Malawi to cut spending after British aid freeze

* Britain freezes aid worth ${esc.dollar}550 million over four years

* Diplomats expelled by both sides last month

* Budget and kwacha to come under pressure

(Updates with details of aid, opposition comment)

By Mabvuto Banda

LILONGWE, May 20 (Reuters) - Malawi will introduce austerity measures this year to deal with a hole in its budget left by the freezing of ${esc.dollar}550 million in British aid over the next four years, Finance Minister Ken Kandodo said on Friday.

Britain was Malawi&${esc.hash}39;s single largest bilateral donor but relations have nosedived since a leaked diplomatic cable had Britain&${esc.hash}39;s ambassador describing President Bingu wa Mutharika as "autocratic and intolerant of criticism".

Malawi expelled the ambassador last month, then Britain responded by expelling its former colony&${esc.hash}39;s acting ambassador to London, and earlier this week said it would freeze new aid.

Despite six years of 7 percent annual economic growth, the the southern African country remains heavily dependent on foreign donors, whose payments account for more than 40 percent of government income.

"Clearly the 2011/12 financial year resource envelope will fall short of our expectations in view of the British decision," Kandodo told Reuters.

"But Malawi is ready to make tough decisions and choices on spending cuts in order to sustain growth and be able to deliver public services."

Kandodo gave no details of how he would raise taxes or cut spending. The loss of the pledged British funds will hit the ${esc.dollar}1.9 billion annual budget hard.

Combined with a predicted fall in tobacco exports, which account for 70 percent of foreign exchange earnings, the aid squeeze will also intensify a dollar supply crunch and put pressure on the kwacha currency <MWK=>. [ID:nLDE72D1LK]

Last month, the United States approved a ${esc.dollar}350 million grant for Malawi&${esc.hash}39;s dilapidated electricity network that had been delayed because of concerns about a law preventing gay marriages and another that lets the government ban newspapers.

Diplomatic sources in Lilongwe said on Friday that Britain&${esc.hash}39;s decision could encourage other donors to follow suit, a serious threat for a country with an 11 percent HIV/AIDS infection rate and per capita income of less than ${esc.dollar}1 a day.

Opposition leader John Tembo blamed Mutharika, a former World Bank economist, for the imbroglio and said he should shoulder responsibility for any impact on the economy.

"For the past two years we have been experiencing shortages of foreign exchange, which has resulted into massive fuel shortages," Tembo said. "This will now worsen the situation and he should be held accountable for that." (Writing by Ed Cropley; Editing by Jon Herskovitz and Kevin Liffey)