Conventional models of foreign aid and macroeconomic support, in which creditors typically demand policy reforms in return for providing financing, are widely criticized as outdated and inequitable. ‘Conditionality’ will remain relevant, but the system must become more cooperative, locally focused and pragmatic.
Introduction
Financial crisis has shaped international financial architecture throughout the modern era, from the 1944 Bretton Woods conference to the 2009 G20 summit and on to the present day. The world’s leading economies have sought global institutions to support financial stability, preserve access to markets, and encourage not only prosperity but convergence between countries at different levels of development. Each of these goals supports the others: as developing economies catch up with their more developed peers, in theory a more stable world economy should emerge and systemic threats should be reduced.
This synergy only works if all stakeholders follow through on their commitments. Too often prospective development projects and stability initiatives are stymied by onerous ‘conditionality’ (in the policy jargon), exacerbated by some combination of micromanagement from creditors and inadequate compliance on the part of funding recipients. A better approach would be to set more modest but achievable parameters from the outset, encouraging local political ‘ownership’ of agreed policy conditions and thus creating the best chances of success. Conditionality only succeeds if the conditions are right.
There is no shortage of need. The G7 countries have estimated that funding for infrastructure in developing regions is more than $40 trillion short of what is required. In July 2022 the Bridgetown Initiative, a high-level forum co-hosted by UN Deputy Secretary-General Amina Mohammed, called on the World Bank and regional development banks to increase lending by $1 trillion per year by 2025 and to mobilize $3 trillion per year in private capital as well. Macroeconomic stability also continues to require global action, as loss of market access can be devastating to countries at all levels of development. Current global economic pressures, including high inflation and rising concerns about debt sustainability in the developing world, increase the need for international organizations that can offer financial support.
Providing that support has fallen traditionally to the International Monetary Fund (IMF) and the World Bank, which formed the post-war vanguard of global economic cooperation under the Bretton Woods agreements. They have been joined by regional institutions such as the European Stability Mechanism and the Asian Infrastructure Investment Bank (AIIB), among many other donors and lenders. While all these institutions typically offer loans and economic oversight, their missions vary considerably: some focus on monetary stability and financial surveillance; others on how to channel public investment to, and encourage development in, countries where the private sector is unwilling or unable to act alone. But almost all such institutions bring conditions and monitoring along with outside funding.
Too often, conditionality is associated with downsides that range from operational inefficiency to political interference, especially when conditions are poorly designed and excessively applied.
At best, these requirements introduce useful guiding frameworks and safeguards to ensure recipient countries make the most of the money disbursed. Too often, however, conditionality is associated with downsides that range from operational inefficiency to political interference, especially when conditions are poorly designed and excessively applied. The overall effect, in recipient countries, can be more one of reducing political ownership of economic reform and development than of preventing moral hazard. The enduring challenge is how to streamline and improve conditionality to increase the chances that funding will be used effectively, without abandoning the core principles of transparency and accountability demanded by investors, donors and creditors.
The need for reform
The IMF and World Bank have not done a good enough job of preventing economic and financial crises around the world, or of following through on internal structural reforms to democratize their own governance and render themselves more responsive to, and reflective of, the contemporary global economic order. In turn, evolving recipient-country needs and widespread dissatisfaction with the Bretton Woods architecture have increased demand for alternative sources of financing, contributing to an increasingly crowded field of more than 40 development banks and international financial institutions. The implications of this trend are uncertain. On the one hand, the growing number of players offers opportunity for swifter and more agile responses to new developments and crises. On the other, overlapping membership and growing bureaucracy suggest inefficiency and wasted resources may be inevitable.
IMF conditions have long been criticized as unworkable, despite their theoretical appeal as a means of optimizing programme performance. While it might seem as if spelling out detailed policy goals should lead to success, history tells a different story. As Axel Dreher, an academic, wrote in 2009 after an extensive survey of research on IMF conditionality: ‘There is no empirical evidence showing that conditions enhance ownership or make program success more likely.’ Dreher further argues that the IMF should not be involved in development aid, and that its market access programmes would do better if countries were subject to ex ante conditions – mandates to strengthen their economic resilience during normal times – as opposed to facing procyclical ex post requirements during and immediately after a crisis period. Instead of eliminating moral hazard as intended, conditionality has prevented full distribution of funding and has made it harder to complete projects. A detailed programme that will never be carried out as planned is unlikely to lead to good outcomes.
Conditionality debates are not purely a one-way conversation in which richer countries – or international organizations dominated by them – dictate policy to the developing world. Sometimes conditionality debates happen even within the developed world. The EU, for example, has been both an aid provider and an aid recipient in recent years. Its policymakers continue to argue that aid money – for disbursement both within the EU and outside it – should come with strings attached, while ignoring lessons from past crises in terms of which conditions are most likely to work. This mistake hurts the effectiveness of new and ongoing programmes, while also making development relationships more combative than collaborative. Mutual accountability is essential.
Lessons from China, Africa and the EU
To see how conditionality fits in with development and economic assistance goals, it is useful to review the shifting landscape of aid providers and the politics of how such aid is provided. If detailed conditions worked as well as their supporters claimed, one would expect their use to be fairly consistent across the board. Instead, evidence finds that the presence of conditions is linked more to the politics of who is lending or donating, rather than the likely project outcome.
The global order of today brings into play a wide range of stakeholders and strategic considerations that potentially shape funder–recipient relationships. China, in particular, stands out for its emergence as an increasingly active provider of development aid – even as it remains a recipient of unsubsidized World Bank development loans itself.
China’s presence in this sector is arguably rendering conditionality, at least in the traditional sense understood by the ‘Washington consensus’, less central. A 2017 study found that for 54 African countries receiving assistance between 1980 and 2013, every percentage point increase in Chinese aid resulted in 15 per cent fewer World Bank conditions, with lesser effects observed during part of that time for aid from Kuwait and the United Arab Emirates. Yet aid from the developed world, as represented in the OECD’s Development Assistance Committee, is associated with increased requirements. This suggests that some official creditors may be piling on conditions in part for political reasons, rather than wholly based on economic fundamentals, given that China’s emergence as an alternate source of funds seems to be enough to lead to a noticeable drop in strings attached.
China stands out for its emergence as an increasingly active provider of development aid – even as it remains a recipient of unsubsidized World Bank development loans itself.
The EU’s experience during its internal debt crisis in the 2010s is instructive in this respect. The evidence shows that policy conditions, and the accompanying stigma that came with their enforcement, repeatedly undercut efforts to restore financial stability. An academic study by Wade Jacoby and Jonathan Hopkin indicates that conditionality took on outsized political influence during the euro crisis, while having only a marginal effect on outcomes.
In playing up the perception of moral hazard if aid-receiving euro members were granted more economic policy autonomy, European policymakers appear to have been unaware of the poor track record of conditionality around the world. Instead, they were swayed by the one-off success of earlier conditions imposed on candidate countries during the process of accession to the EU itself. Policymakers also appear not to have realized that conditionality in relation to EU enlargement may have succeeded in the first instance because the reform milestones for accession to the EU were so concrete, in contrast with the vaguer and broader goals of the macroeconomic assistance programmes. As Jacoby and Hopkin put it, ‘happy economic outcomes are not the EU’s to bestow’.
In hindsight, Europe moved too conservatively to help Greece when the country first lost its ability to borrow in public markets in early 2010, resulting in financial contagion across the euro area. The inadequacy of Greece’s first bailout, followed by overly aggressive pursuit of the many conditions attached to a second rescue package, forced the country to seek an unprecedented third round of economic aid in 2015 as political tensions pushed the euro area to the brink of fragmentation. The debate haunts the euro area still, and investors have not recovered full confidence in the monetary union, where every attempt to strengthen the euro’s basic architecture is laden with moralistic debates about preventing aid from flowing to the ‘undeserving’.
The irony is that at times of risk, the EU’s detailed budget conditions have frequently and successfully been suspended. For example, the EU’s annual budget process has regularly been set aside when enforcement of its longer-term goals has clashed with more urgent economic needs. As a result, countries such as Italy, France and even Germany have avoided censure when in breach of EU fiscal rules. Policy during the COVID-19 pandemic also provided an exception to strict enforcement of the normal protocols. As Mia Mottley, the prime minister of Barbados, said in September 2022, there is a perception in the developing world that ‘the countries which bear the responsibility for the real problems in global financial services, appear to be exempt from rules and scrutiny to which developing countries are subjected’.
Calls now to restore full compliance with the EU’s fiscal rules have at times seemed more driven by ideology than practicality. Yet despite the global and Europe-specific evidence that conditions do not work very well and are not always aligned with participants’ strategic interests, countries such as Germany with a history of supporting fiscal discipline are once again renewing calls for recipients of assistance to accept greater macroeconomic and fiscal discipline, ostensibly as a means of risk mitigation.
A changing global landscape, and new coordination challenges
The Bretton Woods system itself has been responding to a changing world order. The World Bank has continually revisited its own conditionality framework and attempted to adjust to evolving external circumstances. A quantitative text analysis of the bank’s contracts shows that its loan conditions have changed substantially over time – this finding contrasts with outside criticisms that the bank is prone to institutional inertia and susceptible to political influence. The study finds that requirements appear to change based on bank policy, rather than in response to country-specific developments, and are applied in fairly uniform fashion. This suggests that the World Bank is doing a good job of coordinating its internal policies but could do more to adapt its lending to local conditions and expertise.
With the world economy slowing in 2023, emerging markets may have renewed trouble repaying their existing obligations, especially when borrowing in currencies that are not their own. The G20 group of major economies (an economic forum that includes China) and the Paris Club of creditors (which does not) agreed in 2020 on a Debt Service Suspension Initiative, followed by a common framework for debt restructuring for the lowest-income countries that are part of these efforts. Yet these international programmes do not address the quandary of bilateral development loans from China, which is now the largest creditor to some emerging market countries. Such loans are opaque and full of ‘hidden’ default events. Finding ways to restructure these obligations may prove as central to boosting development as finding funding for new projects.
There is also the issue of ensuring the international coherence of assistance relationships, to avoid unwarranted overlap between agendas. The G7 has pledged to improve cooperation on global development finance while managing ‘strategic competition’ with China, as Beijing is tackling similar infrastructure needs via the Belt and Road Initiative (BRI), launched in 2013. China is now working with more than 70 countries in Africa, Europe and Asia on infrastructure and other development projects, and is widely considered to be using the BRI as a mechanism to provide strategic direction as well as financial support. It remains to be seen whether Chinese and other global efforts will work in parallel, in competition or at cross purposes, particularly given the more crowded landscape of international financial institutions.
A more multipolar global economy offers the chance to rebalance the power dynamic between the creditor-country old guard and the developing world. Ngaire Woods, an academic, makes the case that emerging markets are changing the rules of the game without a rush to lower standards and weaken policies. Instead, the presence of newer actors has exposed weaknesses in the old system, and reinforced the argument that donors are most successful when they work collaboratively with other actors.
The debate over the new AIIB, headquartered in Beijing, has added to the salience of these questions. More than 100 countries, including many in Europe, have joined the AIIB since it opened in 2016, but the US and Japan have remained outside its framework and have tried – unsuccessfully – to discourage other Western countries from participating. Some commentators have suggested that the US should drop its reluctance and sign on to the AIIB, but the US continues to keep apart due to a combination of political concern and economic self-interest. To the extent that development aid is a strategic lever as well as an instrument of economic growth and climate investment, these competing considerations limit each other.
Most recently, the conflict in Ukraine, following Russia’s full-scale invasion in early 2022, has caused donors to rethink their strategic and financial priorities. The conflict has exacerbated political fragmentation and cut into development funds available for other uses or recipients. As noted in a June 2022 Chatham House research paper, this has been one of the major factors holding back the G7’s ‘Build Back Better’ partnership in the year after the initiative was put forward (it has subsequently been rebranded, in effect, as the Partnership for Global Infrastructure and Investment). Yet ignoring the needs of lower-income countries will exacerbate the challenges facing the G7 itself, so its members cannot afford to neglect stability and prosperity in the developing world. Donors will need to establish ‘genuine and equitable partnerships’ with recipients, taking advantage of local knowledge and experience so that the multilateral system can work to best effect.
A more collaborative model?
Encouraging local ownership of, and responsibility for, development programmes could have the double benefit of improving outcomes and reducing tension over whether Washington or Beijing may be exercising outsized influence on recipient countries. If such countries feel they have more control, their governments are more likely to find the necessary political will to follow through on promises and comply with programme conditionality. Developing countries also should seek, and be offered, more incentives to work in ways that complement the economic interests of the world’s richest economies, rather than seeing developed-world considerations such as climate change mitigation as an obstacle to their economic goals.
Global economic recovery in the aftermath of the pandemic will require sustained and effective action to build infrastructure and make the transition to climate-friendly technologies. Ricardo Hausmann, a former Venezuelan planning minister turned Harvard academic, says decarbonization efforts ‘will transform global production and trade patterns so radically that new growth opportunities are bound to arise for savvy countries of the Global South’. These countries have an opportunity to carve out a role for themselves and access funding accordingly.
Encouraging local ownership of, and responsibility for, development programmes could have the double benefit of improving outcomes and reducing tension over whether Washington or Beijing may be exercising outsized influence on recipient countries.
To sum up, the Bretton Woods institutions and development banks need an environment of mutual accountability in which to fulfil their missions. This will require their conditions for financing to be fit for purpose. Recipient countries will need to take political responsibility for programme success early on, to help design agendas that advance their own economic development and have realistic targets. Creditor countries and organizations will need to resist the temptation to grandstand in the name of fiscal discipline or combating climate change. In particular, funding providers should resist the urge to invoke moral hazard as a way of justifying parsimony and control. Instead, all stakeholders should cooperate on setting more mundane conditions that can be fully implemented, to give development programmes the best chance of success.
The goal should be a framework that is adaptable, streamlined, and takes account of the ways in which geopolitical and economic power imbalances affect policy. International financial institutions must now adapt to shifts in the global financial system to reconsider which of their conditions remain necessary and which can be set aside.
