1. Coping with Volatility: Monetary & Exchange Rate Policies for Commodity-Exporting Countries like Kazakhstan Jeffrey Frankel Harpel Professor of Capital Formation & Growth July 15, 2013

2. 2 Oil prices & minerals prices have been especially volatile over the last decade – and correlated. Source: UNCTAD

3. 3 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.

4. 4 (i) Pro-cyclical capital flows According to inter-temporal optimization theory, capital flows should be counter-cyclical: flowing in when exports do badly and flowing out when exports do well. In practice, it does not always work this way. Capital flows are more pro-cyclical than counter-cyclical. Gavin, Hausmann, Perotti & Talvi (1996) ; Kaminsky, Reinhart & Vegh (2005) ; Reinhart & Reinhart (2009); and Mendoza & Terrones (2008).

5. 5 (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, incl. land.

6. 6 Macro effects of commodity boom Inflation shows up especially in non-traded goods & services, like construction. Inflation shows up especially in non-traded goods & services, like construction.

7. 7 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, 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, to the extent it is expandable, especially if the commodity boom is permanent. especially if the commodity boom is permanent. But the shift out of manufacturing into NTGs is often an undesirable macroeconomic side effect – But the shift out of manufacturing into NTGs is often an undesirable macroeconomic side effect – the “disease” part of Dutch Disease. the “disease” part of Dutch Disease.

8. 8 1. How can a country avoid pro-cyclical money: 1. How can a country avoid pro-cyclical money: excessive credit creation & inflation in a commodity boom, excessive credit creation & inflation in a commodity boom, deflation & balance of payments crisis in a bust ? deflation & balance of payments crisis in a bust ? Allow some currency flexibility Allow some currency flexibility though not a free float. though not a free float. 2. Nominal anchor for monetary policy: 2. Nominal anchor for monetary policy: What is it to be, if not the exchange rate? CPI? What is it to be, if not the exchange rate? CPI? Two questions for the monetary regime

9. 1) Pros & cons of exchange rate flexibility for oil-exporters, in particular 9 Advantages of more stable exchange rate: Advantages of more stable exchange rate: Lower forex risk & transactions costs facilitate international trade & capital flows -- especially important if country is small & open to trade. Exchange rate provides a nominal anchor for monetary policy, reducing inflation expectations -- especially important if country has history of high inflation e.g., Kazakhstan (1991-95) or even hyperinflation (1992-93).

10. Pros & cons of exchange rate flexibility, continued 10 Advantages of more flexible exchange rate Advantages of more flexible exchange rate Autonomy of monetary policy -- Autonomy of monetary policy -- especially important if country has idiosyncratic shocks & low labor mobility. especially important if country has idiosyncratic shocks & low labor mobility. Automatic accommodation of trade shocks -- Automatic accommodation of trade shocks -- especially important for commodity-exporting countries. especially important for commodity-exporting countries.

11. Other factors to be considered in conjunction with fixed versus floating exchange rate choice Intermediate exchange rate regimes Intermediate exchange rate regimes Band-basket-crawl Band-basket-crawl Managed float Managed float Intervention and sterilization Intervention and sterilization Capital controls Capital controls Denomination of foreign debt Denomination of foreign debt Currency mismatch from foreign denomination (original sin) Currency mismatch from foreign denomination (original sin) The move away from foreign-denominated debt. The move away from foreign-denominated debt. Bank accounts denominated in foreign currency. Bank accounts denominated in foreign currency. 11

12. 12 The challenge of designing a monetary regime when 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: Oil exporters in 1980s (Mexico) or 1997-98 (Russia).

13. 13 Currency regime, continued Floating accommodates terms of trade shocks: If terms of trade improve, currency automatically appreciates, reducing excessive money inflows, credit, overheating, inflation, and real estate bubbles. If terms of trade worsen, currency automatically depreciates, preventing recession & balance of payments crisis.

14. Demand vs. supply shocks An old wisdom regarding the source of shocks: An old wisdom regarding the source of shocks: Fixed rates work best if shocks are mostly internal demand shocks (especially monetary); 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). floating rates work best if shocks tend to be real shocks (especially external terms of trade). One set of supply shocks: natural disasters One set of supply shocks: natural disasters R.Ramcharan (2007) finds floating works better. R.Ramcharan (2007) finds floating works better. A common source of real shocks: trade. A common source of real shocks: trade.

15. Terms-of-trade variability Prices of crude oil & mineral commodities hit record highs in 2008 & 2011. Prices of crude oil & mineral commodities hit record highs in 2008 & 2011. => Favorable terms of trade shocks for some (oil producers, Africa, Latin America, etc. ); => Favorable terms of trade shocks for some (oil producers, Africa, Latin America, etc. ); => Unfavorable terms of trade shock for others (oil importers such as Japan, Korea). => Unfavorable terms of trade shock for others (oil importers such as Japan, Korea). Textbook theory says a country where trade shocks dominate should accommodate by floating. Textbook theory says a country where trade shocks dominate should accommodate by floating. Confirmed empirically: Confirmed empirically: Developing countries facing terms of trade shocks do better with flexible exchange rates than fixed exchange rates. 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)… Broda (2004 ), Edwards & L.Yeyati (2005), Rafiq (2011), and Céspedes & Velasco (2012)…

16. 16 Constant term not reported. (t-statistics in parentheses.) ** Statistically significant at 5% level. Across 107 major commodity boom-bust cycles, output loss is bigger the bigger is the commodity price change & the smaller is exchange rate flexibility. Céspedes & Velasco (Nov. 2012) NBER WP 18569 “Macroeconomic Performance During Commodity Price Booms & Busts”

17. The IMF recommends a more flexible exchange rate for the tenge. “Looking ahead, there is scope to allow greater exchange rate flexibility…” “Looking ahead, there is scope to allow greater exchange rate flexibility…” -- Article IV Consultation Concluding Statement of the IMF Mission to Republic of Kazakhstan— 2013, June 4, para. 7. -- Article IV Consultation Concluding Statement of the IMF Mission to Republic of Kazakhstan— 2013, June 4, para. 7. But, if the exchange rate were no longer the nominal anchor for Kazakh monetary policy, the IMF would then ask what is to take its place. But, if the exchange rate were no longer the nominal anchor for Kazakh monetary policy, the IMF would then ask what is to take its place. 17

18. 18 Monetary regime 2) 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.

19. 19 Needed: Nominal anchors that accommodate the shocks that are common in developing countries Supply shocks, e.g., droughts, floods, hurricanes: => Target Nominal GDP. Terms of trade shocks e.g., fall in price of commodity export. => Target GDP deflator.

20. 20 Nominal GDP target cancels out velocity shocks (vs. M target) & moderates effects of supply shocks (vs. IT) Real GDP P Adverse AS shock AS AD IT Nom. GDP target

21. 21 Does Nominal GDP target give best output/inflation trade-off? Real GDP P Adverse AS shock AD 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.

22. The revival of proposals for Nominal GDP Targeting in 2011-13 heard mostly in the context of advanced economies heard mostly in the context of advanced economies UK, US, Japan… UK, US, Japan… E.g. the new Bank of England Governor, Mark Carney, is a fan. E.g. the new Bank of England Governor, Mark Carney, is a fan. But Nominal GDP Targeting in fact makes more sense for developing & commodity-exporting countries. But Nominal GDP Targeting in fact makes more sense for developing & commodity-exporting countries. To clarify: set a target range at a 1-2-year horizon; To clarify: set a target range at a 1-2-year horizon; not inconsistent with “Flexible Inflation Targeting,” not inconsistent with “Flexible Inflation Targeting,” setting a longer-term target for inflation. setting a longer-term target for inflation. 22

23. Why does Nominal GDP Targeting make more sense for developing & commodity-exporting countries than for advanced countries? More supply shocks, More supply shocks, such as adverse weather events. such as adverse weather events. More terms of trade shocks, More terms of trade shocks, such as rises in the price of imports, & such as rises in the price of imports, & declines in the commodity export price. declines in the commodity export price. 23

24. Comparison of 3 alternative monetary regimes Monetary regime Supply shock, e.g. weather disaster Terms of trade shocks Fall in export price, e.g., oil Rise in import price, e.g., cars Exchange rate target Trade balance ↓ Output Y ↓ Inflation ↑. Trade balance ↓ Output Y ↓ Trade balance ↓ Inflation ↑ CPI target => Exchange rate moves in wrong direction. Money must tighten enough to appreciate currency. => Worse TB ↓ &Y ↓ Depreciation is limited because it would raise import prices, which have more weight than oil in the CPI. Currency appreciates to prevent consumer prices from rising. => Worse TB ↓ & Y ↓ Nominal GDP target => Exchange rate moves in right direction. Currency depreciates. Helps TB &Y. Adverse effects shared between P & Y, rather than all Y. Currency depreciates. Helps TB &Y, prevents recession. No appreciation. Exchange rate here accommodates terms of trade, the opposite of under a CPI target. 24

25. Steps in an evaluation of Nominal GDP Targeting (vs. IT) 1. How wide would announced band have to be so that the outcome usually fell within it? 2. What about subsequent revisions in Nominal GDP statistics? 3. Are supply shocks big enough, and is the AS curve steep enough, for Nominal GDP targeting to be better than price targeting? 25

26. What Kazakh data are needed for the analysis? 1. I have historical data, for Kazakhstan 1991-2012, Nominal GDP, real GDP, deflator, & CPI, Nominal GDP, real GDP, deflator, & CPI, and some year-ahead forecasts of each: and some year-ahead forecasts of each: estimated from the time series by an ARIMA process, or estimated from the time series by an ARIMA process, or Private forecasts from Consensus Economics (for real GDP & CPI). Private forecasts from Consensus Economics (for real GDP & CPI). 2. Ideally I would get real-time revisions for each -- preliminary estimates, revised, & final; preliminary estimates, revised, & final; 3. And data on exogenous supply shocks, if possible : adverse weather events? adverse weather events? 26

27. year Actual Kazakhstan RGDP growth rates (WDI) Consensus Economics Kazakhstan RGDP forecast 1998-1.93 19992.73.7 20009.81.8 200113.53.7 20029.85.1 20039.36.6 20049.67 20059.78.6 200610.78.3 20078.98.1 20083.39 20091.27.3 20107.33.4 20117.54.5 2012 6.2 27

28. Variable (growth rates p.a.) VarianceSt dev Mean of actual rate 68% Confidence Interval LowerUpper NGDP2.29%15.12%19.10%3.98%34.22% RGDP0.20%4.43%6.46%2.03%10.89% Deflator1.85%13.58%12.64%-0.95%26.22% CPI0.21%4.59%8.65%4.06%13.24% 28 Covar (RGDP,Deflator) = 0.114 % How wide would 1-standard-deviation band have to be, encompassing 2/3 of nominal GDP realizations around target?

29. 29 The confidence interval would be narrower if the central bank can influence demand (within one-year horizon). How wide would 1-standard-deviation band have to be?

30. 30 References by the author Project Syndicate, Project Syndicate “Escaping the Oil Curse,” Dec.9, 2011.Escaping the Oil Curse "Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility," Oct.17, 2011. Barrels, Bushels & Bonds How Commodity Exporters Can Hedge Volatility “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. The Natural Resource Curse: A Survey of Diagnoses and Some PrescriptionsRWP12-014 “How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” 2011, in Natural Resources, Finance & Development. R.Arezki, T.Gylfason & A.Sy, eds. (IMF).How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical? in MAS Monetary Review XI, 1, 2012 (Monetary Authority of Singapore). "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review XI, 1, 2012 (Monetary Authority of Singapore). inXI, 1Product Price Targeting -- A New Improved Way of Inflation Targeting inXI, 1 “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America," Economia, 2011. NBER WP 16362. A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America Economia16362 "UAE & Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil,“ Vox, 9 July, 2008. "UAE & Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil,“ Vox, 9 July, 2008.UAE & Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil,“VoxUAE & Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil,“Vox “On the Tenge: Monetary and Exchange Rate Policy for Kazakhstan,” Short-term Consultancy, Republic of Kazakhstan, 2005. (Russian translation, ADB, 2009.) In Growth & Competitiveness in Kazakhstan (Center for International Development): 23-42. “On the Tenge: Monetary and Exchange Rate Policy for Kazakhstan,” Short-term Consultancy, Republic of Kazakhstan, 2005. (Russian translation, ADB, 2009.) In Growth & Competitiveness in Kazakhstan (Center for International Development): 23-42.Growth & Competitiveness in Kazakhstan Growth & Competitiveness in Kazakhstan "Experience of and Lessons from Exchange Rate Regimes in Emerging Economies," in Monetary and Financial Integration in East Asia: The Way Ahead, edited by Asian Development Bank, 2004 (Palgrave Macmillan), v91-138. "Experience of and Lessons from Exchange Rate Regimes in Emerging Economies," in Monetary and Financial Integration in East Asia: The Way Ahead, edited by Asian Development Bank, 2004 (Palgrave Macmillan), v91-138. "Experience of and Lessons from Exchange Rate Regimes in Emerging Economies," "Experience of and Lessons from Exchange Rate Regimes in Emerging Economies," http://www.hks.harvard.edu/fs/jfrankel/

31. Appendix: Nominal GDP statistics Kazakhstan Nominal GDP, quarterly GDP 2000-2012 quarterly (at current prices, mln. tenge) 2000200120022003200420052006200720082009201020112012 1 quarter 524,139.10634,620.20746,291.90949,576.701,270,741.801,650,148.602,040,947.902,536,234.903,207,244.403,055,263.804,020,878.405,306,250.205,976,722.50 2 quarter 590,711.60798,324.00919,581.301,060,280.901,380,820.501,783,707.402,363,805.003,059,192.603,988,726.103,654,517.104,691,265.705,623,135.606,559,138.30 3 quarter 778,203.10975,151.401,094,634.701,331,640.401,646,303.202,009,652.102,648,602.603,400,454.504,607,610.404,511,118.605,423,084.007,243,951.707,842,365.80 4 quarter 706,847.80842,497.701,015,769.301,270,477.301,572,268.802,147,085.403,160,375.703,853,912.004,249,338.305,786,747.507,680,288.909,398,551.509,840,317.70 annual 2,599,901.603,250,593.303,776,277.204,611,975.305,870,134.307,590,593.5010,213,731.12,849,794.16,052,919.17,007,647.21,815,517.27,571,889.30,218,544. 31

32. YearGDP ( constant 2005 US$, m GDP ( current US$, m GDP deflator (2000 = 100) CPI index (2005 = 100) 199050,24326,9330.00 199144,71624,8810.00 199242,34624,9070.08 199338,45023,4091.030.61 199433,60521,25116.9112.02 199530,85020,37444.1133.20 199631,00421,03561.2646.21 199731,53122,16671.1554.25 199830,93222,13575.1858.13 199931,76716,87185.1662.95 200034,88018,292100.0071.25 200139,58922,153110.1677.20 200243,46924,637116.5581.71 200347,51230,834130.2386.97 200452,07343,152151.2492.95 200557,124 178.27100.00 200663,23681,004216.69108.59 200768,864104,850250.34120.28 200871,136133,442302.75140.92 200971,990115,309316.95151.21 201077,245148,052378.89161.97 201183,039188,050445.46175.49 201287,191201,680462.73184.47 32

33. 33 How wide would 1-standard-deviation band for real GDP growth have to be?

34. 34

35. 35 How wide would 1-standard-deviation band for CPI inflation have to be?

36. 36 How wide would 1-standard-deviation band for nominal GDP have to be?

37. 37 How wide would 1-standard-deviation band for nominal GDP have to be?

38. 38 How wide would 1-standard-deviation band for real GDP growth have to be?

39. 39 How wide would 1-standard-deviation band for GDP deflator have to be?