1. Dealing with the Resource Curse: How Can Commodity Exporters Reduce Procylicality? Meeting the Next Macroeconomic Challenges in Africa NBER Africa Project and the Central Bank of Tanzania, Zanzibar, Dec. 18-19, 2012 Jeffrey Frankel Harpel Professor of Capital Formation & Growth, Harvard University and NBER

2. Many countries that are richly endowed with oil, minerals, or fertile land have failed to grow more rapidly than those without. Example: Some studies find a negative effect of oil in particular, on economic performance. Some studies find a negative effect of oil in particular, on economic performance. What is the Natural Resource Curse?

3. Meanwhile, East Asian economies achieved western-level standards of living despite having virtually no exportable natural resources: Japan, Singapore, Hong Kong, Korea & Taiwan, rocky islands or peninsulas; followed by China.

4. 4 Growth falls with fuel & mineral exports

5. 5 Are natural 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 commodity producers in the past, to find the path of success. No, of course not.

6. 6 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 will suggest some policies & institutional innovations to avoid the curse: The lecture will suggest some policies & institutional innovations to avoid the curse: especially ways of managing price volatility. especially ways of managing price volatility.

7. 7 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 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.

8. 8 Procyclicality Commodity-exporting developing countries are historically prone to procyclicality, Commodity-exporting developing countries are historically prone to procyclicality, exacerbating the booms& busts. Procyclicality in: Procyclicality in: Capital inflows; Monetary policy; Capital inflows; Monetary policy; Real exchange rate; Non-traded Goods Real exchange rate; Non-traded Goods Fiscal Policy Fiscal Policy

9. 9 The procyclicality of fiscal policy The procyclicality of fiscal policy A reason for procyclical public spending: receipts from taxes & royalties rise in booms. The government cannot resist the temptation to increase spending rapidly. A reason for procyclical public spending: receipts from taxes & royalties rise in booms. The government cannot resist the temptation to increase spending rapidly. Then it is forced to contract in recessions, Then it is forced to contract in recessions, thereby exacerbating the swings. thereby exacerbating the swings.

10. 10 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. Windfalls are often spent on public sector wages, Windfalls are often spent on public sector wages, which are hard to reverse when boom turns to bust. which are hard to reverse when boom turns to bust. 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..”

11. 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)

12. 12 An important development -- in the most recent decade some developing countries were able to break the historic pattern: An important development -- in the most recent decade some developing countries were able to break the historic pattern: 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, Botswana, China, Indonesia, Korea… Chile, Botswana, China, Indonesia, Korea… How have they done it? How have they done it? The procyclicality of fiscal policy, cont.

13. 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 (2012) procyclical countercyclical

14. Who achieves counter-cyclical fiscal policy? Countries with “good institutions” ”On Graduation from Fiscal Procyclicality” 2013, Frankel with C.Végh & G.Vuletin; J.Dev.Economics.

15. Some that are not recommended: Institutions that try to suppress price volatility. Those recommended fall into 3 categories: Devices to hedge risk. Ideas to reduce macroeconomic procyclicality. Institutions for better governance. Policies & institutions to avoid pitfalls of the Natural Resource Curse

16. Many of the policies that have been intended to suppress commodity volatility do not work out so well 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

17. 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 7 recommendations for commodity-exporting countries Oct. 2011 op-ed “Barrels & Bonds”

18. 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, the GDP deflator, which 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. 7 recommendations for commodity producers continued Countercyclical macroeconomic policy PPT

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

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

21. I) The challenge of designing a monetary 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

22. P roduct P rice T argeting : 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). PPT

23. II) Achieving counter-cyclical fiscal policy 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. Chile ran surpluses in the 2003-07 boom, 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. The example of Chile since 2000

24. Appendices on recommendations for dealing with the natural resource curse Appendix 1: Policies not recommended Appendix 2: Elaboration on proposal to make monetary policy less procyclical – PPT, using GDP deflator to set annual inflation target. Appendix 3: Elaboration on proposal to make fiscal policy less procyclical – emulate Chile, setting structural targets with independent fiscal forecasts

25. Appendix 1: Policies that have been tried but that are not recommended Appendix 1: Policies that have been tried but that are not recommended Producer subsidies Stockpiles Marketing boards Price controls Export controls Blaming derivatives Resource nationalism Nationalization Banning foreign participation

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.”

34. 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.

35. 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.

36. “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.

37. “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.

38. 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.

39. Appendix 2, on Monetary Policy: P roduct P rice T argeting 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. PP T

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

41. Why is PPT better than a fixed exchange rate for countries with volatile export prices ? 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. PPT

42. Why is PPT better than CPI-targeting for countries with volatile terms of trade ? 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. PPT

43. Simulations Gold producers: Burkino Faso, Ghana, Mali, South Africa Other commodities: Coffee (Ethiopia), oil (Nigeria), platinum (S.Africa) 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. Would have appreciated automatically in commodity booms, moderating over-heating. Sources: Frankel (2002, 03a, 05), Frankel & Saiki (2003)

44. Appendix 3, on fiscal policy: Chile’s fiscal institutions 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.

45. The crucial institutional innovation in Chile How has Chile avoided over-optimistic official forecasts? especially the historic pattern of over-exuberance in booms which forecasts in most other governments show? 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.

46. 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. The Pay-off

47. 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.

48. 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).

50. References by the author Project Syndicate, Project Syndicate, Project Syndicate Project Syndicate “Escaping the Oil Curse,” Dec.9, 2011. “Escaping the Oil Curse,” Dec.9, 2011.Escaping the Oil CurseEscaping the Oil Curse "Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility," Oct.17, 2011. "Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility," Oct.17, 2011. Barrels, Bushels & Bonds How Commodity Exporters Can Hedge VolatilityBarrels, 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 & Z.Min, eds.. HKS RWP12-014. High Level Seminar, IMF Annual Meetings, DC, Sept.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 Natural Resource Curse: A Survey of Diagnoses and Some PrescriptionsRWP12-014High Level SeminarThe Natural Resource Curse: A Survey of Diagnoses and Some PrescriptionsRWP12-014High Level Seminar "The Curse: Why Natural Resources Are Not Always a Good Thing,” Milken Institute Review, vol.13, 4 th quarter 2011. "The Curse: Why Natural Resources Are Not Always a Good Thing,” Milken Institute Review, vol.13, 4 th quarter 2011.The Curse: Why Natural Resources Are Not Always a Good ThingReview2011The Curse: Why Natural Resources Are Not Always a Good ThingReview2011 “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. “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.The Natural Resource Curse: A Survey Chapter 2Beyond the Resource CurseU.Penn. Pressproofs notesSummaryThe Natural Resource Curse: A Survey Chapter 2Beyond the Resource CurseU.Penn. Pressproofs notesSummaryCID WP195 “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.How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?T.Gylfason HKS RWP 11-015 “On Graduation from Procyclicality,” 2013, with C.Végh & G.Vuletin; J. Dev. Economics. On Graduation from Procyclicality “Chile’s Solution to Fiscal Procyclicality,” 2012, Transitions blog, Foreign Policy.Chile’s Solution to Fiscal ProcyclicalityTransitions “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.A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by ChileCentral Bank of ChileWP 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). "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review Vol.XI, issue 1, April 2012 (Monetary Authority of Singapore).Product Price Targeting -- A New Improved Way of Inflation TargetinginVol.XI, issue 1Product Price Targeting -- A New Improved Way of Inflation TargetinginVol.XI, issue 1 “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. A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America EconomiaBrookings16362