The Natural Resource Curse I: Pitfalls of Commodity Wealth Jeffrey Frankel Harpel Professor of Capital Formation

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The Natural Resource Curse IPitfalls of
Commodity WealthJeffrey FrankelHarpel
Professor of Capital Formation GrowthHarvard
University

• International Monetary Fund, April 26, 2011

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The Natural Resource Curse

• The NRC pertains especially to oil minerals,
  but sometimes to timber agricultural products
  too.
• Seminal references
• Auty (1990, 2001, 07, 09)
• Sachs Warner (1995, 2001)
• Other studies find a negative effect of oil in
  particular, on economic performance
• including Kaldor, Karl Said (2007) Ross
  (2001) Sala-i-Martin Subramanian (2003) and
  Smith (2004).
• Frankel, The Natural Resource Curse Survey,
• NBER Working Paper 15836, 2010.
• forthcoming in Export Perils,
• edited by B.Shaffer (U. of Pennsylvania Press
  2011)

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• Examples
• Conspicuously high in oil resources and low in
  growth Venezuela Gabon.
• Conspicuously high in growth and low in natural
  resources China other Asian countries.
• The overall relationship on average is slightly
  negative

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Growth falls with fuel mineral exports
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Are natural resources necessarily bad?
No, of course not.

• Commodity wealth need not necessarily lead to
  inferior economic or political development.
• Rather, it is a double-edged sword, with both
  benefits and dangers.
• It can be used for ill as easily as for good.
• The priority for any country should be on
  identifying ways to sidestep the pitfalls that
  have afflicted other mineral producers in the
  past, to find the path of success.

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• The goal is to enjoy the success of
• Chile, vs. Bolivia
• Botswana, vs. Congo
• Norway, vs. Sudan.
• The last section of my paper explores some of
  the policies institutional innovations that
  might help avoid the natural resource curse and
  achieve natural resource blessings instead.

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• How could abundance of commodity wealth be a
  curse?
• What is the mechanism
• for this counter-intuitive relationship?
• At least 7 channels have been suggested

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7 Possible Natural Resource Curse Channels

1. Downward price trend
2. Price volatility
3. Crowding-out manufacturing
4. Inhibited development of institutions
5. Unsustainably rapid depletion as a result of
   unenforceable property rights
6. Proclivity for armed conflict
7. The Dutch Disease

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The 7 NRC Channels Elaborated

1. World commodity price trend could be downward
   (Prebisch-Singer)
2. High volatility of oil prices could be
   problematic
3. Natural resources could be dead-end sectors
   (Matsuyama) they may crowd out manufacturing,
4. which may be the home of dynamic benefits
   spillovers.
5. Industrialization could be the essence of
   development.

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The 7 NRC Channels continued

• 4. Countries where physical command of mineral
  deposits by the government or a hereditary elite
  automatically confers wealth on the holders may
  be less likely to develop the institutions that
  are conducive to economic development
  (Engerman-Sokoloff ),
• e.g., rule of law decentralization of
  decision-making,
• as compared to countries where moderate taxation
  of a thriving market economy is the only way to
  finance government.

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The 7 NRC Channels continued

• 5. Non-renewable resources are depleted too fast,
• where it is difficult to enforce property
  rights,as under frontier conditions.
• 6. Countries that are endowed with minerals may
  have a proclivity for armed conflict, which is
  inimical to economic growth.
• 7. Swings in commodity prices can engender
  macroeconomic instability (Dutch Disease),
• via the real exchange rate
• and government spending.

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(7) The Dutch Disease and Procyclicality

• Developing countries have historically been
  prone to procyclicality
• Especially procyclical government spending
• Procyclical means destabilizing.
• This is particularly true of commodity
  producers.
• The Dutch Disease describes unwanted side-effects
  from a strong, but perhaps temporary, upward
  swing in the world price of the export commodity.

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Procyclicality

• Volatility in developing countries
• arises both from foreign shocks,
• including export commodity price fluctuations,
• and from domestic shocks
• including macroeconomic political instability.

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Procyclicality

• Volatility in developing countries
• Most developing countries in the 1990s brought
  under control the chronic runaway budget
  deficits, money creation, inflation, that they
  experienced,
• but many still showed monetary fiscal policy
  that was procyclical rather than
  countercyclical
• They tend to be expansionary in booms
• and contractionary in recessions,
• thereby exacerbating the magnitudes of the
  swings.
• The aim should be to moderate swings
• -- the countercyclical pattern that economists,
  after the Great Depression, originally hoped
  discretionary policy would take.

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Procyclicality in developing countries

• The procyclicality of fiscal policy
• Many authors have shown that fiscal policy has
  tended to be procyclical in developing countries,
  
• especially in comparison with industrialized
  countries. 1
• A major reason for procyclical public spending
  receipts from taxes or royalties rise in booms.
  The government cannot resist the temptation or
  political pressure to increase spending
  proportionately, or more.
• 1 Cuddington (1989), Tornell Lane (1999),
  Kaminsky, Reinhart, Vegh (2004), Talvi Végh
  (2005), Alesina, Campante Tabellini (2008),
  Mendoza Oviedo (2006), Ilzetski Vegh (2008),
  Medas Zakharova (2009) and Gavin Perotti
  (1997).

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Procyclicality in developing countries

• The procyclicality of fiscal policy, continued
• Procyclicality is especially pronounced in
  countries with natural resources and where
  income from those resources tends to dominate the
  business cycle.
• Cuddington (1989) and Sinnott (2009)
• An important recent development some developing
  countries, including commodity producers, have
  been able to break the historic pattern in the
  most recent cycle
• Taking advantage of the boom of 2002-2008
• to run budget surpluses build reserves,
• thereby earning the ability to expand fiscally in
  the 2008-09 crisis.
• Chile is the outstanding model.

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(i) Public investment projects

• Two large budget items that account for much of
  the increased spending from oil booms
• (i) investment projects and
• (ii) the government wage bill.
• Regarding the 1st budget item, investment in
  infrastructure can have large long-term pay-off
  if it is well designed too often in practice,
  however, it takes the form of white elephant
  projects, which are stranded without funds for
  completion or maintenance, when the oil price
  goes back down.
• Gelb (1986) .

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(ii) Public sector wage bills

• Regarding the 2nd budget item, oil windfalls
  have often been spent on higher public sector
  wages -- Medas Zakharova (2009) .
• They can also go to increasing the number of
  workers employed by the government.
• Either way, they raise the total public sector
  wage bill, which is hard to reverse when oil
  prices go back down.
• Figures 2 3 plot the public sector wage bill,
  for two oil producers, Iran Indonesia.
• against primary product prices over the preceding
  3 years.

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Irans Government Wage Bill Is Influenced by Oil
Prices Over Preceding 3 Years (1974,
1977-1997.)
Source Frankel (2005b)
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Indonesias Government Wage Bill Is Influenced
by Oil Prices Over Preceding 3 Years (1974,
1977-1997.)
Source Frankel (2005b)
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Public sector wage bills, continued

• There is a clear positive relationship.
• That the relationship is strong with a 3-year lag
  shows the problem oil prices may have fallen
  over 3 years, but public sector wages cannot
  easily be cut nor workers laid off.
• Arezki Ismail (2010) find that current
  government spending increases in boom times, but
  is downward-sticky.

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The Dutch Disease 5 side-effects of a commodity
boom

• 1) A real appreciation in the currency
• 2) A rise in government spending
• 3) A rise in nontraded goods prices
• 4) A resultant shift of resources out of
  non-export-commodity traded goods
• 5) A current account deficit

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The Dutch Disease The 5 effects elaborated

• 1) A real appreciation in the currency
• taking the form of nominal currency appreciation
  if the exchange rate floats
• e.g., floating-rate oil exporters
• Kazakhstan, Mexico, Norway, Russia.
• or the form of money inflows inflation if the
  exchange rate is fixed 1
• e.g. fixed-rate oil-exporters, the UAE Saudi
  Arabia.
• 2) A rise in government spending
• in response to increased availability of tax
  receipts or royalties.

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The Dutch Disease 5 side-effects of a commodity
boom

• 3) An increase in nontraded goods prices (goods
  services such as housing that are not
  internationally traded),
• relative to traded goods (manufactures
  other internationally traded goods other than
  the export commodity).
• 4) A resultant shift of resources out of
  non-export-commodity traded goods
• pulled by the more attractive returns in the
  export commodity and in non-traded goods.

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The Dutch Disease 5 side-effects of a commodity
boom

• 5) A current account deficit
• thereby incurring international debt that may be
  difficult to service when the boom ends 2.
• Most developing countries avoided it in 2003-10.
  
• 2 Manzano Rigobon (2008) the negative
  Sachs-Warner effect of resource dependence on
  growth rates during 1970-1990 was mediated
  through international debt incurred when
  commodity prices were high.
• Arezki Brückner (2010a) commodity price booms
  lead to increased government spending, external
  debt default risk in autocracies.
• Arezki Brückner (2010b) the dichotomy extends
  also to effects on sovereign spreads paid by
  autocratic vs democratic commodity producers.

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Summary Channels of the NRC

• (1) Commodity price volatility is high, imposing
  risk costs.
• (2) Specialization can crowd out the
  manufacturing sector.
• (3) Depletion can be unsustainably rapid,
• especially if property rights are not adequately
  protected.
• (4) Mineral riches can lead to civil war.
• (5) Mineral endowments can lead to poor
  institutions, such as corruption, inequality,
  class structure, chronic power struggles, and
  absence of rule of law and property rights.
• (6) The Dutch Disease. A commodity boom
  gt real currency appreciation and increased
  government spending, gt which expand nontraded
  sector and render uncompetitive non-commodity
  export sectors such as manufactures.

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The Natural Resource Curse should not be
interpreted as a rule that resource-rich
countries are doomed to failure.

• The question is what policies to adopt to
  improve the chances of prosperity.
• Destruction or renunciation of resource
  endowments, to avoid dangers such as the
  corruption of leaders, will not be one of these
  policies.
• The survey concludes with ideas for
  policies/institutions designed to address
  aspects of the resource curse and thereby
  increase the chance of economic success.

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Appendices 1) The possible NRC channels in
detail2) Procyclical capital flows3 cycles of
flows to developing countries3) Skeptics of the
NRC
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Appendix 1 The possible NRC channels in detail

• (1) The claim of a negative trend in commodity
  prices on world markets was already dealt with
  the data do not suggest a robust long-term
  trend, certainly not a negative one if updated to
  2010.

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(1) Long-term world price trend

• (i) Determination of the price on world markets
• (ii) The old structuralist school
  (Prebisch-Singer)
• The hypothesis of a declining commodity price
  trend
• (iii) Hypotheses of a rising price trend
• Hotelling
• Malthus
• (iv) Empirical evidence
• Statistical time series studies

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(i) The determination of the export price on
world markets

• Developing countries tend to be smaller
  economically than major industrialized countries,
  and more likely to specialize in the exports of
  basic commodities.
• As a result, they are more likely to fit the
  small open economy model
• they can be regarded as price-takers,
• That is, the prices of their export goods are
  generally taken as given on world markets.

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(ii) The old structuralist school Raul
Prebisch (1950) Hans Singer (1950)

• The hypothesis a declining long run trend in
  prices of mineral agricultural products
• relative to the prices of manufactured goods.
• The theoretical reasoning world demand for
  primary products is inelastic with respect to
  world income.
• That is, for every 1 increase in income, raw
  materials demand rises by less than 1.
• Engels Law, an (older) proposition households
  spend a lower fraction of their income on basic
  necessities as they get richer.
• Demand gt P oil

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(iii) Hypotheses of rising trendsHotelling
on depletable resourcesMalthus on geometric
population growth.

• Persuasive theoretical arguments that we should
  expect oil prices to showan upward trend in the
  long run.

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Assumptions for Hotelling model

• (1) Non-perishable non-renewable resources
• Deposits in the earths crust are fixed in total
  supply and are gradually being depleted.
• (2) Secure property rights
• Whoever currently has claim to the resource can
  be confident that it will retain possession,
• unless it sells to someone else,
• who then has equally safe property rights.
• This assumption excludes cases where warlords
  compete over physical possession of the
  resource.
• It also excludes cases where private mining
  companies fear that their contracts might be
  abrogated or their holdings nationalized.

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One more assumption, to keep the Hotelling model
simple

• (3) The fixed deposits are easily accessible
• the costs of exploration extraction are small
  compared to the value of the mineral.
• Hotelling (1931) deduced from these assumptions
  the theoretical principle
• the price of oil in the long run should rise at
  a rate equal to the interest rate.

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The Hotelling logic

• The owner chooses how much mineral to extract
• and how much to leave in the ground.
• Whatever is mined can be sold at todays price
  (price-taker assumption)
• and the proceeds invested in bank deposits
• or US Treasury bills, which earn the current
  interest rate.
• If the value of the commodity in the ground is
  not expected to rise in the future, then the
  owner has an incentive to extract more of it
  today, so that he earns interest on the
  proceeds.

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The Hotelling logic, continued

• As minng companies worldwide react in this way,
  they drive down the price today,
• below its perceived long-run level.
• When the current price is below its long-run
  level, companies will expect the price to rise in
  the future.
• Only when the expectation of future appreciation
  is sufficient to offset the interest rate will
  the commodity market be in equilibrium.
• Only then will mining companies be close to
  indifferent between extracting at a faster rate
  and a slower rate.

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The complication supply is not fixed.

• True, at any point in time there is a certain
  stock of reserves that have been discovered.
• But the historical pattern has long been that,
  as that stock is depleted, new reserves are
  found.
• When the price goes up, it makes exploration
  development profitable for deposits farther
  under the surface.
• especially as new technologies are developed
  for exploration extraction.

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What is the overall statistical trend in
commodity prices in the long run?

• Some authors find a slight upward trend,
• some a slight downward trend. 1
• The answer seems to depend, more than anything
  else, on the date of the end of the sample
• Studies written after the 1970s boom found an
  upward trend,
• but those written after the 1980s found a
  downward trend,
• even when both went back to the early 20th
  century.
• 1 Cuddington (1992), Cuddington, Ludema
  Jayasuriya (2007), Cuddington Urzua (1989),
  Grilli Yang (1988), Pindyck (1999), Hadass
  Williamson (2003), Reinhart Wickham (1994),
  Kellard Wohar (2005), Balagtas Holt (2009)
  and Harvey, Kellard, Madsen Wohar (2010).

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(2) Effects of Volatility

• Is volatility per se bad for economic growth?
• Cyclical shifts of resources back forth across
  sectors may incur needless transaction costs.
• A diversified country may indeed be betterthan
  one 100 specialized in minerals.
• On the other hand, the private sector dislikes
  risk as much as the government does, and will
  take steps to mitigate it
• thus one must think where the market failure
  lies before assuming that a policy of deliberate
  diversification is necessarily justified.

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Effects of volatility, continued

• Policy-makers may not be better than individual
  private agents at discerning whether a commodity
  boom is temporary or not.
• But the government cannot ignore the issue of
  volatility
• When it comes to exchange rate or fiscal policy,
  governments must necessarily make judgments
  about the likely permanence of shocks.
• More on medium-term cycles when we get to the
  Dutch Disease

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(3) Do natural resources crowd out
manufacturing?

• Matsuyama (1992) provided an influential model
  
• the manufacturing sector is assumed to be
  characterized by learning by doing, while the
  primary sector (agriculture, in his paper) is
  not.
• Also van Wijnbergen (1984) and Gylfason,
  Herbertsson Zoega (1999).
• The implication
• deliberate policy-induced diversification out of
  primary products into manufacturing is
  justified, and
• a permanent commodity boom that crowds out
  manufacturing can indeed be harmful.

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Counterarguments

• There is no reason why learning by doing should
  occur only in manufacturing tradables.
• Nontradable sectors can enjoy learning by doing.
  1
• E.g., construction
• The mineral sector can as well.
• The USA is one example of a country that has
  enjoyed big productivity growth in commodity
  sectors.
• Productivity gains have been aided by American
  public investment,
• since the late 19th century, in such knowledge
  infrastructure institutions as the U.S.
  Geological Survey, School of Mines, and
  Land-Grant Colleges. 2
• 1 Torvik (2001) and Matsen Torvik (2005).
• 2 Wright Czelusta (2003, p.6, 25 18-21).

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Counterarguments, continued

• Public investment in knowledge infrastructure ?
  government subsidy or ownership of the resources
  themselves.
• In Latin America, e.g., public monopoly ownership
  and prohibition on importing foreign expertise or
  capital has often stunted development of the
  mineral sector, whereas privatization has set it
  free.
• Attempts by governments to force linkages between
  the mineral sector and processing industries have
  often failed.

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(4) Institutions

• Recent thinking in economic development
• The quality of institutions is the deep
  fundamental factor that determines which
  countries experience good performance. 1
• It is futile (e.g., for the IMF World Bank) to
  recommend good macroeconomic or microeconomic
  policies if the institutional structure is not
  there to support them.
• 1 Barro (1991) and North (1994).

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What are weak institutions?

• A typical list
• inequality,
• corruption,
• insecure property rights,
• intermittent dictatorship,
• ineffective judiciary branch, and
• lack of any constraints to prevent elites
  politicians from plundering the country.
• Quality of institutions has been quantified by
  World Bank, Freedom House, Transparency
  International, and others.
• Rodrik, Subramanian Trebbi (2003) use a rule of
  law indicator and protection of property rights
  (taken from Kaufmann, Kraay Zoido-Lobaton,
  2002).
• Acemoglu, Johnson, Robinson (2001) use a
  measure of expropriation risk to investors.
• Acemoglu, Johnson, Robinson, Thaicharoen (2003)
  use the extent of constraints on the executive.

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Institutions can be endogenous

• the result of economic growth rather than the
  cause.
• The same problem is encountered with other
  proposed fundamental determinants of growth,
  e.g., openness to trade and freedom from
  tropical diseases.
• Many institutions tend to evolve endogenously,
  in response to the level of income,
• such as the structure of financial markets,
• mechanisms of income redistribution social
  safety nets, tax systems, and intellectual
  property rules

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Addressing endogeneity of institutions
statistically

• Econometricians address the problem of
  endogeneity by means of the technique of
  instrumental variables.
• What is a good instrumental variable for
  institutions, an exogenous determinant?
• Acemoglu, Johnson Robinson (2001) introduced
  the mortality rates of colonial settlers.
• The theory is that, out of all the lands that
  Europeans colonized, only those where Europeans
  actually settled were given good European
  institutions.
• Acemoglu et al figured that initial settler
  mortality determined whether Europeans settled
  in large numbers.1
• 1 Glaeser, et al, (2004) argue against the
  settler variable. Hall Jones (1999) consider
  latitude and the speaking of English or other
  European languages as proxies for European
  institutions.

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Institutions Econometric findings

• The finding is the same, regardless of IV
• Institutions trump everything else Rodrik et
  al (2002)
• Acemoglu et al (2002)
• Easterly Levine (2002)
• Hall Jones (1999)
• Geography and history matter mainly as
  determinants of institutions
• which is not to say that institutions dont also
  have other important determinants.
• In any case, institutions are important.

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The rent cycling theory as enunciated by Auty
(1990, 2001, 07, 09)

• Economic growth requires recycling rents via
  markets rather than via patronage.
• In oil countries the rents elicit a political
  contest to capture ownership,
• whereas in low-rent countries the government must
  motivate people to create wealth,
• e.g., by pursuing comparative advantage,
  promoting equality, fostering civil society.
  

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A related view by economic historians Engerman
Sokoloff (1997, 2000, 2002)

• Why did industrialization take place in North
  America,
• not Latin America?
• Lands endowed with extractive industries
  plantation crops developed slavery, inequality,
  dictatorship, and state control,
• whereas those climates suited to fishing small
  farms developed institutions of individualism,
  democracy, egalitarianism, and capitalism.
• When the Industrial Revolution came, the latter
  areas were well-suited to make the most of it.
• Those that had specialized in extractive
  industries were not,
• because society had come to depend on class
  structure authoritarianism, rather than on
  individual incentive and decentralized
  decision-making.

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Econometric findings that point-source
resources such as oil and minerals lead to
poor institutions
The theory is thought to fit Middle Eastern oil
exporters well. E.g., Iran. Mahdavi
(1970), Skocpol (1982, p. 269), and Smith (2007).

• Isham, Woolcock, Pritchett, Busby (2005)
• Sala-I-Martin Subramanian (2003)
• Bulte, Damania Deacon (2005)
• Mehlum, Moene Torvik (2006)
• Arezki Brückner (2009).

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Which comes first,minerals or institutions?

• Some question the assumption that mineral
  discoveries are exogenous and institutions
  endogenous.
• Mineral wealth is not necessarily the cause and
  institutions the effect, rather than the other
  way around.
• Norman (2009) the discovery development of
  oil is not purely exogenous, but rather is
  endogenous with respect to the efficiency of the
  economy.

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The important determinant is whether the country
already has good institutions at the time that
minerals are discovered, in which case it is
put to use for the national welfare, instead of
the welfare of an elite, on average.

• Mehlum, Moene Torvik (2006),
• Robinson, Torvik Verdier (2006),
• McSherry (2006),
• Smith (2007) and
• Collier Goderis (2007).
• Luong Weinthal (2010), in a study of the 5
  oil-producing former Soviet republicsthe choice
  of ownership structure makes the difference as
  to whether oil turns out a blessing rather than a
  curse.

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The combination ofdevelopment 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.

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(5) Unsustainably rapid depletion

• What happens when a depletable natural resource
  is indeed depleted?
• This question is important for 3 reasons
• Protection of environmental quality.
• A motivation for the strategy of economic
  diversification.
• A motivation for the Hartwick rule
• All rents from exhaustible natural resources
  should be invested in other assets, so that
  future generations do not suffer a diminution in
  total wealth (natural resource plus reproducible
  capital) and therefore in the flow of
  consumption.
• Hartwick (1977) and Solow (1986).

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Rapid depletion, continued

• Each of these problems would be much less severe
  if full assignment of property rights were
  possible,
• thereby giving the owners adequate incentive to
  conserve the resource in question.
• But often this is not possible,
• either physically
• or politically.
• Especially in a frontier situation.
• The difficulty in enforcing property rights over
  some non-renewable resources constitutes a
  category of natural resource curse of its own.

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Unenforceable property rights over
depletable resources

• Some natural resources do not lend themselves to
  property rights, whether the government wants to
  apply them or not.
• Very different from the theory that the physical
  possession of point-source mineral wealth
  undermines the motivation for the government to
  establish a regime of property rights for the
  rest of the economy.
• Overfishing, overgrazing, over-use of water are
  classic examples of the tragedy of the commons
  that applies to open access resources.
• Individual fisherman or farmers have no incentive
  to restrain themselves, while the fisheries or
  pastureland or water aquifers are collectively
  depleted.

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Unenforceable property rights, continued

• The difficulty in imposing property rights is
  particularly severe when the resource is
• dispersed over a wide
• area, as timberland.
• But even the classic point-source resource, oil,
  can suffer the problem, especially when wells
  drilled from different plots of land hit the
  same underground deposit.

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Unenforceable property rights, continued

• This market failure can invalidate some standard
  neoclassical economic theorems in the case of
  open access resources.
• The resource will be depleted more rapidly than
  the optimization of the Hotelling calculation
  calls for. 1
• The benefits of free trade may be another
  casualty
• If exports exacerbate the excess rate of
  exploitation,
• the country might be better worse off.
  21 E.g., Dasgupta Heal (1985). 2
  Brander Taylor (1997).

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(6) War

• Where a valuable resource such as oil or diamonds
  is there for the taking, factions will likely
  fight over it.
• Oil minerals are correlated with civil war.
• Collier Hoeffler (2004), Collier (2007),
  Fearon Laitin (2003) and Humphreys (2005).
• Chronic conflict in such oil-rich countries as
  Angola Sudan comes to mind.
• Civil war is, in turn, very bad for economic
  development.

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Procyclicality in developing countries

• Appendix 2 Procyclical capital flows
• According to theory (intertemporal
  optimization), countries should borrow during
  temporary downturns,
• to sustain consumption investment, and should
  repay or accumulate net foreign assets during
  temporary upturns.
• In practice, it does not always work this way.
  Capital flows are more procyclical than
  countercyclical. 1
• Theories to explain this involve capital market
  imperfections,
• e.g., asymmetric information or the need for
  collateral.
• 1 Kaminsky, Reinhart, Vegh (2005) Reinhart
  Reinhart (2009) Gavin, Hausmann, Perotti Talvi
  (1996) and Mendoza Terrones (2008).

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Procyclicality in developing countries

• Procyclical capital flows, continued
• As countries evolve more market-oriented
  financial systems, the capital inflows during the
  boom phase show up in prices for land
  buildings, and also in prices of financial
  assets.
• Prices of equities bonds are summary measures
  of the extent of speculative enthusiasm,
• often useful for predicting which countries are
  vulnerable to crises in the future.

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Appendix 2 Procyclical capital flows 3 cycles
in capital flows to emerging markets

• 1st developing country lending boom (recycling
  petro dollars) 1975-1981
• Ended in international debt crisis 1982
• 7 Lean years (Lost Decade) 1982-1989
• 2nd lending boom (emerging markets) 1990-96
• Ended in East Asia crisis 1997
• 7 Lean years 1997-2003
• 3rd boom (incl. China India this time)
  2003-2008
• 4th boom? 2010-

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This time, many countries used the inflowsto
build up forex reserves, rather thanto finance
Current Account deficits
2003-07boom
1991-97 boom
67
Procyclicality in developing countries

• Procyclical capital flows, continued
• In the commodity emerging market booms of
  2003-11, net capital flows have typically gone
  to countries with current account surpluses,
  especially Asians and commodity producers in the
  Middle East Latin America,
• where they showed up in record accumulation of
  foreign exchange reserves.
• This is in contrast to the two previous cycles,
  1975-1981 and 1990-97, when the capital flows to
  developing countries largely went to finance
  current account deficits.

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68
Procyclicality in developing countries

• One interpretation of procyclical capital flows
  is that they result from procyclical fiscal
  policy
• when governments increase spending in booms, the
  deficit is financed by borrowing from abroad.
• When they are forced to cut spending in
  downturns, it is to repay the excessive debt
  incurred during the upturn.
• Another interpretation of procyclical capital
  flows to developing countries is that they
  pertain especially to mineral exporters.
• We consider procyclical fiscal policy, return to
  the mineral commodity cycle (Dutch disease) in
  their own sub-sections.

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69
What characteristics have helped emerging markets
resist financial contagion?

• High FX reserves and/or floating currency
• Low foreign-denominated debt (currency mismatch)
• Low short-term debt (maturity mis-match)
• High Foreign Direct Investment
• Strong initial budget, allowing room to ease.
• High export/GDP ratio,
• Sachs (1985) Eaton Gersovitz (1981), Rose
  (2002) Calvo, Izquierdo Talvi (2003) Edwards
  (2004) Cavallo Frankel ( 2008).
• In the 2008-09 crisis, many of the historical
  Early Warning Indicators worked, especially
  reserves
• Frankel Saravelos (2010)

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Appendix 3 Skeptics argue that commodity exports
are endogenous. 1

• On the one hand, basic trade theory saysA
  country may show a high mineral share in exports,
  not necessarily because it has a higher
  endowment of minerals than others (absolute
  advantage) but because it does not have the
  ability to export manufactures (comparative
  advantage).
• This could explain negative statistical
  correlations between mineral exports and economic
  development,
• invalidating the common inference that minerals
  are bad for growth.
• 1 Maloney (2002) and Wright Czelusta (2003,
  04, 06).

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Commodity exports are endogenous, continued.

• On the other hand, skeptics also have plenty of
  examples where successful institutions and
  industrialization went hand in hand with rapid
  development of mineral resources.
• Countries that were able to develop efficiently
  their resource endowments as part of strong
  economy-wide growth include
• the USA during its pre-war industrialization
  period 1,
• Venezuela from the 1920s to the 1970s, Australia
  since the 1960s, Norway since 1969 oil
  discoveries, Chile since adoption of a new mining
  code in 1983, Peru since a privatization program
  in 1992, and Brazil since the lifting of
  restrictions on foreign mining participation in
  1995. 2
• 1 David Wright (1997).
• 2 Wright Czelusta (2003, pp. 4-7, 12-13,
  18-22).

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Commodity exports are endogenous, continued.

• Examples of countries that were equally
  well-endowed geologically but that failed to
  develop their natural resources efficiently
  include
• Chile and Australia before World War I,
• and Venezuela since the 1980s.3
• 3 Hausmann (2003, p.246) Venezuelas growth
  collapse took place after 60 years of expansion,
  fueled by oil. If oil explains slow growth, what
  explains the previous fast growth?