Which Nominal Anchor for Commodity Exporting Countries?

One of the big economic challenges facing major commodity exporters (mainly small developing countries) is the management of risks from random fluctuations in their export prices. Usually these prices are denominated in one of the major currencies, such as the US dollar and the Euro, and so frequent movements in exchange rates alone (such as the depreciation of the dollar against the Euro seen in recent years) can also be problematic.

In CEPR Policy Insight No. 25, Jeffrey Frankel (Harvard Uni.) proposes a solution: pegging the domestic currency only to the export price. For e.g., for a gold exporting country, the proposal would be that, when the dollar price of gold increases in the world market, the domestic currency should appreciate against the dollar (that is, monetary policy should be tighter) and vice versa. Commodities may be viewed as assets (like physical capital), thus in a sense, Frankel favors monetary policy that responds to asset prices, an issue that is still under debate in the academic and policy arenas. Moreover, the proposal is in sharp contrast to the strategy of inflation targeting (IT) adopted by many advanced and emerging-market economies. As a nominal anchor, IT involves setting an inflation target based on the consumer price index (one component of which is import prices). For a defense of the IT strategy, see Lars Svensson's (Princeton Uni.) comment on Frankel's proposal.

Is There a Recipe for Growth and Development?

According to the report by the Commission on Growth and Development (aka the Spence report), there is no single recipe for all countries. This conclusion is in mark contrast to what Dani Rodrick calls the "old" Washington Consensus---liberalisation, deregulation, privatization, and free markets.

But what can developing countries make of the Spence report? Perhaps not much. The report does not provide any novel solutions apart from iterating that each country should find out its mix of ingredients for development. However, the Spence report will surely tilt the balance in the intellectual battle within the development profession, as well as lower the leverage of World Bank/IMF on future development strategies and policies of developing countries.

Should Countries be Like Open Clubs?

Should existing residents of a country have a right to control who joins them or should countries be like open clubs? Martin Wolf, a columnist, and Willem Buiter, a blogger, both from the Financial Times, present two opposing views, raising both positive and normative issues related to immigration policy. Although prompted by a recent report of the House of Lords select committee on Economic Affairs on the impact of immigration on the UK economy, their discussion is broad enough to be of interest to any reader.

On Food Prices and Food Aid

Do poor developing countries benefit from low or high food prices? The answer depends on who is buying and who is selling. Years back when food prices where low, farmers from poor countries were the losers while non-farmers (e.g. city dwellers) were the gainers. The recent increases in food prices will likely have the opposite effect. In any case, in aggregate, these countries are still dependent on food aid. A column from the March 29th issue of The Economist discusses the issue of famine and food aid amid the hiking of food prices all over the world. The column focuses on supply of food and its distribution. However, equally important is the fact that the recent improvements in the balance of payments from soaring prices of commodities, such as oil and metals, have boosted incomes of commodity exporters, which are mainly poor developing countries. Certainly, the higher income from commodities will increase their importing power and lower the need for food aid.

On Gender-based Taxation

What is the economic rationale for taxing incomes of women less than those of men? Does it improves overall welfare or is it just an income redistribution scheme? For an overview of the arguments for and against gender-based taxation, visit the Vox forum; see, in particular, the opposing views contained in the recent articles by Alberto Alesina (and his co-authors) and Gilles Saint-Paul.

Avoiding the Resource Curse

In few years from now, Eritrea will probably become an exporter of mineral resources such as gold and copper. In light of this development, it is appropriate to discuss about the prospects and challenges for an economy that will likely depend heavily on resource revenues.

The discovery of natural resources represents an addition to the wealth of a nation and should normally be welcomed. So why should one worry about it? Well, as experience of resource-rich countries shows, resource abundance may not always be good news. To be specific, on average an abundance of natural resources tends to slowdown overall economic growth, a phenomenon referred to as the "resource curse," and even worsen income inequality.

One obvious cause of resource curse is mismanagement by resource owners (usually governments). Another is that, with the discovery of natural resources, some of the productive inputs (labor and capital) are shifted away from the manufacturing sector, which is the source of long-term growth. Moreover, higher mineral wealth leads to an appreciation of the real exchange rate, which in turn hurts export competitiveness of the economy (so called Dutch disease). Add to these the fact that prices of natural resources are highly volatile with substantial uncertainties about export revenues.

To begin with, mineral wealth represents a collective windfall for a nation's citizens, in some way analogous to an individual winning a lottery worth millions of Nakfa. Naturally, we would expect the individual to spend part of it for current consumption and save the rest. But that is where the analogy ends because collective ownership of natural resources involves solving problems much more complex than those facing an individual.

Of course, Eritrea can avoid the resource curse by taking appropriate measures and learning from success stories such as Norway. One of these measures involves the creation and management of a national fund.

Creation of a national fund: a commitment by the people and the government to create a national fund for saving and investing part of the resource income. In particular, this requires goodwill on the part of the government backed by specific actions.

Independence: setting up an independent professional body for managing the fund. This would prevent misuse of the fund for political purposes and ensures the growth and sustainability of the fund. For example, Norway followed this path by letting its central bank, which is independent by law, manage its "Petroleum Fund." Central banks are the natural choice because they are the authorities responsible for managing reserves of gold and foreign exchange and therefore they have the necessary expertise.

Diversification: the fund is diversified across asset classes and geographical regions, ensuring a balanced risk-return profile. There maybe a temptation for actively managing the fund, that is, frequently moving funds in and out of certain categories of stocks or bonds. However, active management should not be a priority as it relies on speculation and can result in large capital losses.

Intergenerational equity: although the fund should help insulate the economy from unexpected shocks in the short-run, fund managers should take a long-term perspective in order to ensure the equitable distribution of wealth across generations. Intergenerational equity can also be the rationale for limiting active management of the fund.

The Invasion of GM Food

Recent increases in demand for food products across the world, accompanied by a surge in food price inflation, is likely to lead to further growth in the supply of genetically modified (GM) food. In fact, the move towards GM food is already taking hold in many countries. Currently, countries such as America, Argentina, Brazil, India and China are dominating the global supply of GM food (see The Economist). Continent wise, Europe and Africa are still not keen in joining the wagon, but they will if the current trend of strong growth in food demand continues, putting pressure on conventional method of agriculture.

In principle, genetic engineering of crops so that they become resistant to, say, pesticides and extreme weather conditions (such as drought) should be welcome. However, when one scratches the surface, the underlying issue is more complicated. The main reasons are related to health and environmental consequences of GM food production (see, for instance, greenpeace and the interview with the director of the film The Future of Food (2004)).

Ultimately, the success of GM foods will depend on market demand, provided that consumers are aware of GM foods and that they can easily identify GM food labels from supermarket shelves.

The IMF and Fiscal Policy: Back to the Keynesian Solution?

The IMF's long-standing position on fiscal policy austerity, especially in its dealings with countries facing financial or balance-of-payments crisis (up until recently, mainly developing and emerging countries), is well known. However, in a recent commentary, the fund's managing director, Dominique Strauss-Kahn, gave his blessings for fiscal stimulus to ward off the risks of a global economic slowdown due to financial-market turmoil that originated in the US housing market in summer 2007.

While Mr. Strauss-Kahn directed his commentary to developed countries and emerging economies, he did not say a word on how a fiscal package could or could not work in developing countries. Clearly, developing countries are not immune to the problem facing the rest of the world. Rather, as strong global growth over the past few years has helped them earn higher export revenues, any risk of a global slowdown will have the opposite effect. Thus, developing countries face the same sort of policy dilemmas as anyone else.

Actually, the argument for fiscal support rests on the apparent weakness of monetary policy to prop up domestic demand. The reason is that monetary policy is effective only when the banking system is well functioning, which, judging by the recent events, is not the case at the moment. Due to heightened uncertainty about risk exposures, banks are reluctant to lend as much as one would like them to. By this standard, the problem for monetary authorities in developing countries is even be worse because their financial markets are underdeveloped, making monetary policy ineffective as a tool for demand management. The case for using fiscal policy to support their economies is, therefore, stronger than that in developed countries.

What's Special About the Middle Class?

The belief that the middle class matters for economic growth because of its entrepreneurial spirit goes as far back as John Stuart Mill, who said “The virtues of a middle class are those which conduce to getting rich—integrity, economy, and enterprise.” (quote is from The Economist)

However, using household surveys in 13 developing countries, Abhijit Banerjee and Esther Duflo of the Massachusetts Institute of Technology, USA, find little evidence to back the belief (see the paper). The authors analyze the pattern of consumption and investment by the middle class, which they define as those whose daily consumption per capita is between $2 and $10 in 1993 purchasing power parity (that is allowing for cross-country differences in price levels). They conclude that people in the middle class are more likely to prefer a steady well-paying job to running their own business. On family and spending patterns, the authors find that middle class families have fewer children, and spend much more on education and health.

What is equally important but missing from the study is what factors help or hinder the creation and sustainability of the middle class. For instance, the role of education and health in increasing labor productivity (human capital in general) and income, and therefore in the expansion of the middle class. Evidently, the lower class (the poor) in developing countries can not invest or consume as much they like by borrowing because of credit constraints. This is related to underdeveloped capital markets and not necessarily lack of entrepreneurship.

In any case, the notion that the middle class is more of a wage-earning class and less of an entrepreneur class has some merits; see Robert Reich's comment in the Financial Times: America's middle classes are no longer coping.

World Economic Forum 2008

As in previous years, participants at the World Economic Forum 2008 are discussing a wide range of economic and political issues. My favorite so far is the panel discussion on the increasing role of Sovereign Wealth Funds (SWFs) in global finance. As the name indicates, SWFs belong to governments and at present the main sources of SWFs are Asian and Middle East countries, whose economies are experiencing large balance-of-payments surpluses.

The rise of SWFs has attracted attention because, unlike traditional foreign reserves, which are typically invested in financial assets with low but safe returns (e.g. foreign government bonds, mainly the US treasuries), they are directly channeled to foreign private companies, in the form of equities and bonds. The argument in the panel discussion is between SWFs managers, who see themselves as purely profit driven (searching for higher rates of returns), and officials from the countries on the receiving end, who suspect the funds might as well be politicized in one way or another. Not surprisingly, there is a bit of truth in both positions.

In its issue of January 19th-25th, 2008, The Economist devoted its cover story to the Invasion of the sovereign-wealth funds.

Globalization, Inflation and Currency Pegs

In recent years headline inflation rates around the world have accelerated mainly due to double-digit increases in food and energy prices. On the other hand, core inflation, which excludes food and energy prices, has remained more or less stable. See The Economist.

The divergence in the headline and core inflation represents a terms-of-trade improvement for commodity-exporting countries, especially oil-exporters.

If globalization, and the accompanying expansion of trade between developed and developing countries, had contributed to the moderation of global inflation in the1990s and early 2000s, then it is also part of the equation in the recent surge of inflation around the world. There is a demand-pull aspect to the story, especially as developing countries' continued growth has driven the demands and prices for resources higher. On the other hand, the surge in inflation in the US comes at a time when its economy is facing a recession. Thus the possibility of a stagflation--a name for the uncomfortable combination of an economic slow down and higher inflation.

Countries who peg their currencies to the US dollar (such as the Gulf states) will be affected by higher US inflation and the declining exchange rate of dollar, since the peg forces their monetary policymakers to cut interest rates and expand domestic money supplies. Thats why, in a move to combat the inflationary effects of a weaker dollar, Kuwait has recently ended its dollar peg. However, for many least developed countries, including Eritrea, whose inflation rates are higher than that in the US, ending their dollar pegs would not help solve their problems.

Migration and Remittances

According to The Economist's special report on migration and remittances (January 5-11 issue), in 2006 Eritrea was the third biggest recipient of remittances in the world by percentage of GDP (around 37 percent).

The report argues that while remittances help augment incomes of poor countries, they are not a "cure-all". It is hard to disagree.

Interestingly, mobile phones have proved to be useful for requesting and transferring money. The mechanism is simple: A donor sends a text message with a code that a recipient uses to collect his/her money from a money transfer agency. Text messaging has become so popular that a friend or relative in need of help simply pleads "Send me a number!".

How Fit is Eritrea for Doing Business?

How easy is it to do business in Eritrea from the perspective of business regulations? The World Bank's latest report Doing Business 2008 gives an overview.

One observed pattern is that, while Eritrea does better than the regional average (taken as a benchmark) in terms of the direct financial costs involved in doing business, it does worse in terms of the number of paper work and the time needed to get things done, for instance, the time it takes to deliver goods to international customers.

Will Bisha be different from Tabakoto?

Eritrea has given mining license to Nevsun, reports mineweb. Previously mineweb reported

"Construction is expected to take two years with actual mining expected to commence in 2010. The feasibility study completed in Q4 2006 deems the project to be profitable throughout its entire mine life because of the low operational costs."

This upbeat assessment comes against the background of the loss-making Tabakoto mine in Mali that is also owned by Nevsun. Tabakoto's woes are attributed in part to unexpected increases in costs. Thus, one may wonder if anything has changed since Q4 2006, which might necessitate a reassessment of future costs and revenues of the Bisha project. Of course, this depends on accurate forecasts of future developments in world markets. What would be the likely path of capital costs in the period 2008-2010? And operational costs and commodity prices beyond 2010? All theses are affected by world-wide events, beyond the control of Eritrea's economy. For instance oil and commodity prices have increased in recent years due to strong demand from emerging markets, especially China and India, owing to their fast growing economies. The good thing is with modern financial engineering, it is possible to hedge inputs and outputs against price volatilities, if one wants to. Volatilities in the US dollar against other major currencies would probably not matter much, as long as imports of capital and materials for the project and mineral exports are all invoiced in dollar terms.