Macroeconomic Policy Macroeconomic Policy in Countries with Natural Resource in Countries with Natural Resource

WealthWealth

APPENDICESAPPENDICESLeading Economic Growth ProgramLeading Economic Growth Program

February 14, 2013February 14, 2013

Jeffrey Frankel

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How could abundance How could abundance of commodity wealth be a curse? of commodity wealth be a curse?

What is the mechanism What is the mechanism for this counter-intuitive relationship? for this counter-intuitive relationship? At least 5 categories of explanations.At least 5 categories of explanations.

Appendix I: Channels of the Natural Resource

Curse

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1.1. Volatility Volatility 2.2. Crowding-outCrowding-out of of manufacturingmanufacturing

3.3. Autocratic InstitutionsAutocratic Institutions4.4. Anarchic InstitutionsAnarchic Institutions5.5. ProcyclicalityProcyclicality includingincluding

1.1. Procyclical capital flowsProcyclical capital flows2.2. Procyclical monetary policyProcyclical monetary policy3.3. Procyclical fiscal policy.Procyclical fiscal policy.

5 Possible Natural Resource Curse Channels

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

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Commodity prices have been especially volatile over the last

decade

Source: UNCTAD

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Effects of VolatilityEffects of Volatility Volatility Volatility per seper se can be bad for economic growth. can be bad for economic growth.

Hausmann & Rigobon Hausmann & Rigobon (2003),(2003), Blattman, Hwang, & Williamson Blattman, Hwang, & Williamson (2007),(2007), and Poelhekke & van der Ploeg and Poelhekke & van der Ploeg (2007).(2007).

Risk inhibits private investment.Risk inhibits private investment.

Cyclical shifts of labor, land & capital back & Cyclical shifts of labor, land & capital back & forth across sectors may incur needless costs.forth across sectors may incur needless costs.

=> role for government intervention?=> role for government intervention? On the one hand, the private sector dislikes risk as On the one hand, the private sector dislikes risk as

much as government does & takes steps to mitigate it.much as government does & takes steps to mitigate it. On the other hand the government On the other hand the government

cannot entirely ignore the issue of volatility; cannot entirely ignore the issue of volatility; e.g., exchange rate policy.e.g., exchange rate policy.

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2. Natural resources may 2. Natural resources may crowd outcrowd out

manufacturingmanufacturing,, and manufacturing could be the sector and manufacturing could be the sector

that experiences learning-by-doing that experiences learning-by-doing or dynamic productivity gains from spillover.or dynamic productivity gains from spillover. MatsuyamaMatsuyama (1992), (1992), vanvan WijnbergenWijnbergen (1984) (1984) andand SachsSachs && WarnerWarner

(1995).(1995).

So commodities could in theory be a dead-end sector.So commodities could in theory be a dead-end sector.

My own view: a country need not repress the My own view: a country need not repress the commoditycommodity sector to develop the manufacturingsector to develop the manufacturing sector.sector. It can foster growth in both sectors.It can foster growth in both sectors.

E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil…E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil…

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Econometric findings that oil

and 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 The theory is thought to fit Mideastern oil exporters well.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 institutions4. Anarchic institutions1.1. Unsustainably rapid Unsustainably rapid

depletion of resources depletion of resources

2.2. Unenforceable Unenforceable property rightsproperty rights

3.3. Civil warCivil war

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(5) Procyclicality(5) Procyclicality The The Dutch DiseaseDutch Disease describes unwanted describes unwanted

side-effects of a commodity boom.side-effects of a commodity boom.

Developing countries are Developing countries are historically pronehistorically prone to to procyclicality,procyclicality, especially commodity producers.especially commodity producers.

ProcyclicalityProcyclicality in: in: Capital inflows; Monetary policy;Capital inflows; Monetary policy; Real exchangeReal exchange rate; Nontraded Goodsrate; Nontraded Goods Fiscal PolicyFiscal Policy

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The Dutch Disease: The Dutch Disease: 5 side-effects of a commodity 5 side-effects of a commodity

boomboom 1) A real appreciation in the 1) A real appreciation in the

currency currency 2) A rise in government spending 2) A rise in government spending 3) A rise in nontraded goods prices 3) A rise in nontraded goods prices 4) A resultant shift of production 4) A resultant shift of production

out of manufactured goods out of manufactured goods 5) Sometimes a current account 5) Sometimes a current account

deficitdeficit

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The Dutch Disease: The 5 effects elaboratedThe Dutch Disease: The 5 effects elaborated

1) Real appreciation in the currency1) Real appreciation in the currency

taking the form of nominal currency appreciation taking the form of nominal currency appreciation

if the exchange rate floatsif the exchange rate floats

or the form of money inflows, credit or the form of money inflows, credit & inflation if the exchange rate is fixed;& inflation if the exchange rate is fixed;

2) A rise in government spending 2) A rise in government spending in response to availability of tax receipts or royalties.in response to availability of tax receipts or royalties.

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The Dutch Disease: 5 side-effects of a commodity boomThe Dutch Disease: 5 side-effects of a commodity boom

3) An increase in nontraded goods 3) An increase in nontraded goods pricesprices relative to internationally traded goodsrelative to internationally traded goods

4) A resultant shift out of 4) A resultant shift out of non-commodity traded goods,non-commodity traded goods, esp. manufactures,esp. manufactures, pulled by the more pulled by the more

attractive returns attractive returns in the export commodity in the export commodity and in non-traded goodsand in non-traded goods..

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The Dutch The Dutch Disease: 5 side-effects of a commodity boomDisease: 5 side-effects of a commodity boom

5) A current account deficit,5) A current account deficit, as booming countries attract capital as booming countries attract capital flows,flows,

thereby incurring international debt thereby incurring international debt that that is hard to service when the boom is hard to service when the boom ends.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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Summary of channels 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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Some developing countries have avoided Some developing countries have avoided the pitfalls of commodity wealth.the pitfalls of commodity wealth.

E.g., Chile (copper)E.g., Chile (copper)

Botswana (diamonds)Botswana (diamonds)

Some of their innovations are worth Some of their innovations are worth emulating.emulating.

The lecture offers some policies & The lecture offers some policies & institutional innovations to avoid the curse.institutional innovations to avoid the curse.

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Appendiceson recommendations for

dealing with the natural resource curse

Appendix II.1: Elaboration on proposal to make monetary policy less procyclical – PPT, using GDP deflator to set annual inflation target.

Appendix II.2: Elaboration on proposal to make fiscal policy less procyclical – emulate Chile, setting structural targets with independent fiscal forecasts

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Appendix II.1: 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.

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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)

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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 .

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Estimation for each country of weights in national price index on 3 sectors: non tradable goods, leading commodity export, & other tradable goods

Non Tradables

Leading Comm. Export

OilOther

TradablesTotal

CPI 0.6939 0.0063 0.0431 0.2567 1.000PPI 0.6939 0.0391 0.0230 0.2440 1.000CPI 0.5782 0.0163 0.0141 0.3914 1.000PPI 0.5782 0.1471 0.0235 0.2512 1.000CPI 0.5235 0.0079 0.0608 0.4078 1.000PPI 0.5235 0.0100 0.1334 0.3332 1.000CPI 0.5985 -- 0.0168 0.3847 1.000PPI 0.5985 -- 0.0407 0.3608 1.000CPI 0.6413 0.0002 0.0234 0.3351 1.000PPI 0.6413 0.1212 0.0303 0.2072 1.000CPI 0.3749 -- 0.0366 0.5885 1.000PPI 0.3749 -- 0.0247 0.6003 1.000CPI 0.3929 0.1058 0.0676 0.4338 1.000PPI 0.3929 0.0880 0.0988 0.4204 1.000CPI 0.6697 0.0114 0.0393 0.2796 1.000PPI 0.6697 0.040504 0.021228 0.268568 1.000CPI 0.6230 0.0518 0.0357 0.2895 1.000PPI 0.6230 0.2234 0.1158 0.0378 1.000

* Oil is the leading commodity export.

PRY

PER

URY

ARG

BOL

CHL

COL*

JAM

MEX*

Argentina is relatively closed;

The leading export commodity usually has a higher weight in the country’s PPI

than in its CPI, as expected.

(Jamaicans don’t eat bauxite.)

Mexico is relatively open.

“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.  

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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….

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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.

  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        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. 

LAC Countries’ Current Regimes and Monthly Correlations of Exchange Rate Changes ($/local currency) with $ Import Price Changes

Table 1

ITcoun-triesshowcorrel-ations> 0.

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The 4 inflation-targeters in Latin America

show correlation (currency value in $ , import prices in $) > 0 ;

> correlation before they adopted IT;

> correlation shown by non-IT Latin American oil-importing countries.

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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.

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Appendix II.2: Official over-optimism

& Chilean fiscal institutions

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And the Finance Minister?: August 2009

Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

Poll ratings of Chile’s

Presidents and Finance

Ministers

In August 2009, the popularity of the Finance Minister, Andres Velasco,

ranked behind only President Bachelet, despite also having been low two years

before. Why?

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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;

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US official projections have been over-optimistic on average

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Greek official forecasts have always been over-optimistic.

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Chile’s official forecasts have not been over-optimistic.

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The optimism in official budget forecasts is The optimism in official budget forecasts is stronger at the 3-year horizon, stronger among stronger at the 3-year horizon, stronger amongcountries with budget rules,countries with budget rules, & stronger in booms.& stronger in booms.

Frankel, 2010, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile.”

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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) Chile’s official forecasts are not overly optimistic.It has apparently avoided the problem of forecasts that unrealistically extrapolate in boom times.

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

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.

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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 Chile’s innovation or in other ways delegate to independent agencies

estimation of structural budget deficit paths.

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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) ?

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”On Graduation from Fiscal Procyclicality,” Frankel, Végh & Vuletin; J.Dev.Econ., 2013.