Loans from the International Monetary Fund (IMF) and the World Bank that are conditional on policy reform and structural adjustment have become increasingly controversial. As this type of lending has grown, the institutions stand accused of forcing weak governments to introduce unpopular reforms, resulting in protest and a decline in domestic welfare. What determines the impact of conditional lending on a country’s political economy?
This IMF Working Paper uses a stylised game-theoretic model to examine the link between conditionality and domestic welfare. According to the framework, the level of conditionality (the punishment threat if reform fails) determines a government’s ability to push through unwelcome policy changes. If conditionality is strong enough, it can provide governments with the political cover required to deter protest and achieve reform. But if conditionality is inadequate, weak governments may not attempt reform. Or worse, they may pursue reform that meets with protest, leading to policy reversal and damage to welfare. This outcome is more likely where the lending institution derives a low benefit from the reform, but the loan is granted because the need for aid or the desire to reward an ally is high. In this situation, the institution has less of an incentive to impose strong conditionality.
The framework demonstrates that:
- Where conditional threats are low, a weak government collects aid, but does not reform, leaving it better off than the no-reform, no-aid option.
- Where threats are high enough to kick- start reform but not to stop protest, there is maximum damage to the economy and domestic welfare.
- Where threats increase so that reform is achieved without protest, the highest benefits are gained.
- Even when the aim is to reform through political consensus, the same rules apply. In fact, greater threats may be needed to ensure that welfare redistribution takes place. This contradicts the popular view that ownership requires less conditionality.
The IMF and the World Bank are responding to criticism by moving to reform conditionality. Many critics argue that conditionality should be minimised or axed, whereas policy pointers from this paper are more complex:
- To ensure that reforms are implemented and welfare improves, conditionality should be strengthened, not watered down.
- Domestic ownership of reform programmes requires even stronger conditionality than unpopular reform.
- Where international political pressures could result in inadequate conditionality, aid without conditions is preferable.
