Conditionality and Ownership in IMF Lending: A Political Economy Approach. Allan Drazen Tel-Aviv University, University of Maryland, NBER, and CEPR

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1 Conditionality and Ownrship in IMF Lnding: A Political Economy Approach Allan Drazn Tl-Aviv Univrsity, Univrsity of Maryland, NBER, and CEPR Novmbr 2001 Final Draft July 2002 ABSTRACT: Th rlation btwn IMF conditionality and country ownrship of assistanc programs is considrd from a political conomy prspctiv, focusing on th qustion of why conditionality is ndd if it is in a country s bst intrsts to undrtak th rform program. It is argud that htrognity of intrsts must form th basis of any discussion of conditionality and ownrship. Th papr strsss a conflict btwn a rformist govrnmnt and domstic intrst groups that oppos rform, lading to a distinction btwn govrnmnt and country ownrship of a program. A modl of lnding and policy rform is prsntd that illustrats th ffcts of unconditional and conditional assistanc first without and thn with political constraints. It is shown that conditionality can play a ky rol vn whn th Fund and authoritis agr on th goals of an assistanc program. JEL: F34, F35 Kywords: IMF, Forign Aid, Conditionality, Ownrship Papr prpard for th Scond Annual IMF Rsarch Confrnc, Washington D.C., Novmbr 29, 30, I would lik to thank my discussants Jffry Fridn and Mohsin Khan, confrnc participants, and spcially Jromin Zttlmyr for insightful commnts. Shir Raz providd xcllnt rsarch assistanc. Som of th rsarch for this papr was conductd during a visit to th Rsarch Dpartmnt of th IMF in Sptmbr 2001, which I wish to thank for its hospitality. Financial support from th Yal Chair in Comparativ Economics, Tl Aviv Univrsity is gratfully acknowldgd.

2 1 Th IMF is currntly ngagd in a wid-ranging and comprhnsiv rxamination of th natur of its assistanc programs. Many of th issus bing discussd fall undr th gnral hading of conditionality in lnding, dfind as th xplicit link btwn th approval or continuation of th IMF s financing and th implmntation of crtain spcific aspcts of th govrnmnt s policy program. (IMF, 2001) 1 Conditionality is viwd as a cntral fatur of IMF assistanc programs, ssntial to th succss of ths programs. Th dbat on conditionality has raisd both pragmatic and concptual qustions. Th ky pragmatic qustions ar: how ffctiv has conditionality bn in hlping IMF or World Bank assistanc programs achiv thir aims, and how can it b mad mor ffctiv? On a vry basic concptual lvl, thr is th qustion on th propr rlation btwn th IMF and sovrign mmbr countris that wish to borrow, with th natur of IMF conditionality indicating (or prhaps vn dfining) what that rlation is in practic. Thr is th rlatd qustion of th xtnt to which th IMF can or should tak political factors into considration in dsigning assistanc programs, a qustion that touchs on th IMF s institutional slf-imag as tchnocratic and apolitical. Th concptual dbat is vry much tid to th mor pragmatic issus, sinc qustions of th propr rol of IMF conditionality is motivatd in no small part by th dsir to improv its ffctivnss. Mor concrtly, program succss dpnds on succssful implmntation, which in turn rflcts th political constraints, raising th qustion of th xtnt to which program dsign should tak ths constraints into account. Intricatly tid up with th qustion of rform of conditionality is that of program ownrship by a country that participats in an IMF or World Bank program. Ownrship of a program, lik most trms that sound unambiguously positiv, mans diffrnt things to diffrnt popl, but may b roughly dfind as th xtnt to which a country is intrstd in pursuing rforms indpndntly of any incntivs providd by multilatral lndrs. Hr too, concptual and political dimnsions ar rlatd to on anothr, with country ownrship sn as fundamntal to programs with which th IMF should b involvd. Thr is also th pragmatic qustion of ffctivnss. Ownrship is widly sn not simply as gratly incrasing th chancs of program succss but as crucial to succss sinc, without ownrship, programs ar vry likly to fail. In short, rform of conditionality, vn from a vry pragmatic prspctiv, rquirs an 1 S th IMF wbsit undr conditionality for a numbr of paprs on aspcts of this dbat.

3 2 undrstanding of th politics of conditionality in th various snss of that trm st out two paragraphs abov th rol of conditionality in th propr rlation btwn th IMF and borrowing mmbr countris; th ffct of domstic political constraints on th dsign of conditionality; and th xtnt to which th IMF can and should tak ths political constraints into account in program dsign. Unfortunatly, non of ths qustions has rcivd as much discussion in th ovrall dbat on conditionality as thy dsrv. Hnc, it is worthwhil to addrss ths qustions in a mor formal political conomy framwork. Th discussion of conditionality and ownrship that has takn plac is oftn unclar. It is argud that both conditionality and ownrship ar cntral to assistanc programs, vn though th lattr would sm to ngat th nd for th formr. Thr has bn a significant amount of intllctual ffort in IMF documnts to argu that th two go hand-in-hand, much of it striking an outsid obsrvr as displaying som xtraordinary mntal and vrbal gymnastics. Morovr, th tnsion btwn conditionality and ownrship is only on of th points on which th dbat on th rform of conditionality is oftn not clar. Th purpos of this papr is to shd light on som of ths issus. It is not mant to b a comprhnsiv discussion of conditionality and how it may b rformd, but to focus on th rlation btwn conditionality and ownrship. Though it may sound as if th objctivs of th papr ar too narrowly dfind, th qustion of how conditionality and ownrship can b mad consistnt gts at th hart of th dbat of what conditionality is trying to do, and why it may not b succding. Morovr, in addrssing this spcific qustion, th papr will discuss a much widr st of issus. I argu that a political conomy prspctiv may b usful in bttr undrstanding th issus, in hlping to clar up som points on which th dbat has oftn bn unclar and in providing a framwork for discussion (and ultimatly for analysis). Th framwork prsntd is mant to b gnral, so that it will illustrat som crucial points rathr than srv as a vhicl for analysis of spcific conomic policis. As such, th modl is mor pdagogic than on aimd dirctly at policy analysis. I hav argud in Drazn (2000) that htrognity of intrsts is ky to political conomy; I will argu hr that it is also must form th basis of any snsibl discussion of conditionality and ownrship. A political conomy prspctiv also maks clar th importanc of distinguishing btwn conomic and political constraints in undrstanding th limitations of

4 3 conditionality and in hlping to undrstand how ths constraints may intract. It also suggsts on way in which conditionality and ownrship can b rconcild (or at last disntangld) by focusing on conflict of intrsts not btwn th IMF and th borrowing mmbr country but within a rcipint country. Such an argumnt has oftn bn mad vrbally but nvr rally formalizd. I. Conditionality and Its Discontnts Conditionality has bn widly criticizd on a numbr of grounds, but I concntrat on th spcific qustion: to what xtnt ar conditionality and ownrship consistnt with on anothr? I thus focus on th intllctual discontnt with what may b takn as th official viw on th intraction of conditionality and ownrship, whr by official I man what can b gland from IMF documnts on this qustion. This may b an official viw that no IMF official holds any longr, but I think it hlps to highlight what sms to b th ssntial stumbling block that has hindrd much of th discussion. Th Official Viw Conditionality is sn as cntral to IMF lnding, mant to assur a borrowing country that if it taks crtain wll-spcifid actions, continud financing will b forthcoming. It is thus sn as allowing th country to invst in longr-trm policy adjustmnt by assuring thm that if thy do so, IMF financing will not b cut off. 2 To put this in prspctiv, on may argu that lndrs rgularly impos conditions on borrowrs and monitor th us of loans to mak sur that th funds ar not usd in a way that ndangrs th probability that th loan will b rpaid (commonly known as moral hazard ). Banks attmpt to mitigat or liminat moral hazard via collatral, contract dsign, control rights, and rporting rquirmnts. Such safguards may bnfit borrowrs by making lnding mor availabl, so that it can b in th borrowr s intrst to agr to ths safguards. Thus, conditionality in privat lnding is consistnt with ownrship, that is, with th ralization by borrowrs that availability of lnding rquirs thy act in such a way that loans will b rpaid. In 2 On could argu that conditionality is mant as a form of tchnical assistanc: a country may agr with th ovrall program objctivs st out by th IMF, but b unsur how to implmnt th program. This is not a rally satisfactory answr, howvr, and is rcognizd as such. If this wr th problm, th solution would b on of tchnical assistanc rathr than conditionality, a point widly rcognizd (s, for xampl, IMF, 2001).

5 4 contrast to privat lnding, countris borrowing from th IMF do not possss intrnational collatral or hav accss to othr safguards availabl to privat borrowrs. Explicit IMF conditionality is thus mant to substitut for th lack of safguards in privat lnding and, by analogy, to bnfit borrowrs by making loans mor availabl. 3 What is takn for grantd in privat lnding is that th intrsts of lndr and borrowr will not coincid prfctly, thir rlation bing a prim xampl of a principal-agnt problm, with contract dsign mant to bttr align ths intrsts. Th ralization that a conflict of intrsts undrlis th conditions st out in a loan contract causs no problms in th cas of privat lnding. Arguing that IMF lnding is analogous to privat lnding, howvr, raiss a difficult qustion on th rlation of th institution to its sovrign mmbrs: to what xtnt is th IMF inducing a country to tak actions that th country dos not ncssarily s in its own bst intrsts? In th xtrm, conditionality is viwd as th IMF imposing conditions on a country in a way that infrings on its national sovrignty. Hnc, us of conditionality is not simply a qustion of prudnt conomic bhavior, but a potntially politically chargd qustion of th propr rlation of th IMF to its mmbrs. 4 Many in th IMF find it objctionabl vn to us th trm principal-agnt in analyzing lnding programs, as it builds in th assumption of a diffrnc in objctivs and is thus inconsistnt with th notion of ownrship. 5 I rturn to this point shortly. 3 For xampl, Khan and Sharma (2001) argu that th analogy with privat bank lnding is usful in undrstanding IMF lnding. Tirol (2002) prsnts a similar argumnt rconciling conditionality and ownrship. Analogous to th commitmnt argumnts mad abov, h argus that by giving up crtain control rights or othrwis constraining himslf x-ant, a borrowr can commit himslf not to tak spcific actions x post that a lndr would s as dtrimntal to rpaymnt prospcts. (S also Fdrico (2001).) In this approach, structural conditionality can b partially justifid by th argumnt that a crdibl promis of loan rpaymnt rquirs sustaind mdium-trm improvmnt in conomic prformanc. 4 This ssntial tnsion in trms of what conditionality mans about th political status of borrowrs has long bn rcognizd. It was wll statd by Diaz-Aljandro (1984) and forms th basis of rcnt critiqus, such as Killick (1997). 5 conditionality is oftn viwd as an attmpt of intrnational financial institutions (or aid donors) to us financing to buy policy rforms that ar not dsird by authoritis. [This] intrprtation of conditionality is oftn rflctd in th us of a principal-agnt modl, in which th Fund (th principal) stablishs a mchanism intndd to nsur that rforms will b undrtakn by th authoritis (th agnt), in a stting in which th objctivs of th Fund and th authoritis do not fully coincid and thr ar informational asymmtris associatd with th fact that th Fund cannot dirctly obsrv som aspcts of th authoritis actions objctivs and/or circumstancs. This prsntation of th Fund as th principal in this framwork is inconsistnt with that of country ownrship of th program. (IMF, 2001, paragraph 16.)

6 5 Th official viw is that IMF lnding to mmbr countris is charactrizd not by a conflict of intrsts but by a commonality of intrsts. IMF financing and rcipint country policis ar sn by th IMF as two componnts of a succssful program that ar connctd. For xampl, a country with a balanc of paymnts problm nds to undrtak som policy changs but, at th sam tim, nds short-trm financing to wathr th paymnts imbalancs whil ths changs ar bing undrtakn. Lnding is thus sn as complmntary to policy rform. This may b summd up as: Th IMF s financing and agrd policy adjustmnts ar intndd as two sids of an intgratd rspons to a country s balanc-of-paymnts problm in th contxt of its ovrall conomic situation. This can bst b sn in th strotypical situation in which a country facs acut xtrnal imbalancs as a rsult of xcssiv montary financing of a fiscal dficit. In such a situation, th IMF financs short-trm xtrnal imbalancs whil th country pursus macroconomic policis aimd at xtrnal adjustmnt ovr an agrd tim fram, possibly accompanid by structural rforms to nhanc th supply rspons. In such a situation, th nd for adjustmnt would b clar, with or without th IMF; th IMF ssntially provids financing that prmits this adjustmnt to b mad in a mor gradual and ordrly way. Thus, th intndd purpos of conditionality is as a mchanism to hlp bring togthr a combination of financing and policis as a solution to conomic difficultis; it is ndd to provid assurancs to both authoritis and th IMF that that both parts of th packag ar providd togthr. This concpt of conditionality is fully consistnt with a cooprativ approach to dsigning and implmnt programs. (IMF, 2001, paragraphs 12 and15.) Undr this viw of conditionality, country ownrship of a program is sn not simply as consistnt with conditionality but, in fact, crucial to th succss of conditionality. (S paragraph 36, IMF (2001).) It is argud that in th absnc of a high dgr of ownrship, conditionality won t work, and thr is som mpirical vidnc supporting this viw. 6 Th basic ida is that if a country is not sriously intrstd in rform, it will find ways around conditionality, so that conditionality will fail. Th multiplicity of potntial causs for program failur combind with imprfct obsrvability of a govrnmnt s actions mans that th caus of any particular failur is not ncssarily idntifiabl. 6 Many rfrncs could b givn. S, for xampl, Haqu and Khan (1998). Dollar and Svnsson (2000) prsnt convincing vidnc that political conditions in th rciving countris ar much mor important than conditionality in xplaining th succss or failur of World Bank programs.

7 6 Th Basic Intllctual Conundrum What should on mak of th official viw? Though grat ffort has bn invstd into arguing that conditionality and ownrship ar not only consistnt, but also ncssarily complmntary, on cannot scap a strong fling of discontnt. To put it simply, why is conditionality ndd if it is in a country s bst intrsts to undrtak th program in qustion? This, to my opinion, is a qustion with which IMF documnts rally struggl and oftn talk around. I will argu that it is basically impossibl to justify conditionality in th absnc of a conflict of intrsts of som sort. Any attmpt to argu that non rally xists is not only unconvincing but, ultimatly, slf dfating in that it stands in th way of rforming conditionality. This conflict of intrsts may b du to diffrncs btwn th borrowing country and IMF, diffrncs btwn th country and othr lndrs, or (as I will strss) conflict of intrsts within th country. 7 Th argumnt that conditionality only maks sns if thr is a conflict of intrsts dos not fully answr th qustion of how xactly it is rlatd to ownrship. Conditionality maks littl or no sns if thr is full ownrship, but it also maks no sns if thr is no ownrship. How much ownrship is ndd for conditionality to b ffctiv, and how much lack of ownrship justifis conditionality? How can on distinguish thos cass in which th lack of ownrship is so svr, or th caus of problms so fundamntal, that conditionality is a wast of tim from thos in which conditionality could mak a diffrnc? I addrss ths qustions in th formal modl and prsnt xampls that provid spcific answrs. Th cntral rol of htrognity in undrstanding conditionality also suggsts that th principal-agnt approach is possibly a usful tool in hlping to undrstand conditionality, both in spcific dsign issus and in mor gnral lssons. 8 Th optimal dsign of an IMF program towards a borrowr is a principal-agnt problm in th tchnical sns, vn if not in th political sns. If thr is a problm, it is in how th principal-agnt approach should b applid. I will argu that whil th standard principal-agnt modl rfrs to a singl principal and singl agnt, 7 On should not that IMF (2001) xplicitly acknowldgs th importanc of htrognity within a country, for xampl, in paragraph For xampl, th bhavior by an agnt that can b inducd by an optimal contract will dpnd on th xtnt to which th intrsts of th principal and agnt ar alignd.

8 7 th conflict of intrsts within th borrowing country ar mor rlvant. 9 Th principal-agnt litratur has also largly concntratd on nongovrnmnt principals and agnts, also gratly limiting its applicability to th issus bing considrd. Thr is bginning to b intrsting work on principal-agnt modls applid to public agncis, 10 and this may vntually provid som usful modls spcifically applid to IMF lnding, but so far thr ar no such formal modls of IMF bhavior. 11 Attmpting to Rconcil Conditionality and Ownrship A numbr of argumnts hav bn mad on how conditionality may play a rol in th prsnc of ownrship. In this sction, I brifly rviw som of ths argumnts and contnd that htrognity of intrsts must undrli any such assrtion. Put anothr way, th qustion is not whthr thr is htrognity of intrsts, but whthr it is btwn th IMF as lndr and th country as borrowr (th standard principal-agnt approach), btwn th country and othr forign lndrs, or btwn sharply conflicting intrsts within a country. I focus on th last viw as th strongst argumnt, whrby in th prsnc of domstic conflict of intrsts, conditionality may play a rol vn whn th authoritis own a program. A standard argumnt, takn as part of th official viw, is that borrowrs may bnfit from th imposition of conditions that incras th probability of loan payback if it maks lnding mor availabl. As alrady suggstd, this viw rquirs that borrowr s and lndr s intrsts ar not prfctly alignd in th absnc of such conditions. Anothr argumnt is that th conflicts ar scond-ordr. For xampl, it is argud that th ovrall goals of th program ar mutually accptd, but thr may b disagrmnt on th bst mans of or th tim-fram for achiving ths goals. Thr may indd b som cass 9 Thr is now a growing body of work on multipl-principal, multipl-agnt, and multipl-task modls, though th application of xisting formal modls to th spcifics of IMF programs is not immdiat. It has bn suggstd that modls of moral hazard in tams (Holmström (1982)) may b rlvant. In ths modls, th outcom is a function of th actions of svral agnts (and prhaps also a random componnt), whr individual actions ar unobsrvabl, so that thr is a fr ridr problm. Th dsign of an IMF program would b finding a schm that inducs optimal actions by ach agnt. On th on hand, tam bhavior capturs th notion that many agnts must sign off on a program. On th othr, th tam stup dos not sm to dscrib vry wll th natur of th conomic problm an IMF program is mant to addrss nor th natur of policymaking. 10 Prndrgast (1999) and Dixit (2000a) prsnt xcllnt survys of principal-agnt modls as applid to th public sctor. 11 Dixit (2000b) provids som suggstions on how conditionality and othr aspcts of Fund programs may b bttr undrstood in trms of formal principal-agnt thory.

9 8 whr th conflict of intrsts is rally how or whn to bst achiv mutually agrd goals, but this assrtion has th flavor of window-drssing. Unlss on contnds that agrmnt on improving th conomic situation in th country is an indicator of th absnc of a conflict of intrst, any obsrvr would hav to agr that in th majority of cass, th us of conditionality could not b xplaind if thr is gnral agrmnt on a program. A third argumnt concrns tim inconsistncy. Spcifically, conditionality is usd as a commitmnt dvic to ovrcom a tim inconsistncy problm. Sachs (1989) and Diwan and Rodrik (1992) argu that policis of rcipint govrnmnts ar tim inconsistnt, govrnmnts accpting x ant th nd for policy chang as a condition for rciving loans but having a strong incntiv to avoid th chang in policy onc th loans hav bn rcivd. Sachs, for xampl, considrs th choic btwn currnt consumption and invstmnt. Th lattr has a high rturn, so that a country ralizs th valu of taking a loan to incras invstmnt. Th govrnmnt s discount rat is vn highr than th rturn on invstmnt, howvr, so that onc th loan is rcivd, it will b spnt on currnt consumption. Conditionality thus binds a country to a cours of invstmnt and consumption postponmnt, thus incrasing th amount of loans that forign invstors or intrnational financial organizations ar willing to mak. In th tim inconsistncy cas, commitmnt is mant to addrss a conflict of intrsts btwn th country and forign lndrs. Tim consistncy problms aris vn (or spcially) whn thr is full information about a policymakr s prfrncs. Conditionality may also play an important rol whn thr is asymmtric information about th authoritis commitmnt or ability to carry out rforms. 12 Invstors may b unwilling to mak loans to a country if thy ar unsur how th loans will b usd. A govrnmnt that is committd to th policy changs that th IMF or forign invstors favor may accpt conditions on itslf to signal its commitmnt and thus sparat itslf from govrnmnt typs that ar lss committd. 13 Hr, it is th possibility of a conflict of intrsts btwn th lndrs and govrnmnts not committd to rform that givs conditionality a rol in signaling that a govrnmnt is intrstd in rforming. 12 Th typ of conditionality may also dmonstrat commitmnt. For xampl, structural conditions may mor ffctivly dmonstrat th govrnmnt s commitmnt to sustainabl macroconomic stability. 13 Thr ar many modls of this typ. S, for xampl, Dhont (1997) or Marchsi and Thomas (1999).

10 9 Th approach to rconciling conditionality and ownrship that is strssd in this papr bgins with th argumnt that thr ar conflicts within a country about policy. A rformist govrnmnt may b intrstd in carrying out an IMF program, but it facs intrnal opposition. Hnc, though th authoritis may own th program, this is not idntical with ownrship by th country as a whol. Mor formally put, sinc policymaking is th procss of collctiv choic in th fac of conflicting intrsts, ownrship by som important policymakrs is not ownrship by th policymaking apparatus. 14 Conditionality may thn strngthn th hands of th rformrs who ar committd to carrying out rform but fac domstic opposition. Conflict of intrst ovr dsird policy may rflct various causs. In th most bnign cas, thr simply may b idological diffrncs ovr what is th bst way to achiv a commonly agrd goal, a conflict strssd in th official IMF viw of conditionality. Altrnativly, diffrnt groups may hav diffrnt objctivs and, hnc, dsir diffrnt policis. This lattr viw is th on xplord in this papr. In th xtrm, powrful intrst groups may oppos rforms that rduc thir ability to ngag in rnt sking. Numrous cass of ths lattr phnomna could b citd, som of which ar discussd in IMF, II. A Political-Economic Modl I now prsnt a stylizd modl of th dcision of a govrnmnt of what policy to adopt. Th modl is highly stylizd in ordr to highlight th political conomy dimnsions of policy rform in th prsnc of htrognity of intrsts, both btwn th IMF and th govrnmnt of a country and, mor importantly, btwn th govrnmnt and domstic groups opposd to rform. It is not mant to answr spcific policy qustions but to highlight th importanc of political constraints and thir intraction with conomic constraints. Th modl is not xplicitly dynamic, vn though th procss of both lnding, spcially conditional lnding, and rform is inhrntly dynamic, for th sam rason. I bgin with th conomic modl without politics. 14 As Khan and Sharma (2001, p. 15), in pluralistic socitis, dos ownrship rfr to th viws on program dsign of and objctivs hld by ky ministrs and cntral bank officials that ngotiat th program with th IMF, or to th viws of th ntir domstic buraucracy that has to approv th ncssary lgislation, or to th blifs of civil socity at larg?

11 10 A Bnchmark Economic Modl In th bnchmark modl, thr ar no political constraints, and th authoritis and IMF hav idntical objctivs, namly maximization of conomic prformanc. Thr ar two domstic dimnsions to policy, rprsntd by valus of two policy instrumnts, dnotd and τ. Th first may rprsnt macroconomic or xchang rat policy, th scond, structural policy. Economic prformanc (or output ) Y also dpnds on IMF lnding, whos siz is dnotd S (masurd in th sam units as Y), so that Y = Y (, τ, S). 15 Th pr-rform or status quo 16 valus of th policy variabls ar SQ and τ SQ, with th rsulting lvl of output (in th SQ SQ SQ absnc of IMF lnding) givn by Y = Y (, τ, 0). A policy rform is a program to incras conomic prformanc via changs in macroconomic and structural policy. Th following assumptions ar mad about th ffct of policy and lnding on Y. First, th output-maximizing lvl of τ is 0, so that positiv τ is simply sn as a structural distortion. Hnc, Y / τ Yτ < 0 for τ > 0. Scond, in th absnc of structural distortions, rducing high (an ovrvalud xchang rat ) will incras output whn supportd by IMF lnding. This capturs th ida (albit in a static contxt) that from an conomic prspctiv, IMF lnding is mant to nabl a country to addrss a short-trm balanc of paymnts problm (to rduc ) in such a way to incras conomic prformanc (incras Y) rathr than rduc it. To modl this, it is assumd first that for ach valu of S, thr is a valu of that maximizs Y (,0, S). Call this maximizing valu + (S), which is th authoritis raction function in th absnc of + political constraints, with Y (,0, S) / Y < 0 for > (S), Y (,0, S), and Y > 0 for + < (S). (Mor gnrally, it is assumd that for τ > 0, Y / < 0 for valus of abov th output-maximizing lvl.) Th scond drivativs of Y with rspct to and τ ar assumd to b ngativ. W naturally assum that SQ > + (0), that is, that SQ is abov th output-maximizing 15 An IMF program would hav no structural componnt (that is, no rlianc on τ ) to th xtnt that th Fund targts Y, and τ has littl or no ffct on Y. This would rprsnt th cas in which th IMF s prformanc targt is narrowly dfind so that it is a function only of macroconomic variabls such as, so that th IMF s narrowly dfind objctivs imply no rol for structural conditionality. 16 Th trm status quo may b slightly mislading, sinc this could b th stat aftr th conomy has suffrd a larg shock. Th ida is that onc th conomy finds itslf in this position, domstic intrsts may oppos any rform, hnc th trm status quo.

12 11 xchang rat in th absnc of lnding. Assum furthr that Y / S Y < 0 for sufficintly high valus of and low valus of S, both for τ = 0 and for τ > 0. This assumption mans simply that up to a point, mor lnding incrass th ffct that rducing has on incrasing Y. This implis that + (S) is falling in S up to som lvl of aid, say S max S = S. Th + (S) schdul, summarizing conomically constraind policy choics, is shown in Figur 1. Finally, it is assumd that Y / S Y > 0 (onc again, both for zro and positiv τ ), so that aid can S hav a positiv ffct on output vn with no chang in. [PUT FIGURE 1 ABOUT HERE] This modl of th ffct of lnding on conomic prformanc is obviously a gross simplification of a complicatd dynamic story, but I think it capturs ssntial lmnts. Its simplicity allows us to focus on th rol of domstic politics. To furthr simplify th basic modl, I assum throughout thr is no qustion of rpaymnt of lnding. This is clarly a hroic assumption, which liminats a major st of argumnts for conditionality. Howvr, including issus of sovrign dbt rpaymnt and handling thm adquatly in a political modl would b a papr in itslf. Hnc, this assumption is mad in ordr to concntrat on th political constraints on th adoption and implmntation of programs, and th implications of conditionality and ownrship for thos qustions. It is assumd that a fraction r of any lnding must b rpaid, so that 1-r is th concssional part of lnding. Nt output is thn Y (, τ, S) - rs. Suppos that th country, takn as a unitary actor, chooss policy to maximiz nt output Y-rS. (Implicit in this maximization ar any conomic constraints on th maximization of Y.) Rprsnting th authoritis objctiv as W (, τ, S), w hav: Max W (,τ, S),τ = Y(,τ, S) rs. (1) First-ordr conditions ar: W Y = = 0. (2) W Y = 0 τ τ + Using our abov assumptions, this yilds an optimal policy (, τ ) = ( ( S),0).

13 12 If th IMF s objctiv is maximization of nt output, it chooss S to maximiz Y-rS subjct to th first-ordr conditions in quation (2). This yilds a first-ordr condition for S of: + Y S ( ( S),0, S) r = 0. (3) Call th solution to quation (3) = S, whr it R R R + R S and th associatd policis (, τ ) ( ( ( ),0) ) is assumd that R SQ < and R SQ τ < τ. This is th first-bst conomic rform program, which is both th authoritis and th IMF s prfrrd solution (givn idntical objctivs). Thr is no R R R conflict ovr conomic policy. W dnot this rform packag P (,0, S ). In this simpl bnchmark, thr is no rol for conditionality at all. With no htrognity of intrsts, unconditional lnding will achiv th goals of th program. In fact, if th govrnmnt had bttr information than th IMF about th workings of th conomy, unconditional lnding would b suprior to conditional lnding. Lnding is simply a tchnical issu mant to improv conomic prformanc without conomic dislocations. Conditionality as part of a lnding program rquirs htrognity of intrsts, ithr btwn th country and th IMF (or othr lndrs) or within th country. I considr ths in turn. Diffrnt IMF and Country Objctivs in th Economic Modl Suppos that th IMF s objctiv function that F (, τ, S) diffrs from th authoritis objctiv W (, τ, S), whr, in th rlvant rang, F 0, F < 0, F < 0, and F < 0. Th < S optimal amount of unconditional lnding from th IMF s point of viw is th S that maximizs F(, τ, S) subjct to th constraint that th authoritis will choos policy according to quation (2). Diagrammatically, it is givn by th point whr th IMF s highst attainabl indiffrnc curv is just tangnt to th curv + (S), rprsntd by point U E in Figur 2 (drawn on th assumption that τ = 0). Mathmatically, this is givn by th conditions: F S Y = S (4a) F Y Y (,0, S) = 0, (4b) th first condition rprsnting tangncy of th IMF s indiffrnc curv and th authoritis + raction function, th scond, maximization by th authoritis implying = (S). [PUT FIGURE 2 ABOUT HERE] SS

14 13 Conditional lnding in this framwork would man th IMF offrs not a givn amount S, but diffring amounts of lnding in rspons to diffrnt policis. Optimal conditional lnding from th IMF s point of viw would b rprsntd by th its choosing th point on th authoritis indiffrnc curv (rathr than raction function) tangnt to th highst possibl IMF indiffrnc curv. To ti down th quilibrium, on has a participation condition, namly that th country (wakly) prfrs taking aid to not taking aid at all. Mathmatically, ths two conditions ar: F F Y r S S = (5a) Y + + Y ( ( S),0, S) = Y ( (0),0,0), (5b) which may b rprsntd in Figur 2 by point C E. 17 Conditional lnding maks th IMF bttr off, but th country wors off, than unconditional lnding. 18 Conditionality inducs th country to choos a lowr valu of and lts th IMF achiv that objctiv with lss aid. Hr, onc again, w s that thr must b a conflict of intrsts if conditionality is to play a rol. Why might th IMF s objctiv diffr from that of th country s authoritis? On possibility is that th authoritis hav conomic objctivs in addition to maximization of output (or whatvr macroconomic goal th IMF is concrnd with.) Anothr possibility is that both ar concrnd about th sam gnral macroconomic objctivs, but th IMF facs financing constraints (opportunity costs of lnding to othr countris or budgtary constraints), so that its tru cost of funds may xcd r. (Or, th IMF is simply concrnd with rpaymnt.) To mak xplicit th ffct of th IMF s financial constraints, it may b informativ to writ th IMF s objctiv as F(,0, S) Y (,0, S) + H ( ) f ( S), whr f (S) rprsnts th (total) cost of funds to th IMF and H () rprsnts th diffrnc btwn th IMF s and th authoritis macroconomic policy objctivs. Th IMF s financial constraint (and th conflict of intrst it implis) is rprsntd by th assumption that f S > r, that th marginal cost of 17 Th authoritis indiffrnc curvs ar horizontal along ) (S +, sinc this is a raction function in which is chosn optimally for ach S. 18 Th discussion at th bginning of Sction I, whrby conditionality may man highr wlfar for borrowrs rlats to th cas of comparing conditional lnding to no lnding, th unavailability of lnding rflcting problms of moral hazard, tc. In this discussion, in addition to th absnc of such considrations, th lndr is assumd to xtract all th bnfit of conditionality (quation (5b)), so that th borrowr is only wakly bttr off.

15 14 lnding to th IMF is abov that prcivd by th borrowing country. In this cas, th slop of th IMF s indiffrnc curv is: F F Y f S S S =, (6) Y + H whr, as assumd at th bginning of th sction, both, F < 0 and F < 0. Th amount of lnding in th thr cass of idntical objctivs, unconditional lnding with diffrnt objctivs, and conditional lnding with diffrnt objctivs can b rprsntd rspctivly by th conditions: Y S r = 0 (7a) Y Y r = f r) + Y S S H S ( S (7b) Y Y r = ( f S r). (7c) H In quation (7b), th cas of unconditional lnding, whr w hav usd th assumption that on th + (S) curv, Y = 0, thr ar conflicting ffcts. Th financial constraint f S > r S would imply that Y S > r, which rducs IMF lnding rlativ to th cas of no conflict of objctivs, whil its dsir to lowr th xchang rat rlativ to what th authoritis choos ( F H < 0 ) would rais lnding in ordr to induc th authoritis to choos lowr. In = quation (7c), th cas of conditional lnding, th right-hand sid is unambiguously positiv + whn f S > r (rmmbr that Y > 0 for < (S) ), so that with conditional lnding Y S > r unambiguously, which implis an unambiguously lowr lvl of lnding. Domstic Political Constraints On th basis of actual country xprincs with failur to adopt rforms, a political procss in which powrful intrst groups can block rforms (trmd vto playrs in political scinc 19 ) sms spcially rlvant in studying possibl political constraints on IMF lnding programs. 20 This ability may flow from a numbr of sourcs, including th structur of political 19 Tsblis (2002) prsnts a comprhnsiv discussion of vto playr modls and thir application. 20 Vrland (1999, 2001) has usd this typ of modl to study th possibl ffcts of conditionality in a framwork whr policy has a singl dimnsion (in his cas, th siz of th govrnmnt budgt dficit). Othr paprs that

16 15 institutions and th political powr of ths groups within this institutional structur, or from thir conomic powr and th ability it givs thm to influnc political dcisions. For simplicity, I work almost ntirly with th cas of a singl domstic intrst group that has vto powr, sinc th basic rsults can b illustratd in this cas. Extnsion to svral intrst groups is straightforward (s footnot 22) and dos not chang th basic rsults. Suppos that th govrnmnt is th agnda sttr, in that it dtrmins and τ subjct to th approval of th domstic vto playr, who will vto any program lowring its utility I (,τ, S) rlativ to its status quo utility I SQ. Trating th vto playr as a unitary actor whos prfrncs can b summarizd by a utility function with standard proprtis is not a trivial assumption (s, for xampl, th discussion in chaptr 2 of Tsblis (2002)), but is oftn usd in th formal tratmnt of spcial intrst groups (for xampl, Grossman and Hlpman (2001)). Th govrnmnt s choic problm may b writtn as: Max W (,τ, S) + λ[ I(,τ, S) - I,τ SQ ]. (8) W bgin by assuming that th intrst group cars dirctly only about and τ, gtting no dirct utility from IMF lnding, so that its utility may b rprsntd as I (,τ, S) V (, τ), so SQ SQ SQ SQ that I V = V (,τ ). Th formulation in quation (8) maks clar that th constraint on th govrnmnt is a political constraint, namly any rform must satisfy th constraint of bing politically fasibl in that it gains th approval of an intrst group with vto powr. If th political constraint did not bind, th govrnmnt would choos its most prfrrd + policy (subjct to th conomic constraints), namly (,τ) = ( ( S),0), as in quation (1). This would b th cas in which th govrnmnt s prfrrd policy is also prfrrd by th intrst SQ SQ group to th policy (, τ ). In such a cas, a rform problm would not aris, and th rol of IMF assistanc would dpnd on whthr it and th authoritis (or th country, which could b tratd as a unitary actor) agrd on th objctivs or not. If thy agrd on objctivs, th problm would b tchnical in th sns dscribd abov, and thr would b no rol for considr conditionality from a political conomy prspctiv includ Drazn (1999), Jann and Zttlmyr (2001), Martin (2000), Mayr and Mourmouras (2002), Svnsson (2000), and Willtt (2000).

17 16 conditionality. If th objctivs of th IMF wr not th sam as th authoritis, th standard principal-agnt problm would b prsnt with a singl agnt. 21 Th mor rlvant cas thrfor is whn th political constraint in quation (8) is binding. This would b th cas, for xampl, whn th intrst group s dsird policis, which I I SQ SQ can b dnotd (,τ ), ar closr to (,τ ) than to ( + ( S),0) in a modl with spatial prfrncs (that is, whr an actor prfrs policis that ar spatially closr in Euclidan distanc to his first-bst policis than policis that ar farthr away). Put simply, in this cas th intrst group wants valus of and τ that ar abov (prhaps significantly) what th govrnmnt wants. This implis that in th rang of policis that maximiz quation (8), V / > 0 and V / τ > 0, so that th conflict of intrsts is clar. (Scond drivativs ar assumd to b ngativ.) Th govrnmnt s powr is givn by its rol as th agnda sttr, th intrst group s powr by its ability to vto policis it dosn t want, whr th altrnativ is th status quo. Th maximization problm yilds first-ordr conditions: 22 W (, τ, S) I = (, τ, S) V (, τ) = (9a) Wτ (, τ, S) Iτ(, τ, S) Vτ (, τ) V = V SQ (,τ), (9b) which can b solvd for th quilibrium valus of and τ as functions of S. Th politically constraind raction functions ar dnotd P (S) (which, lik + (S), is downward sloping in P S spac), and τ ( S). Whn th govrnmnt s objctiv is to maximiz conomic prformanc nt of lnding, th lft-hand sid of quation (9a) is simply Y / Yτ. As in th cas of only conomically constraind policis in quation (1), ths policis ar clarly functions of th o o amount of lnding S. In th cas of S = 0, lt us dnot th solution by (,τ ). Ths conditions hav a simpl intrprtation. Equation (9a) is simply th condition that 21 Thr is a slight catch in that a conditional lnding program itslf must b assumd not to mak th domstic political constraint binding. 22 With n intrst groups, ach concrnd about som j τ, th first-ordr conditions in a politically constraind r n j j r Y j (, τ, S) V (, τ, S) quilibrium would b Y (, τ, S) = (whr r j τ is th vctor of th τ and th subscript j j j j= 1 V j (, τ, S) j j j j SQ jsq rprsnts th partial drivativ with rspct to τ ) in plac of (9a) and V (, τ ) = V (, τ ) for vry intrst group whr th vto constraint was binding.

18 17 th indiffrnc curv of th govrnmnt ovr and τ is tangnt to th indiffrnc curv of th intrst group ovr and τ. Th st of tangncis of ths indiffrnc curvs yilds th contract curv of Parto optimal points from th viwpoint of th two agnts. Equation (9b) dtrmins which point on th contract curv is th quilibrium. For th intrst group s rvrsion (or thrat ) point bing th status quo, th govrnmnt s rol as th choosr of policy implis that it capturs all th rnts in that policy in a political-conomic quilibrium policy lavs th intrst group no bttr off than in th status quo. 23 Not, howvr, that along th intrst group s indiffrnc curv, can b rducd from SQ only by incrasing τ. Th dtrmination of quilibrium may b rprsntd as in Figur 3, whr th upward sloping lin rprsnts th contract curv, that is th st of tangncis of th indiffrnc curvs dfind by quation (9a), SQ rprsnts th status quo, that is, th pr-rform policy paramtrs, and G th most prfrrd point of th govrnmnt consistnt with th constraint in quation (9b) that th intrst group is no wors off than th status quo. [PUT FIGURE 3 ABOUT HERE] On conomic intrprtation of th solution, which draws th distinction btwn macroconomic and nonmacroconomic policis, would run as follows. Suppos a rformmindd govrnmnt wants to improv macroconomic prformanc Y, which is influncd largly by (xchang rat) policis. Undr th status quo, is at a high lvl inconsistnt with high Y. Th govrnmnt thus wants to rduc in ordr to improv th macroconomy, but an intrst group that has significant political powr and can block rform prfrs th distortd (that is, high) valu of to a lowr valu of. In ordr to gain th accptanc of rducd, th govrnmnt must giv th intrst group highr τ, which could b thought of as a structural distortion that th intrst group may particularly favor. To th xtnt that th govrnmnt s objctiv Y is mor snsitiv to than τ (implicit in th argumnt at th bginning of th 23 Condition (9a) is basically quivalnt to th first-ordr condition drivd in Mayr and Mourmouras (2002) in th absnc of IMF lnding (using a Grossman-Hlpman (1994) mnu-auction modl) whn τ, intrprtd as a political contribution, ntrs linarly and of opposit sign and thr ar many intrst groups. Th diffrnc is in quation (9b), whr a mnu-auction modl with political contributions has a rsrvation utility constraint givn by th rquirmnt that th govrnmnt s utility with positiv contributions undr th policy it chooss is th sam as what it would gt if it ignord th contributions of th intrst groups. In trms of Figur 3, th quilibrium in th mnuauction modl may rprsntd by th point on th contract curv giving th sam utility to th govrnmnt (for a linar formulation for τ ) as th cas whr τ = 0.

19 18 paragraph), and th intrst group s objctiv is mor snsitiv to τ than, th politicalconomic quilibrium rprsntd by quation (9a) will imply a dcras in and an incras in τ rlativ to th status quo. Assistanc Not Dirctly Affcting Intrst Group Wlfar Th natur of IMF lnding in achiving its policy objctivs is now th dsign of policy givn not only th charactristics of th function Y (,τ, S) rprsnting th conomic constraints but also th natur of th political constraint. It is assumd from hr on that th objctiv of both th authoritis and th IMF is maximization of nt output Y (, τ, S) rs. I bgin by driving th charactristics of th authoritis politically constraind raction functions and thn considr th implications for both unconditional and conditional lnding. Whn th political constraint is binding, P (S) will li to th northast of + (S) politically unconstraind raction function, indicating roughly th xtnt to which political constraints worsn th policy mnu. It may also gnrally b flattr, most asily sn in th spcial cas in which τ ntrs th authoritis and th intrst group s objctivs linarly but with opposit signs (ngativly for th authoritis and positivly for th intrst group). In this cas, th slop of th P (S) as:, th schdul may drivd from th first-ordr conditions (9a) and (9b) Y P P S ( ( ), τ ( ), = ) S P ( S ) Y + V S S S, (10) whr P P (S) and τ ( S) + (S) is Y S ( + ( S),0, S) / Y ar dfind by thos first-ordr conditions. In contrast, th slop of. On th assumption that Y S is not significantly diffrnt in th two cass, / S will b smallr in absolut valu along P (S) than along + (S). That is, th curv will b flattr. 24 Th ffct of incrass in S on and τ may b sn most clarly diagrammatically. Sinc unconditional aid dos not affct th position of th constraint V = V SQ (,τ), its ffct coms ntirly from its ffct on th govrnmnt s indiffrnc curv ovr and τ. Whthr 24 In th politically constraind cas, is highr (suggsting aid may b mor ffctiv), but thr ar both structural distortions and political constraints (suggsting aid may b lss ffctiv). Hnc, th diffrnc in th numrator is ambiguous and may b scond ordr rlativ to th diffrnc in th numrator.

20 19 unconditional aid raiss or lowrs (with th opposit ffct on τ, sinc th constraint V = V SQ (,τ) is downward sloping in τ spac) dpnds on how it affcts th slop of th govrnmnt s indiffrnc curv. Diffrntiating th lft-hand sid of quation(9a) with rspct to S for givn valus of and τ, on drivs: Yτ / Y S Y = S Yτ Y Y Y τs, (11) which shows how th slop of th authoritis indiffrnc curv changs at a givn point. Analogous to th assumptions in th pur conomic modl, I assum that th numrator on th Yτ right-hand sid of quation (11) is ngativ, that is, YS Yτ S < 0, maning that th ffct of Y incrass in S in lowring Y is gratr than any ffct of highr S in lowring Y τ. In othr words, highr lnding incrass th output gain obtainabl from lowring, not only in absolut trms ( Y < 0 ) as in th conomic modl, but also rlativ to its ffct on th output gain from S lowring τ. That is, if on intrprts as an xchang rat policy (or mor gnrally a macroconomic policy) and τ as a structural policy, th assumption is that an IMF assistanc program is mor conomically ffctiv in corrcting a balanc of paymnts or xchang rat problm (mor xactly, in th ffct of such a chang on output), than in corrcting a structural problm. This sms to b consistnt with how on viws th ffct of assistanc programs. Undr this assumption, an incras in S causs th govrnmnt s indiffrnc curv to bcom flattr at ach point in τ spac in Figur 4, as in th flattr WW curv in th diagram. Th nw quilibrium is on with lowr and highr τ, as rprsntd by U P th quilibrium with unconditional lnding with a contract curv analogous to that in Figur 3 that would go through U P Yτ. (Undr th opposit assumption that Y S Y τ S > 0, th govrnmnt s indiffrnc Y curv would bcom stpr with an incras in S, so that highr aid would lad th govrnmnt to chos highr and lowr τ.) Th raction function for th politically constraind cas, which w dnot P (S), is also downward sloping in S spac. Not that undr th assumption that o o Y / S > 0 at (, τ ), that is, that IMF lnding can improv output vn if policy is not affctd,

21 20 unconditional lnding unambiguously incrass output (and wlfar from th point of viw of th authoritis and th IMF). 25 [PUT FIGURE 4 ABOUT HERE] This rsult unconditional lnding lowrs in a politically constraind quilibrium Yτ (whn Y S Y τ S < 0 ) may b undrstood as follows. To bgin, suppos that Y τs = 0, so that Y our assumption bcoms Y < In othr words, highr S raiss th rsponsivnss of Y to, S maning that th conomic bnfit of lowring bcoms gratr. Sinc th political cost of lowring (th nd to rais τ to maintain th support of th intrst group) is unchangd, th optimal dcision is to lowr in rspons to gratr lnding, which for an unchangd political constraint mans that τ must b raisd. Th rasoning for th mor gnral cas in which Y τ 0 is idntical. Convrsly, if S Y Y Y τ τ S < S, th conomic bnfit of lowring in trms of Y highr τ has falln rathr than risn, so th optimal rspons to mor aid would b to lowr τ and hnc rais. Unconditional lnding is chosn in ssntially th sam way as in th purly conomic modl. Th IMF chooss S to maximiz Y (,τ, S) rs subjct to constraints (9a) and (9b), that is, givn th govrnmnt s politically constraind raction functions P P (S) and τ ( S). Sinc lnding dos not chang th position of th V = V SQ (,τ) curv, it can only induc a movmnt along th curv, bttr macroconomic or xchang rat policy bing bought at th pric of wors structural policy. Th quilibrium valu of would b largr than in th conomic modl for two rasons. First, th P (S) curv lis to th northast of th + (S) curv, implying a highr valu of for any valu of S. Scond, th P (S) curv is flattr than th + (S) curv, indicating that th point chosn will b mor towards highr and lowr S. Lnding mant to 25 o o o o Sinc (, τ ) is fasibl for S > 0, any othr point chosn must yild highr wlfar than (, τ ), which yilds highr wlfar whn S is positiv than whn it is zro. 26 Th assumption that YτS = 0 dos not man that changs in τ do not affct Y, but rathr that a chang in S dos not chang th ffct of τ on Y.

22 21 maximiz a country s wlfar will b lowr whn th authoritis fac political constraints than whn thy don t. Th analysis of conditionality in th cas of political constraints is also analogous to that in th purly conomic modl, but with th authoritis raction function givn by P (S) rathr than + (S), and with th authoritis indiffrnc curvs similarly dfind as taking into account th political constraint. As was sn in th conomic modl abov, conditional lnding maks th country wors off whn th country and th IMF hav diffrnt objctivs, and can mak th country no bttr off whn thy hav th sam objctivs. 27 (Point C P in Figur 4 rprsnts this. A diagrammatic analysis would paralll Figur 2.) Th sourc of th waknss of both unconditional and conditional lnding rflcts two charactristics of th political modl. First, and quit crucially, th authoritis rol as agnda sttr givs it all th bargaining powr, allowing it to pick th point on th intrst group s indiffrnc curv it finds optimal. Givn this, if IMF lnding dos not affct th intrst group s indiffrnc curv, that is, it dos not affct th political constraint dirctly, it can hav rlativly littl ffct. Any quilibrium must b on th V = V SQ (,τ) curv, with points on th raction function P (S) giving th optimal rspons to lnding S. Hnc th authoritis can do no bttr than whn lnding is unconditional. For conditionality to hav a rol whn th constraint is th political powr of intrst groups (whos intrsts diffr from thos of th authoritis), ithr lnding must dirctly affct thir wlfar or it must strngthn th bargaining powr of th authoritis in a political stup whr this powr is limitd. Assistanc Dirctly Affcting Intrst Groups Utility If lnding inducs a shift in th I S = I SQ (, τ, ) curv to th southwst, it will allow choic of an (, τ) policy closr to what is optimal according to th authoritis (and th IMF s) prfrncs. Prhaps lss obviously, it will also giv a rol to conditionality. Th gnral point is prsntd in this sction and som xampls in Sction IV. 27 In th cas of diffrnt objctivs (such as an IMF financial constraint), a strong distortion du to th political constraint in th sns of P (S) bing vry much abov + (S) mans that th unconditional and conditional lnding solutions will gnrally b farthr apart in th politically constraind cas than in th conomically constraind cas. In this vry limitd sns on might argu that political constraints in thmslvs giv a rol for conditionality, but it is a wak argumnt givn our intrst in th cas whr authoritis and th IMF agr on objctivs.

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