Avoiding Resource Curse Pitfalls: Key Policies and Recommendations

1. The Natural Resource Curse II:Recommendations to Avoid the Pitfalls Jeffrey FrankelHarpel Professor, Harvard University IMF, April 26, 2011

2. Institutions & Policies to Address the Natural Resource Curse • A wide variety of measures have been tried to cope with the commodity cycle. [1] • Some work better than others. [1] E.g., Davis, et al (2003) and Sachs (2007).

3. Policies/Institutions to Deal with the NRC I. Coping with volatility: Devices to share risk II. Monetary / Exchange rate policy III. How to insure saving in boom times IV. Imposing external checks for countries with weak internal institutions.

4. I. Dealing with volatility:Accept its existence and adopt institutions to cope with it 3 Devices to share risk efficiently • For energy producers who sign contracts with foreign companies. • For producers who sell their minerals themselves. • For debtors dependent on mineral revenues.

5. 1. Price setting in contracts with foreign companies • Price setting in contracts between producing countries and foreign mining companies is often plagued by a problem that is known to theorists as “time inconsistency”:(i) A price is set by contract. • (ii) Later the world price goes up, and the government wants to renege. It doesn't want to give the company all the profits, and why should it? • But this is a “repeated game.” • The risk that the locals will renege makes foreign companies reluctant to do business in the first place. • It limits the amount of capital available to the country, and probably raises the cost of that capital. • The process of renegotiation can have large transactions costs, including interruptions in the export flow.

6. Solution for price setting in contracts • Indexed contracts: • the two parties agree ahead of time, “if the world price goes up 10%, then the gains are split between the company and the government” in some particular proportion. • Indexation shares the risks of gains and losses, • without the costs of renegotiation or • damage to a country’s reputation from reneging.

7. 2. Hedging in commodity futures markets • Producers who sell their minerals on international spot markets, • are exposed to the risk that the $ price rises or falls. • The producer can hedge the risk by selling that quantity on the forward or futures market. • Hedging => no need for costly renegotiation if world price changes. • as with indexation of the contract price. • The adjustment happens automatically. • Mexico has hedged its oil revenues in this way. • One possible drawback, if a government ministry hedges: the Minister receives no credit for having saved the country from disaster when the world price falls, but is excoriated for having sold out the national patrimony when the price rises. • Mexico thus uses options to eliminate only the risk of a fall in price.

8. 3. Denomination of debt in terms of the mineral price • An copper-producer should index its debt to the copper price. • So debt service obligations automatically rise & fall with the world price. • Debt crises hit Mexico in 1982 andIndonesia, Russia & Ecuador in 1998, • when the $ prices of their oil exports fell, • and so their debt service ratios worsened abruptly. • This would not have happened if their debts had been indexed to the oil price. • As with contract indexation & hedging, adjustment in the event of fluctuations in the oil price is automatic.

9. II. Monetary/ Exchange Rate policy • Fixed vs. floating exchange rates • Nominal anchors as alternatives to the exchange rate • 2 candidates for nominal anchor that are no longer popular • Inflation targeting • Orthodox implementation: the CPI • Unorthodox versions for commodity producers IT PPT

10. Fixed vs. floating exchange rates • Each has its advantages. • The main advantages of a fixed exchange rate: • it reduces the costs of international trade, • it is a nominal anchor for monetary policy, • helping the central bank achieve low-inflation credibility. • A few commodity producers have firmly fixed: • Gulf oil producers & Ecuador. • The main advantage of floating, for a mineral producer: • automatic accommodation to terms of trade shocks. • During a mineral boom, the currency tends to appreciate, • thus moderating what would otherwise be danger of overheating; • and the reverse during a mineral bust. • A few commodity producers Have been floating fairly freely: • Chile & Mexico

11. Recommendation • A balancing of these pros & cons => an intermediate exchange rate regime such as managed floating. • In the decade 2001-11, many followed the intermediate regime: • While they officially declared themselves as floating (often under IT), in practice these intermediate countries intervened heavily, taking perhaps ½ the increase in demand for their currency in the form of appreciation but 1/2 in the form of increased foreign exchange reserves. • Examples among oil-producers include Kazakhstan & Russia.

12. A loose recommendation, continued • Particularly at the early stages of a boom, there is a good case for intervention in the foreign exchange market, adding to reserves • especially if the alternative is abandoning an established successful exchange rate target. • Perhaps with sterilization, to resist excessive money growth. • In subsequent years, if the increase in world commodity prices looks to be long-lived, there is a stronger case for accommodating it through appreciation of the currency.

13. Nominal anchors for monetary policy • If the exchange rate is not to be nominal anchor, • something else must be… • especially where institutions lack credibility • 2 alternatives for nominal anchor have had ardent supporters in the past, but are no longer in the running: • the price of gold, as 19th century gold standard; • the money supply, the choice of monetarists; and • Inflation targeting • Orthodox implementation: the CPI • Unorthodox versions for commodity producers IT PPT

14. Inflation targeting has, for 10 years, been the conventional wisdom for how to conduct monetary policy. among economists, central bankers, IMF… A narrow definition of Inflation Targeting? 1/ IT is defined as setting yearly CPI targets, to the exclusion of: - asset prices - exchange rates - export prices, Some reexamination may be warranted.1/ A broad definition: Flexible inflation targeting ≡ “Have a long run target for inflation, and be transparent.” Then who could disagree? IT Professor Jeffrey Frankel

15. The shocks of 2007-2010 showed some disadvantages to Inflation Targeting. One disadvantage of IT: no response to asset price bubbles. Another disadvantage: It gives the wrong answer in case of trade shocks: In response to a rise in prices of export commodities, it does not allow monetary tightening and appreciation. In response to a fall in world prices of exports,it does not allow a depreciation to help equilibrate. IT Professor Jeffrey Frankel

16. Proposal for Product Price Targeting PPT • Intended for countries with volatile terms of trade, e.g., those specialized in minerals. • The authorities peg the currency to a basket that gives heavy weight to prices of its mineral exports, rather than to the $ or € or CPI. • The regime combines the best of both worlds: • The advantage of automatic accommodation to terms of trade shocks, together with • the advantages of a nominal anchor. Professor Jeffrey Frankel

17. III. Make National Saving Procyclical • Hartwick rule: rents from mineral wealth should be saved, against the day when deposits run out. • At the same time, traditional macroeconomics says that government budgets should be countercyclical: running surpluses in booms, & spending in recessions. • Mineral producers tend to fail both these principles: they save too little on average and more so in booms. • They need institutions to insure that export earnings are put aside during the boom time, • into a commodity saving fund, • with rules governing the cyclically adjusted budget surplus. • Davis et al (2001a,b, 2003).

18. Chile’s fiscal institutions Chile’s fiscal policy is governed by a set of rules.  • 1st rule: Each government must set a budget target.   • This may sound like the budget deficit ceilings under Europe’s Stability & Growth Pact, • but such attempts have failed, because they are too rigid to allow the need for deficits in recessions, counterbalanced by surpluses in good times.  • The alternative of letting politicians explain away deficits by declaring them the result of unexpected slow growth also does not work, because it imposes no discipline.  • 2nd rule: The government can run a deficit to the extent that: • (1) output falls short of potential, in a recession, or • (2) the price of copper is below its equilibrium.

19. Chile’s fiscal institutions, continued • 3rd rule: two panels of experts have the job, each year, to judge: what is the output gap and the 10-year equilibrium copper price • Thus in the copper boom of 2003-08 when, as usual, the political pressure was to declare the rise in the copper price permanent, thereby justifying spending on a par with export earnings, the panel ruled that most of the price increase was temporary • so most of the earnings had to be saved.  • This turned out right, as the 2008 spike reversed in 2009.    • The fiscal surplus reached almost 9 % when copper prices were high.  • The country saved 12 % of GDP in the SWF.    • This allowed big fiscal easing in the recession of 2009, when the stimulus was most sorely needed.

20. Other fiscal institutions • Commodity funds or Sovereign Wealth Funds • Reducing net inflows during booms • Lump sum distribution • Invest in education, health, and roads.

21. IV. Efforts to Impose External Checks • The Chad experiment • The Extractive Industries Transparency Initiative: “Publish What You Pay” • More drastic solutions

22. External checks: The Chad experiment • In 2000 the World Bank agreed to help Chad, a new oil producer, to finance a new pipeline. • Its government is ranked by Transparency International as one of the two most corrupt in the world. • The agreement stipulated that Chad would • spend 72 % of its oil export earnings on poverty reduction (health, education & road-building) • & put aside 10 % in a “future generations fund.”

23. External checks: The Chad experiment,continued • ExxonMobil was to deposit the oil revenues in an escrow account at Citibank; • the government was to spend them subject to oversight by an independent committee. • But once the money started rolling in, the government reneged on the agreement.

24. External checks, continued • Extractive Industries Transparency Initiative, launched in 2002, includes the principle “Publish What You Pay,” • International oil companies commit to make known how much they pay governments for oil, • so that the public at least has a way of knowing,when large sums disappear. • Legal mechanisms adopted by São Tomé & Principe void contracts if information relating to oil revenues is not made public.

25. External checks, continued • Further proposals would give extra powers to a global clearing house or foreign bank where the Natural Resource Fund is located, e.g. freezing accounts in the event of a coup. [1] • Well-intentioned politicians may spend commodity wealth quickly out of fear that their successors will misspend whatever is left. • If so, adopt an external mechanism that constrains spending both in the present in the future. [1] Humphreys & Sandhu(2007,p. 224-27). When Kuwait was occupied by Iraq, access to Kuwaiti bank accounts in London stayed with the Kuwaitis.

26. Summary: 10 recommendations for oil producing countries Devices to share risks 1. In contracts with foreign companies, partially index the price to the world mineral price. 2. Hedge mineral revenues in options markets 3. Denominate debt in terms of mineral prices

27. Macroeconomic policy Summary: 10 recommendations for oil producers, continued 4. Allow some currency appreciation in response to a rise in world commodity prices, but after adding to foreign exchange reserves. 5. If the monetary regime is to be Inflation Targeting, consider using as the target, in place of the CPI, a price measure that puts more weight on the export commodity (e.g., PPT). 6. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent oil price increases, as judged by independent expert panels.

28. Summary: 10 recommendations for oil producing countries, continued Anti-corruption institutions 7. Run Commodity Funds transparently and professionally. 8. Invest in education, health, and roads. 9. Publish What You Pay. Consider lump-sum distribution of mineral wealth, equal per capita. 10. Mandate an external agent, for example a financial institution that houses the Commodity Fund, to provide transparency and to freeze accounts in the event of a coup.

30. Addendum: • Attempts to reduce price volatility • Elaboration on exchange rate regimes for oil exporters • including the PEP & PPT proposals

31. Appendix I: Dealing with Volatility A number of institutions have been implemented in the name of reducing volatility. Most have failed to do so, and many have had detrimental effects. Marketing boards Taxation of commodity production Producer subsidies Other government stockpiles Price controls for consumers OPEC and other international cartels

32. Implications of External Shocks for Choice of Exchange Rate Regime 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). • Oil producers face big trade shocks => accommodate by floating. • Edwards & L.Yeyati(2003) Professor Jeffrey Frankel

33. 6 proposed nominal targets and the Achilles heel of each: IT Professor Jeffrey Frankel

34. A more moderate version: Product Price Targeting PPT Target an index of domestic production prices. [1] The important point is to include oil in the index and exclude import commodities, whereas the CPI does it the other way around. [1] Frankel (2009). Professor Jeffrey Frankel