Refocusing IMF Conditionality

• Author: Masood Ahmed, Timothy Lane, and Marianne Schulze-Ghattas
• Position: Deputy Director/Chief of the Policy Review Division/Chief of the Surveillance Policy Division, in the IMF's Policy Development and Review Department

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...