The boom and beyond: Managing commodity price cycles Global Economic Outlook, Q1 2014
The end of the commodity price boom is leaving many countries scrambling for ways to diversify their economies accordingly.
Commodity-exporting economies hit the mother lode in recent years when commodity prices boomed in 2006–2008 and then again in 2010–2011. The brisk pace of global economic activity and rising demand from emerging markets drove up commodity consumption and prices. And the boom, in turn, boosted growth and fiscal balances for resource-rich countries.
Overcoming these challenges of commodity dependence will require a targeted pursuit of economic diversification.
However, commodity prices are cooling once again due to a slowing of the global economy, changes in China’s growth model, and other macroeconomic factors. As the good times recede, the pitfalls of an overdependence on commodities are being revealed. Resource-centric economies are finding their economic growth and fiscal health vulnerable to the vagaries of global markets. They are also discovering that a neglect of other sectors has resulted in higher risks and fewer employment opportunities.
Overcoming these challenges of commodity dependence will require a targeted pursuit of economic diversification. Economies can start by focusing on adding value to their resources instead of taking the easy path of exporting raw materials. In addition, they will need to invest in developing a pool of high- and semi-skilled talent that can support diverse industries. Also required will be constitutional mechanisms limiting fiscal reliance on revenues from commodity exports.
Buildup to the boom: Commodity price surge
A key economic characteristic of the new millennium has been the steady rise in commodity prices, especially over the period 2000–2008 (see figure 1). This was the result of a number of factors, including a prolonged period of strong global growth, restricted supplies, and, importantly, a sharp rise in demand from emerging markets. Robust growth in emerging markets has been a prominent driver of resource prices (see figure 2), boosting emerging markets’ share of global commodity consumption. For example, China and India accounted for 2 percent of global fuel and mining imports in 1990; by 2008, their share had gone up to 12 percent, and it climbed further to 18 percent in 2012 (see figure 3). The increasing prominence of commodities as an investment alternative is also influencing commodity prices. However, this phenomenon has also contributed to greater price volatility, particularly for crude oil, whose price fluctuates markedly as a result of politico-economic events.
Among the various commodities, hydrocarbons have undoubtedly been the center of most price-related discussions, with crude oil prices increasing by 244 percent during 2000–2008; this contrasts with price declines of 52 percent in 1980–1989 and 22 percent in 1990–1999. However, other resources have not been far behind (see figure 4). For example, the price of iron ore nearly quadrupled during 2000–2008, while that of copper almost tripled. Both of these metals had fared poorly in the previous decade, with iron ore prices falling by 15 percent and copper prices by 41 percent during 1990–1999.
Meanwhile, food prices also gained steadily from 2000 onward and spiked during 2006–2008, leading to a sharp rise in inflation across the world that resulted in social unrest in a number of developing economies.
Riding the wave: Benefiting from the commodity boom
Resource-rich economies saw the commodity boom of 2000–2008 drive up economic growth (see figure 5) and push external balances into strong surpluses. For example, real GDP growth in oil-rich Saudi Arabia shot up to an annual average of 5.1 percent in 2000–2008, compared to 3.5 percent in 1990–1999. Other notable beneficiaries of the commodity boom were Chile (copper), Australia (iron ore and coal), and Brazil (iron ore, agricultural products, and oil). In fact, Australia, buoyed by China’s continued appetite for its resources, was the only developed economy that avoided a recession during the global economic downturn of 2008–2009. Africa has been another beneficiary of the commodity boom, given the continent’s large mineral reserves.
The commodity boom also bolstered public finances (see figure 6) and encouraged expenditures essential for sustainable economic growth and development (see figure 7).
For instance, in Africa and the Middle East, particularly in the Gulf Cooperation Council (GCC) countries, infrastructure investments and social welfare spending increased. GCC members also started sovereign wealth funds (SWFs) with oil money. They began focusing on diversifying their economies by scaling up the value chain in manufacturing and services as well as by enhancing education, critical for long-term growth and job creation.
On the downswing: Strained commodity prices
Commodity prices slumped in 2009 due to the global economic downturn, and although worldwide stimulus efforts revived prices in 2010–2011, they seem to have stalled yet again, starting in 2012. For example, crude oil prices declined 1.4 percent between January 2012 and October 2013, while metal prices dipped 11.4 percent in the same period (see figure 8).
No doubt, stalling global growth is an important reason for the current period of commodity weakness, with slowing growth in emerging economies of greater concern for commodity exporters. GDP growth for China, a major commodity importer, dipped to 7.8 percent year over year in Q3 2013 from 12.1 percent in Q1 2010 (see figure 9). The decline in growth for India, another large commodity consumer, has been sharper. More worrisome is that China’s growth is unlikely to return to the double-digit levels of 1990–2008 in the medium term, as its policymakers are focusing more on equality.
According to the International Monetary Fund (IMF), real GDP growth in China is set to remain below 8 percent through 2013–2018. Furthermore, any shift in China’s growth model will also alter the country’s commodity consumption mix, affecting global prices. For instance, demand for construction-related commodities could ease as the country moves away from its investment-oriented economic model. Slowing growth in other large commodity importers—the United States and the European Union—has also adversely affected commodity prices.
The current strain on global commodity markets is also due in part to two significant trends: reviving investor risk appetite and a possible winding down of the US Federal Reserve’s (Fed’s) quantitative easing (QE) program. The former has been responsible for rising interest in equities with commodities, with gold especially losing out (see figure 10); gold prices have declined 34.6 percent since their peak in September 2011. Meanwhile, any move by the Fed to trim down QE is likely to impact liquidity, which is a prime driver of speculation in commodity markets. Moreover, as cheap money returns to the United States, the dollar could become stronger, thereby becoming an added drag on commodity prices.
There have been significant changes in the supply situation as well. For example, shale discoveries could help the United States, the world’s foremost importer of petroleum, achieve a high degree of energy self-sufficiency. Rising investments in mining across Africa and Asia are also likely to assist supply in the short to medium term. No wonder, then, that the IMF expects its overall commodity index to decline 12.6 percent over 2013–2018. While metal prices are set to remain nearly flat, double-digit declines are expected in agricultural and energy commodities. The latter is likely to benefit from reduced political risk as well, especially if current strains in the Middle East ease.
Pitfalls: Hazards of commodity-centric growth
Resource-dependent economies are often particularly vulnerable to global economic conditions, as their exports, and therefore their growth, are tied to the volatility of global commodity markets. Easing commodity prices since 2012 have dented growth in several key commodity producers, such as Chile and Russia. While Chile’s economic fortunes are closely tied to international copper prices (see figure 11), Russia’s economic performance follows oil prices. With the price of both products easing, economic growth has slowed in both countries. In Chile, GDP growth declined to 4.1 percent year over year in Q2 2013 from 9.8 percent in Q1 2011; over the same period, Russian growth declined to 1.2 percent from 3.8 percent.
The recent commodity boom also made some countries complacent in their efforts to undertake reforms and bolster public finances. For instance, in Russia, as more oil money flowed in—making up more than 50 percent of government revenue—state spending shot up. The country’s non-oil budget deficit continued to widen: It is set to rise to an estimated 10.3 percent of GDP in 2013 from 3.6 percent in 2007. Closing this gaping non-oil budget deficit by cutting costs and diversifying the economy is only now gaining attention as global oil prices subside and oil production becomes more challenging. GCC economies, meanwhile, have also failed to diversify government revenues, levying negligible taxes and relying heavily on oil sales for public finances.
Furthermore, as commodities become a larger contributor to GDP, some economies appear to have allowed other sectors to take a backseat. This is not only risky for growth, but can also limit job opportunities for people of different abilities and aspirations. For instance, in Australia, even as mining activity has grown, manufacturing has declined due to high labor and energy costs, as well as Australian manufacturers’ relatively low economies of scale compared to US or German manufacturers (see figure 12). Australia ranks the third-highest globally in hourly direct pay in manufacturing, while electricity costs for manufacturers have increased by 67.5 percent since 2008.
In addition, extraction industries in a number of commodity-rich countries are controlled by state-owned monopolies. As a result, such economies often face market inefficiencies and below-par utilization of resources. In Venezuela, for example, the oil sector is hobbled by political demands. The state-owned oil company Petroleos de Venezuela is often called upon to fund social programs and fuel subsidies, leaving the company with little to invest in oil exploration and production. As a result, Venezuela’s total oil output has declined to 2.5 million barrels per day in 2012 from its peak of approximately 3.5 million barrels per day in 1997. Meanwhile, Brazilian state-owned oil company Petrobras has only recently started to undo years of inefficiency by focusing on cutting costs and improving returns from investments.
Economic diversification is tough to attain, but it is the only real safeguard for commodity producers against the vagaries of the commodities market. As the intention to reduce commodity dependence is often left by the wayside at the next boom, constitutional mechanisms may have to be introduced to curb the tendency to rely solely on commodities. Curbs may also need to be placed on the quantity of and purpose for which surpluses arising from commodity exports may be used. For example, Norway directs most of its oil revenue into a fund and allows only 4 percent of the fund to be tapped for public spending.
Countries that formulate their budgets around commodity trade should also ensure that they are incorporating rational price assumptions. For example, while Oman’s budget for 2014 assumes oil prices of $85 per barrel, Russia’s budget assumes prices of $101 per barrel. Using long-term commodity prices rather than spot prices in budget planning is perhaps a wise move; this approach is already being adopted in Chile, which draws substantial state revenue from copper.
A first step toward economic diversification could be to shift from exporting mere raw commodities to more value-added products. The technical know-how required for adding value to raw commodities may call for private-sector participation or even international collaboration. For instance, Ethiopia is collaborating with various entities in India and China to establish leather products industries rather than exporting only semi-processed hides and leathers. Uganda, which discovered oil in 2006, is working to establish the country’s first refinery, which will not only add value in its oil sector but also create jobs and strengthen the country’s infrastructure.
Focusing on research and education will also be important for commodity-rich countries seeking to diversify into manufacturing and services. These efforts are critical to developing a pool of high- and semi-skilled workers who can operate in high-value-added sectors, which in turn can boost overall job opportunities. In this context, Saudi Arabia’s efforts to develop a manufacturing and knowledge economy by 2025 (see figure 13) are laudable. Meanwhile, countries seeking to move away from resource-centric economic models will need to prevent labor market distortions that generally occur during commodity booms. This will help ensure that talent is not diverted into relatively low-skilled but temporarily high-paying positions in the extraction industry.