Coping with Volatility:Monetary & Exchange Rate

Policies for Commodity-Exporting

Countries like Kazakhstan

Jeffrey FrankelHarpel Professor of Capital Formation & Growth

July 15, 2013

2

Oil prices & minerals prices have been especially volatile over the last decade – and

correlated.

Source: UNCTAD

3

Commodity exporters face extra volatility

in their terms of trade

Choices of macroeconomic policies & institutions can help manage the volatility.

Too often, historically, they have exacerbated it:

Pro-cyclical macroeconomics (i) capital flows, money, credit; (ii) currency policy; relative price of nontraded

goods; and (iii) fiscal policy.

4

(i) Pro-cyclical capital flows According to inter-temporal optimization theory,

capital flows should be counter-cyclical: flowing in when exports do badly and flowing out when exports do well.

In practice, it does not always work this way. Capital flows are more pro-cyclical than counter-cyclical. Gavin, Hausmann, Perotti & Talvi (1996);

Kaminsky, Reinhart & Vegh (2005); Reinhart & Reinhart (2009); and Mendoza & Terrones (2008).

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(ii) Pro-cyclical monetary policy

If the exchange rate is fixed, surpluses during commodity booms can lead

to: Rising reserves Excessive money & credit Excess demand for goods; overheating Inflation Asset bubbles, incl. land.

6

Macro effects of commodity boom

Inflation shows up especially in non-traded goods & services, like construction.

7

Pro-cyclical real exchange rateCountries undergoing a commodity boom

experience real appreciation of their currency

The resulting shift of land, labor & capital out of manufacturing, and into the booming commodity sector might be appropriate & inevitable,

to the extent it is expandable, especially if the commodity boom is permanent.

But the shift out of manufacturing into NTGs is often an undesirable macroeconomic side effect –

the “disease” part of Dutch Disease.

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1. How can a country avoid pro-cyclical money: excessive credit creation & inflation in a commodity

boom, deflation & balance of payments crisis in a bust ? Allow some currency flexibility

though not a free float.

2. Nominal anchor for monetary policy: What is it to be, if not the exchange rate? CPI?

Two questions for the monetary regime

1) Pros & cons of exchange rate flexibility

for oil-exporters, in particular

9

Advantages of more stable exchange rate: Lower forex risk & transactions costs

facilitate international trade & capital flows --

especially important if country is small & open to trade.

Exchange rate provides a nominal anchor for monetary policy, reducing inflation expectations --

especially important if country has history of high inflation

e.g., Kazakhstan (1991-95) or even hyperinflation (1992-93).

Pros & cons of exchange rate flexibility, continued

10

Advantages of more flexible exchange rate Autonomy of monetary policy --

especially important if country has idiosyncratic shocks

& low labor mobility.

Automatic accommodation of trade shocks --

especially important for commodity-exporting countries.

Other factors to be considered in conjunction with fixed versus floating

exchange rate choice Intermediate exchange rate regimes

Band-basket-crawl Managed float

Intervention and sterilization Capital controls Denomination of foreign debt

Currency mismatch from foreign denomination (original sin)

The move away from foreign-denominated debt. Bank accounts denominated in foreign

currency.11

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The challenge of designing a monetary regime when terms of trade shocks dominate the cycle

Fixing the exchange rateleads to pro-cyclical monetary policy: Money flows in during commodity booms.

Excessive credit creation can lead to inflation. Example: Saudi Arabia & UAE during the 2003-08 oil

boom.

Money flows out during commodity busts. Credit squeeze can lead to excess supply,

recession & balance of payments crisis. Example: Oil exporters in 1980s (Mexico) or 1997-98

(Russia).

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Currency regime, continued

Floating accommodates terms of trade shocks:

If terms of trade improve, currency automatically appreciates,

reducing excessive money inflows, credit, overheating, inflation, and real estate bubbles.

If terms of trade worsen, currency automatically depreciates,

preventing recession & balance of payments crisis.

Demand vs. supply shocks An 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).

One set of supply shocks: natural disasters

R.Ramcharan (2007) finds floating works better.

A common source of real shocks: trade.

Terms-of-trade variability

Prices of crude oil & mineral commodities hit record highs in 2008 & 2011.

=> Favorable terms of trade shocks for some (oil producers, Africa, Latin America, etc.);

=> Unfavorable terms of trade shock for others (oil importers such as Japan,

Korea). Textbook theory says a country where trade

shocks dominate should accommodate by floating.

Confirmed empirically: Developing countries facing terms of trade shocks

do better with flexible exchange rates than fixed exchange rates.

Broda (2004), Edwards & L.Yeyati (2005), Rafiq (2011), and Céspedes & Velasco (2012)…

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Constant term not reported.

(t-statistics in parentheses.)

** Statistically significant at 5% level.

Across 107 major commodity boom-bust cycles, output loss is bigger the bigger is the commodity price change & the smaller is exchange rate flexibility.

Céspedes & Velasco (Nov. 2012) NBER WP 18569 “Macroeconomic Performance During Commodity Price Booms & Busts”

The IMF recommends a more flexible exchange rate for the

tenge. “Looking ahead, there is scope

to allow greater exchange rate flexibility…” -- Article IV Consultation Concluding

Statement of the IMF Mission to Republic of Kazakhstan—2013, June 4, para. 7.

But, if the exchange rate were no longer the nominal anchor for Kazakh monetary policy, the IMF would then ask what is to take its place.

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Monetary regime

2) If the exchange rate is not to bethe monetary anchor, what is?

The popular choice of the last decade:Inflation Targeting. But CPI targeting can react

perversely to supply shocks & terms of trade shocks.

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Needed: Nominal anchors that accommodate the shocks that are common in developing

countries Supply shocks,

e.g., droughts, floods, hurricanes: => Target Nominal GDP.

Terms of trade shocks e.g., fall in price of commodity

export. => Target GDP deflator.

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Nominal GDP targetcancels out velocity shocks (vs. M target) & moderates effects of supply shocks

(vs. IT)

Real GDP

P Adverse AS shock

AS

AD

IT •••

Nom.GDP

target

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Does Nominal GDP target give best output/inflation trade-off?

Real GDP

PAdverse AS shock

AD

Nom.GDP

target

IT•

•It gives exactly the right answer if the simple Taylor Rule’s equal weights accurately capture what discretion would do. Even if not exact, the “true” objective function would have to put far more weight on P than output, or AS would have to be very steep, for the P rule to give a better outcome.

The revival of proposals for Nominal GDP Targeting in

2011-13 heard mostly in the context of advanced

economies UK, US, Japan… E.g. the new Bank of England Governor,

Mark Carney, is a fan.

But Nominal GDP Targeting in fact makes more sense for developing & commodity-exporting countries.

To clarify: set a target range at a 1-2-year horizon; not inconsistent with “Flexible Inflation Targeting,”

setting a longer-term target for inflation.

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Why does Nominal GDP Targeting make more sense for developing & commodity-

exporting countries than for advanced countries?

More supply shocks, such as adverse weather events.

More terms of trade shocks, such as rises in the price of

imports, & declines in the commodity export

price.23

Comparison of 3 alternative monetary regimes

Monetary

regime

Supply shock,

e.g. weather disaster

Terms of trade shocksFall in export price, e.g., oil

Rise in import price, e.g., cars

Exchange rate target

Trade balance ↓Output Y ↓Inflation ↑.

Trade balance ↓Output Y ↓

Trade balance ↓Inflation ↑

CPI target=> Exchange rate moves in wrong direction.

Money must tighten enough to appreciate currency.=> Worse TB ↓ &Y

↓

Depreciation is limited because it would raise import prices, which have more weight than oil in the CPI.

Currency appreciates to prevent consumer prices from rising.=> Worse TB ↓ & Y

↓

Nominal GDP target

=> Exchange rate moves in right direction.

Currency depreciates.Helps TB &Y.Adverse effects shared between P & Y, rather than all Y.

Currency

depreciates.Helps TB &Y ,prevents recession.

No appreciation.

Exchange rate here accommodates terms of trade, the opposite of under a CPI target.

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Steps in an evaluationof Nominal GDP Targeting (vs. IT)

1. How wide would announced band have to be so that the outcome usually fell within it?

2. What about subsequent revisions in Nominal GDP statistics?

3. Are supply shocks big enough, and is the AS curve steep enough, for Nominal GDP targeting to be better than price targeting?

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What Kazakh data are needed for the analysis?

1. I have historical data, for Kazakhstan 1991-2012,

Nominal GDP, real GDP, deflator, & CPI, and some year-ahead forecasts of each:

estimated from the time series by an ARIMA process, or Private forecasts from Consensus Economics (for real GDP & CPI).

2. Ideally I would get real-time revisions for each --

preliminary estimates, revised, & final;3. And data on exogenous supply shocks, if

possible: adverse weather events?

26

year Actual Kazakhstan RGDP growth rates (WDI)

Consensus EconomicsKazakhstan RGDP forecast

1998 -1.9 31999 2.7 3.72000 9.8 1.82001 13.5 3.72002 9.8 5.12003 9.3 6.62004 9.6 72005 9.7 8.62006 10.7 8.32007 8.9 8.12008 3.3 92009 1.2 7.32010 7.3 3.42011 7.5 4.52012   6.2

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Variable (growth

rates p.a.)Variance St dev

Mean of actual rate

68% Confidence Interval

Lower Upper

NGDP 2.29% 15.12% 19.10% 3.98% 34.22%RGDP 0.20% 4.43% 6.46% 2.03% 10.89%

Deflator 1.85% 13.58% 12.64% -0.95% 26.22%CPI 0.21% 4.59% 8.65% 4.06% 13.24%

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 Covar (RGDP,Deflator) = 0.114 %

How wide would 1-standard-deviation band have to be, encompassing 2/3 of nominal GDP realizations around

target?

29

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

68% CI Band for Actual NGDP rate Vs Forecast rates

ln_ngdprate lnf_ngdprate lowerci_ngdp upperci_ngdp

The confidence interval would be narrower if the central bank

can influence demand (within one-year horizon).

How wide would 1-standard-deviation band have to be?

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-0.3-0.2-0.1

-1.66533453693773E-160.0999999999999998

0.20.30.40.50.6

Nominal GDP growth rates ARIMA-Forecast vs actual

with 68% CI Band around ARIMA Forecast

ln_ngdprate lnf_ngdpratelowercif_ngdp uppercif_ngdp

30

References by the author Project Syndicate,

“Escaping the Oil Curse,” Dec.9, 2011. "Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility,"  Oct.17, 2011. 

“The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,” 2012, Commodity Price Volatility and Inclusive Growth in Low-Income Countries , R.Arezki et al., eds. (IMF); HKS RWP12-014. 

“How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” 2011, in Natural Resources, Finance & Development. R.Arezki, T.Gylfason & A.Sy, eds. (IMF).

 "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review XI, 1, 2012 (Monetary Authority of Singapore).

“A Comparison of Product Price Targeting and Other Monetary Anchor

Options, for Commodity-Exporters in Latin America," Economia, 2011. NBER WP 16362.  "

UAE & Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil,“ Vox, 9 July, 2008.

“On the Tenge: Monetary and Exchange Rate Policy for Kazakhstan,” Short-term Consultancy, Republic of Kazakhstan, 2005. (Russian translation, ADB, 2009.) In Growth & Competitiveness in Kazakhstan (Center for International Development): 23-42.

"Experience of and Lessons from Exchange Rate Regimes in Emerging Economies," in Monetary and Financial Integration in East Asia: The Way Ahead, edited by Asian Development Bank, 2004 (Palgrave Macmillan), v91-138.

http://www.hks.harvard.edu/fs/jfrankel/

Appendix: Nominal GDP statistics

Kazakhstan Nominal GDP, quarterly

 GDP 2000-2012 quarterly (at current prices, mln. tenge)

  2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

1 quarter 524,139.10 634,620.20 746,291.90 949,576.70 1,270,741.80 1,650,148.60 2,040,947.90 2,536,234.90 3,207,244.40 3,055,263.80 4,020,878.40 5,306,250.20 5,976,722.50

2 quarter 590,711.60 798,324.00 919,581.30 1,060,280.90 1,380,820.50 1,783,707.40 2,363,805.00 3,059,192.60 3,988,726.10 3,654,517.10 4,691,265.70 5,623,135.60 6,559,138.30

3 quarter 778,203.10 975,151.40 1,094,634.70 1,331,640.40 1,646,303.20 2,009,652.10 2,648,602.60 3,400,454.50 4,607,610.40 4,511,118.60 5,423,084.00 7,243,951.70 7,842,365.80

4 quarter 706,847.80 842,497.70 1,015,769.30 1,270,477.30 1,572,268.80 2,147,085.40 3,160,375.70 3,853,912.00 4,249,338.30 5,786,747.50 7,680,288.90 9,398,551.50 9,840,317.70

annual 2,599,901.60 3,250,593.30 3,776,277.20 4,611,975.30 5,870,134.30 7,590,593.50 10,213,731. 12,849,794. 16,052,919. 17,007,647. 21,815,517. 27,571,889. 30,218,544.

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Year GDP (constant 2005 US$, m GDP (current US$, m GDP deflator (2000 = 100) CPI index (2005 = 100)

1990 50,243 26,933 0.001991 44,716 24,881 0.001992 42,346 24,907 0.081993 38,450 23,409 1.03 0.611994 33,605 21,251 16.91 12.021995 30,850 20,374 44.11 33.201996 31,004 21,035 61.26 46.211997 31,531 22,166 71.15 54.251998 30,932 22,135 75.18 58.131999 31,767 16,871 85.16 62.952000 34,880 18,292 100.00 71.252001 39,589 22,153 110.16 77.202002 43,469 24,637 116.55 81.712003 47,512 30,834 130.23 86.972004 52,073 43,152 151.24 92.952005 57,124 57,124 178.27 100.002006 63,236 81,004 216.69 108.592007 68,864 104,850 250.34 120.282008 71,136 133,442 302.75 140.922009 71,990 115,309 316.95 151.212010 77,245 148,052 378.89 161.972011 83,039 188,050 445.46 175.492012 87,191 201,680 462.73 184.4732

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How wide would 1-standard-deviation bandfor real GDP growth have to be?

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-0.1

-0.05

0

0.05

0.1

0.15

0.2

Forecast Vs Actual of RGDP rates 68% CI Band around ARIMA Forecast

ln_rgdprate lnf_rgdpratelowercif_rgdp uppercif_rgdp

How wide would 1-standard-deviation bandfor real GDP growth have to be?

34

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-0.3

-0.2

-0.1

-1.66533453693773E-16

0.0999999999999998

0.2

0.3

0.4

0.5

ARIMA Forecast Vs Actual Deflator rateswith 68% CI Band around Forecast

ln_deflrate lnf_deflrate lowercif_defluppercif_defl

351997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-0.0499999999999998

1.80411241501588E-16

0.0500000000000002

0.1

0.15

0.2

0.25

0.3

ARIMA Forecast Vs Actual CPI Inflation 68% CI Band around Forecast

ln_cpirate lnf_cpirate lowercif_cpiuppercif_cpi

How wide would 1-standard-deviation bandfor CPI inflation have to be?

36

How wide would 1-standard-deviation bandfor nominal GDP have to be?

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-0.0499999999999998

1.80411241501588E-16

0.0500000000000002

0.1

0.15

0.2

0.25

0.3

Consensus Forecast Vs Actual Nominal GDP 68% CI Band around 2-year-ahead forecast

ln_ngdprate lnf_ngdpratelowerci_ngdp upperci_ngdp

37

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-0.05

0.00

0.05

0.10

0.15

0.20

0.25

0.30

Consensus Forecast Vs Actual Nominal GDP 68% CI Band around 1-year-ahead forecast

ln_ngdprate lnf_ngdprate lowercif_ngdpuppercif_ngdp

How wide would 1-standard-deviation bandfor nominal GDP have to be?

38

How wide would 1-standard-deviation bandfor real GDP growth have to be?

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-0.1

-0.05

0

0.05

0.1

0.15Consensus Forecast Vs Actual RGDP growth68% CI Band around 1-year ahead forecast

ln_rgdprate lnf_rgdprate lowercif_rgdp

39

How wide would 1-standard-deviation bandfor GDP deflator have to be?

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

00.020.040.060.080.1

0.120.140.160.180.2

Consensus Forecast Vs Actual GDP Deflator with 68% CI Band around 1-year ahead forecast

ln_deflrate lnf_deflratelowercif_defl uppercif_defl