Transcript How Countries Can Deal with Commodity Price Volatility Jeffrey Frankel Harpel Professor of Capital Formation & Growth G-20 Commodities Seminar, Los Cabos, Mexico, 5

How Countries Can Deal
with Commodity Price Volatility
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
G-20 Commodities Seminar, Los Cabos, Mexico, 5 de Mayo, 2012
Start with
The Natural Resource Curse
 Some

seminal references:

Auty (1990, 2001, 2007)

Sachs & Warner (1995, 2001)
By now there is a large body of research,

which I have surveyed
(2011, 2012a, b).
2

Many countries that are richly endowed with oil,
minerals or fertile land have failed
to grow more rapidly than those without.

Examples:

Some oil producers in Africa & the Middle East
have relatively little to show for their resources.

Meanwhile, East Asian economies achieved
western-level standards of living despite having
virtually no exportable natural resources:


Japan, Singapore, Hong Kong, Korea & Taiwan;
followed by China.
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 should be on identifying ways
to sidestep the pitfalls that have afflicted
commodity producers in the past,
to find the path of success.
5




Some developing countries have avoided
the pitfalls of commodity wealth.
 E.g., Chile (copper)
 Botswana (diamonds)
Some of their innovations are worth emulating.
I will offer some policies & institutional
innovations to avoid the resource curse:
especially ways of managing price volatility.


Some lessons apply to commodity importers too.
Including lessons of policies to avoid.
6



How could abundance
of commodity wealth be a curse?
What is the mechanism
for this counter-intuitive relationship?
At least 5 categories of explanations.
7
5 Possible Natural Resource Curse Channels
1.
Volatility
2.
Crowding-out of manufacturing
3.
Autocratic Institutions
4.
Anarchic Institutions
5.
Procyclicality
1.
2.
3.
including
Procyclical capital flows
Procyclical monetary policy
Procyclical fiscal policy.
8
(1) Volatility
in global commodity
prices arises because
supply & demand are
inelastic in the short run.
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Commodity prices have been especially
volatile over the last decade
A.Saiki, Dutch Nat.Bk.
Commodity prices: all commodities
Indices
180
160
140
120
100
80
60
40
20
0
60 61 63 64 66 67 69 71 72 74 75 77 79 80 82 83 85 86 88 90 91 93 94 96 98 99 01 02 04 05 07 09 10
Nominal
in prices of 2010
prices
*) Deflated by US consumer price2010=100
index.
Source: HWWA, Datastream.
Real prices *
In prices
of 2000*
= nominal
in 2000
Effects of Volatility

Volatility per se can be bad for economic growth.

Risk inhibits private investment.


Cyclical shifts of resources back & forth across
sectors may incur needless transaction costs.
=> role for government intervention?


On the one hand,
the private sector dislikes risk as much as the
government does & will take steps to mitigate it.
On the other hand the government
cannot entirely ignore the issue of volatility;

e.g., exchange rate policy.
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2. Natural resources may
crowd out manufacturing,



and manufacturing could be the sector
that experiences learning-by-doing

or dynamic productivity gains from spillover.

Matsuyama (1992) model.
So commodities could in theory be a dead-end sector.
My own view:
a country need not repress the commodity sector
to develop the manufacturing sector.

It can foster growth in both sectors.


E.g. Canada, Australia, Norway…
Now Malaysia, Chile, Brazil…
3. Autocratic or oligarchic institutions
may retard economic development.
Countries where physical command of natural
resources by government or a hereditary elite
automatically confers wealth on the holders


are likely to become rent-seeking societies;
and are less likely to develop the institutions

conducive to economic development,



e.g., rule of law, decentralization, & economic incentives;
as compared to countries where moderate taxation
of a thriving market economy is the only way
government can finance itself.
Engerman-Sokoloff explanation of why industrialization came
in the North of the Western Hemisphere before the South.
13
4. Anarchic institutions
(i) Unsustainably rapid
depletion of resources
(ii) Unenforceable
property rights
(iii) Civil war
14
(5) Procyclicality

Developing countries are
historically prone to procyclicality,


especially commodity producers.
Procyclicality in:
Capital inflows; Monetary policy;
 Real exchange rate; Nontraded Goods
 Fiscal Policy


The Dutch Disease describes unwanted
side-effects of a commodity boom.
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The Dutch Disease:
5 side-effects of a commodity boom

1) A real appreciation in the currency
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2) A rise in government spending
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3) A rise in nontraded goods prices
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4) A resultant shift of resources out of
non-export-commodity traded goods
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5) Sometimes a current account deficit
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The procyclicality of fiscal policy
Fiscal policy has historically tended
to be procyclical in developing countries

Especially among commodity exporters [1]
-- correlation of income & spending mostly positive –
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particularly in comparison with industrialized countries.
A reason for procyclical public spending:
receipts from taxes or royalties rise in booms.
The government cannot resist the temptation
to increase spending proportionately, or more.

Then it is forced to contract in recessions,

thereby exacerbating the magnitudes of swings.
[1] Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart, & Vegh (2004),
Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006),
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Ilzetski & Vegh (2008), Medas & Zakharova (2009), Gavin & Perotti (1997).
Two budget items account for much
of the spending from commodity booms:

(i) Investment projects.

Investment in infrastructure in practice
often consists of “white elephant” projects,

which are stranded without funds for completion
or maintenance when the oil price goes back down.


Gelb (1986) .
(ii) The government wage bill.

Oil windfalls are often spent on public sector wages


Medas & Zakharova
(2009)
which are hard to cut when prices go back down

Arezki & Ismail (2010)
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Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Adapted from Kaminsky,
Reinhart & Vegh (2004)
countercyclical
G always used to be pro-cyclical
for most developing countries.
The procyclicality of fiscal policy, cont.


Procyclicality has been especially strong
in commodity-exporting countries.
An important development -some developing countries, including
commodity producers, were able to break
the historic pattern in the most recent decade:

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.
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Correlations between Government spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2011)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
The Natural Resource Curse should not
be interpreted as a rule that commodityrich countries are doomed to fail.

The question is what policies to adopt
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

to avoid the pitfalls and improve the chances of prosperity.
A wide variety of measures have been tried
by commodity-exporters cope with volatility.
Some work better than others.
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7 recommendations
for commodity-exporting countries
Devices to share risks
1. Index contracts with foreign companies
to the world commodity price.
2. Hedge commodity revenues
in options markets
3. Denominate debt in terms of commodity price
7 recommendations for commodity producers
continued
Countercyclical macroeconomic policy
4. Allow some currency appreciation in response
to a commodity boom, but not a free float.
- Accumulate some forex reserves.
- Raise banks’ reserve requirements, esp. on $ liabilities.
5. If the monetary anchor is to be Inflation Targeting,
consider using as the target, in place of the CPI,
a price measure that puts weight
PPT
on the export commodity (Product Price Targeting).
6. Emulate Chile: to avoid over-spending in boom times,
allow deviations from a target surplus only
in response to permanent commodity price rises.
Summary: 7 recommendations for commodity producers,
concluded
Good governance institutions
7. Manage Commodity Funds
transparently & professionally,
like Botswana’s Pula Fund
-- not subject to politics
like Norway’s Pension Fund.
Elaboration on two proposals to reduce
the procyclicality of macroeconomic policy
for commodity exporters
 I)
To make monetary policy less
procyclical: Product Price Targeting
PPT
 II)
To make fiscal policy less
procyclical: emulate Chile.
I) The challenge of designing
a currency regime for countries where
terms of trade shocks dominate the cycle

Fixing the exchange rate leads to procyclical
monetary policy: credit expands in commodity booms.

Floating accommodates terms of trade shocks.

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Inflation Targeting, in terms of the CPI,
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But volatility can be excessive;
also floating does not provide a nominal anchor.
provides a nominal anchor;
but can react perversely to terms of trade shocks
Needed: an anchor that accommodates trade shocks
Product Price Targeting:
PPT
Target an index of domestic production prices.
• Include export commodities in the index
and exclude import commodities,
• so money tightens & the currency appreciates
when world prices of export commodities rise
• (accommodating the terms of trade),
• not when world prices of import commodities rise.
• The CPI does it backwards:
• It calls for appreciation when import prices rise,
• not when export prices rise !
[1] Frankel (2011).
Professor Jeffrey Frankel
[1]
II) Chile’s fiscal institutions

1st rule – Governments must set a budget target,

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set = 0 in 2008 under Pres. Bachelet.
2nd rule – The target is structural:
Deficits allowed only to the extent that



since 2000
(1) output falls short of trend, in a recession, or
(2) the price of copper is below its trend.
3rd rule – The trends are projected by 2 panels
of independent experts, outside the political process.
 Result: Chile avoids the pattern of 32 other governments,


where forecasts in booms are biased toward over-optimism.
Chile ran surpluses in the 2003-07 boom,

while the U.S. & Europe failed to do so.
Many of the policies that have been
intended to fight commodity price
volatility do not work out so well
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Producer subsidies
Stockpiles
Marketing boards
Price controls
Export controls
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Blaming derivatives
Resource nationalism
Nationalization
Banning foreign
participation
Unsuccessful policies to reduce commodity price volatility:
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1) Producer subsidies to “stabilize” prices at high levels,
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often via wasteful stockpiles & protectionist import barriers.
Examples:
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The EU’s Common Agricultural Policy


Or fossil fuel subsidies



Bad for EU budgets, economic efficiency,
international trade, & consumer pocketbooks.
which are equally distortionary & budget-busting,
and disastrous for the environment as well.
Or US corn-based ethanol subsidies,

with tariffs on Brazilian sugar-based ethanol.
Unsuccessful policies, continued

2) Price controls to “stabilize” prices at low levels

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Discourage investment & production.
Example: African countries adopted
commodity boards for coffee & cocoa at the
time of independence.


The original rationale: to buy the crop in years
of excess supply and sell in years of excess demand.
In practice the price paid to cocoa & coffee farmers
was always below the world price.

As a result, production fell.
Microeconomic policies,

continued
Often the goal of price controls is to shield
consumers of staple foods & fuel from increases.

But the artificially suppressed price
discourages domestic supply, and
 requires rationing to domestic households.
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
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Shortages & long lines can fuel political
rage as well as higher prices can.
Not to mention when the government
is forced by huge gaps to raise prices.
Price controls can also require imports,
to satisfy excess demand.

Then they raise the world price even more.
Microeconomic policies, continued

3) In producing countries, prices are artificially
suppressed by means of export controls

to insulate domestic consumers from a price rise.
In 2008, India capped rice exports.
 Argentina did the same for wheat exports,
 as did Russia in 2010.
 India banned cotton exports in March 2012.

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Results:
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
Domestic supply is discouraged.
World prices go even higher.
An initiative at the G20 meeting
of agriculture ministers in Paris
in June 2011 deserved to succeed:

Producing and consuming countries in grain
markets should cooperatively agree to refrain
from export controls and price controls.


The result would be lower world price volatility.
One hopes for steps in this direction,
perhaps working through the WTO.
An initiative that has less merit:
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4) Attempts to blame speculation for volatility
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and so to ban derivatives markets.
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Yes, speculative bubbles sometimes hit prices.
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But in commodity markets,
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prices are more often the signal for fundamentals.


Don’t shoot the messenger.
Also, derivatives are useful for hedgers.
The overall lesson for
microeconomic policy
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

Attempts to prevent
commodity prices from
fluctuating generally fail.
Even though enacted
in the name of reducing volatility & income inequality,
their effect is often different.
Better to accept volatility and cope with it.

For the poor: well-designed transfers,

along the lines of Oportunidades or Bolsa Familia.
“Resource nationalism”
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Another motive for commodity export controls:

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5) To subsidize downstream industries.
E.g., “beneficiation” in South African diamonds
But it didn’t make diamond-cutting competitive,
 and it hurt mining exports.
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
6) Nationalization of foreign companies.

Like price controls, it discourages investment.
“Resource nationalism”
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7) Keeping out foreign companies altogether.
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
continued
But often they have the needed technical expertise.
Examples: declining oil production in Mexico & Venezuela.
8) Going around “locking up” resource supplies.


China must think that this strategy will
protect it in case of a commodity price shock.
But global commodity markets are increasingly integrated.

If conflict in the Persian Gulf doubles world oil prices,
the effect will be pretty much the same
for those who buy on the spot market and
those who have bilateral arrangements.
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References by the author

Project Syndicate,
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
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“Escaping the Oil Curse,” Dec. 9, 2011.
“Combating Agricultural Price Volatility,” June 27, 2011.
"Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility," Oct.17, 2011.
“The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,”
2012, Commodity Price Volatility and Inclusive Growth in Low-Income Countries , R.Arezki & Z.Min, eds..
HKS RWP12-014. High Level Seminar, IMF Annual Meetings, DC, Sept.2011.

"The Curse: Why Natural Resources Are Not Always a Good Thing,”
Milken Institute Review, vol.13, 4th quarter 2011.

"Increases in Global Commodity Prices: Macroeconomics and Policy Responses of
Developing Countries," slides, V Jornada Monetario, Central Bank of Bolivia, July 2011.

“The Natural Resource Curse: A Survey,” 2012,
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“How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?”




Chapter 2 in Beyond the Resource Curse,
B.Shaffer & T. Ziyadov, eds. (U.Penn. Press); proofs & notes; Summary. CID WP195, 2011.
Natural Resources, Finance & Development, R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011. HKS RWP 11-015.
“On Graduation from Procyclicality,” with C.Végh & G.Vuletin, 2012.
“A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by
Chile,” in Fiscal Policy and Macroeconomic Performance, 2012. Central Bank of Chile WP 604, 2011.
"Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS
Monetary Review Vol.XI, issue 1, April 2012 (Monetary Authority of Singapore).
“A Comparison of Product Price Targeting and Other Monetary Anchor Options, for
Commodity-Exporters in Latin America," Economia, vol.11, 2011 (Brookings), NBER WP 16362.
Appendix I: Anarchic Institutions
i) Unsustainably
rapid depletion
When depletable resources
are in fact depleted,
the country may be left with nothing.

Three concerns:


Protection of environmental quality.

A motivation for a strategy of economic diversification.

A motivation for the Hartwick

(1997)
rule:
Invest rents from exhaustible resources in other assets.
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(ii) Unenforceable property rights

Depletion would be much less of a problem
if full property rights could be enforced,


But often this is not possible



thereby giving the owners adequate incentive
to conserve the resource in question.
Especially under frontier conditions.
Overfishing, overgrazing, & over-logging are classic
examples of the “tragedy of the commons.”
Individual fisherman, farmers or loggers have no
incentive to restrain themselves, while the fisheries or
pastureland or forests are collectively depleted.
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(iii) 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 countries
as Sudan comes to mind.

Civil war is, in turn, very bad
for economic development.
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Appendix II
The Dutch Disease: The 5 effects elaborated
 1)

Real appreciation in the currency
taking the form of nominal currency appreciation
if the exchange rate floats


e.g., floating-rate oil exporters, Colombia, Kazakhstan & Russia.
or the form of money inflows, credit & inflation
if the exchange rate is fixed;

e.g. fixed-rate oil-exporters, Saudi Arabia & UAE.
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The Dutch Disease: The 5 effects elaborated
 2)

A rise in government spending
in response to increased availability
of tax receipts or royalties.
46
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 internationally traded goods


esp. manufactures.
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.
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The Dutch Disease: 5 side-effects of a commodity boom

5) A current account deficit,

as international investors lend into the boom
 thereby
incurring international debt that
is hard to service when the boom ends.
 E.g.

the 1982 end of the 1970s commodity boom.
Many developing countries avoided incurring debts
in the 2003-11 boom.


E.g., by taking capital inflows more in the form of FDI, and
building reserves rather than running current account deficits.
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