1. Macroeconomic Policy in Countries with Natural Resource Wealth APPENDICES Leading Economic Growth Program February 14, 2013 Jeffrey Frankel

2. 22 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

3. 33 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

4. 44 (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.

5. 5 Commodity prices have been especially volatile over the last decade Source: UNCTAD

6. 66 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.

7. 7 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…

8. 8 Econometric findings that oil and 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.

9. 9 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.

10. 10 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.

11. 1111 4. Anarchic institutions 1. Unsustainably rapid depletion of resources 1. Unsustainably rapid depletion of resources 2. Unenforceable property rights 3. Civil war

12. 1212 (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

13. 1313 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

14. 1414 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.

15. 1515 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.

16. 1616 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.

17. 17 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.

18. 1818 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.

19. 19

20. 20 Appendices on recommendations for dealing with the natural resource curse Appendix II.1: Elaboration on proposal to make monetary policy less procyclical – PPT, using GDP deflator to set annual inflation target. Appendix II.2: Elaboration on proposal to make fiscal policy less procyclical – emulate Chile, setting structural targets with independent fiscal forecasts

21. 21 Appendix II.1: 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.

22. 22 Empirical findings 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)

23. 23 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.

24. 24 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

25. 25 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….

26. 26 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.

27. 27 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.

28. 28 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.

29. 29 Appendix II.2: Official over-optimism & Chilean fiscal institutions

30. 30

31. 31 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;

32. 32 US official projections have been over-optimistic on average

33. 33 Greek official forecasts have always been over-optimistic.

34. 34 Chile’s official forecasts have not been over-optimistic.

35. 35 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.”

36. 36 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.

37. 37 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.

38. 38 The crucial institutional innovation in Chile How has Chile avoided over-optimistic official forecasts? especially the historic pattern of over-exuberance in commodity booms? 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.

39. 39 Application to other countries Any country could adopt the Chilean mechanism. Suggestion: give the panels more institutional independence as is familiar from central banking: laws protecting them from being fired. Open questions: Are the budget rules to be interpreted as ex ante or ex post? 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) ?

40. 40 ”On Graduation from Fiscal Procyclicality,” Frankel, Végh & Vuletin; J.Dev.Econ., 2013.