How Countries Can Deal with Commodity Price Volatility Jeffrey Frankel Harpel Professor of Capital Formation & Growth Start with The Natural Resource Curse Some seminal references: Growth falls with fuel & mineral exports (1) Volatility in global commodity prices arises because supply & dem in addition to are inelastic in the short run.

How Countries Can Deal with Commodity Price Volatility Jeffrey Frankel Harpel Professor of Capital Formation & Growth Start with The Natural Resource Curse Some seminal references: Growth falls with fuel & mineral exports (1) Volatility in global commodity prices arises because supply & dem in addition to are inelastic in the short run. www.phwiki.com

How Countries Can Deal with Commodity Price Volatility Jeffrey Frankel Harpel Professor of Capital Formation & Growth Start with The Natural Resource Curse Some seminal references: Growth falls with fuel & mineral exports (1) Volatility in global commodity prices arises because supply & dem in addition to are inelastic in the short run.

Donovan,, Host has reference to this Academic Journal, PHwiki organized this Journal How Countries Can Deal with Commodity Price Volatility Jeffrey Frankel Harpel Professor of Capital Formation & Growth G-20 Commodities Seminar, Los Cabos, Mexico, 5 de Mayo, 2012 Start with The Natural Resource Curse Some seminal references: Auty (1990, 2001, 2007) Sachs & Warner (1995, 2001) By now there is a large body of research, which I have surveyed (2011, 2012a, b). Many countries that are richly endowed with oil, minerals or fertile l in addition to have failed to grow more rapidly than those without. Examples: Some oil producers in Africa & the Middle East have relatively little to show as long as their resources. Meanwhile, East Asian economies achieved western-level st in addition to ards of living despite having virtually no exportable natural resources: Japan, Singapore, Hong Kong, Korea & Taiwan; followed by China.

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Growth falls with fuel & mineral exports Are natural resources necessarily bad Commodity wealth need not necessarily lead to inferior economic or political development. Rather, it is a double-edged sword, with both benefits in addition to dangers. It can be used as long as ill as easily as as long as 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. No, of course not. Some developing countries have avoided the pitfalls of commodity wealth. E.g., Chile (copper) Botswana (diamonds) Some of their innovations are worth emulating. I will offer some policies & institutional innovations to avoid the resource curse: especially ways of managing price volatility. Some lessons apply to commodity importers too. Including lessons of policies to avoid.

How could abundance of commodity wealth be a curse What is the mechanism as long as this counter-intuitive relationship At least 5 categories of explanations. Volatility Crowding-out of manufacturing Autocratic Institutions Anarchic Institutions Procyclicality including Procyclical capital flows Procyclical monetary policy Procyclical fiscal policy. 5 Possible Natural Resource Curse Channels (1) Volatility in global commodity prices arises because supply & dem in addition to are inelastic in the short run.

Commodity prices have been especially volatile over the last decade Nominal prices 2010=100 Real prices = nominal in 2000 A.Saiki, Dutch Nat.Bk. Effects of Volatility Volatility per se can be bad as long as economic growth. Risk inhibits private investment. Cyclical shifts of resources back & as long as th across sectors may incur needless transaction costs. => role as long as government intervention On the one h in addition to , the private sector dislikes risk as much as the government does & will take steps to mitigate it. On the other h in addition to the government cannot entirely ignore the issue of volatility; e.g., exchange rate policy. 2. Natural resources may crowd out manufacturing, in addition to manufacturing could be the sector that experiences learning-by-doing or dynamic productivity gains from spillover. Matsuyama (1992) model. 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. It can foster growth in both sectors. E.g. Canada, Australia, Norway Now Malaysia, Chile, Brazil

3. Autocratic or oligarchic institutions may retard economic development. Countries where physical comm in addition to of natural resources by government or a hereditary elite automatically confers wealth on the holders are likely to become rent-seeking societies; in addition to are less likely to develop the institutions conducive to economic development, e.g., rule of law, decentralization, & economic incentives; as compared to countries where moderate taxation of a thriving market economy is the only way government can finance itself. Engerman-Sokoloff explanation of why industrialization came in the North of the Western Hemisphere be as long as e the South. 4. Anarchic institutions (i) Unsustainably rapid depletion of resources (ii) Unen as long as ceable property rights (iii) Civil war (5) Procyclicality Developing countries are historically prone to procyclicality, especially commodity producers. Procyclicality in: Capital inflows; Monetary policy; Real exchange rate; Nontraded Goods Fiscal Policy The Dutch Disease describes unwanted side-effects of a commodity boom.

The Dutch Disease: 5 side-effects of a commodity boom 1) A real appreciation in the currency 2) A rise in government spending 3) A rise in nontraded goods prices 4) A resultant shift of resources out of non-export-commodity traded goods 5) Sometimes a current account deficit The procyclicality of fiscal policy Fiscal policy has historically tended to be procyclical in developing countries Especially among commodity exporters [1] – correlation of income & spending mostly positive – particularly in comparison with industrialized countries. A reason as long as procyclical public spending: receipts from taxes or royalties rise in booms. The government cannot resist the temptation to increase spending proportionately, or more. Then it is as long as ced to contract in recessions, thereby exacerbating the magnitudes of swings. [1] Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart, & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006), Ilzetski & Vegh (2008), Medas & Zakharova (2009), Gavin & Perotti (1997). Two budget items account as long as much of the spending from commodity booms: (i) Investment projects. Investment in infrastructure in practice often consists of “white elephant” projects, which are str in addition to ed without funds as long as completion or maintenance when the oil price goes back down. Gelb (1986) . (ii) The government wage bill. Oil windfalls are often spent on public sector wages Medas & Zakharova (2009) which are hard to cut when prices go back down Arezki & Ismail (2010)

Correlations between Gov.t Spending & GDP 1960-1999 procyclical } G always used to be pro-cyclical as long as most developing countries. countercyclical Adapted from Kaminsky, Reinhart & Vegh (2004) Procyclicality has been especially strong in commodity-exporting countries. 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 to run budget surpluses & build reserves, thereby earning the ability to exp in addition to fiscally in the 2008-09 crisis. Chile is the outst in addition to ing model. The procyclicality of fiscal policy, cont. 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 (2011) procyclical countercyclical

The Natural Resource Curse should not be interpreted as a rule that commodity-rich countries are doomed to fail. The question is what policies to adopt to avoid the pitfalls in addition to improve the chances of prosperity. A wide variety of measures have been tried by commodity-exporters cope with volatility. Some work better than others. Devices to share risks 1. Index contracts with as long as eign companies to the world commodity price. 2. Hedge commodity revenues in options markets 3. Denominate debt in terms of commodity price 7 recommendations as long as commodity-exporting countries 4. Allow some currency appreciation in response to a commodity boom, but not a free float. – Accumulate some as long as ex reserves. – 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, a price measure that puts weight 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 as long as commodity producers continued Countercyclical macroeconomic policy PPT

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7. Manage Commodity Funds transparently & professionally, like Botswana’s Pula Fund – not subject to politics like Norway’s Pension Fund. Summary: 7 recommendations as long as commodity producers, concluded Good governance institutions Elaboration on two proposals to reduce the procyclicality of macroeconomic policy as long as commodity exporters I) To make monetary policy less procyclical: Product Price Targeting II) To make fiscal policy less procyclical: emulate Chile. PPT I) The challenge of designing a currency regime as long as countries where terms of trade shocks dominate the cycle Fixing the exchange rate leads to procyclical monetary policy: credit exp in addition to s in commodity booms. Floating accommodates terms of trade shocks. But volatility can be excessive; also floating does not provide a nominal anchor. Inflation Targeting, in terms of the CPI, provides a nominal anchor; but can react perversely to terms of trade shocks Needed: an anchor that accommodates trade shocks

Professor Jeffrey Frankel Product Price Targeting: Target an index of domestic production prices. [1] Include export commodities in the index in addition to 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 as long as appreciation when import prices rise, not when export prices rise ! [1] Frankel (2011). PPT II) Chile’s fiscal institutions since 2000 1st rule – Governments must set a budget target, set = 0 in 2008 under Pres. Bachelet. 2nd rule – The target is structural: Deficits allowed only to the extent that (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 as long as ecasts in booms are biased toward over-optimism. Chile ran surpluses in the 2003-07 boom, while the U.S. & Europe failed to do so. 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 as long as eign participation

The Dutch Disease: The 5 effects elaborated 2) A rise in government spending in response to increased availability of tax receipts or royalties. The Dutch Disease: 5 side-effects of a commodity boom 3) An increase in nontraded goods prices (goods & services such as housing that are not internationally traded), relative to internationally traded goods esp. manufactures. 4) A resultant shift of resources out of non-export-commodity traded goods pulled by the more attractive returns in the export commodity in addition to in non-traded goods. The Dutch Disease: 5 side-effects of a commodity boom 5) A current account deficit, as international investors lend into the boom thereby incurring international debt that is hard to service when the boom ends. E.g. the 1982 end of the 1970s commodity boom. Many developing countries avoided incurring debts in the 2003-11 boom. E.g., by taking capital inflows more in the as long as m of FDI, in addition to building reserves rather than running current account deficits.

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