Managing the crash in commodity prices

Rick van der Ploeg

24 December 2016

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Following oil, gas or mineral bonanzas economies often do not fare well. The reasons for this so-called ‘resource curse’ are well known. First, an appreciation of the real exchange rate and a decline in non-resource exports both depress growth, since the traded sectors are the engines of growth, not the non-traded sectors – this effect is referred to as 'Dutch disease'. Second, the notorious volatility of oil and commodity prices wrecks economies, especially if their financial markets are underdeveloped. Third, rent-seeking and weakening of institutions, together with myopic politicians losing sight of value-for-money policies, all lead to windfalls being squandered rather than harnessed for growth and development. Empirical evidence indicates that the curse is worse if countries have bad institutions, poor rule of law and fragmented financial systems, and are ethnically diverse and landlocked (see the surveys in Frenkel 2012 and van der Ploeg 2011).

The permanent-income rule for managing resource bonanzas

The policy advice for managing such windfalls has typically been to put the revenue in an independently managed sovereign wealth fund, which invests only abroad, and to smooth the resource dividends over time. In addition, intertemporal smoothing of the real exchange rate is encouraged, as well as limiting sharp swings in the intersectoral allocation of production factors. The windfall is thus invested for the benefit of future and current generations. Once  a future windfall has been identified, it takes five to seven years of exploitation investments before any oil or gas can be pumped up. During this pre-windfall period, in order to boost consumption, a country should borrow on international capital markets. Then, during the windfall itself, revenue pours in, the debt is repaid, assets are accumulated in a fund, and consumption is again boosted. Finally, after the windfall ceases, the country withdraws money from that fund, to once more boost consumption. This way of managing an intergenerational sovereign wealth fund ensures an equal increase in consumption per capita (the so-called 'resource dividend') before, during and after the windfall. This strategy makes sense for advanced countries, blessed with natural resources, but can be disastrous for developing countries for various reasons (Venables, 2016; van der Ploeg, 2016).

Why smoothing consumption and the real exchange rate may be inappropriate

First, to cope with volatile commodity prices countries should initially rather engage in prudential saving and depress consumption to establish a stabilisation fund.  This is especially the case if countries find it difficult and costly to hedge commodity price risk – given the thinness of these derivatives markets – or if they judge it politically risky to do so. In contrast to the intergenerational fund, such a fund is larger if the windfall is more permanent (e.g. Bems and De Carvalho Filho 2011 and van den Bremer and van der Ploeg 2013). Norway uses the more conservative bird-in-hand rule, which puts all revenue in the fund and takes out a constant fraction (typically 4%). This strategy does not use the windfall itself as collateral and as such is a pragmatic and prudent way of managing it,  but it does lead to substantial consumption volatility.

Second, if a country has poor access to international financial markets, investment is too low and then it is better to invest the bonanzas in the domestic economy (e.g. van der Ploeg and Venables 2012). To put it bluntly, the return on an investment in the education of young girls is much higher than that on US T-bills, especially given their very low returns at the moment. The windfall should also be used to curb capital scarcity, and thus accelerate growth and development. The dividends should be handed out upfront, since current generations will be poorer than future generations.

Third, developing countries suffer severe absorption constraints in education, health, and infrastructure. It takes years before enough teachers, nurses, and doctors have been trained, and in the meantime the numbers necessary cannot all be imported from abroad. Also, the more roads and railways that are in place, the more productive new roads and railways are. These investments are mostly produced in non-traded sectors, which are squeezed already by the boost in the demand for non-tradables. The relative price of non-tradables must thus rise (i.e. the real exchange rate must appreciate) for a prolonged period in order to ensure that these parts of the economy can expand. It is important to set up an investment fund where revenue is temporarily parked until the supply side of the economy is sufficiently strong to absorb the spending on education, health and infrastructure efficiently.

Fourth, managing windfalls should take account of the non-neutrality of government debt. The timing of the handing of a windfall back to citizens matters, especially in developing countries with poorly developed financial markets. Households prefer dividends to be handed back upfront, since they may not be alive to receive them in the far future. The permanent-income rule, then, leads to an overshooting of the real exchange rate and consumption, since households run down assets and the current account eventually turns into surplus. Households temporarily get more upfront and thus save, if the bonanza is immediately handed to them, however, under the permanent-income rule, they borrow. Households thus save if the government fails to smooth withdrawals from the fund.

Finally, even though the management of resource windfalls can be a process spanning decades, it is important to take account of real and nominal wage rigidities and the short-run effects on unemployment. We will discuss this when considering the best response to a commodity price crash.

How to respond to the crash in oil, gas and other commodity prices?

But what to do when oil and commodity prices have plummeted? Would the curse not simply be reversed? Looking at oil- and gas-rich countries such as Russia, Algeria, Nigeria, and Brazil reveals that their experiences during the recent bust have not been good.  They face spiralling deficits and have had to cut government spending and raise revenue from elsewhere. Preventing currency depreciation and erosion of living standards runs down foreign reserves until the currency can no longer be defended. Alternatively, a country may dip into their sovereign wealth fund in order to prevent falls in consumption and the real exchange rate, but most of these countries do not have such funds. So, if the real exchange rate finally depreciates sharply, the hope is that Dutch disease reverses and that non-resource sectors of the economy are boosted.

If real wages respond sluggishly to unemployment and the production of non-tradables is intensive in structures, a crash in commodity prices causes transient periods of unemployment and more so if the whole bonanza is immediately spent, than under the permanent-income or bird-in-hand rule – due to the sharper depreciation of the real exchange rate associated with not saving the windfall. If nominal wages are sluggish in the short run, a monetary policy response is required to mitigate unemployment and inflation, and a Taylor policy rule for the nominal interest rate, reacting to inflation and unemployment, performs better than a nominal exchange rate peg, especially if the fiscal authorities implement a tighten-your-belt instead of a permanent-income rule. Given that a peg severely constrains monetary policy’s ability to respond to demand shocks, including global shocks to commodity prices, it is puzzling that three-quarters of resource-rich countries have a nominal exchange rate peg.

If the central bank steps in during a crash in commodity prices and prevents rapid nominal depreciation of the currency and inflation, foreign reserves will be rapidly depleted and this may lead to a speculative attack on the currency. Governments in developing economies may find it tough to cut spending or raise non-resource taxes to make up for the drop in resource revenue, even though this approach will be needed if the crash is expected to last a long time. Fund wealth is then rapidly depleted and government debt escalates until the market is no longer willing to buy more debt. This myriad of short-run macro misery highlights the importance of sound medium- and long-run management of resource wealth so as to cope with the inevitable volatility in both resource production and commodity prices. 

References

Bems, R. and I. De Carvalho Filho (2011). The current account and precautionary savings for exporters of exhaustible resources, Journal of International Economics, 84, 1, 48-64.

Berg, A., S.-C. S. Yang and L.-F. Zanna (2013). Public investment in resource-abundant developing countries, IMF Economic Review, 61, 1, 92-129.

Bremer, T.S. van den and F. van der Ploeg (2013). Managing and harnessing volatile oil windfalls, IMF Economic Review, 61, 1, 131-167.

Frankel, J. (2012). The natural resource curse: a survey of diagnosis and some prescriptions, in R. Arezki, C. Pattillo, M.Quintyn and M. Zhu (eds.), Commodity Price Volatility and Inclusive Growth in Low-Income Countries, International Monetary Fund, Washington, D.C.

Ploeg, F. van der (2011). Natural resources: curse or blessing?, Journal of Economic Literature, 49, 2, 366-420.

Ploeg, F. van der (2016). Macroeconomic policy responses to natural resource windfalls and the crash in commodity prices, CEPR Discussion Paper 11520.

Ploeg, F. van der and A.J. Venables (2012), Natural resource wealth: the challenge of managing a windfall, Annual Reviews in Economics, 4, 315-337.

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Topics:  Development

Tags:  consumption, Dutch disease, natural resource curse, permanent income hypothesis

Professor of Economics and Research Director of OxCarre, University of Oxford

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