Transcript Energy Economics – II Jeffrey Frankel Harpel Professor, Harvard

Dealing with the Resource Curse:
How Can Commodity Exporters
Reduce Procylicality?
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth, Harvard University
and NBER
Meeting the Next Macroeconomic Challenges in Africa
NBER Africa Project and the Central Bank of Tanzania,
Zanzibar, Dec. 18-19, 2012
What is the Natural Resource Curse?

Many countries that are
richly endowed with oil,
minerals, or fertile land
have failed to grow more
rapidly than those without.

Example:

Some studies find a negative effect of oil
in particular, on economic performance.

Meanwhile, East Asian economies
achieved western-level standards of living
despite having virtually no exportable
natural resources:

Japan, Singapore, Hong Kong, Korea & Taiwan,


rocky islands or peninsulas;
followed by China.
Growth falls with fuel & mineral exports
4
Are natural resources necessarily bad?
No, of course not.

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Commodity wealth need not necessarily lead
to inferior economic or political development.
Rather, it is a double-edged sword,
with both benefits and dangers.

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It can be used for ill as easily as for good.
The priority should be on identifying ways
to sidestep the pitfalls that have afflicted
commodity producers in the past,
to find the path of success.
5
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Some developing countries have avoided
the pitfalls of commodity wealth.

E.g., Chile (copper)
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Botswana (diamonds)
Some of their innovations are worth emulating.
The lecture will suggest some policies &
institutional innovations to avoid the curse:
especially ways of managing price volatility.
6
The Natural Resource Curse should not
be interpreted as a rule that commodityrich countries are doomed to fail.

The question is what policies to adopt
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to avoid the pitfalls and improve the chances of prosperity.
A wide variety of measures have been tried
by commodity-exporters cope with volatility.
Some work better than others.
7
Procyclicality


Commodity-exporting
developing countries are
historically prone to procyclicality,
exacerbating the booms& busts.
Procyclicality in:
Capital inflows; Monetary policy;
 Real exchange rate; Non-traded Goods
 Fiscal Policy

8
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 rapidly.

Then it is forced to contract in recessions,

thereby exacerbating the swings.
9
Two budget items account for much
of the spending from oil booms:

(i) Investment projects.

Investment in practice may be
“white elephant” projects,

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which are stranded without funds
for completion or maintenance
when the oil price goes back down.
Rumbi Sithole took this photo
in “Bayelsa State
in 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
it’s unsalvageable..”
(ii) The government wage bill.

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Windfalls are often spent on public sector wages,
which are hard to reverse when boom turns to bust.
10
Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Adapted from Kaminsky, Reinhart & Vegh (2004)
countercyclical
G always used to be pro-cyclical
for most developing countries.
The procyclicality of fiscal policy, cont.

An important development --
in the most recent decade some developing
countries were able to break the historic pattern:

taking advantage of the boom of 2002-2008
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to run budget surpluses & build reserves,
thereby earning the ability to expand
fiscally in the 2008-09 crisis.
Chile, Botswana, China, Indonesia, Korea…
How have they done it?
12
Correlations between Government spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2012)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
Who achieves counter-cyclical fiscal policy?
Countries with “good institutions”
”On Graduation from Fiscal Procyclicality” 2013,
Frankel with C.Végh & G.Vuletin; J.Dev.Economics.
Policies & institutions to avoid
pitfalls of the Natural Resource Curse


Some that are not recommended:
 Institutions that try to suppress price volatility.
Those recommended fall into 3 categories:

Devices to hedge risk.

Ideas to reduce macroeconomic procyclicality.
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Institutions for better governance.
Many of the policies that have been
intended to suppress commodity
volatility do not work out so well
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Producer subsidies
Stockpiles
Marketing boards
Price controls
Export controls
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Blaming derivatives
Resource nationalism
Nationalization
Banning foreign
participation
7 recommendations
for commodity-exporting countries
Devices to share risks
1. Index contracts with foreign companies
(royalties…) to the world commodity price.
2. Hedge commodity revenues
in options markets
3. Link debt to the commodity price
Oct. 2011 op-ed
“Barrels & Bonds”
7 recommendations for commodity producers
continued
Countercyclical macroeconomic policy
4. Allow some currency appreciation in response
to a commodity boom, but not a free float.
- Accumulate some forex reserves first.
- 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,
the GDP deflator, which puts weight
PPT
on the export commodity (Product Price Targeting).
6. Emulate Chile: to avoid over-spending in boom times,
allow deviations from a target surplus only
in response to permanent commodity price rises.
7 recommendations for commodity producers,
concluded
Good governance institutions
7. Manage commodity funds professionally.
Invest them abroad

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
like Norway’s Pension Fund,
Reasons:
 (1) for diversification,
 (2) to avoid cronyism in investments.
but insulated from politics

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like Botswana’s Pula Fund.
Professionally managed, to optimize financially.
Elaboration on two proposals to reduce
the procyclicality of macroeconomic policy
for commodity exporters
 I)
To make monetary policy less
procyclical: Product Price Targeting
PPT
 II)
To make fiscal policy less
procyclical: emulate Chile.
I) The challenge of designing
a monetary regime for countries where
terms of trade shocks dominate the cycle

Fixing the exchange rate leads to procyclical
monetary policy: credit expands in commodity booms.

Floating accommodates terms of trade shocks.
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Inflation Targeting, in terms of the CPI,
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But volatility can be excessive;
also floating does not provide a nominal anchor.
provides a nominal anchor;
but can react perversely to terms of trade shocks.
Needed: an anchor that accommodates trade shocks
Product Price Targeting:
PPT
Target an index of domestic production prices
[1]
such as the GDP deflator
• 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, 2012).
II) Achieving counter-cyclical fiscal policy
The example of Chile since 2000
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1st rule – Governments must set a budget target,
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2nd rule – The target is structural:
Deficits allowed only to the extent that
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set = 0 in 2008 under Pres. Bachelet.
(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.
Appendices
on recommendations for
dealing with the natural resource curse
Appendix 1: Policies not recommended
Appendix 2: Elaboration on proposal to make
monetary policy less procyclical – PPT, using
GDP deflator to set annual inflation target.
Appendix 3: Elaboration on proposal to make
fiscal policy less procyclical – emulate Chile,
setting structural targets with independent
fiscal forecasts
Appendix 1:
Policies that have been tried
but that are not recommended
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Producer subsidies
Stockpiles
Marketing boards
Price controls
Export controls
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Blaming derivatives
Resource nationalism
Nationalization
Banning foreign
participation
Unsuccessful policies to reduce commodity price volatility:

1) Producer subsidies to “stabilize” prices at high levels,
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often via wasteful stockpiles & protectionist import barriers.
Examples:

The EU’s Common Agricultural Policy

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Or fossil fuel subsidies

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Bad for EU budgets, economic efficiency,
international trade & consumer pocketbooks.
which are equally distortionary & budget-busting,
and disastrous for the environment as well.
Or US corn-based ethanol subsidies,

with tariffs on Brazilian sugar-based ethanol.
Unsuccessful policies, continued

2) Price controls to “stabilize” prices at low levels

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Discourage investment & production.
Example: African countries adopted
commodity boards for coffee & cocoa
at the time of independence.

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The original rationale: to buy the crop in years
of excess supply and sell in years of excess demand.
In practice the price paid to cocoa & coffee farmers
was always below the world price.

As a result, production fell.
Microeconomic policies,

continued
Often the goal of price controls is to shield
consumers of staple foods & fuel from increases.

But the artificially suppressed price
discourages domestic supply, and
 requires rationing to domestic households.
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Shortages & long lines can fuel political
rage as well as higher prices can.
Not to mention when the government
is forced by huge gaps to raise prices.
Price controls can also require imports,
to satisfy excess demand.

Then they raise the world price even more.
Microeconomic policies, continued

3) In producing countries, prices are artificially
suppressed by means of export controls

to insulate domestic consumers from a price rise.
In 2008, India capped rice exports.
 Argentina did the same for wheat exports,
 as did Russia in 2010.
 India banned cotton exports in March 2012.

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Results:

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Domestic supply is discouraged.
World prices go even higher.
An initiative at the G20
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.
An initiative that has less merit:

4) Attempts to blame speculation for volatility

and so to ban derivatives markets.
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Yes, speculative bubbles sometimes hit prices.
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But in commodity markets
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prices are more often the signal for fundamentals.
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Don’t shoot the messenger.
Also, derivatives are useful for hedgers.
An example of commodity speculation
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
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.
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 Cal’s speculation,
not wanting to profit
from others’ misfortunes,
and tells him he will have
to “give the money back.”
An example of commodity speculation, cont.

Cal has been the agent of
Adam Smith’s famous invisible hand:

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
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 farmer’s field,
something real-life speculators seldom get to see.
The overall lesson for microeconomic policy
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
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Attempts to prevent
commodity prices from
fluctuating generally fail.
Even though enacted in the name of reducing volatility
& income inequality, their effect is often different.
Better to accept volatility and cope with it.
“Resource nationalism”
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Another motive for commodity export controls:
5) To subsidize downstream industries.

E.g., “beneficiation” in South African diamonds
But it didn’t make diamond-cutting competitive,
 and it hurt mining exports.

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6) Nationalization of foreign companies.

Like price controls,
it discourages investment.
“Resource nationalism”
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7) Keeping out foreign companies altogether.
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continued
But often they have the needed technical expertise.
Examples: declining oil production in Mexico & Venezuela.
8) Going around “locking up” resource supplies.
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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.
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.
Appendix 2, on Monetary Policy:
Product 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.

6 proposed nominal targets and the Achilles heel of each:
Vulnerability
Targeted
variable
Gold standard
Commodity
standard
Price
of gold
Price of agric.
& mineral
basket
Vulnerability
Example
Vagaries of world
1849 boom;
gold market
1873-96 bust
Shocks in
Oil shocks of
imported
1973-80, 2000-11
commodity
Monetarist rule
M1
Velocity shocks
US 1982
Nominal income
targeting
Fixed
exchange rate
Nominal
GDP
$
Measurement
problems
Appreciation of $
Less developed
countries
(or €)
(or € )
CPI
Terms of trade
shocks
Inflation targeting
EM currency crises
1995-2001
Oil shocks of
1973-80, 2000-11
Professor Jeffrey Frankel
Why is PPT better than a fixed exchange rate
for countries with volatile export prices?
PPT
Better response to trade shocks (countercyclical):

If the $ price of the export commodity goes up,
the currency automatically appreciates,
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moderating the boom.
If the $ price of the export commodity goes down,
the currency automatically depreciates,
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moderating the downturn
& improving the balance of payments.
Why is PPT better than CPI-targeting
for countries with volatile terms of trade?
PPT
Better response to trade shocks (accommodating):


If the $ price of imported commodity goes up,
CPI target says to tighten monetary policy
enough to appreciate the currency.

Wrong response.
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PPT does not have this flaw .
(E.g., oil-importers in 2007-08.)
If the $ price of the export commodity goes up,
PPT says to tighten money enough to appreciate.

Right response.

CPI targeting does not have this advantage.
(E.g., Gulf currencies in 2007-08.)
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Simulations
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Gold producers:
Burkino Faso, Ghana, Mali, South Africa
Other commodities:
Coffee (Ethiopia), oil (Nigeria), platinum (S.Africa)
General finding:
Under Product Price Targets, their currencies
would have depreciated automatically in 1990s
when commodity prices declined,

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perhaps avoiding messy balance of payments crises.
Would have appreciated automatically in commodity booms,

moderating over-heating.
Sources: Frankel (2002, 03a, 05), Frankel & Saiki (2003)
Appendix 3, on fiscal policy:
Chile’s fiscal institutions

In 2000 Chile instituted its structural budget rule.
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The institution was formalized in law in 2006.
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The structural budget deficit must be zero,
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originally BS > 1% of GDP, then cut to ½ %, then 0 -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.
The crucial institutional innovation in Chile

How has Chile avoided over-optimistic official forecasts?
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The estimation of the long-term path
for GDP & the copper price
is made by two panels of independent experts,
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especially the historic pattern
of over-exuberance in booms
which forecasts in most other governments show?
and thus is insulated from political pressure & wishful thinking.
Other countries might usefully emulate Chile’s innovation

or in other ways delegate to independent agencies
estimation of structural budget deficit paths.
The Pay-off

Chile’s fiscal position strengthened immediately:
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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, Chile’s sovereign rating had climbed to A+,
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ahead of some advanced countries.
=> It was able to respond to the 2008-09 recession

via fiscal expansion.

In 2008, with copper prices spiking up,
the government of President Bachelet had been
under intense pressure to spend the revenue.
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She & Fin.Min.Velasco held to the rule, saving most of it.
Their popularity ratings fell sharply.
When the recession hit and the copper price came
back down, the government increased spending,
mitigating the downturn.

Bachelet & Velasco’s
popularity reached
historic highs in 2009.
Evolution of approval and disapproval
of four Chilean presidents
Presidents Patricio Aylwin, Eduardo Frei, Ricardo Lagos and Michelle Bachelet
Data: CEP, Encuesta Nacional de Opinion Publica, October 2009, www.cepchile.cl.
Source: Engel et al (2011).
References by the author

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,”

"The Curse: Why Natural Resources Are Not Always a Good Thing,”

“The Natural Resource Curse: A Survey,” 2012,

“How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?”

“On Graduation from Procyclicality,” 2013, with C.Végh & G.Vuletin; J. Dev. Economics.

“Chile’s Solution to Fiscal Procyclicality,”

“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.


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.
Milken Institute Review, vol.13, 4th quarter 2011.
Chapter 2 in Beyond the Resource Curse,
B.Shaffer & T. Ziyadov, eds. (U.Penn. Press); proofs & notes; Summary. CID WP195, 2011.
Natural Resources, Finance & Development, R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011. HKS RWP 11-015.
2012, Transitions blog, Foreign Policy.
"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.