Transcript Coping with Commodity Volatility:Macroeconomic Policies for

Coping with Commodity Volatility:
Macroeconomic Policies
for Developing Countries
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
May 24, 2013
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 Bachelet
Data: CEP, Encuesta Nacional de Opinion Publica, October 2009, www.cepchile.cl.
Source: Engel et al (2011).
2
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.

3
(i) Pro-cyclical capital flows

According to intertemporal optimization theory,
capital flows should be countercyclical:



In practice, it does not always work this way.
Capital flows are more procyclical than countercyclical.


flowing in when exports do badly
and flowing out when exports do well.
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.
4
(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.

5
Macro effects of commodity boom

Inflation shows up especially
in non-traded goods & services,
like construction.
6
Pro-cyclical real exchange rate
Countries 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.
7
(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.
8
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. 9
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
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).
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.

Oil windfalls are often spent on public sector wages.


Medas & Zakharova (2009)
Arezki & Ismail (2010):
government spending rises in booms, but is downward-sticky.
11
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
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.
13
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 policy:
How can governments be constrained from
over-spending in boom times? Fiscal rule?

4. What microeconomic arrangements
can reduce macroeconomic volatility?
14
1) The challenge of designing
a monetary regime for countries where
terms of trade shocks dominate the cycle

Fixing the exchange rate
leads 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.
15
Currency regime,

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,


continued
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.
16
Demand vs. supply shocks

An old wisdom regarding the source of shocks:



One set of supply shocks:
natural disasters


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).
R.Ramcharan (2007) finds floating works better.
A common source
of real shocks: trade.
Terms-of-trade variability

Prices of crude oil and other agricultural & mineral
commodities hit record highs in 2008 & 2011.

=> Favorable terms of trade shocks for some

=> Unfavorable terms of trade shock for others


(oil producers, Africa, Latin America, etc.);
(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)…
Céspedes & Velasco (Nov. 2012)
NBER WP 18569
“Macroeconomic Performance During Commodity Price Booms & Busts”
** Statistically
significant
at 5% level.
Constant term
not reported.
(t-statistics in
parentheses.)
Across 107 major commodity boom-bust cycles,
output loss is bigger the bigger is the commodity
price change & the smaller is exchange rate flexibility.
19
Monetary regime
If the exchange rate is not
to be the monetary anchor, what is?

The popular choice
of the last decade:
Inflation Targeting.

But CPI targeting can react perversely
to supply shocks
 & terms of trade shocks.

20
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
21
Nominal GDP target
cancels out velocity shocks (vs. M target)
& moderates effects of supply shocks (vs. IT)
P
Nom.
GDP
target
IT
•
Adverse
AS shock
AS
•
•
AD
Real
GDP 22
Does Nominal GDP target give best output/inflation trade-off?
Adverse AS shock
P
Nom.
GDP
target
IT
•
•
It gives exactly the right answer
if the simple Taylor Rule’s 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.
AD
Real GDP
23
Product Price Targeting
PPT
accommodates terms of trade shocks
Target an index of domestic production prices
[1]
such 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).
24
Why is PPT better than a fixed exchange rate
for 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.
25
Why is PPT better than CPI-targeting
for 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.
26
Elaboration on
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.

27
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
Is Inflation Targeting
the reigning orthodoxy
at the Fund?
“Yes”
•
•
•
•
2006:
2007:
2008:
2010:
•
2011
100%
63%
72%
58%
97%
Do you personally
believe in IT? 38%
3. How Can Countries Avoid
Pro-cyclical Fiscal Policy?

“Good institutions.”

But what are they, exactly?
30
Who achieves counter-cyclical fiscal policy?
Countries with “good institutions”
”On Graduation from Fiscal Procyclicality,”
Frankel, Végh & Vuletin; J.Dev.Economics, 2013.
31
The quality of institutions varies,
not just across countries, but also across time.
1984-2009
Frankel, Végh
& Vuletin,2013.
32
The comparison
holds not only
in cross-section,
but also across time.
”On Graduation from
Fiscal Procyclicality,”
Frankel, Végh & Vuletin;
J. Devel. Econ., 2013.
33
How can countries avoid fiscal expansion in booms?

What are “good institutions,” exactly?

Rules?

Budget deficits or debt brakes?


Rules for cyclically adjusted budgets?


Have been tried many times. Usually fail.
Countries more likely to be able to stick with them.
But…
An under-explored problem:

Over-optimism in official forecasts

of growth rates & budgets.
34
Over-optimism in official forecasts

Statistically significant bias among 33 countries




(2011, 2012).
If the boom is forecast to last indefinitely,
there is no apparent need to retrench.
BD rules don’t help.




Frankel
Leads to pro-cyclical fiscal policy:


Worse in booms.
Worse at 3-year horizons than 1-year.
The SGP worsens forecast bias for euro countries.
Cyclically adjusted rules won’t help the bias either.
Frankel & Schreger
(2013).
Solution?
35
The example of Chile’s 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.
36
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.
37
The Pay-off

Chile’s 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, Chile’s sovereign rating had climbed to A+,


ahead of some advanced countries.
=> It was able to respond to the 2008-09 recession.
38

In 2008, with copper prices spiking up,
the government of President Bachelet had been
under 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 & Velasco’s
popularity reached
historic highs by the time
they left office.
39
Poll ratings
of Chile’s
Presidents
and Finance
Ministers
And the
Finance
Minister?:
August 2009
In August 2009, the
popularity of the
Finance Minister,
Andres Velasco,
ranked behind only
President Bachelet,
despite also having
been low two years
before. Why?
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009
40
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;
41
US official projections have been over-optimistic on average.
42
Greek official forecasts have always been over-optimistic.
43
Chile’s official forecasts have not been over-optimistic.
44
The optimism in official budget forecasts is
stronger at the 3-year horizon, stronger among
countries with budget rules, & stronger in booms.
Frankel, 2010, “A Solution to Fiscal Procyclicality:45
The Structural Budget Institutions Pioneered by Chile.”
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) Chile’s official forecasts are not overly optimistic.
It has apparently avoided the problem of forecasts
that unrealistically extrapolate in boom times.
46
In sum, institutions recommended
to make fiscal policy less procyclical:

Chile is not subject to the same bias toward overoptimism 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
47
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) ?
48
4. Other reforms to manage volatility

Contractual provisions to share risks:
1. Index contracts with foreign companies
to the world commodity price.
2. Hedge commodity revenues
in options markets.
3. Denominate debt in terms of commodity price .

Manage commodity funds professionally.
49
Manage commodity funds professionally.
Norway’s 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 Botswana’s Pula Fund,

fully delegated for financial optimization.
50
References by the author

Project Syndicate,



http://www.hks.harvard.edu/fs/jfrankel/
“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. Spanish:Journal 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.
51
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.
52
Press: NY), pp. 173-93.
53
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
5 Possible Natural Resource Curse Channels
1.
Volatility
2.
Crowding-out of manufacturing
3.
Autocratic Institutions
4.
Anarchic Institutions
5.
Procyclicality
1.
2.
3.
including
Procyclical capital flows
Procyclical monetary policy
Procyclical fiscal policy.
55
(1) Volatility
in global commodity
prices arises because
supply & demand are
inelastic in the short run.
56
Commodity prices have been especially
volatile over the last decade
Source: UNCTAD
57
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.
=> 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
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…
59
3. Autocratic/Oligarchic
Institutions
Econometric findings that oil
& other “point-sourceresources” lead to poor 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.
60
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.
61
An example, from economic historians
Engerman & Sokoloff

Why did industrialization take place in North America,





(1997, 2000, 2002)
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.
62
4. Anarchic institutions
1.
2.
3.
Unsustainably rapid
depletion of resources
Unenforceable
property rights
Civil war
63
(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
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
The Dutch Disease: The 5 effects elaborated
 1)


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)

Real appreciation in the currency
A rise in government spending
in response to availability of tax receipts or royalties.
66
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
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

Arezki & Brückner (2010a, b): commodity price booms lead to higher
resources on growth rates during 1970-1990 was mediated through
international debt incurred when commodity prices were high.
government spending, external debt & default risk in autocracies,

but do not have those effects in democracies.
68
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.
69



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
Appendix II:
Empirical 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
PPT
would have depreciated automatically in 1990s
when commodity prices declined,
 perhaps avoiding messy balance of payments crises.
Sources: Frankel (2002, 03a, 05), Frankel & Saiki (2003)
71
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 .
72
Estimation for each country of weights in national price index on 3 sectors:
non tradable goods, leading commodity export, & other tradable goods
Leading
Non
Other
Comm.
Oil
Tradables
Tradables
Export
CPI
0.6939
0.0063
0.0431
0.2567
ARG
PPI
0.6939
0.0391
0.0230
0.2440
CPI
0.5782
0.0163
0.0141
0.3914
BOL
PPI
0.5782
0.1471
0.0235
0.2512
CPI
0.5235
0.0079
0.0608
0.4078
CHL
PPI
0.5235
0.0100
0.1334
0.3332
CPI
0.5985
-0.0168
0.3847
COL*
PPI
0.5985
-0.0407
0.3608
CPI
0.6413
0.0002
0.0234
0.3351
JAM
PPI
0.6413
0.1212
0.0303
0.2072
CPI
0.3749
-0.0366
0.5885
MEX*
PPI
0.3749
-0.0247
0.6003
CPI
0.3929
0.1058
0.0676
0.4338
PRY
PPI
0.3929
0.0880
0.0988
0.4204
CPI
0.6697
0.0114
0.0393
0.2796
PER
PPI
0.6697
0.040504
0.021228
0.268568
CPI
0.6230
0.0518
0.0357
0.2895
URY
PPI
0.6230
0.2234
0.1158
0.0378
* Oil is the leading commodity export.
Total
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
“A Comparison of Product Price
Targeting and Other Monetary
Anchor Options, for CommodityExporters 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 country’s PPI
than in its CPI,
as expected.
(Jamaicans don’t
eat bauxite.)73
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….
74
The 4 inflation-targeters in Latin America
show correlation (currency value
in $
, import prices

>0;

> correlation before they adopted IT;

in $)
> correlation shown by non-IT
Latin American oil-importing countries.
75
Table 1
LAC Countries’ Current Regimes and Monthly Correlations
Exchange
($/local
currency)
withcurrency)
$ Import
Price
Table 1: of
LACA
Countries’ CurrentRate
Regimes Changes
and Monthly Correlations
of Exchange
Rate Changes ($/local
with Dollar Import
PriceChanges
Changes
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
0.0524
-0.0484
CHL
Independently floating
Inflation targeting framework (1990)*
-0.0695
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
IT
countries
show
correlations
> 0.
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.
76
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.
77
Appendix III: Micro policies
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
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 EU’s Common Agricultural Policy


Or fossil fuel subsidies



Bad for EU budgets, economic efficiency,
international trade, & consumer pocketbooks.
which are equally distortionary & budget-busting,
and disastrous for the environment as well.
Or US corn-based ethanol subsidies,

with tariffs on Brazilian sugar-based ethanol.
Unsuccessful policies, continued

2) Price controls to “stabilize” prices at low levels


Discourage investment & production.
Example: African countries adopted
commodity boards for coffee & cocoa at the
time of independence.


The original rationale: to buy the crop in years
of excess supply and sell in years of excess demand.
In practice the price paid to cocoa & coffee farmers
was always below the world price.

As a result, production fell.
Microeconomic policies,

continued
Often the goal of price controls is to shield
consumers of staple foods & fuel from increases.

But the artificially suppressed price
discourages domestic supply, and
 requires rationing to domestic households.




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.


Results:


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.

Yes, speculative bubbles sometimes hit prices.

But in commodity markets,

prices are more often the signal for fundamentals.


Don’t shoot the messenger.
Also, derivatives are useful for hedgers.
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.
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:



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



Attempts to prevent
commodity prices from
fluctuating generally fail.
Even though enacted
in the name of reducing volatility & income inequality,
their effect is often different.
Better to accept volatility and cope with it.

For the poor: well-designed transfers,

along the lines of Oportunidades or Bolsa Familia.
“Resource nationalism”

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.


6) Nationalization of foreign companies

Like price controls, it discourages investment.
“Resource nationalism”

7) Keeping out foreign companies altogether.



continued
But often they have the needed technical expertise.
Examples: declining oil production in Mexico & Venezuela.
8) Going around “locking up” resource supplies.


China must think that this strategy will
protect it in case of a commodity price shock.
But global commodity markets are increasingly integrated.

If conflict in the Persian Gulf doubles world oil prices,
the effect will be pretty much the same
for those who buy on the spot market and
those who have bilateral arrangements.
91