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Dealing with the Resource Curse: How Can Commodity Exporters Reduce Procylicality? Jeffrey Frankel Harpel Professor of Capital Formation & Growth, Harvard University and NBER Meeting the Next Macroeconomic Challenges in Africa NBER Africa Project and the Central Bank of Tanzania, Zanzibar, Dec. 18-19, 2012 What is the Natural Resource Curse? 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. 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. Growth falls with fuel & mineral exports 4 Are natural resources necessarily bad? No, of course not. Commodity wealth need not necessarily lead to inferior economic or political development. Rather, it is a double-edged sword, with both benefits and dangers. It can be used for ill as easily as for good. 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. 5 Some developing countries have avoided the pitfalls of commodity wealth. E.g., Chile (copper) Botswana (diamonds) Some of their innovations are worth emulating. The lecture will suggest some policies & institutional innovations to avoid the curse: especially ways of managing price volatility. 6 The Natural Resource Curse should not be interpreted as a rule that commodityrich countries are doomed to fail. The question is what policies to adopt to avoid the pitfalls and improve the chances of prosperity. A wide variety of measures have been tried by commodity-exporters cope with volatility. Some work better than others. 7 Procyclicality Commodity-exporting developing countries are historically prone to procyclicality, exacerbating the booms& busts. Procyclicality in: Capital inflows; Monetary policy; Real exchange rate; Non-traded Goods Fiscal Policy 8 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. Then it is forced to contract in recessions, thereby exacerbating the swings. 9 Two budget items account for much of the spending from oil booms: (i) Investment 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. 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..” (ii) The government wage bill. Windfalls are often spent on public sector wages, which are hard to reverse when boom turns to bust. 10 Correlations between Gov.t Spending & GDP 1960-1999 procyclical Adapted from Kaminsky, Reinhart & Vegh (2004) countercyclical G always used to be pro-cyclical for most developing countries. The procyclicality of fiscal policy, cont. 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 to run budget surpluses & build reserves, thereby earning the ability to expand fiscally in the 2008-09 crisis. Chile, Botswana, China, Indonesia, Korea… How have they done it? 12 Correlations between Government spending & GDP 2000-2009 procyclical Frankel, Vegh & Vuletin (2012) countercyclical In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. 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. Policies & institutions to avoid pitfalls of the Natural Resource Curse 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. 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 7 recommendations for commodity-exporting countries 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 Oct. 2011 op-ed “Barrels & Bonds” 7 recommendations for commodity producers continued Countercyclical macroeconomic policy 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 PPT on the export commodity (Product Price Targeting). 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, concluded Good governance institutions 7. Manage commodity funds professionally. Invest them abroad like Norway’s Pension Fund, Reasons: (1) for diversification, (2) to avoid cronyism in investments. but insulated from politics like Botswana’s Pula Fund. Professionally managed, to optimize financially. Elaboration on two proposals to reduce the procyclicality of macroeconomic policy for commodity exporters I) To make monetary policy less procyclical: Product Price Targeting PPT II) To make fiscal policy less procyclical: emulate Chile. 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. Inflation Targeting, in terms of the CPI, But volatility can be excessive; also floating does not provide a nominal anchor. provides a nominal anchor; but can react perversely to terms of trade shocks. Needed: an anchor that accommodates trade shocks Product Price Targeting: PPT 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). II) Achieving counter-cyclical fiscal policy The example of Chile since 2000 1st rule – Governments must set a budget target, 2nd rule – The target is structural: Deficits allowed only to the extent that set = 0 in 2008 under Pres. Bachelet. (1) output falls short of trend, in a recession, or (2) the price of copper is below its trend. 3rd rule – The trends are projected by 2 panels of independent experts, outside the political process. Result: Chile avoids the pattern of 32 other governments, where forecasts in booms are biased toward over-optimism. Chile ran surpluses in the 2003-07 boom, while the U.S. & Europe failed to do so. 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 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 Unsuccessful policies to reduce commodity price volatility: 1) Producer subsidies to “stabilize” prices at high levels, often via wasteful stockpiles & protectionist import barriers. Examples: The EU’s Common Agricultural Policy Or fossil fuel subsidies Bad for EU budgets, economic efficiency, international trade & consumer pocketbooks. which are equally distortionary & budget-busting, and disastrous for the environment as well. Or US corn-based ethanol subsidies, with tariffs on Brazilian sugar-based ethanol. Unsuccessful policies, continued 2) Price controls to “stabilize” prices at low levels Discourage investment & production. 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. In practice the price paid to cocoa & coffee farmers was always below the world price. As a result, production fell. Microeconomic policies, continued Often the goal of price controls is to shield consumers of staple foods & fuel from increases. But the artificially suppressed price discourages domestic supply, and requires rationing to domestic households. 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. Price controls can also require imports, to satisfy excess demand. Then they raise the world price even more. Microeconomic policies, continued 3) In producing countries, prices are artificially suppressed by means of export controls to insulate domestic consumers from a price rise. In 2008, India capped rice exports. Argentina did the same for wheat exports, as did Russia in 2010. India banned cotton exports in March 2012. Results: Domestic supply is discouraged. World prices go even higher. 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. The result would be lower world price volatility. 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. An example of commodity speculation 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. Cal “goes long” in the market for beans, in anticipation of a rise in demand if the US enters WWI. 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. 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.” An example of commodity speculation, cont. Cal has been the agent of Adam Smith’s famous invisible hand: By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the Army). 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 overall lesson for microeconomic policy 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. Better to accept volatility and cope with it. “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. “Resource nationalism” 7) Keeping out foreign companies altogether. continued 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. The overall lesson for microeconomic policy 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. Better to accept volatility and cope with it. For the poor: well-designed transfers, along the lines of Oportunidades or Bolsa Familia. Appendix 2, on Monetary Policy: Product Price Targeting PPT 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. 6 proposed nominal targets and the Achilles heel of each: Vulnerability Targeted variable Gold standard Commodity standard Price of gold Price of agric. & mineral basket Vulnerability Example Vagaries of world 1849 boom; gold market 1873-96 bust Shocks in Oil shocks of imported 1973-80, 2000-11 commodity Monetarist rule M1 Velocity shocks US 1982 Nominal income targeting Fixed exchange rate Nominal GDP $ Measurement problems Appreciation of $ Less developed countries (or €) (or € ) CPI Terms of trade shocks Inflation targeting EM currency crises 1995-2001 Oil shocks of 1973-80, 2000-11 Professor Jeffrey Frankel Why is PPT better than a fixed exchange rate for countries with volatile export prices? PPT 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. Why is PPT better than CPI-targeting for countries with volatile terms of trade? PPT 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. PPT does not have this flaw . (E.g., oil-importers in 2007-08.) If the $ price of the export commodity goes up, PPT says to tighten money enough to appreciate. Right response. CPI targeting does not have this advantage. (E.g., Gulf currencies in 2007-08.) 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) 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. The crucial institutional innovation in Chile How has Chile avoided over-optimistic official forecasts? The estimation of the long-term path for GDP & the copper price is made by two panels of independent experts, especially the historic pattern of over-exuberance in booms which forecasts in most other governments show? 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. The Pay-off 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. 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. 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). References by the author Project Syndicate, “Escaping the Oil Curse,” Dec.9, 2011. 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