1. Energy Economics – III Jeffrey Frankel Harpel Professor, Harvard University ADA Summer School, Baku, Azerbaijan 7-9 July, 2010

2. Revenue and Resource Management: Ways to Avoid the Natural Resource Curse Revenue and Resource Management: Ways to Avoid the Natural Resource Curse

3. Institutions & Policies to Address the Natural Resource Curse Institutions & Policies to Address the Natural Resource Curse A wide variety of measures have been tried to cope with the commodity cycle.[1] A wide variety of measures have been tried to cope with the commodity cycle.[1] [1] Some work better than others. Some work better than others. [1][1] E.g., Davis, et al (2003) and Sachs (2007). [1]

4. Institutions That Were Supposed to Stabilize But Have Not Worked A number of institutions have been implemented in the name of reducing volatility. A number of institutions have been implemented in the name of reducing volatility. Most have failed to do so, and many have had detrimental effects. Most have failed to do so, and many have had detrimental effects. Marketing boards Marketing boards Taxation of commodity production Taxation of commodity production Producer subsidies Producer subsidies Other government stockpiles Other government stockpiles Price controls for consumers Price controls for consumers OPEC and other international cartels OPEC and other international cartels

6. Devices to share risks Price-setting in contracts with foreign companies Price-setting in contracts with foreign companies Hedging in commodity futures markets Hedging in commodity futures markets Denominating debt in terms of commodity prices Denominating debt in terms of commodity prices

7. Monetary policy Fixed vs. floating exchange rates Fixed vs. floating exchange rates Nominal anchors as alternatives to the exchange rate Nominal anchors as alternatives to the exchange rate 3 candidates for nominal anchor that are no longer popular 3 candidates for nominal anchor that are no longer popular Inflation targeting Inflation targeting Orthodox implementation: the CPI Orthodox implementation: the CPI Unorthodox versions for commodity producers: PEP Unorthodox versions for commodity producers: PEP PE P

8. Nominal anchors for monetary policy, continued Nominal anchors as alternatives to the exchange rate Nominal anchors as alternatives to the exchange rate 3 candidates for nominal anchor 3 candidates for nominal anchor have had ardent supporters in the past, but are no longer prominently in the running: the price of gold, as 19th century gold standard; the price of gold, as 19th century gold standard; the money supply, the choice of monetarists; and the money supply, the choice of monetarists; and National Income, the choice of many mainstream economists. National Income, the choice of many mainstream economists. Inflation targeting Inflation targeting Orthodox implementation: the CPI Orthodox implementation: the CPI Unorthodox versions for commodity producers: PEP or PPT* Unorthodox versions for commodity producers: PEP or PPT* PE P PP T

9. Professor Jeffrey Frankel Implications of External Shocks for Choice of Exchange Rate Regime Old wisdom regarding the source of shocks: 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 case of supply shocks: natural disasters One case of supply shocks: natural disasters Ramcharan (2007). Ramcharan (2007). Most common case of real shocks: trade Most common case of real shocks: trade

10. Professor Jeffrey Frankel Terms-of-trade variability returns Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008. Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008. => Favorable terms of trade shocks for some (oil producers); => Favorable terms of trade shocks for some (oil producers); => Unfavorable terms of trade shock for others (oil importers like Japan, Korea). => Unfavorable terms of trade shock for others (oil importers like 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. Edwards & L.Yeyati (2003): Among peggers, terms-of-trade shocks are amplified and long-run growth is reduced, as compared to flexible-rate countries. Edwards & L.Yeyati (2003): Among peggers, terms-of-trade shocks are amplified and long-run growth is reduced, as compared to flexible-rate countries.

11. Professor Jeffrey Frankel Inflation targeting is the reigning orthodoxy. Among economists, central bankers, IMF… Among economists, central bankers, IMF… If Flexible inflation targeting ≡ “Have a LR target for inflation, and be transparent.” Who could disagree? If Flexible inflation targeting ≡ “Have a LR target for inflation, and be transparent.” Who could disagree? But if IT is defined as setting yearly CPI targets, to the exclusion of But if IT is defined as setting yearly CPI targets, to the exclusion of asset prices asset prices exchange rates exchange rates export commodity prices, export commodity prices, then some reexamination is warranted. then some reexamination is warranted.

12. Professor Jeffrey Frankel The shocks of 2007-2010 have shown some disadvantages to Inflation Targeting, The shocks of 2007-2010 have shown some disadvantages to Inflation Targeting, analogously to how the emerging market crises of 1994- 2001 showed disadvantages to exchange rate targeting. analogously to how the emerging market crises of 1994- 2001 showed disadvantages to exchange rate targeting. One disadvantage of IT: no response to asset price bubbles. One disadvantage of IT: no response to asset price bubbles. Another disadvantage : Another disadvantage : It gives the wrong answer in case of supply shocks: It gives the wrong answer in case of supply shocks: E.g., in response to a rise in oil import prices, it says to tighten monetary policy & appreciate, to keep CPI steady. E.g., in response to a rise in oil import prices, it says to tighten monetary policy & appreciate, to keep CPI steady. In response to a rise in world prices of export commodities, it does not allow monetary tightening and appreciation. In response to a rise in world prices of export commodities, it does not allow monetary tightening and appreciation.

13. Professor Jeffrey Frankel Proposal to Peg the Export Price (PEP) Intended for countries with volatile terms of trade, particularly those specialized in the production of mineral or agricultural commodity exports. PEP proposal in its pure form : The authorities peg the currency to a basket or price index that includes the price of their leading commodity export (oil, gold, copper, coffee…), rather than to the $ or € or CPI. The regime combines the best of both worlds: (i)The advantage of automatic accommodation to terms of trade shocks, together with (ii)the advantages of a nominal anchor and integration. PE P

14. Professor Jeffrey Frankel 6 proposed nominal targets and the Achilles heel of each:

15. Make national saving procyclical Hartwick rule: rents from a depletable resource should be saved, against the day when deposits run out. Hartwick rule: rents from a depletable resource should be saved, against the day when deposits run out. At the same time, traditional macroeconomics says that government budgets should be countercyclical: running surpluses in booms, & spending in recessions. At the same time, traditional macroeconomics says that government budgets should be countercyclical: running surpluses in booms, & spending in recessions. Commodity producers tend to fail both these principles: they save too little on average and more so in booms. Commodity producers tend to fail both these principles: they save too little on average and more so in booms. Thus some of the most important ways to cope with the commodity cycle are institutions to insure that export earnings are put aside during the boom time, Thus some of the most important ways to cope with the commodity cycle are institutions to insure that export earnings are put aside during the boom time, into a commodity saving fund, into a commodity saving fund, with rules governing the cyclically adjusted budget surplus. with rules governing the cyclically adjusted budget surplus. Davis et al (2001a,b, 2003). Davis et al (2001a,b, 2003).

16. Rules for the budget deficit: The example of Chile. Rules for the budget deficit: The example of Chile. Commodity funds or Sovereign Wealth Funds Commodity funds or Sovereign Wealth Funds Reserve accumulation by central banks Reserve accumulation by central banks Reducing net inflows during booms Reducing net inflows during booms Lump sum distribution Lump sum distribution Institutions to make national saving procyclical

18. Efforts to impose external checks The Chad experiment The Chad experiment

20. External checks: The Chad experiment In 2000 the World Bank agreed to help Chad, a new oil producer, to finance a new pipeline. The agreement stipulated that Chad would spend 72 % of its oil export earnings on poverty reduction (health, education & road-building) and put aside 10 % in a “future generations fund.” ExxonMobil was to deposit the oil revenues in an escrow account at Citibank; the government was to spend them subject to oversight by an independent committee. But once the money started rolling in, the government (ranked by Transparency International as one of the two most corrupt in the world) reneged on the agreement.

21. External checks, continued Extractive Industries Transparency Initiative, launched in 2002, includes the principle “Publish What You Pay,” Extractive Industries Transparency Initiative, launched in 2002, includes the principle “Publish What You Pay,” International oil companies commit to make known how much they pay governments for oil, so that the public at least International oil companies commit to make known how much they pay governments for oil, so that the public at least has a way of knowing when large sums disappear. has a way of knowing when large sums disappear. Legal mechanisms adopted by Sao Tome & Principe void contracts if information relating to oil revenues is not made public. Legal mechanisms adopted by Sao Tome & Principe void contracts if information relating to oil revenues is not made public. Further proposals would give extra powers to a global clearing house or foreign bank where the Natural Resource Fund is located, such as freezing accounts in the event of a coup.[1] Further proposals would give extra powers to a global clearing house or foreign bank where the Natural Resource Fund is located, such as freezing accounts in the event of a coup.[1][1] Perhaps that principle could be generalized: it may be that well-intentioned politicians spend oil wealth quickly out of fear that their successors will misspend whatever is left, in which case the adoption of an external mechanism that constrains spending both in the present in the future might not be an unacceptable violation of sovereignty. Perhaps that principle could be generalized: it may be that well-intentioned politicians spend oil wealth quickly out of fear that their successors will misspend whatever is left, in which case the adoption of an external mechanism that constrains spending both in the present in the future might not be an unacceptable violation of sovereignty. [1] Humphreys & Sandhu (2007, p. 224-227). [1] Humphreys & Sandhu (2007, p. 224-227). [1] During the period when Kuwait was occupied by an Iraqi invasion, access to Kuwaiti bank accounts in London stayed with the Kuwaitis. During the period when Kuwait was occupied by an Iraqi invasion, access to Kuwaiti bank accounts in London stayed with the Kuwaitis.

22. Some of the ideas that most merit consideration by oil exporting countries Include in contracts with foreign purchasers clauses for automatic price adjustment if world market conditions change. Include in contracts with foreign purchasers clauses for automatic price adjustment if world market conditions change. Hedge export proceeds in oil futures markets. Hedge export proceeds in oil futures markets. Denominate debt in terms of commodity prices. Denominate debt in terms of commodity prices. Allow some currency appreciation in response to a rise in world oil prices, but also add to foreign exchange reserves. Allow some currency appreciation in response to a rise in world oil prices, but also add to foreign exchange reserves. If the monetary regime is to be Inflation Targeting, consider using as the target, in place of the CPI, a price measure that puts more weight on the export commodity: PEP or PPT. If the monetary regime is to be Inflation Targeting, consider using as the target, in place of the CPI, a price measure that puts more weight on the export commodity: PEP or PPT. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent oil price increases, as judged by independent expert panels. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent oil price increases, as judged by independent expert panels. Run Commodity Funds transparently and professionally. Run Commodity Funds transparently and professionally. Consider lump-sum distribution of oil wealth, equal per capita. Consider lump-sum distribution of oil wealth, equal per capita. An external agent, for example a financial institution that houses the Commodity Fund, could be mandated to provide transparency and to freeze accounts in the event of a coup. An external agent, for example a financial institution that houses the Commodity Fund, could be mandated to provide transparency and to freeze accounts in the event of a coup.