COMMODITY PRICE VOLATILITY: THE DAMAGE TO ECONOMIC GROWTH
Rapid increases in the price of commodities such as oil can improve economic growth within exporting countries, but this positive impact is often outweighed by the volatility of these prices, which has a negative effect on growth. That is the main finding of research by Kamiar Mohaddes and colleagues, presented at the Royal Economic Society’s 2011 annual conference.
Looking at data on more than 100 countries over the past 40 years, the study finds that the volatility of commodity prices means that the benefits of rising prices are rarely invested in physical capital, such as machinery and infrastructure, or human capital, such as education or training. The result is that economic growth is actually lower when countries gain access to natural resources, particularly those that specialise in the export of just a few primary products.
The negative relationship between natural resources and economic growth has long been observed. But this study offers a different insight to those who label this relationship the ‘resource curse’. Instead of the presence of resources themselves lowering growth, it is the economic volatility they produce that lowers investment, which eventually lowers growth.
The authors conclude that breaking this cycle requires improvements in economic policy, better management of resource income volatility through sovereign wealth funds, a suitable exchange rate regime and diversifying the country’s exports.
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This paper constructs a panel of 118 countries over the period 1970-2007 and examines empirically the effects of commodity price booms and terms of trade volatility on GDP per capita growth and its sources: total factor productivity, physical capital accumulation and human capital acquisition.
The researchers find that while commodity terms of trade (CTOT) growth enhances real output per capita, CTOT volatility has a negative impact on economic growth operating through lower accumulation of physical and human capital.
The ‘resource curse’ hypothesis predicts a negative effect of commodity booms on long-run growth, whereas these empirical findings show quite the contrary: higher levels of CTOT significantly raise growth. They challenge the common view about the resource curse and show that it is CTOT volatility, rather than abundance per se, which drives the under-performance of primary product exporting countries. The results also confirm that the negative growth effects of CTOT volatility offset the positive impact of price booms.
This volatility channel of impact has been overlooked in previous research despite the fact that countries that specialise in the export of just a few primary products and/or depend heavily on natural resource endowments, are usually exposed to substantial commodity price uncertainty and suffer from a high degree of macroeconomic instability.
Another notable aspect of the results is to show the asymmetric effects of CTOT volatility on GDP per capita growth in the two country groups considered: 62 primary commodity exporters; and 56 countries that have a more diversified export basket.
The researchers show that CTOT instability creates a significant negative effect on output growth in the first group but not in the second group or even in the full sample of 118 countries. They attribute this asymmetric pattern to the diversified export nature of the latter group.
Countries with a diversified basket of exports, especially manufacturing or service sector goods, can be expected to grow faster and be better insured against price fluctuations in individual commodities. This analysis is confirmed by the empirical results, suggesting that the export diversification of primary commodity exporting countries contributes to faster growth.
Furthermore, having identified a negative impact of CTOT volatility on GDP per capita growth in natural resource abundant countries, the study investigates the channels through which this effect operates, notably physical and human capital accumulation, and total factor productivity.
It finds that CTOT volatility is associated with lower accumulation of both human and physical capital and hence through that with lower growth. But there is not a significant negative association between volatility and total factor productivity growth, which is in contrast to the argument that commodity and natural resource abundant countries have fewer possibilities for technological progress.
This finding is important as the behaviour of an economy experiencing a boom differs significantly from the standard Dutch disease model in the presence of a sufficiently dynamic and knowledge-intensive natural resource sector. The empirical results presented here have strong policy implications.
Improvements in the conduct of macroeconomic policy, better management of resource income volatility through sovereign wealth funds as well as stabilisation funds, a suitable exchange rate regime and export diversification can all have beneficial growth effects.
Moreover, other recent research has emphasised institutional reform. By setting up the right institutions, one can ensure the proper conduct of macroeconomic policy and better use of resource income revenues, thereby increasing the potential for growth.
The results also indicate that resource rich countries could benefit more from their natural wealth by adopting growth and welfare enhancing policies, such as enabling and maintaining sustained high levels of investment in both human and physical capital.
ENDS
‘Commodity Price Volatility and the Sources of Growth’ by Tiago Cavalcanti, Kamiar Mohaddes and Mehdi Raissi