How Countries Can Deal with Commodity Price Volatility Jeffrey Frankel Harpel Professor of Capital Formation

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How Countries Can Dealwith Commodity Price
VolatilityJeffrey FrankelHarpel Professor of
Capital Formation Growth

• G-20 Commodities Seminar, Los Cabos, Mexico, 5 de
  Mayo, 2012

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Start withThe 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).

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• 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.

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Growth falls with fuel mineral exports
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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.

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• 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.

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

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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.

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• (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.
Nominal prices2010100
Real prices nominal in 2000
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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.
• gt 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

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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.

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4. Anarchic institutions

• (i) Unsustainably rapid depletion of resources
  
• (ii) Unenforceable property rights
• (iii) Civil war

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(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
• 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

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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
• 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), Ilzetski Vegh (2008),
  Medas Zakharova (2009), Gavin Perotti (1997).

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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.
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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)
In the last decade, about 1/3 developing
countries switched to countercyclical fiscal
policyNegative correlation of G GDP.
countercyclical
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The Natural Resource Curse should not be
interpreted as a rule that commodity-rich
countries are doomed to fail.

• The question is what policies to adopt
• 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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Devices to share risks
7 recommendations for commodity-exporting
countries

• 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

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Countercyclical macroeconomic policy
7 recommendations for commodity producers
continued

• 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 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.

PPT
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Good governance institutions
Summary 7 recommendations for commodity
producers, concluded

• 7. Manage Commodity Funds transparently
  professionally,
• like Botswanas Pula Fund -- not subject
  to politics like Norways Pension Fund.

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Elaboration on two proposals to reduce the
procyclicality of macroeconomic policy for
commodity exporters

• I) To make monetary policy less procyclical
  Product Price Targeting
• II) To make fiscal policy less procyclical
  emulate Chile.

PPT
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I) The challenge of designinga 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.
• But volatility can be excessive
• also floating does not provide a nominal anchor.
• Inflation Targeting, in terms of the CPI,
• provides a nominal anchor
• but can react perversely to terms of trade shocks
• Needed an anchor that accommodates trade shocks

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Product Price Targeting
PPT

• Target an index of domestic production prices.
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• 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
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II) Chiles fiscal institutions since 2000

•  
• 1st rule Governments must set a budget target,
• set 0 in 2008 under Pres. Bachelet.   
• 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 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.

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Many 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

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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.

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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.

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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.

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

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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.

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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.

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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.

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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.

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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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References by the author

• Project Syndicate,
• 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,
  Chapter 2 in Beyond the Resource Curse, B.Shaffer
  T. Ziyadov, eds. (U.Penn. Press) proofs
  notes Summary.   CID WP195, 2011.
• How Can Commodity Exporters Make Fiscal and
  Monetary Policy Less Procyclical? 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.  

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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,
• thereby giving the owners adequate incentive to
  conserve the resource in question.
• But often this is not possible
• 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 IIThe 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.

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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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