Coping with Commodity Volatility: Macroeconomic Policies for Developing Countries

1
Coping with Commodity VolatilityMacroeconomic
Policies for Developing Countries
Jeffrey FrankelHarpel Professor of Capital
Formation Growth

• May 24, 2013

2
In 2008, the government of Chilean President
Bachelet her Finance Minister Velasco ranked
low in public opinion polls.
By late 2009, they were the most popular in 20
years. Why?
Evolution of approval and disapproval of four
Chilean presidents
Presidents Patricio Aylwin, Eduardo Frei, Ricardo
Lagos and Michelle BacheletData CEP, Encuesta
Nacional de Opinion Publica, October 2009,
www.cepchile.cl. Source Engel et al
(2011).
3
Commodity exporters face extra volatility in
their terms of trade

• Choices of macroeconomic policies institutions
  can help manage the volatility.
• Too often, historically, they have exacerbated
  it
• Pro-cyclical macroeconomics
• (i) capital flows, money, credit
• (ii) currency policy relative price of nontraded
  goods
• and (iii) fiscal policy.

4
(i) Pro-cyclical capital flows

• According to intertemporal optimization theory,
  capital flows should be countercyclical
• flowing in when exports do badly
• and flowing out when exports do well.
• In practice, it does not always work this way.
  Capital flows are more procyclical than
  countercyclical.
• Gavin, Hausmann, Perotti Talvi (1996)
  Kaminsky, Reinhart Vegh (2005) Reinhart
  Reinhart (2009) and Mendoza Terrones (2008).
• Theories to explain this involve capital market
  imperfections,
• e.g., asymmetric information or the need for
  collateral.

5
(ii) Pro-cyclical monetary policy

• If the exchange rate is fixed,
• surpluses during commodity booms can lead to
• Rising reserves
• Excessive money credit
• Excess demand for goods overheating
• Inflation
• Asset bubbles.

6
Macro effects of commodity boom

• Inflation shows up especially in non-traded
  goods services, like construction.

7
Pro-cyclical real exchange rateCountries
undergoing a commodity boom experience real
appreciation of their currency

• The resulting shift of land, labor capital out
  of manufacturing, and into the booming commodity
  sector might be appropriate inevitable,
• to the extent it is expandable,
• especially if the commodity boom is permanent.
• But the shift out of manufacturing into NTGs is
  often an undesirable macroeconomic side effect
• the disease part of Dutch Disease.

8
(iii) Procyclical fiscal policy

• Fiscal policy has historically tended to be
  procyclical in developing countries
• especially among commodity exporters
• Cuddington (1989), Tornell Lane (1999),
  Kaminsky, Reinhart Végh (2004), Talvi Végh
  (2005), Alesina, Campante Tabellini (2008),
  Mendoza Oviedo (2006), Ilzetski Végh (2008),
  Medas Zakharova (2009), Gavin Perotti (1997).
• Correlation of income spending mostly positive
  
• in comparison with industrialized countries.

9
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.
10

• The procyclicality of fiscal policy
• A reason for procyclical public spending
  receipts from taxes 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 swings.

10
11
Two budget items account for much of the
spending from oil booms

• (i) Investment projects.
• Investment in practice may be 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)
• Arezki Ismail (2010) government spending
  rises in booms, but is downward-sticky.

Rumbi Sithole took this photo in Bayelsa
Statein the Niger Delta,in Nigeria. The state
government received a windfall of money and
didn't have the capacity to have it all absorbed
in social services so they decided to build a
Hilton Hotel. The construction company did a
shoddy job, so the tower is leaning to its right
and its unsalvageable..
11
12
The procyclicality of fiscal policy, cont.

• 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, Botswana, Malaysia, Indonesia, Korea
• How were they able to achieve counter-cyclicality?

12
13
Correlations between Government spending GDP
2000-2009
procyclical
Frankel, Vegh Vuletin (2012)
In the last decade, about 1/3 developing
countries switched to countercyclical fiscal
policyNegative correlation of G GDP.
countercyclical
14
Four questions for macro management

• 1. How can a country avoid excessive credit
  creation inflation in a commodity boom ?
• Eventually allow some currency appreciation.
• But not a free float. Accumulate some fx reserves
  first.
• 2. Nominal anchor for monetary policy
• What is it to be, if not the exchange rate?
  CPI?
• 3. Fiscal policyHow can governments be
  constrained from over-spending in boom times?
  Fiscal rule?
• 4. What microeconomic arrangements can reduce
  macroeconomic volatility?

15
1) The challenge of designinga monetary regime
for countries where terms of trade shocks
dominate the cycle

• Fixing the exchange rateleads to pro-cyclical
  monetary policy
• Money flows in during commodity booms.
• Excessive credit creation can lead to inflation.
• Example Saudi Arabia UAE during the 2003-08
  oil boom.
• Money flows out during commodity busts.
• Credit squeeze can lead to excess supply,
  recession balance of payments crisis.
• Example Exporters of oil other commodities
  in 1980s or 1997-98.

16
Currency regime, continued

• Floating accommodates terms of trade shocks
• If terms of trade improve, currency
  automatically appreciates,
• preventing excessive money inflows, overheating
  inflation.
• If terms of trade worsen, currency automatically
  depreciates,
• preventing recession balance of payments
  crisis.
• Disadvantages of floating
• Volatility can be excessive
• Dutch Disease can be worse
• pro-cyclicality of real exchange rate.
• One needs a nominal anchor.

17
Demand vs. supply shocks

• An 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).
• One set of supply shocks natural disasters
• R.Ramcharan (2007) finds floating works better.
  
• A common source of real shocks trade.

18
Terms-of-trade variability

• Prices of crude oil and other agricultural
  mineral commodities hit record highs in 2008
  2011.
• gt Favorable terms of trade shocks for some
  (oil producers, Africa, Latin America,
  etc.)
• gt Unfavorable terms of trade shock for others
  (oil importers such as Japan, Korea).
• Textbook theory says a country where trade shocks
  dominate should accommodate by floating.
• Confirmed empirically
• Developing countries facing terms of trade shocks
  do better with flexible exchange rates than fixed
  exchange rates.
• Broda (2004), Edwards L.Yeyati (2005), Rafiq
  (2011), and Céspedes Velasco (2012)

19
Céspedes Velasco (Nov. 2012) NBER WP 18569
Macroeconomic Performance During Commodity Price
Booms Busts
Constant term not reported.
(t-statistics in parentheses.)
Statistically significant
at 5 level.
Across 107 major commodity boom-bust
cycles, output loss is bigger the bigger is the
commodity price change the smaller is exchange
rate flexibility.
20
Monetary regimeIf the exchange rate
is not to be the monetary anchor, what is?

• The popular choice of the last decadeInflation
  Targeting.
• But CPI targeting can react perversely
• to supply shocks
• terms of trade shocks.

21
Needed Nominal anchors that accommodate the
shocks that are common in developing countries

• Supply shocks,
• e.g., droughts, floods, hurricanes
• Nominal GDP targeting.
• Terms of trade shocks
• e.g., fall in price of commodity export.
• Product Price Targeting

PPT
22
Nominal GDP targetcancels out velocity shocks
(vs. M target) moderates effects of supply
shocks (vs. IT)
Adverse AS shock

P
Nom.GDPtarget
AS

IT


AD
Real GDP
23
Does Nominal GDP target give best
output/inflation trade-off?
It gives exactly the right answer if the simple
Taylor Rules equal weights accurately capture
what discretion would do. Even if not exact,
the true objective function would have to put
far more weight on P than output, or AS would
have to be very steep, for the P rule to give a
better outcome.
Adverse AS shock

P
Nom.GDPtarget
IT

AD
Real GDP
24
Product Price Targeting accommodates terms of
trade shocks
PPT

• Target an index of domestic production prices
  1such as the GDP deflator.
• Include export commodities in the index
  exclude import commodities,
• so money tightens the currency appreciates
  when world prices of export commodities rise
• accommodating the terms of trade --
• not when 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, 2012).

25
Why is PPT better than a fixed exchange ratefor
countries with volatile export prices?
PPT

• If the price of the export commodity goes up,
  the currency automatically appreciates,
• moderating the boom.
• If the price of export commodity goes down,
  the currency automatically depreciates,
• moderating the downturn
• improving the balance of payments.

26
Why is PPT better than CPI-targetingfor
countries with volatile terms of trade?
PPT

• If the price of imported commodity goes up,
  CPI target says to tighten monetary policy
  enough to appreciate the currency.
• Wrong response. (E.g., oil-importers in
  2007-08.)
• PPT does not have this flaw .
• If the price of the export commodity goes up,
  PPT says to tighten money enough to appreciate.
  
• Right response. (E.g., Gulf currencies in
  2007-08.)
• CPI targeting does not have this advantage.

27
Elaboration onProduct Price Targeting
PPT

• Each of the traditional candidates for nominal
  anchor has an Achilles heel.
• The CPI anchor does not accommodate terms of
  trade changes
• IT tightens M appreciates when import prices
  rise
• not when export prices rise,
• which is backwards.
• Targeting core CPI does not much help.

28
6 proposed nominal targets and the Achilles heel
of each
Vulnerability
IT
Professor Jeffrey Frankel
29

Is Inflation Targeting the reigning orthodoxy
at the Fund? Yes

• 2006 100
• 2007 63
• 2008 72
• 2010 58
• 2011 97 Do you personally
  believe in IT? 38

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3. How Can Countries Avoid Pro-cyclical Fiscal
Policy?

• Good institutions.
• But what are they, exactly?

31
Who achieves counter-cyclical fiscal policy?
Countries with good institutions
On Graduation from Fiscal Procyclicality,
Frankel, Végh Vuletin J.Dev.Economics, 2013.
32
The quality of institutions varies, not just
across countries, but also across time.
1984-2009
Frankel, Végh Vuletin,2013.
33
The comparison holds not only in
cross-section,but also across time.
On Graduation from Fiscal Procyclicality,
Frankel, Végh Vuletin J. Devel. Econ., 2013.
34
How can countries avoid fiscal expansion in booms?

• What are good institutions, exactly?
• Rules?
• Budget deficits or debt brakes?
• Have been tried many times. Usually fail.
• Rules for cyclically adjusted budgets?
• Countries more likely to be able to stick with
  them. But
• An under-explored problem
• Over-optimism in official forecasts
• of growth rates budgets.

35
Over-optimism in official forecasts

• Statistically significant bias among 33 countries
• Worse in booms.
• Worse at 3-year horizons than 1-year.
• Frankel (2011, 2012).
• Leads to pro-cyclical fiscal policy
• If the boom is forecast to last indefinitely,
  there is no apparent need to retrench.
• BD rules dont help.
• The SGP worsens forecast bias for euro countries.
• Cyclically adjusted rules wont help the bias
  either.
• Frankel Schreger (2013).
• Solution?

36
The example of Chiles fiscal institutions

•  
• 1st rule Governments must set a budget
  target,  
• 2nd rule The target is structural Deficits
  allowed only to the extent that
• (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 avoided the pattern of 32 other
  governments,
• where forecasts in booms were biased toward
  optimism.

37
Chilean fiscal institutions

• In 2000 Chile instituted its structural budget
  rule.
• The institution was formalized into law in 2006.
• The structural budget surplus must be
• 0 as of 2008 (was higher before, lower after),
• where structural is defined by output copper
  price equal to their long-run trend values.
• I.e., in a boom the government can only spend
  increased revenues that are deemed permanent
  any temporary copper bonanzas must be saved.

38
The Pay-off

• Chiles fiscal position strengthened immediately
  
• Public saving rose from 2.5 of GDP in 2000 to
  7.9 in 2005
• allowing national saving to rise from 21 to 24
  .
• Government debt fell sharply as a share of GDP
  and the sovereign spread gradually declined.
• By 2006, Chile achieved a sovereign debt rating
  of A,
• several notches ahead of Latin American peers.
• By 2007 it had become a net creditor.
• By 2010, Chiles sovereign rating had climbed to
  A,
• ahead of some advanced countries.
• gt It was able to respond to the 2008-09
  recession.

39

• In 2008, with copper prices spiking up, the
  government of President Bachelet had beenunder
  intense pressure to spend the revenue.
• She Fin.Min.Velasco held to the rule, saving
  most of it.
• Their popularity fell sharply.
• When the recession hit and the copper price came
  back down, the government increased spending,
  mitigating the downturn.
• Bachelet Velascos popularity reached
  historic highs by the time they left office.

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5 econometric findings regarding bias toward
optimism in official budget forecasts.

• Official forecasts in a sample of 33 countries
  on average are overly optimistic, for
• (1) budgets
• (2) GDP .
• The bias toward optimism is
• (3) stronger the longer the forecast horizon
• (4) greater in booms
• (5) greater for euro governments under SGP budget
  rules

42
US official projections have been over-optimistic
on average.
43
Greek official forecasts have always been
over-optimistic.
44
Chiles official forecasts have not been
over-optimistic.
45
The optimism in official budget forecasts
is stronger at the 3-year horizon, stronger
amongcountries with budget rules,
stronger in booms.
Frankel, 2010, A Solution to Fiscal
Procyclicality The Structural Budget
Institutions Pioneered by Chile.
46
5 more econometric findings regarding bias
toward optimism in official budget forecasts.

• (6) The key macroeconomic input for budget
  forecasting in most countries GDP. In
  Chile the copper price.
• (7) Real copper prices revert to trend in the
  long run.
• But this is not always readily perceived
• (8) 30 years of data are not enough
• to reject a random walk statistically 200 years
  of data are needed.
• (9) Uncertainty (option-implied volatility) is
  higher when copper prices are toward the top of
  the cycle.
• (10) Chiles official forecasts are not overly
  optimistic.It has apparently avoided the
  problem of forecasts that unrealistically
  extrapolate in boom times.

47
In sum, institutions recommended to make fiscal
policy less procyclical

• Chile is not subject to the same bias toward
  over-optimism in forecasts of the budget, growth,
  or the all-important copper price.
• The key innovation that has allowed Chile to
  achieve countercyclical fiscal policy
• not just a structural budget rule in itself,
• but rather the regime that entrusts to two panels
  of experts estimation of the long-run trends of
  copper prices GDP,
• insulated from political pressure wishful
  thinking

48
Application to others

• Any country could emulate the Chilean mechanism,
• or in other ways delegate to independent
  agencies.
• Suggestion give panels more institutional
  independence
• as is familiar from central banking
• laws protecting them from being fired.
• Open questions
• How much of the structural budget calculations
  are to be delegated to the independent panels of
  experts?
• Minimalist approach they compute only 10-year
  moving averages.
• Can one guard against subversion of the
  institutions (CBO) ?

49
4. Other reforms to manage volatility

• Contractual provisions to share risks
• 1. Index contracts with foreign companiesto the
  world commodity price.
• 2. Hedge commodity revenues in options markets.
• 3. Denominate debt in terms of commodity price .
• Manage commodity funds professionally.

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Manage commodity funds professionally.

• Norways Pension Fund
• All govt. oil revenues go into it.
• Govermnent (on average over the cycle) can spend
  expected real return, say 4.
• All invested abroad. Reasons
• (1) for diversification,
• (2) to avoid cronyism in investments.
• But insulated from politics,
• like Botswanas Pula Fund,
• fully delegated for financial optimization.

51
References by the author
http//www.hks.harvard.edu/fs/jfrankel/

• Project Syndicate,
• Escaping the Oil Curse,  Dec.9, 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 et al., eds.
  (IMF) HKS RWP12-014. 
• How Can Commodity Exporters Make Fiscal and
  Monetary Policy Less Procyclical? in Natural
  Resources, Finance Development. R.Arezki,
  T.Gylfason A.Sy, eds. (IMF), 2011.  HKS RWP
  11-015.
• On Graduation from Fiscal Procyclicality, with
  C.Végh G.Vuletin, in Journal of Development
  Economics, 100, no.1, Jan.2013 pp. 32-47.   NBER
  WP 17619.  Summary, VoxEU, 2011.
• Chile's Countercyclical Triumph," in
  Transitions, Foreign Policy, June 2012.
• A Solution to Fiscal Procyclicality The
  Structural Budget Institutions Pioneered by
  Chile, Central Bank of Chile WP604, 2011.
  SpanishJournal Economía Chilena , Aug.2011,
  CBC, 39-78.
•  "Product Price Targeting -- A New Improved Way
  of Inflation Targeting," in MAS Monetary Review
  XI, 1, 2012 (Monetary Authority of Singapore).
• A Comparison of Product Price Targeting and
  Other Monetary Anchor Options, for
  Commodity-Exporters in Latin America," Economia,
  2011 (Brookings), NBER WP 16362. 

52
References by others

• Rabah Arezki and Kareem Ismail, 2010, Boom-Bust
  Cycle, Asymmetrical Fiscal Response and the Dutch
  Disease, IMF WP/10/94, April.
• Christian Broda, 2004, "Terms of Trade and
  Exchange Rate Regimes in Developing Countries,"
  Journal of International Economics, 63(1),
  31-58.
• Luis Céspedes Andrés Velasco, 2012,
  Macroeconomic Performance During Commodity Price
  Booms Busts NBER WP 18569, Nov.
• Graciela Kaminsky, Carmen Reinhart Carlos Vegh,
  2005, "When It Rains, It Pours Procyclical
  Capital Flows and Macroeconomic Policies," NBER
  Macroeconomics Annual 2004, 19, pp.11-82.
• Warwick McKibbin Kanhaiya Singh, Issues in the
  Choice of a Monetary Regime for India, 2003, in
  Kaliappa Kalirajan Ulaganathan Sankar (eds.)
  Economic Reform and the Liberalisation of the
  Indian Economy (Edward Elgar Publ., UK), pp.
  221-274.
• James Meade, 1978, The Meaning of Internal
  Balance, The Economic Journal, 91, 423-35.
• Jeffrey Sachs, How to Handle the Macroeconomics
  of Oil Wealth, 2007, in Escaping the Resource
  Curse, M.Humphreys, J.Sachs J.Stiglitz, eds.
  (Columbia Univ. Press NY), pp. 173-93.

53
53
54
Appendix I Channels of the Natural Resource
Curse

• How could abundance of commodity wealth be a
  curse?
• What is the mechanism
• for this counter-intuitive relationship?
• At least 5 categories of explanations.

54
55
5 Possible Natural Resource Curse Channels

1. Volatility
2. Crowding-out of manufacturing
3. Autocratic Institutions
4. Anarchic Institutions
5. Procyclicality including
6. Procyclical capital flows
7. Procyclical monetary policy
8. Procyclical fiscal policy.

55
56

• (1) Volatility in global commodity prices
  arises because supply demand are inelastic in
  the short run.

56
57
Commodity prices have been especially volatile
over the last decade
Source UNCTAD
58
Effects of Volatility

• Volatility per se can be bad for economic growth.
• Hausmann Rigobon (2003), Blattman, Hwang,
  Williamson (2007), and Poelhekke van der Ploeg
  (2007).
• Risk inhibits private investment.
• Cyclical shifts of labor, land capital back
  forth across sectors may incur needless costs.
• gt role for government intervention?
• On the one hand, the private sector dislikes risk
  as much as government does takes steps to
  mitigate it.
• On the other hand the government cannot entirely
  ignore the issue of volatility
• e.g., exchange rate policy.

58
59
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), van Wijnbergen (1984) and Sachs
  Warner (1995).
• 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

60
Econometric findings that oil other
point-source resources lead to poor
institutions
3. Autocratic/Oligarchic Institutions

• Isham, Woolcock, Pritchett, Busby (2005)
• Sala-I-Martin Subramanian (2003)
• Bulte, Damania Deacon (2005)
• Mehlum, Moene Torvik (2006)
• Arezki Brückner (2009).

The theory is thought to fit Mideastern oil
exporters well.
61
What are poor institutions?

• A typical list
• inequality,
• corruption,
• rent-seeking,
• intermittent dictatorship,
• ineffective judiciary branch, and
• lack of constraints to prevent elites
  politicians from plundering the country.

62
An example, from economic historians Engerman
Sokoloff (1997, 2000, 2002)

• Why did industrialization take place in North
  America,
• not the South?
• 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.

63
4. Anarchic institutions

1. Unsustainably rapid depletion of resources
2. Unenforceable property rights
3. Civil war

63
64
(5) Procyclicality

• The Dutch Disease describes unwanted
  side-effects of a commodity boom.
• Developing countries are historically prone to
  procyclicality,
• especially commodity producers.
• Procyclicality in
• Capital inflows Monetary policy
• Real exchange rate Nontraded Goods
• Fiscal Policy

64
65
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 production out of
  manufactured goods
• 5) Sometimes a current account deficit

65
66
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
• or the form of money inflows, credit inflation
  if the exchange rate is fixed
• 2) A rise in government spending
• in response to availability of tax receipts or
  royalties.

66
67
The Dutch Disease 5 side-effects of a commodity
boom

• 3) An increase in nontraded goods prices
  relative to internationally traded goods
  
• 4) A resultant shift out of non-commodity traded
  goods,
• esp. manufactures,
• pulled by the more attractive returns in the
  export commodity and in non-traded goods.

67
68
The Dutch Disease 5 side-effects of a commodity
boom

• 5) A current account deficit,
• as booming countries attract capital flows,
• thereby incurring international debt that is
  hard to service when the boom ends.
• Manzano Rigobon (2008) the negative
  Sachs-Warner effect of resources on growth rates
  during 1970-1990 was mediated through
  international debt incurred when commodity prices
  were high.
• Arezki Brückner (2010a, b) commodity price
  booms lead to higher government spending,
  external debt default risk in autocracies,
• but do not have those effects in democracies.

68
69
Summary of channels

• Five broad categories of hypothesized channels
  whereby natural resources can lead to poor
  economic performance
• commodity price volatility,
• crowding out of manufacturing,
• autocratic institutions,
• anarchic institutions, and
• procyclical macroeconomic policy, including
• capital flows,
• monetary policy and
• fiscal policy.
• But the important question is how to avoid the
  pitfalls,
• to achieve resource blessing instead of resource
  curse.

70

• Some developing countries have avoided the
  pitfalls of commodity wealth.
• E.g., Chile (copper)
• Botswana (diamonds)
• Some of their innovations are worth emulating.
• The lecture offers some policies institutional
  innovations to avoid the curse.

70
71
Appendix IIEmpirical findings for PPT

• Simulations of 1970-2000
• Gold producers Burkino Faso, Ghana, Mali, South
  Africa
• Other commodities Ethiopia (coffee), Nigeria
  (oil), S.Africa (platinum)
• General finding Under Product Price Targets,
  their currencies would have depreciated
  automatically in 1990s when commodity prices
  declined,
• perhaps avoiding messy balance of payments
  crises.

PPT
Sources Frankel (2002, 03a, 05), Frankel Saiki
(2003)
72
Price indices

• CPI GDP deflator each include
• an international good
• import good in the CPI,
• export good in GDP deflator
• And the non-traded good,
• with weights f and (1-f), respectively
• cpi (f)pim (1-f)pn ,
• p (f)px (1-f) pn .

73
Estimation for each country of weights in
national price index on 3 sectors non tradable
goods, leading commodity export, other tradable
goods
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.  
Argentina is relatively closed
Mexico is relatively open.
The leading export commodity usually has a
higher weight in the countrys PPI than in its
CPI, as expected. (Jamaicans dont eat
bauxite.)
74
In practice, IT proponents agree central banks
should not tighten to offset oil price shocks

• They want focus on core CPI, excluding food
  energy.
• But
• food energy ? all supply shocks.
• Use of core CPI sacrifices some credibility
• If core CPI is the explicit goal ex ante, the
  public feels confused.
• If it is an excuse for missing targets ex post,
  the public feels tricked.
• Perhaps for that reason, IT central banks
  apparently do respond to oil shocks by
  tightening/appreciating,
• as the following correlations suggests.

75
The 4 inflation-targeters in Latin Americashow
correlation (currency value in , import prices
in )

• gt 0
• gt correlation before they adopted IT
• gt correlation shown by non-IT Latin American
  oil-importing countries.

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LAC Countries Current Regimes and Monthly
Correlations of Exchange Rate Changes (/local
currency) with Import Price Changes
Table 1
Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes
Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil.
  Exchange Rate Regime Monetary Policy 1970-1999 2000-2008 1970-2008
ARG Managed floating Monetary aggregate target -0.0212 -0.0591 -0.0266
BOL Other conventional fixed peg Against a single currency -0.0139 0.0156 -0.0057
BRA Independently floating Inflation targeting framework (1999) 0.0366 0.0961 0.0551
CHL Independently floating Inflation targeting framework (1990) -0.0695 0.0524 -0.0484
CRI Crawling pegs Exchange rate anchor 0.0123 -0.0327 0.0076
GTM Managed floating Inflation targeting framework -0.0029 0.2428 0.0149
GUY Other conventional fixed peg Monetary aggregate target -0.0335 0.0119 -0.0274
HND Other conventional fixed peg Against a single currency -0.0203 -0.0734 -0.0176
JAM Managed floating Monetary aggregate target 0.0257 0.2672 0.0417
NIC Crawling pegs Exchange rate anchor -0.0644 0.0324 -0.0412
PER Managed floating Inflation targeting framework (2002) -0.3138 0.1895 -0.2015
PRY Managed floating IMF-supported or other monetary program -0.023 0.3424 0.0543
SLV Dollar Exchange rate anchor 0.1040 0.0530 0.0862
URY Managed floating Monetary aggregate target 0.0438 0.1168 0.0564
Oil Exporters Oil Exporters        
COL Managed floating Inflation targeting framework (1999) -0.0297 0.0489 0.0046
MEX Independently floating Inflation targeting framework (1995) 0.1070 0.1619 0.1086
TTO Other conventional fixed peg Against a single currency 0.0698 0.2025 0.0698
VEN Other conventional fixed peg Against a single currency -0.0521 0.0064 -0.0382
Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999. 
IT coun-tries show correl-ations gt 0.
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Why is the correlation between the import price
and the currency value revealing?

• The currency of an oil importer should not
  respond to an increase in the world oil price by
  appreciating, to the extent that these central
  banks target core CPI .
• When these IT currencies respond by appreciating
  instead, it suggests that the central bank is
  tightening money to reduce upward pressure on
  headline CPI.

78
Appendix III Micro policiesMany of the
policies that have been intended to fight
commodity price volatility do not work out so
well.

• Producer subsidies
• Stockpiles
• Marketing boards
• Price controls
• Export controls

• Blaming derivatives
• Resource nationalism
• Nationalization
• Banning foreign participation

79
Unsuccessful policies to reduce commodity price
volatility

• 1) Producer subsidies to stabilize prices at
  high levels,
• often via wasteful stockpiles protectionist
  import barriers.
• Examples
• The EUs Common Agricultural Policy
• Bad for EU budgets, economic efficiency,
  international trade, consumer pocketbooks.
• Or fossil fuel subsidies
• 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.

80
Unsuccessful policies, continued

• 2) Price controls to stabilize prices at low
  levels
• 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.

81
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.
• 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.

82
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.
• Results
• Domestic supply is discouraged.
• World prices go even higher.

83
An initiative at the G20 meetings in 2011
deserved to succeed

• Producers 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.

84
An initiative that has less merit

• 4) Attempts to blame speculation for volatility
• and so to ban derivatives markets.
• Yes, speculative bubbles sometimes hit prices.
• But in commodity markets,
• prices are more often the signal for
  fundamentals.
• Dont shoot the messenger.
• Also, derivatives are useful for hedgers.

85
An example of commodity speculation

• In the 1955 movie version of East of Eden, the
  legendary James Dean plays Cal. 
• Like Cain in Genesis, he competes with his
  brother for the love of his father.  
• Cal goes long in the market for beans, in
  anticipation of a rise in demand if the US
  enters WWI. 

86
An example of commodity speculation, cont.

• Sure enough, the price of beans goes sky high,
  Cal makes a bundle, and offers it to his father,
  a moralizing patriarch. 
• But the father is morally offended by Cals
  speculation, not wanting to profit from others
  misfortunes, and tells him he will have to
  give the money back. 

87
An example of commodity speculation, cont.

• Cal has been the agent of Adam Smiths famous
  invisible hand
• By betting on his hunch about the future, he has
  contributed to upward pressure on the price of
  beans in the present,
• thereby increasing the supply so that more is
  available precisely when needed (by the Army). 
• The movie even treats us to a scene where Cal
  watches the beans grow in a farmers field,
  something real-life speculators seldom get to see.

88
The overall lesson for microeconomic policy

• 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.

89
Resource nationalism

• Another motive for commodity export controls
• 5) To subsidize downstream industries.
• E.g., beneficiation in South African diamonds
• But it didnt make diamond-cutting competitive,
• and it hurt mining exports.
• 6) Nationalization of foreign companies
• Like price controls, it discourages investment.

90
Resource nationalism continued

• 7) Keeping out foreign companies altogether.
• 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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