8. This change in the policy content of programs has gone hand in hand with a change in the modalities by which the Fund monitors policies. The 1979 Conditionality Guidelines envisaged that program monitoring would be mainly through performance criteria: a performance criterion is a condition that must be met for the Fund's financing to continue, unless the Board grants a waiver. The other main tool of conditionality, program reviews, was seen mainly as an occasion to set performance criteria beyond the first year of a program, and in rare cases to monitor policies where uncertainties precluded the setting of performance criteria. In recent years, however, program reviews have increased in importance as an opportunity for both backward- and forward-looking assessments of program implementation.

9. The increasing importance of reviews reflects, in part, greater uncertainty about key macroeconomic relationships in a world of high capital mobility; these circumstances exacerbate the difficulty of specifying a path of performance criteria a year ahead.⁵ It also reflects the increasing role of structural reforms, which are often difficult to characterize quantitatively or even qualitatively with sufficient precision to be suitable as performance criteria. Moreover, many key structural reforms take considerable time to implement, making it important to find some way of tracking progress toward the ultimate objective. This has been done in many cases by using a set of structural benchmarks to map out a series of steps toward an overall policy result. A structural benchmark is different from a performance criterion in that failing to achieve it would not by itself interrupt the Fund's financing. Performance relative to such benchmarks does, however, help inform the Board's assessment of progress on structural reforms during reviews and is bound, therefore, to influence the Board's decision on whether to complete a review. The increasing role of structural benchmarks is reflected in the fact that, behind the overall expansion of conditionality is a proliferation of structural benchmarks, and to a lesser extent of prior actions, compared with a much more modest increase in the number of performance criteria (Figure 4).

10. Along with this shift in monitoring techniques has come an increasing lack of clarity with regard to the boundaries of conditionality. Conditionality is that part of the authorities' policy program that is being monitored as the basis for decisions on the use of Fund resources: the defining question is, "If it's not done, can that stop the Fund's financing?" But in many cases, conditionality has been applied (or has been construed as applying) to reforms that are not really critical to the Fund's decision on whether to continue its financing. Moreover, a Letter of Intent (LOI) is often used to lay out the authorities' entire policy program; and in some cases, it even includes technical assistance advice and the policy priorities of other international financial institutions, regardless of whether the Fund has any intention to make these conditions for its financing.

11. Such murkiness on the boundaries gives the misleading impression that conditionality is all-encompassing. In some cases, this lack of clarity may serve the purposes of the authorities, Fund staff, and/or other international financial institutions, by lending the Fund's imprimatur to elements of the policy agenda whether or not they are at the core of the Fund's concerns; but this comes at the cost of hindering the emergence of a healthy policy debate within the country and of understanding of the role of each international institution in the country. The lack of clarity of the boundaries also has implications for the application of conditionality: in particular, unless the scope of program reviews is precisely delineated, it may not be clear, even within the Fund, which elements of the Letter of Intent can directly affect the completion of a review.

12. Both the increasing structural content of Fund-supported programs and the changing approach to program monitoring has taken place, at least in part, for good reasons. Nevertheless, it has prompted legitimate concerns: in particular, that the Fund is overstepping its mandate and core area of expertise, using its financial leverage to promote an extensive policy agenda and short-circuiting national decision-making processes. Moreover, the expansion of conditionality raises issues regarding its effectiveness. If conditionality is too comprehensive, it may undermine the authorities' assurances of purchase, since it increases the chance of failing to meet all conditions even when the policies that are critical to program objectives are actually on track. A proliferation of measures also has the potential to blur the Fund's focus on what is essential to ensuring that the program fulfills its purposes.

13. Concerns have also been voiced about whether recent Fund-supported programs have taken adequate account of the authorities' ability to muster political support for a multitude of policy changes at one time, as well as their capacity to implement these reforms. In some cases, these concerns may simply point to a need to provide technical assistance and/or elicit support from other international institutions, to guide the implementation of policies that are needed for the program to succeed. In other cases, however, conditionality may have been established on policies that were unlikely to be delivered, calling into question the realism of program design. In instances in which the minimum set of policies required to make a program viable may be beyond the authorities' political and administrative capacity to deliver, saying "no" may be a better choice, albeit often a very difficult one.

14. Finally, there are concerns that overly pervasive conditionality may detract from implementation of desirable policies by undermining the authorities' ownership of the program. It is the authorities who must implement policies, and it is mainly they and their citizens who live with the consequences of either action or inaction. Policies are not likely to be implemented in a sustainable way unless the authorities accept them as their own and unless the policies command sufficiently broad support within the country. Conditionality that is too pervasive may galvanize domestic opposition to the program as well as blurring the authorities' focus on what is essential. Experience suggests that the link between conditionality and program ownership is a complex one; in particular, there are cases in which high program ownership has gone hand in hand with extensive conditionality, as a government wishes to use a Fund program to strengthen its commitment to an ambitious set of domestically-owned reforms. Nonetheless, the strong likelihood that a more focused approach to conditionality will enhance country ownership is an important motivation for streamlining.

III. Streamlining Conditionality

15. The issues highlighted in the previous section set the stage for consideration of how to streamline the Fund's conditionality. Streamlining requires:

• reassessing the scope of conditionality—i.e. what policies are to be covered by the Fund's conditionality—particularly in the structural areas;

• choosing the appropriate degree of detail of conditionality—i.e. how these policies are to be monitored; and

• clarifying the boundaries between what is covered by conditionality and what is not, as well as between the Fund's conditionality and that of other institutions.

16. There are two main approaches to curtailing the scope of structural conditionality. First, a higher threshold of relevance could be applied in deciding whether a particular policy action should be covered by conditionality in a particular instance. The existing Guidelines on Conditionality prescribe that performance criteria should be limited to those needed to ensure the achievement of program objectives. In principle, this is a stricter test than, for instance, the macroeconomic relevance test applied in the context of surveillance.⁶ It can also be compared with the criterion established for the Fund's involvement in governance issues—which is to be "guided by an assessment of whether poor governance would have significant current or potential impact on macroeconomic performance in the short and medium term".⁷ But in practice, the test of macroeconomic criticality has been applied with considerable latitude. Accordingly, the Interim Guidance Note on Streamlining Structural Conditionality stresses the need to limit conditionality to those measures that are critical for the achievement of the program's macroeconomic objectives. The intention in applying a relatively strict criterion for the application of the Fund's conditionality is to change the mindset with which the staff, management, and the Board consider whether certain structural measures should be covered under conditionality, shifting from a presumption of comprehensiveness to a presumption of parsimony, and thus putting the burden of proof in each case on those who would argue for the inclusion of additional measures under conditionality.

17. A second aspect of streamlining is establishing a better division of labor with the World Bank and other involved multilateral and bilateral institutions and agencies. In the past, the Fund's cooperation with these institutions has not generally contributed to streamlining: on the contrary, in many cases policy measures important to these institutions' objectives have been included in the authorities' Letters of Intent and sometimes established as structural benchmarks or even performance criteria. Steps are now underway to establish a more efficient division of labor. Under the Poverty Reduction Strategy Paper (PRSP) framework for low-income countries supported by the Fund's Poverty Reduction and Growth Facility (PRGF), the Fund and Bank work closely together to support the implementation of a common country strategy and to focus their efforts on their respective areas of responsibility. Under this framework, the Fund will not normally establish conditionality outside its mandate and expertise except where these are essential to the country's fiscal and/or external targets. Instead, these structural and social areas will be covered by complementary World Bank-supported programs. The Bank's recent establishment of the Poverty Reduction Support Credit (PRSC) will facilitate this demarcation of responsibilities, inter alia, by better aligning the time-lines of the two institutions' financing. No such framework yet exists for middle-income countries, but greater efforts are being made to improve coordination between the Fund and the Bank in these operations, including through upstream consultation between the two staffs on emerging structural issues in individual programs. Where the Fund's conditionality still needs to cover some measures outside its core areas of competence, it is essential that the authorities receive adequate advice (from the Bank or from other relevant institutions) on how to implement the agreed measures.

18. Another important aspect of streamlining is with regard to the degree of detail with which policies are monitored. Much of the proliferation of conditionality reflects the practice of mapping out a series of steps toward a particular policy outcome, in some instances using tools of conditionality such as structural benchmarks, in others by listing the individual steps in a policy matrix. For instance, in one case the introduction of a value-added tax involved 19 structural benchmarks. In many cases, the intention has been to help guide policy implementation or to clarify the extent of progress that will be required in order to complete a review. But this degree of detail of conditionality creates the perception that the Fund is trying to micromanage the authorities' policy program, hampering their flexibility in choosing a different yet viable road to an agreed destination.

19. One solution to the perception of micromanagement would be to rely to an increasing degree on results-based conditionality: making the Fund's financing conditional on the achievement of specified outcomes—such as bank recapitalization, or improved tax enforcement, or foreign exchange market liberalization—rather than on the steps toward those outcomes. The main argument for this approach is that it would give the authorities greater flexibility in choosing the appropriate method of achieving agreed objectives. If the steps taken by the authorities fail to lead to the desired outcome, the program would need to be reassessed before the Fund's financing would be made available. Such a strategy would undermine the country's assurance of being able to draw on the Fund's resources, but would make the authorities responsible for adapting policies to changing circumstances to achieve the intended results. The Fund's traditional macroeconomic conditionality is already somewhere on the spectrum between actions- and results-based conditionality, as it involves intermediate targets—such as ceilings on central bank credit to government—whose outturns in practice reflect economic developments as well as the actions taken by the authorities.

20. While results-based conditionality may have greater applicability than at present, its main limitation is that many structural as well as macroeconomic results take considerable time to achieve. For instance, there are cases in which policy adjustments in a particular area are essential to program objectives, but are not likely to come to fruition until close to the end of the program or even later; in this instance, ex post conditionality would not safeguard the Fund's resources unless the Fund's financing were heavily back-loaded—which would bring it out of line with the country's financing needs.⁸ This is the motivation for basing the Fund's financing on some assessment of progress toward key policy objectives, in the context of a review.

21. This raises the issue of what guides the Fund's assessment of progress in a review. Here, there are two main models: one is to establish a series of structural benchmarks that are intended to inform the process of assessing progress at the time of a review. An alternative is a more free-form assessment, albeit based on considerations that should be discussed with the authorities ex ante. The latter approach gives the authorities greater flexibility in devising their own path toward an objective that is agreed to be essential, while also giving the Fund greater flexibility in deciding what information is relevant to its assessment of progress; its main drawback is that it gives the authorities less assurance of the conditions on which they will be able to use the Fund's resources. While recognizing this tradeoff, it is worth considering whether the current balance is the right one—or whether a more sparing use of structural benchmarks would be desirable.

22. There are two further issues in the use of structural benchmarks. First, even when an overall policy objective is critical to program objectives, there are cases in which fewer benchmarks would suffice to indicate the path that the authorities would be expected to follow: each benchmark should pertain to a policy action that, while not decisive in itself, is nonetheless a significant and representative step. Second, there is a need for greater prioritization in the areas of policy covered by structural benchmarks: conditionality should not be encumbered with structural benchmarks in cases in which the overall outcome is not critical to the program. Of course, the staff may offer useful advice in many areas (perhaps in the context of technical assistance) while eschewing any impression that the Fund's financing hinges on the authorities' acting on this advice.

23. As noted earlier, the scope of program reviews has seen substantial evolution since the 1979 Guidelines on Conditionality. It is particularly important to clarify and delineate the boundaries of these reviews. These reviews should be used for both backward- and forward-looking assessments of policies in areas that are essential to program objectives. But, there may be a need to adjust policies to achieve the objectives agreed at the start, reviews should not become an opportunity to move the goalposts. Moreover, it is important to clarify up front, to the extent possible, the areas to be covered in reviews and the basis on which policies will be assessed, otherwise reviews have the potential to be catch-all assessments of policy implementation.

24. It is also important to clarify the role of the Letter of Intent. An LOI is not a commitment to the Fund, but a statement of the policies the authorities intend to implement. In many cases, the LOI presents the full sweep of the authorities' policy program; in such cases, the Fund's financing is conditional on only some of these policies. But in many cases, there has been a blurring of the boundaries of the part of the authorities' program covered by conditionality. While in some cases this lack of clarity may have served the purposes of the authorities and the Fund staff—for instance in presenting the program to the public and the markets—it has contributed to a misleading impression that conditionality is all-encompassing. A solution would be either to limit the LOI to those policies that are being monitored by the Fund, or ensure that LOIs include a section that delineates precisely which aspects of the authorities' program actually constitute conditionality. Moreover, it may be desirable simply to end the practice of including detailed matrices of policy actions in LOIs; in most cases, the Fund's financing hinges on only a small subset of the measures in such matrices.

25. These considerations should be carried forward in revising the 1979 Conditionality Guidelines. Some elements of the Guidelines—notably the emphasis on limiting conditions to those needed to monitor policies essential to program objectives—remain appropriate although, as noted, they have not been observed. Other elements of the Guidelines—notably the circumscribed role envisaged for program reviews—should be revised to reflect the changing environment in which Fund-supported programs are framed. It is proposed that, in light of Board discussion of the present set of papers, as well as comments received from outside the institution, the staff would return with a proposal for revising the guidelines following the Spring meetings.

IV. Issues for Discussion

26. Directors may wish to focus their interventions on the following issues.

• Directors may wish to comment on the factors leading to the expansion of conditionality over the past several years, highlighting any lessons for current practice.

• Do Directors agree that the application of conditionality needs to be focused and streamlined to ensure that it is consistent with its intended purpose?

• The paper discussed two different dimensions of streamlining conditionality: curtailing the scope of policies included under conditionality, and reducing the level of detail with which such policies are characterized. With respect to limiting the scope, the basic proposal would be to focus exclusively on those policies that are critical to the main macroeconomic objectives of the program, including external sustainability and growth, rather than those that are merely relevant to those objectives. Directors may wish to comment on whether this general approach is appropriate: in particular, is the appropriate test of whether a measure be included under conditionality that it be critical to a program's macroeconomic objectives?

• In the specific case of the PRGF, close coordination with the World Bank permits an improved division of labor between the two institutions that would enable each to limit conditionality to its core areas. They may also wish to consider the circumstances under which the Fund's conditionality would nonetheless apply to measures outside the Fund's core areas of responsibility.

• How much scope do Directors see for conditionality to focus more on broad policy results rather than on the specific actions intended to achieve those results?

• Another proposal for reducing the degree of detail of conditionality to use structural benchmarks more sparingly, limiting them to important and representative steps toward critical structural objectives of a program. Directors may wish to comment on this.

• The paper notes that the role of reviews has evolved beyond that envisaged in the 1979 Guidelines, to include forward-looking assessment of macroeconomic policies, and an assessment of progress and prospects on structural and institutional reforms, especially those requiring sustained effort over a lengthy period of time. Do Directors see this evolved role as broadly appropriate? Do they believe it would be useful to specify ex ante, to the extent possible, the basis on which policy should be assessed, and to establish that reviews are not to be used to add major new objectives to the program?

• What do Directors see as the appropriate role of the Letter of Intent? The paper suggests that either the LOI should focus only on the aspects of policy covered by the Fund's conditionality or, in cases in which the authorities wish to use the LOI to lay out the broad sweep of their policy program, the LOI should make it clear which elements of this program are subject to this conditionality. Do Directors support this suggestion?

A Guide to the Conditionality Papers

27. In addition to this overview, the staff have prepared three other papers as background for the Board discussion of conditionality. The first paper is entitled Conditionality in Fund-Supported Programs—Policy Issues. It begins with a review of the principles of conditionality, including the basic purposes of conditionality, the desirable properties of any modalities for monitoring program implementation, the tools of monitoring—performance criteria, reviews, prior actions, structural benchmarks—and the relationship between conditionality and ownership. It goes on to describe the expansion of conditionality over the past decade and the reasons for this expansion. Then it discusses approaches to streamlining conditionality and enhancing ownership: narrowing the scope of structural conditionality, reducing the degree of detail, clarifying the use of tools and the boundaries of conditionality, and other steps to enhance ownership. Annexes review literature on the macroeconomic outcomes of Fund-supported programs, the effectiveness of conditionality and ownership, and various reform proposals including those that would eliminate conditionality in its present form.

28. The second paper, Structural Conditionality in Fund-Supported Programs, accounts for the expansion of structural conditionality in recent years. This paper presents factual information on conditionality drawn from the MONA database⁹ and a survey of a sample of mission teams, as well as a number of case studies. It examines the coverage of structural conditions across different areas of economic policies, and discusses the factors influencing the expansion of conditionality, including the pattern of collaboration with the World Bank and other institutions. It also examines the changes in monitoring practices, including the shift to greater use of program reviews and the proliferation of structural benchmarks and prior actions. Finally, it discusses factors influencing the implementation of structural reforms, noting that the data do not shown any significant relationship between the number of conditions in a program and the fraction of these conditions that are implemented.

29. The third paper, Trade Policy Conditionality in Fund-Supported Programs, focuses on a particular area of policy to which conditionality has been applied. It discusses first the role of trade policy in the design of Fund-supported programs, and then goes on to document the extent and focus of trade policy conditions, the way these conditions are monitored, and the experience with their implementation.

30. In addition, the Executive Board recently discussed a paper, Review of the Fund's Experience in Governance Issues, which sets out the evolution of the Fund's recent work in this area, including in the context of Fund-supported programs.