Transcript The Natural Resource Curse I: Pitfalls of Commodity Wealth Jeffrey Frankel Harpel Professor of Capital Formation & Growth Harvard University Low-Income Countries Seminar International Monetary Fund,

The Natural Resource Curse I:
Pitfalls of Commodity Wealth
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
Harvard University
Low-Income Countries Seminar
International Monetary Fund, April 26, 2011
The Natural Resource Curse

The NRC pertains especially to oil & minerals,
but sometimes to agricultural products, logging & fishing too.


Seminal references:

Auty

Sachs & Warner
(1990, 2001, 07, 09)
(1995, 2001)
Frankel, “The Natural Resource Curse: Survey,”


NBER Working Paper 15836, 2010.
forthcoming in Export Perils,

edited by B.Shaffer (U. of Pennsylvania Press: 2011)
2
Examples
 Conspicuously high in oil resources
and low in growth:
Venezuela & Gabon.


Conspicuously high in growth
and low in natural resources:
China & other Asian countries.
The overall relationship
on average is slightly negative:
3
Growth falls with fuel & mineral exports
4
Are natural resources necessarily bad?
No, of course not.


Commodity wealth need not necessarily lead
to inferior economic or political development.
Rather, it is a double-edged sword,
with both benefits and dangers.


It can be used for ill as easily as for good.
The priority for any country should be on
identifying ways to sidestep the pitfalls
that have afflicted other mineral producers
in the past, to find the path of success.
5


The goal is to enjoy the success of
 Chile, vs. Bolivia

Botswana,

Norway,
vs. Congo
vs. Sudan.
The last section of my paper
explores policies & institutional
innovations that might help avoid
the natural resource curse and achieve
natural resource blessings instead.
6



How could abundance
of commodity wealth be a curse?
What is the mechanism
for this counter-intuitive relationship?
At least 7 channels
have been suggested:
7
7 Possible Natural Resource Curse Channels
1.
2.
3.
4.
5.
6.
7.
Price trend
Price volatility
Crowding-out of manufacturing
Inhibited development of institutions
Unsustainably rapid depletion
Proclivity for armed conflict
Procyclical macro policy
8
The 7 NRC Channels Elaborated
1.
2.
3.
World commodity price trend
could be downward (Prebisch-Singer);
High volatility of commodity prices
could be problematic ;
Natural resources
could be dead-end sectors (Matsuyama):
they may crowd out manufacturing,
which may be home to dynamic benefits & spillovers.
9
The 7 NRC Channels
continued
4. Countries where physical command
natural resources by the government
or a hereditary elite automatically confers
wealth on the holders may be less likely
to develop the institutions that are
conducive to economic development
(Engerman-Sokoloff …),


e.g., rule of law & decentralization of decision-making,
as compared to countries where moderate taxation
of a thriving market economy is the only way
to finance government.
10
The 7 NRC Channels
continued
5. Non-renewable resources are depleted too fast,
where it is difficult to enforce property rights,
as under frontier conditions.
6. Countries that are endowed with minerals
may have a proclivity for armed conflict,
which is inimical to economic growth.
7. Procyclical macroeconomic policy can
exacerbate effects of swings in commodity prices
e.g., the Dutch Disease, via spending & the real exchange rate.
11
(7) Procyclicality

Developing countries have historically
been prone to procyclicality:




Especially procyclical government spending
“Procyclical” = destabilizing.
particularly among commodity producers.
The Dutch Disease describes unwanted sideeffects from a strong, but perhaps temporary,
rise in the export commodity’s world price. 12
Volatility in developing countries

arises both from foreign shocks,


including export commodity price fluctuations,
and from domestic shocks

including macroeconomic & political instability.
13


Most developing countries in the 1990s
brought chronic runaway budget deficits,
money creation, & inflation, under control,
but many still show monetary & fiscal policy
that is procyclical rather than countercyclical:



They tend to expand in booms
and contract in recessions,
thereby exacerbating the magnitudes of swings.
14
The procyclicality of fiscal policy
Many authors have shown that fiscal policy
tends to be procyclical in developing countries,



especially in comparison with industrialized countries. [1]
A reason for procyclical public spending:
receipts from taxes or royalties rise in booms;
The government cannot resist the temptation or political
pressure to increase spending proportionately, or more.
[1] Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart, & Vegh (2004),
Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006),
Ilzetski & Vegh (2008), Medas & Zakharova (2009) and Gavin & Perotti (1997).
15
The procyclicality of fiscal policy, cont.

Procyclicality is especially pronounced in countries
where income from natural resources tends
to dominate the business cycle.


Cuddington (1989) and Sinnott (2009)
An important development -some developing countries, including commodity producers,
were able to break the historic pattern in the most recent cycle:



taking advantage of the boom of 2002-2008
 to run budget surpluses & build reserves,
thereby earning the ability to expand fiscally in the 2008-09 crisis.
Chile is the outstanding model.
16
(i) Public investment projects

Two large budget items account for much
of the increased spending from oil booms:



(i) investment projects and
(ii) the government wage bill.
Regarding the 1st budget item, investment
in infrastructure can have big long-term pay-off
if it is well designed; too often in practice, however,
it takes the form of white elephant projects,
which are stranded without funds for completion
or maintenance when the oil price goes back down.

Gelb (1986) .
17
(ii) Public sector wage bills




Regarding the 2nd budget item,
oil windfalls have often been spent on higher
public sector wages -- Medas & Zakharova (2009).
They can also go to increasing the number
of workers employed by the government.
Either way, they raise the total public sector
wage bill, which is hard to reverse when oil
prices go back down.
Figures 2 & 3 plot the public sector wage bill,
for two oil producers, Iran & Indonesia.
18
Iran’s Government Wage Bill Is Influenced
by Oil Prices Over Preceding 3 Years (1974, 1977-1997.)
IRN
Wage Expenditure as % of GDP
16.52
7.4
11.46
59.88
Real Oil Prices lagged by 3 year, in Today's Dollars
Source: Frankel (2005b)
19
Indonesia’s Government Wage Bill Is Influenced
by Oil Prices Over Preceding 3 Years (1974, 1977-1997.)
IND
Wage Expenditure as % of GDP
3.52
1.77
11.46
59.88
Real Oil Prices lagged by 3 year, in Today's Dollars
Source: Frankel (2005b)
20
Public sector wage bills,



cont.
There is a clear positive relationship.
That the relationship is strong with a 3-year lag
shows the problem: oil prices may have fallen
over 3 years, but public sector wages cannot
easily be cut nor workers laid off.
Arezki & Ismail (2010) find that current
government spending increases in boom times,
but is downward-sticky.
21
The Dutch Disease:
5 side-effects of a commodity boom

1) A real appreciation in the currency

2) A rise in government spending

3) A rise in nontraded goods prices

4) A resultant shift of resources out of
non-export-commodity traded goods

5) Sometimes a current account deficit
22
The Dutch Disease: The 5 effects elaborated
 1)

A real appreciation in the currency
taking the form of nominal currency appreciation
if the exchange rate floats

e.g., floating-rate oil exporters


or the form of money inflows & inflation
if the exchange rate is fixed [1] ;

 2)

Kazakhstan, Mexico, Norway, & Russia.
e.g. fixed-rate oil-exporters, the UAE & Saudi Arabia.
A rise in government spending
in response to increased availability
of tax receipts or royalties.
23
The Dutch Disease:
5 side-effects of a commodity boom

3) An increase in nontraded goods prices
(goods & services such as housing that are not internationally traded),


relative to traded goods
(manufactures & other
internationally traded goods other than the export commodity).
4) A resultant shift of resources out of
non-export-commodity traded goods

pulled by the more attractive returns
in the export commodity and in non-traded goods.
24
The Dutch Disease: 5 side-effects of a commodity boom
 5) A current account deficit
 thereby incurring international debt that may be
difficult to service when the boom ends [2].




Most developing countries avoided it in 2003-10.
[2] Manzano & Rigobon (2008): the negative Sachs-Warner effect of
resource dependence on growth rates during 1970-1990 was mediated
through international debt incurred when commodity prices were high.
Arezki & Brückner (2010a): commodity price booms lead to increased
government spending, external debt & default risk in autocracies.
Arezki & Brückner (2010b): the dichotomy extends also to effects on
sovereign spreads paid by autocratic vs democratic commodity producers.
25
The Natural Resource Curse should not
be interpreted as a rule that resourcerich countries are doomed to failure.



The question is what policies to adopt
to improve the chances of prosperity.
Destruction or renunciation of resource endowments,
to avoid dangers such as the corruption of leaders,
will not be one of these policies.
The survey concludes with ideas
for policies/institutions designed to address
aspects of the resource curse and thereby
increase the chance of economic success.
26
27
Appendices:
1) The other possible
NRC channels in detail
2) Skeptics of the NRC
28
Appendix 1: The possible
NRC channels in detail
(1) The claim of a negative trend
in commodity prices on world
markets was already dealt with:
the data do not suggest a robust
long-term trend, certainly not a
negative one if updated to 2010.
29
(1) Long-term world price trend

(i) Determination of the price on world markets

(ii) The old “structuralist school” (Prebisch-Singer):

The hypothesis of a declining commodity price trend
(iii) Hypotheses of a rising price trend



Hotelling
Malthus
(iv) Empirical evidence


Statistical time series studies
30
(i) The determination of the
export price on world markets
Developing countries tend to be smaller
economically than major industrialized
countries, and more likely to specialize in the
exports of basic commodities.

As a result, they are more likely to fit
the “small open economy” model:



they can be regarded as price-takers,
That is, the prices of their export goods are
generally taken as given on world markets.
31
(ii) The old “structuralist school”
Raul Prebisch
(1950)
& Hans Singer
(1950)
The hypothesis: a declining long run trend
in prices of mineral & agricultural products


relative to the prices of manufactured goods.
The theoretical reasoning:
world demand for primary products is inelastic
with respect to world income.


That is, for every 1 % increase in income,
raw materials demand rises by less than 1%.
Engel’s Law, an (older) proposition:
households spend a lower fraction of their income
on basic necessities as they get richer.
Demand
=> P oil


32
(iii) Hypotheses of rising trends
Hotelling on depletable resources;
Malthus on geometric population growth.

Persuasive theoretical arguments
that we should expect oil prices to show
an upward trend in the long run.
33
Assumptions for Hotelling model

(1) Non-perishable non-renewable resources:


Deposits in the earth’s crust are fixed in total supply
and are gradually being depleted.
(2) Secure property rights:
Whoever currently has claim to the resource
can be confident that it will retain possession,

unless it sells to someone else,



who then has equally safe property rights.
This assumption excludes cases where warlords
compete over physical possession of the resource.
It also excludes cases where private mining companies
fear that their contracts might be abrogated
or their holdings nationalized.
34
One more assumption,
to keep the Hotelling model simple:

(3) The fixed deposits are easily accessible:



the costs of exploration & extraction
are small compared to the value of the mineral.
Hotelling (1931) deduced from these
assumptions the theoretical principle:
the price of oil in the long run should rise
at a rate equal to the interest rate.
35
The Hotelling logic:

The owner chooses how much mineral to extract


Whatever is mined can be sold at today’s price
(price-taker assumption)



and how much to leave in the ground.
and the proceeds invested in bank deposits
or US Treasury bills, which earn the current interest rate.
If the value of the commodity in the ground is not
expected to rise in the future, then the owner has
an incentive to extract more of it today,
so that he earns interest on the proceeds.
36
The Hotelling logic,

As minng companies worldwide react in this way,
they drive down the price today,




continued:
below its perceived long-run level.
When the current price is below its long-run level,
companies will expect the price to rise in the future.
Only when the expectation of future appreciation
is sufficient to offset the interest rate will the
commodity market be in equilibrium.
Only then will mining companies be
close to indifferent between extracting
at a faster rate and a slower rate.
37
The complication: supply is not fixed.




True, at any point in time there is a certain
stock of reserves that have been discovered.
But the historical pattern has long been that,
as that stock is depleted, new reserves are found.
When the price goes up, it makes exploration &
development profitable for deposits farther
under the surface.
…especially as new technologies are
developed for exploration & extraction.
38
What is the overall statistical trend
in commodity prices in the long run?

Some authors find a slight upward trend,

some a slight downward trend.

The answer seems to depend, more than anything
else, on the date of the end of the sample:



[1]
Studies written after the 1970s boom found an upward trend,
but those written after the 1980s found a downward trend,
even when both went back to the early 20th century.
[1] Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington & Urzua
(1989), Grilli & Yang (1988), Pindyck (1999), Hadass & Williamson (2003), Reinhart
& Wickham (1994), Kellard & Wohar (2005), Balagtas & Holt (2009) and Harvey,
Kellard, Madsen & Wohar (2010).
39
(2) Effects of Volatility
Is volatility per se bad for economic growth?
Cyclical shifts of resources back & forth across
sectors may incur needless transaction costs.


A diversified country may indeed be better
than one 100% specialized in minerals.

On the other hand, the private sector dislikes risk
as much as the government does,
and will take steps to mitigate it;


thus one must think where the market failure
lies before assuming that a policy of deliberate
diversification is necessarily justified.
40
Effects of volatility, continued


Policy-makers may not be better than individual
private agents at discerning whether
a commodity boom is temporary or not.
But the government cannot
ignore the issue of volatility:


When it comes to exchange rate or fiscal policy,
governments must necessarily make judgments
about the likely permanence of shocks.
More on medium-term cycles
when we get to the Dutch Disease
41
(3) Do natural resources
crowd out manufacturing?


Matsuyama (1992) provided
an influential model:
the manufacturing sector is assumed to be
characterized by learning by doing, while the
primary sector (agriculture, in his paper) is not.


Also van Wijnbergen (1984) and Gylfason, Herbertsson & Zoega (1999).
The implication:


deliberate policy-induced diversification out of
primary products into manufacturing is justified, and
a permanent commodity boom that crowds out
manufacturing can indeed be harmful.
42
Counterarguments


There is no reason why learning by doing
should occur only in manufacturing tradables.
Nontradable sectors can enjoy learning by doing.


E.g., construction…
The mineral sector can as well.


The USA is one example of a country that has enjoyed
big productivity growth in commodity sectors.
Productivity gains have been aided
by American public investment,



[1]
since the late 19th century, in such knowledge infrastructure
institutions as the U.S. Geological Survey, School of Mines, and
Land-Grant Colleges. [2]
[1] Torvik (2001) and Matsen & Torvik (2005).
[2] Wright & Czelusta (2003, p.6, 25; 18-21).
43
Counterarguments, continued



Public investment in knowledge infrastructure
≠ government subsidy or ownership
of the resources themselves.
In Latin America, e.g., public monopoly ownership
and prohibition on importing foreign expertise or
capital has often stunted development of the
mineral sector, whereas privatization has set it free.
Attempts by governments to force linkages
between the mineral sector and processing
industries have often failed.
44
(4) Institutions
Recent thinking in economic development:


The quality of institutions is the deep
fundamental factor that determines which
countries experience good performance. [1]
It is futile (e.g., for the IMF & World Bank)
to recommend good macroeconomic or
microeconomic policies if the institutional
structure is not there to support them.
[1] Barro (1991) and North (1994).
45
What are weak institutions?

A typical list:







inequality,
corruption,
insecure property rights,
intermittent dictatorship,
ineffective judiciary branch, and
lack of any constraints to prevent elites
& politicians from plundering the country.
“Quality of institutions” has been quantified by World Bank,
Freedom House, Transparency International, and others.



Rodrik, Subramanian & Trebbi (2003) use a rule of law indicator and protection of property rights
(taken from Kaufmann, Kraay & Zoido-Lobaton, 2002).
Acemoglu, Johnson, & Robinson (2001) use a measure of expropriation risk to investors.
Acemoglu, Johnson, Robinson, & Thaicharoen (2003) use the extent of constraints on the executive.
46
Institutions can be endogenous:

the result of economic growth rather than the cause.


The same problem is encountered with other proposed
fundamental determinants of growth,
e.g., openness to trade and freedom from tropical diseases.
Many institutions tend to evolve endogenously,
in response to the level of income,


such as the structure of financial markets,
mechanisms of income redistribution & social safety nets,
tax systems, and intellectual property rules…
47
Addressing endogeneity of
institutions statistically



Econometricians address the problem of endogeneity
by means of the technique of instrumental variables.
What is a good instrumental variable
for institutions, an exogenous determinant?
Acemoglu, Johnson & Robinson (2001) introduced
the mortality rates of colonial settlers.



The theory is that, out of all the lands that Europeans colonized,
only those where Europeans actually settled were given good
European institutions.
Acemoglu et al figured that initial settler mortality
determined whether Europeans settled in large numbers.[1]
[1] Glaeser, et al, (2004) argue against the settler variable.
Hall & Jones (1999) consider latitude and the speaking of English
or other European languages as proxies for European institutions.
48
Institutions: Econometric findings

The finding is the same, regardless of IV:





Geography and history matter
mainly as determinants of institutions;


“Institutions trump everything else” – Rodrik et al (2002)
Acemoglu et al (2002)
Easterly & Levine (2002)
Hall & Jones (1999)
which is not to say that institutions don’t
also have other important determinants.
In any case, institutions are important.
49
The “rent cycling theory”
as enunciated by Auty



(1990, 2001, 07, 09)
:
Economic growth requires recycling rents
via markets rather than via patronage.
In oil countries the rents elicit
a political contest to capture ownership,
whereas in low-rent countries the government
must motivate people to create wealth,

e.g., by pursuing comparative advantage,
promoting equality, & fostering civil society.
50
A related view by economic historians
Engerman & Sokoloff

Why did industrialization take place in North America,





(1997, 2000, 2002)
not Latin America?
Lands endowed with extractive industries & plantation crops
developed slavery, inequality, dictatorship, and state control,
whereas those climates suited to fishing & small farms
developed institutions of individualism, democracy,
egalitarianism, and capitalism.
When the Industrial Revolution came, the latter areas
were well-suited to make the most of it.
Those that had specialized in extractive industries were not,

because society had come to depend on class structure & authoritarianism,
rather than on individual incentive and decentralized decision-making.
51
The theory is thought to fit Middle Eastern oil exporters
well.
E.g., Iran. Mahdavi (1970), Skocpol (1982, p. 269), and Smith (2007).
Econometric findings that
“point-source resources”
such as oil and minerals
lead to poor institutions





Isham, Woolcock, Pritchett, & Busby
Sala-I-Martin & Subramanian (2003)
Bulte, Damania & Deacon (2005)
Mehlum, Moene & Torvik (2006)
Arezki & Brückner (2009).
(2005)
52
Which comes first,
minerals or institutions?


Some question the assumption that mineral
discoveries are exogenous and institutions
endogenous.
Mineral wealth is not necessarily the cause
and institutions the effect,
rather than the other way around.

Norman (2009): the discovery & development of oil
is not purely exogenous, but rather is endogenous
with respect to the efficiency of the economy.
53
The important determinant is whether
the country already has good institutions
at the time that minerals are discovered,
in which case it is put to use for the national welfare,
instead of the welfare of an elite, on average.






Mehlum, Moene & Torvik (2006),
Robinson, Torvik & Verdier (2006),
McSherry (2006),
Smith (2007) and
Collier & Goderis (2007).
Luong & Weinthal (2010), in a study of
the 5 oil-producing former Soviet republics:
the choice of ownership structure makes the difference
as to whether oil turns out a blessing rather than a curse.
54
The combination of
development + weak institutions + oil


Bhattacharyya & Hodler (2009) find that natural
resource rents lead to corruption, but only in the
absence of high-quality democratic institutions.
Collier & Hoeffler (2009) find that when
developing countries have democracies, as
opposed to advanced countries, they tend to
feature weak checks and balances;

thus, when developing countries also have high natural
resource rents the result is bad for economic growth.
(5) Unsustainably rapid depletion

What happens when depletable
natural resources are indeed depleted?

This question is important for 3 reasons:

Protection of environmental quality.

A motivation for the strategy of economic diversification.

A motivation for the “Hartwick rule”:


Rents from exhaustible natural resources should be invested
in other assets, so that future generations do not suffer
a loss in total wealth (natural resource + reproducible capital)
and therefore in the flow of consumption.
Hartwick (1977) and Solow (1986).
56
Rapid depletion,

Each of these problems would be much less severe
if full assignment of property rights were possible,


thereby giving the owners adequate incentive
to conserve the resource in question.
But often this is not possible,




continued
either physically
or politically.
Especially in a frontier situation.
The difficulty in enforcing property rights over
some non-renewable resources constitutes a
category of natural resource curse of its own.
57
Unenforceable property rights
over depletable resources

Some natural resources do not lend themselves
to property rights, whether the government
wants to apply them or not.



Very different from the theory that the physical possession of pointsource mineral wealth undermines the motivation for the government
to establish a regime of property rights for the rest of the economy.
Overfishing, overgrazing, & over-use of water are
classic examples of the “tragedy of the commons”
that applies to “open access” resources.
Individual fisherman or farmers have no incentive to
restrain themselves, while the fisheries or pastureland
or water aquifers are collectively depleted.
58
Unenforceable property rights,


continued
The difficulty in imposing property rights
is particularly severe
when the resource is
dispersed over a wide
area, as timberland.
But even the classic point-source resource, oil,
can suffer the problem, especially when wells
drilled from different
plots of land hit the same
underground deposit.
59
Unenforceable property rights,

continued
This market failure can invalidate some
standard neoclassical economic theorems
in the case of open access resources.

The resource will be depleted more rapidly than the
optimization of the Hotelling calculation calls for. [1]

The benefits of free trade may be another casualty:
If exports exacerbate
the excess rate of exploitation,
 the country might be better worse off.

[1] E.g., Dasgupta & Heal
(1985).
[2]
[2] Brander & Taylor (1997).
60
(6) War


Where a valuable resource such as oil or diamonds
is there for the taking, factions will likely fight over it.
Oil & minerals are correlated with civil war.

Collier & Hoeffler (2004), Collier (2007),
Fearon & Laitin (2003) and Humphreys (2005).

Chronic conflict in such oil-rich countries as Angola
& Sudan comes to mind.

Civil war is, in turn, very bad
for economic development.
61
Summary: Channels of the NRC

(1) Commodity price volatility is high, imposing risk & costs.

(2) Specialization can crowd out the manufacturing sector.

(3) Depletion can be unsustainably rapid,

especially if property rights are not adequately protected.

(4) Mineral riches can lead to civil war.

(5) Mineral endowments can lead to poor institutions,

(6) The Dutch Disease.
such as corruption, inequality, class structure, chronic power
struggles, and absence of rule of law and property rights.
A commodity boom:
=> real currency appreciation and increased government spending,
=> which expand nontraded sector and render uncompetitive noncommodity export sectors such as manufactures.
62
Appendix 2: Skeptics argue that
commodity exports are endogenous.


On the one hand, basic trade theory says:
A country may show a high mineral share in exports,
not necessarily because it has a higher endowment of
minerals than others (absolute advantage)
but because it does not have the ability to export
manufactures (comparative advantage).
This could explain negative statistical correlations
between mineral exports and economic development,


[1]
invalidating the common inference that minerals are bad for growth.
[1] Maloney
(2002) and
Wright & Czelusta
(2003, 04, 06).
63
Commodity exports are endogenous,


On the other hand, skeptics also have plenty
of examples where successful institutions and
industrialization went hand in hand with rapid
development of mineral resources.
Countries that were able to develop efficiently
their resource endowments as part of
strong economy-wide growth include:




continued.
the USA during its pre-war industrialization period [1],
Venezuela from the 1920s to the 1970s,
Australia since the 1960s, Norway since 1969 oil discoveries,
Chile since adoption of a new mining code in 1983,
Peru since a privatization program in 1992, and
Brazil since the lifting of restrictions on foreign mining
participation in 1995. [2]
[1] David & Wright (1997).
[2] Wright & Czelusta (2003,
pp. 4-7, 12-13, 18-22).
64
Commodity exports are endogenous,

Examples of countries that were equally
well-endowed geologically but that failed to
develop their natural resources efficiently
include:



continued.
Chile and Australia before World War I,
and Venezuela since the 1980s.[3]
[3] Hausmann (2003, p.246):
“Venezuela’s growth collapse took place after 60
years of expansion, fueled by oil. If oil explains slow
growth, what explains the previous fast growth?”
65
The Natural Resource Curse II:
Recommendations
to Avoid the Pitfalls
Jeffrey Frankel
Harpel Professor, Harvard University
LIC Seminar Series, IMF, April 26, 2011
Institutions & Policies to Address
the Natural Resource Curse

A wide variety of measures
have been tried to cope with
the commodity cycle.
[1]

Some work better than others.
[1] E.g., Davis, et al
(2003) and
Sachs
(2007).
Summary: 10 recommendations
for commodity exporting countries
Devices to share risks
1. In contracts with foreign companies,
index to the world commodity price.
2. Hedge commodity revenues
in options markets
3. Denominate debt in terms of commodity price
Summary: 10 recommendations for commodity producers
continued
Macroeconomic policy
4. Allow some currency appreciation in response
to a rise in world prices of export commodities,
but only after accumulating some foreign exchange reserves.
5. If the monetary regime is to be Inflation Targeting,
consider using as the target, in place of the CPI,
a price measure that puts more weight
PPT
on the export commodity (e.g., PPT).
6. Emulate Chile: to avoid over-spending in boom times,
allow deviations from a target surplus only in response
to permanent commodity price rises,
as judged by independent expert panels.
Summary: 10 recommendations for commodity producers,
continued
Good governance institutions
7. Run Commodity Funds
transparently & professionally.
8. Invest in education, health, & roads.
9. Publish What You Pay.
Consider lump-sum distribution of oil wealth, equal per capita.
10. Mandate an external agent,
e.g., a financial institution that houses
the Commodity Fund, to provide transparency
and to freeze accounts in the event of a coup.
Policies/Institutions
to Deal with the NRC
I. Monetary / Exchange rate policy
II. Saving in boom times
Appendix – Coping with volatility
microeconomically:
Devices to share risk
I. Monetary/ Exchange Rate policy


Fixed vs. floating exchange rates
Nominal anchors as alternatives
to the exchange rate

Inflation targeting


Orthodox implementation: the CPI
Unorthodox version for
commodity exporters
PPT
Fixed vs. floating exchange rates


Each has its advantages.
The main advantages of a fixed exchange rate:


it reduces the costs of international trade,
it is a nominal anchor for monetary policy,


A few commodity exporters have firmly fixed:


helping the central bank achieve low-inflation credibility.
Gulf oil producers & Ecuador.
The main advantage of floating, for commodity exporters:

automatic accommodation to terms of trade shocks.



During a commodity boom, the currency appreciates,
 thus moderating danger of overheating.
The reverse, during a commodity bust.
A few commodity producers have floated fairly freely:

Chile & Mexico
Recommendation



Balancing of these pros & cons =>
an intermediate exchange rate regime
such as managed floating.
Over the last decade
many followed the intermediate regime:
While they officially declared themselves as floating
(often under IT), in practice these intermediate
countries intervened heavily, taking perhaps
½ the increase in demand for their currency
in the form of appreciation but
½ in the form of increased forex reserves.

Examples among oil-producers include Kazakhstan & Russia.
A loose recommendation,

At the early stages of a boom, there is a good
case for foreign exchange intervention, adding
to reserves,



continued
especially if the alternative is abandoning
an established successful exchange rate target.
Perhaps with sterilization, to resist excessive money
growth.
In subsequent years, if the increase in world
commodity prices looks to be long-lived, there is
a stronger case for accommodating it through
Nominal anchors for monetary policy
If the exchange rate is not to be nominal anchor,




something else must be…
especially where institutions lack credibility
2 alternatives for nominal anchor
have had ardent supporters in the past,
but are no longer in the running:



the price of gold, as 19th century gold standard;
the money supply, the choice of monetarists; and
Inflation targeting


Orthodox implementation: the CPI
Unorthodox versions for commodity producers
PPT
Inflation targeting has, for 10 years,
been the conventional wisdom
for how to conduct monetary policy.


among economists, central bankers, IMF…
A narrow definition of Inflation Targeting? 1/
IT is defined as setting yearly CPI targets,
to the exclusion of:
- asset prices
- exchange rates
- export prices,

Some reexamination may be warranted.
A broad definition: Flexible inflation targeting ≡ “Have a long run target for
inflation, and be transparent.”
Then who could disagree?
1/
Professor Jeffrey Frankel



The shocks of 2007-2010 showed
disadvantages to Inflation Targeting.
One disadvantage of IT:
no response to asset price bubbles.
Another disadvantage:

It gives the wrong answer in case of trade shocks:



In response to a rise in prices of export commodities,
it does not allow monetary tightening & appreciation.
In response to a fall in world prices of exports,
it does not allow a depreciation to help equilibrate.
In response to a rise in prices of oil & food imports,
it requires monetary tightening & appreciation.
Professor Jeffrey Frankel
Implications of external shocks
for choice of exchange rate regime

Old wisdom regarding the source of shocks:


Fixed rates work best if shocks are mostly internal
demand shocks (especially monetary);
floating rates work best if shocks tend to be real
shocks (especially external terms of trade).
• Commodity exporters face big trade shocks
=> accommodate by floating.
Edwards & L.Yeyati
(2003)
Professor Jeffrey Frankel
6 proposed nominal targets and the Achilles heel of each:
Monetarist rule
Inflation targeting
Nominal income
targeting
Gold standard
Commodity
standard
Fixed
exchange rate
Targeted
variable
Vulnerability
Example
M1
Velocity shocks
US 1982
CPI
Import price
shocks
Oil shocks of
1973-80, 2000-08
Measurement
problems
Less developed
countries
Vagaries of world
gold market
Shocks in
imported
commodity
Appreciation of $
1849 boom;
1873-96 bust
Nominal
GDP
Price
of gold
Price of agric.
& mineral
basket
$
(or €)
(or € )
Oil shocks of
1973-80, 2000-08
1995-2001
Professor Jeffrey Frankel
Proposal for Product Price Targeting
PPT
Intended for countries with volatile terms of trade,
e.g., those specialized in commodities.
The authorities peg the currency to a basket that gives
heavy weight to prices of its commodity exports,
rather than to the $ or €, or CPI.
The regime combines the best of both worlds:
(i) The advantage of automatic accommodation
to terms of trade shocks, together with
(ii) the advantages of a nominal anchor.
Professor Jeffrey Frankel
PPT
Product Price Targeting:
Target an index of domestic production prices. [1]
• The important point:
include export commodities in the index
and exclude import commodities,
• so money tightens & currency appreciates
when world price of export commodity rises,
• not world price of import commodity.
• The CPI does it backwards.
[1] Frankel (2011).
Professor Jeffrey Frankel
II. Make National Saving Procyclical


Hartwick rule: rents from mineral wealth should be
saved, against the day when deposits run out.
At the same time, traditional macroeconomics says
that government budgets should be countercyclical:
running surpluses in booms, & spending in recessions.

Mineral producers tend to fail both these principles:
they save too little on average and more so in booms.

They need institutions to insure that export earnings
are put aside during the boom time,

into a commodity saving fund,
with rules governing the cyclically adjusted budget surplus.

Davis et al (2001a,b, 2003).

Chile’s fiscal institutions
Chile’s fiscal policy is governed by a set of rules.

1st rule: Each government must set a budget target.

This may sound like the budget deficit ceilings
under Europe’s SGP or a US balanced budget amendment,

but such attempts have failed.



They are too rigid to allow the need for deficits in recessions,
counterbalanced by surpluses in good times.
The alternative of letting politicians explain away deficits
by declaring them the result of unexpected slow growth
also does not work, because it imposes no discipline.
2nd rule: The government can run a deficit to the extent that:
 (1) output falls short of potential, in a recession, or
 (2) the price of copper is below its equilibrium.
Chile’s fiscal institutions, continued


3rd rule:
two panels of experts have the job, each year, to judge:
what is the output gap and the 10-year equilibrium copper price
Thus in the copper boom of 2003-08 when, as usual,
the political pressure was to declare the higher copper price
permanent, thereby justifying spending on a par
with export earnings, the panel ruled that
most of the price increase was temporary





so most of the earnings had to be saved.
This turned out right, as the 2008 spike reversed in 2009.
The fiscal surplus approached 9 % when copper prices were high.
The SWF saved 12 % of GDP.
This allowed big fiscal easing in the 2009 recession,
when the stimulus was most sorely needed.
Other fiscal institutions




Commodity funds or Sovereign Wealth Funds
Reducing net inflows during booms
Lump sum distribution
Invest in education, health, & roads.
Appendices:



I. Recommended ways to reduce price
volatility
II. Non-recommended ways
to reduce price volatility
III. Attempts to impose external checks
Appendix I: Recommendation for dealing
with volatility: Accept its existence
and adopt institutions to cope with it
3 micro devices to share risk efficiently
1.
2.
3.
For commodity exporters who sign
contracts with foreign companies.
For producers who sell
their minerals themselves.
For debtors dependent
on commodity revenues.
1. Price setting in contracts
with foreign companies

Contracts between producing countries & foreign mining
companies are often plagued by “time inconsistency”:
(i) A price is set by contract.



(ii) Later the world price goes up, and the government wants
to renege. It doesn't want to give the company all the profits,
and why should it?
But this is a “repeated game.”
The risk that the locals will renege makes foreign companies
reluctant to do business in the first place.


It limits the availability of capital to the country.
The process of renegotiation can have large transactions costs,
including interruptions in the export flow.
Solution for price setting in contracts



Indexed contracts:
the two parties agree ahead of time, “if the
world price goes up 10%, then the gains are
split between the company and the government”
in some particular proportion.
Indexation shares the risks of gains and losses,


without the costs of renegotiation or
damage to a country’s reputation from reneging.
2. Hedging in commodity
futures markets


Producers who sell their minerals on international spot markets,
are exposed to the risk that the $ price rises or falls.

The producer can hedge the risk by selling
that quantity on the forward or futures market.

Hedging
=> no need for costly renegotiation if world price changes.



as with indexation of the contract price.
The adjustment happens automatically.
Mexico has hedged its oil revenues in this way.


One drawback, if a government ministry hedges:
the Minister receives no credit for having saved the country
from disaster when the world price falls, but is excoriated
for having sold out the national patrimony when the price rises.
Mexico thus uses options to eliminate only the risk of a fall in price.
3. Denomination of debt
in terms of the mineral price





A copper-producer should
index its debt to the copper price.
So debt service obligations automatically
rise & fall with the world price.
Debt crises hit Mexico in 1982 and
Indonesia, Russia & Ecuador in 1998,

when the $ prices of their oil exports fell,

and so their debt service ratios worsened abruptly.
This would not have happened if their debts
had been indexed to the oil price.
As with contract indexation & hedging, adjustment in
the event of fluctuations in the oil price is automatic.
Appendix II: Non-recommended
attempts to dealing with volatility


A number of institutions have been
implemented in the name of reducing volatility.
Most have failed to do so,
and many have had detrimental effects.






Marketing boards
Taxation of commodity production
Producer subsidies
Other government stockpiles
Price controls for consumers
OPEC and other international cartels
Appendix III:
Efforts to Impose External Checks



The Chad experiment
The Extractive Industries Transparency
Initiative: “Publish What You Pay”
More drastic solutions
External checks:
The Chad experiment

In 2000 the World Bank agreed to help Chad,
a new oil producer, to finance a new pipeline.


Its government is ranked by Transparency International
as one of the two most corrupt in the world.
The agreement stipulated that Chad would


spend 72 % of its oil export earnings on poverty
reduction (health, education & road-building)
& put aside 10 % in a “future generations fund.”
External checks:
The Chad experiment,
continued



ExxonMobil was to deposit the oil revenues
in an escrow account at Citibank;
the government was to spend them subject
to oversight by an independent committee.
But once the money started rolling in, the
government reneged on the agreement.
External checks, continued

Extractive Industries Transparency Initiative,
launched in 2002, includes the principle
“Publish What You Pay,”

International oil companies commit to make
known how much they pay governments for oil,


so that the public at least has a way of knowing,
when large sums disappear.
Legal mechanisms adopted by São Tomé &
Principe void contracts if information relating
to oil revenues is not made public.
External checks, continued


Further proposals would give extra powers
to a global clearing house or foreign bank
where the Natural Resource Fund is located,
e.g. freezing accounts in the event of a coup.
[1]
Well-intentioned politicians may spend
commodity wealth quickly out of fear that their
successors will misspend whatever is left.

If so, adopt an external mechanism that constrains
spending both in the present in the future.
[1] Humphreys & Sandhu (2007,
p. 224-27).
When Kuwait was occupied by Iraq, access to Kuwaiti
bank accounts in London stayed with the Kuwaitis.