.7 89.6 Poverty rate (US$ 6.85 in 2017 PPP terms) 97.3 97.4 97.4 97.5 97.5 97.5 Sources: World Bank staff calculations based on MFMod, MoFEA, RBM, NSO, and IMF data. 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