The Natural Resource Curse: Part II -- How to Avoid It Jeffrey Frankel IMF Institute for Capacity Development, July 27, 2012

Part II Policies and institutions to avoid pitfalls of the Natural Resource Curse Some that are not recommended. Institutions that try to suppress price volatility Recommended: Devices to hedge risk. Ideas to reduce macroeconomic procyclicality. Institutions for better governance.

The Natural Resource Curse should not be interpreted as a rule that commodity-rich countries are doomed to fail. The question is what policies to adopt to avoid the pitfalls and improve the chances of prosperity. A wide variety of measures have been tried by commodity-exporters cope with volatility. Some work better than others.

Many of the policies that have been intended to suppress commodity volatility do not work out so well Producer subsidies Stockpiles Marketing boards Price controls Export controls Blaming derivatives Resource nationalism Nationalization Banning foreign participation

for commodity-exporting countries 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 5

Countercyclical macroeconomic policy 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, a price measure that puts weight on the export commodity (Product Price Targeting). 6. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent commodity price rises. PPT 6

Good governance institutions 7 recommendations for commodity producers, concluded Good governance institutions 7. Manage commodity funds professionally. Invest them abroad like Norway’s Pension Fund, Reasons: (1) for diversification, (2) to avoid cronyism in investments. but insulated from politics like Botswana’s Pula Fund. Professionally managed, to optimize financially. 7

I) To make monetary policy less procyclical: Product Price Targeting Elaboration on two proposals to reduce the procyclicality of macroeconomic policy for commodity exporters I) To make monetary policy less procyclical: Product Price Targeting II) To make fiscal policy less procyclical: emulate Chile. PPT

I) The challenge of designing a currency regime for countries where terms of trade shocks dominate the cycle Fixing the exchange rate leads to procyclical monetary policy: credit expands in commodity booms. Floating accommodates terms of trade shocks. But volatility can be excessive; also floating does not provide a nominal anchor. Inflation Targeting, in terms of the CPI, provides a nominal anchor; but can react perversely to terms of trade shocks Needed: an anchor that accommodates trade shocks

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). 10 10

II) Chile’s fiscal institutions since 2000   1st rule – Governments must set a budget target, set = 0 in 2008 under Pres. Bachelet.     2nd rule – The target is structural: Deficits allowed only to the extent that (1) output falls short of trend, in a recession, or (2) the price of copper is below its trend. 3rd rule – The trends are projected by 2 panels of independent experts, outside the political process. Result: Chile avoids the pattern of 32 other governments, where forecasts in booms are biased toward over-optimism. Chile ran surpluses in the 2003-07 boom, while the U.S. & Europe failed to do so. 11

Appendices Appendix 1 (to Part I): The Resource Curse skeptics Appendix 2: Policies not recommended Appendix 3: Elaboration on proposal to make monetary policy less procyclical – PPT, using GDP deflator to set annual inflation target. Appendix 4: Elaboration on proposal to make fiscal policy less procyclical – emulate Chile, setting structural targets with independent fiscal forecasts

Which comes first, oil or institutions? Some question the assumption that oil discoveries are exogenous and institutions endogenous. Oil 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.

The important determinant is whether the country already has good institutions at the time that oil is 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).

Skeptics argue that commodity exports are endogenous. On the one hand, basic trade theory says: A 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. Maloney (2002) and Wright & Czelusta (2003, 04, 06).

Commodity 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 David & Wright (1997). 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 lifting restrictions on foreign mining participation in 1995. Wright & Czelusta (2003, pp. 4-7, 12-13, 18-22).

Commodity exports are endogenous, continued. Examples of countries that were equally well-endowed geologically but that failed to develop their natural resources efficiently include: Chile & Australia before World War I, and Venezuela since the 1980s. Hausmann (2003, p.246): “Venezuela’s growth collapse took place after 60 years of expansion, fueled by oil. If oil explains slow growth, what explains the previous fast growth?”

Appendix 2: Policies that have been tried but that are not recommended Blaming derivatives Resource nationalism Nationalization Banning foreign participation Producer subsidies Stockpiles Marketing boards Price controls Export controls

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 Bad for EU budgets, economic efficiency, international trade & consumer pocketbooks. Or fossil fuel subsidies which are equally distortionary & budget-busting, and disastrous for the environment as well. Or US corn-based ethanol subsidies, with tariffs on Brazilian sugar-based ethanol. 19

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. 20

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. 21

Microeconomic policies, continued 3) In producing countries, prices are artificially suppressed by means of export controls to insulate domestic consumers from a price rise. In 2008, India capped rice exports. Argentina did the same for wheat exports, as did Russia in 2010. India banned cotton exports in March 2012. Results: Domestic supply is discouraged. World prices go even higher. 22

An initiative at the G20 meetings in France 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. One hopes for steps in this direction, perhaps working through the WTO. 23

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. 28

“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” continued 7) Keeping out foreign companies altogether. But often they have the needed technical expertise. Examples: declining oil production in Mexico & Venezuela. 8) Going around “locking up” resource supplies. China must think that this strategy will protect it in case of a commodity price shock. But global commodity markets are increasingly integrated. If conflict in the Persian Gulf doubles world oil prices, the effect will be pretty much the same for those who buy on the spot market and those who have bilateral arrangements.

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. 31

Appendix 3: Product Price Targeting 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 IT Professor Jeffrey Frankel 33

Better response to trade shocks (countercyclical): 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, moderating the boom. If the $ price of the export commodity goes down, the currency automatically depreciates, moderating the downturn & improving the balance of payments. 34

Better response to trade shocks (accommodating): 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. (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. 35

Empirical findings Simulations of 1970-2000 Gold producers: Burkino Faso, Ghana, Mali, South Africa Other commodities: Ethiopia (coffee), Nigeria (oil), S.Africa (platinum) General finding: Under Product Price Targets, their currencies would have depreciated automatically in 1990s when commodity prices declined, perhaps avoiding messy balance of payments crises. Sources: Frankel (2002, 03a, 05), Frankel & Saiki (2003)

Price indices CPI & GDP deflator each include: cpi = (f)pim +(1-f)pn , 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 .

Argentina is relatively closed; Estimation for each country of weights in national price index on 3 sectors: non tradable goods, leading commodity export, & other tradable goods “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America," Economia, vol.11, 2011 (Brookings), NBER WP 16362.   Argentina is relatively closed; Mexico is relatively open. The leading export commodity usually has a higher weight in the country’s PPI than in its CPI, as expected. (Jamaicans don’t eat bauxite.)

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….

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

The 4 inflation-targeters in Latin America show correlation (currency value in $ , import prices in $) > 0 ; > correlation before they adopted IT; > correlation shown by non-IT Latin American oil-importing countries.

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.

Appendix IV: Chilean fiscal policy In 2000 Chile instituted its structural budget rule. The institution was formalized in law in 2006. The structural budget deficit must be zero, 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? especially the historic pattern of over-exuberance in commodity booms? The estimation of the long-term path for GDP & the copper price is made by two panels of independent experts, 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: 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 via fiscal expansion.

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 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).

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;

(4) The optimism in official budget forecasts is stronger at the 3-year horizon, stronger among countries with budget rules, & stronger in booms. Frankel, 2012, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile.”

(4) Official budget forecasts are biased more if GDP is currently high & especially at longer horizons Budget balance forecast error as % of GDP, Full dataset (1) (2) (3) One year ahead Two years ahead Three years ahead GDP relative to trend 0.093*** (0.019) 0.258*** (0.040) 0.289*** (0.063) Constant 0.201 0.649*** 1.364*** (0.197) (0.231) (0.348) Observations 398 300 179 33 countries Variable is lagged so that it lines up with the year in which the forecast was made. *** p<0.01 Robust standard errors in parentheses, clustered by country.

Budget balance forecast error as a % of GDP, Full Dataset (5) Official budget forecasts are more optimistically biased in countries subject to a budget deficit rule (SGP) Budget balance forecast error as a % of GDP, Full Dataset (1) (2) (3) (4) One year ahead Two years ahead SGPdummy 0.658 0.905** 0.407 0.276 (0.398) (0.406) (0.355) (0.438) SGP dummy * (GDP - trend) 0.189** (0.0828) 0.497*** (0.107) Constant 0.033 0.466* (0.228) (0.248) (0.229) (0.249) Observations 399 300 398 33 countries *** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

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.

In sum, institutions recommended to make fiscal policy less procyclical: Official growth & budget forecasts tend toward wishful thinking : unrealistic extrapolation of booms 3 years into the future. The bias is worse among the European countries supposedly subject to the budget rules of the SGP, presumably because government forecasters feel pressured to announce they are on track to meet budget targets even if they are not. Chile is not subject to the same bias toward over-optimism in forecasts of the budget, growth, or the all-important copper price. The key innovation that has allowed Chile to achieve countercyclical fiscal policy: not just a structural budget rule in itself, but rather the regime that entrusts to two panels of experts estimation of the long-run trends of copper prices & GDP.

Application to other countries Any country could adopt the Chilean mechanism, not just commodity-exporters. Suggestion: give the panels more institutional independence as is familiar from central banking: requirements for professional qualifications of the members and laws protecting them from being fired. Open questions: Are the budget rules to be interpreted as ex ante or ex post? 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) ?

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,” 2012, Commodity Price Volatility and Inclusive Growth in Low-Income Countries , R.Arezki & Z.Min, eds.. HKS RWP12-014.  High Level Seminar, IMF Annual Meetings, DC, Sept.2011. "The Curse: Why Natural Resources Are Not Always a Good Thing,”   Milken Institute Review, vol.13, 4th quarter 2011. “The Natural Resource Curse: A Survey,” 2012, Chapter 2 in Beyond the Resource Curse, B.Shaffer & T. Ziyadov, eds. (U.Penn. Press); proofs & notes; Summary.   CID WP195, 2011. “How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” Natural Resources, Finance & Development, R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011.  HKS RWP 11-015. “On Graduation from Procyclicality,” 2012, with C.Végh & G.Vuletin; J. Dev. Economics. “Chile’s Solution to Fiscal Procyclicality,” 2012, Transitions blog, Foreign Policy. “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” in Fiscal Policy and Macroeconomic Performance, 2012.   Central Bank of Chile WP 604, 2011.  "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review Vol.XI, issue 1, April 2012 (Monetary Authority of Singapore). “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America," Economia, vol.11, 2011 (Brookings), NBER WP 16362.