1. Coping with Commodity Volatility: Macroeconomic Policies for Developing Countries May 24, 2013 Jeffrey Frankel Harpel Professor of Capital Formation & Growth

2. 2 In 2008, the government of Chilean President Bachelet & her Finance Minister Velasco ranked low in public opinion polls. 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). Evolution of approval and disapproval of four Chilean presidents By late 2009, they were the most popular in 20 years. Why?

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 intertemporal optimization theory, capital flows should be countercyclical: 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 procyclical than countercyclical. Gavin, Hausmann, Perotti & Talvi (1996) ; Kaminsky, Reinhart & Vegh (2005) ; Reinhart & Reinhart (2009); and Mendoza & Terrones (2008). Theories to explain this involve capital market imperfections, e.g., asymmetric information or the need for collateral.

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.

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 (iii) Procyclical fiscal policy Fiscal policy has historically tended to be procyclical in developing countries Fiscal policy has historically tended to be procyclical in developing countries especially among commodity exporters: especially among commodity exporters: Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart & Végh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006), Ilzetski & Végh (2008), Medas & Zakharova (2009), Gavin & Perotti (1997). Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart & Végh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006), Ilzetski & Végh (2008), Medas & Zakharova (2009), Gavin & Perotti (1997). Correlation of income & spending mostly positive – Correlation of income & spending mostly positive – in comparison with industrialized countries. in comparison with industrialized countries.

9. 9 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)

10. 1010 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 proportionately, or more. A reason for procyclical public spending: receipts from taxes & royalties rise in booms. The government cannot resist the temptation to increase spending proportionately, or more. Then it is forced to contract in recessions, Then it is forced to contract in recessions, thereby exacerbating the swings. thereby exacerbating the swings.

11. 1111 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. Gelb (1986). Gelb (1986). (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. Medas & Zakharova (2009) Medas & Zakharova (2009) Arezki & Ismail (2010) : Arezki & Ismail (2010) : government spending rises in booms, but is downward-sticky. 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..”

12. 1212 An important development -- some developing countries, including commodity producers, were able to break the historic pattern in the most recent decade: An important development -- some developing countries, including commodity producers, 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, Botswana, Malaysia, Indonesia, Korea… Chile, Botswana, Malaysia, Indonesia, Korea… How were they able to achieve counter-cyclicality? How were they able to achieve counter-cyclicality? The procyclicality of fiscal policy, cont.

13. 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. 14 1. How can a country avoid excessive credit creation & inflation in a commodity boom ? 1. How can a country avoid excessive credit creation & inflation in a commodity boom ? Eventually allow some currency appreciation. Eventually allow some currency appreciation. But not a free float. Accumulate some fx reserves first. But not a free float. Accumulate some fx reserves first. 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? 3. Fiscal policy: How can governments be constrained from over-spending in boom times? Fiscal rule? 3. Fiscal policy: How can governments be constrained from over-spending in boom times? Fiscal rule? 4. What microeconomic arrangements can reduce macroeconomic volatility? 4. What microeconomic arrangements can reduce macroeconomic volatility? Four questions for macro management

15. 15 1) The challenge of designing a monetary regime for countries where 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: Exporters of oil & other commodities in 1980s or 1997-98.

16. 16 Currency regime, continued Floating accommodates terms of trade shocks: If terms of trade improve, currency automatically appreciates, preventing excessive money inflows, overheating & inflation. If terms of trade worsen, currency automatically depreciates, preventing recession & balance of payments crisis. Disadvantages of floating: Volatility can be excessive; Dutch Disease can be worse: pro-cyclicality of real exchange rate. One needs a nominal anchor.

17. 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.

18. Terms-of-trade variability Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008 & 2011. Prices of crude oil and other agricultural & 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)…

19. 19 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”

20. 20 Monetary regime 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.

21. 21 Needed: Nominal anchors that accommodate the shocks that are common in developing countries Supply shocks, e.g., droughts, floods, hurricanes: Nominal GDP targeting. Terms of trade shocks e.g., fall in price of commodity export. Product Price Targeting PPT

22. 22 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

23. 23 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.

24. 24 P roduct P rice T argeting accommodates terms of trade shocks Target an index of domestic production prices [1] such as the GDP deflator. Include export commodities in the index & exclude import commodities, so money tightens & the currency appreciates when world prices of export commodities rise accommodating the terms of trade -- not when 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

25. 25 Why is PPT better than a fixed exchange rate for countries with volatile export prices? If the $ price of the export commodity goes up, the currency automatically appreciates, moderating the boom. If the $ price of export commodity goes down, the currency automatically depreciates, moderating the downturn & improving the balance of payments. PPT

26. 26 Why is PPT better than CPI-targeting for countries with volatile terms of trade? 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

27. 27 Elaboration on 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. PPT

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

29. 2006:100% 2007: 63% 2008: 72% 2010: 58% 2011 97% Do you personally believe in IT? 38% Is Inflation Targeting the reigning orthodoxy at the Fund? “Yes”

30. 30 3. How Can Countries Avoid Pro-cyclical Fiscal Policy? “Good institutions.” But what are they, exactly?

31. 31 ”On Graduation from Fiscal Procyclicality,” Frankel, Végh & Vuletin; J.Dev.Economics, 2013. Who achieves counter-cyclical fiscal policy? Countries with “good institutions”

32. The quality of institutions varies, not just across countries, but also across time. 32 1984-2009 Frankel, Végh & Vuletin,2013.

33. 33 ”On Graduation from Fiscal Procyclicality,” Frankel, Végh & Vuletin; J. Devel. Econ., 2013. The comparison holds not only in cross-section, but also across time.

34. 34 How can countries avoid fiscal expansion in booms? What are “good institutions,” exactly? Rules? Budget deficits or debt brakes? Have been tried many times. Usually fail. Rules for cyclically adjusted budgets? Countries more likely to be able to stick with them. But… An under-explored problem: Over-optimism in official forecasts of growth rates & budgets.

35. 35 Over-optimism in official forecasts Statistically significant bias among 33 countries Worse in booms. Worse at 3-year horizons than 1-year. Frankel (2011, 2012). Leads to pro-cyclical fiscal policy: If the boom is forecast to last indefinitely, there is no apparent need to retrench. BD rules don’t help. The SGP worsens forecast bias for euro countries. Cyclically adjusted rules won’t help the bias either. Frankel & Schreger (2013). Solution?

36. 36 1 st rule – Governments must set a budget target, 1 st rule – Governments must set a budget target, 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 avoided the pattern of 32 other governments, Result: Chile avoided the pattern of 32 other governments, where forecasts in booms were biased toward optimism. where forecasts in booms were biased toward optimism. The example of Chile’s fiscal institutions

37. 37 Chilean fiscal institutions In 2000 Chile instituted its structural budget rule. The institution was formalized into law in 2006. The structural budget surplus must be… 0 as of 2008 (was higher before, lower after), 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.

38. 38 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. The Pay-off

39. 39 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 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 by the time they left office.

40. 40

41. 41 5 econometric findings regarding bias toward optimism in official budget forecasts. Official forecasts in a sample of 33 countries on average are overly optimistic, for : (1) budgets & (2) GDP. The bias toward optimism is: (3) stronger the longer the forecast horizon; (4) greater in booms (5) greater for euro governments under SGP budget rules;

42. 42 US official projections have been over - optimistic on average.

43. 43 Greek official forecasts have always been over-optimistic.

44. 44 Chile’s official forecasts have not been over-optimistic.

45. 45 The optimism in official budget forecasts is stronger at the 3-year horizon, stronger among countries with budget rules, The optimism in official budget forecasts is stronger at the 3-year horizon, stronger among countries with budget rules, & stronger in booms. & stronger in booms. Frankel, 2010, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile.”

46. 46 5 more econometric findings regarding bias toward optimism in official budget forecasts. (6) The key macroeconomic input for budget forecasting in most countries : GDP. In Chile : the copper price. (7) Real copper prices revert to trend in the long run. But this is not always readily perceived: (8) 30 years of data are not enough to reject a random walk statistically; 200 years of data are needed. (9) U ncertainty (option-implied volatility) is higher when copper prices are toward the top of the cycle. (10) Chile ’ s official forecasts are not overly optimistic. It has apparently avoided the problem of forecasts that unrealistically extrapolate in boom times.

47. 47 In sum, institutions recommended to make fiscal policy less procyclical: Chile is not subject to the same bias toward over- optimism in forecasts of the budget, growth, or the all-important copper price. The key innovation that has allowed Chile to achieve countercyclical fiscal policy : not just a structural budget rule in itself, but rather the regime that entrusts to two panels of experts estimation of the long-run trends of copper prices & GDP, insulated from political pressure & wishful thinking

48. 48 Application to others Any country could emulate the Chilean mechanism, or in other ways delegate to independent agencies. Suggestion: give panels more institutional independence as is familiar from central banking: laws protecting them from being fired. Open questions: How much of the structural budget calculations are to be delegated to the independent panels of experts? Minimalist approach: they compute only 10-year moving averages. Can one guard against subversion of the institutions (CBO) ?

49. 49 Contractual provisions to share risks: Contractual provisions to share risks: 1. Index contracts with foreign companies to the world commodity price. 2. Hedge commodity revenues in options markets. 3. Denominate debt in terms of commodity price. Manage commodity funds professionally. Manage commodity funds professionally. 4. Other reforms to manage volatility

50. 50 Norway’s Pension Fund Norway’s Pension Fund All govt. oil revenues go into it. All govt. oil revenues go into it. Govermnent (on average over the cycle) can spend expected real return, say 4%. Govermnent (on average over the cycle) can spend expected real return, say 4%. All invested abroad. Reasons: All invested abroad. 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, fully delegated for financial optimization. fully delegated for financial optimization. Manage commodity funds professionally.

51. 51 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 et al., eds. (IMF); HKS RWP12-014. “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 PrescriptionsRWP12-014The Natural Resource Curse: A Survey of Diagnoses and Some PrescriptionsRWP12-014 “How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” in 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?HKS RWP 11-015 “On Graduation from Fiscal Procyclicality,” with C.Végh & G.Vuletin, in Journal of Development Economics, 100, no.1, Jan.2013 ; pp. 32-47. NBER WP 17619. Summary, VoxEU, 2011. “On Graduation from Fiscal Procyclicality,” with C.Végh & G.Vuletin, in Journal of Development Economics, 100, no.1, Jan.2013 ; pp. 32-47. NBER WP 17619. Summary, VoxEU, 2011. “On Graduation from Fiscal Procyclicality,”VéghVuletinin Journal of Development Economics100, no.1NBER WP 17619VoxEU “On Graduation from Fiscal Procyclicality,”VéghVuletinin Journal of Development Economics100, no.1NBER WP 17619VoxEU Chile's Countercyclical Triumph," in Transitions, Foreign Policy, June 2012. Chile's Countercyclical Triumph," in Transitions, Foreign Policy, June 2012. Chile's Countercyclical Triumph inTransitionsForeign PolicyChile's Countercyclical Triumph inTransitionsForeign Policy Spanish:Journal Economía Chilena, Aug.2011, CBC, 39-78. “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” Central Bank of Chile WP604, 2011. Spanish:Journal Economía Chilena, Aug.2011, CBC, 39-78. SpanishJournal Economía ChilenaAug.2011CBCA Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile Central Bank of ChileWP604,2011 SpanishJournal Economía ChilenaAug.2011CBC "Product Price Targeting -- A New Improved Way of Inflation Targeting," 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).Product Price Targeting -- A New Improved Way of Inflation Targeting 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 (Brookings), NBER WP 16362. A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin AmericaEconomiaBrookings16362 http://www.hks.harvard.edu/fs/jfrankel/

52. 52 References by others Rabah Arezki and Kareem Ismail, 2010, “Boom-Bust Cycle, Asymmetrical Fiscal Response and the Dutch Disease,” IMF WP/10/94, April. Rabah Arezki and Kareem Ismail, 2010, “Boom-Bust Cycle, Asymmetrical Fiscal Response and the Dutch Disease,” IMF WP/10/94, April. Christian Broda, 2004, "Terms of Trade and Exchange Rate Regimes in Developing Countries," Journal of International Economics, 63(1), 31-58. Christian Broda, 2004, "Terms of Trade and Exchange Rate Regimes in Developing Countries," Journal of International Economics, 63(1), 31-58. Luis Céspedes & Andrés Velasco, 2012, “Macroeconomic Performance During Commodity Price Booms & Busts” NBER WP 18569, Nov. Luis Céspedes & Andrés Velasco, 2012, “Macroeconomic Performance During Commodity Price Booms & Busts” NBER WP 18569, Nov. Graciela Kaminsky, Carmen Reinhart & Carlos Vegh, 2005, "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Macroeconomics Annual 2004, 19, pp.11-82. Graciela Kaminsky, Carmen Reinhart & Carlos Vegh, 2005, "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Macroeconomics Annual 2004, 19, pp.11-82. When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies, When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies, Warwick McKibbin & Kanhaiya Singh, “Issues in the Choice of a Monetary Regime for India,” 2003, in Kaliappa Kalirajan & Ulaganathan Sankar (eds.) Economic Reform and the Liberalisation of the Indian Economy (Edward Elgar Publ., UK), pp. 221-274. Warwick McKibbin & Kanhaiya Singh, “Issues in the Choice of a Monetary Regime for India,” 2003, in Kaliappa Kalirajan & Ulaganathan Sankar (eds.) Economic Reform and the Liberalisation of the Indian Economy (Edward Elgar Publ., UK), pp. 221-274. Warwick McKibbin & Kanhaiya Singh in Kaliappa Kalirajan & Ulaganathan Sankar (eds.) Economic Reform and the Liberalisation of the Indian Economy (Edward Elgar Publ., UK), pp. 221-274. Warwick McKibbin & Kanhaiya Singh in Kaliappa Kalirajan & Ulaganathan Sankar (eds.) Economic Reform and the Liberalisation of the Indian Economy (Edward Elgar Publ., UK), pp. 221-274. James Meade, 1978, “The Meaning of Internal Balance,” The Economic Journal, 91, 423-35. James Meade, 1978, “The Meaning of Internal Balance,” The Economic Journal, 91, 423-35. Jeffrey Sachs, “How to Handle the Macroeconomics of Oil Wealth,” 2007, in Escaping the Resource Curse, M.Humphreys, J.Sachs & J.Stiglitz, eds. (Columbia Univ. Press: NY), pp. 173-93. Jeffrey Sachs, “How to Handle the Macroeconomics of Oil Wealth,” 2007, in Escaping the Resource Curse, M.Humphreys, J.Sachs & J.Stiglitz, eds. (Columbia Univ. Press: NY), pp. 173-93.

53. 5353

54. 5454 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

55. 5555 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

56. 5656 (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.

57. 57 Commodity prices have been especially volatile over the last decade Source: UNCTAD

58. 5858 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.

59. 59 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…

60. 60 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

61. 61 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.

62. 62 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.

63. 6363 4. Anarchic institutions 1. Unsustainably rapid depletion of resources 1. Unsustainably rapid depletion of resources 2. Unenforceable property rights 3. Civil war

64. 6464 (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

65. 6565 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

66. 6666 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.

67. 6767 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.

68. 6868 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 1970-1990 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.

69. 69 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.

70. 7070 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.

71. 71 Appendix II: Empirical findings for PPT Simulations of 1970-2000 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

72. 72 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.

73. 73 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 16362. A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity- Exporters in Latin America EconomiaBrookings16362

74. 74 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….

75. 75 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.

76. 76 Table 1: LACA Countries ’ Current Regimes and Monthly Correlations of Exchange Rate Changes ($/local currency) with Dollar Import Price Changes Import price changes are changes in the dollar price of oil. Exchange Rate RegimeMonetary Policy1970-19992000-20081970-2008 ARG Managed floatingMonetary aggregate target -0.0212-0.0591-0.0266 BOL Other conventional fixed pegAgainst a single currency -0.01390.0156-0.0057 BRA Independently floatingInflation targeting framework (1999) 0.03660.09610.0551 CHL Independently floatingInflation targeting framework (1990)* -0.06950.0524-0.0484 CRI Crawling pegsExchange rate anchor 0.0123-0.03270.0076 GTM Managed floatingInflation targeting framework -0.00290.24280.0149 GUY Other conventional fixed pegMonetary aggregate target -0.03350.0119-0.0274 HND Other conventional fixed pegAgainst a single currency -0.0203-0.0734-0.0176 JAM Managed floatingMonetary aggregate target 0.02570.26720.0417 NIC Crawling pegsExchange rate anchor -0.06440.0324-0.0412 PER Managed floatingInflation targeting framework (2002) -0.31380.1895-0.2015 PRY Managed floating IMF-supported or other monetary program -0.0230.34240.0543 SLV DollarExchange rate anchor 0.10400.05300.0862 URY Managed floatingMonetary aggregate target 0.04380.11680.0564 Oil Exporters COL Managed floatingInflation targeting framework (1999) -0.02970.04890.0046 MEX Independently floatingInflation targeting framework (1995) 0.10700.16190.1086 TTO Other conventional fixed pegAgainst a single currency 0.06980.20250.0698 VEN Other conventional fixed pegAgainst a single currency -0.05210.0064-0.0382 * Chile declared an inflation target as early as 1990; but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999. LAC Countries ’ Current Regimes and Monthly Correlations of Exchange Rate Changes ($/local currency) with $ Import Price Changes Table 1 IT coun- tries show correl- ations > 0.

77. 77 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.

78. 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

79. 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.

80. 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.

81. 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.

82. 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. Results: Results: Domestic supply is discouraged. Domestic supply is discouraged. World prices go even higher. World prices go even higher.

83. 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.

84. 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.

85. 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.

86. 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.”

87. 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.

88. 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.

89. “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.

90. “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.

91. 91