Reconciling Conditionality and Country Ownership

• Author: Mohsin S. Khan and Sunil Sharma
• Position: Director/Deputy Division Chief of the IMF Institute

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...