Coping with Volatility: Monetary & Exchange Rate Policies for Commodity-Exporting Countries like Kazakhstan

1. Coping with Volatility:Monetary & Exchange Rate Policies for Commodity-Exporting Countries like Kazakhstan Jeffrey FrankelHarpel Professor of Capital Formation & Growth July 15, 2013

2. Oil prices & minerals prices have been especially volatile over the last decade – and correlated. Source: UNCTAD

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 • (i) capital flows, money, credit; • (ii) currency policy; relative price of nontraded goods; • and (iii) fiscal policy.

4. (i) Pro-cyclical capital flows • According to inter-temporal optimization theory, capital flows should be counter-cyclical: • flowing in when exports do badly • and flowing out when exports do well. • In practice, it does not always work this way. Capital flows are more pro-cyclical than counter-cyclical. • Gavin, Hausmann, Perotti &Talvi(1996); Kaminsky, Reinhart&Vegh(2005); Reinhart&Reinhart (2009);and Mendoza&Terrones(2008).

5. (ii) Pro-cyclical monetary policy • If the exchange rate is fixed, • surpluses during commodity booms can lead to: • Rising reserves • Excessive money & credit • Excess demand for goods; overheating • Inflation • Asset bubbles, incl. land.

6. Macro effects of commodity boom • Inflation shows up especially in non-traded goods & services, like construction.

7. Pro-cyclical real exchange rateCountries undergoing a commodity boomexperience 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 boom is permanent. But the shift out of manufacturing into NTGs is often an undesirable macroeconomic side effect – the “disease” part of Dutch Disease.

8. 1. How can a country avoid pro-cyclical money: excessive credit creation & inflation in a commodity boom, deflation & balance of payments crisis in a bust ? Allow some currency flexibility though not a free float. 2. Nominal anchor for monetary policy: What is it to be, if not the exchange rate? CPI? Two questions for the monetary regime

9. 1) Pros & cons of exchange rate flexibilityfor oil-exporters, in particular • Advantages of more stable exchange rate: • Lower forex risk & transactions costs facilitate international trade & capital flows -- • especially important if country is small & open to trade. • Exchange rate provides a nominal anchor for monetary policy, reducing inflation expectations -- • especially important if country has history of high inflation • e.g., Kazakhstan (1991-95) • or even hyperinflation (1992-93).

10. Pros & cons of exchange rate flexibility, continued • Advantages of more flexible exchange rate • Autonomy of monetary policy -- • especially important if country has idiosyncratic shocks & low labor mobility. • Automatic accommodation of trade shocks -- • especially important for commodity-exporting countries.

11. Other factors to be considered in conjunction with fixed versus floating exchange rate choice • Intermediate exchange rate regimes • Band-basket-crawl • Managed float • Intervention and sterilization • Capital controls • Denomination of foreign debt • Currency mismatch from foreign denomination (original sin) • The move away from foreign-denominated debt. • Bank accounts denominated in foreign currency.

12. The challenge of designing a monetary regime when terms of trade shocks dominate the cycle • Fixingthe exchange rateleads to pro-cyclical monetary policy: • Money flows in during commodity booms. • Excessive credit creation can lead to inflation. • Example: Saudi Arabia & UAEduring the 2003-08 oil boom. • Money flows out during commodity busts. • Credit squeeze can lead to excess supply, recession & balance of payments crisis. • Example: Oil exporters in 1980s (Mexico) or 1997-98 (Russia).

13. Currency regime, continued • Floatingaccommodates terms of trade shocks: • If terms of trade improve, currency automatically appreciates, • reducing excessive money inflows, credit, overheating, inflation, and real estate bubbles. • If terms of trade worsen, currency automatically depreciates, • preventing recession & balance of payments crisis.

14. Demand vs. supply shocks An old wisdom regarding the source of shocks: Fixed rates work best if shocks are mostly internal demand shocks (especially monetary); floating rates work best if shocks tend to be real shocks (especially external terms of trade). One set of supply shocks: natural disasters R.Ramcharan(2007) finds floating works better. A common source of real shocks: trade.

15. Terms-of-trade variability Prices of crude oil & mineral commodities hit record highs in 2008 & 2011. => Favorable terms of trade shocks for some (oil producers, Africa, Latin America, etc.); => Unfavorable terms of trade shock for others (oil importers such as Japan, Korea). Textbook theory says a country where trade shocks dominate should accommodate by floating. Confirmed empirically: Developing countries facing terms of trade shocks do better with flexible exchange rates than fixed exchange rates. Broda(2004),Edwards & L.Yeyati(2005), Rafiq(2011), andCéspedes& Velasco (2012)…

16. Céspedes &Velasco(Nov.2012) NBER WP 18569 “Macroeconomic Performance During Commodity Price Booms & Busts” Constant term not reported. (t-statistics in parentheses.) ** Statistically significant at 5% level. Across 107 major commodity boom-bust cycles, output loss is bigger the bigger is the commodity pricechange & thesmallerisexchangerate flexibility.

17. The IMF recommends a more flexible exchange rate for the tenge. • “Looking ahead, there is scope to allow greater exchange rate flexibility…” • -- Article IV Consultation Concluding Statement of the IMF Mission to Republic of Kazakhstan—2013, June 4, para. 7. • But, if the exchange rate were no longer the nominal anchor for Kazakh monetary policy, the IMF would then ask what is to take its place.

18. Monetary regime2) If the exchange rate is not to bethe monetary anchor, what is? The popular choice of the last decade:Inflation Targeting. But CPI targeting can react perversely to supply shocks & terms of trade shocks.

19. Needed:Nominal anchors that accommodate the shocks that are common in developing countries • Supply shocks, • e.g., droughts, floods, hurricanes: • => Target Nominal GDP. • Terms of trade shocks • e.g., fall in price of commodity export. • => Target GDP deflator.

20. Nominal GDP targetcancels out velocity shocks (vs. M target) & moderates effects of supply shocks(vs. IT) Adverse AS shock P Nom.GDPtarget AS • IT • • AD Real GDP

21. Does NominalGDPtarget give best output/inflation trade-off? It gives exactly the right answer if the simple Taylor Rule’s equal weights accurately capture what discretion would do. Even if not exact, the “true” objective function would have to put far more weight on P than output, or AS would have to be very steep, for the P rule to give a better outcome. Adverse AS shock • P Nom.GDPtarget IT • AD Real GDP

22. The revival of proposals for Nominal GDP Targeting in 2011-13 • heard mostly in the context of advanced economies • UK, US, Japan… • E.g. the new Bank of England Governor, Mark Carney, is a fan. • But Nominal GDP Targeting in fact makes more sense for developing & commodity-exporting countries. • To clarify: set a target range at a 1-2-year horizon; • not inconsistent with “Flexible Inflation Targeting,” • setting a longer-term target for inflation.

23. Why does Nominal GDP Targeting make more sense for developing & commodity-exporting countries than for advanced countries? • More supply shocks, • such as adverse weather events. • More terms of trade shocks, • such as rises in the price of imports, & • declines in the commodity export price.

24. Comparison of 3 alternative monetary regimes

25. Steps in an evaluationof Nominal GDP Targeting (vs. IT) • How wide would announced band have to be so that the outcome usually fell within it? • What about subsequent revisions in Nominal GDP statistics? • Are supply shocks big enough, and is the AS curve steep enough, for Nominal GDP targeting to be better than price targeting?

26. What Kazakh data are needed for the analysis? • I have historical data, for Kazakhstan 1991-2012, • Nominal GDP, real GDP, deflator, & CPI, • and some year-ahead forecasts of each: • estimated from the time series by an ARIMA process, or • Private forecasts from Consensus Economics (for real GDP & CPI). • Ideally I would get real-time revisions for each -- • preliminary estimates, revised, & final; • And data on exogenous supply shocks, if possible: • adverse weather events?

28. How wide would 1-standard-deviation band have to be, encompassing 2/3 of nominal GDP realizations around target? Covar(RGDP,Deflator) = 0.114 %

29. How wide would 1-standard-deviation band have to be? The confidence interval would be narrower if the central bank can influence demand (within one-year horizon).

30. References by the author Project Syndicate, “Escaping the Oil Curse,” Dec.9, 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 et al., eds. (IMF); HKS RWP12-014.  “How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” 2011, inNatural Resources, Finance & Development.R.Arezki, T.Gylfason & A.Sy, eds. (IMF).  "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review XI, 1, 2012 (Monetary Authority of Singapore). “A Comparisonof ProductPriceTargeting and OtherMonetaryAnchorOptions, for Commodity-Exporters in LatinAmerica," Economia, 2011. NBER WP 16362. "UAE & Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil,“Vox, 9 July, 2008. “On the Tenge: Monetary and Exchange Rate Policy for Kazakhstan,” Short-term Consultancy, Republic of Kazakhstan, 2005. (Russian translation, ADB, 2009.) In Growth & Competitiveness in Kazakhstan(Center for International Development): 23-42. "Experience of and Lessons from Exchange Rate Regimes in Emerging Economies,"in Monetary and Financial Integration in East Asia: The Way Ahead, edited by Asian Development Bank, 2004 (Palgrave Macmillan), v91-138. http://www.hks.harvard.edu/fs/jfrankel/

31. Appendix: Nominal GDP statisticsKazakhstan Nominal GDP, quarterly

33. How wide would 1-standard-deviation bandfor real GDP growth have to be?

34. How wide would 1-standard-deviation bandfor real GDP growth have to be?

35. How wide would 1-standard-deviation bandfor CPI inflation have to be?

36. How wide would 1-standard-deviation bandfor nominal GDP have to be?

37. How wide would 1-standard-deviation bandfor nominal GDP have to be?

38. How wide would 1-standard-deviation bandfor real GDP growth have to be?

39. How wide would 1-standard-deviation bandfor GDP deflator have to be?