A quarterly magazine of the IMF

June 2002, Volume 39, Number 2

For the international community, one of the biggest challenges is how to reconcile the need for more country ownership of adjustment and reform programs with the need for conditions on IMF loans. Critics charge that IMF conditions are too numerous or too intrusive and hence undermine country ownership. A variety of solutions are being explored, including focusing conditions not just on policies but also on outcomes.

When the IMF lends to member countries, it attaches conditions to those loans—known as "conditionality." This is nothing unusual in the world of borrowers and lenders. Indeed, the finance literature shows that some form of conditionality must be present in virtually all borrower-lender relationships. The IMF is mandated by its charter to extend temporary financial assistance to its member countries facing balance of payments difficulties "under adequate safeguards." It thus has to have assurances that it will be repaid.

Countries in need of IMF loans generally do not possess internationally valuable collateral. If they did, they could use it to borrow from private lenders and would not require IMF funding. In the absence of collateral, private loan contracts typically include various forms of covenants designed to protect the lender and prohibit the borrower from taking actions that could reduce the probability of repayment. IMF conditionality can be viewed as a complex covenant written into the loan agreement. It thus serves, in a sense, as a substitute for collateral.

In recent years, the international community has become increasingly aware of the importance of country ownership of adjustment and reform programs, which, by aligning the incentives of the borrower and the lender, contributes to the programs' success. For the country, program ownership, by reflecting a firm commitment from the government, implies that the difficult policy measures designed to correct macroeconomic problems are more likely to be implemented. For the IMF, program ownership raises the probability of the success of programs and thus increases the "value" of the safeguards on its resources provided by conditionality.

Clearly, both IMF conditionality and country ownership have a rationale, but the challenge is reconciling the two. Why is reconciliation difficult? First, IMF conditionality is much more complicated than the conditionality typically contained in private contracts. It involves assessing the macroeconomic imbalances or structural deficiencies that lead to macroeconomic problems and then negotiating an agreement with country authorities that will address them. Second, it is difficult if not impossible to establish a value for IMF conditionality, because this value depends on the country authorities' commitment to the program. Third, unlike private lenders, for whom it may be sufficient to deal only with a firm's management, the IMF has to take into account the positions of multiple stakeholders in a country. Fourth, the IMF, by design, is a cooperative that makes loans to its sovereign members. In the event of default, there is no court to which it can appeal, and there is no tangible collateral on offer that can be used to make up for its resources. And fifth, compared with private lenders, the IMF, given its mandate and cooperative structure, faces what is called the "Samaritan's dilemma." Countries know that, faced with underperformance and a weak economy, the IMF is unlikely to impose strict conditionality, because it is concerned with the borrowing country's welfare. Simply put, penalties established in advance have limited credibility because they are unlikely to be enforced.

In recent years, the international community has proposed a number of ways to do a better job of reconciliation, all aimed at increasing country ownership—notably, encouraging countries to design "homegrown" programs, developing a menu of policy options for country authorities to choose from, and investing time and effort in selling the program to various domestic constituencies in the country. The poverty reduction strategy papers (PRSPs)—used as a basis since 1999 for IMF lending to poor countries—reflects this new direction, and initial results are promising.

Four other proposals have been made to change the IMF's approach to conditionality and help increase ownership. These include (1) pre-selecting countries eligible for IMF lending; (2) streamlining structural conditionality; (3) introducing flexibility in the timing of structural policy measures, or "floating tranche" conditionality; and (4) applying conditionality to outcomes rather than policies, or "outcomes-based" conditionality. This article explores the pros and cons of each proposal and some early experimentation with them.

Preselecting countries

The preselection approach is based on the idea that, if conditionality is reduced, there must be stricter prequalification of countries eligible to borrow to ensure repayment. Under this approach, which was the main recommendation of the Meltzer Commission Report on International Financial Institutions, the IMF would provide resources up to specific limits to countries that are vulnerable to contagion but have a track record of good policies. This would be consistent with safeguarding IMF resources while encouraging the country to secure market financing before coming to the IMF, thereby reinforcing the role of the IMF as a lender of last resort. Obviously, preselecting countries with good track records reduces the need for explicit conditionality.

What are the drawbacks of this approach? The most serious one is that preselection provides no guarantees against undesirable changes in the domestic policy stance (perhaps through changes in government) and thus may weaken the safeguards on IMF resources. Furthermore, the prequalification requirement would exclude from IMF lending a large number of member countries that do not have access to international capital markets. There is also the serious problem of what the IMF should do when a country's policies deteriorate. The disqualification of a country may itself trigger a crisis. This last is the main reason countries have been reluctant to sign on to the Contingent Credit Lines (CCL) Facility created in 1999 by the IMF, which is based on the prequalification requirement.

Streamlining structural conditions

The second approach centers on streamlining the number of conditions in IMF programs. While the number of conditions in programs relating to macroeconomic performance has been relatively stable over time, the number of structural conditions has increased substantially, going from an average of 3 in the late 1980s to 15 in the late 1990s. There have also been cases where the number of structural conditions ballooned dramatically. This occurred in the programs with countries during the Asian financial crisis and in the Russian program of 1996. It is now widely acknowledged that the expansion of structural conditions left limited scope for domestic policy choices, thereby potentially reducing country ownership.

Why did structural conditionality increase so dramatically? A few reasons stand out.

• In the late 1970s and early 1980s, the IMF was criticized for being interested only in narrow (balance of payments) outcomes and relatively unconcerned about growth. The IMF responded by including policies to remove structural impediments to growth and the efficient allocation of resources.
• The IMF has to aim for sustained medium-term improvement in economic performance, not least because it has to ensure the loan is repaid on the date of maturity. This usually requires structural transformations and reforms.
• The reformers in the government with whom the IMF is usually negotiating frequently want to put in place policy measures that would force the less reform-minded parts of the government to accept reforms.
• Some structural measures may be included in programs for symbolic reasons, to show a new way of doing things. This was the case for some of the reforms included in the Asian programs in the late 1990s. Such measures presumably buy the government credibility, both at home and in the international financial markets.
• Structural conditions have been introduced to address concerns about governance. Faced with the possibility that the country may not be able to implement the policies necessary for a favorable outcome, a private lender could decide not to lend. The IMF cannot disengage itself this way from a member country. Thus, it needs to put in place program conditionality that will compensate for governance problems and protect IMF resources.
• There may be a need to ensure that key structural reforms are tackled. Implicit in the rationale is the view that more structural conditions are needed because countries would otherwise be unwilling to voluntarily undertake the necessary reforms. In other words, structural conditions are necessary because of insufficient country ownership.

These reasons build a case for the expansion in conditionality that has taken place, yet the international consensus is that the IMF has perhaps gone too far in this direction and overloaded programs. Many structural reforms are not critical to achieving macroeconomic stability. There is also no compelling evidence that programs with a greater number of structural conditions have been more successful. Moreover, two key dangers arise. First, increased structural conditions might result in reduced country ownership of programs, thereby impairing their effectiveness. Second, the failure to implement structural reforms that are not critical for macroeconomic stability may undermine confidence in the overall program, thereby triggering negative reactions in domestic and international capital markets.

What is the answer? It would be difficult, as well as undesirable, to turn back the clock and eliminate all structural conditions. Yet careful thought should be given to which structural reforms are critical for achieving a program's principal objectives. Sharply pruning the list of structural conditions is possible without jeopardizing a program's success or repayment of the IMF's loan. In other words, prioritizing or streamlining structural conditionality does not mean weakened overall conditionality. In this case, less can be more.

For this reason, the IMF, in collaboration with the World Bank and other multilateral development banks, has been undertaking a major effort to streamline structural conditionality. In 2000, IMF management issued to staff an Interim Guidance Note on Streamlining Structural Conditionality, stating that IMF conditionality should cover structural reforms that are critical to achieving the program's macroeconomic objectives and that lie within the IMF's core areas of responsibility.

Allowing floating tranches

The floating tranche approach builds on the idea that flexibility should be introduced in the timing of structural measures. The way it works now is that conditionality is implemented through program design and monitoring arrangements that track whether agreed policies are carried out in a timely and effective manner. Monitoring takes various forms, depending on country circumstances and the facility being used, but generally includes the following:

• Prior actions: when a country agrees to undertake certain measures before a program (or program review) is discussed by the IMF Executive Board.
• Performance criteria: quantitative targets (such as a floor on net international reserves) that must be met for the IMF's financing to continue. Structural measures (such as tariff reductions) may also be included.
• Structural benchmarks: indicative targets for macroeconomic variables and structural policies deemed important for effective program implementation (for example, privatization and civil service reforms). These targets do not directly interrupt scheduled disbursements.
• Program reviews: designed to assess overall progress toward program objectives, identify slippages, and take corrective actions. Reviews are usually included in performance criteria.

The problem is that performance criteria and structural benchmarks have specific dates attached to them, and countries often find that rigid timetables for major structural reforms limit their choices as well as strain their implementation capacity.

Under the floating tranche approach, the availability of a loan disbursement would not be tied directly to any specific date; instead, the disbursement would become available upon completion of certain agreed structural reforms. This approach gives the country flexibility in the timing of implementation. Furthermore, it allows the de-linking of disbursements associated with the implementation of one part of the program from another part of the program.

Specifically, the floating tranche approach could be used to divide conditionality into two segments. One part of the IMF financing could be made conditional on achieving the usual quantitative performance criteria under a preset or fixed schedule, while the other part—the floating tranche—would depend on the implementation of certain structural measures at any time prior to the expiration of the arrangement.

Clearly, not all structural reforms should be made subject to floating tranche conditionality. Some reforms are critical to support the macroeconomic framework. For example, the establishment of an independent central bank could be considered necessary to promote monetary stability. The timing of such reforms cannot be left open.

In principle, prior actions can be thought of as a variant of floating tranche conditionality. Program reviews themselves may also be considered a form of floating tranche conditionality, because their completion and the accompanying disbursements depend on the agreed policy measures being taken. The World Bank has also experimented with floating tranches in its Higher Impact Adjustment Lending, introduced in Africa in 1995. It disburses funds through tranches and provides more disbursements after delivery of reforms. The early results have been quite promising.

Focusing on outcomes

The outcomes-based approach would involve the IMF's disbursing loans based on results, rather than on policy measures expected to lead eventually to attainment of the program's objectives. This would mean setting performance criteria on the achievement of targets for the policy objectives by selected dates. The policy objectives would be negotiated with the IMF. But the policy content of the program would be left largely up to the authorities.

This is not as radical an approach as it might seem, because outcome variables have been defined as part of conditionality in programs. For example, IMF-supported programs include a floor on net international reserves as a performance criterion. The list of potential variables that can be subject to outcomes-based conditionality could also include the trade balance, the current account, investment, growth, inflation, and so on.

In principle, there are two major benefits to this approach. First, country authorities would be responsible for designing policies to achieve desired goals. This approach would enhance ownership by requiring that the authorities and the staff agree only on the objectives of the program and not necessarily on the mechanisms that link these objectives to specific policies. Second, funds would be disbursed only when certain goals are attained. IMF resources would be safeguarded because disbursement would depend on the country's achieving the desired results. If policies failed to have the envisaged outcomes, the country and the IMF would be forced to rethink the economic strategy.

Carrying out this approach, however, might pose some difficulties. Outcomes-based conditionality could lead to the backloading of funds, which may be needed to fill a temporary liquidity gap or to finance structural reforms. There may also be significant lags in the reporting of data on outcomes, particularly for the real sector and the trade accounts, and the data may be subject to frequent revisions, thus making timely monitoring and disbursements problematic. Furthermore, program objectives are influenced not just by policies that are under the control of the authorities but also by exogenous factors that they do not control.

How can these problems be overcome? First, even under outcomes-based conditionality, the disbursement of funds could be done in tranches. For example, a program put in place to correct an imbalance in a country's balance of payments could achieve its objective of attaining a comfortable level of international reserves in multiple steps. In fact, even the release of the first tranche could require some prior actions. Hence, by breaking up monitoring and disbursement into a set of smaller components, a sequence of outcomes-based criteria can simultaneously provide sufficient safeguards and prevent excessive backloading of financing. Second, just like any creditor, the IMF would combine outcomes-based conditionality with a system of monitoring so that if a borrower's position deteriorated, the IMF would intervene to contain the damage, take prompt corrective action, and attempt to change the borrower's strategy.

Conclusions

In sum, the IMF is refining its conditionality to achieve greater country ownership through a mix of approaches, including

• limiting the objectives of programs, which in turn would allow for a more focused conditionality and a reduced range of structural measures;
• advising on the merits of various structural reforms but including only those conditions that are critical for directly supporting the macroeconomic policy framework; and
• considering outcomes-based conditionality and exploring the use of floating tranches, especially for structural reforms, in addition to the normal policy-based conditionality.

The bottom line is that these changes should increase ownership of programs by giving authorities greater discretion and flexibility in choosing appropriate macroeconomic and structural policies while providing adequate safeguards for IMF resources.

This article is based on Mohsin S. Khan and Sunil Sharma, 2001, "IMF Conditionality and Country Ownership of Programs," IMF Working Paper 01/142 (Washington). http://www.imf.org/external/pubs/cat/longres.cfm?sk=15374.0

IMF, 2001a, "Streamlining IMF Structural Conditionality: Review of Initial Experience," http://www.imf.org/external/np/pdr/cond/2001/eng/collab/review.htm

———, 2001b, "Strengthening Country Ownership of Fund-Supported Programs," http://www.imf.org/external/np/pdr/cond/2001/eng/strength/120501.htm

———, 2002, "The Modalities of Conditionality—Further Considerations," http://www.imf.org/external/np/pdr/cond/2002/eng/modal/010802.htm