Conditionality

Analysis

The IMF’s Final Frontier? Assessing “Second Generation” Reforms

14 June 2000 | Briefings

Briefing by: Angela Wood , September 1997

Contents

Introduction

The globalisation of the world economy – the growing economic interdependence of countries world-wide may bring benefits to developing countries as trade and investment opportunities increase, but it will also bring with it many problems and risks marginalising entire countries, regions and communities. While the world as a whole may benefit from this process the gains are likely to be unevenly distributed, both between countries and within countries. The contribution of globalisation to poverty reduction and growth is likely to vary for different categories of developing countries. The countries who are likely to benefit least from the globalisation process will be the poorest countries, particularly sub-Saharan African countries, which have been unable to attract much foreign capital and expand trade and are do not have self-sufficient agricultural sectors.

Michel Camdessus, Managing Director of the IMF, recently announced that the IMF was moving into its “second generation” of reforms to enable middle and low income countries to grasp the opportunities presented by the globalisation process. According to the Fund, the pressures of Globalization will increasingly accentuate not only the benefits of good policy but also the costs of bad policy. Two of the risks faced by developing countries, identified by the IMF, are the potential for “bouts of exchange market volatility, the collapse of financial institutions and other financial crises”, and marginalisation, “a process that threatens to leave behind those countries that fail to harness the forces of globalisation to accelerate economic progress.” 1

The “second generation” reforms are aimed at “ensuring that the State fulfills its proper role in a market economy, by creating a level playing field for all sectors and implementing policies for the common good, particularly social policies that will help to alleviate poverty and provide more equal opportunity”. 2 These reforms focus on 4 areas in particular:

  • the financial system – paying greater attention to the soundness of banking systems and encouraging greater transparency, better data dissemination and the liberalisation of capital accounts;
  • “good governance” – by reducing corruption, encouraging transparency of public accounts, improving public resource management and the stability and transparency of the economic and regulatory environment for private sector activity;
  • composition of fiscal adjustment – reducing unproductive expenditures such as military spending and focusing spending on social sectors; and
  • deeper structural reform – including civil service reform, labour market reform, trade and regulatory reform, and agrarian reform.

These new reforms are intended to build on the IMF‘s more traditional measures which focus on achieving balance of payments viability, reducing government deficits, trade liberalisation, freeing upraises and reducing the role of the state. As Camdessus argues “we have learned that this first generation of reform is not, by itself, enough either to accelerate social progress sufficiently, or to allow countries to compete more successfully in global markets”. 3 It would appear that the IMF views itself no longer as simply an institution to achieve macroeconomic stabilisation objectives but is focused much more on structural issues, issues which have previously been the remit of the World Bank. There has been long-standing agreement between the two institutions, based on their expertise and theoretical foundations, that the IMF will focus on macroeconomic issues, and likewise the World Bank would deal with structural issues. It is unclear on what grounds the IMF justifies this latest move. Indeed, if the Fund broadens its remit to cover these deeper structural issues then it raises again the question of why there is a need for two separate institutions. A merging of the two might even bring some benefits if IMF‘staff then had poverty reduction, not current account liberalisation and low inflation, as their primary goal.

Good Governance

Good governance – defined by the IMF as increased transparency of government operations to limit opportunities for corruption and enhanced public accountability, enforcing a simple and transparent regulatory framework for the privatised sector, guaranteeing the professionalism and independence of the judiciary, and enforcing property rights – is, according to the IMF, essential for reaping the benefits and mitigating the costs of globalisation. This is certainly a process to be encouraged but the IMF is not an appropriate institution for doing so, nor is conditionality the appropriate mechanism to achieve it. The IMF is a monetary institution and its staff are, in effect, macroeconomic specialists and they do not deal with political and microeconomic issues. They do not have the background to give appropriate advice and develop appropriate policies to deal with governance issues, and they should not aspire to. Rather than imposing additional conditionalities on its programmes which would involve the IMF in addressing political issues, it would seem more appropriate that the IMF could offer advice on governance issues to governments through its regular Article IV consultations.

Aware that it is stepping into political realms, which its articles of agreement expressly forbid it to enter, the IMF insists that its approach is “to concentrate on those aspects of good governance that are most closely related to our surveillance of macroeconomic policies – namely, the transparency of government accounts, the effectiveness of public resource management, the stability and transparency of the economic and regulatory environment for private sector activity.” 4 The tools for achieving these aims are institutional reforms of treasury budget preparation and approval procedures;tax administration, accounting and audit mechanism; increased transparency of central bank operations; and the establishment of effective audit procedures. The IMF will also seek greater influence over the procedures by which government control their expenditures and collect revenue. But as the IMF‘s directors themselves point out “it is difficult to separate economic aspects of governance from political aspects”. 5 Indeed, if a head of state or government is given the choice between addressing corruption (which is often very complex to unravel and can be disruptive to the administrative process, and which may benefit the elites that sustain a government in power) and remaining in power, it becomes a very political issue.

The IMF has been criticised by NGOs, and others, for overlooking irregularities in the use of funds and its willingness to carry on providing funding to countries such as Zaire and Kenya despite the knowledge that its loans were being siphoned out of the country. Geopolitical considerations are held to account for this and shareholder pressure continues to influence the level and impact of IMF disbursements, for example to Russia and Mexico.

In July this year the IMF‘suspended a $220m loan package to Kenya on the grounds that the government had failed to combat corruption and concerns about the allocation of two controversial power contracts and the overall management of the energy sector. The suspension led to a fall in the value of the shilling, reduced foreign investor confidence, reduced aid flows from other donors and inflation rose as the price of imports, particularly fuel, increased in the shops.

The IMF has since reached a new agreement with the government which must now 6:

  • “strengthen management” of the energy sector;
  • safeguard the independence of the Kenya Revenue Authority;
  • ensure that the Kenya Anti-Corruption Authority will be fully independent and have a wide mandate to investigate corruption and to bring both civil and criminal investigations; and
  • establish full accountability with regard to past financial infractions.

The IMF is insisting that the government must implement these reforms before it will release any further finance. While it is important that funds are used efficiently and for the purpose they are intended, the use of pre-conditions before releasing funds is questionable when the IMF has not clearly made the case that the conditions are the key to achieving stabilisation objectives. The IMF‘s hard-line stance could persuade other donors to withhold their funds too, forcing the country into a very difficult economic position. Ultimately the brunt of the IMF‘s actions are borne by the mass of the population. Furthermore, it is not clear whether the IMF made any efforts to consult with the private sector and civil society let alone politicians before formulating these demands.

Sam Kabue, an NGO policy analyst in for the National Council of Churches in of Kenya, argues that the issue of corruption is very important for the Kenyan people but their number one priority is poverty reduction. While efforts to reduce corruption are welcome, especially since it compounds the problems of poverty, there is inconsistency in the IMF‘s approach. The imposition of IMF advocated structural adjustment programmes (SAPs) has actually led to a worsening situation for many of the poorest people who now have less access to medical and education services due to the cost sharing that the IMF has encouraged in the social sectors. Education enrollment rates in Kenya have fallen from 95% in 1989 to 76% in 1997, this fall is attributed to the introduction of user fees which are too expensive for many households to afford. The IMF, concludes Kabue, “is like any other bank, their own interests are paramount when it comes to them and us. If ending corruption will help the IMF get its money back then it will fight corruption. If structural adjustment programmes will help them get their money back then they will impose SAPs.” 7

The benefits of good governance are not in question, but the IMF‘s competence and suitability as an institution to enforce appropriate conditionality is.

Capital Account Liberalisation

At the IMF Spring Meetings the Interim Committee agreed that the IMF‘s Articles of Agreement should be changed to allow the Fund to actively pursue capital account liberalisation – removal of quantitative controls, taxes, and subsidies on capital movements – in adjusting countries. Previously, the Fund has-been limited to dealing with current account transactions although capital account liberalisation has been included in reform programmes where it has been deemed desirable. The Fund argues that capital account liberalisation has spurred the process of globalisation and liberalisation is necessary inorder for countries to reap the benefits of a globalised economy.

Capital Account liberalisation has encouraged increased portfolio investment flows into a number of mostly middle income countries, helping to ease foreign exchange constraint whilst encouraging economic discipline. But such flows have also brought greater problems for domestic macroeconomic management due to their tendency to flow out of countries at times of instability or during periods of economic slump, and the potential contagion effects.

The attack on the Thai currency, the Baht, in July, forced the Thai government to float the currency, causing a 24% depreciation in its value against the dollar, and to close some of its domestic financial institutions. These actions had significant repercussions throughout the South East Asia region, demonstrating the very large potential problems of financial liberalisation and the ease with which these problems can be transmitted to other economies; even for countries whose policies are viewed to be sound and which have taken appropriate measures to publish timely economic data to keep investors informed. How can a developing economy protect itself from such attacks? The IMF seems to have no answer. More streamlined bureaucratic procedures that give countries quicker access to large emergency loans to shore up the financial system has been one response. This is not very satisfactory because it leaves developing countries with even larger debt burdens at a time when they need to reduce their current account deficits, which tend to be caused by large capital inflows. More preventive measures need to be developed, especially given that the low-income countries have much less opportunity for developing their own mechanisms to deal with these problems.

The capital markets are inherently imperfect: information is imperfect and investors’ behaviour is often based on herd instincts which lead to untenable investment booms and excesses and then large outflows of capital as the collective mood changes. It is highly questionable whether developing countries, particularly the poorest, which are intrinsically more vulnerable to external economic disturbances, can protect themselves adequately against such swings in behaviour. Rather than opening up these fragile economies to greater disruption the Fund should be developing mechanisms to protect them whilst reformulating its adjustment programmes so that they do not have such a negative impact on domestic private investment and government infrastructure investment. It should also pay more attention to developing an effective international institutional framework for oversight, regulation and compensation to deal with shocks emanating from the volatility of short-term international financial flows.

The IMF‘s Executive Board is preparing to vote on whether or not accept the proposed change to the IMF‘s Articles of Agreement to extend the IMF‘s jurisdiction to cover capital account liberalisation. The promotion of capital account liberalisation will become a specific purpose of the Fund if it is accepted by the required 85% majority. If it is agreed, the new article will operate in a similar way to Article 8 which addresses current account liberalisation, and member states will sign up to it as and when they choose to. However, although Article 8 is, in a sense, voluntary, the Fund has pursued current account liberalisation as a primary goal in all adjusting countries. While the Fund suggests that it would not force a country to liberalise its capital account before its financial system was sufficiently advanced and before appropriate regulatory mechanisms were put in place, it is likely that the Fund will prioritise reforms in this area rather than dealing with issues that are more pressing for developing country governments and their people.

Composition Of Fiscal Adjustment

The composition of government spending is very important, particularly for redistributing resources within an economy to address issues of inequality, and for encouraging investment and saving. The IMF claims to improve the quality of public spending by reducing budget deficits and improving the composition of government spending. The Fund advocates that the compositions of spending can be improved by:

  • focusing resources on the education and health sectors and reducing spending on the military to a minimum;
  • reforming public health and pension systems; and
  • providing well targeted and affordable social safety nets.

While the Fund talks about focusing spending on social sectors, particularly health and education, it is uncertain whether the Fund intends to impose conditionality on the distribution of spending between and within these sectors, for example whether spending should be focused on primary services, such as rural health clinics, and in what proportion relative to secondary and tertiary services, such as hospitals. Nor how pension and health systems should be restructured. The Fund, in conjunction with the World Bank, has favoured privatising services and has encouraged the introduction of cost recovery mechanisms such as user fees for health and education services. Cost recovery has proved to have a significant impact on many of the poorest households, who either cannot afford to send their children to school or to use medical services, or who must make sacrifices in other areas, for example selling assets, in order to pay the fees. Moreover, the IMF has advocated these policies for the poorest countries when they are not even generally accepted as appropriate by the IMF‘s most influential and richest shareholder governments.

The Fund does not have detailed knowledge of how budget processes work. Budget decisions are micro level decisions which, if they are to be effective and are to benefit the many different groups within society, have to be made by those within a country who have an understanding of the population’s needs and how it the population is structured. The Fund has neither the theoretical background nor the staff knowledge to deal with these social issues. All IMF operational staff are economists based in Washington, there are no social scientists employed by the Fund dealing with operational issues and there are no staff working on health and education issues, which, the IMF‘s public affairs staff admit is the realm of the World Bank and not the IMF. Moreover, the Fund draws heavily on the World Bank’s analysis.

Of course governments should be encouraged to spend less on the military which is unproductive, especially since arms tend to be bought from the G7 countries. The IMF recently advised the Ukraine government to postpone a planned billion dollar purchase of military helicopters, which if it had gone ahead would have worsened the government’s budget deficit, added to its debt burden and diverted scarce resources away from more pressing needs. However, giving advice about not investing in the military is perhaps relatively clear-cut, but advising governments on matters of education and health spending is far more problematic, especially since the impact it has on the distribution of resources within the economy has more widespread domestic political implications . It seems inconsistent, given the World Bank’s greater expertise, that the Fund should want to move into advising governments on these matters.

Deeper Structural Reform

The IMF justifies its desire to incorporate more structural reforms in its programmes on the grounds that, although its reforms to date have led to better balance of payments positions and lower inflation, adjusting countries have been disappointed that reform efforts have not led to more growth and have not necessarily attracted more foreign investment. While middle income countries have had some success in controlling inflation and reducing their external and internal deficits, this has not generally been the case for low income countries. Preliminary results from the IMF‘s 1997 internal review of the impacts of its adjustment programmes 8 financed through the Enhanced Structural Adjustment Facility, which lends to the poorest, most indebted countries, indicates that the Fund has not achieved significant success in its stabilisation objectives. Decline in real GDP growth for ESAF borrowers as a group was halted but there was no resumption of growth; inflation fell from 94.4% but remained high at 44.9%; budget balance improved but remained negative despite considerable flows of grants and consessional loans to these countries; and the stock of external debt almost doubled.

The Fund has been unable to demonstrate that its reform strategy for achieving its stabilisation goals low inflation, small government deficits and improvements in the balance of payments has had any significant impact for the poorest countries. It therefore seems even more doubtful that its advice on structural reforms will be any more effective for achieving poverty reduction, human development and growth objectives. However, rather than re-examining its policy advice in the light of its weak performance, the Fund has instead insisted that persistent problems are due to a lack of adjustment and that many obstacles to private sector initiative, job creation and foreign investment have been left in place. They advocate that countries need to streamline their civil services; introduce labour market reforms to remove the disincentives to job creation, trade and regulatory reforms to encourage private sector activity, agrarian reforms; enforce property rights; and improve land registration and credit and mortgage regimes.9 However, although the IMF is calling these reforms the “second generation” of reforms, they have actually been pursuing this type of reform, with the support of the World Bank, for the past 10 years and have had little success in achieving growth objectives and have hardly addressed poverty reduction objectives. Moreover, many of the countries that it has commended for being model adjusters have failed to achieve long-term stability and growth. Rather than expanding its role the IMF should be refocusing its efforts to develop appropriate stabilisation policy advice to help those countries still struggling with massive debt burdens.

New Conditionality New Leverage

The IMF‘s involvement in these new areas are most likely to become effective through its conditionality. Leaving doubts about the usefulness of conditionality aside, the IMF‘s movement into areas in which it has no institutional mandate nor intellectual expertise suggests that the IMF‘s agenda is to extend its role to gain new leverage over countries which have less need for its financial resources. For example in the case of Argentina, as was recently reported in the New York Times (15th July 1997), the Fund did not impose any macroeconomic conditions on it latest loan on the grounds that the economy was performing well with minimal inflation and forecast growth of 7%. Instead, the Fund granted its “seal of approval”, i.e., approval from the Fund that the country is taking appropriate steps to improve its economy, on the basis of good governance conditions. Argentina’s economy minister, Roque Fernandez, disclosed that the government would not be drawing down the loan because it had adequate access to private finance. The impetus for seeking the loan and agreeing to the governance conditions was to gain the IMF‘s seal of approval and technical assistance. This would indicate that there is a flaw in the operation of the IMF and the global financial system. If countries have reformed sufficiently to not need IMF finance and the Fund is in agreement with the macroeconomic policies pursued by a country then why is the IMF prepared to lend to countries such as Argentina? The Fund should be able to extend its seal of approval without imposing new conditions or lending new money.

The Fund’s staff are already constrained by their work loads and involving the Fund in more areas will be counterproductive. The IMF is quick to recommend to countries to specialise and yet they appear unable to do this themselves. Rather than extending its remit into inappropriate areas the Fund should look at how it could improve its seal of approval function.

For Whose Benefit?

These “second generation” reforms focus on strengthening the environment for private sector investment as the key to growth through new investment. While it is clear that the private sector is important, the IMF‘s strategy appears to be based on securing a desirable environment for international investors rather than the needs of domestic investors. A country s growth strategy should not be based purely on the needs of foreign investors. Although at present private investors are a significant source of finance governments cannot rely on these flows remaining in their economy over the long-term. Therefore, it is not appropriate for governments to base long term economic decisions on what could be a transitory inflow of capital. Indeed, recent inflows into the East Asian economies have been at the expense of outflows from the Latin American economies.

The recent surge in private investment in emerging markets has been encouraged by the external economic environment, particularly the relatively low rates of interest available on investments in the major developed countries. A turnaround in this position could very quickly see rapid outflows of finance from the less developed countries. Analysis shows that over the last 3 years investors would received a larger return from investing in Wall Street. 10 Furthermore, the opportunities presented by mass privatisation programmes in adjusting countries have also encouraged inflows on international capital but this process is limited as fewer state owned industries remain to be privatised.

Inflows will increasingly be offset by the corresponding outflows to investors in the form of dividends and debt repayments. A sharp decline in inflows could precipitate a new balance of payments crisis which would, by its very nature, be much harder to address than that witnessed since the late 1970s. Moreover, it is doubtful that private sector capital is appropriate for many of the needs of the poorest developing countries, such as infrastructure projects which generate only local currency payments, given its high foreign exchange costs. These resources are likely to be too expensive for these countries particularly if there is little commitment from the private sector to keep resources within a country or sector over the long-term. Long-term commitment is probably only likely in the case of infrastructure investments and foreign direct investment. Yet developing countries need investment in the social sectors, particularly in areas that will benefit the poorest sections of society. Private capital is not likely to be forthcoming, without considerable incentives, to fund investments in the social sectors particularly if returns cannot be easily captured by the private sector and they flow back only in the long-term The market’s determination to ensure that they can withdraw their money at a moments notice is demonstrated by the surge in the flow of money out of the South East Asia region when Mahathir Mohamad, Prime Minister of Malaysia, tried to restrict short selling of stocks on the Malaysian stock exchange.

Conclusion

Globalisation is portrayed as a “win/win” process where the losers are compensated by the winners. But in reality compensation for the losers has not been forthcoming. Rather than opening up economies further to the potentially destabilising impacts of international investment flows and removing regulations to protect labour and domestic industries, the IMF‘should be examining ways in which countries can mitigate the negative impacts of the globalisation process and develop the potential of their domestic private sector to invest, expand their production base and develop their infant industries. The IMF has been quiet on the issue of the redistribution of assets and benefits and the need for compensatory safety net measures for those marginal groups in the population which are likely to lose out from the globalisation process. It should ensure that countries have sufficient funds to allow governments to compensate for the negative impacts of the globalisation process. This may include resources to establish appropriate public works schemes that will be self targeting to provide employment opportunities for the poorest and subsidies on food staples consumed by the poor. How compensation is provided should be decided through consultation with non-governmental organisations and other civil society groups. Governments should ensure the access to the poor and squatters to legal land titles on their urban and rural land. Support should also be given to micro and small scale enterprises and helping those in the informal sector to join the formal sector.

Sub-Saharan Africa will not be able to rely on significant private sector flows for some time to come and official development assistance will continue to play a vital role in the continent for the foreseeable future. With diminishing aid flows every effort should be made to ensure that Africa does not become marginalised further as aid resources flow to stronger adjusting countries. African governments need support to develop their capacity to design and implement appropriate adjustment programmes. Essential for this will be financial and technical support to strengthen civil services and to develop the necessary bureaucratic procedures to implement these programmes. Governments must be allowed to take the initiative on the deeper structural reform issues. The IMF, and other international donors, should examine how it can support governments in these efforts. It should not concern itself with encouraging structural reforms by imposing more conditionalities on its loans. Indeed it is doubtful that the it can develop appropriate structural conditionality nor that governments can or will implement conditionality that has deep political implications.

The IMF needs to consult more widely when advocating reforms. Currently the Fund’s dialogue with the government is focused on the finance ministry to the neglect of other ministries, and its consultation efforts with the private sector, academics or civil society have been weak. What consultation the Fund does enact tends to be more of a public relations exercise to persuade those outside the finance ministry that there is no alternative. Widespread consultation and debate with groups such as trade unions, development groups, women’s organisations, small businesses, independent economists and politicians is essential for designing relevant and beneficial policies. Failure to consult hinders the development of the democratic process which is a fundamental aspect of good governance.

The IMF has taken important steps to provide more information, this positive movement should be accelerated. All operational and policy documents should be made publicly available to enable informed assessment of and debate about the impacts of its policy advice. The IMF should introduce a disclosure policy based on the principle that all information should be publicly released unless there is a compelling stated reason not to do so.

The lack of an independent evaluation department also hampers assessment of the effects of its programmes. The IMF should establish an evaluation department, independent of management, staff and the Executive Board, to analyse the effectiveness of IMF programmes. Its evaluations must be made publicly available.