Coping with Commodity Volatility: Macroeconomic Policies for Developing Countries APPENDICES May 24, 2013 Jeffrey Frankel

22 How could abundance of commodity wealth be a curse? How could abundance of commodity wealth be a curse? What is the mechanism What is the mechanism for this counter-intuitive relationship? for this counter-intuitive relationship? At least 5 categories of explanations. At least 5 categories of explanations. Appendix I: Channels of the Natural Resource Curse

33 1. Volatility 2. Crowding-out of manufacturing 2. Crowding-out of manufacturing 3. Autocratic Institutions 4. Anarchic Institutions 5. Procyclicality including 1. Procyclical capital flows 2. Procyclical monetary policy 3. Procyclical fiscal policy. 5 Possible Natural Resource Curse Channels

44 (1) Volatility in global commodity prices arises because supply & demand are inelastic in the short run. (1) Volatility in global commodity prices arises because supply & demand are inelastic in the short run.

5 Commodity prices have been especially volatile over the last decade Source: UNCTAD

66 Effects of Volatility Volatility per se can be bad for economic growth. Volatility per se can be bad for economic growth. Hausmann & Rigobon (2003), Blattman, Hwang, & Williamson (2007), and Poelhekke & van der Ploeg (2007). Hausmann & Rigobon (2003), Blattman, Hwang, & Williamson (2007), and Poelhekke & van der Ploeg (2007). Risk inhibits private investment. Risk inhibits private investment. Cyclical shifts of labor, land & capital back & forth across sectors may incur needless costs. Cyclical shifts of labor, land & capital back & forth across sectors may incur needless costs. => role for government intervention? => 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 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; On the other hand the government cannot entirely ignore the issue of volatility; e.g., exchange rate policy. e.g., exchange rate policy.

7 2. Natural resources may crowd out manufacturing, and manufacturing could be the sector that experiences learning-by-doing and manufacturing could be the sector that experiences learning-by-doing or dynamic productivity gains from spillover. or dynamic productivity gains from spillover. Matsuyama (1992), van Wijnbergen (1984) and Sachs & Warner (1995). Matsuyama (1992), van Wijnbergen (1984) and Sachs & Warner (1995). So commodities could in theory be a dead-end sector. 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. My own view: a country need not repress the commodity sector to develop the manufacturing sector. It can foster growth in both sectors. It can foster growth in both sectors. E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil… E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil…

8 Econometric findings that oil & other “point-source resources” 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. 3. Autocratic/Oligarchic Institutions

9 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.

10 An example, from economic historians Engerman & Sokoloff (1997, 2000, 2002) Why did industrialization take place in North America, 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.

Anarchic institutions 1. Unsustainably rapid depletion of resources 1. Unsustainably rapid depletion of resources 2. Unenforceable property rights 3. Civil war

1212 (5) Procyclicality The Dutch Disease describes unwanted side-effects of a commodity boom. The Dutch Disease describes unwanted side-effects of a commodity boom. Developing countries are historically prone to procyclicality, Developing countries are historically prone to procyclicality, especially commodity producers. especially commodity producers. Procyclicality in: Procyclicality in: Capital inflows; Monetary policy; Capital inflows; Monetary policy; Real exchange rate; Nontraded Goods Real exchange rate; Nontraded Goods Fiscal Policy Fiscal Policy

1313 The Dutch Disease: 5 side-effects of a commodity boom 1) A real appreciation in the currency 1) A real appreciation in the currency 2) A rise in government spending 2) A rise in government spending 3) A rise in nontraded goods prices 3) A rise in nontraded goods prices 4) A resultant shift of production out of manufactured goods 4) A resultant shift of production out of manufactured goods 5) Sometimes a current account deficit 5) Sometimes a current account deficit

1414 The Dutch Disease: The 5 effects elaborated 1) Real appreciation in the currency 1) Real appreciation in the currency taking the form of nominal currency appreciation if the exchange rate floats 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; or the form of money inflows, credit & inflation if the exchange rate is fixed; 2) A rise in government spending 2) A rise in government spending in response to availability of tax receipts or royalties. in response to availability of tax receipts or royalties.

1515 The Dutch Disease: 5 side-effects of a commodity boom 3) An increase in nontraded goods prices relative to internationally traded goods 3) An increase in nontraded goods prices relative to internationally traded goods 4) A resultant shift out of non-commodity traded goods, 4) A resultant shift out of non-commodity traded goods, esp. manufactures, esp. manufactures, pulled by the more attractive returns in the export commodity and in non-traded goods. pulled by the more attractive returns in the export commodity and in non-traded goods.

1616 The Dutch Disease: 5 side-effects of a commodity boom 5) A current account deficit, 5) A current account deficit, as booming countries attract capital flows, as booming countries attract capital flows, thereby incurring international debt that is hard to service when the boom ends. thereby incurring international debt that is hard to service when the boom ends. Manzano & Rigobon (2008): the negative Sachs-Warner effect of resources on growth rates during was mediated through international debt incurred when commodity prices were high. Arezki & Brückner (2010a, b): commodity price booms lead to higher government spending, external debt & default risk in autocracies, but do not have those effects in democracies.

17 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.

1818 Some developing countries have avoided the pitfalls of commodity wealth. Some developing countries have avoided the pitfalls of commodity wealth. E.g., Chile (copper) E.g., Chile (copper) Botswana (diamonds) Botswana (diamonds) Some of their innovations are worth emulating. Some of their innovations are worth emulating. The lecture offers some policies & institutional innovations to avoid the curse. The lecture offers some policies & institutional innovations to avoid the curse.

19 Appendix II: Empirical findings for PPT Simulations of 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) PPT

20 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)p im +(1-f)p n, p = (f)p x + (1-f) p n.

21 Estimation for each country of weights in national price index on 3 sectors: non tradable goods, leading commodity export, & other tradable goods Argentina is relatively closed; 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.) Mexico is relatively open. “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity- Exporters in Latin America," Economia, vol.11, 2011 (Brookings), NBER WP A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity- Exporters in Latin America EconomiaBrookings16362

22 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….

23 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.

24 Table 1: LACA Countries ’ Current Regimes and Monthly Correlations of Exchange Rate Changes ($/local currency) with Dollar Import Price Changes Import price changes are changes in the dollar price of oil. Exchange Rate RegimeMonetary Policy ARG Managed floatingMonetary aggregate target BOL Other conventional fixed pegAgainst a single currency BRA Independently floatingInflation targeting framework (1999) CHL Independently floatingInflation targeting framework (1990)* CRI Crawling pegsExchange rate anchor GTM Managed floatingInflation targeting framework GUY Other conventional fixed pegMonetary aggregate target HND Other conventional fixed pegAgainst a single currency JAM Managed floatingMonetary aggregate target NIC Crawling pegsExchange rate anchor PER Managed floatingInflation targeting framework (2002) PRY Managed floating IMF-supported or other monetary program SLV DollarExchange rate anchor URY Managed floatingMonetary aggregate target Oil Exporters COL Managed floatingInflation targeting framework (1999) MEX Independently floatingInflation targeting framework (1995) TTO Other conventional fixed pegAgainst a single currency VEN Other conventional fixed pegAgainst a single currency * Chile declared an inflation target as early as 1990; but it also had an exchange rate target, under an explicit band-basket-crawl regime, until LAC Countries ’ Current Regimes and Monthly Correlations of Exchange Rate Changes ($/local currency) with $ Import Price Changes Table 1 IT coun- tries show correl- ations > 0.

25 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 III: Micro policies Many of the policies that have been intended to fight commodity price volatility do not work out so well. 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, 1) Producer subsidies to “ stabilize ” prices at high levels, often via wasteful stockpiles & protectionist import barriers. often via wasteful stockpiles & protectionist import barriers. Examples: Examples: The EU’s Common Agricultural Policy The EU’s Common Agricultural Policy Bad for EU budgets, economic efficiency, international trade, & consumer pocketbooks. Bad for EU budgets, economic efficiency, international trade, & consumer pocketbooks. Or fossil fuel subsidies Or fossil fuel subsidies which are equally distortionary & budget-busting, which are equally distortionary & budget-busting, and disastrous for the environment as well. and disastrous for the environment as well. Or US corn-based ethanol subsidies, Or US corn-based ethanol subsidies, with tariffs on Brazilian sugar-based ethanol. with tariffs on Brazilian sugar-based ethanol.

Unsuccessful policies, continued 2) Price controls to “stabilize” prices at low levels 2) Price controls to “stabilize” prices at low levels Discourage investment & production. Discourage investment & production. Example: African countries adopted commodity boards for coffee & cocoa at the time of independence. 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. 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. In practice the price paid to cocoa & coffee farmers was always below the world price. As a result, production fell. As a result, production fell.

Microeconomic policies, continued Often the goal of price controls is to shield consumers of staple foods & fuel from increases. Often the goal of price controls is to shield consumers of staple foods & fuel from increases. But the artificially suppressed price But the artificially suppressed price discourages domestic supply, and discourages domestic supply, and requires rationing to domestic households. requires rationing to domestic households. Shortages & long lines can fuel political rage as well as higher prices can. 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. Not to mention when the government is forced by huge gaps to raise prices. Price controls can also require imports, to satisfy excess demand. Price controls can also require imports, to satisfy excess demand. Then they raise the world price even more. Then they raise the world price even more.

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

Cal has been the agent of Adam Smith ’ s famous invisible hand: 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, 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). 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 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. An example of commodity speculation, cont.

The overall lesson for microeconomic policy Attempts to prevent commodity prices from fluctuating generally fail. 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. Even though enacted in the name of reducing volatility & income inequality, their effect is often different. Better to accept volatility and cope with it. Better to accept volatility and cope with it. For the poor: well-designed transfers, For the poor: well-designed transfers, along the lines of Oportunidades or Bolsa Familia. 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” continued 7) Keeping out foreign companies altogether. But often they have the needed technical expertise. Examples: declining oil production in Mexico & Venezuela. 8) Going around “locking up” resource supplies. China must think that this strategy will protect it in case of a commodity price shock. But global commodity markets are increasingly integrated. If conflict in the Persian Gulf doubles world oil prices, the effect will be pretty much the same for those who buy on the spot market and those who have bilateral arrangements.

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