Information about Western Hemisphere Hemisferio Occidental
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9 Recent Evolution of Fund Conditionality

Editor(s):
Jacob Frenkel, and Morris Goldstein
Published Date:
September 1991
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Information about Western Hemisphere Hemisferio Occidental
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Author(s)
Azizali F. Mohammed

Policy-based lending by the Fund goes under the rubric of “Fund conditionality.” Three elements are involved: (1) the general policy approach; (2) the particular choice and mix of policy instruments; and (3) the specification of intermediate target variables as performance criteria for the purpose of monitoring program implementation. The contribution of Jacques J. Polak to laying the intellectual foundations of the Fund’s policy approach is described in another paper submitted to this conference.1 This paper focuses on the evolution of the substantive aspects of conditionality in the last decade. While some of the adaptations described here may appear to have moved quite far afield from the elegant simplicity of the “Polak model,” the basic framework of analysis underlying Fund-supported adjustment programs derives directly from the key linkages between financial policy instruments and desired balance of payments outcomes that were forged in that model.

I. Basic Conditionality

The Fund’s current policy approach emphasizes two elements: achieving macroeconomic balance and reducing distortions created by interference with the operation of markets, including price and wage rigidities, inappropriate taxes and subsidies, trade restrictions, ([a-z]+) other direct controls. Since countries turn to the Fund for financial assistance when they have an imbalance in their external payments, the restoration of overall balance between domestic absorption and aggregate supply becomes the dominant objective. However, this has to be combined with incentive policies to move resources into the foreign trading sector, so that treating the balance of payments disequilibrium is not at the expense of growth.

The frequently heard characterization of the Fund’s approach as “demand management” and its objective as “stabilization” has never been correct. Even in the earliest programs, the deployment of the exchange rate instrument and the inclusion of reforms affecting producer prices of major export commodities were strong evidence of the fact that Fund prescriptions went beyond demand management measures in order to switch resources into the balance of payments. The Fund also attached importance to appropriate interest rates, in order to promote savings and an efficient allocation of resources. An emphasis on trade liberalization also showed the Fund’s concern with the efficient use of resources in the tradable goods sector.

The IMF also introduced its extended Fund facility in 1974 to enable it to help members “suffering serious payments imbalance relating to structural maladjustments in production and trade and where prices and cost distortions have been widespread” as well as in economies “characterized by slow growth and an inherently weak balance of payments position which prevents pursuit of an active development policy.”2

It is useful to recall this history because most of the changes in Fund conditionality that emerged in the last decade represent less a break than an elaboration of earlier policies. A few changes, however, may have been of a different character. For example, the Fund has tried to influence the behavior of creditors, especially the commercial banks, in the aftermath of the debt crisis. Yet to the extent that the use of Fund resources by a borrowing member is conditioned upon the evoking of specific responses from other parties, these changes have significant implications for the Fund’s role in the international financial arena.

This paper focuses, however, on adaptations of conditionality that apply to the borrowing member directly. These cover (1) an explicits; and (4) an effort to take account of the impact of adjustment measures on the poor.

II. Evolution in the 1980s

Growth-Oriented Adjustment

The Fund’s purposes (Article I) provide that it contribute “to the development of the productive resources of all members” through facilitating “the expansion and balanced growth of international trade.” In helping member countries deal with their balance of payments difficulties, a concern with how to encourage growth can thus be regarded as an extension of its systemic responsibilities. What happened in the 1980s was an explicit recognition that, for payments adjustment to be durable, there had to be a restoration of growth in the economy or at least an effort to incorporate a growth factor into the design of an adjustment program. This realization was driven home in the aftermath of the debt crisis. An earlier assumption that the middle-income, heavily indebted countries were facing only a liquidity problem was discarded by the mid-1980s3 in favor of the notion that restoration of their creditworthiness necessitated their return to sustained growth.

A similar conviction applied in the case of the low-income countries. In formulating programs under the Fund’s structural adjustment facility (SAF), introduced in 1986, the eligible countries were expected to develop macroeconomic and structural policy objectives, as well as the measures they intended to adopt during a three-year period. These measures would be incorporated in a policy framework paper (PFP) to be reviewed by the Executive Directors both of the IMF and the World Bank. While some observers expressed an apprehension that these procedures were tantamount to applying “cross-conditionality,” most borrowers under the SAF saw the PFP-process as an efficient means of catalyzing and coordinating financial assistance in support of their adjustment programs. An enhanced structural adjustment facility (ESAF) was created at the end of 1987. Programs to be supported by ESAF were expected to incorporate structural measures that would be particularly ambitious in scope and timing. The basic idea of ESAF programs was to foster growth and achieve a substantial strengthening of the balance of payments position, sufficient to allow exceptional financing to be discontinued after the three-year program period. The fact that both SAF and ESAF programs were financed on concessional terms (of 0.5 percent annually), with repayments spread over ten years (starting five and a half years after each disbursement), meant that the international community was prepared to recognize that the normal terms applicable to Fund financial assistance (repayment in three to five years with charges close to market rates) were too onerous for low-income countries undertaking growth-oriented adjustment programs in the prevailing difficult circumstances.

Protecting Against Contingencies

While effective implementation has always been at the heart of program success or failure, there was until recently no provision to take account, in advance, of the main factors that could disrupt programs during the course of implementation. A compensatory financing facility (CFF), created as far back as 1963, did provide financing to offset temporary shortfalls in export earnings arising from circumstances largely outside the country’s control.4 This was extended in 1976 to cover an excess in cereal import costs and in 1990 to cover excess oil import costs (on a temporary basis). No conditionality applied if the country had a satisfactory balance of payments except for the effect of the export shortfall or the excess in cereal import costs. Over the years, however, the application of the CFF tended to become more conditional, as payments problems were found to go beyond these specific and reversible adversities. Countries were expected, in such circumstances, to cooperate with the Fund in finding appropriate solutions to their balance of payments difficulties.

An aspect that came into sharper focus in the 1980s was the importance of helping a member implementing a Fund-supported program to obtain financing (in addition to that provided in support of the program) to cover part of the net effect on its balance of payments of external shocks. It was seen as suitable to cover unfavorable deviations beyond the member’s control in key current account variables that are easily identifiable as well as highly volatile (e.g., key export or import prices or international interest rates). Initially, contingency mechanisms were incorporated into arrangements with Mexico in respect of oil revenues in order to help facilitate that country’s debt negotiations with its banks.5 The experience gained in this transaction provided a precedent for complementing the CFF with an approach to help keep programs on track in the face of unpredictable exogenous developments. Often in the past, the response by creditors to countries surprised by external adversity would be to insist upon more adjustment. The new facility, the compensatory and contingency financing facility, enabled the Fund to provide “fallback financing,” thereby encouraging governments to adopt measures sometimes touching the outer limits of political acceptability with some degree of assurance that the international community would be prepared to compensate them for plain bad luck. The contingency element is coming into greater use to handle unpredictable changes in world oil prices in tandem with the compensatory financing of excess oil import costs in the wake of the Middle East situation.

Assuring Medium-Term Viability

The past decade has witnessed a mounting concern with the incidence of prolonged use of Fund resources of which the problem of arrears owed to the Fund can be treated as a special case.6 Overdue obligations have risen from almost none at the beginning of the decade to over SDR 3 billion owed by nine countries at the end of 1990. While it is not germane to this paper to discuss measures adopted by the Fund to protect its financial position directly or to deal with countries in arrears, the existence of arrears on the part of a few members has sensitized the Fund to the importance of preventing their emergence on the part of other members. This has meant an even stronger emphasis on the quality of programs and increased concern with the capacity of countries to meet their obligations to the IMF. The staff now discusses explicitly with the authorities of a country its capacity to repay. The staff also undertakes a careful evaluation of associated financial arrangements with other creditors and donors; the sensitivity of any shortfalls in financing for the viability of the program and actual flows is closely monitored. The authorities are also expected to acknowledge their readiness to adapt their policies quickly to unexpected developments.

In cases of prolonged use, attention is given to levels and phasing of access, with a view to reducing outstanding Fund credit over time. Continued access requires stronger policy justification. In cases where a country’s record of payments performance indicates difficulties in meeting obligations punctually, a closer examination of the cash flows is undertaken with a view to assuring the Fund that there would be sufficient resources available to meet obligations to the Fund as and when they fall due. Finally, in cases where projections indicate a doubt that viability would be attained in the medium term if certain assumptions were not fulfilled, the Fund seeks additional and clear expressions of support from the international community to the effect that the Fund would be treated as a preferred creditor.

These developments have led the Fund to be increasingly unwilling to see its resources being used as part of “gap-filling” exercises and to put greater weight on the buildup of the borrowing countries’ reserves. The Fund has also tended to give much greater weight to the adoption of corrective measures of a durable character, especially in the fiscal area, while being unprepared to accept measures that are of a “band-aid” type, or measures that would lose effectiveness with the passage of time.

Protecting the Poor

The Fund has traditionally taken the view that it is a country’s prerogative to make social and distributional choices in its adjustment, growth, and development processes. It has also felt that disorderly adjustment is often most damaging to poor groups who are least able to protect themselves from, say, the adverse consequences of open or repressed inflation and that policies that form part of an orderly adjustment process can result in a lasting improvement in the circumstances of the poor.

However, the acute difficulties that confronted many developing countries in the aftermath of the debt crisis have focused attention on the adversities than even an orderly adjustment process can create for some of the most vulnerable elements of society in the short run.

Two elements in program design have been identified to help ameliorate adverse effect on the poor: the implications of different sequencing of policy measures, and the specific nature of revenue and expenditure measures. It is recognized that the speed with which key prices and incomes change in response to policy measures can produce excessive and unintended consequences that are hurtful to certain groups of the poor because of inadequate infrastructure or imperfect markets and lack of access to information. Efforts can be made, to the extent feasible, to coordinate the timing of changes in certain administered prices so as to avoid unintended changes in relative product and factor prices. Also, the level and composition of public expenditures have important implications for poor groups, especially consumption subsidies, expenditures on social services, and transfers under social security and similar arrangements.

The Fund has sought to improve its understanding of the channels through which economic policies affect poor groups. It has given increasing emphasis to an appropriate policy mix for protecting the poor in the adjustment process. In many programs, the pass-through of exchange rate changes on domestic prices of imported essential products, and other adjustments in administered prices, have been made gradually so as to spread their impact on real incomes, and the attendant fiscal burden has been financed through an increase in taxation. Other programs have included wage supplements for low-level public employees affected by price increases. Some recent programs have incorporated social safety nets consisting of funds for unemployed workers, pensioners, or other poor people. The funds for unemployed workers have been aimed both at providing workers with training for alternative employment and at helping them maintain their income during an initial period of unemployment. To help public employees who would lose their jobs as a result of fiscal retrenchment, some programs have made specific budgetary provisions for severance pay, training, or financial assistance.

The basic issue that confronts the international community is the trade-off between such efforts to protect the poor and the implications for the speedy reduction of macroeconomic imbalances. How to incorporate distributional concerns effectively into program design without placing an undue strain on scarce administrative resources is another challenge, especially when recommending the replacement of generalized subsidies with programs targeted to ensure a more effective delivery of benefits to the poorest. To some extent, the trade-offs could be ameliorated if it were possible to mobilize additional domestic and foreign resources, specifically for the purpose of helping to put in place well-designed measures to mitigate short-run adverse effects on the poor. To this end, the Fund has been working in a complementary manner with the World Bank, as well as with United Nations agencies, bilateral aid agencies, church groups, and nongovernmental organizations to catalyze additional resources for poverty alleviation, and to protect the poor, in the context of adjustment programs supported by the Fund.

III. Adaptations to Eastern Europe

The Fund’s dealings with Eastern European countries that are launched on a transition from centrally planned to market-oriented economies are much too recent to allow for more than a few issues to be raised on how the Fund’s conditionality is, or ought to be, adapting to handle the unique problems of these countries. For what these countries are attempting is a transformation that goes far beyond any adjustment of macroeconomic imbalances. The massive changes in institutions—legal, political, and in the organization of the economy—are emerging from a strictly indigenous experience and could not possibly be engineered from the outside. Hence, any kind of policy-based assistance can only seek to support and to influence, at the margins, a radical reshaping of their economic systems.

It is obvious that the large-scale reorganization of productive structures currently under way has serious consequences for employment. The effects of rising unemployment in societies that have had little or no open experience of it emphasizes the critical importance of social safety nets. This becomes a crucial issue in program design since any provision for social transfers must be made at a time of acute budgetary stringency and when strong financial discipline is being applied to government as well as enterprise sectors. The provision of some form of income maintenance for individuals most severely affected must therefore be constructed so as to minimize the drain on the public exchequer. This could be done, for example, by setting up, on a temporary basis, a rationing scheme covering a basket of goods needed for maintaining minimum standards of health and nutrition and targeting its availability to those whose needs are self-identifying, such as the elderly, the disabled, pregnant and nursing women, and infants. Provision could also be made for self-targeted employment through public works at subsistence wages in order to temporarily cushion the impact of restructuring. Without such expedients, the initial experience with a market-oriented system could well create a backlash that would negate the process itself. If the international community becomes convinced of the criticality of this issue, social safety nets would need to be incorporated as an essential, rather than simply as a desirable, ingredient of Fund-supported programs.

Another issue that arises in the Eastern European context is the role of incomes policy as a complement to the application of financial discipline when the transition from central planning is being undertaken in a condition of high inflation, whether open or repressed. Even with a “hard” budget constraint, the freeing of prices can unleash a price-wage spiral, unless specific protections are built into the program. The de-indexation of wage contracts is one such step where indexation mechanisms were part of the wage determination process.

At the level of publicly owned enterprises, however, there may be a need to create strong restraints against the granting of large nominal wage increases, once the sanction of a centrally determined wage fixation arrangement is abandoned. Where such enterprises are operating in an imperfectly competitive environment, because of incomplete trade liberalization or because they service the nontradable goods sector, the need for effective wage containment becomes a critical element in program design.

This leads to another issue—the application of financial discipline at the microeconomic level. In most centrally planned economies, a number of devices have tended to shelter firms from the financial impact of macroeconomic policies, and indeed from the financial consequences of their own mistakes or failures. Firms were used to receiving special treatment—as regards taxes, access to subsidies, availability of credit or imported inputs, and so on. This meant that firms could escape the full brunt of, say, a credit squeeze introduced by the central bank as part of a macroeconomic policy package. In addition, an extensive network of inter-enterprise credits often dampened further the impact of overall financial discipline. Therefore, microeconomic discipline may become a prerequisite for macroeconomic balance.

Another issue relates to the comprehensiveness of economic reform packages. This is mainly because none of the essential elements of a market-oriented economy operates efficiently unless all other main elements are in place. It is not much use, for instance, to allow freedom of pricing (which implies decentralized decision making) unless the decision maker has full responsibility for the financial and other consequences of his decision. The Fund has worked with centrally planned economies in the past on the assumption that some decentralization of economic decisions and some use of realistic prices to guide such decisions were better than none and could help improve economic efficiency in a variety of political and institutional settings. Recent experience in Eastern Europe suggests that broader reforms are essential if the adjustment is to be carried out.

Finally, it is clear that the types of governmental institutions and the skills to operate them that are needed in the transition are quite different from those that were appropriate for operating a planned economy. As an example, the functions of a central bank that are critical to operating a complex monetary policy in a market economy differ markedly from the credit-allocation function of a central bank in a command economy. Only as money becomes a relevant variable can the financial programming approach of the Polak model be directly applied. In the meantime, the Fund must proceed in a rather experimental way.

1

Jacob A. Frenkel, Morris Goldstein, and Mohsin S. Khan, “Major Themes in the Writings of Jacques J. Polak,” Chapter 1 in this volume.

2

International Monetary Fund, Selected Decisions and Selected Documents of the International Monetary Fund, Sixteenth Issue (Washington, 1991), p. 105.

3

This was the essence of the “Baker Plan,” that is, countries had to “grow out of their debts” and only if GDP growth was faster than the growth of debt could debtor countries hope to resume normal market access.

4

As noted in Frenkel, Goldstein, and Khan (Chapter 1 in this volume, p. 16), the basic purpose of the CFF of “preventing temporary, exogenous shocks from throwing good policies in developing countries offtrack, has remained close to Polak’s original conception.”

5

See Joseph Gold, “Mexico and the Development of the Practice of the International Monetary Fund,” World Development (Oxford), Vol. 16 (October 1988), pp. 1127-42.

6

There is, however, no direct link between prolonged use and arrears to the Fund.

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