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NS4540 Winter Term 2017 Latin America: Commodities Commodities: Overview • Commodities have played a key role in the development of Latin America • They are also going to be an important part of the future • If commodities are a significant percentage of total exports and GDP, then changes in commodities markets can have ramifications for the entire economy • For a country that possesses commodities, there may be noticeable differences in economic policy from those countries that are not commodity based • Commodities can potentially distort the entire structure of an economy • For middle income countries of Latin America commodities can be like dynamite • Useful if handled with care but • Potentially dangerous 2 Boom and Bust Cycle I • Commodities in Latin America has a tendency to follow a boom and bust cycle • Commodity booms have two sources • Discovery and widespread use – coffee and tobacco • Discovery of a new source of supply – gold and silver • Booms and busts have made economic management and economic development more difficult • Price volatility also important factor complicating economic policy-making and development . • (% change previous year) 3 Commodity Booms in Latin America 4 Boom and Bust Cycle II • Price volatility largely due to inelastic supply and demand 5 Commodity Shares 6 Boom and Bust Cycle III • For Latin America as a whole, commodity exports make up around • 60% of total exports • 15% of GDP • Commodity price volatility translates into volatility in overall exports • Since exports represent a relatively high percentage of GDP, the rate of real GDP growth in many of region’s countries can be substantially impacted by changes in commodity prices 7 Commodities and Economic Development I • Successful Process of Commodity-based Development • First production of commodities can be quite profitable and a major source of revenues • In turn revenues can be used to finance infrastructure, schools, and other development related activities • Can allow country to grow faster • Second faster growth may require imports that will require foreign exchange from commodity exports • Third country with commodities may find it easier to transition to manufacturing than country without such resources • Some manufacturing activities can add value to existing resources 8 Commodities and Economic Development II • In practice this scenario has been fraught with difficulties so common that they are often referred to as the resource curse • Since Latin America is a large heterogeneous region not all of these problems apply to all countries • However, elements of the resource curse are part of the economic history of Latin America • Colonial times motivation for Spanish settlement gold and silver – little wealth used for economic development. • Post-Independence era issues center on division of resource profits between public and private sectors • Even under ideal circumstances, using commodities to finance development can create tensions between producers and the government. 9 Commodities and Economic Development III • Producers of commodities vulnerable to the ability of the government to take part of the profits earned. • Governments often see taxing commodities as a relatively easy way to raise revenue • Once the revenue has left the private sector, no guarantee it will be wisely used • Aside from outright corruption, the problems may be more subtle. • Revenues from commodities may be used to purchase support from the population that might not otherwise exist • Government employment increases faster than if commodity revenues did not exist • In short, the production and export of commodities may not lead to faster economic growth • Not difficult to image commodity earnings leading to 10 relatively slow growth Commodities and Economic Development IV • Can see this in Latin America, despite being rich in commodities region is poor in • Infrastructure, • Education and • Health care • Things become even more complicated with the involvement of foreign firms in the production of commodities. • Development of commodity may require capital and technical expertise the country may not possess, and FDI is needed 11 Commodities and MNCs I • Negotiations between multinational corporations (MNCs) and the host country may be very difficult • Especially difficult if the commodity is an exhaustible resource. • Conditions of entry, tax rates, and other variables can all influence the final outcome. • In the Golden Age (1870 to 1914) negotiations were based on national treatment. • Foreign firms faced similar taxes and regulations as domestic firms. • However with relatively weak governments in region combined with low taxes and light regulation, national treatment became an increasingly unacceptable form of regulation 12 Commodities and MNCs II • In other cases export enclaves developed, where MNCs were receiving preferential treatment rather than national treatment. • In the 20th century the balance of power has shifted from the MNCs to the governments of the region • Taxes and regulations became stiffer. • In some cases local assets of the MNCs were expropriated with varying degrees of compensation. • Many countries have opted to produce their own resources using state-owned enterprises (SOEs) • In theory SOEs allow the country to extract all the value from its commodities, but in practice this has been proven to be difficult. • PEMEX in Mexico going through difficult period with high debt levels and falling production – same in Venezuela and Brazil 13 Commodities and Manufacturing I • Finally, difficult for Latin America and other regions to leverage their commodities into manufacturing based on these resources • Primary problem has been the level of tariffs and in some cases quotas in developed countries set up to encourage processing of commodities there • Done by escalating the tariffs according to the stage of processing • Raw commodities often have low or zero tariff • If the commodity is processed into an intermediate commodity, the tariff rate rises • If the commodity is further processed into a finished product the tariff is even higher 14 Commodities and Manufacturing II • The point of this tariff structure is to import commodities as cheaply as possible • The tariff then encourages the processing of the commodity in the developed country rather than the developing country • Makes it difficult for Latin American countries to establish manufacturing industries based on their plentiful commodities. • Not the only factor inhibiting industrial development in Latin America, but historically it has been an important factor • In recent years with trade liberalization tariff rates are much lower and less focused on value added 15 Summing - Up • For Latin America the possession of commodities has no doubt made the region better off • However, it is difficult to say that the potential benefits of these commodities have been used to their fullest to enhance economic development • The resource curse has not afflicted the region as badly as in other parts of the world. • On the other hand, traces of this effect are not difficult to find in the region. • Two related factors have impacted manufacturing in Latin America • The rise of China • The commodity based Dutch Disease 16 Latin America and China I • The rise of China has been a mixed blessing • Rapid economic growth in China has created a strong demand for Latin American commodity exports • Include oil, iron ore, soybeans, copper, meat, and pulp and paper • Until recently China’s demand for raw materials grew at double digit rates • Resulting rising commodity prices have had a favorable effect on the terms of trade for the region • In this regard the rise of China has been a positive development 17 Latin America and China II • In another respect, rise of China has created an uneasy feeling in the region • China’s growth has been fueled by booming exports of labor-intensive manufactured goods • While exports of manufactured goods from Latin America have grown significantly over the last several decades, this growth pales in comparison to that of China • Situation not zero sum, but there is the sense that the relative success of China has come partially at the expense of growth in exports from Latin America • Clearly however, China has benefitted Latin America as in the past: booming commodity prices • Cost may be another lost opportunity for the region to diversify out of its traditional pattern of development. 18 Commodities and Dutch Disease I • If a country has a significant production of commodities this can affect its industrial structure, not just by using resources that may have gone to industry, but in more subtle ways. • During a commodity boom, profits are high in this sector. • Acts as a magnet for resources in other parts of the economy • Other sectors of the economy may not be able to compete for capital land are “crowded out” as the price of capital rises • Same thing happens with Labor –makes wages outside of the commodity sector higher and products less competitive. 19 Commodities and Dutch Disease II • In the boom, scarce resources such as capital and human capital are being diverted to one part of the economy • Wages may rise in the entire economy. • While things are going well in the booming commodity sector, other parts of the economy are having a more difficult time growing • When the bust comes, difficult to reverse the process when resources released from the commodity sector • Other parts of he economy cannot grow fast enough to absorb these resources • In addition many of the physical and human resources may have become sector specific and not easily transferable to the noncommodity sector 20 Commodities and Dutch Disease III • How important these effects are depends on how important a commodity is to the economy • The effect of an oil boom would be much greater in Venezuela than in Mexico which has a much more diversified economy • Commodity boom can also affect the exchange rate • Increases in the demand for the commodity during a a boom translates into a demand for the local currency • Causes exchange rate to appreciate – makes • Imports cheaper – increases the relative prices of domestically produced goods that compete with imports • Exports of goods and services other than commodities become more expensive for foreign buyers 21 Commodities and Dutch Disease IV • In total, a commodity boom means a more difficult environment for the tradable goods sectors of the economy • Booming commodity sector leads to more imports and lower domestic production • Effect can be exacerbated if the booming sector is also pulling FDI into the country for its development • This puts additional pressure strengthening the exchange rate • Process referred to as the Dutch disease, because happened in that country with natural gas in the late 1950s 22 Commodities and Dutch Disease V • To a greater or lesser extent, the effects of the Dutch disease are easy to find in Latin America. • Commodity booms have attracted more resources into those parts of many economies with lasting effects on industrial structure • Adjusted for productivity, wages in Latin America tend to be high • Latin America has a history of overvalued exchange rates • This has encouraged imports and discouraged exports of products other than commodities • These effects have been felt most strongly in the manufacturing sector of he region • Dutch Disease can’t account for all the problems in Latin American industry, but is an important component. 23