Since the turn of the century, countries that specialise in oil, minerals, and agricultural commodities have been hit by especially high volatility in world prices for their exports. Big price upswings (2004-08 and 2010-12) have alternated with reversals (2008-09, 2014-16). Financial markets have in practice done little if anything to moderate the impact on the exporting countries (Kaminsky et al. 2005).
Various ideas for policies and institutions have been proposed for commodity-exporters with the hope of making them less vulnerable to such price volatility. Some of the ideas have been more successful than others, while some have not been tried at all.
Four proposals seem particularly promising (Frankel 2017). They concern, respectively: options, commodity bonds, official fiscal forecasting, and pegging to a basket that includes commodities along with currencies. Of the four ideas, the first two are attempts at appropriate financial engineering and the latter two are attempts at countercyclical macroeconomic policy. One in each category is tried and tested; the other two have hardly been tried.
(1) Exporting countries can use option contracts to hedge against short-term declines in the commodity price without giving up the upside.
Mexico annually buys contracts for put options on a large scale to protect itself against a decline in the dollar price of oil (Duclaud and García 2012). This strategy proved especially useful when global commodity prices fell abruptly in 2009 and again in 2014-15.
Why not use the futures or forward market? The futures strategy has a major potential drawback, which might be described as an incentive compatibility problem. The minister who sells the commodity forward is likely to get meagre credit if the dollar price of the commodity subsequently goes down, but lots of blame if the price goes up. Better to use options to eliminate the downside risk while keeping the upside potential.
A limitation in practice for options contracts, as for forwards, is that they are not readily available for most commodities at the long-term horizons needed to finance development of new resources or to hedge possession of existing resources. This observation leads to proposal Number 2.
(2) Commodity-indexed bonds can hedge longer-term risk, and often have a natural ultimate counter-party in multinational corporations that depend on the commodity as an input.
Consider a commodity-exporting country that borrows, for example, a West African country that is developing new mineral deposits, a Gulf country that issues new bonds to fund a budget deficit, or a South American country that needs to restructure old debt. The government should specify the terms of the loan, not in terms of dollars or the local currency, but in terms of the export commodity itself. The principal and interest payments are indexed to the global price of the commodity. Then debt service obligations are matched to revenues: they automatically rise and fall with the value of the exports. One reason that debt crises hit Ecuador, Ghana, Nigeria, and Venezuela in 2015 was that low dollar prices of their oil exports had driven up their debt service ratios. This would not have happened if their debts had been indexed to the oil price.
The indexation idea has been around for a long time (e.g. Attah-Mensah 2004, Frankel 2011, and others before), but it has seldom been put into practice. Potential issuers worry that there is not enough demand for such commodity bonds. Who would want to take the other side of the trade, they ask? There is a good answer to the question. Airlines and power utility companies have reason to go long in oil, steelmakers have reason to go long in iron ore, chocolate makers to go long in cocoa, and so on. They are the natural ultimate potential customers.
(3) The pro-cyclicality of fiscal policy among commodity exporters can be reduced by insulating official forecasters against optimism bias.
Next, we consider two proposed institutional changes that aim to make fiscal and monetary policy automatically more counter-cyclical. They would attempt to combat an historical tendency toward macroeconomic procyclicality among commodity-exporting countries.
Fiscal policy has historically been notoriously pro-cyclical among commodity exporters. Governments cannot resist the temptation or political pressure to increase spending excessively in booms, as if the boom will last forever. Then they are forced to cut back when commodity prices go back down. Many authors have documented this pro-cyclicality.
It is not enough to observe that policymakers should follow wiser policies. What is wanted are institutions that make it more likely that fiscal policy will be counter-cyclical, or at least less pro-cyclical, even when carried out by officials who suffer from the common political and human frailties. Some commodity-exporting developing countries managed after 2000 to overcome their historical pattern of pro-cyclicality. They achieved fiscal counter-cyclicality, taking advantage of the 2002-08 expansion to strengthen their budget balances, which then gave them the ‘fiscal space’ to ease up when the global recession hit in 2009. Which countries managed this achievement? Generally those with ‘good institutions’, defined broadly by such characteristics as the rule of law (Frankel et al. 2013, Céspedes and Velasco 2014).
What institutional innovations, more specifically, can a country adopt to fight fiscal pro-cyclicality? The conventional answer is budget rules, for example legally entrenched ceilings on budget deficits. But such rules alone won’t do the job. Most of them are violated in practice, even more so for emerging market countries than for advanced countries. One major reason is forecasts by official agencies that are overly optimistic toward the cyclical peak.
A study of Chile’s successful fiscal institutions concluded that the key feature was not by itself the adoption of targets for cyclically adjusted budget balance (Frankel 2013). Others have tried this and failed. It was, rather, the delegation to independent committees of the responsibility to estimate the long-run trends in the copper price and GDP. This delegation avoided the systematic over-optimism that plagues official forecasts in most other countries and helps explain how Chile achieved a counter-cyclical fiscal policy.
(4) To make monetary policy automatically more counter-cyclical, peggers can add the export commodity to a currency basket (a ‘currency-plus-commodity basket’).
Commodity-exporting countries have bigger terms-of-trade shocks than industrialised countries. Terms-of-trade volatility makes a country less suited to a currency peg and more suited to a flexible exchange rate regime that allows the exchange rate to accommodate terms of trade shocks.
A fixed exchange rate can render monetary policy pro-cyclical – commodity booms are associated with money inflows, rapid credit expansion, an overheated real economy, inflation in non-traded goods and services, and bubbles in real estate and other assets. Conversely, commodity busts are associated with balance of payments deficits, loss of reserves, credit shortage, recession, and currency or financial crises. Flexible exchange rates allow accommodation of trade shocks and, therefore, a counter-cyclical monetary policy (e.g. Céspedes and Velasco 2012). Under free floating, when the global price of the export commodity rises, threatening overheating, the currency automatically appreciates to mitigate the problem. When the global price of the export commodity falls, threatening external balance difficulties and recession, the currency automatically depreciates to mitigate those problems.
On the other hand, a currency peg has its own advantages. It offers day-to-day transparency and predictability and an anchor to make credible the central bank’s promises of price stability. If the exchange rate is not to be the anchor for monetary policy, what is?
Consider an alternative exchange rate regime, which I call a ‘currency-plus-commodity basket’ (CCB). It is particularly relevant for countries like Kuwait that currently target a basket of major currencies such as the dollar and euro. The CCB proposal is to add the export commodity to the currency basket. If the Kuwaiti dinar were pegged to a basket that gave one-third weight to the dollar, one-third to the euro, and one third to oil, the value of the currency would again automatically move up and down with the value of a barrel of oil. Among Gulf countries, swings in external balance and in internal balance during 2001-16 can be attributed to the inability of their exchange rate to adjust to the ups and downs in oil prices in a way that the CCB proposal would have delivered automatically (Frankel 2018).
The argument in favour of CCB, for a commodity-exporting country, is that it delivers the best of floating together with the best of fixed rates: automatic accommodation of trade shocks, together with a stable and transparent anchor.