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Macroeconomic Policy in Countries with Natural Resource Wealth

This article discusses the importance of implementing effective macroeconomic policies in countries with natural resource wealth and how it can help manage volatility. It also examines the reasons behind the evolution of approval and disapproval of Chilean presidents and the impact of procyclical macroeconomic policies.

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Macroeconomic Policy in Countries with Natural Resource Wealth

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  1. Macroeconomic Policy in Countries with Natural Resource Wealth Jeffrey FrankelHarpel Professor of Capital Formation & Growth Leading Economic Growth ProgramFebruary 14, 2013

  2. In 2008, the government of Chilean President Bachelet& her Fin.Min. Velasco ranked very low in public opinion polls. By late 2009, they were the most popular in 20 years. Why? Evolution of approval and disapproval of four Chilean presidents PresidentsPatricio Aylwin, Eduardo Frei, Ricardo Lagos and Michelle BacheletData: CEP, Encuesta Nacional de Opinion Publica, October 2009, www.cepchile.cl. Source: Engel et al (2011).

  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 • capital flows, money, credit; • currency policy; relative price of nontraded goods; • and fiscal policy.

  4. Pro-cyclical capital flows • According to intertemporal optimization theory, capital flows should be countercyclical: • net capital inflows when exports are doing badly • and net capital outflows 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. Pro-cyclical monetary policy • If the exchange rate is fixed, • surpluses during commodity booms lead to: • Rising reserves • Excessive money & credit • Excess demand for goods; overheating • Inflation • Asset bubbles. • Example: Saudi Arabia & UAE during recent oil boom.

  6. Macro effects of commodity boom • Inflation shows up especially in nontraded goods & services like construction.

  7. Procyclical fiscal policy • Fiscal policy has historically tended to be procyclical in developing countries • especially among commodity exporters: 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). • Correlation of income & spending mostly positive – • in comparison with industrialized countries.

  8. 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.

  9. 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. Then it is forced to contract in recessions, thereby exacerbating the swings. 9

  10. Two budget items account for much of the spending from oil booms: (i) Investment projects. Investment in practice may be “whiteelephant” projects, which are stranded without funds for 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) Arezki & Ismail(2010): government spending rises in booms, but is downward-sticky. Rumbi Sithole took this photo in “Bayelsa Statein 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..” 10

  11. 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 expand fiscally in the 2008-09 crisis. Chile, Botswana, Malaysia, Indonesia, Korea… How were they able to achieve counter-cyclicality? The procyclicality of fiscal policy,cont. 11

  12. Correlations between Government spending & GDP 2000-2009 procyclical Frankel, Vegh & Vuletin(2012) In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP. countercyclical

  13. 1. How can a country avoid excessive credit creation & inflation in a commodity boom ? Eventually allow some currency appreciation. But not a free float. Accumulate some fx reserves first. Raise banks’ reserve requirements. 2. Nominal anchor for monetary policy: 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? 4. How should commodity funds be managed? Four questions for macro management

  14. 1) The challenge of designinga monetary regime for countries where terms of trade shocks dominate the cycle • Fixingthe exchange rate (as noted)leads to pro-cyclical monetary policy: • Money flows in during commodity booms. • Excessive credit creation can lead to inflation. • Example: Saudi Arabia & other Gulf countries • 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, 1997-98.

  15. Currency regime, continued • Floatingaccommodates 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 a nominal anchor.

  16. Pro-cyclical real exchange rateCountries 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 sectormight be appropriate & inevitable, to the extent it is expandable, especially if the commodity price rise is permanent. But the shift out of manufacturing into NTGs is often an undesirable macroeconomic side effect – the “disease” part of Dutch Disease.

  17. Monetary regimeIf the exchange rate is not to bethe monetary anchor, what is? The popular choice of the last decade:Inflation Targeting. But CPI target can react perversely to supply shocks & terms of trade shocks.

  18. Needed:Nominal anchors that accommodate the shocks that are common in developing countries • Supply shocks: • Nominal GDP targeting • Terms of trade shocks: • Product Price Targeting PPT

  19. Nominal Income target moderates effects of supply shocks Adverse AS shock P AS NItarget • • • IT AD Real GDP

  20. PPT ProductPriceTargeting accommodates terms of trade shocks • Targetanindex ofdomesticproductionprices[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).

  21. Why is PPT better than a fixed exchange ratefor 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 the export commodity goes down, the currency automatically depreciates, moderating the downturn & improving the balance of payments. PPT

  22. Why is PPT better than CPI-targetingfor 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

  23. 3. How can countries avoid pro-cyclical fiscal policy? • “Good institutions.” • What are they, exactly?

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

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

  26. 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.

  27. 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?

  28. 1st rule – Governments must set a budget target, 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 independentexperts, outside the politicalprocess. Result: Chile avoided the pattern of 32 other governments, where forecasts in booms were biased toward optimism. The example of Chile

  29. Chilean fiscal institutions In 2000 Chile instituted its structural budget rule. The institution was formalized in 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.

  30. 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. The Pay-off

  31. In 2008, with copper prices spiking up, the government of President Bachelet had beenunder 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

  32. 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. 4.Manage commodityfunds professionally.

  33. References by the author “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.; HKS RWP12-014.  “How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?”Natural Resources, Finance & Development, R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011.  HKS RWP 11-015. “On Graduation from Fiscal Procyclicality,” 2013, with C.Végh & G.Vuletin; J. Dev. Economics. “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,”   Central Bank of ChileWP 604,2011. "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review XI, 1, 2012 (Monetary Authority of Singapore). “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America," Economia, 2011 (Brookings), NBER WP 16362. http://www.hks.harvard.edu/fs/jfrankel/

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