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Energy Economies – III Jeffrey Frankel Harpel Professor, Harvard University ADA Summer School, Baku, Azerbaijan 7-9 July , 2010 Waysto Avoid the Natural Resource Curse Development in Political Resource-Rich Countries: Oil & Democracy Institutions & Policies to Address the Natural Resource Curse A wide variety of measures have been tried to cope with the commodity cycle.  Some work better than others.  E.g., Davis, et al (2003) and Sachs (2007). Policies/Institutions to Deal with the NRC I. Attempts to deal with volatility 1. Unsuccessful attempts to reduce volatility 2. 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. 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 Lesson: Accept the existence of volatility, and adopt institutions to cope with it 3 Devices to share risk efficiently 1. For energy producers who sign contracts with foreign companies. 2. For producers who sell their oil themselves. 3. For debtors dependent on oil revenues. 1. Price setting in contracts with foreign companies Price setting in contracts between energy producers and foreign 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 then 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, such as interruptions in the export flow. 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. 2. Hedging in commodity futures markets Producers who sell their oil on international spot markets, are exposed to the risk that the $/barrel oil 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. 3. Denomination of debt in terms of oil An oil-producer should index its debt to the oil price. (such borrowers as Iran, Nigeria, & Russia). So debt service obligations automatically rise & fall with the world oil price. Debt crises hit Mexico in 1982 and Indonesia, 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. 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 PEP 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. The main advantage of floating, for an oil producer: automatic accommodation to terms of trade shocks. During an oil boom, the currency tends to appreciate, thereby moderating what would otherwise be a danger of excessive capital inflows and overheating of the economy; and the reverse during an oil bust. A loose recommendation A balancing of these pros & cons, appropriate for many middle-size middle-income countries => an intermediate exchange rate regime such as managed floating. In the booming decade 2001-08, many followed the intermediate regime, in between a few commodity producers in the floating corner (Chile & Mexico) and a few in the firmly fixed corner (Gulf oil producers & Ecuador). 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. 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. 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. 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 PEP 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 is warranted. 1/A broad definition: Flexible inflation targeting ≡ ―Have a long run target for inflation, and be transparent.‖ Then who could disagree? Professor Jeffrey Frankel The shocks of 2007-2010 have shown 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. Professor Jeffrey Frankel Proposal to Peg the Export Price PEP Intended for countries with volatile terms of trade, e.g., those specialized oil. PEP proposal in its pure form: The authorities peg the currency to oil rather than to the $ or € or gold or CPI. The regime combines the best of both worlds: (i) The advantage of automatic accommodation to terms of trade shocks, together with (ii) the advantages of a nominal anchor. Professor Jeffrey Frankel III. Make National Saving Procyclical Hartwick rule: rents from oil 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. Oil 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). Chile’s fiscal institutions Chile’s fiscal policy is governed by a set of rules. 1st rule: Target for the budget deficit = 0. 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. Chile’s fiscal institutions, continued 3rd rule: two panels of experts have the job, each mid-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 was indeed temporary. 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 2008-09, when the stimulus was most sorely needed. Other fiscal institutions Commodity funds or Sovereign Wealth Funds Reducing net inflows during booms Lump sum distribution IV. Efforts to Impose External Checks The Chad experiment The Extractive Industries Transparency Initiative: ―Publish What You Pay‖ More drastic solutions 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.‖ 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. 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. 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.  Well-intentioned politicians may spend oil 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.  Humphreys & Sandhu (2007, p. 224-27). When Kuwait was occupied by Iraq, access to Kuwaiti bank accounts in London stayed with the Kuwaitis. Summary: 10 recommendations for oil producing countries Devices to share risks 1. In contracts with foreign companies, partially index the price to the world oil price. 2. Hedge oil revenues in commodity futures markets 3. Denominate debt in terms of oil prices Summary: 10 recommendations for oil producers, continued Macroeconomic policy 4. Allow some currency appreciation in response to a rise in world oil prices, but also add 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., PEP). 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. Summary: 10 recommendations for oil producing countries, continued Anti-corruption institutions 7. Run Commodity Funds transparently and professionally. 8. Consider lump-sum distribution of oil wealth, equal per capita. 9. Publish What You Pay 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. Addendum: Elaboration on exchange rate regimes for oil exporters including the PEP & PPT proposals 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 6 proposed nominal targets and the Achilles heel of each: Targeted Vulnerability Example variable Monetarist rule M1 Velocity shocks US 1982 CPI Import price Oil shocks of Inflation targeting shocks 1973-80, 2000-08 Nominal income Nominal Measurement Less developed targeting GDP problems countries Price Vagaries of world 1849 boom; Gold standard of gold gold market 1873-96 bust Price of agric. Shocks in Commodity Oil shocks of & mineral imported standard 1973-80, 2000-08 basket commodity Fixed $ Appreciation of $ 1995-2001 exchange rate (or €) (or € ) Professor Jeffrey Frankel A more moderate version: PPT Product Price Targeting Target an index of domestic production prices.  The important point is to include oil in the index and exclude import commodities, whereas the CPI does it the other way around.  Frankel (2009). Professor Jeffrey Frankel Political Development in Resource-Rich Countries Oil and Democracy Middle Eastern governments’ access to oil revenue rents may have freed them from the need for taxation of their peoples, which in turn freed them from the need for democracy. Oil and Democracy, continued Tax revenue requires democracy under the theory ―no taxation without representation.‖ Mahdavy (1970) was apparently the first — followed by Luciani (1987), Vandewalle (1998) & many others. Huntington (1991) generalized the principle beyond Middle Eastern oil producers to states with natural resources in other parts of the developing world. Econometric findings Statistical studies across large cross-sections of countries find that economic dependence on oil and mineral is correlated with authoritarian government: Ross (2001), Barro (2000), Wantchekon (2002), Jenson & Wantchekon (2004), and Ross (2006). Some find that authoritarian regimes have lasted longer in countries with oil wealth. Smith (2004, 2007), Ulfelder (2007). Counter-arguments Karl (1997): Venezuela was already authoritarian when oil was developed, and in fact transitioned to democracy at the height of its oil wealth. None of the Central Asian states are democracies, even though Kazakhstan is the only one with major oil production. Haber & Menaldo (2009) do not find in historical time series data the statistically significant link from oil to democracy that is typical of cross-section and panel studies. Noland (2008) claims that oil rents are not a robust factor behind lack of democracy in Middle Eastern countries. Similarly, Dunning (2008) for Latin America (with fixed effects).  Loss of statistical power in pure cointegration time series tests may explain this. Democracy, growth, & causality The question whether oil dependence tends to retard democracy should probably not be regarded as a component of the causal relation between oil and economic performance. Some correlates of democracy – rule of law, political stability, openness to international trade, initial equality of economic endowments and opportunities – do tend to be good for economic growth. But each of these other variables can also exist without democracy. The evidence is much clearer that economic growth leads to democracy than the other way around Econometrics: Helliwell (1994), Huber, Rueschemeyer & Stephens (1993), Lipset (1994) and Minier (1998). Economic growth leads to democracy Examples include Asian economies such as Korea or Taiwan. Some believe that Lee Kwan Yew in Singapore and Augusto Pinochet in Chile could not have achieved their economic reforms without authoritarian powers the one certainly more moderate & benevolent than the other. Why has China has grown so much faster than Russia since 1985? Some answer: because Deng Xiao Peng chose to pursue economic reform before political reform while Mikhail Gorbachev did it the other way around. Does democracy lead to growth? The statistical evidence is at best mixed as to whether democracy per se is good for economic performance. Barro (1996) finds that it is the rule of law, free markets, education, & small government consumption that are good for growth, not democracy per se. Tavares & Wacziarg (2001) find that it is education, not democracy per se. Alesina, et al, (1996) find that it is political stability. The combination of development + weak institutions + oil Bhattacharyya & Hodler (2009) find that natural resource rents lead to corruption, but only in the absence of high-quality democratic institutions. Collier & Hoeffler (2009) find that when developing countries have democracies, as opposed to advanced countries, they tend to feature weak checks and balances; thus, when developing countries also have high natural resource rents the result is bad for economic growth. Democracy is an end in itself, aside from whether it promotes economic growth. Even here, one must note that the benefits of the formalities of elections can be over-emphasized. For one thing, elections can be a sham. Robert Mugabe, Hamid Karzai, & George W. Bush each claimed to have been elected, without having in fact earned more votes than their opponents. Western style or one-man one-vote elections should probably receive less priority in developing countries than the fundamental principles of rule of law, human rights, freedom of expression, economic freedom, minority rights, and some form of popular representation. Zakaria (1997, 2004).
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