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Finance & Development, December 1980
Article

Fund conditionality and the international adjustment process: the early period, 1950-70: The evolution of the principles and the practices of conditionality

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1980
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Manuel Guitián

The International Monetary Fund was established in 1944 to promote economic and financial cooperation among its members—then 45, now 141—in order to facilitate the expansion and balanced growth of world trade. The aims of this cooperation were—as they still are—the attainment and maintenance of high levels of employment and real income within each member country, through the sound development of the productive resources of all members. The broad objectives sought by the Fund can best be attained in the context of a multilateral payments system that fosters exchange stability, where payments imbalances can be redressed without resort to measures that run counter to national or international prosperity. The fundamental purposes were made explicit in the original Articles of Agreement of the Fund, and they have been upheld in the two amendments that were made in 1969 and 1978 to this basic charter. The purposes and objectives provide the framework within which the institution functions, and as such, they lie at the core of its activities with member countries.

The issue at stake … is not whether adjustment will be carried out but whether it will be carried out efficiently…. Conditionality is a means to ensure the efficiency of the international adjustment process….

In order to fulfill its mandate, the Fund has come to play a central and multifaceted role in the international monetary sphere. An essential aspect of this role concerns the provision of financial assistance to members facing potential or actual balance of payments (BOP) difficulties. In extending its financial assistance, the Fund is guided by the provisions of the Articles of Agreement. These prescribe that the Fund should make its resources available to members temporarily and that it should adopt policies on the use of those resources which, first, assist members in overcoming BOP problems and, second, provide adequate safeguards to ensure that the use of the resources is temporary.

Drawing from the experiences gathered from its long and close relationship with a varied and increasing membership, the Fund has developed a pragmatic and flexible body of policies and procedures to accompany the use of its resources in a manner that will fulfill the prescriptions of the Articles of Agreement. Invariably, these policies are aimed at supporting members’ adjustment efforts through the adoption of economic policy measures which are compatible with the particular member’s interests, as well as with those of the Fund membership as a whole. In effect, these policies spell out the terms and conditions under which members can be assured of their access to Fund resources to finance their temporary BOP needs. The set of policies that governs the use of Fund resources has come to be known by the label: conditionality.

This article will examine the rationale of the principle of conditionality, and will trace the practices that were developed for its implementation during the 1950s and the 1960s when the par value system established at Bretton Woods was in effect. The principle of conditionality applies under most circumstances, but its practical implementation has evolved in response to changes in the international economic environment, and a second article will analyze the adaptations that were undertaken during the past decade following the breakdown of the par value system.

The rationale

From the very inception of the Fund, conditionality proved to be a controversial subject. This is not surprising because conditionality is the key determinant of members’ access to Fund financial assistance and, as such, is subject to close scrutiny both inside the Fund and in outside circles. It needs to be recognized that the design and the adaptation of policies on the use- of Fund resources encompass a large number of complex issues and involve important elements of judgment on which consensus is not always easy to attain.

It should be pointed out at the very beginning, however, that, except for a brief period after the Fund came into existence, there has always been general agreement among Fund members that the Fund’s financial assistance should be conditional on the adoption of adjustment policies. This was felt as a necessary requirement to preserve the revolving character of the Fund’s resources that the Articles of Agreement called for. In order to examine the basis for conditionality it is important to underscore a key feature of the international adjustment process—that external payments imbalances have to be adjusted, whenever they are not transitory or reversible. It is critical to recognize that under most circumstances, adjustment will take place with or without policy action; that is, claims on resources will eventually have to be limited to those resources that are available. The issue at stake, therefore, is not whether adjustment will be carried out but whether it will be carried out efficiently without involving unwarranted welfare losses.

Conditionality is a means to ensure the efficiency of the international adjustment process to the benefit of all the Fund’s membership. It also constitutes an essential aspect of the contribution the Fund makes toward easing the BOP difficulties of member countries. The main objective of the Fund’s financial assistance has been to help members to attain, over the medium term, a viable payments position, if feasible in a context of reasonable price and exchange rate stability, as well as a sustainable level and rate of growth of economic activity. This concept of a viable BOP typically means, especially for many developing countries, a current account deficit that can be financed, on a sustainable basis, by net capital inflows on terms that are compatible with the development and growth prospects of the country.

The Fund’s resources help to extend the period during which adjustment takes place, and therefore contribute to making the process less stringent than it would otherwise have to be. The strategies to finance and to adjust external imbalances are closely interwoven, and form the core of the Fund’s policies on conditionality, which seek to attain a sustainable blend between the two. Conditionality is based on an assessment of the need for adjustment, which—in the light of the financing available not only from the Fund but also from other sources—helps to determine the size and the pace of the required adjustment effort.

It is frequently argued that adjustment and financing are alternative or substitute strategies. This argument is only true in the abstract sense that adjustment would not be necessary if financing were available indefinitely, and conversely, that adjustment would be immediate in the absence of financing. In most practical instances, however, adjustment and financing are joint and mutually supporting strategies. Their complementarity is based on the simple but realistic premise that financing imbalances over protracted periods without adjustment is generally untenable. Adjustment without adequate financing, on the other hand, would render the adjustment process unduly arduous, needlessly disruptive, and costly.

Uniformity of treatment, when properly defined, requires that for any given degree of need the effort of economic adjustment sought in programs be broadly equivalent among members.

Strategies of adjustment will vary according to the particular situation of the country requesting support, but there are two principles that the Fund seeks to uphold in all its conditionality programs: the principle of uniformity of treatment among members and the necessity that the Fund’s policies on conditionality take into account the institutional characteristics and the particular circumstances of different countries. It is, therefore, necessary to strike a delicate balance between uniformity and flexibility of treatment, although they may appear to conflict. The conflict, however, is more apparent than real because the principle of uniformity cannot be applied rigidly, regardless of individual country circumstances, nor can individual circumstances be given such weight that uniform treatment loses all meaning. A common feature of programs supported by Fund resources is the need for adjustment and the essence of conditionality is to ensure a commensurate adjustment effort. Uniformity of treatment, when properly defined, requires that for any given degree of need the effort of economic adjustment sought in programs be broadly equivalent among members. Like all other aspects of the principle of conditionality, the achievement of uniformity of treatment necessarily involves a measure of judgment based on a consideration of the particular features of each case.

Policy implications

The restoration of viability to a payments position must mean the elimination, or at least the reduction, of the causes that gave rise to the difficulties. BOP problems may be due to a variety of factors which are often distinguished according to whether they are external or internal, and to whether they are transient or permanent. The particular strategies of adjustment may vary depending on whether the payments difficulties are due to domestic developments in a country’s economy or to developments in the rest of the world. But the more fundamental question of whether adjustment is actually required hinges on the assessment of the permanent or transient character of the disturbance. Deficits stemming from adverse transitory external (or internal) factors, which normally can be expected to be reversible or self-correcting, typically call for temporary financing, either in the form of foreign borrowing, or in the use of international reserves, or a combination of both. Mechanisms have been devised in the Fund and elsewhere to cope with situations of this sort—the Fund’s compensatory financing and buffer stock facilities are examples of such mechanisms. However, if the deficits (whether of external or internal origin) are not likely to disappear, an economy needs to take appropriate domestic and external measures to adjust them. Simply restricting international transactions cannot be considered as an adequate adjustment strategy, because restrictions do not act on the causes of the difficulties, but rather aggravate them.

The conditionality associated with the use of Fund resources requires the member using those resources to undertake a program to adjust its BOP. The general purpose of such a requirement is that the Fund’s financial assistance should be used to support the implementation of economic policies which give a substantial assurance that a viable payments position will be attained within a reasonable period of time. In most instances, this involves restoring a sustainable balance between the aggregate demand for, and the aggregate supply of, resources in an economy. The policies required to bring about this result depend, of course, on the nature and size of the existing and prospective BOP deficit. In turn, the particular policy instruments to be used are designed in the light of the institutional setting and organization of the economy and of the economic and social priorities of the country.

It is generally recognized that domestic fiscal and monetary policies can be of critical importance to the attainment of a sustainable balance between aggregate demand and supply. At times, these policies need to be supported by external debt management and incomes policies, to ensure that the resources demanded do not exceed the resources generated domestically plus those which can be raised from abroad on terms that are compatible with the economy’s productive capacity and development prospects. In attempting to strike such a balance between resource use and availability, such policies aim to set the stage for sound and sustained rates of economic growth by improving the BOP and bringing inflationary pressures under control.

Frequently, imbalances in aggregate demand and supply are also accompanied by distortions in the structure of relative prices which tend to keep the level or growth of aggregate supply below potential. In these cases, measures to improve the allocation of resources and to strengthen exports become necessary. These measures include adjustments of the exchange rate, interest rates, or other prices. Such adjustments are instrumental in correcting disparities between domestic and foreign prices, thereby restoring international competitiveness to the economy, mobilizing domestic savings which are then available for investment, and redirecting resources to the more productive sectors. By bringing the productive capacity of the economy back to its potential level and to a sustainable path of growth, these types of measures lessen the degree of restraint in aggregate demand management—through supporting fiscal, monetary, and other policies—which would be required in their absence.

The assessment of the size and the speed of the required adjustment effort depends on the extent of the imbalance in relation to the likely availability of financing. It is often observed that when an imbalance is allowed to grow and persist over protracted periods, foreign sources of financing tend to dry up. In these circumstances, the severity of the, by then, unavoidable policy measures is likely to be intense and their repercussions on economic performance to be unfavorable. In general, this is a reflection of the fact that unduly large and abrupt adjustments tend to be relatively costly in terms of welfare. These observations argue in favor of the desirability of timely adjustments of emerging imbalances.

in time, the practices of conditionality came to encompass all general aspects of economic policies … so that imbalances could be redressed without resort to restrictions on trade and payments….

The evolution of conditionality

Soon after its establishment, the Fund strove to devise a body of practices and procedures to guide the implementation of the broad principles discussed above. There was uncertainty at first as to what these practices should consist of, but the principle of conditionality itself was incorporated in the Fund’s lending policies as early as 1952. By that time, a broad consensus had emerged that the Fund’s attitude toward a member country seeking its financial assistance would be primarily guided by its judgment as to whether the policies pursued by the member were adequate to cope with its BOP problem so as to enable it to repay the Fund within an outside range of three to five years.

Along with the fundamental principle of conditionality, the Fund developed the stand-by arrangement as the main instrument through which its financial resources would be made available. The stand-by arrangement can be described as a line of credit entitling members to draw on the Fund’s resources. In the early days, the stand-by arrangement was conceived of as a precautionary device to assure access to Fund resources to members that did not need them immediately but felt that a need for financing might arise in the near future. But it soon became evident that the stand-by was also well suited to channeling the Fund’s conditional resources to countries with an urgent need for BOP financing.

The conditionality practices that have evolved over almost three decades of Fund experience were developed in the context of a changing international economic environment and varying international arrangements. The early practices were devised in a world environment characterized, at least by present standards, by a good measure of global economic stability. This was a period of relatively stable growth rates coupled with favorable price performance in most of the industrial countries, and a period when progress was made toward the liberalization of international trade and payments and toward currency convertibility under the par value system agreed upon at Bretton Woods. These were factors that facilitated and contributed to the smooth functioning of the process of international payments adjustment.

The stand-by arrangements developed during this period provided a clear link between a member’s use of Fund resources—its financing—and its adoption of a practical program of policy action—or its adjustment. This link reflected the realization that the most effective way in which the Fund could provide its assistance was to support with its resources, by means of stand-by arrangements, the implementation of a specific set of economic policies designed to correct members’ external imbalances. The policy programs supported by stand-by arrangements normally extended over a year, a period short enough to permit a forecast of the behavior of the economy and long enough to allow for an assessment of the result of the policy measures and to form a judgment as to whether additional policy steps were warranted. Of course, this did not mean that in all cases adjustment was expected to be completed within such a limited time. As a matter of fact, members often entered into consecutive stand-by arrangements with the Fund for several years, and these served to provide continued financial support until the imbalances were redressed.

Programs

BOP difficulties were frequently associated with the prevalence of excess demand pressures. Therefore, the programs typically contained policy measures to control the level or the rate of growth of nominal aggregate demand. The Fund focused attention on the relationship between domestic financial policies and their effect on the BOP. It was observed that excessive levels of demand were often the result of undue expansion of domestic credit by the banking system. This was, at times, accompanied by reliance on foreign borrowing in amounts and on terms unsustainable over the medium to long term. In many instances, fiscal and public sector imbalances were at the root of these developments. Thus, programs contained undertakings in the fiscal, domestic credit, and foreign borrowing areas.

Imbalances were often exacerbated by distortions in cost-price relations that affected the international competitive position of the economy and prevented supply from attaining its potential. In these circumstances, programs were aimed at improving resource allocation and strengthening the external sectors. In these instances, the overall demand management policies referred to above were designed to supplement actions taken in the fields of exchange rates, prices, wages, and interest rates. Thus, in time, the practices of conditionality came to encompass all general aspects of economic policies that influence the demand for and supply of resources, so that imbalances could be redressed without resort to restrictions on trade and payments which, as argued earlier, generally add to, rather than correct, the causes of the imbalances.

Over time, it became clear that to be an effective instrument of action, a program had to be as specific and precise as possible. In particular, the main policy targets and policy instruments that were susceptible to relatively accurate measurement came to be stated in the programs in explicit quantitative terms. In this manner, it became feasible to test consistency among the various components of the programs and to assess their adequacy in relation to the objectives sought. The path of the main policy variables was set in quantitative terms for subperiods—such as quarters—within the whole period of the program in order to allow the member country to assess actual performance. These quantitative targets in effect constituted a set of signals that called for a review of the implementation whenever deviations occurred.

The formulation of policies and of policy targets in quantitative terms was a complex exercise, involving both quantitative techniques and qualitative judgments. It reflected understandings reached by the Fund with the member on the policies to be pursued and the measures to be taken over the period of the program. The quantitative policy instruments and targets, which were called performance criteria, became the guideposts to assess whether the program was being satisfactorily implemented, and consequently whether the Fund’s resources were being appropriately used and the objectives of the programs were being attained. The criteria most frequently included in programs supported by the Fund related to the rate of expansion of credit by the central bank or the banking system; the reliance of the government or the public sector on bank credit; the recourse to external short-term and medium-term foreign borrowing; and the management of net international reserves. A qualitative performance criterion common to all stand-by arrangements was the avoidance of reliance on the introduction of exchange restrictions as a means of coping with BOP problems.

The quantitative formulation of policy programs was accompanied by two developments that became common features of stand-by arrangements. The first development was related to the manner in which Fund resources were made available. Because policy programs were undertaken and took effect over a period of time, it was logical to phase the use of Fund resources over that period in order to facilitate the implementation of policies as well as to prevent an inappropriately rapid use of the resources. The particular profile of the phasing reflected the circumstances of the member and the speed of the expected adjustment. Thus, the total amount of assistance was disbursed in installments at specified intervals. The disbursements were linked to the quantified periodic targets of the program.

The second development was the inclusion in stand-by arrangements of provisions, the performance criteria described earlier, which operate automatically to interrupt a member’s access to Fund resources whenever these criteria have not been observed. Thus, the interplay between the phasing technique and the performance criteria served to indicate to the member the circumstances under which Fund resources would be available and in what amounts at given intervals.

The rationale for these operational features of stand-by arrangements was that failure to observe the performance criteria was a signal that the position, policies, and prospects of the member’s economy were such that a review was necessary. For these reasons, the member was to consult with the Fund before requesting any further resources from the institution. Deviations between actual results and performance criteria could be due to inaccurate forecasts of expected developments, to unexpected developments in the program, or they could be due to insufficient or faulty implementation of policies. Depending on the assessment of the causes of the deviations, and the extent to which they could be remedied, the restoration of the member’s right to borrow from the Fund involved the amendment of the performance criteria or new understandings on the policies or measures to be pursued or taken over the remainder of the program’s period.

During the 1950s and 1960s, the Fund became increasingly active in its operations with member countries. In the 1950s, 57 stand-by arrangements for a total amount of almost US$4 billion were concluded. During the 1960s, the number of stand-by arrangements had increased to 231 for a total amount in excess of $14 billion. As the period came to an end, pressures began to accumulate in the international economy which threatened the viability of the par value system. It is already history that those pressures led to the eventual breakdown of the system of fixed exchange rates in the early 1970s. The international economy was on its way toward a decade that witnessed deep and widespread disturbances to the international payments system.

Related reading

Margaret Garritsen de Vries, The International Monetary Fund, 1966-1971: The System Under Stress (Washington, D.C., International Monetary Fund, 1976).

Joseph Gold, Conditionality (IMF Pamphlet Series, No. 31, Washington, D.C., 1979).

Joseph Gold, Financial Assistance by the International Monetary Fund: Law and Practice (IMF Pamphlet Series, No. 27, second edition, Washington, D.C. 1980).

Joseph Gold, The Stand-By Arrangements of the International Monetary Fund: Commentary on Their Formal, Legal, and Financial Aspects (Washington, D.C., International Monetary Fund, 1970).

J. Keith Horsefield, The International Monetary Fund, 1945-1965: Twenty Years of International Monetary Cooperation (Washington, D.C., International Monetary Fund, 1969).

International Monetary Fund, Articles of Agreement (Washington, D.C., International Monetary Fund).

International Monetary Fund, Selected Decisions of the International Monetary Fund and Selected Documents, Eighth Issue (Washington, D.C., International Monetary Fund, 1976).

Subimal Mookerjee, “Policies on the Use of Fund Resources,” IMF, Staff Papers (November 1966).

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