A quarterly magazine of the IMF

December 2001, Volume 38, Number 4

Shortly after he assumed office as Managing Director of the IMF in May 2000, Horst Köhler launched a reform of the conditionality associated with its lending. What lies behind this change in approach, and what prospects does it have for strengthening implementation of reforms in the IMF's member countries?

The economic policy program that Indonesia undertook, with IMF support, in 1997-98 had to contend with pervasive weaknesses in the financial and corporate sectors. Accordingly, the IMF made the financing it provided conditional on the implementation of reforms in a wide range of economic policies. A conspicuous example was the dismantling of the clove and plywood monopoly. Some observers have cited inclusion of this condition as an example of the IMF overextending its reach, allowing the scope of its conditionality to become excessive. Others point out that this measure not only sent a strong signal of the authorities' commitment to tackle the root causes of the crisis but also brought immediate benefits to disadvantaged groups in Indonesian society—such as the clove farmers who previously had to sell their crops to a politically connected agency. How should the IMF balance these opposing views? This example from Indonesia illustrates a broader debate that has been under way on the appropriate scope and detail of IMF conditionality, especially as it relates to structural policy reform in IMF-supported programs.

Why conditionality?

Providing financing to countries facing serious external payments imbalances is one of the important functions of the IMF. But financing by itself is obviously not enough; it must be accompanied by countries' own efforts to tackle the underlying sources of their imbalances. For instance, if a country has been relying on domestic credit creation to finance a fiscal deficit, and therefore eventually runs out of international reserves, the aim of the IMF's financing is to give the country breathing space to make the necessary policy changes—for example, fiscal retrenchment and credit restraint—to address the underlying sources of the balance of payments problem and avoid disorderly adjustment.

IMF financing, however, can be provided only if the member country's authorities commit to necessary policy changes and reforms, and keep those policies and reforms on track, adjusting them if circumstances warrant. This is IMF conditionality. It involves commitments on both sides. On the one hand, conditionality provides assurances to the country that as long as it implements the agreed policies, it will continue to receive the financing committed by the IMF. On the other hand, conditionality provides safeguards to the IMF that the money it has lent is being used for the intended purpose—to facilitate the adjustment process—and that the member country will be able to repay what it has borrowed from the IMF's pool of funds (to which all of its member countries have contributed).

Broadening of conditionality

Until the 1980s, IMF conditionality was largely limited to policies affecting macroeconomic aggregates, such as controlling domestic credit expansion and reducing government deficits. During the last two decades, however, the complexity and scope of the structural policy conditions attached to IMF loans have increased significantly.

This broadening of conditionality was driven by two factors. First, there was the criticism in the 1980s that the IMF, in dealing with balance of payments crises, did not pay sufficient attention to restoring sustained growth. It was argued that improving economic growth through structural reforms could contribute to balance of payments correction as well as higher living standards. This increased emphasis on growth led the IMF to include structural measures—such as price and trade liberalization, privatization, and a range of policies touching on economic governance—in IMF-supported programs.

Second, the IMF also became increasingly involved in providing financing for countries—including low-income countries, transition countries, and countries undergoing financial crises—facing problems very different from those most IMF member countries had experienced. While old-style monetary and fiscal adjustment was often an essential part of the policy mix, the difficulties facing these countries were not only manifestations of macroeconomic imbalances but also reflections of structural problems that made it difficult to fix imbalances quickly. Achieving economic stabilization and growth thus required structural reforms.

As a result, IMF-supported programs came to cover a broad range of policy measures, some of which were intended to strengthen the structural underpinnings of macroeconomic policies, others to improve the resilience of key sectors of the economy. For example, in many countries, the fiscal deficit partly reflects governments' lack of administrative capacity to collect taxes from many parts of the economy. Consequently, in many cases, the IMF lends on condition that the authorities strengthen their ability to collect taxes from a broader segment of the economy or prioritize their spending better. In others, inefficiently run public enterprises were a major drain on the budget, and restoring the country's long-run fiscal viability meant addressing the causes of inefficiency in these enterprises.

In other cases—notably during the 1997-98 Asian crisis—countries needed the IMF's help because serious problems in their banking systems had triggered large capital outflows and balance of payments crises. If these problems had not been tackled, providing IMF lending would only have financed these flows without doing much to stem them. Thus, structural reforms designed to restore insolvent banking systems to health had a central place in these countries' programs.

Ownership and conditionality

The expansion of structural conditionality has not come without strains. Many aspects of the structural reform agenda are complex, often requiring specification of a series of steps toward an overall policy outcome. For example, in Mauritania, the introduction of a value-added tax—a single structural objective, but one that takes a long time to achieve—involved a series of 19 structural benchmarks (specific, often narrowly focused policy objectives). Similarly, a large number of structural benchmarks were established to guide Indonesia's corporate-debt-restructuring process.

An important question raised by the greater complexity of conditionality is how this may affect member countries' sense of "ownership" of their economic policies. Experience suggests that without sufficient commitment by the government, policies are often implemented improperly and are unlikely to be maintained. Attaching conditions to borrowing does not have to be inconsistent with supporting homegrown programs. There is considerable evidence that a government's resolve to undertake needed reforms depends mainly on its domestic political support. Nevertheless, a country's sense of ownership may be influenced by how conditionality is designed and applied. Establishing conditions covering a wide variety of policies and the detailed steps involved in each policy reform may effectively short-circuit national decision making and undermine political institutions within the country. It may also have the unintended effect of galvanizing opposition to needed reforms. And conditionality that is unrealistically ambitious, given countries' institutional and political constraints, may result in repeated failure to meet agreed targets and foster a culture of nonperformance.

Conditionality covering a broad range of policy areas may also place an enormous burden on limited administrative capacities in borrowing countries and may make it more difficult to focus on getting the most important things done. Further, when IMF conditionality covers areas that are outside the IMF's core areas of expertise, such as privatization and some aspects of financial sector reform, this raises important issues of coordination with other international institutions, such as the World Bank.

Finally, with the broader scope and increased detail of letters of intent, which specify the government's policy intentions, the borders of conditionality have become blurred. Many letters of intent have included long lists of policy measures without clear guidance as to how individual measures should be taken into account when the IMF decides whether agreed policy adjustments are on track and financing will continue. This created the generally inaccurate impression that all measures were equally important.

These concerns—both within the IMF and outside—have led to the current drive to focus and streamline conditionality.

Sharper focus

The agenda for sharpening the focus of conditionality seeks to provide more room for countries to set their own priorities and to enhance transparency by bringing greater clarity to the instruments of conditionality. It has two key aspects.

• First, drawing the line between measures that are critical to the macroeconomic objectives of a program and those that are relevant but not critical will enable the IMF to distinquish between measures to which conditionality must apply and those to which conditionality should be applied much more sparingly.
• Second, improving the division of labor between the IMF and the World Bank and other international institutions will enable the IMF to avoid establishing conditions outside its core areas of expertise while ensuring that member countries receive adequate international support for their broad reform agendas. The net effect of these efforts is not simply to shift conditions to other institutions but rather to ensure that conditions are set only on what is crucial to the program's objectives and with the full involvement of those with the greatest expertise in each policy area.

At the same time, the IMF is addressing some important policy issues related to the application of conditionality, including choosing the appropriate degree of detail of conditionality and clarifying its boundaries. Letters of intent are now clearer about what is essential for the IMF to determine whether the program is on track and, hence, is covered by conditionality; the coverage of program reviews—overall assessments of program performance—is being more clearly delineated; and structural benchmarks are being applied more sparingly to important representative steps in a country's reform program.

The IMF is also grappling with the need for clarity and consistency in the way it applies specific tools of conditionality. For example, it is examining the use of prior actions—economic policy actions member countries agree to take before entering into a formal arrangement with the IMF under which it will provide them with financing. Another example is the ongoing reassessment of the IMF's policy on waivers of performance criteria—that is, decisions taken by its Executive Board, in some cases, to continue to provide financing to a country even though it has not met specific conditions to which it had previously agreed. Some other proposals, such as broadening the scope for results-based conditionality—that is, making the IMF's financing conditional on the achievement of previously specified outcomes, rather than on the steps toward those outcomes—are being considered. The IMF is also undertaking further studies on the nature and complexity of country ownership and how IMF programs can most effectively reinforce such ownership.

The experience so far

The IMF is taking stock of the experience it has gained during the first few months of pursuing the new approach and assessing how conditionality is being handled in each case. Deciding on the appropriate form and coverage of conditionality will require member countries and the IMF to make difficult judgments on a case-by-case basis. Every program that comes to the IMF's Executive Board provides an opportunity to scrutinize the coverage of conditionality, its effect on ownership and the prospects for successful implementation, and the division of responsibilities between the IMF and the World Bank. So far, this approach is bringing about some changes in the way the IMF applies conditionality.

Low-income countries. Already, important steps have been taken to direct both the negotiation and specification of the content of conditionality in ways that help enhance ownership in low-income countries. In these countries, financing is provided on the basis of a poverty reduction strategy paper (PRSP), which a country formulates through a consultative process involving affected groups. While the PRSP approach is a work in progress, it promises to help ensure that policies supported by the IMF are those that would win broad support in the country. In particular, recent programs developed under the Poverty Reduction and Growth Facility (PRGF) show evidence of better prioritization and include fewer detailed conditions.

One indication of the impact of refocusing conditionality is that the average number of conditions has been reduced by one-third, with a better focus on the IMF's core areas and a clearer division of labor with the World Bank. For example, the IMF's previous program for Mozambique included a structural benchmark related to the protection of the domestic sugar-refining industry that acted as a tax on raw sugar production, lowered the incomes of farmers and agricultural workers, and reduced the country's exports of sugar. The IMF's present program with Mozambique does not include any conditions related to sugar. Although reform of this sector is still desirable for efficiency and equity reasons, it was not judged critical to the program's macroeconomic objectives. Similarly, in Madagascar, previous programs included prior actions relating to the privatization of a state-owned bank, a state-owned oil company, and the national airline and telecommunications companies. These conditions have been eliminated in the new program agreed with the IMF in March 2001, and the World Bank has taken over responsibility for advising on the privatizations of the airline and the telecommunications company.

Middle-income countries. The IMF's experience with lending to middle-income countries (usually under Stand-By Arrangements or the Extended Fund Facility) has been mixed—with considerable variation in scope and detail of conditionality, depending on conditions in the particular country—in the handful of programs approved since the new policy came into effect. In some middle-income countries, streamlining conditionality may be difficult, especially in crisis-hit countries, where a wider range of actions, including structural conditions, may be needed to restore market confidence; in others, where the economic problems the country confronts are related primarily to fiscal and monetary imbalances, it may be possible to use conditionality very sparingly.

World Bank-IMF collaboration. Over the past several years, IMF and World Bank operations have evolved in ways that have led to an increased need for their collaboration both in designing support for country programs and in establishing and monitoring the conditions attached to them. The goal of cooperation is that, to the extent possible, the staffs of the IMF and the World Bank should work within a common, country-led policy framework. Another element of cooperation is applying the concept of "lead agency": for each area of policy, one institution should be designated to lead the policy dialogue on a specific issue with the member country, and that institution's assessment of policy implementation should, where relevant, be included in the other institution's reports and be included as an input to an overall assessment of the country's economy.

Over the past two years, the development of the PRSP approach has provided a common framework for the operations, and improved the coordination, of both institutions in low-income countries. Under this joint framework, the IMF will not normally apply conditionality outside its core areas of expertise except where specifying particular conditions is critical to achievement of the external and fiscal objectives of the program. Structural and social policies will be covered by complementary programs supported by the International Development Association, a World Bank affiliate that provides concessional loans to low-income countries.

The problems addressed by IMF- and World Bank-supported programs in middle-income countries are more varied, requiring a more differentiated and flexible approach. However, efforts are also under way to improve operational coordination between the two institutions, including by ensuring that their two staffs discuss at an early stage each country's policy priorities and the division of responsibilities between the two institutions.

IMF's external consultations on conditionality One key element in the IMF's review of conditionality has been two-way public communication and discussion. The IMF invited public comments on a set of staff papers on conditionality (on which this article is based). Comments received on the first set of papers have been conveyed to the Executive Board and posted on the IMF's website (www.imf.org). In addition, a series of seminars on conditionality and ownership were held in Berlin, Tokyo, and London, with wide participation from both borrowing and creditor countries. These insights have provided valuable guidance on many of the issues that are part of the conditionality review, and they are being taken into account by the IMF's staff in further work on conditionality. The relevant staff papers, which are available on the IMF's website, include "Conditionality in Fund-Supported Programs: An Overview," "Conditionality in Fund-Supported Programs: Policy Issues," "Structural Conditionalities in Fund-Supported Programs," "Strengthening IMF-World Bank Collaboration on Country Programs and Conditionality," "Streamlining Conditionality: Review of Initial Experience," and "Conditionality in Fund-Supported Programs: External Consultations."

Conclusion

The IMF's review of conditionality is an ongoing process, building on the lessons from extensive external consultations with country officials, other international organizations, and civil society (see box). The aim is to leave countries more room to make their own choices while focusing conditionality on measures that are critical for the success of the IMF-supported program. But it will take time to achieve the right balance in each country, and lessons will be learned in the process. The result should be conditionality that better serves its intended purpose: ensuring that the IMF's financing helps countries that are taking action to address the problems they face while leaving countries the maximum latitude to choose what kind of actions to take.