The Natural Resource Curse and How to Avoid It

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The Natural Resource Curse and How to Avoid It
Part I Channels of the commodity curse Part
II Policies institutions to avoid the pitfalls

Jeffrey Frankel

• MPA/ID extra lecture, Dec. 18, 2013

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The Natural Resource CursePart I Channels

• 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).

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• Many countries that are richly endowed with oil,
  minerals, or fertile land have failed to grow
  more rapidly than those without.
• Example
• Some studies find a negative effect of oil in
  particular, on economic performance
• including Kaldor, Karl Said (2007) Ross
  (2001) Sala-i-Martin Subramanian (2003) and
  Smith (2004).
• Some oil producers in Africa the Middle East
  have relatively little to show for their
  resources.

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• Meanwhile, East Asian economies achieved
  western-level standards of living despite having
  virtually no exportable natural resources
• Japan, Singapore, Hong Kong, Korea Taiwan,
• rocky islands or peninsulas
• followed by China.

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Growth falls with fuel mineral exports
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Are natural resources necessarily bad?
No, of course not.

• Commodity wealth need not 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 have afflicted
  commodity producers in the past, to find the
  path of success.

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• Some developing countries have avoided the
  pitfalls of commodity wealth.
• E.g., Chile (copper)
• Botswana (diamonds)
• Some of their innovations are worth emulating.
• The 2nd half of the lecture will offer some
  policies institutional innovations to avoid the
  curse
• especially ways of managing price volatility.
• Some lessons apply to commodity importers too.
• Including lessons of policies to avoid.

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• But, 1st How could abundance of commodity
  wealth be a curse?
• What is the mechanism
• for this counter-intuitive relationship?
• At least 5 categories of explanations.

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5 Possible Natural Resource Curse Channels

1. Volatility
2. Crowding-out of manufacturing
3. Autocratic Institutions
4. Anarchic Institutions
5. Procyclicality including
6. Procyclical capital flows
7. Procyclical monetary policy
8. Procyclical fiscal policy.

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

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Commodity prices have been especially volatile
over the last decade
Source UNCTAD
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Effects of Volatility

• Volatility per se can be bad for economic growth.
• Hausmann Rigobon (2003), Blattman, Hwang,
  Williamson (2007), and Poelhekke van der Ploeg
  (2007).
• Risk inhibits private investment.
• Cyclical shifts of labor, land capital back
  forth across sectors may incur needless costs.
• gt role for government intervention?
• On the one hand, the private sector dislikes risk
  as much as government does takes steps to
  mitigate it.
• On the other hand the government cannot entirely
  ignore the issue of volatility
• e.g., exchange rate policy.

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2. Natural resources may crowd out manufacturing,

• and manufacturing could be the sector that
  experiences learning-by-doing
• or dynamic productivity gains from spillover.
• Matsuyama (1992), van Wijnbergen (1984) and Sachs
  Warner (1995).
• 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 .
• E.g. Canada, Australia, Norway Now Malaysia,
  Chile, Brazil

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Econometric findings that oiland other
point-source resources lead to poor
institutions

• Isham, Woolcock, Pritchett, Busby (2005)
• Sala-I-Martin Subramanian (2003)
• Bulte, Damania Deacon (2005)
• Mehlum, Moene Torvik (2006)
• Arezki Brückner (2009).

The theory is thought to fit Mideastern oil
exporters well.
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What are poor institutions?

• A typical list
• inequality,
• corruption,
• rent-seeking,
• intermittent dictatorship,
• ineffective judiciary branch, and
• lack of constraints to prevent elites
  politicians from plundering the country.

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An example, from economic historians Engerman
Sokoloff (1997, 2000, 2002)

• Why did industrialization take place in North
  America,
• not the South?
• Lands endowed with extractive industries
  plantation crops developed slavery, inequality,
  dictatorship, and state control,
• whereas those climates suited to fishing small
  farms developed institutions of individualism,
  democracy, egalitarianism, and capitalism.
• When the Industrial Revolution came, the latter
  areas were well-suited to make the most of it.
• Those that had specialized in extractive
  industries were not,
• because society had come to depend on class
  structure authoritarianism, rather than on
  individual incentive and decentralized
  decision-making.

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4. Anarchic institutions

1. Unsustainably rapid depletion of resources
2. Unenforceable property rights
3. Civil war

See Appendix 2 for elaboration on each.
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(5) Procyclicality

• The Dutch Disease describes unwanted
  side-effects of a commodity boom.
• Developing countries are historically prone to
  procyclicality,
• especially commodity producers.
• Procyclicality in
• Capital inflows Monetary policy
• Real exchange rate Nontraded Goods
• Fiscal Policy

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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 production out of
  manufactured goods
• 5) Sometimes a current account deficit

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The Dutch Disease The 5 effects elaborated

• 1) Real appreciation in the currency
• taking the form of nominal currency appreciation
  if the exchange rate floats
• or the form of money inflows, credit inflation
  if the exchange rate is fixed
• 2) A rise in government spending
• in response to availability of tax receipts or
  royalties.

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The Dutch Disease 5 side-effects of a commodity
boom

• 3) An increase in nontraded goods prices
  relative to internationally traded goods
  
• 4) A resultant shift out of non-commodity traded
  goods,
• esp. manufactures,
• pulled by the more attractive returns in the
  export commodity and in non-traded goods.

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The Dutch Disease 5 side-effects of a commodity
boom

• 5) A current account deficit,
• as booming countries attract capital flows,
• thereby incurring international debt that is
  hard to service when the boom ends.
• Manzano Rigobon (2008) the negative
  Sachs-Warner effect of resources on growth rates
  during 1970-1990 was mediated through
  international debt incurred when commodity prices
  were high.
• Arezki Brückner (2010a, b) commodity price
  booms lead to higher government spending,
  external debt default risk in autocracies,
• but do not have those effects in democracies.

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Procyclical 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).
• Invalidates much of existing theory,
• though certainly not all.
• Theories to explain this involve capital market
  imperfections,
• e.g., asymmetric information or the need for
  collateral.

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Procyclical monetary policy

• If the exchange rate is fixed,
• surpluses during commodity booms lead to rising
  reserves and money supply.
• possibly delayed by sterilization attempts.
• Example Gulf States during recent oil booms.
• Floating can help, accommodating trade shock.
• But,
• under pure floating appreciation can be
  excessive.
• under IT CPI rule says to tighten money
  appreciate when import commodity price goes up
  (or other adverse supply shock).
• Thats backwards. (E.g., oil importers in
  2008.)
• Should appreciate when export commodity price
  goes up.

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Procyclical real exchange rateCountries
undergoing a commodity boom experience real
appreciation of their currency

• taking the form of nominal currency appreciation
• for floating-rate commodity exporters, Colombia,
  Kazakhstan, Russia, S.Africa, Chile, Brazil.
• or the form of money inflows inflation
• for fixed-rate commodity exporters, Saudi Arabia
  UAE.

OK. But real appreciation adds to boom in NTGs.
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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
  
• particularly in comparison with industrialized
  countries.

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• 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.

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Two budget items account for much of the
spending from oil booms

• (i) Investment projects.
• Investment in practice may be 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)
• 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 its unsalvageable..
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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.
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The procyclicality of fiscal policy, cont.

• 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.
• Also Botswana, China, Indonesia, Korea

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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
policyNegative correlation of G GDP.
countercyclical
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Summary of Part I

• Five broad categories of hypothesized channels
  whereby natural resources can lead to poor
  economic performance
• commodity price volatility,
• crowding out of manufacturing,
• autocratic institutions,
• anarchic institutions, and
• procyclical macroeconomic policy, including
• capital flows,
• monetary policy and
• fiscal policy.
• But the important question is how to avoid the
  pitfalls,
• to achieve resource blessing instead of resource
  curse.

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Appendix 1 I exclude a 6th channel, The
Prebisch-Singer (1950) Hypothesis

• that commodities supposedly suffer a long-run
  downward relative price trend.
• Theoretical reasoning world demand for primary
  products is inelastic with respect to income.
• Vs. persuasive theoretical arguments that we
  should expect commodity prices to show upward
  trends in the long run
• Malthus (esp. for food)
• Hotelling (for depletable resources).

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• The up trend idea goes back to Malthus (1798) and
  early fears of environmental scarcity
• Demand grows with population (geometrically),
• Supply does not.
• What could be clearer in economics
• than the prediction that price will rise?

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Hotelling (1931)

• Firms choose how fast to extract oil or minerals
• King Abdullah of Saudi Arabia, with interest
  rates 0 in 2008,apparently believed that the
  rate of return on oil reserves was higher if he
  didn't pump than if he did   
• "Let them remain in the ground for our children
  and grandchildren..."
• Arbitrage gt
• expected rate of price increase interest rate.

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The empirical evidence

• With strong theoretical arguments on both sides,
  either for an upward trend or for a downward
  trend, it is an empirical question.
• Terms of trade for commodity producers had
• a slight up trend from 1870 to World War I,
• a down trend in the inter-war period,
• up in the 1970s,
• down in the 1980s and 1990s,
• and up in the first decade of the 21st century.
  

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What is the overall statistical trend in
commodity prices in the long run?

• Some authors find a slight upward trend,
• some a slight downward trend. 1
• The answer depends on the date of the end of the
  sample.
• 1 Cuddington (1992), Cuddington, Ludema
  Jayasuriya (2007), Cuddington Urzua (1989),
  Grilli Yang (1988), Pindyck (1999), Reinhart
  Wickham (1994), Hadass Williamson (2003),
  Kellard Wohar (2005), Balagtas Holt (2009),
  Cuddington Jerrett (2008), and Harvey, Kellard,
  Madsen Wohar (2010).

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4.1 Unsustainably rapid
depletion
Appendix 2 Elaboration on Anarchyinsufficient
protection of property rights

• When exhaustible resources are in fact
  exhausted, the country may be left with
  nothing.
• Three concerns
• Protection of environmental quality.
• A motivation for a strategy of economic
  diversification.
• The need to save for the day of depletion
• Invest rents from exhaustible resources in other
  assets.
• Hartwick (1977) and Solow (1986).

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The example of Nauruphosphate mining
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4.2 Unenforceable property rights

• Depletion would be much less of a problem if
  full property rights could be enforced,
• thereby giving the owners 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, ranchers, loggers, or
  miners, have no incentive to restrain
  themselves, while the fisheries, pastureland or
  forests are collectively depleted.

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42
Madre de Dios region of the Amazon rainforest in
Peru, the left-hand side stripped by illegal
gold mining.
http//indiancountrytodaymedianetwork.com/2011/02/
27/amazon-gold-rush-laying-waste-to-peruvian-rainf
orestE28099s-madre-de-dios-20021
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4.3 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.
• Fearon Laitin (2003), Collier Hoeffler
  (2004), Humphreys (2005) and Collier (2007).
• Chronic conflict in places such as Sudan comes
  to mind.
• Civil war is, in turn, very bad for economic
  development.

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Appendix 3The NRC SkepticsWhich comes first,
oil or institutions?

• Some question the assumption that oil discoveries
  are exogenous and institutions endogenous.
• Oil wealth is not necessarily the cause and
  institutions the effect, rather than the other
  way around.
• Norman (2009) the discovery development of
  oil is not purely exogenous, but rather is
  endogenous with respect to the efficiency of the
  economy.

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in which case it is put to use for the national
welfare, instead of the welfare of an elite.
The important determinant is whether the country
already has good institutions at the time that
oil is discovered,

• Mehlum, Moene Torvik (2006),
• Robinson, Torvik Verdier (2006),
• McSherry (2006),
• Smith (2007) and
• Collier Goderis (2007).

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Skeptics argue that commodity exports are
endogenous.

• On the one hand, basic trade theory saysA
  country may show a high mineral share in exports,
  not necessarily because it has a higher
  endowment of minerals than others (absolute
  advantage) but because it does not have the
  ability to export manufactures (comparative
  advantage).
• This could explain negative statistical
  correlations between mineral exports and economic
  development,
• invalidating the common inference that minerals
  are bad for growth.
• Maloney (2002) and Wright Czelusta (2003, 04,
  06).

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Commodity exports are endogenous, continued.

• On the other hand, skeptics also have plenty of
  examples where successful institutions and
  industrialization went hand in hand with rapid
  development of mineral resources.
• Countries that were able to develop efficiently
  their resource endowments as part of strong
  economy-wide growth include
• the USA during its pre-war industrialization
  period
• David Wright (1997).
• Venezuela from the 1920s to the 1970s, Australia
  since the 1960s, Norway since 1969 oil
  discoveries, Chile since adoption of a new
  mining code in 1983, Peru since a privatization
  program in 1992, and Brazil since lifting
  restrictions on foreign mining participation in
  1995.
• Wright Czelusta (2003, pp. 4-7, 12-13, 18-22).

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Commodity exports are endogenous, continued.

• Examples of countries that were equally
  well-endowed geologically but that failed to
  develop their natural resources efficiently
  include
• Chile Australia before World War I,
• and Venezuela since the 1980s.
• Hausmann (2003, p.246) Venezuelas growth
  collapse took place after 60 years of expansion,
  fueled by oil. If oil explains slow growth, what
  explains the previous fast growth?

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Addendum Countries with high resource rents (as
of GDP) tend to have lower student math
performance(statistically significant at the
.003 level)
Source OECD education data featured in
 Knowledge and skills are infinite oil is not
by Andreas Schleicher.
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Part II
Policies institutions to avoidpitfalls of
the Natural Resource Curse

• Some that are not recommended
• Institutions that try to suppress price
  volatility.
• Recommended
• Devices to hedge risk.
• Ideas to reduce macroeconomic procyclicality.
• Institutions for better governance.

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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.

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Many of the policies that have been intended to
suppress commodity volatility do not work out so
well

• Producer subsidies
• Stockpiles
• Marketing boards
• Price controls
• Export controls

• Blaming derivatives
• Resource nationalism
• Nationalization
• Banning foreign participation

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Devices to share risks
7 recommendations for commodity-exporting
countries

• 1. Index contracts with foreign
  companies(royalties) to the world commodity
  price.
• 2. Hedge commodity revenues in options markets
• 3. Link debt to the commodity price

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Countercyclical macroeconomic policy
7 recommendations for commodity producers
continued

• 4. Allow some currency appreciation in response
  to a commodity boom, but not a free float.
• - Accumulate some forex reserves first.- 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.

PPT
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Good governance institutions
7 recommendations for commodity producers,
concluded

• 7. Manage commodity funds professionally.
• Invest them abroad
• like Norways Pension Fund,
• Reasons
• (1) for diversification,
• (2) to avoid cronyism in investments.
• but insulated from politics
• like Botswanas Pula Fund.
• Professionally managed, to optimize financially.

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Elaboration on two proposals to reduce the
procyclicality of macroeconomic policy for
commodity exporters

• I) To make monetary policy less procyclical
  Product Price Targeting
• II) To make fiscal policy less procyclical
  emulate Chile.

PPT
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I) The challenge of designinga currency regime
for countries where terms of trade shocks
dominate the cycle

• Fixing the exchange rate leads to procyclical
  monetary policy credit expands 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

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Product Price Targeting
PPT

• Target an index of domestic production prices
  1
• such as the GDP deflator
• 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, 2012).

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Appendix II Who achieves counter-cyclical
fiscal policy?
Countries with good institutions
On Graduation from Fiscal Procyclicality 2013,
Frankel with C.Végh G.Vuletin J.Dev.Economics.
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What, specifically, are good institutions?
The example of Chile 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 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.

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Appendiceson recommendations for dealing with
the natural resource curse

• Appendix 4 Policies not recommended
• Appendix 5 Elaboration on proposal to make
  monetary policy less procyclical PPT, using GDP
  deflator to set annual inflation target.
• Appendix 6 Elaboration on proposal to make
  fiscal policy less procyclical emulate Chile,
  setting structural targets with independent
  fiscal forecasts

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Appendix 4 Policies that have been triedbut
that are not recommended

• Blaming derivatives
• Resource nationalism
• Nationalization
• Banning foreign participation

• Producer subsidies
• Stockpiles
• Marketing boards
• Price controls
• Export controls

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Unsuccessful policies to reduce commodity price
volatility

• 1) Producer subsidies to stabilize prices at
  high levels,
• often via wasteful stockpiles protectionist
  import barriers.
• Examples
• The EUs 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.

64
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.

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Microeconomic policies, continued

• Often the goal of price controls is to shield
  consumers of staple foods 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.

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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.

67
An initiative at the G20 meetings in France in
2011 deserved to succeed

• Producers 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.

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An initiative that has less merit

• 4) Attempts to blame speculation for volatility
• and so to ban derivatives markets.
• Yes, speculative bubbles sometimes hit prices.
• But in commodity markets,
• prices are more often the signal for
  fundamentals.
• Dont shoot the messenger.
• Also, derivatives are useful for hedgers.

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An example of commodity speculation

• In the 1955 movie version of East of Eden, the
  legendary James Dean plays Cal. 
• Like Cain in Genesis, he competes with his
  brother for the love of his father.  
• Cal goes long in the market for beans, in
  anticipation of a rise in demand if the US
  enters WWI. 

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An example of commodity speculation, cont.

• Sure enough, the price of beans goes sky high,
  Cal makes a bundle, and offers it to his father,
  a moralizing patriarch. 
• But the father is morally offended by Cals
  speculation, not wanting to profit from others
  misfortunes, and tells him he will have to
  give the money back. 

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An example of commodity speculation, cont.

• Cal has been the agent of Adam Smiths famous
  invisible hand
• By betting on his hunch about the future, he has
  contributed to upward pressure on the price of
  beans in the present,
• thereby increasing the supply so that more is
  available precisely when needed (by the Army). 
• The movie even treats us to a scene where Cal
  watches the beans grow in a farmers field,
  something real-life speculators seldom get to see.

72
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.

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Resource nationalism

• Another motive for commodity export controls
• 5) To subsidize downstream industries.
• E.g., beneficiation in South African diamonds
• But it didnt make diamond-cutting competitive,
• and it hurt mining exports.
• 6) Nationalization of foreign companies.
• Like price controls, it discourages investment.

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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 locking up 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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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.

76
Appendix 5 Product Price Targeting

• Each of the traditional candidates for nominal
  anchor has an Achilles heel.
• The CPI anchor does not accommodate terms of
  trade changes
• IT tightens M appreciates when import prices
  rise
• not when export prices rise,
• which is backwards.
• Targeting core CPI does not much help.

77
6 proposed nominal targets and the Achilles heel
of each
Vulnerability
IT
Professor Jeffrey Frankel
78
Why is PPT better than a fixed exchange ratefor
countries with volatile export prices?
PPT

• Better response to trade shocks
  (countercyclical)
• 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.

79
Why is PPT better than CPI-targetingfor
countries with volatile terms of trade?
PPT

• Better response to trade shocks (accommodating)
• 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.

80
Empirical findings

• Simulations of 1970-2000
• Gold producers Burkino Faso, Ghana, Mali, South
  Africa
• Other commodities Ethiopia (coffee), Nigeria
  (oil), S.Africa (platinum)
• General finding Under Product Price Targets,
  their currencies would have depreciated
  automatically in 1990s when commodity prices
  declined,
• perhaps avoiding messy balance of payments
  crises.

Sources Frankel (2002, 03a, 05), Frankel Saiki
(2003)
81
Price indices

• CPI GDP deflator each include
• an international good
• import good in the CPI,
• export good in GDP deflator
• And the non-traded good,
• with weights f and (1-f), respectively
• cpi (f)pim (1-f)pn ,
• p (f)px (1-f) pn .

82
Estimation for each country of weights in
national price index on 3 sectors non tradable
goods, leading commodity export, other tradable
goods
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.  
Argentina is relatively closed
Mexico is relatively open.
The leading export commodity usually has a
higher weight in the countrys PPI than in its
CPI, as expected. (Jamaicans dont eat
bauxite.)
83
In practice, IT proponents agree central banks
should not tighten to offset oil price shocks

• They want focus on core CPI, excluding food
  energy.
• But
• food energy ? all supply shocks.
• Use of core CPI sacrifices some credibility
• If core CPI is the explicit goal ex ante, the
  public feels confused.
• If it is an excuse for missing targets ex post,
  the public feels tricked.
• Perhaps for that reason, IT central banks
  apparently do respond to oil shocks by
  tightening/appreciating,
• as the following correlations suggests.

84
LAC Countries Current Regimes and Monthly
Correlations of Exchange Rate Changes (/local
currency) with Import Price Changes
Table 1
Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes Table 1 LACA Countries Current Regimes and Monthly Correlations of Exchange Rate Changes (/local currency) with Dollar Import Price Changes
Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil. Import price changes are changes in the dollar price of oil.
  Exchange Rate Regime Monetary Policy 1970-1999 2000-2008 1970-2008
ARG Managed floating Monetary aggregate target -0.0212 -0.0591 -0.0266
BOL Other conventional fixed peg Against a single currency -0.0139 0.0156 -0.0057
BRA Independently floating Inflation targeting framework (1999) 0.0366 0.0961 0.0551
CHL Independently floating Inflation targeting framework (1990) -0.0695 0.0524 -0.0484
CRI Crawling pegs Exchange rate anchor 0.0123 -0.0327 0.0076
GTM Managed floating Inflation targeting framework -0.0029 0.2428 0.0149
GUY Other conventional fixed peg Monetary aggregate target -0.0335 0.0119 -0.0274
HND Other conventional fixed peg Against a single currency -0.0203 -0.0734 -0.0176
JAM Managed floating Monetary aggregate target 0.0257 0.2672 0.0417
NIC Crawling pegs Exchange rate anchor -0.0644 0.0324 -0.0412
PER Managed floating Inflation targeting framework (2002) -0.3138 0.1895 -0.2015
PRY Managed floating IMF-supported or other monetary program -0.023 0.3424 0.0543
SLV Dollar Exchange rate anchor 0.1040 0.0530 0.0862
URY Managed floating Monetary aggregate target 0.0438 0.1168 0.0564
Oil Exporters Oil Exporters        
COL Managed floating Inflation targeting framework (1999) -0.0297 0.0489 0.0046
MEX Independently floating Inflation targeting framework (1995) 0.1070 0.1619 0.1086
TTO Other conventional fixed peg Against a single currency 0.0698 0.2025 0.0698
VEN Other conventional fixed peg Against a single currency -0.0521 0.0064 -0.0382
Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999.  Chile declared an inflation target as early as 1990 but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999. 
IT coun-tries show correl-ations gt 0.
85
The 4 inflation-targeters in Latin Americashow
correlation (currency value in , import prices
in )

• gt 0
• gt correlation before they adopted IT
• gt correlation shown by non-IT Latin American
  oil-importing countries.

86
Why is the correlation between the import price
and the currency value revealing?

• The currency of an oil importer should not
  respond to an increase in the world oil price by
  appreciating, to the extent that these central
  banks target core CPI .
• When these IT currencies respond by appreciating
  instead, it suggests that the central bank is
  tightening money to reduce upward pressure on
  headline CPI.

87
Appendix 6 Chilean fiscal policy

• In 2000 Chile instituted its structural budget
  rule.
• The institution was formalized in law in 2006.
• The structural budget deficit must be zero,
• originally BS gt 1 of GDP, then cut to ½ , then
  0 --
• 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.

88
The crucial institutional innovation in Chile

• How has Chile avoided over-optimistic official
  forecasts?
• especially the historic pattern of
  over-exuberance in commodity booms?
• The estimation of the long-term path for GDP
  the copper price is made by two panels of
  independent experts,
• and thus is insulated from political pressure
  wishful thinking.
• Other countries might usefully emulate Chiles
  innovation
• or in other ways delegate to independent agencies
  estimation of structural budget deficit paths.

89
The Pay-off

• Chiles 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, Chiles sovereign rating had climbed to
  A,
• ahead of some advanced countries.
• gt It was able to respond to the 2008-09
  recession
• via fiscal expansion.

90

• 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 ratings fell sharply.
• When the recession hit and the copper price came
  back down, the government increased spending,
  mitigating the downturn.
• Bachelet Velascos popularity reached
  historic highs in 2009.

91
Evolution of approval and disapproval of four
Chilean presidents
Presidents Patricio Aylwin, Eduardo Frei, Ricardo
Lagos and Michelle BacheletData CEP, Encuesta
Nacional de Opinion Publica, October 2009,
www.cepchile.cl. Source Engel et al
(2011).
92
5 econometric findings regarding bias toward
optimism in official budget forecasts.

• Official forecasts in a sample of 33 countries
  on average are overly optimistic, for
• (1) budgets
• (2) GDP .
• The bias toward optimism is
• (3) stronger the longer the forecast horizon
• (4) greater in booms
• (5) greater for euro governments under SGP budget
  rules

93
(4) The optimism in official budget forecasts is
stronger at the 3-year horizon, stronger
amongcountries with budget rules,
stronger in booms.
Frankel, 2012, A Solution to Fiscal
Procyclicality The Structural Budget
Institutions Pioneered by Chile.
94
(4) Official budget forecasts are biased more if
GDP is currently high especially at longer
horizons
Budget balance forecast error as of GDP,
Full dataset
(1) (2) (3)
One year ahead Two years ahead Three years ahead

GDP relative to trend 0.093(0.019) 0.258(0.040) 0.289(0.063)

Constant 0.201 0.649 1.364
(0.197) (0.231) (0.348)

Observations 398 300 179
33 countries
Variable is lagged so that it lines up with the
year in which the forecast was made. plt0.01
Robust standard errors in parentheses, clustered
by country.
95
Budget balance forecast error as a of GDP,
Full Dataset
(5) Official budget forecasts are more
optimistically biasedin countries subject to a
budget deficit rule (SGP)
(1) (2) (3) (4)
One year ahead Two years ahead One year ahead Two years ahead
SGPdummy 0.658 0.905 0.407 0.276
(0.398) (0.406) (0.355) (0.438)
SGP dummy (GDP - trend) 0.189(0.0828) 0.497(0.107)
Constant 0.033 0.466 0.033 0.466
(0.228) (0.248) (0.229) (0.249)
Observations 399 300 398 300
33 countries
plt0.01, plt0.05, plt0.1 Robust standard
errors in parentheses, clustered by country.
96
5 more econometric findings regarding bias
toward optimism in official budget forecasts.

• (6) The key macroeconomic input for budget
  forecasting in most countries GDP. In
  Chile the copper price.
• (7) Real copper prices revert to trend in the
  long run.
• But this is not always readily perceived
• (8) 30 years of data are not enough
• to reject a random walk statistically 200 years
  of data are needed.
• (9) Uncertainty (option-implied volatility) is
  higher when copper prices are toward the top of
  the cycle.
• (10) Chiles official forecasts are not overly
  optimistic.It has apparently avoided the
  problem of forecasts that unrealistically
  extrapolate in boom times.

97
In sum, institutions recommended to make fiscal
policy less procyclical

• Official growth budget forecasts tend toward
  wishful thinking
• unrealistic extrapolation of booms 3 years into
  the future.
• The bias is worse among the European countries
  supposedly subject to the budget rules of the
  SGP,
• presumably because government forecasters feel
  pressured to announce they are on track to meet
  budget targets even if they are not.
• Chile is not subject to the same bias toward
  over-optimism in forecasts of the budget, growth,
  or the all-important copper price.
• The key innovation that has allowed Chile to
  achieve countercyclical fiscal policy
• not just a structural budget rule in itself,
• but rather the regime that entrusts to two panels
  of experts estimation of the long-run trends of
  copper prices GDP.

98
Application to other countries

• Any country could adopt the Chilean mechanism.
• Suggestion give the panels more institutional
  independence
• as is familiar from central banking
• laws protecting them from being fired.
• Open questions
• Are the budget rules to be interpreted as ex ante
  or ex post?
• How much of the structural budget calculations
  are to be delegated to the independent panels of
  experts?
• Minimalist approach they compute only 10-year
  moving averages.
• Can one guard against subversion of the
  institutions (CBO) ?

99
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100
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 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,
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• The Natural Resource Curse A Survey, 2012,
  Chapter 2 in Beyond the Resource Curse, B.Shaffer
  T. Ziyadov, eds. (U.Penn. Press) proofs
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• How Can Commodity Exporters Make Fiscal and
  Monetary Policy Less Procyclical? Natural
  Resources, Finance Development, R.Arezki,
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  C.Végh G.Vuletin J. Dev. Economics.
• Chiles Solution to Fiscal Procyclicality,
  2012, Transitions blog, Foreign Policy.
• A Solution to Fiscal Procyclicality The
  Structural Budget Institutions Pioneered by
  Chile, in Fiscal Policy and Macroeconomic
  Performance, 2012.   Central Bank of Chile WP
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•  "Product Price Targeting -- A New Improved Way
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  Vol.XI, issue 1, April 2012 (Monetary Authority
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