Managing Price Volatility: Strategies for Dealing with Commodity Price Fluctuations

1. How Countries Can Dealwith Commodity Price VolatilityJeffrey FrankelHarpel Professor of Capital Formation & Growth G-20 Commodities Seminar, Los Cabos, Mexico, 5 de Mayo, 2012

2. Start withThe 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).

3. Many countries that are richly endowed with oil,minerals or fertile land have failed to grow more rapidly than those without. • Examples: • Some oil producers in Africa & the Middle East have relatively little to show for their resources. • Meanwhile, East Asian economies achieved western-level standards of living despite having virtually no exportable natural resources: • Japan, Singapore, Hong Kong, Korea & Taiwan; • followed by China.

4. Growth falls with fuel&mineral exports

5. Are natural resources necessarily bad? No, of course not. • Commodity wealth neednot 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 haveafflictedcommodityproducers in the past, to find the path of success.

6. 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.

7. How could abundance of commodity wealth be a curse? • What is the mechanism for this counter-intuitive relationship? • At least 5 categories of explanations.

8. 5 Possible Natural Resource Curse Channels • Volatility • Crowding-out of manufacturing • Autocratic Institutions • Anarchic Institutions • Procyclicalityincluding • Procyclical capital flows • Procyclical monetary policy • Procyclical fiscal policy.

9. (1) Volatility in global commodity prices arises because supply & demand are inelastic in the short run.

10. Commodity prices have been especially volatile over the last decade A.Saiki, Dutch Nat.Bk. Nominal prices2010=100 Real prices * = nominal in 2000

11. Effects of Volatility Volatility per se can be bad for economic growth. Risk inhibits private investment. Cyclical shifts of resources back & forth across sectors may incur needless transaction costs. => role for government intervention? On the one hand, the private sector dislikes risk as much as the government does & will take steps to mitigate it. On the other hand the government cannot entirely ignore the issue of volatility; e.g., exchange rate policy. 11

12. 2. Natural resources may crowd outmanufacturing, • and 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…

13. 3.Autocraticoroligarchic institutionsmay retard economic development. • Countries where physical command of natural resources by government or a hereditary elite automatically confers wealth on the holders • are likely to become rent-seeking societies; • and 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 before the South.

14. 4. Anarchic institutions (i) Unsustainably rapid depletion of resources (ii) Unenforceable property rights (iii) Civil war

15. (5) Procyclicality Developing countries are historically proneto procyclicality, especially commodity producers. Procyclicality in: Capital inflows; Monetary policy; Real exchangerate; Nontraded Goods Fiscal Policy The Dutch Disease describes unwanted side-effects of a commodity boom. 15

16. 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

17. 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 for 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 forced 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). 17

18. Two budget items account for much of the spending from commodity booms: (i) Investment projects. Investment in infrastructure in practice often consists of “white elephant” 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) which are hard to cut when prices go back down Arezki & Ismail(2010) 18

19. 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.

20. 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 expand fiscally in the 2008-09 crisis. Chile is the outstanding model. The procyclicality of fiscal policy,cont. 20

21. Correlations between Government spending & GDP 2000-2009 procyclical Frankel, Vegh & Vuletin(2011) In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP. countercyclical

22. 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 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.

23. Devices to share risks 1.Index contracts with foreign companiesto the world commodity price. 2.Hedge commodity revenues in options markets 3.Denominate debt in terms of commodity price 7 recommendations for commodity-exporting countries

24. 4. Allow some currency appreciation in response to a commodity boom, but not a free float. - Accumulate some forex 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 (ProductPriceTargeting). 6. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent commodity price rises. Countercyclical macroeconomic policy 7 recommendations for commodity producers continued PPT

25. 7. Manage Commodity Funds transparently & professionally, like Botswana’s Pula Fund -- not subject to politics like Norway’s Pension Fund. Good governance institutions Summary: 7 recommendations for commodity producers,concluded

26. Elaboration on two proposals to reduce the procyclicality of macroeconomic policyfor commodity exporters • I) To make monetary policy less procyclical: Product Price Targeting • II) To make fiscal policy less procyclical: emulate Chile. PPT

27. I) The challenge of designinga currency regime for countries where terms of trade shocks dominate the cycle • Fixingthe exchange rate leads to procyclical monetary policy: credit expands in commodity booms. • Floatingaccommodates 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

28. ProductPriceTargeting: PPT • Targetanindexofdomesticproductionprices.[1] • 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). Professor Jeffrey Frankel

29. II) Chile’s fiscal institutionssince2000 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 independentexperts, outside the politicalprocess. 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.

30. Producer subsidies Stockpiles Marketing boards Price controls Export controls Blaming derivatives Resource nationalism Nationalization Banning foreign participation Many of the policies that have been intended to fight commodity price volatility do not work out so well

31. Unsuccessful policies to reduce commodity price volatility: 1) Producersubsidies to“stabilize” prices at highlevels, often via wasteful stockpiles & protectionist import barriers. Examples: The EU’s Common Agricultural Policy Bad for EU budgets, economic efficiency, international trade, & consumer pocketbooks. Or fossil fuel subsidies 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.

32. 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.

33. Microeconomic policies, continued Often the goal of price controls is to shield consumers of staplefoods&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.

34. 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.

35. An initiative at the G20 meeting of agriculture ministers in Paris in June 2011 deserved to succeed: Producing 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. One hopes for steps in this direction, perhaps working through the WTO.

36. An initiative that has less merit: • 4) Attempts to blame speculation for volatility • and so to ban derivatives markets. • Yes, speculativebubbles 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.

37. 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.

38. “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.

39. “Resource nationalism” continued • 7) Keeping out foreign companies altogether. • But often they have the needed technical expertise. • Examples: declining oil production in Mexico & Venezuela. • 8) Going around “lockingup” 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.

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41. References by the author ProjectSyndicate, “Escaping the Oil Curse,”  Dec. 9, 2011. “Combating Agricultural Price Volatility,” June 27, 2011. "Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility,"  Oct.17, 2011.  “The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,” 2012, Commodity Price Volatility and Inclusive Growth in Low-Income Countries , R.Arezki & Z.Min, eds.. HKS RWP12-014.  High Level Seminar, IMF Annual Meetings, DC, Sept.2011. "The Curse: Why Natural Resources Are Not Always a Good Thing,”  Milken Institute Review, vol.13, 4th quarter 2011. "Increases in Global Commodity Prices: Macroeconomics and Policy Responses of Developing Countries," slides, V JornadaMonetario, Central Bank of Bolivia, July 2011.  “The Natural Resource Curse: A Survey,” 2012, Chapter 2 in Beyond the Resource Curse, B.Shaffer & T. Ziyadov, eds. (U.Penn. Press); proofs & notes; Summary. CID WP195, 2011. “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 Procyclicality,” with C.Végh & G.Vuletin, 2012. “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” in Fiscal Policy and Macroeconomic Performance, 2012.   Central Bank of ChileWP 604,2011. "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review Vol.XI, issue 1, April 2012 (Monetary Authority of Singapore). “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.

42. Appendix I: Anarchic Institutionsi) Unsustainably rapid depletion When depletable resources are in fact depleted, the country may be left with nothing. Three concerns: Protection of environmental quality. A motivation for astrategy of economic diversification. A motivation for the Hartwick(1997)rule: Invest rents from exhaustible resources in other assets. 42

43. (ii) Unenforceable property rights Depletion would be much less of a problem if full property rights could be enforced, thereby giving the owners adequate incentive to conserve the resource in question. But often this is not possible Especially under frontier conditions. Overfishing, overgrazing, & over-logging are classic examples of the “tragedy of the commons.” Individual fisherman, farmers or loggers have no incentive to restrain themselves, while the fisheries or pastureland or forests are collectively depleted. 43

44. (iii) War Where a valuable resource such as oil or diamonds is there for the taking, factions will likely fight over it. Oil & minerals are correlated with civil war. Collier & Hoeffler (2004), Collier (2007),Fearon & Laitin (2003) and Humphreys (2005). Chronic conflict in such countries as Sudan comes to mind. Civil war is, in turn, very bad for economic development. 44

45. Appendix IIThe Dutch Disease: The 5 effects elaborated 1) Real appreciation in the currency taking the form of nominal currency appreciation if the exchange rate floats e.g., floating-rate oil exporters, Colombia, Kazakhstan & Russia. or the form of money inflows, credit & inflation if the exchange rate is fixed; e.g. fixed-rate oil-exporters, Saudi Arabia & UAE. 45

46. The Dutch Disease: The 5 effects elaborated 2) A rise in government spending in response to increased availability of tax receipts or royalties. 46

47. 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 and in non-traded goods. 47

48. 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 form of FDI, and building reserves rather than running current account deficits. 48