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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. [1]
   Some work better than others.

    [1] 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.            [1]

   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.
        [1] 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.           [1]



The important point is to include oil in the index
  and exclude import commodities, whereas
  the CPI does it the other way around.

[1] 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.[1]
   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).

[1] 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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