1. The Mining Resource ‘Curse’ and How Countries Can Fight It Jeffrey Frankel Harpel Professor of Capital Formation & Growth Toronto, June 20, 2012 Global Mining Conference

2. Many countries richly endowed with oil or minerals have failed to grow more rapidly than those without. Examples: Some oil producers in Africa & the Middle East have relatively little to show for their resources. Meanwhile, East Asian economies achieved western-level standards of living despite having virtually no exportable natural resources: Japan, Singapore, Hong Kong, Korea & Taiwan; followed by China. The Mining Resource Curse

3. 3 Growth falls with fuel & mineral exports

4. 4 Are mining resources necessarily bad? Commodity wealth need not necessarily lead to inferior economic or political development. Commodity wealth need not necessarily lead to inferior economic or political development. Rather, it is a double-edged sword, with both benefits and dangers. Rather, it is a double-edged sword, with both benefits and dangers. It can be used for ill as easily as for good. It can be used for ill as easily as for good. The priority should be on identifying ways The priority should be on identifying ways to sidestep the pitfalls that have afflicted other mining producers in the past, to find the path of success. No, of course not.

5. 5 Some developing countries have avoided the pitfalls of mining wealth. Some developing countries have avoided the pitfalls of mining wealth. E.g., Chile (copper) E.g., Chile (copper) Botswana (diamonds) Botswana (diamonds) They have done some things worth emulating. They have done some things worth emulating. The last section of my paper explores policies & institutional innovations that might help avoid the natural resource curse and achieve natural resource blessings instead. The last section of my paper explores policies & institutional innovations that might help avoid the natural resource curse and achieve natural resource blessings instead.

6. 6 How could abundance of mineral wealth be a curse? How could abundance of mineral 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.

7. 7 1. Volatility 2. Crowding-out of manufacturing 2. Crowding-out of manufacturing 3. Autocracy 4. Anarchy 5. “Dutch disease,” including 1. Procyclical money flows. 2. Procyclical fiscal policy. 5 Possible Mining Resource Curse Channels

8. 8 (1) Volatility in global mining prices arises because supply & demand are inelastic in the short run. (1) Volatility in global mining prices arises because supply & demand are inelastic in the short run.

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

10. 10 Effects of Volatility Volatility per se can be bad for economic growth. Volatility per se can be bad for economic growth. Risk inhibits private investment. Risk inhibits private investment. Cyclical shifts of resources back & forth across sectors may incur needless transaction costs. Cyclical shifts of resources back & forth across sectors may incur needless transaction costs. => role for government intervention? => role for government intervention? On the one hand, the private sector dislikes risk as much as the government does & will take steps to mitigate it. On the one hand, the private sector dislikes risk as much as the government does & will take 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.

11. 2. Mining 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. So mining could be a dead-end sector So mining could be a dead-end sector justifying “import substitution industrialization.” justifying “import substitution industrialization.” Counter-arguments: Counter-arguments: Classic economic theory: follow comparative advantage. Classic economic theory: follow comparative advantage. Productivity gains are not limited to manufacturing; Productivity gains are not limited to manufacturing; they come also in mining. they come also in mining.

12. 12 3. Autocratic/oligarchic institutions may retard economic development. Countries where physical command of mines by government or a hereditary elite automatically confers wealth on the holders Countries where physical command of mines by government or a hereditary elite automatically confers wealth on the holders are likely to become rent-seeking societies; are likely to become rent-seeking societies; and are less likely to develop the institutions conducive to economic development, and are less likely to develop the institutions conducive to economic development, e.g., rule of law, decentralization & economic incentives; e.g., rule of law, decentralization & economic incentives; as compared to countries where moderate taxation of a thriving market economy is the only way government can finance itself. as compared to countries where moderate taxation of a thriving market economy is the only way government can finance itself. Historians explain thus why North America industrialized. Historians explain thus why North America industrialized.

13. 13 4. Anarchic institutions 1. Unsustainably rapid depletion of resources 1. Unsustainably rapid depletion of resources 2. Unenforceable property rights 3. Civil war

14. 14 5. Procyclicality Commodity-exporting countries are historically prone to procyclicality. Commodity-exporting countries are historically prone to procyclicality. Procyclicality in: Procyclicality in: Capital inflows; Monetary policy; Capital inflows; Monetary policy; Real exchange rate Real exchange rate Fiscal Policy Fiscal Policy The Dutch Disease describes unwanted side-effects of a commodity boom. The Dutch Disease describes unwanted side-effects of a commodity boom.

15. 15 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

16. 16 The Dutch Disease: The 5 effects elaborated 1) A real appreciation in the currency 1) A 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 e.g., floating-rate oil exporters, Kazakhstan, Mexico, & Russia. e.g., floating-rate oil exporters, Kazakhstan, Mexico, & Russia. or the form of money inflows & inflation if the exchange rate is fixed ; or the form of money inflows & inflation if the exchange rate is fixed ; e.g. fixed-rate oil-exporters, UAE & Saudi Arabia. e.g. fixed-rate oil-exporters, UAE & Saudi Arabia. 2) A rise in government spending 2) A rise in government spending in response to increased availability of tax receipts or royalties. in response to increased availability of tax receipts or royalties.

17. 17 The Dutch Disease: 5 side-effects of a commodity boom 3) An increase in nontraded goods prices (goods & services such as housing that are not internationally traded), 3) An increase in nontraded goods prices (goods & services such as housing that are not internationally traded), relative to internationally traded goods relative to internationally traded goods esp. manufactures. esp. manufactures. 4) A resultant shift of resources out of manufactured traded goods 4) A resultant shift of resources out of manufactured traded goods pulled by the more attractive returns in the mining sector & in non-traded goods. pulled by the more attractive returns in the mining sector & in non-traded goods.

18. 18 The Dutch Disease: 5 side-effects of a commodity boom 5) A current account deficit 5) A current account deficit Booming countries attract capital flows, Booming countries attract capital flows, leaving international debt that is hard to service when the boom ends. leaving international debt that is hard to service when the boom ends. E.g. the 1970s commodity boom. E.g. the 1970s commodity boom. ended in the international debt crisis of 1982, ended in the international debt crisis of 1982, Esp. in Latin America. Esp. in Latin America.

19. 19 The procyclicality of fiscal policy The procyclicality of fiscal policy Fiscal policy has historically been procyclical in developing countries Fiscal policy has historically been procyclical in developing countries especially among mining exporters especially among mining exporters -- correlation of income & spending mostly positive – -- correlation of income & spending mostly positive – in contrast to industrialized countries. in contrast to industrialized countries. A reason for procyclical public spending: receipts from taxes or royalties rise in booms. The government cannot resist the temptation to increase spending proportionately. A reason for procyclical public spending: receipts from taxes or royalties rise in booms. The government cannot resist the temptation to increase spending proportionately. Then it is forced to contract in recessions, Then it is forced to contract in recessions, thereby exacerbating the magnitudes of swings. thereby exacerbating the magnitudes of swings.

20. 20 Two budget items account for much of the spending from oil booms: (i) Investment projects. (i) Investment projects. Investment in practice may be “white elephant” 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. which are stranded without funds for completion or maintenance when the oil price goes back down. (ii) The government wage bill. (ii) The government wage bill. Oil windfalls are often spent on public sector wages, Oil windfalls are often spent on public sector wages, which are hard to cut when prices go back down. which are hard to cut when prices go back down. 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..”

21. Correlations between Gov.t Spending & GDP 1960-1999 procyclical } G always used to be pro-cyclical for most developing countries. countercyclical Adapted from Kaminsky, Reinhart & Vegh (2004)

22. 22 An important development -- some developing countries, including mineral-exporters, were able to break the historic pattern in the most recent decade: An important development -- some developing countries, including mineral-exporters, were able to break the historic pattern in the most recent decade: taking advantage of the boom of 2002-2008 taking advantage of the boom of 2002-2008 to run budget surpluses & build reserves, to run budget surpluses & build reserves, thereby earning the ability to expand fiscally in the 2008-09 crisis. thereby earning the ability to expand fiscally in the 2008-09 crisis. Chile is the outstanding model. Chile is the outstanding model. The procyclicality of fiscal policy, cont.

23. Correlations between Government spending & GDP 2000-2009 In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. Frankel, Vegh & Vuletin (2011) procyclical countercyclical

24. 24 The Natural Resource Curse should not be interpreted as a rule that mineral-rich countries are doomed to fail. The question is what policies to adopt The question is what policies to adopt to avoid the pitfalls and improve the chances of prosperity. to avoid the pitfalls and improve the chances of prosperity. A wide variety of measures have been tried by commodity-exporters cope with volatility. A wide variety of measures have been tried by commodity-exporters cope with volatility. Some work better than others. Some work better than others.

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

26. Devices to share risks 1. Index contracts with foreign companies to the world commodity price. 2. Hedge mining revenues in options markets 3. Denominate debt in terms of commodity price Summary: 10 recommendations for commodity-exporting countries

27. 4. Allow some currency appreciation in response to a rise in world prices of mining exports, but only after accumulating some foreign exchange reserves. 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 (P roduct P rice T argeting ). 6. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent commodity price rises. 10 recommendations for commodity producers continued Macroeconomic policy PPT

28. 7. Manage Commodity Funds transparently & professionally, like Botswana’s Pula Fund -- not subject to politics like Norway’s Pension Fund. like Botswana’s Pula Fund -- not subject to politics like Norway’s Pension Fund. 8. Invest in education, health, & roads. 9. Publish What You Pay. 10. Consider lump-sum distribution of oil wealth, equal per capita. Summary: 10 recommendations for commodity producers, concluded Good governance institutions

29. Elaboration on two proposals to reduce the procyclicality of macroeconomic policy for mining exporters I) To make monetary/exchange rate policy less procyclical: P roduct P rice T argeting II) To make fiscal policy less procyclical: emulate Chile. PPT

30. I) The challenge of designing a currency regime for countries where terms of trade shocks dominate the cycle Fixing the exchange rate gives a nominal anchor, but leads to procyclical monetary policy: money inflows during booms. Floating accommodates terms of trade shocks, thus giving countercyclical monetary policy; but does not provide a nominal anchor. Inflation targeting, in terms of the CPI, provides a nominal anchor; but reacts perversely to terms of trade. Needed: an anchor that accommodates trade shocks

31. Professor Jeffrey Frankel P roduct P rice T argeting: Target an index of domestic production prices. [1] Include export commodities in the index and exclude import commodities, so money tightens & the currency appreciates when world prices of export commodities rise, not when world priced of import commodities rise. Automatically countercyclical. The CPI does it backwards: It calls for appreciation when import prices rise, and not when export prices rise ! [1] Frankel (2011). PPT

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

33. 33

34. References by the author Escaping the Oil Curse,” Project Syndicate, Dec. 2011. Escaping the Oil Curse Project Syndicate "Barrels, Bushels and Bonds: How Commodity Exporters Can Hedge Volatility," Project Syndicate Oct. 2011.Barrels, Bushels and BondsHow Commodity Exporters Can Hedge Volatility Project Syndicate “The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,” 2012, Commodity Price Volatility & Inclusive Growth in Low-Income Countries, R.Arezki & Z.Min, eds. (IMF). HKS RWP12-014.The Natural Resource Curse: A Survey of Diagnoses and Some PrescriptionsRWP12-014 "The Curse: Why Natural Resources Are Not Always a Good Thing,” Milken Institute Review, 13, no.4, 2011.The Curse: Why Natural Resources Are Not Always a Good Thing Review2011 “How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” in Natural Resources, Finance and Development, R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011. How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?T.Gylfason “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. HKS RWP11-012. A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by ChileCentral Bank of ChileWP 604HKS RWP11-012 “On Graduation from Procyclicality,” with C.Végh & G.Vuletin, 2012. “On Graduation from Procyclicality,” “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America," Economia, vol.11 (Brookings), 2011. NBER WP 16362,. A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America EconomiaBrookings16362 “The Natural Resource Curse: A Survey,” 2012, in Beyond the Resource Curse, edited by B.Shaffer & T.Ziyadov (University of Pennsylvania Press); CID WP195, 2011.The Natural Resource Curse: A SurveyBeyond the Resource CurseShafferUniversity of Pennsylvania PressCID WP195

35. 35 Appendix (I): Anarchic Institutions 4.1 Unsustainably rapid depletion When exhaustible resources are in fact exhausted, the country may be left with nothing. When exhaustible resources are in fact exhausted, the country may be left with nothing. Three concerns: Three concerns: Protection of environmental quality. Protection of environmental quality. A motivation for a strategy of economic diversification. A motivation for a strategy of economic diversification. The need to save for the day of depletion (see Nauru): The need to save for the day of depletion (see Nauru): Invest rents from exhaustible resources in other assets. Invest rents from exhaustible resources in other assets.

36. 36 4.2 Unenforceable property rights Depletion would be much less of a problem if full property rights could be enforced, Depletion would be much less of a problem if full property rights could be enforced, thereby giving the owners incentive to conserve the resource in question. thereby giving the owners incentive to conserve the resource in question. But often this is not possible But often this is not possible especially under frontier conditions. especially under frontier conditions. Overfishing, overgrazing, & over-logging are classic examples of the “tragedy of the commons.” Overfishing, overgrazing, & over-logging are classic examples of the “tragedy of the commons.” Individual fisherman, ranchers, loggers, or miners, have no incentive to restrain themselves, while the fisheries, pastureland or forests are collectively depleted. Individual fisherman, ranchers, loggers, or miners, have no incentive to restrain themselves, while the fisheries, pastureland or forests are collectively depleted.

37. Madre de Dios region of the Amazon rainforest in Peru, the left-hand side stripped by illegal gold mining. http://indiancountrytodaymedianetwork.com/2011/02/27/amazon-gold-rush-laying-waste-to-peruvian-rainforest%E2%80%99s-madre-de-dios-20021

38. 38 4.3 War Where a valuable resource such as oil or diamonds is there for the taking, factions will likely fight over it. Where a valuable resource such as oil or diamonds is there for the taking, factions will likely fight over it. Oil & minerals are correlated with civil war. Oil & minerals are correlated with civil war. Chronic conflict in places such as Sudan comes to mind. Chronic conflict in places such as Sudan comes to mind. Civil war is, in turn, very bad for economic development. Civil war is, in turn, very bad for economic development.

39. Appendix (II): 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.

40. 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. 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.

41. 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 stir political rage as well as higher prices can. Shortages & long lines can stir political rage as well as higher prices can. Not to mention when huge gaps force the government to raise prices. Not to mention when huge gaps force the government to raise prices. “Iran Fuel Rationing Sparks Anger, Protests,” 6/27/07 http://www.payvand.com/news/07/jun/1263.html Price controls can also require imports, to satisfy excess demand. Then they raise the world price even more.

42. 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 2010. as did Russia in 2010. India banned cotton exports in March 2012. India banned cotton exports in March 2012. Results: Results: Domestic supply is discouraged. Domestic supply is discouraged. World prices go even higher. World prices go even higher.

43. An initiative at the G20 meeting of agriculture ministers in Paris in June 2011 deserved to succeed: Producing and consuming countries in grain markets should cooperatively agree to refrain from export controls and price controls. Producing 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. One hopes for steps in this direction, perhaps working through the WTO. One hopes for steps in this direction, perhaps working through the WTO.

44. 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.

45. 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.

46. 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, Adam. Like Cain in Genesis, he competes with his brother for the love of his father, Adam. 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. 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.

47. An example of commodity speculation But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that 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 angrily tells him that he will have to “give the money back.” 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, 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). 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.

48. 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.

49. “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.

50. “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.