MALAWI HIPC AAP REPORT 2004 October 1, 2004 MALAWI. COUNTRY ASSESSMENT AND ACTION PLAN FOR HIPCs

MALAWI HIPC AAP REPORT 2004 October 1, 2004 MALAWI COUNTRY ASSESSMENT AND ACTION PLAN FOR HIPCs October 2004

- 2 - TABLE OF CONTENTS EXECUTIVE SUMMARY 5 I. INTRODUCTION 11 II. HIPC RESOURCES, PRO-POOR EXPENDITURES AND THE MALAWI POVERTY REDUCTION STRATEGY (MPRS) 15 HIPC resources and Pro-Poor Expenditure in Malawi 15 Links between the budget and the MPRSP 18 Decentralization and the involvement of different levels of government 20 III. BUDGET FORMULATION 21 Indicator 1~ Coverage of the budget or fiscal reporting entity 21 Indicator 2 ~ Degree of spending being funded by extrabudgetary sources 22 Indicator 3 ~ Reliability of budget as a guide to future 24 Indicator 4 ~ Inclusion of donor funds 27 Indicator 5 ~ Classification 29 Indicator 6 ~ Identification of poverty-reducing spending 31 Indicator 7 ~ Integration of medium-term forecasts 32 IV. BUDGET EXECUTION 34 Indicator 8 ~ Evidence of budget execution problems Arrears 34 Indicator 9 ~ Effectiveness of the internal control system 36 Indicator 10 ~ Tracking surveys are in use 38 Indicator 11 ~ Quality of fiscal information 39 V. BUDGET REPORTING 40 Indicator 12 ~ Regularity of timely internal fiscal reporting 40 Indicator 14 ~ Closing the accounts 43 Indicator 15 ~ Timeliness of audited financial information 44 Indicator 16 ~ Efficiency and effectiveness of the public procurement system 46 VI. PROGRESS SINCE 2001 REPORT AND ACTION PLAN FOR THE FUTURE 48 Comparison with 2001 HIPC AAP report: achievements and setbacks 48 Action Plan to upgrade PEM capacity in Malawi 50 VII. DONOR INITIATIVES 53 IMF 53

- 3 - World Bank 53 AfDB 54 CIDA 54 DFID 55 EU 55 GTZ 55 JBIC 56 NORWAY / SWEDEN 56 UNDP 56 USAID 57 VIII. SUMMARY TABLES 58 Table S1: Public Expenditure Management AAP Indicators in Malawi 58 Table S2: Overview of Technical and Donor Assistance in Public Expenditure Management in Malawi 59 Table S3: Implementation Status of Actions to Strengthen Tracking of Poverty-Reducing Public Spending in Malawi 60 Table S4: Action plan to upgrade PEM capacity in Malawi 61

- 4 - ABBREVIATIONS AND ACRONYMS AAP FY HIPC MOF MPRSP MTEF PAF PEM PETS PRSP SAI Assessment and action plan Fiscal Year Heavily indebted poor country Ministry of finance Malawi Poverty Reduction Strategy paper Medium term expenditure framework Poverty action fund Public expenditure management Public expenditure tracking survey Poverty reduction strategy paper Supreme audit institution

- 5 - EXECUTIVE SUMMARY In the context of the Enhanced HIPC Initiative, the IMF and the World Bank initiated the HIPC Assessments and Action Plans (AAP). Each assessment evaluates the existing Public Expenditure Management (PEM) system against a selected number of performance indicators, in order to determine countries capacity for tracking public spending with a particular focus on pro-poor spending. A first round of field assessments was carried out in 2001 in 24 countries, including Malawi. This report presents the findings of the second round of field assessment carried out in Malawi in April 2004. The Malawi 2004 HIPC AAP review has been conducted by the IMF and the World Bank in collaboration with the authorities and the representatives of the EU, UK-DFID and Norway i.e. most of the donors providing BoP support to Malawi. The government has provided substantial input into the HIPC AAP both by facilitating and participating in the main fact-finding mission, and subsequently by clarifying various issues as they arose during the drafting of the report. All donors active in Malawi (JICA, USA, Germany, Canada, UNDP) have been consulted and have provided input into the AAP report. Substantial work as been made in assessing the status of PEM systems in Malawi reporting the last few years. This AAP report draws significantly on these studies, notably the 2002 Country Financial Accountability Assessment (CFAA), the 2003 Malawi Financial Accountability Action Plan (MFAAP), and the 2004 MTEF II, updating the information as required, and complementing their analyses in areas which were not explicitly addressed. This AAP report provides an update on the status of existing PEM systems, and a priority action plan to help the government develop a strategy of implementation that can be programmed over the next several years. In addition, the AAP also highlights the importance for the government to accelerate the implementation of the MFAAP in a more decisive and coordinated manner, and helps to further align the work of the Bank, IMF, government, and other donors behind a common assessment, strategy and action plan. Status of Public Expenditure Management systems and comparison with 2001 HIPC AAP report The 2004 HIPC AAP results indicate that Malawi currently meets the benchmarks for 5 indicators (out of 16 indicators see details in Summary Table S1). This is less than the 7 benchmarks Malawi met in the first AAP assessment in 2001. In fact, four indicators have been rated lower in the 2004 assessment than they were in the 2001 assessment. A preliminary reading of the results of the 2004 assessment may therefore give the reader the false impression of a deterioration in the status of PEM in Malawi during the period from 2001 to 2004. However, the changes do not reflect a deterioration in actual practice. Rather they result from an improved information basis, and some adjustments in the evaluation criteria (as the 2004 assessment methodology was refined to take into account the experiences of the 2001 exercise). In fact there have been improvements in several indicators, mainly in the area of final accounts and audit. Although the improvements since 2001 have not been sufficient to

- 6 - warrant any increase in the ratings, Malawi is now closer to meeting the threshold level for several indicators: Firstly, Malawi is currently executing its first PETS in the education sector (indicator 10). The authorities have expressed their intention to also carry out PETS in health and agriculture during 2005. PETS could be very useful in Malawi as an interim instrument for monitoring budget execution and MPRS implementation until internal control and audit systems are functioning well. Also, the reconciliation of fiscal and banking records (indicator 11) has improved significantly. The backload of bank reconciliation has been reduced from 18 months to an average 6 months during the period, and further improvements are expected in the preparation of the IFMIS. Very good progress has also been made in shortening the length of time between the end of the fiscal year and the closing of the accounts (indicator 14). The AGD finished entering the 2002/03 transactions in the final accounts computer system in December 2003, about 6 months after the end of the fiscal year. This compares with the financial statement for 2001/02, which was submitted to the Auditor General some 14 months after the end of the fiscal year. Hence Malawi has made substantial progress and with some effort could meet the target to enter all routine transactions into the main accounting system(s) within two months after the end of the fiscal year. Further, significant improvement has been made in the preparation and audit of the final accounts (indicator 15). Until recently there was a 2-3 years time lag between the end of the relevant fiscal year and the presentation of the audited accounts and report to the legislature, implying that the official accounting records were not very useful for fiscal management purposes. At the time of the assessment mission the Auditor General was ready to present the 2001/02 audited accounts to the new legislature, and was in the process of preparing the audit report for the 2002/03 accounts. In the event, the 2002/03 audited accounts were ready for presentation to Parliament before June 30, 2004 (i.e. within 12 months after the end of the fiscal year), but were not submitted because of national elections in May 2004. Although submission before June 30, 2004 was not achieved, Malawi is well placed to meet the benchmark for the 2003/04 audited accounts. Unfortunately, there are also several areas in which Malawi has failed to make much progress, and overall the quality of Public Expenditure Management systems in Malawi remains very weak. The coverage of fiscal reporting is still very incomplete (indicator 1), and falls short of the Government Finance Statistics definition of the general government sector. There is a need to expand the coverage of fiscal reports and prepare consolidated general government statements, both for ex-ante fiscal plans in conjunction with the budget presentation, and for ex-post reporting in conjunction with the final accounts.

- 7 - Secondly, budget outturn data continue to differ considerably from the original budget (indicator 3). Actual expenditures have differed from the original budget estimates by 2-3 percent of GDP on average, or 6-9 percent of expenditures. In 2003/04 expenditures exceeded the original budget by nearly 11 percent of GDP, of which only about 5 percent of GDP can be attributed to higher interest payments. Mostly, the aggregate variation is the result of regular overshooting of the recurrent budget, and specifically with higher than anticipated interest payments on domestic debt. However, variations in discretionary recurrent expenditures are also quite large, notably benefiting the Office of the President, the State Residences, the Police, the Ministry of Defense, and the Ministry of Foreign Affairs. Reasons for these variations are manifold. The wide variance on recurrent expenditures renders the budget irrelevant as a guide to resource availability during budget execution, resulting in a weakened budget planning process, and attempts by ministries to retain control over resources. Thirdly, the development budget still does not include the large majority of donor funded projects (indicator 4). According to anecdotal estimates, the central government budget only includes 30 to 50 percent of donor sponsored projects funded by grants and executed by government agencies. Grant-funded projects are typically included in the budget when domestic counterpart funds are required. It is understood that loan funded projects are included in the budget. A comprehensive list of all donor projects is now available in the database maintained by Debt and Aid Division, in the Ministry of Finance. However, this information is not included in the budget. There is a need to define a strategy to bring all the donor development projects into the budget, and strengthen timely reporting. A task force could be set up with the purpose to develop clear instructions and operating procedures, and to discuss these with donors. Information and controls on the accumulation of expenditure arrears are inadequate and accumulation of domestic arrears continues to be a problem (indicator 8). A special external audit of 9 ministries and the pension system carried out in 2004 by KPMG under the auspices of the Auditor General has highlighted that domestic arrears amount to about ¾ percent of GDP or 1.7 percent of 2003/04 expenditure, more than 3 times the previous estimate. The audit is expected to continue and cover the whole government. There is a need to prevent the formation of new arrears by strengthening budget preparation and control. Reducing the stock of existing arrears requires establishing a comprehensive database of arrears, and formulating a strategy to clear the backlog. The overall control environment for public expenditure management remains weak (indicator 9). Malawi has an overall sound legal and regulatory framework for public expenditure management. Malawi also has in place a number of systems and procedures that are designed to ensure proper management of public funds, some of which were only introduced recently. Nevertheless, the overall control environment remains weak, and there is less than full compliance with plans, procedures, laws and regulations as stipulated in various guiding documents.

- 8 - Finally, the quality of internal fiscal reporting continues to be inadequate (indicators 12 and 13). Most ministries submit monthly expenditure returns within two weeks of the end of the month. The quality of these reports is improving, but there remain significant gaps and as a result they are not useful for fiscal management. The poor quality of the reports from the ministries is mainly attributed to inadequate capacity due to low staff skills, inadequate numbers of staff and constant movement of staff from the ministries. Fiscal reports classify spending to program, sub program and economic item levels. However, the present classification is not sufficient to track PPE expenditures, since these are identified at the activity level, and not at the program / sub-program level on which detailed budget reports and accounts are prepared. The changes required to enable tracking of PPE expenditures are technically simple to implement, and would allow Malawi to meet this indicator. Finally, improvements are also needed in the efficiency and effectiveness of the public procurement system (indicator 16). The procurement system is in transition. Clear and enforceable rules that promote competition, transparency and value for money have been introduced with the 2003 Public Procurement Act. However, implementation of the new rules has only just started. Action Plan to upgrade PEM capacity in Malawi It is important that the government revamps the efforts to strengthen public expenditure management. As mentioned, this HIPC AAP report draws significantly on other recent substantial analyses of Malawi s PEM systems, that were consolidated into the Malawi Financial Accountability Action Plan (MFAAP) approved by Cabinet in May 2004. The MFAAP constitutes the framework document intended to guide the overall work program on public expenditure management systems in Malawi. It provides a comprehensive list of actionable recommendations to address problems in budget planning, execution, and monitoring, and in public procurement. Within the context of the MFAAP, this AAP report provides an update on the status of existing PEM systems, and a smaller priority action plan to be pursued in the near future. More generally, this AAP reiterates the importance for the government to accelerate the implementation of the MFAAP in a more decisive and coordinated manner, and to facilitate the coordination of the donors support in this area. Progress with implementation of the MFAAP recommendations has been mixed. On the positive side, new legislation (Public Finance Management Act, Public Audit Act and Public Procurement Act) has been passed in May 2003, and the relevant desk manuals and instructions have been almost finalized. However, only limited progress has been made in other areas.

- 9 - In line with the discussion above and the assessment for the individual indicators presented in the previous sections, a number of actions have been identified for implementation within the next 12 months and over the medium term. These actions are briefly summarized below (see also Summary Table S4). Actions to be implemented in the short term: In budget formulation: Expand coverage of fiscal reporting to include financial position or detailed accounts of autonomous agencies and treasury funds. Strengthen budget planning (in line with the MTEF II work plan see details under indicator 3). Improve dialogue with donors on available financing. Maintain comprehensive list of all donor projects, ongoing and under preparation (in line with CIDA Database). Define a strategy to bring all donor development projects into the budget. Develop estimates of disbursements by year, and required counterpart funding. Classify all PPEs as programs and sub-programs. Alternatively, (or in the mediumterm) develop the classification system to ensure that PPEs classified as activities can be recorded throughout the expenditure process. In budget execution: Establish a comprehensive database of arrears, and verify reported arrears. Strengthen the internal audit function: formulate internal audit program, approve IA charter, develop IA manual, follow up on implementation of recommendations, and formulate government wide plans to protect assets. Develop of a complete list of government bank accounts and close all unnecessary accounts. Ensure monthly reconciliations are consistently done In budget reporting: Strengthen budget monitoring and reporting (in line with the MTEF II work plan see details under indicator 12). Ensure predictable and adequate funding for the National Audit Office (NAO). Develop an audit program (NAO). In public procurement: Operationalize the Office of the Director of Public Procurement (DoPP). Introduce an independent complaints mechanism. Actions to be implemented in the medium term: In budget formulation: Rationalize spending and align with available resources, e.g. by implementing recommendations from functional or public expenditure reviews.

- 10 - Expand coverage to include accounts of local government agencies including reporting on pro-poor expenditure. Develop PSIP and improve linkage with budget preparation. Prepare a medium-term plan for implementation of donor projects, and the recurrent cost implications. Develop accounting and recording procedures capable of following the flow of the money. Strengthen reporting mechanisms on the implementation of donor projects. Further align annual budget allocations with MPRS activities. In budget execution: Formulate a program to clear backlog of arrears. Expand use of PETS tracking surveys. Reconcile all bank accounts for the below the line expenditures and bring them above the line. In budget reporting: Pursue development and implementation of IFMIS. Strengthen capacity of NAO. In public procurement: Make fully operational the cadre of public procurement professionals Implement new and comprehensive training programs for procurement staff

- 11 - I. INTRODUCTION In the context of the Enhanced HIPC Initiative, the IMF and the World Bank initiated the socalled HIPC Assessments and Action Plans (AAP). Each assessment evaluates the existing Public Expenditure Management (PEM) system against a selected number of performance indicators, in order to determine countries capacity for tracking public spending with a particular focus on pro-poor spending. Following initial desk assessments, a first round of field assessments in close collaboration with the respective governments was carried out in 2001 in 24 countries that received support under the Enhanced HIPC Initiative. On the basis of these assessments, action plans were developed aimed at addressing the shortcomings in the area of public finance. The initial HIPC AAP for Malawi was finalized in November 2001. This report presents the findings of the 2004 second round of the AAP process aimed at conducting a comprehensive reassessment of the PEM system. This comparative review is designed to update the findings of the initial evaluation and to assess progress in improving PEM including tracking of poverty related expenditures. 1 Substantial work has been made in assessing the status of PEM systems in Malawi since the 2001 AAP report. A Country Financial Accountability Assessment (CFAA) has been prepared by a team of World Bank staff, donor consultants and Government of Malawi officials, and was presented in April 2002. Subsequent to the distribution of the CFAA report, the Government of Malawi and donors jointly agreed that a CFAA action plan was needed that would serve as a comprehensive guide to the government s activities in strengthening financial accountability. The Canadian International Development Agency (CIDA) and the UK Department for International Development (DFID) agreed to jointly support development of the action plan. The resulting document, the Malawi Financial Accountability Action Plan (MFAAP), flows largely, but not exclusively, from the 2002 CFAA report and the two documents are closely linked. The MFAAP was finalized in early 2003, and approved by Cabinet in May 2004. In January 2004, as part of the implementation of the MFAAP the Government (in collaboration with the UK-DFID) has presented the MTEF Phase II work plan, which identifies a set of activities to strengthen budget preparation, execution and monitoring. 1 It should be noted that the indicators and assessment criteria were refined for this second round of AAPs, taking into account experiences of the 2001 assessments. Hence, there are a few indicators for which the evaluation standards were clarified or adjusted. Still, each assessment is considered a snapshot of the best available information at the time, and thus no 2001 assessment was changed on the basis of additional information obtained since. This approach, however, has the drawback that a change in assessment may be reported, even though country practices have not materially changed; alternatively, an improvement in practices may not be recognized in the formal rating. The narrative to each indicator points out such cases.

- 12 - This AAP report draws significantly on the CFAA, the MFAAP, and the MTEF II, updating the information as required, and complementing their analysis in areas which were not explicitly addressed. This AAP report provides an update on the status of existing PEM systems, and a priority action plan to help the government develop a strategy of implementation that can be programmed over the next several years. In addition, the AAP also highlights the importance for the Government to accelerate the implementation of the MFAAP in a more decisive and coordinated manner, and helps to further align the work of the Bank, IMF, government, and other donors behind a common assessment, strategy and action plan. The Malawi 2004 HIPC AAP review has been conducted by the IMF and the World Bank in collaboration with the authorities and the representatives of the EU, UK-DFID and Norway i.e. most of the donors providing BoP support to Malawi. The government has provided substantial input into the HIPC AAP both by facilitating and participating in the main factfinding mission, and subsequently by clarifying various issues as they arose during the drafting of the report. All donors active in Malawi (JICA, USA, Germany, Canada, UNDP) have been consulted and have provided input into the AAP report. 2 The main work was conducted during a joint IMF / WB / donors mission between April 13 to 21, 2004. The team comprised Antonio Nucifora (World Bank, Economist, Mission Leader), Donald Mphande (World Bank, Senior Financial Management Specialist), Patricia Palale (World Bank, Public Sector Management Specialist), Christiane Roehler (IMF, Fiscal Affairs Department), Tori Hoven (Norwegian Embassy, Country Economist), Jomo Matululu (EU, Macro Economist), and Lindsay Mangham (DfID, Economist). The main counterparts from the Government were Mr Z. Soko, Director, Debt and Aid Division, Ministry of Finance, and Mrs D. Banda, Director, Budget Division, Ministry of Finance. The mission gratefully acknowledges the support and helpful input received from numerous other staff. In the Ministry of Finance, contributors were in particular Mr C. Simwaka (Deputy Director, Budget Planning Section, Budget Division), Mr C. Chiunda (Senior Deputy Budget Director, Budget Division), Mr Chipatso (Deputy Director, Budget Monitoring Section, Budget Division), Mr P. Kampanje (Accountant General), Mr Matanda (Deputy Accountant General), and Ms M. Maganga (Deputy Director, Debt and Aid Division). Key contributors to the review in other government ministries and organizations included Mr. Kalongonda (Auditor General, National Audit office), Mr. Kambalame (General Manager Operations, Reserve Bank of Malawi), Mr. Hassan (Director of Internal Audit, 2 The four members of the CABS-Group (Common Approach to Budget Support) are the EU, UK, Norway, and Sweden, but Sweden is not present in Malawi. AfDB was invited but could not participate.

- 13 - Office of the President & Cabinet), Mr. Mhango (Deputy Director of Public Procurement, Department of Public Procurement), Mr. M. Kutengule (Principal Secretary, Ministry of Economic Planning & Development), Mr B. Botolo (Director Monitoring and Evaluation Division, Ministry of Economic Planning & Development), and Mr B. Mtonya (Director, Strategic Planning Division, Ministry of Economic Planning & Development). The AAP report is structured as follows: Section II briefly discusses the use of HIPC resources in Malawi. Sections III, IV and V presents the updated assessment of public expenditure management systems against a high-level set of 16 de minimus performance indicators for budget preparation, execution and monitoring, respectively. For each indicator the report includes a brief narrative that provides the context, detail, and argumentation of the assessment of the current status and the agreed follow up action plan. Section VI presents a brief description of the main ongoing donor activities in support of public expenditure management systems. Section VII presents the summary tables, including a summary indicators table (Table 1); a donor support table, indicating current donor assistance in support of the action plan in any of the 16 core areas (Table 2); an update of the status of actions committed to in the previous AAP (Table 3); and a summary action plan table, indicating short- and medium-term actions planned by the government to redress weaknesses identified in the current assessment (Table 4).

- 14 - Box 1. The HIPC AAP Comprehensive Reassessment Cycle 2003-2004 The aim of the HIPC AAP exercise is to carry out an assessment of the quality of the public expenditure management systems in each country and reflect this in the public expenditure management assessment and action plan, and the associated table of 16 key indicators. These assessments will serve three main purposes: to assess the existing capacity for tracking overall public spending, including poverty-reducing spending; to create an understanding of risks associated with implementing poverty-reducing spending in, especially, but not solely, the context of receiving debt relief; and to clarify what donor and technical assistance should be provided to improve systems for managing povertyreducing and other public spending. These assessments and the ensuing action plans will focus on the primary dimensions of PEM performance: Budget formulation: covering the design of basic budgetary institutions and aspects of the process to prepare the annual budget; Budget execution: covering core aspects required to implement the budget; and Budget reporting: covering in-year, and end-of-year financial statements. This document provides answers to 16 core questions to probe the standard of PEM in a country, and to inform the judgment about the correct assessment for each of 16 key indicators. In each case the requirements for meeting a reasonable performance against the indicator is described as a benchmark. These benchmarks are struck at a level to indicate reasonable, rather than world-leading, practice. Expanded explanations to the benchmarks and the rankings are available upon request and consist of a set of guidelines designed to assist the carrying out these assessments. Completed assessments generally provide five related outputs: (i) a summary indicators table; (ii) a donor support table, indicating current donor assistance in support of the action plan or in any of the 16 core areas ; (iii) a summary action plan table, indicating short- and medium-term actions planned by the country to redress weaknesses identified in the prior assessment ; (iv) an update of the status of actions committed to in the previous AAP; and (v) a country assessment and action plan narrative that provides additional context, detail, and argumentation supporting the assessment, action plan, and donor support summary tables. This instrument focuses on public expenditure management in general, with emphasis on poverty reducing spending. The definition of what constitutes poverty-reducing spending is country determined, often through each country s Poverty Reduction Strategy Paper (PRSP).

- 15 - II. HIPC RESOURCES, PRO-POOR EXPENDITURES AND THE MALAWI POVERTY REDUCTION STRATEGY (MPRS) 3 HIPC resources and Pro-Poor Expenditure in Malawi Malawi has been granted debt relief under the enhanced HIPC initiative (amounting to about 55% of its debt repayments in NPV terms). The debt relief started with interim debt relief at the decision point in December 2000, and will become irrevocable once Malawi reaches the completion point. 4 Under the HIPC initiative, it is presumed that public resources can be redirected from debt service towards increased pro-poor spending. Such priority areas are identified in Malawi s Poverty Reduction Strategy Paper (PRSP). An interim-prsp was completed in August 2000, and a full MPRSP in April 2002. In Malawi, HIPC debt relief resources are channeled directly into the government budget, not kept as a separate poverty fund. HIPC debt relief resources allow the government, in the context of the normal budget prioritization process, to increase funding to poverty reducing areas, supplementing domestic revenues. In order to allow monitoring of inflows, it was agreed that HIPC resources would be administered through a separate bank account that initially was not a sub-account of the government main bank account. Further, in order to ensure that these windfall resources would be used well, and more generally high priority pro-poor expenditures would be protected, a small subset of high-priority activities from the interim-mprsp (since the full MPRSP had not yet been completed) was identified as priority Pro-Poor Expenditures (PPEs), and specifically monitored. Although the use of HIPC resources cannot be directly tracked to PPEs, the total level of annual funding for PPEs was expected to increase by at least as much as the HIPC debt relief provision. The 2001/02 budget was the first budget to include PPEs in its budget plan.. 5 The PPEs have now become a standard feature of the budget process. In line with government s efforts to promote transparency and accountability, it was agreed that the funding allocations to PPEs would be published on the Ministry of Finance website (www.finance.malawi.gov.mw/priorityexp.htm). Further, in the event of shortfalls in revenues, funding for PPE expenditures would be protected to ensure uninterrupted service 3 This section draws heavily on the budget documents for fiscal years 2002/03 and 2003/04. 4 In the case of IDA, the interim assistance provided by IDA prior to reaching completion point, will not exceed one third of the total NPV assistance to be provided by IDA as agreed at the decision point. Other creditors have different conditions. 5 A different arrangement was initially pursued during FY 2000/01. Immediately following the approval of the decision point document in December 2000, ministries were invited to propose projects that could be funded from the immediate HIPC resource inflow during the second half of FY2000/01. A set of projects was selected and benefited from this initial round of funding.

- 16 - delivery (and hence PPEs are also referred to as Protected Pro-poor Expenditures). 6 Table 1 shows the development in PPEs over time. Table 1 Protected Pro-poor Expenditures Over Time 1 Protected Pro-poor Expenditures 1999/2000 Revised 2000/01 Revised 2001/02 Revised 2002/03 Revised 2003/04 Estimate 2 Total PPEs (Malawi Kwacha, thousand) 3,823,058 5,063,230 8,661,203 11,134,479 11,875,600 Funded by GOM 3,823,058 4,484,430 5,363,703 7,623,949 6,576,000 Funded by HIPC - 578,800 3,297,500 3,510,530 5,300,000 Total PPEs (US dollars, thousand) 73,778 76,864 116,351 127,922 115,638 Funded by GOM 73,778 68,078 72,054 87,590 64,031 Funded by HIPC 8,787 44,297 40,332 51,607 Total PPEs as percentage of GDP 4.2 4.5 6.5 7.2 6.8 Source: Government of Malawi, Budget Document N.4, Approved Estimates of Expenditure on Recurrent and Capital Accounts for the Fiscal Year 2003/2004 (Output Based), Table 2, page 4. Note: 1. The government for reporting purposes calculates PPEs funded from GOM resources and from HIPC resources. However, this distinction is not relevant during budget planning or execution, as ministries request only one allocation for PPE activities. 2. Revised to exclude MASAF expenditures (which were included in the original table, but are not part of PPEs). As shown in Table 1, total PPEs increased from MK 3.8 billion in FY 1999/00 to MK 11.1 billion in FY 2002/03, and are budgeted at MK 11.9 billion in FY 2003/04. The level of PPEs during the period has increased in line with the level of HIPC inflows. In fact, the rate of funding for PPEs had been increasing faster than the HIPC inflows up to FY 2002/03, thanks to the increasing level of the government s own allocation. However, this positive trend was reversed during FY 2003/04. The level of PPEs as a percentage of GDP as been increasing steadily during the four years since the HIPC decision point in December 2000. Both recurrent expenditures, and personnel emoluments are being identified as PPEs. Table 2 shows the breakdown of allocations and funding to individual PPE activities during Fiscal Years 2001/02, 2002/03 and 2003/04. 7 It is worth noting that the period was characterized by substantially lower than expected financial inflows from donors, which forced the government to revise budget allocations downwards. However, despite these resource constraints, funding to PPE activities was kept higher than the approved levels in every single year. Actual funding for PPEs was 107 percent of the approved resources in FY 2001/02, 112 percent of approved allocation in FY 2002/03 8 and approximately at the approved allocation in FY 2003/04. 6 Funding to the PPEs is specifically identified in the written funding instructions to the ministries when they are being informed about their monthly cash allocations, that are authorized and monitored through the government s payment management system, the Credit Ceiling Authority (CCA) system. However, PPEs cannot be automatically traced in the CCA system because no separate bank accounts are maintained for PPEs. 7 Detailed breakdowns of PPE funding by program and sub-program are available on the government website. 8 The over performance could be explained by the extended Targeted Inputs Program, increased Teachers' Salaries, and further adjustments to allocations on Teachers' Housing. The only PPE activities that were (continued...)

- 17 - Table 2 PPE allocations and funding in FYs 2001/02, 2002/03 and 2003/04 (MK million) 2001/02 2002/03 2003/04 Pillar/Sector/Activity Approved Revised % use Approved Revised % use Approved Revised % use Total Protected Pro-Poor Expenditures 8,163.5 8,727.7 106.9 9966.3 11134.5 111.7% 11,875.6 12,162.7 102.4 Pillar 1: Pro-Poor Growth 1649.1 1527.8 92.6% Agriculture 528.6 542.8 102.7% 928.1 897.3 96.7 Agriculture Extension and Small Scale Irrigation 217.3 165.4 76.1 528.6 542.8 102.7% 855.3 824.6 96.4 Research extension and farmertechnology 72.8 72.8 100.0 Water 275.0 216.1 92.1% 173.0 143.0 82.7 Rural Water Supplies 77.2 67.8 87.8 75.0 53.7 78.6% 30.2 28.2 93.3 Borehole Construction/Dam 350.0 262.9 75.1 200.0 162.5 71.5% 142.7 114.8 80.4 Roads 400.0 320.0 80.0% 200 150 75.0 Rural Feeder Roads 471.4 801.0 169.9 400.0 320.0 80.0% 200 150 75.0 Natural Resources 161.3 159.9 99.2% 154.2 128.4 88.4 Small-scale mining 77.5 44.4 57.3 78.3 78.2 99.9% 111.1 92.9 83.7 Small-scale fish farming 82.9 81.7 98.5% 34.1 35.4 103.9 Labor 168.1 169.4 100.8% 192.3 198.5 103.2 Technical and Vocational Training 219.6 114.1 52.0 168.1 169.4 100.8% 162.3 168.5 103.8 TEVET 30.0 30.0 100.0 Commerce 24.9 24.9 100.0% 137.7 135.8 98.6 Small-scale and Medium Enterprise Promotion 168.9 47.3 28.0 24.9 24.9 100.0% 137.7 135.8 98.6 Tourism 91.3 94.7 103.7% 111.8 100.3 89.7 Promotion of tourism 95.3 35.7 37.5 33.6 34.0 101.2% 48.6 42.9 88.2 Conservation & Protection of Wildlife 57.7 60.6 105.2% 63.2 57.4 90.8 Pillar 2: Human Capital Development 7866.0 8926.8 113.5% Education 4953.8 5909.8 119.3% 6,197.4 6,695.9 108.0 Primary Education 2,844.9 822.3 28.9 3825.6 4582.6 119.8% 4,301.0 4663.5 108.4 Teaching and Learning Materials 628.9 678.5 107.9 436.3 436.3 100.0% 320.7 577.0 179.9 Teachers' Salaries 1,502.6 2,304.2 153.3 3184.8 3940.7 123.7% 3,691.2 3,815.6 103.4 Secondary Education 831.6 231.5 27.8 667.2 815.2 122.2% 1,489.6 1690.9 113.5 Teaching and Learning Materials 61.9 61.9 100.0% 200.0 424.4 212.2 Teachers' Salaries 319.8 395.8 123.4% 880.9 910.5 103.4 Teacher Training 347.6 130.0 37.4 351.0 372.1 106.0% 313.0 295.6 94.4 Teacher housing 110.0 140.0 127.3% 93.8 45.9 48.9 Health 2767.9 2865.1 103.5% 3,064.6 2995.1 97.7 Preventive Health Care 1,068.0 652.8 61.1 856.8 869.9 101.5% 693.3 709.4 102.3 Curative Health Care 24.3 21.1 86.8 24.3 24.4 100.8% 870.7 906.7 104.1 Infrastructure development, and maintenance 1,105.7 662.7 59.9 567.7 568.1 100.1% 102.4 104.8 102.3 Health Workers' Training 150.0 125.0 83.3 317.2 317.2 100.0% 141.3 148.8 105.3 Drugs 1,108.5 794.0 71.6 1002.0 1085.5 108.3% 1.207 1077.4 89.2 Health Workers Salaries 807.4 839.1 103.9 Health technical services 22..8 21.9 96.0 Clinical and population services 26..8 26.1 97.4 Gender, Comm. Services, Sports and Culture 144.3 151.8 105.2% 139.9 141.0 100.6 Family Welfare Services 18.8 11.3 60.1 61.3 63.9 104.2% 51.8 47.3 91.4 Children Services 11.7 6.6 56.4 9.2 9.5 103.4% 9.9 9.9 100.1 Adult Literacy Education 74.1 59.7 80.6 73.8 78.5 106.3% 55..2 55.3 100.2 Youth, sports and culture 23.1 28.5 123.5 Pillar 3: Improving Life of the Most Vulnerable 100.0 323.0 323.0% Agriculture 100.0 323.0 323.0% Targeted Inputs Program 160.0 196.0 122.5 100.0 323.0 323.0% 151.5 134.9 89.1 Pillar 4: Good Governance 351.3 356.9 101.6% Police 351.3 356.9 101.6% 434.0 442.6 102.0 Community Policing 12.3 2.8 22.8 219.5 223.2 101.7% 185.4 175.3 94.6 Police Officer Training 131.8 133.7 101.5% 103.4 108.2 104.6 Crime and investigation prevention 145.1 159.0 109.6 Cross Cutting Gender Mainstreaming 64.3 44.2 68.7 Source: PPE tables on Ministry of Finance website: http://www.finance.malawi.gov.mw/priorityexp.htm partially funded were Rural Water Supplies, Borehole construction and Dams and Rural Feeder Roads. The Government's commitment to fund PPEs fully remained constant in spite of the tight fiscal position faced throughout the year.

- 18 - Note: Some activities appear to have been allocated funds only in FY 2003/04. However, the same activities might have had allocations in previous years, only they were not classified as PPE-activities. Links between the budget and the MPRSP As mentioned above, the PPEs are only a partial set of high-priority expenditures dedicated toward poverty reduction. The overall priorities of government policies are laid out in the MPRSP, which should provide the comprehensive basis for the government annual budget. The MPRS identifies four pillars that form the main strategic components of a coherent framework for poverty reduction: 1. Sustainable Pro-Poor Economic Growth economically empowering the poor by ensuring macroeconomic stability, access to credit and markets, skills development and employment generation. 2. Human Capital Development ensuring the poor have the health status and education to lift themselves out of poverty. 3. Improving the Quality of Life for the Most Vulnerable providing sustainable safety nets for those who are unable to benefit from the first two pillars. 4. Good Governance ensuring that public and civil society institutions and systems protect and benefit the poor. In addition, there are four issues that cut across these pillars: HIV/AIDS, Gender, Environment, and Science and Technology. Ultimately, it is expected that government implements only the MPRSP which also provides a resource envelope for essential statehood activities of the government. The MPRSP contains a costed and prioritized action plan matrix, which forms the basis for preparing each Ministry s budget estimates. The matrix was designed to match Government s resource constraints, and reflects a consensus on Malawi s priorities that has been built through a highly participatory process and reference to ongoing programs. The full implementation of the MPRSP will require a restructuring of government to focus on delivering MPRSP activities. In particular, human resources will have to be reassigned to priority activities and ultimately ministries and departments implementing non-mprsp activities should be phased out. Efforts to link the MPRSP to the budget are the first stages in a process that will take several years. In principle, the budgeting under a strategic framework like the MPRSP should be output oriented, but there is currently limited capacity at the line ministry level to produce MPRSP and output-based budget estimates. At present the output based estimates largely cover only Other Recurrent Transactions (ORT), rather than Personal Emoluments (PE) and the Development Budget, but additional steps are being taken. The authorities are in the process of reviving the Public Sector Investment Programme (PSIP) to improve prioritization in the development budget; the PSIP is to be guided by the MPRSP. The authorities also have

- 19 - developed a separate growth strategy that is meant to operationalize the growth objective (pillar 1) of the MPRSP. The government has taken first steps toward that objective. Starting with the 2002/03 budget (the first to implement the finalized MPRSP) the key principle employed in budget preparation has been to provide adequate resources to priority activities in the MPRSP and to scale down or stop completely implementation of low priority activities. In preparing their budget estimates, each Ministry and Department was instructed to use the MPRSP as a guiding framework and was requested to link each of its planned activities to an MPRSP activity using a six-digit code. This has enabled an estimate of the proportion of each Ministry and Department s Other Recurrent Transaction (ORT) budget that is allocated to MPRSP activities for each of the four MPRSP Pillars. Table 3 presents a summary of this information for the 2002/03 budget. Unfortunately this calculation has not been carried out for fiscal year 2003/04. As shown in Table 3, about 72 percent of total ORT in FY 2002/03 was allocated to MPRSP activities (including 8 percent allocated to Statehood Activities), leaving about 28 percent to activities outside the MPRSP. Thus a significant share of the budget for ORT expenditures supports the implementation of the MPRSP. 9 In future years, the government intends to further align the Budget with the MPRSP, by continuing to phase out non-mprsp activities and implementing only new activities which are included in the MPRSP. 10 Table 3 The allocation of FY 2002/03 budget by MPRSP Pillar (ORT Only) MK Total Voted ORT 15,078.50 as % total voted ORT as % allocation to MPRSP activities Total MPRSP Activities 9,569.44 63.5% Pillar 1 3,141.94 20.8% 32.8% Pillar 2 5,081.76 33.7% 53.1% Pillar 3 119.97 0.8% 1.3% Pillar 4 1,116.93 7.4% 11.7% Cross-Cutting 66.57 0.4% 0.7% Implementation and Monitoring 42.26 0.3% 0.4% Statehood Activities 1,218.94 8.1% Other (Outside MPRSP) 4,290.12 28.5% Source: Government of Malawi, Budget Document N.4, Approved Estimates of Expenditure on Recurrent and Capital Accounts for the Fiscal Year 2002/2003 (Output Based), Table 3, page 5. 9 Unfortunately the analysis only covers ORT expenditures. It is expected that in future years the analysis will cover all expenditures, including personal emoluments and the development budget. 10 See: Government of Malawi (2002), Approved Estimates of Expenditure on Recurrent and Capital Accounts for the Financial Year 2002/2003 (Output Based), Budget Document N.4, Page 4.

- 20 - In terms of the allocation between the four Pillars of the MPRSP, the budgetary allocations are in line with the MPRSP shares, with Pillar 2 receiving the biggest share (53 percent in the MPRSP against 52 percent in the budget), followed by Pillar 1 (33 percent in the MPRSP against 34 percent in the budget) and Pillar 4 (12 percent in the MPRSP against 12 percent in the Budget). Decentralization and the involvement of different levels of government Malawi has two tiers of elected government: the central government and local assemblies at the district level (a total of 31 districts). To date, the level of involvement of local government has been low. The present policy is that 5 percent of domestic revenues should be passed directly to local government as unconditional grants. The actual amount has been increasing from less than 1 percent in 2001/02 (the first year of activity of local assemblies) to about 1.6 percent in the current fiscal year 2003/04. However, Malawi is planning to decentralize major policy responsibilities to local government, and to increase the participation of lower levels of government in delivering poverty-related spending. The Ministry of Agriculture has undertaken to decentralize ORT funding for extension services to local assemblies, and the decentralization of ORT funding for health facilities and for primary education to local assemblies is planned soon. These three activities represent over 10 percent of the revenues. Plans for further decentralization in other areas are also fairly advanced. Over the next few year, therefore, financial information and reporting basis for the lower level of government is a significant issue. Currently, district assemblies prepare their budgets and accounts in a standardized classification, which however differs from the one used by central government. An interface between the two systems is planned. The plans are to require classification on the same basis as the central government. The Ministry of Local Government currently receives quarterly and monthly reports on the use of financial resources by the district assemblies, although compliance falls short of perfect. While the share of general government executed at the local level is expected to increase over the next years, this report deals with central government spending only. This seems justified, as own revenue of local government likely will remain small, and there do not seem be plans to reassign tax revenues. Hence, the majority of local level resources will be provided through transfers from the central government, allowing at least some basic monitoring from central government records.

- 21 - III. BUDGET FORMULATION Indicator 1~ Coverage of the budget or fiscal reporting entity Target: Fiscal reporting covers the Government Finance Statistics definition of the general government sector, i.e., including central, regional, and local governments, and all government operations, whether funded through the budget or not. Assessment: There are considerable differences from GFS definition. Aggregate government fiscal reports focus on the central government budget sector and do not include local government (district assemblies). They also do not include the own accounts of autonomous government agencies like the Malawi Revenue Authorities, National Food Reserve Agency, National Road Fund, and subvented organizations like universities. Only the transfers to these agencies appear in the budget and fiscal reports. Similarly, the operations of treasury funds are only reflected in the budget appropriations that government agencies use to purchase services from agencies like Central Medical Stores. Even though no consolidated statements for general government are being prepared, the financial statements of many general government agencies are available at a central level. The district assemblies are required to submit their budgets and financial statements to the National Local Government Finance Committee which is charged with supporting financial management of local governments. Autonomous government agencies are expected to prepare their own budgets and submit budgets and final accounts to parliament. The government final accounts include a number of separate statements on autonomous government agencies, and treasury funds. Action plan: Expand the coverage of fiscal reports and prepare consolidated general government statements, both for ex ante fiscal plans in conjunction with the budget presentation, and for ex post reporting in conjunction with the final accounts. In particular: Include financial position or detailed accounts of autonomous central government agencies and treasury funds; Include the accounts of local government agencies including reporting on pro-poor expenditure, especially after the devolution of functions to district assemblies becomes effective.

- 22 - Indicator 2 ~ Degree of spending being funded by extrabudgetary sources Target: Government activities are not funded through extrabudgetary sources to a significant degree. Assessment: Government activities funded through extrabudgetary sources are deemed to be not significant. However, the share of spending is difficult to assess. Ministries are expected to remit all revenues and fees to the central treasury, but central monitoring and auditing of revenue collection is weak and some agencies may not report their revenue. 11 Ministries at times may also obtain additional resources by overdrawing miscellaneous deposit accounts; the 2002/03 Final Accounts, Statement 11 show that a number of such accounts have a negative balance. The levies collected by the Petroleum Control Commission on oil products are included in overall fiscal reporting, including those levies that are earmarked for the National Road Agency (NRA). Own revenues of other autonomous agencies (e.g. university fees) and of district assemblies (fees and charges) are not included in fiscal reporting. The civil service pension scheme is funded from the budget (pay-as-you-go). The government operates more than 30 treasury funds as revolving funds 12. It seems that many are primarily funded from general budget allocation for procurement (like Central Medical Stores, Central General Stores, Government Press Fund), others may have revenues from fees from their activities (Tourism Marketing Fund), while others appear to have been funded by donors (Transportation and Aviation Japanese Counterpart Fund). Treasury funds account for their operations according to commercial accounting principles, and statements for some of these funds are annexed to the final accounts. Tax expenditures appear to be small. The Malawi Revenue Authority (MRA) remits gross tax collections to the treasury. The MRA s operating expenses are funded by a 2.5 percent share of gross tax collections which is transferred by standing instructions from the main government account, and the MRA also receives dedicated funding for tax refunds. In the past, tariff exemptions were quite common, and the Minister of Finance had significant discretion over granting such exemptions. In 2003 all special tariff exemptions were repealed, and under the IMF PRGF the authorities committed not to grant new exemptions. 11 For example, the final accounts 2002/03 show some revenue lines for which revenue collections were budgeted, but for which no actuals are reported. 12 Treasury funds (TF) are: Plant and Vehicle Hire Organization (PVHO) TF, Government Press Fund, Government Printer Advances, Malawi Social Action Fund (MASAF II), Smallholder Macademia Development Project, Horticulture and Food Crops Development Project, Central Medical Stores, Central Government Stores, Borehole Construction (Agriculture), Rural Electrification Fund (Forestry), Public Land Development TF, Lands TF, Lands and Valuation, Local Government TF, Government Hostels, Prison Reward Fund, Japanese Counterpart Fund (Transportation and Aviation), Tourism Marketing Fund, Gender and Community TF, Police TF, Ex-CCCD TF, UNDP Housing Fund, National Parks Fund, Salima ADD Cultivation Assistance Fund, Rural Housing Project Fund, Scholarship Fund, National Disaster Fund, Secondary Development Centers Program Fund, Fisheries Training Project Fund, Civil Service Housing Fund, Energy Fund.