Coping with Commodity Volatility: Macroeconomic Policies for Developing Countries. Jeffrey Frankel Harpel Professor of Capital Formation & Growth. May 24, 2013. In 2008, the government of Chilean President Bachelet & her Finance Minister Velasco ranked low in public opinion polls.
Coping with Commodity Volatility:Macroeconomic Policies for Developing Countries
Jeffrey FrankelHarpel Professor of Capital Formation & Growth
May 24, 2013
By late 2009, they were the most popular in 20 years. Why?
Evolution of approval and disapproval of four Chilean presidents
PresidentsPatricio Aylwin, Eduardo Frei, Ricardo Lagos and Michelle BacheletData: CEP, Encuesta Nacional de Opinion Publica, October 2009, www.cepchile.cl. Source: Engel et al (2011).
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.
Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart & Végh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini(2008), Mendoza & Oviedo (2006), Ilzetski & Végh (2008), Medas & Zakharova (2009), Gavin & Perotti (1997).
Correlations between Gov.t Spending & GDP
Adapted from Kaminsky, Reinhart & Vegh (2004)
G always used to be pro-cyclical for most developing countries.
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.
(i) Investment projects.
Investment in practice may be “whiteelephant” projects,
which are stranded without funds for completion or maintenance when the oil price goes back down.
(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 it’s unsalvageable..”
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, Botswana, Malaysia, Indonesia, Korea…
How were they able to achieve counter-cyclicality?
The procyclicality of fiscal policy,cont.
Frankel, Vegh & Vuletin(2012)
In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP.
1. How can a country avoid excessive credit creation & inflation in a commodity boom ?
Eventually allow some currency appreciation.
But not a free float. Accumulate some fx reserves first.
2. Nominal anchor for monetary policy:
What is it to be, if not the exchange rate? CPI?
3. Fiscal policy:How can governments be constrained from over-spending in boom times? Fiscal rule?
4. What microeconomic arrangements can reduce macroeconomic volatility?
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.
Prices of crude oil and other agricultural & 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.
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)…
Céspedes &Velasco(Nov.2012) NBER WP 18569 “Macroeconomic Performance During Commodity Price Booms & Busts”
(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.
The popular choice of the last decade:Inflation Targeting.
But CPI targeting can react perversely
to supply shocks
& terms of trade shocks.
Adverse AS shock
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
accommodates terms of trade shocks
If the $ price of the export commodity goes up, the currency automatically appreciates,
moderating the boom.
If the $ price of export commodity goes down, the currency automatically depreciates,
moderating the downturn
& improving the balance of payments.
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.
Each of the traditional candidates for nominal anchor has an Achilles heel.
The CPI anchor does not accommodate terms of trade changes:
IT tightensM&appreciates when import prices rise
not when export prices rise,
which is backwards.
Targeting core CPI does not much help.
6 proposed nominal targets and the Achilles heel of each:
Professor Jeffrey Frankel
Is Inflation Targeting the reigning orthodoxy at the Fund? “Yes”
Who achieves counter-cyclical fiscal policy?
Countries with “good institutions”
”On Graduation from Fiscal Procyclicality,” Frankel, Végh & Vuletin; J.Dev.Economics, 2013.
Frankel, Végh & Vuletin,2013.
The comparison holds not only in cross-section,but also across time.
”On Graduation from Fiscal Procyclicality,” Frankel, Végh & Vuletin; J. Devel. Econ., 2013.
1st rule – Governments must set a budget target,
2nd rule – The target is structural: Deficits allowed only to the extent that
(1) output falls short of trend, in a recession, or
(2) the price of copper is below its trend.
3rd rule – The trends are projected by 2 panels of independentexperts, outside the politicalprocess.
Result: Chile avoided the pattern of 32 other governments,
where forecasts in booms were biased toward optimism.
The example of Chile’s fiscal institutions
In 2000 Chile instituted its structural budget rule.
The institution was formalized into law in 2006.
The structural budget surplus must be…
0 as of 2008 (was higher before, lower after),
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.
Chile’s 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, Chile’s sovereign rating had climbed to A+,
ahead of some advanced countries.
=> It was able to respond to the 2008-09 recession.
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 fell sharply.
When the recession hit and the copper price came back down, the government increased spending, mitigating the downturn.
Bachelet&Velasco’s popularity reached historic highs by the time they left office.
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 eurogovernments underSGPbudgetrules;
USofficialprojections have been over-optimistic on average.
Greek official forecasts have always been over-optimistic.
Chile’s official forecasts have not been over-optimistic.
The optimism in official budget forecasts is stronger at the 3-year horizon, stronger amongcountries with budget rules,
& stronger in booms.
Frankel, 2010, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile.”
(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.
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,
insulated from political pressure & wishful thinking
Any country could emulate the Chilean mechanism,
or in other ways delegate to independent agencies.
Suggestion: give panels more institutional independence
as is familiar from central banking:
laws protecting them from being fired.
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) ?
Contractual provisions to share risks:
1. Index contracts with foreign companiesto the world commodity price.
2. Hedge commodity revenues in options markets.
3. Denominate debt in terms of commodity price .
Manage commodity funds professionally.
4. Other reforms to manage volatility
Norway’s Pension Fund
All govt. oil revenues go into it.
Govermnent(on average over the cycle) can spend expected real return, say 4%.
All invested abroad. Reasons:
(1) for diversification,
(2) to avoid cronyism in investments.
But insulated from politics,
like Botswana’s Pula Fund,
fully delegated for financial optimization.
Manage commodityfunds professionally.
“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?” inNatural Resources, Finance & Development.R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011. HKS RWP 11-015.
“On Graduation from Fiscal Procyclicality,”with C.Végh & G.Vuletin, inJournalof Development Economics, 100, no.1, Jan.2013; pp. 32-47. NBER WP 17619. Summary, VoxEU, 2011.
Chile's Countercyclical Triumph," inTransitions, Foreign Policy, June 2012.
“A Solution to Fiscal Procyclicality: The StructuralBudget Institutions Pioneered by Chile,” Central Bank of ChileWP604,2011. Spanish:Journal Economía Chilena , Aug.2011, CBC, 39-78.
"Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review XI, 1, 2012 (Monetary Authority of Singapore).
“A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America," Economia, 2011 (Brookings), NBER WP 16362.
Rabah Arezki and Kareem Ismail, 2010, “Boom-Bust Cycle, Asymmetrical Fiscal Response and the Dutch Disease,” IMF WP/10/94, April.
Christian Broda, 2004, "Terms of Trade and Exchange Rate Regimes in Developing Countries," Journal of International Economics, 63(1), 31-58.
Luis Céspedes & Andrés Velasco, 2012, “Macroeconomic Performance During Commodity Price Booms & Busts” NBER WP 18569, Nov.
GracielaKaminsky, Carmen Reinhart & Carlos Vegh, 2005, "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Macroeconomics Annual 2004, 19, pp.11-82.
Warwick McKibbin & Kanhaiya Singh, “Issues in the Choice of a Monetary Regime for India,” 2003, in Kaliappa Kalirajan & Ulaganathan Sankar (eds.) Economic Reform and the Liberalisation of the Indian Economy (Edward Elgar Publ., UK), pp. 221-274.
James Meade, 1978, “The Meaning of Internal Balance,” The Economic Journal, 91, 423-35.
Jeffrey Sachs, “How to Handle the Macroeconomics of Oil Wealth,” 2007, in Escaping the Resource Curse, M.Humphreys, J.Sachs & J.Stiglitz, eds. (Columbia Univ. Press: NY), pp. 173-93.