Title: The Natural Resource Curse I: Pitfalls of Commodity Wealth Jeffrey Frankel Harpel Professor of Capital Formation
1The Natural Resource Curse IPitfalls of
Commodity WealthJeffrey FrankelHarpel
Professor of Capital Formation GrowthHarvard
University
- Low-Income Countries Seminar
- International Monetary Fund, April 26, 2011
2The Natural Resource Curse
- The NRC pertains especially to oil minerals,
but sometimes to agricultural products, logging
fishing too. - Seminal references
- Auty (1990, 2001, 07, 09)
- Sachs Warner (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)
3- 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
4Growth falls with fuel mineral exports
5Are 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.
6- The goal is to enjoy the success of
- Chile, vs. Bolivia
- Botswana, vs. Congo
- Norway, 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.
7- 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
87 Possible Natural Resource Curse Channels
- Price trend
- Price volatility
- Crowding-out of manufacturing
- Inhibited development of institutions
- Unsustainably rapid depletion
- Proclivity for armed conflict
- Procyclical macro policy
9The 7 NRC Channels Elaborated
- 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.
10The 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.
11The 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.
12(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 side-effects
from a strong, but perhaps temporary, rise in the
export commoditys world price.
13- Volatility in developing countries
- arises both from foreign shocks,
- including export commodity price fluctuations,
- and from domestic shocks
- including macroeconomic political instability.
14- 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.
15- 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).
16- 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.
17(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) .
18(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.
19Irans Government Wage Bill Is Influenced by Oil
Prices Over Preceding 3 Years (1974,
1977-1997.)
Source Frankel (2005b)
20Indonesias Government Wage Bill Is Influenced
by Oil Prices Over Preceding 3 Years (1974,
1977-1997.)
Source Frankel (2005b)
21Public 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.
22The 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
23The 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
- Kazakhstan, Mexico, Norway, Russia.
- or the form of money inflows inflation if the
exchange rate is fixed 1 - e.g. fixed-rate oil-exporters, the UAE Saudi
Arabia. - 2) A rise in government spending
- in response to increased availability of tax
receipts or royalties.
24The 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.
25The 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.
26The Natural Resource Curse should not be
interpreted as a rule that resource-rich
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.
27(No Transcript)
28Appendices 1) The other possible NRC
channels in detail2) Skeptics of the NRC
29Appendix 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
30(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
31(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
32(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. - Engels Law, an (older) proposition households
spend a lower fraction of their income on basic
necessities as they get richer. - Demand gt P oil
32
33(iii) Hypotheses of rising trendsHotelling
on depletable resourcesMalthus on geometric
population growth.
- Persuasive theoretical arguments that we should
expect oil prices to showan upward trend in the
long run.
33
34Assumptions for Hotelling model
- (1) Non-perishable non-renewable resources
- Deposits in the earths 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
35One 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
36The Hotelling logic
- The owner chooses how much mineral to extract
- and how much to leave in the ground.
- Whatever is mined can be sold at todays price
(price-taker assumption) - 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
37The Hotelling logic, continued
- As minng companies worldwide react in this way,
they drive down the price today, - 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
38The 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
39What is the overall statistical trend in
commodity prices in the long run?
- Some authors find a slight upward trend,
- some a slight downward trend. 1
- The answer seems to depend, more than anything
else, on the date of the end of the sample - 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
40(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 betterthan
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
41Effects 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
42(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
43Counterarguments
- There is no reason why learning by doing should
occur only in manufacturing tradables. - Nontradable sectors can enjoy learning by doing.
1 - 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, - 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
44Counterarguments, 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
45(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
46What 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
47Institutions 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
48Addressing 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
49Institutions Econometric findings
- The finding is the same, regardless of IV
- Institutions trump everything else Rodrik et
al (2002) - Acemoglu et al (2002)
- Easterly Levine (2002)
- Hall Jones (1999)
- Geography and history matter mainly as
determinants of institutions - which is not to say that institutions dont also
have other important determinants. - In any case, institutions are important.
49
50The 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
51A related view by economic historians Engerman
Sokoloff (1997, 2000, 2002)
- Why did industrialization take place in North
America, - 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
52Econometric findings that point-source
resources such as oil and minerals lead to
poor institutions
The theory is thought to fit Middle Eastern oil
exporters well. E.g., Iran. Mahdavi
(1970), Skocpol (1982, p. 269), and Smith (2007).
- Isham, Woolcock, Pritchett, Busby (2005)
- Sala-I-Martin Subramanian (2003)
- Bulte, Damania Deacon (2005)
- Mehlum, Moene Torvik (2006)
- Arezki Brückner (2009).
52
53Which 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
54The 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 republicsthe choice
of ownership structure makes the difference as
to whether oil turns out a blessing rather than a
curse.
54
55The combination ofdevelopment 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.
56(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
57Rapid depletion, continued
- 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,
- 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
58 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 point-source 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
59Unenforceable 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
60Unenforceable 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.
21 E.g., Dasgupta Heal (1985). 2
Brander Taylor (1997).
60
61(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
62Summary 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, such as corruption, inequality,
class structure, chronic power struggles, and
absence of rule of law and property rights. - (6) The Dutch Disease. A commodity boom
gt real currency appreciation and increased
government spending, gt which expand nontraded
sector and render uncompetitive non-commodity
export sectors such as manufactures.
62
63Appendix 2 Skeptics argue that commodity exports
are endogenous. 1
- On the one hand, basic trade theory saysA
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, - invalidating the common inference that minerals
are bad for growth. - 1 Maloney (2002) and Wright Czelusta (2003,
04, 06).
64Commodity exports are endogenous, continued.
- 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 - 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).
65Commodity exports are endogenous, continued.
- Examples of countries that were equally
well-endowed geologically but that failed to
develop their natural resources efficiently
include - Chile and Australia before World War I,
- and Venezuela since the 1980s.3
- 3 Hausmann (2003, p.246) Venezuelas growth
collapse took place after 60 years of expansion,
fueled by oil. If oil explains slow growth, what
explains the previous fast growth?
66The Natural Resource Curse IIRecommendations
to Avoid the Pitfalls Jeffrey FrankelHarpel
Professor, Harvard University
LIC Seminar Series, IMF, April 26, 2011
67 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).
68Devices to share risks
Summary 10 recommendations for commodity
exporting countries
- 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
69Macroeconomic policy
Summary 10 recommendations for commodity
producers continued
- 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 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.
PPT
70Good governance institutions
Summary 10 recommendations for commodity
producers, continued
- 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.
71Policies/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
72I. 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
IT
PPT
73Fixed 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,
- helping the central bank achieve low-inflation
credibility. - A few commodity exporters have firmly fixed
- 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
74Recommendation
- Balancing of these pros cons gt 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.
75 A loose recommendation, continued
- At the early stages of a boom, there is a good
case for foreign exchange intervention, adding to
reserves, - 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
appreciation of the currency.
76Nominal 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
IT
PPT
77Inflation targeting has, for 10 years, been the
conventional wisdom for how to conduct monetary
policy.
IT
- 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. 1/ A
broad definition Flexible inflation targeting
Have a long run target for inflation, and be
transparent. Then who could disagree?
Professor Jeffrey Frankel
78IT
- 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
79Implications 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 gt
accommodate by floating. - Edwards L.Yeyati (2003)
Professor Jeffrey Frankel
806 proposed nominal targets and the Achilles heel
of each
IT
Professor Jeffrey Frankel
81Proposal 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
- The advantage of automatic accommodation to
terms of trade shocks, together with - the advantages of a nominal anchor.
Professor Jeffrey Frankel
82PPT
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
83II. 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).
84Chiles fiscal institutions
- Chiles 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 Europes 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.
85Chiles 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.
86Other fiscal institutions
- Commodity funds or Sovereign Wealth Funds
- Reducing net inflows during booms
- Lump sum distribution
- Invest in education, health, roads.
87(No Transcript)
88Appendices
- I. Recommended ways to reduce price volatility
- II. Non-recommended ways to reduce price
volatility - III. Attempts to impose external checks
89Appendix I Recommendation for dealing with
volatility Accept its existence and adopt
institutions to cope with it
- 3 micro devices to share risk efficiently
- For commodity exporters who sign contracts with
foreign companies. - For producers who sell their minerals
themselves. - For debtors dependent on commodity revenues.
901. 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.
91Solution 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 countrys reputation from reneging.
922. 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 gt 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.
933. 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.
94Appendix 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
95Appendix III Efforts to Impose External Checks
- The Chad experiment
- The Extractive Industries Transparency
Initiative Publish What You Pay - More drastic solutions
96External 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.
97External 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.
98External 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.
99External 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.