Unacceptable "strings" may be attached to a loan by a creditor which a borrowing country must accept in order to avail itself of the loan. Compliance with these conditions is required before the loan is granted and/or funds are released.
Conditionality is often associated with the IMF whose low conditionality facilities include the reserve tranche, the first credit tranche, compensatory financing facility, buffer-stock financing facility, oil facilities, and the trust fund. High conditionality loans include the upper credit tranches, extended fund facility, structural adjustment facility. Since 1980 conditionality has been extended to sectoral and macro economic policies.
The severity of the problems facing the world economy has meant that many developing countries have sought the assistance of international agencies in meeting their immediate balance-of-payments needs. This assistance has been rendered on conditional terms, and the "conditionality" attached to the lending has shaped the nature and content of the adjustment programmes adopted by the recipient countries. The common thread running through the various structural adjustment programmes is the premise that a properly functioning market-economy experiences few market failures and that existing market imperfections are mainly due to policy interventions. Removing market distortions, changing the public and private sector balance and market development are the measures proposed by the international agencies to develop the market system. This approach assumes a structural framework of highly integrated markets, with ease of resource flow from sector to sector and price flexibility. But the economic structures of developing countries are quite different and, as a result, the application of a "standard" market-oriented structural adjustment policy can produce negative results quite at variance with the desired outcome.
The main thrust of the new trend in the World Bank's policy-based lending relates to the market-oriented approach to development problems. At a general level, there is widespread agreement on the need for developing countries with mixed or market-oriented economies to ensure appropriate incentive structures to economic agents, secure adequate rates of domestic savings and productive investment and maintain appropriate levels of real exchange rates. The operational implications are, however, much less clear and there is much debate concerning the relative importance of the variables targeted under this approach, such as the role of price incentives versus the removal of non-price impediments in stimulating agricultural production; the emphasis on export promotion versus import substitution; the role of interest rates in raising the savings rate; the impact of changes in the external environment on the domestic policy framework. More controversial aspects under this approach are the respect roles of and balance between public and private sector involvement in economic activities, government policies toward foreign investment and income distribution.
Aid, especially debt relief, to developing countries may only be made available under conditions whereby the country subjects itself to the constraints of an IMF programme. The constraints tend to be such as to prevent the countries maintaining growth, where priority is given by the IMF to restore imbalances of payments at all costs, even when such imbalances are of a short-term character. Since the creditworthiness of developing countries is evaluated by the World Bank (and by commercial banks) on the basis of a country's standing with the IMF, failure to enter into such agreement deprives a country of access to other sources of finance. Issues of policy cross-conditionality associated with Bank-supported adjustment programmes include: the adequacy of the policy package itself, the timing and sequencing of the programmes, and the collaboration between the Bank and the IMF.
In addition to the character and nature of the measures themselves, issues relating to the timing and phasing of implementation may also have negative consequences. The requirement of rapid major structural reforms and balance-of-payments adjustment may be beyond the reach of most poorer countries; political and administrative systems may not be adequate to deal with the speed at which the formulation and implementation of policy changes is advocated. There are also questions relating to policy sustainability: rigid policies phased over an insufficient time period enhance the potential for slippage.
A further specific issue is that of interdependent cross-conditionality, a situation where both the Bank and the Fund select the same policy instrument (eg the exchange rate) as the key element in their respective programmes. Developing countries seeking financial assistance are then exposed to concerted pressure and suffer from negative consequences of inter-agency cooperation.
The expansion of the World Bank's policy-based lending and the establishment of the IMF's Structural Adjustment Facility has led to a more intensive collaboration between the two institutions and the division of labour between them is no longer clear-cut. Although formal cross-conditionality does not occur between the Bretton Woods institutions, informal cross-conditionality arises in a number of cases, especially through the linkage between World Bank policy-based lending and IMF standby arrangements. In fact only three of all the World Bank sector loans approved from 1979 through 1985 occurred in countries where an IMF stabilization programme was not in place. The IMF compensatory financing facility was redesigned in 1982 from a more liberal low-conditionality form to a high-conditionality form.
Where IMF adjustment programmes involve the cutting back of production and income, sacrificing growth, this is not due to any IMF predisposition to favour the adoption of deflationary measures but rather to limitations on the external resources available to the countries concerned.